Emerging Markets

Special Report

Highlights It will be impossible for China to undertake even mild deleveraging and simultaneously accelerate household income growth. All deposits in the banking system have been created by banks “out of thin air” and have not been engendered by household savings. Contrary to widespread beliefs, mainland households are highly leveraged. Cyclically, high equity valuations, crowded investor positioning and the delayed cyclical recovery in the Chinese economy pose downside risks to consumer stocks. Structurally, real income growth per capita is contingent on productivity growth. The latter will slow in China but remain relatively elevated. Overall, investors should consider buying Chinese consumer plays on weakness. Feature Deliberations about China’s successful rebalancing often boils down to whether one believes that consumers will be able to offset the slowdown in investment and exports and keep overall real GDP growth close to current levels. The narrative typically presumes that Chinese households are not spending enough and can boost their spending counteracting the ongoing slowdowns in capital spending as well as in exports. This conjecture is fallible. Chart I-1The Myth Of Deficient Consumer Demand In China Consumer spending in China has in fact been booming over the past 20 years – it has been growing at a compounded annual growth rate (CAGR) of 10% in real terms since 1998 (Chart I-1, top panel). Hence, the imbalance in China has not been sluggish consumer spending. Rather, capital expenditure has been too strong for too long (Chart I-1, bottom panel). Healthy rebalancing entails a slowdown in investment spending – not an acceleration in household demand. Hence, the market relevant question is: Can the growth rate of household expenditure accelerate above 10% CAGR in real terms as capital spending and exports decelerate? Our hunch is that this is unlikely. As the authorities attempt to contain credit and investment excesses and trade war-induced relocation of manufacturers out of China gathers steam, the pertinent question is whether the slowdown in household expenditures in real terms will be mild (from the current 10% pace to 7.5-9% CAGR), medium (6-7.5%) or material (below 6%). In our opinion, the medium scenario has the highest odds of playing out. There are many positives about the vitality of Chinese consumers and we do not mean to downplay them. Nevertheless, many of these positives are well known, and the objective of our report is to reveal misconceptions about this segment.  Deleveraging And Consumers If and when deleveraging does transpire in China, the household income growth rate will decelerate, resulting in weaker spending growth. It will be impossible for the mainland economy to undertake even mild deleveraging and simultaneously accelerate household income growth. Chart I-2Capital Spending Is Much More Important Than Exports Our focus for this report is on a slowdown in credit and capital spending rather than exports. The basis is that the latter in general, and shipments to the U.S. in particular, have a much smaller impact than investment expenditures (Chart I-2). In turn, capital spending is mostly financed by credit. It is crucial to understand the significance of credit in driving national and household income growth in China since 2008. Currently, 2.5 yuan of new credit is needed to generate one yuan of GDP growth. This certifies that the mainland economy has become addicted to credit. As we have argued in depth in past reports, commercial banks do not intermediate savings into credit, but rather create new money/credit “out of thin air” when they lend to or buy securities from non-banks. This entails that output and income growth would have been much weaker had banks not provided credit equal to RMB 19 trillion over the past 12 months. For instance, a company affiliated with the provincial government has borrowed money from banks to build three bridges over the past 10 years, accumulating a lot of debt in the process. Ostensibly, operating these bridges does not generate enough cash flow to service its debt – a common occurrence in China. With the three bridges completed, the company would then apply for a new loan to build a fourth bridge. Should banks lend additional money to construct it? Notwithstanding this hypothetical company’s low creditworthiness, if banks provide additional financing, the credit bubble will become larger, and the issue of overcapacity will intensify. On the other hand, household income and spending growth will remain robust. If banks do not finance the construction of the fourth bridge, labor income growth in the province – employees of this company and its suppliers – will slump. Thus, if for whatever reason banks are unable or unwilling to extend as much in new credit as last year, output and income growth in this province will decelerate, all else equal. Given credit has been playing an enormous role in driving China’s economic growth over the past 10 years, it will be almost impossible to slow down credit without a downshift in household income growth. This example and analysis is not meant to suggest that bank credit origination is the sole growth driver in China. Theoretically, GDP can expand even with bank credit/money contracting. According to the quantity theory of money: Nominal GDP = Money Supply x Velocity of Money This means nominal GDP can grow even when the supply of money/credit is shrinking. For this to happen, the velocity of money should rise faster than the pace of decline in the supply of money/credit. From a practical perspective, this requires enterprises and consumers to increase the turnover (velocity) of their bank deposits and cash on hand (money supply). We have deliberated in past reports that the velocity of money and the savings rate are inversely related: A rising velocity of money entails a declining savings rate, and vice versa. Going back to our example of bridge construction, the relevant question is: Will companies and households in that province increase their spending (i.e., reduce their savings rate) if banks do not finance the construction of the fourth bridge? The realistic answer is not likely. If the fourth bridge does not receive financing, weaker income growth in that province – due to employment redundancies among construction companies and their suppliers – would lead to slower spending growth. Faced with slowing demand growth, other enterprises and households would likely turn cautious and increase their savings rates – i.e., reduce the velocity of money supply. In short, reduced credit origination will mostly likely generate slower household income growth and, consequently, spending. Chart I-3China: No Deleveraging So Far Broadly speaking, household income growth has not yet downshifted because deleveraging in China has not started. Chart I-3 illustrates that aggregate domestic credit – including public sector, enterprises and households – continues to grow above 10% and well above nominal GDP growth. In fact, credit growth has exceeded nominal GDP growth since 2008. This is local currency credit and does not include foreign currency debt, but the latter is small at 14.5% of GDP (or about US$ 2 trillion). To us, deleveraging implies credit growth that is no greater than nominal GDP growth – i.e., a flat or declining credit-to-GDP ratio for at least several years. If China is serious about deleveraging and curbing its money/credit bubble, the pace of credit expansion should decline to or below nominal GDP growth – which is presently 8%. If and when this occurs it will dampen household income and spending growth. Bottom Line: Chinese household income and spending will inevitably slow if money/credit growth slumps, given the Chinese economy’s excessive reliance on new credit origination over the past 10 years. Do Households Have A Savings Or Debt Glut? What about households’ enormous savings in China? Why wouldn’t households reduce their savings and boost spending? When referring to household savings, most allude to bank deposits. But in conventional economic theory – and according to the way household savings are statistically calculated at a national level – savings actually have no relation to bank deposits. Chart I-4No Empirical Evidence That Deposits = Savings Chart I-4 illustrates that in China, the annual change in household deposits is not equal to household savings (Chart I-4, top panel). Similarly, the annual rise in all deposits (based on central bank data) is vastly different from annual national savings (as defined by conventional macroeconomics and calculated by the National Bureau of Statistics) (Chart I-4, bottom panel). Bank deposits are a monetary concept that we will refer to as “money savings.” Deposits are created by banks “out of thin air,” as illustrated in our past reports.Meanwhile, the term “savings” in conventional macroeconomics denotes goods and services that are produced but not consumed, which is a real economic (not monetary) variable. Not surprisingly, there is no relationship between these “real savings” and “money savings,” as illustrated in Chart I-4. To illustrate that household “savings” (as defined by conventional macroeconomics) are not related to money supply/deposits, let us go back to the example of the company building bridges in China. When the company wire transfers a salary of RMB 1,000 to an employee, the amount of money supply in the banking system does not change. Suppose this employee decides to save 100% of her income this month. Will the supply of money increase or decrease? The answer is that it will not change: the deposit will remain at her bank account. Alternatively, if she decides to spend all RMB 1,000 (100% of her income), the supply of money also will not change – deposits will be transferred to other banks where her suppliers have their accounts.  If she cashes out her deposit and puts it under her mattress, the amount of bank deposits will decline, but cash in circulation will rise by the same amount. Provided money supply is equal to the sum of all bank deposits and cash in circulation, the amount of money supply will not change. The only way the supply of money will decline is if she pays down her loan to a bank. Conversely, the supply of money only rises when banks originate loans or buy assets from non-banks. In short, saving/not spending does not alter the amount of money supply. Rather, broad money supply is equal to the cumulative net money creation “out of thin air” primarily by commercial banks and less so by the central bank over the course of their history. This has nothing to do with household and national “savings.” The latter stand for goods and services produced but not consumed. We have discussed what “savings” mean in conventional economics in past reports. Chart I-5Chinese Households Are More Leveraged Than U.S. Ones Critically, Chinese households presently carry more debt as a share of their disposable income than American households (Chart I-5). This chart compares household debt to disposable income using official data from both China and the U.S. In the case of China, we add Peer-to-Peer (P2P) credit to consumer credit data published by the People’s Bank of China to calculate household debt. The argument by many commentators that consumers in China are not highly leveraged is grounded on the comparison of their debt to GDP. However, in all countries, household debt is assessed versus disposable income – not GDP. The income available to households to service their debt is their disposable income – not GDP. It is correct that Chinese households’ assets have surged in the past two decades as they have purchased significant amounts of real estate, and property prices have skyrocketed. A survey by China Economic Trend Institute holds that property accounts for 66% of household assets in China. To assess creditworthiness, investors should not rely on debtors’ asset values. If debtors are en masse forced to sell their assets to service debt, equity prices would tumble well beforehand. Rather, creditworthiness should be assessed based on recurring cash flow (income) available to debtors to service their debt. One should not be surprised as to why real estate prices are very high in China. Money and credit have been surging – have grown four-fold – over the past 10 years (Chart I-6) and are still expanding at close to a 10% pace. In particular, household debt is still growing at a whopping 15.5% annually (Chart I-7). If and as money/credit growth downshifts, property prices will deflate. Chart I-6Helicopter Money In China Chart I-7Household Credit Is Expanding Twice As Fast As Income Growth Importantly, housing affordability is low and households’ ability to service their mortgages is troubling. Chart I-8 exhibits the nationwide house price-to-income ratio for China and the U.S. In the Middle Kingdom, it is currently about 7.2, while in the U.S. the ratio has never been above 4. It only approached 4  at the peak of the housing bubble in 2006. Chart I-8House Prices Are Very Expensive In China   In turn, Table I-1 illustrates mortgage interest-only payments as a share of household disposable income. The national average is 25.5%. These are very high ratios, suggesting an average new home buyer will have to allocate about a quarter of her or his household income just to pay the interest on a mortgage. These averages do not divulge enormous variations among households. High-income and rich households probably do not have much debt, and debt sustainability is not an issue for them. This also implies that there are many low-income households for whom the interest payments on mortgages absorb more than 25% of their disposable income.  Bottom Line: All deposits in the banking system have been created by banks “out of thin air” and have not been engendered by household savings. Contrary to widespread beliefs, mainland households have a lot of debt, and the latter is still expanding faster than nominal disposable income growth (Chart I-7 above). Positives And The Cyclical Outlook This section lists some positives for household incomes and spending, while also highlighting inherent risks: In the long run, per-capita real income growth in any country is equal to productivity growth. Productivity in China is still booming, justifying high real income growth. The question is whether such buoyant productivity growth can be sustained at a high level to justify robust real-income per-capita growth. Typically, easy money breeds complacency, misallocation of capital and ultimately lower productivity growth. Can China sustain productivity growth of 6% to assure a similar growth rate in real income per capita if the nation continues to experience easy money and a misallocation of capital? Forecasting productivity is not easy; only time will tell. Chart I-9Nominal Household Income, Wages And Salaries Per capita aggregate income as well as both wages and salaries are still expanding briskly – by about 8.5% in nominal terms from a year ago (Chart I-9). This is a formidable growth rate and entails vigorous spending power. The cyclical and long-term concern is whether the current rate of income growth is sustainable. So far there has been few redundancies, despite the fact that corporate revenue and profits have slumped. There is anecdotal evidence that the authorities are actively discouraging dismissals among both state-owned and private enterprises. If layoffs are avoided in this cycle, it will imply that the full pain of the slowdown is absorbed by shareholders. As a result, wages and salaries will rise as a share of GDP, causing a profit margin squeeze for companies. Will private shareholders be willing to invest in the future? Over the past year,  authorities have targeted the stimulus at consumers by cutting personal income taxes. However, this has not boosted consumption: First, the individual taxpayers’ base was very small; only one quarter of total employment (or 16% of the population) was paying personal income taxes before the most recent cut. Second, personal income tax savings have amounted to less than 2% of disposable income.   Finally, the savings from tax cuts are unevenly distributed across households. High-income families will probably get higher tax savings than lower-income ones, whereas the propensity to spend is higher for the latter than the former. Household deposit expansion has accelerated at the expense of enterprises (Chart I-10). This confirms that companies have not slowed the payments to employees (wage bill). Consequently, households have firepower which can be unleashed at any time.  However, there are presently no signs of a growing appetite to spend. Quite the contrary, our proxy for household marginal propensity to spend is falling (Chart I-11). Chart I-10Households Are Hoarding Money, Not Spending Chart I-11Household Marginal Propensity To Spend Is Still Falling Non-discretionary consumer spending has remained very robust. In contrast, discretionary spending has been extremely weak and shows no signs of recovery (Chart I-12). Finally, the impulses of non-government credit, broad money and household credit are weak (Chart I-13). Without these improving substantially and households’ marginal propensity to spend rising, it is difficult to expect a meaningful recovery in consumption. Chart I-12Discretionary Spending Is Sluggish Chart I-13Credit/Money Impulses Are Much Weaker Than In Previous Stimulus Bottom Line: A cyclical recovery in consumer spending hinges on another round of major credit and fiscal stimulus as well as improvement in households’ willingness to spend. Structurally, real income growth is contingent on China’s ability to sustain high productivity growth. Investment Implications If and as capital spending and exports growth slow further, the pace of expansion in consumer expenditure will also moderate. In such a scenario, overall economic growth in China will inevitably downshift. Structurally, Chinese consumer spending will slow from the torrid pace of 10% CAGR of the past 10 years to around 6-7.5% CAGR in real terms. This is a formidable growth rate, and warrants a bullish stance on the consumer sector. We identified Chinese consumers as a major investment theme for the current decade in our 2010 report titled How To Play EM This Decade? 1 In that report, we recommended selling commodities and sectors exposed to Chinese construction and instead favoring consumer plays, especially in the health care and tech sectors. This structural theme has played out well and has further to go. Chinese household spending on health care, education and other high-value services will rise as income per capita expands, albeit at a slower rate than before. Chart I-14 demonstrates that Chinese imports of medical and pharmaceutical products are surging, even though overall imports are currently contracting. Domestically, profit margins are expanding within the medical and pharmaceuticals industries but stagnating for the overall industrial sector (Chart I-15). Chart I-14Surging Demand For Medical Products/Goods Chart I-15Continue Favoring Companies In Health Care/Medical Space All that said, a bullish growth story does not always translate into strong equity returns. Charts I-16A and I-16B reveal that share prices of Chinese investible consumer sub-sectors have had mixed performance. With the exception of Alibaba and Tencent, a few of consumer equity sub-sectors have generated strong equity returns. Chart I-16AChinese Consumer Stocks: Mixed Performance Chart I-16BChinese Consumer Stocks: Mixed Performance Such poor equity performance given strong headline consumption growth has often been due to bottom-up problems such as profit margins squeeze, overexpansion, over-indebtedness, equity dilution, quality of management and other issues. Apart from company specific risks, investors should also consider valuations. Buying good companies in great industries at very high equity multiples will probably produce meager returns. Table I-2 shows the trailing P/E ratio for various consumer sub-sectors. The majority of them trade at a trailing P/E ratio of above 20 and in some cases above 30. Besides, China’s consumer story has been well known for some time, and many portfolios are overweight China consumer plays. Consequently, investor positioning adds to near-term risks. Cyclically, high equity valuations, crowded investor positioning and the delayed cyclical recovery in the Chinese economy pose downside risks to consumer stocks as well. However, such a selloff will create conditions for selectively investing in reasonably valued high quality companies.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com   Footnotes 1      Please see Emerging Markets Strategy Special Report, “How To Play Emerging Market Growth In The Coming Decade”, dated June 10, 2010, available at ems.bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Special Report

Highlights The chance of a U.S.-China trade agreement by November 2020 is still only 40% – but an upgrade may be around the corner. Trump is on the verge of a tactical trade retreat due to fears of economic slowdown and a loss in 2020. Xi Jinping is now the known unknown. His aggressive foreign policy is a major risk even if Trump softens. Political divisions in Greater China – Hong Kong unrest and Taiwan elections – could harm the trade talks. Maintain tactical caution but remain cyclically overweight global equities. Feature   “I am the chosen one. Somebody had to do it. So I’m taking on China. I’m taking on China on trade. And you know what, we’re winning.” – U.S. President Donald J. Trump, August 21, 2019 On August 1, United States President Donald Trump declared that he would raise a new tariff of 10% on the remaining $300 billion worth of imports from China not already subject to his administration’s sweeping 25% tariff. Then, on August 13, with the S&P 500 index down a mere 2.4%, Trump announced that he would partially delay the tariff, separating it into two tranches that will take effect on September 1 and December 15 (Chart II-1). Chart II-1Trump's Latest Tariff Salvo Six days later Trump’s Commerce Department renewed the 90-day temporary general license for U.S. companies to do business with embattled Chinese telecom company Huawei, which has ties to the Chinese state and is viewed as a threat to U.S. network security. The same pattern played out on August 23 when President Trump responded to China’s retaliatory tariffs by declaring he would raise tariffs to 30% on the first half of imports and 15% on the remainder by December 15. Within a single weekend he softened his rhetoric and said he still wanted a deal. Trump’s tendency to take two steps forward with coercive measures and then one step back to control the damage is by now familiar to global investors. Yet this backpedaling reveals that like other politicians he is concerned about reelection. After all, there is a clear chain of consequence leading from trade war to bear market to recession to a Democrat taking the White House in November 2020. Trump’s approval rating is already similar to that of presidents who fell short of re-election amid recession (Chart II-2) – an actual recession would consign him to history. Will Trump Stage A Tactical Retreat On Trade? Yes. Trump’s predicament suggests that he will have to adjust his policies. Global trade, capital spending, and sentiment have deteriorated significantly since the last escalation-and-delay episode with China in May and June. Beijing’s economic stimulus measures disappointed expectations, exacerbating the global slowdown (Chart II-3). This leaves him less room for maneuver going forward. The fourth quarter of 2019 may be Trump’s last chance to save the business cycle and his presidency. Even “Fortress America” – consumer-driven and relatively insulated from global trade – has seen manufacturing, private investment, and business sentiment weaken. GDP growth is slowing and has been revised downward for 2018 despite a surge in budget deficit projections to above $1 trillion dollars (Chart II-4). Chart II-3China's Gradual Stimulus Yet To Revive Global Economy Chart II-4Trump's Economy Grew Slower Than Thought Despite Fiscal Stimulus   The U.S. Treasury yield curve inversion is deepening. While we at BCA would point out reasons that this may not be a reliable signal of imminent recession, Trump cannot afford to ignore it. He is sensitive to the widening talk of “recession” in American airwaves and is openly contemplating stimulus options (Chart II-5). His approval rating has lost momentum, partly due to his perceived mishandling of a domestic terrorist attack motivated by racist anti-immigrant sentiment in El Paso, Texas, but negative financial and economic news have likely also played a part (Chart II-6). Chart II-5Trump Fears Growing Talk Of Recession In short, the fourth quarter of 2019 may be Trump’s last chance to save the business cycle and his presidency. The core predicament for Trump continues to be the divergence in American and Chinese policy. In the U.S., the stimulating effect of Trump’s Tax Cut and Jobs Act is wearing off just as the deflationary effect of his trade policy begins to bite. In China, the lingering effects of Xi’s all-but-defunct deleveraging campaign are combining with the trade war, and slowing trend growth, to produce a drag on domestic demand and global trade. The result is a rising dollar, which increases the trade deficit – the opposite of what Trump wants and needs (Chart II-7). Chart II-7Trump's Fiscal Policy Undid His Trade Policy   The United States is insulated from global trade, but only to a point – it cannot escape a global recession should one develop (Chart II-8). With global and U.S. equities vulnerable to additional volatility in the near term, Trump will have to make at least a tactical retreat on his trade policy over the rest of the year. First and foremost this would mean: Chart II-8If Total Trade War Causes A Global Relapse, The U.S. Economy Cannot Escape Expediting a trade deal with Japan – this should get done before a China deal, possibly as early as September. Ratifying the U.S.-Mexico-Canada “NAFTA 2.0” agreement – this requires support from moderate Democrats in Congress. The window for passage is closing fast but not yet closed. Removing the threat to slap tariffs on European car and car part imports in mid-November. There is some momentum given Europe’s need to boost growth and recent progress on U.S. beef exports to the EU. Lastly, if financial and economic pressure are sustained, Trump will be forced to soften his stance on China. The problem for global risk assets – in the very near term – is that Trump’s tactical retreat has not fully materialized yet. The new tariff on China is still slated to take effect on September 1. This tariff hike or other disagreements could result in a cancellation of talks or failure to make any progress.1 Even if Trump does pivot on trade, China’s position has hardened. It is no longer clear that Beijing will accept a deal that is transparently designed to boost Trump’s reelection chances. Thus, the biggest question in the trade talks is no longer Trump, but Xi. Is Xi prepared to receive Trump kindly if the latter comes crawling back? How will he handle rising political risk in Hong Kong SAR and Taiwan island,2 and will the outcome derail the trade talks? The biggest question in the trade talks is no longer Trump, but Xi. Bottom Line: Global economic growth is fragile and President Trump has only rhetorically retracted his latest salvo against China. Nevertheless, the clear signal is that he is sensitive to the financial and economic constraints that affect his presidential run next year – and therefore investors should expect U.S. trade policy to turn less market-negative on the margin in the coming months. This is positive for the cyclical view on global risk assets. But the risk to the view is China: whether Trump will take a conciliatory turn and whether Xi will reciprocate. Can Xi Jinping Accept A Deal? Yes. It is extremely difficult for Xi Jinping to offer concessions in the short term. He is facing another tariff hike, U.S. military shows of force, persistent social unrest in Hong Kong, and a critical election in Taiwan. Certainly, he will not risk any sign of weakness ahead of the 70th anniversary of the People’s Republic of China on October 1, which will be a nationalist rally in defiance of imperialist western powers. After that, however, there is potential for Xi to be receptive to any Trump pivot on trade. China’s strategy in the trade talks has generally been to offer limited concessions and wait for Trump to resign himself to them. Concessions thus far are not negligible, but they can easily be picked apart. They consist largely of preexisting trends (large commodity purchases); minor adjustments (e.g. to car tariffs and foreign ownership rules); unverifiable promises (on foreign investment, technological transfer, and intellectual property); or reversible strategic cooperation (partial enforcement of North Korean and Iranian sanctions) (Table II-1). Many of these concessions have been postponed as a result of Trump’s punitive measures. It is unlikely that Beijing will offer much more under today’s adverse circumstances. The exception is cooperation on North Korea, which should improve. So the contours of a deal are generally known. This is what Trump will have to accept if he seeks to calm markets and restore confidence in the economy ahead of his election. But this slate of concessions is ultimately acceptable for the U.S. Chart II-9China's Ultimate Economic Constraint China’s demands are that Trump roll back all his tariffs, that purchases of U.S. goods must be reasonable in scale, and that any agreement be balanced and conducted with mutual respect. Of these three, the tariffs and the “respect” pose the most trouble. Trade balance: Washington and Beijing can agree on the terms of specific purchases. China can increase select imports substantially – it remains a cash-rich nation with a state sector that can be commanded to buy American goods. Tariff rollback: This is tougher but can be done. The U.S. will insist on some tariffs – or the threat of tech sanctions – as an enforcement mechanism to ensure that Beijing implements the structural concessions necessary for an agreement. But China might accept a deal in which tariffs were mostly rolled back – say to the original 25% tariff on $50 billion worth of goods. This would likely offset the degree of yuan appreciation to be expected from the likely currency addendum to any agreement. Balance and respect: This qualitative demand is the sticking point. Fundamentally, China cannot reward Trump for his aggressive and unilateral protectionist measures. This would be to set a precedent for future American presidents that sweeping tariffs on national security grounds are a legitimate way of coercing China into making economic structural reforms. Moreover if the U.S. wants to improve the trade balance, China thinks, it cannot embargo Chinese high-tech imports but must actually increase its high-tech exports. Clearly this is a major impasse in the talks. The last point, mutual respect, is the likeliest deal-breaker. It may ultimately hinge on strategic events outside of the realm of trade. But before discussing it further, it is important to recognize that China is not invincible – it has a pain threshold. Deterioration in China’s labor market is of utmost seriousness to any Chinese leader (Chart II-9). And the economy is still struggling to revive. Xi’s reform and deleveraging campaign of 2017-18 has largely been postponed but the lingering effects are weighing on growth and the property sector remains under tight regulation. Moreover the removal of implicit guarantees, and rare toleration of creative destruction (Chart II-10), have left banks and corporations afraid to take on new risks. The state’s reflationary measures, including a big boost to local government spending, have so far been merely sufficient for domestic stability. Chart II-10Creative Destruction In China These problems can be addressed by additional policy easing. But the domestic political crackdown and the break with the U.S. have shaken manufacturers and private entrepreneurs to the bone, suppressing animal spirits and reducing the demand for loans. Ultimately a short-term trade deal to ease this economic stress would make sense for Xi Jinping, even though he knows that U.S. protectionism and the conflict over technological acquisition will persist beyond 2020 and beyond Trump. The threat of a sharp and destabilizing divorce from the U.S. is a real and present danger to the long-term stability of China’s economy and the Communist regime. Xi is a strongman leader, but is he really ready for Mao Zedong-style austerity? Is he not more like former President Jiang Zemin (ruled 1993-2003), who imposed some austerity while prizing domestic economic and political stability above all? To this question we now turn. Bottom Line: China has become the wild card in the trade war. Trump’s need to prevent a recession is known. Beijing has a higher pain threshold and could walk away from the deal to punish Trump (upsetting the global economy and diminishing Trump’s reelection prospects). This would set the precedent for future American presidents that China will not bow to gunboat diplomacy. Will Xi Jinping Overplay His Hand? Be Afraid. For decades China’s main foreign policy principle has been to “lie low and bide its time,” to paraphrase former leader Deng Xiaoping. In the current context this means maintaining a willingness to engage with the U.S. whenever it engages sincerely. This approach implies making the above concessions to minimize the immediate threat to stability from the trade war, while biding time in the longer run rivalry against the United States. Such an approach would also imply assisting the diplomatic process on the Korean peninsula, avoiding a military crackdown in Hong Kong, and refraining from aggressive military intimidation ahead of Taiwan’s election in January. Chart II-11China's Vast Market Its Most Persuasive Tool After all, there is no better way for the Communist Party to undercut dissidents in Hong Kong and Taiwan than to strike a deal with the United States. This would demonstrate that Xi is a pragmatic leader who is still committed to “reform and opening up.” It would help generate an economic rebound that would bring other countries deeper into Beijing’s orbit (Chart II-11). China’s vast domestic market is ultimately its greatest strength in its contest with the United States. In short, conventional Chinese policy suggests that Xi should perpetuate the long success story since 1978 by striking another deal with another Republican president. The catch is that Xi Jinping is not conventional. Since coming to power in 2012, Xi has eschewed the subtle strategies of Sun Tzu and Deng Xiaoping in favor of a more ambitious approach: that of declaring China’s arrival as a major power and leveraging its economic and military heft to pursue foreign policy and commercial interests aggressively. Xi’s reassertion of Communist rule and state-guided technological acquisition is the biggest factor behind the new U.S. political consensus – entirely aside from Trump – that China is foe rather than friend. There are several empirical reasons to think that Xi might overplay his hand: Xi failed to make substantive concessions with President Barack Obama’s administration on North Korea, the South China Sea, and cyber security, resulting in Obama’s decision to harden U.S. policy toward both China and North Korea in 2015 – a trend that predates Trump. Xi formally removed presidential term limits from China’s constitution even though he could have attracted less negative attention from the West by ruling from behind the scenes after his term in office, like Deng Xiaoping or Jiang Zemin. China has mostly played for time in negotiations with the Trump administration, as mentioned, and this aggravated tensions. Deep revisions to the draft agreement, and the  extent of tariff rollback which was supposedly 90% complete, broke the negotiations in May, sparking this summer’s standoff. Aggressive policies in territorial disputes have alienated even China’s potential allies. This includes regional states whose current ruling parties have courted China in recent years, in some cases obsequiously – South Korea, the Philippines, and Vietnam. The East and South China Seas remain a genuine source of “black swans” – unpredictable, low-probability, high-impact events – due to their status as critical sea lanes for the major Asian economies. China continues to militarize the islands there and aggressively prosecute its maritime-territorial disputes. We calculate that $6.4 trillion worth of goods flowed through this bottleneck in the year ending April 2019, 8% of which consists of energy goods from the Middle East that are vital to China and its East Asian neighbors, none of whom can stomach Chinese domination of this geographic space (Diagram II-1). Even if Washington abandoned the region, Japan, South Korea, and Taiwan would see Chinese control as a threat to their security. Ultimately, however, China’s adventures in its neighboring seas are a matter of choice. Not so for Greater China – in Hong Kong and Taiwan, political risk is rapidly mounting in a way that enflames the U.S.-China strategic distrust and threatens to prevent a trade agreement. Hong Kong: The Dust Has Not Settled Mass protests in Hong Kong have lost some momentum, based on the size of the largest rally in August versus June. But do not be fooled: the political crisis is deepening. A plurality of Hong Kongers now harbors negative feelings toward mainland Chinese people as well as the government in Beijing – a trend that is spiking amid today’s protests but began with the Great Recession and has roots in the deeper socioeconomic malaise of this capitalist enclave (Chart II-12A & II-12B).   A majority also lacks confidence in the political arrangement that ensures some autonomy from Beijing – known as “One Country, Two Systems” (Chart II-13). This is a particularly worrisome sign since this is the fundamental basis for stable political relations with Beijing. With clashes continuing between protesters and police, students calling for a boycott of school this fall, and Beijing rotating troops into the city and openly drilling its security forces in Shenzhen for a potential intervention, Hong Kong’s unrest is not yet laid to rest and could flare up again ahead of China’s sensitive National Day celebration. U.S. tariffs and sanctions are already in effect, reducing the ability of the U.S. to deter China from using force if it believes instability has gone too far. And as President Trump has warned – and would be true of any U.S. administration – a violent crackdown on civilian demonstrators would greatly reduce the political viability of a trade deal in the United States. Taiwan: The Black Swan Arrives Since Taiwan’s 2016 election, we have argued that it is a potential source of “black swans.” Mass protests in Hong Kong may have taken the cake. But these protests are now affecting the Taiwanese election dynamic and potentially the U.S.-China trade talks. Chart II-14U.S. Approves Big New Arms Sale To Taiwan On August 20, the United States Department of Defense informed Congress that it is proceeding with an $8 billion sale of F-16 fighter jets and other military arms and equipment to Taiwan – the largest sale in 22 years and the largest aircraft sale since 1992 (Chart II-14). This sale is not yet complete and delivered, but ultimately will be – the question is the timing. Arms sales to Taiwan are a perennial source of tension between the United States and China – and China is increasingly assertive in using economic sanctions to get its way over such issues, as it showed in the lead up to South Korea’s election in 2017. This sale is not a military “game changer” – the U.S. did not send over fifth-generation F-35s, for instance – but China will respond vehemently. It is threatening to impose sanctions on American companies like Lockheed Martin and General Electric for their part in the deal. The sale does not in itself preclude the chance of a trade agreement but it contributes to a rise in strategic tensions that ultimately could. Chart II-15A 'Fourth Taiwan Strait Crisis' Would Have A Seismic Equity Impact The context is Taiwan’s hugely important election in January. Four years ago, President Tsai Ing-wen and her pro-independence Democratic Progressive Party swept to power on the back of a popular protest movement – the “Sunflower Movement” – that opposed deeper cross-strait economic integration. It dangerously resembled the kind of anti-Communist “color revolutions” that motivate Xi Jinping’s hardline policies. Tsai shocked the world when she called Trump personally to congratulate him after his election, which violated diplomatic protocol given that Taiwan is a territory of China and not an independent nation-state. Since then Trump has largely avoided provoking the Taiwan issue so as not to strike at a core Chinese interest and obliterate the chance of a trade deal. But the U.S. has always argued that the provision of defensive arms to Taiwan is a condition of the U.S.-China détente – and Trump is so far moving forward with the sale. How will Xi Jinping react if the sale goes through? In 1995-96, China’s use of missile tests to try to intimidate Taiwan produced the opposite effect – driving voters into the arms of Lee Teng-hui, the candidate Beijing opposed. This was the occasion of the Third Taiwan Strait Crisis, in which U.S. President Bill Clinton sent two aircraft carriers to the region, one that sailed through the Taiwan Strait. The negative effect on markets at that time was local, whereas anything resembling this level of tensions would today be a seismic global risk-off (Chart II-15). Since the 1990s, leaders in Beijing have avoided direct military coercion ahead of elections. But Xi Jinping has hardened his stance on Taiwan throughout his term. He has dabbled with such coercion in his use of military drills that encircle Taiwan in recent years. While one must assume that he will use economic sanctions rather than outright military threats – as he did with South Korea – saber-rattling cannot be ruled out. The pressure on him is rising. Prior to the Hong Kong unrest, Taiwan’s elections looked likely to return the pro-mainland Kuomintang (KMT) to power and remove the incumbent President Tsai – a boon for Beijing. That outlook has changed and Tsai now has a fighting chance of staying in power (Chart II-16). The prospect of four more years of Tsai would not be too problematic for Beijing if not for the fact that the U.S. political establishment is now firmly in agreement on challenging China. But even if Tsai loses, Taiwan’s outlook is troublesome. And this makes Xi’s decision-making harder to predict. Taiwan has a lot more dry powder for a political crisis in the long run than Hong Kong. It is not that Tsai or her party will necessarily prevail. The manufacturing slowdown will take a toll and third-party candidates, particularly Ko Wen-je, would likely split Tsai’s vote. Moreover her Democratic Progressives still tie the KMT in opinion polling (Chart II-17). The Taiwanese people are primarily concerned about maintaining the strong economy and cross-strait peace and stability, which her reelection could jeopardize (Chart II-18). Tsai could very well lose, or she could be a lame duck presiding over the KMT in the legislature.   Rather, the problem for Xi Jinping is that the Taiwanese people clearly sympathize with the protesters in Hong Kong (Chart II-19). They fear that their own governance system faces the same fate as Hong Kong’s, with the Communist Party encroaching on traditional political liberties over time.   While Hong Kong ultimately has zero choice as to whether to accept Beijing’s supremacy, Taiwan has much greater autonomy – and the military support of outside forces. It is not a foregone conclusion that Taiwan must suffer the same political dependency as Hong Kong. Indeed, Taiwan has a long history of exercising the democratic vote and has even dabbled into the realm of popular referendums. In short, Taiwan has a lot more dry powder for a political crisis in the long run than Hong Kong. But the Hong Kong events have accentuated this fact, for two key reasons: First, Taiwanese people identify increasingly as exclusively Taiwanese, rather than as both Taiwanese and Chinese (Chart II-20). The incidents in Hong Kong reveal that this sentiment is tied to immediate political relations and therefore deterioration would encourage further alienation from the mainland. Second, while a strong majority of Taiwanese wish to maintain the political status quo to avoid conflict with the mainland, a substantial subset – approaching one-fourth – supports eventual or immediate independence (Chart II-21).   This means that relations with the mainland will eventually deteriorate even if the KMT wins the election. The KMT itself must respond to popular demand not to cozy up too much with Beijing, which is how it fell from power in 2016. Meanwhile, under KMT rule, Taiwan’s progressive-leaning youth are likely to set about reviving their protest movement in the subsequent years and imitating their Hong Kong peers, especially if the KMT warms up relations too fast with the mainland. Ultimately these points suggest that Xi Jinping will strive to avoid a violent crackdown in Hong Kong. A crackdown would be the surest way for him to harm the KMT in the Taiwanese election and to hasten the rebuilding of U.S.-Taiwan security ties. Call The President The best argument for Xi to lie low and avoid a larger crisis in Greater China is that it would unify the West and its allies against China. So far Xi’s foreign policy has not been so aggressive as to lead to diplomatic isolation. Europe is maintaining a studied neutrality due to its own differences with the United States; Asian neighbors are wary of provoking Chinese sanctions or military threats. A humanitarian crisis in Hong Kong or a “Fourth Taiwan Strait Crisis” would change that. For markets, the best-case scenario is that Xi Jinping exercises restraint. This would help Hong Kong protests lose steam, North Korean diplomacy get back on track, and Taiwanese independence sentiment simmer down. China would be more likely to halt U.S. tariffs and tech sanctions, settle a short-term trade agreement, and delay the upgrade in U.S.-Taiwan defense relations. China would still face adverse long-term political trends in both the U.S. and Taiwan, but an immediate crisis would be averted. The worst-case scenario is that Xi indulges his ambition. Hong Kong protests could explode, relations with Taiwan would deteriorate, and U.S.-China relations would move more rapidly in their downward spiral. Trade talks could collapse. Xi Jinping would face the possibility of a unified Western front, instability within Greater China, and a global recession. This might get rid of Donald Trump, but it would not get rid of the U.S. Congress, Navy, or Department of Defense. The choice seems pretty clear. Xi, like Trump, faces constraints that should motivate a tactical retreat from confrontation, at least after October 1. While this does not necessarily mean a settled trade agreement, it does suggest at least a ceasefire or truce. Our GeoRisk indicators show that market-based political risk in Taiwan – and less so South Korea – moves in keeping with global economic policy uncertainty. The underlying U.S.-China strategic confrontation and trade war are driving both (Chart II-22). A deterioration in this region has global consequences. Chart II-22U.S.-China Strategic Conflict Fuels Global Economic Uncertainty And Taiwanese Geopolitical Risk In Tandem Xi is a markedly aggressive “strongman” Chinese leader who has not been afraid to model his leadership on that of Chairman Mao. He could still overplay his hand. This is why we maintain that the odds of a U.S.-China trade agreement remain 40%, though we are prepared to upgrade that probability if Trump and Xi make pro-market decisions. Investment Implications On the three-month tactical horizon, BCA’s Geopolitical Strategy is paring back our tactical safe-haven trades: we are closing our “Doomsday Basket” of long gold and Swiss bonds for a gain of 13.6%, while maintaining our simple gold portfolio hedge going forward.  Trump has not yet decisively staged his tactical retreat on trade policy, while rising political risk in Greater China increases uncertainty over Xi Jinping’s next moves. On the cyclical horizon, the above suggests that there is a light at the end of the tunnel – if both Trump and Xi recognize their political constraints. This means that there is still a political and geopolitical basis to reinforce BCA’s House View to remain optimistic on global and U.S. equities over the next 12 months, with the potential for non-U.S. equities to recover and bond yields to reverse their deep dive.   Matt Gertken Vice President Geopolitical Strategy   Footnotes 1     Negotiations between Trump and Xi are slated for September in Washington. There is a prospect for Trump to hold another summit with Communist Party General Secretary Xi Jinping on the sidelines of the United Nations General Assembly in New York in late September and at the APEC summit in Chile in mid-November. 2     Hong Kong is a Special Administrative Region of the People’s Republic of China, while Taiwan is recognized as a province or territory.

Highlights The U.S.-Sino trade war is taking a dangerous turn, but the U.S. should avoid a recession until 2022. Global growth will bottom in early 2020. The Fed is set to cut rates two to three times in the next year. Safe-haven bonds have more tactical upside, but will perform poorly on a cyclical basis. Long-term investors should use the next six to nine months to offload their corporate bonds. Equities will be volatile for the rest of 2019; a breakout is forecast for 2020. Long-term investors should favor stocks over bonds, and international stocks over U.S. ones. Feature The yield curve has become the punch line of late-night shows, triggered by the 2-/10-year yield curve inversion in early August. Recession fears have hit the front page. There are good reasons for the mounting concern. Historically, yield curve inversions have done an excellent job forecasting recession. The trade war between the U.S. and China is intensifying at an alarming speed. Moreover, global government bond yields are dipping to all-time lows. Additionally, the global ZEW and PMIs are depressed, while the global production of capital goods and machinery is contracting (Chart I-1). Despite this backdrop, the odds of a U.S. recession are overstated. Consumers in the U.S. and other advanced economies are healthy, the U.S. Federal Reserve and other major central banks are easing, and global financial conditions are supporting growth. We expect stocks to break out of their volatile period of consolidation early next year. Bond yields should rise later this year, but it is too early to stand in front of their downward trend. Finally, long-term investors should use any additional narrowing in credit spreads to lighten their exposure to corporates. U.S. Recession Odds Are Low The yield curve signal is not as dire as the headlines suggest. The inversion is incomplete; the curve is inverted up to the five-year mark and beyond that point, it steepens again. If the yield curve foreshadows a recession, then its slope would be negative across all maturities (Chart I-2). Chart I-1The List Of Worries Is Long   The consumer sector is doing well despite the global growth slowdown. Real retail sales, excluding motor vehicles, are growing at 4.4% and have quickly recovered from this past winter’s government shutdown. Meanwhile, retailers such as Walmart, Target, Home Depot and Lowe’s are reporting strong numbers. Three factors insulate consumer spending from global woes. First, household disposable income is expanding at a healthy 4.7% pace, courtesy of a tight labor market. Secondly, household balance sheets are robust. Household debt-servicing costs only represent 9.9% of disposable income, the lowest reading in more than four decades (Chart I-3, first panel). According to a December BIS paper, debt-servicing costs are one of the best forecasters of recessions.1 Additionally, household debt relative to GDP and to household assets is at 16- and 34-year lows, respectively (Chart I-3, second and third panel). Thirdly, the U.S. savings rate, which stands at 8.1%, already offers a cushion against adverse shocks and has limited upside. The corporate sector also displays some easily overlooked positives. So far, the PMIs and capex growth are still in mid-cycle slowdown territory. Meanwhile, debt loads have never provided an accurate recessionary signal. Since the end of the gold standard, recessions have always materialized after debt-servicing costs as a share of EBITDA rose two to four percentage points above their five-year moving average. We are nowhere near there (Chart I-4). Chart I-3Consumer Balance Sheets Are Very Robust Chart I-4Corporate Debt Is Not In Recessionary Territory   Nevertheless, we will remain vigilant on the capex trend. Corporate investment may not indicate a recession, but the escalating trade war with China will hurt capex intentions. Even if capex contracts, as in 2016, the economy can still avoid a recession. The factors that prompted slowdowns in global trade and manufacturing provide a mixed message. Housing is showing some positive signs after subtracting from GDP in the past six quarters. The NAHB Housing Market Index is recovering smartly from its plunge last year and homebuilder stocks have been outperforming the S&P 500 since October 2018 (Chart I-5). Meanwhile, the 139-basis point collapse in mortgage rates since November 2018 is finally impacting the economy. Mortgage demand is surging, according to the Fed’s Senior Loan Officers Survey. The MBA mortgage applications data corroborate this observation. As a result, both existing home sales and residential investment are trying to bottom (Chart I-6). Chart I-5Leading Indicators Of Residential Activity Are Improving Chart I-6Positive Signs For Residential Activity     The liquidity of the U.S. private sector is also strengthening. Deposit growth has reaccelerated after falling to near recessionary levels (Chart I-7) and the non-financial, private sector’s cash holdings are again increasing faster than debt. Furthermore, bank credit is expanding. Chart I-7The Private Sector Is Accumulating Liquidity Waiting For The Global Economy To Bottom Global growth should bottom by early 2020. Thus, while the U.S. economy should avoid a recession, any distinct re-acceleration will wait until next year. The factors that prompted slowdowns in global trade and manufacturing provide a mixed message. The trade war between the U.S. and China is intensifying. Chinese activity has not yet bottomed but policymakers will be increasingly forced to react. However, the global inventory down cycle is advanced, and in Europe, domestic activity indicators are holding up despite the continued deterioration in external and industrial conditions. Trade War The uncertainty created by the Sino-U.S. trade war is hurting global growth. On August 1, U.S. President Donald Trump announced a 10% tariff on the remaining $300 billion of Chinese exports to the U.S. The tariffs are phased in: $112 billions of goods will be taxed on September 1 while $160 billion will be hit on December 15. Unsurprisingly, a vicious circle of retaliation has been unleashed as China imposed a tariff ranging from 5% to 10% on U.S. goods last Friday, to which Trump immediately responded with a tariff hike from 25% to 30% on the $250 billion batch of goods and from 10% to 15% on the $300 billion batch slated to come into place September 1 and December 1. To bring back hedged foreign buying of Treasurys, the Fed will have to engineer a steeper yield curve and lower FX hedging costs. A resumption in talks between Beijing and Washington in September will offer little solace to investors. Even if President Trump is pressured by the stock market and the U.S. electoral calendar to settle for what Beijing is offering, it is not clear that President Xi Jinping will accept a deal. As BCA’s Chief Geopolitical Strategist Matt Gertken discusses in Section II, the two superpowers are locked in a multi-decade geopolitical rivalry and the Hong Kong protests and tensions over Taiwan could move the talks off track. China’s Challenges China’s economy has yet to bottom convincingly. So far, Chinese reflation has been weaker than anticipated. Given that stimulus has not been forceful, the uncertainty produced by the trade war and the illiquidity created by bloated balance sheets is still dragging down China’s marginal propensity to consume (Chart I-8). However, this propensity to spend has little downside, if the past 10 years are any indication. Chinese infrastructure and equipment investment needs to be revived. They are shouldering the bulk of the decline in economic activity and have slowed to an annual pace of 2.8% and -2.1%, respectively. Residential investment is expanding at a 9.4% annual rate (Chart I-9), but according to Arthur Budaghyan, BCA’s Chief Emerging Markets Strategist, even this sector’s strength could be an illusion. Chinese property developers are starting projects to raise funds via pre-sales. However, they are not completing nearly as many projects as they have started.2 Chart I-8A Falling Marginal Propensity To Spend Means More Stimulus Is Needed   We are not yet ready to give up on Chinese stimulus as the economy is on the verge of a deflationary spiral that could push debt-to-GDP abruptly higher. The following developments support this view: The statement following the July Politburo meeting showed a greater willingness to stimulate economic activity, as long as it does not add to the property bubble. Producer prices are again deflating. Contracting PPIs often unleash vicious circles as they push real rates higher and hurt investment, which foments additional price declines. Retail sales are slowing and the employment components of the manufacturing and non-manufacturing PMIs have fallen to 47.1 and 48.7, respectively. China’s economy needs to be insulated from the intensifying trade war with the U.S. or the deteriorating labor market will dampen consumer spending even more. We expect more tax cuts, more credit growth, and more issuance of local government special bonds to finance government spending, following China’s 70th anniversary celebrations on October 1. As Chart I-10 illustrates, an acceleration in total social financing will ultimately lift EM PMIs as well as Asian and European exports. Inventory Cycle The inventory cycle is very advanced. Inventories in the U.S., China and euro area are depleting (Chart I-11). Inventories cannot fall forever, especially when global monetary policy is increasingly accommodative and fiscal policy is loosened. Chart I-10More Chinese Stimulus Will Eventually Support Global Growth Chart I-11The Inventory Purge Is Advanced   Global activity can rebound if the inventory adjustment ends. Inventory fluctuations help drive the Kitchin cycle, a 36-40 month oscillation in activity. According to BCA’s Chief Global Strategist, Peter Berezin, the current slowdown is nearing 18 months, the typical length of a down oscillation in these cycles (Chart I-12).3 Europe     The manufacturing-heavy euro area will benefit when the global industrial cycle bottoms, but domestic tailwinds are also emerging. European deposits accumulation is quickening, driven by households (Chart I-13, top panel). Meanwhile, the European credit impulse has recovered thanks to the fall in both non-performing loans and borrowing costs (Chart I-13, bottom panel). Moreover, consumer spending is healthy as household balance sheets are improving and wage growth is accelerating to a 3.2% annual pace. Finally, last month we highlighted that the euro area fiscal thrust is set to increase by 0.7% of GDP this year.4 Fiscal easing appears set to expand as Germany and Italy study support packages. Finally, the Italian political uncertainty is receding as the Five Star Movement and the Democratic Party have agreed to form a coalition government. Chart I-12The Three-Year Cycle Is Also Advanced Chart I-13Some Ignored Improvements In Europe   At the moment, the biggest risk for Europe is the significant probability of a No-Deal Brexit. After the recent decision to prorogue Parliament, Matt Gertken raised his probability of a No-Deal Brexit to one third from 20%.Such an event would negatively impact Dutch, German and French exports, which could scuttle any improvement in Europe. Adding It Up The combined effects of more Chinese stimulus in the fourth quarter, an impending end to the global inventory drawdown, and an endogenous improvement in Europe, all should ultimately outweigh the negatives created by the U.S.-Sino trade war. Moreover, global financial conditions are easing (Chart I-14). Therefore, the fall in global bond yields should push the G-10 12-month credit impulse higher (Chart I-14, bottom panel). Lower oil prices should also help G-10 consumers. Early indicators support this assessment. BCA’s Global Leading Economic Indicator has been slowly bottoming, and according to its diffusion index, it will soon move higher (Chart I-15, top panel). Moreover, Singapore’s container throughput is tentatively stabilizing, while our Asian EM Diffusion Index is improving, albeit from depressed levels (Chart I-15, second panel). Finally, ethylene and propylene prices are rallying with accelerating momentum (Chart I-15, third and fourth panels). Chart I-14Easier Financial Conditions Favor Credit Growth Chart I-15Some Growth Indicators Are Stabilizing   Bottom Line: The U.S. economy will probably slow further in the coming months, but it will not enter into recession anytime soon. Neither debt nor consumers pose problems, the housing sector is turning the corner and the private sector’s liquidity position is strengthening. Meanwhile, global activity is trying to bottom, but any improvement will be delayed by the latest round of trade tensions. However, global policymakers are responding, thus global growth should improve by early 2020. Fed Policy: More Cuts Expected Chart I-16A Liquidity Crunch In The Interbank Market? Our base case is that the Fed will cut rates twice more in the coming nine months. In the tails of the probability distribution, three supplementary cuts are more likely than only one additional cut. Paradoxically, liquidity considerations support our Fed view. A recurring theme in our research is the improvement in global liquidity indicators such as excess money, deposit growth and our financial liquidity index.5 However, these indicators are not able to boost growth because of an important technical consideration. What might be classified as excess reserves by the Fed may not be free reserves. Higher Supplementary Leverage Ratios under Basel III rules require commercial banks to hold greater levels of excess reserves to meet their mandatory Tier 1 capital ratios. Since the Fed’s balance sheet runoff results in falling excess reserves, the decline in reserves may have already created some illiquidity in the interbank system. Global central banks have been divesting from the T-bill market, which is worsening the decline in excess reserves. They have parked their short-term funds at the New York Fed’s Foreign Repurchase Agreement Pool (Foreign Repo Pool) which limits the availability of reserves in the banking system (Chart I-16).6 These dynamics increase the cost of hedging the dollar for foreign buyers of U.S. assets. When reserves fall below thresholds implied by Basel III regulations, global banks lose their ability to use their balance sheets to conduct capital market transactions. Without this necessary wiggle room, they cannot arbitrage away wider cross-currency basis swap spreads and deviations of FX forward prices from covered interest rate parity. For foreign investors, the cost of hedging their FX exposure increases. Together with the flatness of the U.S. yield curve, hedged U.S. Treasurys currently yield less than German Bunds or JGBs (Table I-1). Chart I-17Declining Excess Reserves Hurt Risk Assets And Growth Lower excess reserves and higher hedging costs have been bullish for the USD and negative for the global economy. Instead of buying hedged Treasurys, foreigners purchase U.S. assets unhedged (agency and corporate bonds, not Treasurys). Thus, falling excess reserves have been correlated with a stronger dollar, softer global growth and weaker EM asset and FX prices (Chart I-17). This adverse environment has accentuated the downside in Treasury yields and flattened the yield curve (Chart I-17, bottom panel). Going forward, these problems should intensify. The Treasury will issue over US$800 billion of debt by year-end to replenish its cash balance and finance the bulging U.S. budget deficit. Primary dealers will continue to plug the void left by foreigners and will purchase the expanding issuance (Chart I-18). In the past year, primary dealers have already increased their repo-market borrowing by $300 billion to finance their inventories of securities. They will need to expand these borrowings, which will further lift the cost of hedging U.S. assets. Thus, foreign investors faced with $16 trillion of assets with negative yields will buy more U.S. assets on an unhedged basis. The dollar will rise and global growth conditions will deteriorate. The Fed will have to cut rates two to three more times, otherwise the dangerous feedback loop described above will take hold. These cuts are more than domestic economic conditions warrant. To bring back hedged foreign buying of Treasurys, the Fed will have to engineer a steeper yield curve and lower FX hedging costs. The end of the balance sheet runoff is a step in the right direction, but it will not be enough. The BCA Financial Stress Index and our Fed Monitor are consistent with this view (Chart I-19). Moreover, the intensifying trade war is hurting the outlook for growth, inflation expectations and the stock market. Chart I-18A Large Inventory Build Up By Primary Dealers Chart I-19Two To Three More Cuts Are Coming   Investment Implications Government Bonds We have revised our position on an imminent end to the bull market. We do expect bond yields to be higher in 12 months, but for now the global economy has too many risks to time a bottom in yields. The cyclical picture for bonds is bearish. Treasurys have outperformed cash by 8% in the past year, a performance normally associated with a fed fund rate that is 200 to 300 basis points below what markets anticipated 12 months ago (Chart I-20). In order for Treasurys to continue outperforming cash, the Fed must cut rates to zero next year. Nonetheless, a U.S. recession is not in the offing and the global economy should perk up by early 2020. At most, the Fed will validate current rate expectations of 96 basis points of cuts. Chart I-20The Fed Must Cut To Zero For Bonds To Further Outperform Cash Next Year Valuations are also consistent with Treasurys delivering negative returns in the next 12 months. According to the BCA Bond Valuation Index, Treasurys are extremely overvalued. Moreover, real 10-year yields are two standard deviations below the three-year moving average of real GDP growth, a proxy for potential GDP (Chart I-21). Investors should wait to sell bonds until the Fed cuts rates by another 50 basis points, global and U.S. PMIs stabilize, and our cyclical indicator sends a sell signal. Technicals also point to poor 12-month prospective returns. The 13-week and 52-week rates of change in yields are consistent with tops in bond prices (Chart I-22). Positioning is also very stretched, as highlighted by the J.P. Morgan Duration Survey, the Bank of America Merrill Lynch Investors Survey, ETF flows, and government bonds futures and options holdings of asset managers. As a result, our Composite Technical Indicator is very overbought (Chart I-22, bottom panel). Chart I-21U.S. Bonds Are Very Expensive ... Chart I-22... And Very Overbought   The quickening pace of accumulation of securities on bank balance sheets also points to higher yields in 12 months (Chart I-23). As banks stockpile liquid assets, they accumulate more juice to fuel future lending. However, the rising cost of hedging FX exposure is bullish for the dollar. Hence, increasing Treasury holdings will not lift yields until the Fed cuts rates more aggressively. We are reluctant to recommend shorting / underweighting bonds. As Chart I-24 illustrates, mounting uncertainty over economic policy anchors U.S. yields. Last week’s round of tariff increases, along with the Brexit saga, suggests that the uncertainty has not yet peaked. Chart I-23A Coiled Spring Chart I-24Uncertainty Is Keeping Global Bonds Expensive   The collapse in German yields is also not finished. The fall in bund yields to -0.7% has dragged down rates worldwide as investors seek positive long-term returns. In response, the U.S. 10-year premium dropped to -1.1%. Historically, bunds end their rally when yields decline 120 basis points below their two-year moving average (Chart I-25). If history is a guide, German yields could bottom toward -1%, which is in line with Swiss 10-year yields. The 1995 experience also argues against an imminent end to the bond rally. In a recent Special Report, BCA’s U.S. Equity Strategy service highlighted the parallels between today’s environment and the aftermath of the December 1994 Tequila Crisis.7 In that episode, global growth troughed and the Fed cut rates three times before the U.S. ISM Manufacturing Index bottomed in January 1996. Only then did Treasury yields turn higher (Chart I-26). A similar scenario could easily unfold. Chart I-25More Downside For German Yields Chart I-26Bottom In Yields: Wait For The ISM To Turn And The Fed To Cut More   EM assets are vulnerable and could spark a last stampede into U.S. Treasurys. Investors of EM fixed-income products have not yet capitulated. EM assets perform poorly when global growth is weak, dollar funding is hard to come by and trade uncertainty is rising. Yet, yields on EM local-currency bonds have fallen, indicating little selling pressure. Rather than dispose of their EM holdings, investors have hedged their EM exposure by selling EM currencies. Therefore, EM bonds are rallying with EM currencies falling (Chart I-27), which is a rare occurrence. Recent cracks in EM high-yield bonds and the breakdown in EM currencies suggest investors will not ignore the trade war for much longer. The ensuing flight to safety should pull down Treasury yields. Chart I-27A Rare Occurrence BCA’s Cyclical Bond Indicator has yet to flash a buy signal, which will only happen when the indicator moves above its 9-month moving average (Chart I-28). Investors should wait to sell bonds until the Fed cuts rates by another 50 basis points, global and U.S. PMIs stabilize, and our cyclical indicator sends a sell signal. As a corollary, we remain positive on gold prices and expect the yellow metal to move to $1,600 in the coming months. Chart I-28BCA Cyclical Bond Indicator: Don't Sell Yet Corporate Bonds Chart I-29Corporate Bond Fundamentals Are Worsening The long-term outlook for corporate bonds is deteriorating enough that long-term investors should use any rally to lighten their exposures. However, on a six- to nine-month horizon, stresses will probably remain contained. A significant deterioration in corporate health will hurt this asset class’s long-term returns. Recent data revisions pushed GDP and productivity well below previous estimates. This curtailed corporate profitability, lifted debt-to-cash flow ratios, and hurt interest coverage measures. BCA’s Corporate Health Monitor is flashing its worst reading since the financial crisis. Moreover, the return on capital is at its lowest level in this cycle. Historically, these developments have pointed to higher default rates and spreads (Chart I-29). Worryingly, average interest coverage and profitability levels are distorted. Tech firms only account for 8% of the U.S. corporate bond universe, yet they represent 19% of cash flows generated by the U.S. corporate sector. Outside the tech sector, cash generation is poorer than suggested by our Corporate Health Monitor. This will amplify losses when the default cycle begins. The poor quality of bond issuance in the past 8 years will also hurt recovery rates when defaults rise. Since then, junk bonds constitute 10% of overall issuance, and BBB-rated bonds represent 42% of investment-grade issues. Historical averages are 9% and 27%, respectively. Additionally, covenants have been particularly light in the same period. Investors with horizons of one year or less still have a window to own corporate bonds. Moreover, since the deviation of corporate debt-servicing costs as a percentage of EBITDA remains well below historical trigger points, an imminent and durable jump in spreads is unlikely. Within the corporate universe, BCA’s U.S. Bond Strategy service currently favors high-yield to investment-grade bonds.8 Breakeven spreads in the junk space are much more rewarding than those offered by investment-grade issues (Chart I-30). Equities We expect the S&P 500 to remain volatile and below 3,000 for the rest of 2019. Early next year, an upside breakout will end this period of churn. The S&P will probably soon test the 2,700 level. Technically, the selling is not exhausted. The number of stocks above their 40-, 30- and 10-week moving averages have formed successively lower highs and are not yet oversold (Chart I-31). Furthermore, the Fed is unlikely to deliver a dovish surprise in September. Fed Chairman Jerome Powell’s recent speech at Jackson Hole suggests that the Fed needs to see more pain before moving ahead of the curve. Chart I-30Short-Term Investors Should Favor Junk Over Investment Grade Issues Chart I-31This Correction Can Run Further   Once stocks stabilize, the subsequent rebound will not lead to an immediate breakout this year. Yields will move up when growth picks up or if President Trump becomes less combative on trade. However, falling interest rates have been a crucial support for stock prices in 2019. As the 1995-1996 experience shows, when the ISM turned up, the S&P 500 did not gain much traction. Higher yields pushed down multiples even as earnings estimates strengthened. We are more positive on the outlook for stocks next year with BCA’s Monetary Indicator pointing to higher stock prices (see Section III). Moreover, bear markets materialize only when a recession is roughly six to nine months away (Chart I-32). The S&P still has time to rally because we do not anticipate a recession until early 2022. Chart I-32No Recession, No Bear Market Chart I-33Better Prospects For Non-U.S. Stocks Cyclical investors should move their equity holdings outside the U.S. International markets are comparatively cheap (Chart I-33, top panel). Moreover, a rebound in global growth early next year is congruent with U.S. underperformance. Finally, our earnings models forecast an end to the deterioration of European profit growth in September 2019, but not yet in the U.S. (Chart I-33, bottom two panels). Stocks should outperform bonds on a long-term basis. According to the BCA Valuation Index, U.S. stocks are extremely expensive (see Section III). Our valuation indicator would be as elevated as in 2000 if interest rates were not so depressed today. As Peter Berezin showed in BCA’s Global Investment Strategy service, based on current valuation levels, investors can expect 10-year returns of 3.0%, 4.5%, 11.9% and 7.4% for the U.S., euro area, Japan and EM equities, respectively.9 This is not appealing. Nonetheless, long-term equity expected returns are superior to bonds. If held to maturity, they will return 1.5%, -0.7%, and -0.3% annually in the U.S., Germany and Japan, respectively. Practically, long-term investors should favor the rest of the world over the U.S. Local-currency expected returns are higher outside the U.S., and the dollar will decline during the next 10 years. As our Foreign Exchange Strategy service recently highlighted, the dollar is very expensive on a long-term basis.10 Exchange rates strongly revert to their purchasing-parity equilibria in such investment horizons. The growing U.S. twin deficit and the strong desire of reserve managers to diversify out of the greenback will only exacerbate the dollar’s decline. Mathieu Savary Vice President The Bank Credit Analyst August 29, 2019 Next Report: September 26, 2019   II. Big Trouble In Greater China The chance of a U.S.-China trade agreement by November 2020 is still only 40% – but an upgrade may be around the corner. Trump is on the verge of a tactical trade retreat due to fears of economic slowdown and a loss in 2020. Xi Jinping is now the known unknown. His aggressive foreign policy is a major risk even if Trump softens. Political divisions in Greater China – Hong Kong unrest and Taiwan elections – could harm the trade talks. Maintain tactical caution but remain cyclically overweight global equities.   “I am the chosen one. Somebody had to do it. So I’m taking on China. I’m taking on China on trade. And you know what, we’re winning.” – U.S. President Donald J. Trump, August 21, 2019 On August 1, United States President Donald Trump declared that he would raise a new tariff of 10% on the remaining $300 billion worth of imports from China not already subject to his administration’s sweeping 25% tariff. Then, on August 13, with the S&P 500 index down a mere 2.4%, Trump announced that he would partially delay the tariff, separating it into two tranches that will take effect on September 1 and December 15 (Chart II-1). Chart II-1Trump's Latest Tariff Salvo Six days later Trump’s Commerce Department renewed the 90-day temporary general license for U.S. companies to do business with embattled Chinese telecom company Huawei, which has ties to the Chinese state and is viewed as a threat to U.S. network security. The same pattern played out on August 23 when President Trump responded to China’s retaliatory tariffs by declaring he would raise tariffs to 30% on the first half of imports and 15% on the remainder by December 15. Within a single weekend he softened his rhetoric and said he still wanted a deal. Trump’s tendency to take two steps forward with coercive measures and then one step back to control the damage is by now familiar to global investors. Yet this backpedaling reveals that like other politicians he is concerned about reelection. After all, there is a clear chain of consequence leading from trade war to bear market to recession to a Democrat taking the White House in November 2020. Trump’s approval rating is already similar to that of presidents who fell short of re-election amid recession (Chart II-2) – an actual recession would consign him to history. Will Trump Stage A Tactical Retreat On Trade? Yes. Trump’s predicament suggests that he will have to adjust his policies. Global trade, capital spending, and sentiment have deteriorated significantly since the last escalation-and-delay episode with China in May and June. Beijing’s economic stimulus measures disappointed expectations, exacerbating the global slowdown (Chart II-3). This leaves him less room for maneuver going forward. The fourth quarter of 2019 may be Trump’s last chance to save the business cycle and his presidency. Even “Fortress America” – consumer-driven and relatively insulated from global trade – has seen manufacturing, private investment, and business sentiment weaken. GDP growth is slowing and has been revised downward for 2018 despite a surge in budget deficit projections to above $1 trillion dollars (Chart II-4). Chart II-3China's Gradual Stimulus Yet To Revive Global Economy Chart II-4Trump's Economy Grew Slower Than Thought Despite Fiscal Stimulus   The U.S. Treasury yield curve inversion is deepening. While we at BCA would point out reasons that this may not be a reliable signal of imminent recession, Trump cannot afford to ignore it. He is sensitive to the widening talk of “recession” in American airwaves and is openly contemplating stimulus options (Chart II-5). His approval rating has lost momentum, partly due to his perceived mishandling of a domestic terrorist attack motivated by racist anti-immigrant sentiment in El Paso, Texas, but negative financial and economic news have likely also played a part (Chart II-6). Chart II-5Trump Fears Growing Talk Of Recession In short, the fourth quarter of 2019 may be Trump’s last chance to save the business cycle and his presidency. The core predicament for Trump continues to be the divergence in American and Chinese policy. In the U.S., the stimulating effect of Trump’s Tax Cut and Jobs Act is wearing off just as the deflationary effect of his trade policy begins to bite. In China, the lingering effects of Xi’s all-but-defunct deleveraging campaign are combining with the trade war, and slowing trend growth, to produce a drag on domestic demand and global trade. The result is a rising dollar, which increases the trade deficit – the opposite of what Trump wants and needs (Chart II-7). Chart II-7Trump's Fiscal Policy Undid His Trade Policy   The United States is insulated from global trade, but only to a point – it cannot escape a global recession should one develop (Chart II-8). With global and U.S. equities vulnerable to additional volatility in the near term, Trump will have to make at least a tactical retreat on his trade policy over the rest of the year. First and foremost this would mean: Chart II-8If Total Trade War Causes A Global Relapse, The U.S. Economy Cannot Escape Expediting a trade deal with Japan – this should get done before a China deal, possibly as early as September. Ratifying the U.S.-Mexico-Canada “NAFTA 2.0” agreement – this requires support from moderate Democrats in Congress. The window for passage is closing fast but not yet closed. Removing the threat to slap tariffs on European car and car part imports in mid-November. There is some momentum given Europe’s need to boost growth and recent progress on U.S. beef exports to the EU. Lastly, if financial and economic pressure are sustained, Trump will be forced to soften his stance on China. The problem for global risk assets – in the very near term – is that Trump’s tactical retreat has not fully materialized yet. The new tariff on China is still slated to take effect on September 1. This tariff hike or other disagreements could result in a cancellation of talks or failure to make any progress.11 Even if Trump does pivot on trade, China’s position has hardened. It is no longer clear that Beijing will accept a deal that is transparently designed to boost Trump’s reelection chances. Thus, the biggest question in the trade talks is no longer Trump, but Xi. Is Xi prepared to receive Trump kindly if the latter comes crawling back? How will he handle rising political risk in Hong Kong SAR and Taiwan island,12 and will the outcome derail the trade talks? The biggest question in the trade talks is no longer Trump, but Xi. Bottom Line: Global economic growth is fragile and President Trump has only rhetorically retracted his latest salvo against China. Nevertheless, the clear signal is that he is sensitive to the financial and economic constraints that affect his presidential run next year – and therefore investors should expect U.S. trade policy to turn less market-negative on the margin in the coming months. This is positive for the cyclical view on global risk assets. But the risk to the view is China: whether Trump will take a conciliatory turn and whether Xi will reciprocate. Can Xi Jinping Accept A Deal? Yes. It is extremely difficult for Xi Jinping to offer concessions in the short term. He is facing another tariff hike, U.S. military shows of force, persistent social unrest in Hong Kong, and a critical election in Taiwan. Certainly, he will not risk any sign of weakness ahead of the 70th anniversary of the People’s Republic of China on October 1, which will be a nationalist rally in defiance of imperialist western powers. After that, however, there is potential for Xi to be receptive to any Trump pivot on trade. China’s strategy in the trade talks has generally been to offer limited concessions and wait for Trump to resign himself to them. Concessions thus far are not negligible, but they can easily be picked apart. They consist largely of preexisting trends (large commodity purchases); minor adjustments (e.g. to car tariffs and foreign ownership rules); unverifiable promises (on foreign investment, technological transfer, and intellectual property); or reversible strategic cooperation (partial enforcement of North Korean and Iranian sanctions) (Table II-1). Many of these concessions have been postponed as a result of Trump’s punitive measures. It is unlikely that Beijing will offer much more under today’s adverse circumstances. The exception is cooperation on North Korea, which should improve. So the contours of a deal are generally known. This is what Trump will have to accept if he seeks to calm markets and restore confidence in the economy ahead of his election. But this slate of concessions is ultimately acceptable for the U.S. Chart II-9China's Ultimate Economic Constraint China’s demands are that Trump roll back all his tariffs, that purchases of U.S. goods must be reasonable in scale, and that any agreement be balanced and conducted with mutual respect. Of these three, the tariffs and the “respect” pose the most trouble. Trade balance: Washington and Beijing can agree on the terms of specific purchases. China can increase select imports substantially – it remains a cash-rich nation with a state sector that can be commanded to buy American goods. Tariff rollback: This is tougher but can be done. The U.S. will insist on some tariffs – or the threat of tech sanctions – as an enforcement mechanism to ensure that Beijing implements the structural concessions necessary for an agreement. But China might accept a deal in which tariffs were mostly rolled back – say to the original 25% tariff on $50 billion worth of goods. This would likely offset the degree of yuan appreciation to be expected from the likely currency addendum to any agreement. Balance and respect: This qualitative demand is the sticking point. Fundamentally, China cannot reward Trump for his aggressive and unilateral protectionist measures. This would be to set a precedent for future American presidents that sweeping tariffs on national security grounds are a legitimate way of coercing China into making economic structural reforms. Moreover if the U.S. wants to improve the trade balance, China thinks, it cannot embargo Chinese high-tech imports but must actually increase its high-tech exports. Clearly this is a major impasse in the talks. The last point, mutual respect, is the likeliest deal-breaker. It may ultimately hinge on strategic events outside of the realm of trade. But before discussing it further, it is important to recognize that China is not invincible – it has a pain threshold. Deterioration in China’s labor market is of utmost seriousness to any Chinese leader (Chart II-9). And the economy is still struggling to revive. Xi’s reform and deleveraging campaign of 2017-18 has largely been postponed but the lingering effects are weighing on growth and the property sector remains under tight regulation. Moreover the removal of implicit guarantees, and rare toleration of creative destruction (Chart II-10), have left banks and corporations afraid to take on new risks. The state’s reflationary measures, including a big boost to local government spending, have so far been merely sufficient for domestic stability. Chart II-10Creative Destruction In China These problems can be addressed by additional policy easing. But the domestic political crackdown and the break with the U.S. have shaken manufacturers and private entrepreneurs to the bone, suppressing animal spirits and reducing the demand for loans. Ultimately a short-term trade deal to ease this economic stress would make sense for Xi Jinping, even though he knows that U.S. protectionism and the conflict over technological acquisition will persist beyond 2020 and beyond Trump. The threat of a sharp and destabilizing divorce from the U.S. is a real and present danger to the long-term stability of China’s economy and the Communist regime. Xi is a strongman leader, but is he really ready for Mao Zedong-style austerity? Is he not more like former President Jiang Zemin (ruled 1993-2003), who imposed some austerity while prizing domestic economic and political stability above all? To this question we now turn. Bottom Line: China has become the wild card in the trade war. Trump’s need to prevent a recession is known. Beijing has a higher pain threshold and could walk away from the deal to punish Trump (upsetting the global economy and diminishing Trump’s reelection prospects). This would set the precedent for future American presidents that China will not bow to gunboat diplomacy. Will Xi Jinping Overplay His Hand? Be Afraid. For decades China’s main foreign policy principle has been to “lie low and bide its time,” to paraphrase former leader Deng Xiaoping. In the current context this means maintaining a willingness to engage with the U.S. whenever it engages sincerely. This approach implies making the above concessions to minimize the immediate threat to stability from the trade war, while biding time in the longer run rivalry against the United States. Such an approach would also imply assisting the diplomatic process on the Korean peninsula, avoiding a military crackdown in Hong Kong, and refraining from aggressive military intimidation ahead of Taiwan’s election in January. Chart II-11China's Vast Market Its Most Persuasive Tool After all, there is no better way for the Communist Party to undercut dissidents in Hong Kong and Taiwan than to strike a deal with the United States. This would demonstrate that Xi is a pragmatic leader who is still committed to “reform and opening up.” It would help generate an economic rebound that would bring other countries deeper into Beijing’s orbit (Chart II-11). China’s vast domestic market is ultimately its greatest strength in its contest with the United States. In short, conventional Chinese policy suggests that Xi should perpetuate the long success story since 1978 by striking another deal with another Republican president. The catch is that Xi Jinping is not conventional. Since coming to power in 2012, Xi has eschewed the subtle strategies of Sun Tzu and Deng Xiaoping in favor of a more ambitious approach: that of declaring China’s arrival as a major power and leveraging its economic and military heft to pursue foreign policy and commercial interests aggressively. Xi’s reassertion of Communist rule and state-guided technological acquisition is the biggest factor behind the new U.S. political consensus – entirely aside from Trump – that China is foe rather than friend. There are several empirical reasons to think that Xi might overplay his hand: Xi failed to make substantive concessions with President Barack Obama’s administration on North Korea, the South China Sea, and cyber security, resulting in Obama’s decision to harden U.S. policy toward both China and North Korea in 2015 – a trend that predates Trump. Xi formally removed presidential term limits from China’s constitution even though he could have attracted less negative attention from the West by ruling from behind the scenes after his term in office, like Deng Xiaoping or Jiang Zemin. China has mostly played for time in negotiations with the Trump administration, as mentioned, and this aggravated tensions. Deep revisions to the draft agreement, and the  extent of tariff rollback which was supposedly 90% complete, broke the negotiations in May, sparking this summer’s standoff. Aggressive policies in territorial disputes have alienated even China’s potential allies. This includes regional states whose current ruling parties have courted China in recent years, in some cases obsequiously – South Korea, the Philippines, and Vietnam. The East and South China Seas remain a genuine source of “black swans” – unpredictable, low-probability, high-impact events – due to their status as critical sea lanes for the major Asian economies. China continues to militarize the islands there and aggressively prosecute its maritime-territorial disputes. We calculate that $6.4 trillion worth of goods flowed through this bottleneck in the year ending April 2019, 8% of which consists of energy goods from the Middle East that are vital to China and its East Asian neighbors, none of whom can stomach Chinese domination of this geographic space (Diagram II-1). Even if Washington abandoned the region, Japan, South Korea, and Taiwan would see Chinese control as a threat to their security. Ultimately, however, China’s adventures in its neighboring seas are a matter of choice. Not so for Greater China – in Hong Kong and Taiwan, political risk is rapidly mounting in a way that enflames the U.S.-China strategic distrust and threatens to prevent a trade agreement. Hong Kong: The Dust Has Not Settled Mass protests in Hong Kong have lost some momentum, based on the size of the largest rally in August versus June. But do not be fooled: the political crisis is deepening. A plurality of Hong Kongers now harbors negative feelings toward mainland Chinese people as well as the government in Beijing – a trend that is spiking amid today’s protests but began with the Great Recession and has roots in the deeper socioeconomic malaise of this capitalist enclave (Chart II-12A & II-12B).   A majority also lacks confidence in the political arrangement that ensures some autonomy from Beijing – known as “One Country, Two Systems” (Chart II-13). This is a particularly worrisome sign since this is the fundamental basis for stable political relations with Beijing. With clashes continuing between protesters and police, students calling for a boycott of school this fall, and Beijing rotating troops into the city and openly drilling its security forces in Shenzhen for a potential intervention, Hong Kong’s unrest is not yet laid to rest and could flare up again ahead of China’s sensitive National Day celebration. U.S. tariffs and sanctions are already in effect, reducing the ability of the U.S. to deter China from using force if it believes instability has gone too far. And as President Trump has warned – and would be true of any U.S. administration – a violent crackdown on civilian demonstrators would greatly reduce the political viability of a trade deal in the United States. Taiwan: The Black Swan Arrives Since Taiwan’s 2016 election, we have argued that it is a potential source of “black swans.” Mass protests in Hong Kong may have taken the cake. But these protests are now affecting the Taiwanese election dynamic and potentially the U.S.-China trade talks. Chart II-14U.S. Approves Big New Arms Sale To Taiwan On August 20, the United States Department of Defense informed Congress that it is proceeding with an $8 billion sale of F-16 fighter jets and other military arms and equipment to Taiwan – the largest sale in 22 years and the largest aircraft sale since 1992 (Chart II-14). This sale is not yet complete and delivered, but ultimately will be – the question is the timing. Arms sales to Taiwan are a perennial source of tension between the United States and China – and China is increasingly assertive in using economic sanctions to get its way over such issues, as it showed in the lead up to South Korea’s election in 2017. This sale is not a military “game changer” – the U.S. did not send over fifth-generation F-35s, for instance – but China will respond vehemently. It is threatening to impose sanctions on American companies like Lockheed Martin and General Electric for their part in the deal. The sale does not in itself preclude the chance of a trade agreement but it contributes to a rise in strategic tensions that ultimately could. Chart II-15A 'Fourth Taiwan Strait Crisis' Would Have A Seismic Equity Impact The context is Taiwan’s hugely important election in January. Four years ago, President Tsai Ing-wen and her pro-independence Democratic Progressive Party swept to power on the back of a popular protest movement – the “Sunflower Movement” – that opposed deeper cross-strait economic integration. It dangerously resembled the kind of anti-Communist “color revolutions” that motivate Xi Jinping’s hardline policies. Tsai shocked the world when she called Trump personally to congratulate him after his election, which violated diplomatic protocol given that Taiwan is a territory of China and not an independent nation-state. Since then Trump has largely avoided provoking the Taiwan issue so as not to strike at a core Chinese interest and obliterate the chance of a trade deal. But the U.S. has always argued that the provision of defensive arms to Taiwan is a condition of the U.S.-China détente – and Trump is so far moving forward with the sale. How will Xi Jinping react if the sale goes through? In 1995-96, China’s use of missile tests to try to intimidate Taiwan produced the opposite effect – driving voters into the arms of Lee Teng-hui, the candidate Beijing opposed. This was the occasion of the Third Taiwan Strait Crisis, in which U.S. President Bill Clinton sent two aircraft carriers to the region, one that sailed through the Taiwan Strait. The negative effect on markets at that time was local, whereas anything resembling this level of tensions would today be a seismic global risk-off (Chart II-15). Since the 1990s, leaders in Beijing have avoided direct military coercion ahead of elections. But Xi Jinping has hardened his stance on Taiwan throughout his term. He has dabbled with such coercion in his use of military drills that encircle Taiwan in recent years. While one must assume that he will use economic sanctions rather than outright military threats – as he did with South Korea – saber-rattling cannot be ruled out. The pressure on him is rising. Prior to the Hong Kong unrest, Taiwan’s elections looked likely to return the pro-mainland Kuomintang (KMT) to power and remove the incumbent President Tsai – a boon for Beijing. That outlook has changed and Tsai now has a fighting chance of staying in power (Chart II-16). The prospect of four more years of Tsai would not be too problematic for Beijing if not for the fact that the U.S. political establishment is now firmly in agreement on challenging China. But even if Tsai loses, Taiwan’s outlook is troublesome. And this makes Xi’s decision-making harder to predict. Taiwan has a lot more dry powder for a political crisis in the long run than Hong Kong. It is not that Tsai or her party will necessarily prevail. The manufacturing slowdown will take a toll and third-party candidates, particularly Ko Wen-je, would likely split Tsai’s vote. Moreover her Democratic Progressives still tie the KMT in opinion polling (Chart II-17). The Taiwanese people are primarily concerned about maintaining the strong economy and cross-strait peace and stability, which her reelection could jeopardize (Chart II-18). Tsai could very well lose, or she could be a lame duck presiding over the KMT in the legislature.   Rather, the problem for Xi Jinping is that the Taiwanese people clearly sympathize with the protesters in Hong Kong (Chart II-19). They fear that their own governance system faces the same fate as Hong Kong’s, with the Communist Party encroaching on traditional political liberties over time.   While Hong Kong ultimately has zero choice as to whether to accept Beijing’s supremacy, Taiwan has much greater autonomy – and the military support of outside forces. It is not a foregone conclusion that Taiwan must suffer the same political dependency as Hong Kong. Indeed, Taiwan has a long history of exercising the democratic vote and has even dabbled into the realm of popular referendums. In short, Taiwan has a lot more dry powder for a political crisis in the long run than Hong Kong. But the Hong Kong events have accentuated this fact, for two key reasons: First, Taiwanese people identify increasingly as exclusively Taiwanese, rather than as both Taiwanese and Chinese (Chart II-20). The incidents in Hong Kong reveal that this sentiment is tied to immediate political relations and therefore deterioration would encourage further alienation from the mainland. Second, while a strong majority of Taiwanese wish to maintain the political status quo to avoid conflict with the mainland, a substantial subset – approaching one-fourth – supports eventual or immediate independence (Chart II-21).   This means that relations with the mainland will eventually deteriorate even if the KMT wins the election. The KMT itself must respond to popular demand not to cozy up too much with Beijing, which is how it fell from power in 2016. Meanwhile, under KMT rule, Taiwan’s progressive-leaning youth are likely to set about reviving their protest movement in the subsequent years and imitating their Hong Kong peers, especially if the KMT warms up relations too fast with the mainland. Ultimately these points suggest that Xi Jinping will strive to avoid a violent crackdown in Hong Kong. A crackdown would be the surest way for him to harm the KMT in the Taiwanese election and to hasten the rebuilding of U.S.-Taiwan security ties. Call The President The best argument for Xi to lie low and avoid a larger crisis in Greater China is that it would unify the West and its allies against China. So far Xi’s foreign policy has not been so aggressive as to lead to diplomatic isolation. Europe is maintaining a studied neutrality due to its own differences with the United States; Asian neighbors are wary of provoking Chinese sanctions or military threats. A humanitarian crisis in Hong Kong or a “Fourth Taiwan Strait Crisis” would change that. For markets, the best-case scenario is that Xi Jinping exercises restraint. This would help Hong Kong protests lose steam, North Korean diplomacy get back on track, and Taiwanese independence sentiment simmer down. China would be more likely to halt U.S. tariffs and tech sanctions, settle a short-term trade agreement, and delay the upgrade in U.S.-Taiwan defense relations. China would still face adverse long-term political trends in both the U.S. and Taiwan, but an immediate crisis would be averted. The worst-case scenario is that Xi indulges his ambition. Hong Kong protests could explode, relations with Taiwan would deteriorate, and U.S.-China relations would move more rapidly in their downward spiral. Trade talks could collapse. Xi Jinping would face the possibility of a unified Western front, instability within Greater China, and a global recession. This might get rid of Donald Trump, but it would not get rid of the U.S. Congress, Navy, or Department of Defense. The choice seems pretty clear. Xi, like Trump, faces constraints that should motivate a tactical retreat from confrontation, at least after October 1. While this does not necessarily mean a settled trade agreement, it does suggest at least a ceasefire or truce. Our GeoRisk indicators show that market-based political risk in Taiwan – and less so South Korea – moves in keeping with global economic policy uncertainty. The underlying U.S.-China strategic confrontation and trade war are driving both (Chart II-22). A deterioration in this region has global consequences. Chart II-22U.S.-China Strategic Conflict Fuels Global Economic Uncertainty And Taiwanese Geopolitical Risk In Tandem Xi is a markedly aggressive “strongman” Chinese leader who has not been afraid to model his leadership on that of Chairman Mao. He could still overplay his hand. This is why we maintain that the odds of a U.S.-China trade agreement remain 40%, though we are prepared to upgrade that probability if Trump and Xi make pro-market decisions. Investment Implications On the three-month tactical horizon, BCA’s Geopolitical Strategy is paring back our tactical safe-haven trades: we are closing our “Doomsday Basket” of long gold and Swiss bonds for a gain of 13.6%, while maintaining our simple gold portfolio hedge going forward.  Trump has not yet decisively staged his tactical retreat on trade policy, while rising political risk in Greater China increases uncertainty over Xi Jinping’s next moves. On the cyclical horizon, the above suggests that there is a light at the end of the tunnel – if both Trump and Xi recognize their political constraints. This means that there is still a political and geopolitical basis to reinforce BCA’s House View to remain optimistic on global and U.S. equities over the next 12 months, with the potential for non-U.S. equities to recover and bond yields to reverse their deep dive.   Matt Gertken Vice President Geopolitical Strategy   III. Indicators And Reference Charts The S&P 500 correction is likely to deepen a bit further. A move toward 2700 remains our base case scenario. Short-term oscillators have not yet reached capitulation levels and the Sino-U.S. trade war remains a source of risks, especially as the Chinese side is unlikely to provide any strong concessions until October. However, we still do not expect a deeper correction to unfold. In other words, equities remain stuck in a trading range for the remainder of the year. Our Revealed Preference Indicator (RPI) continues to shun stocks. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive readings from the policy and valuation measures. Conversely, if strong market momentum is not supported by valuations and policy, investors should lean against the market trend. Global growth remains the biggest problem for stocks. Until the global economy finds a floor, the outlook for profits will be poor and our RPI will argue against buying equities. Beyond this year, the outlook remains constructive of stocks. Our Willingness-to-Pay (WTP) indicator for the U.S. and Japan is markedly improving. However, it continues to deteriorate in Europe. The WTP indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The WTP therefore argues that investors are still looking to buy the dips in the U.S. and in Japan, which limits the downside in those markets. Yields have collapsed, money growth has picked up, and global central banks are cutting rates in unison. As a result, our Monetary Indicator points to the most accommodative global monetary backdrop since early 2015. Moreover, our Composite Technical Indicator is improving and continues to flash a buy signal. In 2015, it was deteriorating after having hit overbought territory. Therefore, unlike four years ago, equities are more likely to avoid the gravitational pull created by their overvaluation, especially as our BCA Composite Valuation index is in fact improving thanks to lower bond yields.  According to our model, 10-year Treasurys have not been this expensive since late 2012. Back then, this level of overvaluation warned of an impending Treasury selloff. Moreover, our technical indicator is now deeply overbought. So are various rate-of-change measures for bond prices. While none of those indicators can tell you if yields will move up in the next few weeks, they do argue that the risk/reward of holding bonds over the coming year is extremely poor. That being said, we are closely monitoring the recent breakdown in the advanced/decline line of commodities, which might herald another down-leg in commodity prices, and therefore, in bond yields as well. On a PPP basis, the U.S. dollar is only growing ever more expensive. Additionally, despite the dollar’s recent strength, our Composite Technical Indicator has lost enough momentum that the negative divergence we flagged last month remains in place. It is worrisome for dollar bulls that despite growing uncertainty and a deteriorating global economy, the euro is not breaking down. If the dollar’s Technical Indicator deteriorates further and falls below zero, the momentum-continuation behavior of the greenback will likely kick in. The USD would suffer markedly were this to happen. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging   Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1       Claudio Borio , Mathias Drehmann, Dora Xia, "The financial cycle and recession risk," BIS Quarterly Review, December 2018. 2       Please see Emerging Markets Strategy Special Report "China’s Property Market: Making Sense Of Divergences," dated May 9, 2019, available at ems.bcaresearch.com 3       Please see Global Investment Strategy Weekly Report, “Three Cycles,” dated July 26, 2019, available at gis.bcaresearch.com 4       Please see The Bank Credit Analyst Section I, “August 2019,” dated July 25, 2019, available at bca.bcaresearch.com 5       Please see The Bank Credit Analyst Section I, “August 2019,” dated July 25, 2019, available at bca.bcaresearch.com 6       For an explanation of the mechanics of the FRP, please see NY Fed’s website: https://www.newyorkfed.org/aboutthefed/fedpoint/fed20 7       Please see U.S. Equity Strategy Special Report "Sector Performance And Fed “Mid-Cycle Adjustments”: For Better Or For Worse," dated August 19, 2019, available at uses.bcaresearch.com 8       Please see U.S. Bond Strategy Weekly Report "The Trump Interruption," dated August 13, 2019, available at usbs.bcaresearch.com 9       Please see Global Investment Strategy Special Report, “TINA To The Rescue?,” dated August 23, 2019, available at gis.bcaresearch.com 10     Please see Foreign Exchange Strategy Special Report, “A Fresh Look At Purchasing Power Parity,” dated August 23, 2019, available at fes.bcaresearch.com 11     Negotiations between Trump and Xi are slated for September in Washington. There is a prospect for Trump to hold another summit with Communist Party General Secretary Xi Jinping on the sidelines of the United Nations General Assembly in New York in late September and at the APEC summit in Chile in mid-November. 12     Hong Kong is a Special Administrative Region of the People’s Republic of China, while Taiwan is recognized as a province or territory. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:

Away from the Sino-U.S. trade-war headlines – and the remarkable commodity price volatility they produce – apparent steel consumption in China is up 9.5% y/y in the first seven months of this year. This is being spurred by fiscal stimulus directed at infrastructure and construction spending, which remains strong relative to year-ago levels (Chart of the Week).1 Demand for copper normally drafts in the wake of China’s steel demand, and picks up when steel-intensive capital projects are being wired for use. In less uncertain times, getting long copper would make sense.2 Chart of the WeekFiscal Stimulus Boosts China Steel Consumption We are holding off getting long for now, given the policy uncertainty – particularly in re trade policy – that dominates commodity markets, none moreso than steel and base metals. While the odds of a resolution to the trade war might be edging up from our 40% expectation, moving them closer to those of a coin toss does not justify taking the risk.3 Highlights Energy: Overweight. Retaliatory tariffs on $75 billion of U.S. imports, including crude oil, into China, provoked an additional 5% duty by President Trump on ~ $550 billion of goods shipped to the U.S. by China. This will lift the total tariff on $250 billion of U.S. imports from China to 30%, and on another $300 billion to 15%, starting Oct. 1 and Sept. 1. Following the imposition of Chinese tariffs, China Petroleum & Chemical Corp, or Sinopec, petitioned Beijing for waivers on U.S. crude imports. Base Metals: Neutral. Included in the latest Chinese tit-for-tat tariff retaliations is a 5% tariff increase on copper scrap imports from the U.S., which takes the duty to 30%; the re-imposition of 25% tariffs on U.S. auto imports, and a 5% tariff on auto parts. The latter tariffs go into effect December 15, according to Fastmarkets MB. Precious Metals: Neutral. We are getting long platinum at tonight’s close, but with a tight stop of -10%, given highly volatile – and uncertain – trading markets. In addition to following the wake of safe-haven demand for gold, a physical deficit for platinum is possible.4 Markets have been well supported technically – bouncing off long-term support of ~ $785/oz dating to the depths of the Global Financial Crisis in 2008 – 09. Ags/Softs: Underweight. The USDA reported 57% of the U.S. corn crop is in good or excellent condition this week, vs. 68% a year ago. The Department also reported 55% of the soybean crop was in good or excellent shape vs. 66% last year at this time. Feature Iron ore price surged more than 38.1% y/y, while steel prices rallied in 1Q19 off their year-end 2018 lows, helped by the Central Committee fiscal stimulus directed at infrastructure and construction, which hit the market after the collapse of Vale’s Brumadinho dam in January (Chart 2). The combination of the fatal dam disaster and fiscal stimulus in China lifted prices for iron ore and steel sharply.5 Chart 2Iron Ore and Steel Rally Leaves Copper Behind Chart 3China's Construction, Real Estate Investment Spur Higher Steel Demand While policymakers guide domestic markets to expect reduced stimulus for the real-estate sector, we continue to expect copper demand to pick up in the short term. Our modeling indicates strong steel consumption presages higher copper consumption, especially when construction’s contribution is high (Chart 3). This is because the projects accounting for that consumption typically are fitted out with electrical wiring six months or so after the structures built with all that steel are made ready for residential or commercial use (Chart 4).6 This should support copper prices as we go through 2H19, although a slowdown in steel’s apparent consumption in 1Q19 followed by a rebound in April could make for a bumpy ride. CPC Central Committee guidance is stressing the need to get stimulus to the “real economy, such as privately-owned manufacturers and high-tech firms, which are the engines of long-term growth.”7 Still, while policymakers guide domestic markets to expect reduced stimulus for the real-estate sector, we continue to expect copper demand to pick up in the short term, as completed construction and infrastructure and projects in the pipeline from past stimulus are made ready for use.8 Chart 4Higher Steel Demand Normally Presages Higher Copper Demand   Copper Puzzle: Why Was It Left Behind? Part of the explanation for copper’s lackluster relative performance likely is USD-related: A strong dollar will reduce demand. Prices for iron ore and steel have come back to earth, following their impressive rallies this year. However, as Chart 2 illustrates, copper prices languished, and retreated to $2.50/lb on the COMEX. This, despite a contraction of physical copper concentrates supply, which kept copper treatment and refining charges (TC/RC) close to record lows, and inventories tight globally (Chart 5).9 Part of the explanation for copper’s lackluster relative performance likely is USD-related: A strong dollar will reduce demand (Chart 6).10 Our House view continues to expect the U.S. Fed to deliver a 25bp rate cut at its mid-September meeting. This could be followed by additional easing if Sino-U.S. trade tensions persist or get worse. Our House view expects Fed easing and a recovery in EM GDP growth will weaken the USD later this year. As iron ore shipments pick up from Brazil and Australia, we would expect pressure on those prices as the additional supply arrives at Chinese docks, and residential construction wanes (Chart 7). This should, in relative terms, mean copper outperforms iron ore, all else equal, since copper supplies and inventories are contracting. And, as construction spending moderates and winter restrictions on steel mills go into effect, we would expect copper to outperform steel. Chart 5Global Copper Inventories Remain Tight   Chart 6Strong USD Restrains Base Metal Demand Chart 7China's Iron Ore Imports Remain Strong Lastly, we would note from a technical perspective that copper has been – and remains – oversold (Chart 8). This could reflect the fact that, among base metals, it has the deepest liquidity, so that when hedgers or speculators are looking for a way to hedge trade-war risk vis-à-vis China – or to simply take a view on EM GDP prospects – copper is the preferred vehicle. It still is too early to wade into buying based on technicals, and, historically, copper has dipped further into oversold territory than where it now sits. But continued excursions into oversold territory will get our attention, and incline us to revisit our bullish bias. Chart 8Technically, Copper's Oversold   Trade War Deadweight The foregoing analysis suggests copper is due to rally. That is our expectation, at any rate. But uncertainty re the Sino-U.S. trade war and other exogenous policy issues – chiefly increasing recession risks arising from higher tariffs on Chinese imports to the U.S., a possible oil-price spike driven by military action in the Persian Gulf, and a disorderly Brexit – forces us to stand aside. Back in May, the N.Y. Fed conducted an analysis of U.S. President Donald Trump’s increase in tariff rates on $200 billion of Chinese imports from 10% to 25%.11 The N.Y. Fed estimated this increase in the tariff rates on that $200 billion would cost the average American household $831/yr, owing to a sharp increase in the deadweight loss arising from the increase. The deadweight loss estimated by the bank arising from tariff increase on the $200 billion of goods subject to the duty went from $132/household/year to $620/household/year. This means the total cost of the tariffs on the $200 billion of goods went from $414/household/year to $831/household/year. The N.Y. Fed notes: Economic theory tells us that deadweight losses tend to rise more than proportionally as tariffs rise because importers are induced to shift to ever more expensive sources of supply as the tariffs rise. Very high tariff rates can thereby cause tariff revenue to fall as buyers of imports stop purchasing imports from a targeted country and seek out imports from (less efficient) producers in other countries. The deadweight loss that comes from importers being forced to buy tariffed goods from higher-cost suppliers is, in other words, highly non-linear. This latest round of tariff increases is being levied on $550 billion of imports come September 1 and October 1. According to the Urban-Brookings Tax Policy Center, a Washington-based research joint-venture between the Urban Institute and the Brookings Institute, U.S. middle-class households earning $50k to $85k, received an average income tax cut of about $800 last year following passage of the 2017 Tax Cuts and Jobs Act (TCJA), which was signed in to law by President Trump December 22, 2017.12 Further increasing tariffs, as proposed, means the after-tax income of average U.S. households will contract, as the total cost of tariffs overwhelms the value of TCJA tax cuts for middle-income households, if they are imposed as scheduled. China's economy is struggling under the strain of the trade war, as it overlaps with President Xi’s reform and deleveraging campaign of 2017-18.  While these campaigns have been postponed, the lingering effects are weighing on growth.  In addition, banks and corporations appear to be backing away from taking on new risks. The state’s reflationary measures, including a big boost to local government spending, have so far been merely sufficient for domestic stability.12 Bottom Line: Fundamentals and technicals align to support copper prices. However, given the uncertainty surrounding the evolution of the Sino-U.S. trade war we are staying on the sidelines, and avoiding putting on a long position at present. Rising tariffs by the U.S. and China increases the risk of recession in both countries.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com   Footnotes 1      In Copper Will Benefit Most From Chinese Stimulus, published April 25, 2019, we noted China would deploy $300 billion (~ 2 trillion RMB) to support policymakers’ GDP growth targets this year. See also the June 2019 issue of Resources and Energy Quarterly, published by the Australian Government’s Department of Industry, Innovation and Science, particularly Section 3 beginning on p. 22. 2      We are referring to Knightian uncertainty here, a distinction developed by economist Frank Knight in his 1921 book "Risk, Uncertainty and Profit". Uncertainty in Knight’s sense refers to a risk that is “not susceptible to measurement,” per the MIT.edu reference above. This differs from the “risk” we routinely consider in this publication, which can be measured via implied volatilities in options markets. A pdf of the book can be downloaded at the St. Louis Fed’s FRASER website. 3      These odds were calculated by BCA Research’s Geopolitical Strategy group. For a discussion, please see our article entitled Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals, published May 9, 2019. It is available at ces.bcaresearch.com. 4      This is not a certainty. In its PGM Market Report for May 2019, Johnson Matthey, the platinum-group metals refiner, forecast a slight physical platinum deficit this year of ~ 4MT, while Metals Focus expects a 20MT surplus. 5      The Australian Government DIIS report footnoted above (fn 1) states, “Production growth in China was driven by stimulatory government spending, which focused on higher infrastructure investment and boosting construction activity.” This is consistent with our framework for analyzing Chinese bulks (iron ore and steel) and base metals markets: Steel production and consumption are directed by the Communist Party of China (CPC) Central Committee, which motivates us to treat China’s steel market as a unified vertically integrated industry. Chinese steel production, accounts for ~ 50% of the global total. Its strong showing this year pushed world steel production up ~ 5% y/y in the first five months of this year, according to the DIIS. 6      In our modeling of copper prices, we lag steel apparent consumption by six months. 7      Please see Property sector cooling to help real economy funding, published by China Daily on August 1, 2019. 8      BCA Research’s China Investment Strategy noted, “The July Politburo statement signaled a greater willingness to stimulate the economy; as a result, we are penciling in a slightly more optimistic scenario on forthcoming credit growth through the remainder of the year, by adding 300 billion yuan of debt-to-bond swaps and 800 billion yuan of extra infrastructure spending to our baseline estimate for the rest of 2019. However, this would only add a credit impulse equivalent of 1 percentage point of nominal GDP and would only marginally reduce the probability of an earnings recession to 40%.” Please see Don’t Bottom-Fish Chinese Assets (Yet), published August 14, 2019. It is available at cis.bcaresearch.com. 9      The International Copper Study Group reported world mine production fell ~ 1% in the January – May 2019 period to ~ 8.3mm MT. Global refined copper production also was down ~ 1% to 9.8mm MT, while refined copper usage was down less than 1% over the same period. China’s refined usage – ~ 50% of world demand – was up 3.5%. 10   Our modeling indicates a 1% y/y increase in the broad trade-weighted USD translates into a 0.7% y/y decrease in the price of copper. Iron ore also is affected by USD levels, but price formation in this market is dominated by the overwhelming influence of Chinese demand on the seaborne iron-ore market, which accounts for close to 70% of global demand. For steel, China accounts for slightly more than half of global supply and demand, which somewhat insulates it from USD effects. 11   Please see New China Tariffs Increase Costs to U.S. Households, published by the N.Y. Fed May 23, 2019. 12   Please see Big Trouble In Greater China, a Special Report published by BCA Research's Geopolitical and China Investment strategies August 23, 2019.  It is available at gps.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q2 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

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Feature According to the official reported growth rate, Chinese industrial profit growth ticked slightly back into positive territory in July, after having fallen into modestly negative territory earlier this year. However, market participants have increasingly noted the gaping difference between the reported year-over-year (YoY) growth rate and the YoY growth rate of the reported level, with the latter having shown a much weaker profile over the past two years (Chart I-1). Chart I-1Will The Real Profit Trend Please Stand Up? The profile in the growth of overall earnings per share of listed companies does not match that of the reported level of industrial profit growth (either in the domestic or investable markets), and it remains unclear whether this is due to changes in shares outstanding or other factors. But the divergence between the two series shown in Chart I-1 has certainly focused investor attention on China’s profit outlook, which has deteriorated over the past year regardless of the data series used. This deterioration in earnings has raised the risk of a bullish cyclical position towards Chinese stocks for two reasons: 1) it makes an eventual uptrend in stock prices conditional on a rebound in EPS and, 2) it had led to a deterioration in corporate health in what has become a highly-leveraged economy. The latter is particularly notable, given the backdrop of serious investor concern over rising (although still low) onshore corporate defaults. To investigate the impact of declining/decelerating profit growth on Chinese corporate health, this week we are updating our China Industry Watch thematic chartpack. The charts shown on pages 6 - 27 present our corporate health monitor (CHM) and its components across multiple industries (see below for our CHM methodology).1 Several observations are noteworthy: Although our aggregate CHM for all industrials hasn’t yet fallen back to levels seen in 2008 or during the early-2000s, the deceleration in profit growth has clearly caused a meaningful deterioration in corporate health (Chart I-2). To underscore the point, our aggregate CHM suggests that Chinese industrial sector health is presently the worst that it has been since the global financial crisis (Chart I-3). While we acknowledge that Chinese authorities remain reluctant to prompt a large rise in the macro leverage ratio, this core finding of our report raises the stakes for policymakers in terms of their ability to tolerate significant further weakness in economic activity. Chart I-2In China, Profit Growth Drives Corporate Health Chart I-3Chinese Corporate Health Now The Worst Since the Global Financial Crisis Our sub-industry CHMs shed some light on what has driven the deterioration in our overall CHM. The monitors show a particularly marked decline in corporate health for the steel, non-ferrous metals, construction materials, autos, and information technology sectors. Three of these sectors (steel, non-ferrous metals, and IT) are particularly sensitive to exports, suggesting that the trade war with the U.S. is at least partially responsible for the worsening corporate health of industrial enterprises. However, the auto and construction materials sectors tend to be domestically-oriented, underscoring that some of the weakness in these sectors is purely homegrown. Corporate health for energy-related sub-industries (oil & gas and coal) continues to improve from a poor starting point, and the incredible two-decade improvement in health for the food & beverage sector has continued, which shows that Chinese demand for consumer staples remains robust. Measured either by debt-to-assets or interest coverage, China’s industrial enterprises have experienced a broad-based worsening of leverage. To the extent that “deleveraging” has happened, it has occurred in some of China’s “old industries” such as coal, steel, and non-ferrous metals. On the efficiency front, coal and steel have been the only sectors experiencing an improvement in inventory turnover due to China’s capacity reduction campaign; besides this, inventory, asset, and receivable turnover has deteriorated in nearly every other sub-industry. Similarly, profit growth has decelerated and/or fallen into negative territory broadly across sub-industries along with a meaningful deceleration in revenue growth. Utilities and food & beverage are the notable outliers, where profit growth has moderately recovered due to a combination of positive revenue growth and wider margins. Chart I-4Non-SOE Profits: A Leading Indicator For Overall Profit Growth? Finally, Chart I-4 provides an interesting perspective about overall profit growth. A breakdown of profit growth by ownership (state-owned vs. non-state-owned enterprises), shows that non-SOE industrial profits led the decline in overall profit growth in 2017-2018. While it has not yet occurred, a significant pickup in non-SOE profit growth may herald a durable bottom for industrial sector profits, which could act as a meaningful outperformance catalyst for Chinese stocks over the coming 6-12 months. To us, the significant decline in corporate health noted in this report reinforces both our tactically bearish and cyclically bullish recommendations towards Chinese stocks. In the near-term, the risks facing Chinese stocks are high, as the combination of the reluctance of policymakers to stimulate aggressively, weaker corporate health, and the likelihood of negative near-term economic and profit momentum is a perfect storm for stock prices. We recommend an underweight position relative to global stocks for the remainder of the year. However, over the cyclical time horizon (i.e. 6-12 month), these circumstances also suggest high odds in favor of Chinese policymakers soon accepting the need to ease meaningfully further. Barring a major episode of earnings dilution among publicly-listed stocks, significant further easing along with controlled currency depreciation makes a strong case for an overweight stance towards Chinese stocks versus the global benchmark in local currency terms.2 We recommend that investors who are not yet invested in Chinese assets to remain on the sidelines until clearer signs of materially stronger stimulus emerge. However, intermediate-term investors who are already positioned in favor of Chinese equities should stay long, as the relative performance trend of Chinese stocks will likely be higher a year from now than it is today.   Qingyun Xu, CFA, Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com   BCA's China Industry Watch The BCA China Industry Watch includes four categories of financial ratios to monitor a sector’s leverage, profitability, growth and efficiency, respectively. Some of these ratios, as shown in Table 1, are slightly tweaked from conventional definitions due to data availability. The financial data in our exercise are from the official statistics on overall industrial firms, of which the listed companies are a subset, but most financial ratios based on the two sets of data are very similar, especially for the heavy industries that dominate the Chinese stock markets - both onshore and offshore. The financial ratios on leverage, growth and profitability are almost identical for some sectors, while some other sectors that are not well represented in the stock market, such as technology, healthcare and consumer sectors, show notable divergences. As the Chinese equity universe continues to expand, we expect that the two sets of data will increasingly converge. Appendix: China Industry Watch All Firms Chart II-1Non-Financial Firms: Stock Price & Valuation Indicators Chart II-2Non-Financial Firms: Relative Performance Of Valuation Indicators Chart II-3Non-Financial Firms: Leverage Indicators Chart II-4Non-Financial Firms: Growth Indicators Chart II-5Non-Financial Firms: Profitability Indicators Chart II-6Non-Financial Firms: Efficiency Indicators Oil & Gas Sector Chart II-7Oil&Gas Sector: Stock Price & Valuation Indicators Chart II-8Oil&Gas Sector: Relative Performance Of Valuation Indicators Chart II-9Oil&Gas Sector: Leverage Indicators Chart II-10Oil&Gas Sector: Growth Indicators Chart II-11Oil&Gas Sector: Profitability Indicators Chart II-12Oil&Gas Sector: Efficiency Indicators   Coal Sector Chart II-13Coal Sector: Stock Price & Valuation Indicators Chart II-14Coal Sector: Relative Performance Of Valuation Indicators Chart II-15Coal Sector: Leverage Indicators Chart II-16Coal Sector: Growth Indicators Chart II-17Coal Sector: Profitability Indicators Chart II-18Coal Sector: Efficiency Indicators Steel Sector Chart II-19Steel Sector: Stock Price & Valuation Indicators Chart II-20Steel Sector: Relative Performance Of Valuation Indicators Chart II-21Steel Sector: Leverage Indicators Chart II-22Steel Sector: Growth Indicators Chart II-23Steel Sector: Profitability Indicators Chart II-24Steel Sector: Efficiency Indicators Non Ferrous Metals Sector Chart II-25Non Ferrous Metals Sector: Stock Price & Valuation Indicators Chart II-26Non Ferrous Metals Sector: Relative Performance Of Valuation Indicators Chart II-27Non Ferrous Metals Sector: Leverage Indicators Chart II-28Non Ferrous Metals Sector: Growth Indicators Chart II-29Non Ferrous Metals Sector: Profitability Indicators Chart II-30Non Ferrous Metals Sector: Efficiency Indicators Construction Material Sector Chart II-31Construction Material Sector: Stock Price & Valuation Indicators Chart II-32Construction Material Sector: Relative Performance Of Valuation Indicators Chart II-33Construction Material Sector: Leverage Indicators Chart II-34Construction Material Sector: Growth Indicators Chart II-35Construction Material Sector: Profitability Indicators Chart II-36Efficiency Indicators Machinery Sector Chart III-37Machinery Sector: Stock Price & Valuation Indicators Chart III-38Machinery Sector: Relative Performance Of Valuation Indicators Chart III-39Machinery Sector: Leverage Indicators Chart III-40Machinery Sector: Growth Indicators Chart III-41Machinery Sector: Profitability Indicators Chart III-42Machinery Sector: Efficiency Indicators Automobile Sector Chart III-43Automobile Sector: Stock Price & Valuation Indicators Chart III-44Automobile Sector: Relative Performance Of Valuation Indicators Chart III-45Automobile Sector: Leverage Indicators Chart III-46Automobile Sector: Growth Indicators Chart III-47Automobile Sector: Profitability Indicators Chart III-48Automobile Sector: Efficiency Indicators Food & Beverage Sector Chart III-49Food&Beverage Sector: Stock Price & Valuation Indicators Chart III-50Food&Beverage Sector: Relative Performance Of Valuation Indicators Chart III-51Food&Beverage Sector: Leverage Indicators Chart III-52Food&Beverage Sector: Growth Indicators Chart III-53Food&Beverage Sector: Profitability Indicators Chart III-54Food & Beverage Sector: Efficiency Indicators Information Technology Sector Chart III-55Information Technology Sector: Stock Price & Valuation Indicators Chart III-56Information Technology Sector: Relative Performance Of Valuation Indicators Chart III-57Information Technology Sector: Leverage Indicators Chart III-58Information Technology Sector: Growth Indicators Chart III-59Information Technology Sector: Profitability Indicators Chart III-60Information Technology Sector: Efficiency Indicators Utilities Sector Chart III-61Utilities Sector: Stock Price & Valuation Indicators Chart III-62Utilities Sector: Relative Performance Of Valuation Indicators Chart III-63Utilities Sector: Leverage Indicators Chart III-64Utilities Sector: Growth Indicators Chart III-65Utilities Sector: Profitability Indicators Chart III-66Utilities Sector: Efficiency Indicators   Footnotes 1      Please see China Investment Strategy Special Report, “Introducing The BCA China Industry Watch”, dated February 10, 2016, available at cis.bcaresearch.com. 2      We continue to recommend that investors hedge the currency exposure of a long Chinese equity position by being long USD-CNH. Cyclical Investment Stance Equity Sector Recommendations

Special Report

Highlights The chance of a U.S.-China trade agreement is still only 40% – but an upgrade may be around the corner. Trump is on the verge of a tactical trade retreat due to fears of economic slowdown and a loss in 2020. Xi Jinping is now the known unknown. His aggressive foreign policy is a major risk even if Trump softens. Political divisions in Greater China – Hong Kong unrest and Taiwan elections – could harm the trade talks. Maintain tactical caution but remain cyclically overweight global equities. Feature “I am the chosen one. Somebody had to do it. So I’m taking on China. I’m taking on China on trade. And you know what, we’re winning.” – U.S. President Donald J. Trump, August 21, 2019 On August 1, United States President Donald Trump declared that he would raise a new tariff of 10% on the remaining $300 billion worth of imports from China not already subject to his administration’s sweeping 25% tariff. Then, on August 13, with the S&P 500 index down a mere 2.4%, Trump announced that he would partially delay the tariff, separating it into two tranches that will take effect on September 1 and December 15 (Chart 1). Chart 1Trump's Latest Tariff Salvo Six days later Trump’s Commerce Department renewed the 90-day temporary general license for U.S. companies to do business with embattled Chinese telecom company Huawei, which has ties to the Chinese state and is viewed as a threat to U.S. network security. Trump’s tendency to take two steps forward with coercive measures and then one step back to control the damage is by now familiar to global investors. Yet this backpedaling reveals that like other politicians he is concerned about reelection. After all, there is a clear chain of consequence leading from trade war to bear market to recession to a Democrat taking the White House in November 2020. Trump’s approval rating is already similar to that of presidents who fell short of re-election amid recession (Chart 2) – an actual recession would consign him to the dustbin of history. Will Trump Stage A Tactical Retreat On Trade? Yes. Trump’s predicament suggests that he will have to adjust his policies. Global trade, capital spending, and sentiment have deteriorated significantly since the last escalation-and-delay episode with China in May and June. Beijing’s economic stimulus measures disappointed expectations, exacerbating the global slowdown (Chart 3). This leaves him less room for maneuver going forward. Chart 3China's Gradual Stimulus Yet To Revive Global Economy Chart 4Trump's Economy Grew Slower Than Thought Despite Fiscal Stimulus Even “Fortress America” – consumer-driven and relatively insulated from global trade – has seen manufacturing, private investment, and business sentiment weaken. GDP growth is slowing and has been revised downward for 2018 despite a surge in budget deficit projections to above $1 trillion dollars (Chart 4).   Q4 may be Trump’s last chance to save the business cycle and his presidency. The U.S. Treasury yield curve inversion is deepening. While we at BCA would point out reasons that this may not be a reliable signal of imminent recession, Trump cannot afford to ignore it. He is sensitive to the widening talk of “recession” in American airwaves and is openly contemplating stimulus options (Chart 5). His approval rating has lost momentum, partly due to his perceived mishandling of a domestic terrorist attack motivated by racist anti-immigrant sentiment in El Paso, Texas, but negative financial and economic news have likely also played a part (Chart 6). Chart 5Trump Fears Growing Talk Of Recession In short, the fourth quarter of 2019 may be Trump’s last chance to save the business cycle and his presidency. The core predicament for Trump continues to be the divergence in American and Chinese policy. Chart 7Trump's Fiscal Policy Undid His Trade Policy In the U.S., the stimulating effect of Trump’s Tax Cut and Jobs Act is wearing off just as the deflationary effect of his trade policy begins to bite. In China, the lingering effects of Xi’s all-but-defunct deleveraging campaign are combining with the trade war, and slowing trend growth, to produce a drag on domestic demand and global trade. The result is a rising dollar, which increases the trade deficit – the opposite of what Trump wants and needs (Chart 7). The United States is insulated from global trade, but only to a point – it cannot escape a global recession should one develop, given that its economy is still closely linked to the rest of the world (Chart 8). With global and U.S. equities vulnerable to additional volatility in the near term, Trump will have to make at least a tactical retreat on his trade policy over the rest of the year. First and foremost this would mean: Chart 8If Total Trade War Causes A Global Relapse, The U.S. Economy Cannot Escape Expediting a trade deal with Japan – this should get done before a China deal, possibly as early as September. Ratifying the U.S.-Mexico-Canada “NAFTA 2.0” agreement – this requires support from moderate Democrats in Congress. The window for passage is closing fast but not closed. Removing the threat to slap tariffs on European car and car part imports in mid-November. There is some momentum given Europe’s need to boost growth and recent progress on U.S. beef exports to the EU. Lastly, if financial and economic pressure are sustained, Trump will be forced to soften his stance on China. The problem for global risk assets – in the very near term – is that Trump’s tactical retreat has not fully materialized yet. The new tariff on China is still slated to take effect on September 1. This tariff hike or other disagreements could result in a cancellation of talks or failure to make any progress.1 Even if Trump does pivot on trade, China’s position has hardened. It is no longer clear that Beijing will accept a deal that is transparently designed to boost Trump’s reelection chances. Thus, the biggest question in the trade talks is no longer Trump, but Xi. Is Xi prepared to receive Trump kindly if the latter comes crawling back? How will he handle rising political risk in Hong Kong SAR and Taiwan island,2 and will the outcome derail the trade talks? Bottom Line: Global economic growth is fragile and President Trump has only tentatively retracted his latest salvo against China. Nevertheless, the clear signal is that he is sensitive to the financial and economic constraints that affect his presidential run next year – and therefore investors should expect U.S. trade policy to turn less market-negative on the margin in the coming months. This is positive for the cyclical view on global risk assets. But the risk to the view is China: whether Trump will take a conciliatory turn and whether Xi will reciprocate. Can Xi Jinping Accept A Deal? Yes. It is extremely difficult for Xi Jinping to offer concessions in the short term. He is facing another tariff hike, U.S. military shows of force, persistent social unrest in Hong Kong, and a critical election in Taiwan. Certainly, he will not risk any sign of weakness ahead of the 70th anniversary of the People’s Republic of China on October 1, which will be a nationalist rally in defiance of imperialist western powers. After that, however, there is potential for Xi to be receptive to any Trump pivot on trade. China’s strategy in the trade talks has generally been to offer limited concessions and wait for Trump to resign himself to them. Concessions thus far are not negligible, but they can easily be picked apart. They consist largely of preexisting trends (large commodity purchases); minor adjustments (e.g. to car tariffs and foreign ownership rules); unverifiable promises (on foreign investment, technological transfer, and intellectual property); or reversible strategic cooperation (partial enforcement of North Korean and Iranian sanctions) (Table 1). Many of these concessions have been postponed as a result of Trump’s punitive measures. Table 1China’s Offers Thus Far In The Trade War It is unlikely that Beijing will offer much more under today’s adverse circumstances. The exception is cooperation on North Korea, which should improve. So the contours of a deal are generally known. This is what Trump will have to accept if he seeks to calm markets and restore confidence in the economy ahead of his election. But this slate of concessions is ultimately acceptable for the U.S. China’s demands are that Trump roll back all his tariffs, that purchases of U.S. goods must be reasonable in scale, and that any agreement be balanced and conducted with mutual respect. Of these three, the tariffs and the “balance” pose the most trouble. Trade balance: Washington and Beijing can agree on the terms of specific purchases. China can increase select imports substantially – it remains a cash-rich nation with a state sector that can be commanded to buy American goods. Tariff rollback: This is tougher but can be done. The U.S. will insist on some tariffs – or the threat of tech sanctions – as an enforcement mechanism to ensure that Beijing implements the structural concessions necessary for an agreement. But China might accept a deal in which tariffs were mostly rolled back – say to the original 25% tariff on $50 billion worth of goods. This would likely offset the degree of yuan appreciation to be expected from the likely currency addendum to any agreement. Balance and respect: This qualitative demand is the sticking point. Fundamentally, China cannot reward Trump for his aggressive and unilateral protectionist measures. This would be to set a precedent for future American presidents that sweeping tariffs on national security grounds are a legitimate way of coercing China into making economic structural reforms. Moreover if the U.S. wants to improve the trade balance, China thinks, it cannot embargo Chinese high-tech imports but must actually increase its high-tech exports. Clearly this is a major impasse in the talks. The last point is the likeliest deal-breaker. It may ultimately hinge on strategic events outside of the realm of trade. But before discussing it further, it is important to recognize that China is not invincible – it has a pain threshold. The threat of a divorce from the U.S. is a danger to China’s economy and the Communist regime. Chart 9China's Ultimate Economic Constraint Deterioration in China’s labor market is of utmost seriousness to any Chinese leader (Chart 9). And the economy is still struggling to revive. Xi’s reform and deleveraging campaign of 2017-18 has been postponed but the lingering effects are weighing on growth and the property sector remains under tight regulation. Moreover the removal of implicit guarantees, and rare toleration of creative destruction (Chart 10), have left banks and corporations afraid to take on new risks. The state’s reflationary measures, including a big boost to local government spending, have so far been merely sufficient for domestic stability. These problems can be addressed by additional policy easing. But the domestic political crackdown and the break with the U.S. have shaken manufacturers and private entrepreneurs to the bone, suppressing animal spirits and reducing the demand for loans. Chart 10Creative Destruction In China Ultimately a short-term trade deal to ease this economic stress would make sense for Xi Jinping, even though he knows that U.S. protectionism and the conflict over technological acquisition will persist beyond 2020 and beyond Trump. The threat of a sharp and destabilizing divorce from the U.S. is a real and present danger to the long-term stability of China’s economy and the Communist regime. Xi is a strongman leader, but is he really ready for Mao Zedong-style austerity? Is he not more like former President Jiang Zemin (ruled 1993-2003), who imposed some austerity while prizing domestic economic and political stability above all? To this question we now turn. Bottom Line: China has become the wild card in the trade war. Trump’s need to prevent a recession is known. Beijing has a higher pain threshold and could walk away from the deal to punish Trump (upsetting the global economy and diminishing Trump’s reelection prospects). This would set the precedent for future American presidents that China will not bow to gunboat diplomacy. Will Xi Jinping Overplay His Hand? Be Afraid. For decades China’s main foreign policy principle has been to “lie low and bide its time,” to paraphrase former leader Deng Xiaoping. In the current context this means maintaining a willingness to engage with the U.S. whenever it engages sincerely. This approach implies making the above concessions to minimize the immediate threat to stability from the trade war, while biding time in the longer run rivalry against the United States. Such an approach would also imply assisting the diplomatic process on the Korean peninsula, avoiding a military crackdown in Hong Kong, and refraining from aggressive military intimidation ahead of Taiwan’s election in January. Chart 11China's Vast Market Its Most Persuasive Tool After all, there is no better way for the Communist Party to undercut dissidents in Hong Kong and Taiwan than to strike a deal with the United States. This would demonstrate that Xi is a pragmatic leader who is still committed to “reform and opening up.” It would help generate an economic rebound that would bring other countries deeper into Beijing’s orbit (Chart 11). China’s vast domestic market is ultimately its greatest strength in its contest with the United States. In short, conventional Chinese policy suggests that Xi should perpetuate the long success story since 1978 by striking another deal with another Republican president. The catch is that Xi Jinping is not conventional. Since coming to power in 2012, Xi has eschewed the subtle strategies of Sun Tzu and Deng Xiaoping in favor of a more ambitious approach: that of declaring China’s arrival as a major power and leveraging its economic and military heft to pursue foreign policy and commercial interests aggressively. Xi’s reassertion of Communist rule and state-guided technological acquisition is the biggest factor behind the new U.S. political consensus – entirely aside from Trump – that China is foe rather than friend. There are several empirical reasons to think that Xi might overplay his hand: Xi failed to make substantive concessions with President Barack Obama’s administration on North Korea, the South China Sea, and cyber security, resulting in Obama’s decision to harden U.S. policy toward both China and North Korea in 2015 – a trend that predates Trump. Xi formally removed presidential term limits from China’s constitution even though he could have attracted less negative attention from the West by ruling from behind the scenes after his term in office, like Deng Xiaoping or Jiang Zemin. China has mostly played for time in negotiations with the Trump administration, as mentioned, and this aggravated tensions. Deep revisions to the draft agreement, which was supposedly 90% complete, broke the negotiations in May, sparking this summer’s standoff. Aggressive policies in territorial disputes have alienated even China’s potential allies. This includes regional states whose current ruling parties have courted China in recent years, in some cases obsequiously – South Korea, the Philippines, and Vietnam. The East and South China Seas remain a genuine source of “black swans” – unpredictable, low-probability, high-impact events – due to their status as critical sea lanes for the major Asian economies. China continues to militarize the islands there and aggressively prosecute its maritime-territorial disputes. We calculate that $6.4 trillion worth of goods flowed through this bottleneck in the year ending April 2019, 8% of which consists of energy goods from the Middle East that are vital to China and its East Asian neighbors, none of whom can stomach Chinese domination of this geographic space (Diagram 1). Even if Washington abandoned the region, Japan, South Korea, and Taiwan would see Chinese control as a threat to their security. Diagram 1The South China Sea As The World’s Traffic Roundabout Ultimately, however, China’s adventures in its neighboring seas are a matter of choice. Not so for Greater China – in Hong Kong and Taiwan, political risk is rapidly mounting in a way that enflames the U.S.-China strategic distrust and threatens to prevent a trade agreement. Hong Kong: The Dust Has Not Settled Mass protests in Hong Kong have lost some momentum, based on the size of the largest rally in August versus June. But do not be fooled: the political crisis is deepening. A plurality of Hong Kongers now harbors negative feelings toward mainland Chinese people as well as the government in Beijing – a trend that is spiking amid today’s protests but began with the Great Recession and has roots in the deeper socioeconomic malaise of this capitalist enclave (Chart 12A & 12B). A majority also lacks confidence in the political arrangement that ensures some autonomy from Beijing – known as “One Country, Two Systems” (Chart 13). This is a particularly worrisome sign since this is the fundamental basis for stable political relations with Beijing. With clashes continuing between protesters and police, students calling for a boycott of school this fall, and Beijing openly drilling its security forces in Shenzhen for a potential intervention, Hong Kong’s unrest is not yet laid to rest and could flare up again ahead of China’s sensitive National Day celebration. U.S. tariffs and sanctions are already in effect, reducing the ability of the U.S. to deter China from using force if it believes instability has gone too far. And as President Trump has warned – and would be true of any U.S. administration – a violent crackdown on civilian demonstrators would greatly reduce the political viability of a trade deal in the United States. Taiwan: The Black Swan Arrives Since Taiwan’s 2016 election, we have argued that it is a potential source of “black swans.” Mass protests in Hong Kong may have taken the cake. But these protests are now affecting the Taiwanese election dynamic and potentially the U.S.-China trade talks. Chart 14U.S. Approves Big New Arms Sale To Taiwan On August 20, the United States Department of Defense informed Congress that it is proceeding with an $8 billion sale of F-16 fighter jets and other military arms and equipment to Taiwan – the largest sale in 22 years and the largest aircraft sale since 1992 (Chart 14). This sale is not yet complete and delivered, but ultimately will be – the question is the timing. Arms sales to Taiwan are a perennial source of tension between the United States and China – and China is increasingly assertive in using economic sanctions to get its way over such issues, as it showed in the lead up to South Korea’s election in 2017. This sale is not a military “game changer” – the U.S. did not send over fifth-generation F-35s, for instance – but China will respond vehemently. It is threatening to impose sanctions on American companies like Lockheed Martin and General Electric for their part in the deal. The sale does not in itself preclude the chance of a trade agreement but it contributes to a rise in strategic tensions that ultimately could. The context is Taiwan’s hugely important election in January. Four years ago, President Tsai Ing-wen and her pro-independence Democratic Progressive Party swept to power on the back of a popular protest movement – the “Sunflower Movement” – that opposed deeper cross-strait economic integration. It dangerously resembled the kind of anti-Communist “color revolutions” that motivate Xi Jinping’s hardline policies. Tsai shocked the world when she called Trump personally to congratulate him after his election, which violated diplomatic protocol given that Taiwan is a territory of China and not an independent nation-state. Since then Trump has largely avoided provoking the Taiwan issue so as not to strike at a core Chinese interest and obliterate the chance of a trade deal. But the U.S. has always argued that the provision of defensive arms to Taiwan is a condition of the U.S.-China détente – and Trump is so far moving forward with the sale. Chart 15A 'Fourth Taiwan Strait Crisis' Would Have A Seismic Equity Impact How will Xi Jinping react if the sale goes through? In 1995-96, China’s use of missile tests to try to intimidate Taiwan produced the opposite effect – driving voters into the arms of Lee Teng-hui, the candidate Beijing opposed. This was the occasion of the Third Taiwan Strait Crisis, in which U.S. President Bill Clinton sent two aircraft carriers to the region, one that sailed through the Taiwan Strait. The negative effect on markets at that time was local, whereas anything resembling this level of tensions would today be a seismic global risk-off (Chart 15). Since the 1990s, leaders in Beijing have avoided direct military coercion ahead of elections. But Xi Jinping has hardened his stance on Taiwan throughout his term. He has dabbled with such coercion in his use of military drills that encircle Taiwan in recent years. While one must assume that he will use economic sanctions rather than outright military threats – as he did with South Korea – saber-rattling cannot be ruled out. The pressure on him is rising. Prior to the Hong Kong unrest, Taiwan’s elections looked likely to return the pro-mainland Kuomintang (KMT) to power and remove the incumbent President Tsai – a boon for Beijing. That outlook has changed and Tsai now has a fighting chance of staying in power (Chart 16). The prospect of four more years of Tsai would not be too problematic for Beijing if not for the fact that the U.S. political establishment is now firmly in agreement on challenging China. But even if Tsai loses, Taiwan’s outlook is troublesome. And this makes Xi’s decision-making harder to predict. It is not that Tsai or her party will necessarily prevail. The manufacturing slowdown will take a toll and third-party candidates, particularly Ko Wen-je, would likely split Tsai’s vote. Moreover her Democratic Progressives still tie the KMT in opinion polling (Chart 17). The Taiwanese people are primarily concerned about maintaining the strong economy and cross-strait peace and stability, which her reelection could jeopardize (Chart 18). Tsai could very well lose, or she could be a lame duck presiding over the KMT in the legislature. Rather, the problem for Xi Jinping is that the Taiwanese people clearly sympathize with the protesters in Hong Kong (Chart 19). They fear that their own governance system faces the same fate as Hong Kong’s, with the Communist Party encroaching on traditional political liberties over time. While Hong Kong ultimately has zero choice as to whether to accept Beijing’s supremacy, Taiwan has much greater autonomy – and the military support of outside forces. It is not a foregone conclusion that Taiwan must suffer the same political dependency as Hong Kong. Indeed, Taiwan has a long history of exercising the democratic vote and has even dabbled into the realm of popular referendums. In short, Taiwan has a lot more dry powder for a political crisis in the long run than Hong Kong. But the Hong Kong events have accentuated this fact, for two key reasons: First, Taiwanese people identify increasingly as exclusively Taiwanese, rather than as both Taiwanese and Chinese (Chart 20). The incidents in Hong Kong reveal that this sentiment is tied to immediate political relations and therefore deterioration would encourage further alienation from the mainland. Second, while a strong majority of Taiwanese wish to maintain the political status quo to avoid conflict with the mainland, a substantial subset – approaching one-fourth – supports eventual or immediate independence (Chart 21). This means that relations with the mainland will eventually deteriorate even if the KMT wins the election. The KMT itself must respond to popular demand not to cozy up too much with Beijing, which is how it fell from power in 2016. Taiwan has a lot more dry powder for a political crisis than Hong Kong. Meanwhile, under KMT rule, Taiwan’s progressive-leaning youth are likely to set about reviving their protest movement in the subsequent years and imitating their Hong Kong peers, especially if the KMT warms up relations too fast with the mainland. Ultimately these points suggest that Xi Jinping will strive to avoid a violent crackdown in Hong Kong. A crackdown would be the surest way for him to harm the KMT in the Taiwanese election and to hasten the rebuilding of U.S.-Taiwan security ties. Call The President The best argument for Xi to lie low and avoid a larger crisis in Greater China is that it would unify the West and its allies against China. So far Xi’s foreign policy has not been so aggressive as to lead to diplomatic isolation. Europe is maintaining a studied neutrality due to its own differences with the United States; Asian neighbors are wary of provoking Chinese sanctions or military threats. A humanitarian crisis in Hong Kong or a “Fourth Taiwan Strait Crisis” would change that. For markets, the best-case scenario is that Xi Jinping exercises restraint. This would help Hong Kong protests lose steam, North Korean diplomacy get back on track, and Taiwanese independence sentiment simmer down. China would be more likely to halt U.S. tariffs and tech sanctions, settle a short-term trade agreement, and delay the upgrade in U.S.-Taiwan defense relations. China would still face adverse long-term political trends in both the U.S. and Taiwan, but an immediate crisis would be averted. The worst-case scenario is that Xi indulges his ambition. Hong Kong protests could explode, relations with Taiwan would deteriorate, and U.S.-China relations would move more rapidly in their downward spiral. Trade talks could collapse. Xi Jinping would face the possibility of a unified Western front, instability within Greater China, and a global recession. This might get rid of Donald Trump, but it would not get rid of the U.S. Congress, Navy, or Department of Defense. The choice seems pretty clear. Xi, like Trump, faces constraints that should motivate a tactical retreat from confrontation, at least after October 1. While this does not necessarily mean a settled trade agreement, it does suggest at least a ceasefire or truce. Our GeoRisk indicators show that market-based political risk in Taiwan – and less so South Korea – moves in keeping with global economic policy uncertainty. The underlying U.S.-China strategic confrontation and trade war are driving both (Chart 22). A deterioration in this region has global consequences. Chart 22U.S.-China Strategic Conflict Fuels Global Economic Uncertainty And Taiwanese Geopolitical Risk In Tandem Xi is a markedly aggressive “strongman” Chinese leader who has not been afraid to model his leadership on that of Chairman Mao. He could still overplay his hand. This is why we maintain that the odds of a U.S.-China trade agreement remain 40%, though we are prepared to upgrade that probability if Trump and Xi make pro-market decisions. Investment Implications On the three-month tactical horizon, BCA’s Geopolitical Strategy is paring back our tactical safe-haven trades: we are closing our “Doomsday Basket” of long gold and Swiss bonds for a gain of 13.6%, while maintaining our simple gold portfolio hedge going forward. Trump has not yet decisively staged his tactical retreat on trade policy, while rising political risk in Greater China increases uncertainty over Xi Jinping’s next moves. On the cyclical horizon, the above suggests that there is a light at the end of the tunnel – if both Trump and Xi recognize their political constraints. This means that there is still a political and geopolitical basis to reinforce BCA’s House View to remain optimistic on global and U.S. equities over the next 12 months, with the potential for non-U.S. equities to recover and bond yields to reverse their deep dive.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Negotiations between Trump and Xi are slated for September in Washington. There is a prospect for Trump to hold another summit with Communist Party General Secretary Xi Jinping on the sidelines of the United Nations General Assembly in New York in late September and at the APEC summit in Chile in mid-November. 2 Hong Kong is a Special Administrative Region of the People’s Republic of China, while Taiwan is recognized as a province or territory.

Analyses on the Philippines, Colombia and Argentina are available below. Highlights Global growth conditions, especially outside the U.S., remain bond friendly. Nevertheless, U.S. bonds are overbought and technical factors might exert upward pressure on them in the near term. Our ubiquitous premise remains that EM currencies and EM risk assets are primarily driven by cycles in global trade and the Chinese economy rather than U.S. growth and interest rates. There are no signs of investor capitulation that mark a major bottom in EM risk assets. Feature Given the recent plunge in bond yields around the world, we are devoting this week’s report to discussing the implications of low U.S. bond yields on EM risk assets. Our key takeaway is that lower U.S. bond yields are not a reason to be long EM risk assets and currencies. Low Bond Yields: Reflective Or Stimulative? With respect to ultra-low bond yield, investors and commentators generally subscribe to one of the following two arguments: Bond yields are reflective – i.e. they are indicative of an upcoming economic calamity and thereby signal a bearish outlook for equity and credit markets; The current low levels of bond yields signify a dovish monetary policy stance and hence are bullish for global risk assets. In our opinion, it is not a certainty that the bond market always has perfect foresight of the economic outlook. At the same time, falling global bond yields and easing central banks do not automatically ensure a pickup in global economic activity. Hence, low bond yields do not justify a bullish stance on global stocks and credit markets. Like any other financial market, bonds are driven by time-varying forces. In certain times, bond yields signal a correct trajectory for growth, inflation and monetary policy. At other times, bond prices are driven by investor sentiment and momentum-chasing trading strategies. In times where the latter is occurring, the bond market can send the wrong signal on growth and inflation, as well as misprice the future path of interest rates. U.S. bond yields are presently correct in signaling that global growth continues to decelerate. This is corroborated by many other indicators that we have been publishing.  Presently, we have the following observations and reflections on U.S. bond yields: U.S. bond yields are presently correct in signaling that global growth continues to decelerate. This is corroborated by many other indicators that we have been publishing. However, this does not imply that U.S. bond yields will be a reliable leading indicator at the bottom of this business cycle. The basis is that U.S. bond yields did not lead at the top of the cycle. On the contrary, U.S. bond yields lagged the global business cycles by a considerable margin in both 2015-‘16 and in 2018-’19, when the growth slowdown emanated from China/EM. Chart I-1 illustrates that Chinese nominal manufacturing output and import volume growth rolled over in December 2017, yet U.S. bond yields rolled over in October 2018. In recent years, U.S. bond yields have also lagged the global manufacturing PMI index by about six to nine months (Chart I-2, top panel). Chart I-1China’s Business Cycle Led U.S. Bond Yields Chart I-2Global Manufacturing And EM Stocks Led U.S. Bond Yields   Remarkably, EM financial markets have been leading U.S. bond yields in recent years, not the other way around (Chart I-2, bottom panel). For some time we have held the view that the ongoing growth slump in China would culminate into a global manufacturing and trade recession that would be negative for the rest of the world, especially for EM, Japan, commodities producers, and Germany. This theme has been the main reason for our negative view on global stocks, especially cyclicals, as well as our positive stance on safe-haven bonds and bullish view on the dollar.  Understanding the origins of this global manufacturing and trade downtrend is critical to gauging the evolution of the business cycle. China is the epicenter of this global trade and manufacturing recession. In turn, the root cause of the mainland’s growth slump is money/credit tightening that has occurred in China in both 2017 and early 2018. ​​​​Money and credit growth remain lackluster in the Middle Kingdom, despite ongoing fiscal and monetary policy easing (Chart I-3). Notably, domestic credit growth and its impulse have been muted, especially when issuance of government bonds is excluded (Chart I-4). The aggregate credit and fiscal stimulus have so far been insufficient to engineer a recovery. Chart I-3China: Fiscal Deficit And Broad Money Growth Chart I-4China: Private Sector Credit Growth Is Weak Federal Reserve’s policy tightening was not the reason behind the current worldwide manufacturing recession. U.S. domestic demand has not been the source of the ongoing global manufacturing and trade recession. U.S. final domestic demand was robust until Q4 2018 and has so far downshifted only modestly (Chart I-5, top panel). Corroborating this, U.S. manufacturing was the last shoe to drop in the global manufacturing recession (Chart I-5, bottom panel). Accordingly, the Federal Reserve’s policy tightening was not the reason behind the current worldwide manufacturing recession. It follows that lower U.S. interest rates might not be essential to instigate a global economic recovery. Critically, the latest plunge in EM currencies and widening in EM credit spreads has occurred amid falling U.S. bond yields and Fed easing. Chart I-5U.S. Economy And Bond Yields Have Lagged In This Cycle Chart I-6U.S. Bond Yields And EM: No Stable Correlation We have long argued against the consensus view that EM equities, credit markets and currencies are much more sensitive to U.S. interest rates than to the global business cycle. Chart I-6 reveals that there has been no stable correlation between U.S. bond yields and EM credit spreads and currencies. Therefore, a bottom in EM currencies and risk assets will occur when global trade and Chinese demand ameliorate rather than as a result of Fed policy. An important question is whether low bond yields are going to support global share prices. Our hunch is that it is not likely.1  First, if U.S. bond yields had not dropped by as much as they have, global equity prices would be lower. In short, reduced long-term interest rate expectations have led investors to pay higher multiples, especially for non-cyclical and growth stocks. The U.S. equity rally since early this year has been due to multiples expansion, especially among non-cyclical and growth stocks. Chart I-7Global Ex-U.S. Share Prices: No Bull Market Here The latter has allowed the S&P 500 to reach new highs recently at a time when global ex-U.S. share prices are not far from their December lows (Chart I-7). Second, falling interest rates are positive for share prices when profits are growing, even if at a slower rate. When corporate profits are contracting, lower interest rates typically do not preclude equity prices from dropping. Going forward, U.S. equities remain at risk due to a potential profit contraction. We do not foresee a recession in U.S. household spending. However, America’s corporate earnings will be under pressure from a stronger dollar and shrinking profit margins due to rising unit labor costs (Chart I-8), notwithstanding the manufacturing recession that is taking hold. Chart I-8U.S. Corporate Profits Are At Risk From Margins One popular narrative attributes exceptionally low bond yields to excess savings over investments. Yet this is not always accurate. Box I-1 below explains why bond yields have little relation to savings and investments in any economy. Chart I-9U.S. Bonds Are High-Yielders Among DM Finally, some investors wonder if the low/negative bond yields in DM ex-U.S. could push U.S. Treasury yields lower. Our take is that it is possible. The spread of U.S. Treasury yields over DM ex-U.S. is very wide, which could entice foreign fixed-income investors to purchase Uncle Sam’s bonds (Chart I-9). ​​​​​​What is preventing foreign fixed-income investors from piling into Treasuries is exchange rate risk. If for whatever reason a consensus emerges among global fixed-income investors that the greenback is not going to depreciate in the next 12-18 months, there could be a stampede of foreign investors into U.S. Treasuries, pushing yields considerably lower. In our opinion, the odds are that the broad trade-weighted dollar will stay firm for now and could make new cycle highs. In such a scenario, investor expectations of U.S. currency depreciation will diminish. This could trigger a stampede of foreign fixed-income investors into U.S. bonds. This is not a forecast but a consideration that bond investors should take into account. Bottom Line: Global growth conditions, especially outside the U.S., remain bond friendly. Nevertheless, bonds are overbought and technical factors discussed in Box I-1 below might exert upward pressure on U.S. bond yields in the near term. Implications For EM  We explore three scenarios for the direction of U.S. bond yields in the coming weeks and months and the corresponding potential dynamics for EM risk assets and currencies. Scenario 1: U.S. bond yields continue to fall as the global trade and manufacturing recession endures, suppressing global growth. Outcome: EM currencies will depreciate and EM risk assets will suffer more. Scenario 2: U.S. Treasury yields increase because U.S. domestic demand firms up, even if the global trade contraction persists.  Outcome: EM currencies will weaken and EM risk assets will sell off further. Scenario 3: U.S. bond yields rise because the global manufacturing recession abates and a recovery in China leads to a global trade revival. Outcome: EM currencies will appreciate and risk assets will rally considerably. Please note that Scenario 3 is not our baseline scenario. The ubiquitous premise in these deliberations is that EM currencies and EM risk assets are primarily driven by cycles in global trade and the Chinese economy rather than U.S. growth and interest rates. EM currencies and EM risk assets are primarily driven by cycles in global trade and the Chinese economy rather than U.S. growth and interest rates. Chart I-10Stay With Short EM Equities / Long 30-Year U.S. Bonds Strategy To capitalize on our view of weaker global growth emanating from China/EM, we have been recommending the following strategy: short EM stocks / long U.S. 30-year Treasuries. This recommendation has panned out nicely, delivering a 21.5% gain since its initiation on April 10, 2017 (Chart I-10). Barring Scenario 3 above, this trade has more upside. EM Financial Markets: No Capitulation So Far Major bottoms in financial markets typically occur after investor capitulation has already taken place. Having reviewed various financial market variables, we conclude that signposts of capitulation in EM risk assets and global equities are absent: The S&P 500 SKEW index is very low. This index reflects the probability that investors are assigning to downside risk in share prices. The SKEW index is currently at one of its lowest readings of the past 30 years (since its existence), which suggests that investors are not hedging themselves against large price swings (Chart I-11). This usually occurs prior to a heightened period of volatility. Chart I-11Are U.S. Equity Investors Complacent? The volatility measures for EM and commodity currencies are still very subdued (Chart I-12). The same is true for EM equity volatility (Chart I-12, bottom panel). Even though EM and commodities currencies as well as EM share prices have fallen substantially, the price of buying insurance is still low – meaning investors are still not particularly worried. This habitually is a sign of complacency. Chart I-12Cyclical Risk Markets: Implied Volatility Remains Low Chart I-13No Capitulation Among EM Equity And Currency Investors Finally, Chart I-13 shows that asset managers’ and leveraged funds’ net long positions in EM equity index futures and high-beta liquid currencies futures were still elevated as of August 15. Bottom Line: There are no signs of investor capitulation that often mark a major bottom in risk assets.   BOX 1 Do Bond Yields Equilibrate Savings And Investment? Mainstream economic theory regards bond yields as the interest rate that balances desired savings and desired investment. According to mainstream theory, when desired savings rise relative to desired investment, bond yields drop. The latter induces less savings and more investment equilibrating the system. Conversely, when desired investment increases relative to desired savings, bond yields climb, discouraging investment and incentivizing more savings. The fundamental shortcoming of this economic model stems from the misrepresentation of banking. When a commercial bank buys any security from a non-bank, it originates a new deposit “out of thin air.” The bank does not allocate someone’s deposit into bonds. Diagram I-1 below exhibits this point. When a U.S. bank purchases a dollar-denominated bond from a pension fund, it does not use someone’s deposit to do so. Rather, a new deposit in the U.S. banking system (often at another bank) is created “out of thin air” as a result of the transaction. The amount of bonds commercial banks can purchase is limited only by regulatory norms, liquidity provision by the central bank as well as its management’s willingness to do so. Nobody needs to save for a bank to buy a bond or make a loan.  We have written in past reports on money, credit and savings that deposits in the banking system have no relationship with national or household savings. When an individual or company saves, the amount of deposits in the banking system does not change. All in all, banks do not intermediate savings/deposits into credit/loans. They create new deposits “out of thin air” when they originate a loan to or buy any security from a non-bank. Provided that banks do not utilize national savings or existing deposits to acquire bonds, fluctuations in bond yields do not reflect changes in national savings. Holding everything else constant, bond yields could drop if commercial banks buy bonds en masse. The opposite also holds true. Chart I-14 demonstrates that U.S. commercial banks have been augmenting their purchases of various types of bonds. This partially explains why bond yields have plunged (bond yields shown inverted on this chart). If U.S. banks’ bonds purchases mean revert, as they often do, U.S. bond yields could rise. Chart I-14Are U.S. Banks' Purchases Of Bonds Driving Bond Yields? This along with more bond issuance by the U.S. Treasury to refill its Treasury’s General Account at the Fed as well as the existing overbought conditions in government bonds could produce a pick-up in yields. Such a rebound in bond yields would be technical and would not signal fundamental changes in the U.S. or global business cycles, or in the savings-investment balance.  Closing Some Positions Long Latin American / short emerging Asian equity indexes. This position has generated a 6% loss since its initiation on October 11, 2018 and we have low confidence that it will generate positive returns going forward. Long Chinese small cap / short EM small-cap stocks. Our bet has been that Chinese private sector companies trading in Hong Kong and represented in the MSCI small-cap index will perform better than the average EM small cap. This strategy has not worked out and has produced a 4.4% loss since its recommendation on November 20, 2013. We are downgrading Colombian equities from neutral to underweight. Please refer to pages 17-20 for a detailed analysis. Instead, we are upgrading the Peruvian bourse from underweight to a neutral allocation within an EM equity portfolio. Our view remains that gold prices will continue outperforming oil.2 Peru benefits from higher gold and silver prices while Colombia is largely an oil play. Consistently, the Peruvian currency will depreciate less than the Colombian peso. These justify this allocation shift between these two bourses.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Philippines: The Currency Holds The Key Government expenditures, in general, and infrastructure investment, in particular, will rise meaningfully in the next few months. Chart II-1Philippine Current Account Deficit Funded By Volatile Portfolio Flows Declining U.S. interest rates coupled with slumping oil prices have supported Philippine financial markets. However, the country’s balance of payments dynamics are still precarious. In particular, Philippine’s wide current account (CA) deficit will need to be funded by volatile foreign portfolio inflows as the basic balance – the sum of CA balance and net FDI – has turned negative (Chart II-1). Critically, the already wide current account deficit is set to balloon even further: First, the 2019 fiscal spending was back-loaded because a Congress impasse delayed the government budget approval to April. Hence, government expenditures, in general, and infrastructure investment, in particular, will rise meaningfully in the next few months. Higher infrastructure spending will drive imports of capital goods higher (Chart II-2). The latter accounts for 32% of total imports. Second, Philippine export growth is likely to contract anew as global trade is not recovering (Chart II-3). Chart II-2Philippine Government Infra Spending Will Accelerate Chart II-3Philippine Exports Will Contract We continue to expect broad portfolio capital outflows from EM. Potential for foreign outflows from the Philippines is large. Foreign ownership of local equities is high at 42%. As to foreign ownership of local currency bonds, it stands at around 13%. A renewed decline in the peso will drive away portfolio flows reinforcing additional currency depreciation. The falling peso will prevent the central bank from reducing interest rates further. Even if the central bank does not hike rates to support the peso, market-driven local rates could rise for a period of time. This is bad news for property stocks – which account for about 27% of the MSCI Philippines index. Having rallied considerably, they are at major risk as local interest rates rise. In addition, these stocks have benefited from strong real estate demand emanating from the Philippine Offshore Gaming Operators (POGO) sector – which itself has been largely driven by Chinese capital flows. Both the Chinese and Philippine authorities have begun cracking down fiercely on these operations because they are link to capital flight out of China. This crackdown will curtail capital flows into these areas and depress revenues of Philippine real estate companies. This will occur at a time when the residential market is experiencing weak demand. We continue to recommend shorting/underweighting property stocks. Finally, small cap stocks are in a bear market and are sending an ominous signal (Chart II-4). Furthermore, this bourse is neither attractive in absolute terms nor relative to EM (Chart II-5). Chart II-4Small-Cap Stocks Are In A Bear Market Chart II-5Philippine Equities Are Expensive Bottom Line: We continue recommending to short the Philippine peso against the U.S. dollar. Overall, EM dedicated investors should continue underweighting the Philippine equity, fixed income and sovereign credit markets within their respective EM universes. Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com Colombia: A Top In The Business Cycle? Colombia’s business cycle has reached a top and growth will slow considerably in the next 12 months. Falling oil prices and fiscal tightening will cause the Colombian economy to slow down in the next 12 months. What’s more, a depreciating peso and sticky inflation will prevent the central bank (Banrep) from frontloading rate cuts to mitigate the downtrend. The Colombian peso is making new cyclical lows and more weakness is in the cards. While the currency is slightly cheap according to the real effective exchange rate based on unit labor costs (Chart III-1), our negative view on oil prices entails further currency depreciation. Colombia is still very heavily reliant on oil exports – the current account deficit is 4.3% of GDP with oil, but 8.4% excluding it (Chart III-2). Moreover, a chunk of FDIs are destined for the energy sector, and foreign portfolio flows are contingent on exchange rate stability. Therefore, falling oil prices and a weaker peso will result in diminishing FDIs and foreign portfolio flows, reinforcing downward pressure on the currency. Chart III-1The Colombian Peso Is Not That Cheap Chart III-2Current Account Deficit Is Large And Widening Notably, there is a significant pass-through effect from the currency to inflation (Chart III-3). Even though Banrep does not target the exchange rate, having both headline and core inflation above the 3% central target will constrict it from cutting interest rates soon. On the whole, odds are that Colombia’s business cycle has reached a top and growth will slow considerably in the next 12 months. The yield curve is signaling an economic slowdown ahead (Chart III-4). Chart III_3The Exchange Rate And Inflation Chart III-4Domestic Demand Is About To Roll Over Our credit and fiscal spending impulse might be peaking, signifying a top in domestic demand growth (Chart III-5). The impulse is rolling over primarily due to the substantial fiscal tightening. Duque’s administration has slashed expenditures and the latter are contracting in inflation-adjusted terms (Chart III-6). Chart III-5A Top In The Business Cycle? Chart III-6Severe Fiscal Tightening   Government revenues are highly dependent on oil exports, and the recent fall in oil prices will bring about a contraction in fiscal revenues. This, and the government’s strong adherence to fiscal surplus, implies no loosening up on the fiscal side. Finally, our proxy for marginal propensity to spend for businesses and households is indicating that growth is about to roll over (Chart III-7). Auto sales are also weakening, and housing sales are contracting (Chart III-8). Chart III-7The Business Cycle Is Peaking Chart III-8Colombia: Certain Segments Have Turned Over Given that both fiscal and monetary policies are unlikely to be relaxed soon, the peso will come under renewed selling pressure, acting as a release valve for the Colombian economy. Investment Recommendations We are downgrading this bourse from neutral to an underweight allocation within a dedicated EM equity portfolio. In its place, we are upgrading Peruvian stocks from underweight to neutral. Continue shorting COP versus RUB. This trade has generated a 14% return since its initiation on May 31st of last year. Finally, within EM local currency bond and sovereign credit portfolios, Colombia warrants a neutral allocation. We also recommend fixed-income investors continue to bet on further yield curve flattening: receive 10-year / pay 1-year swap rates.   Juan Egaña, Research Associate juane@bcaresearch.com   Argentina: Do Not Catch A Falling Knife The latest rout in Argentine markets has brought fears of another sovereign debt default or restructuring. Are conditions right for buying Argentine markets? Politics complicate the assessment of a debt restructuring and we do not recommend bottom fishing in Argentine financial markets. Looking at the profile of past financial crises and debt defaults, there might be more downside in Argentine asset prices. Sovereign U.S. dollar bond prices remain well above their 2002 and 2008 lows (Chart IV-1). Compared with previous EM financial crises, Argentine stocks might still have considerable downside in U.S. dollar terms (Chart IV-2). Chart IV-1Things Could Get Worse Chart IV-2Historical Patterns Suggest More Downside In Bank Stocks The equity market index has relapsed below its 2018 lows in dollar terms, which technically qualifies as a breakdown and entails fresh lows ahead (Chart IV-3). Chart IV-3A Technical Breakdown In Argentine Equities In addition to political uncertainty and rising possibility of a left-wing run government, the nation’s ability to service its foreign currency debt has deteriorated with the currency plunging to new lows. Specifically, the country has large foreign debts of $275 billion. Foreign obligation payments in the next 12 months are about $40 billion. The government lacks foreign currency reserves and export revenues necessary to service its external debt. The central bank’s net foreign exchange reserves (excluding FX swaps and gold) are about $17 billion. The country’s annual exports are $77.5 billion. With agricultural commodities prices falling, exports will likely shrink. By and large, our downbeat stance from April remains intact. Bottom Line: Investors should continue avoiding and underweighting Argentine financial markets.   Andrija Vesic, Research Analyst andrijav@bcaresearch.com   Footnotes 1      Please note this is the view of BCA’s Emerging Markets Strategy service and is different from BCA’s house view. Clients can read the debate between various BCA strategists in the report What Goes On Between Those Walls? BCA’s Diverging Views In The Open. Please click on the link to access it. 2    We recommended the long gold / short copper and oil trade on July 11, 2019 and this position remains intact. Equities Recommendations Currencies, Fixed-Income And Credit Recommendations