Trade

Highlights Just to be clear: The balance of price risks in oil markets remains to the upside - particularly if we see a supply shock resulting from the loss of as much as 2mm b/d of exports from Iran and Venezuela. Neither the supply side nor the demand side in base metals evidence outsized risks, which keeps us neutral ... for now. Still, downside risks for commodities - mostly via threats to trade - loom. In line with our House view, we believe markets are too complacent re the effects of a global trade war.1 However, focusing only on the trade war obscures growing risks to EM imports and exports arising from the Fed's rates-normalization policy, which is pushing the USD higher. A strong USD retards EM trade growth, which is particularly bearish for metals and oil (Chart of the Week). Chart of the WeekStronger USD, Slower EM Import Growth##BR##Bearish For Base Metals And Oil Stronger USD, Slower EM Import Growth Bearish For Base Metals And Oil Stronger USD, Slower EM Import Growth Bearish For Base Metals And Oil An oil-supply shock taking prices above $120/bbl, as one of our scenarios does, would generate a short-term inflationary impulse, and would depress aggregate demand, particularly in EM. Ultimately, it would become a deflationary impulse, as higher energy prices consume a larger share of discretionary incomes, and slow growth. A slowdown in EM trade on the back of a strong USD also would generate a deflationary impulse, as EM income growth slows and aggregate demand falls. Either way, the Fed's rates-normalization policy will be put on hold as current inflation risks morph to deflation risks, if the downside becomes dominant. Highlights Energy: Overweight. The U.S. Strategic Petroleum Reserve (SPR) will release 11mm of oil from its reserves in the October - November period, to allay concerns over the likely loss of 1mm b/d of Iranian exports to U.S. sanctions. We've been expecting this ahead of U.S. mid-term elections, but don't think it will fill the gap in lost exports. Base Metals: Neutral. Union and management leaders at BHP's Escondida mine in Chile averted a strike, after agreeing a contract at the end of last week. Precious Metals: Neutral. Gold rallied more than $35/oz off its lows of last week, as markets took notice of record speculative short positioning, which many view as a bullish contrary indicator. Gold was trading to $1195/oz as we went to press. Ags/Softs: Underweight. The USDA is expected to roll out a $12 billion relief package for farmers on Friday, which includes direct purchases of commodities that were not exported due to tariffs, according to agriculture.com's Successful Farming publication. Feature Overall, the balance of price risks in the industrial commodities are neutral (in base metals) and to the upside (in oil). In the base metals, we think fear of a Sino - U.S. trade war has market participants jittery, and may be getting to the point where it is starting to affect expectations for capex and investment on the production side, and growth on the demand side. Given our expectation EM trade will hold up this year (Chart 2), we continue to expect base metals demand to remain fairly stable, and perhaps pick up as China rolls out modest stimulus measures later this year.2 Chart 2USD Strength Slows EM Trade Growth USD Strength Slows EM Trade Growth USD Strength Slows EM Trade Growth We remain bullish oil demand - expecting growth of ~ 1.6mm b/d on average in 2018 - 19, and continue to expect a supply deficit next year, which will push Brent prices from $70/bbl on average in 2H18 to $80/bbl next year.3 However, if we see continued strength in the USD beginning to degrade actual EM demand, we will be forced to revise our assessment. Downside Risks To Metals And Oil Loom As mentioned above, we are aligned with our House view, and believe markets are all but ignoring the risk of an all-out trade war, spreading from the well-covered Sino - U.S. standoff to the broader global economy. The global economy already appears to be registering the first signs of a trade slowdown, according to the World Bank's July 2018 global outlook, where it observes "softening demand for imports in advanced economies - with the exception of the United States - and weaker exports from Asia."4 We also are picking it up in our modeling (Chart 2). The Bank also notes the slowdown in trade "is accompanied by rising barriers to trade, moderating growth in China, higher energy prices, and elevated policy uncertainty." A prolonged trade war that spreads globally would be especially devastating to EM economies, as two-thirds of them are commodity exporters of one sort or another.5 Fed Policy Is An EM Growth Risk As important as a trade war is for global growth, focusing too heavily on it obscures growing risks to EM imports and exports arising from the Fed's rates-normalization policy, which is pushing the USD higher. Table 1USD Vs. Fed Policy Variables Trade, Dollars, Oil & Metals ... Assessing Downside Risk Trade, Dollars, Oil & Metals ... Assessing Downside Risk Per the Richmond Fed's Summary, the Fed is charged by Congress to "promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates."6 One of the models we use to forecast the broad trade-weighted USD is a Fed policy-variables model, which uses lagged U.S. nonfarm payrolls, core PCEPI (the Fed's preferred measure), U.S. 10-year real rates, and U.S. short-term real-rate differentials vs. DM rates as proxies for these policy goals. We throw lagged copper futures prices in to pick up current industrial activity, as well (Table 1). This model highlights the long-term equilibrium between the USD TWIB and the Fed's policy variables going back to 2000.7 We average the output of the policy-variables model with four other models using close-to-real-time variables, and some other proxies for the Fed's policy variables to generate our forecast (Chart 3). Chart 3BCA USD TWIB Forecast BCA USD TWIB Forecast BCA USD TWIB Forecast The USD TWIB and EM trade volumes form a cointegrated system, as shown in Chart 2. Based on our modeling, we expect EM trade to hold up reasonably well over the next year, with y/y growth remaining positive most of the time. But, as close inspection of the chart reveals, the rate of p.a. growth is slowing as a result of the Fed's rates-normalization policy. This means the rate of growth in EM demand for base metals and oil will slow, although the level of demand will remain high following 20 years of solid growth.8 As a House, we expect the USD TWIB to rise another 5% over the next year, which, given the elasticities in our model, would translate into more than 10% declines in copper and Brent prices, all else equal. The Oil Wildcard As regular readers of this service know, we do not believe "all else equal" applies to commodity markets, particularly oil. We have been highlighting the risks of a confluence of negative supply shocks for months - i.e., the loss of up to 2mm b/d of oil exports from Iran and Venezuela - and the implications of this for prices (Chart 4). This is apparent in our ensemble forecasts, which reflect the physical deficit we expect to the end of 2019 (Chart 5). Chart 4U.S. SPR Release Doesn't Cover Lost Iranian Exports Trade, Dollars, Oil & Metals ... Assessing Downside Risk Trade, Dollars, Oil & Metals ... Assessing Downside Risk The U.S. government has taken notice of these risks. However, we believe this week's announcement by the Trump administration to release 11mm barrels of crude oil from the U.S. SPR over the October - November period might hold gasoline prices down ahead of the U.S. midterms, but will do next to nothing to make up for the lost export volumes we are expecting in 2019 (Chart 4). Chart 5BCA Continues To Expect Physical Deficits BCA Continues To Expect Physical Deficits BCA Continues To Expect Physical Deficits An oil-supply shock taking prices above $120/bbl - the projection from one of our scenarios in Chart 4 - would generate a short-term inflationary impulse in U.S. data the Fed follows. This would depress aggregate demand, particularly in EM, as oil is priced in USD. The Fed likely looks through this spike, but, should it misread the inflation impulse and tighten more aggressively, it would be delivering a double-whammy to EM economies: Higher oil prices and a stronger USD. Many EM governments have relaxed or removed subsidies on fuel prices following the 2015 collapse in oil prices engineered by OPEC. While some governments may re-introduce subsidies, not all will cover all of the price increase in such a shock.9 So, even if some subsidies are re-introduced, a price spike likely would hit EM consumers harder than previous high-price epochs. There is a non-trivial likelihood such an oil-price spike would trigger a recession in the U.S. - and likely in DM and EM economies - per Hamilton's (2011) analysis.10 This would force the Fed to change course and resume its accommodative policies. Ultimately, this would become a global deflationary impulse, as higher energy prices erode discretionary incomes, and slow growth. Bottom Line: An oil-supply shock and slower EM trade growth on the back of a strong USD ultimately produce deflationary impulses. Either way, Fed rates-normalization policy will be put on hold if these downside risks become the dominant theme in industrial commodity markets, and the current inflation risks morph to deflation risks. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see BCA Research's Global Investment Strategy Weekly Report "How To Trade A Trade War," published July 13, 2018. It is available at gis.bcaresearch.com. 2 BCA Research's Geopolitical Strategy is expecting policymakers to deploy modest fiscal stimulus and reflationary policies to counter growing threats from the country's trade war with the U.S. This will be supportive, at the margin, for bulks and base metals. Please see "China: How Stimulating Is The Stimulus?" published by our Geopolitical Strategy August 8, 2018. It is available at gps.bcaresearch.com. 3 Please see BCA Research's Commodity & Energy Strategy Weekly Report "OPEC 2.0 Sailing Close To The Wind," which contains our most recent supply-demand balances and forecasts. It was published August 16, 2018, and is available at ces.bcaresearch.com. 4 Please see The World Bank's Global Monthly, July 2018, p. 2. 5 Please see remarks by World Bank Senior Director for Development Economics, Shantayanan Devarajan, who notes, "two-thirds of developing countries ... depend on commodity exports for revenues." His remarks are in "Global Economy to Expand by 3.1 percent in 2018, Slower Growth Seen Ahead," World Bank press release on June 5, 2018. 6 Please see Steelman, Aaron (2011), "The Federal Reserve's "Dual Mandate": The Evolution Of An Idea," published on the Federal Reserve Bank of Richmond's website. 7 We use a cointegration model to estimate these policy-driven regressions. The output is stout (R2 is greater than 0.95), and it has good out-of-sample results. We use a weighted-average of the five forecasts based on root-mean-square-errors to come up with our USD_TWIB forecast. 8 The World Bank estimates the seven largest EM economies - Brazil, China, India, Indonesia, Mexico, the Russian Federation, and Turkey - accounted for ~ 100% of the increase in metals consumption and close to 70% of the increase in energy demand over the past 20 years. Please see "The Role of Major Emerging Markets In Global Commodity Demand," in the Bank's June 2018 Global Economics Prospects, beginning on p. 61. 9 Please see BCA's Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Scrambles To Reassure Markets," published June 28, 2018. It is available at ces.bcaresearch.com. 10 For an excellent discussion of the correlation between oil-price shocks and recessions, please see Hamilton, James D. (2011), "Historical Oil Shocks," Prepared for the Handbook of Major Events in Economic History. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trade, Dollars, Oil & Metals ... Assessing Downside Risk Trade, Dollars, Oil & Metals ... Assessing Downside Risk Trades Closed in 2018 Summary of Trades Closed in 2017 Trade, Dollars, Oil & Metals ... Assessing Downside Risk Trade, Dollars, Oil & Metals ... Assessing Downside Risk

There is growing evidence that Trump and the U.S.A. are winning not only the war of words, but also the actual trade war, even though it is still early days. Chart 1 clearly depicts that the S&P 500 is having a stellar year compared with the rest of the world's bourses, leaving in the dust the MSCI All Country World Index. As trade policy uncertainty has skyrocketed to two-decade highs (only the 1993/4 Clinton era trade spat hit a higher mark),1 U.S. stocks have been primary beneficiaries. Even in absolute terms, the SPX is also enjoying a healthy and positive return year. Chart 1U.S. Is Winning The Trade War... U.S. Is Winning The Trade War... U.S. Is Winning The Trade War... Similarly, the U.S. dollar, boosted by rising interest rate differentials, has greatly benefited from increased trade rhetoric as the rest of the world bears the brunt of American trade protectionism (Chart 2). Granted, the U.S. profit backdrop remains upbeat, easily surpassing the rest of the world courtesy of the tax fillip for the current calendar year. But, even 10% EPS growth slated both for next year and 2020, at this later stage in the cycle is nothing less than rock-solid. Thus, relative EPS euphoria is a key pillar of the U.S. equity market's global dominance as, at the margin, global capital has flowed to the growth delta of the U.S. (Chart 3). Chart 2... And So Is The U.S. Dollar ... And So Is The U.S. Dollar ... And So Is The U.S. Dollar Chart 3EPS Also Explains The U.S. Outperformance EPS Also Explains The U.S. Outperformance EPS Also Explains The U.S. Outperformance In more detail, Chart 4 breaks down the MSCI ACWI performance in its major components and makes abundantly clear that the U.S. comes out on top, whereas both its DM and EM peers trail far behind. Keep in mind that the U.S. remains a mostly closed economy (70% PCE driven, top panel, Chart 5) and the ultimate consumer of the world, while Europe and Japan are open economies sporting trade surpluses and levered to net exports (bottom panel, Chart 5). This backdrop is also reflected in country equity composition with the U.S. being the most defensive index compared with its European and Japanese peers that are more cyclically exposed. Chart 4Rest Of The World Bears Brunt Of Trade War Rest Of The World Bears Brunt Of Trade War Rest Of The World Bears Brunt Of Trade War Chart 5U.S. Is A Closed Economy U.S. Is A Closed Economy U.S. Is A Closed Economy Nevertheless, U.S. stocks are not 100% insulated from the Administration's trade policy. Chart 6 shows a bifurcated deep cyclical equity market. Materials and industrials stocks have underperformed the SPX year-to-date as the appreciating greenback has dealt a blow both to the CRB raw industrials and base metals indexes. An exception is energy, which has ground higher as crude oil has up to now escaped the greenback's wrath, but may not do so indefinitely. Chart 6Bifurcated Deep Cyclical Market Bifurcated Deep Cyclical Market Bifurcated Deep Cyclical Market Tech has been the shining star, but it is also a risk that can bring the SPX down given its hefty 25% plus market capitalization weighting and the highest export exposure among GICS1 sectors at 60% of sales. The purpose of this Special Report is to delve deeper into the current Administration's increasing trade protectionism rhetoric and document if the equity market cares, using empirical evidence. A Unique Entry Into The U.S. National Archives Much hay has been made over Donald Trump's use of Twitter in the White House. Parsing 280 characters that are as likely to reveal a consequential new trade policy or fire a key staffer as they are to complain about news coverage has become sport for pundits and an endless source of fodder for the media. However, at BCA, we are focused on the wealth preservation of our clients. As such, it is incumbent upon us to perform an analysis of the market implications of these tweets in order to determine whether @realDonaldTrump is a source of investable strategies or merely noise. For the purposes of our analysis, we are examining only tweets relating to trade over the past six months (including those subsequently deleted). These should have the broadest stock market impact. They are plentiful, as summarized in Table 1. The Broad Market Does Not Care... Our analysis begins with the S&P 500's performance on the dates noted in Table 1. The result of the analysis (Table 2) is that there is no statistical correlation between the S&P 500's performance on those dates as the market both rose and fell relatively indiscriminately. In other words, the market does not appear to care what Donald Trump is tweeting with respect to trade. The absence of a confirming result is logical; somewhat less than 40% of the S&P 500's revenues are generated overseas, implying limited negative market repercussions from trade rhetoric. Further, the S&P 500 is far more international than the broad U.S. corporate sector. We thus glean two lessons from the analysis: trade rhetoric does not materially impact the stock market and has even less bearing on the health of corporate America. Table 1Trump Tweets About Trade Trump, Trade, Tweets & Tumult - Does The Stock Market Care? Trump, Trade, Tweets & Tumult - Does The Stock Market Care? Table 2S&P 500 Reaction To Trade Tweets Trump, Trade, Tweets & Tumult - Does The Stock Market Care? Trump, Trade, Tweets & Tumult - Does The Stock Market Care? ...Nor Do Sectors... Still, we presume there must be some market impact from trade rhetoric. Accordingly, we deepened our analysis to the relative performance of the 11 GICS1 sectors vis-à-vis the S&P 500 on the dates noted in Table 1. The results are presented in Table 3. Table 3GICS1 Reaction To Trade Tweets Trump, Trade, Tweets & Tumult - Does The Stock Market Care? Trump, Trade, Tweets & Tumult - Does The Stock Market Care? As with the broad market, there appears to be little correlation between internationally-geared indexes and negative trade tweets. S&P technology, the most international of the GICS1 sectors, underperformed in 75% of the iterations but only by an average of 0.1%, hardly significant enough to make a claim that the market was focused on the president's Twitter account. Further, S&P health care, a mostly trade-insulated index, underperformed the same number of times as S&P technology and by a greater amount. We therefore conclude that sectors do not materially react to trade tweets. ...But The International Champions Do Our last effort to find a correlation between Donald Trump's use of Twitter and the stock market's performance met with greater success. We assumed that the trade bellwether stocks would likely have a greater reaction function to negative trade tweets. We accordingly built an equal-weighted index of Apple, Boeing, Caterpillar, General Electric and 3M that we coined "The Internationals". The relative performance of this index is shown in Table 4. Table 4International Stocks Reaction To Trade Tweets Trump, Trade, Tweets & Tumult - Does The Stock Market Care? Trump, Trade, Tweets & Tumult - Does The Stock Market Care? The Internationals underperformed the S&P 500 in every iteration we tested. Most notable was on March 22, 2018 when the S&P 500 fell 2.5%, the Internationals underperformed even that low mark by 1.8%. The inference is that market implications of negative trade tweets are largely confined to these few international stocks. Considering their heft (these five stocks comprise 6.5% of the S&P 500's weight), they are largely responsible for weighing on the S&P 500 around trade rhetoric iterations. Conclusions: Rhetoric Matters Less Than Reality Chart 7U.S. Has The Upper Hand U.S. Has The Upper Hand U.S. Has The Upper Hand The upshot of our analysis is that, aside from a few notable international trade bellwethers, Donald Trump's trade rhetoric does not have material broad market implications. However, negative trade tweets pose a threat to a few of BCA's U.S. Equity Strategy portfolio recommendations, as we maintain high-conviction overweight ratings on the S&P 500 technology hardware, storage & peripherals and S&P 500 construction machinery & heavy trucks indexes. Apple and Caterpillar each represent more than 60% of the weight of these respective indexes. Nevertheless, we think the rhetoric is mostly noise and any impact will likely be transitory. Of much greater importance are the real world impact of tariffs and the potential earnings impact of a decline in global trade and especially a continuation in the U.S. dollar rally. The U.S. dollar appreciation remains the key risk to U.S. Equity Strategy's cyclically-oriented portfolio positioning. Meanwhile, we recently highlighted the U.S. equity sector implications of a mounting U.S./China trade war in a Special Report. In it, we identified service-oriented industries and defense stocks as relative winners should the dispute escalate - both BCA's Geopolitical Strategy and U.S. Equity Strategy are already bullish defense stocks2 - though few stocks would likely be absolute positive performers. Recent news of a new round of U.S. and China talks is a step in the right direction, but as likely to disappoint as to mark the peak of a protectionist cycle. Bottom Line: Empirical evidence suggests that Trump's trade rhetoric has yet to short-circuit the broad U.S. equity market, despite affecting a select few internationally exposed bellwether stocks. The rest of the world has borne the brunt of hawkish trade comments from the U.S. administration Chart 7 that has helped to put a solid bid under the U.S. dollar. We continue to expect an earnings led advance in the S&P 500 in the coming 9-12 months, but are closely monitoring the U.S. currency given the heightened EPS sensitivity. BCA Geopolitical Strategy Housekeeping On a separate housekeeping note, BCA's Geopolitical Strategy is closing its South Korean curve steepener trade for a gain of 0.2%. Instead, to play our constructive view on the Korean peninsula, BCA's Geopolitical Strategy will go long Korean equities relative to Emerging Markets. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Chris Bowes, Associate Editor U.S. Equity Strategy chrisb@bcaresearch.com 1 In a similar effort to address the trade deficit with Japan, President Clinton threatened a combination of tariffs, quotas and sanctions on Japanese autos. The culmination was a broad agreement on automotive trade. 2 Please see BCA Geopolitical Strategy Special Report, "Brothers In Arms," dated January 11, 2017, available at gps.bcaresearch.com.

