Trade

Highlights The risk/reward balance for risk assets remains unappealing this month, even though our base-case outlook sees them outperforming cash and bonds over the next 6-12 months. The number of items that could take equity markets to new highs appears to fall well short of the number of potential landmines that could take markets down. Tensions vis-à-vis North Korea have eased, but the U.S./China trade war is heating up. Trump's voter base and many in Congress want the President to push China harder. Eurozone "breakup risk" has reared its ugly head once again. The Italian President is trying to install a technocratic government, but the interim between now and a likely summer election will extend the campaign period during which the two contending parties have an incentive to continue with hyperbolic fiscal proposals. The next Italian election is not a referendum on exiting the EU or Euro Area. Nonetheless, the risks posed by the Italian political situation may not have peaked, especially since Italy's economic growth appears set to slow. We are underweight both Italian government bonds and equities within global portfolios. It is also disconcerting that we have passed the point of maximum global growth momentum. We expect growth to remain above-trend in the advanced economies, but the economic data will be less supportive of global risk assets than was the case last year. One reason for the economic "soft patch" is that the Chinese economy continues to decelerate. Our indicators suggest that growth will moderate further, with negative implications for the broader emerging market complex. Dearer oil may also be starting to bite, although prices have not increased enough to derail the expansion in the developed economies. This is especially the case in the U.S., where the shale industry is gearing up. Last year's "global synchronized growth" story is showing signs of wear. While the U.S. economy will enjoy a strong rebound in the second quarter, leading economic indicators in most of the other major countries have rolled over. Similar divergences are occurring in the inflation data. The international growth and inflation decoupling is probably not over, which means that long-dollar positions should continue to pay off in the coming months. U.S. inflation is almost back to target and the FOMC signaled that an overshoot will be tolerated. Policymakers will likely transition from "normalizing" policy to targeting slower economic growth once long-term inflation expectations return to the 2.3%-2.5% range. The advanced stage of the U.S. business cycle, heightened geopolitical risks and our bias for capital preservation keep us tactically cautious on risk assets again this month. Feature The major stock indexes are struggling, even though 12-month forward earnings estimates continue to march higher (Chart I-1). One problem is that a lot of good earnings news was discounted early in the year. The number of items that could take markets to new highs appear to fall well short of the number of potential landmines that could take markets down. Not the least of which is ongoing pain in emerging markets and the return of financial stress in Eurozone debt markets. Last month's Overview highlighted the unappealing risk/reward balance for risk assets, even though our base-case outlook sees them outperforming cash and bonds over the next 6-12 months. The advanced stage of the business cycle and our bias for capital preservation motivated us to heed the recent warnings from our growth indicators and 'exit' timing checklist. We also were concerned about a raft of geopolitical tensions. Fast forward one month and the backdrop has not improved. Our Equity Scorecard Indicator edged up, but is still at a level that historically was consistent with poor returns to stocks and corporate bonds (see Chart I-1 in last month's Overview). Our 'exit' checklist is also signaling that caution is warranted (Table I-1). Meanwhile, the "global synchronized expansion" theme that helped to drive risk asset prices higher last year is beginning to unravel and trade tensions are escalating. Chart I-1Struggling To Make Headway Table I-1Exit Checklist For Risk Assets U.S./Sino Trade War Is Back? The "on again/off again" trade war between the U.S. and China is on again as we go to press. Investors breathed a sigh of relief in mid-May when the Trump Administration signaled that China's minor concessions were sufficient to avoid the imposition of onerous new tariffs. However, the proposed deal did not go down well with many in the U.S., including some in the Republican Party. The President was criticized for giving up too much in order to retain China's help in dealing with North Korea. Trump might have initially cancelled the summit with Kim in order to send a message to China that he is still prepared to play hard ball on trade, despite the North Korean situation. We expect that U.S./North Korean negotiations will soon begin, and that Pyongyang will not be a major threat to global financial markets for at least the near term. It is a different story for U.S./China relations. Trump's voter base and many in Congress on both sides of the isle want the President to push China harder. This is likely to be a headwind for risk assets at least until the U.S. mid-term elections. The Return Of Eurozone Breakup Risk Turning to the Eurozone, "breakup risk" has reared its ugly head once again. Italian President Sergio Mattarella's decision to reject a proposed cabinet minister has led to the collapse of the populist coalition between the anti-establishment Five Star Movement (M5S) and the euroskeptic League. President Mattarella's choice for interim-prime minister, Carlo Cottarelli, is unlikely to last long. It is highly unlikely that he will be able to receive parliamentary support for a technocratic mandate, given the fact that he cut government spending during a brief stint in government from 2013-14. As such, elections are likely this summer. Chart I-2Italy: No Euro Support Rebound Investors continue to fret for two reasons. First, the interim period will extend the campaign period during which both M5S and the League have an incentive to continue with hyperbolic fiscal proposals. Second, M5S has suggested that it will try to impeach Mattarella, a long and complicated process that would heighten political risk, though it will likely fail in our view. As our geopolitical strategists have emphasized throughout 2017, Italy will eventually be the source of a major global risk-off event because it is the one outstanding major European country capable of reigniting the Euro Area break-up crisis.1 While a majority of Italians support the euro, they are less supportive than any other major European country, including Greece (Chart I-2). Meanwhile a plurality of Italians is confident that the future would be brighter if Italy were an independent country outside of the EU. That said, the next election is not a referendum on exiting the EU or Euro Area. The current conflict arises from the coalition wanting to run large budget deficits in violation of Europe's Stability and Growth Pact fiscal rules. Given that the costs of attempting to exit the Euro Area are extremely severe for Italy's households and savers, and that even the Five Star Movement has moderated its previous skepticism about the euro for the time being, it is likely going to require a recession or another crisis to cause Italy seriously contemplate an exit. We are still several steps away from such a move. Nonetheless, the risks posed by the Italian political situation may not have peaked. Italy's leading economic indicator points to slowing growth, which will intensify the populist push for aggressive fiscal stimulus. We are underweight both Italian government bonds and equities within global portfolios. Global Growth Has Peaked Chart I-3Past The Point Of Max Growth Momentum It is also disconcerting that we have passed the point of maximum global growth momentum, as highlighted by the indicators shown in Chart I-3. We expect growth to remain above-trend in the advanced economies, but the economic data will be less supportive of global risk assets than was the case last year. What is behind this year's loss of momentum? First, growth in 2017 was flattered by a rebound from the oil-related manufacturing recession of 2015/16. That rebound is now topping out, while worries regarding a trade war are undoubtedly weighing on animal spirits and industrial activity. Second, the Eurozone economy was lifted last year by the previous recapitalization of parts of the banking system, which allowed some pent-up credit demand to be satiated. This growth impulse also appears to have peaked, which helps to explain the sharp drop in some of the Eurozone's key economic indicators. Still, we do not expect European growth to slip back below a trend pace on a sustained basis unless the Italian situation degenerates so much that contagion causes significantly tighter financial conditions for the entire Eurozone economy. The third factor contributing to the global growth moderation is China. The Chinese economy surged in 2017 in a lagged response to fiscal and monetary stimulus in 2016, as highlighted by the Li Keqiang Index (LKI) and import growth (Chart I-4). Both are now headed south as the policy backdrop turned less supportive. Downturns in China's credit and fiscal impulses herald a deceleration in capital spending and construction activity (Chart I-4, bottom panel). The LKI has a strong correlation with ex-tech earnings and import growth. In turn, the latter is important for the broader EM complex that trade heavily with China. Weaker Chinese import growth has also had a modest negative impact on the developed world (Chart I-5). We estimate that, for the major economies, the contribution to GDP growth of exports to China has fallen from 0.3 percentage points last year to 0.1 percentage points now.2 Japan and Australia have been hit the hardest, but the Eurozone has also been affected. Interestingly, U.S. exports to China have bucked the trend so far. Chart I-4China Growth Slowdown... Chart I-5...Is Weighing On Global Activity China is not the only story because the slowdown in global trade activity in the first quarter was broadly based (Chart I-5). Nonetheless, softer aggregate demand growth out of China helps to explain why manufacturing PMIs and industrial production growth in most of the major developed economies have cooled. Our model for the LKI is still moderating. We do not see a hard economic landing, but our analysis points to further weakening in Chinese imports and thus softness in global exports and manufacturing activity in the coming months. Oil's Impact On The Economy... Finally, oil prices are no doubt taking a bite out of consumer spending power as Brent fluctuates just below $80/bbl. Our energy experts expect the global crude market to continue tightening due to robust growth and ongoing geopolitical tensions. Chief among these are the continuing loss of Venezuelan crude production and the re-imposition of U.S. sanctions on Iran. At the same time, we expect OPEC 2.0 to keep its production cuts in place in the second half of the year. Increasing shale output will not be enough to prevent world oil prices from rising in this environment, and we expect oil prices to continue to trend higher through 2018 and into early 2019 (Chart I-6). Brent could touch $90/bbl next year. There are a few ways to gauge the size of the oil shock on the economy. Chart I-7 shows the U.S. and global 'oil bill' as a share of GDP. We believe that both the level and the rate of change are important. Price spikes, even from low levels, do not allow energy users the time to soften the blow by shifting to alternative energy sources. Chart I-6Oil: Stay Bullish Chart I-7The Oil Bill The level of the oil bill is not high by historical standards. The increase in the bill over the past year has been meaningful, both for the U.S. and at the global level, but is still a long way from the oil shocks of the 1970s. U.S. consumer spending on energy as a share of disposable income, at about 4%, is also near the lowest level observed over the past 4-5 decades (Chart I-8). The 2-year swing in this series shows that rapid increases in energy-related spending has preceded slowdowns in economic growth, even from low starting points. The swing is currently back above the zero line but, again, it is not at a level that historically was associated with a significant economic slowdown. Chart I-8Oil's Impact On U.S. Consumer Spending Moreover, the mushrooming shale oil and gas industry has altered the calculus of oil shocks for the U.S. The plunge in oil prices in 2014-16 was accompanied by a manufacturing and profit mini recession in the developed countries, providing a drag on overall GDP growth. Chart I-9 provides an estimate of the contribution to U.S. growth from the oil and gas industry. We have included capital spending and wages & salaries in the calculation, and scaled it up to include spillover effects on other industries. Chart I-9Oil's Impact On Consumer Spending And Shale The oil and gas contribution swung from +0.5 percentage points in 2012 to -0.4 percentage points in 2016. The contribution has since become only slightly positive again, but it is likely to rise further unless oil prices decline in the coming months. We have included the annual swing in consumer spending on energy as a percent of GDP in Chart I-9 (inverted) for comparison purposes. At the moment, the impact on growth from the shale industry is roughly offsetting the negative impact on consumer spending. The bottom line is that the rise in oil prices so far is enough to take the edge off of global growth, but it is not large enough to derail the expansion in the developed countries. This is especially the case in the U.S., where the shale industry is gearing up. ...And Asset Prices As for the impact on asset prices, it is important to ascertain whether rising oil prices represent more restrictive supply or expanding demand. A mild rise in oil prices might simply be a symptom of increased demand caused by accelerating global growth. Higher oil prices are thus reflective of robust demand, and thus should not be seen as a threat. In contrast, the 1970s experience shows that supply restrictions can send the economy into a tailspin. In order to separate the two drivers of prices, we regressed WTI oil prices on global oil demand, inventories and the U.S. dollar. By excluding supply-related factors such as production restrictions, the residual of the regression model gives an approximate gauge of supply shocks (panel 2, Chart I-10). This model clearly has limitations, but it also has one key benefit: it estimates not just actual disruptions in supply, but also the premium built into prices due to perceived or expected future supply disruptions. For example, the 1990 price spike appears as quite a substantial deviation from what could be explained by changes in demand alone. Similar negative supply shocks are evident in 2000 and 2008. Chart I-10Identifying Supply Shocks In The Oil Market We then examined the impact that supply shocks have on subsequent period returns for both Treasury and risk assets. We divided the Supply Shock Proxy into four quartiles corresponding to the four zones shown in Chart I-10: strong positive shock, mild positive shock, mild negative shock and strong negative shock; the last of these corresponds to the region above the upper dashed line, which we have shaded in the chart. The performance of risk assets does not vary significantly across the bottom three quartiles of the supply shock indicator (Chart I-11). However, performance drops off precipitously in the presence of a strong negative supply shock. This is consistent with the "choke point" argument: investors are initially unconcerned with a modest appreciation in oil prices. It is only when prices are driven sharply above the level consistent with the current demand backdrop that risk assets begin to discount a more pessimistic future. The total returns to the Treasury index behave in the opposite manner (Chart I-12). Treasury returns are below average when the oil shock indicator is below one (i.e. positive supply shock) and above average when oil prices rise into negative supply shock territory. In other words, an excess of oil supply is Treasury bearish, as it would tend to fuel more robust economic growth. Conversely, a supply shock that drives oil prices higher tends to be Treasury bullish. This may seem counterintuitive because higher oil prices can be inflationary and thus should be bond bearish in theory. However, large negative oil supply shocks have usually preceded recessions, which caused Treasurys to rally. Chart I-11Effect On Risk Assets Chart I-12Effect On Treasurys The model clearly shows that the drop in oil prices in 2014/15 was a positive supply shock, consistent with the oil consumption data that show demand growth was fairly stable through that period. The model indicator has moved up toward the neutral line in recent months, suggesting that the supply side of the market is tightening up, but it is still in "mild positive supply shock" territory. The latest data point available is April, which means that it does not capture the surge in oil prices over the past month. Some of the recent jump in prices is clearly related to the cancelled Iran deal and other supply-related factors, although demand continues to be supportive of prices. The implication of this model is that it will probably require a significant further surge in prices, without a corresponding ramp up in oil demand, for the model to signal that supply constraints are becoming a significant threat for risk assets. A rise in Brent above US$85 would signal trouble according to this model. As for government bonds, rising oil prices are bearish in the near term, irrespective of whether it reflects demand or supply factors. This is because of the positive correlation between oil prices and long-term inflation expectations. The oil bull phase will turn bond-bullish once it becomes clear that energy prices have hit an economic choke point. Desynchronization Last year's "global synchronized growth" story is showing signs of wear. First quarter U.S. GDP growth was underwhelming, but the long string of first-quarter disappointment points to seasonal adjustment problems. Higher frequency data are consistent with a robust rebound in the second quarter. Forward looking indicators, such as the OECD and Conference Board's Leading Economic Indicators, continue to climb. This is in contrast with some of the other major economies, such as the Eurozone, U.K., Australia and Japan (Chart I-13). First quarter real GDP growth was particularly soft in Japan and the Eurozone, and one cannot blame seasonal adjustment in these cases. Chart I-13Growth & Inflation Divergences The divergence in economic performance likely reflects Washington's fiscal stimulus that is shielding the U.S. from the global economic soft patch. Moreover, the U.S. is less exposed to the oil shock and the China slowdown than are the other major economies. Similar divergences are occurring in the inflation data. While U.S. inflation continues to drift higher, it has lost momentum in the euro area, Japan and the U.K. (Chart I-13). Renewed stresses in the Italian and Spanish bond markets have sparked a flight-to-quality in recent trading days, depressing yields in safe havens such as U.S. Treasurys and German bunds. Nonetheless, prior to that, the divergence in growth and inflation was reflected in widening bond yield spreads as U.S. Treasurys led the global yields higher. Long-term inflation expectations have risen everywhere, but real yields have increased the most in the U.S. (prior to the flight-to-quality bond rally at the end of May). This is consistent with the growth divergence story and with our country bond allocation: overweight the U.K., Australia and Japan, and underweight U.S. Treasurys within hedged global portfolios. The dollar lagged earlier this year, but is finally catching up to the widening in interest rate spreads. The international growth and inflation decoupling is probably not over, which means that long-dollar positions should continue to pay off in the coming months. Expect More Pain In EM Dollar strength and rising U.S. bond yields are a classic late-cycle combination that often spells trouble for emerging market assets. We do not see the recent selloff across EM asset classes as a buying opportunity since markets have only entered the first stage of the classic final chapter; EM assets underperform as U.S. bond yields and the dollar rise, but commodity prices are resilient. In the second phase, U.S. bond yields top out, but the U.S. dollar continues to firm and commodity prices begin their descent. If the current slowdown in Chinese growth continues, as we expect, it will begin to weigh on non-oil commodity prices. Thus, emerging economies may have to deal with a deadly combination of rising U.S. interest rates, a stronger greenback, falling commodity prices and slowing exports to China (Chart I-14). Which countries are most exposed to lower foreign funding? BCA's Emerging Market Strategy services has ranked EM countries based on foreign funding requirements (Chart I-15). The latter is calculated as the current account balance plus foreign debt that is due in the coming months. Chart I-14EM Currencies Exposed To China Slowdown Chart I-15Vulnerability Ranking: Dependence On Foreign Funding Turkey, Malaysia, Peru and Chile have the heaviest foreign funding requirements in the next six months. These mostly stem from foreign debt obligations by their banks and companies. Even though most companies and banks with foreign debt will not default, their credit spreads will likely widen as it becomes more difficult to service the foreign debt.3 It is too early to build positions even in Turkish assets. Our EM strategists believe that it will require an additional 15% depreciation in the lira versus an equal-weighted basket of the dollar and euro, in combination with 200-250 basis points hike in the policy rate, and a 20% drop in share prices in local currency terms, to create a buying opportunity in Turkish financial instruments. FOMC Expects Inflation Overshoot Escalating turmoil in EM financial markets could potentially lead the Federal Reserve to put the rate hike campaign on hold. However, that would require some signs of either domestic financial stress or slowing growth. The FOMC is monitoring stress in emerging markets and in the Eurozone, but is sticking with its "gradual" tightening pace for now (i.e. 25 basis points per quarter). May's FOMC minutes signaled a rate hike in June. However, the minutes did not suggest that the Fed is getting more hawkish, despite the Staff's forecast that growth will remain above trend and that the labor market will continue to tighten at a time when core inflation is already pretty much back to target. Some inflation indicators, such as the New York Fed's Inflation Gauge, suggest that core inflation will overshoot. The minutes signaled that policymakers are generally comfortable with a modest overshoot of the 2% inflation target because many see it as necessary in order to shift long-term inflation expectations higher, into a range that is consistent with meeting the 2% inflation target on a "sustained" basis (we estimate this range to be 2.3-2.5% for the 10-year inflation breakeven rate). The fact that the FOMC took a fairly dovish tone and did not try to guide rate expectations higher contributed to some retracement of the Treasury selloff in recent weeks. Nonetheless, an inflation overshoot and rising inflation expectations will ultimately be bond-bearish, especially when the FOMC is forced to clamp down on growth as long-term inflation expectations reach the target range. As discussed in BCA's Outlook 2018, one of our key themes for the year is that risk assets are on a collision course with monetary policy because the FOMC will eventually have to transition from simply removing accommodation to targeting slower growth. Timing that transition will be difficult, and depends importantly on how much of an inflation overshoot the FOMC is prepared to tolerate. Is 2½% reasonable? Or could inflation go to 3%? The makeup of the FOMC has changed, but we expect Janet L. Yellen4 to shed light on this question when she speaks at the BCA Annual Investment Conference in September. Investment Conclusions The risks facing investors have shifted, but we do not feel any less cautious than we did last month. Geopolitical tensions vis-à-vis North Korea have perhaps eased. But trade tensions are escalating and investors are suddenly faced with another chapter in the Eurozone financial crisis. The major fear in the first and second chapters was that bond investors would attack Italy, given the sheer size of that economy and the size of Italian government debt. That dreadful day has arrived. The profit backdrop in the major economies remains constructive for equity markets. However, even there, the bloom is coming off the rose. Global growth is no longer synchronized and the advanced economies have hit a soft patch with the possible exception of the U.S. While far from disastrous, our short-term profit models appear to be peaking across the major countries (Chart I-16). Chart I-16Profit Growth: Solid, But Peaking The typical U.S. late cycle dynamics are also threatening emerging markets, at a time when investors are generally overweight and many EM countries have accumulated a pile of debt. U.S. inflation is set to overshoot the target, the FOMC is tightening and the dollar is rising. Throw in slowing Chinese demand and the EM space looks highly vulnerable. If the global economic slowdown is pronounced and drags the U.S. down with it, then bonds will rally and risk assets will take a hit. If, instead, the soft patch is short-lived and growth re-accelerates, then the U.S. Treasury bear market will resume. Stock indexes and corporate bond excess returns would enjoy one last upleg in this scenario, but downside risks would escalate once the Fed begins to target slower economic growth. Either way, EM assets would be hit. Our base case remains that stocks will beat government bonds and cash on a 6-12 month horizon. However, the risk/reward balance is unattractive given the geopolitical backdrop. Thus, we remain tactically cautious on risk assets for the near term. We still expect that the 10-year Treasury yield will peak at close to 3½% before this economic expansion is over. Nonetheless, this would require a calming of geopolitical tensions and an upturn in the growth indicators in the developed world. The risk/reward tradeoff for corporate bonds is no better than for equities and we urge caution in the near term. On a 6-12 month cyclical horizon, we still expect corporate bonds to outperform government bonds, at least in the U.S. European corporates are subject to the ebb and flow of the Italian bond crisis, and face the added risk that the ECB will likely end its QE program later this year. Looking further ahead, this month's Special Report, beginning on page 19, analyzes the Eurozone corporate sector's vulnerability to the end of the cycle that includes rising interest rates and, ultimately, a recession. We find that domestic issuers into the Eurozone market are far less exposed than are foreign issuers. Mark McClellan Senior Vice President The Bank Credit Analyst May 31, 2018 Next Report: June 28, 2018 1 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 2016, available on gps.bcaresearch.com 2 This underestimates the impact on the major countries because it does not account for third country effects (i.e. trade with other countries that trade with China). 3 For more information, please see BCA Emerging Market Strategy Weekly Report, "The Dollar Rally And China's Imports," dated May 24, 2018, available on ems.bcaresearch.com 4 Janet L. Yellen, Chair, Board of Governors, Federal Reserve System (2014-2018). II. Leverage And Sensitivity To Rising Rates: The Eurozone Corporate Sector As interest rates rise, investors are looking for the leveraged pressure points in the global economy to identify the sectors most likely to show strain. We previously identified the U.S. corporate bond market as a definite candidate. This month we look at European corporates. European corporations are still well behind the U.S. in the leveraging cycle. Relative trends in corporate financial health have generally favored European credit quality relative to U.S. issuers. Below the surface, balance sheet repair in the Eurozone has been concentrated in domestic issuers; financial trends among foreign issuers have resembled those in the U.S. market. Foreign issuers are much more vulnerable to higher interest rates and an economic downturn. Interest- and debt-coverage ratios are likely to fall to levels that will spark a raft of downgrades for foreign firms issuing into the Eurozone market, in the event that interest rates rise and a recession follows. Investors should concentrate their European corporate bond portfolios in domestic securities. That said, trends in financial health are unlikely to be the key driver of corporate bond relative returns this year. More important will be the end of the ECB's asset purchase program. We recommend an underweight position in Eurozone IG and HY relative to Eurozone government bonds, and relative to U.S. corporates. Risk assets remain on a collision course with monetary policy, which is the main reason why the "return of vol" is a key theme in the BCA 2018 Outlook. In the U.S., rising inflation is expected to limit the FOMC's ability to cushion soft patches in the economic data or negative shocks from abroad. We expect that ECB tapering will add to market stress, especially now that Eurozone breakup risks are again a concern. We also believe that geopolitics will remain a major source of uncertainty and volatility. All this comes at a time when corporate bond spreads offer only a thin buffer against bad news. On a positive note, we remain upbeat on the earnings outlook in the major countries. The U.S. recession that we foresaw in 2019 has been delayed into 2020 by fiscal stimulus. The longer runway for earnings to grow keeps us nervously overweight corporate bonds, at least in the U.S. That said, corporates are no more than a carry trade now that the lows in spreads are in place for the cycle. We are keeping a close eye on a number of indicators that will help us to time the next downgrade to our global corporate bond allocation. Profitability is just one, albeit important, aspect of the financial backdrop. What about the broader trend in financial health? Does the trend justify wider spreads even if the economy and profits hold up over the next year? We reviewed U.S. corporate financial health in the March 2018 monthly Bank Credit Analyst, using our bottom-up sample of companies. We also stress-tested these companies for higher interest rates and a medium-sized recession. We concluded that the U.S. corporate sector's heavy accumulation of debt in this expansion will result in rampant downgrade activity during the next economic downturn. As interest rates rise, investors are looking for the leveraged pressure points in the global economy to identify the sectors most likely to show strain. The U.S. corporate bond market is a definite candidate. This month we extend the analysis to the European corporate sector. The European Corporate Health Monitor The bottom-up version of the Corporate Health Monitor (CHM) is a complement to our top-down CHM, which uses macro data from the ECB to construct an index of six financial ratios for the non-financial corporate sector. While useful as an indicator of the overall trend in corporate financial health, it does not shed light on underlying trends across credit quality, countries and sectors. It also fails to distinguish between domestic versus foreign issuers in the Eurozone market. A number of features of the European market limit the bottom-up analysis to some extent relative to what we are able to do for the U.S.: the Eurozone market is significantly smaller and company data typically do not have as much history; foreign issuers comprise almost 50% of the market, a much higher percentage than in the U.S.; and the Financial sector features more prominently in the Eurozone index, but we exclude it because our CHM methodology does not lend itself well to this sector. We analyzed only domestic issuers in our study of U.S. corporate health. However, we decided to include foreign issuers in our Eurozone analysis in order to maximize the sample size. Moreover, it is appropriate for some bond investors to consider the whole picture, given that important benchmarks such as Barclay's corporate indexes include both foreign and domestic issuers. The relative composition of domestic versus foreign, investment-grade versus high-yield, and industrial sectors in our sample are comparable with the weights used in the Barclay's index. The CHM is calculated using the median value for each of six financial ratios (Table II-1). We then standardize1 the median values for the six ratios and aggregate them into a composite index using a simple average. The result is an index that fluctuates between +/- 2 standard deviations. A rising index indicates deteriorating health, while a downtrend signals improving health. We defined it this way in order to facilitate comparison with trends in corporate spreads. Table II-1Definitions Of Ratios That Go Into The CHMs One has to be careful in interpreting our Eurozone Monitor. The bottom-up version only dates back to 2005. Thus, while both the level and change in the U.S. CHM provide important information regarding balance sheet health, for the Eurozone Monitor we focus more on the change. Whether it is a little above or below the zero line is less important than the trend. Top-Down Versus Bottom-Up Chart II-1 compares the top-down and bottom-up Eurozone CHMs for the entire non-financial corporate sector.2 The levels are different, although the broad trends are similar. Key differences that help to explain the divergence include the following: the top-down CHM defines leverage to be total debt as a percent of the market value of equity, while our bottom-up CHM defines it to be total debt as a percent of the book value of the company. The second panel of Chart II-1 highlights that the two measures of leverage have diverged significantly since 2012; the top-down CHM defines profit margins as total cash flow as a percent of sales. For data-availability reasons, our bottom-up version uses operating income/total sales; and most importantly, the top-down CHM uses ECB data, which includes only companies that are domiciled in the Eurozone. Thus, it excludes foreign issuers that make up a large part of our company sample and the Barclay's index. When we recalculate the bottom-up CHM using only domestic investment-grade issuers, the result is much closer to the top-down version (Chart II-2). Both CHMs have been in 'improving health' territory since the end of the Great Financial Crisis. The erosion in the profitability components during this period was offset by declining leverage, rising liquidity and improving interest coverage for domestic issuers. Chart II-1Top-Down Vs. Bottom-Up Chart II-2Top-Down Vs. Domestic Bottom-Up It has been a different story for foreign IG issuers (Chart II-3). These firms have historically enjoyed a higher return on capital, operating margins, interest coverage, debt coverage and liquidity. Nonetheless, heavy debt accumulation has undermined their interest- and debt-coverage ratios in absolute terms and relative to their domestic peers until very recently. In other words, while domestic issuers have made an effort to clean up their balance sheets since the Great Recession, financial trends among foreign issuers look more like the trends observed in the U.S. No doubt, this is in part due to U.S. companies issuing Euro-denominated debt, but there are many other foreign issuers in our sample as well. Some analysts prefer total debt/total assets to the leverage measure we use in constructing our CHMs. However, the picture is much the same; leverage among IG domestic and foreign firms has diverged dramatically since 2010 (Chart II-4). Chart II-3Bottom-Up: Domestic Vs. Foreign IG Chart II-4Diverging Leverage Trends Over the past year or so there has been some reversal in the post-Lehman trends; domestic health has stabilized, while that of foreign issuers has improved. Leverage among foreign companies has leveled off, while margins and the liquidity ratio have bounced. The results for high-yield (HY) issuers must be taken with a grain of salt because of the small sample size. Chart II-5 highlights that the HY CHM is improving for both domestic and foreign issuers. Impressively, leverage is declining for both the domestic and foreign components. The return on capital, interest coverage, and debt coverage have also improved, although only for foreign issuers. Chart II-5Bottom-Up: Domestic Vs. Foreign HY Corporate Sensitivity The bottom line is that, while there have been some relative shifts below the surface, the European corporate sector's finances are generally in good shape in absolute terms and relative to the U.S. This is particularly the case for domestic issuers that have yet to catch the equity buyback bug. However, less accommodative monetary policy and rising borrowing rates have focused investor attention on corporate sector vulnerability. Downgrade risk will mushroom if corporate borrowing rates continue rising and, especially, if the economy contracts. If there is a recession in Europe in the next few years it will likely be as a result of a downturn in the U.S. We expect a traditional end to the U.S. business cycle; the Fed overdoes the rate hike cycle, sending the economy into a tailspin. The U.S. downturn would spill over to the rest of the world and could drag the Eurozone into a mild contraction. We estimated the change in the interest coverage ratio for the companies in our bottom-up European sample for a 100 basis-point rise in interest rates across the corporate curve, taking into consideration the maturity distribution of the debt (i.e. the coupons reset only for the bonds, notes and loans that mature in the next three years). We make the simplifying assumptions that all debt and loans maturing in the next three years are rolled over, but that companies do not take on net new obligations. We also assume that EBIT is unchanged in order to isolate the impact of higher interest rates. The 'x' in Chart II-6 denotes the result of the interest rate shock only. The 'o' combines the interest rate shock with a recession scenario, in which EBIT contracts by 15%. The interest coverage ratio declines sharply when rates rise by 100 basis points, but the ratio moves to a new post-2000 low only for foreign issuers. The ratio for domestic issuers falls back to the range that existed between 2009 and 2013. The median interest coverage ratio drops further when we combine this with a 15% earnings contraction in the recession scenario. Again, the outcome is far worse for foreign than it is for domestic issuers. Chart II-7 presents a shock to the median debt coverage ratio. Since debt coverage (cash flow divided by total debt) does not include interest payments, we show only the recession scenario result that reflects the decline in profits. Once again, foreign issuers appear to be far more exposed to an economic downturn than their domestic brethren. Chart II-6Interest Coverage Shocks Chart II-7Debt Coverage Shock Indeed, the results for foreign issuers are qualitatively similar to the shocks we previous published for our bottom-up sample of IG corporates in the U.S. (Chart II-8 and Chart II-9). In both cases, higher interest rates and contracting earnings will take the interest coverage and debt coverage ratios into uncharted territory. Chart II-8U.S. Interest Coverage Shocks Chart II-9U.S. Debt Coverage Shock Conclusions European corporations are still well behind the U.S. in the leveraging cycle. Relative trends in corporate financial health have generally favored European credit quality relative to U.S. issuers, where balance sheet activity has focused on lifting shareholder value since the last recession. Below the surface, balance sheet repair in the Eurozone has been concentrated in domestic issuers; financial trends among foreign issuers have resembled those in the U.S. market. There has been a small convergence of financial health between Eurozone domestic and foreign issuers over the past year or so, but the latter are still much more vulnerable to higher interest rates and an economic downturn. Interest- and debt-coverage ratios are likely to fall to levels that will spark a raft of downgrades for foreign firms issuing into the Eurozone market, in the event that interest rates rise and a recession follows. Investors should concentrate their European corporate bond portfolios in domestic securities. That said, trends in financial health are unlikely to be the key driver of corporate bond returns relative to European government bonds or to U.S. corporates this year. More important will be the end of the ECB's asset purchase program later in 2018. We expect spreads to widen as this important liquidity tailwind fades. For the moment, our Global Fixed Income Strategy service recommends an underweight position in Eurozone IG and HY relative to Eurozone government bonds, and relative to U.S. corporates. Mark McClellan Senior Vice President The Bank Credit Analyst 1 Standardizing involves taking the deviation of the series from the 18 quarter moving average and dividing by the standard deviation of the series. 2 Note that a rising CHM indicates deteriorating health to facilitate comparison with quality spreads. III. Indicators And Reference Charts The divergence between the U.S. corporate earnings data and our equity-related indicators continued in May. We remain cautious, despite the supportive profit backdrop. The U.S. net earnings revisions ratio fell a bit in May, but it remains well in positive territory. Forward earnings continued their ascent, and the net earnings surprise index rose further to within striking distance of the highest levels in the history of the series. Normally, an earnings backdrop this strong would justify an overweight equity allocation within a balanced portfolio. Unfortunately, a lot of good earnings news is discounted based on our Composite Valuation Indicator and extremely elevated 5-year bottom-up earnings growth expectations (see the Bank Credit Analyst Overview, May 2018). Moreover, our equity indicators are sending a cautious signal. Our U.S. Willingness-to-Pay indicator continued to decline in May. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. U.S. flows have clearly turned negative for equities, although flows into European and Japanese markets are holding up for now. Our Revealed Preference Indicator (RPI) for stocks remained on its 'sell' signal in May, for the second month in a row. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. These indicators are not aligned at the moment, further supporting the view that caution is warranted. Moreover, our composite equity Technical Indicator is on the verge of breaking down and our Monetary Indicator moved further into negative territory in May. Meanwhile, market froth has not been completely extinguished according to our Speculation Indicator (which is a negative sign for stocks from a contrary perspective). As for bonds, the powerful rally at the end of May has undermined valuation, but the 10-year Treasury is not yet in expensive territory. Our technical indicator suggests that previously oversold conditions are easing, but bonds are a long way from overbought. This means that yields have room to fall further in the event of more bad news on Italy or on the broader geopolitical scene. The dollar has not yet reached overbought territory according to our technical indicator. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights Trade war between China and U.S. is back on; President Trump is politically constrained from making a quick deal with China; Italian uncertainty will last through the summer and beyond; But bond market will eventually price profligacy over Euro Area exit, which favors bear steepening; A new election in Spain is market positive, there are no Euroskeptics in Iberia; Our tactical bearish view is playing out, stay long DXY and expect more summer volatility. Feature Geopolitical risks are rising across the board. This supports our tactically bearish view, elucidated in April.1 In this Client Note, we review our views on trade wars, Italy, and Spain. Is The U.S.-China Trade War Back On? Most relevant for global assets is that the first official salvo of the trade war between China and the U.S. has been fired: the White House announced, on May 29, tariffs on $50 billion worth of Chinese imports as well as yet-to-be-specified restrictions on Chinese investments in the U.S. and U.S. exports to China.2 We have long raised the alarm on U.S.-China relations, but President Trump threw us a curve-ball last week when Chinese and American negotiators issued a joint statement meant to soothe trade tensions. We responded that "we do not expect the truce to last long."3 Apparently it lasted merely eight days. The significance of the administration's about-face on trade is that it invalidates the conventional view that President Xi and Trump would promptly make a deal to ease tensions. Many of our clients have responded to our bearish view on Sino-American relations by suggesting that Beijing will simply offer to buy more "beef and Boeings," and that Trump will take the deal in order to declare a "quick win." The last ten days should put this view to rest. China did offer to buy more beef explicitly - with the offer of more Boeings also rumored - and yet President Trump rejected the deal. Why? Our suspicion is that President Trump was shocked by the backlash against the deal among Republicans in Congress and conservative commentators in the press. As we have argued since 2016, there is no political constraint to being tough on China on trade. This is a highly controversial view as many in the investment community agree with the narrative that the soybean lobby will prevent a trade war between the U.S. and China. President Trump's election, however, has revealed the preference of the median voter in the U.S. on trade. That preference is far less committed to free trade than previously assumed. Republicans in Congress, once staunch defenders of free trade, have therefore adjusted their policy preference, creating a political constraint to a quick deal with China. Bottom Line: Yes, the trade war is back on. We are re-opening our short China-exposed S&P 500 companies versus U.S. financials and telecoms. Is Italy Going To Leave The Euro Area? The Italian bond market is beginning to price severe geopolitical stress. The 10-year BTP spread versus German bunds has grown 98 basis points since the election (Chart 1), while the 2/10 BTP yield curve has nearly inverted (Chart 2). The latter suggests that investors are beginning to price in default risk, or rather Euro Area exit risk, over the next two years. Chart 1Probability Of Itexit Has Risen... Chart 2...But Two-Year Horizon Is Overstated We have long contended that Italy is the premier developed market political risk.4 Its level of Euroskepticism is empirically higher than that of the rest of Euro Area (Chart 3) and we have expected that Italy would eventually produce a global risk off. It is just not clear to us that this is the moment. Chart 3Italy: No Euro Support Rebound First, support for the Euro Area remains in the high 50% range and has largely bounced between 55-60% for several years. This is low relative to its Euro Area peers, prompting us to raise the alarm on Italy. But it is also still a majority, showing that Italians are not sold on leaving the Euro Area. Second, the anti-establishment Five Star Movement (M5S) has adjusted its policy towards the euro membership question in view of this polling. In other words, M5S is aware that the median Italian voter is not convinced that exiting the Euro Area is the right thing to do. We would argue that the anti-establishment parties performed well in this year's election precisely because of this strategic decision to abandon their Euroskeptic rhetoric on the currency union. Nonetheless, the deal that M5S signed to form a coalition with the far more Euroskeptic Lega was an aggressive deal that signals that Rome is preparing for a fight against Brussels, the ECB, and core Europe. The proposed tax cuts, unwinding of retirement reforms, and increases in social welfare spending would raise Italy's budget deficit from current 2.3% of GDP to above 7%. Given rules against such profligacy, and given Italy's high debt levels, the coalition might as well be proposing a Euro Area exit. There are three additional concerns aside from fiscal profligacy: New Election: President Sergio Mattarella's choice for interim prime minister - now that M5S and Lega have broken off their attempt to form a government - has no chance of gaining a majority in the current parliament. As such, the president is likely to call a new election. The leaders of M5S and the Lega, as well as the leaders of the center-left Democratic Party (DP), want the election to be held on July 29, ahead of the ferragosto holidays that shuts down the country in August.5 The market does not like the uncertainty of new election as the current M5S-Lega coalition looks likely to win again, only this time with even more seats. As such, the last thing investors want is a summer full of hyperbolic, populist, anti-establishment statements that will undoubtedly be part of the electoral campaigns. Polls: The two populist parties, M5S and the Lega, are gaining in the polls, particularly the latter, which is the more Euroskeptic (Chart 4). This suggests to investors that the more Euroskeptic approach is gaining support. Impeachment: The leader of M5S, Luigi Di Maio, has called for the impeachment of President Mattarella. Di Maio accused Mattarella of overstepping his constitutional responsibility when he denied the populist coalition's preferred candidate for economy minister, Paolo Savona. Impeachment would be a major concern for the markets as Mattarella's mandate is set to expire only in 2022, which means that he remains a considerable constraint on populism until then. Our reading is that Mattarella did not violate the constitution and that he is unlikely to be removed from power, even if the parliament does impeach him.6 Over the next month, investors will watch all three factors closely. In our view, it is positive that the election may take place over the summer - for the first time in Italy's history - as it would reduce the period of uncertainty. Second, it is understandable that investors will fret about Lega's rise in the polls. However, the closer Lega approaches M5S in the polls, the less likely the two parties will be to maintain their current coalition. At some point, it will not be in the interest of M5S to form a coalition with its chief opponent, especially if Lega gains support and therefore demands a greater share of power in the revised coalition deal. A much preferable coalition partner for M5S would be the center-left PD, which will be weaker, and hence more manageable, and would be a better ideological match. Therefore we believe that the market is getting ahead of itself. Italian policymakers are looking for a fight with Brussels, Berlin, and the ECB over fiscal room and profligacy. This is a fight that will take considerable time to resolve and should add a fiscal premium to the long-dated Italian bonds. In fact, May 29 had the biggest day-to-day selloff since 1993 (Chart 5). However, policymakers are not (yet) looking for exit from the Euro Area. As such, risk premium on the 10-year BTPs does make sense, but the sharp move on the 2-year notes is premature. Chart 4Italy's Populists Are Ascendant Chart 5Market's Reaction Is More Severe Than In 2011 Bottom Line: Italian policymakers are not looking to exit the Euro Area. Their fight with Brussels, Berlin, and the ECB will last throughout 2018 and makes it dangerous to try to "catch the falling knife" of the BTPs. However, expecting the yield curve to invert is premature as an Italian Euro Area exit over the next two years is unlikely. Over the next ten years, however, we would expect Italy to test the markets with a Euro Area exit attempt. We are sticking to our view that such an event is far more likely to occur following a recession than it is today. Is Spanish Election Threat The Same As Italy? Chart 6Spanish Election Is Market Positive Spain is having its own political crisis. The inconclusive June 2016 election produced a minority conservative government, with the center-right People's Party (PP) supported on critical matters by the center-left Socialist Party (PSOE). The leader of the PSOE, Pedro Sanchez, has decided to withdraw his support for the minority government due to alleged evidence of PP corruption, allegations that have dogged the conservatives for years. A vote of confidence on Friday could bring down the government. Why did the PSOE decide to challenge PP now? Because polls are showing that PP is in decline, as is, Podemos, the far-left party that nearly outperformed PSOE in the 2016 election (Chart 6). The greatest beneficiary of the political realignment in Spain, however, is Ciudadanos, a radically centrist and radically pro-European party that originated in Catalonia. Ciudadanos's official platform in the December 2017 regional elections in Catalonia was "Catalonia is my homeland, Spain is my country, and Europe is our future." New elections in Spain are likely to produce a highly pro-market outcome where the centrist and pro-EU Ciudadanos forms a coalition with PSOE. While such a coalition would lean towards more fiscal spending, it would not unravel the crucial structural reforms painfully implemented by Mariano Rajoy's conservative governments since 2012. It also is as far away from Euroskepticism as exists in Europe at the moment. Bottom Line: A new Spanish election would be a market-positive event. The country would have a more stable government, replacing the current minority PP government that has lost all its political capital after implementing painful structural reforms and being dogged by corruption allegations. There is no Euroskeptic political alternative in Spain at the moment. As such, we are recommending that clients go long 10-year Spanish government bonds against Italian.7 Any contagion from Italy to Spain is inappropriate politically and is a misapplied vestige of the early days of the Euro Area crisis when all peripheral bonds traded in concerto. As such, it should be faded. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Expect Volatility... Of Volatility," dated April 11, 2018, and "Are You Ready For 'Maximum Pressure?'" dated May 16, 2018, available at gps.bcaresearch.com. 2 According to the White House statement, the specific list of covered imports subjected to tariffs will be announced on June 15. 3 Please see BCA Geopolitical Strategy Weekly Report, "Some Good News (Trade), Some Bad News (Italy)," dated May 23, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 2016 and "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 5 Please see Corriere Della Sera, "Governo: cresce l'ipotesi del voto il 29 luglio. Salvini: "Al voto con Savona candidato," dated May 29, 2018, available at www.corriere.it. 6 Like in the U.S., the threshold for impeachment in Italy is low. Both chambers of parliament merely have to impeach the president with a simple majority. However, in Italy, the trial is not held in the parliament, but rather by the Constitutional Court's 15 judges and an additional 16 specially appointed judges - selected randomly. It is highly unlikely that Mattarella, himself a previous member of the court, would be found guilty, particularly since he acted in accordance with presidential powers outlined in Article 87 of the constitution ("The President shall appoint State officials in the cases provided for by the law") and in accordance with precedent (in 1994, the president then refused to appoint Silvio Berlusconi's personal lawyer as the country's minister of justice). In addition, leader of Lega, Matteo Salvini, has stated that he would not want to see Mattarella impeached. This is likely because the process has a low probability of success. Furthermore, the president cannot disband the parliament and call new elections if impeachment proceedings begin against him. 7 Please see BCA Global Fixed Income Strategy Weekly Report, "Hold, Close Or Switch: Reviewing Our Tactical Overlay Trades," dated May 29, 2018, available at gfis.bcaresearch.com.

Highlights China-U.S. trade détente goes against our alarmist forecast, prompting us to reassess the view; We do not expect the truce to last long, as China has not given the U.S. what we believe the Trump administration wants; Instead, we see the truce lasting until at least the completion of the North Korea - U.S. summit, at most early 2019; Market is correct to fret about Italy, as the populist agenda will be constrained by the bond market in due course; Stay long DXY, but close our recommendations to short China-exposed S&P 500 companies. Feature Our alarmist view on trade wars appears to be in retreat, or at least "on hold," following the conclusion of the latest trade talks between U.S. and Chinese officials. Global markets breathed a sigh of relief on Monday, after a weekend of extremely positive comments from President Trump's advisers and cabinet members. Particularly bullish were the comments from Trump's top economic adviser, Larry Kudlow, who claimed that China had agreed to reduce its massive trade surplus with the U.S. by $200 billion (Chart 1). Chart 1China, Not NAFTA, Is The Problem The official bilateral statement, subsequently published by the White House, was vague. It claimed that "there was a consensus" regarding a substantive - but unquantifiable - reduction in the U.S. trade deficit.1 The only sectors that were mentioned specifically were "United States agriculture and energy exports." China agreed to "meaningfully" increase the imports of those products, which are low value- added commodity goods. With regard to value-added exports, China merely agreed that it would encourage "expanding trade in manufactured goods and services." The two sides also agreed to "attach paramount importance to intellectual property protections," with China specifically agreeing to "advance relevant amendments to its laws and regulations in this area." Subsequent to the declaratory statement, China lowered tariffs on auto imports from 25% to 15%. It will also cut tariffs on imported car parts, to around 6%, from the current average of about 10%. Is that it? Was the consensus view - that China would merely write a check for some Boeings, beef, and crude oil - essentially right? The key bellwether for trade tensions has been the proposed tariffs on $50-$150 billion worth of goods, set to come in effect as early as May 21. According to Treasury Secretary Steven Mnuchin, this tariff action is now "on hold." Mnuchin was also supposed to announce investment restrictions by this date, another bellwether that is apparently on hold. This is objective evidence that trade tensions have probably peaked for this year.2 On the other hand, there are several reasons to remain cautious: Section 301 Investigation: Robert Lighthizer, the cantankerous U.S. Trade Representative who spearheaded the Section 301 investigation into China's trade practices that justified the abovementioned tariffs and investment restrictions, immediately issued a statement on Sunday dampening enthusiasm: "Real work still needs to be done to achieve changes in a Chinese system that facilitates forced technology transfers in order to do business in China." In the same statement, Lighthizer added that China facilitates "the theft of our companies' intellectual property and business know-how." In other words, Lighthizer does not appear to be excited by the prospect of trading IP and tech protection for additional exports of beef and crude oil. Political Reaction: The reaction from conservative circles was less than enthusiastic, with both congressional officials and various Trump supporters announcing their exasperation with the supposed deal over the weekend.3 The Wall Street Journal claimed that China refused to put a number - such as the aforementioned $200 billion - in the final statement.4 The implication is that Beijing won this round of negotiations. But President Trump will not want to appear weak. If a narrative emerges that he "lost," we would expect President Trump to pivot back to tariffs and confrontation. Support for free trade has recently rebounded among Republican voters but remains dramatically lower among them than among Democrats (Chart 2). As such, it is a salient issue for the president politically. Chart 2Support For Free Trade Recovering, ##br##But Republicans Still Trail Democrats Chart 3China Already ##br##Imports U.S. Commodities... Investment Restrictions: Senator Cornyn's (Texas, Republican) bill to strengthen the Committee on Foreign Investment in the United States (CFIUS) process continues to move through the Senate.5 The Foreign Investment Risk Review Modernization Act Of 2017 (FIRRMA) is currently being considered by the Senate Committee on Banking, Housing, and Urban Affairs and should be submitted to a vote ahead of the November election. Congress is also looking to pass a bipartisan bill that would prevent President Trump from taking it easy on Chinese telecommunication manufacturer ZTE. Chart 4U.S. Commodity Export Growth Is Solid Chart 5... But Impedes Market Access For Higher Value-Added Goods Beef And Oil Is Not Enough: The U.S. already has a growing market share in China's imports of commodities and crude materials, although it could significantly increase its exports in several categories (Chart 3). As the Chinese people develop middle-class consumption habits, the country was always going to import more agricultural products. And as their tastes matured, the U.S. was always going to benefit, given the higher quality and price point of its agricultural exports. In fact, China's imports of U.S. primary commodity exports have been increasing faster than imports of U.S. manufacturing goods (Chart 4). As such, the statement suggests that the U.S. and China have opted for the easiest compromises (commodities) to grant U.S. greater market access; the U.S. may have fallen short on market access for value-added manufacturing (Chart 5). In addition, there was little acknowledgment of the American demands that China cease forced tech transfers, cut subsidies for SOEs, reduce domestic content requirements under the "Made in China 2025" plan, and liberalize trade for U.S. software and high-tech exporters (Chart 6). Given these outstanding and unresolved issues, there are three ways to interpret the about-face in U.S. trade demands: Geopolitical Strategy is wrong: One scenario is that we are wrong, that the Trump administration is not focused on forced tech transfers and IP theft in any serious way.6 On the other hand, if that is true, the U.S. is also not serious about significantly reducing its trade deficit with China, since structurally, IP theft and non-tariff barriers to trade of high-value exports are a major reason why China has a massive surplus. Instead, the U.S. may only be focused on reducing the trade deficit through assurances of greater market access - a key demand as well, but one that could prove temporary or un-strategic, especially if access is only granted for commodities.7 If this is true, it suggests that President Trump's demands on China are transactional, not geopolitical, as we asserted in March.8 Midterms matter: Another scenario is that President Trump does not want to do anything that would hurt the momentum behind the GOP's polling ahead of the November midterms (Chart 7). The administration can always pick up the pressure on China following the election, given that 2019 is not an election year. Trump's political team may believe that Beijing concessions on agriculture, autos, and energy will be sufficient to satisfy the base until then. By mid-2019, the White House can also use twelve months of trade data to assess whether Beijing has actually made any attempt to deliver on its promises of increased imports from the U.S. Chart 6China's High-Tech Protectionism Chart 7Republicans Are Gaining... North Korea matters: Along the same vein as the midterms, there is wisdom in delaying trade action against China given the upcoming June 12 summit between President Trump and North Korean Supreme Leader Kim Jong-un in Singapore. President Trump's approval ratings began their second surge this year following the announced talks (Chart 8), and it is clear that the administration has a lot of political capital invested in the summit's success. Recent North Korean statements, suggesting that they are willing to break off dialogue, may have been the result of the surprise May 8 meeting between Chinese President Xi Jinping and Kim, the second in two months. As such, President Trump may have had to back off on the imposition of tariffs against China in order to ensure that his summit with Kim goes smoothly. At this point, it is difficult to gauge whether the decision to ease the pressure against China was due to strategic or tactical reasons. We expect that the market will price in both, easing geopolitical risk on equity markets. However, if the delay is tactical - and therefore temporary - then the risk premium would remain appropriate. We do not think that we are wrong when it comes to U.S. demands on China. These include greater market access for U.S. value-added exports and services (not just commodities), as well as a radical change in how China awards such access (i.e., ending the demand that technology transfers accompany FDI and market access). In addition, China still massively underpays for U.S. intellectual property (IP) rights and has been promising to do more on that front for decades (Chart 9). Given that China has launched some anti-piracy campaigns, and given its recent success in other top-down campaigns like shuttering excess industrial capacity, it is hard to believe that Beijing could not crack down on IP theft even more significantly. Chart 8...Thanks To Tax Cuts And Kim Jong-un Chart 9What Happened To ~$100 Billion IP Theft? Furthermore, U.S. demands on China are not merely about market access and IP. There is also the issue of aggressive geopolitical footprint in East Asia, particularly the South China Sea. The U.S. defense and intelligence establishment is growing uneasy over China's pace of economic and technological development, given its growing military aggressiveness. In fact, over the past two weeks, China has: Landed the Xian H-6K strategic bombers capable of carrying nuclear weapons on disputed "islands" in the South China Sea; Installed anti-ship cruise missiles, as well as surface-to-air missiles, on three of its outposts in disputed areas. Of course, if we are off the mark on our view of Sino-American tensions, it would mean that the Trump administration is willing to make transactional economic concessions for geopolitical maneuvering room. In other words, more crude oil and LNG exports in exchange for better Chinese positioning in vital sea and air routes in East Asia. We highly doubt that the Trump administration is making such a grand bargain, even if the rhetoric from the White House often suggests that the "America First" agenda would allow for such a strategic shift. Rather, we think the Trump administration, like the Obama administration, put the South China Sea low on the priority list, but will focus greater attention on it when is deemed necessary at some future date. Bottom Line: Trade tensions between China and the U.S. have almost assuredly peaked in a tactical, three-to-six month timeframe. While still not official, it appears that the implementation of tariffs on $50-$150 billion worth of imports from China, set for any time after May 21, is now on hold. As such, a trade war is on hold. We are closing our short China-exposed S&P 500 companies versus U.S. financials and telecoms, a trade that has returned 3.94% and long European / short U.S. industrials, which is down 2% since inception. This greatly reduces investment-relevant geopolitical risk this summer and makes us far less confident that investors should "sell in May and go away." Our tactical bearishness is therefore reduced, although several other geopolitical risks - such as Iran-U.S. tensions, Italian politics, and the U.S. midterm election- remain relevant.9 We do not think that Sino-American tensions have peaked cyclically or structurally (six months and beyond). The Trump Administration continues to lack constraints when it comes to acting tough on China. As such, investors should expect tensions to renew either right after the summit between Trump and Kim in early June or, more likely, following the November midterm elections. Italy: The Divine Comedy Continues Since 2016, we have noted that Italy remains the premier risk to European markets and politics.10 There are two reasons for the view. First, Italy has retained a higher baseline level of Euroskepticism relative to the rest of Europe (Chart 10). While support for the common currency has risen in other member states since 2013, it has remained between 55%-60% in Italy. This is unsurprising given the clearly disappointing economic performance in Italy relative to that of its Mediterranean peers (Chart 11). Chart 10Italy Remains A Relative Euroskeptic Chart 11Lagging Economy Explains Cyclical Euroskepticism Italy's Euroskepticism, however, is not merely a product of economic malaise. Chart 12 shows that a strong majority of Europeans are outright pessimistic about the future of their country outside of the EU. But when Italians are polled in that same survey, the population is increasingly growing optimistic about the option of exit (Chart 13). The only other EU member state whose citizens are as optimistic about a life outside the bloc is the U.K., where population obviously voted for Brexit. Chart 12Europeans Are Pessimists About EU Exit... Chart 13...But Italians Are More Like Brits Furthermore, Italian respondents have begun to self-identify as Italian only, not as "European" also, which breaks with another long-term trend in the rest of the continent (Chart 14) and is also reminiscent of the U.K. The second reason to worry about Italy is its economic performance. Real GDP is still 5.6% below its 2008 peak, while domestic demand continues to linger at 7.9% below its pre-GFC levels (Chart 15). As we posited at the end of 2017, the siren song of FX devaluation would become a powerful political elixir in the 2018 election, as populist policymakers blame Italy's Euro Area membership for the economic performance from Chart 15.11 Chart 14Italians Feel More Italian Chart 15Italian Demand Never Fully Recovered Is the Euro Area to blame for Italy's ills? No. The blame lies squarely at the feet of Italian policymakers, who flubbed efforts to boost collapsing productivity throughout the 1990s and 2000s (Chart 16). There was simply no pressure on politicians to enact reforms amidst the post-Maastricht Treaty convergence in borrowing costs. Italy punted reforms to its educational system, tax collection, and corporate governance. Twenty years of complacency have led to a massive loss in global market share (Chart 17). Chart 16Italy Has A Productivity Problem Chart 17Export Performance Is A Disaster While it is difficult to prove a counterfactual, we are not sure that even outright currency devaluation would have saved Italy from the onslaught of Asian manufacturing in the late 1990s. Euro Area imports from EM Asia have surged from less than 2% of total imports to nearly 10% in the last twenty years. Italy began losing market share to Asia well before the euro was introduced on January 1, 1999, as Chart 18 illustrates. The incoming populist government is unfortunately coming to power with growing global growth headwinds (Chart 19), with negative implications for Italy (Chart 20). These are likely to act as a constraint on plans by the Five Star Movement (M5S) and Lega coalition to blow out the budget deficit in pursuit of massive tax cuts, reversals of pension reforms, minimum wage hikes, and a proposal to increase spending on welfare. Our back-of-the-envelope calculation sees Italy's budget deficit growing to over 7% in 2019 if all the proposed reforms were enacted, well above the 3% limit imposed by the EU on its member states. Chart 18Italy Lost Market Share Amid Globalization Chart 19Tepid Global Growth... Chart 20...Is Bad News For Italy How would the EU Commission react to these proposals, given that Italy would break the rules of the EU Stability and Growth Pact (SGP)? We think the question is irrelevant. The process by which the EU Commission enforces the rules of the SGP is the Excessive Deficit Procedure (EDP), which would take over a year to put into place.12 First, the Commission would have to review the 2019 budget proposed by the new Italian government in September 2018. It would likely tell Rome that its plans would throw it into non-compliance with SGP rules, at which point the EU Commission would recommend the opening of a Significant Deviation Procedure (SDP). If Italy failed to follow the recommendations of the SDP, the Commission would then likely throw Italy into EDP at some point in the first quarter of 2019, or later that year.13 And what happens if Italy does not conform to the rules of the EDP? Italy would be sanctioned by the EU Commission by forcing Rome to make a non-interest-bearing deposit of 0.2% GDP.14 (Because it makes perfect sense to force a country with a large budget deficit to go into an even greater budget deficit.) Even if Rome complied with the sanctions, the punishment would only be feasible at the end of 2019, most likely at the end of Q1 2020. The point is that the above two paragraphs are academic. The Italian bond market would likely react much faster to Rome's budget proposals. The EU Commission operates on an annual and bi-annual timeline, whereas the bond market is on a minute-by-minute timeline. Given the bond market reaction thus far, it is difficult to see how Rome could be given the benefit of the doubt from investors (Chart 21). Investors have been demanding an ever-greater premium on Italian bonds, relative to their credit rating, ever since the election (Chart 22). Chart 21Uh Oh Spaghettio! Chart 22Bond Vigilantes Are Coming As such, the real question for investors is not whether the EU Commission can constrain Rome. It cannot. Rather, it is whether the bond market will. Rising borrowing costs would obviously impact the economy via several transmission channels, including overall business sentiment. But the real risk is Italy's banking sector. Domestic financial institutions hold 45% of Italian treasury bonds (BTPs) (Chart 23), which makes up 9.3% of all their assets, an amount equivalent to 77.8% of their capital and reserves (Chart 24). Foreign investors own 32%, less than they did before the Euro Area crisis, but still a significant amount. Chart 23Foreign Investors Still Hold A Third Of All Italian Debt Chart 24Italian Banks Also Hold Too Many BTPs In 2011, when the Euro Area crisis was raging, Italian 10-year yields hit 7%, or a spread of more than 500 basis points over German bunds. This was equivalent to an implied probability of a euro area breakup of 20% over the subsequent five years (Chart 25).15 What would happen if the populists in Rome followed through with their fiscal plans by September 2018 by including them in the 2019 budget? The bond market would likely begin re-pricing a similar probability of a Euro Area breakup, if not higher. In the process, Italian bonds could lose 20%-to-30% of their value - assuming that German bunds would rally on risk-aversion flows - which would result in a potential 15%-to-25% hit to Italian banks' capital and reserves. With the still large overhang of NPLs, Italian banks would be, for all intents and purposes, insolvent (Chart 26). Chart 25In 2011, Italian Spreads Signal Euro Break-Up Chart 26Italian Banks Still Carry Loads Of Bad Loans The populist government in Rome may not understand this dynamic today, but they will soon enough. This is perhaps why the leadership of both parties has decided to appoint a relatively unknown law professor, Guiseppe Conte, as prime minister. Conte is, according to the Italian press, a moderate and is not a Euroskeptic. It will fall to Conte to try to sell Europe first on as much of the M5S-Lega fiscal stimulus as he can, followed by the Italian public on why the coalition fell far short of its official promises. If the coalition pushes ahead with its promises, and ignores warnings from the bond market, we can see a re-run of the 2015 Greek crisis playing out in Italy. In that unlikely scenario, the ECB would announce publicly that it would no longer support Italian assets if Rome were determined to egregiously depart from the SGP. The populist government in Rome would try to play chicken with the ECB and its Euro Area peers, but the ATM's in the country would stop working, destroying its credibility with voters. In the end, the crisis will cause the populists to mutate into fiscally responsible Europhiles, just as the Euro Area crisis did to Greece's SYRIZA. For investors, this narrative is not a reassuring one. While our conviction level that Italy stays in the Euro Area is high, the scenario we are describing here would still lead to a significant financial crisis centered on the world's seventh-largest bond market. Bottom Line: Over the next several months, we would expect bond market jitters concerning Italy to continue, supporting our bearish view on EUR/USD, which we are currently articulating by being long the DXY (the EUR/USD cross makes up 57.6% of the DXY index). Given global growth headwinds, which are already apparent in the European economic data, and growing Italian risks, the ECB may also turn marginally more dovish for the rest of the year, which would be negative for the euro. Our baseline expectation calls for the new coalition government in Rome to back off from its most populist proposals. We expect that Italy will eventually flirt with overt Euroskepticism, but this would happen after the next recession and quite possibly only after the next election. If we are wrong, and the current populist government does not back off, then we could see a global risk-off due to Italy either later this summer, or in 2019. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see "Joint Statement of the United States and China Regarding Trade Consultations," dated May 19, 2018, available at whitehouse.gov. 2 President Trump later tweeted that the announced deal was substantive and "one of the best things to happen to our farmers in many years!" 3 The most illustrative comment may have come from Dan DiMicco, former steel industry CEO and staunch supporter of President Trump on tariffs, who tweeted "Did president just blink? China and friends appear to be carrying the day." 4 Please see Bob Davis and Lingling Wei, "China Rejects U.S. Target For Narrowing Trade Gap," The Wall Street Journal, dated May 19, 2018, available at wsj.com. 5 Please see "S. 2098 - 115th Congress: Foreign Investment Risk Review Modernization Act Of 2017," dated May 21, 2018, available at www.govtrack.us. 6 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War," dated March 6, 2018, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Weekly Report, "Are You Ready For 'Maximum Pressure?'" dated May 16, 2018; and "Expect Volatility... Of Volatility," dated April 11, 2018, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 12 Please see, The Treaty on the Functioning of the European Union, "Excessive deficit procedure (EDP)," available at eur-lex.europa.eu. 13 Have you been missing the European alphabet soup over the past three years? 14 The EU Commission can also suspend financing from the European Structural and Investment Funds (ESIF), but Italy has never participated in a bailout and thus could not be sanctioned that way. 15 Please see BCA European Investment Strategy Weekly Report, "Threats And Opportunities In The Bond Market," dated April 7, 2016, available at eis.bcaresearch.com.

Highlights The grand U.S.-China strategic negotiation is focused on Korea and trade - only Korea is seeing good news; The trade war is expanding to include investment - and Chinese capital account liberalization is the silver bullet; Capital account openness has mixed benefits for EMs, yet the risks are dire. China's policymakers will move only gradually; If Trump demands faster liberalization, a full-blown trade war is more likely; Favor DM equities over EM. Feature The American and Chinese economies have diverged for years (Chart 1), threatening to remove the constraint on broader strategic disagreements. Amidst the uncertainty, a grand U.S.-China negotiation is taking place, focused on two primary dimensions: Korea and trade. Chart 1Economic Constraint To Conflict Erodes On the Korea front, the news is mostly positive.1 The leaders of North and South Korea have held their third summit, promising an end to hostilities and a new beginning for economic engagement and possibly denuclearization. They are laying the groundwork for U.S. President Donald Trump to meet North Korean leader Kim Jong Un sometime this month, or in June. From China's point of view, the North Korean developments are mostly positive. A belligerent North Korea provides the U.S. and its allies with a reason to build up their military assets in the region, which can also serve to contain China. A calmer North Korea removes this reason and, over the long run, holds out the potential for the reduction of U.S. troops in South Korea. On net, China has benefited from the opening up of the formerly reclusive Vietnamese and Myanmar economies and stands to do the same if North Korea follows suit. On U.S.-China trade, however, the news is not so good.2 The two countries have just seen another high-level embassy conclude without progress, all but ensuring that relations will get worse before they get better. Investors should prepare for the U.S. to take additional punitive measures and for China to retaliate in kind. The U.S. Treasury Department is on the verge of imposing landmark new restrictions on Chinese investment by May 21 or sooner. Congress, separate from the Trump administration and in a notable sign of bipartisan unity, is considering legislation that would do the same. This is independent from Trump's impending tariffs on $50-$150 billion worth of Chinese goods, which could also come as early as May 21. In other words, the U.S.-China economic conflict is rotating from trade to investment. Hence, in this report, we take a look at the "Holy Grail" of American demands on China: capital account liberalization. So far the Trump administration has not pushed its demands this far. That is a good thing, because China is not willing to move quickly on this front. Rapid and complete opening to global capital flows is a "red line" for China, so it is an important indicator of whether the two great powers are heading toward a full-blown trade war. The Uncertainties Of Capital Account Liberalization A country's capital account covers foreign direct investment (FDI), portfolio investment, cross-border banking transactions, and other miscellaneous international capital flows. Since the 1960s, especially since 1989, developed market economies in the West have encouraged the free flow of capital across national borders (Chart 2). As with the free flow of goods, services, and labor, the flow of capital promised integrated markets and more efficient uses of resources. Just as freer trade would lower prices, spur competition, and improve efficiency and innovation, so would the unfettered movement of capital. Trading partners could use savings to invest in each other's areas of productive potential that lacked funds. In this sense, capital flows were nothing but future trade flows: today's cross-border investment would be tomorrow's production of freely tradable goods.3 The laissez-faire, Anglo-Saxon economies promoted capital account liberalization for several reasons. First, economic theory and practice supported free trade as a means of increasing wealth, and free trade requires some degree of capital liberalization. Furthermore, liberalization played to the advantage of London and New York City, as international financial hubs, and both the U.S. and the U.K. sought to expand their role as providers of global reserve currencies.4 The European Community also sought freer capital flows due to the fact that the creation of the common market, at minimum, required it for trade financing. In the 1980s, France's bad experience with capital controls led it to adopt a more laissez-faire approach, prompting a convergence across Europe to the Anglo-Saxon model. Capital account liberalization joined free trade, fiscal conservatism, and deregulation as part of the "Washington Consensus" orthodoxy. Major economies were encouraged to liberalize their capital accounts if they wanted to join the OECD, like Japan, or if they sought economic and financial assistance from the IMF (Table 1).5 And yet the empirical evidence of the benefits of capital account liberalization is surprisingly mixed. There is not a clear causal connection between free movement of capital and improved macroeconomic variables like higher rates of growth, investment, or productivity. Relative to other kinds of international liberalization - of labor markets, for example - capital account liberalization is likely to bring small gains to growth rates (Table 2). Chart 2Global Capital Flows Expand Table 1Capital Account Liberalization: A Timeline Table 2Economic Benefits Of Open Borders We can illustrate this point simply by showing that emerging market economies with more open capital accounts, whether defined by the IMF's Capital Account Openness Index or by the ratio of direct and portfolio capital flows to GDP, do not necessarily have higher potential GDP growth or productivity (Chart 3 A&B). A change in openness also does not correlate with a change in growth potential or productivity. Chart 3AEM Capital Openness Not Obviously Correlated With Potential Growth (1) Chart 3BEM Capital Openness Not Obviously Correlated With Potential Growth (2) This conclusion can be reinforced by looking at portfolio investment. Portfolio investment is usually one of the last types of investment to be deregulated. Hence a large ratio of portfolio investment to GDP is a proxy for capital liberalization. However, emerging markets that rank high in this regard do not record higher potential growth, productivity, or capital productivity contributions to GDP growth (Chart 4). Chart 4EM: Larger Foreign Stock Inflows Not Correlated With Capital Productivity While the benefits of capital account liberalization are debatable, the risks are dire. It has contributed to, if not caused, a number of financial crises in recent decades. Latin America saw a series of such crises from 1982-89. Mexico's peso crisis of 1994 also owed much of its severity to destabilizing capital flows. Japan opened its capital account in 1979 and over the succeeding decade experienced a rollercoaster of massive capital influx, culminating in the property bubble and financial crash of 1990. Thailand, South Korea, and other Asian countries suffered the Asian Financial Crisis of 1997-98 as a result of premature and poorly sequenced liberalization. All of these countries faced different financial and economic circumstances, and the crises had different causes, but what they shared in common was a relatively recent openness to large inflows and outflows of global capital that triggered or exacerbated currency moves and liquidity shortages.6 This is not to say that there are not benefits to capital account liberalization, or that the benefits never outweigh the costs. The major multilateral global institutions continue to believe that capital account liberalization is optimal policy, if only because the richest, freest, best governed, and most advanced economies have all liberalized. Capital account openness is positively correlated with "rule of law" governance indicators. And back-of-the-envelope exercises such as those shown above suggest that developed market economies do see higher potential growth and capital productivity as a result of capital account liberalization, at least up to a point (Charts 5A & 5B). Chart 5ADM: Capital Openness Is Correlated With Potential Growth (1) Chart 5BDM: Capital Openness Is Correlated With Potential Growth (2) While a number of countries have experienced financial and economic crises after opening their capital accounts, studies have shown that the causal connection is not always clear (the crisis did not necessarily stem from capital account liberalization).7 The removal of barriers to entry or exit of capital does not have a unidirectional effect but can exacerbate capital flows when times are good or bad. Moreover, some research shows that countries are more likely to suffer financial crises from capital controls than from the removal of them.8 And it is very difficult for countries with open current accounts (free trade) to enforce rigid capital controls anyway, since the distinction between capital flows covering trade transactions and other capital flows is difficult in practice to enforce, resulting in leakage. Because of the link between trade and capital, no country has ever fully and permanently reversed liberalization.9 The academic debate rages on, but from a political point of view, two things are clear. First, the best practices of the most advanced countries suggest that capital account liberalization is optimal policy. Second, policymakers in less open economies are faced with uncertainty and a range of views from economic advisers, orthodox and unorthodox. In the wake of crises in recent decades, this uncertainty has made them less inclined over the years to trust to economic orthodoxy or the "Washington Consensus" when making critical decisions about capital flows. Rather, opening is likely when economic problems call for a change in tack, while capital controls are likely when flows are considered excessive or destabilizing. Bottom Line: Capital account liberalization is the best practice among advanced economies but the risk-reward ratio for policymakers in EMs and partly closed economies is likely skewed to the downside. China's Stalled Capital Account Liberalization Chart 6China's Fear Of Capital Flight In recent years China's policymakers have struggled with the problem of capital account liberalization. In the aftermath of the global financial crisis they announced that they would speed up the process. In 2015 they pledged to complete it by 2020, only to re-impose capital controls when financial turmoil that year prompted large capital outflows (Chart 6). In 2017 President Xi Jinping claimed that the country remains committed to gradual liberalization. We have argued that his administration would ease these controls later rather than sooner, in order to pursue tricky domestic financial reforms first.10 As we have seen (Chart 3 above), China lies on the low end of the IMF's "Capital Account Openness" index, which ranks countries across the world based on six economic indicators and 12 asset classes. By this measure, China is slightly more open than India - a notoriously hermetic economy - and less open than the Philippines. China's closed capital account is also clear from its international investment position. China has fewer international assets and liabilities, as a share of output, than the U.S., Japan, Europe, or South Korea (Charts 7A & 7B). China's international assets are largely the result of its government's $3.1 trillion in foreign exchange reserves, as well as outward FDI. As for its liabilities, China has opened up to FDI more so than portfolio investment or other capital flows. This is because FDI is long-term capital that tends to be more closely tied to real production; it is difficult to unwind it in times of crisis. China allows inward and outward FDI to gain knowhow, technology, and natural resources. It is more closed, however, to short-term capital flows, such as dollar-denominated bank debt, currency speculation, and portfolio investment. Typically it is these short-term flows that are most destabilizing, especially when countries are newly open to them. Chart 7AChina Has Fewer Foreign Assets, Mostly Official Forex Reserves Chart 7BChina Has Fewer Foreign Liabilities, Mostly FDI Western economies, however, stand to benefit if China opens up to these shorter-term capital flows. They have a comparative advantage in financial services and thus can rebalance their relationships with China if it gives its households and corporations more freedom to manage their wealth in foreign currencies and assets. It is logical that China's FDI and portfolio investment in western countries would rise if Chinese investors were allowed to go abroad, simply because the latter would wish to diversify their portfolios for the first time. China's neighbors and trade partners would receive a windfall of new investments. Meanwhile they would gain new investment opportunities, as private capital would be able to venture into China, and flee out of it, more easily.11 Western countries are also increasingly agitating for China to loosen its inward capital restrictions. Despite China's openness to FDI relative to other capital flows, it is still one of the world's most restrictive countries in which to invest long-term capital (Chart 8). China's heavy restrictions have granted monopolies to Chinese companies, depriving foreigners of the fruits of China's growth. This is especially important as China moves into consumer- and services-oriented growth. Western countries have a comparative advantage in high-end consumer goods and services relative to low-end goods and manufacturing in general, where they have largely lost out to Chinese competition in recent decades. Chart 8China Is Highly Restrictive Toward Foreign Direct Investment China, too, stands to benefit from freer capital flows, and policymakers believe there is a self-interest in liberalizing. But Beijing has repeatedly demonstrated that it wants to move very gradually because of the skewed risk-reward assessment. China's harrowing experience with capital flight in 2014-16 has vindicated this policy.12 It is not necessarily capital account opening per se that causes destabilizing capital outflows - it is also the macro and financial environment. And China has all the hallmarks of an economy that could suffer a crisis from premature liberalization, including: Large macro imbalances (Chart 9); An immature and shallow financial system (Chart 10); Lack of information transparency; Weak rule of law. Chart 9China Has Macro Imbalances Chart 10China's Financial System Is Shallow Bottom Line: It is guaranteed that China will not pursue capital account liberalization rapidly. It will continue to take small steps, and ultimately "two steps forward and one step back" if necessary to maintain overall stability. Will China Liberalize? By the same logic, why should China liberalize at all? The 2014-16 crisis not only revealed the dangers of too-rapid opening but also the dangers of an inflexible currency and draconian capital controls. When Chinese authorities devalued the yuan in August 2015, they made the capital flight (and global panic) worse. Since then, by imposing strict capital controls, China's leaders have signaled to domestic and foreign investors (1) that they are unwilling to allow global capital flows to discipline their fiscal or monetary policies (a negative sign for China's macro fundamentals), and (2) that they may deny investors the rights of their property or even confiscate it.13 This is why China has made important policy changes since the 2014-16 crisis. First, it has maintained a more flexible "managed float" of the RMB, allowing it to trade more freely along with a basket of currencies that belong to major trading partners and abandoning the dollar peg. Various measures of the exchange rate - offshore deliverable forwards, spot rates, and the exchange rate at interest rate parity - have converged, revealing an exchange rate that is more market-oriented, i.e. less heavily managed by the People's Bank of China (Chart 11).14 This process is being pursued with the long-term interest of rebalancing the economy - making it more flexible and less fixed to an export-led manufacturing model. It is also necessary in order to internationalize the yuan, which is a long and rocky road but, it is hoped, will eventually reduce foreign exchange risk to China's economy (Chart 12). One of the main reasons that governments, including China, have maintained closed capital accounts is to control exchange rates. As currencies float more freely, the economy becomes better able to withstand large or volatile capital flows. At the same time, the yuan will never be a global reserve currency if China never opens the capital account. Chart 11The RMB Is Floating A Bit More Freely Chart 12The RMB Is Going Global ... Slowly Second, while tight capital controls remain in place, Beijing is pursuing long-delayed reforms to the financial sector and fiscal and legal systems to allow for better financial regulation, supervision, and transparency. For instance, the new central bank Governor Yi Gang's reported desire to genuinely liberalize domestic deposit interest rates will prepare China's banks for greater competition with each other, and hence ultimately to greater competition from abroad. This in turn will improve allocation of capital across the economy. Another example is the expansion of the domestic and offshore bond markets - and gradual formalization of the local government debt market - in order to deepen the financial sector.15 These reforms are desirable in themselves but also necessary for eventual capital account liberalization, as countries with deep domestic financial markets have less vulnerability to new surges of foreign inflows or outflows. Naturally, the reform process is taking place on China's timeline. Since Beijing stresses overall stability above all else, it is gradual. But we would expect the Xi administration to continue with piecemeal opening measures through the coming years, so that by 2021, the capital account is materially more open than it is today. As for full liberalization, it is beyond our forecasting horizon. Xi's goal of turning China into a "modern socialist country" by 2035 is not too late of a timeframe to consider, given the potential for serious setbacks. But such delayed progress raises the prospect of a clash with the U.S. A risk to this view is that China backslides yet again on the internal reforms, making it impossible to move to the subsequent stage of opening up to international flows. Vested financial and non-financial corporate interests often oppose capital account liberalization. State-controlled companies, for instance, will gradually have to compete more intensely for capital that comes from better disciplined domestic banks, all while watching small and medium-sized rivals gain market share due to the newfound access to foreign capital, which makes them more competitive.16 Backsliding will, again, antagonize the West. Bottom Line: China is preparing to open its capital account further, as we are in the "two steps forward" phase following Xi Jinping's political recapitalization in 2017. A New Front In The U.S.-China Trade War The U.S. has long argued that China maintains excessive capital controls that violate the conditions of China's accession to the World Trade Organization in 2001.17 The following statement, from one of the U.S. government's annual reports on China's compliance with the WTO, was written before the Trump administration took office and is typical of such reports and of the overall U.S. position: Although China continues to consider reforms to its investment regime ... many aspects of China's investment regime, including lack of a substantially liberalized market, maintenance of administrative approvals and the potential for a new and overly broad national security review system, continue to cause foreign investors great concern ... China has added a variety of restrictions on investment that appear designed to shield inefficient or monopolistic Chinese enterprises from foreign competition.18 The Trump administration's own reports on China's WTO compliance have amplified such criticisms.19 Remember that it was partly China's lack of WTO compliance that the Trump administration highlighted as justification for the sanctions announced in March under Section 301 of the 1974 Trade Act. In particular, the administration argues that U.S.-China investment relations are not fair or reciprocal, i.e. that the U.S. does not have as great of investment access in China as vice versa (Chart 13). Even in FDI, where China is relatively open and the bilateral sums are fairly reciprocal, the U.S. share is smaller than that of comparable developed economies, such as Japan and Europe (Chart 14). While it is not a foregone conclusion that this is the result of discriminatory policies, the U.S. argues that it suffers from unfair practices. What is clear is that China designates a number of sectors "strategic," excluding them from foreign investment, and places caps on foreign ownership. The two countries tried but failed to conclude a bilateral investment treaty under the Obama administration, which was meant to resolve this problem and stimulate private capital flows. China also has not implemented a nationwide foreign investment "negative list," which it has promised since 2013.20 A negative list would explicitly designate sectors that are off-limits to foreign investment and thus implicitly liberalize investment in all others. Chart 13The U.S. Wants Investment Reciprocity Chart 14The U.S. Wants More Investment Access The U.S. is also demanding greater reciprocity for its banks to lend to Chinese borrowers. China is well-known for heavily restricting foreign bank access, with foreign loans accounting for only 2.75% of total. The U.S. grants much larger market access to Chinese lenders than vice versa (Chart 15). While there are perfectly good reasons for U.S. banks to hold a smaller share of China's total cross-border bank loans than European banks and comparable Asian banks (U.S. banks focus on their large domestic market while European and Japanese banks are bigger international lenders), nevertheless the Americans will see their smaller market share as evidence that American market access can go up (Chart 16). Chart 15The U.S. Wants Banking Reciprocity Chart 16The U.S. Wants More Banking Access Thus the silver bullet for the Trump administration would be to demand accelerated, full capital account liberalization from Beijing. This would address the above problems of investment access while also constituting a larger demand for China to hasten structural reforms that would favor American interests. This is why American officials have urged China to liberalize during high-level bilateral dialogues in the past - while knowing that the reform itself was of such significance that China would only move gradually.21 Chart 17Is The RMB Undervalued? So far the Trump administration has not demanded that China accelerate capital account liberalization, perhaps knowing that it would be a non-starter for China.22 One reason may be the expectation that the RMB could depreciate. True, the yuan is roughly at fair value in real effective terms, after a 7.4% appreciation since Trump's inauguration. However, China's 2014-16 capital flight episode suggests that, under the circumstances of a rapid opening of the capital account, outflow pressure could resume and the currency could fall. This would, at least for a time, drive down CNY/USD, contrary to Trump's oft-repeated desire that the currency appreciate. Trump adheres to a view that the RMB is structurally undervalued, as illustrated here by the IMF's purchasing power parity model, which suggests that it should rise by 45% against the greenback (Chart 17). Given Trump's rhetoric, it may not be far-fetched to suggest that Trump is disinclined to push for capital account liberalization and would rather see China maintain its current "managed" system in order to manage the CNY/USD even further upward. The broader point, however, is that previous U.S. administrations have pushed for faster capital account liberalization, and the Trump administration could eventually follow suit. This would mark a major escalation in the standoff, since China possibly cannot, and certainly will not, deliver such a momentous structural change on a timeline imposed by a foreign power. Bottom Line: Rapid capital account liberalization represents China's "red line" in the trade talks. If Trump pushes his demands this far, then he will be seen as threatening China's stability and will be rebuffed. This is a pathway to a full-blown trade war. Investment Conclusions Capital account liberalization is by no means the only indicator for gauging whether the U.S. and China are heading toward a full-blown trade war. As things stand, Trump will soon impose Section 301 tariffs, China will retaliate, and Trump will retaliate to the retaliation. This is our definition of a trade war. Not only is Trump threatening tariffs on $50-$150 billion worth of imports. He is now demanding that China reduce the U.S.'s trade deficit by $200 billion, or 53% of the total, twice as much as earlier. To give an indication of how significant such a change would be for China over the long haul, Table 3 provides a very simple scenario analysis of what would happen to China's trade surplus, current account surplus, and GDP growth rate if the U.S. reduced its bilateral trade deficit by 10%, 33%, or 50%. It shows that if the deficit fell by 33%, Trump's initial goal, then China's current account balance would fall to less than one percent of GDP, and GDP growth would slow down to 6.24% for the year. Table 3Scenario Analysis: Trump Slashes U.S. Trade Deficit With China Table 4 takes the worst-case scenario for China, in which the U.S. cuts the deficit by 50%, while oil prices average $90/bbl due to oil price shocks from unplanned production outages in Iran (where Trump is re-imposing sanctions), or Venezuela or others, amid a very tight global oil market.23 China's current account surplus would go negative, while GDP growth would fall to 5.32%! Table 4Scenario Analysis: Trump Slashes Deficit, Oil Prices Soar These scenarios are significant because they are not very far-fetched. Instead, they show how easily China could undergo a symbolic transition into a "twin deficit" country - a country with an estimated 13% budget deficit and a negative current account balance. Such a development would not necessarily have immediate concrete ramifications. But it would, if it became a trend, mark a turning point in which China begins exporting rather than importing global wealth. It would cause global investors to scrutinize the country in different ways than before and to question the status and long-term trajectory of China's traditional buffers against financial and economic challenges: the country's large national savings and foreign exchange reserves. These scenarios are merely suggestive and meant to show the gravity of Trump's threats and the seriousness with which Xi will take them. In the current U.S.-China trade conflict, if China allows the CNY/USD to weaken - the logical way of alleviating tariff impacts - then it will be depreciating the currency in Trump's face: conflict will intensify. It is not clear how long the conflict will last or how bad it will get, so investors would be wise to hedge their exposure to stocks along the U.S.-China value chain, favoring small caps and domestic plays in both countries. BCA's Geopolitical Strategy recommends staying long DM equities relative to EM equities. We are short Chinese technology stocks outright, and short China-exposed S&P 500 stocks. By contrast, BCA's China Investment Strategy service continues to recommend that investors stay overweight Chinese stocks excluding the technology sector (versus global ex-tech stocks) over the coming 6-12 months with a short leash. As highlighted in this report, the near-term risks to China from the external sector are clearly to the downside, which supports the decision of the China Investment Strategy team to place Chinese stocks on downgrade watch for Q2.24 This watch remains in effect for the coming two months, a period during which we hope fuller clarity on the U.S.-China trade dispute and the pace of decline in China's industrial sector will emerge. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, 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 Please see Barry Eichengreen, "Capital Account Liberalization: What Do Cross-Country Studies Tell Us?" World Bank Economic Review 15:3 (2001), 341-65. Available at documents.worldbank.org. 4 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "Is King Dollar Facing Regicide?" dated April 27, 2018, available at gps.bcaresearch.com. 5 Please see Jeff Chelsky, "Capital Account Liberalization: Does Advanced Economy Experience Provide Lessons for China?" World Bank Economic Premise 74 (2012), available at openknowledge.worldbank.org. 6 Please see Donald J. Mathieson and Liliana Rojas-Suarez, "Liberalization of the Capital Account: Experiences and Issues," International Monetary Fund, March 15, 1993, available at www.imf.org; Ricardo Gottschalk, "Sequencing Trade and Capital Account Liberalization: The Experience of Brazil in the 1990s," United Nations Conference on Trade and Development and United Nations Development Programme Occasional Paper (2004), available at unctad.org; see also Sarah M. Brooks, "Explaining Capital Account Liberalization In Latin America: A Transitional Cost Approach," World Politics 56:3 (2004), 389-430. 7 Please see Peter Blair Henry, "Capital Account Liberalization: Theory, Evidence, and Speculation," Federal Reserve Bank of San Francisco Working Paper 2007-32 (2006); see also Eichengreen in footnote 1 above. 8 Please see Reuven Glick, Xueyan Guo, and Michael Hutchison, "Currency Crises, Capital-Account Liberalization, and Selection Bias," The Review of Economics and Statistics 88:4 (2006), 698-714, available at www.mitpressjournals.org. 9 Please see M. Ayhan Kose and Eswar Prasad, "Capital Accounts: Liberalize Or Not?" International Monetary Fund, Finance and Development, dated July 29, 2017, available at www.imf.org. 10 Please see BCA Geopolitical Strategy Special Report, "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017, available at gps.bcaresearch.com. 11 This western interest in Chinese capital account liberalization exists entirely aside from any of the aforementioned capital flight pressures from Chinese investors, which could reignite again. Foreign countries would welcome such inflows to some extent but not to the point that they become destabilizing at home or abroad. 12 The earliest rumored deadline for capital account liberalization was the seventeenth National Party Congress of the Communist Party in 2007. Please see Derek Scissors, "Liberalization In Reverse," The Heritage Foundation, May 4, 2009, available at www.heritage.org. 13 Eichengreen highlighted these points with regard to the literature and observations on capital account liberalization across a range of countries. They are highly relevant to China today. 14 Please see BCA China Investment Strategy Weekly Report, "Has The RMB Gone Too Far?" dated February 1, 2018, available at cis.bcaresearch.com. 15 Please see BCA China Investment Strategy Weekly Report, "Embracing Chinese Bonds," dated July 6, 2017, available at cis.bcaresearch.com. 16 Raghuram G. Rajan and Luigi Zingales, "The Great Reversals: The Politics of Financial Development in the Twentieth Century," Journal of Financial Economics 69 (2003), 5-50, available at faculty.chicagobooth.edu. 17 China did not commit to fully liberalizing the capital account as part of its WTO accession agreements, but rather the U.S. cites China's use of capital controls as a means of violating other WTO commitments regarding market access, subsidization, etc. At the time China joined the WTO, it was widely believed that its commitments would include gradual liberalization. For instance, the State Administration of Foreign Exchange lifted capital controls imposed during the Asian Financial Crisis in September 2001. Please see Lin Guijun and Ronald M. Schramm, "China's Foreign Exchange Policies Since 1979: A Review of Developments and an Assessment," China Economic Review 14:3 (2003), 246-280, available at www.sciencedirect.com. 18 U.S. Trade Representative, "2015 Report To Congress On China's WTO Compliance," December 2015, available at ustr.gov. 19 U.S. Trade Representative, "2017 Report To Congress On China's WTO Compliance," January 2018, available at ustr.gov. 20 Please see U.S. Department of State, "2012 U.S. Model Bilateral Investment Treaty," available at www.state.gov. See also U.S. Department of the Treasury, "Joint U.S.-China Economic Track Fact Sheet of the Fifth Meeting of the U.S.-China Strategic and Economic Dialogue," July 12, 2013, available at www.treasury.gov. 21 See, for instance, U.S. Department of the Treasury, "2015 U.S.-China Strategic and Economic Dialogue Joint U.S.-China Fact Sheet - Economic Track," June 6, 2015, available at www.treasury.gov. 22 However, Michael Pillsbury, director of the Center for Chinese Strategy at the Hudson Institute and an adviser on Trump's transition team, has argued that the Trump administration's endgame is to implement the well-known World Bank and China State Council Development Research Center report, China 2030, which full-throatedly endorses capital account liberalization. Please see Robert Delaney, "Donald Trump's trade endgame said to be the opening of China's economy," South China Morning Post, April 3, 2018, available at www.scmp.com. For the report, see "China 2030: Building a Modern, Harmonious, and Creative Society," 2013, available at www.worldbank.org. 23 Please see BCA Geopolitical Strategy Weekly Report, "Expect Volatility ... Of Volatility," dated April 11, 2018, available at gps.bcaresearch.com. 24 Please see BCA China Investment Strategy Weekly Report, "Chinese Stocks: Trade Frictions Make For A Tenuous Overweight," dated March 28, 2018, available at cis.bcaresearch.com.

Highlights Feature Chart of the WeekAg Vol Will Rise Over the coming three months markets will be zeroing in on spring planting in the U.S., looking for deviations from the USDA's March intentions report. This will occur against the cyclical backdrop of increased volatility, as markets attempt to price the real impact of Chinese tariffs (Chart of the Week). Putting aside fundamentals, U.S. financial conditions will be a headwind to ag prices this year. Longer term, despite the more favorable USD outlook, a slowdown in China, which accounts for ~ 20% of global food demand, could be bearish for ag prices. Highlights Energy: Overweight. U.S. crude oil output rose to a record 10.3mm b/d in February according to the U.S. EIA. U.S. crude production exceeded Saudi Arabia's in 1Q18; we expect it to exceed Russia's output of 11.2mm b/d by December, 2018. Base Metals: Neutral. Permanent waivers on steel and aluminum tariffs were granted to Australian, Argentine, and Brazilian imports by U.S. firms, while exemptions on imports from the EU, Canada and Mexico were extended to June 1. Precious Metals: Neutral. USD strength is weighing on gold and silver: Our long positions on both metals are down 3.0% and 6.2%, respectively, over the past two weeks. Ags/Softs: Underweight. Ag market volatility will increase, as markets assess U.S. spring planting progress against a backdrop of a possible trade war in ags between the U.S. and China (see below). Feature All Eyes On U.S. Planting Progress It is a busy time of year for U.S. farmers as spring planting is underway. Based on the USDA's annual Prospective Planting Report, released end-March, corn and soybean plantings will fall 2% y/y and 1% y/y, respectively. If realized, corn planted area in the 2018/19 crop year will be the lowest since 2015, and, for only the second time in the history of the series, will fall behind soybean acreage (Chart 2). The USDA's survey also indicates U.S. corn and soybeans will lose ground to wheat, where farmers intend to expand acreage by 3%. Even so, wheat planting intentions are the second lowest on record since the beginning of the series in 1919, surpassed only by last year's all-time low. Mother Nature is not co-operating either: unseasonably cold and wet weather is hindering planting this spring (Table 1). Planting of corn and spring wheat are significantly behind average for this time of the year. Similarly, heading of winter wheat - which accounts for ~ 70% of total wheat intentions - is also behind schedule. Furthermore, harsh winter weather reduced the condition of almost 40% of the crop to poor or very poor, with only 33% qualifying as good or excellent, compared to last year's assessment of 13% and 54%, respectively. Chart 2U.S. Soybean Acreage To Surpass Corn In 2018/19 Table 1U.S. Farmers Are Behind Schedule Weather-related delays are less of a risk for soybean plantings, which begin and end later in the summer. Progress is currently in line with historical averages, and, since farmers have an additional month of planting compared to corn and wheat, it is possible they will opt to switch their unplanted corn and wheat acreage to beans. This is a downside risk to the soybean market: When all is said and done, June soybean acreage may exceed targets indicated in the USDA's March intentions report. Although farmers' current lack of headway on the fields is cause for concern, it is still possible that farmers will be able to catch up, attaining their targeted acreage. A Backdrop Of Falling Inventories The termination of China's corn stockpiling scheme, which, prior to 2016 led to the rapid buildup of domestic inventories, was accompanied by policies designed to incentivize soybean plantings over corn. In the case of corn, these policies have paid off. By the end of the current crop year we expect the drawdown in Chinese inventories - along with U.S. stockpiles - to drag world corn reserves lower for the first time since 2010/11 (Chart 3).1 China's pro-soybean production policy is expected to yield a 1.1% expansion in the oilseed's planting area, leading to a 12.8% increase in output this crop year. Regardless, domestic inventories expressed in stocks-to-use (STU) terms are projected to fall (Chart 4). Similarly, world soybean reserves will contract on the back of a decline in Argentine output, which will lead to the largest - and one of only three on record - soybean deficits in the domestic market. In the case of wheat, although U.S. output is forecast to come down this year, weighing on domestic inventories, global markets remain well supplied (Chart 5). In fact, even though USDA's monthly revisions to U.S. production have been downward, forecasts of total use also were revised down. This means the net impact on the balance will be a wider-than-expected surplus. In the case of global markets, world wheat STU ratio will increase to levels last seen in 1986. Net, despite unfavorable weather weighing on the quality and quantity of U.S. wheat crops, there is no shortage of wheat in the world, unlike corn and soybeans. Chart 3Corn Deficit Eating##BR##Away At Stockpiles Chart 4China STU Falls Despite##BR##Pro-Soybean Policies Chart 5Global Wheat Markets Well Supplied##BR##Amid U.S. Supply Concerns Bottom Line: Given the slower-than-average planting progress this year, near term prices will likely reflect developments in the U.S., as farmers rush to get the crops in the ground. While winter wheat appears to be of poor quality this year, corn and spring wheat plantings are significantly behind schedule. This raises the risk that their acreages will be abandoned in favor of soybeans, which has a later planting window. All in all, if the June acreage report aligns with farmers' planting intentions, we expect to see an increase in wheat acreage at the expense of corn and soybean, which will provide some supply relief to domestic wheat markets. U.S. Farmers Less Competitive, Especially In Soybean Markets In theory, China's announced plans to levy duties on U.S. ag imports puts U.S. farmers - part of President Trump's base - at a disadvantage. But, reality may not be as bearish. The outcome hinges on whether the U.S. will be able to ramp up its exports to other markets amid declining imports from the top bean consumer. Given the impact of weather on soybean output in Argentina - where drought cut soybean output by 30% y/y - there will be a void in global supply. Since soybeans are fungible, we expect ex-China demand to remain supported on the back of limited global supply. This will provide an opportunity for the U.S. to export its surplus, at least in this crop year. To date, there appears to be some evidence of this. Domestic supply will be insufficient to cover Argentinian consumption this year (Chart 6). In an unusual move, USDA export sales data shows Argentina booked a 240k MT purchase of U.S. soybeans for delivery in the next marketing year. Argentina traditionally is a net exporter of soybeans. While we expect tariffs to reshuffle trade flows as China attempts to ensure supplies while avoiding U.S. soybeans, the net effect in terms of global demand for U.S. soybeans may not be as bearish as is feared. China simply does not have the domestic supply to satisfy its demands for beans. While opting for Brazilian or Argentinian beans may be way around importing U.S. supplies, this will open up other export opportunities for the U.S. variety, leading to a simple restructuring of trade flows.2 Recent declines in Chinese imports of U.S. soybeans amid growing imports from Brazil have been cited as evidence of a gloomy future for U.S. soybean farmers. However, this phenomenon is part of the Chinese import cycle: Brazilian soybeans flood Chinese markets in the second and third quarters, while American supplies flow in during the last and first quarters of any given year (Chart 7). Furthermore, U.S. soybean imports have been on the downtrend since the middle of last year. Thus, this observation alone does not signal a change in trend. Chart 6Weak Argentine Output##BR##Restrict Global Supplies Chart 7Chinese Preference For Brazilian Beans##BR##Typical For This Time Of Year In fact, the premium paid for Brazilian beans over those traded in Chicago spiked earlier last month. Although it has since come down slightly, it suggests Chinese consumers will have to bear the brunt of more expensive imports. Furthermore, this makes U.S. beans relatively cheaper - and more attractive - in the global market. All the same, higher costs may entice Chinese consumers to look at adjusting the feed formula by diversifying the source of feed. Although our baseline scenario is that these tariffs will remain in place, U.S. Treasury Secretary Steven Mnuchin and U.S. Trade Representative Robert E. Lightizer's trip to Beijing may be the opening salvo to less hostile trade developments. If this is the case, we would expect these trade-related risks to ease. Bottom Line: Tariffs on U.S. soybean imports to China are, in theory, bearish for U.S. markets. However, China's reliance on these beans, along with a tight market this year, makes the outlook less gloomy. Courses of action that may be pursued by China are (1) diversifying the source of the bean, (2) reducing demand for the bean by adjusting feed formula, and (3) continuing to raise domestic soybean acreage. Given the cyclical nature of China's soybean imports, we are entering a period of naturally low demand for U.S. soybeans. Thus, we will not likely see the real impact of current trade disputes until China's demand for American beans kicks in again in 4Q18. In the meantime, a global deficit will open up alternative opportunities for U.S. exports. U.S. And Foreign Financial Conditions Drive Long Run Outlook As weather and the on-going trade tensions between the U.S. and China evolve, the U.S. financial backdrop - particularly real interest rates and the broad USD trade-weighted index (TWIB) - will remain crucial to ag markets. In line with BCA Research's House View, we expect Fed rate hikes to exceed those of other central banks, providing support to a stronger USD over the next 12 months. This will weigh on ag prices.3 Chinese economic growth also could figure prominently, based on recent research from the CME Group, which operates the world's benchmark grain futures markets.4 The relationship between China's unofficial economic gauge - the Li Keqiang Index (LKI) - and ag prices appear to operate through the currency channel. A weaker Chinese economy - reflected in the LKI - suppresses industrial commodity demand, which ends up weighing on the currencies of major commodity exporters. This means the local costs of production for these exporters fall, which, with a 1- to 2-year lag, incentivizes crop plantings in these regions. The increased supply at the margin is bearish for ag prices, all else equal. Given the current environment of a slowing Chinese economy, this relationship is relevant to the longer-term outlook. The significance of the LKI in our grains models provides some evidence of this relationship (Chart 8). When applying the analysis to Brazilian and Russian ag markets, we find the LKI to be positively correlated with the Brazilian Real and the Russian Ruble. This, in turn, explains the inverse correlation we find between the LKI and future ag production in these two markets (Chart 9). A weaker domestic currency does appear to entice farmers to increase plantings of ag commodities, allowing them to take advantage of greater local currency profits from USD-denominated ag exports. Chart 8China Slowdown May Weigh Down On Ags... Chart 9...By Incentivizing Production Bottom Line: This preliminary analysis uncovers a supply side channel through which China may impact global ag supplies. It implies that a slowing Chinese economy may in effect spur greater global ag supplies, eventually weighing down on ag prices. Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com Hugo Bélanger, Senior Analyst HugoB@bcaresearch.com 1 Despite the increase in domestic supply amid greater offerings of state reserves, much of the state corn stocks are reportedly in poor condition, only suitable as a source for ethanol production - cited as the justification for upward revisions to corn consumption this year. As such, imports will likely remain indispensable. Overall it appears that China intends to raise its industrial consumption of corn in order to digest its stockpiles, with limited impact on prices. Late last year, China announced its target of nationwide use of bioethanol gasoline by 2020. It estimates that corn stockpiles are sufficient to meet near term demand for the grain used as the ingredient in E10, and hopes to achieve a physical corn market balance within five years. 2 Please see the Ags/Softs back section titled "Can China Retaliate With Agriculture," in BCA Research Commodity & Energy Strategy Weekly Report titled "Oil Price Forecast Steady, But Risks Expand," dated March 22, 2018, available at ces.bcaresearch.com. 3 For a more detailed discussion of the impact of U.S. financial variables on ag markets, please see BCA Research Commodity & Energy Strategy Weekly Report titled "Global Financial Conditions Will Drive Grain Prices In 2018," dated November 30, 2017, available at ces.bcaresearch.com. 4 Please see "Will A Sino-U.S. Trade War Impact Grain, Meat Markets?" dated March 28, 2018, available at cmegroup.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Highlights Our constraints-based methodology does not rely on human intelligence or the "rumor mill" to analyze political risks; Yet insights from our travels across the U.S., including inside the Beltway, offer interesting background information and a sense of the general pulse; Anecdotal information suggests that Trump is not "normalizing" in office; that U.S.-China relations will get worse before they get better; and that Trump will walk away from the 2015 Iranian nuclear deal. Stick to our current trades: energy over industrial metals; South Korean bull steepener; long DXY; long DM equities versus EM; long JPY/EUR; short Chinese tech stocks and U.S. S&P500 China-exposed stocks. Feature With the third inter-Korean summit demonstrating our view that "diplomacy is on track,"1 we remind investors of the key geopolitical risks we have been emphasizing - souring U.S.-China relations and rising geopolitical risks over Iran's role in the Middle East.2 We at BCA's Geopolitical Strategy do not base our analysis on information from human "intelligence" sources. No private enterprise can obtain the volume of intelligence that would make the sample statistically significant. Private political analysts relying on such intelligence are at best using flawed reasoning devoid of an analytical framework, and at worst are hucksters. Government intelligence agencies obviously collect a wide swath of not only human but also electronic and signals intelligence. Their sample can be statistically significant. However, the cost of such an effort is prohibitive to the private sector. Nonetheless, we may use human intelligence for background information, insight into how to improve our framework, and to take the subjective pulse of any particular situation. The latter is sometimes the most useful. It is not what a policymaker says that matters so much as how they say it, or the fact that they mention the subject at all. Given that we live in an era of political paradigm shifts, and that "charismatic leadership" is rising in influence relative to more predictable, established institutions and systems,3 we have decided to do something we have not done in the past: share some insights from our recent trips to Washington, DC and elsewhere in the U.S. Caveat emptor: the rumor mill is often wildly misleading, which is why we do not base our research on it. Exhibit A: Donald Trump's tax cuts, which our constraints-based methodology enabled us to predict in spite of the prognostications of in-the-know people throughout the year.4 Trump Is Not Normalizing U.S. domestic politics is the top concern of investors, policymakers, and policy wonks almost everywhere we go. It routinely ranks above concerns about Russia, China, the Middle East, or emerging markets (EM). We frequently heard that the U.S. is entering a period of political turmoil worse than anything since President Richard Nixon and the Watergate scandal. Some old Washington hands even claim that the Trump era will cause even greater uncertainty than the Nixon era did because Congress is allegedly less willing to keep the president in check. Economic policy uncertainty, based on newspaper word count, is at least comparable today to the tumultuous 1973-74 period, which culminated with Nixon's resignation in August 1974, and is trending upward (Chart 1). Chart 1Trump Uncertainty Approaching Nixon Levels? Of course, there is a big difference between Trump's and Nixon's context: today the economy is not going through a recession but rip-roaring ahead, charged with Trump's tax cuts and a bipartisan spending splurge. And the nation is not in the midst of a large-scale and deeply divisive war (not yet, anyway). There is little chance of major new legislation this year, yet deregulation, particularly financial deregulation, will continue to pad corporate earnings and grease the wheels of the economy. The booming economy is lifting Trump's approval ratings, which are trying to converge to the average of previous presidents at this stage in their terms (Chart 2). This development poses the single biggest risk to the unanimous opinion in DC that Republicans face a "Blue Wave" (Democratic Party sweep) in the midterm elections on November 6. However, a key support of the "Blue Wave" theory is that Republicans are split among themselves - and no one in the Washington swamp will deny it. Pro-business, establishment Republicans have never trusted Trump. They are retiring in droves rather than face up to either populist challengers in the Republican primary elections this summer or enthusiastic "anti-Trump" Democrats and independents in the general election (Chart 3).5 Chart 2Is Trump's Stimulus Bump Over? Chart 3GOP Retirements Are Unprecedented Trump is expected to ignite a constitutional crisis by firing Special Counsel Robert Mueller, the man leading the investigation into the Trump campaign's alleged collusion with Russia. Republicans are widely against firing Mueller, but they are not united in legislating against it, leaving Trump unconstrained. Senate Majority Leader Mitch McConnell (R, KY) says he will not allow consideration on the Senate floor of a bill approved by the Senate Judiciary Committee that would protect Mueller from firing.6 If Trump fires Mueller, Democrats expect a political earthquake. Some think that mass protests, and mass counter-protests encouraged by Trump himself, will culminate in violence. (We would expect protests to be mostly limited to activists, but obviously violent incidents are probable at mass rallies with opposing sides.) The Democrats are widely expected to take the House of Representatives; most observers are on the fence about the Senate. The House is enough to impeach Trump, which is widely expected to occur, by hook or by crook. But the impact on the country's political polarization will be much worse if there is impeachment without "smoking gun" evidence against Trump's person. Nixon, recall, refused to hand over evidence (the Watergate tapes) under a court order. When he handed some tapes over, they emitted a suspicious buzzing sound at critical points in the recording. Public opinion turned against him, prompting his party to abandon ship. He resigned because the loss of party support made him unlikely to survive impeachment. By contrast, there is not yet any comparable missing or doctored evidence in Trump's case, nor any sinkhole in Republican opinion that would presage a 67-vote conviction in the Senate (Chart 4). Chart 4Trump Not Yet In Nixon's Shoes Still, clouds are on the horizon. When people raise concerns about geopolitical issues - the U.S.-Russia confrontation, or the potential for a trade war with China - their starting point is uncertainty about President Donald Trump and his administration's policies. The United States is seen as the chief source of political risk in the world. Bottom Line: People in the Beltway who were once willing to believe that Trump would learn on the job and become "normalized" in office now seem to be shifting to the view that he is truly an unorthodox, and potentially reckless, president. The New (Aggressive) Consensus On China China is in the air like never before in D.C. In policy circles, the striking thing is the near unanimity of the disenchantment with China. Republicans are angry with China over trade and national security. Democrats are not to be outdone, having long been angry with China over trade, and also labor issues and human rights violations. It seems that everyone in the government and bureaucracy, liberal or conservative, is either demanding a tougher policy on China or resigned to its inevitability. American officials flatly reject the view that the Trump administration is instigating a conflict with China that destabilizes the world economy. Rather they insist that China has already instigated the conflict and caused destabilizing global imbalances through its mercantilist policies. They firmly believe that the U.S. can and should disrupt the status quo in order to change China's behavior, but that no one wants a trade war. They believe that the U.S. can be aggressive without causing things to spiral out of control. This could be a problem, as we detect a similar hardening of sentiment in China. On our travels there, the attitude was one of defiance toward Trump and Washington. We have received assurances that Beijing will not simply fold, no matter how much pain is incurred from trade measures. Of course, it is in China's interest to bluster in order to deter the U.S. from tariffs. But Chinese policymakers may be ready to sustain greater damage than Washington or the investment community expects. Tech companies are particularly out of the loop with Washington. They are said to have been unprepared for the president's actions upon receiving the Section 301 investigation results. They may also be underestimating the product list that the U.S. Trade Representative has drawn up pursuant to Section 301.7 Even products on that list that are not imported directly from China could have their trade disrupted. While China is demanding that the U.S. ease restrictions on high-tech exports, to reduce the trade imbalance (Chart 5), the U.S. believes that export controls allow for plenty of waivers and exceptions. They do not see export controls as a major risk. Chart 5U.S. Deficit Due To Security Concerns Rather, they see rising U.S. restrictions on Chinese investment in the U.S. as the real risk. The U.S. wants reciprocity in investment as well as trade. The emphasis lies on fair and equal access, which will require massive compromises from China, given its practice of walling off "strategic" sectors (including aviation, energy, electricity, shipping, and communications) from foreign interests. China's recent pledges to allow foreigners majority stakes in financial companies may not be enough to pacify the U.S. negotiators, especially if the promises hinge on long-term implementation. Treasury Secretary Steve Mnuchin will cause a stir when he releases his guidelines for investment restrictions, as expected by May 21 under the president's declaration on the Section 301 probe (Table 1).8 Both the House of Representatives and Senate are expected, within a couple of months, to pass the Foreign Investment Risk Review Modernization Act, proposed by Senator John Cornyn (R, TX) and Representative Robert Pittenger (R, NC). This bill would grant greater powers to the secretive Committee on Foreign Investment in the United States (CFIUS) in conducting investigations into foreign investment deals with national security ramifications. Under the new law CFIUS will be able to review proposed investment deals on grounds that go beyond a strict reading of national security. They will now include economic security, and potential sectoral impacts as well as individual corporate impacts, and previously neglected issues like intellectual property.9 Trump is unlikely to veto the bill, as previous presidents have done when laws cracking down on China have passed Congress, given his desire to shake up the China relationship. Table 1Protectionism: Upcoming Dates To Watch Will CFIUS enforcement truly intensify? Treasury's actions may preempt the bill, and CFIUS has already been subjecting China to greater scrutiny for years (Chart 6). Moreover, American presidents have always canceled investment deals if CFIUS advised against them.10 Presumably broadening CFIUS's powers will result in a wider range of deals struck down. The government already stopped Broadcom, a Singaporean company, from taking over the U.S. firm Qualcomm, in March, for reasons that have more to do with R&D and competitiveness (economic security) than with any military applications of its technologies (national security). Separately, U.S. policy elites are starting to turn their sights toward China's global propaganda and psychological operations. The scandal over the Communist Party's subversive institutional and political influence in Australia has heightened concerns in other Western, especially Anglo-Saxon, countries.11 This is a new trend that will have bigger implications going forward in Western civil society and the business community, with state efforts to create firewalls against Chinese state intrusion exacerbating political and trade tensions. Australians have the most favorable view of China in the West, and on the whole they continue to see China in a positive light. However, this view will likely sour this year. The recent attempt by Prime Minister Malcolm Turnbull to pass legislation guarding against Communist Party interference in Australian politics has already led to a series of diplomatic incidents, including tensions over the South China Sea and Pacific Islands. These can get worse in the near future. Consistently, over 40% of Australians view China as "likely" to become a military threat over the next 20 years (Chart 7), and this number will worsen if attempts to safeguard democratic institutions from state-backed influence operations cause China to retaliate with punitive measures toward Australia. China is offering some concessions to counteract the new, aggressive consensus in Washington. Enforcing UN sanctions against North Korea was the big turn. But it is also allowing the RMB to appreciate against the USD (Chart 8), which is an issue close to Trump's heart. The change in temperature in Washington can be measured by the fact that these concessions seem to be taken for granted while the discussion moves onto other demands like trade and investment reciprocity. Chart 6U.S. To Restrict Chinese Investment Chart 7Australian Fears About China To Rise Chart 8Is This Enough To Stay Trump's Hand On Tariffs? Simultaneously, China is courting Europe. European policymakers say that they share U.S. concerns about China's trade practices but wish to resolve disputes through the World Trade Organization and reject unilateral American actions or aggressive punitive measures that could harm global stability. Meanwhile China hopes that American policy toward Iran and the Middle East will alienate the Europeans while distracting Washington from formulating a coherent pivot to Asia. Bottom Line: Investors are underestimating the potential for a full-blown trade war. Policymakers - in China as well as the U.S. - have greater appetite for confrontation. Iran: Reversing Obama's Legacy The financial news media continue to underrate the importance of geopolitical risk tied to Iran this year (Chart 9). Our sense is that the Trump administration, when in doubt, is still biased towards reversing Obama-era policy on any given issue. Iranian nuclear deal of 2015 appears to be no exception. Chart 9Iranian Geopolitical Risk About to Shoot Up Signs have emerged for months that Trump is likely to refuse to waive Iranian sanctions (Table 2) when the renewal comes due on May 12. He has fired his national security adviser and secretary of state, as well as lesser officials, in preference for Iran hawks.12 French President Emmanuel Macron, having tried to convince Trump to retain the deal on his recent state visit to Washington, is apparently convinced Trump will scrap it.13 Table 2U.S. Sanctions Have Global Reach Moreover, discussions of Iran mark the one exception to the hardening consensus on China. A number of people we spoke with were not convinced that the Trump administration will truly devote the main thrust of its foreign policy to countering China. Some believed U.S. voters did not have the stomach for a trade fight that would affect their pocketbooks. Others believed that the Trump administration would simply revert to a more traditional Republican foreign policy, accepting a "quick win" on China trade while pursuing a confrontational military posture in the Persian Gulf. Still others believed that Trump has unique reasons, such as political weakness at home and the desire to be respected abroad, for wanting to be in lock-step with Israeli Prime Minister Benjamin Netanyahu and Crown Prince Mohammad bin Salman against Iran. All agreed that while a shift to China makes strategic sense, it may not overrule Republican policy preferences or inertia. The stakes are high. Allowing sanctions to snap back into place would affect a substantial portion of the one million barrels per day of oil that Iran has brought onto global markets since sanctions were eased in January 2016 (Chart 10). Chart 10Re-Imposing Iranian Sanctions Threatens Oil Supply And Middle East Stability As BCA's Commodity & Energy Strategy notes, global oil supply is tight and the critical driver - emerging market demand - remains strong. Meanwhile the "OPEC 2.0" cartel plans to extend production cuts throughout 2018 and likely into 2019, further draining global inventories. Inventories are now on track to fall beneath their 2010-14 average level by next year. In this context, the geopolitical risk premium will add to upside oil price risks this year. Our commodity strategists still expect oil prices to average $70-$74 per barrel this year (WTI and Brent respectively), but they can see it shooting above $80 per barrel on occasion, and warn that even small supply disruptions (whether from Iran, Venezuela, Libya, or elsewhere) could send prices even higher (Chart 11).14 Chart 11Oil Prices Can Make Runs Into /Barrel Range If the U.S. re-imposes sanctions on Iran, we doubt that the full one million barrels per day of post-sanctions Iranian production will be taken offline. Global compliance with sanctions will be ineffective this time around. The Trump administration's sanctions will not have the legitimacy or buy-in that the Obama administration's sanctions did. Trump may even intend to impose the sanctions for domestic political consumption while giving Europe, Japan, and others a free pass. Still, the geopolitical and production impact will be significant. As for oil, price overshoots are even more likely when one considers Venezuela, where our oil analysts estimate that state collapse will remove around 500,000 barrel per day from last year's average by the end of this year.15 Bottom Line: We continue to expect energy commodities to outperform metals in an environment where energy prices benefit from a rising geopolitical risk premium, while metals could suffer from ongoing risks to Chinese growth. Investment Conclusions Independently of the above anecdotes, Geopolitical Strategy has laid out a case urging clients to sell in May and go away.16 Last year we were confident recommending that clients forget this old adage because we had clarity on the geopolitical risks and their constraints. This year, with both China and Iran, we lack that clarity. The U.S.'s European allies could perhaps convince Trump to maintain the 2015 Iranian nuclear agreement, and Trump could perhaps accept China's concessions (such as they are) to get a "quick win" on the trade front before the midterm elections. But we have no basis for assessing that he will do either with any degree of conviction. How long will it take to resolve the raft of outstanding U.S.-Iran and U.S.-China tensions? Our uncertainty here gives us a high conviction view that this summer will be turbulent. Geopolitical tensions will likely get worse before they get better. We would reiterate our recommendation that clients be long DXY and hold a "geopolitical protector portfolio" of Swiss bonds and gold. We remain long developed market equities relative to emerging markets and long JPY/EUR. We are also maintaining our shorts on Chinese tech stocks and U.S. stocks exposed to China. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Strategic Outlook, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "Will Trump Fail The Midterm?" dated April 18, 2018, available at gps.bcaresearch.com. 6 Please see Jordain Carney, "McConnell: Senate won't take up Mueller protection bill," April 17, 2018, available at thehill.com. 7 Please see U.S. Trade Representative, "Under Section 301 Action, USTR Releases Proposed Tariff List on Chinese Products," and "USTR Robert Lighthizer Statement on the President's Additional Section 301 Action," dated April 3 and April 5, 2018, available at ustr.gov. 8 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. 9 Please see Senator Jon Cornyn, "S.2098 - Foreign Investment Risk Review Modernization Act of 2017," dated Nov. 8, 2017, available at www.congress.gov. For the argument behind the bill, see Cornyn and Dianne Feinstein, "FIRRMA Act will give Committee on Foreign Investment a needed update," The Hill, dated March 21, 2018, available at thehill.com. 10 Please see Wilson Sonsini Goodrich & Rosati, "CFIUS In 2017: A Momentous Year," 2018, available at www.wsgr.com. 11 Australian Senator Sam Dastyari (Labor Party) resigned on December 11, 2017 after it was exposed that he accepted cash donations from a Chinese property developer that he used to repay his own debts. He had also supported China's position in the South China Sea. The scandal prompted revelations of a range of Chinese state-linked political donations. Prime Minister Malcolm Turnbull has introduced legislation banning foreign political donations and forcing lobbyists for foreign countries to register. 12 Mike Pompeo replaced Rex Tillerson as Secretary of State, John Bolton replaced H.R. McMaster as National Security Adviser, and Chief of Staff John Kelly has been sidelined; Bolton has appointed Mira Ricardel as his deputy, who has been said to clash with Secretary of Defense James Mattis in trying to staff the Pentagon with Trump loyalists. Please see Niall Stanage, "The Memo: Nationalists gain upper hand in Trump's White House," The Hill, April 25, 2018, available at thehill.com. 13 Macron has presented a framework that German Chancellor Angela Merkel and U.K. Prime Minister Theresa May have accepted that would call for improvements to outstanding issues with Iran while keeping the 2015 deal intact. Macron has also spoken with Iranian President Hassan Rouhani about retaining the deal while addressing the Trump administration's grievances. 14 Please see BCA Commodity & Energy Strategy Weekly Report, "Tighter Balances Make Oil Price Excursions To $80/bbl Likely," dated April 19, 2018, available at ces.bcaresearch.com. 15 Please see footnote 14, and BCA Geopolitical Strategy and Energy Sector Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Weekly Report, "Expect Volatility ... Of Volatility," dated April 11, 2018, available at gps.bcaresearch.com. Geopolitical Calendar

Highlights The global economy is slowing. However, growth should stabilize at an above-trend pace over the next few months, as fiscal policy turns more stimulative and interest rates remain in accommodative territory. President Trump's macroeconomic policies are completely at odds with his trade agenda. Fortunately, Trump appears willing to cut a deal on trade, even if it is on terms that are not nearly as favorable to the U.S. as he might have touted. The recently renegotiated South Korea-U.S. Free Trade Agreement is a case in point. We remain cyclically overweight global equities, but acknowledge that valuations are stretched and the near-term market environment could remain challenging until leading economic indicators improve. Feature Global Equities: Near-Term Outlook Is Still Hazy We published a note on February 2nd entitled "Take Out Some Insurance" warning investors that the stock market had become highly vulnerable to a correction.1 The VIX spike began the next day. Although volatility has fallen and equities have rebounded so far in April, we are reluctant to sound the all-clear. The near-term signal from the beta version of our MacroQuant model has improved a bit but remains in bearish territory, as it has for over two months now (Chart 1). Chart 1MacroQuant Model Suggests Caution Is Warranted The model is highly sensitive to changes in growth. Starting early this year, it began to detect a weakening in a variety of leading economic indicators in the U.S. and, to an even greater degree, abroad. Most notably, global PMIs and the German IFO have dipped, Korean and Taiwanese exports have decelerated, Japanese machinery orders have fallen, and the Baltic Dry Index has swooned by 36% from its December high (Chart 2). The model also noted an increase in inflationary pressures, suggesting that monetary policy would likely end up moving in a less accommodative direction. The emergence of stagflationary concerns came at a time when bullish stock market sentiment stood at very elevated levels (Chart 3). Our empirical work has shown that equities perform worst when sentiment is deteriorating from bullish levels and perform best when sentiment is improving from bearish levels (Chart 4). Chart 2Growth Has Peaked Chart 3Stock Market Sentiment Was Very ##br##Bullish Earlier This Year Chart 4Swings In Sentiment And ##br##Stock Market Returns Waiting For The Economic Data To Stabilize The good news is that the drop in equity prices has caused sentiment to return to more normal levels. The bad news is that the activity data has continued to disappoint at the margin, as evidenced by the weakness in economic surprise indices and various "nowcasts" of real-time growth (Chart 5). Ultimately, we expect global growth to stabilize at an above-trend pace over the coming months, which should allow equities to grind higher. Monetary policy is still quite accommodative. The yield on the JP Morgan Global Bond Index has averaged 1.88% since the end of the Great Recession (Chart 6). We do not know where the "neutral" level of bond yields has been over this period. However, we do know that unemployment in the major economies has been falling, which suggests that monetary policy has been in expansionary territory. Despite the move away from quantitative easing by many central banks, the yield on the JP Morgan Global Bond Index is only 1.53% today. This implies a fortiori that bond yields today are well below restrictive levels. The conclusion is further strengthened if one assumes, as seems highly plausible, that the neutral bond yield has risen over the past few years, as deleveraging headwinds have abated and fiscal policy has turned more stimulative (Chart 7). Chart 5Unexpected Slowdown In Growth Chart 6Interest Rates Are Off Their Bottom, ##br##But Are Not Restrictive Chart 7Fiscal Policy Will Be Stimulative ##br##This Year And Next The Protectionism Bugbear Global growth has not been the only thing on investors' minds. The specter of a trade war has also loomed large. It is true that the standard early-19th century Ricardian model that first-year economics students learn predicts very small welfare losses from increased protectionism.2 The model, however, makes highly antiquated assumptions about how trade works. Trade today bears little resemblance to the world in which David Ricardo lived - the one where England exchanged cloth for Portuguese wine (the example Ricardo used to illustrate his famous principle of comparative advantage). Chart 8Trade In Intermediate Goods Dominates To an increasingly large extent, countries do not really trade with one another anymore. One can even go as far as to say that different companies do not really trade with each other in the way they once did. A growing share of international trade is between affiliates of the same companies. Trade these days is dominated by intermediate goods (Chart 8). The exchange of goods and services takes place within the context of a massive global supply chain, where such phrases as "outsourcing," "vertical integration" and "just-in-time inventory management" have entered the popular vernacular. This arrangement has many advantages, but it also harbors numerous fragilities. A small fire at a factory in Japan that manufactured 60 percent of the epoxy resin used in chip casings led to a major spike in RAM prices in 1993. Flooding in Thailand in 2011 wreaked havoc on the global auto industry.3 The global supply chain is highly vulnerable to even small shocks. Now imagine an across-the-board trade war. Equities represent a claim on the existing capital stock, not the capital stock that might emerge after a trade war has been fought. A trade war would result in a lot of stranded capital. It is not surprising that investors are worried. Trump's Dubious Trade Doctrine The psychology of a trade war today is not that dissimilar to that of an actual war among the great powers. It would be immensely damaging if it were to happen, but because everyone knows it would be so damaging, it is less likely to occur. How then should one interpret President Trump's tweet that "Trade wars are good, and easy to win?" One possibility is that he is bluffing. The U.S. exported only $131 billion in goods to China last year, which is less than the $150 billion in Chinese imports that Trump has already targeted for tariffs. China simply cannot win a tit-for-tat trade war with the United States. Unfortunately, there is also a less charitable interpretation, as revealed by the second part of Trump's tweet, where he said, "When we are down $100 billion with a certain country and they get cute, don't trade anymore - we win big. It's easy!" Trump seems to equate countries with companies: Exports are revenues and imports are costs. If a country is exporting less than it is importing, it must be losing money. This is deeply flawed reasoning. I run a trade deficit with the place where I eat lunch, but I don't go around complaining that they are ripping me off. One would think that Trump - whose businesses routinely spent more than they earned, accumulating debt in the process - would understand this. But apparently not. As we discussed two weeks ago, the U.S. runs a trade deficit mainly because its deep and open financial markets, along with a relatively high neutral rate of interest, make it an attractive destination for foreign capital.4 If a country runs a capital account surplus with the rest of the world - meaning that it sells more assets to foreigners than it buys from foreigners - it will necessarily run a current account deficit. Trump's Macro Policy Colliding With His Trade Policy In this respect, President Trump's macroeconomic policies are completely at odds with his trade agenda. By definition, the current account balance is the difference between what a country saves and what it invests. The U.S. fiscal position is set to deteriorate over the coming years, even if the unemployment rate continues to fall - an unprecedented occurrence (Chart 9). A bigger budget deficit will drain national savings. Chart 9The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline Meanwhile, an overheated economy will cause capital spending to rise as firms run out of low-cost workers. If Trump succeeds in boosting infrastructure spending, aggregate U.S. investment will rise even more. The current account deficit is highly likely to widen in this environment. A Temporary Reprieve? Chart 10Trump's Protectionist Agenda Is A ##br##Popular One Among Republican Voters The prospect of a wider trade deficit means that Trump's protectionist wrath will not go quietly into the night. It may, however, go into remission for a little while. Trump's approval rating has managed to rise over the past few months because his protectionist agenda is popular with a large segment of the population (Chart 10). However, if the problems on Wall Street begin to show up on Main Street - as is likely to happen if stocks resume their decline - Trump will change his tune. This is especially true if a trade war threatens to hurt U.S. agricultural interests. Rural areas have been a key source of support for Trump's populist rhetoric. Trump has shown a willingness to cut a deal on trade even if the negotiated outcome falls well short of his bluster. Consider the agreement between the U.S. and Korea in late March to amend their existing trade pact. Trump had called the South Korea-U.S. Free Trade Agreement an "unacceptable, horrible deal" and a "job killer." After the agreement was renegotiated, the President described it as a "wonderful deal with a wonderful ally." What did Trump get that was so wonderful? The Koreans agreed to double the ceiling on the number of U.S. automobiles that can be exported to Korea without having to meet the country's tough environmental standards to 50,000. The problem is that the U.S. only shipped 11,000 autos to Korea last year, so the original quota was nowhere close to binding. The Koreans also agreed to reduce steel exports to the U.S. to about 70% of the average level of the past three years in exchange for a permanent exemption from Trump's 25% steel tariff. That may sound like a major concession, but keep in mind that only 12% of Korea's steel exports go to the United States. Korea also re-exports steel from other countries. These re-exports can be curtailed without causing major damage to Korea's steel industry. The shares of Korea's largest publicly-listed steel companies jumped by 1.7% on the first trading day after news of the deal broke, eclipsing the 0.8% rise in the KOSPI index. Investment Conclusions The global economy is going through a soft patch and this could weigh on stocks in the near term. However, if trade frictions fade into the background and global growth stabilizes over the coming months, as we expect will be the case, global equities should rally to fresh cycle highs. Granted, we are in the late stages of the business-cycle expansion. U.S. interest rates are likely to move into restrictive territory in the second half of 2019. Given the usual lags between changes in monetary policy and the real economy, this would place the next recession in 2020. By then, barring any fresh stimulus, the U.S. fiscal impulse will have dropped below zero. It is the change in the fiscal impulse that matters for growth. If growth has already slowed to a trend-like pace by late 2019 due to a shortage of workers, the economy could easily stall out in 2020. Given the still-dominant role played by U.S. financial markets, a recession in the U.S. would quickly be transmitted to the rest of the world. Stocks will peak before the next recession starts, but if history is any guide, this will only happen six months or so before the economic downturn begins (Table 1). This suggests that the equity bull market still has another 12-to-18 months of life left. The extent to which investors may wish to participate in any blow-off rally this year is a matter of personal preference. As was the case in the late 1990s, long-term expected returns have fallen to fairly low levels. A comparison between the Shiller P/E ratio and subsequent 10-year returns over the past century suggests that the S&P 500 will deliver a total nominal annualized return of only 4% during the next decade (Chart 11). A composite valuation measure incorporating both the trailing and forward P/E ratio, price-to-book, price-to-cash flow, price-to-sales, market cap-to-GDP, dividend yield, and Tobin's Q shows only modestly higher expected returns for stock markets outside the U.S. (Appendix A). Table 1Cyclically, It Is Too Soon To Get Out... Chart 11...But Long-Term Investors, Take Note As such, while we recommend overweighting global equities over a 12-month horizon, we would not fault long-term investors for taking some money off the table now. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Take Out Some Insurance," dated February 2, 2018. 2 Roughly speaking, the Ricardian model predicts that the welfare loss from protectionism will be one-half times the average percentage-point increase in tariffs times the change in the import-to-GDP ratio. Imports are about 15% of U.S. GDP. Consider a 10 percent across-the-board increase in tariffs. Assuming a price elasticity of import demand of 4, this would reduce trade by 1-0.96^10=0.33 (i.e., 33%), which would take the import-to-GDP ratio down from 15% to 10%. As such, the welfare loss would be 0.5*0.1*(15%-10%)=0.25%, or just one quarter of one percent of GDP. 3 James Coates, "Real Chip Shortage Or Just A Panic, Crunch Is Likely To Boost Pc Prices," Chicago Tribune, dated August 6, 1993. "Thailand Floods Disrupt Production And Supply Chains," BBC.com, dated October 13, 2011; Ploy Ten Kate, and Chang-Ran Kim, "Thai Floods batter Global Electronics, Auto Supply Chains," Reuters.com, dated October 28, 2011. 4 Please see Global Investment Strategy Weekly Report, "U.S.-China Trade Spat: Is R-Star To Blame?" dated April 6, 2018. APPENDIX A Chart 1Long-Term Real Return Prospects Are Slightly Better Outside The U.S. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights An additional heavy salvo of U.S. import tariffs, were they to occur, would cause a material deceleration in Chinese economic growth (ceteris paribus). Trade negotiations are likely to produce a relatively benign outcome, but Chinese stocks and related financial assets may suffer meaningfully if not. Chinese policymakers have several policy options at their disposal to ease the impact of a major export sector shock, but many drawbacks make the choice a difficult one. For now, manufacturing sector-specific stimulus is the most likely policy response. A broad reading of key leading indicators for China's business cycle suggest that the industrial sector continues to slow. Recent bright spots in the data appear to be linked to unsustainably strong export demand, which is likely to wane in the months ahead. Stay overweight Chinese ex-tech stocks versus their global peers despite the looming trade threat, but with a short leash. Feature Trade frictions between China and the U.S. continue to dominate the headlines of the financial press. The most significant potential escalation in the conflict came two weeks ago, when President Trump instructed the U.S. Trade Representative to consider an additional $100 billion in tariffs on imports from China (on top of the initially proposed $50 billion). For investors, the possibility of a full-blown trade war between China and the U.S. and its implications for financial markets remains the "question that won't go away". Given that negotiations between trade representatives of both countries are highly active, the President's public suggestion that an additional heavy salvo of tariffs may be levied appears to be a clear case of economic saber-rattling. Still, investors cannot neglect the odds that such a scenario does indeed materialize, and in this week's report we revisit some of our previous work on the impact of proposed U.S. tariffs on Chinese economic growth. We also outline the (difficult) policy options available to Chinese policymakers, update investors on the state of China's business cycle, and reiterate our recommended investment strategy of staying overweight Chinese ex-tech stocks (with a short leash). The Impact Of Proposed Tariffs On Growth, Part II Chart 1150$ Billion In Import Tariffs Would Seriously ##br##Harm Chinese Export Growth We presented our framework for modeling the impact of U.S. import tariffs on overall Chinese export growth in our March 28 Weekly Report.1 Our approach suggested that the original $50 billion in proposed tariffs would cause China's total export growth to decelerate about 2%, which would work to counteract the acceleration in underlying export growth that we would normally expect over the coming months given the pace of the global demand. Chart 1 updates this framework assuming a total of $150 billion in tariffs. While overall nominal export growth would not contract outright as a result of the tariff imposition, it would decelerate materially from our estimate of its underlying rate (currently 10%). There are good odds that Trump's suggestion of an additional $100 billion in tariffs against China was merely a negotiating tactic, and it is clear that China has a strong incentive to agree to a trade deal with the U.S. that will prevent the scenario depicted in Chart 1 from taking place. But were it to, it would represent a significant threat to China's cyclical economic momentum, in a manner that would surpass the direct contribution to Chinese growth from the external sector. Charts 2 and 3 explain why. Chart 2 first presents an annual time series of the net export (NX) contribution to Chinese real GDP growth, relative to final consumption expenditure and gross capital formation. Investors might initially react to this chart by concluding that a significant deceleration in export growth would have a minimal impact on the Chinese economy, since the net contribution to growth from the external sector has typically been small relative to the other expenditure categories. Chart 2Net Exports Are Not A Huge##br## Direct Contributor To Growth... Chart 3...But The Export Sector Is Highly ##br## Investment-Intensive However, this perspective misses two important elements of the Chinese economy that are crucial to understand: China's import demand is strongly tied to the export channel, given that roughly half of Chinese imports are commodity-oriented. This means that Chinese import growth would also suffer from a sudden hit to U.S. exports, which would reverberate the shock to China's trading partners (and back again to China). In short, the imposition of major U.S. tariffs on imports from China would cause a negative feedback loop for China and its key trading partners. Abstracting from the global financial crisis, Chart 3 highlights that there is a strongly positive relationship between the annual change in contribution to growth from China's net exports and subsequent investment. This underscores that an important portion of China's gross capital formation, which is a significant contributor to the Chinese economy, is driven by the export sector. Based on the relationship shown in Chart 3, and the historical relationship between nominal exports and the real contribution from net exports, the scenario depicted in Chart 1 could cause the contribution to growth from Chinese investment to fall 0.5-0.6 percentage points, which could push real GDP growth to or below 6% if consumption remained constant. While we have not focused on real GDP growth as an accurate measure of Chinese economic activity, a deceleration of that magnitude would be on par with what occurred in 2011-2012, when Chinese stocks and related financial assets fared quite poorly. Bottom Line: An additional heavy salvo of U.S. import tariffs, were they to occur, would cause a material deceleration in Chinese economic growth. Trade negotiations are likely to produce a relatively benign outcome, but Chinese stocks and related financial assets may suffer meaningfully if not. China's Policy Options Our analysis above did not incorporate a stimulative response from Chinese policymakers, which we would certainly expect if China experienced a large shock to its export sector. Table 1 presents a brief list of policy actions that the Chinese government could employ in response; some are narrowly focused on the export channel, and some would impact the economy more broadly. Table 1No Easy Cure-Alls To Ease The Impact Of Tariffs Our assumption is that policymakers will initially choose more focused policies and will refrain from broad-based stimulus unless the impact of the export sector shock is expected to much more significant than is currently the case. This is particularly true given that Table 1 highlights the difficulty facing Chinese policymakers, in that there are significant drawbacks associated with any of the policies described. Given that the proposed import tariffs will primarily affect firms manufacturing goods for export to the U.S., the most focused policies would be to provide some offsetting form of stimulus to the manufacturing sector and to depreciate the RMB versus the U.S. dollar. In our view, manufacturing sector-specific stimulus is the most likely to occur of any policies described in Table 1: the drawbacks are primarily structural in nature, and China has already announced a slight reduction in the tax rate for manufacturing industries as part of a series of changes to the VAT regime. We expect to see more announcements in this vein over the coming months. Materially depreciating the RMB vs the U.S. dollar, however, is quite unlikely to occur as a stimulative response, as it would very likely inflame trade tension with the U.S. Chinese authorities may use threats of backtracking on the non-trivial appreciation in CNYUSD over the past year during talks with the U.S., but we doubt that authorities would actually go ahead with this barring a complete breakdown in negotiations. Depreciating versus the euro is similarly problematic. Chart 4 highlights that the RMB has barely risen at all versus the euro over the past year, implying that a meaningful depreciation would likely anger euro area policymakers, especially given that the trade-weighted euro has already risen nearly 10% over the past year. Instead, Chart 5 highlights the most likely route if China chooses to use the RMB as a relief valve: a depreciation against Japan, Korea, Vietnam, and India. China's combined export weight to these countries is meaningful, and the chart shows that there is depreciation potential: a weighted RMB index versus these currencies has risen about 8% in the past 12 months. Chart 4The RMB Has Not Appreciated ##br##Against The Euro Chart 5Room To Depreciate Against A ##br##Basket Of Asian Currencies We will revisit the remaining policies listed in Table 1 if the U.S. does indeed follow through with a second round of significant tariffs against Chinese imports, or if the economic effect of the first round proves to be more significant than we expect. From a bigger picture perspective, the potential for broader stimulus from Chinese authorities (in response to a more impactful shock) raises the interesting possibility of another economic mini cycle in China. While the need to stimulate broadly, were it to occur, would clearly imply that the economy would first be weakening, investors should remember that China's economy ultimately accelerated meaningfully in response to the last episode of material fiscal & monetary easing. We presented our framework for tracking the end of China's current mini-cycle in our October 12 Weekly Report,2 and argued that a benign, controlled deceleration was the most likely outcome (Chart 6). In our view the economic data has validated this call over the past six months, and we do not see any reason yet to deviate from it (see next section below). But a severe export shock followed by a burst of economic stimulus would clearly alter our expectations for China's business cycle dynamics, and would also create some exciting investment opportunities for investors (both on the downside and the upside). While the odds of this scenario are not currently probable, we raise the possibility because of the significance that another cycle would have for global investor sentiment and the returns from Chinese financial assets. Chart 6A Stylized View Of China's Recent "Mini-Cycle" Bottom Line: Chinese policymakers have several policy options at their disposal to ease the impact of a major export sector shock, but many drawbacks make the choice a difficult one. For now, manufacturing sector-specific stimulus is the most likely policy response. Abstracting From Trade, China Continues To Slow As noted above, we have been flagging a deceleration in China's industrial sector since early-October. Table 2 is an updated version of a table that we presented in our March 7 Weekly Report,3 which shows recent data points for several series that we have identified as having leading properties for the Chinese business cycle, as well as the most recent month-over-month change, an indication of whether the series is currently above its 12-month moving average, and how long this has been the case. While we do not yet have all of the March components of our BCA Li Keqiang leading indicator, the four that are available all declined in March from February, suggesting that the ongoing economic slowdown continues. Table 2Key Chinese Data Do Not Signal A Broad Acceleration The table does highlight, however, two relatively positive developments: the Bloomberg Li Keqiang index was materially higher on average in January and February than it was in the two months prior, and now both the official and Caixin manufacturing PMIs are above their 12-month moving average, with the latter having been so for 4 months in a row. An average of the two measures, along with its 12-month moving average, in shown in Chart 7. Are these budding signs of a durable upturn in China's industrial sector? We do not take a dogmatic approach to forecasting China's cyclical trajectory, and will be monitoring this possibility over the coming months. But in our current judgement, the answer is no. The January pop in Bloomberg Li Keqiang index reflects two separate factors: a jump in the annual growth of rail cargo volume in January (which subsequently unwound in February), as well as strong growth in electricity production on average in January and February (Chart 8). Normally this would be an encouraging sign for China's economy, but when connected with the countertrend move in the manufacturing PMIs and the sharp, unsustainable rise in February's export growth, a pattern begins to emerge. Chart 7A Modest Tick Up In China's ##br##Manufacturing PMIs Chart 8The Li Keqiang Index: ##br##A Brief, Countertrend Move While far from conclusive, it would appear that China experienced a very sudden burst of goods production for the purposes of export. Given that this is occurring in the context of considerable trade frictions and the eventual imposition of import tariffs, and against the backdrop of strong but steady (and possibly peaking) global demand, it is conceivable that China's exporters are attempting to front-load shipments for the year before these tariffs take effect. Although a February surge is visible in Chinese export growth to several countries (not just the U.S.), and undoubtedly some of the effect is due to the timing of the Chinese new year, it is possible that Chinese exporters are acting in anticipation of possible additional tariffs on other countries or global industries that China acts as a supplier to. We noted above that the imposition of the first round of U.S. tariffs will likely be enough to arrest any acceleration in overall Chinese export growth, with a second round likely to cause a downward change in trend. Thus, to us, it is difficult to see an export-driven catalyst for China's industrial sector continuing over the coming months. On the import side, the data has also been more positive than we would have expected, given the close link between import growth and the Li Keqiang index (Chart 9). Part of this deviation may be accounted for by unsustainable export growth, given the typically strong link between import and export growth in highly trade-oriented economies. Interestingly, Chart 10 highlights that the flat trend in import growth appears to be supported by an uptrend in manufactured products, whereas the trend of primary products imports is much more consistent with what our indicators would suggest. For now, we are sticking with the signal given by the latter, since it has historically been a more reliable predictor of whether overall future import growth will be growing at an above-trend pace. But as we stated above, our view of a benign slowdown in China is empirically-based, and we will continue to monitor the data for signs that the external sector of China's economy warrants a change in our slowdown view. Chart 9Import Growth Has Held Up##br## Better Than We Expected... Chart 10...But Commodity Imports Suggest##br## Broad Import Growth Will Weaken Bottom Line: A broad reading of key leading indicators for China's business cycle suggest that the industrial sector continues to slow. Recent bright spots in the data appear to be linked to unsustainably strong export demand, which is likely to wane in the months ahead. Investment Implications We noted in our March 28 Weekly Report that the shift in U.S. protectionism from rhetoric to action and the continued decline in our leading indicators makes a tenuous case for a continued overweight stance towards Chinese stocks.1 We recommended in that report that investors put Chinese ex-tech stocks on downgrade watch over the course of Q2. This recommendation stands, although it is notable that the relative performance of Chinese ex-tech shares (versus global) remains comfortably above its 200-day moving average (Chart 11). Chinese tech stocks, on the other hand, have sold off meaningfully over the past month (Chart 11 panel 2) due in part to the tech oriented nature of the U.S.' trade action. We advised investors to reduce their exposure to the tech sector in our February 15 Weekly Report,4 based on elevated earnings momentum and very rich valuation. Conversely, pricing also appears to be at the root of resilient ex-tech relative performance: Chart 12 shows that the 12-month forward earnings yield versus U.S. 10-year Treasurys is considerably higher for Chinese ex-tech companies than in developed or other emerging equity markets. This reinforces an argument that we have made in previous reports, which is that investors should have a high threshold for reducing exposure to China. Chart 11Chinese Ex-Tech Stocks ##br##Are Doing Fine, For Now... Chart 12...Supported By A Sizeable ##br##Risk Premium The key question is therefore whether the probable shock to Chinese export growth coupled with the ongoing slowdown in the industrial sector is significant enough to pre-emptively downgrade Chinese stocks. Our answer to this question remains "no", since investors still do not have the requisite visibility on the magnitude of the hit to exports and the likely policy response. Until this information emerges, we continue to recommend that investors stay overweight Chinese ex-tech stocks unless a technical breakdown emerges, and to watch for additional updates on this issue from BCA's China Investment Strategy service over the coming weeks and months. Bottom Line: Stay overweight Chinese ex-tech stocks versus their global peers despite the looming trade threat. Our downgrade watch remains in effect, and we are likely to advise a reduction in exposure in response to a technical breakdown. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Chinese Stocks: Trade Frictions Make For A Tenuous Overweight", dated March 28, 2018, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Tracking The End Of China's Mini-Cycle", dated October 12, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "China And The Risk Of Escalation", dated March 7, 2018, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report, "After The Selloff: A View From China", dated February 15, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Dear Client, This week, we are publishing a Special Report produced by Mark McClellan, author of The Bank Credit Analyst and Mathieu Savary, author of Foreign Exchange Strategy. This report discusses the long-term outlook for the dollar and argues that the greenback is in a structural downtrend. Cyclically too, the dollar is likely to continue to soften. However, despite this negative multi-year view on the USD, BCA still sees a high probability of a dollar rebound in 2018. This move would therefore be a countertrend bounce. Best regards, John Canally, Senior Vice President U.S. Investment Strategy In this Special Report, we review the theory behind exchange rate determination and examine the cyclical and structural forces that will drive the dollar. The long-term structural downtrend in the dollar is intact. This trend reflects both a slower underlying pace of U.S. productivity growth relative to the rest of the world and a persistent external deficit. The U.S. shortfall on its net international investment position, now at about 40% of GDP, is likely to continue growing in the coming decades. Fiscal stimulus means that the U.S. twin deficits are set to worsen, but the situation is not that dire that the U.S. dollar is about to fall off a cliff because of sudden concerns regarding sustainability. The U.S. is not close to the point where investors will begin to seriously question America's ability to service its debt. The U.S. will continue to enjoy a net surplus on its international investments except under a worst-case scenario for relative returns. From an economic perspective, we see little reason why the U.S. will not be able to easily continue financing its domestic saving shortfall in the coming years. There are some parallels today with the Nixon era, but we do not expect the same outcome for the dollar. The Fed is unlikely to make the same mistake as it made in the late 1960s/early 1970s. There are risks of course. Growing international political tensions and a trade war could threaten the U.S. dollar's status as the world's premier reserve currency. While the underlying trend in the dollar is down, cyclical factors are likely to see it appreciate on a 6-12 month investment horizon. Growth momentum, which moved in favor of the major non-U.S. currencies in 2017, should shift in the greenback's favor this year. U.S. fiscal stimulus is bullish the dollar, despite the fact that this will worsen the current account balance. Additional protectionist measures should also support the dollar as long as retaliation is muted. Feature The U.S. dollar just can't seem to get any respect even in the face of a major fiscal expansion that is sure to support U.S. growth. Nonetheless, there are a lot of moving parts to consider besides fiscal stimulus: a tightening Fed, accumulating government debt, geopolitical tension and growing trade protectionism among others. The interplay of all these various forces can easily create confusion about the currency outlook. Textbook economic models show that the currency should appreciate in the face of stimulative fiscal policy and rising tariffs, at least in the short term, not least because U.S. interest rates should rise relative to other countries. However, one could also equate protectionism and a larger fiscally-driven external deficit with a weaker dollar. Which forces will dominate? In this Special Report, we sort out the moving parts. We review the theory behind exchange rate determination and examine the cyclical and structural forces that will drive the dollar in the short- and long-term. Tariffs And The Dollar Let's start with import tariffs. In theory, higher tariffs should be positive for the currency as long as there is no retaliation. The amount spent on imports will fall as consumer spending is re-directed toward domestically-produced goods and services. A lower import bill means the country does not need to export as much to finance its imports, leading to dollar appreciation (partially offsetting the competitive advantage that the tariff provides). Tariffs also boost inflation temporarily, which means that higher U.S. real interest rates should also lift the dollar to the extent that the Fed responds with tighter policy. Chart 1At Full Employment,##BR##Import Tariffs Raise Rates That said, the tariffs recently announced by the Trump Administration are small potatoes in the grand scheme. The U.S. imported $39 billion of iron and steel in 2017, and $18 billion of aluminum. That's only 2% of total imports and less than 0.3% of GDP. If import prices went up by the full amount of the tariff, this would add less than five basis points to inflation. The positive impact on U.S. growth is also modest as the tariffs benefit only two industries, and higher domestic prices for steel and aluminum undermine U.S. consumers of these two metals. A unilateral tariff increase could be mildly growth-positive if there is no retaliation by trading partners. This was the result of a Bank of Canada study, which found that much of the growth benefits from a higher import tariff are offset by an appreciation of the currency.1 Even a short-term growth boost is not guaranteed. A detailed analysis of the 2002 Bush steel tariff increase found that the import tax killed many more jobs than it created.2 Shortages forced some U.S. steel-consuming firms to source the metal offshore, while others made their steel suppliers absorb the higher costs, leading to job losses. A recent IMF3 study employed a large macro-economic model to simulate the impact of a 10% across-the-board U.S. import tariff without any retaliation. It found that tariffs place upward pressure on domestic interest rates, especially if the economy is already at full employment (Chart 1). This is because the central bank endeavors to counter the inflationary impact with higher interest rates. However, a stronger currency and higher interest rates eventually cool the economy and the Fed is later forced to ease policy. This puts the whole process into reverse as interest rate differentials fall and the dollar weakens. The economic outcome would be much worse if U.S. trading partners were to retaliate and the situation degenerates into a full-fledged trade war involving a growing number of industries. In theory, the dollar would not rise as much if there is retaliation because foreign tariffs on U.S. exports are offsetting in terms of relative prices. But all countries lose in this scenario. China is considering only a small retaliation for the steel and aluminum tariffs as we go to press, but the trade dispute has the potential to really heat up. The bottom line is that the Trump tariffs are more likely to lead to a stronger dollar than a weaker one, although far more would have to be done to see any meaningful impact. Fiscal Stimulus And The Dollar Traditional economic theory suggests that fiscal stimulus is also positive for the currency in the short term. The boost in aggregate demand worsens the current account balance, since some of the extra government spending is satisfied by foreign producers. The U.S. dollar appreciates as interest rates increase relative to the other major countries, attracting capital inflows. The currency appreciation thus facilitates the necessary adjustment (deterioration) in the current account balance. The impact on interest rates is similar to the tariff shock shown in Chart 1. All of the above market and economic adjustments should be accentuated when the economy is already at full employment. Since the domestic economy is short of spare capacity, a vast majority of the extra spending related to fiscal stimulus must be imported. Moreover, the Fed would have to respond even more aggressively to the extent that inflationary pressures are greater when the economy is running hot. The result would be even more upward pressure on the U.S. dollar. Reality has not supported the theory so far. The U.S. dollar weakened after the tax cuts were passed, and it did not even get a lift following the Senate spending plan that was released in February. The broad trade-weighted dollar has traded roughly sideways since mid-2017. Judging by the market reaction to the fiscal news, it appears that investors are worried about a potential replay of the so-called Nixon shock, when fiscal stimulus exacerbated the 'twin deficits' problem, investors lost confidence in policymakers and the dollar fell. Twin deficits refers to a period when the federal budget deficit and the current account deficit are deteriorating at the same time. Chart 2 highlights that the late 1960s/early 1970s was the last time that the federal government stimulated the economy at a time when the economy was already at full employment. Seeing the parallels today, some investors are concerned the dollar will decline as it did in the early 1970s. Chart 2A Replay Of The Nixon Years? Current Account And Budget Balances Often Diverge... Chart 3Twin Deficits And The Dollar The two deficits don't always shift in the same direction. In fact, Chart 3 highlights that they usually move in opposite directions through the business cycle. This is not surprising because the current account usually improves in a recession as imports contract more than exports, but the budget deficit rises as tax revenues wither. The process reverses when the economy recovers. The current account balance equals the government financial balance (i.e. budget deficit) plus the private sector financial balance (savings less investment spending). Thus, swings in the latter mean that the current account can move independently of the budget deficit. Even when the two deficits move in the same direction, there has been no clear historical relationship between the sum of the fiscal and current account balances and the value of the trade-weighted dollar (shaded periods in Chart 3). In the early 1980s, the twin deficits exploded on the back of the Reagan tax cuts and the military buildup, but the dollar strengthened. In contrast, the dollar weakened in the early 2000s, a period when the twin deficits rose in response to the Bush tax cuts, the Iraq War, and a booming housing market. ...But Generally Fiscal Expansion Undermines The Current Account Over long periods, a sustained rise in the fiscal deficit is generally associated with a sustained deterioration in the external balance. Numerous academic studies have found that every 1 percentage-point rise in the budget deficit worsens the current account balance by an average of 0.2-0.3 percentage points over the medium term. One study found that the current account deteriorates by an extra 0.2 percentage points if the fiscal stimulus arrives at a time when the economy is at full employment (i.e. an additional 0.2 percentage points over-and-above the 0.2-0.3 average response, for a total of 0.4 to 0.5).4 Given that the U.S. economy is at full employment today, these estimates imply that the expected two percentage point rise in the budget deficit relative to the baseline over 2018 and 2019 could add almost a full percentage point to the U.S. current account deficit (from around 3% of GDP currently to 4%). It could be even worse over the next couple of years because the private sector is likely to augment the government sector's drain on national savings. The mini capital spending boom currently underway will lift imports and thereby contribute to a further widening in the U.S. external deficit position. Chart 4Structural Drivers Of The U.S. Dollar Nonetheless, theory supports the view that the dollar will rise in the face of fiscal stimulus, at least in the near term, even if this is accompanied by a rising external deficit. Theory gets fuzzier in terms of the long-term outlook for the currency. However, the traditional approach to the balance of payments suggests that the equilibrium value of the dollar will eventually fall. An ongoing current account deficit will accumulate into a rising stock of foreign-owned debt that must be serviced. The Net International Investment Position (NIIP) is the difference between the stock of foreign assets held by U.S. residents and the stock of U.S. assets held by foreign investors. The NIIP has fallen increasingly into the red over the past few decades, reaching 40% of GDP today (Chart 4). The dollar will eventually have to depreciate in order to generate a trade surplus large enough to allow the U.S. to cover the extra interest payments on its growing stock of foreign debt. The structural depreciation of the U.S. dollar observed since the early 1980s supports the theory, because it has trended lower along with the NIIP/GDP ratio. However, the downtrend probably also reflects other structural factors. For example, U.S. output-per-employee has persistently fallen relative to its major trading partners for decades (Chart 4, third panel). The bottom line is that, while the dollar is likely to remain in a structural downtrend, it should receive at least a short-term boost from the combination of fiscal stimulus and higher tariffs. What could cause the dollar to buck the theory and depreciate even in the near term? We see three main scenarios in which the dollar could fall on a 12-month investment horizon. (1) Strong Growth Outside The U.S. First, growth momentum favored Europe, Japan and some of the other major countries relative to the U.S. in 2017. This helps to explain dollar weakness last year because the currency tends to underperform when growth surprises favor other countries in relative terms. It is possible that momentum will remain a headwind for the dollar this year. Nonetheless, this is not our base case. European and Japanese growth appears to be peaking, while fiscal stimulus should give the U.S. economy a strong boost this year and next. (2) A Lagging Fed The Fed will play a major role in the dollar's near-term trend. The Fed could fail to tighten in the face of accelerating growth and falling unemployment, allowing inflation and inflation expectations to ratchet higher. If investors come to believe that the Fed will remain behind-the-curve, rising long-term inflation expectations would depress real interest rates and thereby knock the dollar down. This was part of the story in the Nixon years. Under pressure from the Administration, then-Fed Chair Arthur Burns failed to respond to rising inflation, contributing to a major dollar depreciation from 1968 to 1974. We see this risk as a very low-probability event. Today's Fed acts much more independently of Congress beyond its dual commitment on inflation and unemployment. And, given that the economy is at full employment, there is nothing stopping the FOMC from acting to preserve its 2% inflation target if it appears threatened. Chair Powell is new and untested, but we doubt he and the rest of the Committee will be influenced by any political pressure to keep rates unduly low as inflation rises. Even Governor Brainard, a well-known dove, has shifted in a hawkish direction recently. President Trump would have to replace the entire FOMC in order to keep interest rates from rising. We doubt he will try. (3) Long-Run Sustainability Concerns It might be the case that the deteriorating outlook for the NIIP undermines the perceived long-run equilibrium value of the currency so much that it overwhelms the impact of rising U.S. interest rates and causes the dollar to weaken even in the near term. This scenario would likely require a complete breakdown in confidence in current and future Administrations to avoid a runaway government debt situation. Historically, countries with large and growing NIIP shortfalls tend to have weakening currencies. The sustainability of the U.S. twin deficits has been an area of intense debate among academics and market practitioners for many years. One could argue that the external deficit represents the U.S. "living beyond its means," because it consumes more than it produces. Another school of thought is that global savings are plentiful, and investors seek markets that are deep, liquid and offer a high expected rate of return. Indeed, China has willingly plowed a large chunk of its excess savings into U.S. assets since 2000. If the U.S. is an attractive place to invest, then we should not be surprised that the country runs a persistent trade deficit and capital account surplus. But even taking the more positive side of this debate, there are limits to how long the current situation can persist. The large stock of financial obligations implies flows of income payments and receipts - interest, dividends and the like - that must be paid out of the economy's current production. This might grow to be large enough to significantly curtail U.S. consumption and investment. At some point, foreign investors may begin to question the desirability of an oversized exposure to U.S. assets within their global portfolios. We are not suggesting that foreign investors will suddenly dump their U.S. stocks and bonds. Rather, they may demand a higher expected rate of return in order to accept a rising allocation to U.S. assets. This would imply that the dollar will fall sharply so that it has room to appreciate and thereby lift the expected rate of return for foreign investors from that point forward. Chart 5 shows that a 2% current account deficit would be roughly consistent with stabilization in the NIIP/GDP ratio. Any deficit above this level would imply a rapidly deteriorating situation. A 4% deficit would cause the NIIP to deteriorate to almost 80% of GDP by 2040. The fact that the current account averaged 4.6% in the 2000s and 2½% since 2010 confirms that the NIIP is unlikely to stabilize unless major macroeconomic adjustments are made (see below). Chart 5Scenarios For The U.S. Net International Investment Position Academic research is inconclusive on how large the U.S. NIIP could become before there are serious economic consequences and/or foreign investors begin to revolt. Exorbitant Privilege The U.S. has been able to get away with the twin deficits for so long in part because of the dollar's status as the world's premier reserve currency. The critical role of the dollar in international transactions underpins global demand for the currency. This has allowed the U.S. to issue most of its debt obligations in U.S. dollars, forcing the currency risk onto foreign investors. The U.S. is also able to get away with offering foreign investors a lower return on their investment in the U.S. than U.S. investors receive on their foreign investment. Chart 6 provides a proxy for these two returns. Relatively safe, but low yielding, fixed-income investments are a large component of foreign investments in the U.S., while U.S. investors favor equities and other assets that have a higher expected rate of return when investing abroad (Chart 7). This gap increased after the Great Recession as U.S. interest rates fell by more than the return U.S. investors received on their foreign assets. Today's gap, at almost 1½ percentage points, is well above the 1 percentage point average for the two decades leading up to the Great Recession. Chart 6U.S. Investors Harvest##BR##Higher Returns Chart 7Composition Of Net International##BR##Investment Position A yield gap of 1.5 percentage points may not sound like much, but it has been enough that the U.S. enjoys a positive net inflow of private investment income of about 1.2% of GDP, despite the fact that foreign investors hold far more U.S. assets than the reverse (Chart 6, top panel). In Chart 8 we simulate the primary investment balance based on a persistent 3% of GDP current account deficit and under several scenarios for the investment yield gap. Perhaps counterintuitively, the primary investment surplus that the U.S. currently enjoys will actually rise slightly as a percent of GDP if the yield gap remains near 1½ percentage points. This is because, although the NIIP balance becomes more negative over time, U.S. liabilities are not growing fast enough relative to its assets to offset the yield differential. Chart 8Primary Investment Balance Simulations However, some narrowing in the yield gap is likely as the Fed raises interest rates. Historically, the gap does not narrow one-for-one with Fed rate hikes because the yield on U.S. investments abroad also rises. Assuming that the yield gap returns to the pre-Lehman average of 1 percentage point over the next three years, the primary investment balance would decline, but would remain positive. Only under the assumption that the yield gap falls to 50 basis points or lower would the primary balance turn negative (Chart 8, bottom panel). Crossing the line from positive to negative territory on investment income is not necessarily a huge red flag for the dollar, but it would signal that foreign debt will begin to impinge on the U.S. standard of living. That said, the yield gap will have to deteriorate significantly for this to happen anytime soon. What Drives The Major Swings In The Dollar? While the dollar has been in a structural bear market for many decades, there have been major fluctuations around the downtrend. Since 1980, there have been three major bull phases and two bear markets (bull phases are shaded in Chart 9). These major swings can largely be explained by shifts in U.S./foreign differentials for short-term interest rates, real GDP growth and productivity growth. A model using these three variables explains most of the cyclical swings in the dollar, as the dotted line in the top panel of Chart 9 reveals. Chart 9U.S. Dollar Cyclical Swings Driven By Three Main Factors The peaks and troughs do not line up perfectly, but periods of dollar appreciation were associated with rising U.S. interest rates relative to other countries, faster relative U.S. real GDP growth, and improving U.S. relative productivity growth. Since the Great Recession, rate differentials have moved significantly in favor of the dollar, although U.S. relative growth improved a little as well. Productivity trends have not been a factor in recent years. Note that the current account has been less useful in identifying the cyclical swings in the dollar. Looking ahead, we expect short-term interest rate differentials to shift further in favor of the U.S. dollar. We assume that the Fed will hike rates three additional times in 2018 and another three next year. The Bank of Japan will stick with its current rate and 10-year target for the foreseeable future. The ECB may begin the next rate hike campaign by mid-2019, but will proceed slowly thereafter. We expect rate differentials to widen by more than is discounted in the market. As discussed above, we also expect growth momentum to swing back in favor of the U.S. economy in 2018. U.S. productivity growth will continue to underperform the rest-of-world average over the medium and long term. Nonetheless, we expect a cyclical upturn in relative productivity performance that should also support the greenback for the next year or two. Conclusion Reducing the U.S. structural external deficit to a sustainable level would require significant macro-economic adjustments that seem unlikely for the foreseeable future. We would need to see some combination of a higher level of the U.S. household saving rate, a balanced Federal budget balance or better, and/or much stronger growth among U.S. trading partners. In other words, the U.S. would have to become a net producer of goods and services, and either Europe or Asia would have to become a net consumer of goods and services. Current trends do not favor such a role reversal. Indeed, the U.S. twin deficits are sure to move in the wrong direction for at least the next two years. Longer-term, pressure on the federal budget deficit will only intensify with the aging of the population. The shortfall in terms of net foreign assets will continue to grow, which means that the long-term structural downtrend in the trade-weighted value of the dollar will persist. Other structural factors, such as international productivity trends, also point to a long-term dollar depreciation. It seems incongruous that the U.S. dollar is the largest reserve currency and that U.S. is the world's largest international debtor. The situation is perhaps perpetuated by the lack of an alternative, but this could change over time as concerns over the long-run viability of the Eurozone ebb and the Chinese renminbi gains in terms of international trade. The transition could take decades. The U.S. twin-deficits situation is not that dire that the U.S. dollar is about to fall off a cliff because of sudden concerns about the unsustainability of the current account deficit. Even though the NIIP/GDP ratio will continue to deteriorate in the coming years, it does not appear that the U.S. is anywhere close to the point where investors would begin to seriously question America's ability to service its debt. The U.S. will continue to enjoy a net surplus on its international investments except under a worst-case scenario for relative returns. From an economic perspective, we see no reason why the U.S. will not be able to easily continue financing its domestic saving shortfall in the coming years. There are other risks of course. Growing international political tensions and a trade war could threaten the U.S. dollar's status as the world's premier reserve currency. In 2018, we expect the dollar to partially unwind last year's weakness on the back of positive cyclical forces. Additional protectionist measures should support the dollar as long as retaliation is muted. Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 A Wave of Protectionism? An Analysis of Economic and Political Considerations. Bank of Canada Working Paper 2008-2. Philipp Maier. 2 The Unintended Consequences of U.S. Steel Import Tariffs: A Quantification of the Impact During 2002. Trade Partnership Worldwide, LLC. Joseph Francois and Laura Baughman. February 4, 2003. 3 See footnote to Chart 1. 4 Fiscal Policy and the Current Account. Center for Economic Policy Research, Discussion Paper No. 7859 September 16, 2010.

Dear Client, This week, we are publishing a Special Report co-produced with Mark McClellan, who writes The Bank Credit Analyst. This report discusses the long-term outlook for the dollar and argues that the greenback is in a structural downtrend. Cyclically too, the dollar is likely to continue to soften. However, despite this negative multi-year view on the USD, BCA still sees a high probability of a dollar rebound in 2018. This move would therefore be a countertrend bounce. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Highlights In this Special Report, we review the theory behind exchange rate determination and examine the cyclical and structural forces that will drive the dollar. The long-term structural downtrend in the dollar is intact. This trend reflects both a slower underlying pace of U.S. productivity growth relative to the rest of the world and a persistent external deficit. The U.S. shortfall on its net international investment position, now at about 40% of GDP, is likely to continue growing in the coming decades. Fiscal stimulus means that the U.S. twin deficits are set to worsen, but the situation is not that dire that the U.S. dollar is about to fall off a cliff because of sudden concerns regarding sustainability. The U.S. is not close to the point where investors will begin to seriously question America's ability to service its debt. The U.S. will continue to enjoy a net surplus on its international investments except under a worst-case scenario for relative returns. From an economic perspective, we see little reason why the U.S. will not be able to easily continue financing its domestic saving shortfall in the coming years. There are some parallels today with the Nixon era, but we do not expect the same outcome for the dollar. The Fed is unlikely to make the same mistake as it made in the late 1960s/early 1970s. There are risks of course. Growing international political tensions and a trade war could threaten the U.S. dollar's status as the world's premier reserve currency. While the underlying trend in the dollar is down, cyclical factors are likely to see it appreciate on a 6-12 month investment horizon. Growth momentum, which moved in favor of the major non-U.S. currencies in 2017, should shift in the greenback's favor this year. U.S. fiscal stimulus is bullish the dollar, despite the fact that this will worsen the current account balance. Additional protectionist measures should also support the dollar as long as retaliation is muted. Feature The U.S. dollar just can't seem to get any respect even in the face of a major fiscal expansion that is sure to support U.S. growth. Nonetheless, there are a lot of moving parts to consider besides fiscal stimulus: a tightening Fed, accumulating government debt, geopolitical tension and growing trade protectionism among others. The interplay of all these various forces can easily create confusion about the currency outlook. Textbook economic models show that the currency should appreciate in the face of stimulative fiscal policy and rising tariffs, at least in the short term, not least because U.S. interest rates should rise relative to other countries. However, one could also equate protectionism and a larger fiscally-driven external deficit with a weaker dollar. Which forces will dominate? In this Special Report, we sort out the moving parts. We review the theory behind exchange rate determination and examine the cyclical and structural forces that will drive the dollar in the short- and long-term. Tariffs And The Dollar Let's start with import tariffs. In theory, higher tariffs should be positive for the currency as long as there is no retaliation. The amount spent on imports will fall as consumer spending is re-directed toward domestically-produced goods and services. A lower import bill means the country does not need to export as much to finance its imports, leading to dollar appreciation (partially offsetting the competitive advantage that the tariff provides). Tariffs also boost inflation temporarily, which means that higher U.S. real interest rates should also lift the dollar to the extent that the Fed responds with tighter policy. That said, the tariffs recently announced by the Trump Administration are small potatoes in the grand scheme. The U.S. imported $39 billion of iron and steel in 2017, and $18 billion of aluminum. That's only 2% of total imports and less than 0.3% of GDP. If import prices went up by the full amount of the tariff, this would add less than five basis points to inflation. The positive impact on U.S. growth is also modest as the tariffs benefit only two industries, and higher domestic prices for steel and aluminum undermine U.S. consumers of these two metals. A unilateral tariff increase could be mildly growth-positive if there is no retaliation by trading partners. This was the result of a Bank of Canada study, which found that much of the growth benefits from a higher import tariff are offset by an appreciation of the currency.1 Even a short-term growth boost is not guaranteed. A detailed analysis of the 2002 Bush steel tariff increase found that the import tax killed many more jobs than it created.2 Shortages forced some U.S. steel-consuming firms to source the metal offshore, while others made their steel suppliers absorb the higher costs, leading to job losses. A recent IMF3 study employed a large macro-economic model to simulate the impact of a 10% across-the-board U.S. import tariff without any retaliation. It found that tariffs place upward pressure on domestic interest rates, especially if the economy is already at full employment (Chart I-1). This is because the central bank endeavors to counter the inflationary impact with higher interest rates. However, a stronger currency and higher interest rates eventually cool the economy and the Fed is later forced to ease policy. This puts the whole process into reverse as interest rate differentials fall and the dollar weakens. The economic outcome would be much worse if U.S. trading partners were to retaliate and the situation degenerates into a full-fledged trade war involving a growing number of industries. In theory, the dollar would not rise as much if there is retaliation because foreign tariffs on U.S. exports are offsetting in terms of relative prices. But all countries lose in this scenario. China is considering only a small retaliation for the steel and aluminum tariffs as we go to press, but the trade dispute has the potential to really heat up. The bottom line is that the Trump tariffs are more likely to lead to a stronger dollar than a weaker one, although far more would have to be done to see any meaningful impact. Fiscal Stimulus And The Dollar Chart I-1At Full Employment,##br## Import Tariffs Raise Rates Traditional economic theory suggests that fiscal stimulus is also positive for the currency in the short term. The boost in aggregate demand worsens the current account balance, since some of the extra government spending is satisfied by foreign producers. The U.S. dollar appreciates as interest rates increase relative to the other major countries, attracting capital inflows. The currency appreciation thus facilitates the necessary adjustment (deterioration) in the current account balance. The impact on interest rates is similar to the tariff shock shown in Chart I-1. All of the above market and economic adjustments should be accentuated when the economy is already at full employment. Since the domestic economy is short of spare capacity, a vast majority of the extra spending related to fiscal stimulus must be imported. Moreover, the Fed would have to respond even more aggressively to the extent that inflationary pressures are greater when the economy is running hot. The result would be even more upward pressure on the U.S. dollar. Reality has not supported the theory so far. The U.S. dollar weakened after the tax cuts were passed, and it did not even get a lift following the Senate spending plan that was released in February. The broad trade-weighted dollar has traded roughly sideways since mid-2017. Judging by the market reaction to the fiscal news, it appears that investors are worried about a potential replay of the so-called Nixon shock, when fiscal stimulus exacerbated the 'twin deficits' problem, investors lost confidence in policymakers and the dollar fell. Twin deficits refers to a period when the federal budget deficit and the current account deficit are deteriorating at the same time. Chart I-2 highlights that the late 1960s/early 1970s was the last time that the federal government stimulated the economy at a time when the economy was already at full employment. Seeing the parallels today, some investors are concerned the dollar will decline as it did in the early 1970s. Chart I-2A Replay Of The Nixon Years? Current Account And Budget Balances Often Diverge... The two deficits don't always shift in the same direction. In fact, Chart I-3 highlights that they usually move in opposite directions through the business cycle. This is not surprising because the current account usually improves in a recession as imports contract more than exports, but the budget deficit rises as tax revenues wither. The process reverses when the economy recovers. Chart I-3Twin Deficits And The Dollar The current account balance equals the government financial balance (i.e. budget deficit) plus the private sector financial balance (savings less investment spending). Thus, swings in the latter mean that the current account can move independently of the budget deficit. Even when the two deficits move in the same direction, there has been no clear historical relationship between the sum of the fiscal and current account balances and the value of the trade-weighted dollar (shaded periods in Chart I-3). In the early 1980s, the twin deficits exploded on the back of the Reagan tax cuts and the military buildup, but the dollar strengthened. In contrast, the dollar weakened in the early 2000s, a period when the twin deficits rose in response to the Bush tax cuts, the Iraq War, and a booming housing market. ...But Generally Fiscal Expansion Undermines The Current Account Over long periods, a sustained rise in the fiscal deficit is generally associated with a sustained deterioration in the external balance. Numerous academic studies have found that every 1 percentage-point rise in the budget deficit worsens the current account balance by an average of 0.2-0.3 percentage points over the medium term. One study found that the current account deteriorates by an extra 0.2 percentage points if the fiscal stimulus arrives at a time when the economy is at full employment (i.e. an additional 0.2 percentage points over-and-above the 0.2-0.3 average response, for a total of 0.4 to 0.5).4 Given that the U.S. economy is at full employment today, these estimates imply that the expected two percentage point rise in the budget deficit relative to the baseline over 2018 and 2019 could add almost a full percentage point to the U.S. current account deficit (from around 3% of GDP currently to 4%). It could be even worse over the next couple of years because the private sector is likely to augment the government sector's drain on national savings. The mini capital spending boom currently underway will lift imports and thereby contribute to a further widening in the U.S. external deficit position. Nonetheless, theory supports the view that the dollar will rise in the face of fiscal stimulus, at least in the near term, even if this is accompanied by a rising external deficit. Chart I-4Structural Drivers Of the U.S. Dollar Theory gets fuzzier in terms of the long-term outlook for the currency. However, the traditional approach to the balance of payments suggests that the equilibrium value of the dollar will eventually fall. An ongoing current account deficit will accumulate into a rising stock of foreign-owned debt that must be serviced. The Net International Investment Position (NIIP) is the difference between the stock of foreign assets held by U.S. residents and the stock of U.S. assets held by foreign investors. The NIIP has fallen increasingly into the red over the past few decades, reaching 40% of GDP today (Chart I-4). The dollar will eventually have to depreciate in order to generate a trade surplus large enough to allow the U.S. to cover the extra interest payments on its growing stock of foreign debt. The structural depreciation of the U.S. dollar observed since the early 1980s supports the theory, because it has trended lower along with the NIIP/GDP ratio. However, the downtrend probably also reflects other structural factors. For example, U.S. output-per-employee has persistently fallen relative to its major trading partners for decades (Chart I-4, third panel). The bottom line is that, while the dollar is likely to remain in a structural downtrend, it should receive at least a short-term boost from the combination of fiscal stimulus and higher tariffs. What could cause the dollar to buck the theory and depreciate even in the near term? We see three main scenarios in which the dollar could fall on a 12-month investment horizon. (1) Strong Growth Outside The U.S. First, growth momentum favored Europe, Japan and some of the other major countries relative to the U.S. in 2017. This helps to explain dollar weakness last year because the currency tends to underperform when growth surprises favor other countries in relative terms. It is possible that momentum will remain a headwind for the dollar this year. Nonetheless, this is not our base case. European and Japanese growth appears to be peaking, while fiscal stimulus should give the U.S. economy a strong boost this year and next. (2) A Lagging Fed The Fed will play a major role in the dollar's near-term trend. The Fed could fail to tighten in the face of accelerating growth and falling unemployment, allowing inflation and inflation expectations to ratchet higher. If investors come to believe that the Fed will remain behind-the-curve, rising long-term inflation expectations would depress real interest rates and thereby knock the dollar down. This was part of the story in the Nixon years. Under pressure from the Administration, then-Fed Chair Arthur Burns failed to respond to rising inflation, contributing to a major dollar depreciation from 1968 to 1974. We see this risk as a very low-probability event. Today's Fed acts much more independently of Congress beyond its dual commitment on inflation and unemployment. And, given that the economy is at full employment, there is nothing stopping the FOMC from acting to preserve its 2% inflation target if it appears threatened. Chair Powell is new and untested, but we doubt he and the rest of the Committee will be influenced by any political pressure to keep rates unduly low as inflation rises. Even Governor Brainard, a well-known dove, has shifted in a hawkish direction recently. President Trump would have to replace the entire FOMC in order to keep interest rates from rising. We doubt he will try. (3) Long-Run Sustainability Concerns Chart I-5Scenarios For The U.S. Net ##br##International Investment Position It might be the case that the deteriorating outlook for the NIIP undermines the perceived long-run equilibrium value of the currency so much that it overwhelms the impact of rising U.S. interest rates and causes the dollar to weaken even in the near term. This scenario would likely require a complete breakdown in confidence in current and future Administrations to avoid a runaway government debt situation. Historically, countries with large and growing NIIP shortfalls tend to have weakening currencies. The sustainability of the U.S. twin deficits has been an area of intense debate among academics and market practitioners for many years. One could argue that the external deficit represents the U.S. "living beyond its means," because it consumes more than it produces. Another school of thought is that global savings are plentiful, and investors seek markets that are deep, liquid and offer a high expected rate of return. Indeed, China has willingly plowed a large chunk of its excess savings into U.S. assets since 2000. If the U.S. is an attractive place to invest, then we should not be surprised that the country runs a persistent trade deficit and capital account surplus. But even taking the more positive side of this debate, there are limits to how long the current situation can persist. The large stock of financial obligations implies flows of income payments and receipts - interest, dividends and the like - that must be paid out of the economy's current production. This might grow to be large enough to significantly curtail U.S. consumption and investment. At some point, foreign investors may begin to question the desirability of an oversized exposure to U.S. assets within their global portfolios. We are not suggesting that foreign investors will suddenly dump their U.S. stocks and bonds. Rather, they may demand a higher expected rate of return in order to accept a rising allocation to U.S. assets. This would imply that the dollar will fall sharply so that it has room to appreciate and thereby lift the expected rate of return for foreign investors from that point forward. Chart I-5 shows that a 2% current account deficit would be roughly consistent with stabilization in the NIIP/GDP ratio. Any deficit above this level would imply a rapidly deteriorating situation. A 4% deficit would cause the NIIP to deteriorate to almost 80% of GDP by 2040. The fact that the current account averaged 4.6% in the 2000s and 2½% since 2010 confirms that the NIIP is unlikely to stabilize unless major macroeconomic adjustments are made (see below). Academic research is inconclusive on how large the U.S. NIIP could become before there are serious economic consequences and/or foreign investors begin to revolt. Exorbitant Privilege The U.S. has been able to get away with the twin deficits for so long in part because of the dollar's status as the world's premier reserve currency. The critical role of the dollar in international transactions underpins global demand for the currency. This has allowed the U.S. to issue most of its debt obligations in U.S. dollars, forcing the currency risk onto foreign investors. The U.S. is also able to get away with offering foreign investors a lower return on their investment in the U.S. than U.S. investors receive on their foreign investment. Chart I-6 provides a proxy for these two returns. Relatively safe, but low yielding, fixed-income investments are a large component of foreign investments in the U.S., while U.S. investors favor equities and other assets that have a higher expected rate of return when investing abroad (Chart I-7). This gap increased after the Great Recession as U.S. interest rates fell by more than the return U.S. investors received on their foreign assets. Today's gap, at almost 1½ percentage points, is well above the 1 percentage point average for the two decades leading up to the Great Recession. Chart I-6U.S. Investors Harvest##br## Higher Returns Chart I-7Composition Of Net International##br## Investment Position A yield gap of 1.5 percentage points may not sound like much, but it has been enough that the U.S. enjoys a positive net inflow of private investment income of about 1.2% of GDP, despite the fact that foreign investors hold far more U.S. assets than the reverse (Chart I-6, top panel). In Chart I-8 we simulate the primary investment balance based on a persistent 3% of GDP current account deficit and under several scenarios for the investment yield gap. Perhaps counterintuitively, the primary investment surplus that the U.S. currently enjoys will actually rise slightly as a percent of GDP if the yield gap remains near 1½ percentage points. This is because, although the NIIP balance becomes more negative over time, U.S. liabilities are not growing fast enough relative to its assets to offset the yield differential. Chart I-8Primary Investment Balance Simulations However, some narrowing in the yield gap is likely as the Fed raises interest rates. Historically, the gap does not narrow one-for-one with Fed rate hikes because the yield on U.S. investments abroad also rises. Assuming that the yield gap returns to the pre-Lehman average of 1 percentage point over the next three years, the primary investment balance would decline, but would remain positive. Only under the assumption that the yield gap falls to 50 basis points or lower would the primary balance turn negative (Chart I-8, bottom panel). Crossing the line from positive to negative territory on investment income is not necessarily a huge red flag for the dollar, but it would signal that foreign debt will begin to impinge on the U.S. standard of living. That said, the yield gap will have to deteriorate significantly for this to happen anytime soon. What Drives The Major Swings In The Dollar? While the dollar has been in a structural bear market for many decades, there have been major fluctuations around the downtrend. Since 1980, there have been three major bull phases and two bear markets (bull phases are shaded in Chart 9). These major swings can largely be explained by shifts in U.S./foreign differentials for short-term interest rates, real GDP growth and productivity growth. A model using these three variables explains most of the cyclical swings in the dollar, as the dotted line in the top panel of Chart I-9 reveals. Chart I-9U.S. Dollar Cyclical Swings Driven By Three Main Factors The peaks and troughs do not line up perfectly, but periods of dollar appreciation were associated with rising U.S. interest rates relative to other countries, faster relative U.S. real GDP growth, and improving U.S. relative productivity growth. Since the Great Recession, rate differentials have moved significantly in favor of the dollar, although U.S. relative growth improved a little as well. Productivity trends have not been a factor in recent years. Note that the current account has been less useful in identifying the cyclical swings in the dollar. Looking ahead, we expect short-term interest rate differentials to shift further in favor of the U.S. dollar. We assume that the Fed will hike rates three additional times in 2018 and another three next year. The Bank of Japan will stick with its current rate and 10-year target for the foreseeable future. The ECB may begin the next rate hike campaign by mid-2019, but will proceed slowly thereafter. We expect rate differentials to widen by more than is discounted in the market. As discussed above, we also expect growth momentum to swing back in favor of the U.S. economy in 2018. U.S. productivity growth will continue to underperform the rest-of-world average over the medium and long term. Nonetheless, we expect a cyclical upturn in relative productivity performance that should also support the greenback for the next year or two. Conclusion Reducing the U.S. structural external deficit to a sustainable level would require significant macro-economic adjustments that seem unlikely for the foreseeable future. We would need to see some combination of a higher level of the U.S. household saving rate, a balanced Federal budget balance or better, and/or much stronger growth among U.S. trading partners. In other words, the U.S. would have to become a net producer of goods and services, and either Europe or Asia would have to become a net consumer of goods and services. Current trends do not favor such a role reversal. Indeed, the U.S. twin deficits are sure to move in the wrong direction for at least the next two years. Longer-term, pressure on the federal budget deficit will only intensify with the aging of the population. The shortfall in terms of net foreign assets will continue to grow, which means that the long-term structural downtrend in the trade-weighted value of the dollar will persist. Other structural factors, such as international productivity trends, also point to a long-term dollar depreciation. It seems incongruous that the U.S. dollar is the largest reserve currency and that U.S. is the world's largest international debtor. The situation is perhaps perpetuated by the lack of an alternative, but this could change over time as concerns over the long-run viability of the Eurozone ebb and the Chinese renminbi gains in terms of international trade. The transition could take decades. The U.S. twin-deficits situation is not that dire that the U.S. dollar is about to fall off a cliff because of sudden concerns about the unsustainability of the current account deficit. Even though the NIIP/GDP ratio will continue to deteriorate in the coming years, it does not appear that the U.S. is anywhere close to the point where investors would begin to seriously question America's ability to service its debt. The U.S. will continue to enjoy a net surplus on its international investments except under a worst-case scenario for relative returns. From an economic perspective, we see no reason why the U.S. will not be able to easily continue financing its domestic saving shortfall in the coming years. There are other risks of course. Growing international political tensions and a trade war could threaten the U.S. dollar's status as the world's premier reserve currency. In 2018, we expect the dollar to partially unwind last year's weakness on the back of positive cyclical forces. Additional protectionist measures should support the dollar as long as retaliation is muted. Mark McClellan Senior Vice President The Bank Credit Analyst Mathieu Savary Vice President Foreign Exchange Strategy 1 A Wave of Protectionism? An Analysis of Economic and Political Considerations. Bank of Canada Working Paper 2008-2. Philipp Maier. 2 The Unintended Consequences of U.S. Steel Import Tariffs: A Quantification of the Impact During 2002. Trade Partnership Worldwide, LLC. Joseph Francois and Laura Baughman. February 4, 2003. 3 See footnote to Chart 1. 4 Fiscal Policy and the Current Account. Center for Economic Policy Research, Discussion Paper No. 7859 September 16, 2010. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was mixed: Headline and core producer prices increased at a 3% and 2.7% annual pace, respectively, outperforming expectations; Headline and core inflation came out at 2.4% and 2.1%, respectively, in line with expectations; However, continuing and initial jobless claims both came out higher than expected. The depressing impact on prices of the fall in mobile-phone service costs is passing, creating a base effect that is lifting inflation. While core inflation is now above 2%, core PCE-the Fed's preferred measure - still sits at 1.6%. However, as CPI is set to accelerate further, so will core PCE. Rising U.S. inflation means that the Fed is unlikely to be as responsive to slower global growth as it was in 2016, pointing to a rally in the dollar this year. Report Links: More Than Just Trade Wars - April 6, 2018 Do Not Get Flat-Footed By Politics- March 30, 2018 Are Tariffs Good Or Bad For The Dollar? - March 9, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data was disappointing this week: In monthly terms, German exports and imports contracted by 3.2% and 1.3%, respectively. As a result, the trade and current account surplus decreased; French industrial output disappointed expectations; On an annual basis, European industrial production grew at a disappointing pace of 2.9%, less than the 3.8% anticipated by the market. IP contracted in monthly terms. The euro at first rallied this week, but the ECB's minutes revealed sharp debates among members of the Governing Council about the degree of labor market slack in the euro area. This caused a correction in the euro by Thursday. With global growth waning and geopolitical risks, especially in the Middle East, growing, equity volatility is likely to spread to the fixed income and FX space. This should be unfavorable for the euro as investors remain very long the common currency. Investors should position themselves for the euro's current consolidation to morph into a short-term correction. Report Links: More Than Just Trade Wars - April 6, 2018 Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Labor cash earnings yearly growth outperformed expectations, coming in at 1.3%. Additionally the previous month reading was revised from 0.7% to 1.2%; Moreover, the leading economic indicator also outperformed expectations, coming in at 105.8; However, consumer confidence underperformed expectations, coming in at 44.3. USD/JPY has been relatively flat this week as the yen continues to consolidate previous strength. As global grows is slowing, the Japanese currency will continue to strengthen in the coming quarters. Moreover, geopolitical tensions are set to continue throughout the year, giving an added shine to the yen. That being said, the strength of the yen has already begun to hurt the Japanese economy, thus the BoJ will be forced to lean against this strength. Report Links: The Yen's Mighty Rise Continues... For Now - February 16, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data has been mixed: Halifax house prices outperformed expectations, coming in at 2.7% on a year-on-year basis; However, industrial production annual growth underperformed expectations, coming in at 2.2%; Moreover, manufacturing production annual growth also underperformed expectations, coming in at 2.5%. GBP/USD has rallied nearly 1% this week, mainly due to the weakness in the dollar caused by trade tensions as well as political grandstanding in Syria between major powers. Nevertheless, we continue to believe that the upside for the pound is limited, given that inflation in the U.K. should begin to slow due to the appreciation of the pound. Moreover, the weak housing market will be another factor weighing on the economy, slowing the BoE in their hiking campaign. Report Links: Do Not Get Flat-Footed By Politics - March 30, 2018 Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data was mixed: The AiG Performance of Construction Index in March came out better than expected at 57.2, up from 56; NAB Business Confidence disappointed expectations, coming in at 7; NAB Business Conditions came in at 14, less than the expected 17; Westpac Consumer Confidence came in negative at -0.6%. The Australian economy continues to operate below capacity. Although business investment has picked up, consumer spending growth has been limited by low wage increases. Furthermore, the risk of increasing trade tensions between the U.S. and China remains a big risk for the RBA as the Australian economy is highly geared to global trade. Hence, both the domestic and international environment will keep the RBA from raising rates. Report Links: Who Hikes Again? - February 9, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 NZD/USD has rallied by 1.6% since last week, as the dollar has depreciated amid trade tensions as well as geopolitical tension in the Middle East. Overall, we continue to believe that the trade-weighted NZD will be at risk, particularly against the yen, given that carry and commodity currencies should suffer relative to safe havens in the current environment of slowing growth and rising political risk. That being said, the NZD will probably outperform the AUD. If economic activity slows in China, iron ore prices - Australia's main export - will likely be one of the main victims. On the other hand, dairy products, though affected, will probably hold up better than metals. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canadian data was mixed: Housing starts came out stronger than expected, increasing by 225,000; Building permits, however, contracted by 2.6% on a monthly pace; New housing prices increased at a less than expected annual rate of 2.6%; Progress on the NAFTA negotiations and higher oil prices have helped the CAD's performance so far this month, with the loonie outperforming every G10 currency. This trend is likely to continue based on favorable fundamentals relative to the rest of the G10 economies. Report Links: More Than Just Trade Wars - April 6, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been neutral: The unemployment rate came in line with expectations at 2.9%. Moreover, it remained at last month's level; Additionally, foreign currency reserves came in above expectations at 738 billion, signaling that the SNB was been actively intervening in currency markets. EUR/CHF has risen by more than 1% this week. Overall, we expect this trend to continue in the long term, given that the SNB want to avoid too-strong a franc. That being said this cross could see some upside on a tactical basis, given that rising geopolitical tensions should boost to the attractiveness of safe-heaven currencies like the franc. Report Links: The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been negative: Headline inflation underperformed expectations, coming in at 2.2%; Moreover, core inflation also surprised negatively, coming in at 1.2%. This represented a significant slowdown from last month's 1.4% annual pace. USD/NOK has fallen by about 1% this week, as the dollar weakened and oil prices rallied in response to growing Middle East tensions. Overall, we continue to believe that the NOK will outperform other commodity currencies like the AUD and the NZD, given that oil should outperform other commodities as oil supply is tighter than base metals' and as global growth slows. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 This week's inflation figures from Sweden disappointed once again, with consumer prices growing at a 1.9% annual clip, slightly below expectations of 2%. While this slowdown in inflation is causing investors to question the resolve of the Riskbank to hike interest rates this year, the main reason behind the SEK's surprising weakness is the emerging slowdown in global growth. Because both Sweden economic activity and price indices are very levered to the global industrial cycle, Sweden could suffer significantly if the floor falls under global growth. However, we do not think that global growth is likely to fall below trend, which suggests that the SEK is becoming a great bargain. However, leading indicators of the global business cycle will have to stabilize before investors buy the krona. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades