Currencies

Highlights We always strive to develop new analytical methods to complement our focus on judging currencies based on global liquidity conditions and the business cycle. This week, we introduce a ranking method based strictly on domestic factors: We call it the Aggregate Domestic Attractiveness Ranking. Using this method alone, the USD, the NZD, the AUD, and the NOK are the most attractive currencies over the coming three months, while the JPY, the GBP, the EUR and the CHF are the least attractive ones. If we further filter the results using a valuation gauge, the USD, the NOK and the CAD are the most attractive currencies over the coming three months, while the CHF, the JPY and the GBP are the least attractive ones. Ultimately, the message is clear: if the dollar corrects, domestic factors suggest it will be shallow. However, buying pro-cyclical commodity currencies at the expense of countercyclical ones makes sense no matter what. Feature This publication places significant emphasis on understanding where we stand in the global liquidity and business cycle in order to make forecasts for G-10 currencies. However, we also like to refer to other methods to add supplementary dimensions to our judgment calls. In this optic, we have focused on factor-based analyses such as understanding momentum, carry and valuation considerations. This week, we take another approach: We build a ranking methodology using domestic economic variables only, intentionally excluding global business cycle factors. Essentially, we want to create an additional filter to be used independently of our main method. This way, we can develop a true complement to our philosophy rooted in understanding the global business cycle. With this approach, we rank currencies in terms of domestic growth, slack, inflation, financial conditions, central bank monitors, and real rates. We look at the level of these variables as well as how they have evolved over the past 12 months. After ranking each currency for each criterion, we compute an aggregate attractiveness ranking incorporating all the information. We then compare the attractiveness of each currency to their premiums/discounts to our Intermediate-Term Timing Models. Based on this methodology, the USD, the NOK and the CAD are the most attractive currencies over the coming three months, while the CHF, the JPY, and the GBP are the least attractive ones. Building A Domestic Attractiveness Ranking Domestic Growth The first dimension tries to capture the strength and direction of domestic growth. We begin by looking at the annual growth rate of industrial production excluding construction, as well as how this growth rate has evolved over the past 12 months. Here, the currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. As Chart I-1 illustrates, Sweden is performing particularly well on this dimension, while the euro area, Switzerland, the U.K, and Japan are not. The U.S. stands toward the middle of the pack. When aggregating this dimension on both the first and second derivative of industrial production, Sweden ranks first, followed by the U.S. and Norway (Chart I-2). The U.K. and the euro area rank at the bottom. When trying to gauge the impact of domestic growth on each currency’s attractiveness, we also look at the forward-looking OECD leading economic indicator (LEI). As with industrial production, the currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. This changes the ranking. New Zealand exhibits the highest annual growth rate, followed by the U.S. Meanwhile, when looking at how the annual rate of change has evolved over the past 12 months, Australia shows the least deterioration, and the euro area the most (Chart I-3). Putting these two facets of the LEI together, Australia currently ranks first, followed by the U.S. and New Zealand. Switzerland and the U.K perform the most poorly (Chart I-4). Slack Then, we focus on slack, observing the dynamics in the unemployment gap, calculated using the OECD estimates of the non-accelerating inflation rate of unemployment (NAIRU). Here, the currencies of countries at the top right of the chart are least attractive, while those at the bottom left are most attractive. Switzerland enjoys both a very negative and rapidly falling unemployment gap (Chart I-5). The U.K. also exhibits a clear absence of slack, but in response to the woes surrounding Brexit, this tightness is decreasing. Interestingly, the euro area looks good. Despite its high unemployment rate of 7.9%, the unemployment gap is negative, a reflection of its high NAIRU. Combining the amount of slack with the change in slack, Switzerland, New Zealand and the euro area display the best rankings, while the U.S. and Sweden exhibit the worst (Chart I-6). The poor rankings for both the U.S. and Sweden reflect that there is little room for improvement in these countries. Inflation When ranking currencies on the inflation dimension, we look at core inflation and wages. We assume that rising inflationary pressures are a plus, as they indicate the need for tighter policy. We begin with core inflation itself; the currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. Canada and the U.S. both sport higher core inflation than the rest of the sample, as well positive inflationary momentum (Chart I-7). Switzerland displays both a very low level of inflation as well as declining momentum. U.K. inflation displays the least amount of momentum. On the core CPI ranking, the Canadian dollar ranks first, followed by the USD. Unsurprisingly, Japan and Switzerland rank at the bottom of the heap (Chart I-8).   We also use wages to track inflationary conditions as G-10 central banks have put a lot of emphasis on labor costs. Similar to core inflation, we measure each country’s level of wage growth as well as its wage-growth momentum. The currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. This time, the U.S. and the U.K. display both the highest annual growth rate of wages as well as the fastest increase in wage inflation (Chart I-9). Meanwhile, Norwegian wage growth is very poor, but improving. The U.S. and the U.K. rank first on this dimension, while Switzerland and Canada rank last, the latter is impacted by its very sharp deceleration in wage growth (Chart I-10). Financial Conditions The Financial Conditions Index (FCI) has ample explanatory power when it comes to forecasting a country’s future growth and inflation prospects. This property has made the FCI a key variable tracked by G-10 central banks. Here we plot the level of the FCI relative to the annual change in FCI. A low and easing FCI boosts a nation’s growth prospects, while a high and tightening FCI hurts the outlook. Consequently, the currencies of countries at the top right of the chart are least attractive, while those at the bottom left are most attractive. While Switzerland has the highest level of FCI – courtesy of an overvalued exchange rate – the U.S. has experienced the greatest tightening in financial conditions (Chart I-11). Combining the level and change in FCI, we find that New Zealand currently possess the most pro-growth conditions, followed by both Sweden and Norway. On the other end of the spectrum, Japan and the U.S. suffer from the most deleterious financial backdrop (Chart I-12). Central Bank Monitors   We often use the Central Bank Monitors devised by our Global Fixed Income Strategy sister publication as a gauge to evaluate the most probable next moves by central banks. It therefore makes great sense to use this tool in the current exercise. The only problem is that we currently do not have a Central Bank Monitor for Switzerland, Sweden and Norway. Nonetheless, using this variable to create a dimension, we compare where each available Central Bank Monitor stands with its evolution over the past 12 months. The currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. Currently, Canada and the U.S. show a clear need for tighter policy, without a pronounced fall in their respective Central Bank Monitors (Chart I-13). However, while the U.K. could stand higher rates right now, the British Central Bank Monitor is quickly falling, suggesting the window of opportunity for the Bank of England is dissipating fast. The euro area and Australia do not seem to justify higher rates right now. On this metric, Canada and the U.S. stand at one and two, while Australia and the euro area offer the least attractive conditions for their currencies (Chart I-14). Real Interest Rates   The Uncovered Interest Rate Parity (UIP) hypothesis has been one the workhorses of modern finance in terms of forecasting exchange rates. To conduct this type of exercise, our previous work has often relied on a combination of short- and long-term real rates, a formulation with a good empirical track record.1 Accordingly, in the current exercise, we use this same combination of short- and long-term real rates to evaluate the attractiveness of G-10 currencies. This dimension is created by comparing the level of real rates to the change in real rates over the past 12 months. The currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. The U.S. dollar is buoyed by elevated and rising real rates, while the pound is hampered by low and falling real rates (Chart I-15). This results in the dollar ranking first on this dimension, and the pound ranking last (Chart I-16). Interestingly, the yen ranks second because depressed inflation expectations result in higher-than-average and rising real rates. Aggregate Domestic Attractiveness Ranking and Investment Conclusions   Once we have ranked each currency on each dimension, we can compute the Aggregate Domestic Attractiveness Ranking as a simple average of the ranking of the eight different dimensions. Based on this method, domestic fundamentals suggest that the USD, the NZD, the NOK and the AUD are the most attractive currencies over the next three months or so, while the JPY, the GBP, the EUR and the CHF are the least attractive ones (Chart I-17). Interestingly, this confirms our current tactical recommendation espoused over recent weeks to favor pro-cyclical currencies at the expense of defensive currencies. However, it goes against our view that the U.S. dollar is likely to correct further over the same time frame. This difference reflects the fact that unlike our regular analysis, the Aggregate Domestic Attractiveness Ranking does not take into account the global business cycle, momentum and sentiment. We can refine this approach further and incorporate valuation considerations. We often rely on our Intermediate-Term Timing Model to gauge if a currency is cheap or not. Chart I-18 compares the Aggregate Domestic Attractiveness Ranking of G-10 currencies to their deviation from their ITTM. Countries at the bottom left offer the most attractive currencies, while those at the upper right are the least attractive currencies. This chart further emphasizes the attractiveness of the dollar: not only do domestic factors support the greenback, so do its short-term valuations. The CAD, the NOK and the SEK also shine using this method, while the less pro-cyclical EUR, CHF and JPY suffer. The pound too seems to posses some short-term downside. Ultimately, this tells us that if the global environment is indeed unfavorable to the U.S. dollar right now, we cannot ignore the strength of U.S. domestic factors. Consequently, we refrain from aggressively selling the USD during the tactical anticipated correction. Instead, if the global environment favors the pro-cyclical commodity currencies on a three-month basis, it is optimal to buy them on their crosses, especially against the CHF and JPY. Meanwhile, the pound has very little going for it, and selling it against the SEK or the NOK could still deliver ample gains.   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1  Please see Foreign Exchange Strategy Special Report, "In Search Of A Timing Model" dated July 22, 2016, available at fes.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: January U.S. consumer confidence index surprised to the downside, coming in at 120.2.  U.S. unemployment rate in January increased to 4.0%, from a previous 3.9% reading; however, this data point was likely distorted by the government shutdown Non-farm payrolls in January surprised to the upside, coming in at 304k. The DXY index rebounded by 0.9% this week. Tactically, we remain bearish on the dollar, as we believe that the current easing in financial conditions will help global growth temporarily surprise dismal investor expectations. Nevertheless, we remain cyclical dollar bulls, as the Fed will ultimately hike more than what is currently priced this year, and as China’s current reflation campaign is about mitigating the downside to growth, not generating a new upswing in indebtedness and capex. Report Links: Global Liquidity Trends Support The Dollar, But... - January 25, 2019 So Donald Trump Cares About Stocks, Eh? - January 9, 2019 Waiting For A Real Deal - December 7, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The recent data in euro area has been negative: The Q4 euro area GDP on a year-over-year basis fell to 1.2%, in line with expectations. Euro area headline inflation in January on a year-over-year basis decreased to 1.4%, from the previous 1.6% in December 2018, core inflation rose to 1.1%. January Markit euro area composite PMI fell to 51.0. Euro area retail sales in December fell to 0.8% on a year-over-year basis, from the previous 1.8%. In response to this poor economic performance, EUR/USD has fallen by 0.8% this week. We remain cyclically bearish on the euro, as we believe that the Fed will hike more than anticipated this cycle and that Europe is more negatively impacted by China’s woes than the U.S. is. Hence, slowing global growth will force the ECB to stay dovish much longer than expected. Moreover, our Intermediate Term Timing Model, is showing that the euro is once again trading at a premium to short term fundamentals. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Six Questions From The Road - November 16, 2018 Evaluating The ECB’s Options In December - November 6, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Annual inflation increased to 0.4% from previous 0.3%, core inflation increased to 0.7% from 0.6%, and inflation ex fresh food increased to 1.1% from 0.9%. December retail trade weakened to 1.3% from the previous 1.4%. Japanese unemployment rate in December has fallen to 2.4%. January consumer confidence index fell to 41.9, underperforming the expectations. USD/JPY has risen by 0.3% this week. We remain bearish on the yen on a tactical basis. The recent FOMC meeting kept the U.S. key interest rate unchanged, so did many other central banks. The resulting ease in global financial conditions could be a headwind for safe havens, like the yen. Moreover, U.S. yields are likely to rise even after the easing in financial conditions is passed, as BCA anticipates the Fed to resume hiking in the second half of 2019. This will create additional downside for the yen. Report Links: Yen Fireworks - January 4, 2019 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 The recent data in Britain has been negative: Markit U.K. composite PMI has surprised to the downside, falling to 50.3 in January; service PMI dropped to 50.1 while construction PMI fell to 50.6.  Halifax house prices yearly growth, surprised to the downside, coming in at 0.8%. Finally, Markit Services PMI also underperform, coming in at 50.1. The Bank of England rate decided to keep rates on hold at 0.75%. GBP/USD has lost 0.8% this week. On a long-term basis, we remain bullish on cable, as valuation for the pound are attractive. However, we believe that the current stalemate in Westminster, coupled with the hard-nose approach of Brussels has slightly increase the probability of a No-deal Brexit. This political uncertainty implies that short-term risk-adjusted returns remains low. Report Links: Deadlock In Westminster - January 18, 019 Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been negative: Building permits in December has surprised to the downside, coming in at -8.4% on a month-over-month basis.  December retail sales has slowed down, coming in at -0.4%. Finally, in December, with exports contracted at a -2% pace, and imports, at -6% pace. The RBA decided to leave the cash rate unchanged at 1.5%. While it was at first stable, AUD/USD ultimately has fallen by 2% this week. Overall, we remain bearish on the AUD in the long run. The unhealthy Australian housing market coupled with very elevated debt loads, could drag residential construction and household consumption down. Moreover, the uncompetitive Australian economy could fall into a potential liquidity trap as the credit conditions tighten further. Report Links: CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019 Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The recent data in New Zealand has been negative: The participation rate underperformed expectations, coming in at 70.9%. Moreover, employment growth also surprised to the downside, coming in at 0.1%. Finally, the unemployment rate surprised negatively, coming in at 4.3%. NZD/USD has fallen by 2.3% this week. Overall, we remain bullish on the NZD against the AUD, given that credit excesses are less acute in New Zealand than in Australia. Moreover, New Zealand is much less exposed to the Chinese industrial cycle than Australia. This means that is China moving away from its current investment-led growth model will likely negatively impact AUD/NZD. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The recent data in Canada has been negative: GDP has fallen to 1.7% on a year-over-year basis from the previous 2.2%. The December industrial production growth came in at -0.7% month-on-month, a negative surprise. Canadian manufacturing PMI in January decreased to 53. On the back of these poor data and weaker oil prices, USD/CAD rose by 1.6% this week, more than undoing last week’s fall. We expect the CAD to outperform other commodity currencies like the AUD and the NZD, oil prices are likely to outperform base metals on a cyclical basis. Moreover, the Canadian economy is more levered to the U.S. than other commodity driven economies. Thus, our constructive view on the U.S. implies a positive view on the CAD on a relative basis. Report Links: CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019 Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2   Recent data in Switzerland has been mixed: Real retail sales yearly growth improved this month, coming in at -0.3% versus -0.6% last month. However, the SVME Purchasing Manager’s Index underperformed expectations, coming in at 54.3. EUR/CHF has fell 0.2% this week. Despite this setback, we remain bullish on EUR/CHF. Last year’s EUR/CHF weakness tightened Swiss financial conditions significantly and lowered inflationary pressures. Given that the Swiss National Bank does not want a repeat of the deflationary spiral of 2015, we believe that it will continue with its ultra-dovish monetary policy and increase its interventionism in the FX market, in order to weaken the franc, and bring back inflation to Switzerland. Moreover, on a tactical basis, the ease in financial conditions should hurt safe havens like the franc. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been negative: The December retail sales missed the consensus estimates, coming in at -1.80%. December credit indicator decreased to 5.4%. Registered unemployment rate in January has increased to 2.6%, surprising to the downside. USD/NOK has risen by 1.8% this week. We are positive on USD/NOK on a cyclical timeframe. Although we are bullish on oil prices, USD/NOK is more responsive to real rate differentials. This means, that a hikes later this year by the Fed will widen differentials between these two countries and provide a tailwind for this cross. Nevertheless, the positive performance of oil prices should help the NOK outperform non-commodity currencies like the AUD. We also expect NOK/SEK to appreciate and EUR/NOK to depreciate. Report Links: Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden has been negative: Consumer confidence surprised to the downside, coming in at 92. Moreover, retail sales yearly growth also underperformed expectations, coming in at 5.6%. Finally, manufacturing PMI came in line with expectations at 51.5. USD/SEK has risen by 2.2% this week. Overall, we remain long term bullish on the krona against the euro, given that Swedish monetary policy is much too easy for the current inflationary environment, a situation that will have to be rectified. However, given our positive view on the U.S. dollar on a cyclical basis, we are cyclically bullish on USD/SEK, since krona is the G-10 currency most sensitive to dollar moves. Report Links: Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The current trajectory in global share prices resembles what took place in 2000 and early 2001. The early 2001 rebound in global and EM stocks lasted several weeks only, despite ongoing easing by the Federal Reserve. Corporate profits – not the Fed – was the key driver in 2001 and remains the principal driver of global and EM stocks today. EM corporate profits are set to contract this year due to China’s continuing slowdown and weakening global trade. This suggests the current EM rally is unsustainable; continue underweighting EM. In Chile, bet on lower swap rates. Continue shorting the peso but overweight the local bourse within an EM equity portfolio. Feature The dovish shift by the U.S. Federal Reserve in the past month has boosted EM risk assets and currencies. Yet, we find that in the medium and long term there is a very low correlation between Fed policy and U.S. interest rates, on the one hand, and EM financial markets on the other. Instead, EM risk assets and currencies correlate with EM/China business cycles and global trade (Chart I-1). We have not detected any improvement in China/EM growth, nor in global trade (Chart I-1). What’s more, we expect Chinese growth and world trade to continue to weaken in the coming six months. Therefore, the EM rebound and outperformance will be reversed sooner than later. Chart I-1Global Growth Indicators Do No Confirm EM Rally Please note this is the view of BCA’s Emerging Markets Strategy team. BCA’s house view is presently positive on global risk assets and global growth. The basis for this difference between our current position and that of the majority of our colleagues is the outlook for China’s growth. A Replay Of 2016 Or 2001? Most investors are betting that 2019 will be a replay of 2016, when the Fed’s dovish turn and China’s stimulus propelled the EM and global equity rallies. It is enticing to compare the current episode in financial markets to the one that occurred only three years ago. To be sure, there are a lot of similarities: the global trade slowdown driven by China/EM, selloffs in global equity and credit markets, a dovish shift in the Fed’s stance and policy stimulus in China are all reminiscent of early 2016. Not surprisingly, this has created a stampede into EM. According to the most recent Bank of America Merrill Lynch survey, as of mid-January some 29% of investors were overweight EM stocks compared to 1% overweight in the U.S., 11% underweight in the euro area and 1% underweight in Japan. By now, the overweight in EM equities is most likely even higher, given the stampede into EM assets that has occurred over the past several weeks. This stands in contrast to the 33% underweight in EM equities in January 2016. It is apparent that the majority of investors are indeed extrapolating 2016 into 2019. We hold a different view and believe China’s slowdown will be more protracted than in 2015-’16, and that EM corporate earnings are set to contract (please refer to Chart I-5 on page 6). A key distinction between China’s current policy efforts and what was implemented in 2015-‘16 is the absence of stimulus for real estate. The odds are that China’s property market will continue to languish, weighing on household and business sentiment as well as spending. Further, the efficiency of monetary transmission mechanisms could be lower today than it was in 2016 due to the regulatory tightening on both banks and non-banks. The fiscal multiplier could also be lower due to the fragile sentiment among consumers and businesses. We discussed these issues in detail in our January 17, 2019 report. Remarkably, it appears that global share prices are tracking the pattern of 1998-2001 – their trajectories are identical in terms of both magnitude and duration (Chart I-2). Chart I-2Global Stocks Are Tracking Pattern Of 1998-2001 In Magnitude And Duration That said, there are substantial differences between today and 2001 in respect to the economic backdrops in the U.S. and China. Our focal point is to demonstrate that the Fed easing is not sufficient to prop up share prices if it does not lead to a recovery in corporate earnings. We conclude that the latest rebound in EM risk assets is probably late because neither the Fed’s pause nor China’s stimulus will revive EM corporate profits in the next nine months. In terms of market action, one can draw a number of parallels between the trajectory in global share prices today and in 2000-’01. Following an exponential rally in 1999, the global equity index peaked in January 2000 (Chart I-3). The equity selloff accelerated in the last quarter of 2000, with stocks plunging in December of that year. Chart I-3Is Rebound In Global And EM Stocks Late? Oversold conditions in global share prices and the Fed’s intra-meeting 50-basis-point rate cut on January 3, 2001, generated a 7% and 15% rebound in global and EM stocks, respectively. The bounce lasted from late December 2000 until early February 2001. The current trajectory in global share prices – the rollover in late January 2018, the top formation lasting several months followed by a dramatic plunge, the bottom in late December, 2018 and the subsequent rebound – closely resemble the path global share prices took in 2000 and early 2001 (Chart I-3, top panel). The same holds true for EM share prices (Chart I-3, bottom panel). Critically, the Fed continued to cut interest rates in 2001 and 2002, yet the bear market in global equities, including EM, persisted until March 2003 (Chart I-4A and I-4B, top panels). The culprit was shrinking corporate profits (Chart I-4A and Chart I-4B, bottom panels). Chart I-4AFed Easing Did Not Help Global Stocks In 2001 Chart I-4BFed Easing Did Not Help EM Stocks In 2001 Odds are that EM earnings are set to contract this year as discussed below and shown in Chart I-5. As a result, this view bolsters our conviction that EM equities are likely to roll over soon and plunge anew in absolute terms, and certainly underperform U.S. stocks. Bottom Line: There are many economic differences between today and 2001. Our main point is that the Fed easing-inspired rally in global equities in early 2001 lasted several weeks only and was followed by a new cycle low. The key factor was not Fed policy but corporate profits. Provided our view that corporate earnings in EM and global cyclical sectors will contract this year, the rally in these segments is not sustainable regardless of Fed policy. What Drives EM: Chinese Or U.S. Growth? Predicting the outlook for China and global trade correctly is key to getting the EM call right. First, China’s credit and fiscal spending impulse leads EPS growth of companies included in the EM MSCI equity index by nine months, and it currently points to continued deceleration and contraction in EM EPS in the months ahead (Chart I-5, top panel). The average of new and backlog orders within China’s manufacturing PMI also portends a negative outlook for EM corporate earnings (Chart I-5, bottom panel). Chart I-5EM Profits Are Heading Into Contraction The primary linkage between China’s credit and fiscal spending impulse and EM profits is as follows: China impacts EM and the rest of the world via its imports. This explains why EM share prices correlate with Chinese PMI imports (Chart I-6). Chart I-6Chinese Imports And EM Equities Second, China’s imports are to a large extent driven by capital spending, especially construction. Some 85% of mainland imports are composed of various commodities, industrial goods and materials, and autos. Consumer goods make up only about 15% of imports. Major capital expenditures in general and construction, in particular, cannot be undertaken without financing. This is why the country’s credit and fiscal spending impulse leads its imports cycles (Chart I-7). This impulse is presently foreshadowing a deepening slump in mainland imports and by extension its suppliers’ revenues and profits. Chart I-7Chinese Imports Are Heading South Third, as EM shipments to China dwindle, not only will EM corporate revenues and profits disappoint but EM currencies will also depreciate. The latter bodes ill for EM U.S. dollar and local currency bonds. The basis is that exchange rate depreciation makes U.S. dollar debt more expensive to service, and also pushes up local bond yields in high-yielding EM fixed-income markets. Fourth, The majority of developing economies sell more to China than to the U.S. Remarkably, global trade and global manufacturing decelerated in 2018, even though U.S. goods imports were booming (Chart I-8). Crucially, the more recent strength in the U.S.’s intake of goods was in part due to frontloading of shipments to the U.S. before the import tariffs went into effect on January 1, 2019. Chart I-8U.S. Imports Are Very Robust Yet despite robust U.S. demand, aggregate exports of Korea, Taiwan, and Japan have done poorly and their manufacturing have slumped (Chart I-9A and Chart I-9B). Chart I-9AAsian Exports: Flirting With Contraction Chart I-9BAsian Manufacturing: Flirting With Contraction This highlights the increased significance of Chinese demand and the diminished importance of U.S. domestic demand in world trade. In particular, at $6 trillion, EM aggregate goods and services imports, including Chinese imports (but excluding China’s imports for processing and re-exporting), is greater than the combined imports of the U.S. and EU, which currently stand at $4.7 trillion ($2.5 trillion plus $2.2 trillion, respectively). Finally, the media and many investors have exaggerated the impact of U.S. tariffs on the Chinese economy. We are not implying that the tariffs are not relevant at all, or that they have not damaged sentiment among mainland businesses and households. They have. The point is that China’s exports to the U.S. constitute 3.8% of Chinese GDP only (Chart I-10). This compares to Chinese capital spending amounting to 42% of GDP and total annual credit origination and fiscal spending of 26% of GDP. Chart I-10China's Exports To U.S. Are Small (3.8% of GDP) Overall, China’s growth slowdown in 2018 was not due to its plunging shipments to the U.S. – actually, the latter were rising strongly till December due to frontloading – but due to weakness in credit origination, primarily among non-banks (shadow banking). Bottom Line: The Chinese business cycle – not the U.S.’s – is the key driver of EM share prices and currencies and more important than the Fed. EM And The Fed On the surface, it seems that EM is tracking Fed policy. To us, however, this is akin to“not seeing the forest for the trees”. Investors need to stand back and examine the medium- and long-term relationships between U.S. interest rates, DM central banks’ balance sheets, and EM financial markets. In this broader context, the following becomes apparent: There is no stable correlation between EM share prices, EM currencies and EM sovereign credit, on the one hand, and U.S. 10-year bond yields, on the other (Chart I-11). Chart I-11EM And U.S. Bond Yields: No Stable Correlation Historically, the correlation between EM share prices and the Fed funds rate has been mixed, albeit more positive than negative (Chart I-12). On this 40-year chart, we shaded the periods when EM stocks did well during periods of a rising fed funds rate. These time spans are 1983-1984, 1988-1989, 1999-2000, 2003-2007 and 2017. Chart I-12EM Stocks And Fed Funds Rate: A Historical Perspective The only two episodes when EMs crashed amid rising U.S. interest rates were the 1982 Latin America debt crisis and the 1994 Mexican peso crisis. Yet, it is essential to emphasize that these crises occurred because of poor EM fundamentals: elevated foreign currency debt levels, negative terms-of-trade shocks, large current account deficits and pegged exchange rates. Dire EM fundamentals also prevailed before the Asian/EM crises of 1997-1998. However, these late-1990s crises occurred without much in the way of Fed tightening or rising U.S. bond yields. Remarkably, there is also no correlation between the size and the rate of change of DM central banks’ balance sheets, on the one hand, and EM risk assets and currencies on the other. In particular, Chart I-13 validates that the annual growth rate of G4 central banks’ balance sheets does not correlate with either EM share prices or EM local currency bonds’ total returns in U.S. dollars. Chart I-13Pace Of QEs And EM: No Correlation Finally, there is a low correlation between U.S. real interest rates and the real broad trade-weighted dollar (Chart I-14). Notably, Chart I-15 illustrates that the greenback often acts as a countercyclical currency, appreciating when global growth is slowing and depreciating when the global business cycle accelerating. Please note that the dollar is shown inverted on this chart. Chart I-14The U.S. Dollar And U.S. Real Rates Chart I-15The U.S. Dollar Is Countercyclical Bottom Line: Many analysts and investors assign more significance to the Fed policy’s impact on EM risk assets than historical evidence warrants. Unless Fed policy easing coincides with EM growth recovery, the Fed’s positive impact on EM will prove to be fleeting. Investment Considerations Widespread bullish bias on EM among investors currently and a continuous slew of poor growth data in China and global trade give us the conviction to argue that the current EM rally is not sustainable. Even if the S&P 500 drifts higher, EM stocks and credit will underperform their U.S. counterparts (Chart I-16). Chart I-16Stay Short EM / Long S&P 500 The EM equity index is sitting at a major technical resistance, and a decisive break above this level will challenge our view (Chart I-17, top panel). The same holds true for many EM currencies and copper (Chart I-17, bottom panel). However, for now, we are maintaining our negative bias. Chart I-17EM Equities And Copper Are Facing Resistance Within the EM equity universe, our overweights are Brazil, Mexico, Chile, Russia, central Europe, Korea, and Thailand. Our underweights are Indonesia, India, Philippines, South Africa, and Peru. We continue to recommend shorting the following EM currency basket versus the U.S. dollar: ZAR, IDR, MYR, CLP, and KRW. The full list of our recommended positions across EM equities, local rates, credit, and currencies is available on pages 17-18. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com   Chile: Favor Bonds Over Stocks Local currency bonds will outperform equities in Chile over the next six to nine months (Chart II-1). Chart II-1Chile: Favor Bonds Over Stocks The central bank is raising interest rates to cap inflation. However, we believe this is misguided because China’s ongoing deceleration along with lower copper prices, will slow growth in Chile over the course of this year. In addition, the current domestic inflation dynamics are less worrisome than the central bank contends. There is ongoing debate in the policy circles of Santiago over whether the recent large net immigration wave, particularly from Venezuela, is inflationary or disinflationary. On the one hand, net immigration expands the supply of labor and puts downward pressure on wages, and hence is disinflationary (Chart II-2). On the other hand, net immigration bolsters demand, and thereby inflation. Chart II-2Chile: Labor Force Is Expanding At 2% The central bank has acknowledged both effects but has cited that the latter will overwhelm the former. We disagree with this assessment and believe that current immigration in Chile will be more disinflationary. There are a number of factors that make us believe so: Both nominal and real wage growth are cooling off rapidly (Chart II-3). This corroborates the thesis that the expanding supply of labor is capping wage increases. Chart II-3Chile: Wage Growth Is Decelerating Central banks in any country need to be concerned with rising unit labor costs and service sector inflation. Energy and food prices are beyond a central bank’s control. Monetary policy should not respond to fluctuations in these prices unless there are second-round effects on wages and other prices.  There is presently no genuine inflationary pressures in Chile. The average of Chile’s core and trimmed mean inflation rates stands at 2.5%, and service sector inflation is at 3.7% (Chart II-4). This is within the central bank’s inflation target range of 3% +/-1%. Chart II-4Chile: Inflation Is Within Target Range Finally, Chile’s exports are set to shrink due to the ongoing deceleration in China and lower copper prices (Chart II-5). With exports accounting for 30% of GDP, a negative external shock will slow domestic demand too. This will be disinflationary. Chart II-5Chilean Exports Are About To Contract The fixed-income market in Chile is pricing in rate hikes (Chart II-6). We continue to recommend receiving 3-year swap rates. Even if the central bank continues to tighten, long-term interest rates will decline, anticipating rate cuts down the road. Chart II-6Chile: Receive 3-Year Swap Rates Chilean share prices, in absolute terms, are at risk from the EM and commodities selloff. However, we recommend dedicated EM equity portfolios overweight Chile. The economy is fundamentally and structurally solid, and local equity markets are supported by large local investment pools. Importantly, unlike many other commodity producers, currency depreciation in Chile does not stop the central bank from cutting interest rates. Banco Central de Chile does not target the exchange rate and will cut rates to mitigate the adverse external shock. This will ensure that business cycle fluctuations in Chile will be milder than in other developing economies where central banks tighten to defend their currencies. This is positive for Chilean stocks versus other EM bourses. Finally, the peso is at risk of depreciation from lower copper prices. Bottom Line: Local investors should favor domestic bonds over stocks. Fixed-income traders should bet on lower three-year swap rates. Dedicated EM investors should overweight Chilean equities. Currency traders should maintain a short CLP / long USD trade. Footnotes Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Since 2008, no developed economy central bank has been able to hike interest rates sequentially by more than 2 percent before needing to take a breather… and then reverse course. The current vulnerability to further tightening emanates from stock markets and risk spreads. Through the next couple of years U.S. long bonds will strongly outperform German bunds… …and USD/EUR will trend lower. Since October 2017, no stock market rally or sell-off has lasted more than three months. Overweight equities tactically, but don’t get too comfortable. The broad stock market will remain trendless, but offer excellent tactical opportunities in both directions. Feature More than a decade has passed since the Global Financial Crisis. Yet through the past ten years, no developed economy central bank has been able to hike interest rates sequentially by more than 2 percent before needing to take a breather… and then swiftly reverse course. 2019 is a pivotal year for monetary policy because it will answer a fundamental question: will the 2 percent limit for monetary tightening that has held since 2008 continue to hold, or finally break? (Chart of the Week). The answer will have a huge bearing on European investment strategy for equities, bonds and currencies. Chart of the WeekSince 2008, The Limit For Sequential Rate Hikes Has Been 2 Percent... So Far A History Of Policy Reversals Swedish interest rates peaked near 5 percent in 2008 before collapsing to the zero bound in the financial crisis. But when the Riksbank started its so-called ‘policy normalisation’ in 2010, the interest rate could only reach 2 percent before the central bank had to backtrack; Norway could manage just 1 percent of tightening before its volte-face. Admittedly, Sweden and Norway were caught in the maelstrom of the euro debt crisis in 2011-12. But on the other side of the world and relatively immune to the crisis in Europe, New Zealand could achieve a tightening of only 1 percent; Korea could manage just 1.25 percent (Chart I-2); the Reserve Bank of Australia marched interest rates up by 1.75 percent before taking a breather… and then marched them down again.   Chart I-2Since 2008, The Limit For Sequential Rate Hikes Has Been 2 Percent The Federal Reserve has sequentially raised interest rates by 2 percent, and guess what? It has just decided to take a breather! Last week, Chairman Jay Powell was asked the question as plainly as possible: is the next move in interest rates as likely to be up as down? And his answer: “we don’t have a strong prior… we will patiently wait and let the data clarify.”1 There is no requirement at BCA for strategists to agree. In fact, the opposite is true in that we encourage independent thinking and diverse ways of looking at the world. BCA’s house view is that the Fed will resume its sequential hiking later in the year. But I believe this takes a too rosy view on the global financial system’s capacity to tolerate further tightening. The Vulnerability Is In Stock Markets And Risk Spreads   Monetary policy operates on an economy by adjusting its financial conditions: its bond yields, credit availability, currency, stock market, and risk spreads. And the neutral monetary policy stance – the so-called ‘neutral real interest rate’ – is the policy stance consistent with the economy growing at trend. In the past, a simple rule of thumb was that real rates, over time, should approximate to the real growth in the economy. But some studies argue that the neutral real rate may now be close to zero. All the Fed has done is bring the real interest rate out of negative territory to barely above zero. Yet its recent hikes have been blamed for extreme volatility in stock markets and risk spreads. Last week, Powell acknowledged that if there is a sustained change in financial conditions through any one or more of its components then “that has to play into our thinking.” Furthermore, “the policy stance is now in the range of the Committee’s estimates of neutral… and when you get to that (neutral) range we have to put aside our own priors and let the data speak to us.” All of which raises a salutary observation from my colleague Martin Barnes, BCA Chief Economist: if a real interest rate that is barely above zero is enough to trigger extreme market volatility and threaten the economic expansion, then the system is much more vulnerable than generally assumed.2  Martin has hit the nail on the head. At the current level of tightening, the system is much more vulnerable than generally assumed. But the vulnerable components of financial conditions are not bond yields, credit availability, or currency; the vulnerability emanates from stock markets and risk spreads, and specifically their potential for extreme volatility. Previous reports have focused on the source of this vulnerability. To recap, at low yields, bond prices develop the same unattractive negative asymmetry as equities. Therefore, an extended period of ultra-low interest rates removes the need for an equity risk premium, and justifies sharply higher valuations for equities and other risk-assets. But when the 10-year global bond yield rises back to around 2 percent, the process viciously reverses: bond prices lose their negative asymmetry, re-requiring an equity risk premium and sharply lower valuations for risk-assets.3 Put simply, when interest rates rise from low levels they undermine the support for elevated risk-asset valuations in a viciously non-linear way. The consequent plunge in risk-asset prices aggressively tightens financial conditions and thereby sets an unusually low ceiling for nominal interest rates and bond yields. This dynamic proved to be the major feature of the financial market landscape in 2018 and will loom large in 2019 too. It also solves the riddle as to why the neutral real rate may now be close to zero. An unusually low ceiling for the nominal interest rate combined with inflation hovering around 2 percent, translates into a neutral real interest rate that is not much higher than zero. The Investment Implications When the Riksbank paused after its near 2 percent of hiking, it proved to be a good structural entry point for Swedish long bonds, and a good structural exit point for the Swedish krona (Chart I-3 and Chart I-4). Likewise, when the Reserve Bank of Australia paused after its near 2 percent of hiking, it was an excellent moment to buy Australian long bonds and to sell the Australian dollar (Chart I-5 and Chart I-6). Chart I-3When The Riksbank Paused, It Was A Good Structural Entry Point In To Swedish Bonds... Chart I-4...And A Good Structural Exit Point Out Of The Swedish Krona Chart I-5When The RBA Paused, It Was A Good Structural Entry Point In To Australian Bonds... Chart I-6...And A Good Structural Exit Point Out Of The Australian Dollar Will the the 2 percent limit for monetary tightening that has held since 2008 continue to hold? If, as we expect, the answer is yes the implication is that through the next couple of years U.S. long bonds will strongly outperform German bunds. Over the same time frame, USD/EUR will trend lower (Chart I-7 and Chart I-8).  Chart I-7A Good Structural Entry Point In To Long T-Bonds/Short Bunds Chart I-8A Good Structural Exit Point Out Of USD/EUR Finally, as regards the broad stock market, a quick glance at the MSCI all country world index shows a striking feature. Since October 2017, no rally or sell-off has lasted more than three months (Chart I-9). Given the current highly non-linear relationship between equities and bond yields, this pattern is set to continue. Chart I-9Since October 2017, No Rally Or Sell-Off Has Lasted More Than Three Months In essence, the broad stock market will remain trendless, but offer excellent tactical opportunities in both directions. The current stance is tactically long, but don’t get too comfortable! Fractal Trading System* The sharp recent rally in government bonds has hit a point where tight liquidity conditions could trigger a temporary reversal. Accordingly, the 65-day trade is to go short 30-year T-bonds, setting a profit target at 3 percent with a symmetrical stop-loss. All of the five other open positions are in healthy profit. 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 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.   Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com  * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Footnotes 1 The Federal Reserve has raised the federal funds rate by a total of 2.25 percent comprising an isolated 0.25 percent hike at the end of 2015 and a sequential 2 percent hike from December 2016 through December 2018. 2 Please see the BCA Special Report “A Grumpy View Of The Outlook” January 28, 2019 available at www.bcaresearch.com 3 Please see the European Investment Strategy Weekly Report “Risk: The Great Misunderstanding Of Finance”, October 25, 2018 available at eis.bcaresearch.com  Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields 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 - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

Highlights Our main leading indicator for China’s economy and the broad trend in coincident measures both suggest that investment-relevant Chinese growth is set to slow over the coming months. Even in a trade deal scenario, an earnings recession for Chinese investable stocks looks likely unless the flow of credit soon increases to an annual pace of RMB 26 Trillion. The recent trend in money & credit growth is not yet consistent with this outcome. The RMB has risen relative to several currencies over the past two months, meaning that it does not simply reflect a weaker dollar. The RMB rally is linked to the trade negotiations with the U.S., suggesting that further gains are likely if a genuine truce emerges. Feature Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, our Li Keqiang (LKI) leading indicator continues to point to weaker activity over the coming 6-12 months, even though the LKI itself has actually trended higher over the past year. We maintain that trade frontrunning has caused this gap (which is in the process of unwinding), as broader measures of coincident activity have been trending lower and are poised to decelerate further. The growth rate of housing construction also seems set to decline, given that the current pace of starts is still running substantially above the pace of sales volume. Finally, while we do not expect the speed at which Chinese import and export growth decelerated in December to continue, the export components of China’s PMIs and the end of trade frontrunning both suggest that trade growth will remain weak over the coming few months. Table 1China Macro Data Summary   Table 2China Financial Market Performance Summary From an investment strategy perspective, we continue to recommend a neutral stance towards Chinese stocks within a global equity portfolio over a 6-12 month horizon, and remain tactically long until the end of this month. The recent outperformance of investable stocks vs. the global benchmark reflects global investor expectations of a trade deal between China and the U.S. later this month, but a deal alone will not reverse slowing domestic demand (which will negatively impact earnings). Even in a trade deal scenario, an earnings recession looks likely unless the flow of credit soon increases to an annual pace of RMB 26 Trillion, and the recent trend in money & credit growth is not yet consistent with this outcome. Finally, the rally in the RMB over the past two months does not simply reflect a weaker dollar, as it has risen relative to several currencies. The timing of the rally is clearly linked to the trade negotiations between the U.S. and China, suggesting that further gains are likely if a genuine truce emerges later this month. In reference to Tables 1 and 2, we provide several detailed observations concerning developments in China’s macro and financial market data below: Both the Bloomberg Li Keqiang index (LKI) and our alternative LKI rose to 9.3 in December, maintaining an uptrend that has been in place for the majority of the past 12 months. As we noted in last week’s report,1 this uptrend is not only in contrast to our leading indicator for China’s old economy, but also other coincident measures of economic activity. Chart 1 highlights that China’s investment-relevant economic activity is trending lower when broadly measured, implying that the uptrend in the LKI over the past 12 months is anomalous and is set to wane. Chart 1China's Investment-Relevant Economic Activity Is Trending Lower Our LKI leading indicator ticked down in December, as a rise in the RMB reversed some of the improvement in monetary conditions that had previously lifted the indicator. More important, however, is the very recent trend in the money & credit components of the indicator: while the YoY growth rates in M2, BCA’s calculation of M3, and adjusted total social financing (TSF) have recently stabilized, Chart 2 shows that the trend over the past three months has been down. We highlighted in last week’s report that Chinese credit growth needs to accelerate this year to avoid an earnings recession even assuming a trade deal with the U.S., and Chart 2 illustrates that the recent trend in money & credit growth is not yet consistent with this outcome. Chart 2The Recent Trend In Money & Credit Growth Is Down Based only on the trend in construction, China’s housing market is healthy and growing at a robust pace. However, fundamental support for the housing market is materially weaker: housing sales volume growth is in negative territory, growth in PBOC pledged supplementary lending injections has turned negative, and our house price diffusion indexes are rolling over from elevated levels. Housing sales volume has historically led the trend in construction, suggesting that China’s housing inventories are rising anew and that the pace of construction is set to cool significantly. The NBS and Caixin manufacturing PMIs for January provided conflicting readings: the former ticked up fractionally, whereas the latter deteriorated meaningfully further. The fact that the new export orders components of both PMIs moved higher in January suggests two things: 1) exporter sentiment is stabilizing (at a low level) in response to expectations of a trade truce with the U.S., and 2) the domestic demand outlook is weaker than the external outlook. This underscores that a framework trade deal with the U.S. at the end of the month is not, on its own, likely to lead to a significant reacceleration in the Chinese economy. Chinese investable stocks have rallied significantly in absolute US$ terms since the beginning of 2019, up over 11% year-to-date. Given that Chinese stocks are comparatively high-beta, most of this performance can be attributed to the rally in global stocks (up 8% YTD). However, it is notable that Chinese stocks outperformed global stocks both when the latter sold off aggressively in December, and in response to the recent global rally. This likely reflects global investor expectations of a trade deal between China and the U.S., which was the basis for our recommendation of a tactical overweight towards Chinese stocks in our December 5 Weekly Report.2 Chart 3 provides some additional evidence that global investors have driven the recent rally in investable stocks. First, panel 1 highlights that domestic stocks have underperformed investable stocks meaningfully over the past two months. Second, panel 2 shows that domestic infrastructure stocks, likely beneficiaries of a policy-driven reaccleration in domestic demand, have not rallied at all in absolute terms over the past few months. Chart 3Global Investors Drove The Recent Rally In Investable Stocks Within the equity sector space, the most notable development over the past month has been the substantial outperformance of Chinese consumer discretionary stocks (up almost 11% relative to global consumer discretionary in US$ terms year-to-date). For the most part, these gains reflect the idiosyncratic performance of Alibaba, due to recent changes to the global industrial classification standard (GICS).3 Prior to the changes, the automobiles & components industry group competed with retailing as a driver of the Chinese investable consumer discretionary sector; today, retailing accounts for 3/4ths of the index, with Alibaba accounting for all of the increase in retailer market cap (from 26% in November). Alibaba’s stock price recently bounced in response to a positive Q4 earnings surprise, but disappointing revenue growth underscores the challenges facing investable consumer discretionary stocks from deteriorating consumer sentiment in China.4 Despite the rally in China-related global financial assets over the past two months, Chinese onshore corporate bond spreads remain elevated in reflection of concerns over rising defaults (Chart 4). While we believe that investors are pricing in excessively high default rates over the coming year (i.e. the level of spreads is probably wider than warranted), the trend in onshore corporate spreads is highly informative and served as an early indicator that China’s economy was set to slow. Somewhat concerningly, the trend in spreads of different quality are not moving in a direction that would be consistent even with a stabilization in the Chinese economy. Panel 2 shows that AAA-rated corporate bond spreads have recently been trending higher, in contrast to that of bonds rated AA-. The former has reliably led the latter over the past year, implying that the odds of overall onshore spreads rising have gone up. Chart 4High-Quality Corporate Spreads Are Moving Higher The budding rally in the RMB that we identified last month has continued, with CNY-USD having recently broken above its 200-day moving average (Chart 5). Panels 2 and 3 highlight that this does not simply reflect a weaker dollar, as the RMB has risen relative to the euro and the basket of currencies included in the Bloomberg U.S. dollar spot index. It remains unclear whether this recent strength has been driven by trade talk-related intervention or market expectations of a trade deal, but its link to the negotiations is clear. This suggest that further gains are likely if a genuine truce emerges later this month. Chart 5A Genuine Rebound In The RMB   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com     Footnotes   1 Please see China Investment Strategy Weekly Report “A Gap In The Bridge”, dated January 30, 2019, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report “2019 Key Views: Four Themes For China In The Coming Year”, dated December 5, 2018, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report “GICS Sector Changes: The Implications For China”, dated September 26, 2018, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Special Report “Chinese Household Consumption: Full Steam Ahead?”, dated November 14, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights The CAD and AUD have tactical upside; however, this may well prove to be the last hurrah before some serious declines play out. This time domestic – not global – factors will drive the CAD and AUD lower. Canada and Australia are hitting the end game for their respective debt supercycles as rising U.S. rates will lift the global cost of capital. Canadian and Australian house prices and debt loads are too elevated; a reversal of these excesses is likely to push these two countries toward liquidity traps. These liquidity traps will cause the R-star in Canada and Australia to fall, lagging well behind the U.S. Canada and Australia are uncompetitive, suggesting external demand will not come to their respective rescue, at least not until after the CAD and AUD have fallen significantly. The CAD may fall first, but the AUD has more downside ultimately; not only is Australia even less competitive than Canada, but the Aussie is also more expensive than the Loonie. Feature The Canadian and Australian dollars are in the process of rebounding. This is not surprising. By the end of 2018, both these currencies were deeply oversold, and the recent easing in global financial conditions, helped by the Federal Reserve’s pause, is fueling their rebound (Chart 1). Moreover, pessimism toward China has hit an extreme, yet Sino-U.S. trade relations seem on the cusp of improving and Chinese policymakers are increasingly trying to manage the downside in the Chinese economy. This setup is normally supportive for the Canadian and Australian dollars (Chart 2). Chart 1Financial Conditions Point To A Tactical Rebound In The AUD And The CAD...   Chart 2...So Does Chinese Reflation While we have been recommending that our more tactically minded clients play this rally,1  the longer-term outlook for the CAD and AUD remains poor. These countries are getting closer to the end of their respective debt supercycles. Consequently, the CAD and AUD need to trade at much larger discounts to fair value in order to be attractive. Way Too Much Debt Canada and Australia have become victims of their own success. Canada and Australia have seen real estate prices rise for more than two decades. At first, rising prices reflected solid valuations, growing populations and rising prosperity. However, things changed around the Great Financial Crisis. During this traumatic event, the Bank of Canada and the Reserve Bank of Australia both dropped interest rates by 4.25%. Since both countries’ banking sectors escaped the crisis unscathed, and households did not experience similar losses of wealth as those in the U.S., Ireland or Spain, credit growth remained strong. A real estate bubble became the natural consequence of this easy monetary policy. Banks pushed credit to households, and households – impressed by the solid performance of real estate prices, attracted by low interest rates, and enamored with the dream of easy riches – willingly took on mortgages and piled into the property market. A feedback loop ensued, whereby rising collateral values made credit even easier to access, fomenting further house price gains and even-easier credit conditions. Today, we stand at the end of this process. Vancouver and Toronto in Canada, and Sydney and Melbourne in Australia are some of the most expensive real estate markets in world in terms of price-to-income ratios, when one controls for population density (Chart 3). This has created major systemic risks for both countries. Few would care about the systemic risk created by elevated house prices if debt loads were small. However, in both countries, household indebtedness makes Americans circa 2007 look like a frugal bunch. In Canada, household debt has now reached 176% of disposable income, or 100% of GDP, while in Australia, the same ratios are 189% and 121%, respectively. This is well above the levels that prevailed in the U.S. in 2007 (Chart 4). Mortgage debt alone represents 108% and 140% of disposable income in Canada and Australia, respectively. Moreover, Canadian and Australian households also spend 14.5% and 15.6% of their incomes servicing debt, which also compares unfavorably with the U.S. in 2007. Chart 4ACanadians And Australians Make Americans Look Frugal Chart 4BCanadians And Australians Make Americans Look Frugal Canadian and Australian households thus seem close to having reached their maximum debt loads. Moreover, measures taken in Canada and Australia to limit foreign money inflows and constrain bank lending are beginning to bite. In both countries, real estate transactions are slowing, with property sales declining by 20% and 8% in Canada and Australia, respectively. House prices too are being hit. House prices in Vancouver and Toronto peaked by 2018, and in Sydney and Melbourne in 2017. Residential construction is likely to be the first victim. Real estate inventories in both these countries have been rising, courtesy of the frenetic pace of housing starts going on for decades. Today, residential investment represents 7% of GDP in Canada and 5% of GDP in Australia (Chart 5). Thus, slowing real estate activity could curtail Canadian and Australian GDP by 2% if we move back to the real estate environment that prevailed in the mid-1990s. This would also imply large hits to employment as construction, real estate and finance have created 336-thousand and 250-thousand jobs in Canada and Australia since 2009, respectively. Chart 5AA Decline In Construction Activity Would Be A Vicious Hit To Canada And Australia (1) Chart 5BA Decline In Construction Activity Would Be A Vicious Hit To Canada And Australia (2) Consumption too is likely to suffer. Without a growing wealth effect and with declining equity in their houses, Canadian and Australian households are likely to curtail consumption – consumption that has contributed 60% and 30% of Canada’s and Australia’s cumulative GDP growth since 2009. Already, we are seeing slowing Canadian and Australian retail sales – right behind drops in housing activity. The biggest and most dangerous risk is that Canada and Australia teeter on the verge of falling into a liquidity trap, like the U.S. after 2007. As Chart 6 illustrates, propelled by households binging on cheap money in the form of mortgages, Canadian and Australian banks have managed to maintain higher levels of return on equity after the financial crisis. This robust profitability will decline if non-performing loans, which so far remain low, grow in response to weakening house prices and fragile household financial health (Chart 7). Chart 6Canadian And Australian Banks Remain Profitable... Chart 7...As Long As NPLs Do Not Rise Rising NPLs and declining RoEs tend to limit the willingness of banks to lend. Just as crucially, the poor health of households and falling real estate prices is likely to also limit demand for credit. This combination was behind the sharp decline in the U.S. money multiplier in 2008. No matter how much reserves the Federal Reserve would inject in commercial banks via QE programs, broader money would not respond. A similar fate is likely to ensue in Canada and Australia (Chart 8). The velocity of money is also likely to fall if households are not willing to take on debt anymore and instead focus on rebuilding their financial buffers. Chart 8Canada And Australia Have Avoided A Liquidity Trap... So Far The consequence of this monetary constipation will be much lower interest rates. When an economy enters a liquidity trap, as was the case in the U.S. after 2007, in Japan since the 1990s, or in Europe after 2010, the neutral real rate of interest, the so-called R-star, falls to zero or even lower. Essentially, no matter how low interest rates fall, they cannot equilibrate the demand and supply for savings. Everyone wants to save, no one wants to borrow, and banks are unwilling to lend. This fate looks increasingly likely for both Canada and Australia over the coming two years. Bottom Line: The Canadian and Australian real estate markets have enjoyed incredible runs for more than two decades. Now, not only are real estate prices in these two nations very expensive, households have been left with prodigious debt loads. As real estate activity slows, residential construction will suffer, but most importantly, these two countries are likely to teeter toward becoming liquidity traps as banks curtail lending and households curtail borrowing. This will result in structurally lagging interest rates. Why Now? Betting on the end of the Canadian and Australian housing bubbles has so far been mugs games. Why is the situation different now? Because the U.S. economy is stronger. Until now, very low global interest rates have kept the Canadian and Australian housing bubbles afloat, but rising U.S. interest rates are now putting upward pressure on mortgage rates in both Canada and Australia (Chart 9). This simply reflects the fact that U.S. rates represent the ultimate opportunity cost of investing outside the international reserve currency, the U.S. dollar. After years of household deleveraging, the U.S. seems to be able to handle higher rates. However, because Canadian and Australian balance sheets are much weaker, their tolerance for higher rates is substantially lower. Chart 9Higher U.S. Rates Threaten Canadian And Australian Households BCA sees further upside for U.S. rates and thus for the global cost of capital. In other words, we do not anticipate the Fed’s pause to last beyond June. The following reasons underpin this view: The U.S. labor market is increasingly inflationary. The employment-to-population ratio for prime-age workers continues to rise, which historically has boosted labor costs (Chart 10). The New York City Fed Underlying Inflation Gauge points toward higher core inflation (Chart 11). Moreover, Ryan Swift argues in BCA’s U.S. Bond Strategy that an unfavorable base effect will dissipate after February, further reinforcing the upside risk to inflation.2  Being the only component of our Fed Monitor moving toward “easy money required” territory, the tightening in U.S. financial conditions last year was the lynchpin behind the Fed’s pause. The other components of the Fed Monitor have not deteriorated significantly, and they still argue in favor of further rate hikes (Chart 12). Thus, if the recent easing in financial conditions can persist, the Fed will hike again this year.   Chart 11Budding U.S. Inflationary Pressures   Chart 12The Fed Is Pausing Because Of Tightening Financial Conditions, Not The Economy Finally, U.S. productivity is set to pick up over the coming two years. Since a rising capital stock boosts productivity, the recent strength in capex augurs well (Chart 13). Moreover, the demand deficit created by the deleveraging of U.S. households has weighed on productivity. As U.S. credit growth picks up, so will productivity. This is important as rising productivity lifts the neutral rate, and thus creates more room for the Fed to lift interest rates. Chart 13Upside For U.S. Productivity Equals Upside For U.S. Rates Ultimately, all these factors point to higher U.S. rates. As such, it suggests that Canadian mortgage rates, and to a lesser extent Australian ones as well, will experience upward pressure – exactly at the time when households in these two countries are most vulnerable to higher rates. Bottom Line: Higher U.S. rates are the main reason why we expect the Canadian and Australian housing markets and economies to buckle now, finally heeding the call of doomsayers. Higher U.S. rates lift the global cost of capital. While U.S. households are in robust shape and therefore better able to handle higher rates, the same cannot be said about Canadian and Australian households. Can the External Sector Come To The Rescue? This is unlikely. After years of commodity booms and strong domestic demand supported by rising household wealth, the Canadian and Australian manufacturing sectors have been greatly diminished. Much capacity has vanished, and it will be difficult to replace the lost output from falling domestic demand by exports of manufactured goods. The Australian and especially the Canadian corporate sectors are also already heavily indebted, and thus, it could take quite some time before capacity is expanded. Complicating the situation, Canada and Australia are not competitive exporters anymore. As the top panel of Chart 14 shows, since 1980, U.S. unit labor costs have risen by 156%, but they have risen by 183% in Canada and by a stunning 282% in Australia. Productivity trends paint a similar, albeit less dramatic picture. Since 1980, U.S. labor productivity has risen 22% versus its trading partners; in Canada it has declined by 20%, and in Australia, by 5%. Consequently, both Canadian and Australia labor will have to cheapen. Historically, the mechanism through which labor costs decline is higher unemployment, which forces a painful adjustment in wages. These adjustments are likely to force both interest rates and currencies lower. Chart 14Canada And Australia Are Uncompetitive Could China come to the rescue? Via higher commodity prices, both Canada and Australia have been major beneficiaries of the Chinese economic boom. However, while China today is trying to contain its economic deceleration, Chinese policymakers remain fixated on controlling credit growth. This means that China is unlikely to go on another debt binge similar to what transpired in 2009 or in 2015-‘16. As a result, the recent uptick in commodity prices is unlikely to last long. More fundamentally, China is not only trying to move away from its debt-led growth model: It is also trying to move away from its investment-led growth model. This means that the commodity intensiveness of the Chinese economy is likely to decline. China’s emphasis on controlling air pollution will strengthen this trend. As Chart 15 illustrates, when the share of Capex as a percentage of Chinese GDP declines, so does the labor participation rate of Canada and Australia relative to the U.S. This decline in relative participation rates is associated with falling CAD and AUD values versus the U.S. dollar, a consequence of falling growth potential and interest rates. Chart 15AChanging Chinese Growth Model Points To Falling Canadian And Australian Participation Rates (1) Chart 15BChanging Chinese Growth Model Points To Falling Canadian And Australian Participation Rates (2) Bottom Line: Canada’s and Australia’s lack of manufacturing capacity, poor competitiveness, and China moving away from its investment-led growth model suggest that a deflationary environment will ultimately develop in these two nations, at least relative to the U.S. Moreover, the structurally negative outlook on consumption, debt growth and employment suggests that Canadian and Australian neutral rates are likely to fall relative to the U.S. These economic forces point to deeper lows this cycle in the CAD and AUD against the USD. Investment Implications Based on this economic backdrop, both the Canadian and Australian dollar could suffer significant downside in the coming years as their fair value is likely to fall, dragged by interest rates that will lag those in the U.S. However, if an asset is cheap enough, it may nonetheless be an attractive buy. The CAD and AUD do not fall into that camp. Today, the CAD trades in line with our long-term fair-value model, implying that if its fair value falls, the CAD provides zero insulation and will therefore also have to decline. The AUD is in an even worst spot as it currently trades above its fair value (Chart 16). Additionally, the Australian current account deficit is larger than Canada’s. Chart 16The CAD And AUD Are Not Cheap Enough To Compensate For Secular Risks In terms of timing, the Loonie could start weakening before the Aussie. The Canadian housing bubble is likely to collapse first as Canadian mortgage rates are more tightly linked to U.S. ones than Australian rates are. Moreover, the Canadian economy seems even more levered to rising real estate prices than that of Australia. However, a collapse in Vancouver and Toronto housing prices will promptly catalyze similar weaknesses in Sydney and Melbourne. Thus, while the CAD may be the first to take the great plunge, the AUD will not be far behind. Ultimately, the AUD will suffer the greatest decline. Obviously, the more onerous pricing of the AUD contributes to this assessment, but so does the greater lack of competitiveness in Australia than in Canada. Australia is likely to endure deeper deflationary pressures as its labor costs need greater adjustments. Furthermore, Australia already suffers from a larger degree of underutilized labor than Canada. Since the currency – not wages – is likely to withstand the bulk of the competiveness adjustment, this implies that the AUD has more work to do than the CAD. The more expensive valuations of Australian assets also handicap the Aussie versus the Loonie. Australian real estate is pricier than Canadian property, and Australian stocks are more expensive (Chart 17). This means that Australians could end up with deeper holes in their balance sheets than Canadians, and that Australia has scope to witness greater outflows of capital than Canada. Chart 17Canadian Financial Assets Are Cheaper Than Australian Ones... Where Australia shines relative to Canada is in terms of the ability of fiscal authorities to respond to an economic slowdown. Canadian public debt stands at 90% of GDP versus 41% of GDP in Australia. Canada’s cyclically-adjusted primary deficit is already deteriorating, while Australia’s is improving (Chart 18). This means that the Australian governments have deeper pockets and a greater capacity to support domestic demand than Canada’s. This could cushion the deflationary impact in Australia relative to Canada. That being said, the Japanese, Spanish or U.S. experiences argue that once a real estate bubble bursts, fiscal spending can cushion some of the pain, but it cannot eradicate the problem – at least not until banks are recapitalized and the private sector is once again ready to borrow, something that takes years of balance-sheet rebuilding. Chart 18...But Australia Has More Fiscal Space Bottom Line: Both the CAD and AUD are likely to experience substantial downside over the coming years. The CAD and AUD are not cheap enough to compensate for a BoC and RBA that will greatly lag the Fed. While the CAD may weaken first, the AUD will suffer more long-term downside. The Aussie is more expensive, Australia is less competitive than Canada, and it could suffer greater outflows of capital. Continue to underweight Australian and Canadian assets in global portfolios as the AUD and CAD will drag their performance down. Remain short AUD/CAD on a structural basis.   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, titled “Global Liquidity Trends Support The Dollar, But…”, dated January 25, 2019, 2018, available at fes.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “Buy Corporate Credit”, dated January 15, 2019, available at usbs.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Feature Half Way Back Since BCA went overweight global equities in late December, the MSCI ACWI index has rallied by 8% and the S&P 500 is back to only 8% off its September historical high. So far, this has been little more than a technical rally from the extreme oversold position in Q4. But with U.S. economic growth still resilient, earnings likely to grow healthily again this year (albeit more slowly than in 2018), and the valuation of risk assets (both equities and credit) no longer a headwind, we expect the rally to continue for some time, and so reiterate our overweight on equities. Recommendations True, there have been some disappointments in U.S. data in recent weeks. In particular, the December manufacturing ISM fell sharply to 54.3 from 59.3, raising fears that the U.S. is starting to decelerate in line with other regions (Chart 1). But the ISM may have been affected by the government shutdown and, overall, U.S. data still look solid, with the Citigroup Economic Surprise Index beginning to rebound, and stronger than in other regions (Chart 2). The residential housing market, which was exhibiting signs of stress last year, with existing home sales -6.4% YoY in December, is showing the first signs of stabilization, helped by mortgage interest rates that are now 50 BPs off their recent peak (Chart 3). Chart 1How Worrying Is The U.S. Slowdown? Chart 2U.S. Data Surprisingly Positive Chart 3Housing Market Should Stabilize In particular, the outlook for consumption looks healthy, with average hourly earnings growing at 3.3% YoY, consumer confidence close to an historic high, and the savings rate above 6%. Unsurprisingly, then, retail sales have boomed in recent months (Chart 4). Unless consumer confidence is dented by a repetition of the government shutdown or some other shock, consumption (68% of GDP, remember) should grow strongly this year. Add to this a residual positive impact of close to 0.5% of GDP coming from last year’s fiscal stimulus, and it is hard to imagine the U.S. going into recession over the next 12 months. Chart 4Consumption Booming The Fed will probably go on hold for now, however, given the market jitters in Q4. We are likely back to a situation like that in 2015-2016, where the Fed Policy Feedback Loop becomes the key factor for markets (Chart 5). When financial conditions tighten, with stock prices falling and the dollar appreciating, the Fed turns more dovish. However, this triggers a rally in risk assets and loosens financial conditions, allowing the Fed to start hiking again. With the tightening in financial conditions over the past six months, the Fed is likely to err on the side of caution for now (Chart 6). However, if our macro view is correct – and as inflation starts to pick up again after April, partly due to the base effect – the Fed will want to continue withdrawing accommodation over the course of this year. The Fed Funds Rate, at around 2.4% is still two hikes below what the FOMC sees as the neutral level of interest rates (the 2.8% terminal rate in the FOMC dots). We see the Fed, therefore, raising rates in June and perhaps hiking two or even three times this year. By contrast, the futures market assigns only a 25% probability of even one rate hike this year, and is even pricing in a small probability of a cut. Chart 6Tighter Conditions Mean More Cautious Fed Clearly, there are plenty of risks to the scenario of growth continuing. But those in the hands of President Trump, especially the trade war with China and the fight over funding of the wall on the border with Mexico, we don’t see as being serious impediments. Trump is fully aware that he is unlikely to be reelected in November 2020 if the U.S. is in recession by then. Every incumbent U.S. president since World War Two who fought for reelection during a recession failed to be reelected (Chart 7). The view of BCA’s geopolitical strategists, therefore, is that the White House and Congressional Democrats will agree to concessions to end the shutdown before the end of the current three-week stop-gap period. Less likely, Trump will declare a national emergency that will cause much controversy but have little impact on the economy. Our strategists also argue that there is a 45% probability of trade negotiations with China producing a result (at least a short-term one the president can boast about) before the March 1 deadline, and a further 25% probability of the deadline being extended without further sanctions being imposed.1 Chart 7Trump Won't Be Reelected In A Recession Equities: Analysts have become overly pessimistic about the earnings outlook for this year, cutting 2019 U.S. EPS growth to 7% (and only 2% YoY in Q1). Our top-down model (based on, admittedly optimistic, U.S. growth assumptions, but also headwinds from a stronger dollar) indicates 12% growth. If analysts are forced to revise up their numbers as better earnings come through, that should be a catalyst for further equity performance (Chart 8). We continue to prefer U.S. over European equities. The steady slowdown in European growth over the past 12 months has not yet bottomed, banks in Europe remain troubled, the earnings picture is less positive, and valuations relative to the U.S. are not especially attractive. We also remain underweight on EM equities: they may produce a positive return in a risk-on environment, but we see them underperforming DM as rising U.S. interest rates and a stronger USD put pressure on EM borrowers with excess foreign-currency debt. Chart 8Analysts Have Overdone Downward Revisions Fixed Income: The recent fall in U.S. Treasury yields was mainly caused by the inflation expectation component, itself very sensitive (if rather illogically so) to the oil price (Chart 9). As the oil price recovers (see below), inflation picks up moderately, and the Fed hikes by more than the market expects, we see the 10-year Treasury yield rising to 3.5% during the course of the year. BCA’s fixed-income strategists recently raised their recommendation on global credit to overweight, given more attractive spreads and the likelihood that the Fed will be on hold for the next six months.2 Their recommendation is for 3-6 months, and the Fed restarting the hiking cycle, say in June, might terminate the positive story. We are following their lead, by raising both high-yield and investment-grade bonds to overweight within the (underweight) fixed-income asset class. That means we are neutral credit in the overall portfolio. We would warn, though, that this is a somewhat short-term call: we still prefer equities as a way to play the continuing risk-on rally. Given the high level of U.S. corporate leverage, and the over-owned nature of the credit market, this is likely to be an asset class that performs very poorly in the next recession (Chart 10). Chart 9Inflation Expectations Should Recover Chart 10Corporate Leverage Is A Concern Currencies: Currencies will continue to be driven by relative monetary policy. With the growth desynchronization between the U.S. and other DMs set to continue (to a degree), we see modest further USD appreciation this year. The Fed (as argued above) will probably hike more than the market expects. But, given slow European growth, the ECB is unlikely to be able to hike in Q4 this year, as it currently is guiding for and the futures market implies (Chart 11). We see the ECB reopening the Targeted Long-Term Repo Facility (TLTRO), which expires soon. Italy and Spain have been big borrowers from this facility, and bank loan growth is likely to slow as it ends (Chart 12). A renewed TLRTO would be seen as a dovish move. Tighter dollar liquidity conditions also point to a stronger USD. U.S. credit growth continues to accelerate (to 12% YoY – Chart 13) in an environment where the monetary policy has tightened: credit growth is outpacing U.S. money supply growth by 7%. Historically this has been negative for global growth (mainly because the deteriorating liquidity is a problem for EM dollar borrowers) and positive for the dollar (Chart 14).3 Chart 11Can ECB Really Hike In 2019? Chart 13...U.S. Loan Growth Accelerating... Chart 14... Which Will Tighten Liquidity Further Commodities: The supply/demand situation for oil should improve over coming months. With Saudi Arabia and Russia committed to cut supply by 1.2 million barrels/day, U.S. shale production growth slowing given the low one-year forward price for WTI, Canada reducing production, and Venezuela on the verge of collapse (which alone could remove 700-800k b/d from the market), our energy strategists see the crude oil balance in deficit over the next four quarters (Chart 15). Given this, they forecast Brent crude rebounding to above $80 a barrel. Other commodity prices are mostly driven by Chinese demand. We see China continuing to slow, until the accumulated effects of its fiscal and mild monetary stimulus start to come through in H2 and stabilize growth. Our analysis suggests that China remains very disciplined about the size and nature of its stimulus: it is not turning on the liquidity taps as it did in early 2016. Bank loan growth has stabilized, but shadow banking activity continues to contract, as the authorities persist with their crackdown and their emphasis on deleveraging (Chart 16). Industrial commodities prices are therefore likely to weaken over the next six months.  Chart 15Oil Balance In Deficit This Year Chart 16China Sticking To Credit Crackdown   Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   GAA Asset Allocation Footnotes 1      Please see Geopolitical Strategy Weekly Report, “So Donald Trump Cares About Stocks, Eh?”, dated 9 January 2019, available at gps.bcaresearch.com 2      Please see Global Fixed Income Strategy Weekly Report, “Enough With The Gloom: Upgrade Global Corporates On A Tactical Basis,” dated 15 January 2019, available at gfis.bcaresearch.com 3      For a detailed explanation, please see Foreign Exchange Strategy Weekly Report, “Global Liquidity Trends Support The Dollar, But…,” dated 25 January 2019, available at fes.bcaresearch.com

Highlights We advocate implementing asset allocation not across EM assets, but rather relative to their DM counterparts. EM stocks should be part of a global equity portfolio. EM sovereign and corporate credit should be part of a global credit portfolio. EM local currency government bonds are a unique asset class with idiosyncratic features and a low correlation with other assets. Hence, their addition to any multi-asset class portfolio is beneficial. We continue recommending below benchmark allocation to EM equities, credit and local bonds. The rebound in various EM financial markets is reaching a critical technical level where it will either stop or, if broken, will carry on for some time. In Peru, further decline in industrial metals prices and ongoing involuntary monetary tightening bode ill for share prices; continue underweighting. Feature We frequently receive questions from our clients on how they should be positioning their portfolios within EM asset classes such as equities, EM U.S. dollar bonds (credit markets) and local currency government bonds – whether they should be overweight EM stocks versus EM credit markets and domestic bonds, or vice versa. While BCA’s Emerging Markets Strategy service covers EM stocks, credit and domestic bonds and exchange rates, we do not make asset allocation calls between EM equities, EM credit and local currency bonds. The reason is very simple: in a risk-on market, EM equities always outperform EM credit and local bonds, and in a risk-off environment, stocks always underperform fixed income (Chart I-1). Chart I-1EM Stocks Versus EM Credit And Local Bonds With respect to the relative performance of EM credit markets versus domestic bonds, the performance of EM currencies is key. A large portion of total returns on EM local currency bonds comes from exchange rates (Chart I-2). Hence, when EM currencies appreciate, domestic bonds outperform EM credit markets (U.S. dollar bonds), and vice versa (Chart I-3). Chart I-2EM Currencies Are Key To EM Local Bonds Returns Chart I-3EM Local Bonds Versus EM Credit: It Is A Currency Call For investors willing to allocate across EM asset classes, a directional view on financial markets should drive allocation between equities and fixed-income. In rallies, equities should be favored, while during risk-off periods, fixed income should be preferred. It follows that investors should overweight EM credit markets versus domestic bonds when EM currencies depreciate, and tilt allocation toward local currency bonds versus EM credit markets when EM exchange rates appreciate. Recommended Approach To Asset Allocation We advocate implementing asset allocation not across EM assets, but relative to their DM counterparts: EM stocks should be part of a global equity portfolio. A pertinent asset allocation decision should be whether to be overweight, neutral or underweight EM within a global equity portfolio. In short, EM stocks should not be compared with EM credit or local bonds, but rather versus their DM counterparts. Having mentioned that, we are maintaining our underweight recommendation on EM within a global equity portfolio for now. EM sovereign and corporate credit should be part of a global credit portfolio – i.e., asset allocators should compare them with other credit instruments such as U.S. and European corporate bonds. Total returns on EM U.S. dollar-denominated sovereign and corporate bonds can be deconstructed into the total return on U.S. Treasurys and the excess return of these EM bonds over U.S. Treasurys. Investors can obtain exposure to U.S. Treasurys by owning them outright. Hence, the unique feature of EM sovereign and corporate bonds is their spreads over U.S. government bonds. EM sovereign and corporate bond spreads over U.S. Treasurys reflect issuers' ability and willingness to pay. Thereby, investors should treat EM dollar-denominated bonds as a pure credit product and this asset class should be part of a global credit portfolio. At the moment, we recommend asset allocators underweight EM sovereign and corporate credit versus U.S./DM corporate credit, in line with our short EM equities/long U.S./DM equities strategy (Chart I-4). Within credit markets, EM investment-grade and high-yield credit should be compared with their peers in U.S./DM, respectively. The reason we are negative on EM credit markets relative to the U.S. and DM universe is that the majority of EM sovereign and corporate bond issuers in Latin America and the EMEA are commodity producers. Hence, their revenues fluctuate with commodity prices, and their spreads should be under upward pressure as commodity prices drop further and EM currencies correspondingly depreciate (Chart I-5). Chart I-4EM Credit Versus U.S. Credit Chart I-5EM Credit Spreads Are Sensitive To Commodities And EM Currencies In the meantime, Chinese property companies, financials and industrials/materials remain the largest issuers of corporate debt in emerging Asia. Specifically, U.S. dollar bonds issued by Chinese companies account for 32% of the Barclay’s overall EM USD Credit index and 56% of the EM Asia USD Credit index. Crucially, Chinese corporate credit is essential to trends in emerging Asian credit markets. We are bearish on the fundamentals of Chinese corporate bond issuers due to our negative view on Chinese capital spending, particularly in the real estate sector. With respect to EM local-currency government bonds, this is an entirely different asset class with returns often uncorrelated with any other asset. Table 1 shows that EM local currency bond returns in U.S. dollars have a low correlation with most other asset classes. Therefore, adding EM local-currency bonds to a global multi-asset class portfolio will help achieve risk diversification provided an expectation of a positive return on this asset class in the long run. EM domestic bond returns are comprised of local yield carry and capital gains/losses, as well as currency appreciation/depreciation. Business cycles and monetary policies could from time to time be desynchronized across EM countries, and EM currencies could also at times diverge. In short, all of this will add idiosyncratic risk to any global multi-asset class portfolio and push out the portfolio’s efficient frontier – i.e., the portfolio could achieve higher returns for the same amount of risk (volatility). The exposure to EM local currency bonds should be altered according to the view on this asset’s absolute performance. Presently, we recommend below benchmark allocation to this asset class because we expect the majority of EM currencies to depreciate versus the U.S. dollar, the euro and the Japanese yen. The key driver of EM currencies is not U.S. interest rates but the global business cycle (Chart I-6). Odds are high that global trade will continue disappointing as China’s growth weakens further. This will lead to tumbling EM currencies and outflows from high-yielding EM domestic bonds. Chart I-6What Drive EM Currencies Within an EM local currency bond portfolio, our recommended overweights are Mexico, Brazil, Chile, Russia, central Europe, Thailand and Korea. The list of our overweights and underweight across EM stocks, credit markets, local bonds and currencies is always published at the end of our reports. Bottom Line: Global asset allocation should treat EM stocks as part of a global equity portfolio. EM sovereign and corporate credit should be part of a global credit portfolio. In turn, EM local currency government bonds are a unique asset class with idiosyncratic features and a low correlation with other assets. Hence, their addition to any multi-asset class portfolio is recommended given an expectation of a positive return in the long run. A Make It Or Break It Juncture The rebound in various EM financial market segments is reaching a critical technical level. At that point, it will either reverse, or will break through and carry on the upward momentum for some time: EM share prices have troughed at their three-year moving averages but are now facing resistance at their 200-day moving averages (Chart I-7). Failure to break above their 200-day moving averages would signal higher risks of a major breakdown. Conversely, a decisive break above their 200-day moving averages would suggest that the recent rebound has much farther to go. Our Risk-on versus Safe-Haven currency ratio has found support at its 6-year moving average but is now facing resistance at its 200-day moving average (Chart I-8, top panel). This ratio is highly correlated with EM share prices, and its breakout or breakdown will be an important signal for the direction of EM, commodities and global cyclical assets in general (Chart I-8, bottom panel). Chart I-7EM Share Prices Are Between Support And Resistance Chart I-8This Currency Ratio Is Key To EM And Commodities Trend A relapse from this level would be a major bearish signal, as it would confirm the formation of a head-and-shoulders pattern in this currency ratio. The latter would entail a major breakdown. A number of EM currencies such as ZAR, MXN, KRW, TWD, MYR and CNY are at a critical juncture (Chart I-9). A breakout or failure to do so will entail a major move. Chart I-9AEM Exchange Rates Are At Make It Or Break It Juncture Chart I-9BEM Exchange Rates Are At Make It Or Break It Juncture Meanwhile, the BRL may be forming an inverted head-and-shoulders pattern (Chart I-10). Hence, continuous BRL strength would signal rising odds of an extension to the rally in Brazilian markets. Chart I-10The Brazilian Real: An Inverted Head-And-Shoulder? Finally, industrial metals prices have failed to rebound and appear to be forming a head-and-shoulders formation. This pattern foreshadows considerable downside from current levels (Chart I-11, top panel). In the meantime, oil prices have bounced off their long-term moving average and might have a bit more room to advance before hitting a major resistance between $65-$70 for Brent (Chart I-11, bottom panel). Bottom Line: Our fundamental view on EM risk assets remains negative due to our expectations of further weakness in China’s growth. However, we are monitoring various signals and indicators to gauge whether the latest rebound can last much longer, which would cause us to change our stance tactically. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Peru: Involuntary Monetary Tightening Peru’s central bank is tightly managing the country’s exchange rate. As a result, it has little control over local interest rates. The Impossible Trinity thesis stipulates that in a country that has an open capital account, the central bank can control either interest rates or the exchange rate, not both simultaneously. Provided Peru has an open capital account, its central bank can have tight control over either the exchange rate or interest rates. So long as the central bank focuses on exchange rate stability, local interest rates will fluctuate with its balance of payments (BoP). Therefore, Peru’s credit cycle and hence domestic demand swings and bank share prices are driven by BoP (Chart II-1). Negative BoP dynamics – shrinking inflow of U.S. dollars – causes local interest rates to move higher while a positive BoP leads to lower borrowing costs (Chart II-2). Chart II-1Commodities Prices & Bank Stocks Are Correlated Chart II-2Trade Balance Drives Interbank Rates We expect negative BoP dynamics for Peru going forward – metals prices will drop as China’s growth continues to decelerate, and EM countries will likely experience a bout of portfolio capital outflows. If Peru’s central bank continues to favor limited currency depreciation, its interbank rates will march higher. Chart II-3 illustrates that the pace of net foreign exchange reserves accumulation often negatively correlates with interbank rates and leads loan growth by around 12 months (Chart II-4). Chart II-3Peruvian Local Rates Have Risen Chart II-4Peru: Bank Loan Growth Will Relapse When the monetary authorities purchase foreign exchange reserves, they inject local currency excess reserves (liquidity) into the banking system. More plentiful banking system liquidity drives down interbank rates and allows banks to expand credit, boosting domestic demand. The reverse also holds true. The Peruvian central bank was able to mitigate upside in local rates amid the negative terms-of-trade shock in 2014-‘15 by conducting foreign currency swaps with banks. This swap led to an injection of local currency reserves into the system. Currently these swaps are being unwound and banks’ excess reserves are dwindling, putting upward pressure on local rates. Hence, the rise in interbank rates in the past 12 months has not only been due to negative terms of trade but also due to the expiration of foreign currency swaps. As metals prices drop and exports contraction deepens, the currency will come under selling pressure (Chart II-5). To prevent the currency from depreciating considerably, the central bank has to tighten liquidity, producing higher interbank rates. The latter bodes ill for domestic demand. Chart II-5Money Growth Is Contingent On Trade Bottom Line: We continue to underweight the Peruvian bourse because of its exposure to mining companies and banks. The former is at risk from falling industrial metals prices, while the latter will suffer from rising interbank rates. Within the mining sector, gold and silver stocks should outperform copper producers because we foresee more downside in industrial metals than precious metals prices. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Footnotes Equity Recommendations Fixed-Income, Credit And Currency Recommendations