Trade

Highlights The Trump administration's decision to effectively tariff the second round of imports at 25% materially raises the odds of another significant uptick in Chinese financial market volatility. Even if China ramps up its stimulus efforts in response, the lesson of the 2014-2016 episode is that investors are likely to wait for earnings clarity before buying stocks aggressively. Stay neutral China, at best, relative to global stocks, and overweight low-beta sectors within the investable equity universe. We have a contrarian view about Chinese corporate bonds, and recommend holding a long but diversified position over the coming 6-12 months. Feature Chart 1The RMB Is Acting As A "Panic Barometer" ##br##For Domestic Stocks The Trump administration finally announced its decision this week on the second round of tariffs on Chinese imports, essentially applying a 25% rate. While the rate will initially start at 10%, it will rise to 25% by the end of the year, and the administration has threatened to immediately seek public consultation on tariffs on all remaining imports from China if the country retaliates against the second round (which was announced yesterday). With news reports having suggested that China would reject new trade talks merely if the second round moves forward, the prospect of a breakthrough in negotiations seems dim, at best. We have highlighted in past reports that the RMB has acted as a panic barometer for domestic equities (Chart 1), as evidenced by the recent spike in the correlation between the two. During this period, the percent decline in CNY-USD seems to have closely followed the magnitude of proposed tariffs as a percent of Chinese exports to the U.S., as would be implied in a simple open economy model with flexible exchange rates. Based on this framework, Chart 2 suggests that the RMB may come under considerable further market pressure, even if investors only assume a 10% rate on the third round of tariffs. A break above the psychologically-important level of 7 for USD-CNY appears likely barring a major intervention from the PBOC, suggesting that a meaningful uptick in Chinese financial market volatility is forthcoming. Chart 2USDCNY = 7 Is Likely To Be Breached Barring Strong Action From The PBOC Stimulus To The Rescue? Given that Chinese policymakers have signaled their willingness to stimulate in response to a negative external environment, some investors have argued that China is actually about to enter a mini-cycle upswing. For now, two points suggest that this conclusion is premature: A 10% tariff rate on all remaining imports from China would imply close to $90 billion in tariffs collected, once the second round rate rises to 25%. As noted above, a simple equilibrium exchange rate framework would imply material further weakness in the RMB to counter protectionism of this magnitude. Besides heralding a further selloff in Chinese stocks, this could lead to competitive currency devaluation amongst China's largest trading partners, a "beggar-thy-neighbor" policy that tends to exacerbate rather than alleviate shocks to aggregate demand. As we have noted numerous times over the past year, China's old economy was slowing in the lead up to the U.S./China trade war, and it is not yet clear whether the announced stimulus will generate enough "lift" to convince investors that the low in economic activity is behind them. Chart 3 shows that the August rise in adjusted total social financing as a share of GDP was extremely muted, and that there is no sign yet of a pickup in government spending. Even if China ramps up its stimulus efforts in response to this week's decision from the Trump administration, Chart 4 highlights an important point for investors: there was a considerable lag between a policy response and the low in stock prices during the 2014-2016 episode (a lag that may re-occur today). The chart shows that despite an ongoing depreciation in the RMB and a rebound in our BCA leading indicator for the Li Keqiang index, Chinese stock prices continued to decline for several months. This gap was caused by a lagged decline in earnings, and underscores that investors may ignore the current efforts by policymakers to stabilize the economy until clarity on the stability of earnings presents itself. Chart 3No Sign Yet Of##br## Major Stimulus Chart 4History Suggests Investors Need Both ##br##Stimulus And Earnings Clarity And for now, several signs point to potentially material downside risk for earnings: While the now considerably larger shock from U.S. tariffs has yet to impact the Chinese economy, trailing earnings growth has already peaked and has recently fallen below its trend (Chart 5, panel 1). Despite the recent deceleration in trailing earnings growth and the sharp decline in stock prices, analysts' 12-month forward growth estimates remain quite elevated (Chart 5, panel 2). This suggests that forward earnings could be vulnerable to a decline above and beyond what occurs to trailing earnings, as a full 1/3rd of the increase in the former since late-2015 has been due to very significant shift in growth expectations. The rise in trailing earnings over the past few years appears to be stretched, based the trend in profit margins (Chart 6). The chart highlights that 12-month trailing earnings have well surpassed sales since late-2016, causing margins to rise to their highest level on record and raising the risk of a significant mean-reversion in response to a meaningful economic shock. Net earnings revisions have done a good job at predicting inflection points in forward earnings growth over the past decade, and have recently fallen into negative territory (Chart 7). Chart 5Lofty Earnings Growth Expectations ##br##Are A Risk To Stocks Chart 6The Earnings Recovery Has Been Partly ##br##Reliant On A Margin Expansion Chart 7Earnings Revisions Herald ##br##Slowing Earnings Momentum It is true that some of the above-average levels for profit margins and 12-month forward growth expectations can be explained by the substantial rise in the share of the tech sector in the MSCI China index, whose constituents are significantly more profitable than ex-tech stocks, may have better longer-term growth prospects, and may be more immunized from the trade war with the U.S. Still, Chart 8 illustrates the high earnings hurdle rate for tech stocks over the coming year. Bottom-up analysts continue to expect tech stocks to grow their earnings more than 20% over the next 12 months, despite: Chart 8Are Chinese Tech Stocks Going To Be##br## Able To Grow Earnings 20+%? A poor economic outlook that is likely to impact consumer spending (even if households "outperform" the business sector), and The fact that tech sector net earnings revisions have fallen deeply into negative territory (panel 2). How should investors allocate capital within China in the middle of a trade war with the U.S? First, despite the fact that Chinese stocks have already fallen significantly from their early-January high, it is clearly too early to bottom fish either domestic or investable stocks. Stay neutral China, at best, relative to global stocks. Second, investors should certainly favor low-beta sectors within the Chinese equity universe. Currently, our low-beta equity portfolio includes industrials, telecom services health care, utilities, and consumer staples, but we update the portfolio weights at the end of every month. Third, as discussed below, investors should ignore the very bearish narrative towards Chinese corporate bonds, and hold a long but diversified position over the coming 6-12 months. Bottom Line: The Trump administration's decision to effectively tariff the second round of imports at 25% materially raises the odds of another significant uptick in Chinese financial market volatility. Even if China ramps up its stimulus efforts in response, the lesson of the 2014-2016 episode is that investors are likely to wait for earnings clarity before buying stocks aggressively. Stay neutral China, at best, relative to global stocks, and overweight low-beta sectors within the investable equity universe. Chinese Corporate Bonds: A Contrarian Long Our analysis of the earnings risk facing equities suggests that it is probably still too early to buy Chinese stocks, but in our (contrarian) view there is still one pro-cyclical asset that investors should favor: Chinese corporate bonds. Headlines about defaults in China's corporate bond market continue to appear in the financial press, with concerns most recently focused on low recovery rates of defaulted issues.1 We last wrote about Chinese corporate bonds in June,2 and took a contrarian (i.e. optimistic) stance towards the market. In the meantime, our long China onshore corporate bond trade has continued to gain ground, and an analysis of the inferred credit rating of the market actually strengthens our conviction to stay long. One key element of the bearish narrative towards Chinese corporate bonds is the fact that investment-grade issues in the market are trading like junk. Table 1 highlights that this is largely true: the table presents the spread-inferred credit rating of the four major rating categories of the ChinaBond Corporate Bond Index, and shows that AAA bonds are trading on the border of equivalent maturity investment- and speculative-grade bonds in the U.S. Bonds rates AA+/AA/AA- in China are trading between lower-B and high-CAA, which is firmly in speculative-grade territory. However, in our view market participants are making a mistake when they assume that de-facto junk ratings on Chinese corporate bonds will translate into U.S. junk-style default rates on bonds over the coming 6-12 months (or, frankly, beyond). Chart 9 presents an estimate of the market-implied default rate for the four rating categories shown in Table 1, and suggests that investors are pricing in roughly a 1% default rate for AAA-rated corporate bonds and a 4-5% default rate for AA+/AA/AA-. Table 1Chinese Corporate Bonds Are Trading##br## Like Speculative-Grade Issues Chart 9Allowing Market-Implied Default Rates##br## To Occur Would Be A Huge Policy Error There are two important factors to consider when gauging the validity of these expectations: Based on Moody's most recent Annual Default Study, the market's current expectations for Chinese corporate bond defaults are actually above the average historical one-year default rates for their inferred credit ratings. Average default rates almost never actually occur over a given 12-month period. Chart 10 highlights that default rates in the U.S. have a binary distribution that is almost entirely determined by whether the economy is in recession (not just slowing down). The late-1980s and the post-2015 environment have been exceptions to this rule, which in large part can be explained by industry-specific events (namely, a surge of energy-sector defaults due to a collapse in the price of oil). But the key point is that investors are likely to overestimate the actual default rate over a given 12 month period when assuming an average historical rate, unless the economy shifts from an expansion to an outright recession over the period. From our perspective, the combination of the market's default expectations and the fact that China is easing suggests an outright long position in Chinese corporate bonds is warranted over the coming year. In our judgement, there is simply no way that policymakers can allow default rates on the order of what is being priced in to occur, as it would constitute an enormous policy mistake that would risk destabilizing the financial system at a time when officials are attempting to counter the looming shock to the export sector. In fact, we doubt that China's typical policy of gradualism when liberalizing its economy and financial markets would allow default rates to rise from 0% to 5% over a year in any economic environment, particularly the current one. As a final point, Chart 11 highlights why a significant rise in the default rate is required in order for investors to lose money on Chinese corporate bonds. The chart shows the 12-month breakeven spread for the ChinaBond AA- Corporate Bond index, unadjusted for default. The breakeven spread represents the rise in yields that would be required for investors to lose money over a 12-month horizon (i.e. the yield change that exactly erases the income return from the position), assuming no defaults. Chart 10"Average" Default Rates ##br##Do Not Really Occur Chart 11A 2% Rise In Yields From Tighter Policy Is Not##br## Going To Occur Over The Coming Year The chart shows that AA- bond yields would have to rise approximately 215 bps over the coming year before investors suffer a negative total return, which would be an enormous rise that has a near-zero probability of occurring due of tighter monetary policy. As such, defaults (or the pricing of default risk) remains the only real credible source of potential capital loss from these bonds over the coming year. Our bet, with high conviction, is that holders of Chinese corporate bonds hold a put option that will prevent this from occurring. Bottom Line: Fade investor concerns about rising defaults, and stay long Chinese corporate bonds over the coming 6-12 months. We acknowledge that idiosyncratic risk is likely to be elevated for this asset class, and we recommend that investors take a diversified, portfolio approach when investing in China's corporate bond market. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 For example, please see "In China, Less Than 20% Defaulted Bonds Have Been Paid Back" by Bloomberg News, August 27, 2018 2 Pease see China Investment Strategy Weekly Report "A Shaky Ladder", dated June 13, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights The primary trend for both Chinese stock prices and CNY-USD remains captive to negative surprises related to the trade war between the U.S. and China. Considerable uncertainty remains on this front, but our outlook is that the situation is likely to get worse, not better. It remains too early to forecast a durable stabilization in the exchange rate. It is an open question whether the PBOC will be forced to change short-term interest rates in order to guide the currency in their preferred direction. There is some evidence to suggest that China can control both the interest and exchange rate should it choose to do so, but analyzing the issue is significantly complicated by the approach Chinese policymakers are using to manage the impossible trinity. There is room for Chinese short-term interest rates to rise modestly if the worst of the U.S./China trade war does not materialize. This would be consistent with the goal of avoiding significant releveraging of China's private sector. For now, investors should maintain no more than a benchmark allocation towards Chinese investable stocks within a global equity portfolio, and should continue to favor low-beta sectors within the investable universe. Feature We noted in our August 22 Weekly Report that the persistent weakness of the RMB appeared to be one important factor weighing on Chinese stocks, particularly the domestic market.1 We presented some tentative evidence that part of the decline in CNY-USD since mid-June has been policy-driven (despite the PBOC's statements that it had not been depreciating the currency), but also noted that the RMB had now likely fallen outside the comfort zone of policymakers. The PBOC's re-introduction of its "counter-cyclical factor" when fixing the yuan's daily mid-point supports this view, and suggests that monetary authorities are now aiming for a broadly stable exchange rate (or are aiming to limit further downside). Chart 1 highlights that there have been some, albeit modest, signs of success. Whether they succeed will, first and foremost, be largely determined by what appears to be an imminent decision by the Trump administration to levy tariffs on an additional $200 billion in imports from China. Our previous analysis of potential equilibrium levels for CNY-USD suggests that investors have already priced in the imposition of a second round of tariffs, but the key factor for markets will be whether the tariff rate applied is 10% or 25%. In the first case it is possible that the RMB has overshot to the downside; in the latter case, CNY-USD will very likely come under renewed pressure that would be difficult for the PBOC to fully counter. Chart 1Some Modest Signs Of Currency Stability Chart 2Interest Rate Differentials And CNY-USD: A Tight Link But an additional question is whether the PBOC will be forced to change short-term interest rates in order to guide the currency in their preferred direction. Both our Global Investment Strategy and Emerging Markets Strategy services have highlighted that USD-CNY has broadly tracked the one-year swap differential between the U.S. and China over the past few years (Chart 2). This suggests that, at a minimum, there is some link between the interbank market and the exchange rate, despite the fact that capital controls are still tight in the Chinese economy. It also seems to imply, ominously, that the PBOC may have to choose between potentially significant releveraging and a significant re-appreciation in the exchange rate. Revisiting The Impossible Trinity "With Chinese Characteristics" The exact nature of this interest/exchange rate link is difficult to analyze, because of how China has chosen to manage the "impossible trinity" following the August 2015 devaluation of the yuan. The upper portion of Chart 3 illustrates the standard view of the impossible trinity, which posits that policymakers must choose one side of the triangle, foregoing the opposite economic attribute. For example, most modern economies have chosen "B", allowing the free flow of capital and independent monetary policy by giving up a fixed exchange rate regime. Hong Kong has chosen "A", meaning that its monetary policy is driven by the Fed in exchange for a pegged exchange rate and an open capital account. Chart 3The Possible Trinity? China historically has chosen "C", an economy with a closed capital account, a fixed exchange rate, and independent monetary policy. There is no causal link between interest and exchange rates in the world of option C, but following the PBOC's move in 2015 towards a more market-oriented approach for the exchange rate, it was accused by many market participants of trying to pursue all three goals simultaneously. In short, market participants have not been able to clearly discern what option China has chosen following over the past few years. China, in effect, answered these criticisms by arguing that it was not bound by the standard view of the impossible trinity, but rather one "with Chinese characteristics". The lower portion of Chart 3 presents this theory, which posits that policymakers must distribute a 200% adoption rate among three competing choices. The chart depicts a possible scenario where policymakers are relatively tolerant of capital flow, partially adopting two measures in addition to fully independent monetary policy: quasi-floating exchange rates highly subject to the interest rate dynamics shown in Chart 2, and loosely enforced capital controls. The chart also shows what ostensibly occurred in response to significant capital flight in 2014 and 2015, i.e. a crackdown on capital control enforcement and a less market-driven exchange rate. To the extent that this framework still applies, Charts 4 - 7 suggest that this capital flow crackdown has not abated and that the PBOC may be able to prevent significant further weakness in the currency without dramatically raising interest rates: China tightened scrutiny on trade invoicing verifications in 2016 to crack down on "fake" international trades, such as imports from Hong Kong (local firms fabricated import businesses to move money offshore). Based on the recent trend, these restrictions remain in effect (Chart 4). In addition, quarterly net flows of currency and deposits, which turned sharply negative in Q3 2015, have risen back into positive territory (Chart 5). Chart 4Blocking Capital Leakage In Trade... Chart 5...And Cash Chart 6 presents Chinese foreign reserves measured in SDRs, and highlights that reserves have been stable for the better part of the past two years. This stability is in sharp contrast to the material decline that occurred in 2015, and is supportive of the view that China can control both the interest and exchange rate, should it choose to do so. Chart 7 highlights that there are a few precedents for a divergence between interbank rates and CNY-USD. One divergence in 2012-2013 is particularly noteworthy: CNY-USD trended higher, but interbank interest rates remained flat for some time. Crucially, this does not appear to have been driven by falling U.S. interest rates, as the 2-year Treasury yield had already fallen close to zero in 2011 and did not begin to rise until mid-2013. Chart 6China Has Stabilized Its ##br##Foreign Reserves Chart 7Short-Term Interest Rates And ##br## CNY-USD Have Diverged Before Interest Rates And Moderate Releveraging Despite the evidence presented in Charts 4 - 7, the bottom line is that it is not clear whether the PBOC would be forced to raise short-term interest rates (and by how much) if it chooses to stabilize the currency. Would doing so be a death-knell for the Chinese economy? In our view, the answer is no, unless the trade war does indeed metastasize further. We have argued that the magnitude of the decline in the 3-month repo rate has been excessive, and is not currently consistent with a moderately reflationary scenario. We have argued that the repo rate decline is a side-effect of the PBOC's heavy liquidity injections, which were more likely aimed at ensuring financial system stability against the backdrop of struggling small banks. Chart 8Lending Rates Will Decline Substantially ##br## If Repo Rates Don't Rise But the current level of liquidity support carries risks to the objective of controlling private-sector leveraging. Chart 8 suggests that unless the PBOC raises the benchmark lending rate (which would be interpreted very hawkishly by the market), the magnitude of the decline in the repo rate will push the weighted average lending back to its 2016 low (when the monetary authority had turned the policy dial to "maximum reflation"). Last week's Special Report explained in detail why this would carry significant risks to China's financial stability.2 We noted that most of the private sector leveraging that has occurred in China since 2010 has occurred on the balance sheet of state-owned enterprises (SOEs) and the household sector. While the household debt-to-GDP ratio is still low, it is rising rapidly and may accelerate even further if lending rates fall significantly. The picture for SOEs is even more dire: leverage is extremely elevated, and a comparison of adjusted return on assets to borrowing costs suggests that the marginal operating gain from debt has become negative. This suggests that further leveraging of SOEs could push them into a debt trap and/or shackle the monetary authority's ability to meaningfully raise interest rates. As such, it is actually our expectation that short-term interest rates will rise modestly following a 10% rate on the second round of tariffs (instead of 25%), or if it becomes clear that there will be no third round. If the trade war escalates, however, short-term interest rates would not be expected to rise at all, and the drive to control leverage could be downshifted yet again. Investment Conclusions Chart 9Stay Neutral Towards Chinese Stocks, ##br##And Favor Low-Beta Sectors What does this all mean for our view on the RMB, and what are the implications for Chinese stocks? For now, we can draw the following conclusions: The primary trend for both stock prices and the exchange rate remains captive to negative surprises related to the trade war between the U.S. and China. We would expect further financial market weakness in response to a 25% rate on the second round of tariffs, and especially if President Trump moves forward with plans to tariff the remaining $250 billion of imports from China (the "third round"). Conversely, a 10% second-round tariff rate, or convincing signs that there will be no third round, could soon put a floor under the RMB and stock prices. On this front, the lead-up to a possible meeting between Presidents Trump and Xi in November will be important to monitor. But for now, given our view that the trade war between the U.S. and China is likely to get worse, not better, it remains too early to forecast a durable stabilization in the exchange rate, and an overweight stance towards Chinese equities in absolute terms remains premature. A-shares are deeply oversold and we are watching closely for signs to time a reversal, relative to investable stocks (at least at first). Higher Chinese short-term interest rates are not necessarily negative for stock prices, as long as the rise is modest and not in the context of a further, material uptick in trade tensions between the U.S. and China. While a moderate releveraging scenario would clearly imply a weaker earnings growth outlook than if credit accelerated strongly, earnings growth is still positive and yet Chinese equities are 20-30% off of their 1-year high in local currency terms. Modestly higher interest rates, in the context of durable RMB stability and an end to the escalation of trade threats, is likely to be equity-positive. As we wait for more clarity on the trade outlook, we reiterate our core equity investment recommendations: Investors should maintain no more than a benchmark allocation towards Chinese investable stocks within a global equity portfolio, and should continue to favor low-beta sectors within the investable universe (Chart 9). As always, we will be monitoring developments related to the timing and magnitude of the upcoming export shock, as well as further policymaker responses continually over the coming weeks and months. Stay tuned! Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Pease see China Investment Strategy Weekly Report "In Limbo", dated August 22, 2018, available at cis.bcaresearch.com. 2 Pease see China Investment Strategy Special Report "Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging", dated August 29, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Special Report

Highlights Barring government interference in foreign exchange markets, the path of least resistance for the U.S. dollar is up. The U.S. Treasury has authority to intervene unilaterally in foreign exchange markets. However, conditions for effective interventions to weaken the dollar exist neither within nor outside the U.S. For the time being, central banks in Europe, Japan, and China will not cooperate with the U.S. to depreciate the dollar. The Federal Reserve will effectively team up with the U.S. Treasury to depreciate the greenback only if economic conditions in the U.S. warrant a weaker currency. This is not currently the case. In this context, the dollar will continue to appreciate, but its rally will be accompanied by substantially higher volatility as the U.S. administration aggressively "talks down" the dollar. To capitalize on this theme, traders should consider going long dollar volatility. A firm dollar is consistent with continuous turmoil in EM financial markets. We continue to recommend staying put on EM. Feature Chart I-1U.S. Core Inflation Will Rise Further Economics and politics are set for a major clash in foreign exchange markets. Economic fundamentals and crosscurrents worldwide herald U.S. dollar appreciation. Yet, U.S. President Donald Trump wholeheartedly opposes any dollar strength. The higher the greenback rises, the more forceful Trump's jawboning about the exchange rate and interest rates will become. If the dollar does not halt its advance and overshoots, the odds are material that at a certain point the U.S. Treasury will initiate currency market interventions itself. It would do so by selling dollars and buying foreign assets. What will be the outcome of this battle between economics and politics in financial markets? The conclusion of this report is that for government-led currency market interventions to be effective in reversing the dollar's uptrend, the U.S. administration will have to convince the Federal Reserve to cease rate hikes and balance sheet contraction. Without the Fed recalibrating policy to be more consistent with a weaker dollar, the U.S. Treasury may not succeed in weakening the greenback on a sustainable basis. Given core consumer price inflation in the U.S. will likely surprise to the upside (Chart I-1), the Fed will not be willing to halt its tightening campaign. Hence, it will take time for the U.S. administration to wrestle and convince the Fed to accommodate currency interventions in efforts to weaken the greenback. In the meantime, the dollar will likely continue its volatile ascent. The Dollar Will Rally If Left To Market Forces Based on economic fundamentals, the path of least resistance for the greenback is up - for now. U.S. growth and inflation warrant higher interest rates, and the Fed is willing to continue moving short rates higher. In contrast, the unfolding EM/China slowdown is not only negative for their own respective currencies but is also harmful for commodities currencies in the advanced economies. Besides, the German and Japanese economies are much more vulnerable to a slowdown in EM/China than the U.S. (Chart I-2). Consistently, Chart I-3 illustrates that outperformance by the equal-weighted U.S. stock index versus its global peers in local currency terms - a measure of relative domestic demand - still points to a stronger U.S. dollar. On the whole, the growth and interest rate differentials between the U.S. and the rest of the world will likely continue to move in favor of the former and extend the dollar rally. Chart I-2Germany and Japan Are Much More Exposed ##br##To EM/China Than To The U.S. Chart I-3Relative Share Prices Point ##br##To A Firmer Dollar The dollar is typically a counter-cyclical currency. It depreciates when global trade is improving and appreciates when the global business cycle is slowing (the dollar is shown inverted on this chart) (Chart I-4). Odds are that global trade will continue to decelerate due to the slowdown in EM/China and trade protectionism - even if U.S. domestic demand growth remains robust. Furthermore, U.S. trade protectionism is positive for the dollar. The basis is that exporters to the U.S. could opt for weaker currencies to offset the negative impact of tariffs on their local currency revenues. Financial markets are often self-regulating, and they move to rebalance the global economy and amend economic excesses. A stronger dollar is the right medicine for the global economy for now. A firmer dollar is required to rebalance growth away from the U.S. and towards the rest of the world. In particular, dollar appreciation is needed to cap budding U.S. inflationary pressures. In addition, a stronger greenback will compel unraveling of excesses within the developing economies. While it will cause growth retrenchment and will be painful for EM in the medium term, cheapened currencies and deleveraging (an unwinding of credit excesses) will ultimately create a foundation for stronger and healthier growth in the years ahead. U.S. dollar liquidity is tightening, supporting the greenback (the latter is shown inverted on this chart) (Chart I-5). Continued shrinkage of the Fed's balance sheet entails tighter U.S. dollar liquidity going forward. With respect to currency market technicals, the broad trade-weighted U.S. dollar is not yet overbought, and trader sentiment on the U.S. currency is not extremely bullish (Chart I-6). Hence, conditions for an ultimate cyclical top in the dollar do not yet exist. Chart I-4The Global Business Cycle and The Dollar Chart I-5Upside Risks To The Dollar Chart I-6The Dollar: Market Technicals Finally, the U.S. dollar is not expensive. Our favored currency valuation measure - the real effective exchange rate-based on unit labor costs - currently suggests that the greenback is only slightly above its fair value (Chart I-7). This measure is superior to the real effective exchange rate based on consumer and producer prices because it considers both wages and productivity. Ultimately, competitiveness is not a function of wages (or prices) but wages adjusted for productivity.1 Besides, labor costs typically constitute the largest share of business costs. Hence, the unit labor cost-based real effective exchange rate is the best measure of currency competitiveness. This currency valuation yardstick does not corroborate the widely circulating narrative in the investment community that the U.S. currency is very expensive. The greenback is also not expensive according to the real broad trade-weighted dollar index. The latter is only slightly above its historical mean, and well below its previous highs (Chart I-8). Chart I-7AThe Dollar Is Not Expensive Chart I-7BThese Currencies Are Expensive Chart I-8Trade-Weighted Dollar in Real Terms To be sure, we are not implying the dollar is cheap. It is not. Rather, our point is that the greenback is not yet expensive. When valuations are not extreme, they usually do not prevent a rally or selloff. Odds are that the dollar could become more expensive in this cycle before topping out. Bottom Line: Barring government interference in foreign exchange markets, the path of least resistance for the U.S. dollar is up. The Main Risk To The Dollar Is Trump Chart I-9U.S. Monetary Conditions Are ##br##About To Become Tight Will the U.S. administration invoke the "nuclear" option - currency market interventions - to eclipse the dollar's fundamentals and reverse the greenback's rally? President Trump fiercely opposes a stronger dollar. He prefers a structurally weaker currency to bring back manufacturing jobs to the U.S. Besides, from a cyclical perspective, President Trump has been explicit that higher U.S. interest rates and a stronger dollar are negating his economic stimulus. Trump's worry is that tightening monetary conditions, if they persist, will depress growth by late 2019 when the next presidential election season begins in earnest (Chart I-9). President Trump is a genuine economic populist and is ready to cross boundaries that many presidents refused to. This leaves us little doubt that the U.S. administration will escalate its calls both for a weaker currency and a halt in Fed tightening. The U.S. Treasury is in charge of foreign exchange policy, and it can intervene in currency markets. The Fed can, but is not obliged by law, to supplement the Treasury's interventions in foreign exchange markets. In theory, the U.S. Treasury has a special fund (the Exchange Stabilization Fund) and could opt for unilateral currency market interventions even if the Fed does not cooperate. In such a case, a pertinent question is: What are the essential conditions for currency interventions to succeed in reversing the dollar's uptrend? Conditions For Effective Currency Interventions There have been two major interventions conducted by the U.S. authorities to depreciate the dollar: the 1971 Smithsonian Agreement and the 1985 Plaza Accord. BCA's Geopolitical Strategy service has discussed the political and trade backdrops of these interventions in past reports, and we will not detail them here.2 There was also the Louvre Accord in 1987, but it was aimed at propping up the U.S. dollar, not weakening it. All of these interventions were successful and achieved their objective (Chart I-10). We list below the stipulations that secured the success of these interventions and examine whether conditions for effective interventions are present today. Chart I-10The Smithsonian And Plaza Accords Were Successful Currency interventions accompanied by congruent monetary and fiscal policies tend to be more successful. The previous currency interventions conducted by the U.S. Treasury would not have been successful without the Fed simultaneously adjusting monetary policy. Not only did the Fed join the U.S. Treasury's efforts to depreciate the greenback following the Smithsonian Agreement and the Plaza Accord, but it also altered its monetary policy stance - it pursued a policy of lower-than-otherwise called for real interest rates. Academic literature on this issue is straightforward. Bordo (2010) contends the following about the efficacy of currency interventions: "If intervention were to have anything other than a fleeting, hit-or-miss effect on exchange rates, monetary policy had to support it ... Most of the movements in exchange rates over the Plaza and Louvre period seem attributable to policy changes, not intervention."3 Given current economic conditions in the U.S. economy - a very tight labor market and the prospect of higher inflation - the Fed is unlikely to easily agree to altering its current policy stance to accommodate the Treasury's preferred exchange rate policy. Academic literature finds that sterilized interventions are less effective than non-sterilized ones.4 For the Fed not to sterilize currency interventions aimed at weakening the dollar, it would need to allow commercial banks' reserves to rise. This would conflict with its current explicit objective of reducing commercial banks' reserves and shrinking its balance sheet (Chart I-11). Chart I-11U.S. Banks' Reserves and The Dollar Hence, the bar is presently very high for the Fed to agree to non-sterilized currency interventions to weaken the dollar, as it would go against its current policy objective of tightening and shrinking its balance sheet. Going on the Treasury's leash would substantially damage the Fed's creditability. Bilateral currency interventions are much more effective in achieving the desired objective than unilateral ones. Hence, for interventions to succeed it is critical to involve counterparts in other countries. Back in the 1970s and 1980s, the U.S. used its hegemonic leadership over Europe and Japan as well as tariffs (in 1971) and the threat of tariffs (1980s) to force its allies to agree to bilateral interventions to weaken the dollar. However, it is difficult to envision either Europe or Japan agreeing to allowing their respective currencies to strengthen a lot at this time. First, both Europe and Japan are actively fighting latent deflationary forces at home. Given the high-beta, export-dependent nature of both economies, a strong currency would negatively impact growth. Geopolitically speaking, Europe is not as dependent on the U.S. today as it was at the height of the Cold War. Russia is a "poor man's" Soviet Union, with the combined defense budget of the EU economies dwarfing its own. Besides, in the 1970s and 1980s, the U.S. was "the only market in town." Crossing American policymakers upped the threat of being evicted from the most lucrative global middle class consumer market. This is no longer the case with the rise of emerging markets, China and the common European market. Prominently, Trump's main objective is to depreciate the dollar versus the Chinese RMB. Yet, there is no chance that in the foreseeable future China will agree with the U.S. to engineer considerable yuan appreciation against the dollar. In fact, Beijing has been actively using CNY depreciation to offset the impact of tariffs imposed on its exports by the Trump administration. Chart I-12China: Exchange Rate and Interest Rate##br## Differential Are Correlated Notably, this week there was an article published by China's Xinhua news agency referring to the "... Plaza Accord, in which Tokyo agreed to strengthen the currency against the dollar, as cause of the country's economic woes. ... Rapid and steep yen appreciation and Japan's domestic policy mistakes eventually brought about the nation's "lost decade."5 Chinese policymakers have carefully studied and internalized Japan's mistakes in the late 1980s and early 1990s. The mainland will not accept a considerably stronger yuan at times when deleveraging remains an important policy objective - and the latter is bound to weigh on domestic demand. Amid deleveraging, China requires a weaker - not stronger - currency to mitigate deflationary pressures in the economy. For interventions to be effective, foreign counterparts need to also agree to adjust their monetary and fiscal policy stances to be in sync with exchange rate policy. Presently, both the European Central Bank and the Bank of Japan are still conducting QE and expanding their balance sheets. These policies are compatible with weaker - not stronger - currencies. It is highly unlikely these central banks will abruptly reverse their current policies to accommodate President Trump's economic preferences. With time, if the U.S. dollar overshoots on the strong side and the euro and yen plunge substantially, it is probable that the ECB and BoJ will become willing to support the U.S. administration's efforts to depreciate the dollar. However, conditions for bilateral interventions do not exist at the moment. As to China, policymakers are unlikely to push local rates higher to promote a major currency rally. Chart I-12 illustrates the tradeoff between the exchange rate and interest rates in China might be weak but exist - the CNY/USD rate broadly correlates with the China-U.S. interest rate differential. The PBoC may not be able to appreciate the yuan without tolerating higher money market rates. Yet China's corporate debt burden is enormous, and requires low - not high - borrowing costs to smooth the deleveraging process. Bottom Line: Conditions for effective foreign exchange market interventions do not presently exist in the U.S. For the time being, neither the Fed nor central banks in Europe, Japan and China will cooperate with the U.S. Treasury to depreciate the dollar. Can The U.S. Intervene In CNY/USD Market? Chart I-13Trade-Weighted RMB And Dollar Move Together The U.S. can intervene in the euro, yen and other currency markets, but the focus of President Trump is the dollar's exchange rate with the Chinese yuan. Provided China has capital controls, its government decides which foreign institutions/organizations can buy local currency and assets, and how much. It is highly unlikely the Chinese government will grant permission to the U.S. authorities to freely operate in the RMB market. In short, China will not allow the Fed and other U.S. institutions to act on behalf of the government and push around the exchange rate. The ongoing trade confrontation between the U.S. and China has not produced any agreement. There is, at this time, zero chance that China will agree to appreciate its currency considerably under U.S. pressure. In fact, our geopolitical strategy team still expects the Trump administration to impose tariffs on the announced $200 billion of Chinese imports at some point in September. While the ultimate figure may be smaller than $200 billion, the point remains that the trade war between the U.S. and China continues to heat up, not cool off. The only feasible option for the U.S. authorities is to devalue the dollar against the European and Japanese currencies, triggering a broad-based selloff in the dollar. In this scenario, the RMB might appreciate versus the greenback, but only moderately. The CNY/USD rate is tightly controlled by the PBoC, and the yuan typically depreciates (appreciates) in trade-weighted terms when the greenback weakens (strengthens), respectively (Chart I-13). Consequently, U.S. intervention in currency markets that does not directly embrace the yuan will likely lead to a weaker trade-weighted RMB and make China even more competitive versus other nations. In fact, such an effort would be welcomed by Chinese policymakers, as it would stabilize and even lift the yuan versus the dollar (fostering financial stability in China), but allow the renminbi to depreciate in trade-weighted terms (boosting China's overall trade competitiveness). Bottom Line: There is currently no effective way for the U.S. to intervene and achieve material RMB appreciation in trade-weighted terms. Investment Conclusions Chart I-14Go Long U.S. Dollar Volatility The global macro landscape warrants a continued dollar rally. Yet the U.S. administration will use frequent verbal attacks to halt the greenback's ascent. President Trump is likely to continue to publically oppose the Fed and its interest rate policy. At some point, potentially in the near future, his criticism could become a full-on assault. In this context, the U.S. currency will continue to appreciate, but its rally will be accompanied by large dips, i.e., substantially higher volatility. To capitalize on this theme, traders should consider going long dollar volatility (Chart I-14). The trajectory of the U.S. dollar is critical for many financial markets in general and EM in particular. A firm dollar is consistent with continuous turmoil in EM financial markets. We continue to recommend staying put on EM in absolute terms and underweighting EM versus DM for stocks, credit and currencies. BCA's Emerging Markets Strategy continues to recommend shorting a basket of the following EM currencies versus the U.S. dollar: the Brazilian real, the South African rand, the Chilean peso, the Malaysian ringgit and the Indonesian rupiah. Potential dynamics that would persuade the Fed to arrest its tightening campaign include escalating EM turmoil that spills into U.S. financial markets. An intensifying EM selloff is our baseline view, and the dollar will spike materially in this scenario. Only after this occurs will the Fed likely contemplate halting its tightening, and only then will the dollar peter out. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Unit labor cost = (wage per person per hour) / (productivity per person per hour). 2 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, and "The Dollar May Be Our Currency, But It Is Your Problem," dated July 25, 2018, available at gps.bcaresearch.com. 3 Bordo, M. et al (2010), "U.S. Foreign-Exchange-Market Intervention during the Volcker-Greenspan", NBER Working Paper, September 2010 4 Bordo, M., Humpage, O. & Schwartz, A. (2011), "U.S. Monetary-Policy Evolution and U.S. Intervention", Federal Reserve Bank of Cleveland, Working Paper, October 2011 5 South China Morning Post: Chinese state media cites Japan's 'lost decade' when warning of risks of giving in to US demands; https://www.scmp.com/news/china/diplomacy-defence/article/2160196/chinese-state-media-cites-japans-lost-decade-when Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Special Report

This Special Report examines the impact of a NAFTA cancelation on 21 level-three GICs industries. While the latest news on the NAFTA renegotiation with Mexico is positive as we go to press, there is still a non-negligible risk that the existing trilateral deal will not survive. The U.S.-Mexico bilateral deal is an "agreement in principle" and will take time to ratify. Meanwhile, a framework deal with Canada would leave many thorny issues to be resolved. President Trump can still revert to his tough tactics on Canada ahead of the U.S. mid-term elections. If the President does not gain major concessions that can be presented as "victories" to voters, he is likely to take an aggressive stand in order to fire up his political base. The probability of Trump triggering Article 2205 and threatening to walk away from the suspended U.S.-Canada free trade agreement is still not trivial, despite the deal with Mexico. By itself, the cancelation of NAFTA would not be devastating for any particular U.S. industry because the size of the tariff increases would be fairly small as long as all parties stick with MFN tariff levels. That said, the impact would not be trivial, especially for those industries that have extensive supply lines that run between the three countries involved (especially Autos). We approached the issue from four different perspectives; international supply chains, a model-based approach, and an analysis of foreign revenue exposure and input cost exposure. The broad conclusion is that there are no winners from a NAFTA cancelation for the U.S. manufacturing GICs industries. Pharmaceuticals, Health Care Equipment & Supplies, Personal Products and Construction Materials are lower on the risk scale, but cannot be considered beneficiaries of a NAFTA collapse. The remaining industries are all moderately-to-highly exposed. Considering the four perspectives as a group, the most vulnerable industries are Automobiles, Automobile Components, Metals & Mining, Food Products, Beverages, and Textiles & Apparel. Our U.S. equity sector specialists recommend overweight positions in Defense and Financials; while neither stands to benefit from a NAFTA abrogation, they should at least be relative outperformers. They recommend underweight positions on Auto Components, Steel and Electrical Components & Equipment as relative (and probably absolute) underperformers should NAFTA disappear. While the latest news on the renegotiation of the North American Free Trade Agreement (NAFTA) is positive as we go to press, there is still a non-negligible risk that President Trump could revert to his tough tactics ahead of the U.S. mid-term elections.1 Even if Canada signs on to a framework deal, a lot of thorny details will have to be worked out. A presidential proclamation triggering Article 2205 of the NAFTA agreement (as opposed to tweeting that the U.S. will withdraw) would initiate a six-month "exit" period. Trump could use this deadline, and the threat of canceling the underlying U.S.-Canada FTA, to put pressure on Canada (if not Mexico) to concede to U.S. demands, just as he could revoke his exit announcement anytime within the six-month period. While some market volatility would ensue upon any exit announcement, even a total withdrawal at the end of the six months would have a limited macro-economic impact as long as the U.S. continued to respect its WTO commitments and lifted tariffs only to Most Favored Nation (MFN) levels. Nonetheless, a modest tariff hike is not assured given the Administration's "America First" policy, its looming threat of Section 232 tariffs on auto imports, its warnings against the WTO itself, and the steep tariffs it has already imposed on Canada, including a 20% tariff on softwood lumber and the 300% tariff on Bombardier CSeries jets. Moreover, even a small rise in tariffs to MFN levels would have a significant negative impact on industries that are heavily integrated across borders. Our first report on the evolving U.S. trade situation analyzed the implications of the U.S.-China trade war for the 24 level two U.S. GICs equity sectors. This Special Report examines the impact of a NAFTA cancelation on 21 level three GICs industries (finer detail is required since NAFTA covers mostly goods industries). We find that there are no "winners" among the U.S. equity sectors because the negative impact would outweigh any positive effects. The hardest hit U.S. industries would be Autos, Metals & Mining, Food Products, Beverages, and Textiles and Apparel, but many others are heavily exposed to a failure of the free trade agreement. Out Of Time President Trump is seeking a new NAFTA deal ahead of the U.S. midterms in November. While this timing may yet prove too ambitious, the U.S. has made progress in recent bilateral negotiations with Mexico, raising the potential that Trump will be able to tout a new NAFTA framework deal by November 6. Yet, investors should be prepared for additional volatility. There are technical issues with the bilateral U.S.-Mexico deal that could delay ratification in Congress until mid-2019. The new Mexican Congress must ratify the deal by December 1 if outgoing President Enrique Peña Nieto is to sign off. Otherwise, the incoming Mexican President Andrés Manuel López Obrador may still want to revise any deal he signs, prolonging the process. Meanwhile, it would be surprising if the Canadians signed onto a U.S.-Mexico deal they had no part in negotiating without insisting on any adjustments.2 The important point is that President Trump's economic and legal constraints on withdrawing from NAFTA have fallen even further with the Mexican deal. If Trump does not get major concessions that can be presented as "victories" to voters, he is likely to take an aggressive stand in order to fire up his political base, as a gray area of "continuing talks" will not inspire voters. This could mean imposing the threatened auto tariffs or threatening to cancel the existing trade agreements with Canada. Thus, the risk of Trump triggering Article 2205 is still not trivial. A bilateral Mexican trade deal is not the same as NAFTA. Announcing withdrawal automatically nullifies much of the 1993 NAFTA Implementation Act. Some provisions of NAFTA under this act may continue, but the bulk would cease to have effect, and the White House could refuse to enforce the rest. The potential saving grace for trade with Canada was that the Canada-U.S. Free Trade Agreement (CUSFTA), which took effect in 1989, was incorporated into NAFTA. The U.S. and Canada agreed to suspend CUSFTA's operation when NAFTA was created, but the suspension only lasts as long as NAFTA is in effect. However, Trump may walk away from both CUSFTA and NAFTA in the same proclamation. In that event, WTO rules for preferential trade would require the U.S. and Canada to raise tariffs on trade with each other to Most Favored Nation (MFN) levels. These tariff levels are shown in Charts II-1A and II-1B. The Charts also show the maximum tariff that could potentially be applied under WTO rules. The latter are much higher than the MFN levels, underscoring that the situation could get really ugly if a full trade war scenario somehow still emerged among these three trading partners. Chart II-1AU.S.: MFN Tariff Rates By GICS Industry (2017) Chart II-1BMexico & Canada: MFN Tariff Rates By GICS Industry (2017) Current tariffs are set at zero for virtually all of these GICs industries, which means that the MFN levels also indicate how much tariffs will rise at a minimum if NAFTA is cancelled. Tariffs would rise the most for Automobiles, Textiles & Apparel, and Food Products (especially agricultural products), and Beverages. U.S. tariffs under the WTO are not significantly higher than NAFTA's rates; the average MFN tariff in 2016 was 3½%, which compares to 4.1% for the average Canadian MFN tariff. Would MFN Tariffs Be Painful? An increase in tariff rates of 3-4 percentage points may seem like small potatoes. Nonetheless, even this could have an outsized impact on some industries because tariffs are levied on trade flows, not on production. A substantial amount of trade today is in intermediate goods due to well-integrated supply chains. Charts II-2A and II-2B present a measure of integration. Exports and imports are quite large relative to total production in some industries. The most integrated U.S. GICs sectors include Automobiles & Components, Materials, Capital Goods and Electrical & Optical Equipment. Higher tariffs would slam those intermediate goods that cross the border multiple times at different stages of production. For example, studies of particular automobile models have found that "parts and components may cross the NAFTA countries' borders as many as eight times before being installed in a final assembly in one of the three partner countries."3 Tariffs would apply each time these parts cross the border if NAFTA fails. Chart II-2AU.S./Canada Supply Chain Integration Chart II-2BU.S./Mexico Supply Chain Integration Appendix Tables II-1 to II-4 show bilateral trade by product between the U.S. and Canada, and the U.S. and Mexico. In 2017, the U.S. imported almost $300b in goods from Canada, and exported $282b to that country, resulting in a small U.S. bilateral trade deficit. The bilateral deficit with Mexico is larger, with $314b in U.S. imports and $243b in exports. The largest trade categories include motor vehicles, machinery, and petroleum products. Telecom equipment and food products also rank highly. As mentioned above, the impact of rising tariffs is outsized to the extent that a substantial portion of trade in North America is in intermediate goods. Box II-1 reviews the five main channels through which rising tariffs can affect U.S. industry. Box II-1 Trade Channels There are at least five channels through which rising tariffs can affect U.S. industry: (1) The Direct Effect: This can be positive or negative. The impact is positive for those industries that do not export much but are provided relief from stiff import competition via higher import tariffs. The impact is negative for those firms facing higher tariffs on their exports, as well as for those firms facing higher costs for imported inputs to their production process. These firms would be forced to absorb some of import tariffs via lower profit margins. Some industries will fall into both positive and negative camps. U.S. washing machines are a good example. Whirlpool's stock price jumped after President Trump announced an import tariff on washing machines, but it subsequently fell back when the Administration imposed an import tariff on steel and aluminum (that are used in the production of washing machines). NAFTA also eliminated many non-tariff barriers, especially in service industries. Cancelling the agreement could thus see a return of these barriers to trade; (2) Indirect Effect: The higher costs for imported goods are passed along the supply chain within an industry and to other industries that are not directly affected by rising tariffs. This will undermine profit margins in these indirectly-affected industries to the extent that they cannot fully pass along the higher input costs. There would also be a loss of economies-of-scale and comparative advantage to the extent that firms are no longer able to use an "optimal" supply network that crosses borders, further raising the cost of doing business; (3) Foreign Direct Investment: Some U.S. imports emanate from U.S. multinationals' subsidiaries outside the U.S., or by foreign OEM suppliers for U.S. firms. NAFTA eliminated many national barriers to FDI, expanded basic protections for companies' FDI in other member nations, and established a dispute-settlement procedure. The Canadian and Mexican authorities could make life more difficult for those U.S. firms that have undertaken significant FDI in retaliation for NAFTA's cancellation; (4) Macro Effect: The end of NAFTA, especially if it were to lead to a trade war that results in tariffs in excess of the MFN levels, would take a toll on North American trade and reduce GDP growth across the three countries. Besides the negative effect of uncertainty on business confidence and, thus, capital spending, rising prices for both consumer and capital goods will reduce the volume of spending in both cases. Moreover, corporate profits have a high beta with respect to economic activity. The macro effect would probably not be large to the extent that tariffs only rise to MFN levels; (5) Currency Effect: To the extent that a trade war pushes up the dollar relative to the Canadian dollar and Mexican peso, it would undermine export-oriented industries and benefit those that import. However, while we are bullish the dollar due to diverging monetary policy, the dollar may not benefit much from trade friction given that tariffs would rise for all three countries. Chart II-3 is a scatter chart of GICs industries that compares the average MFN tariff on U.S. imports to the average MFN tariff on Canadian and Mexican imports from the U.S. A U.S. industry may benefit if it garners significant import protection but does not face a higher tariff on its exports to the other two countries. Unfortunately, there are no industries that fall into the north-west portion of the chart. The opposite corner, signifying low import protection but high tariffs on exports, includes Beverages, Household Durables, Household Products, Personal Products and Machinery. Chart II-3Import And Export Tariffs Faced By U.S. GICS Industries Model-Based Approach The C.D. Howe Institute has employed a general equilibrium model to estimate the impact of a NAFTA failure at the industrial level.4 The model is able to capture the impact on trade conducted through foreign affiliates. The study captures the direct implications of higher tariffs, but also includes a negative shock to business investment that would stem from heightened uncertainty about the future of market access for cross-border trade. It also takes into consideration non-tariff barriers affecting services. Table II-1Impact Of NAFTA Cancellation By Industry As with most studies of this type, the Howe report finds that the level of GDP falls by a relatively small amount relative to the baseline in all three countries - i.e. there are no winners if NAFTA goes down. Moreover, the U.S. is not even able to reduce its external deficit. While the trade barriers trim U.S. imports from NAFTA parties by $60b, exports to Canada and Mexico fall by $62b. At the industry level, the model sums the impacts of the NAFTA shock on imports, exports and domestic market share to arrive at the estimated change in total shipments (Table II-1). It is possible that an industry will enjoy a boost to total shipments if a larger domestic market share outweighs the damage to exports. However, the vast majority of U.S. industries would suffer a decline in total shipments according to this study, because the estimated gain in domestic market share is simply not large enough. Beef, Pork & Poultry and Dairy would see a 1-2% drop in total shipments relative to the baseline forecast. Next on the list are textiles & apparel, food products and automotive products. Even some service industries suffer a small decline in business, due to indirect income effects. Foreign-Sourced Revenue And Input Cost Approach Another way to approach this issue is to identify the U.S. industries that garner the largest proportion of total revenues from Mexico and Canada. Unfortunately, few companies provide much country detail on where their foreign revenues are derived. Many simply split U.S. and non-U.S. revenues, or North American and non-North American revenues. Table II-2 presents the proportion of total revenues that is generated from operations outside the U.S. for the top five companies in the industry by market cap (in some cases the proportion that is generated outside of North America was used as a proxy for foreign- sourced revenues). While this approach is not perfect, it does provide a good indication of how exposed a U.S. industry is to Canada and Mexico. This is because any company that has "gone global" will very likely be doing substantial business in these two countries. Table II-2Foreign Revenue Exposure At the top of the list are the Metals & Mining, Personal Products, and Auto Component industries. Between 62% and 81% of revenues in these three industries is derived from foreign sources. Following that is Household Durables, Leisure Products, Chemicals and Tobacco. Indeed, all of the level three GICs industries we are analyzing are moderately-to-highly globally-oriented, with the sole exception of Construction Materials. Table II-3Import Tariff Exposure U.S. companies are also exposed to U.S. tariffs that boost the price of imported inputs to the production process. This can occur directly when firm A imports a good from abroad, and indirectly, when firm A then sells its intermediate good to firm B at a higher price, and then on to firm C. In order to capture the entire process, we used the information contained in the Bureau of Economic Analysis' Input/Output tables. We estimated the proportion of each industry's total inputs that would be affected by a rise in tariffs to MFN levels. We then allocated the industries contained in the input/output tables to the 21 GICs level 3 industries we are considering, in order to obtain an import exposure ranking in S&P industry space (Table II-3). All 21 industries are significantly vulnerable to rising input costs, which is not surprising given that we are focusing on the manufacturing-based GICs industries and NAFTA focused on trade in goods. The vast majority of the industries could face a cost increase on 50% or more of their intermediate inputs to the production process. The Automobile industry is at the top of the list, with 72% of its intermediate inputs potentially affected by the shift up in tariffs (Automobile Components is down the list, at 56%). Containers & Packaging, Oil & Gas, Aerospace & Defense, Textiles and Food Products are also highly exposed to tariff increases. The automobile industry is a special case because of the safeguards built into NAFTA regarding rules-of-origin and the associated tracing list. The U.S. is seeking significant changes in both in order to tilt the playing field toward U.S. production, but this could severely undermine the intricate supply chain linking the three countries. Box II-2 provides more details. Box II-2 Automotive Production In NAFTA; Update Required We are focused on two key aspects to the renegotiation of the NAFTA rules that could have far reaching implications for automakers and the auto component maker supply base: the tracing list and country of origin rules. Regarding the first of these, the Trump administration has a legitimate gripe when it comes to automotive production. A tracing list was written in the early-1990's to define automotive components such that the rules of origin (ROO) could be easily met; anything not on the list is deemed originating in North America. As anyone who has driven a vehicle of early-1990's vintage and one of late-2010's vintage can attest, high tech components (largely not included on the tracing list) have grown exponentially as a percentage of the cost of the vehicle and, at least with respect to electronic and display components, are sourced mostly from overseas. Updating the tracing list would force auto makers to source a significantly greater amount of components domestically, almost certainly raising the cost of the vehicle and either hurting margins or hurting competitiveness through higher prices. The current NAFTA ROO require that 62.5% of the content of a vehicle must be sourced in North America, with no distinction between any of the member nations. The result of this legislation has been the creation of a highly integrated supply base that sees components move back and forth across borders through each stage of the manufacturing process. Early proposals from the Trump administration for a NAFTA rework included a country of origin provision for as much as 50% U.S. content. Such a provision would certainly cause a massive disruption in the automotive supply chain with components manufacturers forced to relocate or automakers electing to source overseas and pay the 2.5% MFN tariff on exports within North America. Either scenario presents a headwind to the tightly woven auto components base, underscoring BCA's U.S. Equity Strategy's underweight recommendation on the sector. The recently announced bilateral trade deal with Mexico raises the ROO content requirements to 75% from the 62.5% contemplated under NAFTA but, importantly, no country of origin provisions appear in the new deal. Still, given how quickly this is evolving, a final NAFTA deal could be significantly different. Chart II-4 presents a scatter diagram that compares import tariff exposure (horizontal axis) with foreign revenue exposure (vertical axis). The industries in the north-east corner of the diagram are the most exposed to NAFTA failure. The problem is that there are so many in this region that it is difficult to choose the top two or three, although Metals & Mining stands out from the rest. It is easier to identify the industries that face less risk in relative terms: Pharmaceuticals, Construction Materials, Health Care & Supplies, Leisure Products and, perhaps, Machinery. The rest rank highly in terms of both foreign revenue exposure and import tariff exposure. Chart II-4Foreign Revenue And Import Tariff Exposure Conclusions: By itself, a total cancelation of NAFTA would not be devastating for any particular U.S. industry because the size of the tariff increases would be fairly small as long as all parties stick with MFN tariff levels. That said, the impact would not be trivial, especially for those industries that have extensive supply lines that run between the three countries involved. The negative impact on GDP growth would likely be worse for Canada (and Mexico if its bilateral somehow fell through), but U.S. exporters would see some loss of business. We approached the issue from four different perspectives; international supply chains, a model-based approach, and an analysis of foreign revenue exposure and import tariff exposure. The broad conclusion is that there are no winners from a NAFTA cancelation for the U.S. manufacturing GICs industries. Pharmaceuticals, Health Care Equipment & Supplies, Personal Products and Construction Materials are lower on the risk scale, but cannot be considered beneficiaries of a NAFTA collapse. The remaining industries are all moderately-to-highly exposed. Considering the four perspectives as a group, the most vulnerable industries are Automobiles, Automobile Components, Metals & Mining, Food Products, Beverages, and Textiles & Apparel. Our U.S. equity sector specialists recommend overweight positions in Defense and Financials; while neither stands to benefit from a NAFTA abrogation, they should at least be relative outperformers. They recommend underweight positions on Auto Components, Steel and Electrical Components & Equipment as relative (and probably absolute) underperformers should NAFTA disappear. As we go to press, rapid developments are taking place in the NAFTA negotiations. The U.S. and Mexico have completed a bilateral agreement in principle and a Canadian team is looking into whether to sign onto the agreement by a U.S.-imposed August 31 deadline. This deadline would enable the current U.S. Congress to proceed to ratification before turning over its seats in January, though it is not a hard deadline. It is possible that the negotiations will conclude this week and the crisis will be averted. But the lack of constraints on President Trump's trade authority gives reason for pause. If Canada demurs, Trump could move to raise the cost through auto tariffs or announcements that he intends to withdraw from existing U.S.-Canada agreements in advance of November 6. While Mexico has now tentatively secured bilaterals with both countries through the new U.S. deal and the Trans-Pacific Partnership (which includes Canada), it still stands to suffer if a trilateral agreement is not in place. Moreover it is technically possible that Canada's refusal to join the U.S.-Mexico bilateral could delay the latter's ratification well into next year. Therefore, we treat Mexico the same as Canada in our analysis, despite the fact that Mexican assets stand to benefit in relative terms from having a floor put under them by the Trump Administration's more constructive posture and this week's framework deal. If Trump does not pursue a hard line with Canada, then it will be an important sign that he is adjusting his trade policy to contain the degree of confrontation with the developed nations and allies and instead focus squarely on China, where we expect trade risks to increase in the coming months. Mark McClellan Senior Vice President The Bank Credit Analyst Matt Gertken Associate Vice President Geopolitical Strategy Chris Bowes Associate Editor U.S. Equity Strategy APPENDIX TABLE II-1 U.S. Imports From Canada (2017) APPENDIX TABLE II-2 U.S. Exports To Canada (2017) APPENDIX TABLE II-3 U.S. Imports From Mexico (2017) APPENDIX TABLE II-4 U.S. Exports To Mexico (2017) 1 Please see BCA Geopolitical Strategy Special Report, "A Mexican Standoff - Markets Vs. AMLO," dated June 28, 2018, and Weekly Report, "Are You 'Sick Of Winning' Yet?" dated June 20, 2018, available at gps.bcaresearch.com 2 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com 3 Working Together: Economic Ties Between the United States and Mexico. Christopher E. Wilson, November 2011. 4 The NAFTA Renegotiation: What if the U.S. Walks Away? The C.D. Howe Institute Working Paper. November 2017.

Special Report

Highlights "When you come to a fork in the road, take it." - Yogi Berra The last time we invoked the great American philosopher Yogi Berra was in September 2015. Back then, the oil market was at a critical juncture, as the market-share war initiated by OPEC in November 2014 approached its dénouement.1 The signal feature of the oil market in September 2015 was a massive 1.5mm b/d oversupply that was rapidly filling storage globally. We noted this surplus "... either will be cleared gradually or convulsively. ... (H)igh-cost supply either will exit the market rationally ... or via sharp lurches toward cash-breakeven costs, as global inventories fill on the back of slowing demand in an oversupplied market. Either way, markets will balance." In the event, prices lurched sharply into the left tail of the distribution toward cash-breakevens, with Brent approaching $25/bbl in 1Q16 (vs. more than $100/bbl in mid-2014). Oil's at a critical juncture again. Only this time, prices are poised to push higher into the right tail of the distribution, ahead of the likely loss of 2mm b/d or more of exports on the back of U.S.-imposed sanctions against Iran, and the all-but-certain collapse of Venezuela's economy. In our modelling, these events - along with constrained U.S. shale oil output due to pipeline bottlenecks in the Permian basin, and still-strong demand assumptions - could send prices above $120/bbl.2 This is not a foregone conclusion, however. Downside risks to global oil demand - largely from tariffs and non-tariff barriers to trade, and the Fed's monetary policy - are building. In this Special Report, we expand our examination of downside risks to oil prices arising from divergent monetary policies at systematically important central banks, particularly their impacts on currency markets, which we began last week. Feature Chart of the WeekOil Prices And USD TWIB Share##BR##Long-Term Trend, Equilibrium We strongly believe Fed policy will, once again, become a key variable in the evolution of oil prices, mostly via the FX markets. As a result, our regular monthly oil price forecast will be complemented by an additional component: our U.S. trade-weighted dollar (USD TWIB) forecast. In the current market, this is a downside scenario not a revised expectation. The FX simulation we describe below for prices hugs the lower boundary of the 95-percent confidence interval we use to situate our scenarios within. This will allow us to judge our expectation against market-cleared expectations. Our thesis that the USD's appreciation earlier this year would have a moderate effect on the evolution of oil prices - i.e., that supply-demand fundamentals would dominate this evolution - has been spot-on so far in 2018.3 This is largely due to OPEC 2.0's remarkable production discipline, and strong demand, particularly out of EM economies, which caused global inventories to draw, and kept the forward curves for Brent and WTI backwardated. 4 However, with the U.S. economy powering ahead - growing at a 3.1% rate in 1H18 - and, per our House view, the Fed continuing to lean into its rates-normalization policy, the USD will rise ~ 5% over the next year.5 We have shown in the past how important the USD can be for oil prices. Our oil financial model uses the USD as its main explanatory variable, and shows these variables are cointegrated in the long run - i.e. they share a common long-term trend and are in an equilibrium relationship (Chart of the Week). Consequently, forecasting the U.S. dollar is crucial step in our oil-price forecasting process. The Fed And Oil Prices As the Iran sanctions approach, OPEC 2.0 has indicated - not in a particularly clear manner - that it will be increasing production. While it appears the producer coalition will raise output slower than it previously led the market to believe, it is raising output.6 In addition, the U.S. Strategic Petroleum Reserve (SPR) also will be releasing 11mm barrels of oil over the October - November period. This short-term measure will help keep gasoline prices down going into the U.S. mid-term elections. While OPEC 2.0 calibrates the output required to offset the Iran-Venezuela supply-side risks, demand growth is being threatened by tariff and non-tariff barriers to trade, and the Fed's monetary policy.7 Between tariffs and U.S. monetary policy, we believe Fed policy trumps U.S. trade policy ... at least for now. Fed Policy Trumps Tariffs A lot of ink has been spilled on the Sino - U.S. trade war, but so far, the actual damage done to the $17 trillion global trading markets is trivial (Chart 2). Of course, this could quickly change if the U.S. and China step up their tit-for-tat tariffs and both plunge into an all-out trade war. Fed policy is neither trivial nor local: It is a global macro variable, largely because it impacts the U.S. dollar directly. This is important for EM economies, especially as it pertains to trade. We have shown EM imports and exports are exquisitely sensitive to the USD TWIB.8 This makes the USD TWIB particularly important to commodity markets, since most of the world's traded commodities are priced in USD and EM demand dominates global demand. When the Fed is tightening, the dollar appreciates, and commodities priced in USD become more costly ex-U.S. at the margin. This lowers demand for goods priced in USD. In addition, a stronger USD lowers the cost of production ex-U.S., which, again, at the margin, incentivizes supply growth, since commodity producers effectively arbitrage their local currency weakness by selling their output for USD. This supply-side effect is tempered somewhat by the degree to which commodity producers ex-U.S. are exposed to dollar strength in their input markets. For example, if a producer's production inputs are priced in USD - e.g., drilling services - its margins suffer, and output increases are constrained or nullified. The Fed is the only systematically important central bank we follow - the others being the ECB, BoJ and PBoC - implementing and executing an interest-rate normalization policy. This has supported USD strength against the systematically important currencies we follow, as well (Chart 3). Chart 2Tariffs Are A Less Threat To Global Growth ... Chart 3Important Central Banks Keeping Policies Accommodative The IMF is encouraging the ECB to maintain its accommodative policy, and the BoJ also is keeping its policy relatively loose.9 The BoJ is keeping policy on hold for now, and is guiding to no rate hikes until 2020. Our colleagues in BCA's FX and Fixed Income desks expect the BoJ to continue with its Yield Curve Control Strategy for the remainder of the year, and most of next year. The absence of monetary tightening will keep Japanese yields lower than other major central banks. The PBoC appears to have moved toward a more accommodative mode, in the wake of the Sino - U.S. trade war. We believe the PBoC will remain accommodative in terms of official lending rates to avoid too-fast a deceleration of the economy, largely because of high private debt levels.10 EM Trade Volumes And Oil Prices Against a largely accommodative backdrop ex-U.S., the USD TWIB appreciated ~5% y/y, while the JP Morgan Emerging Markets FX index dropped ~11% (Chart 4). In the wake of USD TWIB strength, EM trade volumes have held up reasonably well; but growth rates have been under pressure particularly in Central and Eastern Europe (Chart 5, bottom panel). This is being offset by a turn-around in the Middle East and Africa (third panel). Chart 4Fed Policy Drives USD Strength Chart 5EM Trade Slowing, But Still Holding Up Assuming the Fed maintains its existing course re policy-rate normalization, our Fed-policy models indicate the USD TWIB will continue to strengthen (Chart 6).11 On the flip side of that, EM currencies will continue to weaken (Chart 7). This will keep pressure on EM trade volumes, particularly the important import volumes. Over the next year, we expect continued slowing in trade volumes, although, on average, we still expect y/y growth (Chart 8). While growth is slowing in EM trade, the levels of trade will remain high, unless a full-blown global trade war erupts that literally forces trade to contract. Chart 6Fed Policy Will Propel USD TWIB Higher... Chart 7... And Keep EM Currencies Weaker Chart 8Downward Trend In EM Trade Will Continue As USD Strengthens ... Strong USD, Weak EM Trade := Bearish Fed policy will strengthen the USD TWIB and weaken EM trade. These factors will tend to pull crude oil prices down, in and of themselves (Chart 9). We do not think these factors will dominate the evolution of crude oil prices over the next six months, however. That said, the current environment forces us to adapt our modelling procedure in order to account for the possible re-emergence of the USD as a key driver of oil prices. Going forward, our regular monthly oil price forecast will be complemented by our U.S. trade weighted dollar forecast.12 We will be rolling out our new oil-price forecasting models next month, when we update our supply-demand balances and price forecasts. For the immediate future, we continue to believe upside price risk dominates the oil market: The approaching U.S. sanctions against Iran and the all-but-certain collapse of Venezuela's economy could remove as much as 2mm b/d of exports from oil markets by next year, if not sooner. This would constitute an oil-price shock, pushing prices into the right tail of the price distribution, consistent with the modelling we've done for the past several months (Chart 10). Chart 9... Adding A Bearish Factor To##BR##The Evolution Of Brent, WTI Prices Chart 10Upside Risks##BR##Still Dominate We reiterate our conclusion from last week, however, that an oil-supply shock, coupled with slower EM trade growth ultimately will produce strong deflationary impulses. If markets avoid an oil supply shock, and if the Fed maintains its rates-normalization policy while the rest of the world's systemically important central banks remain accommodative, pressure will build on EM trade - and incomes - that reduces commodity demand, in line with lower aggregate demand from the EM economies. In either event, the Fed's rates-normalization policy most likely will have to turn accommodative to counter this. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see our Special Report entitled "Oil Volatility To Stay Higher Longer," published September 17, 2015. It is available at ces.bcaresearch.com. 2 We have written at length regarding this possible price evolution. Please see, e.g., BCA's Commodity & Energy Strategy Weekly Reports from August 16 and August 2, 2018, entitled "OPEC 2.0 Sailing Close To The Wind," and "Calm Before The Storm In Oil Markets." Both are available at ces.bcaresearch.com. 3 For more details, please see Commodity & Energy Strategy Weekly Report published February 8, 2018, "OPEC 2.0 Vs. The Fed." It is available at ces.bcaresearch.com. 4 OPEC 2.0 is the name we coined for the producer coalition lead by the Kingdom of Saudi Arabia (KSA) and Russia. 5 In Jackson Hole last week, Fed Chair Jerome Powell gave a strong endorsement of the Fed's rates-normalization. Please see "Fed Chair Powell: further rate hikes best way to protect recovery," published by reuters.com August 24, 2018. 6 On a 4Q19 vs 4Q18 basis, we expect global oil supply to increase just over 1mm b/d, and for demand to rise 1.8mm b/d, leaving the market in a physical deficit in 2H18 and 2019. We expect Brent to average $70/bbl in 2H18 and $80/bbl in 2019. Please see our updated balances estimates and price forecasts in "OPEC 2.0 Sailing Close To The Wind," published August 16, 2018, by BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 7 Our $80/bbl forecast for Brent crude next year - and the physical deficit we expect - implicitly assumes OPEC 2.0 either wants to keep the market relatively tight, which will force inventories to draw and backwardate the forward curves, or that it is pushing up against the limits of the production it can readily bring to market. 8 We most recently discussed this in our Commodity & Energy Strategy Weekly Report published August 23, 2018, "Trade, Dollars, Oil & Metals ... Assessing Downside Risk." It is available at ces.bcaresearch.com. 9 Please see Abdih, Yasser, Li Lin, and Anne-Charlotte Paret (2018), "Understanding Euro Area Inflation Dynamics: Why So Low for So Long?" published by the IMF this month. 10 Please see BCA Research's Global Fixed Income Strategy Weekly Report, "An R-Star Is Born," dated August 7, 2018, and Foreign Exchange Strategy Weekly Report, "Rhetoric Is Not Always Policy", dated July 27, 2018, available at gfis.bcaresearch.com and fes.bcaresearch.com. 11 We have a suite of models we use to forecast the USD TWIB, many of which use proxies for the Fed's Congressionally mandated policy goals - i.e., maximum employment, stable prices and moderate long-term interest rates. We use cointegrating regressions to estimate these policy-driven models. The R2 coefficients of determination for the models are clustered around 0.95. The out-of-sample results are strong; we use a weighted-average of the five forecasts based on root-mean-square errors to come up with our USD TWIB forecast. We presented our policy-variables USD TWIB models in last week's Commodity & Energy Strategy Weekly Report. Please see "Trade, Dollars, Oil & Metals ... Assessing Downside Risk." It is available at ces.bcaresearch.com. 12 With the introduction of these financial and macro variables, our oil price forecast will be a weighted average of our core Fundamental model and the new Financial model - i.e. the final forecast will look like [aFundamental+(1-a)Financial]. The weights - a and (1-a) - are time-varying, and will reflect our Bayesian probabilities for the relative importance of each model's contribution to price action every month. These weights are crucial. We allow them to vary in order to capture periods in which our analysis tells us we should expect the USD effect to be muted by idiosyncratic supply, demand or inventory dynamics. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Special Report

Highlights Xi Jinping is trying to do two things at once: ease policy while cracking down on systemic financial risk; The trade war with the U.S. is a genuine crisis for China and is eliciting fiscal stimulus; Credit growth is far more likely to "hold the line" than it is to explode upward or collapse downward; The 30% chance of a policy mistake from financial tightening has fallen to 20% only, as bad loan recognition is underway and a critical risk to monitor; Hedge against the risk of a stimulus overshoot. China's policy headwinds have begun to recede, but Beijing is not riding to the rescue for emerging markets; While monetary policy has eased substantively, credit growth will be hampered by the government's financial crackdown; Potential changes to China's Macro-Prudential Assessment framework could be significant, but the impact on credit growth is overestimated at present; The recognition of non-performing loans (NPLs) and cleansing of China's banking system is still in early innings and will weigh on banks' risk appetite; The anti-corruption campaign is another reason to be cautious on EM. Geopolitical Strategy recommends clients stay overweight China (ex-tech) relative to EM. Feature "We have upheld the underlying principle of pursuing progress while ensuring stability." - Xi Jinping, General Secretary of the Communist Party of China, October 18, 2017 "Any form of external pressure can eventually be transformed into impetus for growth, and objectively speaking will accelerate supply-side structural reforms." - Guo Shuqing, Secretary of the China Banking and Insurance Regulatory Commission, July 5 PART I Last year we made the case that China's General Secretary Xi Jinping would double down on his reform agenda in 2018, specifically the bid to control financial risk, and that this would bring negative surprises to global financial markets as policymakers demonstrated a higher pain threshold.1 This view has largely played out, with economic policy uncertainty spiking and a bear market in equities developing alongside an increase in corporate and even sovereign credit default risk (Chart 1). We also argued, however, that Xi's "deleveraging campaign" would be constrained by the Communist Party's need for overall stability. Trade tensions with the U.S., and Beijing's perennial fear of unemployment, would impose limits on how much pain Beijing would ultimately tolerate: The Xi administration will renew its reform drive - particularly by curbing leverage, shadow banking, and local government debt. Growth risks are to the downside. But Beijing will eventually backtrack and re-stimulate, even as early as 2018, leaving the reform agenda in limbo once again.2 Over the past month, China has clearly reached its pain threshold: authorities have announced a series of easing measures in the face of a slowing economy, a trade war, and a still-negative broad money impulse (Chart 2). Chart 1Policy Uncertainty Up, Stocks Down Chart 2PMI Falling, Money Impulse Still Negative How stimulating is the stimulus? Will it lead to a material reacceleration of the Chinese economy? What will it mean for global and China-dedicated investors? We expect policy to be modestly reflationary. A substantial boost to fiscal thrust, and at least stable credit growth, is in the works. Yet Xi's reform agenda will remain a drag on the economy. While this new stimulus will not have as dramatic an effect as the stimulus in 2015-16, it will have a positive impact relative to expectations based on China's performance in the first half of the year. We advise hedging our negative EM view against a rally in China plays and upgrading expectations for Chinese growth in 2019. The policy headwind is receding for now. Xi Jinping's "Three Tough Battles" Chart 3Xi Jinping Caps Government Spending And Credit Xi will not entirely abandon the "Reform Reboot" that began last October. From the moment he came to power in 2012-13, he pursued relatively tight monetary and fiscal policy. Total government spending growth has dropped substantially under his administration, while private credit growth has been capped at around 12% (Chart 3). Xi partly inherited these trends, as China's credit growth and nominal GDP growth dropped after the massive 2008 stimulus. But he also embraced tighter policy as a way of rebalancing the economy away from debt-fueled, resource-intensive, investment-led growth. A comparison of government spending priorities between Xi and his predecessor makes Xi's policy preferences crystal clear: the Xi administration has increased spending on financial and environmental regulation, while minimizing subsidies for housing and railways to nowhere (Table 1 and 2). Table 1Central Government Spending Preferences (Under Leader's Immediate Control) Table 2Total Government Spending Preferences (Under Leader's General Control) These policies are "correct" insofar as they are driven not merely by Xi's preferences but by long-term constraints: The middle class: Pollution and environmental degradation threaten the living standards of the country's middle class. Broadly defined, this group has grown to almost 51% of the population, a level that EM politicians ignore only at their peril (Chart 4). Asset bubbles: The rapid increase in China's gross debt-to-GDP ratio since 2008 is a major financial imbalance that threatens to undermine economic stability and productivity as well as Beijing's global aspirations (Chart 5). The constraint is clear when one observes that "debt servicing" is the third-fastest category of fiscal spending growth since Xi came to power (Table 2). Chart 4Emerging Middle Class A Latent Political Risk Chart 5The Rise And Plateau Of Macro Leverage The problem is that Xi also faces a different, shorter-term set of constraints arising from China's declining potential GDP, "the Middle-Income Trap," and the threat of unemployment.3 The interplay of these short- and long-term constraints has forced Xi to vacillate in his policies. In 2015, the threat of an economic "hard landing," ahead of the all-important mid-term party congress in 2017, forced him to stimulate the "old" industrial economy and sideline his reforms. Only when he had consolidated power over the Communist Party in 2016-17 could he resume pushing the reform agenda.4 In July 2017, Xi announced the so-called "Three Critical Battles" against systemic financial risk, pollution, and poverty. The three battles are interdependent: continuing on the capital-intensive economic model will overwhelm any efforts to cut excessive debt or pollution (Chart 6), yet sudden deleveraging could derail the Communist Party's basic claim to legitimacy through improving the lot of poor Chinese. The macroeconomic impact of the three battles is broadly deflationary, as credit growth falls and industries restructure. The first battle - the financial battle - will determine the outcome of the other two battles as well as the growth rate of China's investment-driven economy, Chinese import volumes, and emerging market stability (Chart 7). Chart 6Credit Stimulus Correlates With Pollution Chart 7Credit Determines Growth And Imports On July 31, in the midst of worldwide speculation about China's willingness to stimulate, Xi reaffirmed this "Three Battles" framework. Remarkably, despite a general slowdown, a sharp drop in the foreign exchange rate, the revival of capital flight, and a bear market, he announced that the battle against systemic financial risk would continue in the second half of 2018. However, he also admitted that domestic demand needed a boost in the short term. Hence there should be no doubt in investors' minds about the overarching policy framework or Xi Jinping's intentions in the long run. The question driving the markets today is what China will do in the short term and whether it will initiate a material reacceleration in economic activity. Bottom Line: Xi Jinping remains committed to the reform agenda that he has pursued since coming to power in 2012. But he is forced by circumstances to vary the pace and intensity. At the top of the agenda is the control of systemic financial risk. This is a policy driven by the belief that China's economic and financial imbalances threaten to undermine its overall stability and global rise. Why The Shift Toward Easier Policy? The gist of the July 31 Politburo statement was that policy will get more dovish in the short term. It mentioned "stability" five times. The Politburo pledged to make fiscal policy "more proactive" and to find a better balance between preventing financial risks and "serving the real economy." This direct promise from Xi Jinping of more demand-side support gives weight to the State Council's similar statement on July 23 and will have reflationary consequences above and beyond the central bank's marginal liquidity easing thus far. What is motivating this shift in policy, which apparently flies in the face of Xi's high-profile deleveraging campaign? If we had to name a single trigger for China's change of tack, it is not the economic slowdown so much as the trade war with the United States. The war began when the U.S. imposed sanctions on Chinese firm ZTE in April and China depreciated the RMB, but it escalated dramatically when the U.S. posted the Section 301 tariff list in June (Chart 8).5 This is a sea change in American policy that is extremely menacing to China. China runs a large trade surplus and has benefited more than any other country from the past three decades of U.S.-led globalization. Its embrace of globalization is what enabled the Communist Party to survive the fall of global communism! Chart 8More Than Market Dynamics At Work Chart 9China Is Less Export-Dependent True, China has already seen its export dependency decline (Chart 9). But Beijing has so far managed this transition gradually and carefully, whereas a not-unlikely 25% tariff on $250-$500 billion of Chinese exports will hasten the restructuring beyond its control (Chart 10). A very large share of China's population is employed in manufacturing (Chart 11). To the extent that the tariffs actually succeed in reducing external demand for Chinese goods, these jobs will be affected. Chart 10Tariffs Will Add More Pain To Factory Workers Chart 11Manufacturing Unemployment A Huge Threat Unemployment is anathema to the Communist Party. And China is simply not as experienced as the U.S. in dealing with large fluctuations in unemployment (Chart 12). While Chinese workers will blame "foreign imperialists" and rally around the flag, the pain of unemployment will eventually cause trouble for the regime. Domestic demand as well as exports will suffer. It is even possible that worker protests could evolve into anti-government protests. Chart 12China Not Experienced With Layoffs Given that Chinese and global growth are already slowing, it is no surprise that the Politburo statement prioritized employment.6 China's leaders will prepare for social instability as the worst possible outcome of the showdown with America - and that will push them toward stimulus. In addition, there will be no short-term political cost to Xi Jinping for erring on the side of stimulus, as there is no opposition party and the public is not demanding fiscal and monetary austerity. Moreover, the main macro implication of Xi's decision last year to remove term limits - enabling himself to be "president for life" in China - is that his reforms do not have to be achieved by any set date. They can be continually procrastinated on the basis that he will return to them later when conditions are better.7 The policy response to tariffs from the Trump administration also signals another policy preference: perseverance. Xi would not be straying from his reform priorities if not for a desire to counter American protectionism. China is not interested in kowtowing but would rather gird itself for a trade war. Still, our baseline view is that the Xi administration will stimulate without abandoning the crackdown on shadow lending or launching a massive "irrigation-style" credit surge that exacerbates systemic risk.8 Policy will be mixed, as Xi is trying to do two things at once. Bottom Line: China's slowdown and the outbreak of a real trade war with the United States is forcing Xi Jinping to ease policy and downgrade the urgency of his attempt to tackle systemic financial risk this year. Can Fiscal Easing Overshoot? Yes. How far will China's policy easing go? China has a low level of public debt, and fiscal policy has been tight, so we fully expect fiscal thrust to surprise to the upside in the second half of the year, easily by 1%-2% of GDP, possibly by 4% of GDP. Chart 13Fiscal Tightening Was The Plan For 2018 A remarkable thing happened this summer when researchers at the People's Bank of China and the Ministry of Finance began debating fiscal policy openly. Such debates usually occur during times of abnormal stress. The root of the debate lay in the national budget blueprint laid out in March at the National People's Congress. There, without changing official rhetoric about "proactive fiscal policy," the authorities revealed that they would tighten policy this year, with the aim of shrinking the budget deficit from 3% of GDP target in 2017 to 2.6% in 2018. The IMF, which publishes a more realistic "augmented" deficit, estimates that the deficit will contract from 13.4% of GDP to 13% (Chart 13). This fiscal tightening coincided with Xi's battle against systemic financial risk. Hence both monetary and fiscal policy were set to tighten this year, along with tougher regulatory and anti-corruption enforcement.9 Thus it made sense on May 8 when the Ministry of Finance revealed that the quota for net new local government bond issuance this year would increase by 34% to 2.18 trillion RMB. This quota governs new bonds that go to brand new spending (i.e. it is not to be confused with the local government debt swap program, which eases repayment burdens but does not involve a net expansion of debt). Local government spending is the key because it makes up the vast majority (85%) of total government spending, which itself is about the same size as new private credit each year. In June, local governments took full advantage of this opportunity, issuing 316 billion RMB in brand new bonds (up from a mere 17 billion in May - an 11.8% increase year-on-year) (Table 3). This spike in issuance is later than in previous years. Combined with the Politburo and State Council pledging to boost fiscal policy and domestic demand, it suggests that net new issuance will pick up sharply in H2 2018 (Chart 14).10 Table 3Local Government Bond Issuance And Quota Chart 14Local Government Debt Can Surprise In H2 At the same time, the risk that special infrastructure spending will fall short this year is receding. About 1.4 trillion RMB of the year's new bond allowance consists of special purpose bonds to fund projects. The State Council said on July 23 it would accelerate the issuance of these bonds, since, at most, only 27% of the quota was issued in the first half of the year (Chart 15). The risk of a shortfall - due to stricter government regulations over the quality of projects - is thereby reduced. What is the overall impact of these moves? The Chinese government provides an annual "debt limit" that applies to the grand total of explicit, on-balance-sheet, local government debt. The limit increased by 11.6% for 2018, to 21 trillion RMB (Table 4), which, theoretically, enables local governments to splurge on a 4.5 trillion RMB debt blowout. Should that occur, 2.6 trillion RMB of that amount, or 3% of GDP, would be completely unexpected new government spending in 2018 (creating a positive fiscal thrust).11 Chart 15June Issuance Surged, Special Bonds To Pick Up Table 4Local Government Debt Quota Is Not A Constraint Such a blowout may not be likely, but it is legally allowed - and the political constraints on new issuance have fallen with the central government's change of stance. This means that local governments' net new bond issuance can move up toward this number. More feasibly, local governments could increase their explicit debt to 19.3 trillion RMB, a 920 billion RMB increase on what is expected, which would imply 1% of GDP in new spending or "stimulus" in 2018.12 The above only considers explicit, on-balance-sheet debt. Local governments also notoriously borrow and spend off the balance sheet. The total of such borrowing was 8.6 trillion RMB at the end of 2014, but there is no recent data and the stock and flow are completely opaque.13 The battle against systemic risk is supposed to curtail such activity this year. But the newly relaxed supervision from Beijing will result in less deleveraging at minimum, and possibly re-leveraging. Similarly, the government has said it is willing to help local governments issue refinancing bonds to deal with the spike in bonds maturing this year.14 This frees them up to actually spend or invest the money they raise from brand new bonds. In short, our constraints-based methodology suggests that the risk lies to the upside for local government debt in 2018, given that it is legal for debt to increase by as much as 2.5 trillion RMB, 3% of GDP, over the 1.9 trillion RMB increase that is already expected in the IMF's budget deficit projections for 2018. What about the central government? Its policy stance has clearly shifted. The central government could quite reasonably expand the official budget deficit beyond the 2.6% target. Indeed, that target is already outdated given that new individual tax cuts have been proposed, which would decrease revenues (add to the deficit) by, we estimate, a minimum of 0.44% of GDP over a 12-month period starting in October.15 Other fiscal boosts have also been proposed that would add an uncertain sum to this amount.16 The total of these measures can quite easily add up to 1% of GDP, albeit with the impact mostly in 2019. Finally, the strongest reason to err on the side of an upward fiscal surprise is that an expansion of fiscal policy will allow the Xi administration to boost demand without entirely relying on credit growth. First, local governments are actually flush with revenues due to strong land sales (Chart 16), which comprise around a third of their revenues. This enables them to increase spending even before they tap the larger debt allowance. Second, China's primary concern about financial risk is due to excessive corporate (and some household) leverage, particularly by state-owned enterprises (SOEs) and shadow banking. It is not due to public debt per se. It is entirely sensible that China would boost public debt as it attempts to limit leverage. In fact, this would be the Zhu Rongji playbook from 1998-2001. This was the last time that China announced a momentous three-year plan to crack down on profligate lending, hidden debts, and credit misallocation. The authorities deliberately expanded fiscal policy to compensate for the anticipate credit crunch and its drag on GDP growth (Chart 17).17 Chart 16Land Sales Enable Non-Debt Fiscal Spending Chart 17China Boosted Fiscal During Last Bad Debt Purge As for the impact on the economy, the money multiplier will be meaningful because the economy is slowing and fiscal policy has been tight. But fiscal spending does operate with a six-to-ten month lag, meaning that China/EM-linked risk assets will move long before the economic data fully shows the impact. Our sense, judging by the unenthusiastic response of copper prices thus far, is that the market does not anticipate the fiscal overshoot that we now do. Bottom Line: The political constraints on local government spending have fallen. Fiscal policy could add as much as 1%-3% of GDP to the budget deficit in H2 2018, namely if local government spending is unleashed by the recently announced policy shift. This is comparable to the 4% of GDP fiscal boost in 2008-09 and 3% in 2015-16. Can Monetary Easing Overshoot? Yes, But Less Likely. Credit is China's primary means of stimulating the economy, especially during crisis moments, and it has a much shorter lag period than fiscal spending (about three months). But Xi's agenda makes the use of rapid, credit-fueled stimulus more problematic. Based on the sharp drop in the interbank rate - in particular, the three-month interbank repo rate that BCA's Emerging Markets Strategy and China Investment Strategy use as a proxy for China's benchmark rate - it is entirely possible that credit growth will increase to some degree in H2 2018. Interbank rates have now fallen almost to 2016 levels, while the central bank never hiked the official 1-year policy rate during the recent upswing (Chart 18). In other words, the monetary setting has now almost entirely reversed the financial crackdown that began in 2017. The sharp drop in the interbank rate is partly a consequence of the three cuts to required reserve ratios (RRRs) this year, which amounts to 2.8 trillion RMB in new base money from which banks can lend.18 One or two more RRR cuts are expected in H2 2018, which could free up another roughly 800 billion-to-1.6 trillion RMB in new base money. With China accumulating forex reserves at a slower pace than in the past, and facing a future of economic rebalancing away from exports and growing trade protectionism, RRRs can continue to decline over the long run (Chart 19). China will not need to sterilize as large of inflows of foreign exchange.19 If China's banks and borrowers respond as they have almost always done, then credit growth should rise. The risk to this assumption is that the banks may be afraid to lend as long as the Xi administration remains even partially committed to its financial crackdown. Moreover, the anti-corruption campaign is continuing to probe the financial sector. While this has only produced a handful of anecdotes so far, they are significant and may have helped cause the decline in loan approvals since early 2017. Critically, China has begun the process of recognizing non-performing loans (NPLs), by requiring that "special mention loans" be reclassified as NPLs, thus implying that NPL ratios will spike, especially among small and regional lenders (Chart 20). This is part of the deleveraging process we expect to continue, but it can take on a life of its own and will almost certainly weigh on credit growth to some extent for as long as it continues. Chart 18Monetary Settings Back To Easy Levels Chart 19RRR Cuts Can Continue Chart 20NPL Recognition Underway (!) What will be the prevailing trend: monetary easing or the financial crackdown? In Chart 21 we consider three scenarios for the path of overall private credit growth (total social financing, ex-equity) for the rest of the year, with our subjective probabilities: Chart 21Three Scenarios For Private Credit In H2 2018 In Scenario A, 10% probability, we present an extreme case in which Beijing panics over the trade war and the banks engage in a 2009-style lending extravaganza. Credit skyrockets up to the 2010-17 average growth rate. This would mark a massive 11.9 trillion RMB or 13.8% of GDP increase in excess of the amount implied by the H1 2018 data. This size of credit spike would be comparable to the huge spikes that occurred during past crises, such as the 22% of GDP increase in 2008-09 or the 9% of GDP increase in 2015-16. Needless to say, this is not our baseline case, but it could materialize if the trade war causes a global panic. In Scenario B, 70% probability, we assume, more reasonably, that traditional yuan bank loans are allowed to rise toward their average 2010-17 growth rate as a result of policy easing, yet Xi maintains the crackdown on non-bank credit in accordance with this "Three Battles" framework. Credit growth would still decelerate in year-on-year terms, but only just: it would fall from 12.3% in 2017 to 11.5% in 2018. Additional policy measures could easily bump this up to a modest year-on-year acceleration, of course. This scenario would result in a credit increase worth 2.9 trillion RMB or 3.4% of GDP on top of the level implied by H1 2018. In Scenario C, 20% probability, we assume that the 2018 YTD status quo persists: bank credit and non-bank credit continue growing at the bleak H1 2018 rate. The administration's attempt to maintain the crackdown on financial risk could frighten banks out of lending. This would mean no credit increase in 2018 beyond what is naturally extrapolated from the H1 2018 data. Credit growth would slow from 12.3% to 10.7% in 2018. This scenario would be surprising, but not entirely implausible given that the Politburo is insisting on continuing the Three Battles. The collapse in interbank rates and the easing measures already undertaken - such as reports that the Macro-Prudential Assessments will lighten up, and that the People's Bank is explicitly softening banks' annual loan quotas20 - lead us to believe that Scenario B is most likely, and possibly too conservative. This is the scenario most consistent with the latest Politburo statement: that authorities will continue the campaign against systemic risk, namely through the policy of "opening the front door" (traditional bank loans go up) and "closing the back door" (shadow lending goes down), which began in January. The Chinese government has always considered control of financial intermediation to be essential. The only way to reinforce the dominance of the state-controlled banks, while preventing a sharp drop in aggregate demand, is to allow them to grow their loan books while regulators tie the hands of their shadow-bank rivals (Chart 22). Chart 22Opening The Front Door, Closing The Back One factor that could evolve beyond authorities' control is the velocity of money. Money velocity is essentially a gauge of animal spirits. If a single yuan changes hands multiple times, it will drive more economic activity, but if it is deposited away for a rainy day, then the bear spirit is in full force. Thus, if credit growth accelerates, but money in circulation changes hands more slowly, then nominal GDP can still decelerate - and vice versa.21 China's money velocity suffered a sharp drop during the tumult of 2015, recovered along with the policy stimulus in 2016, and has tapered a bit in 2018 in the face of Xi's deleveraging campaign. Yet it remains elevated relative to 2012-16 and clearly responds at least somewhat to policy easing. The implication is that money velocity should remain elevated or even pick up in H2. Again, the risk to this view is that Xi's ongoing battle against financial risk, and anti-corruption campaign in the financial sector, could suppress money velocity as well as credit growth. Bottom Line: We see a subjective 70% chance that the drop in credit growth will be halted or reversed in H2 as a result of the central bank's liquidity easing and the Politburo's willingness to let traditional bank lending grow while it discourages shadow lending. Our baseline case says the impact could amount to new credit worth 3.4% of GDP in H2 2018 that markets do not yet expect. Investment Conclusions Beijing's shift in policy suggests that our subjective probability of a policy mistake this year, leading to a sharp economic deceleration, should be reduced from 30% to 20% (Credit Scenario C above).22 Why is this dire scenario still carrying one-to-five odds? Because we fear that the financial crackdown and rising NPLs could take on a life of their own. Meanwhile the risk of aggressive re-leveraging has risen from 0% to 10% (Credit Scenario A above). Summing up, Table 5 provides a simple, back-of-the-envelope estimate of the size of both fiscal and monetary policy measures as a share of GDP. Table 5Potential Magnitude Of Easing/Stimulus Our bias is to expect a strong fiscal response combined with a weak-to-moderate credit response. This would reflect the Xi administration's desire to prevent asset bubbles while supporting growth. A more proactive fiscal policy harkens back to China's handling of its last financial purge in 1998-2001. If banks prove unable or unwilling to lend sufficiently, additional fiscal expansion will pick up the slack. New local government debt can surprise by 1% of GDP or more, while formal bank lending amidst an ongoing crackdown on shadow lending could add new credit of around 3.4% of GDP and hence mitigate or halt the slowdown in credit growth. The combined effect would be an unexpected boost to demand worth 4.4% of GDP in H2 2018, which would exert an unknown, but positive, multiplier effect. We are replacing our "Reform Reboot" checklist, which has seen every item checked off, with a new "Stimulus Checklist" that we will monitor going forward (Appendix). Chart 23How To Monitor The Stimulus Impact Neither the size of this stimulus, nor the composition of fiscal spending, will be quite as positive for EM/commodities as were past stimulus efforts. China's investment profile is changing as the reform agenda seeks to reduce industrial overcapacity and build the foundations for stronger household demand and a consumer society. Increases in fiscal spending today will involve more "soft infrastructure" than in the past. We recommend reinstituting our long China / short EM equity trade, using MSCI China ex-tech equities. We also recommend reinitiating our long China Big Five Banks / short other banks trade, to capture the disparity of the financial crackdown's impact. To capture the new upside risk for global risk assets, our colleague Mathieu Savary at BCA's Foreign Exchange Strategy has devised a "China Play" index that is highly sensitive to Chinese growth - it includes iron ore prices, Swedish industrial stocks, Brazilian stocks, and EM junk bonds (all in USD terms), as well as the Aussie dollar-Japanese yen cross. BCA Geopolitical Strategy also recommends this trade as a portfolio hedge to our negative EM view (Chart 23).23 A major risk to the "modest reflation" argument in this report will materialize if the RMB depreciates excessively in response to the escalating trade war (Trump will likely post a new tariff list on $200 billion worth of goods in September).24 This could result in renewed capital outflows breaking through China's capital controls, the PBC appearing to lose control, EM currencies and capital markets getting roiled, EM financial conditions tightening sharply, and global trade and growth slowing sharply. China would ultimately have to stimulate more (moving in the direction of Credit Scenario A above), but a market selloff would occur first and much economic damage would be done. PART II In the first part of this two-part Special Report, we concluded that policy headwinds to China's economic growth have begun to recede, but recent easing measures will likely disappoint the markets. Chart 24Money Growth Bottomed, Credit Still Weak In essence, China is girding for a trade war with the United States, which favors stimulus. But it is still attempting to reduce systemic financial risk. As a result, fiscal stimulus may surprise to the upside, but credit growth will be lackluster. The problem for investors - especially for emerging market (EM) assets and the commodity complex - is that Chinese fiscal stimulus typically operates with a six-to-ten month lag, as opposed to credit stimulus which only takes about three months to kick in.25 July statistics confirm our suspicion that credit stimulus will be hampered by the government's crackdown on shadow banking. Total credit growth remains weak, although broad money (M2) does appear to be bottoming (Chart 24). Thus far, BCA's China Investment Strategy has been correct in characterizing the latest developments as "taking the foot off the brake" rather than "pressing down on the accelerator."26 In this part of the report we take a deeper dive into the policy factors that cause us to limit our "stimulus overshoot" scenario to a 10% subjective probability. The three chief reasons are: overstated easing of macro-prudential controls; the continuing process of cleansing the banking sector of non-performing loans; and the anti-corruption campaign in the financial sector. A Preemptive Dodd-Frank Since the Xi administration redoubled its efforts to tackle systemic financial risk last year, we have urged investors to be cautious about Chinese growth.27 The creation of new institutions and new regulatory requirements set in motion processes that would be hard to reverse quickly. While these institutions are now making several compromises for the sake of stability, their operations will continue to weigh on credit growth. In July 2017, China's government held the National Financial Work Conference to address the major issues facing the country's financial system. This conference takes place once every five years and has often occasioned significant shakeups in financial regulation. In 1997, it initiated a sweeping purge of the banking system, and in 2002, it saw the creation of three financial watchdogs that would become critical institutional players throughout the 2000s.28 One of the skeletons in the closet from 2002 was the debate over whether financial regulation should be heavily centralized or divided among different, specialized, state agencies. Former Premier Wen Jiabao won the argument with the creation of the three watchdogs covering banking, securities, and insurance. After a series of controversies and conflicts, the Xi administration decided that these agencies had failed in their primary purpose of curbing systemic risk and ordered a reorganization with greater centralization. At the 2017 financial conference, Xi announced the creation of the Financial Stability and Development Committee (FSDC) to act as a centralized watchdog over the entire financial system. The FSDC would coordinate with the central bank, oversee macro-prudential regulation, and prevent systemic risk. Liu He, Xi's right-hand man on the economy and a policymaker with a hawkish reputation, was soon promoted to the Politburo and given the top job at the FSDC.29 As a second step, the Xi administration announced that it would combine the banking and insurance regulators into a single entity - the China Banking and Insurance Regulatory Commission (CBIRC). The CBIRC, to be headed by Xi ally, and notable hawk, Guo Shuqing, would continue and escalate the crackdown on shadow lending that Guo had begun at the helm of the bank watchdog in 2017 (Chart 25). The merging of the agencies would also close the regulatory gap that had seen the insurance regulator increase its dominion and rent-seeking by encouraging "excessive" financial innovation and risky pseudo-insurance products.30 Chart 25Crackdown On Informal Credit Continues The FSDC was expected, rightly, to bring a more hawkish tilt to Chinese macro-prudential regulation. In reference to the U.S.'s Financial Stability Oversight Council, we dubbed these moves a "Preemptive Dodd-Frank."31 We also argued, however, that the purpose was to bring unified command and control to financial regulation and that China would continue to prize stability above all. Therefore the degree of tightening or loosening should vary in accordance this goal.32 After a series of announcements in July and August, it is clear that China's government has shifted to a more accommodative posture (please refer back to Chart 18 and Chart 19). As usual, there are rumors of high-level political intrigue to go along with the policy shift: some argue that Premier Li Keqiang is making a comeback while Xi's golden boy, Liu He, has been sidelined due to his failure to forestall tariffs during his trade talks with Donald Trump this spring.33 Such rumors are valuable only in revealing the intensity of the policy debate in Beijing. What is certain, however, is that the FSDC, with Liu He as chairman, only met for the first time as a fully assembled group in early July, just before the major easing measures were taken. This implies that any initial conclusions were pragmatic (i.e. not excessively hawkish). Moreover, Guo Shuqing is not only the CBIRC head but also the party secretary of the PBOC, meaning that central bank chief Yi Gang cannot have adopted easing measures without Guo's at least condoning it. Chinese policymakers see the recent easing measures as "fine-tuning" even as they continue the rollout of new regulatory institutions and systems. It is thus too soon to claim that Xi Jinping or any of these government bodies have thrown in the towel on their attempts to contain excessive leverage. Both the Politburo and the State Council - the highest party and state decision-makers - have made clear that they do not intend to endorse a massive stimulus on the magnitude of 2008-09 or 2015-16.34 They have also insisted that the "Tough Battle" against systemic financial risk, and the campaign to "deleverage" the corporate sector, will continue. What does this mean in practical terms? While new regulations will be compromised, they will also continue to be implemented. For example, authorities have watered down new regulations governing the $15 trillion asset management industry, yet the regulations are still expected to go into force by 2020. These rules will weigh on shadow banking activity (e.g. wealth management products) as banks prepare to meet the requirements.35 Two other examples are critical and will be discussed below: first, the potential easing of rules under the Macro Prudential Assessment (MPA) framework for stress-testing banks; second, this year's changes to rules governing non-performing loans (NPLs). In the former case, the degree of financial easing is potentially significant but at present overestimated by investors; in the latter case, the degree of tightening is already significant and widely underestimated. Bottom Line: New financial regulatory institutions will inherently suppress credit growth, especially by dragging on informal or non-bank credit growth. Macro-Prudential Assessments: Less Easing Than Meets The Eye A key factor in determining China's credit growth going forward will be banks' responses to any softening of the Macro Prudential Assessment (MPA) requirements. News reports have suggested that a relaxation of these rules may occur, but authorities have not finalized such a move. Furthermore, the impact on credit growth may be far less than the astronomical sums being floated around the investment community. The MPA framework began in 2016. It is an evaluative system of "stress-testing" China's banks each quarter. As such it is part of the upgrade of macro-prudential systems across the world in the aftermath of the global financial crisis, comparable to the American Financial Stability Oversight Committee or the European Systemic Risk Board.36 It is managed by the PBOC and the FSDC. The MPA divides banks into systemically important financial institutions and common institutions, and subdivides the former into those of national and regional importance. The evaluation method contains seven major criteria for assessing bank stability: Capital adequacy and leverage ratios; Bank assets and liabilities; Liquidity conditions; Pricing behavior for interest rates; Quality of assets; Cross-border financing; Execution of credit policy. The first and fourth of these criteria (capital adequacy and leverage ratios, and pricing behavior for interest rates) are in bold font because they result in a "veto" over the entire assessment: if a bank fails to maintain a sufficient capital buffer, or deviates too far from policy interest rates, it can fail the entire stress-test. Otherwise, failure of any two of the other five categories results in overall failure. A system of rewards and punishments awaits banks depending on how they perform (Diagram 1). Diagram 1China's Macro Prudential Assessment Framework Explained On July 20, the PBOC published a document saying that "in order to better regulate assets of financial institutions, during Macro Prudential Assessment (MPA), relevant parameters can be reasonably adjusted." Subsequently Reuters reported that the PBOC would reduce the "structural parameter" and the "pro-cyclical contribution parameter" of the capital adequacy ratio (CAR) requirements, thereby easing rules on one of the veto items. The structural parameter would fall from 1.0 to 0.5. Rumors suggest that the pro-cyclical parameter could fall from 0.4-0.8 to 0.3. No such changes have been finalized - only a few banks actually claim to have received notification of a change and there are regional differences. Clearly a general change of the rule would reduce regulatory constraints on bank credit. But how big would the impact be? Under the MPA, banks' CARs are not allowed to fall too far below the "neutral CAR," or C*, a variable that is calculated using the formula outlined in Diagram 2. Most of the variables in this formula will not change often: for instance, the minimum legal CAR will be slow to change, as will the capital reserve buffer and the bonus buffer for systemically important institutions. The one factor that can change frequently is the "discretionary counter-cyclical buffer," as it responds to the country's current place in the business cycle. Diagram 2China's Macro-Prudential Assessment Framework: Capital Adequacy Ratios The key input to this factor is broad credit growth. Thus, if authorities should reduce the CAR's cyclical parameter from a simple average of 0.6 to 0.3, broad credit growth could go higher without creating an excessive increase in the pro-cyclical buffer. In other words, at present about 60% of bank credit expansion in excess of nominal GDP growth counts toward a counter-cyclical capital buffer, which is added to other capital buffers. A tweak to this parameter could decrease that proportion to 30%, meaning that bank lending could go twice as high with the same impact on the counter-cyclical buffer. More significantly, if authorities should reduce the CAR's structural parameter from 1.0 to 0.5, any increase in credit growth would have a less dramatic impact on C*. Hence banks would be able to lend more while still keeping their neutral CAR within the appropriate range relative to their actual CAR. Banks could theoretically lend twice as much with the same impact on the assessment.37 On paper these changes could result in unleashing as much as 41.4 trillion RMB in new lending in 2018, or 28 trillion (33% of GDP) on top of what could have been expected without any adjustment to the macro-prudential rules. This is because broad credit growth would theoretically be allowed to grow as fast as 30% instead of 17%.38 But in reality this growth rate is extremely unlikely. Why? Because it assumes that banks will grow their lending books as rapidly as they are allowed. In fact, banks are currently increasing broad credit at a rate of about 10%, which is considerably lower than either today's or tomorrow's permitted rate of growth under the MPA framework (Chart 26). Chart 26Banks Are Not Lending To The Regulatory Maximum If tweaks to the MPA increase this speed limit to 30%, it does not mean that banks will drive any faster than they are already driving. They are lending at the current pace for self-interested reasons (and there is fear of excessive debt, default, or insolvency due to the government's ongoing regulatory and anti-corruption crackdown).39 Chart 27Regulators Can Deprive Banks Of MLF Access Still, if the MPA rules are tweaked, then it will send a signal that macro-prudential scrutiny is abating and banks can lend more aggressively - this would have some positive effect on credit growth, at least for major banks that are secure in meeting their CARs. Moreover, there will be a practical consequence in that fewer banks will be punished for having insufficient CARs. At present, only rarely do banks fail the evaluations. But a strict CAR requirement during an economic downturn could change that. The proposed MPA adjustment would show that banks are graded on a sliding rule: the authorities would slide the grading scale downward to enable more banks to pass the test. This means fewer failures, which means fewer punitive measures that could upset liquidity or stability in the banking system. Ultimately, in order for the new system to have any credibility at all, punishment will have to be meted out to banks that fail the stress tests. A key punishment within the MPA system is exclusion from medium-term lending facility (MLF) loans from the PBOC. This is a regulatory action with teeth, as this is one of the PBOC's major means of injecting liquidity (Chart 27). A misbehaving bank could face short-term liquidity shortage or even insolvency. Therefore the authorities are opting to soften the rules so that the new regulatory system is preserved yet the harshest implications are avoided (for now). This would be short-term gain for long-term pain, the opposite of what China needs from the standpoint of an investor looking for improvements to productivity and potential GDP growth. But it would not necessarily be a great boon for global risk assets in the near term. While it could help stabilize expectations for China's domestic growth, it is not clear that it would unleash a mass wave of new bank loans that would reaccelerate China's economy and put wings beneath EM assets and commodity prices. Bottom Line: Tweaking the MPA parameters is a clear example of policy easing. Yet the MPA system itself is a fairly rigorous means of stress-testing banks that is part of a much larger expansion of financial sector regulation. The results of the easier rules - if implemented - will not be as reflationary as might be expected from the headline 41 trillion RMB in new loans that could legally be created. Banks are already expanding loans more slowly than they are allowed to do, so increasing the speed limit will have little effect. The real purpose of the macro-prudential tweaks is to make it more difficult for banks to fail their stress tests in a downturn. As such, any tweaks would actually reveal that Chinese policymakers are expecting a more painful downturn, not that they are asking for a credit splurge. NPL Recognition Will Weigh On Credit Growth Another factor that we have highlighted that separates today's easing measures from outright stimulus: the growing recognition of non-performing loans (NPLs) in China's banks and the financial cleansing process. The government's reform push has already led to two trends that are relatively rare and notable in the Chinese context: rising corporate defaults (Chart 28) and rising bankruptcies (Chart 29). While the impact may be small relative to China's economic size, the direction of change is significant in a country that has been extremely averse to recognizing losses. Chart 28Defaults Are Rising Chart 29Creative Destruction In China These changes reflect the tightening of financial conditions and restructurings of various industries and as such are evidence of Xi's attempt to make progress on reforms while maintaining stability. They also reflect a general environment that is conducive to the realization of bad loans. Two recent policy decisions are affecting banks' accounting of bad loans. First, the CBIRC issued new guidance that eases NPL provision requirements for "responsible" banks (banks with good credit quality) while maintaining the existing requirements for "irresponsible" banks.40 Since the major state-controlled banks will largely meet the standards, they will be able to lend somewhat more (we estimate around 600 billion RMB or 0.7% of GDP). This would support the recent trend in which traditional bank lending rises as a share of total credit growth. Second, however, the CBIRC is requiring banks to reclassify all loans that are 90-or-more-days delinquent as NPLs, resulting in upward revisions of bank NPL ratios. This will send the official rate on an upward march toward 5%, from current extremely low 1.9% (Chart 30). It is the direction of change that matters, as NPL recognition can take on a life of its own. While many state banks may already have recognized the 90-day delinquent loans, many small and regional banks probably have not. Anecdotally, a number of small banks are reporting large NPL ratios as a result of the regulatory clampdown and definition change. Rural commercial banks, in particular, are in trouble with several showing NPLs in double digits (Chart 31). These small and regional banks will have until an unspecified date in 2019 to reclassify these loans and raise provisions against them. The result will hamper credit growth. Chart 30Bad Loan Ratios Set To Rise Chart 31City And Rural Commercial Banks Most At Risk Of Rising Bad Loans To get a more detailed picture of the NPL recognition process, we have updated our survey of 16 commercial banks listed on the A-share market.41 This research reveals that banks have continued to increase the amount of bad loans they have written off. While the NPL ratio has remained roughly the same, cumulative loan-loss write-offs combined with NPLs have reached 7% of total loans and are still rising (Chart 32). This shows that a cleansing process is well underway. It is concerning that write-offs have reached nearly 50% of pre-tax profits. And even as losses mount, the proportion of each year's losses to the previous year's NPLs has fallen, implying that the previous year's NPLs had grown bigger (Chart 33). Chart 32The Bank Cleansing Process Continues Chart 33Write-Offs Almost 50% Of Bank Profits Furthermore, while loan losses grow, the surveyed banks' profit growth has been reduced to virtually zero (Chart 34). Chart 34Write-Offs Almost 50% Of Bank Profits Our updated "stress test" for Chinese banks, which is based on the same sample of 16 commercial banks, suggests that if total NPLs rise to a pessimistic, but still quite realistic, ratio of 13% (a weighted average of NPL ratio assumptions per sector, ranging from 10%-30%), then total losses could amount to 10.4 trillion RMB, or 12% of GDP (Table 6). Table 6Pessimistic Scenario Analysis##br## For Commercial Bank NPLs In this scenario, banks' net equity would be impacted by 38% as this amount surpasses the buffer of net profits (1.75 trillion RMB) and NPL provisions (3 trillion). China's banks are well provisioned, but they would be less so after a hit of this nature. A similar stress-test by BCA's Emerging Markets Strategy found that equity impairment could range from 33%-49%, implying that Chinese banks were roughly 29% overvalued on a fair price-to-book-value basis.42 Looking at different economic sectors, it is apparent that domestic trade, manufacturing, and mining have seen the highest incidence of loans going sour (Table 7). In all three cases, it is reasonable to conjecture that the NPL ratio can continue to expand - and not only because of the definitional change. First, wholesale and retail (4.7%) consists largely of SMEs, and the government is publicly concerned about their ability to get credit. Second, manufacturing (3.9%) has been hit by changing trade patterns and rising labor costs and has not yet suffered the impact from recently imposed U.S. trade tariffs. Third, mining (3.6%) has felt the first wave of the impact from the government's cuts to overcapacity in recent years, but has seen very extensive restructuring and the fallout may continue. Table 7China: Troubled Sectors Can Produce More Bad Loans More realistic NPL recognition is an important and positive development for China over the long run. Over the short run, banks' efforts to write-off NPL losses will weigh on their willingness to lend and could pose a risk to overall economic activity. Bottom Line: The government's reform and restructuring efforts are initiating a process of creative destruction in the Chinese economy. This is most notable in the government's willingness to recognize NPLs, which will continue to weigh on credit growth. The government is trying to control the pace and intensity of this process, but we expect credit stimulus to be disappointing relative to fiscal stimulus as long as the financial regulatory crackdown is at least half-heartedly implemented. Anti-Corruption Campaign Is Market-Negative Another reason to expect total credit growth to remain subdued comes from the anti-corruption campaign and its probes into local government finances and the financial sector. Chart 35Anti-Corruption Campaign Trudges Onward One of the new institutions created in China's 2017-18 leadership reshuffle was the National Supervisory Commission (NSC). This is a powerful new commission that is capable of overseeing the highest state authority (the National People's Congress). It is also ranked above the formal legal system, the Supreme Court and the public prosecutor's office. It is charged with formalizing the anti-corruption campaign and extending it from the Communist Party into the state bureaucracy, including state-owned enterprises.43 Having operated for less than a year, it is not possible to draw firm conclusions about the doings of the NSC, let alone any macro impact. Tentatively, the commission has focused on financial and economic crimes that have the potential to create a "chilling effect" among government officials and bank executives.44 Notably, the NSC has investigated Lai Xiaomin, former chief executive of Huarong, the largest of the big four Asset Management Corporations (AMCs), i.e. China's "bad banks." There is more than one reason for Huarong to attract the attention of investigators, but it is notable that it had extensive investments in areas outside its official duty of acquiring and disposing of NPLs. The implication could be that the government wants the AMCs to focus on their core competency: cleaning up the coming deluge of NPLs. The anti-corruption is also targeting local government officials for misappropriating state funds. These investigations involve punishment of provincial officials for false accounting as well as embezzlement and other crimes. We have noted before that the provinces that revised down their GDP growth targets most aggressively this year were also some of the hardest hit with anti-corruption probes into falsifying data and misallocating capital.45 On several occasions it has appeared as if the anti-corruption campaign was losing steam, but the broadest tally of cases under investigation suggest that it is still going strong despite hitting a peak at the beginning of the year (Chart 35). The campaign remains a potential source of disruption among the very officials whose risk appetite will determine whether central government policy easing actually results in additional bank lending and local government borrowing. Bottom Line: While difficult to quantify, the anti-corruption campaign will dampen animal spirits within local governments and the financial sector as long as the new NSC is seeking to establish itself and the Xi administration remains committed to prosecuting the campaign aggressively. Investment Conclusions Table 8Estimates Of Hidden Local Government Debt We would be surprised if credit growth did not perk up at least somewhat as a result of the past month's easing measures. But as outlined above, these measures may disappoint the markets as a result of the ongoing financial regulatory drive, the baggage of NPL recognition, and any negative impact on risk appetite due to the anti-corruption campaign. And this is not even to mention the dampening effects of ongoing property sector and pollution curbs.46 In lieu of a credit surge, Beijing is likely to rely more on fiscal spending to stabilize growth. Fiscal spending also faces complications, of course. In recent years, China's local governments have built up a potentially massive pool of off-balance-sheet debt due to structural factors limiting local government revenue generation (Table 8). Beijing is now attempting to force this debt into the light. The local government debt maturity schedule suggests a persistent headwind in coming years as hidden debt is brought onto the balance sheet and governments scramble to meet payment deadlines (Chart 36). In addition, the local government debt swap program launched in 2014-15 will wrap up this month. Chart 36Local Governments Face Rising Debt Payments Nevertheless Beijing has introduced a new class of "refinancing bonds" in 2018 to help stabilize the fiscal situation. These bonds are separate from brand new bonds that have the potential to increase significantly over the second half of this year. China's Finance Ministry has also reportedly asked local governments to issue 80 percent of net new special purpose bonds by the end of September. Since only about a quarter of the year's 1.35 trillion RMB quota was issued in H1, this order would mean that about half of the quota (675 billion RMB out of 1.35 trillion RMB) would be issued in August and September alone - implying a significant surge to Chinese demand, albeit with a lag of six months or so.47 The latest data releases from July suggest that Beijing is trying to do two things at once: ease liquidity conditions while cracking down on excess leverage. Until we see a spike in credit growth, we will continue to expect the policy turn to be only moderately reflationary, with the ability to offset existing headwinds but not spark a broad-based reacceleration of the economy. Going forward, data for the month of August will be very important to monitor, as many of the easing measures were not announced until late July. For all the reasons outlined in this two-part Special Report, we would view a sharp increase in total credit as a game-changer that would point toward a "stimulus overshoot" (Appendix). Such an overshoot is less likely if the government relies more heavily on fiscal spending this time around, which is what we expect. Meanwhile, turmoil in emerging markets - which we fully anticipated based on China's policy headwinds this year and our dollar bullish view - will only be exacerbated by China's unwillingness to stimulate massively.48 Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Qingyun Xu, Senior Analyst qingyun@bcaresearch.com Yushu Ma, Contributing Editor yushum@bcaresearch.com Appendix Appendix Appendix 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 3 Please see The Bank Credit Analyst Special Report, "A Long View Of China," dated December 28, 2017, available at bca.bcaresearch.com. 4 The fact that he began tightening financial policy in late 2016 and early 2017 was especially significant because only a very self-assured leader would attempt something so risky ahead of a midterm party congress. 5 Please see BCA Geopolitical Strategy Weekly Reports, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, and "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 6 The statement declared in its first paragraph that China would "maintain the stability of employment," with employment being the first item in a list. A similar emphasis on employment has not been seen in Politburo statements since the troubled year of 2015, and it has not been mentioned substantively in 11 key meetings since the nineteenth National Party Congress last October. 7 Please see footnote 2 above. 8 After the State Council meetings on July 23 and 26, Vice-Minister of Finance Liu Wei elaborated on the government's thinking: "These [measures] further add weight to the overall broad logic at the start of the year ... It isn't at all that the macro-economy has undergone any major volatility, and we are not undertaking any irrigation-style, shock-style measures." Please see "Beijing Sheds Light On Plans For More Active Fiscal Policy," China Banking News, July 27, 2018, available at www.chinabankingnews.com. 9 Our colleagues in BCA's Emerging Markets Strategy service have dubbed this policy "triple tightening." Please see BCA Emerging Markets Strategy Weekly Report, "EM And China: A Deleveraging Update," dated November 8, 2017, available at gps.bcaresearch.com. 10 This spike in net new issuance in the single month of June is equivalent to 19.8% of the total net new issuance in 2017. It is also much higher than the average monthly issuance in 2014-17 or in 2017 alone. However, since June and July have typically seen the largest spikes in new issuance, it will be critical to see if new issuance in 2018 remains elevated after July. Notably, local government bond issuance is currently divided between brand new bonds, debt swap bonds, and refinancing bonds, but the debt swap program will expire in August, and the refinancing bonds are separate, meaning that a larger share of the allowed new issuance will involve new spending. 11 The IMF expects the change in local government explicit debt this year to be 1.9 trillion RMB. That is, a rise from 16.5 trillion existing to 18.4 trillion estimated. 12 This number is derived by assuming that total debt reaches 92.2% of the debt limit in 2018, which is the share it reached in 2015 (since 2015 the share has fallen to 87.5% in 2017). However, 2015 was a year of fiscal easing, so it is not unreasonable to apply this ratio to 2018 as an upper estimate, now that the government's easing signal is clear. One reason that local governments have been increasing debt more slowly than allowed was that the central government was tightening investment restrictions, for instance on urban rail investment. Many new subway projects of second-tier cities have been suspended, and after raising the qualifications for subway and light rail, the majority of third- and fourth-tier cities were not qualified to build urban rail at all. As a result, local governments' investment intentions were dropping. Now this may change. 13 This estimate comes from the Ministry of Finance. The previous estimate was from the National Accounting Office and stood at 7 trillion RMB as of June 2013. 14 Maturities will spike in the coming years, so this policy signal suggests that further support for refinancing will be forthcoming. There are even unconfirmed rumors of a second phase of the local government debt swap program, which would cover "hidden debt." 15 We say "minimum" because we do not include projections of the impact of tax deductions, lacking details. We only estimate the headline savings to household incomes - loss to government revenues - based on the increase of the individual income tax eligibility threshold and the reduction in tax rates for different income brackets. 16 Additional fiscal measures include corporate tax cuts, R&D expense credits, VAT rebates, and reductions in various fees. 17 Please see BCA Geopolitical Strategy Monthly Report, "What Geopolitical Risks Keep Our Clients Awake?" dated March 9, 2016, available at gps.bcaresearch.com. 18 In fact it is more like 1.9 trillion due to strings attached, but a fourth or even fifth RRR cut could push it 3.5 trillion for the year, assuming the average 800 billion cut. 19 Ultimately this trend will result in tightening liquidity conditions in China, but for now forex reserves are not draining massively, while the RRR cuts are easing domestic liquidity. 20 Please see "China Said To Ease Bank Capital Rule To Free Up More Lending," Bloomberg, July 25, and "China's Central Bank Steps Up Effort To Boost Lending," August 1, 2018, available at www.bloomberg.com. 21 Please see BCA Emerging Markets Strategy Special Report, "Ms. Mea Challenges The EMS View," dated October 19, 2017, available at ems.bcaresearch.com. 22 Please see BCA Research Special Report, "China: Party Congress Ends ... So What?" dated November 2, 2017, available at bca.bcaresearch.com. 23 Please see BCA Foreign Exchange Strategy Weekly Report, "The Dollar And Risk Assets Are Beholden To China's Stimulus," dated August 3, 2018, available at fes.bcaresearch.com. 24 Please see BCA Global Investment Strategy Weekly Report, "Three Macro Paradoxes Are About To Come True," dated August 3, 2018, available at gis.bcaresearch.com. 25 Please see BCA China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle," dated November 30, 2017, available at cis.bcaresearch.com. 26 Please see BCA China Investment Strategy Weekly Report, "China Is Easing Up On The Brake, Not Pressing The Accelerator," dated July 26, 2018, available at cis.bcaresearch.com. 27 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 28 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 29 Please see BCA Geopolitical Strategy Special Report, "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017, available at gps.bcaresearch.com. 30 Please see BCA Geopolitical Strategy Special Report, "Politics Are Stimulative, Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 31 Please see BCA Geopolitical Strategy Special Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 32 Please see footnote 31 above. 33 Please see BCA Geopolitical Strategy Weekly Report, "Italy, Spain, Trade Wars... Oh My!" dated May 30, 2018, available at gps.bcaresearch.com. 34 Please see Part I of this report. 35 Please see BCA China Investment Strategy Weekly Report, "Now What?" dated June 27, 2018, available at cis.bcaresearch.com. Note that according to the new asset management rules, financial institutions will be required to have a risk reserve worth 10% of their fee income, or corresponding risk capital provisions. When the risk reserve balance reaches 1% of the product balance, no further risk provision will be required. We estimate that setting aside these funds will be a form of financial tightening worth about 1.2% of GDP. 36 Please see Liansheng Zheng, "The Macro Prudential Assessment Framework of China: Background, Evaluation and Current and Future Policy," Center for International Governance Innovation, CIGI Papers No. 164 (March 2018), available at www.cigionline.com. 37 Recall that the second category of the MPA consists of bank assets and liabilities. This category also has a rule for broad credit growth, which is that it should not exceed broad money (M2) plus 20%-25%. Therefore passing this part of the exam already requires banks to meet a 28%-33% speed limit on new credit. Assuming that that the pro-cyclical parameter of the CAR category remains at its current minimum of 0.4, then the structural parameter cannot be effectively pushed any lower than 0.6-0.8. The bottom line is that pushing the CAR structural parameter lower is not going to yield a significant increase in the allowable rate of credit growth. 38 To reach this estimate, we began with the fact that the outstanding level of broad credit growth was around 207 trillion RMB by the end of 2017 (that is, loans plus bonds plus equities plus wealth management products and other off-balance-sheet assets). The 2017 growth rate was about 10% and is assumed to be the same in 2018. Therefore broad credit should reach 227.7 trillion by the end of the year. Then, if we assume that all banks lend at the maximum weighted growth rate allowed by adjusting the structural parameter in the MPA CAR requirement (which is 30%), outstanding broad credit would reach 269.1 trillion by the end of the year. Hence an extra 41.4 trillion RMB in broad credit growth would be released. For comparison, please see CITIC Bond Investment, "Deep Analysis: Impact of Parameter Adjustments in the MPA Framework," July 30, 2018, available at www.sohu.com. 39 Based on actual CARs in 2017, the limit to broad credit growth was 17%-22% for large state-owned banks, 10%-20% for joint-equity banks, and 15%-20% for city or rural commercial banks. However, the actual broad credit growth for most banks was a lot lower than that. For example, for all five state-owned banks (nationally systemically important financial institutions), it was below 10%, well beneath the 17%-22% determined by their actual CARs and C*. 40 Under current regulations, the loan provision ratio is 2.5% while the NPL provision coverage ratio is 150%. The higher of the two is the regulatory standard for commercial banks. On February 28, 2018, the China Banking Regulatory Commission issued a notice declaring that the coverage requirement would change to a range of 120%-150%, while the loan provision requirement would change to a range of 1.5%-2.5%. Banks would qualify for the easier requirements according to how accurately they classified their loans, whether they disposed of their bad loans, and whether they maintained appropriate capital adequacy ratios. This could result in a release of about 800 billion RMB worth of provisions that can be kept as core tier-1 capital or support new lending. 41 Please see BCA China Investment Strategy Special Report, "Stress-Testing Chinese Banks," dated July 27, 2016, available at cis.bcaresearch.com. 42 Please see BCA Emerging Markets Strategy Weekly Report, "Mind The Breakdowns," dated July 5, 2018, and Special Report, "Long Indian / Short Chinese Banks," dated January 17, 2018, available at ems.bcaresearch.com. 43 Please see Jamie P. Horsley, "What's So Controversial About China's New Anti-Corruption Body?" The Diplomat, May 30, 2018, available at thediplomat.com. 44 The NSC is operationally very close to the Central Discipline Inspection Commission (CDIC), which is the Communist Party corruption watchdog formerly headed by heavyweight Wang Qishan. It received only a 10% increase in manpower over the CDIC in order to expand its target range by 200% (covering all state agencies and state-linked organizations). It has allegedly meted out 240,000 punishments in the first half of 2018, up from 210,000 during the same period last year and 163,000 in H1 2016. About 28 of these cases were provincial-level cases or higher. The controversy over the "rights of the detained" has been highlighted by the beating of a local government official's limousine driver in one of the organization's first publicly reported actions. The NSC has also arrested local government officials tied to "corruption kingpin" Zhou Yongkang and known for misappropriating budgetary funds, and has secured the repatriation of fugitives who fled abroad and recovered the assets that they stole or embezzled. 45 The provinces include Tianjin, Chongqing, Liaoning, Inner Mongolia, etc. Please see BCA Geopolitical Strategy "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. There is empirical evidence that anti-corruption probes are correlated with debt defaults. Please see Haoyu Gao, Hong Ru and Dragon Yongjun Tang, "Subnational Debt of China: The Politics-Finance Nexus," dated September 12, 2017, available at gcfp.mit.edu. 46 Please see BCA Emerging Markets Strategy Special Report, "China Real Estate: A Never-Bursting Bubble?" dated April 6, 2018, available at ems.bcaresearch.com, and Commodity & Energy Strategy Weekly Report, "Blue Skies Drive China's Steel Policy," dated August 9, 2018, available at ces.bcaresearch.com. 47 Please see "As economy cools, China sets deadline for local government special bond sales," Reuters, dated August 14, 2018, available at www.reuters.com. For more on local government bond issuance, see Part I of this series in footnote 1 above. Note also rumors in Chinese media suggesting that a new local government debt swap program could be launched with the responsibility of tackling off-balance-sheet debts that are guaranteed by local governments. The program has thus far only swapped debts that local governments were obligated to pay. It is not clear what would happen to a third class of local debt, that which is neither an obligation upon local governments nor guaranteed by them but that nevertheless is deemed to serve a public interest. 48 Please see BCA Geopolitical Strategy Weekly Report, "The EM Bloodbath Has Nothing To Do With Trump," dated August 14, 2018, available at gps.bcaresearch.com.

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

Special Report

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

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