Trade

Highlights We’ve searched in vain for imminent domestic weakness in the U.S. economy, … : Much of our work this spring has focused on trying to poke holes in our view that the equilibrium fed funds rate remains above the target fed funds rate, but we haven’t found any evidence of overheating in the real economy, or worrisome excesses in financial markets. … but an exogenous shock could well precipitate a recession if it were serious enough: The U.S. is a comparatively closed economy, but there’s no such thing as full-on decoupling. The U.S. may react more slowly than other major economies to what’s going on in the rest of the world, but it’s not immune to it. A trade war would threaten global growth, … : U.S.-China trade negotiations have taken center stage over the last couple weeks, and escalating tension between the world’s two largest standalone economies will surely cast a pall over the global outlook. … but there are other potential threats that bear monitoring: Tensions with Iran could be the catalyst for an oil price shock, while a significant rollback of globalization could crimp corporate profit margins. Either would hasten the end of the equity bull market and the expansion. Feature Tight monetary policy is a necessary, if not sufficient, condition for a recession. We deem policy to be tight if the fed funds rate exceeds our estimate of the equilibrium fed funds rate, and easy if it is below our estimate of equilibrium. Over the six decades for which we compute an estimate of the equilibrium fed funds rate, the U.S. has only ever experienced recessions when the fed funds rate has exceeded our estimate of equilibrium (Chart 1). Tight policy isn’t always tantamount to a recession – nothing came of tight settings in 1984 or 1995 – but recessions don’t occur without it. Chart 1Recessions Only Occur When Monetary Conditions Are Tight Recessions Only Occur When Monetary Conditions Are Tight Recessions Only Occur When Monetary Conditions Are Tight We currently estimate that the equilibrium fed funds rate, a.k.a. the neutral rate, is about 3⅛%, and we continue to project that it will be around 3⅜% by the end of the year. Those estimates leave the Fed with plenty of headroom before it materially slows the economy. If our estimate is on the money, it will take four more rate hikes to induce an inflection in the business cycle. We have not seen anything in the ongoing flow of macro data, or evidence of excesses in the financial markets, that would suggest a recession is already under way or is lurking around the corner. Internal dynamics should continue to support the expansion, but threats from outside the U.S. are growing. We therefore conclude that the next recession may well not arrive for another two years, in the absence of a significantly adverse exogenous event. This week, we extend our focus beyond the U.S. to try to uncover the external threats that could stop the U.S. economy, and the bull markets in risk assets, in their tracks. Beyond the tariff fireworks, we also contemplate the possibility that conflict with Iran could lead to an oil price shock, and the impact of a significant rollback of globalization. It is not our base case that any of the various external threats will tip the U.S. into a recession, but investors should keep tabs on the biggest ones. Tariffs The U.S.-China trade saga has unfolded in three pairs of moves and counter-moves (Diagram 1). While the aggregate $50bn worth of Chinese goods tariffed in the first two salvos mostly targeted industrial equipment and machinery, the third installment, covering $200bn worth of imports, extended the tariffs’ reach to consumer products. Major categories included not only commodities such as base metals, chemical products and mineral fuels and oils, but also a broad swath of foods, textiles, electronics, vehicles and spare parts. After a three-month cease-fire, the developments of the last two weeks arguably marked the most significant escalation of tensions on both sides. The U.S. is now threatening to levy tariffs on the remaining $325bn of Chinese goods that have so far been spared. Diagram 1Anything You Can Do External Threats External Threats Our colleagues at BCA’s Geopolitical Strategy service suggest that recent foreign policy initiatives indicate that the White House does not feel any particular pressure to minimize economic risk this far ahead of the election. The risk of market-disruptive measures has therefore increased, and they see a 50-50 chance that the U.S. and China will fail to reach an accord (Table 1). Although the administration has delayed any action on autos and auto parts for now, Europe could be the next trade partner in its cross hairs. The odds that Section 232 (national-security-threat) tariffs will be levied on European auto imports is rising (Chart 2). Table 1U.S.-China Trade War: Probabilities Of A Deal By End Of June 2019 External Threats External Threats Chart 2 These heightened trade tensions may delay the global growth recovery that we were expecting to bloom in the summer, and they may also allow the dollar to keep advancing. The greenback is a countercyclical currency, moving inversely with global activity (Chart 3), and a bump in the road for global growth would likely extend its upward run. Chart 3The Countercyclical Dollar The Countercyclical Dollar The Countercyclical Dollar Although a strong dollar would be a headwind for exporters, the U.S. economy is comparatively closed. Tariffs are likely to exert the greatest pressure on the economy via softer consumption and investment. So far, the available evidence suggests that U.S. consumers and corporations have borne the brunt of higher tariffs in the form of higher retail prices and lower profit margins.1 Iran Our geopolitical strategists contend that investors have underrated conflict with Iran as a market risk for a while. Now that the contentiousness of U.S.-Iran relations has ratcheted higher upon the administration’s decision not to extend the import waivers on Iranian oil, the issue is back in the spotlight. Our strategists caution that managing the dispute may require more delicacy than the more hawkish elements of the administration realize. In their view, the potential for a misstep increases the odds of a recession and poses a significant risk to the equity bull market. In a joint Special Report by our Commodity and Energy Strategy and Geopolitical Strategy services at the beginning of the month, our in-house experts stressed that there are multiple moving parts driving the supply-demand balance in the global oil market.2 Investors should realize that the world faces the prospect of the loss of Venezuelan production (approximately 600,000 barrels per day (b/d)) and significant outages in Libya (~600,000 to 800,000 b/d), in addition to our strategists’ base-case estimate of 700,000 b/d from Iran’s current 1.3 million b/d output. BCA does not expect that all of that output will be lost, but the key point is that Iran is not the only potential source of a supply shortfall. Our energy strategists believe that OPEC 2.0 – the producer coalition led by Saudi Arabia and Russia, and supported by Saudi Arabia’s OPEC allies – has the capacity to make up for even their larger shortfall scenarios (Chart 4). The problem is that OPEC 2.0 may not have the will to do so in a timely fashion. Saudi Arabia and the rest of the OPEC 2.0 coalition were caught completely off guard by the administration’s issuance of import waivers in November, after they had ramped up production at its request to limit the market disruptions that would have ensued when Iran’s output was taken off the market. The last-minute waiver decision caused oil prices to crater in the wake of a supply glut that OPEC 2.0 has been working to sop up ever since (Chart 5). Chart 4 Chart 5... But The Oil Market Is Pretty Tight ... But The Oil Market Is Pretty Tight ... But The Oil Market Is Pretty Tight   OPEC 2.0’s members may feel that they were badly used last fall, and may not be inclined to move proactively now. Russia is managing its own low-grade conflict with the U.S., and all of the coalition should bear in mind that the U.S. could release over a million b/d from its Strategic Petroleum Reserve (SPR) for a solid six to nine months, according to our energy team’s estimates. If rising oil prices are often viewed as a tax on American consumers, a late summer/early fall release of holdings could be viewed as an election rebate, courtesy of the skilled economic managers in the White House. Our team expects that OPEC 2.0 will likely guard against an oversupply-driven swoon in oil prices by managing its production on something akin to a just-in-time inventory strategy. Our energy and geopolitical strategists caution that there are two other ways the administration may overplay its hand. First, it might overestimate U.S. shale drillers’ ability to export their production. While new pipeline construction will relieve the transportation bottleneck limiting the Permian Basin output that reaches the Gulf of Mexico, oil exports from the Gulf are limited by a shortage of deep-water harbor facilities. If global trade tensions do worsen, both the dollar and U.S. equities may attract safe-haven flows. There is also the possibility that Iran might strike at Iraq, putting some of its 3.5 million b/d output at risk. It could also make good on its repeated threat to close the Straits of Hormuz, through which nearly a fifth of global oil supplies travel daily. Either of these options would dramatically escalate the conflict, but a desperate Iran might pursue them if it felt cornered. The bottom line is that the probability of an oil price shock is not negligible. Brinkmanship with Iran could upset a delicate supply-demand balance in global oil markets, and a delicate geopolitical balance in the Middle East. If the Volcker double-dip is treated as a single event, a surge in oil prices has preceded every recession in the last 45 years, except for the 2001 recession precipitated by the bursting of the dot-com bubble (Chart 6). Chart 6Oil Price Spikes Often Precede Recessions Oil Price Spikes Often Precede Recessions Oil Price Spikes Often Precede Recessions Significant Rollback Of Globalization Our Geopolitical Strategy and Global Asset Allocation services have cited peak globalization as an important long-term investment theme for the last several years. The tariff tensions between the U.S. and its trading partners would seem to have borne out their predictions, especially if one views them as having been inspired by unskilled workers’ losses from globalization. Taking on foreign exporters is likely to play well in the electorally decisive Rust Belt states, where manufacturing job losses have hit especially hard. We fully subscribe to the theory of comparative advantage as formulated by David Ricardo in the early 19th century. By allowing individual countries to specialize in what they do best, free trade increases the size of the global economic pie. Empirical evidence suggests that globalization also re-slices the pie, however. In the developed world, outsourcing manufacturing has operated to the benefit of investors and the detriment of less-skilled workers. For U.S.-based multinationals, tariffs are a minor irritant compared to the prospect of having to reroute supply chains around China. The modest headwinds to globalization observed before the U.S. began engaging in serial bilateral trade conflicts did not undermine corporate profit margins in any material way. A bigger anti-globalization push that forced global supply chains to be rerouted or partially unwound would have much more negative effects. The U.S. is a comparatively closed economy, but the multinationals that dominate equity market capitalization rely heavily on interactions with the rest of the world. Unwinding the global supply chains that have been carefully constructed over the last 30 years would be disruptive and costly. The worst-case scenario envisioned by our geopolitical strategists, in which U.S.-China relations dramatically worsen and the tariff back-and-forth escalates in a major way, would hit equities hard, especially if supply chains had to be rebuilt. As a proxy for what globalization has meant for investors’ and blue-collar workers’ share of the pie, we consider the path of real wages relative to productivity over the last 50 years. From 1970 through 2001, U.S. wages generally kept pace with productivity gains, observing a fairly narrow, well-defined range (Chart 7). Once China entered the WTO (as denoted by the vertical line on the chart), productivity-adjusted wages fell precipitously, and even their periodic bounces have fallen well short of the level that marked the lower end of the previous range. Chart 7The Pie Has Grown, But Unskilled Labor's Slice Has Shrunk The Pie Has Grown, But Unskilled Labor's Slice Has Shrunk The Pie Has Grown, But Unskilled Labor's Slice Has Shrunk Bottom Line: Temporary barriers to free trade, implemented as a negotiating tactic, are not a big deal for equities. A significant rollback of globalization would be, however, and a need to divert global supply chains away from China could stop the bull market in its tracks. Investment Implications Along with our Global Investment Strategy colleagues, we are somewhat more sanguine than our Geopolitical Strategy service that a worst-case outcome between the U.S. and China can be averted. We therefore continue to believe that the U.S. expansion, and the bull markets in risk assets, will persist until the Fed tightens monetary conditions enough to spark the next recession. We reiterate our recommendations that investors should maintain at least an equal weight position in equities and spread product. Enough is at stake in the conflicts with China and Iran, however, that a worsening of either could cause us to change our view, and we will be watching developments on each front closely. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Jennifer Lacombe Senior Analyst, Global ETF Strategy jenniferl@bcaresearch.com   Footnotes 1      Mary Amiti, Stephen J. Redding, and David E. Weinstein, “The Impact of the 2018 Trade War on U.S. Prices and Welfare,” NBER Working Paper No. 25672, (March 2019). 2      Please see Commodity & Energy Strategy/Geopolitical Strategy Special Report, “U.S.-Iran: This Means War?,”dated May 3, 2019, available at ces.bcaresearch.com.

Highlights So What? Odds of a total breakdown in U.S.-China relations are highly underrated. Why? The key market-relevant geopolitical event is Trump’s large risk appetite. Inflationary pressures resulting from the trade tariffs are not prohibitive for Trump’s trade war. Chinese stimulus will surprise to the upside, but a massive stimulus package will depend on talks collapsing and maximum tariffs. Markets will sell before they recover. We will maintain our current portfolio hedge of Swiss bonds and gold. Feature Chart 1Equities Sell, Safe Havens Rally Equities Sell, Safe Havens Rally Equities Sell, Safe Havens Rally Global equities have sold off and safe-haven assets caught a bid since the near-breakdown in U.S.-China trade negotiations on May 5 (Chart 1). Yet financial markets are still complacent, as the 2.8% drawdown to date on global equities and the S&P 500 does not yet reflect the depth of the geopolitical risk to sentiment and corporate earnings. To understand this risk we need to step away from the ups and downs of the trade negotiations and ask, What have we learned about U.S. policy over the past month and what does it mean for global markets on a cyclical and structural horizon? We have learned that in the lead-up to the 2020 election, President Trump is not seeking to protect his greatest asset – namely, a strong American economy – but rather to solidify his support through new ventures. By imposing the full brunt of sanctions on Iran and hiking the tariff rate on Chinese imports, Trump has made two highly significant decisions that could jeopardize the American voter’s pocketbook, with a full 18 months to go before November 3, 2020. Why has he done this? Because he believes the American economy can take the pain and he will achieve resounding foreign policy successes. These, he hopes, will make his reelection more likely. President Trump’s aggressive posture is a direct threat to the global equity bull market due to (1) higher odds of a negative shock to global trade when global growth is already weak, and (2) higher odds of an oil price shock due to a potential vicious spiral of Middle East conflict. Wreaking Havoc Historically, the United States thrives when the rest of the world is in chaos. This was obviously the case during World War I and II (Chart 2). But it also proved true in the chaotic aftermaths of the Soviet Union’s collapse and the global financial crisis, though the U.S. did suffer along with everyone else during the 2008-09 downturn. American equities have generally outperformed during periods of global chaos (Chart 3). Chart 2America Thrives Amid Global Chaos America Thrives Amid Global Chaos America Thrives Amid Global Chaos Chart 3U.S. Equities Outperform During Global Crises U.S. Equities Outperform During Global Crises U.S. Equities Outperform During Global Crises The reasons for U.S. immunity are well known: the U.S. has a large, insulated, consumer-driven economy; it has immense economic advantages enhanced by its dominance of North America; it has vast and liquid financial markets; and it is the world’s preponderant technological and military power. This position enables Washington to act more aggressively than other capitals in pursuit of the national interest – and to recover more quickly from mistakes. Chart 4U.S. Preponderance Declining U.S. Preponderance Declining U.S. Preponderance Declining It follows that there is an influential idea or myth that the country can or should exploit this advantage, when necessary or desirable, by “wreaking havoc” abroad. The prime example is the preemptive invasion of Iraq. In this way Washington can turn the tables on its opponents and keep them off balance. The Trump administration, regardless of Trump’s intentions, could soon become the epitome of this school of thought. First, it is true that, structurally, American preponderance has been decreasing: despite various crises, there has been sufficient peace and prosperity in the twenty-first century to see the rest of the world’s wealth, trade, and arms grow relative to the United States (Chart 4). With the rise of China and resurgence of Russia, U.S. global leadership is at risk and the Trump administration has adopted unorthodox policies to confront its rivals and try to reverse this process. Second, cyclically, President Trump is stymied at home after his Republican Party lost the House of Representatives in the 2018 midterm election. Scandals and investigations plague his inner circle. Unable to secure funding for his signature campaign promise – the southern border wall – Trump faces the risk of irrelevance. Foreign policy, especially trade policy, thus becomes the clearest avenue for him to try to notch up victories. Trump faces the risk of irrelevance. Foreign policy thus becomes the clearest avenue for him to try to notch up victories. Bottom Line: The key market-relevant event over the past month has been the Trump administration’s demonstration of voracious risk appetite. This is fundamentally a cyclical not tactical risk to the bull market due to tit-for-tat tariffs, sanctions, and provocations with rivals like China and Iran. Pocketbooks Versus Patriotism Trump’s vulnerability becomes clear by looking at our electoral Map 1, which highlights his excruciatingly thin margins of victory in the critical “swing states” in the 2016 election. We emphasize the margin of victory among white voters – which are slightly higher than the margins overall – because the Trump campaign courted the white working class specifically in a calculated strategy to swing the Midwest “Rustbelt” states and win the election. Chart The problem for Trump is that while whites remain the majority of the eligible voting population, it is a declining majority due to demographic change. Demographics is not near-term destiny, but the vanishingly thin margins ensure that Trump cannot assume that he will win reelection without generating even more turnout and support among blue-collar whites in the key states. Chart 5 Job creation and rising incomes are the chief hope. The problem is that Trump’s tax cuts and the red-hot economy in 2018 did not prevent Republicans from getting hit hard in the midterm elections, especially in the Midwest. Moreover today’s resilient economy is not preventing the top two Democratic candidates, former Vice President Joe Biden and independent Vermont Senator Bernie Sanders, from beating Trump in head-to-head polling in the key swing states (Chart 5). Trump’s national approval rating, at about 44%, is nearly as good as it gets, but the indications from the Midwest are worrisome, especially because the economy has slowed. If the economy is not winning the argument on the campaign trail in 2020, Trump will need to have another leg to stand on. In addition to hammering home his attempts to build a wall on the border, Trump will highlight his economic nationalism. Protectionism has won the Rustbelt over the past three elections. As we have since 2016 argued, this now boils down to pressure on China. If Trump’s policies provoke China (or Iran) to take aggressive actions, he will have a pretext to exercise American power in a way that will likely create a rally-around-the-flag effect, at least in the short term. Elections do not normally hinge on foreign policy, but they certainly can. While President Trump may not actually want a war with Iran, he knows that George W. Bush cruised to victory amid the Afghan and Iraqi wars. Or he may have in mind 1964, when Lyndon B. Johnson crushed Barry Goldwater, an offbeat, ideological “movement candidate” (can anyone say Bernie Sanders?) in the face of a hulking communist menace, the Soviet Union. A conflict with China (or Iran) could serve similar purposes in 2020, either distracting the populace from a weakening economy or adding to an election bid centered on a reaccelerating economy. The problem is that a patriotic conflict with China or Iran is an insurance policy that threatens to undermine the health and safety of the very thing being insured: the U.S. economy. Indeed, U.S. stocks did not outperform after the September 11th attacks or during the Bush administration’s wars abroad. In essence, Trump is a gambler and is now going for broke. This constitutes a huge risk to the global economy and financial markets – a risk that was subdued just a month ago due to oil sanction waivers and tariff-free trade talks. Bottom Line: President Trump is courting international chaos because his policy priorities are tied down with gridlock and scandal at home. Aggressive foreign policy is a strategy to rack up policy victories and potentially expand his voter base, but it comes at the risk of higher policy uncertainty and negative economic impacts that could derail this year’s fledgling economic rebound and the long-running bull market. “No Deal” Is More Likely Than A Weak Deal It wasn’t just a tweet that sent volatility higher over the past two weeks. Most likely, President Trump decided to raise tariffs on China at the advice of his trade negotiators, who had become convinced that China was not offering deep enough concessions (“structural changes”) and was playing for time. This was always the greatest risk in the trade talks. China is indeed playing for time, as it has no security guarantee from the United States and therefore cannot embrace structural changes in the way that Japan did during the U.S.-Japanese trade war in the 1980s. Originally, the talks were set to last 90 days with the tariff hike by March 1. Trump was apparently determined not to lose credibility on this threat as China drew out the negotiations. Hence, he piled on the pressure to try to force a conclusion by the June 28-29 G20 summit in Japan, which has been the target date for our trade war probabilities over the past several months (Table 1). We have now adjusted those probabilities to upgrade the risk that talks collapse (50%) and downgrade the odds of a deal to 40% by that date. Table 1U.S.-China Trade War: Probabilities Of A Deal By End Of June 2019 How Trump Became A War President How Trump Became A War President The underlying calculation from the Trump administration is that a cosmetic, short-term deal – along the lines of the NAFTA renegotiation – will be difficult to defend on the campaign trail and hence politically risky. We upgraded the risk that talks collapse (50%) and downgraded the odds of a deal to 40% by end of June. If China agreed arbitrarily to increase imports from the U.S. by 10% by 2020, it would only increase the level of imports above the pre-trade war 2015-18 trend by $23 billion dollars in 2029 (Chart 6, panel 1). It would also have a minimal impact on the trade deficit. The deficit has increased so much in recent years that the impact of a 10% increase in exports by 2020 would merely offset the high point we reached during the trade war, leaving Trump with a mere $800 million per year by 2029 (Chart 6, panel 2). Chart 6 For commodities in particular – where China offered the largest purchases – the negative impact of the trade war has been so great that a 10% increase by 2020 over the status quo would fail to offset the recent damages over a ten-year period. China would have to increase imports by at least 17% to offset the trade war-induced decreases. If commodity imports were 30% higher in 2020 than otherwise, the impact 10 years down the line would amount to a mere $11 billion per year. These gains are smaller, as Chinese negotiators have long argued, than what could be made if the U.S. increased exports of advanced technology products to China. If the U.S. exported as many of these products to China as it does to the EU, as a share of EU GDP, it would amount to a $48 billion increase in exports. For Japan, the equivalent would be an $85 billion increase. Increasing the growth of these exports to China to match the recent trend of such exports globally would nearly double the amount sent to China by 2029, earning the U.S. an additional $60 billion that year (Chart 6, panel 3). The problem, of course, is that the confrontation with China is specifically focused on the latter’s technological acquisition and competition with the United States – it is precisely not about making reductions to the trade deficit at the expense of technological superiority. The tech war is more likely to derail the trade talks than the trade talks are likely to resolve the tech war. It is hugely significant that, at the moment of decision, President Trump sided with U.S. Trade Representative Robert Lighthizer and did not accept a deal focused on marginal improvements to the trade deficit. There was always a strong possibility – we previously put it at a 50% chance – that Trump would accept a short-term deal in order to get a “quick win” and minimize tariff pains ahead of the election, while punting the longer-term structural grievances until his second term when he would be less constrained by the economy. But this possibility has clearly fallen. We now put it at 35%, as shown in Table 1 above. Trump sees a shallow deal as a political liability. The most important takeaway from Table 1, however, is that the odds of a “Grand Compromise” have dropped to a mere 5%. Trump still may settle for a deal to reduce economic risks ahead of the election, but a grand compromise is very hard to get. Bottom Line: Our adjusted trade war probabilities suggest that global equities can fall further on a tactical horizon and that downside risks are grave, given a 50% chance that talks utterly collapse by the end of June. This would include a 30% chance of igniting an intense period of saber-rattling, sanctions, and Cold War-esque tensions that would cause a global flight to quality. Won’t The Trade War Turn Voters Against Trump? No. Chart 7 While geopolitical and political constraints push against a weak deal, the economic constraints of a failure to conclude a deal are not prohibitive. The latest tariff hike doubles the dollar magnitude of the tariffs, and an additional 25% tariff on the remaining $300 billion of imports would more than quadruple the magnitude of the tariffs from the April 2019 level (Chart 7). With all U.S. imports from China affected, price rises will percolate upward through all tradable industries and consumer goods. A few points are worth noting: The domestic value-add of Chinese exports to the U.S. is not as low as consensus holds. China’s manufacturing sector is highly competitive, comparable to the EU and Germany in the degree to which its exports to the U.S. incorporate foreign value (Chart 8). This means that Americans cannot substitute other goods for Chinese goods as easily as one might think. Chart 8 There remains a massive gulf between the nominal output of China’s manufacturing sector and the rest of Asia (Chart 9). Strategically it makes sense for the U.S. to want to decrease China’s share of American imports from Asia and reduce China’s centrality to the production process. But Asia cannot yet substitute for China. In practical terms this requires spreading China’s concentrated production system across the Indonesian archipelago. It is inefficient and will raise costs and import prices. Even in areas where China is lacking – such as technology, institutions, and governance – it still has a productivity advantage over the rest of Asia, pointing yet again to the cost-push inflationary consequences of an abrupt transition forced by tariffs (Chart 10). Chart 9Asia Cannot Replace China ... Yet Asia Cannot Replace China ... Yet Asia Cannot Replace China ... Yet Chart 10China's Productivity Beats Rest Of Asia China's Productivity Beats Rest Of Asia China's Productivity Beats Rest Of Asia Nevertheless, these cost factors are not so great as to force Trump into a weak deal. While the new and proposed tariff expansions will impact consumer goods more than the earlier batches that attempted to spare the consumer, the truth is that Chinese imports do not comprise a large share of the U.S. consumer basket (Chart 11). Chart 11American Shoppers Not Too Exposed To China American Shoppers Not Too Exposed To China American Shoppers Not Too Exposed To China Chart 12Goods Price Inflation Not An Immediate Risk Goods Price Inflation Not An Immediate Risk Goods Price Inflation Not An Immediate Risk Goods prices have been flat in the U.S., albeit in great part because of China, and they have fallen while the consumer price index and the real wage component of the CPI have risen by more than 20% since 2001 (Chart 12). Moreover, it is precisely in consumer goods where the American shopper does have considerable ability to substitute away from China – as opposed to the American corporation, which will have a harder time replacing Chinese-made capital goods quickly (Table 2). Thus, the risk impacts Wall Street differently than Main Street. Table 2Capital Goods Harder To Substitute How Trump Became A War President How Trump Became A War President Further, the median American household’s real income growth is still elevated (Chart 13). This comes on top of the fact that net household worth and the saving rate are both in good shape. President Trump has some leeway in waging his trade war. The risk, of course, is that this income growth is decelerating and Trump has given the tariffs 18 months to cause negative impacts for consumers prior to the election. He is also simultaneously wagering that the U.S.’s newfound energy independence – and his own ability to tap the strategic petroleum reserve – will prevent gasoline prices from spiking (Chart 14). This would occur as a result of any Iranian-backed attacks on oil production and export facilities across the Middle East. Chart 13American Household Still In Good Shape American Household Still In Good Shape American Household Still In Good Shape Chart 14Fuel Prices Already Rising Fuel Prices Already Rising Fuel Prices Already Rising Bottom Line: Inflationary pressures will result from trade tariffs (and Iranian sanctions) but they are not prohibitive for Trump thus far. This is not a recipe for cost-push inflation significant enough to trigger a recession or derail Trump’s reelection odds at present, but it is a risk that will need to be monitored. How Will China Respond? More Stimulus! The immediate ramification of a heightened trade war is deteriorating global trade and sentiment and hence slower global growth that pushes down prices. Indeed, the escalation of the trade war brings sharply into focus two long-running Geopolitical Strategy themes: Sino-American Conflict: U.S. and Chinese exports to each other have already sharply fallen off (Chart 15). Trade is interconnected so this will further depress global and Asia-ex-China exports. Chart 15Trade War Hurts Bilateral Trade ... And All Trade Trade War Hurts Bilateral Trade ... And All Trade Trade War Hurts Bilateral Trade ... And All Trade Chart 16Global Trade Already Rolling Over Global Trade Already Rolling Over Global Trade Already Rolling Over Apex of Globalization: Global trade as a whole is contracting as a result of the global slowdown, which the trade war has exacerbated (Chart 16). The negative impact on China is acute and threatens something akin to the global manufacturing recession of 2015 (Chart 17). Given that the trade war is now piling onto a merely fledgling rebound in Chinese and global growth this year, it is possible that the manufacturing slowdown could even get worse than 2015 and culminate in a global recession in our worst case scenario of a major strategic escalation. Preventing this outcome, China will increase fiscal-and-credit stimulus, which we have argued is likely to overshoot expectations this year due to trade war and the country’s desire to meet 2020 urban income goals (Chart 18). The magnitude should be comparable to the 2015-16 stimulus, unless a global recession is immediately in view, in which case it will be larger. Chart 17A Relapse Would Point Toward 2015-Sized Crisis A Relapse Would Point Toward 2015-Sized Crisis A Relapse Would Point Toward 2015-Sized Crisis It was the Xi administration that undertook the huge 2015-16 expansion of credit, so this magnitude is not out of the question. While Xi has attempted to contain leverage and reduce systemic financial risk, he is ultimately like his predecessors, most notably Jiang Zemin, in the sense that he will aim for social stability above all. Chart 18China Will Keep Stimulating China Will Keep Stimulating China Will Keep Stimulating The pain threshold of today’s policymakers has already been discovered, seeing how President Xi and the Politburo began easing policy in July 2018 after the U.S. implemented the initial Section 301 tariffs. The Chinese leaders were willing to tighten credit controls until this external risk materialized. The fact that the trade war is the proximate cause of heightened stimulus was confirmed in the wake of the Buenos Aires summit, where Xi chose to stimulate the economy further – resulting in a surge of credit in Q1 – as a way of improving China’s leverage vis-à-vis the United States in the 90-day talks. China will increase fiscal-and-credit stimulus … The magnitude should be comparable to the 2015-16 stimulus. In short, Xi and his government will stimulate first and ask questions later. Both fiscal and credit stimulus will be utilized, including traditional fiscal infrastructure spending and permissiveness toward shadow banking. A dramatic renminbi depreciation could occur but would be evidence that talks will fail (Chart 19). Chart 19Currency Agreement: Far From A Plaza Accord Currency Agreement: Far From A Plaza Accord Currency Agreement: Far From A Plaza Accord Stimulus will continue to be tactical, rolled out in piecemeal announcements, at least as long as the trade talks continue and there is a prospect of China’s economy rebounding without drastic measures. Only a total breakdown in negotiations – and collapse into outright Cold War – will prompt a massive stimulus package. Bottom Line: Chinese stimulus will surprise to the upside while talks are going, and it will increase dramatically if talks collapse. This will ultimately support global growth but it will not prevent market riots between a negative policy shock and the point at which markets are totally reassured about the magnitude of stimulus. How Will The Negotiations Proceed? Precariously. The risk of a strategic conflict is much higher than the markets are currently pricing. This is highlighted in Table 1 above, but there are additional reasons to have a high conviction on this point. We can demonstrate this by constructing a simple decision tree that outlines the step-by-step process by which the U.S. and China will proceed in their negotiations after the May 10 tariff rate hike (Diagram 1). To these we attach subjective probabilities that we believe are fair and slightly conservative. The result shows that it is not difficult to conclude that the conditional probability of a long-term, durable trade agreement is a mere 4%, whereas the conditional probability of an uncontained escalation in strategic tensions is as high as 59%! This is a much worse outcome than our actual view as expressed in Table 1. Diagram 1A Simple Decision Tree Says Geopolitical Risks Are Huge How Trump Became A War President How Trump Became A War President A similar exercise – an analysis of competing hypotheses conducted according to analytical techniques used by the U.S. intelligence community – reinforces the point that the most likely scenario is a major escalation in tensions, while the least likely is a “grand compromise” (Appendix). While our final trade war probabilities in Table 1 are not as pessimistic as these exercises suggest, the latter reinforce the point that the market is too sanguine. An increase in tariffs after five months of negotiations, with a threat to impose even more sweeping tariffs with a one-month deadline, is not conducive to Chinese concessions and therefore increases the odds of talks failing and an escalation in strategic conflict unprecedented in U.S.-China relations since the rupture from 1989-91. And this rupture would be considerably worse for the global economy. The Trump administration’s political logic is willing to accept such a conflict on the basis that a foreign policy confrontation can produce a rally-around-the-flag effect whereas a short-term deal that does not address significant technological and national security concerns is a political liability on the campaign trail. Yes, it is important that Presidents Trump and Xi are making verifiable preparations to attend the G20 summit in Japan. But they could cancel their attendance or snub each other at the event. In our view investors should wait for something more substantial to become more optimistic about political risk – such as public commitments to structural changes by China and a complementary tariff rollback schedule by the United States. Bottom Line: The odds of a total breakdown in U.S.-China relations and a Cold War-style escalation of strategic conflict are highly underrated. Markets will sell before they recover. Investment Implications Chart 20China's Nuclear Option Might Fizzle China's Nuclear Option Might Fizzle China's Nuclear Option Might Fizzle Equity markets are exposed to further downside in the short run. Even a minor escalation is not fully priced according to our Global Investment Strategy’s equity market forecasts based on our own geopolitical scenario probabilities (see Table 1 above). Our Chief Global Strategist Peter Berezin would recommend increasing exposure to risk if the S&P 500 falls 5% from current levels, other factors being equal. Cyclically, any trade agreement will fail to bring substantial benefits to the U.S.-China trade and investment outlook over a horizon beyond 12-24 months. The tech industries of the two countries will not benefit greatly from the deal. While multinational corporations exposed to the Asian manufacturing supply chain could suffer earnings downgrades from trade war, China’s stimulus will be a countervailing factor, particularly for commodities and commodity-oriented EMs. Therefore, we will keep our China Play Index and long Indonesia trades in place despite near-term risks. Ironically, U.S. treasuries can rally even when China is reducing its holdings, as global demand rises amid crisis (Chart 20). However, given that bonds have already rallied and we expect Chinese stimulus to come sooner rather than later, we will maintain our current portfolio hedge of Swiss bonds and gold, which is up 2%. We are closing our long small caps trade for a loss of 11.9%.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Appendix Image

President Trump’s announcement this week of a new deployment of aid to U.S. farmers, to offset China’s retaliation to steeper tariffs, highlights that agriculture has been the sacrificial lamb in the U.S.’s hawkish trade policy. The $15 billion announcement follows last year’s $12 billion disbursement, and suggests that the path to a trade agreement with China remains fraught. Although China and the U.S. continue to negotiate, and President Trump has indicated that “maybe something will happen” within a “three or four week” timeframe, last week’s events indicate that a resolution is far from guaranteed. Both positive and negative trade war news will dominate the near term evolution of ag prices – stay on the sidelines as negotiations will sway markets. Highlights Energy: Overweight. Crude oil prices are up ~2% since the beginning of the week on escalating tensions in the Middle East, as expected. Two Saudi oil-pumping stations were targeted in a drone attack on Tuesday. This follows attacks on four oil tankers – including two Saudi ships – off the coast of the United Arab Emirates. These events highlight the increased risk of supply outages since the U.S. decision not to extend waivers on Iran sanctions.1 Base Metals: Neutral. The recent escalation in Sino-U.S. trade tensions pushed LMEX prices down 2% since the beginning of last week. Nevertheless, we believe that in the medium term Chinese authorities will manage to offset the negative economic impact on metals by ramping up fiscal-and-credit stimulus.2 Precious Metals: Gold’s geopolitical risk premium is rising amid escalating trade tensions. Gold rallied ~2% since May 3, amid declining global equities. Our gold trade is up 5.3% since inception. Ags/Softs: Underweight. Sino-U.S. trade tensions are weighing heavily on agriculture commodities. The grains and oilseed index is down 9% since the beginning of the year. Continued trade war uncertainty will keep risks elevated in the ags space (see below). Feature Several factors – including dollar strength and bearish fundamentals – have come together to drive down ag prices so far this year. However, the latest plunge highlights that trade risks remain a real threat to ag markets. This is in line with the sharp cutback in Chinese imports of U.S. ags, which make up a large share of Chinese imports from the U.S. and have been hit hard by tariffs (Chart of the Week). Soybeans in particular have become the poster child of the dispute. Uncertainty has taken their prices down to 10 year lows. In 2017, they accounted for $12.4 worth, or 9.3%, of U.S. exports to China. However, since the onset of the dispute, American soybean farmers have been struggling to market their crops. U.S. exports to China are down more than 80% y/y since 2H18 (Chart 2), and while there have been efforts to find other markets, they have yet to offset the impact of lower trade with China (Chart 3). Chart 1 Chart 2Soybeans Are The Poster Child Of The Conflict Soybeans Are The Poster Child Of The Conflict Soybeans Are The Poster Child Of The Conflict Chart 3 A long-term solution is necessary to support the agriculture industry and prices of grains and oilseeds. In fact, the Chinese tariffs add to ongoing trade disputes between the U.S. and some of its other major ag markets (Charts 4A & 4B). Canada, Mexico, and the EU have placed tariffs on a range of U.S. agricultural goods in response to the Section 232 tariffs on steel and aluminum. Chart 4 Chart 4 As such, American farmers are suffering the brunt of the trade war’s burden. Chinese retaliation comes at a time when U.S. ag stockpiles are already elevated (Chart 5). Inflation-adjusted farm income had been deteriorating prior to the trade dispute, falling to about half its 2013 level (Chart 6). The trade dispute has only reinforced this trend. In its most recent Ag Credit Survey, the Kansas City Fed found the pace of decline in farm loan repayment rates increased, while carry-over debt increased for many borrowers, ultimately causing a deterioration in ag credit conditions. Given that exports account for 20% of U.S. farm income, according to USDA estimates, a long-term solution is necessary to support the agriculture industry and prices of grains and oilseeds. Otherwise, tariffs will simply be another constraint on U.S. ag exports, which have been losing global market share since the mid-1990s (Chart 7). Chart 5U.S. Stocks Are Relatively Elevated U.S. Stocks Are Relatively Elevated U.S. Stocks Are Relatively Elevated Chart 6Farmers Suffering The Brunt Of The Burden Farmers Suffering The Brunt Of The Burden Farmers Suffering The Brunt Of The Burden Chart 7U.S. Agriculture Losing Global Market Share U.S. Agriculture Losing Global Market Share U.S. Agriculture Losing Global Market Share Even though China briefly resumed some purchases of U.S. ags this year as a goodwill gesture during negotiations, these purchases stand significantly below those of previous years. They resulted from one-time purchases by Chinese state-owned enterprises, and barriers to trade remain in place. Such ad hoc attempts at reconciliation will not be sufficient to support a distrustful market going forward. The trade war is just one facet of a broader strategic U.S.-China conflict. This means a reso­lution would be only a cyclical improvement in an ongoing structural deterioration in relations. A number of potential outcomes can result from the ongoing negotiations: Most bearish: China raises the tariff rate on U.S. ag exports even further. A situation in which a fallout in the negotiations leads to strategic tensions – a scenario to which BCA’s geopolitical strategists attribute a 50% chance – could result in further ratcheting up of tariffs by China. Given that Chinese imports of U.S. ags are approaching zero, there is limited significant further downside even in this most pessimistic scenario. However, unless the U.S. is able to smoothly market its crops in other regions, upside will also be limited for some time. Since trade tariffs have already been initiated with many of the U.S.’s major ag consumers, securing reliable alternative markets may prove a challenge. Especially since Trump’s hawkish foreign policy raises risks and uncertainties for America’s trade partners. Bearish: Tariffs remain at current levels. Similar to the most bearish scenario, given that the U.S. is already having a difficult time marketing its crops abroad, significant further downside from current levels is also limited. However, any premium priced on the expectation of a resolution of the trade conflict will be eliminated. Again, as in the most bearish scenario, the loss of the Chinese market may be mitigated by an expansion of alternative markets, but challenges will remain. Bullish: Tariffs are cut back to pre-trade war levels. In this scenario, the tariffs imposed since the onset of the trade war will be unwound. This would once again raise the competitiveness of American crops in Chinese markets, and would entail higher ag prices as demand channels are re-established. Most Bullish: Tariffs fall to equalized levels. One of Trump’s key complaints is that U.S. and Chinese tariffs are not “reciprocal in nature and value” (Chart 8). Given that Chinese tariffs are above those of the U.S., this would entail a reduction in Chinese tariffs to below trade war levels (Table 1). Chart 8 Table 1... And They Have Gone Up American Farmers Caught In The Crosshairs Of Sino-U.S. Brinkmanship American Farmers Caught In The Crosshairs Of Sino-U.S. Brinkmanship A lasting trade deal will likely include measures to close the bilateral trade deficit, which in 2018 stood at $379 billion. Last year Trump called on Beijing to reduce this deficit by $200 billion over two years. If we make the overly simplistic assumption that the share of imports remains unchanged, such a reduction would lead to an additional $19 billion in soybeans, $0.54 billion in wheat, and $0.23 billion in corn imports. This back of the envelope calculation implies a doubling of these U.S. exports to China, relative to 2017 levels. As we highlighted in our March ags update, investors had become overly optimistic with their expectation of a swift resolution of the trade war.3 In fact, according to BCA’s geopolitical strategists, the trade war is just one facet of a broader strategic U.S.-China conflict. This means a resolution would be only a cyclical improvement in an ongoing structural deterioration in relations. They assign only 40% odds that a deal will be finalized by year-end, with 30% odds that the frictions will escalate into strategic tensions. In the meantime, Trump’s palliatives – which include a “trade relief” program, an EU promise to purchase more U.S. soybeans, and last week’s suggestion of government purchases for humanitarian aid – are unlikely to lift ag prices. Bottom Line: The U.S.-China trade war has weighed on American ag exports. The impact on farmers – in terms of lower incomes, and higher stockpiles – has been significant. Granting that odds of a resolution this year are no greater than 40%, we recommend a cautious stance on ag markets. However, a trade deal that entails Chinese promises to import U.S. ags – either through more favorable tariff rates or commitments to purchase large volumes – would provide a buying opportunity. In any case, we suspect that prices are near the bottom, but will require a significant catalyst – in the form of a trade deal – to begin to climb materially. No Relief From Fundamentals, Either With spring planting underway, the recent escalation in trade tensions comes at a busy time of year for U.S. farmers. According to the USDA’s annual Prospective Planting Report, released at the end of March, the planted area of corn will likely increase by 4% in 2019, while soybean and wheat will fall 5% y/y and 4% y/y, respectively. If realized, the planting area that farmers intend to dedicate to wheat will be the lowest on record – that is, since 1919 (Chart 9). However, farms in the Midwest were hit by a “bomb cyclone” in March, which has damaged crops and delayed planting. Inundated fields mean farmers are forced to push back their schedule. The latest Weekly Crop Progress Report from the USDA, indicates that farmers have fallen behind relative to typical progress at this time of year (Table 2). Although farmers’ current lack of headway is cause for concern, they may still be able to catch up and attain their targeted acreage. Chart 9Record Low Wheat Acreage Record Low Wheat Acreage Record Low Wheat Acreage Table 2Flooding Has Delayed Spring Planting American Farmers Caught In The Crosshairs Of Sino-U.S. Brinkmanship American Farmers Caught In The Crosshairs Of Sino-U.S. Brinkmanship Given that stockpiles are full, due to years of surplus, the impact of the flooding is unlikely to move international ag prices. Nevertheless, planting delays raise the possibility that corn farmers will switch to soybeans, which can be planted later in the season. In the May update of the World Supply And Demand Estimates – which includes the first estimates for the 2019/20 crop year — the USDA projected a decline in U.S. soybean ending stocks on the back of lower production and a pickup in exports. The switch in planting intentions towards soybeans at the expense of corn may at least partially reverse this expectation, raising global soybean inventories which are expected to remain unchanged (Chart 10). In addition to trade war, the African swine fever has hit pig herds in China – the main consumers of soybeans. According to China’s official statistics, more than a million pigs have been culled, and Chinese pork production is expected to be slashed by between a quarter and a half this year. This will depress demand for soybeans, further weighing on prices. So far this year the greenback has been a source of bearishness toward ags. Since the epidemic has spread to other Asian neighbors including Hong Kong and Vietnam, soybean demand from Asia will be reduced, regardless of the outcome of the trade war. This will also weigh on other major producers such as Brazil and Argentina, which have so far benefited from China’s shunning of the American crop. South American producers are also at risk if a positive outcome emerges from the negotiations. Chart 10No Change In Soybean Inventories Expected In The Coming Crop Year No Change In Soybean Inventories Expected In The Coming Crop Year No Change In Soybean Inventories Expected In The Coming Crop Year Chart 11Preliminary Projections Of Uptick In 2019/20 Wheat Inventories Preliminary Projections Of Uptick In 2019/20 Wheat Inventories Preliminary Projections Of Uptick In 2019/20 Wheat Inventories On the other hand, according to the latest USDA estimates, both global and U.S. year-end wheat inventories are expected to pick up in the 2019/2020 crop year (Chart 11). Greater European production will add to already elevated supplies. While global corn inventories are projected to come down, U.S. inventories will likely rise amid greater production and weaker exports. However, these acres are at risk given the flood delays (Chart 12). In addition to these supply-demand fundamentals, U.S. financial conditions – especially the U.S. dollar – will remain a key driver of ag prices. So far this year the greenback has been a source of bearishness toward ags. Ag prices have an inverse relationship with the U.S. trade-weighted dollar (Chart 13). While in our earlier report we had expected the dollar to peak by mid-year, the May 5 escalation in the trade war poses a risk to this view by threatening the global trade and growth outlook and spurring risk-off sentiment. Chart 12Another Deficit Expected ##br##For Corn Another Deficit Expected For Corn Another Deficit Expected For Corn Bottom Line: Farmers in the U.S. Midwest facing inundated fields are behind schedule in their spring planting. This poses a risk that a greater number of soybeans will be planted at the expense of corn – weighing down on an already depressed soybean market and potentially requiring the USDA to revise down its U.S. bean ending stocks in its next WASDE report. Chart 13U.S. Financial Conditions Continue To Weigh On Ags U.S. Financial Conditions Continue To Weigh On Ags U.S. Financial Conditions Continue To Weigh On Ags What is more, the African swine fever, which is spreading across East Asia, is reducing demand for animal feed there. Unless the trade conflict is resolved, we expect corn and wheat to outperform the soybean market.   Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com   Footnotes 1      Please see BCA Research’s Commodity & Energy Strategy Special Report titled “U.S.-Iran: This Means War?” dated May 3, 2019, available at ces.bcaresearch.com. 2      Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled “Expanded Sino-U.S. Trade War Could Be Bullish For Base Metals,” dated May 9, 2019, available at ces.bcaresearch.com. 3      Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled “Financial Conditions, Trade War Continue To Dominate Ag Market,” dated March 28, 2019, available at ces.bcaresearh.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q1 Image Commodity Prices and Plays Reference Table   Trades Closed in 2019 Summary of Closed Trades Image

While we remain bullish on global equities and other risk assets over 12 months, we went tactically short the S&P 500 last Friday following the market’s complacent reaction to the Trump Administration’s further tariffs increases on Chinese imports. While a moderate trade war would still produce more economic damage than standard economic models imply, this would be greatly mitigated by significant Chinese economic stimulus and a Fed that is in no hurry to raise rates and could even cut rates. Barring any further major developments, we recommend investors start increasing risk exposure if the S&P 500 falls to 2711. A dip in global bourses would also create an opportunity to go overweight EM/European equities. Favor gold over government bonds as a low-cost hedge against trade war risks for now.

Highlights Looking past the day-to-day noise of trade-related announcements, we view the underlying odds of an actual trade agreement this year to have fallen below 50%. For the purposes of investment strategy, China-exposed investors should now simply assume that the U.S. proceeds with 25% tariffs on all imports from China. Given this, investors should stop focusing strictly on the odds of trade war, and should instead start focusing on the likely net impact of the tariff shock and China’s inevitable policy response. Simulated and empirical estimates of the impact of a 25% increase in tariffs affecting all U.S.-China trade suggest that economic conditions in China are likely to deteriorate to 2015/2016-like levels. This implies that a 2015/2016-style policy response will again be required in order for policymakers to be confident that the shock will be overcome. The preference of policymakers is to prevent another significant episode of releveraging, but the constraints facing policymakers suggest that one is unlikely to be avoided. We see a meaningful chance that this tension will be resolved by a classic market “riot” over the coming 3 months as financial markets force reluctant policymakers to capitulate. We would not recommend a long position in Chinese stocks, either in absolute terms or relative to the global benchmark, for investors with a time horizon of less than 3 months. However, over a strictly cyclical (i.e. 6-12 month) time horizon, we would recommend staying long/overweight on the basis that policymakers will ultimately respond as needed. We recommend investors hedge the inherent RMB exposure from a long US$ cyclical position in Chinese stocks by opening a long USD-CNH trade. Feature U.S. and Chinese negotiators failed last week to secure an agreement deferring the threatened increase in the second round tariff rate.1 The tariffs increased on Thursday at midnight for goods not already in transit to the U.S. (effectively doubling the existing tariffs), which was followed by the inevitable retaliation by China on Monday (scheduled to take effect on June 1). The retaliation, coupled with President Trump’s earlier warning that China should not do so, was taken by investors as a sign that 25% tariffs on all goods imported from China will soon be in place. As we go to press, the S&P 500, Hang Seng China Enterprises Index, and the CSI 300 are down 3.5%, 7%, and 6.9%, respectively, since President Trump’s May 5 tweet (Chart 1). Chart 1Investors Are Starting To Price In 25% Tariffs Affecting All U.S.-China Trade Investors Are Starting To Price In 25% Tariffs Affecting All U.S.-China Trade Investors Are Starting To Price In 25% Tariffs Affecting All U.S.-China Trade Stimulus Minus Shock Holding all else equal, the events of the past two weeks are strictly negative for Chinese economic growth and would thus justify a decisively bearish outlook for Chinese stock prices after the rally that has taken place over the past six months. However, all is not equal, because a substantial deterioration in the export outlook will invariably cause a response from Chinese policymakers. Over the coming few weeks, global investors are likely to remain highly focused on developments and announcements related to the trade conflict. But at this point, our geopolitical team believes that the conclusion of an actual trade agreement this year is now only a 40% probability. This underscores that China-exposed investors should, for the purposes of investment strategy, simply assume that the U.S. proceeds with 25% tariffs on all imports from China, and should broaden their focus to the outcome of a simple formula that describes the potential net outcome of this event. Two simple scenarios concerning this formula are outlined below: Scenario 1 (Bullish): Stimulus – Shock > 0 Scenario 2 (Bearish): Stimulus – Shock ≤ 0 In scenario 1, the impact of China’s reflationary efforts more than offsets the negative shock to aggregate demand from the sharp decline in exports to the U.S. In this scenario, investors should actually have a bullish cyclical outlook for China-related assets, even if the near-term outlook is deeply negative. Scenario 2 denotes a bearish outcome where China’s reflationary response is not larger than the magnitude of the shock, which includes a circumstance where the impacts are exactly offsetting (because of the higher uncertainty, and thus risk premium, that this would entail). “Solving” The Formula In order to “solve” this formula, investors need answers to the following three questions: What is the size and disposition of the likely shock to China’s economy in a full-tariff scenario? What kind of reflationary response is required in order to offset this shock? What are the odds that policymakers will deliver the required response? Simulated and empirical estimates of a 25% increase in tariffs affecting all U.S.-China trade suggest a sizeable economic impact. Charts 2 & 3 provide the IMF’s perspective on the first question. The charts show the simulated impact of a 25% increase in tariffs affecting all U.S.-China trade, and they estimate the near-term impact for China to be -1.25% for real GDP (-0.5% over the long-run) and -3.5% for real exports (-4.5% to -5.5% over the long run). Chart 2 Chart 3   A recent IMF working paper came up with a more benign estimate of the first year impact, but a sizeable second year impact and a similar estimate of the long-term ramifications of tariff increases.2 Using a dataset with wide time and country coverage, the aggregate results of the study imply that Chinese output is only likely to fall about 0.2% in the year following the tariff increase. However, the cumulative shock to output increased sharply to roughly 1.6% in the second year of the tariff increase, with a negative yearly impact to output persisting for 5 years (with an average annual impact of -0.6% over the whole period, somewhat higher than the estimates shown in Charts 2 & 3). At the 90% confidence interval, the author’s estimates show that a tariff increase of this magnitude would imply a -1.7% average impact on output per year in the first two years following the increase. Chart 4The IMF's Shock Estimates Suggest A Serious Hit To China's Economy The IMF's Shock Estimates Suggest A Serious Hit To China's Economy The IMF's Shock Estimates Suggest A Serious Hit To China's Economy In order to answer the second question, investors need to have some sense of the relative magnitude of the estimates noted above. Chart 4 provides some perspective and highlights that the estimates above, were they to materialize, would do two things: Taking Chinese real GDP data at face value, it would cause the largest deceleration in China’s real GDP growth rate since 2012, when the economy slowed significantly and authorities responded forcefully. Based on the most recent data for Chinese real export growth, a 3.5% deceleration in export volume would push its growth rate to its lowest level since the global financial crisis. In practice, we doubt that China’s reported real GDP growth rate accurately reflects what occurred in 2015, and it is very possible that a similar deceleration happened in that year. However, economic similarity to the 2015/2016 episode implies that a similar policy response may also be required, a proposition that is supported by our MSCI China Index earnings recession model. Table 1 shows a set of earnings recession probabilities, based on a model that we presented in two recent reports.3 The scenarios express the odds as a function of new credit to GDP and our calculation of China’s export weighted exchange rate, and assume a substantial decline in the new export orders component of the official manufacturing PMI, and flat momentum in forward earnings. Table 1Our Earnings Recession Model Suggests That A 2015/2016 Style Response Is Needed To Counter This Shock Simple Arithmetic Simple Arithmetic The table clearly highlights that a significant further acceleration in new credit to GDP, coupled with a meaningful decline in the exchange rate, is needed in order to stabilize the earnings outlook. We have previously related stability in the outlook for earnings to stability in the economy itself, given the close correlation between Chinese investment-relevant economic activity and the earnings cycle (Chart 5). Given that new credit to GDP peaked at 31.5% during the 2015/2016 episode, it seems reasonable to conclude that a 2015/2016-style policy response will again be required in order for policymakers to be confident that the shock will be overcome. Policymaker Preferences Vs. Constraints This brings us to our third question: What are the odds that policymakers will deliver the stimulus required to confidently overcome the upcoming shock? It seems reasonable to conclude that a 2015/2016-style policy response will again be required in order for policymakers to be confident that the shock will be overcome. If the answer was only dependent on the preferences of policymakers, the odds would be low. China has relied heavily on credit to stimulate its economy over the past decade, and Chart 6 highlights that this has come at a high cost. The BIS’ estimate of the debt service ratio of China’s private non-financial sector is already extraordinarily high relative to other countries, and another round of meaningful re-leveraging will just make this problem even worse. Chart 5Earnings Stability = Economic ##br##Stability Earnings Stability = Economic Stability Earnings Stability = Economic Stability Chart 6Further Leveraging Will Undoubtedly Make A Big Problem Even Worse Further Leveraging Will Undoubtedly Make A Big Problem Even Worse Further Leveraging Will Undoubtedly Make A Big Problem Even Worse   We documented in detail how this has created the risk of a debt trap for China’s state-owned enterprises in an August Special Report,4 and have presented evidence arguing that China’s policymakers appear to have good economic reasons to try and shift China’s economy away from extremely high rates of investment towards more consumption.5 This implies that restraining credit growth to avoid further leveraging has been a reasonable policy objective during periods of relative economic stability. However, policy decisions cannot be made in a vacuum, and this is true even in the case of China. As such, instead of preferences, investors should be focused on policymaker constraints in judging likely policy actions. Given the potential for second round effects, Chinese policymakers need to calibrate their policy response to ensure a positive net impact of the stimulus minus the shock. In our view, three factors point to the conclusion that Chinese policymakers face serious economic constraints in setting their policy response: Charts 2-4 highlighted that 25% tariffs on all U.S.-China trade would constitute a meaningful shock, but it is also the case that this shock would be coming at a time when Chinese economic momentum is already relatively weak. This suggests that policymakers will have to act quickly and decisively to put a floor under economic activity. Charts 7 & 8 suggest that there are meaningful second round effects on Chinese domestic investment from external sector shocks, which raises the possibility that the impact on Chinese economic activity may be larger than Charts 2-4 suggest. Chart 7 shows that while the contribution to official real GDP growth from net exports is small, Chart 8 shows that past changes in net export contribution are reasonably correlated with subsequent changes in the contribution to growth from gross capital formation. While it is possible that this relationship is not actually causal, taking it at face value implies that the IMF’s estimate of the impact on output could be exceeded if the contribution to growth from net exports declines by 0.4% or more (holding the contribution to growth from final consumption expenditure constant). Since 2018’s change in net export contribution declined by three times this amount (1.2%), the downside risks to domestic investment from effectively quadrupling U.S. import tariffs are clear. China does not have a flexible labor market, and its political system is highly sensitive to significant job losses. Chart 9 shows that the employment situation has already seriously deteriorated in lockstep with actual economic activity, further underscoring the need for policymakers to act urgently. Chart 7 Chart 8 Chart 9The Employment Situation Is Already Deteriorating, And Will Do So Further The Employment Situation Is Already Deteriorating, And Will Do So Further The Employment Situation Is Already Deteriorating, And Will Do So Further We are open to the idea that policymakers may be able to devise a stimulative response of similar reflationary magnitude to the 2015/2016 episode without resorting to a major credit overshoot, but we are currently unable to articulate what it might be. This is an area of ongoing research for BCA’s China Investment Strategy service, but for now we assume that a credit overshoot remains the ultimate line of defense for China’s policymakers that will be deployed if the pursuit of alternative strategies fail to quickly stabilize economic activity. Investment Strategy Conclusions In our view, focusing on policymaker constraints rather than their preferences is much more likely to guide investors towards the right strategy conclusions over a 6-12 month time horizon. However, in the near-term, policy mistakes can occur, and are much more likely to occur if policymakers react to the imposition of constraints rather than anticipate their arrival. Over the coming three months, we see meaningful odds that Chinese policymakers remain reluctant to allow another episode of significant releveraging in the economy. If we are correct in our assessment of the damage that the tariff shock is likely to cause, this would set up a classic market “riot”, where policymakers are forced by financial markets to capitulate and respond forcefully to the seriousness of the economic situation. Further RMB weakness is likely. Investors should hedge their exposure and go long USD-CNH. Chart 10Investors Have A Green Light To Bet On A Lower RMB Investors Have A Green Light To Bet On A Lower RMB Investors Have A Green Light To Bet On A Lower RMB Given this, we would not recommend a long position in Chinese stocks, either in absolute terms or relative to the global benchmark, for investors with a time horizon of less than 3 months. However, over a cyclical (i.e. 6-12 month) time horizon, we would recommend staying long/overweight on the basis that policymakers will ultimately deliver the stimulus required to more than offset the upcoming shock to external demand. This means that our long MSCI China Index, MSCI China A onshore index, and MSCI China Growth index trades relative to the global benchmark are explicitly cyclical in orientation, and may suffer meaningful further losses over the coming few months before ultimately recovering. As a final point, Table 1 highlighted that a meaningful decline in the exchange rate is likely required in order to stabilize the earnings outlook. Chart 10 shows that currency weakness persisted well past the trough in relative Chinese investable equity performance during the 2015/2016 episode, and we would expect a similar result in the current environment given the nature of the shock. As such, we recommend investors hedge the inherent RMB exposure from a long US$ cyclical position in Chinese stocks by opening a long USD-CNH trade today, with high odds of a break above 7 in the coming weeks. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1 The first, second, third “round” of tariffs reference the $50/$200/$300 billion tranches of imported goods subject to U.S. tariff announcements since last summer. 2 IMF Working Paper WP/19/9, “Macroeconomic Consequences of Tariffs”, by Davide Furceri, Swarnali A. Hannan, Jonathan D. Ostry, and Andrew K. Rose. 3 Please see China Investment Strategy Special Report “Six Questions About Chinese Stocks,” dated January 16, 2019, and Weekly Report “A Gap In The Bridge,” dated January 30, 2019 available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report “Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging,” dated August 29, 2018, available at cis.bcaresearch.com. 4  Please see China Investment Strategy Weekly Report “Is China Making A Policy Mistake?,” dated October 31, 2018, available at cis.bcaresearch.com.   Cyclical Investment Stance Equity Sector Recommendations

Highlights U.S. Bond Strategy: U.S. Treasury yields are already priced for rate cuts and lower inflation, even as U.S. (and global) growth indicators are improving and U.S. realized inflation has ticked up. Maintain a below-benchmark stance on U.S. duration, even in the face of the current U.S.-China trade tensions. Stay overweight U.S. corporates versus Treasuries as well, with global growth indicators improving and U.S. monetary policy not yet restrictive. European Bond Strategy: Government bond yields in core Europe are too low relative to tentative signs that growth has bottomed out. At the same time, tight euro area corporate bond spreads already discount better economic momentum. Stay below-benchmark on euro area duration exposure, but maintain only a neutral weighting on euro area corporate bonds. Feature Monetary & Fiscal Policy Is More Important Than Trade Policy Chart 1Government Bonds Are Overvalued Government Bonds Are Overvalued Government Bonds Are Overvalued The old market bugaboo from 2018, “global trade uncertainty”, returned last week after the U.S. and China failed to reach a trade deal by last Friday’s deadline. The Trump Administration followed through on its threat to raise the tariff rate on $200 billion of Chinese exports to the U.S. from 10% to 25%, effective immediately. China retaliated by announcing fresh tariffs on $60 billion of U.S. exports to China, effective June 1st. Global equities have responded negatively, with the S&P 500 down -5% since President Trump first Tweeted his threat to increase tariffs on May 5. Global bond yields have declined in a standard risk-off move. The 10-year U.S. Treasury yield dropped -13bps over the past week - despite higher-than-expected April CPI and PPI inflation releases – and now sits at 2.40%. Meanwhile, the 10-year German Bund has dipped back into negative territory despite recent data releases showing an unexpected pickup in German industrial activity in March, and a sharp increase in Euro Area core inflation in April. Despite the greater uncertainty, we do not see a case for making any changes to our recommended pro-growth medium-term fixed income recommendations on duration (below-benchmark) or asset allocation (overweight corporates versus government debt). The BCA Global Fixed Income Strategy Duration Indicator continues to climb, indicating cyclical pressures for higher global bond yields (Chart 1). Yet at the same time, the deeply negative term premium component of yields in the U.S. and Europe (and most other developed markets) suggests that there is a lot of pessimism on growth and inflation (and a big safe-haven bid from investors) embedded in the current level of yields. Despite the greater uncertainty, we do not see a case for making any changes to our recommended pro-growth medium-term fixed income recommendations on duration (below-benchmark) or asset allocation (overweight corporates versus government debt). Our colleagues at BCA Geopolitical Strategy now believe that the odds of a trade agreement being reached this year are a 50/50 coin flip. If the talks do break down completely, however, China’s policymakers will almost certainly ramp up additional stimulus measures to offset the hit to growth from the U.S. tariffs. As a reminder, China’s exports to the U.S. only account for around 3.5% of China’s GDP (Chart 2), so U.S. tariffs matter far less than domestic stimulus via fiscal and monetary easing. Thus, any additional stimulus will help sustain the current blossoming rebound in global growth, which has been fueled in part by improved economic sentiment and a pickup in Chinese credit growth (Chart 3). In addition, Chinese import demand has ticked higher, our global leading economic indicator (LEI) is bottoming out, the ZEW surveys of economic sentiment are climbing higher and even the OECD LEI for China is starting to perk up. Chart 2China-U.S. Trade Is A Small Part Of The Two Economies China-U.S. Trade Is A Small Part Of The Two Economies China-U.S. Trade Is A Small Part Of The Two Economies Dovish central banks will also help limit the damage from increased trade uncertainty. In particular, the Fed will not rock the boat and stay “patient” by keeping rates on hold for longer. Chart 3A Consistent Message On A Global Growth Recovery A Consistent Message On A Global Growth Recovery A Consistent Message On A Global Growth Recovery Although given the inflationary implications of higher tariffs and the FOMC’s belief that the recent dip in core PCE inflation was “transitory”, the current market pricing for Fed easing appears too optimistic. Dovish central banks will also help limit the damage from increased trade uncertainty. We did get our first post-tariff read on the Fed’s thinking last Friday, and it did not sound like rate cuts were on the way. Atlanta Fed president Raphael Bostic noted that the most recent CPI and PPI inflation readings suggest that “price pressures are a little hotter” and that the U.S. is “almost to the cusp where we are going to see prices move”.1 He also noted that U.S. businesses are far more likely to pass on a higher 25% tariff on Chinese imports to consumer prices, where previously they had been more willing to absorb the higher cost of the smaller 10% tariff. Of course, an even bigger near-term selloff in global equity and credit markets is possible, if the current impasse between D.C. and Beijing persists without any indication of fresh negotiations. BCA Global Investment Strategy has recommended a tactical hedge to the overall overweight allocation to global equities in our House View matrix by shorting the S&P 500 index.2 However, we do not see the need to make any similar recommendations on the U.S. fixed income side – both the below-benchmark duration stance and the overweight corporate credit tilt - for the following reasons (Chart 4): Our Fed Monitor continues to signal that no rate cuts are required in the U.S., while -31bps of cuts over the next year are already discounted in the U.S. Overnight Index Swap curve. U.S. financial conditions have only tightened modestly on last week’s moves – after the substantial easing seen year-to-date – and still point to above-trend GDP growth over the rest of 2019. U.S. inflation expectations have dipped back to recent lows, even as realized inflation has hooked up; TIPS breakevens are now 40-50bps below levels consistent with the Fed hitting its 2% PCE inflation target. The Treasury market is now very overbought from a momentum perspective, while duration positioning is now very long according to the JPMorgan Client Survey. The reaction of U.S. corporate credit spreads to the trade headlines has been relatively muted to date (Chart 5), less than what was seen last December when the market feared a hawkish Fed policy mistake – over the medium-term, monetary policy matters more than trade policy for credit markets. Chart 4Stay Below-Benchmark U.S. Duration Stay Below-Benchmark U.S. Duration Stay Below-Benchmark U.S. Duration Chart 5A Modest Reaction (So Far) To The Tariffs A Modest Reaction (So Far) To The Tariffs A Modest Reaction (So Far) To The Tariffs In other words, U.S. Treasury yields now discount a lot of bad news and, thus, have limited downside even in the event of a further breakdown of U.S.-China trade talks. On the other hand, any positive news on fresh U.S.-China negotiations could send both equities and bond yields substantially higher and tighten credit spreads. On a risk/reward basis, a below-benchmark U.S. duration stance and overweight tilt on U.S. corporates are still warranted, even with the more elevated uncertainty on U.S.-China trade. Bottom Line: U.S. bond yields are already priced for rate cuts and lower inflation, even as U.S. (and global) growth indicators are improving and U.S. realized inflation has ticked up. Maintain a below-benchmark stance on U.S. duration, even in the face of the current U.S.-China trade tensions. Stay overweight U.S. corporates versus Treasuries as well, with global growth indicators improving and U.S. monetary policy not yet restrictive. European Bond Markets – Too Much Bad News In Yields, Too Much Good News In Credit Spreads With markets now focused on the U.S.-China trade squabble, the European economic situation is garnering few headlines. Investors may be missing out on a good story, with euro area data now more frequently surprising to the upside (Chart 6). The ZEW measures of economic sentiment have been picking up in the past few months, most notably in Germany and France, even with current conditions still perceived to be soft. Improved sentiment is where economic upturns begin, however, and it looks like better days lie ahead for European growth. Investors may be missing out on a good story, with euro area data now more frequently surprising to the upside. The 2018 downturn in euro area GDP growth was a result of a sharp downturn in exports that fed into large pullbacks in industrial production. The most recent data, however, shows that exports have started growing again, and production growth is stabilizing (Chart 7). Credit growth has also hooked up in Germany and France, while the credit contraction in Italy and Spain is bottoming out. Chart 6Upside Growth Surprises In Europe? Upside Growth Surprises In Europe? Upside Growth Surprises In Europe? Chart 7Starting To Reverse The 2018 Downturn Starting To Reverse The 2018 Downturn Starting To Reverse The 2018 Downturn The improvement in global leading indicators, such as the China credit impulse and our global LEI diffusion index, points to a rebound in euro area export growth over the latter half of the year (Chart 8). The escalation in the U.S.-China trade dispute is a potential source of concern but, as discussed earlier in this report, Chinese policymakers will likely provide additional stimulus measures to offset any hit from U.S. tariffs. This will help boost European exports to China, especially if Chinese citizens are forced to divert demand away from tariffed U.S. goods towards tariff-free European products. The likely result is that a recovery in net exports will help boost overall euro area GDP growth to an above-trend pace over the next few quarters, which could generate some surprising upside pressures on inflation. Overall euro area inflation remains well below the European Central Bank (ECB) target of “just below” 2%. Looking ahead, faster rates of inflation are more likely over the next 6-12 months (Chart 9). The early “flash” estimate for April headline HICP inflation was 1.7%, but the lagged impact of higher oil prices and a soft euro should provide a lift towards Q4/2019, boosted by faster year-over-year comparisons versus the 2018 plunge in global oil prices. The flash estimate for April also showed that core HICP inflation jumped from 1% to 1.3%. That is a large move even for a data series that has always been volatile, and there may be more signal than noise this time with wage growth also accelerating. Chart 8Exports Set To Boost European Growth Exports Set To Boost European Growth Exports Set To Boost European Growth Chart 9A Whiff Of Inflation? A Whiff Of Inflation? A Whiff Of Inflation? In terms of bond investment strategy, the benchmark 10yr German Bund yield looks too low according to most valuation components (Chart 10): Inflation expectations are too low relative to the rising trend in euro-denominated oil prices, and with actual inflation stabilizing. Our estimate of the term premium component of the Bund yield is also depressed, within 25bps of the deeply negative levels seen during 2015/16, when inflation was near zero and the ECB was most aggressively buying government bonds in its Asset Purchase Program. Our proxy for the market’s expectation of the real neutral short-term interest rate in the euro area - the 5-year EUR Overnight Index Swap rate, 5-years forward minus the 5-year EUR CPI swap rate, 5-years forward – is now down to -0.6%. Even allowing for modest potential growth rates in the euro area, and the persistent problems of weak profitability for European banks, such deeply negative real rate expectations discount a lot of pessimism. Similar to the story for U.S. Treasury yields laid our earlier in this report, the medium term risk/reward tradeoff for German Bund yields points to a below-benchmark duration stance as most appropriate. The upside in yields will likely come almost entirely from the inflation expectations component initially, as the ECB will maintain a dovish bias until they are convinced that the economy is indeed accelerating. Thus, we continue to recommend owning inflation protection in the euro area, either through inflation-linked bonds or CPI swaps. Similar to the story for U.S. Treasury yields laid our earlier in this report, the medium term risk/reward tradeoff for German Bund yields points to a below-benchmark duration stance as most appropriate. For spread product, a combination of improving growth, moderate inflation and stable monetary policy should be ideal for the performance of credit. Unfortunately, the robust rally in euro area corporate bonds so far in 2019 has tightened spreads to levels consistent with an accelerating economy (Chart 11). In other words, European corporate credit already discounts the faster growth that is likely to be seen later this year. Just looking at the relationship between credit and the euro area manufacturing PMI, the current level of spreads is more consistent with a PMI several points above the current soft reading that is still below the expansionary 50 line. Chart 10Stay Below-Benchmark ##br##Euro Area Duration Stay Below-Benchmark Euro Area Duration Stay Below-Benchmark Euro Area Duration Chart 11Stay Neutral European Corporates & Underweight BTPs Stay Neutral European Corporates & Underweight BTPs Stay Neutral European Corporates & Underweight BTPs We continue to recommend only a neutral allocation to euro area corporates (both investment grade and high-yield), given the competing forces of cyclical improvement but stretched valuation. As for our other major tilt in Europe, we continue to recommend a cautious, below-benchmark, stance on Italian government bonds. The indicators for the Italian economy are lagging the signs of life seen in other large euro area nations, amidst ongoing fiscal squabbles with the EU. We continue to recommend a below-benchmark stance on Italian government bonds until there is more decisive evidence of a rebound in Italian growth, signaled by a rising OECD LEI for Italy (which has been negatively correlated to Italy-German spreads over the past decade). Bottom Line: Government bond yields in core Europe are too low relative to tentative signs that growth has bottomed out. At the same time, tight euro area corporate bond spreads already discount better economic momentum. Stay below-benchmark on euro area duration exposure, but maintain only a neutral weighting on euro area corporate bonds.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1https://www.bloomberg.com/news/articles/2019-05-09/fed-s-bostic-warns-consumers-may-feel-hit-on-china-tariff-boost 2 Please see BCA Global Investment Strategy Special Alert, “Stay Cyclically Overweight Global Equities, But Hedge Near-Term Downside Risks From An Escalation Of A Trade War”, dated May 10th 2019, available at gis.bcareseach.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

We continue to recommend being overweight global equities and other risk assets over a horizon of 12 months. However, the apparent failure of trade talks between China and the U.S. to gain much traction poses near-term downside risks to our bullish thesis. At this point, our geopolitical team feels that the conclusion of an actual trade agreement this year is a 50/50 prospect. It is easy to envision a scenario where the Trump Administration pursues its “maximum pressure” doctrine in the hopes of wrangling out more concessions. For their part, the Chinese, rather than making sweeping reforms to their legal system as the Trump Administration is insisting, could simply choose to bide their time in the hopes that Joe Biden, an avowed free trader, becomes the next U.S. president. Ultimately, as discussed in this week’s Global Investment Strategy report, in a worst-case scenario where the trade talks break down completely, the combination of aggressive Chinese stimulus and a still-dovish Fed will likely preclude a major global economic downturn. Nevertheless, a 5% correction in global equities from current levels is entirely possible, especially in light of the strong rally since the start of the year. With this in mind, we are putting on a hedge to short the S&P 500 index. We will remove the hedge if stocks fall 5% or trade talks shift in a more positive direction. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com

We continue to recommend being overweight global equities and other risk assets over a horizon of 12 months. However, the apparent failure of trade talks between China and the U.S. to gain much traction poses near-term downside risks to our bullish thesis. At this point, our geopolitical team feels that the conclusion of an actual trade agreement this year is a 50/50 prospect. It is easy to envision a scenario where the Trump Administration pursues its “maximum pressure” doctrine in the hopes of wrangling out more concessions. For their part, the Chinese, rather than making sweeping reforms to their legal system as the Trump Administration is insisting, could simply choose to bide their time in the hopes that Joe Biden, an avowed free trader, becomes the next U.S. president. Ultimately, as discussed in this week’s Global Investment Strategy report, in a worst-case scenario where the trade talks break down completely, the combination of aggressive Chinese stimulus and a still-dovish Fed will likely preclude a major global economic downturn. Nevertheless, a 5% correction in global equities from current levels is entirely possible, especially in light of the strong rally since the start of the year. With this in mind, we are putting on a hedge to short the S&P 500 index. We will remove the hedge if stocks fall 5% or trade talks shift in a more positive direction. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com

Highlights The clear and present deterioration in Sino-U.S. trade negotiations suggests the dollar will remain bid in the near term. While the probability of a trade deal has fallen, the situation remains highly fluid, and the odds could shift either way rather dramatically. Ultimately, it is beneficial for both parties to come to an agreement. We highlighted last week that in an environment where volatility was low and falling, it paid to have insurance in place. The yen and Swiss franc remain attractive from this standpoint. Our thesis remains that the path of least resistance for the dollar is down, but gauging how high the dollar can catapult before ultimately reversing course is paramount for strategy. Our estimation is that the trade-weighted dollar could rise 2-3% before ultimately cresting. Expect more pronounced USD moves vis-à-vis growth-sensitive currencies. We were stopped out of our short USD/SEK position with a 1.9% loss. If global growth rebounds, this will be a high-conviction trade, but we are standing aside for risk-management purposes. Feature Markets received a dose of volatility this week. First, evidence has emerged that China is retracting on previous commitments toward a Sino-U.S. trade deal. A systematic volte face to core pledges such as legally addressing the theft of U.S. intellectual property and trade secrets, fair competition policy, and removing foreign caps on financial services, aggravated the Trump administration and prompted a new round of tariffs. As we go to press, the final details have not been revealed, but the proposal is to raise tariffs on $200 billion worth of Chinese goods from 10% to 25%, while slapping an additional 25% tariff on the remaining $325 billion of Chinese goods “shortly” after (Chart I-1). Almost simultaneously, tensions between the U.S. and Iran are flaring up following President Trump’s decision not to extend sanction waivers to Iranian oil exports beyond May. The Iranian response has been to threaten to claw back some of the commitments it made in the landmark 2015 nuclear deal, mainly a halt to its uranium enrichment program. The risk of miscalculation and escalation is high. With an aircraft carrier strike group departing from U.S. shores, Tehran could be forced into a corner and begin striking key pipelines in the Iraqi region of Basra, which is home to significant oil traffic. Meanwhile, investor exuberance towards green shoots in the global economy continues to be watered down with incoming data. Chinese export data has weakened anew, both in April and on a rolling three-month basis, following weak PMI numbers last week. Money and credit numbers were soft. Swedish manufacturing data, a strong proxy for global growth, continue to disappoint, with industrial new orders contracting by 8.1% in March – the worst pace since November 2016. And after a brisk rise since the start of the year, many China plays including commodity prices, the yuan, emerging market stocks and even A-shares are rolling over (Chart I-2). Chart I-1Back To The Firing Lines Back To The Firing Lines Back To The Firing Lines Chart 1-2Reflation Indicators Are Topping Out Reflation Indicators Are Topping Out Reflation Indicators Are Topping Out These developments have unsurprisingly put a bid under the dollar against pro-cyclical currencies. However, the euro is up versus the dollar this week, while the DXY marginally down. The lack of more pronounced volatility in currency markets despite a ramp-up in trade-war rhetoric is eery. Our thesis remains that the path of least resistance for the dollar is down, but gauging how high the dollar can catapult before ultimately reversing course is paramount for strategy. Tariffs And Exchange Rates Standard theory suggests that exchange rates should move to equalize prices across any two countries. This is simply because if prices rise significantly higher in country B versus Country A, it pays to buy the goods from A and resell them to B for a profit, assuming other costs are minimal. Country A’s currency rises following increased demand, while that of Country B falls, until the price differential is arbitraged away. This very simple concept originated from the School Of Salamanca in 16th century Spain, and still applies to this day in the form of Purchasing Power Parity (PPP). The question that naturally follows is by how much should the currency increase? The answer is that the exchange rate will move by exactly the same percentage point as the price increase, everything else equal. If both countries produce homogeneous goods, then it is easy to see why, since there is perfect substitution. But assuming they produce heterogeneous goods, then the loss of purchasing power in Country A will lead to less demand for Country B’s goods. This means Country B’s currency will have to adjust downwards for the markets to clear. The decrease has to match the magnitude of the price increase, since there are no other outlets to liquidate Country A’s goods. If, say, Country A moves to hike prices as well, then both currencies remain at par. This is obviously a very simplified version of the real world economy, but it highlights an important point that is central to the discussion: The currency move necessary to realign competitiveness will always be equal to, or less, in percentage point terms to the price increase. In the case where the entire production base is tradeable, it will be the former. But with a rise in the number of trading partners, a more complex export basket, import substitution, shipping costs and many other factors that influence tradeable prices, the currency adjustment should be a fraction of the price increase. Since the onset of 2018, the U.S. has slapped various tariffs on China, the most important of which was 10% on $200 billion worth of Chinese goods. Assume for the sake of argument that only China and the U.S. were trading partners. The U.S. currently imports $522 billion worth of goods from China, about 17% of its total imports. However, as a percentage of overall U.S. demand, this only represents 2.5% (Chart I-3). This suggests that at best, a 25% increase on all Chinese imports will only lift import prices by 4.3% and consumer prices by much less. On the Chinese side of the equation, exports to the U.S. account for 20% of total exports, so a tariff of 25% should only lift export prices by 5%. The conclusion is that the yuan and dollar only need to adjust by 4-5% to negate the impact of a 25% tariff. Chart 1-3Sino-U.S. Trade Is Small Relative To Domestic Demand Sino-U.S. Trade Is Small Relative To Domestic Demand Sino-U.S. Trade Is Small Relative To Domestic Demand Chart 1-4No Disorderly Rise In ##br##The Dollar No Disorderly Rise In The Dollar No Disorderly Rise In The Dollar   The DXY index is up 10% since the 2018 trough (Chart I-4), and the dollar was up an average of 74 basis points versus the Chinese Yuan from the day major tariffs were announced until the peak in trade-war rhetoric (Table I-1). This would be in line with economic theory. But there is a caveat: With no corresponding export subsidy for U.S. goods, the rise in the dollar makes exporters worse off. And with over 40% of S&P 500 sales coming from outside the U.S., this would have a meaningful dent on corporate profits. A paper by the Peterson Institute for International Economics showed that imposing a border adjustment tax caused the real effective exchange rate (REER) of the country to rise, hurting competitiveness.1  In quantity terms, the IMF estimated that a 20% import tariff from East Asia would lift the U.S. dollar’s REER by 5% over five years, while dropping output by 0.6% over the same timeframe.2  With the dollar not currently overvalued on a REER basis, this does not bode well for future competitiveness (Chart I-5). Chart I- Finally, trade wars are usually synonymous with recessions. As such, there are acute political constraints inching both sides toward an agreement. For President Trump, a deteriorating U.S. manufacturing sector in the Midwestern battleground states is a thorn in his side. The U.S. agricultural sector has continued to bleed from falling grain prices (Chart I-6). For President Xi, rising unemployment is a key constraint. April manufacturing and credit numbers out of China show that the economy is relapsing anew. So, either China compromises and inches towards a trade deal or launches another round of stimulus. Chart I-5The Dollar Is Not Undervalued On A REER Basis The Dollar Is Not Undervalued On A REER Basis The Dollar Is Not Undervalued On A REER Basis Chart I-6A Drought In Cash Flows For ##br##U.S. Farmers A Drought In Cash Flows For U.S. Farmers A Drought In Cash Flows For U.S. Farmers   Bottom Line: Standard theory suggests the dollar’s bid should be capped at 2-3% on the imposition of new tariffs. Getting the global growth picture right will be more important in dictating the dollar’s trend. Of course, a full-blown trade war puts the entire thesis in jeopardy. Questions From The Road We were on the road this week, talking to clients and teaching the BCA Academy. Most clients agreed that the dollar is in a transition phase, given the presence of emerging green shoots in the global economy (Chart I-7). However, most were also concerned to what degree this view could be offside. The concerns centered around the fact that the growth differential between the U.S. and the rest of the world remains wide, yield differentials still favor the U.S., profit leadership also continues to favor the U.S. and it is unclear to what degree the world is short of U.S. dollars. U.S. profit leadership in the world continues, but one prescient indicator for the dollar is whether banks are easing lending standards for large firms relative to smaller ones.  We continue to lean towards the narrative that most of the factors driving the dollar higher are behind us. U.S. growth tends to be low-beta relative to the world, so a rebound in the global economy will be negative for the dollar. An end to the Federal Reserve’s balance sheet runoff will steer growth in the U.S. monetary base from deeply negative to zero. Meanwhile, a rising external profit environment will lead to an increase in foreign central bank reserves. The yield differential between the U.S. and the rest of the world remains wide, but this has a natural limit since global bond yields tend to converge towards each other over time. Chart I-7Global Growth Should##br## Rebound Global Growth Should Rebound Global Growth Should Rebound Chart I-8Positive Earnings Revisions Bodes Well For Growth Positive Earnings Revisions Bodes Well For Growth Positive Earnings Revisions Bodes Well For Growth   U.S. profit leadership in the world continues (Chart I-8), but one prescient indicator for the dollar is whether banks are easing lending standards for large firms relative to smaller ones. A better external environment will suggest banks will allow credit to flow to larger firms relative to smaller ones, since the latter tend to be more domestic. This is also an environment where global equities tend to outperform. The latest Fed Senior Official Loan survey showed that on the margin, lending standards are easing for large relative to small firms. This may suggest that return on capital is starting to improve outside the U.S., which will be a headwind for the dollar (Chart I-9). Chart I-9S&P 500 Foreign Earnings Need A Weak Dollar S&P 500 Foreign Earnings Need A Weak Dollar S&P 500 Foreign Earnings Need A Weak Dollar From a technical standpoint, almost all currencies are already falling versus the U.S. dollar – a trend that has been in place for several months now. This means most of the factors putting upward pressure on the dollar are well understood by the market. For example, global growth has been slowing for well over a year, based on the global PMI. Putting on fresh U.S. dollar long positions is at risk of a washout from stale investors, just as it was back in 2015, a year after growth had peaked (Chart I-10). It will be difficult for the dollar to act as both a safe-haven and carry currency, because the forces that drive both move in opposite directions.  Dollar technicals are also very unfavorable. Speculators are holding near-record long positions, sentiment is stretched, and our intermediate-term indicator is also flagging yellow. Over the past five years, confirmation from all three indicators has been followed by some period of U.S. dollar indigestion (Chart I-11). This may help explain relative stability in the broad trade-weighted dollar, despite a flare up in global risk aversion. Chart I-10Dollar Bull Case Is Well Known Dollar Bull Case Is Well Known Dollar Bull Case Is Well Known Chart I-11Dollar Technicals Are Unfavorable Dollar Technicals Are Unfavorable Dollar Technicals Are Unfavorable   Finally, with U.S. interest rates having risen significantly versus almost all G10 countries in recent years, the dollar has itself become the object of carry trades. This has also come with a good number of unhedged trades, as the rising exchange rate has lifted hedging costs. It will be difficult for the dollar to act as both a safe-haven and carry currency, because the forces that drive both move in opposite directions. The strength in EUR/USD this week despite the rise in global risk aversion is testament to this thesis. Bottom Line: Aside from the renewed specter of a trade war, most of the factors driving the dollar higher are behind us. House Keeping Chart I-12Buy Some Insurance Buy Some Insurance Buy Some Insurance Rising market volatility suggests some trades could be at risk from being stopped out. First, our long AUD/USD sits right at the epicenter of any growth slowdown in China. Maintain stops of 68 cents. Second, in an environment where volatility is low and falling, it pays to have insurance in place. We continue to favour CHF/NZD (Chart I-12). Third, we were stopped out of our short USD/SEK position for a 1.9% loss. If global growth rebounds, this will be a high-conviction trade. However, we are standing aside for risk-management purposes. Finally, the Reserve Bank Of Australia kept rates on hold this week, while the Reserve Bank Of New Zealand cut rates. This bodes well for our strategic AUD/NZD position.     Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Caroline Freund and Joseph E. Gagnon, “Effects of Consumption Taxes on Real Exchange Rates and Trade Balances,” Peterson Institute for International Economics, April 2017. 2 Maurice Obstfeld, “Tariffs Do More Harm Than Good At Home,” IMFBlog, September 8, 2016. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. have been mostly positive: To begin with the labor market, the unemployment rate fell to a 50-year low of 3.6% in April, despite a slight fall in the participation rate to 62.8%. Change in nonfarm payrolls came in above expectations at 263K in April, while average hourly earnings was unchanged at 3.2%. Moreover, JOLTS job openings came in at 7.5 million, above expectations. On the PMI front, the Markit composite PMI fell to 53 in April. ISM non-manufacturing PMI fell below expectations to 55.5. On the housing market front, mortgage applications increased by 2.7%, an improvement from the last reading of -4.3%. This nudged the MBA Purchase Index from 259.4 to 270.2. DXY index fell by 0.2% this week. On Sunday, Trump tweeted that tariffs on $200 billion worth of Chinese imports will increase from 10% to 25%, which again toppled the market. The ongoing trade disputes increase uncertainty in the global growth outlook. Report Links: Take Out Some Insurance - May 3, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area are improving: Headline and core inflation in the euro area rose to 1.7% and 1.2% year-on-year, respectively in April. Markit composite and services PMI came in at 51.5 and 52.8, respectively, both surprising to the upside. The French composite and services PMI increased to 50.1 and 50.5. The German composite and services PMI increased to 52.2 and 55.7. Sentix investor confidence rose to 5.3 in May, well above consensus. Retail sales increased by 1.9% year-on-year in March. EUR/USD appreciated by 0.3% this week. The European Commission (EU) released the spring 2019 Economic Growth Forecasts this week, citing that “growth continues at a more moderate pace.” While the global growth slowdown and trade policy uncertainties could weigh on the European economy, domestic dynamics are set to support the economy. According to the forecast, growth will continue to pick up in all EU member states next year. Report Links: Take Out Some Insurance - May 3, 2019 Reading The Tea Leaves From China - April 12, 2019 Into A Transition Phase - March 8, 2019 The Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been neutral: Nikkei composite PMI increased to 50.8 in April. The manufacturing PMI increased to 50.2, while the services PMI fell slightly to 51.8. Vehicle sales increased by 2.5% year-on-year in April. Consumer confidence index fell to 40.4 in April. USD/JPY fell by 0.9% this week. Volatility caused by the ongoing trade disputes has reduced risk appetite, enhancing the outperformance of the safe-haven yen. According to the BoJ minutes released this Wednesday, Japanese financial conditions remain highly accommodative, and the domestic demand is likely to bounce, despite the drag from external growth. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 A Trader’s Guide To The Yen - March 15, 2019 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. have been solid: Markit composite PMI increased to 50.9 in April. Services PMI also came in above expectations at 50.4 in April, an improvement from the last reading of 48.9. The British Retail Consortium (BRC) like-for-like retail sales increased by 3.7% year-on-year in April, outperforming expectations. Halifax house prices increased by 1.1% month-on-month in April and 5% year-on-year. GBP/USD fell by 0.9% this week, erasing the gains from last Friday after positive PMI data. We continue to favor the pound given its cheap valuation and healthy domestic fundamentals. However, the window for pound upside will rapidly close as we approach Brexit 2.0. Report Links: Take Out Some Insurance - May 3, 2019 Not Out Of The Woods Yet - April 5, 2019 A Trader’s Guide To The Yen - March 15, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been mostly positive: CBA Australia composite and services PMI both outperformed, increasing to 50 and 50.1, respectively. Building permits contracted by 27.3% year-on-year in March. However, this looks like a volatile bottoming process on a chart. Retail sales increased by 0.3% month-on-month in March. The trade balance came in at a surplus of A$4.95 million in March. AUD/USD has been flat this week. The Reserve Bank of Australia kept interest rate on hold at 1.5% this week, which disappointed the bears. Moreover, in the monetary policy statement, the RBA estimates the economy will grow around 2.75% in 2019 and 2020, supported by increased investment and a pickup in the resources sector. Report Links: Beware Of Diminishing Marginal Returns- April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 Into A Transition Phase - March 8, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been mixed: ANZ commodity prices increased by 2.5% in April, higher than expected. 2-year inflation expectations remain at 2%. Dairy price index increased by 0.4% in April, above the estimated -1.1%. NZD/USD fell by 0.5% this week. On Tuesday, the RBNZ lowered its interest rate by 25 bps to 1.5%. Our long AUD/NZD position, which is currently 0.8% in the money, is likely to profit from the widened interest rate differential. In the monetary policy statement, the RBNZ stated that a lower rate is mostly consistent with the current employment and inflation outlook in New Zealand. Moreover, global uncertainties, coupled with domestic housing market softness and reduced immigration remain a headwind to the economy. Report Links: Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been positive: Ivey Purchasing Managers’ Index increased to 55.9 in April, well above estimates. Housing starts increased by 236K year-on-year in April. Imports and exports increased to C$52 billion and C$49 billion respectively in March, resulting in a small deficit of C$3 billion. New housing price index increased by 0.1% year-on-year in March. USD/CAD has been flat this week. On Monday, Governor Poloz gave a speech focusing on the Canadian housing sector. He aims to provide more flexible mortgage choices for Canadian consumers, which could help the housing market to stabilize. The possible measures include diversifying mortgage terms, developing an MBS market, and encouraging different mortgage designs. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been neutral: Headline inflation fell to 0.2% in April on a month-on-month basis, while unchanged at 0.7% on a year-on-year basis. Core inflation was unchanged at 0.5% year-on-year. Foreign currency reserves increased to 772 billion CHF in April. Unemployment rate was unchanged at 2.4% month-on-month in April. The SECO consumer climate fell to -6 in Q2. USD/CHF fell by 0.2% this week. While the trade disputes and increased global growth uncertainties could support the Swiss franc in the near term, we continue to favor the euro over the franc on a cyclical basis. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been mixed: Registered unemployment fell to 2.3% in April. Manufacturing output contracted by 0.8% in March. House prices rose by 2.2% year-on-year in April, below March’s 3.2% annual growth. USD/NOK increased by 0.2% this week. On Thursday, the Norges Bank kept interest rates on hold at 1%, in line with expectations. The monetary policy continues to be accommodative, which is a tailwind for the Norwegian economy. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been negative: Industrial production contracted by 1.3% year-on-year in March. Manufacturing new orders decreased by 8.1% year-on-year in March, the worst since November 2016. USD/SEK increased by 0.8% this week. Our short USD/SEK position was stopped out at 9.6, due to the weaker-than- expected Swedish data and unexpected U.S. dollar resilience. We will look to put the trade back on when we see more clear signs of a global growth bottom. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades