Emerging Markets

Highlights The ongoing selloff in EM risk assets and commodities resembles a domino effect. Given that domino effects transpire in bear markets - not corrections - we believe that EM risk assets and commodities are indeed in a bear market. We continue to recommend short positions in EM risk assets and underweighting EM versus DM. Finally, we rank individual developing countries in terms of their vulnerability to foreign portfolio capital outflows based on their share of foreign equity and domestic bond holdings. Feature The fundamental case for our negative stance on EM risk assets continues to rest on the following: A deepening slowdown in global trade due to weakening demand in Chinese and EM economies alongside the Federal Reserve's determination to tighten policy are creating a toxic mix for EM risk assets, a stronger U.S. dollar and negative spillovers into DM markets. With the exception of China's latest trade data, which were inexplicably strong,1 recent trade data out of Asia indicate the region's exports are faltering, as evidenced by slumping outward shipments of Taiwan and Korea (Chart I-1). Chart I-1No Improvement In Asian Exports Importantly, not only has capital spending decelerated in China but household spending growth has also slowed considerably. Chart I-2 illustrates that the marginal propensity to spend among mainland households has diminished, passenger car sales are contracting and the nominal growth rate of retail sales of consumer goods has plummeted from 10% last year to 4%. Chart I-2Chinese Consumer Is Decelerating That said, observing past and current economic data alone does not offer enough information to gauge whether a selloff is a correction or a bear market. To assess the potential for further downside in risk assets, one needs to exercise judgement on the growth outlook. The latter is often contingent on the presence of imbalances and excesses as well as potential policy responses and their effectiveness. We have elaborated on these topics - in particular why lingering excesses and imbalances in China/EM could make the present global cyclical downturn extensive - at great length in past reports2 and we will not repeat our arguments today. Instead, this week we focus on the nature and character of the equity selloff to understand whether this is a correction or a bear market. In addition, we estimate the degree of foreign investors' positioning in individual EM equity and local bond markets, with the aim of gauging risks of potential portfolio outflows. Domino Effects Occur During Bear Markets Bear markets evolve in phases resembling domino effect-like patterns, where some markets lead while others lag. In contrast, corrections are abrupt and the majority of markets drop concurrently. For example, the EM crises in 1997-'98 did not occur simultaneously across all EM countries. It began in July 1997 with Thailand, then spread to Korea, Malaysia and Indonesia and finally to the rest of Asia. By August 1998, Russian financial markets had collapsed, triggering the Long-Term Capital Management (LTCM) debacle. The last leg of the crisis appeared in Brazil and culminated in the real's devaluation in January 1999. Similarly, the U.S. financial/credit crisis commenced with the selloff in sub-prime securities in March 2007. Corporate spreads began widening, and bank share prices rolled over in June 2007. Next, the S&P 500 and EM stocks peaked in October 2007 (Chart I-3). Despite these developments, commodities prices and EM currencies continued to rally until the summer of 2008, finally collapsing in the second half of that year (Chart I-3, bottom panel). Chart I-3Domino Effect In 2007-08 We discussed the nature of the current EM selloff in our June 14 report titled, "EM: Sustained Decoupling, Or Domino Effect?" In that report,3 we argued that the selloff in EM risk assets fits the pattern of a bear market - not a correction. We also noted that the odds of U.S. stocks and corporate bonds remaining resilient in the face of a deepening EM selloff were low. In the past month, U.S. equities and corporate bonds have sold off, validating our thesis. In terms of market dynamics, the following observations are noteworthy: The selloff in global risk assets that commenced early this year resembles that of a domino effect, and therefore fits the pattern of a bear market. Following the initial selloff in early February, U.S. stocks recovered and made new highs, but EM risk assets and DM ex-U.S. share prices continued to riot. Since early October, the selloff has snared U.S. stocks and more recently U.S. corporate bonds. Within the EM universe, it began with Turkey and Argentina, then spread to Indonesia, South Africa and Brazil. Chinese, Korean and Taiwanese equities held up until the middle of June. By the second half of June, the selloff spread to these markets as well, causing severe damage. A similar rotational selloff developed in the commodities space. Precious metals prices were the first to drop; followed by industrial metals. While oil made new highs in October, crude oil prices have lately recoupled to the downside. Interestingly, crude oil prices have rolled over at their very long-term moving averages - a phenomenon that often marks a major top and is followed by a large decline (Chart I-4). Chart I-4A Major Top In Oil In terms of market indicators, some of our favorites are signaling more downside in share prices. First, China's narrow money (M1) growth has been a good marker for EM share prices; currently, it is extremely weak and has not yet turned up (Chart I-5). Chart I-5Chinese Money Supply & EM Stocks Second, both U.S. and EM share prices always deflate in tandem with a rise in their corporate bond yields, as illustrated in Chart I-6. Chart I-6Corporate Bond Yields Point To Lower Share Prices Importantly, yields on Chinese property companies' offshore bonds have surged and spreads have widened dramatically (Chart I-7). Such high cost of capital entails a dismal outlook for construction activity and industries that are exposed to it. These include global industrials and materials. Chart I-7A Stress In Chinese Real Estate Credit Table I-1 segregates the EM equity selloffs of the past 35 years into corrections (Table I-1A) and bear markets (Table I-1B). The duration of the corrections range from one to three months, while for bear markets it is three to 19 months. The current EM equity selloff is already 9.5 months old and its drawdown is 25%. As such, it qualifies as a bear market, not a correction. Table I-1 Interestingly, this year the global equity index has exhibited a very similar profile to its 2000 top - Chart I-8 overlays the MSCI global stocks index in U.S. dollars with its profile in 1997-2002. Global share prices peaked in January 2000, attempted a failed breakout in March, and after several months of moving sideways, began plunging in September 2000. The behavior of the equity market this year is very similar to what happened in 2000. Chart I-82018 Top = 2000 Peak? This does not mean the current global equity selloff will last as long as or will be as severe as it was in 2000-2002, but the similarities between these episodes are noteworthy. Some investors have hypothesized that a blow-off phase in global stocks will likely occur when the Fed halts its tightening. Although this is a plausible argument, it is important to note that the rally in global stocks from the early 2016 lows to the tops reached this year was of similar magnitude to the surge that occurred in global equities from their 1998 lows to their peak in 2000. Is a widely expected blow-off phase in global share prices behind us? Only time will tell. Finally, the U.S. equal-weighted stock index as well as share prices of Goldman Sachs and J.P. Morgan - the two financial behemoths leveraged to financial markets - have exhibited negative technical chart patterns (Chart I-9). These are also warnings signals for U.S. share prices and risk assets worldwide. Chart I-9Bearish Technicals In U.S. Stocks How far will this selloff go? Table I-2 compares the current selloff with the one in 2015, when global manufacturing and trade growth flirted with contraction and global cyclical sectors plunged due to a slowdown in China and EM. Table I-2Drawdown In Various Equity Indexes In 2015 And 2018 The current selloff is likely to be at least as bad, if not worse. This is because EM risk assets have entered this selloff more overbought than they were in 2015. We discuss the topic in the following section. Bottom Line: The selloff in EM risk assets and currencies has further to run. Stay short / underweight. EM Portfolio Outflows: Vulnerability Ranking The U.S. dollar is attempting to break out to new cyclical highs, and the odds are in its favor. Both the Fed's tightening and the ongoing global trade slowdown will foster the U.S. dollar rally. As EM currencies depreciate further, there will be considerable pressure on foreign investors to sell their EM assets. To gauge how vulnerable various developing countries are to foreign capital outflows, we have determined how individual countries rank with respect to their share of foreign equity and domestic bond holdings. Table I-3 ranks individual bourses by the share of foreign equity ownership in their largest companies accounting for at least two-thirds of market cap.4 Table I-3What Is The Share Of Foreign Ownership In Local Bourses? This ranking illustrates that South Africa, the Czech Republic, Taiwan, Russia and Hungary have the highest share of foreign holdings, while Colombia, Malaysia, Chile, Thailand and Indonesia have the lowest. China is not a part of this list because its investable stocks are traded in various jurisdictions, making it difficult to define foreign investor ownership. To put the current penetration of foreign ownership into historical perspective, Table I-4 juxtaposes the current share of foreign stock ownership for select bourses with the one from March 2015 - just before the freefall in EM share prices. The share of foreign ownership is larger now than back in March 2015 for Brazil, Turkey and India, while it is lower for Indonesia and unchanged for Russia. Table I-4Share Of Foreign Ownership In Stocks: March 2015 Vs. Today Foreign purchases of local currency bonds have been a major source of capital flows for developing countries as well. Critically, exchange rates substantially influence foreign investors' returns in EM local bonds, as illustrated in Chart I-10. Therefore, EM currency depreciation will lead to further outflows from their local bonds. Chart I-10Return On EM Domestic Bonds: In USD & Local Currency Table I-5 demonstrates that foreigners hold the largest share of domestic bonds in Peru, the Czech Republic, South Africa, Indonesia and Mexico. Meanwhile, India, Brazil, Korea, Thailand and Hungary have the lowest share of foreign investors in their local currency bonds. Table I-5Share Of Domestic Bonds Held By Foreigners The scatter plot in Chart I-11 brings together the share of foreign ownership of equities on the X axis with the share of foreign ownership of local currency bonds on the Y axis. Chart I-11EM Portfolio Outflow Vulnerability Assessment Based on this diagram, South Africa, the Czech Republic, Peru, Mexico and Russia seem to be the most at risk of foreign portfolio outflows, while Colombia, Malaysia, Thailand and India seem to be the least vulnerable. These rankings are only one of the indicators we look at when forming our asset allocation across EM countries. We are currently overweight equity markets in Korea, Thailand, Brazil, Mexico, Colombia, Chile, Russia and central Europe. Our equity underweights are Indonesia, India, the Philippines, Hong Kong, South Africa and Peru. In the local-currency bond space, we favor Korea, Thailand, Brazil, Mexico, Chile, Russia and central Europe. The markets to underweight or avoid are Indonesia, the Philippines, Malaysia, South Africa and India. A complete list of our overweights and underweights across EM equities, fixed-income, credit and currencies as well as specific trade recommendations can be found each week at the end of our reports (please see pages 11-12). Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Most likely they reflect the frontrunning of U.S. import tariffs. 2 Please see Emerging Markets Strategy Weekly Report "Is The EM Pendulum About To Swing Back?" dated November 8, 2018, the link is available on page 13. 3 Please see Emerging Markets Strategy Weekly Report "EM: Sustained Decoupling, Or Domino Effect?" dated June 14, 2018, available at ems.bcaresearch.com. 4 We weighted each company's share of foreign stock ownership by their respective market cap weight. The result is an equity market cap-weighted proxy for the share of foreign stock ownership by country. All of these data are from Bloomberg Finance L.P. and dates as of November 12, 2018. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights When we flagged the increasing likelihood of higher volatility a few weeks ago, we did not expect the Trump Administration's granting of waivers on sanctions against Iranian oil exports, which ultimately led to the oil-price meltdown.1 Neither, it seems, did the market, as the surge in Brent and WTI implied volatilities attests (Chart of the Week). Chart of the WeekOil-Price Volatility Surges As Markets Process Conflicting News In one fell swoop, the Trump Administration's volte-face on Iran oil-export sanctions transformed the threat of an oil-price spike to $100/bbl in 1Q19 into a price rout. Whether that persists depends on how OPEC 2.0 responds to sharply higher short-term supply. Our updated supply - demand balances and price forecast are highly conditional on our expectation OPEC 2.0 will reduce output in response to the 1mm+ b/d or so of oil put back into the market early next year because of waivers. Inventories globally are at risk of swelling once again, if OPEC 2.0 does not cut output. OPEC 2.0's interests will conflict with the Trump Administration's agenda. Going into OPEC 2.0's December 6 meeting in Vienna, we lowered our 2019 Brent expectation $82/bbl, and continue to expect WTI to trade $6/bbl below that. We expect volatility to persist. Energy: Overweight. Natgas futures raced above $4.00/MMBtu on the NYMEX as the U.S. heating season kicked off with inventories of 3.2 TCF - 16% below their five-year average, and the lowest since 2005, according to EIA data. Base Metals: Neutral. China's benchmark copper treatment and refining charges are expected to remain on either side of $82.25/MT next year, as concentrate supply tightens slightly, Metal Bulletin's Fastmarkets reported. Precious Metals: Neutral. The Fed is on course to lift the fed funds range 25bp to 2.25% - 2.50% at its December meeting, which will keep gold under pressure. Ags/Softs: Underweight. The USDA's latest ending stocks estimates for the 2018/19 crop year came in below trade expectations for corn and wheat - at 1.74 billion and 949mm bushels, respectively, vs. expectations of 1.78 billion and 969mm, according to agriculture.com. Soybean estimates came in at 955mm vs. an expected 906mm bushels. Feature Brent and WTI crude oil prices air-dropped from a high of $86.10/bbl in early October to a Wednesday low of $65.01/bbl as we went to press. This was a 24% drop in a little more than a month, reflecting the difficulty markets experienced recalibrating supply - demand balances in the wake of the Trump Administration's volte-face on Iranian export sanctions, which took effect last week. Over the past weeks, markets appear to be pricing the return of more than 1mm b/d of Iranian exports in 1Q19, on the back of these waivers for importers of Iranian crude. The full extent of the additional volumes that will be allowed back on the market still is unknown. Lacking certain information, market participants have to assume the waivers will dramatically expand short-term supplies, which already had been boosted by OPEC 2.0 and U.S. producers, in the lead-up to sanctions (Table 1).2 The sell-off on the back of the waivers did, however, dissipate some of the risk premium we identified in prices in October, and brought price more in line with actual balances (Chart 2).3 Table 1BCA Global Oil Supply - Demand Balances (MMb/d) (Base Case Balances) Chart 2Oil Risk Premium Dissipates Prior to the granting of waivers, markets were girding for sanctions-induced losses of as much as 1.7mm b/d. Now markets could see a far lower supply loss of 500k b/d in Iranian exports. This lower loss of exports from Iran reduced expected prices by $10/bbl in 1H19, vs. our previous expectation of $85/bbl for 1H19 using our ensemble forecast (Chart 3). For market participants hedging or trading based on the expectation of higher losses of Iranian exports, the granting of waivers creates even more "new-found" and unanticipated supply. In a simulation with the waivers extended to end-2019, average 2019 Brent prices fall to $75/bbl vs. $82/bbl using our current assumptions. Chart 3OPEC 2.0 Production Hike Pushes Price Spike To 2Q19 In our estimation, "finding" this much supply via waivers amounts to a supply shock. This was compounded by surging U.S. crude and liquids production, which is boosting oil and product exports from America. Uncertain Balances, Volatile Prices Waivers are not the only factor contributing to price volatility. Fears of weaker global demand come up repeatedly - particularly as regards Asia in general, and China in particular.4 Those fears are not showing up in actual demand. In our balances estimates, we expect demand growth of 1.46mm b/d next year, down slightly from our previous estimate, given realized oil consumption remains strong (Chart 4 and Table 1). Supporting data - e.g., EM import volumes - continue to indicate incomes are holding up. Chart 4Demand Expected To Hold; Supply Highly Conditional On OPEC 2.0 On the supply side, references to an apparent disagreement between the Kingdom of Saudi Arabia (KSA) and Russia - the leaders of OPEC 2.0 - over the need to cut 1mm b/d of production next year, to keep inventories from once again swelling as they did in 2014 - 2016, compounding risks.5 While it appears KSA has carried the day on the need to cut production, that could change at OPEC 2.0's December meeting in Vienna. Output from OPEC 2.0's weakest member states - i.e., Libya and Nigeria - remains strong. Even Venezuela's rate of decline slowed some. Therefore, even without the waivers, KSA and its Gulf Arab allies would have had to reduce output to make room for these states, which are desperately trying to rebuild war-torn infrastructure. In addition to the OPEC 2.0 output surge, U.S. production has been unexpectedly strong, as have U.S. crude and refined product exports (Chart 5). The EIA - in an adjustment that surprised its analysts - revised its U.S. production estimate for October by 400k b/d vs. September's estimate to 11.4mm b/d. Production in the Big 4 shale plays - Permian, Eagle Ford, Bakken, Niobrara - is proving to be even stronger as well (Chart 6). U.S. shale output will be just under 8mm b/d by December, months ahead of schedule. The infrastructure buildout in the Permian will no doubt absorb this production and the subsequent growth in shale output by ~1.35mm b/d next year easily. Chart 5U.S. Production, Exports Surge Chart 6U.S. Shale Production Will Surge U.S. producers do not have an interest in managing their production. OPEC 2.0 does, however. We expect KSA and its Gulf Arab allies to reduce production in December and keep it low until the recently formed overhang brought on by the waivers to Iranian sanctions clears. This means OECD inventory levels will once again be a key variable for OPEC 2.0 in its production management decisions (Chart 7). Chart 7Once Again, OECD Stocks Are OPEC 2.0's Policy Variable We assume KSA will mobilize 800k to 1mm b/d of cuts in the coalition's production at least through 1H19. KSA already has said it will reduce exports by 500k b/d in Dec18, and that could be extended to Jun19. We also expect the rest of the Gulf Arab producers to follow suit, and cut back on the production increases they brought on line at President Trump's urging. By 2H19, the waivers will have expired, but U.S. shale output will be surging and newly built pipelines will be filling. We have been carrying lower 2H19 OPEC 2.0, particularly KSA, production estimates in anticipation of this increased production and exports from the U.S. (Table 1). OPEC 2.0 + 1? President Trump apparently wants to continue to have a say in OPEC 2.0's policy deliberations, as he obviously did in the run-up to U.S. mid-term elections earlier this year. In response to persistent messaging from President Trump, KSA, Russia and their allies surged production ~ 750k b/d in July - November over their 1H18 output, in preparation for the U.S. sanctions against Iran. In addition to pushing for higher production, the U.S. has taken a more activist approach to boosting oil production among U.S. allies, possibly ahead of another attempt to impose sanctions on Iran when the current waivers expire next year in June, assuming the 180-day wind-down begins in January. For example, the U.S. has taken a more active role in re-starting exports of oil from Iraq's semi-autonomous Kurdish province - some 400k b/d, which would flow to Turkey and on to Western consumers. Without higher production from Iraq and others in OPEC 2.0, the Iran waivers almost surely will have to be extended when they expire. As we have shown in our research, Brent prices mostly likely would push toward $100/bbl without a substantial increase in spare capacity within OPEC 2.0.6 President Trump gives every impression he and his administration now share our assessment, as the FT noted: "US president Donald Trump said this week he was 'driving' oil prices down and that he had granted waivers to some of Iran's customers as he did not want to see '$100 a barrel or $150 a barrel' crude."7 BCA's Geopolitical Strategy notes the waivers also send two very important messages to KSA: "First, the U.S. cares about its domestic economic stability. Second, the U.S. does not care about Saudi domestic economic stability. Our commodity strategists believe that Saudi fiscal breakeven oil price is around $85. As such, the U.S. decision to slow-roll the sanctions against Iran will be received with chagrin in Riyadh, especially as the latter will now have to shoulder both lower oil prices and the American request for higher output."8 Forecasting supply-demand fundamentals and, therefore, prices in this environment is extremely difficult, as it involves reconciling conflicting goals between the Trump Administration and OPEC 2.0. If President Trump prevails and KSA increases output - against its own best interests, given it requires higher prices to fund its budget - then prices will be lower for longer, once again. We are inclined to believe President Trump's alarm bells start sounding when oil prices are approaching the $85/bbl level. This also is the price level KSA needs to fund its fiscal obligations. For this reason, we expect KSA and its Gulf allies to reduce output in the near term until the waivers-induced overhang clears. Depending on how quickly they act, this could be done in fairly short order. Bottom Line: Volatility likely will persist as global markets absorb an unexpected supply surge resulting from the Trump Administration's last-minute volte-face on Iranian export sanctions, which is compounded by the supply ramp undertaken by OPEC 2.0 ahead of sanctions being imposed, and surging U.S. production gains. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity," published on October 25, 2018. It is available at ces.bcaresearch.com. 2 OPEC 2.0 is the name we coined for the OPEC - non-OPEC producer coalition formed at the end of the price collapse of 2014 - 16 to get control over global output and bring down swollen crude oil and refined product inventories. The coalition meets December 6 in Vienna to consider formalizing the union as a production-management cartel. 3 Our price-decomposition model's residual term is our proxy for the risk premium in oil prices. This is the red bar in Chart 2. Please see discussion in "Risk Premium In Oil Prices rising; KSA Lifts West Coast Export Capacity," which is cited above. 4 Please see "Asia's weakening economies, record supply threaten to create oil glut," published November 14, 2018, by uk.reuters.com. 5 Please see "OPEC and Russia Prepare for Clash Over Oil Output Cuts," published online by the Wall Street Journal November 9, 2018. 6 Please see BCA Research's Commodity & Energy Strategy Weekly Reports "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl," published on September 20, 2018, and "Risks From Unplanned Oil-Outage Rising; OPEC 2.0's Spare Capacity Is Suspect," published September 27, 2018. Both are available at ces.bcaresearch.com. 7 Please see "Iraq close to deal to restart oil exports from Kirkuk," published by the Financial Times November 9, 2018. 8 Please see BCA Research's Geopolitical Strategy Weekly Report "Insights From The Road - Constraints And Investing," published on November 14, 2018. It is available at gps.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Special Report

Highlights Chinese pro-consumption policy stimulus will likely stabilize Chinese household consumption growth at 8-10% over the next 12-15 months, with service consumption continuing to be the key driver. Our research shows that Chinese nominal retail sales of consumer goods are currently growing at only 3-4%, significantly lower than the 9-10% pace that the Chinese government has reported, and that the market has commonly quoted. We expect it to rebound moderately to 4-6% in 2019 on the government's pro-consumption stimulus. The services sector including healthcare, education, travel, entertainment, sports, high-tech, daycare for kids, nursing homes for the elderly, and so on will likely experience strong growth. In the consumer discretionary space, car sales will also likely rebound as the country may soon release stimulus measures supporting the auto industry. For now, we advise overweighting consumer discretionary stocks versus the benchmark. We also recommend going long consumer discretionary versus consumer staples. Feature The Chinese economy is in transition from investment- and export-led growth to consumer-led growth. With faltering investment growth and escalating China-U.S. trade tensions, the strength and durability of Chinese household consumption has become all the more important to the country's economic growth. To address increasing challenges facing the economy, the government over the past several months has released a slew of policies aimed at stimulating domestic consumption. Our focus in this week's report is to outline these policies and in turn gauge what the strength of Chinese household consumption will be over the next 12-15 months. In order to do this, some key questions need to be addressed, including: What is the current growth rate of household consumption? What pro-consumption policies have already been implemented, and what additional policies are likely on the way? How effective will stimulus be on Chinese household consumption this time around? One of our key findings is that Chinese nominal retail sales of consumer goods - a common proxy for Chinese household spending - is currently growing at only 3-4%, significantly lower than the 9-10% pace the Chinese government has reported, and that the market has commonly quoted (Chart 1). Chart Retail Sales Growth Measure: Which One Is Accurate? Another important finding is that recent pro-consumption policy stimulus will likely increase household income levels by 400-500 billion RMB. In addition, we expect more pro-consumption policies from the Chinese government later this year or early 2019 - i.e., cutting car sales taxes or giving out subsidies to encourage households' purchases of automobiles, especially in rural areas, and/or lowering the policy rate to spur spending by reducing households' borrowing costs. This will stabilize Chinese household consumption growth at 8-10% over the next 12-15 months, with service consumption continuing to be the key driver. Making Sense Of The Data According to the National Bureau of Statistics (NBS) data, Chinese nominal household consumption accounted for about 40% of GDP last year, and grew 8.2% year-on-year (about 9-10% in 2015 and 2016). We estimate that currently about 65-70% of Chinese household consumption is consumer goods, with the remainder going to services. Goods consumption Chinese retail sales figures are probably the most-often-used among market participants as a proxy for Chinese household consumption, despite the fact that the data only provide a partial picture of Chinese household spending: spending on consumer goods. Based on the NBS's definition, Chinese total retail sales of consumer goods refer to the sum of retail sales of commodities sold to urban and rural households for household consumption, and to social institutions for public consumption for non-production purposes. Chinese total retail sales also include online goods sales but do not include online service sales. They also do not include many service sectors including education, medical care, travel, entertainment, eldercare and childcare. In short, while Chinese retail sales cannot represent the full picture of Chinese household consumption, they can indeed reveal the strength of Chinese household consumption on consumer goods. The most quoted retail sales growth data by the majority of market participants is from the NBS - a straight growth number that the bureau reported every month - which recently decelerated to 9% (the dotted line in Chart 1). The bureau does not give out information about how to calculate this growth data. The NBS also reports the level data of retail sales every month, from which the year-on-year growth actually plunged to 3.8% (the solid line in Chart 1). Which one is more accurate? All of the findings below suggest the validity of the growth estimates we calculated from the level of NBS retail sales. For major consuming discretionary goods like cars, washing machines, air conditioners, refrigerators and TVs, all products excluding TVs exhibited a sharp drop in sales volume growth this year (Chart 2). Chart 2Falling Sales Volume Nearly Across The Board From Discretionary Goods... Some major consumer staples such as dairy products, soft drinks and liquor - also experienced a sharp decline in sales-volume terms (Chart 3). Chart 3...To Major Consumer Staples The sub-categories of total nominal retail sales in value terms also showed a significant slowdown in terms of urban and rural, and in terms of commodity goods and catering (Chart 4). Chart 4Weakness In Retail Sales From Urban To Rural Meanwhile, 26 out of 31 provinces experienced retail sales growth slower than 6% for the first six months, with three provinces - Shandong, Jilin and Guizhou - in contraction. Why did Chinese retail sales experience such a significant drop this year? We believe it is because households' sentiment and willingness to consume has diminished considerably (Chart 5). Chart 5Falling Marginal Propensity To Consume The cracking down of peer-to-peer lending, falling stock prices and high mortgage payments this year have all reduced household wealth. Mortgage interest payments currently account for nearly 50% of the nation's household disposable income, higher than 45% a year ago.1 In addition, rising China-U.S. trade tensions have also increased uncertainty on future income growth and affected confidence. Service consumption If our estimate of Chinese retail sales growth can correctly capture the strength of consumer goods consumption, what data can be used to measure services consumption. Chart 6 can at least provide some sense in gauging the strength of household service consumption, as tourism, medical services and entertainment services (i.e., movie box office receipts) are all major household service consumption components. In the meantime, online services sales can also somewhat reflect the overall strength of Chinese household services consumption. Chart 6Services Consumption Still Growing At A Double Digit Pace Chart 6 clearly shows that despite the growth deceleration, nominal services consumption growth is currently still quite strong - in the range of 10-15% - considerably higher than the 3-4% growth in nominal consumer goods consumption. To gauge how Chinese nominal household consumption growth will be going forward, we need to assess the pro-consumption policies that have already been implemented. Consumption Stimulus A flurry of pro-consumption policies has been announced over the past several months, aiming at spurring consumer spending to support the country's underlying economic growth. Personal tax cuts and tax exemptions will increase households' ability to spend, while improvements in the quality of goods and services supplied and more availability of high-quality products will also encourage consumption. On October 21, China unveiled a new income tax law to boost consumption. The law increases the tax-free threshold from 3,000 RMB per month to 5,000 RMB per month and expands the lower tax brackets, effective October 1, 2018. It also adds new itemized tax deductions related to education, housing, eldercare, childcare and medical care, which will come into effect on January 1, 2019. Additional details of the new itemized deductions have so far not been released. The Ministry of Finance estimates that the tax changes will collectively lift household incomes by approximately 320 billion RMB. This is equivalent to about 1% of household consumption expenditures, or about 0.4% of GDP. Given that the total amount of personal income tax was 1.2 trillion RMB last year, the total tax deduction from the new income law and new itemized tax deductions should be much smaller than the amount of total personal income tax. Assuming 40-50% of the 1.2 trillion RMB personal tax will be deducted in 2019, this will be equal to about 500-600 billion RMB in household incomes (1.6-1.9% of household consumption expenditures, and about 0.6-0.7% of GDP). On September 20, the government released a policy guideline: "New measures to spur residential consumption." Two weeks later, on October 11, the government announced a "three-year (2018-2020) action plan to stimulate domestic consumption." The government's plan is geared to facilitating a virtuous cycle in which boosting consumption leads to supply innovation, and subsequently improvement in new consumption growth. According to the plan, the authority will widen the openness of seven key service sectors for private and / or overseas companies to enter in sectors such as tourism, culture, sports, healthcare, eldercare, home services and education/training. The country aims to develop rental markets, promote new-energy automobiles, support high-tech products (VR, robots, etc.), encourage green consumption and upgrade the quality of existing goods and services. Insufficient high-quality supply in these service sectors have in the past curbed consumption growth to some extent. By boosting the supply of high-quality services, the government expects to increase consumption in these sectors. Starting on July 1, China reduced import tariffs on 1449 imported items, resulting in a decline in average import tariffs from 15.7% to 6.9%. Starting on November 1, the government further lowered tariffs with most-favored nations on an additional 1585 items with the average tax rate falling from 10.5% to 7.8%. Clearly, there are two trends from these policies. First, the services sector including healthcare, education, travel, entertainment, sports, high-tech, childcare, eldercare, and so on will benefit most, as households in general have high demand for these services and are willing to spend more on these sectors (Chart 7). Chart 7Service Consumption Vs. Consumer Staples Consumption: Higher Growth For example, while China's aging population will have increasing demands for medical and eldercare service, the termination of the one-child policy will continue to boost demand for childcare and education services. Food and clothing accounts for about 35% of total Chinese household consumption expenditures (Chart 8), significantly higher than the 21% proportion in South Korea. Meanwhile, Chinese consumers spend 11% of their disposable income on education, culture and recreation, lower than the 17% figure in South Korea. Chart 8Chinese Household Consumption Structure Second, the supply of high-quality consumer goods and high-quality services will strongly increase in response to rising demand of wealthier Chinese consumers. This increase in supply will be met by both domestic production of goods and services and overseas imports. What additional policies could be implemented in the remainder of 2018 and 2019? The government may release more supportive policies to promote car sales - i.e., reducing the sales tax on cars with a capacity of 1.6L or lower, or providing subsidies on car purchases. They have implemented similar stimulus measures since 2008. If recent pro-consumption policies and supportive policies for the auto industry still cannot revive household consumption strongly enough, the authorities may cut the policy rate to spur additional spending. After knowing the probable scale of the pro-consumption stimulus, we can now put everything together to see what Chinese household consumption growth could be in 2019. How Strong Will Household Consumption Be? Structurally, we believe growth in Chinese household consumption is facing strong headwinds, including lower household income growth in real terms (inflation-adjusted) because of slowing productivity growth and rising household debt levels (Chart 9). Chart 9Structural Headwinds For Chinese Household Consumption Growth However, over the next 12-15 months, we still expect the government's pro-consumption policies to be able to stabilize domestic household consumption growth at 8-10%. We estimated in the first section that the new income law and itemized tax deduction policy will likely release about 500-600 billion RMB of income available for spending. The ratio of marginal propensity to consume gauges the proportion of one additional unit of disposable income spent on consumption. We estimated that the marginal propensity to consume for Chinese households is currently at about 50%. This will result in 250-300 billion RMB spending on household consumption, equaling about 0.7-0.8% of 2017 Chinese retail sales of consumer goods (36.6 trillion RMB), or 0.8-0.9% of household consumption expenditures. Autos will be another major potential driver of overall household consumption growth. China has stimulated the car industry by slashing the auto sales tax from 10% to 5% in 2009-2010 and again in 2015-2016. As a result, the volume of passenger car sales jumped 50% in 2009 and 15% in 2016, respectively (Chart 10). While car sales have dropped each time the stimulus measures have expired, a temporary growth rebound in auto sales in 2019 is still possible. Chart 10The Government May Stimulate The Auto Market Again As car sales volumes are currently in double-digit contraction, the Chinese government is likely to implement similar stimulus measures in late 2018 or early 2019. If so, Chinese car sales in volume terms may rebound by 5-10% in 2019. By the end of last year, the measure of urban households with cars was about 37.5 out of 100. There is still plenty of upside, with the rural areas having much bigger potential for car sales than urban areas. The value of Chinese auto sales was 4.2 trillion RMB last year. It increased 280 billion RMB in 2016 and 220 billion in 2017, but decreased 220 billion for the first nine months of this year. Assuming a 5% growth in the auto sales value next year because of the stimulus, it will be about 200 billion RMB increase, equivalent to 0.2% of 2017 GDP or 0.6% of household consumption expenditures. Although households have already taken out much more in the way of consumer loans for purchases of homes and other day-to-day expenses, with plenty of consumption-related stimulus policy in place, consumer loan growth will likely continue to grow in the double digits in 2019 (Chart 11). In September, household loans for short-term consumption (non-mortgage) grew at 28% year-on-year. Chart 11Consumer Loan Growth May Remain Strong In 2019 Chart 12 shows that the breakdown of household borrowing - medium- and long-term consumption loans (mostly mortgage loans) accounted for 60% of total household borrowing. Chart 12Most Of Consumption Loans Are Mortgage With the property market now slowing down and a gradual decline in the Chinese central bank's PSL lending,2 property sold has been decelerating (Chart 13). This may lead to less mortgage borrowing, leaving more loans available for short-term spending. Chart 13Household Borrowing In 2019: Less For Mortgage And More For Consumption? How different is this round of stimulus versus the previous two episodes? First, the strength of household consumption growth due to recent policy stimuli will be much weaker than the 2009-2010 and 2015-2016 episodes (Chart 14). Chart 14Stimulus Impact On Household Consumption Growth In 2019: Less Than Previous Episodes Home appliance markets like TVs, air conditioners, washing machines and refrigerators have already entered a mature phase. On average, as of the end of 2017 there were already 133 TVs, 100.3 air conditioners, 97.1 washing machines and 97.2 refrigerators for every 100 urban households (Chart 15, top panel). Even in rural areas, as of the end of last year there were 120 TVs, 52.6 air conditioners, 86.3 washing machines and 91.7 refrigerators for every 100 households, significantly higher than 2008 levels (Chart 15, bottom panel). Chart 15Home Appliance Markets: More Mature Than The Auto Market Second, this time the stimulus is focusing more on the services sector, while the previous two episodes were more on consumer goods. As result, this time the stimulus will have much less impact on commodities than the previous two episodes, in which major commodity goods sales and production experienced significant growth. Overall, China's pro-consumption policies will likely stabilize Chinese household consumption growth at 8-10% over the next 12-15 months, with services consumption remaining the key driver. We expect household service consumption to continue to grow at 10-15%, and retail sales growth to rebound to 4-6% from 3-4%. Investment Implications Chinese pro-consumption policy will likely benefit services and the automobile industry more than consumer staples. Meanwhile, commodity sectors may not benefit much. For now, we recommend overweighting the domestic consumer discretionary sector versus the Chinese CSI300 benchmark, a trade that we are initiating as of today (Chart 16, top panel). The sector's relative P/E and P/B valuations versus the benchmark also suggest its relative attractiveness (Chart 16, middle and bottom panels). Chart 16Overweight Consumer Discretionary Versus Benchmark China's pro-consumption stimulus also warrants the opposite position of what was one of our most successful trades over the past year (long investable staples / short investable discretionary), which we closed at the end of September for a profit of 48%.3 Within the domestic market, investors should go long consumer discretionary versus consumer staples, a trade that we are also initiating as of today (Chart 17). In addition to the cyclical tailwind from policy, relative valuation ratios suggest that the former is likely to outperform the later. Chart 17Go Long Consumer Discretionary Versus Consumer Staples Finally, our conclusion that policymakers are likely to succeed at stabilizing household consumption growth has implications beyond the relative performance of consumer stocks. Our outlook for a stable consumer over the coming year supports the argument that China will not push for a significant reacceleration in credit growth as a response to ongoing economic weakness, and argues in favor of our view that the "strike price" of the China put option has fallen. As we have noted in previous reports, we have no doubt that Chinese policymakers will eventually move to a maximum reflationary stance if they feel that the existing slowdown will lead to deep, threatening economic instability. But it will be impossible for investors and policymakers to make a judgement about the true odds of such an outcome without hard evidence of the magnitude of the tariff-induced export shock, which for now remains obscured by trade front-running (which may persist until the new year). This means that it is too soon to bottom fish deeply oversold Chinese financial assets (such as A-shares), and China-related plays more generally. Ellen JingYuan He, Associate Vice President Emerging Markets Strategy EllenJ@bcaresearch.com 1 Pease refer to Table 1 in the China Investment Strategy Special Reports "China's Property Market: Where Will It Go From Here? ", dated September 13, and Table 1 in the Emerging Markets Strategy Special Report "China Real Estate: A Never-Bursting Bubble?", dated April 6, 2018, available at ems.bcaresearch.com. 2 Pease see China Investment Strategy Special Report "China's Property Market: Where Will It Go From Here?", dated September 13, 2018, available at cis.bcaresearch.com. 3 Pease see China Investment Strategy Special Reports "GICS Sector Changes: The Implications For China", dated September 26, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights So What? The Trump administration is focusing on re-election in 2020, which could push the recession call into 2021. Why? The midterms were investment-relevant, just not in the way most of our clients thought. We are downgrading our alarmism on Iran; Trump is aware of his constraints. But investor optimism regarding the trade war may be overdone. China has contained its capital outflows, which suggests Beijing will be comfortable with more CNY/USD downside. A new GPS mega-theme: Bifurcated Capitalism! Watch carefully for any upcoming trade action on semiconductors. Feature There is no better feeling than hearing from our clients that we got a call wrong because we misjudged the constraints of the Trump administration by focusing too much on its preferences. Why? Because it means that clients are keeping us honest by employing our most important method: constraints over preferences. This is one of the takeaways from a quarter filled with meetings with our clients in the Midwest, Toronto, Amsterdam, Rotterdam, The Hague, Frankfurt, Berlin, Auckland, Melbourne, Sydney, Dubai, Abu Dhabi, and sunny Marbella, Spain! In this report, we discuss several pieces of insight from our clients. Midterms Are Investment Relevant Generally speaking, few of our clients agreed with our assessment that the midterm elections were not investment-relevant. The further away from the U.S. we traveled, the greater the sense among investors that equity markets influence U.S. politics: both the upcoming takeover of the House of Representatives by the Democratic Party and the odds of trade war intensification. We strongly disagree with this assessment. Both periods of equity market turbulence this year were preceded by a rising U.S. 10-year yield, not any particularly damning trade war chatter (Chart 1). In fact, the intensification of the trade war this summer occurred amidst a fairly buoyant S&P 500! Meanwhile, the odds of a Democratic takeover of the House were priced in well before the October equity decline began. Chart 1Yields, Not Trade, Matter For Stocks Generally speaking, even midterms that produce gridlock have led to a relief rally (Chart 2). This time could be the same, especially because the likely next Speaker of the House, Nancy Pelosi, has signalled that the main policy goal for 2019 would be infrastructure spending. In her "victory" speech following the election, Pelosi mentioned infrastructure numerous times (impeachment, zero times). Chart 2Stocks Are Indifferent To Midterm Results Democratic Representative Peter DeFazio, likely head of the House of Representatives committee overseeing transportation, has already signalled that he will ask for "real money, real investment."1 DeFazio has previously proposed a $500bn infrastructure plan, backed by issuance of 30-year Treasuries and raising fuel taxes. He has rejected the February 2017 Trump proposal, which largely relied on raising private money for the job. Would President Trump go with such a plan? Maybe. In early 2018, he stunned lawmakers by saying that he supported hiking the federal gasoline tax by 25 cents a gallon (the federal 18.4 cent-a-gallon gasoline tax has not been hiked since 1993). He has since confirmed that "everything is on the table" to achieve an infrastructure deal. Several clients from around the world pointed out that both Democrats and President Trump have an incentive to make a deal. President Trump wants to avoid the deeply negative fiscal thrust awaiting him in 2020 (Chart 3). Given the House takeover by the Democrats, it is tough to imagine that new tax cuts are the means for Trump to avoid the "stimulus cliff." As such, another round of stimulative fiscal spending may be the only way for him to avoid a late-2020 recession (although the latter is currently the BCA House View). Chart 3Can Trump And Pelosi Reverse... Democrats, on the other hand, have an incentive to ditch "Resistance" and embrace policy-making. Yes, hastening the recession in 2020 would be the Machiavellian play, but President Trump would be able to blame Democrats for the downturn - since they will necessarily have had to participate in planning an infrastructure bill only to sink it. They also learned the lesson from the January 2018 government shutdown, which backfired at the polls and forced Senate Democrats to come to an agreement quickly on a two-year stimulative budget deal. What about the GOP fiscal conservatives? They don't necessarily need to come on board. The House is held by Democrats. And the Democrats in the Senate would only need 15-18 GOP Senators to support a profligate infrastructure plan. Given that infrastructure is popular, that the president will be pushing it, and that the GOP-controlled Senate agreed with the budget bill in January, we think that even more Republican Senators can go along with an infrastructure plan. Another big takeaway from the midterms is that the GOP suffered deep losses in the Midwest. President Trump's party lost ten out of twelve races in the region (Table 1). The two most representative contests were the loss of Republican Wisconsin Governor and one-time rising presidential star Scott Walker, and the victory of the left-wing and über-protectionist Democratic Senator Sherrod Brown of Ohio. Table 1Massive Republican Losses Across The Midwest Senator Brown won his contest comfortably by 6.4% in a state that Trump carried by 8.13%. The appeal of Brown to the very blue-collar voters that Trump himself won is obvious. On trade, there is no daylight between the left-wing Brown and President Trump. Meanwhile, Walker, an establishment Republican who built his reputation on busting public-sector unions, could not replicate Trump's success in Wisconsin. Several of our clients suggested that the GOP performance in the Midwest was poor because of the aggressive trade rhetoric. But that makes little sense. Republicans did not run Trump-style populists in the Midwest, to their obvious detriment. Democrats have always claimed to be for "fair trade" rather than "free trade." And we know, empirically, that Trump saw a key swing of turnout in 2016 in these states, largely thanks to his protectionist rhetoric (Chart 4). Chart 4Trump Owes The Midwest The Presidency President Trump cannot take Michigan, Pennsylvania, and Wisconsin lightly. His performance in 2016 was extraordinary, but also tight. The Democrats will win these states if Trump does not grow voter turnout and support, according to demographic projections - and they lost them by less than a percentage point of white voters (Map 1). As such, we think that Democrats will talk tough on trade and try to reclaim their union and blue-collar voters, while President Trump has to double down on an aggressive trade posture towards China. Map 1Can 'White Hype' Work In 2020? Trump's Margins Are Small The midterms are investment relevant after all, but not in the way some might think. The Democratic takeover of the House, and the resultant gridlock, will potentially avert the "stimulus cliff" in 2020. This ought to support short-term inflation expectations and thus allow the Fed to stay-the-course. For markets, this could be unsettling given the correlation between yields and downturns in 2018. For the dollar, this should be supportive. The odds of an infrastructure deal are good, above 50%, with the key risk being a Democratic House focused on impeaching Trump. Such a bill would augur even higher levels of fiscal spending through 2020, possibly prolonging the business cycle, and setting up an even wider budget deficit when the next recession hits (Chart 5). Chart 5Pro-Cyclical Policy Has To Continue Meanwhile, the shellacking in the Midwest ought to embolden the president to go even harder against China on trade. Rather than the upcoming Xi-Trump meeting in Buenos Aires, the key bellwether of this thesis is whether Trump signals afterwards that he will implement the tariff rate hike on January 1, 2019 (and whether he announces a third round of tariffs). Bottom Line: Go long building products and construction material stocks. Stay short China-exposed S&P 500 companies. The 10-year yield may end the year even closer to 3.5% when the market realizes that the odds of an infrastructure deal are higher than previously thought. The political path of least resistance in the U.S. continues to point towards greater profligacy. Trump Is Aware Of His Constraints In The Middle East Throughout 2018, we have flagged U.S.-Iran tensions as the risk for 2019. In early October, we went long Brent / short S&P 500 as a hedge against this risk, a trade that we closed for a 6% gain last week. During our meetings with clients this quarter, however, several astute observers pointed out that in our own analyses we have stressed the geopolitical and political constraints to President Trump. First, we have argued that the original 2015 nuclear deal signed by President Obama had a deep geopolitical logic, allowing the U.S. to pivot to Asia and stare down China by geopolitically deleveraging the U.S. from the Middle East. If President Trump undermined the détente with Iran, he would be opening up a two-front conflict with both China and Iran, diluting his administration's focus and capabilities. Second, we noted that a rise in oil prices could precipitate an early recession and push up gasoline prices in 2019, a probable death knell for any president's re-election prospects. Our clients were right to ask: Why would President Trump face down these constraints, given the high cost that he would incur? We did not have a very good answer to this question. It is difficult to understand President Trump's preferences for raising tensions against Iran beyond the fact that he promised to do so in his campaign, appears to want to undermine all of President Obama's policies, and turned to Iran hawks to head his foreign policy. Are these preferences worth the risk of a recession in 2019? Or worth the risk of triggering yet another military conflict in the Middle East over a country that only 7% of Americans consider is the 'greatest enemy' (Chart 6)? Chart 6Americans Don't Perceive Iran As 'The Greatest Enemy' Given that the administration has offered exemptions to the oil embargo to eight key importers, it now appears that President Trump is well aware of his geopolitical and domestic constraints. The combined imports of Iranian oil by these eight states is ~1.4mm b/d. While we do not have the detail of the volumes that will be allowed under the waivers, it is likely that these Iranian sales will recover some of the ~1mm b/d of exports lost already (Chart 7). Chart 7Waivers Will Restore Iranian Exports For 180 Days What does this mean for investors? On one hand, it means that the risk of oil prices spiking north of $100 per barrel have substantively decreased. On the other hand, however, it also means that the Trump administration agrees with BCA's Commodity & Energy Strategy view that oil markets remain tight and that OPEC 2.0's spare capacity may be a constraint to future production increases. Bottom Line: The risks of an oil-price-shock-induced 2019 recession have fallen. However, oil prices may yet surge in 2019 to the $85-95 level (Brent) on the back of supply risks in Venezuela and Iran, especially if Saudi Arabia and Russia prove unable to expand production much beyond their current levels. Most of our clients in the Middle East shared the skepticism of our commodity strategists that Saudi Arabia would be able to increase production much higher than current levels in 2019. However, the view was not unanimous. Risks Of Saudi Arabia Going Rogue Have Declined Clients in the Middle East were convinced that the murder of journalist Jamal Khashoggi would have no impact on Saudi oil production decisions. However, the insight from the region is that the incident has probably ended the "blank cheque" that the Trump administration initially gave Riyadh on foreign policy. For global investors, this may not have a major impact. But it may have been at least part of the administration's reasoning behind giving embargo exemptions to such a large number of economies. The incident has likely forced Saudi Arabia to adjust its calculus on three issues: Qatar: The Saudi-Qatari split never made much sense in the first place. It was initially endorsed by President Trump, who may not have understood the strategic value of Qatar to the United States. Defense Secretary James Mattis almost immediately responded by reaffirming the U.S. commitment to the Persian Gulf country which hosts one of the most strategic U.S. air bases in the world. Yemen: The U.S. has now openly called on Saudi Arabia to end its military operations in Yemen. We would expect Riyadh to acquiesce to the request. Iran: With the U.S. giving major importers of Iranian oil exemptions, the message is twofold. First, the U.S. cares about its domestic economic stability. Second, the U.S. does not care about Saudi domestic economic stability. Our commodity strategists believe that Saudi fiscal breakeven oil price is around $85. As such, the U.S. decision to slow-roll the sanctions against Iran will be received with chagrin in Riyadh, especially as the latter will now have to shoulder both lower oil prices and the American request for higher output. Could Saudi Arabia break with the U.S.? Not a chance. The U.S. is the Saudis' security guarantor. As such, it is up to Saudi Arabia to acquiesce to American foreign policy goals, not the other way around. While we think that President Trump ultimately succumbed to geopolitical and political constraints when he decided to take the "phoney war" approach to Iran, he may have been nudged in that direction by Khashoggi's tragic murder. Bottom Line: A major risk for investors in 2019 was that the Trump administration would treat Saudi preferences for a major confrontation with Iran as its own interests. Such a strategy would have destabilized the global oil markets and potentially have unwound the 2015 U.S.-Iran détente that has allowed the U.S. to focus on China. However, the death of Khashoggi has marginally hurt President Trump domestically - given that it makes him look soft on Saudi Arabia, an unpopular stance in the U.S. Moreover, the administration has come to grips with the risks of a dire oil shock should Iran retaliate. The shift in U.S. policy vis-à-vis Saudi Arabia will therefore refocus the Trump administration on its own priorities, not that of its ally in the Middle East. Trade War Is All About CNY/USD In The Short Term... Clients in Australia and New Zealand are the most sophisticated Western investors when it comes to China. The level of macro understanding of the Chinese economy and the markets in these two countries is unparalleled (outside of China itself, of course). We therefore always appreciate the insights we pick up from our clients Down Under. And they are convinced that the massive capital outflow from China has clearly ceased. The flow of Chinese capital into Auckland, Melbourne, and Sydney real estate has definitely slowed, and anecdotal evidence appears to be showing up in the price data (Chart 8). Separately, this intel has been confirmed by clients from British Columbia and California. Chart 8Pacific Rim Home Prices Rolling Over The reality is that China has successfully closed its capital account. How else can we explain that a 4.7% CNY/USD depreciation in 2015 precipitated a $483 billion outflow of forex reserves, whereas a 10.1% depreciation this year has not had a major impact (Chart 9)? Chart 9On Balance, China Is Experiencing Modest Outflows To be fair, forex reserves declined by $34bn in October, but that is still a far cry from the panic in 2015. Our other indicators suggest that the impact on capital seepage is muted this time around, largely due to the official crackdown on various forms of capital outflows: Quarterly data (Chart 10) reflecting the change in foreign exchange reserves minus the sum of the current account balance and FDI, indicate that while net inflows have remained negative, they are still a far cry from 2015 levels. Chart 10Far Cry From 2016 Crisis Import data (Chart 11) no longer show the massive deviation between Chinese national statistics and IMF figures. Imports from Hong Kong (Chart 12), specifically, are now down to normal levels, with the fake invoicing problem having quieted down for now. Chart 11No More Confusion Regarding Imports Chart 12Fake Invoicing Has Been Curbed Growth rate of foreign reserves (Chart 13) is not clearly contracting yet, and has been positive this year. Chart 13Severe FX Reserve Drawdown Has Ended Chinese foreign borrowing (Chart 14) is down from stratospheric levels, which limits the volume of potential outflows. Chart 14China's Foreign Lending Has Eased And the orgy of M&A and investment deals in the U.S. (Chart 15) has ended. Chart 15M&A Deals Have Eased Bottom Line: Anecdotal and official data suggest that capital outflows are in check despite their recent uptick. This could embolden Chinese leaders to continue using CNY/USD depreciation as their primary weapon against President Trump's tariffs, especially if the global backdrop is not collapsing. An increase of the 10% tariff rate to 25% on January 1 could, therefore, precipitate further weakness in the CNY/USD. The announcement of a third round of tariffs covering the remainder of Chinese imports could do the same. This would be negative for global risk assets, particularly EM equities and currencies. ... In the Long Term, Bifurcated Capitalism Our annual pilgrimage to Oceania included our traditional meeting with The Smartest Man In Oceania The Bloke From Down Under.2 He shares our belief that the long-term result of the broader Sino-American geopolitical conflict will be a form of Bifurcated Capitalism. His exact words were that "countries may soon have to choose between being in the Amazon or Alibaba camp," a great real-world implication of our mega-theme. Australian and New Zealand clients are particularly sensitive to the idea that the world may soon be split into spheres of influence because both countries are so high-beta to China, while obviously retaining their membership card in the West. Our suspicion is that both will be fine as they export mainly a high-grade and diversified range of commodities to China. Short of war, it is unlikely that the U.S. will one day demand that New Zealand stop its dairy exports to China, or that Australia stop iron ore and LNG exports. Countries exporting semiconductors to China, on the other hand, could face a choice between enforcing a future embargo or incurring the wrath of their closest military ally. The Bloke From Down Under has pointed out that, given China's dependency on semiconductor technology, a U.S. embargo of this critical tech could be comparable to the U.S. oil embargo against Japan that precipitated the latter's attack on Pearl Harbor. Chart 16China Accounts For 60% Of Global Semiconductor Demand The global semiconductor market reached $354 billion in 2016, with China accounting for 60% of total consumption (Chart 16). Despite the country's insatiable appetite for semiconductors, no Chinese firm is among the world's top 20 makers. This is why Beijing's "Made in China 2025" plan has focused so much on semiconductor capability (Chart 17). The goal is for China to become self-sufficient in semiconductors, gaining 35% share of the global design market. Chart 17China's High-Tech Protectionism A key feature of Bifurcated Capitalism will be impairment of investment in high-tech that has dual-use applications in military. Semiconductors obviously make that list. Another key feature would be investment restrictions in such high-tech sectors, particularly the kind of investments and M&A deals that China has been looking for in the U.S. this decade. Further, clients in California are very concerned about the U.S.'s proposed export controls, which would cut off access to China and wreak havoc on the industry. The Trump administration has already signalled that it will restrict Chinese inbound investment. Congress passed, with a large bipartisan majority, an expanded review system, the Foreign Investment Risk Review Modernization Act (FIRRMA). The law has expanded the purview of the Committee on Foreign Investment in the United States (CFIUS), a secretive interagency panel nominally under control of the Treasury Department that can block inbound investment on national security grounds. CFIUS, at its core, has always been an entity focused on China. While the Treasury Department initially signalled it would take as much as 18 months to adopt the new FIRRMA rules, Secretary Mnuchin has accelerated the process. The procedure now will expand review from only large-stake takeovers to joint ventures and smaller investments by foreigners, particularly in technology deemed critical for national security reasons. This oversight began on November 10 and will allow CFIUS to block foreigners from taking a stake in a business making sensitive technology even if it gives the foreign investors merely a board seat. Countries of "special concern" will inherently receive heightened scrutiny, and a country's history of compliance with U.S. law, as well as cybersecurity and American citizens' privacy, will be considerations. A new interagency process led by the Commerce Department will focus on refurbishing export controls so as to protect "emerging and foundational technologies." Such impediments to capital flows are likely to become endemic and expand beyond the U.S. We may be seeing the first steps in the Bifurcated Capitalism concept that one day comes to dominate the global economy. Entire countries and sectors may become off-limits to Western investors and vice-versa for Chinese market participants. At the very least, companies whose revenue growth is currently slated to come from expansion in overseas markets may see those expectations falter. At its most pessimistic, however, Bifurcated Capitalism may precipitate geopolitical conflict if it denies China or the U.S. critical technology or commodities. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see David Shepardson, "Democrats to push for big infrastructure bill with 'real money' in 2019," Reuters, dated November 7, 2018, available at reuters.com. 2 At the time of publication, the said investor was unable to secure the permission of his wife for the "The Smartest Man" moniker. Geopolitical Calendar

As is tradition, during client visits in Europe last week, I had the pleasure of reconnecting with Ms. Mea, a long-term BCA client.1 It was our third encounter and, as always, Ms. Mea was eager to delve into our reasoning, challenge our views and strategy, as well as gauge our conviction level. We devote this week's report to key parts of our dialogue. I hope clients find it insightful and beneficial. Ms. Mea: Isn't the EM selloff and underperformance already overextended? I am afraid you will overstay your negative view on EM risk assets as happened in 2016. What are you watching to ensure you alter your stance as and when appropriate? Answer: I am very cognizant of not overstaying my negative stance on EM. I viewed the EM/China rally from their 2016 lows as a mid-cycle outperformance in a structural downtrend.2 Consequently, I argued the rally was not sustainable and that it was a matter of time before EMs and China-plays entered into a new bear market. Barring perfect timing, it was difficult to make money during that rally. Investors who averaged in EM stocks and local bonds over the past three years (including late 2015/early 2016 lows) and did not sell early this year have not made money. The current down-leg in EM financial markets may be the last phase of the bear market/underperformance that began in 2011, and it will eventually create a major buying opportunity. That said, this bear market will likely last much longer and be larger in magnitude than many investors expect. In the recent report titled EMs Are In A Bear Market, I elaborated on why this is a bear market and not just a correction. We also discussed how much further it might go.3 Big-picture macro themes - such as China/EM credit excesses and misallocation of capital - have informed my core views in recent years. Notwithstanding, I am watching various market signals that often lead economic data and are typically early in signaling a reversal in financial markets. Just a few examples of market signals and indicators I am following closely: Turns in EM corporate bond yields often coincide with reversals in EM stocks. For now, EM corporate bond yields are rising, and hence they do not signal a bottom in EM share prices (Chart I-1, top panel). Chart I-1EM/Asian Corporate Bonds Signal Downside Risks To Share Prices The same holds true for Emerging Asian markets: surging corporate bond yields are heralding further declines in Asian share prices (Chart I-1, bottom panel). Our Risk-on versus Safe-Haven (RSH) currency ratio positively correlates with EM equity prices. The RSH ratio has recently rebounded but has not broken above its 200-day moving average (Chart I-2). Hence, there is no meaningful buy signal as of yet. Chart I-2Our Market Risk Indicator The annual rate of change of this indicator leads the global trade cycles and entails further slowdown in global trade (Chart I-3). Chart I-3Global Trade Slowdown Is Not Over Finally, a number of EM equity indexes - small-caps and an equal-weighted index - have broken below their 3-year moving averages (Chart I-4). This entails that the selloff in EM stocks is very broad-based. It could also entail that the overall EM index will likely break below its 3-year moving average as well (Chart I-4, bottom panel). Chart I-4EM Equity Selloff Has Been Broad-Based Apart from market signals, I am also monitoring economic data, and so far, there are few signs of a revival in global trade or EM growth. The EM manufacturing PMI is falling (Chart I-5, top panel). Manufacturing output growth in Asia and Germany are decelerating sharply (Chart I-5, bottom panel). When global trade growth underwhelms, EM risk assets and currencies fare poorly. Chart I-5Global Growth And EM Credit Spreads Remarkably, both panels of Chart I-5 corroborate that the key reason for the EM selloff this year has not been the Federal Reserve tightening but the deceleration in global trade. We do not foresee a reversal in global trade and China/EM growth deceleration in the coming months. This heralds maintaining our negative view on EM risk assets and currencies for now. Ms. Mea: It is true that China is slowing, but policymakers are also stimulating and a lot of bad news may already be priced into China-related markets. Why do you believe there is more downside in China-related markets and EM risk assets from today's levels? Answer: Indeed, China is easing policy, but policy stimulus has so far been limited. It also works with a time lag. First, the bottoms in the money and the combined credit and fiscal spending impulses preceded the trough in EM and commodities by 6 months at the bottom in 2015 and by about 15 months at the top in 2017 (Chart I-6). Even if the money as well as credit and fiscal impulses bottom today it could take several more months before the selloff in EM financial markets and commodities prices abates. Chart I-6China: Money, Credit And Fiscal Impulses And Financial Markets Second, the stimulus has so far been limited. The recently increased issuance of special bonds by local governments was already part of this year's budget. Simply, it was delayed early this year and has been pushed into the third quarter. In addition, there are reports that 42% of this recent special bond issuance will be used for rural land purchases rather than infrastructure spending.4 The former will not boost economic activity and demand for raw materials and industrial goods. Additionally, the ongoing regulatory tightening of banks and non-bank financial institutions will hinder these institutions' willingness and ability to extend credit, despite lower interest rates. We discussed in a recent report5 that both the effectiveness of the monetary transmission mechanism and the time lag between policy easing and a bottom in the business cycle are contingent on the money multiplier (creditors' willingness to lend and borrowers' readiness to borrow) and the velocity of money (marginal propensity to spend among households and companies). On both accounts, odds are that the transmission mechanism will be slower and somewhat impaired this time around than in the past. Chart I-7 illustrates that the marginal propensity to spend/invest by companies is diminishing, and it has historically defined the primary trend in industrial metals prices. Chart I-7China: Companies Are Turning More Cautious On Capex Third, most of the fiscal stimulus - tax cuts and income tax deductions - are designed to raise household incomes. This will primarily help spending on some consumer goods and services. Yet, there will be little help for property sales, construction and infrastructure spending. These three types of spending drive most of the demand for commodities, materials and industrial goods. In turn, industrial goods, machinery, commodities and materials account for about 80% of total Chinese imports. Hence, the channels by which China affects the rest of the world are via imports of capital goods, materials and commodities. Overall, China's tax reforms will have little bearing on its imports from other countries. The latter are heavily exposed to the mainland's construction and infrastructure spending, which in turn are driven by the Chinese credit cycle. This is why we spend so much time analyzing mainland money and credit cycles. Finally, the significance of U.S. import tariffs for the Chinese economy should be put into perspective. China's exports to the U.S. make up only 3.6% of its GDP. This compares with the mainland's total exports of 20% and capital spending of 42% of GDP (Chart I-8). Chart I-8What Drives China's Growth Consequently, capital spending is much more important to the Middle Kingdom's growth than its shipments to the U.S. That said, the trade confrontation between the U.S. and China is likely already negatively affecting overall business and consumer confidence in China (Chart I-9). Chart I-9China: Service Sector Is Moderating In addition, Chart I-10 illustrates that China's manufacturing PMI for export orders have plunged, signifying an imminent slump in its exports. This could be due to its shipments not only to the U.S. but also to developing economies, which account for a larger share of total exports than shipments to the U.S. and EU combined. Considerable depreciation in EM currencies has made their imports more expensive, dampening their capacity to import. Chart I-10Chinese Exports Are At Risk In brief, China's growth will continue to disappoint, weighing on China plays in financial markets. Ms. Mea: Why has strong U.S. growth not helped global trade, China and EM in general? How do U.S. economic and financial markets enter into your analysis about the world and EM? Answer: One common mistake that many commentators make is to form a view on the U.S. growth outlook and then extrapolate it to the rest of the world. The U.S. economy is still the largest, but it is no longer the sole dominant force in the global economy. Chart I-11 shows that U.S. and EU annual imports are equal to $2.5 and $2.2 trillion, respectively. Combined annual imports of China and the rest of EM amount to $6 trillion - hence, they are much larger than the aggregate imports of U.S. and EU. This is why global trade can deviate from time to time from U.S. domestic demand cycles. Chart I-11EM Imports Are Larger Than U.S. And EU Imports Together That said, due to their sheer size, U.S. financial markets have a much larger impact on global markets than U.S. imports do on global trade. EM financial markets are greatly influenced by their counterparts in the U.S. In this respect, we have a few observations: U.S. growth is robust, the labor market is tight and core inflation is rising. Barring a major deflation shock from EM, the path of least resistance for U.S. bond yields and the fed funds rate is up. Continued rate hikes by the Fed constitute a major menace to EM risk assets. For now, the growth divergence between the U.S. and rest of the world will continue to be manifested in a stronger U.S. dollar. This is a bad omen for EMs. Chart I-12A Risk To U.S. Share Prices Rising U.S. corporate bond yields have historically been associated with lower U.S. share prices, and presently portend a further drop in American equities (Chart I-12). Finally, the surge in equity market leaders - specifically, new economy stocks - has been on par with previous bubbles, as shown in Chart I-13. Chart I-13History Of Financial Bubbles It is impossible to know whether or not this is a bubble that has already reached its top. But the magnitude and speed of the rally, at minimum, warrant a consolidation phase. On the whole, Fed tightening, rising corporate bond yields, a strong dollar and elevated valuations warrant further correction in U.S. share prices. This will reinforce the downtrend in EM risk assets. Ms. Mea: Are fundamentals in many EM countries not better today than they were amid the taper tantrum in 2013? Specifically, current account balances in many developing nations have improved and their currencies have cheapened. Answer: Your observation is correct - current account deficits have improved and currencies have become much cheaper than before. Nevertheless, these are necessary but not sufficient conditions to turn bullish: First, marginal shifts in balance of payments drive exchange rates. Even though current account deficits are currently smaller and currencies are moderately cheap in many EMs, a deterioration in their current accounts due to weakening exports in general and falling commodities prices in particular will depress their currencies. In this context, China's imports are critical. As they decelerate, EM ex-China's current account balances will deteriorate and their exchange rates will depreciate. Second, current account surpluses do not always preclude currency depreciation. Chart I-14 shows that the Korean won, the Taiwanese dollar and the Malaysian ringgit experienced bouts of depreciation, despite running current account surpluses. Chart I-14Current Account Surpluses And Exchange Rates Third, emerging Asian currencies are at a risk from another spell of RMB depreciation. Chart I-15 illustrates that CNY/USD exchange rate correlates with the interest rate differential between China and the U.S. As the Fed hikes rates further and the People's Bank of China (PBoC) keep interest rates stable, the yuan will likely depreciate against the greenback. Chart I-15CNY/USD And Interest Rates Despite capital controls, it seems the interest rate differential affects the exchange rate in China too. Given the ongoing growth slowdown and declining return on capital in China, there are rising pressures for capital to exit the country. If the authorities push up interest rates to make the yuan attractive to hold, it will hurt the already overleveraged and weak economy. If the PBoC reduces interest rates further to help the real economy, the RMB will come under depreciation pressure. Given the constraints Chinese policymakers are facing, reducing interest rates and allowing the yuan to depreciate further is the least-worst outcome for the nation. Yet, this will rattle Asian currencies and risk assets. Finally, EM currency valuations are but particularly cheap, except Argentina, Turkey and Mexico as depicted in Chart I-16A & Chart I-16B. When currency valuations are not at an extreme, they usually do not matter for the medium-term outlook. Chart I-16AEM Currency Valuations Chart I-16BEM Currency Valuations As to the EM fixed-income market, exchange rates are the key driver of their performance. Currencies depreciation causes a selloff in high-yielding local currency bonds and typically leads to credit spread widening. The latter occurs because U.S. dollar debt becomes more difficult to service when the value of local currency declines. Besides, EM currencies usually weaken amid a global trade slowdown and falling commodities prices. The latter two undermine issuers' revenues and their capacity to service debt, warranting wider credit spreads. Ms. Mea: What about equity valuations? Aren't they cheap? Chart I-17EM Equity Multiples Answer: EM stocks are not very cheap. Our composite valuation indicator based on a 20% trimmed mean of trailing and forward P/Es, PBV, price-to-cash earnings and price-to-dividend ratios denotes a slightly attractive valuation (Chart I-17). According to our cyclically-adjusted P/E ratio, EM equities are also moderately cheap (Chart I-18). Chart I-18EM Equities: Cyclically-Adjusted P/E Ratio In short, EM equity valuations are modestly cheap. As with currencies, however, unless valuations are at an extreme (say, one or two-standard deviations from their mean), they may not matter for a while. Barring extreme over- or undervaluation, share prices are typically driven by profit cycles. Importantly, EM corporate earnings are set to decelerate further and probably contract in the first half of 2019 (Chart I-19). If this scenario transpires, share prices will drop further, regardless of valuations. Chart I-19EM Corporate Earnings Are At Risk Ms. Mea: Why don't you write about risks to your view? And, I would like to use this opportunity to ask what are the risks to your view presently? Answer: The basis of why I do not write about the risks to my view is as follows: The risks to a view are often the cases when the key pillars of analysis do not play out. It follows that in these cases, the risks to the view are obvious and there is no need to write about them. To sum up our discussion today, the key pillars of my view are: China's policy stimulus has so far been moderate and the stimulus usually works with a time lag. Additionally, the combination of the regulatory tightening on banks and non-bank financial organizations and the lingering credit and property market excesses in China will generate a growth slowdown that will be longer and deeper than the markets currently expect. The Fed will continue ratcheting up rates as U.S. core inflation is grinding higher. The combination of the above three will produce weaker global growth, a stronger U.S. dollar, and lower commodities prices. All in all, these are bearish for EM risk assets. It is evident that if these themes and assumptions are incorrect, the view will be wrong. Hence, writing that the risks to my view are that my assumptions and themes are mistaken is nothing other than tautology. That said, there are seldom cases when the underlying economic themes and the assumptions are valid, yet the investment recommendations are amiss. These are, in fact, true risks to the view and they are worthy of discussion. Yet, identifying in advance what could go wrong when the analysis and assumption are accurate is very difficult. Presently, I can think of one reason why my investment recommendations could be erroneous even if my economic themes end up being largely valid: It is the shortage of investable assets worldwide relative to capital that is looking to be invested. Quantitative easing programs in the advanced economies have shrunk the size of investable assets. As a result, too much money is chasing too few assets. Consequently, the risk to my view is that EM assets never become sufficiently cheap and that fundamentals do not matter that much. In other words, investors could rush back into EM risk assets despite the poor growth backdrop and not-so-cheap valuations. This is akin to a game of musical chairs where the number of participants is greater than the number of chairs. To complicate things, some chairs are broken, i.e., some assets are of bad quality. As a result, game participants (i.e., investors) are now facing a tough choice between (1) being somewhat prudent and risking being left without a chair; or (2) rushing in and getting either a good chair or a broken chair (depending on luck). Applying this musical chairs analogy, buying EM risk assets at the current juncture is similar to rushing in and hoping to get a good chair. It is a very high-risk bet and success is contingent on luck. In my subjective assessment, there is about a 30% chance that this strategy - buying EM risk now - will be successful with 70% odds favoring being risk averse for the time being. The latter entails staying with a defensive strategy in EM and underweighting/shorting EM versus DM. Ms. Mea: What is your recommended country allocation currently? Answer: In the EM equity space, our overweights are Korea, Thailand, Brazil, Mexico, Colombia, Chile, Russia, and central Europe. Our underweights, on the other hand, are India, Indonesia, the Philippines, Hong Kong, South Africa and Peru. Chart I-20 demonstrates the performance of our fully invested EM equity portfolio versus the EM MSCI benchmark. This portfolio is constructed based on our country recommendations. Hence, it is a measure of alpha that clients could derive from our country calls and geographical equity allocations. Chart I-20EMS's Fully-Invested Model Equity Portfolio Performance This fully invested equity model portfolio has outperformed the MSCI EM equity benchmark by about 65% with very low volatility since its initiation in May 2008. This translates into 500-basis-points of compounded outperformance per year. In the currency space, we continue recommending shorting a basket of the following EM currencies versus the dollar: ZAR, IDR, MYR, KRW and CLP. The full list of our country recommendations for equity, local fixed-income, credit and currency markets are available below. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Special Reports, "Where Are EMs In The Cycle?" dated May 3, 2018 and "Ms. Mea Challenges The EMS View," dated October 19, 2018, available at ems.bcaresearch.com. 2 Please see Emerging Markets Strategy Weekly Report, "Understanding The EM/China Cycles," dated July 19, 2018, available at ems.bcaresearch.com. 3 Please see Emerging Markets Strategy Weekly Report, "EMs Are In A Bear Market," dated October 18, 2018, available at ems.bcaresearch.com. 4 Please see: https://www.bloomberg.com/news/articles/2018-10-21/china-s-195-billion-debt-splurge-has-less-bang-than-you-think 5 Please see Emerging Markets Strategy Weekly Report, "EMs Are In A Bear Market," dated October 25, 2018, available at ems.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations