India

Highlights Social unrest and populism are on a secular rise in the U.S.; However, the "Breitbart clique" has suffered a critical defeat in the current Administration; This will make headway for upcoming tax legislation and resolution of the debt ceiling imbroglio; We continue to stress that domestic politics will not hurt U.S. equities, but more downside to USD may exist this year; India-China military tensions are not strategic or market relevant, yet. Feature "Most Americans do not find themselves actually alienated from their fellow Americans or truly fearful if the other party wins power. Unlike in Bosnia, Northern Ireland or Rwanda, competition for power in the U.S. remains largely a debate between people who can work together once the election is over." - Newt Gingrich, January 2, 2001 This is the second time we have begun a report with this classic Gingrich quote from 2001, which now seems to come from a different era. On November 9, 2016 we used it to open our election post-mortem in which we argued that American party identifications were ossifying into tribal markers that could cause run-of-the-mill polarization to mutate into something scarier.1 Chart 1 shows that party identification (Republicans vs. Democrats) is now responsible for the greatest difference in attitudes towards 48 values, something historically determined by race and education. Over the long term, these trends are concerning and may spur further social unrest in the U.S. As we wrote in June, the gulf between America's patricians and plebeians has never been as wide as it is now. It is being complemented by a gulf in ideology and worldview.2 Part of the problem is that migration from the traditionally liberal-leaning coastal America as well as the Great Lakes region have significantly altered the demographic makeup of the American South (Chart 2). The combination of pro-business regulation, low taxes, sunshine, affordable real estate, southern charm, and excellent higher-education institutions has been difficult to resist.3 Thus, an influx of young and educated migrants has altered the political makeup of many traditionally conservative states. There are many cities - much like Charlottesville, Virginia - where these recent migrants will come into conflict with the values and traditions of the south. Chart 1Rise Of A Tribal America Is The "Trump Put" Over? Is The "Trump Put" Over? Chart 2Internal Migration Is A Risk... Is The "Trump Put" Over? Is The "Trump Put" Over? Given America's history of internal population movements, these patterns of migration should not be a problem. However, today's polarization is extreme (Chart 3), and it is deepening thanks to radically different information and media streams made available by cable television and especially the Internet (Chart 4). Chart 3... In A Polarized Context... ... In A Polarized Context... ... In A Polarized Context... Chart 4... Where 'Fake News' Proliferates ... Where 'Fake News' Proliferates ... Where 'Fake News' Proliferates What does all of this mean for investors? America is geopolitically very well endowed. It has benign neighbors, strong demographics, and almost all the natural resources it needs. However, hegemons are not born out of plenty, but rather out of need and want. The U.K. built a global empire largely because its rain-drenched island lacked basic materials for superpower status. Spain and Portugal discovered new worlds because stronger empires barred lucrative trading routes. Geography does not preordain hegemony. Strong domestic institutions, luck, and guts and glory do. The USD remains weak despite the fact that the Fed was the first major central bank to start hiking this cycle and despite strong economic data out of the U.S. relative to the rest of the world (Chart 5). Perhaps investors have caught the whiff of something rotten in the American Empire? If so, we may be seeing the beginning of a major USD bear market. Chart 5USD Should Be Outperforming In The Current Global Macro Context USD Should Be Outperforming In The Current Global Macro Context USD Should Be Outperforming In The Current Global Macro Context BCA's Foreign Exchange Strategy sees the current DXY weakness as temporary. We agree, given that the current trajectory of BCA's ECB months-to-hike measure is discounting way too much hawkishness (Chart 6). The dollar index will likely rally in 2018 as inflation data improves and risks in Europe (Italian election) and Asia (Chinese structural reforms) deepen. Chart 6The ECB Hawkishness Is Overstated The ECB Hawkishness Is Overstated The ECB Hawkishness Is Overstated The scope and pace of the 2018 USD rally, however, will depend on whether investors have confidence in America's economy and institutions. If the Republican tax reform agenda stalls later this year, and if social unrest continues, sovereign and long-term investors may begin to think about diversifying away from the dollar. The "Trump Put" Continues We do not expect domestic politics to play a role in an equity correction. At least not yet. First, investors seem to be completely discounting any possibility of tax reform judging by the performance of the high tax-rate basket (Chart 7). This is likely a mistake. Tax reform is a major component of both Trump's and congressional Republicans' agenda. If it fails, Republicans will have to go to their home districts empty-handed to campaign for the November 2018 midterm elections. Second, the market fell 1.58% after President Trump's combative press conference on August 15. The move was not a reprimand for Trump's rhetoric, but concern that Gary Cohn, the scion of the "Goldman clique" and likely the next Fed Chair, would resign over the comments.4 These concerns have now been allayed by the firing of Stephen Bannon, the White House Chief Strategist and leader of the "Breitbart clique." Bannon's departure puts Cohn, Treasury Secretary Steven Mnuchin, and Commerce Secretary Wilbur Ross firmly in charge of economic policy. Meanwhile, three generals are now in charge of foreign and national policy: Defense Secretary James Mattis, National Security Advisor H.R. McMaster, and Chief of Staff John F. Kelly. Between the six of them, and Secretary of State Rex Tillerson, there is not a drop of populism left in the White House. Chart 7What Tax Reform? What Tax Reform? What Tax Reform? Although nationalists and populists may be on the retreat, it is still not clear what form tax legislation will take. The only thing that has certainly changed since earlier this year is that the border adjustment tax is officially dead, which would have raised ~$1 trillion in revenue over ten years.5 This requires the GOP either to moderate its tax cuts by the same amount, or to add more to the deficit, which, according to legislative rules, would make the cuts temporary. It is likely at this point that whatever bill the GOP passes, it will expire after a "budget window" of around ten years. The divergence between the White House and Congress remains the same: the White House wants gigantic tax cuts, while Congress wants tax reform, i.e. to broaden the tax base and reduce inefficiencies and distortions. The White House would blow out the budget deficit by more than would the House GOP. There are two key questions that investors want to know from the upcoming tax legislation. First, how significant will the fiscal thrust be? This will determine the impact to the economy and hence will affect the Federal Reserve's response. The GOP Plan: Both the White House and the House GOP claim that they will reduce the budget deficit over the next ten years despite cutting taxes. They project an average budget deficit of 1.3%-1.4% from 2018-2027, down from a 3%-4% baseline. This projection is rationalized via expectations of faster economic growth as well as "dynamic scoring" to capture the macroeconomic feedback of the tax cuts. The White House and GOP claim that economic feedback will reduce the deficit by $1.5-$2 trillion over the ten-year budget window, which is 26%-37% of the total deficit reduction they are proposing (i.e., likely very optimistic).6 The Tax Policy Center Response: Outside analysis of the budget plan argues the opposite. The Tax Policy Center argues that the White House plan, insofar as the details are known, would add a minimum of $3.4 trillion to the deficit over the next ten years, and that the macroeconomic feedback could even be negative (i.e., add to the deficits). The deficit would rise from 3.2% of GDP to 6.4% by 2026, if we factor in the Congressional Budget Office assumptions that a 4% real growth rate leads to a GDP of $26.9 trillion in 2026.7 The GOP Retort: Republicans claim they will reduce the deficit by means of proposed "revenue offsets," or savings measures, over the ten-year period. The Tax Policy Center highlights the following in particular: $1.6 trillion from repealing personal exemptions; $1.5 trillion from abolishing all itemized deductions (other than the politically sensitive mortgage interest deduction and charity deduction); $622 billion from treating some income from pass-through businesses as dividends; $272 billion from repealing corporate tax breaks; $208 billion from repealing the "head of household" status for tax filers; $49 billion from taxing capital gains upon death (above the $5 million threshold). The total is $4.3 trillion in savings, against $7.8 trillion of losses, for a total deficit that is increased by $3.4 trillion over the ten years. This would amount to around $340 billion of "stimulus" each year, with the biggest thrust felt in 2018-19. We very much doubt that the White House will achieve this slate of proposals. It has not shown an inkling of the ability to coordinate such a difficult legislative feat. Therefore, we expect the tax legislation to be watered down. The budget deficit may rise to something closer to 6%, over the next ten years, than to the gigantic 12% of GDP implied by Trump's proposals on the campaign trail (Chart 8). Chart 8Question Of The Year: Will Tax Reform Be Stimulative? Question Of The Year: Will Tax Reform Be Stimulative? Question Of The Year: Will Tax Reform Be Stimulative? The second question asked by investors is about the impact of tax legislation on assets. It is clearly positive for inflation and growth given that even tepid tax cuts will provide economic stimulus when unemployment is already very low. Our colleagues at BCA already believe, without a tax bill, that inflation is likely to surprise to the upside in 2018-19.8 Fiscal stimulus via tax cuts would obviously add to that. The equity market will cheer any promising developments on tax cuts or reform, especially given that so little is currently priced in. However, whether the USD rallies as it did on hopes of tax legislation earlier this year will largely depend on how the Fed reacts to the legislation. There is a lot of uncertainty, particularly if President Trump decides to go with Gary Cohn as the next Fed chair. Bottom Line: Congressional Republicans cannot gamble with tax legislation. The failure to cut taxes, or reform the tax code, would be a major policy misstep ahead of the midterm elections. If legislation passes, we expect that Congress will have had greater control over the plan than the White House, reducing the eventual magnitude of the tax cut and the fiscal stimulus. Congress controls the purse strings and will reassert that authority in the context of an ineffective executive. Should You Care About The Debt Ceiling? Clients are beginning to fret about the upcoming debt ceiling fight. There is good reason to be nervous. The Republican-held Congress has failed to pass legislation, notably on this year's priority item, Obamacare. The last thing Republicans want is to shut down the government or cause a technical default entirely of their own doing! Clients should note that while government shutdowns have occurred in the past, the debt ceiling has never been breached. This is because the debt ceiling is an anachronism. In other countries, when a budget is passed it automatically contains the implicit authority to issue whatever debt is required to finance the resulting deficit.9 To require separate legislation for a budget and an authorized level of debt is a product of politics and has little bearing on the actual financing needs of the U.S. government. At the end of the day, the debt ceiling will almost inevitably be raised in the U.S. because no government could stand the popular pressure that would result from social security checks not being mailed out to seniors (who vote!) or a halt to other entitlement programs. Only a disastrous chain of events resulting from polarization and brinkmanship, even worse than in the Obama years, would lead to such an outcome. Today, given that Republicans control both chambers of Congress and the White House, there is no way for the Republicans to share the blame with the Democrats, as they did under Obama. Investors are therefore mistaking the game-theoretical paradigm: It is not a "game of chicken," but rather a cooperative game given that Republicans in Congress are largely on the same side. Members of the GOP are starting to "get it," including the fiscally conservative House Freedom Caucus. David Schweikert, influential member of the Freedom Caucus who sits on the House Ways and Means Committee, said last week that he is in favor of a clean bill to raise the debt ceiling. Mark Meadows, North Carolina representative who chairs the group, has also said that he is "bullish" on raising the debt limit, although he added that he preferred to attach some reforms to the bill. On August 2, he said "Either that will get done [some spending cuts attached to the debt ceiling bill] or a clean debt ceiling will get done. We will raise the debt ceiling and there shouldn't be any fear of that." Other members of the Caucus, including its founder Jim Jordan of Ohio, have retorted that no debt limit hike without spending cuts should be contemplated, prompting the media to focus on the brinkmanship. But we note that the Freedom Caucus, the most fiscally conservative grouping in the House, is itself considerably divided on the issue. This augurs well for a clean bill since the Republican majority in the House is 22 and the Freedom Caucus has 31 members. If Schweikert and Meadows are indicative of how the group will vote, the fiscal conservatives may not have enough votes to deprive the GOP of a majority. (The latter would force GOP moderates to go to the Democrats for votes, complicating the negotiations and increasing the risk of mistakes.) What about the Democrats in the Senate? To pass a clean bill on the debt ceiling, Republicans would need at least eight Democrat Senators to get to 60 votes, and probably more given that Rand Paul (R-Kentucky) would likely vote against a clean bill. We doubt that Democrats would remain united in voting against a clean bill. It would allow President Trump and Republicans in Congress to accuse them of hypocrisy and holding U.S. credit hostage, much as Democrats did to Republicans between 2011-2016. As such, the market's fear that Democrats could play the spoiler is a red herring. While some grassroots activists in the Democratic Party are sure to want a confrontation, its median voters tend to be educated and well-informed. The worst-case scenario for the market would be a two-week shutdown, between October 1, when the current funding for the government expires, and sometime in mid-October when the debt ceiling is hit, according to the Congressional Budget Office. Odds of such a scenario are probably around 25%. But the contingent probability of a debt ceiling failure following a government shutdown would be reduced, not increased, given that it would focus public attention on Republican incompetence. In other words, if a shutdown occurs on October 1, we would expect the odds of a debt ceiling crisis to be reduced. Finally, our assessment that the "Goldman Sachs clique" has reasserted control over White House economic policy should also be positive for the likelihood of a clean debt ceiling bill. While we have no evidence that Stephen Bannon was in favor of using the debt ceiling for fiscal cuts (given his opposition to government spending cuts in toto), he did say following his resignation that Trump would be "moderated" by remaining White House staffers. He went on to say "I think he'll sign a clean debt ceiling; I think you'll see all this stuff." The only remaining holdover in the White House on the debt ceiling issue is the Office of Management and Budget Director Mick Mulvaney. Mulvaney has suggested earlier in the year that Republicans should try to tie spending restraint to a debt ceiling bill. However, at a meeting between President Trump and GOP leaders in early June, President Trump said that congressional leaders should take Steven Mnuchin's position as the White House position. "Mnuching is that guy," Trump told party leaders at the meeting, according to GOP sources who spoke to Politico in the summer. Mulvaney's office has also confirmed that the Treasury Department "has point on the debt ceiling," i.e., that Mnuchin is in charge. Bottom Line: Concern over the debt ceiling is natural, given the failure of Republican-held Congress to pass any legislation of note this year. However, it is also overstated. The U.S. government would default on its obligations to its voters, first and foremost. Such a scenario - given Republican control of all branches of government - would put the final nail in the coffin of the Republican-held Congress ahead of the midterm elections. Fade any fear of a U.S. default. Will India And China Fight A War? Clients, particularly in China, have shown considerable concern about geopolitical conflict between China and India. Since early June, a border dispute between China and India has flared up in the Doklam region. Doklam, or rather the India-China-Bhutan border region, is one of three main border disputes in the Himalayas that flare-up from time to time - along with Kashmir and Arunachal Pradesh. The 1962 border war between the two Asian behemoths over the latter two areas marked the biggest flare in recent memory. Today, India is fearful of China's growing military and logistical capabilities and concerned about the long-term security of the Siliguri Corridor, the narrow stretch of land connecting the subcontinent to the Northeast (Map 1). Control of the Doklam Plateau and Chumbi Valley would give China access to Siliguri; they are therefore important areas to monitor.10 India is also threatened by China's improving bilateral relations with neighbors like Pakistan,Bangladesh, Sri Lanka, Nepal, and potentially Bhutan. The latter does not have formal relations with China, has always been under India's sphere of influence, and is at the center of the current dispute. And ultimately, India fears that China seeks to create an economic corridor through Bangladesh to the Indian Ocean, which would, in combination with the Pakistan corridor, surround India. Map 1Too Close For Comfort: Tensions Threaten India's Control Over Vital Siliguri Corridor Is The "Trump Put" Over? Is The "Trump Put" Over? The current dispute ostensibly began - as many do - with contested infrastructure construction. India built some bunkers at a forward outpost in Lalten in 2012; China allegedly bulldozed them on June 6-8 of this year. The same month, Indian troops confronted Chinese troops building a road along the border with Bhutan that would have connected an existing road to a People's Liberation Army outpost and to the border crossing of Doka La. While the territorial dispute is old, China is expanding its pressure tactics on Bhutan, while India has sent troops into disputed Sino-Bhutanese territory in a more assertive defense of Bhutan. Broadly, China is making inroads with infrastructure as it develops its far-flung western regions and seeks to improve connectivity with neighbors via the One Belt One Road (OBOR) initiative. China is capital-rich and can afford to improve its access to regions of strategic value that yield access to key Indian territories or supply water and hydropower to India. India is capital-poor and downstream, so its ability to respond is often limited to military gestures. India also wants to retain its dominance over Bhutanese foreign policy, in place since 1949 and especially 1960, and this dispute is marked by India taking an active military role on Bhutanese territory on Bhutan's behalf. There are several reasons we do not expect this conflict to be market-relevant. First, the Himalayas are isolated and poor, so that China or India would have to make a very dramatic move that poses a genuine strategic threat (e.g., to the Siliguri Corridor, or Chinese control of Tibet, or Indian relations with Pakistan, or Indian water sources) to trigger a larger conflict. Second, while it is true that nationalism is flaring up on both sides, China has a clear interest in pursuing some "rallying around the flag" strategy amid the standoff over North Korea, and ahead of the Communist Party's nineteenth National Party Congress. That it chose to do so in Doklam, where conflict is more easily contained than in the Koreas or the East or South China Seas, suggests that political opportunism and China's desire to make incremental gains, rather than a sweeping Chinese plan to seize strategic territory, is driving the current episode. Meanwhile, India needs to attract capital to build its manufacturing base, and Prime Minister Narendra Modi has reached out to China for this reason. India will undoubtedly defend its strategic interests if attacked, but otherwise it is not eager to clash with China, which has bulked up its military far more than India has done in recent decades. Chart 9India Would Bolster Containment Of China India Would Bolster Containment Of China India Would Bolster Containment Of China However, we do see India-China relations as fitting into the larger, negative geopolitical dynamic where the U.S. and its allies encourage India as a balance to China, while China suspects the U.S. alliance of using India and others to encircle and entrap China (Chart 9). Not that the U.S. stirred up the current dispute, but that the U.S. (and Japan) will generally seek to improve relations with India and to strengthen its military and economy, and China will use its regional influence to try to keep India off balance.11 This structural dynamic, in addition to China's territorial assertiveness, is likely to keep generating frictions. Bottom Line: A conflict between India and China is only market-relevant if it extends beyond disputed territories in the Himalayas to affect core strategic interests like the Siliguri Corridor, Tibetan stability, the Indo-Pakistani balance of power, or water supply and hydropower. It could also become market-relevant by worsening U.S.-China relations - and delaying Chinese economic reforms - if China should come to feel embattled on all geopolitical fronts. For instance, should an adventurous, "lame duck" Donald Trump attempt to combine with India and other neighbors in ways that threaten to cause problems in China's western regions as well as in its East Asian periphery. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Martin H. Barnes, Senior Vice President Economic Advisor mbarnes@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 3 Hook 'em Horns! 4 We recently argued that the White House is torn between two groups, the "Goldman" and the "Breitbart" cliques. The Goldman clique is led by Gary Cohn, Director of the National Economic Council and is pragmatic, un-ideological, and focused on passing tax reform and pro-business regulation. The Breitbart clique is populist, nationalist, and leans to the left on economic matters. Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "Will Congress Pass The Border Adjustment Tax?" dated February 8, 2017, available at gps.bcaresearch.com. 6 Please see Congressional Budget Office, "An Update to the Budget and Economic Outlook: 2017 to 2027," June 2017, available at www.cbo.gov and U.S. Office of Management and Budget, "Budget of the U.S. Government: A New Foundation For American Greatness, Fiscal Year 2018," available at www.whitehouse.gov. 7 Please see the Tax Policy Center, "The Implications Of What We Know And Don't Know About President Trump's Tax Plan," July 12, 2017, and Benjamin R. Page, "Dynamic Analysis of the House GOP Tax Plan: An Update," June 30, 2017, available at www.taxpolicycenter.org. Using White House growth assumptions of 4.7% would lead to a deficit of 5.7% in 2026. 8 Please see BCA U.S. Bond Strategy Portfolio Allocation Summary, "On Hold, But Not For Long," dated August 8, 2017, and U.S. Bond Strategy Weekly Report, "Two Challenges For U.S. Policymakers," dated May 23, 2017, available at usbs.bcaresearch.com. 9 Denmark also has a debt ceiling, but it has set it so high that it does not need to be addressed. 10 Please see Sudha Ramachandran, "Bhutan's Relations With China And India," Jamestown Foundation, China Brief (17:6), April 20, 2017, available at Jamestown.org. 11 In fact, Japan already waded into the India-China dispute. The Japanese ambassador to India issued a statement critical of China, which the Chinese Foreign Ministry immediately rebuked.

Highlights Beware of asset managers' and leveraged funds' large net long positions in EM currencies. Overextended net long positions in EM and commodities currencies signify overbought conditions in EM risk assets in general. This in tandem with the poor outlook for EM/China growth makes the risk-reward of EM financial markets unattractive. Downgrade Korean equities from overweight to neutral, but continue to overweight Korean technology stocks relative to the EM benchmark. Also, maintain the short KRW / long THB trade. Take profits on the long Indian / short Indonesian stocks position. Consistently, downgrade Indian stocks to neutral and upgrade Indonesian bourses to neutral within an EM equity portfolio. Feature Investor positioning in EM currencies is elevated. From a contrarian perspective, this at minimum warrants a correction. Chart I-1 illustrates that asset managers' and leveraged funds' combined net long positions in the Mexican peso, the Brazilian real, the Russian ruble and South African rand are very elevated.1 This aggregate is weighted by notional value of outstanding open interest of each currency, and is shown as a percentage of open interest. Importantly, we have refined positioning data to separate asset managers and leveraged funds from other non-commercial and commercial institutions. Asset managers and leveraged funds reflect investment community sentiment the best. Besides, they are the most inclined to scale back their net long positions if and when these currencies begin to depreciate, i.e., they are more momentum driven. By doing so, they will reinforce the selloff. Currently bullish sentiment on EM and commodities is corroborated by the fact that asset managers' and leveraged funds' aggregate net long positions in non-EM commodities currencies such as the CAD, the AUD and the NZD are at the highest level since 2011 (Chart I-2). Typically, these currencies are at risk of a correction when positioning reaches such excessive levels. Chart I-1Asset Manager's And Leveraged Funds' Net Long Positions In EM Currencies Are Large Asset Manager's And Leveraged Funds' Net Long Positions In EM Currencies Are Large Asset Manager's And Leveraged Funds' Net Long Positions In EM Currencies Are Large Chart I-2Asset Manager's And Leveraged Funds' Net ##br##Long Positions In Commodities Currencies Asset Manager's And Leveraged Funds' Net Long Positions In Commodities Currencies Asset Manager's And Leveraged Funds' Net Long Positions In Commodities Currencies Chart I-3A and Chart I-3B show the same for individual currencies such as the MXN, the BRL, the RUB, the ZAR, the CAD, the AUD and the NZD. The overarching message is that investors' net long exposure to both EM and commodities currencies is large and depreciation risk for these exchange rates is substantial, at least in the near term. Chart I-3AAsset Managers And Leveraged Funds' Net ##br##Long Positions In Select Currencies Asset Managers And Leveraged Funds' Net Long Positions In Select Currencies Asset Managers And Leveraged Funds' Net Long Positions In Select Currencies Chart I-3BAsset Managers And Leveraged Funds' Net ##br##Long Positions In Select Currencies Asset Managers And Leveraged Funds' Net Long Positions In Select Currencies Asset Managers And Leveraged Funds' Net Long Positions In Select Currencies Yet, these positioning data do not reveal whether potential weakness will be a bull market correction or the beginning of bear market. Our bias remains that the potential selloff will evolve into a new phase of the bear market in EM currencies that began in 2011. In turn, as EM currencies depreciate, they will erode foreign investors' returns and trigger a selloff in other EM risk assets such as stocks, domestic bonds and credit markets. In short, investor sentiment on EM risk assets correlates with sentiment toward both EM and commodities currencies. Hence, bullish sentiment and overextended net long positions in EM and commodities currencies signify overbought conditions in EM risk assets in general. The Cyclical Outlook Chart I-4EM Currency Valuations Are Close To Neutral EM Currency Valuations Are Close To Neutral EM Currency Valuations Are Close To Neutral We are negative on the cyclical outlook for EM currencies for the following reasons: With a few minor exceptions, EM currencies are not cheap; their valuations are close to neutral Chart I-4 demonstrates the real effective exchange rate for aggregate EM excluding China, Korea and Taiwan. This is an equity market cap-weighted aggregate. It shows that EM exchange rate valuations are not depressed. The reason why we remove China, Korea and Taiwan from the calculation is because their respective bourses have large equity market-cap weights in the MSCI EM stock index, and thereby dominate the EM aggregate. Excluding these three markets, we get a less skewed perspective on EM currency valuations and assign higher weight to the high-yielding ones. Importantly, the best measure of currency valuation is, in our opinion, the real effective exchange rate based on unit labor costs (ULC). The rationale is that this measure captures changes in wages and productivity. The latter two are critical to competitiveness and, hence, reveal the true valuation of currencies. Unfortunately, there is no available ULC-based real effective exchange rate data for all individual EM currencies. Chart I-5A and Chart I-5B presents the measure for countries where data from reputable sources are available. By and large, the message is that, with the exception of the Mexican peso, EM currencies are not particularly cheap. Chart I-5AReal Effective Exchange Rates ##br##Based On Unit Labor Costs Real Effective Exchange Rates Based On Unit Labor Costs Real Effective Exchange Rates Based On Unit Labor Costs Chart I-5BReal Effective Exchange Rates ##br##Based On Unit Labor Costs Real Effective Exchange Rates Based On Unit Labor Costs Real Effective Exchange Rates Based On Unit Labor Costs The outlook for EM exchange rates has historically been contingent on growth and corporate profitability in developing economies. That said, EM exchange rate fluctuations have in recent years become dependent on U.S. real interest rates as the importance of portfolio fixed-income flows into EM has dramatically surged. Both drivers - EM growth and U.S. real yields - are likely to become headwinds for EM exchange rates going forward. EM growth will relapse anew as Chinese growth slows and EM shipments to China decline. Our new money impulse for China2 has historically been a good leading indicator for EM exchange rates, and it points to potentially considerable EM currency depreciation in the next six to nine months (Chart I-6). Meanwhile, U.S. interest rate expectations are very depressed. It will take only slightly stronger U.S. growth and inflation readings or some non-dovish guidance from the Federal Reserve for U.S. interest rate expectations to move higher. The latter will support the U.S. dollar and hurt EM currencies. Although industrial metals prices have recently spiked to new cyclical highs, we believe commodities prices - both for energy and industrial materials - will be lower in the medium term. Global oil stocks are breaking to new cyclical lows, heralding weakness in crude prices (Chart I-7). The fact that oil has failed to post gains amid a notable rally in the euro could be a sign of fundamental vulnerability. Chart I-6China's Money Impulse And EM Currencies China's Money Impulse And EM Currencies China's Money Impulse And EM Currencies Chart I-7Oil Prices Are Vulnerable Oil Prices Are Vulnerable Oil Prices Are Vulnerable As for industrial metals prices, our analysis has not changed: the considerable slowdown in China's broad money heralds a major top in industrial metals prices, as per Chart I-8. The mainland accounts for 50% of global industrial metals consumption, and its capex cycle is of critical importance. What explains the latest spike in base metals prices? Chart I-9 reveals that since early this year, iron ore prices have been negatively correlated with Chinese money market rates (interest rates are shown inverted and are advanced by 30 days Chart I-9). This year's correction and subsequent rebound in iron ore prices might be attributed to changes in mainland traders' positioning due to swings in domestic interest rates. Chart I-8China-Plays Are At Risk China-Plays Are At Risk China-Plays Are At Risk Chart I-9Chinese Interest Rates And Iron Ore Prices Chinese Interest Rates And Iron Ore Prices Chinese Interest Rates And Iron Ore Prices Going forward, either China's growth will decelerate sufficiently enough to weigh on industrial metals prices, or the authorities will resume policy tightening to rein in financial excesses. All in all, the risk-reward for iron ore and other industrial metals is negative. On the whole, lower energy and industrial metals prices will weigh on EM commodities currencies. As for Asian currencies, they are sensitive to global trade. We expect global trade and tradable goods prices to relapse due to the resumption of a slowdown in China/EM demand. Manufacturing-based Asian currencies will depreciate amid budding weakness in their manufacturing sector (Chart I-10). In addition, Chart I-11 shows global auto sales lead global semiconductor sales by several months. The basis for this correlation is that autos nowadays use a lot of semiconductors, and therefore auto cycles affect semiconductor demand. The boom in semi-cycle has been one of the pillars of Asian exports recovery. As the former moderates, the latter will relapse weighing on Asian non-commodities currencies. Chart I-10Asian Manufacturing ##br##And Exchange Rates Asian Manufacturing And Exchange Rates Asian Manufacturing And Exchange Rates Chart I-11Global Auto Sales Lead ##br##Global Semiconductor Sales Global Auto Sales Lead Global Semiconductor Sales Global Auto Sales Lead Global Semiconductor Sales Bottom Line: Our bet remains that EM currencies will depreciate versus both the U.S. dollar and the euro - and regardless of euro/U.S. dollar exchange rate fluctuations. We recommend a short position in a basket of the following EM currencies: ZAR, TRY, COP, CLP, BRL, IDR, MYR and KRW. For market-neutral portfolios, our currency overweights are MXN, RUB, PLN, CZK, TWD, INR and THB. Korean Equities: Downgrading To Neutral We recommend downgrading Korea to neutral from overweight within EM equity portfolios. North Korea will likely remain a source of uncertainty and volatility. BCA's Geopolitical Strategy service does not expect war on the Korean peninsula as long-standing constraints to conflict are still in place, starting with Pyongyang's ability to cause massive civilian casualties north of Seoul via an artillery barrage. As such, the ultimate resolution to the conflict will be a peaceful one. However, getting from here (volatility) to there (negotiated resolution) requires more tensions. The U.S. has to establish a "credible threat" of war in order to move China and North Korea towards a negotiated resolution.3 And that process could take more time, which means more volatility in the markets.4 The overwhelming portion of Korea's equity rally has been driven by a phenomenal surge in one company's share price: Samsung. Excluding technology companies, the performance of MSCI Korea stock prices and their EPS has been mediocre. Samsung's explosive rally has been partially due to the exponential surge in DRAM prices (Chart I-12). On a macro level, we cannot forecast prices of individual semiconductors (such as DRAM). Nevertheless, our assessment is that the global semi cycle is entering a soft patch as per Chart I-11 above. Furthermore, Korea's cyclical growth has already peaked, and will slow going forward (Chart I-13). Broad money growth is still decelerating, entailing that no turnaround is in the cards (Chart I-13, bottom panel). Chart I-12Samsung Share Prices And DRAM Samsung Share Prices And DRAM Samsung Share Prices And DRAM Chart I-13Korea: Cyclical Profile Korea: Cyclical Profile Korea: Cyclical Profile Importantly, the new government has enacted a law to boost minimum wages by 16% in January 2018 and would need to increase by a similar rate annually to reach its 2020 target. Even though there are fiscal subsidies for businesses and minimum wages affect smaller businesses much more than larger ones, odds are that this will still boost overall wage growth, and hence weigh on companies' profit margins. Chart I-14Korean Won Is Expensive Versus The Yen Korean Won Is Expensive Versus The Yen Korean Won Is Expensive Versus The Yen Finally, the Korean won is modestly expensive, based on the unit labor costs-based real effective exchange rate (Chart I-14, top panel). The won is especially expensive versus the yen (Chart I-14, bottom panel). This is negative for Korean manufacturers and the currency. Investment Recommendations Downgrade Korean stocks from overweight to neutral, but continue to overweight Korean technology stocks relative to the EM benchmark. Close long Korea / short EM equities and long Korean banks / short Indonesian banks positions. These positions have produced small gains since their initiation (details on all our open positions are available at the end of each week's report on page 17). Maintain a short KOSPI / long Nikkei in common currency terms trade: Either the won will depreciate substantially versus the yen or the KOSPI will underperform the Nikkei in local currency terms. In both cases, this trade will be profitable. Continue to bet on lower bond yields in Korea via receiving 10-year swap rates. Deflationary pressures from weaker exports - that make up 35% of GDP - will weigh on economic growth, and the central bank will be forced to cut rates. Maintain a short Korean won / long Thai baht position. The won is a high-beta currency and will underperform the Thai baht in a selloff / Asian exports slowdown. The Thai currency will likely trade in a low beta fashion due to the country's large current account surplus and low exposure to both China and commodities. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Take Profits On Long Indian / Short Indonesian Equities Position This recommendation has generated 8.4% gain since its initiation on July 30, 2014, and we recommend booking profits. Indian share prices have outperformed their Indonesian peers over the past year (Chart II-1) but the outlook for top line growth appears to be slightly better in Indonesia than in India. Specifically: We have combined bank credit to businesses and households with government expenditures to calculate a credit and fiscal spending impulse for both countries. Chart II-2 illustrates that this impulse heralds a more positive outlook for listed companies' revenues in the case of Indonesia than India. Chart II-1Book Profits On Long Indian / ##br##Short Indonesian Stocks Position Book Profits On Long Indian / Short Indonesian Stocks Position Book Profits On Long Indian / Short Indonesian Stocks Position Chart II-2Credit And Fiscal Spending ##br##Impulse Favor Indonesia Over India Credit And Fiscal Spending Impulse Favor Indonesia Over India Credit And Fiscal Spending Impulse Favor Indonesia Over India Other cyclical variables are mixed in both economies: vehicle and two-wheeler sales are sluggish, manufacturing PMIs have rolled over, but imports of capital goods are improving (Chart II-3). In regard to valuation and profitability, both bourses are expensive in absolute terms (Chart II-4, top panel) but India's return on equity (RoE) is well below Indonesia's (Chart II-4, bottom panel). Such a 14% premium of Indian stocks over Indonesian ones along with a poor revenue outlook and lower RoE might prevent further share price outperformance by India. Chart II-3Mixed Cyclical Growth Dynamics Mixed Cyclical Growth Dynamics Mixed Cyclical Growth Dynamics Chart II-4India And Indonesian Equities: P/E Ratios And RoEs India And Indonesian Equities: P/E Ratios And RoEs India And Indonesian Equities: P/E Ratios And RoEs Although our negative outlook for commodities prices and expensive equity valuations entail a negative stance on Indonesian risk assets in absolute terms, we believe this bourse's underperformance versus the EM overall equity index and Indian stocks is late. It makes sense to reduce/eliminate an underweight allocation to Indonesian equities. Bottom Line: We recommend booking gains on the long Indian / short Indonesia equity position initiated on July 30, 2014. Consistently, we downgrade Indian stocks from overweight to neutral and upgrade Indonesian ones from underweight to neutral within an EM equity portfolio. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 CFTC is the U.S. Commodity Futures Trading Commission. The data on South African rand is available from May 2015. 2 Presented and discussed in detail in July 26, 2017 and August 16, 2017 reports; the links are available on page 18. 3 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," April 19, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?," August 16, 2017, available at gps.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Unsurprisingly, OPEC 2.0's leadership agreed on the need to extend the coalition's 1.8mm b/d production-cutting agreement to end-March 2018. Leaders of the coalition - the energy ministers of the Kingdom of Saudi Arabia (KSA) and Russia - will recommend as much when the coalition meets next week in Vienna. Meanwhile, sequential production in U.S. shales during the first four months of the year is up just under 100k b/d, based on the EIA's latest estimates. This was led by surging Permian production. We expect shale-oil production growth to continue, and are revising our year-end 2017 light-tight-oil (LTO) production estimate for the four main shale-oil plays to 5.66mm b/d, up from our earlier assessment of 5.39mm b/d. We also are lifting our year-end 2018 estimate of shale production to 6.64mm b/d. This means December-to-December LTO production will increase ~ 1mm b/d by Dec/17 and by another ~1mm b/d by Dec/18. Energy: Overweight. As of last Thursday's close, we are long Dec/17 Brent $65/bbl calls vs. $45/bbl puts at -$1.16/bbl, and long Dec/17 vs. Dec/18 Brent at -$0.21/bbl. These positions were up 16.4% and 242.9%, respectively. Base Metals: Neutral. The physical deficit in zinc appears to be widening slightly, based on supply-demand estimates from the International Zinc Study Group. Usage totaled 2.282mm MT in Jan-Feb 2017 vs. refined production of 2.28mm MT. For 2016, usage was 13.89mm MT vs. supply of 12.67mm MT. Precious Metals: Neutral. Metal refiner Johnson Matthey expects a 790k oz. palladium deficit this year, up from a little over 160k oz. last year. Separately, the World Platinum Investment Council expects platinum supply to fall 2% this year to 7.33mm oz. Ags/Softs: Underweight. The USDA reported corn planting stood at 71% for the week ended May 14, vs. an average of 70% over the 2012 - 16 period. We remain bearish. Feature The determination of the leaders of OPEC 2.0 to clear the storage overhang could not have been made more clear, following comments earlier this week from KSA's and Russia's energy ministers the coalition's 1.8mm b/d production-cutting agreement would be extended to end-March 2018. This is three months beyond earlier speculation the deal would be extended to year-end 2017. Chart of the WeekBalances Chart Balances Chart Balances Chart Still, when dealing with a political organization of any sort - and OPEC 2.0 is nothing if not a political entity - our bias is to assume less-than-complete compliance with production cuts, and an earlier return to pre-agreement production levels than proffered by the leadership of the coalition. Hence, in our updated balances model (Chart of the Week), in addition to assuming higher U.S. production out of the shales, we have Russian production returning to a level just below 11.30mm b/d by October 2017, up roughly 150k b/d from the 11.15mm b/d we assume they'll be producing until the end of September. We also assume Iraq's production will move up to 4.45mm b/d (up 50k b/d) beginning in January, and that Iran will be steadily, yet slowly, increasing production by 5-10k b/d per month beginning this month. The only assumption we're making for staunch compliance to the OPEC 2.0 accord after our assumed extension to year-end 2017 at next week's Vienna meeting is that KSA and its GCC allies - Kuwait, Qatar, and the UAE - will continue to abide by their voluntary production cuts. This group has maintained solidarity on past production-management deals, we expect them to do so again in this round. Of course, the other members of the coalition could vote against this proposal next week, and instead decide to end the production deal in June under its original conditions. Or, they could agree to extend the deal, but only until year-end 2017. Regardless of whichever policy decisions are agreed to during next week's meeting, come November, when OPEC meets again, they might tweak/change those agreements to reflect their updated outlook at that time. Given this uncertainty, we believe the assumptions we've made are realistic, but we will be monitoring conditions closely so that we can modify our view quickly. Shale Coming On Strong Part of OPEC 2.0's desire to extend its deal likely is the improvement in the performance of shale-oil producers in the U.S. In its latest Drilling Productivity Report (DPR), the EIA noted that sequential production in the first four months of the year has risen ~ 100k b/d per month in the U.S. shales. This surge was led by higher Permian production, which accounted for ~ three-quarters of the increased output (Chart 2). Interestingly, rig-weighted production per rig dropped for the first time in April 2017, but it still is high at 732 b/d, down from 735 b/d in March. We will be watching this closely to see if it is the beginning of a trend of stagnating productivity amid a rapid expansion of industry activity. The resurgence in the shales can be seen in the year-on-year (yoy) growth in total production in the seven basins the EIA tracks, which broke back above 5.0mm b/d in February and crossed into positive yoy growth in March (Chart 3). Net, we expect 2017 global supply to average 97.65mm b/d, for an increase 610k b/d this year, and for demand to average 98.3mm b/d, for an increase of 1.5mm b/d. EM demand, which we proxy using non-OECD consumption, accounts for 1.27mm b/d of this year's global demand growth, and continues to lead overall growth in oil demand (Chart 4, panel 2). Of this, China and India account for 350k and 210k b/d, respectively, of the growth in EM demand. Chart 2Permian Basin Leads##br##U.S. Shale's Resurgence Permian Basin Leads U.S. Shale's Resurgence Permian Basin Leads U.S. Shale's Resurgence Chart 3Year-On-Year LTO Production##br##Breaks Out In 1Q17 Year-On-Year LTO Production Breaks Out In 1Q17 Year-On-Year LTO Production Breaks Out In 1Q17 Chart 4EM Growth Continues##br##To Lead Global Demand EM Growth Continues To Lead Global Demand EM Growth Continues To Lead Global Demand China, India Lead EM Oil Consumption Non-OECD countries represent more than 50% of global oil consumption. Indeed, within the ~1.6mm b/d global oil demand growth we expect for 2017 and again in 2018, slightly more than 87% of it comes from EM economies. Table 1 below shows the average yoy growth by year for different regions - DM and EM - and countries from 2011 to 2018. Over this period, almost all of the world's oil-demand growth comes from non-OECD countries. From 2011-2018, the average p.a. demand growth for non-OECD countries is 2.79%, while for OECD countries it is only 0.12%. Table 1EM Leads Oil-Demand Growth Balancing Oil-Shale's Resilience And OPEC 2.0's Production Cuts Balancing Oil-Shale's Resilience And OPEC 2.0's Production Cuts Looking more closely at the composition of the EM economies, we see that, on average, between 2010 and 2018 Chinese oil consumption accounts for 24% of non-OECD demand, while the Indian oil consumption represents 8.3%, for a combined total of 32.37% of non-OECD average consumption. These two countries alone contributed on average to around 50% of the world oil consumption growth from 2010 to 2018. China has been the fastest-growing oil market in the world since the early 2000s. However, since 2015, when it emerged as an important growth market on the world stage, India's consumption has been increasing at a faster pace than China's. One of the reasons for this likely is the desire of the Chinese government to resume its pivot to a more service-oriented economy, which is less commodity-intensive than the export-oriented economy dominated by heavy industry. India, meanwhile, is looking to increase its manufacturing output, lifting it from the low-teens to 25% of GDP by 2022 under Prime Minister Narendra Modi's "Make in India" campaign. This change in the composition of global oil-demand growth is reducing demand for residual fuel oil and distillates. Indeed, IEA data continues to show a steady decline in yoy consumption for these two types of fuel in China, with residual fuel oil consumption down 26.5% yoy in 2016, and gasoil and diesel (distillates) consumption down close to 3% yoy. By contrast, gasoline consumption, is up more than 8% yoy along with jet fuel and kerosene. LPG demand (propane and butane, along with other light ends) and ethane demand (a petrochemical feedstock) is surging, up 24% in 2016, according to the IEA. In relative terms, China will remain the main driver of global oil consumption. At ~ 12.5mm b/d, China's oil demand is close to three times as high than India's. However, India likely will surpass China in terms of its contribution to global oil demand growth in coming years. A combination of structural and policy-driven factors points toward a possible sustainable growth path for Indian oil consumption for the coming years (oil consumption per capita is increasing, as is vehicle usage, particularly motorcycles (Chart 5); and, the government's desire to increase the share of the manufacturing to 25% of GDP by 2022 will boost oil demand growth as well). Chart 5India Passenger Car Sales Are Soaring India Passenger Car Sales Are Soaring India Passenger Car Sales Are Soaring Recent studies assessing the "take-off" of an economy look at its per capita oil consumption in transportation, in particular, given that this sector accounts for more than half of the world's oil consumption (63% according to IEA Energy Statistics 2014). The theory boils down to the following: As income grows, a larger share of the population becomes vehicle owners. This is referred to as the "motorization" of an economy. In India, the transportation sector represents around 40% of total oil consumption.1 According to Sen and Sen (2016), the level of vehicle-ownership per capita is still low in India compared to other economies that have experienced similar take-offs. The government's targeted increase in manufacturing as a share of GDP to 25% under the "Make In India" program (from a current level of ~ 15%) would, according to the Sen and Sen (2016) formulation, lead to an increase in oil consumption. The "Make in India" campaign was launched in 2014 by Prime Minister Narendra Modi and aims to transform the country's manufacturing sector into a powerhouse for growth and employment. Other key objectives of this campaign include a target of 12-14% annual growth in the manufacturing sector, and the creation of 100 million new jobs by 2020 in the sector.2 In 2017Q1, India's liquid fuels consumption declined by 3% yoy. This decline was, for the most part, caused by the government's "demonetization" program, which was designed to streamline the economy and reduce rampant black-market transactions. The government chose to invalidate the 500- and the 1,000-rupee banknotes, the most-used currency denominations in the economy (around 86% of the total value of currency in circulation). This represented a huge shock to the average citizen, since it limited the purchasing power of a large part of the consumer economy for an extended period of time and impacted India's overall economic activity. Recent data show Indian oil and liquids consumption up 3% in April (yoy), and its money supply is almost back to its pre-demonetization levels, according to the EIA. This suggests economic activity and liquid-fuel consumption will get back to their previous levels. Bottom Line: We believe OPEC 2.0's deal will be extended at next week's Vienna meeting to March 2018. However, after September, we are expecting compliance to fall off meaningfully, leaving KSA and its allies as the only producers adhering to their voluntary cuts past year-end 2017. Even so, we expect the storage overhang to be worked off - mostly this year - but also into next. Even though U.S. shale production is surprising on the upside, the commitment of a majority of OPEC 2.0 to production cutbacks at least through September of this year will force the storage overhang to draw down by year end. KSA and its core allies will maintain production discipline to March 2018, which will keep storage from refilling too quickly during the seasonally weak consumption period in the first quarter next year. We continue to expect oil forward curves to backwardate by December 2017, and remain long Dec/17 Brent vs. short Dec/18 Brent. In addition, we remain long Dec/17 Brent $65/bbl calls vs. short Dec/17 Brent $45/bbl puts, expecting prices to rally toward $60/bbl by the time Brent delivers in December. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Assistant Commodity & Energy Strategy hugob@bcaresearch.com 1 Sen, Amrita; Anupama Sen (2016), "India's Oil Demand: On the Verge of 'Take-Off'?". Oxford Institute for Energy Studies. 2 Some of the recent policies to enhance the manufacturing growth include: Government subsidies of up to 25% for specific manufacturing sub-sectors; area-based incentives to increase the manufacturing development in key regions; allowances for companies that invest a predetermined amount in new plant and machinery; deductions for additional wages paid to new regular employees; deductions for R&D expenditures; and other incentives aimed at promoting the manufacturing sector and improving the India's ease of doing business to attract foreign direct investments. Please see http://www.makeinindia.com/article/-/v/direct-foreign-investment-towards-india-s-growth. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016 Balancing Oil-Shale's Resilience And OPEC 2.0's Production Cuts Balancing Oil-Shale's Resilience And OPEC 2.0's Production Cuts Balancing Oil-Shale's Resilience And OPEC 2.0's Production Cuts Balancing Oil-Shale's Resilience And OPEC 2.0's Production Cuts

Highlights Chinese capex and EM domestic demand will falter again in the second half of this year. This is not contingent on a growth slowdown in the advanced economies, but due to a further slowdown in bank lending in EM and lower commodities prices. The direction of EM share prices in absolute terms and relative to the S&P 500 is determined by EPS trajectory, not equity valuations. We expect EM EPS to drop in absolute terms and to underperform U.S. EPS. India's deleveraging cycle is well advanced, especially when compared with other EM economies. Maintain an overweight position in Indian equities within the EM universe. Continue betting on yield curve steepening. Stay long the Czech koruna versus the euro. Feature EM/China growth will relapse in the second half of this year. Share prices, presuming they are forward-looking, will roll over beforehand. Chinese interest rates have risen, which typically heralds a downtrend in the mainland's credit impulse and business cycle (Chart I-1). Chinese interest rates are shown as an annual percentage change, inverted and advanced. This is a typical relationship between interest rates and credit cycles, and there is currently no reason why it will play out any differently in China. Given the mainland has a lingering credit bubble, rising borrowing costs and regulatory tightening of banks and the shadow banking system are guaranteed to lead to a relapse in credit origination, and in turn economic growth. China's yield curve has been flattening in recent months. This often precedes a selloff in both EM share prices and industrial metals (Chart I-2). Chart I-1China: Interest Rates ##br##And Credit/Business Cycles China: Interest Rates And Credit/Business Cycles China: Interest Rates And Credit/Business Cycles Chart I-2A Flattening Yield Curve In China Is ##br##A Bad Omen For EM And Commodities A Flattening Yield Curve In China Is A Bad Omen For EM And Commodities A Flattening Yield Curve In China Is A Bad Omen For EM And Commodities The Chinese yield curve has been experiencing bear flattening - front-end rates have risen more than long-term rates. Bear flattening in yield curves typically occurs before a major top in growth, when current conditions are still robust but the fixed-income market begins to question growth sustainability going forward. A flattening yield curve is consistent with our assessment: a lack of follow-through from last year's stimulus combined with the recent policy tightening will cause growth to downshift materially very soon. EM narrow (M1) money growth has rolled over decisively, and historically it has been a good leading indicator for EM earnings per share (EPS) (Chart I-3). The former has historically led the latter by about nine months. Chart I-3EM EPS To Roll Over In the Second Half 2017 EM EPS To Roll Over In the Second Half 2017 EM EPS To Roll Over In the Second Half 2017 The same is true in the case of China - the M1 impulse (the second derivative of M1) leads industrial profits by about six months and heralds an imminent reversal (Chart I-4). Chart I-4China's Industrial Profit Growth Recovery Is At A Risk China's Industrial Profit Growth Recovery Is At A Risk China's Industrial Profit Growth Recovery Is At A Risk The commodities currency index (an equally weighted average of AUD, NZD and CAD) has relapsed against the greenback. This index points to global growth deceleration in the second half of this year (Chart I-5). Similarly, these commodities currencies also lead commodities prices, and presently signal a top in the commodities complex (Chart I-6). Chart I-5Commodities Currencies Signify Weakness In Global Trade Commodities Currencies Signify Weakness In Global Trade Commodities Currencies Signify Weakness In Global Trade Chart I-6Commodities Currencies Point To Relapse In Commodities Prices Commodities Currencies Point To Relapse In Commodities Prices Commodities Currencies Point To Relapse In Commodities Prices In EM ex-China, Korea and Taiwan, bank loan growth has still been decelerating despite the global growth recovery of the past 12 months (Chart I-7, top panel). Besides, retail sales volume growth in EM ex-China, Korea and Taiwan has not ameliorated yet (Chart I-7, bottom panel). All of these economic aggregates are equity market cap-weighted. Similarly, auto sales in EM ex-China, Korea and Taiwan have been stabilizing at very low levels but have not recovered at all (Chart I-8). Hence, we infer that domestic demand in EM ex-China has stabilized, but it has not recovered. For example, manufacturing production in Brazil, Russia, South Africa and Indonesia has been rather subdued (Chart I-9). Chart I-7EM Ex-China, Korea And Taiwan: ##br##Domestic Demand Has Not Recovered EM Ex-China, Korea And Taiwan: Domestic Demand Has Not Recovered EM Ex-China, Korea And Taiwan: Domestic Demand Has Not Recovered Chart I-8EM Ex-China, Korea And Taiwan: ##br##Auto Sales Are Stabilizing At Low levels EM Ex-China, Korea And Taiwan: Auto Sales Are Stabilizing At Low levels EM Ex-China, Korea And Taiwan: Auto Sales Are Stabilizing At Low levels Chart I-9Synchronized Global Recovery? Synchronized Global Recovery? Synchronized Global Recovery? As EM ex-China credit growth decelerates further due to the lingering credit excesses and poor banking system health, their domestic demand will disappoint. This is a major risk to the EM profit outlook. Bottom Line: Chinese and EM domestic demand and by extension corporate earnings will falter again in the second half of this year. This view is not contingent on a growth slowdown in the advanced economies but will be the outcome of further slowdown in bank lending in EM and lower commodities prices. A reversal in Chinese imports from other EM is the link that explains how a relapse in the mainland's growth in the second half this year will hurt the rest of the world in general, and EM in particular. Profits Hold The Key Chart I-10Profits, Not Valuations, Hold The Key Profits, Not Valuations, Hold The Key Profits, Not Valuations, Hold The Key Emerging markets' relative performance versus the S&P 500 has historically been driven by EPS (Chart I-10). In the past 12 months, EM EPS has improved modestly but has not outperformed U.S. EPS in U.S. dollar terms. Consistently, EM stocks have failed to outperform the S&P 500 in common currency terms; they have been flat at low levels in the past 12 months. An important message from this chart is that equity valuations are not critical to EM versus U.S. relative equity performance. It is all about corporate profit cycles. The widely held view within the investment community is that EM stocks are cheaper than those in the U.S., and therefore will outperform based on more attractive valuations. The fact that EM stocks are indeed cheaper versus the S&P 500 only reflects the fact that U.S. equity valuations are expensive and EM equity valuations are neutral in absolute terms. Equity valuations may affect the degree of out- and underperformance, but they do not determine the direction of relative performance as vividly illustrated by Chart I-10. The same can be said about EM stocks' absolute performance. Equity valuations do not determine the direction of share prices; the latter rise when profits expand, and fall when EPS contracts. However, valuations affect the magnitude of the move in equity prices: cheap valuations and growing EPS will produce a larger rally compared to neutral equity valuations and identical growth in EPS. We discussed EM equity valuations at great length in our Weekly Report published two weeks ago.1 In absolute terms, EM equity valuations are presently neutral. Therefore, they have no bearing on the direction of share prices. If EM EPS expands, stocks will continue to rally. If EPS growth stalls or turns negative, EM stocks will stumble. As Charts I-3 and I-4 on page 3 illustrate, EM EPS will soon relapse. In addition, U.S. return on equity (RoE) remains well above EM's RoE (Chart I-11), reflecting better equity capital utilization in the U.S. versus the EM. Looking forward, one variable that has had a reasonably good track record in gauging relative performance of EM versus U.S. share prices is the ratio of industrial metals to U.S. lumber prices (Chart I-12). Industrial metals prices are a proxy for economic growth in China/EM, while U.S. lumber prices are indicative of America's business cycle. Industrial metals prices (the LMEX index) have lately underperformed U.S. lumber prices, pointing to renewed EM underperformance versus the S&P 500. Chart I-11EM RoE Is Below U.S. RoE EM RoE Is Below U.S. RoE EM RoE Is Below U.S. RoE Chart I-12EM Stocks To Underperform The S&P 500 EM Stocks To Underperform The S&P 500 EM Stocks To Underperform The S&P 500 Our view is that EM EPS growth will contract again within a cyclical investment horizon (over the next 12 months). While not all sectors' earnings are set to shrink, our view is that banks' profits will decline driven by credit growth deceleration and a rise in non-performing loans in a number of countries. Besides, commodities producers' EPS will drop anew if, as we expect, commodities prices head south again. Table I-1 illustrates the weights of each EM equity sector within total EM-listed companies' profits. Financials account for 24%, while energy and materials comprise 7.5% each of the aggregate EM equity market cap, respectively. In aggregate, these sectors make up 50% of EM EPS and 40% of the stock index. Table I-1EM Sectors: Equity Market Caps ##br##And EPS's Share Of Total EPS Signs Of An EM/China Growth Reversal Signs Of An EM/China Growth Reversal We remain positive on the technology/internet sector's growth outlook. While this sector's weight in terms of both market cap and EPS is very large, it is not yet sufficient to lift the overall EM equity index if other large sectors falter. In fact, technology/internet stocks have already rallied dramatically and are presently overbought. They will likely correct along with the rest of the universe. Nevertheless, we continue to recommend an overweight stance in technology stocks within the EM benchmark. Bottom Line: The direction of EM share prices in absolute terms and relative to the S&P 500 is determined by EPS trajectory, not equity valuations. We expect EM EPS to drop in absolute terms and to underperform U.S. EPS. Consistently, we maintain our long-standing strategy of being short EM / long the S&P 500. Taking Profits On Short Korean Auto Stocks Initiated on July 3, 2013, this recommendation has generated a 35% gain (Chart I-13, top panel). Notably, Korean auto stocks have failed to rally in the past 12 months. Furthermore, Korean auto stocks have underperformed the overall EM equity index by a whopping 22% since our recommendation (Chart I-13, bottom panel). For dedicated investors, we recommend lifting the allocation to this sector from underweight to neutral. In regard to allocation to the KOSPI overall, we maintain our overweight stance within an EM equity portfolio for now. Geopolitical volatility could create near-term disturbance but the primary trend in Korea's relative performance against the EM benchmark is up (Chart I-14). Within the KOSPI, we continue to overweight technology stocks, companies with exposure to DM growth and domestic industries. Meanwhile, companies with exposure to China's capital spending should be avoided. Chart I-13Take Profits On Short ##br##Korean Stocks Recommendation Take Profits On Short Korean Stocks Recommendation Take Profits On Short Korean Stocks Recommendation Chart I-14Korean Equities ##br##Relative To EM Overall Korean Equities Relative To EM Overall Korean Equities Relative To EM Overall Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report, titled "EM Equity Valuations Revisited", dated March 29, 2017, link available on page 21. India: Beyond De-Monetization The growth-dampening effects from India's de-monetization program are beginning to dissipate. Both services and manufacturing PMIs are recovering (Chart II-1). As more cash is injected back into the system, consumer sector growth will improve. Beyond the recovery in consumption, however, capital spending - the key driver of productivity and non-inflationary growth - is still anemic because of structural reasons that began well before de-monetization was announced (Chart II-2). Chart II-1PMIs Are Recovering PMIs Are Recovering PMIs Are Recovering Chart II-2Capital Spending Is Depressed Capital Spending Is Depressed Capital Spending Is Depressed Public Banks: Is Deleveraging Advanced? The Indian authorities appear serious about restructuring their public banks, and the banking downturn cycle is likely approaching its final stages (Chart II-3). As and when India's public banks find themselves on more solid footing, industrial credit growth will pick up meaningfully and capital expenditures will follow. The previous credit boom that occurred in the infrastructure, mining, and materials sectors left a large number of failed and stalled projects. Chart II-4 shows the number of stalled projects remains stubbornly high and is not yet declining. These mal-investments have ended up as non-performing loans primarily on public banks' balance sheets: Non-performing loans (NPLs) currently amount to 11.8% and distressed assets (DRA) stand at around 4% of total loans on Indian public banks' balance sheets. This has forced public banks to curtail credit growth to the industrial sector (Chart II-5). Chart II-3Bank Credit Growth Is At All Time Low Bank Credit Growth Is At All Time Low Bank Credit Growth Is At All Time Low Chart II-4Plenty Of Projects Stalled Plenty Of Projects Stalled Plenty Of Projects Stalled Chart II-5Bank Credit Growth To Industries Is Contracting Bank Credit Growth To Industries Is Contracting Bank Credit Growth To Industries Is Contracting Public banks' NPLs and DRAs have spiked because the Reserve Bank of India (RBI) is forcing commercial banks to acknowledge and provision for these bad loans via the central bank's Asset Quality Review (AQR) program. This is eroding public banks' capital and constraining their ability to grow their loan book. However, the program is bullish for India's economy in the long run and stands in stark contrast to other EM countries where authorities are turning a blind eye on banks attempting to window dress their NPLs. India's government and the RBI are currently working with commercial banks and proposing measures to recover loans from defaulters. The government is also injecting capital into public banks. It has announced 100 billion INR in capital injections for this fiscal year and will inject more if needed. It is also forcing banks to raise more capital by ridding their books of non-core businesses. We have performed a scenario analysis on public banks (presented in Table II-1) to gauge their stock valuations. In all scenarios, we assume that DRAs will be constant at 5% of total loans, and also assume a 70% recovery rate on DRAs. We examine various scenarios for NPLs - the latter vary from 12-15% of total loans (the current actual NPL rate is 11.8%). Equity valuations are very sensitive to the recovery rate on NPLs. We stress test for recovery rates of 30%, 40%, 50% and 60%. If one assumes a 12% NPL ratio and a recovery rate of 60%, public bank stocks would be 30% cheap - their adjusted (post provisions, capital impairment, and recapitalization) price-to-book value (PBV) ratio will be 0.7, which is 30% less than its historical mean PBV ratio for public banks of 1.0. By contrast, assuming a 15% NPL ratio and a 30% recovery rate, banks' equity valuations would be 50% expensive - their adjusted (post provisions, capital impairment, and recapitalization) PBV ratio would be 1.5. Table II-1Under/Overvaluation (In %) Of Public Banks Stocks For A Given NPL Ratio And Recovery Ratio* Signs Of An EM/China Growth Reversal Signs Of An EM/China Growth Reversal Our bias is to believe that the NPL ratio is somewhere between 14-15% and the recovery rate near 40%. In such a case, public bank stocks would presently be 10-20% expensive. This does not offer a great buying opportunity at current levels, but suggests the downside is probably smaller than in other EM bank stocks. Overall, India is much more advanced in terms of recognizing and provisioning for NPLs as well as re-capitalization of its banking system than many other EM countries. Therefore, we believe India's deleveraging cycle is well advanced, especially when compared with other EM economies. Due to this and the fact that this economy is not exposed to China/commodities prices, we still recommend an overweight position in Indian equities within the EM universe. Inflation And Fixed-Income Strategy While headline inflation is easing due to temporarily lower food prices, core inflation remains sticky. The central government's overall and current expenditures - which often drive inflation - are rising rapidly (Chart II-6). Likewise, state governments' current expenditures are also booming and state development loans - borrowing by state governments - are growing at an extremely fast pace. In addition, in June 2016, the Indian central government announced it will raise salaries, allowances and pensions of government employees by 23%. The central government also raised the minimum wage for non-agriculture laborers by 42% in August 2016, and the Ministry of Labor followed by doubling the minimum wage of agricultural workers in March 2017. All of this will entail accumulating inflationary pressures, even if oil and food prices remain tame. The central bank hiked the reverse repo rate last week to absorb excess liquidity from the banking system. Even though it cited service sector inflation as a concern, we believe it will lag behind accumulating inflationary pressures. This warrants a steeper yield curve. Investors should continue to bet on yield curve steepening by paying 10-year swaps / receiving 1-year swap rates (Chart II-7). Chart II-6Government Expenditures Are Rising Government Expenditures Are Rising Government Expenditures Are Rising Chart II-7Bet On A Yield Curve Steepening Bet On A Yield Curve Steepening Bet On A Yield Curve Steepening Rising inflationary pressures and higher bond yields could weigh on Indian stocks in absolute terms, but will likely not preclude them outperforming the EM equity benchmark. Ayman Kawtharani, Associate Editor aymank@bcaresearch.com Stay Long Czech Koruna Versus Euro On September 28th 2016, we recommended going long CZK / short EUR on the back of expectations that the Czech National Bank (CNB) would abandon its currency peg. Last week, the CNB has floated the koruna. We expect this currency to appreciate versus the euro further and suggest keeping this position. Inflationary pressures in the Czech economy are genuine and heightening. The 1.5% appreciation in the koruna versus the euro since last week will not tighten monetary conditions enough to cap inflation. As such, we expect the CNB to eventually start raising interest rates, leading to further koruna appreciation versus the euro (Chart III-1). The output gap is turning positive, which historically has led to a rise in core inflation (Chart III-2). Chart III-1The Czech Koruna Has More Catch-Up To Do The Czech Koruna Has More Catch-Up To Do The Czech Koruna Has More Catch-Up To Do Chart III-2Output Gap And Inflation Output Gap And Inflation Output Gap And Inflation The labor market is tight - the Czech unemployment rate is the lowest in Europe. Both wages and until labor costs growth are robust and trimmed-mean consumer price inflation is accelerating (Chart III-3). The CNB's foreign exchange reserve accumulation has generated an overflow of liquidity in the Czech financial/banking system (Chart III-4). Chart III-3Inflationary Pressures Are Broad-Based Inflationary Pressures Are Broad-Based Inflationary Pressures Are Broad-Based Chart III-4Money And Credit Growth Are Very Strong Money And Credit Growth Are Very Strong Money And Credit Growth Are Very Strong The rapid expansion of liquidity has led to strong credit growth (Chart III-4, bottom panel), and a rapid appreciation in real estate prices. This warrants higher interest rates to prevent the formation of a bubble. Furthermore, the Czech economy has been benefiting from the recovery in European economic growth in general and manufacturing in particular. Tourist arrivals have also been robust. Notably, the nation's current account surplus stands at 1% of GDP. Chart III-5The Koruna Is Mildly Cheap The Koruna Is Mildly Cheap The Koruna Is Mildly Cheap With regards to currency valuations, the koruna is silently cheap and as such has further room to appreciate (Chart III-5). Either the koruna will gradually appreciate over the next few months, tightening monetary conditions to an extent where the CNB does not need to hike interest rates, or the CNB is eventually forced to hike rates considerably. The latter will push up the value of the Czech currency. We suspect that the CNB is still intervening in the forex market in order to prevent a dramatic appreciation in the koruna. The central bank has stated in its last press conference that it stands ready to intervene to mitigate exchange rate fluctuations if needed. However, in an economy with open capital account, the central bank cannot target the exchange rate and interest rates simultaneously. If the CNB desires to cap inflation, it has to hike interest rates or allow the currency to appreciate considerably. If it chooses the former, the koruna will still rally dramatically. Bottom Line: Stay long the Czech koruna versus the euro. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Geopolitics will not spoil the stock rally yet; European election risks remain overstated; In China, look beyond the National Party Congress; China's reforms could re-launch in 2018 ... ... But India's reforms are gaining momentum now. Feature The global economy continues to surprise to the upside, with the latest round of global purchasing managers' indices (PMIs) confirming that the business cycle continues to accelerate (Chart 1). In the context of firming global growth, the Fed's decision to hike rates may not produce as violent of a reaction from the dollar as last year, giving way to further upside in stocks. And while investors continue to fret about valuations, U.S. stocks are expensive only relative to history, not relative to competing assets, as our colleague Lenka Martinek of the U.S. Investment Strategy service points out (Chart 2).1 Chart 1Because I'm Happy Because I'm Happy Because I'm Happy Chart 2U.S. Stocks Pricey By History, Not Peers U.S. Stocks Pricey By History, Not Peers U.S. Stocks Pricey By History, Not Peers What geopolitical news could break up the party over the next six months? Europe: As we argued three weeks ago, the European electoral calendar is unusually busy (Table 1).2 However, we have also posited in our 2017 Strategic Outlook that Europe will be a red herring this year, allowing risk assets to "climb the wall of worry."3 The first test of this thesis comes today, with the Dutch general elections taking place. The polls suggest that the Dutch electorate is not following the populist trend of the Brexit referendum and U.S. election (Chart 3), but rather in the footsteps of the little noticed Austrian presidential election in December, which saw the populist presidential candidate defeated. Dutch Euroskeptics, who have led the polling throughout the last twelve months, are bleeding support as election day approaches. Meanwhile, in France, Marine Le Pen is struggling to keep momentum going with only a month and a half to the first round. Thus far, our thesis on Europe is holding. Table 1Busy Calendar For Europe This Year China Down, India Up? China Down, India Up? Chart 3Dutch Euroskeptics Are An Overstated Threat China Down, India Up? China Down, India Up? The U.S.: Investors will finally get to put numbers to President Trump's rhetoric when the White House announces its budget on March 16. As we argued last week, President Trump is who we thought he was: an economic populist looking to shake up America's status quo. That suggests he will err on the side of greater deficits and large middle-class tax cuts. We do not think Congress will bar his way, as it has rarely restrained a Republican president from profligacy (Chart 4). We could be wrong, but it is unclear if a more fiscally responsible budget would be negative for the markets. On one hand, it may disappoint optimistic growth projections, but on the other, it would mean that the Fed would have no reason to err on the side of more rate hikes in 2017. Meanwhile, while we continue to fear protectionism's impact on the market, it is unlikely that the Trump White House will focus on trade when so many domestic priorities are looming this summer. Russia: As we argued in a Special Report with the Emerging Markets Strategy group last week, Russia may be entering a low-beta paradigm - escaping from its close embrace with oil prices - due to the combination of orthodox monetary policy, modest structural reforms, and growing confidence in its geopolitical predicament.4 This is not the time for President Putin to rattle nerves in the West. He does not want to give Europe and the U.S. a reason to cooperate. We therefore expect Russia's geopolitical risk premium to continue to decline, a boon for European risk assets (Chart 5). Chart 4Budgets: Republican Presidents##br## Get What They Want China Down, India Up? China Down, India Up? Chart 5Russia's Calm##br## Is Europe's Profit Russia's Calm Is Europe's Profit Russia's Calm Is Europe's Profit From a tactical perspective, we believe that the confluence of geopolitical forces supports our continued overweight of developed-market equities versus those of emerging markets. Within developed markets, the BCA House View is to prefer euro-area equities due to overstated geopolitical risks and favorable valuations relative to the U.S. equity market. BCA's Global Investment Strategy has pointed out that euro-area equities are one standard deviation undervalued relative to the U.S., when one applies U.S. sector weights to them (Chart 6). In addition, BCA's U.S. Bond Strategy service believes that Treasury yields have more room to rise, with growth putting upward pressure on inflation and the Fed in a rate-hike cycle. This makes sense to us given that no major geopolitical risk is materializing and considerable upside risk exists in U.S. growth due to Trump's populist policies. Chart 6European Stocks Still A Buy Relative To U.S. European Stocks Still A Buy Relative To U.S. European Stocks Still A Buy Relative To U.S. In what follows, we take a break from poring over geopolitical risks in Europe and the U.S. and focus on emerging markets. Since January, very few investors have asked us about EM politics, save for the occasional question about Brazil. However, the two Asian giants - China and India - are both a source of risk: the first a downside, left-tail risk and the second an upside, right-tail risk. China: What Comes After The Party Congress This Fall? Since 2013, we have been outspoken in our low expectations for China's structural reforms.5 This view was confirmed with a series of stimulus efforts that displaced reforms, including the local government debt swap program in 2014 and extensive fiscal and monetary easing in 2015 and especially 2016.6 The upside of weak reforms was better-than-expected growth in the short run, as stimulus took effect. Indeed, China has pulled off a remarkable economic turnaround since early last year: infrastructure and housing investment have increased, the weaker yuan has boosted exports, and the global recovery in commodity prices has helped producer prices to recover, easing deflationary pressures (Chart 7). Chart 7Deflationary Pressures Easing Deflationary Pressures Easing Deflationary Pressures Easing Chart 8Stimulus Dropped Off Stimulus Dropped Off Stimulus Dropped Off Accordingly, Chinese policymakers, who are attempting to strike a balance between stimulus and restructuring, have begun leaning against the economy's gathering momentum. Government spending has collapsed now that a 6.5% GDP growth "floor" has been established (Chart 8). A new round of property market regulatory tightening began last fall, though it has had little impact so far. Also, the People's Bank of China has begun draining some liquidity (Chart 9). Signals coming out of the "Two Sessions" over the past two weeks, namely the National People's Congress, suggest that the Chinese leadership is content with the current state of affairs. Policymakers set their growth targets for 2017 a little lower than last year's targets and a little higher than last year's actual performance (Table 2).7 It is a line so thin that it is almost imperceptible. They do not want significant change. Chart 9PBoC Draining Liquidity PBoC Draining Liquidity PBoC Draining Liquidity Table 2China's Economic Targets For 2017 China Down, India Up? China Down, India Up? This stance fits with a deeper desire to keep the economy on an even keel during a pivotal year for Chinese politics. The legislative session took place under the shadow of the Communist Party's impending 19th National Party Congress - the "midterm" meeting of the party that happens every five years and features extensive promotions, rotations, and retirements for the party leadership. This year's congress promises to be especially influential because of Xi Jinping's ascendancy and the fact that around 70% of the upper tier of leaders will be replaced. Chart 10, which we have been showing clients over the past year to dampen expectations of stimulus, reveals that the party congress is not normally an excuse to throw open the floodgates of credit and government spending. Rather, it is a reason to avoid anything that might rock the boat, whether stimulus or reform. Chart 10Not Much Evidence Of Aggressive Stimulus Ahead Of Five-Year Party Congresses Not Much Evidence Of Aggressive Stimulus Ahead Of Five-Year Party Congresses Not Much Evidence Of Aggressive Stimulus Ahead Of Five-Year Party Congresses Thus while government spending has declined, it should be expected to rise again if growth slows down too much for too long. There may be a period of slowdown and market jitters before the leaders reach for the fiscal lever again, but the "Socialist Put" remains in place. Meanwhile, we are not surprised that structural reforms continue to suffer. It is not that China has eschewed all reforms but rather that its reforms have focused on centralizing power for the ruling party and alleviating some outstanding social grievances. These are positive in themselves but they do not address the key concerns of foreign investors relating to economic openness, financial stability, and the role of the state. The recent imposition of capital controls and a host of non-tariff barriers in the name of "state security" exemplify a negative trend. The delayed rollout of the property tax is also a sign of Beijing's proclivity to delay policies that may be financially risky.8 And Beijing has only tentatively attempted to cut back state-owned enterprises. Simply put, a push to overhaul any significant sector or sub-sector does not fit Beijing's priorities at the moment. However, if growth, debt, or asset prices should climb too rapidly, then we expect countermeasures to tamp them down. Even on the geopolitical front - where we have a high conviction view that tail risks to financial markets are higher than the market perceives them to be, both in China and the broader Asia Pacific - there have been some signs of the U.S. and China playing ball on a shared desire for "stability," at least for the moment.9 While we expect a negative geopolitical shock, the market will only believe it when it sees it. All of the above suggest that China will focus on "maintaining stability" this year even more than usual due to the party congress. This is clearly bullish, especially given improving U.S. and global growth. However, the mantra of "stability" and "party congress" should not prevent investors from looking beyond October or November of this year. Chart 11China Needs More##br## Credit For Same Growth China Down, India Up? China Down, India Up? Chart 12China Gets Old ##br##Before It Gets Rich China Gets Old Before It Gets Rich China Gets Old Before It Gets Rich Even assuming that China experiences no significant internal or external economic shocks from now until this fall, it is important to remember that China's growth potential is still slowing for structural reasons. Productivity is collapsing and credit dependency is rising (Chart 11). The slowdown stems from deep shifts such as the end of the debt supercycle in the U.S. (weak external demand), the tipping point in Chinese demographics (higher dependency ratio) (Chart 12), and the extremely rapid build-up in corporate debt (Chart 13). Chart 13Corporate Debt Skyrockets Corporate Debt Skyrockets Corporate Debt Skyrockets Chart 14As Good As It Gets As Good As It Gets As Good As It Gets This is what leads our colleague Mathieu Savary, of BCA's Foreign Exchange Strategy, to surmise that China is at the peak of its current economic mini-cycle. This is "as good as it gets," as he shows in Chart 14. Barring a situation in which Xi somehow fails to consolidate power at the party congress, the market impact will depend on which of two scenarios follows: First scenario: Xi achieves a dominant position in all party and state organs, yet 2018 sees a continuation of the current pattern of mini-cycles of stimulus, lackluster reform, and foreign policy aggressiveness. Xi implicitly deems the strategic cost of reform too great, as we argued he would do over the past four years, and dedicates his stint in office to the accumulation of power. Perhaps a successor will be able to use these powers to enact painful reforms in the mid-2020s; that is not Xi's immediate concern. This is short-term bullish for global and Chinese growth, long-term bearish for Chinese assets. Second scenario: Xi achieves a dominant position and uses his power to reinvigorate the country's stalled reforms. Hints of big measures emerge in the wake of the party congress in November or December, and January 2018 begins with a bang. This would necessarily mean that Xi accepts slower growth, or even that he imposes it through tighter fiscal policy, real credit control, SOE failures, and aggressive overcapacity cuts. However, Chinese productivity would begin to recover. This is short-term bearish for Chinese and global growth. However, it is the most bullish outcome for the long-term performance of Chinese assets. In China's current state - with capital controls newly reinstituted (Chart 15), Xi lauding the "central role" of SOEs in development, and Xi's administration still focused on purging the party and controlling the media - the second scenario admittedly seems far-fetched. Chart 15Are Capital Controls Working? Are Capital Controls Working? Are Capital Controls Working? Moreover, Xi seems averse to risky experiments at home that could weaken the country in the face of unprecedented strategic threats from the United States and Japan. Nevertheless, a 2018 reform push should not be dismissed out of hand. Why? Because an overbearing state, credit excesses, and weak productivity really do threaten the sustainability of the Chinese economy and hence the Communist Party's grip on power. Xi must keep them in check, as the current gestures toward tighter policy indicate. The government has overseen a massive monetary and credit expansion to protect the country from faltering external demand since 2008. As the current account surplus has declined, the country's massive savings have built up at home in the form of debt (Chart 16).10 Yet the investment avenues are restricted by the role of the state. As a result, the inefficient state-supported sector is getting propped up while the shadow financial sector grows wildly and creates murky systemic risks that are difficult to monitor and control. The PBoC has undertaken further extraordinary actions to keep financial conditions loose (Chart 17). Chart 16Savings Invested At Home Savings Invested At Home Savings Invested At Home Chart 17PBoC Lends A Helping Hand PBoC Lends A Helping Hand PBoC Lends A Helping Hand What signposts should investors watch for to see which path Xi will take after the party congress? Jockeying ahead of the party congress: The latest NPC session saw some political maneuvering. Several sixth generation leaders made appearances and spoke to media.11 Xi's supposed favorite, Chen Min'er, Party Secretary of Guizhou, distinguished himself by cutting reporters short at a press conference. Meanwhile former President Hu Jintao appeared publicly alongside his apprentice, Hu Chunhua, Party Secretary of Guangdong. Elite party gatherings in the summer, especially any retreat at Beidaihe, should be watched closely for any clues of who may be up and who down, and what general policy trajectory may be forthcoming. Xi's future: First, will Xi Jinping and Li Keqiang establish clear successors for their top two positions in 2022?12 A failure to do so will suggest that Xi intends to stay in power beyond his de facto term limit of 2022. This would mean that Xi will prioritize his own future over painful structural reforms. On the other hand, a clear commitment to a leadership transition in five years may re-focus the Xi-Li administration towards their initial commitment to economic restructuring. National Financial Work Conference: This conference is held every five years, usually connected with a major new financial reform or regulatory push, and due sometime in 2017. The government is looking into serious changes to financial regulation - including the creation of a super-ministry to house the various regulatory agencies. This, or the broader attempt to ensure adequate capitalization of banks, could be behind the delay. New central banker: Central bank governor Zhou Xiaochuan, in office since 2002, may step down this fall. He could be replaced with another technocrat to little fanfare, but his exit introduces the opportunity for shaking up the PBoC regime as a whole. Other new officials: A slew of other appointments and reshuffles will take place this year as a generation of leaders born before the Revolution retires. A new director of the state economic planner, the National Development and Reform Commission, was just named, while late last year a new finance minister took his post. These officials have yet to make their mark. Their statements should be watched closely for any shifts in economic policy emphasis. Time frames for reforms: The market is still waiting for concrete proposals and time frames for major reform initiatives, particularly opening up to foreign competition and restructuring state-owned enterprises. Overcapacity cuts have also had mixed results. We do not expect major advances on big structural reforms this year due to the party congress, but details that can be gleaned about the process and timetables could be important. Bottom Line: Watch for signs of a renewed reform drive after the nineteenth National Party Congress. Xi is not going to reverse what he has done so far. And China is not going to become a market economy on the ideal western model. But a pivot point could be in the cards next year for China to pursue some pro-efficiency reforms that it has already set out for itself in a more resolute way. Xi's decision to stay in power beyond 2022 would be bearish for reforms as it would incentivize the current "Socialist Put" model of policymaking over a genuine paradigm shift. India: What Comes After Modi's Big Win? Prime Minister Narendra Modi has won a crushing victory in India's most populous state, Uttar Pradesh, positioning himself, his Bharatiya Janata Party (BJP), and National Democratic Alliance (NDA) coalition very well for the 2019 general elections. Policymaking is going to become easier for the ruling party - though there are still serious political and economic constraints. We have been long Indian equities relative to EM equities since the "Modi wave" began with Modi's victory in the Lok Sabha or lower house in 2014.13 The end of the commodity bull market signaled an opportunity for India, which imports about a third of its energy. The decline of global trade also heralded the outperformance of domestic demand-driven economies like India. Further, Modi's sweeping victory held out the promise for a reform agenda of tighter monetary and fiscal policy that would reduce inflation and make room for private investment to grow. This would make Indian risk assets attractive, especially relative to other EMs, which were at that time either lagging at reforms or failing to undertake them entirely. Since then we have seen Modi rack up a key legislative victory - the passage of the Goods and Services Tax, in the process of implementation - and engineer a surprise "demonetization" effort late last year to increase bank deposits, bring the country's gray markets into the open, and flush out crime and corruption.14 The ruling coalition's gains in Uttar Pradesh and a few other state elections this year are a striking vindication of popular support after this highly unconventional and controversial maneuver.15 Uttar Pradesh is the most important of these elections. It was slated to be a grand testing ground for Modi well before demonetization. It is the most populous Indian state, with about 200 million people, and the third largest state economy (producing about 10% of GDP). It is the second-poorest state, with a GDP per capita of about $730, it has the highest proportion of "scheduled castes" (untouchables), and ranks around the middle of states in terms of the Hindu share of population - all challenges for the landed, pro-business, Hindu nationalist BJP (Map 1). Politically, aside from its inherent heft in population and centrality, Uttar Pradesh sends the most representatives of any state to India's upper house (31 seats), the Rajya Sabha, where Modi lacks a majority. It is thus a key source of federal power and an important state ally. Map 1Modi's Saffron Wave Takes The Indian Core China Down, India Up? China Down, India Up? Given the above, it is hugely bullish that Modi's BJP romped to a historic victory in the state election, winning 312 out of 403 seats (about 39.7% of the vote), up from 47 seats previously. His coalition rose to 324 seats total (Chart 18). The BJP now has the largest majority of any party in the state since 1980. These results were not anticipated. A close election was predicted and opinion polls had BJP winning 157 seats, short of the 202 needed for a majority. This was only slightly ahead of its closest rival, an alliance made up of the local Samajwadi Party and its national partner, the left-leaning Indian National Congress (INC). Exit polls even suggested that the Samajwadi-INC coalition had edged ahead of the BJP. The immediate takeaway is that Modi will have better luck governing Uttar Pradesh itself now that the state government is on his side. Individual states hold the key to reform in India because of the country's size and socio-economic disparities. The state will now be expected to implement Modi's policies faithfully and push approved policies forward on its own. The second takeaway is that while Uttar Pradesh will not give Modi control of India's upper house of parliament, the Rajya Sabha, it will give him a better position there. The BJP has 56 seats in the upper house (fewer than the INC's 59), and the ruling coalition has 74, out of a total of 250. The coalition needs 52 seats for a simple majority. Uttar Pradesh will deliver 10 seats at most by the 2019 general election. Modi would have to win almost every seat of the 56 non-allied seats coming open between now and 2019 in order to win the upper house by that time (Chart 19). That is unlikely, but Modi is moving in the right direction and an upper-house majority cannot be ruled out in the long run. Chart 18Modi's Big Win In Uttar Pradesh China Down, India Up? China Down, India Up? Chart 19Modi's National Position Improves China Down, India Up? China Down, India Up? Of course, Modi has already shown with the Goods and Services Tax that he can pass very difficult legislation through the upper house without controlling a majority there. This achievement last year was perhaps an even greater surprise than the victory in Uttar Pradesh, which reinforces it. Modi also has a secret weapon: in case of a national emergency, however defined, he can call a joint session of parliament, where his coalition would carry the day. This is now more likely because it is the Indian president who is responsible for calling a joint session, and Modi is now more likely to get his candidate into that position due to the win in Uttar Pradesh. President Pranab Mukherjee, who is affiliated with the INC, will step down on July 25. Though Modi does not have all the votes in the electoral college to choose the president outright, smaller parties may fall in line now that the BJP has so much national momentum.16 Controlling the presidency will also give Modi greater influence over constitutional obstacles and gradually over the legal system. Separately, in August, Modi's alliance will be able to choose the vice president as well. More broadly, the Uttar Pradesh election marks a victory for Modi's style of appealing to voter demand for greater economic development as a general priority over longstanding religious and caste grievances that frequently determine electoral outcomes in state elections. This is a hugely significant indication for India's economic structural reform and nation building. Bottom Line: Modi's victory in Uttar Pradesh is proof that for all of India's sprawling inefficiencies, its political system is capable of responding to the large public demand for economic development. Do not underestimate reform momentum now. Modi's political capital remains high. Investment Conclusions The conventional wisdom has for decades been that China is better at reforming its economy because of its authoritarian regime, whereas India democratized too early and has thus lagged at reforms. We have never agreed with this simplistic view of economic reforms. Structural reforms are always and everywhere painful. As such, they require political capital. As our "J-Curve of Structural Reforms" posits, reforms deplete political capital as the pain spreads through the economy and opposition mounts among both the elite and the common man (Chart 20). Eventually, the government is faced with a "danger zone" in which the pain of reforms lingers, the benefits remain beyond the horizon, and all political capital is exhausted. Many leaders chose to water down the reforms, or back off from them altogether, at this point. Chart 20The J-Curve Of Structural Reform China Down, India Up? China Down, India Up? On the surface, authoritarian regimes have massive political capital with which to burst through the danger zone of reform. But this assumption is not entirely correct. In China's case, the political capital for reform came after disastrous performances by the "conservative" political forces. Reformers in China were buoyed by the failures of the "Cultural Revolution" (which ended in 1976) and the 1989 Tiananmen Square protests. Each political and social crisis gave the reformers an opening - following a consolidation period - to pursue controversial economic reforms at the expense of "conservative" forces. The fruit of these reform efforts has been the growth of China's middle class. And while this middle class expects reforms in the delivery and quality of public services, it is not interested in seeing a slowdown in economic growth, no matter how temporary or healthy it may be. As such, Chinese leaders are faced with a significant hurdle to their reform preference: how to convince the public that a slowdown is needed in order to restructure the economy. We are unsure whether the upcoming party congress will make a difference. However, we can see a scenario where President Xi decides to pursue market-friendly reforms because he sees an increase in his political capital. In particular, he may feel that he has cemented his personal dominance over his intra-party rivals and that the aggressive foreign and trade policy emanating from the Trump White House gives him a foil to blame for any downturn in growth. Reform would also be a return to Xi's original agenda, and would conform to the playbook of former president Jiang Zemin, whose precedents Xi has followed in some other areas. Given Xi's modus operandi, a post-consolidation reform drive would be executed relatively effectively and would therefore present short-term risks to Chinese and hence global growth, despite the long-term improvement. Markets are definitely not expecting such a policy pivot at the moment. China bulls are content with the current reforms, while China bears see no chance of the Xi administration changing tack. While we are just beginning to see the potential for a turn in Chinese policymaking towards reforms, India is a much clearer example of a reformist administration. Modi will feel empowered by the Uttar Pradesh election, a political recapitalization of sorts. Foreign investment will likely continue cheering Modi's ongoing revolution (Chart 21). The question now is whether Modi intends to use the infusion of political capital for genuine reforms. After all, the economy is not looking up (Chart 22). Chart 21Foreign Investors Cheer On Modi Foreign Investors Cheer On Modi Foreign Investors Cheer On Modi Chart 22Indian Economy Still Weak Indian Economy Still Weak Indian Economy Still Weak The evidence is mixed. First, Modi has not maintained strictness on fiscal spending and the budget deficit is creeping back to where it was when he took over the reins (Chart 23). Rising government spending along with higher commodity prices suggest that inflation will continue making a comeback (Chart 24). Poor food production is also driving up inflation. And higher spending and inflation pose a key threat to the sustainability of the reform agenda, since rising government bond yields will crowd out private investment. Chart 23Losing Budgetary Discipline? Losing Budgetary Discipline? Losing Budgetary Discipline? Chart 24Inflation Makes A Comeback Inflation Makes A Comeback Inflation Makes A Comeback Second, the RBI will be less likely to pursue a tighter monetary policy with both political influence and weak growth pressing on it. Moreover, Indian stocks are not all that cheap. In 2014, valuations were favorable and the backdrop included cheap commodities, fiscal prudence, and Modi's electoral success. Today, India is trading at its historical mean relative to EM (Chart 25), but using the equal sector weighted P/E ratio, by which India was very cheap back in 2014, India is at a 52% premium now (Chart 26). Chart 25Indian Stocks Trading##br## At Mean Against EM Indian Stocks Trading At Mean Against EM Indian Stocks Trading At Mean Against EM Chart 26Indian Stocks Pricey##br## Versus EM Sector-Weighted Indian Stocks Pricey Versus EM Sector-Weighted Indian Stocks Pricey Versus EM Sector-Weighted We are therefore taking this opportunity to close our long India / short EM trade for a 28% gain (since May 2014). We will reassess Modi's structural reform priorities in future research and gauge whether a new entry point is warranted. We remain optimistic on India in the long run as Modi certainly has the political capital for reforms. The question is whether he plans to use it. Meanwhile, we remain skeptical about China's long-term trajectory. To become fully optimistic about Chinese risk assets in absolute terms, we need to see the Xi administration chose short-term pain for long-term gain. For the time being, China continues to repress its structural problems rather than deal with them head on, relying on minimal openness, high and rising leverage, and state-owned banks and companies. India may be lagging in its reform effort, but it has at least established market reforms as a priority. And the Modi administration has built political capital through the slow and painful democratic process. Over the long term, India's approach is more sustainable. If President Xi wastes the opportunity afforded to him by the upcoming party congress, we suspect that China will face a much higher probability of left-tail economic risks than India over the long term. Matt Gertken, Associate Editor mattg@bcaresearch.com Marko Papic, Senior Vice President marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 Please see BCA U.S. Investment Strategy Weekly Report, "How Expensive Are U.S. Stocks?," dated March 13, 2017, available at usis.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 4 Please see BCA Emerging Markets Strategy and Geopolitical Strategy Special Report, "Russia: Entering A Lower-Beta Paradigm," dated March 8, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Reflections On China's Reforms," dated December 11, 2013, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com, and "China: The Socialist Put And Rising Government Leverage" in Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 7 Please see BCA China Investment Strategy, "Messages From The People's Congress," dated March 9, 2017, available at cis.bcaresearch.com. 8 Please see Chong Koh Ping, "No plans for NPC to discuss property tax," Straits Times, March 5, 2017, available at www.straitstimes.com. 9 Please see BCA Geopolitical Strategy Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 10 Please see BCA Global Investment Strategy Weekly Report, "Does China Have A Debt Problem Or A Savings Problem?" dated February 24, 2017, available at gis.bcaresearch.com. 11 China's leadership is typically referred to in terms of "generations," with Mao Zedong and his peers the first generation, Deng Xiaoping and his cohort the second, Jiang Zemin the third, Hu Jintao the fourth, and Xi Jinping the fifth. The fifth generation was born in the early 1950s, the sixth generation was born in the early 1960s. 12 Xi may tweak retirement norms to let close allies, like Wang Qishan, the anti-graft attack dog, stay on the Politburo Standing Committee. This might also suggest that Xi himself intends to overstay his age limit in 2022. 13 Please see Geopolitical Strategy Special Report, "Long Modi, Short Jokowi," dated August 28, 2014, available at gps.bcaresearch.com, and Emerging Markets Strategy Special Report, "Long Indian / Short Indonesian Stocks," dated July 30, 2014, available at ems.bcaresearch.com. 14 Please see "India: Demonetization And Opportunities In Equities," in Emerging Markets Strategy Weekly Report, "EM: Untenable Divergences," dated December 21, 2016, available at ems.bcaresearch.com. 15 Though the mixed results also indicate persistent regional differences. Modi's coalition won seats in Uttarakhand and Manipur but lost them in Goa and Punjab. Gujarat, Modi's home state, will hold elections later this year. Himachal Pradesh will also vote this year and will be a subsequent testing ground. 16 Please see Gaurav Vivek Bhatnagar, "BJP Sweep in UP Will Impact Decision on President, Rajya Sabha Numbers," The Wire, March 12, 2017, available at https://thewire.in/116044/bjp-sweep-will-impact-decision-president/

Highlights The U.S. dollar will continue to appreciate while the RMB will depreciate further. This is a bad omen for EM risk assets, commodities, and global late cyclical equity sectors. Gold often leads oil and copper prices. Investors should heed the current downbeat message from gold. EM credit spreads have become detached from fundamentals and are unreasonably tight. Continue overweighting the Indian bourse within an EM equity portfolio. A new equity trade: long Indian software stocks / short the EM overall index. Feature There are several major discrepancies in financial markets that in our view are unsustainable. 1. The gap between EM equity breadth, USD, RMB and EM share prices One way to measure equity market breadth is to compare performance of equal-weighted versus market cap-weighted stock price indexes. Based on this measure, EM stock market breadth has been deteriorating. Poor breadth often heralds a major selloff (Chart I-1). Chart I-1Poor EM Equity Breadth Heralds A Major Selloff Poor EM Equity Breadth Heralds A Major Selloff Poor EM Equity Breadth Heralds A Major Selloff Remarkably, the same measure for the U.S. stock market shows improving breadth. The relative performance of equally-weighted EM stocks against U.S. equity indexes - a measure of breadth in relative performance - can also be a reliable marker for the relative performance of market cap-weighted indexes. It has plummeted to a new low pointing to new lows in EM versus U.S. relative share prices. In addition, a surging U.S. dollar has historically meant lower EM share prices (Chart I-2). We doubt this time is different. Finally, EM risk assets have decoupled from the RMB/USD exchange rate as well. The RMB has been depreciating and China's domestic corporate and government bond yields have spiked. As a result, the on-shore bond prices in RMB terms have plummeted (Chart I-3). Chart I-2A Rising U.S. Dollar Is ##br##A Bad Omen For EM A Rising U.S. Dollar Is A Bad Omen For EM A Rising U.S. Dollar Is A Bad Omen For EM Chart I-3China's On-Shore Corporate Bond##br## Prices Have Crashed bca.ems_wr_2016_12_21_s1_c3 bca.ems_wr_2016_12_21_s1_c3 Experiencing considerable losses on their favorite financial investment of the past year, bonds, Chinese investors, as well as households and companies, could opt to switch into U.S. dollars. The stampede into the U.S. dollar could start as early as January when the annual US$ 50,000 quota per person becomes available. It is hard to see what the government will do to preclude this rush and massive flight towards U.S. dollars. In China, households' and corporates' RMB deposits in the banking system amount to RMB 122 tn or US$17.5 tn. Hence, the PBoC's foreign exchange reserves including gold at US$ 3.2 tn are only equal to 18.5% of these deposits at the current exchange rate. Bottom Line: The U.S. dollar will appreciate and the RMB will depreciate. This is a bad omen for EM share prices and other risk assets. 2. Oil and copper prices deviating from gold prices Historically, when gold and oil prices have diverged, gold in most cases has proven more forward looking, with oil prices ultimately converging toward gold prices. Chart I-4A and Chart I-4B illustrate past episodes of gold and oil decoupling (in the 1980, 1990s and 2008), each of which were resolved via oil prices gravitating toward gold prices. Chart I-4AGold Led Oil Prices bca.ems_wr_2016_12_21_s1_c4a bca.ems_wr_2016_12_21_s1_c4a Chart I-4BGold Led Oil Prices Gold Led Oil Prices Gold Led Oil Prices In short, if history is any guide, the current gap between gold and oil prices will likely close via lower oil prices (Chart I-5, top panel). The same holds true for the recent divergence between gold and copper prices (Chart 5, bottom panel). We identified four historical periods when gold and copper prices diverged. In each case, it was copper prices that amended their trajectory and aligned with the direction of gold prices (Chart I-6A and 6B). Chart I-5Divergence Between Oil, Copper And Gold Divergence Between Oil, Copper And Gold Divergence Between Oil, Copper And Gold Chart I-6AGold Led Copper Prices Too bca.ems_wr_2016_12_21_s1_c6a bca.ems_wr_2016_12_21_s1_c6a Chart I-6BGold Led Copper Prices Too bca.ems_wr_2016_12_21_s1_c6b bca.ems_wr_2016_12_21_s1_c6b In sum, historically there have been a number of episodes when gold has led both oil and copper prices. Investors should heed the current downbeat message from gold. Chart I-7China: Dichotomies bca.ems_wr_2016_12_21_s1_c7 bca.ems_wr_2016_12_21_s1_c7 The underlying rationale could be that gold responds to monetary/liquidity conditions (gold is very sensitive to U.S. TIPS (real) yields) while oil and copper are more sensitive to growth conditions. Tightening in monetary/liquidity conditions often precedes a growth relapse. This could be the reason why gold has led oil and copper prices on several occasions in the past. 3. Dichotomies in China's industrial economy There are two types of dichotomies underway within China's industrial economy: The first is between industrial activity and industrial commodities prices. Commodities prices have surged, but the pace of manufacturing production has not improved at all (Chart I-7). There have been major discrepancies among various segments of China's industrial economy, with utilities surging and the technology sector remaining robust, and many others stagnating. The decoupling between industrial activity and industrial commodities prices can be explained by financial speculation and supply cutbacks. The former is unsustainable, while the latter is reversing as the government is gradually lifting restrictions on supply for coal and steel. The second is between the private- and state-owned parts of the industrial sector. The state-owned segment has experienced a meaningful improvement in output, while private companies in the industrial sector have seen their output growth weaken, albeit the growth rate is higher than in the SOE sector. (Chart I-7, bottom panel). As China's fiscal and credit impulses wane,1 activity in the state-owned industrial segment will relapse anew. 4. EM credit spreads diverging from EM currencies and credit fundamentals EM sovereign and corporate credit spreads (credit markets) are once again proving very resilient, despite the renewed selloff in EM currencies (Chart I-8). EM credit markets have defied deteriorating EM credit fundamentals in the past several years. Below we identify several divergences and anomalies within the EM credit space that give us confidence that EM credit markets have become detached from fundamentals, and that their risk-reward profile is poor. Chart I-8EM Credit Markets And EM Currencies:##br## A Widening Dichotomy EM Credit Markets And EM Currencies: A Widening Dichotomy EM Credit Markets And EM Currencies: A Widening Dichotomy Chart I-9EM Corporate Financial Health:##br## Not Much Improvement bca.ems_wr_2016_12_21_s1_c9 bca.ems_wr_2016_12_21_s1_c9 The EM Corporate Financial Health (CFH) Indicator has stabilized, but remains at a very depressed level (Chart I-9, top panel). This amelioration is largely due to the profit margin component. The other three components have not improved (Chart I-9, second panel). The valuation model based on the EM CFH indicator shows that EM corporate spreads are far too tight (Chart I-10). Chart I-10EM Corporate Bonds Are Expensive EM Corporate Bonds Are Expensive EM Corporate Bonds Are Expensive The strong performance of EM credit markets in recent years has been justified by the persistence of low bond yields in developed markets (DM). Yet the latest spike in DM bond yields has so far not caused EM credit spreads to widen. We expect U.S./DM government bond yields to rise further, and the U.S. dollar to continue to strengthen. This, along with potential broad-based declines in commodities prices, should lead to material widening in EM sovereign and corporate credit spreads in early 2017. With respect to unsustainable discrepancies, the case in point is Brazil. The country's sovereign and corporate spreads have tightened a lot this year, even though economic activity continues to shrink. The country has had numerous boom-bust cycles in the past 100 years, yet this depression is the worst on record. In fact, the nation's economic growth and public debt dynamics are worse than at any time during the past 20 years. Yet, at 300 basis points, sovereign spreads are well below the 1000-2500 basis point trading range that prevailed in the second half of 1990s and early 2000s (Chart I-11). Remarkably, the economy's pace of contraction has lately intensified (Chart I-12). This will likely worsen government revenues and lead to further widening in the fiscal deficit - making debt dynamics unsustainable. Another absurd credit market divergence is between China's sovereign CDS and Chinese offshore corporate spreads. Sovereign CDS spreads have been widening, but corporate credit spreads remain very tight (Chart I-13). Chart I-11Brazil: Dichotomy Between Sovereign ##br##Spreads And Fundamentals Brazil: Dichotomy Between Sovereign Spreads And Fundamentals Brazil: Dichotomy Between Sovereign Spreads And Fundamentals Chart I-12Brazil's Economy: ##br##No Improvement At All Brazil's Economy: No Improvement At All Brazil's Economy: No Improvement At All Chart I-13Chinese Sovereign CDS And ##br##Off-Shore Corporate Spreads Chinese Sovereign CDS And Off-Shore Corporate Spreads Chinese Sovereign CDS And Off-Shore Corporate Spreads Yet there is much more risk in Chinese corporates than in government debt. The corporate sector commands record leverage of 165% of national GDP, while public debt stands at 46% of GDP. Besides, the central government in China will always have immediate access to domestic or foreign debt markets, while some corporations could lose access to financing if creditors question their creditworthiness and decide to tighten credit. There is no rational case to support the rise in sovereign CDS when corporate spreads are tame. The only feasible explanation is that investors - who are invested in Chinese corporate bonds, and are not interested in selling them - are buying sovereign CDS to tactically hedge their credit exposure. If and when market sentiment sours sufficiently, and credit spread widening is perceived durable and lasting, real money will sell corporate bonds, resulting in a major spike in corporate spreads. 5. Divergence between global late cyclicals and the U.S. dollar Another area where we detect that financial markets have lately become overly optimistic is in global late cyclicals - materials, machinery and energy stocks. Typically, the absolute share prices in these sectors correlate with the U.S. dollar exchange rate but they have lately diverged (Chart I-14). Furthermore, global machinery stocks in general, and Caterpillar's share price in particular, have lately staged significant gains, while their EPS and sales continue to plunge (Chart I-15). Notably, Caterpillar's sales have not improved, even on a rate-of-change basis. Chart I-14Global Late Cyclicals And The U.S. Dollar: ##br##Unsustainable Decoupling Global Late Cyclicals And The U.S. Dollar: Unsustainable Decoupling Global Late Cyclicals And The U.S. Dollar: Unsustainable Decoupling Chart I-15Global Machinery Sales And##br## Profits Continue Plunging Global Machinery Sales And Profits Continue Plunging Global Machinery Sales And Profits Continue Plunging EM including China capital spending in real terms is as large as the U.S. and EU capital spending combined (Chart I-16). If the EM and China capex cycle does not post a recovery, which is our baseline view, it will be hard for global late cyclical stocks to continue rallying based solely on the positive outlook for U.S. infrastructure spending and potential U.S. tax reforms. In short, global late cyclicals such as machinery, materials and energy stocks that performed quite well in 2016 are vulnerable to a major pullback as EM/Chinese capital spending disappoints on the back of credit growth deceleration. Notably, these global equity sectors have reached a major technical resistance that will likely become a ceiling for their share prices (Chart I-17). Chart I-16EM/China's Capex Is As Large As ##br##U.S. And Euro Area Combined EM/China's Capex Is As Large As U.S. And Euro Area Combined EM/China's Capex Is As Large As U.S. And Euro Area Combined Chart I-17Global Late Cyclicals Are ##br##Facing Technical Resistance Global Late Cyclicals Are Facing Technical Resistance Global Late Cyclicals Are Facing Technical Resistance 6. Decoupling between the South African rand and precious metals prices The South African rand's recent resilience - despite the considerable drop in precious metal prices - is unprecedented (Chart I-18, top panel). Similarly, the rand has also decoupled from the exchange rate of another major metals producer: Australia (Chart I-18, bottom panel). We cannot think of any reason why these discrepancies can or should persist. Rising global bond yields and a broadening selloff in commodities prices should hurt the rand. In fact, the trade-weighted rand is facing a major technical resistance (Chart I-19) and will likely relapse sooner than later. Chart I-18Rand, AUD And ##br##Precious Metals Rand, AUD And Precious Metals Rand, AUD And Precious Metals Chart I-19Trade-Weighted Rand Is ##br##Facing Technical Resistance Trade-Weighted Rand Is Facing Technical Resistance Trade-Weighted Rand Is Facing Technical Resistance We reiterate our structural short position in the rand versus the U.S. dollar, and on October 12, 2016 initiated a short ZAR / long MXN trade. Traders should consider putting on these trades. Investment Strategy Chart I-20EM Relative Equity Performance ##br##Is Heading To New Lows EM Relative Equity Performance Is Heading To New Lows EM Relative Equity Performance Is Heading To New Lows Emerging markets share prices and currencies have been doing poorly since October, despite U.S. equity shares breaking out to new highs. In fact, almost all relative outperformance has been wiped out (Chart I-20). BCA's Emerging Markets Strategy team expects further declines in EM share prices and currencies, as well as a selloff in domestic bonds and a widening of sovereign and corporate spreads. Absolute return investors should stay put, while asset allocators should maintain underweight positions in EM risk assets within respective global portfolios. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com India: Demonetization And Opportunities In Equities On November 8, India launched a demonetization program with the goal of removing the two most used banknotes - the 500 INR and 1000 INR banknotes - from circulation. Both banknotes accounted for roughly 85% of currency in circulation, which itself accounts for 13% of India's broad money supply. Moreover, almost 90%2 of retail transactions in India are cash-reliant. While around INR 13 trillion of notes (US$ 190 billion) have been deposited in the banking system as of December 10, only INR 5 trillion of new notes have been issued by the Reserve Bank of India (RBI). India is unlikely to turn cashless overnight. According to a Harvard Business Review article,3 less than 10% of Indians have ever used non-cash payment instruments. Likewise, less than 2% of Indians have used a cellular phone to receive a payment. This implies cash shortages could persist for a while and will have a significant impact on short-term economic activity. There are numerous reports that layoffs and business shutdowns have ensued in several industries, particularly in the informal economy (Chart II-1). The service sector PMI already dipped below 50 in November and the manufacturing PMI fell as well (Chart II-2). Chart II-1Very Weak Employment Outlook Very Weak Employment Outlook Very Weak Employment Outlook Chart II-2Indian PMIs Are Sinking Indian PMIs Are Sinking Indian PMIs Are Sinking Having boomed over the past year, motorcycle sales growth is now waning. Similarly, passenger and commercial vehicle sales - that have been anemic - will now dip. However, the consumption slowdown should not continue beyond the next couple of months. As more currency is supplied by the RBI, economic activity will rebound - particularly household spending. Pent-up demand will be unleashed as money circulation is restored. Nevertheless, investment expenditures are the key factors for improving productivity and, hence, as non-inflationary growth potential. Capital spending had been anemic in India well before the demonetization program was announced (Chart II-3). The reason for such lackluster investment expenditure lies in the fact that past investment projects taken on by highly leveraged Indian conglomerates have delivered poor performance. This translated into ever rising non-performing loans (NPLs) at state banks. Without debt restructuring and public bank recapitalization, a new capex cycle is unlikely in India. Consistently, credit to large industries is now contracting (Chart II-4) and foreign lending to Indian companies is declining. Chart II-3Indian Capex Is Anemic Indian Capex Is Anemic Indian Capex Is Anemic Chart II-4Banks Prefer Consumers bca.ems_wr_2016_12_21_s2_c4 bca.ems_wr_2016_12_21_s2_c4 We expect the demonetization program to hurt capital spending only mildly in the coming months, but do not expect a material bounce in investment afterward, unlike the one slated for household consumption. Indian share prices have more downside in absolute terms, as the market is still expensive and growth is slumping. Nevertheless, India will likely outperform the EM equity benchmark going forward (Chart II-5). Chart II-5Indian Share Prices: A Tapering Wedge Indian Share Prices: A Tapering Wedge Indian Share Prices: A Tapering Wedge The rationale for our overweight on Indian equities within the EM stock universe is due to the nation's much better macro fundamentals relative to those in many other EM. In particular, deleveraging and NPL write-offs are more advanced, the current account deficit is small, and India will benefit from potentially lower commodities prices. Within the Indian bourse, we recommend overweighting software stocks that will benefit from a revival in advanced economies' growth and a weaker currency. Besides, Indian software stocks are not exposed to the currently weak domestic consumption cycle and in fact might benefit from the push toward digitalization in banking. Bottom Line: Indian consumption will weaken in the coming three months or so, but will rebound thereafter. The capex cycle is weak and will remain subdued. Continue overweighting the Indian bourse within an EM equity portfolio. A new equity recommendation: long Indian software stocks / short the EM overall index. Ayman Kawtharani, Research Analyst aymank@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report, titled "Key EM Issues Going Into 2017," dated December 14, 2016, available at ems.bcaresearch.com 2 Chakravorti, B., Mazzotta, B., Bijapurkar, R., Shukla, R., Ramesha, K., Bapat, D., &Roy, D. (2013). The cost of cash in India. Institute of Business in the Global Context, Fletcher School, Tufts University. 3 Chakravorti, B. (2016, December 14). India's Botched War on Cash. Retrieved from https://hbr.org Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Demand for food in India is growing briskly, yet the agricultural output per capita has not improved at all, and is unlikely to expand meaningfully in the next few years. Food and headline inflation will remain structurally high in India, which will negatively impact savings and investment dynamics in the years ahead. With respect to cyclical growth, household spending is strong, but investment expenditures are stagnant. For now, we maintain our recommendation to overweight the Indian bourse for dedicated EM equity portfolios. We reiterate that fixed-income traders should bet on yield curve steepening in India. A section Brazil's Business Cycle Illustrated is presented starting on page 12. Feature Yesterday, India's central bank cut interest rates by 25 basis points citing the outlook for lower food prices due to the good monsoon season. However, despite the recent pick-up in monsoon rain this year, rainfall is still low by historical standards suggesting any pick up in food production will be timid (Chart I-1). bca.ems_wr_2016_10_05_s1_c1 bca.ems_wr_2016_10_05_s1_c1 As we argue in this report, beyond the impact of weather fluctuations on food production, in the medium- and long-run food supply will fall short of rising demand, and structural food price inflation will stay high. Food accounts for 46% of the CPI basket and headline inflation in India is reasonably correlated with food inflation (Chart I-2). India: Food Prices Are Key To Inflation India: Food Prices Are Key To Inflation Consequently, the medium- to-long term risks to India's inflation are skewed to the upside. In addition, the central bank's new Monetary Policy Committee is decidedly dovish - dominated by people close to Prime Minister Modi's inner-circle. Hence, the Reserve Bank of India (RBI) will likely continue cutting interest rates. Persistent upward pressure on inflation and a dovish central bank warrant a steeper yield curve in India. Growing Food Demand... India's demand for food is growing rapidly due to rising income levels. As a result, pressure is mounting on the agriculture sector to produce more food. Yet, food grain production per capita has not increased at all over the past 15 years (Chart I-3). Rising rural incomes significantly increase food demand because the rural population is under-nourished. In turn, rural income has been rising due to fiscal spending by different levels of government: Although the central government has been tightening its belt, state (local) government expenditures in rural areas and on various welfare programs is skyrocketing, more than offsetting the central government's tight fiscal policy Chart I-4. bca.ems_wr_2016_10_05_s1_c3 bca.ems_wr_2016_10_05_s1_c3 India: Government Spending In Rural Areas Has Boosted Rural Income India: Government Spending In Rural Areas Has Boosted Rural Income   In the meantime, to support farmers' incomes, the central government continues to raise the minimum support prices (MSP) of grains it procures (Chart I-5). Remarkably, state (local) governments have been increasing agriculture subsidies exponentially. These subsidies now make up 1% of GDP. On the other hand, their capital expenditure in agriculture remains dismal (Chart I-6). bca.ems_wr_2016_10_05_s1_c5 bca.ems_wr_2016_10_05_s1_c5 bca.ems_wr_2016_10_05_s1_c6 bca.ems_wr_2016_10_05_s1_c6 These populist policies are poised to continue. The ruling government's priority is to get re-elected in the upcoming elections in Punjab, Uttar Pradesh, and Gujarat. Bottom Line: Rising incomes in general, but in rural areas in particular, has increased food demand while food output per capita has not grown at all in the past 15 years.   ...But Stagnating Agriculture Output India's agriculture supply side remains mired with inefficiencies and stagnating output. Looking forward, there is no chance of a major improvement. As such, the lack of food supply will keep food and headline inflation sticky in the coming years: Per capita food production has not improved at all in the past 15 years. Moreover, India's agriculture yield lags behind countries with similar development levels, such as Bangladesh. India is not investing enough in its agriculture sector, which has kept agriculture productivity very low. Top panel of Chart I-7 shows that agriculture's real capital formation has been shrinking since 2013. Likewise, agriculture unit labor cost has been surging (Chart I-7, bottom panel) Meanwhile, India's irrigation rates remain low. Only 65.3 million hectares of land was irrigated in 2015 (46% of agricultural land), reinforcing the trend of agriculture production being held hostage to volatile monsoon rains (Chart I-1 on page 1). Worryingly, the number of new irrigation projects is declining steeply (Chart I-8, top panel). bca.ems_wr_2016_10_05_s1_c7 bca.ems_wr_2016_10_05_s1_c7 bca.ems_wr_2016_10_05_s1_c8 bca.ems_wr_2016_10_05_s1_c8   The central government has pledged to complete 89 stalled irrigation projects by 2019, which would add an extra 7.6 million hectares of land under irrigation. These projects, however, have been on hold for almost four decades and face cost overruns on the order of 1,350%. The number of total stalled (private and public) projects is still rising (Chart I-8, bottom panel), indicating that it will be very difficult to catch up and complete them. Irrigation techniques are also highly inefficient and wasteful. Reducing government electricity subsidies to farmers - which are encouraging wasteful large-scale pumping - and investing in new irrigation technologies, could be a solution. However, this is politically difficult in India as it threatens ruling governments from getting re-elected. Please see Box I-1 for more information on India's water problems. Box 1 Major Environmental Issues Ahead India is facing major environmental issues. The Himalayan ice caps that feed India's main rivers in the Indus-Ganges plains are melting quickly. This poses a threat to water flows. Monsoon rains are also becoming extremely volatile causing, in turn, episodes of extreme draught or flood which hurts crops. The problem is exacerbated by India's crumbling water infrastructure. The country does not harvest monsoon rain which accounts for 70% of total rain fall. By comparison China harvests five times more rainfall per person. More Signs Of Inefficiencies & Low Productivity India's Public Distribution System (PDS) - which is mandated to distribute food to the poor - is inefficient and largely fails to meet its objective. For instance, 50% of food rations are wasted. Furthermore, the PDS has inclusion and exclusion errors of 70% according to estimates by the Asian Development Bank. This means that many needy Indians are excluded and vice versa. Given that PDS distributes food via ration cards instead of direct cash transfers, many store owners end up selling the subsidized FCI procured food in the black market at a higher prices. The government, along with the RBI, are trying to address these issues by switching to cash transfers and encouraging people to open bank accounts. However, bank penetration rates are low, only around 53%, and 43% of those existing bank accounts are dormant, meaning many of these accounts have no balance to begin with. Moreover, many account holders complain about the interrupted and inconsistent cash transfers and the long waiting lines they have to go through in order to get paid. The Food Corporation of India (FCI), which is responsible for the maintaining and managing PDS, is also at the heart of India's corruption malaise and is an example of how difficult it is to improve the efficiency of India's public corporations. For example, FCI has 370 departmental laborers that are paid more than the President of India. The average salary for an FCI employee (who loads and unloads food sacks) is 80,000 INR per month ($1,200) - eight times higher than what a contractor would be paid for the same work. The government is addressing the issue and recently allowed the FCI to hire contract workers, however, the workers' unions are challenging the decision. A Low Ranking In The Basics The magnitude of India's agriculture problems is daunting. In 2015, India scored worse than Bangladesh and Sri Lanka, as well as Uganda and Tanzania, in the 2015 Global Hunger Index.India has also ranked the lowest among its developing Asian neighbors since 1990 - a period that captures strong structural economic reform and exceptionally robust growth in India. Fertilizer consumption and production trends are also in a dire state. First, consumption of fertilizers is in decline, and a number of fertilizer projects underway are stalling. Meanwhile, the suboptimal composition and application of fertilizers by farmers is eroding soil health and weighing on agriculture productivity. Despite the application of fertilizers, farm yields are not growing enough. Farmers are disproportionately applying nitrogen-heavy fertilizers, as they are cheaper than those that contain more appropriate levels of phosphorus and potassium. These problems mushroomed after the government introduced its nutrient-based subsidy (NBS) scheme in 2010. In an effort to reduce fertilizer subsidies and balance the use of fertilizer and improve soil health, the program deregulated prices of phosphorus and potassium (P&K), but left that of nitrogen controlled. Remarkably, despite the deregulation of P&K prices, Indian production of these fertilizers did not increase and no clear policy to address this phenomenon has been implemented. These are signs that India's agriculture supply side is mired with inefficiencies and low productivity. The outcome will be higher structural inflation in food prices. Agriculture land is also highly fragmented, and discourages economies of scale. For example, 60% of farmers own one to two hectares of land, which accounts for only 33% of cultivated land, while the average size of land holdings has declined from 2.28 hectares in the early 1970s to 1.16 hectares today. Diseconomies of scale hurt productivity and waste a lot of land area that could otherwise be used for agricultural production. India's agricultural operations and distribution procedures are inferior as well. In fact, India produces enough food to cover overall demand, but wastes plenty in storage and distribution. For instance, while its population needs 230 million tons of food, it produces 263 million tons. Food worth some $8.3 billion - 40% of the total value of annual production - is wasted annually. Wasted meat accounts for 4% of total volume of wasted food (20% in value terms), while a whopping 70% of fruits and vegetables produced perish (40% of total value wasted).1 This in turn makes food unnecessarily more expensive and keeps inflation stubbornly high. Moreover, food wastage is not confined to perishables. It is estimated that 21 million tons of wheat rots yearly due to poor harvesting and inadequate infrastructure. There are currently no policies to address food wastage on a large scale. Please see Box I-1 for more information on India's public distribution system. Bottom Line: India's agriculture sector is mired with a number of structural problems that are not improving. Consequently, food inflation and, thereby, headline inflation will remain structurally high. This will in turn discourage savings, keep long-term interest rates higher than otherwise would be, and impede investment spending. An Update On Cyclical Growth Conditions They key question for investors is whether Indian growth is being driven by capital spending or household spending. Consumer stocks are already expensive - consumer staple stocks currently trade at a trailing P/E ratio of 41. Therefore, the equity market has already priced-in a strong consumer and the bullish outlook for Indian equities from now on is contingent on the industrial sector and capital spending. Household-driven growth is not an exciting proposition for India in the long run. The reason being that strong demand in the absence of increased supply will give rise to inflation, a current account deficit, or a combination of the two. Hence, it will prove self-limiting. A review of cyclical data reveals that growth continues to be driven by household consumption while investment spending has not recovered at all: There is little macro data on consumer spending. Available data show that two-wheeler sales are booming, but passenger car sales and commercial vehicle sales are sluggish (Chart I-9A and Chart I-9B). India's Vehicle Sales Level India's Vehicle Sales Level bca.ems_wr_2016_10_05_s1_c9b bca.ems_wr_2016_10_05_s1_c9b   Industrial production continues to stagnate (Chart I-10). More importantly, manufacturing production is contracting (Chart I-10, second panel). Electricity and cement production are strong but are driven by government infrastructure spending. There are few investment outlays from corporates. Consistently, gross fixed capital formation is very weak; imports and output of capital goods corroborate the tepid capex thesis (Chart I-11). India's Industrial Production Continues To Stagnate India's Industrial Production Continues To Stagnate India's Capital Spending Is In Doldrums India's Capital Spending Is In Doldrums   On the money and credit front, narrow money growth is robust, but lending, especially loans to companies, is very depressed (Chart I-12). In brief, consumer loans are booming, yet industrial companies are reluctant to invest. Finally, export and imports are sluggish (Chart I-13). More importantly, external commercial borrowing - foreign borrowing by companies - is shrinking (Chart I-13, bottom panel). Needless to say, this is constraining capital spending. India: Money And Credit India: Money And Credit No Bullish Signals On The External Side No Bullish Signals On The External Side Bottom Line: We reiterate that the pickup in the capex cycle - a precursor for non-inflationary and sustainable growth in India - has not yet occurred.   Investment Conclusions Indian stocks have lately failed to outperform the EM benchmark (Chart I-14). However, for now we maintain our overweight recommendation. India's macro fundamentals are better than those of many other EM countries. Yet high equity valuations and the very slow progress on the structural reform front are risks to India's relative performance. Structural inflationary pressures and odds of easier fiscal policy due to upcoming state elections may warrant a yield curve steepening trade (Chart I-15). Indian Stocks Relative To EM Indian Stocks Relative To EM bca.ems_wr_2016_10_05_s1_c15 bca.ems_wr_2016_10_05_s1_c15   Traders should continue to position for a steeper yield curve: receive 1-year / pay 10-year swap rates. Ayman Kawtharani, Research Analyst ayman@bcaresearch.com 1 Source: Asit K. Biswas and Cecila Tortajada; and former Prime Minister Manmohan Singh

India's agricultural output per capita has not increased at all. Thus, food and headline inflation will remain structurally high, which will negatively impact savings and investment dynamics in the years ahead. With respect to cyclical growth, household spending is very strong, but investment expenditures are stagnant. Fixed-income traders should bet on yield curve steepening in India. A section <i>Brazil's Business Cycle Illustrated</i> highlights the cyclical profile of this economy.

In a February <i>Special Report</i> titled "Assessing Fair Value In FX Markets" we introduced a set of long-term valuation models based on various fundamentals. We have updated the results and added KRW, INR, PHP, HKD, CLP and COP to our analysis. The dollar still remains expensive, albeit with no signs of a dangerous overvaluation. The yuan is now at its cheapest level since 2009.

Clearing the refined-product overhang in the global storage markets is not as straightforward as it used to be: The Kingdom of Saudi Arabia (KSA), China, and India all are making concerted efforts to boost refining capacity, which is leaving them with surplus product that ends up being sold in export markets.