Dear Client, We had intended to send you the second part of our two-part special report on long-term inflation risks this week, but given the sharp moves in the dollar and emerging market assets, we decided to write this bulletin instead. Barring any further major market turbulence, we will send you the sequel to the inflation report next week. Best regards, Peter Berezin, Chief Global Strategist Highlights The dollar rally and EM selloff have further to go. The U.S. economy is firing on all cylinders, while the rest of the world is sputtering. Turkey is not an isolated case. Emerging markets as a whole have feasted on debt over the past decade, and now will be held to account. We remain neutral on global equities, while underweighting EM relative to DM and overweighting defensives relative to deep cyclicals. Brewing EM stresses could cause the 10-year Treasury yield to temporarily fall to 2.5%, leading to a further flattening of the yield curve. However, the long-term path for yields is up. Feature King Dollar Reigns Supreme Our expectation going into this year was that the dollar would strengthen, triggering turmoil in emerging markets. This thesis has panned out, raising the question of whether it is time to declare victory and move on. We don't think so. While market positioning has clearly shifted closer towards our own views, we still think that the stronger dollar/weaker EM story has further to run. To understand why, it is useful to review the reasoning behind our thesis. Our bullish dollar view was based on a simple observation, which is that the U.S. had finally reached a point where aggregate demand was starting to outstrip supply. This implied that the dollar would need to strengthen in order to shift demand away from the United States. It is amazing how many commentators still think that the U.S. can divert spending towards imported goods without any change in the value of the dollar. Americans do not care what the CBO's or IMF's estimate of the domestic output gap is when they are deciding whether to buy U.S. or foreign-made goods. They care about relative quality-adjusted prices. Since the U.S. is a fairly closed economy - imports are only 15% of GDP - we reckoned that the dollar would need to strengthen considerably in order to displace a significant amount of domestic production with foreign-made goods. This is exactly what happened. Still More Upside For U.S. Rates Currency values tend to track interest rate differentials (Chart 1). As such, our prediction of a stronger dollar entailed the expectation that investors would increasingly price in a more hawkish path for the fed funds rate. This has indeed occurred. Since the start of the year, the expected fed funds rate has risen by 34 basis points for end-2018 and by 65 basis points for end-2019 (Chart 2). Chart 1Historically, The Dollar Has Moved In Line With Interest Rate Differentials Historically, The Dollar Has Moved In Line With Interest Rate Differentials Historically, The Dollar Has Moved In Line With Interest Rate Differentials Chart 2Rate Expectations Have Increased, ##br##But There Is Still A Long Way To Go Rate Expectations Have Increased, But There Is Still A Long Way To Go Rate Expectations Have Increased, But There Is Still A Long Way To Go Our sense is that U.S. interest rate expectations can rise further. Faster wage growth will boost consumption. The household savings rate can also fall from its current elevated level, which will give consumer spending an additional boost (Chart 3). Business investment should remain firm. Chart 4 shows that capex intentions are strong, while bank lending standards for commercial and industrial loans, which tend to lead loan growth, continue to ease. Fiscal stimulus will also goose the economy. Chart 3Consumption Could Accelerate As The Savings Rate Drops Hot Dollar, Cold Turkey Hot Dollar, Cold Turkey Chart 4U.S. Capex Investment Going Strong U.S. Capex Investment Going Strong U.S. Capex Investment Going Strong Could interest rate expectations move up more in the rest of the world than in the U.S., causing the dollar to tumble? It is possible, but unlikely. In contrast to most other central banks, the Fed wants to tighten financial conditions in order to keep the economy from overheating. A weaker dollar would entail an easing of financial conditions, and hence would require an even more hawkish response from the Fed. Currency Intervention Is Unlikely To Succeed Some have speculated that the Trump administration will intervene in the foreign exchange market in order to drive down the value of the dollar. We doubt this will happen, but even if such interventions were to take place, they would not be successful. Presumably, currency interventions would take the form of purchases of foreign exchange, financed through the issuance of Treasurys. The purchase of foreign currency would release U.S. dollars into the financial system, but the sale of Treasury securities would suck out those dollars from the financial system. The net result would be no change in the volume of U.S. dollars in circulation - what economists call a "sterilized" intervention. Both economic theory and years of history show that sterilized interventions do not have lasting effects on currency values. The Fed could, of course, provide funding for the Treasury's purchases of foreign exchange, leading to an increase in the monetary base. This would be tantamount to an unsterilized intervention. However, such a deliberate attempt to weaken the dollar by expanding the money supply would fly in the face of the Fed's efforts to cool growth by tightening financial conditions. We highly doubt the Fed's current leadership would go along with this. Emerging Markets In The Crosshairs This brings us to emerging markets. EM equities almost always fall when U.S. financial conditions are tightening (Chart 5). One can believe that emerging market stocks will go up; one can also believe, as we do, that the Fed will do its job and tighten financial conditions. But one cannot believe that both of these things will happen at the same time. Some pundits think that the plunge in the Turkish lira is not emblematic of the problems facing emerging markets. We are skeptical of this sanguine conclusion. Chart 6 shows that as a share of both GDP and exports, EM dollar-denominated debt is now as high as it was in the late 1990s. Turkey may be the worst of the lot, but it is hardly an isolated case. Chart 5Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Chart 6EM Dollar Debt Is High EM Dollar Debt Is High EM Dollar Debt Is High Chart 7 presents a vulnerability heat map for a number of key emerging markets.1 We consider fourteen variables (expressed as a share of GDP, unless otherwise noted): 1) Current account balance; 2) Net international investment position; 3) External debt; 4) Change in external debt during the past five years; 5) External debt-servicing obligations coming due over the next 12 months as a share of exports; 6) External funding requirements over the next 12 months as a share of foreign exchange reserves; 7) Private sector savings-investment balance; 8) Private-sector debt; 9) Change in private-sector debt over the past five years; 10) Government budget balance; 11) Government debt; 12) Change in government debt over the past five years; 13) Share of domestic debt held by overseas investors; and 14) Inflation. Our analysis suggests that Turkey, Argentina, Colombia, Brazil, Mexico, Chile, South Africa, and Indonesia are all vulnerable to balance of payments stresses. Chart 7Vulnerability Heat Map For Key EM Markets Hot Dollar, Cold Turkey Hot Dollar, Cold Turkey Of course, asset markets in some of these economies have already moved quite a bit over the past few months, so it is useful to benchmark their stock markets and currencies to the underlying macro risks they face. For stock markets, we do this by comparing the heat map score with a composite valuation measure that incorporates price-to-book, price-to-sales, price-to-forward earnings, price-to-cash flow, and the dividend yield. Our analysis suggests that stocks in Russia and Korea are rather cheap, while equities in Indonesia, Mexico, South Africa, and Argentina are still quite expensive (Chart 8, top panel). Chart 8Some EM Stock Markets And Currencies Have Not Fully Priced In Macro Risks Hot Dollar, Cold Turkey Hot Dollar, Cold Turkey For currencies, we compare the heat map score with the level of the real effective exchange rate relative to its ten-year average. The Mexican peso, Brazilian real, Chilean peso, Indonesian rupiah, and South African rand still look pricey on this basis (Chart 8, bottom panel). In contrast, the Turkish lira and the Argentine peso are starting to look fairly cheap, although they could still get quite a bit cheaper before finding a floor. The China Wildcard The last time emerging markets seemed at risk of melting down was in 2015. Fortunately for them, China came to the rescue, delivering a massive double dose of fiscal and credit easing. Things may not be so straightforward this time around. China does not want to let its economy falter, but high debt levels and an overvalued housing market have made the usual policy prescriptions less appealing. As such, we would not necessarily conclude that the recent decline in the Chinese three-month interbank rate is a signal that the authorities want to see much faster credit growth (Chart 9). They may simply want to see a weaker currency. This is an important distinction because while faster credit growth would boost demand for EM exports, a weaker yuan would hurt other emerging markets by giving China a leg up in competitiveness. A weaker yuan would also make it more expensive for Chinese companies to import natural resources, thus putting downward pressure on commodity prices. It is too soon to know what policy mix the Chinese authorities will choose to pursue. Investors should pay close attention to the monthly data on the growth rates of social financing and local government bond issuance. So far, the combined credit and fiscal impulse has continued to weaken, suggesting that the authorities are in no hurry to open the stimulus floodgate (Chart 10). Chart 9Is China Trying To Stimulate Credit ##br##Growth Or Weaken The Yuan? Is China Trying To Stimulate Credit Growth Or Weaken The Yuan? Is China Trying To Stimulate Credit Growth Or Weaken The Yuan? Chart 10China Has Been Slow To Open The Credit And Fiscal Spigots China Has Been Slow To Open The Credit And Fiscal Spigots China Has Been Slow To Open The Credit And Fiscal Spigots Worries About The Euro Area Slower EM growth is likely to take a bigger toll on the euro area than the United States. Exports to emerging markets account for only 3.6% of GDP for the U.S., compared to 9.7% of GDP for the euro area. Euro area banks also have more exposure to emerging markets than U.S. banks. Notably, Spanish banks have sizeable exposure to Turkey and other vulnerable emerging markets (Chart 11). Meanwhile, worries about Italy have resurfaced. The 10-year Italian bond yield has moved back above 3%, not far from its May highs. The gap in fiscal policy between what Italy's new populist government has promised voters and what the European Commission is willing to accept remains a mile wide. Italian banks have become increasingly wary of financing their spendthrift government. With the ECB stepping back from asset purchases, two critical buyers of Italian debt are moving to the sidelines. The credit impulse in the euro area turned negative even before concerns about emerging markets and Italian politics came to the fore. As Chart 12 shows, the credit impulse has reliably tracked euro area growth. Right now, there is little reason to think that European banks will open the credit spigots, suggesting that euro area growth will be lackluster. Chart 11Who Has More Exposure To EM? Hot Dollar, Cold Turkey Hot Dollar, Cold Turkey Chart 12Euro Area Credit Impulse Suggests Growth Will Remain Lackluster Euro Area Credit Impulse Suggests Growth Will Remain Lackluster Euro Area Credit Impulse Suggests Growth Will Remain Lackluster Investment Conclusions If last year was the year of global growth resynchronization, this year is turning into one of desynchronization. The U.S. economy is outperforming the rest of the world, and the dollar is benefiting in the process. As we go to press, the broad trade-weighted dollar is up 6.1% year-to-date and stands only 2.2% below its December 28, 2016 high (Chart 13). From a long-term perspective, the greenback has become expensive, so we are inclined to close our strategic long DXY trade for a potential carry-adjusted profit of 15.7% if it reaches our target of 98 (as of the time of writing, the DXY is at 96.5). However, even if we were to close this trade, our tactical bias would be to remain long the dollar until clearer evidence emerges that the brewing EM crisis is about to abate. We moved from overweight to neutral on global equities on June 19. The MSCI All-Country World index has fluctuated a lot since then, but is currently up only 0.7% in dollar terms. Developed markets have gained 1.4%, while emerging markets have lost 3.8% (Chart 14). We have yet to reach a capitulation point for EM equities. The number of shares in the iShares MSCI Turkey ETF has almost doubled since August 3rd, as a stampede of bottom fishers have plowed into the fund (Chart 15). Equity investors should maintain our recommendation to underweight emerging markets relative to DM and to favor defensive sectors over deep cyclicals. We expect euro area stocks to perform in line with their U.S. peers in local-currency terms, but to underperform in dollar terms over the remainder of the year. Chart 13The Dollar Is Back Near Its Highs The Dollar Is Back Near Its Highs The Dollar Is Back Near Its Highs Chart 14Stock Market Performance: Roller Coaster Ride Stock Market Performance: Roller Coaster Ride Stock Market Performance: Roller Coaster Ride Chart 15Foreign Investors And Turkish Stocks: ##br##Trying To Catch A Falling Knife Foreign Investors And Turkish Stocks: Trying To Catch A Falling Knife Foreign Investors And Turkish Stocks: Trying To Catch A Falling Knife In the fixed-income realm, the long-term trend in global bond yields remains to the upside, but near-term EM stresses could cause the 10-year Treasury yield to temporarily fall back towards 2.5%. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 We collaborated with our colleague Mathieu Savary and his team at BCA’s Foreign Exchange Strategy to build this heat map. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Dear Client, This week we are sending you a Special Report written by Mark McClellan, Chief Strategist, The Bank Credit Analyst, Marko Papic, Chief Strategist, Geopolitical Strategy and our very own Chris Bowes, Associate Editor, U.S. Equity Strategy. This report deals with the implications of the U.S./Sino trade war for U.S. equity sectors. It identifies the next products to be targeted with higher tariffs on both sides of the dispute. A higher U.S. tariff wall will shield some industries from competition, but rising input costs will be widely felt because of extensive supply chains between and within industries. There is only a small handful of industries that will be winners in absolute terms. I trust you will find his report insightful. Kind regards, Anastasios Avgeriou, Vice President U.S. Equity Strategy In this Special Report, we shed light on the implications of the U.S./Sino trade war for U.S. equity sectors. The threat that trade action poses to the U.S. equity market is greater than in past confrontations. Perhaps most importantly, supply chains are much more extensive, globally and between China and the U.S. Automobile Components, Electrical Equipment, Materials, Capital Goods and Consumer Durables have the most extensive supply chain networks. The USTR claims that it is being strategic in the Chinese goods it is targeting, focusing on companies that will benefit from the "Made In China 2025" initiative. The list of Chinese goods targeted in both the first and second rounds covers virtually all of the broad import categories. The only major items left for the U.S. to hit are apparel, footwear, toys and cellphones. Beijing is clearly targeting U.S. products based on politics in order to exert as much pressure on the President's party as possible. Based on a list of products that comprise the top-10 most exported goods of Red and Swing States, China will likely lift tariffs in the next rounds on civilian aircraft, computer electronics, healthcare equipment, car engines, chemicals, wood pulp, telecommunication and integrated circuits. Supply chains within and between industries and firms mean that the impact of tariffs is much broader than the direct impact on exporters and importers. We measure the relative exposure of 24 GICs equity sectors to the trade war based on their proportion of foreign-sourced revenues and the proportion of each industry's total inputs that are affected by U.S. tariffs. The Semiconductors & Semiconductor Equipment sector stands out, but the Technology & Hardware Equipment, Capital Goods, Materials, Consumer Durables & Apparel and Motor Vehicle sectors are also highly exposed to anti-trade policy action. Energy, Software, Banks and all other service sectors are much less exposed. China may also attempt to disrupt supply chains via non-tariff barriers, placing even more pressure on U.S. firms that have invested heavily in China. Wholesale Trade, Chemicals, Transportation Equipment, Computers & Electronic Parts and Finance & Insurance are most exposed. U.S. technology companies are particularly vulnerable to an escalating trade war. Virtually all U.S. manufacturing industries will be negatively affected by an ongoing trade war, even defensive sectors such as Consumer Staples. The one exception is defense manufacturers, where we recommend overweight positions. Our analysis highlights that the best shelter from a trade war can be found in services, particularly services that are insulated from trade. Financial Services appears a logical choice, and the S&P Financial Exchanges & Data subsector is one of our favorites. The trade skirmish is transitioning to a full-on trade war. The U.S. has imposed a 25% tariff on $50 billion worth of Chinese goods, and has proposed a 10% levy on an additional $200 billion of imports by August 31. China retaliated with tariffs on $50 billion of imports from the U.S., but Trump has threatened tariffs on another $300 billion if China refuses to back down. That would add up to over $500 billion in Chinese goods and services that could be subject to tariffs, only slightly less than the total amount that China exported to the U.S. last year. BCA's Geopolitical Strategy has emphasized that President Trump is unconstrained on trade policy, giving him leeway to be tougher than the market expects.1 This is especially the case with respect to China. There will be strong pushback from Congress and the U.S. business lobby if the Administration tries to cancel NAFTA. In contrast, Congress is also demanding that the Administration be tough on China because it plays well with voters. Trump is a prisoner of his own tough pre-election campaign rhetoric against China. The U.S. primary economic goal is not to equalize tariffs but to open market access.2 The strategic goal is much larger. The U.S. wants to see China's rate of technological development slow down. Washington will expect robust guarantees to protect intellectual property and proprietary technology before it dials down the pressure on Beijing. The threat that the trade war poses to the U.S. equity market is greater than in past confrontations, such as that between Japan and the U.S. in the late 1980s. First, stocks are more expensive today. Second, interest rates are much lower, limiting how much central banks can react to adverse shocks. Third, and perhaps most importantly, supply chains are much more extensive, globally and between China and the U.S. Nearly every major S&P 500 multinational corporation is in some way exposed to these supply chains. Chart II-1 shows that Automobile Components, Electrical Equipment, Materials, Capital Goods and Consumer Durables have the most extensive supply chain networks. The Global Value Chain Participation rate, constructed by the OECD, is a measure of cross-border value-added linkages.3 In this Special Report, we shed light on the implications of the trade war for U.S. equity sectors. Complex industrial interactions make it difficult to be precise in identifying the winners and losers of a trade war. Nonetheless, we can identify the industries most and least exposed to a further rise in tariff walls or non-tariff barriers to trade. We focus on the U.S./Sino trade dispute in this Special Report, leaving the implications of a potential trade war with Europe and the possible failure of NAFTA negotiations for future research. Chart II-1Measuring Global Supply Chains August 2018 August 2018 Trade Channels There are at least five channels through which rising tariffs can affect U.S. industry: The Direct Effect: This can be positive or negative. The impact is positive for those industries that do not export much but are provided relief from stiff import competition via higher import tariffs. The impact is negative for those firms facing higher tariffs on their exports, as well as for those firms facing higher costs for imported inputs to their production process. These firms would be forced to absorb some of the tariff via lower profit margins. Some industries will fall into both positive and negative camps. U.S. washing machines are a good example. Whirlpool's stock price jumped after President Trump announced an import tariff on washing machines, but it subsequently fell back when the Administration imposed an import tariff on steel and aluminum (that are used in the production of washing machines); Indirect Effect: The higher costs for imported goods are passed along the supply chain within an industry and to other industries that are not directly affected by rising tariffs. This will undermine profit margins in these indirectly-affected industries to the extent that they cannot fully pass along the higher input costs; Foreign Direct Investment: Some Chinese exports emanate from U.S. multinationals' subsidiaries in China, or by Chinese or foreign OEM suppliers for U.S. firms. Even though it would undermine China's economy to some extent, the Chinese authorities could make life more difficult for these firms in retaliation for U.S. tariffs on Chinese goods. Macro Effect: A trade war would take a toll on global trade and reduce GDP growth globally. Besides the negative effect of uncertainty on business confidence and, thus, capital spending, rising prices for both consumer and capital goods will reduce the volume of spending in both cases. Moreover, corporate profits have a high beta with respect to economic activity. We would not rule out a U.S. recession in a worst-case scenario. Obviously, a recession or economic slowdown would inflict the most pain on the cyclical parts of the S&P 500 relative to the non-cyclicals, in typical fashion. Currency Effect: To the extent that a trade war pushes up the dollar relative to the other currencies, it would undermine export-oriented industries and benefit those that import. However, while we are bullish the dollar due to diverging monetary policy, the dollar may not benefit much from trade friction given retaliatory tariff increases by other countries. Some of the direct and indirect impact can be mitigated to the extent that importers facing higher prices for Chinese goods shift to similarly-priced foreign producers outside of China. Nonetheless, this adjustment will not be costless as there may be insufficient supply capacity outside of China, leading to upward pressure on prices globally. Targeted Sectors: (I) U.S. Tariffs On Chinese Goods As noted above, the U.S. has already imposed tariffs on $50 billion of Chinese imports and has published a list of another $200 billion of goods that are being considered for a 10% tariff in the second round of the trade war. The first round focused on intermediate and capital goods, while the second round includes consumer final demand categories such as furniture, air conditioners and refrigerators. The latter will show up as higher prices at retailers such as Wal Mart, having a direct and visible impact on U.S. households. Appendix Table II-A1 lists the goods that are on the first and second round lists, grouped according to the U.S. equity sectors in the S&P 500. The U.S. Trade Representative (USTR) claims that the Chinese items are being targeted strategically. It is focusing on companies that will benefit from China's structural policies, such as the "Made In China 2025" initiative that is designed to make the country a world leader in high-tech areas (see below). Table II-1 reveals the relative size of the broad categories of U.S. imports from China, based on trade categories. The top of the table is dominated by Motor Vehicles, Machinery, Telecommunication Equipment, Computers, Apparel & Footwear and other manufactured goods. The list of Chinese goods targeted in both the first and second rounds covers virtually all of the broad categories in Table II-1. The only major items left for the U.S. to hit are Apparel and Footwear, as well as two subcategories; Toys and Cellphones. These are all consumer demand categories. Table II-1U.S. Imports From China (January-May 2018) August 2018 August 2018 (II) Chinese Tariffs On U.S. Goods Total U.S. exports to China were less than $53 billion in the first five months of 2018, limiting the amount of direct retaliation that China can undertake (Table II-2). The list of individual U.S. products that China has targeted so far is long, but we have condensed it into the broad categories shown in Table II-3. The U.S. equity sectors that the new tariffs affect so far include Food, Beverage & Tobacco, Automobiles & Components, Materials and Energy. China has concentrated mainly on final goods in a politically strategic manner, such as Trump-supported rural areas and Harley Davidson bikes whose operations are based in Paul Ryan's home district in Wisconsin. Table II-2U.S. Exports To China (January-May 2018) August 2018 August 2018 Table II-3China Tariffs On U.S. Goods August 2018 August 2018 What will China target next? Chart II-2 shows exports to China as percent of total state exports, and Chart II-3 presents the value of products already tariffed by China as a percent of state exports. Other than Washington, the four states most targeted by Beijing are conservative: Alaska, Alabama, Louisiana and South Carolina. Chart II-2U.S. Exports To China By State August 2018 August 2018 Chart II-3Value Of U.S. Products Tariffed By China (By State) August 2018 August 2018 Beijing is clearly targeting products based on politics in order to exert as much pressure on the President's party as possible. To identify the next items to be targeted, we constructed a list of products that comprise the top-10 most exported goods of Red States (solidly conservative) and Swing States (competitive states that can go either to Republican or Democratic politicians). Appendix Tables II-A2 and II-A3 show this list of products, with those that have already been flagged by China for tariffs crossed out. Table II-4 shows the top-10 list of products that are not yet tariffed by China, but are distributed in a large proportion of Red and Swing states. What strikes us immediately is how important aircraft exports are to a large number of Swing and Red States. In total, 27 U.S. states export civilian aircraft, engines and parts to China. This is an obvious target of Beijing's retaliation. In addition, we believe that computer electronics, healthcare equipment, car engines, chemicals, wood pulp, telecommunication and integrated circuits are next. Table II-4Number Of U.S. States Exporting To China By Category August 2018 August 2018 Market Reaction Chart II-4 highlights how U.S. equity sectors performed during seven separate days when the S&P 500 suffered notable losses due to heightened fears of protectionism. Cyclical sectors such as Industrials and Materials fared worse during days of rising protectionist angst. Financials also generally underperformed, largely because such days saw a flattening of the yield curve. Tech, Health Care, Energy and Telecom performed broadly in line with the S&P 500. Consumer Staples outperformed the market, but still declined in absolute terms. Utilities and Real Estate were the only two sectors that saw absolute price gains. The market reaction seems sensible based on the industries caught in the cross-hairs of the trade action so far. At least some of the potential damage is already discounted in equity prices. Nonetheless, it is useful to take a closer look at the underlying factors that should determine the ultimate winners and losers from additional salvos in the trade war. Chart II-4S&P 500: Impact Of Trade-Related Events August 2018 August 2018 Determining The Winners And Losers The U.S. sectors that garner the largest proportion of total revenues from outside the U.S. are obviously the most exposed to a trade war. For the 24 level 2 GICS sectors in the S&P 500, Table II-5 presents the proportion of total revenues that is generated from operations outside the U.S. for the top five companies in the sector by market cap. Company reporting makes it difficult in some cases to identify the exact revenue amount coming from outside the U.S., as some companies regard "domestic" earnings as anything generated in North America. Nonetheless, we believe the data in Table II-5 provide a reasonably accurate picture. Table II-5Foreign Revenue Exposure (2017) August 2018 August 2018 Semiconductors, Tech Equipment, Materials, Food & Beverage, Software and Capital Goods are at the top of the list in terms of foreign-sourced revenues. Not surprisingly, service industries like Real Estate, Banking, Utilities and Telecommunications Services are at the bottom of the exposure list. U.S. companies are also exposed to U.S. tariffs that lift the price of imported inputs to the production process. This can occur directly when firm A imports a good from abroad, and indirectly, when firm A sells its intermediate good to firm B at a higher price, and then on to firm C. In order to capture the entire process, we used the information contained in the Bureau of Economic Analysis' Input/Output tables. We estimated the proportion of each industry's total inputs that are affected by already-implemented U.S. tariffs and those that are on the list for the next round of tariffs. These estimates, shown in Appendix Table II-A4 at a detailed industrial level, include both the direct and indirect effects of higher import costs. At the top of the list is Motor Vehicles and Parts, where Trump tariffs could affect more than 70% of the cost of all material inputs to the production process. Electrical Equipment, Machinery and other materials industries are also high on the list, together with Furniture, Computers & Electronic Parts and Construction. Unsurprisingly, service industries and Utilities are in the bottom half of the table.4 We then allocated all the industries in Appendix Table II-A4 to the 24 GICs level 2 sectors in the S&P 500, in order to obtain an import exposure ranking in S&P sector space (Table II-6). Table II-6U.S. Import Tariff Exposure August 2018 August 2018 Chart II-5 presents a scatter diagram that compares import tariff exposure (horizontal axis) with foreign revenue exposure (vertical axis). The industries clustered in the top-right of the diagram are the most exposed to a trade war. Chart II-5U.S. Industrial Exposure To A Trade War With China August 2018 August 2018 The Semiconductors & Semiconductor Equipment sector stands out by this metric, but the Technology & Hardware Equipment, Capital Goods, Materials, Consumer Durables & Apparel and Motor Vehicle sectors are also highly exposed to anti-trade policy action. Energy, Software, Banks and all other service sectors are much less exposed. Food, Beverage & Tobacco lies between the two extremes. Joint Ventures And FDI Table II-7Stock Of U.S. Direct ##br##Investment In China (2017) August 2018 August 2018 As mentioned above, most U.S. production taking place in China involves a joint venture. The Chinese authorities could attempt to disrupt the supply chain of a U.S. company by hindering production at companies that have ties to U.S. firms. Data on U.S. foreign direct investment (FDI) in China will be indicative of the industries that are most exposed to this form of retaliation. The stock of U.S. FDI in China totaled more than $107 billion last year (Table II-7). At the top of the table are Wholesale Trade, Chemicals, Transportation Equipment, Computers & Electronic Parts and Finance & Insurance. Apple is a good example of a U.S. company that is exposed to non-tariff retaliation, as the iPhone is assembled in China by Foxconn for shipment globally with mostly foreign sourced parts. Our Technology sector strategists argue that U.S. technology companies are particularly vulnerable to an escalating trade war (See Box II-1).5 BOX II-1 The Tech Sector The U.S. has applied tariffs on the raw materials of technology products rather than finished goods so far. At a minimum, this will penalize smaller U.S. tech firms which manufacture in the U.S. and provide an incentive to move production elsewhere. Worst case, the U.S. tariffs might lead to component shortages which could have a disproportionately negative impact, especially on smaller firms. Although it has not been proposed, U.S. tariffs on finished goods would be devastating to large tech companies such as Apple, which outsources its manufacturing to China. China appears determined to have a vibrant high technology sector. The "Made In China 2025" program, for example, combines ambitious goals in supercomputers, robotics, medical devices and smart cars, while setting domestic localization targets that would favor Chinese companies over foreigners. The ZTE sanctions and the potential for enhanced export controls have had a traumatic impact on China's understanding of its relatively weak position with respect to technology. As a result, because most high-tech products are available from non-U.S. sources, Chinese engineers will likely be encouraged to design with non-U.S. components; for example, selecting a Samsung instead of a Qualcomm processor for a smartphone. Similarly, China is a major buyer of semiconductor capital equipment as it follows through with plans to scale up its semiconductor industry. Most such equipment is also available from non-U.S. vendors, and it would be understandable if these suppliers are selected given the risk which would now be associated with selecting a U.S. supplier. The U.S. is targeting Chinese made resistors, capacitors, crystals, batteries, Light Emitting Diodes (LEDs) and semiconductors with a 25% tariff. For the most part these are simple, low cost devices, which are used by the billions in high-tech devices. Nonetheless, China could limit the export of these products to deliver maximum pain, leading to a potential shortage of qualified parts. A component shortage can have a devastating impact on production since the manufacturer may not have the ability to substitute a new part or qualify a new vendor. Since the product typically won't work unless all the right parts are installed, want of a dollar's worth of capacitors may delay shipping a $1,000 product. Thus, the economic and profit impact of a parts shortage in the U.S. could be quite severe. Conclusions: When it comes to absolute winners in case of a trade war, we believe there are three conditions that need to be met: Relatively high domestic input costs. Relatively high domestic consumption/sales; the true beneficiaries of a tariff are those industries who are allowed to either raise prices or displace foreign competitors, with the consumer typically bearing the cost. Relatively low direct exposure to global trade - international trade flows will certainly slow in a trade war. There are very few manufacturing industries that meet all of these criteria. Within manufacturing, one would typically expect the Consumer Staples and Discretionary sectors to be the best performers. However, roughly a third of the weight of Staples is in three stocks (PG, KO and PEP) that are massively dependent on foreign sales. Moreover, a similar weight of Discretionary is in two retailers (AMZN and HD) that are dependent on imports. As such, consumer indexes do not appear a safe harbor in a trade war. Nevertheless, if the trade war morphs into a recession then consumer staples (and other defensive safe-havens) will outperform, although they will still decrease in absolute terms. Transports are an industry that has relatively high domestic labor costs and an output that is consumed virtually entirely within domestic borders. However, their reliance on global trade flows - intermodal shipping is now more than half of all rail traffic - means they almost certainly lose from a prolonged trade dispute. There is one manufacturing industry that could be at least a relative winner and perhaps an absolute winner: defense. Defense manufacturers certainly satisfy the first two criteria above, though they do have reasonably heavy foreign exposure. However, we believe high switching costs and the lack of true global competitors mean that U.S. defense company foreign sales will be resilient. After all, a NATO nation does not simply switch out of F-35 jets for the Russian or Chinese equivalent. Further, if trade friction leads to rising military tension, defense stocks should outperform. Finally, the ongoing global arms race, space race and growing cybersecurity requirements all signal that these stocks are a secular growth story, as BCA has argued in the recent past.6 Still, as highlighted by the data presented above, the best shelter from a trade war can be found in services, particularly services that are insulated from trade. Financial Services appears a logical choice, especially the S&P Financial Exchanges & Data subsector (BLBG: S5FEXD - CME, SPGI, ICE, MCO, MSCI, CBOE, NDAQ). Another appealing - and defensive - sector is Health Care Services. With effectively no foreign exposure and a low beta, these stocks would outperform in the worst-case trade war-induced recession. Mark McClellan Senior Vice President The Bank Credit Analyst Marko Papic Senior Vice President Geopolitical Strategy Chris Bowes Associate Editor U.S. Equity Strategy 1 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 3 For more information, please see: "Global Value Chains (GVSs): United States." May 2013. OECD website. 4 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. 5 Please see BCA Technology Sector Strategy Special Report "Trade Wars And Technology," dated July 10, 2018, available at tech.bcaresearch.com 6 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. Appendix Table II-1 Allocating U.S. Import Tariffs To U.S. GICS Sectors August 2018 August 2018 Appendix Table II-2 Exports By U.S. Red States August 2018 August 2018 Appendix Table II-3 Exports By U.S. Swing States August 2018 August 2018 Appendix Table II-4 Exposure Of U.S. Industries To U.S. Import Tariffs August 2018 August 2018

Highlights If the U.S. Treasury intervenes to push the greenback lower, it would only have a temporary impact. Ultimately, interventions work if they are matched with easy monetary policy. However, U.S. monetary policy will only be tightened going forward. Because inflation expectations have stabilized since the late-1980s, the dollar can influence the slope of the Phillips Curve. However, the combination of a tight labor market and untimely fiscal stimulus is likely to cause a sharp steepening of the Phillips Curve, with lower unemployment and higher inflation. Unlike in the late 1960s and early 1970s, but as in the mid-1980s, the Federal Reserve is unlikely to abide by these inflationary pressures. Thus, if the Phillips Curve steepens significantly, the Fed is likely to end up raising rates much more aggressively than what is currently priced in, in turn leading to a much stronger dollar. Feature In recent days we have heard speculation that U.S. President Donald Trump may be considering ordering the U.S. Treasury to sell dollars, in order to limit the greenback's strength. We have no preconception of whether this is indeed likely to happen or not, but the mere discussion of this risk forces us to ask questions regarding our view that the dollar can keep rallying in 2018. We think that this kind of policy, if implemented, could have a short-lived negative impact on the dollar, but that ultimately the path for the dollar will be conditional on the path taken by the Fed and global growth, not President Trump's whims. As such, we remain firmly focused on charting the most likely path for these two factors, and currently they continue to favor the USD. As a result, we recommend investors either buy into any corrective action in the dollar in the coming weeks, or, hedge them away. It is not the time to abandon our view that the dollar will end 2018 above current levels. Trump Vs The Trinity One of the bedrocks of international economics is called the Impossible Trinity. It is the simple idea that a country has to make a choice. A nation cannot target the level of its exchange rate and have an independent monetary policy while also having an open capital account. A country can pick two of these nodes at any point in time, but not all three simultaneously (Chart I-1). Chart I-1The Impossible Trinity The Unholy Trinity: The White House, The Fed, And The Dollar The Unholy Trinity: The White House, The Fed, And The Dollar Essentially, if Country A has an open capital account and decides to fix its exchange rate with Country B, it needs to follow a very similar monetary policy that the nation it is pegging its currency against follows. If risk-adjusted interest rates in Country A are lower than those in Country B, money will leave country A, creating downward pressures on its FX reserves, and ultimately forcing a downward adjustment in the exchange rate. The exact opposite will happen if Country A's risk-adjusted interest rates rise above those prevailing in Country B. As a result, if Country A wants to peg its currency to Country B and maintain monetary policy that is independent of that conducted in Country B, Country A has to close its capital account. Or, as was the case when the world was under the gold standard, if Country A wants to maintain an open capital account and still have a pegged currency, then it has to relinquish control over its monetary policy. Finally, countries can also follow the strategy currently in place across most advanced economies, and have both an open capital account and an independent monetary policy, but relinquish control over their exchange rate. Since the U.S. capital account is open, the idea that President Trump could target a lower USD by forcing the Treasury to sell greenbacks in the open market ultimately flies in the face of this impossible trinity, as long as the Fed maintains its independence.1 This last clause is crucial. For example, the Japanese Ministry of Finance conducted successful interventions between 1999 and 2000, when it managed to limit upside in the yen. However, the yen only really weakened once the Bank of Japan joined the game, as it was making sure that Japanese interest rates were falling relative to the U.S. (Chart I-2). The same occurred in 1985 around the Plaza Accord. From August 1984 to August 1986, the effective fed funds rate was declining, which buttressed the U.S. Treasury's verbal efforts of seeing a lower dollar (Chart I-3). Coordination with the rest of the G7 also helped. Chart I-2MoF Interventions Worked, Once Japanese##br## Rates Fell Vs. The U.S. MoF Interventions Worked, Once Japanese Rates Fell Vs. The U.S. MoF Interventions Worked, Once Japanese Rates Fell Vs. The U.S. Chart I-3The Plaza Accord Worked Because The##br## Fed Moved In The Same Direction The Plaza Accord Worked Because The Fed Moved In The Same Direction The Plaza Accord Worked Because The Fed Moved In The Same Direction This means that for interventions to have any durable impact on the U.S. dollar, the Fed needs to be easing monetary policy relative to the rest of the world as well. Otherwise, any decline in the dollar caused by interventions is likely to prove transitory as the higher interest rates offered by the U.S. will likely result in inflows into the dollar. Thus, the outlook for the Fed still holds primacy. On this front, the future does not look good for President Trump's desire to see a weaker dollar. Bottom Line: Because the U.S. has an independent monetary policy and an open capital account, the U.S. Treasury cannot unilaterally target a lower exchange rate. It needs the help of either foreign nations or a compliant Fed that eases policy. Right now, foreign nations have little incentive to follow the example of the 1985 Plaza Accord, and the U.S. economic backdrop points toward higher U.S. interest rates, not lower ones. Thus, any negative impact on the dollar from open market operations by the U.S. Treasury should have a limited lifespan. A Filip From The Phillips Curve? If the Treasury selling dollars can only drag the greenback lower on a durable basis only as long as the Fed eases policy as well, the Fed remains a much more important factor in determining the dollar's outlook. At the center of the Fed's reaction function lies a concept called the Phillips Curve, which normally shows a negative relationship between the unemployment rate and the inflation rate. Logically, we would anticipate that the more strongly inflation and the unemployment rate move in opposite directions, the stronger the link with the dollar should be. If inflation surges in response to small declines in unemployment rates, this forces the Fed to respond with greater assertiveness to capacity pressures. As a result, this should lift the dollar higher. If unemployment increases and inflation plunges, the Fed eases and the dollar weakens. However, the reality is very different. As Chart I-4 illustrates, the relationship between the slope of the Phillips Curve and the dollar evolves over time. When inflation expectations were unanchored to the upside, as was the case in the 1970s, the Phillips Curve became inverted - i.e. a rising unemployment rate was associated with rising inflation. Inflation was in the driver's seat. In this environment, the higher inflation and the unemployment rate got, the weaker the dollar became. The Fed was in a bind and remained behind the curve. Consequently, real rates kept falling and the dollar suffered. Chart I-4The Strange Dance Of The Phillips Curve And The Dollar The Strange Dance Of The Phillips Curve And The Dollar The Strange Dance Of The Phillips Curve And The Dollar After 1981 something interesting happened. The Phillips Curve moved back to its normal slope - i.e. negative. During that period, the dollar rallied. The slope of the Phillips Curve normalized because then-Fed Chair Paul Volcker drove up interest rates so high that inflation expectations collapsed, and ex-ante real rates rebounded as a result. This lifted the dollar. Since the second half of the 1980s, something even stranger has been happening. The dollar now moves upward when the Phillips Curve flattens or becomes inverted. The dollar also depreciates when the Phillips curve normalizes. In other words, the dollar today appreciates when the inflation rate and the unemployment rate move in unison, not in opposition. This is strange; very strange. However, this relationship can be understood if we flip the causation around. Essentially, the dollar may be driving the slope of the Phillips Curve. We have long argued that a strong dollar is not very negative for the U.S. economy, but it remains very negative for inflation.2 This can be seen in Chart I-5, which highlights that a strong dollar is associated with a falling unemployment rate, but also falling inflation. When the dollar is strengthening, it supports consumption as the price of imported goods decreases, increasing the purchasing power of households (Chart I-6). Since household consumption accounts for roughly 70% of GDP, what is good for households ends up being good for U.S. growth. However, a strong dollar dampens inflation by curtailing the price of imported goods, by weighing on the price of commodities, and by tightening EM financial conditions, which decreases EM demand and therefore further undermines global prices. This means that a strong dollar is associated with both a lower unemployment rate and lower inflationary pressures, thus a positively sloped Phillips Curve. These dynamics might explain why this cycle, the Fed has faced very limited inflationary pressures, despite facing an unemployment rate well below equilibrium: The dollar was very strong from 2014 to late 2016, and inflation fell as the unemployment rate also declined. Chart I-5A Strong Dollar Is Neutral For The##br## Unemployment Rate But Deflationary A Strong Dollar Is Neutral For The Unemployment Rate But Deflationary A Strong Dollar Is Neutral For The Unemployment Rate But Deflationary Chart I-6A Strong Dollar ##br##Helps Households A Strong Dollar Helps Households A Strong Dollar Helps Households How is this situation likely to evolve going forward? Will the dollar remain the likely driver of the Phillips Curve, or will the Phillips Curve drive the dollar? We opine that the Phillips Curve is likely to once again become the leading partner in this tango. This could help the dollar. Essentially, today's environment is unlike anything we have seen since the current relationship between the dollar and the Phillips Curve emerged in the second half of the 1980s. Not only is the economy at full employment, but also the U.S. government is engaging in massively expansionary fiscal policy. The obvious parallel is with the late 1960s. Back then, the unemployment rate was low, hitting 3.4% in 1969, yet in response to the Vietnam War and former President Lyndon Johnson's Great Society program, the U.S. budget deficit blew up. This generated the kind of excess demand that culminated in high inflation, and down the road, an unmooring of inflation expectations to the upside. This unmooring was crucial in causing the abnormal Phillips Curve slope discussed earlier, and the collapse in the dollar. This policy sowed the seeds of stagflation. However, forgotten in that parallel is the Fed's behavior at the time. As we highlighted two weeks ago, in the late 1960s and early 1970s, the Fed was much more focused on keeping the U.S. at full employment than it was focused on combatting inflation (Chart I-7). The Fed maintained too easy monetary policy, letting the U.S. economy become a pressure cooker.3 After 1977 and the Federal Reserve Reform act, inflation fighting became an official component of the Fed's mandate - one that took preeminence once Paul Volcker took the helm of the central bank. We are still in this regime. Chart I-7Trump's Fed Is Not Nixon's Fed Trump's Fed Is Not Nixon's Fed Trump's Fed Is Not Nixon's Fed As a result, while the current environment has echoes of the late 1960s, it also resonates with the first half of the 1980s, because the Fed is now more focused on inflation than it was in the 1960s. In the first half of the 1980s, Volcker was working on keeping inflation expectations at bay (Chart I-8). However, former President Ronald Reagan wanted to increase military spending and cut taxes. He got his wish. While the U.S. budget balance normally moves in line with the employment rate, as Chart I-9 illustrates, from 1984 to 1986 employment rose but the budget balance did not improve. This could have caused inflation expectations to increase because it represented a period of unwarranted fiscal expansion and excess demand. Yet inflation expectations did not move up. Instead, the Fed let real interest rates move higher, tightening monetary conditions. The dollar surged in response to a violent normalizing of the Phillips Curve. Chart I-8Inflation Expectations ##br##Are Crucial Inflation Expectations Are Crucial Inflation Expectations Are Crucial Chart I-9Investors Anticipating The Reagan / Volcker ##br##Battle Lifted The Dollar Investors Anticipating The Reagan / Volcker Battle Lifted The Dollar Investors Anticipating The Reagan / Volcker Battle Lifted The Dollar Today, the Fed will continue to fight the inflationary impact of Trump's policies. Moreover, we anticipate that the Phillips Curve is likely to become much more negatively sloped as the business cycle progresses. As Chart I-10 illustrates, not only is the unemployment rate very low, the broader U-6 measure is finally consistent with full employment. In fact, the gap between the two unemployment measures also indicates there is no more hidden labor market slack in the U.S. Additionally, while the employment-to-population ratio remains low in the context of the past 30 years, the employment-to-population ratio for prime age workers has normalized (Chart I-11). Moreover, as the bottom panel of Chart I-11 illustrates, the true culprit behind the dichotomy between the employment rate of prime-age workers and that of the rest of the population is the low employment rate of young workers. Essentially, younger Americans are getting more educated, which is keeping them out of the labor force for longer. As a result, the participation age for the population at large is likely to remain below levels that prevailed before the financial crisis. This also mean that since the participation rate for prime age workers has already normalized, additional employment gains are likely to result in additional wage gains and inflationary pressures. Chart I-10The Labor Market Points To##br## A Normalizing Phillips Curve The Labor Market Points To A Normalizing Phillips Curve The Labor Market Points To A Normalizing Phillips Curve Chart I-11Participation Is Low Because ##br##Millenials Stay In School Longer Participation Is Low Because Millenials Stay In School Longer Participation Is Low Because Millenials Stay In School Longer Another symptom highlighting that the labor market is very tight is the fact that the unemployment rate among individuals 25 years and older but without a high school diploma has collapsed to record lows (Chart I-12). Moreover, wage growth among this cohort has skyrocketed, normally a symptom of budding inflationary pressures (Chart I-12, bottom panel). As a result, the combination of evident pressures in the labor market and untimely fiscal stimulus is likely to realize the inflationary pressures suggested by the NFIB small business survey. When companies are much more worried about finding qualified employees than they are about finding demand for their products and services, core CPI hooks up. This time will not be different (Chart I-13). Chart I-12A Clear Sign Of Tightening A Clear Sign Of Tightening A Clear Sign Of Tightening Chart I-13Inflation Set To Pick Up Inflation Set To Pick Up Inflation Set To Pick Up All these dynamics raise the risk that after years of dormancy, the Phillips curve could suddenly become much steeper and more negative. The Fed is likely to use rising inflation and a steeper Phillips curve as a justification to suggest that r-star is rising. As a result, it will use this logic to push both nominal and real interest rate higher. This, in our view, will push the dollar higher. Why? As we have shown in the past, when the U.S. has the highest interest rates among the G-10, the dollar performs well (Chart I-14). However, as the top panel of Chart I-15 shows, U.S. rates are the determinant of this ranking - i.e. when the fed funds rate increases, so does the ranking of U.S. rates within the G-10. This also means the ranking of U.S. rates relative to other G-10 rates follows the U.S. business cycle. Moreover, as the bottom two panels of Chart I-15 illustrate, the current level of aggregate unemployment and of unemployment among the less-educated confirms that the U.S. should have the highest interest rates among G-10 nations. Trump's stimulus will only add fuel to the fire. Chart I-14Supported By The Highest Rates In The G10, ##br##The Dollar Can Rise Further Supported By The Highest Rates In The G10, The Dollar Can Rise Further Supported By The Highest Rates In The G10, The Dollar Can Rise Further Chart I-15The Ranking Of U.S. Rates Depends ##br##On The U.S. Business Cycle The Ranking Of U.S. Rates Depends On The U.S. Business Cycle The Ranking Of U.S. Rates Depends On The U.S. Business Cycle In fact, the combination of a tight labor market, high U.S. rates relative to the rest of the world and a quickly steepening normal (i.e. inverse relationship) Phillips Curve could result in a supercharged rally in the U.S. dollar. Such a rally, if it were to materialize, would likely cause very serious pain on EM economies and assets. As a result, we recommend investors closely watch the slope of the Phillips Curve in coming quarters, as it will hold the key to the dollar's path. Bottom Line: The slope of the Phillips Curve moves around significantly over time, but more interestingly, its relationship with the dollar does as well. Today's environment of a tight labor market accompanied by fiscal stimulus could result in a large steepening of the Phillips Curve. Since now the Fed is much more independent and much more focused on inflation than it was in the 1960s and early 1970s, such a shift in the Phillips Curve could supercharge the dollar's strength. Increasing this likelihood, the Fed is already at the top of the interest rate distribution among the G-10, which means the dollar remains under upward pressure. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 And we believe that the Fed will continue to conduct its monetary policy independently from the desires of the White House. Please see Foreign Exchange Strategy Weekly Report, "Rhetoric Is Not Always Policy", dated July 27, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, "Dollar: The Great Redistributor", dated October 7, 2016, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, "Rhetoric Is Not Always Policy", dated July 27, 2018, 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 negative: Both average hourly earnings yearly growth and the unemployment rate came in line with expectations, at 2.7% and 3.9% respectively. However, non-farm payrolls underperformed expectations, coming in at 157 thousand. Nonetheless, the high upward revisions to the June and May numbers mitigated the blow. Moreover, the participation rate also surprised negatively, coming in at 62.9%. Finally, both Markit Services and Markit Composite PMI underperformed expectations, coming in at 56 and 55.7 respectively. DXY has been flat this week. While we recognize that the dollar could have some tactical downside, it is unlikely to be very playable. Thus, investors should stay long the green back, as the combination of tightening in both China and the U.S. will create an environment of slowing global growth where the dollar benefits. However, because a countertrend correction can always be more painful than anticipated, we have bought some hedges against our long dollar call, sell USD/CAD as a form of protection. Report Links: The Dollar And Risk Assets Are Beholden To China's Stimulus - August 3, 2018 Rhetoric Is Not Always Policy - July 27, 2018 Time To Pause And Breathe - July 6, 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 the euro area has been negative: Markit Services PMI underperformed expectations, coming in at 54.2. Moreover, retail sales yearly growth also surprised negatively, coming in at 1.2%. This measure also decreased relative to last month. German factory orders yearly growth also surprised to the downside, showing a contraction of 0.8%. Finally, German industrial production yearly growth also underperformed, coming in at 2.5%. EUR/USD has been relatively flat this week. The euro is likely to have downside for the rest of the year, as tight labor market in the U.S. and powerful inflationary pressures will push the fed to raise rates more than what is priced into the OIS curve. Meanwhile, the ECB will have to stay put, as deaccelerating global growth will weigh on its export-oriented economy. Report Links: Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 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: Markit Services PMI underperformed expectations, coming in at 51.3. Moreover, the leading economic index also surprised to the downside, coming in at 105.2. However, overall household spending yearly growth surprised positively, coming in at -1.2%. This measure also increased relative to last month's number. Finally, labor cash earnings yearly growth also surprised to the upside, coming in at 3.6%. USD/JPY has gone down by nearly 0.7% this week. We are bullish on the yen versus commodity and European currencies on a 6 month basis, as slowing global growth coupled with trade tensions should generate rising volatility and help safe havens like the yen. Report Links: Rhetoric Is Not Always Policy - July 27, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Rome Is Burning: Is It The End? - June 1, 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: Market Services PMI underperformed expectations, coming in at 53.5. This measure also decreased from last month's number. Moreover, BRC Like-for-like retail sales yearly growth also underperformed expectations, coming in at 0.5%. This measure also decreased from 1.1% last month. However, Halifax house prices yearly growth outperformed expectations, coming in at 3.3%. This measure also increased form 1.8% the previous month. GBP/USD has fallen by 1% this week, as Brexit fears continue to put downward pressure on this cross. Cable will likely continue to fall until the end of the year, as rising U.S. rates will give a boost to the dollar. That being said, as the currency continues to depreciate it is important to keep an eye on whether inflation starts perking up a, as a buying opportunity might emerge. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 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 mixed: Home loans growth underperformed expectations, coming in at -1.1%. This measure also decreased relatively to last month's number. However, retail sales month-on-month growth outperformed expectations, coming in at 0.4%. AUD/USD has rallied by nearly 1% this week, as investors have started to price in Chinese stimulus. Overall, we believe that any relief in tightening from the Chinese authorities will be temporary, which means that the rally in the AUD will likely be short lived. That being said, tactical investors who wish to take a position on Chinese stimulus can buy our designed "China Play Index", a risk adjusted portfolio comprised of AUD/JPY, Brazilian equities, Swedish industrials equities, iron ore and EM high yield debt. Report Links: What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 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 On Thursday, the RBNZ left its policy rate unchanged at 1.75%. NZD/USD fell by 1% following the decision. The monetary policy statement stroke a dovish tone, as the RBNZ stated that they expected "to keep the OCR (Official Cash rate) at this level through 2019 and into 2020", longer than originally projected in their May statement. Moreover, the RBNZ highlighted that the probability of rate cut, while still not its central scenario, has risen. We believe, that growth in the kiwi economy could be at risk as tightening by both the Fed and the PBoC as well as trade tensions will likely prove to be a toxic cocktail for this small open economy very levered to global trade. This means that NZD/USD is likely to continue to go down as we approach2019. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 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 mixed: The Ivey Purchasing Manager's Index underperformed expectations, coming in at 61.8. This measure also decreased from last month's number. Moreover, Building permit month-on-month growth also surprised negatively, coming in at -2.3%. However, International merchandise trade outperformed expectations, coming in at -0.63 billion. USD/CAD has been flat this week. We continue to hold a tactical bearish bias on this cross, as the excessive short positioning in the CAD has yet to be purged. That being said, we are bullish on this cross on a 6-12 month basis, as the Fed will likely keep raising interest rates, hurting EM economies, and consequently commodity producers like Canada. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 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 neutral: Headline inflation came in line with expectations, at 1.2%. This measure also increased relatively to last month's number. The unemployment rate also came in line with expectations at 2.6%. EUR/CHF has declined by roughly 0.6% this week. We believe this cross could continue to have downside on a 6 to 12 month basis if trade tensions and Chinese tightening continue to make for a risk off environment. That being said, on a longer term basis, the franc is not likely to have much upside, given that the SNB will keep ultra-dovish monetary policy in order to help bring back inflation to Switzerland. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 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 USD/NOK has been relatively flat this week. We are bullish on this cross on a 6 to 12 month basis, given that widening interest rate differentials between the U.S. and Norway will likely boost this cross. It is important to remember that while oil prices are an important driver of USD/NOK, our research has shown that interest rate differentials have a stronger correlation. Thus, USD/NOK could rise even amid rising oil prices. With this in mind, we are bullish on the NOK within the commodity complex, as oil should outperform base metals thanks to the supply cuts by OPEC. Strong oil prices should also help the NOK versus the EUR. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 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 USD/SEK has risen by more than 1% this week. We are bearish on this cross on a 6-12 month basis, as our research has shown that the krona is the most sensitive currency to the dollar in the G10. This is likely due to the fact that Sweden is a small very open economy which sits early in the global supply chain, exporting a large proportion of intermediate goods. When the dollar rises and curtails Emerging market demand, Sweden producers are the first to feel the pain from the slowdown. On a longer term basis we are more bullish on the krona, given that inflation continues to be very strong in Sweden, and the Riksbank will eventually have to adjust monetary policy accordingly. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Xi Jinping is trying to do two things at once: ease policy while cracking down on systemic financial risk; The trade war with the U.S. is a genuine crisis for China and is eliciting fiscal stimulus; Credit growth is far more likely to "hold the line" than it is to explode upward or collapse downward; The 30% chance of a policy mistake from financial tightening has fallen to 20% only, as bad loan recognition is underway and a critical risk to monitor; Hedge against the risk of a stimulus overshoot. Feature "We have upheld the underlying principle of pursuing progress while ensuring stability." - Xi Jinping, General Secretary of the Communist Party of China, October 18, 2017 "Any form of external pressure can eventually be transformed into impetus for growth, and objectively speaking will accelerate supply-side structural reforms." - Guo Shuqing, Secretary of the China Banking and Insurance Regulatory Commission, July 5 Last year we made the case that China's General Secretary Xi Jinping would double down on his reform agenda in 2018, specifically the bid to control financial risk, and that this would bring negative surprises to global financial markets as policymakers demonstrated a higher pain threshold.1 This view has largely played out, with economic policy uncertainty spiking and a bear market in equities developing alongside an increase in corporate and even sovereign credit default risk (Chart 1). We also argued, however, that Xi's "deleveraging campaign" would be constrained by the Communist Party's need for overall stability. Trade tensions with the U.S., and Beijing's perennial fear of unemployment, would impose limits on how much pain Beijing would ultimately tolerate: The Xi administration will renew its reform drive - particularly by curbing leverage, shadow banking, and local government debt. Growth risks are to the downside. But Beijing will eventually backtrack and re-stimulate, even as early as 2018, leaving the reform agenda in limbo once again.2 Over the past month, China has clearly reached its pain threshold: authorities have announced a series of easing measures in the face of a slowing economy, a trade war, and a still-negative broad money impulse (Chart 2). Chart 1Policy Uncertainty Up, Stocks Down Policy Uncertainty Up, Stocks Down Policy Uncertainty Up, Stocks Down Chart 2PMI Falling, Money Impulse Still Negative PMI Falling, Money Impulse Still Negative PMI Falling, Money Impulse Still Negative How stimulating is the stimulus? Will it lead to a material reacceleration of the Chinese economy? What will it mean for global and China-dedicated investors? We expect policy to be modestly reflationary. A substantial boost to fiscal thrust, and at least stable credit growth, is in the works. Yet Xi's reform agenda will remain a drag on the economy. While this new stimulus will not have as dramatic an effect as the stimulus in 2015-16, it will have a positive impact relative to expectations based on China's performance in the first half of the year. We advise hedging our negative EM view against a rally in China plays and upgrading expectations for Chinese growth in 2019. The policy headwind is receding for now. Xi Jinping's "Three Tough Battles" Xi will not entirely abandon the "Reform Reboot" that began last October. From the moment he came to power in 2012-13, he pursued relatively tight monetary and fiscal policy. Total government spending growth has dropped substantially under his administration, while private credit growth has been capped at around 12% (Chart 3). Chart 3Xi Jinping Caps Government Spending And Credit Xi Jinping Caps Government Spending And Credit Xi Jinping Caps Government Spending And Credit Xi partly inherited these trends, as China's credit growth and nominal GDP growth dropped after the massive 2008 stimulus. But he also embraced tighter policy as a way of rebalancing the economy away from debt-fueled, resource-intensive, investment-led growth. A comparison of government spending priorities between Xi and his predecessor makes Xi's policy preferences crystal clear: the Xi administration has increased spending on financial and environmental regulation, while minimizing subsidies for housing and railways to nowhere (Table 1 and 2). Table 1Central Government Spending Preferences (Under Leader's Immediate Control) China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? Table 2Total Government Spending Preferences (Under Leader's General Control) China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? These policies are "correct" insofar as they are driven not merely by Xi's preferences but by long-term constraints: The middle class: Pollution and environmental degradation threaten the living standards of the country's middle class. Broadly defined, this group has grown to almost 51% of the population, a level that EM politicians ignore only at their peril (Chart 4). Asset bubbles: The rapid increase in China's gross debt-to-GDP ratio since 2008 is a major financial imbalance that threatens to undermine economic stability and productivity as well as Beijing's global aspirations (Chart 5). The constraint is clear when one observes that "debt servicing" is the third-fastest category of fiscal spending growth since Xi came to power (Table 2). Chart 4Emerging Middle Class A Latent Political Risk Emerging Middle Class A Latent Political Risk Emerging Middle Class A Latent Political Risk Chart 5The Rise And Plateau Of Macro Leverage China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? The problem is that Xi also faces a different, shorter-term set of constraints arising from China's declining potential GDP, "the Middle-Income Trap," and the threat of unemployment.3 The interplay of these short- and long-term constraints has forced Xi to vacillate in his policies. In 2015, the threat of an economic "hard landing," ahead of the all-important mid-term party congress in 2017, forced him to stimulate the "old" industrial economy and sideline his reforms. Only when he had consolidated power over the Communist Party in 2016-17 could he resume pushing the reform agenda.4 In July 2017, Xi announced the so-called "Three Critical Battles" against systemic financial risk, pollution, and poverty. The three battles are interdependent: continuing on the capital-intensive economic model will overwhelm any efforts to cut excessive debt or pollution (Chart 6), yet sudden deleveraging could derail the Communist Party's basic claim to legitimacy through improving the lot of poor Chinese. The macroeconomic impact of the three battles is broadly deflationary, as credit growth falls and industries restructure. The first battle - the financial battle - will determine the outcome of the other two battles as well as the growth rate of China's investment-driven economy, Chinese import volumes, and emerging market stability (Chart 7). Chart 6Credit Stimulus Correlates With Pollution Credit Stimulus Correlates With Pollution Credit Stimulus Correlates With Pollution Chart 7Credit Determines Growth And Imports Credit Determines Growth And Imports Credit Determines Growth And Imports On July 31, in the midst of worldwide speculation about China's willingness to stimulate, Xi reaffirmed this "Three Battles" framework. Remarkably, despite a general slowdown, a sharp drop in the foreign exchange rate, the revival of capital flight, and a bear market, he announced that the battle against systemic financial risk would continue in the second half of 2018. However, he also admitted that domestic demand needed a boost in the short term. Hence there should be no doubt in investors' minds about the overarching policy framework or Xi Jinping's intentions in the long run. The question driving the markets today is what China will do in the short term and whether it will initiate a material reacceleration in economic activity. Bottom Line: Xi Jinping remains committed to the reform agenda that he has pursued since coming to power in 2012. But he is forced by circumstances to vary the pace and intensity. At the top of the agenda is the control of systemic financial risk. This is a policy driven by the belief that China's economic and financial imbalances threaten to undermine its overall stability and global rise. Why The Shift Toward Easier Policy? The gist of the July 31 Politburo statement was that policy will get more dovish in the short term. It mentioned "stability" five times. The Politburo pledged to make fiscal policy "more proactive" and to find a better balance between preventing financial risks and "serving the real economy." This direct promise from Xi Jinping of more demand-side support gives weight to the State Council's similar statement on July 23 and will have reflationary consequences above and beyond the central bank's marginal liquidity easing thus far. What is motivating this shift in policy, which apparently flies in the face of Xi's high-profile deleveraging campaign? If we had to name a single trigger for China's change of tack, it is not the economic slowdown so much as the trade war with the United States. The war began when the U.S. imposed sanctions on Chinese firm ZTE in April and China depreciated the RMB, but it escalated dramatically when the U.S. posted the Section 301 tariff list in June (Chart 8).5 This is a sea change in American policy that is extremely menacing to China. China runs a large trade surplus and has benefited more than any other country from the past three decades of U.S.-led globalization. Its embrace of globalization is what enabled the Communist Party to survive the fall of global communism! Chart 8More Than Market Dynamics At Work More Than Market Dynamics At Work More Than Market Dynamics At Work Chart 9China Is Less Export-Dependent China Is Less Export-Dependent China Is Less Export-Dependent True, China has already seen its export dependency decline (Chart 9). But Beijing has so far managed this transition gradually and carefully, whereas a not-unlikely 25% tariff on $250-$500 billion of Chinese exports will hasten the restructuring beyond its control (Chart 10). A very large share of China's population is employed in manufacturing (Chart 11). To the extent that the tariffs actually succeed in reducing external demand for Chinese goods, these jobs will be affected. Chart 10Tariffs Will Add More Pain To Factory Workers Tariffs Will Add More Pain To Factory Workers Tariffs Will Add More Pain To Factory Workers Chart 11Manufacturing Unemployment A Huge Threat Manufacturing Unemployment A Huge Threat Manufacturing Unemployment A Huge Threat Unemployment is anathema to the Communist Party. And China is simply not as experienced as the U.S. in dealing with large fluctuations in unemployment (Chart 12). While Chinese workers will blame "foreign imperialists" and rally around the flag, the pain of unemployment will eventually cause trouble for the regime. Domestic demand as well as exports will suffer. It is even possible that worker protests could evolve into anti-government protests. Chart 12China Not Experienced With Layoffs China Not Experienced With Layoffs China Not Experienced With Layoffs Given that Chinese and global growth are already slowing, it is no surprise that the Politburo statement prioritized employment.6 China's leaders will prepare for social instability as the worst possible outcome of the showdown with America - and that will push them toward stimulus. In addition, there will be no short-term political cost to Xi Jinping for erring on the side of stimulus, as there is no opposition party and the public is not demanding fiscal and monetary austerity. Moreover, the main macro implication of Xi's decision last year to remove term limits - enabling himself to be "president for life" in China - is that his reforms do not have to be achieved by any set date. They can be continually procrastinated on the basis that he will return to them later when conditions are better.7 The policy response to tariffs from the Trump administration also signals another policy preference: perseverance. Xi would not be straying from his reform priorities if not for a desire to counter American protectionism. China is not interested in kowtowing but would rather gird itself for a trade war. Still, our baseline view is that the Xi administration will stimulate without abandoning the crackdown on shadow lending or launching a massive "irrigation-style" credit surge that exacerbates systemic risk.8 Policy will be mixed, as Xi is trying to do two things at once. Bottom Line: China's slowdown and the outbreak of a real trade war with the United States is forcing Xi Jinping to ease policy and downgrade the urgency of his attempt to tackle systemic financial risk this year. Can Fiscal Easing Overshoot? Yes. How far will China's policy easing go? China has a low level of public debt, and fiscal policy has been tight, so we fully expect fiscal thrust to surprise to the upside in the second half of the year, easily by 1%-2% of GDP, possibly by 4% of GDP. A remarkable thing happened this summer when researchers at the People's Bank of China and the Ministry of Finance began debating fiscal policy openly. Such debates usually occur during times of abnormal stress. The root of the debate lay in the national budget blueprint laid out in March at the National People's Congress. There, without changing official rhetoric about "proactive fiscal policy," the authorities revealed that they would tighten policy this year, with the aim of shrinking the budget deficit from 3% of GDP target in 2017 to 2.6% in 2018. The IMF, which publishes a more realistic "augmented" deficit, estimates that the deficit will contract from 13.4% of GDP to 13% (Chart 13). This fiscal tightening coincided with Xi's battle against systemic financial risk. Hence both monetary and fiscal policy were set to tighten this year, along with tougher regulatory and anti-corruption enforcement.9 Thus it made sense on May 8 when the Ministry of Finance revealed that the quota for net new local government bond issuance this year would increase by 34% to 2.18 trillion RMB. This quota governs new bonds that go to brand new spending (i.e. it is not to be confused with the local government debt swap program, which eases repayment burdens but does not involve a net expansion of debt). Local government spending is the key because it makes up the vast majority (85%) of total government spending, which itself is about the same size as new private credit each year. Chart 13Fiscal Tightening Was The Plan For 2018 China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? Table 3Local Government Bond Issuance And Quota China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? In June, local governments took full advantage of this opportunity, issuing 316 billion RMB in brand new bonds (up from a mere 17 billion in May - an 11.8% increase year-on-year) (Table 3). This spike in issuance is later than in previous years. Combined with the Politburo and State Council pledging to boost fiscal policy and domestic demand, it suggests that net new issuance will pick up sharply in H2 2018 (Chart 14).10 Chart 14Local Government Debt Can Surprise In H2 China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? Chart 15June Issuance Surged, Special Bonds To Pick Up China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? At the same time, the risk that special infrastructure spending will fall short this year is receding. About 1.4 trillion RMB of the year's new bond allowance consists of special purpose bonds to fund projects. The State Council said on July 23 it would accelerate the issuance of these bonds, since, at most, only 27% of the quota was issued in the first half of the year (Chart 15). The risk of a shortfall - due to stricter government regulations over the quality of projects - is thereby reduced. What is the overall impact of these moves? The Chinese government provides an annual "debt limit" that applies to the grand total of explicit, on-balance-sheet, local government debt. The limit increased by 11.6% for 2018, to 21 trillion RMB (Table 4), which, theoretically, enables local governments to splurge on a 4.5 trillion RMB debt blowout. Should that occur, 2.6 trillion RMB of that amount, or 3% of GDP, would be completely unexpected new government spending in 2018 (creating a positive fiscal thrust).11 Table 4Local Government Debt Quota Is Not A Constraint China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? Such a blowout may not be likely, but it is legally allowed - and the political constraints on new issuance have fallen with the central government's change of stance. This means that local governments' net new bond issuance can move up toward this number. More feasibly, local governments could increase their explicit debt to 19.3 trillion RMB, a 920 billion RMB increase on what is expected, which would imply 1% of GDP in new spending or "stimulus" in 2018.12 The above only considers explicit, on-balance-sheet debt. Local governments also notoriously borrow and spend off the balance sheet. The total of such borrowing was 8.6 trillion RMB at the end of 2014, but there is no recent data and the stock and flow are completely opaque.13 The battle against systemic risk is supposed to curtail such activity this year. But the newly relaxed supervision from Beijing will result in less deleveraging at minimum, and possibly re-leveraging. Similarly, the government has said it is willing to help local governments issue refinancing bonds to deal with the spike in bonds maturing this year.14 This frees them up to actually spend or invest the money they raise from brand new bonds. In short, our constraints-based methodology suggests that the risk lies to the upside for local government debt in 2018, given that it is legal for debt to increase by as much as 2.5 trillion RMB, 3% of GDP, over the 1.9 trillion RMB increase that is already expected in the IMF's budget deficit projections for 2018. What about the central government? Its policy stance has clearly shifted. The central government could quite reasonably expand the official budget deficit beyond the 2.6% target. Indeed, that target is already outdated given that new individual tax cuts have been proposed, which would decrease revenues (add to the deficit) by, we estimate, a minimum of 0.44% of GDP over a 12-month period starting in October.15 Other fiscal boosts have also been proposed that would add an uncertain sum to this amount.16 The total of these measures can quite easily add up to 1% of GDP, albeit with the impact mostly in 2019. Finally, the strongest reason to err on the side of an upward fiscal surprise is that an expansion of fiscal policy will allow the Xi administration to boost demand without entirely relying on credit growth. First, local governments are actually flush with revenues due to strong land sales (Chart 16), which comprise around a third of their revenues. This enables them to increase spending even before they tap the larger debt allowance. Second, China's primary concern about financial risk is due to excessive corporate (and some household) leverage, particularly by state-owned enterprises (SOEs) and shadow banking. It is not due to public debt per se. It is entirely sensible that China would boost public debt as it attempts to limit leverage. In fact, this would be the Zhu Rongji playbook from 1998-2001. This was the last time that China announced a momentous three-year plan to crack down on profligate lending, hidden debts, and credit misallocation. The authorities deliberately expanded fiscal policy to compensate for the anticipate credit crunch and its drag on GDP growth (Chart 17).17 Chart 16Land Sales Enable Non-Debt Fiscal Spending Land Sales Enable Non-Debt Fiscal Spending Land Sales Enable Non-Debt Fiscal Spending Chart 17China Boosted Fiscal During Last Bad Debt Purge China Boosted Fiscal During Last Bad Debt Purge China Boosted Fiscal During Last Bad Debt Purge As for the impact on the economy, the money multiplier will be meaningful because the economy is slowing and fiscal policy has been tight. But fiscal spending does operate with a six-to-ten month lag, meaning that China/EM-linked risk assets will move long before the economic data fully shows the impact. Our sense, judging by the unenthusiastic response of copper prices thus far, is that the market does not anticipate the fiscal overshoot that we now do. Bottom Line: The political constraints on local government spending have fallen. Fiscal policy could add as much as 1%-3% of GDP to the budget deficit in H2 2018, namely if local government spending is unleashed by the recently announced policy shift. This is comparable to the 4% of GDP fiscal boost in 2008-09 and 3% in 2015-16. Can Monetary Easing Overshoot? Yes, But Less Likely. Credit is China's primary means of stimulating the economy, especially during crisis moments, and it has a much shorter lag period than fiscal spending (about three months). But Xi's agenda makes the use of rapid, credit-fueled stimulus more problematic. Based on the sharp drop in the interbank rate - in particular, the three-month interbank repo rate that BCA's Emerging Markets Strategy and China Investment Strategy use as a proxy for China's benchmark rate - it is entirely possible that credit growth will increase to some degree in H2 2018. Interbank rates have now fallen almost to 2016 levels, while the central bank never hiked the official 1-year policy rate during the recent upswing (Chart 18). In other words, the monetary setting has now almost entirely reversed the financial crackdown that began in 2017. The sharp drop in the interbank rate is partly a consequence of the three cuts to required reserve ratios (RRRs) this year, which amounts to 2.8 trillion RMB in new base money from which banks can lend.18 One or two more RRR cuts are expected in H2 2018, which could free up another roughly 800 billion-to-1.6 trillion RMB in new base money. With China accumulating forex reserves at a slower pace than in the past, and facing a future of economic rebalancing away from exports and growing trade protectionism, RRRs can continue to decline over the long run (Chart 19). China will not need to sterilize as large of inflows of foreign exchange.19 Chart 18Monetary Settings Back To Easy Levels Monetary Settings Back To Easy Levels Monetary Settings Back To Easy Levels Chart 19RRR Cuts Can Continue RRR Cuts Can Continue RRR Cuts Can Continue If China's banks and borrowers respond as they have almost always done, then credit growth should rise. The risk to this assumption is that the banks may be afraid to lend as long as the Xi administration remains even partially committed to its financial crackdown. Moreover, the anti-corruption campaign is continuing to probe the financial sector. While this has only produced a handful of anecdotes so far, they are significant and may have helped cause the decline in loan approvals since early 2017. Critically, China has begun the process of recognizing non-performing loans (NPLs), by requiring that "special mention loans" be reclassified as NPLs, thus implying that NPL ratios will spike, especially among small and regional lenders (Chart 20). This is part of the deleveraging process we expect to continue, but it can take on a life of its own and will almost certainly weigh on credit growth to some extent for as long as it continues. Chart 20NPL Recognition Underway (!) NPL Recognition Underway (!) NPL Recognition Underway (!) Chart 21Three Scenarios For Private Credit In H2 2018 China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? What will be the prevailing trend: monetary easing or the financial crackdown? In Chart 21 we consider three scenarios for the path of overall private credit growth (total social financing, ex-equity) for the rest of the year, with our subjective probabilities: In Scenario A, 10% probability, we present an extreme case in which Beijing panics over the trade war and the banks engage in a 2009-style lending extravaganza. Credit skyrockets up to the 2010-17 average growth rate. This would mark a massive 11.9 trillion RMB or 13.8% of GDP increase in excess of the amount implied by the H1 2018 data. This size of credit spike would be comparable to the huge spikes that occurred during past crises, such as the 22% of GDP increase in 2008-09 or the 9% of GDP increase in 2015-16. Needless to say, this is not our baseline case, but it could materialize if the trade war causes a global panic. In Scenario B, 70% probability, we assume, more reasonably, that traditional yuan bank loans are allowed to rise toward their average 2010-17 growth rate as a result of policy easing, yet Xi maintains the crackdown on non-bank credit in accordance with this "Three Battles" framework. Credit growth would still decelerate in year-on-year terms, but only just: it would fall from 12.3% in 2017 to 11.5% in 2018. Additional policy measures could easily bump this up to a modest year-on-year acceleration, of course. This scenario would result in a credit increase worth 2.9 trillion RMB or 3.4% of GDP on top of the level implied by H1 2018. In Scenario C, 20% probability, we assume that the 2018 YTD status quo persists: bank credit and non-bank credit continue growing at the bleak H1 2018 rate. The administration's attempt to maintain the crackdown on financial risk could frighten banks out of lending. This would mean no credit increase in 2018 beyond what is naturally extrapolated from the H1 2018 data. Credit growth would slow from 12.3% to 10.7% in 2018. This scenario would be surprising, but not entirely implausible given that the Politburo is insisting on continuing the Three Battles. The collapse in interbank rates and the easing measures already undertaken - such as reports that the Macro-Prudential Assessments will lighten up, and that the People's Bank is explicitly softening banks' annual loan quotas20 - lead us to believe that Scenario B is most likely, and possibly too conservative. This is the scenario most consistent with the latest Politburo statement: that authorities will continue the campaign against systemic risk, namely through the policy of "opening the front door" (traditional bank loans go up) and "closing the back door" (shadow lending goes down), which began in January. The Chinese government has always considered control of financial intermediation to be essential. The only way to reinforce the dominance of the state-controlled banks, while preventing a sharp drop in aggregate demand, is to allow them to grow their loan books while regulators tie the hands of their shadow-bank rivals (Chart 22). Chart 22Opening The Front Door, Closing The Back Opening The Front Door, Closing The Back Opening The Front Door, Closing The Back One factor that could evolve beyond authorities' control is the velocity of money. Money velocity is essentially a gauge of animal spirits. If a single yuan changes hands multiple times, it will drive more economic activity, but if it is deposited away for a rainy day, then the bear spirit is in full force. Thus, if credit growth accelerates, but money in circulation changes hands more slowly, then nominal GDP can still decelerate - and vice versa.21 China's money velocity suffered a sharp drop during the tumult of 2015, recovered along with the policy stimulus in 2016, and has tapered a bit in 2018 in the face of Xi's deleveraging campaign. Yet it remains elevated relative to 2012-16 and clearly responds at least somewhat to policy easing. The implication is that money velocity should remain elevated or even pick up in H2. Again, the risk to this view is that Xi's ongoing battle against financial risk, and anti-corruption campaign in the financial sector, could suppress money velocity as well as credit growth. Bottom Line: We see a subjective 70% chance that the drop in credit growth will be halted or reversed in H2 as a result of the central bank's liquidity easing and the Politburo's willingness to let traditional bank lending grow while it discourages shadow lending. Our baseline case says the impact could amount to new credit worth 3.4% of GDP in H2 2018 that markets do not yet expect. Investment Conclusions Beijing's shift in policy suggests that our subjective probability of a policy mistake this year, leading to a sharp economic deceleration, should be reduced from 30% to 20% (Credit Scenario C above).22 Why is this dire scenario still carrying one-to-five odds? Because we fear that the financial crackdown and rising NPLs could take on a life of their own. Meanwhile the risk of aggressive re-leveraging has risen from 0% to 10% (Credit Scenario A above). Summing up, Table 5 provides a simple, back-of-the-envelope estimate of the size of both fiscal and monetary policy measures as a share of GDP. Table 5Potential Magnitude Of Easing/Stimulus China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? Our bias is to expect a strong fiscal response combined with a weak-to-moderate credit response. This would reflect the Xi administration's desire to prevent asset bubbles while supporting growth. A more proactive fiscal policy harkens back to China's handling of its last financial purge in 1998-2001. If banks prove unable or unwilling to lend sufficiently, additional fiscal expansion will pick up the slack. New local government debt can surprise by 1% of GDP or more, while formal bank lending amidst an ongoing crackdown on shadow lending could add new credit of around 3.4% of GDP and hence mitigate or halt the slowdown in credit growth. The combined effect would be an unexpected boost to demand worth 4.4% of GDP in H2 2018, which would exert an unknown, but positive, multiplier effect. We are replacing our "Reform Reboot" checklist, which has seen every item checked off, with a new "Stimulus Checklist" that we will monitor going forward (Appendix). Chart 23How To Monitor The Stimulus Impact How To Monitor The Stimulus Impact How To Monitor The Stimulus Impact Neither the size of this stimulus, nor the composition of fiscal spending, will be quite as positive for EM/commodities as were past stimulus efforts. China's investment profile is changing as the reform agenda seeks to reduce industrial overcapacity and build the foundations for stronger household demand and a consumer society. Increases in fiscal spending today will involve more "soft infrastructure" than in the past. We recommend reinstituting our long China / short EM equity trade, using MSCI China ex-tech equities. We also recommend reinitiating our long China Big Five Banks / short other banks trade, to capture the disparity of the financial crackdown's impact. To capture the new upside risk for global risk assets, our colleague Mathieu Savary at BCA's Foreign Exchange Strategy has devised a "China Play" index that is highly sensitive to Chinese growth - it includes iron ore prices, Swedish industrial stocks, Brazilian stocks, and EM junk bonds (all in USD terms), as well as the Aussie dollar-Japanese yen cross. BCA Geopolitical Strategy also recommends this trade as a portfolio hedge to our negative EM view (Chart 23).23 A major risk to the "modest reflation" argument in this report will materialize if the RMB depreciates excessively in response to the escalating trade war (Trump will likely post a new tariff list on $200 billion worth of goods in September).24 This could result in renewed capital outflows breaking through China's capital controls, the PBC appearing to lose control, EM currencies and capital markets getting roiled, EM financial conditions tightening sharply, and global trade and growth slowing sharply. China would ultimately have to stimulate more (moving in the direction of Credit Scenario A above), but a market selloff would occur first and much economic damage would be done. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Qingyun Xu, Senior Analyst qingyun@bcaresearch.com Yushu Ma, Contributing Editor yushum@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 3 Please see The Bank Credit Analyst Special Report, "A Long View Of China," dated December 28, 2017, available at bca.bcaresearch.com. 4 The fact that he began tightening financial policy in late 2016 and early 2017 was especially significant because only a very self-assured leader would attempt something so risky ahead of a midterm party congress. 5 Please see BCA Geopolitical Strategy Weekly Reports, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, and "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 6 The statement declared in its first paragraph that China would "maintain the stability of employment," with employment being the first item in a list. A similar emphasis on employment has not been seen in Politburo statements since the troubled year of 2015, and it has not been mentioned substantively in 11 key meetings since the nineteenth National Party Congress last October. 7 Please see footnote 2 above. 8 After the State Council meetings on July 23 and 26, Vice-Minister of Finance Liu Wei elaborated on the government's thinking: "These [measures] further add weight to the overall broad logic at the start of the year ... It isn't at all that the macro-economy has undergone any major volatility, and we are not undertaking any irrigation-style, shock-style measures." Please see "Beijing Sheds Light On Plans For More Active Fiscal Policy," China Banking News, July 27, 2018, available at www.chinabankingnews.com. 9 Our colleagues in BCA's Emerging Markets Strategy service have dubbed this policy "triple tightening." Please see BCA Emerging Markets Strategy Weekly Report, "EM And China: A Deleveraging Update," dated November 8, 2017, available at gps.bcaresearch.com. 10 This spike in net new issuance in the single month of June is equivalent to 19.8% of the total net new issuance in 2017. It is also much higher than the average monthly issuance in 2014-17 or in 2017 alone. However, since June and July have typically seen the largest spikes in new issuance, it will be critical to see if new issuance in 2018 remains elevated after July. Notably, local government bond issuance is currently divided between brand new bonds, debt swap bonds, and refinancing bonds, but the debt swap program will expire in August, and the refinancing bonds are separate, meaning that a larger share of the allowed new issuance will involve new spending. 11 The IMF expects the change in local government explicit debt this year to be 1.9 trillion RMB. That is, a rise from 16.5 trillion existing to 18.4 trillion estimated. 12 This number is derived by assuming that total debt reaches 92.2% of the debt limit in 2018, which is the share it reached in 2015 (since 2015 the share has fallen to 87.5% in 2017). However, 2015 was a year of fiscal easing, so it is not unreasonable to apply this ratio to 2018 as an upper estimate, now that the government's easing signal is clear. One reason that local governments have been increasing debt more slowly than allowed was that the central government was tightening investment restrictions, for instance on urban rail investment. Many new subway projects of second-tier cities have been suspended, and after raising the qualifications for subway and light rail, the majority of third- and fourth-tier cities were not qualified to build urban rail at all. As a result, local governments' investment intentions were dropping. Now this may change. 13 This estimate comes from the Ministry of Finance. The previous estimate was from the National Accounting Office and stood at 7 trillion RMB as of June 2013. 14 Maturities will spike in the coming years, so this policy signal suggests that further support for refinancing will be forthcoming. There are even unconfirmed rumors of a second phase of the local government debt swap program, which would cover "hidden debt." 15 We say "minimum" because we do not include projections of the impact of tax deductions, lacking details. We only estimate the headline savings to household incomes - loss to government revenues - based on the increase of the individual income tax eligibility threshold and the reduction in tax rates for different income brackets. 16 Additional fiscal measures include corporate tax cuts, R&D expense credits, VAT rebates, and reductions in various fees. 17 Please see BCA Geopolitical Strategy Monthly Report, "What Geopolitical Risks Keep Our Clients Awake?" dated March 9, 2016, available at gps.bcaresearch.com. 18 In fact it is more like 1.9 trillion due to strings attached, but a fourth or even fifth RRR cut could push it 3.5 trillion for the year, assuming the average 800 billion cut. 19 Ultimately this trend will result in tightening liquidity conditions in China, but for now forex reserves are not draining massively, while the RRR cuts are easing domestic liquidity. 20 Please see "China Said To Ease Bank Capital Rule To Free Up More Lending," Bloomberg, July 25, and "China's Central Bank Steps Up Effort To Boost Lending," August 1, 2018, available at www.bloomberg.com. 21 Please see BCA Emerging Markets Strategy Special Report, "Ms. Mea Challenges The EMS View," dated October 19, 2017, available at ems.bcaresearch.com. 22 Please see BCA Research Special Report, "China: Party Congress Ends ... So What?" dated November 2, 2017, available at bca.bcaresearch.com. 23 Please see BCA Foreign Exchange Strategy Weekly Report, "The Dollar And Risk Assets Are Beholden To China's Stimulus," dated August 3, 2018, available at fes.bcaresearch.com. 24 Please see BCA Global Investment Strategy Weekly Report, "Three Macro Paradoxes Are About To Come True," dated August 3, 2018, available at gis.bcaresearch.com. Appendix China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus?

Highlights The 2018 dollar rally is principally the consequence of the slowdown in global industrial activity and global trade, itself a reverberation of China's efforts to de-lever and reform its economy. For China, reforms and deleveraging are here to stay, suggesting the dollar rally and EM rout are not over. However, in response to U.S. President Donald Trump's trade battling, China is stimulating its economy in order to limit its own downside. The chances of miscalculation on the part of Beijing are high. This raises the risk that investors begin pricing in a much more aggressive reflation campaign. Such a reflation campaign would cause a correction in the dollar and give more lift to the current rebound in EM assets. In order to track this risk and hedge it, investors should monitor and buy a portfolio made up of iron ore, Brazilian equities, AUD/JPY, Swedish industrial equities and EM high-yield bonds. Feature Many assign the strength in the dollar this year to the Federal Reserve increasing interest rates at a faster pace than other advanced economies. While monetary divergences seems like both a historically plausible and intuitive explanation, it rings hallow. The Fed was hiking rates at a much faster pace than the rest of the world last year, yet the dollar had a horrendous 2017, falling 10%. In our view, the trend in global growth has had a much more important role in explaining the dollar's performance. When global trade and global industrial production is strong, this normally leads to a period of weakness in the dollar. The opposite also holds true; soft global growth is associated with a strong dollar (Chart I-1). Behind this relationship lies the low-beta nature of the U.S. economy. Since its economy is not as levered to exports and manufacturing as the rest of the world is, the U.S. benefits less when global growth is improving (Chart I-2). As a result, when global growth is on the up and up, investors can upgrade the economic and inflation outlook for Europe faster than they can for the U.S. In the process, long-term rate expectations rise faster in Europe than the U.S., attracting money into Europe and out of the U.S. The process can be replicated across most economies outside the U.S. This hurts the dollar. Chart I-1The Dollar Likes ##br##Poor Global Growth The Dollar Likes Poor Global Growth The Dollar Likes Poor Global Growth Chart I-2The U.S. Economy Is Less##br## Sensitive To Global Growth The Dollar And Risk Assets Are Beholden To China's Stimulus The Dollar And Risk Assets Are Beholden To China's Stimulus To understand the outlook for the greenback, it is crucial to understand the outlook for global economic activity. Many commentators have pinned the blame of slowing global growth on the back of rising protectionism. The problem with this thesis is that global growth began slowing before investors took protectionist risks seriously. Instead, in our view, the key culprit behind the global growth slowdown has been policy tightening in China. Therein lies the issue. China has slowed, and President Xi Jinping is signaling that his administration will continue to push ahead with deleveraging the Chinese economy. This should imply weaker industrial growth in China and in the rest of the world and therefore a stronger dollar. However, with protectionism on the rise, the Chinese authorities are announcing virtually every day new measures to soften the blow to the Chinese economy. This stimulus could support global growth, and hurt the dollar, at least tactically. Our Geopolitical Strategy team believes the desire to reform and de-lever the Chinese economy will ultimately prevail, and thus so will a stronger dollar. However, the growing list of stimulus measures implemented in China supports our thesis, articulated last month, that a counter-trend correction in the dollar will first materialize before the greenback rally begins anew.1 As such, we continue to recommend investors hedge their long USD bets, and that traders with a short-term horizon take advantage of a portfolio we propose in this report. China Drives Growth And Returns Differentials We have long argued that China has a disproportionate role in determining what happens to growth outside the U.S. To some extent, this argument is almost tautological: at PPP exchange rates, China produces 24% of global GDP outside the U.S. But there is more than meets the eye to this argument. China is the world largest investor, with Chinese capital investment accounting for 26% of global capital formation, or 6.5% of the world's GDP. This means that the growth rate of Chinese investment has a large direct impact on global industrial good exports around the world. There is a second-round effect as well: China is also the largest consumer of industrial commodities globally. This implies that China is the marginal consumer and thus the price-setter of many natural resources. However, commodity producers account for a large share of global capex, 10.5% from 2004 to 2017. Thus, through its impact on commodity prices, China also impacts the demand for global industrial and capital goods via the capex needs of commodity exports. This large footprint can result in some counterintuitive relationships. For example, why is it that Chinese economic variables explain so well the gyrations of French exports to Germany, its largest export market (Chart I-3)? This conundrum is explained by the fact that German economic activity is deeply affected by Chinese growth. Since German growth is the key determinant of German imports, it follows that Chinese activity plays a large role in driving French exports. This pattern gets repeated across Europe, as Germany is the leading trading partner of most European nations. China does not have the same impact on the U.S. economy (Chart I-4) as total U.S. exports only represent 13% of GDP and exports to China, a measly 0.6% of GDP. Manufacturing also only represents 11% of U.S. GDP, again limiting the impact of secondary benefits of Chinese growth on the U.S. economy. Chart I-3What Drives French Exports To Germany: China What Drives French Exports To Germany: China What Drives French Exports To Germany: China Chart I-4Chinese Growth Has Little Impact On U.S. Growth Chinese Growth Has Little Impact On U.S. Growth Chinese Growth Has Little Impact On U.S. Growth Thanks to this difference, we can spot one very useful relationship that we have highlighted to our clients for more than a year: when the Chinese authorities stimulate their economy, European growth picks up sharply vis-a-vis the U.S. (Chart I-5).2 In this optic, the growth outperformance of Europe in 2017 made perfect sense; it was a consequence of China's aggressive push to reflate after 2015. 2018 is the mirror image of 2017; European growth is underperforming as a result of China's efforts to limit growth. This also means that wherever China goes going forward, so will the growth gap between the euro area and the U.S. Chart I-5AIf European Growth Beats That ##br##Of The U.S., Thank China (I) If European Growth Beats That Of The U.S., Thank China (I) If European Growth Beats That Of The U.S., Thank China (I) Chart I-5BIf European Growth Beats That ##br##Of The U.S., Thank China (II) If European Growth Beats That Of The U.S., Thank China (II) If European Growth Beats That Of The U.S., Thank China (II) Since Chinese growth affects the distribution of economic activity around the world, China affects the distribution of rates of returns around the world as well. Nowhere is the influence of China more evident than in the spread between U.S. and global bond yields. If we accept that Chinese growth exerts a limited influence on the domestically driven U.S. economy but exerts a large impact on the rest of the world, Chinese economic fluctuations should have an implication on the relative interest rate outlook between the U.S. and the rest of the world. This is indeed the case. As Chart I-6 shows, when the growth of China's nominal manufacturing GDP slows relative to the U.S., U.S. bond yields rise relative to yields in other major economies. Since money flows where it is best treated, the impact of China on relative rates of returns and interest rates around the world should be felt in the dollar. This is also the case. When Chinese nominal manufacturing GDP growth accelerates, the dollar tends to suffer as money leaves the U.S. and finds its way into Europe, Australia, Canada, EM and so forth to take advantage of rising marginal rates of returns relative to the U.S. (Chart I-7). Chart I-6Treasurys Vs. The World Equals U.S. Nominal GDP ##br##Vs. Chinese Manufacturing Treasurys Vs. The World Equals U.S. Nominal GDP Vs. Chinese Manufacturing Treasurys Vs. The World Equals U.S. Nominal GDP Vs. Chinese Manufacturing Chart I-7The DXY Moves In Opposition##br## To Chinese Manufacturing The DXY Moves In Opposition To Chinese Manufacturing The DXY Moves In Opposition To Chinese Manufacturing Bottom Line: The U.S. economy does not benefit as much from rising Chinese economic activity as the rest of the world does. This means that U.S. relative rates of return fall when China booms and rise when China busts. This also implies that China is just as important as the Fed in determining the trend in the dollar: A strong China is associated with a weak dollar, and vice-versa. Chinese Deleveraging Is Dollar Bullish, But... Despite its large debt load, China does not have a debt problem per se. With a savings rate of 46% of GDP and a limited stock of foreign currency debt, China does not exhibit the necessary conditions to end up like Argentina or Asian economies in the late 1990s. Instead, China's problem remains misallocated capital. China's debt load has increased by USD23.6 trillion since 2008. This is a lot of capital to invest in a short time span. Poor investments have been made, resulting in excess capacity in many industries, and most crucially a collapse in total factor productivity (Chart I-8). This decline in productivity represents a real threat to China's long-term viability, especially as China's labor force is set to begin declining and its leadership wants to avoid the middle-income trap that has plagued so many EM economies in the past. In order to avoid this trap, China's long-term growth is dependent on a sustained effort to de-lever and reform. Our Geopolitical Strategy team is adamant that Xi Jinping remains committed to this agenda. Long-term growth is his priority - a luxury now made possible by his "long-term" mandate.3 The impact of reforms is most evident through the evolution of credit growth. As Chart I-9 illustrates, total social financing has been slowing. The bottom panel of Chart I-9 also illustrates that the collapse in the Chinese credit impulse has followed the implosion of bond issuance by small financial institutions. This essentially tells us that the ongoing administrative and regulatory tightening of the shadow banking system is bearing fruit: Financial institutions are curtailing their issuance of exotic instruments, which is hurting overall credit growth - even if old-school bank loans are proving resilient. Chart I-8China: Labor Force And Total Factor ##br##Productivity The Need For Reforms China: Labor Force And Total Factor Productivity The Need For Reforms China: Labor Force And Total Factor Productivity The Need For Reforms Chart I-9Deleveraging In ##br##Action Deleveraging In Action Deleveraging In Action Since credit growth is so fundamental to generating investment and supporting the country's manufacturing sector, this implies that Chinese manufacturing activity has ample downside. As a result, we would anticipate that China will continue to be a drag on the rest of the world for many more quarters. This implies that the U.S. dollar has upside, and that EM plays as well as commodity currencies are especially vulnerable. While this view seems clear, and most investors now well understand the investment ramifications of Chinese reforms and deleveraging, sand has been thrown in the wheels of this narrative. As a result, the uptrend in the dollar and the downtrend in EM assets may take a pause. Bottom Line: China needs to de-lever further and reform its economy. Without this growth strategy, the country will be stuck in the dreaded middle-income trap, as its productivity has collapsed. Since deleveraging in China means less investment and slower manufacturing sector growth, this also means that the dollar should benefit, and EM-related assets should suffer, but... ... Stimulus Is A Potent Narrative The sand in the wheels of the dollar-bullish scenario created by Chinese reforms and their retardant effect on Chinese industrial growth is, paradoxically, President Trump's trade war with China. China decided to implement reforms last year because stronger growth out of the euro area and the U.S., its two largest export markets, should have buffeted its economy against some of the deflationary consequences of deleveraging. However, if President Trump tries to limit the growth of Chinese exports to the U.S., this create yet another shock that China does not need. This makes it much more difficult for China to deal with the deflationary consequences of its own reform efforts. As a result, not only have the Chinese authorities let the yuan depreciate by 8% since April, the fastest pace of decline since the 1994 devaluation, they have also begun announcing a slew of stimulus measures over the course of recent weeks: The People's Bank of China has engaged in RMB502 billion of liquidity injections, especially through its medium-term lending facility; Three reserve requirement ratio cuts have been implemented, freeing up RMB2.8 trillion of liquidity; Local governments have been allowed to increase net new bond issuance this year by up to RMB2.2 trillion; The issuance of special purpose bonds by local governments has been accelerated; Banks with high credit quality standards can reduce provisioning for NPLs; Individual income tax cuts have been announced; And modifications to the macro prudential assessment's structural component have been announced, which will free up new lending by commercial banks. These stimulus measures are not designed to cause growth to accelerate. In fact, as Jonathan LaBerge argues in our China Investment Strategy service, they pale in comparison to the total amount of stimulus implemented in 2015, especially as back then, RMB5 trillion in credit had also been injected into the economy.4 However, a problem remains for investors. Even if these measures are far from enough to cause Chinese growth to re-accelerate, they can easily foment the following narrative: Chinese policymakers are trying to calibrate their policy response in order to support growth. However, they are human beings, and do not know a priori how much stimulus will be needed to support growth without causing credit growth to actually surge. As a result, they will push stimulus into the system until the economy responds. But once the economy responds, it will be too late, and the lagged impact of stimulus will cause a sharp rebound in credit and capex. The opacity of Chinese policy and data raises the chance that this simplification will take over the investment community. Such reversion to simplicity in the face of ambiguity and intractable complexity is a well-documented phenomenon in sociology.5 Even if this narrative is mistaken and not based in actual reality, investors who view Chinese fundamentals as bullish to the dollar and bearish to EM and commodity plays need to be ready for this eventuality. We are reluctant to close our long dollar trade based on a narrative alone. Instead, we have purchased protection by selling USD/CAD as a hedge. However, we also offer investors a mean to observe if this narrative does take hold of the market, by tracking a portfolio of assets very sensitive to the outlook for Chinese growth, and thus very sensitive to Chinese reflation. These assets are: Chinese Iron ore prices, expressed in USD; Swedish industrial equities, expressed in USD; Brazilian equities, expressed in USD; AUD/JPY; And EM high-yield bond denominated in USD. Chart I-10 illustrates the performance of a portfolio composed of these assets, weighted in such a way that they contribute equally to the variance of the portfolio. As the chart illustrates, not only is this portfolio massively oversold, suggesting there is plenty of negatives already priced into China-linked assets, it has begun to rebound. Chart I-11 illustrates that the Chinese Li-Keqiang Index of industrial activity leads this index.6 The recent rebound in the LKI already supports the idea that this portfolio could have upside in the coming months. Moreover, if investors do extrapolate that additional stimulus measures are likely to come out of Beijing, this will support even greater upside to this portfolio. Chart I-10An Index To Monitor... An Index To Monitor... An Index To Monitor... Chart I-11...Or A Vehicle To Bet On Impactful Stimulus ...Or A Vehicle To Bet On Impactful Stimulus ...Or A Vehicle To Bet On Impactful Stimulus As a result, we would go one step beyond suggesting this portfolio as a tracker for Chinese reflation. Investors should buy it. If you are bearish on the Chinese growth outlook, buying this portfolio offers protection against countertrend moves that would hurt long-dollar and short-EM bets (our preferred strategy). If, however, you are bullish on Chinese reflation, this portfolio should prove a very rewarding vehicle to implement such views. Bottom Line: Chinese reforms are a tailwind for the dollar. However, they are now confronted with the reality of trade wars, which is causing the Chinese authorities to stimulate their economy to put a floor under growth. Nevertheless, this exercise is fraught with calibration errors - a risk that market participants can easily uncover. This raises the probability that a countertrend correction in the dollar will emerge. To monitor this risk, we recommend investors track a portfolio of assets heavily influenced by Chinese growth: Iron ore, Swedish industrial equities, Brazilian stocks, AUD/JPY, and EM high-yield bonds. Moreover, if one is already long the dollar, this portfolio can also be used as a hedge against the risk created by investors pricing in large-scale Chinese stimulus. If one disagrees with our view that reforms will ultimately take primacy on stimulus, one can also use this portfolio as a high-octane way to play Chinese reflation. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Reports, titled "Time To Pause And Breathe", dated July 6, 2018 and "That Sinking Feeling" dated July 13, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, "ECB: All About China?" dated April 7, 2017, available at fes.bcaresearch.com 3 Please see Geopolitical Strategy Special Reports, titled "China: Looking Beyond The Party Congress" dated July 19, 2017, and "China: Party Congress Ends...So What?" dated November 1, 2017, both available at gps.bcaresearch.com 4 Please see China Investment Strategy Weekly Report, "China Is Easing Up On The Brake, Not Pressing The Accelerator" dated July 26, 2018, available at cis.bcaresearch.com 5 Smelser, Neil J. "The Rational and the Ambivalent in the Social Sciences: 1997 Presidential Address." American Sociological Review, vol. 63, no. 1, Feb. 1998, pp. 1-16. 6 The Li-Keqiang index is based on railways freight traffic, bank credit, and electricity output. 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: Gross Domestic Product growth underperformed expectations slightly, coming in at 4.1%, reflecting a large decline in inventories. In fact, real final sales were strong, growing at a 5.1%. The ISM manufacturing survey also came in slightly below expectations, softening to 58.1 from 60.2 in July. It is still indicative of above-trend growth. However, the Chicago PMI surprised positively, coming in at 65.5. This measure also increased form last month's reading. While the DXY was able to rally this week thanks to growing tensions between the U.S. and China, we expect the dollar to have short-term downside, as the temporary stimulus by the Chinese authorities should give an ephemeral boost to global growth, a development that would hurt the dollar. That being said, impact should ultimately prove to be transient, and the dollar. Report Links: Rhetoric Is Not Always Policy - July 27, 2018 Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn't Always Help The World - June 29, 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 the euro area has been mixed: The yearly growth of GDP underperformed expectations, coming in at 2.1%. This also represented a decrease relative to the previous quarter. However, both core and headline inflation surprised to the upside, coming in at 2.1% and 1.1% respectively. Moreover, the European Commission's economic sentiment indicator also outperformed to the upside, coming in at 112.1. However, this measure decreased from last month's reading. EUR/USD was relatively flat for most of the week until a wave of risk aversion prompted by worries of a Sino-U.S. trade war took hold of the market, lifting the dollar in the process. In a mirror image to our dollar view, we expect the euro to have upside in the next couple of months, but resume its downward trajectory by the end of the year. Report Links: Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 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: Retail sales yearly growth beat expectations, coming in at 1.5%. Moreover, the jobs-to-applicants ratio also surprised to the upside, coming in at 1.62. However, the unemployment rate surprised negatively, coming in at 2.4% and increasing from last month's number. However, this reflected an increase in the participation rate. Finally, the consumer confidence index also underperformed expectations, coming in at 43.5. USD/JPY has risen by roughly 0.5% this week after it became clear that the BoJ only marginally adjusted its policy, in a way that only confirmed its highly dovish bias. Interestingly, while the spike in JGB yields has reverberated across global bond markets, it has not been able to provide a boost for the yen. While we expect the trade-weighted yen to appreciate by the end of this year as Chinese policymakers still want China to de-lever, a period of interim weakness is possible as the PBoC tries to buffet the Chinese economy against the impact of U.S. protectionism. Report Links: Rhetoric Is Not Always Policy - July 27, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Rome Is Burning: Is It The End? - June 1, 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: The Nationwide house price index yearly growth rate outperformed expectations, coming in at 2.5%. This measure also increased relatively to last month's number. Moreover, PMI construction also surprised to the upside, coming in at 55.8, and increasing from last month's reading. However, Markit manufacturing PMI underperformed expectations, coming in at 54. GBP/USD was relatively flat this week, but ultimately experienced a large fall following the hike by the BoE as investors began to worry that the "old lady" is making a policy error that will need to be reversed. Overall, we remain negative on cable, as the ability for the BoE to continue on their hiking campaign will be limited given the current political turmoil in Britain. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 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 mixed: Building permit yearly growth outperformed expectations, coming in at 1.6%. Moreover, producer prices also surprised positively, coming in at 1.5%. However this measure decreased compared to last month's reading. Finally, the RBA Commodity Index SDR yearly growth surprised to the downside, coming in at 7.6%. AUD/USD fell this week as market wrestle with the risk to global growth created by the China-U.S. trade war. Overall, we continue to be negative on the Aussie on a cyclical basis, as this currency is the most exposed in the G10 to a slowdown in the Chinese industrial sectors. That said, a bout of stimulus in China could provide some short-term upside to AUD. Report Links: What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 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: Employment growth surprised to the upside, coming in at 0.5%. However, this measure slowed from last month's reading. Moreover, the participation rate outperformed expectations, coming in at 10.9% and increasing from last month's number. However, the unemployment rate underperformed expectations, coming in at 4.5% and increasing from last month's reading. NZD/USD experienced a large fall this week. We are negative on the NZD on a cyclical basis, as tightening by both China and the U.S. along with trade tensions will provide for a toxic cocktail for small open economies like New Zealand. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 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 mixed: Industrial production month-mon-month growth outperformed expectations, coming in at 0.5%. Moreover, Monthly GDP growth also surprised positively, coming in at an annualized rate of 0.5%. However, the Markit Manufacturing PMI underperformed expectations, coming in at 56.9. This measure also declined relative to last month's number. The CAD is the only currency that managed to appreciate against the USD this week, despite a rather pitiful performance for crude oil. This dynamics comforts in our tactical bullish stance on the loonie. In fact, this pair is our preferred vehicle to play the countertrend correction in the U.S. dollar. Meanwhile, on a cyclical basis we are positive on the Canadian dollar within the commodity complex. Not only do supply constraint within OPEC will help oil outperform base metals, but also, the BoC is the only central bank within this group that is currently lifting interest rates. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 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 mixed: The KOF leading indicator underperformed expectations, coming in at 101.1, and declining relatively to last month's reading. However, retail sales yearly growth surprised to the upside, coming in at 0.3%. Finally, the SVME Purchasing Manager's Index also surprised positively, coming in at 61.9, and increasing from last month's number. EUR/CHF has been relatively flat this week. On a long term basis, we are bullish on this cross, as inflationary pressures are still very weak in Switzerland. Therefore, the SNB will maintain its ultra-dovish stance, hurting the franc in the process. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 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 USD/NOK rallied vigorously this week. While the generalized dollar strength has been key culprit behind the depreciation of the NOK, the fall in oil prices only added fuel to the fire. Overall, we expect this cross to go up by the end of the year, as the interaction of Chinese and U.S. policy will likely push up the USD and weigh on commodities. That being said, the NOK will probably outperform within the commodity space, given that it is cheap and that supply cuts by OPEC should help oil prices on a relative basis. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 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 mixed: Retail sales yearly growth surprised to the downside, coming in at 0.2%, and declining substantially, from 3.1% last month. However, the annual growth rate of GDP outperformed expectations, coming in at very strong 3.3%. This measure stayed flat relative to the first quarter. Finally, Manufacturing PMI came in at 57.4, increasing from last month's number. USD/SEK still rallied this week as the SEK is particularly sensitive to the outlook for global growth. We are positive on the Swedish Krona on a long-term basis, as Sweden is the country in the G10 where monetary policy is most misaligned with economic fundamentals. Thus, if the Sweden continues to show strength, the Riksbank will eventually have to respond. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

According to market lore, one should never say, "It's Different This Time". But every time is always different: there is a never a previous period that perfectly matches the current environment. That is why forecasting is so difficult and why all model-based predictions should be treated with caution. Yet, some basic common sense can go a long way in helping to assess investment risks and potential rewards. As I look at the world, it looks troubled enough to warrant a very conservative investment stance, but that clearly puts me at odds with the majority of investors. In aggregate, investors and market analysts are upbeat. Major equity indexes are close to all-time highs, earnings expectations are ebullient and surveys of investor sentiment do not imply much concern about the outlook. There is a strong consensus that a U.S. recession will not occur before 2020, meaning that risk assets still have decent upside. That may indeed turn out to be true, but I can't shake off my concerns about a number of issues: The consensus may be too complacent about the timing of the next U.S. recession. The dark side of current strong growth is growing capacity pressures that warn of upside surprises for inflation and thus interest rates. Uncertainty about trade wars represents a risk to the global economic outlook beyond the direct impact of tariffs because it also gives companies a good reason to hold back on investment spending. Profit growth in the U.S. has remained much stronger than I expected, but the forces driving this performance are temporary. Rising pressures on wages suggest that labor's share of income will rise, leading to lower margins. The geopolitical environment is ugly, ranging from a shambolic Brexit process to rising populist pressures in Europe, a flaring in U.S./Iran tensions and possible disappointment with North Korea negotiations. The Debt Supercycle may be over, but global debt levels remain worryingly high in several major economies. This could become a problem in the next economic downturn. It would be easier to live with the above concerns if markets were cheap, but that is far from the case - especially in the U.S. Credit spreads in the corporate bond market are below historical averages while equities continue to trade at historically high multiples to earnings. Even if equity prices do move higher, the upside from current levels is likely to be limited. Yes, there could be a final, dramatic blow-off phase similar to that of the late 1990s, but that would be an incredibly risky period and not one that I would want to participate in. Timing The Next Recession Sad to say, economists do a very poor job of forecasting recessions. As I showed in a report published last year, the Fed has missed every recession in the past 60 years (Table 1).1 One could argue that the Fed could never publish a forecast of recession because it would be an admission of policy failure: they generally have to be seen aiming for soft landings. But private forecasters have not done any better. For example, the consensus of almost 50 private forecasters published in mid-November 2007 was that the U.S. economy would grow by 2.5% in the year to 2008 Q4.2 The reality was that the economy was then at the precipice of its worst downturn since the 1930s. Table 1Fed Economic Forecasts Versus Outcome Personal Observations On The Current Environment Personal Observations On The Current Environment The U.S. economy currently is very strong, but that often is the case just a few quarters before a recession starts. Strong growth today is not a predictor of future strong growth. As has been widely acknowledged, the yield curve has been one of the few indicators to give advance warning of economic trouble ahead. Yet, in the past, its message typically was ignored or downplayed, with the result that most forecasters stayed too bullish on the economy for too long. History is repeating itself with a flurry of reports explaining why the recent flattening of the yield curve is giving a misleading signal. The principal argument is that term premiums have been artificially depressed by the Fed's bond purchases. However, the curve has flattened even as the Fed has pulled back from quantitative easing. As usual, the flattening reflects the tightening in monetary policy and, therefore, should not be discounted. To be fair, there is still a positive slope across the curve, so this indicator is not yet flashing red. But it is headed in that direction (Chart 1). Chart 1Recession Indicators: Not Flashing Red...Yet Recession Indicators: Not Flashing Red...Yet Recession Indicators: Not Flashing Red...Yet The other series to watch closely is the Conference Board's Leading Economic Index. Typically, the annual rate of change in this index turns negative ahead of recessions, although once again, there is a history of forecasters ignoring or downplaying the message of this signal. Currently, the growth in the index is firmly in positive territory, so no alarm bells are ringing. Overall, there are no indications that a U.S. recession is imminent. At the same time, late cycle pressures and thus risks are building. Anecdotal evidence abounds of labor shortages and supply bottlenecks in a number of industries. Wage growth has stayed relatively muted given the low unemployment rate, but that is starting to change. My colleague Peter Berezin has shown compelling evidence of a "kinked" relationship between wage growth and unemployment whereby the former accelerates noticeably after the latter drops below its full employment level (Chart 2). We are at the point where wage growth should accelerate and it is significant that the 2.8% rise in the employment cost index in the year to the second quarter was the largest rise in a decade. It also should be noted that the Fed's preferred inflation measure (the core personal consumption deflator) has been running at around a 2% pace in the past three quarters, in line with its target (Chart 3). As capacity pressures build, an overshoot of 2% seems inevitable, forcing the Fed to react. Current market expectations that the funds rate will rise by only 25 basis points over the remainder of this year and by 100 basis points in 2019 are likely to prove too optimistic. Chart 2Faster Wage Growth Ahead Personal Observations On The Current Environment Personal Observations On The Current Environment Chart 3Core Inflation At The Fed's Target Core Inflation At The Fed's Target Core Inflation At The Fed's Target Admittedly, there is huge uncertainty about what interest rate level will be restrictive enough to damage growth. Historically, recessions did not occur until the fed funds rate reached at least the level of potential GDP growth. The Congressional Budget Office estimates that potential GDP growth will average around 4% over the coming year, and the funds rate probably will not reach that level in 2019. However, additional restraint is coming from the strong dollar, and lingering high debt burdens mean that rates are likely to bite at lower levels than past relationships would suggest. Chart 4U.S. Trade Performance: No Major Surprises U.S. Trade Performance: No Major Surprises U.S. Trade Performance: No Major Surprises Trade Wars Etc. President Trump appears to believe that the large U.S. trade deficit is largely a reflection of unfair trade practices. The reality is obviously more complicated, even if there is truth to the claim that the playing field with China is far from level. The key drivers of trade imbalances are relative economic growth rates and relative real exchange rates. The trend in the volume of U.S. non-oil merchandise imports has been exactly in line with that of domestic demand for goods (Chart 4). In other words, there is no indication that the U.S. is being "taken advantage of". The growth in U.S. non-oil exports has been a little on the soft side relative to overseas growth in recent years, but that occurred against the background of a rising real dollar exchange rate. Overall, the trend in the ratio of U.S. real non-oil imports to exports has broadly followed the ratio of U.S. real GDP to that of other OECD economies. The periods where the trade ratio deteriorated somewhat faster than the GDP ratio were times when the real trade-weighted dollar was strong, such as in the past few years. The irony, which seems to escape the administration, is that recent policy actions - tax cuts and efforts to boost private investment spending - are bound to further boost the trade deficit. This may partly explain the clumsy attempt to encourage the Fed to slow down its rate hikes in order to dampen the dollar's ascent. Of course, that will not work - the Fed will not be deflected from its policy course by political interference. Meanwhile, the administration's imposition of tariffs will not change the underlying drivers of the U.S. trade deficit. I have no way of knowing whether current trade skirmishes will degenerate into an all-out war. There are some glimmers of hope with the EU and U.S. promising to engage in talks about reducing trade barriers. But the more important issue is what happens with China. While China has an economic incentive to make concessions, I cannot imagine that President Xi wants to be seen as giving ground in the face of U.S. bullying. My rather unhelpful conclusion is that trade wars are a serious risk that need watching but are unforecastable at this stage. Earnings Galore, But... It's confession time. The performance of U.S. corporate earnings has been far better than I have been predicting during the past few years. In several previous reports, I argued that earnings growth was bound to slow sharply as labor's share of income eventually climbed from its historically low level. I certainly had not expected that the annual growth in S&P 500 operating earnings would average 20% in the two years to 2018 Q2 (Chart 5). In defense, my original argument was not completely wrong. Labor's share of corporate income bottomed in the third quarter of 2014 and that marked the peak in margins, based on national income data of pre-tax profits (Chart 6). Margins have fallen particularly sharply for the national income measure of non-financial profits before interest, taxes and depreciation (EBITD). I believe this is a good measure of the underlying performance of the corporate sector as it is unaffected by policy changes to taxes, depreciation rates and monetary policy. This measure of margins used to be very mean reverting but currently is still far above its historical average. Given the tightness in the labor market, there is still considerable downside in margins as wage costs edge higher. Chart 5Spectacular U.S. Earnings Growth Spectacular U.S. Earnings Growth Spectacular U.S. Earnings Growth Chart 6Profit Margins Have Peaked Profit Margins Have Peaked Profit Margins Have Peaked An unusually large gap has opened up in recent years between S&P earnings data and the national accounts numbers. While there are several definitional differences between the two datasets, this cannot explain the large divergence shown in Chart 7. The national income data are generally believed to be less susceptible to accounting gimmicks and are thus a better reflection of underlying trends. Analysts remain extraordinarily bullish on future earnings prospects. Not only are S&P 500 earnings forecast to rise a further 14% over the next 12 months, but the current expectation of 16% per annum long-run earnings growth was only exceeded at the peak of the tech bubble (Chart 8). And we know how that episode ended! Chart 7A Strange Divergence in Profit Data A Strange Divergence in Profit Data A Strange Divergence in Profit Data Chart 8Insanely Bullish Long-Term Earnings Expectations Insanely Bullish Long-Term Earnings Expectations Insanely Bullish Long-Term Earnings Expectations I am inclined to stick to my view that earnings surprises will disappoint over the next year. The impact of corporate tax cuts will disappear, and both borrowing costs and wage growth are headed higher. A marked slowdown in earnings growth will remove a major prop under the bull market. Brexit As a Brit, I am totally appalled with the Brexit fiasco. It was all so unnecessary. Yes, the EU has an intrusive bureaucracy that imposes some annoying rules and regulations on member countries. However, OECD data show that the U.K. is one of the world's least regulated economies and it scores high in the World Bank's Ease of Doing Business rankings. In other words, there is no compelling evidence that EU bureaucratic meddling has undermined business activity in the U.K. The vote for Brexit probably had more to do with immigration than anything else, and that also makes little sense given that the U.K. has a tight labor market and needs a plentiful supply of immigrant workers. History likely will dictate that former Prime Minister David Cameron's decision to call for the Brexit referendum was the U.K.'s greatest political miscalculation of the post-WWII period. Not only was the decision to hold the referendum a mistake, but it also was foolhardy to base such a momentous vote on a simple majority rather than a super-majority of at least 60%. Adjusting the referendum result by voter turnout, those backing Brexit represented only around 37% of the eligible voting public.3 Clearly, the government was unprepared for the vote result and divorce proceedings have moved ahead with no viable plan to achieve an acceptable separation. Meanwhile, the inevitable confusion has created huge uncertainty for businesses and is doing significant damage to the economy. This is not the place to get into the minutiae of the Brexit morass such as the Northern Ireland border issue and the difficulty of agreeing new trade relationships. Those have been well aired in the press and by many other commentators. My lingering hope is that the enormous challenges of coming up with a mutually acceptable deal with the EU will prove intractable, resulting in a new referendum or election that will consign the whole idea to its grave. We should not have to wait too long to discover whether that is a futile wish. Investment Strategy Chart 9The U.S. Equity Market Is Expensive The U.S. Equity Market Is Expensive The U.S. Equity Market Is Expensive Equities are still in a bull market and we are thus in a period where investors are biased to be optimistic. Bears have been discredited and the current strength of the economy gives greater credence to the market's cheerleaders. I have been in the forecasting business for long enough (45+ years) to be suitably humble about my ability to forecast where markets are headed. I am very sympathetic to the famous Keynes quote that "the market can stay irrational longer than you can stay solvent". Investors will have their own set of preferences and constraints about whether it makes sense to stay heavily invested during times when markets appear to have diverged from fundamentals. The U.S. equity market's price-earnings ratio (PER) currently is about 20% above historical averages, based on both trailing and 12-month forward earnings and more than 30% above based on cyclically-adjusted earnings (Chart 9). Yes, interest rates are low by historical standards, giving scope for higher PERs, but rates are going up and profit margins are at historically elevated levels with lots of downside potential. I fully accept that equity markets can continue to rise over the next year, beating the meagre returns available from cash and bonds. For those investors being measured by quarterly performance, it is difficult to stay on the sidelines while prices march higher. Nevertheless, I believe this is a time for caution. The perfect time for equity investing is when markets are cheap, earnings expectations are overly pessimistic and the monetary environment is highly accommodative. Currently, the opposite conditions exist: valuations are stretched, earnings expectations are euphoric and the Fed is in tightening mode. It does not seem a propitious time to be aggressive. The future is always shrouded in mist, but there currently is an unusually large number of important economic and political questions hanging over the market. These include the timing of the next recession, the related path of monetary policy, the outcome of the U.S. midterm elections, trade wars, U.S.-Sino relations and Brexit, just to name a few. The good news is that our Annual Investment Conference on September 24/25 will be tackling these issues head on with an incredible group of experts. I am looking forward to hearing, among others, from Janet Yellen on monetary policy, Leland Miller and Elizabeth Economy on China, Greg Valliere on U.S. politics, and Stephen King and Stephen Harper on global trade. It promises to be an exceptional event and I hope to see you there. Martin H. Barnes, Senior Vice President Economic Advisor mbarnes@bcaresearch.com 1 BCA Special Report "Beware The 2019 Trump Recession," March 7, 2017. Available at bca.bcaresearch.com. 2 Source: Federal Reserve Bank of Philadelphia, Survey of Professional Forecasters (www.philadelphiafed.org). 3 The referendum result was 51.9% in favor of Brexit, with a voter turnout of close to 72%.

Highlights Paradox 1: U.S. growth will slow, and this will force the Fed to raise rates MORE quickly. Paradox 2: China will try to stimulate its economy, and this will HURT commodities and other risk assets. Paradox 3: Global rebalancing will require the euro area and Japan to have LARGER current account surpluses. Feature Faulty Assumptions Investors assume that slower U.S. growth will cause the Fed to turn more dovish; efforts by China to stimulate its economy will boost market sentiment towards risk assets; and global rebalancing requires the euro area and Japan to reduce their bloated current account surpluses. In this week's report, we consider the possibility that all three assumptions are wrong. Let's start with the U.S. growth picture. U.S. Growth About To Slow? The U.S. economy grew by 4.1% in the second quarter, the fastest pace since 2014. The composition of growth was reasonably solid. Net exports boosted real GDP by 1.1 percentage points, but this was largely offset by a 1.0 point drag from a slower pace of inventory accumulation. As a result, domestic final demand increased at a robust rate of 3.9%, led by personal consumption (up 4.0%) and business fixed investment (up 7.3%). Unfortunately, the second quarter is probably as good as it gets for growth. We say this not because we expect aggregate demand growth to falter to any great degree. Quite the contrary. Consumer confidence is high and the labor market is strong, with initial unemployment claims near 49-year lows. The Bureau of Economic Analysis' latest revisions revealed a much higher personal savings rate than had been previously estimated (Chart 1). The savings rate is now well above levels that one would expect based on the ratio of household net worth-to-disposable income (Chart 2). This raises the odds that consumer spending will accelerate. Chart 1Households Are Saving More ##br##Than Previously Thought Households Are Saving More Than Previously Thought Households Are Saving More Than Previously Thought Chart 2Consumption Could Accelerate ##br##As The Savings Rate Drops Three Macro Paradoxes Are About To Come True Three Macro Paradoxes Are About To Come True Rising consumer demand will prompt businesses to expand capacity (Chart 3). Core capital goods orders surprised on the upside in June, with positive revisions made to past months. Capex intention surveys remain at elevated levels. So far, fears of a trade war have not had a major impact on business investment. Fiscal spending is also set to rise. Federal government expenditures increased by only 3.5% in Q2, far short of the 10%-plus growth rate that some forecasters were projecting. The effect of the tax cuts have also yet to make their way fully through the economy. Supply Matters Considering all these positive drivers of demand, why do we worry that growth could slow meaningfully later this year or in early 2019? The answer is that for the first time in over a decade, demand is no longer the binding constraint to growth - supply is. Today, there are fewer unemployed workers than job vacancies (Chart 4). The number of people outside the labor force who want a job is near all-time lows. Businesses are reporting increasing difficulty in finding qualified labor. Chart 3U.S. Companies Plan To Boost Capex U.S. Companies Plan To Boost Capex U.S. Companies Plan To Boost Capex Chart 4Companies Are Struggling To Fill Job Openings Companies Are Struggling To Fill Job Openings Companies Are Struggling To Fill Job Openings New business investment will add to the economy's productive capacity over time, but in the near term, the boost to aggregate demand from new investment spending will easily exceed the contribution to aggregate supply.1 The Congressional Budget Office estimates that potential real GDP growth is running at around 2%. What happens when the output gap is fully eliminated, and aggregate demand growth begins to eclipse supply growth? The answer is that inflation will rise. Instead of more output, we will see higher prices (Chart 5). Chart 5Inflationary Pressures Tend To Increase ##br##When Spare Capacity Is Absorbed Three Macro Paradoxes Are About To Come True Three Macro Paradoxes Are About To Come True Rising inflation will force the Fed to engineer an increase in real interest rates, even in the face of slower GDP growth. Such a stagflationary outcome is not good for equities, which is one reason why we downgraded our cyclical recommendation on risk assets from overweight to neutral in June. Higher-than-expected real interest rates will put upward pressure on the U.S. dollar. A stronger dollar will hurt U.S. companies with significant foreign exposure more than it hurts their domestically-oriented peers. If history is any guide, a resurgent greenback will also cause credit spreads to widen (Chart 6). Chinese Stimulus: Be Careful What You Wish For Chinese stimulus helped reignite global growth after the Global Financial Crisis and again during the 2015-2016 manufacturing downturn. With global growth slowing anew, will China once again come to the rescue? Not quite. China does not want to let its economy falter, but high debt levels, and an overvalued property market plagued by excess capacity, limit what the authorities can do (Chart 7). Chart 6A Stronger Dollar Usually Corresponds ##br##To Wider Corporate Borrowing Spreads A Stronger Dollar Usually Corresponds To Wider Corporate Borrowing Spreads A Stronger Dollar Usually Corresponds To Wider Corporate Borrowing Spreads Chart 7China: High Debt Levels Make ##br##Credit-Fueled Stimulus A Risky Proposition Three Macro Paradoxes Are About To Come True Three Macro Paradoxes Are About To Come True Granted, the government has loosened monetary policy at the margin and plans to increase fiscal spending. However, our China strategists feel these actions are more consistent with easing off the brake than pressing down on the accelerator.2 They note that the authorities continue to squeeze the shadow banking system, as evidenced by the continued deceleration in money and credit growth, as well as rising onshore spreads for the riskiest corporate bonds (Chart 8). The Specter Of Currency Wars If Chinese growth continues to decelerate, what options do the authorities have? One possibility is to double down on what they are already doing: letting the RMB slide. Chart 9 shows that the Chinese currency has weakened substantially more over the past six weeks than its prior relationship with the dollar would have suggested. Chart 8Chinese Credit Growth Has Been Slowing Chinese Credit Growth Has Been Slowing Chinese Credit Growth Has Been Slowing Chart 9The Yuan Has Weakened More Than Expected ##br##Based On the Broad Dollar Trend The Yuan Has Weakened More Than Expected Based On the Broad Dollar Trend The Yuan Has Weakened More Than Expected Based On the Broad Dollar Trend Letting the currency weaken is a risky strategy. Global financial markets went into a tizzy the last time China devalued the yuan in August 2015. The devaluation triggered significant capital outflows, arguably only compounding China's problems. This has led some commentators to conclude that the authorities would not make the same mistake again. But what if the real mistake was not that China devalued its currency, but that it did not devalue it by enough? Standard economic theory says that a country should always devalue its currency by enough to flush out expectations of a further decline. Perhaps China was simply too timid? Capital controls are tighter in China today than they were in 2015. This gives the authorities more room for maneuver. China is also waging a trade war with the United States. The U.S. exported only $188 billion of goods and services to China in 2017, a small fraction of the $524 billion in goods and services that China exported to the United States. China simply cannot win a tit-for-tat trade war with the United States. In contrast, China is better positioned to wage a currency war with the United States. The Chinese simply need to step up their purchases of U.S. Treasurys, which would drive up the value of the dollar. Efforts by China to devalue its currency would invite retaliation from the United States. However, since the Trump Administration seems keen on pursuing a protectionist trade agenda no matter what happens, the Chinese may see their decision to weaken the yuan as the least bad of all possible outcomes. Unlike traditional stimulus in the form of additional infrastructure spending and faster credit growth, a currency devaluation would roil financial markets, causing risk asset prices to plunge. Metal prices would take it on the chin, since a weaker RMB would make it more expensive for Chinese businesses to import commodities. China now consumes close to half of the world's supply of copper, zinc, nickel, aluminum, and iron ore (Chart 10). Investors should remain underweight emerging market equities relative to developed markets and shun the currencies of commodity-exporting economies. We are currently short AUD/CAD on the grounds that a China shock would hurt metal prices more than energy prices. The Canadian dollar is highly levered to the latter, while the Aussie dollar is more levered to the former. Global Rebalancing: It's Not About Getting To Zero We have argued before that China's high savings rate explains why the country has maintained a structural current account surplus, despite the economy's rapid GDP growth rate.3 Both the euro area and Japan also have an excessive savings problem, minus the mitigating effect of rapid trend growth. The euro area's excessive savings problem was masked during the nine years following the introduction of the euro by a massive credit boom across much of the region (Chart 11). Germany did not partake in that boom, but it was still able to export its excess savings to the rest of the euro area via a rising current account balance. Chart 10China Is A More Dominant Consumer ##br##Of Metals Than Oil China Is A More Dominant Consumer Of Metals Than Oil China Is A More Dominant Consumer Of Metals Than Oil Chart 11Germany Did Not Take Part ##br##In The Credit Boom Germany Did Not Take Part In The Credit Boom Germany Did Not Take Part In The Credit Boom Germany Needs A Spender Of Last Resort Chart 12 shows that Germany's current account surplus with other euro area members mirrored the country's increasing competitiveness vis-à-vis the rest of the region. In essence, the spending boom in southern Europe sucked in German exports, with German savings financing the periphery's swelling current account deficits. This is the main reason why German banks were hit so hard during the Global Financial Crisis: They were the ones who underwrote the periphery's spendthrift ways. That party ended in 2008. With the periphery no longer the spender of last resort in Europe, Germany had to find a way to export its savings to the rest of the world. But that required a cheaper currency, which Mario Draghi ultimately delivered in 2014 when he set in motion the ECB's own quantitative easing program. So where do we go from here? Germany's excess savings problem is not about to go away anytime soon. The working-age population is set to decline over the next few decades, which means that most domestically oriented businesses will have little incentive to expand capacity (Chart 13). The peripheral countries remain in belt-tightening mode. This will limit demand for German imports. Meanwhile, countries such as Spain have made significant progress in reducing unit labor costs in an effort to improve competitiveness and shift their current account balances back into surplus. Chart 12Competitiveness Gains In The 2000s Allowed ##br##Germany To Increase Its Current Account Surplus Competitiveness Gains In The 2000s Allowed Germany To Increase Its Current Account Surplus Competitiveness Gains In The 2000s Allowed Germany To Increase Its Current Account Surplus Chart 13Germans Need To Have More Children Three Macro Paradoxes Are About To Come True Three Macro Paradoxes Are About To Come True The ECB And The BOJ Can't Afford To Raise Rates The private sector financial balance in the euro area - effectively, the difference between what the private sector earns and spends - now stands near a record high (Chart 14). Fiscal policy also remains fairly tight. The IMF estimates that the euro area's cyclically-adjusted primary budget balance will be in a surplus of 0.9% of GDP in 2018-19, compared to a deficit of 3.8% of GDP in the United States (Chart 15). Chart 14Euro Area: Private Sector ##br##Balance Remains Elevated Euro Area: Private Sector Balance Remains Elevated Euro Area: Private Sector Balance Remains Elevated Chart 15The Euro Area's Fiscal Policy Is Tight The Euro Area's Fiscal Policy Is Tight The Euro Area's Fiscal Policy Is Tight If the public sector is unwilling to absorb the private sector's excess savings by running large fiscal deficits, those savings need to be exported abroad in the form of a current account surplus. Failure to do so will result in higher unemployment, and ultimately, further political upheaval. This means that the ECB has no choice other than to keep rates near rock-bottom levels in order to ensure that the euro remains cheap. Japan has been more willing than Europe to maintain large budget deficits, but the problem is that this has resulted in a huge debt-to-GDP ratio. The Japanese would like to tighten fiscal policy, starting with the consumption tax hike scheduled for October 2019. However, this may require the economy to have an even larger current account surplus, which can only be achieved if the yen weakens further. This, in turn, suggests that the Bank of Japan will not abandon its yield curve control policy anytime soon. We were not in the least bit surprised this week when Governor Kuroda poured cold water on the idea that the BoJ was contemplating raising either its short or long-term interest rate targets. The bottom line is that thinking about global imbalances solely in terms of current account positions is not enough. One should also think about the distribution of aggregate demand across the world. Countries with demand to spare such as the United States can afford to run current account deficits, while economies with insufficient demand such as the euro area and Japan should run current account surpluses. The key market implication is that interest rates will remain structurally higher in the United States, which will keep the dollar well bid. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 This is partly because it can take a while for additional capital spending to raise aggregate supply. For example, it may take a few years to build an office tower or a new factory. Corporate R&D investment may not generate tangible benefits for a long time, especially in cases where the research is focused on something complicated (i.e., the design of new computer chips or pharmaceuticals). And even if investment spending could be transformed into additional productive capacity instantaneously, aggregate demand would still rise more than aggregate supply, at least temporarily. Here is the reason: The nonresidential private-sector capital stock is about 120% of GDP in the United States. As such, a one percent increase in investment spending would raise the capital stock by four-fifths of a percentage point. Assuming a capital share of income of 40% of national income, a one percent increase in the capital stock would lift output by 0.4%. Thus, a one-dollar increase in business investment would boost aggregate demand by one dollar in the year it is undertaken, while increasing supply by only 4/5*0.4 = roughly 32 cents. 2 Please see China Investment Strategy Weekly Report, "China Is Easing Up On The Brake, Not Pressing The Accelerator," dated July 26, 2018. 3 Please see Global Investment Strategy Weekly Report, "U.S.-China Trade Spat: Is R-Star To Blame?" dated April 6, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Dear Client, This week I am sending you a Special Report written by Mark McClellan, Chief Strategist of the monthly Bank Credit Analyst. Mark deals with the implications of the U.S./Sino trade war for U.S. equity sectors. He identifies the next products to be targeted with higher tariffs on both sides of the dispute. A higher U.S. tariff wall will shield some industries from competition, but rising input costs will be widely felt because of extensive supply chains between and within industries. There is only a small handful of industries that will be winners in absolute terms. I trust you will find his report very informative. Best regards, Peter Berezin, Chief Global Strategist Global Investment Strategy Highlights In this Special Report, we shed light on the implications of the U.S./Sino trade war for U.S. equity sectors. The threat that trade action poses to the U.S. equity market is greater than in past confrontations. Perhaps most importantly, supply chains are much more extensive, globally and between the U.S. and China. Automobile Components, Electrical Equipment, Materials, Capital Goods and Consumer Durables have the most extensive supply chain networks. The USTR claims that it is being strategic in the Chinese goods it is targeting, focusing on companies that will benefit from the "Made In China 2025" initiative. The list of Chinese goods targeted in both the first and second rounds covers virtually all of the broad import categories. The only major items left for the U.S. to hit are apparel, footwear, toys and cellphones. Beijing is clearly targeting U.S. products based on politics in order to exert as much pressure on the President's party as possible. Based on a list of products that comprise the top-10 most exported goods of Red and Swing States, China will likely lift tariffs in the next rounds on civilian aircraft, computer electronics, healthcare equipment, car engines, chemicals, wood pulp, telecommunication and integrated circuits. Supply chains within and between industries and firms mean that the impact of tariffs is much broader than the direct impact on exporters and importers. We measure the relative exposure of 24 GICs equity sectors to the trade war based on their proportion of foreign-sourced revenues and the proportion of each industry's total inputs that are affected by U.S. tariffs. The Semiconductors & Semiconductor Equipment sector stands out, but the Technology & Hardware Equipment, Capital Goods, Materials, Consumer Durables & Apparel and Motor Vehicle sectors are also highly exposed to anti-trade policy action. Energy, Software, Banks and all other service sectors are much less exposed. China may also attempt to disrupt supply chains via non-tariff barriers, placing even more pressure on U.S. firms that have invested heavily in China. Wholesale Trade, Chemicals, Transportation Equipment, Computers & Electronic Parts and Finance & Insurance are most exposed. U.S. technology companies are particularly vulnerable to an escalating trade war. Virtually all U.S. manufacturing industries will be negatively affected by an ongoing trade war, even defensive sectors such as Consumer Staples. The one exception is defense manufacturers, where we recommend overweight positions. Our analysis highlights that the best shelter from a trade war can be found in services, particularly services that are insulated from trade. Financial Services appears a logical choice, and the S&P Financial Exchanges & Data subsector is one of our favorites. Feature The trade skirmish is transitioning to a full-on trade war. The U.S. has imposed a 25% tariff on $50 billion worth of Chinese goods, and has proposed a 10% levy on an additional $200 billion of imports by August 31. China retaliated with tariffs on $50 billion of imports from the U.S., but Trump has threatened tariffs on another $300 billion if China refuses to back down. That would add up to over $500 billion in Chinese goods and services that could be subject to tariffs, only slightly less than the total amount that China exported to the U.S. last year. BCA's Geopolitical Strategy has emphasized that President Trump is unconstrained on trade policy, giving him leeway to be tougher than the market expects.1 This is especially the case with respect to China. There will be strong pushback from Congress and the U.S. business lobby if the Administration tries to cancel NAFTA. In contrast, Congress is also demanding that the Administration be tough on China because it plays well with voters. Trump is a prisoner of his own tough pre-election campaign rhetoric against China. The U.S. primary economic goal is not to equalize tariffs but to open market access.2 The strategic goal is much larger. The U.S. wants to see China's rate of technological development slow down. Washington will expect robust guarantees to protect intellectual property and proprietary technology before it dials down the pressure on Beijing. The threat that the trade war poses to the U.S. equity market is greater than in past confrontations, such as that between Japan and the U.S. in the late 1980s. First, stocks are more expensive today. Second, interest rates are much lower, limiting how much central banks can react to adverse shocks. Third, and perhaps most importantly, supply chains are much more extensive, globally and between China and the U.S. Nearly every major S&P 500 multinational corporation is in some way exposed to these supply chains. Chart 1 shows that Automobile Components, Electrical Equipment, Materials, Capital Goods and Consumer Durables have the most extensive supply chain networks. The Global Value Chain Participation rate, constructed by the OECD, is a measure of cross-border value-added linkages.3 Chart 1Measuring Global Supply Chains U.S. Equity Sectors: Trade War Winners And Losers U.S. Equity Sectors: Trade War Winners And Losers In this Special Report, we shed light on the implications of the trade war for U.S. equity sectors. Complex industrial interactions make it difficult to be precise in identifying the winners and losers of a trade war. Nonetheless, we can identify the industries most and least exposed to a further rise in tariff walls or non-tariff barriers to trade. We focus on the U.S./Sino trade dispute in this Special Report, leaving the implications of a potential trade war with Europe and the possible failure of NAFTA negotiations for future research. Trade Channels There are at least five channels through which rising tariffs can affect U.S. industry: 1. The Direct Effect: This can be positive or negative. The impact is positive for those industries that do not export much but are provided relief from stiff import competition via higher import tariffs. The impact is negative for those firms facing higher tariffs on their exports, as well as for those firms facing higher costs for imported inputs to their production process. These firms would be forced to absorb some of the tariff via lower profit margins. Some industries will fall into both positive and negative camps. U.S. washing machines are a good example. Whirlpool's stock price jumped after President Trump announced an import tariff on washing machines, but it subsequently fell back when the Administration imposed an import tariff on steel and aluminum (that are used in the production of washing machines); 2. Indirect Effect: The higher costs for imported goods are passed along the supply chain within an industry and to other industries that are not directly affected by rising tariffs. This will undermine profit margins in these indirectly-affected industries to the extent that they cannot fully pass along the higher input costs; 3. Foreign Direct Investment: Some Chinese exports emanate from U.S. multinationals' subsidiaries in China, or by Chinese or foreign OEM suppliers for U.S. firms. Even though it would undermine China's economy to some extent, the Chinese authorities could make life more difficult for these firms in retaliation for U.S. tariffs on Chinese goods. 4. Macro Effect: A trade war would take a toll on global trade and reduce GDP growth globally. Besides the negative effect of uncertainty on business confidence and, thus, capital spending, rising prices for both consumer and capital goods will reduce the volume of spending in both cases. Moreover, corporate profits have a high beta with respect to economic activity. We would not rule out a U.S. recession in a worst-case scenario. Obviously, a recession or economic slowdown would inflict the most pain on the cyclical parts of the S&P 500 relative to the non-cyclicals, in typical fashion. 5. Currency Effect: To the extent that a trade war pushes up the dollar relative to the other currencies, it would undermine export-oriented industries and benefit those that import. However, while we are bullish the dollar due to diverging monetary policy, the dollar may not benefit much from trade friction given retaliatory tariff increases by other countries. Some of the direct and indirect impact can be mitigated to the extent that importers facing higher prices for Chinese goods shift to similarly-priced foreign producers outside of China. Nonetheless, this adjustment will not be costless as there may be insufficient supply capacity outside of China, leading to upward pressure on prices globally. Targeted Sectors: (I) U.S. Tariffs On Chinese Goods As noted above, the U.S. has already imposed tariffs on $50 billion of Chinese imports and has published a list of another $200 billion of goods that are being considered for a 10% tariff in the second round of the trade war. The first round focused on intermediate and capital goods, while the second round includes consumer final demand categories such as furniture, air conditioners and refrigerators. The latter will show up as higher prices at retailers such as Wal Mart, having a direct and visible impact on U.S. households. Appendix Table 1 lists the goods that are on the first and second round lists, grouped according to the U.S. equity sectors in the S&P 500. The U.S. Trade Representative (USTR) claims that the Chinese items are being targeted strategically. It is focusing on companies that will benefit from China's structural policies, such as the "Made In China 2025" initiative that is designed to make the country a world leader in high-tech areas (see below). Table 1 reveals the relative size of the broad categories of U.S. imports from China, based on trade categories. The top of the table is dominated by Motor Vehicles, Machinery, Telecommunication Equipment, Computers, Apparel & Footwear and other manufactured goods. The list of Chinese goods targeted in both the first and second rounds covers virtually all of the broad categories in Table 1. The only major items left for the U.S. to hit are Apparel and Footwear, as well as two subcategories; Toys and Cellphones. These are all consumer demand categories. Table 1U.S. Imports From China (January-May 2018) U.S. Equity Sectors: Trade War Winners And Losers U.S. Equity Sectors: Trade War Winners And Losers (II) Chinese Tariffs On U.S. Goods Total U.S. exports to China were less than $53 billion in the first five months of 2018, limiting the amount of direct retaliation that China can undertake (Table 2). The list of individual U.S. products that China has targeted so far is long, but we have condensed it into the broad categories shown in Table 3. The U.S. equity sectors that the new tariffs affect so far include Food, Beverage & Tobacco, Automobiles & Components, Materials and Energy. China has concentrated mainly on final goods in a politically strategic manner, such as Trump-supported rural areas and Harley Davidson bikes whose operations are based in Paul Ryan's home district in Wisconsin. Table 2U.S. Exports To China (January-May 2018) U.S. Equity Sectors: Trade War Winners And Losers U.S. Equity Sectors: Trade War Winners And Losers Table 3China Tariffs On U.S. Goods U.S. Equity Sectors: Trade War Winners And Losers U.S. Equity Sectors: Trade War Winners And Losers What will China target next? Chart 2 shows exports to China as percent of total state exports, and Chart 3 presents the value of products already tariffed by China as a percent of state exports. Other than Washington, the four states most targeted by Beijing are conservative: Alaska, Alabama, Louisiana and South Carolina. Chart 2U.S. Exports To China By State U.S. Equity Sectors: Trade War Winners And Losers U.S. Equity Sectors: Trade War Winners And Losers Chart 3Value Of U.S. Products Tariffed By China (By State) U.S. Equity Sectors: Trade War Winners And Losers U.S. Equity Sectors: Trade War Winners And Losers Beijing is clearly targeting products based on politics in order to exert as much pressure on the President's party as possible. To identify the next items to be targeted, we constructed a list of products that comprise the top-10 most exported goods of Red States (solidly conservative) and Swing States (competitive states that can go either to Republican or Democratic politicians). Appendix Tables 2 and 3 show this list of products, with those that have already been flagged by China for tariffs crossed out. Table 4 shows the top-10 list of products that are not yet tariffed by China, but are distributed in a large proportion of Red and Swing states. What strikes us immediately is how important aircraft exports are to a large number of Swing and Red States. In total, 27 U.S. states export civilian aircraft, engines and parts to China. This is an obvious target of Beijing's retaliation. In addition, we believe that computer electronics, healthcare equipment, car engines, chemicals, wood pulp, telecommunication and integrated circuits are next. Table 4Number Of U.S. States Exporting To China By Category U.S. Equity Sectors: Trade War Winners And Losers U.S. Equity Sectors: Trade War Winners And Losers Market Reaction Chart 4 highlights how U.S. equity sectors performed during seven separate days when the S&P 500 suffered notable losses due to heightened fears of protectionism. Cyclical sectors such as Industrials and Materials fared worse during days of rising protectionist angst. Financials also generally underperformed, largely because such days saw a flattening of the yield curve. Tech, Health Care, Energy and Telecom performed broadly in line with the S&P 500. Consumer Staples outperformed the market, but still declined in absolute terms. Utilities and Real Estate were the only two sectors that saw absolute price gains. Chart 4S&P 500: Impact Of Trade-Related Events U.S. Equity Sectors: Trade War Winners And Losers U.S. Equity Sectors: Trade War Winners And Losers The market reaction seems sensible based on the industries caught in the cross-hairs of the trade action so far. At least some of the potential damage is already discounted in equity prices. Nonetheless, it is useful to take a closer look at the underlying factors that should determine the ultimate winners and losers from additional salvos in the trade war. Determining The Winners And Losers The U.S. sectors that garner the largest proportion of total revenues from outside the U.S. are obviously the most exposed to a trade war. For the 24 level 2 GICS sectors in the S&P 500, Table 5 presents the proportion of total revenues that is generated from operations outside the U.S. for the top five companies in the sector by market cap. Company reporting makes it difficult in some cases to identify the exact revenue amount coming from outside the U.S., as some companies regard "domestic" earnings as anything generated in North America. Nonetheless, we believe the data in Table 5 provide a reasonably accurate picture. Table 5Foreign Revenue Exposure (2017) U.S. Equity Sectors: Trade War Winners And Losers U.S. Equity Sectors: Trade War Winners And Losers Semiconductors, Tech Equipment, Materials, Food & Beverage, Software and Capital Goods are at the top of the list in terms of foreign-sourced revenues. Not surprisingly, service industries like Real Estate, Banking, Utilities and Telecommunications Services are at the bottom of the exposure list. U.S. companies are also exposed to U.S. tariffs that lift the price of imported inputs to the production process. This can occur directly when firm A imports a good from abroad, and indirectly, when firm A sells its intermediate good to firm B at a higher price, and then on to firm C. In order to capture the entire process, we used the information contained in the Bureau of Economic Analysis' Input/Output tables. We estimated the proportion of each industry's total inputs that are affected by already-implemented U.S. tariffs and those that are on the list for the next round of tariffs. These estimates, shown in Appendix Table 4 at a detailed industrial level, include both the direct and indirect effects of higher import costs. At the top of the list is Motor Vehicles and Parts, where Trump tariffs could affect more than 70% of the cost of all material inputs to the production process. Electrical Equipment, Machinery and other materials industries are also high on the list, together with Furniture, Computers & Electronic Parts and Construction. Unsurprisingly, service industries and Utilities are in the bottom half of the table.4 We then allocated all the industries in Appendix Table 4 to the 24 GICs level 2 sectors in the S&P 500, in order to obtain an import exposure ranking in S&P sector space (Table 6). Chart 5 presents a scatter diagram that compares import tariff exposure (horizontal axis) with foreign revenue exposure (vertical axis). The industries clustered in the top-right of the diagram are the most exposed to a trade war. Table 6U.S. Import Tariff Exposure U.S. Equity Sectors: Trade War Winners And Losers U.S. Equity Sectors: Trade War Winners And Losers Chart 5U.S. Industrial Exposure To A Trade War With China U.S. Equity Sectors: Trade War Winners And Losers U.S. Equity Sectors: Trade War Winners And Losers The Semiconductors & Semiconductor Equipment sector stands out by this metric, but the Technology & Hardware Equipment, Capital Goods, Materials, Consumer Durables & Apparel and Motor Vehicle sectors are also highly exposed to anti-trade policy action. Energy, Software, Banks and all other service sectors are much less exposed. Food, Beverage & Tobacco lies between the two extremes. Joint Ventures And FDI Table 7Stock Of U.S. Direct Investment In China (2017) U.S. Equity Sectors: Trade War Winners And Losers U.S. Equity Sectors: Trade War Winners And Losers As mentioned above, most U.S. production taking place in China involves a joint venture. The Chinese authorities could attempt to disrupt the supply chain of a U.S. company by hindering production at companies that have ties to U.S. firms. Data on U.S. foreign direct investment (FDI) in China will be indicative of the industries that are most exposed to this form of retaliation. The stock of U.S. FDI in China totaled more than $107 billion last year (Table 7). At the top of the table are Wholesale Trade, Chemicals, Transportation Equipment, Computers & Electronic Parts and Finance & Insurance. Apple is a good example of a U.S. company that is exposed to non-tariff retaliation, as the iPhone is assembled in China by Foxconn for shipment globally with mostly foreign sourced parts. Our Technology sector strategists argue that U.S. technology companies are particularly vulnerable to an escalating trade war (See Box 1).5 BOX 1 The Tech Sector The U.S. has applied tariffs on the raw materials of technology products rather than finished goods so far. At a minimum, this will penalize smaller U.S. tech firms which manufacture in the U.S. and provide an incentive to move production elsewhere. Worst case, the U.S. tariffs might lead to component shortages which could have a disproportionately negative impact, especially on smaller firms. Although it has not been proposed, U.S. tariffs on finished goods would be devastating to large tech companies such as Apple, which outsources its manufacturing to China. China appears determined to have a vibrant high technology sector. The "Made In China 2025" program, for example, combines ambitious goals in supercomputers, robotics, medical devices and smart cars, while setting domestic localization targets that would favor Chinese companies over foreigners. The ZTE sanctions and the potential for enhanced export controls have had a traumatic impact on China's understanding of its relatively weak position with respect to technology. As a result, because most high-tech products are available from non-U.S. sources, Chinese engineers will likely be encouraged to design with non-U.S. components; for example, selecting a Samsung instead of a Qualcomm processor for a smartphone. Similarly, China is a major buyer of semiconductor capital equipment as it follows through with plans to scale up its semiconductor industry. Most such equipment is also available from non-U.S. vendors, and it would be understandable if these suppliers are selected given the risk which would now be associated with selecting a U.S. supplier. The U.S. is targeting Chinese made resistors, capacitors, crystals, batteries, Light Emitting Diodes (LEDs) and semiconductors with a 25% tariff. For the most part these are simple, low cost devices, which are used by the billions in high-tech devices. Nonetheless, China could limit the export of these products to deliver maximum pain, leading to a potential shortage of qualified parts. A component shortage can have a devastating impact on production since the manufacturer may not have the ability to substitute a new part or qualify a new vendor. Since the product typically won’t work unless all the right parts are installed, want of a dollar’s worth of capacitors may delay shipping a $1,000 product. Thus, the economic and profit impact of a parts shortage in the U.S. could be quite severe. Conclusions: When it comes to absolute winners in case of a trade war, we believe there are three conditions that need to be met: Relatively high domestic input costs. Relatively high domestic consumption/sales; the true beneficiaries of a tariff are those industries who are allowed to either raise prices or displace foreign competitors, with the consumer typically bearing the cost. Relatively low direct exposure to global trade - international trade flows will certainly slow in a trade war. There are very few manufacturing industries that meet all of these criteria. Within manufacturing, one would typically expect the Consumer Staples and Discretionary sectors to be the best performers. However, roughly a third of the weight of Staples is in three stocks (PG, KO and PEP) that are massively dependent on foreign sales. Moreover, a similar weight of Discretionary is in two retailers (AMZN and HD) that are dependent on imports. As such, consumer indexes do not appear a safe harbor in a trade war. Nevertheless, if the trade war morphs into a recession then consumer staples (and other defensive safe-havens) will outperform, although they will still decrease in absolute terms. Transports are an industry that has relatively high domestic labor costs and an output that is consumed virtually entirely within domestic borders. However, their reliance on global trade flows - intermodal shipping is now more than half of all rail traffic - means they almost certainly lose from a prolonged trade dispute. There is one manufacturing industry that could be at least a relative winner and perhaps an absolute winner: defense. Defense manufacturers certainly satisfy the first two criteria above, though they do have reasonably heavy foreign exposure. However, we believe high switching costs and the lack of true global competitors mean that U.S. defense company foreign sales will be resilient. After all, a NATO nation does not simply switch out of F-35 jets for the Russian or Chinese equivalent. Further, if trade friction leads to rising military tension, defense stocks should outperform. Finally, the ongoing global arms race, space race and growing cybersecurity requirements all signal that these stocks are a secular growth story, as BCA has argued in the recent past.6 Still, as highlighted by the data presented above, the best shelter from a trade war can be found in services, particularly services that are insulated from trade. Financial Services appears a logical choice, especially the S&P Financial Exchanges & Data subsector (BLBG: S5FEXD - CME, SPGI, ICE, MCO, MSCI, CBOE, NDAQ). Another appealing - and defensive - sector is Health Care Services. With effectively no foreign exposure and a low beta, these stocks would outperform in the worst-case trade war-induced recession. Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Chris Bowes, Associate Editor U.S. Equity Strategy chrisb@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 3 For more information, please see: "Global Value Chains (GVSs): United States." May 2013. OECD website. 4 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. 5 Please see BCA Technology Sector Strategy Special Report "Trade Wars And Technology," dated July 10, 2018, available at tech.bcaresearch.com 6 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. Appendix Table 1Allocating U.S. Import Tariffs To U.S. GICS Sectors U.S. Equity Sectors: Trade War Winners And Losers U.S. Equity Sectors: Trade War Winners And Losers Appendix Table 2Exports By U.S. Red States U.S. Equity Sectors: Trade War Winners And Losers U.S. Equity Sectors: Trade War Winners And Losers Appendix Table 3Exports By U.S. Swing States U.S. Equity Sectors: Trade War Winners And Losers U.S. Equity Sectors: Trade War Winners And Losers Appendix Table 4Exposure Of U.S. Industries To U.S. Import Tariffs U.S. Equity Sectors: Trade War Winners And Losers U.S. Equity Sectors: Trade War Winners And Losers Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades