Policy

While the trade-war cease-fire agreed at the G20 summit between the U.S. and China boosted grain markets – particularly as China agreed to begin “substantial” purchases from the U.S. – the future of the trade relationship remains uncertain. The agreement to work out an agreement only holds for 90 days, and there’s a lot to get through. An increase in Chinese purchases of U.S. ag products could realign prices for the grains traded on the Chicago Mercantile Exchange with their global counterparts, by reversing the inefficiencies created by the 25% tariffs announced last summer, particularly re soybean trade flows. However, until concrete steps are announced, this remains nothing more than a hope at present. Then there’s the USD. We expect a stronger dollar in 1H19 to continue to weigh on ag markets, by keeping U.S. exports relatively expensive versus foreign competition. We continue to believe the market underestimates the number of rate hikes the Fed will deliver next year – our House view calling for four policy-rate increases next year is higher than the market consensus – and that positive news on the trade front will be offset by relatively tighter financial conditions in the U.S. Highlights Energy: Overweight. We continue to expect OPEC 2.0 to agree cuts of 1.0mm to 1.4mm b/d at its meeting in Vienna today and tomorrow. Our $82/bbl Brent forecast for 2019 remains in place. Base Metals: Neutral. Zinc treatment charges in Asia hit a three-year high of $170 to $190/MT in November, a one-month gain of $50/MT. Chinese smelters are keeping capacity offline in the wake of lower prices for the metal and holding out for higher treatment charges, according to Metal Bulletin. Precious Metals: Neutral. Gold’s rally to $1,240/oz is consistent with a more dovish read on Fed policy. Nonetheless, we continue to expect a December rate hike, and four more next year. Ags/Softs: Underweight. Grain markets are hopeful for a reprieve following the G20 rapprochement between presidents Trump and Xi. However, a strong USD remains a headwind for U.S. exports. Feature Throughout 2018, ag markets have been in the cross-hairs of Sino – U.S. geopolitical warfare. President Trump’s meeting with his Chinese counterpart Xi Jinping at last week’s G20 summit in Buenos Aires is nothing more than an agreement to begin negotiations. Nevertheless, ags – particularly grains – are poised to benefit from a “substantial” increase in Chinese purchases “immediately.” Although uncertainty regarding the U.S. – China trade relationship will drag on into 2019, we are likely to see at least a thaw in ag markets. Apart from trade, U.S. financial conditions will continue to impact ags. More Fed rate hikes than are currently priced in by markets, which will keep the U.S. dollar well bid relative to the currencies of other ag exporters, will weigh on these markets. Weather will remain a wildcard. The World Meteorological Organization (WMO) assigns an 80% probability to an El Niño event occurring this winter, which, in the past, has led to higher volatility in ag markets due to flooding and droughts. Overall we would not be surprised to see some upside in the short term as Chinese consumers resume purchases of American crops. However, this will be muted when markets begin reassessing Fed policy expectations, and pricing in more hikes than the two currently anticipated over the next 12 months. American Farmers Breathe A Sigh Of Relief … In our most recent assessment of ag markets, we argued that while trade policy had weighed on the ag complex, further downside in these markets was unlikely.1 So far, this narrative has played out. Soybeans, corn, and wheat prices fell 22%, 19%, and 11%, respectively between the end of May and mid-July (Chart of the Week). By Tuesday of this week, they had rebounded, gaining 12%, 13%, and 8%, respectively. Chart of the WeekBetter Days To Come? Grain prices now are more in line with fundamentals. Moreover, the signing of the United States-Mexico-Canada Agreement (USMCA), which replaces NAFTA and eliminates uncertainty in agricultural trade within the North American market, was a market-positive development. The potential breakdown of North American trade was a significant risk to U.S. agriculture: Mexico is the second-largest destination for U.S agricultural exports, accounting for 13% of all U.S. exports of agricultural bulks (Chart 2). Canada makes up a smaller 2% share. Chart 2Trade Negotiations Hit American Farmers Hard Away from the USMCA, the agreement to a trade truce between the U.S. and China at the G20 summit is a ray of hope. President Donald Trump agreed to postpone hiking rates from 10% to 25% on the second round of tariffs imposed by the U.S. on Chinese imports until March 1, in exchange for a promise by President Xi Jinping to pursue structural changes to its economy, and that China will raise its imports from the U.S. – specifically of agricultural goods. While the current truce could be an opening salvo to a more favorable trade relationship, BCA Research’s geopolitical strategists warn that this development is inconsistent with their structurally bearish view of the U.S. – China relationship. Given the obstacles still in place, they are skeptical that the truce will endure.2 While China did agree to buy “substantial” agricultural products from U.S. farmers immediately, it is still unclear whether China will remove the tariffs on imports of American grains as part of the truce.3 For now, China’s 25% tariff on its imports of U.S. soybeans, corn, and wheat is still in place. Apart from state-owned enterprises acting in response to government orders to purchase U.S. ags, Chinese traders are unlikely to fulfill this promise on their own unless the tariffs are removed. In any case, there are high odds that this will happen – in order to make room for Chinese traders to purchase the grains, as well as to show of good faith in negotiations with the U.S. … Thank You President T The current global ag landscape mirrors the disputes shadowing the world’s two largest economies. The trade rift – highlighted by the 25% tariff on China’s imports of U.S. grains and other ags – has created two parallel agriculture markets. In one market, China is scrambling to secure supplies, creating a deficit. In the other, U.S. farmers are struggling to market their produce overseas, suffering from storage shortages and in some cases left with no option but to leave their crops to rot. This dichotomy is evident in physical markets. Take soybeans, an especially vulnerable crop, given that almost 60% of U.S. exports have traditionally been consumed in China. While Brazil is facing a shortage amid insatiable Chinese demand, a record 11% of American beans are projected to be left over after accounting for exports and domestic consumption (Chart 3). This comes at a bad time as the global trend over the past few years has been an increase in land devoted to soybeans at the expense of corn. Further evidence of the impact of the tariffs are as follows: Chart 3A Soybean Glut In The U.S., Tight Supplies In Brazil China’s total soybean imports technically do not qualify as having collapsed. However, the 0.5% y/y decline in volumes so far this year is in stark contrast with the average 10% y/y growth over the past four years (Chart 4). Chart 4China Has Been Shunning American Beans Chinese consumers are clearly avoiding beans sourced in the U.S. China’s soybean imports from America over the September-to-August 2017/18 crop year are significantly lower than last year’s volumes. There is clear seasonality in China’s sourcing of soybeans, with the U.S. crop gaining a larger share in the fall and winter (Chart 5). Nevertheless, this year is a clear outlier. Previously, in October, ~ 20% of China’s soybean imports were generally from the U.S. This year, the share stands at a mere 1%. Instead, China has been relying on Brazilian-sourced beans. Chart 5Unusual Trade Flows For This Time Of Year These factors are creating strong demand for beans from Brazil, where crushers are reportedly suffering from a lack of soybean supply and tight margins. The premium paid for Brazilian beans over CBOT prices reached a record high in September (Chart 6). Chart 6Record Premiums For Brazilian Beans In 2018 While Brazilian farmers are benefiting from the U.S. – China standoff, American farmers are suffering significant losses. U.S. soybean exports to the world are severely behind schedule for this time of the year. This is a clear consequence of weak demand from China, which has completely died down (Chart 7). Even though American farmers are searching for alternative destinations to replace China – and despite exports to countries other than China being double last year’s levels for this time of the year – they are not yet sufficient to compensate for the loss of sales there. Chart 7The Rest Of The World Does Not Compensate For Chinese Bean Purchases A normalization of agricultural trade between China and the U.S. – if it were to emerge as a consequence of the trade truce – would go a long way toward reversing these trends. However, exogenous factors likely will keep soybean prices, in particular, under pressure: Chinese demand for soybeans – which it uses as feed for its massive pig herds – will likely take a hit due to an outbreak of African Swine Flu. Soybean inventories in China have grown significantly (Chart 8). This is a sign that buyers there had been frontloading imports in anticipation of weaker imports from the U.S. over the winter period, when Brazilian supply dies down. Chart 8Chinese Buyers Well Stocked Ahead Of The Winter In addition, Brazilian farmers have raised their soybean plantings for next year. According to latest USDA estimates, Brazilian production in the 2018/19 will come in at 120.5mm MT, up from 119.8mm MT and 114.6mm MT in the previous two years, respectively. Similarly, exports from Brazil are projected to stand at 77mm MT, up from 76.2 and 63.1mm MT, in the previous two years, respectively. In its November World Agriculture Supply and Demand Estimates – published prior to the trade truce – the USDA projected U.S. exports will come down sharply from 59.0mm MT and 58.0mm MT in 2016/17 and 2017/18, respectively, to 51.7mm MT in the 2018/19. As a result, global ending stocks will swell to a record 112.1mm MT in the next crop year. Thus, even if there is a swift resolution to the trade war, soybean supplies will remain abundant, keeping a lid on prices. Even so, a resolution to the trade war likely would return the spread between Brazilian and American bean prices to their historical mean. In fact, globally the soybean market is projected to remain in a surplus again next year – the volume of which represents 4% of total production (Chart 9). As such, inventories measured in terms of stocks-to-use, are projected to continue rising, setting a new record surpassing 30% (Chart 10). Given that soybean supply is in abundance globally, a resolution in the trade war likely will not be accompanied by a significant rebound in soybean prices. Chart 9Another Global Surplus In Beans... Chart 10... Will Push Inventories To New Record High On the other hand, corn and wheat, which are less susceptible to trade disputes with China, are expected to be in deficit next year which will bring down their inventories. However, since global stocks levels are already so elevated, we don’t expect much upside on the back of these deficits. Bottom Line: It is too early to call an end to Sino - U.S. trade tensions just yet. However, an increase in Chinese purchases of U.S. ags will go a long way in reversing the inefficiencies created by the 25% tariffs announced last summer. This will move ags traded on the Chicago Mercantile Exchange more in line with their global counterparts. The Other Factors Driving Ags In addition to the trade war, which has created winners and losers out of Brazilian and American farmers, respectively, currency markets are also more favorable for the former compared with the latter. As such, U.S. financial conditions will remain an important determinant of ag prices. The Fed’s monetary policy decisions impact ags both directly – through changes in real rates – as well as indirectly, through the U.S. dollar. We expect the Fed will make decisions consistent with its mandate to contain inflation. As such, there will likely be more interest rate hikes over the coming twelve months than the market’s current expectation of two. This will affect agricultural markets as follows: Higher real rates increase borrowing costs for farmers, discouraging investment, and research and development. Tighter credit can weigh on growth. This depresses consumption and demand for goods and services in general, and to some extent agricultural commodities as well. In addition to this direct channel of impact of Fed policy on the agricultural markets, U.S. monetary policy decisions vis-à-vis the rest of the world will drive ags through its impact on the U.S. dollar. Moreover, weak global growth in 1H19 will keep a floor under the dollar. When global growth lags U.S. growth, it is usually associated with a strong dollar. These factors suggest upside potential for the dollar over the coming 6 months. This will continue as long as U.S. growth outperforms the rest of the world. Since farmers’ costs are priced in local currencies while commodities – and thus sales -- are priced in U.S. dollars, a stronger dollar vis-à-vis domestic currency raises revenues of non-U.S. farmers. This incentivizes plantings, raising supply, and in turn weighing down on prices (Chart 11). This explains the inverse relationship observed between the U.S. dollar and agricultural prices (Chart 12). Chart 11A Strong Dollar Will Incentivize Planting... Chart 12...And Weigh Down On Prices As always, weather is the wildcard in agricultural markets and can destroy and damage crops. The Australian Bureau of Agricultural and Resource Economics and Sciences (ABARES) recently lowered its wheat production forecast by 11% on the back of a drought. This will be the smallest crop in a decade. The El Niño event expected this winter will likely prolong the drought into early next year. Thus the risk of an El Niño event is especially relevant. This weather phenomenon occurs when there is an increase in sea surface temperatures in the central tropical Pacific Ocean which increases the chances of heavy rainfall and flooding in South America and drought in Africa and Asia. According to the World Meteorological Organization, there’s a 75-80% chance of a weak El Niño forming this winter. This raises the possibility of damage or destruction to crops, which could bid up agricultural prices. Bottom Line: A stronger dollar, at least into 1H19, will weigh on ags. Thus, ag markets will be hit with headwinds as the market begins to appreciate the possibility of a greater number of rate hikes than is currently priced in. This will mute the impact of positive news on the trade front.   Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com Footnotes 1      Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled “Policy Uncertainty Could Trump Ag Fundamentals,” dated July 26, 2018, available at ces.bcaresearch.com. 2      Please see BCA Research’s Geopolitical Strategy Weekly Report titled “Trade Truce: Narrative Vs. Structural Shift?” dated December 3, 2018, available at gps.bcaresearch.com. 3      The USDA has not changed its plan to provide the second round of its aid package to farmers in attempt to offset losses from the trade war. Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table TRADES CLOSED IN 2018 Trades Closed in Summary of Trades Closed in 2017

Highlights Downside risks to EM assets remain substantial. Stay put. EM stocks, credit and currencies will underperform their DM counterparts in the first half of 2019. The key and necessary condition for a new secular EM bull market to emerge is the end of abundant financing. The latter is imperative to compel corporate restructuring, bank recapitalization as well as structural reforms. The cyclical EM outlook hinges on China’s business cycle. The slowdown in China is broad-based and will deepen. The slowdown in China/EM will likely lead to global trade contraction. The latter is negative for global cyclicals yet bullish for the U.S. dollar. Feature As we head into 2019, the past decade is shaping up to be a lost one for emerging markets (EM) assets. In particular: EM stocks have underperformed DM markets substantially since the end of 2010 (Chart I-1). In absolute terms, EM share prices are at the same level as they were in early 2010. Chart I-1EM Equities Have Been Underperforming DM For Eight Years EM currencies have depreciated substantially since 2011, and the EM local currency bond index (GBI-EM) on a total-return basis has produced zero return in U.S. dollar terms since 2010 (Chart I-2). Chart I-2A Lost Decade For Investors In EM Local Currency Bonds? Finally, EM sovereign and corporate high-yield bonds have not outperformed U.S. high-yield corporate bonds on an excess-return basis. Will 2019 witness a major reversal of such dismal EM performance? And if so, will it be a structural or cyclical bottom? The roots underneath this lost decade for EM stem neither from trade wars nor from Federal Reserve tightening. Therefore, a structural bottom in EM financial markets is contingent neither on the end of Fed tightening nor the resolution of current trade tussles. We address the issues of Fed tightening and trade wars below. A Lost Decade: Causes And Remedies What led to a lost decade for EM was cheap and plentiful financing. When the price of money is low and financing is abundant, companies and households typically rush to borrow and spend unwisely. Capital is misallocated and, consequently, productivity and real income growth disappoint – and debtors’ ability to service their debts worsens. This is exactly what has happened in EM, as easy money splashed all over developing economies since early 2009. There have been three major sources of financing for EM: Source 1: Chinese Banks Chinese banks have expanded their balance sheets by RMB 198 trillion to RMB 262 trillion (or the equivalent of $28.8 trillion) over the past 10 years (Chart I-3, top panel). When commercial banks expand their balance sheets by lending to or buying an asset from non-banks, they create deposits (money). Consistently, the broad money supply has expanded by RMB 175 trillion to RMB 234 trillion (or the equivalent of $25.5 trillion). Chart I-3Enormous Boom In Chinese Banks' Assets And Money Supply Notably, the People’s Bank of China (PBoC) has increased commercial banks’ excess reserves by RMB 1.5 trillion to RMB 2.8 trillion (or the equivalent of $0.22 trillion) (Chart I-3, bottom panel). Hence, the meaningful portion of money supply expansion has been due to the money multiplier – money created by mainland banks – not a provision of excess reserves by the PBoC (Chart I-4). Chart I-4Attribution Of Rise In Money Supply To Excess Reserves And Money Multiplier Not only has such enormous money creation by commercial banks generated purchasing power domestically, but it has also boosted Chinese companies’ and households’ purchases of foreign goods and services. The Middle Kingdom’s imports of goods and services have grown to $2.5 trillion compared with $3.2 trillion for the U.S. (Chart I-5). China’s spending has boosted growth considerably in many Asian, Latin American, African, Middle Eastern, and even select advanced economies. Chart I-5Imports Of Goods And Services: China And The U.S. Source 2: DM Central Banks’ QE By conducting quantitative easing, the central banks of several advanced economies have crowded out investors from fixed-income markets, incentivizing them to search for yield in EM. The Fed, the Bank of England, the European Central Bank and the Bank of Japan have in aggregate expanded their balance sheets by $10 trillion (Chart I-6). Chart I-6Quantitative Easing In DM This has led to massive inflows of foreign portfolio capital into EM, and reflated asset prices well beyond what was warranted by their fundamentals. Specifically, since January 2009, foreign investors have poured $1.5 trillion on a net basis into the largest 15 developing countries excluding China, Taiwan and Korea (Chart I-7, top panel). For China, net foreign portfolio inflows amounted to $560 billion since January 2009 (Chart I-7, bottom panel). Chart I-7Cumulative Foreign Portfolio Inflows Into EM And China Source 3: EM Ex-China Banks EM ex-China began expanding their balance sheets aggressively in early 2009, originating new money (local currency) and thereby creating purchasing power. This was especially the case between 2009 and 2011. Since that time, money creation by EM ex-China banks has decelerated substantially due to periodic capital outflows triggering currency weakness and higher borrowing costs. Out of these three sources, China’s money/credit cycles remain the primary driver of EM. The mainland’s imports from developing economies serves as the main nexus between China and the rest of EM. Essentially, Chinese money and credit drive imports, influencing growth and corporate profits in the EM universe (Chart I-8). Chart I-8China's Credit Cycle Leads Its Imports In turn, EM business cycle upturns attract international capital. Meanwhile, credit creation by local banks in EM ex-China – primarily in economies with high inflation or current account deficits – is a residual factor. In these countries, domestic credit creation is contingent on a healthy balance of payments and a stable exchange rate. The latter two, in turn, transpire when exports to China and international portfolio capital inflows are improving. The outcome of easy financing is over-borrowing and capital misallocation. The upshot of the latter is usually lower efficiency and productivity growth. Not surprisingly, productivity growth in both China and EM ex-China has decelerated considerably since 2009 (Chart I-9). EM return on assets has dropped a lot in the past 10 years and is now on par with levels last seen during the 2008 global recession (Chart I-10). Chart I-9Falling Productivity Growth In EM And China =... Chart I-10... = Low Profit Margins And Low Return On Capital Accordingly, the ability to service debt by EM companies has deteriorated considerably in the past decade – the ratios of cash flows from operations to both interest expenses and net debt have dropped (Chart I-11). Chart I-11EM: Deteriorating Ability To Service Debt These observations offer unambiguous confirmation that money has been spent inefficiently – i.e., misallocated. Credit booms and capital misallocations warrant a period of corporate restructuring and banking sector recapitalization. Without this, a new cycle cannot emerge. A secular bull market in equities and exchange rates arises when productivity growth and hence income-per-capita growth accelerates, and return on capital begins to climb. This is not yet the case for most developing economies. The end of cheap and abundant financing is imperative to compel corporate restructuring, bank recapitalization as well as structural reforms. These are necessary conditions to create the foundation for a new secular bull market. Ironically, the best remedy for an addiction to easy money is a period of tight money. For example, U.S. share prices would not be as high as they currently are if the U.S. did not go through the Lehman crisis. This 10-year bull market in U.S. equities was born from the ashes of the Lehman crisis. Vanished financing and the private sector’s tight budgets in 2008-‘09 compelled corporate restructuring as well as a focus on efficiency and return on equity. Has EM financing become scarce and tight? Cyclically, China’s money creation and credit flows have slowed, pointing to a cyclical downturn in EM share prices and commodities (please see below for a more detailed discussion). International portfolio flows to EM have also subsided since early this year. There has been selective corporate restructuring post the 2015 commodities downturn, including in the global/EM mining and energy sectors, China steel and coal industries as well as among Russian and Brazilian companies. However, there are many economies and industries where corporate restructuring, bank recapitalization and structural reforms have not been undertaken. Yet from a structural perspective, China’s money and credit growth remain elevated and excesses have not been purged. Besides, international portfolio flows to EM have had periodic “stop-and-gos” but have not yet retrenched meaningfully (refer to Chart I-7 on page 4). Consequently, structural overhauls and corporate restructuring in China/EM have by and large not yet occurred – in turn negating the start of a new secular bull market. Bottom Line: Conditions for a structural bull market in EM/China are not yet present. EM/China: A Cyclical Bottom Is Not In Place From a cyclical perspective, China is an important driving force for the majority of EM economies, and its deepening growth slowdown will continue to weigh on EM growth and global trade. In fact, odds are that global trade will contract in the first half of 2019: In China, tightening of both monetary policy as well as bank and non-bank regulation from late 2016 has led to a deceleration in money and credit growth. The latter has, with a time, lag depressed growth since early this year. Policymakers have undertaken some stimulus since the middle of this year, but it has so far been limited. Stimulus also works with a time lag. Besides, even though the broad money impulse has improved, the credit and fiscal spending impulse remains in a downtrend (Chart I-12). Therefore, there are presently mixed signals from money and credit. Chart I-12China's Stimulus Leads EM And Commodities As illustrated in Chart I-12, the bottoms in the money and combined credit and fiscal spending impulses, in July 2015, preceded the bottom in EM and commodities by six months and their peak led the top in financial markets by about 15 months in January 2018. Besides, in 2012-‘13, the rise in the money and credit impulses did not do much to help EM stocks or industrial commodities prices. Hence, even if the money as well as credit and fiscal impulses bottom today, it could take several more months before the selloff in EM financial markets and commodities prices abates. Additionally, the ongoing regulatory tightening of banks and non-bank financial institutions will hinder these institutions' willingness and ability to extend credit, despite lower interest rates. We discussed in a recent report that both the effectiveness of the monetary transmission mechanism and the time lag between policy easing and a bottom in the business cycle are contingent on the money multiplier (creditors' willingness to lend, and borrowers' readiness to borrow) and the velocity of money (the marginal propensity to spend among households and companies). Growth in capital spending in general and construction in particular have ground to a halt (Chart I-13). Chart I-13China: Weak Capital Spending Not only has capital spending decelerated but household consumption has also slowed since early this year, as demonstrated in the top panel of Chart I-14. Chart I-14China: A Broad-Based Slowdown Finally, mainland imports are the main channel in terms of how China’s growth slowdown transmits to the rest of the world. Not surprisingly, EM share prices and industrial metals prices correlate extremely well with the import component of Chinese manufacturing PMI (Chart I-15). Chart I-15China's Imports And EM And Commodities Bottom Line: The slowdown in China is broad-based, and our proxies for marginal propensity to spend by households and companies both point to further weakness (Chart I-14, middle and bottom panels). Constraints And Chinese Policymakers’ Dilemma Given the ongoing slowdown in the economy, why are Chinese policymakers not rushing to the rescue with another round of massive stimulus? First, policymakers in China realize that the stimulus measures of 2009-‘10, 2012-‘13 and 2015-‘16 led to massive misallocations of capital and fostered both inefficiencies and speculative excesses in many parts of the economy – the property markets being among the main culprits. Indeed, policymakers recognize that easy money does not foster productivity growth, which is critical to the long-term prosperity of any nation. For China to grow and prosper in the long run, the economy’s addiction to easy financing should be curtailed. Second, policymakers are currently facing a dilemma. The real economy is saddled with enormous debt and is slowing. This warrants lower interest rates – probably justifying bringing down short-term rates close to zero. Yet, despite enforcing capital controls, it seems the exchange rate has been correlated with China’s interest rate differential with the U.S. since early 2010 (Chart I-16). Given the ongoing growth slowdown and declining return on capital in China, there are rising pressures for capital to exit the country. Notably, the PBoC’s foreign exchange reserves of $3 trillion are only equivalent to 10-14% of broad money supply (i.e., all deposits in the banking system) (Chart I-17). Chart I-16Chinese Currency And Interest Rates Chart I-17China: Foreign Currency Reserves Are Very Low Compared To Money Supply/Deposits The current interest rate differential is only 33 basis points. If the PBoC guides short-term rates lower and the Fed stays on hold or hikes a few more times, the spread will drop to zero or turn negative. Based on the past nine-year correlation, the narrowing interest rate spread suggests yuan depreciation. This will weigh on EM and probably even global risk assets. In a scenario where policymakers prioritize defending the yuan’s value, they may not be able to reduce borrowing costs and assist indebted companies and households. As a result, the downtrend in the real economy would likely worsen. Consequently, EM and global growth-sensitive assets will drop further. Given the constraints Chinese policymakers are facing, reducing interest rates and allowing the yuan to depreciate further is the least-bad outcome. Yet this will rattle Asian and EM currencies and risk assets. What About The Fed And Trade Wars? The Fed and EM: Fed policy and U.S. interest rates are relevant to EM, but they are of secondary importance. The primary driver of EM economies are their own domestic fundamentals as well as global trade – not just U.S. growth. Historically, the correlation between EM risk assets and the fed funds rate has been mixed, albeit more positive than negative (Chart I-18). On this chart, we have shaded the five periods over the past 38 years when EM stocks rallied despite a rising fed funds rate. Chart I-18The Fed And EM Share Prices: A Historical Perspective There were only two episodes when EMs crashed amid rising U.S. interest rates: the 1982 Latin American 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 crises occurred without much in the way of Fed tightening or rising U.S. bond yields. Trade Wars: China’s current growth slowdown has not originated from a decline in its exports. In fact, Chinese aggregate exports and those to the U.S. have been growing at a double-digit pace, largely due to the front running ahead of U.S. import tariffs. More importantly, China’s exports to the U.S. and EU account for 3.8% and 3.2% of its GDP, respectively (Chart I-19). Total exports amount to 20% of GDP, with almost two-thirds of that being shipments to developing economies. This compares with capital spending that makes up 42% of GDP and household consumption of 38% of GDP. Hence, capital expenditures and household spending are significantly larger than shipments to the U.S. Chart I-19Structure Of Chinese Economy There is little doubt that the U.S.-China confrontation has affected consumer and business sentiment in China. Nevertheless, the slowdown in China has - until recently - stemmed from domestic demand, not exports. Investment Recommendations It is difficult to forecast whether the current EM down leg will end with a bang or a whimper. Whatever it is, the near-term path of least resistance for EM is to the downside. “A bang” scenario – where financial conditions tighten substantially and for an extended period – would likely compel corporate and bank restructuring as well as structural reforms. Therefore, it is more likely to mark a structural bottom in EM financial markets. “A whimper” scenario would probably entail only moderate tightening in financial conditions. Thereby, it would not foster meaningful corporate restructuring and structural reforms. Hence, such a scenario might not mark a secular bottom in EM stocks and currencies. In turn, the EM cyclical outlook hinges on China’s business cycle. If and when Chinese policymakers reflate aggressively, the mainland business cycle will revive, producing a cyclical rally in EM risk assets. At the moment, Chinese policymakers are behind the curve. With respect to investment strategy, we continue to recommend: Downside risks to EM assets remain substantial. Stay put. EM stocks, credit and currencies will underperform their DM counterparts in the first half of 2019. The slowdown in China/EM will likely lead to global trade contraction. The latter is negative for global cyclicals yet bullish for the U.S. dollar. For dedicated EM equity portfolios, our overweights are: Brazil, Mexico, Chile, Colombia, Russia, central Europe, Korea and Thailand. Our underweights are: South Africa, Peru, Indonesia, India, the Philippines and Hong Kong stocks. We are neutral on the remaining bourses. In the currency space, we continue to recommend shorting a basket of the following EM currencies versus the U.S. dollar: ZAR, CLP, IDR, MYR and KRW. The latter is a play on RMB depreciation. The full list of our recommendation across EM equity, fixed-income, currency and credit markets is available on pages 14-15. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights China’s old economy is set to decelerate in the first half of 2019, regardless of the recent tariff ceasefire. Our base case view is that growth will modestly firm in the second half of 2019, but timing the trough will depend on the dynamics of a battle between debt-focused policymakers and a credit-driven economy. Renewed weakness in China's currency has the potential to rekindle (and reinforce) the now-dormant concern of widespread capital flight. Investors should be alert to its re-emergence, as it would likely have implications for a broad range of financial assets (not just the exchange rate). A tactical overweight stance towards Chinese stocks (either the domestic or investable market) within a global equity portfolio is probably warranted over the coming three months. The conditions for a cyclical overweight stance (6-12 months) are not yet present but may emerge sometime in 2019, particularly if money & credit growth begin to pick up. Defaults in China’s onshore corporate bond market will rise next year, but will likely positively surprise investors. We continue to recommend a diversified position in this asset class for domestic investors and qualified global investors in hedged currency terms. Feature BCA recently published its special year end Outlook report for 2019,1 which described the macro themes that are likely to drive global financial markets over the coming year. In this week’s China Investment Strategy report we expand on the Outlook, by reviewing our four key themes for China in the year ahead. Key Theme # 1: The Battle Between Reluctant Policymakers And A Weakening Economy We presented a stylized view of China’s recent mini-cycle late last year (Chart 1), and argued that while an economic slowdown was underway it would most likely be a benign and controlled deceleration. Chart 1China’s Growth Profile Has Largely Been In Line With What We Forecasted Last Year… Chart 2 highlights that this view has broadly panned out, although the trade war with the United States has ironically (and only temporarily) boosted economic activity over the past several months. When measured by nominal GDP growth, the chart shows that the Chinese economy has retraced roughly 40% of the acceleration that occurred from late-2015 to early-2017, which is entirely consistent with the benign slowdown scenario that we presented a year ago. However, when measured by the Li Keqiang index, the chart shows that growth momentum stumbled quite significantly earlier this year, only to somewhat recover over the past two quarters. Chart 2...But Growth Stumbled In The First Half Of 2018 Chart 3 suggests that this recent recovery in the coincident data has been strongly driven by trade front-running. The chart shows an average of nominal Chinese import and export growth alongside growth in freight volume and manufacturing fixed-asset investment, and makes it clear that the recent pickup in activity has been due to persistently strong trade growth that is unlikely to continue. Chart 3Trade Front-Running Has Clearly Boosted Economic Activity This weekend’s short-term tariff ceasefire between the U.S. and China means that the trade shock will be of considerably reduced intensity than originally feared during the negotiation period. Nonetheless, the front-running effect is set to wane regardless of the existence of negotiations, implying that China’s old economy is set to recouple with our BCA Li Keqiang leading indicator in the first half of 2019. While the indicator has recently ticked up, this is almost entirely due to the recent depreciation in the RMB, as money and credit growth remain flat. For now, investors should focus on the level of the indicator, which is predicting a slowdown in economic activity over the coming several months (Chart 4). Chart 4A Slowdown In China's Old Economy Is Coming Our judgement is that a true deal between the U.S. and China next year that durably ends the trade war remains unlikely, although the odds have certainly increased as a result of this weekend’s announcement. But Chinese domestic demand had been slowing prior to the onset of the trade war, a fact that the market ignored until the middle of this year when it moved to price in both the underlying slowdown and the trade situation (Chart 5). This raises two questions: how much of a deceleration in growth will ultimately occur, and at what point will the economy bottom? Chart 5Investors Ignored A Slowing Economy Until The Trade War Emerged The answers to these questions are subject to the outcome of a battle between policymakers who are reluctant to push for sizeable releveraging, and an economy that appears to be strongly linked to money and credit growth. We have highlighted in several previous reports why Chinese policymakers want to avoid another sharp increase in the private-sector debt-to-GDP ratio,2 reasons that have solid grounding in both political and economic fundamentals and that become more pertinent if a trade deal between the U.S. and China is in fact negotiated. Still, Chinese policymakers, like those in any other country, will forcefully act to stabilize their economy (using whatever policy tools are required) if they conclude that conditions are about to deteriorate past the “point of no return”. Forecasting exactly when or whether this will occur is difficult, but both policymakers and investors will know more once the front-running effect on coincident activity wanes, and the true outlook for the external sector comes into view. For now, our base case view is that growth will modestly firm in the second half of 2019, which would provide a somewhat stronger demand backdrop for commodities and emerging economies that sell goods to China. We will be closely monitoring the incoming macro data in the first quarter of the year to judge whether it is consistent with our outlook. Key Theme # 2: Renewed Investor Scrutiny Of China’s Capital Controls Prior to the G20 summit, our expectation was that a break above the psychologically-important threshold of 7 for USD-CNY was imminent, likely in response to the escalation of the second round tariff rate to 25% on January 1. This catalyst has now clearly been deferred for the next three months, at least. However, Chart 6 shows that a resumption in the trade war is not the only source of potential weakness in the RMB. The chart illustrates the tight link between USD-CNY and the short-term interest rate differential between China and the U.S., and that the latter fell sharply in advance of the collapse in the former. Chart 6Interest Rate Differentials And USD-CNY: A Tight Link The true nature of the relationship between the two variables shown in Chart 6 remains a source of debate within BCA, as classic, open-economy interest rate arbitrage (the dynamic that enables currency carry trades) does not apply to countries that have officially closed capital accounts. But to the extent that the relationship holds over the coming year, Fed rate hikes alone have the potential for USD-CNY to rise above 7, as it would imply that the 1-year swap rate spread between the two countries will fall to zero (assuming no change in Chinese monetary policy). Regardless of the catalyst, renewed weakness in China's currency has the potential to rekindle (and reinforce) the narrative of capital flight that was last present following the August 2015 devaluation of the RMB. Global investor scrutiny of China's capital controls is likely to intensify significantly in such a scenario, and could contribute to negative investor sentiment towards China. As we noted in a September Weekly Report,3 several measures suggest that the capital flow crackdown that China initiated following the severe outflow pressures in 2015 and early-2016 has been successful. However, some other proxies of capital flight show persistent outflow since 2015 (Chart 7), with at least one measure having deteriorated rather significantly over the past few months. Chart 7Some Proxies Of Capital Flight Suggest Persistent Outflow Since 2015 Compiling an exhaustive inventory of different capital flow metrics (and their reliability) is part of our ongoing research efforts, and we hope to publish a Special Report on the topic early in 2019. For now, investors should be alert to any signs suggesting that a capital outflow narrative is becoming more prominent, as it is likely to have broader implications for financial markets than just the bilateral exchange rate. Key Theme # 3: Timing When (And Whether) To Go Long Chinese Stocks On A Cyclical Basis Many global investors are strongly focused on the question of when to go outright long Chinese stocks (either the domestic or investable market), on the basis of a substantial improvement in valuation, deeply oversold technical conditions, expectations of further action from policymakers, and a belief that the trade war with the U.S. will soon be resolved. This weekend’s agreement between the U.S. and China still does not make a trade deal probable,4 but we acknowledge that the odds have increased. This, coupled with the fact that Chinese stocks are still roughly 25% below their January high (Chart 8), suggests that a near-term sentiment-driven rally is possible. Over a 3-month time horizon, a tactical overweight stance towards Chinese stocks (either the domestic or investable market) within a global equity portfolio is probably warranted. Chart 8A Sentiment-Driven Rally Over The Next 3 Months Is Possible However, several points suggest that a long cyclical position (i.e. over a 6-12 month period) is currently pre-mature: We noted above that the Chinese economy is set to decelerate further over the coming several months, suggesting that earnings uncertainty is likely to rise. This, in combination with reactive policymakers, already-slowing earnings momentum, and the fact that 12-month forward earnings have only just started to be adjusted downward (Chart 9), suggests that investors have not yet observed the true point of maximum bearishness for Chinese stock prices. Chart 9The Earnings-Adjustment Process Is Only Beginning The 2014-2016 episode shows that China-related financial assets rallied prematurely in advance of a durable and broad-based improvement in the Chinese macro data, and the belief on the part of investors that a short-term rebound in Chinese stock prices over the coming 3 months is the beginning of a sustained upleg could be a repeat of this mistake. Chart 10 shows our BCA Market-Based China Growth Indicator compared with our Li Keqiang Leading Indicator, and shows that Chinese-related financial assets clearly jumped the gun in the first-half of 2015, and then lagged the improvement in the leading indicator. In the case of 2015, it was the August devaluation in the RMB that caused a severe deterioration in investor sentiment towards China; in the first-half of 2019, a failed attempt at a trade deal coupled with a further slowdown in domestic activity may do the same. Chart 10A Near-Term Rally Will Likely Fizzle, Like In 2015 While a near-term rally in CNY-USD may occur, the currency may come under renewed pressure if the interest rate differential effect shown in Chart 6 becomes the dominant driver of the exchange rate. For global investors managing their equity portfolios in unhedged terms, further declines in the RMB will negatively impact U.S. dollar performance. Finally, Chart 11 shows that, based on a trailing earnings and cash flow basis, the investable market is not as cheap relative to the global benchmark as it was in early-2016, casting some doubt on valuation as a rally catalyst. Undoubtedly, part of this discrepancy reflects the substantial rise in the BAT stocks (Baidu, Alibaba, Tencent) as a share of investable market capitalization, which are priced at a premium but also viewed by many investors as largely immune to a slowdown in China’s old economy. But the fact that the trade war largely reflects the decision of the Trump administration to crack down on Chinese technology transfer and intellectual property theft suggests that the market share of these companies could be negatively impacted by any successful trade deal, implying that a higher risk premium for the tech sector is warranted today than in the past. Chart 11Investable Stocks Aren't Massively Cheap We do not rule out the possibility that conditions will justify shifting to an overweight cyclical stance (6-12 month time horizon) for Chinese stocks sometime in 2019, particularly if money & credit growth begin to pick up. But for now, this is something that remains on our watch list for next year, rather than a recommendation to act on today. Key Theme # 4: Onshore Corporate Bonds – Position For Positive Default Surprises Our fourth theme for 2019 is a highly contrarian view that is, to some, at odds with our pessimistic view of the Chinese economy. BCA’s China Investment Strategy service has maintained a long China onshore corporate bond trade since June 2017, and we continue to recommend a diversified portfolio of these bonds for domestic investors and qualified global investors in hedged currency terms. The fear of sharply rising defaults stemming from refocused efforts to reform China’s financial system is the basis for the predominantly bearish outlook for onshore corporate bonds. The value of defaulted bonds reportedly rose to 100 Bn RMB in 2018, a sharp increase (of approximately 70 Bn RMB) from 2017,5 and many market participants have argued that defaults will be even higher next year. We do not dispute that China’s onshore corporate bond default rate is rising, and it is certainly possible that the rate will be even higher in 2019. To us, the problem with the bearish corporate bond narrative is that 100 Bn RMB amounts to a default rate of approximately 0.4%, whereas investors are pricing the onshore market for a 4-5% default rate over the coming year (Chart 12). In other words, domestic investors appear to be expecting over a tenfold increase in corporate defaults over the coming 12 months from what occurred this year, a scenario that we believe is extremely unlikely. Chart 12Allowing Market-Implied Default Rates To Occur Would Be A Huge Policy Error In our judgement, there is simply no way that policymakers can allow default rates on the order of what is being priced in to occur, as it would constitute an enormous policy mistake that would risk destabilizing the financial system at a time when officials are attempting to counter a domestic economic slowdown. In fact, we doubt that China’s typical policy of gradualism when liberalizing its economy and financial markets would allow default rates to rise from 0% to 4-5% over a year in any economic environment, particularly the current one. We therefore do not see a long recommendation favoring Chinese corporate bonds as being at odds with a slowing economy, because spreads are more than pricing in what is likely to be a modest worsening in corporate defaults. In short, defaults will rise, but will likely positively surprise investors. As a final point, our positive view towards the onshore corporate bond market should not be taken as a positive sign for the offshore US$ market. BCA’s Emerging Market Strategy service has recently reiterated its recommendation to position defensively within EM US$ sovereign and corporate bonds,6 and China accounts for roughly 1/3rd of the latter. Chart 13 highlights the difference in spread between the onshore and offshore market, the latter proxied by the Bloomberg Barclays China Corporate & Quasi-Sovereign index. The chart shows that the onshore market substantially led the offshore market in terms of pricing in a deterioration in credit fundamentals, with the latter only now starting to catch up to the former. As such, we have a clear preference for the onshore market, and would not argue against a bearish offshore corporate bond view. Chart 13Onshore Corporate Bonds Offer More Compelling Value Than Those Offshore   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1      Pease see BCA Special Report "Outlook 2019 Late-Cycle Turbulence," published on November 27, 2018. Available at cis.bcaresearch.com. 2      Pease see Geopolitical Strategy/China Investment Strategy Special Report “China: How Stimulating Is The Stimulus?,” published August 15, 2018; Geopolitical Strategy/China Investment Strategy Special Report “China: How Stimulating Is The Stimulus? Part Two," published August 15, 2018; and China Investment Strategy Special Report “Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging,” published August 29, 2018. All available at cis.bcaresearch.com. 3      Pease see China Investment Strategy Weekly Report “Moderate Releveraging And Currency Stability: An Impossible Dream?," published on September 5, 2018, available at cis.bcaresearch.com. 4      Pease see Geopolitical Strategy Weekly Report “Trade Truce: Narrative Vs. Structural Shift?,” published December 3, 2018, available at gps.bcaresearch.com. 5      Please see “China Bond Defaults Surpass 100 Billion Yuan For 1st Time”, Bloomberg News, November 29, 2018. 6      Pease see Emerging Markets Strategy/Global Fixed Income Strategy Special Report “EM Corporate Health And Credit Spreads,” published November 22, 2018, available at gfis.bcaresearch.com.   Cyclical Investment Stance Equity Sector Recommendations

Highlights The Reserve Bank of Australia (RBA) may consider a rate hike in 2019 if additional tightening of labor markets leads to higher wage inflation, which would help lift core inflation back to the midpoint of the RBA’s 2-3% target band.  Reflation in China could also embolden the RBA to tighten monetary policy – though the odds of a more aggressive stimulus package will decline as long as China’s overall economy remains stable and the U.S. maintains its tariff ceasefire. The Labor Party is favored to win the federal election, which is most likely to occur in May. This is a low-conviction view, as polls are tight and economic improvement will help the ruling Liberal-National Coalition. Feature 2018 has been a challenging year for global financial markets, as investors have had to deal with greater economic uncertainty, less dovish central banks and more volatile asset prices. One country that has bucked the trend to some degree is Australia. The nation has famously avoided a recession since 1991 and last saw a tightening of monetary policy in 2010. While the recession streak is unlikely to be broken in 2019, there are growing risks that the era of interest rate tranquility will soon end. In this Special Report, jointly published with our colleagues at BCA Geopolitical Strategy, we update our views on Australia for 2019 – a year when the investment backdrop has the potential to become far more interesting, and volatile, due to election year uncertainty and a potential shift to a more hawkish bias for monetary policy. The Bond Outlook: What To Watch To Turn Bearish BCA Global Fixed Income Strategy has maintained an overweight stance on Australian government bonds since the end of 2017. That high-conviction view stemmed from our expectation that the Reserve Bank of Australia (RBA) would keep policy rates on hold for longer due to sluggish economic growth and underwhelming inflation. This recommendation has performed well, with Australian government bonds returning 2.4% (currency-hedged into U.S. dollars) in 2018 year-to-date, beating the Bloomberg Barclays Global Treasury index by 190bps. The benchmark 10-year Australian government is now yielding 36bps below the equivalent 10-year U.S. Treasury yield, the tightest spread since 1980 (Chart 1). Chart 1Australian Bonds Have Outperformed Looking ahead, we still have a positive opinion on Australian debt relative to its global peers over the next six months. The RBA is unlikely to make any adjustments to the Cash Rate - which remains at a highly-accommodative level of 1.5% - without seeing some signs of accelerating inflation in both the Q4 2018 and Q1 2019 CPI reports. This is especially true given the political uncertainty with another federal election due by May 18,1 which could change the outlook for fiscal policy (as we discuss later in this report) and impact the RBA’s economic projections. In our view, the RBA will only be able to seriously consider an interest rate hike, warranting a downgrade of our recommended overweight stance, if all three of the following conditions occur: Australia’s underemployment rate falls below 8% China’s economy shows convincing evidence of reacceleration, especially in commodity-intensive industries like construction Core CPI inflation rises back to at least the midpoint of the RBA’s 2-3% target band We will now discuss each of these in turn. Underemployment Australia is a fairly open economy with a large export sector, but consumer spending is still the largest share of GDP (60%) so it matters most for growth. On that front, real consumption has grown in a narrow and uninspiring range between 2-3% over the past five years. Anemic wages and disposable incomes have been the problem, with the growth of both (in nominal terms) struggling to grow faster than low realized inflation, which now sits below the RBA’s inflation target range of 2-3% (Chart 2). Households have been forced to deploy a greater share of that modest income growth just to maintain spending, with the savings rate plunging from 8% at the end of 2014 to 1% this year and consumer debt piling up. Chart 2An Income-Fueled Pickup In Consumer Spending The dynamics may be changing in a more positive direction, however. Growth rates of nominal wage (+2.3%) and disposable income (+3.1%) have accelerated this year to a pace faster than inflation. With real incomes perking up, the year-over-year growth rate of real consumer spending growth accelerated to 3% in Q3/2018, driving real GDP growth to similar levels. A sustained pickup in wage growth is necessary before the RBA would even contemplate a rate hike. For that to occur, there must be decisive evidence of a tightening Australian labor market and increased resource utilization. While the headline unemployment rate of 5.0% is below the OECD’s estimate of the full employment NAIRU for Australia (5.3%), broader measures of labor market slack are still at elevated levels. Specifically, the “underemployment” rate, which includes workers who are working fewer hours than they would like or at jobs below their skill levels, is still at an elevated 8.3% (Chart 3). That is down from the peak of just below 9% seen in early 2017, but well above the 2012 trough near 7% (when wage growth was close to 4%).  Chart 3UNDERemployment Rate Matters More For Australian Wages Australian wage growth tends to correlate more with the underemployment rate than the traditional unemployment rate (middle panel). This suggests that the recent blip higher in wage growth could be the beginning of a new trend, given that it has occurred alongside the recent drop in underemployment. Already, underemployment is back below the levels that prevailed when the RBA did its last interest rate cut back in 2016 (bottom panel).  A further dip lower in the underemployment rate to below the 8% threshold would likely confirm that wage growth has more upside. That outcome would give the RBA greater confidence that consumer spending will gain more strength even with a low savings rate, and that CPI inflation will return back into the target range – both outcomes that would justify some removal of the RBA’s highly stimulative monetary accommodation. China Stimulus The main connection from China’s economy to Australia is through Chinese demand for Australian exports. There is also an indirect, but very important, link between Chinese demand boosting industrial commodity prices. The latter boosts Australian growth through positive terms-of-trade effects and increased capital spending in commodity-related sectors like mining. Iron ore is the most important of those commodities, representing 18% of total Australian goods exports, with 85% of those iron ore exports going to China. Australian export growth has decelerated during 2018 from the very robust 15% year-over-year pace to a still solid 10% rate. This has mirrored the trends seen in many other economies, where exports have slowed alongside diminished demand from China. If Chinese authorities change their current policy trajectory, and embrace more aggressive fiscal and credit stimulus, then they will reaccelerate the country’s flagging demand, which should benefit Australian exporters. If the increase in spending occurs in commodity-intensive parts of China’s economy, like construction, then Australia can also benefit from a terms-of-trade impact if commodity prices rise. However, BCA’s Geopolitical Strategy and China Investment Strategy remain skeptical that China will launch a major economic stimulus package along the lines of what occurred in 2015-16. That surge not only boosted Chinese GDP and import demand but also triggered a boost to global industrial commodity prices that benefitted many commodity exporters, including Australia. In recent months, there has been a pickup in overall Chinese import growth, as well as some acceleration of higher frequency growth indicators like the Li Keqiang index (Chart 4). Australian exports to China have not picked up though, and Chinese iron ore imports are contracting. Part of that is due to the elevated levels of Chinese iron ore inventories. More likely, there is little demand for additional iron ore given China’s reform agenda and the struggles of its construction sector (which accounts for roughly 35% of Chinese steel demand). Chart 4China Stimulus Not Helping Australia...Yet? Our colleagues at BCA China Investment Strategy2 have noted that both weakening sales and tighter funding sources for real estate developers point to declining growth in property starts and construction. This will be negative for construction-related commodity markets and construction-related machinery. This is coming at a time when the Chinese government is trying specifically to address over-indebted industries like construction. As for the U.S.