Trade / BOP

Highlights Coming up on the deadline for President Trump’s China – U.S. tariff ultimatum, tariffs on $200 billion of Chinese imports could go to 25% from 10% on Friday – the outlook for base metals remains complicated, particularly for aluminum and copper.1 Of course, the U.S. and China could have a meeting of the minds and agree to resolve the outstanding issues in the trade negotiations. This would be supportive of continued global supply-chain expansion, EM income growth and base metals prices generally. On the downside, an escalation of the Sino – U.S. trade war could retard investment in global supply chains, as firms hunker down for an extended and contentious contraction in global trade.2 This would be bearish for EM income growth, which would translate directly into lower base metals demand and, all else equal, depress prices. Still, a breakdown in trade talks could be bullish for base metals, as China likely would increase its fiscal, monetary and credit stimulus, in an attempt to offset the income-suppressing effects of reduced global trade and investment. As we said, it’s complicated. Two of the three outcomes above are supportive of base metals prices – i.e., a deal is agreed, and increased Chinese stimulus in the event of a breakdown in negotiations. Against this backdrop, we are closing our long tactical trading recommendations in copper and aluminum at tonight’s close, and replacing them with a call spread on July CME COMEX copper, in which we will get long $3.00/lb calls vs. short $3.30/lb calls. The call spreads are a low-risk way of positioning in a volatile market for a likely price-supportive outcome in these talks – the max loss on this position is the net premium paid to get long the spread. Highlights Energy: Overweight. Supply-side fundamentals continue to dominate oil price formation. An unplanned outage in Russia that took ~ 1mm b/d of oil off the market this week, following the contamination of exports with organic chloride left in shipments via Transneft’s European pipeline system. Russia’s Energy Ministry is guiding markets to expect the contamination will be cleared up toward the end of this month.3 Base Metals: Neutral. We are closing our tactical aluminum and copper trade recommendations at tonight’s close. We do see the potential for higher base metals prices – particularly copper – if China expands fiscal and monetary stimulus in the wake of a breakdown in trade talks with the U.S., or both sides can resolve their differences. We expect copper will benefit most from such outcomes. However, we believe a call spread – long July $3.00/lb CME COMEX calls vs. short $3.30/lb calls expiring in July – is a lower-risk way of expressing this view. Precious Metals: Neutral. Gold could rally in the wake of an expanded trade war, if the Fed and the PBOC – along with other systemically important central banks – adopt more accommodative monetary policies in anticipation of a widening trade conflict. Greater fiscal, credit and monetary stimulus by China in response to a breakdown in trade talks also could boost safe-haven demand for gold. Ags/Softs: Underweight. The risk of a wider Sino – U.S. trade war – particularly the likely retaliation by China if U.S. tariffs are raised to 25% on already-targeted exports of $200 billion – would be especially bearish for soybeans and grain exports from the U.S. We remain underweight. Feature In the wake of President Donald Trump’s ultimatum to China to resolve trade talks by tomorrow, BCA Research’s geopolitical strategists give 50% odds to a successful trade deal being concluded by end-June. The odds of an extension of trade talks are 10%; and the odds of no deal on trade, 40% (Table 1). Table 1Updated Trade War Probabilities (May 2019) Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals Of these possible outcomes, the no-deal scenario – i.e., an escalation in the trade war including raising tariffs on imports from China to 25% on the $200 billion of goods now carrying a 10% duty – would be the most volatile, and likely would push base metals’ prices lower in the short-term. A trade deal would set markets to estimating the extent of supply-chain investment and trade-flow revival, as the drawn-out uncertainty around the outcome of the Sino – U.S. trade war fades. Given the slim wedge our geopolitical strategists see between the deal and no-deal outcomes to these trade talks, we believe the implications of the latter need to be sorted. An agreement to extend trade talks likely would be welcomed with the same aplomb shown by markets prior to this current level of high drama. In this scenario, markets likely would price in an economically rational outcome to the U.S. – China trade negotiations, which resolves the uncertainty around tariffs and other investment-retarding policies. Given the slim wedge our geopolitical strategists see between the deal and no-deal outcomes to these trade talks, we believe the implications of the latter need to be sorted. In the short term – i.e., following a breakdown in the talks – market sentiment likely would become more negative, as traders priced in the implications for reduced global supply-chain investment and trade flows, particularly re China and EM exporters. In addition, base metals markets would discount the income hit to EM these effects would feed into, raising the likelihood commodity demand growth would slow. News flow would then dictate price action for the metals over the short term. As markets discount these expectations, we believe Chinese policymakers would act to increase the levels of fiscal, credit and monetary stimulus domestically, to counter the hit to domestic income. The lagged effects of this stimulus will have a strong influence on base metals’ price formation, and, depending on the level of stimulus, could be bullish for metals prices. China’s Influence on Base Metals Higher Post-GFC In previous research, we found copper, and to lesser extent aluminum and the LMEX index, which is heavily weighted to both, benefit most from monetary, credit and fiscal stimulus in China.4 Other metals also experience a lift when the level of these Chinese policy variables rises; however, their relationship with EM and China’s industrial production cycle is weaker and time varying (Chart of the Week). Chart 1 In Table 2, we show how different policy and macro factors affect various base metal prices and the LMEX; these models generate the output for the curves in the Chart of the Week. The table show the coefficients of determination for single-variable regressions for each metal on the EM- or China-focused factor shown in the columns for the period 2000 to now, and 2010 to now. Within the base metals complex, copper, the LMEX index and aluminum exhibit the strongest and most reliable relationships with the explanatory variables shown at the top of each column. Table 2Coefficients Of Determination: Base Metals Prices (yoy) Vs. Key Factors Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals The biggest takeaway from this analysis is that, for each individual metal, Chinese economic activity in particular, and EM income dynamics generally dominate price determination. The importance of these factors increased considerably post-Global Financial Crisis (GFC). As was the case with our correlation analysis, this is best captured by our Global Industrial Activity (GIA) Index (Chart 2, panel 1). This is clearly seen in the co-movement of our GIA index and copper prices (Chart 2, panel 2), and EM GDP.5 Chart 3 shows the GIA index disaggregated in its four main components. Chart 2BCA's GIA Index Vs. EM GDP, Copper Prices BCA's GIA Index Vs. EM GDP, Copper Prices BCA's GIA Index Vs. EM GDP, Copper Prices Chart 3BCA GIA Index Components' Performance BCA GIA Index Components' Performance BCA GIA Index Components' Performance Our analytical framework for base metals in China holds the nonferrous “pillar industries” behave as vertically integrated conglomerates. The influence of China’s economy on base metals prices is not unexpected: As China’s relative share of base metals supply and demand versus the rest of the world has grown, the marginal impact of its fiscal, credit, monetary and trade policies increased (Chart 4). The principal effect would be visible in China’s demand-side effects, to which the supply side would respond. That is to say, China’s monetary, credit and fiscal policies post-GFC lifted domestic incomes, which lifted demand domestically. In addition, aggressive export-oriented trade policy contributed to income growth, as well. This prompted increased base metals and bulk (e.g., steel) output on the supply side. Chart 4 A large part of this dynamic likely is explained by the role of state-owned enterprises (SOEs) in the base-metals markets in China. It is important to note these SOEs are strategic government holdings, responding to and directing government policy, as was recently noted in a University of Alberta study on SOEs:      … the government maintains control over a number of economically significant industries, such as the automobile, equipment manufacturing, information technology, construction, iron and steel, and nonferrous metals sectors, which are all considered to be ‘pillar industries’ of the Chinese economy. The government, as a matter of official policy, intends to maintain sole ownership or apply absolute control over only what it considers to be strategic industries, but also maintains relatively strong control over the pillar industries.6 Our analytical framework for base metals in China holds the nonferrous “pillar industries” behave as vertically integrated conglomerates – ranging from firms refining of raw ore to those producing finished products used in infrastructure, construction, etc. In this framework, nonferrous metals in China are not commodity markets per se, but vertically integrated policy-driven industries responding to directives from the Chinese Communist Party’s (CCP) Politburo through to the State Council and the various ministries directing production and consumption.7 At the heart of this is the CCP’s efforts to direct economic growth. Investment Implications The implication of our policy-focused research is investors should focus on metals for which a large share of the variance in y/y prices can be explained by movements in Chinese economic activity. The no-deal outcome could be positive for base metals prices. To get a handle on this, we looked at the variance decomposition of each metal’s price in response to exogenous shocks originating from (1) Chinese economic activity, (2) EM (ex-China) and Complex Economies industrial activity, (3) U.S. industrial activity, and (4) the U.S. trade weighted dollar (Table 3).8 Using this approach, we found that: Copper, aluminum and the LMEX’s variances are mostly explained by China’s economic activity (~ 25%); specifically, shocks to the state’s industrial activity and credit cycle. This corroborates our earlier research, in which we focused on correlations between base metals and these factors. Idiosyncratic factors seem to account for a large part of nickel, lead and zinc’s price formation. This is seen by the large proportion of their variances that is unexplained by our selected explanatory variables. Given the opacity of fundamental data in these markets, we tend to avoid positioning in them. On average, EM ex-China and U.S. industrial activity account for a similar proportion of the variance in metal’s prices (~ 8%). While the U.S. dollar appears to be the second most important variable (~ 14%). Table 3China’s Economic Activity Drives Metals’ Return Variability Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals Our analysis indicates that, as a group, base metals will be supported by the ongoing credit stimulus in China. Each metal is positively correlated with China’s credit cycle and industrial activity. Nonetheless, from our correlation, regression and variance-decomposition analysis, we believe copper and aluminum provide a better and more reliable exposure, as does exposure to the LMEX index, because of its high aluminum and copper weightings. Bottom Line: Approaching the ultimatum set by U.S. President Trump for a resolution to the Sino – U.S. trade war, markets are understandably taut. The odds of a deal vs. no-deal outcome by end-June are close, while the odds trade talks are extended account for the difference. In our estimation, the no-deal outcome could be positive for base metals prices, given our expectation Chinese policymakers will lift the amount of stimulus to the domestic economy to offset the negative effects of an expanded trade war. A deal would remove a lot of the uncertainty currently holding back global supply-chain capex and trade flows, which also would be bullish for base metals.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1      For further discussion, please see “U.S. And China Get Cold Feet,” a Special Alert published by BCA Research’s Geopolitical Strategy May 6, 2019. It is available at gps.bcaresearch.com. Our geopolitical strategists give the odds of a successful trade deal being concluded by end-June 50%; that trade talks continue, 10%; and the odds of no deal on trade, 40%. 2      Please see “Global market structures and the high price of protectionism,” delivered at the Jackson Hole central bank conference August 25, 2018, by Agustín Carstens, General Manager, Bank for International Settlements. 3      Please see “Russia sees oil quality normalizing in late May after contamination, output drops,” published May 7, 2019, by reuters.com. 4      Please see our Weekly Report of April 25, 2019, entitled “Copper Will Benefit Most From Chinese Stimulus.” It is available at ces.bcaresearch.com. 5      BCA’s GIA index is heavily weighted toward EM industrial-commodity demand. Please see “Oil, Copper Demand Worries Are Overdone,” where we introduce and discuss the GIA index, published February 14, 2019, in BCA Research’s Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 6      Please see “State-Owned Enterprises in the Chinese Economy Today: Role, Reform, and Evolution,” China Institute, University of Alberta, May 2018. 7      Something approximating a pure commodity market is crude oil – the supply and demand curves of many globally distributed sellers and buyers meet and clear the market. As such, a reasonable explanatory model for the evolution of prices can be generated using fundamental inputs (i.e., supply, demand and inventories). Fitting such models to base metals has proved difficult. We have better success explaining base metals prices using macro economic policy variables we believe are important to CCP policymakers – trade, credit, domestic GDP, etc. This is a new avenue of research, which we hope to use to hone in on a good explanatory model to account for ~ 50% of global base metal demand, and, in some instances (e.g., copper and steel, respectively) close to 40% - 50% of supply, as seen in Chart 4. Our current base metals research is focused on trying to disprove the hypothesis these are policy-directed markets within China. This aligns with Karl Popper’s falsifiability condition, which states a theory must be subject to independent, disinterested testing capable of refuting it, to be considered scientific. Please see “Popper, The Logic of Scientific Discovery,” (reprinted 2008), Routledge Classics, particularly Chapter 4. 8      Complex economies are countries ranking at the top of MIT’s Economic Complexity Index (ECI), and which export industrial goods to EM and China. The EM (ex-China) and Complex Economies variable is the first principal component extracted from a group of ~60 series related to industrial production in these countries. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q1 Image Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades Image

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

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

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

Highlights Central bankers appear to be in a rush to boost inflation expectations before the next economic downturn. This in practice should be stimulative for the global economy. Historically, currencies of small, open economies are typically the first to benefit from rebounding global growth. Ditto for those whose output gaps have fully closed. However, there appears to be a shift in the behavior of certain currency pairs in the current cycle. For example, the U.S. dollar has tended to perform better in a low-volatility environment in recent years, a shift from the past. Correspondingly, its safe-haven status may have been marginally eroded. The U.S. decision not to extend waivers on Iranian oil exports beyond the May 2 deadline is bullish for petrocurrencies such as the RUB and NOK. The Bank of Canada kept rates on hold but will be hard pressed to meet its inflation mandate before the next downturn. This suggests standing aside on USD/CAD. Rising net short positioning on the yen and Swiss franc is making them attractive from a contrarian standpoint. Place a limit-buy on CHF/NZD at 1.45. Feature Chart I-1Volatility Is Due For A Bounce Volatility Is Due For A Bounce Volatility Is Due For A Bounce The four most important financial variables that could give a near-complete snapshot of the world economy at any point in time are probably the level of the S&P 500, the U.S. 10-year Treasury yield, the trade-weighted dollar and a commodity bellwether, say, crude oil prices. Any permutation of these variables can identify what quadrant the world economy is operating in, with the two most important states being either boom or bust. Taking three of those variables today – the S&P 500 breaking to all-time highs, crude oil prices up 40% from their lows and U.S. 10-year Treasury yields off by almost 100 basis points from their October highs – it is hard to justify why the dollar has hardly budged, this week’s rally aside. Obviously, this is a very simplified view of an intricately complex world economy. But it highlights a point we have been making in recent bulletins: that extended periods of low currency volatility have been very unusual in the post-Bretton Woods world (Chart I-1). The typical narrative has been that as we enter a reflationary window, pro-cyclical currencies should outperform. The reason is simple enough: These economies are export-oriented and tied to the global cycle. So, a rising current account surplus as demand for their goods and services picks up provides underlying support for the currency. Should there be little slack in their domestic economies, this also raises the probability that the central bank tightens monetary policy to fend off future inflationary pressures. It does not hurt if these countries are also commodity producers, since rising terms of trade also provides an additional exchange-rate boost. The reality is that the world is not static, and some of these dynamics have been shifting. The evidence is in the counterfactual: At current levels, China’s credit injection should have lit a fire under pro-cyclical trades because they tend to work in real-time rather than with a lag. The foreign exchange market is one of the deepest and most liquid where new information tends to get digested and discounted instantaneously. As such, the lack of more pronounced strength in pro-cyclical currencies like the Australian, New Zealand and Canadian dollar exchange rates is genuine reason for concern and worth investigation. Why Is The Dollar Breaking Higher? Our Special Report1 on March 29th highlighted the fact that the dollar should be 5-10% higher simply based on measures of relative trends, and recent data corroborate this view. The growth differential between the U.S. and the rest of the world remains wide. Meanwhile, exports and industrial production from Southeast Asia continue to decelerate. Interbank rates in China are spiking higher, suggesting most of the monetary stimulus may have already been frontloaded. And on the earnings front, U.S. profit leadership also continues. It is unclear which of these catalysts was the actual trigger for dollar strength, since these have been in place for a while now, but confirmation from any and all of them was sufficient to reinvigorate the dollar bulls. That said, it is important to pay heed to shifting market forces, but it will be imprudent to change investment strategy on this week’s moves alone. Given these moves, a few observations are in order: Almost all currencies are already falling versus the U.S. dollar – a trend that has been in place for several months now (Chart I-2). This means most of the factors putting upward pressure on the dollar are well understood by the market. For example, global growth has been slowing for well over a year, based on the global PMI. Putting on fresh U.S. long positions is at risk of a washout from stale investors, just as it was back in 2015, a year after growth had peaked. Dollar technicals are also very unfavorable (Chart I-3). Speculators are holding near-record long positions, sentiment is stretched and our intermediate-term indicator is also flagging yellow. Over the past five years, confirmation from all three indicators has been followed by some period of U.S. dollar indigestion. This time should be no different. Chart I-2Is It Time To Initiate Fresh Dollar Longs? Is It Time To Initiate Fresh Dollar Longs? Is It Time To Initiate Fresh Dollar Longs? Chart I-3Dollar Technicals Are Unfavourable Dollar Technicals Are Unfavourable Dollar Technicals Are Unfavourable A breakout in the dollar along with rising equity markets suggests that the correlation is once again shifting. The dollar has tended to trade as a counter-cyclical currency for most of the time, with a negative correlation even to global equities (Chart I-4). Importantly, given current low levels of volatility and elevated equity market valuations, the dollar would have been a great insurance policy for any stock market correction. But with U.S. interest rates having risen significantly versus almost all G10 countries in recent years, the dollar has itself become the object of carry trades. This has also come with a good number of unhedged trades, as the rising exchange rate has lifted hedging costs (Table I-1). Chart I-4The Dollar Remains A 'Risk-Off' Currency The Dollar Remains A 'Risk-Off' Currency The Dollar Remains A 'Risk-Off' Currency Chart I- It will be difficult for the dollar to act as both a safe-haven and carry currency, because the forces that drive both move in opposite directions. For one, safe-haven assets tend to be lower-yielding but also during episodes of capital flight, investors choose to repatriate capital to pay down debt, with creditor nations having the upper hand. And given U.S. investors have already been repatriating close to $400 billion in assets over the past 12 months, it is unlikely this pace persists (Chart I-5). The bottom line is that investors who believe that the U.S. dollar has become a high-beta currency should be prepared to stampede out the door on any rise in volatility. Our bias remains that the U.S. dollar will ultimately weaken, given that the forces driving it higher are mostly behind us. Meanwhile, currencies such as the Japanese yen or even Swiss franc that have been used to fund carry trades are very ripe for short-covering flows. Putting everything together suggests at minimum building portfolio hedges. It will be difficult for the dollar to act as both a safe-haven and carry currency. One such hedge is going long CHF/NZD. This trade has a high negative carry, so we do not intend to hold it for longer than three months. But speculative positioning and relative economic trends also support this cross for the time being (Chart I-6). We are placing a limit-buy at 1.45. Chart I-5How Much More Will Repatriation Flows Help? How Much More Will Repatriation Flows Help? How Much More Will Repatriation Flows Help? Chart I-6CHF/NZD Is An Attractive ##br##Hedge CHF/NZD Is An Attractive Hedge CHF/NZD Is An Attractive Hedge A Shifting Landscape If the dollar eventually weakens, let’s consider the premise that the most export-dependent economies should benefit more from a rebound in global growth, and by extension, their currencies should appreciate the most. Within the G10 universe, this will be notably the European currencies led by the Swiss franc, the Swedish Krona, the euro and the pound (Chart I-7). However, from the trough in the global Purchasing Managers’ Index (PMI) in December 2008 until the peak in April 2010, it was the commodity currencies that outperformed. During that time frame, the Swiss franc actually fell. It is well known that Switzerland’s persistent trade surplus over the decades has been a key factor behind structural appreciation in the currency. However, at any point in time, other nuances such as whether the rebound is China or commodities driven, the starting point for valuations or even interest rate differentials take center stage in explaining currency moves. The lesson is that investors have to become nimble with currency investment strategy. The lesson is that investors have to become nimble with currency investment strategy. For pro-cyclical currencies, there have been dramatic shifts in the export share of GDP for various countries, according to World Bank data. Most euro area countries have massively expanded their export share of GDP as they have gained ground in value-added products and services. Meanwhile, the export share in Australian GDP has been stuck at 20% for many years, while that in Norway, New Zealand and Canada has seen a huge drop, even since 2009 (Chart I-8). At first blush, this suggests diminishing marginal returns to their currencies from global growth. Chart I-7 Chart I-8A Shifting Export ##br##Landscape A Shifting Export Landscape A Shifting Export Landscape Take the example of New Zealand, where commodities are over 75% of exports. Since the 2000s, the government has been actively trying to redistribute growth from net exports to domestic demand. This has been mainly via the skilled workers program. The result has been a collapse in the export share of GDP from 36% to about 26%. This means that the New Zealand dollar, which has typically been a higher-beta play on global growth, is giving way to other currencies such as the euro and the Swedish krone (Chart I-4). In addition to this, while global growth might eventually recover, part of the widespread deterioration since the global financial crisis may be structural. If the overarching theme over slowing global trade is a global economy that is trying to lift its precautionary savings and spend less, then the world may not see the high rates of trade growth registered in the 1990s anytime soon. This is because at a lower rate of potential GDP growth, trade elasticities also tend to fall.2 There are many reasons for this, including less willingness among creditor nations to finance current account deficits, the paradox of thrift or just outright saturation in the turnover of trade. All of this dampens marginal returns toward all pro-cyclical currency trades. Chart I-9Trade Volatility Has Fallen Trade Volatility Has Fallen Trade Volatility Has Fallen The bottom line is that the overall magnitude and volatility of trade relative to GDP has fallen, at least until the recent China – U.S. trade spat (Chart I-9). This has had the effect of dampening the volatility of the corresponding mediums of trade exchanges. Part of this is clearly cyclical, but a part may be structural as well. If we embrace confirmation that the Chinese economy has bottomed, it will be important to monitor if this cycle plays out like those in the past. Notes On Petrocurrencies, And The BoC The U.S. has decided not to extend waivers on Iranian oil exports beyond the May 2 deadline. Supposedly, a coalition with both Saudi Arabia and the United Arab Emirates would ensure that oil markets remain adequately supplied, though Saudi Arabia has since signaled they are in no rush to raise production. Overall, this increases the bullish narrative for oil. First, the Iranian response to a shutoff in their exports could be unpredictable. The U.S. threat of driving Iranian oil exports to zero increases the geopolitical risk premium in prices, as full implementation pushes Iran to a wall, raising the odds of retaliation. Chart I-10Iran Is A Meaningful Oil Supplier Iran Is A Meaningful Oil Supplier Iran Is A Meaningful Oil Supplier Second, oil production is being curtailed at a time when Venezuelan output is rapidly falling, conflict in Libya is reviving and OPEC spare capacity remains tight. This could nudge the oil market dangerously close to a negative supply shock (Chart I-10). Meanwhile, there is the non-negligible risk of unplanned outages which have been rising in 2019, which is another source of risk for oil supply Oil futures have responded positively to the news, with both Brent and WTI making fresh 2019 highs. However, while initially reacting favorably, petrocurrencies such as the Canadian dollar, Russian ruble and Norwegian krone are selling off amid dollar strength. We think Brent will continue to trade at a premium to WCS crude. This bodes well for currencies tied to North Sea production. Hold short CAD/NOK and long NOK/SEK positions, despite the selloff this week. As for Canada, we are neutral on the loonie both short and medium term. The dovish shift by the BoC and looser fiscal policy are likely to be growth tailwinds. So is the rise in oil prices. However, there appears to be a genuine slowdown in the Canadian economy that is not yet fully reflected in economic forecasts.  The key drivers for the CAD/USD exchange rate are interest rate differentials with the U.S. (which we think will compress further) and energy prices (which we think Canada benefits less from due to the discount Canadian oil sells for, and persistent infrastructure problems). As such, we think domestic conditions will continue to knock down whatever benefit comes from rising oil prices (Chart I-11). Chart I-11CAD/USD Will Benefit From##br## Rising Terms Of Trade CAD/USD Will Benefit From Rising Terms Of Trade CAD/USD Will Benefit From Rising Terms Of Trade Chart I-12Can The BoC Hike Given ##br##This Backdrop? (1) Can The BoC Hike Given This Backdrop? (1) Can The BoC Hike Given This Backdrop? (1) On the consumer side, real retail sales are deflating at the worst pace since the financial crisis, and demand for housing loans is falling off (Chart I-12). This is unlikely to improve if house prices continue to roll over (Chart I-13). A study by the Reserve Bank of New Zealand shows that on average, the elasticity of consumption growth to house price changes is asymmetric with negative housing shocks, hurting consumption by more than the boost received from positive shocks. This asymmetry may be due to the fact that at very elevated debt levels, leveraged gains are used to pay down debt aggressively, whereas leveraged losses hit bottom lines directly. There appears to be a genuine slowdown in the Canadian economy that is not yet fully reflected in economic forecasts. On the corporate side of the equation, the latest Canadian Business Outlook Survey is very telling. Firms’ expectations for sales have softened significantly, as businesses in several sectors are less optimistic about demand. This is driven by uncertainty in the oil patch, weak housing and weak external conditions. This in turn, has led to a steep drop in plans to increase capex (Chart I-14). For external investors, the large stock of debt in the Canadian private sector and overvaluation in the housing market are likely to continue leading to equity outflows on a rate-of-change basis. Chart I-13Can The BoC Hike Given This Backdrop? (2) Can The BoC Hike Given This Backdrop? (2) Can The BoC Hike Given This Backdrop? (2) Chart I-14Can The BoC Hike Given This Backdrop? (3) Can The BoC Hike Given This Backdrop? (3) Can The BoC Hike Given This Backdrop? (3) Technically, USD/CAD failed to break below the upward sloping trendline drawn from its 2017 lows. The next resistance zone is the 1.36-1.38 level. Our bias is that this zone will prove to be formidable resistance. We continue to recommend investors short the CAD, mainly via the euro. Housekeeping Our limit-buy on AUD/USD was triggered at 0.70. Place tight stops at 0.68 until further evidence that global growth has bottomed. Our short USD/SEK position garnered losses this week. The RiksBank’s dovish shift surprised the market, and triggered panic selling as important technical levels were broken. With a manufacturing PMI at 52.8, inflation at 1.8% and wages growing near 3%, this is not exactly the symptoms of an economy that needs more stimulus. We recommend holding onto positions, but will respect our stop loss a few hundred pips away. Finally, the dovish shift by the Bank of Japan does not change our thinking on the yen. The resilience in the currency might indicate the pool of yen bears has been exhausted.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report, titled “Tug Of War With Gold As Umpire,” dated March 29, 2019, available at fes.bcaresearch.com. 2 Cristina Constantinescu, Aaditya Mattoo, and Michele Ruta, “The Global Trade Slowdown: Cyclical Or Structural?” IMF working paper (2015). Currencies U.S. Dollar Chart II-1 USD Technicals 1 USD Technicals 1 Chart II-2 USD Technicals 2 USD Technicals 2 ​​​​​ Recent data in the U.S. suggest a weaker housing market: In March, building permits contracted by 1.7% month-on-month, falling to 1.27 million; housing starts decreased by 0.3% month-on-month, coming in at 1.14 million. March new home sales grew by 4.5% month-on-month, coming in at 0.69 million. However, existing home sales contracted by 4.9% month-on-month, falling to 5.21 million. The house price index grew by 0.3% month-on-month in February, in line with expectations. MBA mortgage applications decreased by 7.3% in April. The Chicago Fed National Activity index fell to -0.15 in March, underperforming expectations. Durable goods orders increased by 2.7% in March, surprising to the upside. DXY index appreciated by 1% this week, hitting the highest level since June 2017. While a more accommodative monetary policy stance has been taken in China, global growth momentum remains weak, which is a cause for concern. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 The Euro Chart II-3 EUR Technicals 1 EUR Technicals 1 Chart II-4 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area continue to soften: Italian business confidence and consumer confidence in March fell to 100.6 and 110.5, respectively. April preliminary consumer confidence in the euro area fell to -7.9, below expectations. German IFO business climate fell to 99.2 in April; expectations and current assessment fell to 95.2 and 103.3, respectively. French business confidence improved to 105, while business climate decreased to 101 in April. Italian trade balance came in at a larger surplus of 3.42 billion euro in April. EUR/USD depreciated by 1% this week. The incoming data from the euro area and globally have been weaker than expected. The recent ECB Economic Bulletin remains positive for the growth outlook going forward, stating that “the supportive financing conditions, favorable labor market dynamics and rising wage growth should continue to underpin the euro area expansion.” Report Links: Reading The Tea Leaves From China - April 12, 2019 Into A Transition Phase - March 8, 2019 A Contrarian Bet On The Euro - March 1, 2019 The Yen Chart II-5 JPY Technicals 1 JPY Technicals 1 Chart II-6 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been negative: Headline inflation and core inflation were unchanged at 0.5% and 0.4% year-on-year in March, respectively. Machine tool orders in March contracted by -28.5% year-on-year. All industry activity index fell by 0.2% month-on-month in February, in line with expectations. USD/JPY surged initially by 0.4% ahead of BoJ’s rate decision, then fell sharply, returning flat this week. The BoJ has decided to keep the interest rate on hold at -0.1%. The shift to a calendar-based form of forward guidance is unlikely to be a game-changer on its own. Moreover, the BoJ expects the Japanese economy to pick up through 2021 supported by highly accommodative financial conditions and government spending, despite the weakness of global growth and scheduled consumption tax hike. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 A Trader’s Guide To The Yen - March 15, 2019 British Pound Chart II-7 GBP Technicals 1 GBP Technicals 1 Chart II-8 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. have been positive: Public sector net borrowing increased to 0.84 billion pounds in March. In April, the CBI retailing reported sales increased to 13. The CBI business optimism came in at -16 in April, an improvement compared to the last reading of -23. GBP/USD fell by 1% this week, mostly affected by the U.S. dollar’s broad strength. The pound is likely to rebound once we see more signs confirming the strength in global growth, given Brexit has been kicked down the road. Report Links: Not Out Of The Woods Yet - April 5, 2019 A Trader’s Guide To The Yen - March 15, 2019 Balance Of Payments Across The G10 - February 15, 2019 Australian Dollar Chart II-9 AUD Technicals 1 AUD Technicals 1 Chart II-10 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been negative: Headline inflation fell to 1.3% year-on-year in Q1, missing expectations. Trimmed mean inflation in Q1 fell to 1.6% year-on-year. AUD/USD fell by 2.3% this week, which triggered our limit buy order at 0.7 on Wednesday. Inflation is a lagging indicator. While the Q1 inflation number missed expectations, the Australian dollar is likely to bottom as Chinese stimulus plays out and global growth starts to pick up. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 Into A Transition Phase - March 8, 2019 New Zealand Dollar Chart II-11 NZD Technicals 1 NZD Technicals 1 Chart II-12 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been negative: Credit card spending contracted by 5.1% year-on-year in March, underperforming expectations. NZD/USD fell by 1.36% this week. We remain bearish on the New Zealand dollar due to the Achilles’ heel of an overvalued housing market. Moreover, the Kiwi is still expensive compared to its fair value. Report Links: Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Canadian Dollar Chart II-13 CAD Technicals 1 CAD Technicals 1 Chart II-14 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been positive: Wholesale sales grew by 0.3% month-in-month in February, surprising to the upside. CFIB business barometer increased to 56.7 in April. USD/CAD surged by 0.95% this week. The Canadian dollar seems to be less responsive to the energy prices this week due to lots of concerns regarding the pipeline issue in Alberta. The Bank of Canada maintained its overnight interest rate target at 1.75% on Wednesday. In the April Monetary Policy Report, the BoC projects real GDP growth of 1.2% in 2019, and around 2% in 2020 and 2021. Given the current developments in household spending, energy investment, and trade conditions, a dovish stance by BoC is warranted. Report Links: A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swiss Franc Chart II-15 CHF Technicals 1 CHF Technicals 1 Chart II-16 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been mostly positive: Money supply M3 grew by 3.5% year-on-year in March, same as last month. ZEW survey expectations increased to -7.7 from the previous reading of -26.9. USD/CHF increased by 0.66% this week. While global growth is set to rebound, the uncertainties regarding geopolitical risks, trade conditions, and oil prices will weigh on the growth pace. We remain neutral on the Swiss franc against U.S. dollar, but acknowledge that the large short positioning is attractive from a contrarian standpoint. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Norwegian Krone Chart II-17 NOK Technicals 1 NOK Technicals 1 Chart II-18 NOK Technicals 2 NOK Technicals 2 There is no significant data from Norway this week. USD/NOK appreciated by 2.2% this week. We remain overweight the NOK based on our bullish outlook for oil. The Trump administration said they would not renew the waivers for Iranian oil exports, a move that roiled the energy market. The spike in oil prices will eventually benefit the Norwegian krone once global growth stabilizes. Report Links: A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Swedish Krona Chart II-19 SEK Technicals 1 SEK Technicals 1 Chart II-20 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden suggest a more positive sentiment: Consumer confidence increased to 95.8 in April, surprising to the upside. Economic tendency survey increased to 102.7 in April. Moreover, the manufacturing confidence also improved to 108.4 in April. USD/SEK appreciated by 2.64% this week. The Riksbank has kept its interest rate unchanged at -0.25% this week, as widely expected. The dovish shift of central banks worldwide is likely to help the global economy, which will benefit the Swedish krona. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The short-term trade is to overweight the DAX or Euro Stoxx 50… …versus German bunds or the S&P 500. These trades have outperformed since late last year and can continue to do so for a while longer. But moving into the second half of the year, it will be time to take profits in these growth-sensitive trades. The long-term position is to own German real estate equities. The hedged position is long German real estate equities, short Swedish real estate equities. Feature Let’s begin with a trivia question. What do Germany, Finland, and Ireland have in common, that the other EU28 countries do not have? Chart of the WeekEuro Stoxx 50 Vs. S&P500 And EM Vs. DM Have Followed Near Carbon Copy Profiles Euro Stoxx 50 Vs. S&P500 And EM Vs. DM Have Followed Near Carbon Copy Profiles Euro Stoxx 50 Vs. S&P500 And EM Vs. DM Have Followed Near Carbon Copy Profiles The answer: Germany, Finland, and Ireland are the only three European countries that have a trade surplus with China.1 Germany Catches A Cold When China Sneezes… Chart 2Slowdown In Germany And Finland, No Slowdown In France And Spain U.S. GDP Growth Slowed By 1.5 Percent Slowdown In Germany And Finland, No Slowdown In France And Spain U.S. GDP Growth Slowed By 1.5 Percent Slowdown In Germany And Finland, No Slowdown In France And Spain Germany and Finland are the European economies most exposed to China, with 17 percent and 14 percent respectively of their extra-EU28 exports heading to the dominant emerging economy (for Ireland it is only 7 percent). This equates to almost 3 percent of GDP for Germany and around 1.5 percent for Finland. Hence, when China sneezes – as it did last year – Germany and Finland are the European economies most likely to catch a cold. It is not a coincidence that Germany and Finland suffered near identical short-term slowdowns in 2018 with the pain focussed in the third quarter. By contrast, the European economies with much less exposure to China – say, France and Spain – suffered no discernible slowdown (Chart I-2). In fact, Spain seemed completely unaffected, growing at a steady and robust 2 percent clip throughout 2018! The corollary is that when China rebounds – as it has recently – Germany and Finland are the European countries most likely to benefit. Since early January, Germany’s DAX has outperformed the 10-year German bund by 15 percent. For the past three months, the DAX has also outperformed the S&P 500, albeit modestly. The trends can continue for a while, but be warned: these short-term cyclical moves are likely to reverse later in the year, perhaps viciously. More about this later. …But Germany’s Structural Growth Model Has Changed Germany’s gross exports of €1.6 trillion equate to almost half of its €3.4 trillion economy. Inevitably, this makes the German economy highly vulnerable to down-oscillations in global growth as, for example, when China sneezes. But here’s the paradox: while the level of German exports is very high, it has been flat-lining at this elevated level since 2012 (Chart I-3). Hence, Germany is no longer deriving any structural growth from its export sector. All of Germany’s post-2012 structural growth has come from domestic demand. Germany’s structural growth model has changed. Through 1999-2007, Germany’s net export contribution accounted for the vast majority of its structural growth; and in 2008, net exports accounted for two-thirds of Germany’s severe economic contraction. But remarkably, since 2012, net exports have made no contribution to Germany’s structural growth (Chart I-4). Meaning that all of Germany’s post-2012 structural growth has come from domestic demand. Chart 3The Level Of German Exports Is High But Flat-Lining The Level Of German Exports Is High But Flat-Lining The Level Of German Exports Is High But Flat-Lining Chart 4Since 2012, Net Exports Have Made No Contribution To Germany's Structural Growth Since 2012, Net Exports Have Made No Contribution To Germanys Structural Growth Since 2012, Net Exports Have Made No Contribution To Germanys Structural Growth One manifestation of this is the post-2012 recovery in Germany’s real estate market. When Germany was deriving most of its growth from external demand, the domestic real estate market withered. In recent years, when growth has come from domestic demand, Germany’s real estate market has started to flourish (Chart I-5). Chart 5German Real Estate Prices Still Need To Catch Up German Real Estate Prices Still Need To Catch Up German Real Estate Prices Still Need To Catch Up Chart 6German Real Estate Book Values Have Trebled German Real Estate Book Values Have Trebled German Real Estate Book Values Have Trebled With Germany’s average house price, in real terms, at the same level as it was in 1995, there is still considerable upside outside the major cities such as Berlin, Frankfurt, and Munich. Especially so, because one of the main enemies of the real estate market – substantially higher bond yields – will be absent for some time.2 The strong performance of German real estate equities – a near trebling since 2012 – is just tracking the strong performance of their book values (Chart I-6), which itself is a leveraged function of real estate prices. On the basis that the real estate sector is benefiting from a structural tailwind, the sector is a long-term hold, but for those who want to hedge their exposure, the recommendation is: long German real estate equities, short Swedish real estate equities. What Is Driving Euro Stoxx Outperformance? In response to this week’s title question, some people will ask: has Euro Stoxx 50 outperformance even started? The answer is a clear yes. Relative to both global equities and the S&P 500, the Euro Stoxx 50 has been in a well-established – though modest – uptrend since last September. Interestingly, emerging markets (EM) versus developed markets (DM) has followed a near carbon copy profile, albeit the outperformance was front-end loaded (Chart of the Week and Chart I-7). Euro Stoxx 50 has been gently outperforming. Can this continue? Recent history is not very encouraging. Since the Global Financial Crisis, no bout of Euro Stoxx 50 outperformance has lasted more than a year (Chart I-8). If this pattern continues to hold, it implies that the current bout of Euro Stoxx 50 outperformance will be exhausted within another four months. Chart 7Euro Stoxx 50 Has Been Gently Outperforming Euro Stoxx 50 Has Been Gently Outperforming Euro Stoxx 50 Has Been Gently Outperforming Chart 8Euro Stoxx 50 Vs. S&P500 ##br##Follows… Euro Stoxx 50 Vs. S&P500 Follows Euro Stoxx 50 Vs. S&P500 Follows   Chart 9…Euro Area Banks Vs. U.S. Tech Euro Area Banks Vs. U.S. Tech Euro Area Banks Vs. U.S. Tech Could it be different this time? We think not. Euro Stoxx 50 performance relative to the S&P 500 lines up almost perfectly with the relative performance of euro area banks versus U.S. tech (Chart I-9). Given that this defines the sector skew ‘fingerprint’ of the relative position, this defining relationship is fundamental. Meaning that for the Euro Stoxx 50 to outperform the S&P 500 on a sustained basis, euro area banks have to outperform U.S. tech. Likewise, EM versus DM lines up almost perfectly with the relative performance of global resources versus global healthcare (Chart I-10 and Chart I-11). Again, this is not surprising as this just defines the sector skew fingerprint of EM versus DM. Admittedly, in this case the causality could sometimes run from the EM economy to the sector performance – given China’s role in driving resource demand – rather than from sector relative performance to EM versus DM. Nevertheless, for EM to outperform DM, resources have to outperform healthcare. EM versus DM lines up almost perfectly with the relative performance of global resources versus global healthcare. Since last autumn, Euro Stoxx 50 versus S&P 500 and EM versus DM have followed near carbon copy profiles because growth-sensitive financials and resources have outperformed less growth-sensitive technology and healthcare. Chart 10EM Vs. DM Follows… 10. EM Vs. DM Follows 10. EM Vs. DM Follows Chart 11…Basic Resources Vs. Healthcare Basic Resources Vs. Healthcare Basic Resources Vs. Healthcare From Sweet Spot To Weak Spot Nevertheless, there is a puzzle: why have growth-sensitive sectors, the DAX, Euro Stoxx 50, and EM outperformed since late last year when the high-profile hard economic data – such as GDP growth and CPI inflation – have been unambiguously weak? High-profile hard data are a record of what happened in the past. The simple answer is that these high-profile hard data are a record of what happened in the past, sometimes the distant past. Yet they matter because central banks’ increasingly ‘data dependent’ reaction functions have become slaves to this backward-looking data. Here’s the paradox: the ‘sweet spot’ for growth-sensitive sectors and markets is when the high-profile backward-looking data – GDP and inflation – are actually weak, while real-time measures of growth – such as short-term credit impulses – are strengthening. This creates a win-win for markets because the dovish pivot by data-dependent central banks lifts asset valuations and the acceleration in real-time growth lifts profit expectations. Sound familiar? It describes the situation since last autumn, and explains why the DAX, Euro Stoxx 50, and EM have outperformed. Now comes the unfortunate corollary: the ‘weak spot’ for growth-sensitive sectors and markets is when the high-profile backward-looking data are strong, while real-time measures of growth – such as short-term credit impulses – are weakening. This is a lose-lose for markets because the hawkish pivot by central banks weighs on asset valuations and the deceleration in real-time growth depresses profit expectations. Almost certainly, this will be the situation later in the year as the high-profile hard data starts to perk up – removing some of the central bank support for valuations – just as short-term credit impulses inevitably roll over – weighing on profit growth expectations. To sum up, growth-sensitive sectors, the DAX, and Euro Stoxx 50 have outperformed since late last year, especially versus bonds and cash – in line with our house view. These trends can continue for a while longer. But moving into the second half of the year, these growth-sensitive positions will transition from sweet spot to weak spot, and it will be time to take profits. As ever, we will tell you when. Stay tuned.   Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System* This week, we note that that the 65-day fractal dimension for technology versus healthcare is at an all-time low – implying that the recent strong outperformance is highly vulnerable to a technical reversal. Accordingly, this week’s recommended trade is short technology versus healthcare with a profit target of 6.5 percent and a symmetrical stop-loss. In other trades, we are pleased to report that long aluminium versus tin achieved its 6.5 percent profit target at which it was closed. This leaves five open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 Short Tech Versus Healthcare Short Tech Versus Healthcare The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Footnotes 1 Based on the EU28 net exports of goods to China in 2018 by Member State. 2 Please see the European Investment Strategy Weekly Report ‘Monetarists, Keynesians, And Modern Monetary Theory’ April 11 2019 available at eis.bcaresearch.com. Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Dear Client, This Special Report is the full transcript and slides of a keynote presentation I recently gave to the Sovereign Investor Institute in London titled: 'The Biggest Risks To The Global Economy Are…' The short presentation pulls together several concepts and observations which identify the ‘weak links’ in the global economy. Therefore, the presentation should serve as a useful summary of the global economy’s current vulnerabilities. The report then explains how each of the risks translates into a European investment context. I hope you find it insightful. Best regards, Dhaval Joshi, Chief European Investment Strategist Image Feature Full Transcript And Slides Image Good morning Thank you for inviting me to give today’s keynote presentation under the title: ‘The Biggest Risks To The Global Economy Are…’ (Slide 1). I will not discuss all the risks out there, but the four risks that I will present are the ones that I think are the most significant. And the biggest of these four risks I will leave to the end. So let’s begin. Risk 1 is China’s Credit Cycle (Slide 2). You can see this very clearly in this slide (Slide 3) which shows the short-term accelerations and decelerations in credit within the world’s three largest economies – Europe, the United States, and China. In essence, it is showing how much new credit was created in the last six months compared with the preceding six months. Was it more credit creation or was it less, and how much more or less? Everything is in dollars to allow a fair comparison. Image Image Now look at the red line. The red line is China. Just ten years ago, China’s credit cycle was irrelevant. It simply didn’t matter. But after the GFC, China’s short-term credit expansions and contractions suddenly became as large as those in Europe and the U.S. More recently, China’s cycle is dwarfing the others, so now it is the European and the U.S. credit cycles that are irrelevant! This means that whenever China’s short-term credit cycle turns down, as it did in late 2015, early 2017, and 2018, the global economy feels a chill. The point is that this short-term cycle is a near-perfect oscillator. Down-oscillations will occur every eighteen months or so, and any of them has the potential to turn nasty. Though we are currently in an up-oscillation, the next down-oscillation is due later this year. And I predict that it will pose a big risk to the global economy. Risk 2 is Trade Imbalances (Slide 4). This slide (Slide 5) has a mischievous title ‘Where President Trump Is Right About Europe’. The red line shows where the president is absolutely right: Europe is running a massive – a record-high – trade surplus with the United States. It is an undeniable fact. But the president is wrong about the underlying cause. The underlying cause is not unfair trade practices or tariffs, the underlying cause is the other line, the blue line, which shows the divergent monetary policies of the ECB and the Fed. Image Image The trade imbalance and monetary policy divergence are moving together tick for tick, and the transmission mechanism is of course the exchange rate. The divergent monetary policies have depressed the euro, and a depressed euro obviously makes German cars cheaper for American consumers. That is the reason that the president is seeing so many BMWs driving down Fifth Avenue! My point is that these record-high imbalances are being used to justify economic nationalism – retaliatory tariffs, restricted trade, and potentially all-out trade wars. Alternatively, this chart suggests that the imbalances would correct with large-scale movements of exchange rates. But to me, either of these options poses a big risk to the global economy. Risk 3 Is Technological Disruption (Slide 6). To understand why, I want to introduce you to a concept known as Moravec’s Paradox (Slide 7). A professor of robotics, Hans Moravec, noticed something odd. He realized that things that we find very hard are actually very easy for AI. Things like complex mathematics, speaking multiple languages, or advance pattern recognition. Typically, as few people have these skills, they are well-paid skills. Image Image Whereas things that we find very easy are incredibly difficult for AI. Things like human movement and recognizing, and responding to, emotional signals. Typically, as everybody has these skills, they are low-paid skills.  Moravec’s Paradox means that the current wave of technological progress is much more disruptive than previous waves. The steam engine destroyed low-paid jobs, forcing workers up the income ladder. But the current wave of technology, led by AI, is destroying well-paid jobs forcing workers down the income ladder. Image You can see it in the data. While job creation in most major economies is on the face of it very strong, just look at what type of jobs are being created (Slide 8). Food delivery, bar work, care work and social work. Now you’ll agree that this is not highly paid work with career prospects!  In essence, the current wave of technology is revealing a huge misallocation of capital. You might have invested huge amounts of time and money in say, becoming a linguist. Only to find that AI can translate languages much better than you – and your employment opportunities are limited to lower-income work. Well that misallocation of capital is very disruptive.  In my opinion, it’s one of the main reasons why even though economies are growing and unemployment is very low, people don’t feel good. Making them susceptible to simplistic fixes such as ‘take back control’ and economic nationalism. My point is that the current wave of AI-led job disruption has much further to run, and the populist backlash will remain a big risk to the global economy. But now I want to turn to what I believe is the biggest risk of all. Risk 4 Is Higher Bond Yields (Slide 9). Most people believe that economic downturns cause financial market downturns. But the truth is the complete opposite: the causality almost always runs the other way! In the vast majority of cases, it is financial market imbalances and mispricing that cause economic downturns and crises. Take the last three economic downturns – in 2001, in 2008 and in 2011. They all had their roots in financial mispricing – the dot com bubble, the U.S. mortgage market, and euro area sovereign debt. Likewise for the Great Depression in the 30s, Japan’s recession in the early 90s. I could go on. You get the point… What is the financial vulnerability today that could cause an economic downturn? (Slide 10) The answer is that the very rich valuation of equities and other risk-assets is highly sensitive to bond yields. Which means that substantially higher bond yields pose a very big risk to the global economy. Image Image You see, at very low bond yields, the bond price can no longer go up much but it can go down massively (Slide 11). The latest advances in financial theory now conclusively show that this unattractive ‘negative’ asymmetry is what defines ‘risk’ for investors. The crucial point is that at low bond yields, bonds become as risky, or more risky, than equities (Slide 12). And this necessarily means that equities no longer need to deliver a superior return, a risk-premium, over the low bond yield (Slide 13). As bond yields decline this means equity valuations get an exponential boost because both components of the equity’s required return – the risk-free component and the risk-premium component – are collapsing simultaneously (Slide 14). Image Image Image Image But if bond yields rise substantially, the process would go into vicious reverse and equity valuations would fall off a cliff. Other risk-assets too, and bear in mind that if we include real estate – as we should – global risk-assets are worth $400 trillion, five times the size of the global economy!   Our research shows that the point of vulnerability is if the global 10-year bond yield approaches 2 percent, which is about 50 basis points above where it stands right now. And that, to me, is by far the biggest risk to the global economy. Image So to summarise, the biggest risks to the global economy are: China’s credit cycle; trade imbalances and technological disruption and their associated populist backlash; and the biggest risk is higher bond yields (Slide 15). In the near future I think alarm bells should start to ring if China’s credit cycle has tipped into a down-oscillation and/or the global 10-year bond yield is 50 bps higher. Don’t worry, the alarm bells are not ringing right now but they might be later this year. Finally, given the title you gave me, this presentation has necessarily focussed on the key risks. But I don’t want you to get too negative. I also have another presentation called ‘The Biggest Positives For The Global Economy Are…’ And for balance, I hope you invite me to present that next time! Thank you. How Do The Risks Translate Into A European Investment Context? Risk 1: China’s Credit Cycle, is highly relevant to European investors, for two reasons. First, the European economy is very open, meaning that exports make a substantial contribution to GDP growth. This is especially true in Europe’s engine economy, Germany, but it is also important for other major economies like Sweden. And it is evidenced in large trade surpluses as, for example, illustrated in Slide 5. Therefore, whenever China’s credit cycle enters a down-oscillation, as it did last year, Germany cannot escape the nasty chill coming through its all-important net export channel. Second, the European equity market is over-exposed to global growth sensitive sectors and companies – specifically, Industrials, Materials, and Financials. These sectors tend to have a very high operational gearing to global growth. Meaning that a small change in global growth has a disproportionate effect on these companies’ profits and share price performance. The upshot is that in a credit cycle up-oscillation, Europe’s global-growth sensitive stock markets and sectors benefit from a sharp burst of outperformance. The opposite applies in a credit cycle down-oscillation. It follows that if China’s credit cycle is due to tip into a down-oscillation later this year, it would be time to close our successful relative overweighting to European equities and to the global growth sensitive cyclical sectors. Risk 2: Trade Imbalances, is also highly relevant to European investors, for the obvious reason that European economies – especially Germany – are running huge trade surpluses. This puts these economies squarely in the cross-hairs of a retaliatory salvo involving tariffs, trade barriers, or worse, an all-out trade war. Clearly, Europe’s ‘exporting champions’ are the most vulnerable to this risk. The issue is important for the exchange rate too. We showed conclusively that Europe’s trade imbalance is the consequence of the depressed euro. It follows that another way to correct this imbalance is via a stronger euro. In this sense, the fundamentals imply euro upside from here. Risk 3: Technological Disruption, manifests through disruption in the jobs market, the lack of feel good, and the ensuing backlash leading to populism and nationalism. This is particularly relevant to Europe because its collection of nations, each with its own political processes, provides more scope for a political tail-event. A lull in the major political-event cycle is a good thing for Europe. In this regard, the upcoming EU parliamentary elections is not a big risk given the EU parliament’s inability, by itself, to drive policy. The risk increases approaching a meaningful political event, and this includes the date of Brexit. Therefore, this risk is likely to rise somewhat towards the end of the year. Risk 4: Higher Bond Yields, is clearly very relevant to Europe because many of the core euro area bond yields are at their lower bound. This means that the negative asymmetry of returns has its maximum impact on, for example, German bunds. It follows that German bunds are a sell in the near-term. Nevertheless, the upside to yields is ultimately limited given the aforementioned vulnerability of risk-asset valuations to higher bond yields. Therefore, the better long-term strategy is to short German bunds relative to U.S. T-bonds. Finally, a 50 basis points rise in 10-year yields from current levels would be a trigger to flip to underweight European equities.  Fractal Trading System* Crude oil is at a technical reversal level. The best way to play this is on a hedged basis versus metals: short WTI, long LMEX. Set the profit target at 5 percent with a symmetrical stop-loss. In other trades, we are pleased to report long AUD/CNY achieved its profit target at which it was closed. This leaves five open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Short WTI / Long LMEX Short WTI / Long LMEX The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart I-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations   Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights Evidence continues to mount that the Chinese economy is in a bottoming process. This suggests the path of least resistance for the RMB is up. Meanwhile, as the U.S. and China move closer to a trade deal, any geopolitical risk premium in the RMB will slowly erode. The ultimate catalyst for CNY longs will be depreciation in the U.S. dollar, which we believe is slowly underway. The ECB is turning more dovish at a time when euro area growth is hitting a nadir. This will be bullish for the euro beyond the near term. Our limit buy on the pound was triggered at 1.30. Target 1.45 with stops at 1.25. With the Aussie dollar close to the epicenter of Chinese stimulus, data down under is increasingly stabilizing. We are closing our short AUD/NOK position for a small profit. Feature Chart I-1The Chinese Yuan Is Pro-cyclical The Chinese Yuan Is Pro-cyclical The Chinese Yuan Is Pro-cyclical In addition to the dovish shift by global central banks, most investors are rightly fixated on China at this juncture in the economic cycle.  For one, it has been mostly responsible for the mini cycles in the global economy since 2014. And with improvements in both Chinese credit and manufacturing data in recent months, the consensus is drawing closer to the fact that we may be entering a reflationary window. Looking at risk assets, MSCI China is up 25% from its lows, while the S&P 500 is up 20%. Commodity prices are also rising, with crude oil hitting a new calendar-year high this week. The corollary is that if the improvement in Chinese data proves sustainable, it will propel these asset markets to fresh highs. The evolution of the cycle has important implications for the yuan exchange rate, because the RMB has been trading like a pro-cyclical currency in recent years. The USD/CNY has been moving tick for tick with emerging market equities, Asian currencies, and even some commodity prices (Chart I-1). Ever since its liberalization over a decade ago, the RMB may finally be behaving like a free-floating exchange rate. Therefore, a simple evaluation of how relative prices between China and the rest of the world evolve will be valuable input for the fair value of the RMB exchange rate. Reading the tea leaves from Chinese credit data can be daunting, but we agree with the assessment of our China Investment Strategy team that while the credit impulse has clearly bottomed,1 the magnitude of the rise is unlikely to be what we saw in 2015-2016. That said, a higher credit-to-GDP ratio also requires a smaller increase in credit growth to have an outsized effect on GDP. As such, monitoring what is happening with hard data in the economy concurrently – in particular, green shoots – could add valuable evidence to the reflation theme. A Repeat Of 2016? Cycle bottoms can be protracted and volatile, but also V-shaped. So it is useful when economic data is at a nadir to pay attention to any green shoots emerging, because by the time the last piece of pertinent economic data has turned around, it may well be too late to call the cycle. Admittedly, most measures of Chinese (and global) growth remain weak. But there have been notable improvements in recent months that suggest economic velocity may be picking up: Production of electricity and steel, all inputs into the overall manufacturing value chain, are inflecting higher. Intuitively, these tend to lead overall industrial production. Overall industrial production remains weak, but the production of electricity and steel, all inputs into the overall manufacturing value chain, are inflecting higher. Intuitively, these tend to lead overall industrial production (Chart I-2). Electricity production for the month of February grew 5% after grinding to a halt in 2015-2016. Production of steel also rose by 7%. If these advance any further, they will begin to exceed Q4 GDP growth, indicating a renewed mini-cycle. Chart I-2A Revival In Industrial Activity A Revival In Industrial Activity A Revival In Industrial Activity Chart I-3Metal Prices Are Sniffing A Rebound Metal Prices Are Sniffing A Rebound Metal Prices Are Sniffing A Rebound   In recent weeks, both steel and iron ore prices have been soaring. Many commentators have attributed these increases to supply bottlenecks and/or seasonal demand. However, it is evident from both the manufacturing data and the trend in prices that demand is also playing a role (Chart I-3). Overall residential property sales remain soft, but evidence from tier-1 and even tier-2 cities is signalling that this may be behind us, given robust sales. Over the longer term, the ebb and flow of property sales has tended to be in sync across city tiers. A revival in the property market will support construction activity and investment. House prices have been rising to the tune of 10% year-on-year, and real estate stocks in China may be sniffing an eventual pick-up in property volumes (Chart I-4). Over the last 20 years or so, Chinese credit growth has been a reliable indicator for car sales with a lead of about six months. Government expenditures were already inflecting higher ahead of last month’s China National People’s Congress (NPC). Again, this suggests stimulus this time around may be more fiscal than monetary (Chart I-5). In addition to the recent VAT cut for manufacturing firms from 16% to 13%, a string of policy easing measures will begin to accrue, including a cut to social security contributions effective May 1st, and perhaps a pickup in infrastructure spending. Already, real estate infrastructure spending growth is perking up, with that in the mining sector soaring to multi-year highs. Chart I-4Real Estate Volumes Could Pick Up Real Estate Volumes Could Pick Up Real Estate Volumes Could Pick Up Chart I-5The Fiscal Spigots Are Opening The Fiscal Spigots Are Opening The Fiscal Spigots Are Opening Finally, Chinese retail sales including those of durable goods remain very weak. Car sales are deflating at the fastest pace in over two decades. But the latest VAT cut by the government is being passed through to consumers, with an increasing number of car manufactures cutting retail prices. Chart I-6Car Sales Typically Have V-Shaped Recoveries Car Sales Typically Have V-Shaped Recoveries Car Sales Typically Have V-Shaped Recoveries   Over the last 20 years or so, Chinese credit growth has been a reliable indicator for car sales with a lead of about six months (Chart I-6). The indicator right now suggests we could witness a coiled-spring rebound in Chinese car sales over the next few months. Bottom Line: Both Chinese stocks and commodity prices have been suggesting a bottoming process in the domestic economy for a while now. Incoming data is beginning to corroborate this view. This has important implications for both the Chinese yuan and other global assets. Capital Flows Improving domestic and external conditions will likely offset any renewed pressure on the Chinese yuan from capital outflows. Our China Investment Strategy team reckons that even after adjusting for cross-border RMB settlements and illicit capital outflows, there is less evidence of capital flight today than there was in 2015-2016.2  Chart I-7Offshore Markets Don't See RMB Weakness Offshore Markets Don't See RMB Weakness Offshore Markets Don't See RMB Weakness Typically, offshore markets have had a good track record of anticipating depreciation in the yuan. Back in 2014, offshore markets started pricing in a rising USD/CNY rate, and maintained that view all the way through to 2018, when the yuan eventually bottomed. Right now, no such depreciation is being priced in (Chart I-7). The reason offshore markets in Hong Kong and elsewhere can be prescient is because more often than not, they are the destination for illicit flows out of China. For example, one of the often-rumored ways Chinese money has left the country is through junkets, key operators in Macau casinos.3 These junkets bankroll their Chinese clients in Macau while collecting any debts in China allowing for illicit capital outflows. This was particularly rampant ahead of the Chinese 2015-2016 corruption clampdown, when Macau casino equities were surging while equity prices in China remained subdued. Historically, both equity markets tend to move together, since over 70% of visitors to Macau come from China (Chart I-8). Right now, both the Chinese MSCI index and Macau casino stocks are rising in tandem, suggesting gains are more related to fundamentals than hot money outflows. Chart I-8Macau Casinos: A Good Proxy For Chinese Spending Macau Casinos: A Good Proxy For Chinese Spending Macau Casinos: A Good Proxy For Chinese Spending A surge in illicit capital outflows could also be part of the reason for an explosion in sight deposits in Hong Kong ahead of the 2015-2016 clampdown (Chart I-9). Admittedly, most of these deposits were and still are due to cross-border RMB settlements, but it is also possible that part of these constituted hot money outflows. With these sight deposits rising at a more reasonable pace, it suggests little evidence of capital flight. Chart I-9The Chinese Government Has Clamped Down On Illicit Flows The Chinese Government Has Clamped Down On Illicit Flows The Chinese Government Has Clamped Down On Illicit Flows Trade Truce A trade truce between the U.S. and China will be the final catalyst for a stronger yuan. The news flow so far has been positive, with both U.S. President Donald Trump and Chinese President Xi Jinping publicly acknowledging they are closer to a deal. Even well-known China hawk Peter Navarro, head of the U.S. National Trade Council, has admitted that the two sides are in the final stages of talks. But with a still-ballooning U.S. trade deficit with China, Trump will want to take home a win (Chart I-10). Chart I-10Trump Needs To Take A Win Back To America Trump Needs To Take A Win Back To America Trump Needs To Take A Win Back To America Concessions on the Chinese side so far seem reasonable, allowing us to speculate that there is a rising probability of a deal. They have agreed to increase agriculture and energy imports from the U.S. by about $1 trillion over the next six years, announced a cut on import tariffs, revised their Patent Law to improve protection of intellectual property, and provided a clear timeline for when foreign caps will be removed in sectors such as autos and financial services. These seem like very reasonable concessions that will allow Trump to go home and declare victory. Trade wars are usually synonymous with recessions. As such, there are acute political constraints inching both sides towards an agreement. For President Trump, a deteriorating U.S. manufacturing sector in the midwestern battleground states is a thorn in his side. For President Xi, rising unemployment is a key constraint. On the currency front, the details of any agreement are still unknown, but should Chinese economic fundamentals start to genuinely improve, it will put upward pressure under rates – and ergo the yuan (Chart I-11). A gradually rising yuan exchange rate will further assuage any doubts or concerns that Trump may have. Bottom Line: Our fundamental models show the yuan as undervalued by about 3%. This means China could allow its currency to gradually appreciate towards fair value, with little impact on the domestic economy or even exports. Given some green shoots in incoming economic data, little risk of capital flight, and the rising likelihood of a trade deal between the U.S. and China, our bias is that the path of least resistance for the Chinese RMB is up (Chart I-12). Chart I-11Rising Chinese Rates Will Favor The Yuan Rising Chinese Rates Will Favor The Yuan Rising Chinese Rates Will Favor The Yuan Chart I-12The RMB Is Not Expensive The RMB Is Not Expensive The RMB Is Not Expensive     Another Dovish Shift By The ECB In another dovish twist, the European Central Bank kept monetary policy unchanged following this week’s meeting, while highlighting that it might be on hold for longer. Unsurprisingly, incoming data has been weak of late, which the ECB (like other central banks) blamed on the external environment. It did fall short of speculation that it will introduce a tiered system for its marginal deposit facility, which would have alleviated some cash flow pressures for euro area banks. Our bias is for the new Targeted Long Term Refinancing Operation (TLTRO III – in other words, cheap loans), to remain a better policy tool than a tiered central bank deposit system. In the case of a TLTRO, the ECB can effortlessly decentralize monetary policy, since liquidity gravitates towards the countries that need it the most. While a tiered system can allow a bank to offer higher rates and attract deposits, there is no guarantee that these deposits will find their way into new loans. It is also likely to benefit countries with the most excess liquidity. In the case of a TLTRO, the ECB can effortlessly decentralize monetary policy. Beyond any short-term volatility in the euro, we think the ECB’s dovish shift could be paradoxically bullish. If a central bank eases financing conditions at a time when growth is hitting a nadir, it is tough to argue that it is bearish for the currency. Meanwhile, fiscal policy is also set to be loosened. Swedish new orders-to-inventories lead euro area growth by about five months, and the recent bounce could be a harbinger of positive euro area data surprises ahead (Chart I-13). Chart I-13Euro Area Growth Will Recover Euro Area Growth Will Recover Euro Area Growth Will Recover Bottom Line: European rates are further below equilibrium compared to the U.S., and the ECB’s dovish shift will help lift the euro area’s growth potential. Meanwhile, investors are currently too pessimistic on euro area growth prospects. Our bias is that the euro is close to a floor. House Keeping Our buy-stop on the British pound was triggered at 1.30. We recommend placing stops at 1.25, with an initial target of 1.45. As we argued last week,4 the odds of a hard Brexit continue to fall, with U.K. Prime Minister Theresa May explicitly saying this week that the path for the U.K. going forward is either a deal with the EU or with no Brexit at all. As we go to press, EU leaders have granted the U.K. an extension until the end of October, with a review in June. Chart I-14What Next For The Pound? What Next For The Pound? What Next For The Pound? Back when the referendum was held in June 2016, even the pro-Brexit Tories, a minority in the party, promised continued access to the Common Market. Fast forward to today and there are simply not enough committed Brexiters in Westminster to deliver a hard exit. Given that the can has been kicked down the road, markets are likely to turn their focus on incoming economic data. On that front, economic surprises in the U.K. relative to both the U.S. and euro area are soaring (Chart I-14). Elsewhere, we are also taking profits on our short AUD/NOK position. Since 2015, the market has been significantly dovish on Australia, in part due to a more accelerated downturn in house prices and a marked slowdown in China. The reality is that the downturn in Australia has allowed some cleansing of sorts and has brought it far along the adjustment path relative to its potential. Any potential growth pickup in China will light a fire under the Aussie dollar, which is a risk to this position. Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see China Investment Strategy Special Report, titled “China: Stimulating Amid The Trade Talks,” dated February 20, 2019, available at fes.bcaresearch.com 2 Please see China Investment Strategy Special Report, titled “Monitoring Chinese Capital Outflows,” dated March 20, 2019, available at fes.bcaresearch.com 3 Farah Master, “Factbox: How Macau's casino junket system works,” Reuters, October 21, 2011. 4 Please see Foreign Exchange Strategy Weekly Report, titled “Not Out Of The Woods Yet,” dated April 5, 2019, available at bca.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. have been mostly positive: In March, 196K nonfarm jobs were created, surprising to the upside; unemployment rate stayed low at 3.8%, though average hourly earnings growth fell to 3.2% year-on-year. The factory orders in February contracted by 0.5% month-on-month. More importantly, headline consumer price inflation in March rose to 1.9% year-on-year, however this was mostly lifted by rising energy prices. Core inflation excluding food and energy dropped by 10 basis points to 2%. JOLTs job openings unexpectedly fell to 7.1 million in February, from 7.6 million. However, initial jobless claims fell to 196K. After a 3-month lull, producer prices are inflecting higher at a pace of 2.2% year-on-year for the month of March. DXY index fell by 0.44% this week. Global risk assets are on the rise this week. Meanwhile, the Fed minutes highlighted that members are in no rush to raise rates. Stalling interest rate differentials will be a headwind for the dollar.  Report Links: Not Out Of The Woods Yet - April 5, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 Into A Transition Phase - March 8, 2019 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been positive: The Sentix Investor Confidence index continues to inflect higher, coming in at -0.3 from -2.2.  German industrial production grew by 0.7% month-on-month in February. Trade balances improved across the euro area. In France, the trade deficit fell to €-4.0B in February. In Germany, the trade surplus increased to €18.7B. Italian retail sales increased by 0.9% year-on-year in February. On the inflation front, consumer price inflation in Germany and France both stayed at 1.3% year-on-year in March. EUR/USD rose by 0.57% this week. On Wednesday, the ECB has decided to leave policy unchanged as expected. Mario Draghi also highlighted more uncertainties and downside risks to the euro area amid the ongoing trade disputes. While the global trade war might add volatility to the pro-cyclical euro, easier financial conditions should eventually backstop growth. Report Links: Into A Transition Phase - March 8, 2019 A Contrarian Bet On The Euro - March 1, 2019 Balance Of Payments Across The G10 - February 15, 2019 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been negative: Preliminary cash earnings fell by 0.8% year-on-year in February, the only decline since mid-2017. Household confidence continues to tick lower, coming in at 40.5 in March. The trade balance in February came in at a surplus of ¥489.2B. Capex is rolling over. Machinery orders fell by 5.5% year-on-year in February. Machine tool orders remain extremely weak, at -28.5% year-on-year for the month of March. Lastly, the foreign investment in Japanese stocks increased to ¥1,463.7B. USD/JPY fell by 0.46% this week. In its April regional outlook, the BoJ downgraded most of the prefectures in Japan, with only Hokkaido that had an upgrade in the aftermath of the earthquake. As domestic deflationary pressures intensify, this will favor the yen.  This also raises the probability the government defers the consumption tax hike. Report Links: Tug OF War, With Gold As Umpire - March 29, 2019 A Trader’s Guide To The Yen - March 15, 2019 Balance Of Payments Across The G10 - February 15, 2019 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. have been strong: In February, manufacturing production increased by 0.6% year-on-year; industrial production also increased by 0.1% year-on-year, both surprising to the upside. Both were deflating in January. The goods trade balance in February fell to £-14.1B, however the total trade balance came in at a smaller deficit of £4.86B. Monthly GDP also came in higher at 2% year-on-year in February. House prices gains have pared the increase of previous years, but the Halifax house price index still increased by 2.6% year-on-year for the month of March.  GBP/USD rose by 0.41% this week. Theresa May got an extension for Brexit to October 31. Meanwhile, U.K. data have been stronger than consensus recently. We are long GBP/USD from 1.30, with a 0.6% profit. Report Links: Not Out Of The Woods Yet - April 5, 2019 A Trader’s Guide To The Yen - March 15, 2019 Balance Of Payments Across The G10 - February 15, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have continued to improve: Investment lending for homes in February grew by 2.6%. Home loans in February increased by 2% month-on-month, surprising to the upside. Westpac consumer confidence came in at 100.7 in April, increasing by 1.9%.  AUD/USD surged by 0.64% this week. The RBA Deputy Governor Guy Debelle hinted that a wait-and-see approach for interest rates seemed like the appropriate path, signaling that policy will continue to be accommodative. Meanwhile, the Australian dollar is probably anticipating better upcoming data from China, as it is Australia’s largest trading partner. If the world’s second largest economy can turn around, the Aussie dollar is likely to grind higher. Report Links: Not Out Of The Woods Yet - April 5, 2019 Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 There was little data out of New Zealand this week: The food price index came in at 0.5% month-on-month in March, shy of the estimate of 1.3%. NZD/USD plunged after rising by 0.5% initially this week, returning flat. Incoming data in New Zealand is likely to lag its commodity currency counterparts pushing the kiwi relatively lower. Our long AUD/NZD position is now 0.7% in the money since entry last Friday. Report Links: Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been negative: On the labor market front, the participation rate in March fell slightly to 65.7%; 7,200 jobs were lost, underperforming the estimated creation of 1,000 jobs; unemployment rate was unchanged at 5.8%. On the housing market front, starts in March increased by 192.5K year-on-year, underperforming the expected 196.5K; building permits dropped by 5.7% month-on-month in February. USD/CAD rebounded quickly after falling by 0.7% earlier this week, offsetting the loss. While the dovish shift by the BoC and looser fiscal policy, together with rising oil prices are likely to be growth tailwinds, the data disappointment coming from the housing market and overall economy limit upside in the CAD. Report Links: A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 There was scant data in Switzerland this week: The foreign currency reserves came in at 756B CHF in March. Unemployment rate in March was unchanged at 2.4%, in line with expectations. USD/CHF appreciated by 0.44% this week. With the euro area economy slowly recovering, the franc is likely to underperform as risk appetite rises. We are long EUR/CHF for a 0.1% profit. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Waiting For A Real Deal - December 7, 2018 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been strong, with inflation grinding higher: Headline consumer price inflation increased to 2.9% year-on-year in March; core inflation also rose to 2.7% year-on-year, both surprising to the upside. Producer price index grew by 5.2% year-on-year in March, outperforming expectations. USD/NOK depreciated by 1.16% this week. The improving domestic economy, rising oil prices, and the tick up in inflation are all the reasons why we favor the Norwegian krone. We are playing the NOK via a few pairs, notably long NOK/SEK and short AUD/NOK, which are currently 3.11% and 0.75% in the money, respectively. Report Links: A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been mixed: Industrial production fell to 0.7% year-on-year in February, lower than the previous reading of 3%. New manufacturing orders contracted by 2.8% year-on-year in February. However, the leading manufacturing new orders to inventory ratio is rising suggesting we might be near a bottom. Consumer price inflation came in higher at 1.9% year-on-year in March. USD/SEK fell by 0.21% this week. We remain bullish on the Swedish krona due to its cheap valuation and the imminent pickup in the euro area economy. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Foreign investors have been rushing into Indian equities in anticipation of a Modi win. While Modi’s chances are reasonable, he may not win an outright majority. Keep tactically underweighting Indian stocks for now. The structural outlook for Vietnam is strong and improving. A bottom in Vietnamese equities is in the making. Investors should overweight Vietnamese stocks within an EM equity portfolio. Feature Indian Equities: A Window Of Risk Remains Foreign investors have been rushing into Indian equities in anticipation of a win by current Prime Minister Narendra Modi in the upcoming general elections. As a result, Indian stocks have been outperforming the EM benchmark. Nevertheless, a window of risk for the Indian bourse remains. While Modi’s chances of winning the elections are reasonable, he and his party – the Bharatiya Janata Party, or BJP – may not win an outright majority in the lower house, as occurred in May 2014. While Modi’s chances of winning the elections are reasonable, he and his party – the Bharatiya Janata Party, or BJP – may not win an outright majority in the lower house, as occurred in May 2014. The basis for Modi not being able to win an outright majority is that rural area incomes have weakened substantially due to falling food prices (Chart I-1). Corroborating this distress in rural areas, stock prices of rural-exposed companies have massively underperformed urban-exposed ones (Chart I-2). Chart I-1India's Food Prices Have Been Falling Despite Low Rainfall India's Food Prices Have Been Falling Despite Low Rainfall India's Food Prices Have Been Falling Despite Low Rainfall Chart I-2Rural-Exposed Stocks Have Massively Underperformed Urban Stocks Rural-Exposed Stocks Have Massively Underperformed Urban Stocks Rural-Exposed Stocks Have Massively Underperformed Urban Stocks   Even though both monetary and fiscal policies are easing, these macro policies always work with a time lag and will not improve domestic growth before the elections. A BJP-led minority-government will force Modi to increasingly rely on his allies in the National Democratic Alliance (NDA) coalition. The prime minister will then be forced to frequently offer concessions, watering down his reform agenda. The BJP’s allies in the NDA coalition are not necessarily as market-friendly. This is why we believe such an outcome would upset Indian financial markets after its most recent outperformance. Meanwhile, rural demand weakness has spilled over into the broader Indian economy. Passenger car sales, as well as sales of two- and three-wheelers are on the verge of contraction, and growth in tractor sales is falling sharply (Chart I-3). Chart I-3Indian Cyclical Growth Is Decelerating Indian Cyclical Growth Is Decelerating Indian Cyclical Growth Is Decelerating Chart I-4Indian EPS Growth Will Likely Contract Indian EPS Growth Will Likely Contract Indian EPS Growth Will Likely Contract Moreover, the bottom panel of Chart I-3 illustrates that the production of intermediate goods is contracting and manufacturing production is decelerating. Worryingly, the domestic growth slowdown has stalled EPS growth for the overall market, and net profit margins are falling (Chart I-4). The large-cap equity index has so far disregarded poor earnings performance, which magnifies the risk to Indian stocks if the BJP fails to win a majority government. Notably, small-cap stocks have failed to advance much and have not corroborated the rally in large-caps (Chart I-5). India’s stock market breadth is also poor, which is a bad omen for the sustainability of the current rally (Chart I-6). Chart I-5India Small Cap Stock Are Not Confirming The Rally India Small Cap Stock Are Not Confirming The Rally India Small Cap Stock Are Not Confirming The Rally Chart I-6India's Stock Market Breadth Is Poor India's Stock Market Breadth Is Poor India's Stock Market Breadth Is Poor   Finally, rising oil prices will negatively impact India’s trade balance dynamics (Chart I-7, top panel). The stock market’s relative performance has diverged from the recent rise in oil prices – an unsustainable trend (Chart I-7, bottom panel).           Investment Recommendations Chart I-7Higher Oil Prices Are Not Discounted By Indian Equities Higher Oil Prices Are Not Discounted By Indian Equities Higher Oil Prices Are Not Discounted By Indian Equities The Indian economy will remain weak over the next several months, which places Modi’s majority re-election bid at risk. Beyond the elections, fiscal and monetary easing will kick in and boost cyclical growth in the second half of the year. Food prices are also beginning to pick up due to below average rainfall (Chart I-1, page 1). The latter will revive rural income and by extension spending. We recommend tactically underweighting Indian stocks for now. A better entry point to upgrade will likely emerge in the next few months as euphoria surrounding the upcoming elections comes to an end and a growth slowdown is finally priced in. For fixed-income investors, we recommend continuing to bet on yield-curve steepening. A dovish central bank will cut interest rates and keep them low. This, along with fiscal easing, will revive growth later this year. A growth recovery and rising food inflation will lift the long end of the yield curve.   Ayman Kawtharani, Associate Editor ayman@bcaresearch.com   Vietnam: Structural Tailwinds Getting Stronger; Buy On A Dip Our negative call on Vietnamese stocks since last May has turned out well.1 The significant deceleration in export growth alongside the selloff in broader emerging markets has generated a double-digit drop in Vietnamese stock prices over the past 12 months (Chart II-1, top panel). Chart II-1Vietnamese Equities: An Upturn Is Ahead Vietnamese Equities: An Upturn Is Ahead Vietnamese Equities: An Upturn Is Ahead Looking forward, a new upturn in Vietnamese equities is in the making. The structural outlook for Vietnam is strong and improving. Investors should overweight Vietnamese stocks within an EM equity portfolio (Chart II-1, bottom panel). Shifting Supply Chain For some time, companies in China have been moving their supply chain to Vietnam due to its cheap labor, inexpensive land and supportive policies. The geopolitical confrontation between the U.S. and China that began last year has served to accelerate this process. The U.S. and China may soon reach a trade deal. This will give Chinese manufacturers and multinational companies more time to prepare for their relocation, but it will not stop the ongoing supply chain shift. Both multinationals and Chinese producers would prefer to have alternative supply chains that are not exposed to a potential re-escalation in geopolitical tensions between the U.S. and China in the years to come.2 Chart II-2 shows that Chinese companies have nearly tripled their foreign direct investment in Vietnam over the past nine months. The surge in relocations from the mainland has boosted land prices and wages in Vietnam significantly. For example, the rental price of industrial land at Giang Dien industrial park on a long-term lease of up to 50 years has risen as much as 50% to US$90 per square meter last October from US$60-70 a year ago. The relocations have occurred not only for low-value-added companies such as textile and footwear makers, but also for high-value-add companies like electronics assembly producers. According to the Chairman of Shenzhen-Vietnam Industrial Park, most of the companies that established factories in the park last year have been focused on light processing such as electronic assembly. Chart II-2Accelerating Supply Chain Shift Accelerating Supply Chain Shift Accelerating Supply Chain Shift Chart II-3Strong U.S. Imports From Vietnam Strong U.S. Imports From Vietnam Strong U.S. Imports From Vietnam Chart II-3 shows that U.S. imports from Vietnam have been much stronger than those from China and the rest of the world. This may be the result of both the accelerated supply chain shift last year and the structural competitiveness of Vietnamese goods. Vietnam continues to take market share from China in global markets such as footwear, garments and electronics (Chart II-4). Both multinationals and Chinese producers would prefer to have alternative supply chains that are not exposed to a potential re-escalation in geopolitical tensions between the U.S. and China in the years to come. In fact, rising FDIs have already led to a growth rebound in imports among foreign invested enterprises (FIE), heralding an export growth acceleration in the months ahead (Chart II-5). FIEs import most of the input materials they need to manufacture their goods, which are then exported overseas. This is why this segment’s imports lead export growth. Chart II-4Vietnam: Taking More Market Share From China Vietnam: Taking More Market Share From China Vietnam: Taking More Market Share From China Chart II-5Rising FIE Imports Herald Export Growth Acceleration Rising FIE Imports Herald Export Growth Acceleration Rising FIE Imports Herald Export Growth Acceleration   Escaping A Global Slowdown In Smartphone Demand The biggest contributor to Vietnam’s current account and trade surplus has been the smartphone sector (Chart II-6). However, the ongoing downturn in global smartphone shipments may not affect Vietnam due to the latter’s gains in the global smartphone production and assembly market share: Vietnam mobile phone output (mostly Samsung smartphones) fell only slightly (1.2%) last year when Samsung smartphone shipments contracted by 8% (Chart II-7). This reflected Vietnam’s strong competitiveness relative to the other five countries where Samsung smartphones are manufactured: China, India, Brazil, Indonesia and South Korea. Over half of Samsung smartphones were produced in Vietnam last year. Chart II-6Phone Sector: The Biggest Driver Of Vietnamese Trade Surplus Phone Sector: The Biggest Driver Of Vietnamese Trade Surplus Phone Sector: The Biggest Driver Of Vietnamese Trade Surplus Chart II-7Vietnam May Withstand Well In A Global Smartphone Demand Slowdown Vietnam May Withstand Well In A Global Smartphone Demand Slowdown Vietnam May Withstand Well In A Global Smartphone Demand Slowdown Last December, Samsung closed its Chinese Tianjin plant. Without any additional production reductions in other plants, total Samsung capacity will be cut by about 7%. This further lowers the odds of a considerable production cut in Vietnam in the case of a further drop in global smartphone demand. Other Encouraging Signs Many other positive signs have emerged that point to a cyclical upturn ahead for Vietnam: Chart II-8Strong Domestic Demand Strong Domestic Demand Strong Domestic Demand Retail sales growth has been accelerating, and automobile sales have reached new highs, suggesting strong domestic demand (Chart II-8). Despite declining visitor arrivals, the country’s tourism revenue still grew at a robust 10% pace last year. In 2019, the country is expecting a 15% year-on-year growth in visitor arrivals. The Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP), which came into force for Vietnam in January, and the EU-Vietnam Free Trade Agreement (EVFTA), which will take effect later this year, will be highly beneficial to the Vietnamese economy. Both headline and core inflation are low. The country’s foreign reserves also jumped by 14% over the past 12 months to a record high of US$63.5 billion, equivalent to 26% of GDP. Investment Recommendations We recommend buying Vietnamese equities on dips. Dedicated equity investors should overweight Vietnam in an EM equity portfolio: The Vietnamese property market is booming on surging income growth and low interest rates. The real estate sector accounts for 45% of the MSCI Vietnam Index and 28% of the VN All-Share Index. According to CBRE Vietnam, there was a sharp rise in overseas investors in Vietnamese real estate in 2018, particularly from China. The real estate services firm reported that Chinese customers accounted for 44% of total transactions in the first nine months of 2018. In 2017, there was a 21% year-on-year increase in Chinese buyers. Buoyant household income growth is positive for consumer staples stocks, which accounts for 34% of the MSCI Vietnam Index and 8% of the VN All-Shares Index. Buoyant household income growth is positive for consumer staples stocks, which accounts for 34% of the MSCI Vietnam Index and 8% of the VN All-Shares Index. Vietnamese corporate earnings will outpace broader EM EPS, warranting equity market outperformance (Chart II-9). Vietnam's inclusion into some influential EM equity indices would significantly boost interest from foreign investors (Chart II-10). Chart II-9Vietnamese Corporate Earnings Growth: Better Than EM Vietnamese Corporate Earnings Growth: Better Than EM Vietnamese Corporate Earnings Growth: Better Than EM Chart II-10Rising Interest From Foreign Investors Rising Interest From Foreign Investors Rising Interest From Foreign Investors   Technically, it seems the correction in Vietnamese stocks is late, and that the equity market will resume its upturn sooner rather than later.   Ellen JingYuan He, Associate Vice President Emerging Markets Strategy ellenj@bcaresearch.com Footnotes 1 Please see Frontier Markets Strategy Special Report titled “Vietnamese Equities: Take A Step Back For Now, ” dated May 15, 2018. Available at fms.bcaresearch.com. 2 Please see Geopolitical Strategy and China Investment Strategy Special Report titled “China-U.S. Trade: A Structural Deal?” dated March 6, 2019. Available at gps.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

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