Protectionism/Competitive devaluation

… quick’s the word and sharp’s the action. Jack Aubrey1 Idiosyncratic supply-demand adjustments – some induced by head-spinning reversals of policy (e.g., the U.S. about-face on Iran oil export sanctions) – and uncertainty regarding monetary policy and trade will keep volatility in oil, metals and grains elevated in 2019. We remain overweight energy – particularly oil – expecting OPEC 2.0 to maintain production discipline, and for demand to remain resilient.2 We remain neutral base metals and precious metals, seeing the former relatively balanced, and the latter somewhat buoyant, even as the Fed continues its rates-normalization policy. We remain underweight ags, although weather-induced supply stress has reduced the global inventories some. While we continue to favor being long the energy-heavy S&P GSCI on a strategic basis, tactical positioning will continue to dominate commodity investing in 2019. Highlights Energy: Overweight. OPEC 2.0’s 1.2mm b/d of production cuts goes into effect in January vs. October levels, and should allow inventories to resume drawing. Base Metals: Neutral. Fundamentally, base metals are largely balanced, which is keeping us neutral going into 2019. Precious Metals: Neutral. Gold prices will remain sensitive to Fed policy and policy expectations. Palladium prices have soared as a growing physical deficit noted earlier widens.3 If China cuts sales taxes on autos again, demand could soar. Ags/Softs: Underweight. A strong USD will weigh on ag markets, particularly grains, next year. An agreement on contentious Sino – U.S. trade issues could re-open Chinese markets to U.S. exports. However, the arrest of the CFO of China’s Huawei Technologies in Canada for possible extradition to the U.S. complicates negotiations.   Feature Going into 2019, commodity markets once again are sending conflicting signals. While we continue to favor exposure to commodities as an asset class by being long the energy-heavy S&P GSCI index, which fell 6% this year on the back of the collapse in crude oil prices and flattening of the forward curves in Brent and WTI.  Nonetheless, we believe investors will continue to be rewarded by taking tactical exposure on an opportunistic basis. Volatility remains the watchword, particularly in 1H19, for the primary industrial commodities – oil and base metals. While idiosyncratic supply-demand adjustments will drive prices in each market, Fed policy also will contribute to volatility, as the U.S. central bank likely remains the only systemically important monetary authority following through on rates-normalization. In line with our House view, we expect the Fed to deliver its fourth rate hike of 2018 at its December meeting next week, and four additional hikes next year. On the back of Fed policy, we expect the broad trade-weighted USD to rise another 3-5% in 2019, following a 6% increase in 2018 (Chart of the Week). This will supress demand ex-U.S. for commodities priced in USD, by raising the USD cost of these commodities. Chart of the WeekStronger USD Pressures Commodity Demand Stronger USD Pressures Commodity Demand Stronger USD Pressures Commodity Demand Below, we highlight the key themes we believe will dominate commodities in 2019. Oil Markets Still Re-Calibrating Fundamentals We continue to expect global oil demand to remain strong next year, despite the slight downgrading of global GDP growth earlier this year by the IMF. We expect EM import volumes – one of the key variables we track to proxy EM income levels – to hold up in 1H19, which supports our assessment commodity demand will grow, albeit at a slower rate than this year (Chart 2).4 Chart 2Slowing Trade Volumes Might Pre-sage Softer Commodity Demand Slowing Trade Volumes Might Pre-sage Softer Commodity Demand Slowing Trade Volumes Might Pre-sage Softer Commodity Demand In 2H19, we see the volume of EM imports dipping y/y from higher levels, then recovering toward year-end. This indicates the all-important level of EM income – hence commodity demand – will remain resilient, but the rate of growth in incomes will slow. This is confirmed by the behavior of the Global Leading Economic Indicators we use to cross check our EM income expectation via import volumes (Chart 3). Chart 3Global Leading Economic Indicators Lead EM Import Volume Changes Global Leading Economic Indicators Lead EM Import Volume Changes Global Leading Economic Indicators Lead EM Import Volume Changes There is a chance Sino – U.S. trade relations will thaw, which would remove a large uncertainty over the evolution of demand next year. This would be supportive for EM trade volumes generally, particularly imports. However, this is not a given, and we are not assuming any pick-up in demand in anticipation of such a development. We need to see concrete actions, followed by tangible trade improvement first. On the supply side, oil markets still are in the process of re-adjusting to an extraordinary policy reversal by the Trump administration on its Iranian oil-export sanctions last month – i.e., the last-minute granting of waivers to Iran’s largest oil importers. However, following OPEC 2.0’s decision last week to cut 1.2mm b/d of production to re-balance markets in 1H19, we continue to expect prices to recover. Indeed, going into the OPEC 2.0 meeting last week, we had already lowered our December 2018 production estimates for OPEC 2.0, and also reduced 2019 output estimates by ~ 1mm b/d, so the producer coalition’s action did not come as a surprise (Chart 4).5 Chart 4BCA's Global Oil Balances Anticipated OPEC 2.0 Cuts BCA's Global Oil Balances Anticipated OPEC 2.0 Cuts BCA's Global Oil Balances Anticipated OPEC 2.0 Cuts In addition to the cuts by OPEC 2.0, the Alberta, Canada, government mandated production cuts, which will become effective January 1, 2019, to clear a persistent supply overhang that was decimating producers’ revenues in the province. We estimate there is ~ 200k b/d of trapped Alberta supply – i.e., excess production over takeaway capacity (pipeline and rail) – along with ~ 35mm bbls of accumulated excess production in storage the government intends to draw over the course of 2019 at a rate of ~ 96k b/d. This will lower overall OECD inventories, even if the Canadian barrels are transferred south. Net, in addition to the 1.2mm b/d of cuts from OPEC 2.0, the ~ 300k b/d coming from Canada next year will mean close to 1.5 mm b/d of production, or ~1.4mm b/d of actual supply when accounting for the inventory release, is being cut or curtailed from these two sources. We cannot, at this point, forecast over-compliance with the OPEC 2.0 accord, which was one of the signal features of the deal in 2017 and 1H18. The Trump administration’s waivers for Iran’s eight largest oil importers expire May 2019. We view it as highly unlikely the Trump administration will re-impose export sanctions in full on Iranian exports following the expiration of waivers, and fully expect they will be extended at least for 90 days. This is because oil fundamentals will remain tight next year, despite the massive de-bottlenecking of the Permian Basin in West Texas. While an additional 2mm b/d of new takeaway capacity will be added to the region, it will not be fully operational until 4Q19. We have ~ 300k b/d of additional supply coming out of the Permian after the pipeline expansions are done in 2H19. Even as pipeline capacity is filled, the U.S. still needs to significantly increase its deep-water oil-export capacity to get this crude to market.6 Bottom Line: We expect the oil market to re-balance in 1H19, as production falls by ~ 1.4mm b/d – the combination of OPEC 2.0 and Canadian production cuts – and consumption grows by a similar amount. The USD will continue to appreciate next year, which, at the margin, will temper demand growth and prices. Gold: Remaining Long Equity And Inflation Risks Trump Higher Rates in 2019 As the U.S. economic cycle matures and advances into its final innings, we continue to recommend holding gold in a diversified portfolio. U.S. inflationary pressure will surprise to the upside in 2019, per our House view, which will offset the effects of somewhat less accommodative U.S. monetary policy in the U.S. The October equity correction is a reminder that, when rising UST yields drag stocks down in late-cycle markets, gold works as an effective hedge against equity risks, and can outperform bonds. In fact, both of the corrections we saw in 2018 likely were caused by a sharp increase in bond yields. This convexity on the upside and downside is what makes gold our preferred portfolio hedge. Easy Monetary Policy + Rising Rate = Bullish Gold Prices Despite being negatively correlated with interest rates, gold tends to perform well when the fed funds rate is below r-star – known as the “natural rate of interest” – and is rising (Chart 5, panel 1).7 When this happens, policy rates are below the so-called natural interest rate consistent with a fully employed economy, which, all else equal, is inflationary. In these late-cycle environments, gold’s ability to hedge against inflation and equity risks dominate its price formation, while its correlation with U.S. real rates diminishes. Chart 5Gold Will Stay in Trading Range Gold Will Stay in Trading Range Gold Will Stay in Trading Range In our view, gold will remain in an upward trading range until rates become restrictive enough to depress the inflation outlook (Chart 5, panel 2). Our U.S. strategists estimate the equilibrium fed funds rate is at ~ 3%, and project it will rise to ~ 3⅜% by end-2019. Therefore, despite our House view of four rate hikes next year, we expect the U.S. economy to remain in a below-r-star-and-rising phase for most of the year. Consistent with our House view, we believe U.S. inflation is likely to surprise to the upside next year, which will push gold prices higher (Chart 6, panel 1). The U.S. economy remains strong, particularly on the employment front. This means wage growth will work its way through inflation rates. Chart 6U.S. Inflation Likely to Surprise U.S. Inflation Likely to Surprise U.S. Inflation Likely to Surprise Admittedly, this is not the consensus view. Investors are not worried about significantly higher inflation (Chart 6, panel 2). However, our Bond strategists argue that long-maturity TIPS breakeven inflation is stuck below historical levels because of this abnormally low fear of elevated inflation (i.e. > 2.5%). Once inflation starts drifting higher, there will be an upward shift in investors’ inflation expectations. Any short-term dip in inflation on the back of lower oil prices will be transitory, given our view that oil prices will recover next year. If such a transitory dip, or concerns about a global growth slowdown spilling back into the U.S. causes the Fed to pause, we would add to our precious metal view position, given our assessment that this would raise the probability of an inflation overshoot. Lastly, gold prices recently have been depressed by an abnormally high correlation with the U.S. dollar (Table 1). We put this down to speculative positioning: Net speculative positions are stretched for both the U.S. dollar and gold, Table 1Gold Vs. USD Correlations Running Higher Than Normal 2019 Key Views: Policy-Induced Volatility Will Drive Markets 2019 Key Views: Policy-Induced Volatility Will Drive Markets therefore, any change in expectations likely will be amplified by a reversal in positioning (Chart 7). In the medium-term, we expect the gold-dollar correlation to converge back to its average, which would mute the dollar’s impact on gold. This would, all else equal, raise inflation and equity risks factors. Chart 7Spec Positioning Stretched Spec Positioning Stretched Spec Positioning Stretched Bottom Line: We continue to recommend gold as a portfolio hedge for investors, given its convexity – it outperforms during equity downturns, and participates on the upside (albeit not as much). Given our out-of-consensus House view for inflation, we believe gold also will provide a hedge against this risk. Palladium: China Tax Policy Could Lift Price Palladium soared to dizzying heights this year, on the back of an expanding physical deficit (Chart 8). Were it not for the loss of an automobile-tax break in China, which reduced the rate of growth in sales there to unchanged y/y, this deficit likely would have been considerably wider, inventories would have drawn even harder, and palladium prices would have been higher (Chart 9). Chart 8Palladium's Physical Deficit Expanding Palladium's Physical Deficit Expanding Palladium's Physical Deficit Expanding Chart 9Palladium Inventories Collapse Palladium Inventories Collapse Palladium Inventories Collapse Palladium’s demand is mainly driven by its use in catalytic converters for gasoline-powered cars, which dominate sales in the U.S. and China, the world’s two largest car markets (Chart 10). U.S. sales growth has leveled off this year (Chart 11), as has China’s. However, the China Automobile Dealers Association (CADA) is pressing policymakers to reduce the 10% auto sales tax by half, which could keep palladium demand elevated relative to supply, should it happen.8 Chart 10Auto Catalyst Demand Dominates Palladium 2019 Key Views: Policy-Induced Volatility Will Drive Markets 2019 Key Views: Policy-Induced Volatility Will Drive Markets Chart 11China Car Sales Could Revive With Tax Cut China Car Sales Could Revive With Tax Cut China Car Sales Could Revive With Tax Cut Russian producers, led by Norilsk Nickel, supply ~ 40% of the world’s palladium. Markets have been fearful U.S. sanctions could be imposed on Norilsk and other Russian producers throughout the year by the U.S., most recently in re Russia’s seizure of Ukrainian naval vessels in international waters, and over Russia’s response to the threatened withdraw from the Intermediate-Range Nuclear Forces (INF) Treaty by the U.S., which could be keeping a risk premium firmly embedded in palladium prices.9 With platinum trading below $800/oz, or ~ 65% of palladium’s value, autocatalyst makers could begin to switch out their catalysts (Chart 12). Chart 12Platinum Could Fill Palladium Supply Gap Platinum Could Fill Palladium Supply Gap Platinum Could Fill Palladium Supply Gap Base Metals: Trade Tensions, USD Cloud Outlook Base metals remain inextricably bound up with EM income growth. When EM incomes are growing, commodity demand – particularly for base metals – is growing, and vice versa. This typically shows up in EM GDP and import volume levels, which we use as explanatory variables in our base-metals price modeling (Chart 13). Chart 13Base Metals Demand Tied To EM Income, Trade Volumes Base Metals Demand Tied To EM Income, Trade Volumes Base Metals Demand Tied To EM Income, Trade Volumes There are, in our view, two significant risks to EM income growth over the short and medium terms: Sino – U.S. trade disputes, which erupted earlier this year. They carry the risk of spreading globally and unwinding supply chains that have taken decades to develop between DM and EM economies;10 Fed monetary policy, which is immediately reflected in USD levels. A strong dollar raises the local-currency costs of commodities for consumers ex-U.S., and debt-servicing costs in EM economies. In addition, it lowers the local-currency costs of producing commodities ex-U.S., which incentivizes producers to raise production to capture this arbitrage, since they are paid in USD. The trade-war risk remains, despite the agreement between presidents Trump and Xi at the G20 in Buenos Aires to work on a trade deal. Even so, the actual level of tariffs imposed by both sides is trivial relative to the level of global trade, which is in excess of $20 trillion p.a. – ~$17 trillion for goods, $5 trillion for services, according to the WTO (Chart 14). Chart 14Sino – U.S. Tariffs Remain Trivial Relative to Overall Global Trade 2019 Key Views: Policy-Induced Volatility Will Drive Markets 2019 Key Views: Policy-Induced Volatility Will Drive Markets Fed policy, on the other hand, is a threat of far greater moment to EM income growth, and, through this, import volumes, which we use to proxy that growth. The LMEX index, a gauge of base-metals prices traded on the LME, is extremely sensitive to changes in EM import volumes. This is not unexpected, given the income elasticity of trade for EM economies is greater than 1.0. Our modeling finds a 1% increase in EM import volumes translates to a 1.3% increase in the LMEX, which is consistent with the World Bank’s estimate of EM income elasticity of trade.11 Per our House view, we believe markets are too sanguine regarding the possibility of a Sino – U.S. trade deal. Such an event, should it occur, would immediately affect base metals markets, as China accounts for roughly half of base metals demand globally(Chart 15). Market participants’ default setting appears to be the U.S. and China will resolve their trade differences in short order – i.e., by the March 1, 2019, deadline agreed at the G20 meeting – resulting in a win-win for both countries and the world. We are hopeful this view is correct, but we would not take any positions in base metals in expectation of such an outcome. Instead, we think the substantive technological and strategic differences between the two countries, and underlying distrust, will result in a renewed escalation of tensions. Chart 15China Demand Remains Pivotal Base Metals Demand Could Wobble China Demand Remains Pivotal Base Metals Demand Could Wobble China Demand Remains Pivotal Base Metals Demand Could Wobble Bottom Line: We remain neutral base metals going into 2019. Fundamentally, most of the metals in the LME index are in balance, or can get there in short order. The Fed’s rates-normalization policy continues to represent a larger short-term risk to EM income growth than Sino – U.S. trade tensions, but, longer term, we continue to expect tension between the world’s dominant economies to escalate. Ags: Trade Tensions, USD Cloud Outlook That’s not a typo in the sub-head above; ags – particularly soybeans – are dealing with the same headwinds bedeviling base metals. The agreement to work on a trade agreement reached at the G20 summit between the U.S. and China lifted grain markets, and supported the upward trend in grain and bean prices. All the same, Sino – U.S. trade relations are prone to go off the rails at any time. The Buenos Aries understanding, after all, only holds for 90 days. In addition to the hoped-for agreement to resolve trade-war issues, grain prices received support from the signing of the United States-Mexico-Canada Agreement (USMCA). This helped align supply-demand fundamentals globally with prices. Focusing too much on China can obscure the fact that the USMCA, which replaces the North American Free Trade Agreement (NAFTA), eliminated major uncertainties over the fate of U.S. grain exports to Mexico, the second-largest destination for U.S grains, beans and cotton. In fact, Mexico accounts for 13% of all U.S. ag exports (Chart 16).12 Chart 16Trade Negotiations Hit American Farmers Hard 2019 Key Views: Policy-Induced Volatility Will Drive Markets 2019 Key Views: Policy-Induced Volatility Will Drive Markets All the same, the Sino – U.S. trade war is hitting U.S. ags hard, particularly soybeans. The 25% tariff on China’s imports of U.S. grains 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. Close to 60% of U.S. bean exports historically went to China. The U.S. – China trade war caused a soybean shortage in Brazil, as demand from China for its crops soared, while a record 11% of American beans are projected to be left over after accounting for exports and domestic consumption (Chart 17). Chart 17Bean Shortage in Brazil, Supply Glut in the U.S. Bean Shortage in Brazil, Supply Glut in the U.S. Bean Shortage in Brazil, Supply Glut in the U.S. A successful resolution to the U.S. – China trade tensions is unlikely to reverse the over-supply of beans globally (Chart 18). In fact, we expect beans stocks-to-use (STU) ratios to build next year, unlike global corn and wheat stocks (Chart 19). This will set a record for the soybean STU ratios, pushing them above 30%. Chart 18Expect Another Bean Surplus Expect Another Bean Surplus Expect Another Bean Surplus Chart 19Bean STU Ratios Will Grow Bean STU Ratios Will Grow Bean STU Ratios Will Grow As is the case for metals, the USD will weigh on ag markets, which will make U.S. exports more expensive than their foreign competition (Chart 20). As is the case for all of the commodities we cover, a strong dollar will weigh on prices at the margin. Chart 20A Strong USD Will Make U.S. Exports Expensive A Strong USD Will Make U.S. Exports Expensive A Strong USD Will Make U.S. Exports Expensive Bottom Line: A thaw in the Sino – U.S. trade war should realign global grain markets, but will not keep soybeans from setting new global inventory records. A strong USD will be a headwind for ag markets, as it is for other commodity markets we cover.     Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1      This is a fictional character in the movie Master and Commander, based on the novels of Patrick O’Brian. 2      OPEC 2.0 is the name we coined for the OPEC/non-OPEC coalition led by the Kingdom of Saudi Arabia (KSA) and Russia.  It was formed in November 2016 to manage oil production. 3      Please see “Silver, Platinum At Risk As Fed Tightens; Palladium Less So,” published by BCA Research’s Commodity & Energy Strategy February 15, 2018.  It is available at ces.bcaresearch.com. 4      Please see “The Role of Major Emerging Markets in Global Commodity Demand,” published as a Special Focus in the IMF’s Global Economic Prospects in June 2018 for a discussion of income elasticities for oil, base metals and other commodities in large EM economies. 5      In our current forecast for 2019, we expect Brent to average $82/bbl next year, and for WTI to trade $6/bbl below that.  Please see “All Fall Down: Vertigo In the Oil Market … Lowering 2019 Brent Forecast to $82/bbl,” published by BCA Research’s Commodity & Energy Strategy November 15, 2018.  We will be updating our supply-demand balances and price forecast next week. 6      At 11.7mm b/d and growing, the U.S. is the largest crude oil producer in the world, having recently eclipsed Russia’s total crude and liquids production of 11.4mm b/d, and the U.S. EIA’s projected 2019 output of 11.6mm b/d.  U.S. crude oil exports hit 3.2mm b/d for the week ended November 30, 2018, an all-time high, according to EIA data.  It is worthwhile recalling crude oil exports were illegal until December 2015.  U.S. product exports totalled 5.8mm b/d for the week ended November 30, and 6.3mm b/d the week before that.  Total U.S. crude and product exports are running ~ 9mm b/d at present, which placed them just above total imports of crude and products – i.e., the U.S. became a net exporter of crude and products at the end of November. 7      The San Francisco Fed defines r-star as the inflation-adjusted “natural” rate of interest consistent with a fully employed economy, with inflation close to the Fed’s target.  r-star is used to guide interest-rate policy consistent with long-term macro goals set by the Fed.  Please see “R-star, Uncertainty, and Monetary Policy,” by Kevin J. Lansing, published in the FRBSF Economic Letter May 30, 2017. 8      Please see “Exclusive: Reverse gear - China car dealers push for tax cut as auto growth stalls,” published by reuters.com October 11, 2018. 9      Please see “Is Norilsk Nickel too big to sanction?” published by ft.com on April 19, 2018, and “U.S. to Tell Russia It Is Leaving Landmark I.N.F. Treaty,” published by nytimes.com October 19, 2018. 10     We discuss this in “Escalating Trade Disputes Pressuring Base Metals,” published July 12, 2018, in BCA Research’s Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 11     For a discussion of the World Bank’s trade elasticities, please see “Trade Wars, China Credit Policy Will Roil Global Copper Markets” published by BCA Research’s Commodity & Energy Strategy June 21, 2018. It is available at ces.bcaresearch.com. 12     Canada makes up a smaller share of U.S. exports, at ~ 2%. Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table Trade Recommendation Performance In 3Q18 2019 Key Views: Policy-Induced Volatility Will Drive Markets 2019 Key Views: Policy-Induced Volatility Will Drive Markets Trades Closed in 2018 Summary of Trades Closed in 2017 2019 Key Views: Policy-Induced Volatility Will Drive Markets 2019 Key Views: Policy-Induced Volatility Will Drive Markets

Highlights So What? The tech war will continue to disrupt the trade truce. Why? The U.S. and China have legitimate national security concerns about each other’s tech policies. The 90-day trade talks cannot succeed without some compromises on tech issues. Chinese structural reforms could also reduce U.S. concerns over tech transfer. Feature The fanfare over President Donald Trump’s tariff ceasefire, agreed at the G20 summit on December 1, has already proved short-lived. We know now that on the same day President Trump sat down with Chinese President Xi Jinping to negotiate the truce, Canadian authorities arrested Meng Wanzhou, the chief financial officer of Huawei, under a U.S. warrant. Huawei is the world’s biggest telecoms equipment maker, second-biggest smartphone maker, and one of China’s high-tech champions. So far the controversial arrest – which prompted Beijing to make representations to the U.S. ambassador – has not derailed the trade truce. China’s Commerce Ministry has announced that tariffs will be eased and imports of American goods will increase. The CNY-USD has climbed upwards despite a rocky global backdrop in financial markets (Chart 1). Chart 1Currency Part Of The Trade Truce? Currency Part Of The Trade Truce? Currency Part Of The Trade Truce? Nevertheless, Meng’s arrest calls attention to our chief reason for skepticism about the ability of the U.S. and China to conclude a substantive trade deal. In essence, “trade war” is a misnomer for a broader strategic conflict that is centered on the military-industrial balance rather than the trade balance. Trade War? Tech War! The historian Paul Kennedy, in his bestselling The Rise and Fall of the Great Powers, argued that the history of competition between nations is determined by economic and technologically advanced industrial production.1 Eighteenth-century Britain defeated France; Ulysses S. Grant defeated Robert E. Lee; and the U.S., the allies, and Russia defeated Nazi Germany and Imperial Japan. This thesis helps to explain why China’s recent technological acceleration has provoked a more aggressive reaction from the U.S. than its general economic rise over the past four decades. For example, while China is rapidly catching up to the U.S. in research and development spending, it is only spending about half as much as the U.S. relative to its overall economy (Chart 2). If it comes to match the U.S.’s ratio then it will overwhelm it in real R&D investment, at least in dollar value. And R&D is just one of many factors showing that China is eroding the U.S.’s global dominance. Chart 2The U.S. Has Some Competition The U.S. Has Some Competition The U.S. Has Some Competition In September, an inter-agency U.S. government task force initiated by President Trump’s Executive Order 13806 sought to assess the strength of the U.S. defense industrial base and resilience of its supply chains.2 The conclusion was that the U.S.’s military-industrial base is suffering from a series of macro headwinds that need to be addressed urgently. The report cited key domestic issues, such as the erosion of the U.S. manufacturing sector (Chart 3). It argued that the country is rapidly losing the ability to source its defense needs from home, develop human capital for future needs, and surge capabilities in a national emergency. Chart 3Decline Of The U.S. Manufacturing Base Decline Of The U.S. Manufacturing Base Decline Of The U.S. Manufacturing Base However, foreign competition, specifically “Chinese economic aggression,” also holds a central place in the report. The obvious risk is U.S. overreliance on singular Chinese sources for critical inputs, as highlighted during the 2010 rare earth embargo, when Beijing halted exports of these metals to Japan during a flare-up of their maritime-territorial dispute in the East China Sea (Chart 4). Chart 4China’s Rare Earth Supply Chain Leverage U.S.-China: The Tech War And Reform Agenda U.S.-China: The Tech War And Reform Agenda The authors’ point is not simply that China’s near-monopoly of rare earths remains a threat to the U.S. supply chain, but that Beijing’s willingness to leverage its advantageous position in the supply chain to coerce its neighbors could be used in other areas. After all, Washington’s reliance on China is rapidly extending to industrial goods that are critical for U.S. defense supply chains, such as munitions for missiles. But Washington’s greatest fear is China’s move into higher-end manufacturing and information technology – and hence the flare-up in tensions over ZTE and Huawei this year. Bottom Line: Technological sophistication and economic output determine which nations rise and which fall over the course of history. While the U.S. can accept China’s eventually surpassing it in economic output, it cannot accept China’s technological superiority. This would translate into military and strategic supremacy over time. Semiconductors: The Next Battlefront While the U.S. lacks a national industrial policy, Beijing has made a concerted effort to promote indigenous production and innovation. The obvious example is Beijing’s state-backed ascent to the top of the global solar panel market. More broadly, China’s export growth has been fastest in the categories of goods where the U.S. has the greatest competitive advantage (Chart 5). Again, the U.S. concern is not market share in itself, but China’s ability to compete as an economically advanced “great power.” Chart 5China’s Comparative Advantage Threatens U.S. Global Market Share U.S.-China: The Tech War And Reform Agenda U.S.-China: The Tech War And Reform Agenda Semiconductors are rapidly becoming the next major battleground, as China is trying to build its domestic industry and the U.S. is considering a new slate of export controls that could constrict the flow of computer chips to China.3 Semiconductors are critical as the building blocks of the next generation of technologies. The semiconductor content of the world’s electronic systems is ever rising. Breakthroughs such as artificial intelligence and the Internet of Things (IoT) promise to create a huge boost in demand for chips in the coming decades. China’s predicament is that the U.S. and its allies control 95% of the global semiconductor market (Chart 6), and yet China is the world’s largest importer, making up about a third of all imports, and its largest consumer (Chart 7). This is a dangerous vulnerability that China has been working to mitigate. Back in 2014 Beijing launched a $100-$150 billion semiconductor development program and has more or less stuck with it. The Made in China 2025 program projects that China will produce 70% of its demand for integrated circuits by 2030 (Chart 8). Chart 6China’s Chip Makers Are Still Small Fry U.S.-China: The Tech War And Reform Agenda U.S.-China: The Tech War And Reform Agenda Chart 7China Accounts For 60% Of Global Semiconductor Demand U.S.-China: The Tech War And Reform Agenda U.S.-China: The Tech War And Reform Agenda While China-domiciled chip companies have a long way to go, they are rising rapidly, and China has already become a big player in global semiconductor equipment manufacturing (18% market share to the U.S.’s 11%). Chart 8Made In China 2025 Targets U.S.-China: The Tech War And Reform Agenda U.S.-China: The Tech War And Reform Agenda The problem for the U.S. is that semiconductors are one area where China runs a large trade deficit. Indeed, the U.S.’s share of China’s market is somewhat larger than the U.S. share of the global market, suggesting that the U.S. has not yet gotten shut out of the market (Chart 9). Chart 9U.S. Chips Still Have An Edge In China U.S.-China: The Tech War And Reform Agenda U.S.-China: The Tech War And Reform Agenda Moreover, 60% of U.S. semi imports from China and 70% of exports are with “related parties,” i.e. U.S. corporate subsidiaries operating in China. The U.S.’s highly competitive semiconductor industry is the most exposed to the imposition of tariffs (Chart 10). This may explain why so many exemptions were granted to the U.S. Trade Representative’s third tariff schedule: out of $37 billion in semi-related Chinese imports to face tariffs, $22.9 billion were given waivers.4 Chart 10Tariffs Are Harmful To U.S. Chip Makers U.S.-China: The Tech War And Reform Agenda U.S.-China: The Tech War And Reform Agenda The Barack Obama administration, initially faced with China’s disruptive entrance into this sector, determined that the U.S.’s best response would be to “win the race by running faster.” A council on science and technology warned that the U.S. would have to make extensive investments in STEM education, job retraining, manufacturing upgrades, research and development, international collaboration, and export promotion in order to stay ahead.5 However, these initiatives proved to be either too rhetorical (due to policy priorities and gridlock in Washington) or too slow-in-coming to make a difference in light of China’s rapid state-directed investments under the Xi Jinping administration. The Trump administration has obviously taken a more punitive approach. Trump originally focused on China’s alleged currency manipulation and criticized its large trade surpluses with the United States, but his focus has evolved since taking office. Under the influence of U.S. Trade Representative Robert Lighthizer – who is now heading up the 90-day talks – Trump’s complaints have given way to a Section 301 investigation into forced technology transfers, intellectual property theft, and indigenous innovation. This investigation eventually provided the justification for imposing tariffs on $250 billion worth of Chinese imports. Over this time period, it has become clear that there is considerable consensus across the U.S. government, on both sides of the aisle, to take a more aggressive approach with China that includes tariffs, sanctions, foreign investment reviews, and potentially new export controls. Significantly, the high-tech conflict has escalated separately from the trade war: it operates on a different timeline and according to a different set of interests. For example: The ZTE affair: The Commerce Department’s denial order against telecoms equipment maker ZTE came on April 15, even as the U.S. and China were trying (ultimately failing) to negotiate a trade deal to head off the Section 301 tariffs. CFIUS reforms: The U.S. Congress proceeded throughout the summer on its efforts to modernize the Committee on Foreign Investment in the United States, culminating in the Foreign Investment Risk Review Modernization Act (FIRRMA). The Treasury Department released its implementing rules for the law in October, which will take effect even as trade negotiations get underway. The secretive body’s major actions have always been to block deals with China or related to China (Table 1). Table 1U.S. Foreign Investment Reviews Usually Hit China U.S.-China: The Tech War And Reform Agenda U.S.-China: The Tech War And Reform Agenda Chipmaker sanctions: The U.S. Department of Justice indicted Chinese chipmaker Fujian Jinhua Integrated Circuit despite the November diplomatic “thaw” between the two countries in preparation for the G20 summit.6 This action occurred even as top American and Chinese diplomats and generals engaged in talks intended to simmer down strategic tensions in the South China Sea and elsewhere. New export controls: Despite the 90-day trade talks scheduled through March 1, the U.S. government is currently holding public hearings on whether to expand U.S. export controls to cover a range of emerging technologies. These hearings, to conclude on December 19, are being held pursuant to the Export Control Reform Act signed into law in August along with the CFIUS reform. Most recently, the arrest of Meng Wanzhou, the CFO of Huawei, falls into this trend – casting doubt on the viability of the tariff ceasefire and forthcoming trade talks. The incident highlights how the pace, scale, and momentum of the tech conflict are substantial and will be difficult to reverse. Furthermore, the U.S. is building alliances with like-minded Western countries in order to encourage a unified embargo of Huawei, ZTE, and potentially other Chinese tech companies. In particular the U.S. and its allies are trying to block Chinese companies out of their upcoming 5G networks. The U.S. banned Huawei back in 2012, but it fears that allied countries – particularly those that host U.S. military bases – will have their commercial networks compromised by Huawei.7 5G will enable superfast connections that form the basis of the Internet of Things. If Huawei is embedded in 5G networks, it could theoretically gain unprecedented penetration into Western society and industry. Since China’s Communist Party has prioritized the “fusion” of civilian capabilities with military,8 and since the country’s security forces and cyber regulators are authorized to have access to Chinese companies’ critical infrastructures and data at will, American government departments have been soliciting allied embassies not to adopt Huawei as a supplier despite its competitive pricing and customizability. Australia, New Zealand, and Japan have effectively banned Huawei from 5G for their own reasons; the U.K. and others are considering doing the same. The expansion of this coalition creates a difficult backdrop for negotiating a final trade deal by March 1. And yet the G20 ceasefire clearly improved the odds of such a deal. So what will break first, the tech war or the trade ceasefire? Bottom Line: The tech war is intensifying even as the trade war takes a pause. The large-scale U.S. mobilization of a coalition of states opposed to China’s growing presence is a bad sign for the 90-day talks, though so far they are intact. What A Deal Might Look Like To get a sense of whether the tech war will upend the trade talks, or vice versa, we need to consider what a final trade deal that includes the U.S.’s technological demands would look like. It is significant that on November 20, the eve of the G20 summit, U.S. Trade Representative Lighthizer released a report updating the findings of his Section 301 investigation.9 Lighthizer’s position matters because he is leading the 90-day talks and a critical swing player within the administration.3 Lighthizer’s report is essentially the guideline for the U.S. position in the 90-day talks. It makes the following key claims: China has not altered its abusive and discriminatory trade practices since the Section 301 investigation was concluded. These practices include grave accusations of cyber-theft and industrial espionage. The report also argues that China’s state-driven campaign to acquire tech through mergers and acquisitions is ongoing, despite the drop in Chinese mergers and acquisitions in the United States over 2017-18 (Chart 11). The reason, the USTR alleges, is that China tightened controls on investment in real estate and other non-strategic sectors (essentially capital flight from China), whereas Chinese investment to acquire sensitive technology in Silicon Valley is still intense and is being carried out increasingly through venture capital deals (Chart 12). Chart 11M&A No Longer China’s Best Way To Get Tech... U.S.-China: The Tech War And Reform Agenda U.S.-China: The Tech War And Reform Agenda Chart 12...Now Venture Capital Deals Offer A Better Way U.S.-China: The Tech War And Reform Agenda U.S.-China: The Tech War And Reform Agenda China’s concessions so far are “incremental” and in some cases deceptive. For instance, China’s propaganda outlets have de-emphasized the “Made in China 2025” program even though the government is continuing apace with this program, as well as other state-subsidized industrial programs that utilize stolen tech, such as the “Strategic Emerging Industries” (SEI) policy. Not only has China maintained certain targets for domestic market share in key technologies, but modifications to the program have in some cases increased these targets, such as in the production of “new energy vehicles” (Chart 13). Other concessions, such as on foreign investment equity caps, are similarly unsatisfactory thus far, according to the USTR. For instance, China’s pledge gradually to allow foreigners to operate wholly owned foreign ventures in the auto sector is said to arrive too late to benefit foreign car manufacturers, who have already spent decades building relationships under required joint ventures. Chart 13The Opposite Of U.S.-China Compromise U.S.-China: The Tech War And Reform Agenda U.S.-China: The Tech War And Reform Agenda Trade partners share the U.S.’s concerns and are taking actions to address the same problems. In addition to the aforementioned actions on the 5G, the EU is developing foreign investment review procedures for the first time. Foreign industry groups share the U.S. business lobby’s fear of China’s forced tech transfers. Ultimately, Lighthizer’s report shows both that a trade deal is possible and that it will be extremely difficult to achieve: Possible, because while the report touches on deep structural factors underlying China’s practices, it emphasizes technical issues. Since these issues can often be adjusted by degree, there is ostensibly room to bargain. Difficult, because the main takeaway of the report is that the U.S. is giving China an ultimatum to stop cyber theft and industrial espionage. At minimum, the U.S. will demand assurances that China’s military, intelligence, and cyber agencies will rein in their hacking, spying, and tech acquisition campaigns. Other disputes are more susceptible to tradeoffs, but it will be hard for the U.S. to compromise on a list of grievances that so plainly enumerates national security violations. Can China really compromise on aspects of its Made in China 2025 industrial plan? Possibly. What China cannot compromise on is technological advancement in general, since its future economic sustainability and prosperity depend on it. So China may not accept getting shut out of investment opportunities in Silicon Valley. But if the 2025 plan provokes foreign sanctions, then it interferes with China’s technological advance, and hence can be compromised in order to achieve China’s true end. It makes sense for China and the U.S. to focus on the above tech issues – that is, for the “structural” part of the trade talks – as opposed to any macroeconomic structural demands that are more difficult to pull off at a time when China’s credit cycle is exceedingly weak and the economy is slowing. For instance, on China’s currency, while the U.S. will have to have some kind of agreement, and China has already shown it will allow some appreciation to appease the U.S., China is highly unlikely to agree to a dramatic, Plaza Accord-style currency appreciation. Therefore the negotiators will have to accept a nominal agreement on currency practices, perhaps as an addendum as was done with the U.S.-Korea trade renegotiation. As for other strategic tensions, China is continuing to support the Trump administration’s diplomatic efforts with North Korea. Therefore the U.S. is unlikely to get much traction on its demand that China remove missiles from the South China Sea. But unlike cyber theft and corporate hacking, the South China Sea could conceivably be set aside for the purposes of a short-term trade deal and left for later rounds of negotiations, much as Trump’s border wall with Mexico was set aside during the NAFTA renegotiation. Bottom Line: The U.S. is demanding that China (1) rein in its hacking and spying (2) shift its direct investment to less tech-sensitive sectors (3) adjust its Made in China targets to allow for more foreign competition (4) lower foreign investment equity restrictions. Our sense, from looking at these demands, is that a trade deal is possible. But given the underlying strategic rivalry, and the intensity of the tech conflict, we think it is more likely that the tech war will ultimately derail the trade talks than vice versa. China’s Reform And Opening Up Turns 40 Finally, a word about China’s reforms, which are no longer discussed much by investors, given that many of the ambitious pro-market reforms outlined at the 2013 Third Plenum flopped. This month marks the 40th anniversary of China’s “Reform and Opening Up” policies under Deng Xiaoping. The original Third Plenum, the third meeting of the 11th Central Committee at which Deng launched his sweeping policy changes, occurred on December 18-22, 1978. In the coming days, General Secretary Xi Jinping will commemorate the anniversary with a speech. Various party media outlets have been celebrating reform and opening up over the past few months. We have no interest in adding to the hype. But we do wish to highlight the interesting overlap in the deadline for the trade talks, March 1, with the annual meeting of China’s legislature, when new policy initiatives are rolled out. To conclude a substantive trade deal, China needs to make at least a few structural concessions. And to satisfy the Trump administration, these concessions will have to be implemented, not merely promised, since the administration has argued consistently that past dialogues have gone on forever without tangible results. The surest way to achieve such a compromise would be to strike a trade deal and then begin implementation at the appropriate time in China’s own political calendar, which would be the March NPC session – right after the 90-day negotiation period ends. What kind of structural changes might China make? Of the four points outlined above, the one that is likely to get the most traction is lifting foreign venture equity caps (Table 2). This would be substantive because it would remove an outstanding structural barrier to foreign market access – China’s prohibitive FDI environment – while depriving China of a means of pressuring firms into conducting technology transfers. It would also have the added benefit of attracting investment that could push up the renminbi. Table 2China’s Foreign Investment Equity Caps U.S.-China: The Tech War And Reform Agenda U.S.-China: The Tech War And Reform Agenda In this context, we will watch very carefully both for progress in the 90-day talks and for any new and concrete proposals within President Xi’s upcoming economic statements. This includes the annual Central Economic Work Conference as well as the 40th anniversary of the historic Third Plenum. Bottom Line: The basis for a substantial U.S.-China trade deal would be Chinese structural changes to grant the U.S. (and others) greater market access for investment and a safer operating environment for foreign intellectual property. While we remain pessimistic, the reform agenda is important to watch. Investment Conclusions We continue to believe that a final trade deal between the U.S. and China is not likely forthcoming – at least not in the 90-day timeframe. The difficulty of working out a deal with the tech issues above should support this baseline view. Nevertheless, given that there is a possible path forward, and given that Chinese tech stocks are heavily oversold, is now a good time for investors to buy? Our view is no, on a cyclical 6-12 month horizon. Relative to the MSCI China investable index, tech stocks are not so badly beaten down as they first appear (Chart 14). The incredible earnings performance of this sector over the past five years has rolled over lately, as reflected in trailing earnings-per-share. This is true relative to U.S. tech stocks and the global equity market as well (Chart 15). Chart 14China's Tech Selloff In Line With Market China's Tech Selloff In Line With Market China's Tech Selloff In Line With Market Chart 15Tech Earnings Rolled Over Pre-Tariffs Tech Earnings Rolled Over Pre-Tariffs Tech Earnings Rolled Over Pre-Tariffs Since this is a decline in trailing earnings, it does not stem from the trade war, but rather from internal factors like consumer sentiment and retail sales (given the large weights of consumer-related firms like Alibaba and Tencent in this sector). Relative to global tech stocks, Chinese tech has definitely become less expensive after the recent selloff. But they are still not cheap (Chart 16). Given the headwinds outlined above – the fact that the tech war is more likely to derail the trade talks than the trade talks are likely to resolve the tech war – we think it is too early to bottom-feed. Chart 16Tech Stocks Not All That Cheap Tech Stocks Not All That Cheap Tech Stocks Not All That Cheap In short, U.S.-China tensions are rising when looked at from the perspective of, first, China’s aggressive state-backed industrial programs and technological acquisition and, second, the U.S.’s emerging technological protectionism and alliance formation. Two long-term implications can be drawn: First, many of the United States’ complaints stem not only from China taking advantage of its economic openness, but also from the U.S.’s low-regulation environment and opposition to state-driven industrial policy. The U.S. will not have much luck demanding that China stop pouring billions of dollars of government funds into its nascent industries; it will deprive its own emerging sectors of funds if it prevents Chinese investment into Silicon Valley. In other words, the U.S. will have to become less open and more heavily regulated. The CFIUS reforms and the proposed export controls highlight this trend. In addition, any escalation of tensions will likely result in Chinese reprisals against U.S. companies. The U.S. tech sector is the marginal loser (Table 3). Table 3S&P Tech Companies With Large China Exposure U.S.-China: The Tech War And Reform Agenda U.S.-China: The Tech War And Reform Agenda Second, while it is often believed that China is playing “the long game,” the government’s technological acquisition policies suggest a very short-term modus operandi. The allegations of widespread and flagrant use of tech company employees by intelligence agencies, and gross cyber intrusions, if true, imply that China is making a mad dash for technology even at the risk of alienating its trading partners and driving them into a coalition against it. Since no government can overlook the national security implications of such practices, China will continue to suffer from foreign sanctions and embargoes, until it convinces foreign competitors it has changed its ways. As a result, China’s tech and industrial sectors are the marginal losers. The big picture is that the U.S. is setting up a “firewall” of rules and regulations to protect its knowledge and innovation, and China is frantically “downloading” as much data as possible before the firewall is fully operational. This dynamic will be difficult to reverse given that the overall context is one of rising suspicion and strategic distrust.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1      The Rise and Fall of the Great Powers: Economic Change and Military Conflict from 1500-2000 (Random House, 1988). 2      Please see “Assessing and Strengthening the Manufacturing and Defense Industrial Base and Supply Chain Resiliency of the United States,” Interagency Task Force in Fulfillment of Executive Order 13806, September 2018, available at media.defense.gov. 3      Please see U.S. Bureau of Industry and Security, “Review of Controls for Certain Emerging Technologies,” Department of Commerce, November 19, 2018, available at www.federalregister.gov. 4      Please see Dan Kim, "Semiconductor Supply Chains and International Trade,” SEMI ITPC, November 5, 2018. 5      Please see President’s Council of Advisors on Science and Technology, “Ensuring Long-Term U.S. Leadership In Semiconductors,” Report to the President, January 2017, available at obamawhitehouse.archives.gov. 6      Please see Department of Justice, “PRC State-Owned Company, Taiwan Company, and Three Individuals Charged With Economic Espionage,” Office of Public Affairs, November 1, 2018, available at www.justice.gov. 7      Please see Stu Woo and Kate O’Keeffe, “Washington Asks Allies To Drop Huawei,” Wall Street Journal, November 22, 2018, available at www.wsj.com. 8      Please see Lorand Laskai, “Civil-Military Fusion and the PLA’s Pursuit of Dominance in Emerging Technologies,” China Brief 18:6, April 9, 2018, available at Jamestown.org. 9      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 ustr.gov.

Highlights The dollar will continue to rally despite the trade truce agreed upon last weekend between U.S. President Donald Trump and China President Xi Jinping. Not only is this truce far from a permanent deal, but global growth continues to slow. Moreover, if the truce were to generate a genuine improvement in global growth conditions, this would likely result in a much more hawkish Federal Reserve than the market is currently pricing in. This would lead to a further deterioration in global liquidity conditions, causing additional growth problems for the world. Buy EUR/CHF, as the Swiss National Bank will soon have to intervene in the market. Sell AUD/NOK, as oil should outperform metals and the Norges Bank is better placed to tighten policy than the Reserve Bank of Australia. Feature Presidents Donald Trump and Xi Jinping have agreed to freeze additional new tariffs on Chinese exports to the U.S. for three months. This means that as of January 1, 2019, U.S. tariffs on US$200 billion of Chinese exports to the U.S. will remain at 10%, and will not jump to 25%. Meanwhile, China has agreed to immediately resume its imports of soybeans and LNG from the U.S. Moreover, China has also agreed to begin talks to open up Chinese markets to U.S. exports as well as to address U.S. worries regarding intellectual property theft. The world has let out a collective sigh of relief. A potent narrative exists that fears of a trade war have been the root cause of the slowdown in global growth witnessed this year. Consequently, since the dollar performs well when global industrial activity slows, this also means that ending the trade war could be key to abort the dollar’s bull market. We are doubtful this narrative will pan out, and we do not think that the Buenos Aires truce will lead to the end of the dollar rally. This also means that the G-20 armistice is also unlikely to reverse the underperformance of commodity and Scandinavian currencies. First, this truce does not mark the end of the trade war. It is only an agreement to delay the implementation of U.S. tariffs. Come March, the Trump administration may well sing a very different tune. The U.S. domestic political climate has not changed one iota, and protectionism, particularly when directed at China, still wins votes (Chart I-1). Meanwhile, the concessions China is willing to give are long-term in nature; however, Trump wants visible wins well ahead of the 2020 elections. This mismatch creates a real danger that the White House imposes new tariffs again beyond the three-month armistice agreed at the G-20. The news yesterday afternoon that the CFO of Huawei was indicted in Vancouver already casts doubts on the deal. Chart I-1Americans Will Remain Tough On China Waiting For A Real Deal Waiting For A Real Deal Second, the dollar has been strong, and risk assets have been weak for more reasons than the trade war alone. As shown by the slowdown in Japanese or Taiwanese exports, as well as by the contraction in German foreign orders and in the CRB Raw Industrial Index’s inflation, global trade and global growth are slowing (Chart I-2). This development is likely to last until mid-2019, as our global leading economic indicator continues to fall. This deterioration in the global LEI does not look set to stop soon, as normally any improvement in the global LEI is first telegraphed by a stabilization in the Global LEI Diffusion Index – an indicator that is still falling (Chart I-3). Chart I-2Global Growth Continues To Slow Global Growth Continues To Slow Global Growth Continues To Slow Chart I-3No Bottom In Sight For The Global LEI No Bottom In Sight For The Global LEI No Bottom In Sight For The Global LEI China is not yet coming to the rescue either. The slowdown in Chinese economic activity continues, and in fact, the paucity of a rebound in Chinese credit growth despite injections of liquidity by Beijing suggests that a bottom is not yet in sight (Chart I-4). Hopes that were raised by increased bond issuance from local governments have also been dashed as this proved to be a very temporary phenomenon (Chart I-5). What is more worrisome is that so far Chinese exports have held their ground; however, the decline in the new export orders of the Chinese PMI suggests that this support to growth is likely to taper sharply in the coming months (Chart I-6). Chart I-4Credit Growth Decelerating Despite Stimulus Credit Growth Decelerating Despite Stimulus Credit Growth Decelerating Despite Stimulus   Chart I-5Chinese Infrastructure Push Looks Transitory Waiting For A Real Deal Waiting For A Real Deal   Chart I-6Chinese Exports: The Last Shoe To Drop Chinese Exports: The Last Shoe To Drop Chinese Exports: The Last Shoe To Drop Finally, despite the cloudy outlook for global growth that built up this year, U.S. yields had risen 80 basis points by November 8, adding stress to economies already negatively impacted by weakening manufacturing activity. This increase in global borrowing costs has worsened the already noticeable decline in U.S.-dollar based liquidity (Chart I-7). This decline in liquidity has been a great source of concern as EM economies, the source of marginal growth in the global economy, have large dollar-denominated debt loads, and thus need abundant dollar liquidity in order to support their economies (Chart I-8). Chart I-7Slowing Dollar Liquidity Explains Weak Global Growth... Slowing Dollar Liquidity Explains Weak Global Growth... Slowing Dollar Liquidity Explains Weak Global Growth... Chart I-8...Because There Is A Lot Of Dollar Debt Where Growth Is Generated ...Because There Is A Lot Of Dollar Debt Where Growth Is Generated ...Because There Is A Lot Of Dollar Debt Where Growth Is Generated This last point is especially unlikely to change in response to the Buenos Aires truce. Since November, 10-year U.S. yields have fallen around 25 basis points, and now fed funds rate futures are only pricing in 45 basis points of rate hikes over the coming two years, including the December hike. If business sentiment improves because of a trade truce, and consequently U.S. capex proves more resilient than anticipated by market participants, the Federal Reserve will increase rates by much more than what is currently priced into the futures curve (Chart I-9). Chart I-9U.S. Rates Have Plenty Of Upside, Even More So If The Trade Truce Becomes A Peace Treaty Waiting For A Real Deal Waiting For A Real Deal This will lift yields, resuscitating one of the first reasons why markets have been weak this fall. This risk is even greater than the market appreciates. After Fed Chair Jerome Powell gave what was perceived as a dovish speech last week, markets were further emboldened to bet on a Fed pause. However, Fed Vice-Chairman Richard Clarida and New York Fed President John Williams have both argued since that the U.S. economy will continue to run above trend and warrants further gradual increases in interest rates. A truce in Buenos Aires may only provide them with more ammunition to implement those hikes. Global liquidity conditions are unlikely to improve significantly anytime soon. Moreover, the truce could also change the calculus in Beijing. Much of the stimulus implemented since last summer in China has been to limit the negative impact of a trade war. However, if a trade war is not in the cards, Beijing has fewer reasons to abandon its deleveraging campaign. It thus raises the possibility that with a risk to China evaporating, the Xi Jinping administration would instead not do anything to limit the slowdown in credit. This implies that Chinese capex would stay weak and that China’s intake of raw materials and machinery would not pick up. This means that the euro area and countries like Australia will continue to lag behind the U.S.  Ultimately, the market speaks louder than anything else. The incapacity for risk assets to catch a bid in the wake of what was good news is disconcerting. It suggests that the combined assault of slowing global growth and a tightening Fed remains the main problem for global financial markets. Hence, in this kind of deflationary environment, the dollar reign supreme – even if U.S. growth were to slow (Chart I-10). Chart I-10A Strong Dollar Is Not A Function Of Strong U.S. Growth A Strong Dollar Is Not A Function Of Strong U.S. Growth A Strong Dollar Is Not A Function Of Strong U.S. Growth Bottom Line: A trade truce in Buenos Aires could have aborted the bull market in the dollar. So far, it has not, and we do not think it will be able to end the dollar’s rally. First, this truce remains flimsy, and does not guarantee an end of the trade war between China and the U.S. Second, global growth continues to exhibit downside. Finally, the Fed is unlikely to change its course and pause its hiking campaign. In fact, if a trade truce is so good for trade, it will give more reasons for the Fed to hike and may even incentivize Chinese authorities to abandon their efforts to cushion the Chinese economy against slowing global trade. Stay long the dollar and keep a defensive exposure in the FX market, one that favors the yen and the greenback at the expense of Scandinavian and commodity currencies. Buy EUR/CHF Despite our view that global growth is set to slow, we are inclined to buy EUR/CHF this week. We expect the Swiss National Bank to stop sitting on its hands as a stronger CHF is becoming too painful. First, as we highlighted last week, aggregate Swiss economic activity is slowing sharply.1 What is more concerning is that consumer spending is also suffering, as shown by the contraction in real retail sales (Chart I-11). This implies that despite record-low interest rates, Swiss households are feeling the pinch of the tightening in Swiss monetary conditions created by the stronger CHF. Chart I-11Swiss Households Are Feeling The Pinch Swiss Households Are Feeling The Pinch Swiss Households Are Feeling The Pinch Second, the franc remains a problem for Swiss competitiveness. As Chart I-12 shows, Swiss labor costs are completely out of line with its competitors. This phenomenon worsened significantly after 2008 due to the Franc’s strength vis-à-vis the euro. Despite the weakness in the franc from mid-January 2015 to April 2018, Swiss unit labor costs remain uncompetitive. This means that going forward, either the SNB will have to tolerate a further contraction in wages, something unpalatable as Swiss households have a debt load equal to 212% of disposable income, or the franc will have to fall. Chart I-12The CHF Makes Switzerland Uncompetitive The CHF Makes Switzerland Uncompetitive The CHF Makes Switzerland Uncompetitive Third, the franc’s recent strength is only accentuating the deflationary impact of softer global growth on the local economy. As Chart I-13 illustrates, the recent strengthening in the trade-weighted CHF portends to a potentially painful contraction in import prices, while core inflation is already well off the SNB’s 2% objective. Moreover, as the second panel of Chart I-13 shows, our CPI model suggests that Swiss inflation is about to fall into negative territory again. This would imply that not only will the Swiss economy suffer from the recent strengthening in the franc, but also that Swiss real interest rates are about to increase by 100 basis points, the last thing a slowing economy needs. Chart I-13Swiss Deflation Will Return Swiss Deflation Will Return Swiss Deflation Will Return This economic backdrop suggests to us that after 16 months where the SNB played nearly no active role in managing the CHF exchange rate, the Swiss central bank is about to come back to the market in order to limit the downside in EUR/CHF. This makes buying this cross attractive, as it offers a favorable asymmetric payoff. EUR/CHF generates a small positive carry, has limited downside and offers ample upside if the SNB intervenes – all while offering low volatility. Meanwhile, if global growth picks up, EUR/CHF should also rebound. In fact, the pro-cyclical behavior of EUR/CHF, as well as its asymmetric payoff, increases the attractiveness of this trade within our broadly defensive portfolio stance: It hedges us against being wrong on the global growth outlook and the importance of the trade truce. Furthermore, any resolution to Italy’s battle with Brussels will also boost this cross. Bottom Line: EUR/CHF normally depreciates when global growth slows. While this pattern materialized in 2018, we anticipate EUR/CHF to stabilize and potentially rally, even if global growth slows. The strong CHF is now causing serious pain to the Swiss economy, and the SNB will have to prevent any deepening of the malaise. The SNB is thus set to begin intervening in the market. Additionally, if we are wrong and global growth does not slow further, being long EUR/CHF provides a hedge to our defensive market stance. AUD/NOK To Be Knocked Down An attractive opportunity to sell AUD/NOK has emerged. First, on the back of the weakness in oil prices relative to metals prices, AUD/NOK has caught a furious bid in recent weeks (Chart I-14). However, we expect the underperformance of oil relative to metals to peter off. The main factor that has weighed on petroleum prices is that Saudi Arabia has kept extracting oil at full speed, expecting a shortage of oil in global markets once U.S. sanctions on Iran kicked in. Chart I-14AUD/NOK Strength: A Reflection Of Weak Crude Prices AUD/NOK Strength: A Reflection Of Weak Crude Prices AUD/NOK Strength: A Reflection Of Weak Crude Prices However, with President Trump greatly softening his stance and allowing exemptions for some countries to import Iranian oil, the crude market instead has experienced a mini unforeseen oil glut. OPEC 2.0, just agreed to essentially remedy this problem by limiting their oil output. This should boost oil prices. Meanwhile, slowing global growth centered on slowing Chinese capex will have a much deeper impact on industrial metals prices than on oil. This represents a negative terms-of-trade shock for Australia vis-à-vis Norway. Second, domestic economic conditions also favor betting on a weaker AUD/NOK. Australian nominal GDP growth often weakens when compared to Norway’s ahead of periods of depreciation in AUD/NOK. Today, Australia’s nominal GDP growth is sagging relative to Norway’s, and the contraction in Australia’s LEI relative to Norway suggests that this trend will deepen (Chart I-15). A rebound in oil prices relative to metals prices will only reinforce this process. Chart I-15Domestic Economic Conditions Point To A Lower AUD/NOK Domestic Economic Conditions Point To A Lower AUD/NOK Domestic Economic Conditions Point To A Lower AUD/NOK Third, AUD/NOK seems expensive relative to the anticipated path of policy of the Reserve Bank of Australia relative the Norges Bank (Chart I-16). Moreover, the Norwegian central bank has begun lifting rates, and since real interest rates in Norway are still negative, it will continue to tighten policy next year. Meanwhile, the RBA remains reticent to increase interest rates as Australian inflation and wage growth are still tepid. The recent deceleration in Australian GDP growth as well as budding problems in the Aussie real estate market will only further cajole the RBA in its reluctance to lift the cash rate higher. Hence, the real interest rate differentials will continue to point toward a lower AUD/NOK. Chart I-16AUD/NOK At A Premium To Expected Rates AUD/NOK At A Premium To Expected Rates AUD/NOK At A Premium To Expected Rates Fourth, AUD/NOK is once again very expensive, trading at a 12% premium to it purchasing power parity equilibrium (Chart I-17). It only traded for an extended period of time at a richer premium when Brent was free-falling to US$25/bbl. Since we anticipate oil to rebound, such a premium in AUD/NOK is unwarranted. Chart I-17AUD/NOK Is Pricey AUD/NOK Is Pricey AUD/NOK Is Pricey Finally, all our technical indicators show that AUD/NOK is massively overbought (Chart I-18). The study on momentum we conducted last year showed that out of 45 G-10 FX pairs tested, after AUD/SEK, AUD/NOK was the second worst one to implement momentum-continuation trades.2 As a result, we would anticipate that the recent period of overbought conditions will lead to a period of oversold conditions. Chart I-18The Mean-Reverting AUD/NOK Is Overbought The Mean-Reverting AUD/NOK Is Overbought The Mean-Reverting AUD/NOK Is Overbought Bottom Line: Selling AUD/NOK today makes sense. BCA anticipates oil prices to rebound relative to metals prices, the Australian economy is slowing relative to Norway’s, monetary policy is moving in a NOK-friendly fashion, AUD/NOK is expensive, and the cross is well-placed to experience a large episode of momentum reversal.   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com  Footnotes 1 Please see Foreign Exchange Strategy Special Report, titled “2019 Key Views: The Xs And The Currency Market”, dated November 30, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report, titled “Riding The Wave: Momentum Strategies In Foreign Exchange Markets”, dated December 8, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. has been mixed: The price component of the ISM manufacturing survey underperformed expectations, coming in at 60.7. This measure also declines sharply from the previous month. However, the headline ISM Manufacturing survey surprised to the upside, coming in at 59.3. Total vehicle sales also outperformed expectations, coming in at 17.50 million. The DXY U.S. dollar Index was flat for the past two weeks. We continue to be bullish on the U.S. dollar. The current environment of falling global growth and falling inflation has historically been very positive for this currency. Moreover, the fed will likely hike more than anticipated by the market, providing another tailwind for the dollar until at least the first quarter of 2019. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in Europe has been mixed: Retail sales growth underperformed expectations, coming in at 1.7%. Moreover, core inflation also surprised to the downside, coming in at 1%. However, market services and composite PMI surprised positively, coming in at 53.4 and 52.7 respectively. EUR/USD has been flat for the past two weeks. We are bearish on the euro, given that we expect Chinese tightening to continue to weigh on global growth. Furthermore, recent disappointment in euro area inflation confirms our view that it will be very difficult for the ECB to tighten policy. This means that rate differentials will continue to move against EUR/USD. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Six Questions From The Road - November 16, 2018 Evaluating The ECB’s Options In December - November 6, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: The Nikkei manufacturing PMI outperformed expectations, coming in at 52.2. Moreover, housing starts yearly growth came in line with expectations, at 0.3%. However, Markit Services PMI came in at 52.3, decreasing from last month’s number. USD/JPY has decreased by -0.4% these past two weeks. We are positive on the yen for the first quarter of 2019. The current risk off environment should be positive for safe havens like the yen. We are particularly negative on EUR/JPY, as this cross is very well correlated with bond yields, which should keep decreasing as markets continue to sell off. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Nationwide housing prices yearly growth came in at 1.9%, outperforming expectations. Moreover, Markit manufacturing PMI as well as construction PMI both surprised positively, coming in at 53.1 and 53.4 respectively. However, Markit Services PMI underperformed expectations, coming in at 50.4. GBP/USD has decreased by 0.7% these past two weeks. The pound continues to be a complex currency to forecast. While the pound is cheap and makes for a potentially attractive long-term buy, current political risk continue to make a shorter-term position very risky. Report Links: Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia has been negative: Gross domestic product yearly growth underperformed expectations, coming in at 2.8%. Moreover, building permits month-on-month growth also surprised negatively, coming in at -1.5%. Finally, construction done also surprised to the downside, coming in at -2.8%. AUD/USD has decreased by -0.5% these past two weeks. We believe that the AUD is the currency with the most potential downside in the G10. After all, the Australian economy is the economy in the G10 most leveraged to the Chinese industrial cycle, due to Australia’s high reliance on industrial metal exports. This means that the continued tightening by Chinese authorities should be most toxic for this currency. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 What Is Good For China Doesn’t Always Help The World - June 29, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been mixed: Building permits month on month growth outperformed expectations, coming in at 1.5%. However, retail sales as well as retail sales ex-autos both declines from the previous quarter, coming in at 0% and 0.4%. NZD/USD has increased by 1% these past two weeks. After being bullish in the NZD for a couple of months, we have recently turned bearish, as we believe that this currency is very likely to suffer in the current environment of declining inflation and global growth. With that said, we remain bullish on the NZD relative to the AUD, given that the kiwi economy is less exposed to the Chinese industrial cycle than Australia. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada has been positive: Retail sales month on month growth outperformed expectations, coming in at 0.2%. Moreover, headline inflation also surprised to the upside, coming in at 2.4%. Finally, the BOC core inflation measure increased from last month’s number, coming in at 1.6%. USD/CAD has risen by 1.7% these past two weeks. A lot of this weakness was caused by the dovish communication of the Bank of Canada following their announcement to keep rates on hold at 1.75%. This change in stance is likely a response to the collapse in oil prices in the past months. With that in mind, we are inclined to believe that the CAD might be reaching oversold levels, as oil is likely to stabilize and the economy continue to show signs of strength. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been negative: Gross domestic product yearly growth underperformed expectations, coming in at 2.4%. Moreover, the KOF leading indicator also surprised to the downside, coming in at 99.1. Finally, headline inflation also surprised negatively, coming in at 0.9%. EUR/CHF has decreased by 0.5% these past two weeks. Our bullish view on EUR/CHF is a high conviction view for the first part of 2019. This is because the recent strength in the franc is choking out any inflationary pressures in the Swiss economy. Thus, we are reaching the threshold at which the SNB is very likely to intervene in the currency market to prevent the franc’s strength from derailing the path toward the inflation target. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been negative: Retail sales growth underperformed expectations, coming in at -0.2%. Moreover, registered unemployment also surprised negatively, coming in at 2.3%. Finally, the credit indicator came in line with expectations at 5.7%. USD/NOK has been flat these past two weeks. We are shorting AUD/NOK this week, as a way to take advantage of stabilizing oil prices and a continued growth slowdown in China. Moreover, AUD/NOK is expensive in PPP terms, and is technically overbought. Finally, this currency shows one the most mean reverting tendencies in the G10, which means that the recent surge in this cross is likely to reverse. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden has been negative: Consumer confidence underperformed expectations, coming in at 97.5. Moreover, retail sales growth also underperformed expectations, coming in at -0.1%. Finally, gross domestic product yearly growth also surprised negatively, coming in at 1.6%. USD/SEK has fallen by roughly 1% these past two weeks. On a short-term basis, we are negative on the krona, given that this currency is very sensitive to global growth dynamics, which means that the continued tightening by both Chinese authorities and the Fed will create a headwind for any SEK rally. That being said, on a longer-term basis we are more positive on the krona, as the Riksbank continues to be too dovish given the current inflationary backdrop. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Deep-seated economic and political forces will undermine the trade truce between China and the United States. U.S. economic momentum is strong enough to allow the Fed to deliver more rate hikes next year than what the market is discounting. Global growth should stabilize by the middle of next year as China picks up the pace of stimulus and the dollar peaks. Until then, a cautious stance towards global equities and other risk assets is warranted. Global bond yields will fall further in the near term, but will rise by a faster-than-expected pace over a horizon of 6-to-18 months. Feature Trade War Roller Coaster Investors breathed a short-lived sigh of relief following the G20 summit in Buenos Aires this past weekend. During the course of a two-and-a-half hour dinner on the sidelines of the summit, President Donald Trump agreed to postpone raising tariffs from 10% to 25% on $200 billion of Chinese imports by two months to March 1st. For his part, President Xi Jinping pledged to engage in substantive talks to open up the Chinese economy to U.S. imports, while addressing U.S. concerns about forced technology transfers and IP theft. In one of the more ironic moments in history, China also agreed to restrict opioid exports to the West. Unfortunately, the euphoria did not last very long. By Tuesday, President Trump was back to his old self, calling himself “Tariff Man” and ominously warning that “We are going to have a REAL DEAL with China, or no deal at all – at which point we will be charging major Tariffs against Chinese product being shipped into the United States.” News reports indicated that the Chinese were “puzzled and irritated” by Trump’s change in tone. The mood brightened on Wednesday. Trump sounded more conciliatory, perhaps reflecting China’s decision to immediately resume importing soybeans and liquefied natural gas from the United States. By Wednesday night, however, global equities were in turmoil again due to revelations that a high-ranking Chinese tech executive had been arrested in Canada at the behest of the U.S. government on suspicion of violating sanctions against Iran. U.S. stocks recouped some of their losses Thursday afternoon, but the S&P 500 still finished down fractionally for the day. Political Stumbling Blocks To A Trade Deal At times like this, it is crucial to focus on the big picture, which is that major hurdles remain to consummating a trade deal that satisfies both sides. As our geopolitical strategists have argued, the trade war is just as much a tech war.1 China wants access to western technology, but the West, fearful of China’s ascent, is reluctant to provide it. The fact that China has had a history of appropriating western technology without due compensation only makes things worse. It is notable that U.S. Trade Representative Robert Lighthizer issued a hawkish report ahead of the summit concluding that China has not substantively changed any of the trade practices that initiated U.S. tariffs.2 Domestic U.S. politics will also undermine prospects for a lasting trade war ceasefire. Protectionism against China remains popular in the U.S., especially in the Midwestern swing states. If Trump agrees on a permanent deal to end the trade war, who will he blame if the trade deficit continues to widen? This is not just idle speculation. Trump’s trade goals are inconsistent with his fiscal policy. Fiscal stimulus will boost aggregate demand, which will suck in more imports. An overheated economy will prompt the Fed to raise rates more aggressively than it otherwise would, leading to a stronger dollar. The result will be a wider trade deficit. This does not mean that Chinese stocks cannot rally for a few weeks. The MSCI China investable index is in oversold territory, trading at less than 11-times forward earnings, compared to 14-times at the start of the year (Chart 1). Given that China represents nearly one-third of EM stock market capitalization, any sentiment-driven rally that pushes up Chinese stocks is likely to give a solid lift to the aggregate EM equity index (Chart 2). However, for EM equities to put in a durable bottom, two things need to happen: Chinese growth needs to stabilize and the dollar needs to peak. We do not see either happening until the middle of next year. Chart 1Chinese Stocks Have Taken It On The Chin Chinese Stocks Have Taken It On The Chin Chinese Stocks Have Taken It On The Chin Chart 2China Is Large Enough To Give EM A Lift Sorry, But The Trade Truce Won’t Last And The Fed Will Keep Hiking Sorry, But The Trade Truce Won’t Last And The Fed Will Keep Hiking Waiting For A Bottom In Chinese Growth The slowdown in Chinese growth this year has been concentrated in domestic demand rather than in trade. Chinese exports to the U.S. have actually increased by 13% in the first ten months of the year compared to the same period last year. A lull in the trade war, a weaker yuan, and lower energy input costs are all beneficial to Chinese exporters. However, the collapse in the new export order component of the Chinese manufacturing PMI suggests that these positive developments will not be enough to prevent exports from decelerating sharply in the first half of 2019 (Chart 3). Chart 3China: An Ominous Sign For Exports China: An Ominous Sign For Exports China: An Ominous Sign For Exports If Chinese growth is to rebound, domestic demand will need to reaccelerate. While the Chinese government has loosened fiscal and monetary policy at the margin, this has not been sufficient to revive animal spirits. Growth continues to sag, as measured by a variety of activity measures (Chart 4). After a brief rebound, credit growth relapsed in October, pushing the year-over-year change to a multi-year low (Chart 5). Chart 4Still Waiting For Growth To Stabilize Still Waiting For Growth To Stabilize Still Waiting For Growth To Stabilize Chart 5The Chinese Credit Spigot Has Not Been Opened The Chinese Credit Spigot Has Not Been Opened The Chinese Credit Spigot Has Not Been Opened Looking out, there is a risk that undue optimism over the resolution of the trade war will prompt the government to redouble its efforts on its reform agenda. This agenda has been focused on reducing debt-financed investment spending – exactly the sort of expenditure commodity producers and capital goods exporters around the world rely on. Ultimately, China will be forced to pick up the pace of stimulus, as it becomes increasingly clear that the economy needs it. However, this is likely to be a story only for the second or third quarter of 2019, suggesting Chinese growth may continue to disappoint until then. No Help From The Fed The equity sell-off on Tuesday was exacerbated by comments by New York Fed President John Williams who noted that the Fed should continue raising rates “over the next year or so.”3 Williams is regarded as one of the thought-leaders at the Federal Reserve. He is also generally seen as a centrist on monetary policy. As such, his words often echo the views of the majority of FOMC members.  Williams said that the U.S. economy was “on a very strong path with a lot of momentum.” We tend to agree with this assessment. Despite weakness in a few areas such as housing, the economy continues to grow at an above-trend pace. The Atlanta Fed’s GDP tracker is pointing to growth of 2.7% in the fourth quarter. Personal consumption is set to rise by 3.4%, one full percentage point above the average during the recovery. The manufacturing sector remains robust. The ISM manufacturing index rose to 59.3 in November from 57.7 the prior month. The all-important new orders component jumped 4.7 points to a three-month high of 62.1. The non-manufacturing ISM index also surprised on the upside. Strong wage growth, lower gasoline prices, and a declining savings rate will boost consumer spending next year. High levels of capacity utilization, easing lending standards, and rising labor costs will also support business investment. Residential investment should stabilize as well, given the recent decline in bond yields (Chart 6). We see the fed funds rate rising by 125 basis points through to end-2019. This stands in sharp contrast to current market pricing, which foresees only 40 basis points of hikes during this period (Chart 7). Chart 6U.S. Residential Investment Should Stabilize U.S. Residential Investment Should Stabilize U.S. Residential Investment Should Stabilize Chart 7The Market Is Ignoring The Fed Dots Sorry, But The Trade Truce Won’t Last And The Fed Will Keep Hiking Sorry, But The Trade Truce Won’t Last And The Fed Will Keep Hiking Don’t Fear A Flatter Yield Curve… Yet The flattening of the yield curve would seem like a major rebuke to our positive U.S. economic outlook. The 10-year/2-year Treasury spread has declined to 14 basis points. The 5-year/2-year spread has fallen into negative territory, marking the first notable inversion of any part of the Treasury curve.  How worried should we be? Some concern is clearly warranted. Policymakers have been too quick to downplay the signal from the yield curve in the past. In 2006, they blamed the “global savings glut” for dragging down long-term yields. In 2000, they argued that the U.S. federal government’s budget surplus was reducing the supply of long-term bonds. In both cases, the bond market turned out to be seeing something more ominous than they were. Nevertheless, one should keep two points in mind. First, part of the recent decline in long-term bond yields reflects a fall in inflation expectations stemming from lower oil prices (Chart 8). As we discussed last week, lower oil prices should give consumers more spending power without hurting energy capex to the degree that they did in 2015.4 Chart 8Oil Price Decline Is Dragging Down Inflation Expectations Oil Price Decline Is Dragging Down Inflation Expectations Oil Price Decline Is Dragging Down Inflation Expectations Second, the term premium – the extra compensation that investors demand for buying long-term bonds compared to rolling over short-term bills – is currently negative (Chart 9). This partly stems from the fact that investors see long-term Treasurys as a good hedge against recession risk (i.e., bond prices tend to go up when the economy weakens). Chart 9The U.S. Term Premium Is Negative Partly Because Bonds Are A Good Hedge Against A Weaker Economy The U.S. Term Premium Is Negative Partly Because Bonds Are A Good Hedge Against A Weaker Economy The U.S. Term Premium Is Negative Partly Because Bonds Are A Good Hedge Against A Weaker Economy Quantitative easing has also driven down the term premium. While this effect has diminished as the Fed’s balance sheet has shrunk, estimates by the New York Fed indicate that the 10-year yield is still 65 points lower than it would have been in the absence of asset purchases.5 If the term premium were 84 basis points – the average between 2004 and 2007 – the 10-year/3-month slope would be 195 basis points. Empirically, the 10-year/3-month slope is the best recession predictor of any yield curve measure. It still stands at 50 basis points. If long-term yields stay put and the Fed raises rates once per quarter, this part of the yield curve will not invert until the second half of next year. It usually takes about 12-to-18 months for an inversion in the 10-year/3-month slope to culminate in a recession (Chart 10). In the last downturn, the slope fell into negative territory in February 2006, 22 months before the start of the recession. This suggests that the next recession will not occur until late 2020 at the earliest. Chart 10The U.S. Yield Curve: An Admirable Track Record In Forecasting Recessions The U.S. Yield Curve: An Admirable Track Record In Forecasting Recessions The U.S. Yield Curve: An Admirable Track Record In Forecasting Recessions Investment Conclusions The signal for global equities from our tactical MacroQuant model has improved since early October, mainly because the sell-off has gone a long way towards discounting some of the negative macro developments that have occurred. Nevertheless, the model continues to signal downside risks for global stocks stretching into early 2019 (Chart 11). Chart 11The MacroQuant Equity Score Has Improved, But Is Still In Bearish Territory Sorry, But The Trade Truce Won’t Last And The Fed Will Keep Hiking Sorry, But The Trade Truce Won’t Last And The Fed Will Keep Hiking The model utilizes a “what you see is what you get” approach, meaning that it only relies on observable data rather than estimates of unobservable variables like the neutral rate of interest. Right now, global growth is decelerating and financial conditions have tightened, which has caused the model to turn bearish on the near-term outlook for stocks. If we are correct that China will be forced to step up the pace of stimulus; that worries over Italian debt will fade, at least temporarily, with an agreement over next year’s budget; and that U.S. growth will remain buoyant even in the face of higher rates (implying that the neutral rate is higher than widely believed), then global growth should stabilize by the middle of next year. The dollar tends to weaken whenever global growth accelerates, which should provide a further reflationary impulse to the world economy (Chart 12). Chart 12Accelerating Global Growth Tends To Be Bearish For The Dollar Accelerating Global Growth Tends To Be Bearish For The Dollar Accelerating Global Growth Tends To Be Bearish For The Dollar Equity bull markets typically end about six months before the onset of a recession (Table 1). If the next global recession does not occur for at least another two years, this will provide enough time for a blow-off rally in stocks starting in mid-2019. Hence, investors should stay tactically cautious towards global equities over a 3-month horizon, but be prepared to turn cyclically opportunistic over a 6-to-18 month horizon. Table 1Too Soon To Get Out Sorry, But The Trade Truce Won’t Last And The Fed Will Keep Hiking Sorry, But The Trade Truce Won’t Last And The Fed Will Keep Hiking Over the past few months, we have argued that bond yields will temporarily decline due to slower global growth amid widespread bearish bond sentiment. This has indeed happened. Yields are likely to remain under downward pressure into early 2019, but should then begin to stabilize and move higher, ultimately rising much more than expected as global inflation accelerates. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1      Please see Geopolitical Strategy Weekly Report, “Trade Truce: Narrative Vs. Structural Shift?” dated December 3, 2018; and “Trump’s Demands On China,” dated April 4, 2018. 2      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. 3      Jonathan Spicer, “Fed's Williams says rate hikes 'over next year or so' still make sense,” Reuters, December 4, 2019. 4      Please see Global Investment Strategy Weekly Report, “Shades Of 2015,” dated November 30, 2018. 5      Please see Brian Bonis, Ihrig, Jane, and Wei, Min, “The Effect of the Federal Reserve’s Securities Holdings on Longer-term Interest Rates,” FEDS Notes, Federal Reserve (April 20, 2017). Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

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? Better Days To Come? Better 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 Reprieve For Grain Markets Following G20? Reprieve For Grain Markets Following G20? 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 A Soybean Glut In The U.S., Tight Supplies In Brazil A 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 Reprieve For Grain Markets Following G20? Reprieve For Grain Markets Following G20? 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 Reprieve For Grain Markets Following G20? Reprieve For Grain Markets Following G20? 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 Record Premiums For Brazilian Beans In 2018 Record 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 Reprieve For Grain Markets Following G20? Reprieve For Grain Markets Following G20? 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 Chinese Buyers Well Stocked Ahead Of The Winter Chinese 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... Another Global Surplus In Beans... Another Global Surplus In Beans... Chart 10... Will Push Inventories To New Record High ... Will Push Inventories To New Record High ... 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... A Strong Dollar Will Incentivize Planting... A Strong Dollar Will Incentivize Planting... Chart 12...And Weigh Down On Prices ...And Weigh Down On Prices ...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 Reprieve For Grain Markets Following G20? Reprieve For Grain Markets Following G20? Trades Closed in Summary of Trades Closed in 2017 Reprieve For Grain Markets Following G20? Reprieve For Grain Markets Following G20?

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 Equities Have Been Underperforming DM For Eight Years EM 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? A Lost Decade For Investors In EM Local Currency Bonds? A 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 Enormous Boom In Chinese Banks' Assets And Money Supply Enormous 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 Attribution Of Rise In Money Supply To Excess Reserves And Money Multiplier Attribution 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. Imports Of Goods And Services: China And The U.S. Imports 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 Quantitative Easing In DM Quantitative 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 Cumulative Foreign Portfolio Inflows Into EM And China Cumulative 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 China's Credit Cycle Leads Its Imports China'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 =... Falling Productivity Growth In EM And China =... Falling Productivity Growth In EM And China =... Chart I-10... = Low Profit Margins And Low Return On Capital ... = Low Profit Margins And Low Return On Capital ... = 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 EM: Deteriorating Ability To Service Debt EM: 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 China's Stimulus Leads EM And Commodities China'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 China: Weak Capital Spending China: 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 China: A Broad-Based Slowdown China: 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 China's Imports And EM And Commodities China'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 Chinese Currency And Interest Rates Chinese Currency And Interest Rates Chart I-17China: Foreign Currency Reserves Are Very Low Compared To Money Supply/Deposits China: Foreign Currency Reserves Are Very Low Compared To Money Supply/Deposits China: 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 The Fed And EM Share Prices: A Historical Perspective The 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 Structure Of Chinese Economy Structure 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… 2019 Key Views: Four Themes For China In The Coming Year 2019 Key Views: Four Themes For China In The Coming 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 ...But Growth Stumbled In The First Half Of 2018 ...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 Trade Front-Running Has Clearly Boosted Economic Activity Trade 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 A Slowdown In China's Old Economy Is Coming A 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 Investors Ignored A Slowing Economy Until The Trade War Emerged Investors 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 Interest Rate Differentials And USD-CNY: A Tight Link Interest 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 Some Proxies Of Capital Flight Suggest Persistent Outflow Since 2015 Some 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 A Sentiment-Driven Rally Over The Next 3 Months Is Possible A 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 Earnings-Adjustment Process Is Only Beginning The 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 A Near-Term Rally Will Likely Fizzle, Like In 2015 A 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 Investable Stocks Aren't Massively Cheap Investable 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 Allowing Market-Implied Default Rates To Occur Would Be A Huge Policy Error Allowing 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 Onshore Corporate Bonds Offer More Compelling Value Than Those Offshore Onshore 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 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 Trade Deficit To Rise Despite Tariffs Trade 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 Trade Truce: Narrative Vs. Structural Shift? Trade Truce: Narrative Vs. Structural Shift? 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 Trade Truce: Narrative Vs. Structural Shift? Trade Truce: Narrative Vs. Structural Shift? 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 Trade Truce: Narrative Vs. Structural Shift? Trade Truce: Narrative Vs. Structural Shift? 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 Trade Truce: Narrative Vs. Structural Shift? Trade Truce: Narrative Vs. Structural Shift? 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 U.S. Outperformance Should Be Bullish USD U.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? U.S. Growth Weakening? U.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? Does The Fed Like It Hot? Does The Fed Like It Hot? Chart 9Fiscal Policy Becomes More Proactive Trade Truce: Narrative Vs. Structural Shift? Trade Truce: Narrative Vs. Structural Shift? 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 China's M2 Turned Positive China's M2 Turned Positive Chart 11An Up-Oscillation In Global Credit Growth Technically Favours EM An Up-Oscillation In Global Credit Growth Technically Favours EM An 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 China's Total Credit Is Weak China's Total Credit Is Weak Chart 13U.S. Is Winning The Trade War U.S. Is Winning The Trade War U.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 A Tight Labor Market A Tight Labor Market Chart 15Compare Any Stimulus To Previous Efforts Compare Any Stimulus To Previous Efforts Compare 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 So What? A trade deal is unlikely at the G20. Stay short CNY/USD. Why? The odds of a U.S.-China tariff ceasefire are around 30%-40%. Investors should see any ceasefire as a temporary reprieve. Stay neutral on Chinese equities. Expect a weaker CNY/USD. Fade any rally in U.S. China-exposed equities. In Taiwan, local elections do not herald a decline in geopolitical risk, which is elevated. Feature The scheduled meeting between U.S. President Donald Trump and Chinese President Xi Jinping on the sidelines of the G20 summit in Buenos Aires on December 1 has generated a fair amount of speculation that the trade war will be resolved or at least put on pause. A major de-escalation would bring some consolation to global equity markets that have fallen by 11% since their peak in late January, 2018, especially to Chinese and Asian cyclicals, which have fallen by 27% and 21% respectively over the same time period (Chart 1). Chart 1Desperate For Good News Desperate For Good News Desperate For Good News We are doubtful that the summit will cause a major positive catalyst for markets. Yes, it is tempting to think that President Trump could wrap up the whole trade war promptly, just as he wrapped up negotiations with Mexico and Canada in October. If President Xi could add a few sweeteners to concessions he has already made, then Trump could proclaim a “historic new deal” and roll back the tariffs. Equity markets would celebrate. The past year would seem like a bad dream. But this is all fantasy. U.S.-China relations have gotten worse every year since 2008 for a host of economic, political, military, and strategic reasons. Is the current stock market selloff really enough to force Trump into a major capitulation, given that trade tensions were not the primary cause either of the October correction or of the earlier pullback in February? And is Xi really going to make significant concessions with Trump holding bigger threats over his head? We admit that some kind of improvement is plausible – say, a tariff ceasefire and an agreement to launch a new round of talks. We attach a 30%-40% subjective probability to such a scenario. But our base case – which is driven as always by structural factors – is that the summit will turn out to be a flop and the trade war will escalate in 2019. How Likely Is A Tariff Ceasefire? Presidential summits can have major consequences, but context is everything. Trump’s impending meeting with President Xi will be the third since he took office. The first two – in April and November 2017 – did not prevent the trade war. Neither did high-level negotiations in May 2018, which produced a “trade truce” that did not last a week. However, much has changed since then: the U.S. has imposed tariffs on half of Chinese imports, while China has suffered a bear market and some signs of domestic economic stress (Chart 2). Chart 2Signs Of Economic Weakness Signs Of Economic Weakness Signs Of Economic Weakness Over the past month, some developments suggest that the U.S. and China are managing their strategic tensions a bit better than they were earlier this year. Tensions peaked in early October, when the U.S. imposed sanctions on China’s People’s Liberation Army for purchasing Russian Sukhoi-25 jets and S400 surface-to-air missiles, under a law designed to punish Russia for meddling in the U.S.’s 2016 election. Meanwhile CNN reported that the U.S. military was considering staging a “global show of force” in November, a show that would have included sensitive operations in the Taiwan Strait and South China Sea. Since then, however, positive signs have emerged: Presidents Trump and Xi confirmed their meeting at the G20 in Buenos Aires. The two sides have exchanged letters and will bring trade negotiators to the summit, making it at least possible for substantive work to be done. Various preparatory discussions have been held, including a phone call between Treasury Secretary Steve Mnuchin and top Chinese economic adviser and negotiator, Vice Premier Liu He. Beijing offered to hold military-to-military talks that it had previously canceled between Defense Minister Wei Fenghe and Secretary of Defense James Mattis. The two officials met in Singapore and in Washington for the second round of the U.S.-China Diplomatic and Security Dialogue. The U.S. and China tentatively agreed to a multilateral protocol for avoiding accidental encounters by military aircraft, supplementing a similar agreement covering unplanned encounters at sea.1 Treasury Secretary Mnuchin met with People’s Bank of China Governor Yi Gang on the sidelines of the World Bank’s annual meeting in Bali, Indonesia in October, and afterwards refrained from accusing China of currency manipulation in the Treasury’s biannual foreign exchange report. Director of the National Trade Council Peter Navarro, a fierce trade hawk on China, is reportedly not attending the G20 summit. National Economic Adviser Larry Kudlow publicly chastised Navarro for criticizing the new negotiations as a Wall Street capitulation to China.2 This piece of anecdotal evidence has captured the imagination of sell-side analysts and many of our clients. These developments, in addition to Trump’s positive tweets on the subject, suggest that both China and the U.S. are trying to step back from the brink and accomplish something at the upcoming summit. However, there are many reasons to take these developments with a grain of salt: China is negotiating under duress: In statements over the past month, and reiterated by President Trump as we go to press, the U.S. has warned that if the G20 summit does not go well, it will ratchet up the pressure. In early December, it might move forward with the third round of threatened tariffs, covering the remaining $267 billion in imports from China. On December 19, the U.S. Department of Commerce will conclude consultations on whether to impose new export controls on “emerging technologies.” And on January 1, 2019, the existing tariff rate on $200 billion worth of imports (the second round) is supposed to rise from 10% to 25%, which implies that a third round of tariffs would eventually have the same rate. Indeed, since the confirmation of the G20 summit, the U.S. has imposed sanctions on Chinese technology companies like Fujian Jinhua. It has also begun implementing a new law strengthening the Committee for Foreign Investment in the United States and its foreign investment reviews, which already mostly target China (Chart 3). Chart 3Rising Scrutiny Of Chinese Investment Rising Scrutiny Of Chinese Investment Rising Scrutiny Of Chinese Investment Further, the U.S. has taken the occasion in the recent military and diplomatic dialogue to demand, for the first time ever, that China remove its missile systems from the Spratly Islands in the South China Sea.3 Some of these moves can be read as evidence that the U.S. will impose penalties for various grievances even if China agrees to some of its key trade demands. The demands on the South China Sea and arms purchases, for instance, will stand even if China makes major concessions on key trade issues like technology acquisition. At minimum, the above details suggest that Xi Jinping will be negotiating with a sword over his head and thus may refuse to make concessions on principle, despite the negative impact on China’s stock market and export sector (Chart 4). Chart 4The Impending Tariff Impact The Impending Tariff Impact The Impending Tariff Impact Leaks from the negotiations do not suggest any breakthroughs: China’s written response to Trump’s letter reportedly contains no new, significant trade concessions.4 U.S. Trade Representative Robert Lighthizer, the sine qua non of any trade deal, has issued a hawkish report on the eve of the summit arguing that China has not substantively changed any of the trade practices that prompted the tariffs so far.5 The report, an update to his initial Section 301 report, makes grave accusations about China’s use of cyber theft and corporate espionage over the past year alone, in addition to earlier years. These activities go far beyond trade disputes and clearly affect national security: a tariff freeze is hardly possible without substantial commitments by China to rein in these operations. Lighthizer also argues that China’s trade concessions so far are merely “incremental” and in several cases deceptive. For instance, China’s propaganda outlets have de-emphasized the “Made in China 2025” program even though the government is continuing apace with this program as well as other state-subsidized industrial programs that utilize stolen tech, such as the “Strategic Emerging Industries” (SEI) policy. Not only has China maintained certain targets for domestic market share in key technologies (Chart 5), but modifications to the program have in some cases increased these targets, such as in the production of “new energy vehicles” (Chart 6). Chart 5China’s High-Tech Protectionism Trump And Xi: Third Time Not A Charm Trump And Xi: Third Time Not A Charm Chart 6More High-Tech Protectionism Trump And Xi: Third Time Not A Charm Trump And Xi: Third Time Not A Charm Lighthizer further claims that China’s state-backed investment campaign in Silicon Valley continues despite a headline reduction in capital flight to the United States. And he also presents evidence that the full range of U.S. government agencies as well as the U.S.’s major allies are observing the same malicious or abusive practices from China and share the U.S.’s concerns. As for China hawk Navarro – who is far less important than Lighthizer to trade negotiations – his status today is not worse than it was in 2017, when his office was subordinated to that of former National Economic Council Director Gary Cohn. Of course, Cohn got fired, while Navarro’s office was upgraded and his pro-tariff argument won out. Trump’s olive branch is suspicious: Trump and his administration adopted friendly rhetoric during the lead-up to the midterm election, when it might have been desirable to show “progress” in the trade negotiations. It would have been impossible to engineer credible signs of progress without genuinely engaging the Chinese. Now, however, the midterms are over and there is no pressing political need for Trump to agree to a deal. Many of our clients – and almost all broker research – believe that Trump has a financial need to agree to a deal – i.e. to calm the stock market. However, there are two problems with this thesis. First, it is not clear that stock performance has had any relationship with President Trump’s approval rating (Chart 7). Chart 7Trump No Slave To Stock Market Trump No Slave To Stock Market Trump No Slave To Stock Market Second, both of the U.S. stock market pullbacks this year were catalyzed by sharp rises in treasury yields, not disruptive news on the trade front (Chart 8). As such, positive news about the trade war will yield only a passing relief rally in the United States. Chart 8Yields, Not Trade, Drive U.S. Selloff Yields, Not Trade, Drive U.S. Selloff Yields, Not Trade, Drive U.S. Selloff On this basis, we doubt that President Trump will agree to a hurried, watered-down trade deal that the Democrats will slam as a “giveaway” to China for the remaining two years of his presidency. With the U.S. economy fired up, the trade deficit is likely to widen regardless of tariffs (Chart 9), rendering any weak Trump-China deal a humiliation. Chart 9Trade Deficit To Rise Despite Tariffs Trade Deficit To Rise Despite Tariffs Trade Deficit To Rise Despite Tariffs However, while a trade deal is out of reach, there is a logic to suspending further tariff impositions: Trump may wish to disperse the negative impact of the trade tariffs over a longer period of time. This would give him room to try to settle a very tricky trade agreement before the 2020 election. Then, if the talks succeed, he can present himself as a great dealmaker. If the talks fail, he has all the more ammunition to launch a third round of tariffs. (And on this time frame, the effects of the third round would not be felt by consumers until after the election.) Xi, for his part, may wish to “lock in” Trump with concessions today rather than wait to see how aggressive Trump will become as 2020 draws near. True, Xi cannot afford to “lose face” by capitulating abjectly. But he is the dictator of a regime that has full control of the media; he will be able to suppress domestic criticism of his concessions. In fact, the most insidious criticism of Xi is that he flouted the maxims of both Sun Tzu and Deng Xiaoping by provoking the wrath of China’s greatest enemy prematurely. Thus, if he stays Trump’s hand on tariffs in exchange for a new round of talks or minor concessions, then he comes out of Buenos Aires looking okay. The reason we put this ceasefire scenario at only 30%-40% probability is that we still do not see Trump as heavily constrained by the trade war. His greatest constraint is political and works against a trade deal: it comes from the Democrats, whose protectionist candidates performed very well in the midterm election in the Rust Belt states that are critical for Trump’s reelection (Table 1). Table 1Massive Republican Losses Across The Midwest Trump And Xi: Third Time Not A Charm Trump And Xi: Third Time Not A Charm Economically, our assessment is that the selloff in U.S. financial markets is a correction, not a bear market, and that there is no sign that the U.S. economy is likely to slip into recession (Chart 10). Trump is constrained by the unemployment rate, not by the stock market alone. As long as Trump shares this assessment, he will not be lulled into a politically damaging capitulation to China. Chart 10No Sign Of Recession Yet No Sign Of Recession Yet No Sign Of Recession Yet Also, Xi will fear that difficult concessions will encourage Washington to continue what Chinese government officials have called “trade bullyism,” i.e. using coercive measures and upping its demands. In other words, the main argument for a tariff ceasefire is that Trump might simply prefer one to boost the stock market and thus may accept few or no concessions. And that preference is not enough to change our baseline view in light of his political constraints. Bottom Line: There is no basis for a resolution of the trade war at present, but there is a basis for a tariff ceasefire and a new effort at trade negotiations. Still, it is not our base case. Xi has good reason not to make major concessions under duress and Trump does not want to get outflanked by his political opponents by freezing tariffs without major Chinese concessions. Do Presidential Summits Matter? Have presidential summits between the U.S. and China ever brought about major breakthroughs? Yes, but not since the Great Recession. As Table 2 demonstrates, looking at 50 U.S.-China leadership summits since 1972, only 18 qualify as true “green light” summits in which the outcome was a concrete improvement in relations over the period before the next summit – and 10 of these were during the first decade of the 2000s, the heyday of “Chinamerica,” when China and Emerging Market economies roared ahead while George W. Bush courted China’s cooperation on terrorism and North Korea. Table 2U.S.-China Leaders Summits: A Chronology Trump And Xi: Third Time Not A Charm Trump And Xi: Third Time Not A Charm Only eight summits mark truly historic positive inflection points: Nixon 1972, Carter 1979, Reagan 1984, Clinton 1997, Clinton 2000, Bush 2002, Bush 2005, and arguably Obama 2009. Since 2009, under four different leaders (two from each country), Sino-American relations have categorically worsened. Moreover, both President Obama’s and President Trump’s major meetings with President Xi, at the Sunnylands estate in California in 2013 and at the Mar-a-Lago resort in Florida in 2017, saw much fanfare at the time but were followed by a significant deterioration in relations. Indeed, the Obama administration launched a more aggressive China policy in September 2015, including freedom of navigation operations in disputed areas of the South China Sea. This was after President Xi declared that China “does not intend to pursue militarization” of the Spratly Islands – a statement that American officials have repeatedly cited when arguing that China’s foreign policy is increasingly aggressive and that China is not following through with diplomatic promises. Investors should focus not on the Trump-Xi summit on December 1 but rather on the two governments’ actions afterwards. The substance of any positive outcome will depend, in particular, on whether Trump indicates that he will proceed with the tariff rate hike on January 1, 2019 and/or the initiation of a third round of tariffs covering the remainder of U.S. imports from China.6 Bottom Line: History does not give reason for optimism about the summit – especially not recent history, in which heavily hyped summits have not been able to arrest the secular decline in U.S.-China cooperation due to underlying strategic distrust. Investment Implications The primary driver of the recent selloff in global risk assets is not the trade war but the divergence between U.S. and Chinese economic policy writ large. The U.S. economy continues to support the case for Fed normalization, while China’s stimulus continues to disappoint. The result is a double whammy for commodity prices and EM assets as the dollar strengthens and exports of resources and capital goods to China soften (Chart 11). Chart 11A Bad Combination For EM A Bad Combination For EM A Bad Combination For EM Given that China’s December Central Economic Work Conference will likely reinforce the message of greater policy support, and that China tends to frontload new credit expansion in the beginning of the year (Chart 12), it is entirely possible that a rally in global risk assets on the back of positive trade news in late November could gain traction in December and the New Year. BCA’s Geopolitical Strategy will continue to hedge against the risk of substantial reflation in China by means of our Foreign Exchange Strategy’s long “China Play Index” trade (Chart 13). Chart 12China May See A Q1 Credit Spike Trump And Xi: Third Time Not A Charm Trump And Xi: Third Time Not A Charm Chart 13Monitoring The Risk To Our View Monitoring The Risk To Our View Monitoring The Risk To Our View Fundamentally, however, we would view a December-January rally as a short-term movement that is not worth playing. We expect the Xi administration to remain disciplined in its use of stimulus measures, for the purposes of economic restructuring. Ever worsening trade tensions give Xi the option of blaming the American administration for the economic pain incurred due to his reform agenda. Therefore we think global divergence can persist, which is positive for the dollar and USD/CNY exchange rate. While acknowledging the potential for a near-term rally, we remain neutral Chinese stocks relative to their global counterparts over a 6-12 month horizon and continue to favor low-beta stocks within the Chinese equity universe. We also remain neutral on Taiwanese equities. The ruling Democratic Progressive Party’s (DPP) loss in local elections on November 24 was severe (Chart 14), though not unexpected. The election result does not change Geopolitical Strategy’s view that Taiwan faces heightened geopolitical risk. Chart 14Taiwanese Voters Seek More Conciliatory Approach To Beijing Trump And Xi: Third Time Not A Charm Trump And Xi: Third Time Not A Charm Indeed, the election suggests that the Tsai Ing-wen administration may only have 14 months remaining in power, and hence that it will try rapidly to finalize some material improvement in the U.S.-Taiwan relationship. Since the Trump administration will also try to exploit this closing window of opportunity, the potential is rising for a controversy to erupt over diplomatic or military relations. This could prompt a negative, market-relevant reaction from Beijing. It is also too soon to bottom-fish within the tech sector in China and the U.S., and we remain pessimistic about the earnings outlook for companies exposed to the U.S.-China trade relationship.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1      While these agreements do not ensure collisions will not occur, given the USS Decatur incident earlier this year, they are at least a sign of coordination. 2      Navarro had said the following at a speech at the Center for Strategic and International Studies: “Consider the shuttle diplomacy that’s now going on by a self-appointed group of Wall Street bankers and hedge fund managers between the U.S. and China. As part of a Chinese government influence operation, these globalist billionaires are putting a full-court press on the White House in advance of the G-20 in Argentina. The mission of these unregistered foreign agents – that’s what they are; they’re unregistered foreign agents – is to pressure this president into some kind of deal.” Please see “Economic Security as National Security: A Discussion with Dr. Peter Navarro,” CSIS, November 13, 2018, available at www.csis.org. 3      Please see U.S. Department of State, “U.S.-China Diplomatic and Security Dialogue,” November 9, 2018, available at www.state.gov.   For the proposed export controls, open for public comment until December 19, 2018, please see U.S. Department of Commerce, “Review of Controls for Certain Emerging Technologies,” Bureau of Industry and Security, November 19, 2018, available at www.bis.doc.gov. 4      Please see Jeff Mason and David Shepardson, “Exclusive: China sends written response to U.S. trade reform demands - U.S. government sources,” Reuters, November 14, 2018, available at www.reuters.com. 5      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 https://ustr.gov/ 6      It is very unlikely, but perhaps not impossible, that China would accept a ceasefire that allows the January 1 tariff hike to go forward but forswears the third round of tariffs on the remaining Chinese imports.