-China trade truce, a permanent de-escalation of tensions – which has not yet occurred – could provide a boost to Australian export demand, as with other export-focused countries. But the negative impact of bilateral U.S.-China tariffs on the global economy is much smaller than that of China’s attempt to limit indebtedness. Moreover, a trade truce will remove China’s primary incentive to adopt more aggressive stimulus. Nevertheless, from the RBA’s perspective, any boost to China’s construction-related activity would have a big impact on Australia’s economy and would strengthen the case for a rate hike in 2019.  Core Inflation Australia’s headline CPI inflation has struggled to hit even the bottom end of the RBA’s 2-3% target band since 2015, reaching only 1.9% in Q3 of this year (Chart 5). The story is even worse for inflation excluding food and energy, with core CPI inflation now only at 1.2% after having drifted lower in two consecutive quarters. Both market-based and survey-based measures of inflation expectations are also hovering near 2%. Chart 5Australian Inflation Well Below RBA Target When breaking down the CPI into tradeables (i.e. more globally-focused) and non-tradeables (i.e. more domestically-focused), the two types of inflation have not been accelerating at the same time since the 2009-11 period. Since then, faster tradeables inflation has occurred alongside slowing non-tradeables inflation, and vice versa.  While volatility on the tradeables side should be expected given the correlation to swings in commodity prices and the Australian dollar, the weakness in non-tradeables is more directly related to the spare capacity in the domestic economy. Therefore, if wage growth continues to pick up as the labor market tightens, then non-tradeables inflation should follow suit and boost Australian CPI inflation back towards the RBA target range. The implication for the RBA is that a move in core CPI inflation back towards 2.5% (the midpoint of the RBA band), occurring after an acceleration in wage growth as described above, would give the central bank confidence that a higher Cash Rate is required. Bottom Line: The RBA has kept interest rates on hold for over two years, but may consider a rate hike in 2019 if additional tightening of labor markets leads to higher wage inflation, which would help lift core inflation back to the midpoint of the RBA’s 2-3% target band. A more aggressive fiscal and monetary stimulus package in China, while not our base case, would also embolden the RBA to tighten monetary policy. Risks From Australian Banks? Throughout 2018, the Australian financial industry has had to endure the slings and arrows of a government inquiry into its questionable business practices and misconduct. Revelations of bribery, fraud, the charging of fees for no service and from the accounts of deceased people, as well as board-level deception of regulators, have roiled Australia's financial sector since the explosive inquiry began in February. The final report of the Australian Financial Services Royal Commission will be published in February, but the impact is already being felt throughout the industry. Bank CEOs have been publically shamed, while other senior financial sector executives have been forced from their jobs. The chairman of National Australia Bank stated before the inquiry that customers’ trust in lenders had been “pretty well eroded to zero”, and that it could take as long as a decade to successfully overhaul the culture within the banks. The biggest impacts from the Commission will come through hits to banks’ earnings and funding costs, as well as the potential impact on lending standards for new loans. Australian banks will be less profitable because of fines, customer refunds, setting aside provisions for potential misconduct penalties and the government wanting increased competition. If banks also choose to be more conservative with the marking of loans, then higher loan-loss provisions could be an additional drag on bank earnings. Already, Australian bank stocks have severely underperformed the overall domestic market, and there has been some slowing of domestic credit growth (Chart 6). There are also signs of bank funding stresses from contracting bank deposit growth (second panel) and wider offshore funding costs like relatively elevated LIBOR-OIS spreads (bottom panel). Considering how heavily Australian banks rely on offshore funding, any squeeze in those markets could severely influence the availability of credit within the Australian economy. Chart 6Australian Banks Under Some Stress... Looking ahead, if banks do tighten up their lending standards in response to the criticism and findings of the Commission, that will be from a starting point of very accommodative levels. In other words, getting a loan will likely still be “easy”, rather than “incredibly easy”. The reason is that Australian bank balance sheets remain in excellent condition. Credit crunches begin when banks are undercapitalized and are forced to retrench new loan activity as losses on existing loans pile up. That is not the case in Australia, where the major banks have Tier 1 capital ratios in the 10-12% range and non-performing loans are a tiny share of total lending. In our view, a true credit crunch would likely only occur after the Australian housing bubble bursts and the economy enters a severe downturn. That outcome would most likely be triggered by monetary policy tightening via multiple RBA rate hikes. Importantly, some of the steam has already been taken out of Australian house prices thanks to changes in regulations on new lending (Chart 7), potentially reducing some of the immediate risks to growth from a sharp plunge in home values.  Chart 7...But No Credit Crunch Expected Bottom Line: In 2019, the Australian government and its key financial regulators will have to work together to enforce responsible lending without triggering a catastrophic property market unwind. RBA policymakers are less likely to hike rates given their desire to maintain financial stability in the aftermath of the Commission – or at least until the inflation story forces their hand, as outlined in this report. The Federal Election: Polling Slightly Favors Labor Scandals in the financial sector are of utmost importance to the other major factor that could make 2019 a year of significant change in Australia: the federal election that looms most likely in the spring. Parliament is balanced on a knife’s edge, with the Australian Liberal Party’s loss of former Prime Minister Malcolm Turnbull’s parliamentary seat in a Sydney by-election on October 20. The ruling Liberal-National Coalition no longer has a majority and must rely on independent MPs to survive any no-confidence vote. This precarious situation suggests that the election could come even sooner than May and that the slightest twist in the campaign could deliver at least a small majority to either of the top two parties. Indeed, at this early stage, a high-conviction view on the election outcome is not warranted. After all, the 2016 election was decided in the Coalition’s favor only after a shift in opinion in the final month! Chart 8Labor Party Narrowly Leads All-Party Opinion Polls Nevertheless, with all due caveats, our baseline case is for a Labor majority in 2019, however slim it may be.3 Labor is slightly ahead of the Coalition in the primary opinion polling, which includes all parties (Chart 8). In two-party preference polling, Labor has gradually widened its general lead since the July 2016 election and now holds a 10% advantage in the federal polls – albeit only a 6% lead when a moving average is taken (Chart 9). Labor is also winning or tied in every major state. Chart 9Labor Has Large Lead In Two-Party Preference Polls The dramatic shift in polling since August is significant because that is when the knives came out and the Coalition ousted Turnbull in favor of the current Prime Minister Scott Morrison. The purpose of this move was to give the party a facelift ahead of the election. It is true that public opinion views Morrison as the preferred prime minister to Labor’s Bill Shorten. Shorten has a negative net approval rating and has never been viewed as an inspiring politician, while Morrison is just barely net positive. This perception works against Labor’s lead in the party polling – which is very competitive anyway – and suggests the election will be close. Critically, the Liberal-National Coalition’s polling as a whole has not benefited from the change in leadership. And in fact the data does not support the two major Australian parties’ abiding belief that a leadership coup will boost their popularity: Australia has seen four of these coups since 2010, two from Labor and two from the Coalition, and the party in question lost an average of 8% of the popular vote and 14 seats in parliament in the succeeding election (Table 1). Table 1Intra-Party Coups Don’t Win Votes Turnbull’s ouster also calls attention to another detrimental factor for the Coalition: the challenge on the right flank from minor and anti-establishment parties. Pauline Hanson’s One Nation has a relatively low support rate both historically and in today’s race, currently at 8%, but anti-establishment feeling may have forced the Coalition into an error. Judging by the party’s weak polling since August, the negative response to Turnbull’s ouster has been more detrimental than the nomination of Morrison, an immigration hardliner and social conservative, has been beneficial. Meanwhile, Labor’s momentum has been corroborated by a string of surprise victories in by-elections and a sweeping win in the Victoria state elections on November 24. In the latter case, the party not only defended its hold on government, as one might expect in this progressive state, but exceeded expectations to win 56 seats out of 88 in the lower House, while the Coalition lost nearly half of its seats, falling from 37 to 21. Still, Labor’s lead is by no means decisive. In the average of the various primary polls its edge over the Coalition is within the margin of error. Moreover, the Coalition holds more “safe” (uncompetitive) seats than Labor.4 The bottom line is that a small swing in either party’s favor can produce a thin majority. The Coalition’s best case is the economy. But as concerns about unemployment and job creation recede, voters will make other demands. The top issues in recent polling are the cost of living, health care, housing affordability, and wages. Some polls also emphasize social mobility and climate change and renewable energy. Will Shorten’s Labor Party be able to capture the median voter? It is highly significant that the party has taken a rightward turn on immigration and taxes even as it holds out a more left-wing agenda on health, education, regulation, and social benefits. Immigration has played a major role in Australian politics and Labor is currently positioned near the political center – in other words, if Morrison hardens his line to guard against populists, he risks over-hardening and moving away from the median voter (Chart 10). Shorten has proposed a large bipartisan task force to determine the proper limits to immigration and how to deal with congestion and infrastructure pressures. Shorten’s platform also calls attention to abuse of temporary visas by foreign workers. Chart 10Labor Is Not Too Soft On Immigration On taxes, Shorten has attempted to separate small and big companies, again in a bid for the political center. When Prime Minister Morrison sought to establish his anti-tax credentials (Chart 11), Shorten met him halfway and proposed relief for middle class families and small and medium-sized enterprises. Yet he doubled down on higher taxes for multinational corporations and high-income earners. Chart 11Liberal-National Coalition Cutting Corporate Tax Rates Critically, the latter redistributive stances are more in line with the median voter than the Liberal Party’s more conservative, supply-side, tax cut agenda. All of Australia’s parties, including the increasingly popular “minority parties,” have a more favorable attitude toward redistribution than the Coalition, which is the outlier (Chart 12). Indeed, the National Party is closer in line with the others than the Liberals, highlighting the divisions within the Coalition that have been jeopardizing votes. As for tax cuts on middle income earners and small businesses, Labor’s acceptance of them speaks to voter concerns about living costs, jobs, and wages. Chart 12The Coalition Is Out Of Synch On Taxes Labor is also closer to the median voter on the aforementioned financial sector scandals. The Coalition stands to suffer because it has developed a reputation for being too cozy with the banks (Chart 13). This is one of the biggest perceived differences between the two major parties – in addition to the negative perception of intra-Coalition betrayal – and it is possibly one of the most salient issues in the election. This presents a serious danger for the Coalition. Chart 13Banks: The Coalition’s Ball And Chain What would a Labor government bring? The market will be jittery about Shorten’s attempts to increase tax revenue, which threatens a non-negligible tightening of fiscal policy. Shorten wants to raise taxes on high income earners; remove or lower deductions and discounts (such as on capital gains); crack down on tax evasion; and tighten control over a range of tax practices specific to Australia (limiting “negative gearing” and cutting cash refunds for “franking credits”). He is also taking a tough position on banks and the energy sector. At the same time, it is clear from Labor’s proposals in 2016 (Chart 14) that there will be a hefty amount of new spending coming down the pike if a Labor government is formed – primarily on education, health, infrastructure and job training. The tax cuts that Shorten does support will go to those with a higher propensity to consume, as well as to SMEs that are responsible for job creation. Chart 14Labor’s Spending Plans Unlikely To Change Much Ultimately, Australia’s recent history, taken in consideration with the global business cycle, does not suggest that the Labor Party is all that much more fiscally profligate than the Coalition – but the current budget balance does suggest that there is substantial room to increase deficits, which is convenient for a government that is predisposed to give voters more services (Chart 15). Hence fiscal easing is the path of least resistance - one that could make the RBA even more comfortable in raising interest rates if the conditions laid out earlier in this report come to pass. Chart 15Australia's Next Government Will Have Room To Spend! Bottom Line: The Australian Labor Party is slightly favored to win the next Australian election. This is a low-conviction call given the tight competition in public opinion polling and other mixed indicators. Broadly speaking, Labor’s shift to the political center on immigration and some tax issues makes the party more electable relative to the Coalition; meanwhile its promise of more government services fits with voter demands. We do not accept the narrative that Shorten’s Labor Party will engage in substantial fiscal tightening. The path of least resistance is for tax cuts as well as revenue collection, and for greater government spending. On the other hand, if the Coalition capitalizes on the incumbent advantage and stays in power, larger tax cuts will be in store. Hence we expect Australia to see marginally larger-than-expected budget deficits and fiscal thrust as the one reliable takeaway of next year’s election. Fixed Income Investment Implications We continue to recommend an overweight stance on Australian government bonds in currency-hedged global bond portfolios. While we have laid out the conditions that would make us change that view in this report, it is still too soon to position for such a move. Our RBA Monitor, which measures the cyclical pressures on the central bank to change monetary policy settings, is modestly below the zero line (Chart 16). This indicates a need for easier policy, although the indicator is starting to rise driven by the inflation components in the Monitor (bottom panel). In terms of market pricing, there are only 15bps of rate hikes over the next year discounted in the Australian Overnight Index Swap (OIS) curve, so markets are exposed to any shift to a more hawkish bias by the RBA as 2019 progresses. Chart 16Our RBA Monitor Starting To Turn Less Dovish Looking purely at Australian government bond yields, the forward curves are priced for very little change in yields over the next year (Chart 17). This suggests that outright duration trades in Australia look uninteresting from a carry perspective of betting against the forwards. We continue to prefer Australian bonds on a relative basis to global developed market peers until there is more decisive evidence pointing to convergence of Australian growth and inflation to the other major economies (bottom panel). Chart 17Stay Overweight Australian Government Bonds Over the past year, Global Fixed Income Strategy has recommended tactical trades in Australian money market futures to fade the pricing of RBA hikes that we did not expect to materialize. Specifically, we entered a long position in December 2018 Australian 90-Day Bank Bill futures on October 17, 2017, then switched to a long October 2019 90-Day Bank Bill futures position on May 29, 2017. The latter contract is now trading at implied interest rate levels just above the RBA’s 1.5% Cash Rate (Chart 18), suggesting that there is no more value in this trade.  Chart 18Taking Profits On Our Long Bank Bill Futures Trade We therefore take a profit of 21bps on the Bank Bill futures trade, while awaiting evidence from the “RBA Hike Checklist” introduced in this report before considering trades that will benefit from a more hawkish central bank.   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Footnotes 1      Technically the House of Representatives election could occur as late as November 2, while the half Senate election is due May 18, but the norm is to hold the election simultaneously. The 2016 election was a “double dissolution” involving the election of the entire Senate and House of Representatives.  2      Please see BCA China Investment Strategy Special Report, “China’s Property Market: Where Will It Go From Here?” dated September 13, 2018, available at cis.bcareserach.com. 3      We would slightly favor Labor leading a slim majority in the Senate as well as in the House. In the Senate, the half of the seats that are up for grabs are evenly split and the polling at this early stage favors Labor over the Coalition. The poor performance of the Greens, in recent polling and in the Victoria state election, suggests a positive development for Labor on the margin, whereas One Nation, whose polls are improving, poses a threat to the Coalition. 4      Labor is fighting for 15 “marginal” (hotly contested) seats and 28 “fairly safe” seats, while the Coalition is only fighting for 12 marginal seats and 14 fairly safe seats.  

Dear Commodity & Energy Strategy clients, We went into the G20 meeting this past weekend expecting the leaders of OPEC 2.0 to instruct their ministers to cut oil output by 1.0mm – 1.4mm b/d at their upcoming meeting in Vienna. However, we could see higher cuts: News reports suggest OPEC 2.0 – the OPEC/non-OPEC coalition lead by Saudi Arabia and Russia – could agree to re-instate its original production-management accord agreed in November 2016, under which 1.8mm b/d of output was taken off the market. In addition to the G20 news, Alberta Premier Rachel Notley served notice an 8.7% production cut – 325k b/d of crude and oil-sands output in the province – will commence January 1. The province also intends to secure rail transport to move 120k b/d. In this update, we reprise the events that led to the price collapse of the past month, and present what we consider the most likely outcome of the OPEC 2.0 Vienna meeting on December 6. As was the case in 2015, this agreement will be one of the critical determinants of oil prices next year. First a brief review of the price collapse of the past month. Toward end-October, the Trump administration – likely the State Department – realized the re-imposition of sanctions on Iran could remove as much as 1.7mm b/d of exports from the market. Our own estimate had 1.25mm b/d of Iranian exports being lost to the market under the re-imposition of the Iran sanctions. At the upper end of market estimates, the amount of crude removed from the market could have exceeded total global spare capacity to meet any unplanned oil-production outage. Such an outage – e.g., losing 500k b/d from Iraq, Libya or Nigeria, or the total collapse of Venezuela, which would take ~ 1mm b/d off the market – would have produced a supply shock. In such a scenario, prices would rally through $100/bbl, and likely would push even higher if a large unplanned outage occurred while Iranian exports were falling. With U.S. shale supplies growing 1.3mm b/d, and demand growing 1.45mm b/d next year, per our modeling, demand destruction would have ensued, with higher prices required to allocate increasingly scarce supply, if such an outage hit the market. Following what appears to have been a lengthy internal debate on the sanctions at the end of October and beginning of November, the Trump administration ended up granting waivers on the sanctions to Iran’s eight (8) largest importers. In so doing, a potential supply shock that almost surely would have resulted in a price spike was transformed into a short-term supply glut, which collapsed prices. The waivers, in other words, were a supply shock to the downside.  Little if any detail has been made available regarding the waivers by the Trump administration. Markets literally were left to scramble to calibrate new supply-demand balances in the dark (Chart 1). Chart 1Waivers Were A Downside Supply Shock to Markets ... Following the waivers, longer-dated futures followed the front of the curve lower and backwardated markets – reflecting increasingly tight supply-demand balances – became contango to flat markets (Chart 2). The immediate shock of the waivers likely was compounded by speculative liquidation along the curve, not just at the front (Chart 3). The vertical jump in implied volatilities suggests the entire market – hedgers and speculators – was caught off guard by the waivers (Chart 4). The waivers likely prompted producers to accelerate hedging programs, as speculators unwound long positions. In addition, upward revisions of U.S. production – following the addition of more than 2mm b/d of new takeaway capacity from the Permian Basin by the end of 2019 – likely played a role in accelerating longer-dated hedging programs. It is worthwhile noting the backwardation in Brent returns to the forward curve in 2H19 then flattens, while for WTI, the curve carries slightly month-on-month to the end of 2020, then pretty much flattens out thereafter (Chart 5). It also is worthwhile noting the back of the curve fell less than the front of the curve, as the graphs above show. Chart 2... And Backwardations Disappeared, As Supply Suddenly Increased Chart 3Speculators Exited Oil Chart 4Volatility Surged Following Waivers Chart 5Waivers Flatten Forward Curves Markets Still Are In The Dark OPEC 2.0 member states – having access to their customers’ demand schedules – have some idea of what the waivers entail, and are adjusting their supply schedules accordingly. We went into the G20 meeting expecting production cuts of between 1.0mm and 1.4mm b/d. All the same, we could see higher cuts: News reports suggest OPEC 2.0 could re-instate its original production-management accord agreed in November 2016, under which 1.8mm b/d of output was taken off the market. Nonetheless, we continue to expect cuts to come in on either side of 1.2mm b/d from OPEC 2.0 following its Vienna meeting. In Alberta, as we discussed in last week’s CES, the government’s action was undertaken to narrow the sometimes-massive basis differentials between WTI, the U.S. benchmark, and WCS, the Canadian benchmark for crude-oil pricing. The WTI – WCS spread has been under persistent pressure due to a lack of storage and takeaway capacity. According to the CBC, the government is losing $80mm per day due to the takeaway and storage constraints. The 8.7% cuts will remain in place until some 35mm barrels of oil in storage is shipped to refining markets, most likely in the Spring, according to the CBC. By the end of next year, the production cuts are expected to fall to 95k b/d, following the opening of new takeaway pipeline capacity. There are a few caveats to keep in mind going forward: Production cuts from OPEC 2.0 could be larger than the upper estimate we are working with (1.4mm b/d). The Iranian import waivers are expected to expire in 2H19. However, the Trump administration could unilaterally extend them, given the expansion of Permian takeaway capacity will not be fully completed till 4Q19. Also, U.S. crude oil export capacity will not be sufficient to move surplus crude from the U.S. to global markets for a couple of years at best. This likely is what underlies the forward market’s flattening post-2020. Venezuela is still subject to larger-than-expected decrease in production: We attach a 33% probability to the total collapse of Venezuela over the next year, which could remove ~ 800k b/d of exports from the market, and severely test OPEC 2.0’s spare capacity. On the demand-side, the market (and BCA Research) expect a slowdown in global growth next year. However, the Trump – Xi talks at the G20 this past weekend pointing toward a greater willingness to resolve trade differences could revive global trade and commodity demand, particularly for oil and base metals. This is not a given, however, and we are not adjusting our demand expectation of 1.46mm b/’d of growth next year because of it.       Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com

Highlights So What? The U.S.-China tariff ceasefire is a net positive, but a final deal is by no means assured. Why? In the near term there may be a play on global risk assets, but beyond that we remain cautious. Global divergence remains the key theme, and China now has less reason to stimulate. What to watch for a final deal: Trump’s approval rating, China’s structural concessions, and geopolitical tensions. We recommend booking gains on our long DM / short EM trades. Go long EM oil producers on OPEC 2.0 cuts. Feature U.S. President Donald Trump and Chinese President Xi Jinping have agreed to a trade truce at the G20 summit in Buenos Aires. The deal includes: Tariff Ceasefire: A 90-day ceasefire – until March 1 – on hiking the second-round tariffs from 10% to 25% on $200bn of Chinese imports. Substantive Talks: The talks will center on structural changes to the Chinese economy, including forced tech transfer, IP theft, hacking, and non-tariff barriers. Vice-Premier Liu He, Xi Jinping’s key economics and trade advisor, may visit Washington in mid-December. Imports: China has agreed to import more goods to lower the U.S. trade deficit, including agricultural and capital goods. This harkens back to the failed May 20 “beef and Boeings” deal. As with the previous deal, there are no deadlines or quantities promised. Not included in the two-and-a-half-hour dinner between Trump and Xi was a substantive discussion on geopolitical tensions. While Chinese statements following the summit did reaffirm Chinese commitment to the U.S.-North Korean diplomacy, there was no broader agreement on tensions, particularly in the South China Sea. The U.S. has recently demanded that China demilitarize the area. Should investors “play” the summit? Tactically, there is an opportunity to play global risk assets in the near term. Cyclically and structurally, however, both economic fundamentals and the underlying trajectory of U.S.-China relations call for caution over the course of 2019. Will The Truce Hold? There are five reasons to doubt the sustainability of the truce: Trade imbalance: It is highly unlikely that the trade imbalance between China and the U.S. can be substantively altered over the course of 90 days. The U.S. economy is in “rude health,” the USD is strong, unemployment is low and pushing up wages, and the output gap is closed. These are the macroeconomic conditions normally associated with an elevated trade imbalance (Chart 1). Chart 1Trade Deficit To Rise Despite Tariffs Domestic politics: The just-concluded midterm election saw no opposition to President Trump on trade. The Democratic Party candidates campaigned against the president on a range of issues throughout the election season, but not on the issue of his aggressive China policy. Polling from the summer also shows that a majority of American voters consider trade with China unfair, unlike trade with other countries (Chart 2). As such, President Trump will have to produce a convincing deal in order to ensure that his base, and many Democrats, support the deal. Chart 2Americans Are Focused On China As Unfair Structural tensions: U.S. Trade Representative Robert Lighthizer issued a hawkish report ahead of the G20 summit concluding that China has not substantively changed any of the trade practices that initiated U.S. tariffs.1 The report was an update to the original investigation that launched the Section 301 tariffs against China. Lighthizer’s report therefore provides a road-map for what the U.S. will want to see over the course of 90 days. High-tech transfers: The Department of Commerce announced on November 19 a “Review of Controls for Certain Emerging Technologies.” This review will conclude on December 19 when the public comment period ends. In the report, the federal government lists biotech, AI, genetic computation, microprocessors, data analytics, quantum computing, logistics, 3D printing, robotics, hypersonic propulsion, advanced materials, and advanced surveillance as technologies with potential “dual-use” that may be critical to U.S. national security and thus might merit consideration for export control.2 As such, the U.S. may decide to impose export controls on technologies that China deems critical to accomplishing its “Made in China 2025” goals within the period of the 90 day talks. If those export controls were to include critical items – such as semiconductors, which are critical to China’s export-oriented manufacturing (Chart 3) – negotiations may become more complicated. Geopolitics: The trade truce did not contain any substantive resolution to ongoing strategic tensions between the U.S. and China. These tensions precede President Trump: we have detailed them in these pages since 2012.3 As such, the U.S. defense and intelligence community will have to be on board with any trade deal and that may suggest that Beijing will be asked to make geopolitical concessions over the course of the next 90 days. Chart 3China Accounts For 60% Of Global Semiconductor Demand Despite the above, the trade truce is a meaningful and substantive move away from an open trade war. Yes, the U.S. will retain tariffs on $250bn Chinese imports, with China maintaining tariffs on $66bn of U.S. imports (Chart 4). No, the U.S. did not rule out a third round of tariffs covering the remaining $267 billion of Chinese imports, if things go awry. Nevertheless, the 90-day truce implies that the U.S. will not ratchet up the tensions for now. Chart 4U.S.-China Trade Hit By Tariffs The truce also allows China to make substantive changes to its domestic economic policies that may satisfy some of the structural concerns cited in the above U.S. Trade Representative report. The soundest basis for a durable deal lies in China recommitting to structural reforms: this would both be positive for China’s productivity and would assuage some of Washington’s underlying anxieties about China’s state-backed industrial policies. Significantly, China’s Ministry of Foreign Affairs now says that it will “gradually resolve the legitimate concerns of the U.S. in the process of advancing a new round of reform and opening up in China.” When would this new round of reform occur? The upcoming Central Economic Work Conference, and the 40th anniversary of Deng Xiaoping’s reforms, should be watched closely for new initiatives. Also, the new March 1 tariff deadline lines up with the calendar for China’s National People’s Congress (NPC). The NPC meets every year and is the occasion when any major new domestic reforms would need to be laid out. Thus, any Chinese compromises on structural issues could be rolled out as part of a more general reform agenda in March. This is important because the U.S. administration is determined to focus on implementation and not to let China delay resolution of differences through endless rounds of dialogue. As such, investors should watch the following issues over the course of the next three months in order to gauge the likelihood of a substantive deal that not only rules out new tariffs but also rolls back the existing ones: Polls: President Trump is focused on his 2020 reelection. As such, he will want to see political gains from the easing of pressure on China, both in the general populace and amongst his GOP base (Chart 5). A slump in the polls, or a threatening turn in the Mueller investigation, may justify a shift in the narrative come March-April and thus end the truce. Chart 5Trump’s Approval Will Affect Trade Talks Big ticket announcements: China is going to have to make big-ticket item purchases. A huge order of Boeing airplanes, a massive ramp-up in the purchase of agricultural products, a raft of direct investments in manufacturing in the heartland … these are the type of announcements that President Trump could use to sell a substantive deal to his base. Structural changes to the Chinese economy: China will have to prove that it is addressing the concerns outlined in the U.S. Trade Representative report. We suspect that Lighthizer issued the report ahead of the G20 summit so as to set the benchmark for what the U.S. wants to see from Beijing. It is a high benchmark as it includes: An end to cyber theft, hacking, and corporate espionage; Substantive, rather than merely “incremental,” improvements to U.S. market access, including increased ownership of ventures; Serious changes to state-subsidized industrial programs that utilize stolen technology, particularly the so-called “Strategic Emerging Industries” program and “Made in China 2025”; An end to China’s state-backed investment campaign in Silicon Valley. No new U.S. embargoes: The public comment period for the newly proposed U.S. export controls ends on December 19. That suggests that high-tech restrictions could emerge over the course of the first quarter of 2019. These could exacerbate tensions. No new geopolitical tensions: Geopolitical tensions, such as over human rights in Xinjiang or the militarization of the South China Sea, would obviously make a deal less likely.  Bottom Line: The trade truce could lead to a substantive trade deal between China and the U.S. However, many impediments remain. Investors have to answer three key questions: is the deal politically useful for President Trump ahead of the 2020 election? Does the deal resolve the concerns laid out in the U.S. Trade Representative’s Section 301 report? And will geopolitical and national security tensions ease? Since 2012, we have had a structurally bearish view of the Sino-American relationship. This view is based on long-term structural factors that we do not think can be resolved over the course of 90 days. That said, every structural view can have cyclical deviations. The question we now turn to is how to play such a cyclical deviation in terms of the markets. What Does The Truce Mean For The Markets? In our view, the trade war has been of secondary importance to global markets. Far more relevant to the BCA House View that DM assets will outperform EM has been our conclusion that U.S. and Chinese economies would experience policy divergence. The U.S. economy has been buoyed by pro-cyclical stimulus, whereas Chinese policymakers have created a macro-prudential framework that has impaired the country’s credit channel. This divergence has led to the outperformance of the U.S. economy over the rest of the world, leading to a substantive USD rally (Chart 6). Chart 6U.S. Outperformance Should Be Bullish USD While this view has worked out well in 2018, it appears to be fraying as the year comes to the end: Chart 7U.S. Growth Weakening? Fed dovishness: Our recent travels to Asia, the Middle East, Europe, and the Midwest have revealed unease among investors regarding the health of the U.S. economy. Some recent data, such as the woeful core durable goods orders (Chart 7) and weak housing, have prompted calls for a more dovish Fed. On cue, Fed Chair Jay Powell delivered what was perceived as a dovish speech. BCA’s Chief Global Strategist, Peter Berezin, makes a strong case for why investors should fade the enthusiasm.4 Specifically, Peter thinks that investors are focusing too much on the unknown – the neutral rate – and not enough on the known – the budding inflationary pressures (Chart 8). Nonetheless, in the near-term, the narrative of a “Fed pause” may overwhelm the data. Chart 8Does The Fed Like It Hot? Chart 9Fiscal Policy Becomes More Proactive Chinese stimulus: Evidence of a broad-based, irrigation-style, credit stimulus is scant in China’s data. Nonetheless, many investors we have met on the road are latching on to higher local government bond issuance (Chart 9) and a positive M2 credit impulse (Chart 10). Moreover, Q1 almost always brings a boost in new lending in China. Our colleague Dhaval Joshi, BCA’s Chief European Strategist, has recently pointed out that the global credit impulse has hooked up, suggesting that EM underperformance is over (Chart 11).5 We do not think that China can turn the corner on a slumping economy without a substantive increase in its total social financing, which remains subdued both in growth terms and as a second derivative (Chart 12). However, we concede that the narrative may have shifted sufficiently in the near term to warrant some tactical caution on our cyclical House View. ​​​​​​​Chart 10China's M2 Turned Positive Chart 11An Up-Oscillation In Global Credit Growth Technically Favours EM Trade truce: Trade concerns have had a clear impact on the outperformance of U.S. equities relative to the rest of the world (Chart 13). As such, a trade truce may alter the narrative sufficiently in the near term to change the direction. In this report, we cite why we are cautious regarding the truce leading to a substantive deal. However, we are biased by our structural perspective that Sino-American tensions are unavoidable. The vast majority of our clients and global investors does not share this view. In fact, the trade war has caught the investment community by surprise. As such, we would argue that investors are biased towards a “win-win” scenario. Therefore, investors may not be cautious, but may in fact project a much higher probability of a final deal into their market decisions. Chart 12China's Total Credit Is Weak Chart 13U.S. Is Winning The Trade War Over the course of 2019, we do not think the global risk asset bullishness is sustainable. In fact, a reprieve rally now is going to make global growth resynchronization less likely and continued policy divergence more likely. Why? First, Chinese policymakers will have less of a reason to deploy an irrigation-style credit stimulus if fears of an accelerated trade war abate. Second, the Fed will have less of a reason to back off from its hiking trajectory if both the DXY rally and equity market volatility ease. That said, we are going to close our long DM / short EM trades for the time being. This includes: Our long DM equities / short EM equities, for a gain of 15.70%; Our long U.S. Dollar (DXY) index for a gain of 0.56%; Our long USD / Short EM currency basket for a loss of 0.76%; Our long JPY/GBP call, for a gain of 0.32%. Our hedge of being long China play index ought to outperform on a tactical horizon, so we are leaving it open despite its paltry return so far of 0.32%. Also, we are keeping our long Chinese equities ex. Tech / short EM equities trade, as Chinese assets should rally on the back of the truce. Note that, as outlined above, China’s tech sector is not out of the woods yet. Our decision to close these recommendations is to preserve profits, not change our investment stance. On a cyclical horizon, we remain skeptical that global risk assets will outperform DM, and U.S. assets in particular, over the course of 2019. In the end, we do not believe that a mere narrative shift will be sustainable, especially given the robustness of the U.S. labor market (Chart 14) and the tepidness of Chinese stimulus (Chart 15). Chart 14A Tight Labor Market Chart 15Compare Any Stimulus To Previous Efforts Finally, a word on oil prices. The G20 was crucial for the oil call, as well as the trade war, given that Saudi Arabia and Russia suggested that their OPEC 2.0 union would produce supply cuts at the upcoming Vienna meeting on December 6. This proves that fundamentals were more important than the narrative that Saudi leadership “owed” a favor to President Trump. In particular, the Saudis have fiscal constraints given their budget breakeven oil price is around $80-$85 per barrel. As such, we are reinitiating our long EM energy producers (ex-Russia) / short broad EM (ex-China) equity call. We are excluding Russia from the “long” due to lingering geopolitical concerns – sanctions and Ukraine – and China from the “short,” as we are now tactically bullish on China.   Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1      Please see Office of the United States Trade Representative, “Update Concerning China’s Acts, Policies, And Practices Related To Technology Transfer, Intellectual Property, And Innovation,” dated November 20, 2018, available at www.ustr.gov. 2      Please see The Federal Register, “Review of Controls for Certain Emerging Technologies,” dated November 19, 2018, available at www.federalregister.gov. 3      Please see Geopolitical Strategy Special Report, “Power And Politics In East Asia: Cold War 2.0?,” dated September 25, 2012, Global Investment Strategy Special Report, “Searing Sun: Japan-China Conflict Heating Up,” dated January 25, 2013, “Sino-American Conflict: More Likely Than You Think, Part II,” dated November 6, 2015, and “The South China Sea: Smooth Sailing?,” dated March 28, 2017, available at gps.bcaresearch.com. 4      Please see Global Investment Strategy Weekly Report, “Shades Of 2015,” dated November 30, 2018, available at gis.bcaresearch.com. 5      Please see European Investment Strategy Weekly Report, “DM Versus EM, And Two European Psychodramas,” dated November 22, 2018, available at eis.bcaresearch.com. 

Highlights Portfolio Strategy Higher interest rates, with the Federal Reserve tightening monetary policy three more times in the next seven months, will be the dominant theme next year. All four of our high-conviction underweight calls are levered to this theme. The later stages of the U.S. capex upcycle underpin three of our high-conviction overweight calls for 2019. Recent Changes Downgrade the S&P Home Improvement Retail index to underweight today. Trim the S&P Interactive Media & Services index to a below benchmark allocation today.  Table 1 Feature Fed policy will dominate markets next year as the dual tightening backdrop – rising fed funds rate and accelerated downsizing of the Fed balance sheet – remains intact. Two weeks ago we raised the question: is the Fed tightening monetary policy too far too fast?1 In more detail, we put the latest monetary tightening cycle in historical perspective and examined trough-to-peak moves in the fed funds rate since the 1950s (Chart 1). Chart 1Too Far Too Fast? A good friend I call “the smartest man in California” correctly pointed out that 500bps of tightening today is not the same as in the 1970s or 1980s. Chart 2 adjusts for that by including the average nominal GDP growth rate during these tightening episodes and adds more color to each era. As a reminder, the latest cycle that commenced in December 2015 is already 25bps above the median, if one uses the Wu-Xia shadow fed funds rate to capture the full quantitative easing effect, and above-average nominal output growth. Chart 2Trough-To-Peak Tightening Cycle Already Above Historical Median Trying to answer the question, we are concerned that as the Fed remains committed to tighten monetary policy three more times by mid-2019, a yield curve inversion looms, especially if the U.S. economy suffers a soft patch in the first half of next year (please refer to our Economic Impulse Indicator analysis in the October 22ndand November 19th Weekly Reports). This would signal at least a pause, if not reversal, in Fed policy. With that in mind, this week we are revealing our high-conviction calls for 2019. Four of our calls are a play on this tightening monetary backdrop that is one of BCA’s themes for next year.2 The later stages of the U.S. capex upcycle underpin three of our high-conviction calls. Table 22018 High-Conviction Calls Recap However, before we highlight our 2019 high-conviction calls in detail, Table 2 tallies our calls from last year. We had a stellar performance in our 2018 high-conviction calls with an average excess return of 11.6% versus the S&P 500. As the year turns the corner, closing out the remaining calls brings down the average relative return to 7.5%, still a very impressive number, with a total of ten hits and only two misses for the year.    Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com     Software (Overweight, Capex Theme) Software stocks are our first hold out from last year’s high-conviction overweight list, levered to the capex upcycle theme. Chart 3 shows that relative capital outlays and the share price ratio are joined at the hip. Software upgrades offer the simplest, quickest and most effective capital deployment, especially when productivity gains ground to a halt. Importantly, leading indicators of overall capex remain upbeat and should continue to underpin software profits. Beyond capex, M&A has been fueling software stock prices. It did not take long for the large CA acquisition to get surpassed by RHT and more recently SYMC was also rumored to be in play (Chart 3). Inter-industry M&A activity is reaching fever pitch and this frenzy is bidding up premia to stratospheric levels. The push to the cloud, SaaS and even AI has boosted the appeal of software stocks and brought them to the forefront of potential takeout candidates. These are secular trends and will likely continue to gain steam irrespective of the different stages in the business cycle. As a result, software stocks should remain core tech holdings in equity portfolios. The recovery in the software price deflator (Chart 3), a proxy for industry pricing power, corroborates the upbeat demand backdrop. With regard to financial statements, software stocks have pristine balance sheets with more cash on hand than debt, which sustains the net debt-to-EBITDA ratio in negative territory. Interest coverage is great at 10x and free cash flow generation is expanding smartly. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, INTU, RHT, ADSK, SNPS, CTXS, ANSS, CDNS, FTNT and SYMC. Chart 3Software   Air Freight & Logistics (Overweight, Capex Theme) Air freight & logistics stocks are the second hold out from our high-conviction overweight list, although we added it to list only in late-March. This transportation sub-index laggered is a capex and trade de-escalation play for the first half of 2019. Importantly, energy costs comprise a large chunk of freight services input costs and the recent drubbing in oil markets will boost margins especially on the eve of the busiest season for courier delivery services (top panel, Chart 4). On that front, there are high odds that this holiday sales season will be another record setting one, as wage inflation is underpinning discretionary incomes. Keep in mind that the accelerating domestic manufacturing shipments-to-inventories ratio confirms that demand for hauling services is upbeat. The implication is that rising demand for freight services will buoy industry profits and lift valuations out of their recent funk (Chart 4). Firming industry operating metrics also tell a positive story and suggest that relative share prices will soon take off. Air freight pricing power has been healthy, in expansionary territory and above overall inflation measures. While the U.S./China trade tussle and the appreciating greenback are clear risks to our sanguine S&P air freight & logistics transportation subindex, most of the grim news is already reflected in depressed relative forward profit estimates, bombed out valuations and washed out technicals (Chart 4). The ticker symbols for the stocks in this index are: BLBG: S5AIRF - FDX, UPS, EXPD and CHRW. Chart 4Air Freight & Logistics   Defense (Overweight, Capex Theme) We have been overweight the pure-play BCA defense index since late-2015 and there are high odds that this juggernaut that really commenced with the George Walker Bush presidency remains in a secular growth trajectory. Our strategy is to add exposure on any meaningful pullbacks and keep this index as a structural overweight within the GICS1 S&P industrials index. The recent drawdown offers such an opportunity and we are adding this index to the 2019 high-conviction overweight list. The rise of global "multipolarity" - or competition between the world's great nations - and the decline of globalization, along with a global arms race and increased risk of cyber-attacks, have been documented in our "Brothers In Arms" Special Report. These trends all signal that global defense related spending will remain upbeat in the coming decade.3 In the U.S. in particular, where military spending in absolute terms is greater than the rest of the world put together, defense spending and investment have bottomed and will continue to accelerate (Chart 5). In fact, the CBO continues to project that defense outlays will jump further next year. While such a breakneck pace is clearly unsustainable, President Trump is serious about upgrading and updating the U.S. military in order to keep China's geopolitical and military ascendancy in check (as well as to deal with Russia and Iran).4 The upshot is that defense outlays will continue to expand into the 2020s. Such a buoyant demand backdrop is music to the ears of defense contractor CEOs, and represents a boost to defense equity revenue growth prospects. This capital goods sub-industry has extremely high fixed costs and thus any increase in top line growth flows straight to the bottom line. Put differently, defense contractors enjoy high operating leverage. No wonder M&A activity is robust: at least four large deals have been announced in the past year that are underpinning takeout premia. A closer look at operating metrics corroborates that defense goods manufacturers are firing on all cylinders. New orders recently jumped to fresh all-time highs and the industry's shipments-to-inventories ratio is rising, on track to surpass the 2008 peak. Unfilled orders are also running at a high rate, signaling that factories will keep on humming at least for the next few quarters. Importantly, the industry is not standing still and is making significant investments. U.S. defense capex as reported in the financial statements of constituent firms is growing at roughly 20%/annum or twice as fast as overall capex (Chart 5 on page 7). While interest coverage has been modestly deteriorating, it is twice as high as the overall market (Chart 5 on page 7). Impressively, defense ROE is running near 30%, again roughly double the rate of the broad market. The ticker symbols for the stocks in the BCA defense index are: LMT, LLL, NOC, GD and RTN. Chart 5Defense   Consumer Discretionary (Underweight, Higher Fed Funds Rate Theme) We recommend investors avoid the consumer discretionary sector that suffers when interest rates rise. Chart 6 depicts this inverse correlation consumer discretionary equities have with interest rates, especially the fed funds rate. Most discretionary equites are levered off of floating rates and thus any increase in the fed funds rates gets reflected immediately in banks' prime lending rate. Also, most consumer debt is floating rate debt and thus tighter monetary conditions, at the margin, dampen consumer debt uptake and, as a knock-on effect, weigh on discretionary consumer outlays. Recently we highlighted that, now that the Fed has been raising rates and allowing bonds to roll off its balance sheet, volatility is making a comeback. Unsurprisingly, the consumer discretionary share price ratio is inversely correlated with the VIX index, signaling that more pain lies ahead for this early cyclical index (VIX shown inverted, Chart 6). Sentiment and technical indicators also point to more downside ahead for this interest-rate sensitive index. Our sector advance/decline line is waning and EPS breadth has plunged. Worrisomely, sell-side analysts are penciling in an extremely optimistic 5-year outlook with EPS growth 23.4%/annum or 1.4 times higher than the overall market. Clearly this is not realistic as it assumes a tripling of EPS in the coming 5 years. Relative EPS estimates have already given way as AMZN commands very little EPS weight, despite its massive market cap weight (30% of the S&P consumer discretionary sector), and suggests that relative share prices will converge lower (Chart 6 on page 9). As a result, the 12-month forward P/E ratio is trading at a 24% premium to the broad market and significantly above the historical mean. Technicals are almost as extended as relative valuations and cyclical momentum has likely peaked, warning that a downdraft in relative share prices looms (Chart 6 on page 9). Chart 6Consumer Discretionary   Home Improvement Retail (Underweight, Higher Fed Funds Rate Theme) While the probablity of a housing recession remains low, we are concerned that too much euphoria is already priced in the S&P home improvement retail (HIR) index, and there are high odds that next year HIR will suffer the same fate as homebuilders did this year (Chart 7). Thus, we are downgrading the S&P HIR index to underweight and adding it to the high-conviction underweight list for 2019. Fixed residential investment (FRI) as a percentage of GDP is up 50% from trough to the recent peak, whereas relative HIR performance is up 170% in the same time frame. Our worry is that optimistic sell side analysts' relative profit forecasts will be hard to attain, let alone surpass as FRI is steadily sinking (Chart 7). Worrisomely, our HIR model has plunged on the back of the wholesale liquidation in lumber prices and rising interest rates (Chart 7). Lumber deflation will prove a profit headwind as building supply Big Box retailers make a set margin on wood products. Select industry operating metrics suggest that the easy profits are behind HIR. Not only is our productivity growth proxy (sales per employee) on the verge of deflating, but also an inventory surge has sunk the HIR sales-to-inventories ratio into the contraction zone. Finally, there is rising supply of new and existing homes for sale already on the market, and that puts off remodeling activity at least until this supply glut clears (months' supply shown inverted, Chart 7). The ticker symbols for the stocks in this index are: BLBG: S5HOMI - HD, LOW. Chart 7Home Improvement Retail   Short Small Caps/Long Large Caps (Higher Fed Funds Rate Theme) The days in the sun are over for small cap stocks and we are compelled to put the size bias favoring large caps in our high-conviction calls list for 2019. Small caps are severely debt saddled. Sustained small cap balance sheet degradation is worrying, with S&P 600 net debt-to-EBITDA close to 4 compared with less than 2 for the SPX (Chart 8). Such gearing is fraught with danger as the default rate has nowhere to go but higher. Small and medium enterprises (SMEs) have a higher dependency on bank credit as opposed to the bond market access that mega caps enjoy. Most bank credit is floating rate debt and so are lines of credit, and as the Fed remains firm on tightening monetary policy, interest expense costs are skyrocketing for SMEs. In a relative sense this will weigh on net profits. Moreover, small caps are a lot more sensitive to interest rates, and the selloff in the 10-year Treasury note heralds more pain in 2019 (Chart 8). Small caps are high(er) beta stocks and when volatility spikes they underperform large caps. When the Fed ballooned its balance sheet and dropped the fed funds rate to zero it suppressed volatility. Now that the Fed has been decreasing the size of its balance sheet and raising interest rates, this is working in reverse and volatility is making a comeback as we have been highlighting in our research, and will continue to weigh on small caps (VIX shown inverted, middle panel, Chart 8). Another way to showcase small caps' riskier status is the close correlation they have with the relative EM equity share price ratio. When EMs outperform the SPX, small caps follow suit and vice versa. Importantly a wide gap has opened recently and we suspect that it will narrow via small caps following the EM higher beta stocks lower (SPX vs. EM ratio shown inverted, fourth panel, Chart 8 on page 12). Chart 8Small Vs. Large   Interactive Media & Services (Underweight, Higher Fed Funds Rate Theme) In our initiation of coverage on the S&P interactive media & services index,5 we highlighted three key risks that offset the revenue & profit growth vigor of this group, comprised almost entirely of Alphabet (Google) and Facebook. These were a renewed regulatory focus, rapid unpredictable changes in tastes & technology and an appreciating U.S. dollar. It is the first of these that has risen most dramatically since that report. Tack on the inverse correlation these growth stocks have with interest rates (top panel, Chart 9) and that is causing us to lower our recommendation to underweight and include this index in the high-conviction underweight list for 2019. Increasing regulatory efforts on technology will be a key theme next year, one we explored this past summer.6 Our conclusion was that both antitrust (particularly in the case of Alphabet) and privacy regulation (particularly in the case of Facebook) added significant risk to these near monopolies; calls for legislating both have dramatically amplified. Tim Cook, Apple’s CEO, recently commented that more regulation for Facebook and Alphabet was inevitable; we agree. While the form such regulation might take remains open to debate (for example, the U.S. could adopt an EU-style General Data Protection Regulation (GDPR)), we fear the associated headline risk (not to mention likely profit headwinds) will impair stock prices in the S&P interactive media & services index. This communication services sub-index is particularly prone to such a risk when it already trades at close to a 40% valuation premium to the broad market (middle panel, Chart 9 on page 14). Adding insult to injury is the PEG ratio that is trading at a 60% premium to the broad market (bottom panel, Chart 9 on page 14). In the face of the Fed’s sustained tightening cycle these extreme growth stocks are vulnerable to massive gravitational pull. The ticker symbols in the stocks in this index are: S5INMS – GOOGL, GOOG, FB, TWTR and TRIP. Chart 9Interactive Media & Services Footnotes 1      Please see BCA U.S. Equity Strategy Report, "Manic Market," dated November 19, 2018, available at uses.bcaresearch.com. 2      Please see BCA The Bank Credit Analyst Report, "OUTLOOK 2019: Late-Cycle Turbulence", dated November 26, 2018, available at bca.bcaresearch.com. 3      Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. 4      Please see BCA Geopolitical Strategy Special Report, "A Global Show Of Force?" dated October 10, 2018, available at gps.bcaresearch.com. 5      Please see BCA U.S. Equity Strategy Special Report, "New Lines Of Communication," dated October 1, 2018, available at uses.bcaresearch.com. 6      Please see BCA U.S. Equity Strategy Special Report, "Is The Stock Rally Long In The FAANG?", dated August 1, 2018, available at uses.bcaresearch.com.   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights We are exploring the key FX implications of the views presented in BCA’s 2019 annual outlook. Global growth is set to weaken further in the first half of the year. As a result, the U.S. dollar should benefit from a last hurrah before beginning a long painful period of depreciation. The euro will mirror these dynamics and should depreciate below EUR/USD 1.10 before appreciating significantly during the second half. The yen is likely to rally against the EUR in the first half of the year, but the JPY will be left very vulnerable once global growth picks up again. The Swiss franc might be a safe-haven currency, but risks are rising that the Swiss National Bank will increasingly fight against the CHF’s upside vis-à-vis the euro. Thus, EUR/CHF has limited downside while global growth slows, and plenty of upside once global growth firms. The GBP could continue to experience some volatility, but we recommend using any additional weaknesses to buy cable. The commodity and Scandinavian currencies will suffer in the first half of the year, but they should prove the stars of the currency market in the second half. Feature Key View From The Outlook This past Monday we sent you BCA’s Annual Outlook, exploring the key macroeconomic themes that we expect will shape 2019. This year, the discussion between BCA’s editors and Mr. X, and his daughter, Ms. X, yielded the following key views:1 The collision between policy and markets that we discussed last year finally came to a head in October. Rather than falling as they normally do when stocks plunge, U.S. bond yields rose as investors reassessed the Federal Reserve’s willingness to pause hiking rates, even in the face of softer growth. Likewise, hopes that China would move swiftly to stimulate its economy were dashed as it became increasingly clear that the authorities were placing a high emphasis on their reforms agenda of deleveraging and capacity reduction. The ongoing Brexit saga and the stalemate between the populist Italian government and the EU have increased uncertainty in Europe at a time when the region was already beginning to slow. We expect the tensions between policy and markets to be an ongoing theme in 2019. With the U.S. unemployment rate at a 48-year low, it will take a significant slowdown for the Fed to stop hiking rates. Despite the deterioration in economic data over the past month, real final domestic demand is still tracking to expand by 3% in the fourth quarter, well above estimates of a sustainable pace of economic growth. Ultimately, the Fed will deliver more hikes next year than discounted in the markets. This will push up the dollar and keep the upward trend in Treasury yields intact. The dollar should peak midway next year. China will also become more aggressive in stimulating its economy, which will boost global growth. However, until both of these things happen, emerging markets will remain under pressure. For the time being, we continue to favor developed-market equities over their EM peers. We also prefer defensive equity sectors such as health care and consumer staples over cyclical sectors such as industrials and materials. Within the developed market universe, the U.S. will outperform Europe and Japan for the next few quarters, especially in dollar terms. A stabilization in global growth could ignite a blow-off rally in global equities. If the Fed is raising rates in response to falling unemployment, this is unlikely to derail the stock market. However, once supply side constraints begin to fully bite in early 2020 and inflation rises well above the Fed’s 2% target, stocks will begin to buckle. This means a window exists next year where stocks will outperform bonds. We are maintaining a benchmark allocation to stocks for now but will increase exposure if global bourses were to fall significantly from current levels without a corresponding deterioration in the economic outlook. Corporate credit will underperform stocks as government bond yields rise. A major increase in spreads is unlikely so long as the economy is still expanding, but spreads could still widen modestly given their low starting point. U.S. shale companies have been marginal producers in the global oil sector. With breakeven costs in shale at close to $50/bbl, crude prices are unlikely to rise much from current levels over the long term. However, over the next 12 months, we expect production cuts in Saudi Arabia will push prices up, with Brent crude averaging around $82/bbl in 2019. A balanced portfolio is likely to generate average returns of only 2.8% a year in real terms over the next decade. This compares to average returns of around 6.6% a year between 1982 and 2018. Essentially, global growth is likely to stay weak in the first half of 2019. However, even if it experiences a benign slowdown, the U.S. economy continues to run above trend, and a U.S. recession next year is a low-probability event (Chart 1). This suggests the Fed will continue to increase rates at a gradual pace of one hike per quarter until U.S. financial conditions become tight enough to force a re-assessment of the U.S. growth outlook. This configuration is likely to result in additional market stress globally and a stronger dollar. As a result, a defensive stance in the FX market seems warranted. Chart 1The Fed Isn't Ready To Capitulate However, China has a role to play in this script as well. The Chinese authorities are getting very uncomfortable with the continued deceleration in Chinese activity. They will likely further support their economy, which should cause global growth to trough toward the middle of the year. This will result in a major selling opportunity for the dollar, and a buying opportunity for the most pro-cyclical currencies. Implications For The FX Markets What are the key implications of these views for currency markets? Based on this outlook for global growth and the Fed, the USD should generate a healthy performance in the first half of the year. As Chart 2 illustrates, the dollar is often strong when global growth and global inflation weaken. However, if global growth is indeed set to rebound in the second half of the year, then, at this point, the dollar should depreciate considerably. This is even more likely as speculators are already very long the greenback, and thus there will be ample firepower to sell the USD once macroeconomic conditions warrant it (Chart 3). As a result, a DXY dollar index above 100 could represent an interesting opportunity for long-term investors to lighten up their dollar exposure. Chart 2The Dollar And The Global Business Cycle   Chart 3Fuel For The Dollar's Downside The euro continues to behave as the anti-dollar; since buying EUR/USD is the simplest, most liquid vehicle for betting against the dollar, and vice versa. Our bullish dollar stance is therefore synonymous with a negative take on the euro. Also, while American growth is showing budding signs of deceleration, slowing global trade and Chinese economic activity have a more pronounced impact on Europe. As a result, euro area growth is underperforming the U.S. Finally, since the Great Financial Crisis, EUR/USD has lagged the differential between European and U.S. core inflation by roughly six months. Today, this inflation spread does point to a weaker EUR/USD for the opening quarters of 2019, but it also highlights that the euro may rebound toward the end of the second quarter (Chart 4). Chart 4The Euro Will Rebound, But This Will Not Happen Immediately Additionally, since momentum has a great explanatory power for the dollar, it tends to work well for the anti-dollar, the euro. Currently, momentum suggests that the euro has also more downside. Our favored fair value model for EUR/USD – which includes real short rate differentials, the relative slope yield curves, and the price of copper relative to lumber – stands at 1.11 (Chart 5). Since the euro tends to bottom at discounts to its equilibrium, this suggests that the common currency is likely to find a floor toward 1.08. Chart 5The Euro Will Fall Between 1.08 And 1.05 On a long-term basis, the yen is cheap, and therefore, already reflects the fact that the Bank of Japan’s balance sheet has now grown to 100% of GDP (Chart 6). However, this is of little comfort for the next 12 months. Over this period, movements in global bond yields will determine the yen’s gyrations. Since we expect global growth to slow further in the first half of the year, global yields are likely to remain contained until the second half of 2019. The impact on the yen of fluctuating global yields will be magnified by Japan’s incapacity to generate much inflationary pressure, with core inflation stuck at 0.4%. This means that while JGB yields have limited downside when global bonds rally, they only have very limited upside when global yields rise. Hence, during the first six months or so of the new year the yen is likely to experience limited downside against the dollar and may even experience significant upside against the euro (Chart 7). However, the second half of 2019 is likely to witness a significant reversal of this trend, with a weaker yen against the dollar, and a much stronger EUR/JPY. Chart 6The Yen Is Very Cheap   Chart 7Selling EUR/JPY Should Be A Winner In H1 At this juncture, the pound remains the trickiest currency to forecast. We are entering the last innings of the Brexit negotiations, and Prime Minister Theresa May looks particularly frail. Bad news out of Westminster will most likely continue to hit the pound at regular intervals. However, GBP/USD is cheap enough on a long-term basis that after the month of March, it could experience meaningful upside against the dollar (Chart 8). We are therefore reluctant to sell the pound at current levels, and instead are looking to buy cable each time undesirable headlines knock it down. As the probability grows that the ultimate form of divorce agreement will be a “soft Brexit,” this also means that once the ultimate deal between London and Brussels is set to be ratified by the British Parliament, EUR/GBP could experience significant downside as well (Chart 9). Chart 8Start Buying The Pound Chart 9Substantial Downside In EUR/GBP The Swiss franc benefits against the euro when global growth weakens and asset market volatility rises. This safe-haven attribute of the franc lies behind the 5.4% decline in EUR/CHF since April. Therefore, our view on global growth would suggest that EUR/CHF could experience additional downside in the first half of 2019. However, we are not willing to make this bet. The Swiss National Bank continues to characterize the Swiss franc as being expensive, and Swiss inflation, retail sales and industrial production have all decelerated. In fact, the Economic Expansion Survey indicator is plunging at its quickest pace since the Swiss economy relapsed directly after the botched re-evaluation of the franc in January 2015 (Chart 10). This suggests the SNB will likely soon put a cap on the franc’s strength as it is causing potent damage to the country. This means that EUR/CHF has limited downside in the first half of 2019, even if global growth deteriorates, and should have large upside in the second half of the year as global growth perks up. Chart 10The SNB Will Not Seat On Its Hands: Buy EUR/CHF Commodity currencies could perform very well in the second half of the year, once global growth finds a firmer footing. The oil currencies should perform best over that period, as BCA’s oil view remains firmly bullish, with a 2019 target of $82/bbl if OPEC agrees to a deal. Moreover, the CAD and the NOK are still the cheapest currencies within this group. However, in the first half of the year, the commodity currency complex remains at risk. Slowing global growth and a Fed committed to lifting interest rates to levels more consistent with the U.S. neutral rate are likely to cause the volatility of the currency market to trend higher (Chart 11). Historically, commodity currencies perform poorly when this happens. This is because when FX volatility picks up, carry trades suffer, which hurts global liquidity conditions and hampers global growth further (Chart 12). The AUD is particularly vulnerable as it is the currency most exposed to China’s capex and construction cycles. Moreover, the Reserve Bank of Australia is still very dovish, as there are no inflationary pressures in Australia. Chart 11The Global Macro Outlook Points To Higher FX Vol... Chart 12...And Higher FX Vol Hurts Global Growth Via The Carry Trades Scandinavian currencies are traditionally very pro-cyclical. This reflects the high sensitivity of the Swedish and Norwegian economies to the global business cycle. As a result, when global growth weakens and global inflation disappoints, they are likely to perform as poorly as the AUD and the NZD (Chart 13). Chart 13Weak Global Growth Will Hurt Scandinavian Currencies In H1 2019... Despite this clouded outlook for the beginning of the year, the scandies should perform very well in the second half of 2019, once global growth stabilizes. With their economies at full employment and exhibiting growing imbalances, both the Riksbank and the Norges Bank are in the process of slowly moving away from extremely easy monetary policy settings. However, they have a long way to go before reaching tight monetary conditions, which implies plenty of upside for real interest rates in both countries. This means that the boost to the SEK and the NOK from rising global growth in the second half of the year will be magnified by domestic factors. Finally, both the SEK and the NOK are very cheap, adding upside risks to these currencies (Chart 14). Chart 14...But Scandies Will Have A Stellar H2 2019   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnote 1 The full report – a BCA Research Special – titled “OUTLOOK 2019: Late-Cycle Turbulence”, dated November 26, 2018, is available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

Dear Client, In addition to today’s report, we sent you our 2019 Outlook earlier this week, featuring a discussion between BCA editors and Mr. and Ms. X. Best regards, Peter Berezin, Chief Global Strategist Highlights Today’s macroeconomic backdrop of slowing global growth, plunging oil prices, falling equity prices, widening credit spreads, and a strong dollar is reminiscent of what transpired in 2015. We do not expect global capital spending to contract as much as it did back then, partly because Saudi output cuts should preclude the need for shale producers to slash capex plans. Nevertheless, global growth is likely to slow further into the first half of next year, suggesting that equities and other risk assets could face renewed near-term pressures. The sell-off in the dollar following Powell’s speech is unwarranted. We expect the DXY to reach 100 by early next year. Global bond yields will rise by more than currently discounted over a 12-to-18 month horizon, but are likely to fall somewhat over the next few months. Feature Echoes From The Past Today’s macroeconomic backdrop is starting to look increasingly similar to 2015, a year when the global economy slowed sharply and commodity prices took it on the chin. In 2014, the Fed was gearing up to raise rates while other central banks were still in full-out easing mode. The divergence in monetary policies between the U.S. and the rest of the world caused the U.S. dollar to surge. The broad trade-weighted dollar strengthened by 16% between July 2014 and March 2015 (Chart 1). Chart 1Current Dollar Strength: Replay Of 2015? The effects of the stronger dollar rippled across the global economy. Notably, since China had a de facto currency peg to the dollar at the time, the resurgent greenback made Chinese companies less competitive in global markets. The appreciation of the yuan came at a time when the Chinese government was tightening both monetary and fiscal policy. The year-over-year change in total social financing (TSF) reached as high as 23% in April 2013 but fell to 12% in May 2015 (Chart 2). Chart 2Just Like Today, China Was Tightening Monetary And Fiscal Policy Going Into 2015 Eager to give its export sector a competitive boost, China allowed the currency to weaken by about 4% in August 2015 (Chart 3). The “mini-devaluation” backfired. Rather than instilling confidence in the economy, it caused investors to bet on further currency declines. Capital outflows intensified as the yuan came under further pressure. Between June 2014 and January 2016, China lost almost US$1 trillion in foreign exchange reserves. Chart 3China's Mini-Devaluation Backfired The combination of a stronger dollar and sagging Chinese growth led to a steep decline in commodity prices. The London Metals Exchange index fell by nearly 40% between July 2014 and January 2016. Brent crude oil prices plunged from $110/bbl to as low as $26/bbl during this period (Chart 4). Capital spending in the commodity sector collapsed. Fears over the financial health of commodity producers and related firms caused credit spreads to widen (Chart 5).  Chart 4Stronger Dollar And Soggy Chinese Growth Were A Bad Combination For Commodity Prices Chart 5Weakness In The Commodity Complex Weighed On High-Yield Bonds In 2015 Throughout the course of 2015, the Fed refused to back off from its plans to start raising rates. It hiked rates in December of that year and signaled four more hikes for 2016. However, as markets continued to swoon, the FOMC quickly backed off. The Fed would not raise rates again for a full 12 months. The Federal Reserve’s decision to temper its hawkish rhetoric, along with China’s decision to ramp up stimulus in early 2016, put a floor under risk assets. Fast forward to the present and investors are again wondering if the Fed is about to blink and whether the Chinese authorities are set to deliver a massive dose of global reflationary stimulus. We would not exclude either option. However, we think that a lot more pain is required before either occurs. China’s Begrudging Stimulus Program The Chinese government’s reform agenda remains focused on curbing credit growth and reducing excess capacity. China has historically stimulated its economy with ever-more debt and investment spending (Chart 6). There is an obvious tension here – one that is likely to make the authorities reluctant to turn on the credit spigot unless the economy slows further. Chart 6China: Debt And Capital Accumulation Have Gone Hand In Hand Of course, China can try to stimulate its economy without relying on more debt-financed investment spending. In particular, it can try to boost consumption or net exports. The problem is that neither of these two options would be welcome news for other nations. Capital goods and raw materials account for more than 80% of Chinese imports. The rest of the world relies on Chinese investment, not Chinese consumption. Similarly, while stricter capital controls have given the authorities greater scope to weaken the yuan than they had in 2015, such a move would only hurt China’s competitors and curb Chinese imports.  The Fed Will Keep Hiking Stocks rallied and the dollar sold off on Wednesday after Chairman Powell seemingly suggested that the fed funds rate was already close to neutral. This appeared to be a sharp recanting of his statement in early October that the Fed was a “long way” from neutral. We think the financial media and many pundits overreacted to Powell’s remarks. What he actually said was that “interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy.”1 The “broad range” of estimates that Powell was referring to is drawn from September’s Summary of Economic Projections, which showed that FOMC members saw the appropriate “longer run” level of the fed funds rate as ranging between 2.5% and 3.5%. Given that the current target for the fed funds rate is 2%-to-2.25%, Powell was merely stating a fact about the current position of the Fed dots, not offering new forward guidance. In any case, investors are focusing too much on what Powell may or may not be thinking. The Fed does not know where the neutral rate is. True to its “data-dependent” approach, it will keep raising rates until the economy slows by enough that it needs to stop. Our base-case scenario envisions only a modest slowdown in U.S. growth, driven in part by increasing capacity constraints (the latter should make the Fed more, not less, eager to raise rates). So far, the data are consistent with this benign slowdown scenario. Holiday sales have been stronger than expected, based on data from Johnson-Redbook and Adobe Digital Insights. According to the Atlanta Fed’s GDPNow model, real GDP is on track to increase by 2.6% in the fourth quarter. Net exports and inventory destocking are expected to shave about half a percentage point off growth. This means that real final domestic demand is still growing at a healthy 3% pace. GDP growth could slow to about 2.5% next year as the fiscal impulse declines and the lagged effects from the recent tightening in financial conditions make their way through the economy. Nevertheless, given that most estimates peg potential growth at around 1.7%-to-1.8%, this should still be enough to push the unemployment rate towards 3% by the end of 2019, bringing it to the lowest level since the Korean War. This should keep price and wage inflation on an upward trajectory (Chart 7). Chart 7Does The Fed Like It Hot? The “dots” in the September Summary of Economic Projections foresaw one rate increase this December and three additional hikes next year. The market is currently pricing in only two hikes through to end-2019 and no hikes beyond then (Chart 8). If our baseline scenario for the U.S. economy unfolds as expected, the Fed will raise rates four times next year, which will keep the U.S. dollar well bid.  Chart 8The Market Does Not Buy The Dots Oil And The Global Economy: Why It Will Not Be As Bad This Time Around As in 2015, a key question today is how the recent drop in oil prices will affect both the U.S. and the global economy. Here there is some good news. The balance sheets of U.S. energy companies have improved markedly over the past few years. Rapid productivity has allowed shale producers to boost production to record levels without having to incur substantially higher costs. In fact, capital spending in the energy sector is far lower as a share of GDP today than it was in the lead-up to the 2015 shale bust (Chart 9). Chart 9Energy Sector Capex Is Far Below Its 2014 Peak Saudi Arabia’s reaction to the slide in oil prices is also likely to be different this time around. In 2015, the Saudis refrained from cutting output in the hope that this would undermine Iran and decimate the fledgling U.S. shale industry. In the end, the Iranian regime endured, and while U.S. production did fall temporarily, it quickly rebounded (Chart 10). Chart 10Who Won The Market Share War Of 2015? Going into September, the Saudis ramped up production after President Trump indicated his intent to tighten sanctions on Iranian oil exports. In the end, Trump declined to reimpose the sanctions. This left the market with a surfeit of crude. There is a limit to how much Saudi Arabia can cut output. Now that the stock market is well off its highs, President Trump has started to take credit for low oil prices. Nevertheless, the Saudis are keenly aware that they need crude to trade at about $83 per barrel just to balance their budget. Our geopolitical and energy strategists expect the Kingdom to cut production by enough to push up prices from current levels. Russia has also hinted at restraining supply. If U.S. producers fill part of the void created by Saudi and Russian production cutbacks, U.S. energy sector capital spending will hold up much better than it did in 2015. Provided that oil prices do not return all the way to their September highs, U.S. consumers will also benefit from an increase in spending power. Investment Conclusions We do not expect the global economy to weaken as much as it did in 2015. Nevertheless, most forward-looking economic indicators point to slower growth over the next few quarters (Chart 11). Global growth will likely bottom out by the middle of 2019, but until then, investors should continue to favor developed over emerging market stocks. They should also overweight defensive equity sectors, such as consumer staples and health care, relative to deep cyclicals, such as materials and industrials. Given sector skews, this implies a regional preference for the U.S. over Europe and Japan. Chart 11Global Growth Is Slowing As far as the near-term absolute direction of stocks is concerned, the equity score from our MacroQuant market-timing model has risen from its recent lows thanks to an improvement in sentiment/technical components. Nevertheless, the model is still pointing to heightened downside risks to global equities over the remainder of the year and into early 2019 due to slowing growth and the lagged effects of the recent tightening in financial conditions (Chart 12). Chart 12MacroQuant Equity Model* Score Is Off Its Lows, But Is Still Warning Of More Downside For Stocks Slower global growth and ongoing Fed rate hikes should keep the dollar well bid. Consistent with our qualitative analysis, our model is currently sending a very bullish signal on the greenback (Chart 13). We expect the DXY to reach 100 by early next year. Chart 13MacroQuant U.S. Dollar Model Is Pointing To Further Upside For The Greenback The model’s near-term outlook on bonds has improved greatly in recent weeks after having spent the better part of the last 18 months in bearish territory (Chart 14). To be clear, this is a tactical signal: The model’s cyclical fair-value estimate for the U.S. 10-year Treasury yield stands at 3.71% – 67 basis points above current levels – which implies that the 12-to-18 month path for yields remains to the upside (Chart 15). Nevertheless, with global growth slowing and lower energy prices dragging down inflation, there is a good chance that the 10-year yield will temporarily fall below 3% before resuming its structural uptrend. Chart 14MacroQuant Recommended Portfolio*: Tactically Favor Bonds Over Stocks   Chart 15MacroQuant U.S. Bond Model*: Treasury Yields Are Still Well Below Fair Value, But The Upside Is Capped Tactically Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1      Jerome H. Powell, “The Federal Reserve’s Framework for Monitoring Financial Stability,” Federal Reserve, November 28, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades