Economy

Special Report

Highlights We are exploring the key FX implications of the views presented in BCA’s 2019 annual outlook. Global growth is set to weaken further in the first half of the year. As a result, the U.S. dollar should benefit from a last hurrah before beginning a long painful period of depreciation. The euro will mirror these dynamics and should depreciate below EUR/USD 1.10 before appreciating significantly during the second half. The yen is likely to rally against the EUR in the first half of the year, but the JPY will be left very vulnerable once global growth picks up again. The Swiss franc might be a safe-haven currency, but risks are rising that the Swiss National Bank will increasingly fight against the CHF’s upside vis-à-vis the euro. Thus, EUR/CHF has limited downside while global growth slows, and plenty of upside once global growth firms. The GBP could continue to experience some volatility, but we recommend using any additional weaknesses to buy cable. The commodity and Scandinavian currencies will suffer in the first half of the year, but they should prove the stars of the currency market in the second half. Feature Key View From The Outlook This past Monday we sent you BCA’s Annual Outlook, exploring the key macroeconomic themes that we expect will shape 2019. This year, the discussion between BCA’s editors and Mr. X, and his daughter, Ms. X, yielded the following key views:1 The collision between policy and markets that we discussed last year finally came to a head in October. Rather than falling as they normally do when stocks plunge, U.S. bond yields rose as investors reassessed the Federal Reserve’s willingness to pause hiking rates, even in the face of softer growth. Likewise, hopes that China would move swiftly to stimulate its economy were dashed as it became increasingly clear that the authorities were placing a high emphasis on their reforms agenda of deleveraging and capacity reduction. The ongoing Brexit saga and the stalemate between the populist Italian government and the EU have increased uncertainty in Europe at a time when the region was already beginning to slow. We expect the tensions between policy and markets to be an ongoing theme in 2019. With the U.S. unemployment rate at a 48-year low, it will take a significant slowdown for the Fed to stop hiking rates. Despite the deterioration in economic data over the past month, real final domestic demand is still tracking to expand by 3% in the fourth quarter, well above estimates of a sustainable pace of economic growth. Ultimately, the Fed will deliver more hikes next year than discounted in the markets. This will push up the dollar and keep the upward trend in Treasury yields intact. The dollar should peak midway next year. China will also become more aggressive in stimulating its economy, which will boost global growth. However, until both of these things happen, emerging markets will remain under pressure. For the time being, we continue to favor developed-market equities over their EM peers. We also prefer defensive equity sectors such as health care and consumer staples over cyclical sectors such as industrials and materials. Within the developed market universe, the U.S. will outperform Europe and Japan for the next few quarters, especially in dollar terms. A stabilization in global growth could ignite a blow-off rally in global equities. If the Fed is raising rates in response to falling unemployment, this is unlikely to derail the stock market. However, once supply side constraints begin to fully bite in early 2020 and inflation rises well above the Fed’s 2% target, stocks will begin to buckle. This means a window exists next year where stocks will outperform bonds. We are maintaining a benchmark allocation to stocks for now but will increase exposure if global bourses were to fall significantly from current levels without a corresponding deterioration in the economic outlook. Corporate credit will underperform stocks as government bond yields rise. A major increase in spreads is unlikely so long as the economy is still expanding, but spreads could still widen modestly given their low starting point. U.S. shale companies have been marginal producers in the global oil sector. With breakeven costs in shale at close to $50/bbl, crude prices are unlikely to rise much from current levels over the long term. However, over the next 12 months, we expect production cuts in Saudi Arabia will push prices up, with Brent crude averaging around $82/bbl in 2019. A balanced portfolio is likely to generate average returns of only 2.8% a year in real terms over the next decade. This compares to average returns of around 6.6% a year between 1982 and 2018. Essentially, global growth is likely to stay weak in the first half of 2019. However, even if it experiences a benign slowdown, the U.S. economy continues to run above trend, and a U.S. recession next year is a low-probability event (Chart 1). This suggests the Fed will continue to increase rates at a gradual pace of one hike per quarter until U.S. financial conditions become tight enough to force a re-assessment of the U.S. growth outlook. This configuration is likely to result in additional market stress globally and a stronger dollar. As a result, a defensive stance in the FX market seems warranted. Chart 1The Fed Isn't Ready To Capitulate However, China has a role to play in this script as well. The Chinese authorities are getting very uncomfortable with the continued deceleration in Chinese activity. They will likely further support their economy, which should cause global growth to trough toward the middle of the year. This will result in a major selling opportunity for the dollar, and a buying opportunity for the most pro-cyclical currencies. Implications For The FX Markets What are the key implications of these views for currency markets? Based on this outlook for global growth and the Fed, the USD should generate a healthy performance in the first half of the year. As Chart 2 illustrates, the dollar is often strong when global growth and global inflation weaken. However, if global growth is indeed set to rebound in the second half of the year, then, at this point, the dollar should depreciate considerably. This is even more likely as speculators are already very long the greenback, and thus there will be ample firepower to sell the USD once macroeconomic conditions warrant it (Chart 3). As a result, a DXY dollar index above 100 could represent an interesting opportunity for long-term investors to lighten up their dollar exposure. Chart 2The Dollar And The Global Business Cycle   Chart 3Fuel For The Dollar's Downside The euro continues to behave as the anti-dollar; since buying EUR/USD is the simplest, most liquid vehicle for betting against the dollar, and vice versa. Our bullish dollar stance is therefore synonymous with a negative take on the euro. Also, while American growth is showing budding signs of deceleration, slowing global trade and Chinese economic activity have a more pronounced impact on Europe. As a result, euro area growth is underperforming the U.S. Finally, since the Great Financial Crisis, EUR/USD has lagged the differential between European and U.S. core inflation by roughly six months. Today, this inflation spread does point to a weaker EUR/USD for the opening quarters of 2019, but it also highlights that the euro may rebound toward the end of the second quarter (Chart 4). Chart 4The Euro Will Rebound, But This Will Not Happen Immediately Additionally, since momentum has a great explanatory power for the dollar, it tends to work well for the anti-dollar, the euro. Currently, momentum suggests that the euro has also more downside. Our favored fair value model for EUR/USD – which includes real short rate differentials, the relative slope yield curves, and the price of copper relative to lumber – stands at 1.11 (Chart 5). Since the euro tends to bottom at discounts to its equilibrium, this suggests that the common currency is likely to find a floor toward 1.08. Chart 5The Euro Will Fall Between 1.08 And 1.05 On a long-term basis, the yen is cheap, and therefore, already reflects the fact that the Bank of Japan’s balance sheet has now grown to 100% of GDP (Chart 6). However, this is of little comfort for the next 12 months. Over this period, movements in global bond yields will determine the yen’s gyrations. Since we expect global growth to slow further in the first half of the year, global yields are likely to remain contained until the second half of 2019. The impact on the yen of fluctuating global yields will be magnified by Japan’s incapacity to generate much inflationary pressure, with core inflation stuck at 0.4%. This means that while JGB yields have limited downside when global bonds rally, they only have very limited upside when global yields rise. Hence, during the first six months or so of the new year the yen is likely to experience limited downside against the dollar and may even experience significant upside against the euro (Chart 7). However, the second half of 2019 is likely to witness a significant reversal of this trend, with a weaker yen against the dollar, and a much stronger EUR/JPY. Chart 6The Yen Is Very Cheap   Chart 7Selling EUR/JPY Should Be A Winner In H1 At this juncture, the pound remains the trickiest currency to forecast. We are entering the last innings of the Brexit negotiations, and Prime Minister Theresa May looks particularly frail. Bad news out of Westminster will most likely continue to hit the pound at regular intervals. However, GBP/USD is cheap enough on a long-term basis that after the month of March, it could experience meaningful upside against the dollar (Chart 8). We are therefore reluctant to sell the pound at current levels, and instead are looking to buy cable each time undesirable headlines knock it down. As the probability grows that the ultimate form of divorce agreement will be a “soft Brexit,” this also means that once the ultimate deal between London and Brussels is set to be ratified by the British Parliament, EUR/GBP could experience significant downside as well (Chart 9). Chart 8Start Buying The Pound Chart 9Substantial Downside In EUR/GBP The Swiss franc benefits against the euro when global growth weakens and asset market volatility rises. This safe-haven attribute of the franc lies behind the 5.4% decline in EUR/CHF since April. Therefore, our view on global growth would suggest that EUR/CHF could experience additional downside in the first half of 2019. However, we are not willing to make this bet. The Swiss National Bank continues to characterize the Swiss franc as being expensive, and Swiss inflation, retail sales and industrial production have all decelerated. In fact, the Economic Expansion Survey indicator is plunging at its quickest pace since the Swiss economy relapsed directly after the botched re-evaluation of the franc in January 2015 (Chart 10). This suggests the SNB will likely soon put a cap on the franc’s strength as it is causing potent damage to the country. This means that EUR/CHF has limited downside in the first half of 2019, even if global growth deteriorates, and should have large upside in the second half of the year as global growth perks up. Chart 10The SNB Will Not Seat On Its Hands: Buy EUR/CHF Commodity currencies could perform very well in the second half of the year, once global growth finds a firmer footing. The oil currencies should perform best over that period, as BCA’s oil view remains firmly bullish, with a 2019 target of $82/bbl if OPEC agrees to a deal. Moreover, the CAD and the NOK are still the cheapest currencies within this group. However, in the first half of the year, the commodity currency complex remains at risk. Slowing global growth and a Fed committed to lifting interest rates to levels more consistent with the U.S. neutral rate are likely to cause the volatility of the currency market to trend higher (Chart 11). Historically, commodity currencies perform poorly when this happens. This is because when FX volatility picks up, carry trades suffer, which hurts global liquidity conditions and hampers global growth further (Chart 12). The AUD is particularly vulnerable as it is the currency most exposed to China’s capex and construction cycles. Moreover, the Reserve Bank of Australia is still very dovish, as there are no inflationary pressures in Australia. Chart 11The Global Macro Outlook Points To Higher FX Vol... Chart 12...And Higher FX Vol Hurts Global Growth Via The Carry Trades Scandinavian currencies are traditionally very pro-cyclical. This reflects the high sensitivity of the Swedish and Norwegian economies to the global business cycle. As a result, when global growth weakens and global inflation disappoints, they are likely to perform as poorly as the AUD and the NZD (Chart 13). Chart 13Weak Global Growth Will Hurt Scandinavian Currencies In H1 2019... Despite this clouded outlook for the beginning of the year, the scandies should perform very well in the second half of 2019, once global growth stabilizes. With their economies at full employment and exhibiting growing imbalances, both the Riksbank and the Norges Bank are in the process of slowly moving away from extremely easy monetary policy settings. However, they have a long way to go before reaching tight monetary conditions, which implies plenty of upside for real interest rates in both countries. This means that the boost to the SEK and the NOK from rising global growth in the second half of the year will be magnified by domestic factors. Finally, both the SEK and the NOK are very cheap, adding upside risks to these currencies (Chart 14). Chart 14...But Scandies Will Have A Stellar H2 2019   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnote 1 The full report – a BCA Research Special – titled “OUTLOOK 2019: Late-Cycle Turbulence”, dated November 26, 2018, is available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

Dear Client, In addition to today’s report, we sent you our 2019 Outlook earlier this week, featuring a discussion between BCA editors and Mr. and Ms. X. Best regards, Peter Berezin, Chief Global Strategist Highlights Today’s macroeconomic backdrop of slowing global growth, plunging oil prices, falling equity prices, widening credit spreads, and a strong dollar is reminiscent of what transpired in 2015. We do not expect global capital spending to contract as much as it did back then, partly because Saudi output cuts should preclude the need for shale producers to slash capex plans. Nevertheless, global growth is likely to slow further into the first half of next year, suggesting that equities and other risk assets could face renewed near-term pressures. The sell-off in the dollar following Powell’s speech is unwarranted. We expect the DXY to reach 100 by early next year. Global bond yields will rise by more than currently discounted over a 12-to-18 month horizon, but are likely to fall somewhat over the next few months. Feature Echoes From The Past Today’s macroeconomic backdrop is starting to look increasingly similar to 2015, a year when the global economy slowed sharply and commodity prices took it on the chin. In 2014, the Fed was gearing up to raise rates while other central banks were still in full-out easing mode. The divergence in monetary policies between the U.S. and the rest of the world caused the U.S. dollar to surge. The broad trade-weighted dollar strengthened by 16% between July 2014 and March 2015 (Chart 1). Chart 1Current Dollar Strength: Replay Of 2015? The effects of the stronger dollar rippled across the global economy. Notably, since China had a de facto currency peg to the dollar at the time, the resurgent greenback made Chinese companies less competitive in global markets. The appreciation of the yuan came at a time when the Chinese government was tightening both monetary and fiscal policy. The year-over-year change in total social financing (TSF) reached as high as 23% in April 2013 but fell to 12% in May 2015 (Chart 2). Chart 2Just Like Today, China Was Tightening Monetary And Fiscal Policy Going Into 2015 Eager to give its export sector a competitive boost, China allowed the currency to weaken by about 4% in August 2015 (Chart 3). The “mini-devaluation” backfired. Rather than instilling confidence in the economy, it caused investors to bet on further currency declines. Capital outflows intensified as the yuan came under further pressure. Between June 2014 and January 2016, China lost almost US$1 trillion in foreign exchange reserves. Chart 3China's Mini-Devaluation Backfired The combination of a stronger dollar and sagging Chinese growth led to a steep decline in commodity prices. The London Metals Exchange index fell by nearly 40% between July 2014 and January 2016. Brent crude oil prices plunged from $110/bbl to as low as $26/bbl during this period (Chart 4). Capital spending in the commodity sector collapsed. Fears over the financial health of commodity producers and related firms caused credit spreads to widen (Chart 5).  Chart 4Stronger Dollar And Soggy Chinese Growth Were A Bad Combination For Commodity Prices Chart 5Weakness In The Commodity Complex Weighed On High-Yield Bonds In 2015 Throughout the course of 2015, the Fed refused to back off from its plans to start raising rates. It hiked rates in December of that year and signaled four more hikes for 2016. However, as markets continued to swoon, the FOMC quickly backed off. The Fed would not raise rates again for a full 12 months. The Federal Reserve’s decision to temper its hawkish rhetoric, along with China’s decision to ramp up stimulus in early 2016, put a floor under risk assets. Fast forward to the present and investors are again wondering if the Fed is about to blink and whether the Chinese authorities are set to deliver a massive dose of global reflationary stimulus. We would not exclude either option. However, we think that a lot more pain is required before either occurs. China’s Begrudging Stimulus Program The Chinese government’s reform agenda remains focused on curbing credit growth and reducing excess capacity. China has historically stimulated its economy with ever-more debt and investment spending (Chart 6). There is an obvious tension here – one that is likely to make the authorities reluctant to turn on the credit spigot unless the economy slows further. Chart 6China: Debt And Capital Accumulation Have Gone Hand In Hand Of course, China can try to stimulate its economy without relying on more debt-financed investment spending. In particular, it can try to boost consumption or net exports. The problem is that neither of these two options would be welcome news for other nations. Capital goods and raw materials account for more than 80% of Chinese imports. The rest of the world relies on Chinese investment, not Chinese consumption. Similarly, while stricter capital controls have given the authorities greater scope to weaken the yuan than they had in 2015, such a move would only hurt China’s competitors and curb Chinese imports.  The Fed Will Keep Hiking Stocks rallied and the dollar sold off on Wednesday after Chairman Powell seemingly suggested that the fed funds rate was already close to neutral. This appeared to be a sharp recanting of his statement in early October that the Fed was a “long way” from neutral. We think the financial media and many pundits overreacted to Powell’s remarks. What he actually said was that “interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy.”1 The “broad range” of estimates that Powell was referring to is drawn from September’s Summary of Economic Projections, which showed that FOMC members saw the appropriate “longer run” level of the fed funds rate as ranging between 2.5% and 3.5%. Given that the current target for the fed funds rate is 2%-to-2.25%, Powell was merely stating a fact about the current position of the Fed dots, not offering new forward guidance. In any case, investors are focusing too much on what Powell may or may not be thinking. The Fed does not know where the neutral rate is. True to its “data-dependent” approach, it will keep raising rates until the economy slows by enough that it needs to stop. Our base-case scenario envisions only a modest slowdown in U.S. growth, driven in part by increasing capacity constraints (the latter should make the Fed more, not less, eager to raise rates). So far, the data are consistent with this benign slowdown scenario. Holiday sales have been stronger than expected, based on data from Johnson-Redbook and Adobe Digital Insights. According to the Atlanta Fed’s GDPNow model, real GDP is on track to increase by 2.6% in the fourth quarter. Net exports and inventory destocking are expected to shave about half a percentage point off growth. This means that real final domestic demand is still growing at a healthy 3% pace. GDP growth could slow to about 2.5% next year as the fiscal impulse declines and the lagged effects from the recent tightening in financial conditions make their way through the economy. Nevertheless, given that most estimates peg potential growth at around 1.7%-to-1.8%, this should still be enough to push the unemployment rate towards 3% by the end of 2019, bringing it to the lowest level since the Korean War. This should keep price and wage inflation on an upward trajectory (Chart 7). Chart 7Does The Fed Like It Hot? The “dots” in the September Summary of Economic Projections foresaw one rate increase this December and three additional hikes next year. The market is currently pricing in only two hikes through to end-2019 and no hikes beyond then (Chart 8). If our baseline scenario for the U.S. economy unfolds as expected, the Fed will raise rates four times next year, which will keep the U.S. dollar well bid.  Chart 8The Market Does Not Buy The Dots Oil And The Global Economy: Why It Will Not Be As Bad This Time Around As in 2015, a key question today is how the recent drop in oil prices will affect both the U.S. and the global economy. Here there is some good news. The balance sheets of U.S. energy companies have improved markedly over the past few years. Rapid productivity has allowed shale producers to boost production to record levels without having to incur substantially higher costs. In fact, capital spending in the energy sector is far lower as a share of GDP today than it was in the lead-up to the 2015 shale bust (Chart 9). Chart 9Energy Sector Capex Is Far Below Its 2014 Peak Saudi Arabia’s reaction to the slide in oil prices is also likely to be different this time around. In 2015, the Saudis refrained from cutting output in the hope that this would undermine Iran and decimate the fledgling U.S. shale industry. In the end, the Iranian regime endured, and while U.S. production did fall temporarily, it quickly rebounded (Chart 10). Chart 10Who Won The Market Share War Of 2015? Going into September, the Saudis ramped up production after President Trump indicated his intent to tighten sanctions on Iranian oil exports. In the end, Trump declined to reimpose the sanctions. This left the market with a surfeit of crude. There is a limit to how much Saudi Arabia can cut output. Now that the stock market is well off its highs, President Trump has started to take credit for low oil prices. Nevertheless, the Saudis are keenly aware that they need crude to trade at about $83 per barrel just to balance their budget. Our geopolitical and energy strategists expect the Kingdom to cut production by enough to push up prices from current levels. Russia has also hinted at restraining supply. If U.S. producers fill part of the void created by Saudi and Russian production cutbacks, U.S. energy sector capital spending will hold up much better than it did in 2015. Provided that oil prices do not return all the way to their September highs, U.S. consumers will also benefit from an increase in spending power. Investment Conclusions We do not expect the global economy to weaken as much as it did in 2015. Nevertheless, most forward-looking economic indicators point to slower growth over the next few quarters (Chart 11). Global growth will likely bottom out by the middle of 2019, but until then, investors should continue to favor developed over emerging market stocks. They should also overweight defensive equity sectors, such as consumer staples and health care, relative to deep cyclicals, such as materials and industrials. Given sector skews, this implies a regional preference for the U.S. over Europe and Japan. Chart 11Global Growth Is Slowing As far as the near-term absolute direction of stocks is concerned, the equity score from our MacroQuant market-timing model has risen from its recent lows thanks to an improvement in sentiment/technical components. Nevertheless, the model is still pointing to heightened downside risks to global equities over the remainder of the year and into early 2019 due to slowing growth and the lagged effects of the recent tightening in financial conditions (Chart 12). Chart 12MacroQuant Equity Model* Score Is Off Its Lows, But Is Still Warning Of More Downside For Stocks Slower global growth and ongoing Fed rate hikes should keep the dollar well bid. Consistent with our qualitative analysis, our model is currently sending a very bullish signal on the greenback (Chart 13). We expect the DXY to reach 100 by early next year. Chart 13MacroQuant U.S. Dollar Model Is Pointing To Further Upside For The Greenback The model’s near-term outlook on bonds has improved greatly in recent weeks after having spent the better part of the last 18 months in bearish territory (Chart 14). To be clear, this is a tactical signal: The model’s cyclical fair-value estimate for the U.S. 10-year Treasury yield stands at 3.71% – 67 basis points above current levels – which implies that the 12-to-18 month path for yields remains to the upside (Chart 15). Nevertheless, with global growth slowing and lower energy prices dragging down inflation, there is a good chance that the 10-year yield will temporarily fall below 3% before resuming its structural uptrend. Chart 14MacroQuant Recommended Portfolio*: Tactically Favor Bonds Over Stocks   Chart 15MacroQuant U.S. Bond Model*: Treasury Yields Are Still Well Below Fair Value, But The Upside Is Capped Tactically Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1      Jerome H. Powell, “The Federal Reserve’s Framework for Monitoring Financial Stability,” Federal Reserve, November 28, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Special Report

Highlights Turkish commercial banks have been ramping up purchases of local currency government bonds. Given that commercial banks create new money “out of thin air” when they buy assets from non-bank entities, should investors interpret this phenomenon positively or negatively? Under the backdrop of a severe recession, we view this phenomenon as a stabilizing factor that can provide moderate relief - a painkiller rather than a poison. Meanwhile, record-wide net interest rate spreads as well as rising purchases of government bonds yielding around 20% are positive for banks’ earnings amid an otherwise dismal economic outlook. To express a selective positive bias toward this depressed and still fundamentally challenged market versus other EMs, we recommend a relative equity trade: long Turkish banks / short EM banks, currency unhedged. Feature On August 15, 2018, we upgraded our stance on Turkish markets from underweight to neutral and closed our shorts in the currency and bank stocks after having been bearish/underweight for several years.1 Our rationale was that Turkish equity and currency valuations had become cheap, and its financial markets oversold. Yet we stated that the adjustment in interest rates and ensuing economic slowdown were still pending – preventing us from going overweight. Are Turkish interest rates now sufficiently high to put a floor under the currency? In other words, is monetary demagoguery – relentless bank lending promoted by the authorities amid high inflation – a thing of the past?2 At first glimpse, the answer appears to be no. Turkish banks have been aggressively buying local currency government bonds – at a time when foreigners have been selling their holdings (Chart I-1). Chart I-1Turkish Banks Have Been Buying Local Government Bonds As we demonstrate in Box I-1 on page 9, commercial banks in all countries create new money when they purchase any asset, including any security, from non-bank entities. One can argue that the Turkish banks’ creation of money “out of thin air” holds the potential to trigger renewed currency depreciation. Furthermore, banks’ financing of the government depresses government bond yields, bringing down market-determined local currency interest rates. On the other hand, there is also evidence that banks have drastically curtailed financing to the real economy, which is causing a severe collapse in domestic demand. This has already squeezed imports and has started to narrow the current account deficit - a necessary condition for macro and exchange rate stabilization (Chart I-2). As such, it seems Turkey’s necessary macro adjustment is already under way. Chart I-2Turkey: Current Account Deficit Is Narrowing These two dynamics – (1) banks financing the government by creating money “out of thin air” and (2) banks inhibiting financing to households and companies – are conflicting. While many economists refer to this phenomenon as a crowding out of the private sector by the government, we disagree with this analytical framework. Please refer to Box I-1 on page 9 for a more detailed discussion. Our assessment of these dynamics is as follows: In the current context of rapidly shrinking domestic demand, banks’ financing of the government is a mitigating factor in the ongoing macro adjustment. Commercial banks’ financing of the public sector via bond purchases caps market-determined interest rates and allows the government to spend, therefore diminishing the blow to the real economy. Consequently, the expansion of Turkish banks’ purchases of government bonds is a silver lining in an otherwise harsh macro adjustment. So long as this phenomenon is not prolonged indefinitely and does not cause the currency to plunge anew, it is an acceptable strategy for both banks and the government. In fact, it could form a fertile ground for Turkish banks’ stock prices to start rising from the ashes, at least relative to other emerging markets. Fiscal Deficit Financing By Banks: Poison Or Painkiller? Diagnosing a patient in critical condition and prescribing the right medicine is a complex task. Assessing monetary conditions in a financial crisis-stricken economy and determining the correct policy mix is no different. While monetary tightening may be the right medicine for some parts of the economy, monetary easing can be appropriate for others parts. In fact, this is what is currently happening in Turkey. There is a dichotomy occurring between monetary easing for the government (in the local currency bond market) and monetary tightening for companies and households. Chart 3 demonstrates that local currency broad money growth now slightly exceeds bank loan growth. One of the reasons for this is that banks are literally creating money by purchasing government securities. With a low likelihood of default and a yield of 20%, government securities are currently attractive for Turkish banks. On the surface, government deficit financing via money creation by banks might seem like a recipe for higher inflation. Yet, we have to put this phenomenon in the context of current cyclical economic conditions in Turkey. The economy is on the precipice of a major recession which will likely produce a major deflationary shockwave. Money and credit growth in real terms is negative (Chart I-3, bottom panel). In addition, government expenditures in real terms are now contracting, suggesting that fiscal policy is tight (Chart I-4). Furthermore, government debt levels are low – total public debt stands at 31% of GDP. This means that fiscal expansion is a lever that authorities can and should be using. Chart I-3Turkey: Money And Loan Growth Are Negative In Real Terms Chart I-4Turkey: Fiscal Policy Is Tight Hence, we infer that banks’ financing of government expenditures are not excessive from a macro perspective; particularly when considering the currently heightened recessionary crosscurrents. Bottom Line: The expansion of Turkish banks’ purchases of government bonds are capping local bond yields and, on the margin, allowing the government to support the economy. Given the backdrop of a severe recession, we view this as a stabilizing factor – a painkiller rather than a poison. Monetary Tightening In The Real Economy Commercial banks have substantially tightened financing to companies and households. Interest rates on bank loans to businesses and consumers have risen much more than the central bank’s policy rate. The former are now 850 basis points higher than the latter (Chart I-5, top panel). Chart I-5Turkey: Tight Monetary Conditions In The Real Economy In real terms (deflated by core CPI), commercial bank loan interest rates are now 8% (Chart I-5, bottom panel). High real bank loan rates charged to households and companies will cause domestic demand to collapse – despite a real policy rate at zero. Provided economic activity is already shrinking, it will be difficult for debtors to achieve a hurdle real rate of 8%. This is already producing a collapse in loan demand and a material retrenchment in consumer and business spending. A statistical regression of economic activity variables on the change in borrowing costs demonstrates that the Turkish economy is in for a severe recession across all sectors, with capital expenditures being the hardest hit (Chart I-6). Chart I-6Turkey: The Recession Will Be Severe A cheapened currency and high borrowing costs are the correct medicine for the nation’s deep economic imbalances – i.e. its large and persistent current account deficits. In fact, the real economy has already been adjusting: the current account excluding oil is starting to narrow (refer to Chart I-2 on page 2). This together with cheap valuations may help put a floor under the lira (Chart I-7). Chart I-7The Turkish Lira Is Cheap Bottom Line: Interest rates on bank loans have increased much more than the central bank policy rate and are sufficiently high in real terms, foreshadowing a severe, but necessary, domestic demand contraction. Go Long Turkish Banks / Short EM Banks There appears to be a relative tactical opportunity to go long Turkish banks while shorting EM banks. Relative share prices in dollar terms between Turkish and EM banks are at an all-time low (Chart I-8). Odds are that Turkish banks will outperform for the time being. Chart I-8Long Turkish Banks / Short EM Banks Not only are Turkish banks charging a large spread on loans relative to the policy rate, they are also enjoying a wide net interest rate spread – lending rates minus deposit rates. In fact, Turkish banks’ net interest rate spread is presently the highest in recorded history (Chart I-9, top panel). This is very positive for banks’ net interest margins (NIM) – net interest income as percent of loans - and earnings (Chart I-9, bottom panel). Chart I-9Turkish Banks' Margins Are Widening In addition, banks’ purchases of government bonds allows them to expand their balance sheets and earn a yield that is around 20%. Given the government’s low credit risk, this is also positive for banks’ profits. On the negative side, non-performing loans (NPLs) are set to surge. Therefore, any investment consideration should take into account banks’ equity erosion due to surging NPLs. Turkish banks are presently extremely under-provisioned, as illustrated in Chart I-10. Yet their share prices have already plunged substantially, discounting a higher level of NPLs than banks have acknowledged and provisioned for. Chart I-10Turkey: NPLs Are Set To Surge We have performed a credit stress test for the Turkish banking system. The scenario analysis shown in Table I-1 illustrates that banks’ share prices are already pricing in a significant amount of bad news regarding the NPL cycle. For example, in a scenario where the non-performing credit assets (NPCA) ratio rises to 20% from its current 3.5% level, bank stocks would be fairly valued at current levels. Table I-1Credit Stress Test For Turkish Banks Considering that the NPL-to-total-loan ratio reached 18% after the 2001 currency crisis, we believe 20% is a reasonable estimate. The key difference between now and the 2001 crisis is that woes in 2001 were related to unsustainable government debt, while Turkey’s present problems stem from excessive private debt. This valuation part of the stress test assumes that the fair value for the price-to-book value (PBV) ratio adjusted for all credit losses is 1.3 - the average PBV ratio for EM banks since 2011. In short, banks’ stock prices are currently trading close to their fair value assuming 20% NPCA (Table I-1). In all scenarios, we assume a recovery rate of 40%. In terms of structural valuations, using our model for the cyclically-adjusted P/E (CAPE) ratio, Turkish banks are currently trading at two standard deviations below their fair value in absolute terms, and two-and-half standard deviations relative to the other EM banks (Chart I-11). Chart I-11Turkish Bank Stocks Are Cheap Given that we expect an additional selloff in EM risk assets, Turkish bank stocks will likely relapse in absolute terms. This is why we recommend a market-neutral bet. In short, we expect more downside in the share price of EM banks than in Turkish ones for now. Investment Conclusions Given our overarching negative view on emerging markets as a whole, we are reluctant to be bullish on Turkish risk assets in absolute terms. The basis behind why we are not upgrading our stance on Turkey’s overall stock index is as follows: Non-financials companies are about to experience severe profit shrinkage as the recession deepens. Conversely, contraction in banks’ earnings will be mitigated by a very wide NIM and an increased financing of the government at yields above 20%. In addition, we expect EM currencies and high-yielding local bonds to resume their selloff, and corporate and sovereign credit spreads to widen. Given Turkey has historically been a high-beta market, it is difficult to bet on its financial markets outperforming EM peers in a bear market. Finally, the recent rebound in Turkish markets was from quite oversold levels and is currently facing its first technical resistance (Chart I-12). Chart I-12The Lira And Local Government Bonds Are Facing Their First Technical Resistance Overall, we continue to recommend a neutral allocation to Turkey for EM dedicated equity investors, as well as local currency bond and credit portfolios. Nevertheless, to express a selective positive bias toward this depressed market versus other EMs, we recommend a relative equity trade: Long Turkish banks / short EM banks, currency unhedged. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Box 1 How Banks Create Money By Purchasing Assets From A Non-Bank Entity We demonstrate, in a stylized example, how a commercial bank (Bank 1) creates a new deposit in the banking system – which consists of two banks (Bank 1 and Bank 2) - when it purchases a bond from an investor (Investor A) that is a non-bank. For simplicity, we presume that this is the only transaction in the banking system on that day. All numbers we cite here are local currency values and all transactions take place in local currency. We assume at the beginning of Day 1 that both Bank 1 and Bank 2 each have excess reserves (ERs) of 1000 and existing deposits of 1000 (Figure I-1). Hence, the overall banking system ERs amount to 2000 and total deposits are equal to 2000. Figure I-1Begining Of Day 1 Balance Sheet & Transactions As Bank 1 purchases a bond at the price of 300 from Investor A, the following balance sheet accounting entries take place (these entries are shown in red in Figure I-1): Bank 1 acquires a bond and its assets now include a bond valued at 300. Investor A has an account at Bank 2, so to pay for this purchase Bank 1 transfers 300 from its ERs to Bank 2’s ERs account at the central bank. Bank 1 ERs decline by 300. Hence, its assets and liabilities have not changed – it has just swapped 300 in ERs with 300 in bond (Figure I-1). Bank 2 credits Investor A’s deposit account by 300. Hence, Investor A received a deposit valued at 300 that it previously did not have. This is a new deposit for the whole banking system that was created “out of thin air”. Bank 2’s ERs and hence its total assets have risen by 300. This rise in Bank 2’s assets is balanced by the increase of its deposit by 300 (Figure I-2). In brief, this deposit is nothing more than an accounting entry to balance Bank 2’s assets and liabilities. Yet, deposits represent money and give their holders purchasing power. Figure I-2End Of Day 1 Balance Sheet Assuming that during the day there was no other transaction in this banking system, the latter’s ERs have remained unchanged at 2000 yet its total deposits have risen from 2000 to 2300. A new deposit worth 300 was created without the central bank providing any funding (new ERs) to the banking system. Money supply is the sum of all deposits in the banking system and commercial banks create deposits “out of thin air” when they lend to non-banks or purchase assets from non-banks. As such, banks do not need to reduce private sector lending to fund the government. In other words, no “crowding out” of the private sector needs to take place for banks to buy government bonds.   Footnotes 1      Please see Emerging Markets Strategy Special Alert "Turkey: Booking Profits On Shorts," dated August 15, 2018, the link available on page 14. 2      Please see Emerging Markets Strategy Special Report "Turkey's Monetary Demagoguery," dated June 1, 2016, available at ems.bcaresearch.com   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Special Report

Highlights So What? A trade deal is unlikely at the G20. Stay short CNY/USD. Why? The odds of a U.S.-China tariff ceasefire are around 30%-40%. Investors should see any ceasefire as a temporary reprieve. Stay neutral on Chinese equities. Expect a weaker CNY/USD. Fade any rally in U.S. China-exposed equities. In Taiwan, local elections do not herald a decline in geopolitical risk, which is elevated. Feature The scheduled meeting between U.S. President Donald Trump and Chinese President Xi Jinping on the sidelines of the G20 summit in Buenos Aires on December 1 has generated a fair amount of speculation that the trade war will be resolved or at least put on pause. A major de-escalation would bring some consolation to global equity markets that have fallen by 11% since their peak in late January, 2018, especially to Chinese and Asian cyclicals, which have fallen by 27% and 21% respectively over the same time period (Chart 1). Chart 1Desperate For Good News We are doubtful that the summit will cause a major positive catalyst for markets. Yes, it is tempting to think that President Trump could wrap up the whole trade war promptly, just as he wrapped up negotiations with Mexico and Canada in October. If President Xi could add a few sweeteners to concessions he has already made, then Trump could proclaim a “historic new deal” and roll back the tariffs. Equity markets would celebrate. The past year would seem like a bad dream. But this is all fantasy. U.S.-China relations have gotten worse every year since 2008 for a host of economic, political, military, and strategic reasons. Is the current stock market selloff really enough to force Trump into a major capitulation, given that trade tensions were not the primary cause either of the October correction or of the earlier pullback in February? And is Xi really going to make significant concessions with Trump holding bigger threats over his head? We admit that some kind of improvement is plausible – say, a tariff ceasefire and an agreement to launch a new round of talks. We attach a 30%-40% subjective probability to such a scenario. But our base case – which is driven as always by structural factors – is that the summit will turn out to be a flop and the trade war will escalate in 2019. How Likely Is A Tariff Ceasefire? Presidential summits can have major consequences, but context is everything. Trump’s impending meeting with President Xi will be the third since he took office. The first two – in April and November 2017 – did not prevent the trade war. Neither did high-level negotiations in May 2018, which produced a “trade truce” that did not last a week. However, much has changed since then: the U.S. has imposed tariffs on half of Chinese imports, while China has suffered a bear market and some signs of domestic economic stress (Chart 2). Chart 2Signs Of Economic Weakness Over the past month, some developments suggest that the U.S. and China are managing their strategic tensions a bit better than they were earlier this year. Tensions peaked in early October, when the U.S. imposed sanctions on China’s People’s Liberation Army for purchasing Russian Sukhoi-25 jets and S400 surface-to-air missiles, under a law designed to punish Russia for meddling in the U.S.’s 2016 election. Meanwhile CNN reported that the U.S. military was considering staging a “global show of force” in November, a show that would have included sensitive operations in the Taiwan Strait and South China Sea. Since then, however, positive signs have emerged: Presidents Trump and Xi confirmed their meeting at the G20 in Buenos Aires. The two sides have exchanged letters and will bring trade negotiators to the summit, making it at least possible for substantive work to be done. Various preparatory discussions have been held, including a phone call between Treasury Secretary Steve Mnuchin and top Chinese economic adviser and negotiator, Vice Premier Liu He. Beijing offered to hold military-to-military talks that it had previously canceled between Defense Minister Wei Fenghe and Secretary of Defense James Mattis. The two officials met in Singapore and in Washington for the second round of the U.S.-China Diplomatic and Security Dialogue. The U.S. and China tentatively agreed to a multilateral protocol for avoiding accidental encounters by military aircraft, supplementing a similar agreement covering unplanned encounters at sea.1 Treasury Secretary Mnuchin met with People’s Bank of China Governor Yi Gang on the sidelines of the World Bank’s annual meeting in Bali, Indonesia in October, and afterwards refrained from accusing China of currency manipulation in the Treasury’s biannual foreign exchange report. Director of the National Trade Council Peter Navarro, a fierce trade hawk on China, is reportedly not attending the G20 summit. National Economic Adviser Larry Kudlow publicly chastised Navarro for criticizing the new negotiations as a Wall Street capitulation to China.2 This piece of anecdotal evidence has captured the imagination of sell-side analysts and many of our clients. These developments, in addition to Trump’s positive tweets on the subject, suggest that both China and the U.S. are trying to step back from the brink and accomplish something at the upcoming summit. However, there are many reasons to take these developments with a grain of salt: China is negotiating under duress: In statements over the past month, and reiterated by President Trump as we go to press, the U.S. has warned that if the G20 summit does not go well, it will ratchet up the pressure. In early December, it might move forward with the third round of threatened tariffs, covering the remaining $267 billion in imports from China. On December 19, the U.S. Department of Commerce will conclude consultations on whether to impose new export controls on “emerging technologies.” And on January 1, 2019, the existing tariff rate on $200 billion worth of imports (the second round) is supposed to rise from 10% to 25%, which implies that a third round of tariffs would eventually have the same rate. Indeed, since the confirmation of the G20 summit, the U.S. has imposed sanctions on Chinese technology companies like Fujian Jinhua. It has also begun implementing a new law strengthening the Committee for Foreign Investment in the United States and its foreign investment reviews, which already mostly target China (Chart 3). Chart 3Rising Scrutiny Of Chinese Investment Further, the U.S. has taken the occasion in the recent military and diplomatic dialogue to demand, for the first time ever, that China remove its missile systems from the Spratly Islands in the South China Sea.3 Some of these moves can be read as evidence that the U.S. will impose penalties for various grievances even if China agrees to some of its key trade demands. The demands on the South China Sea and arms purchases, for instance, will stand even if China makes major concessions on key trade issues like technology acquisition. At minimum, the above details suggest that Xi Jinping will be negotiating with a sword over his head and thus may refuse to make concessions on principle, despite the negative impact on China’s stock market and export sector (Chart 4). Chart 4The Impending Tariff Impact Leaks from the negotiations do not suggest any breakthroughs: China’s written response to Trump’s letter reportedly contains no new, significant trade concessions.4 U.S. Trade Representative Robert Lighthizer, the sine qua non of any trade deal, has issued a hawkish report on the eve of the summit arguing that China has not substantively changed any of the trade practices that prompted the tariffs so far.5 The report, an update to his initial Section 301 report, makes grave accusations about China’s use of cyber theft and corporate espionage over the past year alone, in addition to earlier years. These activities go far beyond trade disputes and clearly affect national security: a tariff freeze is hardly possible without substantial commitments by China to rein in these operations. Lighthizer also argues that China’s trade concessions so far are merely “incremental” and in several cases deceptive. For instance, China’s propaganda outlets have de-emphasized the “Made in China 2025” program even though the government is continuing apace with this program as well as other state-subsidized industrial programs that utilize stolen tech, such as the “Strategic Emerging Industries” (SEI) policy. Not only has China maintained certain targets for domestic market share in key technologies (Chart 5), but modifications to the program have in some cases increased these targets, such as in the production of “new energy vehicles” (Chart 6). Chart 5China’s High-Tech Protectionism Chart 6More High-Tech Protectionism Lighthizer further claims that China’s state-backed investment campaign in Silicon Valley continues despite a headline reduction in capital flight to the United States. And he also presents evidence that the full range of U.S. government agencies as well as the U.S.’s major allies are observing the same malicious or abusive practices from China and share the U.S.’s concerns. As for China hawk Navarro – who is far less important than Lighthizer to trade negotiations – his status today is not worse than it was in 2017, when his office was subordinated to that of former National Economic Council Director Gary Cohn. Of course, Cohn got fired, while Navarro’s office was upgraded and his pro-tariff argument won out. Trump’s olive branch is suspicious: Trump and his administration adopted friendly rhetoric during the lead-up to the midterm election, when it might have been desirable to show “progress” in the trade negotiations. It would have been impossible to engineer credible signs of progress without genuinely engaging the Chinese. Now, however, the midterms are over and there is no pressing political need for Trump to agree to a deal. Many of our clients – and almost all broker research – believe that Trump has a financial need to agree to a deal – i.e. to calm the stock market. However, there are two problems with this thesis. First, it is not clear that stock performance has had any relationship with President Trump’s approval rating (Chart 7). Chart 7Trump No Slave To Stock Market Second, both of the U.S. stock market pullbacks this year were catalyzed by sharp rises in treasury yields, not disruptive news on the trade front (Chart 8). As such, positive news about the trade war will yield only a passing relief rally in the United States. Chart 8Yields, Not Trade, Drive U.S. Selloff On this basis, we doubt that President Trump will agree to a hurried, watered-down trade deal that the Democrats will slam as a “giveaway” to China for the remaining two years of his presidency. With the U.S. economy fired up, the trade deficit is likely to widen regardless of tariffs (Chart 9), rendering any weak Trump-China deal a humiliation. Chart 9Trade Deficit To Rise Despite Tariffs However, while a trade deal is out of reach, there is a logic to suspending further tariff impositions: Trump may wish to disperse the negative impact of the trade tariffs over a longer period of time. This would give him room to try to settle a very tricky trade agreement before the 2020 election. Then, if the talks succeed, he can present himself as a great dealmaker. If the talks fail, he has all the more ammunition to launch a third round of tariffs. (And on this time frame, the effects of the third round would not be felt by consumers until after the election.) Xi, for his part, may wish to “lock in” Trump with concessions today rather than wait to see how aggressive Trump will become as 2020 draws near. True, Xi cannot afford to “lose face” by capitulating abjectly. But he is the dictator of a regime that has full control of the media; he will be able to suppress domestic criticism of his concessions. In fact, the most insidious criticism of Xi is that he flouted the maxims of both Sun Tzu and Deng Xiaoping by provoking the wrath of China’s greatest enemy prematurely. Thus, if he stays Trump’s hand on tariffs in exchange for a new round of talks or minor concessions, then he comes out of Buenos Aires looking okay. The reason we put this ceasefire scenario at only 30%-40% probability is that we still do not see Trump as heavily constrained by the trade war. His greatest constraint is political and works against a trade deal: it comes from the Democrats, whose protectionist candidates performed very well in the midterm election in the Rust Belt states that are critical for Trump’s reelection (Table 1). Table 1Massive Republican Losses Across The Midwest Economically, our assessment is that the selloff in U.S. financial markets is a correction, not a bear market, and that there is no sign that the U.S. economy is likely to slip into recession (Chart 10). Trump is constrained by the unemployment rate, not by the stock market alone. As long as Trump shares this assessment, he will not be lulled into a politically damaging capitulation to China. Chart 10No Sign Of Recession Yet Also, Xi will fear that difficult concessions will encourage Washington to continue what Chinese government officials have called “trade bullyism,” i.e. using coercive measures and upping its demands. In other words, the main argument for a tariff ceasefire is that Trump might simply prefer one to boost the stock market and thus may accept few or no concessions. And that preference is not enough to change our baseline view in light of his political constraints. Bottom Line: There is no basis for a resolution of the trade war at present, but there is a basis for a tariff ceasefire and a new effort at trade negotiations. Still, it is not our base case. Xi has good reason not to make major concessions under duress and Trump does not want to get outflanked by his political opponents by freezing tariffs without major Chinese concessions. Do Presidential Summits Matter? Have presidential summits between the U.S. and China ever brought about major breakthroughs? Yes, but not since the Great Recession. As Table 2 demonstrates, looking at 50 U.S.-China leadership summits since 1972, only 18 qualify as true “green light” summits in which the outcome was a concrete improvement in relations over the period before the next summit – and 10 of these were during the first decade of the 2000s, the heyday of “Chinamerica,” when China and Emerging Market economies roared ahead while George W. Bush courted China’s cooperation on terrorism and North Korea. Table 2U.S.-China Leaders Summits: A Chronology Only eight summits mark truly historic positive inflection points: Nixon 1972, Carter 1979, Reagan 1984, Clinton 1997, Clinton 2000, Bush 2002, Bush 2005, and arguably Obama 2009. Since 2009, under four different leaders (two from each country), Sino-American relations have categorically worsened. Moreover, both President Obama’s and President Trump’s major meetings with President Xi, at the Sunnylands estate in California in 2013 and at the Mar-a-Lago resort in Florida in 2017, saw much fanfare at the time but were followed by a significant deterioration in relations. Indeed, the Obama administration launched a more aggressive China policy in September 2015, including freedom of navigation operations in disputed areas of the South China Sea. This was after President Xi declared that China “does not intend to pursue militarization” of the Spratly Islands – a statement that American officials have repeatedly cited when arguing that China’s foreign policy is increasingly aggressive and that China is not following through with diplomatic promises. Investors should focus not on the Trump-Xi summit on December 1 but rather on the two governments’ actions afterwards. The substance of any positive outcome will depend, in particular, on whether Trump indicates that he will proceed with the tariff rate hike on January 1, 2019 and/or the initiation of a third round of tariffs covering the remainder of U.S. imports from China.6 Bottom Line: History does not give reason for optimism about the summit – especially not recent history, in which heavily hyped summits have not been able to arrest the secular decline in U.S.-China cooperation due to underlying strategic distrust. Investment Implications The primary driver of the recent selloff in global risk assets is not the trade war but the divergence between U.S. and Chinese economic policy writ large. The U.S. economy continues to support the case for Fed normalization, while China’s stimulus continues to disappoint. The result is a double whammy for commodity prices and EM assets as the dollar strengthens and exports of resources and capital goods to China soften (Chart 11). Chart 11A Bad Combination For EM Given that China’s December Central Economic Work Conference will likely reinforce the message of greater policy support, and that China tends to frontload new credit expansion in the beginning of the year (Chart 12), it is entirely possible that a rally in global risk assets on the back of positive trade news in late November could gain traction in December and the New Year. BCA’s Geopolitical Strategy will continue to hedge against the risk of substantial reflation in China by means of our Foreign Exchange Strategy’s long “China Play Index” trade (Chart 13). Chart 12China May See A Q1 Credit Spike Chart 13Monitoring The Risk To Our View Fundamentally, however, we would view a December-January rally as a short-term movement that is not worth playing. We expect the Xi administration to remain disciplined in its use of stimulus measures, for the purposes of economic restructuring. Ever worsening trade tensions give Xi the option of blaming the American administration for the economic pain incurred due to his reform agenda. Therefore we think global divergence can persist, which is positive for the dollar and USD/CNY exchange rate. While acknowledging the potential for a near-term rally, we remain neutral Chinese stocks relative to their global counterparts over a 6-12 month horizon and continue to favor low-beta stocks within the Chinese equity universe. We also remain neutral on Taiwanese equities. The ruling Democratic Progressive Party’s (DPP) loss in local elections on November 24 was severe (Chart 14), though not unexpected. The election result does not change Geopolitical Strategy’s view that Taiwan faces heightened geopolitical risk. Chart 14Taiwanese Voters Seek More Conciliatory Approach To Beijing Indeed, the election suggests that the Tsai Ing-wen administration may only have 14 months remaining in power, and hence that it will try rapidly to finalize some material improvement in the U.S.-Taiwan relationship. Since the Trump administration will also try to exploit this closing window of opportunity, the potential is rising for a controversy to erupt over diplomatic or military relations. This could prompt a negative, market-relevant reaction from Beijing. It is also too soon to bottom-fish within the tech sector in China and the U.S., and we remain pessimistic about the earnings outlook for companies exposed to the U.S.-China trade relationship.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1      While these agreements do not ensure collisions will not occur, given the USS Decatur incident earlier this year, they are at least a sign of coordination. 2      Navarro had said the following at a speech at the Center for Strategic and International Studies: “Consider the shuttle diplomacy that’s now going on by a self-appointed group of Wall Street bankers and hedge fund managers between the U.S. and China. As part of a Chinese government influence operation, these globalist billionaires are putting a full-court press on the White House in advance of the G-20 in Argentina. The mission of these unregistered foreign agents – that’s what they are; they’re unregistered foreign agents – is to pressure this president into some kind of deal.” Please see “Economic Security as National Security: A Discussion with Dr. Peter Navarro,” CSIS, November 13, 2018, available at www.csis.org. 3      Please see U.S. Department of State, “U.S.-China Diplomatic and Security Dialogue,” November 9, 2018, available at www.state.gov.   For the proposed export controls, open for public comment until December 19, 2018, please see U.S. Department of Commerce, “Review of Controls for Certain Emerging Technologies,” Bureau of Industry and Security, November 19, 2018, available at www.bis.doc.gov. 4      Please see Jeff Mason and David Shepardson, “Exclusive: China sends written response to U.S. trade reform demands - U.S. government sources,” Reuters, November 14, 2018, available at www.reuters.com. 5      Please see Office of the United States Trade Representative, “Update Concerning China’s Acts, Policies, And Practices Related To Technology Transfer, Intellectual Property, And Innovation,” dated November 20, 2018, available at https://ustr.gov/ 6      It is very unlikely, but perhaps not impossible, that China would accept a ceasefire that allows the January 1 tariff hike to go forward but forswears the third round of tariffs on the remaining Chinese imports.