Trade

Highlights Even if higher tariffs are imposed tonight, there is a good chance that China and the U.S. will reach a temporary trade truce over the coming weeks. Contrary to President Trump’s assertion, U.S. companies and consumers have borne all of the costs of the tariffs. With the next U.S. presidential campaign less than one year away, the self-described “master negotiator” will actually need to prove that he can negotiate a trade deal. If trade talks do collapse, the Chinese will ramp up credit/fiscal stimulus “MMT style,” thus providing a cushion under global growth and risk assets. In fact, there is a very high probability that the Chinese will overreact to the risks to growth, much like they did in 2009 and 2016. Investors should remain overweight global equities for the next 12 months, while positioning for a modestly weaker U.S. dollar and somewhat higher global bond yields. Feature Tariff Man Strikes Again Hopes for a quick end to the trade war were dashed last Sunday. President Trump threatened to hike tariffs on $200 billion of Chinese goods and begin proceedings to tax the remaining $325 billion of imports currently not subject to tariffs. Although details remain sketchy, U.S. Trade Representative Robert Lighthizer apparently informed the president that the Chinese were backtracking on prior commitments to change laws dealing with issues such as market access, forced technology transfers, and IP theft.1 This infuriated Trump. Trump’s announcement came just as Vice Premier Liu He and a 100-person Chinese trade delegation were set to depart for Washington. As BCA’s Chief Geopolitical Strategist Matt Gertken has noted, the relationship between the two sides was deteriorating even before Trump fired his latest salvo.2 The Chinese government was incensed by the U.S. request that Canada detain and extradite a senior official at Huawei, a top Chinese telecom firm. For its part, the Trump Administration was irked by China’s questionable enforcement of Iranian oil imports, the escalation of Chinese military drills around Taiwan, and the perception that China had not done enough to keep North Korea in check following the failed summit with Kim Jong-Un in Hanoi. It would be naïve to expect these ongoing geopolitical issues to fade anytime soon. The world is shifting from a unipolar to a multipolar one (Chart 1). In an environment where there are overlapping spheres of influence, geopolitical tensions will rise. Chart 1The Era Of Unipolarity Is Over The Era Of Unipolarity Is Over The Era Of Unipolarity Is Over That said, stocks still managed to advance during the first four decades of the post-war era even though the U.S. and the Soviet Union were at each other’s throats. What investors need today is some reassurance that the current trade spat will not degenerate into a full-out trade war that undermines global commerce. Ultimately, we think they will get this reassurance for the same reason that the Soviets and Americans never ended up lobbing missiles at each other: It would have been a lose-lose proposition to do so. Yet, the path from here to there will be a bumpy one. Investors should expect heightened volatility over the coming weeks. As It Turns Out, Trade Wars Are Neither Good Nor Easy To Win There was never any doubt that Wall Street would suffer from a trade war. What was less clear at the outset was the impact that higher tariffs would have on Main Street. Despite President Trump’s claim that the tariffs paid to the U.S. Treasury were “mostly borne by China,” the evidence suggests that close to 100% of the tariffs were, in fact, borne by U.S. companies and consumers. What investors need today is some reassurance that the current trade spat will not degenerate into a full-out trade war that undermines global commerce. A recent NBER paper compared the prices of Chinese imports that were subject to tariffs and similar goods that were not.3 Had Chinese producers been forced to bear the cost of the tariffs, one would have expected pre-tariff import prices to decline. In fact, they didn’t. The tariffs were simply absorbed by U.S. importers in the form of lower profit margins and by U.S. consumers in the form of higher selling prices. This does not mean that Chinese producers escaped unscathed. The paper showed that imports of tariffed goods dropped sharply as U.S. demand shifted away from China and towards domestically-produced goods and imports from other countries. Chart 2Support For Protectionism Rises When Unemployment Is High Support For Protectionism Rises When Unemployment Is High Support For Protectionism Rises When Unemployment Is High One might think that the decision to divert spending from Chinese goods to, say, Korean goods would be irrelevant for U.S. welfare. However, a simple thought experiment reveals that this is not the case. Suppose that a 10% tariff raises the price of an imported good from $100 to $110. If the consumer buys this good from China, the consumer will lose $10 while the U.S. government will gain $10, implying no loss in welfare. However, suppose the consumer buys the same good, tariff-free, from Korea for $105. Then the consumer loses $5 while the government gets no additional revenue, implying a net loss in national welfare of $5. Things get trickier when we consider the case where the consumer buys an identical domestically-produced good for say, $107, in order to avoid the tariff. If the economy is suffering from high unemployment, the additional demand will boost GDP by $107. The consumer who bought the domestically-produced good will be worse off by $7, but wages and profits will rise by $107, leaving a net gain of $100 for the economy. When unemployment is high, beggar-thy-neighbor policies make more sense. This is a key reason why support for protectionism tends to rise when unemployment increases (Chart 2). Today, however, the U.S. unemployment rate is at a 49-year low. To the extent that tariffs shift demand towards locally sourced goods, this is likely to require that workers and capital be diverted from other uses. When this occurs, there is no change in overall GDP. Within the context of the example above, all that would happen is that consumers would lose $7, reducing national welfare by the same amount. In fact, it is even worse than that. The example above does not include the impact on welfare from any resources that would need to be squandered from having to shift workers and capital equipment from sectors of the economy that lose from higher tariffs to those that gain from them. Nor does the example include the adverse impact on national welfare from any retaliatory policies. Ironically, while the evidence suggests that U.S. tariffs did not have much effect on Chinese import prices, it does appear that Chinese tariffs had an effect on U.S. export prices. Agricultural prices are highly sensitive to market conditions. Chart 3 shows that grain and soybean prices fell noticeably in 2018 on days when trade tensions intensified. This pattern has continued into the present. It is not surprising that Senators Chuck Grassley and Joni Ernst, along with other senior Iowa politicians, penned a letter to President Trump imploring him to reach a trade deal in order to help the state’s farming communities.4 Chart 3 China’s Secret Weapon: MMT To be fair, the arguments above do not account for the strategic possibility that the threat of punitive tariffs forces the Chinese to open their markets and refrain from corporate espionage and IP theft. If Trump is able to wrangle these concessions from the Chinese, then he could remove the tariffs, creating an environment more favorable to American corporate interests. The problem is that China will resist conceding so much ground. True, a trade war would hurt Chinese exporters much more than it would hurt U.S. firms. However, China is no longer as dependent on trade as it once was. Chinese exports to the U.S. account for only 3.6% of GDP, down from 7.3% of GDP in 2006 (Chart 4). China also has plenty of tools to support the economy in the event of a trade war. Chief among these is credit/fiscal stimulus. As we discussed three weeks ago, investors are underestimating China’s ability to ramp up credit growth in order to support spending throughout the economy.5 High levels of household savings have kept interest rates below the growth rate of the economy (Chart 5). When GDP growth exceeds the interest rate at which the government can borrow, even a persistently large budget deficit will produce a stable debt-to-GDP ratio in the long run. Chart 4China Is No Longer As Dependent On Trade With The U.S. As It Once Was China Is No Longer As Dependent On Trade With The U.S. As It Once Was China Is No Longer As Dependent On Trade With The U.S. As It Once Was Chart 5China: High Levels Of Household Savings Have Kept Interest Rates Below The Growth Rate Of The Economy China: High Levels Of Household Savings Have Kept Interest Rates Below The Growth Rate Of The Economy China: High Levels Of Household Savings Have Kept Interest Rates Below The Growth Rate Of The Economy   The standard counterargument is that governments cannot control the interest rate at which they borrow. This means that they run the risk of experiencing a vicious circle where high debt levels cause bond yields to rise, making it more difficult for the government to service its debt. This could lead to even higher bond yields and, eventually, default. However, this argument applies only to countries that do not issue their own currencies. Since a sovereign government can always print cash to pay for the goods and services, it can never run out of money. Chinese exports to the U.S. account for only 3.6% of GDP, down from 7.3% of GDP in 2006. The main reason a sovereign central bank would wish to raise rates is to prevent the economy from overheating. If a rising fiscal deficit is the consequence of a decline in private-sector spending (which is something that would likely happen during a trade war), there is no risk of overheating, and hence, there is no need to raise interest rates. We are not big fans of Modern Monetary Theory, but at least on this point, the MMT crowd is right while most analysts are wrong. Investment Conclusions It is impossible to say with any confidence what the next few days will bring on the trade front. If the Trump Administration’s allegation that the Chinese backtracked on prior commitments turns out to be true, it is possible that some of them will be reinstated, thus allowing the negotiations to resume. This could prompt Trump to offer a “grace period” to the Chinese of one or two weeks later tonight before scheduled tariff hikes are set to occur. If tariffs do go up, what should investors do? The answer depends on how much stocks fall in response to the news. If global equities were to decline by more than five percent, our inclination would be to get more bullish. There are two reasons for this. First, the failure to reach a deal this week does not mean that the talks will irrevocably break down. The point of Trump’s tariffs was never to raise revenue. It was to force the Chinese into a trade agreement that served America’s interests. With less than a year to go before the presidential campaign kicks into high gear, the self-described “master negotiator” needs to prove to the American public that he can actually negotiate a trade deal. This means some sort of an agreement is more likely than not. Second, as noted above, China will respond aggressively with fresh stimulus if the U.S. slaps tariffs on its exports. This will help cushion global growth and risk assets. Infrastructure spending tends to be more commodity intensive than manufacturing production. Thus, even if the Chinese government exactly offsets the loss of manufacturing exports with additional infrastructure spending, the net effect on global growth will probably be positive. China will respond aggressively with fresh stimulus if the U.S. slaps tariffs on its exports. In reality, there is a very high probability that the Chinese will do more than that. As the 2009 and 2016 episodes illustrate, when faced with a clear downside shock to growth, the government calibrates the policy response based on the worst-case scenario. Not only would a bout of hyperstimulus provide downside protection to the Chinese economy against a growth shock, it would also give the government more negotiating leverage with Trump. After all, it is much easier to brush away threats of punitive tariffs if you have an economy that is humming along. Investors should remain overweight global equities for the next 12 months, while positioning for a modestly weaker U.S. dollar and somewhat higher global bond yields. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1      David Lawder, Jeff Mason, and Michael Martina, “Exclusive: China backtracked on almost all aspects of U.S. trade deal – sources,” Reuters, May 8, 2019. 2      Please see Geopolitical Strategy Special Alert, “U.S. And China Get Cold Feet,” dated May 6, 2019. 3      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). 4      “Young, Ernst Lead Iowa Delegation in Letter Urging President Not to Impose Tariffs,” Joni Ernst United States Senator For Iowa, March 7, 2018. 5      Please see Global Investment Strategy Weekly Report, “Chinese Debt: A Contrarian View,” dated April 19, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 6 Tactical Trades Strategic Recommendations Closed Trades

Highlights Coming up on the deadline for President Trump’s China – U.S. tariff ultimatum, tariffs on $200 billion of Chinese imports could go to 25% from 10% on Friday – the outlook for base metals remains complicated, particularly for aluminum and copper.1 Of course, the U.S. and China could have a meeting of the minds and agree to resolve the outstanding issues in the trade negotiations. This would be supportive of continued global supply-chain expansion, EM income growth and base metals prices generally. On the downside, an escalation of the Sino – U.S. trade war could retard investment in global supply chains, as firms hunker down for an extended and contentious contraction in global trade.2 This would be bearish for EM income growth, which would translate directly into lower base metals demand and, all else equal, depress prices. Still, a breakdown in trade talks could be bullish for base metals, as China likely would increase its fiscal, monetary and credit stimulus, in an attempt to offset the income-suppressing effects of reduced global trade and investment. As we said, it’s complicated. Two of the three outcomes above are supportive of base metals prices – i.e., a deal is agreed, and increased Chinese stimulus in the event of a breakdown in negotiations. Against this backdrop, we are closing our long tactical trading recommendations in copper and aluminum at tonight’s close, and replacing them with a call spread on July CME COMEX copper, in which we will get long $3.00/lb calls vs. short $3.30/lb calls. The call spreads are a low-risk way of positioning in a volatile market for a likely price-supportive outcome in these talks – the max loss on this position is the net premium paid to get long the spread. Highlights Energy: Overweight. Supply-side fundamentals continue to dominate oil price formation. An unplanned outage in Russia that took ~ 1mm b/d of oil off the market this week, following the contamination of exports with organic chloride left in shipments via Transneft’s European pipeline system. Russia’s Energy Ministry is guiding markets to expect the contamination will be cleared up toward the end of this month.3 Base Metals: Neutral. We are closing our tactical aluminum and copper trade recommendations at tonight’s close. We do see the potential for higher base metals prices – particularly copper – if China expands fiscal and monetary stimulus in the wake of a breakdown in trade talks with the U.S., or both sides can resolve their differences. We expect copper will benefit most from such outcomes. However, we believe a call spread – long July $3.00/lb CME COMEX calls vs. short $3.30/lb calls expiring in July – is a lower-risk way of expressing this view. Precious Metals: Neutral. Gold could rally in the wake of an expanded trade war, if the Fed and the PBOC – along with other systemically important central banks – adopt more accommodative monetary policies in anticipation of a widening trade conflict. Greater fiscal, credit and monetary stimulus by China in response to a breakdown in trade talks also could boost safe-haven demand for gold. Ags/Softs: Underweight. The risk of a wider Sino – U.S. trade war – particularly the likely retaliation by China if U.S. tariffs are raised to 25% on already-targeted exports of $200 billion – would be especially bearish for soybeans and grain exports from the U.S. We remain underweight. Feature In the wake of President Donald Trump’s ultimatum to China to resolve trade talks by tomorrow, BCA Research’s geopolitical strategists give 50% odds to a successful trade deal being concluded by end-June. The odds of an extension of trade talks are 10%; and the odds of no deal on trade, 40% (Table 1). Table 1Updated Trade War Probabilities (May 2019) Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals Of these possible outcomes, the no-deal scenario – i.e., an escalation in the trade war including raising tariffs on imports from China to 25% on the $200 billion of goods now carrying a 10% duty – would be the most volatile, and likely would push base metals’ prices lower in the short-term. A trade deal would set markets to estimating the extent of supply-chain investment and trade-flow revival, as the drawn-out uncertainty around the outcome of the Sino – U.S. trade war fades. Given the slim wedge our geopolitical strategists see between the deal and no-deal outcomes to these trade talks, we believe the implications of the latter need to be sorted. An agreement to extend trade talks likely would be welcomed with the same aplomb shown by markets prior to this current level of high drama. In this scenario, markets likely would price in an economically rational outcome to the U.S. – China trade negotiations, which resolves the uncertainty around tariffs and other investment-retarding policies. Given the slim wedge our geopolitical strategists see between the deal and no-deal outcomes to these trade talks, we believe the implications of the latter need to be sorted. In the short term – i.e., following a breakdown in the talks – market sentiment likely would become more negative, as traders priced in the implications for reduced global supply-chain investment and trade flows, particularly re China and EM exporters. In addition, base metals markets would discount the income hit to EM these effects would feed into, raising the likelihood commodity demand growth would slow. News flow would then dictate price action for the metals over the short term. As markets discount these expectations, we believe Chinese policymakers would act to increase the levels of fiscal, credit and monetary stimulus domestically, to counter the hit to domestic income. The lagged effects of this stimulus will have a strong influence on base metals’ price formation, and, depending on the level of stimulus, could be bullish for metals prices. China’s Influence on Base Metals Higher Post-GFC In previous research, we found copper, and to lesser extent aluminum and the LMEX index, which is heavily weighted to both, benefit most from monetary, credit and fiscal stimulus in China.4 Other metals also experience a lift when the level of these Chinese policy variables rises; however, their relationship with EM and China’s industrial production cycle is weaker and time varying (Chart of the Week). Chart 1 In Table 2, we show how different policy and macro factors affect various base metal prices and the LMEX; these models generate the output for the curves in the Chart of the Week. The table show the coefficients of determination for single-variable regressions for each metal on the EM- or China-focused factor shown in the columns for the period 2000 to now, and 2010 to now. Within the base metals complex, copper, the LMEX index and aluminum exhibit the strongest and most reliable relationships with the explanatory variables shown at the top of each column. Table 2Coefficients Of Determination: Base Metals Prices (yoy) Vs. Key Factors Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals The biggest takeaway from this analysis is that, for each individual metal, Chinese economic activity in particular, and EM income dynamics generally dominate price determination. The importance of these factors increased considerably post-Global Financial Crisis (GFC). As was the case with our correlation analysis, this is best captured by our Global Industrial Activity (GIA) Index (Chart 2, panel 1). This is clearly seen in the co-movement of our GIA index and copper prices (Chart 2, panel 2), and EM GDP.5 Chart 3 shows the GIA index disaggregated in its four main components. Chart 2BCA's GIA Index Vs. EM GDP, Copper Prices BCA's GIA Index Vs. EM GDP, Copper Prices BCA's GIA Index Vs. EM GDP, Copper Prices Chart 3BCA GIA Index Components' Performance BCA GIA Index Components' Performance BCA GIA Index Components' Performance Our analytical framework for base metals in China holds the nonferrous “pillar industries” behave as vertically integrated conglomerates. The influence of China’s economy on base metals prices is not unexpected: As China’s relative share of base metals supply and demand versus the rest of the world has grown, the marginal impact of its fiscal, credit, monetary and trade policies increased (Chart 4). The principal effect would be visible in China’s demand-side effects, to which the supply side would respond. That is to say, China’s monetary, credit and fiscal policies post-GFC lifted domestic incomes, which lifted demand domestically. In addition, aggressive export-oriented trade policy contributed to income growth, as well. This prompted increased base metals and bulk (e.g., steel) output on the supply side. Chart 4 A large part of this dynamic likely is explained by the role of state-owned enterprises (SOEs) in the base-metals markets in China. It is important to note these SOEs are strategic government holdings, responding to and directing government policy, as was recently noted in a University of Alberta study on SOEs:      … the government maintains control over a number of economically significant industries, such as the automobile, equipment manufacturing, information technology, construction, iron and steel, and nonferrous metals sectors, which are all considered to be ‘pillar industries’ of the Chinese economy. The government, as a matter of official policy, intends to maintain sole ownership or apply absolute control over only what it considers to be strategic industries, but also maintains relatively strong control over the pillar industries.6 Our analytical framework for base metals in China holds the nonferrous “pillar industries” behave as vertically integrated conglomerates – ranging from firms refining of raw ore to those producing finished products used in infrastructure, construction, etc. In this framework, nonferrous metals in China are not commodity markets per se, but vertically integrated policy-driven industries responding to directives from the Chinese Communist Party’s (CCP) Politburo through to the State Council and the various ministries directing production and consumption.7 At the heart of this is the CCP’s efforts to direct economic growth. Investment Implications The implication of our policy-focused research is investors should focus on metals for which a large share of the variance in y/y prices can be explained by movements in Chinese economic activity. The no-deal outcome could be positive for base metals prices. To get a handle on this, we looked at the variance decomposition of each metal’s price in response to exogenous shocks originating from (1) Chinese economic activity, (2) EM (ex-China) and Complex Economies industrial activity, (3) U.S. industrial activity, and (4) the U.S. trade weighted dollar (Table 3).8 Using this approach, we found that: Copper, aluminum and the LMEX’s variances are mostly explained by China’s economic activity (~ 25%); specifically, shocks to the state’s industrial activity and credit cycle. This corroborates our earlier research, in which we focused on correlations between base metals and these factors. Idiosyncratic factors seem to account for a large part of nickel, lead and zinc’s price formation. This is seen by the large proportion of their variances that is unexplained by our selected explanatory variables. Given the opacity of fundamental data in these markets, we tend to avoid positioning in them. On average, EM ex-China and U.S. industrial activity account for a similar proportion of the variance in metal’s prices (~ 8%). While the U.S. dollar appears to be the second most important variable (~ 14%). Table 3China’s Economic Activity Drives Metals’ Return Variability Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals Our analysis indicates that, as a group, base metals will be supported by the ongoing credit stimulus in China. Each metal is positively correlated with China’s credit cycle and industrial activity. Nonetheless, from our correlation, regression and variance-decomposition analysis, we believe copper and aluminum provide a better and more reliable exposure, as does exposure to the LMEX index, because of its high aluminum and copper weightings. Bottom Line: Approaching the ultimatum set by U.S. President Trump for a resolution to the Sino – U.S. trade war, markets are understandably taut. The odds of a deal vs. no-deal outcome by end-June are close, while the odds trade talks are extended account for the difference. In our estimation, the no-deal outcome could be positive for base metals prices, given our expectation Chinese policymakers will lift the amount of stimulus to the domestic economy to offset the negative effects of an expanded trade war. A deal would remove a lot of the uncertainty currently holding back global supply-chain capex and trade flows, which also would be bullish for base metals.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1      For further discussion, please see “U.S. And China Get Cold Feet,” a Special Alert published by BCA Research’s Geopolitical Strategy May 6, 2019. It is available at gps.bcaresearch.com. Our geopolitical strategists give the odds of a successful trade deal being concluded by end-June 50%; that trade talks continue, 10%; and the odds of no deal on trade, 40%. 2      Please see “Global market structures and the high price of protectionism,” delivered at the Jackson Hole central bank conference August 25, 2018, by Agustín Carstens, General Manager, Bank for International Settlements. 3      Please see “Russia sees oil quality normalizing in late May after contamination, output drops,” published May 7, 2019, by reuters.com. 4      Please see our Weekly Report of April 25, 2019, entitled “Copper Will Benefit Most From Chinese Stimulus.” It is available at ces.bcaresearch.com. 5      BCA’s GIA index is heavily weighted toward EM industrial-commodity demand. Please see “Oil, Copper Demand Worries Are Overdone,” where we introduce and discuss the GIA index, published February 14, 2019, in BCA Research’s Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 6      Please see “State-Owned Enterprises in the Chinese Economy Today: Role, Reform, and Evolution,” China Institute, University of Alberta, May 2018. 7      Something approximating a pure commodity market is crude oil – the supply and demand curves of many globally distributed sellers and buyers meet and clear the market. As such, a reasonable explanatory model for the evolution of prices can be generated using fundamental inputs (i.e., supply, demand and inventories). Fitting such models to base metals has proved difficult. We have better success explaining base metals prices using macro economic policy variables we believe are important to CCP policymakers – trade, credit, domestic GDP, etc. This is a new avenue of research, which we hope to use to hone in on a good explanatory model to account for ~ 50% of global base metal demand, and, in some instances (e.g., copper and steel, respectively) close to 40% - 50% of supply, as seen in Chart 4. Our current base metals research is focused on trying to disprove the hypothesis these are policy-directed markets within China. This aligns with Karl Popper’s falsifiability condition, which states a theory must be subject to independent, disinterested testing capable of refuting it, to be considered scientific. Please see “Popper, The Logic of Scientific Discovery,” (reprinted 2008), Routledge Classics, particularly Chapter 4. 8      Complex economies are countries ranking at the top of MIT’s Economic Complexity Index (ECI), and which export industrial goods to EM and China. The EM (ex-China) and Complex Economies variable is the first principal component extracted from a group of ~60 series related to industrial production in these countries. 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

Feature In lieu of our regular Weekly Report this week, tomorrow we will be publishing a joint Special Report on the Chinese housing market with our Emerging Markets Strategy service, authored by my colleague Ellen JingYuan He. Ellen’s previous housing report was extremely well received,1 and clients should look forward to tomorrow’s update. Chart 1A Full Trade War: Clear Near-Term Risk, But An Uncertain Cyclical Outlook A Full Trade War: Clear Near-Term Risk, But An Uncertain Cyclical Outlook A Full Trade War: Clear Near-Term Risk, But An Uncertain Cyclical Outlook Turning to the financial markets, investors have been squarely focused this week on the sudden escalation in tension between the U.S. and China, caused by President Trump’s renewed threat on May 5 to heighten tariffs on Chinese imports at the end of this week. Specifically, President Trump has claimed that he would increase the current 10% tariff rate on $200 billion worth of Chinese imports to 25%, a move that was originally due on March 1, but was delayed to extend the talks and seek a better agreement. Trump also threatened to raise tariffs on the remaining $325 billion of Chinese imports that are so far untouched. This is the most significant escalation in rhetoric since before the tariff truce agreed on December 1 between Trump and Chinese President Xi Jinping in Buenos Aires. The financial market reaction was swift: Chinese A shares fell nearly 6% on Monday, and USD-CNY surged nearly half a percent (Chart 1). Chinese stocks fared better on Tuesday, but may come under pressure again later in the week as China’s trade delegation returns to the U.S. for talks on Thursday & Friday. Despite this week’s volatility, we would not yet recommend any portfolio strategy changes to investors who are positioned in favor of Chinese stocks or China-related assets more generally. First, we still see the combined odds of a deal or a further extension in talks as being as high as 60%, and investors would view an agreement to extend the negotiations in a positive light after this week’s selloff. At a minimum, investors are likely to get a better chance to sell in such a scenario. Second, over that past year we have steadfastly maintained that China’s economy and its earnings cycle are driven by monetary conditions, money, and credit growth, and two of these three drivers are clearly now pointing to improving economic activity over the coming year. Certainly, the imposition of a 25% import tariff on all Chinese goods would represent a new, negative shock to the Chinese economy, but in this scenario Chinese policymakers would also substantially dial up their reflationary response. As such, while the near-term response in the equity market is likely to be very negative if President Trump follows through with his threat, the cyclical (i.e. 6-12 month outlook) for Chinese relative equity performance is not yet clear. This is only true in local currency (i.e. hedged) terms, however, as we agree that there is meaningful downside potential for the RMB in a full tariff scenario. So while we are likely to advise investors to wait and assess the likely reflationary response if a 25% “second round” tariff rate is imposed this week before changing their equity stance, we would recommend a long USD-CNY/CNH position in the interim as a hedge against a potentially substantial decline in the RMB. Stay tuned.   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com   Footnotes 1      Please see BCA Research’s China Investment Strategy Special Report, “China’s Property Market: Where Will It Go From Here?,” published September 13, 2018. Available at cis.bcaresearch.com.   Cyclical Investment Stance Equity Sector Recommendations

Feature The U.S.-China trade talks have not yet collapsed but they appear to be reaching a “make it or break it” moment. President Donald Trump renewed his threat of heightening tariffs on Chinese imports on May 5, in the interim between two weeks of shuttle diplomacy in Beijing and next in Washington that have been billed as the final round of negotiations. Chinese officials responded to Trump’s new tariff remarks by threatening to pull out of the talks. The status of the Chinese delegation due in Washington this week is unclear as we go to press. Specifically, President Trump has claimed that he would increase the current 10% tariff rate on $200 billion worth of Chinese imports to 25%, a move that was originally due on March 1, but was delayed to extend the talks and seek a better agreement. Trump also threatened to raise tariffs on the remaining $325 billion of Chinese imports that are so far untouched. This is the most significant escalation in rhetoric since before the tariff truce agreed on December 1 between Trump and Chinese President Xi Jinping in Buenos Aires. True, the threat to increase the tariffs is a last-minute pressure tactic tied to the administration’s attempt to make this week “the final week” of the talks. American advisers have said that at the end of these two weeks they would make a recommendation to the president either to sign a deal or walk away. For this reason, it is not certain that Trump will follow through with the increase. However, we consider the threat credible. The costs of trade war are not prohibitive to the U.S. or China considering the strategic interests at stake in their great power competition (Chart 1). And since December 1, we have argued that a relapse into trade war and rising tariffs was a substantial risk at 30% odds; this threat increases those odds. Chart 1The Era Of U.S.-China Detente Is Over The Era Of U.S.-China Detente Is Over The Era Of U.S.-China Detente Is Over Talks have been deteriorating for the past month at least. First, the trade grievances at the root of the trade war with China – namely corporate espionage, hacking, forced technology transfer, intellectual property theft, and the American-allied restrictions on Chinese telecoms firm Huawei – were always going to be extremely difficult to settle. These are apparently weighing on the ability of Washington and Beijing to close an agreement. Second, tensions have recently flared across the entire range of U.S.-China strategic disagreements, including most importantly North Korea and Iran. In late April, the U.S. demanded that China halt all imports of Iranian oil by the end of May in order to avoid secondary sanctions that, in theory, could affect China’s central bank and other banks. Meanwhile North Korea has conducted two minor but provocative weapon tests (including short-range missiles on May 4) since the failed summit between Trump and Kim Jong Un in Hanoi. Washington expects Beijing to keep North Korea in check and involved in diplomacy as part of the broader strategic negotiation. Taiwan and the South China Sea are also simmering due to U.S.-Taiwan diplomacy and arms sales, Chinese military drills, and the U.S. decision to treat China’s “maritime militia” like its navy. Trump’s latest threat reduces the chances of an extension of the talks beyond June to 10%, while raising the odds of a collapse in talks and escalation of trade war to 40%. As a result of these developments, and the dragging on of talks, we put the odds of a trade deal by the end of June at 50% in our April 10 report. Trump’s latest threat reduces the chances of an extension of the talks beyond June to 10%, while raising the odds of a collapse in talks and escalation of trade war to 40% (Table 1). Table 1Updated Trade War Probabilities (May 2019) U.S. And China Get Cold Feet U.S. And China Get Cold Feet From the Chinese point of view, Trump’s threat makes it harder to clinch a deal. Trump’s use of sweeping, unilateral tariffs on national security grounds has forced China into an awkward position. It is politically and ideologically toxic for Beijing to appear to capitulate to coercion, i.e. nineteenth-century-style tactics of gunboat diplomacy and western imperialism. The tariff truce in Buenos Aires minimized the appearance that China is negotiating under duress, giving Xi Jinping the ability to negotiate and make concessions without losing face. While China is in the weaker position economically, and therefore would prefer a deal, it will batten down the hatches and fight a trade war if forced to do so. The risk of other executive decisions disruptive to markets is going up. The implication for investors is threefold. First, the USD and U.S. equities will continue to outperform global counterparts as trade policy uncertainty shoots back up (Chart 2). The American economy is more insulated from global trade and the dollar is counter-cyclical. But as U.S. equities have rallied and volatility will go up, U.S. equities may simply fall less rapidly than Chinese and others. Chart 2U.S. Will Outperform On Rising Trade Uncertainty U.S. Will Outperform On Rising Trade Uncertainty U.S. Will Outperform On Rising Trade Uncertainty Second, our view that China’s economic stimulus will surprise to the upside is reinforced by this development, as Beijing cannot afford to withdraw or pause stimulus when it still faces such a severe external risk to its manufacturing sector and employment (Chart 3). This will counteract the negative impact to global sentiment and manufacturing expected from any additional tariffs, creating more volatility in commodity and emerging market assets. Third, as we recognized in the case of Trump’s renewed “maximum pressure” tactic on Iran, the president is apparently not concerned with minimizing risks to the economy ahead of the 2020 election. His risk appetite remains voracious. Therefore the risk of other executive decisions disruptive to markets is going up. For instance, our 35% chance that Trump will impose Section 232 tariffs on auto and auto part imports, particularly from Europe, is rising toward 50% (Chart 4). Chart 3China Cannot Afford to Withhold Stimulus China Cannot Afford to Withhold Stimulus China Cannot Afford to Withhold Stimulus Chart 4   Bottom Line: The odds of a re-escalation of the trade war have risen to 40%. American equities should outperform global, while safe-haven assets, such as a portfolio hedge of Swiss bonds and gold, should catch a bid. We are closing out our long copper trade for a loss of 3.58% as well as our long Chinese equities ex-tech trade for a gain of 6.59%. Matt Gertken, Geopolitical Strategist mattg@bcaresearch.com

Feature The U.S.-China trade talks have not yet collapsed but they appear to be reaching a “make it or break it” moment. President Donald Trump renewed his threat of heightening tariffs on Chinese imports on May 5, in the interim between two weeks of shuttle diplomacy in Beijing and next in Washington that have been billed as the final round of negotiations. Chinese officials responded to Trump’s new tariff remarks by threatening to pull out of the talks. The status of the Chinese delegation due in Washington this week is unclear as we go to press. Specifically, President Trump has claimed that he would increase the current 10% tariff rate on $200 billion worth of Chinese imports to 25%, a move that was originally due on March 1, but was delayed to extend the talks and seek a better agreement. Trump also threatened to raise tariffs on the remaining $325 billion of Chinese imports that are so far untouched. This is the most significant escalation in rhetoric since before the tariff truce agreed on December 1 between Trump and Chinese President Xi Jinping in Buenos Aires. True, the threat to increase the tariffs is a last-minute pressure tactic tied to the administration’s attempt to make this week “the final week” of the talks. American advisers have said that at the end of these two weeks they would make a recommendation to the president either to sign a deal or walk away. For this reason, it is not certain that Trump will follow through with the increase. However, we consider the threat credible. The costs of trade war are not prohibitive to the U.S. or China considering the strategic interests at stake in their great power competition (Chart 1). And since December 1, we have argued that a relapse into trade war and rising tariffs was a substantial risk at 30% odds; this threat increases those odds. Chart 1The Era Of U.S.-China Detente Is Over The Era Of U.S.-China Detente Is Over The Era Of U.S.-China Detente Is Over Talks have been deteriorating for the past month at least. First, the trade grievances at the root of the trade war with China – namely corporate espionage, hacking, forced technology transfer, intellectual property theft, and the American-allied restrictions on Chinese telecoms firm Huawei – were always going to be extremely difficult to settle. These are apparently weighing on the ability of Washington and Beijing to close an agreement. Second, tensions have recently flared across the entire range of U.S.-China strategic disagreements, including most importantly North Korea and Iran. In late April, the U.S. demanded that China halt all imports of Iranian oil by the end of May in order to avoid secondary sanctions that, in theory, could affect China’s central bank and other banks. Meanwhile North Korea has conducted two minor but provocative weapon tests (including short-range missiles on May 4) since the failed summit between Trump and Kim Jong Un in Hanoi. Washington expects Beijing to keep North Korea in check and involved in diplomacy as part of the broader strategic negotiation. Taiwan and the South China Sea are also simmering due to U.S.-Taiwan diplomacy and arms sales, Chinese military drills, and the U.S. decision to treat China’s “maritime militia” like its navy. Trump’s latest threat reduces the chances of an extension of the talks beyond June to 10%, while raising the odds of a collapse in talks and escalation of trade war to 40%. As a result of these developments, and the dragging on of talks, we put the odds of a trade deal by the end of June at 50% in our April 10 report. Trump’s latest threat reduces the chances of an extension of the talks beyond June to 10%, while raising the odds of a collapse in talks and escalation of trade war to 40% (Table 1). Table 1Updated Trade War Probabilities (May 2019) U.S. And China Get Cold Feet U.S. And China Get Cold Feet From the Chinese point of view, Trump’s threat makes it harder to clinch a deal. Trump’s use of sweeping, unilateral tariffs on national security grounds has forced China into an awkward position. It is politically and ideologically toxic for Beijing to appear to capitulate to coercion, i.e. nineteenth-century-style tactics of gunboat diplomacy and western imperialism. The tariff truce in Buenos Aires minimized the appearance that China is negotiating under duress, giving Xi Jinping the ability to negotiate and make concessions without losing face. While China is in the weaker position economically, and therefore would prefer a deal, it will batten down the hatches and fight a trade war if forced to do so. The risk of other executive decisions disruptive to markets is going up. The implication for investors is threefold. First, the USD and U.S. equities will continue to outperform global counterparts as trade policy uncertainty shoots back up (Chart 2). The American economy is more insulated from global trade and the dollar is counter-cyclical. But as U.S. equities have rallied and volatility will go up, U.S. equities may simply fall less rapidly than Chinese and others. Chart 2U.S. Will Outperform On Rising Trade Uncertainty U.S. Will Outperform On Rising Trade Uncertainty U.S. Will Outperform On Rising Trade Uncertainty Second, our view that China’s economic stimulus will surprise to the upside is reinforced by this development, as Beijing cannot afford to withdraw or pause stimulus when it still faces such a severe external risk to its manufacturing sector and employment (Chart 3). This will counteract the negative impact to global sentiment and manufacturing expected from any additional tariffs, creating more volatility in commodity and emerging market assets. Third, as we recognized in the case of Trump’s renewed “maximum pressure” tactic on Iran, the president is apparently not concerned with minimizing risks to the economy ahead of the 2020 election. His risk appetite remains voracious. Therefore the risk of other executive decisions disruptive to markets is going up. For instance, our 35% chance that Trump will impose Section 232 tariffs on auto and auto part imports, particularly from Europe, is rising toward 50% (Chart 4). Chart 3China Cannot Afford to Withhold Stimulus China Cannot Afford to Withhold Stimulus China Cannot Afford to Withhold Stimulus Chart 4   Bottom Line: The odds of a re-escalation of the trade war have risen to 40%. American equities should outperform global, while safe-haven assets, such as a portfolio hedge of Swiss bonds and gold, should catch a bid. We are closing out our long copper trade for a loss of 3.58% as well as our long Chinese equities ex-tech trade for a gain of 6.59%. Matt Gertken, Geopolitical Strategist mattg@bcaresearch.com

Highlights BCA’s China Investment Strategy team recommended that investors upgrade Chinese stocks to overweight (both investable and domestic) in a Special Alert last week. Investors had a legitimate macro fundamental basis to go overweight Chinese stocks as of February 15, but we hesitated to shift our stance due to several still-present risks and out of concern that the sheer magnitude of the spike in credit could cause a regulatory response that would constrain credit growth in future months. The March credit data has confirmed that Chinese policymakers have chosen to prioritize growth for now, but we are unconvinced that a shift back to controlling leverage is out of the question over the coming year. Investors should continue to monitor this and several other risks noted below. Despite having already rallied significantly this year, Chinese investable and domestic stocks have the potential to earn double-digit relative returns (12-15%) in an optimistic scenario in US$ terms versus global stocks over the coming year. Conservatively, we expect high single-digit relative returns (6-8%). Feature BCA’s China Investment Strategy team recommended that investors upgrade Chinese stocks to overweight (both investable and domestic) in a Special Alert last week.1 In this week’s report we address several issues concerning the outlook for the economy and for Chinese stocks in a Q&A format where we answer the questions of a hypothetical, representative investor. In particular, we will discuss how much relative equity upside investors can expect over the coming year, whether the recent pace of credit growth significantly increases the chance of another credit overshoot, and when investors should expect to see a pickup in actual economic activity. Q: First, a question about timing. Why did it take so long to recommend upgrading Chinese stocks? Haven’t Chinese equities been forecasting an economic recovery for several months? A: Prior to the release of the January total social financing data on February 15, investors had no legitimate macro fundamental basis to go overweight Chinese stocks and were instead responding to a relatively less important factor for the economy – the Sino/U.S. trade war. We placed Chinese stocks on upgrade watch in late-February, and waited for confirmation that the spike in credit was not a one-off surge to be reversed by policymakers dead set against “flood irrigation-style” stimulus. As investors are surely aware, no two economic or financial market cycles are exactly alike. This is particularly true in the case of China; its economy experienced a major structural shift a decade ago, and economic and financial market oscillations since then have been highly disparate. As part of our ongoing search to identify tools that reliably predict the Chinese economy, we presented detailed evidence in a November 2017 Special Report2 that suggested monetary conditions, money, and credit growth have been among the most reliable predictors of Chinese “investment-relevant economic activity” (Chart 1). Chinese activity, in turn, has reliably led investable equity earnings growth, and we have therefore followed this framework closely when judging the economic outlook and the attendant implications for investment strategy. Chart 1Monetary Conditions, Money, And Credit Growth Reliably Lead Chinese Economic Activity Monetary Conditions, Money, And Credit Growth Reliably Lead Chinese Economic Activity Monetary Conditions, Money, And Credit Growth Reliably Lead Chinese Economic Activity Given that financial markets typically lead turning points in economic activity, many market participants have incorrectly suggested that the bottom in Chinese stocks in late-October reflected prescient expectations of a durable re-acceleration in Chinese credit growth. Rather, a detailed examination of the events of the past year highlights that the opposite is true: global investors, the most influential “buyer” of Chinese investable stocks, materially lagged or ignored important developments in leading economic indicators and focused instead on a relatively less important factor for the economy – the Sino/U.S. trade war. Two important pieces of evidence support this point: We prominently discussed the risk that a trade war would pose to China’s economy in the first-half of 2018,3 but we underscored numerous times that this risk was on top of an ongoing and much more concerning slowdown in leading indicators for China’s industrial sector. By June of last year our leading indicator for the Li Keqiang index had been in a downtrend for 16 months straight (Chart 2), and yet investors only sold Chinese investable stocks once President Trump began imposing tariffs against Chinese exports to the U.S. We placed Chinese stocks on downgrade watch at the end of March 2018,4 well in advance of the selloff versus global stocks, and deftly triggered the downgrade on June 20.5 Relative to the global benchmark, November 2018 represented the largest month of relative performance for Chinese investable stocks. At that time, there was zero credible evidence to suggest that a credit upturn was underway; in fact, money and credit growth weakened on a sequential basis for most of Q4. It is true that monetary policy eased significantly following the imposition of U.S. tariffs in June, but given the extent of the decline in interbank rates, this would have led to a bottom in relative performance in July or August if investors were willing to assume that China’s monetary transmission mechanism would work without impairment. November 2nd marks the clear inflection point for Chinese investable stocks and our BCA Market-Based China Growth Indicator (Chart 3), and in our view this proves beyond a doubt that investors have been solely focused on trade: on that day, news broke that President Trump wanted to make a deal with Xi Jinping at the G20 meeting in Argentina later that month, and had instructed aides to begin “drafting terms”.6 Chart 2Until Tariffs Arrived, Investors Completely Ignored The Decline In Leading Indicators Until Tariffs Arrived, Investors Completely Ignored The Decline In Leading Indicators Until Tariffs Arrived, Investors Completely Ignored The Decline In Leading Indicators Chart 3It Was News Of A Trade Deal That Caused A Bottom In China-Related Assets It Was News Of A Trade Deal That Caused A Bottom In China-Related Assets It Was News Of A Trade Deal That Caused A Bottom In China-Related Assets   Besides recommending a tactical overweight stance on December 5,7 we generally failed to forecast and position for a meaningful détante in the trade war, and we acknowledge that this contributed to a period of missed potential outperformance. But our research suggests that a trade deal would have been irrelevant had the drivers of China’s relevant economic activity continued to deteriorate, and investors had no concrete signs to suggest otherwise prior to the release of the January total social financing data on February 15 (Chart 4). We conservatively forecast high single-digit relative returns versus global stocks, on the order of 6-8%. There is even more upside potential in an optimistic scenario. Chart 4Before February 15, There was No Basis To Confidently Project An Upturn In Credit Before February 15, There was No Basis To Confidently Project An Upturn In Credit Before February 15, There was No Basis To Confidently Project An Upturn In Credit Starting on February 15, investors did have a legitimate macro fundamental basis to go overweight Chinese stocks. We responded to the January data by placing Chinese stocks on upgrade watch,8 but we hesitated to move to an outright cyclical overweight at that time due to several still-present risks (discussed below) and out of concern that the sheer magnitude of the spike in credit could cause a regulatory response, discreet or otherwise, that would constrain credit growth in future months. The public spat between Premier Li Keqiang and the PBOC over whether the January credit spike represented “flood irrigation-style” stimulus and the disappointing February credit data were both emblematic of these concerns, but ultimately the March credit data has confirmed that a significant credit expansion is underway. This has indeed raised the odds of a major credit overshoot, although we reiterate below why policymakers are likely to remain reluctant to allow one to occur. Q: Chinese investable stocks have already rallied 22% year-to-date in US$ terms; domestic stocks are up 37%. How much further upside can investors realistically expect? A: In an optimistic scenario, Chinese investable and domestic stocks have the potential to earn double-digit relative returns (12-15%) in US$ terms versus global stocks over the coming year. Conservatively, we expect high single-digit relative returns (6-8%). Chart 5 presents our earnings recession model for the MSCI China index. The recent improvement in credit, forward earnings momentum, and the new export orders component of the official manufacturing PMI have already caused the model probability to peak. The dotted line shows that the odds of a contraction in earnings over the coming year are set to fall very sharply if credit even just continues on a moderate expansion path, and assuming that the current values of the remaining model predictors stay constant. Chart 6 shows that while there has been an earnings “response” to the ongoing economic slowdown in China, the response has so far been less intense than what might be expected. While this raises a near-term risk for Chinese stocks if Q1 & Q2 earnings disappoint (see below), it also implies that the level of 12-month trailing earnings may not trend lower over the coming year. Chart 5The Odds Of An Earnings Decline Over The Next Year Have Peaked And Will Fall Further The Odds Of An Earnings Decline Over The Next Year Have Peaked And Will Fall Further The Odds Of An Earnings Decline Over The Next Year Have Peaked And Will Fall Further Chart 6The 'Response' Of Earnings To A Slowing Economy Has Been Less Intense Than Expected The 'Response' Of Earnings To A Slowing Economy Has Been Less Intense Than Expected The 'Response' Of Earnings To A Slowing Economy Has Been Less Intense Than Expected   If Chinese earnings are largely stable over the next year, we think it is reasonable to expect that investable Chinese stock prices will re-approach or fully return to their early-2018 high. We noted in our March 27 Weekly Report that China’s potential to command a higher multiple than global stocks is probably capped barring a major structural improvement in earnings growth,9 but Chart 7 highlights that Chinese stocks were still cheaper than their global counterparts at their peak early last year. Chart 7Even At Their 2018 High, Chinese Stocks Were Cheaper Than Global Stocks Even At Their 2018 High, Chinese Stocks Were Cheaper Than Global Stocks Even At Their 2018 High, Chinese Stocks Were Cheaper Than Global Stocks It is true that the multiple expansion that occurred for Chinese stocks in 2016 and 2017 was quite large, but in our view this was due to the index addition and growth of technology companies with potential structural growth stories (such as the “BAT” stocks) rather than due to a significant decline in the risk premium assigned to Chinese stocks. These firms are still present in the investable index, and we have no reason to believe that investors over the coming year will perceive their structural earnings potential to be any different than was the case early last year, which suggests that a forward P/E ratio of 14 to 14½ is again achievable. Domestic equities do not directly benefit from the “BAT effect”, but their realized earnings growth has been somewhat superior than the investable index over the past few years. In effect, we have no strong reasons to argue against a return of both domestic and investable forward multiples back to levels seen in early-2018. Chart 8 highlights that a return to these levels would imply a relative price return of about 12% for investable stocks and 14-15% for domestic stocks, in US$ terms. Several risks (highlighted below) underscore the possibility that Chinese stocks will trend higher but not fully return to their early-2018 levels over the coming year. Given this, we conservatively forecast high single-digit relative returns versus global stocks, on the order of 6-8%. As a final point, for investors focused on A-shares, we should note that our domestic equity call is based on the MSCI China A Onshore index, not the CSI 300 or the FTSE/Xinhua A50 index. While the former very closely tracks the latter two, Chart 9 highlights that the CSI 300 and the A50 have rebounded closer to their early-2018 highs than the MSCI China A Onshore index, suggesting that there is somewhat less upside potential for the former than the latter. Chart 8There Is Meaningful Further Upside Potential For Chinese Stocks Vs. Global There Is Meaningful Further Upside Potential For Chinese Stocks Vs. Global There Is Meaningful Further Upside Potential For Chinese Stocks Vs. Global Chart 9A-Shares: Favor MSCI Indexes Over The CSI300 And The A50 A-Shares: Favor MSCI Indexes Over The CSI300 And The A50 A-Shares: Favor MSCI Indexes Over The CSI300 And The A50   Q: What specific trades would you recommend as a result of your change in stance towards Chinese stocks? A: We are making five changes to our trade book, four of which are directly linked to our upgrade recommendation. In addition, we are closing another trade related to iron ore, given that prices have risen to a multi-year high. We are opening the following new trades in response to our recommendation to upgrade Chinese stocks: Open long MSCI China Index / short MSCI All Country World Index (US$) Open long MSCI China A Onshore Index / short MSCI All Country World Index (US$) Open long MSCI China Growth Index / short MSCI All Country World Index (US$) Regarding the latter trade, we noted in a previous report that value stocks have been responsible for more of the rally in China’s investable market versus the global average than their growth peers, and Chart 10 highlights that a long China growth / short broad market trade is strongly correlated with China’s relative performance trend versus global stocks. This means that a long MSCI China Growth Index / short MSCI All Country World Index trade represents a higher octane version of our long MSCI China Index position, which we offer as a riskier trade for investors seeking maximum upside potential in response to a cyclical recovery in China’s economy. Chart 10China Growth: A High Octane Version Of The MSCI China Index China Growth: A High Octane Version Of The MSCI China Index China Growth: A High Octane Version Of The MSCI China Index In addition to these new trades, we are closing the following two existing positions in our trade book: Long MSCI China Low-Beta Sectors / short MSCI China trade, initiated on June 27, 2018 and closed at a modest loss of 0.7% Long September 2019 iron ore futures / short September 2019 steel rebar futures trade initiated on October 17, 2018 and closed at a substantial gain of 22% We initiated our low-beta sectors position soon after we downgraded Chinese stocks in June of last year, which acted as a defensive trade for investors to play while waiting out a selloff in Chinese relative performance. The profit from the trade peaked at approximately 11% in early-October, but has since given back most of its gains. Lastly, we are closing our iron ore / steel rebar pair trade to lock in a healthy profit from the position. An improvement in Chinese economic growth would typically be bullish for iron ore prices, but they have recently surged to a multi-year high in response to supply restrictions. This implies that stronger demand over the coming 6-12 months may not necessarily be positive for prices if it is accompanied by easier supply-side conditions. Q: What are the risks facing Chinese relative equity performance over the coming year? A: A collapse in the trade talks or an underwhelming deal, a lagged and series decline in earnings per share, a sharp slowdown in credit growth after a trade deal is signed, and a meaningful lag between the upturn in credit and an improvement in Chinese “hard data”. There are four non-trivial risks to a bullish relative stance towards Chinese stocks over the coming year. In general, these scenarios pose a risk to the magnitude of an uptrend in Chinese relative performance, but in some cases could prevent Chinese relative performance from trending higher over the coming year (and thus bear monitoring). There are still four non-trivial risks to a bullish relative stance towards Chinese stocks over the coming year. The trade deal between the U.S. and China falls through or substantially underwhelms. Despite signs continuing to point to the likelihood of a deal, a meaningful breakdown in trade talks or an underwhelming deal clearly have the potential to derail an uptrend in Chinese relative performance given that global investors have (incorrectly) treated the conflict as the primary risk factor facing the Chinese economy. A full resumption of the trade war would definitely cause Chinese stocks to actively underperform until evidence presented itself that the inevitable policy response is stabilizing economic activity. An underwhelming deal would probably weigh on the magnitude of China’s outperformance, but would probably not constitute a threat on its own to an uptrend in relative performance unless the “deal” did not result in a significant removal of tariffs (which, to us, is the point of China participating in the negotiations in the first place). Chinese earnings per share decline significantly from current levels. We noted in Chart 6 on page 6 that the earnings “response” to the ongoing economic slowdown in China has been less intense than we expected. Our earnings recession model suggests that the odds of a contraction in earnings over the coming 12 months has fallen meaningfully, but that does not rule out further near-term weakness stemming from the slowdown in activity that has already occurred. Chart 11Any Further Weakness In EPS Growth Should Be Temporary Any Further Weakness In EPS Growth Should Be Temporary Any Further Weakness In EPS Growth Should Be Temporary We noted earlier that Chinese economic and financial market oscillations have been highly disparate since 2010 (when the economy experienced a clear structural shift), and as such we are unable to confidently predict the magnitude of a decline in EPS in response to a given amount of weakness in China’s old economy. For now, the meaningful uptick in net earnings revisions as well as the stabilization in forward EPS momentum (Chart 11) suggests that any further weakness in EPS growth will be temporary, but a larger or more prolonged decline should be acknowledged as a serious risk to our stance. Chinese credit growth slows meaningfully after a U.S./China trade deal is signed. To the extent that Chinese policymakers are still serious about preventing significant further leveraging, it is possible that the recent pace of credit growth will slow following the signing of a trade deal. This could occur because of a shift to tighter monetary policy, or due to the use of informal “administrative controls” to limit the pace of further lending. Chart 12 highlights that the pace of credit growth in the first quarter, if sustained, would actually imply a credit overshoot; our recommendation to upgrade Chinese stocks was based on the assumption of a moderate credit expansion, and thus we would not be surprised (or worried) if the pace of credit growth slows somewhat. However, a more meaningful slowdown, particularly if coupled with signals from policymakers that a much slower pace of growth is desired, could pose a risk to our stance. A recovery in China’s “hard data”, i.e. its coincident activity measures, meaningfully lags the pickup in credit growth. The March credit data has made us sufficiently confident that a rebound in Chinese investment-relevant economic activity is forthcoming, but it is difficult to pinpoint exactly when the data will bottom and whether further near-term weakness is likely. On the latter point, we noted in our April 3 Weekly Report that coincident economic activity sharply converged in January and February with our leading indicator for China’s economy (shown in Chart 1 on page 2), as most if not all of the previously beneficial tariff front-running effect washed out of the data.10 This implies that future changes in activity measures are now more likely to reflect actual changes in underlying economic circumstances, but a lagged response may still occur and could weigh on investor sentiment towards Chinese stocks over the coming few months. Q: What is your best estimate as to when investors can expect to see a pickup in China’s “hard” economic data? A: China’s activity data is likely to bottom between now and the middle of the year, implying that activity will pickup in 2H2019. Chart 13 presents an average correlation profile of our BCA Li Keqiang leading indicator and its main credit component (adjusted total social financing, “TSF”, as a share of GDP) with four activity measures: 1) the Bloomberg Li Keqiang index, 2) nominal manufacturing output, 3) nominal total import growth in US$, and 4) nominal total import growth in RMB. Values to the left of the zero line show that the leading indicator / TSF as a share of GDP tend to lead the four activity measures, with the x-axis values showing by how many months. Chart 12Q1 Credit Growth, If Sustained, Would Lead To An Overshoot Q1 Credit Growth, If Sustained, Would Lead To An Overshoot Q1 Credit Growth, If Sustained, Would Lead To An Overshoot Chart 13Our Indicators Tend To Lead Actual Economic Activity By 4-6 Months Our Indicators Tend To Lead Actual Economic Activity By 4-6 Months Our Indicators Tend To Lead Actual Economic Activity By 4-6 Months China’s activity data is likely to bottom between now and the middle of the year. The chart suggests that our predictors tend to lead actual economic activity by 4-6 months on average, depending on the predictor and the activity measure in question. Our LKI leading indicator technically bottomed in June of last year, although the rise has since been narrowly-based and it has retreated since October. TSF as a share of GDP clearly bottomed in December, which implies that China’s activity data is likely to bottom between now and the middle of the year. This is consistent with our view that the global economy will improve in the second half of the year, as well as our recommendation to overweight Chinese stocks on a cyclical basis. The risk, as noted above, is that investors react negatively to any further weakness in China’s measures of economic activity before they durably bottom. Q: Final question – In your list of potential risks facing Chinese relative equity performance, you cited the issue of whether policymakers are serious about preventing significant further leveraging. It seems as if they are stepping away from that. Will they, and is this fundamentally justified? A: For now, Chinese policymakers have chosen to prioritize growth, out of fear that the economy will decelerate significantly and possibly spiral out of control. But we are unconvinced that a shift back to controlling leverage is out of the question over the coming year. Policymakers have good economic reasons to try and shift China’s economy away from extremely high rates of investment towards more consumption, and they are likely to see the act of restraining credit growth as furthering this goal. Arguably, this is one of the most important questions facing global investors over both cyclical and secular time horizons, and it is likely to feature prominently in our research over the coming year. The question of the sustainable growth rate of China’s debt is a controversial one, even among BCA strategists. While it is by no means a conclusive answer, we tackled the question in our October 31 Weekly Report,11 and came down on the side that China’s policymakers have good economic reasons to try and shift China’s economy away from extremely high rates of investment towards more consumption. To the extent that attempts to restrain credit growth further this goal, our sense is that it is more wisdom than folly. We noted three key points in our October report: First, while there is a strong empirical cross-country relationship between average rates of investment over the past half-century and the level of real per capita GDP today, that relationship also shows that China’s current rate of investment is nearly off the scale and thus probably cannot be sustained. Second, in 2014, based on the definition of the data from the Penn World Table (GDP share of gross capital formation at current purchasing power parity), China had maintained its investment share above 30% for 12 years. At first blush, there appears to be some precedent suggesting that China’s outsized investment run can go on for longer: among the 80 countries with data available since 1950, 14 of them have experienced a longer continuous run of investment as a share of GDP. However, Chart 14 shows that most of these concurrent experiences occurred in the 1960s and 1970s, when global exports as a share of GDP were rising from a very low base. This implies that historical examples of outsized investment runs have largely reflected export-driven catch-up stories, which bodes poorly for China’s ability to continue to invest at its recent massive scale given that global exports to GDP appear to have peaked. Chart 14High And Sustained Rates Of Investment Have Been Driven By Exports High And Sustained Rates Of Investment Have Been Driven By Exports High And Sustained Rates Of Investment Have Been Driven By Exports Third, the historical relationship between investment and real per capita GDP captures the potential gains of profitable and rational investment (the accumulation of a “useful” stock of capital). But an unfortunate reality facing savers is that while one can certainly choose to save or invest, one cannot necessarily choose the accompanying rate of return. If China invests heavily at very low or negative rates of return, the idea that continued heavy investment will lead China out of the middle-income trap is very likely wrong. On the third point, there is good evidence to suggest that the marginal gains from investment in China have been falling. The private sector debt-to-GDP ratio features prominently in the case against profitable investment in China: despite a massive rise in investment and debt from 2002-2007, the ratio barely rose, because this debt was used to accumulate capital that verifiably delivered nominal GDP growth (Chart 15). Yet following 2010 the ratio rose sharply, implying that the returns from the investment that has taken place over the past decade have been (at least so far) considerably lower than those of the prior decade. Also, we noted in our August 29 Special Report that state-owned enterprises (SOEs) have accounted for a sizeable portion of the private sector leveraging that occurred after 2010,12 and that the marginal net return on borrowed funds for SOEs has become negative (Chart 16). A gap between the cost/return on borrowed funds strongly implies that the investment channeled through SOEs over the past several years does not represent, on balance, the accumulation of useful capital. Chart 15A Rise In Debt-To-GDP Inherently Implies That Investment Is Increasingly Unproductive A Rise In Debt-To-GDP Inherently Implies That Investment Is Increasingly Unproductive A Rise In Debt-To-GDP Inherently Implies That Investment Is Increasingly Unproductive Chart 16Strong Evidence Against Productive SOE Investment Strong Evidence Against Productive SOE Investment Strong Evidence Against Productive SOE Investment We believe that Chinese policymakers now understand the risks posed with extremely high and prolonged rates of investment. Whereas most modern central banks characterize their monetary policy decisions within the context of a trade-off between growth and inflation, Chinese policymakers now appear to face a trade-off between growth and leveraging. For now, they have chosen growth, out of fear that the economy will decelerate significantly and possibly spiral out of control. But we are unconvinced that a shift back to controlling leverage is out of the question over the coming year, particularly after a trade deal has been signed with the U.S. As noted above, this is a non-trivial risk to our recommendation to overweight Chinese stocks over the coming year, and thus bears monitoring To be continued!   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1 Please see China Investment Strategy Special Alert, “Upgade Chinese Stocks To Overweight”, dated April 12, 2019, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Special Report, “The Data Lab: Testing The Predictability Of China’s Business Cycle”, dated November 30, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Reports, “The Question That Won’t Go Away”, dated April 18, 2018, “China: A Low-Conviction Overweight”, dated May 2, 2018, “The Three Pillars Of China’s Economy”, dated May 16, 2018, and “A Shaky Ladder”, dated June 13, 2018, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report, “Chinese Stocks: Trade Frictions Make For A Tenuous Overweight”, dated March 28, 2018, available at cis.bcaresearch.com. 5 Please see China Investment Strategy Special Report, “Downgrade Chinese Stocks To Neutral”, dated June 20, 2018, available at cis.bcaresearch.com. 6 Please see “Trump Said To Ask Cabinet To Draft Possible Trade Deal With Xi”, Bloomberg News, November 2, 2018. 7 Please see China Investment Strategy Weekly Report, “2019 Key Views: Four Themes For China In The Coming Year”, dated December 5, 2018, available at cis.bcaresearch.com. 8 Please see China Investment Strategy Weekly Report, “Dealing With A (Largely) False Narrative”, dated February 27, 2019, available at cis.bcaresearch.com. 9 Please see China Investment Strategy Weekly Report, “Ready, Aim, But Don’t Fire (Yet)”, dated March 27, 2019, available at cis.bcaresearch.com. 10 Please see China Investment Strategy Weekly Report, “China Macro and Market Review”, dated April 3, 2019, available at cis.bcaresearch.com. 11 Please see China Investment Strategy Weekly Report, “Is China Making A Policy Mistake?”, dated October 31, 2018, available at cis.bcaresearch.com. 12 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. Cyclical Investment Stance Equity Sector Recommendations

Highlights Evidence continues to mount that the Chinese economy is in a bottoming process. This suggests the path of least resistance for the RMB is up. Meanwhile, as the U.S. and China move closer to a trade deal, any geopolitical risk premium in the RMB will slowly erode. The ultimate catalyst for CNY longs will be depreciation in the U.S. dollar, which we believe is slowly underway. The ECB is turning more dovish at a time when euro area growth is hitting a nadir. This will be bullish for the euro beyond the near term. Our limit buy on the pound was triggered at 1.30. Target 1.45 with stops at 1.25. With the Aussie dollar close to the epicenter of Chinese stimulus, data down under is increasingly stabilizing. We are closing our short AUD/NOK position for a small profit. Feature Chart I-1The Chinese Yuan Is Pro-cyclical The Chinese Yuan Is Pro-cyclical The Chinese Yuan Is Pro-cyclical In addition to the dovish shift by global central banks, most investors are rightly fixated on China at this juncture in the economic cycle.  For one, it has been mostly responsible for the mini cycles in the global economy since 2014. And with improvements in both Chinese credit and manufacturing data in recent months, the consensus is drawing closer to the fact that we may be entering a reflationary window. Looking at risk assets, MSCI China is up 25% from its lows, while the S&P 500 is up 20%. Commodity prices are also rising, with crude oil hitting a new calendar-year high this week. The corollary is that if the improvement in Chinese data proves sustainable, it will propel these asset markets to fresh highs. The evolution of the cycle has important implications for the yuan exchange rate, because the RMB has been trading like a pro-cyclical currency in recent years. The USD/CNY has been moving tick for tick with emerging market equities, Asian currencies, and even some commodity prices (Chart I-1). Ever since its liberalization over a decade ago, the RMB may finally be behaving like a free-floating exchange rate. Therefore, a simple evaluation of how relative prices between China and the rest of the world evolve will be valuable input for the fair value of the RMB exchange rate. Reading the tea leaves from Chinese credit data can be daunting, but we agree with the assessment of our China Investment Strategy team that while the credit impulse has clearly bottomed,1 the magnitude of the rise is unlikely to be what we saw in 2015-2016. That said, a higher credit-to-GDP ratio also requires a smaller increase in credit growth to have an outsized effect on GDP. As such, monitoring what is happening with hard data in the economy concurrently – in particular, green shoots – could add valuable evidence to the reflation theme. A Repeat Of 2016? Cycle bottoms can be protracted and volatile, but also V-shaped. So it is useful when economic data is at a nadir to pay attention to any green shoots emerging, because by the time the last piece of pertinent economic data has turned around, it may well be too late to call the cycle. Admittedly, most measures of Chinese (and global) growth remain weak. But there have been notable improvements in recent months that suggest economic velocity may be picking up: Production of electricity and steel, all inputs into the overall manufacturing value chain, are inflecting higher. Intuitively, these tend to lead overall industrial production. Overall industrial production remains weak, but the production of electricity and steel, all inputs into the overall manufacturing value chain, are inflecting higher. Intuitively, these tend to lead overall industrial production (Chart I-2). Electricity production for the month of February grew 5% after grinding to a halt in 2015-2016. Production of steel also rose by 7%. If these advance any further, they will begin to exceed Q4 GDP growth, indicating a renewed mini-cycle. Chart I-2A Revival In Industrial Activity A Revival In Industrial Activity A Revival In Industrial Activity Chart I-3Metal Prices Are Sniffing A Rebound Metal Prices Are Sniffing A Rebound Metal Prices Are Sniffing A Rebound   In recent weeks, both steel and iron ore prices have been soaring. Many commentators have attributed these increases to supply bottlenecks and/or seasonal demand. However, it is evident from both the manufacturing data and the trend in prices that demand is also playing a role (Chart I-3). Overall residential property sales remain soft, but evidence from tier-1 and even tier-2 cities is signalling that this may be behind us, given robust sales. Over the longer term, the ebb and flow of property sales has tended to be in sync across city tiers. A revival in the property market will support construction activity and investment. House prices have been rising to the tune of 10% year-on-year, and real estate stocks in China may be sniffing an eventual pick-up in property volumes (Chart I-4). Over the last 20 years or so, Chinese credit growth has been a reliable indicator for car sales with a lead of about six months. Government expenditures were already inflecting higher ahead of last month’s China National People’s Congress (NPC). Again, this suggests stimulus this time around may be more fiscal than monetary (Chart I-5). In addition to the recent VAT cut for manufacturing firms from 16% to 13%, a string of policy easing measures will begin to accrue, including a cut to social security contributions effective May 1st, and perhaps a pickup in infrastructure spending. Already, real estate infrastructure spending growth is perking up, with that in the mining sector soaring to multi-year highs. Chart I-4Real Estate Volumes Could Pick Up Real Estate Volumes Could Pick Up Real Estate Volumes Could Pick Up Chart I-5The Fiscal Spigots Are Opening The Fiscal Spigots Are Opening The Fiscal Spigots Are Opening Finally, Chinese retail sales including those of durable goods remain very weak. Car sales are deflating at the fastest pace in over two decades. But the latest VAT cut by the government is being passed through to consumers, with an increasing number of car manufactures cutting retail prices. Chart I-6Car Sales Typically Have V-Shaped Recoveries Car Sales Typically Have V-Shaped Recoveries Car Sales Typically Have V-Shaped Recoveries   Over the last 20 years or so, Chinese credit growth has been a reliable indicator for car sales with a lead of about six months (Chart I-6). The indicator right now suggests we could witness a coiled-spring rebound in Chinese car sales over the next few months. Bottom Line: Both Chinese stocks and commodity prices have been suggesting a bottoming process in the domestic economy for a while now. Incoming data is beginning to corroborate this view. This has important implications for both the Chinese yuan and other global assets. Capital Flows Improving domestic and external conditions will likely offset any renewed pressure on the Chinese yuan from capital outflows. Our China Investment Strategy team reckons that even after adjusting for cross-border RMB settlements and illicit capital outflows, there is less evidence of capital flight today than there was in 2015-2016.2  Chart I-7Offshore Markets Don't See RMB Weakness Offshore Markets Don't See RMB Weakness Offshore Markets Don't See RMB Weakness Typically, offshore markets have had a good track record of anticipating depreciation in the yuan. Back in 2014, offshore markets started pricing in a rising USD/CNY rate, and maintained that view all the way through to 2018, when the yuan eventually bottomed. Right now, no such depreciation is being priced in (Chart I-7). The reason offshore markets in Hong Kong and elsewhere can be prescient is because more often than not, they are the destination for illicit flows out of China. For example, one of the often-rumored ways Chinese money has left the country is through junkets, key operators in Macau casinos.3 These junkets bankroll their Chinese clients in Macau while collecting any debts in China allowing for illicit capital outflows. This was particularly rampant ahead of the Chinese 2015-2016 corruption clampdown, when Macau casino equities were surging while equity prices in China remained subdued. Historically, both equity markets tend to move together, since over 70% of visitors to Macau come from China (Chart I-8). Right now, both the Chinese MSCI index and Macau casino stocks are rising in tandem, suggesting gains are more related to fundamentals than hot money outflows. Chart I-8Macau Casinos: A Good Proxy For Chinese Spending Macau Casinos: A Good Proxy For Chinese Spending Macau Casinos: A Good Proxy For Chinese Spending A surge in illicit capital outflows could also be part of the reason for an explosion in sight deposits in Hong Kong ahead of the 2015-2016 clampdown (Chart I-9). Admittedly, most of these deposits were and still are due to cross-border RMB settlements, but it is also possible that part of these constituted hot money outflows. With these sight deposits rising at a more reasonable pace, it suggests little evidence of capital flight. Chart I-9The Chinese Government Has Clamped Down On Illicit Flows The Chinese Government Has Clamped Down On Illicit Flows The Chinese Government Has Clamped Down On Illicit Flows Trade Truce A trade truce between the U.S. and China will be the final catalyst for a stronger yuan. The news flow so far has been positive, with both U.S. President Donald Trump and Chinese President Xi Jinping publicly acknowledging they are closer to a deal. Even well-known China hawk Peter Navarro, head of the U.S. National Trade Council, has admitted that the two sides are in the final stages of talks. But with a still-ballooning U.S. trade deficit with China, Trump will want to take home a win (Chart I-10). Chart I-10Trump Needs To Take A Win Back To America Trump Needs To Take A Win Back To America Trump Needs To Take A Win Back To America Concessions on the Chinese side so far seem reasonable, allowing us to speculate that there is a rising probability of a deal. They have agreed to increase agriculture and energy imports from the U.S. by about $1 trillion over the next six years, announced a cut on import tariffs, revised their Patent Law to improve protection of intellectual property, and provided a clear timeline for when foreign caps will be removed in sectors such as autos and financial services. These seem like very reasonable concessions that will allow Trump to go home and declare victory. Trade wars are usually synonymous with recessions. As such, there are acute political constraints inching both sides towards an agreement. For President Trump, a deteriorating U.S. manufacturing sector in the midwestern battleground states is a thorn in his side. For President Xi, rising unemployment is a key constraint. On the currency front, the details of any agreement are still unknown, but should Chinese economic fundamentals start to genuinely improve, it will put upward pressure under rates – and ergo the yuan (Chart I-11). A gradually rising yuan exchange rate will further assuage any doubts or concerns that Trump may have. Bottom Line: Our fundamental models show the yuan as undervalued by about 3%. This means China could allow its currency to gradually appreciate towards fair value, with little impact on the domestic economy or even exports. Given some green shoots in incoming economic data, little risk of capital flight, and the rising likelihood of a trade deal between the U.S. and China, our bias is that the path of least resistance for the Chinese RMB is up (Chart I-12). Chart I-11Rising Chinese Rates Will Favor The Yuan Rising Chinese Rates Will Favor The Yuan Rising Chinese Rates Will Favor The Yuan Chart I-12The RMB Is Not Expensive The RMB Is Not Expensive The RMB Is Not Expensive     Another Dovish Shift By The ECB In another dovish twist, the European Central Bank kept monetary policy unchanged following this week’s meeting, while highlighting that it might be on hold for longer. Unsurprisingly, incoming data has been weak of late, which the ECB (like other central banks) blamed on the external environment. It did fall short of speculation that it will introduce a tiered system for its marginal deposit facility, which would have alleviated some cash flow pressures for euro area banks. Our bias is for the new Targeted Long Term Refinancing Operation (TLTRO III – in other words, cheap loans), to remain a better policy tool than a tiered central bank deposit system. In the case of a TLTRO, the ECB can effortlessly decentralize monetary policy, since liquidity gravitates towards the countries that need it the most. While a tiered system can allow a bank to offer higher rates and attract deposits, there is no guarantee that these deposits will find their way into new loans. It is also likely to benefit countries with the most excess liquidity. In the case of a TLTRO, the ECB can effortlessly decentralize monetary policy. Beyond any short-term volatility in the euro, we think the ECB’s dovish shift could be paradoxically bullish. If a central bank eases financing conditions at a time when growth is hitting a nadir, it is tough to argue that it is bearish for the currency. Meanwhile, fiscal policy is also set to be loosened. Swedish new orders-to-inventories lead euro area growth by about five months, and the recent bounce could be a harbinger of positive euro area data surprises ahead (Chart I-13). Chart I-13Euro Area Growth Will Recover Euro Area Growth Will Recover Euro Area Growth Will Recover Bottom Line: European rates are further below equilibrium compared to the U.S., and the ECB’s dovish shift will help lift the euro area’s growth potential. Meanwhile, investors are currently too pessimistic on euro area growth prospects. Our bias is that the euro is close to a floor. House Keeping Our buy-stop on the British pound was triggered at 1.30. We recommend placing stops at 1.25, with an initial target of 1.45. As we argued last week,4 the odds of a hard Brexit continue to fall, with U.K. Prime Minister Theresa May explicitly saying this week that the path for the U.K. going forward is either a deal with the EU or with no Brexit at all. As we go to press, EU leaders have granted the U.K. an extension until the end of October, with a review in June. Chart I-14What Next For The Pound? What Next For The Pound? What Next For The Pound? Back when the referendum was held in June 2016, even the pro-Brexit Tories, a minority in the party, promised continued access to the Common Market. Fast forward to today and there are simply not enough committed Brexiters in Westminster to deliver a hard exit. Given that the can has been kicked down the road, markets are likely to turn their focus on incoming economic data. On that front, economic surprises in the U.K. relative to both the U.S. and euro area are soaring (Chart I-14). Elsewhere, we are also taking profits on our short AUD/NOK position. Since 2015, the market has been significantly dovish on Australia, in part due to a more accelerated downturn in house prices and a marked slowdown in China. The reality is that the downturn in Australia has allowed some cleansing of sorts and has brought it far along the adjustment path relative to its potential. Any potential growth pickup in China will light a fire under the Aussie dollar, which is a risk to this position. Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see China Investment Strategy Special Report, titled “China: Stimulating Amid The Trade Talks,” dated February 20, 2019, available at fes.bcaresearch.com 2 Please see China Investment Strategy Special Report, titled “Monitoring Chinese Capital Outflows,” dated March 20, 2019, available at fes.bcaresearch.com 3 Farah Master, “Factbox: How Macau's casino junket system works,” Reuters, October 21, 2011. 4 Please see Foreign Exchange Strategy Weekly Report, titled “Not Out Of The Woods Yet,” dated April 5, 2019, available at bca.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. have been mostly positive: In March, 196K nonfarm jobs were created, surprising to the upside; unemployment rate stayed low at 3.8%, though average hourly earnings growth fell to 3.2% year-on-year. The factory orders in February contracted by 0.5% month-on-month. More importantly, headline consumer price inflation in March rose to 1.9% year-on-year, however this was mostly lifted by rising energy prices. Core inflation excluding food and energy dropped by 10 basis points to 2%. JOLTs job openings unexpectedly fell to 7.1 million in February, from 7.6 million. However, initial jobless claims fell to 196K. After a 3-month lull, producer prices are inflecting higher at a pace of 2.2% year-on-year for the month of March. DXY index fell by 0.44% this week. Global risk assets are on the rise this week. Meanwhile, the Fed minutes highlighted that members are in no rush to raise rates. Stalling interest rate differentials will be a headwind for the dollar.  Report Links: Not Out Of The Woods Yet - April 5, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 Into A Transition Phase - March 8, 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 have been positive: The Sentix Investor Confidence index continues to inflect higher, coming in at -0.3 from -2.2.  German industrial production grew by 0.7% month-on-month in February. Trade balances improved across the euro area. In France, the trade deficit fell to €-4.0B in February. In Germany, the trade surplus increased to €18.7B. Italian retail sales increased by 0.9% year-on-year in February. On the inflation front, consumer price inflation in Germany and France both stayed at 1.3% year-on-year in March. EUR/USD rose by 0.57% this week. On Wednesday, the ECB has decided to leave policy unchanged as expected. Mario Draghi also highlighted more uncertainties and downside risks to the euro area amid the ongoing trade disputes. While the global trade war might add volatility to the pro-cyclical euro, easier financial conditions should eventually backstop growth. Report Links: Into A Transition Phase - March 8, 2019 A Contrarian Bet On The Euro - March 1, 2019 Balance Of Payments Across The G10 - February 15, 2019 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been negative: Preliminary cash earnings fell by 0.8% year-on-year in February, the only decline since mid-2017. Household confidence continues to tick lower, coming in at 40.5 in March. The trade balance in February came in at a surplus of ¥489.2B. Capex is rolling over. Machinery orders fell by 5.5% year-on-year in February. Machine tool orders remain extremely weak, at -28.5% year-on-year for the month of March. Lastly, the foreign investment in Japanese stocks increased to ¥1,463.7B. USD/JPY fell by 0.46% this week. In its April regional outlook, the BoJ downgraded most of the prefectures in Japan, with only Hokkaido that had an upgrade in the aftermath of the earthquake. As domestic deflationary pressures intensify, this will favor the yen.  This also raises the probability the government defers the consumption tax hike. Report Links: Tug OF War, With Gold As Umpire - March 29, 2019 A Trader’s Guide To The Yen - March 15, 2019 Balance Of Payments Across The G10 - February 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 strong: In February, manufacturing production increased by 0.6% year-on-year; industrial production also increased by 0.1% year-on-year, both surprising to the upside. Both were deflating in January. The goods trade balance in February fell to £-14.1B, however the total trade balance came in at a smaller deficit of £4.86B. Monthly GDP also came in higher at 2% year-on-year in February. House prices gains have pared the increase of previous years, but the Halifax house price index still increased by 2.6% year-on-year for the month of March.  GBP/USD rose by 0.41% this week. Theresa May got an extension for Brexit to October 31. Meanwhile, U.K. data have been stronger than consensus recently. We are long GBP/USD from 1.30, with a 0.6% profit. Report Links: Not Out Of The Woods Yet - April 5, 2019 A Trader’s Guide To The Yen - March 15, 2019 Balance Of Payments Across The G10 - February 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 continued to improve: Investment lending for homes in February grew by 2.6%. Home loans in February increased by 2% month-on-month, surprising to the upside. Westpac consumer confidence came in at 100.7 in April, increasing by 1.9%.  AUD/USD surged by 0.64% this week. The RBA Deputy Governor Guy Debelle hinted that a wait-and-see approach for interest rates seemed like the appropriate path, signaling that policy will continue to be accommodative. Meanwhile, the Australian dollar is probably anticipating better upcoming data from China, as it is Australia’s largest trading partner. If the world’s second largest economy can turn around, the Aussie dollar is likely to grind higher. Report Links: Not Out Of The Woods Yet - April 5, 2019 Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 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 There was little data out of New Zealand this week: The food price index came in at 0.5% month-on-month in March, shy of the estimate of 1.3%. NZD/USD plunged after rising by 0.5% initially this week, returning flat. Incoming data in New Zealand is likely to lag its commodity currency counterparts pushing the kiwi relatively lower. Our long AUD/NZD position is now 0.7% in the money since entry last Friday. 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 negative: On the labor market front, the participation rate in March fell slightly to 65.7%; 7,200 jobs were lost, underperforming the estimated creation of 1,000 jobs; unemployment rate was unchanged at 5.8%. On the housing market front, starts in March increased by 192.5K year-on-year, underperforming the expected 196.5K; building permits dropped by 5.7% month-on-month in February. USD/CAD rebounded quickly after falling by 0.7% earlier this week, offsetting the loss. While the dovish shift by the BoC and looser fiscal policy, together with rising oil prices are likely to be growth tailwinds, the data disappointment coming from the housing market and overall economy limit upside in the CAD. Report Links: A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 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 There was scant data in Switzerland this week: The foreign currency reserves came in at 756B CHF in March. Unemployment rate in March was unchanged at 2.4%, in line with expectations. USD/CHF appreciated by 0.44% this week. With the euro area economy slowly recovering, the franc is likely to underperform as risk appetite rises. We are long EUR/CHF for a 0.1% profit. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Waiting For A Real Deal - December 7, 2018 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been strong, with inflation grinding higher: Headline consumer price inflation increased to 2.9% year-on-year in March; core inflation also rose to 2.7% year-on-year, both surprising to the upside. Producer price index grew by 5.2% year-on-year in March, outperforming expectations. USD/NOK depreciated by 1.16% this week. The improving domestic economy, rising oil prices, and the tick up in inflation are all the reasons why we favor the Norwegian krone. We are playing the NOK via a few pairs, notably long NOK/SEK and short AUD/NOK, which are currently 3.11% and 0.75% in the money, respectively. Report Links: A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 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 mixed: Industrial production fell to 0.7% year-on-year in February, lower than the previous reading of 3%. New manufacturing orders contracted by 2.8% year-on-year in February. However, the leading manufacturing new orders to inventory ratio is rising suggesting we might be near a bottom. Consumer price inflation came in higher at 1.9% year-on-year in March. USD/SEK fell by 0.21% this week. We remain bullish on the Swedish krona due to its cheap valuation and the imminent pickup in the euro area economy. 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

Highlights So what? The U.S.-China deal is not shaping up as well as the consensus holds. Why? The odds of reaching a deal by June are rising, but no higher than 50%. Unemployment is a constraint on the Chinese side but stimulus reduces urgency. Structural concessions on currency and foreign investment are limited in scope. Strategic concessions are limited to North Korea; Taiwan risks are rising. Stay overweight U.S. and Chinese equities on a relative basis at least until the deal is signed.   Feature Once again investors are faced with a stream of headlines suggesting that a U.S.-China trade deal is all but finished, only to find critical caveats buried on page six. For instance, President Donald Trump and President Xi Jinping have not yet scheduled a summit to sign a trade agreement, though Trump insists a summit is necessary. Chief U.S. negotiator Robert Lighthizer says that he is “hoping but not necessarily hopeful.”1 There is still room for U.S. and Chinese bourses to outperform on a relative basis while negotiations continue. Still, the news flow is encouraging. Trump has said “we’ve agreed to far more than we have left to agree to,” while Xi Jinping has called for an “early conclusion of negotiations.” The other negotiators are also making positive sounds, with Vice Premier Liu He saying that a “new consensus” has been reached on a text of the trade agreement. National Economic Council Director Larry Kudlow says that key structural issues are on the table and that negotiations are continuing by videoconference after two successful rounds of direct talks in Beijing and Washington. Even the notorious China hawk, Peter Navarro, Director of the U.S. National Trade Council, has begrudgingly admitted that the two sides are in the final stage of the talks, saying, “the last mile of the marathon is actually the longest and the hardest.”2 Readers know that we take a pessimistic view of U.S.-China relations over the long run. We were skeptical about the possibility of a tariff truce on December 1. However, the signs are stacking up in favor of a deal. While we would not be surprised if talks extended to the June 28-29 G20 summit in Osaka, Japan, President Trump has suggested that a summit could come as early as May 5-19. Chart 1Still Some Room To Run Still Some Room To Run Still Some Room To Run Judging by the performance of U.S. and Chinese equities relative to the rest of the world since the first tariffs were imposed on June 14, 2018, there is still room for these two bourses to outperform on a relative basis while negotiations continue. Relative to global equities excluding China and U.S., Chinese stocks have retraced 78% of the ground they lost, while U.S. stocks have not surpassed the high points reached at the peak of the global economic divergence in 2018 (Chart 1). Once a deal is reached, will investors that bought equities on the rumor sell the news? We would buy, though equity leadership should rotate away from the U.S. and China depending on the timing and external conditions discussed below. As a House we are overweight global equities on a 12-month horizon. Xi Is Not Mao China’s economic stimulus is a key swing factor for global growth and the corporate earnings outlook this year. Our China Investment Strategy has highlighted that the BCA Activity Indicator has now fully registered the negative impact of trade tariffs as well as the broader slowdown (Chart 2). Chart 2Slowdown Fully Priced In Slowdown Fully Priced In Slowdown Fully Priced In Previously it was more buoyant than our leading indicator suggested it should be, largely because companies placed orders throughout the second half of 2018 to front-run Trump’s tariffs and this artificially boosted China’s exports and manufacturing activity. Now that this front-running is over, any improvement or deterioration in underlying monetary conditions, money supply, and lending should be reflected in the BCA Activity Indicator itself. Hence a stout credit number for March will cause an uptick that will confirm that China’s economy is recovering. We expect this to occur because, to be blunt, President Xi Jinping is not truly a modern-day Chairman Mao Zedong. While he has revived aspects of Maoism, he has responded pragmatically, rather than ideologically, to the Communist Party’s Number one political constraint: the tradeoff between productivity and employment. When Xi consolidated power in 2017, he launched a deleveraging campaign and doubled down on various structural reforms in order to make progress in rebalancing China’s economy. The result was renewed weakness in the labor market as the stimulus measures of 2015-16 wore off (Chart 3). Labor “incidents,” or protests, particularly those sparked by the relocation of workers from closed factories, began to rise again (Chart 4). Significantly, the number of bankruptcies also increased, demonstrating that the government was willing to tolerate some economic pain in order to make the allocation of capital more efficient (Chart 5). Chart 3A Key Constraint On Xi Jinping A Key Constraint On Xi Jinping A Key Constraint On Xi Jinping Chart 4Labor Incidents On The Rise Labor Incidents On The Rise Labor Incidents On The Rise Chart 5 China’s policymakers pursued these reforms while believing that President Trump’s threat of a trade war was largely bluster. But when Trump proceeded to impose tariffs, confidence collapsed and China’s private sector found itself sandwiched between stricter government at home and an impending squeeze of demand abroad. The labor and business indicators in Charts 3-5 suffered further deterioration in 2018 as animal spirits evaporated across the economy. President Xi’s response could have been to close China’s doors to trade and to the West and undertake an even more aggressive purge of “capitalist roaders.” The possibility is inherent in his cult of personality, aggressive anti-corruption campaign, and cyber-security state apparatus. This would have meant a dramatic reckoning with the country's economic and financial imbalances, but it would have given the hardliners in the Communist Party an opportunity to establish absolute control and national “self-sufficiency.” Instead, Xi entered into talks with Trump and launched supply-side, tax-and-tape-cutting measures to stimulate private economic activity, and boosted fiscal spending. He chose reflation rather than revolution. Chinese stimulus does not make a trade deal more likely in itself, as it gives President Xi more leverage in negotiations. But without a trade deal, private sector sentiment and animal spirits will remain depressed and stimulus measures will eventually falter. So it makes sense that Xi wants a deal. China will be the center of two market-positive outcomes in the near term: more domestic reflation and less conflict with the United States. To put this into context: if China’s credit impulse turns positive it will push the overall fiscal-and-credit impulse higher than 2% of GDP (Chart 6), foreshadowing a rebound in Chinese imports and global growth and enabling China’s own corporate earnings to recover. Our China Investment Strategy estimates that if the past three months’ rate of credit growth continues, while manufacturing sentiment improves on a trade deal and the renminbi remains flat, then the probability of an earnings recession on the MSCI China Index falls from 92% to 21%, as shown in Chart 7. From a policy perspective this looks conservative, as the actual rate of credit growth will probably be faster than that of the past three months. Chart 6Credit Will Add To Fiscal Boost Credit Will Add To Fiscal Boost Credit Will Add To Fiscal Boost Chart 7Earnings Unlikely To Contract Earnings Unlikely To Contract Earnings Unlikely To Contract Of course, President Trump has even more acute political constraints than President Xi urging him toward a deal. A deterioration in the U.S. manufacturing sector is a serious liability, especially in the Midwestern battleground states (Chart 8), and Trump has apparently calculated that a tailored infusion of Chinese cash and promises is a better reelection strategy than a continuation of trade war amid a slowdown.   Chart 8A Key Constraint On Donald Trump A Key Constraint On Donald Trump A Key Constraint On Donald Trump The implication of all of the above is that China will be the center of two market-positive outcomes in the near term: more domestic reflation and less conflict with the United States. The former is not yet consensus, while the latter is lacking in specifics. Yet both are beneficial for Chinese equities on an absolute and relative basis. And once there is a concluded trade deal and clarity over stimulus, emerging markets can also outperform their developed market counterparts. Note that we do not expect China to launch a massive 2008-09-style stimulus unless the tariff war reignites. Such an outcome would only be bullish for some EMs, since beneath the initial surge in Chinese imports would lie the disruption of the global supply chain and broader de-globalization. Bottom Line: Unemployment is a key political constraint suggesting both that China’s stimulus will surprise to the upside and that a trade deal is forthcoming. We are reducing the odds of an extension of trade talks beyond June from 35% to 20%, leaving a 50% chance for some kind of trade deal to emerge by the end of that month (Table 1). Table 1Updated Trade War Probabilities (April 2019) U.S.-China Conflict: The End Of The Beginning U.S.-China Conflict: The End Of The Beginning Trump Is Not Nixon If Xi is not Mao, then Trump is not Nixon. Despite a likely trade deal, we are not on the verge of a historic 1972-esque “grand compromise” that will usher in a new era of U.S.-China engagement. This should temper enthusiasm regarding the long-term durability of the trade truce, highlighting that China’s credit data is the more important factor for the 12-month horizon, though the trade issue is an impediment that needs to be removed for a sustainable rally. China may be increasingly willing to embrace structural concessions, but the depth of the structural change should be doubted until the details of the trade deal prove otherwise. For example, at the moment there is still no agreement on tariff levels. And there can be no “enforcement mechanism” to satisfy the U.S. side other than the perpetual threat of tariffs, which erodes trust and discourages Chinese implementation of structural changes. Two structural issues highlight the conundrum: currency and foreign investment. First, while the details of the currency agreement are unknown, the U.S. will definitely not get anything comparable to what it got from Japan after the Plaza Accord in 1985. The Japanese were a subordinate ally to the U.S. in the midst of the Cold War; they did not negotiate with the suspicion that the U.S. secretly wanted to destroy their economy. China has neither the security guarantee nor the economic trust. The implication is that the CNY-USD may rise by about 10% or so from current levels (Chart 9), as opposed to the 54% that the JPY-USD witnessed from 1985-88. The upside for the U.S. is that Trump may get some yuan appreciation, while the upside for China is that limited appreciation means no excessively deflationary impact. Chart 9Currency Agreement: Far From A Plaza Accord Currency Agreement: Far From A Plaza Accord Currency Agreement: Far From A Plaza Accord Second, China’s new foreign investment law, which received a rubber stamp from the legislature in March, is not an unqualified success for American negotiators. We have illustrated this in Table 2 by denoting white flags for aspects of the law that are genuine concessions and red flags for aspects that will raise new suspicions about China’s foreign investment framework. It is a mixed bag. Moreover, the law itself has no power and will depend entirely on the central government’s dedication to imposing strict adherence down through the local layers of government, where forced technology transfer actually takes place. Table 2New Foreign Investment Law: A Mixed Bag U.S.-China Conflict: The End Of The Beginning U.S.-China Conflict: The End Of The Beginning American negotiators will also want bilateral agreements on tech transfer and intellectual property protection since otherwise they will not receive any particular benefit from a law that applies equally to all foreign investors (e.g. Europeans). But it is not yet clear that they will get anything more concrete. The upside for the U.S. is that it will have some means of redress for forced tech transfer and intellectual property theft, while the upside for China is that foreign direct investment should improve. The strategic conflicts between the U.S. and China are even less likely to be dealt with than the economic issues. How can we be sure? Peer Competition: The U.S.-China détente under Nixon occurred at a time when a vast asymmetry between U.S. and Chinese national power existed, whereas today China’s power increasingly rivals that of the U.S., making it easier for China to write its own rules for global interactions and to resist U.S. pressure (Chart 10). Unilateralism: Trump did not leverage American alliances and partnerships across the world to create a “coalition of the willing” to confront China over its mercantilist trade and investment practices. There is some cooperation but it has been inconsistent and tentative, even on deep national security concerns like Huawei’s involvement in 5G networks and the Internet of Things. Had the U.S. created such a coalition and then set out to prosecute its claims, the threat to China’s economy would have been so immense that much greater structural changes could be expected than is the case today (Chart 11). Chart 10The Era Of U.S.-China Detente Is Over The Era Of U.S.-China Detente Is Over The Era Of U.S.-China Detente Is Over Chart 11Trump Eschewed A Coalition Of The Willing Trump Eschewed A Coalition Of The Willing Trump Eschewed A Coalition Of The Willing Core Interests: The trade talks only nominally address dangerous conflicts in China’s near abroad. China’s enforcement of sanctions on North Korea has produced limited results so far but we ultimately expect diplomacy to bear fruit (Chart 12). However, Taiwan is more rather than less likely to be the site of conflict. This is not because of pro-independence sentiment, which is actually on decline in public opinion relative to pro-unification sentiment (Chart 12, second panel). It is because the lame duck Tsai Ing-wen administration may attempt to secure last-minute benefits from the U.S., while an unexpected primary election challenge could lead to the nomination of Lai Ching-te (William Lai), a more outspoken pro-independence candidate, on April 24. Either could provoke Beijing. There is zero chance that any trade deal in the coming months will reduce the threat of reunification of Taiwan by force. Underlying distrust will remain. Chart 12Geopolitical Risk Down In Korea But Up In Taiwan Geopolitical Risk Down In Korea But Up In Taiwan Geopolitical Risk Down In Korea But Up In Taiwan Furthermore, the South China Sea is not a “red herring” but a potential “black swan,” as it is connected to Taiwan’s security and more broadly to U.S. alliance security. After all, 96%-97% of Taiwan’s, South Korea’s, and Japan’s oil imports flow through these sea lanes. Critical supplies become vulnerable if China expands its military’s capabilities there (Diagram 1). The U.S. and China will likely be just as provocative as before in this area after they sign a deal. Technology: The tech conflict is more likely to limit the trade deal than vice versa. The sanctions and embargoes on Chinese companies like ZTE, Fujian Jinghua, and Huawei have operated on a separate track from the trade talks, and it is not at all clear that the U.S. will embrace Huawei as part of any final deal. The initial actions of the newly beefed-up Committee on Foreign Investment in the United States (CFIUS) send warning signals. CFIUS is largely a vehicle for U.S. oversight of China (Table 3) and, if anything, that country-specific focus is intensifying. For instance, the U.S. has deemed Chinese ownership of a gay and lesbian hook-up app, Grindr, to pose an excessive national security risk.3 This is not a high bar for intervention and it suggests that any trade deal will fail to improve China’s investment options in the U.S. tech sector. Diagram 1South China Sea As Traffic Roundabout U.S.-China Conflict: The End Of The Beginning U.S.-China Conflict: The End Of The Beginning Table 3CFIUS Is Mostly About China U.S.-China Conflict: The End Of The Beginning U.S.-China Conflict: The End Of The Beginning The takeaway is that while both sides want a deal over the short term, it will not mark the end of the trade war. It is more likely the end of the beginning of a cold war. As long as China’s economy and industrial capabilities continue to grow relative to the United States, its geographic periphery remains a cauldron of geopolitical risks, and its technological advancement remains rapid, the competition will continue. Bottom Line: There is no substantial evidence from the current trade talks that underlying strategic conflicts will be resolved. This implies that the U.S. and China will shift their focus to these conflicts in the weeks and months after any trade deal. That process will be a nuisance to global equity markets expecting a clean deal; Chinese and American tech stocks in particular will remain exposed to tail risks. The status of Chinese tech companies is a critical risk, as a deal for the U.S. to admit Huawei would be a game-changer. Investment Conclusions Ironically, an early resolution of the trade war – in April or May – offers less of a benefit for Chinese equities and other risk assets than a later resolution in June or thereafter. While we expect to have greater clarity on China’s stimulus magnitude from the March data, it is still possible that stimulus will remain mixed or disappointing. Stimulus measures may also be toned down after a deal is approved, which means that an earlier deal would reduce the total stimulus by the end of 2019. The Trump administration will use the new flexibility gained from a China deal to toughen its policies in other areas, potentially with negative market consequences. The decision to designate the Iranian Revolutionary Guard Corps (IRGC) as a foreign terrorist organization is an important example. This decision is squarely within the Trump administration’s policy of pressuring Iran, which is a high-risk policy with substantial market-relevance. Trump may have made the decision in order to save face while planning to renew waivers on Iranian oil sanctions on May 4 – we would be extremely surprised if he did not renew. Sanctioning the IRGC involves a string of consequences but it is not a direct attack on oil supply that could produce an oil shock dangerous to Trump’s re-election prospects in 2020 (Chart 13). Of course, Iran will retaliate to the IRGC blacklisting – and one way it could do so would be through oil production in various places, including Iraq. The result would be oil volatility and higher prices. Chart 13 Further, an early deal could encourage Trump to instigate a trade war with Europe. Trump’s four-to-six week time frame for the conclusion of talks with China is conspicuously close to the tentative May 18 deadline by which he is required to determine whether to impose tariffs on foreign auto and auto part imports (Chart 14). Such tariffs would be pursuant to the Section 232 investigation that likely found such imports a threat to national security. We have argued that a U.S.-China deal raises the risk of tariffs on European cars to 35%, with Japanese and Korean cars less at risk, progressively. The EU is ready to retaliate so this would be a drawn-out trade conflict. Chart 14 Chart 15   By contrast, we are less concerned about the market impact of Trump’s recent threats to close the border with Mexico or include Mexico in car tariffs (Chart 15). True, Trump could close the border and generate a temporary drag on trade and the border economy. However, the Republicans have limited patience for the economic blowback of an extended border closure, and Trump cannot afford to jeopardize passage of his USMCA trade deal as long as he has alternative ways of looking tough on the border. Geopolitical Strategy would view the U.S. and China as good overweights relative to global equities and within their respective developed and emerging market contexts. What about a later resolution of the trade deal, in June or later in the summer? This would remove some risks. By that time, the Iran decision and possibly the car tariff decision will be past and there will be greater clarity on the magnitude of China’s stimulus. More extensive negotiations could also suggest that the ensuing trade deal will resolve deeper disagreements – unless the talks drag on without consequence amid signs of declining trust. Given the risk of trade war with Europe, oil volatility, and uncertainties about China’s stimulus, Geopolitical Strategy would view the U.S. and China as good overweights relative to global equities and within their respective developed and emerging market contexts. When and if the above political hurdles are cleared, the emphasis can shift to other bourses. Geopolitical Strategy’s preferred emerging market plays are EM energy producers and EM Asian states like Thailand and Indonesia.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 See Ailsa Chang, “U.S. Trade Representative Robert Lighthizer Discusses Ongoing Trade Talks With China,” National Public Radio, March 25, 2019, www.npr.org. 2 For the above quotations see Andrew Mayeda, Xiaoqing Pi, and Margaret Talev, “Kudlow Sees No Letup in China Talks as Both Sides Cite Progress,” Bloomberg, April 4, 2019, www.bloomberg.com. 3 See David E. Sanger, “Grindr Is Owned by a Chinese Firm, and the U.S. Is Trying to Force It to Sell,” March 28, 2019, www.nytimes.com.

Dear Client, Instead of our regular Weekly Report, this week we are sending you a Special Report written on February 20 by our Geopolitical Strategy service colleagues that discusses China’s recent stimulating efforts. We have only made a few minor revisions to account for the past month’s events. We trust that you will find this Special Report useful and insightful. Best regards, Anastasios Avgeriou, U.S. Equity Strategist   Highlights So What? China’s January-February credit data suggest that stimulus is here. Why? China’s early-year credit and fiscal policies suggest that stimulus risks are to the upside. January-February credit was a blowout number and fiscal spending is up. Equity bourses in South Korea and Russia are the most likely to benefit from Chinese stimulus. Industrial metals such as copper will also benefit – with a delay. Feature New credit data for China in January-February improves the chances that Beijing’s stimulus measures will overshoot this year, causing China’s economy to bottom in 2019 and jumpstart global growth. In our annual outlook for this year we argued that while China was stimulating the economy, the magnitude of stimulus would be the decisive factor for the global macro environment in 2019. We argued that the type of stimulus would remain primarily fiscal – tax cuts for households and small and medium-sized enterprises – and hence that it would be modest as fiscal easing would merely offset relatively weak credit growth. This view stemmed from our assessment of the Xi Jinping administration, highlighted in April 2017, as an “elitist” (not populist) administration. Its policy priorities are to discipline the Chinese economy, and in particular to contain systemic financial risk, which President Xi has cited as a national security threat. This view is not wrong, but the latest data clearly show that Xi has decided to pause these painful efforts at limiting leverage and rebalancing China’s economy. Witness January-February’s decisive uptick in both total social financing (total private credit) and local government bond issuance (Chart 1). Chart 1Higher Risk Of An Overshoot Higher Risk Of An Overshoot Higher Risk Of An Overshoot A massive spike in new credit is the single most important criterion in our “Checklist For A Stimulus Overshoot.” Thus, from a policy perspective, we are now at higher risk of an overshoot (Table 1). Not only credit as a whole but also informal lending saw a surge in January-February, implying that the government is relenting in its crackdown on the shadow banks. The approval of local government bond issuance for early in the year – and the People’s Bank of China’s announcement of a “Central Bank Bills Swap” program – reinforce this policy shift.1 Table 1Checklist For A Chinese Stimulus Overshoot In 2019 China: Stimulating Amid The Trade Talks China: Stimulating Amid The Trade Talks   A stimulus overshoot is positive for Chinese demand in the short run but negative for potential GDP in the long run. A “traditional” credit surge of this nature cannot be surgically targeted at SMEs or households. It will go to state-owned enterprises, privileged corporations, property developers, and the like, which have always had the advantage in China’s financial system. SOEs have taken a much larger share of new loans than private companies in recent years,2 and the only silver lining of this trend was the possibility that tighter credit controls would discipline the SOEs. That silver lining is now fading, barring some new and surprising development on the reform front. China needs to create 26 trillion renminbi in new credit over the course of the year to avoid a corporate earnings contraction. These January-February numbers put China on track to do just that (Chart 2), assuming that President Xi and U.S. President Donald Trump agree to a short-term, framework trade deal this year. Chart 2On Track To Avoid An Earnings Contraction On Track To Avoid An Earnings Contraction On Track To Avoid An Earnings Contraction Of course, a few caveats are in order. First, January-February’s credit number is only one data point and credit growth is always abnormally strong in the first month of the year. Early in the year, banks seek to expand their assets rapidly in a bid to get as much market share as possible before administrative credit quotas kick in. Because of Chinese New Year, it is best to combine January and February data to get a sense of the rate of credit expansion in the first part of the year. This year’s January-February numbers are very strong relative to previous years (Chart 3) and the context is more accommodative than the 2017 January-February credit surge, when authorities were beginning to tighten rather than ease macroprudential policy. Still a rapid rate of credit expansion will have to be sustained in the coming months in order to meet the 26 trillion RMB requirement highlighted above. Image Second, there is some risk that China’s households and private businesses will not respond as positively today as in the past. The intensification of Communist Party control over the society and economy, President Xi’s cancellation of term limits, and the strategic confrontation with the United States have created a bearish sentiment in the private sector. Our Emerging Markets Strategy would point out that if the propensity to consume, and money velocity,3 do not accelerate, then a surge in new credit may fail to ignite a reacceleration in China (Chart 4). Chart 4Chinese Are Holding On To Their Money Chinese Are Holding On To Their Money Chinese Are Holding On To Their Money Still, what we now know is that Xi Jinping and his top economic adviser, Vice Premier Liu He, are not initiating the “assault phase of reform” that their predecessors initiated in the late 1990s in order to cleanse China’s economy of bad loans and zombie companies. Instead, they are likely reestablishing the “Socialist Put” in order to reverse the current deceleration, demonstrate China’s continued economic might and face down the United States’ threat of tariffs. Bottom Line: China’s stimulus measures are increasingly likely to overshoot, with positive implications for both Chinese and global growth. China is still facing a corporate earnings recession, but the odds of averting it are increasing. Trade Deadline More Likely To Be Extended What of the trade war? First, we would warn clients that China’s annual credit origination is a much bigger factor for the global economy than China’s exports to the United States (Chart 5). The trade war can escalate from here and yet, if China’s stimulus works as it has in the past, the results will be manageable for China’s economy save for Chinese companies expressly exposed to the U.S. economy through exports. In reality, both the U.S. and China are now effectively stimulating their economies and in this sense global trade as a whole will benefit regardless of bilateral tariffs. Chart 5Watch China Credit, Not So Much The Trade War Watch China Credit, Not So Much The Trade War Watch China Credit, Not So Much The Trade War But it is possible that just as global equity markets ignored China’s economic slowdown and only sold off when the tariffs were levied (Chart 6), they may not continue to rally much on China’s credit data. Given the already considerable rally in global risk assets since October, markets may not be satisfied merely with one or two months of solid credit data out of China without a clear resolution to the trade conflict. After all, if a collapse in U.S.-China trade talks portends a new Cold War, then institutional investors may be justified in taking a wait-and-see approach despite China’s credit cycle upswing. Chart 6Will Equities Ignore China Data (Again)? Will Equities Ignore China Data (Again)? Will Equities Ignore China Data (Again)? In the past, we have highlighted that the U.S. and China are not economically prohibited from engaging in a trade war – the export exposure is too small – and China’s new stimulus reinforces this point. However, President Trump is concerned about causing a sell-off in the tech sector and hence the broad equity market which could translate into a bear market and raise the probability of a recession occurring prior to November 2020. Meanwhile, in China, given Beijing’s reported trade concessions, there is apparently a desire to pacify the relationship and discourage U.S. unilateral tariffs and sanctions that could become seriously destabilizing for the Chinese economy and society. The need to have a happy 2021 centenary celebration for the Communist Party may factor into policymakers’ thinking. The latest news flow is mildly positive for the odds of getting a framework deal sometime this year. President Trump visited the Chinese negotiators in Washington, D.C. while President Xi reciprocated with the American negotiators in Beijing. A new round of two-week shuttle diplomacy is beginning. Trump has extended the tariff ceasefire and the two sides reportedly have arrived at an agreement on currency and are drafting written agreements on other areas of dispute. China’s National People’s Congress has passed a new Foreign Investment Law that ostensibly guarantees many of the American demands on forced tech transfer, intellectual property theft, and discriminatory treatment of U.S. companies (Table 2). Table 2New Foreign Investment Law Would Be A Positive For U.S.-China Negotiations China: Stimulating Amid The Trade Talks China: Stimulating Amid The Trade Talks However, Presidents Trump and Xi have yet to schedule a new summit, which is probably necessary for a final deal. And there are murmurs from the press suggesting that China’s new law and other concessions are not going to satisfy the U.S. negotiators on the critical point of “structural changes” and a verification process. This leaves us inclined to change our trade war probabilities to increase the odds of an extension (Table 3). The improvement in U.S. financial conditions and China’s stimulus, if anything, make it more likely that negotiations will be extended, as both sides feel their economic and financial constraints less acutely. Table 3Updated Trade War Probabilities China: Stimulating Amid The Trade Talks China: Stimulating Amid The Trade Talks Bottom Line: Global and Chinese risk assets should rally on China’s credit uptick, but the lack of resolution of the trade war could continue to inhibit animal spirits – and the odds of a March 1 resolution are declining. Who Are The Equity Winners Of China’s Stimulus? China’s strong January-February credit number is supportive of global equity markets. That much is obvious. But which equity markets will benefit the most? In what follows we examine the relationship between Chinese credit and MSCI equity returns of various countries. We find that Malaysian, Australian, South Korean, and Indonesian equities are the most highly correlated with Chinese credit growth and are thus most likely to benefit from the recent upturn (Chart 7). On the other hand, France and Italy stand out as countries whose bourses are more insulated. Chart 7 Out of the markets that are positively correlated, South Korea and Russia stand out as relatively cheap (Chart 8). Thus we expect these equities to do especially well. By contrast, while Indonesia and the Philippines are highly leveraged to China, these markets are currently relatively expensive. BCA’s Emerging Markets Strategy is currently overweight Korean and Russian equities within the EM space, neutral Turkey (although recently upgraded from underweight), and underweight Indonesia and the Philippines. Chart 8 In addition to credit stimulus, we expect Chinese household consumption to also gain support going forward. This will likely be driven by policy stimulus targeting the consumer specifically and is best exemplified by the recently announced tax cuts (Chart 9), which we expect to trickle down to greater consumer demand and growth in retail sales. Our base case calls for 8%-10% growth in household consumption over the coming 12 months, up from the current 3.5%. Chart 9 However, consumer sentiment in China is weak. BCA’s Emerging Markets Strategy’s proxy for household marginal propensity to spend ticked up recently, after falling since early last year (see Chart 4 above). A resumption in the decline would highlight that households are increasingly unwilling to spend, which would translate into weaker retail sales despite policy efforts to boost consumption. Such a scenario – in which credit growth accelerates without a substantial uptick in consumer spending – is plausible, given that it occurred between mid-2015 and mid-2016 (Chart 10). In any case, whether Chinese stimulus comes in the form of the traditional credit channel, or instead in the form of fiscal stimulus to household consumption, the same equity markets will generally benefit the most (Chart 11). Chart 10...But Flattish Retail Sales Are Also A Possibility ...But Flattish Retail Sales Are Also A Possibility ...But Flattish Retail Sales Are Also A Possibility Chart 11 Indeed, global equity markets react the same way regardless of the type of stimulus implemented. For instance, MSCI returns for the Philippines, Sweden, Malaysia, Indonesia, and Turkey are more closely correlated to both Chinese credit growth and retail sales growth compared to Italy, Japan, and France. The same conclusion is reached when we look at the correlations between Chinese credit growth or consumption growth and individual MSCI sectors such as industrials and consumer discretionary (Chart 12). Chart 12 The relatively stronger correlation between Chinese credit growth and equity returns – as opposed to Chinese retail sales and equity returns – can be put down to the nature of Chinese imports. While industrial goods account for the bulk of China’s purchases of foreign goods, consumer goods excluding autos make up only 15% of China’s imports (Table 4). However, as Chart 12 illustrates, the relationship between China’s retail sales growth and global equities is much tighter in the case of the consumer discretionary sector, whether the latter is compared to global industrials sectors or the overall MSCI index. Table 4Import Composition Of Chinese Imports China: Stimulating Amid The Trade Talks China: Stimulating Amid The Trade Talks Equity market exposure to China is not always in line with the extent of each country’s trade exposure to China (Chart 13). Chart 13 There are some clear exceptions – most notably Mexico, which has the highest correlation coefficient with Chinese credit and consumption variables since 2010. However, this is likely due to idiosyncratic factors.4 Correlation does not imply causation, and we cannot conclude with certainty that Mexican equities will outperform amid China’s new round of stimulus. Nevertheless, given that Mexico is a very deeply liquid market that benefits amid EM bull markets, this may not be entirely coincidental. The correlations between global equity markets and Chinese credit peak two months after the stimulus measures are first implemented (Chart 14). This is more or less in line with adjusted total social financing’s correlation versus industrial metals. However, BCA’s Commodity & Energy Strategy has shown that copper’s correlations versus other measures of Chinese money and credit peak after roughly three quarters (Chart 15).5 This is evident in both the 2012 and 2015-16 stimulus episodes in which the bottom in copper prices lagged the bottom in China’s credit growth. Thus we may witness a rebound in equity markets on the back of China’s credit splurge before we see an improvement in annual returns on copper prices. Chart 14 Chart 15Copper Rallies Lag China Credit Stimulus Copper Rallies Lag China Credit Stimulus Copper Rallies Lag China Credit Stimulus Bottom Line: South Korean and Russian equities are best positioned to benefit from the positive surprise in China’s credit data. France and Italy are the worst positioned. Copper prices will rebound with a delay.  Investment Implications BCA’s Geopolitical Strategy recommends that investors stay long Chinese equities ex-tech relative to the emerging market benchmark. This is a tactical call initiated in August 2018 that is now becoming a cyclical call on the basis of the credit upswing. We also remain long the “China Play Index,” a basket of China-sensitive assets. A rebound in China’s credit data and stronger global growth will support copper demand. Prices are still 15% below the mid-2018 peak and are poised to benefit in this environment, especially given that global inventories are already falling. BCA’s Geopolitical Strategy recommends that investors go long copper. Meanwhile, BCA’s China Investment Strategy recommends (for now) staying only tactically overweight Chinese equities relative to the global benchmark, pending higher conviction that the pace of credit growth will be strong enough to overwhelm the negative ramifications of a continued deceleration in actual activity over the coming few months on sentiment and 12-month forward earnings expectations. Over the long run, Geopolitical Strategy would look to underweight Chinese equities, as we are not optimistic about China’s productivity and potential GDP. This is because of the negative structural consequences of continuing the Socialist Put (i.e., bad loans, zombie companies, trade protectionism). We would expect CNY/USD to remain relatively buoyant in the context of both trade negotiations with the U.S. and fiscal-and-credit stimulus. The trade talks can hardly succeed if CNY/USD is falling. Depending on whether and how soon China’s stimulus results in a durable economic bottom, global growth could stabilize and the USD could see a substantial countertrend selloff.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist roukayai@bcaresearch.com   Footnotes 1          Please see Emerging Markets Strategy Special Report titled “China: Prepping A Bazooka?” dated February 14, 2019 available at ems.bcaresearch.com 2      Please see Nicholas Lardy, “The State Strikes Back: The End Of Economic Reform In China?” Peterson Institute For International Economics, January 29, 2019, available at piie.com. 3          Please see Emerging Markets Strategy Weekly Report titled “Dissecting China’s Stimulus,” dated January 17, 2019 available at ems.bcaresearch.com 4       The 2012 election of President Enrique Peña Nieto caused Mexican equities to outperform their EM counterparts. Similarly in 2015-16, U.S. outperformance relative to EM also supported Mexico relative to EM because Mexico’s economy is highly leveraged to its northern neighbor. In both periods Mexico’s outperformance was not caused by – but instead coincided with – Chinese credit stimulus. These idiosyncratic events biased the correlation between Mexico’s equity markets and Chinese credit growth to the upside. 5      Please see Commodity & Energy Strategy Weekly Report titled “Trade Wars, China Credit Policy Will Roil Global Copper Markets,” dated June 21, 2018, available at ces.bcaresearch.com.                  

Highlights Just when it looked like the agricultural complex was starting to perk up, it was slapped down again. After crawling its way back from a mid-2018 crash – retracing more than half of its decline – the CCI Grains and Oilseeds index plummeted in February, declining by nearly 9% (Chart Of The Week). The decline was broad-based, but was led by wheat, which was dragged down by muted demand and accounted for most of the index’s decline. Looking forward, we expect U.S. financial conditions and developments on the trade-war front to remain the main forces driving ag prices. Ample inventories will provide the cushion necessary to moderate the impact of potential supply-side shocks. Highlights Energy: Overweight. Venezuela suffered another power outage earlier this week, indicating the deterioration of its infrastructure is accelerating. While officials claim to have restored power, we expect more such outages going forward, which will severely reduce the country’s production and export capacity. Separately, Aramco announced it will buy 70% of Sabic, a Saudi state-owned petchem producer, for $69 billion, according to the Wall Street Journal. Base Metals: Neutral. China’s MMG Ltd was set to declare force majeure following protests at its Las Bambas mine in Peru earlier this week. The mine produces ~ 385k MT p.a., most of which goes to China. Precious Metals: Neutral. The inversion of the U.S. yield curve put a bid into the gold market this week, as investors sought a safe-haven refuge. Continued weakness in bond yields, and accommodative central banks responding to low inflation expectations globally will continue to support gold. Agriculture: Underweight. A more patient Fed will be supportive of ag prices in 2H19, as we discuss below. Feature Chart of the WeekWheat Had A Rough Start To 2019 Wheat Had A Rough Start To 2019 Wheat Had A Rough Start To 2019 A Patient Fed Will Support Ags In 2H19 While differences across ag markets will arise due to idiosyncratic supply shocks and targeted trade policies, a common determinant of ag price movements more generally is U.S. financial conditions. Since our last assessment of global ag markets, Fed policymakers have adopted a much more patient approach to monetary policy.1 In line with the pause in the Fed’s rates-normalization policy, financial conditions have eased considerably (Chart 2). We believe this will, ceteris paribus, bring relief to commodity markets in general, ags in particular, in the second half of this year. Chart 2Easier Financial Conditions Bode Well For Ags Easier Financial Conditions Bode Well For Ags Easier Financial Conditions Bode Well For Ags The bulk of this relief will be transmitted through the impact of a weaker dollar. Since the dollar is a countercyclical currency, its weakness implies an improvement in global growth. This more solid economic backdrop is associated with greater aggregate demand, particularly in EM economies, as well as demand for agricultural products. The lagged effects of financial tightening, weak Chinese credit growth and the trade war will persist in 2Q19. Furthermore, when the USD weakens against the currencies of ag exporting countries, farmers there are incentivized to hoard or cut exports – thus reducing supply – awaiting periods when a stronger greenback will raise their profits. At the same time, ags priced in USD become relatively more affordable for importing nations, incentivizing them to raise consumption. The net impact of this contraction in supply amid greater demand will pull up prices – illustrated by the relatively tight inverse relationship between ag prices and the dollar (Chart 3). Chart 3A Weaker USD Will Be A Tailwind In 2H19 A Weaker USD Will Be A Tailwind In 2H19 A Weaker USD Will Be A Tailwind In 2H19 Going into mid-2019, we expect global economic indicators to continue to be uninspiring. The lagged effects of financial tightening, weak Chinese credit growth and the trade war will persist in 2Q19. However, as these factors fade and give way to an improvement in global economic conditions and easier financial conditions, we expect the dollar to peak around mid-year. As such, a resurgence in global growth in the second half of the year will be reflected in an improvement in the value of the currencies of major ag exporters ex-U.S. (Chart 4). Ceteris paribus, this also benefits ag prices. Chart 4Weak Local Currencies Supporting Farm Profits, Incentivizing Production Weak Local Currencies Supporting Farm Profits, Incentivizing Production Weak Local Currencies Supporting Farm Profits, Incentivizing Production China’s Economy Remains Central Our outlook hinges on developments in the Chinese economy. Peter Berezin – our Chief Global Investment Strategist – expects Chinese authorities to not only stabilize credit growth, but also increase it, creating room for improvement in the world’s second largest economy.2 This combination of supportive global growth and a softer dollar bodes well for ag prices in 2H19. The Fed pause and associated easing in U.S. financial conditions will support global growth, causing the U.S. dollar to weaken – a bullish force for ag markets. Apart from the currency impact, easy financial conditions are supportive of global growth. A rise in income levels of emerging economies will support demand for goods and services generally, and agricultural commodities specifically.3 The market now expects 36 and 51 basis points of rate cuts over the coming 12 and 24 months, respectively. Similarly, following last week’s FOMC meeting, the median Fed dot indicates no rate hikes this year from the U.S. central bank, and only one in 2020. While our Global Investment Strategists would not be surprised to see a hike this year, the noticeably less hawkish tone in the Fed’s forward guidance and dot plots are positive for ag markets.4 Looking beyond that into late-2020 or early 2021, a potential pick-up in inflation will force the Fed to take a more hawkish stance, and once again support the U.S. dollar. This will weigh down on ag prices over the strategic time horizon. Bottom Line: The Fed pause and associated easing in U.S. financial conditions will support global growth, causing the U.S. dollar to weaken – a bullish force for ag markets. However, this is unlikely to occur before mid-year. In the meantime, a stronger dollar on the back of the lagged effects of growth dampening events in 2018, will remain a headwind. Ample Inventories Will Cushion Against Supply Shocks Putting aside the more or less uniform impact of U.S. financial conditions, individual supply-demand fundamentals will manifest as idiosyncratic risks and opportunities. The USDA has been revising its projections for ending stocks higher in its monthly World Agricultural Supply and Demand Estimates (WASDE) across the board since it released the first projections for the 2018/2019 crop year last May. However, we find that solely on the back of fundamentals, soybeans are more likely to resist upward pressure from easier U.S. financial conditions in 2H19 vs. wheat and corn. The USDA’s latest projections for the current crop year indicate that global bean markets are well supplied. Expectations of a global surplus this crop year – for the seventh consecutive year – will add to the growing cushion (Chart 5). Chart 5Beans Surplus Will Add To the Glut Beans Surplus Will Add To the Glut Beans Surplus Will Add To the Glut Since May, global ending bean stocks have been revised higher by a total of 20.47mm MT. The change in projections comes on the back of upward revisions to production and beginning stocks, compounded by downward revisions to consumption. The latter will likely contract further if the U.S. and China do not reach an agreement on the trade front (see below). Consequently, unless a weather disruption weakens supply, we expect soybean inventories to stand at record highs relative to consumption at the end of the current crop year. In the case of wheat, the impact on prices will likely be marginal. The global balance is expected to shift to a deficit in the current marketing year, following five years of surplus (Chart 6). While this is a positive for wheat prices, given that global inventory levels are relatively elevated – capable of supporting 37% of consumption – and the current deficit is relatively small, we do not expect the deficit to pressure prices in the near term. Chart 6Elevated Wheat Inventories Will Cushion Against Minor Deficit Elevated Wheat Inventories Will Cushion Against Minor Deficit Elevated Wheat Inventories Will Cushion Against Minor Deficit Despite continued downward revisions to the USDA’s wheat production projections, expectations of ending stocks have actually risen on the back of downward revisions to consumption. Similarly, corn fundamentals are also unlikely to sway prices much. The grain is expected to remain in deficit for the second consecutive year, which will pull inventories down off their 2016/17 peak to be capable of covering ~27% of global consumption (Chart 7). Despite this contraction in availability, global supplies remain relatively elevated, especially compared to the 2003 to 2012 period. Thus unless there is a significant supply shock, we don’t expect much support from fundamentals. Chart 7A Global Corn Deficit ... A Global Corn Deficit ... A Global Corn Deficit ... Unlike wheat demand, which has been downgraded, the USDA has revised corn consumption up relative to the first projections for the crop year released last May. Nevertheless, stronger expectations of consumption have been overwhelmed by upward revisions to production and beginning inventory levels. Given that world inventories already are bloated, we do not expect the likely deficit in wheat and corn supplies this crop year to pressure prices much to the upside. Since the mid-1990s, U.S. farmers had been planting more corn and wheat at the expense of soybean acreage (Chart 8). On a global level, while wheat remains more popular in terms of acreage, it is generally trending downwards, while corn and soybean plantings are trending up. However, over the longer term, U.S. farmers are expected to dedicate more land to corn relative to soybeans. Chart 8... Will Be Met By Rising U.S. Acreage ... Will Be Met By Rising U.S. Acreage ... Will Be Met By Rising U.S. Acreage Bottom Line: Given that world inventories already are bloated, we do not expect the likely deficit in wheat and corn supplies this crop year to pressure prices much to the upside. Similarly, a global glut in soybean supplies will only add to swelling inventories. The Trade War And Soybeans: It Ain’t Over Till It’s Over Aside from U.S. financial conditions and supply-demand balances, U.S. trade policy has also been roiling ag markets since China slapped U.S. soybeans with 25% tariffs in mid-2018. In fact, since the escalation of the trade dispute, soybean prices have been moving largely in response to developments on the trade front (Chart 9). As developments since the G20 Summit in Buenos Aires last December have been more favorable, soybean markets are on the path to recovery. Chart 9Markets Optimistic Of A Trade War Resolution Markets Optimistic Of A Trade War Resolution Markets Optimistic Of A Trade War Resolution So far, even though U.S. soybean exports to China picked up over the past two months, total U.S. exports still lag levels typical for this time of year (Chart 10). This comes despite U.S. efforts to raise shipments to other trading partners. Furthermore, U.S. exports will now be in direct competition with the Brazilian crop, which usually dominates trade flows at this time of year (Chart 11). Chart 10 While the U.S. tariff hike from 10% to 25% on $200bn of Chinese goods has been postponed, a resolution to the trade war has yet to occur. The path to a resolution is fraught with risks. Chart 11 While the U.S. tariff hike from 10% to 25% on $200bn of Chinese goods has been postponed, a resolution to the trade war has yet to occur. The path to a resolution is fraught with risks. The Trump-Xi meeting that was expected to occur in late-March was postponed; the next most likely date for a meeting is at the G20 summit in end-June. This leaves another 3 months of trade uncertainty. Nevertheless, our models indicate that soybeans are now priced at fair value, based on U.S. financial variables – absent a trade war (Chart 12). Chart 12 Furthermore, the premium priced into Brazilian beans above those traded on the CBOT has returned to its historical average (Chart 13). Thus, we do not expect a further reduction in the premium in the event Sino-U.S. trade negotiations are successful. Chart 13Premium For Brazilian Beans Has Normalized Premium For Brazilian Beans Has Normalized Premium For Brazilian Beans Has Normalized Rather, markets will be disappointed if the U.S. and China are unable to conclude a deal. This would put CBOT prices at risk and support the premium on those traded in Brazil. Given that our geopolitical strategists assign a non-negligible 30% probability that the trade war escalates further, we believe markets are overly optimistic that a deal will be concluded.5 If the trade war drags on and turns into a multi-year conflict, soybean markets will likely take a more meaningful hit. According to the USDA’s latest long-term projections released earlier this month, China’s soybean imports were projected to rise 32.1mm MT during the 2018-28 period – a massive downward revision from the 46mm MT expected for the 2017-2027 period contained in the previous long-run projections. Furthermore, outbreaks of African swine fever in China may put demand there at risk. Over 100 cases have so far been reported in China, with several cases already reported in Vietnam as well. This threatens to depress China’s need for soybean as animal feed, regardless of what happens on the trade front. Bottom Line: A positive outcome from the U.S.-China trade negotiations is not a given. Nevertheless, soybean markets are treating it as such. Our geopolitical strategists assign 30% odds that a final deal falls through. This non-negligible probability threatens to cause soybean prices to relapse anew, should Sino-U.S. trade negotiations break down.   Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com Footnotes 1 Please see “2019 Key Views: Policy-Induced Volatility Will Drive Markets,” published by BCA Research’s Commodity & Energy Strategy December 13, 2018.  It is available at ces.bcaresearch.com. 2 Please see BCA Research’s Global Investment Strategy Weekly Report titled “What’s Next For The Dollar,” dated March 15, 2019, available at gis.bcaresearch.com. 3 Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled “Global Financial Conditions Will Drive Grain Prices In 2018,” dated November 30, 2017, available at ces.bcaresearch.com. 4 Please see BCA Research’s Global Investment Strategy Weekly Report titled “Questions From The Road,” dated March 22, 2019, available at gis.bcaresearch.com. 5 Please see BCA Research’s Geopolitical Strategy Special Report titled “China-U.S. Trade: A Structural Deal?,” dated March 6, 2019, available at gps.bcaresearch.com.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table   Trades Closed in 2019 Summary of Trades Image