China

Highlights China's old economy continues to slow in the leadup to the negative effect of U.S. import tariffs on Chinese export growth. Weaker trade data over the coming few months is likely to weigh further on investor sentiment. Our Li Keqiang leading indicator has risen off of its low, but not in a broad-based fashion. While the RMB depreciation has caused Chinese monetary conditions indexes to move sharply higher, money and credit growth remain weak. The recent breakdown in Chinese consumer staples stocks is an exception to the broad trend of low-beta sector outperformance. Fears have risen that the Chinese consumer is faltering, a concern that we will address in a Special Report next week. Feature Tables 1 and 2 highlight key developments in China's economy and its financial markets over the past month. On the growth front, the September update to Bloomberg's measure of the Li Keqiang index (LKI), and our newly created alternative LKI, makes it clear that China's economy continues to slow in the leadup to the negative shock from the external sector. The fact that both LKIs peaked early in 2017 highlights that the slowdown was precipitated by monetary tightening, which has only recently reversed. This easing in monetary conditions has likely improved the liquidity situation in China, but it remains to be seen whether it will prompt any meaningful acceleration in credit growth. Table 1The Trend In Domestic Demand, And The Outlook For Trade, Is Negative Table 2Financial Market Performance Summary From an investment strategy perspective, our recommendations remain unchanged. Despite deeply oversold conditions in China's stock markets, investors should avoid outright long positions for now due to the high odds of additional negative catalysts over the coming few months. We expect further weakness in the RMB, and expect USD-CNY to break through 7, suggesting that investors trading within the Chinese equity universe should only favor domestic stocks in currency-hedged terms for now. Finally, we continue to recommend an overweight stance towards low-beta sectors within the investable market, and believe that onshore corporate bonds are a buy despite pervasive default concerns. In reference to Tables 1 and 2, we provide several detailed observations concerning developments in China's macro and financial market data below: Bloomberg's measure of the Li Keqiang index (LKI) fell in September, confirming that activity in China's old economy is trending lower. A downtrend in industrial activity is even more apparent in our alternative LKI (Chart 1), which is constructed using total freight (instead of railway freight) and secondary industry electricity consumption (instead of overall electricity production). Chart 1China's Old Economy Is Slowing, Before The Trade Shock Hits Our BCA Li Keqiang leading indicator has risen somewhat from its June low, driven by the two monetary conditions indexes (MCIs) included in the indicator. Both of these MCIs have, in turn, been driven by the substantial weakness in the RMB over the past four months. This sharp improvement has not been matched by the other components of the indicator: Chart 2 illustrates that the low end of the component range remains quite weak, in contrast to mid-2015 when both the high and low ends of the range were in a clear uptrend. Chart 2A Narrow Pickup In Our LKI Leading Indicator Nearly all of the housing market indicators included in Table 1 are above their 12-month moving average, with the exception of pledged supplementary lending by the PBOC. Pledged supplementary lending itself sequentially increased quite meaningfully in October, underscoring that policymakers are keen to avoid the risk of overtightening the economy at a time when external demand is likely to weaken considerably. Still, smoothed residential sales volume growth has ticked down for two months in a row, suggesting that the extremely stretched pace of floor space started is likely to moderate over the coming months. Chinese export growth remains buoyant, despite several manufacturing and general business condition surveys showing a substantial deterioration over the past few months. As we go to press, China's October trade data has not yet been released, but we expect exports to weaken considerably in the coming few months. This could further weigh on investor sentiment if the slowdown exceeds the market's expectations. Within China's equity market universe, both domestic and investable stocks are deeply oversold in absolute terms, having declined 30% and 28% from their late-January peaks, respectively. Our technical indicators for both markets suggest that Chinese stocks have actually reached 1 standard deviation oversold, a level that has historically served as a platform for a rebound. Still, this speaks merely to the odds of a rebound, not when one will occur, and we can identify further negative catalysts for the equity over the coming 3 months. Avoid outright long positions for now. Despite having fallen significantly themselves, Taiwan and Hong Kong's equity markets have materially outperformed Chinese investable stocks since the beginning of the year (Chart 3). However, Taiwan's outperformance trend has recently moved in the opposite direction, as global investors begin to price in the fact that tensions between the U.S. and China are strategic and long-term in nature, not merely focused on trade.1 Taiwan is extremely exposed to this rivalry, warranting a higher equity risk premium. Chart 3Taiwan's Recent Outperformance Is Likely Reversing Within Chinese investable stocks, low-beta equity sectors have in general continued to outperform over the past month. Our long MSC China low-beta sectors / short MSCI China trade is up 10% since initiation on June 27, and we expect further gains in the near-term. One exception to this trend is the relative performance of domestic and investable consumer staples stocks, which have recently underperformed their respective broad markets (Chart 4). The selloff has been sharp in the case of the domestic market, and has been in response to heightened fears that household consumption is weakening, a sector of the economy that heretofore had been reliably strong. In response to these developments, please note that BCA's China Investment Strategy service will be publishing a Special Report outlook detailing the outlook for the Chinese consumer next week. Chart 4Fears About Chinese Consumers Are Growing The Chinese government bond yield curve has bull steepened considerably since the middle of the year, although it has oscillated without a trend over the past month. To the extent that traditional interpretations of the yield curve apply similarly to China, this suggests that domestic investors are pessimistic about the growth outlook, and expect monetary policy to remain easy. For now, this supports our recommendation to avoid outright long positions in Chinese stocks. Domestic Chinese and global investors remain deeply averse to Chinese corporate bonds, and we continue to disagree that aversion is warranted. Chart 5 highlights that the ChinaBond Corporate Bond total return index remains in a solid uptrend, even for bonds rated AA-. Incredibly, panel 2 of Chart 5 illustrates that global investors who have access to onshore corporate bonds have not lost money this year in unhedged terms, despite the material weakness in the RMB since the middle of the year. We continue to recommend onshore corporate bond positions over the coming 6-12 months.2 Chart 5Chinese Corporate Bonds: A Contrarian Long CNY-USD rose materially last week, in response to speculation that the U.S. is readying a possible trade deal with China. Our geopolitical strategists recommend fading the odds of a near-term trade truce, implying that the odds of USD-CNY breeching 7 over the coming months are substantial. While economically meaningless in and of itself, the threshold is psychologically important and its failure to hold could spark meaningful renewed fears of uncontrolled capital outflow from China. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "EMs Are In A Bear Market," published October 18, 2018. Available at ems.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report "Investing In The Middle Of A Trade War," published September 19, 2018. Available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights So What? Donald Trump's reelection depends on the timing of the next recession. Why? The midterm elections will not determine Trump's reelection chances. Rather, the timing of the next recession will. BCA's House View expects it by 2020. Otherwise, President Trump is favored to win. Trump may be downgrading "maximum pressure" on Iran, reducing the risk of a 2019 recession. Trade war with China, gridlock, and budget deficits are the most investment-relevant outcomes of U.S. politics in 2018-20. Feature The preliminary results of the U.S. midterm elections are in, with the Democrats gaining the House and failing to gain the Senate, as expected. Our view remains that the implications for investors are minimal. The policy status quo is now locked in - a gridlocked government is unlikely to produce a major change in economic policy over the next two years. While the election is to some extent a rebuke to Trump, this report argues that he remains the favored candidate for the 2020 presidential election - unless a recession occurs. A Preliminary Look At The Midterms First, the preliminary takeaways from the midterms, as the results come in: The Democrats took the House of Representatives, with a preliminary net gain of 27 seats, resulting in a 51%-plus majority, and this is projected to rise to 34 seats as we go to press Wednesday morning. This is above the average for midterm election gains by the opposition party, especially given that Republicans have held the advantage in electoral districting. Performance in the Midwest, other swing states, and suburban areas poses a threat to Trump and Republicans in 2020. Republicans held the Senate, with a net gain of at least two seats, for a 51%-plus majority. Democrats were defending 10 seats in states that Trump won in 2016. While Democrats did well in the Midwest, these candidates had the advantage of incumbency. On the state level, the Democrats gained a net seven governorships, two of them in key Midwestern states. The gubernatorial races were partly cyclical, as the Republicans had hit a historic high-water mark in governors' seats and were bound to fall back a bit. However, the Democratic victory in Michigan and Wisconsin, key Midwestern Trump states, is a very positive sign for the Democrats, since they were not incumbents in either state and had to unseat incumbent Governor Scott Walker in Wisconsin. (Their victory in Maine could also help them in the electoral college in 2020.) The governors' races also suggest that moderate Democrats are more appealing to voters than activist Democrats. Candidate Andrew Gillum's loss in Florida is a disappointment for the progressive wing of the Democratic Party.1 With the House alone, Democrats will not be able to push major legislation through. In the current partisan environment it will be nigh-impossible to reach the 60 votes needed to end debate in the Senate ("cloture"), and even then House Democrats will face a presidential veto. They will not be able to repeal Trump's tax cuts, re-regulate the economy, abandon the trade wars, resurrect Obamacare, or revive the 2015 Iranian nuclear deal. Like the Republicans after 2010, they will be trapped in the position of controlling only one half of one of the three constitutional branches. The most they can do is hold hearings and bring forth witnesses in an attempt to tarnish Trump's 2020 reelection chances. They may eventually bring impeachment articles against him, but without two-thirds of the Senate they cannot remove him from office (unless the GOP grassroots abandons him, giving senators permission to do so). U.S. equities generally move upward after midterm elections - including midterms that produce gridlock (Chart 1A & Chart 1B). However, the October selloff could drag into November. More worryingly, as Chart 1B shows, the post-election rally tends to peter out only six months after a gridlock midterm, unlike midterms that reinforce the ruling party. Chart 1AMidterm U.S. Elections Tend To Be Bullish... Chart 1B... But Markets Lose Steam Six Months Post-Gridlock However, the 2018 midterms could be mildly positive for the markets, as they do not portend any major new policies or uncertainty. Trump's proposed additional tax cuts would have threatened higher inflation and more Fed rate hikes, whereas House Democrats will not be able to raise taxes or cut spending alone. Bipartisan entitlement reform seems unlikely in 2018-20 given the acrimony of the two parties and structural factors such as inequality and populism. An outstanding question is health care, which Republicans left unresolved after failing to repeal Obamacare, and which exit polls show was a driving factor behind Democratic victories. Separately, as an additional marginal positive for risk assets, the Trump administration has reportedly granted eight waivers to countries that import Iranian oil. We have signaled that Trump's "maximum pressure" doctrine poses a key risk for markets due to the danger of an Iran-induced oil price shock. A shift toward more lax enforcement reduces the tail-risk of a recession in 2019 (Chart 2). Of course, the waivers will expire in 180 days and may be a mere ploy to ensure smooth markets ahead of the midterm election, so the jury is still out on this issue. Chart 2Rapid Increases In Oil Prices Tend To Precede Recessions This brings us to the main focus of this report: what do the midterms suggest about the 2020 election? Bottom Line: The midterm elections have produced a gridlocked Congress. Trump can continue with his foreign policy, most of his trade policy, his deregulatory decrees, and his appointment of court judges with limited interference from House Democrats. The only thing the Democrats can prevent him from doing is cutting taxes further. He tends to agree with Democrats on the need for more spending! While the U.S. market could rally on the back of this result, we do not see U.S. politics being a critical catalyst for markets going forward. On balance, a gridlocked result brings less uncertainty than would otherwise be the case, which is positive for markets in the short term. The Midterms And The 2020 Election There is a weak relationship at best between an opposition party's gains in the midterms and its performance in the presidential election two years later. Given that the president's party almost always loses the midterms - and yet that incumbent presidents tend to be reelected - the midterm has little diagnostic value for the presidential vote, as can be seen in recent elections (Chart 3A & Chart 3B). Chart 3AMidterm Has Little Predictive Power For Presidential Popular Vote ... Chart 3B... Nor For Presidential Electoral College Vote Nevertheless, historian Allan Lichtman has shown that since 1860, a midterm loss is marginally negative for a president's reelection chances.2 And for Republicans in recent years, losses in midterm elections are very weakly correlated with Republican losses of seats in the electoral college two years later (Chart 4). Chart 4Republican Midterm Loss Could Foreshadow Electoral College Losses Still, this midterm election does not give any reason to believe that Trump's reelection chances have been damaged any more than Ronald Reagan's were after 1982, or Bill Clinton's after 1994, or Barack Obama's after 2010. All three of these presidents went on to a second term. A midterm loss simply does not stack the odds against reelection. Why are midterm elections of limited consequence for the president? They are fundamentally different from presidential elections. For instance, "the buck stops here" applies to the president alone, whereas in the midterms voters often seek to keep the president in check by voting against his party in Congress.3 Despite the consensus media narrative, the president is not that unpopular. Trump's approval rating today is about the same as that of Clinton and Obama at this stage in their first term (Chart 5). This week's midterm was not a wave of "resistance" to Trump so much as a run-of-the-mill midterm in which the president's party lost seats. Its outcome should not be overstated. Bottom Line: There is not much correlation between midterms and presidential elections. The best historians view it as a marginal negative for the incumbent. This result is not a mortal wound for Trump. Chart 5President Trump Is Hardly Losing The Popularity Contest 2020: The Recession Call Is The Election Call The incumbent party has lost the White House every single time that a recession occurred during the campaign proper (Chart 6).4 The incumbent party has lost 50%-60% of the time if recession occurred in the calendar year before the election or in the first half of the election year. Chart 6A 2020 Recession Is Trump's Biggest Threat This is a problem for President Trump because the current economic expansion is long in the tooth. In July 2019, it will become the longest running economic expansion in U.S. history, following the 1991-2001 expansion. The 2020 election will occur sixteen months after the record is broken, which means that averting a recession over this entire period will be remarkable. BCA's House View holds that 2020 is the most likely year for a recession to occur. The economy is at full employment, inflation is trending upwards, and the Fed's interest rate hikes will become restrictive sometime in 2019. The yield curve could invert in the second half of 2019 - and inversion tends to precede recession by anywhere from 5-to-16 months (Table 1). No wonder Trump has called the Fed his "biggest threat."5 Table 1Inverted Yield Curve Is An Ominous Sign The risks to this 2020 recession call are probably skewed toward 2021 instead of 2019. The still-positive U.S. fiscal thrust in 2019 and possibly 2020 and the Trump administration's newly flexible approach to Iran sanctions, if maintained, reduce the tail-risk of a recession in 2019. If there is not a recession by 2020, Trump is the favored candidate to win. First, incumbents win 69% of all U.S. presidential elections. Second, incumbents win 80% of the time when the economy is not in recession, and 76% of the time when real annual per capita GDP growth over the course of the term exceeds the average of the previous two terms, which will likely be the case in 2020 unless there is a recession (Chart 7). Chart 7Relative Economic Performance Could Give Trump Firepower The above probabilities are drawn from the aforementioned Professor Allan Lichtman, at American University in Washington D.C., who has accurately predicted the outcome of every presidential election since 1984 (except the disputed 2000 election). Lichtman views presidential elections as a referendum on the party that controls the White House. He presents "13 Keys to the Presidency," which are true or false statements based on historically derived indicators of presidential performance. If six or more of the 13 keys are false, the incumbent will lose. On our own reading of Lichtman's keys, Trump is currently lined up to lose a maximum of four keys - two shy of the six needed to unseat him (Table 2). This is a generous reading for the Democrats: Trump's party has lost seats in the midterm election relative to 2014; his term has seen sustained social unrest; he is tainted by major scandal; and he is lacking in charisma. Yet on a stricter reading Trump only has one key against him (the midterm). Table 2Lichtman's Thirteen Keys To The White House* What would it take to push Trump over the edge? Aside from a recession (which would trigger one or both of the economic keys against him), he would need to see two-to-four of the following factors take shape: a serious foreign policy or military failure, a charismatic Democratic opponent in 2020, a significant challenge to his nomination within the Republican Party, or a robust third party candidacy emerge. In our view, none of these developments are on the horizon yet, though they are probable enough. For instance, it is easy to see Trump's audacious foreign policy on China, Iran, and North Korea leading to a failure that counts against him. Thus, as things currently stand, Trump is the candidate to beat as long as the economy holds up. What about impeachment and removal from office prior to 2020? As long as Trump remains popular among Republican voters he will prevent the Senate from turning against him (Chart 8). What could cause public opinion to change? Clear, irrefutable, accessible, "smoking gun" evidence of personal wrongdoing that affected Trump's campaigns or duties in office. Nixon was not brought down until the Watergate tapes became public - and that required a Supreme Court order. Only then did Republican opinion turn against him and expose him to impeachment and removal - prompting him to resign. Chart 8Trump Cannot Be Removed From Office All that being said, Trump tends to trail his likeliest 2020 adversaries in one-on-one opinion polling. Given our recession call, we would not dispute online betting markets giving Trump a less-than-50% chance of reelection at present (Chart 9). The Democratic selection process has hardly begun: e.g. Joe Biden could have health problems, and Michelle Obama, Oprah Winfrey, or other surprise candidates could decide to run. The world will be a different place in 2020. Bottom Line: The recession call is the election call. If BCA is right about a recession by 2020, then Trump will lose. If we are wrong, then Trump is favored to win. Chart 9A Strong Opponent Has Yet To Emerge Is It Even Possible For Trump To Win Again? Election Scenarios Is it demographically possible for Trump to win? Yes. In 2016 BCA dubbed Trump's electoral strategy "White Hype," based on his apparent attempt to increase the support and turnout of white voters, primarily in "Rust Belt" battleground states. While Republican policy wonks might have envisioned a "big tent" Republican Party for the future, demographic trends in 2016 suggested that this strategy was premature. Indeed, drawing from a major demographic study by the Center for American Progress and other Washington think tanks,6 we found that a big increase in white turnout and support was the only 2016 election scenario in which a victory in both the popular vote and electoral college vote was possible. In other words, while "Minority Outreach" have worked as a GOP strategy in the future, Donald Trump's team was mathematically correct in realizing that only White Hype would work in the actual election at hand. This strategy did not win Trump the popular vote, but it did secure him the requisite electoral college seats, notably from the formerly blue of Wisconsin, Michigan, and Pennsylvania. Comparing the 2016 results with our pre-election projections confirms this point: Trump won the very swing states where he increased white GOP support and lost the swing states where he did not. Pennsylvania is the notable exception, but he won there by increasing white turnout instead of white GOP support.7 Can Trump do this again? Yes, but not easily. Map 1 depicts the 2016 election results with red and blue states, plus the percentage swing in white party support that would have been necessary to turn the state to the opposite party (white support for the GOP is the independent variable). In Michigan, a 0.3% shift in the white vote away from Republicans would have deprived Trump of victory; in Wisconsin and Pennsylvania, a 0.8% shift would have done the same; in Florida, a 1.5% change would have done so. Map 1The 'White Hype' Strategy Narrowly Worked In 2016 Critically, the country's demographics have changed significantly since 2016 - to Trump's detriment. The white eligible voting population in swing states will have fallen sharply from 81% of the population to 76% of the population by 2020 (Chart 10). Chart 10Demographic Shift Does Not Favor Trump Thus, to determine whether Trump still has a pathway to victory, we looked at eight scenarios, drawing on the updated Center for American Progress study. The assumptions behind the scenarios in Table 3 are as follows: Status Quo - This replicates the 2016 result and projects it forward with 2020 demographics. 2016 Sans Third Party - Replicates the 2016 result but normalizes the third party vote, which was elevated that year. Minority Revolt - In this scenario, Hispanics, Asians, and other minorities turn out in large numbers to support Democrats, even with white non-college educated voters supporting Republicans at a decent rate. The Kanye West Strategy - Trump performs a miracle and generates a swing of minority voters in favor of Republicans. Blue Collar Democrats - White non-college-educated support returns to 2012 norms, meaning back to Democrats. Romney's Ghost - White college-educated support returns to 2012 levels. White Hype - White non-college-educated support swings to Republicans. Obama versus Trump - White college-educated voters ally with minorities in opposition to a surge in white non-college-educated voters for Republicans. Table 3Assumptions For Key Electoral Scenarios In 2020 The results show that Trump's best chance at remaining in the White House is still White Hype, as it is still the only scenario in which Trump can statistically win a victory in the popular vote (Chart 11). Another pathway to victory is the "2016 Sans Third Party" scenario. But this scenario still calls for White Hype, since a third party challenger is out of his hands (Chart 12).8 Chart 11'White Hype' May Be Only Way To Secure Both Popular And Electoral College Vote...   Chart 12... Although Moving To The Center Could Still Yield Electoral College Vote However, the data show that Trump cannot win merely by replicating his white turnout and support from 2016, due to demographic changes wiping away the thin margins in key swing states. He needs some additional increases in support. These increases will ultimately have to be culled from his record in office - which reinforces the all-important question of the timing of recession, but also raises the question of whether Trump will move to the center to woo the median voter. In the "Kanye West" and "Romney's Ghost" scenarios, Trump wins the electoral college by broadening his appeal to minorities and college-educated white voters. This may sound far-fetched, but President Clinton reinvented himself after the "Republican Revolution" of 1994 by compromising with Republicans in Congress. The slim margins in the Midwest suggest that the probability of Trump shifting to the middle is not as low as one might think. Especially if there is no recession. Independents remain the largest voting block - and they have not lost much steam, if any, since 2016. Moreover, the number of independents who lean Republican is in an uptrend (Chart 13). Without a recession, or a failure on Lichtman's keys, Trump will likely broaden his base. Chart 13Trump Shows Promise Among Independents Bottom Line: Trump needs to increase white turnout and GOP support beyond 2016 levels in order to win 2020. Demographics will not allow a simple repeat of his 2016 performance. However, he may be able to generate the requisite turnout and support by moving to the center, courting college-educated whites and even minorities. His success will depend on his record in office. Investment Implications What are the implications of the above findings for 2018-20 and beyond? The Rust Belt states of Michigan, Pennsylvania, and Wisconsin will become pseudo-apocalyptic battlegrounds in 2020. The Democrats must aim to take back all three to win the White House, as they cannot win with just two alone.9 They are likely to focus on these states because they are erstwhile blue states and the vote margin is so slim that the slightest factors could shift the balance - meaning that Democrats could win here without a general pro-Democratic shift in opinion that hurts Trump in other key swing states such as Florida, North Carolina, or Arizona. The "Blue Collar Democrat" scenario, for instance, merely requires that white non-college-educated voters return to their 2012 level of support for Democrats. Joe Biden is the logical candidate, health permitting, as he is from Pennsylvania and was literally on the ballot in 2012! Moreover, these states are the easiest to flip to the Democratic side via the woman vote. In Michigan, a 0.5% swing of women to the Democrats would have turned the state blue again; in Pennsylvania that number is 1.6% and in Wisconsin it is 1.7% (Table 4). These are the lowest of any state. Women from the Midwest or with a base in the Midwest - such as Michelle Obama or Oprah Winfrey - would also be logical candidates. Table 4Women Voters May Hold The Balance The Democrats could also pursue a separate or complementary strategy by courting African American turnout and support, especially in Florida, Georgia, and North Carolina. But it is more difficult to flip these states than the Midwestern ones. With the Rust Belt as the fulcrum of his electoral strategy and reelection, Trump has a major incentive to maintain economic nationalism over the coming two years. Trump may be more pragmatic in the use of tariffs, and will certainly engage in talks with China and others, but he ultimately must remain "tough" on trade. He has fewer constraints in pursuing trade war with China than with Europe. For the same Rust Belt reason, the Democrats, if they get into the Oval Office, will not be overly kind to the "butchers of Beijing," as President Clinton called the Chinese leadership in the 1992 presidential campaign (after the 1989 Tiananmen Square incident). Hence we are structurally bearish U.S.-China relations and related assets. Interestingly, if Trump moves to the middle, and tones down "white nationalism" in pursuit of college-educated whites and minorities, then he would have an incentive to dampen the flames of social division ahead of 2020. The key is that in an environment without recession, Trump has the option of courting voters on the basis of his economic and policy performance alone. Whereas if he is seen fanning social divisions, it could backfire, as Democrats could benefit from a sense of national crisis and instability in a presidential election. Either way, culture wars, controversial rhetoric, identity politics, unrest, and violence will continue in the United States as the fringes of the political spectrum use identity politics and wedge issues to rile up voters.The question is how the leading parties and their candidates handle it. What about after 2020? Are there any conclusions that can be drawn regardless of which party controls the White House? The two biggest policy certainties are that fiscal spending will go up and that generational conflict will rise. On fiscal spending, Trump was a game changer by removing fiscal hawkishness from the Republican agenda. Democrats are not proposing fiscal responsibility either. The most likely areas of bipartisan legislation in 2018-20 are health care and infrastructure - returning House Speaker Nancy Pelosi mentioned infrastructure several times in her election-night speech - which would add to the deficit. The deficit is already set to widen sharply, judging by the fact that it has been widening at a time when unemployment is falling. This aberration has only occurred during the economic boom of the 1950s and the inflation and subsequent stagflation beginning in the late 1960s (Chart 14). The current outlook implies a return of the stagflationary scenario. In the late 1960s, the World War I generation was retiring, lifting the dependent-to-worker ratio and increasing consumption relative to savings. Today, as Peter Berezin of BCA's Global Investment Strategy has shown, the Baby Boomers are retiring with a similar impact. Chart 14The Deficit Is Blowing Out Even Without A Recession Trump made an appeal to elderly voters in the midterms by warning that unfettered immigration and Democratic entitlement expansions would take away from existing senior benefits. By contrast, Democrats will argue that Republicans want to cut benefits for all to pay for tax cuts for the rich, and will try to activate Millennial voters on a range of progressive issues that antagonize older voters. The result is that policy debates will focus more on generational differences. Mammoth budget deficits - not to mention trade war - will be good for inflation, good for gold, and a headwind for U.S. government bonds and the USD as long as the environment is not recessionary. The greatest policy uncertainties are health care and immigration. These are the two major outstanding policy issues that Republicans and Democrats will vie over in 2018 and beyond. While President Trump could achieve something with the Democrats on either of these issues with some painful compromises, it is too soon to have a high conviction on the outcome. But assuming that over the coming years some immigration restrictions come into play and that some kind of public health care option becomes more widely available, there are two more reasons to expect inflation to trend upward on a secular basis. Also on a secular basis, defense stocks stand to benefit from geopolitical multipolarity, especially U.S.-China antagonism. Tech stocks stand to suffer due to the trade war and an increasingly bipartisan consensus that this sector needs to be regulated.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com   1 Furthermore, victories on the state level, if built upon in the 2020 election, could give the Democrats an advantage in gerrymandering, i.e. electoral redistricting, which is an important political process in the United States. 2 Please see Allan J. Lichtman, Predicting The Next President: The Keys To The White House 2016 (New York: Rowman and Littlefield, 2016). 3 Please see Joseph Bafumi, Robert S. Erikson, and Christopher Wlezien, "Balancing, Generic Polls and Midterm Congressional Elections," The Journal of Politics 72:3 (2010), pp. 705-19. 4 Please see footnote 2 above. 5 Please see Sylvan Lane, “Trump says Fed is his ‘biggest threat,’ blasting own appointees,” The Hill, October 16, 2018, available at thehill.com. 6 Please see Rob Griffin, Ruy Teixeira, and William H. Frey, "America's Electoral Future: Demographic Shifts and the Future of the Trump Coalition," Center for American Progress, dated April 14, 2018, available at www.americanprogress.org. 7 In several cases, he did not have to lift white support by as much as we projected because minority support for the Democrats dropped off after Obama left the stage. 8 Interestingly, however, this scenario would result in an electoral college tie! Since the House would then vote on a state delegation basis, it would likely hand Trump the victory (and Pence would also win the Senate). 9 However, if they win Pennsylvania plus one electoral vote in Maine, they can win the electoral college with either Michigan or Wisconsin.

Highlights After tumbling more than 20% between June and August, copper prices have remained largely static. This reflects the tug-of-war between the near-term bullish physical market fundamentals, and the cloudier macro headwinds ahead, arising from a stronger U.S. dollar. Furthermore, Chinese policymakers are unlikely to abandon their reform agenda and stimulate massively, which will put downside pressure on copper prices further down the road. Despite our negative 12-month outlook, we do not rule out the potential for some upside going into year-end, on the back of falling inventories. Energy: Overweight. News leaked earlier this week indicates the Trump administration is divided over whether to grant waivers on Iranian crude oil imports to big importers like China, India and Turkey, following the re-imposition of sanctions on November 4.1 The U.S. State Department, in particular, appears worried the sanctions will produce a price spike that could derail growth in the U.S. and its allies. This suggests the Administration will be less determined to enforce its Iranian export sanctions, until it has been assured Saudi Arabia and Russia will be able to bring enough production on line in 1H19 to cover the lost Iranian exports, and possible deeper Venezuelan losses. Markets will remain focused on actual export losses from Iran - if they come in at the high end of expectations (i.e., greater than 1.5mm b/d), we expect higher prices; if it becomes apparent the U.S. will go soft on enforcing sanctions, prices would fall. Expect higher volatility. Base Metals: Neutral. Copper prices could rally over the short term, on the back of lower inventories. However, longer term, we see no catalysts to push prices toward recent highs of ~ $3.30/lb on the COMEX. Precious Metals: Neutral. Gold's break above $1,200/oz is holding, but it continues to grind in a $1,210 to $1,240/oz range. Ags/Softs: Underweight. The USDA will report on export sales of grains and oil seeds today. Soybean exports were down 21% y/y for the current crop year, based on the Department's October 18 report. Feature Tight Market Conditions Suggest A Brief Upswing ... After remaining in the $2.90-$3.30/lb trading range for the better part of 1H18, copper prices plunged ~20% since their June peak. The trigger? The escalation of the U.S.-China trade war. The increasingly acrimonious trade relationship acted as a reality check. Investors betting on strike-induced mine supply shortfalls earlier this year were forced to adjust expectations regarding the resilience of the global, and, more specifically, the Chinese business cycles.2 The negative impact of the trade war is clear: copper prices moved to the downside with each escalation in the dispute (Chart of the Week). While current market fundamentals do not necessarily warrant such drastic declines, we see these developments as a wake-up call to market participants. Copper sentiment - previously buoyed by expectations of mine strikes (which failed to materialize) - has come crashing down (Chart 2). Chart of the WeekCopper Down On Trade War Chart 2Sentiment Has Come Crashing Down However, the outlook in the very near term is not so bleak. The evidence below suggests tight physical conditions, indicating copper's next move could be to the upside: Chinese copper imports came in strong in September (Chart 3). While unwrought copper imports reached a 2.5-year high, ores and concentrates forged new record highs. Chart 3Chinese Imports Came In Strong The resilience of Chinese purchases comes on the back of restrictions on scrap imports, which account for a significant share global copper supply (Chart 4). As we have been highlighting, Chinese restrictions on the purity of scrap imports require other forms of the metal to fill the supply gap.3 At the same time, the 25% tariff imposed on Chinese imports of U.S. scrap since August also manifests itself in greater demand for other forms of the metal. This is evident in weak scrap copper imports (Chart 5). Chart 4A Dependable Secondary Market Is Essential For Global Supply Chart 5Scrap Import Restrictions Raise Need For Other Forms Of Copper Copper inventories at the three major global exchange warehouses have been declining steadily and together now stand at half their late April peak (Chart 6). This is their lowest level since late 2016. Chart 6Exchange Inventories At Two Year Low The above evidence of a tight market is in line with copper's futures curve, which is recently pricing a premium for physical delivery (Chart 7). Chart 7Markets Pricing A Premium For Physical Delivery Going into the winter, smelter disruptions may lend further upside support amid these tight conditions: The Vedanta copper smelter in the Indian state of Tamil Nadu was forced to shut down in May due to violent protests. The smelter has an annual production of over 400k MT. In Chile, Codelco gave notice to the market that two of its four smelters will undergo weeks-long outages, in order to comply with tightening of emissions rules - requiring smelters to capture 95% of emissions - due to take effect in December. This will halt production from smelters at the Chuquicamata and Salvador mines for 75 days and 45 days, respectively. Furthermore, in mid-October BHP Billiton reduced its 2018 copper production forecast by 3% to between 1.62mm MT and 1.7mm MT, due to shutdowns at its Olympic Dam facility in Australia and Spence in Chile. Bottom Line: Dynamics at the scrap level in China and disruptions at major smelters in India, Chile and Australia justify tight copper market conditions. This offers potential for a minor rebound in copper prices in the very near term. ... Ahead Of Macro Headwinds In the medium term, macro headwinds will dominate the physical market, capping gains in copper prices. Most notably, fall-out from the U.S.-China trade war in absence of aggressive traditional forms of stimulus, will weigh on demand there. Furthermore, U.S. dollar strength on the back of economic and monetary policy divergences, will make the red metal more expensive for global consumers. Ex-U.S. Growth Unpromising Given the stimulative fiscal policies in the U.S., our House View still does not expect a recession before late-2020. However in the meantime, the global economy will be characterized by divergence in favor of the U.S. (Chart 8). Chart 8Global Economic Divergence Favors U.S. Of utmost importance is, of course, China - where roughly half of global refined copper is consumed. The trade dispute with the U.S. has raised concerns over the resilience of the Chinese economy. Recent data releases have done little to ease fears of a manufacturing slowdown. The Li Keqiang Index and our China construction proxy - both of which are strongly correlated with copper prices - are on a slight downtrend (Chart 9). Chart 9Ominous Signs From China China's 3Q18 GDP data indicate the Chinese economy grew by the slowest pace in nearly a decade (Chart 10). At the same time, PMI's have fallen to or near the 50 level - the boom-bust line - reflecting pessimism in the manufacturing sector. The real estate market - where 45% of China's copper is consumed - also looks gloomy. Home sales rolled over, boding ill for future housing starts. Chart 10Weak Q3 GDP Mirrors Manufacturing And Property Sectors What's more, we are not betting on a flood of stimulus to rescue China's ailing economy. As our colleagues at BCA's Geopolitical Strategy service have been highlighting, the drive to combat vulnerabilities in financial markets raised the pain threshold of Chinese policymakers.4 As such, they are not likely to abandon their reform agenda at the first sign of weakness, as they traditionally have. Although some measures have already been implemented to ease policy, the current response is not yet as promising for commodity markets as has historically been the case. For one, credit growth is constrained by China's de-leveraging campaign. Although there is some evidence that the clampdown on shadow financing is easing, it is not yet at simulative levels (Chart 11). And while the money impulse is rebounding thanks to Reserve Requirement Ratio cuts, the credit impulse is still falling deeper into negative territory. Chart 11Shadow Banking Restrained By Reform Agenda Additionally, as Peter Berezin who heads BCA's Global Investment Strategy highlights, China's more recent forms of (consumption-based) stimulus such as income tax reforms do not boost commodity demand. The same goes for the other way in which Chinese authorities are trying to stabilize their economy: by depreciating the RMB. This is in clear contrast to traditional measures such as fixed asset investment, which stimulate demand for raw materials and capital goods.5 Overall, the current level of stimulus is not sufficient to boost the Chinese economy. Nor, by extension, is it enough to lift EMs, and commodity prices in the process. In fact, copper markets have been oblivious to various announcements by Chinese authorities that they are easing policy (Chart 12). Chart 12Copper Markets Oblivious To Chinese Stimulus Our Geopolitical Strategists warn that the U.S.-China trade war could get worse before it improves. Thus, while policymakers are not yet compelled to throw in the towel with their reform agenda, they are pragmatic and will likely intensify their response if conditions deteriorate further. If authorities were to deploy massively stimulative fiscal and monetary policy by propping up infrastructure and the real estate sector - as they traditionally have done - chances are that we would be able to escape further price weakness in copper markets. For now, the evidence points at a more modest policy approach. Green Dollar, Red Metal As a counter-cyclical currency, the U.S. dollar will shine in the current weaker ex-U.S. growth environment. What's more, limited spare capacity in the U.S. and a strong labor market foreshadow rising U.S. inflation readings. This will justify continued tightening by the Fed. Economic divergences favoring the U.S. economy will amplify the impact. Rising U.S. borrowing costs will be painful for debt-laden EM economies. Their Central Banks will struggle to keep the pace with the Fed. Similarly, the European Central Bank - conscious of turmoil in Italy - will be forced to maintain a more dovish stance. This will weigh down on the EUR/USD. A stronger dollar generally dents demand by making commodities - priced in U.S. dollars - more expensive for foreign consumers. While energy markets dominated by supply risks remain disconnected from their long-term negative correlation with the U.S. dollar, the relationship with metals has re-converged (Chart 13).6 This leaves copper more vulnerable to the downside amid dollar strengthening. The impact will be magnified for Chinese consumers as the RMB weakens further, forcing the top consumer to cut down on imports of the red metal. Chart 13USD-Copper Relationship Re-converged Bottom Line: Headwinds from weakness in China and a stronger dollar will be a drag on demand next year. Unless Chinese policymakers temporarily abandon their reform agenda and stimulate massively, medium term copper prices will face pressures to the downside. Model Updates Given the macro headwinds outlined above, we revised our copper demand forecast. Our balances now point to a slight surplus in 2019 (Chart 14). In the context of 24mm MT of consumption p.a., a 100k MT surplus can be characterized as a balanced market. This makes prices vulnerable to upside or downside surprises, which can easily tip the scale. Chart 14Broadly Balanced Market In line with our market assessment, we simulated forecasts for copper prices based on a 5% and 10% appreciation in the USD over the coming 12 months (Chart 15). Chart 15Macro Headwinds In 2019   Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Reuters published an interesting analysis containing the apparently leaked information re the internal disputes in the Trump administration entitled "Trump's sanctions on Iran tested by oil-thirsty China, India" on October 29, 2018. 2 In the Commodity & Energy Strategy Weekly Report published January 25, 2018, we highlighted the risk to mine supply in 2018 on the back of an unusually large number of labor contract renegotiations taking place this year - representing ~ 5 mm MT worth of mined copper. Most noteworthy was the risk of a strike at the Escondida copper mine in Chile. These have been largely resolved with minimal impact on supply. Please see "Stronger USD, Slower China Growth Threaten Copper," available at ces.bcaresearch.com. 3 Please see BCA Research Commodity & Energy Strategy Weekly Report titled "Copper: A Break Out, Or A Break Down?" dated May 17, 2018. Available at ces.bcaresearch.com. 4 Please see BCA Research Geopolitical Strategy Special Report titled "China Sticks To The Three Battles," dated October 24, 2018. Available at gps.bcaresearch.com. 5 Please see BCA Research Global Investment Strategy Weekly Report "Chinese Stimulus: Not So Stimulating" dated October 26, 2018, available at gis.bcaresearch.com. 6 Please see BCA Research Commodity & Energy Strategy Weekly Report titled "Correlations Vs. USD Weaken," dated June 14, 2018. Available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Highlights Economic data and policy announcements over the past month reflect the view that policymakers are serious about restraining credit growth, and that they will attempt to combat any weakness in external demand by boosting domestic consumption. A review of historical episodes of "outsized" investment intensity shows that policymakers have good reason to try and shift the composition of China's economy towards consumption, as it suggests that China's current experience probably cannot be sustained. A shift even somewhat away from heavy investment-led growth means that the "strike price" of the China put option has fallen relative to past economic slowdowns, implying that it will take more pain before investors can cash in. It is too soon to move towards an outright long position favoring domestic stocks, even though considerable bad news has been priced in. CNY-USD likely has further downside, and investors allocating among Chinese stocks should only favor domestic over investable equities in currency-hedged terms. Feature September's total social financing data, released earlier this month, provided important evidence supporting our view that Chinese policymakers are not aiming for a significant acceleration in private sector credit growth. Chart 1 highlights that the year-over-year growth rate of adjusted total social financing (TSF) actually ticked modestly lower in September, in clear contrast to the bet of many investors that China is following its "old stimulus rulebook". Chart 1Chinese Policymakers Are Not Pumping The Credit Taps Some market participants have pointed to the fact that adjusted TSF is rising sharply on a 3-month annualized basis after adjusting for seasonality (Chart 2), and have concluded from this fact that a sustained expansion in credit growth is forthcoming. However, Chart 3 illustrates that the pickup shown in Chart 2 is due to a surge in special local government bond issuance, which reflects front-loading of fiscal spending. Financial news outlets have reported that "provincial authorities had by the end of September already raised 92 percent of the 1.35 trillion yuan ($195 billion) worth of special infrastructure bonds that the central government has targeted for the entire year",1 implying that local government bond issuance in Q4 will drop off significantly relative to the past three months. Chart 2A Near-Term Pickup... Chart 3...Caused By Front-Loaded Fiscal Spending The September credit data aside, we acknowledge that there have been several small-scale stimulus announcements from the Chinese government over the past month. But the bottom line for now is that developments over this period reflect the view that policymakers are serious about restraining credit growth, and that they will attempt to combat any weakness in external demand by boosting domestic consumption.2 Restraining Credit Growth: Wisdom Or Folly? China's unwillingness to resort to a significant acceleration in credit growth to help stabilize its economy has surprised some investors, and raised criticism in some corners that the country is making a policy mistake. A recurring argument in this vein, particularly among perennial China bulls, is that policymakers should not be concerned about China's elevated levels of private sector debt because it is the natural and inevitable result of a high savings rate. According to this view, restraining credit growth and attempting to boost consumption merely dooms China's ability to escape the middle-income trap, because higher per capita income can only be achieved by further growth in the stock of capital. BCA's China Investment Strategy service does not dispute the notion that a high savings rate can lead to a high leverage ratio, particularly among small, fast-growing economies. But in the case of China, the sharp rise in private sector debt that has occurred since 2010 was not natural, and certainly was not inevitable. Instead, our view is that it was the result of an explicit "least-bad" choice made by policymakers to weather the reality of poor external demand following the global financial crisis. Chart 4 presents, in a nutshell, the theoretical support for the "keep investing" view. The chart depicts real per capita GDP for 80 countries in 2014 as a function of the average share of gross capital formation to GDP from 1960 to 2014. The chart clearly shows that richer countries today have tended to invest more on average in the past, which is entirely consistent with textbook economic theory. Chart 4Higher Investment Has Led To Higher Per Capita GDP Growth... However, there are two reasons why the simple inference from Chart 4 that China should just "keep investing" is deeply flawed. First, while investment as a share of GDP in China has recently declined from its 2011-2014 peak, it remains close to 45%. This is a massive rate of investment, and a historical review points to the conclusion that it probably cannot be sustained: 45% is nearly off the x-axis scale shown in Chart 4, suggesting that China's current rate of investment is not achievable over extended periods of time. In fact, the chart suggests that 30% is the highest realistic rate of investment as a share of GDP that a country can maintain over an extended period. In 2014, based on the definition of the data from the Penn World Table (GDP share of gross capital formation at current purchasing power parity), China had maintained its investment share above 30% for 12 years. At first blush, there appears to be some precedent suggesting that China's outsized investment run can go on for longer: among the 80 countries included in Chart 4, 14 of them have experienced a longer continuous run of investment as a share of GDP. However, Chart 5 shows that most of these experiences occurred in the 1960s and 1970s, when global exports as a share of GDP were rising from a very low base. This implies that historical examples of outsized investment runs have largely reflected export-driven catch-up stories, which bodes poorly for China's ability to continue to invest at its recent massive scale given that global exports to GDP appear to have peaked. Chart 5...But Very High Rates Of Investment Have Driven By Exports Second, the relationship shown in Chart 4 captures the potential gains of profitable and rational investment, or in other words the accumulation of a "useful" stock of capital. But an unfortunate reality facing savers is that while one can choose to save or invest, one cannot necessarily choose the accompanying rate of return. If China invests heavily at very low or negative rates of return, the idea that investment will lead China out of the middle-income trap is very likely wrong. As we have discussed in previous reports, there is good evidence to suggest that the marginal gains from investment in China have been falling. The private sector debt-to-GDP ratio features prominently in the case against profitable investment in China: despite a massive rise in investment and debt from 2002-2007, the private sector debt-to-GDP ratio barely rose, because this debt was used to accumulate capital that verifiably delivered nominal GDP growth. Yet following 2010 the ratio rose sharply, implying that the returns from the investment that has taken place over the past decade have been (at least so far) considerably lower than those of the prior decade. Also, we noted in our August 29 Special Report that state-owned enterprises (SOEs) have accounted for a sizeable portion of the private sector leveraging that occurred after 2010,3 and that the marginal operating gain from debt for SOEs has become negative (Chart 6). A gap between the cost/return on borrowed funds strongly implies that the investment channeled through SOEs over the past several years does not represent, on balance, the accumulation of useful capital. Chart 6Strong Evidence Against Productive SOE Investment In our view, a cohesive story emerges from the above analysis, one that counters the view that China is making a policy mistake by trying to avoid another significant episode of private sector leveraging. China's enormous catchup in per capita GDP over the past 20 years was initially export-led, but was sustained after 2010 by quasi-fiscal spending in the form of a material leveraging of state-owned enterprises. This shadow government spending was aimed at preventing large-scale job losses, but proved to be considerably less productive than the private, export-driven investment-boom that preceded it. This suggests that China is simply investing too much for an economy that needs to accumulate capital for the purposes of domestic production, and that any further, aggressive leveraging of the private sector will simply raise the odds or the cost of the eventual bailout. While investors who are hoping to profit from China's credit excesses may wish for a different outcome, the bottom line is that Chinese policymakers will act in the best interests of their country, and they have good reason to try and shift China's economy away from extremely high rates of investment towards more consumption. Implications For Investment Strategy As would be the case in any other major country, we have no doubt that Chinese policymakers will eventually move to a maximum reflationary stance (which would imply a significant reacceleration in credit growth) if they feel that the existing slowdown will lead to deep, threatening economic instability. The key point for investors is that a desire of policymakers to shift even somewhat away from heavy investment-led growth means that the "strike price" of the China put option has fallen relative to past economic slowdowns, implying that it will take more pain before investors can cash in. Within the universe of Chinese financial assets, there are three pertinent investment strategy questions that arise from this reality: Even if there is more pain to come, Chinese domestic stocks have fallen 30% in local currency terms, and close to 40% in U.S. dollar terms (Chart 7). Is it time to go outright long? Should investors allocating among Chinese stocks favor domestic or investable equities? What is the outlook for CNY-USD? For now, our answers are as follows: 1) not yet, 2) domestic over investable in currency-hedged terms, and 3) weaker (possibly significantly so). Chart 7The Bear Market In A-Shares Is Advanced... We agree that 30% is a reasonable estimate of the likely decline in domestic earnings over the coming year, which normally would suggest that A-shares have fully priced the bad news and that investors should consider buying. However, there are two key reasons why we think this conclusion is premature: We noted in our September 19 Weekly Report that the lesson of 2014/2015 was Chinese stocks needed both policy stimulus and earnings clarity before bottoming.4 For now, China's stimulative response has been measured, and we have yet to see any decline in domestic 12-month forward earnings (Chart 8). While it is not the only factor contributing to the decline, the escalation in the trade war with the U.S. acted as a clear negative catalyst for the Chinese stock market. We have argued that the evolution of the trade positions of both sides suggests that the imposition of a third and final round of import tariffs covering all Chinese exports to the U.S. is likely, which would further reduce Chinese earnings visibility for investors. News reports this week suggested that an announcement to this effect could occur in early-December, if a meeting between Presidents Trump and Xi is called off or fails (as we expect). Chart 8...But Forward EPS Have Yet To Start Falling Chart 9 presents our framework for forecasting CNY-USD as a function of various U.S. import tariff scenarios, which we used to argue that a break above the psychologically-important level of 7 for USD-CNY appeared likely barring strong action from the PBOC4. The RMB has weakened in line with our view over the past month, and Chart 9 shows that it stands to weaken further, potentially significantly, if the U.S. does move ahead with a 25% import tariff on all imports from China. Chart 9Further Downside In CNY-USD Is Likely Finally, our negative outlook for the currency informs our view that a relative position favoring domestic over investable stocks should be currency-hedged. Chart 10 shows that an uptrend in relative performance does appear to be forming in local currency terms, but not in U.S. dollar terms (due to the recent renewed weakness in CNY-USD). Chart 10Relative To Investable Stocks, Only Favor A-Shares In Hedged Terms We opened a shadow trade in our July 5 Weekly Report of being long the MSCI China A Onshore index / short MSCI China index,5 which we said we would consider implementing in response to a 5% rally in relative performance. Our intention was to structure this trade in unhedged terms (consistent with most of the trades in our trade book), and our judgement is that it is simply too early to do so despite the fact that a 5% relative rise in U.S. dollar terms has indeed occurred. Signs of a durable bottom in CNY-USD, or an assessment of minimal further downside coupled with strong outperformance of domestic stocks in local currency terms, are likely catalysts for a green light. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 "China Is Struggling To Find Projects To Spend Bond Splurge On", Bloomberg News, October 22, 2018. 2 Pease see China Investment Strategy Special Reports "China: How Stimulating Is The Stimulus?", dated August 8, 2018, and "China: How Stimulating Is The Stimulus? Part Two", dated August 15, 2018, available at cis.bcaresearch.com. 3 Pease see China Investment Strategy Special Report "Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging", dated August 29, 2018, available at cis.bcaresearch.com. 4 Pease see China Investment Strategy Weekly Report "Investing In The Middle Of A Trade War", dated September 19, 2018, available at cis.bcaresearch.com. 5 Pease see China Investment Strategy Weekly Report "Standing On One Leg", dated July 5, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights The correction in global equities is not yet over, but we would turn more constructive if stocks retreated about 6% from current levels. Among the many things bothering investors, the fate of the Chinese economy remains high on the list. Chinese growth continues to slow, with the impact of the trade war yet to be fully felt. Investors are likely to end up being disappointed by both the size and the composition of Chinese stimulus. High debt levels and excess capacity limit the prospective benefits of traditional fiscal/credit easing. Stimulus measures aimed at boosting consumption, which is what the authorities are increasingly focusing on, would help the Chinese economy. However, they would generate only small gains for the rest of the world. A weaker yuan would be outright negative for other economies. Cyclically and structurally, we expect the bond bear market to continue, but slower Chinese growth and a stronger dollar could temporarily cap Treasury yields over the coming months. Feature Correction Slightly More Than Halfway Through We argued in our October 5th report that "prudent investors should consider scaling back risk if they are currently overweight risk assets" because the market was at an elevated risk of a "phase transition" from unbridled optimism to a more sober appreciation of the risks presently facing the global economy.1 The good news is that the ongoing correction will be just that, a correction. Both monetary and fiscal policy in the U.S. remain highly accommodative. The next recession will not occur until late-2020 at the earliest. U.S. equities, which account for over half of global stock market capitalization, rarely enter sustained bear markets outside of recessions (Chart 1). Chart 1Recessions And Bear Markets Usually Overlap The bad news is that we have yet to reach a capitulation point. As we noted last week, corrections usually end when investors stop believing that they are witnessing a correction and start thinking that a bear market is afoot.2 Normally, stocks need to break through prior support levels several times before "buy the dip" investors throw in the towel. This week saw the S&P 500 fall below its October 11th lows. A few more iterations of this pattern may be necessary. To repeat what we wrote before, barring any major new developments, we would turn bullish on global equities again if the MSCI All-Country World Index were to fall by 12% 10% 8% 6% from current levels. With that in mind, we are putting in a limit order to buy the ACWI ETF at $64.3 Emerging Markets: Time To Pay The Piper Even if we were to turn more positive on global equities, we would maintain our preference for developed market stocks over emerging markets, despite the latter's higher beta nature. The wave of liquidity created by the Fed and other major central banks over the past decade ended up flowing into places where it was not needed. Emerging markets were a prime destination: Dollar-denominated debt in emerging markets now stands at levels reached just before the late-1990s Asian Crisis (Chart 2). Chart 2EM Dollar Debt At Late-1990s Levels While EM valuations have cheapened considerably, they are not yet at washed out levels. The latest BofA Merrill Lynch Global Fund Manager Survey showed that managers were slightly net overweight emerging market equities in October. This is a far cry from 2015, when a net 30% of managers were underweight EM stocks. Chinese Stimulus To The Rescue? China figures heavily into the equation. If the Chinese government were to deliver a massive dose of traditional fiscal/credit easing, this would boost fixed-asset investment and thus commodity prices, helping emerging markets in the process. Such a dollop of stimulus would also lift global growth. As a countercyclical currency, the U.S. dollar tends to weaken when global growth accelerates (Chart 3). The reflationary impulse from higher commodity prices and a softer dollar would be manna from heaven for emerging markets. Chart 3Decelerating Global Growth Tends To Be Bullish For The Dollar If we had strong confidence that such a burst of stimulus were forthcoming, we would be comfortable in calling the end of the global stock market correction now and going overweight EM assets. Unfortunately, the evidence so far suggests that while the Chinese authorities are stimulating the economy, they are not doing so by enough to reignite growth (Chart 4). Chart 4Chinese Growth Remains Soft Real GDP increased at a weaker-than-expected pace in the third quarter. Industrial production surprised on the downside in September, echoing declines in the manufacturing PMI. Home sales are running well below housing starts, suggesting downside risk for the latter in the months ahead. Goldman's China Current Activity Indicator has continued to grind lower, while the economic surprise index remains mired in negative territory. Our conversations with clients suggest that most are expecting the recently announced stimulus measures to arrest and then reverse the downward trend in growth. We are not so sure. As our geopolitical team has stressed, the Chinese government has expended a lot of political capital on its reform agenda.4 Abandoning it now would not only cause the government to lose credibility, but it would undermine the very reasons it was implemented in the first place. Waves of stimulus have caused total debt to soar from 140% of GDP in 2008 to 260% of GDP at present (Chart 5). Since most of the new credit has been used to finance fixed-asset investment, China has ended up with a severe overcapacity problem. The rate of return on assets in the state-owned corporate sector has fallen below borrowing costs (Chart 6). Our China team estimates that 15%-to-20% of apartments are sitting vacant.5 Chart 5China: Debt And Capital Accumulation Went Hand In Hand Chart 6Rate Of Return On Assets Below Borrowing Costs For Chinese SOEs Today, Chinese banks are being told that they must lend more money to support the economy, while ensuring that their loans do not sour. This has become an impossible feat. As such, we are skeptical that the recent acceleration in credit growth will have long legs (Chart 7). Anecdotal evidence suggests that some companies which are receiving credit are simply holding on to the cash, rather than running the risk of being accused of investing in money-losing projects. Monetary policy in China is increasingly pushing on a string. Chart 7China: Only A Modest Acceleration In Credit Growth Rebalancing: Be Careful What You Wish For This does not mean that China will not try to prop up its economy. It will. But the form of stimulus the government pursues may not be to foreign investors' liking. For example, consider the recently announced income tax reforms, which raise the threshold at which households need to start paying taxes while increasing deductions for education, health, housing, and eldercare. In and of themselves, these measures are admirable and long overdue. The Chinese income tax system is fairly regressive. Poor households face an effective income tax rate exceeding 40%. This is well above OECD norms (Chart 8).6 A more progressive tax system would boost consumption among poorer households. Chart 8High Tax Burden For Low-Income Households In China The snag is that raw materials and capital goods comprise 85% of Chinese imports. As Arthur Budaghyan, BCA's Chief EM strategist, has long noted, policies that boost Chinese consumption are simply less beneficial to the rest of the world than policies that boost investment.7 Pundits who talk about the virtue of "rebalancing" the Chinese economy away from fixed-asset investment and towards consumer spending should be careful what they wish for! The Trade War Will Heat Up One of the more notable aspects of China's recent slowdown is that it has been concentrated in domestic demand rather than in net exports. Remarkably, Chinese exports to the U.S. actually increased by 12% in dollar terms in the first nine months of the year, compared to the same period in 2017. However, judging from the steep drop in the export component of both the official and private-sector Chinese manufacturing PMI, the export sector is likely to come under increasing pressure over the next few quarters as the headwinds from higher tariffs fully manifest themselves (Chart 9). Chart 9China: An Ominous Sign For Exports Investors hoping that U.S. President Donald Trump and his Chinese counterpart Xi Jinping will reach a deal to end the trade war on the sidelines of the G20 leaders' summit in Buenos Aires on November 29 are likely to be disappointed. As we have stressed in the past, Trump's fiscal policy is completely inconsistent with his trade agenda. Fiscal stimulus in a full-employment economy will suck in imports. It will also force the Fed to raise rates more aggressively than it otherwise would, leading to a stronger dollar. The result will be a larger trade deficit. Trump will not be able to blame Canada or Mexico for a deteriorating trade position because he just signed a "big, beautiful" trade agreement with them (incidentally, the new USCAM USMCA agreement is remarkably similar to the "horrible" one that it replaced with the notable exception that it contains a clause barring Canada and Mexico from negotiating bilateral trade deals with China). This means Trump needs a patsy who will take the blame for America's burgeoning trade deficit. Reaching a deal with China would actually be a strategic mistake for Trump's political career. A Weaker RMB Ahead A weaker Chinese currency would blunt some of the pain inflicted on China's export sector from Trump's tariffs. There is obviously a limit to how far China can let its currency slide, but last week's decision by the U.S. Treasury to refrain from labeling China a currency manipulator will probably embolden the Chinese to allow the currency to depreciate some more from current levels.8 A weaker Chinese currency would be a cold shower for the rest of the world. Not only will it make other economies less competitive in global markets; it will also reduce Chinese imports. Concluding Thoughts Investors spend a lot of time debating the magnitude of China's stimulus plans and not enough time thinking about the composition of that stimulus. Credit/fiscal easing of the sort China has historically engaged in is good for other emerging markets because it sucks in raw materials and capital goods. In contrast, consumption-based stimulus is only modestly beneficial to the rest of the world, while a weaker Chinese currency is an outright negative for other economies. If China focuses more on the latter two types of stimulus and less on the former, global investors are likely to be disappointed. Emerging market assets have cheapened considerably over the past few months and will likely find a bottom in the first half of next year. For now, however, investors should overweight developed market stocks relative to their EM peers. Consistent with our July 5, 2016 call declaring "The End Of The 35-Year Bond Bull Market," both the cyclical and structural trend in bond yields is firmly to the upside. Tactically, however, bonds are deeply oversold (Chart 10). The combination of slower EM growth, disappointments over the magnitude and composition of Chinese stimulus, and a stronger dollar will put a lid on yields over the next few months. Chart 10Treasurys Are Oversold Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "The Next U.S. Recession: Waiting For Godot?" dated October 5, 2018. 2 Please see Global Investment Strategy Weekly Report, "Phase Transitions In Financial Markets: Lessons For Today," dated October 19, 2018. 3 Valid during extended trading hours. 4 Please see Geopolitical Strategy and China Investment Strategy Special Report, "How Stimulating Is The Stimulus? Part Two," dated August 15, 2018. 5 Please see Emerging Market Strategy Special Report, "China Real Estate: A Never-Bursting Bubble?" dated April 6, 2018. 6 Please see Global Investment Strategy Special Report, "Is China Heading For A Minsky Moment?" dated April 13, 2018. 7 Please see Emerging Markets Strategy Weekly Report, "The Dollar Rally And China's Imports," dated May 24, 2018. 8 Ironically, while China may not be manipulating its currency based on the Treasury's legal definition, economic logic suggests it is. True, China is no longer buying dollars in a bid to weaken the yuan. In fact, its reserves have actually declined significantly since 2015. However, the value of the yuan is determined not just by current dollar purchases; it is also determined by those that have taken place in the past. If a central bank buys dollars, this bids up the value of those dollars relative to its own currency. If it then stops buying dollars, its currency does not instantly fall back to its original level. All things equal, it just stays where it is. The best parallel is with quantitative easing. Both theory and evidence suggest that it is the stock of bonds that a central bank owns, rather than the flow of bonds in and out of its balance sheet, that determines the level of yields. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades