Latin America

Highlights The U.S. dollar still has meaningful upside versus the majority of currencies. We continue to recommend shorting a basket of the following EM currencies versus the U.S. dollar: TRY, ZAR, BRL, IDR, MYR and KRW. Fixed-income investors should continue to adopt a defensive allocation with respect EM local bonds. Asset allocators should underweight EM sovereign and corporate credit within a global credit portfolio. Argentine financial markets are rioting. We elaborate on our investment strategy below. Downgrade Indonesian stocks from neutral to underweight within an EM equity portfolio. Feature The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought. Rüdiger Dornbusch Emerging markets (EM) currencies have come under substantial selling pressure. Various indexes of EM currencies versus the U.S. dollar have broken below their 200-day moving averages (Chart I-1). EM sovereign spreads are widening, and local bonds yields are moving higher from very low levels. Chart I-1EM Currencies: A Breakdown? EM Currencies: A Breakdown? EM Currencies: A Breakdown? Our view is that we are witnessing the beginning of a major down leg in EM currencies and a major up leg in the U.S. dollar. This constitutes a negative environment for all EM risk assets. As the above quote from professor Rüdiger Dornbusch eloquently states, a meltdown in financial markets could take much longer to develop, but once it commences it is likely to play out much faster than investors expect. This does not mean we are certain that a full-blown EM crisis is bound to happen. Neither can we predict the speed of financial market moves. Nevertheless, based on our macro themes, we maintain that this down leg in EM currencies and EM risk assets will likely be large enough to qualify as a bear market rather than a correction. Consistently, we continue to recommend that investors adopt defensive strategies or play EM risk assets on the short side. This bear market in EM could be comparable to the EM selloff episodes of 2013 (Taper Tantrum) or 2015 (China's slowdown). In this report, we first discuss the outlook for the broad U.S. dollar, then examine the factors that typically drive EM currencies, and those that do not. The Dollar: A Major Bottom In Place The U.S. dollar has recently rebounded sharply, and we believe this marks the beginning of a major rally. The following factors will support the greenback in the months ahead: The U.S. dollar does well in periods of a slowdown in global trade (Chart I-2). The average manufacturing PMI index of export-oriented Asia economies such as Korea, Taiwan and Singapore points to a peak in global export volumes (Chart I-3). Further, China's Container Freight index signifies an impending deceleration in Asian export shipments (Chart I-4, top panel). Chart I-2U.S. Dollar Rallies When Global Trade Slows U.S. Dollar Rallies When Global Trade Slows U.S. Dollar Rallies When Global Trade Slows Chart I-3A Peak In Global Export Growth A Peak In Global Export Growth A Peak In Global Export Growth Chart I-4A Leading Indicator For Asian Exports ##br##And Asian Currencies A Leading Indicator For Asian Exports And Asian Currencies A Leading Indicator For Asian Exports And Asian Currencies Notably, this freight index - the price to ship containers - also correlates with emerging Asia currencies, and suggests that the latter stands to depreciate (Chart I-4, bottom panel). Chart I-5U.S. Dollar Liquidity And Exchange Rate U.S. Dollar Liquidity And Exchange Rate U.S. Dollar Liquidity And Exchange Rate The dollar should do particularly well if the epicenter of the global growth slowdown is centred in China - and if U.S. domestic demand remains robust due to fiscal stimulus, as we expect. Within advanced economies, the U.S. is the least vulnerable to a China and EM slowdown. Delta of relative growth will be shifting in favor of the U.S. versus the rest of the world. This will propel the dollar higher. Amid weakness in the world trade, growth will be priced at a premium. This will favor financial markets with stronger growth. The greenback will be the winner in the coming months. The U.S. twin deficits - the current account and budget deficits - would have acted as a drag on the dollar if global growth was robust/recovering. However, amid weakening global growth, the U.S. twin deficits are not a malignant phenomenon for the dollar; they will in fact support it as they instigate and reflect strong U.S. growth. As the Federal Reserve continues to reduce its balance sheet, the banking system's excess reserves will decline. Our U.S. dollar liquidity measure has petered out, which has historically been consistent with a bottom in the dollar; the latter is shown inverted on Chart I-5. As we have argued for some time, and to the contrary of widespread investor consensus, the U.S. dollar is not expensive. According to the real effective exchange rate based on unit labor costs, the greenback is fairly valued, as is the euro (Chart I-6). The yen is cheap but the Korean won is expensive (Chart I-6, bottom two panels). In our opinion, a real effective exchange rate based on unit labor costs is the most pertinent measure of exchange rate valuation. The basis is that it takes into account both wages and productivity. Labor costs are the largest cost component in many companies and unit labor costs are critical to competitiveness. Chart I-7 demonstrates that commodities-related currencies including those of Australia, New Zealand and Norway are on the expensive side, while the Canadian dollar is fairly valued. Chart I-6The U.S. Dollar Is Not Expensive The U.S. Dollar Is Not Expensive The U.S. Dollar Is Not Expensive Chart I-7Commodities Currencies Are Not Cheap Commodities Currencies Are Not Cheap Commodities Currencies Are Not Cheap There are no measures of real effective exchange rate based on unit labor costs for many EM currencies. If DM commodities currencies are not cheap, then it is fair to assume that EM commodities currencies are not cheap either. We are not suggesting that exchange rates of commodity producing EM nations are expensive, but we do believe their valuations are probably closer to neutral. When valuations are neutral, they are not a constraint for the underlying asset price. The latter can go either up or down. In short, the dollar is not expensive, and valuations will not deter its appreciation in the coming months. Finally, from the perspective of market technicals, the dollar's exchange rates versus many currencies appear to have encountered resistance at their long-term moving averages, as illustrated in Chart I-8A and Chart I-8B. Usually, when a market finds support (or resistance) at its long-term moving average, it often makes new highs (or lows). Chart I-8ATechnicals Are Positive For Dollar, ##br##Negative For EM Currencies Technicals Are Positive For Dollar, Negative For EM Currencies Technicals Are Positive For Dollar, Negative For EM Currencies Chart I-8BTechnicals Are Positive For Dollar, ##br##Negative For EM Currencies Technicals Are Positive For Dollar, Negative For EM Currencies Technicals Are Positive For Dollar, Negative For EM Currencies We are not certain if the broad trade-weighted U.S. dollar will make a new high. However, some EM currencies will drop close to or retest their early 2016 lows. Such potential downside is substantial enough to short the most vulnerable EM currencies. Bottom Line: The U.S. dollar has meaningful upside versus the majority of currencies. We continue to recommend shorting a basket of the following EM currencies versus the U.S. dollar: TRY, ZAR, BRL, IDR, MYR and KRW. What Really Drives EM Currencies A common narrative is that EM balance of payments and fiscal balances have already improved, making many EMs less vulnerable than they were during the 2013 Taper Tantrum. What's more, the interest rate differential between EM and the U.S. is still positive, heralding upward pressure on EM currencies. We do not subscribe to this analysis. First, current account balances do not always drive EM exchange rates. Chart I-9A and Chart I-9B illustrates that there is no meaningful positive correlation between EM currencies and both the level and changes in their current account balances. The same holds for the correlation between fiscal balances and exchange rates. Chart I-9ACurrent Account Balances ##br##And Currencies: No Correlation Current Account Balances And Currencies: No Correlation Current Account Balances And Currencies: No Correlation Chart I-9BCurrent Account Balances ##br##And Currencies: No Correlation Current Account Balances And Currencies: No Correlation Current Account Balances And Currencies: No Correlation Second, neither nominal nor real interest rate differentials over U.S. rates explain the trend in EM currencies, as shown in Chart I-10. Further, neither the level nor changes in interest rate differentials explain trends in EM exchange rates. On the contrary, it is the trend in EM currencies that drives local interest rates in EM. That is why getting the currencies right is of paramount importance to investors in various EM asset classes. So which factors do drive EM exchange rates? The key variables that define trends in EM currencies are U.S. bond yields, global trade cycles and commodities prices. The changes in U.S. bond yields and TIPS (inflation-adjusted) yields - not their difference with EM yields - have explained EM currency moves in recent years (Chart I-11). Chart I-10Interest Rate Differential Does Not ##br##Explain EM Exchange Rates Moves Interest Rate Differential Does Not Explain EM Exchange Rates Moves Interest Rate Differential Does Not Explain EM Exchange Rates Moves Chart I-11EM Currencies And U.S. Bond Yields EM Currencies And U.S. Bond Yields EM Currencies And U.S. Bond Yields Chart I-4 on page 3 demonstrates that China's Container Freight index leads regional exports and strongly correlates with emerging Asian currencies. Non-Asian EM currencies are mostly leveraged to commodities prices, as these countries (all nations in Latin America, Russia and South Africa) produce commodities. Not surprisingly, the EM exchange rate composed primarily of EM non-Asian currencies correlates well with commodities prices (Chart I-12). Finally, EM currencies are substantially more exposed to China than to DM economies. Chart I-13 shows that when Chinese imports are underperforming DM imports, EM currencies tend to depreciate. Chart I-12EM Currencies And Commodities Prices EM Currencies And Commodities Prices EM Currencies And Commodities Prices Chart I-13EM Currencies Are Exposed To China Not DM EM Currencies Are Exposed To China Not DM EM Currencies Are Exposed To China Not DM As such, what has caused EM currencies to riot in recent weeks? In short, it is the combination of the rise in U.S. bond yields and budding signs of slowdown in global trade. Chart I-14EM Currencies' Vol Is Still Low EM Currencies' Vol Is Still Low EM Currencies' Vol Is Still Low Commodities prices have so far been firm with oil prices skyrocketing. We expect the combination of China's slowdown and a stronger U.S. dollar to eventually suppress commodities prices in the months ahead. That will produce another down leg in EM currencies. Finally, the volatility measure for EM currencies is still very low, albeit rising (Chart I-14). This suggests that investors remain somewhat complacent on EM exchange rates. Bottom Line: Our negative view on EM currencies has been anchored on two pillars: the U.S. dollar rally driven by higher U.S. interest rate expectations and weaker Chinese growth/lower commodities prices. We are now witnessing the first down leg in EM currency bear market propelled by the first pillar. It is not over yet. The second down leg will come when China's growth slows and commodities prices relapse in the coming months. All in all, there is still material downside in EM exchange rates. EM Local Bond And Credit Markets EM local bond yields typically rise when EM currencies drop meaningfully (Chart I-15). Foreign investors hold a large share of EM local currency bonds (Table I-1). Chart I-15EM Local Bond Yields And EM Currencies EM Local Bond Yields And EM Currencies EM Local Bond Yields And EM Currencies Table I-1Foreign Ownership Of EM Local Bonds EM: A Correction Or Bear Market? EM: A Correction Or Bear Market? As EM currency depreciation erodes foreign investors' returns on EM local currency bonds, there could be a rush to exit their positions. Chart I-16 portrays that the total return on J.P. Morgan GBI EM local currency bonds in U.S. dollar terms has broken below its 200-day moving average. Fluctuations in total return on local bonds is primary driven by currency moves. If our negative EM currency view is correct, there will be more downside in this EM domestic bonds total return index. EM sovereign and corporate credit spreads often widen when EM currencies depreciate (Chart I-17). As EM currencies lose value, U.S. dollar debt becomes more expensive to service, and credit spreads should widen to reflect higher credit risks. Chart I-16EM Local Bonds Total ##br##Return Index In U.S. Dollars EM Local Bonds Total Return Index In U.S. Dollars EM Local Bonds Total Return Index In U.S. Dollars Chart I-17EM Credit Spreads And EM Currencies EM Credit Spreads And EM Currencies EM Credit Spreads And EM Currencies Finally, the ratios of U.S. dollar debt-to-exports and U.S. dollar debt-to-international reserves for EM ex-China are very elevated (Chart I-18). If these nations' exports stumble in the months ahead, the inflows of foreign currency will diminish, and credit spreads could widen to price this in. Chart I-18EM Ex-China: U.S. Dollar Debt ##br##Burden In Perspective EM Ex-China: U.S. Dollar Debt Burden In Perspective EM Ex-China: U.S. Dollar Debt Burden In Perspective To be sure, this does not mean there will be widespread defaults. Simply, credit spreads are too low and investor sentiment is too upbeat. As EM growth deteriorates, asset prices will have to re-price. Bottom Line: Asset allocators should continue to adopt a defensive allocation with respect EM local bonds. Asset allocators should underweight EM sovereign and corporate credit within a global credit portfolio. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Argentina Is Under Fire 10 May 2018 Argentine financial markets have been rioting, with the currency plunging by 11% versus the U.S. dollar since the beginning of April. What is the underlying cause of turbulence, and what should investors do? Argentina's macro vulnerability stems from the following factors: First, the country has very large twin deficits, and has relied on foreign portfolio flows to finance them (Chart II-1). Second, private credit growth has lately surged as households and companies have borrowed to buy imported consumer goods and capital goods (Chart II-2). This has created demand for U.S. dollars at a time when the greenback has begun to rebound and foreign investors' appetite for EM assets has diminished. Finally, progress on disinflation has been slow. Core inflation is still above 20% as sticky regulated prices have kept inflation high (Chart II-3). Chart II-1Argentina's Achilles Heal: Twin Deficits Argentina's Achilles Heal: Twin Deficits Argentina's Achilles Heal: Twin Deficits Chart II-2Argentina: Credit Growth Has To Be Reined In Argentina: Credit Growth Has To Be Reined In Argentina: Credit Growth Has To Be Reined In Chart II-3Argentina: Inflation Is Still A Problem Argentina: Inflation Is Still A Problem Argentina: Inflation Is Still A Problem Faced with a market riot, the Argentine central bank hiked its policy rate from 27.25% to 40% in the span of 8 days. Furthermore the government has requested a $30 billion IMF credit line. The aggressive rate hikes prove that the Argentine authorities, unlike many of their EM counterparts, have been adhering to orthodox macro policies. This makes Argentina stand out versus others in general, and Turkey in particular. Such orthodox macro policy responses leads us to maintain our long position in Argentine local bonds. The central bank has hiked interest rates well above both the inflation rate and nominal GDP growth (Chart II-4). Real interest rates are now at their highest level in the past 13 years (Chart II-5). We reckon that this policy tightening will likely be sufficient to stabilize macro dynamics, albeit at the cost of a growth downturn. Chart II-4Argentina: Are Interest ##br##Rates High Enough? Argentina: Are Interest Rates High Enough? Argentina: Are Interest Rates High Enough? Chart II-5Argentina: Highest Real Interest ##br##Rates In Over 13 Years! Argentina: Highest Real Interest Rates In Over 13 Years! Argentina: Highest Real Interest Rates In Over 13 Years! The drastic monetary tightening will crash credit growth and hence depress domestic demand and imports (Chart II-6). This will help narrow the trade deficit. The monetary squeeze with some fiscal tightening, shrinking real wages (deflated by headline consumer inflation) and a minimum wage nominal growth ceiling of 12.5% for 2018, will bring down inflation, albeit with a time lag (Chart II-7). The fixed-income market could look through the near-term spike in inflation due to the currency plunge. Chart II-6Argentina: High Borrowing Costs ##br##Will Crash Domestic Demand Argentina: High Borrowing Costs Will Crash Domestic Demand Argentina: High Borrowing Costs Will Crash Domestic Demand Chart II-7Argentina: Real Wage Growth Is Moderate Argentina: Real Wage Growth Is Moderate Argentina: Real Wage Growth Is Moderate Finally, the authorities have been gradually implementing their structural reform agenda. Crucially, recent tax and pension reforms were major wins for President Mauricio Macri's Cambiemos coalition, and should help ameliorate the country's fiscal balance. This stands in stark contrast to Brazil, which has so far failed to enact social security reforms despite a mushrooming public debt burden. High interest rates and a domestic demand squeeze are negative for corporate profits, including banks' earnings. However, they are positive for local bonds and ultimately for the currency. The diminishing current account deficit - due to contracting imports - and IMF financing will ultimately put a floor under the Argentine exchange rate. In turn, a cyclical growth downturn, moderating inflation, orthodox macro policies and high yields will entice investors into local currency bonds. Investment Recommendations Wait for the currency to depreciate another 5-10% versus the dollar in the next several weeks, and use that as an opportunity to double down on local currency bonds. While the peso could still depreciate by another 10% in the following 12 months, the extremely high coupon and potential for capital gains as yields ultimately decline will more than offset losses on the exchange rate. This makes the risk-reward of local bonds attractive. Maintain long Argentine sovereign credit and short Venezuelan and Brazilian sovereign credit positions. Orthodox macro policies, a continuation of structural reforms and an IMF credit line will likely cap upside in sovereign credit spreads versus Venezuela and Brazil, where public debt dynamics are worse. The difference between Argentine local currency bonds and U.S. dollar bonds is as follows: Local currency bond yields at 18% offer better value than sovereign credit spreads trading at 300 basis points over U.S. Treasurys. This is the reason why we are taking the risk of an unhedged position in domestic bonds, but remain reluctant to bet on the nation's sovereign U.S. dollar bonds in absolute terms. In addition, correlation among EM nations' sovereign spreads is much higher than correlation between their local bonds. We expect more turmoil in EM financial markets, but there is a chance that Argentine local bonds could decouple from the EM aggregates in the coming weeks or months. We are closing our long ARS/short BRL and long Argentine banks/short Brazilian banks trades. We had been expecting a riot in EM financial markets, but had not anticipated that Argentina would be affected more than Brazil. Finally, structurally we remain optimistic on Argentina's equity outperformance versus the frontier equity benchmark. Tactically (say the next 3 months), however, Argentine equities could underperform. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Indonesia: Facing Major Headwinds 10 May 2018 Indonesian stocks appear to be in freefall in absolute terms and relative to the EM benchmark (Chart III-1). Meanwhile, the currency has been selling off and local currency as well as sovereign (U.S. dollar) bonds spreads are widening versus U.S. Treasurys from low levels (Chart III-2). Chart III-1Indonesian Equities: Absolute ##br##And Relative Performance Indonesian Equities: Absolute And Relative Performance Indonesian Equities: Absolute And Relative Performance Chart III-2Indonesian Local Bonds ##br##And Sovereign Spreads Indonesian Local Bonds And Sovereign Spreads Indonesian Local Bonds And Sovereign Spreads These developments have been occurring due to vulnerabilities relating to Indonesia's balance of payments (BoP) dynamics. We believe Indonesia's BoP dynamics will deteriorate further and as such there is more downside for both the rupiah and its financial markets from here: Stronger U.S. growth and higher inflation prints will likely lead to higher interest rate expectations in the U.S. and lift the U.S. dollar further. This will likely lead to Indonesia's underperformance. Chart III-3 shows that Indonesia's relative equity performance versus the EM benchmark has been extremely sensitive to moves in U.S. Treasury yields. Hence, the cost of funding has been a critical variable for Indonesia. Indonesia is also a large commodities exporting nation and the latter account for around 30% of its exports. Specifically, coal, palm oil and copper make up about 9%, 8% and 2% of its exports, respectively. Coal exports are facing major headwinds. The Chinese government has moved to restrict coal imports in several Chinese ports in order to protect its domestic coal producers as we argued in our Special Report titled Revisiting China's De-Capacity Reforms.1 This development will be devastating for Indonesia's coal industry. Chart III-4 shows that the Adaro Energy's stock price - a large Indonesian coal mining company - is falling sharply. This stock price has already fallen by 40% in U.S. dollar terms since its peak on January 30. Chart III-3Indonesia Is Very Sensitive ##br##To U.S. Bond Yields Indonesia Is Very Sensitive To U.S. Bond Yields Indonesia Is Very Sensitive To U.S. Bond Yields Chart III-4Trouble In Indonesia's Coal Sector Trouble In Indonesia's Coal Sector Trouble In Indonesia's Coal Sector Further, palm oil prices have been weak while copper prices might be on edge of breaking down. Meanwhile, there are others negatives related to shipments of these commodities. Palm oil exports are at risk because India has imposed import duties on palm oil, while the European Parliament voted in favor of a ban on the use of palm oil in bio fuel by 2021. Offsetting these, however, China has just agreed to purchase more palm oil from Indonesia. In regard to copper, the ongoing dispute on environmental regulation between Freeport-McMoRan - a U.S. mining company that operates a large copper mine in Indonesia - and the Indonesian government, risks disrupting Freeport's copper production in Indonesia, hurting the country's export revenues. On the whole, export revenues are at risk of plummeting at a time when Indonesian imports are already too strong. This will worsen BoP dynamics further. Chart III-5 shows that a deteriorating trade balance in Indonesia is usually bearish for its equity market. It seems that the current account deficit will be widening when foreign funding is drying up. This requires either a major depreciation in the currency or much higher interest rates. As such, Bank Indonesia (BI) - Indonesia's central bank - might be forced to raise interest rates to cool down domestic demand and attract foreign funding to stabilize the rupiah. Even if the BI does not raise rates, it might opt to defend the rupiah by selling its international reserves. This would still bid up local interbank rates as defending the currency entails drawing down banking system liquidity, i.e., banks' reserves at the central bank. Chart III-6 shows that Indonesian interbank rates are starting to rise in response to falling international reserves. Chart III-5Indonesia: Swings In Trade ##br##Balance And Share Prices Indonesia: Swings In Trade Balance And Share Prices Indonesia: Swings In Trade Balance And Share Prices Chart III-6Indonesia: Currency Defense By Selling ##br##FX Reserves Leads To Higher Interbank Rates Indonesia: Currency Defense By Selling FX Reserves Leads To Higher Interbank Rates Indonesia: Currency Defense By Selling FX Reserves Leads To Higher Interbank Rates Higher rates will weaken domestic demand and are bearish for share prices. Importantly, foreign ownership of local bonds is still high at 39% and a weaker rupiah could cause selling by foreign investors, pushing yields even higher. Chart III-7Indonesia: Banks Profits Are At Risk As Banks' NPL Provisions Rise, Bank Stocks Could Fall Indonesia: Banks Profits Are At Risk As Banks' NPL Provisions Rise, Bank Stocks Could Fall Indonesia: Banks Profits Are At Risk Finally, a word on Indonesian banks is warranted. Financials account for 42% of Indonesia's MSCI market cap and 47% of its total earnings. Thus their performance is also very crucial for the outlook of the overall stock market. In our March 1st Weekly Report,2 we argued that Indonesian banks have been lowering their provisions to artificially boost earnings. This is not sustainable as these provisions are insufficient and will have to rise. As they ultimately rise, bank profits and share prices will hurt (Chart III-7). Bottom Line: We recommend investors to downgrade Indonesia's stocks from neutral to underweight within an EM equity portfolio. We also reiterate our short IDR / long USD trade and the short position in local bonds. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report "Revisiting China's De-Capacity Reforms," dated April 26, 2018, the link available on page 23. 2 Please see Emerging Markets Strategy Weekly Report "EM Equity Valuations (Part II)," dated March 1, 2018, the link available on page 23. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Apart from rising geopolitical tensions, our main macro themes remain a growth slowdown in China and a rise in U.S. core inflation. This combination bodes ill for EM financial markets. Continue underweighting EM stocks, credit and currencies versus their DM peers. Subsiding NAFTA risks argue for overweighting Mexican stocks within an EM equity portfolio. This is in line with our recent upgrade of Mexican local and U.S. dollar sovereign bonds as well as the peso's outlook versus their EM peers. A new trade: Fixed-income trades should bet on yield curve steepening in Mexico by paying 10-year swap rates and receiving 2-year rates. Close overweight Russian markets positions in the wake of escalating U.S. sanctions. Feature Before discussing Mexico and Russia, we offer an update on our thoughts on the overall market outlook. EM: Looking Under The Hood Investor sentiment remains buoyant on global risk assets, and the buy-on-dips mentality remains well entrenched. On the surface, investors are not finding enough reasons to turn negative on global or EM risk markets. Nevertheless, when looking under the EM hood, we see several leading and coincident indicators that are beginning to flash red. Not only do geopolitics and the U.S.-China trade confrontation pose downside risks, there are also several macro developments that are turning from tailwinds to headwinds for EM risk assets. Specifically: EM manufacturing and Asian trade cycles have probably topped out. The relative total return (carry included) of three equally weighted EM1 (ZAR, BRL and CLP) and three DM (AUD, NZD and CAD) commodities currencies versus an equally weighted average of two safe-haven currencies - the Japanese yen and Swiss franc - has relapsed since early this year, coinciding with the rollover in the EM manufacturing PMI index (Chart I-1). This currency ratio is herein referred to as the risk-on/safe-haven currency ratio. Chart I-1Risk On / Safe-Haven Currency Ratio And EM Manufacturing PMI bca.ems_wr_2018_04_12_s1_c1 bca.ems_wr_2018_04_12_s1_c1 The risk-on/safe-haven currency ratio also correlates with the average of new and backlog orders components of China's manufacturing PMI (Chart I-2). The latter does not herald an upturn in this currency ratio at the moment. Share prices of global machinery, chemicals and mining companies have so far underperformed the overall global equity index in this selloff, as exhibited in Chart I-3. Chart I-2China's Industrial Cycle Has Rolled Over bca.ems_wr_2018_04_12_s1_c2 bca.ems_wr_2018_04_12_s1_c2 Chart I-3Global Cyclicals Have Underperformed, Though Not Tech Global Cyclicals Have Underperformed, Though Not Tech Global Cyclicals Have Underperformed, Though Not Tech Potential trade wars, the setback in technology stocks and a resurgence of volatility in global equity markets have recently dominated news headlines. Yet, the underperformance of China-exposed global sectors and sub-sectors signifies that beneath the surface Chinese growth is weakening. Meanwhile, global tech stocks have not yet underperformed much (Chart I-3, bottom panel), implying the selloff has not been driven by this high-flying sector. The combination of weakening global trade amid still-robust U.S. domestic demand bodes well for the U.S. dollar, at least against EM and commodities currencies. U.S. and EU imports account for only 13% and 11% of global trade, respectively (Chart I-4). Meanwhile, aggregate EM including Chinese imports account for 30% of world imports. Hence, global trade can slow even with U.S. and EU domestic demand remaining robust. We addressed the twin deficit issue in the U.S. in our February 21 report,2 and will add the following: If U.S. fiscal stimulus coincides with abundant global growth, the greenback will weaken. If on the contrary, the U.S. fiscal expansion overlaps with weakening global trade, U.S. growth will be priced at a premium and the U.S. dollar will appreciate especially against the currencies of economies where growth will fall short. The majority of EM exchange rates will likely be in the latter group. The relative performance of EM versus DM stocks correlates with the relative volume of imports between China and the DM (Chart I-5). The rationale is that EM countries and their publically listed companies are much more leveraged to China's business cycle than DM. The opposite is true for DM-listed companies. Our view is that China's industrial recovery and growth outperformance versus DM since early 2016 is about to end. This, if realized, should undermine EM equities and currencies versus their DM counterparts. Last week, we published a Special Report on the Chinese real estate market.3 We documented that despite a drawdown in housing inventories over the past two years, both residential and non-residential inventories remain very elevated. This, along with poor affordability and the implementation housing purchase restrictions for investors, will dampen housing sales, which in turn will lead to a contraction in property development and construction activity. Chart I-4Global Trade Is More Leveraged To EM Not DM Global Trade Is More Leveraged To EM Not DM Global Trade Is More Leveraged To EM Not DM Chart I-5EM Underperforms When Chinese Imports Lag DM Ones EM Underperforms When Chinese Imports Lag DM Ones EM Underperforms When Chinese Imports Lag DM Ones Combined with a slowdown in infrastructure investment due to tighter controls on local government finances, this poses downside risks to China's demand for commodities, materials and industrial goods. This is the main risk to EM stocks and currencies, and the primary reason we continue to maintain our negative stance on EM risk assets. Last but not least, it is widely believed that Chinese households are not indebted and that there is a lot of pent-up demand for household credit. Chart I-6 reveals that this conjecture is simply not true - the household debt-to-disposable income ratio has surged to 110% of disposable income in China. The same ratio is currently 107% in the U.S. Given borrowing costs in general and mortgage rates in particular are higher in China than in the U.S. (the mortgage rate is 5.2% in China versus 4.4% in the U.S.), interest payments on debt account for a larger share of households' disposable income in China than in America right now. In the U.S., the surprise on the macro front in the coming months will likely be both rising wage growth and core inflation. Chart I-7 highlights that average hourly earnings in manufacturing and construction have been accelerating. This underscores that wages are rising fast in these cyclical sectors. This will spread to other sectors sooner rather than later. Core inflation in America is rising and has already moved above 2% (Chart I-8). The rise is broad-based as all different core consumer price measures are rising and heading toward 2%. Chart I-6Chinese Households Are As Leveraged As Americans Chinese Households Are As Leveraged As Americans Chinese Households Are As Leveraged As Americans Chart I-7U.S. Wages Are Accelerating U.S. Wages Are Accelerating U.S. Wages Are Accelerating Chart I-8U.S. Core Inflation Is Above 2% U.S. Core Inflation Is Above 2% U.S. Core Inflation Is Above 2% While this does not entail that the U.S. is heading into runaway inflation, rising core inflation and wage growth will likely lead many investors to believe that the Federal Reserve cannot back off too fast from rate hikes, particularly when the U.S. fiscal thrust remains so positive, even if the drawdown in share prices persist. This may especially weigh on EM risk assets, where growth will be subsiding due to their links with Chinese imports. Bottom Line: Our main macro themes remain a slowdown in China and a rise in U.S. core inflation. This combination bodes ill for EM financial markets. Continue underweighting EM stocks, credit and currencies versus their DM peers. Upgrade Mexican Equities To Overweight In our March 29 report,4 we upgraded our stance on the Mexican peso, local currency bonds and U.S. dollar sovereign credit from neutral to overweight. The main rationale was receding odds of NAFTA abrogation and the country's healthy macro fundamentals. In addition, we instituted a new currency trade: long MXN / short BRL and ZAR. Continuing with this theme, we today recommend upgrading Mexican stocks to overweight within an EM equity portfolio: The odds of NAFTA retraction are rapidly subsiding as the U.S. is shifting its focus to China. Hence, chances are that NAFTA negotiations will be completed this summer, and a deal will be signed off before Mexico's presidential elections on July 1st. A more benign outcome together with an early end to NAFTA negotiations will reduce uncertainty and the risk premium priced into Mexican financial markets. This will help the latter outperform their EM peers. A final note on Mexican politics: The leftist presidential candidate Andres Manuel Lopez Obrador has high chances of winning the presidential elections in July. Yet Our colleagues at BCA's Geopolitical Strategy service believe political risks are overstated.5 The basis is that Obrador will balance the left-leaning preferences of his electorate with the prudent policies needed to produce robust growth. While political uncertainty in Mexico is subsiding, it is rising in many other EM countries such as Russia, China and Brazil. In brief, geopolitical dynamics favor Mexico versus the rest of EM. We expect dedicated EM managers across various asset classes to rotate into Mexico from other EM countries. We outlined two weeks ago that a stable exchange rate will bring down inflation, opening a door for the central bank to cut interest rates no later than this summer. As local interest rate expectations in Mexico continue to subside both in absolute terms as well as relative to EM, Mexican share prices will outpace their EM peers (Chart I-9). Consistently, tightening Mexican sovereign credit spreads versus EM overall should also foster this nation's equity outperformance (Chart I-10). Chart I-9Relative Equity Performance Tracks Relative ##br##Local Bond Yields Relative Equity Performance Tracks Relative Local Bond Yields Relative Equity Performance Tracks Relative Local Bond Yields Chart I-10Relative Equity Performance Tracks Relative ##br##Sovereign Spreads Relative Equity Performance Tracks Relative Sovereign Spreads Relative Equity Performance Tracks Relative Sovereign Spreads Domestic demand growth has plunged following monetary and fiscal tightening in the past two years (Chart I-11). As both fiscal and monetary policy begin to ease, domestic demand will recover later this year. Chances are that share prices will sniff this out and begin their advance/outperformance sooner than later. Consumer staples and telecom stocks together account for 50% of the MSCI Mexico market cap, while the same sectors make up only 11% of overall EM market cap. Hence, Mexico's relative equity performance is somewhat hinged on the outlook for these two sectors in general and consumer staples in particular. EM consumer staple stocks have massively underperformed the EM benchmark since early 2016 (Chart I-12, top panel), and odds are this sector will outperform in the next six to 12 months as defensive sectors outperform cyclicals. This in turn heralds Mexico's relative outperformance versus the EM benchmark, which seems to be forming a major bottom (Chart I-12, bottom panel). Chart I-11Mexico: Economic Downturn Is Well Advanced Mexico: Economic Downturn Is Well Advanced Mexico: Economic Downturn Is Well Advanced Chart I-12Mexican Bourse Is A Play On Consumer Staples Mexican Bourse Is A Play On Consumer Staples Mexican Bourse Is A Play On Consumer Staples Unlike many EM countries, the Mexican economy is much more leveraged to the U.S. than to China. One of our major themes remains favoring U.S. growth plays versus Chinese ones. Finally, Mexican equity valuations have improved quite a bit both in absolute terms and relative to EM. Chart I-13 shows our in-house CAPE ratios for Mexican stocks in absolute terms and relative to the EM overall benchmark: Mexican equity valuations are not cheap but they are no longer expensive. Consistent with upgrading our economic outlook on Mexico, fixed-income investors should bet on yield curve steepening in local rates. We initiated this strategy on January 31 but hedged the NAFTA risk by complementing it with a yield curve flattening leg in Canada. Now, we are closing that trade and initiating a new one: fixed-income traders should consider paying 10-year swap rates and receiving 2-year swap rates. The yield curve is as flat as it typically gets (Chart I-14, top panel). Moreover, 2-year swap rates are not yet pricing enough rate cuts (Chart I-14, bottom panel) but will soon begin gapping down pricing in a large (potentially close to 200 basis points) rate cut cycle. Chart I-13Mexican Equities Are No Longer Expensive Mexican Equities Are No Longer Expensive Mexican Equities Are No Longer Expensive Chart I-14Bet On Yield Curve Steepening In Mexico Bet On Yield Curve Steepening In Mexico Bet On Yield Curve Steepening In Mexico Bottom Line: In line with our recent upgrade of Mexican local and U.S. dollar bonds as well as the currency outlook versus their EM peers, this week we recommend EM dedicated equity portfolios shift to an overweight position in Mexican stocks. Fixed-income trades should bet on yield curve steepening by paying 10-year swap rates and receiving 2-year rates. Investors who are positive on global risk assets should consider buying Mexican local bonds outright. Russia: Geopolitics Trumps Economics Chart I-15Russian Assets Relative To EM Benchmarks:##br## Various Asset Classes Russian Assets Relative To EM Benchmarks: Various Asset Classes Russian Assets Relative To EM Benchmarks: Various Asset Classes The sudden crash in Russian financial markets this week following the imposition of new U.S. sanctions has reminded us that geopolitics can often eclipse economics. Our overweight recommendation on Russian assets versus their EM peers was based on two pillars: (1) healthy and improving macro fundamentals and an unfolding cyclical economic recovery; and (2) easing tensions between Russia and the West. Clearly, the second part of our assessment is wrong, or at least premature. While BCA's Geopolitical Service team maintains that on a 12-month horizon tensions between Russia and the West will subside, the near-term risks are impossible to assess. For this reason we are closing our overweight allocation in Russian financial markets and recommend downgrading it to neutral. In particular, we are shifting Russia to a neutral allocation within the EM equity, sovereign and corporate credit and local currency bonds portfolios (Chart I-15). Consistently, we are closing the following trades: Long Russian / short Malaysian stocks (27.6% gain); Long Russian energy / short global energy stocks (2.8% gain); Long RUB / short MYR (3.1% loss); Short COP / long basket of USD & RUB (16.2% loss); Long RUBUSD / short crude oil (29.1% loss). Sell Russian 5-year CDS / buy South African 5-year CDS (317 basis points gain); Long Russian and Chilean / short Chinese Corporate Credit (12% gain); Long Russian 5-year bonds / short Brazilian 5-year bonds (flat). Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 We have removed the Russian ruble from the version of this chart shown in March 29, 2018 EMS report to assure that the recent idiosyncratic developments - the selloff triggered by the U.S. sanctions - in Russia's financial markets do not impact the reading of this indicator. 2 Pease see Emerging Markets Strategy Weekly Report "EM Local Bonds And U.S. Twin Deficits", dated February 21, 2018, Page 14. 3 Pease see Emerging Markets Strategy Weekly Report "China Real Estate: A Never-Bursting Bubble?", dated April 6, 2018, Page 14. 4 Pease see Emerging Markets Strategy Weekly Report "EM: Perched On An Icy Cliff", dated March 29, 2018, available at ems.bcaresearch.com. 5 Pease see Geopolitcial Strategy Weekly Report "Expect Volatility... Of Volatility", dated April 11, 2018, available at gps.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights There is more downside risk ahead as the geopolitical calendar is packed in May; Protectionism remains in play, but markets could also fall on Iran-U.S. tensions, military intervention in Syria, and Russia-West confrontation; Investors should expect volatility to go up as we approach a turbulent summer; We were wrong on Russia-West tensions peaking and are closing all of our Russian trades for now, but may look for new entry points soon; Go long a basket of NAFTA currencies versus the Euro and expect reflation to remain the "only game in town" in Japan. Feature "I'm not saying there won't be a little pain, but the market has gone up 40 percent, 42 percent so we might lose a little bit of it. But we're going to have a much stronger country when we're finished. So we may take a hit and you know what, ultimately we're going to be much stronger for it." President Donald Trump, April 6, 2018 Chart 1Teflon Trump Teflon Trump Teflon Trump There are times when conventional wisdom is spectacularly wrong. Last week was such a moment. Since Donald Trump became president, the "smart money" has believed that he was obsessed with the stock market. Therefore, the view went, none of his policies would threaten the bull market. We have pushed back against this assumption because our view is that geopolitical risks - specifically the lack of constraints on the executive branch in foreign and trade policy - would become investment relevant.1 This view has been correct thus far: we called the volatility spike and trade protectionism in 2018. Not only have President Trump's tariff pronouncements produced stock market drawdowns, but his popularity appears to be unaffected. Astonishingly, President Trump's approval rating collapsed as the stock market went up in 2017 and recovered as the stock market went in reverse this year (Chart 1)! It is therefore empirically incorrect that President Trump is constrained by the stock market. His actions over the past month, as well as his approval ratings, suggest that he is quite comfortable with volatility. There are two broad reasons why we never bought into the media hype. First, there is no real correlation, or only a weak one, between equity declines of 10% and presidential approval ratings (Chart 2). Generally, presidential approval rating does decline amidst market drawdowns of 10% or greater, but the effect on the presidency is only permanent if the momentum of the approval rating was already heading lower, otherwise the effect is minimal and temporary. Second, the median American does not really own stocks (Table 1). President Trump considers blue collar white voters his base and they care more about unemployment and wages, not their equity portfolios. At some point, equity market drawdowns will affect hard data and the real economy. This is the point at which President Trump will care about the stock market. Given that the market is already down 10% from the peak, we are not far away from this pain threshold. But in this way, President Trump is no different from any other president. Chart 2AThe Stock Market Mattered For Eisenhower, JFK, Bush Sr., And Obama... The Stock Market Mattered For Eisenhower, JFK, Bush Sr., And Obama... The Stock Market Mattered For Eisenhower, JFK, Bush Sr., And Obama... Chart 2B...But Not For Johnson, Nixon, Ford, Carter, Reagan, And Bush Jr. ...But Not For Johnson, Nixon, Ford, Carter, Reagan, And Bush Jr. ...But Not For Johnson, Nixon, Ford, Carter, Reagan, And Bush Jr. The pessimistic view on trade protectionism risk, that there is more downside to equities ahead, is therefore still in play. Investors should be careful not to overreact to positive developments, such as President Xi's speech at the Boao Forum where he largely reiterated previous Beijing promises to open up individual sectors to foreign investment. In fact, it is the investment community itself that is the target of President Trump's rhetoric. In order to convince Beijing that his threat of protectionism is credible, President Trump has to show that he is willing to incur pain at home, which explains the quote with which we began this report. Table 1Stock Ownership Is Concentrated Amongst The Wealthiest Households Expect Volatility... Of Volatility Expect Volatility... Of Volatility This is not dissimilar to President Trump's doctrine of "maximum pressure" which, when applied to North Korea, produced a significant bond rally last summer. The 10-year Treasury yield topped 2.39% on July 7 and then collapsed to a low of 2.05% in September.2 The vast majority of the yield decline, at the time, came from falling real yields as investors flocked into safe-haven assets amidst North Korean tensions and not lower inflation expectations. It is therefore dangerous to rely on conventional wisdom when assessing the limits of volatility or equity drawdowns. Any buoyant market reaction may in fact elicit a more aggressive policy from Washington. As if on cue, President Trump shocked the markets on April 7 by suggesting that he would impose another round of tariffs on a further $100bn worth of Chinese imports, bringing the total under threat to $160 billion. The announcement came after the market closed 0.89% up on April 6. Perhaps President Trump was irked that the market was so dismissive of his trade threats and decided to jolt it back to reality. In addition to trade, there are several other reasons to be bearish on risk assets as we approach May: Chart 3Inflation Will Pick Up In 2018 Inflation Will Pick Up In 2018 Inflation Will Pick Up In 2018 Chart 4Service Sector Wage Growth Is At A Cyclical Peak Service Sector Wage Growth Is At A Cyclical Peak Service Sector Wage Growth Is At A Cyclical Peak Inflation: Unemployment is low, with wage pressures starting to build (Chart 3). Meanwhile, teacher strikes in Red States like Oklahoma, Kentucky, West Virginia, and Arizona are signalling that public service sector wage pressures are building in the most fiscally prudent states. Service sector wages cannot be suppressed through automation or outsourcing and are therefore likely to add to inflationary pressures (Chart 4). The Fed remains in tightening mode, despite the mounting geopolitical risks. "Stroke of pen risk:" Another sign that President Trump is comfortable with market drawdowns is his increasingly aggressive rhetoric on Amazon. There is a rising probability that the current administration decides to up the regulatory pressure on the technology and retail giant, as well as a possibility that other technology companies like Facebook and Google face "stroke of pen" risks. Iran: This year's premier geopolitical risk is the potential for renewed U.S.-Iran tensions.3 Ahead of the all-important May 12 deadline - when the White House will decide whether to end the current waiver of economic sanctions against Iran - President Trump has staffed his cabinet with two hawks, new Secretary of State Mike Pompeo and National Security Advisor John Bolton. Meanwhile, tensions in Syria are building with potential for U.S. and Iranian forces to be directly implicated in a skirmish. The U.S. is almost certain to militarily respond to the alleged chemical attack by the Syrian government forces against the rebel-held Damascus suburb of Douma. Throughout it all, investors appear to remain unfazed by the rising probability that Iran's 2 million barrels of oil exports come under renewed sanction risk, mainly because the media is ignoring the risk (Chart 5). Chart 5The Media Is Ignoring Iran As A Risk The Media Is Ignoring Iran As A Risk The Media Is Ignoring Iran As A Risk Russia: As we discuss below, tensions between the West and Russia appear to be building up anew. Particularly concerning is the aforementioned chemical attack in Syria, which Moscow considers a "false flag operation." The Russian government hinted in mid-March that precisely such an attack may occur and that the U.S. would use it as a pretext to attack Syrian government forces and structures.4 Our view that tensions have peaked, elucidated in a recent report, therefore appears to have been spectacularly wrong. Chinese reforms: Now that Xi Jinping has finished setting up his new government, his initiatives are starting to be implemented. While some slight tax cuts are on the docket, and interbank rates have eased significantly, there is no sign of broad policy easing or economic recovery (Chart 6). Rather, both Xi and his economic czar Liu He have continued to stress the "Three Battles" of systemic financial risk, pollution, and poverty - the first two requiring tighter policy. Xi has stated that deleveraging will focus on state-owned enterprises (SOEs) and local governments. SOEs will have debt caps and will not be allowed to lend to local governments. Instead, local governments will have to borrow through formal bond markets, giving the central government greater control. Meanwhile, the Ministry of Housing says property restrictions will remain in place. All in all, the risk of negative surprises in China this year remains significant, with a likely negative impact on global growth.5 There is also a fundamental reason for equity market weakness: the market is likely coming to grips with a calendar 2019 EPS growth of a more reasonable 10% annual rate compared with this year's near 20% peak growth rate. This transition, which our colleague Anastasios Avgeriou of BCA's U.S. Equity Strategy has highlighted in recent research, will be turbulent.6 In addition, Anastasios has pointed out that stocks are reacting to a more bearish mix of soft and hard data (Chart 7), suggesting that not all of the market volatility is due to headline risk. Chart 6China Will Slow Down Further In 2018 China Will Slow Down Further In 2018 China Will Slow Down Further In 2018 Chart 7Trade Is Not The Only Risk To The Market Trade Is Not The Only Risk To The Market Trade Is Not The Only Risk To The Market How should investors make sense of these budding risks? Going forward, we would fade any enthusiasm or narratives of "peak pessimism" on trade protectionism. It is in the interest of the Trump administration that investors take his threats seriously. President Trump literally needs stocks to go down in order to show Beijing that he is serious. The summer months could be volatile as market confusion grows amidst the upcoming event risk (Table 2). This may be a good time to be risk-averse, with the old adage "sell in May and go away" appropriate this year. Table 2Protectionism: Upcoming Dates To Watch Expect Volatility... Of Volatility Expect Volatility... Of Volatility There are several reasons why protectionism is a much bigger deal than it was in the 1980s when investors last had to price a trade war between two major economies (Japan and the U.S. at the time): Chart 8This Time Is Different... Because Of Supply Chains... This Time Is Different... Because Of Supply Chains... This Time Is Different... Because Of Supply Chains... Chart 9...Globalization... ...Globalization... ...Globalization... Supply chains are a much bigger deal today than thirty years ago (Chart 8); The share of global exports as a percent of GDP is much higher today (Chart 9); Interest rates are much lower, leaving little room for policymakers to ease (Chart 10); Stock market valuations are higher, leaving stocks exposed to drawbacks (Chart 11); Unlike 1981-88, when Japan and the U.S. waged a nearly decade-long trade war while remaining allies in the Cold War, China and the U.S. are outright rivals. This increases the probability that Beijing's reprisal, given its constraints in retaliating against U.S. exports (Chart 12), could take a geopolitical turn. Chart 10...Policymaker Ammunition... ...Policymaker Ammunition... ...Policymaker Ammunition... Chart 11...And Valuations ...And Valuations ...And Valuations Chart 12China May Run Out Of U.S. Exports To Sanction Expect Volatility... Of Volatility Expect Volatility... Of Volatility Investors should therefore prepare for volatility of volatility. Amidst the confusion, there could be some not-so-positive news that the market overreacts to with optimism, and some not-so-negative news that the market reacts to with pessimism. In our six years of publishing geopolitically driven investment strategy, we have not seen a similar period where a confluence of risks and tensions are building up at the same time. May should therefore be a busy month. Mexico: A Silver Lining Amidst Mercantilism Risk? Mexico began the year with clouds over its head due to the Trump team's tough negotiating line on NAFTA. The third round of negotiations, in September 2017, ended on a bad note. The peso tumbled and headline and core inflation soared, portending both tighter monetary policy and weaker domestic demand.7 Today, however, the odds of renewing NAFTA have improved significantly. We have reduced our probability of Trump abrogating the trade deal from 50% to 20%. The administration appears to be focused on China and therefore looking to wrap up the NAFTA negotiations quickly over the summer. This would give time to send the new deal to the Mexican and U.S. congresses prior to the September changeover in Mexico's legislature and January changeover in the U.S. legislature. The U.S. has reportedly compromised on an earlier demand that NAFTA-traded automobiles have a U.S. domestic content of 50%.8 Meanwhile, inflation has peaked and the peso has firmed up (Chart 13), which will help buoy real incomes and boost purchasing power. Economic policy has been prudent, with central bank rate hikes restraining inflation and government spending cuts producing a primary budget surplus (and a much-reduced headline budget deficit of -1% of GDP) (Chart 14).9 Chart 13Mexico: Peso & Inflation Mexico: Peso & Inflation Mexico: Peso & Inflation Chart 14Mexico: Improved Macro Fundamentals Mexico: Improved Macro Fundamentals Mexico: Improved Macro Fundamentals In this more bullish context, the Mexican elections on July 1 are market-neutral. True, it is hard to present a strong pro-market outcome. The public is shifting to the left on the economic spectrum while the outgoing "pro-market" administration of Enrique Pena Nieto has lost credibility. The latest polling suggests that Andres Manuel Lopez Obrador (AMLO) is polling in the lower 30-percentile (around 33%), above his next competitors, Ricardo Anaya (PAN) at 26% and Jose Antonio Meade (PRI) at 14% (Chart 15). However, the latest data point of the admittedly volatile polling gives AMLO a much less commanding lead of 6-7% over Anaya than he had before. AMLO is polling around his performance in the 2006 and 2012 elections (35% and 32%, respectively), has increased his lead over the other candidates, and his National Regeneration Movement (MORENA) and "Together We'll Make History" coalition are also polling with double-digit leads (Chart 16). The general shift to the left is also apparent in the fact that Ricardo Anaya's PAN has been forced to combine with the left-wing PRD in order to garner votes. Chart 15AMLO's Lead Is Not Insurmountable Expect Volatility... Of Volatility Expect Volatility... Of Volatility Chart 16Likely No Majority In Congress Expect Volatility... Of Volatility Expect Volatility... Of Volatility Nevertheless, political risk is overstated for the following reasons: AMLO is not Hugo Chavez:10 True, he is a leftist, a populist, and has a reputation for egotism. He is Mexico's fitting anti-Trump. Nevertheless, he is also a known quantity, having run for president and engaged with the major parties for over a decade. While he elevates headline political risk, we would fade the risk based on the fact that Mexico is a relatively right-wing country (Chart 17), and his movement will probably not garner a majority in Congress (see next bullet). Notably, AMLO's rhetoric on Trump and NAFTA has been restrained, and his personnel decisions have been competent and orthodox. He has not suggested he will revoke new private Mexican oil concessions, under the outgoing government's privatization scheme, but only halt the auctions. AMLO will be constrained by Congress: The trend in Mexico is towards "pluralization" or fragmentation in Congress (see Chart 18), meaning that ruling parties will have to share power. This is not a negative development. As we recently pointed out, political plurality engenders stability by drawing protest parties into centrist coalitions and by allowing establishment parties to coopt protest narratives without having to actually protest or revolt.11 At this point in time, it is difficult to see how AMLO's MORENA garners enough support to get a majority in Congress. AMLO's closest challenger is right-wing and pro-market: If AMLO loses the election, Ricardo Anaya of PAN will not be scorned by financial markets. In 2006, AMLO looked like he would win the election but then lost to Felipe Calderon (PAN). Of course, a victory by Anaya is not very market positive either, as PAN is in an unstable coalition with the left-wing PRD and would also be constrained in Congress. Still, there would be a lower probability of reversing the outgoing PRI administration's policies than under AMLO. AMLO is unlikely to repeal NAFTA: Mexico's exports to NAFTA partners comprise 30% of GDP, and it would be exceedingly dangerous for a Mexican leader to provoke Trump on the issue. A plurality of the Mexican public (44%) supports the ongoing NAFTA negotiations as they have been handled by the current government (Chart 19), as of late February polling by the Wilson Center. The same polling shows that Mexicans are generally aware of how important NAFTA is for their economy. This is despite the polls showing that a majority of Mexicans have a negative view of the U.S., due largely to Trump's rhetoric (though that majority has fallen considerably since last year to 56%). In other words, anti-American sentiment is not turning the Mexican public against compromising on a new NAFTA deal. Chart 17Mexicans Lean Right Expect Volatility... Of Volatility Expect Volatility... Of Volatility Chart 18Mexico's Rising Political Plurality Expect Volatility... Of Volatility Expect Volatility... Of Volatility Finally, Mexico is more exposed to U.S. growth (which is charged with fiscal stimulus), and to BCA's robust outlook on oil prices (as opposed to our weaker metals outlook), while it is less exposed to weakening Chinese demand than other EMs (such as South Africa or Brazil).12 The peso looks particularly attractive relative to the latter two currencies (Chart 20). Chart 19Mexicans Want NAFTA To Survive Expect Volatility... Of Volatility Expect Volatility... Of Volatility Chart 20A Major Bottom In MXN's Cross? A Major Bottom In MXN's Cross? A Major Bottom In MXN's Cross? None of the above should suggest that the Mexican election will be a smooth affair. The rise of AMLO will create jitters in the marketplace, particularly as he faces off against Trump, who will continue to try to pressure Mexico over immigration and border security even once NAFTA negotiations are squared away. Nevertheless, the cyclical backdrop has improved while the major headwind of NAFTA abrogation seems to be abating. Bottom Line: Mexico's presidential campaign, election, and aftermath will give rise to plenty of occasion for volatility, particularly as President Trump and a likely President Obrador will not shy from a war of words. Nevertheless, Mexico's economic policy is stable and the NAFTA headwind is abating. We recommend going long Mexican local currency bonds relative to the EM benchmark. We also recommend that clients go long a NAFTA basket of currencies - the peso and the loonie - versus the euro. Our currency strategist - Mathieu Savary - has recently pointed out that the euro has moved ahead of long-term fundamentals and is ripe for a near-term correction.13 Japan: Abe Will Survive Japanese Prime Minister Shinzo Abe has come under rising public criticism in recent that is dragging down his approval ratings (Chart 21). Three separate scandals are weighing on his administration: one relating to the government's sale of land at knockdown prices to a nationalist school, Moritomo Gakuen, tied to Abe's wife; another relating to the discovery of "lost" journals of Japan Self-Defense Force activity during the Iraq war; another tied to the mishandling of statistics in promoting the government's new revisions to the labor law. Abe's popularity has tested lower lows in the past, but he is approaching the floor. And while Abe is still polling in line with the popular Prime Minister Junichiro Koizumi at this stage in his term (Chart 22), nevertheless he is approaching his 65th month in office when Koizumi stepped down. Chart 21Abe's Approval Testing The Floor Expect Volatility... Of Volatility Expect Volatility... Of Volatility Chart 22Abe Holding At Koizumi's Levels Of Support Expect Volatility... Of Volatility Expect Volatility... Of Volatility More importantly, the all-important September leadership election is approaching. The challenges arising today are at least partly motivated by factions within the LDP that want to challenge Abe's leadership. Koizumi stepped aside in September 2006 because he could not contend for the LDP's leadership due to party rules that limited the leader to two consecutive three-year terms. Abe is not constrained on this front. He has already revised those rules to three terms, giving him until September 2021 to remain eligible as party leader. He wants to run again and incumbents are heavily favored in party elections. Abe also secured his second two-thirds supermajority in the House of Representatives, in October 2017. This was a remarkable feat and one that will make it difficult for contenders to convince the rank and file in Japan's prefectures that they can lead the party more effectively. While Abe's 38% approval is now slightly below the psychologically important 40% level, and below the LDP's overall approval rating (Chart 23), there is no alternative to the LDP heading into July 2019 elections for the House of Councillors. This is manifest from the October election result. Chart 23Still No Alternative To LDP Still No Alternative To LDP Still No Alternative To LDP What happens if Abe's popularity sinks into the 20-percentile range? Financial markets will selloff in anticipation that he will be ousted. He could conceivably survive a scrape with the upper 20% approval range, but markets will assume the worst once he dips beneath 30% in the average polling on a sustainable basis. Markets will also assume that the remarkably reflationary period in Japanese economic policy is coming to an end. Even when Abe's successor forms a government, investors may believe that the best of the reflationary push is over. We think that the market would be wrong to doubt Japan's inflationary push. First, if Abe is ousted, the LDP will remain in power: it has until October 2021 before it faces another general election that could deprive it of government control. (A loss in the upper house election in 2019 can prevent it from passing constitutional changes but not from running the country.) This ensures that policy will be continuous in the transition and that any changes in trajectory will be a matter of degree, not kind. Second, the phenomenon of "Abenomics" is not only Abe's doing but the LDP's answer to its first shocking experience in the political wilderness, from 2009-12. This experience taught the LDP that it needed to adopt bolder policies. The result was dovish monetary policy under Haruhiko Kuroda, who just began his second five-year term on April 9 and whose faction has the majority on the monetary policy board. Looser fiscal policy was another consequence - and ultimately it came to pass.14 It will be hard for a new LDP leader to tighten policy. Factions that are criticizing Abe or Kuroda today will find it harder to phase out stimulus once they are in office. Abe's successor will, like him, have to try policies that boost corporate investment, wages, the fertility rate, immigration, social spending and military spending.15 Without such initiatives, Japan will sink back into a deflationary spiral. As for BoJ policy, over the next 18 months the biggest challenges are meeting the 2% inflation target while the yen is rising due to both China's slowdown and trade war risks.16 Tokyo is also ostensibly required to hike the consumption tax in October 2019. This is more than enough to convince Kuroda to stand pat for the time being.17 In the meantime, Abe's push to revise the constitution is a significant factor in encouraging persistently loose monetary and fiscal policy. The national referendum on the matter could be held along with the early 2019 local elections or the July 2019 upper house election. It will be hard to win 50%+ of the popular vote and nigh impossible if the economy is failing. What should investors look for to determine if Abe's downfall is imminent? In addition to Abe's approval rating we will watch to see if the ongoing scandal probes produce any direct link to Abe, or if top cabinet ministers are forced to resign (like Finance Minister Taro Aso or Defense Minister Itsunori Onodera). It will also be a telling sign if Abe's "work-style" reforms to liberalize the labor market, which have received cabinet approval, wither in the Diet due to lack of party discipline (not our baseline view).18 But even granting Abe's survival, we would expect that China's slowdown and the U.S.-China trade war will keep the yen well bid. We are sticking with our tactical long JPY/EUR trade, which is up 2.6% thus far. Bottom Line: Shinzo Abe is likely to be re-elected as LDP leader in September and to lead his party in the charge toward the 2019 upper house election and constitutional referendum. Should he fall into the 20% of popular approval, the markets should sell off. His leadership and alliances have been remarkably reflationary and the policy tailwind could dwindle. We would fade this risk, but we still think the yen will remain buoyant due to China's internal dynamics and the U.S.-China trade war. We remain long yen/euro until we see signs that Washington and Beijing are able to defuse the immediate trade war. Russia: Tensions With The West Have Not Peaked Our view that tensions between Russia and the West would peak following President Putin's reelection has been spectacularly wrong.19 We still encourage clients to review the report, penned in early March, as it sets out the limits to Russia's aggressive foreign policy. The country is geopolitically a lot more constrained then investors think, and thus there are material limits to how far the Kremlin can take the rivalry with the West. What we did not account for is that such weakness is precisely the reason for the tensions. Specifically, the Trump administration - riding high following the success of its "maximum pressure" doctrine in the Korea imbroglio - smells blood. President Trump is betting that the view of Russian constraints is correct and therefore the time to pressure Putin - and prove his own anti-Kremlin credentials - is now. But has the market gotten ahead of itself? The expanded sanctions target specific individuals and companies - EN+ Group, GAZ Group, and Rusal - and yet the broad equity market in Russia has tumbled.20 Sberbank, which is nowhere mentioned in the sanctions, fell by an extraordinary 16% since the announcement. On one hand, there does appear to be a material step-up in sanctions. Despite being focused on specific companies, the new restrictions are designed to make the entire Russian secondary bond market "not clearable." The targeting of specific companies, therefore, was merely a shot-across-the-bow. The implication for the future - and the reason that Sberbank fell as much as it did - is that U.S. investors could be forbidden - or the compliance costs could rise by so much that they might as well be forbidden - from participating in Russian debt and equity markets in the future. On the other hand, our Russia geopolitical risk index has not priced in the renewed tensions (Chart 24). This means that either our currency-derived measure is wrong or the sell off in equity and debt markets is not translating into bearishness about the overall economy. Given our bullish oil outlook and our view of the limits of Russian aggression investors should expect, the index may actually be signaling that these tensions are an opportunity to buy Russian assets. Chart 24The Russia GPI Says No Risk The Russia GPI Says No Risk The Russia GPI Says No Risk That said, we have learned our lesson. There is no point in trying to catch a falling knife as the Kremlin and the White House square off over Syria and other geopolitical issues. As such, we are closing all of our Russia trades until we find a better entry point to capitalize on our structural view that there are material limits to geopolitical tensions between the West and Russia. The long Russia equities / short EM equities has been stopped out at 5% loss. Our buy South African / sell Russian 5-year CDS protection is down 20 bps and our long Russian / short Brazilian local currency government bonds is up 1.07 bps. Investment Implications In April 2017, we penned a report titled "Buy In May And Enjoy Your Day!," turning the old "sell in May and go away" adage on its head.21 At the time, investors were similarly facing a number of geopolitical risks, from the second round of French elections to concerns about President Trump's domestic agenda. However, we had a very high conviction view that these risks were overstated. This time around, we fear that the markets are mispricing constraints on President Trump. Geopolitical risks ahead of us are largely in the realm of foreign policy, where the U.S. Constitution gives the president large leeway. This includes trade policy. As such, it is much more difficult to have a high conviction view on how the Trump administration will act towards China, Iran, and Russia. Furthermore, the success of the "maximum pressure" doctrine has emboldened President Trump to talk tough, worry about consequences later. Investors have to understand that we are the target of President Trump's rhetoric. There is no better way for the White House to show China, Iran, and Russia that it is serious - that its threats are credible - than if it strongly counters the view that it will do nothing to harm domestic equities. We therefore expect further volatility in the markets. We propose that clients hedge the risks this summer with our "geopolitical protector portfolio" - equally-weighted basket of Swiss bonds and gold - which is currently up 1.46%, although adding 10-Year U.S. Treasurys to the mix may make sense as well. We would also recommend that clients expect both a spike in the VIX and a rise in the volatility of the VIX (volatility of volatility). Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com; and Global Fixed Income Strategy Weekly Report, "Have Bond Yields Peaked For The Cycle? No," dated September 12, 2017, available at gfis.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 28, 2018, available at gps.bcaresearch.com. 4 Please see "Russia says U.S. plans to strike Damascus, pledges military response," Reuters, dated March 13, 2018, available at reuters.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 6 Please see BCA U.S. Equity Strategy Weekly Report, "Bumpier Ride," dated March 26, 2018, available at uses.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 8 Please see "US drops contentious demand for auto content, clearing path in NAFTA talks," Globe and Mail, March 21, 2018, available at www.theglobeandmail.com. 9 Please see BCA Emerging Markets Strategy Weekly Report, "EM: Perched On An Icy Cliff," dated March 29, 2018, available at ems.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Weekly Report, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "Should Investors Fear Political Plurality?" dated November 29, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Outlook, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 13 Please see BCA's Foreign Exchange Strategy Weekly Report, "The Euro's Tricky Spot," dated February 2, 2018, available at fes.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "Japan: Kuroda Or No Kuroda, Reflation Ahead," dated February 7, 2018, available at gps.bcaresearch.com. 15 Please see "Japan: Abe Is Not Yet Dead, Long Live Abenomics," in BCA Geopolitical Strategy Weekly Report; "The Wrath Of Cohn," dated July 26, 2017; and "Japan: Abenomics Will Survive Abe," in Geopolitical Strategy Weekly Report, "Is King Dollar Back?" dated October 4, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 28, 2018; and "Politics Are Stimulative, Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 17 Please see Cory Baird, "BOJ Chief Haruhiko Kuroda Begins New Term By Vowing To Continue Stimulus In Pursuit Of 2% Inflation," Japan Times, April 9, 2018, available at www.japantimes.co.jp. 18 Please see "Work style reform legislation gets Abe Cabinet approval," Jiji Press, April 6, 2018, available at www.the-japan-news.com. 19 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Vladimir Putin, Act IV," dated March 7, 2018, available at gps.bcaresearch.com. 20 Please see Department of the Treasury, "Ukraine Related Sanctions Regulations - 31 C.F.R. Part 589," dated April 7, 2018, available at treasury.gov. 21 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com.

Highlights There is growing evidence that China's industrial sector is slowing, as are Asian trade flows. EM stocks have seen their tops. Even though current trade tensions between the U.S. and China could well dissipate, we are at the beginning of a long-term geopolitical standoff between these two superpowers. We are reinstating our long MXN / short BRL and ZAR trade. We are also upgrading Mexican sovereign credit and local bonds to overweight within their respective EM benchmarks. This week we review our recommended country allocation for the EM sovereign credit space. Feature The combination of budding signs of deceleration in both China and global trade, the trade confrontation between the U.S. and China as well as elevated equity valuations, leaves EM stocks extremely vulnerable. Odds are that EM share prices have made a major top. A few financial indicators point to a top in EM risk assets and commodities, while several leading economic indicators herald a global trade slowdown. Taken together we are reiterating our bearish stance on EM risk assets. Market- And Liquidity- Based Indicators Financial market indicators are signalling a major top in EM risk assets and commodities prices: The relative total return (carry included) of four equally weighted EM (ZAR, RUB, BRL and CLP) and three DM (AUD, NZD and CAD) commodities currencies versus an equally weighted average of two safe-haven currencies - the Japanese yen and Swiss franc - has rolled over at its previous highs, and is about to break below its 200-day moving average (Chart I-1). This technical profile points to rising odds of a major down-leg in this carry adjusted ratio of seven 'risk-on' versus two 'safe-haven' currencies, herein referred to as the risk-on / safe-haven currency ratio. Importantly, Chart I-2 demonstrates that this risk-on / safe-haven currency ratio has historically been coincident with EM share prices. A breakdown in this ratio would herald a major downtrend in EM equities. This is consistent with our qualitative assessment that EM equities have seen the peak in this rally. Chart I-1A Major Top In Risk-On Versus ##br##Safe-Haven Currency Ratio bca.ems_wr_2018_03_29_s1_c1 bca.ems_wr_2018_03_29_s1_c1 Chart I-2Risk-On Versus Safe-Haven Currency Ratio##br## And EM Share Prices: Twins? bca.ems_wr_2018_03_29_s1_c2 bca.ems_wr_2018_03_29_s1_c2 The annual rate of change in the risk-on / safe-haven currencies ratio leads global export volumes by several months. It currently indicates that global trade has already peaked, and a meaningful slowdown is in the cards (Chart I-3). As we documented in March 15 report,1 global cyclical sectors - mining, machinery and chemicals - have been underperforming since January. Industrial metals prices, including copper, are gapping down, as are steel and iron ore prices in China (Chart I-4). Chart I-3Global Trade Is Set To Slow bca.ems_wr_2018_03_29_s1_c3 bca.ems_wr_2018_03_29_s1_c3 Chart I-4A Breakdown In Metals Prices Is In The Making A Breakdown In Metals Prices Is In The Making A Breakdown In Metals Prices Is In The Making Our aggregate credit and fiscal spending impulse for China projects considerable downside risks for industrial metals prices (Chart I-5). In this context, a question arises: Why is oil doing well so far? Chart I-6 illustrates that industrial metals prices typically lead oil at peaks. Oil prices have historically been a lagging variable of global business cycles. Chart I-5China's Slowdown Is Far From Over China's Slowdown Is Far From Over China's Slowdown Is Far From Over Chart I-6Industrial Metals Lead Oil Prices At Tops Industrial Metals Lead Oil Prices At Tops Industrial Metals Lead Oil Prices At Tops Furthermore, our two measures of U.S. dollar liquidity have rolled over. These two measures have a high correlation with EM share prices and are inversely correlated with the trade-weighted U.S. dollar (Chart I-7A and Chart I-7B). The dollar is shown inverted on Chart I-7B. The rollover in these measures of U.S. dollar liquidity is due to shrinking U.S. banks' excess reserves at the Federal Reserve. The Fed's ongoing balance sheet reduction and the Treasury's replenishment of its account at the Fed will continue to shrink banks' excess reserves, and thereby weigh on these measures of U.S. dollar liquidity. In short, downside risks to EM stocks and upside risks to the U.S. dollar have increased. Last but not least, China's yield curve has recently ticked down again and is about to invert, signaling weaker growth ahead (Chart I-8). Chart I-7AU.S. Dollar Liquidity And EM Stocks... U.S. Dollar Liquidity And EM Stocks... U.S. Dollar Liquidity And EM Stocks... Chart I-7B...And Trade-Weighted Dollar (Inverted) ...And Trade-Weighted Dollar (Inverted) ...And Trade-Weighted Dollar (Inverted) Chart I-8China's Yield Curve Is About To Invert China's Yield Curve Is About To Invert China's Yield Curve Is About To Invert Hard Data In addition, certain economic data have also decisively rolled over, in particular: Taiwanese shipments to China lead global trade volumes by several months, and they now portend a meaningful slowdown in global export volumes (Chart I-9). The basis for this relationship is that Taiwan sends a lot of intermediate products to mainland China. These inputs are in turn assembled by China and then shipped worldwide. Therefore, diminishing trade flow from Taiwan to China is a sign of a slowdown in world trade. The three-month moving average of Korea's 20-day exports growth rate, which includes the March data point, reveals that considerable softness in global trade is underway (Chart I-10). Chart I-9Another Sign Of Peak In Global Trade Another Sign Of Peak In Global Trade Another Sign Of Peak In Global Trade Chart I-10Korean Export Growth Is Already Weak Korean Export Growth Is Already Weak Korean Export Growth Is Already Weak China's shipping freight index - the freight rates for containers out of China - is softening, and its annual rate of change points to weaker Asian exports (Chart I-11). The annual growth rate of vehicle sales in China has dropped to zero, with both passenger cars and commercial vehicles registering no growth in the past three months from a year ago (Chart I-12). Chart I-11Container Freight Rates In Asia Are Softening Container Freight Rates In Asia Are Softening Container Freight Rates In Asia Are Softening Chart I-12China's Auto Sales: Post-Stimulus Hangover China's Auto Sales: Post-Stimulus Hangover China's Auto Sales: Post-Stimulus Hangover Finally, measures of industrial activity in China such as total freight volumes and electricity output growth continue to downshift (Chart I-13). Next week we are planning to publish a Special Report on China's property market. Our initial research shows that structural imbalances remain acute in the nation's real estate market, and a downturn commensurable if not worse than those that occurred in 2011 and 2014-'15 is very likely. Will the Fed and the People's Bank of China (PBoC) reverse their stance quickly to stabilize growth or preclude a downdraft in global risk assets? In the U.S., the primary trend in core inflation is up. Chart I-14 demonstrates that measures of core inflation have recently risen. This, along with the tight labor market, potential upside surprises in U.S. wages and a still-large fiscal stimulus entails that the bar for the Fed to turn dovish will be somewhat higher this year. It may take a large drawdown in the S&P 500 and a meaningful appreciation in the dollar for the Fed to come to the rescue of risk assets. Chart I-13Chinese Industrial Sector Is Decelerating Chinese Industrial Sector Is Decelerating Chinese Industrial Sector Is Decelerating Chart I-14U.S. Core Inflation Has Bottomed U.S. Core Inflation Has Bottomed U.S. Core Inflation Has Bottomed The Chinese authorities on the other hand, had already been facing enormous challenges in balancing the needs for structural reforms and achieving robust growth before the eruption of the trade confrontation with the U.S. As such, the balancing task is becoming overwhelming. Even if the Chinese authorities stop tightening liquidity now, the cumulated impact of earlier liquidity and regulatory tightening will continue to work its way into the economy, thereby slowing growth. Bottom Line: There is growing evidence that China's industrial sector is slowing, as are Asian trade flows. This is bearish for commodities and EM risk assets. Geopolitics: Icing On The Cake The recent U.S. trade spat with China has arrived at a time when global trade and China's industrial cycle have already begun to downshift, as discussed above. At the same time, investor sentiment on global risk assets remains very complacent, and equity and credit markets are pricey. As such, the U.S.-China trade confrontation has become the icing on the cake. U.S. equity valuations are elevated - the median stock's P/E ratio is at an all-time high (Chart I-15). While EM share prices are not at record expensive levels, valuations are on the pricey side. The top panel of Chart I-16 shows the equal-weighted average of trailing and forward P/E, price-to-book, price-to-cash earnings and price-to-dividend ratios for the median EM sub-sector. This valuation indicator is about one standard deviation above its historical mean. Chart I-15U.S. Equities: Median P/E ##br##Is At Record High U.S. Equities: Median P/E Is At Record High U.S. Equities: Median P/E Is At Record High Chart I-16EM Stocks Are Expensive##br## In Absolute Term bca.ems_wr_2018_03_29_s1_c16 bca.ems_wr_2018_03_29_s1_c16 The bottom panel of Chart I-16 illustrates the same valuation ratio relative to DM. Contrary to prevailing consensus, EM equities are not cheap relative their DM peers. Using median multiples of sub-sectors helps remove outliers. We discussed EM stock valuations in greater detail in our January 24 and March 1 special reports; the links to these reports are available on page 17. As to the duration and depth of the U.S.-China trade confrontation, we have the following remarks: If the U.S.'s plan to impose import tariffs on Chinese goods is primarily about domestic politics ahead of the mid-term elections later this year, as well as to obtain some trade concessions from China, then the current standoff will be resolved in a matter of months. If the true intention of the U.S. is to contain China's geopolitical rise to preserve its global hegemony, this episode of import tariffs will likely mark the beginning of a much longer and drawn-out geopolitical confrontation. In such a case, the U.S.-China relationship will likely witness a roller-coaster pattern with periods of ameliorations followed by periods of escalation and confrontation. Critically, mutual distrust will set in - if not already the case - which will hamper cooperation on various issues. As trade tensions ebb and flow in the months ahead, the reality is that America is worried about losing its geopolitical hegemony to the Middle Kingdom. Our colleagues at BCA's Geopolitical Strategy service have been noting for several years that a U.S.-China confrontation is unavoidable.2 Bottom Line: Even though the current trade tensions between the U.S. and China could well dissipate, we are at the beginning of a long-term geopolitical standoff between these two superpowers. Re-Instating Long MXN / Short BRL and ZAR Trade Chart I-17MXN's Carry Is Above Those Of BRL And ZAR MXN's Carry Is Above Those Of BRL And ZAR MXN's Carry Is Above Those Of BRL And ZAR Odds are that the Mexican peso will begin outperforming the Brazilian real and the South African rand. The main reason why we closed these trades in October was due to NAFTA renegotiation risks. Presently, with the U.S.-Sino trade confrontation escalating, the odds of NAFTA abrogation are declining. In fact, the U.S. may attempt to strike a deal with its allies, including its NAFTA partners, to focus more directly on China. Consequently, a menace hanging over the peso from the Sword of Damocles, i.e., NAFTA retraction, will continue to diminish. Consistently, the risk premium priced into Mexican risk assets will wane, helping Mexican markets outperform their EM peers. Interestingly, for the first time in many years, the Mexican peso's carry is above those of the Brazilian real and the South African rand (Chart I-17). Therefore, going long MXN versus ZAR and BRL are carry positive trades. Importantly, the Mexican peso is cheap. Chart I-18A illustrates the peso is cheap in absolute terms, according to the real effective exchange rate (REER) based on unit labor costs. Chart I-18B shows the peso's relative REER against those of the rand and real. These measures are constructed using consumer and producer prices-based REERs. The peso is cheaper than the South African and Brazilian currencies. Not only is Mexico's currency cheap versus other EM currencies, but Mexican domestic bonds and sovereign spreads also offer great value relative to their EM benchmarks (Chart I-19).Finally, the Mexican equity market has massively underperformed the EM benchmark and is beginning to look attractive on a relative basis. Chart I-18AMXN Is Cheap In Trade-Weighted Terms... MXN Is Cheap In Trade-Weighted Terms... MXN Is Cheap In Trade-Weighted Terms... Chart I-18B...And Relative BRL And ZAR ...And Relative BRL And ZAR ...And Relative BRL And ZAR Chart I-19Mexican Local Currency And Dollar Bonds Offer Value Mexican Local Currency And Dollar Bonds Offer Value Mexican Local Currency And Dollar Bonds Offer Value If and as dedicated EM portfolios rotate into Mexican domestic bonds and equities, this will bid up the peso. Brazil and South Africa are leveraged to China and metals, while Mexico is exposed to the U.S. and oil. Our main theme remains that U.S. growth will do much better than that of China. While a potential drop in oil prices is a risk to the peso, Mexican goods shipments to the U.S. will remain strong, benefiting the nation's balance of payments. Macro policy in Mexico has been super-orthodox: the central bank has hiked interest rates significantly, and the government has tightened fiscal policy (Chart I-20, top panel). This has hurt growth but is positive for the trade balance and the currency (Chart I-20). Mexico will elect a new president in July, and odds of victory by leftist candidate Lopez Obrador are considerable. However, we do not expect a massive U-turn in macro policies after the elections. Importantly, the starting point of Mexico's macro settings is very healthy. In Brazil, government debt dynamics remain unsustainable, yet its financial markets have been extremely complacent. Brazil needs much higher nominal GDP growth and much lower interest rates to stabilize its public debt dynamics. As we have repeatedly argued, a major currency depreciation is needed to boost nominal GDP and government revenues. Besides, Brazil is set to hold general elections in October, and there is no visibility yet on the type of government that will enter office. In South Africa, financial markets have cheered the election of President Cyril Ramaphosa, but the outlook for structural reforms is still very uncertain. The recent decision to consider a constitutional change in Parliament that would allow the confiscation of land from white landlords may be an indication that investors have become overly optimistic on the outlook for structural reforms. In short, the median voter in both Brazil and South Africa favors leftist and populist policies. This entails that the odds of supply side reforms without meaningful riots in financial markets are not great. Finally, the relative performance of the MXN against the BRL and ZAR, including carry, seems to be attempting to make a bottom (Chart I-21). Chart I-20Mexico: Improved Macro Fundamentals Mexico: Improved Macro Fundamentals Mexico: Improved Macro Fundamentals Chart I-21A Major Bottom In MXN's Cross? A Major Bottom In MXN's Cross? A Major Bottom In MXN's Cross? Bottom Line: Go long MXN versus an equally weighted basket of BRL and ZAR. Consistently, we also recommend overweighting Mexican local currency bonds and sovereign credit relative to their respective EM benchmarks. We will review the outlook for Mexican stocks in the coming weeks. EM Sovereign Credit Space: Country Allocation Asset allocators should compare EM sovereign and corporate credit with U.S. and European corporate bonds rather than EM local bonds or equities. The basis is that EM sovereign U.S. dollar bonds are a credit market, and vastly differ from local bonds and equities in terms of volatility, risk-reward trade-off and many other parameters. In short, EM credit markets should be compared to DM credit markets and EM equities to DM equities. EM local currency bonds are a separate, unique asset class.3 We continue to recommend underweighting EM sovereign and corporate credit versus U.S. and European corporate bonds. Within the EM sovereign space, our overweights are: Mexico, Argentina, Russia, Hungary, Poland, the Philippines, Chile and Peru. Neutral: Colombia, Indonesia, Egypt and Nigeria. Our underweights are: Brazil, Venezuela, Malaysia, Turkey and South Africa. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "EM: Disguised Risks", dated March 15, 2018; the link is available on page 17. 2 Please see Geopolitical Strategy Weekly Report "We Are All Geopolitical Strategies Now", dated March 28, 2018, available at gps.bcaresearch.com. 3 You may request May 7, 2013 Emerging Markets Strategy Weekly Report discussing our perspectives on how asset allocation for EM financial markets should be done. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights China and Brazil are two extremes in regard to investment and savings - the former saves and invests a lot, the latter very little. The key difference between Brazil and China is neither the existing amount of deposits nor their propensity to save. Rather, it is their real economies' capacity to produce goods and services. Regardless of how capital expenditures are financed, when inputs for capital spending are procured domestically it is recorded as national "savings," but when they are imported there is no change in the level of national "savings." In China, policymakers are currently being forced to walk a very thin line between inflation and deflation. Brazilian consumers do not need to save more for companies to get financing for their investments. Instead, businesses - along with facilitation from the government - should build the supply side. Banks can finance the latter by originating loans "out of thin air." However, the natural consequence of this adjustment in Brazil will be considerable currency deprecation. Feature The Fallacy This is the fifth report in our series on money, credit, savings and investment. Its objective is to show that financing of investments is not constrained by national and foreign savings. This report argues against a postulate in mainstream economic literature which holds that in order to invest, nations with low savings rates need to either reduce consumption and boost national savings or to borrow foreign savings. Some examples of this economic thesis can be seen here: As Lindner neatly summarizes: "Many economists hold the position that "saving finances investment." They argue that saving - a reduction of consumption relative to income - is necessary for the provision of loans and the financing of investment." (Lindner 2015).1 Linder also provides other examples suggesting that this thesis is well entrenched in the economic theory and analysis. For example, he cites Gregory Mankiw's influential introductory macroeconomics textbook that upholds: "Saving is the supply of loans - individuals lend their saving to investors, or they deposit their saving in a bank that makes the loan for them. [. . . ] At the equilibrium interest rate, saving equals investment, and the supply of loans equals the demand." (1997, p. 63) (Lindner 2015).2 This mainstream economic thesis - that financing is constrained by savings - is intuitive, and not surprisingly many investors take it for granted. Yet this is a false proposition. This thesis is correct for barter economies but is not pertinent to modern economies with their own banking systems and national currencies. Further, Lindner (2015)3 argues: "The fallacies loanable funds theory commits might be explainable by the mis-application of some ideas and concepts of neoclassical growth models - especially the Ramsey (1928), Solow (1956) and Diamond (1965) models - to the sphere of money and finance... The Ramsey and Solow models are models of real investment only. Financial markets, financial assets and financial saving do not play any role in those models. There is only one good which, for simplicity, will be called "corn". Corn has three functions: it can be consumed, invested and used as a means of payment since wages and interest payments are made with it..." Clearly, modern economies with their fiat money systems are much more complicated than a barter economies with no banks and money. The Veracity: Financing Is Different From "Savings" This and previous reports4 clarify and elaborate on the following aspects of banking, money creation and financing as well as savings and investments: 1. Attributing the lack of investment in many emerging market (EM) economies to their low savings is a major fallacy. Borio (2015)5 argues: "Crucially, the provision of financing does not require someone to abstain from consuming. It is purely a financial transaction and hence distinct from saving... The equality of saving and investment is an accounting identity that always holds ex post and reveals nothing about financing patterns. In ex post terms, being simply the outcome of expenditures, saving does not represent a constraint on how much agents are able to spend ex ante. If we step back from comparative statics and consider the underlying dynamics, it is only once expenditures take place that income and investment, and hence saving, are generated." 2. Banks do not need deposits or "savings" to lend. They create money/deposits when they originate loans or buy assets from non-banks. To settle payments with their peers as well as the central bank, they require reserves at the central bank. Reserves at the central bank - not client deposits - constitute true liquidity for banks. For a more detailed discussion on loan origination and money creation in absence of new deposits entering into the banking system, please refer to Appendix 1 and 2 on pages 14 and 18. Certainly, there are several factors such as regulations and shareholder preferences that can curtail banks' ability to expand their balance sheets. However, households' or nations' "savings" do not constrain banks' ability to originate new loans/create deposits. 3. In an economy where banks exist, "savings" and financing are very different things. Many investors use the term "savings" to refer to bank deposits. Yet, in macroeconomics, national and household "savings" are not related to deposits or money in the banking system at all. Chart I-1 demonstrates that there is no relationship between the savings and changes in the amount of money in the banking system. Chart I-1Savings And New Money ##br##Creation Do Not Correlate Savings And New Money Creation Do Not Correlate Savings And New Money Creation Do Not Correlate The confusion between national "savings" and financing creation is dealt with nicely again by Fabian Lindner. Having modelled it, Lindner argues: "... the aggregate economy's saving is equal to the newly produced tangible assets and inventories. That total saving is equal to just the increase in tangible assets ... (because) all changes in net financial assets in the economy add up to zero... Thus, for every economic agent increasing her net financial assets, there is a corresponding decrease in net financial assets of all other economic agents in the economy (Lindner 2015).6 Put in more general terms: An economic agent can only save financially if other agents dis-save financially by the same amount... That is why in the entire economy (that is the world economy or a closed economy) only the increase in tangible assets, thus investment, is saving...." In another paper, Lindner asserts: "Investment is the production of any non-financial asset in an economy and thus is always directly and unambiguously savings: it increases the economy's net worth... The economy as a whole cannot change its net financial wealth since it always equals zero. The aggregate economy can only save in the form of non-financial assets...The only way an economy can save is by increasing its non-financial wealth, i.e., its physical capital stock" (Lindner 2012).7 On the whole, deposits are a monetary concept; they represent money savings. Deposits are created by banks "out of thin air," as illustrated in Appendix 1 on page 14. Meanwhile, "savings" are a net addition to capital stock. Not surprisingly, there is no relationship between "real savings" and money savings, as illustrated in Chart I-1. In a nutshell, "savings" is an addition to the capital stock of a nation, which is the same as investment. Hence, the Savings = Investment identity for a closed economy is nothing other than a tautology as it de-facto means Investment = Investment. That is why in this report we use "savings" in quotations whenever we refer to it in the traditional sense of economic theory. 4. Households' (or businesses') propensity to save alters the velocity of money, not the amount of deposits/money in the banking system. A decision by a household to spend more rather than save does not change the amount of deposits in the banking system and does not affect the banking system's ability to provide more financing. When households or companies decide to spend their deposits, the velocity of money rises. Conversely, when households and companies decide to save (retain) their deposits, the velocity of money drops. The amount of deposits in the banking system stays constant. In turn, the amount of deposits and hence broad money supply in any banking system equals the cumulative net money creation by banks and the central bank over the course of their history. This has nothing to do with household and national "savings," which form the country's capital stock. 5. In a country with its own national currency, the true macro constraint on commercial banks' ability to expand financing infinitely are inflation and currency depreciation - not "savings." This is of course apart from demand for loans, regulations and shareholder preferences that can limit commercial banks' capacity to expand their balance sheets. Bottom Line: In an economy with banks, one does not need to save in the form of a deposit in a bank for the latter to lend money to another entity. Tales Of Brazil And China Chart I-2Two Extremes Of Investment ##br##And Savings: China And Brazil Two Extremes Of Investment And Savings: China And Brazil Two Extremes Of Investment And Savings: China And Brazil We use China and Brazil solely for illustrative purposes. One can use any country with a low savings rate instead of Brazil or a high savings rate economy such as Korea, Taiwan or Singapore in place of China. China has enjoyed a very high national savings rate and has been investing substantially (Chart I-2). In contrast, both the national savings rate and the investment-to-GDP ratio in Brazil have been depressed. It is very tempting to argue that Brazil has been experiencing very low investment because it saves so little. The narrative goes like this: Brazil's national savings rate is low because households save so little and the public sector dis-saves a lot - i.e., the government runs enormous fiscal deficits. This constrains the pool of available "savings" to finance private capital expenditures. This typical analysis concludes that Brazil needs to boost its "savings" - i.e., reduce its spending. This will allegedly enlarge the pool of available "savings" for investment and allow the country to invest, and consequently boost productivity and its potential growth rate. This narrative is misplaced in our view, because as we have shown in the past and in this report, banks do not need households, businesses or the government to save in order to provide financing. Banks can provide financing by simply expanding the money multiplier, among other things (see a more detailed discussion about the money multiplier below). So what is the true difference between Brazil and China? How has the latter achieved such high savings and investment rates, while the former has failed to finance its capital spending? Why have Brazilian banks not expanded their balance sheets more rapidly to finance investment (Chart I-3)? Chart I-3Snapshot Of Bank Assets-To-GDP Ratios Snapshot Of Bank Assets-To-GDP Ratios Snapshot Of Bank Assets-To-GDP Ratios Let's consider a hypothetical example. For simplicity and illustrative purposes, we assume there are two economies of equal size and have the same level of investment: savings and net exports. In short, they have identical starting points. We refer to these economies as Brazil and China. Now, commercial banks in both countries provide new financing of $50 - or equal to 5% of their respective GDP - to businesses for infrastructure building. This is new purchasing power created by commercial banks "out of thin air" in both economies. We assume that the only difference between these two countries is that in China, 100% of inputs for infrastructure (materials, machinery/equipment and so on) are produced/purchased domestically. In contrast, in Brazil, 100% of the inputs for infrastructure construction are imported, because this economy lacks production capacity. Table I-1 illustrates this hypothetical numerical example. As this infrastructure project is implemented, Brazil's imports will surge, and its net exports will deteriorate. Chart I-4 shows that this indeed is the case in Brazil - when capital spending expands, its current accounts deficit widens, entailing that Brazil imports a considerable portion of inputs for its investments. Table I-1A Hypothetical Example Of Investment - Saving Dynamics Is Investment Constrained By Savings? Tales Of China And Brazil Is Investment Constrained By Savings? Tales Of China And Brazil Chart I-4Foreign Content Of Brazil's ##br##Capital Spending Is High Foreign Content Of Brazil's Capital Spending Is High Foreign Content Of Brazil's Capital Spending Is High If there is no matching rise in foreign investor demand for Brazilian assets, the nation's currency will depreciate. Consequently, to support the plunging currency, Brazilian interest rates would have to rise. As a result, higher borrowing costs short-circuit the credit cycle. In China, because inputs for infrastructure are sourced and procured locally, there is no impact on its exchange rate or interest rates. If there is excess capacity in China to produce these inputs for infrastructure building, this new purchasing power will not lift inflation. A caveat is in order: Similar dynamics in trade balance deterioration, currency depreciation and inflation will prevail if there is a rise in consumer spending instead of capital expenditures. Importantly, the outcome will be the same in both economies if investment spending is done using existing money savings (deposits), not new credit. This example illustrates that a similar amount of capital expenditures financing via money creation "out of thin air" in both economies has increased national savings in China from $250 to $300, yet Brazilian savings stayed at $250 (Table I-1). In terms of savings rate, China will record a rise in its national savings rate from 25% to 28.6% of GDP (Table I-1). In Brazil, however, the national savings rate will remain at 25% of GDP, even though its banks, like Chinese ones, originated money "out of thin air" to finance infrastructure spending. The starting-point difference between China and Brazil is neither their banking systems' ability to expand their balance sheets nor the existing amount of deposits and assets. Rather, it is their real economies' capacity to produce goods and services. Therefore, we conclude: Regardless of how capital expenditures are financed - via new borrowing from banks or non-banks or using the investing company's own financial resources - when inputs for capital spending are procured domestically it is recorded as an increase in national "savings" level, but when they are imported there is no change in the level of national "savings." Over the decades, China, Korea, Taiwan, Singapore and Japan have all aggressively expanded their capacity to produce goods and services. They funded this capacity build-up via both money creation "out of thin air" and by attracting foreign capital. In the meantime, their large exports shielded their currencies from abrupt depreciation - as and when local bank financing was used to acquire foreign inputs. In the past decade, in China, loans - which banks have originated to build infrastructure - were largely spent on domestic inputs: cement, steel, chemicals, machinery and equipment all produced in the mainland. Even though some of that money/loans was used to purchase foreign inputs (commodities and equipment), China had large U.S. dollar revenues from exports that acted as an offset in its balance of payments. In short, Brazil and other low "savings" rate nations do not need to raise interest rates to curtail consumption and boost savings in order to release funds for financing capital expenditures. Chart I-5 demonstrates that there has been no positive relationship between real interest rates and the national savings rate in Brazil. Remarkably, real interest rates in this nation were often very high but that still did not lead to high "savings." Chart I-5Real Interest Rates And Savings Are Not Positively Correlated As They Are Supposed To Be Real Interest Rates And Savings Are Not Correlated Real Interest Rates And Savings Are Not Correlated What Brazil and other low "savings" rate economies need is to build efficient and competitive productive capacity - i.e., they need changes in the supply side of their economies. Only then can their banks expand their balance sheets and provide financing similar to how banks in high "savings" countries do. However, to shield the exchange rate from depreciation, these nations need to boost their exports first. This can be done by depreciating the currency and developing their global competitiveness. This is in effect what China has done in the past 25-30 years. Bottom Line: The key difference between Brazil and China is not their propensity to consume versus save, but their ability to produce goods and services domestically. So long as a nation builds and maintains excess productive capacity, its banks can originate loans "out of thin air" and finance capital and consumer expenditures. Money Multiplier Versus "Savings" Redundancy of the mainstream economic view that a pool of "savings" represents a constraint on financing investments becomes apparent when one applies the money multiplier concept, which is in fact accepted by mainstream economic theory. The money multiplier is the ratio of broad money relative to excess reserves. A rise in the money multiplier will lead to more money creation and financing in an economy per one unit of excess reserves (liquidity provided by the central bank), everything else held constant. In brief, money supply/the amount of deposits in the banking system will change regardless of the level of national or household "savings." Let's assume two countries with the same level of income per capita and GDP have identical national savings and investment rates as well as money supply and excess reserves. In short, they have indistinguishable macro parameters. Now suppose their banking systems in the past year had different money multipliers. The monetary authorities in both countries maintain the banking system's excess reserves at 10 units. If the money multiplier were to remain constant, say at 15, the money supply/deposits in both banking systems would remain at 150 units (10x15). Let's assume the money multiplier increased to 20 in Country A while held constant at 15 in Country B. In such a case, broad money supply would have risen to 200 units (10x20) in Country A and would stay at 150 (10x15) units in Country B. This entails that banks in Country A increased their funding yet those in Country B did not. That is despite the fact that the savings rates (and amount of savings) were identical before the change in the money multipliers occurred. This is one way to prove that a nation does not need to cut consumption for its banks to provide financing. The reason why the money multipliers could vary in these two countries with otherwise similar macro-economic parameters is due to animal spirits: In Country A, banks may have felt increasingly confident to lend more per one unit of their excess reserves, and there was demand for credit from borrowers. In the meantime, the money multiplier remained the same in Country B. In China, the money multiplier - the ratio of broad money to excess reserves - has risen dramatically since 2013 (Chart I-6). Interestingly, the amount of excess reserves at the People's Bank of China has been broadly the same over the past five years, yet broad money has grown by an enormous 75% (Chart I-6, middle and bottom panel). The exponential money/credit creation in China since 2009 has to a large extent been due to the rising money multiplier - wild animal spirits among bankers and borrowers - rather than high national "savings." Bottom Line: In any country, banks can provide more financing simply by expanding the money multiplier. This can happen regardless of the country's savings rate. Investment Relevance Why is this analysis pertinent to investors? First, this issue is critical to assess whether China's excessive credit expansion is an outcome of the nation's high savings - like many economists and investors claim - or due to the enormous amount of money/deposits and credit originated by the mainland's banks "out of thin air." If it is the former, investors have no need to worry about China's money and credit dynamics. If it is the latter, we are facing a typical banking and money/credit bubble. This report corroborates that it is the latter. Chart I-7 shows that China's broad money has grown 4-fold since January 2009 and has reached RMB 200 trillion, or the equivalent of $30 trillion. Chart I-6China: Money Multiplier Has Risen A Lot China: Money Multiplier Has Risen A Lot China: Money Multiplier Has Risen A Lot Chart I-7A Money Bubble In China? A Money Bubble In China? A Money Bubble In China? Does this enormous quantity of RMBs pose an inflation and/or currency depreciation risk? Or will the ongoing policy tightening cause another deflationary slump in China? It is clear that Chinese policymakers are currently being forced to walk a very thin line: On the one hand, the immense amount of money created "out of thin air" could stoke inflation or currency depreciation. It may not take much of a rise in the velocity of money for inflation to become a problem. On the other, tightening policy amid high leverage in an economy that is addicted to money and credit could push it into a growth slump and deflation. There is always a chance that policymakers will get it right and manage it perfectly so that neither inflation/currency depreciation nor a growth slump transpire. We would assign a 25-30% probability to this benign outcome. Hence, in our opinion there are 70-75% odds of either inflation or deflation in China in the next 12-24 months. Given these odds, we have been and remain reluctant to chase the rally in EM and China-related plays. In particular, the Chinese authorities have been tightening liquidity and banking/shadow banking regulation as well as projecting the ongoing anti-corruption campaign into the financial industry. This poses a meaningful risk given the existing macro imbalances. Second, this analysis re-shapes how investors should think about economic development and understand how nations with low savings can grow without relying on foreign funding. This provides us with a framework to assess the developmental path and the sustainability of growth in various developing economies. These include but are not limited to nations with low national savings rates such as Brazil, South Africa, Turkey, Russia, Colombia and many others. Finally, this analysis leads us to argue that Brazil does not need to maintain high real interest rates as a way to force consumers to cut spending and boost savings. In fact, this is the wrong prescription for Brazil. The most optimal macro adjustment path for Brazil is to reduce interest rates much further and encourage banks to finance private investment. Brazil needs to build an efficient supply side, and banks can provide funding by originating loans "out of thin air." Brazilian consumers do not need to save more for companies to get financing for their projects and invest. The natural causality of this adjustment will be considerable currency deprecation. However, Brazil is currently suffering from low inflation and high real interest rates (Chart I-8). Hence, reflationary policies are the right policy prescription. Chart I-8Brazil Needs To Reduce ##br##Interest Rates Much Further Brazil Needs To Reduce Interest Rates Much Further Brazil Needs To Reduce Interest Rates Much Further Foreign investors are therefore at risk due to potential currency depreciation. The new leaders to be elected in the October presidential elections may well adopt such a macro policy mix. Markets will front run this by pushing the real down and this will be negative for foreign investors. However, there will be a buying opportunity after the currency finds a floor. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Analyst andrijav@bcaresearch.com Appendix 1: Loan Origination, Deposits/Money Creation And Settlement The amount of deposits is not a constraint on a banking system's ability to make loans and buy assets from non-banks. Figure I-1 and I-2 present stylized cases of how commercial banks can originate new loans without requiring a new deposit or extra excess reserves entering the banking system. Specifically Figure I-1 illustrates how commercial banks can originate loans with the subsequent net settlements among themselves taking place via inter-bank borrowing/lending. In this stylized example, the banking system is comprised of three commercial banks. These commercial banks hold all deposits in the system. Cash does not exist and all payments are done via wire transfers. Figure I-1Money Creation By Banks With Net Settlement Among Banks Via Inter-Bank Lending/Borrowing Is Investment Constrained By Savings? Tales Of China And Brazil Is Investment Constrained By Savings? Tales Of China And Brazil Figure I-2Money Creation By Banks With Net Settlement Between Banks & Central Bank Is Investment Constrained By Savings? Tales Of China And Brazil Is Investment Constrained By Savings? Tales Of China And Brazil 1. Loan Origination/Money Creation In the morning, Bank 1 originates a new loan worth $100 for Client 1. This transaction creates a new asset and, for the balance sheet to balance, Bank 1 should also increase the liabilities side of its balance sheet. Therefore, it simultaneously credits Client 1's chequing account by $100. Bank 1 does not transfer other depositors' money to Client 1's chequing account; it creates a new $100 deposit. The rest of the bank's depositors still have their full deposits, which they can draw on. In a nutshell, both assets and liabilities of Bank 1 rose by $100 - this was done "out of thin air" by just pressing the enter button on the computer. That also means that a $100 of new money was created by Bank 1 which increases the overall money stock in the banking system. Meanwhile, Bank 2 lends $200 to Client 2 and Bank 3 lends $300 to Client 3. Let's assume these were the only lending transactions during that day. In aggregate, the three banks originated $600 of new loans, and consequent new deposits/money "out of thin air." 2. Money Transfer / Payments Debtors do not borrow money and leave it sitting idle. They borrow money to pay their suppliers and others they owe. Even though Clients 1, 2 and 3 wire their payments to their respective suppliers on the same day, the total amount of deposits in the banking system does not change: Deposits simply move from one bank to another or from one bank client to another. In Figure I-1, Client 1 wires its $100 from Bank 1 to Supplier B that has an account at Bank 2; Client 2 pays its $200 invoice to Supplier C which in turn has an account at Bank 3; and finally Client 3 transfers $300 to Supplier A, who holds an account at Bank 1. The amount of money/deposits in the overall banking system has not changed as a result of these wire transfers. 3. Multilateral Net Settlement At the end of the day, banks should settle with other banks. Many countries employ a multilateral net settlement system typically operated by the central bank. In a multilateral net settlement system, at the end of the day, each bank pays (receives from) the system only the net amount they are due to pay to (receive from) other banks combined. Importantly, banks settle their payments with other banks using their excess reserves (herein called reserves) at the central bank, not the deposits of their clients. This entails that banks do not need deposits to pay their dues to other banks or the central bank. Figure I-1 illustrates the impacts on the banks' reserves under the multilateral net settlement system: Bank 1's reserves at the central bank change as follows: -$100 (Client 1's wire transfer out) + $300 (this is the amount that Supplier A with an account in Bank 1 gets from Client 3) = $200. The impact on Bank 2's reserves is as follows: -$200 (Client 2's wire transfer out) + $100 (this is the amount that Supplier B with an account in Bank 2 gets from Client 1) = -$100. The net change in Bank 3's reserves is: -$300 (Client 3's wire transfer out) + $200 (this is the amount that Supplier C with an account in Bank 3 gets from Client 2) = -$100. If we assume that all banks had no excess reserves before this day, then how do they settle their accounts? There are various alternatives, but we highlight two: Figure I-1 demonstrates the case of interbank lending. As a result of the settlements, Bank 1 has $200 in extra reserves, while Bank 2 and Bank 3 each have a $100 deficit in reserves. As such, Bank 1 lends $100 to each of Bank 2 and Bank 3. Why does it lend to other banks rather than keeping these reserves at the central bank? Because interbank rates are typically slightly above the central bank's rate - the rate Bank 1 would get if it were to lend the $200 to the central bank. Figure I-2 portends the same transactions with the sole difference being the reserves flow. Unlike Figure I-1, here banks do not lend to/borrow from each other. Banks lend excess reserves to the central bank as well as borrow deficient reserves from the central bank. This is done to settle their payments with other banks. Bank 1 lends its free reserves of $200 to the central bank. Bank 2 and Bank 3 each borrow $100 reserves from the central bank to settle with the system at the end of the day. As a result, the aggregate amount of reserves at the central bank does not change. On the whole, banks created $600 of new deposits/money/loans during the day without requiring savings from households, companies, the government or foreigners. Thereby, the money supply was expanded and new financing in the amount of $600 was provided "out of thin air." Appendix 2: Deposits Versus Liquidity Below are additional questions that we seek to answer to provide further elaboration on the issues of banks creating money and the difference between deposits and liquidity: 1. Why would central banks provide reserves to banks? When a central bank targets interest rates, which is nowadays the most common policy framework in both advanced and developing countries, it must provide liquidity to banks: the latter is required to preclude interbank rates from deviating from the policy rate. Under an interest rate targeting regime, the central bank does not have complete control over banks' reserves nor broad money supply. A central bank can control either the quantity of money or the price of money (interest rates), but not both simultaneously. The following two quotes from the New York Federal Reserve Chairman William Dudley and the European Central Bank confirm that central banks nowadays provide banks with reserves on demand - i.e., the amount of reserves is determined by demand from banks. "The Federal Reserve has committed itself to supply sufficient reserves to keep the fed funds rate at its target. If banks want to expand credit and that drives up the demand for reserves, the Fed automatically meets that demand in its conduct of monetary policy. In terms of the ability to expand credit rapidly, it makes no difference whether the banks have lots of excess reserves or not." (Dudley, 2009) European Central Bank (2012), May 2012 Monthly Bulletin: "The Eurosystem ... always provides the banking system with the liquidity required to meet the aggregate reserve requirement. In fact, the ECB's reserve requirements are backward-looking, i.e. they depend on the stock of deposits (and other liabilities of credit institutions) subject to reserve requirements as it stood in the previous period, and thus after banks have extended the credit demanded by their customers." 2. Why do banks compete for deposits if they create deposits themselves? The true reason banks compete for deposits is not that they require more deposits, but because they require more reserves. When a bank attracts a deposit from another bank, the latter must transmit to the former reserves equal to the amount of the deposit transferred. When a bank is experiencing a liquidity shortage, more deposits are of no help. Banks can always create more deposits themselves, but they cannot create reserves at the central bank. The true liquidity for banks is their reserves at the central bank - not deposits. Reserves are solely created by central banks "out of thin air." A central bank may decide not to provide funding to certain banks in some cases when the authorities deem these banks insolvent and/or in breach of regulations. Otherwise, if the central bank wants to keep policy rates stable, it must provide all liquidity (reserves) banks require. 3. Why do banks attract deposits if the central bank provides liquidity on demand? The primary reason why banks seek to attract deposits instead of borrowing from the central bank is due to the cost of funding and duration of liabilities as well as regulatory requirements. Deposits may be cheaper and have longer duration than short-term funding from the central bank. 1 Lindner, F. (2015), "Does Savings Increase the Supply of Credit? A Critique of Loanable Funds Theory", Macroeconomic Policy Institute, World Economic Review 4, 2015. 2 Lindner, F. (2015), "Did Scarce Global Savings Finance the US Real Estate Bubble? The Global Saving Glut thesis from a stock flow Consistent Perspective", Macroeconomic Policy Institute, Working Paper 155, July 2015. 3 Lindner, F. (2015), "Does Savings Increase the Supply of Credit? A Critique of Loanable Funds Theory", Macroeconomic Policy Institute, World Economic Review 4, 2015. 4 Please refer to the Emerging Markets Strategy Special Reports from October 26, 2016, November 23, 2016, January 18, 2017 and December 20, 2017; available on ems.bcaresearch.com 5 Borio, C. and Disyatat, P. (2015), "Capital flows and the current account: Taking financing (more) seriously", BIS Working Papers, No. 525, October 2015. 6 Lindner, F. (2015), "Did Scarce Global Savings Finance the US Real Estate Bubble? The Global Saving Glut thesis from a stock flow Consistent Perspective", Macroeconomic Policy Institute, Working Paper 155, July 2015. 7 Lindner, F. (2012), "Savings does not finance Investment: Accounting as an indispensable guide to economic theory", Macroeconomic Policy Institute, Working Paper 100, October 2012. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Bond Strategy: The investment backdrop is broadly evolving the way that we forecasted in our 2018 Outlook, thus we continue to maintain our core strategic recommendations. Maintain below-benchmark portfolio duration and overweight global corporate debt versus government bonds (focused on the U.S.). Look to reverse that positioning sometime during the latter half of 2018 after global inflation increases and central banks tighten policy more aggressively. Japan Corporates: Japanese companies are in excellent financial shape, according to our new Japan Corporate Health Monitor. Although softening Japanese growth and a firming yen may prevent an outperformance of Japanese corporate debt in the coming months. Feature "I love it when a plan comes together." - Hannibal Smith, Leader of The A-Team Many investors likely came down with serious case of a sore neck last week, given the head-turning headlines that came out: Chart 1A Pause In The 'Inflation Scare' A Pause In The 'Inflation Scare' A Pause In The 'Inflation Scare' U.S. President Donald Trump announcing a blanket tariff on metals imports, then exempting some important countries (Canada, Mexico, Australia) only days later. Trump agreeing to an unprecedented meeting with North Korean leader Kim Jong Un on the nuclear issue, only to have the White House press secretary later announce that no meeting would take place without North Korean "concessions". The European Central Bank (ECB) hawkishly altering its forward guidance to markets at the March monetary policy meeting, but then having that immediately followed by dovish comments from ECB President Mario Draghi. The strong headline number on the February U.S. employment report blowing away expectations, but the soft readings on wages suggesting that the Fed will not have to move more aggressively on rate hikes. For bond markets in particular, the ECB announcement and the U.S. Payrolls report were most important. Investors had been growing worried about a more hawkish monetary policy shift in Europe or the U.S. This was especially true in the U.S. after the previous set of employment data was released in early February showing a pickup in wage inflation that could force the Fed to shift to a more hawkish stance. That created a spike in Treasury yields and the VIX and a full-blown equity market correction. Since then, inflation expectations have eased a bit and market pricing of future Fed and ECB moves has stabilized, helping to bring down volatility and supporting some recovery in global equity markets (Chart 1). With all of these "tape bombs" hitting the news wires, investors can be forgiven for re-thinking their medium-term investment strategy in light of the changing events. We think it is more productive to check if the initial expectations on which that strategy was based still make sense. On that note, the developments seen so far this year fit right in with the key themes we outlined in our 2018 Outlook, which we will review in this Weekly Report. The Critical Points From Our Outlook Still Hold Up In a pair of reports published last December, we translated BCA's overall 2018 Outlook into broad investment themes (and strategic implications) for global fixed income markets. We repeat those themes below, with our updated assessment on where we currently stand. Theme #1: A more bearish backdrop for bonds, led by the U.S.: Faster global growth, with rebounding inflation expectations, will trigger tighter overall global monetary policy. This will be led by Fed rate hikes and, later in 2018, ECB tapering. Global bond yields will rise in response, primarily due to higher inflation expectations. ASSESSMENT: UNFOLDING AS PLANNED, BUT WATCH INFLATION EXPECTATIONS. Economic growth is still broadly expanding at a solid pace, as evidenced by the elevated levels of the OECD leading economic indicator and our global manufacturing PMI (Chart 2). The U.S. is clearly exhibiting the strongest growth momentum looking at the individual country PMIs (bottom panel), while there is a more mixed picture in the most recent readings in other countries and regions. Importantly, all of the manufacturing PMIs remain well above the 50 line indicating expanding economic activity. Last week's U.S. Payrolls report for February showed that great American job creation machine can still produce outsized employment gains with only moderate wage inflation pressures, even in an economy that appears to be at "full employment". The +313k increase in jobs, which included upward revisions to both of the previous two months of a combined +54k, generated no change in the U.S. unemployment rate which stayed unchanged at 4.1% with the labor force participation rate increasing modestly (Chart 3). Chart 2U.S. Growth Leading The Way U.S. Growth Leading The Way U.S. Growth Leading The Way Chart 3The Fed Can Still Hike Rates Only 'Gradually' The Fed Can Still Hike Rates Only 'Gradually' The Fed Can Still Hike Rates Only 'Gradually' The wage data was perhaps the most important part of the report, given that the spike in global market volatility seen last month came on the heels of an upside surprise in U.S. average hourly earnings (AHE) for January. There was no follow through of that acceleration in February, with the year-over-year growth rate of AHE slowing back to 2.6% from 2.9%, reversing the previous month's increase (middle panel). The immediate implication is that the Fed does not have to start raising rates faster or by more than planned. That pullback in U.S. wage growth, combined with the continued sluggishness of inflation in the other developed economies and the sideways price action seen in global oil markets, does suggest that inflation expectations may struggle to be the main driver of higher global bond yields in the near term. Overall nominal bond yields are unlikely to decline, however, as real yields are slowly rising in response to faster global growth and markets pricing in tighter monetary policy in response (Chart 4). Chart 4Real Yields Rising Now,##BR##Inflation Expectations Will Rise Again Later Real Yields Rising Now, Inflation Expectations Will Rise Again Later Real Yields Rising Now, Inflation Expectations Will Rise Again Later We have not seen enough evidence to cause us to change our view on inflation expectations moving higher over the course of 2018, particularly with BCA's commodity strategists now expecting oil prices to trade between $70-$80/bbl in the latter half of 2018.1 One final point: it is far too soon to determine if the protectionist trade leanings of President Trump will alter the current trajectory of global growth and interest rates. The implication is that investors should not change their overall planned investment strategy for this year at this juncture. Theme #2: Growth & policy divergences will create cross-market bond investment opportunities: Global growth in 2018 will become less synchronized compared to 2016 & 2017, as will individual country monetary policies. Government bonds in the U.S. and Canada, where rate hikes will happen, will underperform, while bonds in the U.K. and Australia, where rates will likely be held steady, will outperform. ASSESSMENT: UNFOLDING AS PLANNED. As shown in Chart 2, the big coordinated upward move in global growth seen in 2017 is already starting to become less synchronized in 2018. Recent readings on euro area growth have softened a bit while, more worryingly, a growing list of Japanese data is slowing. U.K. data remains mixed, while the Canadian economy is showing few signs of cooling off. China's growth remains critical for so many countries, including Australia, but so far the Chinese data is showing only some moderation off of last year's pace. Net-net, the data seen so far this year is playing out according to our 2018 Themes - better in the U.S. and Canada, softer in the U.K. and Australia. We are sticking to our view that the rate hikes currently discounted by markets in the U.S. and Canada will be delivered, but that there will be little-to-no monetary tightening in the U.K. and Australia (Chart 5). Theme #3: The most dovish central banks will be forced to turn less dovish: The ECB and Bank of Japan (BoJ) will both slow the pace of their asset purchases in 2018, in response to strong domestic economies and rising inflation. This will lead to bear-steepening of yield curves in Europe, mostly in the latter half of 2018. The BoJ could raise its target on JGB yields, but only modestly, in response to an overall higher level of global bond yields. ASSESSMENT: UNFOLDING AS PLANNED, ALTHOUGH WE NOW EXPECT NO BoJ MOVE TO TAKE PLACE THIS YEAR. Both central banks have already dialed back to pace of the asset purchases in recent months. This is in addition to the Fed beginning its own process of reducing its balance sheet by not rolling over maturing bonds in its portfolio. Growth of the combined balance sheet of the "G-4" central banks (the Fed, ECB, BoJ and Bank of England) has been slowing steadily as a result (Chart 6). The ECB continues to contribute the greatest share of that aggregate "G-4" liquidity expansion, although that is projected to slow over the balance of 2018 as the ECB moves towards a full tapering of its bond buying program by the end of the year (top panel). Chart 5Not Every Central Bank##BR##Will Deliver What's Priced Not Every Central Bank Will Deliver What's Priced Not Every Central Bank Will Deliver What's Priced Chart 6Risk Assets Are##BR##Exposed To ECB Tapering Risk Assets Are Exposed To ECB Tapering Risk Assets Are Exposed To ECB Tapering Barring a sudden sharp downturn in the euro area economy, the ECB is still on track for that taper. We have been expecting a signaling of the taper sometime in the summer, likely after the ECB gains even greater confidence that its inflation target can be reached within its typical two-year forecasting horizon. That story will not be repeated in Japan, however, where core inflation is still struggling to stay much above 0% and economic data is softening. We see very little chance that the BoJ will make any alterations of its current policy settings - with negative deposit rates and a target of 0% on the 10-year JGB yield - this year, as we discussed in a recent Special Report.2 We continue to expect a diminishing liquidity tailwind for global risk assets over the rest of 2018 (bottom two panels). Theme #4: The low market volatility backdrop will end through higher bond volatility: Incremental tightening by central banks, in response to faster inflation, will raise the volatility of global interest rates. This will eventually weigh on global growth expectations over the course of 2018, and create a more volatile backdrop for risk assets in the latter half of the year. ASSESSMENT: UNFOLDING AS PLANNED. We saw a sneak preview of how this theme would play out during that volatility spike at the beginning of February, triggered by only a brief blip up higher in U.S. wage inflation. With a more sustained increase in realized global inflation likely to develop within the next 3-6 months, a return to that world of high volatility is still set to unfold in the latter half of 2018, in our view. After reviewing our four investment themes for 2018 in light of the latest news, we conclude that the themes are largely playing out. Therefore, we will continue to stick with the investment strategy conclusions for this year that were derived from those themes (Table 1):3 Table 1A Pro-Risk Recommended Portfolio In H1/2018, Looking To Get Defensive Later In The Year Sticking With The Plan Sticking With The Plan 2018 Model Bond Portfolio Positioning: Target a moderate level of portfolio risk, with below-benchmark duration and overweights on corporate credit versus government debt. These allocations will shift later in the year as central banks shift to a more restrictive monetary policy stance and growth expectations for 2018 become more uncertain. Chart 7Tracking Our Recommendations Tracking Our Recommendations Tracking Our Recommendations 2018 Country Allocations: Maintain underweight positions in the U.S., Canada and the Euro Area, keeping a moderate overweight in low-beta Japan, and add small overweights in the U.K. and Australia (where rate hikes are unlikely). The year-to-date performance of the main elements of our model bond portfolio are shown in Chart 7. All returns are shown on a currency-hedged basis in U.S. dollars. Our country underweights are shown in the top panel, our country overweights in the 2nd panel, our credit overweights in the 3rd panel and our credit underweights in the bottom panel. The broad conclusion is that our best performing underweight is the U.S. and best performing overweight is Japan. All other country allocations are essentially flat on the year (in currency-hedged terms). Our call to overweight corporate debt vs. government debt, focused on the U.S., has performed well, but mostly through our overweight stance on U.S. high-yield. Bottom Line: The investment backdrop is broadly evolving the way that we forecasted in our 2018 Outlook, thus we continue to maintain our core strategic recommendations. Maintain below-benchmark portfolio duration and overweight global corporate debt versus government bonds (focused on the U.S.). Look to reverse that positioning sometime during the latter half of 2018 after global inflation increases and central banks tighten policy more aggressively. Introducing The Japan Corporate Health Monitor Japan's relatively small corporate bond market has not provided much excitement for non-Japanese investors over the years. Japanese companies have always been highly cautious when managing leverage on their balance sheets, and have traditionally relied heavily on bank loans, rather than bond issuance, for debt financing. The result is a corporate bond market with far fewer defaults and downgrades compared to other developed economies, with much lower yields and spreads as well. Due to its small size, poor liquidity and low yields/spreads, we have not paid much attention to Japanese corporate debt in the past. Thus, we don't have the same kinds of indicators available to us for Japanese corporate bond analysis as we have in the U.S., euro area or U.K. One such indicator is the Corporate Health Monitor (CHM) to assess the financial health of corporate issuers.4 We are changing that this week by adding a Japan CHM to our global CHM suite of indicators. In other countries, we have both top-down and bottom-up versions of the CHM. The former uses GDP-level data on income statements and balance sheets to determine the individual ratios that go into the CHM (a description of the ratios is shown in Table 2), while the latter uses actual reported financial data at the individual firm level which is aggregated into the CHM. Table 2Definitions Of Ratios##BR##That Go Into The CHM Sticking With The Plan Sticking With The Plan Consistent and timely data availability is an issue for building a top-down CHM, as there is no one source of top-down data on the corporate sector. Some data is available from the BoJ or the Ministry of Finance, or even from international research groups like the OECD, but not all are presented using a consistent methodology. Some data is only available on an annual basis, which significantly diminishes the usefulness of a top-down CHM as a timely indicator for bond investment. Thus, we focused our efforts on only building a bottom-up version of a Japan CHM, using publically available financial information released with higher frequency (quarterly). We focused on non-financial companies (as we do in the CHMs for other countries) and exclude non-Japanese issuers of yen-denominated corporate bonds. In the end, we used data on 43 companies for our bottom-up CHM. By way of comparison, there are only 36 individual issuers in the Bloomberg Barclays Japan Corporate Bond Index that fit the same description of non-financial, non-foreign issuers, highlighting the relatively tiny size of the Japanese corporate bond market. Our new Japan bottom-up CHM is presented in Chart 8. The overall conclusions are the following: Japanese corporate health is in overall excellent shape, with the CHM being in the "improving health" zone for the full decade since the 2008 Financial Crisis. Corporate leverage has steadily declined since 2012, mirroring the rise in company profits and cash balances over the same period. Return on capital is currently back to the pre-2008 highs just below 6%, although operating margins remain two full percentage points below the pre-2008 highs. Interest coverage and the liquidity ratio are both at the highest levels since the mid-2000s, while debt coverage is steadily improving. The overall reading from the CHM is one of solid Japanese creditworthiness and low downgrade and default risks. It is no surprise, then, that corporate bond spreads have traded in a far narrower range than seen in other countries. In Chart 9, we present the yield, spread, return and duration data for the Bloomberg Barclays Japanese Corporate Bond Index. We also show similar data for the Japanese Government Bond Index for comparison. Japanese corporates have a much lower index duration than that of governments, which reflects the greater concentration of corporate issuance at shorter maturities. Chart 8The Japan Corporate Health Monitor The Japan Corporate Health Monitor The Japan Corporate Health Monitor Chart 9The Details Of Japan Corporate Bond Index The Details Of Japan Corporate Bond Index The Details Of Japan Corporate Bond Index Japanese corporates currently trade at a relatively modest spread of 36bps over Japanese government debt, although that spread only reached a high of just over 100bps during the 2008 Global Financial Crisis - a much lower spread compared to U.S. and European debt of similar credit quality. That is likely a combination of many factors, including the small size of the Japanese corporate market and the relatively smaller level of interest rate volatility in Japan versus other countries. Given the dearth of available bond alternatives with a positive yield in Japan, the "stretch for yield" dynamic has created a demand/supply balance that is very favorable for valuations - especially given the strong health of Japanese issuers. Chart 10Japan Corporates Do Not Like A Rising Yen Japan Corporates Do Not Like A Rising Yen Japan Corporates Do Not Like A Rising Yen It remains to be seen how the market will respond to a future economic slowdown in Japan, which may be starting to unfold given the recent string of sluggish data. On that note, the performance of the Japanese yen bears watching, as the currency has a positive correlation to Japanese corporate spreads (Chart 10). The linkage there could be a typical one of risk-aversion, where the yen goes up as risky assets selloff. Or it could be linked to growth expectations, where markets begin to price in the impact on Japanese growth and corporate profits from a stronger currency. Given our view that the BoJ is highly unlikely to make any changes to its monetary policy settings this year, the latest bout of yen strength may not last for much longer. For now, given the link between the yen and Japanese credit spreads, we would advise looking for signs that the yen is rolling over before considering any allocations to Japanese corporate debt. Bottom Line: Japanese companies are in excellent financial shape, according to our new Japan Corporate Health Monitor. Although softening Japanese growth and a firming yen may prevent an outperformance of Japanese corporate debt in the coming months. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst Ray@bcaresearch.com 1 Please see BCA Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Getting Comfortable With Higher Prices", dated February 22nd 2018, available at ces.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Special Report, "What Would It Take For The Bank Of Japan To Raise Its Yield Target?", dated February 13th 2018, available at gfis.bcareseach.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "Our Model Bond Portfolio In 2018: A Tale Of Two Halves", dated December 19th 2017, available at gfis.bcaresearch.com. 4 For a summary of all of our individual country CHMs, including a description of the methodology, please see the BCA Global Fixed Income Strategy Weekly Report, "BCA Corporate Health Monitor Chartbook: No Improvement Despite A Strong Economy", dated November 21st 2017, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Sticking With The Plan Sticking With The Plan Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The call on EM local bonds boils down to the outlook for EM exchange rates. Forthcoming EM currency depreciation will halt the rally in local bonds. EM currencies positively correlate with commodities prices but not with domestic real interest rates. Widening U.S. twin deficits are not a reason to be long EM currencies. There has historically been no consistent relationship between the U.S. exchange rate and America's twin deficits in general, or its fiscal balance, in particular. For investors who have to be invested in EM domestic bonds, our recommended overweights are Russia, Argentina, Poland, the Czech Republic, Korea, India and Thailand. Feature The stampede into EM local currency bonds has persisted even amid recent jitters in global equity markets. Notably, surging U.S./DM bond yields have failed to cause a spike in EM local yields, despite past positive correlations (Chart I-1). Chart I-1Will EM Domestic Bond Yields Continue Defying Rising U.S. Treasury Yields? Will EM Domestic Bond Yields Continue Defying Rising U.S. Treasury Yields? Will EM Domestic Bond Yields Continue Defying Rising U.S. Treasury Yields? The main reason is the resilience of EM currencies. The latter have not sold off even during the recent correction in global share prices. In high-yielding EM domestic bond markets, total returns are substantially affected by exchange rates. Not only do U.S. dollar total returns on local bonds suffer when EM currencies depreciate, but also weaker EM exchange rates cause spikes in domestic bond yields (Chart I-2). Consequently, the call on EM local bonds, especially in high-yielding markets, boils down to the outlook for EM exchange rates. Chart I-2EM Currencies Drive EM Local Yields EM Currencies Drive EM Local Yields EM Currencies Drive EM Local Yields We are negative on EM currencies versus the U.S. dollar and the euro. The basis for our view is two-fold: Strong growth in the U.S. and higher U.S. bond yields should be supportive of the greenback vis-à-vis EM currencies; the same applies to euro area growth and the euro against EM exchange rates; Weaker growth in China should weigh on commodities prices and, in turn, on EM currencies. So far, this view has not played out. In fact, negative sentiment on the U.S. dollar has recently been amplified by concerns about America's widening fiscal and current account deficits. In fact, one might argue that EM local bonds stand to benefit from the potential widening in U.S. twin deficits and the flight out of the U.S. dollar. We address the issue of U.S. twin deficits first. Twin Deficits And The U.S. Dollar... The recent narrative that the dollar typically depreciates during periods of widening twin deficits is not supported by historical evidence. We are not suggesting that twin deficits lead to currency appreciation. Our argument is that twin deficits have historically coincided with both appreciation and depreciation of the U.S. dollar. Chart I-3 exhibits the relationship between the U.S. dollar and the fiscal and current account balances. It appears that there is no consistent relationship between the fiscal and current account balances and the exchange rate. Chart I-3No Stable Relationship Between U.S. Twin Deficits And Dollar No Stable Relationship Between U.S. Twin Deficits And Dollar No Stable Relationship Between U.S. Twin Deficits And Dollar To produce a quantitative measure of the twin deficits, we sum up both the fiscal and current account balances. Chart I-4 demonstrates the relationship between the latter measure and the trade-weighted U.S. dollar. This analysis encompasses the entire history of the floating U.S. dollar since 1971. Chart I-4Combination Of U.S. Twin Deficits And Real Bond Yields Better Explain Dollar Combination Of U.S. Twin Deficits And Real Bond Yields Better Explain Dollar Combination Of U.S. Twin Deficits And Real Bond Yields Better Explain Dollar The vertical lines denote the tax cuts under former U.S. President Ronald Reagan in 1981 and 1986, and under former U.S. President George W. Bush in 2001 and 2003. As can be seen from Chart I-4, there is no stable relationship between the twin deficits and the greenback. In the 1970s, there was no consistent relationship at all; In the first half of the 1980s, the twin deficits widened substantially, but the dollar rallied dramatically. The tailwind behind the rally was tightening monetary policy and rising/high real U.S. interest rates; From 1985 through 1993, there was no consistent relationship between America's twin deficits and the currency; From 1994 until 2001, the greenback appreciated as the twin deficits narrowed, particularly the fiscal deficit; From 2001 through 2011, the dollar was in a bear market as the twin deficits expanded; From 2011 until 2016, the shrinking-to-stable twin deficits were accompanied by a U.S. dollar rally. Bottom Line: We infer from these charts that there has historically been no stable relationship between the U.S. exchange rate and America's twin deficits in general, or its fiscal balance, in particular. ... And A Missing Variable: Interest Rates Twin deficits are often associated with rising inflation. In fact, a widening current account deficit can mask hidden price pressures. In particular, an economy that over-consumes - consumes more than it produces - can satisfy its demand via imports without exerting pressure on the economy's domestic productive capacity. Booming imports will lead to a widening trade deficit rather than higher consumer price inflation. Hence, in an open economy, over-consumption can lead to a widening current account deficit, rather than rising inflation. A currency is likely to plunge amid widening twin deficits if the central bank is behind the inflation curve. In such a case, the low real interest rates would undermine the value of the exchange rate. If the central bank, however, embarks on monetary tightening that is adequate, the currency can in fact strengthen amid growing twin deficits. In this scenario, rising real interest rates would support the currency. With respect to the U.S. dollar today, its future trajectory depends on the Fed, and the market's perception of its policy stance. If the market discerns that the Fed is behind the curve, the greenback will plummet. By contrast, if the market reckons that the Fed policy response is appropriate, and U.S. real interest rates are sufficiently high/rising, the dollar could in fact appreciate amid widening twin deficits. Specifically, the U.S. dollar was in a major bull market in the early 1980s, with Reagan's tax cuts in 1981 and the ensuing widening of the country's twin deficits doing little to thwart the dollar bull market (Chart I-4). In turn, the Bush tax cuts in 2001 and 2003 were followed by a major dollar bear market. The main culprit between these two and other episodes was probably real interest rates. U.S. real interest rates/bond yields rose between 1981 and 1985, generating an enormous dollar rally. In the decade of the 2000s, by contrast, U.S. real interest rates fell and that coincided with a major bear market in the greenback (Chart I-4). Overall, the combination of U.S. twin deficits and real bond yields together, help better explain U.S. dollar dynamics than twin deficits alone. We agree that America's twin deficits will widen materially. That said, odds are that the Fed commits to further rate hikes and that U.S. bond yields continue to rise. In fact, not only are U.S. inflation breakeven yields climbing, but TIPS (real) yields have also spiked significantly. Rising real yields, which in our opinion have more upside, should support the U.S. dollar. As a final point, if the Fed falls behind the curve and the dollar continues to tumble, the markets could begin to fear a material rise in U.S. inflationary pressures. That scenario would actually resemble market dynamics that prevailed before the 1987 stock market crash. Although this is a negative scenario for the U.S. currency and is, by default, bullish for EM exchange rates and their local bonds, this is not ultimately an optimistic scenario for global risk assets. Bottom Line: Twin deficits are not solely sufficient to produce a currency bear market. Twin deficits accompanied by a central bank that is behind the inflation curve - i.e., combined with low/falling real interest rates - are what generate sufficient conditions for currency depreciation. EM Currencies And Commodities Many EM exchange rates - such as those in Latin America, as well as South African, Russian, Malaysian and Indonesian currencies - are primarily driven by commodities prices. Not surprisingly, the underlying currency index of the EM local bond benchmark index (the JPM GBI index) - which excludes China, India, Korea and Taiwan - positively correlates with commodities prices (Chart I-5). Hence, getting commodities prices right is of paramount importance to the majority of high-yielding EM local bonds. We have the following observations: First, investors' net long positions in both oil and copper are extremely elevated (Chart I-6). The last datapoint is as of February 16. Any rebound in the U.S. dollar or mounting concerns about China's growth could produce a meaningful drop in commodities prices as investors rush to close their long positions. Second, we maintain that China's intake of commodities is bound to decelerate, as decelerating credit growth and local governments' budget constraints lead to curtailment of infrastructure and property investment (Chart I-7). Chart I-5EM Currencies Positively Correlate ##br##With Commodities Prices EM Currencies Positively Correlate With Commodities Prices EM Currencies Positively Correlate With Commodities Prices Chart I-6Investors Are Very Long##br## Copper And Oil Investors Are Very Long Copper And Oil Investors Are Very Long Copper And Oil Chart I-7Slowdown In ##br##China's Capex Slowdown In China's Capex Slowdown In China's Capex Strong growth in the U.S. and EU will not offset the decline in China's intake of raw materials (excluding oil). China accounts for 50% of global demand for industrial metals. America's consumption of industrial metals is about 6-7 times smaller. For crude oil, China's share of global consumption is 14% compared with 20% and 15% for the U.S. and EU, respectively. We do not expect outright contraction in China's crude imports or consumption. The point is that when financial markets begin to price in weaker mainland growth or the U.S. dollar rebounds, oil prices will retreat as investors reduce their record high net long positions. Finally, even though EM twin deficits have ameliorated in recent years, they remain wide (Chart I-8). In turn, the majority of these countries have been financing their deficits by volatile foreign portfolio flows, as FDIs into EM remain largely depressed. If commodities prices relapse and EM currencies depreciate, there will be a period of reversal in foreign portfolio inflows into EM. While EM real local bonds yields are reasonably high, they are unlikely to prevent outflows if the U.S. dollar rallies. In the past, neither high absolute EM real yields nor their wide spreads over U.S. TIPS prevented EM currency depreciation (Chart I-9). Chart I-8AEM Twin Deficits Have Ameliorated ##br##But Are Still Wide EM Twin Deficits Have Ameliorated But Are Still Wide EM Twin Deficits Have Ameliorated But Are Still Wide Chart I-8BEM Twin Deficits Have Ameliorated ##br##But Are Still Wide EM Twin Deficits Have Ameliorated But Are Still Wide EM Twin Deficits Have Ameliorated But Are Still Wide Chart I-9EM Local Real Yields Do Not ##br##Drive Their Currencies EM Local Real Yields Do Not Drive Their Currencies EM Local Real Yields Do Not Drive Their Currencies EM Local Bonds: Country Allocation Strategy Chart I-10 attempts to identify pockets of value in EM domestic bonds. It exhibits the sum of current account and fiscal balances on the X axis, and domestic bond yields deflated by headline inflation on the Y axis. Chart I-10Identifying Pockets Of Value In EM Domestic Bonds EM Local Bonds And U.S. Twin Deficits EM Local Bonds And U.S. Twin Deficits Markets in the upper-right corner should be favored as they offer high real yields and maintain healthy fiscal and current account balances. Bond markets in the lower-left corner should be underweighted. They have low inflation-adjusted yields and large current account and fiscal deficits. Based on these metrics as well as fundamental analysis, our recommended country allocation for EM domestic bond portfolios has been and remains: Overweights: Russia, Argentina, Poland, the Czech Republic, Korea, India and Thailand. Neutral: Brazil, Mexico, Indonesia, Hungary, Chile and Colombia. Underweights: Turkey, South Africa and Malaysia. The below elaborates on Brazil, Russia and South Africa. Russia Fiscal and monetary policies are extremely tight. While they are curtailing the economic recovery, they are very friendly for creditors. Interest rates deflated by both headline and core consumer price inflation are at their highest on record, government spending is lackluster, and the new fiscal rule has replenished the country's foreign currency reserves (Chart I-11). Besides, the government's budget assumption for oil prices is very conservative - in the low-$40s per barrel for this year and 2019. Commercial banks have been increasing provisions, even though the NPL ratio is falling. In fact, Russia is well advanced in terms of both corporate and household deleveraging as well as banking system adjustment. On the whole, having experienced two large recessions in the past 10 years and having pursued extremely orthodox fiscal and monetary policies, Russian markets have become much more insulated from negative external shocks than many of their peers. In brief, Russian financial markets have become low-beta markets,1 and they will outperform their EM peers in a selloff even if oil prices slide. Brazil Brazilian local bonds offer the highest inflation-adjusted yields. However, unlike Russia, Brazil has untenable public debt dynamics, and its politics remain a wild card. The public debt-to-GDP ratio is 16% in Russia and 80% in Brazil. The fiscal deficit in Brazil stands at a whopping 8% of GDP, and interest payments on public debt are equal to 6% of GDP. Without major fiscal reforms, Brazil's public debt will continue to surge and will likely reach almost 100% of GDP by the end of 2020. High real interest rates are not only holding back the recovery but are also making public debt dynamics unsustainable. Chart I-12 illustrates that nominal GDP growth is well below local government bond yields. Chart I-11Continue Favoring ##br##Russian Local Bonds Continue Favoring Russian Local Bonds Continue Favoring Russian Local Bonds Chart I-12Brazil: Borrowing Costs Are Dreadful ##br##For Public Debt Dynamics Brazil: Borrowing Costs Are Dreadful For Public Debt Dynamics Brazil: Borrowing Costs Are Dreadful For Public Debt Dynamics Brazil needs either much higher nominal growth or major fiscal tightening to stem the surge in the public debt-to-GDP ratio. The necessary fiscal reforms - social security restructuring or primary budget surpluses - are not politically feasible right now. Meanwhile, materially higher nominal growth can be achieved only if interest rates are brought down quickly and drastically and the currency is devalued meaningfully. Hence, the primary risk to Brazilian local bonds is the exchange rate. The currency is at risk from potentially lower commodities prices on the external side, and continuous public debt deterioration, debt monetization or drastic interest rate cuts on the domestic side. Remarkably, Chart I-13 demonstrates that historically real interest rates in Brazil do not explain fluctuations in the real. The currency, rather, positively correlates with commodities prices (Chart I-14). Chart I-13Brazil: No Relationship Between##br## Real Yields And Currency Brazil: No Relationship Between Real Yields And Currency Brazil: No Relationship Between Real Yields And Currency Chart I-14The Brazilian Real And ##br##Commodities Prices The Brazilian Real And Commodities Prices The Brazilian Real And Commodities Prices It is possible that policymakers find an optimal balance between these adjustment paths, and financial markets continue to rally. However, with the current government lacking any political capital and great uncertainty surrounding the October presidential elections; the outlook is very risky, We recommend a neutral allocation to Brazilian local bonds for EM domestic bond portfolios. South Africa The South African rand and fixed-income markets have surged in the wake of Cyril Ramaphosa's win of the ANC leadership elections and his taking over of the presidency from Jacob Zuma. This has been devastating to our short rand and underweight local bonds positions. Chart I-15The South African Rand And Metals Prices The South African Rand And Metals Prices The South African Rand And Metals Prices There is no doubt that President Ramaphosa will adopt some market-friendly policies. This will constitute a major change from Zuma's handling of the economy in the past nine years. Yet the outlook for the rand is also contingent on global markets. If commodities prices do not relapse and EM risk assets generally perform well, the rand will continue strengthening, and local bond yields will decline further. However, if metals prices begin to drop and EM currencies sell off, it will be hard for the South African currency to rally further (Chart I-15). While we acknowledge the potential for positive political announcements and actions from the new political leadership, the main drivers of the rand, in our opinion, remain the trends in the U.S. dollar and commodities prices. Some investors might be tempted to compare South Africa to Brazil in terms of political headwinds turning into tailwinds. From a political vantage point, it is a fair comparison. Nevertheless, investors should put Brazil's rally into perspective. If commodities prices did not rise in 2016-2017, the Brazilian real would not have rallied. In brief, external tailwinds are as - if not more - important for EM high-yielding currencies than domestic political developments. Positive political developments are magnified amid a benign external backdrop. Conversely, in a negative external environment, positive political transformations can have limited impact on the direction of financial markets. To reflect the potential for a positive political change and forthcoming orthodox macro policies, we are closing our bet on yield curve steepening in South Africa. This position was stipulated by unorthodox macro policies of the previous government. This trade has been flat since its initiation on June 28, 2017. Weighing pros and cons, we are reluctant to upgrade the South African rand and its fixed-income market at the moment because of our negative view on metals prices and EM currencies versus the U.S. dollar. Investment Conclusions The broad trade-weighted U.S. dollar is at record oversold levels (Chart I-16). Given the forthcoming U.S. fiscal stimulus, the Fed will likely lift its dots and the greenback will rebound. This is bearish for EM currencies, especially if China's growth slows and commodities prices roll over, as we expect. EM exchange rate depreciation will halt the rally in local bonds, especially in high-yielding markets. Foreign holdings of EM local bonds are elevated (Table I-1). Hence, risks of unwinding of some positions are not trivial. Chart I-16The U.S. Dollar Is Due For A Rally The U.S. Dollar Is Due For A Rally The U.S. Dollar Is Due For A Rally Table I-1Foreign Ownership Of EM Local Bonds Is High EM Local Bonds And U.S. Twin Deficits EM Local Bonds And U.S. Twin Deficits Nevertheless, as we have argued in the past, EM local bonds offer great diversification benefits to all type of portfolios, as their correlations with many asset classes are low. For domestic bond investors who have to be invested, our recommended overweights are Russia, Argentina, Poland, the Czech Republic, Korea, India and Thailand. As to the sovereign and corporate credit markets, asset allocators should compare these with U.S. corporate credit. Consistent with our negative view on EM currencies and equities vis-à-vis their U.S. counterparts, we recommend favoring U.S. corporates versus EM sovereign and corporate credit. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report, titled "Russia: Entering A Lower-Beta Paradigm," dated March 8, 2017, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights A potential rise in U.S. inflation and China's growth slowdown represent formidable headwinds to EM risk assets. A manifestation of these tectonic macro shifts will be a U.S. dollar rally and weakening commodities prices. These two will dent the EM risk asset rally. Strong DM growth will not offset the impact of a slower Chinese economy on EMs and commodities. A new fixed-income trade: bet on a steeper swap curve in Mexico relative to Canada. Feature The global macro landscape in 2018 will be shaped by the two tectonic shifts: U.S. fiscal stimulus amid vigorous growth, and policy tightening in China amid lingering credit and money excesses. The former will grease the wheels of the already robust U.S. economy, generating a whiff of inflation and fueling a further selloff in the U.S. bond market. China's tightening will in turn weigh on commodities prices and curtail the emerging market (EM) economic recovery. A manifestation of these tectonic macro shifts will be a U.S. dollar rally and weakening commodities prices producing formidable headwinds to EM risk assets. As such, we are reiterating our recommendation to underweight EM risk assets versus their DM peers. As to the absolute performance, we believe EM risk assets are close to a major market top. A Whiff Of U.S. Inflation Strong U.S. growth could in fact be damaging to EM financial markets, as it will likely augment U.S. consumer price inflation. Investors are currently extremely sanguine on U.S. inflationary pressures. An upside surprise to inflation will lift U.S. interest rate expectations further, supporting the greenback and hurting EM carry trades. There is some evidence that U.S. inflation is about to pick up: The New York Federal Reserve underlying inflation gauge is rising, signaling higher inflation ahead (Chart I-1). The nascent revival in the MZM (money of zero maturity) impulse presages a trough in inflation (Chart I-2). Chart I-1Fed Price Pressure Gauge Signifies Higher Inflation Fed Price Pressure Gauge Signifies Higher Inflation Fed Price Pressure Gauge Signifies Higher Inflation Chart I-2U.S. Money Growth And CPI U.S. Money Growth And CPI U.S. Money Growth And CPI The weak U.S. dollar will also help augment inflation in America. U.S. import prices from emerging Asia and Mexico have been rising - even before the latest carnage in the U.S. dollar (Chart I-3). This will filter through into higher domestic price pressures. Chart I-3U.S. Import Prices Are Rising U.S. Import Prices Are Rising U.S. Import Prices Are Rising In brief, fiscal stimulus amid buoyant growth as well as overwhelming optimism among consumers and businesses is creating fertile ground for companies to raise prices. This will amplify corporate profit growth but will also lead to higher inflation. We are not making a case that U.S. inflation is about to surge. Our thesis is that market participants are very complacent on inflation. The money market is pricing in only 96 basis points in rate hikes in 2018-'19. In the meantime, the term premium in the U.S. yield curve is extremely depressed. Therefore, even modest inflation surprises will likely produce an additional meaningful selloff in U.S./DM bond markets. Will global share prices rise in response to strong corporate profit growth, or sell off in the face of higher U.S. inflation? Our hunch is that share prices will suffer as rising bond yields cause multiples to shrink. Rising bond yields will overpower the profit growth impact on share prices. The basis is that multiples are disproportionately and inversely linked to percentage change interest rates but are proportionately and positively linked to EPS.1 At still-low yields, a 50-basis-point rise in bond yields constitutes a sizable percentage change in the bond yield, likely leading to a meaningful P/E de-rating. Current sky-high bullish sentiment towards equities combined with elevated valuations and overbought conditions will mean that even a modest rise in inflation readings will likely trigger equity market jitters. EMs will underperform DMs amid such a selloff, as the former has benefited much more than the latter from low interest rates. Bottom Line: U.S. fiscal stimulus is arriving at a time when final demand is robust, the labor market is tight and business and consumer confidence is buoyant. This will encourage companies to raise prices, resulting in a whiff of U.S. inflation. The latter will rattle markets in the months ahead. China: Tightening Amid Credit/Money Excesses Inflation in China has already been steadily rising (Chart I-4). Interest rates adjusted for inflation remain low. Rising inflation along with still-lingering credit and money excesses necessitates policy tightening. We have written extensively about China's ongoing tightening trifecta - liquidity tightening, increased regulatory oversight and clampdown as well as an anti-corruption crackdown in the financial industry.2 Regulatory tightening in particular could inflict a particular bite as it outright constrains banks' ability to originate credit. This tightening has already led to record low broad money growth, and credit growth is downshifting too (Chart I-5). The cumulative impact of this tightening will play out in the months ahead, weighing further on money and credit growth and ultimately on final demand. Chart I-4China: Inflation Is In Steady Uptrend China: Inflation Is In Steady Uptrend China: Inflation Is In Steady Uptrend Chart I-5China: Broad Money And Credit Growth bca.ems_wr_2018_01_31_s1_c5 bca.ems_wr_2018_01_31_s1_c5 On the fiscal front, local government spending has languished in recent months (Chart I-6, top panel) and general (central plus local) government spending growth has been lackluster (Chart I-6, bottom panel). In 2017, local government annual spending amounted to RMB 19 trillion, or 22% of nominal GDP. Central government expenditures are about 6-fold smaller. Local governments rely on land sales to replenish their coffers, but timid money growth points to weaker land sales ahead (Chart I-7). In the meantime, their annual borrowing is restricted by the central government. Overall, this will constrain local government expenditures in 2018. Chart I-6China: Government Expenditures China: Government Expenditures China: Government Expenditures Chart I-7China: Land Sales To Slump bca.ems_wr_2018_01_31_s1_c7 bca.ems_wr_2018_01_31_s1_c7 The combined credit and fiscal spending impulse heralds a relapse in mainland imports of goods and commodities (Chart I-8). This constitutes a major threat to commodities prices, and consequently to EM. A pertinent question is whether financial markets will react to rising U.S. inflation or a slowdown in Chinese growth. Clearly, one could argue that strong U.S. growth would offset a mainland growth slump, resulting in a stable global macro environment. However, financial markets are an emotional discounting mechanism, and they do not always follow rational thinking. For example, in the first half of 2008 - just a few months ahead of the Global Financial Crisis - global financial markets were preoccupied with mounting global inflation due to strong growth in EM/China. At the time, oil and many other commodities prices were literally surging, and U.S. bond yields were climbing (Chart I-9). Global financial markets were not concerned with the ongoing U.S. recession, shrinking bank loans and deflating house prices. Chart I-8China's Impact On Rest Of The World China's Impact On Rest Of The World China's Impact On Rest Of The World Chart I-92008: An Inflation Scare Just ##br##Before Deflationary Bust 2008: An Inflation Scare Just Before Deflationary Bust 2008: An Inflation Scare Just Before Deflationary Bust In retrospect, financial markets traded on the theme of rising global inflation in the first half of 2008 even though the U.S. was already in a recession, and was heading into the most severe deflationary bust of the past 80 years. Similarly, the financial markets today could trade on the U.S. inflation theme for a couple months, even though China will be slowing. Bottom Line: China's policy tightening is particularly dangerous because it is occurring amid substantial and still-lingering credit, money and property market excesses. Won't Strong DM Growth Support China And Other EMs? Our investment stance on EM has been and remains negative, despite our positive view on U.S. and European growth. The key rationale for this stance is that EMs are much more leveraged to China than to the U.S. and Europe. Hence, our view assumes de-synchronization of growth between EM and DM. In our opinion, an EM slowdown will be largely due to China's deceleration and the latter's impact on commodities prices and non-commodity economies in Asia via trade. South America, Russia, South Africa, Malaysia and Indonesia are commodities producers, and as such are sensitive to fluctuations in commodities prices. The rest of Asia - Korea, Taiwan, Singapore, Thailand and the Philippines - are still exposed to the mainland economy as the latter is their largest export destination. Thus out of the EM sphere, China's dynamics will have a limited impact on only Mexico, India, and Turkey. However, Mexico is at risk of a NAFTA abrogation, while Turkey is at risk of runaway inflation and monetary profligacy. India on the other hand has its own problems and its bourse is unlikely to do well, given it is overbought and expensive. Furthermore, while we are bullish on the growth outlook in central European economies, they are too small to matter from an EM benchmark perspective. It might be useful to contemplate the late 1990s macro dynamics when major decoupling occurred between DM and EM. The booming economies of the U.S. and Europe did not prevent recurring crises in EM in the second half of the 1990s. Chart I-10 illustrates that U.S. and European imports growth was surging at that time, but EM stocks and currencies collapsed. What's more, despite the economic boom in DM during that period - U.S. and euro area real GDP growth rates averaged 4.2% and 2.6%, respectively, between 1996 and 1998 - commodities prices were in a bear market (Chart I-11). Chart I-10EM Crises In 1997-98: U.S. And ##br##Europe's Imports Were Booming EM Crises In 1997-98: U.S. And Europe's Imports Were Booming EM Crises In 1997-98: U.S. And Europe's Imports Were Booming Chart I-11Booming DM GDP And ##br##Falling Commodities Prices Booming DM GDP And Falling Commodities Prices Booming DM GDP And Falling Commodities Prices One might suspect that EM crises in the second half of the 1990s occurred because booming DM growth led to rising U.S. bond yields. However, Chart I-12 portrays that U.S. bond yields actually fell in 1997 and 1998 due to the deflationary shock stemming from the EM turmoil. Chart I-12EM Crises Occurred Amid ##br##Falling U.S. Bond Yields EM Crises Occurred Amid Falling U.S. Bond Yields EM Crises Occurred Amid Falling U.S. Bond Yields By and large, the 1997-98 EM crises occurred despite buoyant DM growth and falling DM bond yields. Nowadays, advanced economies carry much smaller weight in global trade and GDP than they did 20 years ago. Furthermore, EMs are much less dependent on exporting to DMs than they were two decades ago. In addition, China was not an economic powerhouse 20 years ago like it is today, and it did not buy as much from the rest of EMs as it does today. Presently, China holds the key to the EM outlook, and the link is through Chinese imports of goods and commodities. As China's credit and fiscal spending impulse suggests, mainland imports are likely to slow, weighing on commodities prices (refer to Chart I-8 on page 6). To be sure, we are not suggesting that EMs are facing crises similar to what transpired in 1997-98. The point of this comparison is to highlight that robust DM growth in of itself is not sufficient to head off an EM downturn if the latter faces a negative shock from China. With respect to DM growth benefiting China itself, it is critical to realize that China's exports to the U.S. and EU together account for only 6.6% of Chinese GDP (Chart I-13). By far, the largest component of the mainland economy is capital spending, constituting 42% of GDP. Construction and infrastructure are an integral part of capital expenditures, and they are very sensitive to money/credit cycles. Finally, from a global trade perspective, China and the rest of EM account for 46% of global imports, while the U.S. and EU account for 20% and 15%, respectively (Chart I-14). Hence, the total import bill of EM including China is larger than that of the U.S.'s and EU's imports combined. This entails that the pace of global trade growth is set to moderate if EM/China domestic demand decelerates. Chart I-13What Drives Chinese Economy: ##br##Capex Not Exports To DM What drives Chinese Economy: Capex Not Exports To DM What drives Chinese Economy: Capex Not Exports To DM Chart I-14Important Of EM/China In Global Trade Important Of EM/China In Global Trade Important Of EM/China In Global Trade Bottom Line: Strong DM growth will not offset the impact of a slower Chinese economy on EMs and commodities. Investment Conclusions A manifestation of the above-discussed tectonic macro shifts - a rise in U.S. inflation and China's slowdown - will be a U.S. dollar rally and weakening commodities prices. These two macro shifts will produce a perfect storm for EM risk assets. As a harbinger of a forthcoming selloff in EM exchange rates and DM commodities currencies (AUD, NZD and CAD), their implied volatility measures are already picking up (Chart I-15). As to a China/Asia slowdown, Korean, Taiwanese and Singaporean manufacturing output volume growth rates have already relapsed (Chart I-16). Their exports and corporate profits still appear robust because of rising prices. This certifies that there are inflationary pressures, even in Asia. Chart I-15Currency VOLs Are Rising Currency VOLs Are Rising Currency VOLs Are Rising Chart I-16Asian Manufacturing Output Volume Asian Manufacturing Output Volume Asian Manufacturing Output Volume All in all, we maintain a negative stance on EM risk assets in absolute terms and recommend underweighting them versus their DM peers. Within the EM universe, our equity market overweights are Taiwan, India, Korean technology, Thailand, Russia, central Europe and Chile. Our underweights are South Africa, Turkey, Brazil, Peru and Malaysia. Among currencies, our favorite shorts are the TRY, the ZAR, the MYR and the BRL. For investors who prefers relative EM currency trades, we recommend the following longs for crosses: RUB, TWD, THB, CNY and INR. For fixed-income trades, please refer to our open position table on page 18. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Mexico: Bet On A Steeper Swap Curve Relative To Canada For Mexican financial markets, the key uncertainty at the moment is the outcome of the ongoing NAFTA negotiations. Mexico's macro backdrop argues for considerable central bank easing, as inflation is about to roll over and domestic demand is extremely weak. However, if the U.S. pulls out of NAFTA - the odds of which are considerable, as our Geopolitical Strategy team has argued3 - the peso will sell off and interest rates are likely to rise. How should investors position themselves in Mexican fixed-income markets given this binominal outcome from the NAFTA negotiations and uncertainty over its timing? One way is to position for a swap curve steepening in Mexico, and hedge it by betting on a swap curve flattening in Canada by entering the following pair trades (Chart II-1): Chart II-1Mexico, Canada And Their ##br##Relative Swap Curve Mexico, Canada And Their Relative Swap Curve Mexico, Canada And Their Relative Swap Curve Receive 6-month and pay 10-year swap rates in Mexico Pay 6-month and receive 10-year swap rates in Canada In A Scenario Where The U.S. Withdraws From NAFTA: The Mexican swap curve would invert due to short-term rates going up more than long-term rates. In Canada, potential risks from NAFTA abrogation and tightening monetary policy amid frothy property markets and high household debt will cap upside in its long-term interest rates. With its long-term bond swap rates at par with those in the U.S., it seems as though the Canadian fixed income market is underpricing the risk of potential growth disappointments beyond the near run. In essence, should the U.S. withdraw from NAFTA, the loss realized on the Mexican steepener leg would partially be offset by the potential gain on the Canadian flattener leg. In A Scenario Where The U.S. Does Not Withdraw From NAFTA: The Mexican swap curve would start steepening. The rationale is that domestic dynamics suggest inflation has peaked and Banxico should begin its easing cycle soon. Monetary and fiscal policies have been extremely restrictive in Mexico, and considerable monetary easing is justified going forward: A significant part of the rise in inflation in 2017 was caused by peso depreciation in 2016. Last year's peso rally suggests that inflation should start to roll over soon (Chart II-2). Besides, one-off effects on inflation - such as the gasoline subsidy removal that took place at the end of 2016 - will subside as the base effect it has caused fades. In brief, the consumer inflation rate will rapidly decline, justifying substantial monetary easing. Banxico's 425 basis points in rate hikes since the end of 2015 are still filtering through the economy. The persistent slowdown in money and credit growth will continue to weigh on domestic demand for the time being. Notably, retail sales volume and gross fixed capital formation are both contracting while domestic vehicles sales are shrinking sharply (Chart II-3). Chart II-2Mexico: Inflation Is Set To Drop Mexico: Inflation Is Set To Drop Mexico: Inflation Is Set To Drop Chart II-3Mexico: Consumer And Business ##br##Spending Are Extremely Weak Mexico: Consumer And Business Spending Are Extremely Weak Mexico: Consumer And Business Spending Are Extremely Weak Due to currently high inflation, real wage growth remains weak. This will continue to weigh on consumer spending (Chart II-4). Fiscal policy has been tightening. Fiscal expenditures, excluding interest payments, are contracting in nominal terms (Chart II-5). Chart II-4Mexico: Real Wage Growth Is Very Timid Mexico: Real Wage Growth Is Very Timid Mexico: Real Wage Growth Is Very Timid Chart II-5Mexico: Fiscal Policy Is Super Tight Mexico: Fiscal Policy Is Super Tight Mexico: Fiscal Policy Is Super Tight Canada is currently on the opposite side of the business cycle spectrum relative to Mexico. The Canadian economy is very strong, being led by domestic demand. Real consumer spending is growing at its fastest pace in nearly 10 years, while the unemployment rate is at 40-year lows. Moreover, a record proportion of Canadian firms are having difficulty meeting demand because of capacity constraints and a tight labor market (Chart II-6, top and middle panel). Chart II-6Canadian Economy Is ##br##Above Full-Employment Canadian Economy Is Above Full-Employment Canadian Economy Is Above Full-Employment As such, the output gap is positive and growing, which has historically led to rising inflation (Chart II-6, bottom panel). Robust growth and rising inflation will force the Bank of Canada to hike rates further. In the meantime, real estate and consumer credit in Canada are overextended, leaving the Canadian consumer at risk from much higher interest rates. The threat that monetary tightening will hurt domestic demand in the future will cap the swap curve in Canada relative to Mexico. On the whole, in the scenario where the U.S. remains in NAFTA, the potential for swap curve steepening in Canada is less than in Mexico. Investment Recommendations We have been recommending that investors maintain a neutral stance across all asset classes in Mexico and wait for clarity on NAFTA negotiations before going overweight the country's currency, fixed-income markets and possibly equities relative to their EM peers. In the face of lingering NAFTA uncertainty, fixed-income investors should contemplate the following relative trade: Receive 6-month and pay 10-year swap rates in Mexico / pay 6-month and receive 10-year swap rates in Canada. Overall, this trade is exposed to minimal losses in the scenario where the U.S. withdraws from NAFTA but is exposed to considerable gains where the U.S. remains in NAFTA, making the overall risk/reward attractive. Provided the NAFTA negotiations could drag till year-end, this trade offers a reasonable risk-reward for traders. It offers a profitable opportunity to profit from Mexico's swap curve steepening, while limiting downside in case NAFTA is terminated before year-end. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 This is due to the fact that interest rates are in the denominator of the Gordon Growth model while EPS/dividends are in the numerator. 2 Please refer to Emerging Markets Strategy Weekly Report, titled "Questions For Emerging Markets," dated November 29, 2017, the link is available on page 19. 3 Please refer to the Geopolitical Strategy Special Report, titled "Nafta - Populism Vs. Pluto-Populism," dated November 10, 2017, the link is available at gps.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Feature Chilean stocks have surged recently following the victory of conservative businessman Sebastian Pinera in the presidential elections. Odds are that we could be witnessing the beginning of a period of Chilean outperformance against the EM equity benchmark, rather than just a short-term political relief rally. Pieces have fallen into place to produce a re-rating in Chilean equities relative to other emerging markets, as illustrated by the top panel of Chart I-1. The cyclically adjusted P/E ratio shows that Chilean stocks are cheap relative to their EM peers. Furthermore, Chilean stocks in common currency terms are presently near a 20-year bottom relative to EM equities (Chart I-1, bottom panel). Hence, just from a mean reversion perspective, Chile's performance relative to EM stocks has the potential to rise. Besides the above points, Chile's business cycle and monetary policy also warrant this bourse's outperformance versus the EM benchmark. A Sweet Spot For Equities There are several signs that the business cycle has passed its bottom and is slowly recovering (Chart I-2). Chart I-1Chilean Stocks Relative To EM Chilean Stocks Relative To EM Chilean Stocks Relative To EM Chart I-2Chilean Economy Is Reviving... Chile: Money And Economic Activity Are Bottoming Out Chilean Economy Is Reviving... Chile: Money And Economic Activity Are Bottoming Out Chilean Economy Is Reviving... Moreover, there are also several factors that will lead the Central Bank of Chile (CBC) to keep monetary policy easy for the coming 6-12 months. This will create a sweet spot for share prices where economic growth starts to pick up but the central bank does not tighten. Capital expenditures in real terms and the bank loan impulse to corporations - the second derivative of outstanding commercial loans - might have bottomed although they are still very weak (Chart I-3, top panel). Furthermore, residential and non-residential construction starts are still shrinking while the improvement in the housing loan impulse seems to be stalling (Chart I-3, bottom panel). This suggests that the capex and credit cycles - the two most interest rate-sensitive segments of the economy - remain feeble, justifying low interest rates for a while. Most importantly, there are no signs of inflationary pressures: the output gap is negative and widening, which historically has led to falling core inflation (Chart I-4). Chart I-3...But Interest Rate Sensitive Sectors Are Still Weak ...But Interest Rate Sensitive Sectors Are Still Weak ...But Interest Rate Sensitive Sectors Are Still Weak Chart I-4Chile: The Output Gap And Inflation Chile: The Output Gap And Inflation Chile: The Output Gap And Inflation A wide range of inflation measures - consumer services and trimmed mean inflation rates - are low and remain in a downtrend (Chart I-5). The key driver and measure of underlying genuine inflation is wages. Overall and key sectors' wage growth are either slowing or muted (Chart I-6). Chart I-5Chile: Inflation Is Low CHILE: INFLATION IS LOW CHILE: INFLATION IS LOW Chart I-6Chile: Wage Growth Is Tame CHILE: WAGE GROWTH IS TAME CHILE: WAGE GROWTH IS TAME Notably, the number of unemployed people is still rising while the number of job vacancies has plummeted to very low levels (Chart I-7). This heralds low wage growth and disinflationary pressures ahead. Chilean local rates, unlike high-yielding EM local fixed-income markets, will not rise if commodities prices relapse and the Chilean peso depreciates. On the contrary, the CBC can and probably will cut interest rates if the economic recovery is endangered. Therefore, we expect money supply in Chile to continue outgrowing the same measure for aggregate EM. This tends to help Chilean stocks outperform the EM equity benchmark (Chart I-8). Chart I-7Chile: A Lot Of Slack In Labor Market Chile: A Lot Of Slack In Labor Market Chile: A Lot Of Slack In Labor Market Chart I-8Upgrade Chilean Stocks Versus EM Upgrade Chilean Stocks Versus EM Upgrade Chilean Stocks Versus EM Finally, the health of the Chilean banking system is better than that of some other EM peers as the former is well provisioned and not exposed to foreign currency risk. This will also help this equity market to outperform. As to absolute performance in U.S. dollar terms, it depends on copper prices and the trend in EM absolute performance. Our base case remains that copper prices will relapse due to a deceleration in Chinese capital expenditures in general and construction (both infrastructure and property development) in particular (Chart I-9). This will drive both the Chilean peso (and probably equity prices) down. In a nutshell, the equity valuations in absolute terms are neutral. Chart I-10 illustrates that the cyclically adjusted P/E ratio for the MSCI Chile index is 21, around its fair value. Barring a reversal in EM risk assets (which we expect to start sooner rather than later), share prices could rise further. Chart I-9Downside Risks To Copper Prices bca.ems_wr_2018_01_03_s1_c9 bca.ems_wr_2018_01_03_s1_c9 Chart I-10Chile: Cyclically-Adjusted P/E Ratio Chile: Cyclically-Adjusted P/E Ratio Chile: Cyclically-Adjusted P/E Ratio Investment Conclusions We recommend EM dedicated equity investors to upgrade their allocation to Chile from neutral to overweight. The macro backdrop favors Chilean assets over their emerging markets peers. As such we recommend an overweight allocation in equity and corporate credit portfolios within their respective EM benchmarks. Can Chilean stocks outperform EM when copper prices fall? Chart I-11 suggests yes: historically there were periods when copper prices and Chile's relative equity performance versus EM were not correlated or even negatively correlated. Hence, our decision to upgrade Chilean stocks to an overweight while being negative on copper prices is not inconsistent. Chart I-11Copper Prices & Chilean Equities Versus EM: Not Always Positively Correlated Copper Prices & Chilean Equities Versus EM: Not Always Positively Correlated Copper Prices & Chilean Equities Versus EM: Not Always Positively Correlated For absolute return investors, the risk-reward profile for Chilean assets is not attractive if our baseline negative view on EM and industrial commodities prices plays out. Finally, we have been recommending to complement a short position in copper with a long leg in the Chilean peso. This allows traders to earn a bit of carry while waiting for copper prices to gap down. The CLP has lagged the recent spike in copper prices but we reiterate this position as risks to copper prices remain to the downside over the next six months. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Breadth within EM equity markets has been deteriorating both in absolute terms and relative to DM equities. This points to a major top in EM share prices. In Brazil, falling inflation has led to a relapse in nominal GDP growth. This has endangered the already-bad public debt dynamics. Without the social security reforms, the country needs to boost nominal growth to stabilize public debt dynamics. Currency depreciation will likely be required to achieve this. When the Brazilian currency sells off, the nation's financial markets perform poorly. Feature Deteriorating EM Equity Breadth Breadth within EM equity markets has been deteriorating, especially in relative terms, versus DM stock markets. This heralds a major downleg in EM versus DM relative share prices, at a minimum, and a relapse in EM share prices in absolute terms as well. Chart I-1 demonstrates that the relative performance of EM equal-weighted stock index versus the DM equal-weighted share price index has decoupled from the relative performance of EM versus DM market cap-weighted equity benchmarks. Such a gap has emerged for the first time since 1999, when MSCI's equal-weighted equity data became available. Chart I-1EM Equity Outperformance Narrowly Based Versus DM... EM Equity Outperformance Narrowly Based Versus DM... EM Equity Outperformance Narrowly Based Versus DM... Each stock has the same weight in the equal-weighted index, while the regular indexes are market-cap weighted. Hence, an equal-weighted index reflects performance of an average stock while the market cap-weighted ones are skewed by the performances of large-cap stocks. This confirms what many investors already know: that in 2017, EM outperformance versus DM has been largely due to the surge in four large-cap technology stocks in Asia. Comparing EM against the U.S. only on similar measures, the message is identical (Chart I-2). Chart I-3 illustrates the absolute performance of MSCI EM market cap-weighted and MSCI EM equal-weighted equity indexes. It appears that the EM equal-weighted stock index has failed to make new cyclical highs lately. Thereby, it has not confirmed the new high in the EM market-cap weighted equity benchmark (Chart I-3). Chart I-2...And U.S. ...And U.S. ...And U.S. Chart I-3EM Equal-Weighted Index Did Not ##br##Confirm EM Market-Cap Recent Highs EM Equal-Weighted Index Did Not Confirm EM Market-Cap Recent Highs EM Equal-Weighted Index Did Not Confirm EM Market-Cap Recent Highs Similarly, the rally in share prices of EM banks - an important macro-driven sector of the EM equity universe - has lately paused. As such, it has also not confirmed the new high in the overall EM equity benchmark (Chart I-4). Given EM tech stocks (29% of MSCI benchmark index) are extremely overbought, the EM equity rally can be sustained if leadership rotates to EM financials and commodities stocks, which account for 23% and 14% of market cap, respectively. The failure of both EM financials and commodities stocks to make new cyclical highs of late suggests the EM equity rally is wearing off. The advance-decline line for EM stocks has lately dropped below the 50 line (Chart I-5, top panel). By contrast, the DM measure is still above 50 (Chart I-5, bottom panel). This signals a major bout of EM underperformance versus DM, as well as downside risks to EM's absolute performance. Chart I-4EM Banks Also Did Not Confirm ##br##EM Market-Cap Recent Highs EM Banks Also Did Not Confirm EM Market-Cap Recent Highs EM Banks Also Did Not Confirm EM Market-Cap Recent Highs Chart I-5Poor Advance-Decline Line In EM Equities Poor Advance-Decline Line In EM Equities Poor Advance-Decline Line In EM Equities The weak technical profile for EM equities is consistent with our fundamental assessment that the main risks to global growth and share prices stem from EM/China rather than DM economies. Therefore, EM/China plays will be the first to roll over, while DM stocks will lag. Investors looking for signs of reversal in the rally in global risk assets should monitor EM/China plays. Finally, EM small cap stocks' relative performance against their DM counterparts has not confirmed the EM outperformance based on an aggregate index (Chart I-6). This is a negative signal as well, and heralds new lows in relative performance. This also corroborates that, outside those EM large-cap tech stocks that have gone exponential, the EM equity rally has been much less exuberant and vigorous. More importantly, the EM rally has recently shown signs of fatigue. Bottom Line: Breadth within EM equity markets has been deteriorating both in absolute terms and relative to DM equities. This implies that a major downturn in EM share prices as well as EM risk assets generally is approaching. Investors should stay put/underweight EM risk assets. Brazil: A Political Economy Dilemma The Nominal Impediment We are aware that the pace of economic activity in Brazil is presently gathering speed. Manufacturing, retail sales and hiring are all recovering (Chart I-7). Even capital spending that has been shrinking until recently is now starting to show signs of life. Chart I-6EM Small Caps Have Not Confirmed ##br##EM Large Cap Outperformance EM Small Caps Have Not Confirmed EM Large Cap Outperformance EM Small Caps Have Not Confirmed EM Large Cap Outperformance Chart I-7Brazil: Economic Activity Is Recovering Brazil: Economic Activity Is Recovering Brazil: Economic Activity Is Recovering Nevertheless, Brazil's public debt dynamics remain unsustainable. Nominal GDP growth has declined to its 2015 low - as falling inflation has more than offset the revival in real output (Chart I-8). Besides, real interest rates remain elevated and nominal GDP growth is well below the government's borrowing costs (Chart I-9). Chart I-8Brazil: Real Growth Is Recovering ##br##While Nominal Growth Is Relapsing Brazil: Real Growth Is Recovering While Nominal Growth Is Relapsing Brazil: Real Growth Is Recovering While Nominal Growth Is Relapsing Chart I-9Brazil: Borrowing Costs Are Still High Brazil: Borrowing Costs Are Still High Brazil: Borrowing Costs Are Still High Therefore, without full-fledged social security reforms and/or lowering ex-ante real interest rates substantially, the public debt trajectory will likely spin out of control. Interest rates in real terms are also elevated for the private sector. This suggests that credit stress among companies and households might not recede quickly, and high real interest rates might cap the recovery in loan growth (Chart I-10). Interestingly, Chart I-11 demonstrates that private banks' NPLs (non-performing loans) inversely correlate with nominal GDP growth (nominal GDP is inverted on the chart). This entails that the amelioration in Brazil's NPL cycle is at least due for a pause. Chart I-10Brazil: Bank Loan Growth Is Stabilizing Brazil: Bank Loan Growth Is Stabilizing Brazil: Bank Loan Growth Is Stabilizing Chart I-11Brazil: Nominal GDP & Bank NPLs Brazil: Nominal GDP & Bank NPLs Brazil: Nominal GDP & Bank NPLs In short, to stabilize public and private debt dynamics, higher nominal GDP growth and much lower borrowing costs in real terms are vital. The latter means an unexpected rise in inflation is required. Chart I-12Brazil In the Late 1990s Brazil In the Late 1990s Brazil In the Late 1990s To boost nominal growth considerably and finance government at lower real interest rates, a combination of quantitative easing (QE) and currency depreciation will be needed. This is not a forecast that the Brazilian central bank will certainly implement QE. Rather, our point is that without extensive social security reforms - which are politically unfeasible now (more on this below) - a meaningful currency depreciation and/or public debt monetization by the central bank will be necessary to stabilize public debt dynamics and put the economy on a sustainable expansion path. Remarkably, in the late 1990s, faced with low inflation and weak nominal growth, the Brazilian government opted for large currency devaluation, which boosted nominal GDP growth (Chart I-12). Notably, the currency was devalued despite the large share of public foreign currency debt. This ratio is now very low. Hence, currency depreciation will be less painful now than it was in 1998. A Political Economy Dilemma: Growth Versus Creditors Brazil's elected politicians (congressmen and senators) are facing a political economy dilemma: (a) Should they satisfy interests of government creditors (including foreign investors) - i.e., pursue painful fiscal reforms to make public debt sustainable? Or (b) Should they gratify the electorate - i.e., avoid austerity and stimulate the still-beleaguered economy? To put this in perspective, the economy is just exiting one of the worst recessions of the past century, and the unemployment rate is still at a decade high. Over the next several months, the government of President Michel Temer will try to pass a diluted version of the pension reform bill. The government is desperate to enact this bill to keep financial markets buoyant and preserve the ongoing economic recovery heading into the elections. Being already very unpopular, government officials realize this is the only way their candidate has a chance to get elected in the presidential elections next year. However, the diluted version will not be enough to ensure debt sustainability. Chart I-13Brazil's Median Voter Favors ##br##Anti-Government Candidates Brazil's Median Voter Favors Anti-Government Candidates Brazil's Median Voter Favors Anti-Government Candidates Moreover, many of the government's coalition partners have different incentives. Going into the general elections in October 2018, odds favor that the majority of congressmen and senators will likely vote for avoiding austerity. As a result, the pension reforms draft - even in its diluted form - will likely fail. The median voter in Brazil remains on the left. Chart I-13 reveals that according to the latest polls, 60% of voters support anti-market candidates. Hence, any politician who wants to be elected needs to heed to the electorate. Worsening Fiscal Dynamics Public debt sustainability has been worsening: The primary and overall deficits have lately widened to 2.9% and 9.3% of GDP, respectively (Chart I-14). Public debt sustainability necessitates that the primary fiscal balance swings into a surplus, and borrowing costs drop below nominal GDP. None of these requirements have been satisfied or are likely to be anytime soon. Meanwhile, central government total revenue growth has dwindled (Chart I-15, top panel). In turn, central government net revenue - i.e. excluding transfers to local governments - are mildly contracting due to the increase in revenue transfers to the latter (Chart I-15, bottom panel). Chart I-14Brazil: Fiscal Deficit Has Not Improved Brazil: Fiscal Deficit Has Not Improved Brazil: Fiscal Deficit Has Not Improved Chart I-15Central Government Revenues Are Very Weak Central Government Revenues Are Very Weak Central Government Revenues Are Very Weak Furthermore, the overall fiscal deficit excluding social security is at 6% of GDP and has widened over the past year (Chart I-14, bottom panel). Interest payments account for 32% of government spending and 6.4% of GDP. On the whole, without a large fiscal retrenchment and with real interest rates close to current levels, the gross public debt-to-GDP ratio will likely reach 85% by the end of 2018 and 92% in two years' time - even if nominal GDP growth recovers to 6-6.5%. This puts the impetus solely on the central bank to reflate nominal growth aggressively and/or bring down real interest rates. This can be achieved via currency depreciation or public debt monetization. The outcome of the latter will necessarily be a major drop in the currency's value. This, along with our negative view on commodities prices in general and iron ore prices in particular, prompts us to retain our bearish stance on the Brazilian real. Chart I-16 demonstrates that the currency is highly correlated with iron ore prices, and has no correlation with the level of and changes in the interest rate differential between Brazil and the U.S. Investment Implications The path of least resistance for the Brazilian real is down - it will depreciate more than 2% and 4% that are implied by 6- and 12-month forwards, respectively. Stay short. When the Brazilian currency sells off, the nation's financial markets perform poorly. In particular, Brazil's sovereign and corporate credit spreads are very narrow, and will widen as investors begin doubting public debt sustainability. In turn, currency depreciation will raise the cost of foreign currency debt for the private sector. Dedicated EM investors should underweight Brazilian sovereign and corporate credit relative to their benchmarks. The relapse in narrow money (M1) growth presages downside risk in share prices (Chart I-17). Chart I-16Driver Of BRL: Commodities Not Interest Rates Driver Of BRL: Commodities Not Interest Rates Driver Of BRL: Commodities Not Interest Rates Chart I-17Brazil: M1 Growth And Share Prices Brazil: M1 Growth And Share Prices Brazil: M1 Growth And Share Prices The broad stock market is not particularly cheap, given the magnitude of the rally that has considerably exceeded the EPS recovery. Finally, in the local fixed-income market we continue recommending a bet on yield curve flattening that typically happens when the currency sells off. Foreign investors should wait for currency depreciation to play out before going long local currency government bonds. Local investors should overweight local bonds versus stocks. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations