Money Trends / Liquidity

Highlights Since 2010, China's private sector has accounted for the majority of the country's increase in the debt-to-GDP ratio, most of which has been on the balance sheets of state-owned enterprises (SOEs) and the household sector. While policymakers achieved their goal of maintaining aggregate demand in the decade following the global financial crisis, the financial condition of SOEs has been greatly sacrificed as a result. An analysis of SOE return on equity highlights a sharp decline in return on assets, which has occurred due to both declining profit margins and a falling asset turnover ratio. Even worse, a comparison of adjusted SOE ROA to borrowing costs suggests that the marginal operating gain from debt has become negative. This has profound implications for policymakers, as it suggests that further leveraging of SOEs could push them into a debt trap and/or shackle the monetary authority's ability to meaningfully raise interest rates. We can envision a modest releveraging scenario over the coming 12-18 months, but even that scenario is not consistent with a surge in investment-driven economic activity. Policymakers face a clear choice between growth and leveraging, and our bet is that they will choose just enough of the latter to prevent the former from decelerating significantly. This implies that the typical beneficiaries of Chinese reflation are not likely to outperform global risk assets, and that China's contribution to global growth is not set to rise sharply. However, over the coming 6-12 months, we acknowledge that domestic stocks are significantly oversold, and we are watching closely for an opportunity to time a reversal. Feature Global investors have paid considerable attention to China over the past month, focusing on the likely stimulative response of policymakers to an upcoming, tariff-induced export shock. We recently presented our view of the likely character and magnitude of upcoming Chinese stimulus in a two-part joint special report with our geopolitical team,1 and concluded that an acceleration in fiscal spending was far more likely than a sharp pickup in credit growth. In this report, we further examine the constraints facing Chinese policymakers and again conclude that they are likely to remain committed to preventing a significant releveraging of the economy. The financial condition of Chinese state-owned enterprises features prominently in our argument, and we highlight how the damage caused by China's post-2008 "business model" is a serious roadblock to further credit excesses. Whereas most modern central banks characterize their monetary policy decisions within the context of a trade-off between growth and inflation, Chinese policymakers now appear to understand that they face a trade-off between growth and leveraging. While we agree that economic stability will always remain the paramount objective of policymakers and a major policy mistake is not likely in the cards, reflationary efforts are likely to be carefully calibrated to avoid a dramatic overshoot of credit growth. This means that there is both limited downside and upside to Chinese economic activity, implying that expectations of a material, credit-driven reacceleration in growth are not likely to be met. A Brief Review Of Chinese Private Sector Debt Chart 1A Now Familiar Concern Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging After several years of intense concern about China's elevated debt, Chart 1 should be familiar to most investors. It highlights the significant rise in Chinese credit to the non-financial sector (i.e. total credit to governments, households, and non-financial corporations) based on data from the Bank for International Settlements (BIS), most of which has occurred in the private sector (non-financial firms and households). But Charts 2-4 presents a different breakdown of credit to the non-financial sector, based on IMF data, that includes a separation of corporate debt into private and state-owned enterprises (SOEs). The data shown in Charts 2-4 covers the 2010-2016 period; for reference, private non-financial sector debt continued to rise relative to GDP in 2017, in large part due to households (see Table A1 in Appendix 1 for the most recent IMF estimate of China's non-financial sector debt, absent the breakdown in corporate debt by ownership that the fund previously provided). Chart 2 presents the IMF's version of the rise in total non-financial debt (akin to Chart 1 from the BIS), and Charts 3 and 4 attribute the rise in debt to different sectors. Chart 3 shows that the increase in private sector debt accounts for 70% of the increase in leverage since 2010, and Chart 4 shows that the rise in SOE debt has accounted for nearly half of the rise in private sector debt. Within the private sector, household leverage has also risen substantially, accounting for roughly 40% of the rise from 2010-2016. Non-SOE corporates accounted for only 12% of the total rise in private leverage, the smallest of all sectors. Chart 2Another Perspective On Chinese Leveraging, With A Breakdown Of Corporate Debt By Ownership Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging   Chart 3The Private Sector Has Accounted For ##br##Most Of Chinese Leveraging... Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging Chart 4...Due Mostly To State-Owned ##br##Enterprises And Households Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging     When considering the potential economic impact of a sharp rise in leverage, BCA's view is that the focus should usually be on the increase in private sector debt rather than government debt. Public sector deleveraging is fundamentally a political choice in countries that have control over their own monetary policy, and simply will not occur in China over the coming year given the headwinds facing the economy. Given this, Chart 4 suggests that to understand any constraints facing policymakers from excessive leverage, investors should primarily devote their attention towards China's SOEs. China's State-Owned Enterprises: The Sacrifice Of Profitability For Stability Chart 5Within SOEs, Industrial And Construction Firms ##br##Account For Half Of The Increase In Debt Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging When assessing the risk of a potential private sector debt crisis in China, many investors have a sanguine view. The common refrain is that Chinese corporations, particularly state-owned enterprises, will be bailed out by the government if debt problems arise. Ultimately, we agree with this view, although we would note that the market pressure required to force the government to act could be quite severe. Still, there is a more pressing concern for investors: an analysis of the financial condition of China's state-owned enterprises suggests that the country may have reached the limit of how much SOEs can be further leveraged by policymakers in an attempt to rescue the economy, without significantly increasing the ultimate cost to the public. Our sense is that the campaign to control debt growth over the past two years reflects this economic reality, suggesting that the motivation behind the campaign will not be easily abandoned. Chart 2 showed that non-financial SOE debt-to-GDP rose by 20 percentage points from 2010-2016, a change in the stock of debt of roughly RMB33 trillion. Chart 5 shows that roughly half of this amount can be accounted for by the change in liabilities of state-owned industrial and construction enterprises over the same period. To the extent that they broadly reflect the condition of all non-financial SOEs, the availability of income statement and balance sheet data for these two industries allows us to make some inferences about the debt sustainability of China's state-owned firms.   Table 1 presents a breakdown of return on equity (ROE) for state-owned/state-holding companies in these industries, using the DuPont approach. Several points are noteworthy: Industrial & construction SOEs are highly leveraged entities, with an assets to equity ratio of 2.7. This explains the substantial difference between return on equity, which has been decently high, and a low single-digit return on assets (ROA). From 2010-2016, the ROE for industrial & construction SOEs fell from 14% to 8%, entirely because of a substantial decline in ROA. The decline in ROA occurred because of a roughly equal combination of declining profit margins and a falling asset turnover ratio. Based on the DuPont approach to expressing leverage,2 SOEs in the industrial and construction industries increased their leverage only very modestly during the period. But when leverage is expressed as liabilities relative to net income, a considerably more relevant measure when considering the potential to service debt, leverage nearly doubled. Table 1A Meaningful Decline In SOE Efficiency And Profitability Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging We presented Chart 6 in our last weekly report of 2017,3 and used it to represent a stylized timeline of China's economic history over the past 15 years. The chart describes how China's extremely rapid growth phase from 2002-2008 was followed by the global financial crisis and a normal, counter-cyclical rise in the debt-to-GDP ratio from 2008 to 2010. Chart 6A Stylized Timeline Of China's Recent Economic History Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging However, amidst the Great Recession, it became clear that China's export-enabled catchup growth phase was durably over, and policymakers were faced with a hard choice. They could either replace exports with debt-fueled domestic demand as a growth driver in order to buy time to transition to a services-led economy (the "reflate" path), or allow the labor market to suffer the consequences of a sharp slowdown in export growth while preserving fiscal and state-owned firepower for some uncertain future opportunity (the "stagnate" path). The picture that emerges from the combination of this narrative and our analysis of the evolution of SOE financial health is straightforward, but sobering. State-owned enterprises, already highly indebted at the onset of the global economic recovery, were levered even further in order to pursue the "reflate" path described above. While policymakers achieved their goal of maintaining aggregate demand, the consequence of their choice is that both the profitability and efficiency of SOEs have declined significantly. Avoiding An SOE Debt Trap A significant deterioration in SOE efficiency against the backdrop of a sharp rise in leverage speaks to the existence of capital misallocation, i.e. investment that has been funded by debt but cannot produce sufficient income to repay the debt. This suggests that SOEs are likely to have a bad debt problem at some point that will need to be resolved with government support. But in our view, the decline in profitability is a more immediate problem for policymakers, because it does not appear that SOEs can be leveraged any further without pushing them dangerously towards a self-reinforcing debt trap. Chart 7 illustrates why. The chart shows SOE ROA adjusted for interest expenses (a proxy for EBIT/Assets) versus a market-based proxy for SOE borrowing rates.4 Adjusted ROA fell below borrowing rates in 2013, suggesting that some of the observed decline in SOE profitability has occurred because the marginal operating gain from debt for Chinese state-owned enterprises has become negative. If so, this has profound implications for Chinese policymakers. Chart 8 illustrates how the process of perpetually leveraging an entity with a negative marginal operating gain from new borrowing eventually leads to a debt trap. An initial increase in debt causes interest costs to rise and profits to fall, as the return on new assets fails to exceed the interest rate on the debt used to acquire the assets. The process repeats itself as the entity is directed to leverage further, although management may choose to raise the entity's debt in this situation regardless of policy objectives (e.g. to cover a working capital deficit) if they mistakenly believe that the decline in ROA below debt costs is temporary. In addition, the existence of a negative marginal gain from new borrowing for a significant portion of the private sector would imply that China's natural rate of interest may have fallen. Chart 9 shows some evidence in support of this notion: the rise in the weighted average lending rate since late-2016 was relatively minor compared with levels that have prevailed over the past decade, and yet it is clear that it succeeded in materially slowing the investment-driven sectors of China's economy. This suggests that further leveraging of SOEs could tighten the shackles on the PBOC in terms of its ability to meaningfully raise interest rates, potentially fueling credit excesses in other sectors of the economy Chart 7SOEs Now Appear To Have A Negative ##br##Financial Gain From Debt SOEs Now Appear To Have A Negative Financial Gain From Debt SOEs Now Appear To Have A Negative Financial Gain From Debt Chart 8A Stylized Example Of ##br## Debt Trap Dynamics Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging Chart 9Has SOE Leveraging Caused China's ##br##Natural Rate Of Interest To Fall? Has SOE Leveraging Caused China's Natural Rate Of Interest To Fall? Has SOE Leveraging Caused China's Natural Rate Of Interest To Fall?         In short, the financial condition of China's state-owned enterprises appears to represent a proximate constraint preventing policymakers from responding to economic weakness with a significant acceleration in credit growth. It is not just that SOEs are highly levered and there is "a lot of debt in the system"; material further leveraging of these entities risks deteriorating what is already very poor profitability, which may push SOEs into an outright debt trap. That would precipitate a crisis and necessitate a bailout from the government, the cost of which will increase directly in line with the amount of additional debt taken. We agree that economic stability will always remain the paramount objective of policymakers, and we fully expect a policy response to address the upcoming export shock from the U.S. But whereas most modern central banks characterize their monetary policy decisions within the context of a trade-off between growth and inflation, our analysis of China's state-owned enterprises suggests that Chinese policymakers now seem to understand that they face a trade-off between growth and leveraging. This implies that current reflationary efforts from policymakers are likely to be carefully calibrated to avoid a dramatic overshoot of credit growth. Envisioning Modest Releveraging Chart 10Modest Releveraging Is Ok, As Long As ##br##Its Pace Continues To Slow Modest Releveraging Is Ok, As Long As Its Pace Continues To Slow Modest Releveraging Is Ok, As Long As Its Pace Continues To Slow What is a carefully calibrated credit response likely to look like, and what does it mean for private sector debt growth? As noted above, my colleague Matt Gertken addressed this question by presenting three scenarios in part 1 of the recent joint special report with our geopolitical team.5 His base-case view, to which he assigned 70% odds, implied that there would be a very modest reacceleration in total social financing (on the order of 1% or so). In this report we take a second approach to estimating the potential magnitude of a modest reacceleration scenario using the BIS private sector credit data, primarily to incorporate different growth rates for the corporate and household sectors. Using the BIS data, Chart 10 shows the growth rate in Chinese total private sector debt, nominal GDP, and the difference between the two. The significant leveraging period from 2010-2016 is evidenced by the persistently positive gap between credit and GDP growth (it was only briefly negative in 2011).   But the chart also shows that there has been a downtrend in the gap since 2013, with 2017 representing a major overshoot (to the downside). Given that the trend shown in Chart 10 points downward and reflects policy efforts to control debt growth, we could envision Chinese policymakers tolerating some acceleration in credit growth relative to GDP, as long as it does not materially overshoot the trendline to the upside. Using this framework as a guide, we can calculate what modest releveraging might mean for corporate sector debt, assuming the following: Chinese policymakers, through a combination of fiscal spending and modest releveraging, succeed in stabilizing nominal GDP growth at current levels. Policymakers tolerate total non-financial private sector credit growth that is 4% in excess of nominal GDP growth. Household credit growth remains well in excess of GDP growth, in-line with its average of the past 5 years. Given the significant leveraging of the household sector and the recent uptick in home sales, this appears to be a reasonable assumption barring a major crackdown on the property market by Chinese officials. Chart 11 presents the result of these assumptions, which shows non-financial corporation credit growth accelerating to roughly 12% by the end of 2019. At first blush, the chart appears to show a meaningful acceleration, as the annual change in year-over-year credit growth based on this measure would meet or exceed that of the past two credit cycles. But there are two important caveats for investors: Even as depicted in Chart 11, non-financial corporate credit growth would still be extremely weak relative to its recent history. At the end of 2019, the chart shows that corporate credit growth would be almost two percentage points lower than its weakest point in 2015. Chart 11 illustrates a scenario where the level of credit to the total private non-financial sector grows by RMB36 trillion by the end of 2019. Chart 12 shows that when compared to our estimate of the stock of adjusted total social financing, this rise barely even registers as an acceleration. Chart 11A Rebound, But Weak Relative To History A Rebound, But Weak Relative To History A Rebound, But Weak Relative To History Chart 12Barely Even Registers As An Acceleration In Adjusted TSF Barely Even Registers As An Acceleration In Adjusted TSF Barely Even Registers As An Acceleration In Adjusted TSF In short, while the degree of acceleration in credit growth as implied in our scenario varies depending on the definition of credit employed, the bottom line for investors is that a modest releveraging scenario is not consistent with a surge in investment-driven economic activity. Policymakers face a clear choice between growth and leveraging, and our bet is that they will choose just enough of the latter to prevent the former from decelerating significantly. This cautious, contingent attitude towards an acceleration in private sector credit growth would be in marked contrast to previous episodes of reflation, suggesting that investors who are following China's "old stimulus rulebook" are likely to be disappointed. Implications For Investment Strategy Chart 13No Signs Yet Of A Heavy, Credit-Based Response No Signs Yet Of A Heavy, Credit-Based Response No Signs Yet Of A Heavy, Credit-Based Response There are two clear implications of our analysis for investment strategy. First, in ironic reference to Reinhart & Rogoff's book that coined the term, "this time" is likely to be different for China because policymakers seem resolute in their intention to prevent a financial crisis (as opposed to the term having been used in the past by those who have ended up contributing to one). Our analysis shows that the debt burden for state-owned enterprises is already extreme, and that further, material, forced leveraging of the sector risks a possible debt trap. This implies that the typical beneficiaries of Chinese reflation are not likely to outperform global risk assets, and that China's contribution to global growth is not set to rise sharply. For now, our BCA China Play Index and the relative performance of infrastructure stocks seem to support our conclusion (Chart 13). Second, if this time is not different, i.e. if policymakers allow a significant further releveraging of the private sector, either intentionally or by accident, investors should recognize that the longer-term outlook for China may darken considerably if the country is not capable of quickly shifting away from its old growth model over the next few years. Unfortunately for officials in China, the reality of economics is that positive NPV projects for SOEs to invest in cannot simply be willed into existence. The significant decline in profitability and asset turnover that we have observed in state-owned enterprises since 2010 speaks to the poor use of credit, and policymaker reliance on the traditional methods of stimulus is likely to achieve the country's short-term goals at the expense of making the already large debt problem (and the cost of the eventual bailout by the public sector) much worse. This would raise both the political and economic risks facing the country, at a time when a U.S. and/or global recession appears likely within the next 2-3 years. As a final point, despite our caution against over-optimism concerning China's stimulative response, we acknowledge that policymakers are likely to succeed in preventing a significant deceleration in their economy over the coming 6-12 months. Given how materially Chinese stock prices have declined, it remains a debate whether a mere stabilization of economic activity at a modest pace will be enough for domestic or investable equities to meaningfully rally in absolute or relative terms. For now, we have highlighted that the relative selloff in domestic stocks appears to be quite late, particularly in common currency terms, and we are watching closely for an opportunity to time a reversal.   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com   Appendix 1 Appendix A-1Chinese Non-Financial Sector Debt Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging 1 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 2 The DuPont approach breaks down return on equity into the product of profit margins (profits / revenue), asset turnover (revenue / assets), and financial leverage (assets / equity). 3 Pease see China Investment Strategy Weekly Report "Legacies Of 2017", dated December 21, 2017, available at cis.bcaresearch.com 4 We use the yield-to-maturity of the ChinaBond Corporate Bond Index as our proxy for the interest rate paid by state-owned firms, given that the index includes bonds issued by central and local government SOEs. Importantly, our proxy is closely aligned with the weighted average bank loan borrowing rate paid by SOEs from 2014-2016, as per a 2017 report from the China Academy of Fiscal Science ("Cost reduction: 2017 survey and analysis", August 28, 2017). 5 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 Cyclical Investment Stance Equity Sector Recommendations

Highlights Xi Jinping is trying to do two things at once: ease policy while cracking down on systemic financial risk; The trade war with the U.S. is a genuine crisis for China and is eliciting fiscal stimulus; Credit growth is far more likely to "hold the line" than it is to explode upward or collapse downward; The 30% chance of a policy mistake from financial tightening has fallen to 20% only, as bad loan recognition is underway and a critical risk to monitor; Hedge against the risk of a stimulus overshoot. China's policy headwinds have begun to recede, but Beijing is not riding to the rescue for emerging markets; While monetary policy has eased substantively, credit growth will be hampered by the government's financial crackdown; Potential changes to China's Macro-Prudential Assessment framework could be significant, but the impact on credit growth is overestimated at present; The recognition of non-performing loans (NPLs) and cleansing of China's banking system is still in early innings and will weigh on banks' risk appetite; The anti-corruption campaign is another reason to be cautious on EM. Geopolitical Strategy recommends clients stay overweight China (ex-tech) relative to EM. Feature "We have upheld the underlying principle of pursuing progress while ensuring stability." - Xi Jinping, General Secretary of the Communist Party of China, October 18, 2017 "Any form of external pressure can eventually be transformed into impetus for growth, and objectively speaking will accelerate supply-side structural reforms." - Guo Shuqing, Secretary of the China Banking and Insurance Regulatory Commission, July 5 PART I Last year we made the case that China's General Secretary Xi Jinping would double down on his reform agenda in 2018, specifically the bid to control financial risk, and that this would bring negative surprises to global financial markets as policymakers demonstrated a higher pain threshold.1 This view has largely played out, with economic policy uncertainty spiking and a bear market in equities developing alongside an increase in corporate and even sovereign credit default risk (Chart 1). We also argued, however, that Xi's "deleveraging campaign" would be constrained by the Communist Party's need for overall stability. Trade tensions with the U.S., and Beijing's perennial fear of unemployment, would impose limits on how much pain Beijing would ultimately tolerate: The Xi administration will renew its reform drive - particularly by curbing leverage, shadow banking, and local government debt. Growth risks are to the downside. But Beijing will eventually backtrack and re-stimulate, even as early as 2018, leaving the reform agenda in limbo once again.2 Over the past month, China has clearly reached its pain threshold: authorities have announced a series of easing measures in the face of a slowing economy, a trade war, and a still-negative broad money impulse (Chart 2). Chart 1Policy Uncertainty Up, Stocks Down Policy Uncertainty Up, Stocks Down Policy Uncertainty Up, Stocks Down Chart 2PMI Falling, Money Impulse Still Negative PMI Falling, Money Impulse Still Negative PMI Falling, Money Impulse Still Negative How stimulating is the stimulus? Will it lead to a material reacceleration of the Chinese economy? What will it mean for global and China-dedicated investors? We expect policy to be modestly reflationary. A substantial boost to fiscal thrust, and at least stable credit growth, is in the works. Yet Xi's reform agenda will remain a drag on the economy. While this new stimulus will not have as dramatic an effect as the stimulus in 2015-16, it will have a positive impact relative to expectations based on China's performance in the first half of the year. We advise hedging our negative EM view against a rally in China plays and upgrading expectations for Chinese growth in 2019. The policy headwind is receding for now. Xi Jinping's "Three Tough Battles" Chart 3Xi Jinping Caps Government Spending And Credit Xi Jinping Caps Government Spending And Credit Xi Jinping Caps Government Spending And Credit Xi will not entirely abandon the "Reform Reboot" that began last October. From the moment he came to power in 2012-13, he pursued relatively tight monetary and fiscal policy. Total government spending growth has dropped substantially under his administration, while private credit growth has been capped at around 12% (Chart 3). Xi partly inherited these trends, as China's credit growth and nominal GDP growth dropped after the massive 2008 stimulus. But he also embraced tighter policy as a way of rebalancing the economy away from debt-fueled, resource-intensive, investment-led growth. A comparison of government spending priorities between Xi and his predecessor makes Xi's policy preferences crystal clear: the Xi administration has increased spending on financial and environmental regulation, while minimizing subsidies for housing and railways to nowhere (Table 1 and 2). Table 1Central Government Spending Preferences (Under Leader's Immediate Control) China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? Table 2Total Government Spending Preferences (Under Leader's General Control) China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? These policies are "correct" insofar as they are driven not merely by Xi's preferences but by long-term constraints: The middle class: Pollution and environmental degradation threaten the living standards of the country's middle class. Broadly defined, this group has grown to almost 51% of the population, a level that EM politicians ignore only at their peril (Chart 4). Asset bubbles: The rapid increase in China's gross debt-to-GDP ratio since 2008 is a major financial imbalance that threatens to undermine economic stability and productivity as well as Beijing's global aspirations (Chart 5). The constraint is clear when one observes that "debt servicing" is the third-fastest category of fiscal spending growth since Xi came to power (Table 2). Chart 4Emerging Middle Class A Latent Political Risk Emerging Middle Class A Latent Political Risk Emerging Middle Class A Latent Political Risk Chart 5The Rise And Plateau Of Macro Leverage China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? The problem is that Xi also faces a different, shorter-term set of constraints arising from China's declining potential GDP, "the Middle-Income Trap," and the threat of unemployment.3 The interplay of these short- and long-term constraints has forced Xi to vacillate in his policies. In 2015, the threat of an economic "hard landing," ahead of the all-important mid-term party congress in 2017, forced him to stimulate the "old" industrial economy and sideline his reforms. Only when he had consolidated power over the Communist Party in 2016-17 could he resume pushing the reform agenda.4 In July 2017, Xi announced the so-called "Three Critical Battles" against systemic financial risk, pollution, and poverty. The three battles are interdependent: continuing on the capital-intensive economic model will overwhelm any efforts to cut excessive debt or pollution (Chart 6), yet sudden deleveraging could derail the Communist Party's basic claim to legitimacy through improving the lot of poor Chinese. The macroeconomic impact of the three battles is broadly deflationary, as credit growth falls and industries restructure. The first battle - the financial battle - will determine the outcome of the other two battles as well as the growth rate of China's investment-driven economy, Chinese import volumes, and emerging market stability (Chart 7). Chart 6Credit Stimulus Correlates With Pollution Credit Stimulus Correlates With Pollution Credit Stimulus Correlates With Pollution Chart 7Credit Determines Growth And Imports Credit Determines Growth And Imports Credit Determines Growth And Imports On July 31, in the midst of worldwide speculation about China's willingness to stimulate, Xi reaffirmed this "Three Battles" framework. Remarkably, despite a general slowdown, a sharp drop in the foreign exchange rate, the revival of capital flight, and a bear market, he announced that the battle against systemic financial risk would continue in the second half of 2018. However, he also admitted that domestic demand needed a boost in the short term. Hence there should be no doubt in investors' minds about the overarching policy framework or Xi Jinping's intentions in the long run. The question driving the markets today is what China will do in the short term and whether it will initiate a material reacceleration in economic activity. Bottom Line: Xi Jinping remains committed to the reform agenda that he has pursued since coming to power in 2012. But he is forced by circumstances to vary the pace and intensity. At the top of the agenda is the control of systemic financial risk. This is a policy driven by the belief that China's economic and financial imbalances threaten to undermine its overall stability and global rise. Why The Shift Toward Easier Policy? The gist of the July 31 Politburo statement was that policy will get more dovish in the short term. It mentioned "stability" five times. The Politburo pledged to make fiscal policy "more proactive" and to find a better balance between preventing financial risks and "serving the real economy." This direct promise from Xi Jinping of more demand-side support gives weight to the State Council's similar statement on July 23 and will have reflationary consequences above and beyond the central bank's marginal liquidity easing thus far. What is motivating this shift in policy, which apparently flies in the face of Xi's high-profile deleveraging campaign? If we had to name a single trigger for China's change of tack, it is not the economic slowdown so much as the trade war with the United States. The war began when the U.S. imposed sanctions on Chinese firm ZTE in April and China depreciated the RMB, but it escalated dramatically when the U.S. posted the Section 301 tariff list in June (Chart 8).5 This is a sea change in American policy that is extremely menacing to China. China runs a large trade surplus and has benefited more than any other country from the past three decades of U.S.