Latin America

Highlights Geopolitical risks were overstated in 2017, but have now become understated; If Donald Trump becomes an early "lame duck" president, he will seek relevance abroad; This could mean a protectionist White House, or increased geopolitical tensions with Iran and North Korea; North Korean internal stability could come into question as economic sanctions begin to bite; Political risks in the U.K. and Italy could rise with markets overly complacent on both; Emerging markets, particularly Brazil and Mexico, will see renewed political risk. Feature Buoyant global growth, political stability in Europe, and steady policymakers' hands in China have fueled risk assets in 2017. As the year draws to a close, investors also have tax cuts in the U.S. to celebrate. Our high conviction view that tax cuts would happen - and that they would be fiscally profligate - is near the finish line.1 In making this call, we ignored the failure to repeal Obamacare, the "wisdom" of old "D.C. hands," and direct intelligence from a source inside the White House circle who swore tax reform would be revenue neutral. Throughout the year, BCA's Geopolitical Strategy remained confident that the GOP would ignore its fiscal conservative credentials and focus on the midterm elections.2 That election is increasingly looking like a bloodbath-in-the-making for the Republican Party (Chart 1). What of the latest opinion polls showing that the tax cuts are unpopular with half of all Americans? The polls also show that a solid one-third of all Americans remain in support of the Republican plan (Chart 2). We suspect - as do Republican strategists - that those are the Republicans who vote in midterm elections. Given the atrociously low turnout in midterm elections - just 36.4% of Americans voted in 2014 - Republicans need their base to turn out in November. The tax cuts are not about the wider American public but the Republican base. Chart 1Midterm Election: A Bloodbath? Midterm Election: A Bloodbath? Midterm Election: A Bloodbath? Chart 2Republican Base Supports Tax Cuts Five Black Swans In 2018 Five Black Swans In 2018 As we close the book on 2017, we look with trepidation towards 2018. Our main theme for next year is that the combination of economic stimulus from the tax cuts in the U.S. and structural reforms in China will create a U.S.-dollar-bullish policy mix that will combine into a headwind for global risk assets, particularly emerging market equities.3 However, in this report, we focus on some of the more exotic risks that investors may have to deal with. In particular we focus on five potential "black swans" - low probability, high market-impact events - that are neither on the market's radar nor the media's. To qualify for our list, the events must be: Unlikely: There must be less than a 20% probability that the event will occur in the next 12 months. Out of sight: The scenario we present should not be receiving media coverage, at least not as a serious market risk. Geopolitical: We must be able to identify the risk scenario through the lens of our geopolitical methodology. Genuinely unpredictable events - such as meteor strikes, pandemics, crippling cyber-attacks, solar flares, alien invasions, and failures in the computer program running the simulation that we call the universe - do not make the cut. Black Swan 1: Lame Duck Trump "Lame duck" presidents - leaders whose popularity late in their term has sunk so low that they can no longer affect policy - are said to be particularly adventurous in the foreign arena. While this adage has a spotty empirical record, there are several notable examples in recent memory.4 American presidents have few constitutional constraints when it comes to foreign policy. Therefore, when domestic constraints rise, U.S. presidents seek relevance abroad. Chart 3The Day After The Midterms, Trump's Overall Popularity Will Matter More Than That Among Republicans Five Black Swans In 2018 Five Black Swans In 2018 President Trump may become the earliest, and lamest, lame duck president in recent U.S. history. While his Republican support remains healthy, his overall popularity is well below the average presidential approval rating at this point in the political cycle (Chart 3). Based on these poll numbers, his party is likely to underperform in the upcoming midterm election (Chart 4). A Democrat-led House of Representatives would have the votes to begin impeachment, which we would then consider likely in 2019. As we have argued in our "impeachment handbook," the market impact of such a crisis would ultimately depend on market fundamentals and the global context, not political intrigue.5 Chart 4Trump Is Becoming A Liability For The GOP Five Black Swans In 2018 Five Black Swans In 2018 President Trump's political capital ahead of the midterm elections is based on his ability to influence Republican legislators. Despite low overall poll numbers, President Trump can use the threat of endorsing primary challengers against conservative peers in Congress to move his agenda in the legislature. He has effectively done this with tax cuts. However, the day after the midterm elections, President Trump's own numbers will matter for the GOP. Given that President Trump will be on the ballot in the 2020 general election, his low approval numbers with non-Republican voters will hang like an albatross around the party's neck. This is a serious issue, particularly given that 22 of the 33 Senators up for reelection in 2020 will be Republican.6 Robust economic growth and a roaring stock market have not boosted Trump's popularity so far. At the same time, a strong economy ready to translate into higher wages is about to be "pump-primed" by stimulative tax cuts (Chart 5). We would expect the result to be a stronger dollar, which should keep the U.S. trade deficit widening well into Trump's second year in office. At some point, this will become a sore political point, given Trump's protectionist rhetoric and his administration's focus on the trade balance as a key measure of U.S. power. Chart 5Wage Pressures Are Building Wage Pressures Are Building Wage Pressures Are Building What kind of adventures would we expect to see President Trump embark on in 2018? There are three prime candidates: China-U.S. trade war: The Trump administration started off with threats against China and then proceeded to negotiations. However, neither the North Korean situation nor the trade deficit has seen substantial improvement, and a lame duck Trump administration would be more likely to resort to serious punitive actions. Even improvements on the Korean peninsula would not necessarily prevent Washington from getting tougher on Beijing over trade, as the Trump administration will be driven by domestic politics. Investors should carefully watch whether the World Trade Organization deems China a "market economy," which could trigger a U.S. backlash, and whether the various investigations by U.S. Trade Representative Robert Lighthizer and Commerce Secretary Wilbur Ross result in anti-dumping and countervailing duties being imposed more frequently on specific Chinese exports. Thus far, the empirical evidence suggests that the Trump administration has picked up the pace of protectionist rulings (Chart 6). Notably, the Trump administration claims that the Comprehensive Economic Dialogue has "stalled," and it is reviving deeper, structural demands on Chinese policymakers.7 Iran Jingoism: Rumors that Secretary of State Rex Tillerson may be replaced by CIA Director Mike Pompeo - who would be replaced at the CIA by Senator Tom Cotton - can only mean one thing: the White House has Iran in its sights. Both Pompeo and Cotton are hawks on Iran. The administration may be preparing to shift its focus from North Korea, where American allies in the region are urging caution, to the Middle East, where American allies in the region are urging aggression. Investors should watch whether Tillerson is removed and especially how Congress reacts to President Trump's decision on October 15 to decertify the Iran nuclear agreement (also called the Joint Comprehensive Plan of Action or JCPOA). The Republican-controlled Congress has until December 15 to reimpose sanctions on Iran that were suspended as part of the deal, with merely a simple majority needed in both chambers. However, President Trump will also have an opportunity, as early as January, to end waivers on a slew of sanctions that were not covered under the JCPOA. North Korea: It would be natural to slot North Korea as first on our list of potential foreign policy adventures for President Trump. However, it does not really fit our qualification of a black swan. North Korea is not "out of sight." Additionally, President Trump has already broken with the tradition of previous administrations by upping the pressure on Pyongyang. In fact, a North Korean black swan would be if President Trump succeeded in breaking the regime in Pyongyang. To that scenario we turn next. Chart 6Trump: Game Changer In U.S. Trade Policy? Five Black Swans In 2018 Five Black Swans In 2018 Bottom Line: Geopolitics has not affected the markets in 2017, with risk assets reaching record highs and the VIX reaching record lows (Chart 7). This was our view throughout the year and we called for investors to "buy in May and have a nice day" as a result of our analysis.8 We do not see this as likely in 2018. The Trump administration has no credible legislative agenda after tax cuts. We expect Congress to stall as we enter the summer primary season and for the GOP to lose the House to the Democrats. President Trump is an astute political analyst and will sense these developments before they happen. There is a good chance that he will attempt to sway the election and pre-empt his lame duck status with an aggressive foreign policy. Chart 72017 Goldilocks: S&P 500 Up, VIX Down 2017 Goldilocks: S&P 500 Up, VIX Down 2017 Goldilocks: S&P 500 Up, VIX Down Investment implications are twofold. First, we continue to recommend an equally weighted basket of Swiss 10-year bonds and gold as a portfolio hedge.9 Second, risk premium for oil prices should rise in 2018. Not only is the supply-demand balance favorable for oil prices, but geopolitical risks are likely to rise as well. Black Swan 2: A Coup In Pyongyang Our colleague Peter Berezin, BCA's Chief Global Strategist, has suggested that a coup d'état against Supreme Leader Kim Jong-un could be a black swan trigger that spooks the markets.10 While Peter used the scenario as a tongue-in-cheek way to weave Kim into a narrative that tells of a late 2019 recession, we have long raised North Korean domestic politics as the true Korean black swan.11 Here we entertain Peter's idea for three reasons.12 First, China has upped the economic pressure on Pyongyang. Under Kim Jong-un, the North Korean state has attempted some limited economic "opening up," namely to China. But the attempt to finalize the nuclear deterrent has delayed an already precarious process. There has now been a $617 million drop in Chinese imports from the country since the beginning of the year (Chart 8), with coal imports particularly affected (Chart 9). China has also pulled back on tourism. Meanwhile, North Korea's imports of Chinese goods have risen, which suggests that the country's current account balance may be widening. At some point, if these trends continue, Pyongyang will run out of foreign currency with which to purchase Chinese and Russian imports. Chart 8China Is Turning The Screws On Pyongyang... China Is Turning The Screws On Pyongyang... China Is Turning The Screws On Pyongyang... Chart 9...Particularly On Coal Imports ...Particularly On Coal Imports ...Particularly On Coal Imports Second, Pyongyang is well aware of pressures against the regime. The assassination of Kim Jong-nam - the older half-brother of Kim Jong-un - in February of this year sent a message to the world, but especially to China, which kept Kim Jong-nam around as an alternative to the current Kim. That Pyongyang went to the extreme lengths of poisoning Kim Jong-nam with VX nerve agent in a foreign airport suggests that Kim Jong-un is still worried about threats to his rule.13 If Beijing's economic sanctions continue to tighten in 2018, the military could conceivably see the Supreme Leader's aggressive foreign policy as a risk to regime survival. Third, Pyongyang could miscalculate and create a crisis from which it cannot deescalate. A provocation that disrupts international infrastructure and commerce or kills civilians from the U.S. or Japan could trigger a downward spiral. For instance, an attack against international shipping in the Yellow Sea or Sea of Japan by North Korean submarines would be an unprecedented act that the U.S. and Japan would likely retaliate against.14 We could see the U.S. following the script from Operation Praying Mantis in the Persian Gulf in 1988 - the largest surface engagement by the U.S. Navy since the Second World War. In that incident, the U.S. sunk half of Iran's navy in retaliation for the mining of the guided missile frigate USS Samuel B. Roberts. In the case of North Korea, this would primarily mean taking out its approximately 20 Romeo-class submarines and an unknown number of domestically-produced - Yugoslav-designed - newly built submarines. Such a conflict is not our baseline case, but we assign much higher probability to it than an all-out war on the Korean Peninsula. How would Pyongyang react to the sinking of its submarines? Our best case is that the regime would do nothing. The leadership in Pyongyang is massively constrained by its quantifiable military inferiority. True, North Korea has around 6 million military personnel - about 25% of the total population is under arms - but unfortunately for Pyongyang, this large army is arrayed against one of the most sophisticated defenses ever constructed by man: the Demilitarized Zone (DMZ). To support its ground forces, North Korea would have at its disposal only about 20-30 Mig-29s. Countering two dozen jets would be South Korea's combined 177 F-15s and F-16s, plus American forces that would vary in size depending on how many aircraft carriers were deployed in the vicinity. Given that a single American aircraft carrier holds up to 48 fighter jets, North Koreans would quickly find themselves fighting a losing battle. Which is why they may never initiate one. If Kim Jong-un insists on retaliation, the military could remove and replace him with, for instance, his 30-year old sister, who has recently risen in party ranks, or his 36-year old brother Kim Jong-chul, who is apparently not entirely uninvolved in the regime despite living an unassuming life in Pyongyang. What would a regime change mean for the markets? It depends on whether it is successful or not. An unsuccessful coup could lead to a massive purge and likely a total break in Pyongyang's relations with the outside world, including China. This would seriously destabilize North Korea's decision-making. The global community would have to begin contemplating a total war on the Korean peninsula. Alternatively, a successful coup could lead to temporary volatility, yet long-term stability. The military regime in the North may even be open to reunification over the long term, depending on how U.S.-China relations evolve. Bottom Line: China does not want to cripple North Korea or throw a coup. But it is cooperating with sanctions and could therefore trigger one by mistake. At least two regimes have collapsed in the past when facing the pincer movement of economic sanctions and American military pressure - South Africa's apartheid regime in 1991 and Slobodan Miloševic's Yugoslavia in 1999. Kim Jong-un could face a similar fate, particularly if China applies excessive economic pressure. Black Swan 3: Prime Minister Jeremy Corbyn There is no election scheduled in the U.K. for 2018, but if one were to be held the ruling Tories would be in trouble (Chart 10). In fact, the combined anti-Brexit forces are currently in a solid lead over the pro-Brexit parties, Conservatives and the U.K. Independence Party (UKIP) (Chart 11). Chart 10Labour Is In The Lead... Labour Is In The Lead... Labour Is In The Lead... Chart 11...As Are Anti-Brexit Forces Writ-Large ...As Are Anti-Brexit Forces Writ-Large ...As Are Anti-Brexit Forces Writ-Large What could trigger such an election? Ultimately, the final exit deal may prompt a new election. More immediately, the ongoing negotiations over the status of the Irish border would be a prime candidate. As our colleague Dhaval Joshi, head of BCA's European Investment Strategy noted recently, Prime Minister Theresa May's government is propped up by the Northern Irish Unionists to whom May has promised that there will be no hard border between Northern Ireland and the Republic of Ireland. This will likely create a crisis as the EU negotiations may inadvertently threaten the Good Friday peace agreement. The Northern Ireland Unionists will not tolerate the border moving to the Irish Sea. This would effectively take Northern Ireland into the EU customs union and single market, and out of the U.K.'s domestic trading zone. It would also embolden Scotland's push for single market access. In essence, the Tory government may collapse because of differences within the U.K.'s "three kingdoms" before it even has the chance to collapse over differences with the EU.15 The market may cheer a Labour-Scottish National Party (SNP) coalition government, a potential winner of an early election, as it would mean that a new referendum on the U.K. leaving the EU could be held. The latest polls suggest that "Bremorse" (remorse for Brexit) has set in, as a clear majority in the U.K. thinks that Brexit was a bad idea (Chart 12). However, we suspect that it would take Prime Minister Jeremy Corbyn several months, if not over a year, before he called such a referendum. First, Corbyn is on record supporting a soft Brexit, not a new referendum, and he has only just begun to adjust this position. Second, a soft Brexit is far more difficult to achieve than the hard Brexit of Prime Minister Theresa May since it requires the U.K. to subvert its sovereignty in significant ways (i.e., accepting EU regulation) in order to access the EU Common Market. Third, the most politically palatable way to re-do the referendum is to put a U.K.-EU deal up to the people to decide, which means that Corbyn first has to spend a long time negotiating that deal. Chart 12Bremorse Sets In Bremorse Sets In Bremorse Sets In The market may be disappointed to find out that PM Corbyn is not willing or able to put the question of the U.K.'s EU exit up to a vote right away. Instead, the market would have to deal with Corbyn's economic policies, which are markedly left-wing. Corbyn harkens back to the 110 Propositions pour la France of French President François Mitterrand, if not exactly to the ghastly 1970s of the U.K.'s own history. A brief sample platter of Labour's proposals under Corbyn includes: Increasing the U.K. corporate tax rate to 26% from 20%; Increasing the minimum wage; Forcing companies not to out-source operations; Nationalizing public infrastructure companies. How should investors play a Corbyn victory? We think that the U.K. pound would likely rally on a higher probability of reversing Brexit. However, this "no Brexit" rally would quickly dissipate as PM Corbyn reiterated his promise to fulfill the democratic desire of the population to exit the EU. While Corbyn's negotiating team set to work on getting a better Brexit deal out of Brussels, the market would quickly turn its attention to the reality that Corbyn is not kidding about socialism.16 The result would be a selloff in the pound. Bottom Line: BCA's Foreign Exchange Strategy has pointed out that the pound remains well below its fair value (Chart 13). However, as BCA's chief FX strategist Mathieu Savary points out, the valuation technicals may be misleading as the currency has entered a new economic, trade, and political paradigm. A Corbyn premiership is not clearly positive for Brexit, while opening up a completely different question: is the U.K. also exiting the free-market, laissez-faire paradigm that it has helped lead since May 1979? Black Swan 4: Italy Is A Black Swan Hiding In Plain Sight The spread between Italian and German 10-year government bonds has narrowed 72 basis points since April, suggesting that investors have grown comfortable with the risks associated with the Italian election due by May (Chart 14). There are three reasons why we agree with the market: Chart 13Pound Valuation Reflects Post-Brexit Paradigm Pound Valuation Reflects Post-Brexit Paradigm Pound Valuation Reflects Post-Brexit Paradigm Chart 14Investors Not Worried About Italy Investors Not Worried About Italy Investors Not Worried About Italy New electoral rules passed in October make it highly likely that a center-right alliance will take shape between the Forza Italia of former Prime Minister Silvio Berlusconi and the mildly Eurosketpic Lega Nord. These two could form a government alone, or in a grand coalition with the center-left Democratic Party (PD) (Chart 15). Both Lega Nord and the anti-establishment Five Star Movement (M5S) have moved to the center on the questions of European integration and membership in the currency union; The European migration crisis is over and its supposedly constant impact on Italy is waning (Chart 16). Meanwhile, Italy's economy is on the mend, with its banking sector finally following the Spanish trajectory with a drop in non-performing loans (Chart 17). Chart 15Italy Set For A Hung Parliament Italy Set For A Hung Parliament Italy Set For A Hung Parliament Chart 16Migration Crisis Is Over (Yes, Even In Italy) Migration Crisis Is Over (Yes, Even In Italy) Migration Crisis Is Over (Yes, Even In Italy) Chart 17Italian Recovery Is Just Starting Italian Recovery Is Just Starting Italian Recovery Is Just Starting That said, we continue to warn clients that the underlying support for the common currency is lagging in Italy. The support level is just above 55%, despite a strong rally in the rest of the Euro Area (Chart 18). Similarly, over 40% of Italians appear confident in the country's future outside of the EU (Chart 19). Chart 18Italians Stand Out For Distrust Of Euro Italians Stand Out For Distrust Of Euro Italians Stand Out For Distrust Of Euro Chart 19Italians Not Enthusiastic About EU Italians Not Enthusiastic About EU Italians Not Enthusiastic About EU Our baseline case is that Italian elections will produce a weak and ineffective government, though crucially not a Euroskeptic one. How could we be wrong? Easy: one of the three reasons why we agree with the market could shift. For example, M5S could alter its pledge to remain in the Euro Area and surprisingly win on a Euroskeptic platform. Why would the party do something like that? Because it makes sense! Polls are already showing that M5S's recent moderation on the euro is not paying political dividends, with its support sharply sliding since the summer. With power quickly slipping out of reach for the party, why wouldn't they put a down-payment on the next election by trusting the underlying trend in opinion polling and investing in a Euroskeptic platform that might pay political dividends in the future? If we think that this strategy makes sense based on the data, then the M5S leadership might as well. Chart 20Can MIB Keep Outperforming? Can MIB Keep Outperforming? Can MIB Keep Outperforming? Another scenario is a major terror attack perpetrated by recent migrants from North Africa. Italy has been spared from radical Islamic terror. As such, the country may not be as desensitized to it as other European nations. A strong showing by Lega Nord and the far-right Fratelli d'Italia could force Forza Italia to move to the right as well. On our travels, we have noticed that few investors want to talk about Italy. There is wide acknowledgement of the structural trends pointing to a rise of Euroskepticism in the country, but also an appearance of consensus that this is a problem for a later date. We agree with this consensus, but our conviction is low. Bottom Line: Italian election risk is completely unappreciated by the markets. The country's equity market is one of the best performing this year (Chart 20), while government bonds are pricing in no political risk as the election approaches. We believe that shorting both would present a good hedging opportunity. Black Swan 5: Bloodbath In Latin America Our last black swan risk is not really a black swan to us but a forecast we believe will happen. As we outlined last month, we fear that Chinese policy-induced credit contraction will be negative for emerging markets, as BCA's Emerging Markets Strategy data asserts (Chart 21). BCA's Foreign Exchange Strategy has pointed out in its latest missive that its "Carry Canary Indicator" - performance of EM/JPY crosses - is signaling that a sharp deceleration in global growth is coming in Q1 2018 (Chart 22).17 Latin America (especially Chile, Peru, and Brazil) is the region most exposed to the combination of a slowing China and a China-induced drop in commodity prices. Chart 21When China Sneezes, EM Gets The Flu When China Sneezes, EM Gets The Flu When China Sneezes, EM Gets The Flu Chart 22Ominous Signal From EM/JPY Ominous Signal From EM/JPY Ominous Signal From EM/JPY From a political perspective, this is most negative for Brazil and Mexico. Both countries hold elections in 2018, with the Mexican election further complicated by the ongoing NAFTA renegotiations. We believe that the future of NAFTA hangs in the balance, with a high probability that the Trump administration will decide to abrogate the deal.18 Currently, anti-market political forces are in the lead in both countries. In Brazil, no pro-market candidate is leading in the polls (Chart 23). In fact, anti-market options have a 48% lead on the centrists. Granted, there are ten months until the election, but we are skeptical that the Brazilian population will change its mind and support reformers. If the "median voter" in Brazil supported reforms, the current Temer administration would have passed them already. In Mexico, anti-establishment candidate Andrés Manuel López Obrador (also known as AMLO) is leading in the polls (Chart 24), as is his new party Morena (Chart 25). If Morena wins the most seats in the Mexican Congress, it will be more difficult for the opposition parties to combine to counter it.19 Chart 23There Is No Pro-Market Option In Brazil There Is No Pro-Market Option In Brazil There Is No Pro-Market Option In Brazil Chart 24AMLO Is In The Lead ... Five Black Swans In 2018 Five Black Swans In 2018 Chart 25...As Is Morena Five Black Swans In 2018 Five Black Swans In 2018 In 2017, we argued that politics were not a tailwind for EM asset performance. Instead, investors chased yield in the favorable economic context of Chinese economic stimulus, low developed market yields, and a weak U.S. dollar. In reality, politics was just as dire in much of EM as it was in prior years of asset underperformance, but the surge of global liquidity in 2018 masked the problems. We do not think the EM rally is sustainable in 2018. As the global economic and market context shifts, investors will start paying attention. Suddenly, political problems will enter into focus. Here we argue that Brazil and Mexico are likely to be the main targets of portfolio outflows, but a strong case could be made for South Africa and Turkey as well.20 Bottom Line: Political risk in Latin America will return. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy, "U.S. Election: Outcomes & Investment Implications," dated November 9, 2016, and "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," dated May 31, 2017, "How Long Can The 'Trump Put' Last?" dated June 14, 2017, and "Is King Dollar Back?" dated October 4, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy, "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017, available at gps.bcaresearch.com. 4 President Clinton launched the largest NATO military operation against Yugoslavia amidst impeachment proceedings against him while President George H. W. Bush ordered U.S. troops to Somalia a month after losing the 1992 election. Ironically, President George H. W. Bush intervened in Somalia in order to lock in the supposedly isolationist Bill Clinton, who had defeated him three weeks earlier, into an internationalist foreign policy. President George W. Bush ordered the "surge" of troops into Iraq in 2007 after losing both houses of Congress in 2006; President Obama arranged the Iranian nuclear deal after losing the Senate (and hence Congress) to the Republicans in 2014. 5 Please see BCA Geopolitical Strategy, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 6 Particularly vulnerable, in our view, will be Cory Gardner (R, Colorado), Joni Ernst (R, Iowa), Susan Collins (R, Maine), and Thom Tillis (R, North Carolina). 7 U.S. Treasury Under Secretary for International Affairs David Malpass recently claimed that high-level talks had "stalled" and re-emphasized the U.S.'s structural complaints: "We are concerned that China's economic liberalization seems to have slowed or reversed, with the role of the state increasing ... State-owned enterprises have not faced hard budget constraints and China's industrial policy has become more and more problematic for foreign firms. Huge export credits are flowing in non-economic ways that distort markets." The growing presence of Communist Party cells within corporations is another important structural concern that puts the administration at loggerheads with China's leaders. Please see Andrew Mayeda and Saleha Mohsin, "US Rebukes China For Backing Off Market Embrace," Bloomberg, November 30, 2017, available at www.bloomberg.com. 8 Please see BCA Geopolitical Strategy, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, available at gps.bcaresearch.com. 10 Please see BCA Global Investment Strategy, "A Timeline For The Next Five Years: Part II," dated December 1, 2017, available at gis.bcaresearch.com. 11 Please see "North Korea: From Overstated To Understated" in BCA Geopolitical Strategy, "Strategic Outlook 2016: Multipolarity & Markets," dated December 9, 2015, available at gps.bcaresearch.com. A notable coup attempt occurred in 1995-96 in North Hamgyong; something like a coup attempt may have occurred in 2013; and defectors from North Korea have reported various stories of plots and conspiracies against the regime. 12 After all, Peter predicted that Donald Trump would be a serious candidate for the U.S. presidency back in September 2015! 13 Still worried, that is, even after Kim Jong-un's supposed "consolidation of power" in 2013-14 when he executed his influential and China-aligned uncle, Jang Song Thaek, and purged the latter's faction. There were reports of rogue military operations at that time. With low troop morale reported by North Korean defectors, the possibility of insubordination cannot be ruled out. 14 A North Korean submarine sank the South Korean corvette Cheonan in 2010, and North Korean artillery shelled two islands killing South Korean civilians later that year, but these attacks were still within the norm of North Korean provocations. The two countries are still technically at war and have contested maritime as well as land borders. 15 Please see BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 16 To help investors get ready for a Corbyn premiership, we thought his appearance on President Nicolás Maduro's weekly radio show would be a good place to start: https://www.youtube.com/watch?v=7eL8_wtS-0I 17 Please see BCA Foreign Exchange Strategy, "Canaries In The Coal Mine Alert: EM/JPY Carry Trades," dated December 1, 2017, available at fes.bcaresearch.com. 18 Please see BCA Geopolitical Strategy and Global Investment Strategy, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy and Emerging Markets Strategy "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy, "South Africa: Crisis Of Expectations," dated June 28, 2017, and "Turkey: Military Adventurism And Capital Controls," dated December 7, 2016, available at gps.bcaresearch.com. Geopolitical Calendar

Highlights Geopolitical risks were overstated in 2017, but have now become understated; If Donald Trump becomes an early "lame duck" president, he will seek relevance abroad; This could mean a protectionist White House, or increased geopolitical tensions with Iran and North Korea; North Korean internal stability could come into question as economic sanctions begin to bite; Political risks in the U.K. and Italy could rise with markets overly complacent on both; Emerging markets, particularly Brazil and Mexico, will see renewed political risk. Feature Buoyant global growth, political stability in Europe, and steady policymakers' hands in China have fueled risk assets in 2017. As the year draws to a close, investors also have tax cuts in the U.S. to celebrate. Our high conviction view that tax cuts would happen - and that they would be fiscally profligate - is near the finish line.1 In making this call, we ignored the failure to repeal Obamacare, the "wisdom" of old "D.C. hands," and direct intelligence from a source inside the White House circle who swore tax reform would be revenue neutral. Throughout the year, BCA's Geopolitical Strategy remained confident that the GOP would ignore its fiscal conservative credentials and focus on the midterm elections.2 That election is increasingly looking like a bloodbath-in-the-making for the Republican Party (Chart 1). What of the latest opinion polls showing that the tax cuts are unpopular with half of all Americans? The polls also show that a solid one-third of all Americans remain in support of the Republican plan (Chart 2). We suspect - as do Republican strategists - that those are the Republicans who vote in midterm elections. Given the atrociously low turnout in midterm elections - just 36.4% of Americans voted in 2014 - Republicans need their base to turn out in November. The tax cuts are not about the wider American public but the Republican base. Chart 1Midterm Election: A Bloodbath? Midterm Election: A Bloodbath? Midterm Election: A Bloodbath? Chart 2Republican Base Supports Tax Cuts Five Black Swans In 2018 Five Black Swans In 2018 As we close the book on 2017, we look with trepidation towards 2018. Our main theme for next year is that the combination of economic stimulus from the tax cuts in the U.S. and structural reforms in China will create a U.S.-dollar-bullish policy mix that will combine into a headwind for global risk assets, particularly emerging market equities.3 However, in this report, we focus on some of the more exotic risks that investors may have to deal with. In particular we focus on five potential "black swans" - low probability, high market-impact events - that are neither on the market's radar nor the media's. To qualify for our list, the events must be: Unlikely: There must be less than a 20% probability that the event will occur in the next 12 months. Out of sight: The scenario we present should not be receiving media coverage, at least not as a serious market risk. Geopolitical: We must be able to identify the risk scenario through the lens of our geopolitical methodology. Genuinely unpredictable events - such as meteor strikes, pandemics, crippling cyber-attacks, solar flares, alien invasions, and failures in the computer program running the simulation that we call the universe - do not make the cut. Black Swan 1: Lame Duck Trump "Lame duck" presidents - leaders whose popularity late in their term has sunk so low that they can no longer affect policy - are said to be particularly adventurous in the foreign arena. While this adage has a spotty empirical record, there are several notable examples in recent memory.4 American presidents have few constitutional constraints when it comes to foreign policy. Therefore, when domestic constraints rise, U.S. presidents seek relevance abroad. Chart 3The Day After The Midterms, Trump's Overall Popularity Will Matter More Than That Among Republicans Five Black Swans In 2018 Five Black Swans In 2018 President Trump may become the earliest, and lamest, lame duck president in recent U.S. history. While his Republican support remains healthy, his overall popularity is well below the average presidential approval rating at this point in the political cycle (Chart 3). Based on these poll numbers, his party is likely to underperform in the upcoming midterm election (Chart 4). A Democrat-led House of Representatives would have the votes to begin impeachment, which we would then consider likely in 2019. As we have argued in our "impeachment handbook," the market impact of such a crisis would ultimately depend on market fundamentals and the global context, not political intrigue.5 Chart 4Trump Is Becoming A Liability For The GOP Five Black Swans In 2018 Five Black Swans In 2018 President Trump's political capital ahead of the midterm elections is based on his ability to influence Republican legislators. Despite low overall poll numbers, President Trump can use the threat of endorsing primary challengers against conservative peers in Congress to move his agenda in the legislature. He has effectively done this with tax cuts. However, the day after the midterm elections, President Trump's own numbers will matter for the GOP. Given that President Trump will be on the ballot in the 2020 general election, his low approval numbers with non-Republican voters will hang like an albatross around the party's neck. This is a serious issue, particularly given that 22 of the 33 Senators up for reelection in 2020 will be Republican.6 Robust economic growth and a roaring stock market have not boosted Trump's popularity so far. At the same time, a strong economy ready to translate into higher wages is about to be "pump-primed" by stimulative tax cuts (Chart 5). We would expect the result to be a stronger dollar, which should keep the U.S. trade deficit widening well into Trump's second year in office. At some point, this will become a sore political point, given Trump's protectionist rhetoric and his administration's focus on the trade balance as a key measure of U.S. power. Chart 5Wage Pressures Are Building Wage Pressures Are Building Wage Pressures Are Building What kind of adventures would we expect to see President Trump embark on in 2018? There are three prime candidates: China-U.S. trade war: The Trump administration started off with threats against China and then proceeded to negotiations. However, neither the North Korean situation nor the trade deficit has seen substantial improvement, and a lame duck Trump administration would be more likely to resort to serious punitive actions. Even improvements on the Korean peninsula would not necessarily prevent Washington from getting tougher on Beijing over trade, as the Trump administration will be driven by domestic politics. Investors should carefully watch whether the World Trade Organization deems China a "market economy," which could trigger a U.S. backlash, and whether the various investigations by U.S. Trade Representative Robert Lighthizer and Commerce Secretary Wilbur Ross result in anti-dumping and countervailing duties being imposed more frequently on specific Chinese exports. Thus far, the empirical evidence suggests that the Trump administration has picked up the pace of protectionist rulings (Chart 6). Notably, the Trump administration claims that the Comprehensive Economic Dialogue has "stalled," and it is reviving deeper, structural demands on Chinese policymakers.7 Iran Jingoism: Rumors that Secretary of State Rex Tillerson may be replaced by CIA Director Mike Pompeo - who would be replaced at the CIA by Senator Tom Cotton - can only mean one thing: the White House has Iran in its sights. Both Pompeo and Cotton are hawks on Iran. The administration may be preparing to shift its focus from North Korea, where American allies in the region are urging caution, to the Middle East, where American allies in the region are urging aggression. Investors should watch whether Tillerson is removed and especially how Congress reacts to President Trump's decision on October 15 to decertify the Iran nuclear agreement (also called the Joint Comprehensive Plan of Action or JCPOA). The Republican-controlled Congress has until December 15 to reimpose sanctions on Iran that were suspended as part of the deal, with merely a simple majority needed in both chambers. However, President Trump will also have an opportunity, as early as January, to end waivers on a slew of sanctions that were not covered under the JCPOA. North Korea: It would be natural to slot North Korea as first on our list of potential foreign policy adventures for President Trump. However, it does not really fit our qualification of a black swan. North Korea is not "out of sight." Additionally, President Trump has already broken with the tradition of previous administrations by upping the pressure on Pyongyang. In fact, a North Korean black swan would be if President Trump succeeded in breaking the regime in Pyongyang. To that scenario we turn next. Chart 6Trump: Game Changer In U.S. Trade Policy? Five Black Swans In 2018 Five Black Swans In 2018 Bottom Line: Geopolitics has not affected the markets in 2017, with risk assets reaching record highs and the VIX reaching record lows (Chart 7). This was our view throughout the year and we called for investors to "buy in May and have a nice day" as a result of our analysis.8 We do not see this as likely in 2018. The Trump administration has no credible legislative agenda after tax cuts. We expect Congress to stall as we enter the summer primary season and for the GOP to lose the House to the Democrats. President Trump is an astute political analyst and will sense these developments before they happen. There is a good chance that he will attempt to sway the election and pre-empt his lame duck status with an aggressive foreign policy. Chart 72017 Goldilocks: S&P 500 Up, VIX Down 2017 Goldilocks: S&P 500 Up, VIX Down 2017 Goldilocks: S&P 500 Up, VIX Down Investment implications are twofold. First, we continue to recommend an equally weighted basket of Swiss 10-year bonds and gold as a portfolio hedge.9 Second, risk premium for oil prices should rise in 2018. Not only is the supply-demand balance favorable for oil prices, but geopolitical risks are likely to rise as well. Black Swan 2: A Coup In Pyongyang Our colleague Peter Berezin, BCA's Chief Global Strategist, has suggested that a coup d'état against Supreme Leader Kim Jong-un could be a black swan trigger that spooks the markets.10 While Peter used the scenario as a tongue-in-cheek way to weave Kim into a narrative that tells of a late 2019 recession, we have long raised North Korean domestic politics as the true Korean black swan.11 Here we entertain Peter's idea for three reasons.12 First, China has upped the economic pressure on Pyongyang. Under Kim Jong-un, the North Korean state has attempted some limited economic "opening up," namely to China. But the attempt to finalize the nuclear deterrent has delayed an already precarious process. There has now been a $617 million drop in Chinese imports from the country since the beginning of the year (Chart 8), with coal imports particularly affected (Chart 9). China has also pulled back on tourism. Meanwhile, North Korea's imports of Chinese goods have risen, which suggests that the country's current account balance may be widening. At some point, if these trends continue, Pyongyang will run out of foreign currency with which to purchase Chinese and Russian imports. Chart 8China Is Turning The Screws On Pyongyang... China Is Turning The Screws On Pyongyang... China Is Turning The Screws On Pyongyang... Chart 9...Particularly On Coal Imports ...Particularly On Coal Imports ...Particularly On Coal Imports Second, Pyongyang is well aware of pressures against the regime. The assassination of Kim Jong-nam - the older half-brother of Kim Jong-un - in February of this year sent a message to the world, but especially to China, which kept Kim Jong-nam around as an alternative to the current Kim. That Pyongyang went to the extreme lengths of poisoning Kim Jong-nam with VX nerve agent in a foreign airport suggests that Kim Jong-un is still worried about threats to his rule.13 If Beijing's economic sanctions continue to tighten in 2018, the military could conceivably see the Supreme Leader's aggressive foreign policy as a risk to regime survival. Third, Pyongyang could miscalculate and create a crisis from which it cannot deescalate. A provocation that disrupts international infrastructure and commerce or kills civilians from the U.S. or Japan could trigger a downward spiral. For instance, an attack against international shipping in the Yellow Sea or Sea of Japan by North Korean submarines would be an unprecedented act that the U.S. and Japan would likely retaliate against.14 We could see the U.S. following the script from Operation Praying Mantis in the Persian Gulf in 1988 - the largest surface engagement by the U.S. Navy since the Second World War. In that incident, the U.S. sunk half of Iran's navy in retaliation for the mining of the guided missile frigate USS Samuel B. Roberts. In the case of North Korea, this would primarily mean taking out its approximately 20 Romeo-class submarines and an unknown number of domestically-produced - Yugoslav-designed - newly built submarines. Such a conflict is not our baseline case, but we assign much higher probability to it than an all-out war on the Korean Peninsula. How would Pyongyang react to the sinking of its submarines? Our best case is that the regime would do nothing. The leadership in Pyongyang is massively constrained by its quantifiable military inferiority. True, North Korea has around 6 million military personnel - about 25% of the total population is under arms - but unfortunately for Pyongyang, this large army is arrayed against one of the most sophisticated defenses ever constructed by man: the Demilitarized Zone (DMZ). To support its ground forces, North Korea would have at its disposal only about 20-30 Mig-29s. Countering two dozen jets would be South Korea's combined 177 F-15s and F-16s, plus American forces that would vary in size depending on how many aircraft carriers were deployed in the vicinity. Given that a single American aircraft carrier holds up to 48 fighter jets, North Koreans would quickly find themselves fighting a losing battle. Which is why they may never initiate one. If Kim Jong-un insists on retaliation, the military could remove and replace him with, for instance, his 30-year old sister, who has recently risen in party ranks, or his 36-year old brother Kim Jong-chul, who is apparently not entirely uninvolved in the regime despite living an unassuming life in Pyongyang. What would a regime change mean for the markets? It depends on whether it is successful or not. An unsuccessful coup could lead to a massive purge and likely a total break in Pyongyang's relations with the outside world, including China. This would seriously destabilize North Korea's decision-making. The global community would have to begin contemplating a total war on the Korean peninsula. Alternatively, a successful coup could lead to temporary volatility, yet long-term stability. The military regime in the North may even be open to reunification over the long term, depending on how U.S.-China relations evolve. Bottom Line: China does not want to cripple North Korea or throw a coup. But it is cooperating with sanctions and could therefore trigger one by mistake. At least two regimes have collapsed in the past when facing the pincer movement of economic sanctions and American military pressure - South Africa's apartheid regime in 1991 and Slobodan Miloševic's Yugoslavia in 1999. Kim Jong-un could face a similar fate, particularly if China applies excessive economic pressure. Black Swan 3: Prime Minister Jeremy Corbyn There is no election scheduled in the U.K. for 2018, but if one were to be held the ruling Tories would be in trouble (Chart 10). In fact, the combined anti-Brexit forces are currently in a solid lead over the pro-Brexit parties, Conservatives and the U.K. Independence Party (UKIP) (Chart 11). Chart 10Labour Is In The Lead... Labour Is In The Lead... Labour Is In The Lead... Chart 11...As Are Anti-Brexit Forces Writ-Large ...As Are Anti-Brexit Forces Writ-Large ...As Are Anti-Brexit Forces Writ-Large What could trigger such an election? Ultimately, the final exit deal may prompt a new election. More immediately, the ongoing negotiations over the status of the Irish border would be a prime candidate. As our colleague Dhaval Joshi, head of BCA's European Investment Strategy noted recently, Prime Minister Theresa May's government is propped up by the Northern Irish Unionists to whom May has promised that there will be no hard border between Northern Ireland and the Republic of Ireland. This will likely create a crisis as the EU negotiations may inadvertently threaten the Good Friday peace agreement. The Northern Ireland Unionists will not tolerate the border moving to the Irish Sea. This would effectively take Northern Ireland into the EU customs union and single market, and out of the U.K.'s domestic trading zone. It would also embolden Scotland's push for single market access. In essence, the Tory government may collapse because of differences within the U.K.'s "three kingdoms" before it even has the chance to collapse over differences with the EU.15 The market may cheer a Labour-Scottish National Party (SNP) coalition government, a potential winner of an early election, as it would mean that a new referendum on the U.K. leaving the EU could be held. The latest polls suggest that "Bremorse" (remorse for Brexit) has set in, as a clear majority in the U.K. thinks that Brexit was a bad idea (Chart 12). However, we suspect that it would take Prime Minister Jeremy Corbyn several months, if not over a year, before he called such a referendum. First, Corbyn is on record supporting a soft Brexit, not a new referendum, and he has only just begun to adjust this position. Second, a soft Brexit is far more difficult to achieve than the hard Brexit of Prime Minister Theresa May since it requires the U.K. to subvert its sovereignty in significant ways (i.e., accepting EU regulation) in order to access the EU Common Market. Third, the most politically palatable way to re-do the referendum is to put a U.K.-EU deal up to the people to decide, which means that Corbyn first has to spend a long time negotiating that deal. Chart 12Bremorse Sets In Bremorse Sets In Bremorse Sets In The market may be disappointed to find out that PM Corbyn is not willing or able to put the question of the U.K.'s EU exit up to a vote right away. Instead, the market would have to deal with Corbyn's economic policies, which are markedly left-wing. Corbyn harkens back to the 110 Propositions pour la France of French President François Mitterrand, if not exactly to the ghastly 1970s of the U.K.'s own history. A brief sample platter of Labour's proposals under Corbyn includes: Increasing the U.K. corporate tax rate to 26% from 20%; Increasing the minimum wage; Forcing companies not to out-source operations; Nationalizing public infrastructure companies. How should investors play a Corbyn victory? We think that the U.K. pound would likely rally on a higher probability of reversing Brexit. However, this "no Brexit" rally would quickly dissipate as PM Corbyn reiterated his promise to fulfill the democratic desire of the population to exit the EU. While Corbyn's negotiating team set to work on getting a better Brexit deal out of Brussels, the market would quickly turn its attention to the reality that Corbyn is not kidding about socialism.16 The result would be a selloff in the pound. Bottom Line: BCA's Foreign Exchange Strategy has pointed out that the pound remains well below its fair value (Chart 13). However, as BCA's chief FX strategist Mathieu Savary points out, the valuation technicals may be misleading as the currency has entered a new economic, trade, and political paradigm. A Corbyn premiership is not clearly positive for Brexit, while opening up a completely different question: is the U.K. also exiting the free-market, laissez-faire paradigm that it has helped lead since May 1979? Black Swan 4: Italy Is A Black Swan Hiding In Plain Sight The spread between Italian and German 10-year government bonds has narrowed 72 basis points since April, suggesting that investors have grown comfortable with the risks associated with the Italian election due by May (Chart 14). There are three reasons why we agree with the market: Chart 13Pound Valuation Reflects Post-Brexit Paradigm Pound Valuation Reflects Post-Brexit Paradigm Pound Valuation Reflects Post-Brexit Paradigm Chart 14Investors Not Worried About Italy Investors Not Worried About Italy Investors Not Worried About Italy New electoral rules passed in October make it highly likely that a center-right alliance will take shape between the Forza Italia of former Prime Minister Silvio Berlusconi and the mildly Eurosketpic Lega Nord. These two could form a government alone, or in a grand coalition with the center-left Democratic Party (PD) (Chart 15). Both Lega Nord and the anti-establishment Five Star Movement (M5S) have moved to the center on the questions of European integration and membership in the currency union; The European migration crisis is over and its supposedly constant impact on Italy is waning (Chart 16). Meanwhile, Italy's economy is on the mend, with its banking sector finally following the Spanish trajectory with a drop in non-performing loans (Chart 17). Chart 15Italy Set For A Hung Parliament Italy Set For A Hung Parliament Italy Set For A Hung Parliament Chart 16Migration Crisis Is Over (Yes, Even In Italy) Migration Crisis Is Over (Yes, Even In Italy) Migration Crisis Is Over (Yes, Even In Italy) Chart 17Italian Recovery Is Just Starting Italian Recovery Is Just Starting Italian Recovery Is Just Starting That said, we continue to warn clients that the underlying support for the common currency is lagging in Italy. The support level is just above 55%, despite a strong rally in the rest of the Euro Area (Chart 18). Similarly, over 40% of Italians appear confident in the country's future outside of the EU (Chart 19). Chart 18Italians Stand Out For Distrust Of Euro Italians Stand Out For Distrust Of Euro Italians Stand Out For Distrust Of Euro Chart 19Italians Not Enthusiastic About EU Italians Not Enthusiastic About EU Italians Not Enthusiastic About EU Our baseline case is that Italian elections will produce a weak and ineffective government, though crucially not a Euroskeptic one. How could we be wrong? Easy: one of the three reasons why we agree with the market could shift. For example, M5S could alter its pledge to remain in the Euro Area and surprisingly win on a Euroskeptic platform. Why would the party do something like that? Because it makes sense! Polls are already showing that M5S's recent moderation on the euro is not paying political dividends, with its support sharply sliding since the summer. With power quickly slipping out of reach for the party, why wouldn't they put a down-payment on the next election by trusting the underlying trend in opinion polling and investing in a Euroskeptic platform that might pay political dividends in the future? If we think that this strategy makes sense based on the data, then the M5S leadership might as well. Chart 20Can MIB Keep Outperforming? Can MIB Keep Outperforming? Can MIB Keep Outperforming? Another scenario is a major terror attack perpetrated by recent migrants from North Africa. Italy has been spared from radical Islamic terror. As such, the country may not be as desensitized to it as other European nations. A strong showing by Lega Nord and the far-right Fratelli d'Italia could force Forza Italia to move to the right as well. On our travels, we have noticed that few investors want to talk about Italy. There is wide acknowledgement of the structural trends pointing to a rise of Euroskepticism in the country, but also an appearance of consensus that this is a problem for a later date. We agree with this consensus, but our conviction is low. Bottom Line: Italian election risk is completely unappreciated by the markets. The country's equity market is one of the best performing this year (Chart 20), while government bonds are pricing in no political risk as the election approaches. We believe that shorting both would present a good hedging opportunity. Black Swan 5: Bloodbath In Latin America Our last black swan risk is not really a black swan to us but a forecast we believe will happen. As we outlined last month, we fear that Chinese policy-induced credit contraction will be negative for emerging markets, as BCA's Emerging Markets Strategy data asserts (Chart 21). BCA's Foreign Exchange Strategy has pointed out in its latest missive that its "Carry Canary Indicator" - performance of EM/JPY crosses - is signaling that a sharp deceleration in global growth is coming in Q1 2018 (Chart 22).17 Latin America (especially Chile, Peru, and Brazil) is the region most exposed to the combination of a slowing China and a China-induced drop in commodity prices. Chart 21When China Sneezes, EM Gets The Flu When China Sneezes, EM Gets The Flu When China Sneezes, EM Gets The Flu Chart 22Ominous Signal From EM/JPY Ominous Signal From EM/JPY Ominous Signal From EM/JPY From a political perspective, this is most negative for Brazil and Mexico. Both countries hold elections in 2018, with the Mexican election further complicated by the ongoing NAFTA renegotiations. We believe that the future of NAFTA hangs in the balance, with a high probability that the Trump administration will decide to abrogate the deal.18 Currently, anti-market political forces are in the lead in both countries. In Brazil, no pro-market candidate is leading in the polls (Chart 23). In fact, anti-market options have a 48% lead on the centrists. Granted, there are ten months until the election, but we are skeptical that the Brazilian population will change its mind and support reformers. If the "median voter" in Brazil supported reforms, the current Temer administration would have passed them already. In Mexico, anti-establishment candidate Andrés Manuel López Obrador (also known as AMLO) is leading in the polls (Chart 24), as is his new party Morena (Chart 25). If Morena wins the most seats in the Mexican Congress, it will be more difficult for the opposition parties to combine to counter it.19 Chart 23There Is No Pro-Market Option In Brazil There Is No Pro-Market Option In Brazil There Is No Pro-Market Option In Brazil Chart 24AMLO Is In The Lead ... Five Black Swans In 2018 Five Black Swans In 2018 Chart 25...As Is Morena Five Black Swans In 2018 Five Black Swans In 2018 In 2017, we argued that politics were not a tailwind for EM asset performance. Instead, investors chased yield in the favorable economic context of Chinese economic stimulus, low developed market yields, and a weak U.S. dollar. In reality, politics was just as dire in much of EM as it was in prior years of asset underperformance, but the surge of global liquidity in 2018 masked the problems. We do not think the EM rally is sustainable in 2018. As the global economic and market context shifts, investors will start paying attention. Suddenly, political problems will enter into focus. Here we argue that Brazil and Mexico are likely to be the main targets of portfolio outflows, but a strong case could be made for South Africa and Turkey as well.20 Bottom Line: Political risk in Latin America will return. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy, "U.S. Election: Outcomes & Investment Implications," dated November 9, 2016, and "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," dated May 31, 2017, "How Long Can The 'Trump Put' Last?" dated June 14, 2017, and "Is King Dollar Back?" dated October 4, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy, "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017, available at gps.bcaresearch.com. 4 President Clinton launched the largest NATO military operation against Yugoslavia amidst impeachment proceedings against him while President George H. W. Bush ordered U.S. troops to Somalia a month after losing the 1992 election. Ironically, President George H. W. Bush intervened in Somalia in order to lock in the supposedly isolationist Bill Clinton, who had defeated him three weeks earlier, into an internationalist foreign policy. President George W. Bush ordered the "surge" of troops into Iraq in 2007 after losing both houses of Congress in 2006; President Obama arranged the Iranian nuclear deal after losing the Senate (and hence Congress) to the Republicans in 2014. 5 Please see BCA Geopolitical Strategy, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 6 Particularly vulnerable, in our view, will be Cory Gardner (R, Colorado), Joni Ernst (R, Iowa), Susan Collins (R, Maine), and Thom Tillis (R, North Carolina). 7 U.S. Treasury Under Secretary for International Affairs David Malpass recently claimed that high-level talks had "stalled" and re-emphasized the U.S.'s structural complaints: "We are concerned that China's economic liberalization seems to have slowed or reversed, with the role of the state increasing ... State-owned enterprises have not faced hard budget constraints and China's industrial policy has become more and more problematic for foreign firms. Huge export credits are flowing in non-economic ways that distort markets." The growing presence of Communist Party cells within corporations is another important structural concern that puts the administration at loggerheads with China's leaders. Please see Andrew Mayeda and Saleha Mohsin, "US Rebukes China For Backing Off Market Embrace," Bloomberg, November 30, 2017, available at www.bloomberg.com. 8 Please see BCA Geopolitical Strategy, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, available at gps.bcaresearch.com. 10 Please see BCA Global Investment Strategy, "A Timeline For The Next Five Years: Part II," dated December 1, 2017, available at gis.bcaresearch.com. 11 Please see "North Korea: From Overstated To Understated" in BCA Geopolitical Strategy, "Strategic Outlook 2016: Multipolarity & Markets," dated December 9, 2015, available at gps.bcaresearch.com. A notable coup attempt occurred in 1995-96 in North Hamgyong; something like a coup attempt may have occurred in 2013; and defectors from North Korea have reported various stories of plots and conspiracies against the regime. 12 After all, Peter predicted that Donald Trump would be a serious candidate for the U.S. presidency back in September 2015! 13 Still worried, that is, even after Kim Jong-un's supposed "consolidation of power" in 2013-14 when he executed his influential and China-aligned uncle, Jang Song Thaek, and purged the latter's faction. There were reports of rogue military operations at that time. With low troop morale reported by North Korean defectors, the possibility of insubordination cannot be ruled out. 14 A North Korean submarine sank the South Korean corvette Cheonan in 2010, and North Korean artillery shelled two islands killing South Korean civilians later that year, but these attacks were still within the norm of North Korean provocations. The two countries are still technically at war and have contested maritime as well as land borders. 15 Please see BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 16 To help investors get ready for a Corbyn premiership, we thought his appearance on President Nicolás Maduro's weekly radio show would be a good place to start: https://www.youtube.com/watch?v=7eL8_wtS-0I 17 Please see BCA Foreign Exchange Strategy, "Canaries In The Coal Mine Alert: EM/JPY Carry Trades," dated December 1, 2017, available at fes.bcaresearch.com. 18 Please see BCA Geopolitical Strategy and Global Investment Strategy, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy and Emerging Markets Strategy "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy, "South Africa: Crisis Of Expectations," dated June 28, 2017, and "Turkey: Military Adventurism And Capital Controls," dated December 7, 2016, available at gps.bcaresearch.com. Geopolitical Calendar

Highlights We are putting the Indonesian stock market on an upgrade watch list. Indonesia's financial markets' beta relative to EM peers has been declining. As such, Indonesian markets will likely outperform the EM benchmark in a sell-off. Inflation in Mexico is peaking and will drift lower. The Mexican peso is particularly attractive relative to the South African rand and the Brazilian real. However, we still recommend that investors maintain a neutral stance on Mexican assets relative to EM peers until more clarity emerges from the NAFTA negotiations. Feature Indonesia: Putting On Upgrade Watch List Indonesian share prices have considerably underperformed the EM benchmark since February 2016 (Chart I-1). This has occurred despite exports growing at an annual rate of 18% in U.S. dollar terms in 2017. The surge in Indonesian exports has been largely driven by soaring prices for thermal coal, palm oil and copper. Export prices have soared by 24% for coal and copper and 11% for palm oil from their lows in early 2016. Nevertheless, their export volumes have been rather stagnant (Chart I-2). These commodities are large drivers of Indonesia's exports. Thermal coal and palm oil account for around 20% of total exports, while copper accounts for around 4%, in value terms. Chart I-1Indonesian Stock Prices: Relative & Absolute Indonesian Stock Prices: Relative & Absolute Indonesian Stock Prices: Relative & Absolute Chart I-2Indonesian Exports: Volume Vs. Prices Indonesian Exports: Volume Vs. Prices Indonesian Exports: Volume Vs. Prices We expect coal1 and base metals prices to drop considerably in 2018 due to China's meaningful growth slowdown. Having this backdrop in mind, we discuss the outlook for Indonesia's stock market in both absolute and relative terms. We continue recommending a neutral allocation to Indonesian stocks within an EM equity portfolio for now, but are putting this bourse on an upgrade watch list and will wait for the following triggers to go overweight: Chart I-3Chinese & Indonesian Equities: ##br##A Rotating Dance Investors Rotating Between Chinese And ASEAN/Indonesian Equities Investors Rotating Between Chinese And ASEAN/Indonesian Equities The first trigger is when Chinese H-shares and large-cap tech stocks begin underperforming the EM overall equity index. Interestingly, the relative performance of Indonesian equities and Chinese stocks has been negatively correlated (Chart I-3). Indonesia's stock market's underperformance relative to the EM benchmark can be also partially explained by the manic rise in a small number of EM large-cap tech stocks. Tech stocks are absent from Indonesia's stock exchange and when tech stocks' relative performance does turn south, it will be easier for the Indonesian bourse to outperform the EM benchmark. The second trigger for upgrading Indonesian stocks is when the initial phase of decline in commodities prices (10-15%) occurs. This phase could be the most painful for commodities plays like Indonesia, as nervous investors bail out. In short, we are waiting for the momentum of Indonesia's relative performance to turn up before overweighting the bourse. Domestic Demand And Exports: Parting Ways? The Indonesian economy and its financial markets have historically been highly correlated with commodities prices and exports: a positive external shock would trigger an export boom and foreign inflows would ensue. These inflows would in turn lead to currency appreciation and a subsequent fall in interest rates. The end result was the overheating of the economy and financial markets. Recently, however, Indonesia's economy and financial markets have been slowly disconnecting from exports in general and commodities prices in particular. The top panel of Chart I-4 shows that while exports used to be extremely correlated with the rupiah, these correlations have been breaking down since early 2016. Similarly, a disconnect is occurring between exports and other domestic macro variables like bank loans (Chart I-4, bottom panel). What is also noteworthy is the absence of a notable pickup in domestic demand growth amid the strong recovery in global trade. Chart I-5 shows that car and motorcycle sales are still anemic. Chart I-4Disconnect Between Indonesian ##br##Exports Vs. Rupiah & Bank Loans Disconnect Between Indonesian Exports Vs. Rupiah & Bank Loans Disconnect Between Indonesian Exports Vs. Rupiah & Bank Loans Chart I-5Indonesia's Domestic Sector Remains Sluggish Indonesia's Domestic Sector Remains Sluggish Indonesia's Domestic Sector Remains Sluggish Below are some of the reasons that help shed light as to why this divergence between exports and domestic demand has been taking place: First, the ratio of Indonesia's commodities' exports to total has fallen more sharply than in other commodities-producing EM nations (Chart I-6). Exports have also become generally less important for the overall Indonesian economy post the global financial crisis. Chart I-7 shows that private non-financial debt as a whole has risen, while exports have fallen as a share of GDP. Chart I-6Indonesia's Commodities ##br##Exports Ratio Has Plunged Indonesia's Commodities Exports Ratio Has Plunged Indonesia's Commodities Exports Ratio Has Plunged Chart I-7Private Debt Is A Bigger Driver Of ##br##Indonesia's Economy Than Exports Private Debt Is A Bigger Driver Of Indonesia's Economy Than Exports Private Debt Is A Bigger Driver Of Indonesia's Economy Than Exports The government has been following cautious and prudent policies. This is another reason why domestic demand growth has been mediocre amid robust exports. Chart I-8 signifies that growth in government expenditures has stalled in nominal terms and contracted in real terms. Indeed, the impulse in the banking system's net domestic assets (the combined aggregate of the central bank and commercial banks) remains negative, albeit improving on a rate of change basis (Chart I-9). Net domestic assets (NDA) measure the banking system's2 credit to the domestic sector - i.e. the government and the private sector. Chart I-8Indonesia's Government ##br##Has Been Prudent Indonesia's Government Has Been Prudent Indonesia's Government Has Been Prudent Chart I-9Banking System's Net Domestic ##br##Assets & Fiscal Deposit Drain Banking System's Net Domestic Assets & Fiscal Deposit Drain Banking System's Net Domestic Assets & Fiscal Deposit Drain The NDA impulse has been negative because the government has borrowed less from the banking system. In addition, the government has been shifting deposits from commercial banks to the central bank (Chart I-9, bottom panel). This has drained liquidity in the system and has slowed broad money growth and capped commercial banks' reserves at Bank Indonesia. As the potential negative term-of-trade shock transpires, the government will have enough of a buffer to spend by deploying its deposits from the central bank and by borrowing and spending more. That will in turn provide support for the economy when commodities prices fall and the external sector suffers. Chart I-10Central Bank Has Been Building FX Firepower Central Bank Has Been Building FX Firepower Central Bank Has Been Building FX Firepower As for the currency, the central bank has recently accumulated plenty of foreign exchange assets, creating commercial bank reserves in the process (Chart I-10). The central bank now has plenty of room to defend the currency by selling foreign assets when the rupiah comes under selling pressure. Bank Indonesia will also have more leeway managing a reasonable balance between a depreciating currency and rising local interbank rates. Bottom Line: Indonesia's domestic demand has been mediocre, despite the surge in exports and commodities prices. Meanwhile, the central bank and the government have used the positive global environment to accumulate firepower. This puts them in a position to act as shock absorbers when the external environment turns hostile. As a result, the Indonesian financial markets' beta to their EM peers will decline. We therefore recommend putting the Indonesian stock market on an upgrade watch list. Consistently, the potential downside in the currency and a sell-off in the domestic bond markets will be smaller than we previously anticipated. While still advocating a cautious/neutral stance on this market, we will be looking to upgrade it to overweight versus its EM peers after the first phase of a potential EM and commodities sell-off transpires. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Mexico: Waiting For A Better Entry Point In Mexico, inflation has very likely peaked and will drift lower as the central bank maintains a tight monetary policy stance: A large part of the rise in inflation in 2017 was caused by depreciation in the peso. The firmness in the peso this year entails that inflation will roll over soon (Chart II-1). Consumer spending and capital expenditure are set to contract as the impact of higher interest rates continue to filter through the economy (Chart II-2). In fact, domestic vehicles sales are shrinking sharply. Chart II-1Mexico: Peso & Inflation Mexico: Peso Inflation Mexico: Peso Inflation Chart II-2Higher Interest Rates Are ##br##Slowing Domestic Spending Higher Interest Rates Are Slowing Domestic Spending Higher Interest Rates Are Slowing Domestic Spending Furthermore, weak real wage growth will continue to weigh on consumer spending (Chart II-3). In addition, contracting fiscal non-interest expenditures will remain a headwind on economic growth (Chart II-4). Chart II-3Lower Real Wages = Lower Inflation Lower Real Wages = Lower Inflation Lower Real Wages = Lower Inflation Chart II-4Belt-Tightening By The Government Belt-Tightening By The Government Belt-Tightening By The Government Finally, one-off effects on inflation - such as the gasoline subsidy removal that took place at the end of last year - will subside as the base effect of these price increases abates. The inflation rate will in turn moderate. Despite all this, Banxico will continue to keep monetary policy tight due to lingering uncertainty related to NAFTA negotiations. Within the EM currency universe, the Mexican peso is particularly attractive relative to the South African rand and the Brazilian real. We will be looking to reinstate long positions in the MXN versus both the ZAR and the BRL for the following reasons: Relative trade balance dynamics will continue to favor Mexico relative to South Africa and Brazil. Mexican exports are likely to remain robust due to strong U.S. growth (Chart II-5), while South African and Brazilian exports will slow down as China's growth and imports falter (Chart II-6). Chart II-5Mexican Exports Will Remain ##br##Robust Due To Strong U.S. Growth Mexican Exports Will Remain Robust Due To Strong U.S. Growth Mexican Exports Will Remain Robust Due To Strong U.S. Growth Chart II-6South African & Brazilian Exports ##br##Will Take A Hit As China Slows bca.ems_wr_2017_12_06_s2_c6 bca.ems_wr_2017_12_06_s2_c6 Furthermore, metals prices will be affected more negatively than oil prices due to China's growth slump. China's share of world consumption in base and industrial metals at 50-55% is much larger than oil (12.5%). This will leave Mexican exports less negatively affected than those of Brazil and South Africa. Mexico does not suffer from rapidly rising public debt like Brazil and South Africa (Chart II-7). Large fiscal deficits and rising public debt burdens in Brazil and South Africa require a higher risk premium in their respective financial markets, leaving further room for the MXN to outperform both the BRL and the ZAR. While Mexico has already gone through some structural reforms, Brazil and South Africa have yet to deliver any substantial efforts on that front. This leaves Mexico in a much better position to attract long-term capital inflows compared to Brazil and South Africa. Finally, on a real effective exchange rate basis, the peso remains cheap relative to the rand and the real (Chart II-8). Chart II-7Public & Private Debt Is Lower In Mexico Public & Private Debt Is Lower In Mexico Public & Private Debt Is Lower In Mexico Chart II-8The Mexican Peso Is Still Cheap The Mexican Peso Is Still Cheap The Mexican Peso Is Still Cheap We closed our long MXN/BRL and long MXN/ZAR trades on October 25th because at present there is too much uncertainty with respect to NAFTA negotiations that could have a negative impact on the peso. However, with regards to the national general elections, uncertainty in South Africa and Brazil is even greater than in Mexico. In Mexico, the anti-establishment candidate Andres Manuel Lopez Obrador is currently leading the polls, but his new party - National Regeneration Movement (MORENA) - is unlikely to gain a majority in Congress. Investment Conclusions We recommend that investors maintain a neutral stance across all asset classes in Mexico and wait for clarity on NAFTA3 negotiations before going overweight the country's currency and fixed-income markets relative to their EM peers. Mexican stocks have been selling off sharply in absolute terms and have substantially underperformed the EM benchmark. This poor performance is mainly attributed to financials and consumer discretionary stocks. While these two sectors only account for 20% of the total MSCI market cap, the retrenchment in their share price has been large enough to bring the whole market down. We have the following observations on these two equity sectors: The consumer discretionary sector has been underperforming due to disappointing earnings. Our bias is that it is still too early to call a bottom in the consumer cycle in Mexico. With regards to banks, we believe that tight monetary policy will continue to weigh on their share prices. More importantly, the yield curve remains inverted, and until we see it steepen, it will be hard for banks to rally. All in all, we continue recommending a neutral weighting in Mexican stocks within an EM equity portfolio. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Report, titled "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017, the link is available on page 15. 2 Banking system is the sum of the central bank and commercial banks. 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

Highlights Agricultural markets are informationally efficient for the most part, which is to say that at any given time, prices already reflect most public information available to traders, and a lot of private information as well. Even so, we believe markets are underestimating the Fed's resolve in normalizing interest-rate policy next year - particularly when it comes to the number of rate hikes we are likely to see - and thus are underestimating the likelihood of lower grain prices in 2018. Energy: Overweight. Oil markets will emerge from their suspended animation following OPEC 2.0's Vienna meeting today. Our Brent and WTI call spreads in May, July and December 2018 - long $55/bbl calls vs. short $60/bbl calls - are up an average 50.2%. Our long Jul/18 WTI vs. short Dec/18 WTI trade anticipating steepening backwardation is up 13.3%. Base Metals: Neutral. China's refined zinc imports were up 145% yoy to 61,355 MT in October, based on customs data. Metal Bulletin noted tight domestic supplies accounted for the increase. Precious Metals: Neutral. Gold is breaking away from its attachment to $1,280/oz., as the USD weakens. Our long gold portfolio hedge is up 5.2% since inception May 4, 2017. Ags/Softs: Neutral. Global financial conditions will become increasingly important to grain prices going forward, a trend we explore below. Feature Record output and ending stocks will ensure that ag markets remain well supplied globally next year. While we see risks as balanced in the upcoming year, and remain neutral ags generally, we believe markets are underestimating the Fed's resolve when it comes to normalizing interest rates, and thus underestimate upside USD potential. This means the likelihood of lower grain prices also is being underestimated. Weather will add volatility to the mix, as well. We believe the fundamentals supporting the assessment of record output and season-ending stocks-to-use ratios are fully reflected in prices. However, financial conditions - particularly USD strength next year - are not being fully priced by markets. This makes grains, in particular, vulnerable to the downside. Financial conditions driving ag markets: Fed policy & real rates: we expect U.S. financial conditions to tighten, and for the Fed to hike rates once more this year, and up to three more times in 2018.1 FX rates: With higher U.S. policy rates next year, the USD is likely to strengthen. This will weaken grain prices generally. Wheat, in particular, is most vulnerable to a strengthening USD and a weakening of the currencies of some of the commodity's top exporters - the European Union, Russia, and Australia. We've narrowed down the fundamental factors to look out for in 2018 as follows: Strong demand amid an extension of supply cuts by the OPEC 2.0 coalition will support oil prices in 2018. Higher energy prices will increase profit-margin pressure in ag markets through input and shipping costs. Weather risks from La Nina threaten to curb yields this winter, especially in Argentina and Brazil, which will add volatility to prices. Policy shifts in Argentina, China, and Brazil will influence farmers' planting decisions in the upcoming crop year. A Look Back At 2017 Chart of the WeekGrains Outperformed Softs This Year Grains Outperformed Softs This Year Grains Outperformed Softs This Year As predicted in our 2017 outlook, grains reversed their 2016 underperformance vis-à-vis softs this year, and outperformed them.2 While prices for sugar, coffee, and cotton were up 28%, 8%, and 12% in 2016, they have since declined by 21%, 8%, and 2%, respectively. In fact, sugar - our top ag in 2016 - took the biggest hit this year (Chart of the Week). On the other hand, as a complex, grains currently stand at largely the same level as the beginning of last year. However, there are some idiosyncrasies within the class. The two worst performing grains last year - rice and wheat - have been the strongest performers so far this year. Rice rallied 30% year-to-date (ytd) on the back of tighter supplies, completely reversing its 19% decline in 2016. Similarly, wheat, which lost 13% of its value last year, is up a modest 3% ytd. On the other hand, soybeans surrendered its title as the most profitable grain in 2016. After gaining 14% last year, its fate turned and it fell 3% ytd. Finally, out of the lot, corn is the only ag we cover that has fallen in both years consecutively, by a minor 1.9% in 2016, and an additional 4.4% so far this year. A Recap Of Long Term Trends According to the International Grains Council's November estimates, grains production is projected to come down this crop year. With an increase in consumption, this will ultimately lead to a 5.2% decline in ending stocks - the first drawdown in five years. Despite the year-on-year (y-o-y) decline, grain inventories are expected to stand at their second highest level on record (Table 1). Table 1Grain Production Down While Consumption Inches Higher Global Financial Conditions Will Drive Grain Prices In 2018 Global Financial Conditions Will Drive Grain Prices In 2018 The decline in expected grain ending stocks is mainly driven by corn, which - despite a large upwards revision to U.S. yields in the most recent WASDE - is expected to experience a 3.6% decline in production. This, together with a boost in consumption, leads to a 13.6% fall in ending stocks - the first drawdown since the 2010/11 crop year. The decline in corn expectations reflects a shift in the planting preferences of some of the major producers. The U.S., Brazil, Argentina, and China are the top soybean and corn exporters - accounting for 78% and 49% of global soybean and corn area harvested in the 2016/17 crop year, respectively. What is significant in the current cycle is that farmers in these countries are moving away from planting corn and towards more soybeans (Chart 2). China, which accounted for 19% of global corn area harvested and 6% of global soybean area harvested in 2016/17, is leading this change. While corn area harvested fell by an average 4.2% in the 2015 and 2016 crop years, soybean area harvested gained 9.8% during that period. Similarly, in Brazil, which accounted for 10% and 28% of global corn and soybean area harvested in 2016/17, respectively, corn area harvested by farmers has been growing at a much slower rate than soybean area harvested, with the former expanding by 16.4% and the latter by 39.6% since 2010/11. Likewise, harvested area in the U.S., which accounted for 18% and 29% of global corn and soybean area harvested, respectively, shrunk by 0.9% in the case of corn, and expanded by 21.3% in the case of soybeans since 2010/11. The exception to this rule is Argentina. Argentine farmland accounted for 3% and 15% of global corn and soybean area harvested in 2016/17, respectively. Since 2010/11, both corn area harvested as well as soybean area harvested increased by roughly the same level - 1.6 Mn Ha for the former and 1.5 Mn Ha for the latter - representing a 44.4% and 8.6% increase in area harvested for corn and soybeans, respectively. However, this is due to export policies, which in effect, encourage corn production over soybeans. As we discuss below, soybean export tariffs will be phased out in the coming years, likely changing the incentives structure for Argentine farmers. This trend is mirrored in production data, with global soybean output gaining 32% since 2010/11, compared to a 25% increase in global corn production. However, this shift is in large part due to demand patterns which also favor soybeans to corn. Over the same period, global soybean consumption increased by 36%, compared to 24% in the case of corn (Chart 3). Chart 2Farmers Favor Soybeans Over Corn... Farmers Favor Soybeans Over Corn... Farmers Favor Soybeans Over Corn... Chart 3...As Do Consumers ...As Do Consumers ...As Do Consumers In fact, at 28%, global soybean stock-to-use ratios are significantly more elevated than that of corn, which stand at 19%. Furthermore, while soybeans are expected to record a 3.9mm MT surplus by the end of the current crop year, corn is projected to experience a 17.7mm MT deficit. Powell's Fed And Dollar Movements Our modelling of ags reveals that U.S. financial factors are important determinants of agriculture commodity price developments.3 Fed policy decisions and their impact on real rates have a direct effect on ag commodity prices, as well as an indirect effect through the exchange rate channel (Chart 4). Chart 4Fed Policy Drives Ag Markets Fed Policy Drives Ag Markets Fed Policy Drives Ag Markets While U.S. inflation has remained stubbornly low, forcing the Fed to slow down their interest rate normalization process, the anticipation - and eventual acceleration - of the Fed tightening cycle will weigh on ag prices. However, thanks in part to softer-than-expected inflation readings coming out of the U.S. this year, the USD broad trade-weighted index (TWIB) has weakened by 6.8% since the beginning of the year. In terms of the impact of real rates, monetary policy impacts agriculture markets through the following channels: The Fed's interest-rate normalization process will, all else equal, increase borrowing costs for farmers, and discourage investments in general - impacting both agricultural investments as well as outlays in research and development. Tighter credit also leads to a slowdown in growth which - ceteris paribus - depresses consumption and demand for goods and services generally, and agricultural commodities specifically. Finally, real rates have an indirect effect on agricultural commodity prices through its effect on the U.S. dollar. Higher U.S. rates encourage investment in U.S. bonds and entail a strengthening of the U.S. dollar making U.S. exports less competitive vis-à-vis those of its international competitors. Since commodities are priced in U.S. dollars while costs are priced in local currencies, a weakening of the domestic currency vis-à-vis the dollar would increase profitability for farmers selling in international markets. This can incentivize farmers to plant more, despite depressed global ag prices, which increases supply. As our modelling reveals, the net effect is an inverse relationship, whereby easier monetary policy is generally more favorable for agriculture markets. The Fed Will Remain Behind The Inflation Curve Our U.S. Bond Strategy team expects the Fed to remain behind inflation, in which case the USD will remain weak in the beginning of next year. The 2/10 Treasury curve is flat highlighting the market's belief that the Fed will continue with interest rate normalization despite below target levels of inflation.4 Since this would be a huge error on the part of new Chairman Powell, our U.S. bond strategists believe that the Fed will avoid such a policy mistake. Consequently, if inflation does not pick up soon, the Fed will be forced to turn dovish. In any case, U.S. monetary policy will "fall behind the curve." This means that the U.S. dollar will remain weak until inflation starts to tick higher, and the Fed can resume its interest rate normalization process. In fact, our bond strategists find that there is a resemblance between the current cycle and that of the late 1990s where the unemployment rate significantly undershot its natural level before inflation started to accelerate. Thus, they find it significant that most of the indicators that predicted the 1999 increase in inflation are now positive. This reinforces our faith that inflation will soon rebound, allowing the Fed to fall behind the curve and simultaneously hike rates at a pace of one more hike this year, and three more in 2018.5 In terms of the future path of the U.S. dollar, our foreign exchange strategists argue interest rate differentials will be a more significant determinant of dollar dynamics going forward. They expect inflation will start its ascent sometime before the end of 1H2018, which would lift the interest rate curve and the dollar. Our expectation is that inflation will bottom towards the end of this year/beginning of next, giving room for the Fed to proceed with its anticipated rate-hiking cycle, resulting in two to three hikes next year. Markets are pricing one to two rate hikes next year, which means our out-of-consensus rates call could cause the USD to rally far more than what markets have priced in to the USD TWIB. Following a 4.4% appreciation in trade weighted terms in 2016, the U.S. dollar has depreciated by 6.8% so far this year. The U.S. accounts for a larger share of global exports of corn and soybeans than rice and wheat, which means a strengthening of the USD TWIB will likely have a bigger impact on wheat and rice, in which the U.S. faces greater international competition for market share (Table 2). Table 2Wheat & Rice Vulnerable To USD Dynamics Global Financial Conditions Will Drive Grain Prices In 2018 Global Financial Conditions Will Drive Grain Prices In 2018 This is, in fact, in line with the price behavior that we have observed. Wheat and rice prices fell the most in 2016 as the U.S. dollar appreciated, and have outperformed soybeans and corn so far this year, as the U.S. dollar depreciated. Thus, in the absence of supply shocks that affect a particular grain, changes in the U.S. dollar going forward will have a greater impact on rice and wheat than on corn and soybeans. Keep An Eye On The Brazilian Real Of the major ag exporters, Brazil is most vulnerable to USD depreciation risk. Poor productivity trends have made our foreign exchange strategists single out the Brazilian Real (BRL) as one of the most expensive currencies they track. While they expect the BRL to depreciate over a one- to two-year horizon, the current strength in EM asset prices means that the BRL is likely to remain at its current level in the near term. However, given that the BRL provides an high carry, it will likely move sideways until U.S. interest rate expectations adjust to a rebound in inflation - which we expect toward the end of this year, or beginning of next. Brazil is a major ag producer - making up 45%, 44%, 27%, 23% and 12% share of the global export pies for soybeans, sugar, coffee, corn and cotton, respectively. Thus, a weaker BRL vis-à-vis the USD is a major downside risk to these commodity prices. Downside FX Risks Will Keep Wheat Prices Depressed Chart 5Downside FX Risks For Wheat Exporters Downside FX Risks For Wheat Exporters Downside FX Risks For Wheat Exporters In addition to the risks from an overvalued BRL, our foreign exchange strategists have highlighted the EUR, RUB, and AUD as currencies that are at risk of falling back to their fair value in the near term. Given that these regions are major wheat exporters, this would weigh on the grain's price as exports increase (Chart 5).6 On the back of expectations that the European Central Bank will adopt a significantly less aggressive monetary policy than the Fed, our foreign exchange strategists expect the EUR to weaken toward the end of the year and beginning of next. Given that Europe is a major wheat exporter - making up ~20% of global exports - a weaker EUR would make European wheat more attractive, weighing on prices in 2018. The currencies of other major exporters could be drawn in different directions in the near term. Our FX strategists see the Russian Rouble (RUB) as overvalued and at risk of weakening when U.S. inflation starts accelerating late this year or early next. However, higher oil prices would push up the ruble's fair value, correcting some of its overvaluation. As with the EUR, the wheat market is most vulnerable to a weaker RUB since Russia accounts for 14% of global wheat exports. Likewise, Australia - another major wheat exporter which accounts for 10% of world exports - has been identified as having an expensive currency. It is at risk of a depreciation over the next 24 months, but could rally if iron ore markets turn higher. Some Additional (Potential) Fundamental Forces Among the news and noise in the ags sphere, we see higher oil prices and La Nina as the most significant near-term risks to current supply/demand dynamics. Longer term, shifting policies in China, Argentina, and Brazil will become more relevant in determining the trajectory of ag markets. Our Out-Of-Consensus Call On Oil Is Bullish For Ags Chart 6Higher Energy Prices Upside Risk Higher Energy Prices Upside Risk Higher Energy Prices Upside Risk We expect oil prices will tread higher next year - averaging $65/bbl for Brent and $63/bbl for WTI - on the back of stronger demand and an extension of the OPEC 2.0 coalition's supply restrictions.7 This will support ag commodity prices. Higher oil prices affect ags by increasing input costs and global shipping prices. In addition, the supply of ocean-going transport for grains is tight. The Baltic Dry index, a measure of the global cost of shipping dry goods, and has been on the uptrend this year, as freight costs have more than doubled since mid-February, mostly on the back of a slowdown in shipping transportation supply (Chart 6). La Nina: A Literal Tailwind? Against a backdrop of falling stocks-to-use ratios in the corn and soybean markets, weather will add volatility to prices into 1H2018. In the near term La Nina, which is predicted to continue through the 2017-18 Northern Hemisphere winter, threatens to curb agricultural output. This phenomenon affects weather and rainfall, causing floods and droughts, by cooling the Pacific Ocean. Australia's Bureau of Meteorology recently pegged the chance of a La Nina at 70%, expecting it to last from December to at least February. However, this season's La Nina is forecast to be weak and weather conditions are expected to neutralize in 1Q2018.8 In the case of ags, the greatest threat from La Nina is the risk of droughts in Brazil and Argentina which could hurt the regions soybean, corn, sugar, and cotton harvests. Furthermore, excess rainfall in Australia and Colombia threaten wheat, cotton, and sugar yields in the former and coffee output in the latter. Furthermore, the weather phenomenon raises chances of a potential drought in the U.S. Midwest.9 However, it is noteworthy that by the time La Nina hits, much of the harvest in the Northern Hemisphere will have been completed. So the main risk will be to harvests in the Southern Hemisphere. Gradualismo In Argentina, Stockpiling In China, And Ethanol In Brazil 1. Since taking office late 2015, Argentine President Mauricio Macri has reversed his predecessor's unfavorable agricultural policies - allowing the Argentine peso to float, and eliminating export taxes on wheat and corn. Marci's Gradualismo reforms have been successful - incentivizing plantings and leading to record harvests (Chart 7). While a 30% export tax remains on soybeans - Argentina's main cash crop - it is down from 35% under the presidency of Macri's predecessor. Further cuts to soybean export taxes have been delayed in order to finance the country's fiscal deficit, however they are expected to resume next year with a 0.5pp reduction/month for the next two years. This would stimulate soybean plantings, if it materializes. Argentine farmers produce 18% of global soybean output, and account for 9% of global soybean exports. The change in export policy, as it unfolds, will thus weigh on soybean prices as Argentine farmers increase their soybean acreage in the coming crop years. 2. Although we will likely get more clarity regarding Chinese ag policies with the release of China's Number 1 Central document - which for the past 14 years has focused on agriculture - in February, we expect Beijing to continue incentivizing soybean farming over corn. China's soybean inventory levels stand significantly lower than its notoriously massive stocks of corn, wheat, and cotton (Chart 8). Chart 7Argentine Reforms Will Raise Soybean Exports Argentine Reforms Will Raise Soybean Exports Argentine Reforms Will Raise Soybean Exports Chart 8China's Soybean Stocks Are Relatively Low China's Soybean Stocks Are Relatively Low China's Soybean Stocks Are Relatively Low As such, China's top corn producing province - Heilongjian - cut the subsidy for corn farmers by 13 percent this year. Farmers there now receive 8.90 yuan/hectare of corn, down from the 10.26 yuan/hectare they received last year. This compares with subsidies for soybean farmers which at 11.56 yuan/hectare is much higher. According to the China National Grain and Oils Information Center, corn acreage in Heilongjiang is down 9.3 percent in 2016/17. However, with corn prices in China increasing, the higher subsidy for soybeans may not be sufficient. Nonetheless, according to a report by the Brazilian state Mato Grosso's official news agency, over the next five years the Chinese commodities trader COFCO intends to almost double its soybean imports from the Brazilian grains state. This means that China's demand for soybeans will drive the market in the near term as they look to buildup soybean reserves and bring down their corn stocks.10 Chart 9Higher Oil Prices Incentivize Ethanol Over Sugar Higher Oil Prices Incentivize Ethanol Over Sugar Higher Oil Prices Incentivize Ethanol Over Sugar 3. Ethanol Demand will raise the opportunity costs of bringing sugar and corn to market. In addition to the direct effect of higher oil prices on ag commodities in general, our forecast of increasing prices will pressure sugar prices indirectly through the ethanol channel in Brazil. Since July, Brazil's state-controlled oil company, Petrobras, has shifted its pricing policy allowing gasoline and diesel prices to follow those of international oil markets. As a result, the gasoline-ethanol price gap is widening.11 This will revive demand for the biofuel, which will cause mills to divert sugarcane away from the sweetener in favor of producing more ethanol (Chart 9). In fact, according to UNICA - the Brazilian sugarcane industry association - mills in the country's center-south region - from which 90% of Brazil's sugar output is derived - are favoring ethanol production over sugar. Data for the first half of October shows that 46.5% of sugarcane was diverted to producing sugar, down from 49.6% in the same period last year. However, in the near term, increased production from the EU amid their scrapping of domestic sugar production quotas will likely keep the global market in balance.12 Global sugar supply is forecast to remain strong on the back of supplies from Thailand, Europe and India. There are reports that ethanol producers in Brazil are evaluating the adoption of "corn-cane flex" ethanol plants.13 However this is a longer run risk which would increase demand for corn, and reduce demand for sugar. Bottom Line: Financial conditions will drive ag prices in 2018. The Fed's resolve to normalize interest rates - more so than markets expect - will keep a lid on prices. This will offset risks from higher energy prices. Nonetheless, some weather induced volatility is likely into 1Q2018. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 In fact, our Global Investment Strategists expect the Fed to hike rates in December 2017, and again four more times in 2018. Please see BCA Research's Global Investment Strategy Weekly Report titled "A Timeline For the Next Five Years: Part I," dated November 24, 2017, available at gis.bcaresearch.com. 2 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "2017 Commodity Outlook: Grains & Softs," dated December 22, 2016, available at ces.bcaresearch.com. 3 A 1% move in the USD TWI is associated with a 1.4% change in the CCI Grains & Oilseed Index, in the opposite direction. Similarly, a 1pp move in 5-year real rates is associated with a 18% change in the CCI Grains & Oilseed Index, in the opposite direction. The adjusted R2 is 0.84. 4 Please see BCA Research's U.S. Bond Strategy Portfolio Allocation Summary titled "Into The Fire," dated November 7, 2017, available at usbs.bcaresearch.com. 5 Please see BCA Research's U.S. Bond Strategy Weekly Report titled "The Fed Will Fall Behind The Curve," dated October 24, 2017, available at usbs.bcaresearch.com. 6 Please see BCA Research's Foreign Exchange Strategy Weekly Report titled "Updating Our Long-Term Fair Value Models," dated September 15, 2017, available at fes.bcaresearch.com. 7 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "Oil Balances Continue To Point To Higher Prices," dated November 23, 2017, available at ces.bcaresearch.com. 8 El Nino/Southern Oscillation (ENSO) alternates between warm ("El Nino") and cool ("La Nina") phases, impacting global precipitation and temperatures. These episodes are identified by looking at temperatures in the "Nino region 3.4" whereby readings of at least 0.5 degrees Celsius above or below seasonal average for several months would qualify as an El Nino or La Nina. 9 La Nina is often associated with wet conditions in eastern Australia, Indonesia, the Philippines, Thailand, and South Asia. It usually leads to increased rainfall in northeastern Brazil, Colombia, and other northern parts of South America, and drier than normal conditions in Uruguay, parts of Argentina, coastal Ecuador and northwestern Peru. The effect on the U.S. and Canada tends to be milder since they are located further away from the heart of ENSO, on the other hand it has the greatest impact on countries around the Pacific and Indian Oceans. 10 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "Ags in 2017/18: Move To Neutral," dated October 5, 2017, available at ces.bcaresearch.com. 11 Flex-fuel vehicles in Brazil means that ethanol demand is not constrained by a "blending wall". Thus ethanol is a substitute for gasoline- rather than a complement to, as in the U.S. 12 France, Belgium, Germany and Poland reportedly have the capacity to ramp up sugar beet production. 13 Please see "Brazil mills eye corn-cane flex plant to extend production cycle," dated November 7, 2017, available at reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Global Financial Conditions Will Drive Grain Prices In 2018 Global Financial Conditions Will Drive Grain Prices In 2018 Commodity Prices and Plays Reference Table Trade Recommendation Performance In 3Q17 Global Financial Conditions Will Drive Grain Prices In 2018 Global Financial Conditions Will Drive Grain Prices In 2018 Trades Closed in 2017 Summary of Trades Closed in 2016

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

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

Highlights Our out-of-consensus call on oil prices - Brent and WTI are expected to trade to $65 and $63/bbl, respectively, next year - has the most upside risk from unplanned production outages in Iraq and Venezuela. The potential for export losses from Libya, while not as acute, remains high. Downside price risks - e.g., a meaningful softening of demand, or sharply higher U.S. shale-oil production - are not as elevated as upside price risks, in our view. Favorable global macro conditions will continue to support the synchronized global upturn in GDP, keeping oil demand growth on track. The strained balance sheets of many U.S. shale-oil producers and deepwater-producing Majors likely will limit their ability to fund drilling, as recent earnings calls from oil-services companies attest.1 We continue to monitor global monetary conditions, particularly in the U.S. With global oil markets tightening as supply contracts and demand expands, the broad trade-weighted USD will become more of a factor in oil-price determination next year. Energy: Overweight. Our long $55/bbl WTI calls vs. short $60/bbl WTI call spreads in Jul/18 and Dec/18 recommended last week are up 9.3% and 5.8%, respectively. Base Metals: Neutral. Copper has been well bid, and is up 8.5% since the beginning of the month. The proximate cause of the price strength is investor optimism regarding global growth, particularly in China. However, following their biannual meeting earlier this week, the International Copper Study Group kept its projected 2017 deficit unchanged, and downgraded their 2018 projection to 105k MT, from 170k MT. Precious Metals: Neutral. Gold is under pressure as markets weigh the possibility President Trump will appoint a more hawkish Fed Chair to succeed Janet Yellen. Ags/Softs: Neutral. Following a backlash from Midwestern politicians, the Environmental Protection Agency (EPA) abandoned proposed changes to the U.S. Renewable Fuel Standard. The EPA also will keep 2018 renewable fuel volume mandates at or above current proposed levels. Corn gained 2.4% since this announcement last week. Our corn-vs.-wheat spread is up 1.6% since inception. Feature Our out-of-consensus call on Brent and WTI prices for next year has a significant amount of daylight between the prices we expect - $65 and $63/bbl for Brent and WTI, respectively - and price estimates we derive using the U.S. EIA's supply, demand and inventory expectations, which are $15.1 and $13.8/bbl lower (Chart of the week). Chart of the WeekPrices Derived Using BCA And EIA##BR##Global Balance Estimates Prices Derived Using BCA And EIA Global Balance Estimates Prices Derived Using BCA And EIA Global Balance Estimates Our bullish oil price call is predicated on stronger global demand growth than EIA and other forecasters' estimates (Chart 2 & Table 1), and an extension of the OPEC 2.0 production cuts to end-June 2018 (Chart 3).2 These fundamentals combine to sustain a supply deficit for the better part of 2018 (Chart 4), which results in stronger inventory draws in the OECD (Chart 5). Net, we expect OECD stocks to fall below their five-year average level by year-end 2018. Chart 2Stronger Global Demand Growth ... Stronger Global Demand Growth ... Stronger Global Demand Growth ... Chart 3...And Continued OPEC 2.0 Discipline... ...And Continued OPEC 2.0 Discipline... ...And Continued OPEC 2.0 Discipline... Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Upside Risks Dominate BCA's Oil Price Forecast Upside Risks Dominate BCA's Oil Price Forecast Chart 4...Produce A Supply Deficit For Most Of 2018... ...Produce A Supply Deficit For Most Of 2018... ...Produce A Supply Deficit For Most Of 2018... Chart 5...Leading To OECD Inventory Normalization ...Leading To OECD Inventory Normalization ...Leading To OECD Inventory Normalization Upside Price Risks Dominate In 2018 In assessing the "known unknown" risks to our call, those on the upside clearly dominate in 2018. Chief among these risks are unplanned production outages, which have been somewhat under control versus the past two years (Chart 6). Nonetheless, we believe the risk of unplanned outages within OPEC - in Iraq and Venezuela, in particular - are elevated. The potential for export losses from Libya, while not as acute, remains high (Chart 7). Chart 6Unplanned Outages Are Down ... Upside Risks Dominate BCA's Oil Price Forecast Upside Risks Dominate BCA's Oil Price Forecast Chart 7...But Key States Are At Risk ...But Key States Are At Risk ...But Key States Are At Risk The risk of unplanned outages is highest in Iraq, where production is running at ~ 4.5mm b/d in 3Q17 (Chart 7, panel 1). Exports on the Ceyhan pipeline from Iraq's northern Kurdish region through Turkey to the Mediterranean fell by more than half to as low as 225k b/d, following a non-binding independence referendum in Iraq's restive Kurdistan region at the end of September. This led to armed conflict between Iraqi and Kurdish forces.3 Independence for the semi-autonomous region was supported by more than 90% of Iraqi Kurds. However, the Iraqi government in Baghdad, along with its neighbors in Turkey and Iran, opposed the referendum, as did the U.S. This lack of support likely prompted the Kurdistan Regional Government's (KRG) offer to "freeze" the referendum this week, and to seek immediate cease-fire talks with Baghdad. Export flows from Kirkuk and the Kurdish region have been restored this week to ~ 300k b/d, or half of the volumes exported prior to the referendum, according to Bloomberg.4 Even with the offer to freeze the referendum - presumably, this means the semi-autonomous Kurdish government will abstain from pressing for independence if its offer is accepted and Baghdad agrees to negotiate an immediate cease-fire - this issue is far from settled. BCA's Geopolitical Strategy noted last month, the critical issue for the oil market remains sustained conflict between the Iraqi central government and the KRG. The question that cannot be answered yet is what "would (a conflict) do to future efforts to boost Iraqi production. Iraq is the last major oil play on the planet that can cheaply and easily, with 1920s technologies, access significant new production. If a major war breaks out in the country, it is difficult to see how Iraq would sustain the necessary FDI inflows to develop its fields to boost production, even if the majority of production is far from the Kurdish region. Given steady global oil demand, the world is counting on Iraq to fill the gap with cheap oil. If it cannot, higher oil prices will have to incentivize tight-oil and off-shore production."5 A huge "known unknown" resides in Venezuela, where we have production running at ~ 1.96mm b/d in 3Q17, sharply down from 2.4mm b/d during 2011-2015. The state oil company, Petroleos de Venezuela, SA, or PDVSA, is struggling to amass enough cash to meet critical near-term international interest and debt payment obligations, and can no longer afford to buy the chemicals and equipment required to make the country's heavy oil suitable for refining. This lack of cash is causing oil quality from Venezuela to deteriorate, as more exports are showing up with high levels of water, salt or metals. This is raising the odds refiners from the U.S. to China could turn barrels away in the near future unless the situation is reversed.6 Indeed, Reuters reported Phillips 66, a U.S. refiner, cancelled "at least eight crude cargoes because of poor oil quality in the first half of the year and demanded discounts on other deliveries, according to ... PDVSA documents and employees from both firms. The cancelled shipments - amounting at 4.4 million barrels of oil - had a market value of nearly $200 million." Venezuela's financial condition has steadily worsened following the collapse of oil prices at the end of 2014. Production is at its lowest level in 30 years, and banks have stopped extending letters of credit, which are critical to trading in the international oil market, in the wake of U.S. sanctions ordered by President Trump, as Reuters notes. In addition, PDVSA has been denied access to storage facilities in St. Eustatius terminal, because it owes the owner of the facility, Texas-based NuStar Energy, some $26 million in fees.7 Markets will be watching closely to see if Venezuela performs on $2 billion in USD-denominated bond payments, one of which is due tomorrow, and the other due next week (November 2). Venezuela missed debt coupon payments of some $350mm earlier this month, and has a total outstanding obligation for this year of $3.4 billion.8 In all likelihood, Venezuela will once again turn to Russia for additional financial support, which has stepped in as a "lender of last resort" replacing China.9 Venezuela owes Russia some $17 billion. Of this, Rosneft Oil Co., a Russian oil company, has loaned PDVSA $6 billion.10 In Libya, where we have production at 910k b/d in 3Q17 (Chart 7, panel 3), the risk of unplanned production outages is not as acute as the risks in Iraq and Venezuela, but important nonetheless. As a failed and fractured state, Libya faces particular challenges in maintaining production. Wood Mackenzie believes Libyan production likely has plateaued. The oil consultancy believes Libya's max production is limited to 1.25 million b/d.11 However, "Reaching this would be quite an achievement, given ongoing challenges, including international oil companies' reluctance to recommit capital and expertise, a national oil company starved of funding - and, not least, the propensity for violence to flare up and armed groups to hinder oil output." Downside Price Risks Less Daunting In 2018 Chart 8The USD Will Become More Important##BR##As Oil Markets Tighten Next Year The USD Will Become More Important As Oil Markets Tighten Next Year The USD Will Become More Important As Oil Markets Tighten Next Year Downside price risks - e.g., a meaningful softening of demand, or sharply higher U.S. shale-oil production - are not as elevated as risks to the upside, in our view. The favorable global macro conditions we discussed in last week's forecast will continue to support the synchronized global upturn in GDP. This will keep global oil demand growing at ~ 1.67mm b/d on average in 2017 and 2018, based on our estimates. We expect U.S. shale production to increase to 5.17 mm b/d in 2017 and to 6.09 mm b/d next year, as higher prices incentivize renewed drilling activity. However, the strained balance sheets of many shale-oil producers and a renewed - although perhaps only temporary - push from equity investors for shale producers to focus on improving economic returns rather than merely pursuing maximal production growth, likely will limit their ability to fund drilling, as recent earnings calls from oil-services companies attest. Away from fundamentals, we are monitoring U.S. monetary policy closely, given the potential for the USD to become a headwind once again for commodity prices generally, and oil prices in particular. As we noted last week, we expect the tightening of oil markets globally to restore the linkage between the USD and oil prices - i.e., the inverse correlation between them (a stronger USD is bearish for crude oil prices, and vice versa). The transitory noise surrounding the next Fed Chair will dissipate within the next few weeks, allowing the U.S. central bank and markets to focus on the evolution of monetary policy next year, following a widely expected rate hike in December. During the transitional phase the oil market is currently passing through - falling supply and stout demand are tightening the market globally - the USD's importance will increase as a determinant of oil prices (Chart 8). Bottom Line: Our oil-price call for next year - $65/bbl for Brent and $63/bbl for WTI - is predicated on stronger global demand growth, and an extension of the OPEC 2.0 production cuts to end-June 2018. These fundamentals will produce stronger inventory draws in the OECD, and bring stocks below their five-year average by year-end 2018. In our view, upside price risks clearly dominate in 2018. Chief among these risks are unplanned production outages in key OPEC states - Iraq, Venezuela and Libya - which account for ~ 7.4mm b/d of production at present. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Assistant HugoB@bcaresearch.com 1 Please see BCA Research's Energy Sector Strategy Weekly Report "Oilfield Service Quarterly Update: U.S. Stagnation," published October 25, 2017. It is available at nrg.bcaresearch.com. 2 OPEC 2.0 is the producer coalition lead by the Kingdom of Saudi Arabia (KSA) and Russia. Please see last week's feature article in Commodity & Energy Strategy Weekly Report, "Oil Forecast Lifted As Markets Tighten," for a discussion of our assumptions, models and estimates. It is available at ces.bcaresearch.com. 3 Please see "Update 2 - Iraqi Kurdistan faces first major oil outage since referendum," published by uk.reuters.com October 18, 2017. See also "Iraq's NOC vows to maintain Kirkuk oil flows after ousting Kurds," published by S&P Global Platts October 17, 2017, for additional background. 4 Please see "Iraqi Kurds Offer To Freeze Independence Referendum Results," published October 25, 2017, by Bloomberg.com. 5 Please see BCA Research's Geopolitical Strategy Weekly Report "Iraq: An Emergent Risk," p. 23 in the September 20, 2017 issue. It is available at gps.bcaresearch.com. 6 Please see "Venezuela's deteriorating oil quality riles major refiners," published by reuters.com October 18, 2017. 7 Please see "Exclusive: PDVSA blocked from using NuStar terminal over unpaid bills," published by uk.reuters.com October 20, 2017. 8 Please see "Venezuela is blowing debt payments ahead of a huge, make-or-break bill," published by cnbc.com on October 20, 2017. 9 Please see "Special Report: Vladimir's Venezuela - Leveraging loans to Caracas, Moscow snaps up oil assets," published by reuters.com on August 11, 2017. 10 Rosneft's majority owner is the Russian government. See "Glencore sells down stake in Russia's Rosneft," published by telegraph.co.uk on September 8, 2017. Glencore's 14.6% stake in Rosneft was sold to CEFC China Energy, according to the Telegraph. 11 Please see "WoodMac: Libya's oil production might have reached near-term potential," in the October 20, 2017, issue of Oil & Gas Journal. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Upside Risks Dominate BCA's Oil Price Forecast Upside Risks Dominate BCA's Oil Price Forecast Trades Closed in 2017 Summary of Trades Closed in 2016

Please note that in addition to today's abbreviated Weekly Bulletin, we are also publishing a Special Report on Argentina. Feature Regarding recent financial market dynamics, it appears that the high-yielding EM currencies are breaking down as U.S. bond yields march higher. Several EM exchange rates have formed a tapering wedge pattern, as shown in Chart I-1. Such patterns eventually lead a major break out or break down. Our bias remains that we are witnessing a major breakdown in several EM high-yielding currencies. If this transpires, it would be a precursor for a wider selloff in EM risk assets. Below we discuss interesting dynamics that have emerged in India's onshore fixed-income market lately, and their implications for the nation's equity market. India Several signals tentatively indicate that the price of liquidity has risen at the margin in India. Onshore BBB corporate bond yields have increased and their respective credit spreads have widened (Chart I-2). In addition, the yield curve has steepened modestly. Chart I-1A Tapering Wedge: ##br##A Breakout Or Breakdown? A Tapering Wedge: A Breakout Or Breakdown? A Tapering Wedge: A Breakout Or Breakdown? Chart I-2India: Onshore BBB Corporate Bond ##br##Yields And Spreads Have Spiked India: Onshore BBB Corporate Bond Yields And Spreads Have Spiked India: Onshore BBB Corporate Bond Yields And Spreads Have Spiked Rising corporate bond yields and widening corporate credit spreads have been negative for share prices in the past (Chart I-3). Similarly, steepening yield curves have been associated with a pullback in equity prices in recent years (Chart I-4). Note that yields, spreads and the yield curve are shown inverted on Charts I-3 and I-4. Chart I-3India: Corporate Bond Yields ##br##And Spreads Versus Stocks India: Corporate Bond Yields And Spreads Versus Stocks India: Corporate Bond Yields And Spreads Versus Stocks Chart I-4India: Yield Curve ##br##And Share Prices India: Yield Curve And Share Prices India: Yield Curve And Share Prices Why has the market price of liquidity risen in India? In our opinion, it has to do with both the domestic and external environments. On the domestic side, the fiscal deficit has widened, implying that borrowing requirements by central and state governments have risen (Chart I-5). Increased demand for credit from the government would not have been a problem had the commercial banks accommodated for it by creating enough new money. Yet, broad money supply growth remains depressed (Chart I-6). Chart I-5India: Ballooning Fiscal Deficits ##br##And Weak Money Creation India: Ballooning Fiscal Deficits And Weak Money Creation India: Ballooning Fiscal Deficits And Weak Money Creation Chart I-6Indian Money Growth: ##br##New Record Low INDIA MONEY GROWTH: NEW RECORD LOW INDIA MONEY GROWTH: NEW RECORD LOW As a result, the diminished amount of new money relative to demand for money, among other reasons, pushed marginal borrowing costs higher. Chart I-7 shows our proxy for new money available to the private sector has dipped into negative territory. On the external side, the recent rise in U.S. bond yields and the rebound in the U.S. dollar against several EM currencies might have also contributed to higher borrowing costs in India. We expect this U.S. dollar rebound versus EM currencies to persist and U.S. Treasury yields to continue drifting higher. Hence, the global backdrop heralds marginally higher bond yields in India. Although the onshore corporate bond market - and its BBB segment - is not very large, investors should heed to its signals because it reflects the cost of borrowing for the marginal corporate borrower. Besides, its signals have worked quite well in the past as shown in previous Chart I-3 on page 2. Some commentators might argue that the mild rise in government bond yields has been driven by a rise in inflation and growth expectations. We will not disagree with that, but both economic growth and inflation variables are still muted. Chart I-8 shows economic activity is lukewarm at best. Chart I-7India: Proxy For New Money ##br##Available To Private Sector India: Proxy For New Money Available To Private Sector India: Proxy For New Money Available To Private Sector Chart I-8India's Growth Is ##br##Lukewarm At Best India's Growth Is Lukewarm At Best India's Growth Is Lukewarm At Best On the inflation outlook, the picture is mixed as well. Consumer price inflation, especially core measures, might have bottomed (Chart I-9). Critically, the government approved a draft bill in July that allows the central government to set minimum wages across all sectors and states. The central government is currently reviewing the formula used to set minimum wage and the new formula might lead to significant increases in minimum wages. These policy changes come on top of the pay raises that public sector workers saw earlier this year. Importantly, if consumer demand accelerates while capital spending remains in the doldrums, inflationary pressures will mount. Chart I-10 shows that since 2012 consumer spending has outpaced investment by a large margin. Chart I-9India: Consumer Inflation ##br##Might Be Bottoming India: Consumer Inflation Might Be Bottoming India: Consumer Inflation Might Be Bottoming Chart I-10India: Consumer Spending ##br##Has Outpaced Investment India: Consumer Spending Has Outpaced Investment India: Consumer Spending Has Outpaced Investment Provided India has been, and remains, an underinvested economy, if this gap persists, it will produce either inflation or a widening current account deficit. Rising consumption without an equal increase in the supply of goods and services will either lead to higher prices or mushrooming consumer goods imports. Both scenarios bode ill for the macro dynamics, the currency, and ultimately equity multiples. As to financial markets, the Indian bourse is one of the most expensive in the EM space, so it is not very surprising that share prices could react negatively to marginally higher interest rates. For dedicated EM equity investors, we downgraded India from overweight to neutral on August 23, and this stance remains intact. While near-term underperformance cannot be ruled out, the medium-term outlook for relative performance warrants a neutral stance. Bottom Line: There are signals that liquidity is tightening on the margin in India's fixed-income markets due to domestic and external reasons. This will likely hurt share prices. Dedicated EM equity investors should keep a neutral allocation on India's bourse. Mexico: Close Currency, Rates, And Credit Overweights NAFTA risks to Mexico are escalating again. According to our Geopolitical Strategy team, there is non-trivial probability that the NAFTA negotiations will become negative for Mexican financial markets. The recent relapse in Mexico's financial markets will likely endure. We are closing the following positions: long MXN / short BRL; long MXN / short ZAR; receive Mexican 2-year / pay 2-year swap rates as well as overweight positions in Mexican sovereign credit versus Colombia and Indonesia. Dedicated equity investors should stay neutral on this bourse. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Either China's growth will slump soon, capping budding inflationary pressures, or policymakers will have to hike interest rates meaningfully to tackle inflation. If the PBoC drags its feet and does not hike interest rates amid rising inflation, the RMB will come under major selling pressure. EM/China corporate profits have expanded predominantly due to price increases. However, rapid price increases warrant higher interest rates. The latter is a formidable risk to share prices. The U.S. dollar has made a major bottom. Stay short select EM currencies. The EM equity rally momentum remains strong but the risk-reward is quite unfavorable. We expect the external backdrop - metals prices and portfolio flows to EM - to deteriorate inhibiting the current easing cycle in Peru. Stay underweight this bourse within the EM universe (page 13). Feature A key question for investors at the current juncture is whether the global economic backdrop is moving toward inflation or deflation - or whether it will remain in its present "goldilocks" state. One can cite numerous examples that support each of the three scenarios. Proponents of deflation cite low consumer price inflation in the U.S., euro area and Japan, as well as very weak money growth in China and the U.S. as being leading indicators of budding deflationary pressures. Advocates of goldilocks - improving growth with low inflation - point to robust global trade and low consumer price inflation, as well as benign financial market dynamics in the form of higher share prices and low bond yields. Last but not least, inflationists can cite very tight labor markets among advanced economies as well as rising core and services consumer price inflation rates in China (Chart I-1). Chart I-1China: Inflation Is Grinding Higher China: Inflation Is Grinding Higher China: Inflation Is Grinding Higher At BCA's annual conference in New York held last week, the broad consensus was that there is a lack of considerable inflationary pressures worldwide amid improving global growth. This is consistent with the goldilocks outcome currently priced by the financial markets - i.e., a combination of robust growth and low inflation. Given the current pricing in financial markets, one economic variable that could disturb benign global financial dynamics is inflation. This report examines inflationary dynamics in China and briefly touches on the U.S. and euro area inflation outlooks. Our take is as follows: Unless China's money and credit growth slow further and generate another deflationary slump in China and world trade, the odds are that the balance both globally and within China will tilt toward inflation in the next 12 months. To be clear, our main theme remains that a material slowdown in China's growth will dampen China/EM growth, derail the EM corporate profit recovery and cap inflationary pressures in China, at least. Therefore, to some extent, this report is counter-factual - it examines what may happen if a meaningful growth deceleration in China does not transpire. Our analysis also addresses the question of what may happen if policymakers in China allow money/credit to accelerate again, without permitting the economy to slow too much. The short response: Inflation is already slowly but surely rising in China and it will soon become a constraint, limiting Chinese policymakers' options. China/Asia Recovery: Prices Or Volumes? China's industrial revival, as well as Asia's export recovery over the past 12-18 months, has largely been due to price increases amid modest volume growth. In particular: China's manufacturing production volume growth has not improved at all, but manufacturing producer prices have surged, producing substantial recovery in nominal output growth (Chart I-2). This is strictly within manufacturing, and does not include mining and ferrous metal production, where output cuts have led to surging prices for raw materials. In brief, one can observe higher inflation beyond the steel and coal industries. Furthermore, producer price inflation has improved for consumer goods (Chart I-3, top panel), and for the first time in 17 years ex-factory producer price deflation has ended in durable consumer goods as well as in electronics goods and communication equipment (Chart I-3, middle and bottom panels). Chart I-2China's Industrial Recovery: Surging ##br##Prices Amid Subdued Volume Growth China's Industrial Recovery: Surging Prices Amid Subdued Volume Growth China's Industrial Recovery: Surging Prices Amid Subdued Volume Growth Chart I-3China: Producer Price ##br##Inflation Is Broad-Based China: Producer Price Inflation Is Broad-Based China: Producer Price Inflation Is Broad-Based Notably, China's core (ex-food and energy) consumer price inflation has moved above 2%, and consumer services price inflation has risen to 3% (Chart I-1 on page 1). Importantly, these consumer inflation measures have risen, even though food prices are deflating in China and energy prices are stable. This entails that consumer price inflation pressures are genuine and reasonably broad-based. In Asian trade, the dichotomy between prices and volumes is especially apparent in the case of Korea's exports. The U.S. dollar value of Korean exports has mushroomed, but there has been only modest revival in export volumes (Chart I-4). Remarkably, both the 2014-'15 slump and the 2016-'17 recovery in Korean exports were largely due to prices, not volumes. The latter have been expanding modestly in recent years, while prices crashed in 2013-'15 and surged in 2016-'17. Finally, Korean and Taiwanese export prices as well as U.S. import prices from Asia have risen in the past 12-18 months, following years of deflation (Chart I-5). Chart I-4Korean Export Recovery: Prices Versus Volumes Korean Export Recovery: Prices Versus Volumes Korean Export Recovery: Prices Versus Volumes Chart I-5Asian Export Prices: A Reversal? Asian Export Prices: A Reversal? Asian Export Prices: A Reversal? Beyond higher prices for steel and other commodities, Korea's export prices are climbing because of skyrocketing DRAM semiconductor prices (Chart I-6). Price changes are much more important to corporate profits than volume changes. For example, a 5% rise in prices boosts corporate profits by much more than a 5% gain in output volume. By the same token, profits decline more when prices drop by 2% than when volumes fall by 2%. We discussed this phenomenon and illustrated an example in our January 28, 2016 report.1 Rising prices across various commodities and manufactured goods have allowed Chinese and Asian companies to deliver strong profits in the past 12 months. China's industrial profits have ballooned, even though output volume growth has been modest. On the whole, the enormous money/credit injection in China in the past two years has hindered lingering price deflation and led to rising prices for various goods and services. Chart I-7 illustrates that the recovery in corporate pricing power and, hence, mushrooming industrial corporate earnings can be attributed to the mainland's credit/money impulses. Chart I-6DRAM Semi Price Has ##br##Surged 4-Fold In Last 12 Months DRAM Semi Price Has Surged 4-Fold In Last 12 Months DRAM Semi Price Has Surged 4-Fold In Last 12 Months Chart I-7China: A Peak In Producer ##br##Prices And Industrial Profits? China: A Peak In Producer Prices And Industrial Profits? China: A Peak In Producer Prices And Industrial Profits? If pricing power deteriorates, as the money/credit impulse is signaling, corporate earnings will be at risk. In such a scenario, inflation will not be a problem, as deflationary pressures will resurface. However, corporate profits will shrink. Bottom Line: EM/China corporate profits have expanded predominantly due to price increases. Investors have celebrated it by flocking into EM/Chinese stocks. However, rapid price increases warrant higher interest rates. The latter is a formidable risk to share prices. Barring a material growth deceleration in China, which is our baseline view, odds are that inflation will rise further. Why Now? Inflation is rising in China because of rampant money/credit creation complemented with a weak productivity growth rate. In addition, policymakers have engineered a reversal in raw materials price deflation since early 2016. It is impossible to know if the Chinese economy has reached a point where growth rates of 6-6.5% and above will lead to inflation. It is hard to estimate potential GDP growth rates and output gaps for advanced countries, but it is practically impossible to do so in the case of China. Its economy has undergone multiple dramatic structural transformations in the past 30 years, changes that continue today. That said, it is possible to argue that China may have reached a point where further rampant money and credit creation leads to higher inflation. The key thesis is that productivity growth has slowed because of the following: Channeling credit to SOEs - which often misallocate capital - and to property markets does not boost productivity. Infrastructure projects will take years to produce productivity gains, even if they are well thought out. Chart I-8 illustrates that in recent years an increasing share of investment has been on structures and installations rather than equipment and new technologies. Investment in structures does not boost productivity as much as equipment purchases. Meanwhile, private capital spending has been in the doldrums over the past four years, as has been the case for manufacturing investment (Chart I-9). This argues for less efficiency/productivity and, thereby, diminished potential growth. Chart I-8Unfavorable Mix For Productivity Growth Unfavorable Mix For Productivity Growth Unfavorable Mix For Productivity Growth Chart I-9Private And Manufacturing Capex Remain Weak Private And Manufacturing Capex Remain Weak Private And Manufacturing Capex Remain Weak Historically, it was private investment and manufacturing capacity expansion that fostered productivity gains in China. Private projects are often more efficient than public investment, and it is much easier to achieve higher productivity in manufacturing than in the service sector. This is not to argue that there are no innovation and rapid technological changes in China. A lot of innovation and technological advancement is happening but it might not be sufficient to boost productivity growth above 6% (Chart I-10). China's extremely fast productivity gains in the past 20 years have largely been due to rapid expansion of manufacturing and construction. Manufacturing cannot rise fast because it is hard for China to gain more market share in global trade without causing political backslashes. In turn, construction has been driven by excessive credit expansion and property market speculation and policymakers want to reduce this. It is imperative to understand that in any country productivity is much lower in the service sector than in manufacturing and construction. A shift away from manufacturing and construction toward services will surely lead to much lower productivity and, hence, potential economic growth. If policymakers allow/encourage rapid money/credit expansion to achieve growth rates above 6-6.5% or so, the outcome will be inflation. Implications For Chinese Policymakers If economic growth does not slow, odds are that inflation will continue to rise in China due to a lower potential GDP growth rate. As such, policymakers will have to tackle inflation by raising interest rates. The deposit rate in China is at 1.5%, and is presently negative when deflated by core consumer price inflation (Chart I-11). This is occurring for the first time in ten years. Chart I-10Potential Growth = Labor Force + ##br##Productivity Growth Potential Growth = Labor Force + Productivity Growth Potential Growth = Labor Force + Productivity Growth Chart I-11China: Deposit Rate In ##br##Real Terms Is Negative China: Deposit Rate In Real Terms Is Negative China: Deposit Rate In Real Terms Is Negative If inflationary pressures continue building up and policymakers do not hike interest rates, households will become even more dissatisfied by negative deposit rates and opt for converting their RMB deposits into foreign currency, or buying real estate. Both scenarios will eventually lead to financial instability, which policymakers are trying to avoid. Chart I-12 demonstrates that the current level of foreign exchange reserves of US$ 3.3 trillion is equal to only 34% of household deposits and 15% of total (corporate and household) deposits, and 10% of our broad M3 money measure. In brief, the failure to proactively hike deposit rates will likely lead to capital flight. Policymakers realize that the Chinese banking system has created so much money that even the sheer size of foreign currency reserves is insufficient to defend the currency if and when households and companies choose to convert their liquid savings into foreign currency. This argues for higher interest rates in China, unless growth downshifts very soon and caps inflation. Bottom Line: Either China's growth will slump soon, capping budding inflationary pressures, or policymakers will have to hike interest rates meaningfully to avoid another run on the exchange rate. What About DM And Non-Asian EM? In the majority of non-Asian EM economies, inflation is either muted or under control. The exceptions are Turkey and central European economies. We have discussed the inflation outbreak in central Europe in detail in past reports (also see Chart I-13 below), and will be revisiting Turkey next week.2 Chart I-12Too Much Money Has Been Created Too Much Money Has Been Created Too Much Money Has Been Created Chart I-13Inflation Outbreak In Central Europe Inflation Outbreak In Central Europe Inflation Outbreak In Central Europe The basis is that there has been little recovery in Latin American economies as well as Russia and South Africa for inflationary pressures to transpire. While some may be prone to structural inflation, cyclical business conditions are still too weak to warrant rising pricing power. In the Euro Area, investors should closely monitor German wage dynamics. Manufacturing wages and core consumer price inflation in central Europe are ramping up (Chart I-13). If and when labor shortages and rising wages in central Europe discourage German manufacturing companies from relocating/outsourcing production to the former, it will put more pressure on the already very tight German labor market and will lead to higher wages. As a result, genuine inflation in the largest European economy will heighten. In the U.S., the tight labor market and vibrant growth argue for higher inflation ahead. The Trump administration's proposed tax cuts amid robust growth will boost demand and rekindle inflation. Bottom Line: Inflation expectations are very depressed worldwide, and it will not take much in the way of upward inflation surprises to re-price interest rate expectations and, consequently, financial assets. Financial Markets Ramifications The Foreign Exchange Market: The U.S. dollar has probably made a major bottom and will stage a multi-month rally (Chart I-14). Chart I-14Will The Greenback Find ##br##Support At Current Levels? Will The Greenback Find Support At Current Levels? Will The Greenback Find Support At Current Levels? The Federal Reserve will be the first central bank to hike interest rates if global inflation or inflation expectations rise. In turn, the European Central Bank and the People's Bank of China will likely move slower in tightening policy. Such a proactive policy stance of the Fed, especially relative to its peers, will benefit the greenback. Furthermore, the potential appointment of Kevin Warsh as Fed Chairman could lead to higher interest rate expectations in the U.S., and will be currency bullish. In short, the potential mix of tight monetary policies and easy fiscal policies is bullish for the dollar. In the interim, U.S. bond yields are likely to move higher. This is true in the near term, even if Chinese growth disappoints. It will take time until China's growth deceleration caps the upside in U.S./global bond yields. Consistent with our U.S. dollar view, we believe commodities prices have reached a major peak. In sum, the path of least resistance for the U.S. dollar is up. Stay long the U.S. dollar versus a basket of EM currencies: ZAR, TRY, MYR, IDR, BRL and CLP. Local Currency Bonds: As and when EM currencies depreciate versus the greenback and U.S. bond yields grind higher, EM high-yielding local currency bonds could sell off. Chart I-15 reveals that the spread between the EM-GBI local currency benchmark yield and five-year U.S. Treasurys has fallen to a 10-year low. The risk-reward is not attractive for U.S. dollar- and euro-based investors. EM credit versus U.S. investment grade bonds. On August 16, 2017, we advised shifting our underweight EM sovereign bonds recommendation away from U.S. high yield to U.S. investment grade corporate credit. This strategy remains intact. This is consistent with EM currencies depreciating versus the U.S. dollar, U.S. bond yields moving higher and commodities prices softening. Continue underweighting EM stocks versus DM: A stronger U.S. dollar and rising U.S. bond yields will reverse EM equities' relative outperformance versus DM. In fact, manufacturing PMIs certify that EM manufacturing growth remains subdued relative to DM (Chart I-16). Chart I-15EM Local Currency Bonds: Little Yield Advantage EM Local Currency Bonds: Little Yield Advantage EM Local Currency Bonds: Little Yield Advantage Chart I-16EM Equities Versus DM: A Sign Of Reversal? EM Equities Versus DM: A Sign Of Reversal? EM Equities Versus DM: A Sign Of Reversal? If this coincides with inflation or growth concerns in China, it will create a perfect storm for all EM risk assets. As to EM stocks' absolute performance, we are approaching a major top, even though the exact timing of a major relapse is uncertain. Flows into EM equities remain robust, but they will reverse if one or more of the following transpires: rising U.S. interest rate expectations, a stronger U.S. dollar, high and rising inflation in China and policy tightening, or the opposite - an imminent growth slump in China and a relapse in commodities prices. All in all, the EM equity rally momentum remains strong but the risk-reward is quite unfavorable. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Peru: External Backdrop Holds The Key The external environment has been and will remain key to the performance of Peruvian financial markets. The Peruvian bourse has rallied massively, outperforming the EM equity benchmark over the past year, even as domestic demand in Peru has been weakening. Despite stronger global growth and higher commodities prices, GDP growth along with consumer and capital growth have not recovered at all (Chart II-1). Meanwhile, bank loan growth remains very weak (Chart II-2). Chart II-1Peru: Weak Domestic Demand... Peru: Weak Domestic Demand... Peru: Weak Domestic Demand... Chart II-2...Corroborated By Weak Credit Growth ...Corroborated By Weak Credit Growth ...Corroborated By Weak Credit Growth If metals prices stay firm and strong capital flows in EM persist, Peru's currency will remain under appreciation pressure. This will provide the central bank with more room to ease policy by cutting interest rates and adding liquidity to the banking system as it accumulates foreign exchange reserves (Chart II-3). Continued policy easing by the central bank will in turn revive bank loan growth, and the economy will recover. Chart II-3FX Reserve Accumulation = Liquidity Easing FX Reserve Accumulation = Liquidity Easing FX Reserve Accumulation = Liquidity Easing Our baseline scenario, however, is that industrial metals prices in general and copper prices in particular will relapse materially in the next 12 months. Furthermore, odds are that U.S. bond yields will drift higher and the U.S. dollar will strengthen (as discussed on pages 11-12). Under such a scenario: The Peruvian sol would come under depreciation pressure if and when metals prices relapse (Chart II-4). With precious and industrial metals representing 60% of total exports, a drop in metals prices will lead to considerable deterioration in Peru's trade balance and FDI inflows will slump. The central bank is committed to maintaining a stable exchange rate due to high foreigner ownership of government local currency bonds and a still-partially dollarized economy. Hence, if the currency comes under attack, the central bank will defend the sol by selling its international reserves, which will deplete local currency liquidity (Chart II-3). Consequently, local rates will rise and banks will curtail bank loan growth, which in turn will preclude any recovery in domestic demand. Overall, the external environment and its impact on the exchange rate holds the key for a domestic-led recovery. A relapse in industrial metals and copper prices and ensuing depreciation pressure on the currency will undo the recent loosening in monetary policy and stall a potential domestic demand recovery. In terms of financial markets strategy, we recommend the following: Despite domestic demand weakness, the Peruvian equity market has been on a tear, led by banking and mining stocks. Given our negative view on industrial metals and copper prices, we recommend staying underweight Peruvian equities relative to the EM benchmark (Chart II-5). Chart II-4Terms Of Trade Dictate The Currency Terms Of Trade Dictate The Currency Terms Of Trade Dictate The Currency Chart II-5Has Peru's Relative Equity Performance Peaked? Has Peru's Relative Equity Performance Peaked? Has Peru's Relative Equity Performance Peaked? With respect to our absolute call on bank stocks and our relative trade versus Colombian banks, we recommend closing both trades with large losses. Finally, we recommend being long Peru credit relative to Brazilian sovereign credit. Public debt burden is much lower in Peru (24% of GDP) than in Brazil (74% of GDP). Andrija Vesic, Research Assistant andrijav@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "Corporate Profits: Recession Is Bad, Deflation Is Worse," dated January 28, 2016, link available at ems.bcaresearch.com 2 Please see Emerging Markets Strategy Special Report "Central Europe: Beware Of An Inflation Outbreak," dated June 21, 2017, and Emerging Markets Strategy Weekly Report, dated September 6, 2017; pages 15-18; links are available on page 18. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights EM EPS growth is set to decelerate significantly and will likely turn negative in 2018 based on the China/EM money/credit indicators. All measures of Chinese broad money growth have fallen to a record low signifying a major growth slump. The two pillars of the EM currency rally - strong growth in China that manifests in higher commodities prices and lower U.S. bond yields- are set to reverse. EM equities and credit markets relative performance versus their DM peers is about to relapse. A new fixed-income trade: receive 2-year swap rates in Mexico / pay 2-year swap rates in the U.S. Feature Last week we were on the road, meeting with some of our U.S. East Coast clients. This week we address some of the common questions we received. Q: Why do you think EM profits will relapse in the next six-to-nine months, given both global and EM growth continue to show strength? A: Our reluctance to change our view on EM risk assets in general and equities in particular has to do with EM/China business cycle/corporate profit indicators. Several indicators for EM profits - which have exhibited very good track records - presently forecast a material slowdown and possibly a contraction in EM EPS starting late this year and well into next year. In particular, China's broad and narrow money impulses lead EM EPS by about nine months, and are currently signaling that EPS growth is set to peak and begin to decline in the next nine months (Chart I-1). What's more, a few business cycle indicators from Korea and Taiwan, such as nominal manufacturing production and manufacturing shipments-to-inventory ratios, corroborate a peak in EM EPS growth (Chart I-2). Chart I-1EM EPS Is Set to Decelerate ##br##And Probably Contract EM EPS Is Set to Decelerate And Probably Contract EM EPS Is Set to Decelerate And Probably Contract Chart I-2More Signs Of Relapse##br## In EM EPS Growth More Signs Of Relapse In EM EPS Growth More Signs Of Relapse In EM EPS Growth Importantly, the EM corporate earnings slowdown will not occur in a vacuum. It will transpire amid a slowdown in Asian trade and lower commodities prices. In particular: China's broad money M3 impulse leads domestic industrial orders, nominal manufacturing production and imports (Chart I-3). Even though Asian export data were strong in August, China's container freight index signals a slowdown in Asian trade lies ahead (Chart I-4). Chart I-3China: M3 Impulse And Domestic Demand China: M3 Impulse And Domestic Demand China: M3 Impulse And Domestic Demand Chart I-4Asian Export Growth To Slow Asian Export Growth To Slow Asian Export Growth To Slow The Chinese broad money impulse also points to a rollover in Korean, Taiwanese, other EM as well as DM countries' shipments to the mainland (Chart I-5). This is how the slowdown in China's money/credit will hurt corporate profits in EM as well as in DM sectors with substantial exposure to Chinese growth. Besides, China's broad money impulse leads industrial metals prices in general and iron ore prices in particular (Chart I-6). This signifies downside risks to commodities producers. Finally, China's yield curve suggests that mainland manufacturing PMI will roll over after its recent ascent (Chart I-7). Chart I-5Shipments To China Are At Risk Shipments To China Are At Risk Shipments To China Are At Risk Chart I-6Industrial Metals Prices Have Peaked Industrial Metals Prices Have Peaked Industrial Metals Prices Have Peaked Chart I-7China: The Yield Curve And Manufacturing PMI China: The Yield Curve And Manufacturing PMI China: The Yield Curve And Manufacturing PMI In short, China has been gradually tightening monetary policy, which has already manifested in record-low broad money growth. The next phase is evidence of a material deterioration in sales and profits among China-exposed plays. The EM stock markets are unlikely to ignore it. Q: It seems you are putting a lot of emphasis on China's broad money M3 measure. Why do you look at your version of Chinese broad money M3 and not at official M2 and total social financing (TSF)? A: Over the past several months we have done a lot of research and analysis on China's money and credit, and believe that our broad money M3 measure and private and public credit aggregate calculated by BIS are presently better measures of money and credit than official broad money M2 and TSF: First, the TSF data have become distorted because of the local government financing vehicles (LGFV) debt swap program. Specifically, according to the LGFV debt swap mechanics, starting in 2015 provincial governments began issuing bonds that have been purchased by banks. The amount of bonds issued was RMB 3.2 trillion in 2015, RMB 4.9 trillion in 2016 and expected to be RMB 4.8 trillion in 2017. This amounts to total issuance of RMB 12.9 trillion since the commencement of the program. As the next step, local governments were supposed to transfer the proceeds from these bond issuances to their LGFVs, with the latter using the money to pay down their debt. The ultimate goal of the program is to shift the debt from LGFVs to provincial governments, as the latter's creditworthiness is much better than the former. This has also reduced interest rates on the debt as provincial governments borrow at lower interest rates than LGFVs. All that said, it is unclear how much of their debt LGFVs have repaid. The main problem with using TSF data is knowing the amount of proceeds from the issued debt swap bonds that were used to pay down LGFV debt. If the entire amount of these bonds issued by provincial governments was used to pay down LGFV debt, there would not be an impact on economic activity, and only a very short-term impact on money supply. When banks buy bonds from non-banks (including governments), they create new money. When debtors (including governments and their entities) pay down debt to banks, money is destroyed. Nevertheless, both official M1 growth and our measure of broad money (M3) were too strong in 2015 and 2016 – i.e., they remained strong much longer than would have been justified by the LGFV debt swap. Furthermore, private and public credit, M2 and M3 money measures have decoupled from TSF since the middle of 2015 (Chart I-8A). TSF adjusted for the LGFV debt swap – the latter is added to TSF – has also diverged from official M2, our broad money M3 and BIS’s private and public credit measures (Chart I-8B). This corroborates that TSF data can no longer serve as a reliable measure of credit/money origination. Chart I-8AChina: TSF Has Diverged From ##br##Other Money/Credit Measures China: TSF Has Diverged From Other Money/Credit Measures China: TSF Has Diverged From Other Money/Credit Measures Chart I-8BChina: TSF Adjusted For LGFV Debt Swap Has Also Decoupled From Money/Credit Measures China: TSF Adjusted for LGFV Debt Swap Has Also Decoupled From Other Money/Credit Measures China: TSF Adjusted for LGFV Debt Swap Has Also Decoupled From Other Money/Credit Measures Markedly, paying down debt by LGFVs should have reduced corporate debt outstanding by RMB 12.9 trillion, which would represent a 12% drop from the RMB 112 trillion outstanding at the end of 2015. However, corporate debt has continued to expand rapidly, even as government debt has surged. Given all of the above, we doubt all of the proceeds from bonds issued within the LGFV debt swap program were immediately used to repay LGFV debt. Instead, we suspect the proceeds from the bond issuance might have been at least partially invested into the economy in 2016, in defiance of the rules of LGFV debt swap operation. We played down the rise in M1 in late 2015 and early 2016 because we regarded it as temporary, reflecting the LGFV debt swap program. In retrospect, it was a mistake - this was one of the main reasons we did not heed the message from recovering money growth in early 2016 to turn cyclically positive on China's growth, and consequently on commodities and broader EM. Provided we do not know what portion of LGFV debt was repaid and when, corporate credit and total social financing data have become difficult to interpret. Chart I-8A and Chart I-8B demonstrate that TSF with and without the LGFV debt swap has diverged from private and public debt since the middle of 2015 when the LGFV debt swap program commenced. Apparently, one no longer can rely on TSF or adjust it by the amount of LGFV debt swap to gauge money and credit creation in China. In this context, the aggregate of private and public credit is a much more appropriate measure of credit provision and debt creation than TSF. The basis is because it includes both private and public debt. Indeed, the reshuffling of debt between local governments and LGFVs (the latter are treated as enterprises in China's banking statistics), does not affect either aggregate borrowing or amount of debt held in the economy. Second, when credit numbers are distorted, one needs to resort to money supply measures to judge credit dynamics. The reason is because financial engineering and, in the case of China, the LGFV debt swap program, can obscure the amount of outstanding credit, but they cannot conceal the amount of money banks create when they lend or purchase bonds or any other asset. Money is created when a bank originates claims on non-banks, and money is destroyed when a debt is paid back to the bank. Accordingly, money traces debt creation by banks. Banks can disguise their assets, and corporations and governments can conceal their liabilities, but none of them can camouflage the amount of money in circulation. In short, we trace money to gauge the amount of private and public sector borrowing from banks. This is why we have calculated various measures of money in China to overcome the shortcomings of the TSF. Specifically, we have calculated broad money M3 (see details of our calculation below) and credit-money. The latter is the sum of commercial banks' assets such as claims on non-financial institutions, claims on other financial institutions, claims on government and claim on other resident sectors and commerical banks' as well as the central bank's foreign currency assets. Chart I-9 demonstrates various measures of broad money and outstanding credit: official M2, our measure of broad money M3, our credit-money measure, and private and public debt (source BIS). Importantly, all measures of money and private and public credit suggest that credit origination/money creation was very strong in 2015 and 2016, and that it has slowed substantially in 2017. In brief, the message from various measures of money/credit is consistent. Chart I-9China: Money/Credit Growth Has Decelerated To New Lows China: Money/Credit Growth Has Decelerated To New Lows China: Money/Credit Growth Has Decelerated To New Lows Interestingly, broad money M3 rose by RMB 21 trillion in 2015, RMB 20 trillion in 2016 and by only RMB 16.5 trillion in the past 12 months through end of August. This is why the M3 impulse - a change in money flows - has turned negative since early this year. Third, we prefer our broad money measure M3 to official M2 because it is more consistent with the BIS's measure of private and public credit. It has also served as a better tool in forecasting the 2016-2017 recovery in Chinese growth. As can be seen in Chart 1, 3, 4, 5 and 6 on previous pages, the M3 impulse - its second derivative - has a great track record in forecasting China's business cycle dynamics. The acceleration in M2 growth in 2015-16 was milder than one would expect in order to achieve meaningful acceleration in nominal economic activity. M2 growth was more subdued than a rise in both private and public debt (Chart I-9). We suspect that M2 is no longer an encompassing measure of broad money in China, and therefore we have calculated other measures of broad money to gauge true money/credit creation. Chart I-10China: Consumer Price Inflation Is Rising China: Consumer Price Inflation Is Rising China: Consumer Price Inflation Is Rising Broad money consists of various liabilities of commercial banks. While the official M2 includes many of their liabilities such as corporate demand deposits, corporate time deposits and personal deposits. It does not include some others. We have added the following commercial banks' liabilities - transferable deposits and other deposits which are not included in M2, liabilities to other financial corporations and other liabilities - to M2 to produce a more all-inclusive measure of broad money M3. Q: Why can't the Chinese authorities stimulate and revive growth again, like they have done many times in the past? A: Of course, they can. However, if the authorities begin easing monetary/credit and fiscal policies now, it will affect growth six to nine months down the road. Based on money and credit indicators shown in the charts above, growth is set to slow over the next nine months because of the time lag that money/credit has on the economy. In the next six to nine months, economic activity and corporate profits are likely to decelerate considerably, based on the monetary/credit tightening that has already occurred in China. Provided China-related financial markets in general and EM risk assets in particular have so far not discounted the slowdown suggested by China's money/credit indicators, they are very vulnerable. Finally, the magnitude of the impending growth slump is likely to be large, as evidenced by the substantial decline in these money and credit indicators that has already occurred. In brief, policymakers have been tightening credit/money creation, and it has not yet impacted financial markets. Furthermore, inflation is rising in China (Chart I-10) and policymakers are unlikely to start easing before they witness a major growth slump. Until the latter becomes visible in economic data and on the ground, financial markets leveraged to mainland growth will sell off notably. Q: There is no indication that the Federal Reserve will turn hawkish. This will be especially true if global growth slows - as you argue it will because of China. Why do you expect the EM currency rally to peter out amid a dovish Fed? Historical empirical evidence suggests that EM currencies are often driven by commodities prices, not the interest rate differential over U.S. rates. Let's take the BRL and the ZAR as examples. Charts I-11A and Chart I-11B illustrate that the BRL and ZAR exchange rates versus the U.S. dollar have historically been closely correlated with commodities prices, not the level of or change in their interest rate differential over the U.S. Chart I-11ABrazil: What Drives The Currency? Brazil: What Drives The Currency? Brazil: What Drives The Currency? Chart I-11BSouth Africa: What Drives The Currency? South Africa: What Drives The Currency? South Africa: What Drives The Currency? This has also been true over the past 18 months. The rally in EM currencies since early 2016 can be largely attributed to the rise in commodities prices. As and when commodities prices roll over - as we expect to occur - the trade balances of commodities-producing nations will deteriorate, as will their currencies. Remarkably, there are tentative signs that the drop in U.S. bond yields and the greenback's depreciation are late and overdone. Two-year U.S. bond yields have bounced from their 200-day moving average (please refer to the middle panel of Chart II-1 in the Mexican section). Typically, such a technical profile leads to new highs. Our sense is that U.S. bond yields will rebound in the coming months, which will also weigh on EM currencies. Importantly, one of the drivers behind the U.S. dollar selloff since early this year has been the rise in banks' excess reserves at the Fed (Chart I-12). The latter was due to the debt ceiling, as the U.S. Treasury was running down its account at the Fed by issuing less paper. In short, since the beginning of this year the U.S. Treasury did not issue bonds/bills and deposit them at its Treasury General Account (TGA) at the Fed - meaning it was not destroying banking system reserves as it typically does. This boosted the supply of U.S. dollars - banks' excess reserves at the Fed rose by US$ 300 billion. More dollar supply depressed both the exchange rate and U.S. interest rates. Chart I-12 demonstrates that in the post-QE era, banks' excess reserves at the Fed have correlated with the U.S. dollar's exchange rate. The debt ceiling has been resolved for now, and the Treasury will now begin accumulating dollars in its TGA account again. It has already announced that its TGA will rise from $73 billion now to $400 billion at the end of this year. The Treasury will issue more paper, and deposit U.S. dollars in the TGA. This will shrink banks' excesses reserves. This, in tandem with the reduction in the Fed's balance sheet, will diminish banks' excess reserves. The latter will reduce U.S. dollar supply in off-shore markets and will likely trigger a U.S. dollar rebound. On the whole, the two pillars of the EM currency rally - strong growth in China that manifests in higher commodities prices and lower U.S. bond yields - are set to reverse. In turn, a potential EM currency selloff along with deteriorating EM corporate profits will likely weigh on EM equities and EM sovereign and corporate debt. Q: Does this mean EM stocks will relapse in absolute terms, or simply underperform the DM equity markets? Our strongest conviction at the moment is on EM relative equity performance versus DM equity markets. Odds are that a relapse in relative performance is imminent as and if U.S. bond yields rise (Chart I-13). Chart I-12U.S. Banks' Excess Reserves ##br##And The U.S. Dollar U.S. Banks' Excess Reserves And The U.S. Dollar U.S. Banks' Excess Reserves And The U.S. Dollar Chart I-13U.S. Stocks Outperform EM Ones When ##br##U.S. Bond Yields Are Rising U.S. Stocks Outperform EM Ones When U.S. Bond Yields Are Rising U.S. Stocks Outperform EM Ones When U.S. Bond Yields Are Rising In addition, U.S. stocks' underperformance versus the global equity index in common currency terms is at a technical support (Chart I-14, top panel), and will likely reverse as the dollar firms up. Historically, when U.S. stocks outperform the global benchmark in common currency terms - denoted by shaded periods in Chart I-14, EM stocks typically underperform the global equity index. The dynamics of EM equity absolute performance depends on investor's risk appetite. It will be hard for EM share prices to drop meaningfully as the DM rally persists. Global stocks are still trading well, and it is very difficult to pinpoint any trigger that will lead to a reversal. As our readers well know, we do not forecast triggers for the simple reason that the chances of getting it right are much lower than a coin toss. That said, in the medium term, the reason for a correction in DM stocks could well be EM/China growth, as it was in 2015. In such a scenario, EM risk assets will sell off first. As to timing, it is hard to find indicators that lead share prices, but aggregate EM narrow (M1) money growth has historically been coincident or leading with EM share prices - and it presently points to a considerable drop in EM equity prices (Chart I-15). This EM M1 aggregate is equity market-cap weighted making it relevant to investors. Chart I-14EM And U.S. Equites Typically Do Not Outperform Global Stocks Simultaneously EM And U.S. Equites Typically Do Not Outperform Global Stocks Simultaneously EM And U.S. Equites Typically Do Not Outperform Global Stocks Simultaneously Chart I-15EM M1 Growth And EM Share Prices EM M1 Growth And EM Share Prices EM M1 Growth And EM Share Prices Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com A New Trade: Receive Mexican / Pay U.S. 2-Year Swap Rates Mexico's 2-year bond yield has recently fallen through a technical support line while the U.S. 2-year bond yield has recently bounced off a major support level (Chart II-1). Our bias is that the 2-year yield in Mexico will fall relative to 2-year U.S. yield (Chart II-1, bottom panel). We recommend a new trade: receive 2-year swap rates in Mexico and pay U.S. 2-year swap rates. Historically, the domestic demand cycle in Mexico was synchronized with the business cycle in the U.S., mainly due to the fact these two economies are heavily integrated. However, the two economies have recently become desynchronized. This is evident by the fact that the Mexican export sector - which is leveraged to U.S. - is booming while the domestic demand in Mexico is slowing down (Chart II-2). Chart II-12-Year Bond Yields: Mexico And U.S. 2-Year Bond Yields: Mexico And U.S. 2-Year Bond Yields: Mexico And U.S. Chart II-2Divergence Within Mexican Economy Divergence Within Mexican Economy Divergence Within Mexican Economy The culprit behind this desynchronization is the previous collapse in the peso. Falling oil prices and excessive money/credit expansion in Mexico led to a major peso depreciation in 2014 and 2015. The election of Trump pushed it off the cliff in 2016. Inflation in Mexico spiked due to the massive currency depreciation. Consequently, the Mexican central bank has hiked interest rates by 400 basis points since the end of 2015. This, along with fiscal tightening, has choked domestic demand growth in Mexico. At this point, our bias is that the short-term interest rate differential between Mexico and the U.S. is unjustifiably wide and is about to narrow. Going forward, we expect inflation to fall in Mexico and interest rate expectations will at minimum not rise. Inflation in Mexico will roll over soon and moderate because of the following: A large part of the rise in inflation was caused by the depreciation in the peso. The peso's material appreciation this year will reduce the inflation rate (Chart II-3). Consumer spending and capital expenditure are set to continue slumping as the impact of higher interest rates continues filtering through the economy (Chart II-4, top and bottom panel). Chart II-3Mexico: Exchange Rate And Core Inflation Mexico: Exchange Rate And Core Inflation Mexico: Exchange Rate And Core Inflation Chart II-4Mexico: Domestic Demand To Disappoint Further Mexico: Domestic Demand To Disappoint Further Mexico: Domestic Demand To Disappoint Further Domestic vehicle sales are shrinking signifying no revival in interest rate-dependent sectors. Fiscal policy has been tightening and this will continue to be a headwind on economic growth (Chart II-5). Hence, despite flourishing exports to the U.S., very weak domestic demand will dampen inflation in Mexico. Finally, there were several one-off effects to inflation such as the gasoline subsidy removal that took place at the end of last year, and the minimum wage hike that was implemented at the beginning of the year. As the base effect of these fade, the inflation rate will moderate. In the U.S., our bias is that interest rate expectations are too low given the tight labor market, reasonably strong growth, and the U.S. dollar depreciation this year. Odds are that the U.S. interest rate expectations will rise as core inflation moves up (Chart II-6). Chart II-5Mexico: A Major Improvement In Fiscal Position Mexico: A Major Improvement In Fiscal Position Mexico: A Major Improvement In Fiscal Position Chart II-6U.S. Core Inflation To Rise U.S. Core Inflation To Rise U.S. Core Inflation To Rise Investment Recommendations We recommend fixed-income traders to receive Mexican / pay U.S. 2-year swap rates. The main risk to this trade lies in the event of an abrupt sell-off in the peso against the U.S dollar that could push up the 2-year swap rate differential. While we expect EM currencies, including the peso, to depreciate, this trade is still favorable in terms of risk-reward because of the starting point in interest rate differential and peso valuations: Despite the rally this year, the peso is still cheap (Chart II-7). Furthermore, its current account and fiscal balances have improved dramatically. So, the peso should depreciate less than many other EM currencies. Chart II-7The MXN Is Still Cheap The MXN Is Still Cheap The MXN Is Still Cheap In fact, the interest rate spread between Mexico and the U.S. is already historically high, and the peso depreciation might not push it much higher. We would not be recommending this trade if the peso was fairly or overvalued, or if interest rates in Mexico were not this high. Entering this position under these current circumstances reduces the downside risk and, therefore, makes the risk-reward attractive. As to Mexican financial markets in general, we remain constructive on the peso versus other EM currencies. More specifically, we continue to recommend long positions in MXN versus ZAR and BRL. Mexican local currency bonds and sovereign credit offer good value relative to their EM counterparts. Fixed income investors should continue to overweight Mexican local currency and sovereign credit within their respective EM benchmarks. Finally, the outlook for Mexican stocks in absolute terms is poor as domestic demand will slump, further hampering corporate profits. Within an EM equity portfolio we recommend neutral allocation to this bourse mainly due to our expectations of the peso outperforming other EM currencies. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations