Economy

Special Report

Highlights So What? More downside to CNY/USD ahead. Why? The trade war is spilling into political and military arenas, making it harder to de-escalate and negotiate a trade deal. Official U.S. and Chinese rhetoric is increasingly antagonistic, reflecting once-in-a-generation policy shifts toward a new Cold War. Tensions will not subside after the U.S. midterm election - neither the U.S.-Mexico-Canada agreement nor any quick deals with Japan and the EU will speed up U.S.-China negotiations. Feature Clients know that BCA's Geopolitical Strategy has been alarmist on U.S.-China relations since we started as a service in 2012.1 This structural view is based on the long-term decline of U.S. power relative to China and the emergence of global multipolarity.2 However, the rise of General Secretary Xi Jinping in 2012 and President Donald Trump in 2016 have reinforced our view that "Sino-American conflict is more likely than you think."3 This includes military as well as economic conflict. Setting aside the risk of war, a geopolitical "incident" of some kind is becoming increasingly likely. As the two sides engage in brinkmanship, the probability of a miscalculation or provocation rises, and the probability of a grand new compromise falls. For investors, the takeaway is supportive of Geopolitical Strategy's current stance: long U.S. dollar, long U.S. stocks relative to DM, and long DM stocks relative to EM. We expect CNY/USD to fall further as markets question the ability to discount trade uncertainties via tariff rates alone (Chart 1). We continue to recommend a "safe haven" hedge of Swiss bonds and gold. Chart 1CNY/USD Has More Downside The risk is that China could respond to U.S. pressure by stimulating its economy aggressively. So far, the "China Play Index," devised by our Foreign Exchange Strategy, does not signal reflation. Nor do Chinese domestic infrastructure stocks relative to global, which our China Investment Strategy watches closely (Chart 2). Chart 2Small Stimulus Thus Far Trade Tensions Are Spilling Over A corollary of our view that U.S.-China tensions are secular and strategic in nature - i.e., not limited to the U.S. trade deficit - is the view that trade tensions will spill over into strategic areas, exacerbating those tensions and generating negative outcomes for investors exposed to the U.S.-China economic partnership.4 This strategic spillover is now taking shape. Since President Trump went forward with the second round of tariffs - 10% on $200 billion worth of imports, to ratchet up to 25% on January 1, 2019 - a series of negative events have taken place in U.S.-China relations (Table 1), culminating in the USS Decatur incident on September 30. Table 1Trade War Spills Into Strategic Areas The Decatur, an Arleigh Burke-class guided-missile destroyer, was conducting operations in the Spratly Islands in the South China Sea when it sailed within 12 nautical miles of Gaven and Johnson Reefs, which China claims as sovereign islands. At around 8:30am that Sunday morning, a Luyang-class destroyer from China's People's Liberation Army Navy "approached within 45 yards of Decatur's bow, after which Decatur maneuvered to prevent a collision," according to the U.S. Pacific Fleet spokesman. This was not an unprecedented incident in itself, but it came very close to a collision that could easily have resulted in a shipwreck, a full-blown U.S.-China crisis, and a global risk-off event in financial markets. The Decatur sailed close to the Chinese-claimed reefs because it was conducting a "Freedom of Navigation Operation" (FONOP) to assert the international right of free passage. A major point of contention between China and the U.S. (and between China and most of its neighbors and the western world) is that China claims outright sovereignty over about 80% of the South China Sea, including the Spratly Islands. In July 2016, the International Court of Arbitration ruled that none of the contested rocks and reefs in the sea qualify as islands and hence that they are not entitled to 12 nautical miles of "territorial" sea. China rejects this ruling and asserts sovereignty over the maritime features and much of the sea itself.5 In Diagram 1 we illustrate how a FONOP works based on a similar operation last year. The U.S. has conducted these operations for decades, but in late 2015 it began a series of FONOPs focusing on countering China's excessive claims in the South China Sea.6 This was also a way of opposing China's construction, reclamation, and "militarization" of the reefs under its possession. Diagram 1What Is A 'Freedom Of Navigation Operation'? It is not remotely a surprise that this year's trade tensions came close to exploding in the South China Sea. It is the premier geographic location of U.S.-China strategic friction: a hub for international trade; a vital supply route for all major Asian economies; and the primary focus of China's attempt to rewrite global rules (Diagram 2).7 The Appendix updates our list of clashes in this area. Diagram 2South China Sea As Traffic Roundabout The takeaway is that, far from capitulating to the Trump administration's trade demands, China is taking a more aggressive stance - and it is doing so outside the trade context. The U.S., for its part, has not diminished the significance of this incident, as it has often done on similar occasions.8 Instead, Vice President Mike Pence gave a remarkable speech at the Hudson Institute on October 4 in which he highlighted the Decatur, among a range of other "predatory" Chinese state-backed actions, to make a comprehensive case that China is a geopolitical rival seeking to undermine the United States and specifically the Trump administration.9 Pence's comments reflect a decision to "go public" with a shift in national strategy that has been developing in recent years, beginning - albeit tepidly - even in the Obama administration. A similar shift is underway in China - and has accelerated with the U.S.'s implementation of tariffs. Official Communist Party rhetoric increasingly characterizes the U.S. as an enemy whose real intention is to "contain" China's rise and has recently called for Chinese "self-reliance" in the face of U.S. sanctions.10 The two sides are bracing for conflict and are now seeking to mold public opinion more actively. Bottom Line: Investors should take note: markets were 45 yards away from a significant correction! The U.S.-China trade tensions are spilling outside of economic relations into political and military domains, as we expected. The South China Sea remains a hot zone that could be the setting of a geopolitical incident as tensions mount. What Is A Show Of Force? Notably, the U.S. military is said to be considering a "global show of force" during an unspecified week in November in order to deter China from its current policy trajectory. If this occurs, it will be market-relevant as it will be seen as a provocation by China and other U.S. rivals. A "show of force" is a formal military operation conducted by a nation with the purpose of demonstrating that it has both the will and the ability to use force in defense of its interests. It is fundamentally a political action, even though it utilizes military resources. The declared intention is to demonstrate resolve and prevent or deter an undesirable course of action by a rival state.11 Nevertheless, it is the equivalent of a dog baring its teeth and should not be taken lightly, especially when conducted by one major power against another. The U.S. holds shows of force fairly frequently. Over recent decades it has been the third most common type of operation for U.S. forces.12 However, for most of the past several decades, the U.S. conducted very few operations in the Asia Pacific not pertaining to the Vietnam War, and these were usually of limited length and intensity. They were often shows of force to deter North Korea from various acts of terrorism and sabotage. China was rarely involved - there was, for example, no U.S. deployment during the Tiananmen crisis. Nevertheless there are a few highly relevant precedents: By far the most important exception is the Third Taiwan Strait Crisis in 1996. This was a major show of force - and one whose shadow still hangs over the Taiwan Strait. In July 1995, Beijing launched a series of missile tests and military exercises, hoping to discourage pro-independence sentiment and dissuade the Taiwanese people from voting for President Lee Teng-hui - who was rightly suspected of favoring independence - ahead of the 1996 elections. The United States responded on March 1, 1996 by deploying two aircraft carriers, USS Nimitz and USS Independence, and various warships to the area. The Nimitz even sailed through the strait. Tensions peaked ahead of the Taiwanese election on March 23, 1996 - in which voters went against China's wishes - and the show of force concluded after 48 days on April 17. Of course, tensions simmered for years afterwards. The Taiwan incident was the only operation involving China in the 1990s, and the first to do so since a minor contingency operation upon the Chinese invasion of Vietnam in 1979. It is generally deemed successful in demonstrating U.S. commitment to Taiwan's security - but it also spurred a revolution in Chinese military affairs, such that China is today in a far better position to attack Taiwan than ever before.13 The market effects were pronounced: Chinese and Taiwanese equities sold off. American stocks were unaffected (Chart 3). Chart 3Naval Shows Of Force Can Rattle Markets The second major exception was the Hainan Island Incident, or EP-3 Incident. On April 1, 2001 a Chinese jet struck a U.S. EP-3 ARIES II signals reconnaissance plane in the skies over the South China Sea. The U.S. plane landed on China's island province of Hainan, where its crew was detained and interrogated for 10 days while their aircraft was meticulously disassembled. Ultimately the U.S. issued a half-hearted apology and the crew was released. This was a much smaller show of force than the third Taiwan crisis. The U.S. Navy positioned three destroyers in the area for two days. Chart 4A South China Sea Incident Helped Kill The Bull Market This incident marked the peak of the cycle in U.S. equities ex-tech (Chart 4). In China, both A-shares and H-shares experienced volatility before selling off in subsequent months (Chart 5, top panel). Chart 5Volatility And Selloffs Amid Asian Shows Of Force The Cheonan and Yeonpyeong Island incidents occasioned a show of force. On March 26, 2010 a North Korean miniature submarine conducted a surprise torpedo attack against the Cheonan, a South Korean Corvette, sinking it and killing 46 sailors. The U.S. intended to respond by positioning the USS George Washington in the Yellow Sea, but was intimidated from doing so by China's fiercely negative diplomatic reaction. Instead it deployed the carrier to the Sea of Japan. Later that year, however, after North Korea shelled Yeonpyeong Island and killed four South Koreans, the U.S. responded with a beefed up version of regular military drills, including the George Washington, for four days in the Yellow Sea. This incident is significant in showing how aggressively China will oppose demonstrations of American naval power in its near abroad. Unlike in 1996, China is today much better positioned to react to U.S. naval action in its neighborhood. If Beijing was so resistant to a U.S. show of force against North Korea in the wake of a North Korean attack, it will be even more resistant to a U.S. display of might in China's nearby waters aimed at China in response to what China views as a defense of maritime-territorial sovereignty. Chinese A-shares sold off, while H-shares were somewhat more resilient, during this episode (Chart 5, second panel). Fire and Fury: The United States' latest significant show of force occurred in 2017 when the navy positioned three aircraft carrier strike groups in the region to deter North Korean nuclear and missile tests and belligerent rhetoric against the United States. This action ultimately led to Chinese enforcement of sanctions and North Korean capitulation to U.S. demands. Chinese stocks only briefly sold off during this episode (Chart 5, third panel). However, the U.S. 10-year Treasury yield fell during the peak of tensions in the summer. So what about the global show of force that the U.S. is considering in November? Details on the specific operation under consideration are scant because they fall under a "classified proposal," written by members of the U.S. Navy's Pacific Command and only partially leaked to the press (apparently to coincide with Vice President Pence's speech).14 The proposal is still being discussed by the Joint Chiefs of Staff and the Intelligence Community, so nothing is final. From the information that is publicly available, it is highly significant that the proposed show of force is supposed to be "global" in range. It would reportedly involve a "series" of military missions on "several fronts," including the South China Sea, the Taiwan Strait, an unspecified area near Russia, and the west coast of South America. It would also involve multiple military services - the navy, the air force, the marines, and potentially cyber and space capabilities. While the various missions would reportedly be "concentrated" and "focused," implying that the U.S. wants to manage the escalation of tensions carefully, the locations that have been named are extremely sensitive. A show of force in the Taiwan Strait and South China Sea would be provocative enough. A simultaneous show of force against both China and Russia in today's context would be truly extraordinary.15 In short, if the report is accurate, the U.S. is contemplating a rare and provocative display of its global power projection capabilities. Why would the U.S. stage such a grand demonstration merely because of a taunt by a Chinese ship? The Decatur incident is only the proximate cause. Washington is in the midst of attempting a very dangerous "two-front war" against China and Iran, the latter of whom faces oil sanctions from November 4.16 Moreover, this is a "three-front war" if today's historically bad relations with Russia are taken into account. Indeed, the U.S. may well be responding to the joint show of force by Russian President Vladimir Putin and Chinese President Xi in their own large-scale military exercises in September, in which Chinese soldiers participated in a Russian drill outside the auspices of the Shanghai Cooperation Organization for the first time.17 As such, we would not put any stock in the idea that a sudden drop-off in geopolitical tensions, with China or anyone else, will occur after the U.S. midterm election on November 6. Rather, investors should expect an increase in geopolitical risk. There is no combination of midterm election results in which Trump will be forced to pull back on his "Maximum Pressure" doctrine. The proposal is not final, and the idea alone is a low-level threat that could be used in negotiations. But under the circumstances, we think it more likely than not that the U.S. will go forward with it. Ultimately, the U.S. proposal epitomizes our mega-theme of multipolarity. The U.S. is in relative decline and is reasserting itself with a muscular national security policy, particularly against China and Iran but also against Russia. However, its actions are highly unlikely to cause a change in China's behavior now that Beijing has determined that the U.S. is seeking Cold War-style strategic containment. Instead, China will hasten its efforts to become self-reliant and to deter U.S. aggression in its near abroad. Global economic policy uncertainty, and trade policy uncertainty, are likely to increase, not decrease, in such an environment. Saber-rattling and supply-chain risk will weigh on EM Asia in particular. Bottom Line: The U.S. government is contemplating an extraordinary "global show of force" that could involve a series of joint military operations across the globe. The chief focus is China, but the unknown array of operations could also target Russia or Iran. We think such operations are plausible and will increase global economic uncertainty. We would expect them to create volatility in global markets, adding to jitters over China tariffs (supply-chain risks) and Iranian sanctions (oil prices). How Will China Retaliate? China does not have the ability to respond proportionately to the U.S. - it cannot hold a global show of force of its own. Because its own shows of force will appear diminutive next to American fireworks, it may not react immediately. Beijing is more likely to respond by changing its policies to address the underlying increase in antagonism with the United States and improve its national security. We would classify its potential responses into two main groups: the low road and the high road. The low road consists of policies meant to confront the U.S. directly and forcefully. In our view, these policies bring significant costs that will make China reluctant to embrace them fully: Raise the stakes in the South China Sea: China could go for broke and deploy the full range of military assets in the islands that it has repurposed. This would provoke an even larger international naval response from the U.S. and its allies.18 Remove sanctions on North Korea: China could reverse sanctions enforcement on North Korea (Chart 6) and undermine President Trump's signature foreign policy overture. The problem is that China would then provide the U.S. with a pretext for an even greater military presence in Northeast Asia. Chart 6China Could Reverse Sanctions Enforcement Flout sanctions on Iran: China could subsidize Iran (Chart 7) in the hopes of helping to create a huge American distraction comparable to the second Iraq war. But this confrontation would threaten China with an oil shock and economic dislocation, an even greater conflict with the U.S., and the risk of regime change in Iran.19 Chart 7China Could Flout Iran Sanctions Punish U.S. companies: China could raise the pressure on U.S. companies doing business on its territory. The problem is that the U.S. has already demonstrated, through the ZTE affair this year, that it can inflict devastating reprisals against the tech champions on whom China's economic future depends (Chart 8). Chart 8U.S. Could Punish Chinese Tech Firms Thus China is most likely to take the "high road," i.e. seeking alternatives to the United States throughout the rest of the world: Chart 9China's Market Is Its Biggest Advantage Import more goods: China's greatest strength in winning friends is that its domestic demand remains relatively robust (Chart 9). China can substitute away from the U.S. by shifting to other developed markets. Emerging markets are becoming more connected with China and less so with the U.S. (Chart 10). Chart 10China's Trade Ties Grow, Ex-U.S. Maintain outward investment: China's outward investment profile is expanding rapidly (Chart 11), but there is potential for a negative political backlash - as has occurred in Malaysia.20 China will need to focus on improving relations with those countries where it expands investment, including in the Belt and Road Initiative (BRI).21 Chart 11China's Outward Investment Strategy: Priorities Over The Past Decade Court U.S. regional allies: Relations with South Korea have already improved; Shinzo Abe of Japan is soon to make a rare state visit to China; and trilateral trade talks between these three have revived for the first time since 2015 (Chart 12). Both the Philippines and Thailand currently have governments that are friendly to China. Beijing will need to ensure that its growing trade surpluses do not get out of whack. Chart 12Can China Court U.S. Allies? Sign multilateral trade pacts: China is trying to position itself as a leader of free trade. This is a tough sell, but a successful completion of negotiations on the Regional Comprehensive Economic Partnership (RCEP) will generate some momentum. This Asia Pacific trade grouping is far larger in terms of total imports than its more sophisticated rival, the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP), the latter being shorn of U.S. participation (Chart 13). Chart 13RCEP Is Bigger Than CPTPP Play nice in the South China Sea: Now that the U.S. is proposing to push back against Chinese militarization of the islands, it makes sense for China to take a conciliatory approach. It is proposing joint energy exploration with the Philippines and others at least as long as offshore activity is depressed (Chart 14). China might also try to settle a diplomatic "Code of Conduct" for the sea with its neighbors. Chart 14A Reason For China To Play Nice The most important consequence is an alliance with Russia, whether formal or not. The security agenda of these two powers is increasingly aligned with their robust economic partnership (Chart 15).22 The differences and distrust between them cannot override their need to guard themselves against a more assertive United States. Chart 15Embrace Of Dragon And Bear Bottom Line: China's "high road" strategies are its best options when more aggressive options have higher risks of undermining China's own long-term interests. But an alliance with Russia is quickly becoming inevitable. Investment Implications A global show of force targeting China's "core interests" in Taiwan and the South China Sea will make trade negotiations even more difficult. China is not going to offer concessions when facing U.S. military intimidation in addition to tariffs.23 Investors should watch closely for any signs that nationalist protests and boycotts of U.S. goods are developing in China. Such a movement would not be allowed to continue for long without the Communist Party condoning it. A boycott would mark a form of retaliation that is much more impactful than tariffs. A deterioration in cultural ties is also in the cards. The United States is reported to be considering restrictions on Chinese student visas after intelligence assessments of non-traditional technological and intellectual property theft via graduate students in advanced programs such as artificial intelligence and quantum computing.24 U.S. markets remain insulated today, as in the last big rupture in U.S.-China relations in 1989, so we continue to expect U.S. equities to outperform Chinese (and global) stocks amid trade tensions and saber-rattling. Chart 16Last U.S.-China Crisis Prompted Stimulus... However, an important takeaway from the 1989 episode is that China stimulated the economy (Chart 16). This time we think stimulus will remain lackluster, reflecting Xi's need to keep overall leverage contained (Chart 17). But conflict escalation with the U.S. is clearly the biggest risk to this view. Chart 17...But Stimulus Muted Thus Far One oft-discussed retaliatory option is that China could sell off its vast $1.17 trillion holdings of U.S. treasuries. Rapidly dumping them is not effective, but slowly tapering is precisely what China has been doing since 2011 (Chart 18). This will accelerate its need to invest in real assets abroad and to purchase alternative reserve currencies, such as the euro, pound, and yen. Chart 18China Weans Itself Off Treasuries Ultimately, the significance of Vice President Pence's speech is that the U.S. now views China as both a great power and a threat to U.S. supremacy. This raises the potential for a large share of the $33 billion in cumulative U.S. direct investment in China since 2006 to become, effectively, stranded capital (Chart 19). If that is indeed the case, it would mean that investors in S&P 500 China-exposed companies would have to take note and re-rate their investments. Companies with significant investment in China may have to make capital investments in alternative supply-chain options, leading to a significant hit to their profit margin. Chart 19Stranded Capital In China? Other countries in Europe and the rest of Asia stand to benefit from the U.S. getting squeezed out of China's market, unless and until the new Cold War forces them to choose sides. Their choice is by no means a foregone conclusion, underscoring that China's policy response will be to seek better bonds with its neighbors and non-U.S. partners. Over the longer term, we think that our mega-theme of multipolarity will produce the bifurcation of capitalism. Within each sphere of influence globalization will continue to operate, but between spheres, or in the border areas, it will become a much less tidy affair. In addition to our recommendations above on page 2, we are reinitiating our short U.S. S&P 500 China-exposed stocks relative to the broad market. These companies have sold off heavily in recent months but the negative backdrop suggests that there is farther to go. Housekeeping On a separate note, BCA's Geopolitical Strategy is closing our long U.S. high-tax rate basket relative to S&P 500 trade for a gain of 8.26%. This was a play on the Trump tax cuts that we initiated in April 2017. Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation)," dated July 13, 2016, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Underestimating Sino-American Tensions," dated November 6, 2015, available at gis.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "The South China Sea: Smooth Sailing?" dated March 28, 2017, and "The Looming Conflict In The South China Sea," May 29, 2012, available at gps.bcaresearch.com. 8 Comparable incidents in December 2013, August 2014, May 2016, December 2016, August 2017, and March 2018 did not receive such a high-level response from U.S. leaders, reflecting both the seriousness of the Decatur incident and the administration's sense of political expediency amidst the trade conflict and midterm election cycle. 9 Pence criticized Chinese President Xi by name for allegedly breaking his word on the militarization of the Spratly Islands. He suggested that China's outward investment should be understood in strategic rather than economic terms, implying that the Belt and Road Initiative is a Soviet-style plan to organize a "bloc" of nations under Chinese hegemony. And he hinted at a new defense of the Monroe Doctrine in his criticism of China's recent assistance to the collapsing socialist regime in Venezuela. Please see the White House, "Remarks by Vice President Pence on the Administration's Policy Toward China," dated October 4, 2018, available at www.whitehouse.gov. 10 The Trump administration's key document is Secretary of Defense James Mattis, "Summary of the 2018 National Defense Strategy of the United States of America," Department of Defense, 2018, available at dod.defense.gov. For the Xi administration, see Orange Wang and Zhou Xin, "Xi Jinping says trade war pushes China to rely on itself and 'that's not a bad thing,'" South China Morning Post, dated September 26, 2018, available at www.scmp.com; and the Information Office of the State Council, "The Facts and China's Position on China-US Trade Friction," September 2018, available at www.chinadaily.com. 11 For this discussion of shows of force please see W. Eugene Cobble, H. H. Gaffney, and Dmitry Gorenburg, "For the Record: All U.S. Forces' Responses to Situations, 1970-2000 (with additions covering 2000-2003)," Center for Strategic Studies, May 2005, available at www.dtic.mil. 12 See footnote 11 above. 13 Please see William S. Murray, "Asymmetric Options for Taiwan's Defense," Testimony before the U.S.-China Economic and Security Review Commission, June 5, 2014, available at www.uscc.gov. 14 Please see Barbara Starr, "US Navy proposing major show of force to warn China," dated October 4, 2018, available at www.cnn.com. 15 Even the South American location implies that Chinese, Russian, and Iranian influence on that continent is now deemed meaningful enough to require a reassertion of the Monroe Doctrine. Over the past decade, the U.S. has tended to regard these activities as limited, but now that may be changing. 16 Please see BCA Geopolitical Strategy Special Report, "2019: The Geopolitical Recession?" dated October 3, 2018, available at gps.bcaresearch.com. 17 Please see "Russia Holds Massive War Games, As Putin And Xi Tout Ties," Radio Free Europe, Radio Liberty, September 11, 2018, available at www.rferl.org. 18 Australia, Japan, and the U.K. have already begun enforcing freedom of navigation alongside the U.S. 19 The U.S. could also impose secondary sanctions on China for non-compliance. State-owned energy firm Sinopec, for instance, was said to be reducing imports of crude from Iran by half in the month of September. Our Commodity & Energy Strategy notes that Chinese refiners, like other Asian refiners, are preparing to run more light-sweet crude from the U.S. in the future, which gives a good yield in high-value-added products like gasoline. So far China has not imposed retaliatory tariffs on these imports from the U.S. Please see Chen Aizhu and Florence Tan, "China's Sinopec halves Iran oil loadings under U.S. pressure: sources," Reuters, dated September 28, 2018, available at uk.reuters.com. 20 Please see BCA Geopolitical Strategy Weekly Report, "Are You Ready For 'Maximum Pressure?'," dated May 16, 2018, available at gps.bcaresearch.com. 21 Please see BCA Emerging Markets Strategy Special Report, "China's Belt And Road Initiative: Can It Offset A Mainland Slowdown?" dated September 13, 2017, available at ems.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Special Report, "Can Russia Import Productivity From China?" dated June 29, 2016, and "The Embrace Of The Dragon And The Bear," dated April 11, 2014, available at gps.bcaresearch.com. 23 Xi Jinping's refusal to meet with Secretary of State Mike Pompeo over the past weekend, and decision to visit North Korea for the first time in his term, underscores this point. 24 Please see Demetri Sevastopulo and Tom Mitchell, "US considered ban on student visas for Chinese nationals," Financial Times, dated October 2, 2018, available at www.ft.com. Appendix Notable Clashes In The South China Sea (2010-18) Notable Clashes In The South China Sea (2010-18) (Continued) Notable Clashes In The South China Sea (2010-18) (Continued)

Highlights Portfolio Strategy A playable sector rotation opportunity has emerged, as we first argued at the recent BCA investment conference: Financials, industrials and select tech subgroups will lead the next phase of the market advance, a result of the bond market selloff gaining steam into year-end and beyond. In contrast, rising interest rates, a vibrant U.S. economy, softening operating metrics and high indebtedness signal that it is time to shed utility stocks. Recent Changes Trim the S&P Utilities sector to underweight today. Table 1 Feature On the eve of earnings season, the SPX remains close to an all-time high. The most recent spate of investor optimism was driven by President Trump cementing another deal last week, this time with Canada. While the renaming of NAFTA to USMCA is a step in the right direction (i.e. a deal was struck), a deal with China remains the elephant in the room. On that front, U.S. hawkish trade rhetoric should remain in vogue and any deal will have to wait until at least after the election, if not until Q1/2019. Up to now Trump's trade hawkishness has not infiltrated U.S. profits, but we continue to closely monitor IBES reported profit growth expectations. Following up from last week, the rest of the world is bearing the brunt of the U.S. trade-related rhetoric according to our profit growth models, a message sell-side analysts' forecasts also corroborate (we use forward EBITDA in order to gauge trend profit growth and filter out the tax-induced jump in U.S. EPS, Chart 1). Meanwhile, at the margin, seasonality can prop up stocks. While September - a historically negative return month, but not this year - is behind us, stock market crash-prone October is upon us, and thus a pick-up in volatility would not come as a surprise. Beyond October's dreaded crash history, the Presidential cycle has piqued our interest, especially years two and three. Building on our sister Geopolitical Strategy publication's research,1 and given the upcoming midterm elections, we created a cycle-on-cycle profile of SPX returns during these two middle Presidential cycle years (Chart 2). Chart 1U.S. Has The Upper Hand Chart 2Seasonality Boost Until Midyear 2019? In more detail, we analyzed 17 cycles starting in 1950 using S&P 500 daily data (reconstructed S&P 500 prior to 1957). During these iterations, only two two-year periods ended in the red, 1974/75 and 2002/03. The first coincided with a recession and the second took place in the aftermath of the dotcom bust. In addition, two other cycles produced roughly 5% two-year returns, 1962/63 and 1966/67. Finally, 1954/55 was the outlier when the SPX went parabolic and nearly doubled. While every cycle is different, it is clear from Chart 2 that the Presidential cycle should continue to underpin the SPX, if history is an accurate guide, especially given our forecast of no recession in the coming 9-to-12 months. In fact, the S&P could rise another 10%, in line with our 2019 expectation, predicated upon a 10% increase in profits and a lateral multiple move. Interestingly, according to the median Presidential cycle-on-cycle roadmap, while the back half of 2019 is likely to prove more challenging, the first half of next year should enjoy most of the returns (Chart 2). An assessment of recent data releases in the U.S. and abroad is also revealing. Chart 3 shows that the domestic economy is firing on all cylinders. Consumer confidence and sentiment hit multi-decade highs recently. Similarly, the job market remains vibrant and small business euphoria reigns supreme. Not only are small business owners optimistic on all employment-related subcomponents of the NFIB survey, but SME capex intentions are also as good as they get. The ISM manufacturing survey ticked down from the August peak, but remains close to 60. Its close sibling, the ISM services survey, vaulted into uncharted territory. All of this is reflected in the still-growing U.S. leading economic indicator and signals that the U.S. equity market remains on a solid footing. Outside U.S. shores, the bearish narrative is well established with EMs, especially the U.S. dollar debt-saddled fragile five that have to contend with twin deficits, sinking in a bear market. China's debt load is also coming under intense scrutiny as U.S. tariffs are all but certain to weigh on Chinese output growth. Nonetheless, there is a chance that the EMs have depreciated their currencies by enough to engineer a modest rebound (bottom panel, Chart 4). In other words, absent the currency peg straightjacket that dominated the region in the late-1990s, free-floating FX devaluations may serve as a relief valve in order to boost exports. The latest Korean MARKIT manufacturing PMI spiked above the boom/bust line to a multi-year high signaling that already humming Korean factories (industrial production is accelerating) will likely remain busy in the coming months. Other hard economic data also confirm these greenshoots: Korean manufacturing exports are expanding smartly. In particular, exports to China are soaring. Reaccelerating manufacturing selling prices also corroborate this budding Korean recovery (third panel, Chart 4). Chart 3U.S. Is On Fire Chart 4Reflationary Impulse? While it is premature to call an end to the EM carnage, most of the bad news on global export volumes and prices may be nearing an end and the EMs may even export some of their inflation to the U.S. Play The Sector Rotation Into Financials And Industrials... In recent research, we have been highlighting that inflation is slowly rearing its ugly head and there are high odds that the selloff in the bond market gains steam into year-end and beyond2 (as a reminder BCA's fixed income publications continue to recommend below-benchmark portfolio duration). Against such a backdrop, sectors that benefit from rising interest rates and that serve as inflation hedges should outperform in the coming quarters. The "FIT" market refers to financials, industrials and select technology stocks. In more detail, we expect a sector rotation, especially into financials and industrials that have been laggards and remain compellingly valued (Chart 5). With regard to financials, Chart 6 shows that this early cyclical sector enjoys a positive correlation with interest rates and inflation expectations, and a catch up phase in relative share prices looms in the coming quarters. Chart 5Rotate Into Financials... Chart 6...And Industrials Industrials stocks also benefit from rising inflation and interest rates as large parts of this deep cyclical sector are levered to the commodity cycle (Chart 7). In other words, industrials stocks are an indirect inflation hedge and trouble surfaces only when capital goods producers cannot pass rising input costs down the supply chain or to the consumer. But, we are not there yet. Keep in mind that during the last cycle, relative (and absolute) industrials performance peaked prior to relative energy stock prices. Similarly, the relative industrials stock price ratio troughed in early 2009 before their deep cyclical brethren put in a (temporary) bottom a year later (Chart 8). Chart 7Industrials Lead Chart 8Undervalued True, energy stocks are also going to perform well if our thesis of higher interest rates/inflation pans out in the coming quarters and especially if BCA's Commodity & Energy Strategy service's view of a looming oil price spike materializes (Chart 9). Thus, we sustain the high-conviction overweight stance in the broad sector and reaffirm our recent upgrade to an above benchmark allocation in the S&P oil & gas exploration & production (E&P) subgroup.3 We also reiterate our recent market-neutral and intra-commodity pair trade: long S&P oil & gas E&P / short global gold miners.4 This trade is off to a great start up 10.3% since inception and will benefit further from an inflationary impulse. Chart 9Energy Remains A High-Conviction Overweight While tech stocks have really delivered and led the market advance year-to-date, a bifurcated tech market should remain in place with capex levered S&P software and S&P tech hardware, storage & peripherals indexes (both are high-conviction overweights) outperforming early cyclical tech groups, semi and semi equipment stocks (we remain underweight both semi subindexes). Bottom Line: A playable rotation into financials and industrials is in the offing especially if the selloff in the bond market accelerates on the back of an inflationary whim. We continue to recommend an overweight allocation to both the S&P financials and S&P industrials sectors. ...But Lights Are Out For Utilities Utilities stocks are the ultimate loser from a backup in interest rates as they serve as premier fixed income proxies in the equity space and we are compelled to trim exposure to below benchmark. The niche S&P utilities sector yields 3.5% and when the competing risk free asset is near 3.2% and rising, investors prefer to shed, at the margin, riskier high-yielding equities and park the proceeds in U.S. Treasurys (Chart 10). While arguably most of the bad news is already reflected in washed out technicals and bombed out short and even long-term profit expectations (Chart 11), the selling will only accelerate into yearend and 2019. Chart 10Higher Yields Bite Chart 11Oversold And Unloved... Apart from the tight inverse correlation utilities have with interest rates, they are also a defensive sector that outperforms the broad market when the economy is in retreat. Currently a plethora of recent economic releases are signaling that the U.S. economy is overheating. Chart 12 illustrates the safe haven status of utility stocks (ISM surveys shown inverted). On the operating front, despite the upbeat economic data, electricity capacity utilization remains anemic. Capacity growth is likely responsible for this weak resource utilization signal as utilities construction continues unabated (private construction shown inverted, top panel, Chart 13). Adding insult to injury, inventory accumulation is also weighing on the sector (turbine inventories shown inverted, middle panel, Chart 13). Chart 12...But More Pain Looms Chart 13Weak Operating Metrics Worrisomely, all these expansion plans have been financed with debt. While this is not typically an issue for stable cash flow generating utilities, the sector's net debt-to-EBITDA profile has gone parabolic, nearly doubling since the GFC and even overtaking the early 2000s when a California deregulation wave first led to exuberance and then an electricity crisis (Chart 14). Any letdown in cash flow growth will be disruptive, especially given that the sector has no valuation cushion (bottom panel, Chart 14). Nevertheless, there are some risks that could put our underweight position offside. Natural gas prices have spiked of late and given that they are the marginal price setter for the sector they could boost utility pricing power and thus profits (top & middle panels, Chart 15). As the U.S. economy is firing on all cylinders, electricity demand should remain brisk and provide an offset to the otherwise weakening utility operating backdrop (bottom panel, Chart 15). Chart 14Heavily Indebted And Pricey Chart 15Risks To Underweight View Netting it all out, rising interest rates, a vibrant U.S. economy, softening operating metrics and high indebtedness signal that the time is ripe to sell utility stocks. Bottom Line: Downgrade the S&P utilities sector to underweight. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Fade The Midterms, Not Iraq Or Brexit," dated September 12, 2018, available at gps.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Deflation - Reflation - Inflation," dated August 20, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Soldiering On," dated July 16, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "Deflation - Reflation - Inflation," dated August 20, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Jair Bolsonaro, an ex-army captain and a right-leaning, law-and-order candidate has won a surprising victory in the first round of the Brazilian presidential election (Chart I-1). Bolsonaro came within striking distance of 50%, but did not cross that threshold, which means that the second round will go ahead on October 28. Given that he only needs another 4% to gain a majority of votes, his victory in the second round is now the most likely outcome by far. Importantly, the results of the congressional election similarly saw a swing to the right in both legislative houses. Chart I-1Bolsonaro Outperformed In The First Round What are the prospects for pro-market structural reforms amid this apparent regime shift in Brazilian politics? How should investors be positioned over the coming months? In the short term, a Bolsonaro presidency will boost business and market sentiment. This is mainly due to the right-leaning balance of parties in Congress and hence Bolsonaro's ability to form a majority coalition. This should lead to an outperformance of Brazilian assets relative to EM on expectations of reforms being passed and implemented. BCA's Emerging Markets Strategy service recommends upgrading Brazil to an overweight within EM equity, credit, and local fixed-income portfolios. However, in the longer term, we expect that Bolsonaro's presidency will still be constrained on social security reforms. It is still not clear if Brazil's median voter is demanding the kind of policies touted by Bolsonaro's economic advisors. Given Bolsonaro's populism, he may not be willing to expend his political capital on painful and unpopular reforms. In light of this, investors with a 2-5 year horizon should be wary of increasing their absolute exposure to Brazilian assets. Private investors looking for long-term exposure to Brazil should be especially concerned about Bolsonaro's anti-democratic, pro-military inclinations. A New Political Regime... Bolsonaro outperformed expectations in the first round by winning 46% of the popular vote, soundly beating his main rival Fernando Haddad of the left-wing Worker's Party. Polls over the past few weeks had seen him pegged at around 30%. Yet, Sunday night's results showed Bolsonaro beating all pollsters' expectations and nearly gaining the victory in the first round. Table I-1First Round Turnout Was Low In Contrast To Pass Elections Notably, and in contrast to previous elections, overall turnout for the first round was low, standing at just 79% (Table I-1). This played into Bolsonaro's hands. Even though there will be strategic voting in the second round - and our expectation is that most left-leaning voters will switch to Haddad, the remaining left-wing candidate - Haddad's chances look slim. He needs a mass wave of Lula supporters to turn out for the vote. The fact that they did not in the first round bodes ill for him. Thus, Bolsonaro stands at strong odds of becoming Brazil's next president. Attention will turn to the mandate that Bolsonaro will receive over the next four years. In our view, the factors below will be key: Short-term constraints have fallen off: The surprising surge in right-leaning parties at the congressional level suggests that President Bolsonaro will have no immediate legislative constraints to his agenda. He will be free to pursue his policy preferences relatively unimpeded. Chart I-2Chamber Of Deputies Results This is due to both legislative houses shifting towards the right, giving Bolsonaro a mandate to form a majority right-wing government for the first time since 1998 (Chart I-2). So far, 63% of seats in the lower house have gone to center-right and right-wing parties (according to our back-of-the-envelope calculation). If all of these parties joined into a coalition it would represent a historically strong mandate. Markets will surely interpret this as a positive development. However, not all of these parties will necessarily join Bolsonaro. Moreover, reforms requiring a constitutional amendment, such as the all-important reform of Brazil's unsustainable pension system, would require a supermajority of 308 out of 513 seats (60%) in the lower house. Historically, this has proven difficult, and it will be especially tricky for a president with no executive experience, little legislative record, and who denounces the use of pork-barrel spending.1 Otherwise, Congress can ultimately be cajoled into following Bolsonaro. As such, for the first time since Lula's first election (2002 to 2006), the Brazilian president is well-positioned to pursue his agenda. Bolsonaro will likely initiate some easy supply-side policies like cutting corporate taxes and red tape for businesses. Besides, business sentiment could surge due to the emergence of a business-friendly government. Hence, Bolsonaro has some short-term, easy "boosters" before the long-term challenges resurface. Long-term constraints uncertain: Despite the above, the pace of reforms will be slow given that Bolsonaro is, in the end, a populist who will want to maintain power above all. We continue to doubt Bolsonaro's willingness and ability to pursue social security reforms. We suspect that the vast majority of his voters chose to cast their ballot due to his law-and-order agenda that included a focus on battling crime and corruption. His economic advisor, Paulo Guedes, spent more time touting his reformist credentials in foreign financial publications than on the campaign trail. As such, it is difficult to conclude that Bolsonaro actually has a strong mandate for painful pension reforms. Polls ahead of the election suggest that only 4% of the public wants pension reforms (Chart I-3). Chart I-3Brazil's Population Is Not Open To Fiscal Austerity Chart I-4The J-Curve Of Structural Reform That said, we are open-minded and willing to be proved wrong. If Bolsonaro supports very dramatic reforms in his first 12 months in office, when his political capital is strongest, he could pull through despite the likely opposition from the median voter. As our J-Curve Of Structural Reform suggests, Bolsonaro can survive the "danger zone" if he pushes ahead with painful reforms right away (Chart I-4). He will start with sufficient political capital to do so. For long-term investors, the chief question is this: Is Bolsonaro a Brazilian Ronald Reagan or merely a Brazilian Rodrigo Duterte? Judging from everything he himself - not his advisors - has said in the past and on the campaign trail, we would bet on the latter. ...But The Same Economic Problems Brazil is getting a new government, but the macro economic challenges remain the same. Namely, ballooning public debt, still high interest rates and an unsustainable pension system (Chart I-5). As discussed above, it is not evident that Bolsonaro will strive to enact major cuts in the social security system that would be very unpopular. Apart from pensions and privatization, other choices to tackle the unsustainable public debt dynamics include reducing interest rates and boosting nominal growth (Chart I-6). Bolsonaro's economic team has repeatedly discussed the need to reduce high interest rates. Chart I-5Much Needed Pension Reform! Chart I-6Brazil's Macro Distortions   Chart I-7The Real Is Still At Risk Of Depreciation Rapid and large interest rate cuts by the central bank will help to service the public debt given that 96% of public debt is in local currency. Yet, lower interest rates could put pressure on the currency to depreciate - the interest rate differential between Brazil and the U.S. is at all-time lows (Chart I-7). Meanwhile, a weaker currency is needed to increase nominal growth. Notably, extremely low inflation and weak nominal growth have worsened the nation's public debt dynamics in recent years. Overall, lower policy rates and currency devaluation are required to reflate Brazil out of a public debt trap. If the exchange rate stabilizes in the short run as foreign investors come back to Brazil, the central bank will reduce interest rates considerably. Lower borrowing costs in combination with a sharp rise in business confidence and existing pent-up investment demand will propel capital spending, employment and overall growth. In short, these are necessary conditions for Brazilian markets to outperform their EM peers, i.e., for relative outperformance. As to absolute performance, it also depends on the outlook for global markets. In a complete global risk-off mode (the odds of which are considerable at the moment) - in which EM currencies and risk assets continue rioting and U.S. share prices drop - it will be difficult for Brazilian risk assets to rally meaningfully. That said, they will still outperform their EM peers. In the long run, pursuing policies of lower-than-needed interest rates and, hence, of chronic currency depreciation appears to be more palatable to Bolsonaro's populist credentials than difficult structural reforms. Therefore, investors who look to commit long-term capital to Brazil should mind the exchange rate. Populist policies favoring nominal growth in the long run lead to chronic currency depreciation. Bottom Line: Bolsonaro's election and his initial policies will be cheered by markets and will help Brazilian markets to outperform their EM peers for now. However, Bolsonaro is a populist and in the long term will choose economic policies that favor high nominal growth and, thereby, warrant chronic currency depreciation. Investment Recommendations Chart I-8Overweight Brazilian Assets Relative To EM In terms of market recommendations, we have the following: For EM dedicated portfolios, we recommend upgrading Brazil to overweight within the equity, credit, and local currency bonds universes (Chart I-8). BCA's Emerging Market Strategy service is taking a 14% profit on its structural short BRL versus USD position. Also, we are closing the short BRLMXN and short BRLARS trades with a 12% gain and a 5.7% loss, respectively. We also recommend closing the short Brazilian bank stocks trade initiated on May 16, 2018, as its return is now flat due to the recent rebound over the past few days. Absolute performance of Brazilian risk assets is contingent on global financial markets sentiment and at the moment odds of global risk off are considerable. This could cap the rally in Brazilian risk assets for now. Long-term investors should realize that timing Brazilian markets in general, and the exchange rate in particular, will be critical to protect gains. We believe that the path of least resistance for Bolsonaro and his team will be to depreciate the currency and engender nominal GDP growth in order to inflate away the country's public debt. This is a smart strategy for which they have a political mandate. But it will be a death-knell for foreign investors with major positions in the country.   Andrija Vesic, Research Analyst andrijav@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 In late 1998, for instance, even President Cardoso's own PSDB party deprived him of the votes needed to seal a painstakingly negotiated deal with the IMF, which led to a loss of confidence among creditors and a sharp devaluation of the real in January 1999.