-led globalization. Its embrace of globalization is what enabled the Communist Party to survive the fall of global communism! Chart 8More Than Market Dynamics At Work More Than Market Dynamics At Work More Than Market Dynamics At Work Chart 9China Is Less Export-Dependent China Is Less Export-Dependent China Is Less Export-Dependent True, China has already seen its export dependency decline (Chart 9). But Beijing has so far managed this transition gradually and carefully, whereas a not-unlikely 25% tariff on $250-$500 billion of Chinese exports will hasten the restructuring beyond its control (Chart 10). A very large share of China's population is employed in manufacturing (Chart 11). To the extent that the tariffs actually succeed in reducing external demand for Chinese goods, these jobs will be affected. Chart 10Tariffs Will Add More Pain To Factory Workers Tariffs Will Add More Pain To Factory Workers Tariffs Will Add More Pain To Factory Workers Chart 11Manufacturing Unemployment A Huge Threat Manufacturing Unemployment A Huge Threat Manufacturing Unemployment A Huge Threat Unemployment is anathema to the Communist Party. And China is simply not as experienced as the U.S. in dealing with large fluctuations in unemployment (Chart 12). While Chinese workers will blame "foreign imperialists" and rally around the flag, the pain of unemployment will eventually cause trouble for the regime. Domestic demand as well as exports will suffer. It is even possible that worker protests could evolve into anti-government protests. Chart 12China Not Experienced With Layoffs China Not Experienced With Layoffs China Not Experienced With Layoffs Given that Chinese and global growth are already slowing, it is no surprise that the Politburo statement prioritized employment.6 China's leaders will prepare for social instability as the worst possible outcome of the showdown with America - and that will push them toward stimulus. In addition, there will be no short-term political cost to Xi Jinping for erring on the side of stimulus, as there is no opposition party and the public is not demanding fiscal and monetary austerity. Moreover, the main macro implication of Xi's decision last year to remove term limits - enabling himself to be "president for life" in China - is that his reforms do not have to be achieved by any set date. They can be continually procrastinated on the basis that he will return to them later when conditions are better.7 The policy response to tariffs from the Trump administration also signals another policy preference: perseverance. Xi would not be straying from his reform priorities if not for a desire to counter American protectionism. China is not interested in kowtowing but would rather gird itself for a trade war. Still, our baseline view is that the Xi administration will stimulate without abandoning the crackdown on shadow lending or launching a massive "irrigation-style" credit surge that exacerbates systemic risk.8 Policy will be mixed, as Xi is trying to do two things at once. Bottom Line: China's slowdown and the outbreak of a real trade war with the United States is forcing Xi Jinping to ease policy and downgrade the urgency of his attempt to tackle systemic financial risk this year. Can Fiscal Easing Overshoot? Yes. How far will China's policy easing go? China has a low level of public debt, and fiscal policy has been tight, so we fully expect fiscal thrust to surprise to the upside in the second half of the year, easily by 1%-2% of GDP, possibly by 4% of GDP. Chart 13Fiscal Tightening Was The Plan For 2018 China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? A remarkable thing happened this summer when researchers at the People's Bank of China and the Ministry of Finance began debating fiscal policy openly. Such debates usually occur during times of abnormal stress. The root of the debate lay in the national budget blueprint laid out in March at the National People's Congress. There, without changing official rhetoric about "proactive fiscal policy," the authorities revealed that they would tighten policy this year, with the aim of shrinking the budget deficit from 3% of GDP target in 2017 to 2.6% in 2018. The IMF, which publishes a more realistic "augmented" deficit, estimates that the deficit will contract from 13.4% of GDP to 13% (Chart 13). This fiscal tightening coincided with Xi's battle against systemic financial risk. Hence both monetary and fiscal policy were set to tighten this year, along with tougher regulatory and anti-corruption enforcement.9 Thus it made sense on May 8 when the Ministry of Finance revealed that the quota for net new local government bond issuance this year would increase by 34% to 2.18 trillion RMB. This quota governs new bonds that go to brand new spending (i.e. it is not to be confused with the local government debt swap program, which eases repayment burdens but does not involve a net expansion of debt). Local government spending is the key because it makes up the vast majority (85%) of total government spending, which itself is about the same size as new private credit each year. In June, local governments took full advantage of this opportunity, issuing 316 billion RMB in brand new bonds (up from a mere 17 billion in May - an 11.8% increase year-on-year) (Table 3). This spike in issuance is later than in previous years. Combined with the Politburo and State Council pledging to boost fiscal policy and domestic demand, it suggests that net new issuance will pick up sharply in H2 2018 (Chart 14).10 Table 3Local Government Bond Issuance And Quota China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? Chart 14Local Government Debt Can Surprise In H2 China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? At the same time, the risk that special infrastructure spending will fall short this year is receding. About 1.4 trillion RMB of the year's new bond allowance consists of special purpose bonds to fund projects. The State Council said on July 23 it would accelerate the issuance of these bonds, since, at most, only 27% of the quota was issued in the first half of the year (Chart 15). The risk of a shortfall - due to stricter government regulations over the quality of projects - is thereby reduced. What is the overall impact of these moves? The Chinese government provides an annual "debt limit" that applies to the grand total of explicit, on-balance-sheet, local government debt. The limit increased by 11.6% for 2018, to 21 trillion RMB (Table 4), which, theoretically, enables local governments to splurge on a 4.5 trillion RMB debt blowout. Should that occur, 2.6 trillion RMB of that amount, or 3% of GDP, would be completely unexpected new government spending in 2018 (creating a positive fiscal thrust).11 Chart 15June Issuance Surged, Special Bonds To Pick Up China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? Table 4Local Government Debt Quota Is Not A Constraint China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? Such a blowout may not be likely, but it is legally allowed - and the political constraints on new issuance have fallen with the central government's change of stance. This means that local governments' net new bond issuance can move up toward this number. More feasibly, local governments could increase their explicit debt to 19.3 trillion RMB, a 920 billion RMB increase on what is expected, which would imply 1% of GDP in new spending or "stimulus" in 2018.12 The above only considers explicit, on-balance-sheet debt. Local governments also notoriously borrow and spend off the balance sheet. The total of such borrowing was 8.6 trillion RMB at the end of 2014, but there is no recent data and the stock and flow are completely opaque.13 The battle against systemic risk is supposed to curtail such activity this year. But the newly relaxed supervision from Beijing will result in less deleveraging at minimum, and possibly re-leveraging. Similarly, the government has said it is willing to help local governments issue refinancing bonds to deal with the spike in bonds maturing this year.14 This frees them up to actually spend or invest the money they raise from brand new bonds. In short, our constraints-based methodology suggests that the risk lies to the upside for local government debt in 2018, given that it is legal for debt to increase by as much as 2.5 trillion RMB, 3% of GDP, over the 1.9 trillion RMB increase that is already expected in the IMF's budget deficit projections for 2018. What about the central government? Its policy stance has clearly shifted. The central government could quite reasonably expand the official budget deficit beyond the 2.6% target. Indeed, that target is already outdated given that new individual tax cuts have been proposed, which would decrease revenues (add to the deficit) by, we estimate, a minimum of 0.44% of GDP over a 12-month period starting in October.15 Other fiscal boosts have also been proposed that would add an uncertain sum to this amount.16 The total of these measures can quite easily add up to 1% of GDP, albeit with the impact mostly in 2019. Finally, the strongest reason to err on the side of an upward fiscal surprise is that an expansion of fiscal policy will allow the Xi administration to boost demand without entirely relying on credit growth. First, local governments are actually flush with revenues due to strong land sales (Chart 16), which comprise around a third of their revenues. This enables them to increase spending even before they tap the larger debt allowance. Second, China's primary concern about financial risk is due to excessive corporate (and some household) leverage, particularly by state-owned enterprises (SOEs) and shadow banking. It is not due to public debt per se. It is entirely sensible that China would boost public debt as it attempts to limit leverage. In fact, this would be the Zhu Rongji playbook from 1998-2001. This was the last time that China announced a momentous three-year plan to crack down on profligate lending, hidden debts, and credit misallocation. The authorities deliberately expanded fiscal policy to compensate for the anticipate credit crunch and its drag on GDP growth (Chart 17).17 Chart 16Land Sales Enable Non-Debt Fiscal Spending Land Sales Enable Non-Debt Fiscal Spending Land Sales Enable Non-Debt Fiscal Spending Chart 17China Boosted Fiscal During Last Bad Debt Purge China Boosted Fiscal During Last Bad Debt Purge China Boosted Fiscal During Last Bad Debt Purge As for the impact on the economy, the money multiplier will be meaningful because the economy is slowing and fiscal policy has been tight. But fiscal spending does operate with a six-to-ten month lag, meaning that China/EM-linked risk assets will move long before the economic data fully shows the impact. Our sense, judging by the unenthusiastic response of copper prices thus far, is that the market does not anticipate the fiscal overshoot that we now do. Bottom Line: The political constraints on local government spending have fallen. Fiscal policy could add as much as 1%-3% of GDP to the budget deficit in H2 2018, namely if local government spending is unleashed by the recently announced policy shift. This is comparable to the 4% of GDP fiscal boost in 2008-09 and 3% in 2015-16. Can Monetary Easing Overshoot? Yes, But Less Likely. Credit is China's primary means of stimulating the economy, especially during crisis moments, and it has a much shorter lag period than fiscal spending (about three months). But Xi's agenda makes the use of rapid, credit-fueled stimulus more problematic. Based on the sharp drop in the interbank rate - in particular, the three-month interbank repo rate that BCA's Emerging Markets Strategy and China Investment Strategy use as a proxy for China's benchmark rate - it is entirely possible that credit growth will increase to some degree in H2 2018. Interbank rates have now fallen almost to 2016 levels, while the central bank never hiked the official 1-year policy rate during the recent upswing (Chart 18). In other words, the monetary setting has now almost entirely reversed the financial crackdown that began in 2017. The sharp drop in the interbank rate is partly a consequence of the three cuts to required reserve ratios (RRRs) this year, which amounts to 2.8 trillion RMB in new base money from which banks can lend.18 One or two more RRR cuts are expected in H2 2018, which could free up another roughly 800 billion-to-1.6 trillion RMB in new base money. With China accumulating forex reserves at a slower pace than in the past, and facing a future of economic rebalancing away from exports and growing trade protectionism, RRRs can continue to decline over the long run (Chart 19). China will not need to sterilize as large of inflows of foreign exchange.19 If China's banks and borrowers respond as they have almost always done, then credit growth should rise. The risk to this assumption is that the banks may be afraid to lend as long as the Xi administration remains even partially committed to its financial crackdown. Moreover, the anti-corruption campaign is continuing to probe the financial sector. While this has only produced a handful of anecdotes so far, they are significant and may have helped cause the decline in loan approvals since early 2017. Critically, China has begun the process of recognizing non-performing loans (NPLs), by requiring that "special mention loans" be reclassified as NPLs, thus implying that NPL ratios will spike, especially among small and regional lenders (Chart 20). This is part of the deleveraging process we expect to continue, but it can take on a life of its own and will almost certainly weigh on credit growth to some extent for as long as it continues. Chart 18Monetary Settings Back To Easy Levels Monetary Settings Back To Easy Levels Monetary Settings Back To Easy Levels Chart 19RRR Cuts Can Continue RRR Cuts Can Continue RRR Cuts Can Continue Chart 20NPL Recognition Underway (!) NPL Recognition Underway (!) NPL Recognition Underway (!) What will be the prevailing trend: monetary easing or the financial crackdown? In Chart 21 we consider three scenarios for the path of overall private credit growth (total social financing, ex-equity) for the rest of the year, with our subjective probabilities: Chart 21Three Scenarios For Private Credit In H2 2018 China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? In Scenario A, 10% probability, we present an extreme case in which Beijing panics over the trade war and the banks engage in a 2009-style lending extravaganza. Credit skyrockets up to the 2010-17 average growth rate. This would mark a massive 11.9 trillion RMB or 13.8% of GDP increase in excess of the amount implied by the H1 2018 data. This size of credit spike would be comparable to the huge spikes that occurred during past crises, such as the 22% of GDP increase in 2008-09 or the 9% of GDP increase in 2015-16. Needless to say, this is not our baseline case, but it could materialize if the trade war causes a global panic. In Scenario B, 70% probability, we assume, more reasonably, that traditional yuan bank loans are allowed to rise toward their average 2010-17 growth rate as a result of policy easing, yet Xi maintains the crackdown on non-bank credit in accordance with this "Three Battles" framework. Credit growth would still decelerate in year-on-year terms, but only just: it would fall from 12.3% in 2017 to 11.5% in 2018. Additional policy measures could easily bump this up to a modest year-on-year acceleration, of course. This scenario would result in a credit increase worth 2.9 trillion RMB or 3.4% of GDP on top of the level implied by H1 2018. In Scenario C, 20% probability, we assume that the 2018 YTD status quo persists: bank credit and non-bank credit continue growing at the bleak H1 2018 rate. The administration's attempt to maintain the crackdown on financial risk could frighten banks out of lending. This would mean no credit increase in 2018 beyond what is naturally extrapolated from the H1 2018 data. Credit growth would slow from 12.3% to 10.7% in 2018. This scenario would be surprising, but not entirely implausible given that the Politburo is insisting on continuing the Three Battles. The collapse in interbank rates and the easing measures already undertaken - such as reports that the Macro-Prudential Assessments will lighten up, and that the People's Bank is explicitly softening banks' annual loan quotas20 - lead us to believe that Scenario B is most likely, and possibly too conservative. This is the scenario most consistent with the latest Politburo statement: that authorities will continue the campaign against systemic risk, namely through the policy of "opening the front door" (traditional bank loans go up) and "closing the back door" (shadow lending goes down), which began in January. The Chinese government has always considered control of financial intermediation to be essential. The only way to reinforce the dominance of the state-controlled banks, while preventing a sharp drop in aggregate demand, is to allow them to grow their loan books while regulators tie the hands of their shadow-bank rivals (Chart 22). Chart 22Opening The Front Door, Closing The Back Opening The Front Door, Closing The Back Opening The Front Door, Closing The Back One factor that could evolve beyond authorities' control is the velocity of money. Money velocity is essentially a gauge of animal spirits. If a single yuan changes hands multiple times, it will drive more economic activity, but if it is deposited away for a rainy day, then the bear spirit is in full force. Thus, if credit growth accelerates, but money in circulation changes hands more slowly, then nominal GDP can still decelerate - and vice versa.21 China's money velocity suffered a sharp drop during the tumult of 2015, recovered along with the policy stimulus in 2016, and has tapered a bit in 2018 in the face of Xi's deleveraging campaign. Yet it remains elevated relative to 2012-16 and clearly responds at least somewhat to policy easing. The implication is that money velocity should remain elevated or even pick up in H2. Again, the risk to this view is that Xi's ongoing battle against financial risk, and anti-corruption campaign in the financial sector, could suppress money velocity as well as credit growth. Bottom Line: We see a subjective 70% chance that the drop in credit growth will be halted or reversed in H2 as a result of the central bank's liquidity easing and the Politburo's willingness to let traditional bank lending grow while it discourages shadow lending. Our baseline case says the impact could amount to new credit worth 3.4% of GDP in H2 2018 that markets do not yet expect. Investment Conclusions Beijing's shift in policy suggests that our subjective probability of a policy mistake this year, leading to a sharp economic deceleration, should be reduced from 30% to 20% (Credit Scenario C above).22 Why is this dire scenario still carrying one-to-five odds? Because we fear that the financial crackdown and rising NPLs could take on a life of their own. Meanwhile the risk of aggressive re-leveraging has risen from 0% to 10% (Credit Scenario A above). Summing up, Table 5 provides a simple, back-of-the-envelope estimate of the size of both fiscal and monetary policy measures as a share of GDP. Table 5Potential Magnitude Of Easing/Stimulus China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? Our bias is to expect a strong fiscal response combined with a weak-to-moderate credit response. This would reflect the Xi administration's desire to prevent asset bubbles while supporting growth. A more proactive fiscal policy harkens back to China's handling of its last financial purge in 1998-2001. If banks prove unable or unwilling to lend sufficiently, additional fiscal expansion will pick up the slack. New local government debt can surprise by 1% of GDP or more, while formal bank lending amidst an ongoing crackdown on shadow lending could add new credit of around 3.4% of GDP and hence mitigate or halt the slowdown in credit growth. The combined effect would be an unexpected boost to demand worth 4.4% of GDP in H2 2018, which would exert an unknown, but positive, multiplier effect. We are replacing our "Reform Reboot" checklist, which has seen every item checked off, with a new "Stimulus Checklist" that we will monitor going forward (Appendix). Chart 23How To Monitor The Stimulus Impact How To Monitor The Stimulus Impact How To Monitor The Stimulus Impact Neither the size of this stimulus, nor the composition of fiscal spending, will be quite as positive for EM/commodities as were past stimulus efforts. China's investment profile is changing as the reform agenda seeks to reduce industrial overcapacity and build the foundations for stronger household demand and a consumer society. Increases in fiscal spending today will involve more "soft infrastructure" than in the past. We recommend reinstituting our long China / short EM equity trade, using MSCI China ex-tech equities. We also recommend reinitiating our long China Big Five Banks / short other banks trade, to capture the disparity of the financial crackdown's impact. To capture the new upside risk for global risk assets, our colleague Mathieu Savary at BCA's Foreign Exchange Strategy has devised a "China Play" index that is highly sensitive to Chinese growth - it includes iron ore prices, Swedish industrial stocks, Brazilian stocks, and EM junk bonds (all in USD terms), as well as the Aussie dollar-Japanese yen cross. BCA Geopolitical Strategy also recommends this trade as a portfolio hedge to our negative EM view (Chart 23).23 A major risk to the "modest reflation" argument in this report will materialize if the RMB depreciates excessively in response to the escalating trade war (Trump will likely post a new tariff list on $200 billion worth of goods in September).24 This could result in renewed capital outflows breaking through China's capital controls, the PBC appearing to lose control, EM currencies and capital markets getting roiled, EM financial conditions tightening sharply, and global trade and growth slowing sharply. China would ultimately have to stimulate more (moving in the direction of Credit Scenario A above), but a market selloff would occur first and much economic damage would be done. PART II In the first part of this two-part Special Report, we concluded that policy headwinds to China's economic growth have begun to recede, but recent easing measures will likely disappoint the markets. Chart 24Money Growth Bottomed, Credit Still Weak Money Growth Bottomed, Credit Still Weak Money Growth Bottomed, Credit Still Weak In essence, China is girding for a trade war with the United States, which favors stimulus. But it is still attempting to reduce systemic financial risk. As a result, fiscal stimulus may surprise to the upside, but credit growth will be lackluster. The problem for investors - especially for emerging market (EM) assets and the commodity complex - is that Chinese fiscal stimulus typically operates with a six-to-ten month lag, as opposed to credit stimulus which only takes about three months to kick in.25 July statistics confirm our suspicion that credit stimulus will be hampered by the government's crackdown on shadow banking. Total credit growth remains weak, although broad money (M2) does appear to be bottoming (Chart 24). Thus far, BCA's China Investment Strategy has been correct in characterizing the latest developments as "taking the foot off the brake" rather than "pressing down on the accelerator."26 In this part of the report we take a deeper dive into the policy factors that cause us to limit our "stimulus overshoot" scenario to a 10% subjective probability. The three chief reasons are: overstated easing of macro-prudential controls; the continuing process of cleansing the banking sector of non-performing loans; and the anti-corruption campaign in the financial sector. A Preemptive Dodd-Frank Since the Xi administration redoubled its efforts to tackle systemic financial risk last year, we have urged investors to be cautious about Chinese growth.27 The creation of new institutions and new regulatory requirements set in motion processes that would be hard to reverse quickly. While these institutions are now making several compromises for the sake of stability, their operations will continue to weigh on credit growth. In July 2017, China's government held the National Financial Work Conference to address the major issues facing the country's financial system. This conference takes place once every five years and has often occasioned significant shakeups in financial regulation. In 1997, it initiated a sweeping purge of the banking system, and in 2002, it saw the creation of three financial watchdogs that would become critical institutional players throughout the 2000s.28 One of the skeletons in the closet from 2002 was the debate over whether financial regulation should be heavily centralized or divided among different, specialized, state agencies. Former Premier Wen Jiabao won the argument with the creation of the three watchdogs covering banking, securities, and insurance. After a series of controversies and conflicts, the Xi administration decided that these agencies had failed in their primary purpose of curbing systemic risk and ordered a reorganization with greater centralization. At the 2017 financial conference, Xi announced the creation of the Financial Stability and Development Committee (FSDC) to act as a centralized watchdog over the entire financial system. The FSDC would coordinate with the central bank, oversee macro-prudential regulation, and prevent systemic risk. Liu He, Xi's right-hand man on the economy and a policymaker with a hawkish reputation, was soon promoted to the Politburo and given the top job at the FSDC.29 As a second step, the Xi administration announced that it would combine the banking and insurance regulators into a single entity - the China Banking and Insurance Regulatory Commission (CBIRC). The CBIRC, to be headed by Xi ally, and notable hawk, Guo Shuqing, would continue and escalate the crackdown on shadow lending that Guo had begun at the helm of the bank watchdog in 2017 (Chart 25). The merging of the agencies would also close the regulatory gap that had seen the insurance regulator increase its dominion and rent-seeking by encouraging "excessive" financial innovation and risky pseudo-insurance products.30 Chart 25Crackdown On Informal Credit Continues Crackdown On Informal Credit Continues Crackdown On Informal Credit Continues The FSDC was expected, rightly, to bring a more hawkish tilt to Chinese macro-prudential regulation. In reference to the U.S.'s Financial Stability Oversight Council, we dubbed these moves a "Preemptive Dodd-Frank."31 We also argued, however, that the purpose was to bring unified command and control to financial regulation and that China would continue to prize stability above all. Therefore the degree of tightening or loosening should vary in accordance this goal.32 After a series of announcements in July and August, it is clear that China's government has shifted to a more accommodative posture (please refer back to Chart 18 and Chart 19). As usual, there are rumors of high-level political intrigue to go along with the policy shift: some argue that Premier Li Keqiang is making a comeback while Xi's golden boy, Liu He, has been sidelined due to his failure to forestall tariffs during his trade talks with Donald Trump this spring.33 Such rumors are valuable only in revealing the intensity of the policy debate in Beijing. What is certain, however, is that the FSDC, with Liu He as chairman, only met for the first time as a fully assembled group in early July, just before the major easing measures were taken. This implies that any initial conclusions were pragmatic (i.e. not excessively hawkish). Moreover, Guo Shuqing is not only the CBIRC head but also the party secretary of the PBOC, meaning that central bank chief Yi Gang cannot have adopted easing measures without Guo's at least condoning it. Chinese policymakers see the recent easing measures as "fine-tuning" even as they continue the rollout of new regulatory institutions and systems. It is thus too soon to claim that Xi Jinping or any of these government bodies have thrown in the towel on their attempts to contain excessive leverage. Both the Politburo and the State Council - the highest party and state decision-makers - have made clear that they do not intend to endorse a massive stimulus on the magnitude of 2008-09 or 2015-16.34 They have also insisted that the "Tough Battle" against systemic financial risk, and the campaign to "deleverage" the corporate sector, will continue. What does this mean in practical terms? While new regulations will be compromised, they will also continue to be implemented. For example, authorities have watered down new regulations governing the $15 trillion asset management industry, yet the regulations are still expected to go into force by 2020. These rules will weigh on shadow banking activity (e.g. wealth management products) as banks prepare to meet the requirements.35 Two other examples are critical and will be discussed below: first, the potential easing of rules under the Macro Prudential Assessment (MPA) framework for stress-testing banks; second, this year's changes to rules governing non-performing loans (NPLs). In the former case, the degree of financial easing is potentially significant but at present overestimated by investors; in the latter case, the degree of tightening is already significant and widely underestimated. Bottom Line: New financial regulatory institutions will inherently suppress credit growth, especially by dragging on informal or non-bank credit growth. Macro-Prudential Assessments: Less Easing Than Meets The Eye A key factor in determining China's credit growth going forward will be banks' responses to any softening of the Macro Prudential Assessment (MPA) requirements. News reports have suggested that a relaxation of these rules may occur, but authorities have not finalized such a move. Furthermore, the impact on credit growth may be far less than the astronomical sums being floated around the investment community. The MPA framework began in 2016. It is an evaluative system of "stress-testing" China's banks each quarter. As such it is part of the upgrade of macro-prudential systems across the world in the aftermath of the global financial crisis, comparable to the American Financial Stability Oversight Committee or the European Systemic Risk Board.36 It is managed by the PBOC and the FSDC. The MPA divides banks into systemically important financial institutions and common institutions, and subdivides the former into those of national and regional importance. The evaluation method contains seven major criteria for assessing bank stability: Capital adequacy and leverage ratios; Bank assets and liabilities; Liquidity conditions; Pricing behavior for interest rates; Quality of assets; Cross-border financing; Execution of credit policy. The first and fourth of these criteria (capital adequacy and leverage ratios, and pricing behavior for interest rates) are in bold font because they result in a "veto" over the entire assessment: if a bank fails to maintain a sufficient capital buffer, or deviates too far from policy interest rates, it can fail the entire stress-test. Otherwise, failure of any two of the other five categories results in overall failure. A system of rewards and punishments awaits banks depending on how they perform (Diagram 1). Diagram 1China's Macro Prudential Assessment Framework Explained China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? On July 20, the PBOC published a document saying that "in order to better regulate assets of financial institutions, during Macro Prudential Assessment (MPA), relevant parameters can be reasonably adjusted." Subsequently Reuters reported that the PBOC would reduce the "structural parameter" and the "pro-cyclical contribution parameter" of the capital adequacy ratio (CAR) requirements, thereby easing rules on one of the veto items. The structural parameter would fall from 1.0 to 0.5. Rumors suggest that the pro-cyclical parameter could fall from 0.4-0.8 to 0.3. No such changes have been finalized - only a few banks actually claim to have received notification of a change and there are regional differences. Clearly a general change of the rule would reduce regulatory constraints on bank credit. But how big would the impact be? Under the MPA, banks' CARs are not allowed to fall too far below the "neutral CAR," or C*, a variable that is calculated using the formula outlined in Diagram 2. Most of the variables in this formula will not change often: for instance, the minimum legal CAR will be slow to change, as will the capital reserve buffer and the bonus buffer for systemically important institutions. The one factor that can change frequently is the "discretionary counter-cyclical buffer," as it responds to the country's current place in the business cycle. Diagram 2China's Macro-Prudential Assessment Framework: Capital Adequacy Ratios China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? The key input to this factor is broad credit growth. Thus, if authorities should reduce the CAR's cyclical parameter from a simple average of 0.6 to 0.3, broad credit growth could go higher without creating an excessive increase in the pro-cyclical buffer. In other words, at present about 60% of bank credit expansion in excess of nominal GDP growth counts toward a counter-cyclical capital buffer, which is added to other capital buffers. A tweak to this parameter could decrease that proportion to 30%, meaning that bank lending could go twice as high with the same impact on the counter-cyclical buffer. More significantly, if authorities should reduce the CAR's structural parameter from 1.0 to 0.5, any increase in credit growth would have a less dramatic impact on C*. Hence banks would be able to lend more while still keeping their neutral CAR within the appropriate range relative to their actual CAR. Banks could theoretically lend twice as much with the same impact on the assessment.37 On paper these changes could result in unleashing as much as 41.4 trillion RMB in new lending in 2018, or 28 trillion (33% of GDP) on top of what could have been expected without any adjustment to the macro-prudential rules. This is because broad credit growth would theoretically be allowed to grow as fast as 30% instead of 17%.38 But in reality this growth rate is extremely unlikely. Why? Because it assumes that banks will grow their lending books as rapidly as they are allowed. In fact, banks are currently increasing broad credit at a rate of about 10%, which is considerably lower than either today's or tomorrow's permitted rate of growth under the MPA framework (Chart 26). Chart 26Banks Are Not Lending To The Regulatory Maximum China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? If tweaks to the MPA increase this speed limit to 30%, it does not mean that banks will drive any faster than they are already driving. They are lending at the current pace for self-interested reasons (and there is fear of excessive debt, default, or insolvency due to the government's ongoing regulatory and anti-corruption crackdown).39 Chart 27Regulators Can Deprive Banks Of MLF Access Regulators Can Deprive Banks Of MLF Access Regulators Can Deprive Banks Of MLF Access Still, if the MPA rules are tweaked, then it will send a signal that macro-prudential scrutiny is abating and banks can lend more aggressively - this would have some positive effect on credit growth, at least for major banks that are secure in meeting their CARs. Moreover, there will be a practical consequence in that fewer banks will be punished for having insufficient CARs. At present, only rarely do banks fail the evaluations. But a strict CAR requirement during an economic downturn could change that. The proposed MPA adjustment would show that banks are graded on a sliding rule: the authorities would slide the grading scale downward to enable more banks to pass the test. This means fewer failures, which means fewer punitive measures that could upset liquidity or stability in the banking system. Ultimately, in order for the new system to have any credibility at all, punishment will have to be meted out to banks that fail the stress tests. A key punishment within the MPA system is exclusion from medium-term lending facility (MLF) loans from the PBOC. This is a regulatory action with teeth, as this is one of the PBOC's major means of injecting liquidity (Chart 27). A misbehaving bank could face short-term liquidity shortage or even insolvency. Therefore the authorities are opting to soften the rules so that the new regulatory system is preserved yet the harshest implications are avoided (for now). This would be short-term gain for long-term pain, the opposite of what China needs from the standpoint of an investor looking for improvements to productivity and potential GDP growth. But it would not necessarily be a great boon for global risk assets in the near term. While it could help stabilize expectations for China's domestic growth, it is not clear that it would unleash a mass wave of new bank loans that would reaccelerate China's economy and put wings beneath EM assets and commodity prices. Bottom Line: Tweaking the MPA parameters is a clear example of policy easing. Yet the MPA system itself is a fairly rigorous means of stress-testing banks that is part of a much larger expansion of financial sector regulation. The results of the easier rules - if implemented - will not be as reflationary as might be expected from the headline 41 trillion RMB in new loans that could legally be created. Banks are already expanding loans more slowly than they are allowed to do, so increasing the speed limit will have little effect. The real purpose of the macro-prudential tweaks is to make it more difficult for banks to fail their stress tests in a downturn. As such, any tweaks would actually reveal that Chinese policymakers are expecting a more painful downturn, not that they are asking for a credit splurge. NPL Recognition Will Weigh On Credit Growth Another factor that we have highlighted that separates today's easing measures from outright stimulus: the growing recognition of non-performing loans (NPLs) in China's banks and the financial cleansing process. The government's reform push has already led to two trends that are relatively rare and notable in the Chinese context: rising corporate defaults (Chart 28) and rising bankruptcies (Chart 29). While the impact may be small relative to China's economic size, the direction of change is significant in a country that has been extremely averse to recognizing losses. Chart 28Defaults Are Rising China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? Chart 29Creative Destruction In China China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? These changes reflect the tightening of financial conditions and restructurings of various industries and as such are evidence of Xi's attempt to make progress on reforms while maintaining stability. They also reflect a general environment that is conducive to the realization of bad loans. Two recent policy decisions are affecting banks' accounting of bad loans. First, the CBIRC issued new guidance that eases NPL provision requirements for "responsible" banks (banks with good credit quality) while maintaining the existing requirements for "irresponsible" banks.40 Since the major state-controlled banks will largely meet the standards, they will be able to lend somewhat more (we estimate around 600 billion RMB or 0.7% of GDP). This would support the recent trend in which traditional bank lending rises as a share of total credit growth. Second, however, the CBIRC is requiring banks to reclassify all loans that are 90-or-more-days delinquent as NPLs, resulting in upward revisions of bank NPL ratios. This will send the official rate on an upward march toward 5%, from current extremely low 1.9% (Chart 30). It is the direction of change that matters, as NPL recognition can take on a life of its own. While many state banks may already have recognized the 90-day delinquent loans, many small and regional banks probably have not. Anecdotally, a number of small banks are reporting large NPL ratios as a result of the regulatory clampdown and definition change. Rural commercial banks, in particular, are in trouble with several showing NPLs in double digits (Chart 31). These small and regional banks will have until an unspecified date in 2019 to reclassify these loans and raise provisions against them. The result will hamper credit growth. Chart 30Bad Loan Ratios Set To Rise Bad Loan Ratios Set To Rise Bad Loan Ratios Set To Rise Chart 31City And Rural Commercial Banks Most At Risk Of Rising Bad Loans China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? To get a more detailed picture of the NPL recognition process, we have updated our survey of 16 commercial banks listed on the A-share market.41 This research reveals that banks have continued to increase the amount of bad loans they have written off. While the NPL ratio has remained roughly the same, cumulative loan-loss write-offs combined with NPLs have reached 7% of total loans and are still rising (Chart 32). This shows that a cleansing process is well underway. It is concerning that write-offs have reached nearly 50% of pre-tax profits. And even as losses mount, the proportion of each year's losses to the previous year's NPLs has fallen, implying that the previous year's NPLs had grown bigger (Chart 33). Chart 32The Bank Cleansing Process Continues China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? Chart 33Write-Offs Almost 50% Of Bank Profits Write-Offs Almost 50% Of Bank Profits Write-Offs Almost 50% Of Bank Profits Furthermore, while loan losses grow, the surveyed banks' profit growth has been reduced to virtually zero (Chart 34). Chart 34Write-Offs Almost 50% Of Bank Profits Write-Offs Almost 50% Of Bank Profits Write-Offs Almost 50% Of Bank Profits Our updated "stress test" for Chinese banks, which is based on the same sample of 16 commercial banks, suggests that if total NPLs rise to a pessimistic, but still quite realistic, ratio of 13% (a weighted average of NPL ratio assumptions per sector, ranging from 10%-30%), then total losses could amount to 10.4 trillion RMB, or 12% of GDP (Table 6). Table 6Pessimistic Scenario Analysis##br## For Commercial Bank NPLs China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? In this scenario, banks' net equity would be impacted by 38% as this amount surpasses the buffer of net profits (1.75 trillion RMB) and NPL provisions (3 trillion). China's banks are well provisioned, but they would be less so after a hit of this nature. A similar stress-test by BCA's Emerging Markets Strategy found that equity impairment could range from 33%-49%, implying that Chinese banks were roughly 29% overvalued on a fair price-to-book-value basis.42 Looking at different economic sectors, it is apparent that domestic trade, manufacturing, and mining have seen the highest incidence of loans going sour (Table 7). In all three cases, it is reasonable to conjecture that the NPL ratio can continue to expand - and not only because of the definitional change. First, wholesale and retail (4.7%) consists largely of SMEs, and the government is publicly concerned about their ability to get credit. Second, manufacturing (3.9%) has been hit by changing trade patterns and rising labor costs and has not yet suffered the impact from recently imposed U.S. trade tariffs. Third, mining (3.6%) has felt the first wave of the impact from the government's cuts to overcapacity in recent years, but has seen very extensive restructuring and the fallout may continue. Table 7China: Troubled Sectors Can Produce More Bad Loans China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? More realistic NPL recognition is an important and positive development for China over the long run. Over the short run, banks' efforts to write-off NPL losses will weigh on their willingness to lend and could pose a risk to overall economic activity. Bottom Line: The government's reform and restructuring efforts are initiating a process of creative destruction in the Chinese economy. This is most notable in the government's willingness to recognize NPLs, which will continue to weigh on credit growth. The government is trying to control the pace and intensity of this process, but we expect credit stimulus to be disappointing relative to fiscal stimulus as long as the financial regulatory crackdown is at least half-heartedly implemented. Anti-Corruption Campaign Is Market-Negative Another reason to expect total credit growth to remain subdued comes from the anti-corruption campaign and its probes into local government finances and the financial sector. Chart 35Anti-Corruption Campaign Trudges Onward Anti-Corruption Campaign Trudges Onward Anti-Corruption Campaign Trudges Onward One of the new institutions created in China's 2017-18 leadership reshuffle was the National Supervisory Commission (NSC). This is a powerful new commission that is capable of overseeing the highest state authority (the National People's Congress). It is also ranked above the formal legal system, the Supreme Court and the public prosecutor's office. It is charged with formalizing the anti-corruption campaign and extending it from the Communist Party into the state bureaucracy, including state-owned enterprises.43 Having operated for less than a year, it is not possible to draw firm conclusions about the doings of the NSC, let alone any macro impact. Tentatively, the commission has focused on financial and economic crimes that have the potential to create a "chilling effect" among government officials and bank executives.44 Notably, the NSC has investigated Lai Xiaomin, former chief executive of Huarong, the largest of the big four Asset Management Corporations (AMCs), i.e. China's "bad banks." There is more than one reason for Huarong to attract the attention of investigators, but it is notable that it had extensive investments in areas outside its official duty of acquiring and disposing of NPLs. The implication could be that the government wants the AMCs to focus on their core competency: cleaning up the coming deluge of NPLs. The anti-corruption is also targeting local government officials for misappropriating state funds. These investigations involve punishment of provincial officials for false accounting as well as embezzlement and other crimes. We have noted before that the provinces that revised down their GDP growth targets most aggressively this year were also some of the hardest hit with anti-corruption probes into falsifying data and misallocating capital.45 On several occasions it has appeared as if the anti-corruption campaign was losing steam, but the broadest tally of cases under investigation suggest that it is still going strong despite hitting a peak at the beginning of the year (Chart 35). The campaign remains a potential source of disruption among the very officials whose risk appetite will determine whether central government policy easing actually results in additional bank lending and local government borrowing. Bottom Line: While difficult to quantify, the anti-corruption campaign will dampen animal spirits within local governments and the financial sector as long as the new NSC is seeking to establish itself and the Xi administration remains committed to prosecuting the campaign aggressively. Investment Conclusions Table 8Estimates Of Hidden Local Government Debt China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? We would be surprised if credit growth did not perk up at least somewhat as a result of the past month's easing measures. But as outlined above, these measures may disappoint the markets as a result of the ongoing financial regulatory drive, the baggage of NPL recognition, and any negative impact on risk appetite due to the anti-corruption campaign. And this is not even to mention the dampening effects of ongoing property sector and pollution curbs.46 In lieu of a credit surge, Beijing is likely to rely more on fiscal spending to stabilize growth. Fiscal spending also faces complications, of course. In recent years, China's local governments have built up a potentially massive pool of off-balance-sheet debt due to structural factors limiting local government revenue generation (Table 8). Beijing is now attempting to force this debt into the light. The local government debt maturity schedule suggests a persistent headwind in coming years as hidden debt is brought onto the balance sheet and governments scramble to meet payment deadlines (Chart 36). In addition, the local government debt swap program launched in 2014-15 will wrap up this month. Chart 36Local Governments Face Rising Debt Payments China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? Nevertheless Beijing has introduced a new class of "refinancing bonds" in 2018 to help stabilize the fiscal situation. These bonds are separate from brand new bonds that have the potential to increase significantly over the second half of this year. China's Finance Ministry has also reportedly asked local governments to issue 80 percent of net new special purpose bonds by the end of September. Since only about a quarter of the year's 1.35 trillion RMB quota was issued in H1, this order would mean that about half of the quota (675 billion RMB out of 1.35 trillion RMB) would be issued in August and September alone - implying a significant surge to Chinese demand, albeit with a lag of six months or so.47 The latest data releases from July suggest that Beijing is trying to do two things at once: ease liquidity conditions while cracking down on excess leverage. Until we see a spike in credit growth, we will continue to expect the policy turn to be only moderately reflationary, with the ability to offset existing headwinds but not spark a broad-based reacceleration of the economy. Going forward, data for the month of August will be very important to monitor, as many of the easing measures were not announced until late July. For all the reasons outlined in this two-part Special Report, we would view a sharp increase in total credit as a game-changer that would point toward a "stimulus overshoot" (Appendix). Such an overshoot is less likely if the government relies more heavily on fiscal spending this time around, which is what we expect. Meanwhile, turmoil in emerging markets - which we fully anticipated based on China's policy headwinds this year and our dollar bullish view - will only be exacerbated by China's unwillingness to stimulate massively.48 Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Qingyun Xu, Senior Analyst qingyun@bcaresearch.com Yushu Ma, Contributing Editor yushum@bcaresearch.com Appendix Appendix China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? Appendix China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 3 Please see The Bank Credit Analyst Special Report, "A Long View Of China," dated December 28, 2017, available at bca.bcaresearch.com. 4 The fact that he began tightening financial policy in late 2016 and early 2017 was especially significant because only a very self-assured leader would attempt something so risky ahead of a midterm party congress. 5 Please see BCA Geopolitical Strategy Weekly Reports, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, and "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 6 The statement declared in its first paragraph that China would "maintain the stability of employment," with employment being the first item in a list. A similar emphasis on employment has not been seen in Politburo statements since the troubled year of 2015, and it has not been mentioned substantively in 11 key meetings since the nineteenth National Party Congress last October. 7 Please see footnote 2 above. 8 After the State Council meetings on July 23 and 26, Vice-Minister of Finance Liu Wei elaborated on the government's thinking: "These [measures] further add weight to the overall broad logic at the start of the year ... It isn't at all that the macro-economy has undergone any major volatility, and we are not undertaking any irrigation-style, shock-style measures." Please see "Beijing Sheds Light On Plans For More Active Fiscal Policy," China Banking News, July 27, 2018, available at www.chinabankingnews.com. 9 Our colleagues in BCA's Emerging Markets Strategy service have dubbed this policy "triple tightening." Please see BCA Emerging Markets Strategy Weekly Report, "EM And China: A Deleveraging Update," dated November 8, 2017, available at gps.bcaresearch.com. 10 This spike in net new issuance in the single month of June is equivalent to 19.8% of the total net new issuance in 2017. It is also much higher than the average monthly issuance in 2014-17 or in 2017 alone. However, since June and July have typically seen the largest spikes in new issuance, it will be critical to see if new issuance in 2018 remains elevated after July. Notably, local government bond issuance is currently divided between brand new bonds, debt swap bonds, and refinancing bonds, but the debt swap program will expire in August, and the refinancing bonds are separate, meaning that a larger share of the allowed new issuance will involve new spending. 11 The IMF expects the change in local government explicit debt this year to be 1.9 trillion RMB. That is, a rise from 16.5 trillion existing to 18.4 trillion estimated. 12 This number is derived by assuming that total debt reaches 92.2% of the debt limit in 2018, which is the share it reached in 2015 (since 2015 the share has fallen to 87.5% in 2017). However, 2015 was a year of fiscal easing, so it is not unreasonable to apply this ratio to 2018 as an upper estimate, now that the government's easing signal is clear. One reason that local governments have been increasing debt more slowly than allowed was that the central government was tightening investment restrictions, for instance on urban rail investment. Many new subway projects of second-tier cities have been suspended, and after raising the qualifications for subway and light rail, the majority of third- and fourth-tier cities were not qualified to build urban rail at all. As a result, local governments' investment intentions were dropping. Now this may change. 13 This estimate comes from the Ministry of Finance. The previous estimate was from the National Accounting Office and stood at 7 trillion RMB as of June 2013. 14 Maturities will spike in the coming years, so this policy signal suggests that further support for refinancing will be forthcoming. There are even unconfirmed rumors of a second phase of the local government debt swap program, which would cover "hidden debt." 15 We say "minimum" because we do not include projections of the impact of tax deductions, lacking details. We only estimate the headline savings to household incomes - loss to government revenues - based on the increase of the individual income tax eligibility threshold and the reduction in tax rates for different income brackets. 16 Additional fiscal measures include corporate tax cuts, R&D expense credits, VAT rebates, and reductions in various fees. 17 Please see BCA Geopolitical Strategy Monthly Report, "What Geopolitical Risks Keep Our Clients Awake?" dated March 9, 2016, available at gps.bcaresearch.com. 18 In fact it is more like 1.9 trillion due to strings attached, but a fourth or even fifth RRR cut could push it 3.5 trillion for the year, assuming the average 800 billion cut. 19 Ultimately this trend will result in tightening liquidity conditions in China, but for now forex reserves are not draining massively, while the RRR cuts are easing domestic liquidity. 20 Please see "China Said To Ease Bank Capital Rule To Free Up More Lending," Bloomberg, July 25, and "China's Central Bank Steps Up Effort To Boost Lending," August 1, 2018, available at www.bloomberg.com. 21 Please see BCA Emerging Markets Strategy Special Report, "Ms. Mea Challenges The EMS View," dated October 19, 2017, available at ems.bcaresearch.com. 22 Please see BCA Research Special Report, "China: Party Congress Ends ... So What?" dated November 2, 2017, available at bca.bcaresearch.com. 23 Please see BCA Foreign Exchange Strategy Weekly Report, "The Dollar And Risk Assets Are Beholden To China's Stimulus," dated August 3, 2018, available at fes.bcaresearch.com. 24 Please see BCA Global Investment Strategy Weekly Report, "Three Macro Paradoxes Are About To Come True," dated August 3, 2018, available at gis.bcaresearch.com. 25 Please see BCA China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle," dated November 30, 2017, available at cis.bcaresearch.com. 26 Please see BCA China Investment Strategy Weekly Report, "China Is Easing Up On The Brake, Not Pressing The Accelerator," dated July 26, 2018, available at cis.bcaresearch.com. 27 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 28 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 29 Please see BCA Geopolitical Strategy Special Report, "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017, available at gps.bcaresearch.com. 30 Please see BCA Geopolitical Strategy Special Report, "Politics Are Stimulative, Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 31 Please see BCA Geopolitical Strategy Special Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 32 Please see footnote 31 above. 33 Please see BCA Geopolitical Strategy Weekly Report, "Italy, Spain, Trade Wars... Oh My!" dated May 30, 2018, available at gps.bcaresearch.com. 34 Please see Part I of this report. 35 Please see BCA China Investment Strategy Weekly Report, "Now What?" dated June 27, 2018, available at cis.bcaresearch.com. Note that according to the new asset management rules, financial institutions will be required to have a risk reserve worth 10% of their fee income, or corresponding risk capital provisions. When the risk reserve balance reaches 1% of the product balance, no further risk provision will be required. We estimate that setting aside these funds will be a form of financial tightening worth about 1.2% of GDP. 36 Please see Liansheng Zheng, "The Macro Prudential Assessment Framework of China: Background, Evaluation and Current and Future Policy," Center for International Governance Innovation, CIGI Papers No. 164 (March 2018), available at www.cigionline.com. 37 Recall that the second category of the MPA consists of bank assets and liabilities. This category also has a rule for broad credit growth, which is that it should not exceed broad money (M2) plus 20%-25%. Therefore passing this part of the exam already requires banks to meet a 28%-33% speed limit on new credit. Assuming that that the pro-cyclical parameter of the CAR category remains at its current minimum of 0.4, then the structural parameter cannot be effectively pushed any lower than 0.6-0.8. The bottom line is that pushing the CAR structural parameter lower is not going to yield a significant increase in the allowable rate of credit growth. 38 To reach this estimate, we began with the fact that the outstanding level of broad credit growth was around 207 trillion RMB by the end of 2017 (that is, loans plus bonds plus equities plus wealth management products and other off-balance-sheet assets). The 2017 growth rate was about 10% and is assumed to be the same in 2018. Therefore broad credit should reach 227.7 trillion by the end of the year. Then, if we assume that all banks lend at the maximum weighted growth rate allowed by adjusting the structural parameter in the MPA CAR requirement (which is 30%), outstanding broad credit would reach 269.1 trillion by the end of the year. Hence an extra 41.4 trillion RMB in broad credit growth would be released. For comparison, please see CITIC Bond Investment, "Deep Analysis: Impact of Parameter Adjustments in the MPA Framework," July 30, 2018, available at www.sohu.com. 39 Based on actual CARs in 2017, the limit to broad credit growth was 17%-22% for large state-owned banks, 10%-20% for joint-equity banks, and 15%-20% for city or rural commercial banks. However, the actual broad credit growth for most banks was a lot lower than that. For example, for all five state-owned banks (nationally systemically important financial institutions), it was below 10%, well beneath the 17%-22% determined by their actual CARs and C*. 40 Under current regulations, the loan provision ratio is 2.5% while the NPL provision coverage ratio is 150%. The higher of the two is the regulatory standard for commercial banks. On February 28, 2018, the China Banking Regulatory Commission issued a notice declaring that the coverage requirement would change to a range of 120%-150%, while the loan provision requirement would change to a range of 1.5%-2.5%. Banks would qualify for the easier requirements according to how accurately they classified their loans, whether they disposed of their bad loans, and whether they maintained appropriate capital adequacy ratios. This could result in a release of about 800 billion RMB worth of provisions that can be kept as core tier-1 capital or support new lending. 41 Please see BCA China Investment Strategy Special Report, "Stress-Testing Chinese Banks," dated July 27, 2016, available at cis.bcaresearch.com. 42 Please see BCA Emerging Markets Strategy Weekly Report, "Mind The Breakdowns," dated July 5, 2018, and Special Report, "Long Indian / Short Chinese Banks," dated January 17, 2018, available at ems.bcaresearch.com. 43 Please see Jamie P. Horsley, "What's So Controversial About China's New Anti-Corruption Body?" The Diplomat, May 30, 2018, available at thediplomat.com. 44 The NSC is operationally very close to the Central Discipline Inspection Commission (CDIC), which is the Communist Party corruption watchdog formerly headed by heavyweight Wang Qishan. It received only a 10% increase in manpower over the CDIC in order to expand its target range by 200% (covering all state agencies and state-linked organizations). It has allegedly meted out 240,000 punishments in the first half of 2018, up from 210,000 during the same period last year and 163,000 in H1 2016. About 28 of these cases were provincial-level cases or higher. The controversy over the "rights of the detained" has been highlighted by the beating of a local government official's limousine driver in one of the organization's first publicly reported actions. The NSC has also arrested local government officials tied to "corruption kingpin" Zhou Yongkang and known for misappropriating budgetary funds, and has secured the repatriation of fugitives who fled abroad and recovered the assets that they stole or embezzled. 45 The provinces include Tianjin, Chongqing, Liaoning, Inner Mongolia, etc. Please see BCA Geopolitical Strategy "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. There is empirical evidence that anti-corruption probes are correlated with debt defaults. Please see Haoyu Gao, Hong Ru and Dragon Yongjun Tang, "Subnational Debt of China: The Politics-Finance Nexus," dated September 12, 2017, available at gcfp.mit.edu. 46 Please see BCA Emerging Markets Strategy Special Report, "China Real Estate: A Never-Bursting Bubble?" dated April 6, 2018, available at ems.bcaresearch.com, and Commodity & Energy Strategy Weekly Report, "Blue Skies Drive China's Steel Policy," dated August 9, 2018, available at ces.bcaresearch.com. 47 Please see "As economy cools, China sets deadline for local government special bond sales," Reuters, dated August 14, 2018, available at www.reuters.com. For more on local government bond issuance, see Part I of this series in footnote 1 above. Note also rumors in Chinese media suggesting that a new local government debt swap program could be launched with the responsibility of tackling off-balance-sheet debts that are guaranteed by local governments. The program has thus far only swapped debts that local governments were obligated to pay. It is not clear what would happen to a third class of local debt, that which is neither an obligation upon local governments nor guaranteed by them but that nevertheless is deemed to serve a public interest. 48 Please see BCA Geopolitical Strategy Weekly Report, "The EM Bloodbath Has Nothing To Do With Trump," dated August 14, 2018, available at gps.bcaresearch.com.

Dear client, Our publishing schedule will be shifting over the next two weeks. Next Friday, we will publish a Special Report aggregating various pieces from our colleague Matt Gertken of BCA's Geopolitical Strategy detailing the reforms taking place in China and their past and future evolution, and the economic and investment implications for China and the rest of the world. Matt argues that Chinese reforms are in place and here to stay, which should deepen the malaise in EM and support the dollar. We will not publish any report on August 31st. We will resume our regular publishing schedule on September 7. I hope you enjoy the rest of your summer. Best regards, Mathieu Savary Highlights The 1997 Asian Crisis was a deflationary event, causing commodity prices, commodity currencies and the yen to fall against the dollar, but it had a limited impact on the euro. When Russia collapsed in 1998, the LTCM crisis hit the U.S. banking system, with fears of solvency dragging Treasury yields lower, hurting the dollar against the yen and the euro. Today is not 1997, but the tightness of the U.S. economy suggests the Federal Reserve will need a large shock before abandoning its current pace of a hike per quarter; additionally, global liquidity conditions are tightening and China is slowing. The EM crisis is therefore not over, and vulnerable Brazil, Chile, Mexico, Colombia and South Africa could still experience significant pain. Unlike in 1998, the hot potato is not hiding in the U.S. but in Europe. A contagion event is therefore more likely to hurt the euro than 20 years ago; meanwhile, the yen stands to benefit. DXY could hit 100, and commodity currencies still have ample downside, the AUD in particular. Continue to monitor our China Play Index to gauge if Chinese stimulus could delay the day of reckoning for EM; this index can also be employed as a hedge for investors long the dollar or short EM plays. Feature "Misfortune tests the sincerity of friends." - Aesop This summer is oddly reminiscent of that of 1997. The Federal Reserve is tightening policy because the U.S. economy is not only at full employment but is also growing strongly and generating increasing domestic inflationary pressures. But the most familiar echoes come from outside the U.S. Specifically, emerging market trepidations are once again front page news as the Turkish lira, which had already fallen by 24% between January 2018 and July 31st, dropped by an additional 28% at its worst in a mere two weeks. Consequently, investors are now fretting about the risks of contagion across EM markets, one that could reverberate among G10 economies as well. We too worry that the echoes of 1997 are becoming increasingly louder. EM economies have built up large stocks of debt, and have financed themselves heavily by tapping foreign investors. However, these investors can be rather fickle friends, and we are set to test their sincerity. In this piece, we review how the events of 1997-'98 unfolded, what it meant for G10 currencies, and whether the same lessons can be applied today. We find that in 2018, an EM crisis could ultimately be more supportive for the dollar versus the euro, as unlike in 1998, where the hot potatoes were held by U.S. hedge funds, this time the mess sits squarely in Europe. Tom Yum Goong Goes Viral Initiated in the second half of the 1980s, the peg of the Thai baht seemed like a very successful experiment. The stability created by this institutional setup not only contributed to keeping Thai inflation at manageable levels, but by incentivizing capital inflows in the country it also helped Thailand build up its capital stock. At the time, this yielded a large growth dividend, with real GDP growth averaging 9% from 1985 to 1996. However, the economic boost generated by this cheap financing had a dark side. The Thai current account balance ballooned to a deficit of 8% of GDP in 1995-'96. As Herb Stein famously expressed, if something cannot go on forever, it will stop. Like in Aesop's fable where one of two travelers climbed up a tree to avoid a bear, leaving his friend to fend off the bear on his own, foreign investors abandoned Thailand, which was left on its own to finance its large current account deficit. While the Bank of Thailand was able to fend off the attacks for a few weeks, on July 2nd, 1997, it abandoned its efforts. The THB was left to float freely and dropped 56% against the USD over the subsequent six months. Other EM countries including Malaysia, Brazil and Korea, to name a few, had implemented similar U.S. dollar pegs. They too enjoyed stable inflation, growing money inflows and improved growth, but also experienced growing current account deficits and foreign currency debt loads. It did not take long for investors to extrapolate Thailand's woes to other countries. The Malaysian ringgit and the Indonesian rupiah began falling soon after the THB, while the Korean won began its own steep descent four months later (Chart 1). The economic pain was felt globally. The collapse in EM Asian exchange rates and the deep recessions experienced in these countries caused their export prices to collapse, which created a global deflationary shock (Chart 2). This shock was compounded by a fall in commodity prices that materialized as market participants realized that demand for commodities from the crisis-stricken countries was set to evaporate (Chart 2, bottom panel). Chart 1How The Thai Crisis Morphed Into An Asian Crisis How The Thai Crisis Morphed Into An Asian Crisis How The Thai Crisis Morphed Into An Asian Crisis Chart 2The Asian Crisis Was A Deflationary Shock The Asian Crisis Was A Deflationary Shock The Asian Crisis Was A Deflationary Shock Not only did this deflationary shock lift the USD against EM currencies and commodity currencies, it also caused inflation breakevens in the U.S. to fall significantly (Chart 3). However, because the U.S. economy remained robust through the second half of 1997 and in the early days of 1998, real rates did not respond much (Chart 3, bottom panel). Markets where not very concerned that this shock would force the Fed to cut rates, as it did not seem to affect the outlook for U.S. growth and employment. However, this combination of stable real rates in the face of weaker growth in EM, as well as the collapse in commodity prices ended up having large second-round effects. Russia defaulted in August 1998, prompting a collapse in the ruble. To patch up its finances, Russia began pumping ever more oil out of the ground, causing oil prices to fall below US$10/bbl in December 1998, deepening the malaise in commodity prices. This caused the Brazilian real to collapse in 1999, and the Argentinian peso to follow in 2002 (Chart 4). Chart 31997: Falling Breakevens, Stable Real Yields 1997: Falling Breakevens, Stable Real Yields 1997: Falling Breakevens, Stable Real Yields Chart 4Asian Crisis Goes Global Asian Crisis Goes Global Asian Crisis Goes Global Among these contagions, the Russian default was the event with the greatest systemic impact. This was because it was a direct hit to the U.S. banking system. Long Term Capital Management, a large Connecticut-based hedge fund, had accumulated massive bets on Russia. The country's default plunged the fund into the abyss. However, LTCM had liabilities to banks to the tune of US$125 billion. The exposure was perceived as an existential threat to the banking sector, and the market began to anticipate a repeat of the 1907 panic.1 Junk bond spreads jumped, the S&P 500 fell by 18%, and U.S. government bond yields collapsed by 120 basis points (Chart 5). The Fed was forced to respond, coming out of hibernation and cutting rates by 75 basis points between September and November of 1998. As the Fed forcefully responded to this shock and 10-year Treasury yields fell, the dollar, which had managed to stay somewhat stable against the synthetic euro from July 1997 to August 1998, fell 11%. Within the same one-year window starting in July 1997, the yen dropped 23%, dragged lower by the competitive pressures created by weaker Asian currencies. However, as soon as U.S. bond yields collapsed, the yen began to surge, rising by 36% from August 1998 to January 1999 (Chart 6). Only once the Fed started increasing rates anew did the euro and the yen level off. Chart 5The Russian Default Was The Real Shock For The U.S. The Russian Default Was The Real Shock For The U.S. The Russian Default Was The Real Shock For The U.S. Chart 6The Dollar Buckled After LTCM The Dollar Buckled After LTCM The Dollar Buckled After LTCM In aggregate, the dollar's performance through the 1997-1998 period was very mixed. The trade-weighted dollar managed to rise from July 1997 to August 1998. Nevertheless, this was a complex picture. During this timeframe the dollar rose against EM currencies - against the CAD, the AUD, the NZD and the JPY - but was flat against the euro. The USD then fell against everything from August 1998 to the first half of 1999. Only once the Fed started hiking again in the summer 1999, was the greenback able to resuming its broad ascent, one that lasted all the way until late 2001. Bottom Line: In 1997, the first domino to fall was Thailand. Since many East Asian economies suffered the same ills - current account deficits, foreign currency debt loads and falling foreign exchange reserves - Asian currencies followed, dragging the yen lower in the process. This generated a deflationary shock that hurt commodity prices and commodity currencies, leading to the infamous Russian default of 1998. The associated LTCM bankruptcy threatened the survival of the U.S. banking system, forcing bond yields much lower as the Fed cut rates three times. The dollar suffered because of this policy move, especially against the yen. However, once the Fed resumed its hiking campaign, the dollar recovered across the board, making new highs all the way to late 2001 and early 2002. Is 2018: 1997, 1998, Or 2018? In one key regard, today is not the late 1990s: Dollar pegs are few and far between. However, in many respects, similarities abound. First and most obviously, EM foreign currency debt loads, as measured against exports, GDP or reserves, are at similar levels to those prevailing in the late 1990s (Chart 7). This means that EM economies suffer when the dollar rises, as it represents an increase in their cost of capital, and thus a tightening in financial conditions. Second, the Fed has been increasing interest rates. Most importantly, the Fed is growingly concerned that domestic inflationary pressures in the U.S. are intensifying, courtesy of strong growth - at least relative to potential; a high degree of capacity utilization, especially in the labor market (Chart 8); and, unique to today, the U.S. has received a large degree of unneeded fiscal stimulus. Chart 7EM Dollar Debt Is High EM Have More ##br##Foreign-Currency Debt Than In The 1990s EM Dollar Debt Is High EM Have More Foreign-Currency Debt Than In The 1990s EM Dollar Debt Is High EM Have More Foreign-Currency Debt Than In The 1990s Chart 8The Foreign Pain Threshold For The Fed Is Much Higher ##br##Now Than In 2015 or 2016 The Foreign Pain Threshold For The Fed Is Much Higher Now Than In 2015 or 2016 The Foreign Pain Threshold For The Fed Is Much Higher Now Than In 2015 or 2016 This means it will take a lot of pain to derail the Fed from its desire to hike rates once a quarter. This also makes the current environment very different from 2015, the most recent episode of EM tumult. In 2015-2016, the Fed easily abandoned its hiking campaign. When it hiked rates in December 2015, the Fed anticipated increasing rates four times over the following 12 months. It delivered only one hike in December 2016. The reason was straightforward: Unlike today, the U.S. economy was still replete with slack (Chart 8) and was not on the receiving end of a large fiscal stimulus program, suggesting the Fed could not tolerate the deflationary impact of tightening financial conditions. Third, global liquidity is tightening, which is hurting the global growth outlook. Today, global excess money, as defined by the growth of broad money supply above that of loan growth in the U.S., the euro area and Japan, is contracting. Today, as in 1997, this indicator forebodes important weaknesses in global industrial production (Chart 9). U.S. liquidity is particularly important. Not only is dollar-based liquidity crucial to financing the large stock of dollar-denominated foreign debt, but the U.S. is also driving the fall in global excess money. The pick-up in U.S. economic activity is sucking liquidity from both the rest world and from the financial system to finance U.S. loan growth (Chart 10). This phenomenon was also at play in 1997. Chart 9Excess Money Is Contracting Global Excess ##br##Money Contracting, Just Like In Early 1997 Excess Money Is Contracting Global Excess Money Contracting, Just Like In Early 1997 Excess Money Is Contracting Global Excess Money Contracting, Just Like In Early 1997 Chart 10The U.S. Economy Is ##br##Sucking In Liquidity The U.S. Economy Is Sucking In Liquidity The U.S. Economy Is Sucking In Liquidity Why does this matter? Simply put, U.S. financial liquidity; built as a composite of 3-month T-bills, total bank deposits minus bank loans, bank investments, and M2 money supply; is a wonderful leading indicator. The current collapse in financial liquidity suggests that the global economy is about to hit a rough patch. As Chart 11 illustrates, the weakness of this indicator points to declines in our Global Leading Economic Indicators and in global commodity prices. This suggests the indicator is foretelling that a deflationary scare could materialize, an event normally also associated with a stronger dollar and downside in EM export prices (Chart 12). In a logically consistent fashion, the liquidity indicator is also warning that the AUD, CAD and NZD have substantial downside, while EM equity prices could also suffer more (Chart 13). Finally, it also highlights that even the U.S. stock market may not be immune to upcoming troubles (Chart 14). Chart 11U.S. Financial Liquidity Points To Weaker Growth... U.S. Financial Liquidity Points To Weaker Growth... U.S. Financial Liquidity Points To Weaker Growth... Chart 12...And A Stronger Dollar But Weaker EM Export Prices... ...And A Stronger Dollar But Weaker EM Export Prices... ...And A Stronger Dollar But Weaker EM Export Prices... Chart 13...Falling EM Stocks And Commodity Currencies... ...Falling EM Stocks And Commodity Currencies... ...Falling EM Stocks And Commodity Currencies... Chart 14...And Maybe Even A Correction In U.S. Stock Prices ...And Maybe Even A Correction In U.S. Stock Prices ...And Maybe Even A Correction In U.S. Stock Prices Fourth, gold is sending a similar signal as in the late 1990. As we have argued in the past, gold is a very good gauge of global liquidity conditions. During the Asian Crisis and the Russia/LTCM fiasco, industrial commodity prices only experienced a serious decline after the Thai baht had dragged down Asia into a tailspin. However, gold had been falling since 1996, a move predating the fall in Asian currencies (Chart 15). The precious metal was confirming that global liquidity was tightening and being sucked back into the booming U.S. economy. Today, gold prices are sending an ominous signal. After forming a large tapering wedge from 2011 to 2018, gold prices have broken down below the major upward-sloping trend line that had defined the bull market that began in 2001 (Chart 16). This indicates that gold may be starting another leg of a major bear market. Moreover, as the bottom panel of Chart 16 illustrates, it is true that net speculative positions in the yellow metal have plunged, but they remain far above the large net short positions that prevailed in the late 1990s. If gold is indeed entering another major down leg, this would confirm that tightening liquidity will further hurt EM asset prices, commodity prices and non-U.S. economic activity. Chart 15As Early As 1996, Gold Warned Of Upcoming Problems In Asia As Early As 1996, Gold Warned Of Upcoming Problems In Asia As Early As 1996, Gold Warned Of Upcoming Problems In Asia Chart 16Is A Secular Bear Market In Gold Beginning? Is A Secular Bear Market In Gold Beginning? Is A Secular Bear Market In Gold Beginning? Finally, adding insult to injury is China. The current communist party leadership is hell-bent on reforming the Chinese economy, moving it away from its dependence on capex and leverage. Consequently, China is in the midst of a major deleveraging campaign concentrated in the shadow banking sector, which has already caused money growth and total social financing to plumb to new lows (Chart 17). This is deflationary for the global economy as weaker Chinese credit weighs on capex, which in turns weighs on Chinese imports, as 69% of China's intake from the rest of the world are commodities and intermediate as well as industrial goods. Chart 17Chinese Monetary And Credit Conditions Remain ##br##Tight China Deleveraging Is Biting Chinese Monetary And Credit Conditions Remain Tight China Deleveraging Is Biting Chinese Monetary And Credit Conditions Remain Tight China Deleveraging Is Biting Chart 18No Capitulation ##br##Yet No Capitulation Yet No Capitulation Yet Moreover, the recent wave of renminbi weakness is exacerbating these deflationary pressures. The 9% fall in the yuan versus the dollar since April 11th represents a competitive devaluation that will hurt many EM countries. It also implies downside in China's import volumes, as it increases the prices paid by Chinese economic agents for foreign-sourced industrial goods and commodities.2 All these forces suggest that the pain that started in Argentina and Turkey could continue to spread across other vulnerable EM economies. It is doubtful that economies with large debt loads, large upcoming debt rollovers and other underlying economic problems will find it easy to receive financing in an environment of declining global liquidity, a strong dollar, budding deflationary pressures and a slowing China. Making this worry even more real, EM investors have not capitulated, as bottom-fishing has prompted massive inflows into Turkey in recent days (Chart 18). 2018 may not be 1997 or 1998, but it is likely to be a year to remember. Bottom Line: EM currency pegs to the dollar may not be as prevalent as they were back in the 1990s, but enough risks are present that contagion from Argentina and Turkey to other EM economies is a very real risk. Specifically, the domestic economic situation in the U.S. warrants higher interest rates, which suggests the Fed is unlikely to be fazed by EM market routs unless they become deep enough to present a threat to U.S. growth itself. Moreover, global liquidity conditions are tightening as the U.S.'s economic strength is sucking in capital from around the world. This combination means that EM countries with large dollar debt loads are likely to find debt refinancing a very onerous exercise. Finally, China is slowing and letting the RMB fall, which is exerting a deflationary impact on the world. Investment implications An environment of slower global economic activity, tightening global liquidity conditions and a potential deflationary scare is positive for the dollar. But 1998 shows that if the hot potato hides in the U.S. and the Fed is forced to ease aggressively, the dollar could nonetheless suffer. In order to get a sense as to whether the dollar can continue to strengthen or not, it is important to get a sense of where the exposure to an EM accident may lie. To begin this exercise, we need to first assess which EM countries are most vulnerable to catching the "Turkish Flu." To do so, we collaborated with our colleague Peter Berezin and his team at BCA's Global Investment Strategy to build a heat map of vulnerable EM economies. This heat map is based on the following factors: current account balance, net international investment position, external debt, external debt service obligation, external funding requirements, private sector savings/investment balance, private sector debt, government budget balance, government debt, foreign ownership of local currency bonds, and inflation. This method shows that after Turkey and Argentina, the next six most vulnerable countries are Colombia, Brazil, Mexico, Chile, South Africa, and Indonesia in this order (Chart 19). Chart 19Vulnerability Heat Map For Key EM Markets The Bear And The Two Travelers The Bear And The Two Travelers While our long-term valuation models show that the Colombian peso is already trading at a significant discount to its fair value, the BRL, the CLP, the ZAR, and the MXN are not (Chart 20). This highlights that these markets could provide serious fireworks in the coming months. Moreover, they all have their own idiosyncrasies that accentuate these risks. Brazil will soon undergo elections that will likely not result in a market-friendly outcome.3 Chile has an extremely large dollar-debt load, copper prices are tanking and the CLP is very pricey. Finally, South Africa is contemplating the kind of land expropriations reminiscent of those that plunged Zimbabwe into chaos - not a good optic for a still-expensive currency. So, who is most exposed to this potential mess? The answer is the euro area, most specifically, Spain. As Chart 21 shows, the exposure of Spanish banks to the most vulnerable EM markets totals nearly 170% of the banking system's capital and reserves. This means that 30% of the capital and reserves of the banking systems in the euro area's five largest economies is exposed to these markets. Making the risk even more acute, French banks have large exposure to Spain, and German banks to France. This combined exposure dwarfs the exposure of the U.K., Japan or the U.S. to the most vulnerable EM economies. To be fair to Spain, Spanish banks often have set up their foreign affiliates as separate legal entities. This means that the impact on the balance sheets of the Spanish banking system of defaults in vulnerable EM countries may be more limited than seems at face value. Yet, this is far from certain. Chart 20BRL, CLP, ZAR, And MXN Are Too Expensive##br## In Light Of Their Vulnerabilities BRL, CLP, ZAR, And MXN Are Too Expensive In Light Of Their Vulnerabilities BRL, CLP, ZAR, And MXN Are Too Expensive In Light Of Their Vulnerabilities Chart 21Who Has More Exposure To EM? The Bear And The Two Travelers The Bear And The Two Travelers As a result, we would not be surprised if the European Central Bank is forced by an EM accident to back away from its desire to abandon its extraordinary accommodative stance. The ECB would first use forward guidance to message that a hike will be delayed ever further in the future. The ECB may even be forced to resume government and corporate bonds purchases past 2018. This is a potential nightmare scenario for the euro. In fact, as Chart 22 illustrates, a euro at parity may not be a far stretch. Historically, the euro bottoms when it trades 10% below our fair value model, based on real short rate differentials, relative yield curve slopes and the ratio of copper to lumber prices. Such a discount would correspond to EUR/USD at parity. Because under such circumstances the Fed could be forced to pause its own hiking cycle for a quarter or two, a move to EUR/USD between 1.10 and 1.05 seems more likely than a collapse to parity right now. This also means that in conjunction with BCA's Geopolitical Strategy team, we recommend our clients close overweight positions in Spanish assets. Chart 22The Euro Still Has Downside If EM Go Bust The Euro Still Has Downside If EM Go Bust The Euro Still Has Downside If EM Go Bust What about the yen? In the late 1990s, the yen fell against the U.S. dollar as Asian currencies were collapsing, but surged once the Fed backtracked and bond yields tanked in 1998. This time could follow a different road map. Japan does not compete against Brazil, Colombia, Mexico, Chile and South Africa in the same way as it was competing against industrial companies in countries like Taiwan, Singapore or South Korea. This means that Japan is unlikely to need to competitively devalue to remain afloat if the BRL, COP, MXN, CLP and ZAR collapse further. However, since an EM shock is likely to prove to be a deflationary event, this means that bond yields could experience downside, especially as positioning in the U.S. bond market is massively crowded to the short side (Chart 23). A countertrend bull market in bonds would greatly flatter the yen. As a result, we are maintaining our short EUR/JPY bias over the coming months. The G10 commodity currency complex is also at risk. Not only does tightening dollar liquidity imply further weakness in this group of currencies, so does slowing EM activity and a deflationary scare. Additionally, the CAD and the NZD are not trading at much of a discount to their fair value, and the AUD trades at a premium (Chart 24). This means we would anticipate these currencies to suffer more in the coming quarters, led by the AUD, which is not only the most expensive of the group, but also the most geared to EM economic activity. Being short AUD/CAD still makes sense. Chart 23A Bond Rally Would ##br##Support The Yen A Bond Rally Would Support The Yen A Bond Rally Would Support The Yen Chart 24TDollar-Bloc Currencies Offer Limited Cushion##br## In The Event of An EM Selloff TDollar-Bloc Currencies Offer Limited Cushion In The Event of An EM Selloff TDollar-Bloc Currencies Offer Limited Cushion In The Event of An EM Selloff Finally, the pound is its own animal. GBP/USD is now quite cheap, but the U.K.'s large current account deficit of 3.9% of GDP, which is not funded through FDIs anymore, means that Great Britain remains vulnerable to tightening global liquidity conditions. Moreover, Brexit negotiations will heat up in the fall, as the March 2019 deadline for reaching a deal with the EU looms large. This means that political tumult in the U.K. will remain a large source of risk for the pound. We will explore the outlook for the pound in an upcoming report this September. Currently, our long DXY trade is posting an 8.5% profit, with a target at 98. The above picture suggests that the dollar could move well past 98, especially as the momentum factor that is so important to the greenback still plays in favor of the USD.4 As a result, we are upgrading our target on the dollar to 100. However, we are also tightening our stop loss to 94.88. We will update our stop loss to 97 if the DXY hits 98 in the coming weeks, in order to protect gains while still being exposed to the dollar's potential upside. Bottom Line: Beyond Turkey and Argentina, the EMs most vulnerable to tightening global liquidity conditions are Brazil, Colombia, Mexico, Chile and South Africa. Spanish banks have outsized exposure to these markets, which means the euro area is at risk if the "Turkish Flu" becomes contagious. As such, the ECB could be forced to remain easier than it wants to. The euro is still at risk. The yen could strengthen if global bond yields suffer. Hence, it still makes sense to be short EUR/JPY. While the CAD, AUD and NZD are also all vulnerable to a deflationary scare, the Aussie is the worst positioned of the three. Shorting AUD/CAD still makes sense. The DXY is likely to experience significant upside from here, with a move to 100 becoming an increasingly probable scenario. Risks To Our View Chart 25A Gauge And A Hedge Against Chinese Stimulus A Gauge And A Hedge Against Chinese Stimulus A Gauge And A Hedge Against Chinese Stimulus The biggest risk to our view is China. In 2016, a vicious EM selloff was staunched by a large wave of stimulus that put a floor under Chinese economic activity, and caused China to re-lever. The impact was felt around the world, lifting commodity prices and EM assets while plunging the dollar into a vicious selloff in 2017. It is conceivable that such an outcome materializes anew, especially as China is, in fact, injecting stimulus into its economy. However, as we wrote two weeks ago, the current stimulus still pales in comparison to what took place in 2015. Moreover, reforms and deleveraging have much greater primacy now than they did back then.5 BCA believes that the current wave of stimulus is not designed to cause growth to surge again, as was the case in 2015, but is instead aimed at limiting the negative impact of the ongoing trade war with the U.S. Yet, we cannot be dogmatic. Not only is it hard to gauge the actual degree of stimulus currently applied to the Chinese economy, there is a heightened risk that the flow of policy announcements causes a shift in the dominant narrative among market participants. Such a shift in attitudes could easily cause a mass buying of EM assets and commodities, delaying the day of reckoning for vulnerable EM. As a result, we continue to promulgate that investors track the behavior of our China Play Index, introduced two weeks ago (Chart 25).6 Not only does this index provide a live read on how traders are pricing in Chinese developments, but it also provides a great hedge for investors long the dollar, short EM, or short the commodity complex. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 In the panic of 1907, the Knickerbocker Trust Company went bankrupt, threatening the health of the U.S. banking system. The stock market crashed, money markets went into paralysis, and a consortium of bankers led by J.P. Morgan himself ended up acting as a lender of last resort, staunching the crisis. As a consequence of this panic, the Federal Reserve System was born in 1913. 2 For a more detailed discussion of the deflationary risk created by the RMB, please see Foreign Exchange Strategy Weekly Report, "What Is Good For China Doesn't Always Help The World", dated June 29, 2018, available at fes.bcaresearch.com 3 Please see Emerging Markets Strategy Special Report, "Brazil: Faceoff Time", dated July 27, 2018, available at ems.bcaresearch.com 4 Please see Foreign Exchange Strategy Special Report, "Riding The Wave: Momentum Strategies In Foreign Exchange Markets", dated December 8, 2017, available at fes.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report, "The Dollar And Risk Assets Are Beholden To China's Stimulus", dated August 3, 2018, available at fes.bcaresearch.com 6 Ibid. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights China's policy headwinds have begun to recede, but Beijing is not riding to the rescue for emerging markets; While monetary policy has eased substantively, credit growth will be hampered by the government's financial crackdown; Potential changes to China's Macro-Prudential Assessment framework could be significant, but the impact on credit growth is overestimated at present; The recognition of non-performing loans (NPLs) and cleansing of China's banking system is still in early innings and will weigh on banks' risk appetite; The anti-corruption campaign is another reason to be cautious on EM. Geopolitical Strategy recommends clients stay overweight China (ex-tech) relative to EM. Feature In the first part of this two-part Special Report, we concluded that policy headwinds to China's economic growth have begun to recede, but recent easing measures will likely disappoint the markets.1 Chart 1Money Growth Bottomed, Credit Still Weak Money Growth Bottomed, Credit Still Weak Money Growth Bottomed, Credit Still Weak In essence, China is girding for a trade war with the United States, which favors stimulus. But it is still attempting to reduce systemic financial risk. As a result, fiscal stimulus may surprise to the upside, but credit growth will be lackluster. The problem for investors - especially for emerging market (EM) assets and the commodity complex - is that Chinese fiscal stimulus typically operates with a six-to-ten month lag, as opposed to credit stimulus which only takes about three months to kick in.2 July statistics confirm our suspicion that credit stimulus will be hampered by the government's crackdown on shadow banking. Total credit growth remains weak, although broad money (M2) does appear to be bottoming (Chart 1). Thus far, BCA's China Investment Strategy has been correct in characterizing the latest developments as "taking the foot off the brake" rather than "pressing down on the accelerator."3 In this report we take a deeper dive into the policy factors that cause us to limit our "stimulus overshoot" scenario to a 10% subjective probability. The three chief reasons are: overstated easing of macro-prudential controls; the continuing process of cleansing the banking sector of non-performing loans; and the anti-corruption campaign in the financial sector. A Preemptive Dodd-Frank Since the Xi administration redoubled its efforts to tackle systemic financial risk last year, we have urged investors to be cautious about Chinese growth.4 The creation of new institutions and new regulatory requirements set in motion processes that would be hard to reverse quickly. While these institutions are now making several compromises for the sake of stability, their operations will continue to weigh on credit growth. In July 2017, China's government held the National Financial Work Conference to address the major issues facing the country's financial system. This conference takes place once every five years and has often occasioned significant shakeups in financial regulation. In 1997, it initiated a sweeping purge of the banking system, and in 2002, it saw the creation of three financial watchdogs that would become critical institutional players throughout the 2000s.5 Chart 2Crackdown On Informal Credit Continues Crackdown On Informal Credit Continues Crackdown On Informal Credit Continues One of the skeletons in the closet from 2002 was the debate over whether financial regulation should be heavily centralized or divided among different, specialized, state agencies. Former Premier Wen Jiabao won the argument with the creation of the three watchdogs covering banking, securities, and insurance. After a series of controversies and conflicts, the Xi administration decided that these agencies had failed in their primary purpose of curbing systemic risk and ordered a reorganization with greater centralization. At the 2017 financial conference, Xi announced the creation of the Financial Stability and Development Committee (FSDC) to act as a centralized watchdog over the entire financial system. The FSDC would coordinate with the central bank, oversee macro-prudential regulation, and prevent systemic risk. Liu He, Xi's right-hand man on the economy and a policymaker with a hawkish reputation, was soon promoted to the Politburo and given the top job at the FSDC.6 As a second step, the Xi administration announced that it would combine the banking and insurance regulators into a single entity - the China Banking and Insurance Regulatory Commission (CBIRC). The CBIRC, to be headed by Xi ally, and notable hawk, Guo Shuqing, would continue and escalate the crackdown on shadow lending that Guo had begun at the helm of the bank watchdog in 2017 (Chart 2). The merging of the agencies would also close the regulatory gap that had seen the insurance regulator increase its dominion and rent-seeking by encouraging "excessive" financial innovation and risky pseudo-insurance products.7 The FSDC was expected, rightly, to bring a more hawkish tilt to Chinese macro-prudential regulation. In reference to the U.S.'s Financial Stability Oversight Council, we dubbed these moves a "Preemptive Dodd-Frank."8 We also argued, however, that the purpose was to bring unified command and control to financial regulation and that China would continue to prize stability above all. Therefore the degree of tightening or loosening should vary in accordance this goal.9 After a series of announcements in July and August, it is clear that China's government has shifted to a more accommodative posture (Chart 3). As usual, there are rumors of high-level political intrigue to go along with the policy shift: some argue that Premier Li Keqiang is making a comeback while Xi's golden boy, Liu He, has been sidelined due to his failure to forestall tariffs during his trade talks with Donald Trump this spring.10 Such rumors are valuable only in revealing the intensity of the policy debate in Beijing. Chart 3Monetary Policy Has Eased Substantively Monetary Policy Has Eased Substantively Monetary Policy Has Eased Substantively What is certain, however, is that the FSDC, with Liu He as chairman, only met for the first time as a fully assembled group in early July, just before the major easing measures were taken. This implies that any initial conclusions were pragmatic (i.e. not excessively hawkish). Moreover, Guo Shuqing is not only the CBIRC head but also the party secretary of the PBOC, meaning that central bank chief Yi Gang cannot have adopted easing measures without Guo's at least condoning it. Chinese policymakers see the recent easing measures as "fine-tuning" even as they continue the rollout of new regulatory institutions and systems. It is thus too soon to claim that Xi Jinping or any of these government bodies have thrown in the towel on their attempts to contain excessive leverage. Both the Politburo and the State Council - the highest party and state decision-makers - have made clear that they do not intend to endorse a massive stimulus on the magnitude of 2008-09 or 2015-16.11 They have also insisted that the "Tough Battle" against systemic financial risk, and the campaign to "deleverage" the corporate sector, will continue. What does this mean in practical terms? While new regulations will be compromised, they will also continue to be implemented. For example, authorities have watered down new regulations governing the $15 trillion asset management industry, yet the regulations are still expected to go into force by 2020. These rules will weigh on shadow banking activity (e.g. wealth management products) as banks prepare to meet the requirements.12 Two other examples are critical and will be discussed below: first, the potential easing of rules under the Macro Prudential Assessment (MPA) framework for stress-testing banks; second, this year's changes to rules governing non-performing loans (NPLs). In the former case, the degree of financial easing is potentially significant but at present overestimated by investors; in the latter case, the degree of tightening is already significant and widely underestimated. Bottom Line: New financial regulatory institutions will inherently suppress credit growth, especially by dragging on informal or non-bank credit growth. Macro-Prudential Assessments: Less Easing Than Meets The Eye A key factor in determining China's credit growth going forward will be banks' responses to any softening of the Macro Prudential Assessment (MPA) requirements. News reports have suggested that a relaxation of these rules may occur, but authorities have not finalized such a move. Furthermore, the impact on credit growth may be far less than the astronomical sums being floated around the investment community. The MPA framework began in 2016. It is an evaluative system of "stress-testing" China's banks each quarter. As such it is part of the upgrade of macro-prudential systems across the world in the aftermath of the global financial crisis, comparable to the American Financial Stability Oversight Committee or the European Systemic Risk Board.13 It is managed by the PBOC and the FSDC. The MPA divides banks into systemically important financial institutions and common institutions, and subdivides the former into those of national and regional importance. The evaluation method contains seven major criteria for assessing bank stability: Capital adequacy and leverage ratios; Bank assets and liabilities; Liquidity conditions; Pricing behavior for interest rates; Quality of assets; Cross-border financing; Execution of credit policy. The first and fourth of these criteria (capital adequacy and leverage ratios, and pricing behavior for interest rates) are in bold font because they result in a "veto" over the entire assessment: if a bank fails to maintain a sufficient capital buffer, or deviates too far from policy interest rates, it can fail the entire stress-test. Otherwise, failure of any two of the other five categories results in overall failure. A system of rewards and punishments awaits banks depending on how they perform (Diagram 1). Diagram 1China's Macro Prudential Assessment Framework Explained China: How Stimulating Is The Stimulus? Part Two China: How Stimulating Is The Stimulus? Part Two On July 20, the PBOC published a document saying that "in order to better regulate assets of financial institutions, during Macro Prudential Assessment (MPA), relevant parameters can be reasonably adjusted." Subsequently Reuters reported that the PBOC would reduce the "structural parameter" and the "pro-cyclical contribution parameter" of the capital adequacy ratio (CAR) requirements, thereby easing rules on one of the veto items. The structural parameter would fall from 1.0 to 0.5. Rumors suggest that the pro-cyclical parameter could fall from 0.4-0.8 to 0.3. No such changes have been finalized - only a few banks actually claim to have received notification of a change and there are regional differences. Clearly a general change of the rule would reduce regulatory constraints on bank credit. But how big would the impact be? Under the MPA, banks' CARs are not allowed to fall too far below the "neutral CAR," or C*, a variable that is calculated using the formula outlined in Diagram 2. Most of the variables in this formula will not change often: for instance, the minimum legal CAR will be slow to change, as will the capital reserve buffer and the bonus buffer for systemically important institutions. The one factor that can change frequently is the "discretionary counter-cyclical buffer," as it responds to the country's current place in the business cycle. Diagram 2China's Macro-Prudential Assessment Framework: Capital Adequacy Ratios China: How Stimulating Is The Stimulus? Part Two China: How Stimulating Is The Stimulus? Part Two The key input to this factor is broad credit growth. Thus, if authorities should reduce the CAR's cyclical parameter from a simple average of 0.6 to 0.3, broad credit growth could go higher without creating an excessive increase in the pro-cyclical buffer. In other words, at present about 60% of bank credit expansion in excess of nominal GDP growth counts toward a counter-cyclical capital buffer, which is added to other capital buffers. A tweak to this parameter could decrease that proportion to 30%, meaning that bank lending could go twice as high with the same impact on the counter-cyclical buffer. More significantly, if authorities should reduce the CAR's structural parameter from 1.0 to 0.5, any increase in credit growth would have a less dramatic impact on C*. Hence banks would be able to lend more while still keeping their neutral CAR within the appropriate range relative to their actual CAR. Banks could theoretically lend twice as much with the same impact on the assessment.14 On paper these changes could result in unleashing as much as 41.4 trillion RMB in new lending in 2018, or 28 trillion (33% of GDP) on top of what could have been expected without any adjustment to the macro-prudential rules. This is because broad credit growth would theoretically be allowed to grow as fast as 30% instead of 17%.15 But in reality this growth rate is extremely unlikely. Why? Because it assumes that banks will grow their lending books as rapidly as they are allowed. In fact, banks are currently increasing broad credit at a rate of about 10%, which is considerably lower than either today's or tomorrow's permitted rate of growth under the MPA framework (Chart 4). If tweaks to the MPA increase this speed limit to 30%, it does not mean that banks will drive any faster than they are already driving. They are lending at the current pace for self-interested reasons (and there is fear of excessive debt, default, or insolvency due to the government's ongoing regulatory and anti-corruption crackdown).16 Chart 4Banks Are Not Lending To The Regulatory Maximum China: How Stimulating Is The Stimulus? Part Two China: How Stimulating Is The Stimulus? Part Two Still, if the MPA rules are tweaked, then it will send a signal that macro-prudential scrutiny is abating and banks can lend more aggressively - this would have some positive effect on credit growth, at least for major banks that are secure in meeting their CARs. Moreover, there will be a practical consequence in that fewer banks will be punished for having insufficient CARs. At present, only rarely do banks fail the evaluations. But a strict CAR requirement during an economic downturn could change that. The proposed MPA adjustment would show that banks are graded on a sliding rule: the authorities would slide the grading scale downward to enable more banks to pass the test. This means fewer failures, which means fewer punitive measures that could upset liquidity or stability in the banking system. Ultimately, in order for the new system to have any credibility at all, punishment will have to be meted out to banks that fail the stress tests. A key punishment within the MPA system is exclusion from medium-term lending facility (MLF) loans from the PBOC. This is a regulatory action with teeth, as this is one of the PBOC's major means of injecting liquidity (Chart 5). A misbehaving bank could face short-term liquidity shortage or even insolvency. Therefore the authorities are opting to soften the rules so that the new regulatory system is preserved yet the harshest implications are avoided (for now). Chart 5Regulators Can Deprive Banks Of MLF Access Regulators Can Deprive Banks Of MLF Access Regulators Can Deprive Banks Of MLF Access This would be short-term gain for long-term pain, the opposite of what China needs from the standpoint of an investor looking for improvements to productivity and potential GDP growth. But it would not necessarily be a great boon for global risk assets in the near term. While it could help stabilize expectations for China's domestic growth, it is not clear that it would unleash a mass wave of new bank loans that would reaccelerate China's economy and put wings beneath EM assets and commodity prices. Bottom Line: Tweaking the MPA parameters is a clear example of policy easing. Yet the MPA system itself is a fairly rigorous means of stress-testing banks that is part of a much larger expansion of financial sector regulation. The results of the easier rules - if implemented - will not be as reflationary as might be expected from the headline 41 trillion RMB in new loans that could legally be created. Banks are already expanding loans more slowly than they are allowed to do, so increasing the speed limit will have little effect. The real purpose of the macro-prudential tweaks is to make it more difficult for banks to fail their stress tests in a downturn. As such, any tweaks would actually reveal that Chinese policymakers are expecting a more painful downturn, not that they are asking for a credit splurge. NPL Recognition Will Weigh On Credit Growth Another factor that we have highlighted that separates today's easing measures from outright stimulus: the growing recognition of non-performing loans (NPLs) in China's banks and the financial cleansing process. The government's reform push has already led to two trends that are relatively rare and notable in the Chinese context: rising corporate defaults (Chart 6) and rising bankruptcies (Chart 7). While the impact may be small relative to China's economic size, the direction of change is significant in a country that has been extremely averse to recognizing losses. Chart 6Defaults Are Rising China: How Stimulating Is The Stimulus? Part Two China: How Stimulating Is The Stimulus? Part Two Chart 7Creative Destruction In China China: How Stimulating Is The Stimulus? Part Two China: How Stimulating Is The Stimulus? Part Two These changes reflect the tightening of financial conditions and restructurings of various industries and as such are evidence of Xi's attempt to make progress on reforms while maintaining stability. They also reflect a general environment that is conducive to the realization of bad loans. Two recent policy decisions are affecting banks' accounting of bad loans. First, the CBIRC issued new guidance that eases NPL provision requirements for "responsible" banks (banks with good credit quality) while maintaining the existing requirements for "irresponsible" banks.17 Since the major state-controlled banks will largely meet the standards, they will be able to lend somewhat more (we estimate around 600 billion RMB or 0.7% of GDP). This would support the recent trend in which traditional bank lending rises as a share of total credit growth. Second, however, the CBIRC is requiring banks to reclassify all loans that are 90-or-more-days delinquent as NPLs, resulting in upward revisions of bank NPL ratios. This will send the official rate on an upward march toward 5%, from current extremely low 1.9% (Chart 8). It is the direction of change that matters, as NPL recognition can take on a life of its own. While many state banks may already have recognized the 90-day delinquent loans, many small and regional banks probably have not. Anecdotally, a number of small banks are reporting large NPL ratios as a result of the regulatory clampdown and definition change. Rural commercial banks, in particular, are in trouble with several showing NPLs in double digits (Chart 9). These small and regional banks will have until an unspecified date in 2019 to reclassify these loans and raise provisions against them. The result will hamper credit growth. Chart 8Bad Loan Ratios Set To Rise Bad Loan Ratios Set To Rise Bad Loan Ratios Set To Rise Chart 9City And Rural Commercial Banks Most At Risk Of Rising Bad Loans China: How Stimulating Is The Stimulus? Part Two China: How Stimulating Is The Stimulus? Part Two To get a more detailed picture of the NPL recognition process, we have updated our survey of 16 commercial banks listed on the A-share market.18 This research reveals that banks have continued to increase the amount of bad loans they have written off. While the NPL ratio has remained roughly the same, cumulative loan-loss write-offs combined with NPLs have reached 7% of total loans and are still rising (Chart 10). This shows that a cleansing process is well underway. It is concerning that write-offs have reached nearly 50% of pre-tax profits. And even as losses mount, the proportion of each year's losses to the previous year's NPLs has fallen, implying that the previous year's NPLs had grown bigger (Chart 11). Chart 10The Bank Cleansing Process Continues China: How Stimulating Is The Stimulus? Part Two China: How Stimulating Is The Stimulus? Part Two Chart 11Write-Offs Almost 50% Of Bank Profits Write-Offs Almost 50% Of Bank Profits Write-Offs Almost 50% Of Bank Profits Furthermore, while loan losses grow, the surveyed banks' profit growth has been reduced to virtually zero (Chart 12). Our updated "stress test" for Chinese banks, which is based on the same sample of 16 commercial banks, suggests that if total NPLs rise to a pessimistic, but still quite realistic, ratio of 13% (a weighted average of NPL ratio assumptions per sector, ranging from 10%-30%), then total losses could amount to 10.4 trillion RMB, or 12% of GDP (Table 1). Chart 12Write-Offs Weigh On##br## Bank Profit Growth China: How Stimulating Is The Stimulus? Part Two China: How Stimulating Is The Stimulus? Part Two Table 1Pessimistic Scenario Analysis ##br##For Commercial Bank NPLs China: How Stimulating Is The Stimulus? Part Two China: How Stimulating Is The Stimulus? Part Two In this scenario, banks' net equity would be impacted by 38% as this amount surpasses the buffer of net profits (1.75 trillion RMB) and NPL provisions (3 trillion). China's banks are well provisioned, but they would be less so after a hit of this nature. A similar stress-test by BCA's Emerging Markets Strategy found that equity impairment could range from 33%-49%, implying that Chinese banks were roughly 29% overvalued on a fair price-to-book-value basis.19 Looking at different economic sectors, it is apparent that domestic trade, manufacturing, and mining have seen the highest incidence of loans going sour (Table 2). In all three cases, it is reasonable to conjecture that the NPL ratio can continue to expand - and not only because of the definitional change. First, wholesale and retail (4.7%) consists largely of SMEs, and the government is publicly concerned about their ability to get credit. Second, manufacturing (3.9%) has been hit by changing trade patterns and rising labor costs and has not yet suffered the impact from recently imposed U.S. trade tariffs. Third, mining (3.6%) has felt the first wave of the impact from the government's cuts to overcapacity in recent years, but has seen very extensive restructuring and the fallout may continue. Table 2China: Troubled Sectors Can Produce More Bad Loans China: How Stimulating Is The Stimulus? Part Two China: How Stimulating Is The Stimulus? Part Two More realistic NPL recognition is an important and positive development for China over the long run. Over the short run, banks' efforts to write-off NPL losses will weigh on their willingness to lend and could pose a risk to overall economic activity. Bottom Line: The government's reform and restructuring efforts are initiating a process of creative destruction in the Chinese economy. This is most notable in the government's willingness to recognize NPLs, which will continue to weigh on credit growth. The government is trying to control the pace and intensity of this process, but we expect credit stimulus to be disappointing relative to fiscal stimulus as long as the financial regulatory crackdown is at least half-heartedly implemented. Anti-Corruption Campaign Is Market-Negative Another reason to expect total credit growth to remain subdued comes from the anti-corruption campaign and its probes into local government finances and the financial sector. Chart 13Anti-Corruption Campaign Trudges Onward Anti-Corruption Campaign Trudges Onward Anti-Corruption Campaign Trudges Onward One of the new institutions created in China's 2017-18 leadership reshuffle was the National Supervisory Commission (NSC). This is a powerful new commission that is capable of overseeing the highest state authority (the National People's Congress). It is also ranked above the formal legal system, the Supreme Court and the public prosecutor's office. It is charged with formalizing the anti-corruption campaign and extending it from the Communist Party into the state bureaucracy, including state-owned enterprises.20 Having operated for less than a year, it is not possible to draw firm conclusions about the doings of the NSC, let alone any macro impact. Tentatively, the commission has focused on financial and economic crimes that have the potential to create a "chilling effect" among government officials and bank executives.21 Notably, the NSC has investigated Lai Xiaomin, former chief executive of Huarong, the largest of the big four Asset Management Corporations (AMCs), i.e. China's "bad banks." There is more than one reason for Huarong to attract the attention of investigators, but it is notable that it had extensive investments in areas outside its official duty of acquiring and disposing of NPLs. The implication could be that the government wants the AMCs to focus on their core competency: cleaning up the coming deluge of NPLs. The anti-corruption is also targeting local government officials for misappropriating state funds. These investigations involve punishment of provincial officials for false accounting as well as embezzlement and other crimes. We have noted before that the provinces that revised down their GDP growth targets most aggressively this year were also some of the hardest hit with anti-corruption probes into falsifying data and misallocating capital.22 On several occasions it has appeared as if the anti-corruption campaign was losing steam, but the broadest tally of cases under investigation suggest that it is still going strong despite hitting a peak at the beginning of the year (Chart 13). The campaign remains a potential source of disruption among the very officials whose risk appetite will determine whether central government policy easing actually results in additional bank lending and local government borrowing. Bottom Line: While difficult to quantify, the anti-corruption campaign will dampen animal spirits within local governments and the financial sector as long as the new NSC is seeking to establish itself and the Xi administration remains committed to prosecuting the campaign aggressively. Investment Conclusions We would be surprised if credit growth did not perk up at least somewhat as a result of the past month's easing measures. But as outlined above, these measures may disappoint the markets as a result of the ongoing financial regulatory drive, the baggage of NPL recognition, and any negative impact on risk appetite due to the anti-corruption campaign. And this is not even to mention the dampening effects of ongoing property sector and pollution curbs.23 In lieu of a credit surge, Beijing is likely to rely more on fiscal spending to stabilize growth. Fiscal spending also faces complications, of course. In recent years, China's local governments have built up a potentially massive pool of off-balance-sheet debt due to structural factors limiting local government revenue generation (Table 3). Beijing is now attempting to force this debt into the light. The local government debt maturity schedule suggests a persistent headwind in coming years as hidden debt is brought onto the balance sheet and governments scramble to meet payment deadlines (Chart 14). In addition, the local government debt swap program launched in 2014-15 will wrap up this month. Table 3Estimates Of Hidden Local Government Debt China: How Stimulating Is The Stimulus? Part Two China: How Stimulating Is The Stimulus? Part Two Chart 14Local Governments Face Rising Debt Payments China: How Stimulating Is The Stimulus? Part Two China: How Stimulating Is The Stimulus? Part Two Nevertheless Beijing has introduced a new class of "refinancing bonds" in 2018 to help stabilize the fiscal situation. These bonds are separate from brand new bonds that have the potential to increase significantly over the second half of this year. China's Finance Ministry has also reportedly asked local governments to issue 80 percent of net new special purpose bonds by the end of September. Since only about a quarter of the year's 1.35 trillion RMB quota was issued in H1, this order would mean that about half of the quota (675 billion RMB out of 1.35 trillion RMB) would be issued in August and September alone - implying a significant surge to Chinese demand, albeit with a lag of six months or so.24 The latest data releases from July suggest that Beijing is trying to do two things at once: ease liquidity conditions while cracking down on excess leverage. Until we see a spike in credit growth, we will continue to expect the policy turn to be only moderately reflationary, with the ability to offset existing headwinds but not spark a broad-based reacceleration of the economy. Going forward, data for the month of August will be very important to monitor, as many of the easing measures were not announced until late July. For all the reasons outlined in this two-part Special Report, we would view a sharp increase in total credit as a game-changer that would point toward a "stimulus overshoot" (Table 4). Such an overshoot is less likely if the government relies more heavily on fiscal spending this time around, which is what we expect. Table 4Will China Over-Stimulate This Time Around? China: How Stimulating Is The Stimulus? Part Two China: How Stimulating Is The Stimulus? Part Two Meanwhile, turmoil in emerging markets - which we fully anticipated based on China's policy headwinds this year and our dollar bullish view - will only be exacerbated by China's unwillingness to stimulate massively.25 Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Qingyun Xu, Senior Analyst qingyun@bcaresearch.com Yushu Ma, Contributing Editor yushum@bcaresearch.com 1 Please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "China: How Stimulating Is The Stimulus?" dated August 8, 2018, available at gps.bcaresearch.com. 2 Please see BCA China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle," dated November 30, 2017, available at cis.bcaresearch.com. 3 Please see BCA China Investment Strategy Weekly Report, "China Is Easing Up On The Brake, Not Pressing The Accelerator," dated July 26, 2018, available at cis.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Politics Are Stimulative, Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 9 Please see footnote 8 above. 10 Please see BCA Geopolitical Strategy Weekly Report, "Italy, Spain, Trade Wars... Oh My!" dated May 30, 2018, available at gps.bcaresearch.com. 11 Please see Part I of this series in footnote 1 above. 12 Please see BCA China Investment Strategy Weekly Report, "Now What?" dated June 27, 2018, available at cis.bcaresearch.com. Note that according to the new asset management rules, financial institutions will be required to have a risk reserve worth 10% of their fee income, or corresponding risk capital provisions. When the risk reserve balance reaches 1% of the product balance, no further risk provision will be required. We estimate that setting aside these funds will be a form of financial tightening worth about 1.2% of GDP. 13 Please see Liansheng Zheng, "The Macro Prudential Assessment Framework of China: Background, Evaluation and Current and Future Policy," Center for International Governance Innovation, CIGI Papers No. 164 (March 2018), available at www.cigionline.com. 14 Recall that the second category of the MPA consists of bank assets and liabilities. This category also has a rule for broad credit growth, which is that it should not exceed broad money (M2) plus 20%-25%. Therefore passing this part of the exam already requires banks to meet a 28%-33% speed limit on new credit. Assuming that that the pro-cyclical parameter of the CAR category remains at its current minimum of 0.4, then the structural parameter cannot be effectively pushed any lower than 0.6-0.8. The bottom line is that pushing the CAR structural parameter lower is not going to yield a significant increase in the allowable rate of credit growth. 15 To reach this estimate, we began with the fact that the outstanding level of broad credit growth was around 207 trillion RMB by the end of 2017 (that is, loans plus bonds plus equities plus wealth management products and other off-balance-sheet assets). The 2017 growth rate was about 10% and is assumed to be the same in 2018. Therefore broad credit should reach 227.7 trillion by the end of the year. Then, if we assume that all banks lend at the maximum weighted growth rate allowed by adjusting the structural parameter in the MPA CAR requirement (which is 30%), outstanding broad credit would reach 269.1 trillion by the end of the year. Hence an extra 41.4 trillion RMB in broad credit growth would be released. For comparison, please see CITIC Bond Investment, "Deep Analysis: Impact of Parameter Adjustments in the MPA Framework," July 30, 2018, available at www.sohu.com. 16 Based on actual CARs in 2017, the limit to broad credit growth was 17%-22% for large state-owned banks, 10%-20% for joint-equity banks, and 15%-20% for city or rural commercial banks. However, the actual broad credit growth for most banks was a lot lower than that. For example, for all five state-owned banks (nationally systemically important financial institutions), it was below 10%, well beneath the 17%-22% determined by their actual CARs and C*. 17 Under current regulations, the loan provision ratio is 2.5% while the NPL provision coverage ratio is 150%. The higher of the two is the regulatory standard for commercial banks. On February 28, 2018, the China Banking Regulatory Commission issued a notice declaring that the coverage requirement would change to a range of 120%-150%, while the loan provision requirement would change to a range of 1.5%-2.5%. Banks would qualify for the easier requirements according to how accurately they classified their loans, whether they disposed of their bad loans, and whether they maintained appropriate capital adequacy ratios. This could result in a release of about 800 billion RMB worth of provisions that can be kept as core tier-1 capital or support new lending. 18 Please see BCA China Investment Strategy Special Report, "Stress-Testing Chinese Banks," dated July 27, 2016, available at cis.bcaresearch.com. 19 Please see BCA Emerging Markets Strategy Weekly Report, "Mind The Breakdowns," dated July 5, 2018, and Special Report, "Long Indian / Short Chinese Banks," dated January 17, 2018, available at ems.bcaresearch.com. 20 Please see Jamie P. Horsley, "What's So Controversial About China's New Anti-Corruption Body?" The Diplomat, May 30, 2018, available at thediplomat.com. 21 The NSC is operationally very close to the Central Discipline Inspection Commission (CDIC), which is the Communist Party corruption watchdog formerly headed by heavyweight Wang Qishan. It received only a 10% increase in manpower over the CDIC in order to expand its target range by 200% (covering all state agencies and state-linked organizations). It has allegedly meted out 240,000 punishments in the first half of 2018, up from 210,000 during the same period last year and 163,000 in H1 2016. About 28 of these cases were provincial-level cases or higher. The controversy over the "rights of the detained" has been highlighted by the beating of a local government official's limousine driver in one of the organization's first publicly reported actions. The NSC has also arrested local government officials tied to "corruption kingpin" Zhou Yongkang and known for misappropriating budgetary funds, and has secured the repatriation of fugitives who fled abroad and recovered the assets that they stole or embezzled. 22 The provinces include Tianjin, Chongqing, Liaoning, Inner Mongolia, etc. Please see BCA Geopolitical Strategy "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. There is empirical evidence that anti-corruption probes are correlated with debt defaults. Please see Haoyu Gao, Hong Ru and Dragon Yongjun Tang, "Subnational Debt of China: The Politics-Finance Nexus," dated September 12, 2017, available at gcfp.mit.edu. 23 Please see BCA Emerging Markets Strategy Special Report, "China Real Estate: A Never-Bursting Bubble?" dated April 6, 2018, available at ems.bcaresearch.com, and Commodity & Energy Strategy Weekly Report, "Blue Skies Drive China's Steel Policy," dated August 9, 2018, available at ces.bcaresearch.com. 24 Please see "As economy cools, China sets deadline for local government special bond sales," Reuters, dated August 14, 2018, available at www.reuters.com. For more on local government bond issuance, see Part I of this series in footnote 1 above. Note also rumors in Chinese media suggesting that a new local government debt swap program could be launched with the responsibility of tackling off-balance-sheet debts that are guaranteed by local governments. The program has thus far only swapped debts that local governments were obligated to pay. It is not clear what would happen to a third class of local debt, that which is neither an obligation upon local governments nor guaranteed by them but that nevertheless is deemed to serve a public interest. 25 Please see BCA Geopolitical Strategy Weekly Report, "The EM Bloodbath Has Nothing To Do With Trump," dated August 14, 2018, available at gps.bcaresearch.com.

Highlights U.S. Investment Strategy is getting back to basics: We follow last week's report outlining our stance on interest rates with a review of the credit cycle and its current position. The credit cycle is not just about borrowers: Lender willingness is inversely related to loan performance over a five-year horizon, but it amplifies near-term performance swings. Our bond strategists use three broad indicators to track the credit cycle...: Valuation, monetary conditions and credit quality all offer insight into corporate bond performance. ... and we also consider the fed funds rate cycle: The way that lenders interact with the monetary policy backdrop is discouraging for the course of human evolution, but it follows a well-defined pattern that helps demarcate the credit cycle. The cycle is in its latter stages, and investors should be in the process of dialing down credit exposures: Our bond strategists downgraded spread product to neutral in mid-June, and we won't return to overweight until the next recession is well underway. Feature U.S. Investment Strategy is meant to provide analyses and forecasts of financial markets and the economy for the purpose of helping our clients make asset-allocation decisions. This report continues our focus on going back to the basics of meeting that mandate. Next week's Special Report will present a simple indicator for anticipating the onset of a recession and the end of the equity bull market. After Labor Day, we will publish a Special Report updating, and expanding upon, our work on the fed funds rate cycle. By the unofficial end of the summer, then, we will have outlined our positions on rates, credit, the business cycle, and the state of monetary policy. That will provide us with a framework for evaluating incoming data and engaging in an ongoing investment-focused dialogue. It will also hopefully put us in position to identify the first set of major cyclical inflection points since 2007-8 in a timely fashion. 2019 is shaping up as a pivotal year for asset allocation, and we look forward to navigating it alongside our clients. Lenders Never Learn, Part I: Lending Standards Investors typically think of the credit cycle exclusively in terms of borrower performance. After all, cycle peaks and troughs are defined by default-rate troughs and peaks. There are two parties to every loan, though, and a narrow focus on debtors precludes a full understanding of the landscape. The credit cycle encompasses lender willingness as well as borrower performance. Bad loans are made in good times, just as surely as good loans are made in bad times. Skepticism and gloom carry the day in a recession and its immediate aftermath, and the loans that manage to get made early in the credit cycle are tightly underwritten, insulated with a margin of safety that would warm Benjamin Graham's heart. As the cycle stretches on, however, lenders forget about the trauma of the last downturn and focus more on market share than standards. The fact that standards impact performance with a lag much longer than the annual bonus cycle obscures their importance and helps them persist. Like the rest of us, loan officers and their managers learn best when they receive immediate feedback that clearly results from their decisions. Over the three-decade history of the Federal Reserve's senior loan officer survey the last three cycles, however, it appears that lending standards impact loan performance with as much as a five-year lag. The Chart Of The Week shows the net percentage of loan officers tightening standards for commercial and industrial (C&I) loans to large and mid-sized companies, inverted and advanced by 20 quarters. Easy standards line up with peak defaults, and tight standards align with default troughs. Chart of the WeekLending Standards Are Negatively Correlated With Intermediate-Term Loan Performance ... Lending Standards Are Negatively Correlated With Performance In The Intermediate-Term ... Lending Standards Are Negatively Correlated With Performance In The Intermediate-Term ... The lag between loan approval and loan performance is far too long to reinforce learning, however. Over the course of five years, factors that could not have been foreseen at origination may well end up precipitating a default. Lenders' response to that long-term uncertainty may help explain the positive short-term correlation (Chart 2). Partially goaded by pro-cyclical loan-loss reserve standards, lenders react to surging default rates by getting more conservative, nudging default rates higher in a feedback loop that plants the seeds for strong intermediate-term performance. Chart 2... But They March In Lockstep With Loan Performance In The Near Term ... But They March In Lockstep With Loan Performance In The Near Term ... But They March In Lockstep With Loan Performance In The Near Term Bottom Line: 2014's cyclical bottom in standards suggests that rising default rates will not peak until late 2019 or 2020. Increased near-term lender caution will reinforce the upward move. Tracking The Credit Cycle: Default Rates When the economy is expanding, borrowers in the aggregate find it easier to service their debts, just as recessions make debt service more onerous. The pro-cyclicality of inflation, which eases debt burdens, helps reinforce the relationship. There is more to tracking the credit cycle than tracking the business cycle, however. While defaults have peaked within five months after the end of the last three recessions, default-rate troughs have varied wildly, occurring anywhere from six years before the recession to the month it began (Chart 3). Our credit strategists try to identify the point at which defaults begin to take off by tracking lending standards, monetary conditions, and credit quality. None of these factors suggests that default rates can make new lows. The loan officer survey could improve, but tight spreads leave almost no room for the bond market to become more receptive (Chart 4). Monetary conditions are steadily becoming less accommodative, helped along by the rate-hike/dollar-strength loop (Chart 5). Our bond strategists expect that credit quality will weaken as soon as upward wage pressure snuffs out pre-tax corporate profits'1 ability to keep up with double-digit debt growth. It's hard to say just when default rates will begin to erode total returns in a meaningful way, but our bond strategists are of a mind that risk is rapidly catching up with reward. Chart 3The Business Cycle Reliably Calls Peaks,##BR##But It's No Help With Troughs The Business Cycle Reliably Calls Peaks, But It's No Help With Troughs The Business Cycle Reliably Calls Peaks, But It's No Help With Troughs Chart 4Little Room##BR##For Improvement Little Room For Improvement Little Room For Improvement Chart 5Tightening,##BR##But Not Yet Tight Tightening, But Not Yet Tight Tightening, But Not Yet Tight Tracking The Credit Cycle: Corporate Spreads Chart 6Spreads Aren't Ready To Blow Out Yet Spreads Aren't Ready To Blow Out Yet Spreads Aren't Ready To Blow Out Yet High-yield data only exist for the last two spread-widening episodes, but what they lack in quantity they make up for in consistency. Heading into both the dot-com bust and the financial crisis, spreads did not widen in earnest (Chart 6, top panel) until the Fed had completed its tightening cycle (Chart 6, second panel), BCA's proprietary Corporate Health Monitor (CHM) began to deteriorate (Chart 6, third panel), and lenders tightened their standards (Chart 6, bottom panel). That template suggests that spreads are not poised to blow out anytime soon, as we expect the Fed will not be finished tightening before the end of 2019 (or later), and lenders are still actively easing their standards for commercial borrowers. As noted above, we expect that deterioration in the CHM will pick up again, once runaway profit growth ceases to paper over surging leverage. All in all, our bond strategists do not think it is anywhere near time to panic. As with defaults, they think it is still too soon to expect the beginning of sustained spread widening. On balance, however, the indicators suggest that return expectations should be modest, and limited to coupon yields. It is too late to buy bonds with the expectation of realizing capital gains, and prudent return projections should pencil in some minor capital losses. Lenders Never Learn, Part II: The Fed Funds Rate Cycle The fed funds rate cycle has been a U.S. Investment Strategy pillar, informing many of our views on cycles and asset markets. We will publish a Special Report delving into it more fully the first week of September, but a quick summary is sufficient to illustrate its relevance to the credit cycle. We divide the fed funds rate cycle into four phases based on whether the Fed is hiking rates or cutting them, and whether or not the fed funds exceeds our estimate of the equilibrium rate. Per our stylized representation of the cycle (Chart 7), we are currently in Phase I (the Fed is hiking, but policy remains accommodative) and are likely to remain there until the second half of 2019, when we expect that policy will turn restrictive, ushering in Phase II. While we have found that the level of the fed funds rate trumps its direction when it comes to explaining equity and bond returns, loan growth is more sensitive to the direction of rates. Banks expand their loan books more rapidly when the Fed is tightening than they do when it's easing. The effect is most pronounced for C&I loans, which grow five times faster during rake-hiking campaigns than they do during rate-cutting campaigns (Table 1). The conclusion may seem counter-intuitive on its face, but one must remember that the Fed is charged with leaning against the cycle: it tightens when times are good to keep them from becoming too good, and its eases when times are bad to get the economy back on its feet. Chart 7The Fed Funds Rate Cycle Taking Stock Of The Credit Cycle Taking Stock Of The Credit Cycle Table 1An Example Of What Not To Do Taking Stock Of The Credit Cycle Taking Stock Of The Credit Cycle Lenders who take a countercyclical tack operate with the policy wind at their back. Those who follow the cycle are actually fighting the Fed. Most lenders short-sightedly follow the crowd aping the cycle, basing future projections on the most recent data samples and hewing to career incentives that encourage herding. Bankers who load up on loans when the cycle is demonstrably old and approaching its peak make two errors: they ignore a well-established cyclical pattern (tightening leads recessions, which lead defaults and higher losses given default), and they deploy capital when it's widely available in the marketplace, but husband it when it's scarce. Bottom Line: Banks reinforce the credit cycle by avidly deploying capital when conditions are about to take a turn for the worse, and withholding it when they're about to get better. We recommend investors reject their example, and limit their exposure to spread product. Investment Implications If our view that the Fed is going to hike rates more than the consensus expects is correct, all bonds will have to contend with a persistent headwind. Thanks to positive carry, and high-yield bonds' structurally shorter duration, spread product will be less vulnerable than Treasuries. Our bond strategists are nonetheless lukewarm on the risk-reward offered by investment-grade and high-yield bonds. The cycle is clearly in its latter stages and spreads are historically tight. We remain constructive on both the business cycle and the monetary policy cycle, and we are not yet ready to throw in the towel on the equity bull market. Although our equity take is more sanguine than the BCA consensus, our optimism does not extend to the credit cycle, which has clearly passed its peak. While neither modest spread widening nor a mild pickup in defaults is likely to wipe out all of spread product's excess returns, we do not expect that they will be large enough to merit more than benchmark weighting in balanced portfolios. Our sister Global ETF Strategy service's model portfolios hold benchmark spread-product positions (while underweighting Treasuries, maintaining below-benchmark duration across all bond categories, and overweighting cash) and that is the way we intend to be positioned in the small basket of ETFs we will recommend once we've completed our review of the most impactful macro drivers. A Note On Payrolls Friday's Goldilocks employment situation report for July reinforced our views on the economy and rates, but it was mixed enough to have satisfied anyone's preconceived notions. July's net payroll gains fell shy of the consensus expectation, but revisions to May and June pushed the 3-month moving average of net gains to over 224,000, slightly above expectations. Neither hours worked nor average hourly earnings set off any alarm bells, but the "hidden" unemployment rate slid 30 basis points to 7.5%, the lowest level since May 2001. We see the seeds of future inflation pressures in the continued absorption of slack, and believe that the Fed does as well. We continue to expect four hikes this year and next, two more than the money market is currently discounting. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 Annualized profit growth calculated with data from the BEA's National Income and Profit Accounts.

Highlights The 2016-2017 China/EM recovery was not the beginning of a new economic and financial cycle. We view it as a mid-cycle recovery, or hiatus, in an unfinished downtrend that began in 2011. Our basis: In EM at large and especially in China, the excesses and "deadwood" left from the 2009-2011 credit boom were not cleansed. Easy money masked the negative fundamentals in 2016-2017. Yet as Chinese money and credit growth continues to fall and the Federal Reserve steadily shrinks its balance sheet, cracks are re-surfacing in EM and China. In Thailand, continue overweighting equities, currency and fixed-income market versus their respective EM benchmarks. Feature The most striking difference between our view on EM and that of the overwhelming majority of investors and experts is as follows: Most investors and commentators view the 2016-2017 EM recovery as the beginning of a new economic and financial cycle. Hence, the narrative goes that both the EM economic expansion and the rally in EM financial markets are still at an early stage, and barring severe tightening from the U.S. Federal Reserve, it is unlikely that EM growth will slump much. BCA's Emerging Markets Strategy team regards the 2016-2017 revival in EM economies in general and China in particular as a mid-cycle recovery, or hiatus, in an unfinished downtrend that began in 2011. This is why we were reluctant to turn bullish after EM financial markets rallied in 2016-2017. China is more important to EM than the U.S. In our opinion, it was only a matter of time before China's and the Fed's tightening would lead to a considerable relapse in EM financial markets. In brief, the rally of last year was nothing more than a bull trap. In this week's report we highlight where EM and China are in their respective economic cycles, and elaborate on why we believe their pre-2016 downturns and adjustments remain incomplete.1 EM/China Cycles Chart I-1 presents the best way to visualize the EM/China cycles. Chart I-1Where Are EMs & Commodities In The Cycle? Where Are EMs & Commodities In The Cycle? Where Are EMs & Commodities In The Cycle? Following the devastating crises of 1997-'98, the new structural bull market in EM began in 1999-2001. By the early 2000s, crises-hit EM banks had recognized and provisioned for their bad assets, and were in the process of restructuring. In turn, companies had considerably ameliorated their financial health by restructuring debt (including foreign debt), and cutting capital spending and employment, thereby boosting their free cash flows. By 2004, China completed aggressive structural reforms, such as shutting down unprofitable SOEs, tolerating massive layoffs and allowing market forces to play a greater role in the economy (Chart I-2, top panel). The Middle Kingdom also joined the WTO in 2001, which opened global markets for Chinese exports (Chart I-2, bottom panel). The structural reforms of the late 1990s and the WTO accession created fertile ground for China's structural growth boom in the 2000s. Chart I-2China Implemented Structural ##br##Reforms In Late 1990s China Implemented Structural Reforms In Late 1990s China Implemented Structural Reforms In Late 1990s China's nominal manufacturing output growth - depicted on the top panel of Chart I-1 on page 2 - accelerated throughout the 2000s, reaching a 20% annual growth rate in 2007. Consistently, commodities prices and EM share prices were in a structural bull market over that period (Chart I-1, bottom panel). The U.S. credit crisis in 2008 compelled a vicious, but relatively brief, bust in commodities and EM equities. Following the Lehman crash that year, China and many other developing nations injected considerable monetary and fiscal stimulus into their economies. As a result, Chinese and EM domestic demand boomed well before the DM recovery in the second half of 2009. It was in 2009-2011 that EM and China were in the late cycle phase. This period was characterised by booming credit and capital spending, strong income growth, capacity shortages, and a surge in inflation across many economies. Starting in 2011-2012, China and EM economies entered a major downtrend. Consistently, the bear market in commodities began in 2011.2 In 2015, the downtrend escalated, and the selloff became vicious. In the second half of 2015, Chinese policymakers became unnerved and, once again, injected enormous amounts of credit and fiscal stimulus into the mainland economy. These reflationary efforts led to a revival in China's economy, which in turn lifted commodities prices in 2016-2017. China's growth impulse boosted many EM economies that are more leveraged to China than to the U.S. It is this 2016-2017 mid-cycle revival in EM/China/commodities'- that we refer to as a hiatus in a bear market. Chart I-3Chinese Money Growth ##br##Points To More Downside bca.ems_wr_2018_07_19_s1_c3 bca.ems_wr_2018_07_19_s1_c3 Recognizing the long-run unsustainability of this easy money-based growth model and the need to manage escalating financial risks (China's official code word for "bubbles") motivated Chinese policy makers to begin tightening in late 2016. Consequently, money/credit have decelerated, and with a time lag, the business cycle has rolled over (Chart I-3, top panel). In turn, EM risk assets and commodities have been suffering since early 2018 (Chart I-3, bottom panel). Diagnosis Of EM Fundamentals Like doctors examining and diagnosing patients in regard to their medical conditions and prescribing medicines to cure them, the global investment community attempts to diagnose the health of economies and companies, and predict their outlook. In turn, a forecast of the future will have higher odds of being right if the diagnosis it relies upon is correct. Applying this reasoning to EM and the Chinese economies, we need to diagnose their conditions: Have the hangovers following their respective credit/easy money booms dissipated? What are the productivity trends in these economies, and are they in a position to embark on a structural growth trajectory? Our hunch has been and remains that EM economies have not sufficiently dealt with their excesses and are therefore not ready to embark on a new structural growth trajectory for the following reasons: First, China's credit and money excesses remain enormous (Chart I-4). Mild deleveraging has been occurring only in the past 12 months. Importantly, the consequence of this deleveraging is that the current growth slowdown will deepen. Domestic credit has tightened somewhat in the past 12 months, but Chinese companies' and banks' foreign indebtedness has surged (Chart I-5, top panel). Remarkably, external debt repayments and interest payments due in 2018 amount to $125 billion (Chart I-5, bottom panel). This presents a risk to the value of the yuan. Chart I-4China: Not Much Deleveraging So Far bca.ems_wr_2018_07_19_s1_c4 bca.ems_wr_2018_07_19_s1_c4 Chart I-5China: A Lot of Foreign Debt Is Due In 2018 China: A Lot of Foreign Debt Is Due In 2018 China: A Lot of Foreign Debt Is Due In 2018 Second, the mainland's economy recovered in 2016 due to exceptionally soft budgets for SOEs and local governments as well as easier access to credit for the private sector. Notably, consistent with skyrocketing credit, money supply has been exploding in China. Chart I-6 illustrates that broad money in China has expanded by RMB 170 trillion (equivalent to $28 trillion) in the past 12.5 years - which is equal to the entire money supply in the U.S. and the euro area combined, i.e., the same as the money created by the U.S.'s and euro area's respective banking systems over their entire history. Chart I-6Helicopter Money' In China bca.ems_wr_2018_07_19_s1_c6 bca.ems_wr_2018_07_19_s1_c6 The overwhelming majority of commentators mistakenly believe that China's money and credit excesses are due to households' high savings rates. We have documented - in a series of Special Reports3 on money, credit and savings - that banks do not need savings to originate loans - i.e., there is no relationship between the savings rate of a nation and the rate of deposits growth in the banking system (Chart I-7). Banks create money (deposits) out of thin air when they originate loans or buy assets from non-banks. This is true for any country, regardless of income level and type of economic system. Chart I-7No Link Between Savings And Deposits No Link Between Savings And Deposits No Link Between Savings And Deposits In short, the enormous money boom in China is just the mirror image of the gigantic credit bubble. The bottom panel of Chart I-6 illustrates that money growth in China has hugely exceeded money growth in countries that have undertaken QE programs. Hence, one can argue that China has done more than QE - it is fair to say the Middle Kingdom has dropped "helicopter money." And if the supply of money has any relevance to its price, the RMBs value is set to drop relative to other countries. The behavior of mainland households corroborates that there is an oversupply of local currency. Eagerness among households in China to exchange their RMBs for foreign currency and assets confirms that they are very concerned about preserving the purchasing power of their savings. This pent-up demand for dollars from mainland firms and banks due to forthcoming foreign debt servicing obligations - see Chart I-5 on page 5 - along with lingering pent-up demand for foreign assets among households and companies will weigh on the RMB's value. On top of that, the narrowing interest rate differential between China and the U.S. also points to further yuan depreciation (Chart I-8). Do the authorities hold enough international reserves to satisfy Chinese individuals' and companies' demand for foreign currency? Chart I-9 reveals the central bank's foreign exchange reserves including gold (about US$3 trillion) are equal to 10% and 14% of broad money (M3) and total deposits, respectively. In brief, the US$3 trillion foreign exchange reserves are not sufficient to back up the enormous deposit base which has been created by banks out of thin air. Chart I-8More RMB Weakness Ahead More RMB Weakness Ahead More RMB Weakness Ahead Chart I-9China: FX Reserves Are Thin ##br##Relative RMB Deposits bca.ems_wr_2018_07_19_s1_c9 bca.ems_wr_2018_07_19_s1_c9 Importantly, these money excesses and ultimately Chinese households' willingness to hold RMBs - with the exchange rate acting as the litmus test - represent a major constraint on policymakers to indefinitely stimulate the economy. Third, the mainland's real estate market bubble has in recent years moved from coastal areas to third- and fourth-tier cities. Consistently, construction activity has recovered in the past two years, but the sustainability of the revival is dubious. The decline in inventories in third- and fourth-tier cities has been achieved via the monetization of excess housing inventories. The central bank has been funding "slum" development in smaller cities via cheap and direct financing. Since the start of 2014, the PSL program has injected RMB 3 trillion into housing and construction in tier-3 and smaller cities. In brief, the authorities have extended the property cycle by a few more years by conducting outright monetization of housing stock. In the process, property developers' leverage has continued surging, while their net cash flows have more recently deteriorated (Chart I-10). In short, the adjustment in the real estate market has been delayed, and imbalances have become larger. Fourth, consistent with easy money policies and soft budget constraints for government entities, efficiency and productivity continue to deteriorate in China (Chart I-11). Chart I-10Chinese Property Developers: ##br##Leverage And Cash Flow Chinese Property Developers: Leverage And Cash Flow Chinese Property Developers: Leverage And Cash Flow Chart I-11China: Declining Efficiency ##br##And Productivity China: Declining Efficiency And Productivity China: Declining Efficiency And Productivity In any economy, easy money leads to less productivity. Other EMs are no different (Chart I-12). Fifth, easy money in China finds its way into many other developing economies via mainland imports. As such, slower Chinese growth will translate into weaker mainland imports of commodities, materials and industrial goods. As a result, EM ex-China trade balances will deteriorate. In turn, EM corporate profits are at major risk of plunging due to a slowdown in China. Chart I-13 illustrates that the mainland's money/credit cycle leads EM corporate profits. This is why we spend ample time understanding and discussing China's cycle and fundamentals. Chart I-12EM Ex-China: Weak Productivity Growth EM Ex-China: Weak Productivity Growth EM Ex-China: Weak Productivity Growth Chart I-13EM Corporate Earnings Are At Risk bca.ems_wr_2018_07_19_s1_c13 bca.ems_wr_2018_07_19_s1_c13 Remarkably, EM non-financial companies' return on assets and profit margins are at levels that prevailed at the height of previous major downturns/crises (Chart I-14). If they relapse from these levels, this would entail very poor corporate profitability, and investors may question the multiples they are paying for EM equities. Finally, there has been little deleveraging in EM ex-China, Korea and Taiwan: External debt and debt servicing in 2018 remains elevated (Chart I-15). Chart I-14EM Non-Financials: Return On Assets Are ##br##At Levels Seen In Major Downturns EM Non-Financials: Return On Assets Are At Levels Seen In Major Downturns EM Non-Financials: Return On Assets Are At Levels Seen In Major Downturns Chart I-15EM Ex-China: External Debt And Servicing EM Ex-China: External Debt And Servicing EM Ex-China: External Debt And Servicing Local currency debt has been reduced in the Brazilian, Russian and Indian corporate sectors only. There has been little deleveraging outside of these segments. In Brazil, loan contraction in the banking system has been offset by a surge in public debt. Public debt dynamics in Brazil are unsustainable - the result will be either the monetization of public debt or severe fiscal contraction and renewed recession. We will discuss the outlook for Brazil in a Special Report next week. More importantly, banking systems not only in China but in most EM countries, have not provisioned for non-performing loans (NPLs). NPL recognition and provisioning are very low relative to the magnitude of preceding credit booms. Notably, with nominal GDP growth relapsing in many EM economies, their NPL provisions should rise, as demonstrated in Chart I-16A and Chart 16 I-B (nominal GDP growth is shown inverted in this chart). Chart I-16AEM Banks' Provisions Are Set To Rise EM Banks' Provisions Are Set To Rise EM Banks' Provisions Are Set To Rise Chart I-16BEM Banks' Provisions Are Set To Rise EM Banks' Provisions Are Set To Rise EM Banks' Provisions Are Set To Rise Bottom Line: In EM at large and in China above all, the excesses and "deadwood" of 2009-2011 were not cleansed during the 2011-2015 downturn. Specifically, credit excesses have gotten larger - not smaller - in China while the property market has become even more bubbly. Likewise, the misallocation of capital, inefficiencies and speculative behavior in both the financial system and real economy have proliferated. Easy money masked all these negatives in 2016-'17. Yet, as money and credit growth in China have plunged and the Fed steadily shrinks its balance sheet, these negatives are now re-surfacing. EM And The Fed Fed policy and U.S. interest rates are not irrelevant to EM, but they are of secondary importance. The primary driver of EM economies are their domestic fundamentals and the overall global business cycle. Historically, the correlation between EM risk assets and the fed funds rate has been mixed, albeit more positive than negative (Chart I-17). On this chart, we shaded the periods when EM stocks rallied despite a rising fed funds rate. Chart I-17EM Share Prices And Fed Funds Rate: Mixed Correlation EM Share Prices And Fed Funds Rate: Mixed Correlation EM Share Prices And Fed Funds Rate: Mixed Correlation The episodes when EMs crashed amid rising U.S. interest rates were 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 and pegged exchange rates. 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. Importantly, EM stocks, credit markets and currencies did well during periods of rising fed funds rate in 1988-1989, 1999-2000, and 2017, as illustrated in Chart I-17. Presently, the Fed's policy is bullish for the U.S. dollar, and, hence bearish for EM currencies. When EM currencies depreciate, their equities, credit and local bond markets typically sell off. As the Fed is shrinking its balance sheet, commercial banks' reserves at the Fed are also declining. In recent years, changes in banks' excess reserves have been inversely correlated with the dollar (the dollar is shown inverted in the chart) (Chart I-18). Furthermore, U.S. dollar liquidity is also relapsing, which is a bad omen for EM risk assets (Chart I-19). Chart I-18Fed Balance Sheet And U.S. Dollar Fed Balance Sheet And U.S. Dollar Fed Balance Sheet And U.S. Dollar Chart I-19U.S. Dollar Liquidity Is Bearish For EM U.S. Dollar Liquidity Is Bearish For EM U.S. Dollar Liquidity Is Bearish For EM Bottom Line: Rising U.S. interest rates in of themselves are not a sufficient condition for EM to sell off. Only in combination with poor EM fundamentals or a weakening global business cycle are rising U.S. borrowing costs negative for EM financial markets. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Thailand: Will It Be A Low-Beta Market? 19 July 2018 Thai equities have been selling off in absolute terms and have lately begun to underperform the emerging markets (EM) equity benchmark (Chart II-1, top panel). Meanwhile, the currency has also been weakening (Chart II-1, bottom panel). Chart II-1Thai Financial Markets Thai Financial Markets Thai Financial Markets It is very unlikely that Thai share prices and the currency will decouple from their EM peers. Hence, given our negative outlook on EM stocks and currencies, odds are that Thai stocks and the baht will weaken further in absolute terms. However, we believe that Thai financial markets will act defensively amid the ongoing EM selloff. The basis on which we are reiterating our overweight stance on both Thai equities and the baht relative to their EM peers, is founded on the relative resilience of this country's macro fundamentals: Thailand runs a very large current account surplus of 10% of GDP and this provides the baht with a significant cushion. Further, Thai exports are not susceptible to a rollover in commodities prices and a downtrend in Chinese demand. Thailand's main exports are electronics, semiconductor chips, and autos - all of which account for about 40% of total exports. These categories are facing less downside risks than industrial metals and oil prices from weaker Chinese demand. Importantly, exports to China make up 12% while shipments to the U.S. and EU account for 12% and 11% of Thai total goods exports, respectively. We are less negative on the outlook of exports to the U.S. and EU than to China. Thailand has the lowest levels of foreign debt servicing obligations and foreign funding requirements among EM countries (Charts II-2). This stands in stark contrast to the onset of the Asian financial crisis when Thailand had the highest level of external debt. Accordingly, low external debt will limit Thai baht selling by local companies looking to hedge their foreign debt liabilities. Finally, foreign ownership of local government bonds is relatively low (15%). This will limit potential outflows. Chart II-2FX Debt Vulnerability Ranking: Foreign Debt Service Obligations (FX Debt Service In Next 12 Months) Understanding The EM/China Cycles Understanding The EM/China Cycles Remarkably, domestic demand in Thailand is beginning to improve. Chart II-3 shows that loan growth is picking up noticeably. In turn, growth in manufacturing production and consumption is starting to turn upwards (Chart II-3, middle panel). Passenger vehicle sales are also growing robustly (Chart II-3, bottom panel). Improving domestic demand will continue to be supported by low and stable domestic rates. In the recent months, interest rates have risen in many South East Asian countries but not in Thailand (Chart II-4). This is a critical difference that places Thailand apart from many of its peers. The Bank of Thailand (BoT) is in no rush to raise its policy rates even if the currency depreciates further. Thai core inflation remains slightly below target and the currency depreciation can in fact be viewed as a positive reflationary force. In a nutshell, the enormous current account surplus, low public debt/fiscal deficit and structurally low inflation provide Thailand with the ability to maintain low interest rates amid the ongoing EM storm. This will in turn fortify domestic demand resilience to a negative external shock. Chart II-3Thai Growth Is Firming Up Thai Growth Is Firming Up Thai Growth Is Firming Up Chart II-4Policy Divergence Policy Divergence Policy Divergence A quick comment on political risks is warranted. The Thai military junta and political institutions have begun preparations to hold elections sometime next year (likely February to May) that will return the country to civilian rule. A transfer of power from the currently stable military rule to a more uncertain civilian rule will likely trigger a period of rising volatility. However, the junta's economic management has been fairly successful. Growth is strong and, crucially, public debt is low at 33% of GDP and the fiscal deficit is manageable. The junta has the capacity to continue to appease rural voters - who traditionally vote for the populist, anti-junta Pheu Thai party - by increasing government spending. Moreover, the junta has rewritten the constitution, which was approved in a popular referendum and ratified in 2017, to influence both the electoral system and parliament in its favor. Nevertheless, the opposition Pheu Thai Party, which has won every election since 2001, retains the edge in popular opinion. Our colleagues from the Geopolitical Strategy team believe that in the 20%-30% chance scenario where the elections enable the opposition to form a government, policy uncertainty will spike. Yet, this will only occur next year and in the meantime macro factors still make Thailand immune to external shocks. Importantly, uncertainty over the transition period, and the outcome of the elections has probably caused an exodus of foreign investors from this bourse (Chart II-5). However, foreigners' diminished holdings of Thai stocks will limit the downside in the months ahead and allow this market to outperform the EM equity benchmark. Chart II-5Foreigners Have Bailed Out of Thai Stocks Foreigners Have Bailed Out of Thai Stocks Foreigners Have Bailed Out of Thai Stocks Bottom Line: We recommend EM dedicated portfolios keep an overweight position in Thai equity, currency and fixed income markets. Macro factors make Thailand more immune to external shocks vis a vis other EM economies. Political risks by themselves do not justify this bourse's underperformance versus the EM benchmark. In turn, the Thai baht should outperform other EM currencies amid the ongoing weakness in global growth. In line with this view, we maintain the long 5-year Thai bonds / short 5-year Malaysian bonds trade. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report "Where Are EMs In The Cycle?," dated May 3, 2018, available on page 20. 2 Industrial metals prices began falling and oil prices peaked in 2011 even though oil prices stayed flat till 2014 when they crashed. 3 Please see Emerging Markets Strategy Special Report "The True Meaning Of China's Great 'Savings' Wall," dated December 20, 2017, available on ems.bcaresearch.com; and Emerging Markets Strategy Special Report "Is Investment Constrained By Savings? Tales Of China And Brazil," dated March 22, 2018, available on page 20. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The 10-year Italian BTP yield at 4% yield marks a 'line in the sand' at which the current drama could escalate into something considerably worse. The global 6-month credit impulse is now indisputably in a mini-downswing phase. Stay underweight in the classically cyclical sectors: banks, basic materials and industrials. Prefer France's CAC over Italy's MIB and Spain's IBEX. The equity market's range-bound pattern can continue, as long as the line in the sand isn't breached. It is a good time to own a small portfolio of high-quality 30-year government bonds. It was a spectacular week for our fractal trades with four positions hitting their profit targets: long Poland/short Italy; short energy/long basic materials; short Spanish Bonos/long German bunds; and long AUD/NOK. Feature Italian politics have blindsided almost everybody, us included. Few anticipated that the unlikely bedfellows 5S and Lega would try and form a 'government of change'. In March we wrote: "The Italian election result is not an investment game changer. The one exception would be if 5S and Lega joined forces to govern, as it could throw EU integration into reverse. But the likelihood of this unholy alliance seems very low." Even fewer anticipated that Italy's President, Sergio Mattarella, would then scupper this government of change by vetoing the proposed Finance Minister. This has cast a new pall of uncertainty over Italian politics and Italian public support for EU rules and institutions. The 10-Year BTP Yield At 4% Marks A 'Line In The Sand' The market's response has been to fear the worst: shoot first, ask questions later. The danger is that this sets off a negative feedback loop. Higher bond yields weaken Italy's still-fragile banks; which threatens Italy's economic recovery; ahead of a possible new election, this increases the support for parties and policies that push back against EU rules; which further lifts bond yields; and then in a vicious circle until the fear of the worst becomes a self-fulfilling prophecy... Chart of the WeekItalian Banks' Solvency Would Be In Question If The 10-Year BTP Yield Breached 4% Italian Banks' Solvency Would Be In Question If The 10-Year BTP Yield Breached 4% Italian Banks' Solvency Would Be In Question If The 10-Year BTP Yield Breached 4% The Italian BTP versus German bund yield spread is effectively a fear gauge for Italy's future in the euro (Chart I-2). As these fears increase, and Italian bond prices decline, it erodes the value of Italian banks' €350 billion portfolio of BTPs and weakens the banks' balance sheets. Chart I-2The BTP-Bund Yield Spread Is A Fear ##br## Gauge For Italy's Future In The Euro The BTP-Bund Yield Spread Is A Fear Gauge For Italy's Future In The Euro The BTP-Bund Yield Spread Is A Fear Gauge For Italy's Future In The Euro As a rule of thumb, investors start to get nervous about a bank's solvency when equity capital no longer covers net non-performing loans (NPLs). On this rule, the largest Italian banks now have €165 billion of equity capital against €130 billion of net NPLs, implying excess capital of €35 billion (Chart I-3). Chart I-3Italian Banks' Equity Capital Exceeds Net NPLs By Euro 35 Bn Italian Banks' Equity Capital Exceeds Net NPLs By €35Bn Italian Banks' Equity Capital Exceeds Net NPLs By €35Bn It follows that there would be fresh doubts about Italian banks' mark-to-market solvency if their bond valuations sustained a drop of just a tenth from the recent peak. We estimate this equates to the 10-year BTP yield breaching and remaining above 4%.1 Hence, the 10-year BTP yield at 4% marks a 'line in the sand' at which the current drama could escalate into something considerably worse (Chart of the Week). To short-circuit the negative feedback loop, the financial markets would need to sense a discernible shift in Italian support for its populist parties; or an explicit de-escalation in the populist pushback against the EU. The question is: could this happen quickly enough? Global Growth Is In A Mini-Downswing The market's concerns about Italy come at a time when global growth has in any case been losing momentum. This is one development that did not blindside us, and has unfolded exactly as predicted. In January we wrote: "Global growth experiences remarkably consistent - and therefore predictable - 'mini-cycles', with half-cycle lengths averaging 8 months. As the current mini-upswing started in May 2017 we can infer that it is likely to end at some point in early 2018. So one surprise could be that global growth will lose steam in the first half of 2018 rather than in the second half - contrary to what the consensus is expecting." The theory underlying these mini-cycles is an economic model called the Cobweb Theorem.2 When bond yields rise, interest rate sensitive sectors in the economy feel a headwind, but with a delay. Similarly, when bond yields decline, interest rate sensitive sectors feel a tailwind, but again with a delay. The delay occurs because credit demand leads credit supply by several months (Chart I-4). Chart I-4Turning Points In The Bond Yield Lead Turning Points In The Credit Impulse Turning Points In The Bond Yield Lead Turning Points In The Credit Impulse Turning Points In The Bond Yield Lead Turning Points In The Credit Impulse As credit demand leads credit supply, the turning point in the price of credit (the bond yield) always leads the quantity of credit supplied (the credit impulse). The result is a perpetual mini-cycle oscillation in both economic variables. And because the quantity of credit supplied is a marginal driver of economic activity, this also creates mini-cycles in economic activity. These mini-cycles are remarkably regular with half-cycle lengths averaging around eight months, and the regularity creates predictability. Moreover, as most investors are unaware of these cycles, the next turning point is not discounted in financial market prices - providing a compelling investment opportunity for those who do recognise the predictability. The global 6-month credit impulse is now indisputably in a mini-downswing phase, and exactly as predicted in January, the majority of economically sensitive sectors have underperformed. The glaring anomaly is oil, whose supply-side dynamics have dominated price action (Chart I-5). Given oil's major impact on headline inflation, inflation expectations, and on central bank reaction functions, the global bond yield has also disconnected from the mini-cycle - until now. Chart I-5Oil Is The Glaring Anomaly Oil Is The Glaring Anomaly Oil Is The Glaring Anomaly Mini-downswings last six to eight months and the usual release valve is a decline in bond yields. So one concern is that the apparent disconnect between decelerating global activity and slow-to-react bond yields could extend the current mini-downswing phase beyond the summer. How To Invest Right Now From an equity market perspective, the relative performance of the classically cyclical sectors - banks, basic materials and industrials - very closely tracks the phases of the global credit impulse mini-cycle (Chart I-6 and Chart I-7). For example, in all five of the last five mini-downswings, banks have underperformed healthcare, and we are seeing exactly the same in the current mini-cycle. Chart I-6In A Mini-Downswing##br## Banks Underperform In A Mini-Downswing, Banks Underperform In A Mini-Downswing, Banks Underperform Chart I-7In A Mini-Downswing ##br##Basic Materials Underperform In A Mini-Downswing, Basic Materials Underperform In A Mini-Downswing, Basic Materials Underperform For the next few months at least, it is appropriate to stick with underweights in the classically cyclical sectors: banks, basic materials and industrials. This strategy has worked extremely well since we initiated it at the start of the year, and it should continue to do so. Sector strategy necessarily impacts stock market allocation. Our core philosophy of investment reductionism teaches us that for most stock markets, the sector (and dominant company) skews swamp any effect that comes from the domestic economy. The defining skew for Italy's MIB and Spain's IBEX is their large overweighting to banks (Chart I-8 and Chart I-9). Irrespective of the political uncertainties, our sector allocation establishes our near-term caution on these two markets. Prefer France's CAC over Italy's MIB and Spain's IBEX. Chart I-8Italy's MIB = Long Banks Italy's MIB = Long Banks Italy's MIB = Long Banks Chart I-9Spain's IBEX = Long Banks Spain's IBEX = Long Banks Spain's IBEX = Long Banks For bonds, the implication is that yields can move only slightly higher before stronger headwinds to risk-assets and/or the global economy provide a natural cap and a tradeable reversal in yields. Hence, it is a good time to own a portfolio of high-quality 30-year government bonds. Regarding currencies, the recent developments in Italy have hurt our 50:50 combined long position in EUR/USD and SEK/USD; but this has been countered by gains in our short position in EUR/JPY. We have no tactical conviction on any of these crosses, but we will maintain this medium term currency portfolio unless the Italian 10-year BTP yield breaches the 4% line in the sand. Finally, the hardest call to make is on the direction of equity market. This is because a mini-downswing in global growth creates a headwind to earnings expectations; conversely, if bond yields are capped, this will provide some support to equity market valuations. On balance, this suggests that the year-to-date pattern of a range-bound equity market is set to continue. The caveat is that if Italy's line in the sand is breached, it would warrant a substantial de-risking. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Assuming that the average maturity of Italian banks' BTPs is around 5 years. 2 Please see the European Investment Strategy Special Report 'The Cobweb Theory And Market Cycles' published on January 11 2018 and available at eis.bcaresearch.com. Fractal Trading Model* It was a spectacular week for our fractal trades with four positions hitting their profit targets: long Poland/short Italy; short energy/long basic materials; short Spanish Bonos/long German bunds; and long AUD/NOK. This week, we note that the 65-day fractal dimension of the Polish zloty / U.S. dollar (or inverse) is approaching its lower limit. Go long PLN/USD with a profit target of 3.5% and 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-10 Long PLN/USD Long PLN/USD 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 The labor market continues to tighten and pressure the Fed. Tightening financial conditions suggest more muted returns for U.S. dollar assets and are associated with a peak in cyclical sectors. BCA's proprietary Monetary Indicator (MI) has turned lower, indicating that liquidity is drying up. Assessing performance of financial markets and the economy as financial conditions tighten. Feature Chart 1Oil Prices And Breakevens##BR##Moving In Lock Step Oil Prices And Breakevens Moving In Lock Step Oil Prices And Breakevens Moving In Lock Step Oil prices rose last week, U.S. equity prices climbed and credit spreads narrowed. Energy prices surged in the wake of President Trump's withdrawal from the 2015 JCPOA deal with Iran. BCA's Commodity & Energy Strategy team noted that the decision is unambiguously bullish for oil prices.1 Escalating geopolitical risks2 with Iran will add the potential for oil supply losses down the road and hence, add a premium to prices. Venezuelan oil production has been declining for the past two years, sitting at only 1.5 million b/d. The pace of future declines is unknown, but the potential for another steep contraction is worrisome as Venezuela's economic collapse continues and links in the oil export supply chain are breaking down. In light of these factors, BCA expects oil prices to test $90/bbl by the end of year. Importantly, inflation expectations are escalating along with oil prices (Chart 1). Continued upward pressure will have implications for monetary policy, particularly in the U.S. where inflation is approaching the Fed's target. The bottom panel of Chart 1 shows that the correlation between Brent crude and the 10-year Treasury breakeven swaps is positive and rising. BCA's U.S. Bond Strategy service pegs fair value for the 10-year Treasury yield at 3.28%.3 The Fed is poised to raise rates gradually this year and next as the labor market tightens further, pushing up wage inflation. Fed rate hikes will squeeze financial conditions and ultimately trigger the next recession in early 2020. Tightening financial conditions suggest more muted returns for U.S. dollar assets and are associated with a peak in cyclical sectors of the economy. Meanwhile, liquidity indicators remain generally favorable for financial assets and the U.S. economy. Nonetheless, BCA's proprietary Monetary Indicator (MI) has turned lower, indicating that liquidity is drying up. The March To 3.5% Data from the National Federation of Independent Business (NFIB) in April and the Job Openings and Labor Turnover Survey (JOLTS) in March support our stance that the slack in the U.S. labor market is tightening and will ultimately lead to higher wage inflation. As noted in last week's report,4 the U.S. economy created an average of 208,000 new jobs in the three months ending April and the unemployment rate fell to a new cycle low of 3.9%. Annual wage inflation moderated in April to just 2.6% from a recent high of 2.8% in January. Chart 2 shows that small business owners' compensation plans remained near all-time highs in April. This metric is closely aligned with the wages and salaries component of the Employment Cost Index (ECI) and suggests further acceleration ahead for the ECI (panel 1). Job openings via the JOLTS data also hit a new zenith in March, creating an even wider gap between openings and hires (panel 2). Moreover, quits minus layoffs, another indicator of labor market slack, reached a record high (panel 3). The stout labor market has lifted the prime age (25-54 years) participation rate. BCA expects that the overall participation rate will remain flat in the next year or so. However, we concur with the Congressional Budget Office that due to demographics, the participation rate will drift lower in the next decade.5 Moreover, the robustness of the labor market is widespread. Charts 3A and 3B show the ratio of job openings to the number of unemployed in 10 sectors of the economy. The ratio is at an all-time high in 9 of the 10 sectors. The exception is the information sector, which includes industries such as newspaper and magazine publishing, broadcasting and telecommunications. Chart 2Labor Market Slack Is Disappearing Labor Market Slack Is Disappearing Labor Market Slack Is Disappearing Chart 3AStrength In The Labor Market... Strength In The Labor Market... Strength In The Labor Market... Chart 3B... Is Broad-Based ... Is Broad-Based ... Is Broad-Based Bottom Line: The U.S. labor market continued to tighten as Q2 began. BCA's stance is that the unemployment rate will fall to a 50-year low of 3.5% by mid-2019.6 The FOMC pegs the longer-term unemployment rate at 4.5%.7 The implication is that BCA and the FOMC expect the U.S. economy to continue to run below full employment this year. However, BCA's view is that the FOMC's forecast for the unemployment rate at the end of 2018 (3.8%) is too high and only marginally lower than the current 3.9%. This is inconsistent with real GDP growth well in excess of its supply-side potential. The macro backdrop will likely justify the FOMC hiking more quickly than the March 2018 dots forecast. The risks are skewed to the upside. BCA expects the 2/10 curve to remain around 50bps until the inflation breakevens are re-anchored between 2.3% and 2.5% as upward pressure on the short end from Fed rate hikes is offset by the upward thrust of the breakevens on the long end.8 Stay underweight duration. How High Is High? Chart 4Cyclical Spending Suggests That##BR##Monetary Policy Remains Accommodative Cyclical Spending Suggests That Monetary Policy Remains Accommodative Cyclical Spending Suggests That Monetary Policy Remains Accommodative The uptrend in cyclical spending suggests that U.S. monetary policy remains accommodative for the time being. Chart 4 shows overall cyclical spending as a share of potential GDP (panel 1) and for sectors most sensitive to the business cycle and interest rates: consumer spending on durables (panel 2), capital spending (panels 3 and 4) and housing (panel 4). All of these metrics are in an uptrend, although the rate of increase has declined during the past few quarters because of slightly weaker consumer spending on durables. In last week's report, we noted that rising rates and tighter financial conditions will not impact household and business spending this year.9 Table 1 shows that since 1960 total cyclical spending as a share of potential GDP has peaked six quarters prior to the onset of a recession. Consistent with our prior research,10 housing reached a zenith several quarters before other sectors. On the other hand, business spending on commercial real estate topped out only a year before a recession. Housing also provides the earliest warning in long economic cycles,11 peaking 14 quarters before the end of an expansion. Overall, cyclical sectors in long expansions crest 10 quarters before the onset of a downturn. Bottom Line: The performance of cyclical segments of the economy suggests that monetary policy is still accommodative. A distinct peak in these sectors will signal that Fed policy has turned restrictive and that long-term rates are close to their cyclical highs. Until then, stay long stocks over bonds and underweight duration. Tightening liquidity and financial conditions are associated with peaks in the cyclical sectors of the economy. Table 1Recession Signals From Cyclical Sectors Of The Economy Tightening Up Tightening Up Liquidity And Financial Conditions While liquidity conditions are accommodative, they are not nearly as abundant as prior to the Lehman event. The October 2017 Bank Credit Analyst Special Report on liquidity12 noted that monetary conditions are super easy, while balance sheet and financial market liquidity are reasonably constructive. In contrast, funding liquidity, while vastly improved since the global financial crisis (GFC), is still a long way from the pre-Lehman go-go years, according to several important indicators such as bank leverage. Moreover, the Fed is in the process of unwinding a massive amount of monetary liquidity provided by its quantitative easing program. The gauges of liquidity have turned restrictive in recent months. Chart 5 shows M2 growth less GDP growth (top panel) along with monetary conditions and world reserves ex gold. Furthermore, the gap between nominal GDP growth and short rates has narrowed this year (Chart 6). Still, GDP growth is outpacing short rates, a sign that monetary liquidity is still present. Chart 5Monetary Liquidity Indicators (I) Monetary Liquidity Indicators (I) Monetary Liquidity Indicators (I) Chart 6Monetary Liquidity Indicators (II) Monetary Liquidity Indicators (II) Monetary Liquidity Indicators (II) Balance sheet liquidity for corporations, households and the banking sector remains supportive. The top panel of Chart 7 presents short-term assets-to-total liabilities for the corporate sector. It is a measure of readily available cash or cash-like instruments that make it easier to weather economic downturns and/or credit tightening phases. The non-financial corporate sector is in very good shape from this perspective. The seizure of the commercial paper market during the GFC encouraged firms to hold more liquid assets on their balance sheets. However, the uptrend began in the early 1990s and likely reflects tax avoidance efforts. The impact of the Tax Cut and Jobs Act of 2017 may partially reverse this trend. Households are also very liquid when short-term assets are compared with income (panel 2). Liquidity is low as a share of individuals' total discretionary financial portfolios, but this is not surprising given extraordinarily unattractive interest rates. In the banking sector, short-term assets as a percentage of total bank credit has climbed in the past decade as banks were forced to hold more liquid assets in the wake of the 2007-2009 financial crisis (Chart 8). Chart 7Balance Sheet Liquidity Balance Sheet Liquidity Balance Sheet Liquidity Chart 8Banking Sector Liquidity Banking Sector Liquidity Banking Sector Liquidity Charts 9 and 10 show market liquidity in the U.S. equity and high-yield markets. For the equity market, we present the one-year moving average of trading volume divided by shares outstanding or share turnover to get a sense of relative liquidity between firms (Chart 9). This measure has improved in recent years, but remains compressed vis-a-vis pre-crisis levels. BCA's Equity Trading System favors firms with lower liquidity, since investors pay a premium for liquidity.13 Liquidity in the high-yield market has recovered in recent years, but flows into high-yield bond funds turned negative in mid-2017 (Chart 10, panels 1 and 2). Nonetheless, the default-adjusted junk spread remains below its long-term average (panel 3). BCA's U.S. Bond Strategy service recommends investors overweight high-yield bonds relative to Treasuries.14 Chart 9Equity Market Liquidity Equity Market Liquidity Equity Market Liquidity Chart 10High Yield Bond Market Liquidity High Yield Bond Market Liquidity High Yield Bond Market Liquidity Funding liquidity - as measured by primary dealers' securities lending - has recovered from financial crisis lows, but has not reached pre-crisis highs (Chart 11, panel 1). Primary dealers make loans to other financial institutions with the purpose of buying securities, thereby providing both funding liquidity and market liquidity. The uptrend in margin debt remains in place (panel 2). The steep escalation in this direct measure of funding liquidity is less impressive when compared with the S&P 500's market cap. Bank's lending standards for C&I loans are another measure of funding liquidity (Chart 12). These surveys reflect bank lending standards on loans to the household or corporate sectors. Nonetheless, a financial institution's appetite for lending for the purposes of securities purchases is highly correlated. Lending standards eased in 2017 and in early 2018, but they are not as loose as they were earlier in this cycle or in the pre-crisis period (2005-2007). Chart 11Funding Liquidity:##BR##Securities Lending And Margin Debt bca.usis_wr_2018_05_14_c11 bca.usis_wr_2018_05_14_c11 Chart 12Funding Liquidity:##BR##Bank Lending Standards Funding Liquidity: Bank Lending Standards Funding Liquidity: Bank Lending Standards Perspective On Liquidity And Financial Conditions BCA expects that both monetary and financial conditions will constrict in the next year as inflation moves through the Fed's 2% target and the FOMC gradually boosts rates in the next 12 months. A stronger dollar and higher bond yields will contribute to the tightening, but higher equity prices are an offset. Chart 13, Appendix Chart 1, and Tables 2 and 3 show BCA's MI versus key U.S. financial assets and commodities, and U.S. economic variables. The S&P 500 index has historically rallied strongly when the MI is above its long-term average. Moreover, BCA's stocks-to-bonds ratio rises, investment-grade and high-yield corporate bonds outperform Treasuries. However, oil prices struggle in this environment (Chart 13 and Table 2). Chart 13Risk Assets When BCA's Proprietary Monetary Indicator Is Below Zero Risk Assets When BCA's Proprietary Monetary Indicator Is Below Zero Risk Assets When BCA's Proprietary Monetary Indicator Is Below Zero Table 2Performance Of Risk Assets When Monetary Indicator Is Above Zero Tightening Up Tightening Up Table 3Performance Of Risk Assets When Monetary Indicator Is Below Zero Tightening Up Tightening Up When MI is below zero, on the other hand, economic performance is mixed. GDP growth, cyclical spending as a share of GDP, and employment tend to peak when the MI is decelerating, but recessions rarely occur when the MI is negative (Appendix Chart 1, panels 2, 3 and 4). Core inflation often peaks when the MI is above zero (not shown). However, the MI is sending a negative signal because interest rates have increased and credit growth has slowed. Table 3 indicates the performance of U.S. financial assets when the MI is below zero. We used the periods in which the MI was persistently below zero to avoid false signals. Note that the average and median returns for most asset classes in Table 3 (MI below zero) are well below those in Table 2 (MI above zero). Notable exceptions are oil and the dollar, which strengthen when the MI is below zero. S&P 500 earnings growth struggles during this episodes. Chart 14, Appendix Chart 2, and Tables 4 and 5 present financial conditions versus key U.S. financial assets and commodities, and U.S. economic variables. BCA expects the financial conditions index (FCI) to decline further into negative territory in the next few years. U.S. equities and credit tend to perform better when the FCI rises (Table 4) rather than when it falls (Table 5). However, when it does fall, gold and oil are stronger. Chart 14Risk Assets When Financial Conditions Tighten Risk Assets When Financial Conditions Tighten Risk Assets When Financial Conditions Tighten Table 4Performance Of Risk Assets When Financial Conditions Are Easing Tightening Up Tightening Up Table 5Performance Of Risk Assets When Financial Conditions Are Tightening Tightening Up Tightening Up Moreover, we note that GDP growth and cyclical spending as a share of GDP often peak when FCI drops. Employment and inflation are mixed at best when the FCI decelerates (Appendix Chart 2). Bottom Line: The U.S. economy is growing above its long-term potential, the labor market is tightening and inflation is at the Fed's target but poised to move higher next year. The Fed will increase rates to cool the overheating economy. Therefore, liquidity and financial market conditions will deteriorate further in the next year as Treasury yields increase and the dollar climbs in tandem with a more aggressive Fed. Stay overweight stocks versus bonds for now, but look to pare back exposure later this year. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's Energy Sector Strategy Weekly Report "Geopolitical Certainty: OPEC Production Risks Are Playing To Shale Producers' Advantage," published May 9, 2018. Available at nrg.bcaresearch.com. 2 Please see BCA Research's Geopolitical Strategy Weekly Report "We Are All Geopolitical Strategists Now," published March 28, 2018. Available at gps.bcaresearch.com. 3 Please see BCA Research's U.S. Bond Strategy Weekly Report "Coming To Grips With Gradualism," published May 9, 2018. Available at usbs.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Weekly Report "Stressing The Housing And Consumer Sectors," published May, 7 2018. Available at usis.bcaresearch.com. 5 https://www.cbo.gov/system/files/115th-congress-2017-2018/workingpaper/53616-wp-laborforceparticipation.pdf 6 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Waiting...," published March 26, 2018. Available at usis.bcaresearch.com. 7 https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20180321.pdf 8 Please see BCA Research's U.S. Bond Strategy Weekly Report, "Back To Basics," published April 17, 2018. Available at usbs.bcaresearch.com. 9 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Stressing The Housing And Consumer Sectors," published May 7, 2018. Available at usis.bcaresearch.com. 10 Please see BCA Research's U.S. Investment Strategy Weekly Reports, "2018: Synchronized Global Growth," published December 4, 2017, and "Drives U.S. Economy And Markets," published December 4, 2017. Both available at usis.bcaresearch.com. 11 Please see The Bank Credit Analyst Monthly Report, published November 24, 2016. Available at bca.bcarearch.com. 12 Please see The Bank Credit Analyst Monthly Report, "Liquidity And The Great Balance Sheet Unwind," published October 2017. Available at bca.bcarearch.com. 13 Please see BCA Research's Equity Trading Strategy Special Report, "Introducing ETS: A Top-Down Approach to Bottom-Up Stock Picking," published December 3, 2015. Available at ets.bcaresearch.com. 14 Please see BCA Research's U.S. Bond Strategy Portfolio Allocation Summary "Coming To Grips With Gradualism," published May 8, 2018. Available at usbs.bcaresearch.com. Appendix Appendix Chart 1The Economy When Monetary Indicator Is Below Zero Tightening Up Tightening Up Appendix Chart 2The Economy When Financial Conditions Are Tightening Tightening Up Tightening Up

Highlights The global 6-month credit impulse is now indisputably in a mini-downswing phase. Stick with underweights in the classically cyclical sectors: banks, basic materials and industrials. The strategy has worked well since the start of the year, and it is too early to exit. For bonds, the implication is that yields can move only slightly higher before stronger headwinds to risk-assets and/or the economy provide a tradeable reversal in yields. The trade-weighted euro has some support given that the BoE and/or the Fed have tightening expectations that can be priced out, while the ECB doesn't. We have a slight preference for the FTSE100 and S&P500 over the Eurostoxx50. Feature Entering the fifth month of the year, one puzzle for investors is the conflicting messages coming from banks and bonds. While banks' relative performance is close to its 2018 low, bond yields are not far from their year-to-date high (Chart of the Week). Chart of the WeekBanks Or Bonds: Which One Is Right? Banks or Bonds: Which One Is Right? Banks or Bonds: Which One Is Right? This poses a puzzle because the performances of banks and bond yields are usually joined at the hip. The underperformance of the economically sensitive banks would suggest that global growth is decelerating, whereas the performance of bond yields would suggest that global activity is holding up well. Which one is right? The Global 6-Month Credit Impulse Is Indisputably In A Mini-Downswing Looking at the other classically cyclical sectors, the mystery seems to deepen. Industrials and basic materials are also in very clear downtrends this year, which corroborates the message from the banks. But the oil and gas sector is close to a year high, which corroborates the message from bond yields (Charts I-2-I-4). Chart I-2Industrials Have Underperformed... Industrials Have Underperformed... Industrials Have Underperformed... Chart I-3...And Basic Materials Have Underperformed ...And Basic Materials Have Underperformed ...And Basic Materials Have Underperformed Chart I-4...But Oil And Gas Has Outperformed... ...But Oil And Gas Has Outperformed... ...But Oil And Gas Has Outperformed... The conflicting messages from banks, basic materials and industrials on one side and bond yields and oil and gas equities on the other side reflect the disconnect between non-oil commodity prices which have drifted lower this year and oil prices which have moved sharply higher (Chart I-5). This disconnect, resulting from differing supply dynamics in the different commodity markets, points us to a likely solution to our puzzle. Chart I-5...Because Oil Has Disconnected ##br##From Other Commodities ...Because Oil Has Disconnected From Other Commodities ...Because Oil Has Disconnected From Other Commodities The classically cyclical sectors are taking their cue from global growth and industrial activity, which does appear to be losing momentum. The global 6-month credit impulse is now indisputably in a mini-downswing phase. In contrast, bond yields are taking their cue from the oil price, given its major impact on headline inflation, inflation expectations, and thereby on central bank reaction functions. Based on previous mini-cycles, we can confidently say that mini-downswing phases last at least six to eight months and that the usual release valve is a decline in bond yields. In this regard, the apparent disconnect between decelerating activity and un-budging bond yields risks extending this mini-downswing phase. Therefore, for the next few months, it is appropriate to stick with underweights in the classically cyclical sectors: banks, basic materials and industrials. The strategy has worked well since we initiated it at the start of the year, and it is too early to exit. This sector strategy necessarily impacts regional allocation as explained in the next section. For bonds, the implication is that yields can move only slightly higher before stronger headwinds to risk-assets and/or the economy provide a natural cap and a tradeable reversal in yields. Even More Investment Reductionism Imagine a world in which all the global commodity firms decided to get their stock market listings in London; all the global financials decided to list on euro area bourses; all the major tech companies listed in New York; and all the industrials listed in Tokyo. Clearly, each major stock market would just be a play on its underlying global sector and nothing more. Our imagined world is an exaggeration, but it does illustrate an important truth. A quarter of the market capitalisation of each major stock market is in one dominant sector, and this gives each equity index its defining fingerprint: for the FTSE100 it is commodity firms; for the Eurostoxx50 it is financials; for the S&P500 it is technology; and for the Nikkei225 it is industrials (Table I-1). Table I-1Each Major Stock Market Has A Defining Fingerprint Banks Or Bonds: Which One Is Right? Banks Or Bonds: Which One Is Right? There is another important factor to consider: the currency. A global oil company like BP receives its revenue and incurs its costs in multiple major currencies, such as euros and dollars. In this sense, BP's global business is currency neutral. But BP's stock price is quoted in pounds. This means that if the pound strengthens, the company's multi-currency profits will decline relative to the stock price and weigh it down. Conversely, if the pound weakens, it will lift the BP stock price. So the currency is the channel through which the domestic economy can impact its stock market, albeit it is an inverse relationship: a strong currency hinders the stock market; a weak currency helps it. The upshot is that the defining fingerprints for the major indexes turn out to be: FTSE100: global commodity shares expressed in pounds. Eurostoxx50: global banks expressed in euros. S&P500: global technology expressed in dollars. Nikkei225: global industrials expressed in yen. And that's pretty much all you need to know for regional equity allocation! The charts in this report should leave you in no doubt. True to our Investment Reductionism philosophy, the relative performance of the regional equity indexes just reduces to their defining fingerprints: FTSE100 versus S&P500 reduces to global commodity companies in pounds versus global tech companies in dollars, Eurostoxx50 versus Nikkei225 reduces to global banks in euros versus global industrials in yen. And so on (Charts I-6-I-11). Chart I-6FTSE 100 Vs. S&P 500 = Global Commodity##br## Equities In Pounds Vs. Global Tech In Dollars FTSE 100 Vs. S&P 500 = Global Commodity Equities In Pounds Vs. Global Tech In Dollars FTSE 100 Vs. S&P 500 = Global Commodity Equities In Pounds Vs. Global Tech In Dollars Chart I-7FTSE 100 Vs. Nikkei 225 = Global Commodity ##br##Equities In Pounds Vs. Global Industrials In Yen FTSE 100 Vs. Nikkei 225 = Global Commodity Equities In Pounds Vs. Global Industrials In Yen FTSE 100 Vs. Nikkei 225 = Global Commodity Equities In Pounds Vs. Global Industrials In Yen Chart I-8FTSE 100 Vs. Euro Stoxx 50 = Global Commodity##br## Equities In Pounds Vs. Global Banks In Euros FTSE 100 Vs. Euro Stoxx 50 = Global Commodity Equities In Pounds Vs. Global Banks In Euros FTSE 100 Vs. Euro Stoxx 50 = Global Commodity Equities In Pounds Vs. Global Banks In Euros Chart I-9Euro Stoxx 50 Vs. S&P 500 = Global Banks In ##br##Euros Vs. Global Tech In Dollars Euro Stoxx 50 Vs. S&P 500 = Global Banks In Euros Vs. Global Tech In Dollars Euro Stoxx 50 Vs. S&P 500 = Global Banks In Euros Vs. Global Tech In Dollars Chart I-10Euro Stoxx 50 Vs. Nikkei 225 = Global Banks In##br## Euros Vs. Global Industrials In Yen Euro Stoxx 50 Vs. Nikkei 225 = Global Banks In Euros Vs. Global Industrials In Yen Euro Stoxx 50 Vs. Nikkei 225 = Global Banks In Euros Vs. Global Industrials In Yen Chart I-11S&P 500 Vs. Nikkei 225 = Global Tech In ##br##Dollars Vs. Global Industrials In Yen S&P 500 Vs. Nikkei 225 = Global Tech In Dollars Vs. Global Industrials In Yen S&P 500 Vs. Nikkei 225 = Global Tech In Dollars Vs. Global Industrials In Yen The Right Way To Invest In The 21st Century One important implication of Investment Reductionism is that the head-to-head comparison of stock market valuations is a meaningless and potentially dangerous exercise. Two sectors with vastly different structural growth prospects - say, banks and technology - must necessarily trade on vastly different valuations. So the sector with the lower valuation is not necessarily the better-valued sector. By extension, the stock market with the lower valuation because of its sector fingerprint is not necessarily the better-valued stock market. Another implication is that simple 'value' indexes may not actually offer better value! In reality, they comprise a collection of sectors on the lowest head-to-head valuations which, to repeat, does not necessarily make them better-valued. Some people suggest comparing a valuation with its own history, and assessing how many 'standard deviations' it is above or below its norm. The problem is that the whole concept of standard deviation assumes 'stationarity' - meaning, no step changes in a sector's valuation through time. Unfortunately, sector valuations are 'non-stationary': they undergo major step changes when they enter a vastly different economic climate. For example, the structural outlook for bank profits undergoes a step change when a credit boom ends. Therefore, comparing a bank valuation after a credit boom with the valuation during the credit boom is like comparing an apple with an orange. Pulling together these complexities of sector effects, currency effects, and step changes in sector valuations, we offer some strong advice on how to sequence the investment process: 1. Make your asset class decision at a global level. This is because asset classes tend to move as global entities, not regional entities. And also because at a global level, asset class valuation comparisons are less distorted by sector and currency effects. 2. Make your sector decisions. Given that the companies that dominate European (and all major) indexes are multinationals, the sector decision should be based on the direction of the global economy. 3. Make your currency decisions. 4. You do not need to make any more major decisions! The main regional equity allocation, country allocation and value/growth allocation just drop out from the sector and currency decision. With the global 6-month credit impulse now indisputably in a mini-downswing phase (Chart I-12), the classically cyclical sectors are likely to continue underperforming for the next few months; the rise in bond yields faces resistance; and the euro - at least on a trade-weighted basis - has some support given that the BoE and/or the Fed have tightening expectations that can be priced out, while the ECB doesn't. Chart I-12The Global 6-Month Credit Impulse Is Indisputably In A Mini-Downswing The Global 6-Month Credit Impulse Is Indisputably In A Mini-Downswing The Global 6-Month Credit Impulse Is Indisputably In A Mini-Downswing Finally, in terms of regional equity allocation, Investment Reductionism implies a slight preference for the FTSE100 and S&P500 over the Eurostoxx50. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* In addition to the fundamental arguments in the main body of this report, fractal analysis finds that the outperformance of Oil and Gas relative to other commodity equities is technically extended. Hence, this week's trade recommendation is to underweight euro area Oil and Gas versus global Basic Materials. Set a profit target of 5%, with a symmetrical stop-loss. In other trades, we are pleased to report that long USD/ZAR hit its 6% profit target, and is now closed. This leaves us with five open positions. 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-13 Short Euro Area Energy Vs. Global Basic Materials Short Euro Area Energy Vs. Global Basic Materials 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 Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Trade wars have captured investors' imaginations, but slowing global growth is a more immediate risk for both asset prices and exchange rates. As reflationary forces ebb, slow global growth will help the dollar stage a rally. EUR/USD and GBP/USD could decline over the next two quarters. We are selling EUR/CHF. The AUD has more downside. It is too early to close short AUD/NZD or AUD/JPY. Short EUR/CAD with a first target at 1.44. Feature The growing trade skirmish between China and the U.S. has been blamed for much of the movements in risk assets this year. We do not deny that this has been a very important factor determining the price action of all assets globally; after all, market participants are trying to price in the probability that global supply chains as we currently know them will be forever impaired. If this were to happen, global growth and profits would suffer considerably. This warrants a risk premium, one that is currently being estimated by the market.1 As we have written in recent weeks, this will be a stop-and-go pattern, and behind-the-scene negotiations between China and the U.S. will remain intense until June, when the U.S. tariffs are in fact implemented. However, trade wars are not the only force impacting asset returns today. Global asset prices are also slowly adjusting to a world where reflation is ebbing and where growth may be dipping from its heightened state. This week, we examine the role of liquidity and how it is affecting growth,2 and the implications for various currency pairs. From Reflation To Less Growth Through most of 2016 and 2017, risk assets, EM plays, commodity prices and growth greatly benefited from a wave of global reflation implemented by monetary and fiscal authorities around the world in the wake of a market meltdown that culminated in January 2016. A great victim of this reflationary effort was the U.S. dollar. Once global growth and inflation perked up, the dollar sold off. The U.S. economy is not as levered to global growth as the rest of the world is, thus investors were attracted by greater shift in expected returns outside the U.S. than in the U.S. But how is this reflation story faring today? Global monetary policy is not as supportive as it once was as central banks are not adding to global base money as forcefully as before. For example, the Federal Reserve has begun the rundown of its balance sheet, and the real fed funds rate is closing in on the Laubach-Williams estimate of the neutral rate; the European Central Bank has begun tapering it asset purchases, the European shadow policy rate has increased by 400 basis points; and the Bank of Japan has not hit its JGB target of JPY80 trillion of purchases since mid-2016. Even the Swiss National Bank has not seen any increase in its sight deposits since mid-2017. We like to use excess money growth to measure the impact of these changes in base money growth. Excess money supply growth is measured as the difference between broad money supply growth and money demand as approximated by loan growth. As base money and deposits become scarcer in the banking system relative to the pool of existing loans, the liquidity position of commercial banks deteriorates. This deprives them of the necessary fuel to generate further loan growth down the road. Chart I-1 not only shows that excess money in the U.S., euro area and Japan has been decelerating sharply in recent months, but also that this decline points toward slowing global industrial activity, widening junk spreads and decline EM stock prices. Beyond quantity-based measures of liquidity, price-based measures are sending a similar signal. The widening in the LIBOR-OIS spread has now been well documented. It is true that technical factors such as the issuance of T-bills by the Treasury and the progressive move away from LIBOR as a key benchmark for the pricing of loans partly explain this phenomenon. However, this development is now spreading outside the U.S., with Australia in particular experiencing some especially sharp widening in the spread between deposit rates and the OIS. In fact, the LIBOR-OIS spread for the G-10 as a whole is now at its widest since 2012 (Chart I-2). This also portends a situation where liquidity is becoming scarcer than it once was. Chart I-1Deteriorating Liquidity Conditions Deteriorating Liquidity Conditions Deteriorating Liquidity Conditions Chart I-2Price Of Liquidity Is Increasing Price Of Liquidity Is Increasing Price Of Liquidity Is Increasing Growth is responding to these dynamics, and the softening in PMIs around the world was in full display this week. Interestingly, two bellwethers of global growth are showing especially clear signs of a slowing.3 In Korea, exports have greatly decelerated, industrial production is contracting and PMIs are well below 50 (Chart I-3). Taiwan is also showing some signs of weakness, as exports and export orders are both slowing sharply (Chart I-4). Chart I-3Korea: A Key Global Bellweather Is Slowing Korea: A Key Global Bellweather Is Slowing Korea: A Key Global Bellweather Is Slowing Chart I-4Taiwan Echoes Korea's Message Taiwan Echoes Korea's Message Taiwan Echoes Korea's Message This message is also being relayed by the Japanese economy. Japan's exports to Asia have been slowing sharply as well. As Chart I-5 illustrates, weak Japanese shipments to Asia correlate closely with a weak AUD/JPY, weak EM stock prices and widening junk spreads, suggesting that these specific shipments capture systematic developments behind global growth. Key growth-sensitive currencies are flashing a similar signal. As the top panel of Chart I-6 shows, NZD/JPY has historically rolled over and declined ahead of recessions, growth slowdowns or EM crashes. It has clearly weakened for eight months now. Meanwhile, the bottom panel of Chart I-6 shows the Swedish krona versus the euro. This cross is also a good leading indicator of global growth, and it is clearly pointing south. Chart I-5Japanese Exports Point To A Malaise Japanese Exports Point To A Malaise Japanese Exports Point To A Malaise Chart I-6NZD/JPY And EUR/SEK: Confirming The Risks NZD/JPY And EUR/SEK: Confirming The Risks NZD/JPY And EUR/SEK: Confirming The Risks Finally, one of our favorite gauges to measure the impact of reflation has substantially weakened: the combination of global growth and inflation surprises. This indicator clearly shows that after a massive upsurge in reflationary forces over the past two years, reflation is now waning (Chart I-7). Chart I-7Economic Surprises Are Declining The Reflation Trade In One Chart Economic Surprises Are Declining The Reflation Trade In One Chart Economic Surprises Are Declining If reflation is about pushing growth and prices upward, removing stimulus could have the opposite impact. While it is clear that global growth is slowing, what about inflation? We do not think that global inflation is set to slow significantly: global growth is unlikely to move back below trend, and the U.S. is experiencing increasingly potent domestic inflationary pressures supercharged by fiscal profligacy. That being said, the uptrend in global inflation is nonetheless set to flatten for now as our Global Inflation Diffusion Index based on consumer and producer prices across 27 economies has begun to fall, which normally points to lower global headline and core consumer prices (Chart I-8). Bottom Line: The market's attention has been captured by the dramatic flare-up in trade tensions between the U.S. and China, but a more imminent risk has been garnering less press: the decline of reflation. China sent the first salvo on this front; DM central banks have also slowly been either tightening outright or not expanding monetary aggregates as aggressively as before. As a result, global liquidity is tightening and global growth is slowing. Global inflation is also set to decelerate as well, suggesting the decline in economic activity will not be a real phenomenon only, but a nominal one as well. Key Currency Market Implications One of the key implications of lower global growth and ebbing inflationary pressures is likely to be a stronger dollar. As Chart I-9 illustrates, when our Global Inflation Diffusion Index declines and global inflationary pressures ebb, the dollar tends to strengthen. This makes sense: the dollar does best when global growth weakens, inflation slows and commodity prices soften. This time around, the case for a few quarters of dollar strength may be even better defined. U.S. inflation is unlikely to decelerate as much as non-U.S. inflation as U.S. capacity utilization is tighter, the U.S. labor market is at full employment and America is receiving an extraordinarily large amount of fiscal stimulus at this late stage of the business cycle. Chart I-8No Acceleration For Now In Global Inflation No Acceleration For Now In Global Inflation No Acceleration For Now In Global Inflation Chart I-9Ebbing Inflationary Pressures Will Help The Dollar Ebbing Inflationary Pressures Will Help The Dollar Ebbing Inflationary Pressures Will Help The Dollar Technical considerations suggest the dollar is well placed to take advantage of these dynamics. On a short-term basis, both our intermediate-term oscillator and 13-week rate-of-change measures have formed positive divergences with the DXY itself (Chart I-10). While the pattern does not look as bullish as the one registered in 2014, it evokes deep similarities with the 2011 formation. On a longer-term basis, the dollar is massively oversold, as measured by the 52-week rate of change measure. It is true that it managed to stay at similarly oversold levels for nearly a year in 2003, but back then the dollar was much more expensive than today: the U.S. current account deficit was 4.4% of GDP versus 2.4% today and the basic balance of payments deficit was at 3% of GDP versus 2% today (Chart I-11). It is reasonable that with these stronger fundamentals, the dollar will not need to hit as oversold levels as back then before staging a significant rebound. Chart I-10Positive Divergences For The Greenback Positive Divergences For The Greenback Positive Divergences For The Greenback Chart I-11Dollar Technicals And Valuations: 2003 Vs. Today Dollar Technicals And Valuations: 2003 Vs. Today Dollar Technicals And Valuations: 2003 Vs. Today With global growth slowing, especially in Asia, it is easy to paint a picture where the dollar only strengthens against EM and commodity currencies - the currencies most exposed to both global growth and this specific geographic area. However, while we do see downside in USD/JPY, we expect the greenback to rally against the euro toward EUR/USD 1.15. Our model for EUR/USD shows that the euro is trading 10% above its fair value determined by real rate differentials, the relative slope of yield curves and the price of copper relative to lumber (Chart I-12). In fact, since Europe is more levered to global economic activity than the U.S., these drivers are likely to deteriorate a bit further for the remainder of 2018. Chart I-12EUR/USD Is Vulnerable EUR/USD Is Vulnerable EUR/USD Is Vulnerable GBP/USD also looks set to experience a period of weakness against the greenback. Historically, GBP/USD and EUR/USD have been correlated. This is a simple reflection of the fact that the U.K. has a deeper economic relationship with the euro area than the U.S., and thus benefits from the same economic impulses as the eurozone. Chart I-13GBP/USD: ##br##Extremely Overbought GBP/USD: Extremely Overbought GBP/USD: Extremely Overbought Some pound-specific factors will also play against GBP/USD. As we argued last week, the British domestic economy is rather weak; this week's construction PMI confirmed this assessment.4 Additionally, the British basic balance of payments is in deficit anew. This is not only a reflection of the U.K.'s current account deficit of 4% of GDP, it also reflects the fact that FDI into the U.K. has been melting in response to uncertainty surrounding Brexit. This means the U.K. is dependent upon global liquidity to finance this large deficit. An environment where global growth is set to decelerate and where global liquidity is tightening will make it more expensive to finance this large hole. The fastest means to increase expected returns on British assets to attract foreigners' funds is to depreciate the pound today. Finally, the GBP's annual momentum has hit levels consistent with a reversal in cable (Chart I-13). Staying in Europe, another pair is currently interesting and devoid of taking on any USD risk: EUR/CHF. While we think EUR/CHF has more upside over the remainder of the economic cycle,5 this is unlikely to be the case in the second and third quarters of 2018. The Swiss franc tends to outperform the euro when reflationary forces retreat, when global growth slows and when FX volatility increases - all views we espouse for the coming quarters. Moreover, Switzerland's current account and basic balance-of-payment surpluses are 6.5% of GDP and 11.5% of GDP greater than that of the euro area, providing further attraction in a growth soft spot. Finally, EUR/CHF is massively overbought right now, pointing to heightened vulnerability to the economic risks highlighted above (Chart I-14). We are opening a short EUR/CHF trade this week. In the same vein, we remain bearish EUR/JPY. Finally, in previous reports, we highlighted the AUD as being the currency most at risk from any downshift in global growth.6 Despite its recent weakness, we think the AUD is likely to remain very vulnerable. We have been short AUD/NZD since last October, and we do believe this pair will retest 1.04 before forming a base. Australia is experiencing even less inflationary pressures than New Zealand, and is more exposed to slower global industrial production than its neighbor. Technically, AUD/NZD still has some downside. As Chart I-15 illustrates, the 13-week rate of change measure for AUD/NZD has not yet hit the kind of depressed levels associated with complete capitulation. In fact, the recent breakdown in momentum points toward such capitulation as being imminent. AUD/JPY too is not yet oversold enough to be a buy, especially in the context of slowing global growth. Thus, we continue to recommend investors stay short this pair. Chart I-14Technical Indicators Confirm ##br##The Fundamental Vulnerability Of EUR/CHF Technical Indicators Confirm The Fundamental Vulnerability Of EUR/CHF Technical Indicators Confirm The Fundamental Vulnerability Of EUR/CHF Chart I-15AUD/NZD Has A Little Bit More Downside AUD/NZD Has A Little Bit More Downside AUD/NZD Has A Little Bit More Downside Bottom Line: Ebbing reflationary forces suggest the trade-weighted dollar is likely to rally over the coming months. We do see upside for the USD against EM and commodity currencies, but against European currencies as well. Only the yen is anticipated to buck this trend. Within the commodity-currency complex, we foresee that the AUD will suffer the most, and the CAD the least. Within the European currency complex, we are selling EUR/CHF. We are not selling EUR/USD as we are already long the DXY. A Cyclical Opportunity To Sell EUR/CAD This trade is an attractive means to bet on global growth slowing, especially relative to the U.S. As we have argued, U.S. financial conditions have eased relative to the rest of the world, the U.S. is enjoying large injections of fiscal stimulus and it is less exposed to declining global growth. As a result, we anticipate the outperformance of the U.S. ISM to continue relative to global PMIs. Historically, this is an environment where EUR/CAD tends to depreciate (Chart I-16). This is because while 75% of Canadian exports go to the U.S., only 13% of euro area exports end up there. Thus, Canada is much more exposed to the U.S. business cycle than Europe, who is exposed to the rest of the world's. Domestic factor also argues in favor of shorting EUR/CAD. Canadian core inflation is in an uptrend, and at 2% is at the Bank of Canada's target. European core inflation meanwhile only stands at 1%. Moreover, Canada's unemployment's rate is already 0.5% below equilibrium, while the euro area's is 0.4% above such equilibrium (Chart I-17). Thus, European wages and service sector inflation is likely to continue to lag behind Canada's. As a result, we continue to expect the BoC to keep hiking in line with the Fed, or another three times this year. The same cannot be said for the ECB. Chart I-16EUR/CAD: A Play Global Vs. U.S. Growth EUR/CAD: A Play Global Vs. U.S. Growth EUR/CAD: A Play Global Vs. U.S. Growth Chart I-17No Slack In Canada, Plenty In Europe No Slack In Canada, Plenty In Europe No Slack In Canada, Plenty In Europe Making the trade even more attractive, EUR/CAD is currently trading at a premium on many metrics. First, our augmented interest rate parity models show that the EUR/CAD trades anywhere between 10-15% above fair value (Chart I-18).7 Relative productivity trends have been a reliable long-term indicator of the path for EUR/CAD. On this metric as well, EUR/CAD is trading at a significant 9% premium (Chart I-19). Finally, EUR/CAD has tended to trend in an inverse relationship with oil prices. Today, it is well above levels implied by various oil prices (Chart I-20). Chart I-18EUR/CAD Trades At A Premium To Rate Differentials... EUR/CAD Trades At A Premium To Rate Differentials... EUR/CAD Trades At A Premium To Rate Differentials... Chart I-19...At A Premium To Relative Productivity... ...At A Premium To Relative Productivity... ...At A Premium To Relative Productivity... In our view, a key factor explains these discounts: Fears regarding the future of the North American Free Trade Agreement. An abandonment of NAFTA would hurt Canadian growth and prompt the BoC to be much more dovish than we anticipate. However, while there will be some small tweaks to NAFTA, the probability of a major overhaul that deeply affects the North American supply chain has declined, as Canada and Mexico are being exempted from steel and aluminum tariffs and as the White House has softened its stance on the U.S. content of Canadian auto exports back to the U.S. Our Geopolitical team assesses that the probability of a major NAFTA overhaul has declined from 50% to less than 20%, especially as Trump now has bigger fish to fry with China. As a result of these improvements in negotiations, EUR/CAD is potentially set to decline toward 1.44 over the rest of 2018, especially as our oil strategists continue to expect Brent prices to average US$74/bbl this year. Meanwhile, the ratio of copper prices to oil prices, which has been a decent early directional indicator for this cross, suggests the timing is ripe to bet against euro/CAD (Chart I-21), especially as slowing global growth will further weigh on copper relative to oil. Chart I-20...And A Premium To Oil ...And A Premium To Oil ...And A Premium To Oil Chart I-21Where Copper-To-Oil Goes, So Does EUR/CAD Where Copper-To-Oil Goes, So Does EUR/CAD Where Copper-To-Oil Goes, So Does EUR/CAD Bottom Line: An attractive means to bet on slowing global growth while benefiting from the impact of the U.S.'s fiscal stimulus is to short EUR/CAD. Not only is this cross a play on the differential between international and U.S. growth, it is also currently trading at a large premium on various metrics. Dissipating risks that NAFTA will be abrogated in a major way are providing an attractive cyclical entry point to short EUR/CAD, with an initial target of 1.44. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Analyst haarisa@bcaresearch.com 1 For more analysis on trade wars and the current China/U.S. spat, please see Foreign Exchange Strategy Weekly Report, "Are Tariffs Good or Bad For The Dollar?" dated March 9, 2018, available at fes.bcaresearch.com as well as the Geopolitical Strategy Weekly Report, "Trump's Demands On China", dated April 4, 2018, available at gps.bcaresearch.com. 2 We have already gone over the role of China at length to explain the global growth slowdown. For detailed discussions on the topic, Please see Foreign Exchange Strategy Weekly Report, "The Return Of Macro Volatility", dated March 16, 2018, available at fes.bcaresearch.com. 3 For more indicators pointing toward slower global growth, Please see Foreign Exchange Strategy Weekly Report, "Canaries In the Coal Mine Alert: EM/JPY Carry Trades", dated December 1, 2017 and "Canaries In the Coal Mine Alert 2: More On EM Carry Trades And Global Growth", dated December 15, 2017, available at fes.bcaresearch.com. 4 Please see Foreign Exchange Strategy Weekly Report, "Do not Get Flat-Footed By Politics", dated March 30, 2018, available at fes.bcaresearch.com. 5 Please see Foreign Exchange Strategy Special Report, "The SNB Doesn't Want Switzerland To Become Japan", dated March 23, 2018, available at fes.bcaresearch.com. 6 Please see Foreign Exchange Strategy Weekly Report, "From Davos To Sydney, With a Pit Stop in Frankfurt", dated January 26, 2018, available at fes.bcaresearch.com. 7 EUR/CAD trades 15% above a fair value model, that does not encapsulate the trend in the cross. If the recent cross is taken into account through a model that incorporates mean-reversion, EUR/CAD trades at a more modest 10% above its fair value. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. has been mixed: ISM Manufacturing came in slightly weaker than expected at 59.3; However, ISM Prices Paid was a very strong number, 78.1, up from the previous 74.2; Services PMI and Non-Manufacturing ISM also disappointed expectations; The trade balance in February fell to US$ -57.6 bn; Initial jobless claims, however, came in much higher than expected at 242,000. The dollar is now up more than 2% from its February lows. This has been driven by slowing global growth, particularly in Korean and Taiwanese trade data. The greenback should fare well in this environment. Report Links: Do Not Get Flat-Footed By Politics - March 30, 2018 Are Tariffs Good Or Bad For The Dollar? - March 9, 2018 The Dollar Deserves Some Real Appreciation - March 2, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 European data was mixed: German retail sales disappointed, growing at a 0.7% monthly pace and a 1.3% annual pace; German Manufacturing PMI came in slightly lower than expected at 58.2; European unemployment dropped to 8.5% as expected; Headline inflation improved to 1.4% also as expected, but core inflation came in weaker than expected at 1%. The euro is set to experience a period of correction as inflation in the Eurozone remains weak and global growth is slowing, as Asian economic data increasingly shows. Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: Housing starts yearly growth outperformed despite coming in at -2.6%. The Nikkei manufacturing PMI surprised on the strong side, coming in at 53.1 However, the Markit Services PMI underperformed expectations coming in at 50.9. USD/JPY has been relatively flat this week. Overall, we expect that the yen will continue to strengthen, given that the market will continue to be rattled by the increasing a weakening in global growth. This risk off environment should benefit the yen. However, given the slowdown in Japanese economic data, the BoJ will eventually have to intervene to make sure that the rise in the yen does not derail the economic recovery and particularly, its inflation objective. Report Links: The Yen's Mighty Rise Continues... For Now - February 16, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Markit Manufacturing PMI outperformed expectations, coming in at 55.1. It also increased slightly from last month's reading. However PMI construction underperformed expectations substantially, coming in at 47. This is the lowest level in more than 2 years. GBP/USD has been relatively flat this week. Overall the latest construction PMI number confirms our analysis: the uncertainty caused by Brexit is weighing heavily on Britain's housing market. This weakness in the housing sector, coupled with a strong pound, will likely limit how high British interest rates can go. Therefore GBP/USD has downside on a tactical basis. Report Links: Do Not Get Flat-Footed By Politics - March 30, 2018 Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Australian data was weak: The RBA's Commodity Index in SDR terms contracted by 2.1% annually, much more than the expected 0.1% contraction; Building permits contracted on a monthly basis at a rate of 6.2%, while also contracting at a 3.1% pace in annual terms; However, retail sales did pick up in monthly terms at a rate of 0.6%. At the monetary policy meeting on Tuesday, Governor Philip Lowe referenced the increase in short-term funding costs that have spilled over from the U.S. into foreign markets owing to higher volatility, particularly in Australia. An escalation of a trade war will also prove to be very damaging for the Australian economy, which is a large export-based and commodity-dependent nation. Report Links: Who Hikes Again? - February 9, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 NZD/USD has been flat this week. Overall we expect this cross to weaken going forward, given that New Zealand is one of the most open economies in the G10, and thus, it stands to risks the most from both an increasing risk of trade wars and slowing global growth. Moreover, there are also some negative aspects of New Zealand on a more structural basis, as the neutral rate is set to be lowered. This is because the populist government is looking to lower immigration while also implementing a dual mandate for the central bank. All of these factors will cause the kiwi to suffer on a long term basis. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Data out of Canada was mixed: Manufacturing PMI came in line with expectations of 55.7; Exports and Imports for February came in at CAD 45.94 bn and CAD 48.63 bn, respectively, sinking the trade balance to CAD -2.69 bn. The CAD received a fillip on Tuesday as President Trump hopes to conclude preliminary negotiations for NAFTA by the end of next week. While the outcome for these negotiations remains uncertain, the Canadian economy is still in great shape, with a tight labor market, high wage growth and a closing output gap. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been mixed: Headline inflation outperformed expectations, coming in at 0.8%. Real retail sales yearly growth outperformed expectations, coming in at -0.2%. However, the SVME PMI underperformed expectations, coming in at 60.3. EUR/CHF has been relatively flat this week. Overall, we expect EUR/CHF to have further upside on a long-term basis. The Swiss economy is still weak and inflationary pressures are tepid. This means that any further appreciation by the franc will weigh heavily on the SNB's goals. While for now EUR/CHF could suffer as global growth declines, the SNB will fight this trend in order for them to achieve their inflation target. Thus, any rally in the CHF will prove temporary. Report Links: The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 USD/NOK has been relatively flat this week. Overall, the krone should outperform most other commodity currencies given that oil should perform better than the rest of the commodity complex in the current environment. While all commodities would be affected by a possible slowdown in global growth and Chinese industrial production, oil will probably hold up the best given that advanced economies consume a greater proportion of oil than they do of other commodities, making oil less sensitive to gyrations in global industrial activity than metals. Moreover, the supply backdrop for oil remains more favorable than that of other commodities thanks to OPEC and Russia's production restrains. All of these developments should help the NOK outperform currencies like the NZD and the AUD. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Swedish data was disappointing: Manufacturing PM came in at 55.9, below last month's 59.9; New Orders increased annually only by 1.3% compared to 8.7% in January; Industrial production contracted in monthly terms by 0.5%, and grew annually by 5.7%, but it was still a deceleration relative to the previous 7.7% reading. The SEK has been weakening because of three factors: the talk of trade wars, the slowdown in the global manufacturing sector, and Sweden's housing bubble. While these risks are very real, Sweden's favorable macro backdrop of a cheap currency, a high basic balance of payments surplus and an economy operating above capacity mean that inflation will pick up meaningfully. This will prompt the SEK to rally once global growth can find its floor. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades