Manufacturing

As the world’s second most populous country with an economy projected to grow over 7% annually, India’s potential as a commodity consumer is massive. However, years of distortionary and unfriendly policies have held back the Indian manufacturing sector – the prime consumer of commodities. This has translated into weak “consumption intensity” of industrial commodities. The past four years have witnessed a shift to more business-friendly policies. These policies and an eventual expansion of the manufacturing base will support steeper demand for industrial commodities over the longer term. India’s economic model stands in stark contrast with China’s, which became a voracious consumer of commodities as it industrialized. It is not “the next China” when it comes to metals demand, but it will play an important and growing global role. In terms of agricultural commodities, favorable demographic trends will raise aggregate demand, regardless of the success of India’s industrialization. Highlights Energy: Overweight. Russia’s production was down 42k b/d in January, a trifle compared to the ~ 450k b/d reduction by the Kingdom of Saudi Arabia (KSA) in December. Officials indicate Russia will cut production by 228k b/d in 1Q19. Base Metals/Bulks: Neutral. Indian steelmakers are seeking relief from increasing imports in the form of higher duties, as slowing Asian demand leads to higher shipments from China, Korea, and Japan, according to Reuters.1 Precious Metals: Neutral. Gold markets appear more confident in the Fed’s capitulation on its rates-normalization policy, at least in 1H19, as prices rallied above USD 1,320/oz in end-January. Gold traded slightly lower this week. We remain long as a portfolio hedge. Ags/Softs: Underweight. The USDA releases its WASDE report tomorrow. Feature The impact of China’s rapid industrialization since 2000 on commodity markets is well known. Its share of global consumption of copper and crude oil rose from a modest 10.9% and 6.0% in 2000 to 51.1% and 13.5%, respectively (Chart of the Week). As such, China fueled global demand growth over this period (Chart 2) and, in large part, is responsible for the commodity price boom that ensued. Chart of the WeekChina Now Dominates Industrial Commodity Demand With such a large chunk of demand originating in China, its economic health remains a dominant variable in accurately predicting the path of industrial commodity prices globally. However, with economic priorities shifting from the industrial sector to consumer-driven services, the era of insatiable Chinese commodity demand growth looks to be nearing its end. In search of a replacement to take up the slack, India has often been singled out as a potential leading source of commodity demand growth going forward, and for good reason: India is massive. In terms of population, it is roughly on par with China, boasting a population of 1.3 billion people. And while its share of global wealth is dwarfed by China’s, India’s economy is growing at a rapid pace. According to the most recent IMF projections, its GDP will expand at a 7.5%, and 7.7% clip this year and next – faster than China’s projected 6.2% for both years. Typically, as low income economies develop, their manufacturing sector outpaces economy-wide growth, raising the contribution of industry to overall GDP. Stronger activity in this sector correlates well with industrial commodity demand, which rises accordingly. Meanwhile ag demand is determined by both population and income growth. India, however, has missed the boat (Table 1). Its share of global demand is disproportionate to its current size and its future potential. Table 1India’s Consumption Of Industrial Metals Stands Out As Disproportionately Low In fact, the intensity of commodity usage per dollar of GDP is low even relative to countries at similar income levels (Chart 3). This is most clear in the case of metals. It can be put down to the relatively small role of manufacturing in India’s economy. India did not follow the traditional path of growing its manufacturing base first before re-orienting its economy towards services. Rather, the manufacturing sector has been held back by poor infrastructure and distortionary policies. In fact, services – such as financial services, business services, and telecom – already dominate India’s economy, accounting for 53.9% of GDP, compared to 16.7% in the case of manufacturing (Chart 4). This is in stark contrast with other economies such as China, Korea, and Thailand, in which manufacturing accounts for 29%, 28%, and 27%, respectively (Chart 5). Chart 5No Pickup In Manufacturing Yet Given that the services sector is relatively less metals- and energy-intensive, India’s contribution to global demand for industrial commodities has been disproportionately low. Bottom Line: India’s growth model to date is oriented toward the services sector. As a result, the intensity of industrial commodity demand there – measured as consumption per dollar of GDP – is significantly lower than its peers. This has prevented India from playing a larger role in global commodity markets. The Case For Greater Commodity Demand: Theories And Evidence Economist Walt Whitman Rostow postulated that economies develop through five distinct phases: Traditional society: subsistence agriculture, low level of technology, labor-intensive Preconditions to takeoff: regional trade, the development of manufacturing Take off: the beginning of industrialization Drive to maturity: rising living standards, economic diversification, strong use of technology High mass consumption: mass production and consumerism Along this path, economies in phases (2), (3), and (4) are the most notable in terms of rising appetite for industrial commodities. During these stages, the industrialization and urbanization processes require an expansion of electricity grids, infrastructure and housing. As such, these stages are characterized by high base metals demand. Yet as illustrated by the sigmoid, or S curve, the period of exponential growth in commodity demand eventually slows down and in many cases falls after the country reaches a certain level of GDP per capita (Chart 6). Evidence from metals and oil corroborate this theory. In fact, if we single out the commodity intensity path of DM economies as their incomes were rising, we find that commodity intensity there has already started to decline (Chart 7). This S-curve is also evident in the commodity intensity of emerging economies (Chart 8). China’s path to development stands out as an extreme case of high consumption usage. While not all economies follow China, the paths are similar. In the case of oil, it appears that the consumption intensity of countries that have developed more recently peaked at both a lower income level and a lower oil usage level than countries that developed earlier. This is clearly the case for Korea and Malaysia, and suggests that technology has raised the efficiency of oil. On this basis, we do not expect India’s commodity intensity to reach the same peaks as its more wealthy peers. However, India’s usage has remained stagnant and in some cases fallen. This highlights the relatively muted role of manufacturing in India’s economy. As India’s economy grows and evolves, this should change. We project India’s commodity intensity path as it grows its manufacturing base (Chart 9). Based on this exercise, we find that by the year 2040, India’s consumption of refined copper will account for 12% of global consumption -- up from 2% today.  The impact is more muted in the oil sector -- we expect it will account for almost 12% of global crude oil demand, from the current 5%. This trajectory reveals that the scope for rising demand is greater for metals than for the oil sector, implying that industrial commodities are set to benefit in the case of a boom in Indian manufacturing. Bottom Line: Both theory and evidence suggests that the intensity of India’s commodity usage is set to rise over time as its manufacturing sector expands. This is especially true in the case of metals. Even in our most conservative projection, India’s copper consumption is set to rise more than 10-fold by 2040. The Path Forward: “Make In India” While the Rostow model is instructive in framing our thinking on the path to development, it is a crude theory – not all countries will necessarily follow the same path to development. These are the lessons from economist Alexander Gerschenkron’s theory of economic backwardness, which highlights that countries’ growth paths may not be identical or replicable due to cross-country differences, and differences in the state of technology available at varying points of time. Applying these ideas to India means that while India is able to access current technology, which supports a more rapid industrialization process, its economic model is also very different. The China model rested on a powerful single-party state, with privileged access to the American market, that used its control of the financial system to funnel a swell of national savings into an aggressive industrialization effort. On the other hand, the India model required the government to move forward incrementally. Indian leaders had to pursue industrialization while grappling for democratic consensus in the context of extreme social diversity and a more restrictive trade environment. Thus, India is likely to mimic the circuitous path of emerging markets like Brazil or Mexico. Over the past four years, Indian policymakers have tried to unwind unfavorable business policies and spur growth in the manufacturing sector. The “Make in India” initiative of Prime Minister Narendra Modi seeks to encourage both foreign and domestic investment, and to raise the manufacturing sector’s contribution to GDP to 25% by the year 2025. In the process it aims to create 100 million jobs. This target is unrealistic. In fact, the manufacturing sector’s contribution to GDP has come down slightly, with economists blaming the demonetization drive and the chaotic, complicated and unclear roll out of the new Goods and Services Tax. Modi also faces tough elections this spring, which could put his initiative on ice. Nevertheless, there is a positive omen in the automobile industry. According to figures from the Society of Indian Automobile Manufacturers, roughly 4 million cars were manufactured last year – up from 3.2 million just five years ago (Chart 10). This is in line with India’s Automotive Mission Plan 2026, which aims for the auto industry to become one of the top three, accounting for 40% of the manufacturing sector and contributing 12% to India’s GDP by 2026. Chart 10An Encouraging Trend For Manufacturing Moreover, Modi’s impact has been a net positive in making India more welcoming for investment. While poor infrastructure, red tape, and restive labor laws are still constraining industry, measures of institutional performance are improving (Chart 11). This is a prerequisite for a brighter manufacturing future. As for the election, even if India’s opposition Congress Party should come to power, it will have learned from its five years in the political wilderness that Modi’s message of economic development resonates with the public. Their current stance on economic policy calls for import substitution, economic liberalization, and a faster pace of development – consistent with a growing manufacturing sector. Chart 11The Business Environment Is Improving The Business Environment Is Improving Bottom Line: While the “Make In India” campaign says as much about Modi’s flair for public relations as anything, India’s business environment is now more conducive to growth and investment. This bodes well for commodity demand going forward. Ags In The Age Of Manufacturing While a much-needed push in India’s manufacturing sector would clearly have a direct impact on its demand for industrial metals, the resulting improvement in the economy and employment would also raise incomes. In theory, this would support the consumption of agricultural commodities. Nonetheless, a couple of observations suggest that India is less of an opportunity for ags as it is for metals (Chart 12): In terms of the level of ag consumption per capita, rice usage is actually relatively high in India. While corn intensity levels are still quite low, wheat consumption per capita is near the level at which China plateaued. The differences across these grains likely reflects differences in preferred sources across countries and implies there is not as much room for catch up. Furthermore, ag consumption per capita generally plateaus at fairly low-income levels, in stark contrast to the industrial metals. A clear outlier is corn consumption in the United States, where high-usage patterns can be put down to the rising use of corn for ethanol production on the back of biodiesel mandates. We do not expect growth in ag consumption intensity on the back of rising incomes. Nevertheless, India’s population is projected to continue rising, in turn supporting aggregate food consumption there. That said, policies promoting India’s self-sufficiency in agriculture have generally prevented rising demand from spilling over into global markets. In fact, in terms of the trade balance, India is usually a net exporter of these grains, especially in the case of rice (Chart 13). This is a positive for India – in that it has so far avoided the risk of food shortage that occasionally rears its head – but it is a negative for global ag demand. Chart 13Self-Sufficiency Policies Insulate The Indian Ag Sector Bottom Line: Unlike industrial commodities, we do not anticipate a rise in per capita ag consumption in India. Nevertheless, a rapidly growing population will mean that aggregate demand for ags will grow briskly.    Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Pavel Bilyk, Research Analyst Commodity & Energy Strategy PavelB@bcaresearch.com Footnotes 1      Please see “Exclusive: Indian steel firms seek higher duties on steel imports as prices drop,” published by Reuters.com on February 5, 2019. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 4Q18 Commodity Prices and Plays Reference Table Summary of Trades Closed in 2018  

Highlights EM equity and credit outperformance versus the U.S. in the past three months was an aberration in the cyclical and structural downtrend. Hence, the recent outperformance of EM assets provides a good entry point for investors to short EM/China assets against their U.S. counterparts. In our opinion, this strategy will work in the coming months regardless of whether global risk assets rebound or sell off – i.e., they are not dependent on market direction. Feature The fourth quarter of 2018 was marked by a precipitous plunge in global equities, led by the U.S. In the meantime, EM stocks have outperformed the global equity benchmark in the past three months. Will EM and U.S. stocks trade places again, or will EM continue to outperform U.S. and DM equities? By the end of December, global share prices had become extremely oversold, and investor sentiment was downbeat. A trifecta of confidence-boosting developments – the rapprochement between the U.S. and China in trade negotiations, the announcement of more policy stimulus in China and reassurances from Federal Reserve Chairman Jerome Powell that monetary policy tightening is not predetermined – have since led to a rebound in global stocks. A key question for asset allocators heading into 2019 is: Will EM continue to outperform the global equity index in this rebound? We do not think so. The odds are considerable that EM will resume its underperformance versus DM in general and the U.S. in particular. The fundamental rationale for staying bearish on EM is that global trade and manufacturing remain on a downward trajectory. Chart I-1 illustrates that EM risk assets sell off when global trade is slowing, especially when the weakness stems from China. Chart I-1EM Selloff Has Been Due To Slowdown In China Chinese policymakers are easing both fiscal and monetary policies, but the impact of their efforts on the economy is yet to be seen. Declining interest rates in China do not constitute a sufficient condition to buy EM risk assets. Importantly, EM stocks often drop when Chinese interest rates are falling, as that reflects a deteriorating growth outlook (Chart I-2). Chart I-2Lower Interest Rates In China Is Not A Reason To Buy EM In short, monetary and fiscal stimulus in China are not yet sufficient to revive the mainland’s business cycle. The latter is critical to the performance of EM risk assets. We will explore China’s fiscal and credit stimulus efforts in much more detail in the coming weeks. Finally, EM equity valuations are no better than those in the U.S. In particular, our EM/U.S. relative stock valuation indicator based on a 20% trimmed mean is currently neutral (Chart I-3). This valuation measure strips out the top and bottom 10% for EM as well as U.S. sub-sectors and computes an equally weighted average of the other 80%. Hence, it eliminates the outliers that for structural or industry specific reasons trade at much lower or higher multiples. Consequently, contrary to the common narrative in the investment industry, EM equities are not cheap versus U.S. ones. Chart I-3EM Equities Are Not Cheaper Than U.S. Ones Given our high conviction on the view that U.S. will outperform EM over the coming several months, we are reiterating a few of our long-standing strategic recommendations/pair trades: Short EM stocks / long the S&P 500; Short EM banks / long U.S. banks; Short EM high-yield corporate credit / long U.S. high-yield corporate credit; Short Chinese property developers / long U.S. homebuilders. In all four cases, the recent outperformance of EM assets provides a good entry point for investors who do not yet have these positions. In our opinion, these recommendations will work in the coming months regardless of whether global risk assets rebound or sell off – i.e., they are not dependent on market direction. No Turnaround In Global Trade/Manufacturing Global cyclical equity sectors have plunged significantly and their prices may be recovering/stabilizing due to oversold conditions. Yet there are few signs of improvement in global trade and manufacturing, and no indication of a significant turnaround in financial markets that are most sensitive to global trade and Chinese growth. Our Risk-On-to-Safe-Haven (RSH) currency ratio1 has relapsed again following a failed rebound attempt (Chart I-4, top panel). Interestingly, this ratio seems to be forming a head-and-shoulders pattern, suggesting the next big move could be to the downside. As we have shown in past reports, EM share prices correlate strongly with this indicator, and a major downleg in this indicator would be consistent with a major drop in EM stocks. Chart I-4No Buy Signal For EM From The Global Currency Markets Furthermore, the annual rate of change on this currency ratio leads the EM manufacturing PMI, and it presently foreshadows more downside in the latter (Chart I-4, bottom panel). Korean and Taiwanese exports contracted slightly in December from a year ago. As frontloading from U.S. import tariffs wanes, their exports will shrink further. Chips prices are falling, signaling that the slump of the global tech hardware sector is not yet over (Chart I-5). Chart I-5Chip Prices Are Still Plunging Continued deterioration in global trade and manufacturing is bad news for emerging Asia. The technical profile of Asian stock markets is also poor, raising the odds of a meltdown as cyclical economic conditions in the region deteriorate further. The region’s relative equity performance versus global and Latin American indexes is relapsing, having failed to break above long-term moving averages (Chart I-6). Chart I-6Underweight Emerging Asian Stocks Versus Both World And Latin America Odds are that emerging Asian stocks will drop in absolute terms, underperforming both the EM and global equity benchmarks. This will drag the EM index down further. We continue to recommend the following strategy: long Latin American stocks / short emerging Asian equities. The U.S. manufacturing leading indicator – the ISM manufacturing new orders-to-inventory ratio – remains in a downtrend (Chart I-7). Chart I-7The U.S. Selloff Has Been Partially Due To Manufacturing Slowdown The average of new and backlog orders from the Chinese manufacturing PMI survey has plunged to its previous lows (Chart I-8, top panel). The domestic orders component of the People’s Bank of China’s latest 5000 industrial enterprise survey is also in a free fall (Chart I-8, bottom panel). Chart I-8China: No Sign Of Bottom In Industrial Sectors Meanwhile, the impact of Chinese domestic demand on the rest of the world occurs via mainland imports. The leading indicator for imports – the manufacturing PMI import sub-component – has plunged to 46, well below the 50 boom-bust line (see Chart I-1, bottom panel on page 1). Within the investable Chinese equity universe, cyclical sectors exposed to capital spending are making new lows in absolute terms (Chart I-9, top and middle panels). At the same time property stocks are relapsing again (Chart I-9, bottom panel). Chart I-9China: Not Much Rebound In Cyclical Equity Sectors While the authorities are once again boosting infrastructure spending by allowing local governments to issue more special bonds, the mainland’s real estate market has ground to a halt. The latter will likely offset the former. Finally, the MSCI China All Shares index – which incorporates all Chinese stocks trading inside and outside the country – has not rebounded much, despite being oversold (Chart I-10, top panel). Chart I-10China All Share Index: Poor Performance Continues Notably, this index’s relative performance versus both DM and EM equity indexes has failed to break above its 200-day moving average, despite the announced policy stimulus (Chart I-10, middle and bottom panels). These are negative technical signposts that bode ill for the outlook for Chinese share prices. Bottom Line: Odds are high that the global trade/manufacturing or related equity sectors/segments will continue struggling in the months ahead. What About The U.S. Dollar? The trade-weighted U.S. dollar has been going sideways for several months. While lower U.S. interest rate expectations have weighed on the greenback, the global manufacturing slowdown and risk-off sentiment in financial markets have put a floor under its value. The dollar is a countercyclical currency, and it does well when global growth is weakening, and vice versa (Chart I-11). Chart I-11The U.S. Dollar Is A Counter-Cyclical Currency It is impossible to know how long this standstill phase in the currency markets will last. What we do know is that when it breaks one way or another, the move will be violent and large. We believe risks to the U.S. currency are to the upside. First, U.S. consumer spending growth remains robust, and the labor market is very tight. Unless the rest of the world plunges into a major growth slump, pulling the U.S. down with it, U.S. interest rate expectations should recover, lifting the dollar. Second, a further downshift in U.S. interest rate expectations will likely occur only if the global economic slowdown is so severe that it leads the market to price in Fed rate cuts. In this scenario, the greenback will rally violently as well. The basis is that the dollar tends to appreciate during global slumps and sell off amid global growth recoveries, as illustrated in Chart I-11. Third, the only scenario where the dollar could plunge is where global trade recovers briskly, driven by growth outside the U.S. in general and in China/EM in particular. This is the least-likely scenario at the current juncture, in our opinion. The trend in the dollar is critical to the relative performance between EM and U.S. stocks. Chart I-12 demonstrates that periods of EM equity underperformance versus the U.S. typically coincide with an appreciation in the trade-weighted greenback, and vice versa. Chart I-12When EM Stocks Outperform The Global Benchmark, U.S. Underperforms And Dollar Weakens And Vice Versa Bottom Line: The next big move in the U.S. dollar will likely be up, not down. Investment Considerations Global equity prices are already reflecting a lot of bad news; they are oversold, and investor sentiment on global growth has become downbeat (Chart I-13). This could create a window for global equities to rebound on a tactical basis. Chart I-13U.S./Global Stocks Are Oversold The majority of our colleagues at BCA believe global equities are primed for a cyclical rally. We within BCA’s EM team agree with the equity rebound narrative but on a tactical basis and believe that any rebound will be led by U.S. stocks – and that EM will lag. We are not convinced that global equities are in a cyclical bull market yet. The main difference between BCA’s house view and the EM team’s outlook is the risks related to China’s economy and their impact on global cyclical equity sectors. The U.S. is relatively unexposed to Chinese growth, EM economies, commodities producers, Japan and Germany. Therefore, U.S. stocks will outperform and the dollar will do well if Chinese growth continues disappointing. Ongoing trade talks between China and the U.S. may bring about some positive results, and the Fed may continue to sound more dovish. However, we contend that the main culprit behind the global equity selloff in 2018 was neither the trade war nor the Fed, but the slowdown in global trade/manufacturing (please refer to Chart 1 and 7 on pages 1 and 6, respectively). On this front, we do not foresee an imminent reversal, as argued above. The latest underperformance of the U.S. has created a good entry point for our relative strategies/trades to be short EM / long U.S. We reiterate the following strategies/trades (Chart I-14): Chart I-14Reiterating Four EM Vs. U.S. Strategies/Trades Short EM stocks / long the S&P 500; Short EM banks / long U.S. banks; Short EM HY corporate credit / long U.S. HY corporate credit; Short Chinese property developers / long U.S. homebuilders. Within the EM equity space, we continue to recommend underweighting emerging Asia while overweighting Latin America, Russia and Central Europe. In particular, we are reiterating our long Latin America / short Emerging Asian equities trade initiated on October 11, 2018 (please refer to Chart I-6 on page 5). The complete list of our country equity allocations is presented on page 12. Finally, the path of least resistance for the dollar is up. We continue to recommend shorting a basket of the following EM currencies against the dollar: ZAR, IDR, MYR, KRW, COP and CLP. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Footnotes 1      Average of CAD, AUD, NZD, BRL, CLP & ZAR total return indices relative to average of JPY & CHF total returns (including carry). Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Special Report

Highlights The odds of a significant reversal in the current structural downtrend of China's manufacturing productivity growth are low. Meanwhile, the country's manufacturing sector remains highly competitive in the global goods markets. The extent of China's manufacturing productivity growth will largely rely on the scale of its research and development (R&D) investment. China's high-tech sector will likely experience higher productivity growth than other traditional manufacturing sectors, including textiles and metals manufacturing. Feature By definition, increases in productivity1 allow a country to produce greater output for the same level of input, which boosts profits and ultimately improves economic growth and household living standards. In the context of the post-1990 "economic miracle" in China, persistently positive productivity growth has indeed drastically improved the nation's wealth and living standards. Over the past 10 years, however, China's productivity growth has actually decelerated significantly, which carries worrying implications for the future (Chart I-1). Given that productivity is a country's key source of economic growth and competitiveness, two important questions arise: 1. Will there be meaningful improvement in China's productivity growth over the next five years (Chart I-2)? Chart I-1China: Decelerating Productivity Growth Chart I-2Any Possibility Of A Productivity Boom Ahead? 2. Is China's competitiveness on a declining trajectory (Chart I-3)? In this report we focus on answering these questions as they pertain to China's manufacturing sector, which is still a very important part of the country's economic engine. We conclude that while the odds of a meaningful reversal of the downtrend in China's manufacturing productivity growth are low, Chinese manufacturers are unlikely to experience major losses in global market share. Yet, this underscores the importance of re-orienting China away from the "old economy" model and the difficulty policymakers continue to face in doing so. A long-term shift away from the country's investment-intensive economic sectors is a clear negative for traditional "China plays" such as industrial commodities and emerging market stocks. China's Productivity Growth Downtrend: A Meaningful Reversal Ahead? When examining trends in productivity, measurement issues frequently come into play. For China, we have presented three measures of labor productivity growth (Chart I-1 on the first page). All three exhibit a similar pattern since the early 1990s. However, in the past two years, some divergences have occurred among the three, with the National Bureau Of Statistics (NBS) and Conference Board data showing slight improvement, as opposed to the World Bank data, which declined sharply in 2017. We tend to rely on the Conference Board data over the World Bank, and the recent rebound in the former seems to better reflect both improved manufacturing output and a significant reduction in the number of employees since late 2015 (Chart I-4). Chart I-3Will China's Competitiveness Decline? Chart I-4Significant Reduction In Manufacturing Workers In order to understand the outlook for labor productivity, it is first and foremost important to understand what has already occurred. Chart I-1 on page 1 shows that the Conference Board's estimate of Chinese labor productivity growth decelerated significantly from 2008 to 2015, which in our judgement was caused by strong growth in employment, falling manufacturing output growth due to weaker global demand for goods following the 2008 global financial crisis, and, finally, diminishing returns from global technological innovation in the past 30 years. Looking forward over the next five years, several factors point to the conclusion that productivity growth will stay positive but that the odds of a meaningful reversal of the downtrend is low: First, further declines in the number of manufacturing-sector workers are likely to be limited. The manufacturing sector accounts for nearly 90% of total jobs in the industrial sector. Since December 2015, China's supply side reform efforts as well as the increased adoption of automation and technology have already resulted in a 15% decline in the number of manufacturing sector jobs, with employee cuts occurring across all 30 manufacturing sub-sectors covered by the NBS. As such, the lion's share of productivity gains from job cuts has probably occurred already. In fact, since the beginning of this year, the number of employees in the manufacturing sector has actually increased by 0.5%, with positive growth in two-thirds of the 30 manufacturing sub-sectors. Second, overall improvement in manufacturing output volume has been moderate in the past two years, a period when global import volumes have accelerated. Production volumes in nearly half of the 90 major manufacturing product categories contracted during the economic downturn period of 2014-2015. In comparison, about 40% still had negative output growth over the recovery period of 2015-2017 (Chart I-5). Chart I-5Manufacturing Output: Moderate Improvement The likelihood of continued de-leveraging and restructuring will constrain domestic demand growth, while escalating trade wars may even cut external demand for Chinese products. This will create tough headwinds for the Chinese manufacturing sector over the next several years. Third, we examined productivity growth of a sample of nine manufacturing sub-sectors (out of 30) by using key product output volumes divided by the number of employees in each respective sector. The results show that productivity growth for nearly all of the sub-sectors is currently running below 5%, while in some sectors it is actually contracting. The "computers, communication and other electronic equipment" sector is the biggest export sector for China, accounting for over 40% of total export value in U.S. dollars. This is one of the most important high-tech sectors the country is aiming to develop. However, even within this sector, different products show diverging productivity growth. For example, semiconductor integrated circuits are growing at a strong 15% rate, while mobile handsets are contracting at a 13% rate (Chart I-6). Chart I-7 and Chart I-8 drive home the point: productivity growth was positive in four high-value-added manufacturing sectors and four low-value-added commodity process sectors, but most of these sectors' productivity growth was less than 5%. Chart I-6Diverging Productivity Growth Chart I-7Low Productivity Growth In High-Value-Added ##br##Manufacturing Sectors... Chart I-8...And In Low-Value-Added Sectors As Well Fourth, we expect Chinese R&D expenditure growth to strengthen, given the government's goal of turning the country into a global leader in digital technology and innovation (Chart I-9, top and middle panels). Chart I-9Rebounding R&D Expenditures Vs. Falling FAIs However, in terms of fixed asset investment (FAI) in the manufacturing sector, which is a much broader investment measure than the R&D investment, its growth already dropped to 3% last year, significantly lower than the compound annual growth rate of 24% over the 2004-2014 period (Chart I-9, bottom panel). Manufacturing FAI growth will likely stay within the range of 0-5% and to some extent will counteract any increases in productivity growth from increased R&D spending. Bottom Line: The recent improvement in China's labor productivity reflects - at least in part - short-term factors that appear to have run their course. China's manufacturing productivity growth will stay low over the coming years, and a meaningful reversal of this downtrend is unlikely. Sustaining Competitiveness Faltering productivity growth, however, does not mean fading competitiveness. For instance, while China's productivity growth plunged from 14.3% in 2007 to 7% in 2017, the country's contribution to global exports climbed from 7.3% to 10.5% during the same period (Chart I-3 on page 2). Meanwhile, Chinese high-tech exports have also gained global market share (Chart I-10). More recently, however, China's exports have lost some global market share both in overall terms and in the high-tech sector over the past two years. Does this herald a declining trajectory in China's manufacturing competitiveness? In our view, the answer is no. We believe China's manufacturing sector will remain highly competitive in the global marketplace: While clearly trending lower, China's productivity growth was the highest among major developed and emerging economies last year (Chart I-11, top panel). It also has always been well above the global average (Chart I-11, bottom panel). Chart I-10Competitive Chinese High-Tech Products Chart I-11China's Productivity Growth: Higher ##br##Than Most Major Economies China's manufacturing labor costs are also much lower than many other major exporters (Chart I-12, top panel). In addition, growth of average annual nominal wages in the Chinese manufacturing sector has declined to the lowest since 1997 (Chart I-12, bottom panel). China's R&D investment as a share of GDP is relatively high among major emerging economies (Chart I-13, top panel). With the country allocating more R&D investment into high-tech manufacturing, the pace of technology innovation is set to increase (Chart I-13, middle and bottom panels). Currently, China is already the biggest producer in several high-tech industries, including new energy vehicles, smart phones, communication equipment, solar cells and wind turbines. Chart I-12China's Manufacturing Labor Costs: ##br##Lower Than Most Major Economies Chart I-13China's R&D Spending: ##br##Higher Than Most EM Economies Even in low-value-added export sectors like textiles and metals, China's competitiveness is still strong. This has likely occurred in part due to supply side reforms - which have accelerated the consolidation of domestic industries - reducing costs and increasing production efficiencies. The 8% depreciation in China's currency versus the U.S. dollar over the past three months will also help improve the country's competitiveness. Bottom Line: China's manufacturing sector will remain highly competitive in the global goods market, despite faltering productivity growth. Investment Conclusions BCA's China Investment Strategy service has previously written about how China's export-enabled, catch-up growth phase in the early-2000s came to an abrupt end after the global financial crisis, and how policymakers were subsequently faced with a hard choice: China could either replace exports as a growth driver with debt-fueled domestic demand in order to buy the economy time to move up the value-added chain and transition to a services-led economy, or it could allow the labor market to suffer the consequences of a sharp slowdown in export growth while preserving fiscal and state-owned firepower for some uncertain future opportunity.2 This report highlights the difficulty experienced by China's manufacturing sector at reversing a downtrend in its productivity growth, which can be viewed as a microcosm of China's struggle to reorient itself and move away from its "old economy" towards one that is led by services. For investors, there are two key implications from this: First, the inherent difficulty of transitioning China's economy suggests that it will continue to experience economic mini-cycles around an uncertain primary growth trend, as policymakers periodically shift between aggressive supply-side reforms and demand-side countercyclical policies. In fact, some investors have come to believe that China is about to enter another mini-cycle upswing in response to recent stimulus announcements, but we have noted that the stimulus proposed so far falls short of a "big bang" response that would not only reverse the underlying slowdown and any trade shock but also reaccelerate the growth rate above trend.3 Second, to us the prospect of a potentially long, grinding shift away from China's investment-intensive economic sectors does not present an attractive risk-reward trade-off for traditional "China plays", such as industrial commodities and emerging market equities, over the coming few years. While it is true that periodic mini-cycle upswings may provide tactical opportunities for investors to go long these assets, the China "transition" theme suggests that an investors' strategic allocation to traditional China plays should be below benchmark. Chart I-14Prominence Of Investable ##br##Tech Ex-Internet Stocks Will Rise As a final point, periods of economic transition typically create both winners and losers, and China's continued focus on R&D spending suggests that the overlooked elements of China's tech sector may be winners. Chart I-14 highlights that over 90% of China's investable technology sector market capitalization is made up of companies in the internet software and services (ISS) industry, suggesting that investable tech ex-ISS may rise in prominence over time. More generally, identifying potential winners from increased Chinese R&D spending is an area of ongoing research at BCA, and is a theme that we hope to revisit in the future. Stay tuned! Ellen JingYuan He, Associate Vice President Emerging Markets Strategy ellenj@bcaresearch.com 1 The most common productivity measure is labor productivity, typically calculated as a ratio of real gross domestic product (GDP) to hours worked or employed persons. 2 Please see BCA China Investment Strategy Weekly Report, "Legacies Of 2017," dated December 21, 2017, available at cis.bcaresearch.com. 3 Please see BCA China Investment Strategy Weekly Report, "China Is Easing Up On The Brake, Not Pressing The Accelerator," dated July 26, 2018, available at cis.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Neither the weakness in emerging market economies nor political turmoil in Europe are likely to significantly affect the U.S. economy. Although the U.S. economy is increasingly service-oriented, financial markets have become more bound to the manufacturing economy in the past 30 years. The U.S.'s large trade surplus in services fosters faster job creation and better pay than in the goods-producing area where the U.S. has a trade deficit. Our energy strategists believe that the risks for oil prices remain biased to the upside, although we are less bullish in view of OPEC 2.0's possible production increases in the near future. Feature U.S. risk assets are rebounding amid solid economic news and rising hopes that another Eurozone financial crisis has been averted. Still, investors remain concerned about rising rates, protectionist trade policies, and the health of emerging market economies. In addition, market participants continue to scan the U.S. economic data in both the manufacturing and service sectors looking for signs that the late-cycle phase of the expansion is ending and that a recession is nigh. The NASDAQ and small cap U.S. stocks rallied past their February peaks last week, but the S&P 500 remains 3.7% below its early 2018 heights. Moreover, BCA's stock-to-bond ratio continues in an uptrend and we expect stocks to beat bonds in the next year. However, neither U.S. high-yield spreads nor the VIX have returned to their January lows. 10-year Treasury yields are 53 bps higher and the dollar is up by 5%. West Texas Intermediate oil prices peaked at $72.26/bbl on May 21. We discuss BCA's latest view on oil later in this report. U.S. economic growth remains solid. May's reading (58.6) on the ISM non-manufacturing index released last week is consistent with 3.5% real GDP growth. Moreover, the May sounding (58.7) on manufacturing indicates that the U.S. economy is growing near 5%. We discuss the signal from both the ISM's manufacturing and non-manufacturing indicators in the next section. In any case, U.S. economic activity in 1H 2018 will easily surpass the FOMC's view of both potential GDP growth (1.8%) and its estimate for actual growth in 2018 (2.7%) (Chart 1). The Fed will provide a new set of dot plots and economic forecasts this week. BCA expects the Fed to bump up rates this week and then gradually during the next year. The Fed and the market's view of the path of rates in the next 12 months is aligned (Chart 2). However, BCA's stance is that inflation will accelerate in 2019, which would elicit a more aggressive response from the central bank starting in the second half of 2019. Our view is that the Fed will stick to its gradual path unless economic growth is much weaker than expected or inflation spikes higher. Moreover, because inflation is at the Fed's 2% target and the economy is at full employment, the price at which the Fed's "policy put" gets exercised is much lower than earlier in the cycle. The implication is that neither the weakness in emerging market economies nor political turmoil in Europe are likely to significantly affect the U.S. economy. Still, a wider trade war is a risk to U.S. and global growth, and we address this issue in the service sector below. Chart 11H GDP Tracking Well Above##BR##Potential & Fed's Forecast Chart 2Fed And Market Aligned##BR##On Rate Path In Next 12 Months On The Same Page The ISM surveys - manufacturing and non-manufacturing - are aligned. The top panel of Chart 3 shows that both metrics have climbed since their troughs in late 2015 (manufacturing) and early 2016 (non-manufacturing). These lows occurred amid EM-related economic and market turbulence. The 2015 nadir in the manufacturing series was more pronounced, thus the rise outpaced the non-manufacturing indicator (panel 2). U.S. financial markets, and the stock market more specifically, are sensitive to the performance of the manufacturing sector. The service sector accounts for 62% of U.S. economic activity and 86% of private-sector employment (Chart 4). Charts 5 and 6 show the relationship between the year-over-year change in BCA's stock-to-bond ratio and the level of manufacturing (Chart 5) versus non-manufacturing (Chart 6) composites. The relationship (r-squared 0.56) between our stock-to-bond ratio and the manufacturing sector is more robust that the r-squared (0.43) between the stock-to-bond ratio and the non-manufacturing sector. Chart 3Manufacturing And Non-Manufacturing ISM Are Aligned, But That's Not Always The Case Chart 4U.S. Economy Is 60% Services... Although the U.S. economy is increasingly service-oriented, Charts 7 and 8 show that the financial markets have become more bound to the manufacturing economy in the past 30 years. Between 1958 and 1988, the r-squared between our stock-to-bond ratio and manufacturing data was 0.19 (Chart 7). That increased to 0.34 from 1988 to 2018 (Chart 8). Chart 5Tighter Relationship Between##BR##Stock-To-Bond Ratio And Manufacturing ISM... Chart 6... Than With##BR##Non Manufacturing ISM Chart 7ISM Manufacturing Vs.##BR##Stock-To-Bond Ratio 1958-1988... Chart 8... And##BR##1988-2018 Chart 9 shows that there have been six other periods when the manufacturing index recovered more quickly than non-manufacturing. Five of the intervals were associated with EM stress.1 Moreover, as is currently the case, the economy was at or below full employment in four of the six occasions when manufacturing outpaced the service sector. Furthermore, the Fed initiated rate hikes in four of the seven episodes, including the current one (Appendix Chart 1). EM stocks tend to outpace U.S. equities as the non-manufacturing index rises faster than the manufacturing index. In addition, when the U.S. manufacturing sector is accelerating relative to the service sector, China's growth prospects (as measured by the LI Keqiang Index) improve. Chart 9Performance Of EM Assets When Manufacturing ISM Outpaces Service Sector ISM The peak in our Relative ISM composite index is consistent with BCA's view that the economic expansion that began in 2009 is nearing an end. Our Relative ISM Composite dipped prior to the 2001 recession, but began to rise as the 2007-2009 downturn commenced. Both the manufacturing and non-manufacturing indices collapsed at the same pace prior to the 2007-2009 recession, because the breakdown of the banking system related to the housing crisis weighed on the non-manufacturing data. Unfortunately, the ISM non-manufacturing data only begins in 1997. However, using the goods and service-sector GDP as proxies for the ISM metrics, we find that the manufacturing sector tends to underperform the service sector in the late stages of an expansion (Chart 10). Our earlier work2 details the performance of U.S. financial assets in a late-cycle environment. Chart 10Manufacturing Sector Tends To Underperform The Service Sector In Late Cycle Environments Bottom Line: Last year's "global synchronized growth" story is showing signs of wear. While the U.S. economy will enjoy a strong rebound in the second quarter, leading economic indicators in most of the other major countries have rolled over. The advanced stage of the U.S. business cycle, heightened geopolitical risks and our bias for capital preservation keep us tactically cautious on risk assets again this month. Service Sector: An Update Even with the increasingly dominant role of the service sector (Chart 4 again), the majority of high frequency economic data measures activity in the manufacturing sector. However, the Quarterly Services Survey (QSS) initiated in 2003-2004 by the Bureau of Economic Analysis (BEA), measures the service sector which includes small- and medium-sized companies3 and produces timely revenue figures on a quarterly basis. The dataset is used primarily by the BEA to paint a more accurate picture of national accounts, notably personal consumption and the intellectual property segment of private-fixed investment. The survey is also essential for FOMC policymakers because it is very useful to track economic performance. Moreover, the QSS is an important source of revisions to real GDP because over 40% of the quarterly estimates of personal consumption expenditures (PCE) for services is based on the QSS. The "key services statistics" include information services, health care services, professional, scientific and technical services, administrative and support, and waste management and remediation services. The QSS for Q1 2018 found that total revenues for selected services fell by 1.2% over the previous quarter but rose 5.2% over the last four quarters (in nominal terms and only non-seasonally adjusted data available). Nominal GDP climbed 4.7% year-over-year in Q1 (Chart 11). Several areas of the service economy saw sales growth in Q1 outpace nominal GDP. Sales were strongest in finance and insurance (+7.8%) followed by information (+7%). Real estate and rental leasing sales increased by 4.7% in the past year while revenue in health care & social assistance rose +3.4%. Together, sales in finance & insurance and health care & social assistance make up about 50% of total revenues. Chart 11Many Areas Of Service Sector##BR##Advancing Faster Than Nominal GDP Chart 12Sales Growth In The Service Sector##BR##Is Broad Based However, revenue growth in several categories decelerated in Q1 and grew more slowly than nominal GDP. Arts, entertainment and recreation, administration support and waste management, and other services are in this category. Bottom Line: Given that the majority of service industries from the QSS sample survey continue to show upward momentum, perhaps we will see a similar revision to real consumer spending for services for the third estimate of Q1 real GDP in late June (Chart 12). We continue to expect U.S. GDP growth to match or exceed the Fed's modest target for 2018. This above-trend growth will continue to put downward pressure on the unemployment rate and push inflation higher, setting the stage for a more aggressive Fed next year and a recession in 2020. The Wrong Trade War? The large trade surplus in the U.S. service sector is a hidden source of strength for the economy and labor market (Chart 13). President Trump campaigned on his ability to create high-paying manufacturing jobs and he has focused his attention on the goods side of the U.S. trade deficit. Nonetheless, his America First rhetoric threatens jobs in the high-paying service sector. Since the mid-1970s, the U.S. has imported more than it has exported, acting as a drag on GDP growth. The trade gap reflects a large and persistent goods deficit, which more than offsets a growing trade surplus on the service side (Chart 14). U.S. imported goods exceeded exports by $807 billion in 2017. Service exports reached an all-time high of $798 billion in 2017 - $255 billion more than imports - up from $249 billion in 2016. It is too soon to tell if the smaller surplus in services is related to Trump's protectionist trade rhetoric. Exports of services have increased by 6% a year on average since 2000, which is nearly twice as fast as nominal GDP. Service exports expanded by just 4% in 2017 versus 2016, which is below the pace of nominal GDP (4.7%) The trade surplus in services subtracted 0.08% from real GDP in Q1 2018, but added 0.05% in 2017. Moreover, the trade surplus in services has consistently added to GDP growth over the past few decades, although the trade surplus in services is swamped by the large drag on GDP due to the trade deficit on goods. Industries where the U.S. enjoys a trade surplus have experienced job growth that is faster than in industries where the U.S. runs a deficit. In addition, median wages ($30.07 as of April 2018) among surplus-producing industries are more than 20% higher than in industries in the goods sector ($24.94) where there is a trade deficit. Moreover, wages in the trade-oriented service sector have escalated quicker than in the goods-producing sector in the past year (Chart 15). Chart 13The U.S. Runs Trade##BR##Surplus In Services... Chart 14...But It's Not Large Enough To Offset##BR##The Big Trade Deficit In Goods Chart 15Wages In Export-Led Service Industries##BR##21% Higher Than In Goods Sector Furthermore, exports in the U.S. service sector tend to compete on quality (not on price) and, therefore, will not be as affected as U.S. goods exports if the dollar meets BCA's forecast for a modest increase this year (Chart 16). That said, the Trump administration's trade policies threaten to reduce the U.S.'s global dominance in services. Chart 16Services Exports Compete On Quality, Not Price Table 1 shows that the U.S. has the largest trade surplus in travel ($82 billion surplus in 2016), intellectual property ($80 billion), financial services ($73 billion) and other business services ($43 billion), which includes legal, accounting, consulting and architectural services. The U.S. also runs a surplus in maintenance and repair services. Table 1Key Components Of U.S. Trade Surplus In Services Trump's trade and immigration policies put this trade surplus at risk. In 2016, foreigners spent $82 billion more to vacation in, travel to, and be educated in the U.S. than what U.S. citizens spent on those services overseas. Moreover, a recent U.N. report4 noted that "Global flows of foreign direct investment fell by 23 per cent in 2017. Cross-border investment in developed and transition economies dropped sharply, while growth was near zero in developing economies." If foreign governments continue to react to Trump's directives on trade and immigration, then the U.S. trade advantage in financial services ($73 billion), software services ($29 billion), TV and film rights ($12 billion), architectural services ($5 billion) and advertising ($10 billion) will also be at risk. Bottom Line: The U.S.'s large trade surplus in services fosters faster job creation and better pay than in the goods-producing area where the U.S. has a trade deficit. The Trump administration's rhetoric and actions on trade and globalism potentially risks America's dominance in the service sector. In theory, U.S. trade restrictions could add to U.S. GDP growth via increased manufacturing output and a smaller goods trade deficit. However, many U.S. trading partners have already announced tariffs on U.S. goods which will put the brakes on growth. Even so, any gains on the manufacturing trade front could be largely offset by damage to the U.S. surplus in services trade. BCA's Geopolitical Strategy service expects that trade-related uncertainty will persist at least until the midterm elections in November.5 On a related note, an increase in onshore oil production in the past 10 years reduced the U.S's large trade deficit in petroleum and petroleum products. BCA's energy strategists recently updated their oil price and production forecasts for this year and next. Still Bullish On Oil BCA's Commodity & Energy Strategy service remains bullish on oil, although two key elements of the outlook makes forecasting particularly difficult.6 Our base case forecast has been bullish for some time, based on our assumption that OPEC 2.0 would retain its previous output cuts, at least through the end of 2018. Venezuela's production has contracted sharply and we penciled in a further modest decline. Iranian exports will also shrink due to the re-imposition of U.S. sanctions. The only substantial growth on the production side is expected to come from U.S. shale producers. The supply/demand backdrop pointed toward higher prices with world demand projected to remain robust. We estimated that Brent could reach $90/bbl early next year. Chart 17Ensemble Forecast Accounts For##BR##Collapse In Venezuela's Exports However, some major oil consumers, including the U.S., are starting to complain. The U.S. has asked the OPEC 2.0 countries to increase output, which may remove further upward pressure on prices. OPEC 2.0's leadership has signaled that it will consider reversing the production cuts during the second half of this year. This could add an extra 870 b/d of production. The other major unknown is how much further Venezuelan production will slide. Our oil strategists have run alternative scenarios to gauge the risks to the base case. The optimistic case sees OPEC 2.0 retaining production cuts and Venezuelan production dipping by another 1m b/d. The pessimistic case sees OPEC 2.0 reversing the production cuts, while Venezuelan production erodes modestly compared with the base and optimistic cases. Chart 17 shows that Brent hits $100/bbl in 2019 in the optimistic case, but drops to $60 in the pessimistic scenario. The ensemble forecast, shown in red in Chart 17, is a weighted average of the three scenarios. It shows that the price of oil will be roughly flat over the next 18 months. Bottom Line: Our energy strategists believe that the risks for oil prices remain biased to the upside, although we are less bullish in view of OPEC 2.0's possible production increases in the near future. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com Appendix Appendix Chart 1Fed Policy And Labor Market Slack When Manufacturing ISM Outpaces Service Sector ISM 1 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Cleanup On Aisle Two", published June 4, 2018. Available at usis.bcaresearch.com. 2 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View," published October 16, 2017. Available at usis.bcaresearch.com. 3 https://www.census.gov/services/qss/about_the_survey.html 4 http://unctad.org/en/PublicationsLibrary/wir2018_overview_en.pdf 5 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump's Demands On China," April 4, 2018. Available at gps.bcaresearch.com. 6 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Guiding To Higher Output; Volatility Set To Rise ... Again", published May 31,2018. Available at ces.bcaresearch.com.

Special Report

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 Chart 2U.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 Chart 4Globalization 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 Chart 6America Belongs To The Anti-Globalization Bloc 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 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 Chart 9Shale 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 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 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 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 Chart 13Who 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 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 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 Chart 17Hillary Lost Rust Belt Voters 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 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 Chart 19Tax 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. 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