South Korea

Highlights This week, we are reviewing all our current active trades in our Tactical Overlay. As a reminder, these positions (Table 1) are meant to complement our strategic GFIS Model Fixed Income Portfolio, typically with shorter holding periods and occasionally in smaller or less liquid markets outside our usual core bond market coverage (i.e. U.S. TIPS or Swedish interest rate swaps). This report includes a short summary of the rationale behind each position, as well as a decision on whether to continue holding the trade, close it out or switch to a new position that may more efficiently express our view. The trades are grouped together by the country/region that is most relevant for the performance of each trade. Table 1GFIS Tactical Overlay Trades Feature U.S. Short July 2018 Fed Funds futures (HOLD). Long 5-year U.S. Treasury (UST) bullet vs. 2-year/10-year duration-matched UST barbell (HOLD). Long U.S. TIPS vs. nominal USTs (HOLD). Short 10-year USTs vs. 10-year German Bunds (HOLD). The tactical trades that we have been recommending within U.S. markets all have a common theme - positioning for an expected rebound in U.S. inflation that will push up U.S. bond yields. We are maintaining all of them. The drift lower in realized inflation rates since the spring has been a surprise given the backdrop of above-potential growth, low unemployment and a weakening U.S. dollar. On the back of this, markets have priced out several of the Fed rates hikes that had been expected over the next year, leaving U.S. Treasury yields at overly-depressed levels. Back on July 11th, we initiated a recommendation to short the July 2018 fed funds futures contract (Chart 1). This was a position that would turn a profit if the market moved to once again discount multiple Fed rate hikes by mid-2018. The trade has a modest profit of 9bps, but with scope for additional gains if the market moves to discount 2-3 hikes by the middle of next year. Our base case scenario is that the Fed will lift rates again this December, and deliver additional increases next year amid healthy growth and with inflation likely to grind higher towards the Fed's 2% target. With the market discounting 46bps of rate hikes over the next year, there is scope for additional profits in our fed funds futures trade. Another tactical position that we've been recommending is a butterfly trade within the U.S. Treasury (UST) curve, long a 5-year UST bullet versus a duration-matched 2-year/10-year UST barbell. This is a position that would benefit from a bearish steepening of the UST curve as the market priced in higher longer-term inflation expectations (Chart 2). We have held that trade for a much longer period than a typical tactical trade, going back nearly a full year to December 20th, 2016. Yet while the UST curve has flattened since that date, our trade has delivered a return of +18bps. This outperformance can be attributed to the undervalued level of the 5-year bullet at the initiation of the trade. Chart 1Stay Short July 2018##BR##Fed Funds Futures Chart 2Stay Long The 5yr UST Bullet Vs.##BR##The 2yr/10yr UST Barbell While that valuation cushion no longer exists (bottom panel), longer-term TIPS breakevens are back to the levels seen last December (middle panel), thanks in no small part to much higher energy prices (top panel). This leaves the UST curve at risk of a bearish re-steepening on the back of rising inflation expectations. Add in a U.S. dollar that is -2.5% weaker from year-ago levels (Chart 3, middle panel), and a solid U.S. economic expansion that should eventually translate into rising core inflation momentum (bottom panel), and the case for a steeper UST curve over the next 3-6 months is a strong one. The above logic also supports our trade recommendation to go long U.S. TIPS vs. nominal USTs, which is up +248bps since inception on August 23, 2016. We have been holding this trade for much longer than our usual tactical recommendations, but we will not look to take profits until we see the 10-year breakeven (now at 186bps) return back to levels consistent with the Fed's 2% PCE inflation target (i.e. headline U.S. CPI inflation back to 2.5%). One final tactical trade that will benefit from higher UST yields is our recommendation to position for a wider spread between 10-year USTs and 10-year German Bunds. This trade was initiated on August 9th of this year, and has delivered a profit of +9bps. Yet the UST-Bund spread still looks too low relative to shorter-term interest rate differentials that favor the U.S. (Chart 4, top panel). With U.S. data starting to surprise more on the upside than Euro Area data (middle panel), and with UST positioning still quite long (bottom panel), there is potential for additional near-term UST-Bund spread widening. The upcoming decision by the European Central Bank (ECB) on potential tapering of its asset purchases next year represents a potential risk for the long Bund leg of our recommended trade. Any hawkish surprises on that front would be a likely catalyst for us to close out this position. Chart 3Stay Long U.S. TIPS Vs. Nominal USTs Chart 4Stay Short 10yr USTs Vs. German Bunds Euro Area Long 10yr Euro Area CPI swaps (HOLD). Long 5-year Spain vs. 5-year Italy in government bonds (HOLD). We have two recommended tactical trades that are specifically focused on developments in the Euro Area. We are maintaining both of them. As a way to position for an eventual pickup in European inflation, we entered a long position in 10-year Euro Area CPI swaps back on December 20th, 2016. That trade is now estimated to have a profit of +29bps, as market-based inflation expectations have drifted higher in the Euro Area. The simple reason for that increase is that realized inflation has moved higher on the back of rising energy costs, as there is a very robust correlation between the annual growth rate of oil prices (denominated in euros) and headline Euro Area inflation (Chart 5). More importantly, the booming Euro Area economy, which has eaten up much of the spare capacity in the Europe, has boosted wage growth and core inflation to levels seen prior to the disinflation shock from the 2014/15 collapse in oil prices (bottom panel). With no signs of any imminent slowing of Euro Area growth that could raise unemployment and slow underlying inflation pressures, the trend for inflation expectations in Europe is still upward. The current 10-year Euro Area CPI swap at 1.5% is still well beneath the ECB's inflation target of "just below" 2% on headline CPI, so there is room for inflation expectations to continue drifting higher. ECB tapering of asset purchases is not an immediate threat to this trade, as the central bank is still likely to keep buying bonds next year (at a slower pace), while holding off on any interest rate increases until late 2019. In other words, the ECB will not be looking to act to slow economic growth to bring down Euro Area inflation anytime soon. Our other tactical trade recommendation in Europe is a relative value spread trade, long 5-year Spanish government debt versus 5-year Italian bonds. This trade was initiated on December 13th, 2016 and currently has only a modest gain of +9bps, although the profits were much larger earlier this year. Italian bonds have been outperforming on the back of improving Italian economic growth (Chart 6, top panel) and, recently, a generalized sell-off in Spanish financial assets on the back of the political uncertainty in Catalonia. Chart 5Stay Long 10yr##BR##Euro Area CPI Swaps Chart 6Stay Long 5yr Spanish Government Bonds Vs.##BR##5-Year Italian Debt Our colleagues at BCA Geopolitical Strategy have been downplaying the threat to Spanish political stability from the Catalonian independence movement, given that the polling data shows only 35% for outright independence from Spain. At the same time, the poll numbers in Italy for the upcoming parliamentary elections are much closer, with parties favoring less integration with Europe holding a slight lead over more "establishment" parties (bottom two panels). With the bulk of the cyclical convergence between Italian and Spanish growth now largely completed, and with a greater potential for future political instability in Italy compared to Spain, we expect that Spain-Italy spreads will tighten further back to the lows seen at the beginning of 2017 (-64bps on the 5-year spread). That is a level we are targeting on our current tactical trade recommendation. Canada Short 10-year Canadian government bonds vs. 10-year USTs (TAKE PROFITS). Long Canada/U.K. 2-year/10-year government bond yield curve box, positioning for a relatively flatter Canadian curve (TAKE PROFITS). Short 5-year Canada government bond versus a duration-matched 2-year/10-year barbell (TAKE PROFITS). We have three different Canadian fixed income trades in our Tactical Overlay, all of which were biased towards tighter monetary policy in Canada: a Canada-U.S. bond spread widener, a yield curve box trade versus the U.K. and a curve flattener expressed as a barbell trade (Chart 7) All three positions are in the money, but we now recommend taking profits. We had initiated these recommendations in a very timely fashion earlier in the year at a time when the Bank of Canada (BoC) was sending a relative dovish message. In our view, the Canadian economy was building significant upward momentum that would eventually force the central bank to shift its policy bias. This would especially be true with the Fed also in a tightening cycle, given the typical tendency for the BoC to follow the Fed's policy actions. Several members of the BoC monetary policy committee began to sing a more hawkish tune over the summer, particularly after the release of the Q2 BoC Business Outlook Survey. That robust report, which was confirmed by a 2nd quarter GDP growth rate of nearly 4% (Chart 8), led the BoC to deliver not one by two unexpected interest rate hikes in July and September. Markets reacted accordingly, driving Canadian bond yields higher and flattening the yield curve. Chart 7Take Profits On Bearish Canadian Bond Trades Chart 8Canadian Growth Set To Cool Off A Bit Now, we see the market pricing as having gone a bit too far, too quickly. The Q3 Business Outlook Survey, released yesterday, was still positive but with readings softer than the booming Q2 report. Meanwhile, the commentary from the BoC has become more balanced, with BoC Governor (and BCA alumnus) Stephen Poloz describing the central bank as being more "data dependent" after the recent rate hikes. Markets are now pricing in another 72bps of rate hikes over the next year, even with our own BoC Monitor off the peak (Chart 9). Chart 9Our BoC Monitor Is Peaking From a tactical perspective, the repricing of the BoC that we expected earlier this year is now largely complete. Thus, we are taking profits on all three Canadian trades: Canada-U.S. spread trade: initiated on January 17th, profit of +43bps. Canada/U.K. box trade: initiated on May 16th, profit of +67bps. Canada 2yr/5yr/10yr butterfly trade: initiated on December 6th, 2016, profit of +95bps. From a strategic perspective, we still see a case where the BoC can deliver additional rate hikes and keep upward pressure on Canadian bond yields. The output gap in Canada is now closed, according to BoC estimates, and additional strength in the economy now has a greater chance in translating to higher inflation. Strong global growth, especially in the U.S., will also support Canadian export growth and feed into rising capital spending. While the rate hikes have help boost the value of the Canadian dollar (CAD), the exchange rate (on a trade-weighted basis) also largely reflects a rising value of energy prices and is, therefore, should provide an additional boost to growth via stronger terms-of-trade (bottom panel). In other words, the rising CAD will not prevent additional BoC rate hikes if oil prices remain strong. Thus, we are maintaining our underweight recommendation on Canadian government bonds in our strategic model bond portfolio, even as we take profits on our bearish Canadian tactical trades. Australia Long a 2-year/10-year Australia government bond curve flattener (SELL AND SWITCH TO NEW TRADE). On July 25th of this year, we entered into a 2-year/10-year curve flattener trade for Australia. Though employment was improving and house prices were booming in Australia, the wide output gap, high level of consumer indebtedness and lack of real wage growth was keeping the Reserve Bank of Australia (RBA) inactive. In our view, nothing has changed since then; the RBA remains in a very difficult position. While the yield curve flattened substantially following the initiation of our trade, the global rise in long-term yields since mid-September lifted Australian longer-maturity yields, and the yield curve with it (Chart 10). Now, Australian long-term yields are not reflecting domestic fundamentals but are instead driven by improving global growth. As such, we are closing the trade and initiating a new position - long Dec 2018 Australian Bank Bill futures - as a more focused way to express the view that the RBA will stay on hold for longer than markets expect. Markets are currently pricing in 30bps of RBA rate hikes over the next twelve months. We believe this will be unlikely, for several reasons. Macroprudential measures on the Australian housing market will continue to dampen credit growth. Core inflation is slowly rising but still far below the central bank's target. Additionally, there is plenty of slack in the labor market despite the spike in employment growth. This is evidenced in anemic real wage growth, stubbornly high underemployment rate, low hours worked and high percentage of part-time to full-time workers (Chart 11). Chart 10Close Australian Government##BR##Bond 2yr/10yr Flattener Chart 11RBA Unlikely To Deliver##BR##Discounted Rate Hikes The biggest risk to our new trade would if signs of a tighter Australian labor market started to feed through into faster wage growth, which would likely coincide with faster underlying price inflation and a more hawkish turn by the RBA. New Zealand Long 5-year NZ government bonds vs. 5-year USTs (currency hedged). Long 5-year NZ government bonds vs. 5-year Germany (currency unhedged). Chart 12Stay Long 5yr NZ Government Bonds##BR##Vs. U.S, & Germany We entered two New Zealand (NZ) tactical bond trades on May 30th, going long 5-year government bonds vs. U.S. and Germany (Chart 12). We expected NZ spreads to tighten faster than the forwards based on our more hawkish views on the Fed and, to a lesser extent, the ECB relative to the more dovish view on the Reserve Bank of New Zealand (RBNZ). The outright bond spreads have tightened and, on a currency-hedged basis, both trades are in the money. Our dovish view on the RBNZ came from the central bank's own forecasts, which called for slowing headline inflation on the back of softer "tradeables" inflation and a sharp cooling of domestic "non-tradeables" inflation through a slowing housing market (Chart 13, bottom two panels). Our own RBNZ Monitor has been calling for the need for higher interest rates in NZ, mostly from the strength in the labor market. Yet we have been ignoring that signal, as has the market which has priced out one full expected RBNZ rate hike since the beginning of the year. With business confidence rolling over, and with the trade-weighted NZ dollar still staying at stubbornly strong levels, the case for the RBNZ to deliver even a single rate hike is not a strong one - especially given the soft inflation forecasts of the central bank. Thus, we are sticking with our tactical spread trades for NZ versus the U.S. and Germany. We are maintaining the currency hedge on the U.S. version of the trade, as we typically do for the vast majority of our cross-country spread trade recommendations. Occasionally, however, we will make an active decision to do a spread trade UN-hedged if we felt very strongly about a currency move. We did that for our NZ-Germany spread trade and this has cost us in the performance of the trade, which is down -3.4%. This is because of a surprisingly large decline in the New Zealand dollar (NZD) versus the euro since the inception of our trade. Yet a review of the technical indicators on the NZD/EUR currency cross shows that the currency pair is now very stretched versus its medium-term trend (the 40-week moving average), with price momentum also at some of the most negative levels of the past decade (Chart 14). These measures suggest that the worst of the downturn in the currency is likely over. The relative positioning on the two individual currencies is now neutral, as long positions on the NZD have been reduced (bottom panel). Chart 13RBNZ Dovishness Is Justified Chart 14Keep NZ/Germany Position Currency Unhedged Given these technical indicators, and from these current levels, we see greater upside potential for NZD/EUR in the months ahead. This leads us to maintain our unhedged currency position on the NZ-Germany spread trade so as not to realize the current mark-to-market losses on the trade. Sweden Pay 18-month Sweden Overnight Index Swap (OIS) rate (TAKE PROFITS). We entered into a bearish Swedish rates position back on November 22nd, 2016, paying Sweden 18-month Overnight Index swap rates (Chart 15). At the time, we expected the Riksbank to begin hiking interest rates earlier than what was priced in the markets IF inflation reached the central bank target faster due to a weaker Swedish krona. We also believed that the economy would continue to expand at a robust pace when the economy had no spare capacity, creating additional upside inflation surprises. According to the Riksbank's latest Monetary Policy Statement (MPS), the central bank will likely keep the repo rate at -0.5% until mid-2018, while continuing its asset purchase program until the end of this year - even with an overheating economy. This is because realized inflation has remained below the Riksbank target for a long period of time and, although current inflation is above target, it was not necessary to immediately tighten conditions. More likely, the Riskbank is worried about the potential for the krona to appreciate - especially versus the euro - if rate hikes are delivered. It will only be a matter of time before the central bank is forced to tighten policy with the economy likely to strengthen further, led by solid domestic demand, strong productivity growth, and improving exports. Consumption is also expected to increase as households have scope to cut back their high level of savings. Combining the Riksbank's easing policy with the current strength of the economy and the tightness of the labor market, inflation is very likely to return to the 2% target in the next year or two (Chart 16). Chart 15Close Sweden OIS Trade Chart 16Riksbank More Worried About SEK Than Inflation However, if the Riskbank remains too concerned about the currency versus the euro, as we suspect, then this will prevent any shift to a more hawkish stance before any change from the ECB. That is unlikely to happen over the next year, at least, even if the ECB slows the pace of asset purchases as we expect. Thus, we are closing out our Sweden 18-month Overnight Index Swap position at a small profit of 12bps. We have already kept this trade for longer than the typical investment horizon for one of our tactical overlay trades. We will investigate the potential for more profitable trade opportunities in the Swedish fixed income markets in a future report. Korea Long a 2-year/10-year Korean government bond yield curve steepener (HOLD). We recommended entering into a 2-year/10-year steepening trade in the Korean government bond yield curve on May 30th, 2017. Since then, the yield curve has flattened by 7bps, which was mainly caused by an unexpected rise in the 2-year yield, rather than a decline in 10-year yield (Chart 17). Korea is currently enjoying a solid business cycle upturn. Leading economic indicators are rising, the year-over-year growth in exports has risen to a 7-year high and previously sluggish private consumption has also rebounded recently. The Bank of Korea (BoK) is of the view that the recovery will continue and consumer price inflation will stabilize at the target level over the medium-term. This recovery should cause the 2/10 curve to steepen as longer-term inflation expectations rise. Based on South Korean President Moon's aggressive fiscal plans to increase welfare spending and create jobs in the public sector, at a time when the economy is good shape, we still believe that long-end of the curve (10-year) will rise. In addition, as shown in Chart 18, the 26-week rolling beta of changes in the 10-year UST yield and Korean 10-year bond is very high, nearly 1. Given our bearish view on USTs, this implies Korean yields can follow suit. On the other hand, the correlation between the 2-year UST yield and equivalent maturity Korean yields is much lower (4th panel), as Korean rate expectations have not been following those of the U.S. higher - even with a stronger Korean economy. Most likely, this is due to investors downplaying the potential for the BoK to match Fed rate hikes tick-for-tick given the heightened tensions between the U.S. and North Korea. Chart 17Stay In Korea 2yr/10yr##BR##Government Bond Steepener Chart 18Long-Term Korean##BR##Yields Are Too Low We still believe the Korean curve can steepen as longer-term yields rise, although we will be monitoring the behavior of shorter-dated Korean yield as the situation between D.C. and Pyongyang evolves. If investors begin to demand a higher risk premium on Korean assets, particularly the Korean won, then 2-year Korean yields may rise much faster and our curve trade may not go our way. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Patrick Trinh, Associate Editor Patrick@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Special Report

Feature Valuations, whether for currencies, equities, or bonds, are always at the top of the list of the determinants of any asset's long-term performance. This means that after large FX moves like those experienced this year, it is always useful to pause and reflect on where currency valuations stand. In this context, this week we update our set of long-term valuation models for currencies that we introduced in February 2016 in a Special Report titled, "Assessing Fair Value In FX Markets". Included in these models are variables such as productivity differentials, terms-of-trade shocks, net international investment positions, real rate differentials and proxies for global risk aversion.1 The models cover 22 currencies, incorporating both G10 and EM FX markets. Twice a year, we provide clients with a comprehensive update on all of these long-term models in one stop. These models are not designed to generate short- or intermediate-term forecasts. Instead, they reflect the economic drivers of a currency's equilibrium. Their purpose is therefore threefold. First, they provide guideposts to judge whether we are at the end, beginning, or middle of a long-term currency cycle. Second, by providing strong directional signals, the models help us judge whether any given move is more likely be a countertrend development or not, offering insight on potential longevity. Finally, they assist us and our clients in cutting through the fog and understanding the key drivers of cyclical variations in a currency's value. The U.S. Dollar Chart 1The Dollar's Overvaluation Is Gone After its large 7.5% fall in trade-weighted terms since the end of 2016, the real effective dollar is now trading at a 2% discount vis-à-vis its fair value based on its principal long-term drivers - real yield differentials and relative productivity between the U.S. and its trading partners (Chart 1). The U.S. dollar's equilibrium - despite having been re-estimated higher earlier this year due to upward revisions by the Conference Board to its U.S. productivity series - has flattened as of late, as real rate differentials between the U.S. and the rest of the world have declined. While 2017 has been an execrable year for dollar bulls, glimmers of hope remain. First, the handicap created by expensive valuations has been purged. Second, the excessive bullishness toward the greenback that prevailed earlier this year has morphed into deep pessimism. Third, U.S. real interest rates have fallen as investor doubts that the Federal Reserve will be able to increase interest rates as much as it wants to in the face of paltry inflation have surged. However, the U.S. economy is strong and at full capacity, suggesting that inflation will hook back up at the end of 2017 and in the first half of 2018. This should once again lift the U.S. interest rate curve, the dollar's fair value, and the dollar itself. That being said, this story is unlikely to become fully relevant over the next three months. The Euro Chart 2The Euro's Fair Value Is Now Rising On a multi-year time horizon, the euro is driven by the relative productivity trend of the euro area with its trading partners, its net international investment position, terms-of-trade shocks and rate differentials. Thanks to its powerful rally this year, the euro's discount to its fair value has narrowed from 7% in February to 6% today (Chart 2). This narrowing is not as great as the rally in the trade-weighted euro itself as its fair value has also improved, mainly thanks to continued improvement in the euro area's net international position - a development driven by the euro zone's current account of 3% of GDP. Nonetheless, the EUR's current discount to fair value is still not in line with previous bottoms, such as those experienced in both early 1985 or in 2002. We do expect a new wave of weakness in the EUR to materialize toward the end of the year and in early 2018 as markets once again move to discount much more aggressive tightening by the Fed than what will be executed by the European Central Bank: U.S. inflation is set to move back towards the Fed's target, but European inflation will remain hampered by the large amount of labor market slack still prevalent in the European periphery. What's more, euro area inflation is about to suffer from the lagged effects of the tightening in financial conditions that have been created by a higher euro. However, the fact that the euro's fair value has increased implies it is now very unlikely for the EUR/USD to hit parity this cycle. The Yen Chart 3The Yen Is Very Cheap, But It May Not Count For Much The yen's long-term equilibrium is a function of Japan's net international investment position, global risk aversion, and commodity prices. The JPY discount to this fair value has deepened this year, despite the fall in USD/JPY from 118 to 108 (Chart 3). This is mainly because the euro and EM as well as commodity currencies have all appreciated against the Japanese currency. Low domestic inflation has been an additional factor that has depressed the Japanese real effective exchange rate. While valuations point to a higher yen in the coming year, this will be difficult to achieve. The Bank of Japan remains committed to boosting Japanese inflation expectations. To generate such a shock to expectations, the BoJ will have to keep policy at massively accommodative levels for an extended period. As global growth remains robust, global bond yields should experience some upside over the next 12 months. With JGB yields capped by the Japanese central bank, this will create downside for the yen. However, because the yen is so cheap, it is likely to occasionally rally furiously each time a risk-off event, such as any additional North Korean provocations, puts temporary downward pressure on global yields. The British Pound Chart 4The Pound Is Attractive On A Long-Term Basis The pound has fallen 6% against the euro this year, the currency of its largest trading partner. This has dragged down the GBP's real effective exchange rate to a large 11% discount to its fair value, the largest since the direct aftermath of the Brexit vote (Chart 4). Because Great Britain has entered a paradigm shift - the exit from the European Union will change the nature of the U.K. relationship on 43% of its trade - assessing where the pound's fair value lies is a more nebulous exercise than normal. However, signs are present that the pound is indeed cheap. British inflation remains perky, the current account has narrowed to 4% of GDP, and despite large regulatory uncertainty, net FDI into the U.K. has hit near record highs of 7% of GDP. Movements in cable are likely to remain a function of the gyrations in the U.S. dollar. However, at this level of valuation, the pound is attractive against the euro on a long-term basis. We had a target on EUR/GBP at 0.93, which was hit two weeks ago. This cross is likely to experience downside for the next 12 months. The biggest risk for the pound remains British politics - and not Brexit itself but its aftershock. The EU has made clear the transition process will be long, leaving time for the British economy to adjust. However, the conservative party has been greatly weakened, and Jeremy Corbyn's popularity is increasing. This raises the specter that, in the not-so-distant future, a Labour government could be formed. Under Corbyn's leadership, this would be the most left-of-center administration in any G10 country since François Mitterrand became French president in 1981. The early years of the Mitterrand presidency were marked by a sharp decline in the franc as he nationalized broad swaths of the French private sector, increased taxes and implemented inflationary policies. Keep this in mind. The Canadian Dollar Chart 5The CAD Has Lost Its Valuation Advantage The loonie's fair value is driven by commodity prices, relative productivity trends, and the Canadian net international position. In February, the CAD was trading in line with its fair value. However, after its blistering rally since May, when the Bank of Canada began to hint that policy could be tightened this year, the Canadian dollar is now expensive vis-à-vis its long-term fundamental drivers (Chart 5). In a Special Report two months ago, we argued that the BoC was one of the major global central banks best placed to increase interest rates.2 With the Canadian economy firing on all cylinders, and with the output gap closing faster than the BoC anticipated in its July Monetary Policy Statement, the two interest rate hikes recorded this year so far make sense, and another one is likely to materialize in December. However, while the CAD could continue to rise until then, traders have moved from being massively short the CAD to now holding very sizeable net long positions. Additionally, interest rate markets are now discounting more than two hikes in Canada over the next 12 months, while expecting less than one full hike in the U.S. over the same time frame. If this scenario were to pan out, the tightening in monetary conditions emanating from a massive CAD rally would likely choke the Canadian recovery. Instead, we expect U.S. rates to increase more than what is currently embedded in interest rate markets, thus limiting the downside in USD/CAD. We prefer to continue betting on a rising loonie over the next 12 months by buying it against the euro and the Australian dollar. The Australian Dollar Chart 6The AUD Is Very Expensive The fair value of the Aussie is driven by Australia's net international position and commodity prices. Even with the tailwind of stronger metal prices, the AUD's rallies have been beyond what fundamentals justify, leaving it at massively overvalued levels (Chart 6). This suggests the AUD is at great risk of poor performance over the next 24 months. Timing the beginning of this decline is trickier, and valuations offer limited insight. One of the key factors that has supported the AUD has been the large increase in fiscal and public infrastructure spending in China this year - a move by Beijing most likely designed to support the economy in preparation for the 19th National Congress of the Communist Party of China, where the new members of the Politburo are designated. As this event will soon move into the rearview mirror, China may abandon its aggressive support of the industrial and construction sectors - two key consumers of Australia's exports. The other tailwind behind the AUD has been the very supportive global liquidity backdrop. Global reserves growth has increased, dollar-based liquidity has expanded and generalized risk-taking in global financial markets has generated large inflows into EM and commodity plays.3 While U.S. inflation remains low and investors continue to price in a shy Fed, these conditions are likely to stay in place. However, a pick-up in U.S. inflation at the end of the year is likely to force a violent re-pricing of U.S. interest rates and drain much of the global excess liquidity, especially as the Fed will also be shrinking its balance sheet. This is likely to be when the AUD's stretched valuations become a binding constraint. The New Zealand Dollar Chart 7No More Premium In The NZD Natural resources prices, real rate differentials and the VIX are the key determinants of the kiwi's fair value, highlighting the NZD's nature as both a commodity currency and a carry currency. Both the fall in the VIX and the rebound in commodities prices are currently causing gradual appreciation in the New Zealand's dollar equilibrium exchange rate. However, despite these improving fundamentals, the real trade-weighted NZD has fallen this year, and now trades in line with its fair value (Chart 7). Explaining this performance, the NZD began 2017 at very expensive levels, even when compared to the already-pricey AUD. Also, despite a very strong New Zealand economy, the Reserve Bank Of New Zealand has disappointed investors by refraining from increasing interest rates, as the expensive currency has tightened monetary conditions on its behalf. Going forward, the recent weakness in the real effective NZD represents a considerable easing of policy, which could warrant higher rates in New Zealand. As a result, while a tightening of global liquidity conditions could hurt the NZD in addition to the AUD, the kiwi is likely to fare better than the much more expensive Aussie, pointing to an attractive shorting opportunity in AUD/NZD over the next 12 months. The Swiss Franc Chart 8The CHF Is Cheap, The SNB Is Happy Switzerland's enormous and growing net international investment position continues to be the most important factor lifting the fair value of the Swiss franc. The recent sharp rally in EUR/CHF has now pushed the Swissie into decisively cheap territory (Chart 8). The decline in political risk in the euro area along with the lagging economic and inflation performance of the Swiss economy fully justify the discount currently experienced by the Swiss franc: money has flown out of Switzerland, and the Swiss National Bank is doing its utmost to keep monetary policy as easy as it can. For a small open economy like Switzerland, this means keeping the exchange rate at very stimulative levels. The continued growth in the SNB's balance sheet is a testament to the strength of its will. For the time being, there is very little reason to bet against SNB policy; the CHF will remain cheap because the economy needs it. However, this peg contains the seeds of its own demise. The cheaper the CHF gets, the larger the economic distortions in the Swiss economy become. Already, Switzerland sports the most negative interest rates in the world. This directly reflects the large injections of liquidity required from the SNB to keep the CHF down. These low real rates are fueling bubble-like conditions in Switzerland real estate and are threatening the achievability of return targets for Swiss pension plans and insurance companies, forcing dangerous risk-taking. But until core inflation and wage growth can move and stabilize above 1%, these conditions will stay in place. The Swedish Krona Chart 9The Swedish Krona Has More Upside Even after its recent rebound, the Swedish krona continues to trade cheaply, even if its long-term fair value remains on a secular downward trajectory (Chart 9). Yet the undemanding valuations of the SEK hide a complex picture. It is approximately fairly valued against the GBP and expensive against the NOK, two of its largest trading partners. However, the SEK is cheap against the USD and the euro. We expect the SEK to continue appreciating. While Swedish PMIs have recently softened, the Swedish economy is running well above capacity, and the Riksbank resources utilization indicator suggests the recent surge in inflation has further to run. Moreover, Sweden is in the thralls of a dangerous real-estate bubble that has pushed nonfinancial private-sector debt above 228% of GDP. With many amortization periods on new mortgages now running above 100 years, the Swedish central bank is concerned that further inflating this bubble could result in a milder replay of the debt crisis experienced in the early 1990s. The shift in leadership at the Riksbank's helm at the beginning of 2018 is likely to be the key factor that prompts the beginning of the removal of policy accommodation in that country. We like buying the krona against the euro. The USD/SEK tends to be a high-beta play on the greenback, and thus is very much a call on the USD. However, EUR/SEK displays a much lower correlation, and thus tends to be a more effective medium to isolate the upcoming tightening in monetary policy we expect from the Riksbank. The Norwegian Krone Chart 10The NOK is The Cheapest Commodity Currency The Norwegian krone remains the cheapest commodity currency in the world, along with the Colombian peso (Chart 10). The slowdown in Norwegian inflation and a very negative output gap of 2% of GDP implies that the Norges Bank will remain one of the most accommodative central banks in the G10. Thus, the NOK should remain cheap. However, we continue to like buying the krone against the euro. EUR/NOK has only traded above current levels when Brent prices have been below US$40/bbl. Not only is Brent currently trading above US$50/bbl, but the outlook for oil remains bright: production is in control as the agreement between Russian and OPEC is still in place. Additionally, the recent carnage and refinery shutdowns caused by hurricane Harvey should result in large drawdowns to finished-products inventories in the coming months. This will contribute to an anticipated normalization in global excess petroleum inventories, which have been the most important headwind to oil prices. Finally, the fact that the Brent curve is now backwardated also represents a support for oil prices, as this creates a "positive carry" for oil investors. The Yuan Chart 11The Yuan Can Rise On A Trade-Weighed Basis Despite the recent strength in both the trade-weighted RMB and the yuan versus the U.S. dollar, the renminbi still trades at a discount to its long-term fair value (Chart 11). Confirming this insight, China continues to sport a sizeable current account surplus, and its share of global exports is still on an expanding path. With the RMB being cheap, now that China is once again accumulating reserves instead of spending them to create a floor under its currency, the downside risk to the CNY has decreased significantly. Thus, since the People's Bank of China targets a basket of currencies when setting the yuan's value, to legitimize any bullish view on USD/CNY one needs to have a bullish view on the USD. While we do anticipate the dollar to rally toward the end of the year, our expectation that it will remain flat until then implies that we do not see much upside for now to USD/CNY. However, our bullish medium-term USD view, along with the cheapness of the CNY, suggests that the RMB could continue to appreciate on a trade-weighted basis going forward. While Chinese policymakers have highlighted their desire to make their currency a more countercyclical tool, the recent stability in Chinese inflation implies there is no need to let the CNY depreciate to reflate China. In fact, at this point, elevated PPI readings would argue that the Chinese authorities do have a built-in incentive to let the CNY appreciate on a trade-weighted basis for the coming six to 12 months. The Brazilian Real Chart 12The BRL is Vulnerable To A Pullback In Global Liquidity Hampered by poor productivity trends, which weigh on the Brazilian current account balance, the fair value of the real remains quite depressed, even as commodity prices have sharply rebounded since early 2016. In fact, the violent rally in the BRL over the same timeframe has made it one of the most expensive currencies tracked by our models (Chart 12). This level of overvaluation points to poor returns for the BRL on a one-to-two-year basis, however, it gives no clue to timing. The strong sensitivity of the Brazilian real to EM asset prices implies that the BRL is unlikely to weaken significantly so long as EM bonds remain well-bid. Moreover, because the BRL still offers an elevated carry, until U.S. interest rate expectations turn the corner, U.S. market dynamics will continue to put a floor under the real. However, this combination suggests the BRL could become one of the prime casualties of any rebound in U.S. inflation. Such a development would cause global liquidity to fall, hurting EM bonds in the process and making the BRL's high-risk carry much less attractive. Confirming this danger, the fact that the USD/BRL has not been able to breakdown for more than a year despite the weakness in the USD suggests momentum under the BRL is rather weak. The Mexican Peso Chart 13Mexican Peso: From Bargain To Luxury In the direct aftermath of Trump's electoral victory, the Mexican peso quickly became one of the cheapest currencies in the world. However, the peso's 25% rally versus the U.S. dollar since January has eradicated this valuation advantage to the point where it is now one of the most expensive major currencies in the world (Chart 13). As the peso was collapsing through 2016, the Mexican central bank fought back, increasing interest rates. The massive surge in the prime lending rate points to a protracted period of weakness in the growth of nonfinancial private credit, which should weigh on consumption and investment. Actually, the growth in retail sales volumes has already begun to weaken. This could force the Banxico to cut rates, especially as inflation will slow in the face of peso's rebound this year. Lower Mexican rates, in the face of stretched long positioning in MXN by speculators, could be the key to generating a weakening in the peso over the next 12 months. To see real fireworks in the peso, one would need to see a resumption in the U.S. dollar bull market. Mexico has external debt equivalent to 66% of GDP, the highest among large EM nations. This makes the Mexican economy especially vulnerable to a strong dollar, as such a move would imply a massive increase in debt servicing costs. Thus, while the MXN may not be as vulnerable as the BRL, it could still suffer greatly if global liquidity becomes less generous next year. The Chilean Peso Chart 14CLP Needs HIgh Copper Prices The Chilean peso real effective exchange rate is driven by the country's productivity trend relative to its trading partners and the real price of copper - which proxies Chilean terms-of-trade. Thanks to the CLP's rally since the winter of 2015, the real peso is at a four-year high and is now in expensive territory (Chart 14). We expect copper to see downside from now until the end of the year, pulling down the CLP with it. Current dynamics in the Chinese real estate market and the Chinese credit cycle, which tend to be leading indicators of industrial metals prices, point to an upcoming selloff. Moreover, Chinese monetary conditions have begun to tighten, and are set to continue doing so. This will weigh on Chinese credit growth and capex, creating headwinds for copper and the peso. That being said, the CLP will likely outperform the BRL and the ZAR. M1 money growth is back in positive territory after contracting last year, while industrial activity seems to have hit a bottom and is now picking up. Moreover, since Chile's economy does not have the credit excesses of its other EM peers, we expect the CLP to show more resilience than other currencies linked to industrial metals. The Colombian Peso Chart 15COP: A Rare Bargain Among EM The real COP's fair value is driven by Colombia's relative productivity trends and the price of oil, the country's main export. The fall in oil prices since the beginning of the year have caused a small decline in the fair value of the COP. Nevertheless, the peso is still one standard deviation below fair value (Chart 15). This partly reflects the premium demanded by investors to compensate for Colombia's large current account deficit of 6.3% of GDP. Overall the COP looks attractive, particularly against other commodity currencies. Historically a discount of 20% or more, like what the peso has today, marks a bottom in the real effective exchange rate. Furthermore, our Commodity and Energy Strategy Service expects Brent prices to climb to US$60/bbl towards the end of year, as OPEC's and Russia's production controls translate into oil inventory drawdowns. This should further increase the value of the COP against the ZAR and the BRL. Domestic dynamics also point to outperformance of the peso against other EM currencies. As opposed to countries like Brazil, where private debt stands at nearly 85% of GDP, Colombia has a more modest 60% leverage ratio - the byproduct of an orthodox banking system. Thus, the peso should be able to withstand a liquidity drawdown in EM better than its peers. The South African Rand Chart 16Lack Of Productivity And Politics Are The Greatest Risk To The Rand South Africa's dismal productivity trend continues to be the greatest factor pulling the rand's long-term fair value lower. Due to this adverse trend, while the ZAR has been broadly stable this year, it is now slightly more expensive than it was in February (Chart 16). Not captured by the model, the political risks in South Africa remain elevated, creating a further handicap for the rand. The story behind the ZAR is very similar to the one underpinning the gyrations in the BRL. Both currencies, thanks to their elevated carries and deep liquidity - at least by EM currency standards - will continue to be buoyed by very generous global liquidity conditions. However, global real rates seem dangerously low and could move sharply higher, especially when U.S. inflation picks up at the end of the year and in early 2018. Such a move would cause the currently very supportive reflationary conditions to dissipate. This would put the expensive ZAR in a very precarious position. An additional danger for the ZAR is the price of gold. Gold and precious metals have also benefited from these generous global liquidity conditions. This has helped the South African terms of trade. However, gold is likely to be a key victim if U.S. interest rates rise because it is negatively correlated with both real interest rates and the U.S. dollar. Thus, while we do not see much upside for the expensive ZAR for the time being, it is likely to suffer greatly once U.S. inflation turns around, suggesting the ZAR possesses a very poor risk/reward ratio. The Russian Ruble Chart 17The Ruble Is Expensive But Russia Has The Best EM Fundamentals The RUB is currently trading at a very large premium to fair value (Chart 17). The risk created by such an overvaluation is only likely to materialize once U.S. inflation turns the corner and U.S. interest rates pick up - a scenario we've mentioned for late 2017 and early 2018. This risk is most pronounced against DM currencies, the U.S. dollar in particular. The RUB remains one of our favorite currencies within the EM space, especially when compared to other EM commodity producers. The Russian central bank is pursuing very orthodox policy, despite the fall in realized inflation, and is maintaining very elevated real interest rates in order to fully tame inflation expectations. Moreover, oil prices are likely to experience upside in the coming months as oil inventories are drawn down. This could result in an increase in the ruble's equilibrium exchange rate, which would help correct some of the RUB's overvaluation. The Korean Won Chart 18KRW Is Where You Can Really See The North Korean Tensions The fair value of the Korean won continues to be lifted by the combined effect of lower Asian bond spreads and Korea's current account surplus. Yet, the KRW is trading at an increasingly large discount to its equilibrium (Chart 18). At first glance, this seems highly surprising as global trade is growing at its fastest pace in six years - a situation that always benefits trading nations like South Korea. Instead, political developments are to blame. Not only is North Korea ramping up its tests of intercontinental ballistic missiles and nuclear devices, but also Seoul is within range of Pyongyang's conventional artillery. BCA's Geopolitical Strategy service does not expect the current standoff to result in military conflict. Ultimately, North Korea is no match for the military might of the U.S. and its allies. Moreover, the capacity for Pyongyang's actions to shock financial markets is exhibiting diminishing returns. This suggests the risk premium imbedded in the won should dissipate. However, the won will remain very exposed to dynamics in the USD, global liquidity and global trade. Instead, a lower-risk way for investors to take advantage of the KRW's cheapness is to buy it against the Singapore dollar. While just as exposed to global liquidity as the won, the SGD is currently trading at a premium to fair value. The Philippine Peso Chart 19The PHP Has Over-Discounted The Fall In The Current Account The fair value of the Philippine peso is driven by the country's net international investment position and commodity prices. After falling 6% this year, the real effective PHP now trades at a 13% discount to its fair value (Chart 19). A deteriorating current account, which is now in deficit, has fueled a selloff in the peso, making the Philippine currency one of the worst performing in the EM space. Worryingly, this has occurred alongside faltering foreign exchange reserves. However, the deficit is mainly the mirror image of large capital inflows, fueled by the government's ambitious infrastructure spending. Remittances are growing again and, with a weaker peso, will support consumer spending going forward. Employment had a setback last year, but is growing again. Higher investment and consumer spending will likely push rates up. As inflation rebounded alongside commodity prices last year, it is now at its 3% target. Bangko Sentral ng Pilipinas will need to rein in inflationary pressures to avoid overheating the economy. While the Philippines economy should expand further, the 'Duterte Discount' remains in place. Negative net portfolio flows reflect negative investor sentiment, as policy uncertainty remains elevated. The Singapore Dollar Chart 20SGD Remains Expensive The fair value of the Singapore dollar is driven by commodity prices. This is because the exchange rate is the main policy tool used by the Monetary Authority of Singapore. As a result, when commodity prices rise, which leads to inflationary pressures, MAS tightens policy by spurring appreciation in the SGD. The opposite holds true when commodity prices weaken. Based on this metric, the SGD is currently 4.2% overvalued (Chart 20). Domestically, dynamics are quite mixed. Retail sales have picked up. However, both manufacturing and construction employment are contracting and labor market slack is increasing, pointing to continued subdued wage growth. Additionally, property prices are contracting and vacancy rates are on the rise, led by the commercial property sector. Thus, the recent pickup in inflation could soon vanish, especially as it has been driven by the rebound in oil prices in 2016. This combination suggests that Singapore still needs easy monetary conditions. USD/SGD closely follows the DXY. While the Fed will be able to increase interest rates by more than the 35 basis points priced over the next 24 months, Singapore still needs a lower exchange rate to maintain competitiveness and alleviate deflationary pressures. The Hong Kong Dollar Chart 21The Fall In The USD Has Helped The HKD The HKD remains quite expensive. However, being pegged to the USD, its valuation premium has decreased this year (Chart 21). The fall in the greenback has driven the HKD - which itself has fallen 0.75% versus the U.S. dollar - lower against the CNY and other EM currencies. If the U.S. dollar does resume its uptrend over the next six months, the valuation improvement in the HKD will once again dissipate. However, this does not spell the end of the HKD peg. With reserves of US$414 billion, or 125% of GDP, the Hong Kong Monetary Authority has the firepower to support the peg, which has been one of the cornerstones of Hong Kong economic stability since 1983. Instead, the HKMA will tolerate deep deflationary pressures that will cause a fall in the real effective exchange rate. This is the path that Hong Kong picked in the 1990s, and it will be the path followed again in the face of any broad-based USD appreciation. This suggests that Hong Kong real estate prices could experience significant downside in the coming years. The Saudi Riyal Chart 22The Riyal Is Still Expensive The Saudi riyal remains prohibitively expensive, even as its valuation premium has decreased this year (Chart 22). The SAR is afflicted by similar dynamics as the HKD: its peg with the USD means the greenback's gyrations are the main source of variation in the SAR's real effective exchange rate on a cyclical basis. However, on a structural horizon, the fair value of the riyal is dominated by Saudi Arabia's poor productivity. An economy dominated by crude extraction and processing and living on one of the most sizable economic rents in the world, Saudi Arabia has not endured the competitive pressures that are often the source of productivity enhancement in most nations. Additionally, Saudi capital expenditures are heavily skewed to the oil sector, a sector whose output growth has been limited for many decades by natural constraints. We do not believe the current valuation premium in the riyal will force the Saudi Arabian Monetary Authority to devalue the SAR versus the USD. Saudi Arabia, like Hong Kong, possesses copious foreign exchange reserves, and growth has improved now that oil prices have rebounded. Additionally, the KSA is also likely to tolerate deflationary pressures. Not only has it done so in the past, but Saudi Arabia imports most of its household products, especially its food needs. A fall in the SAR would cause a large amount of food inflation, representing a massively negative price shock for a very young population. This is a recipe for disaster for the royal family of a country with no democratic outlet. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant haarisa@bcaresearch.com Juan Manuel Correa, Research Analyst juanc@bcaresearch.com 1 For a more detailed discussion of the various variables incorporated in the models, please see Foreign Exchange Strategy Special Report, "Assessing Fair Value In FX Markets", dated February 26, 2016, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy and Global Alpha Sector Strategy Special Report, "Who Hikes Next?", dated June 30, 2017, available at fes.bcaresearch.com 3 For a more detailed discussion on the global liquidity environment, please Foreign Exchange Strategy Weekly Report, "Dollar-Bloc Currencies: More Than Just China", dated August 18, 2017, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

Highlights Beware of asset managers' and leveraged funds' large net long positions in EM currencies. Overextended net long positions in EM and commodities currencies signify overbought conditions in EM risk assets in general. This in tandem with the poor outlook for EM/China growth makes the risk-reward of EM financial markets unattractive. Downgrade Korean equities from overweight to neutral, but continue to overweight Korean technology stocks relative to the EM benchmark. Also, maintain the short KRW / long THB trade. Take profits on the long Indian / short Indonesian stocks position. Consistently, downgrade Indian stocks to neutral and upgrade Indonesian bourses to neutral within an EM equity portfolio. Feature Investor positioning in EM currencies is elevated. From a contrarian perspective, this at minimum warrants a correction. Chart I-1 illustrates that asset managers' and leveraged funds' combined net long positions in the Mexican peso, the Brazilian real, the Russian ruble and South African rand are very elevated.1 This aggregate is weighted by notional value of outstanding open interest of each currency, and is shown as a percentage of open interest. Importantly, we have refined positioning data to separate asset managers and leveraged funds from other non-commercial and commercial institutions. Asset managers and leveraged funds reflect investment community sentiment the best. Besides, they are the most inclined to scale back their net long positions if and when these currencies begin to depreciate, i.e., they are more momentum driven. By doing so, they will reinforce the selloff. Currently bullish sentiment on EM and commodities is corroborated by the fact that asset managers' and leveraged funds' aggregate net long positions in non-EM commodities currencies such as the CAD, the AUD and the NZD are at the highest level since 2011 (Chart I-2). Typically, these currencies are at risk of a correction when positioning reaches such excessive levels. Chart I-1Asset Manager's And Leveraged Funds' Net Long Positions In EM Currencies Are Large Chart I-2Asset Manager's And Leveraged Funds' Net ##br##Long Positions In Commodities Currencies Chart I-3A and Chart I-3B show the same for individual currencies such as the MXN, the BRL, the RUB, the ZAR, the CAD, the AUD and the NZD. The overarching message is that investors' net long exposure to both EM and commodities currencies is large and depreciation risk for these exchange rates is substantial, at least in the near term. Chart I-3AAsset Managers And Leveraged Funds' Net ##br##Long Positions In Select Currencies Chart I-3BAsset Managers And Leveraged Funds' Net ##br##Long Positions In Select Currencies Yet, these positioning data do not reveal whether potential weakness will be a bull market correction or the beginning of bear market. Our bias remains that the potential selloff will evolve into a new phase of the bear market in EM currencies that began in 2011. In turn, as EM currencies depreciate, they will erode foreign investors' returns and trigger a selloff in other EM risk assets such as stocks, domestic bonds and credit markets. In short, investor sentiment on EM risk assets correlates with sentiment toward both EM and commodities currencies. Hence, bullish sentiment and overextended net long positions in EM and commodities currencies signify overbought conditions in EM risk assets in general. The Cyclical Outlook Chart I-4EM Currency Valuations Are Close To Neutral We are negative on the cyclical outlook for EM currencies for the following reasons: With a few minor exceptions, EM currencies are not cheap; their valuations are close to neutral Chart I-4 demonstrates the real effective exchange rate for aggregate EM excluding China, Korea and Taiwan. This is an equity market cap-weighted aggregate. It shows that EM exchange rate valuations are not depressed. The reason why we remove China, Korea and Taiwan from the calculation is because their respective bourses have large equity market-cap weights in the MSCI EM stock index, and thereby dominate the EM aggregate. Excluding these three markets, we get a less skewed perspective on EM currency valuations and assign higher weight to the high-yielding ones. Importantly, the best measure of currency valuation is, in our opinion, the real effective exchange rate based on unit labor costs (ULC). The rationale is that this measure captures changes in wages and productivity. The latter two are critical to competitiveness and, hence, reveal the true valuation of currencies. Unfortunately, there is no available ULC-based real effective exchange rate data for all individual EM currencies. Chart I-5A and Chart I-5B presents the measure for countries where data from reputable sources are available. By and large, the message is that, with the exception of the Mexican peso, EM currencies are not particularly cheap. Chart I-5AReal Effective Exchange Rates ##br##Based On Unit Labor Costs Chart I-5BReal Effective Exchange Rates ##br##Based On Unit Labor Costs The outlook for EM exchange rates has historically been contingent on growth and corporate profitability in developing economies. That said, EM exchange rate fluctuations have in recent years become dependent on U.S. real interest rates as the importance of portfolio fixed-income flows into EM has dramatically surged. Both drivers - EM growth and U.S. real yields - are likely to become headwinds for EM exchange rates going forward. EM growth will relapse anew as Chinese growth slows and EM shipments to China decline. Our new money impulse for China2 has historically been a good leading indicator for EM exchange rates, and it points to potentially considerable EM currency depreciation in the next six to nine months (Chart I-6). Meanwhile, U.S. interest rate expectations are very depressed. It will take only slightly stronger U.S. growth and inflation readings or some non-dovish guidance from the Federal Reserve for U.S. interest rate expectations to move higher. The latter will support the U.S. dollar and hurt EM currencies. Although industrial metals prices have recently spiked to new cyclical highs, we believe commodities prices - both for energy and industrial materials - will be lower in the medium term. Global oil stocks are breaking to new cyclical lows, heralding weakness in crude prices (Chart I-7). The fact that oil has failed to post gains amid a notable rally in the euro could be a sign of fundamental vulnerability. Chart I-6China's Money Impulse And EM Currencies Chart I-7Oil Prices Are Vulnerable As for industrial metals prices, our analysis has not changed: the considerable slowdown in China's broad money heralds a major top in industrial metals prices, as per Chart I-8. The mainland accounts for 50% of global industrial metals consumption, and its capex cycle is of critical importance. What explains the latest spike in base metals prices? Chart I-9 reveals that since early this year, iron ore prices have been negatively correlated with Chinese money market rates (interest rates are shown inverted and are advanced by 30 days Chart I-9). This year's correction and subsequent rebound in iron ore prices might be attributed to changes in mainland traders' positioning due to swings in domestic interest rates. Chart I-8China-Plays Are At Risk Chart I-9Chinese Interest Rates And Iron Ore Prices Going forward, either China's growth will decelerate sufficiently enough to weigh on industrial metals prices, or the authorities will resume policy tightening to rein in financial excesses. All in all, the risk-reward for iron ore and other industrial metals is negative. On the whole, lower energy and industrial metals prices will weigh on EM commodities currencies. As for Asian currencies, they are sensitive to global trade. We expect global trade and tradable goods prices to relapse due to the resumption of a slowdown in China/EM demand. Manufacturing-based Asian currencies will depreciate amid budding weakness in their manufacturing sector (Chart I-10). In addition, Chart I-11 shows global auto sales lead global semiconductor sales by several months. The basis for this correlation is that autos nowadays use a lot of semiconductors, and therefore auto cycles affect semiconductor demand. The boom in semi-cycle has been one of the pillars of Asian exports recovery. As the former moderates, the latter will relapse weighing on Asian non-commodities currencies. Chart I-10Asian Manufacturing ##br##And Exchange Rates Chart I-11Global Auto Sales Lead ##br##Global Semiconductor Sales Bottom Line: Our bet remains that EM currencies will depreciate versus both the U.S. dollar and the euro - and regardless of euro/U.S. dollar exchange rate fluctuations. We recommend a short position in a basket of the following EM currencies: ZAR, TRY, COP, CLP, BRL, IDR, MYR and KRW. For market-neutral portfolios, our currency overweights are MXN, RUB, PLN, CZK, TWD, INR and THB. Korean Equities: Downgrading To Neutral We recommend downgrading Korea to neutral from overweight within EM equity portfolios. North Korea will likely remain a source of uncertainty and volatility. BCA's Geopolitical Strategy service does not expect war on the Korean peninsula as long-standing constraints to conflict are still in place, starting with Pyongyang's ability to cause massive civilian casualties north of Seoul via an artillery barrage. As such, the ultimate resolution to the conflict will be a peaceful one. However, getting from here (volatility) to there (negotiated resolution) requires more tensions. The U.S. has to establish a "credible threat" of war in order to move China and North Korea towards a negotiated resolution.3 And that process could take more time, which means more volatility in the markets.4 The overwhelming portion of Korea's equity rally has been driven by a phenomenal surge in one company's share price: Samsung. Excluding technology companies, the performance of MSCI Korea stock prices and their EPS has been mediocre. Samsung's explosive rally has been partially due to the exponential surge in DRAM prices (Chart I-12). On a macro level, we cannot forecast prices of individual semiconductors (such as DRAM). Nevertheless, our assessment is that the global semi cycle is entering a soft patch as per Chart I-11 above. Furthermore, Korea's cyclical growth has already peaked, and will slow going forward (Chart I-13). Broad money growth is still decelerating, entailing that no turnaround is in the cards (Chart I-13, bottom panel). Chart I-12Samsung Share Prices And DRAM Chart I-13Korea: Cyclical Profile Importantly, the new government has enacted a law to boost minimum wages by 16% in January 2018 and would need to increase by a similar rate annually to reach its 2020 target. Even though there are fiscal subsidies for businesses and minimum wages affect smaller businesses much more than larger ones, odds are that this will still boost overall wage growth, and hence weigh on companies' profit margins. Chart I-14Korean Won Is Expensive Versus The Yen Finally, the Korean won is modestly expensive, based on the unit labor costs-based real effective exchange rate (Chart I-14, top panel). The won is especially expensive versus the yen (Chart I-14, bottom panel). This is negative for Korean manufacturers and the currency. Investment Recommendations Downgrade Korean stocks from overweight to neutral, but continue to overweight Korean technology stocks relative to the EM benchmark. Close long Korea / short EM equities and long Korean banks / short Indonesian banks positions. These positions have produced small gains since their initiation (details on all our open positions are available at the end of each week's report on page 17). Maintain a short KOSPI / long Nikkei in common currency terms trade: Either the won will depreciate substantially versus the yen or the KOSPI will underperform the Nikkei in local currency terms. In both cases, this trade will be profitable. Continue to bet on lower bond yields in Korea via receiving 10-year swap rates. Deflationary pressures from weaker exports - that make up 35% of GDP - will weigh on economic growth, and the central bank will be forced to cut rates. Maintain a short Korean won / long Thai baht position. The won is a high-beta currency and will underperform the Thai baht in a selloff / Asian exports slowdown. The Thai currency will likely trade in a low beta fashion due to the country's large current account surplus and low exposure to both China and commodities. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Take Profits On Long Indian / Short Indonesian Equities Position This recommendation has generated 8.4% gain since its initiation on July 30, 2014, and we recommend booking profits. Indian share prices have outperformed their Indonesian peers over the past year (Chart II-1) but the outlook for top line growth appears to be slightly better in Indonesia than in India. Specifically: We have combined bank credit to businesses and households with government expenditures to calculate a credit and fiscal spending impulse for both countries. Chart II-2 illustrates that this impulse heralds a more positive outlook for listed companies' revenues in the case of Indonesia than India. Chart II-1Book Profits On Long Indian / ##br##Short Indonesian Stocks Position Chart II-2Credit And Fiscal Spending ##br##Impulse Favor Indonesia Over India Other cyclical variables are mixed in both economies: vehicle and two-wheeler sales are sluggish, manufacturing PMIs have rolled over, but imports of capital goods are improving (Chart II-3). In regard to valuation and profitability, both bourses are expensive in absolute terms (Chart II-4, top panel) but India's return on equity (RoE) is well below Indonesia's (Chart II-4, bottom panel). Such a 14% premium of Indian stocks over Indonesian ones along with a poor revenue outlook and lower RoE might prevent further share price outperformance by India. Chart II-3Mixed Cyclical Growth Dynamics Chart II-4India And Indonesian Equities: P/E Ratios And RoEs Although our negative outlook for commodities prices and expensive equity valuations entail a negative stance on Indonesian risk assets in absolute terms, we believe this bourse's underperformance versus the EM overall equity index and Indian stocks is late. It makes sense to reduce/eliminate an underweight allocation to Indonesian equities. Bottom Line: We recommend booking gains on the long Indian / short Indonesia equity position initiated on July 30, 2014. Consistently, we downgrade Indian stocks from overweight to neutral and upgrade Indonesian ones from underweight to neutral within an EM equity portfolio. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 CFTC is the U.S. Commodity Futures Trading Commission. The data on South African rand is available from May 2015. 2 Presented and discussed in detail in July 26, 2017 and August 16, 2017 reports; the links are available on page 18. 3 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," April 19, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?," August 16, 2017, available at gps.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Geopolitical tensions will stay elevated. We are not changing our strategic views. So long as the situation does not degenerate into a major military conflict or escalating trade wars with significant economic damages, the impact on both the broader growth outlook and financial markets should be limited. President Trump's recent decision to probe China's IPR practices is his first direct trade measure against China, and therefore is of important symbolic significance, but the near term impact should be limited. There is enough common ground for the two sides to avoid direct confrontation. We expect Beijing to cooperate with the U.S. administration to intensify pressure on North Korea. Short KRW/JPY as a hedge against geopolitical risk in The Korean Peninsula. There is an economic case for the trade, even without geopolitical considerations. Feature The Chinese economy is experiencing a summer lull, as most recent growth figures have disappointed, albeit slightly. Exports, production, investment and retail sales have all decelerated, underscoring that growth momentum is softening across the board. Investors have largely shrugged off the weaker-than-expected numbers, a sign that the market is not overly concerned about a major relapse down the road. We share investors' optimism, as discussed in some recent reports,1 but are watchful for signs of market complacency.2 After the most recent rally, multiples of Chinese equities are no longer exceptionally cheap by historical norms, even though they are still a lot cheaper compared with most other major global and EM bourses. We will discuss Chinese equity valuations in greater detail in the coming weeks. Geopolitical risks have dominated Greater China markets of late. The escalation of tensions surrounding North Korea briefly took their toll in the past week. On Monday, U.S. President Donald Trump authorized U.S. Trade Representative Robert Lighthizer to determine whether to launch an investigation into China's alleged theft of intellectual property. Overall, both events underscore rising geopolitical tensions globally, particularly around China. So long as the situation does not degenerate into a major military conflict or an escalating trade war that causes major economic damage, the tensions should not have a material impact on the outlook for the Chinese and global economy, as well as financial markets. A short position on the Korean won versus the Japanese yen offers a low-risk hedge against a sudden escalation of geopolitical tensions in the region. Intellectual Property Investigation: The Knowns And Unknowns It is unclear at the moment whether Trump is simply using the investigation as a bargaining chip to seek concessions/cooperation from China, or to start a trade war with lose-lose outcomes. The situation needs to be closely monitored and assessed continuously. For now, a few observations are in order: This is the first direct trade measure by the Trump administration against China, and therefore is of important symbolic significance, but the near-term impact should be limited. President Trump has only authorized his administration to determine whether or not to formally investigate Chinese policies and practices. It may take a year to finalize the decision, and even longer to begin negotiations and discussions with Chinese officials for solutions and remedies. Previous similar investigations against Chinese products resulted in bilateral agreements rather than all-out confrontations. Trump's decision is based on Section 301 of the Trade Act of 1974, which allows the president to unilaterally impose tariffs or other trade restrictions to protect U.S. industries from "unfair trade practices" of foreign countries. This was a popular trade tool in the 1980s and was used to impose tariffs against certain Japanese and Korean products, but has been rarely used in the past decade. In 2010 the Obama administration also accepted a petition under Section 301 to investigate China's state support for clean-energy exports, particularly solar panels and wind turbines, and the Chinese government later promised to limit some of these practices through bilateral negotiations. The World Trade Organization (WTO) has ruled that taking any such actions against other member countries without first securing approval under WTO rules is, in of itself, a violation of the WTO Agreement, and can be challenged under the WTO framework. In fact, section 301 investigations have not resulted in any trade sanctions since the WTO was set up in 1995. Table 1Top Challenges Doing Business In China More importantly, we see common ground enabling the U.S. and China to work together to improve China's Intellectual Property Rights, or IPR practices. From the U.S.'s perspective, while Trump's blunt accusations on China's trade policies are not completely justified and will not solve the massive trade imbalances between the two countries, his challenge on China's IPR infringement has legitimate ground, and resonates well within the broader American business community. American companies doing business in China have long listed intellectual property rights infringement and protectionism as top challenges, especially among industrial and resources businesses (Table 1). In other words, Trump's complaints on China's IPR practices reflects corporate America's rational voice rather than a sensational rant. China's own practices are also in conflict with its intentions to build a more open and market-friendly policy environment. Indeed, China has also been making notable progress to enhance IPR protections. In September 2015, in his state visit to the U.S., President Xi promised to limit the scope of national security reviews on investment, refrain from cyber-enabled IP theft, and uphold WTO agreements regarding market access for information and communications technology (ICT) products. China's deficits in IP royalty fees has increased sharply in recent years, while America's royalties surpluses have been expanding (Chart 1). Furthermore, 90% of American firms doing business in China believe that China's IPR enforcement has improved over the last five years, according to American Chamber Of Commerce In China (AmCham China) surveys.3 In short, there is certainly room for further improvement in China's IPR practices, and the broad direction fits with Trump's expectations, creating common ground for the two sides to avoid direct confrontation. We expect China's IPR practices will continue to converge towards international standards going forward. Chart 2 shows Chinese patent applications have exploded in recent years. As the country's technology continues to advance and local businesses are growing more aware of the value of intellectual property, China will develop a keen interest to safeguard its own IPRs. We are hopeful that Trump's investigation will provide a catalyst for further improvement in Chinese IPR practices, rather than derail broader bilateral trade. Chart 1China's Widening Deficits In IPR Royalty Chart 2China's Exploding Patent Applications ##br##Will Demand Stricter IPR Protections North Korea Tensions, And Short KRW/JPY As A Crisis Hedge The escalation of geopolitical tensions surrounding North Korea briefly took a toll on global and Greater China markets in the past week. The situation remains highly fluid, and the stakes are exceedingly high - both of which will put investors on edge in the weeks and months ahead. Our Geopolitical team in their latest assessment concludes that the U.S. is not likely to preemptively attack North Korea. However, the U.S. has an interest in signaling that it may conduct precisely such an attack, and brinkmanship could last for a long time.4 As far as China is concerned, there is genuine interest among the Chinese leadership to de-escalate tensions on the Korean Peninsula, but there is no easy solution. On one hand, it is absolutely against the country's best interests to collapse the North Korea regime. Such an outcome could see a surge of refugees to its densely populated and economically struggling Northeast region. Moreover, it could also potentially lead to a strong and unified Korea at the Chinese border that is a military ally to the United States. On the other hand, Beijing also feels that it has fallen victim to North Korea's nuclear ambitions, and has become growingly frustrated by its escalating provocations. China also fears that North Korea's nuclear program could encourage countries in the region, particularly Japan, to develop their own nuclear arsenals, which would be viewed as strategically threatening to China's national security. For now, we expect Beijing to cooperate with the U.S. administration to intensify pressure on North Korea. Already, China has supported the United Nations Security Council in imposing new sanctions on North Korea last week. Early this week, the Commerce Ministry announced a ban on imports of iron ore, iron, lead and coal from North Korea. These actions may have contributed to the softened tones from North Korea since, but it remains to be seen whether the impact will be long-lasting. The upshot is that the shared interests between China and the U.S. on various major global issues mean that the risk of an escalating trade war between the two countries should remain under control. For investors, bouts of geopolitical tension will likely bid up traditional safe-haven assets such as gold and the Swiss franc going forward. Another way to play the geopolitical risk is to short the Korean won (KRW) and long the Japanese yen (JPY). The KRW will obviously suffer devastating losses in even mild military skirmishes between the U.S. and North Korea, while the JPY may benefit from any "risk-off" unwinding of the yen carry trade. More importantly, economic fundamentals are not supportive of a stronger KRW, especially against the JPY, which means the downside risk in shorting the KRW/JPY is quite low, even without geopolitical considerations. Chart 3The Won Is Expensive Against The Yen The KRW is expensive against the JPY, based on a purchasing power parity (PPP) assessment (Chart 3). The 30% rally of KRW/JPY since 2012 has pushed it to an over two-sigma overshoot above its PPP fair value. Historically the won has rarely been sustainable at such elevated levels. Korea's economic outlook remains uninspiring. Capacity utilization has continued to decline, pricing power is weak, money growth is decelerating and real retail sales growth has stalled (Chart 4). Exports have been the bright spot in the overall growth picture, recovering strongly from last year's slump, but it is unrealistic to expect the export sector to continue to accelerate if growth numbers in China downshift. Softening exports will further weigh on Korea's growth outlook. In contrast, the latest growth numbers confirm that the Japanese economy has improved notably (Chart 5). Real GDP expanded by 1% in the second quarter compared with the previous three months, significantly beating expectations. While it remains to be seen whether Japan is able to maintain its regained momentum going forward, its growth gap with Korea has narrowed considerably of late, which will also lend support to the yen against its Korean counterpart. Chart 4Korea Growth Is Set To Moderate Chart 5Japan And Korea: Growth Gap Has Narrowed The bottom line is that geopolitical tensions in the Korean Peninsula will stay elevated. We are not changing our strategic views. So long as the situation does not degenerate into a significant military conflict that causes major economic damage, the geopolitical skirmishes should not have a material impact on both the broader growth outlook and financial markets. Investors may consider shorting the KRW/JPY as a hedge for geopolitical risks. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Reports, "China Outlook: A Mid-Year Revisit", dated July 13, 2017, and "Rising Odds Of PBoC Rate Hikes", dated July 20, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China: What Could Go Wrong?" dated August 3, 2017, available at cis.bcaresearch.com. 3 AmCham In China 2016 White Paper 4 Please see Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, available at gps.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Washington must establish a "credible threat" if it is to convince Pyongyang that negotiations offer the superior outcome; The process of establishing such a credible threat is volatile; U.S. Treasurys, along with Swiss and Japanese government bonds have been consistent safe haven assets; The risk of a U.S. attack against North Korea is a red herring, while the crisis itself is not; We suggest that investors hedge the risk with an equally-weighted basket of Swiss bonds and gold. Feature Brinkmanship between Pyongyang and Washington, D.C. has roiled markets over the past week. The uptick in rhetoric has not come as a surprise. Since last year, BCA's Geopolitical Strategy has stressed that souring Sino-American relations were the premier geopolitical risk to investors and that China's periphery, especially the Korean peninsula, would be the "decisive" factor for markets.1 North Korea's nuclear ambitions - which could be snuffed out immediately by a concerted and coordinated effort by China and the U.S. - are a derivative of the broader U.S.-China dynamic. The U.S. is unlikely to use military force to resolve its standoff with North Korea. There are long-standing constraints to war, ones that all of the interested parties know only too well from their experience in the Korean War of 1950-53. The first of these is that war is likely to bring a high death toll: Pyongyang can inflict massive civilian casualties in Seoul with a conventional artillery barrage; U.S. troops and Japanese troops and civilians would also likely suffer. Second, China is unlikely to remain neutral, given its behavior in the 1950s, its persistent strategic interest in the peninsula, and its huge increase in military strength relative to both the past and to the United States. However, the process by which the U.S. establishes a "credible threat" of military action is volatile.2 Such a credible threat is necessary if Washington is to convince Pyongyang that negotiations offer a superior outcome to the belligerent status quo. Viewed from this perspective - which is informed by game theory -President Donald Trump has not committed any grave mistakes so far, but has rather shrewdly manipulated the world's perception that he is mentally unhinged in order to enhance his negotiating leverage. It is unclear how long it will take Trump to convince North Korea that the threat of a U.S. preemptive strike is "credible." As such, it is unclear how long the current standoff will persist. From an investor perspective, it will be difficult to gauge whether the brinkmanship and military posturing are part of this "territorial threat display" or evidence of real preparations for an actual attack. As such, further volatility is likely. The ongoing crisis in North Korea is neither the first nor the last geopolitical crisis the world will face in today's era of paradigm shifts.3 We have long identified East Asia as the cauldron of investment-relevant geopolitical risks.4 This is a dynamic produced by the multipolar global context and the geopolitical disequilibrium in the Sino-American relationship. For now, investors have been able to ignore the rising global tensions (Chart 1) due to the ample liquidity emanating from central banks, but the day of reckoning is nigh (Chart 2). Chart 1Multipolarity Increases Conflict Frequency Chart 2Day Of Reckoning? Q&A On North Korea Back on April 19, we wrote a Special Report, "North Korea: Beyond Satire," which argued that North Korea had at last become a market-relevant geopolitical risk after decades of limited impact (Chart 3).5 Chart 3North Korean Provocations Rarely Affect Markets For Long Looking to the next steps, we introduced the "arc of diplomacy," a framework comparable to the U.S.-Iran nuclear negotiations from 2010-15 (Chart 4). We predicted that the U.S. would ultimately ramp up threats for the purpose of achieving a diplomatic solution. The U.S. was constrained and would only go to war if an act of war were committed, or appeared imminent.6 Chart 4Arc Of Diplomacy: Tensions Ramp Up As Nuclear Negotiations Begin This assessment is now playing out. But not all clients are convinced of our logic, as we have found in our travels throughout Asia Pacific and elsewhere this month. Below we offer a short Q&A based on questions we have received from clients: Q: Diplomacy has already been tried, so why won't the U.S. attack? A: The U.S. public has less appetite for war, especially a preemptive strike, in the wake of the Iraq War, and has not suffered a 9/11 or Pearl Harbor-type catalyst. The U.S. will exhaust diplomatic options before joining a catastrophic second Korean War. And the diplomatic options are far from exhausted. The latest round of sanctions are tighter and more serious than past ones, but still leave categories untouched (like fuel supplies to the North) and are still very hard to enforce (like cutting illegal North Korean labor remittances). Enforcement is always difficult, and the U.S. is currently attempting to ensure that its allies enforce the sanctions strictly, not to mention its rivals (i.e. Russia and China). While we do not think China will ever impose crippling sanctions, we do think it can tighten them up considerably, which could be enough to change the North's behavior. Q: Why doesn't China just take North Korea out? A: China is a formal political, military, and ideological ally of North Korea, and has a strategic interest in maintaining a buffer space on the Korean peninsula - which it defended at enormous human cost in the Korean War. This interest remains in place. China is far more likely to aid and abet a nuclear-armed ally in North Korea than it is to endorse (much less participate in) regime change. The fallout from a new war, such as North Korean refugees flooding into China, is extremely undesirable for China, though it could handle the problem ruthlessly. China would also prefer not to have to occupy a collapsing North, which would be an extensive and dangerous entanglement. Therefore, expect China to twist Pyongyang's arm but not to break its legs. On a more topical note, China is consumed with domestic politics ahead of the nineteenth National Party Congress. It is perhaps more likely to take action after the congress in October-November. Q: Will U.S. allies cooperate with Trump? Why not bandwagon with China to gain economic benefit? A: South Korea is the best litmus test for whether Trump is causing U.S. allies to drift. The new South Korean President Moon Jae-In, who is politically left-of-center, has played his cards very carefully and started out on good footing with President Trump. A disagreement appears to be a likely consequence of Moon's agenda, which calls for extensive engagement with the North and a review of the U.S. THAAD missile defense deployment in Korea. So far, however, Moon is reaffirming the alliance, in his own way, and Trump has not (yet) expressed misgivings about him. If this changes significantly - as in, South Korea joining with China to give North Korea significant economic aid in defiance of U.S. sanctions efforts - then it would be a sign of division among the allies that would benefit North Korea and could even increase the risk of the U.S. taking unilateral action. The odds of that are still low, however. We have been short the Korean won versus the Thai baht since March 1, and the trade is up 6.03%. We also expect greater volatility and higher prices of credit default swaps to plague South Korea while the crisis continues over the coming months. We are closing our long Korean consumer stocks trade versus Taiwanese exporters for a loss of 4.24%. Q: What is Japan's role in the current crisis? What is the impact on Japan? A: Japan is one of the few countries whose relations with the U.S. have benefited under the Trump administration. The Japanese are in lock-step so far in reacting to North Korea. The government has been sounding louder alarms about North Korea for the past year, including by conducting evacuation drills in the case of attack. Japan has long been within range of North Korea's missiles, but its successes in nuclear miniaturization pose a much greater threat. Not only does North Korea pose a legitimate security risk, but Japanese Prime Minister Shinzo Abe also stands to benefit at least marginally in terms of popular support and support for his controversial constitutional revision. This will, in turn, feed into the region's insecurities. Yen strength as a result of the crisis, however, would be a headwind to Japan's economic growth. Thus Abe has a tightrope to walk. We expect him to take actions to ensure the economy continues to reflate. Q: Is Trump rational? How do we know he won't push the nuclear button? A: Ultimately this is unknowable. It also involves one's philosophical outlook. Josef Stalin and Mao Zedong both committed atrocities by the tens of millions but did not use nuclear weapons. Nikita Khrushchev practically wrote the playbook that North Korea's Kim dynasty has used in making its belligerent nuclear threats. Yet Khrushchev ultimately agreed to détente. Kim Jong Un makes Trump look calm. The combination of Kim and Trump is worrisome; but so was the combination of Eisenhower and Khrushchev, one believing nuclear weapons should be used if needed, the other threatening wildly to use them. It may be the case that the threat of an atrocity, or (in Kim's case) of total annihilation, is enough to keep decisions restrained. As we go to press, Kim has ostensibly suspended his plan to fire missiles around Guam and U.S. officials have repeatedly stated that they would not attack unless attacked. Stairway To (Safe) Haven Revisited In expectation of increased frequency of geopolitical risks, BCA's Geopolitical Strategy has produced two quantitative analyses of safe haven assets over the past two years. The first, "Geopolitics And Safe Havens," unequivocally crowned gold as the ultimate safe haven (Table 1), while showing that the USD is not much of a defense against geopolitical events (Chart 5).7 Table 1Safe-Haven Demand Rises During Crises Table 1Safe-Haven Demand Rises During Crises As such, investors should fade the narrative that the failure of the USD to appreciate amidst the latest North Korean imbroglio is a sign of some structural weakness. The greenback continues to underperform due to weak inflation in the U.S., a fleeting condition that our macro-economist colleagues expect to reverse. Mathieu Savary, BCA's currency strategist, believes that more upside exists for the USD regardless of the geopolitical outcome: Chart 5Gold Loves Geopolitical Crises Chart 6DXY Is Cheap... Chart 7...But The Euro Is Not First, the dollar is currently trading at its deepest discount to the BCA Foreign Exchange Service augmented interest rate parity model since 2010 (Chart 6). The euro, which accounts for 58% of the DXY index, is its mirror image, being now overvalued by two sigma, the most since 2010 (Chart 7). Second, bullish euro bets will dissipate as Europe's economic outperformance versus the U.S. fades. Financial conditions have massively eased in the U.S., while they have tightened in Europe, resulting in the biggest upswing on euro area growth relative to the U.S. in over two years (Chart 8). Such an economic outperformance by the U.S. should lead to a strengthening greenback (Chart 9).8 Chart 8Easing Versus Tightening FCI Chart 9PMIs Point To USD Rally Our second attempt to quantify safe-haven assets, "Stairway To (Safe) Haven: Investing In Times Of Crisis," concluded that U.S. Treasurys, Swiss bonds, and Japanese bonds are the best performers in times of crisis.9 We considered 65 assets10 (Table 2) with five different methodologies and back-tested them empirically within the context of 25 financial and geopolitical events since January 1988. Some of these assets have been proven to perform as safe havens by previous academic research, some are commonly utilized in investment strategies, and others could provide alternatives (see Box 1 for further details). Table 2Scrutinizing The World For Safe Havens This report demystifies four key issues related to safe havens: Part I identifies what qualifies as a safe-haven asset. Unsurprisingly, the best performers are U.S. Treasurys along with Swiss and Japanese bonds due to their currency effects. Part II examines if safe havens change over time. We find that gold and Treasurys have changed places as safe havens, and that JGBs and Swiss bonds have a long history as portfolio protectors. Part III breaks down safe havens through an event analysis. We look at the country of origin, the nature of the crisis, and whether the risk is a "black swan" or "red herring" - two classifications of events that BCA's Geopolitical Strategy has established - all of which have an impact on their performance. But red herrings or black swans are only defined after the fact, thus requiring geopolitical analysis or market timing indicators to be able to act on them. Part IV demonstrates that timing plays a crucial part when investing in safe havens as their performance is coincident with that of equities. Box 1 Safe Havens - A Literature Review In a previous Geopolitical Strategy Special Report published in November 2015, it was established that shifts in economic and political regimes alter investors' preferences for safe-haven assets, and that Swiss bonds and U.S. 10-year Treasurys were at the top of that list.11 Also, statistical methods were used to demonstrate that gold had acted as a safe haven from the 1970s to the early 90s, but has since lost its status due in part to a new era of looming deflationary risks. Li and Lucey (2013) have identified a pattern in precious metals, through a series of quarterly rolling regressions testing the significance of the 1st, 5th and 10th percentile movements in U.S. equity movements against safe-haven assets, catching extreme negative events. For instance, the 1st percentile captures the very worst corrections that have occurred, the one that represent the bottom 1% of the equity performances. The 5th and 10th percentiles represent the 5% and 10% lowest returns for equities, respectively. The authors demonstrated that silver, platinum and palladium act as safe havens when gold does not.12 Similarly, Bauer and McDermott (2013) examined the 1st, 5th and 10th percentile movements in U.S. equity movements and proved that both gold and U.S. Treasurys can serve as safe havens, but that gold has the best record in times of extreme financial stress.13 Baele et al. (2015) concentrated on flight-to-safety episodes, which they characterized as events in which the VIX, TED spreads and a basket of CHF, JPY, and USD all increased drastically.14 They found that during flight-to-safety episodes, large cap stocks outperform small caps, precious metal and gold prices (measured in dollars) increase slightly, while bond returns exceed those of the equity market by 2.5-4 percentage points. Baur and Glover (2012) provide further evidence that gold can no longer be utilized as a safe haven due to increased speculation and hedging. Their main finding is that gold cannot be both an investment and a safe-haven asset. That is, gold can only be effective as a safe haven if the periods prior to the event had not generated significant investment demand for gold.15 Using high-frequency exchange rate data, Ranaldo and Soederlind (2010) conclude that the CHF, EUR and JPY have significant safe-haven characteristics, but not the GBP.16 The strongest safe havens are identified as the CHF and JPY, but the returns are partly reversed after a day of safe-haven protection. They also find that the nature of the crisis has a significant effect on safe-haven properties. For instance, a financial crisis and a natural disaster produced drastically different outcomes for the yen. Part I - Safety In Numbers Our first step in identifying safe-haven assets was to review each asset's performance against equities in times of crisis. As such, we conducted a series of threshold regressions to generate a list of true safe-haven assets - assets that have a statistically significant positive performance in times of turmoil. Our method is explained as follows: Step 1 - Percentile Dummies: Following methods from Li and Lucey (2013) and Bauer and McDermott (2013), we created dummy variables for the 1st, 5th and 10th percentile of the S&P 500 daily total returns since 1988. We then multiplied each of these dummies by their corresponding stock returns (see Box 1 for further detail). Step 2 - Regressions: Using the 64 potential safe-haven assets, we ran a series of regressions both in USD and the local currency, testing each asset's returns explained by the three percentile dummies.17 Step 3 - Identifying Safe Havens: We then quantified strong safe-havens as assets having significant coefficients for all three return thresholds (1st, 5th and 10th percentile of the S&P 500 daily total returns). Results - Seek Refuge In Currencies And Government Bonds: Our quantitative results are mainly consistent with what others have found in the past: the Japanese yen and most G10 government bonds are safe havens. Table 3 shows the safe-haven assets that generated negative coefficients versus equities for all three threshold percentiles. Table 3Seeking Protection Against Corrections In our threshold regressions expressed in USD terms, we found that the Japanese yen, Quality Stocks,18 and Japanese, Swiss and U.S. bonds acted as strong safe havens. Currencies play a crucial part in the performance of safe havens. In fact, in local-currency terms, a series of G10 government bonds (U.S., Canada, Belgium, France, Germany, Netherlands, Sweden, Switzerland, and the U.K.) proved to be the most useful safe havens. In sum, true or strong safe havens are government bonds that have currencies that add to positive returns during times of crisis. Unsurprisingly, this select group of strong safe-haven assets is comprised of U.S., Japanese, and Swiss government bonds. Quality Stocks did provide positive and statistically significant results, but the returns were very low - for this reason, we excluded them from our basket of strong safe havens. While gold, the Swiss franc, and the U.S. dollar did generate positive returns during times of crisis, they failed to generate statistically significant results at all three thresholds. Bottom Line: Based on our econometric work, most G10 government bonds can act as safe havens. But due to strong currency effects, our models favor what are already commonly known as safe havens: U.S., Japanese, and Swiss government bonds. Simply put, the difference between this select group and other G10 bonds is that their currencies rise or are stable during turmoil, while the currencies of the other G10 bonds do not. Part II - Are Safe Havens Like Fine Wines? U.S., Japanese, and Swiss government bonds were not always the top assets providing protection against the downside in equities, however. To determine whether safe-haven properties change, we examined the evolution of the relationship between safe havens and U.S. equity markets over time with the following model: Step 1 - Rolling Regressions: Considering the results obtained in Part I, we restricted our sample to G10 governments in USD and local-currency terms, Quality Stocks, gold, JPY, EUR, and USD for this statistical procedure. We put these remaining assets, both in USD and local-currency terms, through a series of 1-year rolling regressions.19 Step 2 - Identifying Trends: Each regression generated a coefficient that explained the relationship between equities and safe havens (B1). We created a new time series by collecting the coefficients for each data point and smoothing them using a five-year moving average, thus depicting a long-term pattern in the evolution of safe havens. Results - A Regime Shift In Gold And Treasurys: Our findings show that safe-haven assets fall in and out of favor through time (Charts 10A, B & C). Most striking are the changes in U.S. Treasurys and gold. Only after 2000 did Treasurys start providing a good hedge for equity corrections. The contrary is true for gold - it acted as one of the most secure investments during corrections until that time, but has since become correlated with S&P 500 total returns. That said, gold's coefficient has been falling closer to zero lately, illustrating that it could soon resurface as a proper safe haven, especially if deflation risks begin to dissipate. Given that this is precisely the conclusion stated by our colleague Peter Berezin - BCA's Chief Global Strategist - and our own political analysis, we suspect that gold may be resurrected as a safe haven very soon.20 Chart 10ASafe Havens Don't Necessarily Age Well Chart 10BSafe Havens Don't Necessarily Age Well Chart 10CSafe Havens Don't Necessarily Age Well Another important finding is that the currency effect plays a key role during recent risk-off periods (Charts 11A & B). The best protector currencies are the ones that are negatively correlated with equity returns. According to our results, the CHF and the JPY have generally been risk-off currencies, while the USD has only been one since 2007, switching places with the euro. This reinforces the case for U.S., Japanese, and Swiss government bonds, which are supported by risk-off currencies. Chart 11ACurrencies Are Difference Makers Chart 11BCurrencies Are Difference Makers Bottom Line: Safe havens change over time. Gold fell out of favor due to global deflationary dynamics. With inflation on the horizon, we will keep monitoring the relationship between gold and equities for a possible return of the yellow metal as a safe haven. Since the July 4 North Korean ICBM test, for example, gold has rallied 4.8%. Part III - Red Herrings And Black Swans Since 1988, we identified 25 economic and (geo)political events that generated instant panic or acute uncertainty in the media and financial markets.21 We analyzed the short-term reactions of the safe-haven assets, both in USD and local-currency terms. This methodology allowed for the deconstruction of the impact of the events by the following factors: Country of origin of the crisis, the nature of the crisis, and whether the event was a "red herring" or a "black swan." Generally speaking, a red herring event is a crisis of some sort with little lasting financial impact. A black swan, on the other hand, is an event that has a very low probability of occurring but has a pronounced market impact if it does. Quantitatively, our definition of a black swan is an event that produces an immediate negative response in the S&P 500 below -1%, while creating a rise in either U.S., Japanese, or Swiss government bonds above 0% (Table 4). Of course, determining which event is a red herring or a black swan is only obvious post-facto and thus requires thorough geopolitical analysis. Table 4Understanding The Crises Results - Red Herrings And Black Swans Matter: Our event analysis solidifies our findings with regards to U.S., Japanese, and Swiss government bonds, but also builds a case for some European bonds as well as gold during black swan events. Our main findings can be summarized as follows. Fade The Red Herrings: Out of the sixteen geopolitical events, ten were identified as red herrings, in which safe havens underperformed the equity market. This, then, suggests that it is not always beneficial to buy safe-haven assets when tensions are rising. What is interpreted as a major geopolitical crisis - say, Ukraine in 2014 or Greece in 2015 - often ends up being a "red herring." Geopolitical Risk = Gold: Geopolitical black swan events, on the other hand, have a significant, negative impact on the market. During these events, gold emerges as the strongest hedge against a downturn in equities. U.S. Treasurys And The Swiss Franc Provide A Baseline: Under all black swan events considered - geopolitical and non-geopolitical - U.S. Treasurys and the Swiss franc had the strongest performance, generating positive returns on the day of the stock market crash in 85% of the cases. G10 Government Bonds Will Also Do: German, Dutch, Swiss and Swedish government bonds also provided protection during black swan events in local and common-currency terms, albeit to a lesser extent. U.S. And Swiss Bonds Outperform During Financial Episodes: During black swan financial crises, Swiss and U.S. government bonds stand out as the best safe havens due to their capacity to generate positive returns both in USD and local-currency terms in eight out of the nine examined crashes. Other findings that are interesting, yet less robust due to a limited sample size, include: When the crisis originated on U.S. soil, U.S. Treasurys and the dollar performed relatively poorly compared to other safe-haven assets. This is a somewhat surprising finding, as most investors believe that U.S. assets rally even at a time of U.S.-based crises, such as the 2011 budget crisis. We show that they may perform well, but in USD, non-U.S. based assets do better. When the crisis originated in Europe, European bonds performed very well both in USD and local-currency terms. When the crisis originated in Europe, Swiss and U.K. government bonds performed poorly in USD terms, but offered strong protection in local-currency terms. When the crisis originated in Russia, precious metals acted as a poor hedge. Bottom Line: It is crucial to gain an understanding of the nature of any potential crisis. Red herrings should always be faded, not hedged against, as they produce poor results in safe-haven assets. U.S. Treasurys, Swiss and Japanese government bonds have been very consistent safe-haven assets during previous periods of acute risk. Part IV: Timing Is Everything As a final step in our quantitative approach, we put our results through numerous timing exercises to test how the assets would perform in real time. Based on our Risk Asset Spectrum (Diagram 1), which summarizes our findings, one could argue that investing in times of crisis simply boils down to buying an equal-weighted basket of U.S. Treasurys, Swiss, and Japanese government bonds. Although this is technically true, such a strategy would require perfect foresight, unparalleled timing, or dumb luck - since black swan events are, by definition, very difficult to predict. Diagram 1Risk Asset Spectrum Proof Of The Ultimate Safe Haven: The first experiment we conducted was to illustrate how powerful safe havens can be when timed perfectly in a trading strategy. We started off by comparing two baskets. The first was a benchmark portfolio comprised of 60% U.S. equities and 40% U.S. bonds. The other contained the same two assets, but with 100% allocated to a basket comprised of U.S. Treasurys, Swiss, and Japanese government bonds during times of negative returns for equities. Of course, this strategy is not realistic and would be impossible to implement, since the trading rule depends on future events. But as Chart 12 shows, if one were able to predict every single period of negative returns for global equities and hold safe-haven assets instead, the trading rule would outperform almost 10-fold. Chart 12Safe Havens Work Wonders With Perfect Information... One-Month Lag Is Already Too Late: Repeating the same exercise, but with a one-month lag in the execution, produces drastically different results. More specifically, whenever the previous month's equity return is negative (t=0), the portfolio allocates 100% to a single safe-haven asset for the current month (t=1), otherwise it keeps the allocation identical to that of the benchmark. The rationale for using such a simple rule is that average investors are generally late in identifying a crisis and only react once they have validation that the market is in a correction. Chart 13 shows that being late by one month changes the performance of the safe haven basket from astronomically outperforming the benchmark to underperforming it. Chart 13... But Timing Is Everything Reaction Is Key: As a final timing exercise, we analyzed the reaction function of our assets to see how quickly they react after the correction in equities begins (Chart 14). Unsurprisingly, the top assets that we identified start appreciating as soon as the crisis hits (t=0). Gold is, on average, the quickest asset to react from investors seeking refuge. Swiss bonds come in as a close second, almost mirroring gold during the first few days of the correction. But both assets start to flatten out and even roll over after a few days. Japanese bonds react slightly later than gold and Swiss bonds, but keep increasing for a longer period of time and start plateauing around the 30th day after the crisis. U.S. Treasurys and Quality Stocks, on the other hand, remain rather flat and constant over the short term. These results attest to the importance of timing the crisis using the best safe-haven assets. Chart 14Safe Havens React Instantly Bottom Line: Timing plays a crucial part in investing in safe-haven assets, as their performance is coincident to that of equities. Investment Implications: Is Pyongyang A Red Herring Or A Black Swan? The results of our quantitative analysis are clear: hedging geopolitical risk depends on whether it is persistent or fleeting. So, is Pyongyang a red herring or a black swan? From our geopolitical analysis we make three key conclusions: The U.S. is not likely to preemptively attack North Korea; However, the U.S. has an interest in signaling that it may conduct precisely such an attack; Brinkmanship could last for a long time. Even if the risk of a U.S. attack against North Korea itself is a red herring, the crisis itself is not. In fact, between now and when a negotiated solution emerges, investors may face several new crises, which may include limited military attacks or skirmishes. While markets have faded such North Korean provocations in the past, the current context is clearly different. As such, we would suggest that investors hedge the risk with an equally-weighted basket of Swiss bonds and gold. Even though a "buy and hold" strategy with such a "Doomsday Basket" will likely underperform the market if tensions with North Korea subside, we are betting that it may take time for the U.S. and North Korea to get to the negotiating table. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com David Boucher, Associate Vice President Quantitative Strategist davidb@bcaresearch.com 1 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 6, 2016, available at gis.bcaresearch.com. We upgraded North Korea to the status of a genuine market-relevant risk in "North Korea: A Red Herring No More?" in Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Client Note, "Trump Re-Establishes America's 'Credible Threat'," dated April 7, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2017 available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0," dated September 25, 2012, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. In particular, we argued, "the current saber-rattling is carefully orchestrated. But North Korea can no longer be consigned to the realm of satire. The very fact that the U.S. administration is adopting greater pressure tactics makes this year a heightened risk period. Investors should be especially wary of any missile tests that reveal North Korean long-range capabilities to be substantially better than is known to be the case today." Then, on May 13 and July 4, North Korea conducted its first ICBM launches; the UN Security Council agreed to a new round of even tighter economic sanctions on August 5; and the U.S. and North Korea engaged in an alarming war of words. 6 Specifically, we wrote: "Diplomacy is the only real option. And in fact it is already taking shape. The theatrics of the past few weeks mark the opening gestures. And theatrics are a crucial part of any foreign policy. The international context is looking remarkably similar to the lead-up to the new round of Iranian negotiations in 2012. The United States pounded the war drums and built up the potential for war before coordinating a large, multilateral sanctions-regime and then engaging in talks with real willingness to compromise." 7 Please see BCA Geopolitical Strategy Special Report, "Geopolitics And Safe Havens," dated November 11, 2015, available at gps.bcaresearch.com. 8 Please see BCA Foreign Exchange Strategy Weekly Report, "Fade North Korea, And Sell The Yen," dated August 11, 2017, available at fes.bcaresearch.com. 9 Please see BCA Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com. 10 Forty-one assets were denominated in USD only, while G10 bonds, Credit Suisse Swiss Real Estate Fund, and European 600 real estate were used both in local-currency terms and USD, for a total of 65 assets. 11 Please see Geopolitical Strategy Special Report, "Geopolitics And Safe Havens," dated November 11, 2015, available at gps.bcaresearch.com. 12 Sile Li and Brian M. Lucey, "What precious metals act as safe havens, and when? Some U.S. evidence," Applied Economic Letters, 2013. 13 Dirk G. Bauer and Thomas K.J. McDermott, "Financial Turmoil and Safe Haven Assets," 2013. 14 Lieven Baele, Geer Bekaert, Koen Inghelbrecht and Min Wei, "Flights to Safety," National Bank of Belgium Working Paper No. 230, 2015. 15 Dirk G. Baur and Kristoffer J. Glover, "The Destruction of Safe Haven Asset?,"2012. 16 Angelo Ranaldo and Paul Soederlind, "Safe Haven Currencies," Review of Finance, Vol. 10, pp. 385-407, 2010. 18 Quality stocks are defensive equity plays with high, steady earnings with an elevated return on investments. They are estimated by Deutsche Bank's Factor Index Equity Quality Excess Return in USD. 20 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation)," dated July 13, 2016, available at gps.bcaresearch.com, and BCA Global Investment Strategy Weekly Report, "A Secular Bottom In Inflation," dated July 28, 2017, available at gis.bcaresearch.com. 21 Since we were interested in the immediate, often unexpected, response to the event, we did not include economic recessions in our event analysis.

Highlights A number forward-looking indicators for EM corporate profits point to a major deceleration in the next several months, and potentially a contraction early next year. The most reliable forward-looking indicators for EM EPS have been EM/China narrow and broad money growth and they herald a bearish outlook for EM EPS. We continue deciphering the differences between China's various money and credit aggregates. Irrespective of which money measure we use, and regardless of their past track record, all of them are currently extremely weak and point to a major and imminent slump in China's growth in the next six to 12 months. We recommend shifting the underweight EM corporate and sovereign credit position versus U.S. high-yield to underweight versus U.S. investment-grade corporate credit. Feature Chart I-1Asian Exports And EM EPS The recovery in EM earnings per share (EPS) has been instrumental to the EM stock rally this year. As such, the equity strategy at the moment hinges on the outlook for corporate profits. In this report, we revisit coincident and leading indicators for EM profits. At the moment, EM corporate profit growth still appears robust, though several forward-looking indicators point to a major deceleration in the next several months, and potentially a contraction early next year. Korean and Taiwanese exports can be used as proxy for global trade. The latest data for July reveal that the sum of Taiwanese exports and Korean total exports excluding vessels has rolled over (Chart I-1). Historically, the U.S. dollar values of both economies' exports have correlated with EM EPS, and Chart I-1 entails that EM EPS growth will roll over very soon. The reason why we exclude vessel exports in the case of Korea is because vessel shipments are one-off occurrences and when they take place, they distort export growth. This was the case in the last several months - vessel (shipbuilding) exports surged by 75% from a year ago, distorting the annual growth rate of total exports. Overall, Korea's and Taiwan's overseas shipments in the past three months have averaged about 10%, which is lower than the mid-teen growth rates recorded earlier this year. In China, export growth is close to 9% in the past three months, and it is also rolling over. On a similar note, Korea's and Taiwanese shipments-to-inventory ratios lead EM EPS cycles, and they are presently sending a downbeat message (Chart I-2). China's import growth has relapsed, as suggested by both Chinese trade data and their counterparties export data to China (Chart I-3). Chart I-2Asia's Shipment-To-Inventory Ratios And EM EPS Chart I-3Exports To China And Chinese Imports The recovery in Chinese imports has been responsible for a considerable part of the recovery in global trade. Importantly, Chinese import cycles correlate very well with EM EPS growth (Chart I-4). The key pillar of our view remains that Chinese imports will contract going forward, which will depress both advanced and developing countries' shipments to China. Exports to China are much more important for EM than DM economies, and deteriorating sales to China will weigh considerably on EM profits and currencies. The most reliable forward-looking indicators for EM EPS have been EM/China narrow and broad money growth. Chart I-5A and Chart I-5B demonstrate that both EM narrow (M1) growth and China's broad money impulse (the second derivative) - herald a major slump in EM EPS. This is the main reason behind our negative stance on EM share prices and other risk assets. Chart I-4Chinese Imports And EM EPS Chart I-5AChina Broad Money Impulse And EM EPS Chart I-5BEM Narrow Money And EM EPS Both narrow and broad money growth in China have already relapsed, and it is a matter of time until economic growth and imports downshift enough to produce a major selloff in EM risk assets. We discuss China's monetary aggregates in the section below. Finally, if Chinese imports and commodities prices relapse, any reasonable strength in DM domestic demand will not be sufficient to preclude a meaningful EM slowdown. The basis is that exports to the U.S. and EU only make up 7% of GDP for China, 8% for Korea and 11% for Taiwan. While exports to China account for 10% of Korean GDP and 15% of Taiwanese GDP. The same holds true for most East Asian countries. With the exceptions of India and Turkey, non-Asian EM countries are primarily commodities producers. These two have their own idiosyncratic problems. Most of our analysis is not applicable to smaller central European economies that are leveraged to the EU business cycle. That said, neither Turkey, India, nor central European markets have large enough financial markets to make a difference in the EM benchmarks. The above is the primary reason behind our bearish view on EM growth and profits. That said, there are a few other interesting considerations regarding EM corporate profits dynamics. First, EM share prices lead EM EPS by six to nine months. Therefore, to be bullish on EM stocks, it is not sufficient to expect EM EPS growth to be robust over the next three months. Rather, to be bullish on EM stocks at the current juncture, one should have a bullish view on EM EPS by the end of this year and into the early part of 2018. Consistently, we believe that EM EPS growth will decelerate materially by the end of this year and shrink in the early part of 2018. Second, the top-line shrinkage in 2015 and the consequent recovery for EM exporters has been mostly driven by prices rather than volumes. Chart I-6A illustrate that Korean, Taiwanese and Chinese manufacturing production growth is rather muted. Chart I-6ACorporate Pricing Power Chart I-6BAsian Manufacturing Production Price fluctuations affect profits much more than output volume changes. Therefore, if global tradable goods prices deflate - at the moment they have rolled over (Chart I-6B) - EM EPS will contract materially. Third, in EM excluding China, Korea and Taiwan, there has been little economic recovery, as evidenced by Chart I-7. Along the same lines, the latest (July) manufacturing PMI for EM ex-China, Korea and Taiwan has dropped below the crucial 50 line (Chart I-7, bottom panel). This and the majority of other economic aggregates we use are equity market-cap weighted averages, so they are relevant to investors. This corroborates the fact that outside China, Korea and Taiwan there has been little genuine growth improvement in EM domestic demand - despite the decent recovery in global trade. This challenges the prevailing widespread consensus of a synchronized global economic recovery/expansion. This is also consistent with the fact that the overwhelming EM profit recovery has occurred in technology and resource sectors while domestic sectors have not seen much of corporate earnings recovery (Chart I-8). Chart I-7EM Ex-China, Korea And Taiwan: ##br##No Strong Recovery Chart I-8EM Sectors' EPS: Exporters ##br##Have Outperformed Domestic Finally, bottom-up equity analysts have recently downgraded their EPS estimates for listed EM companies (Chart I-9). Typically, analysts alter their forecasts simultaneously with swings in share prices. Hence, the latest decoupling is puzzling. Chart I-9EM EPS And Analysts' Net Revisions Notably, EM net EPS revisions have failed to move into positive territory in the past 7 years. This entails that analysts' expectations have been chronically high in recent years, and/or that companies have failed to deliver profits that match these projections. Bottom Line: The EM EPS outlook is downbeat, and listed companies profits will likely contract early next year. Deciphering China's Money Puzzle Based on our assessment of multiple measures, our conclusion with respect to Chinese broad money growth is as follows: Irrespective of which measure we use, and regardless of their individual past track records, all Chinese monetary growth aggregates are currently weak (Chart 10), and point to a major and imminent slump in China's growth in the next six to 12 months. In recent weeks, we have been working to understand differences among various measures of money growth in China. Our motivation is because neither M2 nor total social financing and fiscal spending - variables that we relied on last year - did a good job of forecasting the duration and magnitude of China's economic and profit revival in the past 12 months. In our July 26 report,1 we introduced the concept of broad money calculated using commercial banks' assets. We called it credit-money. This week, we discuss a different broad money calculation based on commercial banks' liabilities, and refer to it as deposit-money. Deposit-money is an aggregate of non-financial companies' time and demand deposits, household deposits, transferable and other deposits, other liabilities, bonds issued and liabilities to non-depository financial corporations. This measure is broader than official broad money (M2) because the latter includes only non-financial companies' time and demand deposits, household deposits and some of liabilities to non-depository financial corporations. In brief, our deposit-money calculation is more comprehensive than the official broad money figures (M2). In turn, banks' credit-money is the sum of commercial banks' claims on companies, households, non-bank financial institutions and all levels of government, as well as banks' foreign assets. Also, we deduct government deposits at the central bank (see July 26 Emerging Markets Strategy report1 for more details). Chart I-10 illustrates the differences between credit-money, deposit-money, total social financing and M2. Based on our calculations, deposit-money grew faster in 2015-'16 than both M2 and total social financing. Yet its current and ongoing slowdown is as bad as that of credit-money or M2. Chart I-10Dichotomy Among Various Money And Credit Aggregates In China The reason why M2 growth has lagged behind deposit-money growth since the middle of 2015 until now is the fact that the latter's components that are not included in the official M2 measure have outpaced M2 growth by a wide margin since late 2015. The main components of deposit-money are shown in Chart I-11. This is one of the main reasons why we missed the latest China-play rally - we relied on the official measure of money and credit published by the PBoC that has been much tamer than the broader money and credit, as banks have originated credit and hence money in a way that official monetary aggregates have not captured. In addition, banks' credit-money and deposit-money measures should theoretically be identical, but this has not been the case in China in recent years. Deposit-money is larger and it may well be more comprehensive than credit-money (Chart I-12). Chart I-11China: Components Of Deposit-Money Aggregate Chart I-12The Outstanding Stock And Flow Of Money Understanding these discrepancies is an ongoing work-in-progress for us, and we will be refining these measures going forward. For now, we would say that these differences are probably due to banks' efforts to misrepresent/hide their assets and liabilities to meet the regulatory ratios and avoid penalties, as well as maximize short-term profits. All that said, the gaps between M2 and deposit-money has recently narrowed: both deposit-money and M2 growth and their impulses are at all-time lows (Chart I-13). Furthermore, we expect deposit-money to slow further because of the lagged impact of higher interest rates and regulatory tightening that is intended to curb commercial banks' ability to originate more money via shadow banking activities. Finally, as can be seen from Chart I-14A, Chart I-14B and Chart I-15, deposit-money's impulse - its second derivative - leads many cyclical economic variables such as nominal GDP, producer prices, freight index, and imports. Chart I-13China: Two Measures Of Broad Money Chart I-14ADeposit-Money Leads Real Business Cycle Chart I-14BDeposit-Money Leads Real Business Cycle There are several other data points from China's real economy that portend developing weakness. Specifically, car sales growth has almost ground to a halt, real estate floor space sold and started are decelerating (Chart I-16). Chart I-15Deposit-Money Leads Metals Prices And Construction Chart I-16China: More Signs Of Slowdown Bottom Line: Regardless of which money measure we use, and regardless of their past track record, all of them are currently weak and point to a major and imminent slump in China's growth in the next six to 12 months. This gives us confidence in reiterating our negative view on China plays (including commodities) and EM. Credit Markets Strategy We have been recommending a strategy of shorting/underweighting EM sovereign and corporate credit versus U.S. high-yield (HY) credit and this strategy has shown strong performance, producing 15% gains with low volatility since August 2011 (Chart I-17). However, today we recommend shifting the underweight EM corporate and sovereign credit position from U.S. HY to U.S. investment grade (IG) corporate credit. The primary reason is that credit spreads are extremely tight and odds favor credit spreads widening in both U.S. and EM. Chart I-18 shows that when U.S. TIPS yields rise U.S. IG usually outperforms U.S. HY on an excess return basis. We expect U.S. Treasurys and TIPS yields to grind higher in the near term because U.S. growth and inflation are much stronger than the bond market is currently pricing in. Chart I-17Book Gains On This Strategy Chart I-18Higher U.S. Bond (TIPS) Yields Warrant Rotation Rising U.S. bond yields also warrants EM credit underperformance versus U.S. IG because the EM credit benchmark is riskier than U.S. IG. While the two segments have similar durations, the duration times spread measure of risk is greater for EM credit. Furthermore, U.S. HY spreads have narrowed versus both EM sovereign and corporate spreads since early 2016 (Chart I-19, top panel). Hence, there is little value favoring the former versus EM credit. In contrast, U.S. IG spreads versus both EM sovereign and corporate credit are appealing historically (Chart I-19, bottom panel). Therefore, there is a valuation aspect to this strategy change. Relative spread differences have historically correlated quite well with the subsequent 12-month return. Given where relative spreads are, the subsequent 12-month return for investing in U.S. IG relative EM credit is positive (Chart I-20, top panel) but it is negative for investing in U.S. HY versus EM credit (Chart I-20, bottom panel). Chart I-19EM Credit Offers Value Relative ##br##To U.S. HY But Not Versus U.S. IG Chart I-20Projected Returns Of EM Credit ##br##To Both U.S. IG And HY As to the rationale of favoring U.S. credit to EM credit, this is consistent with our theme that the growth outlook, corporate leverage, and health of the banking system are in much better shape in the U.S. than in EM. Bottom Line: Book profits on the short EM sovereign and corporate credit / long U.S. HY credit position. Institute a new position: short EM sovereign and corporate credit / long U.S. IG corporate credit. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report, titled "Follow The Money, Not The Crowd", dated July 26, 2017, link available on page 18. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Special Report

Highlights Unilateral economic sanctions show that geopolitical risks are rising in Asia Pacific; China is using sanctions to get its way with its neighbors; South Korea was the latest victim, and will be rewarded for its pro-China shift; Trump's Mar-a-Lago honeymoon with Xi Jinping is over; Tactically, go long South Korean consumers / short Taiwanese exporters. Feature Geopolitical risk is shifting to the Asia Pacific region - and the increasing use of economic sanctions is evidence of the trend. Korean stocks have rallied sharply since the leadership change from December 2016 through May of this year (Chart 1). The impeachment rally was entirely expected after a year of domestic political turmoil.1 The election is also eventually expected to decrease Korean geopolitical risks - the country's new President Moon Jae-in, of the left-leaning Democratic Party, aims to patch up relations with China and revive diplomacy with North Korea.2 Chart 1South Korean Impeachment Rally Over A key barometer of Moon's success will be whether he convinces China to remove economic sanctions imposed since last summer as punishment for his predecessor's agreement to host the U.S. THAAD missile defense system. Moon has suspended the system's deployment in a nod to China.3 South Korea is thus the latest example of an important trend in the region: China's successful use of "economic statecraft" to pressure wayward neighbors into closer alignment with its interests. Since 2014, Thailand, Malaysia, Vietnam and the Philippines have each sought in different ways to reorient their foreign policies toward China, either to court Chinese assistance or get relief from Chinese pressure. Judging by our research below, the rewards are palpable, and a sign of Beijing's rising global influence. Because U.S.-China tensions are rising structurally, we see these country-by-country shifts toward China not as a decisive loss for the U.S. alliance but rather as the latest phase in a long game of tug-of-war that will intensify in the coming years.4 Hence the trend of unilateral economic sanctions will continue. Who is next on China's hit list? How will the U.S. respond? What countries are most and least likely to be affected? And what are the market implications? China's Economic Statecraft The United States launched a "pivot to Asia" strategy under the Obama administration to reassert American primacy in Asia Pacific and address the emerging challenge from China. The U.S.'s Asian partners largely welcomed this shift. Over the preceding decade, they had struggled with China's emergence as a military and strategic superior. The most prominent flashpoints came in the East and South China Seas. Beijing's newfound naval and air power caused regional anxiety. As the allies invited a larger U.S. role, Beijing began to assert its sovereignty claims over disputed waters and rocks, most ambitiously by creating artificial islands in the South China Sea and fortifying them with military capabilities. In three notable periods since the Great Recession, China's tensions with its neighbors have splashed over into the economic realm, prompting Beijing to impose punitive measures: Chart 2Japan's 2012 Clash With China Chart 3Chinese Boycotted Japanese Cars... Japan 2010-2012: In 2010, China and Japan clashed as the former challenged Japan's control of the Senkaku (Diaoyu) islands in the East China Sea. In the September-November 2010 clash, China notoriously cut off exports of rare earths to Japan.5 A greater clash occurred from July-November 2012. Chinese people rose up in large-scale protests, damaging Japanese and other foreign property and assets. Impact: The growth of Japanese exports to China slowed noticeably between the 2010 and 2012 clashes, underperforming both that of China's neighbors and Europe (Chart 2). In particular, Chinese consumers stopped buying as many Japanese cars and switched to other brands (Chart 3). Chinese investment in Japan, which is generally very small, fell sharply in the year after the major 2012 clash, by contrast with the global trend (Chart 4). Chinese tourism to Japan also fell sharply after both incidents, though only for a short period of time (Chart 5). Chart 4...And Cut Investments In Japan... Chart 5...While Tourists Went Elsewhere Philippines 2012-2016: Tensions between China and the Philippines over the contested Spratly Islands and other rocks in the South China Sea have a long history. The latest round began in the mid-2000s, and the two countries have skirmished many times since then, including in a major showdown at Scarborough Shoal in 2012 that required the intercession of the United States to be resolved. The pressure intensified after January 2013, when the Philippines brought a high-profile case against China's maritime-territorial claims to the Permanent Court of Arbitration at the Hague. The U.S. and the Philippines upped the ante in April 2014 by signing an Enhanced Defense Cooperation Agreement. Ultimately, the court dealt a humiliating blow to China's maritime-territorial claims in July 2016, but a bigger confrontation was avoided because of what had happened in the remarkable May 2016 Philippine elections, which put China-friendly populist President Rodrigo Duterte in Manila on July 1. Impact: China tightened phytosanitary restrictions on Philippine bananas during the 2012 crisis and Philippine exports to China underperformed those of its neighbors after the onset of diplomatic crisis in 2013 (Chart 6). Nevertheless, the overall impact on headline exports is debatable. Tourism suffered straightforwardly both after the 2012 showdown at sea and after the new U.S.-Philippines military deal in 2014 (Chart 7). As with Japan, the impact was temporary. Chart 6Philippine Clash With China Over Sovereignty Chart 7Chinese Tourists Snub The Philippines Vietnam 2011-14: China's quarrels with Vietnam go back millennia, but in recent years have centered on the South China Sea. As with the Philippines, frictions began rising in the mid-2000s and flared up after the global financial crisis. In the summer of 2012, Vietnam and China engaged in a dispute over new laws encompassing their territorial claims. In May 2014, the two countries fought a highly unorthodox sea-battle near the Paracel Islands. Anti-Chinese protests erupted throughout Vietnam, prompting China to restrict travel.6 Impact: It is not clear that China imposed trade measures against Vietnam - export growth was plummeting in 2012 because of China's nominal GDP slowdown as well - but certainly exports skyrocketed after the two sides began tothaw diplomatic relations in August 2014 (Chart 8).7 Direct investment from China into Vietnam fell in 2014, even as that from the rest of the world rose. Chinese tourism to Vietnam shrank in the aftermath. Chart 8Vietnam Reboots China Trade The above incidents complement a growing body of academic research demonstrating China's use of unilateral economic sanctions and their trade and market impacts.8 Bottom Line: China has employed unilateral, informal, and discrete economic sanctions and has encouraged or condoned citizen boycotts and popular activism against Japan, the Philippines, Vietnam, Taiwan, and other states since at least the early 2000s. Moreover, three international confrontations since 2010 suggest that China's foreign policy is growing bolder - it is not afraid to throw its economic weight around to get what it wants politically or to deter countries from challenging its interests. How Significant Is China's Wrath? Both our evidence and the scholarly literature reveal that China-inflicted economic damage tends to be temporary and sometimes ambiguous from a macro-perspective.9 For instance, if there were negative trade effects of Vietnam's 2014 clash with China, they were overwhelmed by Vietnam's rising share of China's market in the following years (Chart 9). And, as hinted above, Chinese sanctions on Philippine banana exports in 2012 can be overstated according to close inspection of the data.10 Nevertheless, since 2016, three new episodes have reinforced the fact that China's punitive measures are a significant trend with potentially serious consequences for Asian economies: Taiwan 2016: Taiwanese politics have shifted away from mainland China in recent years. The "Sunflower Protests" of 2014 marked a shift in popular opinion away from the government's program of ever-deeper economic integration with the mainland. Local elections later that year set the stage for a sweeping victory by the Democratic Progressive Party (DPP), taking both the presidency and, for the first time, the legislature, in January 2016.11 Tsai is a proponent of eventual Taiwanese independence and dissents from key diplomatic agreements with the mainland, the "One China Policy" and "1992 Consensus." Within six months of the election Beijing had cut off diplomatic communication. Impact: The number of mainland visitors has nosedived, by contrast with global trends (Chart 10). Taiwan's exports and access to China's market are arguably weaker than they would otherwise be. Given the historic cross-strait Economic Cooperation Framework Agreement in 2010, and the strong export growth in the immediate aftermath of that deal, it is curious that exports have been so weak since 2014 (Chart 11). Chart 9China Flings Open Doors To Vietnam Chart 10Mainland Tourists Punish Rebel Taiwan Chart 11So Much For Cross-Strait Trade Deals? South Korea 2016-17: China and South Korea are on the cusp of improving relations after a year of Beijing-imposed sanctions. The former government of President Park Geun-hye, who was impeached in December 2016 and removed from office in March this year, moved rapidly with the U.S. to deploy the THAAD missile defense system on South Korean soil while her government was collapsing, so as to make it a fait accompli for her likely left-leaning (and more China-friendly) successor. Her government agreed to the deployment in July 2016 and since then China has exacted substantial economic costs via Korean exports and Chinese tourism.12 The new President Moon Jae-in is now calling on China to remove these sanctions, while initiating an "environmental review" that will delay deployment of THAAD, possibly permanently. Impact: South Korean exports to China have underperformed the regional trend throughout the downfall of the Park regime and its last-minute alliance-building measures with both the U.S. and Japan (Chart 12). South Korea has also lost market share in China since agreeing to host THAAD in July 2016 (Chart 13). Furthermore, Korean car sales on the mainland have deviated markedly both from their long-term historical trend and from Japan's contemporary sales (Chart 14), the inverse of what occurred in 2012 (see Chart 3 above). Chinese tourism to South Korea has sharply declined. Chart 12China Cools On Korean Imports Chart 13China Hits South Korea Over THAAD Chart 14Korean Car Sales And Tourist Sales Slump North Korea 2016-17: Ironically, China brought sanctions against both Koreas last year - the South for THAAD, the North for its unprecedented slate of missile and nuclear tests. These provoked the United States into pressuring China via "secondary sanctions." Impact: China's sanctions on the North - which include a potentially severe ban on coal imports - are limited so far, according to the headline trade data, as China is wary of destabilizing the hermit kingdom (Chart 15). But if China does grant President Trump's request and increase the economic pressure on North Korea, it will be no less of a sign of a greater willingness to utilize economic statecraft, especially given that the North is China's only formal ally. Other countries will not fail to see the implications should they, like either Korea, cross Beijing's interests. Bottom Line: Doubts about China's new foreign policy "assertiveness" are overstated. China is increasing its unilateral use of economic levers to pressure political regimes in its neighborhood, including major EMs like Taiwan and South Korea over the past year. Korean President Moon Jae-in's rise to power is likely to produce better Sino-Korean relations, but neither it nor Taiwan is out of the woods yet, according to the data. Moreover, the rest of the region may be cautious before accepting new U.S. military deployments or contravening China's demands in other ways. The Asian "Pivot To China" Over the past two years, several Asian states have begun to vacillate toward China, not because they fear American abandonment but because the U.S. "pivot" gave them so much security reassurance that it threatened to provoke conflict with China - essentially risking a new Cold War. They live on the frontlines and wanted to discourage this escalation. At the same time, the growth slump in China/EM in 2014 - followed by China's renewed stimulus in 2015 - encouraged these states to improve business with China. Thailand began to shift in 2014, when a military junta took power in a coup and sought external support. China's partnership did not come with strings attached, as opposed to that of the U.S., with its demands about democracy and civil rights.13 The rewards of this foreign policy shift are palpable (Chart 16). China signed some big investment deals and improved strategic cooperation through arms sales. It did the same with Malaysia for similar reasons.14 China's "One Belt One Road" (OBOR) economic development initiative provided ample opportunities for expanding ties. Chart 15No Chinese Embargo On North Korea... Yet Chart 16China Opens Doors To Thai Junta The year 2016 was a major turning point. Three of China's neighbors - two of which U.S. allies - underwent domestic political transitions ushering in more favorable policies toward China: Vietnam: The Vietnamese Communist Party held its twelfth National Congress in January 2016. Prime Minister Nguyen Tan Dung, a pro-market reformer from the capitalist south, failed to secure the position of general secretary of the party and retired. The incumbent General Secretary Nguyen Phu Trong retained his seat, and oversaw the promotion of key followers, strengthening Vietnam's pro-China faction. Since then Trong has visited President Xi in Beijing and signed a joint communique on improving strategic relations. As mentioned above, Vietnamese exports to China have exploded since tensions subsided in 2014. South Korea: In April 2016, South Korean legislative elections saw the left-leaning Democratic Party win a plurality of seats, setting the stage for the 2017 election discussed above, when Korea officially moved in a more China-friendly direction under President Moon. The Philippines: In May 2016, the Philippines elected Duterte, a firebrand southern populist who declared that the Philippines would "separate" itself from the U.S. and ally with Russia and China. Though Duterte has already modified his anti-American stance - as we expected - he is courting Chinese trade and investment at the expense of the Philippines' sovereignty concerns.15 Trump's election contributed to this regional trend. By suggesting a desire for the U.S. to stop playing defender of last resort in the region, Trump reinforced the need for allies like Thailand, the Philippines, and South Korea to go their own way. And by canceling the Trans-Pacific Partnership, Trump forced Malaysia and Vietnam to make amends with China, while vindicating those (like Thailand and Indonesia) that had remained aloof. Bottom Line: Having brandished its sticks, China is now offering carrots to states that recognize its growing regional influence. These do not have to be express measures, given that China is stimulating its economy and increasing outbound investment for its own reasons. All China need do is refrain from denying access to its market and investment funds. Whom Will China Sanction Next? Geopolitical risk on the Korean peninsula remains elevated given that North Korea remains in "provocation mode" and Trump has prioritized the issue. However, we expect that Moon will cooperate with China enough to give a boost to South Korean exports and China-exposed companies and sectors. With South Korea's shifting policy, Beijing has a major opportunity to demonstrate the positive economic rewards of pro-China foreign policy. If a new round of international negotiations gets under way and North Korean risk subsides for a time (our baseline view),16 then East Asian governments will turn to other interests. We see two key places of potential confrontation over the next 12-24 months: Taiwan is the top candidate for Chinese sanctions going forward. The cross-strait relationship is fraught and susceptible to tempests. The ruling DPP lacks domestic political constraints, which could be conducive to policy mistakes. Moreover, Trump has signaled his intention to strengthen the alliance with Taiwan, which could cause problems. China is likely to oppose the new $1.4 billion package of U.S. arms more actively than in the past, given its greater global heft. Trump's initial threat of altering the One China Policy has not been forgotten. In terms of timing, China may not want to give a tailwind to the DPP by acting overly aggressive ahead of the 2018 local elections, which are crucial for the opposition Kuomintang's attempt to revive in time for the 2020 presidential vote. But this is not a hard constraint on Beijing's imposing sanctions before then. Japan is the second-likeliest target of Chinese economic pressure. Japanese Prime Minister Shinzo Abe is up for re-election no later than December 2018 and is becoming more vulnerable as he shifts emphasis from pocketbook issues to Japan's national security.17 Needless to say, the revival of the military is the part of Abe's agenda that Beijing most opposes. China would like to see Abe weakened, or voted out, and would especially like to see Abe's proposed constitutional revisions fail in the popular referendum slated for 2020. China would not want to strengthen Abe by provoking Japanese nationalism. But if Abe is losing support, and Beijing calculates that the Japanese public is starting to view Abe and his constitutional revisions as too provocative and destabilizing, then a well-timed diplomatic crisis with economic sanctions may be in order.18 Next in line are Hong Kong and Singapore, though Beijing has already largely gotten its way in recent disputes with the two city-states.19 Other possibilities on the horizon: The eventual return to a fractious civilian government in Thailand, or improved U.S.-Thai relations, could spoil China's infrastructure plans and sour its willingness to support an otherwise lackluster Thai economy. Also, a surprise victory by the opposition in Malaysian general elections (either this year or next) could see the recent rapprochement with China falter. The latter would be cyclical tensions, whereas suppressed structural tensions with Vietnam and the Philippines could boil back up to the surface fairly quickly at any time and provoke Chinese retaliation. Bottom Line: The most likely targets of Chinese economic sanctions in the near future are Taiwan and Japan. South Korea could remain a target if events should force Moon to abandon his policy agenda, though we see this as unlikely. Hong Kong and Singapore also remain in the danger zone, as do Vietnam and the Philippines in the long run. Investment Implications Cyclical and structural macro trends drive exports and investment trends in Asia Pacific. The biggest immediate risk to EM Asian economies stems not from Chinese sanctions - given that most of these economies have adjusted their policies to appease China to some extent - but from China's economic policy uncertainty, which remains at very elevated levels (Chart 17). It was after this uncertainty surged in 2015 that China's neighbors took on a more accommodating stance with a focus on economic cooperation rather than strategic balancing. Chart 17Chinese Economic Policy Uncertainty Still Asia's Biggest Risk Currently Chinese economic policy uncertainty is hooking back up as a result of the decision by state authorities to intensify their financial crackdown - the so-called "deleveraging campaign." BCA's Emerging Markets Strategy has recently pointed out that China's slowing fiscal and credit impulse will drag down both Chinese import volumes and emerging market corporate earnings in the coming months (Chart 18). Already commodity prices and commodity currencies have dropped off, heralding a broader slowdown in global trade as a result of China's policy tightening. This trend will overwhelm the effect of almost any new geopolitical spats or sanctions. The same can be said for Chinese investment as for Chinese trade. Over the past couple of decades, China has emerged as one of the world's leading sources of direct investment (Chart 19). This is a secular trend. Thus while foreign relations have affected China's investment patterns - most recently in giving the Philippines a boost under Duterte - the general trend of rising Chinese investment abroad will continue regardless of temporary quarrels. This is particularly true in light of China's efforts to energize OBOR. Chart 18China: Stimulus Fading Chart 19China's Emergence As Major Global Investor The key question is how will China's political favor or disfavor impact neighboring economies on the margin, in relative terms, on a sectoral basis, or in the short term? The evidence above feeds into several trends in relative equity performance: China fights either Japan or Korea: Going long Korea / short Japan would have paid off throughout the major Sino-Japanese tensions 2010-12, and would have paid off again during the South Korean impeachment rally (Chart 20). Of course, geopolitics is only one factor. But even Japan's economic shift in 2012 (Abenomics) is part of the geopolitical dynamic. Chart 20China Fights Either Japan Or Korea Chart 21Taiwan's Loss = Japan's Gain Taiwan's loss is Japan's gain: China's measures against Japanese exporters from 2010-12 coincided with a period of intense cross-strait economic integration that benefited Taiwanese exporters. Then Japan adopted Abenomics and dialed down tensions with China, and Taiwan underwent a pro-independence turn, provoking Beijing's displeasure (Chart 21). If one of these countries ends up quarreling with China in the near future, as we expect, the other country's exporters may reap the benefit. If relations worsen with both, South Korea stands to gain. Favor EM reformers: Vietnamese and Philippine equities outperformed EM from 2011-16 despite heightened tensions in the South China Sea (Chart 22). During this time, we recommended an overweight position on both countries relative to EM, even though we took the maritime tensions very seriously, because we favored EM reformers and both countries were undertaking structural reforms.20 Later, in May 2016, we downgraded the Philippines to neutral, expecting a loss of reform momentum after Duterte's election. The Philippines has notably underperformed the EM equity benchmark since that time.21 The "One China Policy": We closed out our "long One China Policy" trade on June 14 as a result of China's persistence in its crackdown on the banks, which we see as very risky.22 However, we may reinitiate the trade in the future, as Hong Kong and Taiwan remain vulnerable both to the slowdown in globalization and to Beijing's sanctions over deepening political differences (Chart 23). Chart 22Reforms Pay... Even During Island Tensions Chart 23The 'One China Policy' As A Trade From Sunshine to Moonshine: South Korea's Moon Jae-in has substantial political capital and we expect that he will succeed in boosting growth, wages, and the social security net, all of which will be bullish for South Korean consumer stocks. Yet we remain wary of the fact that North Korea is not yet falling into line with new negotiations. A way to hedge is to go long the South Korean consumer relative to Taiwanese exporters (Chart 24), which will live under the shadow of Beijing's disfavor at least until the 2020 elections, if not beyond. Taiwan has also allowed its currency to appreciate notably against the USD since Trump's post-election phone call with President Tsai, which is negative for Taiwanese exporters. Chart 24Go Long Korean Consumer /##br## Short Taiwanese Exporter China's sanctions are essentially a "slap on the wrist" in economic terms. But sometimes they reflect deeper structural tensions, and thus they may foreshadow far more damaging clashes down the road that could have longer term consequences, just as the Sino-Japanese incident of 2012 demonstrated. That is all the more reason to hedge one's bets on Taiwan today. These sanctions are bound to recur and will provide investors with trading opportunities, if not long-term investment themes. It will pay to capitalize quickly at the outset of any serious increase in tensions going forward. As a final word, the Trump administration's recent moves to impose economic penalties on China - namely through "secondary sanctions" due to North Korea, but also through potential trade tariffs and/or penalties related to human trafficking and human rights - highlight the fact that the use of unilateral sanctions is not limited to China. Geopolitical risk is rising in Asia as a result of actions on both sides of the Pacific. Sino-American antagonism in particular poses the greatest geopolitical danger to global markets, as we have frequently emphasized.23 And as Trump's domestic agenda struggles he will seek to get tougher on China, as he promised to his populist base on the campaign trail. In the event of a major geopolitical crisis in the region, we recommend the same mix of safe-haven assets that we have recommended in the past: U.S. treasuries, Swiss bonds, JGBs, and gold.24 Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. For our longstanding investment theme of rising geopolitical risk in East Asia, please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, and Monthly Report, "The Great Risk Rotation," dated December 11, 2013, available at gps.bcaresearch.com. 2 Please see BCA Emerging Market Equity Sector and Geopolitical Strategy Special Report, "South Korea: A Comeback For Consumer Stocks?" dated June 27, 2017, available at gps.bcaresearch.com. 3 However, Moon is walking a tight rope in relation to the United States. During his visit to Washington on June 29, he assured Congressman Paul Ryan among others that he did not necessarily intend to reverse the THAAD agreement as a whole. That would depend on the outcome of the environmental review and due legal process in South Korea as well as on whether North Korea's behavior makes the missile defense system necessary. Please see Kim Ji-eun, "In US Congress, Pres. Moon Highlights Democratic Values Of Alliance With US," The Hankyoreh, July 1, 2017, available at English.hani.co.kr. 4 Please see BCA Geopolitical Strategy Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 5 Please see Jeffrey R. Dundon, "Triggers of Chinese Economic Coercion," Naval Postgraduate School, September, 2014, available at calhoun.nps.edu. 6 For a very conservative estimate of China's actions during the Haiyang Shiyou 981 incident, please see Angela Poh, "The Myth Of Chinese Sanctions Over South China Sea Disputes," Washington Quarterly 40:1 (2017), pp. 143-165. 7 Please see "Vietnam Party official heads to China to defuse tensions," Thanh Nien Daily, August 25, 2014, available at www.thanhniennews.com. 8 Please see Faqin Lin, Cui Hu, and Andreas Fuchs, "How Do Firms Respond To Political Tensions? The Heterogeneity Of The Dalai Lama Effect On Trade," University of Heidelberg Department of Economics Discussion Paper Series 628, August 2016, available at papers.ssrn.com. This study improves upon earlier ones, notably Andreas Fuchs and Nils-Hendrik Klann, "Paying A Visit: The Dalai Lama Effect On International Trade," Journal Of International Economics 91 (2013), pp 164-77. See also Christina L. Davis, Andreas Fuchs, and Kristina Johnson, "State Control And The Effects Of Foreign Relations On Bilateral Trade," October 16, 2016, MPRA Paper No. 74597, available at https://mpra.ub.uni-muenchen.de/74597/ ; Yinghua He, Ulf Nielsson, and Yonglei Wang, "Hurting Without Hitting: The Economic Cost of Political Tension," Toulouse School of Economics Working Papers 14-484 (July 2015), available at econpapers.repec.org; Raymond Fisman, Yasushi Hamao, and Yongxiang Wang, "Nationalism and Economic Exchange: Evidence from Shocks to Sino-Japanese Relations," NBER Working Paper 20089 (May 2014) available at www.nber.org; Scott L. Kastner, "Buying Influence? Assessing the Political Effects of China's International Trade," Journal of Conflict Resolution 60:6 (2016), pp. 980-1007. 9 The "Dalai Lama effect," in which countries that host a visit from the Dalai Lama suffer Chinese trade retaliation, has been revised downward over the years - the trade costs are only statistically significant in the second quarter after the visit. Please see "How Do Firms Respond," cited in footnote 8. 10 See "Myth Of Chinese Sanctions," cited in footnote 6. Chinese sanctions on Norwegian salmon exports after Liu Xiaobo's Nobel Peace Prize in 2010 also fall under this category. 11 Please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, available at gps.bcaresearch.com. 12 Please see Lee Ho-Jeong, "Thaad may lead to $7.5B in economic losses in 2017," Joongang Daily, May 4, 2017, available at www.joongangdaily.com. 13 Please see Ian Storey, "Thailand's Post-Coup Relations With China And America: More Beijing, Less Washington," Yusof Ishak Institute, Trends in Southeast Asia 20 (2015). 14 Malaysia began to move closer to China after its 2013 election, which initiated a period of political turbulence and scandal. This trend, along with economic slowdown, prompted the ruling coalition to turn to Beijing for support. 15 He is also, as current chair of the Association of Southeast Asian Nations (ASEAN), assisting China's negotiations toward settling a "Code of Conduct" in the South China Sea. This is not likely to be a binding agreement - China will not voluntarily reverse its strategic maritime-territorial gains - but it could dampen tensions for a time in the region and encourage better relations between China and Southeast Asia. For the 2016 Asian pivot to China discussed above, please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, and Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 17 The LDP's dramatic defeat in Tokyo's local elections on July 2 is the first tangible sign that the constitutional agenda, Abe's corruption scandals, and the emergence of a competing political leader, Yuriko Koike, are taking a toll on the LDP. 18 Also, Beijing may at any point rotate its maritime assertiveness back to the East China Sea, where tensions with Japan have quieted since 2013-14. Further, Beijing will want to exploit worsening relations between Japan and South Korea, and drive a wedge between Japan and Russia as they attempt a historic diplomatic thaw. 19 Beijing is attempting to steal a march on these states, especially in finance, while putting pressure on them to avoid activities that undermine Beijing's regional influence. So far there is only small evidence that tensions have affected trade. First, Hong Kong saw a drop in tourists and a block on cultural exports amid the Umbrella Protests of 2014. China's central government has acted aggressively over the past year to suppress Hong Kong agitation, by excluding rebel lawmakers from office and by drawing a "red line" against undermining Chinese sovereignty. Yet agitation will persist because of the frustration of local political forces and the youth, both of which resent the mainland's increasing heavy-handedness. Meanwhile, China and Singapore are in the process this month of improving relations after the November-January spat relating to Singapore-Taiwanese military ties. But China's encroachment on Singapore's traditional advantages - finance, oil refining, freedom of navigation, strong military relations with the U.S. and Taiwan, political stability - is likely to continue. 20 Please see BCA Geopolitical Strategy Monthly Report, "The Coming Bloodbath In Emerging Markets," dated August 12, 2015, "Geopolitical Risk: A Golden Opportunity?" dated July 9, 2014, and "In Need Of Global Political Recapitalization," dated June 2012, available at gps.bcaresearch.com. See also Frontier Markets Strategy Special Report, "Buy Vietnamese Stocks," dated July 17, 2015, available at fms.bcaresearch.com. 21 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Weekly Report, "Has Europe Switched From Reward To Risk," dated June 7, 2017, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 24 Please see The Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Special Report

Highlights Unilateral economic sanctions show that geopolitical risks are rising in Asia Pacific; China is using sanctions to get its way with its neighbors; South Korea was the latest victim, and will be rewarded for its pro-China shift; Trump's Mar-a-Lago honeymoon with Xi Jinping is over; Tactically, go long South Korean consumers / short Taiwanese exporters. Feature Geopolitical risk is shifting to the Asia Pacific region - and the increasing use of economic sanctions is evidence of the trend. Korean stocks have rallied sharply since the leadership change from December 2016 through May of this year (Chart 1). The impeachment rally was entirely expected after a year of domestic political turmoil.1 The election is also eventually expected to decrease Korean geopolitical risks - the country's new President Moon Jae-in, of the left-leaning Democratic Party, aims to patch up relations with China and revive diplomacy with North Korea.2 Chart 1South Korean Impeachment Rally Over A key barometer of Moon's success will be whether he convinces China to remove economic sanctions imposed since last summer as punishment for his predecessor's agreement to host the U.S. THAAD missile defense system. Moon has suspended the system's deployment in a nod to China.3 South Korea is thus the latest example of an important trend in the region: China's successful use of "economic statecraft" to pressure wayward neighbors into closer alignment with its interests. Since 2014, Thailand, Malaysia, Vietnam and the Philippines have each sought in different ways to reorient their foreign policies toward China, either to court Chinese assistance or get relief from Chinese pressure. Judging by our research below, the rewards are palpable, and a sign of Beijing's rising global influence. Because U.S.-China tensions are rising structurally, we see these country-by-country shifts toward China not as a decisive loss for the U.S. alliance but rather as the latest phase in a long game of tug-of-war that will intensify in the coming years.4 Hence the trend of unilateral economic sanctions will continue. Who is next on China's hit list? How will the U.S. respond? What countries are most and least likely to be affected? And what are the market implications? China's Economic Statecraft The United States launched a "pivot to Asia" strategy under the Obama administration to reassert American primacy in Asia Pacific and address the emerging challenge from China. The U.S.'s Asian partners largely welcomed this shift. Over the preceding decade, they had struggled with China's emergence as a military and strategic superior. The most prominent flashpoints came in the East and South China Seas. Beijing's newfound naval and air power caused regional anxiety. As the allies invited a larger U.S. role, Beijing began to assert its sovereignty claims over disputed waters and rocks, most ambitiously by creating artificial islands in the South China Sea and fortifying them with military capabilities. In three notable periods since the Great Recession, China's tensions with its neighbors have splashed over into the economic realm, prompting Beijing to impose punitive measures: Chart 2Japan's 2012 Clash With China Chart 3Chinese Boycotted Japanese Cars... Japan 2010-2012: In 2010, China and Japan clashed as the former challenged Japan's control of the Senkaku (Diaoyu) islands in the East China Sea. In the September-November 2010 clash, China notoriously cut off exports of rare earths to Japan.5 A greater clash occurred from July-November 2012. Chinese people rose up in large-scale protests, damaging Japanese and other foreign property and assets. Impact: The growth of Japanese exports to China slowed noticeably between the 2010 and 2012 clashes, underperforming both that of China's neighbors and Europe (Chart 2). In particular, Chinese consumers stopped buying as many Japanese cars and switched to other brands (Chart 3). Chinese investment in Japan, which is generally very small, fell sharply in the year after the major 2012 clash, by contrast with the global trend (Chart 4). Chinese tourism to Japan also fell sharply after both incidents, though only for a short period of time (Chart 5). Chart 4...And Cut Investments In Japan... Chart 5...While Tourists Went Elsewhere Philippines 2012-2016: Tensions between China and the Philippines over the contested Spratly Islands and other rocks in the South China Sea have a long history. The latest round began in the mid-2000s, and the two countries have skirmished many times since then, including in a major showdown at Scarborough Shoal in 2012 that required the intercession of the United States to be resolved. The pressure intensified after January 2013, when the Philippines brought a high-profile case against China's maritime-territorial claims to the Permanent Court of Arbitration at the Hague. The U.S. and the Philippines upped the ante in April 2014 by signing an Enhanced Defense Cooperation Agreement. Ultimately, the court dealt a humiliating blow to China's maritime-territorial claims in July 2016, but a bigger confrontation was avoided because of what had happened in the remarkable May 2016 Philippine elections, which put China-friendly populist President Rodrigo Duterte in Manila on July 1. Impact: China tightened phytosanitary restrictions on Philippine bananas during the 2012 crisis and Philippine exports to China underperformed those of its neighbors after the onset of diplomatic crisis in 2013 (Chart 6). Nevertheless, the overall impact on headline exports is debatable. Tourism suffered straightforwardly both after the 2012 showdown at sea and after the new U.S.-Philippines military deal in 2014 (Chart 7). As with Japan, the impact was temporary. Chart 6Philippine Clash With China Over Sovereignty Chart 7Chinese Tourists Snub The Philippines Vietnam 2011-14: China's quarrels with Vietnam go back millennia, but in recent years have centered on the South China Sea. As with the Philippines, frictions began rising in the mid-2000s and flared up after the global financial crisis. In the summer of 2012, Vietnam and China engaged in a dispute over new laws encompassing their territorial claims. In May 2014, the two countries fought a highly unorthodox sea-battle near the Paracel Islands. Anti-Chinese protests erupted throughout Vietnam, prompting China to restrict travel.6 Impact: It is not clear that China imposed trade measures against Vietnam - export growth was plummeting in 2012 because of China's nominal GDP slowdown as well - but certainly exports skyrocketed after the two sides began tothaw diplomatic relations in August 2014 (Chart 8).7 Direct investment from China into Vietnam fell in 2014, even as that from the rest of the world rose. Chinese tourism to Vietnam shrank in the aftermath. Chart 8Vietnam Reboots China Trade The above incidents complement a growing body of academic research demonstrating China's use of unilateral economic sanctions and their trade and market impacts.8 Bottom Line: China has employed unilateral, informal, and discrete economic sanctions and has encouraged or condoned citizen boycotts and popular activism against Japan, the Philippines, Vietnam, Taiwan, and other states since at least the early 2000s. Moreover, three international confrontations since 2010 suggest that China's foreign policy is growing bolder - it is not afraid to throw its economic weight around to get what it wants politically or to deter countries from challenging its interests. How Significant Is China's Wrath? Both our evidence and the scholarly literature reveal that China-inflicted economic damage tends to be temporary and sometimes ambiguous from a macro-perspective.9 For instance, if there were negative trade effects of Vietnam's 2014 clash with China, they were overwhelmed by Vietnam's rising share of China's market in the following years (Chart 9). And, as hinted above, Chinese sanctions on Philippine banana exports in 2012 can be overstated according to close inspection of the data.10 Nevertheless, since 2016, three new episodes have reinforced the fact that China's punitive measures are a significant trend with potentially serious consequences for Asian economies: Taiwan 2016: Taiwanese politics have shifted away from mainland China in recent years. The "Sunflower Protests" of 2014 marked a shift in popular opinion away from the government's program of ever-deeper economic integration with the mainland. Local elections later that year set the stage for a sweeping victory by the Democratic Progressive Party (DPP), taking both the presidency and, for the first time, the legislature, in January 2016.11 Tsai is a proponent of eventual Taiwanese independence and dissents from key diplomatic agreements with the mainland, the "One China Policy" and "1992 Consensus." Within six months of the election Beijing had cut off diplomatic communication. Impact: The number of mainland visitors has nosedived, by contrast with global trends (Chart 10). Taiwan's exports and access to China's market are arguably weaker than they would otherwise be. Given the historic cross-strait Economic Cooperation Framework Agreement in 2010, and the strong export growth in the immediate aftermath of that deal, it is curious that exports have been so weak since 2014 (Chart 11). Chart 9China Flings Open Doors To Vietnam Chart 10Mainland Tourists Punish Rebel Taiwan Chart 11So Much For Cross-Strait Trade Deals? South Korea 2016-17: China and South Korea are on the cusp of improving relations after a year of Beijing-imposed sanctions. The former government of President Park Geun-hye, who was impeached in December 2016 and removed from office in March this year, moved rapidly with the U.S. to deploy the THAAD missile defense system on South Korean soil while her government was collapsing, so as to make it a fait accompli for her likely left-leaning (and more China-friendly) successor. Her government agreed to the deployment in July 2016 and since then China has exacted substantial economic costs via Korean exports and Chinese tourism.12 The new President Moon Jae-in is now calling on China to remove these sanctions, while initiating an "environmental review" that will delay deployment of THAAD, possibly permanently. Impact: South Korean exports to China have underperformed the regional trend throughout the downfall of the Park regime and its last-minute alliance-building measures with both the U.S. and Japan (Chart 12). South Korea has also lost market share in China since agreeing to host THAAD in July 2016 (Chart 13). Furthermore, Korean car sales on the mainland have deviated markedly both from their long-term historical trend and from Japan's contemporary sales (Chart 14), the inverse of what occurred in 2012 (see Chart 3 above). Chinese tourism to South Korea has sharply declined. Chart 12China Cools On Korean Imports Chart 13China Hits South Korea Over THAAD Chart 14Korean Car Sales And Tourist Sales Slump North Korea 2016-17: Ironically, China brought sanctions against both Koreas last year - the South for THAAD, the North for its unprecedented slate of missile and nuclear tests. These provoked the United States into pressuring China via "secondary sanctions." Impact: China's sanctions on the North - which include a potentially severe ban on coal imports - are limited so far, according to the headline trade data, as China is wary of destabilizing the hermit kingdom (Chart 15). But if China does grant President Trump's request and increase the economic pressure on North Korea, it will be no less of a sign of a greater willingness to utilize economic statecraft, especially given that the North is China's only formal ally. Other countries will not fail to see the implications should they, like either Korea, cross Beijing's interests. Bottom Line: Doubts about China's new foreign policy "assertiveness" are overstated. China is increasing its unilateral use of economic levers to pressure political regimes in its neighborhood, including major EMs like Taiwan and South Korea over the past year. Korean President Moon Jae-in's rise to power is likely to produce better Sino-Korean relations, but neither it nor Taiwan is out of the woods yet, according to the data. Moreover, the rest of the region may be cautious before accepting new U.S. military deployments or contravening China's demands in other ways. The Asian "Pivot To China" Over the past two years, several Asian states have begun to vacillate toward China, not because they fear American abandonment but because the U.S. "pivot" gave them so much security reassurance that it threatened to provoke conflict with China - essentially risking a new Cold War. They live on the frontlines and wanted to discourage this escalation. At the same time, the growth slump in China/EM in 2014 - followed by China's renewed stimulus in 2015 - encouraged these states to improve business with China. Thailand began to shift in 2014, when a military junta took power in a coup and sought external support. China's partnership did not come with strings attached, as opposed to that of the U.S., with its demands about democracy and civil rights.13 The rewards of this foreign policy shift are palpable (Chart 16). China signed some big investment deals and improved strategic cooperation through arms sales. It did the same with Malaysia for similar reasons.14 China's "One Belt One Road" (OBOR) economic development initiative provided ample opportunities for expanding ties. Chart 15No Chinese Embargo On North Korea... Yet Chart 16China Opens Doors To Thai Junta The year 2016 was a major turning point. Three of China's neighbors - two of which U.S. allies - underwent domestic political transitions ushering in more favorable policies toward China: Vietnam: The Vietnamese Communist Party held its twelfth National Congress in January 2016. Prime Minister Nguyen Tan Dung, a pro-market reformer from the capitalist south, failed to secure the position of general secretary of the party and retired. The incumbent General Secretary Nguyen Phu Trong retained his seat, and oversaw the promotion of key followers, strengthening Vietnam's pro-China faction. Since then Trong has visited President Xi in Beijing and signed a joint communique on improving strategic relations. As mentioned above, Vietnamese exports to China have exploded since tensions subsided in 2014. South Korea: In April 2016, South Korean legislative elections saw the left-leaning Democratic Party win a plurality of seats, setting the stage for the 2017 election discussed above, when Korea officially moved in a more China-friendly direction under President Moon. The Philippines: In May 2016, the Philippines elected Duterte, a firebrand southern populist who declared that the Philippines would "separate" itself from the U.S. and ally with Russia and China. Though Duterte has already modified his anti-American stance - as we expected - he is courting Chinese trade and investment at the expense of the Philippines' sovereignty concerns.15 Trump's election contributed to this regional trend. By suggesting a desire for the U.S. to stop playing defender of last resort in the region, Trump reinforced the need for allies like Thailand, the Philippines, and South Korea to go their own way. And by canceling the Trans-Pacific Partnership, Trump forced Malaysia and Vietnam to make amends with China, while vindicating those (like Thailand and Indonesia) that had remained aloof. Bottom Line: Having brandished its sticks, China is now offering carrots to states that recognize its growing regional influence. These do not have to be express measures, given that China is stimulating its economy and increasing outbound investment for its own reasons. All China need do is refrain from denying access to its market and investment funds. Whom Will China Sanction Next? Geopolitical risk on the Korean peninsula remains elevated given that North Korea remains in "provocation mode" and Trump has prioritized the issue. However, we expect that Moon will cooperate with China enough to give a boost to South Korean exports and China-exposed companies and sectors. With South Korea's shifting policy, Beijing has a major opportunity to demonstrate the positive economic rewards of pro-China foreign policy. If a new round of international negotiations gets under way and North Korean risk subsides for a time (our baseline view),16 then East Asian governments will turn to other interests. We see two key places of potential confrontation over the next 12-24 months: Taiwan is the top candidate for Chinese sanctions going forward. The cross-strait relationship is fraught and susceptible to tempests. The ruling DPP lacks domestic political constraints, which could be conducive to policy mistakes. Moreover, Trump has signaled his intention to strengthen the alliance with Taiwan, which could cause problems. China is likely to oppose the new $1.4 billion package of U.S. arms more actively than in the past, given its greater global heft. Trump's initial threat of altering the One China Policy has not been forgotten. In terms of timing, China may not want to give a tailwind to the DPP by acting overly aggressive ahead of the 2018 local elections, which are crucial for the opposition Kuomintang's attempt to revive in time for the 2020 presidential vote. But this is not a hard constraint on Beijing's imposing sanctions before then. Japan is the second-likeliest target of Chinese economic pressure. Japanese Prime Minister Shinzo Abe is up for re-election no later than December 2018 and is becoming more vulnerable as he shifts emphasis from pocketbook issues to Japan's national security.17 Needless to say, the revival of the military is the part of Abe's agenda that Beijing most opposes. China would like to see Abe weakened, or voted out, and would especially like to see Abe's proposed constitutional revisions fail in the popular referendum slated for 2020. China would not want to strengthen Abe by provoking Japanese nationalism. But if Abe is losing support, and Beijing calculates that the Japanese public is starting to view Abe and his constitutional revisions as too provocative and destabilizing, then a well-timed diplomatic crisis with economic sanctions may be in order.18 Next in line are Hong Kong and Singapore, though Beijing has already largely gotten its way in recent disputes with the two city-states.19 Other possibilities on the horizon: The eventual return to a fractious civilian government in Thailand, or improved U.S.-Thai relations, could spoil China's infrastructure plans and sour its willingness to support an otherwise lackluster Thai economy. Also, a surprise victory by the opposition in Malaysian general elections (either this year or next) could see the recent rapprochement with China falter. The latter would be cyclical tensions, whereas suppressed structural tensions with Vietnam and the Philippines could boil back up to the surface fairly quickly at any time and provoke Chinese retaliation. Bottom Line: The most likely targets of Chinese economic sanctions in the near future are Taiwan and Japan. South Korea could remain a target if events should force Moon to abandon his policy agenda, though we see this as unlikely. Hong Kong and Singapore also remain in the danger zone, as do Vietnam and the Philippines in the long run. Investment Implications Cyclical and structural macro trends drive exports and investment trends in Asia Pacific. The biggest immediate risk to EM Asian economies stems not from Chinese sanctions - given that most of these economies have adjusted their policies to appease China to some extent - but from China's economic policy uncertainty, which remains at very elevated levels (Chart 17). It was after this uncertainty surged in 2015 that China's neighbors took on a more accommodating stance with a focus on economic cooperation rather than strategic balancing. Chart 17Chinese Economic Policy Uncertainty Still Asia's Biggest Risk Currently Chinese economic policy uncertainty is hooking back up as a result of the decision by state authorities to intensify their financial crackdown - the so-called "deleveraging campaign." BCA's Emerging Markets Strategy has recently pointed out that China's slowing fiscal and credit impulse will drag down both Chinese import volumes and emerging market corporate earnings in the coming months (Chart 18). Already commodity prices and commodity currencies have dropped off, heralding a broader slowdown in global trade as a result of China's policy tightening. This trend will overwhelm the effect of almost any new geopolitical spats or sanctions. The same can be said for Chinese investment as for Chinese trade. Over the past couple of decades, China has emerged as one of the world's leading sources of direct investment (Chart 19). This is a secular trend. Thus while foreign relations have affected China's investment patterns - most recently in giving the Philippines a boost under Duterte - the general trend of rising Chinese investment abroad will continue regardless of temporary quarrels. This is particularly true in light of China's efforts to energize OBOR. Chart 18China: Stimulus Fading Chart 19China's Emergence As Major Global Investor The key question is how will China's political favor or disfavor impact neighboring economies on the margin, in relative terms, on a sectoral basis, or in the short term? The evidence above feeds into several trends in relative equity performance: China fights either Japan or Korea: Going long Korea / short Japan would have paid off throughout the major Sino-Japanese tensions 2010-12, and would have paid off again during the South Korean impeachment rally (Chart 20). Of course, geopolitics is only one factor. But even Japan's economic shift in 2012 (Abenomics) is part of the geopolitical dynamic. Chart 20China Fights Either Japan Or Korea Chart 21Taiwan's Loss = Japan's Gain Taiwan's loss is Japan's gain: China's measures against Japanese exporters from 2010-12 coincided with a period of intense cross-strait economic integration that benefited Taiwanese exporters. Then Japan adopted Abenomics and dialed down tensions with China, and Taiwan underwent a pro-independence turn, provoking Beijing's displeasure (Chart 21). If one of these countries ends up quarreling with China in the near future, as we expect, the other country's exporters may reap the benefit. If relations worsen with both, South Korea stands to gain. Favor EM reformers: Vietnamese and Philippine equities outperformed EM from 2011-16 despite heightened tensions in the South China Sea (Chart 22). During this time, we recommended an overweight position on both countries relative to EM, even though we took the maritime tensions very seriously, because we favored EM reformers and both countries were undertaking structural reforms.20 Later, in May 2016, we downgraded the Philippines to neutral, expecting a loss of reform momentum after Duterte's election. The Philippines has notably underperformed the EM equity benchmark since that time.21 The "One China Policy": We closed out our "long One China Policy" trade on June 14 as a result of China's persistence in its crackdown on the banks, which we see as very risky.22 However, we may reinitiate the trade in the future, as Hong Kong and Taiwan remain vulnerable both to the slowdown in globalization and to Beijing's sanctions over deepening political differences (Chart 23). Chart 22Reforms Pay... Even During Island Tensions Chart 23The 'One China Policy' As A Trade From Sunshine to Moonshine: South Korea's Moon Jae-in has substantial political capital and we expect that he will succeed in boosting growth, wages, and the social security net, all of which will be bullish for South Korean consumer stocks. Yet we remain wary of the fact that North Korea is not yet falling into line with new negotiations. A way to hedge is to go long the South Korean consumer relative to Taiwanese exporters (Chart 24), which will live under the shadow of Beijing's disfavor at least until the 2020 elections, if not beyond. Taiwan has also allowed its currency to appreciate notably against the USD since Trump's post-election phone call with President Tsai, which is negative for Taiwanese exporters. Chart 24Go Long Korean Consumer /##br## Short Taiwanese Exporter China's sanctions are essentially a "slap on the wrist" in economic terms. But sometimes they reflect deeper structural tensions, and thus they may foreshadow far more damaging clashes down the road that could have longer term consequences, just as the Sino-Japanese incident of 2012 demonstrated. That is all the more reason to hedge one's bets on Taiwan today. These sanctions are bound to recur and will provide investors with trading opportunities, if not long-term investment themes. It will pay to capitalize quickly at the outset of any serious increase in tensions going forward. As a final word, the Trump administration's recent moves to impose economic penalties on China - namely through "secondary sanctions" due to North Korea, but also through potential trade tariffs and/or penalties related to human trafficking and human rights - highlight the fact that the use of unilateral sanctions is not limited to China. Geopolitical risk is rising in Asia as a result of actions on both sides of the Pacific. Sino-American antagonism in particular poses the greatest geopolitical danger to global markets, as we have frequently emphasized.23 And as Trump's domestic agenda struggles he will seek to get tougher on China, as he promised to his populist base on the campaign trail. In the event of a major geopolitical crisis in the region, we recommend the same mix of safe-haven assets that we have recommended in the past: U.S. treasuries, Swiss bonds, JGBs, and gold.24 Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. For our longstanding investment theme of rising geopolitical risk in East Asia, please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, and Monthly Report, "The Great Risk Rotation," dated December 11, 2013, available at gps.bcaresearch.com. 2 Please see BCA Emerging Market Equity Sector and Geopolitical Strategy Special Report, "South Korea: A Comeback For Consumer Stocks?" dated June 27, 2017, available at gps.bcaresearch.com. 3 However, Moon is walking a tight rope in relation to the United States. During his visit to Washington on June 29, he assured Congressman Paul Ryan among others that he did not necessarily intend to reverse the THAAD agreement as a whole. That would depend on the outcome of the environmental review and due legal process in South Korea as well as on whether North Korea's behavior makes the missile defense system necessary. Please see Kim Ji-eun, "In US Congress, Pres. Moon Highlights Democratic Values Of Alliance With US," The Hankyoreh, July 1, 2017, available at English.hani.co.kr. 4 Please see BCA Geopolitical Strategy Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 5 Please see Jeffrey R. Dundon, "Triggers of Chinese Economic Coercion," Naval Postgraduate School, September, 2014, available at calhoun.nps.edu. 6 For a very conservative estimate of China's actions during the Haiyang Shiyou 981 incident, please see Angela Poh, "The Myth Of Chinese Sanctions Over South China Sea Disputes," Washington Quarterly 40:1 (2017), pp. 143-165. 7 Please see "Vietnam Party official heads to China to defuse tensions," Thanh Nien Daily, August 25, 2014, available at www.thanhniennews.com. 8 Please see Faqin Lin, Cui Hu, and Andreas Fuchs, "How Do Firms Respond To Political Tensions? The Heterogeneity Of The Dalai Lama Effect On Trade," University of Heidelberg Department of Economics Discussion Paper Series 628, August 2016, available at papers.ssrn.com. This study improves upon earlier ones, notably Andreas Fuchs and Nils-Hendrik Klann, "Paying A Visit: The Dalai Lama Effect On International Trade," Journal Of International Economics 91 (2013), pp 164-77. See also Christina L. Davis, Andreas Fuchs, and Kristina Johnson, "State Control And The Effects Of Foreign Relations On Bilateral Trade," October 16, 2016, MPRA Paper No. 74597, available at https://mpra.ub.uni-muenchen.de/74597/ ; Yinghua He, Ulf Nielsson, and Yonglei Wang, "Hurting Without Hitting: The Economic Cost of Political Tension," Toulouse School of Economics Working Papers 14-484 (July 2015), available at econpapers.repec.org; Raymond Fisman, Yasushi Hamao, and Yongxiang Wang, "Nationalism and Economic Exchange: Evidence from Shocks to Sino-Japanese Relations," NBER Working Paper 20089 (May 2014) available at www.nber.org; Scott L. Kastner, "Buying Influence? Assessing the Political Effects of China's International Trade," Journal of Conflict Resolution 60:6 (2016), pp. 980-1007. 9 The "Dalai Lama effect," in which countries that host a visit from the Dalai Lama suffer Chinese trade retaliation, has been revised downward over the years - the trade costs are only statistically significant in the second quarter after the visit. Please see "How Do Firms Respond," cited in footnote 8. 10 See "Myth Of Chinese Sanctions," cited in footnote 6. Chinese sanctions on Norwegian salmon exports after Liu Xiaobo's Nobel Peace Prize in 2010 also fall under this category. 11 Please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, available at gps.bcaresearch.com. 12 Please see Lee Ho-Jeong, "Thaad may lead to $7.5B in economic losses in 2017," Joongang Daily, May 4, 2017, available at www.joongangdaily.com. 13 Please see Ian Storey, "Thailand's Post-Coup Relations With China And America: More Beijing, Less Washington," Yusof Ishak Institute, Trends in Southeast Asia 20 (2015). 14 Malaysia began to move closer to China after its 2013 election, which initiated a period of political turbulence and scandal. This trend, along with economic slowdown, prompted the ruling coalition to turn to Beijing for support. 15 He is also, as current chair of the Association of Southeast Asian Nations (ASEAN), assisting China's negotiations toward settling a "Code of Conduct" in the South China Sea. This is not likely to be a binding agreement - China will not voluntarily reverse its strategic maritime-territorial gains - but it could dampen tensions for a time in the region and encourage better relations between China and Southeast Asia. For the 2016 Asian pivot to China discussed above, please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, and Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 17 The LDP's dramatic defeat in Tokyo's local elections on July 2 is the first tangible sign that the constitutional agenda, Abe's corruption scandals, and the emergence of a competing political leader, Yuriko Koike, are taking a toll on the LDP. 18 Also, Beijing may at any point rotate its maritime assertiveness back to the East China Sea, where tensions with Japan have quieted since 2013-14. Further, Beijing will want to exploit worsening relations between Japan and South Korea, and drive a wedge between Japan and Russia as they attempt a historic diplomatic thaw. 19 Beijing is attempting to steal a march on these states, especially in finance, while putting pressure on them to avoid activities that undermine Beijing's regional influence. So far there is only small evidence that tensions have affected trade. First, Hong Kong saw a drop in tourists and a block on cultural exports amid the Umbrella Protests of 2014. China's central government has acted aggressively over the past year to suppress Hong Kong agitation, by excluding rebel lawmakers from office and by drawing a "red line" against undermining Chinese sovereignty. Yet agitation will persist because of the frustration of local political forces and the youth, both of which resent the mainland's increasing heavy-handedness. Meanwhile, China and Singapore are in the process this month of improving relations after the November-January spat relating to Singapore-Taiwanese military ties. But China's encroachment on Singapore's traditional advantages - finance, oil refining, freedom of navigation, strong military relations with the U.S. and Taiwan, political stability - is likely to continue. 20 Please see BCA Geopolitical Strategy Monthly Report, "The Coming Bloodbath In Emerging Markets," dated August 12, 2015, "Geopolitical Risk: A Golden Opportunity?" dated July 9, 2014, and "In Need Of Global Political Recapitalization," dated June 2012, available at gps.bcaresearch.com. See also Frontier Markets Strategy Special Report, "Buy Vietnamese Stocks," dated July 17, 2015, available at fms.bcaresearch.com. 21 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Weekly Report, "Has Europe Switched From Reward To Risk," dated June 7, 2017, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 24 Please see The Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com.

Special Report

Dear Client, We hope that you will find value in this report, a product of collaboration between BCA’s Geopolitical Strategy and EM Equity Sector Strategy. My colleagues Oleg Babanov and Matt Gertken look for investment opportunities in the recent geopolitical changes on the Korean Peninsula. The election of President Moon Jae-in will be a boon for domestic consumer sentiment and relations with China. This will produce a tailwind for the consumer-oriented South Korean stocks, which have high exposure to the country’s trade with China. We deliver this report to you both for its investment value and as an example of BCA Research commitment to seek alpha in the intersection of economics, markets, and geopolitics. Kindest Regards, Marko Papic Senior Vice President Chief Geopolitical Strategist Overweight South Korea Consumer Staples We are recommending an overweight position in select South Korean consumer staples on a long-term (one year-plus) time horizon. A decline in geopolitical tensions between South Korea and China, and a potential improvement on the Korean peninsula, will provide tailwinds to the performance of Korean consumer staples, which have high exposure to China. We expect Chinese tourist numbers to Korea to recover gradually, and sales of South Korean products in mainland China to pick up over the rest of the year. Presidential elections in South Korea and a slowly improving economy are bolstering consumer sentiment and aiding a turnaround in retail sales in the country, with companies in the consumer space displaying better earnings momentum and trading at more attractive valuations than their EM peers (Table 1). Sector Backdrop We are turning cautiously positive on consumer staples in South Korea. We believe the following factors will trigger a turnaround in consumer sentiment and support share price performance of consumer-oriented South Korean stocks. Geopolitics The election of President Moon Jae-in by a wide margin, as well as a geopolitical shift toward more accommodative policy on China, will alleviate geopolitical risks and help consumer sentiment. Moon has already kicked off his administration's tenure with considerable political capital. For one, his administration represents a return to stable and legitimate government after over a year of turmoil surrounding the scandal, impeachment and removal of former President Park Geun-hye - a relief for South Korean voters. What's more, voter turnout was higher than usual, at 77%, and Moon's margin of victory over his closest contender was over 15%, the second-highest since South Korea became a full-fledged democracy in 1987 (Chart 1). There are also institutional factors playing to Moon's advantage. He was the leading contender for the presidency even without Park being removed from office - but if she had not been removed, he would have taken office in January 2018. Now, Moon has half a year longer in office than he otherwise would have had before he faces his first serious political hurdle in the April 2020 legislative elections. This half year could make a difference. Since Korean presidents serve a single, five-year term, they often become lame ducks in the second half of their term, and therefore move rapidly on policy in the first half while their political capital is high. The only significant domestic political constraint on Moon is the rival left-of-center party, the People's Party. It holds the kingmaker position in the legislature, with the ability to give a majority to either Moon's ruling Democratic Party or to the conservative opposition (Chart 2). However, the People's Party has serious weaknesses and has been compelled by its voting base to cooperate on much of Moon's platform of expanding social spending and thawing relations with North Korea and China. Moreover, the conservative opposition is discredited and fractured. Thus, Moon has limited political constraints. Given that his administration is competent - i.e. the clear populist elements are not joined with a lack of experience or pragmatism - the key question is what policies he will prioritize while his political capital is high. Chart 3THAAD Deployment Hurt ##br##Bilateral China-Korea Trade It is our view that China-exposed companies stand to benefit in the short term as China eases sanctions over the recently deployed U.S. THAAD missile defense system (Chart 3), and as better relations with China benefit the economy more broadly (Chart 4). However, if Moon prioritizes China and North Korea excessively, he risks squandering his political capital. Korea remains stuck in the middle of U.S.-China tensions that are growing on a secular basis. Tensions with the U.S. will rise as a result of Moon's orientation, and North Korean political risks will remain elevated over the medium and long term. Moon's attempts to engage with North Korea will collide with Trump's efforts to ratchet up pressure against it. Therefore, Moon is likely to find the most success in his domestic agenda of increasing government spending, hiring more public workers, raising wages and instilling worker protections, expanding the social safety net and subsidizing small- and medium-sized enterprises. These measures will boost both public and private consumption. We do not have particularly high hopes for Moon's ability to reform the so-called 'chaebol', a South Korean term denoting large, typically family-owned corporate conglomerates, but his attempt to do so will add a modicum of corporate governance and competitiveness improvements that markets will likely cheer. Macroeconomics With improvement in the geopolitical situation, stabilization in the local political system following the Park Geun-hye scandal and new elections has aided in a recovery in consumer sentiment (Chart 5). Meanwhile, a rebound in total employment numbers together with a decline in household debt is providing support to consumer spending (Charts 6A, 6B, 6C). Chart 5Consumer Confidence Is ##br##Back To A Five-Year High Chart 6ANumber Of Employed ##br##Higher Than In 2015... Chart 6B...While The Household Debt ##br##Burden Is Slowly Declining... Chart 6C...Aiding A Recovery##br## In Retail Sales Sector Specifics From a sector perspective, South Korean consumer staples remain highly competitive, outperforming their EM peers (Chart 7). At the same time, valuations are attractive for South Korean companies (Charts 8A & 8B). Chart 7South Korean Consumer Stocks Outperforming EM Consumer Staples' Aggregate... Chart 8ASouth Korean Companies Trading At Cheaper ##br##Valuations Since Mid-2016... Chart 8B...And At One Standard Deviation Below ##br##Their Seven-Year Average Furthermore, bottom-line expansion of South Korean companies remains strong, supported by solid margin trends (Charts 9A, 9B, 9C). Chart 9A...Earnings Growth In South Korea##br## Is Outperforming EM Peers Chart 9B...With Gross Margin Nearly Twice ##br## The EM Industry Average... Chart 9C...And EBTIDA Margin Is Steadily ##br## Above EM Peers We also like the fact that the net debt level for South Korean consumer staples companies is low to negative, while companies have managed to generate excess free cash flow. One undesirable implication, however, is notoriously low dividend yields, which are discouraging investors and raising corporate governance issues (Charts 10A, 10B, 10C). Taking into account the factors listed above, we have created a portfolio of six South Korean consumer staples stocks (Table 2). Chart 10ADebt Levels Have Fallen Significantly ##br## Over The Past Seven Years... Chart 10B...While Cash Generation ##br## Has Recovered... Chart 10C...But Dividend Yields ##br## Remain Disappointing Low The Overweight Basket Chart 11Performance Since June 2016: ##br## Amorepacific Corp Vs. MSCI EM Amorepacific Corp (090430 KS): A leading beauty and cosmetics producer in South Korea (Chart 11). Founded in the 1940s by Yun Dok-jeong as a company distributing camellia oil for hair treatment, the company was inherited by Yun's son and later grandson, who became the second-richest man in South Korea, controlling directly 10% of the company's free float. Today, Amorepacific is the world's 14th largest cosmetics company, with oversight of some 33 brands around the world such as Etude House, Sulwhasoo and others. In terms of revenue, the bulk is generated by beauty and cosmetic products (91%), where luxury cosmetics constitute 43%, followed by premium brands with 18%. Personal care products contribute 9% to total revenue. Geographically, 70% of revenues are generated in South Korea, and another 19% in China. Amorepacific reported weaker-than-expected first-quarter 2017 financial results on April 24. Revenue increased by 5.7% year over year, with falling Chinese tourist numbers weighing on local sales, and weaker sales in mainland China. At the same time, cost of sales went up by 10.6% year over year, which resulted in gross margin compression by 100 basis points. As a result of an operating cost increase of 8.4% year over year, mainly driven by SG&A expansion (increased labor costs and one-off bonus payments), operating profit fell 6.2% year over year. Operating margin finished at 20.2% compared to 22.8% same period last year, while EBTDA margin contracted to 17.8% from 19.5% last year. Weak operating performance and disproportionate expense growth led to the bottom line falling 15% year over year. Amorepacific is currently trading at a forward P/E of 30.0x, while the market is forecasting an EPS CAGR of 13% over the next three years. We believe the share price will continue to recover strongly, taking into account that easing tensions with China will restore demand and organic volume growth as well as strong momentum in overseas sales, supporting an earnings recovery. Chart 12Performance Since June 2016: ##br## E-Mart Vs. MSCI EM E-Mart (139480 KS): Number one hypermarket brand in South Korea (Chart 12). E-Mart was established in 1993 and has grown into the largest hypermarket and discount store chain in South Korea, operating over 148 branch locations locally and another 16 in China. In 2006 the company also acquired its largest competitor in the country - Wal-Mart Korea - strengthening its market share. Additionally, E-Mart runs speciality shops such as "Emart" discount stores, the "Emart Mall" online store, "Emart Traders," an everyday low-price store, as well as pet and sports/outdoor stores. In terms of revenue breakdown, the flagship E-Mart brand is responsible for 78% of total revenue, followed by the food distribution and supermarket segment with 7% each respectively. From a geographic perspective, 98% of revenue originates in South Korea and only 2% in China. E-Mart reported first-quarter 2017 financial results on May 11, missing estimates. Revenue growth was solid, up 7.4% year over year, helped by 1% same-store sales growth in the main hypermarket segment, while cost of sales increased by 6.5% year over year, which resulted in gross margin falling slightly by 20 basis points to 28.2%. Operating profit increased by 2.8% year over year, weighed on by a year-on-year jump in operating expenses of 11.1%. Operating margin stood at 4.1%, down from 4.3% in 2016, while EBITDA margin finished virtually flat at 6.7%. Thanks to better operating performance, the bottom line improved by 5% year over year. The main detraction to performance came from one-off store opening expenses and a negative calendar effect. E-Mart is currently trading at a forward P/E of 14.0x, while the market is forecasting an EPS CAGR of 9% over the next three years. A store restructuring program is currently underway, and management has done well in accelerating closures of non-performing stores, which has already led to cost savings and margin turnaround. We expect this process to continue. Together with strong performance of the discount and online segments, this should warrant a further re-rating of the share price. Chart 13Performance Since June 2016: ##br## GS Retail Vs. MSCI EM GS Retail (007070 KS): Number one convenience store chain in South Korea (Chart 13). GS Retail is part of the GS Group, a former part of LG Group and the sixth-largest conglomerate in South Korea, which controls just under 66% of the company. GS Retail was incorporated back in 1971 and today operates GS25 - the largest convenience store brand in South Korea - as well as other brands such as GS Supermarkets, Watsons - a health and beauty chain, and Parnas Hotel. The largest contributor to total revenue is the convenience store segment, with 77%, followed by the supermarket business with 20% and the hotel operation with 3%. Geographically, all the revenue originates in South Korea. GS Retail reported first-quarter 2017 financial results on May 11. Revenue displayed strong growth, up 12.5% year over year, driven by solid performance in the convenience store segment (+21% year over year), while cost of sales increased by 12.3% year over year, which brought gross margin up by 20 basis points to 18.4%. A 15% year-over-year increase in operating costs due to the ongoing consolidation of the Watsons business brought operating income down slightly by 1.5% year over year, suppressing operating margin by 20 basis points to 1.4%. EBITDA margin stood at 5.9% compared to 6.2% a year ago. Despite weak operating performance, the bottom line grew by 18.8%, helped by a non-operating gain and lower interest expenses. GS Retail is currently trading at a forward P/E of 19.6x, while the market is forecasting an EPS CAGR of 14% over the next three years. We expect the non-convenience store segments to contribute more to performance in the second part of the year. Furthermore, non-performing supermarket store closedowns together with seasonally strong second and third quarters, where the summer weather typically helps sales, should support stock performance. Chart 14Performance Since June 2016: ##br## H&H Vs. MSCI EM LG Household & Healthcare (051900 KS): Producer of the very first cosmetic products in Korea (Chart 14). LG H&H was incorporated in 1947 by Koo In-Hwoi, the founder of LG Corp., and had the initial name Lucky Chemical Industrial Corp. The company produced the first-ever Korean cosmetic product, "Lucky Cream," followed by "Lucky Toothpaste." From 1995 to 2001, LG H&H was part of LG Chem before being spun off. In addition to the cosmetics and household goods businesses, the company also acquired Coca Cola Beverage in 2007, turning itself into an exclusive bottler and distributor of Coca Cola products in South Korea. In terms of revenue breakdown, the cosmetics business contributes 53% to overall revenue, followed by personal products with 27% and the soft drink division with 20%. Geographically, 84% of revenue originates in South Korea, followed by China with 8% and Japan with 4%. LG H&H reported better-than-expected first-quarter 2017 financial results on April 28. Revenue expanded by 5.3% year over year, driven by strong sales in the luxury cosmetics and beverage segments, while cost of sales grew by 4% year over year, bringing gross margin 50 basis points higher to 60.9%. Furthermore, operating income displayed strong growth, up 11.3%, helped by good management of operating expenses (+4.5% year over year). As a result, operating margin improved by 90 basis points to 16.2% and EBITDA margin finished at 16.9%, up from 15.7% last year. The bottom line increased by 11.9% year over year, helped by strong operating performance. LG H&H is currently trading at a forward P/E of 24.1x, while the market is forecasting an EPS CAGR of 8% over the next three years. As with Amorepacific, the trigger to a re-rating in the share price of LG H&H is the improving geopolitical situation. We expect tourist numbers to South Korea to gradually increase, which will aid in both sales recovery and earnings revisions, while strong momentum in the luxury cosmetics segment will contribute to further margin expansion. Chart 15Performance Since June 2016: ##br## KT&G Vs. MSCI EM KT&G Corp (033780 KS): Korea Tobacco & Ginseng (Chart 15). Initially founded as a government monopoly with the name "Korea Tobacco & Ginseng," the company was later privatized and rebranded as the "Korea Tomorrow & Global Corporation." Today, the company is the largest tobacco company in South Korea, controlling the majority of the local market. The company also has extensive exposure to Eastern European countries. In addition to the tobacco business, KT&G also has a pharma arm, the Korea Ginseng Corp. The revenue stream is broken down into the cigarette business, which contributes 60% to overall revenue, followed by the ginseng-pharma segment, adding another 30%. KT&G reported in-line first-quarter 2017 financial results on April 27. Revenue increased by a solid 8% year over year, helped by strong ginseng sales, which expanded despite a market contraction and were also alleviated by market share gain and higher prices. Cost of sales, meantime, were up 12.7%, bringing gross margin down to 59.4% from 61.1% previously. Due to a strong increase in operating costs (+11.3% year over year), driven by higher SG&A expenses, operating income edged up only 0.6% year over year. Operating margin fell 45 basis points from last year, while EBITDA margin stood at 35.5%, or 80 basis points lower compared to the same period last year. The bottom line fell by 17.5% year over year, weighted on by higher foreign exchange losses. KT&G is currently trading at a forward P/E of 12.8x, while the market is forecasting an EPS CAGR of 6.5% over the next three years. Several factors have been weighing on the company's share price recently, including the introduction of warning messages on cigarette packages and the introduction of e-cigarettes in the domestic market - making the stock one of the cheapest among its global peers (~20% discount). We believe that worries regarding e-cigarette introduction and projections of the Japanese experience are overstated due to differences in law (e.g. prohibition of smoking indoors), as well as the age composition of the market. Furthermore, we expect a strong revival in overseas sales in the second part of the year, with less headwinds from foreign exchange swings and double-digit growth due to low base effects - as well as an offset to flat local market expansion via higher selling prices. Chart 16Performance Since June 2016: ##br## Nongshim Vs. MSCI EM Nongshim (004370 KS): Farmer's Heart (Chart 16). Nongshim, or Farmer's Heart, was founded in 1965 under the name Lotte Food Industrial Company, and later changed its name. The company first focused on ramyun (instant noodle) production, later expanding into snacks - it was the first to introduce the "Shrimp Cracker" as well as beverages. Today, Nongshim is the largest ramyun and snack company in South Korea, selling to over 100 countries, with production facilities in Korea, China and the U.S. From a revenue perspective, ramyun products contribute 67% to total revenue, followed by other food products with 17.5% and snacks with 15.6%. Geographically, most sales occur in South Korea, with 80%, followed by the U.S. with 10% and China with 8%. Nongshim reported slightly better-than-expected first-quarter 2017 financial results on May 15. Revenue declined slightly by 2.2% year over year due to a fall in domestic ramyun sales by 9%, while cost of sales actually declined by 5% year over year, which led to a gross margin improvement by 190 basis points to 33.7% (helped by price increases.) Operating income was virtually flat year over year, as operating costs increased by 4%. Operating margin stood at 5.85% compared to 5.70% in 2016, while EBITDA margin declined to 7.9% from 9.4% last year. Nongshim is currently trading at a forward P/E of 18.5x, while the market is forecasting an EPS CAGR of 5.6% over the next three years. We expect a reversal of weak sales in China (-5% year over year) due to an easing of the geopolitical situation. Furthermore, Nongshim has already begun to claw back market share, helped by new starts and forced price hikes among its competition, which will continue to help turn around margins and improve profitability. How To Trade? The EMES team recommends gaining exposure to the sector through a basket of listed equities consisting of six overweight recommendations. The main goal is active alpha generation by excluding laggards and including out-of-benchmark plays, to avoid passive index-hugging via an ETF. Direct: Equity access through the tickers (Bloomberg): Amorepacific Corp (090430 KS); E-Mart (139480 KS); GS Retail (007070 KS); LG Household & Healthcare (051900 KS); KT&G Corp (033780 KS); Nongshim (004370 KS). ETFs: At the moment, there are no ETFs with significant consumer staples sector exposure for South Korea. Funds: At the moment, there are no funds with significant consumer staples sector exposure for South Korea. Please note this trade recommendation is long term (1Y+) and based on an overweight trade. We do not see a need for specific market timing for this call (for technical indicators please refer to our website link). For convenience, the performance of both market cap-weighted and equal-weighted equity baskets will be tracked (please see upcoming updates as well as the website link to follow performance). Risks To Our Investment Case We believe that one of the main risks is the geopolitical situation and further developments surrounding North Korea. Although the usual springtime tensions have passed, the underlying dynamic remains highly precarious. North Korea has not moderated its behavior despite President Moon's olive branch and U.S. President Trump continues to prioritize the issue and threaten bolder action. Any kind of escalation in tensions, whether they be driven by North Korea or the U.S., would negatively affect both Chinese interests and the new South Korean administration's attempts at engagement. Given that South Korea has not yet fully reversed the THAAD missile deployment, for instance, it is possible that China could maintain or intensify its informal sanctions on South Korea, such as travel and product bans, and that renewed tensions could depress overall consumer sentiment in South Korea. We are also cognizant that debt levels in the South Korean manufacturing sector as well mass layoffs in shipyards and a slowdown in exports could continue to create pressure on household disposable income levels and, in turn, spending. However, President Moon's efforts for a supplementary budget to support employment in the public sector, if approved, should alleviate some pain from layoffs. On a company level, we see increased price competition as one of the main risks to our investment case. Since many of the companies in the basket are market leaders, they will need to defend their market share aggressively in case of increased competition. Furthermore, for companies operating abroad, we see increased expansion costs as one of the risk factors for future performance. Finally, Chinese economic policy pose a risk to our view. The fiscal spending and credit impulse in China have rolled over, suggesting that demand will slow in the coming months. Moreover, the Communist Party’s ongoing “deleveraging campaign” – a crackdown on various risky financial practices and the shadow banking sector – raises the risks of a policy mistake. A slowdown in China would have negative repercussions for the South Korean companies most exposed to China and the broader Korean economy. Nevertheless, we think Chinese authorities are willing and able to meet their growth target this year. Oleg Babanov, Senior Editor obabanov@bcaresearch.co.uk Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.co.uk

Highlights Reflation Trade: The backdrop for global growth and monetary liquidity remains positive, and suggests that risk assets will outperform government debt for the balance of 2017. However, there are some early signs of fading momentum which raises risks for financial markets in 2018. New Zealand: The more dovish tone taken by the RBNZ reflects the more uncertain outlook for New Zealand growth and inflation. Go long 5-year New Zealand government bonds versus 5-year U.S. Treasuries (currency-hedged) and also versus 5-year German government debt (currency-unhedged). South Korea: Large expected increases in fiscal spending from the new government in Seoul will drive up the longer end of the South Korean government bond curve, while the Bank of Korea's easing stance and weak domestic economy will anchor the short-end of the curve. Position for this by entering a 2-year/10-year steepening trade in the South Korean government bond market. Feature "I know it makes no difference to what you're going through; but I see the tip of the iceberg, and I worry about you." - Rush Is The Liquidity Party Starting To Wind Down? Global financial markets continue to enjoy the "sweet spot" of a solidly expanding global economy, but without enough inflation pressure to force central banks to slam on the monetary brakes. That backdrop is starting to change, though. Odds are rising that the European Central Bank (ECB) will begin tapering its bond buying next year, with some hints of that possibly being announced as soon as next week's monetary policy meeting. At the same time, the Bank of Japan (BoJ) - faced with the operational constraints of buying an ever-increasing share of Japanese financial assets - is focused on targeting long-term interest rates rather than increasing liquidity. Even the Federal Reserve is now talking about reducing its massive balance sheet later this year. The liquidity tailwind to global growth and risk assets is now at risk of becoming a headwind. Already, the growth rate of the major central bank balance sheets has rolled over and is on course to decelerate further over the next year (Chart of the Week). Importantly, this downshift in global liquidity momentum is happening as signs of slowing growth have appeared in some major economies like China and the U.S. (Chart 2). Chart of the WeekLiquidity Tailwind To Risk##BR##Assets Is Fading Chart 2Growth Momentum##BR##Already Starting To Cool Off We remain concerned that the Chinese economy will see a policy-induced deceleration in the 2nd half of the year. However, we still expect the U.S. to rebound after the soft patch of growth in the first quarter, and we see nothing in the Euro Area data to suggest that the current solid expansion is at risk of fading quickly. This should allow inflation expectations to drift upward toward the central bank targets given the apparent lack of spare capacity on both sides of the Atlantic (Chart 3). Chart 3Fed & ECB Facing##BR##Economic Capacity Constraints We still expect the Fed to deliver another two rate hikes before year-end and the ECB to begin its exit strategy from the current extraordinary monetary policies by slowing the pace of asset purchases starting early next year. For now, the backdrop will remain supportive for the outperformance of growth-sensitive assets like corporate credit and equities over government bonds in the U.S. and Europe over the balance of 2017. However, the early signals sent by "leading leading" indicators such as our Global Leading Economic Indicator diffusion index (Chart 2, top panel) suggests that liquidity and growth trends will become far more challenging for the markets in 2018. Bottom Line: The backdrop for global growth and monetary liquidity remains positive, and suggests that risk assets will outperform government debt for the balance of 2017. However, there are some early signs of fading momentum which raises risks for financial markets in 2018. Maintain a below-benchmark duration exposure and an overweight allocation to corporate debt in global fixed income portfolios. New Zealand: Safety From A Global Bond Apocalypse? A growing number of the world's most wealthiest (and, arguably, most paranoid) people are reportedly buying real estate in New Zealand as a safe haven place to live if modern civilization collapses.1 While the immediate need for taking such precautions can be debated, there is sound logic in treating New Zealand as a location far removed from the current geopolitical and socio-economic problems of the world. We now see a case for treating New Zealand bonds as a potential "safe haven" market for global fixed income investors. The Economic Backdrop Has Become More Muddled We have been running a SHORT position in New Zealand (paying 12-month OIS rates) in our Tactical Overlay portfolio since last November. Our view then was that the New Zealand economy would surprise to the upside in 2017 and inflation was likely to start drifting upward. This would pressure the Reserve Bank of New Zealand (RBNZ) to raise the Official Cash Rate (OCR) from the highly accommodative level of 1.75%. So far, that expectation has not panned out as the RBNZ has held rates steady amid a more uncertain outlook for the New Zealand economy. Growth indicators have been a bit mixed over the past few months, but the current uptick in the manufacturing purchasing managers' index (PMI) is pointing to real GDP expanding around 3% on a year-over-year basis (Chart 4). If maintained for the full year, this would be slightly above the RBNZ's estimate of potential growth at 2.8%. There are some downside risks, however, given that consumer and business confidence are both below previous cyclical peaks and fiscal policy is expected to be mildly restrictive in 2017 (bottom three panels). The housing market remains a key cyclical wild card. Residential construction has been a significant source of growth over the past few years, driven by a surge in net immigration into New Zealand and declining interest rates (Chart 5). However, the RBNZ is projecting immigration inflows to slow from the current high level, largely due to improving labor market conditions in the developed economies (most notably, Australia, which is the largest source of New Zealand immigrants). Chart 4Stable NZ Growth...For Now Chart 5NZ Housing Activity Starting To Peak Out Slower immigration would reduce the demand for New Zealand housing at a time when mortgage rates have already been rising off the record lows seen in 2016 (bottom panel). This has occurred without any rate hikes from the RBNZ, as rising global bond yields have put upward pressure on New Zealand bank funding costs, which have been passed through to higher mortgage rates. The RBNZ is currently projecting growth in house prices to slow sharply from last year's robust 15% pace to just 5% in 2017. The main drivers are higher borrowing costs and the ongoing impact of macro-prudential regulations against high loan-to-value ratio mortgage lending. Importantly, slower housing activity will not only have a direct impact on GDP growth through softer construction, but will also indirectly dampen consumer spending growth via wealth effects. Yet even with this expected drag on growth from housing, the New Zealand economy is still expected to face capacity constraints over the rest of the year. Higher Uncertainty Over Price Pressures Both the RBNZ and the International Monetary Fund estimate that the output gap has fully closed and is projected to move into positive territory this year (Chart 6). At the same time, the current unemployment rate of 4.9% is below the OECD's estimate of the full employment level and the RBNZ projects a further decline in joblessness in 2017 (third panel). Despite this evidence of the economy reaching capacity constraints, both wage growth and price inflation remain subdued and inflation expectations remain well-anchored around 2% - the midpoint of the RBNZ's 1-3% target range. Wage costs are particularly depressed, growing only 1% on a year-over-year basis in Q1. This may be related to the rise in the labor force participation rate - up to an all-time high of 70.6% in Q1 from a cyclical low of 68.2% at the end of 2015 - that has increased the available supply of labor. The most recent headline inflation print for Q1 was quite strong, taking the year-over-year growth rate up to 2.2%. Yet in the RBNZ's April Monetary Policy Statement (MPS), the central bank took a surprisingly dovish tone, citing uncertainty over the true degree of slack in the economy and downside risks to growth that would prevent a further acceleration of inflation.2 The RBNZ now forecasts inflation to not rise above 2.2% this year and to fall back to 1.1% in both 2018, led by a sharp decline in growth for tradeables, mostly energy and food inflation (Chart 7). Importantly, this forecast includes the recent decline in the trade-weighted New Zealand Dollar (NZD). Non-tradeables inflation is also expected to stabilize on the back of slower housing-related items in the consumer price index. Chart 6RBNZ Not Expecting A Big Rise In Inflation... Chart 7...As Growth In Tradeables Prices Cools A Weaker Case For Tighter Monetary Policy The official RBNZ projection is that the OCR will stay unchanged at 1.75% until September 2019. The market expectation priced into the NZD OIS curve calls for 27bps of hikes over the next twelve months (Chart 8). Our New Zealand Central Bank Monitor has been suggesting the need for tighter monetary policy since mid-2016, but appears to be rolling over (2nd panel). The diminished rate hike expectations have coincided with a decline in the NZD and a sharp underperformance of New Zealand equities. The markets are giving a consistent signal on softening growth prospects in New Zealand, confirming the central bank's more recent dovish turn. Chart 8Market Expectations Of##BR##RBNZ Hikes Are Fading Given the newfound uncertainties over the New Zealand growth and inflation outlook, the case for owning New Zealand interest rate exposure has grown a little bit stronger. Admittedly, we do not envision a major pullback in growth, and inflation may not fall by as much as the RBNZ is expecting given how little spare capacity there appears to be in the economy. Yet there is now just enough uncertainty to keep the central bank on hold for longer than expected, as was noted in the "scenario analysis" section of the April MPS.3 The RBNZ noted that if the level of spare capacity is smaller than currently assumed, then the latest growth forecast will result in inflation eventually moving to 2.0% in 2018 and 2.3% in 2019, resulting in the OCR needing to rise to 2.25% in two years. Alternatively, if housing demand slows even faster than current projections, inflation would be below the 2% target during the next two years and the OCR would need to fall to 1.25% by the end of 2018. Our takeaway from this is that, even in the more positive scenario, interest rates are not expected to rise by much more than the markets are currently discounting. Position For Tighter New Zealand Spreads Versus Treasuries & Bunds The economic risks in New Zealand now appear evenly balanced. This argues for stable monetary policy and diminished bond volatility. Current market forwards for both government bonds and NZD swaps shows that very little movement in interest rates is expected over the next year (Chart 9). We generally agree with this pricing, although the uncertainty over the degree of spare capacity, and underlying inflation pressures, make a directional view on interest rates or the shape of the yield curve an unattractive risk proposition. A more interesting opportunity presents itself in looking at spread trades between New Zealand government bonds versus other developed market sovereign debt. The yield betas for New Zealand versus the U.S. and Germany have fallen steadily over the past year (Chart 10), indicating that New Zealand bonds can be more insulated from the rise in yields that we expect for U.S. Treasuries and German Bunds over the latter half of 2017. Given the competitively high yields on offer in New Zealand, even on a currency-hedged basis (bottom panel), we see a case for going long New Zealand interest rate exposure versus U.S. and Germany. Chart 9Higher NZ Bond Yields##BR##Priced Into Forwards Chart 10NZ Bonds: Now Lower Beta##BR##With Higher Hedged Yields At current yield levels, going long New Zealand versus Germany looks more compelling relative to spread compression trades versus U.S. Treasuries. We see strong potential for New Zealand-Germany spreads to tighten faster than the forwards over the next six months (Chart 11), largely through rising German yields as the ECB signals that a tapering of bond purchases is set to begin next year. The downside potential for New Zealand-U.S. spread compression looks less likely from current tight levels, although if Treasury yields rise by as much as we expect in the coming months, some spread tightening should occur here, as well. Chart 11Go Long 5Yr NZ Bonds Vs##BR##USTs and German OBLs Based on our analysis, we are closing our current NZD rates trade in our Tactical Overlay portfolio with a tiny profit of +3bps , and entering two new trades: long 5-year NZD government bonds versus 5-year U.S. Treasuries, on a currency-hedged basis; and long 5yr NZD government bonds versus 5-year German government debt, on a currency-unhedged basis.4 We are choosing to hedge the currency exposure back into USD for the former given the view of BCA's currency strategists that the EUR/USD exchange rate is now stretched too far to the upside and is at risk of declining as the Fed delivers on additional rate hikes in the coming months.5 In other words, we see a greater potential for a decline in NZD/USD than NZD/EUR in the next 3-6 months. Bottom Line: The more dovish tone taken by the RBNZ reflects the more uncertain outlook for New Zealand growth and inflation, in contrast to the strong likelihood of additional Fed rate hikes and an ECB taper announcement in the next few months. Go long 5-year New Zealand government bonds versus 5-year U.S. Treasuries (currency-hedged) and also versus 5-year German government debt (currency-unhedged). South Korea: A Bad Moon Rising For Bond Yields Chart 12Markets Not Worried##BR##About The New President The new South Korean president, Moon Jae-In was elected on May 9th, ending a year of political turmoil after the previous president's scandal and impeachment. Our colleagues at BCA Geopolitical Strategy view Moon and his Democratic Party as a major shift to the political left.6 The new president's policy agenda is aimed at economic stimulus for the working class alongside reforms of the country's chaebol industrial giants. Korean financial markets have greeted the election result positively, with the benchmark KOSPI equity index up 2.7%, and the Korean won up 1% versus the U.S. dollar, from the pre-election levels on May 8th. (Chart 12). This is consistent with past market behavior, as the won tends to be less reactive toward domestic events (i.e. after the previous president's impeachment, the won actually strengthened) and more sensitive to international uncertainties (i.e. North Korea-U.S. military tensions, as occurred in mid-March). Korean interest rates, however, have shown little response to the change in leadership in Seoul, with bond yields unchanged since the election. We see this as presenting an opportunity for fixed income investors. Clearly, the new regime in Seoul represents a real change for the Korean people, but it also represents a potential shift in the economic backdrop - namely, through an expected large fiscal stimulus from the new government - that will impart a steepening bias to the Korean interest rate curve. A Sluggish Economy Greets The New President While the steady, if unspectacular, pace of global growth in the past few years has been enough to absorb spare capacity in many countries, South Korea's sub-par economic performance has left the country with a widening output gap (Chart 13). Policymakers are well aware that consumer spending, which contributes about 60% of GDP, has been steadily weakening alongside slowing credit growth. Chart 13Sluggish Growth In South Korea The new government will attempt to boost domestic consumption, and thus overall growth, by increasing social welfare spending. Moon's economic agenda calls for raising the minimum wage by 55% by 2020, increasing subsidies for education costs and parental leave, and doubling the basic pension payment for the elderly regardless of their income level. It might prove to be very effective in the short term at boosting consumer spending, but this may not prove to be a sustainable driver of growth in South Korea, where the marginal swings in the economy have historically been driven more by exports. Youth joblessness is another problem that Moon will attempt to tackle with his ambitious economic program. While the labor market may appear healthy, with an overall unemployment rate of only 3.7%, the situation is far more challenging for young adults in South Korea - the jobless rate for those aged 20-29 is 11.3%. One of the reasons for such a high unemployment rate among young South Koreans is that university graduates, of which there are many in this highly-educated nation, expect (and look for) high-paying jobs, but cannot find enough of them.7 The labor market has become more competitive in recent years as weak economic growth has limited the ability of private sector, especially large corporations, to hire as much. To solve this problem, the new government has promised to create 810,000 jobs in the public sector. Creating public sector jobs may temporarily solve the high unemployment rate, but in the long run, this will also cause larger fiscal burdens for taxpayers. Position For A Steeper South Korean Yield Curve Headline CPI inflation in South Korea is currently hovering around the 2% target of the Bank of Korea (BoK), while core CPI growth is lower at 1.3%. The BoK has maintain the policy rate at 1.25% since June 2016, with a bias towards additional easing given the lack of sustained inflationary pressure amid weak domestic demand. The BoK did sound a slightly more upbeat tone on the economy at last week's monetary policy meeting, led by the spillover effects from improving global growth rather than a more bullish expectation on the Korean consumer. Importantly, the central bank still expects inflation pressures to remain subdued - no surprise given the large output gap. The BoK did note that it is monitoring several factors in judging future policy decisions: the pace of rate hikes by the Fed, trends in global trade, geopolitical tensions, the pace of household debt accumulation and "the directions of the new government's fiscal policies." The latter may end up being the most important factor, as President Moon is proposing an increase in government spending equal to 0.7% of GDP - an amount equal to ½ of the estimated output gap coming after a 2016 budget surplus of 1% of GDP. This increase in fiscal spending could directly drive up the longer-end of Korean yield curve, as this would result in a narrower budget surpluses and greater KGB issuance. At the same time, the lack of domestic inflation pressures, even with the fiscal stimulus, will keep the BoK on an easing bias that will keep short dated yields well anchored. Therefore, we see the potential for the Korean yield curve to eventually steepen and break the downward-sloping trendline in place since 2014 (Chart 14). We recommend positioning for this move by entering a 2-year/10-year steepening trade in the Korean yield curve. Admittedly, this trade is more structural than tactical in nature, as the Moon stimulus policies will take time to unfold. Importantly, a flattening of the 2-year/10-year KGB curve is currently priced into the forwards, meaning that positioning now for a steepener does not incur negative carry (Chart 15). Chart 14More Fiscal Stimulus =##BR##Steeper Korea Curve Chart 15Enter A 2Yr/10Yr##BR##Korean Bond Curve Steepener Also, Korean 10-year bond yields are currently exhibiting a strong correlation to similar maturity U.S. Treasuries with a yield beta around 1.0 (bottom panel). Given our view that longer-dated U.S. yields have upside risk from both additional Fed rate increases and higher U.S. inflation expectations, that high yield beta suggests that the Korean yield curve could suffer some of the same cyclical bear-steepening pressures that we expect for U.S. Treasuries in the next 3-6 months. Bottom Line: Large expected increases in fiscal spending from the new government in Seoul will drive up the longer end curve of the South Korean government bond curve, while the Bank of Korea's easing stance and weak domestic economy will anchor the short-end of the curve. Position for this by entering a 2-year/10-year steepening trade in the South Korean bond curve. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 https://www.theguardian.com/technology/2017/jan/29/silicon-valley-new-zealand-apocalypse-escape 2 The central bank noted that its "suite" of output gap estimates, using varying methodologies, have an unusually wide range at the moment between -1.5% and +2%. 3 http://www.rbnz.govt.nz/monetary-policy/monetary-policy-statement 4 These trades can be done using interest rate swaps as well (receiving NZD rates vs paying USD & EUR rates), as swap spreads are expected to remain broadly stable in all three regions. 5 Please see BCA Foreign Exchange Strategy Weekly Report, "Bloody Potomac", dated May 19 2017, available at fes.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets" dated May 24 2017, available at gps.bcaresearch.com. 7 According to the OECD, Korea's college enrollment rate was a whopping 87% as recently as 2014. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns