Trade

Highlights So What? Global divergence will persist beyond the near term. Why? China’s stimulus will be disappointing unless things get much worse. U.S.-China trade war will reignite and strategic tensions will continue. European risks are limited short-term, but will surge without reform. U.S. assets will outperform; oil and the yen will rise; the pound is a long-term play; EM pain will continue. Feature The year 2019 will be one of considerable geopolitical uncertainty. Three issues dominate our Outlook, with low-conviction views on all three questions: Question 1: How much will China stimulate? Question 2: Will the trade war abate? Question 3: Is Europe a Black Swan or a Red Herring? U.S. Outperformance Should Be Bullish USD U.S. Outperformance Should Be Bullish USD The main story in 2018 was policy divergence. American policymakers ramped up stimulus – both through the profligate tax cuts and fiscal spending – at the same time that Chinese policymakers stuck to their guns on de-levering the economy. The consequence of this policy mix was that the synchronized global recovery of late 2016 and 2017 evolved into a massive outperformance by the U.S. economy (Chart 1). The Fed responded to the bullish domestic conditions with little regard for the global economy, causing the DXY to rally from a 2018 low of 88.59 in February to 97.04 today. Fiscal Conservatism Melts Away Fiscal Conservatism Melts Away Republicans Change Their Minds When In Power Republicans Change Their Minds When In Power While the policy divergence narrative appears to be macroeconomic in nature, it is purely political. There is nothing cyclical about the ‘U.S.’ economic outperformance in 2018. President Donald Trump campaigned on an economic populist agenda and then proceeded to deliver on it throughout 2017 and 2018. He faced little opposition from fiscal conservatives, mainly because fiscal conservativism melts away from the public discourse when budget deficits are low (Chart 2) and when the president is a Republican (Chart 3). Meanwhile, Chinese policymakers have decided to tolerate greater economic pain in an effort to escape the Middle Income Trap (Chart 4). They believe this trap will envelop them if they cannot grow the economy without expanding the already-massive build-up of leverage (Chart 5). 2019 Key Views: Balanced On A Knife’s Edge 2019 Key Views: Balanced On A Knife’s Edge Debt Still Rising Debt Still Rising Geopolitics is not just about “things blowing up somewhere in the desert.” In today’s world, emblematized by paradigm shifts, politicians are more than ever in the driver’s seat. While technocrats respond to macroeconomic factors, politicians respond to political and geopolitical constraints. Few investment narratives last much longer than a year and policy divergence is coming to a close. Will the Fed pause given the turn in global growth? Will China respond with effective stimulus in 2019? If the answer to both questions is yes, global risk assets could light up in the next quarter and potentially beyond. Already EM has outperformed DM assets for a month and some canaries in the coal mine for global growth – like the performance of Swedish economic indicators – signal that the outperformance is real. Global Economic Divergence Will Continue Global Economic Divergence Will Continue 2019 Key Views: Balanced On A Knife’s Edge 2019 Key Views: Balanced On A Knife’s Edge We are skeptical that the move is sustainable beyond a quarter or two (Chart 6). As our colleague Peter Berezin has highlighted, the market is pricing less than one hike in 2019 (Chart 7). Regardless, the impact on the U.S. dollar, remains muted, with the DXY at 97.04. This suggests that the backing off that the Fed may or may not have already done is still not enough from the perspective of weakening global growth (Chart 8). Global risk assets need more from the Fed than what the market is already pricing. And with U.S. inflationary pressures building (Chart 9), the BCA House View expects to see multiple Fed hikes in 2019, disappointing investors bullish on EM and global risk assets. Global Growth Leading Indicators Global Growth Leading Indicators Does The Fed Like It Hot? Does The Fed Like It Hot? With our Fed view set by the House View, we therefore turn to where we can add value. To this end, the most important question of 2018 largely remains the same in 2019: How much will China stimulate? Question 1: How Much Will China Stimulate In 2019? bca.gps_sr_2018_12_14_c10 bca.gps_sr_2018_12_14_c10 China is undoubtedly already stimulating, with a surge in local government bond issuance earlier this year and a bottoming in the broad money impulse (Chart 10). M2 is in positive territory. However, the effort can best be characterized as tepid, with a late-year collapse in bond issuance (Chart 11) and a still-negative total social financing (TSF) impulse (Chart 12). TSF is the broadest measure of private credit in China’s economy.   2019 Key Views: Balanced On A Knife’s Edge 2019 Key Views: Balanced On A Knife’s Edge China's Total Credit Is Weak China's Total Credit Is Weak We expect a surge in TSF in Q1, but this is a normal seasonal effect. A typical Q1 credit surge will not be enough to set global risk assets alight for very long, particularly if the market has already priced in as much of a “pause” from the Fed as we are going to get. Investors should specifically focus on new local government bond issuance and whether the “shadow financing” component of TSF gets a bid, since the primary reason for the weakness in TSF over the past year is the government’s crackdown on shadow lending. As Chart 13A & B shows, it was new local government bonds that led the way for stimulus efforts in 2015, followed by a surge in both bank lending and shadow lending in 2016. Don't Focus Just On TSF... Don't Focus Just On TSF... ...But Shadow Financing In Particular ...But Shadow Financing In Particular We would also expect further monetary policy easing, with extra RRR cuts or even a benchmark policy rate cut. However, monetary policy has been easy all year and yet the impact on credit growth has remained muted. This begs two important questions: Is the credit channel impaired? A slew of macroprudential reforms – which we have dubbed China’s “Preemptive Dodd-Frank” – may have impaired the flow of credit in the system. The official policy of “opening the front door, closing the back door” has seen bank loans pick up modestly but shadow lending has been curtailed (Chart 14A & B). This way of controlling the rise of leverage has its costs. For private enterprises – with poor access to the official banking sector – the shadow financial system was an important source of funding over the past several years. Opening The Front Door... Opening The Front Door... ...Closing The Back Door ...Closing The Back Door Is policy pushing on a string? An even more dire scenario would be if China’s credit channel is not technically, but rather psychologically, impaired. Multiple reasons may be to blame: a negative net return on the assets of state-owned enterprises (Chart 15); widespread trade war worries; mixed signals from policymakers; or a general lack of confidence in the political direction of the country. The rising M2/M1 ratio suggests that the overall economy’s “propensity to save” is rising (Chart 16). Old China Is A Zombie China Old China Is A Zombie China Propensity To Save Propensity To Save Why would Chinese policymakers keep their cool despite a slow pickup in credit growth? Are they not concerned about unemployment, social unrest, and instability? Of course, they are. But Chinese policymakers are not myopic. They also want to improve potential GDP over the long run. Table 1China: The Trend In Domestic Demand, And The Outlook For Trade, Is Negative 2019 Key Views: Balanced On A Knife’s Edge 2019 Key Views: Balanced On A Knife’s Edge So far, the economy has weathered the storm relatively well. First, eight out of ten of our China Investment Strategy’s housing price indicators (Table 1) are flat-to-up – although it is true that the October deterioration in floor space started and especially floor space sold (Chart 17) is cause for concern. If and when the housing market weakens further, stimulus will be used to offset it, despite the fact that the government is attempting to prevent a sharp increase in prices at the same time. With so much of China’s middle-class savings invested in the housing market, the key pillar of socio-economic stability is therefore real estate. A Possible Clue For China Stimulusr A Possible Clue For China Stimulusr Second, credit has fueled China’s “old economy,” but policymakers want to buoy “new China” (Chart 18). This means that measures to boost consumption and the service sector economy will be emphasized in new rounds of stimulus, as has occurred thus far (tax cuts, tariff cuts, deregulation, etc). This kind of stimulus is not great news for global risk assets leveraged to “old China,” such as EM and industrial metals. Rebalancing Of The Chinese Economy Rebalancing Of The Chinese Economy Third, policymakers are not exclusively focused on day-to-day stability but are also focused on the decades-long perseverance of China’s political model. And that means moving away from leverage and credit as the sole fuel for the economy. This is not just about the Middle Income Trap, it is also about national security and ultimately sovereignty. Relying on corporate re-levering for stimulus simply doubles-down on the current economic model, which is still export-oriented given that most investment is geared toward the export sector. But this also means that China will be held hostage to foreign demand and thus geopolitical pressures, a fact that has been revealed this year through the protectionism of the White House. As such, moving away from the investment-led growth model and towards a more endogenous, consumer-led model is not just good macro policy, it makes sense geopolitically as well. Will the trade war – or the current period of trade truce – change Chinese policymakers’ decision-making? We do not see why it would. First, if the trade truce evolves into a trade deal, the expected export shock will not happen (Chart 19) and thus major stimulative measures would be less necessary. Second, if we understand correctly why policymakers have cited leverage as an “ill” in the first place, then we would assume that they would use the trade war as an excuse for the pain that they themselves have instigated. In other words, the trade war with the U.S. gives President Xi Jinping the perfect excuse for the slowdown, one that draws attention from the real culprit: domestic rebalancing. Trump's Initial Tariffs Soon To Be Felt Trump's Initial Tariffs Soon To Be Felt Bottom Line: Since mid-2018, we have been asking clients to focus on our “Stimulus Overshoot” checklist (Table 2). We give the first item – “broad money and/or total credit growth spike” – a premier spot on the list. If a surge in total credit occurs, we will know that policymakers are throwing in the towel and stimulating in a major way. It will be time to turn super-positive on global risk assets, beyond a mere tactical trade, as a cyclical view at that point. Note that if one had gone long EM in early February 2016, when January data revealed a truly epic TSF splurge, one would not have been late to the rally. Table 2Will China’s Stimulus Overshoot In 2019? 2019 Key Views: Balanced On A Knife’s Edge 2019 Key Views: Balanced On A Knife’s Edge Our low-conviction view, at the moment, is that the increase in credit growth that we will see in Q1 will be seasonal – the usual frontloading of lending at the beginning of the year – rather than an extraordinary surge that would signal a policy change. A modest increase in credit growth will not be enough to spark a sustainable – year-long – rally in global risk assets. The Fed has already backed off as far as the market is concerned. As such, a pickup in Chinese credit could temporarily excite investors. But global stabilization may only embolden the Fed to refocus on tightening after a Q1 pause. Question 2: Will The Trade War Abate? The first question for investors when it comes to the trade war is “Why should we care?” Sure, trade policy uncertainty appears to have correlated with the underperformance of global equity indices relative to the U.S. (Chart 20). However, such market action was as much caused by our policy divergence story – being as it is deeply negative for EM assets – as by a trade war whose impact on the real economy has not yet been felt. U.S. Is 'Winning' The Trade War U.S. Is 'Winning' The Trade War Nonetheless, we do believe that getting the trade war “right” is a big call for 2019. First, while the impact of the U.S.-China trade war has been minimal thus far, it is only because China front-loaded its exports ahead of the expected tariffs, cut interbank rates and RRRs, accelerated local government spending, and allowed CNY/USD to depreciate by 10%. A restart of trade tensions that leads to further tariffs will make frontloading untenable over time, whereas further currency depreciation would be severely debilitating for EMs. We doubt the sustainability of the trade truce for three reasons: U.S. domestic politics: The just-concluded midterm election saw no opposition to President Trump on trade. The Democratic Party candidates campaigned against the president on a range of issues, but not on his aggressive China policy. Polling from the summer also shows that a majority of American voters consider trade with China unfair (Chart 21). In addition, President Trump will walk into the 2020 election with a wider trade deficit, due to his own stimulative economic policy (Chart 22). He will need to explain why he is “losing” on the one measure of national power that he campaigned on in 2016. Structural trade tensions: Ahead of the G20 truce, the U.S. Trade Representative Robert Lighthizer issued a hawkish report that concluded that China has not substantively changed any of the trade practices that initiated U.S. tariffs. Lighthizer has been put in charge of the current trade negotiations, which is a step-up in intensity from Treasury Secretary Steven Mnuchin, who was in charge of the failed May 2018 round. Geopolitical tensions: The G20 truce did not contain any substantive resolution to the ongoing strategic tensions between the U.S. and China, such as in the South China Sea. Beyond traditional geopolitics, tensions are increasingly involving high-tech trade and investment between the two countries and American allegations of cyber theft and spying by China. The recent arrest of Huawei’s CFO in Canada, on an American warrant, will likely deepen this high-tech conflict in the short term. 2019 Key Views: Balanced On A Knife’s Edge 2019 Key Views: Balanced On A Knife’s Edge Trade Deficit To Rise Despite Tariffs Trade Deficit To Rise Despite Tariffs Since the G20 truce with Xi, President Trump has seen no significant pickup in approval ratings (Chart 23). Given that the median American voter has embraced protectionism – against China at least – we would not expect any. Meanwhile, U.S. equities have sold off, contrary to what President Trump, or his pro-trade advisors, likely expected in making the G20 decision to delay tariffs. Appeasing China Doesn't Pay Appeasing China Doesn't Pay At some point, President Trump will realize that he risks considerable political capital on a trade deal with China that very few voters actually want or that the U.S. intelligence and defense community supports. Democrats did not oppose his aggressive China policy in the midterm election because they know that the median voter does not want it. As such, it is guaranteed that Trump’s 2020 Democratic Party opponent will accuse him of “surrender,” or at least “weakness.” If, over the next quarter, the economic and market returns on his gambit are paltry, we would expect President Trump to end the truce. Furthermore, we believe that a substantive, and long-lasting, trade deal is unlikely given the mounting tensions between China and the U.S. These tensions are not a product of President Trump, but are rather a long-run, structural feature of the twenty-first century that we have been tracking since 2012.1 Tensions are likely to rise in parallel to the trade talks on the technology front. We expect 2019 to be the year when investors price in what we have called Bifurcated Capitalism: the segmentation of capital, labor, and trade flows into geopolitically adversarial – and yet capitalist in nature – economic blocs. Entire countries and sectors may become off-limits to Western investors and vice-versa for their Chinese counterparts. Countries will fall into either the Tencent and Huawei bloc or the Apple and Ericsson bloc. This development is different from the Cold War. Note our emphasis on capitalism in the term Bifurcated Capitalism. The Soviet Union was obviously not capitalist, and clients of BCA did not have interests in its assets in the 1970s and 1980s. Trade between Cold War economic blocs was also limited, particularly outside of commodities. The closest comparison to the world we now inhabit is that of the nineteenth century. Almost all global powers were quite capitalist at the time, but they engaged in imperialism in order to expand their economic spheres of influence and thus economies of scale. In the twenty-first century, Africa and Asia – the targets of nineteenth century imperialism – may be replaced with market share wars in novel technologies and the Internet. This will put a ceiling on how much expansion tech and telecommunication companies can expect in the competing parts of Bifurcated Capitalism. The investment consequences of this concept are still unclear. But what is clear is that American policymakers are already planning for some version of the world we are describing. The orchestrated effort by the U.S. intelligence community to encourage its geopolitical allies to ban the use of Huawei equipment in their 5G mobile networks suggests that there are limits to the current truce ever becoming a sustainable deal. So does the repeated use of economic sanctions originally designed for Iran and Russia against Chinese companies. President Trump sets short- and medium-term policies given that he is the president. However, the intelligence and defense communities have “pivoted to Asia” gradually since 2012. This shift has occurred because the U.S. increasingly sees China as a peer competitor, for the time being confined in East Asia but with intentions of projecting power globally. To what extent could President Trump produce a trade deal with Xi that also encompasses a change in the U.S. perception of China as an adversary? We assign a low probability to it. As such, President Xi has little reason to give in to U.S. pressure on trade, as he knows that the geopolitical and technology pressure will continue. In fact, President Xi may have all the reason to double-down on his transformative reforms, which would mean more pain for high-beta global plays. Bottom Line: What may have appeared as merely a trade conflict has evolved into a broad geopolitical confrontation. President Trump has little reason to conclude a deal with China by March. Domestic political pressures are not pushing in the direction of the deal, while America’s “Deep State” is eager for a confrontation with China. Furthermore, with President Trump “blinking” on Iranian sanctions, his administration has implicitly acknowledged the constraints discouraging a deeper involvement in the Middle East. This puts the geopolitical focus squarely on China. Question 3: Is Europe a Black Swan or a Red Herring? The last two years have been a dud in Europe. Since the Brexit referendum in mid-2016, European politics have not been a catalyst for global markets, save for an Italy-induced sell-off or two. This could substantively change in 2019. And, as with the first two questions, the results could be binary. On one hand, there is the positive scenario where the stalled and scaled-back reforms on the banking union and Euro Area budget get a shot in the arm in the middle of the year. On the other hand, the negative scenario would see European-wide reforms stall, leaving the continent particularly vulnerable as the next global recession inevitably nears. At the heart of the binary distribution is the broader question of whether populism in Europe is trending higher. Most commentators and our clients would say yes, especially after the protests and rioting in Paris over the course of November. But the answer is more complicated than that. While populists have found considerable success in the ballot box (Chart 24), they have not managed to turn sentiment in Europe against the currency union (Chart 25). Even in Italy, which has a populist coalition government in power, the support for currency union is at 61%, the highest since 2012. This number has apparently risen since populists took over. Anti-Establishment Parties Are Rising... Anti-Establishment Parties Are Rising... ...But Euroskepticism Is A Failed Strategy ...But Euroskepticism Is A Failed Strategy What explains this divergence? Effectively, Europe’s establishment parties are being blamed for a lot of alleged ills, liberal immigration policy first amongst them. However, European integration remains favored across the ideological spectrum. Few parties that solely focus on Euroskepticism have any chance of winning power, something that both Lega and Five Star Movement found out in Italy. Italy’s Deputy Prime Minister Matteo Salvini confirmed his conversion away from Euroskepticism by stating that he wants to “reform the EU from the inside” and that it was time to give the “Rome-Berlin axis” another go.2 Salvini is making a bet – correct in our view – that by moderating Lega’s populism on Europe, he can capture the center ground and win the majority in the next Italian election, which could happen as soon as 2019. As such, we don’t think that the “rise of populism” in Europe is either dramatic or market-relevant. In fact, mainstream parties are quickly adopting parts of the anti-establishment agenda, particularly on immigration, in a bid to recoup lost voters. A much bigger risk for Europe than populism is stagnation on the reform front, a perpetual Eurosclerosis that leaves the bloc vulnerable in the next recession. What Europe needs is the completion of a backstop to prevent contagion. Such a backstop necessitates greatly enhancing the just-passed banking union reforms. The watered-down reforms did not include a common backstop to the EU’s single resolution fund nor a deposit union. A working group will report on both by June 2019, with a potential legislative act set for some time in 2024. What could be a sign that the EU is close to a grand package of reforms in 2019? We see three main avenues. First, a political shift in Germany. Investors almost had one, with conservative Friedrich Merz coming close to defeating Merkel’s hand-picked successor Annegret Kramp-Karrenbauer (also known as AKK) for the leadership of the ruling Christian Democratic Union (CDU). Merz combined a right-leaning anti-immigrant stance with staunch pro-European integration outlook. It is unclear whether AKK will be willing to make the same type of “grand bargain” with the more conservative factions of the CDU electorate. However, AKK may not have a choice, with both Alternative for Germany (AfD) and the Green Party nibbling at the heels of the right-of-center CDU and left-of-center Social-Democratic Party (SPD) (Chart 26). The rise of the Green party is particularly extraordinary, suggesting that a larger portion of the German electorate is radically Europhile rather than Euroskeptic. AKK may have to adopt Merz’s platform and then push for EU reforms. Challengers To The Established Parties Challengers To The Established Parties Second, French President Emmanuel Macron may have to look abroad for relevance. With his reform agenda stalled and political capital drained, it would make sense for Macron to spend 2019 and beyond on European reforms. Third, a resolution of the Brexit debacle. The longer the saga with the U.K. drags on, the less focus there will be in Europe on integration of the Euro Area. If the U.K. decides to extend the current negotiating period, it may even have to hold elections for the European Parliament. As such, we are not focusing on the budget crisis in Italy – our view that Rome is “bluffing” is coming to fruition –or a potential early election in Spain. And we are definitely not focusing on the EU Parliamentary election in May. These will largely be red herrings. The real question is whether European policymakers will finally have a window of opportunity for strategic reforms. And that will require Merkel, AKK, and Macron to expend whatever little political capital they have left and invest it in restructuring European institutions. Finally, a word on Europe’s role in the global trade war. While Europe is a natural ally for the U.S. against China – given its institutional connections, existing alliance, and trade surplus with the latter and deficit with the former (Chart 27) – we believe that the odds are rising of a unilateral tariff action by the U.S. on car imports. EU Surplus With U.S. Pays For Deficit With China EU Surplus With U.S. Pays For Deficit With China This is because the just-concluded NAFTA deal likely raised the cost of vehicle production in the trade bloc, necessitating import tariffs in order for the deal to make sense from President Trump’s set of political priorities. The Trump administration may not have the stomach for a long-term trade war with Europe, but it can shake up the markets with actions in that direction. Bottom Line: In the near term, there are no existential political risks in Europe in 2019. As such, investors who are bullish on European assets should not let geopolitics stand in the way of executing on their sentiment. We remain cautious for macroeconomic reasons, namely that Europe is a high-beta DM play that needs global growth to outperform in order to catch a bid. However, 2019 is a make-or-break year on key structural reforms in Europe. Without more work on the banking union – and without greater burden sharing, broadly defined – the Euro Area will remain woefully unprepared for the next global recession. Question 4: Will Brexit Happen? Given the volume of market-relevant geopolitical issues, we have decided to pose (and attempt to answer) five additional questions for 2019. We start with Brexit. Prime Minister Theresa May has asked for a delay to the vote in the House of Commons on the Withdrawal Treaty, which she would have inevitably lost. The defeat of the subsequent leadership challenge is not confidence-inspiring as the vote was close and a third of Tory MPs voted against her. May likely has until sometime in January to pass the EU Withdrawal Agreement setting out the terms of Brexit, given that all other EU member states have to get it through their parliaments before the Brexit date on March 29. The real question is whether any deal can get through Westminster. The numbers are there for the softest of soft Brexits, the so-called Norway+ option where the U.K. effectively gets the same deal as Norway, if May convinces the Labour Party to break ranks. Such a deal would entail Common Market access, but at the cost of having to pay essentially for full EU membership with no ability to influence the regulatory policies that London would have to abide by. The alternative is to call for a new election – which may usher the even less pro-Brexit Labour Party into power – or to delay Brexit for a more substantive period of time, or simply to buckle under the pressure and call for a second referendum. We disagree that the delay signals that the “no deal Brexit,” or the “Brexit cliff,” is nigh. Such an outcome is in nobody’s interest and both May and the EU can offer delays to ensure that it does not happen. Whatever happens, one thing is clear: the median voter is turning forcefully towards Bremain (Chart 28). It will soon become untenable to delay the second referendum. And even if the House of Commons passes the softest of Soft Brexit deals, we expect that the Norway+ option will prove to be unacceptable when Westminster has to vote on it again in two or three year’s time. Bremain Surging Structurally Bremain Surging Structurally Is it time to buy the pound, particularly cable, which is cheap on a long-term basis (Chart 29)? It is a tough call. On one hand, our confidence that the U.K. ultimately has to remain in the EU is rising. However, to get there, the U.K. may need one last major dose of volatility, either in the form of a slow-burn crisis caused by Tory indecision or in the form of a far-left Labour government that tries its own hand at Brexit while pursuing a 1970s style left-wing economic agenda. Can any investor withstand this kind of volatility in the short and potentially long-ish term? Only the longest of the long-term investors can.  Start Buying The Pound Start Buying The Pound Question 5: Will Oil Prices Rally Substantively In 2019? Several risks to oil supply remain for 2019. First, there is little basis for stabilization in Venezuelan oil production, and further deterioration is likely (Chart 30). Second, sectarian tensions in Iraq remain unresolved. Third, supply risks in other geopolitical hot spots – like Nigeria and Libya – could surprise in 2019. Venezuela: On A Downward Spiral Venezuela: On A Downward Spiral The most pressing geopolitical issue, however, is a decision on the Iranian sanction waivers. President Trump induced considerable market-volatility in 2019 by signaling that he would use “maximum pressure” against Iran. As a result, the risk premium contribution to the oil price – illustrated in Chart 31 by the red bar – rose throughout 2018, only to collapse as the White House offered six-month sanction waivers. Not only did the risk premium dissipate, but Saudi Arabia then scrambled to reverse the production surge it had instituted to offset the Iran sanctions. 2019 Key Views: Balanced On A Knife’s Edge 2019 Key Views: Balanced On A Knife’s Edge We agree with BCA’s Commodity & Energy Strategy that oil market fundamentals are tight and numerous supply risks loom. We also struggle to see why President Trump will seek to pick a fight with Iran in the summer of 2019. Our suspicion is that if President Trump was afraid of a gasoline-price spike right after the midterm election, why would he not “blink” at the end of the spring? Not only will the U.S. summer driving season be in full swing – a time of peak U.S. gasoline demand – but the 2020 election primaries will only be six months away. Furthermore, it is highly unlikely that OPEC and Russia will do the U.S. president’s bidding by turning on the taps to offset any unforeseen supply losses in 2019. They did not do so even when President Trump asked, very nicely, ahead of the just-concluded Vienna meeting. Once Trump prioritized domestic politics over Saudi geopolitical interests – by backing away from his maximum pressure tactic against Iran – he illustrated to Riyadh that his administration is about as reliable of an ally as the Obama White House. Meanwhile, his ardent defense of Riyadh in the Khashoggi affair, at a cost of domestic political capital, means that he lost the very leverage that he could have used to pressure Saudi Arabia. We therefore remain cautiously bullish on oil prices in 2019, but with the caveat that a big-bang surge in prices due to a U.S.-Iran confrontation – our main risk for 2019 just a few months ago – is now less likely. Question 6: Will Impeachment Become A Risk In 2019? While we have no way to forecast the Mueller investigation, it is undoubtedly clear that risks are rising on the U.S. domestic front. President Trump’s popularity among GOP voters is elevated and far from levels needed to convince enough senators to remove him from power (Chart 32). However, a substantive finding by Mueller may leave the moderate Democrats in the House with no choice but to pursue impeachment. 2019 Key Views: Balanced On A Knife’s Edge 2019 Key Views: Balanced On A Knife’s Edge This may rattle the market for both headline and fundamental reasons. The headline reasons are obvious. The fundamental reasons have to do with the looming stimulus cliff in 2020. A pitched battle between the House Democrats and the White House would make cooperation on another substantive stimulus effort less likely and thus a recession in 2020 more likely. The market may start pricing in such an outcome at some point in 2019. Furthermore, sentiment could be significantly impacted by a protracted domestic battle that impairs Trump’s domestic agenda. President Bill Clinton sought relevance abroad amidst his impeachment proceedings by initiating an air war against Yugoslavia. President Trump may do something similar. There is also an unclear relationship between domestic tensions and trade war. On one hand, President Trump may want a clear win and so hasten a deal. On the other hand, he may want to extend the trade war to encourage citizens to “rally around the flag” and show his geopolitical mettle amidst a distracting “witch hunt.” While we have faded these domestic risks in 2017 and 2018, we think that it may be difficult to do so in 2019. We stick by our view that previous impeachment bouts in the U.S. have had a temporary effect on the markets. But if market sentiment is already weakened by global growth and end of cycle concerns, a political crisis may become a bearish catalyst.  Question 7: What About Japan? Japan faces higher policy uncertainty in 2019, after a period of calm following the 2015-16 global turmoil. We expect to see “peak Shinzo Abe” – in the sense that after this year, his political capital will be spent and all that will remain will be for him to preside over the 2020 Tokyo Olympics. The primary challenge for Abe is getting his proposed constitutional revisions passed despite economic headwinds. Assuming he goes forward, he must get a two-thirds vote in both houses of parliament plus a majority vote in a popular referendum. The referendum is unscheduled but could coincide with the July upper house elections. This will be a knife’s edge vote according to polling. If he holds the referendum and it passes, he will have achieved the historic goal of making Japan a more “normal” country, i.e. capable of revising its own constitution and maintaining armed forces. He will never outdo this. If he fails, he will become a lame duck – if he does not retire immediately like David Cameron or Matteo Renzi. And if he delays the revisions, he could miss his window of opportunity.   This uncertain domestic political context will combine with China/EM and trade issues that entail significant risks for Japan and upward pressure on the yen. Hence government policy will resume its decidedly reflationary tilt in 2019. It makes little sense for Abe, looking to his legacy, to abandon his constitutional dream while agreeing to raise the consumption tax from 8% to 10% as expected in October. We would take the opposite side of the bet: he is more likely to delay the tax hike than he is to abandon constitutional revision. If Abe becomes a lame duck, whether through a failed referendum, a disappointing election, or a consumption tax hike amid a slowdown, it is important for investors to remember that “Abenomics” will smell just as sweet by any other name. Japan experienced a paradigm shift after a series of “earthquakes” from 2008-12. No leader is likely to raise taxes or cut spending aggressively, and monetary policy will remain ultra-easy for quite some time. The global backdrop is negative for Japan but its policy framework will act as a salve. Question 8: Are There Any Winners In EM? We think that EM and global risk assets could have a window of outperformance in early 2019. However, given the persistence of the policy divergence narrative, it will be difficult to see EM substantively outperforming DM over the course of 2019. Mexico Over Brazil That said, we do like a few EM plays in 2019. In particular, we believe that investors are overly bullish on Brazil and overly bearish on Mexico. In both countries, we think that voters turned to anti-establishment candidates due to concerns over violence and corruption. However, Brazilian President-elect Jair Bolsonaro has a high hurdle to clear. He must convince a traditionally fractured Congress to pass a complex and painful pension reform. In other words, Bolsonaro must show that he can do something in order to justify a rally that has already happened in Brazilian assets. In Mexico, on the other hand, Mexican President Andrés Manuel López Obrador (AMLO) remains constrained by the constitution (which he will be unable to change), the National Supreme Court of Justice, and political convention that Mexico is right-of-center on economic policy (an outwardly left-wing president has not won an election since 1924). In other words, AMLO has to show that he can get out of his constraints in order to justify a selloff that has already happened. To be clear, we are not saying that AMLO is a positive, in the absolute, for Mexico. The decision to scrap the Mexico City airport plans, to sideline the finance ministry from key economic decisions, and to threaten a return to an old-school PRI-era statism is deeply concerning. At the same time, we are not of the view that Bolsonaro is, in the absolute, a negative for Brazil. Rather, we are pointing out that the relative investor sentiment is overly bullish Bolsonaro versus AMLO. Especially given that both presidents remain constrained by domestic political intricacies and largely campaigned on the same set of issues that have little to do with their perceived economic preferences. They also face respective median voters that are diametrically opposed to their economic agendas – Bolsonaro, we think, is facing a left-leaning median voter, whereas the Mexican median voter is center-right. The macroeconomic perspective also supports our relative call. If our view on China and the Fed is correct, high-beta plays like Brazil will suffer, while an economy that is tied-to-the-hip of the U.S., like Mexico, ought to outperform EM peers. Mexico Finally Has Some Positive Carry Mexico Finally Has Some Positive Carry As such, we are putting a long MXN/BRL trade on, to capture this sentiment gap between the two EM markets. Investors will be receiving positive carry on Mexico relative to Brazil for the first time in a long time (Chart 33). The relative change in the current account balance also favors Mexico (Chart 34). Finally, the technicals of the trade look good as well (Chart 35). Mexico Looks Good On Current Account Mexico Looks Good On Current Account Technicals Look Good Too Technicals Look Good Too South Korea Over Taiwan  Diplomacy remains on track on the Korean peninsula, despite U.S.-China tensions in other areas. Ultimately China believes that peace on the peninsula will remove the raison d’être of American troops stationed there. Moreover, Beijing has witnessed the U.S.’s resolve in deterring North Korean nuclear and missile tests and belligerent rhetoric. It will want to trade North Korean cooperation for a trade truce. By contrast, if Trump’s signature foreign policy effort fails, he may well lash out. We view deeply discounted South Korean equities as a long-term buy relative to other EMs. Taiwan, by contrast, is a similar EM economy but faces even greater short-term risks than South Korea. In the next 13-month period, the Tsai Ing-wen administration, along with the Trump administration, could try to seize a rare chance to upgrade diplomatic and military relations. This could heighten cross-strait tensions and lead to a geopolitical incident or crisis. More broadly, U.S.-China trade and tech tensions create a negative investment outlook for Taiwan. Thailand Over India Five state elections this fall have turned out very badly for Prime Minister Narendra Modi and his National Democratic Alliance (NDA). These local elections have a negative impact, albeit a limited one, on Modi’s and the NDA’s reelection chances in the federal election due in April (or May). Nevertheless, it is entirely possible to lose Chhattisgarh, Madhya Pradesh, and Rajasthan while still winning a majority in the Lok Sabha – this is what happened to the Indian National Congress in 2004 and 2009. So far federal election opinion polling suggests anything from a hung parliament to a smaller, but still substantial, BJP majority. Modi was never likely to maintain control of 20 out of 29 states for very long, nor to repeat his party’s sweeping 2014 victory. He was also never likely to continue his reform push uninhibited in the lead up to the general election. Nevertheless, the resignation of Reserve Bank of India Governor Urjit Patel on December 10 is a very worrisome sign. Given that Indian stocks are richly valued, and that we expect oil prices to drift upwards, we remain negative on India until the opportunity emerges to upgrade in accordance with our long-term bullish outlook. By contrast, we see the return to civilian rule in Thailand as a market-positive event in the context of favorable macro fundamentals. Thai elections always favor the rural populist “red” movement of the Shinawatra family, but presumably the military junta would not hold elections if it thought it had not sufficiently adjusted the electoral system in favor of itself and its political proxies. Either way, the cycle of polarization and social unrest will only reemerge gradually, so next year Thailand will largely maintain policy continuity and its risk assets will hold up better than most other EMs.   Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim, Editor Strategist roukayai@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com   Footnotes 1      Please see Geopolitical Strategy Special Report, “Power And Politics In East Asia: Cold War 2.0?” dated September 25, 2012, Global Investment Strategy Special Report, “Searing Sun: Japan-China Conflict Heating Up,” dated January 25, 2013, “Sino-American Conflict: More Likely Than You Think, Part II,” dated November 6, 2015, and “The South China Sea: Smooth Sailing?” dated March 28, 2017, available at gps.bcaresearch.com. 2      Yes. He literally said that.   Geopolitical Calendar

Highlights So What? Global divergence will persist beyond the near term. Why? China’s stimulus will be disappointing unless things get much worse. U.S.-China trade war will reignite and strategic tensions will continue. European risks are limited short-term, but will surge without reform. U.S. assets will outperform; oil and the yen will rise; the pound is a long-term play; EM pain will continue. Feature The year 2019 will be one of considerable geopolitical uncertainty. Three issues dominate our Outlook, with low-conviction views on all three questions: Question 1: How much will China stimulate? Question 2: Will the trade war abate? Question 3: Is Europe a Black Swan or a Red Herring? Chart 1U.S. Outperformance Should Be Bullish USD U.S. Outperformance Should Be Bullish USD U.S. Outperformance Should Be Bullish USD The main story in 2018 was policy divergence. American policymakers ramped up stimulus – both through the profligate tax cuts and fiscal spending – at the same time that Chinese policymakers stuck to their guns on de-levering the economy. The consequence of this policy mix was that the synchronized global recovery of late 2016 and 2017 evolved into a massive outperformance by the U.S. economy (Chart 1). The Fed responded to the bullish domestic conditions with little regard for the global economy, causing the DXY to rally from a 2018 low of 88.59 in February to 97.04 today. Chart 2Fiscal Conservatism Melts Away Fiscal Conservatism Melts Away Fiscal Conservatism Melts Away Chart 3Republicans Change Their Minds When In Power Republicans Change Their Minds When In Power Republicans Change Their Minds When In Power While the policy divergence narrative appears to be macroeconomic in nature, it is purely political. There is nothing cyclical about the ‘U.S.’ economic outperformance in 2018. President Donald Trump campaigned on an economic populist agenda and then proceeded to deliver on it throughout 2017 and 2018. He faced little opposition from fiscal conservatives, mainly because fiscal conservativism melts away from the public discourse when budget deficits are low (Chart 2) and when the president is a Republican (Chart 3). Meanwhile, Chinese policymakers have decided to tolerate greater economic pain in an effort to escape the Middle Income Trap (Chart 4). They believe this trap will envelop them if they cannot grow the economy without expanding the already-massive build-up of leverage (Chart 5). Chart 4Policymakers Fear The Middle Income Trap 2019 Key Views: Balanced On A Knife’s Edge 2019 Key Views: Balanced On A Knife’s Edge Chart 5Debt Still Rising Debt Still Rising Debt Still Rising Geopolitics is not just about “things blowing up somewhere in the desert.” In today’s world, emblematized by paradigm shifts, politicians are more than ever in the driver’s seat. While technocrats respond to macroeconomic factors, politicians respond to political and geopolitical constraints. Few investment narratives last much longer than a year and policy divergence is coming to a close. Will the Fed pause given the turn in global growth? Will China respond with effective stimulus in 2019? If the answer to both questions is yes, global risk assets could light up in the next quarter and potentially beyond. Already EM has outperformed DM assets for a month and some canaries in the coal mine for global growth – like the performance of Swedish economic indicators – signal that the outperformance is real. Chart 6Global Economic Divergence Will Continue Global Economic Divergence Will Continue Global Economic Divergence Will Continue Chart 7The Market Has Already Priced-In A Fed Pause 2019 Key Views: Balanced On A Knife’s Edge 2019 Key Views: Balanced On A Knife’s Edge We are skeptical that the move is sustainable beyond a quarter or two (Chart 6). As our colleague Peter Berezin has highlighted, the market is pricing less than one hike in 2019 (Chart 7). Regardless, the impact on the U.S. dollar, remains muted, with the DXY at 97.04. This suggests that the backing off that the Fed may or may not have already done is still not enough from the perspective of weakening global growth (Chart 8). Global risk assets need more from the Fed than what the market is already pricing. And with U.S. inflationary pressures building (Chart 9), the BCA House View expects to see multiple Fed hikes in 2019, disappointing investors bullish on EM and global risk assets. Chart 8Global Growth Leading Indicators Global Growth Leading Indicators Global Growth Leading Indicators Chart 9Does The Fed Like It Hot? Does The Fed Like It Hot? Does The Fed Like It Hot? With our Fed view set by the House View, we therefore turn to where we can add value. To this end, the most important question of 2018 largely remains the same in 2019: How much will China stimulate? Question 1: How Much Will China Stimulate In 2019? Chart 10A Ray Of Hope From Broad Money bca.gps_sr_2018_12_14_c10 bca.gps_sr_2018_12_14_c10 China is undoubtedly already stimulating, with a surge in local government bond issuance earlier this year and a bottoming in the broad money impulse (Chart 10). M2 is in positive territory. However, the effort can best be characterized as tepid, with a late-year collapse in bond issuance (Chart 11) and a still-negative total social financing (TSF) impulse (Chart 12). TSF is the broadest measure of private credit in China’s economy.   Chart 11Fiscal Policy Becomes More Proactive? 2019 Key Views: Balanced On A Knife’s Edge 2019 Key Views: Balanced On A Knife’s Edge Chart 12China's Total Credit Is Weak China's Total Credit Is Weak China's Total Credit Is Weak We expect a surge in TSF in Q1, but this is a normal seasonal effect. A typical Q1 credit surge will not be enough to set global risk assets alight for very long, particularly if the market has already priced in as much of a “pause” from the Fed as we are going to get. Investors should specifically focus on new local government bond issuance and whether the “shadow financing” component of TSF gets a bid, since the primary reason for the weakness in TSF over the past year is the government’s crackdown on shadow lending. As Chart 13A & B shows, it was new local government bonds that led the way for stimulus efforts in 2015, followed by a surge in both bank lending and shadow lending in 2016. Chart 13ADon't Focus Just On TSF... Don't Focus Just On TSF... Don't Focus Just On TSF... Chart 13B...But Shadow Financing In Particular ...But Shadow Financing In Particular ...But Shadow Financing In Particular We would also expect further monetary policy easing, with extra RRR cuts or even a benchmark policy rate cut. However, monetary policy has been easy all year and yet the impact on credit growth has remained muted. This begs two important questions: Is the credit channel impaired? A slew of macroprudential reforms – which we have dubbed China’s “Preemptive Dodd-Frank” – may have impaired the flow of credit in the system. The official policy of “opening the front door, closing the back door” has seen bank loans pick up modestly but shadow lending has been curtailed (Chart 14A & B). This way of controlling the rise of leverage has its costs. For private enterprises – with poor access to the official banking sector – the shadow financial system was an important source of funding over the past several years. Chart 14AOpening The Front Door... Opening The Front Door... Opening The Front Door... Chart 14B...Closing The Back Door ...Closing The Back Door ...Closing The Back Door Is policy pushing on a string? An even more dire scenario would be if China’s credit channel is not technically, but rather psychologically, impaired. Multiple reasons may be to blame: a negative net return on the assets of state-owned enterprises (Chart 15); widespread trade war worries; mixed signals from policymakers; or a general lack of confidence in the political direction of the country. The rising M2/M1 ratio suggests that the overall economy’s “propensity to save” is rising (Chart 16). Chart 15Old China Is A Zombie China Old China Is A Zombie China Old China Is A Zombie China Chart 16Propensity To Save Propensity To Save Propensity To Save Why would Chinese policymakers keep their cool despite a slow pickup in credit growth? Are they not concerned about unemployment, social unrest, and instability? Of course, they are. But Chinese policymakers are not myopic. They also want to improve potential GDP over the long run. Table 1China: The Trend In Domestic Demand, And The Outlook For Trade, Is Negative 2019 Key Views: Balanced On A Knife’s Edge 2019 Key Views: Balanced On A Knife’s Edge So far, the economy has weathered the storm relatively well. First, eight out of ten of our China Investment Strategy’s housing price indicators (Table 1) are flat-to-up – although it is true that the October deterioration in floor space started and especially floor space sold (Chart 17) is cause for concern. If and when the housing market weakens further, stimulus will be used to offset it, despite the fact that the government is attempting to prevent a sharp increase in prices at the same time. With so much of China’s middle-class savings invested in the housing market, the key pillar of socio-economic stability is therefore real estate. Chart 17A Possible Clue For China Stimulusr A Possible Clue For China Stimulusr A Possible Clue For China Stimulusr Second, credit has fueled China’s “old economy,” but policymakers want to buoy “new China” (Chart 18). This means that measures to boost consumption and the service sector economy will be emphasized in new rounds of stimulus, as has occurred thus far (tax cuts, tariff cuts, deregulation, etc). This kind of stimulus is not great news for global risk assets leveraged to “old China,” such as EM and industrial metals. Chart 18Rebalancing Of The Chinese Economy Rebalancing Of The Chinese Economy Rebalancing Of The Chinese Economy Third, policymakers are not exclusively focused on day-to-day stability but are also focused on the decades-long perseverance of China’s political model. And that means moving away from leverage and credit as the sole fuel for the economy. This is not just about the Middle Income Trap, it is also about national security and ultimately sovereignty. Relying on corporate re-levering for stimulus simply doubles-down on the current economic model, which is still export-oriented given that most investment is geared toward the export sector. But this also means that China will be held hostage to foreign demand and thus geopolitical pressures, a fact that has been revealed this year through the protectionism of the White House. As such, moving away from the investment-led growth model and towards a more endogenous, consumer-led model is not just good macro policy, it makes sense geopolitically as well. Will the trade war – or the current period of trade truce – change Chinese policymakers’ decision-making? We do not see why it would. First, if the trade truce evolves into a trade deal, the expected export shock will not happen (Chart 19) and thus major stimulative measures would be less necessary. Second, if we understand correctly why policymakers have cited leverage as an “ill” in the first place, then we would assume that they would use the trade war as an excuse for the pain that they themselves have instigated. In other words, the trade war with the U.S. gives President Xi Jinping the perfect excuse for the slowdown, one that draws attention from the real culprit: domestic rebalancing. Chart 19Trump's Initial Tariffs Soon To Be Felt Trump's Initial Tariffs Soon To Be Felt Trump's Initial Tariffs Soon To Be Felt Bottom Line: Since mid-2018, we have been asking clients to focus on our “Stimulus Overshoot” checklist (Table 2). We give the first item – “broad money and/or total credit growth spike” – a premier spot on the list. If a surge in total credit occurs, we will know that policymakers are throwing in the towel and stimulating in a major way. It will be time to turn super-positive on global risk assets, beyond a mere tactical trade, as a cyclical view at that point. Note that if one had gone long EM in early February 2016, when January data revealed a truly epic TSF splurge, one would not have been late to the rally. Table 2Will China’s Stimulus Overshoot In 2019? 2019 Key Views: Balanced On A Knife’s Edge 2019 Key Views: Balanced On A Knife’s Edge Our low-conviction view, at the moment, is that the increase in credit growth that we will see in Q1 will be seasonal – the usual frontloading of lending at the beginning of the year – rather than an extraordinary surge that would signal a policy change. A modest increase in credit growth will not be enough to spark a sustainable – year-long – rally in global risk assets. The Fed has already backed off as far as the market is concerned. As such, a pickup in Chinese credit could temporarily excite investors. But global stabilization may only embolden the Fed to refocus on tightening after a Q1 pause. Question 2: Will The Trade War Abate? The first question for investors when it comes to the trade war is “Why should we care?” Sure, trade policy uncertainty appears to have correlated with the underperformance of global equity indices relative to the U.S. (Chart 20). However, such market action was as much caused by our policy divergence story – being as it is deeply negative for EM assets – as by a trade war whose impact on the real economy has not yet been felt. Chart 20U.S. Is 'Winning' The Trade War U.S. Is 'Winning' The Trade War U.S. Is 'Winning' The Trade War Nonetheless, we do believe that getting the trade war “right” is a big call for 2019. First, while the impact of the U.S.-China trade war has been minimal thus far, it is only because China front-loaded its exports ahead of the expected tariffs, cut interbank rates and RRRs, accelerated local government spending, and allowed CNY/USD to depreciate by 10%. A restart of trade tensions that leads to further tariffs will make frontloading untenable over time, whereas further currency depreciation would be severely debilitating for EMs. We doubt the sustainability of the trade truce for three reasons: U.S. domestic politics: The just-concluded midterm election saw no opposition to President Trump on trade. The Democratic Party candidates campaigned against the president on a range of issues, but not on his aggressive China policy. Polling from the summer also shows that a majority of American voters consider trade with China unfair (Chart 21). In addition, President Trump will walk into the 2020 election with a wider trade deficit, due to his own stimulative economic policy (Chart 22). He will need to explain why he is “losing” on the one measure of national power that he campaigned on in 2016. Structural trade tensions: Ahead of the G20 truce, the U.S. Trade Representative Robert Lighthizer issued a hawkish report that concluded that China has not substantively changed any of the trade practices that initiated U.S. tariffs. Lighthizer has been put in charge of the current trade negotiations, which is a step-up in intensity from Treasury Secretary Steven Mnuchin, who was in charge of the failed May 2018 round. Geopolitical tensions: The G20 truce did not contain any substantive resolution to the ongoing strategic tensions between the U.S. and China, such as in the South China Sea. Beyond traditional geopolitics, tensions are increasingly involving high-tech trade and investment between the two countries and American allegations of cyber theft and spying by China. The recent arrest of Huawei’s CFO in Canada, on an American warrant, will likely deepen this high-tech conflict in the short term. Chart 21Americans Are Focused On China As Unfair 2019 Key Views: Balanced On A Knife’s Edge 2019 Key Views: Balanced On A Knife’s Edge Chart 22Trade Deficit To Rise Despite Tariffs Trade Deficit To Rise Despite Tariffs Trade Deficit To Rise Despite Tariffs Since the G20 truce with Xi, President Trump has seen no significant pickup in approval ratings (Chart 23). Given that the median American voter has embraced protectionism – against China at least – we would not expect any. Meanwhile, U.S. equities have sold off, contrary to what President Trump, or his pro-trade advisors, likely expected in making the G20 decision to delay tariffs. Chart 23Appeasing China Doesn't Pay Appeasing China Doesn't Pay Appeasing China Doesn't Pay At some point, President Trump will realize that he risks considerable political capital on a trade deal with China that very few voters actually want or that the U.S. intelligence and defense community supports. Democrats did not oppose his aggressive China policy in the midterm election because they know that the median voter does not want it. As such, it is guaranteed that Trump’s 2020 Democratic Party opponent will accuse him of “surrender,” or at least “weakness.” If, over the next quarter, the economic and market returns on his gambit are paltry, we would expect President Trump to end the truce. Furthermore, we believe that a substantive, and long-lasting, trade deal is unlikely given the mounting tensions between China and the U.S. These tensions are not a product of President Trump, but are rather a long-run, structural feature of the twenty-first century that we have been tracking since 2012.1 Tensions are likely to rise in parallel to the trade talks on the technology front. We expect 2019 to be the year when investors price in what we have called Bifurcated Capitalism: the segmentation of capital, labor, and trade flows into geopolitically adversarial – and yet capitalist in nature – economic blocs. Entire countries and sectors may become off-limits to Western investors and vice-versa for their Chinese counterparts. Countries will fall into either the Tencent and Huawei bloc or the Apple and Ericsson bloc. This development is different from the Cold War. Note our emphasis on capitalism in the term Bifurcated Capitalism. The Soviet Union was obviously not capitalist, and clients of BCA did not have interests in its assets in the 1970s and 1980s. Trade between Cold War economic blocs was also limited, particularly outside of commodities. The closest comparison to the world we now inhabit is that of the nineteenth century. Almost all global powers were quite capitalist at the time, but they engaged in imperialism in order to expand their economic spheres of influence and thus economies of scale. In the twenty-first century, Africa and Asia – the targets of nineteenth century imperialism – may be replaced with market share wars in novel technologies and the Internet. This will put a ceiling on how much expansion tech and telecommunication companies can expect in the competing parts of Bifurcated Capitalism. The investment consequences of this concept are still unclear. But what is clear is that American policymakers are already planning for some version of the world we are describing. The orchestrated effort by the U.S. intelligence community to encourage its geopolitical allies to ban the use of Huawei equipment in their 5G mobile networks suggests that there are limits to the current truce ever becoming a sustainable deal. So does the repeated use of economic sanctions originally designed for Iran and Russia against Chinese companies. President Trump sets short- and medium-term policies given that he is the president. However, the intelligence and defense communities have “pivoted to Asia” gradually since 2012. This shift has occurred because the U.S. increasingly sees China as a peer competitor, for the time being confined in East Asia but with intentions of projecting power globally. To what extent could President Trump produce a trade deal with Xi that also encompasses a change in the U.S. perception of China as an adversary? We assign a low probability to it. As such, President Xi has little reason to give in to U.S. pressure on trade, as he knows that the geopolitical and technology pressure will continue. In fact, President Xi may have all the reason to double-down on his transformative reforms, which would mean more pain for high-beta global plays. Bottom Line: What may have appeared as merely a trade conflict has evolved into a broad geopolitical confrontation. President Trump has little reason to conclude a deal with China by March. Domestic political pressures are not pushing in the direction of the deal, while America’s “Deep State” is eager for a confrontation with China. Furthermore, with President Trump “blinking” on Iranian sanctions, his administration has implicitly acknowledged the constraints discouraging a deeper involvement in the Middle East. This puts the geopolitical focus squarely on China. Question 3: Is Europe a Black Swan or a Red Herring? The last two years have been a dud in Europe. Since the Brexit referendum in mid-2016, European politics have not been a catalyst for global markets, save for an Italy-induced sell-off or two. This could substantively change in 2019. And, as with the first two questions, the results could be binary. On one hand, there is the positive scenario where the stalled and scaled-back reforms on the banking union and Euro Area budget get a shot in the arm in the middle of the year. On the other hand, the negative scenario would see European-wide reforms stall, leaving the continent particularly vulnerable as the next global recession inevitably nears. At the heart of the binary distribution is the broader question of whether populism in Europe is trending higher. Most commentators and our clients would say yes, especially after the protests and rioting in Paris over the course of November. But the answer is more complicated than that. While populists have found considerable success in the ballot box (Chart 24), they have not managed to turn sentiment in Europe against the currency union (Chart 25). Even in Italy, which has a populist coalition government in power, the support for currency union is at 61%, the highest since 2012. This number has apparently risen since populists took over. Chart 24Anti-Establishment Parties Are Rising... Anti-Establishment Parties Are Rising... Anti-Establishment Parties Are Rising... Chart 25...But Euroskepticism Is A Failed Strategy ...But Euroskepticism Is A Failed Strategy ...But Euroskepticism Is A Failed Strategy What explains this divergence? Effectively, Europe’s establishment parties are being blamed for a lot of alleged ills, liberal immigration policy first amongst them. However, European integration remains favored across the ideological spectrum. Few parties that solely focus on Euroskepticism have any chance of winning power, something that both Lega and Five Star Movement found out in Italy. Italy’s Deputy Prime Minister Matteo Salvini confirmed his conversion away from Euroskepticism by stating that he wants to “reform the EU from the inside” and that it was time to give the “Rome-Berlin axis” another go.2 Salvini is making a bet – correct in our view – that by moderating Lega’s populism on Europe, he can capture the center ground and win the majority in the next Italian election, which could happen as soon as 2019. As such, we don’t think that the “rise of populism” in Europe is either dramatic or market-relevant. In fact, mainstream parties are quickly adopting parts of the anti-establishment agenda, particularly on immigration, in a bid to recoup lost voters. A much bigger risk for Europe than populism is stagnation on the reform front, a perpetual Eurosclerosis that leaves the bloc vulnerable in the next recession. What Europe needs is the completion of a backstop to prevent contagion. Such a backstop necessitates greatly enhancing the just-passed banking union reforms. The watered-down reforms did not include a common backstop to the EU’s single resolution fund nor a deposit union. A working group will report on both by June 2019, with a potential legislative act set for some time in 2024. What could be a sign that the EU is close to a grand package of reforms in 2019? We see three main avenues. First, a political shift in Germany. Investors almost had one, with conservative Friedrich Merz coming close to defeating Merkel’s hand-picked successor Annegret Kramp-Karrenbauer (also known as AKK) for the leadership of the ruling Christian Democratic Union (CDU). Merz combined a right-leaning anti-immigrant stance with staunch pro-European integration outlook. It is unclear whether AKK will be willing to make the same type of “grand bargain” with the more conservative factions of the CDU electorate. However, AKK may not have a choice, with both Alternative for Germany (AfD) and the Green Party nibbling at the heels of the right-of-center CDU and left-of-center Social-Democratic Party (SPD) (Chart 26). The rise of the Green party is particularly extraordinary, suggesting that a larger portion of the German electorate is radically Europhile rather than Euroskeptic. AKK may have to adopt Merz’s platform and then push for EU reforms. Chart 26Challengers To The Established Parties Challengers To The Established Parties Challengers To The Established Parties Second, French President Emmanuel Macron may have to look abroad for relevance. With his reform agenda stalled and political capital drained, it would make sense for Macron to spend 2019 and beyond on European reforms. Third, a resolution of the Brexit debacle. The longer the saga with the U.K. drags on, the less focus there will be in Europe on integration of the Euro Area. If the U.K. decides to extend the current negotiating period, it may even have to hold elections for the European Parliament. As such, we are not focusing on the budget crisis in Italy – our view that Rome is “bluffing” is coming to fruition –or a potential early election in Spain. And we are definitely not focusing on the EU Parliamentary election in May. These will largely be red herrings. The real question is whether European policymakers will finally have a window of opportunity for strategic reforms. And that will require Merkel, AKK, and Macron to expend whatever little political capital they have left and invest it in restructuring European institutions. Finally, a word on Europe’s role in the global trade war. While Europe is a natural ally for the U.S. against China – given its institutional connections, existing alliance, and trade surplus with the latter and deficit with the former (Chart 27) – we believe that the odds are rising of a unilateral tariff action by the U.S. on car imports. Chart 27EU Surplus With U.S. Pays For Deficit With China EU Surplus With U.S. Pays For Deficit With China EU Surplus With U.S. Pays For Deficit With China This is because the just-concluded NAFTA deal likely raised the cost of vehicle production in the trade bloc, necessitating import tariffs in order for the deal to make sense from President Trump’s set of political priorities. The Trump administration may not have the stomach for a long-term trade war with Europe, but it can shake up the markets with actions in that direction. Bottom Line: In the near term, there are no existential political risks in Europe in 2019. As such, investors who are bullish on European assets should not let geopolitics stand in the way of executing on their sentiment. We remain cautious for macroeconomic reasons, namely that Europe is a high-beta DM play that needs global growth to outperform in order to catch a bid. However, 2019 is a make-or-break year on key structural reforms in Europe. Without more work on the banking union – and without greater burden sharing, broadly defined – the Euro Area will remain woefully unprepared for the next global recession. Question 4: Will Brexit Happen? Given the volume of market-relevant geopolitical issues, we have decided to pose (and attempt to answer) five additional questions for 2019. We start with Brexit. Prime Minister Theresa May has asked for a delay to the vote in the House of Commons on the Withdrawal Treaty, which she would have inevitably lost. The defeat of the subsequent leadership challenge is not confidence-inspiring as the vote was close and a third of Tory MPs voted against her. May likely has until sometime in January to pass the EU Withdrawal Agreement setting out the terms of Brexit, given that all other EU member states have to get it through their parliaments before the Brexit date on March 29. The real question is whether any deal can get through Westminster. The numbers are there for the softest of soft Brexits, the so-called Norway+ option where the U.K. effectively gets the same deal as Norway, if May convinces the Labour Party to break ranks. Such a deal would entail Common Market access, but at the cost of having to pay essentially for full EU membership with no ability to influence the regulatory policies that London would have to abide by. The alternative is to call for a new election – which may usher the even less pro-Brexit Labour Party into power – or to delay Brexit for a more substantive period of time, or simply to buckle under the pressure and call for a second referendum. We disagree that the delay signals that the “no deal Brexit,” or the “Brexit cliff,” is nigh. Such an outcome is in nobody’s interest and both May and the EU can offer delays to ensure that it does not happen. Whatever happens, one thing is clear: the median voter is turning forcefully towards Bremain (Chart 28). It will soon become untenable to delay the second referendum. And even if the House of Commons passes the softest of Soft Brexit deals, we expect that the Norway+ option will prove to be unacceptable when Westminster has to vote on it again in two or three year’s time. Chart 28Bremain Surging Structurally Bremain Surging Structurally Bremain Surging Structurally Is it time to buy the pound, particularly cable, which is cheap on a long-term basis (Chart 29)? It is a tough call. On one hand, our confidence that the U.K. ultimately has to remain in the EU is rising. However, to get there, the U.K. may need one last major dose of volatility, either in the form of a slow-burn crisis caused by Tory indecision or in the form of a far-left Labour government that tries its own hand at Brexit while pursuing a 1970s style left-wing economic agenda. Can any investor withstand this kind of volatility in the short and potentially long-ish term? Only the longest of the long-term investors can.  Chart 29Start Buying The Pound Start Buying The Pound Start Buying The Pound Question 5: Will Oil Prices Rally Substantively In 2019? Several risks to oil supply remain for 2019. First, there is little basis for stabilization in Venezuelan oil production, and further deterioration is likely (Chart 30). Second, sectarian tensions in Iraq remain unresolved. Third, supply risks in other geopolitical hot spots – like Nigeria and Libya – could surprise in 2019. Chart 30Venezuela: On A Downward Spiral Venezuela: On A Downward Spiral Venezuela: On A Downward Spiral The most pressing geopolitical issue, however, is a decision on the Iranian sanction waivers. President Trump induced considerable market-volatility in 2019 by signaling that he would use “maximum pressure” against Iran. As a result, the risk premium contribution to the oil price – illustrated in Chart 31 by the red bar – rose throughout 2018, only to collapse as the White House offered six-month sanction waivers. Not only did the risk premium dissipate, but Saudi Arabia then scrambled to reverse the production surge it had instituted to offset the Iran sanctions. Chart 31Trump Sanctions Boosted Risk Premium 2019 Key Views: Balanced On A Knife’s Edge 2019 Key Views: Balanced On A Knife’s Edge We agree with BCA’s Commodity & Energy Strategy that oil market fundamentals are tight and numerous supply risks loom. We also struggle to see why President Trump will seek to pick a fight with Iran in the summer of 2019. Our suspicion is that if President Trump was afraid of a gasoline-price spike right after the midterm election, why would he not “blink” at the end of the spring? Not only will the U.S. summer driving season be in full swing – a time of peak U.S. gasoline demand – but the 2020 election primaries will only be six months away. Furthermore, it is highly unlikely that OPEC and Russia will do the U.S. president’s bidding by turning on the taps to offset any unforeseen supply losses in 2019. They did not do so even when President Trump asked, very nicely, ahead of the just-concluded Vienna meeting. Once Trump prioritized domestic politics over Saudi geopolitical interests – by backing away from his maximum pressure tactic against Iran – he illustrated to Riyadh that his administration is about as reliable of an ally as the Obama White House. Meanwhile, his ardent defense of Riyadh in the Khashoggi affair, at a cost of domestic political capital, means that he lost the very leverage that he could have used to pressure Saudi Arabia. We therefore remain cautiously bullish on oil prices in 2019, but with the caveat that a big-bang surge in prices due to a U.S.-Iran confrontation – our main risk for 2019 just a few months ago – is now less likely. Question 6: Will Impeachment Become A Risk In 2019? While we have no way to forecast the Mueller investigation, it is undoubtedly clear that risks are rising on the U.S. domestic front. President Trump’s popularity among GOP voters is elevated and far from levels needed to convince enough senators to remove him from power (Chart 32). However, a substantive finding by Mueller may leave the moderate Democrats in the House with no choice but to pursue impeachment. Chart 32Barometer Of Trump’s Survival 2019 Key Views: Balanced On A Knife’s Edge 2019 Key Views: Balanced On A Knife’s Edge This may rattle the market for both headline and fundamental reasons. The headline reasons are obvious. The fundamental reasons have to do with the looming stimulus cliff in 2020. A pitched battle between the House Democrats and the White House would make cooperation on another substantive stimulus effort less likely and thus a recession in 2020 more likely. The market may start pricing in such an outcome at some point in 2019. Furthermore, sentiment could be significantly impacted by a protracted domestic battle that impairs Trump’s domestic agenda. President Bill Clinton sought relevance abroad amidst his impeachment proceedings by initiating an air war against Yugoslavia. President Trump may do something similar. There is also an unclear relationship between domestic tensions and trade war. On one hand, President Trump may want a clear win and so hasten a deal. On the other hand, he may want to extend the trade war to encourage citizens to “rally around the flag” and show his geopolitical mettle amidst a distracting “witch hunt.” While we have faded these domestic risks in 2017 and 2018, we think that it may be difficult to do so in 2019. We stick by our view that previous impeachment bouts in the U.S. have had a temporary effect on the markets. But if market sentiment is already weakened by global growth and end of cycle concerns, a political crisis may become a bearish catalyst.  Question 7: What About Japan? Japan faces higher policy uncertainty in 2019, after a period of calm following the 2015-16 global turmoil. We expect to see “peak Shinzo Abe” – in the sense that after this year, his political capital will be spent and all that will remain will be for him to preside over the 2020 Tokyo Olympics. The primary challenge for Abe is getting his proposed constitutional revisions passed despite economic headwinds. Assuming he goes forward, he must get a two-thirds vote in both houses of parliament plus a majority vote in a popular referendum. The referendum is unscheduled but could coincide with the July upper house elections. This will be a knife’s edge vote according to polling. If he holds the referendum and it passes, he will have achieved the historic goal of making Japan a more “normal” country, i.e. capable of revising its own constitution and maintaining armed forces. He will never outdo this. If he fails, he will become a lame duck – if he does not retire immediately like David Cameron or Matteo Renzi. And if he delays the revisions, he could miss his window of opportunity.   This uncertain domestic political context will combine with China/EM and trade issues that entail significant risks for Japan and upward pressure on the yen. Hence government policy will resume its decidedly reflationary tilt in 2019. It makes little sense for Abe, looking to his legacy, to abandon his constitutional dream while agreeing to raise the consumption tax from 8% to 10% as expected in October. We would take the opposite side of the bet: he is more likely to delay the tax hike than he is to abandon constitutional revision. If Abe becomes a lame duck, whether through a failed referendum, a disappointing election, or a consumption tax hike amid a slowdown, it is important for investors to remember that “Abenomics” will smell just as sweet by any other name. Japan experienced a paradigm shift after a series of “earthquakes” from 2008-12. No leader is likely to raise taxes or cut spending aggressively, and monetary policy will remain ultra-easy for quite some time. The global backdrop is negative for Japan but its policy framework will act as a salve. Question 8: Are There Any Winners In EM? We think that EM and global risk assets could have a window of outperformance in early 2019. However, given the persistence of the policy divergence narrative, it will be difficult to see EM substantively outperforming DM over the course of 2019. Mexico Over Brazil That said, we do like a few EM plays in 2019. In particular, we believe that investors are overly bullish on Brazil and overly bearish on Mexico. In both countries, we think that voters turned to anti-establishment candidates due to concerns over violence and corruption. However, Brazilian President-elect Jair Bolsonaro has a high hurdle to clear. He must convince a traditionally fractured Congress to pass a complex and painful pension reform. In other words, Bolsonaro must show that he can do something in order to justify a rally that has already happened in Brazilian assets. In Mexico, on the other hand, Mexican President Andrés Manuel López Obrador (AMLO) remains constrained by the constitution (which he will be unable to change), the National Supreme Court of Justice, and political convention that Mexico is right-of-center on economic policy (an outwardly left-wing president has not won an election since 1924). In other words, AMLO has to show that he can get out of his constraints in order to justify a selloff that has already happened. To be clear, we are not saying that AMLO is a positive, in the absolute, for Mexico. The decision to scrap the Mexico City airport plans, to sideline the finance ministry from key economic decisions, and to threaten a return to an old-school PRI-era statism is deeply concerning. At the same time, we are not of the view that Bolsonaro is, in the absolute, a negative for Brazil. Rather, we are pointing out that the relative investor sentiment is overly bullish Bolsonaro versus AMLO. Especially given that both presidents remain constrained by domestic political intricacies and largely campaigned on the same set of issues that have little to do with their perceived economic preferences. They also face respective median voters that are diametrically opposed to their economic agendas – Bolsonaro, we think, is facing a left-leaning median voter, whereas the Mexican median voter is center-right. The macroeconomic perspective also supports our relative call. If our view on China and the Fed is correct, high-beta plays like Brazil will suffer, while an economy that is tied-to-the-hip of the U.S., like Mexico, ought to outperform EM peers. Chart 33Mexico Finally Has Some Positive Carry Mexico Finally Has Some Positive Carry Mexico Finally Has Some Positive Carry As such, we are putting a long MXN/BRL trade on, to capture this sentiment gap between the two EM markets. Investors will be receiving positive carry on Mexico relative to Brazil for the first time in a long time (Chart 33). The relative change in the current account balance also favors Mexico (Chart 34). Finally, the technicals of the trade look good as well (Chart 35). Chart 34Mexico Looks Good On Current Account Mexico Looks Good On Current Account Mexico Looks Good On Current Account Chart 35Technicals Look Good Too Technicals Look Good Too Technicals Look Good Too South Korea Over Taiwan  Diplomacy remains on track on the Korean peninsula, despite U.S.-China tensions in other areas. Ultimately China believes that peace on the peninsula will remove the raison d’être of American troops stationed there. Moreover, Beijing has witnessed the U.S.’s resolve in deterring North Korean nuclear and missile tests and belligerent rhetoric. It will want to trade North Korean cooperation for a trade truce. By contrast, if Trump’s signature foreign policy effort fails, he may well lash out. We view deeply discounted South Korean equities as a long-term buy relative to other EMs. Taiwan, by contrast, is a similar EM economy but faces even greater short-term risks than South Korea. In the next 13-month period, the Tsai Ing-wen administration, along with the Trump administration, could try to seize a rare chance to upgrade diplomatic and military relations. This could heighten cross-strait tensions and lead to a geopolitical incident or crisis. More broadly, U.S.-China trade and tech tensions create a negative investment outlook for Taiwan. Thailand Over India Five state elections this fall have turned out very badly for Prime Minister Narendra Modi and his National Democratic Alliance (NDA). These local elections have a negative impact, albeit a limited one, on Modi’s and the NDA’s reelection chances in the federal election due in April (or May). Nevertheless, it is entirely possible to lose Chhattisgarh, Madhya Pradesh, and Rajasthan while still winning a majority in the Lok Sabha – this is what happened to the Indian National Congress in 2004 and 2009. So far federal election opinion polling suggests anything from a hung parliament to a smaller, but still substantial, BJP majority. Modi was never likely to maintain control of 20 out of 29 states for very long, nor to repeat his party’s sweeping 2014 victory. He was also never likely to continue his reform push uninhibited in the lead up to the general election. Nevertheless, the resignation of Reserve Bank of India Governor Urjit Patel on December 10 is a very worrisome sign. Given that Indian stocks are richly valued, and that we expect oil prices to drift upwards, we remain negative on India until the opportunity emerges to upgrade in accordance with our long-term bullish outlook. By contrast, we see the return to civilian rule in Thailand as a market-positive event in the context of favorable macro fundamentals. Thai elections always favor the rural populist “red” movement of the Shinawatra family, but presumably the military junta would not hold elections if it thought it had not sufficiently adjusted the electoral system in favor of itself and its political proxies. Either way, the cycle of polarization and social unrest will only reemerge gradually, so next year Thailand will largely maintain policy continuity and its risk assets will hold up better than most other EMs.   Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim, Editor Strategist roukayai@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com   Footnotes 1      Please see Geopolitical Strategy Special Report, “Power And Politics In East Asia: Cold War 2.0?” dated September 25, 2012, Global Investment Strategy Special Report, “Searing Sun: Japan-China Conflict Heating Up,” dated January 25, 2013, “Sino-American Conflict: More Likely Than You Think, Part II,” dated November 6, 2015, and “The South China Sea: Smooth Sailing?” dated March 28, 2017, available at gps.bcaresearch.com. 2      Yes. He literally said that.   Geopolitical Calendar

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

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

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

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

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

Highlights Downside risks to EM assets remain substantial. Stay put. EM stocks, credit and currencies will underperform their DM counterparts in the first half of 2019. The key and necessary condition for a new secular EM bull market to emerge is the end of abundant financing. The latter is imperative to compel corporate restructuring, bank recapitalization as well as structural reforms. The cyclical EM outlook hinges on China’s business cycle. The slowdown in China is broad-based and will deepen. The slowdown in China/EM will likely lead to global trade contraction. The latter is negative for global cyclicals yet bullish for the U.S. dollar. Feature As we head into 2019, the past decade is shaping up to be a lost one for emerging markets (EM) assets. In particular: EM stocks have underperformed DM markets substantially since the end of 2010 (Chart I-1). In absolute terms, EM share prices are at the same level as they were in early 2010. Chart I-1EM Equities Have Been Underperforming DM For Eight Years EM Equities Have Been Underperforming DM For Eight Years EM Equities Have Been Underperforming DM For Eight Years EM currencies have depreciated substantially since 2011, and the EM local currency bond index (GBI-EM) on a total-return basis has produced zero return in U.S. dollar terms since 2010 (Chart I-2). Chart I-2A Lost Decade For Investors In EM Local Currency Bonds? A Lost Decade For Investors In EM Local Currency Bonds? A Lost Decade For Investors In EM Local Currency Bonds? Finally, EM sovereign and corporate high-yield bonds have not outperformed U.S. high-yield corporate bonds on an excess-return basis. Will 2019 witness a major reversal of such dismal EM performance? And if so, will it be a structural or cyclical bottom? The roots underneath this lost decade for EM stem neither from trade wars nor from Federal Reserve tightening. Therefore, a structural bottom in EM financial markets is contingent neither on the end of Fed tightening nor the resolution of current trade tussles. We address the issues of Fed tightening and trade wars below. A Lost Decade: Causes And Remedies What led to a lost decade for EM was cheap and plentiful financing. When the price of money is low and financing is abundant, companies and households typically rush to borrow and spend unwisely. Capital is misallocated and, consequently, productivity and real income growth disappoint – and debtors’ ability to service their debts worsens. This is exactly what has happened in EM, as easy money splashed all over developing economies since early 2009. There have been three major sources of financing for EM: Source 1: Chinese Banks Chinese banks have expanded their balance sheets by RMB 198 trillion to RMB 262 trillion (or the equivalent of $28.8 trillion) over the past 10 years (Chart I-3, top panel). When commercial banks expand their balance sheets by lending to or buying an asset from non-banks, they create deposits (money). Consistently, the broad money supply has expanded by RMB 175 trillion to RMB 234 trillion (or the equivalent of $25.5 trillion). Chart I-3Enormous Boom In Chinese Banks' Assets And Money Supply Enormous Boom In Chinese Banks' Assets And Money Supply Enormous Boom In Chinese Banks' Assets And Money Supply Notably, the People’s Bank of China (PBoC) has increased commercial banks’ excess reserves by RMB 1.5 trillion to RMB 2.8 trillion (or the equivalent of $0.22 trillion) (Chart I-3, bottom panel). Hence, the meaningful portion of money supply expansion has been due to the money multiplier – money created by mainland banks – not a provision of excess reserves by the PBoC (Chart I-4). Chart I-4Attribution Of Rise In Money Supply To Excess Reserves And Money Multiplier Attribution Of Rise In Money Supply To Excess Reserves And Money Multiplier Attribution Of Rise In Money Supply To Excess Reserves And Money Multiplier Not only has such enormous money creation by commercial banks generated purchasing power domestically, but it has also boosted Chinese companies’ and households’ purchases of foreign goods and services. The Middle Kingdom’s imports of goods and services have grown to $2.5 trillion compared with $3.2 trillion for the U.S. (Chart I-5). China’s spending has boosted growth considerably in many Asian, Latin American, African, Middle Eastern, and even select advanced economies. Chart I-5Imports Of Goods And Services: China And The U.S. Imports Of Goods And Services: China And The U.S. Imports Of Goods And Services: China And The U.S. Source 2: DM Central Banks’ QE By conducting quantitative easing, the central banks of several advanced economies have crowded out investors from fixed-income markets, incentivizing them to search for yield in EM. The Fed, the Bank of England, the European Central Bank and the Bank of Japan have in aggregate expanded their balance sheets by $10 trillion (Chart I-6). Chart I-6Quantitative Easing In DM Quantitative Easing In DM Quantitative Easing In DM This has led to massive inflows of foreign portfolio capital into EM, and reflated asset prices well beyond what was warranted by their fundamentals. Specifically, since January 2009, foreign investors have poured $1.5 trillion on a net basis into the largest 15 developing countries excluding China, Taiwan and Korea (Chart I-7, top panel). For China, net foreign portfolio inflows amounted to $560 billion since January 2009 (Chart I-7, bottom panel). Chart I-7Cumulative Foreign Portfolio Inflows Into EM And China Cumulative Foreign Portfolio Inflows Into EM And China Cumulative Foreign Portfolio Inflows Into EM And China Source 3: EM Ex-China Banks EM ex-China began expanding their balance sheets aggressively in early 2009, originating new money (local currency) and thereby creating purchasing power. This was especially the case between 2009 and 2011. Since that time, money creation by EM ex-China banks has decelerated substantially due to periodic capital outflows triggering currency weakness and higher borrowing costs. Out of these three sources, China’s money/credit cycles remain the primary driver of EM. The mainland’s imports from developing economies serves as the main nexus between China and the rest of EM. Essentially, Chinese money and credit drive imports, influencing growth and corporate profits in the EM universe (Chart I-8). Chart I-8China's Credit Cycle Leads Its Imports China's Credit Cycle Leads Its Imports China's Credit Cycle Leads Its Imports In turn, EM business cycle upturns attract international capital. Meanwhile, credit creation by local banks in EM ex-China – primarily in economies with high inflation or current account deficits – is a residual factor. In these countries, domestic credit creation is contingent on a healthy balance of payments and a stable exchange rate. The latter two, in turn, transpire when exports to China and international portfolio capital inflows are improving. The outcome of easy financing is over-borrowing and capital misallocation. The upshot of the latter is usually lower efficiency and productivity growth. Not surprisingly, productivity growth in both China and EM ex-China has decelerated considerably since 2009 (Chart I-9). EM return on assets has dropped a lot in the past 10 years and is now on par with levels last seen during the 2008 global recession (Chart I-10). Chart I-9Falling Productivity Growth In EM And China =... Falling Productivity Growth In EM And China =... Falling Productivity Growth In EM And China =... Chart I-10... = Low Profit Margins And Low Return On Capital ... = Low Profit Margins And Low Return On Capital ... = Low Profit Margins And Low Return On Capital Accordingly, the ability to service debt by EM companies has deteriorated considerably in the past decade – the ratios of cash flows from operations to both interest expenses and net debt have dropped (Chart I-11). Chart I-11EM: Deteriorating Ability To Service Debt EM: Deteriorating Ability To Service Debt EM: Deteriorating Ability To Service Debt These observations offer unambiguous confirmation that money has been spent inefficiently – i.e., misallocated. Credit booms and capital misallocations warrant a period of corporate restructuring and banking sector recapitalization. Without this, a new cycle cannot emerge. A secular bull market in equities and exchange rates arises when productivity growth and hence income-per-capita growth accelerates, and return on capital begins to climb. This is not yet the case for most developing economies. The end of cheap and abundant financing is imperative to compel corporate restructuring, bank recapitalization as well as structural reforms. These are necessary conditions to create the foundation for a new secular bull market. Ironically, the best remedy for an addiction to easy money is a period of tight money. For example, U.S. share prices would not be as high as they currently are if the U.S. did not go through the Lehman crisis. This 10-year bull market in U.S. equities was born from the ashes of the Lehman crisis. Vanished financing and the private sector’s tight budgets in 2008-‘09 compelled corporate restructuring as well as a focus on efficiency and return on equity. Has EM financing become scarce and tight? Cyclically, China’s money creation and credit flows have slowed, pointing to a cyclical downturn in EM share prices and commodities (please see below for a more detailed discussion). International portfolio flows to EM have also subsided since early this year. There has been selective corporate restructuring post the 2015 commodities downturn, including in the global/EM mining and energy sectors, China steel and coal industries as well as among Russian and Brazilian companies. However, there are many economies and industries where corporate restructuring, bank recapitalization and structural reforms have not been undertaken. Yet from a structural perspective, China’s money and credit growth remain elevated and excesses have not been purged. Besides, international portfolio flows to EM have had periodic “stop-and-gos” but have not yet retrenched meaningfully (refer to Chart I-7 on page 4). Consequently, structural overhauls and corporate restructuring in China/EM have by and large not yet occurred – in turn negating the start of a new secular bull market. Bottom Line: Conditions for a structural bull market in EM/China are not yet present. EM/China: A Cyclical Bottom Is Not In Place From a cyclical perspective, China is an important driving force for the majority of EM economies, and its deepening growth slowdown will continue to weigh on EM growth and global trade. In fact, odds are that global trade will contract in the first half of 2019: In China, tightening of both monetary policy as well as bank and non-bank regulation from late 2016 has led to a deceleration in money and credit growth. The latter has, with a time, lag depressed growth since early this year. Policymakers have undertaken some stimulus since the middle of this year, but it has so far been limited. Stimulus also works with a time lag. Besides, even though the broad money impulse has improved, the credit and fiscal spending impulse remains in a downtrend (Chart I-12). Therefore, there are presently mixed signals from money and credit. Chart I-12China's Stimulus Leads EM And Commodities China's Stimulus Leads EM And Commodities China's Stimulus Leads EM And Commodities As illustrated in Chart I-12, the bottoms in the money and combined credit and fiscal spending impulses, in July 2015, preceded the bottom in EM and commodities by six months and their peak led the top in financial markets by about 15 months in January 2018. Besides, in 2012-‘13, the rise in the money and credit impulses did not do much to help EM stocks or industrial commodities prices. Hence, even if the money as well as credit and fiscal impulses bottom today, it could take several more months before the selloff in EM financial markets and commodities prices abates. Additionally, the ongoing regulatory tightening of banks and non-bank financial institutions will hinder these institutions' willingness and ability to extend credit, despite lower interest rates. We discussed in a recent report that both the effectiveness of the monetary transmission mechanism and the time lag between policy easing and a bottom in the business cycle are contingent on the money multiplier (creditors' willingness to lend, and borrowers' readiness to borrow) and the velocity of money (the marginal propensity to spend among households and companies). Growth in capital spending in general and construction in particular have ground to a halt (Chart I-13). Chart I-13China: Weak Capital Spending China: Weak Capital Spending China: Weak Capital Spending Not only has capital spending decelerated but household consumption has also slowed since early this year, as demonstrated in the top panel of Chart I-14. Chart I-14China: A Broad-Based Slowdown China: A Broad-Based Slowdown China: A Broad-Based Slowdown Finally, mainland imports are the main channel in terms of how China’s growth slowdown transmits to the rest of the world. Not surprisingly, EM share prices and industrial metals prices correlate extremely well with the import component of Chinese manufacturing PMI (Chart I-15). Chart I-15China's Imports And EM And Commodities China's Imports And EM And Commodities China's Imports And EM And Commodities Bottom Line: The slowdown in China is broad-based, and our proxies for marginal propensity to spend by households and companies both point to further weakness (Chart I-14, middle and bottom panels). Constraints And Chinese Policymakers’ Dilemma Given the ongoing slowdown in the economy, why are Chinese policymakers not rushing to the rescue with another round of massive stimulus? First, policymakers in China realize that the stimulus measures of 2009-‘10, 2012-‘13 and 2015-‘16 led to massive misallocations of capital and fostered both inefficiencies and speculative excesses in many parts of the economy – the property markets being among the main culprits. Indeed, policymakers recognize that easy money does not foster productivity growth, which is critical to the long-term prosperity of any nation. For China to grow and prosper in the long run, the economy’s addiction to easy financing should be curtailed. Second, policymakers are currently facing a dilemma. The real economy is saddled with enormous debt and is slowing. This warrants lower interest rates – probably justifying bringing down short-term rates close to zero. Yet, despite enforcing capital controls, it seems the exchange rate has been correlated with China’s interest rate differential with the U.S. since early 2010 (Chart I-16). Given the ongoing growth slowdown and declining return on capital in China, there are rising pressures for capital to exit the country. Notably, the PBoC’s foreign exchange reserves of $3 trillion are only equivalent to 10-14% of broad money supply (i.e., all deposits in the banking system) (Chart I-17). Chart I-16Chinese Currency And Interest Rates Chinese Currency And Interest Rates Chinese Currency And Interest Rates Chart I-17China: Foreign Currency Reserves Are Very Low Compared To Money Supply/Deposits China: Foreign Currency Reserves Are Very Low Compared To Money Supply/Deposits China: Foreign Currency Reserves Are Very Low Compared To Money Supply/Deposits The current interest rate differential is only 33 basis points. If the PBoC guides short-term rates lower and the Fed stays on hold or hikes a few more times, the spread will drop to zero or turn negative. Based on the past nine-year correlation, the narrowing interest rate spread suggests yuan depreciation. This will weigh on EM and probably even global risk assets. In a scenario where policymakers prioritize defending the yuan’s value, they may not be able to reduce borrowing costs and assist indebted companies and households. As a result, the downtrend in the real economy would likely worsen. Consequently, EM and global growth-sensitive assets will drop further. Given the constraints Chinese policymakers are facing, reducing interest rates and allowing the yuan to depreciate further is the least-bad outcome. Yet this will rattle Asian and EM currencies and risk assets. What About The Fed And Trade Wars? The Fed and EM: Fed policy and U.S. interest rates are relevant to EM, but they are of secondary importance. The primary driver of EM economies are their own domestic fundamentals as well as global trade – not just U.S. growth. Historically, the correlation between EM risk assets and the fed funds rate has been mixed, albeit more positive than negative (Chart I-18). On this chart, we have shaded the five periods over the past 38 years when EM stocks rallied despite a rising fed funds rate. Chart I-18The Fed And EM Share Prices: A Historical Perspective The Fed And EM Share Prices: A Historical Perspective The Fed And EM Share Prices: A Historical Perspective There were only two episodes when EMs crashed amid rising U.S. interest rates: the 1982 Latin American debt crisis and the 1994 Mexican Tequila crisis. Yet it is vital to emphasize that these crises occurred because of poor EM fundamentals – elevated foreign currency debt levels, negative terms-of-trade shocks, large current account deficits and pegged exchange rates. Dire EM fundamentals also prevailed before the Asian/EM crises of 1997-1998. However, these late-1990s crises occurred without much in the way of Fed tightening or rising U.S. bond yields. Trade Wars: China’s current growth slowdown has not originated from a decline in its exports. In fact, Chinese aggregate exports and those to the U.S. have been growing at a double-digit pace, largely due to the front running ahead of U.S. import tariffs. More importantly, China’s exports to the U.S. and EU account for 3.8% and 3.2% of its GDP, respectively (Chart I-19). Total exports amount to 20% of GDP, with almost two-thirds of that being shipments to developing economies. This compares with capital spending that makes up 42% of GDP and household consumption of 38% of GDP. Hence, capital expenditures and household spending are significantly larger than shipments to the U.S. Chart I-19Structure Of Chinese Economy Structure Of Chinese Economy Structure Of Chinese Economy There is little doubt that the U.S.-China confrontation has affected consumer and business sentiment in China. Nevertheless, the slowdown in China has - until recently - stemmed from domestic demand, not exports. Investment Recommendations It is difficult to forecast whether the current EM down leg will end with a bang or a whimper. Whatever it is, the near-term path of least resistance for EM is to the downside. “A bang” scenario – where financial conditions tighten substantially and for an extended period – would likely compel corporate and bank restructuring as well as structural reforms. Therefore, it is more likely to mark a structural bottom in EM financial markets. “A whimper” scenario would probably entail only moderate tightening in financial conditions. Thereby, it would not foster meaningful corporate restructuring and structural reforms. Hence, such a scenario might not mark a secular bottom in EM stocks and currencies. In turn, the EM cyclical outlook hinges on China’s business cycle. If and when Chinese policymakers reflate aggressively, the mainland business cycle will revive, producing a cyclical rally in EM risk assets. At the moment, Chinese policymakers are behind the curve. With respect to investment strategy, we continue to recommend: Downside risks to EM assets remain substantial. Stay put. EM stocks, credit and currencies will underperform their DM counterparts in the first half of 2019. The slowdown in China/EM will likely lead to global trade contraction. The latter is negative for global cyclicals yet bullish for the U.S. dollar. For dedicated EM equity portfolios, our overweights are: Brazil, Mexico, Chile, Colombia, Russia, central Europe, Korea and Thailand. Our underweights are: South Africa, Peru, Indonesia, India, the Philippines and Hong Kong stocks. We are neutral on the remaining bourses. In the currency space, we continue to recommend shorting a basket of the following EM currencies versus the U.S. dollar: ZAR, CLP, IDR, MYR and KRW. The latter is a play on RMB depreciation. The full list of our recommendation across EM equity, fixed-income, currency and credit markets is available on pages 14-15. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations