China

Special Report

Highlights In any country, excess national savings, i.e., current account surpluses, lead to an accumulation of net foreign assets, but have no implications on domestic loan creation. Savings are not necessary for the banking system to originate loans. Quite the opposite, new loans boost purchasing power and spending and, thereby, create new income and additional savings. Unlimited loan/money creation will ultimately lead to currency depreciation and/or inflation. The RMB is at major risk because Chinese banks continue creating enormous amount of credit/money "out of thin air." Feature This week we publish the third report in our trilogy series on money, credit, savings and investment, where we address several misconceptions that dominate mainstream macroeconomic thought as well as the investment industry. Our previous Special Reports were: Misconceptions About China's Credit Excesses, and China's Money Creation Redux And The RMB.1 This third report focuses on: (1) Elaborating on the link - or lack thereof - between the investment-savings identity and domestic credit creation in any country; (2) Demonstrating how new loans lead to new income and ultimately new savings creation, and not, vice versa; (3) Discussing the macro limits to money/credit creation among banks. Macroeconomics has many areas that are not well understood or developed. We do not pretend to have all the answers related to savings and loan origination and their links to other factors. Even though all points of this report are applicable to any economy, the practical relevance and goal of our analysis is to demonstrate that China's credit excesses are not the natural outcome of its unique macro features such as a high savings rate. In fact, the leverage expansion that has been underway since early 2009 (Chart I-1) is nothing more than a credit bubble driven by banks willingness to create credit exponentially and policymakers' tolerance of it. Chart I-1Chinese Companies Are Extremely Leveraged That said, this does not mean that the Chinese credit bubble is about to burst. BCA's Emerging Markets Strategy service has been negative on China's credit cycle and growth since 2010, yet has never used the word "crisis". China may well experience one at some point, but it is impossible to time it. A more distinct possibility is that the country's growth could stagnate/slump further, and financial markets leveraged to its growth sell off materially - particularly in the wake of last year's rally. The investment implications are that there is more downside to Chinese financial markets and China-related plays globally. National Savings And Domestic Credit Creation One of the prevailing notions that justifies China's large credit excesses, as elaborated by some of my colleagues at BCA and others in the investment industry as well as academia is as follows: A current account surplus implies that national savings exceed investment. If a country generates a lot of national savings, as China does, it must either absorb those savings through domestic investment or, where possible, export the savings to the rest of the world by running a large current account surplus. As a reminder to readers, the investment-savings identity is as follows: Investment = Savings is an identity for a closed economy; and Savings (S) - Investment (I) = Current Account Balance (CA) holds true for an open economy. While on the surface this proposition might appear very intuitive, a deeper examination reveals there is no link at all between the national savings-investment identity (S - I = CA) and domestic credit creation in any country: S - I = CA is an identity of the real economy. It means an economy produces more goods and services than it consumes, and that the difference between production and consumption (excess supply) is being exported. Hence, "excess savings" here are "real excess savings" in the form of goods and services that were produced but not consumed in the economy, but rather sold abroad. These "real excess savings," or the CA surplus, have nothing to do with aggregate deposits in the country's banking system, or money/credit origination by its banks. As we elaborated in the first report of our three-part series, banks do create loans and deposits "out of thin air". Banks do not intermediate deposits into loans. They create deposits when they originate loans. For a more detailed discussion on this, readers should refer to our report titled, Misconceptions About China's Credit Excesses.2 Consequently, banks can create as much in the way of loans as they like (subject to the regulatory capital constraints), regardless of the country's current account balance. Chart I-2 and Chart I-3 depict that, historically, in various countries there has been no correlation between the national and household savings rates and bank credit origination. Chart I-2China: Credit And Savings ##br##Are Not Correlated Chart I-3The U.S., Korea And Taiwan: ##br##Credit And Savings Are Not Correlated When a country runs a current account surplus, it does not mean it brings in "excess savings" and invests those funds domestically. A current account surplus (or an excess of national savings over investment) only means that the country's net foreign assets will rise - i.e., the nation's "excess savings" have to be exported in the form of capital outflows (more on this below). On the whole, the S - I = CA identity is derived from the national accounts and balance of payments, and it has no relationship to how loans and deposits are created within the domestic banking system. Empirical evidence supports neither positive nor negative correlation between the current account balance and loan origination. For example, Germany has had massive current account surpluses, but its non-financial debt-to-GDP ratio has been stable (Chart I-4). On the contrary, the U.S. and Turkey have been running large current account deficits, while their domestic credit and leverage has boomed (Chart I-5 and Chart I-6). Chart I-4Germany: National Savings And Debt Chart I-5U.S.: National Savings And Debt Chart I-6Turkey: National Savings And Debt As the popular argument goes, more national savings lead to more deposits within the domestic banking system and ultimately more domestic loans stem from the application of the intermediation of loanable funds (ILF) model of banking. The ILF model states that banks intermediate deposits (savings) into loans. Yet, as we argued in the first report of this series, the ILF model is simply wrong. Commercial banks create both loans and deposits, simultaneously, "out of thin air". Consequently, any macro thesis that uses or relies on the ILF model is misguided. Bottom Line: National savings is a real economy concept, and has no relevance to loan creation and leverage in the country in question. Below we show that current account (CA) surpluses ("excess savings") lead to an accumulation of net foreign assets, but have no implication for domestic leverage. CA Surplus = Accumulation Of Net Foreign Assets CA surpluses are consistent with a nation expanding its net foreign assets, while CA deficits are congruent with a reduction in a country's net foreign assets. They do not suggest anything about domestic credit origination and leverage. Chart I-7U.S. Net International Investment Position The mechanism of converting CA surpluses into net foreign assets (external assets minus external liabilities) is somewhat different between fully floating and managed exchange rate regimes, so we consider both cases: A fully flexible exchange rate (the central bank does not interfere in the currency market): Let's assume Country A had a current account surplus over a given period. Exporters can keep the proceeds abroad and buy foreign assets, or bring them back and sell these dollars to other domestic players who want to buy foreign assets. Alternatively, exporters can sell these dollars to foreigners who sold assets in Country A and want to repatriate capital out of Country A. In this case, the nation's net foreign assets still rise because foreigners' claims on its assets shrink. Provided the central bank does not intervene in the currency market and the balance of payments, by definition, equals zero, the current account surplus is offset by a deficit on capital/financial accounts. In brief, the sole result of an excess of national savings relative to domestic investment is net capital/financial outflows and an ensuing increase in a country’s net foreign assets. This does not lead to any change in the banking system’s local currency loans.3 Chart I-7 demonstrates that the U.S.'s net foreign assets have dropped from - US$ 0.4 trillion in 1995 to - US$ 6 trillion currently, because the U.S. has been running current account deficits - i.e., on a net basis, foreigners have accumulated enormous amounts of claims on America. In spite of these persistent CA deficits and a low national savings rate, the U.S. bank loan-to-GDP ratio has risen substantially over the same period, proving the lack of relationship between national savings and loan origination. In the case of a managed or fixed exchange rate system (i.e., when the central bank intervenes in the currency market, by buying/selling foreign exchange), the dynamics are somewhat different, yet the end result is the same. If Country B has a current account surplus and its central bank is involved in managing the exchange rate, the central bank could buy foreign currency and thereby accumulate net foreign assets. Hence, the dynamics are the same, but the nation's central bank, rather than other economic agents, amasses more net foreign assets. If foreign exchange interventions are not completely sterilized, the central bank’s accumulation of foreign assets will be accompanied by issuance of high-power money (banks' reserves at the central bank) and new money (bank deposit) creation, but not a loan creation.4 Some observers might argue that the increase of bank reserves at the central bank would lead commercial banks to originate more loans. However, in the first and second reports of our trilogy series, we documented that commercial banks in the majority of countries, including all advanced economies and China, do not require central bank liquidity to originate loans. On the contrary, banks originate loans first and then, if needed, ask the central bank for liquidity. Chart I-8The PBoC Has Begun ##br##Targeting Rates In Recent Years In the case of China, there is evidence that from early 2014 until very recently, the People's Bank of China (PBoC) was targeting short-term interest rates (Chart I-8). When any central bank targets the price of money (interest rates), it cannot steer/manage the quantity of money - i.e., it has to provide/withdraw as much liquidity as commercial banks desire at a given interest rate level. Therefore, since early 2014, the PBoC has met commercial banks' demand for liquidity by keeping interest rates at its preferred target. In such a case, commercial banks - not the PBoC - decide on the amount of loan origination at a given interest rate level. Even in this case, the CA balance has no bearing on loan origination by commercial banks. Central banks nowadays steer loan growth and economic growth primarily via interest rates. Unless the current account dynamics lead the monetary authorities to alter interest rates, balance of payments dynamics will not have direct impact on credit growth. Bottom Line: A CA surplus raises a nation's net foreign assets, while a CA deficit reduces its net foreign assets. CA balances do not affect or determine commercial banks' capacity for domestic credit creation. Savings Are Not A Constraint On Loan Origination Mainstream economic literature typically relies on treating deposits as savings - i.e., refraining from spending by households or enterprises. Then, it uses the Intermediation of Loanable Funds (ILF) model to argue those savings flow to the banking system to become deposits. In turn, banks intermediate these savings (deposits) into loans. We have to again emphasize that the ILF model is simply wrong - in reality, this is not how the banking system works in any country in the world. This was the focal point of the first report of our trilogy. In particular, Fabian Lindner states that "...saving does not finance investment. No saving and abstention of consumption is needed for any lending to take place since lending and borrowing money are pure financial transactions that only affect gross financial assets and liabilities."5 Similarly, Zoltan Jakab and Michael Kumhof utter: "In the ILF model, bank loans represent the intermediation of real savings, or loanable funds, between non-bank savers and non-bank borrowers. But in the real world, the key function of banks is the provision of financing, or the creation of new monetary purchasing power through loans, for a single agent that is both borrower and depositor". 6 They also provide a further distinction between savings and financing: "...if the loan is for physical investment purposes, this new lending and money is what triggers investment and therefore, by the national accounts identity of saving and investment (for closed economies), saving. Saving is therefore a consequence, not a cause, of such lending. Saving does not finance investment, financing does." 6 Let's consider an example: Company A - which intends to build a production facility - requests a loan from Bank Z. After approving the loan request, Bank Z opens an account for Company A and grants a loan of $100 million by crediting Company A's bank account and in turn creating purchasing power for the company. Hence, Bank Z originated a loan and deposit of $100 million "out of thin air". As Company A uses this amount to pay for construction of production facility, it pays the builder, architects, engineers and various suppliers. These entities, in turn, pay their own suppliers as well as their employees, while the profits (dividends) are remitted to shareholders. All entities, and ultimately their employees and shareholders involved in the project, derived income from the original loan. Thus, their income was contingent on the loan that was originated by Bank Z and spent by Company A. Without it, these households, other companies and their shareholders would not have earned that income. In turn, these households and companies would spend/consume part of their income and save the other part. A few observations: Loan creation by Bank Z generated household income and enterprise profits that otherwise would not have occurred. This extra income would produce extra saving. In other words, without the loan origination by Bank Z, these extra savings would not have arisen. The fact that all companies and their employees involved in this project decided to save a part of their income does not mean they deposited new funds at their banks. Their "savings" already existed in the banking system. In fact, these deposits were created by Bank Z when the latter originated the loan. Ultimately, with banks willing to originate new loans, spending can exceed current income. Claudio Borio of the Bank for International Settlements corroborates this point: "Crucially, the provision of financing does not require someone to abstain from consuming. It is purely a financial transaction and hence distinct from saving... The equality of saving and investment is an accounting identity that always holds ex post and reveals nothing about financing patterns. In ex post terms, being simply the outcome of expenditures, saving does not represent a constraint on how much agents are able to spend ex ante. If we step back from comparative statics and consider the underlying dynamics, it is only once expenditures take place that income and investment, and hence saving, are generated".7 Bottom Line: Savings are not necessary for the banking system to originate loans and finance investment and consumption. Quite the opposite, new loans boost spending and create new income and additional savings (even though they may not impact the savings rate). Applying this to China, this means that the absolute amount of household savings is high because before 2008 booming exports, and since 2008 mushrooming loan growth, produced robust income growth. In sum, households decide on their savings rate, yet the credit boom since 2008 has tremendously boosted their income and has thereby expanded the absolute amount of their savings. Limits On Country Loan Origination Does this mean any country (specifically, its commercial banks) can originate unlimited amounts of loans/money, and thereby print their way to prosperity? To date, no country we are aware of has accomplished this. Indeed, if this were the case, there would be no poor countries. In the first report of our trilogy, we elaborated on the constraints banks face in originating loans, such as tighter monetary policy, lack of credit demand, government regulations and capital requirements, bank shareholders appetite to lend and liquidity constraints for banks. Chart I-9China: Signs Of Budding Inflation Herein we elaborate on limits at a macro level for banks to originate loans and finance investment and consumption. The supply side of an economy and its capacity to produce goods and services that are in demand is ultimately a macro constraint on credit/money issuance. China's ability to sustain such rapid money creation has been due to its strong supply side - i.e., its productive capacity. This makes China different from other emerging markets such as Turkey. China has low inflation and a CA surplus, while Turkey has had high inflation and a large CA deficit. Ultimately, a country's growth trajectory depends on its potential growth, which is the sum of labor force growth and productivity growth. China's "economic miracle" of the past 30 years has been due to its productivity, not credit/money creation. Money/credit origination greases the wheels of the supply side "machine" but does not replace it. Indeed, China's productivity boom over the past three-plus decades has been due to reforms that have allowed for the emergence and development of private enterprises, and attracting foreign technology/know-how. It has not been due to government control over the economy and credit creation. By and large, China is facing two potential growth trajectories, as depicted in Chart I-12 and Chart I-13 and explained in Box 1 on pages 13-15. A credit-driven economic downtrend entails deflation, while the path towards socialism warrants inflation. Barring a deflationary credit-driven growth slump, inflation in China will pick up sooner than later. The reason is that growing state control of the economy and resource allocation means poor capital allocation and much slower productivity - and in turn potential GDP growth. The latter, along with double-digit credit, creates fertile ground for an inflation outbreak (Chart I-9). If banks create too much money/credit, the price of money will go down- i.e., the currency will ultimately depreciate both versus foreign currencies as well as relative to goods/services and real assets like property. Chinese banks have created too much money (RMBs), and it is not surprising property prices have gone exponential and that the RMB is under downward pressure. In fact, Chinese households may be sensing there are too many RMBs floating around, and want to get rid of them by converting them into foreign currencies and buying real assets (real estate). On the whole, the exchange rate is a key to China's macro dynamics. If unrelenting credit creation persists, the yuan will continue to fall because Chinese households and companies will be reluctant to hold local currency. In such a case, credit origination will have to be curtailed to stabilize the exchange rate. Bottom Line: Unlimited credit/money creation will ultimately produce a major currency depreciation and/or inflation. These, in turn, will short-circuit the credit boom. Conclusions When investors and commentators justify exponential moves in credit or asset prices by the unique features of a particular economy - implying this time is really different - critical consideration is warranted. For example, Japan's 1980s bubble was justified by exclusive particularities of the Japanese economy; Hong Kong's real estate bubble of the 1990s was justified by limited land on the island; and the U.S. tech bubble of the late 1990s was explained by a "new era of productivity brought on by technology." Needless to say, in retrospect we know that these were bubbles, and they all deflated. Explaining away China's exponential surge in domestic leverage as a bi-product of its high savings rate makes us wary. The report explains why high national savings rates do not warrant high credit creation. China is facing two potential growth roadmaps, as depicted in Chart I-11 and Chart I-12 and elaborated in Box 1 (see page 13-15). Regardless of which way China's economy evolves, the medium-term outlook for mainland growth is downbeat. BCA's Emerging Markets Strategy team expects double-digit RMB depreciation in the next 12 months. We continue to recommend short positions in the RMB via 12-month NDFs. This is the rationale behind our negative stance on Asian currencies. We believe EM equities, credit markets and currencies will underperform their DM counterparts, regardless of the trajectory of share prices in the U.S./DM. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com BOX 1 Two Growth Path Forward For China1 1. Short-Term Pain / Long-Term Gain If the authorities were to allow market forces to prevail, the state should withdraw meaningfully from the credit allocation process. In that case, credit markets will bring discipline to both debtors and creditors - in effect, an emerging perception of potential losses rather than government-led bailouts will make creditors less willing to lend, and debtors less willing to borrow and expand. The result will be a considerable dampening in credit origination. In this scenario, it is very likely that credit growth slows from 12% currently to the level of potential nominal GDP growth of 7-8% or lower (Chart I-10), leading to a classic credit-driven economic downtrend (Chart I-11). In that case, cyclical growth will undershoot. Chart I-10China: Credit Is Outpacing ##br##GDP Growth By Wide Margin Chart I-11Capitalist-Style Credit-Driven Downtrend However, potential GDP growth (the red line in Chart I-11) - which has been falling in recent years - will stabilize and probably improve. The reason being that by allowing market forces to prevail in credit allocation and corporate restructuring/reorganization, China will ultimately improve its capital allocation and productivity. In brief, potential GDP growth - which equals productivity growth plus labor force growth - will stop falling and, in fact, could improve as productivity growth ameliorates. 2. No Short-Term Pain But Long-Term Stagnation It is essential to differentiate cyclical growth drivers from structural ones. If the government does not allow credit growth to slow, cyclical growth will hold up. However, in this scenario, structural growth will tumble and China will embark on a path of economic stagnation. That said, the growth deceleration would be gradual, as depicted in Chart I-12. Chart I-12Toward Socialism = Secular Stagnation And Inflation A rising role of state and government officials in capital allocation and business decision-making guarantees suboptimal capital allocation, resulting in poor efficiency and declining productivity growth. Since China's labor force growth is projected to be flat-to-negative, the sole source of potential GDP growth going forward will be productivity growth. Besides, it is much easier to achieve high productivity growth in manufacturing than in the service sector. Finally, high productivity growth is possible when the productivity level was low. From the current levels, it is hard to grow productivity more than 5-6% annually. Chart I-13Socialist Put Will Depress ##br##Productivity Growth If we assume China's productivity is now about 6% (which is already very high) (Chart I-13), and if the country embarks down this path, odds are that productivity growth might drop by 100 basis points in each of the following years. In five years or so, productivity growth would be only around 1%. Given that labor force growth will be zero, if not contracting, in five years' time, potential GDP will drop to 1% or so, as shown in Chart I-12 on page 14. Hence, this path is the ultimate recipe for economic stagnation in China. The only thing the authorities can do in this scenario is to boost growth from time to time via credit and fiscal stimulus. This will produce mini-recovery cycles around a falling primary growth trend. The latest acceleration in China's growth is probably the first mini-cycle. How can investors invest in this scenario? The mini-cycles depicted in Chart I-12 look nice, because we drew them ourselves. In reality, they will not be symmetric or smooth. Besides, financial market swings for China-related plays will differ from the economy's growth mini-cycles because markets can be driven by factors other than growth like politics, geopolitics, credit events, and other global variables such as the U.S. dollar and bond yields. In short, this analysis explains why we have been and remain bearish on China-related financial markets despite the stimulus that has been injected about a year ago. Investing around economic mini-cycles is difficult because it assumes near-perfect timing. Without that, investors cannot make money. 1 Originally published in January 11, 2017 EMS Weekly Report. 1 Please refer to the Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses," dated October 26, 2016, and Emerging Markets Strategy Special Report, titled "China's Money Creation Redux And The RMB," dated November 23, 2016, the links are available on page 18. 2 Please refer to the Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses," dated October 26, 2016, the link is available on page 18. 3 This example assumes that neither the central bank nor local commercial banks are buying foreign currency. In the case when a commercial bank buys foreign currency, that transaction creates new money/deposit in the banking system although it does not create a new loan. The opposite is also true: when a commercial bank sells foreign currency, existing money/deposits are destroyed. 4 This example assumes that the local commercial banks are not buying foreign currency and only the central bank buys foreign currency from non-banks. 5 Lindner, F. (2015), "Does Saving Increase the Supply of Credit? A Critique of the Loanable Funds Theory", World Economic Review 4: 1-26, 2015 6 Jakad, Z. and Kumhof, M. (2015), "Banks Are Not Intermediaries of Loanable Funds - and why this Matters", Bank of England, Working Paper 529, May 2015 7 Borio, C. and Disyatat, P. (2015), "Capital Flows and the Current Account: Taking Financing (more) Seriously", BIS Working Papers, No. 525, October 2015 Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights China's monetary and fiscal policy in 2017 will likely remain accommodative, in order to achieve the goal of an average 6.5% GDP growth over the next five years. China's policies related to its property market will be much more restrictive than the previous two years. Chinese metal demand will grow at a slower pace than last year, as reflationary policies are throttled back. Feature Base metals and bulk markets had a fantastic year in 2016, a complete reversal of their miserable performance in 2015 (Chart 1, panels 1 and 2). Last year, the LMEX base metal index, steel prices and iron ore prices were up 30%, 75%, and 91%, respectively (using average prices in January and December). In comparison, during the same period of 2015, the LMEX index, steel and iron ore were down 22%, 30%, and 41%, respectively. Massive supply reductions, and recovering demand caused by China's reflationary fiscal and monetary policies, were the driving forces behind these sharp rallies in bulks and base metals prices last year. Both the official manufacturing PMI and Keqiang index, which are broadly used as key measures of Chinese economic conditions, reached a three-year high in late 2016 (Chart 1, panels 3 and 4). Clearly, metal prices had already discounted a positive outlook vis-a-vis Chinese economic growth, which was boosted by a series of reflationary policy initiatives in the past two years. The question now is: will reflationary monetary and fiscal policies continue into 2017? If so, on how large a scale will it be? What factors could limit or even prevent reflationary policies in China? A look back China's reflationary policies actually started in late 2014, when the property market and overall economy showed signs of weakness. The country accelerated its reflationary policies throughout 2015 and maintained a moderate reflationary stance in 2016, in order to spur domestic economic growth. Monetary policy: China cut its central-bank directed policy rate five times in 2015 from 5.6% to 4.35%, the lowest level since the data started in 1980 (Chart 2, panel 1). The People's Bank of China (PBoC), the country's central bank, also lowered the reserve requirement ratio at banks - the amount of reserves banks must keep on hand - four times in 2015 and once in 2016 from 18% to 15%, the lowest level since May 2010 (Chart 2, panel 2). Chart 1China Reflationary Policy Drove ##br##Metal Price Rallies In 2016 Chart 2Both Monetary and Fiscal Policies ##br##Were Reflationary Last Year Fiscal policy: China halved its 10% sales tax on passenger cars with engines up to 1.6 liters in October 2015, which boosted auto sales and production significantly last year (Chart 2, panel 3). The country also maintained its high-growth infrastructure investment last year (Chart 2, panel 4). Real estate-related policy: China loosened its housing-related policies extensively since September 2014, by among other things, reducing down-payment requirements for first-time home buyers, and reducing down payments needed to finance second homes. The goal of the policies was to reduce elevated housing inventories. Indeed, those policies, along with the combination of falling mortgage rates, revived the Chinese property market in 2016, and sparked a massive rally in steel-making commodities - metallurgical coal and iron ore - and in base metals. For the first 11 months of last year, the average selling prices of 70 cities and the total floor-space-sold area rose 13.6% and 24.3% yoy, respectively, which considerably improved from the 2015 same period's 6% and 7.4% yoy growth. The floor-space-started area had an even more significant improvement - a growth of 7.6% for the first 11 months of last year versus a deep contraction of 14.7% yoy for the same period of 2015 (Chart 3). What now? This year, we continue to expect accommodative monetary and fiscal policy in China. "Stability" was the key word during the three-day Central Economic Work Conference (December 14-16, 2016), an annual meeting that set out economic targets and policy priorities for next year. "Stability" means the country's leaders will try to implement policies designed to keep the country's GDP growth around 6.5% this year, the average GDP growth target for the five years between 2016 and 2020, under China's five-year plan. China's economic growth is on a downtrend, coming in at 6.9% in 2015, and a predicted 6.7% in 2016 (for the first three quarters of 2016, China's GDP growth was all 6.7%) (Chart 4, panel 1). Chart 3Property Market Policy: ##br##Greatly Loosened In 2015 And 2016 Chart 4We Expect Chinese Monetary And Fiscal Policies ##br##To Stay Accommodative This Year The market's expectation for China's 2017 GDP growth currently is 6.5%. Even though President Xi has stated he is open to growth in China falling below 6.5%, too far below this level - for example, below 6% - could cause widespread disappointment in the country and trigger the "instability" leaders are trying to avoid. Hence, monetary accommodation likely will persist in 2017. As both headline inflation and core inflation in China still are not elevated, we do not expect any rate hikes or increases in the reserve requirement ratio to be announced by the PBoC this year (Chart 4, panel 2). In addition, the RMB depreciated considerably last year, which helps the country's exports and, to some extent, stimulates domestic economic growth (Chart 4, panel 3). In mid-December last year, Chinese policymakers raised the tax on small-engine autos slightly - from 5% last year to 7.5% this year - but this is still below its normal 10% level. This also indicates the country wants to maintain a moderate, but not too expansionary, level of fiscal stimulus In 2017. In 2016, most of Chinese automobile production growth came from small-engine passenger cars, which clearly benefited from this policy (Chart 4, panel 4). This year, we still expect positive growth in Chinese vehicle production but at a much slower rate than last year. Curbing Property Market Exuberance Regarding the Chinese property market, our take-away from the Central Economic Work Conference was that "curbing the speculative home purchases, containing asset bubbles and financial risks" will be among the country's top 2017 priorities. In comparison, back in 2016, reducing housing inventories was the focus. Indeed, with property sales recovering, inventory has fallen from its 2015 peak. Inventories still are elevated, but most of the overhang is in third- and fourth-tier cities, with some of it in even smaller cities (Chart 4, panel 5). A continuation of stricter housing policies deployed since last September to cool the over-heated domestic property market is expected. For example, Beijing raised the down payment for first-time homebuyers from 30% to 35%. Down payments for second homes rose from 30% to a minimum of 50%. For a second home larger than 140 square meters, the down payment is now 70%. So far, more than 20 cities have declared similarly strict policies to control speculative buying in property markets. Currently, a record high 20% of people surveyed plan to buy a new house in the next three months, which indicates further cooling measures are needed for the property market (Chart 5, panel 1). In the meantime, new mortgage loans as a share of home sales in value also reached a record high of 49%, and real estate-related loans as a share of total new bank loans now stand at a 6-year high, signaling financial risk in these markets is rising (Chart 5, panels 2 and 3). All of these factors signal that the Chinese authorities will maintain their restrictive property market policies in 2017. This will be negative for the country's bulk and base metals demand, as the property market accounts for some 35% of demand for these commodities. In conclusion, China's monetary and fiscal policies are likely to stay accommodative in 2017, while the country's housing market is facing restrictive policies. Shifting Economic Drivers For Bulk and Base Metal Demand We would like to remind our clients that China's economic structure is shifting: Services (also known as the "tertiary sector") account for a rising share of GDP, and are not big users of bulks or metals, while manufacturing (i.e., the "secondary sector) demand for these commodities is slowing. Services now account for 51.4% of GDP, while manufacturing now accounts for 39.8% (Chart 6). The GDP weight of services is up from 42% ten years ago, while the GDP weight of manufacturing is down 8 percentage points over the same period. Chart 5Property Market Policy Will Remain ##br##Restrictive in 2017 Chart 6China's Economic Structure Shift Is ##br##Negative To Metals Demand This shift is negative for metal demand growth, as the related manufacturing activity growth slows faster than the overall GDP growth. Overall, we believe Chinese bulk and base metal demand growth in 2017 will slow as a result of less expansionary policies than prevailed last year, and a more restrictive domestic housing market. Next week The Chinese Central Economic Work Conference also emphasized that 2017 will be a year to deepen supply-side structural reforms, which we will discuss in our next week's pub. We also will address the impact of Chinese environmental policy on Chinese metal output. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com ENERGY Chart 7Evidence Of Production Cuts Will Lift Oil Prices Oil Production Expected To Fall Reports of production cuts and reduced volumes being made available to U.S. and Asian refiners have been trickling out since the start of the year, lending underlying support to prices globally (Chart 7). The Kingdom of Saudi Arabia (KSA) is reducing exports of heavy-sour crudes favored by U.S. Gulf refiners, and boosting light-sweet sales, which will compete with North Sea volumes and U.S. shale production. This should tighten the spread between the light-sweet benchmarks Brent and WTI vs. Dubai (medium/heavy-sour). Reduced volumes being shipped by KSA to Asian refiners - particularly to Chinese refiners - will support Brent prices. We continue to expect the production cuts negotiated under the leadership of KSA and Russia to become apparent next month, and for inventories to draw in response. Continued high output by Iraq likely will be reduced in the near future. U.S. shale-oil output most likely will increase in 2H17 by ~ 200k to 300k b/d on average, given higher prices supporting drilling economics. Our expectation for global demand growth remains ~ 1.4mm b/d this year, roughly in line with 2016 growth. Given these underlying fundamentals, we expect inventories will begin showing sharp draws, causing backwardation in crude-oil markets to re-emerge in 2H17. As such, we are re-establishing our Dec/17 vs. Dec/18 WTI front-to-back spread - i.e., buying Dec/17 WTI and selling Dec/18 WTI against it. This spread was in contango going to press, making it particularly compelling. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017

Highlights Barring major external disruption, Chinese GDP growth will likely continue to accelerate into the first half of 2017. The overall policy stance will stay accommodative to safeguard against potentially negative shocks from abroad. Trade tensions between the world's two largest economies will inevitably increase, the degree of which matters greatly for how the Chinese economy as well as the global economy perform in the medium to long term. The dollar trend will continue to dictate the USD/RMB cross rate in the near term. The PBoC will continue to intervene heavily to prevent excessive currency weakness. Shorting the CNH/USD is not much different from a direct bet on the dollar index. Aggressive directional bet on Chinese shares is not warranted in the near term. Strategically favor Chinese equities over their global peers. Feature China has rung into 2017 with strengthening growth momentum that has been building in recent months, but the New Year clearly brings new challenges. China is on the receiving end of two major external uncertainties - namely, the anti-globalization backlash from the U.S. under President-elect Donald Trump and the outlook for the U.S. dollar, both of which are completely beyond its control. 2017 will also be a highly charged year in Chinese politics, as the ruling Communist Party prepares for a generational leadership reshuffle. This means the Chinese leadership will be more sensitive to perceived "provocations" from abroad, making political risk between the U.S. and China even less predictable. The Chinese authorities will remain highly vigilant about economic and financial stability. Meanwhile, the government will continue to mobilize the public sector and fiscal resources to support the economy, as external uncertainties mount. Domestic Demand Should Remain Buoyant Most of the recent data releases coming out of China have surprised to the upside, and the regained strength appears rather broad-based (Chart 1). Some indicators that are highly sensitive to industrial activity such as transportation freight, electricity generation and construction machine sales have rebounded sharply, partly due to last year's low base. Meanwhile, the consumer sector has remained buoyant, with strong expansion in durable goods sales such as cars and air conditioners. Looking forward, we expect the economy to continue to improve, at least in the next two quarters. Leading indicators are still strengthening. The latest PMI figures, both manufacturing and non-manufacturing, have continued to climb, and remain above the boom-bust threshold. The labor market is on the mend. The employment component of the PMIs has been rising in recent months, indicating increased hiring as the economy picks up (Chart 2). This could lead to a self-feeding virtuous cycle where an improving labor market leads to rising income growth and strengthening aggregate demand, which further boosts overall business activity and the labor market. Chart 1Broad-Based Recovery Chart 2Labor Market On The Mend The corporate sector is recovering. Inventories are exceptionally low, setting the stage for inventory restocking, which could further boost production (Chart 3). Profit growth among both private and state-owned enterprises has continued to accelerate. Rising profits are easing financial stress, particularly for debt-laden, asset-heavy sectors. This is also reflected in banks' asset quality; banks' non-performing loan accumulation has slowed sharply of late (Chart 4). In addition, recovery in the corporate sector should also bode well for investment, which is still subdued. The housing crackdown since early October has once again set the stage for negative surprises. Home sales have already begun to slow, and the government appears determined to check housing demand. A key difference between now and previous rounds of housing crackdowns is that developers have been quite cautious throughout the current cycle1: confidence has been downbeat, and housing starts have remained quite weak. Consequently, housing inventories have been quickly depleted nationwide. The demand crackdown has dashed hopes for a housing-led growth recovery, but low inventories and sluggish housing construction has also reduced the risk of another housing-led investment bust, which has typically followed previous housing tightening campaigns. Chart 3Inventory Restocking Will ##br##Further Boost Production Chart 4Corporate Sector Recovery ##br## Also Helps Banks Our model shows that Chinese GDP growth likely accelerated notably in the final quarter of the year, and the momentum will probably carry forward into the first half of 2017, assuming no major external disruption (Chart 5). The inauguration of Donald Trump next week marks the biggest uncertainty for China's growth outlook in recent history due to his well-publicized anti-globalization stance, especially his proposed harsh anti-China trade policies. Chart 5Growth Should Continue To Improve The Trump Wildcard Speculation on President-elect Trump's forthcoming China policies run amok, ranging from pragmatic deal-making, simmering frictions and tit-for-tat retaliation, to the inevitability of a full-fledged trade war and even to a geo-strategic alliance with Russia against China. It is impossible to tell at the moment where reality will eventually end up, but what is clear is that trade tensions between the world's two largest economies will inevitably increase, the degree of which matters greatly for how the Chinese economy as well as the global economy perform in the medium to long term. Low-profile trade tensions and punitive barriers will prove damaging to specific sectors and industries, but should not have a major macro impact. Chinese products that are likely to be subject to American punitive tariffs are some heavy industries such as metals. The usual suspects that may fall victim to Chinese retaliation are American transportation equipment and agricultural products - two main American export items to China. At the macro level, however, China's export sector performance should improve on a cyclical basis, especially if "Trumponomics" successfully lifts U.S. economic growth this year (Chart 6). As one of the major beneficiaries of globalization, China stands to suffer if the broad globalization trend reverses. The saving grace is that exports as a share of the Chinese economy have already almost halved to below 20%, a level comparable to the early 2000s before China joined the World Trade Organization (Chart 7). In other words, China's "globalization dividends" have already diminished to some extent. Moreover, Chinese exports depend more on the U.S. market than the other way around. Therefore, it is in China's best interests to avoid an escalation of trade frictions with the U.S., simply because it has more to lose.2 Nonetheless, it goes without saying that no country gains in a trade war, and the world risks a deep economic recession if the two largest economies engage in an all-out trade battle. Geo-strategic containment of some kind further darkens the outlook for both China and the world. A "cold war" between China and the U.S. would mark a drastic break from the global environment of the past four decades that allowed China to focus solely on economic development. One can only hope that a "clash of the titans" will not drag the world into a self-destructive downward spiral. Chart 6Trumponomics Should Also ##br##Help Chinese Exports Chart 7Globalization Dividends ##br## Have Already Diminished In short, it is too early to evaluate the impact of America's new trade policy on China's growth outlook. We suspect the near-term impact should be limited, as it is unlikely that trade tensions will immediately erupt once Trump takes office. Nonetheless, the situation needs to be monitored closely going forward. Policy: Fiscal Takes The Helm We expect the Chinese authorities will further downplay the significance of the annual GDP growth target as a binding policy constraint. Growth recovery and improvement in labor market conditions reduce the need for further pump-priming, but the overall policy stance will stay accommodative to safeguard against potentially negative shocks from abroad. On the monetary policy front, the case for further interest rate cuts has diminished (Chart 8). The People's Bank of China (PBoC) recently reiterated that its monetary stance will stay decisively "neutral." In our view, this means the PBoC will continue to fine-tune interbank liquidity, but any symbolic policy move in either direction can be ruled out, unless the economic situation takes a sudden turn. In contrast, fiscal policy will be more stimulative. The annual budget deficit will likely be further increased in the March session of the People's Congress. Moreover, some high-profile investment plans have been released in recent weeks, meaning policy-led investment spending will remain elevated going forward. The country aims to invest RMB 2 trillion, or US$290 billion, in tourism between 2016 and 2020. This would translate into annual growth of more than 14% in direct investment in the industry. China's National Energy Administration (NEA) plans to invest RMB 2.5 trillion (US$360 billion) to develop the nation's energy sector over the next five years, with a focus on renewable resources. Installed renewable power capacity including wind, hydro, solar and nuclear is expected to contribute to about half of new electricity generation in five years, which will boost growth and reduce pollution. The government continues to promote private-public partnerships (PPPs) to build infrastructure. The published PPP proposals so far amount to a whopping RMB 12.5 trillion, with a heavy concentration on the transportation network and urban development (Chart 9). Chart 8Expect No Change In Policy Interest Rate Chart 9Fiscal Takes The Helm It is worth noting that recent growth improvement has been accompanied by a notable slowdown in fiscal spending, leaving room for reacceleration going forward (Chart 10). In short, fiscal spending and policy-led investment will remain the key tools for the Chinese government to stabilize the economy. Chart 10Fiscal Spending Is Set To Reaccelerate Chart 11Weak RMB Or Strong Dollar? The RMB: Which Way Will The Wind Blow? Since the New Year, offshore RMB (CNH) liquidity has tightened dramatically, which has led to a massive surge in the Hong Kong Interbank Offered Rate (HIBOR) of the RMB and a sharp rebound in the CNH/USD cross rate. This is widely viewed as a successful short squeeze engineered by the PBoC to punish speculators. It is certainly true that the authorities "allowed" offshore RMB liquidity to dry up, but the sharp spike in the HIBOR rate also closely resembles a classic emerging market currency crisis: speculative attacks on the exchange rate forces the monetary authorities to dramatically jack up interest rates to maintain exchange rate stability - a textbook example of the "Impossible Trinity" thesis at work. In China's case, however, the offshore HIBOR rate bears no relevance on the funding cost of the Chinese corporate sector. As such, the PBoC couldn't care less about periodic tightening in CNH liquidity, as it has no consequence on the domestic economy. This bodes poorly for the internationalization of the RMB, but is a low-cost tool for the PBoC to maintain control over the exchange rate. Two observations can be made from this episode: It is unlikely that the PBoC will completely give up control over the RMB exchange rate, especially in this politically charged year. Sharp depreciation in the RMB/USD may be viewed as a sign of systemic financial risk and economic weakness, a taboo ahead of the Party Congress later this year. Since the New Year, the Chinese authorities have further tightened capital account controls to restrict capital outflows - a reflection of the PBoC's determination to maintain exchange rate stability. There is now an almost universal consensus that the U.S. dollar will strengthen further this year, and that the RMB will decline. It is of course foolish to blindly bet against consensus, but it also means shorting the CNH/USD has already become a very crowded trade. The sharp rebound of the CNH/USD a few days ago is a classic example of a market stampede where investors rush to a narrow exit when conditions change. All this has made the risk-return profile of shorting the RMB against the dollar unfavorable, as the PBoC, with its formidable resources, could unexpectedly hit back at any time. Indeed, the performance of the CNH/USD cross rate has closely tracked the broad U.S. dollar index over the past two years, a situation unlikely to change going forward (Chart 11). The bottom line is that the dollar trend will continue to dictate the USD/RMB cross rate in the near term. The PBoC will continue to intervene heavily to prevent excessive currency weakness. For investors, shorting the CNH/USD is not much different from a direct bet on the dollar index. What To Do With Chinese Stocks? Chart 12Chinese Shares Valuation Perspective Chinese stocks will likely range-bound in the near term. The downside is limited by accommodative policy, stable/improving growth and depressed valuation, especially for H shares (Chart 12). The upside is capped by the ongoing macro concerns and brewing tension with the incoming U.S. administration. Chinese shares may also be vulnerable if the more frothy global bourses correct. Therefore, aggressive directional bet is not warranted in the near term. From a big picture point of view, however, we remain convinced that market concerns on China's macro conditions are overdone, and Chinese equities have been unduly punished. Investors with longer-term horizons should hold H shares. Strategically we favor Chinese equities over their global peers. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010," dated October 13, 2016, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China-U.S. Trade Relations: The Big Picture," dated November 17, 2016, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights The U.S. dollar will likely overshoot. This is negative for EM. China by and large has a choice between two potential roadmaps: (1) short-term pain / long-term gain and (2) growth stagnation with mini-cycles around it. Regardless of which scenario transpires - so far the second scenario has been in effect - the medium-term outlook is downbeat. Given we are already advanced in this mini-cycle, the risk-reward for China plays in financial markets is negative. Feature Chart I-1Equity Investors Are ##br##Bullish With Minimum Hedges The U.S. dollar is overbought, but the primary trend remains up. A confluence of cyclical and structural economic forces, along with geopolitical and political risks, argue for further upside in the greenback. As the dollar grinds higher, emerging markets (EM) will suffer. EM stocks, currencies, and credit markets will not only underperform their developed market (DM) peers, but also relapse in absolute terms in the months ahead. Additional U.S. dollar strength and ongoing complacency in the U.S. equity market (Chart I-1) means that the 6-12 month outlook for global equity markets is poor. While momentum can carry DM markets higher in the very near term, EM share prices have already topped out, and the path of the least resistance is down. Dollar appreciation will be brought on by both global/EM and U.S. dynamics. Global Factors Supporting The U.S. Dollar The following global factors support the greenback's strength: Global demand for U.S. dollars is rising faster than the supply of U.S. dollars. We computed two measures of U.S. dollar liquidity. Measure 1 is the sum of the U.S. monetary base and U.S. Treasury securities held in custody for foreign official and international accounts. Measure 2 is the sum of the U.S. monetary base and U.S. Treasury securities held by all foreign residents (Chart I-2A and Chart I-2B). Chart I-2AU.S. Dollar Liquidity (Measure 2) Chart I-2BU.S. Dollar Liquidity (Measure 1) Notably, the U.S. monetary base and the amount of U.S. Treasury securities held by foreign official and international accounts are contracting, while the amount of U.S. Treasury securities held by all foreigners has stalled (Chart I-3). The monetary base shrinkage manifests the rise in reverse repos by the Fed, i.e., the Fed is siphoning in the banks' excess reserves (Chart I-3, bottom panel). The weakness in foreign holdings of U.S. Treasury securities is largely due to the selling of U.S. securities by EM central banks to provide U.S. dollars in order to meet strong dollar demand locally. China is the largest contributor to the surge in U.S. dollar demand as the depletion of its international reserves has been enormous. In short, the drop in U.S. dollar liquidity does not mean that U.S. dollar supply is shrinking. Instead, it implies that the demand for U.S. dollars is accelerating relative to its supply. When the pace of demand growth outpaces that of supply, the price of that commodity, good/service, or asset, rises. This will be the case for the greenback - it will appreciate further. Importantly, the RMB will remain under downward pressure, which will drag down other Asian currencies. China's unaccounted net capital outflows - measured by the balance of payment's net errors and omissions - have swelled to a record level of US$ 205 billion, or 2% of GDP (Chart I-4). Furthermore, the PBoC has been conducting full-out "reverse" sterilization of its U.S. dollar sales. By selling U.S. dollars to defend the RMB, the PBoC initially shrunk local currency liquidity. To preclude onshore interbank interest rates from spiking, the mainland monetary authorities have simultaneously re-injected RMB into the system via outright lending to banks and open-market operations (Chart I-5). Chart I-3Components Of U.S. Dollar Liquidity Chart I-4China: Unrecorded Capital Outflows Chart I-5The PBoC: By doing so, they have kept interest rates low, but the supply of high-powered money has been restored. It is reasonable to expect such RMB liquidity injections to continue. This, in turn, will allow commercial banks to continue creating money/credit/deposits out of thin air. As such, the mushrooming supply of yuan will weigh on the currency's value. We discussed these issues in detail in our November 23, 2016 Special Report, titled China: Money Creation Redux and RMB.1 U.S. dollar borrowing costs are rising: Not only have U.S. bond yields spiked but the LIBOR rate has also continued its unrelenting uptrend, especially when compared to the EURIBOR (Chart I-6). Higher borrowing costs and expectations for further U.S. dollar strength will make non-American debtors with U.S. dollar liabilities reluctant to keep their short dollar exposure. They will try to either repay U.S. dollar debt or hedge it. This will ultimately increase the demand for U.S. dollars in the months ahead. Importantly, EM countries (outside of China) have US$ 5 trillion of foreign currency debt outstanding. Thus, higher U.S. borrowing costs will raise the demand for U.S. dollars as debtors rush to repay or hedge their U.S. dollar liabilities. We published an extensive review of EM foreign currency debt on January 4 in our Weekly Report titled EM: Overview of External Debt.2 This report provides information about various categories of borrowers (government, nonfinancial companies and financials), types of debt (loans versus bonds) and debt maturity (short- versus long-term) for each individual developing economy. The report also ranks countries according to their foreign debt burdens and short-term funding pressures. This report can be accessed by clicking on the link on page 19. The yield differential between EM local bonds and U.S. Treasurys has narrowed (Chart I-7), as U.S. bond yields have risen more than duration-adjusted EM domestic bond yields. Such a compression in the spread has reduced the attractiveness of EM local bonds. As U.S. bond yields resume their ascent, odds are that inflows into EM local bonds will diminish, and EM bonds will sell off. Chart I-8 illustrates that the J.P. Morgan EMLI EM currency total return index (including carry) has failed to break above an important technical resistance. When such a technical profile transpires, it is often followed by a major breakdown. Chart I-6Rising LIBOR Will Hurt Debtors ##br##With U.S. Dollar Liabilities Chart I-7The EM-U.S. Bond Yield ##br##Gap Has Narrowed Chart I-8EM Currency Return With ##br##Carry: More Downside Trade protectionism is bound to rise. The proposed U.S. Border-Adjusted Corporate Tax and any potential U.S. import tariffs will lead many exporter countries to devalue their currencies substantially to offset the loss in exporter revenues in local- currency terms. For example, Chart I-9 shows that U.S. import prices from China have been deflating in U.S. dollar terms but have risen a lot in RMB terms. The latter is what matters to producers. Hence, China and many other exporters to the U.S. will seek to devalue their currencies further to offset import tariffs and the resulting drop in US. dollar revenues from their sales in America. Finally, the outlook for foreign capital inflows (both FDI and equity flows) into EM remains very poor. EM growth is weak and will remain so. The growth acceleration in advanced economies will not help EM economies much for reasons we discussed at length in our December 14, 2016 Weekly Report.3 Remarkably, the worsening trend in relative manufacturing PMIs between EM and DM suggests EM growth and share prices will continue to underperform DM (Chart I-10). Chart I-9Deflation In U.S. Dollars, Rising In RMB Terms Chart I-10EM Will Continue Underperforming DM Bottom Line: The current confluence of global economic forces and rising trade protectionism in the U.S. will propel the U.S. dollar higher. Domestic Underpinnings Of The U.S. Dollar Rising U.S. interest rate expectations will extend the U.S. dollar rally: The U.S. labor market is tight, and wage growth is accelerating (Chart I-11). This is what the Federal Reserve has been waiting for years, and the central bank will now gradually but steadily ramp up its hawkishness. This will push up U.S. interest rate expectations and prop up the dollar. The exchange rate appreciation will cool off the manufacturing sector at a time when the rest of the economy will be robust. In brief, a strong dollar will be needed to avoid overheating in the U.S. economy. While an overshoot in the dollar will certainly have a deflationary impact on the U.S. economy, especially its manufacturing sector, the negative impact will be somewhat offset because of potential trade protectionist measures introduced by the U.S. authorities. Remarkably, U.S. interest rates are still too low. In particular, 10-year TIPS yields are a mere 0.5%, and long-term bond yields are low relative to wage growth (Chart I-12). Chart I-11U.S. Labor Market Is Tight Chart I-12U.S. Bond Yields Are Low U.S. credit growth is strong and the real estate market is vibrant. There is no reason for U.S. interest rates to stay at emergency low levels that have prevailed since the Lehman crisis. Notably, potential fiscal stimulus from the incoming Trump administration warrants higher interest rates to avoid boom-bust cycles. The Fed will tighten policy sooner rather than later, as policymakers know that policy works with time lags and they will not wait for the economic impact of fiscal spending to works its way through the economy. We believe the 50 basis points hikes over the next 12 months currently priced into the U.S. fixed income market are too low, and interest rate expectations will climb by about 50 basis points in the months ahead. Finally, the U.S. dollar has not yet overshot. It is only modestly above its fair value, according to the real effective exchange rate based on unit labor costs. Typically, bull and bear markets do not end at fair value; financial markets tend to over- and under-shoot. We believe the U.S. dollar is primed to overshoot before this current bull run peters out. Bottom Line: Robust U.S. growth and tight labor market conditions put the U.S. in a unique global position to tolerate a stronger currency, for a while. We continue recommending short positions in a basket of the following EM currencies: KRW, IDR, MYR, TRY, ZAR, BRL, CLP and COP. We are also short the RMB via 12-month NDFs. China: Growth Revival And Hard Choices Ahead China's growth has revived, spurred by another round of credit and fiscal stimulus. However, BCA's Emerging Markets Strategy team maintains that the latest improvement in growth will prove unsustainable and vulnerabilities abound. In particular: Despite improving economic data, the Chinese equity indexes have fared extremely poorly. China's MSCI Investable index was essentially flat during 2016, and domestic A-shares were down 20% in the U.S. dollar terms. This compares with 9.5%, 5.7% and 8.5% gains in the S&P 500, global, and EM share prices in U.S. dollar terms, respectively, over the course of 2016. The relative performance of the Chinese MSCI Investable index to the global stock index has rolled over after failing to break above its technical resistance (Chart I-13, top panel). The same is true for share prices in absolute terms (Chart I-13, bottom panel). These chart profiles hint that Chinese stocks have failed to enter a bull market, and downside is material. How do we explain the divergence between weak Chinese share prices and the rally in commodities prices and commodities stocks globally? Chart I-14 demonstrates that apart from the 2014-'15 bubble run in Chinese equities, the latter's relative performance versus global stocks has been a good forward-looking indicator for industrial metals prices. Chart I-13Chinese Stocks Have ##br##Failed To Break Out Chart I-14Underperformance Of Chinese ##br##Stocks Bodes Ill For Commodities Based on this chart and our qualitative analysis, our bias is to argue that the poor performance of Chinese share prices signals lingering downside risks in Chinese growth, and an associated drop in commodities prices and commodities related equities. Besides, the rally in both oil and metals can largely be explained by investor buying rather than by the real economy demand exceeding supply. Chart I-15 shows that net long positions of non-commercial traders (investors) in oil and copper are overextended. In addition, OECD oil product inventories continue their unrelenting uptrend, suggesting that supply is still exceeding consumption (Chart I-16). Following property market restrictions, China's home purchases have dived (Chart I-17). This will depress construction activity, which will weigh on demand for industrial goods/equipment and commodities over course of 2017. Chart I-15Traders Are Very Long Oil And Copper Chart I-16Global Oil Inventories Continue Rising Chart I-17China: Home Sales Have Plummeted Onshore bond yields, including corporate bond yields, have spiked, and the PBoC has allowed the repo rate for non-bank financial organizations to rise. This will, at a minimum, dampen non-bank (shadow) credit growth. Given that non-bank credit (entrusted loan, trusted loan, bank acceptance bill and net corporate bond issuance) accounts for 30% of total outstanding claims on companies and households, a deceleration in non-bank (shadow) credit will have a non-trivial impact on growth. Finally, there are considerable geopolitical and political risks in and around China. Many investors have become sanguine about China-related political risks, assuming the authorities will guarantee growth remains robust going into the fall 2017 Party Congress, which will decide on the leadership transition. However, a drop in perceived China-linked risks could be a sign of the calm before the storm. First off, the Chinese government might strive for economic stability ahead of this fall's Party Congress, but political volatility ahead of that time cannot be ruled out. It is an open secret that President Xi Jinping's aggressive consolidation of power and "non-collegial" decision-making has created opposition within the Communist party. The opposition cannot wait past the Party Congress when President Xi further strengthens his grip on power. The opposition, if it is able, will likely attempt to strike preemptively in order to prevent a further consolidation of power by President Xi. While it is impossible to know details or forecast the dynamics of the Communist Party's internal discourse, investors should not be complacent. Second, China will retaliate in some form against U.S. trade protectionist measures. It is difficult to know how this trade standoff between the U.S. and China will unfold, but our sense is that risks are underpriced in global financial markets. U.S.-China trade disputes could evolve into broader geopolitical tensions in Asia. BCA's Geopolitical Strategy service has written about geopolitical risks in Asia at great length.4 In short, political and geopolitical risks abound in and around China. Remarkably, in recent years financial markets have been more preoccupied by political rather than economic developments. Examples include Brazil, Turkey, Malaysia, Russia, the Philippines, Mexico, and South Africa. In these countries, financial markets have been much more sensitive to political changes than economic fundamentals. This may be the case in China too. Growth could stay firm for a while, but the markets will sell off based on heightened political and geopolitical volatility and tensions. Apart from the above-mentioned downside risks, China's growth model is facing two major ways forward from a big-picture perspective: 1. Short-Term Pain / Long-Term Gain: If the authorities were to allow market forces to prevail, the state should withdraw meaningfully from the credit allocation process. In that case, credit markets will bring discipline to both debtors and creditors - in effect, an emerging perception of potential losses rather government-led bailouts will make creditors less willing to lend, and debtors less willing to borrow and expand. The result will be a considerable dampening in credit origination. In this scenario, it is very likely that credit growth slows from 12% currently to the level of potential nominal GDP growth of 7-8% or lower (Chart I-18), leading to a classic credit-driven economic downtrend (Chart I-19). In that case, cyclical growth will undershoot. Chart I-18China: Credit Is Outpacing GDP ##br##Growth By Wide Margin Capitalist-Style Credit-Driven Downtrend However, potential GDP growth (the red line in Chart I-19) - which has been falling in recent years - will stabilize and probably improve. The reason being that by allowing market forces to prevail in credit allocation and corporate restructuring/reorganization, China will ultimately improve its capital allocation and productivity. In brief, potential GDP growth - which equals productivity growth plus labor force growth - will stop falling and, in fact, could improve as productivity growth ameliorates. 2. No Short-Term Pain But Long-Term Stagnation: It is essential to differentiate cyclical growth drivers from structural ones. If the government does not allow credit growth to slow, cyclical growth will hold up. However, in this scenario, structural growth will tumble and China will embark on a path of economic stagnation. As we have argued in past reports,5 banks in any country can originate unlimited amounts of credit/money/deposits if and when the central bank accommodates them, and shareholders and regulators do not object. China has been following this model over the past several years. Yet, this model does not bring about lasting prosperity. On the contrary, it leads to economic stagnation. China would be no different in this scenario, though the growth deceleration would be gradual, as depicted in Chart I-20. Toward Socialism = Secular Stagnation A rising role of state and government officials in capital allocation and business decision-making guarantees suboptimal capital allocation, resulting in poor efficiency and declining productivity growth. Since China's labor force growth is projected to be flat-to-negative (Chart I-21), the sole source of potential GDP growth going forward will be productivity growth. If the authorities do not allow market forces to play a larger role in resource allocation, including credit, the former will contract. The bullish camp on China argues that the authorities have a firm grip and control over the economy, and that they will never allow it to slow by injecting an unlimited amount of credit and fiscal stimulus. While this may be true, policymakers can do that, it is not a reason to be bullish. Quite the opposite: it is a reason to be structurally bearish on Chinese growth. Unrelenting credit and fiscal stimulus, and a resurging role of government in resource allocation, corporate restructuring, and increasingly in business decision-making, means the economy is moving back toward its socialist bend. In socialist economies, productivity growth is weak or sometimes negative. China's success over the past 30 years was based on a move towards private enterprise, entrepreneurism, and transition toward a more market-based model, and not on government credit injections. As China refuses to give greater say to market forces, and state officials and bureaucrats gets even more involved in credit and resource allocation to prevent genuine deleveraging and bankruptcies, economic efficiency and productivity will suffer. If we assume China's productivity is now about 6% (which is already a very high number) (Chart I-22), and if the country embarks down this path, odds are that productivity growth might drop by 100 basis points in each of the following years. In five years or so, productivity growth would be only around 1%. Given that labor force growth will be zero, if not contracting, in five years' time, potential GDP will drop to 1% or so, as shown in Chart I-20 on page 14. Hence, this path is the ultimate recipe for economic stagnation in China. Chart I-21China: Labor Force Is Projected To Contract Chart I-22Socialist Put Will Depress Productivity Growth The only thing the authorities can do in this scenario is to boost growth from time to time via credit and fiscal stimulus. This will produce mini-recovery cycles around a falling primary growth trend. The latest acceleration in China's growth is probably the first mini-cycle. How can investors invest in this scenario? The mini-cycles depicted in Chart I-20 on page 14 look nice, because we drew them ourselves. In reality, they will not be symmetric or smooth. Besides, financial market swings for China-related plays will differ from the economy's growth mini-cycles because markets can be driven by factors other than growth like politics, geopolitics, credit events, and other global variables such as the U.S. dollar and bond yields. In short, this analysis explains why we have been and remain bearish on China-related financial markets despite the stimulus that has been injected about a year ago. Investing around economic mini-cycles is difficult because it assumes near-perfect timing. Without that, investors cannot make money. Bottom Line: China by and large has two potential roadmaps going forward: (1) Short-term pain / long-term gain and (2) growth stagnation with mini-cycles around it. Regardless of which scenario transpires - so far, the second scenario has been in effect - the medium-term outlook is negative. Given that we are already advanced in the mini-cycle, the risk-reward for China plays in financial markets is negative. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Report, titled "China's Money Creation Redux And The RMB," dated November 23, 2016, link available on page 19. 2 Please refer to the Emerging Markets Strategy Weekly Report, titled "EM: Overview Of External Debt," dated January 4, 2017, link available on page 19. 3 Please refer to the Emerging Markets Strategy Weekly Report, titled "Key EM Issues Going Into 2017," dated December 14, 2016, link available on page 19. 4 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 5 Please refer to the Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses," dated October 26, 2016, and Emerging Markets Strategy Special Report, titled "China's Money Creation Redux And The RMB," dated November 23, 2016, links available on page 19. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Will inflation return in Europe & Japan? Can Trumponomics successfully boost U.S. economic growth? Will global market volatility remain this low? Can China avert a crisis and still be the engine of global growth? Feature With a New Year now upon us, fixed income investors are trying to determine what the next move is for global bond yields after the rapid rise at the end of 2016. While much has been made of the impact of the 2016 U.S. election result on the global bond rout, many other important factors will drive fixed income markets this year (Chart of the Week). In our first Weekly Report of the New Year, we present our list of the most important questions for global bond markets in 2017. Chart 1The Big Questions For 2017 Chart 2Taper Tantrum 2.0? Will Inflation Return In Europe & Japan? Extremely low inflation in the Euro Area and Japan over the past few years has forced both the European Central Bank (ECB) and Bank of Japan (BoJ) to pursue exceptionally accommodative monetary policies like negative interest rates and large scale quantitative easing (QE) programs - the latter acting to depress bond term premia among the major developed markets. Much of this decline in headline inflation in both regions was due to the 2014/15 collapse in oil prices and the previous strength in both the euro and yen (Chart 2), but core inflation and wage growth have also been subdued. If headline inflation were to move higher in either Europe or Japan, it could call into question the central banks' commitment to continue hyper-easy monetary stimulus programs. This could raise the threat of another "taper tantrum" in developed bond markets later in 2017. The recovery in global energy prices in 2016, combined with significant currency depreciations related to ECB/BoJ QE, have boosted the annual growth in the local currency price of oil to 72% in the Euro Area and 63% in Japan. Already, headline inflation measures have begun to move higher in response and, judging by past relationships, a move up to 2% headline inflation in both regions by year-end is possible. In Chart 3 & Chart 4, we present simulations for headline inflation in both the Euro Area and Japan assuming the only changes come from movements in oil prices, the euro and the yen. We show two scenarios where the Brent oil price rises to $65/bbl (the high end of the range expected by our commodity strategists in 2017) and $75/bbl (an extreme scenario). In both simulations, the euro and yen continue to weaken versus the U.S. dollar until mid-2017 before recovering to near current levels by year-end. Chart 3Euro Area Inflation Simulation Chart 4Japan Inflation Simulation Our simulations show that headline inflation in both the Euro Area and Japan could rise to at least the 2% level, and perhaps even higher, if oil prices continue to climb and both the yen and Euro weaken towards 125 and parity versus the U.S. dollar, respectively. Given our views on the likely path of interest rates in the U.S. - higher, as the Fed continues hiking rates - the U.S. dollar is likely to strengthen more in 2017. The oil price moves incorporated in our simulations are somewhat more bullish than our base case expectation, but not extraordinarily so. If there are any upside surprises to global growth this year, oil prices could show surprising strength given the production cutbacks occurring in many of the major oil exporting nations. Higher inflation would be welcome by both the ECB and BoJ, especially if it were accompanied by a rise in inflation expectations. Both central banks have acknowledged the role played by low realized inflation in recent years in depressing expected inflation, but the latter could move up surprisingly fast if the markets believe that either central bank will be slow to respond to the rise in realized inflation. That seems like more of a risk in Japan, where the BoJ is aiming for an overshoot of its 2% inflation target and is promising to keep the Japanese government bond (JGB) curve at current levels until that point is reached. The ECB would be much more likely to make the decision to begin tapering their bond purchases if Euro Area inflation approaches 2%. We see this as the biggest potential threat to global bond markets in 2017 - even more than the expected Fed rate hikes, which are already largely priced into the U.S. yield curve. The ECB was able to successfully kick the tapering can down the road last month by choosing to extend its QE program to the end of 2017, but a decision to defer tapering again will be much harder to make if Euro Area inflation is closer to 2%. If the ECB were to announce a taper later in 2017, this would be very damaging for the long ends of yield curves in the developed markets as bond term premia would begin to normalize - perhaps very rapidly. There is more room for adjustment for term premia in core Euro Area government bonds relative to U.S. Treasuries. An ECB taper announcement, or even just expectations of it, would mark the peak in the spread between U.S. Treasuries and German Bunds which is now at the highest levels in a quarter century. Given the busy upcoming election calendar in the Euro Area, the ECB will not want to even mention the word "taper" until later in the year. Until then, owning inflation protection in Europe, and Japan as well, is the best way to position for upside surprises in inflation in those regions. Bottom Line: Rising inflation in the Euro Area and Japan in 2017 will prompt a rethink of the hyper-easy monetary policies of both the ECB and BoJ, but only the former is likely to consider a taper of its bond purchase program this year. That decision would push global bond yields higher via wider term premia and cause Euro Area government bond markets to underperform U.S. Treasuries, but not until later in the year. Can Trumponomics Successfully Boost U.S. Economic Growth? After a long and divisive U.S. election campaign, the curtain is about to officially be raised on the Trump era on January 20. In anticipation of a more pro-growth agenda from the new president, investors have already bid up the valuations of assets sensitive to U.S. economic growth, like equities and corporate bonds, while also driving up both U.S. Treasury yields and the U.S. dollar. Chart 5Time To Spruce Up U.S. Infrastructure Markets are now discounting a fairly rosy scenario for a solid "Trump bump" to U.S. economic growth in 2017. This is to be expected, given that the president-elect won the White House on a platform full of promises to, among other things, boost government infrastructure spending, cut corporate taxes, tear down excess regulations on U.S. companies and adopt a more protectionist U.S. trade policy. In terms of a direct impact to U.S. GDP growth, there are three obvious places where the economic plan of Candidate Trump could turn into stronger growth this year for President Trump: government fixed investment, net exports and private capital expenditure. Trump's infrastructure plans have received much of the attention from those bullish on U.S. growth in 2017; unsurprising given the proposed size of the proposals ($550 billion). This stimulus would appear to be a source of low-hanging fruit to boost U.S. economic growth, as years of underinvestment has left America with an aging government infrastructure in need of an upgrade (Chart 5). Yet the boost to growth from government investment spending has historically not been large, adding between 0.25% and 0.5%, at most, over the past 40 years (bottom panel). Trump's proposed figure of $550 billion would fit right in with that experience, as it would represent 0.3% of the current $18.6 trillion U.S. economy. That assumes that all the proposed infrastructure spending occurs in a single year. Given the usual long lead times for big government infrastructure projects, and the discussions between the White House and the U.S. Congress over the scope and funding of any major government spending initiative, it is highly unlikely that the direct effect of more infrastructure spending will provide much of a boost to U.S. growth in 2017. That impact is more likely to be seen in 2018. A boost to growth from trade is also possible given Trump's fiery protectionist election rhetoric and his decision to nominate China hawks for major cabinet positions. It is unclear if Trump is willing to risk entering a trade war with China (or even Mexico) by raising import tariffs soon after taking office. It is even more uncertain if this will provide much of an immediate lift to U.S. net exports, if tariffs merely raise the cost of imports without any material substitution to domestically produced goods and services. Even if it did, trade has rarely contributed positively to real U.S. GDP growth outside of recessions since 1960. That leaves private fixed investment as the biggest potential source of new growth in the U.S. in 2017. Trump is proposing a cut in the U.S. corporate tax rate from 35% to 15%, while the Republican plan already set out by House Speaker Paul Ryan is calling for a cut to 25%. Both sides also are in favor of a lower "repatriation tax" on corporate profits held abroad, at a rate of 10-15%. So with all parts of the U.S. government in agreement, a move to cut corporate taxes appears to be a near certainty. In the past, efforts to initiate comprehensive tax reform have been not been done quickly in Washington. Our colleagues at BCA Geopolitical Strategy, however, believe that a deal between the White House and Congress could happen in the first half of 2017. The details of the other major policy initiatives that Trump wants done early in his first term - repealing and replacing Obamacare, and the infrastructure spending program - will be much harder to iron out than a tax cut on which both Trump and the Republican Congress agree. Doing the tax reform first will be the easier choice for a new president.1 Cutting corporate taxes seems like a move that should help boost U.S. private investment spending, as it would raise the after-tax return on capital. However, investment spending has already been underperforming relative to after-tax cash flows since the 2008 Financial Crisis, and the effective tax rate paid by the U.S. corporate sector is already much lower than the 35% marginal tax rate (Chart 6). Something else besides tax levels has been weighing on U.S. corporate sentiment with regards to capital spending intentions. It may be that the burden of excess government regulations, which has soared during the years of the Obama administration (bottom panel), has dampened animal spirits in the U.S. corporate sector. On that front, Trump's proposals to slash regulations - none bigger than repealing Obamacare - could help boost business confidence and fuel an upturn in capital spending. Chart 6A Regulatory Burden, Not A Tax Burden Chart 7Making Corporate America Happy Again Some rebound in capex was likely to occur, Trump or no Trump, given the recent improvement in U.S. corporate profits (Chart 7, top panel). This is especially true in the Energy sector which generated the biggest drag on U.S. corporate investment spending after the collapse in oil prices in 2014/15. Since the election, however, there has been a noticeable improvement in confidence within the "C-suite" for American companies. The Duke University/CFO Magazine measure of optimism on the U.S. economy hit the highest level in over a decade (middle panel), while the Conference Board index of CEO optimism soared to the highest level in three years, at the end of 2016. Executive confidence at those levels would be consistent with a pace of capital spending that could add up to 1 full percentage point to U.S. real GDP growth, based on past relationships - (bottom panel). For both of these surveys, executives cited a more positive outlook on future growth after the U.S. election as a major reason for the increase in optimism. In sum, the biggest potential lift to U.S. economic growth in 2017 from Trumponomics will come from business investment and not government spending or exports, and likely by enough to boost overall U.S. GDP growth to an above-trend pace that will prompt the Fed to deliver at least 2-3 rate hikes by year-end. Bottom Line: A major boost to U.S. economic growth from government investment spending and net exports is unlikely in 2017. A pickup in corporate investment, however, seems far more likely given the boost to longer-term business confidence seen after the U.S. elections, coming at a time of improving global economic growth. Will Market Volatility Stay This Low? Given all the uncertainties over the latter half of 2016, from Brexit to Trump to Italy, it is surprising how low market volatility has been. Measures of implied volatility like the VIX index for U.S. equities have remained incredibly subdued, while even the uptick in MOVE index has been relatively modest considering the year-end carnage in the Treasury market (Chart 8). The fact that global risk assets can remain so relatively well-behaved, even after a surprising U.S election result and a Fed rate hike that has boosted the U.S. dollar, is a sign that the "Fed Policy Loop" - where a more hawkish U.S. monetary stance causes an unwanted surge in the U.S. dollar and a selloff in equity and credit markets - has been broken. As we discussed in our 2017 Outlook report, the Fed Policy Loop framework would not apply in an environment where non-U.S. economic growth was improving, as is the currently the case.2 This may be the most obvious explanation for why market volatilities are low, with developed market equities hitting cyclical highs and corporate credit spreads staying at cyclical lows. In other words, volatility is low because growth is accelerating and global central banks (most notably, the Fed) are not slamming on the brakes. Chart 8The Death Of The Fed Policy Loop? Chart 9U.S. Dollar Strength Will Persist In 2017 The strength of the U.S. dollar has been a function of the widening real interest rate differential between the U.S. and the rest of the world (Chart 9), which is likely to continue this year as the Fed delivers a few more rate hikes while U.S. inflation grinds slowly higher. We do not expect the Fed to be forced to shift to a more aggressive pace of tightening than currently implied by the FOMC forecasts. On the margin, this will help keep market volatility at subdued levels. A predictable Fed slowly tightening into an improving economy is not overly problematic for financial markets. That logic would be turned upside down if non-U.S. growth were to begin to slow sharply (not our base case) or if there were some non-U.S. source of uncertainty that could make markets jittery. Last year, political surprises ended up being the biggest shock for financial markets. Given the busy upcoming election schedule in Europe (Table 1), there is concern that a similar story could play out in 2017. Table 1Europe In 2017 Will Be A Headline Risk The shock of Brexit and Trump have investors asking "where will the next populist uprising be?" France seems like the most obvious possibility, with the well-known right-wing (and anti-EU) populist Marine Le Pen running in this year's presidential election. French government debt has already priced in some modestly higher risk premium in recent months (Chart 10). Even in the bastion of stability, Germany, the rise of anti-immigration parties has some forecasting a difficult re-election campaign for Chancellor Angela Merkel later in the year. Our geopolitical strategists have long argued that there is not enough support for populist, anti-EU, anti-immigration parties in either Germany, France or the Netherlands (who also have an election this year) to win an election.3 The recent polling data strongly supports that view, with Le Pen's popularity on the decline for the past three years and with Merkel's popularity holding steady over the past year (Chart 11) - even as horrific terror incidents committed by "foreigners" have occurred on both French and German soil. Chart 10Not Worried About European Populism... Chart 11...For Good Reasons BCA's Chief Geopolitical Strategist, Marko Papic, believes that Italy remains the greatest political risk in Europe in 2017, with elections possible as early as the spring. With the Senate reforms defeated in the December referendum, the country needs to re-write its already complicated electoral laws. This will likely take time, pushing the potential election date to late spring or early summer. If an early election is not called, a new vote must be held by the expiry of the government's mandate in May 2018. Chart 12Italy Is The Biggest Political Risk In Europ Chart 13A Managed Renminbi Depreciation Given the lower support for the euro in Italy than the rest of the Euro Area (Chart 12), and given the strong showing in the polls for the anti-establishment, anti-EU Five Star Movement led by Beppe Grillo, an early Italian election could be the biggest potential political shock for markets in 2017. This likely will not be enough to cause a major flare-up of global market volatility, but it does suggest that investors should remain underweight Italian government debt. Bottom Line: Improving global growth will continue to support low market volatility during 2017, even with the Fed remaining in a tightening cycle. European political risk should not be a Brexit/Trump-type source of concern for investors outside of Italy. Can China Avert A Crisis And Still Be The Engine Of Global Growth? This is a question that we may be asking every year for the next decade, given China's high debt levels and decelerating potential economic growth. Periodic episodes of uncertainty over Chinese currency policy are always a threat to trigger capital outflows, as has occurred over the past year and half (Chart 13). The Chinese authorities have chosen to allow currency depreciation versus the U.S. dollar to help manage the pace of that outflow, particularly during the past year when interest rate differentials have moved in a more dollar-positive direction. With over US$3 trillion in foreign exchange reserves at the government's disposal, the odds remain low that a true economic crisis can unfold in China. Additional renminbi weakness versus the U.S. dollar is likely in 2017, but the recent actions to sharply raise offshore renminbi interest rates is an indication that Chinese authorities will not tolerate a rapidly weakening currency. The incoming Trump administration is obviously an unforecastable wild card here, and China could respond to a new trade war with the U.S. by allowing a more rapid pace of currency weakness versus the dollar. Having said that - if China-U.S. relations don't boil over, then the underlying story for China will be one of improving economic growth in 2017. The underlying growth indicators in our "China Checklist" unveiled late last year (Table 2) continue to improve (Chart 14), and we continue to see China as being a positive contributor to the global economic cycle in 2017 (Donald Trump and his band of China hawks notwithstanding). This is important, as the global upturn seen in 2016 began in China early in the year. This fed through into many other countries either directly via exports to China or indirectly through an improvement in the pricing power for commodity exporters that benefitted from faster Chinese demand. Table 2The GFIS China Checklist Chart 14Chinese Growth Still Improving Bottom Line: China will likely remain a positive driver of the global economic upturn in 2017, with the biggest risk coming from increased tensions with the incoming Trump administration, not accelerating domestic capital outflows. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency", dated November 20th 2016, available at gps.bcaresearch.com 2 Please see BCA Global Fixed Income Strategy Special Report, "How To Think About Global Bond Investing In 2017", dated December 20th 2016, available at gfis.bcarsearch.com 3 Please see BCA Geopolitical Strategy Strategic Outlook 2017, "5 Themes For 2017", dated December 2016, available at gps.bcaresearch.com Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The economy is near full employment, but betting on significant inflation is premature. Market-based inflation expectations have risen substantially in recent weeks but these moves are not corroborated by survey measures of inflation expectations. Consumer inflation expectations are very well anchored due to ongoing deflation in many frequently purchased goods and services. We are on high alert for a near-term equity pullback, with Chinese liquidity tightening as a potential catalyst. Feature Chart 1Market-Based Inflation ##br##Expectations Breaking Out After years of focusing on deflation, the possibility of inflation has made a comeback on investors' radars. The shift makes sense, given that the labor market is now operating near full employment. The December payroll report showed that payrolls increased by 156,000, slightly lower than the 3-month average of 165,000. But, average hourly earnings increased by 0.4%, suggesting that slightly weaker employment growth is not due to sluggish demand, and reflects a smaller available pool of workers. However, as we explain below, the potential for a major inflation surge is low in 2017 and is premature as an investment theme. We are on high alert for a near-term pullback to the equity bull market, given that valuation and sentiment are stretched. But as we outline, the threat to the equity market is less likely to be domestic inflation than an external event, such as the fallout from tightening liquidity in China (similar to what occurred in mid-2015 and early 2016). In the past few weeks, one-year inflation expectations have moved to their highest level since mid-2014, when oil prices were above $110/bbl. Long-run inflation expectations have also spiked since the U.S. election (Chart 1). The extent to which this trend is judged sustainable, and provides an accurate forecast for general inflation, has important investment implications. Our view is that, although TIPS could move a bit higher, the market move should not be interpreted as a harbinger for a broad-based inflation acceleration. Policymakers consider a range of inflation expectations measures, but in recent years, market-based measures have garnered a lot of attention. The 5-year/5-year forward TIPS breakeven rate in particular is often viewed as the market's assessment of whether the Fed can successfully achieve its inflation target. According to the Minutes of the December FOMC meeting, the recent rise in market-based inflation expectations was discussed at length. On this basis, the rise in TIPS is important as it could have a significant role in setting monetary policy. Beyond that, we have argued for some time that a major challenge for firms this cycle will be to raise selling prices, i.e. a lack of pricing power will restrain profit margins and, ultimately, earnings growth. If the recent pick-up in market-based inflation expectations heralds a more robust rise in actual inflation, then profits could positively surprise this year. The Rise In TIPS Is Partially Energy-Driven... Since 2010, there has been a strong correlation between oil prices and TIPS (Chart 2). The correlation has somewhat confounded policymakers.1 In theory, any oil price shock, even if it is considered to be permanent, should not exert any lasting impact on long-dated forward measures of inflation expectations. The reason is that as long as the Fed is committed to its 2% inflation target, then the market should expect that monetary policy will prevent a one-time shock to oil prices from having any permanent effect on the overall inflation rate. This is why, in theory, the 5-year/5-year forward TIPS breakeven rate is a good indicator for policymakers. Chart 2Oil Prices And Breakevens As our fixed income team explained in a report last year,2 the main reason for the tight correlation between TIPS and oil prices stems from the market perception that monetary policy has been constrained. Prior to the financial crisis, oil prices rose from below $40 in 2003 to $140 in 2008. During that time, long-dated breakevens remained stable. One possible explanation for this lack of correlation is that the Fed tightened policy during this period, offsetting the inflationary impact from higher oil prices. But in 2015-2016, when oil prices fell from above $100 to below $40, breakevens plunged alongside. If the market perceives monetary policy to be constrained by the zero lower bound, then it could be the case that the cost of inflation compensation is highly sensitive to falling oil prices because the market perceives that the Fed has no ability to offset the deflationary shock. In other words, the 5-year/5-year TIPS breakeven rate has fallen because the zero lower bound is challenging the credibility of the Fed's inflation target. Our U.S. fixed income team forecasted that breakevens will head higher once oil prices move up and that the correlation between oil prices and breakevens will eventually weaken as the fed funds rate moves further away from the zero lower bound. The bottom line is that TIPS are most likely being unduly affected by energy price movements. ..And Only Thinly Corroborated By Alternative Inflation Indicators Despite our bias that the recent moves in market-based inflation expectations are exaggerated, TIPS are not the only gauge sending a more inflationary signal. This week's ISM manufacturing and non-manufacturing surveys both reported an uptick in prices paid (Chart 3). According to the manufacturing survey, 18 out of 21 recorded inputs were up in price over the past month. However, the bulk of these are commodities that have gone up in price alongside other financial market prices, and it is not clear the extent that the price rise is physical demand-driven, or financial demand-driven. In the non-manufacturing survey, the price rise was not quite as broad-based, but is nonetheless suggestive of upward price pressure. The NFIB small business survey also hinted at higher prices, although much more modestly than the ISM surveys (Chart 3). The Atlanta Fed's Business Inflation Expectations Survey has not broken out of the range that has held since 2011. There was no change in inflation expectations from the most recent survey of professional forecasters. Meanwhile, as we noted last week, consumers are not at all worried about inflation. In fact, according to the Conference Board survey, consumer inflation expectations are at a new cyclical low! At least part of the reason that consumers do not expect more inflation is likely due to their experience with frequently-purchased items. Table 1 shows inflation rates for selected high-frequency spending items, which account for about 30% of the total CPI basket. The table makes it easy to understand why perceptions about inflation are low: almost half of the items in the table are in deflation and only two are above the Fed's target of 2%. It may not matter that a good or service accounts for a small share of spending: if its price is going up/down at a steady pace, then there will be an impact on perceptions about inflation. Currently, very low or negative rates of inflation among frequently purchased items are likely pulling down consumers' perceptions of broad-based inflation. In this sense, one could argue that inflation expectations are very well-anchored. Chart 3Survey-Based Inflation ##br##Expectations More Mixed Table 1Inflation Rates For Selected ##br## High-Frequency Spending Items Actual Inflation Will Stay Subdued In 2017... Chart 4Only Mild Uptrend Likely In 2017 For many years, we have deconstructed core CPI and core PCE into their three major components to better understand and forecast the trend in consumer price inflation (Chart 4). Performing this exercise today continues to give a fairly benign forecast for inflation. Shelter, the largest component of core CPI, is mostly determined by rental vacancies which appear to be stabilizing just as market rents are rolling over. Our model suggests that shelter will not drive inflation higher in 2017. Core goods inflation (25% of core CPI) will also remain very low and possibly stay in deflationary territory. This component of inflation is most tightly correlated with the trade-weighted dollar (Chart 4, panel 3), and so will stay depressed as long as the bull market in the dollar remains intact. Wage growth is most tightly correlated with service sector inflation excluding shelter and medical care (Chart 4, bottom panel). This component, which accounts for 25% of core CPI, is the most likely source of inflation pressure now that wages are beginning to rise. But as we wrote in a Special Report on November 28, 2016, any wage inflation and pass-through is likely to be very gradual based on several structural headwinds at play this cycle. All in all, core PCE may converge on the Fed's target of 2% in the second half of 2017, but an inflation overshoot should not be a major driver of investment decision-making over the next six - twelve months. ...And Don't Blame Government Spending For Higher Inflation When It Does Come One missing ingredient from the above analysis is the likelihood that the political environment will become inflationary. This subject has been thoroughly covered by the financial press. Our own view has been that upcoming policies may not turn out to be particularly inflationary, at least not this year. For example, Trump's fiscal package may not boost aggregate demand by as much as the more optimistic estimates suggest. There simply are not enough marquee "shovel-ready" projects around that can make use of the public-private partnership structure that Trump's plan envisions in 2017. As for proposed personal tax cuts, the impact is likely to be modest, given that the benefits are tilted towards higher income groups that tend to save much of their earnings. Likewise, corporate tax cuts will have only an incremental effect on business capex, given that many companies are already flush with cash and effective tax rates are well below statutory levels. Our benign view about the impact of government spending on inflation is shared by researchers at the St Louis Federal Reserve. In a recent paper,3 researchers looked at periods when the central bank was not working to offset the potentially inflationary effects of fiscal policy, e.g. between 1959 and 1979, when the Fed followed a policy in which it accommodated increases in inflation. They found almost no effect of government spending on inflation. For example, a 10 percent increase in government spending during that period led to an 8 basis point decline in inflation. Note that this period covers years of when the economy was operating at full employment and below. As the researchers point out, this does not imply that countercyclical government spending is ineffective at boosting output, but it simply demonstrates that empirical evidence of inflation related to government spending is thin. The bottom line is that we view the likelihood of significant inflation pressure as low in 2017. The implication is that under this scenario, the Fed can afford to adjust their "dots" gradually, diminishing the risk for stocks and bonds of an aggressive adjustment to the policy backdrop. Equity Correction: Will China Be A Contributing Factor? Chart 5Is China Liquidity Tightening##br## A Repeat Threat To U.S. Equities? Over the past few weeks, we have argued that the odds of a meaningful equity correction are running high, given the aggressive rise in bond yields and exaggerated move in sentiment relative to only minor upside surprises in economic and earnings growth. We are still on high alert for this outcome and believe that one possible trigger is tighter liquidity conditions in China, which are aimed at supporting the renminbi. Indeed, just like the start of 2016, the Chinese renminbi is kicking off 2017 on a weak note. Chinese policymakers are again tightening rules to limit capital outflows: earlier this week, they adjusted the FX basket used to set the CNY's official daily fix. The new FX basket will include 24 currencies (up from 13). Consequently, the weight of the U.S. dollar drops from 26.4% to 22.4%. This will make it easier for the authorities to target a relatively stable renminbi versus the basket even as USD/CNY pushes higher. These attempts to support the renminbi is leading to tighter liquidity conditions and higher interbank interest rates. In Hong Kong, 3-month CNH Hibor has spiked to 10%. In the past, a combination of a weaker renminbi and rising interbank rates has spelled trouble for U.S. and global equities (Chart 5). There is no guarantee that history will repeat itself and one big difference with the sharp market sell-offs in mid-2015 and early 2016 is that the Chinese economy is not as weak as it was then. The PMIs released this week were generally firm. Overall, we are positive on equities and negative on bonds on a 12-month horizon but still see the risk of a correction to the Trump trade as elevated. Thus, investors should continue to stick close to benchmark tactically, looking to implement positions after a pullback in stock prices. Like in 2015 and early 2016, China could provide the trigger to that pullback if the authorities give up on capital controls and allow a sharp depreciation of the RMB. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 https://www.stlouisfed.org/~/media/Files/PDFs/Bullard/remarks/Bullard-N… 2 Please see U.S. Bond Strategy Weekly Report "A Tale Of Two Rallies", dated March 29, 2016, available at usbs.bcaresearch.com 3 https://www.stlouisfed.org/on-the-economy/2016/may/how-does-government-…

Special Report

Feature China's corporate debt problem has been widely perceived as an alarming systemic risk - not only to China but also to the rest of the world. This has prompted a deep concern within the investment community, and has also become a major consideration in China's policy setting in recent years. This grand judgement, however, is almost entirely derived from observing the rapid increase in China's debt-to-GDP ratio. In our previous reports, we discussed various reasons behind China's rising debt-to-GDP ratio, with focus on looking beyond this widely scrutinized conventional indicator in search of the true leverage situation.1 This week, we further explore this path with bottom-up data-mining by looking at key leverage ratios of listed companies. Our latest findings confirm our previous conclusions that the Chinese corporate sector leverage situation is not as precarious as widely perceived both historically and in a global context. A "Bottom-Up" Glance From a bottom-up perspective, we gathered several key ratios to examine the leverage situation of Chinese-listed companies in comparison to their global peers. The ratios are broadly grouped into two categories to check leverage ratios and debt servicing capacity, respectively (Please refer to Appendix 1 for description of the ratios and indexes we used in our calculation). Leverage ratios include liability-to-assets, calculated as total liabilities to total assets and total debt-to-assets, which only includes interest-bearing debt on a company's balance sheet. Moreover, we also look at the cash-to-asset ratio to evaluate the "net debt" situation. Debt servicing ratios include net debt-to-EBITDA and interest coverage ratio, which is defined as EBITDA divided by interest expenses. A higher net debt-to-EBITDA ratio means higher debt obligations relative to profits, and is therefore an indication of more financial stress. Similarly, a lower interest coverage ratio implies more difficulties in honoring interest payment obligations, let alone principal, and is therefore an indication of higher vulnerability to default. Leverage Ratios Chinese-listed companies' median liability-to-asset ratio has increased marginally, from 55% prior to the global financial crisis to about 60% currently (Chart 1). This is roughly comparable to the ratio calculated by using the top-down data provided by the Chinese National Bureau of Statistics (NBS).2 Measuring only interest-bearing debt, the median debt-to-asset ratio is about 25%, rising in recent years but largely comparable to pre-crisis levels. Moreover, companies' holdings of cash and short-term investments make up 15% of total assets. As a result, the net debt-to-asset ratio is a mere 12%, according to our calculations. In all leverage ratios, the ones of Chinese firms do not look exceptionally high compared with other major markets (Chart 2). In fact, the Chinese ratios sit almost exactly in the middle of a global comparison (Please refer to Appendix 2 on page 8 for detailed historical data of other countries). Chinese companies' cash holdings appear high compared with other countries, ranking the second highest in our sample. This is probably because Chinese companies' access to bank loans or the commercial paper market is not as easy or reliable as in other countries where financial markets are more developed. Chinese regulators frequently change policies on bank loans, making companies' access to bank loans and other credit instruments unpredictable. Therefore, Chinese companies may have been forced to hoard large sums of cash to meet working capital needs. This is obviously suboptimal and inefficient, but also gives the corporate sector more flexibility in dealing with debt. Chart 1Chinese Leverage Ratios Chart 2Leverage Ratios In Global Context Net Debt-To-EBITDA Ratio The net debt-to-EBITDA ratio measures a company's debt obligations to its income-generating ability. Chinese firms' net debt-to-EBITDA ratio has increased in the past five years, which means their debt servicing capacity has indeed deteriorated (Chart 3, to panel). Moreover, with a median ratio of 1 and an average of 2, the ratio implies that larger firms, likely state-controlled in asset-heavy industries, have a more challenging debt-servicing problem, which is consistent with anecdotal evidence. Nonetheless, Chinese firms' net debt-to-EBITDA does not appear high compared with other markets (Chart 4 top panel). In fact, the median of Chinese firms' net debt-to-EBITDA ratio is among the lowest, according to our calculation. Conventional wisdom holds that a net debt-to-EBITDA ratio higher than 4 or 5 normally raises a red flag in terms of debt servicing issues. Using this measure, the debt situation of Chinese firms has indeed deteriorated significantly. Currently, about 30% of Chinese-listed companies have a net debt-to-EBITDA of higher than 4, up from 15% before the crisis (Chart 3, bottom panel). Nonetheless, similar deterioration has also been observed in almost all of our sample markets. The bottom panel of Chart 4 shows a similar percentage of firms in other countries with a net debt-to-EBITDA ratio over the threshold of 4. Chart 3Chinese Net Debt-To-EBITDA##br## Has Deteriorated... Chart 4...But Not Exceptional ##br## In Global Context Interest Coverage Ratio Interest Coverage ratio measures EBITDA relative to interest expenses, and therefore a lower reading indicates a greater probability of default and insolvency. The median interest coverage ratio of Chinese-listed companies has dropped from a peak of over 10 to about 6 in recent years, while the average has dropped even further - from 6 to 4 - both of which underscore a notable deterioration in debt servicing capacity (Chart 5, top panel). Similarly, the gap between the average and median interest coverage ratios of Chinese firms suggests that larger firms tend to have a worse debt situation than smaller ones. Chinese firms' interest coverage ratio is also right in the middle in our global comparison (Chart 6, top panel). Moreover, a key factor to consider is interest rates in these countries, as lower interest rates certainly help improve interest coverage, and vice versa. It is therefore not surprising that Japan, with its near-zero interest rates, has the higher interest coverage ratio, and Brazil the lowest. Companies with an EBITDA lower than interest expenses certainly are much more prone to default, and are sometimes regarded as "zombie" firms. Currently, over 6% of Chinese firms cannot cover interest expenses with current-year EBITDA, roughly unchanged in the past decade (Chart 5, bottom panel). Other markets also have a similar share "zombie" firms with an interest coverage ratio lower than 1, implying that Chinese firms do not look exceptional in a global context (Chart 6, bottom panel). Chart 5Chinese Interest Coverage Ratio ##br##Has Also Deteriorated... Chart 6...But Does Not Stand Out ##br##In Global Comparison Summary And Conclusions We remain skeptical about the widely held consensus that China's corporate sector leverage is dangerously high. At minimum, we believe it is inaccurate to solely rely on the debt-to-GDP ratio to reach such a crucial conclusion. Our extensive data exercise, both from the top down and the bottom up, suggest that China's leverage situation is comparable if not superior to its global peers. There are indeed signs of deterioration in leverage ratios and debt servicing capacity in recent years among Chinese firms, but the growth slowdown is at least partially to blame, as similar deterioration is also visible in other countries.3 From policymakers' point of view, boosting aggregate demand, lowering the cost of funding and improving operational efficiency should all be part of the solution to address the debt sustainability issue. From investors' perspective, we hold the view that Chinese equities, particularly H shares, have been unduly punished by macro concerns on corporate debt, and will be re-rated as this misperception unwinds. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com Sheng Kong, Research Assistant shengk@bcaresearch.com 1 Please see China Investment Strategy Special Reports, "Chinese Deleveraging? What Deleveraging!" dated June 15, 2016, and "Rethinking Chinese Leverage," dated October 27, 2016, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Special Report, "Rethinking Chinese Leverage," dated October 27, 2016, available at cis.bcaresearch.com. 3 A detailed study on U.S. corporate leverage situation was also conducted by BCA U.S. group. Please refer to "U.S. Corporate Health Gets A Failing Grade" dated January 28, 2016 published by The Bank Credit Analyst, available at bca.bcaresearch.com. Appendix 1 Table 1Indexes Used In Cross-Country Comparison Table 2Leverage Ratios Appendix 2 Chart 7 Chart 8 Chart 9 Chart 10 Chart 11 Chart 12 Chart 13 Chart 14 Chart 15 Chart 16 Chart 17 Chart 18 Chart 19 Chart 20 Chart 21 Chart 22 Cyclical Investment Stance Equity Sector Recommendations

Dear Client, We are pleased to present our 2017 Outlook for Grains & Softs, covering corn, wheat, soybeans and rice in the grain markets, and cotton and sugar. This is our last regular Weekly Report for the year. You should have received BCA's annual "Mr. X" interview on December 20, and we trust you found it stimulating and insightful. We will resume regular publishing on January 5th with our annual Review and Outlook summarizing the performance of our market recommendations for 2016, with an eye on where we see value going into the New Year. As a preview, the average return on our recommendations this year was 33.1%, led by our Energy recommendations, which were up an average 95.1% in 2016. Please see page 15 of this week's report for a summary. The Commodity & Energy Strategy team wishes you and yours a wonderful holiday season and a prosperous New Year. Turning to the Ags, we believe there is a limited downside for grain prices in 2017. The downtrend since August 2012 may form a bottom next year under the assumption of normal weather conditions. However, the principal upside risk remains unfavorable weather in major grain-producing countries, which could send badly battered grain prices surging as they did in 2016H1. Among grains, we favor wheat and rice over corn and soybeans. Global soybean acreage is likely to expand as the crop provides higher returns than other grains. South American corn output will continue rising on favorable policies and weak currencies, adding further pressure to already-high U.S. corn inventories. Softs - cotton and sugar - likely will underperform grains in 2017, reversing their outperformance this year. We are tactically bearish cotton, as U.S. cotton acreage is likely to increase next spring. Strategically, we are neutral cotton. For the global sugar market, barring extremely unfavorable weather, we are tactically and strategically bearish. This year's extreme rally in prices may result in a small supply surplus in 2017. Our Ag strategies will continue to focus on relative-value investments. We have three investment strategies: We look to go long wheat versus cotton, long corn versus sugar, and long rice versus soybeans. Kindest regards, Robert P. Ryan, Senior Vice President Chart 1Ag In 2017: A Reversal Of Grain ##br##Underperformance? Feature Limited Downside For Grains; Softs ... Not So Much As of December 20, the CCI grain index had declined 0.3% since the beginning of this year. In comparison, sugar and cotton prices rallied 19.8% and 9.6% during the same period of time, respectively. For individual grains, soybean prices were up 15.4%, while corn, wheat and rice declined 2.4%, 14.2% and 18.2%, respectively. Cotton and sugar outperformed grains considerably this year (Chart 1, panel 1). Among grains, soybeans had the best run, while wheat and rice had the worst (Chart 1, panel 2). Going forward, the question is: Will these trends continue into 2017, or is a reversal likely to occur? For now, we cannot rule out the possibility of a continuation of these trends, but a reversal is possible, depending on weather conditions. We will tread water carefully and re-evaluate our calls next April when U.S. farmers' planting decisions are made, and the outlook for the South American soybean and sugar harvests become clearer. Grains In 2017: Likely Bottoming With Potential Upside We believe there is limited downside for grain prices in 2017. Four consecutive years of supply surpluses have driven grain prices down by more than 50% since August 2012, when grain prices reached all-time highs (Chart 2, panels 1 and 2). In the meantime, global grain inventories also rose to their highest levels since 2002 (Chart 2, panel 3). True, it is difficult to get bullish on such elevated inventories. Another year of supply surpluses obviously would send prices lower. Will that happen? No doubt, it could. But we believe the odds are fairly low. A Dissection Of This Year's Supply Increase Global grain output grew 5.2% this year, the second highest rate of growth since 2005. Yield growth, mainly due to extremely favorable weather, contributed 87% of the supply increase, while acreage expansion accounted for the rest (Chart 3, panels 1 and 2). Chart 2Grain: Too Much Supply In 2016... Chart 3...Less Supply in 2017? Now, with yields of corn, soybeans and wheat all at record highs, and rice yields near their record highs, grain yields are more likely to have a pullback than a continuation of growth in 2017. If global grain yields revert to their trend line as the third panel of Chart 3 suggests, global grain yields will decline 1.4% in 2017. This year, the world aggregate harvested grain acreage only grew 0.7%. Currently low grain prices are discouraging grain plantings, while new supportive policies in Argentina and a strengthening dollar are likely to encourage grain sowing in the southern hemisphere. Taking all related factors into account, we expect a 0.2 - 0.5% expansion in global grain acreage next year. Based on our analysis, we believe world grain output is likely to decline about 1% next year, assuming normal weather conditions. On the other side of the ledger, global grain demand has been growing steadily over the past 30 years (Chart 3, panel 4). Last year demand grew 3.4%. In 2017, low prices likely will boost consumption. Therefore, we expect similar growth in global grain demand next year. In the current crop year, the global grain market has a supply surplus of 55 million metric tons (mmt). Based on our calculations, given the assumptions we've outlined above, a 1% decline in global grain output coupled with 3.4% growth in global grain demand will swing the grain market into a supply deficit of 58 mmt. If we assume a more conservative scenario in which global grain output does not decline at all, a 2.2% rate of growth in global consumption still will send the global grain market into a supply deficit. The odds of seeing this scenario unfold are relatively high, given that the average growth in global grain consumption was 2.5% over the past 10 years, and 2.9% over the past four years, when grain prices were mired in a downtrend. We believe this would clearly be positive to global grain prices. Considering the elevated global grain inventories and the expected supply deficit we foresee, we believe, even if prices do not move to the upside, the downside for grain prices should be at least limited in 2017 as inventories are drawn down. In addition to the supply deficit, rising oil prices are supportive to grain prices as well. All else equal, higher oil prices will increase the production cost of grains. Bottom Line: We expect limited downside for grain prices next year. The 2017 Outlook For Individual Grains Corn, soybeans, wheat and rice prices are highly correlated with each other (Chart 4, panel 1). In terms of end consumption, they can all be consumed as either human food or animal feed. In terms of supply, farmers rotate among these crops depending on their profit outlook, soil conditions, and government policies. In 2017, we believe wheat and rice likely will outperform corn and soybeans, for two reasons: Crop-rotation economics and inventories. Chart 4Wheat & Rice May Outperform ##br##Corn & Soybeans In 2017 Firstly, global acreage rotation still favors soybeans most, then corn, over wheat and rice. If we rebase grain prices back to the beginning of 2006, corn and soybean prices are currently 62% and 67% higher than they were at the start of this interval. In comparison, wheat and rice prices are only 19% and 16% higher, respectively (Chart 4, panel 1). The U.S. is the world's biggest corn exporter, the second-largest soybean and wheat exporter. Informa Economics, a private consulting firm, projects 2017 soybean plantings will rise 6.2% to 88.862 million acres, while corn and winter wheat plantings will fall 4.6% and 8.1% to 90.151 million acres and 33.213 million acres, respectively. If these projections are realized, the 2017 U.S. winter wheat planted acreage will be the lowest since 1911. Winter wheat accounts for about 70% of U.S. total wheat production. Secondly, wheat and rice inventories ex-China declined, while corn and soybean inventories ex-China increased. Yes, it is true that the world wheat and rice stocks-to-use ratios rose to the highest since 2002 and 2003, respectively. (Chart 4, panel 2). But this does not show the full picture for these markets: 58% of global rice inventories and 44% of global wheat inventories are in China, even though that country accounts for only 12% of global rice imports and 2% of global wheat imports. China is unlikely to export these inventories to the world: the country tends to hold massive grain inventories, in order to prevent domestic food crises. This means that global wheat and rice importers outside China, which account for about 88% of the global rice trade and 98% of the global wheat trade, will compete for inventories outside China. The third panel of Chart 4 shows the rice stocks-to-use ratio for the ex-China world has already dropped to its lowest level since 2008, while the wheat stocks-to-use ratio ex-China already has declined for two years in a row. This is positive for wheat and rice prices. In comparison, the soybean and corn stocks-to-use ratios ex-China looks much less promising. Both ratios are at or near record highs (Chart 4, panel 3). China only accounts for 2% of the global corn trade, therefore corn importers outside China will have more abundant supplies available to them in 2017. China is the largest buyer of soybeans, accounting for 63% of the global soybean trade. The country will have more bargaining power, on the back of increasing competition among major soybean exporters (the U.S., Brazil and Argentina). In the meantime, China's central policy is currently focused on encouraging domestic soybean plantings mainly at the cost of corn, which is negative for global soybean prices and good for global corn prices. In 2016, the corn acreage in China fell for the first time since 2004 while its soybean acreage jumped 9.1% - the largest increase since 2001 (Chart 4, panel 4). Chart 5Downside Risks To Grains Downside Risks To Our Grain View Grain prices could decline more than 10% from current levels next year, if favorable weather results in a slight drop (less than 1.4%) or even an increase in global grain yields. Also, if grain prices rise significantly in 2017H1 - for whatever reason - this likely would spur plantings and depress prices. If either of these events transpire, we will re-evaluate our grain view. A strengthening dollar is also a major risk to our view. BCA's Foreign Exchange Strategy expects a further 5%-7% appreciation in U.S. dollar in 2017. We believe most of the negative effects of a strengthening dollar already are reflected in depressed grain prices, as the U.S. dollar has already appreciated 36% since July 2011. At the end of last week, the U.S. dollar was only 2% lower than all-time highs reached in February 2002 (Chart 5, panel 1). Another risk to watch is acreage expansion in Argentina, Brazil and the Former Soviet Union (FSU) region. All of these countries/regions had massive currency depreciations and supportive agricultural policies this year, especially in Argentina (Chart 5, panels 2, 3 and 4). However, our calculations show that for corn and wheat, acreage increases in these countries/regions are mostly offset by declines in the U.S. With an expectation of a continuing decline in U.S. wheat and corn plantings, we expect an insignificant growth in overall global wheat and corn acreage. For soybeans, however, the acreage expansion could pose a downside risk as all top three producers (the U.S., Brazil and Argentina) are likely to increase their plantings. We will re-evaluate the grain market at the end of March, when the U.S. posts its planting intentions for all major crops. Softs In 2017: Less Positive Than Grains Both cotton and sugar prices had strong rallies in 2016, following the second consecutive year of supply deficits (Chart 6). Global cotton acreage has declined 19% during the past five years when cotton prices fell significantly from peak prices in 2011. This is the main reason for the 18.3% decline in global cotton production during the same period of time and also for the two consecutive years of supply deficit in 2015 and 2016. For sugar, the El Niño phenomenon that ended this past summer hurt sugar plantings and crop development in major producing countries (Brazil, India, China and Thailand) in both 2015 and 2016, resulting in two years of supply deficit and a supercharged rally in 2016 sugar prices. Both cotton and sugar prices fell from their 2016 highs, with a 9.6% drop for cotton and a 23.4% decline for sugar. However, we are still tactically bearish on both commodities as speculators' net long positions are still crowed (Chart 7). Chart 6Cotton & Sugar: Supply Deficit in 2016 Chart 7Cotton & Sugar: Crowed Net Long Spec Positions Strategically, we are neutral cotton and bearish sugar. For cotton, global demand will stay sluggish in 2017. Even though there has been no growth at all in global cotton demand for the past three years, the bad news is that there still are no signs of improvement in global textile demand (Chart 8). On the supply side, global cotton output may rise significantly next year, if farmers shift some of their grain acreage to cotton due to a better profit profile for cotton (Chart 9). We believe, barring extreme weather, the global cotton market will become more balanced next year, leaving us neutral in our price outlook. For sugar, with weather patterns back to normal and the extreme rally in prices this year, sugar output in India, Thailand, China and the EU (European Union) should receive a strong boost. In addition, a strengthening U.S. dollar will also encourage sugar production in those countries whose currency had massive depreciation like Brazil, Russia and India (Chart 10). Chart 8Cotton: Demand Does Not Look Good Chart 9Cotton: Supply Will Increase In 2017 Chart 10Sugar Production Will Recover On the demand side, average global sugar consumption growth was only 1.3% p.a. during 2013-2015, even though average sugar prices declined every year during that period. This year, global demand growth slowed to only 0.6%, as average sugar prices were 35% higher than last year. If sugar prices go sideways, the average prices will still be higher than this year, which may result in an even slower growth in global sugar demand. Given an extremely oversupplied corn market, cheaper corn syrup will replace sugar in its industrial uses. Chart 11Ag Investment Strategies: ##br##Focus On Relative-Value Trades Our calculations indicate the global sugar market is likely to have a supply surplus next year, which will be a big shift from this year's supply deficit. This likely will pressure sugar prices lower. Upside Risks To Our Softs View Both the cotton and sugar markets are still in supply deficits, which means any unfavorable weather in the major producing countries could send prices sharply higher. For sugar, Brazilian sugarcane mills could favor ethanol production instead of sugar in 2017 if the country keeps hiking gasoline prices and promotes ethanol consumption. So far, the sugar/ethanol price ratio in Brazil still favors sugar production. This can change quickly if ethanol prices in Brazil rise faster than sugar prices in 2017. We will monitor this risk closely. Investment Strategy Our Ag strategies continue to focus on relative-value investments. As such, we look to go long wheat versus cotton, long corn versus sugar, and long rice versus soybeans through the following recommendations: Long July/17 wheat vs. short July/17 cotton: We recommend putting this relative trade on if the wheat-to-cotton ratio drops to 5.75 (current: 6.14) (Chart 11, panel 1). Long July/17 corn vs. short July/17 sugar: We put a limit-buy order at 17 on this position on November 3, 2016. Since then, this ratio rose 12.8% and only declined to 17.47 on November 9. Now, we suggest initiating this position if the ratio falls back to 18.5 (Chart 11, panel 2). Long November/17 rice vs. short November/17 soybeans: We recommend putting this relative-value trade on if the ratio drops to 0.95 (current: 1.01) (Chart 11, panel 3). Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com Investment Views and Themes Recommendations Tactical Trades Commodity Prices and Plays Reference Table Closed Trades

Highlights 1.How Will The European Economy Cope With Higher Interest Rates? 2. How Will The European Stock Market Cope With Higher Interest Rates? 3. How Will The EU Respond To The Start Of Brexit? 4. Will The Bank of Japan's 0% Bond Yield Peg Undermine ECB Credibility? 5. What Does China's Debt Super Cycle Mean For Euro/Yuan? Feature Our strong sense is that the promised elixir of 'Trumponomics' has disoriented investors' concept of value. Suddenly thrown out of their comfort zone, long-term investors are struggling to assess: how much of Trumponomics is reality and how much is just fantasy? Chart of the WeekBrexit And Pound/Euro As rational and analytical long-term investors have become disoriented, emotional and impulsive short-term traders have been left unchecked to drive markets (Chart I-2). Chart I-2Markets Are Excessively Emotional Understand that the financial markets are an ecosystem in which long-term investors jostle with short-term traders. The stable equilibrium of this ecosystem relies on rationality and analysis ultimately checking emotion and impulse. And therein, perhaps, lies the essence of life itself. The descriptions "rationality and analysis" versus "emotion and impulse" are not judgements. They are simply the very different qualities needed to do very different jobs. Long-term investors must take time to rationalise and analyse the concept of fundamental value; whereas traders must use their immediate emotions and impulses to ride short-term market momentum. Therefore what happens in 2017 will depend on what the rational and analytical long-term investors conclude after their pause for reflection. This brings us to our five pressing questions for the coming year. 1. How Will The European Economy Cope With Higher Interest Rates? Now you could argue that the level of interest rates is very low by historical standards, even after last week's rate hike by the Federal Reserve. However, it is the change in interest rates that drives the change in credit growth (Chart I-3); and it is the change in credit growth that drives the change in GDP growth (Chart I-4). Chart I-3The Change In Bond Yield Drives##br## The Change In Credit Growth... Chart I-4...And The Change In Credit Growth Drives ##br##The Change In GDP Growth You could also argue that a 25bps hike in the Fed funds rate constitutes the tiniest of baby steps of monetary tightening. The problem is that bond yields have already jumped many multiples of this: the U.S. 15-year and 30-year bond yield and mortgage rate have spiked by over 75bps; the German 30-year bond yield is up 90bps; the Italian 30-year bond yield is up 100bps; and so on. It is these substantial increases in market interest rates that will weigh on credit-sensitive sectors and prospective 6-month GDP growth. Chart I-5Despite Dollar Strength, The Trade-Weighted##br## Euro Has Hardly Budged Another argument we hear is that higher bond yields are simply discounting better growth prospects ahead. The problem here is the inter-temporal distribution of growth. Higher market interest rates are a near-certain headwind to be felt within 3-6 months. Whereas Trumponomics is a very uncertain tailwind to be felt in 2018, or end 2017 at the earliest. Then there is the geographical distribution of growth. Trumponomics, at best, would boost U.S. growth. Yet market rates have also gone up aggressively in Europe, where there would be a minimal boost to growth. Bear in mind that despite dollar strength, the trade-weighted euro has depreciated just 3% from its October high (Chart I-5). Likewise, emerging market economies will see minimal growth benefits. Whereas higher dollar funding costs, stronger dollar-linked currencies, and the threat of protectionism constitute a meaningful headwind. The bigger question is: can a modern day King Canute1 single-handedly turn the tide of global deflation - the combined structural forces of over-indebtedness, demographics, technology, and globalization? There is much debate about this issue at BCA, but on balance this publication believes that the tide has not turned. 2. How Will The European Stock Market Cope With Higher Interest Rates? Trumponomics is not the structural game changer that the market seems to believe. But even if we are wrong on this, there is one over-arching relationship that will hold true irrespective: the relationship between stock market valuation and subsequent 10-year total nominal return (Chart I-6). This long-term relationship is independent of the economic backdrop: Keynesian, monetarist, neo-classical, deflationary, inflationary, or Trumponomics. Chart I-6Long-Term Returns Always Depend On Valuation The reason is that the 10-year total nominal stock market return comprises two components: the nominal income received through the next 10 years; and the terminal value of the market at the end of the 10 years. Crucially, an environment that boosts one component symmetrically depresses the second component, and vice-versa. For example, inflation boosts nominal income received, but depresses the terminal value (because the discount rate is then much higher). Deflation has the opposite effect. Therefore the relationship between valuation and subsequent 10-year total nominal return is environment-independent. Today, stock markets are priced to generate very low single-digit 10-year returns. But with the recent spike in long-term interest rates, investors can now obtain similar 10-year returns from bonds. In other words, the equity risk premium is dangerously compressed. Emotional and impulsive short-term traders do not care about this structural relationship, but rational and analytical long-term investors ultimately do. Bear in mind that the cross-asset and cross-sector moves over the past six weeks - whether in equity market, bond yield and dollar elevation, or bank outperformance, or yield-proxy and defensive underperformance - are all just various guises of the Trump reflation trade. We expect that rationality and analysis will conclude that Trumponomics is not the structural game changer that the market seems to believe right now. The trade: an unwinding of the various guises of the Trump reflation trade is likely, at least tactically. 3. How Will The EU Respond To The Start Of Brexit? Chart I-7Brexit Must Not Be A Gift To Le Pen The silence is deafening. While there is much daily noise from the U.K. about the type of Brexit it wants, the EU has been intentionally silent. Once the formal legal process of Brexit begins, it will be the EU that holds the balance of power on what Brexit ultimately looks like. The chatter from some U.K. government quarters is that it can negotiate advantageous Brexit terms. Good luck with that. Given the proximity of the French Presidential Election in April/May, the EU's opening position has to be uncompromising - so as to not hand Marine Le Pen any gifts (Chart I-7). The EU must make an example of the U.K. "pour encourager les autres". And if exiting the EU must come with a demonstrable cost, one casualty would be the pound. That said, 2017 will be an especially unpredictable year for U.K. politics and economics because Brexit creates a larger number of moving parts, complex interactions and feedback loops, both negative and positive. For example, if the Supreme Court grants the Scottish parliament a greater say in the terms of Brexit, it could compromise Theresa May's current strategy. The pound would rally on that tail-event possibility. The trade: the pound is unlikely to stay near today's €1.18. Expect a sharp move one way or the other (Chart of the Week). A good strategy might be to sell the middle of the distribution. There are many permutations of this but one example would be to short the pound and simultaneously buy call options at, say, €1.30. 4. Will The Bank of Japan's 0% Bond Yield Peg Undermine ECB Credibility? Chart I-8Pegs Get Broken 2016 was the year when QE peaked. The ECB committed to lowering its monthly asset purchases. More significantly, the BoJ shifted its policy aim from targeting an amount of asset purchases to targeting a price (or yield) on the 10-year JGB. Thereby, the central bank policy experiment has moved into a more dangerous phase. As we explained in Dangers Of Linear-Thinking In A Non-Linear World 2 economies and markets are complex, non-linear systems. The inherent unpredictability of a non-linear system makes it futile and dangerous to aim for an over-precise point target in anything that we do. And that principle applies to central banks as much as to anybody else. Indeed, a 2% inflation target is a price target, albeit a price of a basket of goods and services, and the annual change of that price. The track record of any central bank achieving its self-imposed 2% inflation target in recent years is truly disastrous. Recall also that the Swiss National Bank had to break the franc's peg with the euro, one of the more recent in a long list of failed price pegs (Chart I-8). Our Fixed Income strategists believe the JGB 0% yield peg will hold. Nevertheless, the risk is underestimated that the BoJ will have to break the peg, in 2017 or beyond. The credibility of the ECB to suppress long-term bond yields would then be severely damaged. And the greatest danger would be to those euro area bond yields closest to zero. The trade: stay underweight French OATS. 5. What Does China's Debt Super Cycle Mean For Euro/Yuan? One defining feature of the last 40 years is a steady sequence of private sector credit booms which have inevitably turned to busts: notably, Japan in 1990, the Asian 'tigers' in 1998, the U.S. in 2007, and the U.K., Spain and other European countries in 2008 (Chart I-9). Chart I-9Credit Booms Sequentially Turned To Bust. Who's Next? In this defining feature, China's is the last of the major credit booms that hasn't turned to bust - yet. Admittedly, the ability of the Chinese authorities to 'extend and pretend' is probably greater than elsewhere in the world, and this might prevent another violent tipping point. Irrespective, the debt super cycle is over when the cost of malinvestment and misallocation of capital outweighs the benefit of good credit creation. With private sector indebtedness (including SOEs) now at, or beyond, the level where every other credit boom peaked, China appears to be approaching this point. One manifestation would be continued weakness in its currency against the major developed market crosses. The trade: go long euro/yuan. And with that, we are signing off for 2016. I do hope that this year's reports have provided some insight during particularly turbulent times, and that you might have even enjoyed the reading experience! It just remains for me to wish you a Merry Christmas and a successful and happy 2017. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 In fact, the story of King Canute has been misinterpreted. Rather than show that he could turn the tide, he wanted to show the opposite: that he was powerless against the tide. 2 Published on February 11, 2016 and available at eis.bcaresearch.com. Fractal Trading Model* Pleasingly, two of our open trades hit their profit targets: long platinum / short palladium and short the Greek 10-year bond. Given the extended break, we are not opening any new trades over the Christmas and New Year holiday period. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Dear Clients, This is the final publication for the year, in which we recap some of the key developments in 2016 and their long-term implications. We will resume our regular publishing schedule on January 5, 2017. The China Investment Strategy team wishes you a very happy holiday season and a prosperous New Year! Best regards, Yan Wang, Senior Vice President China Investment Strategy Feature Senior Chinese policymakers conveyed in Beijing last week for their annual economic work conference - a high-profile gathering where top officials review the past year's economic performance and set the broad policy tone and development priorities for the coming year. The key messages from this year's meeting suggest that "stability and progress" remain a top priority, but that the importance of a GDP growth target appears less significant. Policymakers recognize the mounting challenges both globally and domestically, which suggests the policy environment will stay accommodative, especially on the fiscal front. Furthermore, the authorities intend to make material progress on "supply-side" reforms, which is both an admission of defeat in terms of progress this year and a pledge for more aggressive efforts going forward. We will be addressing China's policy orientation, growth outlook and asset prices in the New Year. As a year-end tradition, we dedicate this week's report to recapping some important developments of the past year and their long-term implications. A V-Shaped Recovery Under The Economic "New Normal" Chart 1V-Shaped Rebound##br## In The Economic New Normal The Chinese economy entered 2016 with worsening growth deceleration, but ended the year with a V-shaped rebound in industrial activity - even though GDP growth remained curiously stable1 (Chart 1). Destocking in the housing market and de-capacity in some industrial sectors were listed as two top priorities of the government for 2016, both of which were abruptly reversed as the year unfolded: strong home sales depleted housing inventories more quickly than expected, leading to a dramatic increase in home prices in major cities - prompting policymakers to re-impose restrictions on housing demand.2 Meanwhile, de-capacity in steel mills and coal mines greatly constrained domestic supply of related products, leading to both a massive increase in imports and a sharp rally in prices as demand improved. As a result, the authorities scrambled to remove some administrative constraints on domestic production on these two industries. The economy's V-shaped growth performance this year challenges some conventional thinking on China's growth fundamentals, particularly on the housing market and overcapacity. On housing, there is no doubt that some regions have abundant supply, which may take a long time to clear. On an aggregate level, however, the massive increase in home prices in some major cities suggest housing inventories may be much smaller than generally perceived.3 Similarly, overcapacity is widely regarded as a chronic feature of the Chinese economy inherent to its investment-heavy growth model - steelmakers and coalmines being two prime examples. However, the dramatic turnaround in these two industries this past year defies this widely held consensus.4 At minimum, China's overcapacity issue cannot be analyzed in isolation from a global context as well as from the current stage of the business cycle. Chart 2Monetary Conditions And ##br##Business Conditions Furthermore, while "supply-side" reforms were listed as a key theme for 2016, improvement in the industrial sector was to a large extent due to measures that boosted aggregate demand. Fiscal spending remained robust at the beginning of the year, following strong acceleration in 2015. More importantly, monetary conditions began to ease notably from the beginning of the year, leading to a notable improvement in business conditions among industrial enterprises (Chart 2). Nonetheless, the growth "new normal" envisioned by the Chinese leadership underlines the assumption of an "L-shaped" growth trajectory. Therefore, the V-shaped rebound in some key industrial indicators was both surprising and possibly unwelcome from the policymakers' point of view. The authorities will likely continue to switch priorities between supply side reforms and demand-side management going forward. Premature withdrawal of policy stimulus remains a key risk for the economy as well as financial markets. From Deflation To Inflation? 2016 marked a decisive end to Chinese producer price deflation, which lasted for more than four years. PPI, still falling at a 5% annual rate at the beginning of the year, turned up sharply toward the end of 2016, rising by over 3% in November, likely even higher this month. Investors' perception on Chinese producer prices and the broader inflation picture has also shifted dramatically. A mere few months ago China was widely blamed for exporting deflation to the rest of the world, which has quickly been replaced by a consensus that China is now exporting inflation. The sudden shift may have to some extent contributed to the bond market riot of late both globally and within China. The end of PPI deflation is a major positive development for the Chinese corporate sector, as it both improves its pricing power and also reduces its real cost of funding (Chart 3). Real bank lending rates deflated by PPI stayed at close to record highs early this year, and have since tumbled by a whopping 10 percentage points - largely due to easing deflation. This is a dramatic relief for some highly levered asset-heavy industries. Importantly, these industries were the biggest casualties in the growth slowdown and posed material risks to the banking sector due to their high debt levels. In this vein, rising PPI and easing financial stress among these firms also bodes well for the banking sector. Nonetheless, it is wrong to conclude that the end of PPI deflation in China means the country will export inflation going forward: Rising producer price inflation, measured as year-over-year growth, is to some extent due to the base effect. In terms of level, producer prices have clearly stopped falling, but gains have been rather mild and still remain at relatively low levels. It is too soon to worry about inflation (Chart 4, bottom panel). Easing deflation has also been attributable to the falling trade-weighted RMB this year (Chart 4, top panel), as producer prices typically follow exchange rate performance by about six months. While PPI may continue to follow the RMB higher in the coming several months, the trade-weighted RMB depreciation has already stalled, which may cap any additional upside in PPI. Unless the economy continues to recover strongly and/or the RMB resumes its depreciation, it is premature to expect PPI to continue to rise going forward. Chart 3Easing Deflation Helps Reduce##br## Real Interest Rates, Massively Chart 4PPI Inflation##br## In Perspective Domestic inflation does not necessarily lead to rising export prices, if a weaker RMB is the main factor to boost domestic prices (Chart 5). Indeed, rising Chinese domestic producer prices also means Chinese export prices in RMB terms have also been rising. Measured in U.S. dollar terms, however, Chinese export prices are still falling on a year-over-year basis. Similarly, U.S. import prices from China measured in RMB terms have been rising smartly, but in dollar terms are still been falling. This is positive for Chinese exporters' profitability, but is not inflating U.S. prices. Finally, a word on the sharp increase in Chinese bond yields. While growth improvement and easing deflation may have contributed to the sharp rebound in Chinese bond yields in recent weeks, global factors are likely more important. Chart 6 shows Chinese government bond yields have been increasingly synchronized with U.S. Treasurys in recent years, an interesting development considering China's still relatively closed capital markets. The rising correlation could be driven by economic fundamentals due to the tight connection between these two economies. Rising U.S. bond yields reflects changes in growth and inflation expectations in the U.S., which also impact the Chinese economy. Furthermore, the 123-basis-point spike in U.S. Treasurys since July 2016 has narrowed the yield gap with Chinese government bonds, which in turn has pushed up Chinese yields. This means that Chinese interest rates may remain under upward pressure should U.S. Treasury yields continue to grind higher. Chart 5End Of Chinese Deflation Does Not ##br## Necessarily Inflate The World Chart 6Chinese Bonds: ##br##The Global Connection Bottom Line: Easing deflation is good news for Chinese domestic firms, but it does not mean that China is about to export inflation to the rest of the world. Chinese government bond yields may have also made a cyclical low, and will likely continue to move higher along with global yields. The RMB's Bumpy Transition The RMB officially joined the Special Drawing Right (SDR) basket of the IMF in October, a historical moment marking an emerging country being admitted to the "elite currency" club. Joining the SDR helps promote the international status of the Chinese currency, which may offer some longer-term benefits.5 The immediate challenge for policymakers, however, is to fend off the constant downward pressure on the RMB against the dollar. More specifically, the People's Bank of China (PBoC) has clearly signaled its intention to allow the exchange rate to float, but has been deeply troubled by the potential of a downward spiral between capital outflows and outsized RMB depreciation. Overall, 2016 marks a tentative transition of the RMB exchange rate mechanism to a dirty float scheme. Indeed, the PBoC at the beginning of 2016 explicitly presented its formula of how the RMB's daily official fixing rate against the dollar is calculated. Strictly following this formula would lead to a largely stable trade-weighted RMB. In reality, however, the PBoC appears to have deliberately targeted a weaker exchange rate: the RMB was soft-pegged to the dollar whenever the dollar weakened against other currencies, and it was allowed to fall against the dollar whenever it strengthened broadly. As a result, the RMB depreciated by almost 10% in trade-weighted terms from its 2015 peak, which in no small part helped the economy reflate. However, this strategy also reinforced an already well-entrenched expectation of the RMB's one-way descent against the greenback. Shorting the RMB became a risk-free bet, which further encouraged capital outflows. There has been a rush to purchase foreign assets by the corporate sector, likely also incentivized by the RMB outlook.6 It is unclear how the PBoC will break this dilemma going forward. We expect the central bank will stay the course in further lowering the trade-weighted RMB, while at the same time tightening capital account controls to prevent capital flight.7 Its large current account surplus and official reserves should offer plenty of resources to maintain control. Its tight grip on the exchange rate may be progressively relaxed as it perceives the trade-weighted RMB to be "cheapened enough," which could generate two-way flows of capital. From this perspective, joining the SDR helps attract long-term foreign capital for Chinese risk-free assets. Bottom Line: Joining the SDR marks a historic milestone for the RMB, but the near-term significance is largely symbolic. The RMB's soft peg to the dollar is over. The PBoC is experimenting with a new exchange rate regime. Market Volatility And Financial Reforms Chart 7Policy Uncertainties And ##br##Equity Valuations The dramatic stock market rollercoaster ride in 2015 had already seriously damaged Chinese policymakers' credibility. The short-lived circuit-breaker system designed to curb market fluctuations in fact greatly exaggerated volatility at the beginning of the year, which further exposed the regulators' incompetency. Global investors' anxiety on China's macro situation has eased notably in recent months. However, Chinese stocks have ended the year largely flat, even though the industrial sector has staged a sharp recovery with strong earnings growth. Perceived high and rising policy uncertainty clearly dampens investors' appetite for Chinese assets, resulting in a large valuation discount to their global peers (Chart 7). Underneath, regulators' apparent policy blunders in the past two years represent a deeper and more systemic challenge than just incompetency. The country's rapidly developing financial system and capital markets have become increasingly complex, while the regulatory system lagged way behind. The current regulatory framework is poorly coordinated with sometimes conflicting priorities, leaving potentially systemically important developments falling through the cracks. The dramatic buildup of leverage in the stock market in 2015 outside of regulatory oversight was a prime example. This year, the leverage situation in commodities and bond markets has also been poorly scrutinized. A key reform initiative for the financial sector under the "reform blueprint" published a few years ago was to improve coordination among different regulators. The authorities plan to enhance supervision on systemically important financial institutions and systemically important financial infrastructure such as payment, clearing and custody systems to improve coordination of macro-prudential measures as well as collaboration on key financial statistics and information - all of which has yet to begin. The dramatic financial market volatility and policy blunders of late have created a pressing need to accelerate the process. In short, preventing financial risks has become an increasingly important priority of the government, and will remain a key task for 2017, as noted from last week's economic work conference. This necessarily involves fundamental reforms of the country's financial regulatory framework. We will follow up on these issues in the New Year. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Chinese Growth, Cyclical Risks And The Rally In Commodities," dated December 1, 2016, available at cis.bcaresearch.com 2 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010," dated October 13, 2016 available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "The Chinese Housing Market Conundrum," dated May 25, 2016 available at cis.bcaresearch.com. 4 Please see China Investment Strategy Special Report, "The Myth Of Chinese Overcapacity," dated October 6, 2016 available at cis.bcaresearch.com. 5 Please see China Investment Strategy Weekly Report, "The RMB's Near-Term Dilemma And Long-Term Ambition," dated October 20, 2016 available at cis.bcaresearch.com. 6 Please see China Investment Strategy Special Report, "Demystifying China's Foreign Assets," dated December 15, 2016 available at cis.bcaresearch.com. 7 Please see China Investment Strategy Weekly Report, "How Will China Manage The Impossible Trinity," dated December 8, 2016 available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations