Money/Credit/Debt

Dear Client, Barring any major market developments, we will not be sending you a report next week. Instead, I will be working with my colleagues on BCA's Annual Outlook, which will be published on Monday, November 26. The outlook will feature a wide-ranging discussion with Mr. X and his daughter Ms. X on the key themes that we see shaping global markets in 2019. Best regards, Peter Berezin, Chief Global Strategist Highlights The stock market correction has further to run. We would turn more bullish if global equities were to drop another 8% from current levels. A mundane economic identity - savings minus investment equals the current account balance - provides deep market insight into the workings of the global economy. The U.S. economy is suffering from a shortage of savings, which will push up interest rates and the value of the dollar. In contrast, China has a surfeit of savings. Rectifying this will require a weaker yuan. The political impasse between the EU and Italy over next year's budget will be resolved. However, the fact that Italy lacks a readily available outlet for its excess private-sector savings could spell doom for the euro area down the road. Feature The Correction Ain't Over Our MacroQuant model continues to signal downside risks for global equities over the coming weeks (Chart 1). The model is flagging a deterioration in a variety of leading economic indicators, both in the U.S. and abroad, which tends to be bearish for stocks (Chart 2). Global financial conditions have also tightened since the summer due to the rise in government bond yields, higher credit spreads, and a firmer dollar. Chart 1MacroQuant* Model Suggests Caution Is Still Warranted S-I=CA In The U.S., China, And Italy S-I=CA In The U.S., China, And Italy Chart 2Global Growth Indicators Are Deteriorating Global Growth Indicators Are Deteriorating Global Growth Indicators Are Deteriorating Sentiment remains reasonably upbeat, a bearish contrarian indicator. The November Bank of America Merrill Lynch Global Fund Manager Survey revealed that a net 31% of managers were still overweight global stocks. Past major bottoms in 2008, 2011, 2012, and 2016 all saw equity allocations fall into underweight territory. Strikingly, EM allocations rose in November, with a net 13% of fund managers overweight the asset class. This is in stark contrast to 2015 when a net 30% of fund managers were underweight EM stocks. We do not expect the correction which began in October to morph into a full-fledged bear market. Nevertheless, the near-term path of least resistance for stocks remains to the downside. We would only upgrade global equities to overweight if the MSCI All-Country World index were to fall another 8% from current levels, consistent with a price of $64 on the ACWI ETF. At that level, the forward P/E on the index would be back to 2013 levels (Chart 3). Chart 3A Valuation Reset A Valuation Reset A Valuation Reset A Key Macro Identity One of the first identities undergraduate economics students learn is S-I=CA: The difference between what a country saves and invests is equal to its current account balance.1 While it is easy to dismiss this identity as yet another abstract concept that only egghead economists would find interesting, it has real-world implications for investors of all stripes. To see this, it is useful to expand the identity a bit. Total savings is just the sum of private-sector and public-sector savings. Thus, we can write: Private-sector savings = fixed asset investment + government budget deficit + current account balance In other words, the savings that the private sector generates must either be recycled into investment, soaked up by the government through a budget deficit, or exported abroad via a current account surplus. This relationship always holds ex post. But what happens if it does not hold ex ante? Then "something" must adjust to make the relationship hold. In a normal environment, this "something" is interest rates. If there is a shortfall of private-sector savings - that is, if the right-hand side of the equation above exceeds the left-hand side - an increase in rates can restore the identity by encouraging private savings, discouraging investment, and potentially making it more difficult for the government to pursue an expansionary fiscal policy. Higher rates will also produce a stronger currency, leading to a deterioration in the current account balance. The exact opposite will happen if there is an excess of private-sector savings. What happens if there is excessive savings but the central bank cannot lower interest rates either because it lacks monetary independence - i.e., when a country has a currency peg - or because monetary policy is constrained by the zero lower bound on nominal short-term rates? In that case, employment will decline. One cannot save if one does not have a job that generates income. In practice, this can lead to a vicious circle where falling employment causes households to try to save more for precautionary reasons, while discouraging companies from investing in new capacity. The resulting increase in desired savings is likely to lead to further declines in employment. Keynes referred to this outcome as the paradox of thrift: A situation where one person's desire to save more leads to a collective decline in savings because aggregate income shrinks. Let's turn to what all this means for investors today. The U.S.: Trump's Fiscal Policy Is Inconsistent With His Trade Goals The IMF estimates that the U.S. cyclically-adjusted budget deficit will reach 5.6% of GDP next year. The results of the midterm elections are unlikely to change this outcome. While the takeover of the House of Representatives by the Democrats will preclude Congress from passing another round of tax cuts, our geopolitical strategists believe that there is a better than 50% chance that a bipartisan deal will be reached to increase infrastructure spending.2 They point out that Nancy Pelosi mentioned infrastructure five times during her election night address, without mentioning impeachment once. Recent data on U.S. capital spending has been on the soft side (Chart 4). Core capital goods orders have decelerated and capex intention surveys have come off their highs. Residential investment has also been weak, as reflected in declining housing starts and building permits. Chart 4Both Residential And Nonresidential Investment Have Softened Both Residential And Nonresidential Investment Have Softened Both Residential And Nonresidential Investment Have Softened We would tend to fade the weakness in capital spending (Chart 5). The ISM industrial capacity utilization rate is near cycle highs. Rising wages will incentivize firms to substitute labor with capital, leading to more investment spending. The downside risk to home building is also limited, given that residential investment stands at only 3.9% of GDP, well below the high of 6.7% reached in 2005. If anything, the U.S. is not churning out enough fixed capital, as evidenced by the fact that the average age of the capital stock has risen swiftly over the past decade. As my colleague Doug Peta likes to say, you don't get hurt falling out of a basement window. Chart 5Running Out Of Spare Capacity Running Out Of Spare Capacity Running Out Of Spare Capacity Meanwhile, the personal savings rate stands at over 6%, significantly higher than what one would expect based on its typical relationship with household net worth (Chart 6). Chart 6U.S. Household Savings Rate Is High Relative To Wealth S-I=CA In The U.S., China, And Italy S-I=CA In The U.S., China, And Italy The identity described at the outset of this report implies that the trade balance will necessarily deteriorate if the savings rate falls, investment rises, and the budget deficit remains elevated. If President Trump strikes a trade deal with China, he will have no one to blame for a larger U.S. trade deficit. Hence, he has little incentive to make a deal. Protectionism remains popular in the U.S. Midwest, the battleground on which the next presidential election will be fought. Democrat Sherrod Brown won the Ohio Senate race by 6.4% - a state that Trump carried by 8.1% - on a highly protectionist platform. Trump simply cannot afford to go soft on one of his signature issues. China: What To Do With Excess Savings? The slowdown in Chinese growth this year has been concentrated in domestic demand (Chart 7). Exports have held up well. In fact, Chinese exports to the U.S. are up 13% in dollar terms in the first ten months of the year compared with the same period last year. Chart 7China's Domestic Economy Is Weakening China's Domestic Economy Is Weakening China's Domestic Economy Is Weakening Unfortunately, judging from the steep drop in the export component of the Chinese manufacturing PMI, exports are likely to come under increasing pressure over the coming months (Chart 8). This makes it all the more important for the Chinese authorities to prop up domestic growth. Chart 8China's Export Outlook Is Dire China's Export Outlook Is Dire China's Export Outlook Is Dire China has historically stimulated its economy through debt-financed fixed-investment spending (Chart 9). This made eminent sense when China needed more factories, infrastructure, and modern housing. However, now that China has all this in spades, it is looking for different stimulus options. Chart 9China: Debt And Capital Accumulation Have Gone Hand In Hand China: Debt And Capital Accumulation Have Gone Hand In Hand China: Debt And Capital Accumulation Have Gone Hand In Hand Our formula reveals what those other options must be. If China wants to reduce investment spending to a more sustainable level, it must either boost consumption, increase the fiscal deficit, or raise net exports. Given a hostile export backdrop, it is therefore no surprise that the Chinese government has been cutting taxes, increasing social transfer payments, and letting the currency slide. The problem is that none of these other forms of stimulus are beneficial to the rest of the world, and in some cases, they may be quite detrimental. The rest of the world relies on Chinese investment, not Chinese consumption. Raw materials and capital goods comprise 80% of Chinese imports. China represents close to half of the world's demand for aluminum, copper, zinc, nickel, and steel (Chart 10). Whether it be services or manufactured goods, what Chinese households consume is generally produced in China. Chart 10China Is The Predominant Source Of Global Demand For Metals China Is The Predominant Source Of Global Demand For Metals China Is The Predominant Source Of Global Demand For Metals A weaker yuan will make the Chinese economy more competitive, but at the expense of other emerging markets. A weaker yuan will also raise the price of imported goods, leading to a lower volume of imports. The implication is that both the magnitude and composition of China's stimulus may disappoint. This week's much weaker-than-expected credit and money data - new CNY loans clocked in at RMB 697 billion in October, well below consensus expectations of RMB 905 billion - validates this view. Italy: Getting To "Yes" Is The Easy Part The showdown between Italy's populist leaders and the EU continues. The Lega-Five Star coalition government promised big tax cuts and generous increases in social spending. It is loath to backtrack on its campaign pledges so soon after the election. As long as there is no contagion from Italy to the rest of Europe, the EU has no incentive to back off. While it will never admit it, the EU establishment would love nothing more than to humiliate the Italians in order to dissuade voters across Europe from electing populist politicians. In the end, we expect the Italian government to give in to the EU's demands. Business confidence has plunged (Chart 11). The economy is again teetering on the brink of recession. Italy's banking system would be technically insolvent if the ten-year BTP yield were to rise above 4% based on a mark-to-market accounting of Italian bank holdings of government debt. Chart 11Italy: Is The Economy Heading For Another Dip? Italy: Is The Economy Heading For Another Dip? Italy: Is The Economy Heading For Another Dip? A political resolution to the ongoing crisis would provide short-term relief. However, it may not solve Italy's problems - indeed, it could exacerbate them. Italy's working-age population is shrinking (Chart 12). This has made companies reluctant to expand capacity. Meanwhile, households are busily saving for retirement. Their motivation to save more would only be amplified by the cuts to pension benefits that the previous caretaker government promised and that the EU is insisting be implemented. The overall private-sector financial balance - the difference between what the private sector saves and invests - reached a surplus of 5.1% of GDP in 2017 (Chart 13). Chart 12The Italian Workforce Is Shrinking S-I=CA In The U.S., China, And Italy S-I=CA In The U.S., China, And Italy Chart 13Italy: Private Sector Saves Too Much And Spends Too Little Italy: Private Sector Saves Too Much And Spends Too Little Italy: Private Sector Saves Too Much And Spends Too Little Our formula shows that counterbalancing this private-sector surplus will require a persistent government fiscal deficit or current account surplus. Italy's primary budget balance - its overall budget balance excluding interest payments - hit 1.7% of GDP in 2017 (Chart 14). This primary surplus is necessary to cover the 3.6% of GDP in interest payments that the government has to make, a number that will only rise if the ECB raises rates (hence, our high-conviction view that the ECB will have to keep rates low for years to come). Chart 14Italy Needs A Primary Budget Surplus Italy Needs A Primary Budget Surplus Italy Needs A Primary Budget Surplus Italy runs a modest current account surplus of 2% of GDP. However, its current account balance would be far smaller, and perhaps even negative, if the economy were operating at full employment since stronger domestic demand would suck in more imports. Italy would love to copy Germany, a country which habitually over-saves but exports its excess savings to the rest of the world through a gargantuan 8% of GDP current account surplus. Alas, achieving a larger current account surplus would require either a currency depreciation or productivity-enhancing structural reforms. The former is impossible as long as Italy is a member of the euro area, while the latter has proven to be wishful thinking for as long as people have talked about it. We do not expect Italy to default on its debt or jettison the euro in the near term. But when the next synchronized global downturn arrives - probably in about two years or so - all hell could break loose. Concluding Thoughts An economy facing a shortfall in savings is one where desired spending exceeds income. When the economy has spare capacity, such a savings shortfall is a good thing; it means more demand, more employment, and ultimately, more income. However, once spare capacity is soaked up, a shortage of savings will lead to higher inflation. The U.S. finds itself in the latter situation today. The output gap is fully closed, but growth remains above trend. As we have discussed in past reports, the Fed is likely to raise rates more than the market expects.3 This will lead to higher Treasury yields and a stronger dollar. With that in mind, we are raising our end-year target on our long DXY trade recommendation from 98 to 100, implying another 3% increase from current levels. In the absence of offsetting Chinese stimulus, a stronger dollar will put further pressure on emerging markets. EM equities will likely bottom in the first half of next year once the dollar peaks and global growth stabilizes. Until then, investors should overweight DM stocks relative to their EM peers. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 National savings, S, is equal to Y-C-G, where Y is national income and C and G are household and government consumption, respectively. Substituting this identity into the standard Y=C+I+G+X-M equation yields S-I=X-M. National income includes net foreign earnings. In this case, the trade balance, X-M, is equal to the current account balance. 2 Please see Geopolitical Strategy Special Report, "The 2020 U.S. Election: A "Way Too Soon" Forecast," dated November 7, 2018. 3 Please see Global Investment Strategy Weekly Report, "Bond Bears Maul Goldilocks," dated October 12, 2018; and "The Next U.S. Recession: Waiting For Godot?" dated October 5, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Bond yields have trapped equities, and equities have trapped bond yields. The double-digit investment opportunities are within asset-classes. From a tactical perspective: Banks will outperform the broad market. EM will outperform DM. The Eurostoxx50 will briefly outperform the S&P500. Raw industrial commodities will outperform crude oil. Feature What has been the biggest driver of financial markets this year? Trade wars and the emerging market slowdown? The budget spat between Italy and the EU Commission? The U.S. mid-term elections? Or perhaps, central bank policy normalization? These are all sensible answers, and each one has generated endless output of commentary and analysis. But none of these tells the biggest story of 2018. Chart of the WeekIn 2018, Bond Yields Have Trapped Equities, And Equities Have Trapped Bond Yields In 2018, Bond Yields Have Trapped Equities, And Equities Have Trapped Bond Yields In 2018, Bond Yields Have Trapped Equities, And Equities Have Trapped Bond Yields The Biggest Story Is Not Economics Or Politics... It Is Mathematics This year, the two largest five-day plunges in the global stock market - 6 percent in February and 7 percent in mid-October - resulted directly from the two largest five-day spikes in the global bond yield (Chart I-2 and Chart I-3). This simple observation reveals the biggest story in the financial markets this year: the hypersensitivity of the stock market to rising bond yields, and especially when the global 10-year yield approaches 2 percent - or equivalently 'the rule of 4': when the sum of the 10-year U.S. T-bond, German bund and Japanese government bond approaches 4 percent (Chart of the Week).1 Chart I-2Equities Plunged In February After A Spike In Bond Yields Equities Plunged In February After A Spike In Bond Yields Equities Plunged In February After A Spike In Bond Yields Chart I-3Equities Plunged In October After A Spike In Bond Yields Equities Plunged In October After A Spike In Bond Yields Equities Plunged In October After A Spike In Bond Yields With the global stock market now flat year-to-date, it follows that excluding these two five-day plunges, global equities would be comfortably higher even with the emerging market slowdown, trade war quarrels, and political spats. Meaning that this year's market action is not explained by economics or by politics. It is explained by mathematics, and specifically the great misunderstanding of investment risk. Previous reports have focused on this great misunderstanding, most recently Risk: The Great Misunderstanding Of Finance, to which we refer our readers. Here, we will just summarize:2 An investment's risk depends on the negative asymmetry of its short-term returns. At very low bond yields, bond returns develop the same negative asymmetry as equity returns. This means that equities lose their excess riskiness versus bonds, requiring equity valuations to experience a phase transition sharply higher. But when bond yields normalize, equities regain their excess riskiness versus bonds - and their valuations must suffer a phase transition sharply lower. This phase transition to sharply lower equity valuations is most pronounced when the global 10-year bond yield rises to 2 percent. This dynamic has proved to be the biggest driver of financial markets in 2018, and is likely to be the biggest driver in 2019 too. Essentially, higher bond yields can suddenly and viciously undermine the valuation support of equities, limiting the upside in the stock market (Chart I-4). In turn, a plunge in the stock market and other risk-assets threatens a disinflationary impulse, limiting the sustainable upside in bond yields. Chart I-4Equities Remain Richly Valued Equities Remain Richly Valued Equities Remain Richly Valued In effect, bond yields have trapped equities, and equities have trapped bond yields (Chart I-5). The result is that in 2018 the global asset-classes: equities, bonds, commodities, and cash have all ended up going nowhere. Indeed, the global 30-year bond yield has been trapped since early 2017!3 Chart I-5The Global 30-Year Bond Yield Has Been Trapped For Two Years The Global 30-Year Bond Yield Has Been Trapped For Two Years The Global 30-Year Bond Yield Has Been Trapped For Two Years The Double-Digit Investment Opportunities Are Within Asset-Classes Although the global asset-classes have ended up going nowhere this year (Chart I-6), 2018 has still provided double-digit investment opportunities. But to find these double-digit opportunities, you have to look below the main asset allocation decision to within the asset-classes, in sector, region and country allocation. Chart I-6In 2018, Global Asset-Classes Have Ended Up Going Nowhere In 2018, Global Asset-Classes Have Ended Up Going Nowhere In 2018, Global Asset-Classes Have Ended Up Going Nowhere For example, until very recently: banks had underperformed the broad equity market by 10 percent globally and 25 percent in Europe; emerging market equities had underperformed developed market equities by 15 percent; the Eurostoxx50 had underperformed the S&P500 by 13 percent; and raw industrial commodities had underperformed crude oil by 30 percent. But in the last month or so, these strong trends have exhausted and even started to reverse: banks have started to outperform the market; the Eurostoxx50 has eked ahead of the S&P500; emerging market equities have retraced versus developed market equities; and raw industrial commodities have made up much lost ground on crude oil (Charts I-7 - Chart I-10). One important reason is that the sharp down-oscillation in global credit growth which was responsible for many of this year's intra asset-class trends has now clearly rebounded into an up-oscillation. Chart I-7Banks Have Started To Outperform Banks Have Started To Outperform Banks Have Started To Outperform Chart I-8The Eurostoxx50 Is Starting To Outperform The S&P500 The Eurostoxx50 Is Starting To Outperform The S&P500 The Eurostoxx50 Is Starting To Outperform The S&P500 Chart I-9EM Has Started To Outperform DM EM Has Started To Outperform DM EM Has Started To Outperform DM Chart I-10Industrial Commodities Are Starting To Outperform Crude Oil Industrial Commodities Are Starting To Outperform Crude Oil Industrial Commodities Are Starting To Outperform Crude Oil Hence, we expect these trend reversals to continue in the coming months. From a tactical perspective only, this means: 1. Banks will outperform the broad market. 2. EM will outperform DM. 3. The Eurostoxx50 will briefly outperform the S&P500. 4. Raw industrial commodities will outperform crude oil. Such an inflection point can leave investors scratching their heads in confusion, because sector performances seem to conflict with the economic data releases. But the conflict is easily resolved. Though we are now in mid-November, the economic data releases - for example, German exports - are a lagging indicator, referring to a time in the past, September, when global credit growth might still have been in a down-oscillation. Whereas the financial markets - for example, bank equities' relative performance - are a contemporaneous indicator, sensing credit growth's switch to an up-oscillation in real-time. Always remember that market prices move on the marginal change in information and expectations. To be absolutely clear, we are not referring to the business cycle. We are referring to predictable oscillations in credit growth that occur within the business cycle, but which nevertheless create double-digit investment opportunities - such as bank equities' relative performance. The Importance Of 6-Month Credit Growth Still, several clients have asked about our choice of 6-month credit growth, as it appears to be an arbitrary period plucked out of thin air or, more cynically, 'data-mined'. In fact, our choice of 6-month growth has a rock-solid foundation in economic theory.4 For any item, if supply lags demand by a period t, then economic theory proves that both the quantity of the item and its price will experience oscillations with half-cycle length t. Clearly, bank credit is such an item whose supply does lag demand. For example, a mortgage is only allocated and released after a time-consuming process of checking collateral and creditworthiness. For bank credit in aggregate, the lag between demand and supply, and specifically final spending of the funds, averages six to eight months. Once you accept this fundamental truth, it follows that credit growth must also experience oscillations whose half-cycles last six to eight months. So we end with a very important investment lesson. If you only look at the conventionally examined year-on-year credit growth data, you will not see the predictable oscillations in 6-month credit growth. And if you do not look at 6-month credit growth, you will miss the double-digit investment opportunities that are always on offer (Chart I-11). Chart I-11A Sharp Down-Oscillation In Global Credit Growth Has Rebounded Into An Up-Oscillation A Sharp Down-Oscillation In Global Credit Growth Has Rebounded Into An Up-Oscillation A Sharp Down-Oscillation In Global Credit Growth Has Rebounded Into An Up-Oscillation The choice is yours. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 We use the MSCI All Country World Index in local currency terms to capture the global stock market. 2 Negative asymmetry of returns means the possibility of larger short-term losses than short-term gains. Please see the European Investment Strategy Weekly Report, "Risk: The Great Misunderstanding Of Finance", October 25, 2018 available at eis.bcaresearch.com. 3 Please see the European Investment Strategy Weekly Report, "Trapped: Have Equities Trapped Bonds?", September 13, 2018 available at eis.bcaresearch.com. 4 Please see the European Investment Strategy Special Report, "The Cobweb Theory And Market Cycles", January 11, 2018 available at eis.bcaresearch.com. Fractal Trading Model* Palladium has outperformed nickel by 50% in the past three months, but this strong trend is nearing exhaustion according to its 65-day fractal dimension. Hence, this week's trade recommendation is long nickel/short palladium setting a profit target of 14% with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-12 Long Platinum / Short Nickel Long Platinum / Short Nickel The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Investors are worrying too much about the things that caused the global financial crisis, and not enough about those that could cause the next downturn. Despite the recent patch of soft data, the U.S. housing market is in good shape. Go long homebuilders relative to the S&P 500. Imbalances in the corporate debt market have increased, but are not severe enough to generate systemic economic distress. U.S. rates will need to rise quite a bit more than the market anticipates before the economy slows by enough to force the Fed to back off. The combination of a stronger dollar and inadequate Chinese stimulus will continue to pressure emerging markets. Even Brazil's pro-capitalist new president may not be able to reverse the country's bleak fiscal dynamics. Our MacroQuant model, which predicted the correction, points to further near-term downside risk for global equities. The cyclical (12-to-18 month) outlook looks much better, however. Feature The Market's Maginot Line One of the most reliable ways to make money as an investor is to figure out the market's collective biases and trade against them. Behavioral economists have long noted that people tend to assign too much weight to recent experience in taking decisions. As a result, in finance, as in military strategy, there is a constant temptation to fight the last war. The last war policymakers waged was against the scourge of deflation that followed the housing bust and financial crisis. For much of the past decade, investors have held a magnifying glass over anything that could possibly resemble the conditions that led up to the Global Financial Crisis. While such behavior is understandable, it is misplaced. History suggests that both lenders and borrowers tend to act prudently for years, if not decades, following major financial crises. Mistakes are still made, but they are different mistakes. People overcompensate. They obsess about the past rather than focusing on the future. U.S. Housing Is Okay There is no denying that the U.S. housing market has softened this year (Chart 1). Housing starts, building permits, and home sales have all fallen. Residential investment has subtracted from GDP growth over three consecutive quarters. Chart 1Housing Has Been A Drag On The U.S. Economy This Year Housing Has Been A Drag On The U.S. Economy This Year Housing Has Been A Drag On The U.S. Economy This Year There is little mystery as to why the housing market has been on the back foot. The Trump tax bill capped the deduction on state and local property taxes, while reducing the amount of mortgage debt on which homeowners can deduct interest payments from $1 million to $750,000. This had a negative effect on housing activity, especially in high-tax Democrat-leaning states with elevated real estate prices. More importantly, mortgage rates have risen by over 100 basis points since last August. Chart 2 shows that home sales and construction almost always decline after mortgage rates rise. In this respect, the weakness in housing activity is reminiscent of the period following the taper tantrum, when housing activity also slowed sharply. Chart 2No Mystery Why U.S. Housing Has Been Weak... No Mystery Why U.S. Housing Has Been Weak... No Mystery Why U.S. Housing Has Been Weak... We do not expect mortgage rates to fall from current levels. But they are not going to rise at the same pace as they have over the past year. Thus, while the headwinds from higher financing costs will not disappear, they will abate to some extent. Fundamentally, the housing market is on solid ground (Chart 3). Mortgage rates are still well below their historic average. Home prices have risen considerably, but do not appear excessively stretched compared to rents or incomes. Unlike in 2006, the home vacancy rate is near its historic lows. Residential investment stands at only 3.9% of GDP, compared with a peak of 6.7% of GDP in the second half of 2005. The average age of the residential capital stock has risen by nearly five years since 2006, the largest increase since the Great Depression. With household formation rebounding briskly from its post-recession lows, homebuilders are still arguably not churning out enough new homes. Chart 3A...But Fundamentals Are Still In Good Shape (I) ...But Fundamentals Are Still In Good Shape (I) ...But Fundamentals Are Still In Good Shape (I) Chart 3B...But Fundamentals Are Still In Good Shape (II) ...But Fundamentals Are Still In Good Shape (II) ...But Fundamentals Are Still In Good Shape (II) Mortgage lenders have learned from past mistakes (Chart 4). While lending standards have eased modestly over the past 4 years, underwriting standards have remained high. The average FICO score for new borrowers is more than 40 points above pre-recession levels. The Urban Institute Housing Credit Availability index, which measures the percentage of home purchase loans that are likely to default over the next 90 days, is at reassuringly low levels. This is particularly the case for private-label mortgages, whose default risk has hovered at just over 2% during the past few years, down from a peak of 22% in 2006. Moreover, banks today hold much more high-quality capital than in the past, which gives them additional space to absorb losses (Chart 5). Chart 4Lending Standards Have Been Tight, But Are Starting To Loosen Lending Standards Have Been Tight, But Are Starting To Loosen Lending Standards Have Been Tight, But Are Starting To Loosen Chart 5U.S. Banks Are Well Capitalized U.S. Banks Are Well Capitalized U.S. Banks Are Well Capitalized With all this in mind, we are initiating a new strategic trade to go long U.S. homebuilders relative to the S&P 500.1 Corporate Debt: How Big Are The Risks? Unlike household debt, U.S. corporate debt has risen over the past decade and now stands at a record high level as a share of GDP. The quality of the lending has also been less than pristine, as evidenced by the proliferation of "covenant lite" loans. The interest coverage ratio for the economy as a whole - defined as the volume of profits corporations generate for every dollar of interest paid - is still above its historic average (Chart 6). However, this number is skewed by a few mega-cap tech companies that hold a lot of cash and have little debt. Chart 6Interest Coverage Looks Relatively High Interest Coverage Looks Relatively High Interest Coverage Looks Relatively High My colleague Mark McClellan, who writes our monthly Bank Credit Analyst publication, has shown that the interest coverage ratio for companies comprising the Bloomberg Barclays index would drop close to the lows of the Great Recession if interest rates were to rise by a mere 100 basis points across the corporate curve. The damage would be far worse if profits also fell by 25% in this scenario.2 While the corporate debt market has become increasingly frothy, it does not pose an imminent danger to the economy. There are several reasons for this. First, while U.S. corporate debt is high in relation to the past, it is still quite low in comparison with many other economies (Chart 7). The ratio of corporate debt-to-GDP, for example, is 30 percentage points higher in the euro area. This suggests that U.S. businesses still have the "carrying capacity" to take on additional debt. Chart 7U.S. Corporate Debt Is Not That High By Global Standards U.S. Corporate Debt Is Not That High By Global Standards U.S. Corporate Debt Is Not That High By Global Standards Second, the average maturity of U.S. corporate debt has risen over the past decade, with an increasing share of companies opting for fixed over floating-rate borrowings. This implies that it will take a while for the effect of higher rates to make their way through the system. Third, and perhaps most importantly, corporate bonds are generally held by non-leveraged investors such as pension funds, insurance companies, and ETFs. Bank loans account for only 18% of nonfinancial corporate-sector debt, down from 40% in 1980 (Chart 8). The share of leveraged loans held by banks has declined from about 25% a decade ago to less than 10% today. Chart 8Banks Have Reduced Their Exposure To The Corporate Sector Banks Have Reduced Their Exposure To The Corporate Sector Banks Have Reduced Their Exposure To The Corporate Sector Tellingly, we already had a dress rehearsal for what a corporate debt scare might look like. Credit spreads spiked in 2015. Default rates rose, but the knock-on effects to the financial system were minimal (Chart 9). This suggests that corporate America could withstand quite a bit of monetary tightening without buckling under the pressure. Chart 9The 2015 Debt Scare Did Not Topple The Economy The 2015 Debt Scare Did Not Topple The Economy The 2015 Debt Scare Did Not Topple The Economy Government Debt: No Worries... Yet If the risks posed by both the housing market and corporate debt market are contained, what about the risks posed by soaring government debt? The long-term fiscal outlook is certainly bleak, but the near-term risks are low.3 President Trump's tweets aside, the U.S. has an independent central bank which has been able to keep inflation expectations well anchored. The U.S. private sector is also running a financial surplus at the moment, meaning that it earns more than it spends (Chart 10). Not only does this make the economy more resilient, it also provides the government with additional savings with which to finance its fiscal deficit. Chart 10The U.S. Private Sector Is A Net Saver The U.S. Private Sector Is A Net Saver The U.S. Private Sector Is A Net Saver The private sector's financial balance will deteriorate over the next two years as household savings decline and corporate investment rises. This will put upward pressure on Treasury yields. However, if rising yields are reflective of stronger aggregate demand, this is unlikely to derail the economy. When Things Break Recessions are usually caused when the Fed raises rates by enough to undermine spending on interest rate-sensitive purchases such as housing, or when higher rates prick an asset bubble just waiting to burst. Given the lack of clear imbalances either in the real economy or financial markets, the Fed may have to raise rates significantly more than the market is currently anticipating. In fact, far from having to press the pause button midway through next year, our baseline expectation is that the Fed will expedite the pace of rate hikes in late 2019 as inflation finally starts to accelerate. Aggressive Fed rate hikes combined with an incrementally less expansionary fiscal policy will sow the seeds of a recession in late 2020 or 2021. Before the next U.S. downturn arrives, the dollar will have strengthened further. A resurgent greenback will cast a long shadow over emerging markets and commodity producers. As we discussed last week, China is unlikely to save the day by launching a massive stimulus program of the sort that it orchestrated in both 2009 and 2015.4 True, not all emerging markets are equal. Emerging Asia is more resilient now than it was two decades ago. Thailand, for example, was patient zero for the Asian crisis in 1997. Today, it sports a current account surplus of over 10% of GDP and low levels of external debt. This resilience will not prevent Asian economies from experiencing slower growth on the back of weaker Chinese demand, but it will prevent a full-blown balance of payments crisis from spiraling out of control. In contrast to Emerging Asia, Latin America looks more vulnerable (Table 1). BCA's chief emerging market strategist, Arthur Budaghyan, wisely upgraded Brazilian assets on a tactical basis on October 9th ahead of the presidential elections. Nevertheless, Arthur still worries that Brazil's daunting fiscal challenges - the budget deficit currently stands at 7.8% of GDP and the IMF expects government debt to rise to nearly 100% of GDP over the next five years (Chart 11) - are so grave that even South America's answer to Donald Trump may not be able to save the Brazilian economy. Table 1Vulnerability Heat Map For Key EM Markets Fighting The Last War Fighting The Last War Chart 11Brazil Is Fiscally Challenged Brazil Is Fiscally Challenged Brazil Is Fiscally Challenged A Correction, Not A Bear Market The current market environment bears some similarities to the late 1990s. The Fed is tightening monetary policy in order to keep the domestic economy from overheating. The U.S. economy is responding to higher rates to some extent, but the main effects are being felt overseas. The Asian Crisis did not end the bull market in U.S. stocks, but it did generate a few nasty selloffs, the most notable being the 22% peak-to-trough decline in the S&P 500 between July 20 and October 8, 1998. We witnessed such a selloff this October. The bad news is that our MacroQuant model is pointing to additional equity weakness over the coming weeks (Chart 12). The model tends to downgrade stocks whenever growth is slipping, financial conditions are tightening, and sentiment is deteriorating from bullish levels. All three of these things are currently occurring. Chart 12MacroQuant* Model Suggests Caution Is Warranted Fighting The Last War Fighting The Last War The good news is that none of our recession indicators are flashing red. Since recessions and bear markets typically overlap (Chart 13), the odds are high that the current stock market correction will be just that, a correction. Chart 13Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 The corresponding ETFs are long ITB/short SPY. 2 Please see The Bank Credit Analyst Special Report, "The Long Shadow Of The Financial Crisis," dated October 25, 2018. 3 It is actually not even clear that a loss of confidence in America's fiscal management would cause a recession. The Fed largely determines borrowing costs at the short-to-medium end of the yield curve, which is where the government finances most of its debt. If people lose confidence in the dollar, they will either need to run down their cash balances by purchasing more goods and services or try to move their wealth abroad. The former will directly increase aggregate demand, while the latter will indirectly increase it through a weaker currency. To be clear, we are not suggesting that such an outcome would be beneficial to the economy; it would, among other things, greatly slow potential GDP growth by discouraging investment. But the near-term effect would likely be economic overheating and rising inflation rather than a recession. 4 Please see Global Investment Strategy Weekly Report, "Chinese Stimulus: Not So Stimulating," dated October 26, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Economic data and policy announcements over the past month reflect the view that policymakers are serious about restraining credit growth, and that they will attempt to combat any weakness in external demand by boosting domestic consumption. A review of historical episodes of "outsized" investment intensity shows that policymakers have good reason to try and shift the composition of China's economy towards consumption, as it suggests that China's current experience probably cannot be sustained. A shift even somewhat away from heavy investment-led growth means that the "strike price" of the China put option has fallen relative to past economic slowdowns, implying that it will take more pain before investors can cash in. It is too soon to move towards an outright long position favoring domestic stocks, even though considerable bad news has been priced in. CNY-USD likely has further downside, and investors allocating among Chinese stocks should only favor domestic over investable equities in currency-hedged terms. Feature September's total social financing data, released earlier this month, provided important evidence supporting our view that Chinese policymakers are not aiming for a significant acceleration in private sector credit growth. Chart 1 highlights that the year-over-year growth rate of adjusted total social financing (TSF) actually ticked modestly lower in September, in clear contrast to the bet of many investors that China is following its "old stimulus rulebook". Chart 1Chinese Policymakers Are Not Pumping The Credit Taps Chinese Policymakers Are Not Pumping The Credit Taps Chinese Policymakers Are Not Pumping The Credit Taps Some market participants have pointed to the fact that adjusted TSF is rising sharply on a 3-month annualized basis after adjusting for seasonality (Chart 2), and have concluded from this fact that a sustained expansion in credit growth is forthcoming. However, Chart 3 illustrates that the pickup shown in Chart 2 is due to a surge in special local government bond issuance, which reflects front-loading of fiscal spending. Financial news outlets have reported that "provincial authorities had by the end of September already raised 92 percent of the 1.35 trillion yuan ($195 billion) worth of special infrastructure bonds that the central government has targeted for the entire year",1 implying that local government bond issuance in Q4 will drop off significantly relative to the past three months. Chart 2A Near-Term Pickup... A Near-Term Pickup... A Near-Term Pickup... Chart 3...Caused By Front-Loaded Fiscal Spending ...Caused By Front-Loaded Fiscal Spending ...Caused By Front-Loaded Fiscal Spending The September credit data aside, we acknowledge that there have been several small-scale stimulus announcements from the Chinese government over the past month. But the bottom line for now is that developments over this period reflect the view that policymakers are serious about restraining credit growth, and that they will attempt to combat any weakness in external demand by boosting domestic consumption.2 Restraining Credit Growth: Wisdom Or Folly? China's unwillingness to resort to a significant acceleration in credit growth to help stabilize its economy has surprised some investors, and raised criticism in some corners that the country is making a policy mistake. A recurring argument in this vein, particularly among perennial China bulls, is that policymakers should not be concerned about China's elevated levels of private sector debt because it is the natural and inevitable result of a high savings rate. According to this view, restraining credit growth and attempting to boost consumption merely dooms China's ability to escape the middle-income trap, because higher per capita income can only be achieved by further growth in the stock of capital. BCA's China Investment Strategy service does not dispute the notion that a high savings rate can lead to a high leverage ratio, particularly among small, fast-growing economies. But in the case of China, the sharp rise in private sector debt that has occurred since 2010 was not natural, and certainly was not inevitable. Instead, our view is that it was the result of an explicit "least-bad" choice made by policymakers to weather the reality of poor external demand following the global financial crisis. Chart 4 presents, in a nutshell, the theoretical support for the "keep investing" view. The chart depicts real per capita GDP for 80 countries in 2014 as a function of the average share of gross capital formation to GDP from 1960 to 2014. The chart clearly shows that richer countries today have tended to invest more on average in the past, which is entirely consistent with textbook economic theory. Chart 4Higher Investment Has Led To Higher Per Capita GDP Growth... Is China Making A Policy Mistake? Is China Making A Policy Mistake? However, there are two reasons why the simple inference from Chart 4 that China should just "keep investing" is deeply flawed. First, while investment as a share of GDP in China has recently declined from its 2011-2014 peak, it remains close to 45%. This is a massive rate of investment, and a historical review points to the conclusion that it probably cannot be sustained: 45% is nearly off the x-axis scale shown in Chart 4, suggesting that China's current rate of investment is not achievable over extended periods of time. In fact, the chart suggests that 30% is the highest realistic rate of investment as a share of GDP that a country can maintain over an extended period. In 2014, based on the definition of the data from the Penn World Table (GDP share of gross capital formation at current purchasing power parity), China had maintained its investment share above 30% for 12 years. At first blush, there appears to be some precedent suggesting that China's outsized investment run can go on for longer: among the 80 countries included in Chart 4, 14 of them have experienced a longer continuous run of investment as a share of GDP. However, Chart 5 shows that most of these experiences occurred in the 1960s and 1970s, when global exports as a share of GDP were rising from a very low base. This implies that historical examples of outsized investment runs have largely reflected export-driven catch-up stories, which bodes poorly for China's ability to continue to invest at its recent massive scale given that global exports to GDP appear to have peaked. Chart 5...But Very High Rates Of Investment Have Driven By Exports ...But Very High Rates Of Investment Have Driven By Exports ...But Very High Rates Of Investment Have Driven By Exports Second, the relationship shown in Chart 4 captures the potential gains of profitable and rational investment, or in other words the accumulation of a "useful" stock of capital. But an unfortunate reality facing savers is that while one can choose to save or invest, one cannot necessarily choose the accompanying rate of return. If China invests heavily at very low or negative rates of return, the idea that investment will lead China out of the middle-income trap is very likely wrong. As we have discussed in previous reports, there is good evidence to suggest that the marginal gains from investment in China have been falling. The private sector debt-to-GDP ratio features prominently in the case against profitable investment in China: despite a massive rise in investment and debt from 2002-2007, the private sector debt-to-GDP ratio barely rose, because this debt was used to accumulate capital that verifiably delivered nominal GDP growth. Yet following 2010 the ratio rose sharply, implying that the returns from the investment that has taken place over the past decade have been (at least so far) considerably lower than those of the prior decade. Also, we noted in our August 29 Special Report that state-owned enterprises (SOEs) have accounted for a sizeable portion of the private sector leveraging that occurred after 2010,3 and that the marginal operating gain from debt for SOEs has become negative (Chart 6). A gap between the cost/return on borrowed funds strongly implies that the investment channeled through SOEs over the past several years does not represent, on balance, the accumulation of useful capital. Chart 6Strong Evidence Against Productive SOE Investment Strong Evidence Against Productive SOE Investment Strong Evidence Against Productive SOE Investment In our view, a cohesive story emerges from the above analysis, one that counters the view that China is making a policy mistake by trying to avoid another significant episode of private sector leveraging. China's enormous catchup in per capita GDP over the past 20 years was initially export-led, but was sustained after 2010 by quasi-fiscal spending in the form of a material leveraging of state-owned enterprises. This shadow government spending was aimed at preventing large-scale job losses, but proved to be considerably less productive than the private, export-driven investment-boom that preceded it. This suggests that China is simply investing too much for an economy that needs to accumulate capital for the purposes of domestic production, and that any further, aggressive leveraging of the private sector will simply raise the odds or the cost of the eventual bailout. While investors who are hoping to profit from China's credit excesses may wish for a different outcome, the bottom line is that Chinese policymakers will act in the best interests of their country, and they have good reason to try and shift China's economy away from extremely high rates of investment towards more consumption. Implications For Investment Strategy As would be the case in any other major country, we have no doubt that Chinese policymakers will eventually move to a maximum reflationary stance (which would imply a significant reacceleration in credit growth) if they feel that the existing slowdown will lead to deep, threatening economic instability. The key point for investors is that a desire of policymakers to shift even somewhat away from heavy investment-led growth means that the "strike price" of the China put option has fallen relative to past economic slowdowns, implying that it will take more pain before investors can cash in. Within the universe of Chinese financial assets, there are three pertinent investment strategy questions that arise from this reality: Even if there is more pain to come, Chinese domestic stocks have fallen 30% in local currency terms, and close to 40% in U.S. dollar terms (Chart 7). Is it time to go outright long? Should investors allocating among Chinese stocks favor domestic or investable equities? What is the outlook for CNY-USD? For now, our answers are as follows: 1) not yet, 2) domestic over investable in currency-hedged terms, and 3) weaker (possibly significantly so). Chart 7The Bear Market In A-Shares Is Advanced... The Bear Market In A-Shares Is Advanced... The Bear Market In A-Shares Is Advanced... We agree that 30% is a reasonable estimate of the likely decline in domestic earnings over the coming year, which normally would suggest that A-shares have fully priced the bad news and that investors should consider buying. However, there are two key reasons why we think this conclusion is premature: We noted in our September 19 Weekly Report that the lesson of 2014/2015 was Chinese stocks needed both policy stimulus and earnings clarity before bottoming.4 For now, China's stimulative response has been measured, and we have yet to see any decline in domestic 12-month forward earnings (Chart 8). While it is not the only factor contributing to the decline, the escalation in the trade war with the U.S. acted as a clear negative catalyst for the Chinese stock market. We have argued that the evolution of the trade positions of both sides suggests that the imposition of a third and final round of import tariffs covering all Chinese exports to the U.S. is likely, which would further reduce Chinese earnings visibility for investors. News reports this week suggested that an announcement to this effect could occur in early-December, if a meeting between Presidents Trump and Xi is called off or fails (as we expect). Chart 8...But Forward EPS Have Yet To Start Falling ...But Forward EPS Have Yet To Start Falling ...But Forward EPS Have Yet To Start Falling Chart 9 presents our framework for forecasting CNY-USD as a function of various U.S. import tariff scenarios, which we used to argue that a break above the psychologically-important level of 7 for USD-CNY appeared likely barring strong action from the PBOC4. The RMB has weakened in line with our view over the past month, and Chart 9 shows that it stands to weaken further, potentially significantly, if the U.S. does move ahead with a 25% import tariff on all imports from China. Chart 9Further Downside In CNY-USD Is Likely Further Downside In CNY-USD Is Likely Further Downside In CNY-USD Is Likely Finally, our negative outlook for the currency informs our view that a relative position favoring domestic over investable stocks should be currency-hedged. Chart 10 shows that an uptrend in relative performance does appear to be forming in local currency terms, but not in U.S. dollar terms (due to the recent renewed weakness in CNY-USD). Chart 10Relative To Investable Stocks, Only Favor A-Shares In Hedged Terms Relative To Investable Stocks, Only Favor A-Shares In Hedged Terms Relative To Investable Stocks, Only Favor A-Shares In Hedged Terms We opened a shadow trade in our July 5 Weekly Report of being long the MSCI China A Onshore index / short MSCI China index,5 which we said we would consider implementing in response to a 5% rally in relative performance. Our intention was to structure this trade in unhedged terms (consistent with most of the trades in our trade book), and our judgement is that it is simply too early to do so despite the fact that a 5% relative rise in U.S. dollar terms has indeed occurred. Signs of a durable bottom in CNY-USD, or an assessment of minimal further downside coupled with strong outperformance of domestic stocks in local currency terms, are likely catalysts for a green light. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 "China Is Struggling To Find Projects To Spend Bond Splurge On", Bloomberg News, October 22, 2018. 2 Pease see China Investment Strategy Special Reports "China: How Stimulating Is The Stimulus?", dated August 8, 2018, and "China: How Stimulating Is The Stimulus? Part Two", dated August 15, 2018, available at cis.bcaresearch.com. 3 Pease see China Investment Strategy Special Report "Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging", dated August 29, 2018, available at cis.bcaresearch.com. 4 Pease see China Investment Strategy Weekly Report "Investing In The Middle Of A Trade War", dated September 19, 2018, available at cis.bcaresearch.com. 5 Pease see China Investment Strategy Weekly Report "Standing On One Leg", dated July 5, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Policy easing is a necessary but not sufficient condition for a bottom in the business cycle. For monetary easing to become effective, there should be loan demand, banks should be willing to lend, and businesses and consumers should be keen to spend more. In China, risks to both the money multiplier and the velocity of money are to the downside. This will hinder the effectiveness of monetary policy easing in generating economic growth. Eroding business and consumer confidence in China will - for now - negate the budding improvement in its broad money impulse. Emerging markets risk assets and currencies are set to drop further. Stay put. Feature The selloff in EM and Chinese stocks has begun to weigh heavily on DM share prices. The global equity index has broken below its January lows, entailing further downside. Importantly, global cyclical equity sectors such as global industrials, materials and semiconductors are underperforming, and are breaking down in absolute terms. This confirms global trade is in a full downturn swing (Chart I-1). Chart I-1Global Trade Is Decelerating Global Trade Is Decelerating Global Trade Is Decelerating What is required to turn around this global trade slowdown? Our bias is that this growth slump has roots in China/EM and trade tensions are dampening business and investor sentiment on top of that. Consequently, a reversal in the equity selloff is largely contingent on an improvement in China's economy. It is in this context that we devote this week's report to an extensive discussion surrounding the issues of policy stimulus, deleveraging and growth in China. In this report, we answer the questions we think are most pertinent to investors at this moment. Question: Why are financial markets rioting, even though China has announced stimulus? Answer: The market's interpretation is that these stimuli are insufficient to turn around China's business cycle immediately. We agree with this assessment. Policy easing does not always immediately translate into higher share prices and improving growth. For example, amid China's 2015 stock market crash, the Chinese authorities began aggressively stimulating in the middle of 2015, yet Chinese and global markets continued to riot until February 2016 (Chart I-2). Chart I-2China In 2015: Money Growth Preceded Bottom In Markets By Seven Months China In 2015: Money Growth Preceded Bottom In Markets By Seven Months China In 2015: Money Growth Preceded Bottom In Markets By Seven Months Indeed, there was a period of seven months when EM and DM stocks plummeted, despite on-going and very aggressive policy easing in China. In short, these stimulus measures did not preclude a considerable drawdown in global and EM share prices. Outside China, there have been other examples where policy easing did not preclude a full-fledged bear market. For instance, in 2001-'02 and 2007-'08, the Federal Reserve was cutting interest rates aggressively, yet the bear market in U.S. equities did not reverse (Chart I-3). Chart I-3AFed's Easing Did Not Prevent Equity Bear Market Fed's Easing Did Not Prevent Equity Bear Market Fed's Easing Did Not Prevent Equity Bear Market Chart I-3BFed's Easing Did Not Prevent Equity Bear Market Fed's Easing Did Not Prevent Equity Bear Market Fed's Easing Did Not Prevent Equity Bear Market Similarly, the ECB was expanding its balance sheet from the onset of the euro area debt crisis in 2011, yet the region's share prices did not bottom until the middle of 2012, 12 months later (Chart I-4). Chart I-4ECB Balance Sheet Expansion Did Not Prevent Equity Bear Market ECB Balance Sheet Expansion Did Not Prevent Equity Bear Market ECB Balance Sheet Expansion Did Not Prevent Equity Bear Market Question: It is clear there could be a time lag between policymakers stimulating and financial markets and the business cycle turning the corner. What is causing these time lags, and how should one handicap them? Answer: Indeed, monetary and fiscal policies affect the economy with time lags. These lags vary from cycle to cycle. In China, the broad money impulse has improved of late (Chart I-5). Historically, this has led the mainland's business cycle by about nine months on average. Hence, it signifies a tentative bottom early next year. Chart I-5China: Money Impulse Has Bottomed China: Money Impulse Has Bottomed China: Money Impulse Has Bottomed The credit impulse, however, has not improved at all (Chart I-6). The current divergence between credit and money impulses is due to a plunge in shadow (non-bank) credit (Chart I-7). The distinction between broad money and credit is as follows: money is originated by commercial banks when they lend to or acquire an asset from non-banks. Meanwhile, total credit also includes lending and bond purchases by non-banks. Chart I-6China: Credit Impulse Has Not Yet Bottomed China: Credit Impulse Has Not Yet Bottomed China: Credit Impulse Has Not Yet Bottomed Chart I-7Bank And Non-Bank Credit Have Diverged Bank And Non-Bank Credit Has Diverged Bank And Non-Bank Credit Has Diverged Importantly, money/credit fluctuations are not the sole factors that generate swings in economic activity. Companies' and households' willingness to consume and invest matter too. We have written extensively in the past that changes in the velocity of money mirror fluctuations in the marginal propensity to consume and invest.1 Technically speaking, nominal GDP growth is a product of money growth and change in the velocity of money. Nominal GDP = Money Growth x Velocity Of Money When a decline in the velocity of money - stemming from eroding business and consumer confidence - overwhelms an acceleration in money growth, economic growth weakens, despite improvement in the money impulse. Notably, money and credit have led previous business cycles in China by varying time periods. In other words, the velocity of money has not been constant on the mainland. In particular, both the money and credit impulses were early - by about 12 months - in forecasting a growth slowdown in China and global trade at the beginning of 2017. The reason why a growth slowdown did not commence at that time was due to the surge in the velocity of money. The latter is akin to confidence among economic agents. In short, companies and households turned their money balances faster, which offset the impact of weak money/credit impulses on economic activity. Concerning fiscal policy, time lags differ because of implementation delays and varying fiscal multipliers. In China, aggregate fiscal spending, including central, local governments and managed funds, has not yet accelerated (Chart I-8). Chart I-8China: No Rebound In Broad Fiscal Spending China: No Rebound In Broad Fiscal Spending China: No Rebound In Broad Fiscal Spending While special bond issuance by local governments spiked in August and September, overall credit flows in the economy have not yet improved - please refer to Chart I-6. As an aside, there are reports that 42% of the amount raised via special bond issuance will be used to purchase land rather than for infrastructure spending.2 This will not benefit economic growth much. Question: Do you think the time lag between the bottom in China's money/credit impulses and the business cycle will be longer or shorter this time around? Answer: Our bias is that the time lag between the bottom in money/credit impulses and the resultant pickup in growth will be longer than before. Presently, there is some evidence that both business and consumer sentiment in China are beginning to whither at the hands of the trade wars, tanking domestic share prices and budding deflation in real estate prices. Eroding business and consumer confidence in China will - for now - negate the improvement in the broad money impulse. Chart I-9 depicts the velocity of money in China. After rising over the past two years, our bias is that it will drop again. It is critical to realize that forecasting the direction and magnitude of swings in the velocity of money - the marginal propensity to spend - is a dismal science. It reflects business and consumer sentiment, and any assessment on this is very subjective. This is why economic forecasting and investment calls are more of an art. Chart I-9China: The Velocity Of Money China: The Velocity Of Money China: The Velocity Of Money Among many variables we are monitoring to gauge the turn in the mainland's business cycle is the marginal propensity to invest among mainland industrial companies. This indicator is falling, suggesting that monetary policy easing is facing formidable hurdles in re-igniting investment appetite among Chinese companies (Chart I-10). Chart I-10Companies' Marginal Propensity To Spend Companies' Marginal Propensity To Spend Companies' Marginal Propensity To Spend The BCA Emerging Markets Strategy team's assessment is that China-related financial markets are in an air pocket. Investors should not try to catch falling knives. On the contrary, there is still meaningful downside. Question: But the People's Bank of China has been injecting a lot of liquidity into the system via various facilities. Would this liquidity not find its way into financial markets and the real economy? Answer: When a central bank injects liquidity into the banking system, it creates excess reserves. Excess reserves also rise when a central bank cuts the required reserve ratio (RRR). It is essential to differentiate money that households and business use to conduct transactions from reserves of commercial banks at the central bank. Required and excess reserves are not a part of narrow and broad monetary aggregates. Excess reserves are the banking system's liquidity held at the central bank. Importantly, banks do not lend reserves, and do not use reserves to pay for assets they purchase from non-banks. Banks use reserves to settle transactions/payments among themselves. Reserves are "manufactured" solely by central banks. Commercial banks cannot create reserves. They do, however, create the overwhelming majority of money when they lend to or purchase an asset from non-banks. Central banks create broad money - that circulates in the economy - only when they lend to or buy assets from non-banks. Given central banks typically do few transactions with non-banks, central banks originate a very small portion of the broad money supply. For example, as a part of quantitative easing efforts, new money is originated only when a central bank buys bonds from a non-bank (say, an insurance company). In contrast, no money is created when a central bank buys bonds from a bank. In brief, there is no automatic leakage of reserves into the real economy and financial markets. Banks need to be willing to lend to and purchase assets from non-banks for the money supply to expand. Question: But won't expanding excess reserves - banking system liquidity - eventually encourage banks to lend and purchase financial assets? Answer: It will at some point, but it is not imminent. The mainland banking system's excess reserves ratio is depicted in Chart I-11. A few observations are in order: Chart I-11China: Excess Reserves Not Are Growing China: Excess Reserves Not Are Growing China: Excess Reserves Not Are Growing First, the excess reserve ratio - excess reserves (ER) as a share of total deposits - is currently rather low (Chart I-11, top panel). The absolute level of ER is not elevated either (Chart I-11, middle panel). To adjust the absolute level of ER for seasonality, we show the annual change of this measure - it has dropped to zero in September (Chart I-11, bottom panel). This is in contrast to the prevailing market narrative that the PBoC is injecting a lot of liquidity into the system. While they have been injecting liquidity via RRR cuts, at the same time many lending facilities have been maturing without renewal. Does the low level of ER ratio mean the PBoC has been tightening? No, it has not been tightening. Shrinking excess reserves that lead to higher money market rates would qualify as tightening. Provided money market rates are low and are not rising in China, there has been no de-facto tightening, despite the low level of reserves (Chart I-12). Chart I-12China: Excess Reserves And Interest Rates China: Excess Reserves And Interest Rates China: Excess Reserves And Interest Rates Second, any central bank can simultaneously target either quantity of reserves or short-term interest rates, but not both. Before 2014, the PBoC was targeting the level of ER. As a result, short-term interest rates fluctuated a lot to equilibrate demand and supply for ER. Since early 2014, the PBoC has switched to targeting interest rates. Therefore, the level of ER is no longer a policy objective, but rather a tool to navigate interest rates. Chart I-13 illustrates what drives PBoC policy in terms of interest rates and liquidity management. The PBoC sets interest rates based on the strength in the economy - i.e., interest rates rise when loan demand is improving and fall when loan demand is weakening (Chart I-13, top panel). Chart I-13China: What Drives Interest Rates? China: What Drives Interest Rates? China: What Drives Interest Rates? Then, the central bank adjusts the amount of ER to achieve its desired level of short-term interest rates. Hence, the amount of ER is a function of demand for reserves by banks at the current level of interest rates. The current low level of ER is indicative of weak demand for ER by banks. As loan origination has diminished, economic activity has cooled off and the number of transactions by companies and consumers has dwindled, demand for reserves among banks has declined. Third, declining/expanding ER do not always cause a slowdown/acceleration in money/credit growth, as demonstrated on Chart I-14. There is another variable that stands between ER and money/credit: the money multiplier (MM). The latter is defined as how much broad money/credit banks create per one unit of ER. A rising money multiplier reflects banks' willingness and ability to expand their balance sheets aggressively. A falling multiplier signifies growing risk aversion among banks, or their inability to expand their balance sheets. Chart I-14China: Excess Reserves And Money/Credit Impulses China: Excess Reserves And Money/Credit Impulses China: Excess Reserves And Money/Credit Impulses Notably, the credit boom in China since 2009 has been driven not by rapidly expanding ER but primarily by a surging MM. The MM has skyrocketed from 40 in 2008 to 65 presently (Chart I-15). This was the manifestation of excessive risk taking by banks. Chart I-15China: Money Multiplier China: Money Multiplier China: Money Multiplier Why is it sensible to expect the MM in China to decline? With ongoing regulatory tightening, falling asset prices and rising defaults, the odds are non-trivial that mainland banks will be reluctant to expand their balance sheets aggressively. We are not implying they will not boost lending forever, but they may be slower to do so compared to previous downturns. Following the peak in their respective credit bubbles and experiencing deteriorating asset quality, banks in Japan, the U.S., the U.K. and euro area shrunk their balance sheets - even though their respective central banks provided enormous amount of excess reserves, and interest rates were at zero. We do not expect bank credit growth to contract in China like it did in those countries. In fact, bank assets and broad credit are still growing at an annual rate of 7% and 12%, respectively (Chart I-16 and Chart I-7 above). Our point is that deleveraging in China has barely begun, and it still remains a policy priority. Consequently, money and credit growth will languish longer in this downturn than in previous ones. Chart I-16China: Bank Asset Growth To Stay Tame China: Bank Asset Growth To Stay Tame China: Bank Asset Growth To Stay Tame Question: So, how would you summarize the key known unknowns to gauge whether and when monetary policy easing will translate into stronger economic growth? Answer: For monetary policy easing to translate effectively into economic growth, the MM and the velocity of money should rise. Both are driven by sentiment and marginal propensity to lend, borrow and spend. Hence, variations in the MM as well as the velocity of money are contingent on sentiment and behavior among bankers, companies and households. The regulatory clampdown on banks and non-bank financial institutions will hamper their willingness and ability to lend, despite sufficient liquidity and low interest rates. Hence, the MM could surprise on the downside. A combination of the ongoing crackdown on leverage, the starting point of high indebtedness, falling asset prices and trade confrontations, will likely weigh on corporate and consumer sentiment, curb their spending and, thereby, dampen the velocity of money. All in all, risks to both the MM and the velocity of money are to the downside rather than upside at the moment. This will hinder the transmission mechanism from policy easing to economic growth. Question: What is your take on financial markets? Are we close to the bottom in EMs and China-related plays? Answer: EMs and China-plays are in a genuine bear market as we have argued in past.3 BCA's Emerging Markets Strategy service reckons there is still meaningful downside in EM risk assets and currencies. The EM/China bear market will continue. The Fed is not about to come to markets' rescue, because U.S. growth is very robust and inflation is rising. A very important market to watch is the RMB exchange rate. If the RMB depreciates further - which is our baseline scenario - Asian and other EM financial markets will continue plunging. The RMB/USD exchange rate has been closely tracking the interest rate differential between China and the U.S. (Chart I-17). As the Fed continues to raise rates and China maintains rates at their current level or reduces them to stimulate, the RMB will depreciate. Chart I-17RMB/USD And Interest Rate Differentials RMB/USD And Interest Rate Differentials RMB/USD And Interest Rate Differentials Yuan depreciation will lead to a decline in other Asian currencies. In fact, the Korean won is at a critical technical juncture, and a major move is in the cards. Our bias is it will likely break down, consistent with our bearish view on EM risk assets and currencies. As the RMB depreciates, the amount of U.S. dollars that China emits to emerging economies via imports will decline. This will hurt EM exports to China, their currencies and commodities prices. Overall, the U.S. dollar has more upside. The growth disparity between the U.S. and the rest of world warrants a stronger greenback. The latter and a slowdown in EM/China herald a considerable drop in commodities prices. Question: One commodity that has defied the dollar rally and slowdown in China is oil. Will crude continue to float higher? Answer: Oil prices have risen much further and for far longer than we expected.That said, it appears that oil prices are finally beginning to crack, and we see considerable downside.4 China's imports of oil and petroleum products has decelerated substantially (Chart I-18, top panel). This is occurring at a time when Chinese oil strategic and commercial inventories are very elevated (Chart I-18, bottom panel). Chart I-18China's Oil Imports To Weaken Further China's Oil Imports To Weaken Further China's Oil Imports To Weaken Further Oil prices in local currency terms are at record highs in many developing countries. Given oil and fuel subsidies have been removed or reduced in recent years, high oil prices are curbing oil demand in many emerging economies. Global oil production has been outpacing global oil demand since May (Chart I-19, top panel). Typically, this heralds a rollover in oil prices (Chart I-19, bottom panel). Chart I-19A Risk To Oil Prices A Risk To Oil Prices A Risk To Oil Prices Finally, oil output has been surging in the U.S. and strong in Russia (Chart I-20); further, Saudi Arabia could boost its crude output as per its recent pledge. Chart I-20Global Oil Output Has Been Surging Global Oil Output Has Been Surging Global Oil Output Has Been Surging While geopolitics remains a supportive factor for crude prices, it seems a lot of good news is already priced in the oil market and investors are very long. In short, oil prices are probably heading south. This will contribute to the negative investment sentiment toward EM financial markets. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report, "Questions For Emerging Markets," dated November 29, 2017, available at ems.bcaresearch.com. 2https://www.bloomberg.com/news/articles/2018-10-21/china-s-195-billion-debt-splurge-has-less-bang-than-you-think 3 Please see Emerging Markets Strategy Weekly Report, "EMs Are In A Bear Market," dated October 18, 2018; the link is available on page 17. 4 This is BCA's Emerging Markets Strategy team's view and differs from the BCA house view on oil. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Asset allocation: Go long industrial commodities versus equities on a 6-month horizon. If an inflationary impulse is dominating, beaten-down industrial commodities have more upside than richly valued equities; and if a disinflationary impulse is dominating, its main casualty will be equities. Currencies: Take profits on long EUR/CNY. Maintain a broadly neutral stance to EUR, with short EUR/JPY counterbalancing long EUR/USD. Equity sectors: overweight basic materials versus the market. And within the basic materials sector, overweight basic resources versus chemicals. Chart of the WeekChina's 6-Month Credit Impulse Provides A Perfect Explanation For Commodity Inflation China's 6-Month Credit impulse Provides A Perfect Explanation For Commodity Inflation China's 6-Month Credit impulse Provides A Perfect Explanation For Commodity Inflation Feature Equity markets are entering the crossfire between two opposing forces: an inflationary impulse coming from the global economy; and a disinflationary impulse as higher bond yields threaten to deflate the very rich valuations of equities and other risk-assets. As this battle plays out in the coming months a good strategy is to go long commodities versus equities. The logic is simple: if the inflationary impulse from the economy is dominating, then beaten-down industrial commodities have more upside than richly valued equities; and if the disinflationary impulse from higher bond yields is dominating, then commodities have less downside than equities, because commodities have a much weaker valuation link with bond yields. Therefore, going long industrial commodities versus equities on a 6-month horizon should be a good strategy however the battle between inflationary and disinflationary impulses plays out. Inflationary Impulse Battles Disinflationary Impulse Chart I-2 shows the credit impulse oscillations in the euro area, U.S., and China since the start of the millennium, all expressed in dollars to allow a comparison between the three major economies. It is a fascinating chart because the change in the dominant oscillation - the one with the highest amplitude - perfectly illustrates the shift in global economic power and influence from Europe and the U.S. to China. Chart I-2The Shift In Economic Power From Europe And The U.S. To China The Shift In Economic Power From Europe And The U.S. To China The Shift In Economic Power From Europe And The U.S. To China Through 2000-08 the impulses in the euro area and the U.S. dominated. But during the global financial crisis that all changed: the credit stimulus from China dwarfed the responses from the western economies. Then through 2009-12 the impulse oscillations from the three major economies were briefly the same size, before China took on the undisputed mantle of dominant impulse, which it has held consistently since 2013. The world's three major economies are now all in 'up' oscillations according to their credit impulses. This means the global economy will experience an inflationary impulse for the next couple of quarters or so. However, battling the inflationary impulse is a disinflationary impulse. As the inflationary impulse pushes up bond yields, it threatens to deflate the very rich valuations of equities (and other risk-assets). Crucially, this disinflationary force is particularly vicious when bond yields are rising from ultra-low levels. We have described this dynamic exhaustively in previous reports, so we will not go into the detail here. But in a nutshell, both parts of an equity's required return - the risk-free component and the risk premium - go up together when bond yields are rising from ultra-low levels. Meaning that rising yields deflate equity valuations exponentially (Chart I-3).1 Chart I-3At Low Bond Yields The Valuation Of Equities Changes Exponentially Go Long Commodities Versus Equities Go Long Commodities Versus Equities But Which Inflationary Impulse? At our recent investment conference in Toronto, the three speakers on the China panel gave three different conclusions on China: aggressively bullish, moderately bullish, and bearish! The aggressive bull pointed out that the 3-month credit impulse has gone vertical (Chart I-4); the moderate bull pointed out that the 6-month credit impulse appears to be turning up (Chart I-5); while the bearish argument was that the level of the 12-month credit and fiscal impulse remains depressed. Chart I-4The 3-Month Impulse Is Up Sharply... The 3-Month Impulse Is Up Sharply... The 3-Month Impulse Is Up Sharply... Chart I-5But The 6-Month Impulse Is Just Turning But The 6-Month Impulse Is Just Turning But The 6-Month Impulse Is Just Turning So which narrative should we use? The answer is the one that provides the best explanatory power for the cycles that we actually observe in the economic and financial market data. As we described in our Special Report The Cobweb Theory And Market Cycles, the theory and evidence powerfully identifies the 6-month credit impulse as the one with the best explanatory power for the oscillations that we actually observe in the economy and markets - because the 6-month period aligns most closely with the lag between credit demand and credit supply.2 In any case, as we use the 6-month impulse to powerful effect in Europe, consistency demands that we must use the 6-month impulses in U.S. and China too. For the sceptics, the Chart of the Week should finally obliterate any lingering doubts. China's 6-month impulse gives a spookily perfect explanation for the industrial commodity inflation cycle. The important takeaway right now is that if the 6-month impulse is turning up, so will industrial commodity inflation. What Does All Of This Mean For Investors? This brings us to our central message. As we have just seen, an up-oscillation in 6-month impulses, especially in China, will lift industrial commodity inflation. But it will likely have a much smaller influence on developed market equities which, in these circumstances, will be under the strong constraining spell of higher bond yields. On this basis the asset allocation recommendation is to go long industrial commodities versus equities on a 6-month horizon (Chart I-6). Chart I-6Go Long Commodities Vs. Equities Go Long Commodities Vs. Equities Go Long Commodities Vs. Equities Interestingly, technical analysis also supports this recommendation over the next three months or so. Our tried and tested measure of excessive trending and groupthink suggests that the recent underperformance of industrial commodities relative to developed market equities is extreme and at a point which indicates a countertrend move, or at least a trend exhaustion (Chart I-7). Chart I-7The Underperformance Of Industrial Commodities Is Technically Stretched The Underperformance Of Industrial Commodities Is Technically Stretched The Underperformance Of Industrial Commodities Is Technically Stretched For currencies, the foregoing analysis and charts means it is time to take profits in our long position in the euro versus the Chinese yuan. This leaves us with a broadly neutral exposure to the euro, with a short position versus the yen counterbalancing a long position versus the dollar. As for European equities, many years ago they were a pure play on events in Europe. Today, this might still be true for European 'tail-events' such as the euro sovereign debt crisis, or a potential 'no deal' Brexit. However, for the most part, European equity markets are tightly integrated with global equity markets - at least in direction if not level. Given that industrial commodity inflation takes its cue from the 6-month credit impulse - especially in China - it is hardly surprising that the European basic materials sector follows exactly the same cycle, both in absolute terms (Chart I-8) and relative to the broader equity market (Chart I-9). Therefore the equity sector recommendation is to overweight basic materials versus the market. Chart I-8China's 6-Month Credit Impulse Drives Europe's Basic Material Equities In Absolute Terms... China's 6-Month Credit Impulse Drives Europe's Basic Material Equities In Absolute Terms... China's 6-Month Credit Impulse Drives Europe's Basic Material Equities In Absolute Terms... Chart I-9...And In Relative Terms ...And In Relative Terms ...And In Relative Terms Interestingly, there is also a play within the basic materials sector. The basic resources sector which represents the miners and extractors of raw materials should fare better than the chemicals sector which uses these raw materials as an input (Chart I-10). Hence, overweight basic resources versus chemicals. Chart I-10Overweight Basic Resources Vs. Chemicals Overweight Basic Resources Vs. Chemicals Overweight Basic Resources Vs. Chemicals Readers may argue that most of the foregoing charts illustrate the same cycle. But that's precisely the point! Never forget that financial markets follow the Pareto principle: the most important 20 percent of analysis explains 80 percent of the moves across all asset classes across all geographies across all times. The key to successful investing is to find the most important 20 percent of analysis. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Weekly Reports 'Trapped: Have Equities Trapped Bonds?' September 13, 2018 and 'The Rule Of 4 For Equities And Bonds' August 2, 2018 available at eis.bcaresearch.com 2 Please see the European Investment Strategy Special Report 'The Cobweb Theory And Market Cycles' January 11, 2018 available at eis.bcaresearch.com Fractal Trading Model* It was a busy week for our trades. Long basic resources versus chemicals achieved its profit target, but short U.S. telecom versus U.S. autos hit its stop-loss. Meanwhile, short trade-weighted dollar reached the end of its 65 day holding period broadly flat. All three trades are now closed. In line with the main body of the report, this week's trade recommendation is to go long industrial commodities (represented by the CRB industrials index) versus equities (represented by the MSCI World Index in USD). The profit target is 2% with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart 11 Long CRB Industrials Vs. MSCI World Long CRB Industrials Vs. MSCI World The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Set your overall investment strategy with two 'rules of 4' based on 10-year bond yields: If either the Italian BTP or the sum of the U.S. T-bond, German bund and JGB stays above 4 percent, then sell equities and buy bonds. If both the Italian BTP and the sum of the U.S. T-bond, German bund and JGB are in the 3-4 percent range, then remain broadly neutral. If both the Italian BTP and the sum of the U.S. T-bond, German bund and JGB fall below 3 percent, then buy equities and sell bonds. Stay neutral to Italy's MIB and Italian banks for the time being. Among the mainstream European equity markets our top pick remains France's CAC. Feature Many people believe that Italy has one of the world's most indebted economies, but this widely-held belief is wrong. Although Italy's public indebtedness is high, Italy's private indebtedness is one of the lowest in the world (Chart of the Week). This means that Italy's total indebtedness is less than that of France and the U.K., and broadly similar to that of the U.S. (Chart I-2 - Chart 1-5).1 Chart of the WeekItaly's Private Sector Indebtedness Is One Of The Lowest In The World Italy's Private Sector Indebtedness Is One Of The Lowest In The World Italy's Private Sector Indebtedness Is One Of The Lowest In The World Chart I-2Italy: Total Indebtedness = 260% Of GDP Italy: Total Debt Up From 195% To 265% Of GDP Italy: Total Debt Up From 195% To 265% Of GDP Chart I-3France: Total Indebtedness = 305% Of GDP France: Total Debt Up From 190% To 305% Of GDP France: Total Debt Up From 190% To 305% Of GDP Chart I-4U.K.: Total Indebtedness = 280% Of GDP U.K.: Total Indebtedness = 280% Of GDP U.K.: Total Indebtedness = 280% Of GDP Chart I-5U.S.: Total Indebtedness = 250% Of GDP U.S.: Total Indebtedness = 250% Of GDP U.S.: Total Indebtedness = 250% Of GDP The Myth Of Italian Indebtedness An economy's debt sustainability depends on its total indebtedness, and not on its public indebtedness or its private indebtedness in isolation. Debt becomes unsustainable when the marginal extra euro of debt results in misallocation of resources and mal-investment. At this point, the extra debt adds nothing to growth or, worse, it subtracts from growth. Therefore, debt reaches its sustainable limit when the economy has exhausted all productive uses for it. But it does not matter whether these productive uses are funded with private debt or with public debt. For example, successful economies require investment in high-quality healthcare and education. Some economies fund this with private debt, while others fund it with public debt. This means that if productive private indebtedness is low, there is more scope for productive public indebtedness. The crucial point is that Italy has extremely low private indebtedness, which means that it can afford relatively high public indebtedness before reaching the limit of debt sustainability. Right now, this is especially true because the Italian banking system remains dysfunctional, preventing the private sector from borrowing (Chart I-6). Under these circumstances, the Italian government can borrow the private sector's excess savings and debt repayments and put them to highly productive use - which will paradoxically reduce the deficit in the long term. Chart I-6Italy's Private Sector Is Not Borrowing Italy's Private Sector Is Not Borrowing Italy's Private Sector Is Not Borrowing Hence, the M5S/Lega government is following excellent economic policy in proposing a modest increase in the fiscal deficit in 2019. An appropriately sized and targeted fiscal stimulus is exactly what Italy needs right now. But this excellent economic policy will take time to bear fruit and show up in Italy's growth and deficit data. Italy's big problem is that bond vigilantes do not wait, they shoot first and ask questions later. Italy Is Especially Vulnerable To Bond Vigilantes Italy is also a world leader in running primary surpluses (Chart I-7 and Table I-1). In plain English, this means that the Italian government spends considerably less than it receives, if interest payments are excluded. Chart I-7Italy Is A World Leader In Running Primary Surpluses Italy Is A World Leader In Running Primary Surpluses Italy Is A World Leader In Running Primary Surpluses Table I-1Italy Has Consistently Run Primary Surpluses Italy, Bond Vigilantes, And Bubbles Italy, Bond Vigilantes, And Bubbles Put differently, Italy's government deficit results not from its operational spending relative to its income, but from the interest payments on its debt. This makes Italy especially vulnerable to the bond vigilantes. If the bond vigilantes distort Italy's interest rate, they can tip the Italian government into financial distress, even if that distress is not justified by the economic fundamentals. Is this a real risk? Sadly, yes. The euro debt crisis was essentially a liquidity crisis which resulted from bond vigilantes running amok. When irrational markets refuse to lend to sovereigns at a fair interest rate, maturing debt has to be refinanced at a penalising interest rate, causing an undeserved deterioration in the government's finances. Thereby, the irrational fear of insolvency becomes a self-fulfilling prophecy. Italy has an additional problem. When Italian bond prices decline, it erodes the value of the banking system's euro 350 billion portfolio of BTPs and weakens the banks' fragile balance sheets. If a bank's equity capital no longer covers its net non-performing loans (NPLs), investors get nervous. In this regard, the largest Italian banks now have euro 160 billion of equity capital against euro 130 billion of net NPLs, implying a cushion of euro 30 billion (Chart I-8). Chart I-8Italian Banks' Equity Capital Exceeds ##br##Net NPLs By Euro 30 Bn... Italian Banks' Equity Capital Exceeds Net NPLs By €30 Bn... Italian Banks' Equity Capital Exceeds Net NPLs By €30 Bn... So the markets would start to worry about Italian banks' mark-to-market solvency if their bond portfolios sustained a loss of €30 billion. We estimate this equates to the 10-year BTP yield breaching and remaining above 4 percent (Chart I-9).2 Chart I-9...The Excess Would Disappear If The 10-Year BTP Yield Stayed Above 4% ...The Excess Would Disappear If The 10-Year BTP Yield Stayed Above 4% ...The Excess Would Disappear If The 10-Year BTP Yield Stayed Above 4% The ECB solved the euro debt crisis at a stroke by committing to act as lender of last resort to distressed sovereigns at an 'undistorted' interest rate. Indeed, the commitment alone was enough to defeat the bond vigilantes without the ECB spending a single cent from its Outright Monetary Transaction (OMT) program.3 But recall that the ECB only threatened its firepower when the 2-year Spanish Bono yield had breached 6.5 percent and the 10-year yield had breached 7.5 percent. It follows that if the 10-year Italian BTP yield breached 4 percent, the yield would be high enough to hurt the Italian banks, but not nearly high enough for any powerful intervention from the ECB. Hence, the 10-year BTP yield at 4 percent is the level at which we would return to a pro-defensive strategy. Conversely, a level below 3 percent would create some margin of safety providing one precondition for a more pro-cyclical investment stance. In the meantime, the current level at 3.3 percent justifies a neutral cyclical stance to Italy's MIB and Italian banks. Among the mainstream European equity markets our top pick remains France's CAC. The Connection Between Bubbles And Liquidity Crises Bubble formation may seem to have no connection with a liquidity crisis but the two phenomena are closely related. Bubble formation is simply a brewing liquidity crisis resulting from irrational euphoria rather than irrational fear. A bubble forms when value investors stop investing on the basis of a valuation framework. Instead, they get lured into the momentum herd that is participating in a strong rally, and the additional buy orders fuel the euphoria. However, once all of the value investors have joined the momentum herd, and a value investor then suddenly reverts to type and puts in a sell order, the market will suffer a liquidity crisis. There are no buyers left! And finding one might require a substantial reversal in the price to attract an ultra-long-term deep value investor. As regular readers know, fractal analysis measures whether the herding behaviour in any financial instrument is becoming excessive. The analysis suggests that developed market equities are not yet at the tipping point of excessive euphoria that signalled the last two trend exhaustions in May 2017 and January 2018 (Chart I-10). But this does not mean that there are clear blue skies ahead. Chart I-10Developed Market Equities Are Not Yet At A Trend Exhaustion Developed Market Equities Are Not Yet At A Trend Exhaustion Developed Market Equities Are Not Yet At A Trend Exhaustion The danger is not that the rich valuation is irrationally excessive, but that it is hyper-sensitive to bond yields. At low bond yields, bonds offer no price upside but substantial price downside. Confronted with this increased riskiness of bonds, equity returns justifiably collapse to the feeble returns offered by bonds with no additional 'risk premium', giving equity valuations an exponential uplift. But if bond yields normalise, the process goes into vicious reverse - the rich valuation of equities must decline as exponentially as it rose. We have defined the danger point as when the sum of the 10-year yields on the U.S. T-bond, German bund, and JGB breaches and stays above 4 percent. In summary, set your overall investment strategy with two 'rules of 4' based on 10-year bond yields: If either the Italian BTP or the sum of the U.S. T-bond, German bund and JGB stays above 4 percent, then sell equities and buy bonds. If both the Italian BTP and the sum of the U.S. T-bond, German bund and JGB are in the 3-4 percent range, then remain broadly neutral. If both the Italian BTP and the sum of the U.S. T-bond, German bund and JGB fall below 3 percent, then buy equities and sell bonds. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Indebtedness defined as a share of GDP. 2 Assuming that the average maturity of Italian banks' BTPs is around 5 years. 3 The ECB's Outright Monetary Transaction (OMT) program was created in 2012 in response to the euro debt crisis and facilitates the ECB's lender of last resort function to solvent but illiquid sovereign borrowers. Fractal Trading Model* We are pleased to report that our long China/short India trade achieved its 9% profit target and is now closed. This week, we note that the underperformance of the Eurostoxx50 versus the Nikkei225 is technically stretched, with a 65-day fractal dimension approaching the limit which signaled a very recent trend reversal. Hence, this week's recommended trade is long Eurostoxx50 versus Nikkei225. The profit target is 3.5% with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 Long Eurostoxx50 VS. Nikkei 225 Long Eurostoxx50 VS. Nikkei 225 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Fed policy and U.S. interest rates are not irrelevant to EM, but they are of secondary importance. The most vital factors that drive EM financial markets - the direction of global trade, domestic demand, corporate profits, and borrowing costs - do not currently indicate a sustainable bottom. Stay short/underweight EM risk assets. Feature How long and how deep will the selloff in emerging markets (EM) be? There are many factors that investors should be watching to gauge potential for further downside in the EM universe, and to exercise judgement about a bottom. These include the business cycle trajectory, policy actions and shifts, market technicals, liquidity, valuations and other fundamental variables. Not all of preconditions typically need to be satisfied before a major bottom emerges. What's more, not all bottoms are identical and contingent on the same factors. Hence, there is no magical formula for calling a bottom or top in any financial market. Today we revisit some of the variables that, in our opinion, are worth monitoring in terms of gauging a bottom. To begin, we address a currently popular narrative within the investment industry, which contends the following: EM woes are primarily being driven by Federal Reserve tightening. According to this view, when the Fed halts its tightening campaign, the skies will clear for EM risk assets. By and large, we disagree with this narrative. EM And The Fed: Let's Get Things Straight Fed policy and U.S. interest rates are not irrelevant to EM, but they are of secondary importance. The primary drivers of EM economies are domestic fundamentals and the overall global business cycle. Historically, the correlation between EM risk assets and the fed funds rate has been mixed (Chart 1). On this chart, we shaded the periods in which EM stocks rallied, despite a rising fed funds rate. Chart 1EM Equity Prices And Fed Funds Rate: Mixed Correlation 1. EM Equity Prices And Fed Funds Rate: Mixed Correlation 1. EM Equity Prices And Fed Funds Rate: Mixed Correlation There were only two episodes when EMs crashed amid rising U.S. interest rates: the 1982 Latin America debt crisis and the 1994 Mexican Tequila crisis. Yet, it is vital to emphasize that these crises occurred because of poor EM fundamentals: elevated foreign currency debt levels, negative terms-of-trade shocks, large current account deficits, pegged exchange rates, and so on. Importantly, EM stocks and currencies did well during other periods of a rising fed funds rate: in 1983-1984, 1988-1989, 1999-2000 and 2017, as illustrated by the shaded periods in Chart 1. Hence, statistically there is no case that EMs plunge when the Fed is tightening policy. Why did the behavior of EM risk assets during various Fed tightening episodes differ? The key was EM fundamentals at the time: When fundamentals were healthy, EM managed to rally, despite Fed tightening; when fundamentals were flawed, EM markets relapsed regardless of the Fed's policy stance. Dire EM fundamentals also prevailed before the Asian/EM crises of 1997-1998. However, these late-1990s EM crises occurred without much in the way of Fed tightening or rising U.S. bond yields. Notably, U.S. and EU growth were booming and U.S. bond yields were dropping in 1997-'98. Specifically, U.S. and EU import volumes were growing at double-digit rates but this did not preclude EM crises, including in export-dependent Asian economies such as Korea, Malaysia and Thailand (Chart 2). It is critical to emphasize that China was not an economic superpower in the late 1990s. EM economic dependence on the U.S. and European economies was much greater than it is today. Yet neither booming demand in the U.S. and EU nor falling U.S. government bond yields prevented the Asian/EM crises from rolling across the globe in 1997-'98 (Chart 3A). Moreover, the S&P 500 was in a bull market in the second half of 1990s, as it is today (Chart 3B), but it did not help EM either. Chart 2Asian/EM Crises In 1997-98 Occurred Amid Booming Growth In U.S. And EU Asian/EM Crises In 1997-98 Occurred Amid Booming Growth In U.S. And EU Asian/EM Crises In 1997-98 Occurred Amid Booming Growth In U.S. And EU Chart 3AAsian/EM Crises In 1997-98 Took Place Amid Falling U.S. Bond Yields And Rising S&P 500 Asian/EM Crises In 1997-98 Took Place Amid Falling U.S. Bond Yields And Rising S&P 500 Asian/EM Crises In 1997-98 Took Place Amid Falling U.S. Bond Yields And Rising S&P 500 Chart 3BAsian/EM Crises In 1997-98 Took Place Amid Falling U.S. Bond Yields And Rising S&P 500 Asian/EM Crises In 1997-98 Took Place Amid Falling U.S. Bond Yields And Rising S&P 500 Asian/EM Crises In 1997-98 Took Place Amid Falling U.S. Bond Yields And Rising S&P 500 Hence, we can safely conclude that the EM fallout in 1997-'98 was due to EM domestic fundamentals - not developed market dynamics in general and Fed tightening in particular. An essential question is: Why are EM risk assets currently plunging while U.S. stocks and credit markets are holding up just fine? The U.S. economy is much more exposed to rising U.S. borrowing costs than EM. Despite this, the American economy, U.S. share prices and corporate bonds have been performing very well. In our view, this also stipulates that the core root for the current EM bear market is EM fundamentals. As we have repeatedly noted in various reports,1 EM fundamentals have been very frail, and the end of easy Fed monetary policy has not helped. The Fed's tightening can be regarded as the trigger - not the cause - of the EM bear market. The cause is weak EM fundamentals, such as credit excesses, low return on capital, weakening productivity growth and, in some cases, inflation and dependence on external funding. Importantly, the dependence of EM countries on the Chinese economy is presently greater than their dependence on the U.S. as shown in Table 1. Further, mainland growth is decelerating. Adding it all up, it is not surprising to us that EM financial markets are in turmoil. Table 1Many Emerging Economies Sell More##br## To China Than to The U.S. EM: Stay Put EM: Stay Put Our bearish view on EM has not been based on a negative view on U.S./EU growth. On the contrary, we have been bearish on EM/China and positive on domestic demand in the U.S. and the EU. Early this year, we promoted the theme of tectonic macro shifts,2 arguing that China/EM growth would slump and the U.S. economy would accelerate - and that such dynamics would propel the U.S. dollar higher. In turn, a firm dollar would inflict substantial pain on EM. Bottom Line: Rising U.S. interest rates, in and of itself, is neither a necessary nor a sufficient condition for EM to sell off. Consequently, the Fed adopting an easier policy stance or lower U.S. Treasury yields may not, in and of themselves, create sufficient conditions for a reversal in EM financial markets, unless they coincide with a turnaround in other variables that matter for EM. What Matters For EM? As of now, we do not think sufficient conditions exist for a bottom in EM financial markets because of several pertinent factors: The most important factor for EM assets in the medium term is the direction of the business cycle in EM in general, and in China in particular. The EM business cycle is still decelerating, as evidenced by falling manufacturing PMI indexes in EM ex-China and China (Chart 4). Consistently, corporate earnings growth is decelerating for EM non-financial companies and Chinese non-financial A-share corporates (Chart 5). The rationale for our focus on non-financial corporate earnings is that non-performing loans are usually not recognized and provisioned for by banks in a timely way to reflect their true profitability. Typically, banks' earnings cycle lags the real economy. When the real economy is slowing, banks' profits typically deteriorate with a time lag. Chart 4Manufacturing Is Slowing In China And EM Ex-China Manufacturing Is Slowing In China And EM ex-China Manufacturing Is Slowing In China And EM ex-China Chart 5EM/China Corporate Profit Growth Is Decelerating bca.ems_wr_2018_09_06_s1_c5 bca.ems_wr_2018_09_06_s1_c5 Corporate profits in China and in EM have not yet contracted, but our view is that there will be a meaningful profit contraction in this downturn. As and when corporate earnings shrink, share prices will sell off. In brief, we are not out of the woods yet. In China, the industrial part of the economy continues to weaken, as evidenced by the slump in the total freight index and electricity consumption by manufacturing and resource sectors (Chart 6). So far, the cumulative impact of policy easing in China has not been sufficient to reverse its business cycle. As we discussed in our prior report,3 money/credit impulses lead China's industrial sector by nine months or so. Even if the government's recent stimulus initiatives cause money/credit impulses to improve materially today (which we still doubt), the impact on growth will be felt only next year. While financial markets are forward-looking, they are unlikely to bottom a full six months before the bottom in the real economy. Hence, we are currently in the window where China plays in financial markets remain at risk. Global trade is also weakening, as evidenced by falling semiconductor prices (Chart 7) and industrial metals. Similarly, the container freight index at Chinese ports is sluggish, and broader Asian export volumes are slowing (Chart 8). Chart 6Signs Of Industrial Slowdown In China bca.ems_wr_2018_09_06_s1_c6 bca.ems_wr_2018_09_06_s1_c6 Chart 7Semiconductor Prices Are Plunging Semiconductor Prices Are Plunging Semiconductor Prices Are Plunging Chart 8Asian Export To Slow Further Asian Export To Slow Further Asian Export To Slow Further Regarding liquidity, there are various definitions and ways to measure liquidity. One measure of EM liquidity is EM local interest rates. Chart 9A and 9B shows that interbank rates in various EM countries are rising due to the ongoing currency weakness. EM benchmark local currency bond yields are also under upward pressure (Chart 10, top panel). These are all signs of tightening liquidity. The ramifications of higher interest rates will be a slowdown in money and credit, and consequently a slump in domestic demand. Chart 9AEM: Interbank Rates##br## Are Rising EM: Interbank Rates Are Rising EM: Interbank Rates Are Rising Chart 9BEM: Interbank Rates##br## Are Rising EM: Interbank Rates Are Rising EM: Interbank Rates Are Rising Chart 10EM: Local Currency Bonds Yields##br## And Narrow Money Growth EM: Local Currency Bonds Yields And Narrow Money Growth EM: Local Currency Bonds Yields And Narrow Money Growth Chart 10 illustrates that local bond yields negatively correlate with narrow money growth in EM ex-China, Korea, Taiwan and India. These four markets are not included in the EM GBI local bond index; to maintain consistency, we have removed them from the money supply aggregate. EM sovereign and corporate bond yields continue to rise. As we have shown numerous times in previous reports, EM share prices do not bottom until EM corporate and sovereign bond yields roll over on a sustainable basis. Finally, we discussed EM equity and currency valuations in our August 23 report. We maintain that aggregate EM equity and currency valuations are not yet cheap enough to warrant bottom-fishing. Bottom Line: The most vital factors that drive EM financial markets - the direction of global trade, domestic demand, corporate profits, and borrowing costs - do not currently indicate a sustainable bottom. Stay short/underweight EM risk assets. 6 September 2018 The list of our trades and country allocation is always presented at the end of each report (please see page 10-11). Specifically, we continue shorting BRL, CLP, ZAR, IDR and MYR versus the U.S. dollar. Within the equity space, our overweights are Taiwan, Korea, Thailand, Chile, India, Mexico and central Europe; and underweights are Brazil, Peru, Malaysia, Indonesia, and South Africa. Among local currency bonds we are overweight Russia, Korea, Mexico, Thailand, and central Europe and underweight Brazil, South Africa, Turkey, Malaysia, and Indonesia. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see BCA Emerging Markets Strategy Weekly Report, "Understanding The EM/China Cycles," July 19, 2018. 2 Please see BCA Emerging Markets Strategy Weekly Report, "Two Tectonic Macro Shifts," January 31, 2018. 3 Please see BCA Emerging Markets Strategy Weekly Report, "EM: Do Note Catch A Falling Knife," August 23, 2018. Equity Recommendations Fixed-Income, Credit And Currency Recommendations