Fiscal

Dear Client, We are sending you a Special Report prepared by my colleague Matt Gertken, associate vice president of our Geopolitical Strategy team. This report focuses on the upcoming 19th Party congress and discusses its implications on China’s economic and political outlook, as well as its impact on financial markets. I trust you will find this report insightful. Best regards, Yan Wang, Senior Vice President China Investment Strategy Highlights The Communist Party will hold its nineteenth National Congress on Oct. 18. This is the "midterm election" for President Xi Jinping, whose political capital will be replenished; Recent Chinese leaders have a greater impact in their second term than their first; Base case: Xi consolidates power while preserving a balance on the Politburo Standing Committee; Stay long Chinese equities versus emerging market peers. Feature China's Communist Party will hold the nineteenth National Party Congress on October 18-25. This is a critical "midterm" leadership reshuffle that will also mark the halfway point of General Secretary Xi Jinping's term in office. Investors around the world will watch closely to see what insight can be gained about the political trajectory of the world's second-largest economy. This report serves as a "primer" for readers to understand the party congress and its investment takeaways. Why Is The Party Congress Important? Because it rotates China's political leaders! Chart 1So Long To The 18th Central Committee China's Nineteenth Party Congress: A Primer China's Nineteenth Party Congress: A Primer In a political system without popular representation, the rotation of personnel according to promotion and retirement is the only way to rejuvenate the policy process. The average rate of turnover on the Communist Party's Central Committee at each five-year congress has been 62%, which is a remarkably high rate (Chart 1). It reveals an underrated dynamism in Chinese politics. This leadership rotation also allows the top leader (Xi Jinping) to consolidate power by putting his supporters into key positions. This in turn alters the policymaking environment and the way in which China formulates policies and responds to external events. China has a "parallel" political system in which the ruling Communist Party operates alongside (and above) the state. Xi Jinping is "General Secretary" of the party, president of the People's Republic of China, and (not least) chairman of the Central Military Commission. The party maintains supremacy by independently controlling the state and the army. Since fall 2016, Xi has been dubbed the "core" of the Communist Party, putting him on a par with previous core leaders Mao Zedong, Deng Xiaoping and Jiang Zemin.1 The party's nearly 90 million members convene large congresses of about 2,000 members every five years to select the membership of the key decision-making bodies (Diagram 1), a practice known as "intra-party democracy."2 The key body is the Central Committee, which consists of about 200 full members and another 100-some alternative members. The Central Committee then "elects" the General Secretary, Political Bureau (a.k.a. "Politburo," the top 25 or so leaders) and Politburo Standing Committee (the "PSC," the top five-to-nine leaders) - though in reality the Politburo and the PSC are chosen through intense negotiations among the incumbent PSC and former leaders. Diagram 1National Party Congress Of The Communist Party Of China China's Nineteenth Party Congress: A Primer China's Nineteenth Party Congress: A Primer The handful of men on the PSC are the chief decision-makers in China, often in league with the broader Politburo (and former PSC members who exercise some power through the back door). Most of the key personnel decisions will have been made before the Central Committee votes.3 Hence the current top leaders have a chance to put their loyalists and supporters in key positions, potentially improving the implementation of their agenda. The outgoing eighteenth Central Committee will meet for its last session on October 11, and then the nineteenth party congress will meet on October 18 to elect a new Central Committee. It will in turn ratify the new Politburo and PSC. At the beginning of the party congress, Xi Jinping will deliver a keynote political report on the state of the party and nation, reviewing the progress of the past five years and mapping out a vision for the next five. The party congress will also amend the Communist Party constitution.4 By the end of the week, the members of the new PSC will step out to meet the press together for the first time. Only later will the party's key decisions be incorporated by the state, i.e. China's central government, including key personnel appointments and policy initiatives. This will occur when the legislature, the National People's Congress ("NPC," not to be confused with party congress), convenes at its annual "Two Sessions" in early March 2018. Chart 2Bold Action Can Follow Midterm Congresses China's Nineteenth Party Congress: A Primer China's Nineteenth Party Congress: A Primer Any NPC session following a five-year party congress carries more weight than usual not only because it approves of the party congress's leadership decisions but also because it kicks off major new policy initiatives. For instance, Premier Zhu Rongji was appointed to launch the "assault stage" of President Jiang Zemin's reforms of state-owned enterprise at the NPC in March 1998 (Chart 2). Similarly, Hu Jintao's Premier Wen Jiabao launched extensive administrative reforms at the NPC meeting in early 2008.5 How does a "midterm" party congress differ from others? Typically, in even-numbered years, the top two leaders change over, as with Xi Jinping and Premier Li Keqiang in 2012. These transitions are highly significant as they mark a leadership succession, a transfer of power to a new general secretary in a heavily centralized, authoritarian system that does not have a codified succession process. By contrast, in odd-numbered years like 2017, the Communist Party promotes, demotes, and retires a large number of other top leaders. Thus Xi Jinping's place is assured, and Li Keqiang's place is probably assured as well, but most likely the other five members of the PSC will be gone.6 This year's transition is also significant because the total turnover on the Central Committee is expected to be higher than usual (perhaps 70%) as a result of President Xi's aggressive anti-corruption campaign and other factors (see Chart 1 above).7 Leaders often spend the bulk of their first five years consolidating power and the second five years pushing forward their true policy agenda. Even President Hu Jintao, who failed to see his preferred social safety-net policies fully implemented, had a vastly more influential second term than first term in office: the 2007-12 period saw the 4 trillion RMB stimulus package to thwart the Global Recession. Moreover, Chinese leaders do not normally become "lame ducks" toward the end of their last term: Deng Xiaoping recommitted the country to pro-market reforms in 1992, after having stepped down as general secretary, while Jiang Zemin reached the height of his power at the end of his term in 2002, when he chose to hang onto the position of top military leader for two extra years. Many observers suspect that Xi Jinping will hold onto power beyond 2022. Bottom Line: The National Party Congress coincides with a sweeping rotation of the Chinese political elites, which is a critical way of ensuring that China, unlike a monarchy or personalized "dictatorship," has an orderly way of updating its policy-makers and (hopefully) policies. Midterm reshuffles allow top leaders to promote supporters and re-energize the implementation of their policy agenda. The past two Chinese leaders were more consequential in their second term than their first. How Is The Nineteenth Congress Unique? Chart 3Xi Jinping's Generation Taking Command China's Nineteenth Party Congress: A Primer China's Nineteenth Party Congress: A Primer The most important change this year is the passing of a generation.8 China's political elites are classified into "leadership generations," with Mao Zedong symbolizing the first generation, Deng Xiaoping the second, Jiang Zemin the third, Hu Jintao the fourth, and Xi Jinping the fifth generation. The current reshuffle will see the following generational trends: The End of the Jiang Zemin Era: The key figures retiring on the PSC are those who were born before 1950 and put in place by Jiang Zemin. Thus in a very real sense, Jiang Zemin's influence is coming to a close (Chart 3).9 This generational shift is likely to force the retirement of 11 of the 25-member Politburo, and five of the seven PSC members (Table 1), as well as other major figures, such as the long-serving central bank Governor Zhou Xiaochuan. Table 1Chinese Leaders Set To Retire On Politburo And Politburo Standing Committee China's Nineteenth Party Congress: A Primer China's Nineteenth Party Congress: A Primer Jiang-era leaders are defined by certain characteristics that are now fading. As Chart 4 demonstrates, these leaders came of age in the early, idealistic days of the Revolution, leading them to have a conservative streak in ideological matters. Yet they are well-known pragmatists in economic matters. They studied engineering and natural sciences in answer to the call for the young to develop the country's heavy industry. They tended to hail from capitalist-leaning coastal provinces, and often gained first-hand experience operating China's state-owned enterprises. This last point became especially important when they pioneered pro-market corporate reforms in the 1990s. By contrast, fewer of them served as government ministers on the State Council (China's cabinet) than subsequent generations. Chart 4Leadership Characteristics Of The Politburo Standing Committee China's Nineteenth Party Congress: A Primer China's Nineteenth Party Congress: A Primer The Middle of the Hu Jintao Era: The passing of Jiang's cohort will necessarily give his successor Hu Jintao's cohort a boost in relative influence at the top levels. Hu's generation is marked by leaders who studied the "soft sciences" (like law and economics). Several of them (including Hu and Premier Wen Jiabao) have links with the politically liberal wing of the party. They have far less experience in the military or state-owned business, but are more likely to have governing experience in the central government and especially the provinces (Chart 4 above). This includes the interior provinces from which they often hail. They are thus highly attuned to the problem of maintaining social stability, arguably to the neglect of economic dynamism. Hu Jintao's influence may be underrated. Xi's administration has shown important continuities with Hu's, and Hu's followers are well positioned in the Central Committee, the Politburo, and the provincial governments (though not the current PSC). If Xi does not take decisive moves to replace some of Hu's acolytes on the PSC at the coming party congress, then Hu's men will likely outnumber Xi's on the PSC as they graduate up the ladder from the Politburo.10 A strong showing by Hu's faction could affect China's policy priorities, given that Xi showed different preferences from Hu in the first few years of his rule (Table 2). However, the factions do not maintain consistent policy platforms. The bottom line is that Hu's faction could act as more or less of a constraint on Xi regardless of what policies the latter pursues. Table 2Fiscal Priorities Of Recent Chinese Presidents China's Nineteenth Party Congress: A Primer China's Nineteenth Party Congress: A Primer The True Beginning of the Xi Jinping Era: Xi's generation has yet to reveal its full character - the demographics of the new Central Committee will help determine it. So far it is a continuation of the trends above: more likely than not to come from interior than coastal provinces, to have studied the humanities, to have governed in the provinces or central ministries, and to lack military or business experience (Chart 4 above). The coming reshuffle could initiate a change in some of these trends, given some of Xi's revealed preferences, but that will not become clear until this fall.11 Xi is not stereotypical when it comes to China's political cycles: he consolidated power rapidly in his first term.12 The question, then, is whether Xi can continue to accrue power at the party congress, or whether his second term will become complicated by an infusion of Hu Jintao supporters into top party posts. Thus the success of Hu's supporters (particularly on the PSC) is the critical moving part that could determine the political constraints on Xi Jinping from 2017-22. Will Xi be able to arrange a favorable power-sharing agreement? Or will he go further and try to remove this political constraint entirely, even at the risk of political instability? The above points raise two critical questions: Will Chinese politics become more institutionalized? Investors should expect China to maintain a stridently informal political system. Rules and norms can and will be bent, but key principles will be upheld. In other words, the goal posts can be moved, but not too far. Going beyond certain limits would be destabilizing for China's political, institutional, and factional balances, and so far Xi has exhibited poise and the desire to maintain stability that is characteristic of post-1978 Chinese leaders.13 We think there is a low probability that Xi will overthrow all the norms of leadership selection and overturn the balance of power on the Politburo and PSC. If he does, it will raise alarms that he is setting up a new "cult of personality" like Mao, which could cause domestic economic and market instability. Rather, we expect him to modify the rules to maintain control of the PSC without excluding Hu Jintao's faction from power. Will Xi initiate the succession process for 2022? Some commentators suspect that Xi will use the party congress to pave the way for him to cling to power beyond 2022. Clearly Xi could retain the top military post and stay within recent precedent. But any hints at altering recent succession patterns, despite the fact that they are informal, are dangerous for investors in the long run because they raise deep uncertainty about the range of possibilities and political conflicts that could occur upon the actual change of power in 2022. Nevertheless, bear in mind the following points: The question of succession will not be resolved this October. If Xi plans to hang on beyond 2022, then he will continue amassing power and positioning loyalists over the next five years so that he will have full institutional support at the critical moment in 2022 - like Jiang Zemin did when he chose to hang onto the military chairmanship from 2002-04. Thus while Xi may lay some groundwork that makes political observers uneasy, the question will not be resolved either way this fall. Xi's tenure will be an ongoing topic for investors to monitor. Xi is already set to be the most powerful Chinese leader well into the 2020s. Xi's anti-corruption campaign is remarkable evidence of his strength as a ruler. Significantly, this campaign has focused on rooting out Jiang Zemin's influence. Yet Jiang stepped down way back in 2004! In other words, Jiang wielded massive influence between 2004 and 2017. Indeed, Xi's boldest move this year so far was to remove Sun Zhengcai, a Jiang acolyte. It stands to reason that, even if Hu Jintao's faction pulls off a relative victory this year, Xi Jinping's faction will likely be well positioned for a victory in 2022. And if Hu loses out this year, Xi's followers will be better positioned in 2027, as well as 2022. In short, market participants are unlikely to be able to tell the difference this October between (1) Xi getting a boost of political capital for his second term and (2) Xi getting such a big boost that he is on track to overstay his second term.14 Xi might intend to become a dictator and cling to power for longer, but all the market will know for certain is that he has maintained control of the PSC and his general policy framework will be more or less continuous, which is likely a relief in the near term. Finally, investors may not initially care if Xi seizes additional power at the expense of party norms and the succession process. A-shares sold off, but H-shares rallied, when Jiang Zemin decided not to step down entirely in 2002 (Chart 5). Russian stocks and the RUB/USD only fleetingly sold off when Vladimir Putin made clear his intention to return to the presidency yet again in 2011 (Chart 6). Chart 5Foreign Investors Cheered Jiang's Clinging To Power Foreign Investors Cheered Jiang's Clinging To Power Foreign Investors Cheered Jiang's Clinging To Power Chart 6Russian Investors Cheered Putin's Second Presidency Russian Investors Cheered Putin's Second Presidency Russian Investors Cheered Putin's Second Presidency While it is impossible to know whether markets will cheer any signs of "Papa Xi" doing away with term limits, it is bad for China's governance in the long run if Xi does not clearly begin grooming a successor with this fall's promotions. An heir-apparent for 2022 would reduce the risks of disruptive power-struggle and would impose a personal deadline on Xi Jinping's reform agenda. That is, a deadline above and beyond the 2020 deadline in the 13th Five Year Plan and the 2021 deadline for the 100th anniversary of the Communist Party's founding. That reform agenda, in turn, is essential for improving China's long-term productivity.15 Bottom Line: The Chinese political system is informal, which means that rules and norms can be bent without altering the underlying principles of balance among the key factions and stability of the regime and society as a whole. Our baseline scenario is a market-positive one: that Xi Jinping will win a victory at the party congress, but that he will not overthrow Hu Jintao's followers and abandon the "collective leadership" model, since that would destroy the overall balance of power and heighten domestic political risks. If Xi loses out to the Hu faction, then we would expect Chinese and China-exposed risk assets to sell off, at least initially. If Xi romps to total victory, excluding Hu's clique from power, we would fade any market rally. Such a development would heighten political risks for the foreseeable future. Investment Conclusions The prospect of a Xi-dominated, yet stable, PSC in China is promising because it suggests that China will have at least a marginally improved policy framework for managing the immense challenges it faces. On the economic front, the loss of the demographic dividend threatens to make China old before it gets rich (Chart 7). Xi will need a unified party, as well as loyal supporters in key posts, if he is to re-energize his productivity-enhancing reforms. On the socio-political front, China's intensifying focus on domestic security is symbolized by draconian media censorship ahead of the party congress and, more broadly, a faster rate of spending on public security than national defense in recent years (Chart 8). Such trends suggest that policy makers are concerned about public support. Income inequality and regional disparities are burning issues in an authoritarian country with a larger and more connected middle class and an incipient civil rights movement. Chart 7Rising Participation Boosted Euro Area Labor Force Growth China's Demographic Challenge Rising Participation Boosted Euro Area Labor Force Growth China's Demographic Challenge Rising Participation Boosted Euro Area Labor Force Growth China's Demographic Challenge Chart 8Social Stability A Major Concern In China China's Nineteenth Party Congress: A Primer China's Nineteenth Party Congress: A Primer In terms of the likely economic and market response, we have highlighted in the past that larger macro-economic trends tend to swamp any effects of China's five-year party congresses. There is no observable correlation between these events and the deviations of China's nominal GDP, credit, or fixed investment from long-term averages going back to 1992 (Chart 9). Chart 9No Clear Policy Impact From Past Party Congresses No Clear Policy Impact From Past Party Congresses No Clear Policy Impact From Past Party Congresses Moreover, China only has two midterm party congresses to compare to today's party congress, and both occurred in the thick of global financial crises (1997, 2007). This makes it difficult to draw firm conclusions about any impact on Chinese risk assets. A-shares were mostly flat after the 1997 congress but fell after 2007, while H-shares broadly fell after both meetings, as one might expect given the crises raging around them (Chart 10 A&B). Chart 10AChinese Stocks Were Flat Or Down ... Chinese Stocks Sold Off After Past Midterm Congresses Chinese Stocks Sold Off After Past Midterm Congresses Chart 10B... After Past Midterm Party Congresses Chinese Stocks Sold Off After Past Midterm Congresses Chinese Stocks Sold Off After Past Midterm Congresses H-shares, being highly responsive to global financial market turmoil, fell relative to emerging market (EM) equities as well in 1997 and 2007. A-shares were more insulated and outperformed EM stocks during the 1997 crisis, though not in the 2007 crisis (Chart 11 A&B). What is clear - for Chinese domestic investors - is that A-shares outperformed H-shares after the party congresses in 1997 and 2007 (Chart 12). Chart 11AChinese Stocks Sold Off In Relative Terms... Chinese Stocks Sold Off In Relative Terms... Chinese Stocks Sold Off In Relative Terms... Chart 11B...Except A-Shares During The Asian Crisis ...Except A-Shares During The Asian Crisis ...Except A-Shares During The Asian Crisis Chart 12A-Shares Outperformed H-Shares After Midterm Congresses A-Shares Outperformed H-Shares After Midterm Congresses A-Shares Outperformed H-Shares After Midterm Congresses This fall, it would not be surprising to see Chinese and global risk-on attitudes prevail in the immediate aftermath of China's party congress: in the broadest sense, the meeting represents a political recapitalization for the Xi administration. Moreover, the backdrop is positive: global and Chinese growth are on a synchronized upswing, Chinese industrial profits have improved, the Fed is on hold, and China's growth risks and capital outflow pressures have diminished.16 This suggests a marginal positive impact for H-shares as well as A-shares. However, Chinese stocks are no longer trading at a discount relative to peers. Moreover, BCA's Geopolitical Strategy believes that the Xi administration's reform reboot will likely bring tougher financial and environmental regulation that will slow credit growth and cut into corporate profits.17 It also seems likely that 2018 will see the dollar stage a comeback as inflation recovers and the Fed resumes hiking rates.18 For all these reasons, we recommend staying long Chinese stocks relative to EM, on the basis that China's reform efforts will be positive for China's productivity outlook but negative for commodities and EM in 2018. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Mao's successor Hua Guofeng, and Xi's predecessor Hu Jintao, are the two leaders who did not obtain "core" status. 2 The current norms developed mostly in the 1980s and have evolved since. The list of candidates is mostly pre-arranged by the top leaders. The party congress then votes on which candidates to include, leaving a remainder of about 10% who do not take seats in the Central Committee. 3 Nevertheless, the Central Committee could produce a few surprises. It is almost inevitable that a few major personalities will fail to get promoted into key positions, while others will be catapulted to higher places. There will also be some tea leaves to read about the share of negative votes or abstentions and the implications for different candidates. 4 The political report is filled with arcane Communist Party jargon but is very important. It is a consensus document that takes multiple committees a year or more to draft, though Xi Jinping will give the finishing touches. It will cover a comprehensive range of policies and will be scrutinized closely by experts for slight changes of terminology, emphasis, or omission. Key things to watch for are whether Xi adds or removes entire sections; whether he alters developmental goals outlined in previous administrations; and whether he inserts new concepts or revises party ideology to make way for contentious reforms. As for the party's constitution, the main question of any change is whether Xi's leadership philosophy is incorporated into the Communist Party's guiding thought, and if so, whether Xi's name is explicitly attached to it. The latter in particular would be a sign that Xi's political capital within the party is massive. For additional commentary, please see Alice Miller, "How To Read Xi Jinping's 19th Party Congress Political Report," China Leadership Monitor 53 (2017), available at www.hoover.org. 5 For the "assault stage" of reform, see Robert Lawrence Kuhn, The Man Who Changed China: The Life And Legacy Of Jiang Zemin (NY: Crown, 2004). Jiang had first targeted SOE reform in 1996 in a speech, he launched the policy itself at the party congress in September 1997, and the state began to implement it at the NPC in March 1998. For Hu Jintao's and Wen Jiabao's administrative reforms after the seventeenth party congress, see Willy Wo Lap Lam, "Beijing Unveils Plan For Super Ministries," China Brief, Jamestown Foundation, February 4, 2008. These reforms, which were only part of the overall agenda after the congress, included restructuring the State Council, empowering the National Development and Reform Commission, and setting up "Super-Ministries" to streamline cabinet-level functions. 6 Rumor has it that Xi will keep his anti-corruption chief, Wang Qishan, on the PSC beyond the 69-year mandatory retirement age, and that he could even replace Premier Li Keqiang. We do not expect either to happen, but both are well within the realm of political possibility - particularly retaining Wang. 7 For this estimate, please see Cheng Li, Chinese Politics In The Xi Jinping Era: Reassessing Collective Leadership (Washington, D.C.: Brookings, 2016), chapter 9. 8 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 9 Traces of Jiang's power will persist here and there, especially if Wang Qishan remains on the PSC, but the overall effect will be a diminishment of this powerful leadership cohort. Symbolically, just as Deng Xiaoping's death loomed over the fifteenth party congress in 1997, Jiang's impending death will loom over the nineteenth party congress today. 10 Indeed judging solely by the cyclical rotation of Chinese leaders according to generation and faction, Hu Jintao's acolytes are favored to outnumber Jiang Zemin's and Xi Jinping's in the 2017 reshuffle. Please see BCA Geopolitical Strategy, "China: Two Factions, One Party," dated September 2012, available at gps.bcaresearch.com. However, Xi's effectiveness and good luck since coming to power lead us to believe that he will secure his followers on the PSC and Politburo this year: please see BCA Geopolitical Strategy Strategic Outlook 2017, "We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 11 For example, Xi Jinping's recent promotions have re-emphasized SOE managers and his policies have supported large "state champion" SOEs. Please see Cheng Li and Lucy Xu, "The rise of state-owned enterprise executives in China's provincial leadership," Brookings, February 22, 2017, available at www.brookings.edu. 12 He came to the top office at a time of significant public dissatisfaction (2012), which meant that he received a kind of "mandate" to make big changes. His faction dominated the PSC, and his sweeping anti-corruption campaign purged the party and state of formidable rivals. In the fall of 2016 he clinched his status as the "core" of the party. 13 As to specific rules, no one should be surprised if they are altered. Take the age limit, which is hotly debated: Jiang Zemin introduced a hard age limit into the PSC in 1997, specifically in a way that prevented the promotion of a heavy-hitting politician, Qiao Shi, while allowing Jiang to continue in power. Now, assume Xi alters the rules to preserve Wang Qishan: this would not necessarily mean that Xi plans to overstay his term limits, though some observers will take it that way. For market participants, the important point is that slight tweaks to informal rules are unlikely to have a big market impact. Consider that Wang has overseen a massive crackdown on corruption, helping clean up the party's image, and is known to be competent in financial regulation as well. If he is retained, will the market really protest? We doubt it. Having said that, we expect him to retire according to the existing rule of thumb. 14 The exception to this statement is if Xi reforms Communist Party political institutions, as some commentators suspect he might, in order to allow the Central Committee to elect the Politburo and PSC directly from its members, thus expanding "intra-party democracy" while also giving Xi a higher likelihood of staying in power. Please see Bo Zhiyue, "Commentary: Sweeping Reforms Expected At Party Congress, But Will Xi Jinping Get All He Wants?" Channel News Asia, August 20, 2017, available at www.channelnewsasia.com. 15 Please see BCA Geopolitical Strategy Monthly Report, "Reflections On China's Reforms," in "The Great Risk Rotation - December 2013," dated December 11, 2013; and Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. Please also see BCA China Investment Strategy, "Understanding China's Master Plan," dated November 20, 2013, available at cis.bcaresearch.com. 16 Please see BCA China Investment Strategy Weekly Reports, "China: Earnings Scorecard And Market Tea Leaves," dated September 7, 2017, and "Monitoring Chinese Capital Outflows And The RMB Internationalization Process," dated August 24, 2017, available at cis.bcaresearch.com. 17 Please see BCA China Investment Strategy Weekly Report, "A Closer Look At Chinese Equity Valuations," dated August 31, 2017, available at cis.bcaresearch.com. For the reform agenda, please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 18 Please see BCA Global Investment Strategy Weekly Report, "Central Bank Showdown," dated September 8, 2017, available at gis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights The Communist Party will hold its nineteenth National Congress on Oct. 18. This is the "midterm election" for President Xi Jinping, whose political capital will be replenished; Recent Chinese leaders have a greater impact in their second term than their first; Base case: Xi consolidates power while preserving a balance on the Politburo Standing Committee; Stay long Chinese equities versus emerging market peers. Feature China's Communist Party will hold the nineteenth National Party Congress on October 18-25. This is a critical "midterm" leadership reshuffle that will also mark the halfway point of General Secretary Xi Jinping's term in office. Investors around the world will watch closely to see what insight can be gained about the political trajectory of the world's second-largest economy. This report serves as a "primer" for readers to understand the party congress and its investment takeaways. Why Is The Party Congress Important? Because it rotates China's political leaders! Chart 1So Long To The 18th Central Committee China's Nineteenth Party Congress: A Primer China's Nineteenth Party Congress: A Primer In a political system without popular representation, the rotation of personnel according to promotion and retirement is the only way to rejuvenate the policy process. The average rate of turnover on the Communist Party's Central Committee at each five-year congress has been 62%, which is a remarkably high rate (Chart 1). It reveals an underrated dynamism in Chinese politics. This leadership rotation also allows the top leader (Xi Jinping) to consolidate power by putting his supporters into key positions. This in turn alters the policymaking environment and the way in which China formulates policies and responds to external events. China has a "parallel" political system in which the ruling Communist Party operates alongside (and above) the state. Xi Jinping is "General Secretary" of the party, president of the People's Republic of China, and (not least) chairman of the Central Military Commission. The party maintains supremacy by independently controlling the state and the army. Since fall 2016, Xi has been dubbed the "core" of the Communist Party, putting him on a par with previous core leaders Mao Zedong, Deng Xiaoping and Jiang Zemin.1 The party's nearly 90 million members convene large congresses of about 2,000 members every five years to select the membership of the key decision-making bodies (Diagram 1), a practice known as "intra-party democracy."2 The key body is the Central Committee, which consists of about 200 full members and another 100-some alternative members. The Central Committee then "elects" the General Secretary, Political Bureau (a.k.a. "Politburo," the top 25 or so leaders) and Politburo Standing Committee (the "PSC," the top five-to-nine leaders) - though in reality the Politburo and the PSC are chosen through intense negotiations among the incumbent PSC and former leaders. Diagram 1National Party Congress Of The Communist Party Of China China's Nineteenth Party Congress: A Primer China's Nineteenth Party Congress: A Primer The handful of men on the PSC are the chief decision-makers in China, often in league with the broader Politburo (and former PSC members who exercise some power through the back door). Most of the key personnel decisions will have been made before the Central Committee votes.3 Hence the current top leaders have a chance to put their loyalists and supporters in key positions, potentially improving the implementation of their agenda. The outgoing eighteenth Central Committee will meet for its last session on October 11, and then the nineteenth party congress will meet on October 18 to elect a new Central Committee. It will in turn ratify the new Politburo and PSC. At the beginning of the party congress, Xi Jinping will deliver a keynote political report on the state of the party and nation, reviewing the progress of the past five years and mapping out a vision for the next five. The party congress will also amend the Communist Party constitution.4 By the end of the week, the members of the new PSC will step out to meet the press together for the first time. Only later will the party's key decisions be incorporated by the state, i.e. China's central government, including key personnel appointments and policy initiatives. This will occur when the legislature, the National People's Congress ("NPC," not to be confused with party congress), convenes at its annual "Two Sessions" in early March 2018. Chart 2Bold Action Can Follow Midterm Congresses China's Nineteenth Party Congress: A Primer China's Nineteenth Party Congress: A Primer Any NPC session following a five-year party congress carries more weight than usual not only because it approves of the party congress's leadership decisions but also because it kicks off major new policy initiatives. For instance, Premier Zhu Rongji was appointed to launch the "assault stage" of President Jiang Zemin's reforms of state-owned enterprise at the NPC in March 1998 (Chart 2). Similarly, Hu Jintao's Premier Wen Jiabao launched extensive administrative reforms at the NPC meeting in early 2008.5 How does a "midterm" party congress differ from others? Typically, in even-numbered years, the top two leaders change over, as with Xi Jinping and Premier Li Keqiang in 2012. These transitions are highly significant as they mark a leadership succession, a transfer of power to a new general secretary in a heavily centralized, authoritarian system that does not have a codified succession process. By contrast, in odd-numbered years like 2017, the Communist Party promotes, demotes, and retires a large number of other top leaders. Thus Xi Jinping's place is assured, and Li Keqiang's place is probably assured as well, but most likely the other five members of the PSC will be gone.6 This year's transition is also significant because the total turnover on the Central Committee is expected to be higher than usual (perhaps 70%) as a result of President Xi's aggressive anti-corruption campaign and other factors (see Chart 1 above).7 Leaders often spend the bulk of their first five years consolidating power and the second five years pushing forward their true policy agenda. Even President Hu Jintao, who failed to see his preferred social safety-net policies fully implemented, had a vastly more influential second term than first term in office: the 2007-12 period saw the 4 trillion RMB stimulus package to thwart the Global Recession. Moreover, Chinese leaders do not normally become "lame ducks" toward the end of their last term: Deng Xiaoping recommitted the country to pro-market reforms in 1992, after having stepped down as general secretary, while Jiang Zemin reached the height of his power at the end of his term in 2002, when he chose to hang onto the position of top military leader for two extra years. Many observers suspect that Xi Jinping will hold onto power beyond 2022. Bottom Line: The National Party Congress coincides with a sweeping rotation of the Chinese political elites, which is a critical way of ensuring that China, unlike a monarchy or personalized "dictatorship," has an orderly way of updating its policy-makers and (hopefully) policies. Midterm reshuffles allow top leaders to promote supporters and re-energize the implementation of their policy agenda. The past two Chinese leaders were more consequential in their second term than their first. How Is The Nineteenth Congress Unique? Chart 3Xi Jinping's Generation Taking Command China's Nineteenth Party Congress: A Primer China's Nineteenth Party Congress: A Primer The most important change this year is the passing of a generation.8 China's political elites are classified into "leadership generations," with Mao Zedong symbolizing the first generation, Deng Xiaoping the second, Jiang Zemin the third, Hu Jintao the fourth, and Xi Jinping the fifth generation. The current reshuffle will see the following generational trends: The End of the Jiang Zemin Era: The key figures retiring on the PSC are those who were born before 1950 and put in place by Jiang Zemin. Thus in a very real sense, Jiang Zemin's influence is coming to a close (Chart 3).9 This generational shift is likely to force the retirement of 11 of the 25-member Politburo, and five of the seven PSC members (Table 1), as well as other major figures, such as the long-serving central bank Governor Zhou Xiaochuan. Table 1Chinese Leaders Set To Retire On Politburo And Politburo Standing Committee China's Nineteenth Party Congress: A Primer China's Nineteenth Party Congress: A Primer Jiang-era leaders are defined by certain characteristics that are now fading. As Chart 4 demonstrates, these leaders came of age in the early, idealistic days of the Revolution, leading them to have a conservative streak in ideological matters. Yet they are well-known pragmatists in economic matters. They studied engineering and natural sciences in answer to the call for the young to develop the country's heavy industry. They tended to hail from capitalist-leaning coastal provinces, and often gained first-hand experience operating China's state-owned enterprises. This last point became especially important when they pioneered pro-market corporate reforms in the 1990s. By contrast, fewer of them served as government ministers on the State Council (China's cabinet) than subsequent generations. Chart 4Leadership Characteristics Of The Politburo Standing Committee China's Nineteenth Party Congress: A Primer China's Nineteenth Party Congress: A Primer The Middle of the Hu Jintao Era: The passing of Jiang's cohort will necessarily give his successor Hu Jintao's cohort a boost in relative influence at the top levels. Hu's generation is marked by leaders who studied the "soft sciences" (like law and economics). Several of them (including Hu and Premier Wen Jiabao) have links with the politically liberal wing of the party. They have far less experience in the military or state-owned business, but are more likely to have governing experience in the central government and especially the provinces (Chart 4 above). This includes the interior provinces from which they often hail. They are thus highly attuned to the problem of maintaining social stability, arguably to the neglect of economic dynamism. Hu Jintao's influence may be underrated. Xi's administration has shown important continuities with Hu's, and Hu's followers are well positioned in the Central Committee, the Politburo, and the provincial governments (though not the current PSC). If Xi does not take decisive moves to replace some of Hu's acolytes on the PSC at the coming party congress, then Hu's men will likely outnumber Xi's on the PSC as they graduate up the ladder from the Politburo.10 A strong showing by Hu's faction could affect China's policy priorities, given that Xi showed different preferences from Hu in the first few years of his rule (Table 2). However, the factions do not maintain consistent policy platforms. The bottom line is that Hu's faction could act as more or less of a constraint on Xi regardless of what policies the latter pursues. Table 2Fiscal Priorities Of Recent Chinese Presidents China's Nineteenth Party Congress: A Primer China's Nineteenth Party Congress: A Primer The True Beginning of the Xi Jinping Era: Xi's generation has yet to reveal its full character - the demographics of the new Central Committee will help determine it. So far it is a continuation of the trends above: more likely than not to come from interior than coastal provinces, to have studied the humanities, to have governed in the provinces or central ministries, and to lack military or business experience (Chart 4 above). The coming reshuffle could initiate a change in some of these trends, given some of Xi's revealed preferences, but that will not become clear until this fall.11 Xi is not stereotypical when it comes to China's political cycles: he consolidated power rapidly in his first term.12 The question, then, is whether Xi can continue to accrue power at the party congress, or whether his second term will become complicated by an infusion of Hu Jintao supporters into top party posts. Thus the success of Hu's supporters (particularly on the PSC) is the critical moving part that could determine the political constraints on Xi Jinping from 2017-22. Will Xi be able to arrange a favorable power-sharing agreement? Or will he go further and try to remove this political constraint entirely, even at the risk of political instability? The above points raise two critical questions: Will Chinese politics become more institutionalized? Investors should expect China to maintain a stridently informal political system. Rules and norms can and will be bent, but key principles will be upheld. In other words, the goal posts can be moved, but not too far. Going beyond certain limits would be destabilizing for China's political, institutional, and factional balances, and so far Xi has exhibited poise and the desire to maintain stability that is characteristic of post-1978 Chinese leaders.13 We think there is a low probability that Xi will overthrow all the norms of leadership selection and overturn the balance of power on the Politburo and PSC. If he does, it will raise alarms that he is setting up a new "cult of personality" like Mao, which could cause domestic economic and market instability. Rather, we expect him to modify the rules to maintain control of the PSC without excluding Hu Jintao's faction from power. Will Xi initiate the succession process for 2022? Some commentators suspect that Xi will use the party congress to pave the way for him to cling to power beyond 2022. Clearly Xi could retain the top military post and stay within recent precedent. But any hints at altering recent succession patterns, despite the fact that they are informal, are dangerous for investors in the long run because they raise deep uncertainty about the range of possibilities and political conflicts that could occur upon the actual change of power in 2022. Nevertheless, bear in mind the following points: The question of succession will not be resolved this October. If Xi plans to hang on beyond 2022, then he will continue amassing power and positioning loyalists over the next five years so that he will have full institutional support at the critical moment in 2022 - like Jiang Zemin did when he chose to hang onto the military chairmanship from 2002-04. Thus while Xi may lay some groundwork that makes political observers uneasy, the question will not be resolved either way this fall. Xi's tenure will be an ongoing topic for investors to monitor. Xi is already set to be the most powerful Chinese leader well into the 2020s. Xi's anti-corruption campaign is remarkable evidence of his strength as a ruler. Significantly, this campaign has focused on rooting out Jiang Zemin's influence. Yet Jiang stepped down way back in 2004! In other words, Jiang wielded massive influence between 2004 and 2017. Indeed, Xi's boldest move this year so far was to remove Sun Zhengcai, a Jiang acolyte. It stands to reason that, even if Hu Jintao's faction pulls off a relative victory this year, Xi Jinping's faction will likely be well positioned for a victory in 2022. And if Hu loses out this year, Xi's followers will be better positioned in 2027, as well as 2022. In short, market participants are unlikely to be able to tell the difference this October between (1) Xi getting a boost of political capital for his second term and (2) Xi getting such a big boost that he is on track to overstay his second term.14 Xi might intend to become a dictator and cling to power for longer, but all the market will know for certain is that he has maintained control of the PSC and his general policy framework will be more or less continuous, which is likely a relief in the near term. Finally, investors may not initially care if Xi seizes additional power at the expense of party norms and the succession process. A-shares sold off, but H-shares rallied, when Jiang Zemin decided not to step down entirely in 2002 (Chart 5). Russian stocks and the RUB/USD only fleetingly sold off when Vladimir Putin made clear his intention to return to the presidency yet again in 2011 (Chart 6). Chart 5Foreign Investors Cheered Jiang's Clinging To Power Foreign Investors Cheered Jiang's Clinging To Power Foreign Investors Cheered Jiang's Clinging To Power Chart 6Russian Investors Cheered Putin's Second Presidency Russian Investors Cheered Putin's Second Presidency Russian Investors Cheered Putin's Second Presidency While it is impossible to know whether markets will cheer any signs of "Papa Xi" doing away with term limits, it is bad for China's governance in the long run if Xi does not clearly begin grooming a successor with this fall's promotions. An heir-apparent for 2022 would reduce the risks of disruptive power-struggle and would impose a personal deadline on Xi Jinping's reform agenda. That is, a deadline above and beyond the 2020 deadline in the 13th Five Year Plan and the 2021 deadline for the 100th anniversary of the Communist Party's founding. That reform agenda, in turn, is essential for improving China's long-term productivity.15 Bottom Line: The Chinese political system is informal, which means that rules and norms can be bent without altering the underlying principles of balance among the key factions and stability of the regime and society as a whole. Our baseline scenario is a market-positive one: that Xi Jinping will win a victory at the party congress, but that he will not overthrow Hu Jintao's followers and abandon the "collective leadership" model, since that would destroy the overall balance of power and heighten domestic political risks. If Xi loses out to the Hu faction, then we would expect Chinese and China-exposed risk assets to sell off, at least initially. If Xi romps to total victory, excluding Hu's clique from power, we would fade any market rally. Such a development would heighten political risks for the foreseeable future. Investment Conclusions The prospect of a Xi-dominated, yet stable, PSC in China is promising because it suggests that China will have at least a marginally improved policy framework for managing the immense challenges it faces. On the economic front, the loss of the demographic dividend threatens to make China old before it gets rich (Chart 7). Xi will need a unified party, as well as loyal supporters in key posts, if he is to re-energize his productivity-enhancing reforms. On the socio-political front, China's intensifying focus on domestic security is symbolized by draconian media censorship ahead of the party congress and, more broadly, a faster rate of spending on public security than national defense in recent years (Chart 8). Such trends suggest that policy makers are concerned about public support. Income inequality and regional disparities are burning issues in an authoritarian country with a larger and more connected middle class and an incipient civil rights movement. Chart 7Rising Participation Boosted Euro Area Labor Force Growth China's Demographic Challenge Rising Participation Boosted Euro Area Labor Force Growth China's Demographic Challenge Rising Participation Boosted Euro Area Labor Force Growth China's Demographic Challenge Chart 8Social Stability A Major Concern In China China's Nineteenth Party Congress: A Primer China's Nineteenth Party Congress: A Primer In terms of the likely economic and market response, we have highlighted in the past that larger macro-economic trends tend to swamp any effects of China's five-year party congresses. There is no observable correlation between these events and the deviations of China's nominal GDP, credit, or fixed investment from long-term averages going back to 1992 (Chart 9). Chart 9No Clear Policy Impact From Past Party Congresses No Clear Policy Impact From Past Party Congresses No Clear Policy Impact From Past Party Congresses Moreover, China only has two midterm party congresses to compare to today's party congress, and both occurred in the thick of global financial crises (1997, 2007). This makes it difficult to draw firm conclusions about any impact on Chinese risk assets. A-shares were mostly flat after the 1997 congress but fell after 2007, while H-shares broadly fell after both meetings, as one might expect given the crises raging around them (Chart 10 A&B). Chart 10AChinese Stocks Were Flat Or Down ... Chinese Stocks Sold Off After Past Midterm Congresses Chinese Stocks Sold Off After Past Midterm Congresses Chart 10B... After Past Midterm Party Congresses Chinese Stocks Sold Off After Past Midterm Congresses Chinese Stocks Sold Off After Past Midterm Congresses H-shares, being highly responsive to global financial market turmoil, fell relative to emerging market (EM) equities as well in 1997 and 2007. A-shares were more insulated and outperformed EM stocks during the 1997 crisis, though not in the 2007 crisis (Chart 11 A&B). What is clear - for Chinese domestic investors - is that A-shares outperformed H-shares after the party congresses in 1997 and 2007 (Chart 12). Chart 11AChinese Stocks Sold Off In Relative Terms... Chinese Stocks Sold Off In Relative Terms... Chinese Stocks Sold Off In Relative Terms... Chart 11B...Except A-Shares During The Asian Crisis ...Except A-Shares During The Asian Crisis ...Except A-Shares During The Asian Crisis Chart 12A-Shares Outperformed H-Shares After Midterm Congresses A-Shares Outperformed H-Shares After Midterm Congresses A-Shares Outperformed H-Shares After Midterm Congresses This fall, it would not be surprising to see Chinese and global risk-on attitudes prevail in the immediate aftermath of China's party congress: in the broadest sense, the meeting represents a political recapitalization for the Xi administration. Moreover, the backdrop is positive: global and Chinese growth are on a synchronized upswing, Chinese industrial profits have improved, the Fed is on hold, and China's growth risks and capital outflow pressures have diminished.16 This suggests a marginal positive impact for H-shares as well as A-shares. However, Chinese stocks are no longer trading at a discount relative to peers. Moreover, BCA's Geopolitical Strategy believes that the Xi administration's reform reboot will likely bring tougher financial and environmental regulation that will slow credit growth and cut into corporate profits.17 It also seems likely that 2018 will see the dollar stage a comeback as inflation recovers and the Fed resumes hiking rates.18 For all these reasons, we recommend staying long Chinese stocks relative to EM, on the basis that China's reform efforts will be positive for China's productivity outlook but negative for commodities and EM in 2018. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Mao's successor Hua Guofeng, and Xi's predecessor Hu Jintao, are the two leaders who did not obtain "core" status. 2 The current norms developed mostly in the 1980s and have evolved since. The list of candidates is mostly pre-arranged by the top leaders. The party congress then votes on which candidates to include, leaving a remainder of about 10% who do not take seats in the Central Committee. 3 Nevertheless, the Central Committee could produce a few surprises. It is almost inevitable that a few major personalities will fail to get promoted into key positions, while others will be catapulted to higher places. There will also be some tea leaves to read about the share of negative votes or abstentions and the implications for different candidates. 4 The political report is filled with arcane Communist Party jargon but is very important. It is a consensus document that takes multiple committees a year or more to draft, though Xi Jinping will give the finishing touches. It will cover a comprehensive range of policies and will be scrutinized closely by experts for slight changes of terminology, emphasis, or omission. Key things to watch for are whether Xi adds or removes entire sections; whether he alters developmental goals outlined in previous administrations; and whether he inserts new concepts or revises party ideology to make way for contentious reforms. As for the party's constitution, the main question of any change is whether Xi's leadership philosophy is incorporated into the Communist Party's guiding thought, and if so, whether Xi's name is explicitly attached to it. The latter in particular would be a sign that Xi's political capital within the party is massive. For additional commentary, please see Alice Miller, "How To Read Xi Jinping's 19th Party Congress Political Report," China Leadership Monitor 53 (2017), available at www.hoover.org. 5 For the "assault stage" of reform, see Robert Lawrence Kuhn, The Man Who Changed China: The Life And Legacy Of Jiang Zemin (NY: Crown, 2004). Jiang had first targeted SOE reform in 1996 in a speech, he launched the policy itself at the party congress in September 1997, and the state began to implement it at the NPC in March 1998. For Hu Jintao's and Wen Jiabao's administrative reforms after the seventeenth party congress, see Willy Wo Lap Lam, "Beijing Unveils Plan For Super Ministries," China Brief, Jamestown Foundation, February 4, 2008. These reforms, which were only part of the overall agenda after the congress, included restructuring the State Council, empowering the National Development and Reform Commission, and setting up "Super-Ministries" to streamline cabinet-level functions. 6 Rumor has it that Xi will keep his anti-corruption chief, Wang Qishan, on the PSC beyond the 69-year mandatory retirement age, and that he could even replace Premier Li Keqiang. We do not expect either to happen, but both are well within the realm of political possibility - particularly retaining Wang. 7 For this estimate, please see Cheng Li, Chinese Politics In The Xi Jinping Era: Reassessing Collective Leadership (Washington, D.C.: Brookings, 2016), chapter 9. 8 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 9 Traces of Jiang's power will persist here and there, especially if Wang Qishan remains on the PSC, but the overall effect will be a diminishment of this powerful leadership cohort. Symbolically, just as Deng Xiaoping's death loomed over the fifteenth party congress in 1997, Jiang's impending death will loom over the nineteenth party congress today. 10 Indeed judging solely by the cyclical rotation of Chinese leaders according to generation and faction, Hu Jintao's acolytes are favored to outnumber Jiang Zemin's and Xi Jinping's in the 2017 reshuffle. Please see BCA Geopolitical Strategy, "China: Two Factions, One Party," dated September 2012, available at gps.bcaresearch.com. However, Xi's effectiveness and good luck since coming to power lead us to believe that he will secure his followers on the PSC and Politburo this year: please see BCA Geopolitical Strategy Strategic Outlook 2017, "We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 11 For example, Xi Jinping's recent promotions have re-emphasized SOE managers and his policies have supported large "state champion" SOEs. Please see Cheng Li and Lucy Xu, "The rise of state-owned enterprise executives in China's provincial leadership," Brookings, February 22, 2017, available at www.brookings.edu. 12 He came to the top office at a time of significant public dissatisfaction (2012), which meant that he received a kind of "mandate" to make big changes. His faction dominated the PSC, and his sweeping anti-corruption campaign purged the party and state of formidable rivals. In the fall of 2016 he clinched his status as the "core" of the party. 13 As to specific rules, no one should be surprised if they are altered. Take the age limit, which is hotly debated: Jiang Zemin introduced a hard age limit into the PSC in 1997, specifically in a way that prevented the promotion of a heavy-hitting politician, Qiao Shi, while allowing Jiang to continue in power. Now, assume Xi alters the rules to preserve Wang Qishan: this would not necessarily mean that Xi plans to overstay his term limits, though some observers will take it that way. For market participants, the important point is that slight tweaks to informal rules are unlikely to have a big market impact. Consider that Wang has overseen a massive crackdown on corruption, helping clean up the party's image, and is known to be competent in financial regulation as well. If he is retained, will the market really protest? We doubt it. Having said that, we expect him to retire according to the existing rule of thumb. 14 The exception to this statement is if Xi reforms Communist Party political institutions, as some commentators suspect he might, in order to allow the Central Committee to elect the Politburo and PSC directly from its members, thus expanding "intra-party democracy" while also giving Xi a higher likelihood of staying in power. Please see Bo Zhiyue, "Commentary: Sweeping Reforms Expected At Party Congress, But Will Xi Jinping Get All He Wants?" Channel News Asia, August 20, 2017, available at www.channelnewsasia.com. 15 Please see BCA Geopolitical Strategy Monthly Report, "Reflections On China's Reforms," in "The Great Risk Rotation - December 2013," dated December 11, 2013; and Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. Please also see BCA China Investment Strategy, "Understanding China's Master Plan," dated November 20, 2013, available at cis.bcaresearch.com. 16 Please see BCA China Investment Strategy Weekly Reports, "China: Earnings Scorecard And Market Tea Leaves," dated September 7, 2017, and "Monitoring Chinese Capital Outflows And The RMB Internationalization Process," dated August 24, 2017, available at cis.bcaresearch.com. 17 Please see BCA China Investment Strategy Weekly Report, "A Closer Look At Chinese Equity Valuations," dated August 31, 2017, available at cis.bcaresearch.com. For the reform agenda, please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 18 Please see BCA Global Investment Strategy Weekly Report, "Central Bank Showdown," dated September 8, 2017, available at gis.bcaresearch.com.

Highlights We estimate total Belt & Road Initiative (BRI) investment will rise from US$120 billion this year to about US$170 billion in 2020. The size of BRI investments is about 47 times smaller than China's annual gross fixed capital formation (GFCF). Therefore, a slump in domestic capital spending in China will fully offset the increase in demand for industrial goods and commodities as a result of BRI projects. Pakistan, Kazakhstan and Ghana will benefit the most among major frontier markets from BRI. Investors should consider buying these bourses in sell-off. On a positive note, BRI leads to improved global capital allocation, allows China to export its excess construction and heavy industry capacity, and boosts recipient countries' demand for Chinese exports. Feature China's 'Belt and Road' Initiative (BRI) is on an accelerating path (Chart I-1), with total investment expected to rise from US$120 billion to about US$170 billion over the next three years. Chart I-1Accelerating BRI Investment From China bca.ems_sr_2017_09_13_s1_c1 bca.ems_sr_2017_09_13_s1_c1 The BRI has been one of the central government's main priorities since late 2013. The primary objectives of the BRI are: To export China's excess capacity in heavy industries and construction to other countries - i.e., build infrastructure in other countries; To expand the country's international influence via a grand plan of funding investments into the 69 countries along the Belt and the Road (B&R) (Chart I-2); To build transportation and communication networks as well as energy supply to facilitate trade and provide China access to other regions, especially Europe and Africa; To facilitate the internationalization of the RMB; To speed up the development of China's poor (and sometimes restive) central and western regions, namely by turning them into economic hubs between coastal China and the BRI countries in the rest of Asia; To boost China's strategic position in central, south, and southeast Asia through security linkages arising from BRI cooperation, as well as from assets (like ports) that could provide military as well as commercial uses in the long run. From a cyclical investment perspective, the pertinent questions for investors are: How big is the current scale of BRI investment, and where is the funding coming from? Will rising BRI investment be able to offset the negative impact from a potential slowdown in Chinese capex spending? Which frontier markets will benefit most from Chinese BRI investment? Chart I-2The Belt And Road Program China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's BRI: Scale And Funding Scale China has been implementing its strategic BRI since 2013. To date it has invested in 69 B&R countries through two major approaches: infrastructure project contracts and outward direct investment (ODI). The first approach - investment through projects - is the main mechanism of BRI implementation. BRI projects center on infrastructure development in recipient countries, encompassing construction of transportation (railways, highways, subways, and bridges), energy (power plants and pipelines) and telecommunication infrastructure. The cumulative size of the signed contracts with B&R countries over the past three years is US$383 billion, of which US$182 billion of projects are already completed. However, the value of newly signed contracts in a year does not equal the actual project investment occurred in that year, as generally these contracts will take several years to be implemented and completed. Table I-1 shows our projection of Chinese BRI project investment over the years of 2017-2020, which will reach US$168 billion in 2020. This projection is based on two assumptions: an average three-year investing and implementation period for BRI projects from the date of signing the contract to the commercial operation date (COD) of the project, and an average annual growth rate of 10% for the total value of the annual newly signed contracts over the next three years. Table I-1Projection Of Chinese BRI Project Investment Over The Years 2017-2020 China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? The basis for the first assumption is that the majority of the completed BRI projects were by and large finished within three years, and most of the existing and future BRI projects are also expected to be completed within a three-year period.1 The second assumption of the 10% future growth rate is reasonable, given the 13.5% average annual growth rate for the past two years, but from a low base. These large-scale infrastructure projects were led mainly by Chinese state-owned enterprises (SOEs), and often in the form of BOTs (Build-Operate Transfers), Design-Build-Operate (DBOs), BOOT (Build-Own-Operate-Transfers), BOO (Build-Own-Operate) and other types of Public-Private Partnerships (PPPs). After a Chinese SOE successfully wins a bid on an infrastructure project in a hosting country, the company will typically seek financing from a Chinese source to fund the project, and then execute construction of the project. After the completion of the project, depending on the terms pre-specified in the contract, the company will operate the project for a number of years, which will generate revenues as returns for the company. The second approach - investing into the recipient countries through ODI - is insignificant, with an amount of US$14.5 billion last year. This was only 12% of BRI project investment, and only 8.5% of China's total ODI. Chinese ODI has so far been mainly focused on tertiary industries, particularly in developed countries that can educate China in technology, management, innovation and branding. Besides, most of the Chinese ODI has been in the form of cross-border M&A purchases by Chinese firms, with only a small portion of the ODI targeted at green-field projects, which do not lead to an increase in demand for commodities and capital goods. Therefore, in this report we will only focus on the analysis of project investment as a proxy of Chinese BRI investment, as opposed to ODI. The focal point of this analysis is to gauge the demand outlook for commodities and capital goods originating from BRI. The Sources Of Chinese Funding The projected US$120 billion to US$170 billion BRI investment every year seems affordable for China. This is small in comparison to about US$3-3.5 trillion of new money origination, or about US$3 trillion of bank and shadow-bank credit (excluding borrowing by central and local governments) annually in the past two years. The financing sources for China's BRI investment include China's two policy banks (China Development Bank and the Export-Import Bank of China), two newly established funding sources (Silk Road Fund and Asia Infrastructure Investment Bank), Chinese commercial banks, and other financial institutions/funds. Table I-2 shows our estimate of the breakdown of BRI funding in 2016. Table I-2BRI Funding Sources In 2016 China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China Development Bank (CDB): As the country's largest development bank, the CDB has total assets of US$2.1 trillion, translating into more than US$350 billion of potential BRI projects over the next 10 years, which could well result in US$35 billion in funding annually from the CDB. The Export-Import Bank of China (EXIM): The EXIM holds an outstanding balance of over 1,000 BRI projects, and has also set up a special lending scheme worth US$19.5 billion over the next three years. This will increase EXIM's BRI lending from last year's US$5 billion to at least US$6.5 billion per year. Silk Road Fund (SRF): The Chinese government launched the SRF in late 2014 with initial funding of US$40 billion to directly support the BRI mission. This year, Chinese President Xi Jinping pledged a funding boost to the SRF with an extra 100 billion yuan (US$15 billion). Therefore, SRF funding to BRI projects over the next three years will be higher than the US$6 billion recorded last year. The Asian Infrastructure Investment Bank (AIIB): The AIIB was established in October 2014 and started lending in January 2016. It only invested US$1.7 billion in loans for nine BRI projects last year. The BRI funding from the AIIB is set to accelerate as the number of member countries has significantly expanded from an original 57 to 80 currently. Chinese commercial banks: Chinese domestic commercial banks, the largest source of BRI funding, have been driving BRI investment momentum. Chinese commercial banks currently fund about 62% of BRI investment and the main financiers are Bank of China (BoC) and Industrial & Commercial Bank of China (ICBC). After lending about US$60 billion over the past two years, the BOC plans to provide US$40 billion this year. The ICBC has 412 BRI projects in its pipeline, involving a total investment of US$337 billion over the next 10 years, which will likely result in an annual US$34 billion in BRI investment. The China Construction Bank (CCB) also has over 180 BRI projects in its pipeline, worth a total investment of US$90 billion over the next five to 10 years. Only three commercial banks will likely fund US$80 billion of BRI projects over the next three years. A few more words about the currency used in BRI funding. The U.S. dollar and Chinese RMB will be the two main currencies employed in BRI funding. Chinese companies can get loans denominated either in RMBs or in USDs from domestic commercial banks/policy banks/special funds/multilateral international banks to buy machinery and equipment (ME) from China. For some PPP projects that involve non-Chinese companies or governments (i.e. those of recipient countries), the local presence can use either USD loans or their central bank's Chinese RMB reserves from the currency swap deal made with China's central bank. China has long looked to recycle its large current account surpluses by pursuing investments in hard assets (land, commodities, infrastructure, etc.) across the world, to mitigate its structural habit of building up large foreign exchange reserves that are mostly invested in low-interest-bearing American government securities. Risky but profitable BRI infrastructure projects are a continuation of this trend. China had so far signed bilateral currency swap agreements worth an aggregate of more than 1 trillion yuan (US$150 billion) with 22 countries or regions along the B&R. The establishment of cross-border RMB payment, clearing and settlement has been gaining momentum, and the use of RMB has been expanding gradually in global trade and investment, notwithstanding inevitable setbacks. Bottom Line: We estimate total BRI investment with Chinese financing will rise from US$120 billion this year to about US$170 billion in 2020, and Chinese financial institutions will be capable of funding it. Can BRI Offset A Slowdown In China's Capex? From a global investors' perspective, a pertinent question around the BRI program is whether the BRI-funded capital spending can offset the potential slowdown in China's domestic investment expenditure. This is essential to gauge the demand outlook for industrial commodities and capital goods worldwide. Our short answer is not likely. Table I-3 reveals that in 2016, gross fixed capital formation (GFCF) in China was estimated by the National Bureau of Statistics to be at RMB 32 trillion, or $4.8 trillion. Table I-3China's GFCF* Vs. China's BRI Investment Expenditures China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? Meantime, China-funded BRI investment expenditure amounted to US$102 billion in 2016. In a nutshell, last year GFCF in China was about 47 times larger than BRI investment expenditures. The question is how much of a drop in mainland GFCF would need to take place to offset the projected BRI investment. The latter will likely amount to US$139 billion in 2018, US$153 billion in 2019 and US$168 billion in 2020. Provided estimated sizes of Chinese GFCF in 2017 are RMB 33.5 trillion (US$4.9 trillion), it would take only 0.4% contraction in GFCF in 2018, 0.3% in 2019 and 2020 to completely offset the rise in BRI-related investment expenditure (Table 3). Chart I-3Record Low Credit Growth... bca.ems_sr_2017_09_13_s1_c3 bca.ems_sr_2017_09_13_s1_c3 We derive these results by comparing the expected absolute change in BRI capital spending expenditures with the size of China's GFCF. The expected increases in BRI in 2018, 2019 and 2020 are US$20 billion, US$14 billion and US$15 billion. Given the starting point of GFCF in 2017 was US$4.9 trillion, it will take only about 0.4% of decline in $4.9 trillion to offset the $20 billion rise in BRI. In the same way, we estimated that it would take only an annual 0.3% contraction in nominal GFCF in China to completely offset the rise in BRI capital spending in both 2019 and 2020. To be sure, we are not certain that the GFCF will contract in each of the next three years. Yet, odds of such shrinkage in one of these years are substantial. As always, investors face uncertainty, and they need to make assessments. Is an annual 0.4% decline in China's GFCF likely in 2018? In our opinion, it is quite likely, based on our money and credit growth, as illustrated in Chart I-3. Importantly, interest rates in China continue to drift higher. A higher cost of borrowing and regulatory tightening on banks and shadow banking will lead to a meaningful deterioration in China's credit origination. The latter will weigh on investment expenditures. The basis is that the overwhelming portion of GFCF is funded by credit to public and private debtors, and aggregate credit growth has already relapsed. Chart I-4 and Chart I-5 demonstrate that money and credit impulses lead several high-frequency economic variables that tend to correlate with capital expenditure cycles. Chart I-4Negative Money Credit Impulses Point To... ...Negative Money Credit Impulses Point To... ...Negative Money Credit Impulses Point To... Chart I-5...Slowing Capital Expenditure ...Slowing Capital Expenditure ...Slowing Capital Expenditure Therefore, we conclude that meaningful weakness in the GFCF is quite likely in 2018, and that it will spill out to 2019 if the government does not counteract it with major stimulus. By and large, odds are that a slump in domestic capital spending in China offset the rise in BRI-related capital expenditures. BCA's Emerging Markets Strategy service has written substantively on motives surrounding China's capital spending and how it is set to slow, and we will not cover these topics. Some reasons why investment spending is bound to slow include: considerable credit excesses/high indebtedness of companies; misallocation of capital and resultant weak cash flow position of companies; non-performing assets on banks' and other creditors' balance sheets and their weak liquidity position. To be sure, investors often ask whether or not material weakness in mainland growth will lead the authorities to stimulate. Odds are they will. Yet, before the slowdown becomes visible in economic numbers, financial markets will likely sell-off. In brief, policymakers are currently tightening and will be late to reverse their policies. Finally, should one compare the entire GFCF, or only part of it? There is a dearth of data to analyze various types of capital spending. In a nutshell, Chart I-6 reveals that installation accounts for roughly 70% of investment, while purchases of equipment account for the remaining 18%. Therefore, we guess the composition of BRI projects will be similar to structure of investment spending in China, and hence it makes sense to use overall GFCF as a comparative benchmark. In addition, the GFCF data is a better measure for Chinese capital spending over Chinese fixed asset investment (FAI) data, as the FAI number includes land values, which have risen significantly over the years and already account for about half of the FAI (Chart I-7). Chart I-6Chinese Fixed Investment Structure Chinese Fixed Investment Structure Chinese Fixed Investment Structure Chart I-7GFCF Is A Better Measure Than FAI GFCF Is A Better Measure Than FAI GFCF Is A Better Measure Than FAI Bottom Line: While it is hard to forecast and time exact dynamics over the next several years, odds are that the next 12-24 months will turn out to be a period of a slump in China's capital spending. This will more than offset the increase in demand for industrial goods and commodities as a result of BRI projects. Implication For Frontier Markets The BRI, which currently covers 69 countries, will keep expanding its coverage for the foreseeable future. Insofar as it is a way for China to create new markets for its exports, Beijing has no reason to exclude any country. In practice, however, certain countries will receive greater dedication, for the simple reason that their development fits into China's political, military and strategic interests as well as economic interests. As most of the investments are infrastructure-focused, aiming to improve transportation, energy and telecommunication connectivity as well as special economic zones, the recipient countries, especially underdeveloped frontier markets, will benefit considerably from China's BRI. Table I-4 shows that Pakistan, Kazakhstan and Ghana will benefit the most among major frontier markets, as the planned BRI investment in those countries amounts to a significant amount of their GDP. Chart I-8 also shows that, in terms of current account deficit coverage by the Chinese BRI funding, the three countries that stand to benefit most are also Pakistan, Kazakhstan and Ghana. Table I-1The B&R Countries That Benefit From ##br##China's BRI Investment (Ranged From High-To-Low) China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? Chart I-8Chinese BRI Funding's Impact On ##br##External Account Of B&R Countries China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? Of these, clearly Pakistan and Kazakhstan have the advantage of attracting China's strategic as well as economic interest: Kazakhstan offers China greater access into Central Asia and broader Eurasia; Pakistan is a large-population market that offers a means of accessing the Indian Ocean without the geopolitical complications of Southeast and East Asia. These states also neighbor China's restive Xinjiang, where Beijing hopes economic development can discourage separatist and terrorist activities. Pakistan Pakistan is a key prospect for China's exports in of itself, and in the long run offers a maritime waystation and an energy transit hub separate from China's other supply lines. For China, it is a critical alternative to Myanmar and the Malacca Strait. In April 2015, China announced a remarkable US$46.4 billion CPEC (China-Pakistan Economic Corridor) investment plan in Pakistan, equal to 16.4% of Pakistani GDP. It is expected to be implemented over five years. In particular, the planned US$33.2 billion energy investment will increase Pakistan's existing power capacity by 70% from 2017 to 2023. On the whole, China's CPEC plan will be significantly positive to economic development in Pakistan in the long run, but in the near term it is still not enough to boost the nation's competitiveness (Chart I-9A, top panel). Chart I-9AOur Calls Have Been Correct Top 3 Frontier Markets Benefiting Most From Chinese BRI Investment Top 3 Frontier Markets Benefiting Most From Chinese BRI Investment Chart I-9BTop 3 Frontier Markets Benefiting Most ##br##From Chinese BRI Investment Our Calls Have Been Correct Our Calls Have Been Correct Also, as about 40% of the investment has already been invested over the previous two years, odds are that China's CPEC investment will go slower and smaller this year and over the next few years. BCA's Frontier Markets Strategy service's recent tactical bearish call on Pakistani stocks has been correct, with a 25% decline in the MSCI Pakistan Index in U.S. dollar terms since our recommendation in March (Chart I-9B, top panel).2 We remain tactically cautious for now. Kazakhstan Kazakhstan is a key transit corridor for Chinese goods to enter Europe and the Middle East. In June 2017, Chinese and Kazakh enterprises and financial institutions signed at least 24 deals worth more than US$8 billion. China's BRI investment in Kazakhstan facilitated the country's accelerated economic growth (Chart I-9A, middle panel). BCA's Frontier Markets Strategy service reiterates its positive view on Kazakhstan equities because of a recuperating economy, considerable fiscal stimulus and rising Chinese BRI investment (Chart I-9B, middle panel).3 Ghana Ghana is not strategic for China (it is a minor supplier of oil). Instead, it illustrates the fact that BRI is not always relevant to China's strategic or geopolitical interests. Sometimes it is simply about China's need to invest its surplus U.S. liquidity into hard assets around the world. Of course, Ghana itself will benefit considerably from the committed US$19 billion BRI investment, which was announced only a few months ago. This is a huge amount for the country, equaling 45% of Ghana's 2016 GDP. This massive fresh investment will boost Ghana's economic growth in both the near and long term (Chart I-9A, bottom panel). BCA's Frontier Markets Strategy service upgraded its stance on the Ghanaian equity market from negative to neutral in absolute terms at the end of July, and we also recommended overweighting the bourse relative to the broader MSCI EM universe (Chart I-9B, bottom panel).4 Our positive view on Ghana remains unchanged for now and we are looking to establish a long position in the absolute terms in this bourse amid a potential EM-wide sell-off. Other Macro Ramifications Industrial goods and commodities/materials are vulnerable. BRI will not change the fact that a potential relapse in capital spending in China will lead to diminishing growth in commodities demand. If there is a massive slowdown in property market like China experienced in 2015, which is very likely due to lingering excesses, Chinese commodity and industrial goods demand could even contract (Chart I-10). Notably, mainland's imports of base metals have been flat since 2010, and imports of capital goods shank in 2015 even though GDP and GFCF growth were positive (Chart I-11). The point is that there could be another cyclical contraction in Chinese imports of commodities and industrial goods, even if headline GDP and GFCF do not contract. Chart I-10Chinese Capital Goods Imports Could Contract Again bca.ems_sr_2017_09_13_s1_c10 bca.ems_sr_2017_09_13_s1_c10 Chart I-11Imports Of Metals Could Slow Further Imports Of Metals Could Slow Further Imports Of Metals Could Slow Further As China accounts for 50% of global demand of industrial metals and it imports about US$ 589 billion of industrial goods and materials annually, either decelerating growth or outright demand contraction will be negative news for global commodities markets and industrial goods producers. China's Exports Have A Brighter Outlook China's machinery and equipment (ME) exports account for 47% of total exports, and 9% of its GDP (Table I-5). The BRI investment will boost Chinese ME exports directly through large infrastructure projects. Table I-5Structure Of Chinese Exports (2016) China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? Meantime, robust income growth in the recipient countries will boost their demand for household goods (Chart I-12). China has a very strong competitive advantage in white and consumer goods production, especially in low-price segments that are popular in developing economies. Therefore, not only is China exporting its excess construction and heavy industry capacity, but the BRI is also boosting recipient countries' demand for Chinese household and other goods exports. Adding up dozens of countries like Ghana can result in a meaningful augmentation in China's customer base. Notably, Chinese total exports have exhibited signs of improvement as Chinese ME exports and exports to the major B&R countries have contributed to a rising share of total Chinese exports since 2015 (Chart I-13). Chart I-12BRI Will Lift Chinese Exports Of ##br##Capital And Consumer Goods BRI Will Lift Chinese Exports Of Capital And Consumer Goods BRI Will Lift Chinese Exports Of Capital And Consumer Goods Chart I-13Signs Of Improvement In Chinese Exports ##br##Due To Rising BRI Investment Signs Of Improvement In Chinese Exports Due To Rising BRI Investment Signs Of Improvement In Chinese Exports Due To Rising BRI Investment BRI Leads To Improved Global Capital Allocation BRI is one of a very few global initiatives that improves the quality of global capital allocation. Therefore, it is bullish for global growth from a structural perspective. By shifting capital spending from a country that has already invested a lot in the past 20 years (China) to the ones that have been massively underinvested, BRI boosts the marginal productivity of capital. One billion dollars invested in the underinvested recipient countries will generate more benefits than the same amount invested in China. Risks To BRI Projects Notable deterioration in the health of Chinese banks may meaningfully curtail BRI funding, as Chinese non-policy banks will likely need to provide 60% of BRI projects' funding. Political stability/changes in destination countries: As most infrastructure projects have been authorized by the top government and need their cooperation, any changes in the recipient countries' governments or regimes may slow down or deter BRI projects. China already has a checkered past with developing countries where it has invested heavily. This is because of its employment of Chinese instead of local labor, its pursuit of flagship projects seen as benefiting elites rather than commoners, its allegedly corrupt ties with ruling parties, and perceived exploitation of natural resources to the neglect of the home nation. As China's involvement grows, local politics will be more difficult to manage, requiring China to suffer occasional losses due to political reversals or to defend its assets through aggressive economic sanctions, or even expeditionary force. For now, as there are no clear signs that any these risks are imminent, we remain positive on the further implementation of China's BRI program. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 China has long been known to use three-year periods - as distinct from its better known "five year plans" - for major domestic initiatives. In 2016, the National Development and Reform Commission re-emphasized three-year planning periods for "continuous, rolling" implementation. 2 Please see BCA's Frontier Markets Strategy Special Report "Pakistani Stocks: A Top Is At Hand", published March 13, 2017. Available at fms.bcaresearch.com. 3 Please see BCA's Frontier Markets Strategy Special Report "Kazakhstan: A Touch Less Dependent On Oil Prices", published March 28, 2017. Available at fms.bcaresearch.com. 4 Please see BCA's Frontier Markets Strategy Special Report "Ghana: Sailing On Chinese Winds", published July 31, 2017. Available at fms.bcaresearch.com.

Feature The Brazilian economy is finally improving following a devastating depression of about 3 years, where real GDP dropped by a whopping 7.4%. Does the current economic revival warrant a bullish stance on its financial markets? If the global risk-on trade persists among EM risk assets and commodities and there are no domestic political blunders in Brazil, the country's financial markets will continue to rally as economic growth improves. If the EM and commodities rallies wane and an EM risk-off cycle develops, Brazilian risk assets will sell off, regardless of domestic economic recovery. Provided economies around the world have become interconnected, it is often difficult to separate global economic and financial market impact from domestic economic dynamics. Yet, it is possible to do so in Brazil in the latest cycle. Chart I-1 demonstrates that the Brazilian real bottomed with iron ore prices on December 21, 2015 - not with the bottom in the Brazilian economy in early Q1 2017 (Chart I-1, bottom panel). In turn, the currency's rally amid the collapse in domestic demand has led to a material drop in inflation and allowed the central bank to cut interest rates aggressively. The exchange rate is the main variable driving financial markets in many developing countries, including Brazil. In these countries, it is the exchange rate that causes swings in interest rate expectations, not the other way around. Furthermore, other important variables that led to the bottom in iron ore prices and the BRL were the Chinese manufacturing PMI and money growth, both of which bottomed in the second half of 2015 (Chart I-2). Chart 1BRL Correlates With Commodities ##br##Not Domestic Demand BRL Correlates With Commodities Not Domestic Demand BRL Correlates With Commodities Not Domestic Demand Chart 2Chinese Data Led##br## The Bottom In BRL Chinese Data Led The Bottom In BRL Chinese Data Led The Bottom In BRL In short, economic recovery arrived much later in Brazil, and so far it has been exceptionally tame and tentative (Chart I-3). Brazil's domestic demand performance has in no way justified the rally in its financial markets since January 2016. If anything, it is the opposite: the domestic economic recovery emerged too late, and has been extremely subdued compared with the sizable gains in share prices. For example, banks' EPS bottomed only in May 2017, while their share prices troughed in January 2016 (Chart I-4). Similarly, Brazil's fiscal outlook and debt profile has continued to deteriorate, even though the country's sovereign spreads have tightened substantially (Chart I-5). Chart 3Brazil: Economic Recovery Is Exceptionally Tame Brazil: Economic Recovery Is Exceptionally Tame Brazil: Economic Recovery Is Exceptionally Tame Chart 4Brazil: Bank Share Prices And EPS Brazil: Bank Share Prices And EPS Brazil: Bank Share Prices And EPS Chart 5Brazil's Fiscal And Debt Profiles Have Deteriorated Brazil's Fiscal And Debt Profiles Have Deteriorated Brazil's Fiscal And Debt Profiles Have Deteriorated Hence, one can safely argue that economic growth and domestic fundamentals were not the basis behind why Brazilian financial markets found a bottom and rallied starting January 2016. Rather, the critical driving force has been commodities prices, China, the U.S. dollar and global risk appetite. This is consistent with the defining features of bull and bear markets: In a bull market, liquidity lifts all boats, and all flaws are overlooked or discharged while minor positives are magnified by the market. In a bear market, even marginal negatives are overblown, and the market punishes severely for minor missteps. In short, global risk assets have been in a genuine bull market since early 2016, and that has overridden Brazil's poor domestic fundamentals. Going forward, we recommend avoiding Brazilian risk assets - not because we do not expect an economic recovery in Brazil to progress, but because our view on China's impact on commodities and the potential U.S. dollar rebound will curb overall risk appetite toward EM. We discussed this EM/China/commodities outlook at length in last week's report.1 Timing a shift in financial market regimes is always a difficult task, but our sense is that a top in EM risk assets will likely occur between now and the end of October, as China's Communist party Congress reiterates its focus on containing financial risk and leverage, as well as the authorities' marginal tolerance for slightly slower growth. Furthermore, our broad money (M3) impulse for China suggests an imminent relapse in Goldman Sach's current economic activity indicator for the mainland economy (Chart I-6). Our assumption is that commodities prices will drop due to potential weakness in China, and that the U.S. dollar and U.S. bond yields are oversold and will recover, respectively. Altogether, these views warrant a cautious stance on EM currencies. The real has historically been correlated with commodities prices, and this positive correlation will likely continue. As and when the Brazilian currency resumes its depreciation, the risk-on trade in Brazilian equities and credit markets will end. As for Brazilian financial markets, a few relationships are worth highlighting: Since early this year, iron ore prices have been inversely correlated with Chinese money market rates (Chart I-7). A possible explanation is that iron ore and other commodities prices trading on Chinese exchanges have been driven by meaningful speculative buying that negatively correlates with borrowing costs on the mainland. Chart 6China's Growth Is Set To Slow bca.ems_wr_2017_09_13_s1_c6 bca.ems_wr_2017_09_13_s1_c6 Chart 7Iron Ore Prices Are Vulnerable Iron Ore Prices Are Vulnerable Iron Ore Prices Are Vulnerable Given the latest relapse in Brazil's nominal GDP growth, the pace of amelioration in private banks' NPL and NPL provisions could stall (Chart I-8). In turn, Brazilian banks' share prices seem to move inversely with the rate of change in private banks' NPL and NPL provisions (Chart I-9A & Chart I-9B). If these relationships hold, we might be close to a peak in Brazilian bank share prices. Chart 8Brazil: Is The Improvement In NPL Cycle Over? Brazil: Is The Improvement In NPL Cycle Over? Brazil: Is The Improvement In NPL Cycle Over? Chart 9ABrazil: NPL Cycles and Bank Stocks Brazil: NPL Cycles and Bank Stocks Brazil: NPL Cycles and Bank Stocks Chart 9BBrazil: Provisions Cycles And Bank Stocks Brazil: Provisions Cycles And Bank Stocks Brazil: Provisions Cycles And Bank Stocks Finally, the pace of economic recovery will likely disappoint because the Brazilian economy is facing numerous headwinds: High borrowing costs - the real prime lending rate is 12.5% and the policy rate in the real terms is 6.8%, while public banks' lending rates are set to rise due to the TJLP reform that will remove the government budget's subsidy for borrowers. With 50% of outstanding credit being earmarked credit (previously subsidized by the government and provided by public banks), the impact on economic activity will be non-trivial; Lower government spending, as 2018 government expenditure growth cannot exceed the 2017 June headline inflation rate of 3%. Besides, the fiscal balance is so disastrous that risks to taxes are to the upside, not downside. Furthermore, the recently augmented 2017 year-end fiscal primary deficit target of BRL 159 billion is smaller than the deficit of BRL 182 billion for the past 12 months. This entails government spending cuts are likely this year, which will weigh on growth. The Brazilian exchange rate is not cheap. The nation needs a cheaper currency to reflate its economy. Lingering political uncertainty amid the corruption scandals and upcoming presidential elections in fall 2018 will continue to weigh on capital spending and employment, which have not yet recovered. Bottom Line: Our overarching negative view on EM, China and commodities heralds staying cautious on Brazil's financial markets despite the early signs of domestic economic recovery. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report, titled "Copper Versus Money/Credit In China - Which One Is Right?", dated September 6,. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Even isolated North Korean attacks are unlikely to lead to a full-scale war; The USD sell-off will start to reverse once Trump makes Gary Cohn his official pick for Fed chairman; Europe is not a risk for investors ... even Italy is only a longer-term risk; France is reforming; stay long French industrials versus German. Feature Last week, in London, we were scheduled to give a talk on Sino-American tensions, East Asian geopolitical risks, and North Korea specifically. We submitted our topic of choice about a month ahead of the event, when tensions between Pyongyang and Washington were at their height. As tensions temporarily subsided following Supreme Leader Kim Jong-Un's decision to delay the planned missile launch towards Guam, several colleagues wondered if the topic was still a pertinent one. We stressed in our research that tensions would not dissipate and would continue to be market-relevant, if not critical for S&P 500.1 Unfortunately, we have been proven right. Forecasting geopolitics requires insight, multi-disciplinary methodology, and a treasure trove of empirical knowledge. But sometimes it also just comes down to using Google and looking at a calendar. For example, given the present context of heightened tensions, the annual U.S.-South Korean military exercises - Key Resolve, which occurs normally in the spring, and Ulchi-Freedom Guardian, which occurs in August - are obvious dates to monitor. They are provocations that North Korea has to respond to for both foreign and domestic audiences. Pyongyang has chosen to do so by firing an ICBM across Japan and testing a sixth nuclear device, allegedly a miniaturized hydrogen bomb. While both these actions qualitatively expand on previous acts (missile and nuclear tests), neither cross a threshold. We are still in the realm of "territorial threat display." President Trump and Supreme Leader Kim are angling their "swords," but have not dared to cross them yet. Nonetheless, our clients have pointed out that our "arch of diplomacy" approach leaves a lot to imagination. Therefore, the first insight from the road of this week is that we need to put our thinking cap on and imagine a scenario where tensions do blow over into open conflict. How do we imagine such a scenario occurring and why would it not devolve into full out war that forces the U.S. to attack the North Korean mainland? Is North Korea About To Become A Praying Mantis? We can imagine a scenario where North Korea commits an act that takes us beyond the nuanced thresholds set by recent history (Chart 1). For example, we have cited to clients that an attack against international shipping in the Yellow Sea or Sea of Japan by North Korean submarines would be an unprecedented act that the U.S. and Japan would likely retaliate against.2 We could see the U.S. following the script from 1988 Operation Praying Mantis in the Persian Gulf - the largest surface engagement by the U.S. Navy since the Second World War - when the U.S. sunk half of Iran's navy in retaliation for the mining of the guided missile frigate USS Samuel B. Roberts. In the case of North Korea, this would primarily mean taking out its approximately 20 Romeo-class submarines and an unknown number of domestically-produced - Yugoslav-designed - newly built submarines.3 Chart 1North Korean Provocations Rarely Affect Markets For Long North Korean Provocations Rarely Affect Markets For Long North Korean Provocations Rarely Affect Markets For Long Such an increase in tensions is not our baseline case, but we assign much higher probability to it than to an all-out war on the Korean Peninsula (which we still see as highly unlikely). How would the markets react to the sinking of North Korean submarines? How would Pyongyang react? The answer to the former (market's reaction) depends on the answer to the latter (what does Pyongyang do?). Our best guess is that Pyongyang would do nothing. In fact, we may never know that North Korean submarines were sunk. We would suspect that North Korean military strategists would chalk the subs as a loss and quietly move on to more missile tests. Leadership in Pyongyang is massively constrained by its quantifiable military inferiority. This part requires a bit of "order-of-battle" analysis, so bear with us for a few paragraphs. North Korea has around 6 million military personnel, about 25% of the total North Korean population, ready to fight. Which would be great if it were preparing to charge Verdun in WWI. Unfortunately for Pyongyang, it is arrayed against one of the most sophisticated defenses ever constructed by man. To burst through the Demilitarized Zone (DMZ), its mammoth ground forces would have at their disposal about 2000 T-55s (designed in the 1950s) and an unknown number of T-72s (designed in the 1970s). The former are obsolete, but the latter are solid main battle tanks that could do damage ... that is, in a world where war was not airborne. The problem is that North Korea would lose air superiority within hours of any serious engagement leaving its tanks and ground troops vulnerable to death-from-above. Since North Korean troops would have to enter about 20 miles into South Korea to threaten Seoul with occupation, they would have to exit the range of most of their air defenses. Choosing to turn on the most powerful of their systems - such as the KN-06 with a 150km range - would leave them vulnerable to the U.S. AGM-88 HARM missiles that sniff out active radar antenna or transmitters. To protect its invading forces, North Korea would have at its disposal only about 20-30 Mig-29s. Countering two dozen jets would be South Korea's combined 177 F-15 and F-16s, plus American forces that would vary in size depending how many aircraft carriers were deployed in the vicinity and whether U.S. forces in Japan were deployed to counter the attack. Given that a single American aircraft carrier holds up to 48 fighter jets, North Koreans would likely quickly find themselves fighting a losing battle. Once the North Korean fighter jets were destroyed, the South Korean air force would turn the invasion into a massacre. The reality is that North Korea's ground forces are just for show. Its tanks and fighter jets will never see battle. North Korea really only has two gears: P & N. The first is for "Provocation" and the second is for "Nuclear Armageddon." This is why we highly doubt that we will see our Praying Mantis scenario play out, or lead to full-scale war if it does. North Korea is constrained by its technological inferiority. It does not have the ability to conduct war across a full spectrum of engagement. Neither did Iran in 1988, which is why it never retaliated for the loss of its navy, put all its revolutionary zeal and chest-thumping aside, and sued the U.S. at the International Court of Justice instead.4 The U.S. has a range of limited military engagements, particularly at sea, that could hurt Pyongyang's ability to project what little power it has. Given our constraint-based methodology, which requires one to have some understanding of military affairs, we have a fairly high conviction view that North Korea will continue to toe-the-line of the expected and thus accepted provocations along the lines of the history surveyed in Chart 1. Going beyond that list would threaten to expose the paucity of North Korea's military capabilities. Bottom Line: We are still in for a wild ride with North Korea. As we expected, regional safe haven assets continue to perform well. We will hold on to our safe haven basket of Swiss bonds and gold, up 2.6% since August 16. Nonetheless, we expect North Korea to steer clear of provoking a war. Gary Cohn Will Collapse The USD! (But What If He Already Did?) Several fast-money clients - both in the U.S. and Asia - have a theory for why the greenback continues to suffer: Gary Cohn. The theory goes that Cohn is an ultra-dove whose job as the next Fed Chair will be to stay "behind the curve" and drive down the USD. This would accomplish President Trump's lofty nominal GDP growth goals despite legislative hurdles to his fiscal policy. It would also keep risk assets well bid and help begin rebalancing the U.S. trade deficit. What do we know of Mr. Cohn's views on monetary policy? Not much: He defended the Trump administration goal of a 3% GDP growth target, suggesting that he has a far more optimistic view of U.S. growth than the current Fed projection;5 He believes that monetary policy is "globalized," intoning at a conference in Florida quickly after the election that the Fed policy of raising rates before the rest of the world is ready to do the same would be a mistake;6 In a January 2016 Bloomberg TV interview, he said that both the U.S. and Chinese currencies were overvalued and would both have to devalue.7 People who know and have worked with Gary Cohn (including one colleague at BCA!) speak highly of his pragmatism, work ethic, and focus. Most agree that he would likely be dove-ish, but there is not a single person we have spoken to who thinks that he will be Trump's puppet. As such, his disconnected statements largely say nothing about his potential style of leadership. His most ultra-dovish, USD-slaying comment comes from January 2016, with DXY 6.9% down since then (Chart 2). Mission Accomplished Mr. Cohn? The real reason for the USD slide, aside from a persistently disappointing inflation print, has been a realization by the market that President Trump's bark has no bite. On a slew of measures, President Trump's initial bravado has dissipated into flabby rhetoric. Chart 3 shows the initial surge in optimism regarding growth, tax reform, infrastructure spending, Mexico's comeuppance, and bi-partisanship (measured as support among independents). Each data point has not only fallen back to pre-election levels, but appears to have now been desensitized to any news that would have excited it in the past. For example, NAFTA negotiations are off to a poor start, President Trump continues to bash the trade deal, and yet the peso has rallied since Trump's inauguration! Chart 2Mission Accomplished, Mr. Cohn? Mission Accomplished, Mr. Cohn? Mission Accomplished, Mr. Cohn? Chart 3Trump's Bark Has No Bite? Trump's Bark Has No Bite? Trump's Bark Has No Bite? The Fed itself has lost faith in the president. The number of FOMC members who see upside risks to inflation and GDP growth, not unrelated to fiscal policy, has fallen after a brief surge after the election (Chart 4). Chart 4The Fed Also Doubts Trump Insights From The Road - The Rest Of The World Insights From The Road - The Rest Of The World What chances are there for the White House and Congress to re-write the fiscal narrative over the final quarter of 2017? As we wrote last week, Hurricane Harvey will ensure that a debt ceiling breach and government shutdown are avoided. However, Congress is likely to spend September making one last attempt at Obamacare repeal and replace, thus largely wasting the month before returning to tax reform in earnest in the new fiscal year. We expect some form of tax legislation to take shape by the end of December. Will it be comprehensive tax reform? Unlikely. It will now almost certainly be merely a tax-cutting exercise, with some revenue offsets attached to it. With the Republicans in Congress now leading the tax reform effort, it is unlikely that the budget deficit hole will be as wide as President Trump would have wanted. The problem is that both Trump's July tax reform proposal and the House GOP August plan come short of revenue-neutrality by around $3-3.5 trillion (over the decade-long period) (Table 1). Given that such a massive increase in the deficit would be unacceptable to fiscal hawks (or Democrats) in the House, we would expect tax rates to be cut by a much more modest degree. Table 1By How Much Will Republican Tax Cuts Widen The Deficit? Insights From The Road - The Rest Of The World Insights From The Road - The Rest Of The World Table 1 gives a detailed survey of the preferences (Tax Cuts) and constraints (Revenue Offsets). It is difficult to see how all the constraints are overcome through the legislative process. This will force Republicans to modify their preferences on the scale of tax cuts. We would expect that a corporate tax cut from 35% to around 27-28% could be possible, along with a minimal middle-class tax cut. Anything beyond that would be overly complicated. Therein lies the paradox for Chair Cohn. The only way that he can be "behind the curve" is if the curve gets "in front of him." But why would it if any coming tax legislation has very little stimulative effect on the economy? Currently, the expected change in the Fed Funds Rate over the next two years stands at a measly 40 bps (Chart 5). That is just barely two rate hikes until September 2019. How can Mr. Cohn get the expectations any lower at this point? Bottom Line: The appointment of Gary Cohn will be a classic "sell the (USD on the) rumor, buy (the USD) on the news." We expect his appointment in late November or early December, if President Trump goes by the lead time from the past two nominations (Chart 6). That may be the time to pare back USD shorts for those investors who have been bearish on the greenback. Chart 5Hard To Drive Expectations##BR##Lower For Rate Hikes Hard To Drive Expectations Lower For Rate Hikes Hard To Drive Expectations Lower For Rate Hikes Chart 6How Long Does It Take To##BR##Confirm The Fed Chair? Insights From The Road - The Rest Of The World Insights From The Road - The Rest Of The World Europe Is Not A Risk Chart 7Europe's Economy Zooming Along Europe's Economy Zooming Along Europe's Economy Zooming Along One clear insight from our five weeks on the road this summer is that Europe is no longer on anyone's radar. We had hardly any questions regarding the upcoming German or Italian elections. And while most investors were somewhat pessimistic regarding French structural reforms, none expressed any interest in betting against them either. The obvious reason is that Europe's economy has genuinely recovered (Chart 7). Consumer and business confidence are holding up while the manufacturing PMI and industrial production remain strong. That said, uniformity of view among clients across several geographies makes us nervous. On the future of the Euro Area, investors have swung wildly from morose to resigned that it is here to stay. Nonetheless, we generally agree with the consensus. Unlike at the beginning of this year, when we boldly claimed that European risks would turn out to be a "trophy red herring," we have no alpha to generate by disagreeing with the market.8 Here is why: German Election: We have a policy of not wasting our client's time by covering major geopolitical events that have no market-relevance. Germany is the world's fourth-largest economy and it will hold an election on September 24. However, we see no investment relevance in the election and therefore no reason to spend time covering it. Polls show that the center-left opposition Social Democratic Party (SPD) has arrested its decline and may force another Grand Coalition (Chart 8). The only moderately interesting question is whether Chancellor Angela Merkel's Christian Democratic Union (CDU) will be able to get its favored coalition ally, the Free Democratic Party (FDP), into government instead. The FDP has turned towards soft Euroskepticism since 2009. Its parliamentarians voted against several bills dealing with the Euro Area crisis during their 2009-2013 coalition with the CDU. That said, Chancellor Merkel has turned much more forcefully pro-Europe since the dark days of Greek bailouts and bond market rioting. The Chancellor can read the polls: Germans support the common currency at 81%, compared to 66% average between 2009-2013 (Chart 9). We expect the FDP to play along with the Europhile conversion by the CDU. Chart 8Another Grand Coalition? Another Grand Coalition? Another Grand Coalition? Chart 9Merkel Knows Germans Support The Euro Merkel Knows Germans Support The Euro Merkel Knows Germans Support The Euro If there is any significance to the calm ahead of the German election, it is that the country is at "peak normal." Its policymakers have dealt with a massive migration crisis, geopolitical crises to the East, terrorist attacks, and severe political and economic stresses in its sphere of influence, all with a near-complete absence of internal drama. This looks like either "as good as it gets," or the start of a new Golden Age in Europe, with Berlin in the lead. It is probably neither, but given European asset prices, and gearing to the growing global economy, we would remain overweight Euro Area equities going forward. Italian Election: Polls remain too-close-to-call in the upcoming Italian election, with Euroskeptic parties continuing to poll well (Chart 10). However, we are not sure one can truly call these parties Euroskeptic anymore. Despite a high level of Euroskeptic sentiment in the country (Chart 11), its Euroskeptic parties have been scared off by the failures of peers in Austria, the Netherlands, and France. Chart 10Italy: Euroskeptic Parties Poll Well... Italy: Euroskeptic Parties Poll Well... Italy: Euroskeptic Parties Poll Well... Chart 11...Reflecting Broader Euroskepticism ...Reflecting Broader Euroskepticism ...Reflecting Broader Euroskepticism Luigi Di Maio, leader of the anti-establishment Five Star Movement (M5S) in the Italian Chamber of Deputies, and Matteo Salvini, head of the right-wing, populist Lega Nord, both reversed positions on the euro this month. Di Maio will be 5SM candidate for prime minister in the upcoming elections - which must be held by May and will likely take place in February or March. He reiterated a position, which 5SM hinted at in the past, that leaving the Euro Area would only be the "last resort" if Brussels refused to relax strict budget rules. Meanwhile, the firebrand, populist, Salvini hid behind Italy's constitution, claiming that a referendum on the euro would be illegal. In the short term, this means that the election in 2018 is no longer a risk. In the long term, it does not change the fact that Italy is ripe for a bout of Euroskeptic crisis at some later stage. Migration Crisis: Bad news for right-wing populists everywhere: the migration crisis is over and in quite a dramatic fashion. This is an empirical fact (Chart 12). Europe's enforcement efforts and collaboration with Libyan authorities (such as they are) have now forced even the humanitarian agencies to abandon the Mediterranean route. One of the largest such agencies - the Migrant Offshore Aid Station (MOAS) - recently announced that it was packing its mothership, the Phoenix, for Myanmar. The group is the fourth to stop patrols for migrants. Medecins sans Frontieres, Save the Children, and Germany's Sea Eye all cited hostile actions taken by Libyan authorities towards their vessels as the main reason to stop rescuing migrants in Libyan waters. Chart 12The 'Migration Crisis' Is Definitively Over The 'Migration Crisis' Is Definitively Over The 'Migration Crisis' Is Definitively Over To be clear, what is happening in the Mediterranean is a result of European enforcement efforts, not any sudden awakening of Libyan capacity or sovereignty. The European Union and Italy are training and funding the Libyan Coast Guard, which has started to intercept humanitarian vessels, threaten them with force (often right in front of the Italian Navy!), and force them to return migrants to Libya, where they are subjected to extremely cruel internment. Prior to this development, human smugglers would launch barely seaworthy "crafts" towards humanitarian ships waiting literally yards away in Libyan waters to "rescue" the "migrants" to Europe. As such, humanitarian agencies were aiding and abetting human smuggling, by making it a lucrative enterprise with no downside risk for the smugglers. We expect the step-up in enforcement in Libyan waters to severely impair the cost-benefit calculus of attempting a Mediterranean crossing for a would-be migrant. Instead of a welcoming NGO vessel many will find themselves in Libyan Internment camps. Word will spread fast and the migration crisis will abate further. We have now come full circle on the migration crisis, which we predicted back in September 2015 would end precisely in such an illiberal fashion.9 Europe has a vicious streak ... who knew? Structural Reforms In France: In February, we penned a bullish report on France, arguing with high conviction that Marine Le Pen would lose and that structural reforms would follow.10 What is the status of the latter forecast? Despite a decline in President Emmanuel Macron's popularity (Chart 13), he is expending his political capital early in his term. He understands our "J-curve of Structural Reform" (Diagram 1). Policymakers who understand how the reform J-curve works know that they have to spend their political capital while they have it, at the beginning of their term, in order to reap the benefits, if there are any, while they are still in power. Chart 13Macron's Popularity Slips Insights From The Road - The Rest Of The World Insights From The Road - The Rest Of The World Diagram 1The J-Curve Of Structural Reform Insights From The Road - The Rest Of The World Insights From The Road - The Rest Of The World How do Macron's reforms compare with previous efforts? Generally speaking, Macron's reforms (Table 2) compare favorably with both the 2012 Mariano Rajoy reforms in Spain and the 2003 Hartz reforms in Germany. The Hartz reforms were instrumental in expanding temporary work contracts and restructured generous unemployment benefits. Similarly, the Rajoy reforms in Spain clarified economic grounds for dismissal and created more flexible "entrepreneur contracts." Macron's reforms fit these efforts, especially the proposals to put in place "project contracts" - an open-ended contract lasting for the duration of a project - and to establish a floor and a ceiling for allowances in cases of unfair terminations, and make termination for economic reasons easier. Table 2French Labor Reforms: The Key Bits Insights From The Road - The Rest Of The World Insights From The Road - The Rest Of The World The two criticisms of the reform efforts we most often hear are that France has not had a crisis to spur reforms and that unions will launch vicious protests. The first criticism is dubious, given that France is itself emerging from the low-growth doldrums of the post-Great Financial Crisis. It is simply false to say that France has had no crisis. The French public is acutely aware that its real per-capita GDP growth has been closer to Greek levels than German ones over the last two decades (Chart 14) and that it has lost competitiveness in the global marketplace (Chart 15). One cannot have a conversation with a French friend, colleague, or client without wanting to order a strong drink!11 Chart 14France's Lost Millennium Insights From The Road - The Rest Of The World Insights From The Road - The Rest Of The World Chart 15France's Lost Competitiveness France's Lost Competitiveness France's Lost Competitiveness Besides, what monumental crisis was it that propelled Germany into reforms in the early 2000s? A vicious recession? A massive bank crisis? It was neither. Germany was simply weighed down for a decade by fiscal transfers to East Germany and sensing that its export-oriented industry was facing a massive challenge from the Asian move up the value chain. It was this acute sense of competitive pressure, of falling behind, that spurred Germany to reform. With France, the acute sense of falling behind Germany (Chart 16) is at the heart of today's effort. Chart 16German Competition Puts A Fire Under France German Competition Puts A Fire Under France German Competition Puts A Fire Under France The second criticism, that the unions will hold protests, misjudges the political capital arrayed behind Macron. Despite his sagging popularity, 85.9% of the seats in the National Assembly are of pro-reform orientation (Diagram 2). The second-largest party in the parliament is Les Republicains, an even more zealously pro-reform group. This is a unique situation in French history and will allow the government to ignore protests on the street. Diagram 2The Balance Of Power In France's National Assembly Insights From The Road - The Rest Of The World Insights From The Road - The Rest Of The World In fact, two of the largest unions in France - Force Ouvrière and CFDT - have both said they would not protest the labor reforms. This leaves only the more militant CGT to protest, along with the left-wing presidential candidate Jean-Luc Mélenchon. The reason investors will still fret about protests this month is because CGT retains a strong representation in heavy industry and infrastructure sectors like energy and railways. As such, their industrial action could grind the country to a halt. We suspect that a repeat of the 1995 general strike or the 2010 French pension reform unrest - both of which CGT spearheaded - will be the final nail in the coffin of "Old France." Unlike those previous reform efforts, President Macron's effort has been clearly signaled ahead of the election and thus retains considerable democratic legitimacy. As such, any repeat of the 1995 or especially 2010 unrest would delegitimize the unions and give President Macron even more political capital. Bottom Line: We agree with the now conventional view that all is well in Europe. Stability ahead of the German election reminds investors of what a healthy country is supposed to look like. Italian election risks have dissipated. And our French structural reforms call remains on track. This gives us an opportunity to do some house-cleaning regarding our calls. First, we are closing our long French 10-year bond / short Italian 10-year bond trade for a gain of only 1 bps. Second, we are closing our overweight Euro Area equities relative to U.S. equities call for a gain of 7.88%. Given our euro-bullishness, we never recommended that this call be currency hedged. We are now reinstating it with a currency hedge. We are also closing our long German 10-Year CPI Swap for a gain of 45.5 bps. We will stick with our long French industrial equities / short German industrials, which is currently up 9.25%. This is a way we have chosen to articulate our bullish view on the reforms, although clients with greater sophistication in European sectors could come up with a more direct way to articulate the view. Separately, we are also booking profits on our long China volatility trade (CBOE China ETF Volatility Index) for a gain of 16.82%. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, available at gps.bcaresearch.com. 2 A North Korean submarine sank the South Korean corvette Cheonan in 2010, but that was still within the norm of behavior for the two countries that are still effectively at war and have contested maritime borders. 3 Romeo-class submarines are nearly 70 years old. As much as we harken back to Yugoslav engineering with pride at BCA's Geopolitical Strategy, Belgrade was never much of a naval power. Nonetheless, diesel-powered submarines are quite proficient in staying undetected and could present a problem for the U.S. Navy. At least until they had to resurface or get back to base, where nuclear-powered U.S. Virginia-class attack-subs would lie in wait for them. 4 Tehran won the court case in 2003! And the ICJ forced the U.S. to compensate Iran for its lost ships or else face invasion by the United Nations army. (We are just kidding obviously. Iran did win, but it got nothing.) Please see Pieter H.F. Bekker, "The World Court Finds that U.S. Attacks on Iranian Oil Platforms in 1987-1988 Were Not Justifiable as Self-Defense, but the United States Did Not Violate the Applicable Treaty with Iran," American Society of International Law Volume 8, Issue 25, dated November 11, 2003, available at: asil.org. 5 Please see CNBC, "Tax reform is coming in September, Trump economic advisor Gary Cohn says," dated June 29, 2017, available at cnbc.com. 6 Please see Wall Street Journal, "How Donald Trump's New Top Economic Adviser Views the World," dated December 14, 2016, available at wjs.com. 7 Please see Business Insider, "Trump and his top economic adviser have had completely different views on China," dated January 3, 2017, available at businessinsider.com. 8 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "The Great Migration - Europe, Refugees, And Investment Implications," dated September 23, 2015, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "The French Revolution," dated February 3, 2017, available at gps.bcaresearch.com. 11 Thankfully for France, the choice would still be French wine!

Feature Dear Client, In addition to this abbreviated Weekly Report, I am sending you a Special Report written by Mark McClellan, Managing Editor of the monthly Bank Credit Analyst. Mark makes a compelling case that the deflationary effects of the "Amazon economy" are overstated. I trust you will find his report very informative. Best regards, Peter Berezin, Chief Global Strategist Global Investment Strategy Chart 1September Is Generally ##br##Not A Good Time Of Year For Stocks Sticking With Bullish ... For Now Sticking With Bullish ... For Now My colleagues and I convened a meeting earlier this week to discuss whether to abandon our long-standing cyclically bullish view towards risk assets. Several of them felt it was time to turn more cautious. I am sympathetic to their concerns: Valuations are stretched, volatility is low, and geopolitical risks (most notably North Korea) are on the rise. Profit growth is likely to decelerate later this year, as the easy comps stemming from the depressed level of earnings in the first half of 2016 vanish. Meanwhile, stocks are entering the volatile early autumn months, a period which has historically seen poor returns (Chart 1). Nevertheless, at times like these, it is useful to fall back on our time-tested indicators. Bear markets have almost always coincided with economic recessions, with the latter usually causing the former (Chart 2). None of our recession-timing signals are flashing red: To cite just a few examples, ISM manufacturing new orders are strong, initial unemployment claims are low, core capital goods orders are accelerating, and the yield curve is not in any immediate risk of inverting (Chart 3). Chart 2Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Chart 3No Warnings Of Recession Here No Warnings Of Recession Here No Warnings Of Recession Here U.S. financial conditions have eased sharply this year, which should support growth over the next few quarters (Chart 4). A recent IMF report highlighted that easier U.S. financial conditions tend to generate positive spillovers onto other countries.1 The fact that all 45 countries monitored by the OECD are on track to grow this year - the first time this has happened since 2007 - is a testament to the strong fundamentals underpinning the global economy. Chart 4Easing Financial Conditions Bode Well For Growth Easing Financial Conditions Bode Well For Growth Easing Financial Conditions Bode Well For Growth The Fed's Dot Problem In this light, the Fed's projection that the unemployment rate will end this year at 4.3% and only fall to 4.2% by end-2018 no longer looks credible. If U.S. GDP growth remains above trend, as we expect, the unemployment rate could fall below its 2000 low of 3.8% by next summer. That will be enough to prompt investors to price in a few more rate hikes. Considering that the market expects just 22 basis points in hikes through to end-2018, this is not a high bar to clear. A bit more fiscal stimulus would add to the pressure to tighten monetary policy. While any meaningful progress on tax reform will be difficult to achieve, the odds are good that Congress will agree to cut statutory corporate and personal tax rates, with the latter focusing mainly on middle-income earners. Failure to raise the debt ceiling or extend federal spending authority beyond the current budget window could scuttle the benefits from lower tax rates. Fortunately, the risks of such an outcome have receded. If there is a silver lining from Hurricane Harvey, it is that the disaster could at least temporarily overcome the political impasse in Washington. Congress will need to appropriate additional disaster relief funds over the coming weeks. Politicians who are seen as creating roadblocks to such funding will face the electorate's wrath. The odds of an infrastructure bill passing through Congress have also risen. All recoveries eventually run out of steam, but this one can last at least until the second half of 2019, which will make it the longest U.S. expansion on record. As we discussed several weeks ago, the next recession is likely to be triggered by the Fed scrambling to hike rates in response to rising inflation.2 This is not an immediate concern, given that it usually takes a while for an overheated economy to generate inflation - especially since the U.S. currently can satisfy rising domestic demand with higher imports. However, the risks of overheating will increase as unemployment falls further and excess capacity elsewhere in the world is absorbed. Draghi After Jackson Hole Chart 5A Stronger Euro Is Deflationary A Stronger Euro Is Deflationary A Stronger Euro Is Deflationary Textbook economic theory states that a shift in consumption towards imported goods requires a real appreciation of the currency. The dollar, of course, has done exactly the opposite of that, depreciating by 6.6% in trade-weighted terms since the start of the year. The euro, in particular, has gained significant ground against the greenback, rising above $1.20 at one point this week. Mario Draghi's failure to express concerns about the resurgent euro during his Jackson Hole address was construed by many market participants as a green light for further currency strength. We are skeptical of this "saying nothing means you are saying something" interpretation. Draghi wanted to acknowledge (and partly take credit for) the recovery across the euro area, but he is cognizant of the problems posed by a stronger euro. The ECB's June forecast showed inflation rising to only 1.6% in 2019. In the period since those forecasts were compiled, the trade-weighted euro has appreciated by 3.9%, bringing the year-to-date gain to 6.2% (Chart 5). ECB staff calculations, which Draghi has approvingly quoted, show that a 10% appreciation in the euro would reduce inflation by 0.2 percentage points in the first year and 0.6-to-0.8 points in the subsequent two years.3 Better-than-expected growth since the June forecasts will offset some of the deflationary impact from the stronger euro, but probably not by much, given that the Phillips curve is quite flat at high-to-moderate levels of spare capacity. With labor market slack across the euro area still 3.2 percentage points higher today than in 2008 (and 6.7 points higher outside of Germany), it will be a while before stronger growth generates markedly higher inflation. We expect the ECB to reduce its 2018/2019 inflation forecast by 0.1-to-0.2 percentage points next week. It would be awkward for the central bank to play up the prospect of monetary policy normalization while it is simultaneously trimming its inflation projections. This suggests that the ECB's communications could turn more dovish, thereby limiting further upside for the euro. EUR/USD is currently trading near the top of the $1.10-to-$1.20 range that we foresee lasting for the next 10 months. Thus, our expectation is that the euro will weaken over the next few months, ending the year near $1.15, and potentially moving back towards its 2017 lows in the second half of next year, as an overheated U.S. economy forces the Fed to pick up the pace of rate hikes. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see "Getting The Policy Mix Right," IMF Global Financial Stability Report, (Chapter 3), (April 2017). 2 Please see Global Investment Strategy Weekly Report, "From Slow Burn Recovery to Retro-Recession?" dated August 18, 2017. 3 Please see European Central Bank, "March 2017 ECB Staff Macroeconomic Projections For The Euro Area." APPENDIX 1 Tactical Global Asset Allocation Monthly Update To complement our analysis, we use a variety of time-tested models to assess the global investment outlook. At present, these models favor global equities over bonds over a three-month horizon (Appendix Table 1). Appendix Table 1BCA's Tactical Global Asset Allocation Recommendations* Sticking With Bullish ... For Now Sticking With Bullish ... For Now Our business cycle equity indicators remain in bullish territory, as reflected in strong global growth and rising corporate earnings. Our monetary and financial indicators are also generally supportive. In contrast, our sentiment readings are sending mixed signals. On the one hand, implied equity volatility remains low and institutional exposure to stocks is quite high. On the other hand, surveys of retail investors show a healthy skepticism towards the bull market, which is a positive contrarian indicator. As has been the case for some time, our valuation measures are signaling that stocks are expensive, but these are typically useful only over horizons beyond one or two years. As we flagged last month, stocks tend to do poorly in August and September, which may hurt returns over the next few weeks. The stronger euro will negatively impact earnings in the euro area. This has caused our models to suggest a slight downgrade to European equities. However, we are inclined to fade this signal, given our expectation that the euro will give up some of its recent gains. Japanese stocks continue to score well on our metrics, buoyed by strengthening corporate profits and attractive valuations. Emerging market equities are fairly valued, although China still appears cheap. The rally in U.S. Treasurys has caused the gap between the 10-year yield and our model's fair value estimate to widen to around 50 basis points, the highest since last September. European and Japanese bonds also look somewhat overvalued, although the latter will continue to receive support from the BoJ's yield curve targeting operations. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Financial markets have slipped into a 'risk off' phase. The upbeat second quarter earnings season in the U.S., Japan and the Eurozone was overwhelmed by a number of negative events. Equity bear markets are usually associated with recessions. On that score, we do not see any warning signs of an economic downturn. However, geopolitical risks are rising at a time when valuation measures suggest that risk assets are vulnerable. We do not see the debt ceiling or the failure of movement on U.S. tax reform as posing large risks for financial markets. However, trade protectionism and, especially, North Korea are major wildcards. We don't believe the tensions in the Korean peninsula will end the cyclical bull market in global equities. Nonetheless, investors should expect to be tested numerous times over the next year to 18 months. BCA Strategists debated trimming equity exposure to neutral. However, the majority felt that, while there will be near-term volatility, the main equity indexes are likely to be higher on a 6-12 month horizon. Riding out the volatility is a better approach than trying to time the short-term ups and downs. That said, it appears prudent to be well shy of max overweight positions and to hold some safe haven assets within diversified portfolios. On a positive note, we have upgraded our EPS growth forecasts, except in the Eurozone where currency strength will be a significant drag in the near term. The Fed faced a similar low inflation/tight labor market environment in 1999. Policymakers acted pre-emptively and began to tighten before inflation turned up. This time, the FOMC will want to see at least a small increase in inflation just to be sure. Wages may be a lagging indicator for inflation in this cycle. Watch a handful of other indicators we identify that led inflection points in inflation in previous long economic expansions. This year's euro strength is unlikely to delay the next installment of ECB tapering, which we expect in early in 2018. Investors seem to be taking an "I'll believe it when I see it" attitude toward the U.S. inflation outlook, which has led to very lopsided rate expectations. Keep duration short. Feature Chart I-1Trump Popularity Headwind For Tax Reform September 2017 September 2017 A 'risk off' flavor swept over financial markets in August. The upbeat second quarter earnings season in the U.S., Japan and the Eurozone was overwhelmed by a number of negative events, from President Trump's Charlottesville controversy to the never-ending staff changes in the White House to North Korean tensions to the Texas flood and the terror attack in Spain. Trump's popularity rating is steadily declining, even now among Republican voters (Chart I-1). This has raised concerns that none of his business-friendly policies, tax cuts or initiatives to boost growth will be successfully enacted. It is even possible that the debt ceiling will be used as a bargaining chip among the various Republican factions. The political risks are multiplying at a time when the equity and corporate bond markets are pricey. Valuation measures do not help with timing, but they do inform on the potential downside risk if things head south. At the moment, we do not see any single risk as justifying a full retreat into safe havens and a cut in risk asset allocation to neutral or below. Nonetheless, there is certainly a case to be cautious and hold some traditional safe haven assets. Timing The Next Equity Bear Market It is rare to have an equity bear market without a recession in the U.S. There have been plenty of market setbacks that did not quite meet the 20% bear-market threshold, but were nonetheless painful even in the absence of recession (Black Monday, LTCM crisis, U.S. debt ceiling showdown and euro crises). Unfortunately, these corrections are very difficult to predict. At least with recessions, investors have a fighting chance in timing the exit from risk exposure. The slope of the yield curve and the Leading Economic Indicator (LEI) are classic recession indicators, and for good reason (Chart I-2). Over the past 50 years they have both successfully called all seven recessions with just one false positive. We can eliminate the false positive signals by combining the two indicators and follow a rule that both must be in the red to herald a recession.1 Chart I-2The Traditional Recession Indicators Have Worked Well The Traditional Recession Indicators Have Worked Well The Traditional Recession Indicators Have Worked Well It will be almost impossible for the yield curve to invert until the fed funds rate is significantly higher than it is today. Thus, it may be the case that a negative reading on the LEI, together with a flattening (but not yet inverted) yield curve, will be a powerful signal that a recession is on the way. Neither of these two indicators are warning of a recession. Global PMIs are hovering at a level that is consistent with robust growth. The erosion in the Global ZEW and the drop in the diffusion index of the Global LEI are worrying signs, but at the moment are consistent with a growth slowdown at worst (Chart I-3). Financial conditions remain growth-friendly and subdued inflation is allowing central banks to proceed cautiously when tightening (in the case of the Fed and Bank of Canada) or tapering (ECB). As highlighted in last month's Overview, the global economy has entered a synchronized upturn that should persist for the next year. The U.S. will be the first major economy to enter the next recession, but that should not occur until 2019 or 2020, barring any shocks in the near term. That said, risk asset prices have been bid up sharply and are therefore vulnerable to a correction. Below, we discuss five key risks to the equity bull market. (1) Is All Lost For U.S. Tax Cuts? Our recent client meetings highlight that investors are skeptical that any fiscal stimulus or tax cuts will see the light of day in the U.S. Tax cuts and infrastructure spending appear to have been priced out of the equity market, according to the index ratios shown in Chart I-4. We still expect a modest package to eventually be passed, although time is running out for this year. Tax reform is a major component of Trump's and congressional Republicans' agenda. If it fails, Republicans will have to go to their home districts empty-handed to campaign for the November 2018 midterm elections. Chart I-3Some Worrying Signs On Growth Some Worrying Signs On Growth Some Worrying Signs On Growth Chart I-4Fiscal Stimulus Largely Priced Out Fiscal Stimulus Largely Priced Out Fiscal Stimulus Largely Priced Out One implication of Tropical Storm Harvey is that it might force Democrats and Republicans to cooperate on an infrastructure bill for rebuilding. Even a modest spending boost or tax reduction would be equity-market positive given that so little is currently discounted. The dollar should also receive a lift, especially given that the Fed might respond to any fiscally-driven growth impulse with higher interest rates. (2) Who Will Lead The Fed? There is a significant chance that either Yellen will refuse to stay on when her term expires next February or that Trump will appoint someone else anyway. In this case, we would expect the President to do everything he can to ensure that the Fed retains its dovish bias. This means that he is likely to favor a non-economist and a loyal adviser, like Gary Cohn, over any of the more traditional, and hawkish, Republican candidates. Cohn could not arrive at the Fed and change the course of monetary policy on day one. The FOMC votes on rate changes, but in reality decisions are formed by consensus (with one or two dissents). The only way Cohn could implement an abrupt change in policy is if the Administration stacks the Fed Governors with appointees that are prepared to "toe the line" (the Administration does not appoint Regional Fed Presidents). Stacking the Governorships would take time. Nonetheless, it is not clear why President Trump would take a heavy hand in monetary policy when the current FOMC has been very cautious in tightening policy. The bottom line is that we would not see Cohn's appointment to the Fed Chair as signaling a major shift in monetary policy one way or the other. (3) The Debt Ceiling A more immediate threat is the debt ceiling. Recent fights over Obamacare and tax reform have pit fiscally conservative Republicans against the moderates, and it is possible that the debt ceiling is used as a bargaining chip in this battle. While government shutdowns have occurred in the past, the debt ceiling has never been breached. At the end of the day, the debt ceiling will always be raised because no government could stand the popular pressure that would result from social security checks not being mailed out to seniors or a halt to other entitlement programs. Even the Freedom Caucus, the most fiscally conservative grouping in the House, is considerably divided on the issue. This augurs well for a clean bill to raise the debt ceiling as the Republican majority in the House is 22 and the Freedom Caucus has 31 members. Democrats will not stand in the way of passage in the Senate. The worst-case scenario for the market would be a two-week shutdown in the first half of October, just before the debt ceiling is hit. We would not expect a shutdown to have any lasting impact on the economy, although it could provide an excuse for the equity market to correct. That said, the risk of even a shutdown has been diminished by events in Houston. It would be very difficult and damaging politically to shut down the government during a humanitarian emergency. (4) Trade And Protectionism The removal of White House Chief Strategist Stephen Bannon signals a shift in power toward the Goldman clique within the Trump Administration. National Economic Council President Gary Cohn, Treasury Secretary Steven Mnuchin, and Commerce Secretary Wilbur Ross are now firmly in charge of economic policy. The mainstream media has interpreted this shift within the Administration as reducing the risk of trade friction. We do not see it that way. President Trump still sounds hawkish on trade, particularly with respect to China. Our geopolitical experts point out that there are few constraints on the President to imposing trade sanctions on China or other countries. He could use such action to boost his popularity among his base heading into next year's midterm elections. On NAFTA, the Administration took a hard line as negotiations kicked off in August. This could be no more than a negotiating tactic. Our base case is that it will be some time before investors find out if negotiations are going off the rails. That said, the situation is volatile for both NAFTA and China, and we can't rule out a trade-related risk-off phase in financial markets over the next year. (5) North Korea North Korea's missile launch over Japan highlights that the tense situation is a long way from a resolution. The U.S. is unlikely to use military force to resolve the standoff. There are long-standing constraints to war, including the likelihood of a high death toll in Seoul. Moreover, China is unlikely to remain neutral in any conflict. However, the U.S. will attempt to establish a credible threat in order to contain Kim Jong-un. From an investor's perspective, it will be difficult to gauge whether the brinkmanship and military displays are simply posturing or evidence of real preparations for war.2 We don't believe the tensions in the Korean peninsula will end the cyclical bull market in global equities. Nonetheless, investors should expect to be tested numerous times over the next year to 18 months. Adding it all up, there is no shortage of things to keep investors awake at night. We would be de-risking our recommended portfolio were it not for the favorable earnings backdrop in the major advanced economies. Profit Outlook Update Chart I-5EPS Growth Outlook EPS Growth Outlook EPS Growth Outlook Second quarter earnings season came in even stronger than our upbeat models suggested in the U.S., Eurozone and Japan. This led to upward revisions to our EPS growth forecast, except in the Eurozone where currency strength will be a significant drag in the near term. The U.S. equity market enjoyed another quarter of margin expansion in Q2 2017 and the good news was broadly based. Earnings per share were higher versus Q2 2016 in all 11 sectors. Results were particularly strong in energy, technology and financials. Looking ahead, an update of our top-down model suggests the EPS growth will peak just under 20% late this year on a 4-quarter moving average basis, before falling to mid-single digits by the end of 2018 (Chart I-5). The peak is predicted to be a little higher than we previously forecast largely due to the feed-through of this year's pullback in the dollar. In Japan, a solid 70% of reporting firms beat estimates. Chart I-6 shows that Japan led all other major stock markets in positive earnings surprises in the second quarter. Manufacturing sectors, such as iron & steel, chemicals and machinery & electronics, were particularly impressive in the quarter, reflecting yen weakness and robust overseas demand. Japanese earnings are highly geared to the rebound in global industrial production. Moreover, Japan's nominal GDP growth accelerated in the second quarter and the latest PPI report suggested that corporate pricing power has improved. Twelve-month forward EPS estimates have risen to fresh all times highs, and have outperformed the U.S. in local currencies so far this year. Corporate governance reform - a key element of Abenomics - can take some credit for the good news on earnings. The share of companies with at least two independent directors rose from 18% in 2013 to 78% in 2016. The number of companies with performance-linked pay increased from 640 to 941, while the number that publish disclosure policies jumped from 679 to 1055. Analysts have been slow to factor in these positive developments. We expect trailing EPS growth to peak at about 25% in the first half of 2018 on a 4-quarter moving total basis, before edging lower by the end of the year. This is one reason why we like the Japanese market over the U.S. in local currency terms. Second quarter results in the Eurozone were solid, although not as impressive as in the U.S. and Japan. The 6% rise in the trade-weighted euro this year has resulted in a drop in the earnings revisions ratio into negative territory. Our previous forecast pointed to a continued rise in the 4-quarter moving average growth rate into the first half of 2018. However, we now expect the growth rate to dip by year end, before picking up somewhat next year. If the euro is flat from today's level, our model suggests that the drag on EPS growth will hover at 3-4 percentage points through the first half of next year as the negative impact feeds through (Chart I-7, bottom panel). Chart I-6Japan Led In Q2 Earning Surprises September 2017 September 2017 Chart I-7Currency Effects On Eurozone EPS Currency Effects On Eurozone EPS Currency Effects On Eurozone EPS Our top-down EPS model highlights that Eurozone earnings are quite sensitive to swings in the currency. In Chart I-7, we present alternative scenarios based on the euro weakening to EUR/USD 1.10 and strengthening to EUR/USD 1.30. For demonstration purposes we make the extreme assumption that the trade-weighted value of the euro rises and falls by the same amount in percentage terms. Profit growth decelerates by the end of 2017 in all three scenarios because of the lagged effect of currency swings. The projections begin to diverge only in 2018. EPS growth surges to around 20% by the end of next year in the euro-bear case, as the tailwind from the weakening currency combines with continuing robust economic growth. Conversely, trailing earnings growth hovers in the 5-8% range in the euro bull scenario, which is substantially less than we expect in the U.S. and Japan over the next year. EPS growth remains in positive territory because the assumed strength in European and global growth dominates the drag from the euro. The strong euro scenario would be negative for Eurozone equity relative performance versus global stocks in local currencies, although Europe might outperform on a common currency basis. The bottom line is that 12-month forward earnings estimates should remain in an uptrend in the three major economies. This means that, absent a negative political shock, the equity bull phase should resume in the coming months. Monetary policy is unlikely to spoil the party for risk assets, although the bond market is a source of risk because investors seem unprepared for even a modest rise in inflation. FOMC Has Seen This Before The Minutes from the July FOMC meeting highlighted that the key debate still centers on the relationship between labor market tightness and inflation, the timing of the next Fed rate hike and how policy should adjust to changing financial conditions. Chart I-8The FOMC Has Been Here Before The FOMC Has Been Here Before The FOMC Has Been Here Before The majority of policymakers are willing for now to believe that this year's soft inflation readings are driven largely by temporary 'one-off' factors. The hawks worry that a further undershoot of unemployment below estimates of full employment could suddenly generate a surge of inflation. They also point to the risk that low bond yields are promoting excess risk taking in financial markets. Moreover, the recent easing in financial conditions is stimulative and should be counterbalanced by additional Fed tightening. The hawks are thus anxious to resume tightening, despite current inflation readings. Others are worried that inflation softness could reflect structural factors, such as restraints on pricing power from global developments and from innovations to business models spurred by advances in technology. In this month's Special Report beginning on page 18, we have a close look at the impact of "Amazonification" in holding down overall inflation. We do not find the evidence regarding e-commerce compelling, but the jury is still out on the impact of other technologies. If robots and new business strategies are indeed weighing on inflation, it would mean that the Phillips curve is very flat or that the full employment level of unemployment is lower than the Fed estimates (or both). Either way, the doves would like to see the whites-of-the-eyes of inflation before resuming rate hikes. The last time the Fed was perplexed by a low level of inflation despite a tight labor market was in the late 1990s (Chart I-8). The FOMC cut rates following the LTCM financial crisis in late 1998, and then held the fed funds rate unchanged at 4¾% until June 1999. Core inflation was roughly flat during the on-hold period at 1% to 1½%, even as the unemployment rate steadily declined and various measures pointed to growing labor shortages. The FOMC 's internal debate in the first half of 1999 sounded very familiar. The minutes from meetings at that time noted that some policymakers pointed to the widespread inability of firms to raise prices because of strong competitive pressures in domestic and global markets. Some argued that significant cost saving efforts and new technologies also contributed to the low inflation environment for both consumer prices and wages. One difference from today is that productivity growth was solid at that time. The FOMC decided to hike rates in June 1999 by a quarter point, despite the absence of any clear indication that inflation had turned up. Policymakers described the tightening as "a small preemptive move... (that) would provide a degree of insurance against worsening inflation later". The Fed went on to lift the fed funds rate to 6½% by May 2000. Interestingly, the unemployment rate in June 1999 was 4.3%, exactly the same as the current rate. There are undoubtedly important differences in today's macro backdrop. The Fed is also more fearful of making a policy mistake in the aftermath of the Great Recession and financial crisis. Nonetheless, the point is that the Fed has faced a similar low inflation/tight labor market environment before, but in the end patience ran out and policymakers acted pre-emptively. Inflation Warning Signs During Long-Expansions We have noted in previous research that inflation pressures are slower to emerge in 'slow burn' recoveries, such as the 1980s and 1990s. In Chart I-9, we compare the core PCE inflation rate in the current cycle with the average of the previous two long expansion episodes (the inflection point for inflation in the previous cycles are aligned with June 2017 for comparison purposes). The other panels in the chart highlight that, in the 1980s and 1990s, wage growth was a lagging indicator. Economic commentators often assume that inflation is driven exclusively by "cost push" effects, such that the direction of causation runs from wage pressure to price pressure. However, causation runs in the other direction as well. Households see rising prices and then demand better wages to compensate for the added cost of living. This is not to say that we should totally disregard wage information. But it does mean that we must keep an eye on a wider set of data. Indicators that provided some leading information in the previous two long cycles are shown in Chart I-10. To this list we would also add the St. Louis Fed's Price Pressure index, which is not shown in Chart I-10 because it does not have enough history. At the moment, the headline PPI, ISM Prices Paid and BCA's pipeline inflation pressure index are all warning that inflation pressures are gradually building. However, this message is not confirmed by the St. Louis Fed's index and corporate selling prices. We are also watching the velocity of money, which has been a reasonably good leading indicator for U.S. inflation since 2000 (Chart I-11). Chart I-9In The 80s & 90s Wage Growth ##br##Gave No Early Warning On Inflation In The 80s & 90s Wage Growth Gave No Early Warning On Inflation In The 80s & 90s Wage Growth Gave No Early Warning On Inflation Chart I-10Leading Indicators Of Inflation ##br##In "Slow Burn" Recoveries Leading Indicators Of Inflation In "Slow Burn" Recoveries Leading Indicators Of Inflation In "Slow Burn" Recoveries Chart I-11Money Velocity And Inflation Money Velocity And Inflation Money Velocity And Inflation Our Fed view remains unchanged from last month; the FOMC will announce its balance sheet diet plan in September and the next rate hike will take place in December. Nonetheless, this forecast hangs on the assumption that core inflation edges higher in the coming months. Some indicators are pointing in that direction and recent dollar weakness will help. Wake Me When Inflation Picks Up Investors seem to be taking an "I'll believe it when I see it" attitude toward the U.S. inflation outlook. They also believe that persistent economic headwinds mean that monetary policy will need to stay highly accommodative for a very long time. Only one Fed rate hike is discounted between now and the end of 2018, and implied forward real short-term rates are negative until 2022. While we do not foresee surging inflation, the risks for market expectations appear quite lopsided. We expect one rate hike by year end, followed by at least another 50 basis points of tightening in 2018. The U.S. 10-year yield is also about almost 50 basis points below our short-term fair value estimate (Chart I-12). Moreover, over the medium- and long-term, reduced central bank bond purchases will impart gentle upward pressure on equilibrium bond yields. Twenty-eighteen will be the first time in four years in which the net supply of government bonds available to private investors will rise, taking the U.S., U.K., Eurozone and Japanese markets as a group. This year's euro strength is unlikely to delay the next installment of ECB tapering, which we expect in early in 2018. The currency appreciation will keep a lid on inflation in the near term. However, we see the euro's ascent as reflective of the booming economy, rather than a major headwind that will derail the growth story. Overall financial conditions have tightened this year, but only back to levels that persisted through 2016 (Chart I-13). Chart I-12U.S. 10-year Yield Is Below Fair Value U.S. 10-year Yield Is Below Fair Value U.S. 10-year Yield Is Below Fair Value Chart I-13Financial Conditions Financial Conditions Financial Conditions It will take clear signs that the economy is being negatively affected by currency strength for the ECB to back away from tapering. Indeed, the central bank has little choice because the bond buying program is approaching important technical limits. European corporate and peripheral bond spreads are likely to widen versus bunds as a result. The implication is that global yields have significant upside potential relative to forward rates, especially in the U.S. market. Duration should be kept short. JGBs are the only safe place to hide if global yields shift up because the Bank of Japan is a long way from abandoning its 10-year yield peg. Treasury yields should lead the way higher, which will finally place a bottom under the beleaguered dollar. Nonetheless, we are tactically at neutral on the greenback. Conclusions Chart I-14Gold Loves Geopolitical Crises September 2017 September 2017 In light of rising geopolitical risk, the BCA Strategists recently debated trimming equity exposure to neutral. Some argued that the risk/reward balance has deteriorated; the upside is limited by poor valuation, while there is significant downside potential if the North Korean situation deteriorates alarmingly. However, the majority felt that, while there will be near-term volatility, the main equity indexes are likely to be higher on a 6-12 month horizon. Riding out the volatility is a better approach than trying to time the short-term ups and downs. That said, it appears prudent to be well shy of max overweight positions and to hold some safe haven assets within diversified portfolios. BCA research has demonstrated that U.S. Treasurys, Swiss bonds and JGBs have been the best performers in times of crisis (Chart I-14).3 The same is true for the Swiss franc and the Japanese yen, such that the currency exposure should not be hedged in these cases. The dollar is more nuanced. It tends to perform well during financial crises, but not in geopolitical crises or recessions. Gold has tended to perform well in geopolitical events and recessions, although not in financial crises. We continue to prefer Japanese to U.S. stocks in local currency terms, given that EPS growth will likely peak in the U.S. first. Japanese stocks are also better valued. Europe is a tough call because this year's currency strength will weigh on earnings in the next quarter or two. However, the negative impact on earnings will reverse if the euro retraces as we expect. EM stocks have seen the strongest positive earnings revisions this year. We continue to worry about some of the structural headwinds facing emerging markets (high debt levels, poor governance, etc.). However, the cyclical picture remains more upbeat. Chinese H-shares remain our favorite EM market, trading at just 7.5 times 2017 earnings estimates. Our dollar and duration positions have been disappointing so far this year. Much hinges on U.S. inflation. Investors appear to have adopted the idea that structural headwinds to inflation will forever dominate the cyclical pressures. This means that the bond market is totally unprepared for any upside surprises on the inflation landscape. Admittedly, a rise in bond yields may not be imminent, but the risks appear to us to be predominantly to the upside. Lastly, crude oil inventories are shrinking as our commodity strategists predicted. They remain bullish, with a price target of USD60/bbl. Mark McClellan Senior Vice President The Bank Credit Analyst August 31, 2017 Next Report: September 28, 2017 1 Please see BCA Global ETF Strategy, "A Guide To Spotting And Weathering Bear Markets," dated August 16, 2017, available at etf.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, available at gps.bcaresearch.com 3 Please see BCA Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com II. Did Amazon Kill The Phillips Curve? A "culture of profound cost reduction" has gripped the business sector since the GFC according to one school of thought, permanently changing the relationship between labor market slack and wages or inflation. If true, it could mean that central banks are almost powerless to reach their inflation targets. Amazon, Airbnb, Uber, robotics, contract workers, artificial intelligence, horizontal drilling and driverless cars are just a few examples of companies and technologies that are cutting costs and depressing prices and wages. In the first of our series on inflation, we will focus on the rise of e-commerce and the related "Amazonification" of the economy. In theory, positive supply shocks should not have more than a temporary impact on inflation if the price level is indeed a monetary phenomenon in the long term. But a series of positive supply shocks could make it appear for quite a while that low inflation is structural in nature. We are keeping an open mind and reserving judgement on the disinflationary impact of robotics, artificial intelligence and the gig economy until we do more research. But in terms of the impact of e-commerce, it is difficult to find supportive evidence at the macro level. The admittedly inadequate measures of online prices available today do not suggest that e-commerce sales are depressing the overall inflation rate by more than 0.1 or 0.2 percentage points. Moreover, it does not appear that the disinflationary impact of competition in the retail sector has intensified over the years. Today's creative destruction in retail may be no more deflationary than the shift to 'big box' stores in the 1990s. Perhaps lower online prices are forcing traditional retailers to match the e-commerce vendors, allowing for a larger disinflationary effect than we estimate. However, the fact that retail margins are near secular highs outside of department stores argues against this thesis. The sectors potentially affected by e-commerce make up a small part of the CPI index. The deceleration of inflation since the GFC has been in areas unaffected by online sales. High profit margins for the overall corporate sector and depressed productivity growth also argue against the idea that e-commerce represents a large positive macro supply shock. Perhaps the main way that e-commerce is affecting the macro economy and financial markets is not through inflation, but via the reduction in the economy's capital spending requirement. This would reduce the equilibrium level of interest rates, since the Fed has to stimulate other parts of the economy to offset the loss of demand in capital spending in the retail sector. Anecdotal evidence is all around us. The global economy is evolving and it seems that all of the major changes are deflationary. Amazon, Airbnb, Uber, robotics, contract workers, artificial intelligence, horizontal drilling and driverless cars are just a few examples of companies and technologies that are cutting costs and depressing prices and wages. Central banks in the major advanced economies are having difficulty meeting their inflation targets, even in the U.S. where the labor market is tight by historical standards. Based on the depressed level of bond yields, it appears that the majority of investors believe that inflation headwinds will remain formidable for a long time. One school of thought is that low inflation reflects a lack of demand growth in the post-Great Financial Crisis (GFC) period. Another school points to the supply side of the economy. A recent report by Prudential Financial highlights "...obvious examples of ... new business models and new organizational structures, whereby higher-cost traditional methods of production, transportation, and distribution are displaced by more nontraditional cost-effective ways of conducting business."1 A "culture of profound cost reduction" has gripped the business sector since the GFC according to this school, permanently changing the relationship between labor market slack and wages or inflation (i.e., the Phillips Curve). Employees are less aggressive in their wage demands in a world where robots are threatening humans in a broadening array of industrial categories. Many feel lucky just to have a job. In a highly sensationalized article called "How The Internet Economy Killed Inflation," Forbes argued that "the internet has reduced many of the traditional barriers to entry that protect companies from competition and created a race to the bottom for prices in a number of categories." Forbes believes that new technologies are placing downward pressure on inflation by depressing wages, increasing productivity and encouraging competition. There are many factors that have the potential to weigh on prices, but analysts are mainly focusing on e-commerce, robotics, artificial intelligence, and the gig economy. In the first of our series on inflation, we will focus on the rise of e-commerce and the related "Amazonification" of the economy. The latter refers to the advent of new business models that cut out layers of middlemen between producers and consumers. Amazonification E-commerce has grown at a compound annual rate of more than 9% over the past 15 years, and now accounts for about 8½% of total U.S. retail sales (Chart II-1). Amazon has been leading the charge, accounting for 43% of all online sales in 2016 (Chart II-2). Amazon's business model not only cuts costs by eliminating middlemen and (until recently) avoiding expensive showrooms, but it also provides a platform for improved price discovery on an extremely broad array of goods. In 2013, Amazon carried 230 million items for sale in the United States, nearly 30 times the number sold by Walmart, one of the largest retailers in the world. Chart II-1E-Commerce: Steady Increase In Market Share E-Commerce: Steady Increase In Market Share E-Commerce: Steady Increase In Market Share Chart II-2Amazon Dominates September 2017 September 2017 With the use of a smartphone, consumers can check the price of an item on Amazon while shopping in a physical store. Studies show that it does not require a large price gap for shoppers to buy online rather than in-store. Amazon appears to be impacting other retailers' ability to pass though cost increases, leading to a rash of retail outlet closings. Sears alone announced the closure of 300 retail outlets this year. The devastation that Amazon inflicted on the book industry is well known. It is no wonder then, that Amazon's purchase of Whole Foods Market, a grocery chain, sent shivers down the spines of CEOs not only in the food industry, but in the broader retail industry as well. What would prevent Amazon from applying its model to furniture and appliances, electronics or drugstores? It seems that no retail space is safe. A Little Theory Before we turn to the evidence, let's review the macro theory related to positive supply shocks. The internet could be lowering prices by moving product markets toward the "perfect competition" model. The internet trims search costs, improves price transparency and reduces barriers to entry. The internet also allows for shorter supply chains, as layers of wholesalers and other intermediaries are removed and e-commerce companies allow more direct contact between consumers and producers. Fewer inventories and a smaller "brick and mortar" infrastructure take additional costs out of the system. Economic theory suggests that the result of this positive supply shock will be greater product market competition, increased productivity and reduced profitability. In the long run, workers should benefit from the productivity boost via real wage gains (even if nominal wage growth is lackluster). Workers may lower their reservation wage if they feel that increased competitive pressures or technology threaten their jobs. The internet is also likely to improve job matching between the unemployed and available vacancies, which should lead to a fall in the full-employment level of unemployment (NAIRU). Nonetheless, the internet should not have a permanent impact on inflation. The lower level of NAIRU and the direct effects of the internet on consumer prices discussed above allow inflation to fall below the central bank's target. The bank responds by lowering interest rates, stimulating demand and thereby driving unemployment down to the new lower level of NAIRU. Over time, inflation will drift back up toward target. In other words, a greater degree of the competition should boost the supply side of the economy and lower NAIRU, but it should not result in a permanently lower rate of inflation if inflation is indeed a monetary phenomenon and central banks strive to meet their targets. Still, one could imagine a series of supply shocks that are spread out over time, with each having a temporary negative impact on prices such that it appears for a while that inflation has been permanently depressed. This could be an accurate description of the current situation in the U.S. and some of the other major countries. We have sympathy for the view that the internet and new business models are increasing competition, cutting costs and thereby limiting price increases in some areas. But is there any hard evidence? Is the competitive effect that large, and is it any more intense than in the past? There are a number of reasons to be skeptical because most of the evidence does not support Forbes' claim that the internet has killed inflation. (1) E-commerce affects only a small part of the Consumer Price Index As mentioned above, online shopping for goods represents 8.5% of total retail sales in the U.S. E-commerce is concentrated in four kinds of businesses (Table II-1): Furniture & Home Furnishings (7% of total retail sales), Electronics & Appliances (20%), Health & Personal Care (15%), and Clothing (10%). Since goods make up 40% of the CPI, then 3.2% (8% times 40%) is a ballpark estimate for the size of goods e-commerce in the CPI. Table II-1E-Commerce Market Share Of Goods Sector (2015) September 2017 September 2017 Table II-2 shows the relative size of e-commerce in the service sector. The analysis is complicated by the fact that the data on services includes B-to-B sales in addition to B-to-C.2 However, e-commerce represents almost 4% of total sales for the service categories tracked by the BLS. Services make up 60% of the CPI, but the size drops to 26% if we exclude shelter (which is probably not affected by online shopping). Thus, e-commerce in the service sector likely affects 1% (3.9% times 26%) of the CPI. Table II-2E-Commerce Market Share Of Service Sector (2015) September 2017 September 2017 Adding goods and services, online shopping affects about 4.2% of the CPI index at most. The bottom line is that the relatively small size of e-commerce at the consumer level limits any estimate of the impact of online sales on the broad inflation rate. (2) Most of the deceleration in inflation since 2007 has been in areas unaffected by e-commerce Table II-3 compares the average contribution to annual average CPI inflation during 2000-2007 with that of 2007-2016. Average annual inflation fell from 2.9% in the seven years before the Great Recession to 1.8% after, for a total decline of just over 1 percentage point. The deceleration is almost fully explained by Energy, Food and Owners' Equivalent Rent. The bottom part of Table II-3 highlights that the sectors with the greatest exposure to e-commerce had a negligible impact on the inflation slowdown. Table II-3Comparison Of Pre- and Post-Lehman Inflation Rates September 2017 September 2017 (3) The cost advantages for online sellers are overstated Bain & Company, a U.S. consultancy, argues that e-commerce will not grow in importance indefinitely and come to dominate consumer spending.3 E-commerce sales are already slowing. Market share is following a classic S-shaped curve that, Bain estimates, will top out at under 30% by 2030. First, not everyone wants to buy everything online. Products that are well known to consumers and purchased on a regular basis are well suited to online shopping. But for many other products, consumers need to see and feel the product in person before making a purchase. Second, the cost savings of online selling versus traditional brick and mortar stores is not as great as many believe. Bain claims that many e-commerce businesses struggle to make a profit. The information technology, distribution centers, shipping, and returns processing required by e-commerce companies can cost as much as running physical stores in some cases. E-tailers often cannot ship directly from manufacturers to consumers; they need large and expensive fulfillment centers and a very generous returns policy. Moreover, online and offline sales models are becoming blurred. Retailers with physical stores are growing their e-commerce operations, while previously pure e-commerce plays are adding stores or negotiating space in other retailers' stores. Even Amazon now has storefronts. The shift toward an "multichannel" selling model underscores that there are benefits to traditional brick-and-mortar stores that will ensure that they will not completely disappear. (4) E-commerce is not the first revolution in the retail sector The retail sector has changed significantly over the decades and it is not clear that the disinflationary effect of the latest revolution, e-commerce, is any more intense than in the past. Economists at Goldman Sachs point out that the growth of Amazon's market share in recent years still lags that of Walmart and other "big box" stores in the 1990s (Chart II-3).4 This fact suggests that "Amazonification" may not be as disinflationary as the previous big-box revolution. (5) Weak productivity growth and high profit margins are inconsistent with a large supply-side benefit from e-commerce As discussed above, economic theory suggests that a positive supply shock that cuts costs and boosts competition should trim profit margins and lift productivity. The problem is that the margins and productivity have moved in the opposite direction that economic theory would suggest (Chart II-4). Chart II-3Amazon Vs. Walmart: ##br##Who's More Deflationary? September 2017 September 2017 Chart II-4Incompatible With A Supply Shock Incompatible With A Supply Shock Incompatible With A Supply Shock By definition, productivity rises when firms can produce the same output with fewer or cheaper inputs. However, it is well documented that productivity growth has been in a downtrend since the 1990s, and has been dismally low since the Great Recession. A Special Report from BCA's Global Investment Strategy5 service makes a convincing case that mismeasurement is not behind the low productivity figures. In fact, in many industries it appears that productivity is over-estimated. If e-commerce is big enough to "move the dial" on overall inflation, it should be big enough to see in the aggregate productivity figures. Chart II-5Retail Margin Squeeze ##br##Only In Department Stores Retail Margin Squeeze Only In Department Stores Retail Margin Squeeze Only In Department Stores One would also expect to see a margin squeeze across industries if e-commerce is indeed generating a lot of deflationary competitive pressure. Despite dismally depressed productivity, however, corporate profit margins are at the high end of the historical range across most of the sectors of the S&P 500. This is the case even in the retailing sector outside of department stores (Chart II-5). These facts argue against the idea that the internet has moved the economy further toward a disinflationary "perfect competition" model. (6) Online price setting is characterized by frictions comparable to traditional retail We would expect to observe a low price dispersion across online vendors since the internet has apparently lowered the cost of monitoring competitors' prices and the cost of searching for the lowest price. We would also expect to see fairly synchronized price adjustments; if one vendor adjusts its price due to changing market conditions, then the rest should quickly follow to avoid suffering a massive loss of market share. However, a recent study of price-setting practices in the U.S. and U.K. found that this is not the case.6 The dataset covered a broad spectrum of consumer goods and sellers over a two-year period, comparing online with offline prices. The researchers found that market pricing "frictions" are surprisingly elevated in the online world. Price dispersion is high in absolute terms and on par with offline pricing. Academics for years have puzzled over high price rigidities and dispersion in retail stores in the context of an apparently stiff competitive environment, and it appears that online pricing is not much better. The study did not cover a long enough period to see if frictions were even worse in the past. Nonetheless, the evidence available suggests that the lower cost of monitoring prices afforded by the internet has not led to significant price convergence across sellers online or offline. Another study compared online and offline prices for multichannel retailers, using the massive database provided by the Billion Prices Project at MIT.7 The database covers prices across 10 countries. The study found that retailers charged the same price online as in-store in 72% of cases. The average discount was 4% for those cases in which there was a markdown online. If the observations with identical prices are included, the average online/offline price difference was just 1%. (7) Some measures of online prices have grown at about the same pace as the CPI index The U.S. Bureau of Labor Statistics does include online sales when constructing the Consumer Price Index. It even includes peer-to-peer sales by companies such as Airbnb and Uber. However, the BLS admits that its sample lags the popularity of such services by a few years. Moreover, while the BLS is trying to capture the rising proportion of sales done via e-commerce, "outlet bias" means that the CPI does not capture the price effect in cases where consumers are finding cheaper prices online. This is because the BLS weights the growth rate of online and offline prices, not the price levels. While there may be level differences, there is no reason to believe that the inflation rates for similar goods sold online and offline differ significantly. If the inflation rates are close, then the growing share of online sales will not affect overall inflation based on the BLS methodology. The BLS argues that any bias in the CPI due to outlet bias is mitigated to the extent that physical stores offer a higher level of service. Thus, price differences may not be that great after quality-adjustment. All this suggests that the actual consumer price inflation rate could be somewhat lower than the official rate. Nonetheless, it does not necessarily mean that inflation, properly measured, is being depressed by e-commerce to a meaningful extent. Indeed, Chart II-6 highlights that the U.S. component of the Billion Prices Index rose at a faster pace than the overall CPI between 2009 and 2014. The Online Price Index fell in absolute and relative terms from 2014 to mid-2016, but rose sharply toward the end of 2016. Applying our guesstimate of the weight of e-commerce in the CPI (3.2% for goods), online price inflation added to overall annual CPI inflation by about 0.3 percentage points in 2016 (bottom panel of Chart II-6). There is more deflation evident in the BLS' index of prices for Electronic Shopping and Mail Order Houses (Chart II-7). Online prices fell relative to the overall CPI for most of the time since the early 1990s, with the relative price decline accelerating since the GFC. However, our estimate of the contribution to overall annual CPI inflation is only about -0.15 percentage points in June 2017, and has never been more than -0.3 percentage points. This could be an underestimate because it does not include the impact of services, although the service e-commerce share of the CPI is very small. Chart II-6Online Price Index Online Price Index Online Price Index Chart II-7Electronic Shopping Price Index Electronic Shopping Price Index Electronic Shopping Price Index Another way to approach this question is to focus on the parts of the CPI that are most exposed to e-commerce. It is impossible to separate the effect of e-commerce on inflation from other drivers of productivity. Nonetheless, if online shopping is having a significant deflationary impact on overall inflation, we should see large and persistent negative contributions from these parts of the CPI. We combined the components of the CPI that most closely matched the sectors that have high e-commerce exposure according to the BLS' annual Retail Survey (Chart II-8). The sectors in our aggregate e-commerce price proxy include hotels/motels, taxicabs, books & magazines, clothing, computer hardware, drugs, health & beauty aids, electronics & appliances, alcoholic beverages, furniture & home furnishings, sporting goods, air transportation, travel arrangement and reservation services, educational services and other merchandise. The sectors are weighted based on their respective weights in the CPI. Our e-commerce price proxy has generally fallen relative to the overall CPI index since 2000. However, while the average contribution of these sectors to the overall annual CPI inflation rate has fallen in the post GFC period relative to the 2000-2007 period, the average difference is only 0.2 percentage points. The contribution has hovered around the zero mark for the past 2½ years. Surprisingly, price indexes have increased by more than the overall CPI since 2000 in some sectors where one would have expected to see significant relative price deflation, such as taxis, hotels, travel arrangement and even books. One could argue that significant measurement error must be a factor. How could the price of books have gone up faster than the CPI? Sectors displaying the most relative price declines are clothing, computers, electronics, furniture, sporting goods, air travel and other goods. We recalculated our e-commerce proxy using only these deflating sectors, but we boosted their weights such that the overall weight of the proxy in the CPI is kept the same as our full e-commerce proxy discussed above. In other words, this approach implicitly assumes that the excluded sectors (taxis, books, hotels and travel arrangement) actually deflated at the average pace of the sectors that remain in the index. Our adjusted e-commerce proxy suggests that online pricing reduced overall CPI inflation by about 0.1-to-0.2 percentage points in recent years (Chart II-9). This contribution is below the long-term average of the series, but the drag was even greater several times in the past. Chart II-8BCA E-Commerce Proxy Price Index BCA E-Commerce Proxy Price Index BCA E-Commerce Proxy Price Index Chart II-9BCA E-Commerce Adjusted Proxy Price Index BCA E-Commerce Adjusted Proxy Price Index BCA E-Commerce Adjusted Proxy Price Index Admittedly, data limitations mean that all of the above estimates of the impact of e-commerce are ballpark figures. Conclusions We are keeping an open mind and reserving judgement on the disinflationary impact of robotics, artificial intelligence and the gig economy until we do more research. But in terms of the impact of e-commerce, it is difficult to find supportive evidence. The available data are admittedly far from ideal for confirming or disproving the "Amazonification" thesis. Perhaps better measures of e-commerce pricing will emerge in the future. Nonetheless, the measures available today do not suggest that online sales are depressing the overall inflation rate by more than 0.1 or 0.2 percentage points, and it does not appear that the disinflationary impact has intensified by much. One could argue that lower online prices are forcing traditional retailers to match the e-commerce vendors, allowing for a larger disinflationary effect than we estimate. Nonetheless, if this were the case, then we would expect to see significant margin compression in the retail sector. The sectors potentially affected by e-commerce make up a small part of the CPI index. The deceleration of inflation since the GFC has been in areas unaffected by online sales. High corporate profit margins and depressed productivity growth also argue against the idea that e-commerce represents a large positive macro supply shock. Finally, today's creative destruction in retail may be no more deflationary than the shift to 'big box' stores in the 1990s. Perhaps the main way that e-commerce is affecting the macro economy and financial markets is not through inflation, but via the reduction in the economy's capital spending requirement. Rising online activity means that we need fewer shopping malls and big box outlets to support a given level of consumer spending. This would reduce the equilibrium level of interest rates, since the Fed has to stimulate other parts of the economy to offset the loss of demand in capital spending in the retail sector. To the extent that central banks were slow to recognize that equilibrium rates had fallen to extremely low levels, then policy was behind the curve and this might have contributed to the current low inflation environment. Mark McClellan Senior Vice President The Bank Credit Analyst 1 Robert F. DeLucia, "Economic Perspective: A Nontraditional Analysis Of Inflation," Prudential Capital Group (August 21, 2017). 2 Business to business, and business to consumer. 3 Aaron Cheris, Darrell Rigby and Suzanne Tager, "The Power Of Omnichannel Stores," Bain & Company Insights: Retail Holiday Newsletter 2016-2017 (December 19, 2016). 4 "US Daily: The Internet And Inflation: How Big Is The Amazon Effect?" Goldman Sachs Economic Research (August 2, 2017). 5 Please see Global Investment Strategy Weekly Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com 6 Yuriy Gorodnichenko, Viacheslav Sheremirov, and Oleksandr Talavera, "Price Setting In Online Markets: Does IT Click?" Journal of the European Economic Association (July 2016). 7 Alberto Cavallo, "Are Online And Offline Prices Similar? Evidence From Large Multi-Channel Retailers," NBER Working Paper No. 22142 (March 2016). III. Indicators And Reference Charts Stocks struggled in August on the back of intensifying geopolitical risks, such that equity returns slipped versus bonds in the month. The earnings backdrop remains constructive for global stocks. In the U.S., 12-month forward EPS estimates continue to climb, in line with upbeat net revisions and earnings surprises. Nonetheless, the risk/reward balance has deteriorated due to escalating risks inside and outside of the U.S. Allocation to risk assets should still exceed benchmark, but should be shy of maximum settings. It is prudent to hold some of the traditional safe haven assets, including gold. Our new Revealed Preference Indicator (RPI) remained at 100% in August, sending a bullish message for equities. We introduced the RPI in the July report. Quite simply, it 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 signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Our Willingness-to-Pay (WTP) indicators are also bullish on stocks for the U.S., Europe and Japan. These indicators track flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The U.S. WTP topped out in June and the same occurred in August for the Japan and the Eurozone indexes. While the indicators are still bullish, they highlight that flows into the equity markets in the major countries are beginning to moderate. These indicators would have to clearly turn lower to provide a bearish signal for stocks. The VIX increased last month, but remains depressed by historical standards. This implies that the equity market is vulnerable to bad news. However, investor sentiment is close to neutral and our speculation index has pulled back from previously elevated levels. These suggest that investors are not overly long at the moment. Our monetary indicator is only slightly negative, but the equity technical indicator is close to breaking below the 9-month moving average (a negative technical sign). Bond valuation continues to hover near fair value, according to our long-standing model that is based on a simple regression of the nominal 10-year yield on short-term real interest rates and a moving average of inflation. Another model, presented in the Overview section, estimates fair value based on dollar sentiment, a measure of policy uncertainty and the global PMI. This model suggests that the 10-year yield is almost 50 basis points on the expensive side. We think that Fed rate expectations are far too benign, suggesting that bond yields will rise. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And ##br##Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And ##br##Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-10U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China

Highlights Monetary Policy: The Fed's inflation forecast will continue to guide interest rate policy. This means that while an announcement about winding down the balance sheet will occur in September, a December rate hike is only in the cards if inflation shows some strength in the coming months. Fiscal Policy: The market is likely too pessimistic on the potential for fiscal stimulus from tax cuts, especially given the recent shift in power within the White House. Corporate Spread Valuation: With the exception of Aaa-rated credits (which appear expensive), investment grade corporate spreads are fairly valued after adjusting for changes in credit rating, duration and the stage of the cycle. Investors should expect to earn excess returns from corporate bonds consistent with carry on a 6-12 month horizon. Feature Several developments during the past two weeks provided a lot of information about the near-term outlooks for both monetary and fiscal policy. On the monetary front, the minutes from the July FOMC meeting elucidated the trade-off faced by the Fed between low inflation on one hand and easing financial conditions on the other. Then, at last week's Jackson Hole symposium, both Janet Yellen and Mario Draghi expounded on the topic of financial stability and how central bankers incorporate it into their frameworks. On the fiscal front, the dismissal of White House Chief Strategist Stephen Bannon has the potential to alter the Trump administration's legislative agenda for the remainder of the year, making fiscal stimulus more likely. In this week's report we reflect on how all of these developments impact our 6-12 month policy and market views. Monetary Policy From The Minutes: Low Inflation Vs. Easy Financial Conditions The minutes from the July FOMC meeting showed that "some participants [...] argued against additional adjustments until incoming information confirmed that the recent low readings on inflation were not likely to persist." Meanwhile, "some other participants were more worried about the risks arising from [...] the easing in financial conditions that had developed since the Committee's policy normalization process was initiated in December 2015." In other words, the Committee is roughly evenly split into two groups. Those that would rather delay rate hikes until inflation moves higher, and those that think easier financial conditions are reason enough to continue tightening. Those in the dovish group could point to Chart 1 for support. That chart shows that the real fed funds rate is approaching at least one popular estimate of its neutral level. In the Fed's mental framework it is crucial that the real fed funds rate stays below its neutral level because monetary policy must remain accommodative if inflation is to rise back to the 2% target. In other words, the Fed does not have "room" for further rate hikes unless inflation rises first, causing the real fed funds rate to fall. We won't re-hash prior arguments about why core inflation is likely to rise on a 6-12 month horizon,1 but we will note that our diffusion indexes for both PCE and CPI inflation have recently swung into positive territory. These indexes have strong track records capturing the near-term moves in year-over-year core inflation (Chart 2), and this development gives us some confidence that the downtrend in inflation will soon reverse. Chart 1Closing In On Neutral Closing In On Neutral Closing In On Neutral Chart 2A Positive Signal On Inflation A Positive Signal On Inflation A Positive Signal On Inflation While the dovish camp wants to see strength in core inflation before delivering another hike, the hawkish camp views the easing of financial conditions as sufficient to forecast stronger growth and higher inflation in the near future. This view is backed by some solid empirical evidence. Chart 3 shows one measure of financial conditions - the financial conditions component of our Fed Monitor.2 This index performs reasonably well predicting near-term swings in GDP, and at the moment it suggests that growth will accelerate further in the back half of the year. This "financial conditions approach" to policymaking suggests that monetary policy impacts financial markets and that financial market performance then translates into economic outcomes. From this perspective, the fact that financial conditions have continued to ease since the Fed started tightening in December 2015 means that, so far, monetary tightening has not had any impact cooling the economy (Chart 4). Chart 3Financial Conditions##br## Lead Growth Financial Conditions Lead Growth Financial Conditions Lead Growth Chart 4Financial Conditions Easier, ##br##Despite Fed Tightening Financial Conditions Easier, Despite Fed Tightening Financial Conditions Easier, Despite Fed Tightening To us, this is the crucial point about the arguments made by the hawkish camp. This group focuses on financial conditions because it believes that easier financial conditions will soon lead to stronger growth and higher inflation. The group is not making the case that the Fed should abandon its 2% inflation target because of concerns about stability in financial markets. From Jackson Hole: Financial Conditions Vs. Financial Stability The focus on financial stability at Jackson Hole led many commentators to forecast that the Fed might tighten due to concerns about excessive leverage and risk-taking in financial markets, ignoring progress toward its inflation target.3 We think this is incorrect, and would draw an important distinction between when central bankers talk about "financial conditions" and when they talk about "financial stability". While the two concepts are obviously similar, central bankers tend to focus on financial conditions as a leading indicator for the economy. It is not separate from the 2% inflation target, rather, it is an input to the Fed's growth and inflation forecasts. However, when central bankers talk about financial stability, they are typically referring to an assessment of the amount of risk-taking and leverage in financial markets. If the risk-taking and leverage in financial markets is deemed excessive, it could pose a downside risk to future growth. Currently, central bankers in general do not believe that there is an imminent threat from financial stability. But more importantly, no current prominent central banker has proposed tightening policy to deal with financial stability risks while disregarding the inflation target. Here is what Janet Yellen had to say on the topic at Jackson Hole: I expect that the evolution of the financial system in response to global economic forces, technology, and, yes, regulation will result sooner or later in the all-too-familiar risks of excessive optimism, leverage, and maturity transformation reemerging in new ways that require policy responses. And Mario Draghi: [W]hen monetary policy is accommodative, lax regulation runs the risk of stoking financial imbalances. By contrast, the stronger regulatory regime that we have now has enabled economies to endure a long period of low interest rates without any significant side-effects on financial stability[.] The above passages make a couple of points abundantly clear: Neither central banker views financial stability as currently posing an economic risk. The preferred method for dealing with this risk, if it were to arise in the future, would be through macroprudential regulation. That is, regulations that limit leverage and maturity transformation. In fact, Draghi plainly said that a robust regulatory regime is important because it allows central banks to use interest rate policy to manage inflation back to target. Janet Yellen also pointed out in her remarks that financial stability risks in the future will almost certainly emerge in "new ways". This makes these risks much more difficult to detect in real time. Meanwhile, it is comparatively easy for Fed policymakers to look at inflation and judge it relative to the 2% target. This is yet another reason why interest rate policy will continue to be guided by inflationary pressures in the economy, not concerns about financial stability. Put differently, if inflation does not reach the Fed's 2% target before the next recession, that would be an easily quantifiable policy failure. This is an outcome that Fed policymakers will seek to avoid at all costs. Bottom Line: The Fed's inflation forecast will continue to guide interest rate policy. This means that while an announcement about winding down the balance sheet will occur in September, a December rate hike is only in the cards if inflation shows some strength in the coming months. Financial conditions are an important input to the Fed's growth and inflation forecasts, but the Fed will not tighten policy due to concerns about financial stability alone. Fiscal Policy Judging from the performance of a high tax-rate basket of U.S. stocks, investors appear to have completely priced out any possibility of tax reform (Chart 5). This is likely a mistake. Tax reform is a major component of both President Trump's and congressional Republicans' agendas. If it fails, Republicans will have to go to their home districts empty-handed to campaign for the November 2018 midterm elections. Chart 5Too Complacent On Tax Cuts? Too Complacent On Tax Cuts? Too Complacent On Tax Cuts? Further, as was recently discussed in depth by our Geopolitical Strategy service,4 until recently the White House had been divided into two cliques. The "Goldman clique", led by National Economic Council Director Gary Cohn, is pragmatic and un-ideological. It is focused on passing tax reform and pro-business regulation. In contrast, the "Breitbart clique" is populist and nationalist. It also leans to the left on economic matters. The recent removal of White House Chief Strategist (and Breitbart clique leader) Stephen Bannon signals a shift in power toward the Goldman clique. Cohn, Treasury Secretary Steven Mnuchin, and Commerce Secretary Wilbur Ross are now firmly in charge of economic policy. Meanwhile, three generals are now in charge of foreign and national policy: Defense Secretary James Mattis, National Security Advisor H.R. McMaster, and Chief of Staff John F. Kelly. Between the six of them, and Secretary of State Rex Tillerson, there is not a drop of populism left in the White House. This likely points to an increased resolve to push through some sort of tax legislation. While the size of any tax cut is still very much in question, given how little is priced in, it will not take much to move the needle on financial markets. Bottom Line: The market is likely too pessimistic on the potential for fiscal stimulus from tax cuts, especially given the recent shift in power within the White House. Corporate Spread Valuation How expensive are corporate bonds compared to history? On its face, a simple question. But one that quickly gets complicated when we dig into the details. Case in point, the top panel of Chart 6 shows the average option-adjusted spread (OAS) on the Bloomberg Barclays Investment Grade Corporate Bond Index going back to 1990. A cursory glance at this chart shows that the OAS is somewhat below its historical average, but also that it has been tighter in the past. But this simple visual obscures a few important factors: The average credit quality of the index has worsened since the financial crisis (Chart 6, panel 2). All else equal, this means the average spread should be wider. The average duration of the index has risen over time as bond yields have fallen (Chart 6, panel). This means that the same change in spreads has a larger return impact today than in years past. The stage of the credit/monetary policy cycle is also important. In the top panel of Chart 6 we see that the OAS does not spend a lot of time near its long-run average. Rather, it tends to be very wide in the negative phases of the cycle and very tight in the positive phases. In past reports we have considered the performance of corporate bonds across the four phases of the Fed cycle (Chart 7). To recap, these phases are defined as follows: Chart 6Corporate Spreads Need To Be Adjusted Corporate Spreads Need To Be Adjusted Corporate Spreads Need To Be Adjusted Chart 7Stylized Fed Cycle Policy Reflections Policy Reflections Phase I represents the early stage of the withdrawal of monetary stimulus. This phase begins with the first rate hike of a new tightening cycle and ends when the fed funds rate crosses above its equilibrium (or neutral) level. Phase II represents the late stage of the tightening cycle, when the Fed hikes its target rate above equilibrium in an effort to slow the economy. Phase III represents the early stage of the easing cycle. It begins with the first rate cut from the peak and lasts until the Fed cuts its target rate below equilibrium. Phase IV represents the late stage of the easing cycle. It encompasses both the period when the fed funds rate descends to its cycle trough and the subsequent adjustment period when the Fed remains on hold in an effort to kick start an economic recovery. In phases I and IV, we can expect tight spreads and relatively strong excess returns from corporate bonds. Phases II and III are characterized by wider spreads and lower returns. At the moment we judge that we are firmly in phase I of the cycle. The Fed has begun to tighten policy, but by all accounts monetary conditions remain accommodative and the real fed funds rate is below its neutral level (Chart 6, bottom panel).5 Adjusting Corporate Spreads On the first necessary adjustment, we can easily adjust for differences in average credit rating by looking at the different credit tiers of the corporate bond index rather than the index as a whole. As for the second necessary adjustment, we adjust for changes in duration over time by using a 12-month breakeven spread instead of the OAS. The 12-month breakeven spread is defined as the spread widening (in basis points) required over a 12-month period before the given corporate bond index delivers a negative excess return relative to duration-matched Treasuries. It thus includes both the OAS and the impact of lower duration.6 Chart 8 shows 12-month breakeven spreads for each investment grade corporate bond credit tier alongside its historical average and +/- one standard deviation. In each case we observe that breakeven spreads are well below average. In fact, the breakeven spread makes corporate bonds appear slightly more expensive than does the OAS. The final adjustment we need to make is to consider current spreads relative to other similar phases of the Fed cycle. In Chart 9 we show OAS for each credit tier, with dashed lines denoting the historical average, minimum and maximum OAS seen during prior Phase I periods. Adjusting only for credit rating and the stage of cycle (not for changes in duration), we find that Aaa, Aa and A-rated credits appear quite cheap, while Baa-rated credits appear close to fair value. In Chart 10 we show 12-month breakeven spreads for each credit tier relative to other similar phases of the Fed cycle. In other words, the spreads here are adjusted for credit rating, duration and the stage of the cycle. This chart tells a somewhat different story. Here, Aaa-rated credits appear very expensive. Meanwhile, Aa, A and Baa-rated credits appear close to fairly valued. Chart 8Breakeven Spreads Versus Long-Run Average Breakeven Spreads Versus Long-Run Average Breakeven Spreads Versus Long-Run Average Chart 9Cycle-Adjusted OAS Cycle-Adjusted OAS Cycle-Adjusted OAS Chart 10Cycle-Adjusted Breakeven Spreads Cycle-Adjusted Breakeven Spreads Cycle-Adjusted Breakeven Spreads Bottom Line: With the exception of Aaa-rated credits (which appear expensive), investment grade corporate spreads are fairly valued after adjusting for changes in credit rating, duration and the stage of the cycle. Investors should expect to earn excess returns from corporate bonds consistent with carry on a 6-12 month horizon. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Low Inflation And Rising Debt", dated June 13, 2017, available at usbs.bcaresearch.com 2 For more details on the Fed monitor, please see U.S. Bond Strategy Weekly Report, "Buy The Back-Up In Junk Spreads", dated March 14, 2017, available at usbs.bcaresearch.com 3 https://www.bloomberg.com/news/articles/2017-08-25/el-erian-says-markets-too-sanguine-about-fed-view-on-instability 4 Please see Geopolitical Strategy Weekly Report, "The Wrath Of Cohn", dated July 26, 2017, available at gps.bcaresearch.com 5 As was stated earlier in this report, the gap between the real fed funds rate and its neutral level will widen as inflation bounces back in the coming months. 6 For simplicity we assume no convexity impact on excess returns. The 12-month breakeven spread is then calculated as OAS divided by duration. Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Yellen sidesteps monetary policy at Jackson Hole. The Fed raised rates in late 1990s before seeing any inflation. Tax cut deal is still likely... ..but a prolonged debt ceiling battle or government shutdown is not. Inflation surprise has not yet followed economic surprise higher. Earnings and earnings guidance matters more than politics. Feature Fed Chair Yellen's speech on financial stability at the Jackson Hole symposium on Friday, August 25 shed little light on the timing of the central bank's next policy move. Some investors were fearing that Yellen would give a nod to the hawks in her speech. Yellen did no such thing. She simply noted "that the core reforms we have put in place have substantially boosted resilience without unduly limiting credit availability or economic growth". Yellen made no comments to suggest that monetary policy needs to tighten in order to reduce financial froth and foster greater stability. Financial stability1 matters to the Fed almost as much as maintaining low and stable inflation, and full employment. In this week's report, we discuss the FOMC's deliberations when the economy was at full employment in the late 1990s, and note that the Fed was willing to raise rates even before inflation accelerated. Gary Cohn, a potential replacement for Yellen, suggested in an interview last week that tax cut legislation is on the way. We agree and discuss below. The economic surprise index is rebounding, but that has not yet led to positive surprises on inflation as it has in the past. We also examine what history says about earnings guidance, U.S. equities and the stock-to-bond ratios during and after earnings reporting season. Fed Deliberations At Full Employment Chart 1The Fed And Inflation At Full Employment The Fed And Inflation At Full Employment The Fed And Inflation At Full Employment Minutes from FOMC meetings in the late 1990s are instructive in understanding the central bank's reaction function due to a lack of inflation as the economy moves beyond full employment (Chart 1). The Fed cut rates following the LTCM financial crisis in late 1998 and subsequently held the fed funds rate at 4¾% until June 1999. Core inflation was roughly flat during the on-hold period, even as the unemployment rate steadily declined and various measures pointed to significant labor market tightness. The FOMC discussion in the late 1990s of why inflation was still quiescent sounds very familiar. Policymakers pointed to the widespread inability of firms to raise prices because of strong competitive pressures in domestic and global markets. In the Fed's view, significant cost-saving efforts and new technologies also contributed to the low inflation environment for both consumer prices and wages. Moreover, rapid increases in imports and a drawdown in the pool of available workers was also seen as satisfying growing demand and avoiding upward pressure on inflation. One difference from today is that productivity growth was solid at that time. The FOMC decided to hike rates in June 1999 by a quarter point, despite any indication that inflation had turned up. Policymakers described the tightening as "a small preemptive move... (that) would provide a degree of insurance against worsening inflation later". The Fed went on to lift the fed funds rate to 6½% by May 2000. Interestingly, the unemployment rate in June 1999 was 4.3%, the same as the current rate. There are undoubtedly important differences in today's macro backdrop. The Fed is also more fearful of making a policy mistake in the aftermath of the Great Recession and financial crisis. Nonetheless, the point is that the Fed has faced a similar low inflation / tight labor market environment before. Question marks regarding the structural headwinds to inflation will remain in place, but it will not take much of a rise in core inflation in the coming months for the Fed to deliver the next rate hike (most likely in December). Any fiscal stimulus, were it to occur, would reinforce the FOMC's bias to normalize interest rates. Is All Lost For U.S. Tax Cuts? Although tax reform was a major component of President Trump's legislative agenda, investors are skeptical that any fiscal stimulus or tax cuts will succeed (Chart 2). In our view, there is a high probability that at least a modest package will be passed. The reason is that, if it fails, Republicans will return empty-handed to their home districts to campaign for the November 2018 mid-term elections. Historically, Republican Presidents who have low approval ratings ahead of mid-term elections tend to lose a larger number of seats to Democrats (Chart 3). Chart 2Market Has Priced Out Trump's Economic Agenda Market Has Priced Out Trump's Economic Agenda Market Has Priced Out Trump's Economic Agenda Chart 3GOP Is Running Out Of Time Surprise, Surprise Surprise, Surprise Now that the border adjustment tax is officially dead, the GOP must either significantly moderate its tax cuts or add to the deficit. BCA's geopolitical strategists argue that regardless of which bill is passed by the GOP, the legislation will expire after a "budget window" of around 10 years.2 Tax cut plans ultimately will be watered down, but even a modest cut would be positive for the equity market. The dollar should also receive a boost, especially given that the Fed would have to respond to any fiscally driven growth impulse with higher interest rates. We expect Trump to ensure that the Fed retains its dovish bias when Chair Janet Yellen's term expires on February 3, 2018. He may favor a non-economist and a loyal adviser, such as Gary Cohn, over any of the more traditional and hawkish Republican candidates. Cohn could not single-handedly affect the course of monetary policy. The FOMC votes on rate changes, but decisions are formed by consensus (with one or two dissents). Cohn could implement an abrupt change in policy in the unlikely event that the Administration stacks the Fed Governors with appointees that are prepared to "toe the line." (The Administration does not appoint Regional Fed Presidents). Stacking the Governorships would take time. The FOMC has been very cautious in tightening policy and we do not see Trump taking an active role in monetary policy. The bottom line is that Cohn's possible appointment to the Fed Chair would not signal a major shift in monetary policy. Raising The Debt Ceiling Recent fights over Obamacare and tax reform have pitted fiscally conservative Republicans against moderates, with the debt ceiling used as a bargaining chip in the battles. While government shutdowns have occurred in the past, the debt ceiling has never been breached. At the end of the day, the debt ceiling will always be raised because government could not withstand the public pressure. Democrats can't be blamed because the Republicans control both chambers of Congress and the White House. Even the Freedom Caucus, the most fiscally conservative grouping in the House, is divided on the issue. This augurs well for a clean bill to raise the debt ceiling because the Republican majority in the House is 22 and the Freedom Caucus has 31 members. Democrats will not stand in the way of passage in the Senate. The worst-case scenario for the market would be a two-week shutdown, between October 1 when the current funding for the government will expire, and mid-October when the CBO predicts that the debt ceiling will be reached. Odds of such a scenario are probably around 25%. We would not expect a shutdown to have any lasting impact on the economy, although it could provide an excuse for the equity market to correct. The good news is that at least the economy is cooperating. Economic Surprise Versus Inflation Surprise Economic expectations are now low enough for the still-tepid activity data to beat, but this trend has not yet spilled over into the inflation data. Elevated economic expectations post-election led to a four-month period (early March-mid June) when the Citi Economic surprise index rolled over3 (Chart 4). In mid-July, the data began to top washed-out expectations and the surprise index accelerated. In the past two months, readings across a wide spectrum of economic indicators (consumer and business sentiment, consumer spending, home prices, manufacturing sentiment, and employment) have outpaced lowered expectations. Even so, inflation readings continue to disappoint relative to forecasts. Chart 4Inflation Surprise Usually Follows Economic Surprise Higher... But Not This Time Inflation Surprise Usually Follows Economic Surprise Higher... But Not This Time Inflation Surprise Usually Follows Economic Surprise Higher... But Not This Time After briefly moving above zero in early 2017 - indicating that inflation data was stronger than analysts projected- the Citi inflation surprise index rolled over again (Chart 4, bottom panel). Reports on the CPI, PPI, and average hourly earnings continued to fall short of consensus forecasts. This despite the rebound in the economic surprise index and the tightening of labor and product markets. The disappointment on price data relative to consensus forecasts is not new. Although there were brief periods where prices exceeded forecasts in 2010 and 2011, the last time that inflation exceeded market consensus in this business cycle was in late 2009 and early 2010. In the last few years of the 2001-2007 economic expansion through early 2009, the price data eclipsed forecasts more than half of the time. During this interval, economists underestimated the impact of surging energy prices on inflation readings. Moreover, the disconnect between economic surprise and inflation surprise has never been wider, but the inflation surprise index should follow the economic surprise index upward. In the past 13 years, there have been 15 periods when economic surprise has climbed after a trough. The inflation surprise index has temporarily increased in 13 of those episodes. For example, in the aftermath of the oil price peak in the U.S. in mid-2014, both economic surprise and inflation surprise diminished through early 2015 and then began moving up. However, today's inflation surprise index has rolled over while economic surprise has gained, but remember that inflation is a lagging indicator.4 Asset class performance since the economic surprise index formed a bottom in mid-June has run counter to history as risk assets have underperformed (Table 1). Returns on the S&P 500 have lagged Treasuries since the June 14 trough, driving down the stocks-to-bond ratio. U.S. large cap equities have outperformed Treasuries by an average of 290 basis points in the 11 prior episodes in this expansion as economic surprise climbed. Similarly, both high yield and investment-grade corporate bond returns have lagged Treasuries since mid-June. During previous episodes when the surprise index was climbing, credit outperformed Treasuries. Small caps have also lagged large caps, which is counter to the historical pattern, although oil and gold have both gained since the trough in economic surprise. The evidence is mixed for these two commodities after a bottom in economic surprise. Table 1Performance Of Risk Assets As Economic Surprise Rises Surprise, Surprise Surprise, Surprise BCA's view5 is that a Fed-led recession will begin in 2019. Nonetheless, markets were concerned about a recession occurring this year as the economic data underwhelmed in the first part of the year. Despite market fears, reliable leading indicators of a recession such as the LEI, the yield curve and the 26-week change in claims, are not signaling a recession (Chart 5). BCA does not expect the buildup of the types of imbalances that led to economic downturns in the past. Instead, a recession may be triggered by a Fed policy mistake, or a terrorist attack that disrupts economic activity over large area for an extended time, or a widespread natural disaster. Chart 5Data Suggest Low Odds Of A##BR##Recession In Next 12 Months Data Suggest Low Odds Of A Recession In Next 12 Months Data Suggest Low Odds Of A Recession In Next 12 Months Bottom Line: There are few imbalances in the economy and a recession in the U.S. is more than a year away. Although risk assets have not outperformed as is typical after a trough in economic surprise, we anticipate that stocks will beat bonds in the next 12-18 months. Inflation will surprise to the upside in the coming months, pressuring the Fed and the bond market. Stay short duration. Is Trump To Blame For The Stalled Stock Market Rally? Corporate earnings, not politics, drive equity prices. The S&P 500 has retreated from its all-time highs in early August despite another terrific earnings reporting season.6 Investors are concerned that Trump's erratic presidency may be to blame, but we take a different view Since the start of the economic expansion, the S&P 500 rose in 83% of the periods when large U.S. corporations provide results for the prior quarter and guidance on subsequent periods. (Table 2, bottom panel) U.S. equities increased only 66% of the time when managements were silent on profitability and future prospects (Table 3, bottom panel). However, there are periods when exogenous events like the 2011 U.S. debt downgrade and the 2015 Chinese devaluation that can disrupt the normal pattern, and we have excluded those from our calculations. Nevertheless, with the Q2 earnings reporting season over, the odds are less favorable for a rising U.S. equity market in the next few months. Table 2S&P 500, Stock-Bond-Ratio And Guidance During Earnings Season Surprise, Surprise Surprise, Surprise Table 3S&P 500, Stock-Bond-Ratio And Guidance Outside Of Earnings Season Surprise, Surprise Surprise, Surprise The stock-to-bond ratio also fares better during earnings season than during corporate quiet periods, and moves higher more often. When companies report profits, the stock-to-bond ratio increases 73% (Table 2, bottom panel) of the time versus just 65% outside of earnings season (Table 3, bottom panel). Since the start of 2010, the median return for the stock-to-bonds ratio is 0.046% per day during reporting season (Table 2, top panel) and 0.037% when it is not earnings season (Table 3, top panel). The implication is that the stock-to-bond ratio over the next two months may move higher, and at a faster rate than it did during the just completed Q2 earnings reporting season. Counter-intuitively, earnings guidance increases more often outside of earnings season (90% of the time and 0.04% per day, Table 3) than during it (77% of the time and 0.019% per day, Table 2). The top panels of Tables 3 and 2 respectively also show that the median daily return on stocks is higher outside of earnings reporting season (0.074% per day) than it is as earnings are being reported (0.054% per day). This is also somewhat counter-intuitive, as over the long term, earnings trends drive stock prices. We intend to examine the shorter term relationship between stock prices, the stocks to bond ratio and earnings guidance in a future Weekly Report. Bottom Line: The path of corporate earnings and not politics, ultimately drive stock prices. In the past eight years, the stocks to bond ratio during earnings season rises more and more often than when there was no new information on earnings. We remain upbeat on the earnings outlook for at least the remainder of this year, which will help the equity market weather the ongoing turbulence emanating from Washington. Next year, the earnings backdrop will not be as supportive. Stay overweight stocks versus bonds. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate", dated July 24, 2017. It is available at usis.bcaresearch.com. 2 Please see Geopolitical Strategy Weekly Report, "Is The Trump Put Over" dated August 23, 2017. It is available at gps.bcaresearch.com. 3 Please see BCA's U.S. Investment Strategy Weekly Report, "Global Monetary Policy Recalibration", published July 17, 2017. It is available at usis.bcaresearch.com. 4 Please see Global Investment Strategy Weekly Report, "From Slow Burn Recovery To Retro-Recession?," August 18, 2017. It is available at gis.bcaresearch.com. 5 Please see BCA's Global Investment Strategy Weekly Report, "The Timing Of The Next Recession" published June 16, 2017. It is available at gis.bcaresearch.com. 6 Please see BCA's U.S. Investment Strategy Weekly Report, "The Stage Is Set For Jackson Hole", August 21, 2017. It is available at usis.bcaresearch.com.

Feature Turkey's banking system has in recent years relied on enormous liquidity provisions by the central bank (Chart I-1) to sustain its ongoing credit boom, and hence economic growth. Since early this year, the authorities have doubled down: they have also begun using fiscal policy to prop up growth. Chart I-1Turkey: Central Bank Large Liquidity Injections Turkey: Central Bank Large Liquidity Injections Turkey: Central Bank Large Liquidity Injections On the whole, this combination of colossal credit and fiscal stimulus is indisputably bearish for the currency. Despite strong performance by Turkish stocks this year, we are maintaining our bearish call on the lira. The lira is set to depreciate by 20-25% in the next 12 months or so versus both an equally-weighted basket of the U.S. dollar and the euro. Bringing Fiscal Stimulus Into Play The Turkish authorities have recently begun using fiscal means to stimulate growth: Last summer, a sovereign wealth fund was set up by presidential decree to pool shares in companies owned by the government and use them as collateral to raise debt and initiate spending on various infrastructure projects. The target size of the fund is US$ 200 billion, compared with the government non-interest expenditure of US$ 165 billion in the last 12 months. This would effectively allow the government to issue debt and increase expenditures off-balance sheet. In addition, this past March, the government decided to recapitalize the Credit Guarantee Fund. This initiative allowed it to underwrite US$ 50 billion, or 7% of GDP, worth of credit to Turkish companies. This is considerable as it compares with US$ 93 billion worth of loan origination by commercial banks last year. By assuming credit risk on these loans, the government is effectively encouraging banks to lend, in turn boosting economic growth. In effect, this has lowered lending standards and given a green light to banks to flood the economy with credit. Even though interest rates have risen since last November, credit growth has accelerated as banks have provided loans covered by government guarantees (Chart I-2). On top of this quasi-fiscal stimulus, government expenditures excluding interest payments have accelerated (Chart I-3). Chart I-2Bank Loan Growth Has Accelerated ##br##Despite Higher Interest Rates Bank Loan Growth Has Accelerated Despite Higher Interest Rates Bank Loan Growth Has Accelerated Despite Higher Interest Rates Chart I-3Turkey: Fiscal Spending Has Surged Turkey: Fiscal Spending Has Surged Turkey: Fiscal Spending Has Surged Such a rise in government spending has been financed by commercial banks whose holdings of government bonds have risen sharply. Essentially, government spending has also been funded by commercial banks' money creation. In short, fiscal and credit stimulus have boosted domestic demand, thereby widening the country's current account deficit once again (Chart I-4A and Chart I-4B). Chart I-4AWidening Twin Deficit Widening Twin Deficit Widening Twin Deficit Chart I-4BWidening Twin Deficit Widening Twin Deficit Widening Twin Deficit Given that the starting point of the government's fiscal position is good - public debt stands at only 28% of GDP - the authorities have ample room to rely on fiscal levers to promote growth. However, a widening fiscal deficit will be bearish for the currency. Bottom Line: Widening twin (current account and fiscal) deficits (Chart I-4A and Chart I-4B) are a bad omen for the lira. Monetary Tightening? What Monetary Tightening? Chart I-5Turkey: Money/Credit Growth Is Too Strong Turkey: Money/Credit Growth Is Too Strong Turkey: Money/Credit Growth Is Too Strong Although interbank and lending rates have risen in recent months, money and credit growth have been booming (Chart I-5). This does not support the idea that monetary policy is tight. On the contrary, thriving money and credit growth suggest that the policy stance is very easy. The Central Bank of Turkey (CBT) raised various policy rates and capped the overnight liquidity facility at the beginning of this year. However, commercial banks' usage of the late liquidity window facility - the one facility that has been left uncapped - has literally gone exponential - it has risen from zero to TRY 70 billion in the past 8 months. On the whole, the central bank’s net liquidity injections into the banking system continue to make new highs, even though the price of liquidity has been rising. Adding all the liquidity facilities – the intraday, overnight and late window facilities – the CBT's outstanding funding to banks is 90 billion TRY, or 3% of GDP, more than ever recorded (Chart 1, bottom panel). This entails that monetary policy is loose rather than tight. On the whole, commercial banks are requiring more and more liquidity, and the CBT is continuously supplying it. These injections maintain liquidity in the banking system to a sufficiently high level to allow aggressive money/credit creation among commercial banks. Bottom Line: The CBT is facilitating/accommodating an economy-wide credit binge by providing copious amounts of liquidity to commercial banks. The Victim Is The Lira The lira will inevitably depreciate in the months ahead: Chart I-6Turkey: Central Bank's Foreign ##br##Reserves Have Been Depleted Turkey: Central Bank's Foreign Reserves Have Been Depleted Turkey: Central Bank's Foreign Reserves Have Been Depleted The lira's exchange rate versus an equally-weighted basket of the U.S. dollar and the euro has been mostly flat year-to-date, despite the CBT intervening in the market to support the lira by selling U.S. dollars. Aggressive selling of CBT foreign exchange reserves has so far prevented much steeper lira depreciation in Turkey. However at this stage, the central bank is literally running out of reserves and will soon lose its ability to support the currency (Chart I-6). A developing country with foreign exchange reserves worth less than three months' imports is considered vulnerable. Therefore, at 0.5 months of imports coverage, or US$ 9.7 billion, the CBT has little capacity to continue supporting the currency via interventions. Economic growth has recovered: export volumes are very strong, driven by shipments to Europe, while loan growth is supporting private domestic demand and government expenditures have mushroomed. The ongoing economic recovery will boost inflation, and strong domestic demand will assure the current account deficit widens. This will weigh on the exchange rate. Core inflation measures have subsided from 10% to 7%, but remain well above the central bank's target of 5%. Provided inflation is a lagging variable, the acceleration in money growth and domestic demand this year will lead to higher inflation in the months ahead. Wage growth remains high and our profit margin proxy for both manufacturing and service industries - calculated as core CPI divided by unit labor costs - has relapsed signifying deteriorating corporate profitability (Chart I-7). This in turn will force businesses to raise prices. Provided demand is strong, companies will likely succeed in passing through higher prices to customers. In brief, odds are that inflation will rise significantly soon. Escalating unit labor costs also offsets the benefit of nominal currency depreciation. Chart I-8 illustrates that the real effective exchange rate is not cheap based on consumer prices, or unit labor costs. Chart I-7Companies Profit Margins Are Shrinking Companies Profit Margins Are Shrinking Companies Profit Margins Are Shrinking Chart I-8The Lira Is Not Cheap At All The Lira Is Not Cheap At All The Lira Is Not Cheap At All As inflation rises, residents' desire to convert their deposits from local to foreign currency will increase. In fact, this is already happening - households' foreign currency deposit growth is accelerating. In short, lingering high inflation will continue to weigh on the currency's value. Bottom Line: The authorities have doubled down on fiscal and credit stimulus, warranting a doubling down on bearish bets on the lira. Investment Implications On the whole, the authorities will continue resorting to fiscal and monetary stimulus to sustain economic growth. According to the Impossible Trinity theory, in countries with an open capital account structure, the authorities can control either interest rates or the exchange rate, but not both simultaneously. Chart I-9Bank Stocks Have Rallied Despite ##br##Shrinking Net Interest Margins Bank Stocks Have Rallied Despite Shrinking Net Interest Margins Bank Stocks Have Rallied Despite Shrinking Net Interest Margins In Turkey, policymakers will eventually opt to control interest rates, meaning they will not have much control over the exchange rate. We suggest currency traders who are not shorting the lira do so at this time. We remain short the lira versus the U.S. dollar. A weaker lira will undermine U.S. dollar returns on Turkish stocks and domestic bonds. Dedicated EM equity investors as well as those overseeing EM fixed income and credit portfolios should continue to underweight Turkish assets within their respective EM universes. Bank stocks have rallied strongly, and have decoupled from interest rates (Chart I-9). This reflects the recent credit binge, where banks are making profits on loan originations while the government is holding responsibility for bad loans. These dynamics could persist for a while. However, both loan growth and banks' profitability will be hurt if the credit guarantee scheme is not renewed. So far, it is estimated that TRY 200 billion of an announced TRY 250 billion of this credit guarantee scheme has been utilized. Continuous credit guarantee schemes and accumulation of off-balance-sheet liabilities by the government will widen sovereign credit spreads. In many EM countries, including Turkey, bank share prices have historically correlated with sovereign spreads. Hence, rising sovereign risk will weigh on banks stocks too. Finally, as the lira begins to depreciate and inflation rises, local interest rates will have to climb. This will also weigh on bank share prices. In brief, we are reiterating our negative/underweight stance on Turkish banks. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations