Financial Markets

Feature GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of August 31, 2018. The quant model has further lifted its U.S. allocation to overweight from neutral, and the U.K. underweight has also been reduced by half. On the other hand, Italy is downgraded and the overweight in Spain, Germany and the Netherlands are all significantly reduced, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1, 2 and 3, the overall model underperformed its benchmark by 32 bps in August, largely driven by Level 2 model which underperformed its benchmark by 75 bps. expected, the model did not catch the "Turkey Effect" which drove deep losses in the Italian and Spanish markets. The Level 1 model slightly unperformed its MSCI World benchmark by 2 bps in August. Since going live, the overall model has outperformed its benchmarks by 87bps, driven by the Level 2 outperformance of 260 bps offset by the 5 bps of Level 1 underperformance. Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, "Global Equity Allocation: Introducing The Developed Markets Country Allocation Model," dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model Dear Client, The GAA Equity Sector Selection Model has been live since July 2016, and has outperformed the benchmark over this period in line with our back-testing. However, GICS will make significant changes to sector compositions at the end of September, most notably creating a new "Communication Services" sector, dominated by internet-related companies, to replace "Telecommunication Services". However, MSCI has not yet made available the final details of membership or historical performance of the revised sectors. Accordingly, after this update we are temporarily suspending publication of this model until full data is available and we have been able to rebuild the model using the newly constituted sectors. The GAA Equity Sector Selection Mode (Chart 4) is updated as of August 31, 2018. Table 3Allocations Table 4Performance Since Going Live Chart 4Overall Model Performance The model continues to have a negative outlook on global growth and consequently has a net underweight on cyclical sectors. However, the magnitude of this tilt was reduced from 5.8% to 2.8%. The biggest move was a downgrade of consumer staples from a 2.5% overweight to a 1.4% underweight on the back of unfavorable momentum indicators. The only two sectors with favorable momentum are healthcare and technology. Finally, energy stocks also saw a 0.8% boost in its overweight recommendation on the back of attractive valuations. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," dated July 27, 2016, available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Aditya Kurian, Senior Analyst adityak@bcaresearch.com

Feature Desynchronization To Continue This year has been characterized by strong growth and asset performance in the U.S., and weakness everywhere else. While U.S. stocks are up by 10% year-to-date, those in the rest of the world have fallen by 3% in dollar terms (Chart 1). GDP growth in Q2 was 4.2% QoQ annualized in the U.S., compared to 1.6% in the euro area and 1.9% in Japan. Leading economic indicators point to this continuing and, therefore, to the U.S. dollar strengthening further (Chart 2). This has already put significant pressure on emerging markets, where equities have fallen by 7% this year in USD terms. Recommended Allocation Chart 1U.S. Has Outperformed Chart 2...And Leading Indicators Suggest This Will Continue There are many reasons why the desynchronization is likely to continue: U.S. growth continues to be boosted by tax cuts and increased fiscal spending which, according to IMF estimates, will add 0.7% to GDP growth this year and 0.8% next. The peak impact from the stimulus will not come until around Q1 next year. Further protectionist tariff increases. Despite August's tentative agreement between the U.S. and Mexico, the Trump administration still plans to implement 10-25% tariffs on $200 billion of Chinese imports, and also possibly 25% tariffs on auto imports, in September. This will - initially at least - be more negative for global exporters, such as China, the euro area and Japan, than for the U.S. China is unlikely to implement the sort of massive stimulus that it carried out in 2009 and 2015.1 It has recently cut interest rates and brought forward fiscal spending to cushion downside risk. But, given the Xi administration's focus on deleveraging and structural reform, we do not expect to see a substantial increase in credit creation (Chart 3). This indicates that emerging markets, and capital goods and commodities exporters, will continue to struggle. European banks will stay under pressure because of the problems in Italy (which will fight this fall with the European Commission over its fiscal stimulus plans) and Turkey. Euro zone equity relative performance is heavily influenced by the performance of financials, even though the sector is only 18% of market cap (Chart 4). The euro zone and Japan are also far more sensitive to a slowdown in EM growth: exports to EM are 8.4% and 6.4% of GDP in the euro zone and Japan respectively, but only 3.6% in the U.S. Chart 3China Unlikely To Repeat 2009 and 2015 Chart 4Banks Drive European Equity Performance Eventually, however, strong growth in the U.S. will become a headwind for U.S. assets too. Already, there are some signs of wage growth ticking up (Chart 5), suggesting that the labor market is finally becoming tight. Fed chair Jerome Powell, in his speech at Jackson Hole last month, reiterated that a "gradual process of normalization [of monetary policy] remains appropriate", suggesting that the Fed will continue to hike by 25 basis points a quarter. But the futures market is pricing in only 75 basis points in hikes over the next two years (Chart 6). And, if core PCE inflation were to rise above the Fed's forecast of 2.1% (it is currently 2.0%), the Fed would need to accelerate the pace of tightening. This all points to further dollar strength which will hurt emerging markets, given the consistent inverse correlation between U.S. financial conditions and EM asset performance (Chart 7). Chart 5Is Wage Growth Finally Accelerating? Chart 6Markets Pricing In Only Three More Fed Hikes Chart 7Tightening Financial Conditions Are Bad For EM We continue for now, therefore, to remain overweight U.S. equities in USD terms within a global multi-asset portfolio, despite their strong performance this year. We are neutral on equities overall and expect to move to negative perhaps early next year, when we will see some of the classic warning signs of recession (inverted yield curve, rise in credit spreads, peak in profit margins) starting to flash. Profit expectations are one key to the timing of this. Analysts forecast 22% YoY EPS growth for S&P 500 companies in Q3 and 21% in Q4, slowing to 10% in 2019. Those are strong numbers. But if companies are unable to beat these forecasts, what would be the catalyst for stocks to continue to rise? Moreover, analysts' expectations for long-term earnings growth are more optimistic currently than any time since 2000 (Chart 8). It would not take much of a downside earnings surprise - perhaps caused by the strength of the dollar, or regulatory change for internet companies - to disappoint the market. Equities: Our strongest conviction call remains an underweight on emerging markets. Emerging markets are entering what is likely to be a prolonged period of deleveraging, given their elevated levels of debt relative to GDP and exports (Chart 9). That makes them very vulnerable to the stronger U.S. dollar and higher interest rates that we expect. While EM equities have already fallen significantly, they are not yet cheap and investors have mostly not capitulated: outflows from EM funds have been small relative to inflows in previous years (Chart 10). Among developed markets, we keep our overweight on the U.S.: not only does its lower beta mean it should outperform in the event of a sell-off, but if markets were to see a last-year-of-the-bull-market "melt-up" (similar to 1999), this would likely be led by tech and internet stocks, where the U.S. is overweight. Chart 8Analysts Too Optimistic About Long-Term Earnings Growth Chart 9Long Period Of Deleveraging Ahead For EM Chart 10No Signs Of Capitulation In EM Yet Fixed Income: Higher inflation, and more Fed tightening than the market is pricing in, suggest that long-term rates have further to rise. Fed rate surprises have historically been a good indicator of the return from U.S. Treasury bonds (Chart 11). We expect to see the 10-year yield reach 3.3-3.5% by early next year. We therefore remain underweight duration, and prefer TIPS over nominal bonds. We recently lowered our weighting in corporate credit to neutral (within the underweight fixed-income category). Junk bonds have continued to perform well, thanks to their 250 basis point default-adjusted spread over Treasuries. But spreads typically start to widen one to two quarters before equities peak, so we think caution is already warranted, particularly in the light of the higher leverage, longer duration, and falling average credit rating which currently characterize the U.S. corporate credit market. Currencies: As described above, mainly because of divergent growth and monetary policy, we expect the U.S. dollar to strengthen further, but more against emerging market currencies than against the yen or euro. Short-term, however, the dollar may have overshot and speculative positions are significantly dollar-long (Chart 12), so a temporary pullback would not be surprising. Chart 11More Fed Hikes Means Higher Long-Term Rates Chart 12Are Investors Too Dollar Bullish? Chart 13Dollar And China Hurting Commodities Commodities: Industrial metals prices have declined sharply over the past few months, on the back of the stronger dollar and slowdown in China (Chart 13). We expect this to continue. Gold, we have long argued, has a place in a portfolio as an inflation hedge. But it is also negatively impacted by rises in the dollar and real interest rates, and these are likely to continue to be a drag on performance. The oil price is currently being driven by supply dynamics: How much more oil will Saudi Arabia produce? Will the E.U. and Japan follow the U.S. in imposing sanctions on Iran? Will Venezuelan production fall further? These will make the crude oil price more volatile, but our energy strategists see Brent softening a little to average $70 in H2 this year, but with potential upside surprises taking it up to an average of $80 in 2019. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 For details on why we think massive stimulus is unlikely, please see BCA Geopolitical Strategy Special Reports, "China: How Stimulating Is The Stimulus?" Parts One and Two, dated 8 August 2018 and 15 August 2018, available at gps.bcaresearch.com GAA Asset Allocation

Special Report

Highlights We decompose the fed funds rate cycle into four phases based on the interaction between the level of the fed funds rate and its direction to examine monetary policy's impact on equities. The policy backdrop matters for equity returns. All of the S&P 500's price gains over the last six decades have accrued while policy settings have been accommodative. From a policy perspective, equities have been in an extended sweet spot ever since the Fed began aggressively cutting rates to combat the crisis. We estimate that they will remain there for close to another year. The fed funds rate cycle is only one of the variables we consider when calibrating investment strategy. Its bullish message faces resistance from decelerating growth, full valuations, and trade tensions between China and the U.S. The net impact of the individual crosscurrents is subject to spirited debate within BCA. Feature You really can't fight the Fed. As longtime U.S. Investment Strategy readers know, the fed funds rate cycle has been a consistently robust predictor of the direction and magnitude of equity returns. Over nearly six decades, the S&P 500 has risen at a 10% annualized clip when policy is easy; it's scratched out just a percentage point a year when it's tight. Adjusted for inflation, the easy/tight performance disparity has been even wider. In this Special Report, we update and revise the full-scale analysis we first performed nearly five years ago. In this iteration, we evaluate performance for each phase of the cycle on the basis of chained aggregate returns, rather than in terms of means and medians. That tweak expands our sample size to 685 months from 60 cycle phases, and eliminates the individual phases' sensitivity to short-term outliers. We have also revised the demarcation of the cycle phases to correct for a flaw in our historical effective fed funds rate data feed.1 The Fed Funds Rate Cycle We decompose the fed funds rate cycle into four phases based on the interaction between the level of rates and their direction, as follows: 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 our estimate of the equilibrium rate2 (shown as a dashed line in Chart 1 and Chart 2). Chart 1It's Easiest To Be Easy Chart 2The Fed Funds Rate Cycle Phase II represents the latter stages of the tightening cycle, when the Fed hikes its target rate above equilibrium in a deliberate effort to cool an overheating 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 breaks below its equilibrium level, and the subsequent adjustment period when the Fed remains on hold at the cycle trough in an effort to kick start an economic recovery. What Is The Equilibrium Fed Funds Rate? The equilibrium fed funds rate is the policy rate that neither encourages nor discourages economic activity. That is a simple enough idea, but we note that the equilibrium rate is just a concept. No one can put a blood pressure cuff around the economy's arm, or stick a thermometer in its mouth, to determine the rate objectively and precisely. Our equilibrium rate, which uses potential GDP growth to adjust a smoothed and filtered long-run series of the actual fed funds rate, is simply the modeled estimate of a concept. Why Bother Pursuing Such Elusive Quarry? 70 years ago, BCA sprang from our founder's insight that investors might be able to intuit a good deal about the future direction of the economy and financial markets by studying the flow of credit through the banking system. The Bank Credit Analyst owes its name and existence to the proposition that money flows matter. Tracking monetary conditions is in our DNA, and the fed funds rate is the foremost input into standard monetary conditions models. The empirical record suggests that the monetary backdrop holds such powerful sway over financial markets that tracking the equilibrium rate's relationship to the actual fed funds rate is worthwhile even if our ability to pin it down in real time is limited. Stocks And The Fed Funds Rate Cycle History convincingly demonstrates that the monetary backdrop matters, and that the level of rates (accommodative or restrictive) exerts far more influence on equity returns than their direction (higher or lower). Table 1 presents annualized price returns for the S&P 500 by fed funds cycle phase for the nearly 60 years covered by our equilibrium fed funds rate estimate. When policy is easy, as in Phases I and IV, the S&P has appreciated at a 10% annual rate; when it's tight, as in Phases II and III, it's barely advanced. Table 2 adjusts the nominal returns for inflation, making the easy/tight policy divide even starker - in real terms, the S&P 500 has lost considerable ground when the fed funds rate has exceeded our estimate of equilibrium. Table 1Tight Policy Is Hazardous To Stocks' Health, ... Table 2... Especially In Real Terms, ... Estimated Earnings And Forward Multiples Although overall equity returns are a function of the level of rates, their underlying components - earnings growth and the multiple investors are willing to pay for future earnings - are more sensitive to rates' direction. Earnings estimates are directly related to rate moves - they rise more when rates rise than they do when rates fall (Table 3). The direct relationship follows from the countercyclical nature of monetary policy. If the Fed is cutting rates, it must anticipate a softer growth environment in which estimates should be revised lower, whereas if it's hiking them, it must foresee such robust growth that it fears the economy could overheat. Table 3... But Earnings Thrive When The Fed Hikes Multiples are inversely related to the direction of rates; they contract in the aggregate when rates rise, and expand when they fall (Table 4). Although multiples are constrained by their mean-reverting properties, their movement around the mean adheres to a tidal pattern: ebbing when the Fed's trying to rein in the economy with rate hikes (and future earnings are subject to an increasing discount factor), and rising when it's trying to give it a boost (and the discount factor is falling). Multiples' action vis-à-vis the rate cycle suggests that they are forward-looking - moving in accordance with the Fed's intentions - while estimates are backward-looking, primarily extrapolating from actual results. In terms of S&P 500 returns, estimates' and multiples' tendency to counter one another when policy is tight has maintained the overall easy/tight dynamic over the four decades covered by forward earnings data (Table 5). Table 4Stocks De-Rate When Rates Rise, ##br##And Re-Rate When They Fall Table 5A Rising Tide Lifts All Boats, But Easy Phases Still Lead The Way Why Does The Fed Funds Rate Cycle Work? For all of its import, monetary policy is a blunt instrument that works with indeterminate lags. Its shortcomings heavily influence the way the Fed deploys it, and impose a predictable pattern on its economic and market impacts. In this analysis we focus on the Fed's inability to make targeted, precise adjustments; its uncertainty over when its effects will take hold; and its mandate's explicit focus on managing inflation, a lagging indicator. All of these factors come into play when the Fed embarks on a rate-hiking campaign, kicking off a new iteration of the policy rate cycle. New rate cycles begin from the previous cycle's trough level, when the Fed's primary concern is to avoid revisiting the adversity that inspired accommodation. It does not want to induce a double-dip by being too aggressive, especially when inflation readings are tame (Table 6). The Fed does not begin Phase I, or proceed very far with it, until it is all but certain that the economy can withstand higher rates. It therefore predictably embarks upon Phase I with a bias to err on the side of being too easy. Table 6Has The Tail Been Wagging The Dog? This bias gives the economy a chance to build up momentum in Phase I, consonant with a cycle peak in earnings growth (Chart 3, third panel). In markets, that momentum helps to feed meaningful excess returns in spread product,3 and sizable outperformance among late-cyclical equity sectors at home and abroad,4 as well as outsized returns in the S&P 500. Left unchecked, the momentum could promote higher inflation. Inflation can move stealthily because of its lagging nature, and the Fed is often compelled to intervene forcefully to counter it. Chart 3Monetary Policy Matters, A Lot Forceful intervention brings about Phase II of the cycle, when economic activity may still be expanding at a good clip, as indicated by double-digit earnings growth. Wielding a blunt instrument that works with a lag, however, the Fed is at risk of going too far, and Phase II hikes often induce a recession. Investors begin to sniff out the looming downturn and de-rate equities. By the time the Fed backs off and initiates a new easing campaign (Phase III), earnings growth has stalled out and measured inflation is peaking (Chart 3, bottom panel). Equities mark time (Chart 3, first and second panels) and spread product generates negative excess returns until, with the recession plainly evident and measured inflation sliding, there is nothing stopping the Fed from full-on accommodation (Phase IV), and it maintains market-friendly settings until the economy begins to look too strong, and the Fed intervenes to hold it back (Phase II). This stylized example focused on the Fed and markets, but monetary policy impacts all aspects of the real economy. Consumer demand for homes and other durable goods that have to be financed, along with businesses' appetite for investment, are keenly sensitive to monetary conditions. There is a powerful self-reinforcing dynamic that joins corporate earnings, business expansion and hiring, and consumption. The links between equity performance and the fed funds rate cycle are real and lasting. Investment Implications In its current setting, the fed funds rate cycle is issuing a risk-friendly signal. Even if it were our only guide to asset allocation and investment strategy, however, we would need to heed a couple of caveats before rushing out to overweight equities and other risk assets. First of all, estimates of the equilibrium fed funds rate are notoriously imprecise - equilibrium is a concept that can only be observed after the fact. Secondly, there is no guarantee that asset returns in this iteration of the fed funds rate cycle will continue to hew closely to the historical record. Following 10-plus years of accommodation, equity valuations are at fairly demanding levels. We continue to have a constructive view of the business, market and policy cycles, but the current environment carries significant risks. Activity is broadly decelerating outside of the U.S., public-market valuations are full nearly everywhere around the world, and the unsettled trade picture has the potential to upend financial markets. BCA is closely monitoring China to see whether or not it will provide monetary or fiscal stimulus that might help mitigate the forces threatening to undermine global trade and the economies that rely upon it. We remain on hold, recommending a benchmark equity allocation, while underweighting bonds and overweighting cash, in line with the house view. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 A bug in our third-party provider's conversion of daily effective fed funds rate data into monthly data slightly skewed our previous phase definitions. 2 Potential GDP growth is the key input to our model estimating the equilibrium policy rate level. 3 Please see the May 27, 2014 U.S. Investment Strategy Special Report, "Bonds and the Fed Funds Rate Cycle." Available at usis.bcaresearch.com. 4 Please see the July 3, 2017 Global ETF Strategy Model Portfolios Review, "Overhauling the U.S. Equity Exposures," and the May 11, 2018 Global Alpha Sector Strategy Special Report, "Global Equity Sectors and the Fed Funds Rate Cycle."Available at getf.bcaresearch.com and gss.bcaresearch.com.

Special Report

Highlights Barring government interference in foreign exchange markets, the path of least resistance for the U.S. dollar is up. The U.S. Treasury has authority to intervene unilaterally in foreign exchange markets. However, conditions for effective interventions to weaken the dollar exist neither within nor outside the U.S. For the time being, central banks in Europe, Japan, and China will not cooperate with the U.S. to depreciate the dollar. The Federal Reserve will effectively team up with the U.S. Treasury to depreciate the greenback only if economic conditions in the U.S. warrant a weaker currency. This is not currently the case. In this context, the dollar will continue to appreciate, but its rally will be accompanied by substantially higher volatility as the U.S. administration aggressively "talks down" the dollar. To capitalize on this theme, traders should consider going long dollar volatility. A firm dollar is consistent with continuous turmoil in EM financial markets. We continue to recommend staying put on EM. Feature Chart I-1U.S. Core Inflation Will Rise Further Economics and politics are set for a major clash in foreign exchange markets. Economic fundamentals and crosscurrents worldwide herald U.S. dollar appreciation. Yet, U.S. President Donald Trump wholeheartedly opposes any dollar strength. The higher the greenback rises, the more forceful Trump's jawboning about the exchange rate and interest rates will become. If the dollar does not halt its advance and overshoots, the odds are material that at a certain point the U.S. Treasury will initiate currency market interventions itself. It would do so by selling dollars and buying foreign assets. What will be the outcome of this battle between economics and politics in financial markets? The conclusion of this report is that for government-led currency market interventions to be effective in reversing the dollar's uptrend, the U.S. administration will have to convince the Federal Reserve to cease rate hikes and balance sheet contraction. Without the Fed recalibrating policy to be more consistent with a weaker dollar, the U.S. Treasury may not succeed in weakening the greenback on a sustainable basis. Given core consumer price inflation in the U.S. will likely surprise to the upside (Chart I-1), the Fed will not be willing to halt its tightening campaign. Hence, it will take time for the U.S. administration to wrestle and convince the Fed to accommodate currency interventions in efforts to weaken the greenback. In the meantime, the dollar will likely continue its volatile ascent. The Dollar Will Rally If Left To Market Forces Based on economic fundamentals, the path of least resistance for the greenback is up - for now. U.S. growth and inflation warrant higher interest rates, and the Fed is willing to continue moving short rates higher. In contrast, the unfolding EM/China slowdown is not only negative for their own respective currencies but is also harmful for commodities currencies in the advanced economies. Besides, the German and Japanese economies are much more vulnerable to a slowdown in EM/China than the U.S. (Chart I-2). Consistently, Chart I-3 illustrates that outperformance by the equal-weighted U.S. stock index versus its global peers in local currency terms - a measure of relative domestic demand - still points to a stronger U.S. dollar. On the whole, the growth and interest rate differentials between the U.S. and the rest of the world will likely continue to move in favor of the former and extend the dollar rally. Chart I-2Germany and Japan Are Much More Exposed ##br##To EM/China Than To The U.S. Chart I-3Relative Share Prices Point ##br##To A Firmer Dollar The dollar is typically a counter-cyclical currency. It depreciates when global trade is improving and appreciates when the global business cycle is slowing (the dollar is shown inverted on this chart) (Chart I-4). Odds are that global trade will continue to decelerate due to the slowdown in EM/China and trade protectionism - even if U.S. domestic demand growth remains robust. Furthermore, U.S. trade protectionism is positive for the dollar. The basis is that exporters to the U.S. could opt for weaker currencies to offset the negative impact of tariffs on their local currency revenues. Financial markets are often self-regulating, and they move to rebalance the global economy and amend economic excesses. A stronger dollar is the right medicine for the global economy for now. A firmer dollar is required to rebalance growth away from the U.S. and towards the rest of the world. In particular, dollar appreciation is needed to cap budding U.S. inflationary pressures. In addition, a stronger greenback will compel unraveling of excesses within the developing economies. While it will cause growth retrenchment and will be painful for EM in the medium term, cheapened currencies and deleveraging (an unwinding of credit excesses) will ultimately create a foundation for stronger and healthier growth in the years ahead. U.S. dollar liquidity is tightening, supporting the greenback (the latter is shown inverted on this chart) (Chart I-5). Continued shrinkage of the Fed's balance sheet entails tighter U.S. dollar liquidity going forward. With respect to currency market technicals, the broad trade-weighted U.S. dollar is not yet overbought, and trader sentiment on the U.S. currency is not extremely bullish (Chart I-6). Hence, conditions for an ultimate cyclical top in the dollar do not yet exist. Chart I-4The Global Business Cycle and The Dollar Chart I-5Upside Risks To The Dollar Chart I-6The Dollar: Market Technicals Finally, the U.S. dollar is not expensive. Our favored currency valuation measure - the real effective exchange rate-based on unit labor costs - currently suggests that the greenback is only slightly above its fair value (Chart I-7). This measure is superior to the real effective exchange rate based on consumer and producer prices because it considers both wages and productivity. Ultimately, competitiveness is not a function of wages (or prices) but wages adjusted for productivity.1 Besides, labor costs typically constitute the largest share of business costs. Hence, the unit labor cost-based real effective exchange rate is the best measure of currency competitiveness. This currency valuation yardstick does not corroborate the widely circulating narrative in the investment community that the U.S. currency is very expensive. The greenback is also not expensive according to the real broad trade-weighted dollar index. The latter is only slightly above its historical mean, and well below its previous highs (Chart I-8). Chart I-7AThe Dollar Is Not Expensive Chart I-7BThese Currencies Are Expensive Chart I-8Trade-Weighted Dollar in Real Terms To be sure, we are not implying the dollar is cheap. It is not. Rather, our point is that the greenback is not yet expensive. When valuations are not extreme, they usually do not prevent a rally or selloff. Odds are that the dollar could become more expensive in this cycle before topping out. Bottom Line: Barring government interference in foreign exchange markets, the path of least resistance for the U.S. dollar is up. The Main Risk To The Dollar Is Trump Chart I-9U.S. Monetary Conditions Are ##br##About To Become Tight Will the U.S. administration invoke the "nuclear" option - currency market interventions - to eclipse the dollar's fundamentals and reverse the greenback's rally? President Trump fiercely opposes a stronger dollar. He prefers a structurally weaker currency to bring back manufacturing jobs to the U.S. Besides, from a cyclical perspective, President Trump has been explicit that higher U.S. interest rates and a stronger dollar are negating his economic stimulus. Trump's worry is that tightening monetary conditions, if they persist, will depress growth by late 2019 when the next presidential election season begins in earnest (Chart I-9). President Trump is a genuine economic populist and is ready to cross boundaries that many presidents refused to. This leaves us little doubt that the U.S. administration will escalate its calls both for a weaker currency and a halt in Fed tightening. The U.S. Treasury is in charge of foreign exchange policy, and it can intervene in currency markets. The Fed can, but is not obliged by law, to supplement the Treasury's interventions in foreign exchange markets. In theory, the U.S. Treasury has a special fund (the Exchange Stabilization Fund) and could opt for unilateral currency market interventions even if the Fed does not cooperate. In such a case, a pertinent question is: What are the essential conditions for currency interventions to succeed in reversing the dollar's uptrend? Conditions For Effective Currency Interventions There have been two major interventions conducted by the U.S. authorities to depreciate the dollar: the 1971 Smithsonian Agreement and the 1985 Plaza Accord. BCA's Geopolitical Strategy service has discussed the political and trade backdrops of these interventions in past reports, and we will not detail them here.2 There was also the Louvre Accord in 1987, but it was aimed at propping up the U.S. dollar, not weakening it. All of these interventions were successful and achieved their objective (Chart I-10). We list below the stipulations that secured the success of these interventions and examine whether conditions for effective interventions are present today. Chart I-10The Smithsonian And Plaza Accords Were Successful Currency interventions accompanied by congruent monetary and fiscal policies tend to be more successful. The previous currency interventions conducted by the U.S. Treasury would not have been successful without the Fed simultaneously adjusting monetary policy. Not only did the Fed join the U.S. Treasury's efforts to depreciate the greenback following the Smithsonian Agreement and the Plaza Accord, but it also altered its monetary policy stance - it pursued a policy of lower-than-otherwise called for real interest rates. Academic literature on this issue is straightforward. Bordo (2010) contends the following about the efficacy of currency interventions: "If intervention were to have anything other than a fleeting, hit-or-miss effect on exchange rates, monetary policy had to support it ... Most of the movements in exchange rates over the Plaza and Louvre period seem attributable to policy changes, not intervention."3 Given current economic conditions in the U.S. economy - a very tight labor market and the prospect of higher inflation - the Fed is unlikely to easily agree to altering its current policy stance to accommodate the Treasury's preferred exchange rate policy. Academic literature finds that sterilized interventions are less effective than non-sterilized ones.4 For the Fed not to sterilize currency interventions aimed at weakening the dollar, it would need to allow commercial banks' reserves to rise. This would conflict with its current explicit objective of reducing commercial banks' reserves and shrinking its balance sheet (Chart I-11). Chart I-11U.S. Banks' Reserves and The Dollar Hence, the bar is presently very high for the Fed to agree to non-sterilized currency interventions to weaken the dollar, as it would go against its current policy objective of tightening and shrinking its balance sheet. Going on the Treasury's leash would substantially damage the Fed's creditability. Bilateral currency interventions are much more effective in achieving the desired objective than unilateral ones. Hence, for interventions to succeed it is critical to involve counterparts in other countries. Back in the 1970s and 1980s, the U.S. used its hegemonic leadership over Europe and Japan as well as tariffs (in 1971) and the threat of tariffs (1980s) to force its allies to agree to bilateral interventions to weaken the dollar. However, it is difficult to envision either Europe or Japan agreeing to allowing their respective currencies to strengthen a lot at this time. First, both Europe and Japan are actively fighting latent deflationary forces at home. Given the high-beta, export-dependent nature of both economies, a strong currency would negatively impact growth. Geopolitically speaking, Europe is not as dependent on the U.S. today as it was at the height of the Cold War. Russia is a "poor man's" Soviet Union, with the combined defense budget of the EU economies dwarfing its own. Besides, in the 1970s and 1980s, the U.S. was "the only market in town." Crossing American policymakers upped the threat of being evicted from the most lucrative global middle class consumer market. This is no longer the case with the rise of emerging markets, China and the common European market. Prominently, Trump's main objective is to depreciate the dollar versus the Chinese RMB. Yet, there is no chance that in the foreseeable future China will agree with the U.S. to engineer considerable yuan appreciation against the dollar. In fact, Beijing has been actively using CNY depreciation to offset the impact of tariffs imposed on its exports by the Trump administration. Chart I-12China: Exchange Rate and Interest Rate##br## Differential Are Correlated Notably, this week there was an article published by China's Xinhua news agency referring to the "... Plaza Accord, in which Tokyo agreed to strengthen the currency against the dollar, as cause of the country's economic woes. ... Rapid and steep yen appreciation and Japan's domestic policy mistakes eventually brought about the nation's "lost decade."5 Chinese policymakers have carefully studied and internalized Japan's mistakes in the late 1980s and early 1990s. The mainland will not accept a considerably stronger yuan at times when deleveraging remains an important policy objective - and the latter is bound to weigh on domestic demand. Amid deleveraging, China requires a weaker - not stronger - currency to mitigate deflationary pressures in the economy. For interventions to be effective, foreign counterparts need to also agree to adjust their monetary and fiscal policy stances to be in sync with exchange rate policy. Presently, both the European Central Bank and the Bank of Japan are still conducting QE and expanding their balance sheets. These policies are compatible with weaker - not stronger - currencies. It is highly unlikely these central banks will abruptly reverse their current policies to accommodate President Trump's economic preferences. With time, if the U.S. dollar overshoots on the strong side and the euro and yen plunge substantially, it is probable that the ECB and BoJ will become willing to support the U.S. administration's efforts to depreciate the dollar. However, conditions for bilateral interventions do not exist at the moment. As to China, policymakers are unlikely to push local rates higher to promote a major currency rally. Chart I-12 illustrates the tradeoff between the exchange rate and interest rates in China might be weak but exist - the CNY/USD rate broadly correlates with the China-U.S. interest rate differential. The PBoC may not be able to appreciate the yuan without tolerating higher money market rates. Yet China's corporate debt burden is enormous, and requires low - not high - borrowing costs to smooth the deleveraging process. Bottom Line: Conditions for effective foreign exchange market interventions do not presently exist in the U.S. For the time being, neither the Fed nor central banks in Europe, Japan and China will cooperate with the U.S. Treasury to depreciate the dollar. Can The U.S. Intervene In CNY/USD Market? Chart I-13Trade-Weighted RMB And Dollar Move Together The U.S. can intervene in the euro, yen and other currency markets, but the focus of President Trump is the dollar's exchange rate with the Chinese yuan. Provided China has capital controls, its government decides which foreign institutions/organizations can buy local currency and assets, and how much. It is highly unlikely the Chinese government will grant permission to the U.S. authorities to freely operate in the RMB market. In short, China will not allow the Fed and other U.S. institutions to act on behalf of the government and push around the exchange rate. The ongoing trade confrontation between the U.S. and China has not produced any agreement. There is, at this time, zero chance that China will agree to appreciate its currency considerably under U.S. pressure. In fact, our geopolitical strategy team still expects the Trump administration to impose tariffs on the announced $200 billion of Chinese imports at some point in September. While the ultimate figure may be smaller than $200 billion, the point remains that the trade war between the U.S. and China continues to heat up, not cool off. The only feasible option for the U.S. authorities is to devalue the dollar against the European and Japanese currencies, triggering a broad-based selloff in the dollar. In this scenario, the RMB might appreciate versus the greenback, but only moderately. The CNY/USD rate is tightly controlled by the PBoC, and the yuan typically depreciates (appreciates) in trade-weighted terms when the greenback weakens (strengthens), respectively (Chart I-13). Consequently, U.S. intervention in currency markets that does not directly embrace the yuan will likely lead to a weaker trade-weighted RMB and make China even more competitive versus other nations. In fact, such an effort would be welcomed by Chinese policymakers, as it would stabilize and even lift the yuan versus the dollar (fostering financial stability in China), but allow the renminbi to depreciate in trade-weighted terms (boosting China's overall trade competitiveness). Bottom Line: There is currently no effective way for the U.S. to intervene and achieve material RMB appreciation in trade-weighted terms. Investment Conclusions Chart I-14Go Long U.S. Dollar Volatility The global macro landscape warrants a continued dollar rally. Yet the U.S. administration will use frequent verbal attacks to halt the greenback's ascent. President Trump is likely to continue to publically oppose the Fed and its interest rate policy. At some point, potentially in the near future, his criticism could become a full-on assault. In this context, the U.S. currency will continue to appreciate, but its rally will be accompanied by large dips, i.e., substantially higher volatility. To capitalize on this theme, traders should consider going long dollar volatility (Chart I-14). The trajectory of the U.S. dollar is critical for many financial markets in general and EM in particular. A firm dollar is consistent with continuous turmoil in EM financial markets. We continue to recommend staying put on EM in absolute terms and underweighting EM versus DM for stocks, credit and currencies. BCA's Emerging Markets Strategy continues to recommend shorting a basket of the following EM currencies versus the U.S. dollar: the Brazilian real, the South African rand, the Chilean peso, the Malaysian ringgit and the Indonesian rupiah. Potential dynamics that would persuade the Fed to arrest its tightening campaign include escalating EM turmoil that spills into U.S. financial markets. An intensifying EM selloff is our baseline view, and the dollar will spike materially in this scenario. Only after this occurs will the Fed likely contemplate halting its tightening, and only then will the dollar peter out. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Unit labor cost = (wage per person per hour) / (productivity per person per hour). 2 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, and "The Dollar May Be Our Currency, But It Is Your Problem," dated July 25, 2018, available at gps.bcaresearch.com. 3 Bordo, M. et al (2010), "U.S. Foreign-Exchange-Market Intervention during the Volcker-Greenspan", NBER Working Paper, September 2010 4 Bordo, M., Humpage, O. & Schwartz, A. (2011), "U.S. Monetary-Policy Evolution and U.S. Intervention", Federal Reserve Bank of Cleveland, Working Paper, October 2011 5 South China Morning Post: Chinese state media cites Japan's 'lost decade' when warning of risks of giving in to US demands; https://www.scmp.com/news/china/diplomacy-defence/article/2160196/chinese-state-media-cites-japans-lost-decade-when Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The global 6-month credit impulse is likely to turn up in the fourth quarter. This warrants profit-taking in some pro-defensive equity sector, regional, and country allocation... ...for example, in the 35 percent outperformance of European healthcare versus banks in just seven months. But do not become aggressively pro-cyclical until the 10-year yield on the Italian BTP (now at 3.2) moves closer to 3... ...and the sum of the 10-year yields on the U.S. T-bond, German bund and JGB (now at 3.4) also moves closer to 3. Chart Of The WeekThe Cycle Is About To Turn Feature One of the most common questions we get is, when will the cycle turn? And our response is always, which cycle? The cycle that most people focus on is the so-called business cycle, which describes multi-year economic expansions punctuated by recessions. However, the business cycle - to the extent that it is a cycle - is very irregular. Its upswings and downswings vary greatly in length (Chart I-2). This irregularity is one reason why economists are useless at calling the turns. Nevertheless, investors still obsess with calling the business cycle because they think this is the only cycle that drives the financial markets. Chart I-2The Business Cycle Is Very Irregular We disagree. Nature bestows us with a multitude of cycles with different periodicities: the daily tides, the monthly phases of the moon, the annual seasons, and the multi-year climate cycles. So it would be unnatural, and somewhat arrogant, to assume the economy and financial markets possess only one cycle. In fact, just as in nature, the economy and financial markets experience a multitude of cycles with different periodicities. There Is Not One Cycle In The Economy, There Are Many If you plotted yearly changes in temperature, you would get a flat line and you would think there were no seasons! The point being that you cannot see a yearly cycle if you look at yearly changes. To see the cyclicality of the seasons, you must plot 6-month changes in temperature. Likewise, you cannot see the shorter-term cycles in the economy and financial markets using analysis, such as yearly changes, designed to see longer-term cycles. Once you grasp this basic maths, the mini-cycles in the economy and financial markets will stare you in the face (Chart I-3), and a whole new world of investment opportunities will open up. Chart I-3The Mini-Cycle Is Very Regular As we advised on January 4: "Global growth experiences remarkably consistent - and therefore predictable - 'mini-cycles', with half-cycle lengths averaging eight months. As the current mini-upswing started in May 2017 we can infer that it is likely to end at some point in early 2018. So one surprise could be that global growth will lose steam in the first half of 2018 rather than in the second half, contrary to what the consensus is expecting... Pare back exposure to cyclicals and redeploy to defensives" The advice proved to be very prescient. The global economy did enter a mini-downswing sourced in the emerging markets (Charts I-4 - I-6). Chart I-4The U.S. Mini-Downswing Was Muted... Chart I-5...The Euro Area Mini-Downswing Was Also Muted... Chart I-6...But The China Mini-Downswing Was Severe Nevertheless, the global nature of financial markets meant that the German 10-year bund yield declined by 40 bps, while European healthcare equities outperformed banks by a mouth-watering 35 percent, and materials by 15 percent (Chart I-7 and Chart I-8). Some of these performances are as large as can be gained in a full business cycle begging the question: Why obsess with the impossible-to-predict business cycle when there are equally rich pickings in the easier-to-predict mini-cycle? Chart I-7Banks Vs. Healthcare Tracks The Mini-Cycle Chart I-8Materials Vs. Healthcare Tracks The Mini-Cycle Furthermore, if you get the equity sector calls right, you will get the equity regional and country calls right too. As cyclicals have underperformed, the less cyclically-exposed S&P500 has been the star performer of the major regional indexes. And cyclical-heavy stock markets like Italy's MIB have strongly underperformed defensive-heavy stock markets like Denmark's OMX (Chart I-9). Chart I-9Italy Vs. Denmark = Banks Vs. Healthcare It follows that the evolution of the global economic mini-cycle is pivotal in every investment decision (Box 1). BOX 1 The Theory Of Economic And Market Mini-Cycles The academic foundation of the global economic mini-cycles is a model called the Cobweb Theorem.1 When bond yields rise, interest rate sensitive sectors in the economy feel a headwind, but with a lag. Similarly, when bond yields decline, interest rate sensitive sectors feel a tailwind, but again with a lag. The lag occurs because credit demand leads credit supply by several months. As credit demand leads credit supply, the turning point in the price of credit (the bond yield) always leads the quantity of credit supplied (the credit impulse). The result is a perpetual mini-cycle oscillation in both economic variables. And because the quantity of credit supplied is a marginal driver of economic activity, this also creates mini-cycles in economic activity. These mini-cycles are remarkably regular with half-cycle lengths averaging around eight months and the regularity creates predictability. Moreover, as most investors are unaware of this predictability, the next turning point is not discounted in financial market prices - providing a compelling investment opportunity for those who do recognise the existence and predictability of these cycles. The Mini-Cycle Will Soon Turn Up The global 6-month credit impulse entered its current mini-downswing in January. Given that mini-downswings tend to last around eight months, we should expect the global economy to exit its mini-downswing in September, the escape valve being the recent decline in bond yields (Chart Of The Week). The caveat is that bond yields were slow to react to the mini-downswing and the decline in 10-year yields, averaging around 40 bps from the peak, has been pretty shallow. It follows that the next mini-upswing could be delayed to October/November, and be somewhat muted. Nevertheless, the surprise could be that global growth will stabilise in the fourth quarter of 2018, contrary to what the consensus is expecting. And this would suggest taking some of the most mouth-watering profits in pro-defensive equity sector, regional, and country allocation - for example, in the 35 percent outperformance of European healthcare versus banks (Chart I-10). Chart I-10Banks Have Severely Underperformed Healthcare Would we go a step further and become pro-cyclical? Not yet. One reason is that there is a limit to how far bond yields can rise before destabilising the very rich valuations of all risk-assets. This is captured in our 'rule of 4' which says that when the sum of the 10-year yields on the U.S. T-bond, German bund, and Japanese government bond (JGB) exceeds 4 - which broadly equates to the global 10-year yield exceeding 2 percent - it is time to go underweight equities. With the sum now equal to 3.4, yields can rise by only 25-30 bps before hurting risk-assets. Another reason for circumspection is that the investment landscape is still scattered with a large number of landmines, one of which has its own rule of 4. The Other 'Rule Of 4': The Italian 10-Year Bond Yield When Italian bond prices decline, it erodes the value of Italian banks' €350 billion portfolio of BTPs and weakens the banks' balance sheets. Investors start to get nervous about a bank's solvency when equity capital no longer covers net non-performing loans (NPLs). On this basis, the largest Italian banks now have €160 billion of equity capital against €130 billion of net NPLs, implying excess capital of €30 billion (Chart I-11). It follows that the markets would start to worry about Italian banks' mark-to-market solvency if their bond valuations sustained a drop of around a tenth from the recent peak. We estimate this equates to the 10-year BTP yield breaching and remaining above 4 percent (Chart I-12).2 Chart I-11Italian Banks' Equity Capital Exceeds Net NPLs By 30 Bn Euro Chart I-12Italian Banks' Solvency Would Be In Question If The 10-Year Yield Breached 4% Today the 10-year BTP yield stands just shy of 3.2 percent, but it is about to enter a testing period. The Italian government must agree its 2019 budget by September and present a draft to the European Commission by mid-October. The budget must tread a fine line. Cutting the structural deficit to appease the Commission would diminish the credibility of the populist government. It would also be terrible economics, making it harder for Italy to escape its decade-long stagnation.3 On the other hand, locking horns with Brussels and aggressively increasing the structural deficit might panic the bond market. The optimal outcome would be to leave the structural deficit broadly where it is now. To sum up, the global 6-month credit impulse is likely to turn up in the fourth quarter, warranting some profit-taking in pro-defensive positions. But we do not advise aggressive pro-cyclical sector, regional, and country allocation until the 10-year yield on the Italian BTP (now at 3.2) - and the sum of the 10-year yields on the U.S. T-bond, German bund and JGB (now at 3.4) - both move closer to 3. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Special Report 'The Cobweb Theory And Market Cycles' published on January 11 2018 and available at eis.bcaresearch.com. 2 Assuming that the average maturity of Italian banks' BTPs is around 5 years. 3 Please see the European Investment Strategy Special Report 'Monetarists Vs Keynesians: The 21st Century Battle' July 12 2018 available at eis.bcaresearch.com. Fractal trading Model* In support of the preceding fundamental analysis, the outperformance of healthcare versus banks is technically extended. Its 130-day fractal dimension is at the lower bound which has reliably signalled previous trend exhaustions. On this basis we would position for a 10% reversal with a symmetrical stop-loss. In other trades, long PLN/USD reached the end of its 65-day holding period comfortably in profit, and is now closed. This leaves six open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-13 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

Bank Credit Analyst

Highlights Two key issues will remain important drivers of global financial markets in the coming quarters: the direction of the dollar and Chinese policy stimulus. Policy and growth divergences will remain tailwinds for the dollar and there is little the Trump Administration can do to reverse the upward trend. Dollar strength is exposing poor macro fundamentals in many emerging market economies. The problems facing EM economies run deep, and will not disappear anytime soon. Expect more EM fireworks. EM market turmoil could pause the Fed's tightening campaign, but this would require evidence that the U.S. economy and/or financial markets are being negatively affected. Chinese stimulus is a risk to our base-case outlook. A growth impulse might keep the RMB from weakening further, boost commodity prices and support EM exports. However, we believe that Chinese stimulus will not be a 'game changer', and might even cause more problems if the authorities push the RMB lower. The U.S. economy and financial system are less exposed to emerging markets than in the Eurozone. An excellent profit backdrop also provides U.S. risk assets with a strong tailwind. Nonetheless, the U.S. is not immune to EM woes. Poor valuation implies a meaningful correction in U.S. risk assets on any flight-to-quality event. Stay cautious on asset allocation. Fed Chair Powell is willing to wait for the "whites of the eyes" of inflation before becoming alarmed, almost ensuring that the FOMC will fall behind the inflation curve. Evidence of labor market overheating is accumulating. Bond yields will rise as the FOMC tries to catch up and long-term inflation expectations bounce. We believe that investors are underestimating the upside in U.S. inflation risks over the medium term. We recommend below-benchmark duration, although government bonds would temporarily rally if EM turbulence sparks a flight-to-quality. We still expect the supply/demand balance in the world oil market to tighten later this year. Stay positioned for higher oil prices. Japanese corporate profits have been stellar, but that will soon change. EPS growth is likely to soften in the Eurozone too. Favor the U.S. market in unhedged terms. Feature There are numerous key issues on the investment landscape, but two stand out at the moment because they both have wide-ranging global implications: (1) Will the U.S. dollar continue to appreciate; and (2) Will Chinese policymakers place structural reform on the back burner and 'go for growth' in the near term? The latest U.S. economic and profit data provide a strong tailwind for American risk assets. Nonetheless, the mighty U.S. dollar is casting a dark shadow over the heavily-indebted emerging market economies, sparking comparisons with the late 1990s. Could Turkey be the start of a 'domino' effect, similar to Thailand's plunge into financial crisis in 1997 that eventually spread to Brazil and Russia, and finally contributed to the demise of Long-Term Capital Management in the fall of 1998? On the global growth front, the story has not changed much from our assessment last month. Growth is solid, but slowing, in part due to a deceleration in developed-economy capital spending. The global expansion has become less synchronized and relative growth dynamics are pointing to more upside for the greenback (Chart I-1). Chart I-1Cyclical Divergence Is Still Dollar Bullish As in the late 1990s, the Fed is likely to ignore turbulence in EM financial markets and will continue on its tightening path until it begins to affect the U.S. economy or asset prices. The path of least resistance for the dollar is up until something breaks. A major policy impulse from China could alter the feedback loop between the strengthening dollar and EM asset prices. A growth pickup would lift China's imports and commodity prices, both of which would support emerging market economies and asset prices. There is plenty of uncertainty regarding the size of the recently-announced Chinese stimulus measures, but our take is that they are likely to underwhelm because a major growth push would undermine the authorities' structural initiatives. The implication is that the global backdrop will remain unfriendly to emerging market assets at a time when they are more vulnerable than the consensus believes. The risk of a financial accident is escalating. The good news is that the U.S. earnings picture remains excellent, which precludes us from being underweight on risk assets. Nonetheless, investors should have no more than a benchmark allocation to equities and corporate bonds in the major advanced economies. We are upgrading government bonds to neutral at the expense of cash on a tactical basis, to reflect the rising possibility of a global flight-to-quality. The First Domino Turkey has had all the hallmarks of a crisis for a long while. Erdogan's slim hold on power has motivated several populist policy decisions that have stretched Turkey's macro fundamentals. The central bank has been forced to provide large injections of liquidity into the banking system, despite double-digit inflation readings. The country suffers from a classic "twin deficit" problem. Turkish private sector external debt stands at 40% of GDP, of which 13% of GDP is short-term, the highest among EM countries. Erdogan wants economic growth at all costs, but has done little in terms of the structural reforms necessary to lift the country's growth potential. The Lira has lost almost 26% of its value versus the dollar since August 1 and Turkish spreads have blown out. It appears that a lot of bad news has been discounted, but our EM strategists do not see this as a buying opportunity. One risk is that Erdogan imposes capital controls next. Our emerging market team's long held caution on EM is rooted in concern for failing fundamentals.1 They emphasize that Turkey was the catalyst, not the main cause, for the broader financial stress observed across EM assets in August. BCA has highlighted for some time that EM debt is a ticking time bomb. Chart I-2 shows that EM dollar-denominated debt is now as high as it was in the late 1990s as a share of both GDP and exports. Chart I-3 highlights the most vulnerable EM economies in terms of the foreign currency funding requirement, and the foreign debt-servicing obligation relative to total exports. Turkey stands out as the most vulnerable, along with Argentina, Brazil, Indonesia, Chile, and Colombia. Chart I-2Debt Makes EM Vulnerable Chart I-3EM Debt Exposure In all previous major EM selloffs, any decoupling between different EM regions proved to be unsustainable. And it certainly does not help that the Fed remains on its tightening path; EM equities usually fall when U.S. financial conditions tighten (Chart I-4). The combination of a strong dollar and weak RMB is a deadly combination for highly-indebted emerging market economies. Chart I-4EM Highly Sensitive To U.S. Financial Conditions... Investors should expect contagion to intensify. China To The Rescue? Some investors are hoping that China will 'save the day' by providing a major dose of policy stimulus, as it did in 2015, the last time that EM was close to a tipping point. We doubt China will be able to play the same stabilizing role. The Chinese authorities are committed to their long-term structural goals. They have been trying to reorient the economy toward consumption and away from investment and exports, as well as undertake other reforms to reduce financial risk, pollution, poverty and corruption. China kept policy on the tight side until recently, which resulted in a gradual growth slowdown. The Li Keqiang index (LKI) is a good coincident indicator for economic growth (Chart I-5). This index has ticked up in recent months, along with imports, but this likely reflects industrial activity designed to fill foreign orders before the new U.S. tariffs take effect. Our LKI model, based on money and credit, points to further economic weakness ahead. Chart I-5China: Watch Credit And Fiscal Impulse The escalation of the trade war with the U.S. is forcing the Chinese authorities to provide some short-term policy stimulus in order to pre-empt any resulting economic damage. A flurry of policy announcements over the past month has given investors the impression that Beijing has cranked up the policy dial, including cuts to short-term interest rates, a decrease in reserve requirements, liquidity provision to the banking system, and promises of various forms of fiscal stimulus. Chinese stimulus has historically been positive for commodity prices and EM assets. However, we are less sanguine this time. First, the authorities are not abandoning structural reforms, which means that the associated growth headwinds will not disappear. Second, our China experts believe that Chinese policy is only turning moderately reflationary; this is not the 'big bang' that followed the Great Recession in the late 2000s, or the same level of stimulus provided following the 2015-16 global manufacturing downturn. There will no doubt be some fiscal stimulus, but we do not expect a major expansion in bank credit to the private sector because of the government's crackdown on shadow banking, excessive leverage and growing non-performing loans. The change in the policy stance amounts to 'taking the foot off the brake' rather than pressing firmly on the accelerator.2 Third, and perhaps most importantly, the authorities may rely even more on the currency lever to do the heavy lifting if the economy continues to slow and/or the tariff war escalates further. This would be negative for commodity demand because a weaker RMB will make commodities dearer for Chinese producers. Metals prices are particularly at risk. China's competitors will also feel the sting of a cheaper RMB. It will be critical to watch the Chinese money and credit data in the coming months to gauge whether our view on the policy stimulus is correct. We will also be watching the combined credit and fiscal impulse which, at the moment, points to continued weakening in import growth in the near term (Chart I-5, bottom panel). Slower EM growth and/or more financial market turbulence is likely to take a larger toll on the euro area than the United States. Exports to emerging markets account for only 3.6% of GDP for the U.S., compared to 9.7% of GDP for the euro area. Euro area banks also have more exposure to emerging markets than U.S. banks (Chart I-6). Notably, Spanish banks - BBVA in particular - has sizable exposure to Turkey. Meanwhile, Italian assets have come under pressure as the rift between the European Commission and the new populist government widens and Italian banks become increasingly wary of financing their government. Chart I-6DM Bank Exposure To EM European growth will therefore likely continue to trail that of the U.S. Our base case does not see euro area growth falling below a trend pace in the coming quarters, but relative growth momentum and the ongoing policy divergence will favor the dollar over the euro. FOMC: No Urgency The key message from the latest FOMC Minutes and Chairman Powell's Jackson Hole speech is that policymakers are sticking with the "gradual" approach to tightening, despite the late-cycle acceleration in economic growth. The blowout second-quarter GDP report supports the view that fiscal stimulus is stoking the economy at a time when there is little slack. Evidence that the labor market is overheating is not simply anecdotal anymore. In past cycles, an acceleration in growth at a time when inflation is already at target and unemployment is below estimates of full employment would have sparked aggressive Fed action. But the Minutes and Powell's speech revealed no sense of urgency. Powell made the case that the Fed must proceed carefully in an environment where there is much uncertainty about the level of the neutral policy rate, the natural rate of unemployment and the slope of the Phillips curve. Moreover, long-term inflation expectations are still hovering below a level that is consistent with meeting the 2% target over the medium term. Some FOMC policymakers believe that this fact justifies taking chances with an inflation overshoot in the coming quarters. Another reason for the FOMC to proceed cautiously is the wage picture, which is confusing even to economic experts because the official measures paint a mixed picture (Chart I-7). The Employment Cost Index for private sector workers continues to march higher. However, growth in compensation per hour, average hourly earnings (AHE) and unit labor costs have all eased a little this year. The Atlanta Fed Wage Tracker, one of the cleanest measures of wages, reveals an even more significant pullback. The softening in wage growth has been fairly widespread across age cohorts, educational attainment and regions, according to the Atlanta Fed data (Chart I-8). Part-time workers appear to be the only segment that has bucked the trend. It is not clear why workers in the 16-24 age group, as well as those with bachelor's degrees (of any age), have seen the most pronounced softening in wage growth this year. Chart I-7Mixed U.S. Wage Data Chart I-8U.S. Wage Slowdown Broadly-Based Which measure is telling the correct story: the ECI or the Atlanta Wage Tracker? Both are a relatively clean measure of wages and it is difficult to tell based on the relative merits of each index alone. Nonetheless, there is little doubt that the labor market is now very tight by historical standards. Small business owners' compensation plans remained near record levels in July, while concerns about the "quality of labor" have never been higher (Chart I-9). Chart I-10 shows that the ratio of the level of job openings to unemployed workers has surpassed the pre-recession level in all but one sector according to the Jolts survey. Indeed, in most cases this ratio is well above the previous peak. Unemployment is now below the estimated level of full-employment in more than 80% of U.S. states. Chart I-9U.S. Labor Shortage Is Growing Chart I-10JOLTS Signals Very Tight Jobs Market No Evidence Of U.S. Overheating? Labor shortages first appeared for skilled workers, helping to explain why highly-skilled workers have enjoyed the fastest wage gains in recent years. But this year's Fed Beige Books have noted that many businesses are now having trouble finding low- and middle-skilled workers, as listed in Table I-1. These industries roughly line up with the ones that reveal above-average growth in average hourly earnings, and with the ones where labor market tightness is the most acute according to the Jolts survey (second and third columns in the table). The shortages appear to be broadly based, ranging from truck transportation to financial services, manufacturing and construction. This makes it all the more curious that Chairman Powell finds that there is no evidence of overheating in the labor market. The evidence seems pretty conclusive to us and it even features in the Fed's own Beige Book. Keep in mind that inflation is not always the 'cost push' type, beginning in the labor market and traveling to consumer prices. Sometimes inflation can begin in the market for goods and services, and then affect wage demands. U.S. consumer price inflation appears to be headed higher based on the New York Fed's Underlying Inflation Gauge (Chart I-11). Our CPI diffusion index shows that inflation is accelerating in a majority of categories. Other measures of underlying inflation, such as the Sticky Price Index, the Trimmed Mean, and the Median inflation rate are all in a solid uptrend. Dollar strength this year will eventually put downward pressure on core goods inflation, but that will take some time; non-energy goods inflation is more likely to rise in the near term as it catches up to the previous acceleration in imported goods prices (Chart I-11, bottom panel). Table I-1Labor 'Shortages' Identified In The Beige Book Chart I-11U.S. Underlying Inflation Is Rising U.S. Inflation To Surprise On Upside We believe that the market is underestimating the risk of a meaningful inflation overshoot over the medium term. Investors still do not believe that the Fed will be able to consistently meet the 2% target over the long-term, based on CPI swaps and TIPS breakeven rates. BCA's Chief Global Strategist, Peter Berezin, penned a two-part Special Report in August on the potential for upside inflation surprises over the coming years.3 First, increasing political pressure on the major central banks is worrying. Second, policymakers are coming around to the idea that there may be an exploitable trade-off between higher inflation and lower unemployment. This was a mistake last made in the inflationary 1970s. Finally, the pressure to keep monetary policy accommodative until the "whites of the eyes" of inflation are visible will remain strong. Bonds are in for some trouble if we are correct on the inflation outlook. We recommend that investors with a 6-12 month investor horizon remain short in duration and overweight TIPS versus conventional Treasurys. That said, we cannot rule out a flight-to-quality episode at some point, possibly reflecting trade tensions and/or EM turmoil, which would send Treasury yields temporarily lower. The Fed may be forced to place rate hikes on hold if financial conditions tighten too quickly. No Margin Peak Yet In The U.S.... The S&P 500 was unfazed by the turmoil in emerging markets and the re-widening in Italian bond spreads in August, likely because of continuing good news on the profit front. Corporate earnings remained in a sweet spot in the second quarter. Nominal GDP grew by a whopping 5.4% from a year ago, helping to boost the top line for the corporate sector. The lagged effect of previous dollar depreciation is still flattering earnings, although this only accounts for about two percentage points according to our model (Chart I-12). Meanwhile, equity buybacks have kicked into overdrive (Chart I-13). Chart I-12U.S. Dollar Impact On EPS Growth Chart I-13U.S. Equity Buyback In Overdrive Margins continued their impressive ascent in the second quarter to well above the pre-Lehman peak (Chart I-14). A lot of the increase is related to the tax cuts; EBITDA margins are still substantially below the 2007 peak according to the S&P data. It is disconcerting that all of the surge in S&P 500 margins is due to the Tech sector (Chart I-14, bottom panel). Excluding Tech, S&P after-tax margins have simply moved sideways since 2010. Looking ahead, the tailwind from previous dollar depreciation will shift to a headwind by mid-2019. Chart I-12 shows that the contribution from changes in the dollar to EPS growth will shift from a positive two percentage points to a drag of 1½ percentage points if the dollar is flat from today's level in broad trade-weighted terms. If the dollar rises by another 5% this year, then next year's drag on EPS growth will reach three percentage points. Moreover, the impact of the tax cuts on after-tax profits will fade next year. Wage pressures are building and this should eventually squeeze profit margins. That said, a margin peak does not appear to be imminent. Last month we introduced some macro indicators for profit margins (Chart I-15). Most appeared to be rolling over a month ago, but they have all since ticked up. Chart I-14Tech And Taxes Driving Profit Margins Chart I-15U.S. Margin Indicators Have Turned Up The bottom line is that we continue to expect a mean reversion in U.S. profit margins in the coming years, but this is not a risk for at least the rest of 2018. ...But Profit Outlook Darkening In Japan Second quarter earnings season was also a good one for Japanese companies. Twelve-month forward earnings estimates have been in a steep incline and margins have been rising (Chart I-16). Despite this, the Nikkei has only managed to move sideways this year in local currency terms. Concerns over trade and global growth have perhaps weighed on Japanese stock performance. Company profits have a high beta with respect to global growth. Things are looking shaky on the domestic front too. Domestic demand growth is decelerating, consistent with a weakening Economy Watcher's Survey. Some of the weakness may be related to poor weather, but the LEI suggests that this trend will continue in the coming quarters (Chart I-17, bottom panel). Chart I-16Japan: Trailing Earnings Are Solid... Chart I-17...But Profit Margins Will Narrow Chart I-17 presents some of the variables that have helped to explain historical trends in Japanese EPS. Industrial production growth, a good proxy for top line growth, is decelerating. Nominal GDP growth has fallen to just 1.1% year-over-year, at a time when total labor compensation has surged by more than 4%. The difference between these two, a proxy for profit margins, has therefore plunged. Previous shifts in the yen have not had a large impact on EPS growth over the past year and we do not expect that to change much in 2019. On a positive note, Japanese stocks are attractively valued now that the 12-month forward P/E ratio has fallen below 13 (Chart I-16, bottom panel). It is also constructive that the Bank of Japan is the only central bank that is not backing away from monetary stimulus. The recent widening of the trading band for the 10-year JGB yield was a technical change meant to give the central bank more flexibility, not a signal that policymakers are planning to change tack. Nonetheless, we believe that earnings growth and margins will disappoint market expectations over the next year. The story is much the same for the Eurozone. Both trailing and forward profit margins have been in a strong uptrend. Twelve-month forward EPS growth has been holding at a solid 9%. Nonetheless, the data that feed into our Eurozone profit model point to some softening ahead, including industrial production and the difference between nominal GDP and the aggregate wage bill (not shown). The Eurozone's credit impulse turned negative even before concerns about EM and Italian politics exploded onto the scene. Thus, home-grown profit generation is likely to moderate along with foreign-sourced earnings. For the moment, the BCA House View remains at benchmark on Japanese and Eurozone stocks in currency-hedged terms. In unhedged terms, we prefer the U.S. market to these other bourses because of our bullish dollar bias. Investment Conclusions: Two key issues will remain important drivers of global financial markets in the coming months and quarters: the direction of the dollar and Chinese policy stimulus. We believe that the U.S. dollar has additional upside potential due to growth and policy divergences. There is some speculation in the financial community that President Trump might resort to currency intervention. However, any intervention would be sterilized by the Fed. The only way to shift currencies on a sustained basis would be to organize a coordinated change in monetary or fiscal policies among the U.S. and its main trading partners. This is highly unlikely. Thus, the path of least resistance is up for the U.S. dollar. Dollar strength is exposing poor macro fundamentals in many emerging market economies. The problems facing EM economies run deep, and will not disappear anytime soon because high debt levels make these economies vulnerable to any weakness in global growth, commodity prices or global liquidity conditions. EM financial market turmoil could cause the Fed tightening campaign to go on hold, but this would require evidence that the former is negatively affecting the U.S. economy and/or financial markets. In other words, we need to see some pain before the Fed blinks. Chinese stimulus is a risk to our base-case EM outlook. Policy stimulus might keep the RMB from weakening further, boost commodity prices and support EM exports. This would not change the EM debt situation, but would at least give emerging economies a temporary reprieve. Careful analysis suggests that Chinese stimulus will not be a 'game changer', and might even cause problems if the authorities push the RMB lower. But it will be critical to monitor the next couple of money and credit reports. The U.S. economy and financial system are less exposed to further EM turmoil than in the Eurozone. But as the LTCM event demonstrated in 1998, the U.S. is not immune. Moreover, U.S. equity prices are more expensive than they were during previous EM selloffs that have occurred since the Great Recession. This could mean a larger equity re-rating on any flight-to-quality. This is not to say that we expect a bear market in DM risk assets to get underway in the near future. A U.S./global recession before 2020 is unlikely. Nonetheless, the risk of a meaningful correction is elevated enough that caution is warranted, especially at a time when all risk assets appear expensive. Chart I-18 updates our valuation measures for some major asset classes. All appear to be expensive, especially U.S. equities, raw materials and gold. EM sovereigns and equities are at the cheaper end of the spectrum, but are still not cheap in absolute terms even after the recent selloff. Chart I-18Major Asset Valuation Comparison Treasurys rallied briefly after Chairman Powell signaled that he is not willing to accelerate the pace of rate hikes in light of the U.S. economy's growth acceleration. He is willing to wait until he sees the "whites of the eyes" of inflation before becoming alarmed, almost ensuring that the FOMC will fall behind the inflation curve. Bond yields will rise as the FOMC tries to catch up and long-term inflation expectations bounce. Over the medium term, we believe that investors are underestimating the upside in U.S. inflation risks. We recommend below-benchmark duration, although bonds may temporarily rally if EM turbulence sparks a flight-to-quality. We still expect the supply/demand balance in the world oil market to tighten later this year. Stay positioned for higher oil prices. Finally, as we go to press, the U.S. is trying to force Canada to sign on to the U.S./Mexico 'agreement in principal' by August 31. A framework deal with Canada would likely leave many tough issues unresolved. There is also a chance that Canada misses the deadline and that the existing trilateral deal will not survive. It is technically possible that Canada's refusal to join the U.S.-Mexico bilateral deal will delay its ratification well into next year. In the meantime, Trump could raise the stakes for Canada by boosting tariffs on Canadian autos and/or by suspending NAFTA altogether. As a result, we decided to go ahead and publish our Special Report on U.S. equity sector implications if NAFTA is not ratified and tariffs rise to WTO levels. The report begins on page 20. Mark McClellan Senior Vice President The Bank Credit Analyst August 30, 2018 Next Report: September 27, 2018 1 Please see BCA Emerging Market Strategy Weekly Report "What's Really Driving The EM Selloff?"dated June 28, 2018, available on ems.bcaresearch.com 2 Please see BCA China Investment Strategy Weekly Report "China is Easing Up On The Brake, Not Pressing The Accelerator," dated July 26, 2018, available on cis.bcaresearch.com 3 Please see BCA Global Investment Strategy Special Reports: "1970s-Style Inflation: Could It Happen Again? Parts I and II," dated August 10 and 24, 2018, available on gis.bcaresearch.com II. What If NAFTA Is Not A Done Deal? U.S. Equity Implications This Special Report examines the impact of a NAFTA cancelation on 21 level-three GICs industries. While the latest news on the NAFTA renegotiation with Mexico is positive as we go to press, there is still a non-negligible risk that the existing trilateral deal will not survive. The U.S.-Mexico bilateral deal is an "agreement in principle" and will take time to ratify. Meanwhile, a framework deal with Canada would leave many thorny issues to be resolved. President Trump can still revert to his tough tactics on Canada ahead of the U.S. mid-term elections. If the President does not gain major concessions that can be presented as "victories" to voters, he is likely to take an aggressive stand in order to fire up his political base. The probability of Trump triggering Article 2205 and threatening to walk away from the suspended U.S.-Canada free trade agreement is still not trivial, despite the deal with Mexico. By itself, the cancelation of NAFTA would not be devastating for any particular U.S. industry because the size of the tariff increases would be fairly small as long as all parties stick with MFN tariff levels. That said, the impact would not be trivial, especially for those industries that have extensive supply lines that run between the three countries involved (especially Autos). We approached the issue from four different perspectives; international supply chains, a model-based approach, and an analysis of foreign revenue exposure and input cost exposure. The broad conclusion is that there are no winners from a NAFTA cancelation for the U.S. manufacturing GICs industries. Pharmaceuticals, Health Care Equipment & Supplies, Personal Products and Construction Materials are lower on the risk scale, but cannot be considered beneficiaries of a NAFTA collapse. The remaining industries are all moderately-to-highly exposed. Considering the four perspectives as a group, the most vulnerable industries are Automobiles, Automobile Components, Metals & Mining, Food Products, Beverages, and Textiles & Apparel. Our U.S. equity sector specialists recommend overweight positions in Defense and Financials; while neither stands to benefit from a NAFTA abrogation, they should at least be relative outperformers. They recommend underweight positions on Auto Components, Steel and Electrical Components & Equipment as relative (and probably absolute) underperformers should NAFTA disappear. While the latest news on the renegotiation of the North American Free Trade Agreement (NAFTA) is positive as we go to press, there is still a non-negligible risk that President Trump could revert to his tough tactics ahead of the U.S. mid-term elections.1 Even if Canada signs on to a framework deal, a lot of thorny details will have to be worked out. A presidential proclamation triggering Article 2205 of the NAFTA agreement (as opposed to tweeting that the U.S. will withdraw) would initiate a six-month "exit" period. Trump could use this deadline, and the threat of canceling the underlying U.S.-Canada FTA, to put pressure on Canada (if not Mexico) to concede to U.S. demands, just as he could revoke his exit announcement anytime within the six-month period. While some market volatility would ensue upon any exit announcement, even a total withdrawal at the end of the six months would have a limited macro-economic impact as long as the U.S. continued to respect its WTO commitments and lifted tariffs only to Most Favored Nation (MFN) levels. Nonetheless, a modest tariff hike is not assured given the Administration's "America First" policy, its looming threat of Section 232 tariffs on auto imports, its warnings against the WTO itself, and the steep tariffs it has already imposed on Canada, including a 20% tariff on softwood lumber and the 300% tariff on Bombardier CSeries jets. Moreover, even a small rise in tariffs to MFN levels would have a significant negative impact on industries that are heavily integrated across borders. Our first report on the evolving U.S. trade situation analyzed the implications of the U.S.-China trade war for the 24 level two U.S. GICs equity sectors. This Special Report examines the impact of a NAFTA cancelation on 21 level three GICs industries (finer detail is required since NAFTA covers mostly goods industries). We find that there are no "winners" among the U.S. equity sectors because the negative impact would outweigh any positive effects. The hardest hit U.S. industries would be Autos, Metals & Mining, Food Products, Beverages, and Textiles and Apparel, but many others are heavily exposed to a failure of the free trade agreement. Out Of Time President Trump is seeking a new NAFTA deal ahead of the U.S. midterms in November. While this timing may yet prove too ambitious, the U.S. has made progress in recent bilateral negotiations with Mexico, raising the potential that Trump will be able to tout a new NAFTA framework deal by November 6. Yet, investors should be prepared for additional volatility. There are technical issues with the bilateral U.S.-Mexico deal that could delay ratification in Congress until mid-2019. The new Mexican Congress must ratify the deal by December 1 if outgoing President Enrique Peña Nieto is to sign off. Otherwise, the incoming Mexican President Andrés Manuel López Obrador may still want to revise any deal he signs, prolonging the process. Meanwhile, it would be surprising if the Canadians signed onto a U.S.-Mexico deal they had no part in negotiating without insisting on any adjustments.2 The important point is that President Trump's economic and legal constraints on withdrawing from NAFTA have fallen even further with the Mexican deal. If Trump does not get major concessions that can be presented as "victories" to voters, he is likely to take an aggressive stand in order to fire up his political base, as a gray area of "continuing talks" will not inspire voters. This could mean imposing the threatened auto tariffs or threatening to cancel the existing trade agreements with Canada. Thus, the risk of Trump triggering Article 2205 is still not trivial. A bilateral Mexican trade deal is not the same as NAFTA. Announcing withdrawal automatically nullifies much of the 1993 NAFTA Implementation Act. Some provisions of NAFTA under this act may continue, but the bulk would cease to have effect, and the White House could refuse to enforce the rest. The potential saving grace for trade with Canada was that the Canada-U.S. Free Trade Agreement (CUSFTA), which took effect in 1989, was incorporated into NAFTA. The U.S. and Canada agreed to suspend CUSFTA's operation when NAFTA was created, but the suspension only lasts as long as NAFTA is in effect. However, Trump may walk away from both CUSFTA and NAFTA in the same proclamation. In that event, WTO rules for preferential trade would require the U.S. and Canada to raise tariffs on trade with each other to Most Favored Nation (MFN) levels. These tariff levels are shown in Charts II-1A and II-1B. The Charts also show the maximum tariff that could potentially be applied under WTO rules. The latter are much higher than the MFN levels, underscoring that the situation could get really ugly if a full trade war scenario somehow still emerged among these three trading partners. Chart II-1AU.S.: MFN Tariff Rates By GICS Industry (2017) Chart II-1BMexico & Canada: MFN Tariff Rates By GICS Industry (2017) Current tariffs are set at zero for virtually all of these GICs industries, which means that the MFN levels also indicate how much tariffs will rise at a minimum if NAFTA is cancelled. Tariffs would rise the most for Automobiles, Textiles & Apparel, and Food Products (especially agricultural products), and Beverages. U.S. tariffs under the WTO are not significantly higher than NAFTA's rates; the average MFN tariff in 2016 was 3½%, which compares to 4.1% for the average Canadian MFN tariff. Would MFN Tariffs Be Painful? An increase in tariff rates of 3-4 percentage points may seem like small potatoes. Nonetheless, even this could have an outsized impact on some industries because tariffs are levied on trade flows, not on production. A substantial amount of trade today is in intermediate goods due to well-integrated supply chains. Charts II-2A and II-2B present a measure of integration. Exports and imports are quite large relative to total production in some industries. The most integrated U.S. GICs sectors include Automobiles & Components, Materials, Capital Goods and Electrical & Optical Equipment. Higher tariffs would slam those intermediate goods that cross the border multiple times at different stages of production. For example, studies of particular automobile models have found that "parts and components may cross the NAFTA countries' borders as many as eight times before being installed in a final assembly in one of the three partner countries."3 Tariffs would apply each time these parts cross the border if NAFTA fails. Chart II-2AU.S./Canada Supply Chain Integration Chart II-2BU.S./Mexico Supply Chain Integration Appendix Tables II-1 to II-4 show bilateral trade by product between the U.S. and Canada, and the U.S. and Mexico. In 2017, the U.S. imported almost $300b in goods from Canada, and exported $282b to that country, resulting in a small U.S. bilateral trade deficit. The bilateral deficit with Mexico is larger, with $314b in U.S. imports and $243b in exports. The largest trade categories include motor vehicles, machinery, and petroleum products. Telecom equipment and food products also rank highly. As mentioned above, the impact of rising tariffs is outsized to the extent that a substantial portion of trade in North America is in intermediate goods. Box II-1 reviews the five main channels through which rising tariffs can affect U.S. industry. Box II-1 Trade Channels There are at least five channels through which rising tariffs can affect U.S. industry: (1) The Direct Effect: This can be positive or negative. The impact is positive for those industries that do not export much but are provided relief from stiff import competition via higher import tariffs. The impact is negative for those firms facing higher tariffs on their exports, as well as for those firms facing higher costs for imported inputs to their production process. These firms would be forced to absorb some of import tariffs via lower profit margins. Some industries will fall into both positive and negative camps. U.S. washing machines are a good example. Whirlpool's stock price jumped after President Trump announced an import tariff on washing machines, but it subsequently fell back when the Administration imposed an import tariff on steel and aluminum (that are used in the production of washing machines). NAFTA also eliminated many non-tariff barriers, especially in service industries. Cancelling the agreement could thus see a return of these barriers to trade; (2) Indirect Effect: The higher costs for imported goods are passed along the supply chain within an industry and to other industries that are not directly affected by rising tariffs. This will undermine profit margins in these indirectly-affected industries to the extent that they cannot fully pass along the higher input costs. There would also be a loss of economies-of-scale and comparative advantage to the extent that firms are no longer able to use an "optimal" supply network that crosses borders, further raising the cost of doing business; (3) Foreign Direct Investment: Some U.S. imports emanate from U.S. multinationals' subsidiaries outside the U.S., or by foreign OEM suppliers for U.S. firms. NAFTA eliminated many national barriers to FDI, expanded basic protections for companies' FDI in other member nations, and established a dispute-settlement procedure. The Canadian and Mexican authorities could make life more difficult for those U.S. firms that have undertaken significant FDI in retaliation for NAFTA's cancellation; (4) Macro Effect: The end of NAFTA, especially if it were to lead to a trade war that results in tariffs in excess of the MFN levels, would take a toll on North American trade and reduce GDP growth across the three countries. Besides the negative effect of uncertainty on business confidence and, thus, capital spending, rising prices for both consumer and capital goods will reduce the volume of spending in both cases. Moreover, corporate profits have a high beta with respect to economic activity. The macro effect would probably not be large to the extent that tariffs only rise to MFN levels; (5) Currency Effect: To the extent that a trade war pushes up the dollar relative to the Canadian dollar and Mexican peso, it would undermine export-oriented industries and benefit those that import. However, while we are bullish the dollar due to diverging monetary policy, the dollar may not benefit much from trade friction given that tariffs would rise for all three countries. Chart II-3 is a scatter chart of GICs industries that compares the average MFN tariff on U.S. imports to the average MFN tariff on Canadian and Mexican imports from the U.S. A U.S. industry may benefit if it garners significant import protection but does not face a higher tariff on its exports to the other two countries. Unfortunately, there are no industries that fall into the north-west portion of the chart. The opposite corner, signifying low import protection but high tariffs on exports, includes Beverages, Household Durables, Household Products, Personal Products and Machinery. Chart II-3Import And Export Tariffs Faced By U.S. GICS Industries Model-Based Approach The C.D. Howe Institute has employed a general equilibrium model to estimate the impact of a NAFTA failure at the industrial level.4 The model is able to capture the impact on trade conducted through foreign affiliates. The study captures the direct implications of higher tariffs, but also includes a negative shock to business investment that would stem from heightened uncertainty about the future of market access for cross-border trade. It also takes into consideration non-tariff barriers affecting services. Table II-1Impact Of NAFTA Cancellation By Industry As with most studies of this type, the Howe report finds that the level of GDP falls by a relatively small amount relative to the baseline in all three countries - i.e. there are no winners if NAFTA goes down. Moreover, the U.S. is not even able to reduce its external deficit. While the trade barriers trim U.S. imports from NAFTA parties by $60b, exports to Canada and Mexico fall by $62b. At the industry level, the model sums the impacts of the NAFTA shock on imports, exports and domestic market share to arrive at the estimated change in total shipments (Table II-1). It is possible that an industry will enjoy a boost to total shipments if a larger domestic market share outweighs the damage to exports. However, the vast majority of U.S. industries would suffer a decline in total shipments according to this study, because the estimated gain in domestic market share is simply not large enough. Beef, Pork & Poultry and Dairy would see a 1-2% drop in total shipments relative to the baseline forecast. Next on the list are textiles & apparel, food products and automotive products. Even some service industries suffer a small decline in business, due to indirect income effects. Foreign-Sourced Revenue And Input Cost Approach Another way to approach this issue is to identify the U.S. industries that garner the largest proportion of total revenues from Mexico and Canada. Unfortunately, few companies provide much country detail on where their foreign revenues are derived. Many simply split U.S. and non-U.S. revenues, or North American and non-North American revenues. Table II-2 presents the proportion of total revenues that is generated from operations outside the U.S. for the top five companies in the industry by market cap (in some cases the proportion that is generated outside of North America was used as a proxy for foreign- sourced revenues). While this approach is not perfect, it does provide a good indication of how exposed a U.S. industry is to Canada and Mexico. This is because any company that has "gone global" will very likely be doing substantial business in these two countries. Table II-2Foreign Revenue Exposure At the top of the list are the Metals & Mining, Personal Products, and Auto Component industries. Between 62% and 81% of revenues in these three industries is derived from foreign sources. Following that is Household Durables, Leisure Products, Chemicals and Tobacco. Indeed, all of the level three GICs industries we are analyzing are moderately-to-highly globally-oriented, with the sole exception of Construction Materials. Table II-3Import Tariff Exposure U.S. companies are also exposed to U.S. tariffs that boost the price of imported inputs to the production process. This can occur directly when firm A imports a good from abroad, and indirectly, when firm A then sells its intermediate good to firm B at a higher price, and then on to firm C. In order to capture the entire process, we used the information contained in the Bureau of Economic Analysis' Input/Output tables. We estimated the proportion of each industry's total inputs that would be affected by a rise in tariffs to MFN levels. We then allocated the industries contained in the input/output tables to the 21 GICs level 3 industries we are considering, in order to obtain an import exposure ranking in S&P industry space (Table II-3). All 21 industries are significantly vulnerable to rising input costs, which is not surprising given that we are focusing on the manufacturing-based GICs industries and NAFTA focused on trade in goods. The vast majority of the industries could face a cost increase on 50% or more of their intermediate inputs to the production process. The Automobile industry is at the top of the list, with 72% of its intermediate inputs potentially affected by the shift up in tariffs (Automobile Components is down the list, at 56%). Containers & Packaging, Oil & Gas, Aerospace & Defense, Textiles and Food Products are also highly exposed to tariff increases. The automobile industry is a special case because of the safeguards built into NAFTA regarding rules-of-origin and the associated tracing list. The U.S. is seeking significant changes in both in order to tilt the playing field toward U.S. production, but this could severely undermine the intricate supply chain linking the three countries. Box II-2 provides more details. Box II-2 Automotive Production In NAFTA; Update Required We are focused on two key aspects to the renegotiation of the NAFTA rules that could have far reaching implications for automakers and the auto component maker supply base: the tracing list and country of origin rules. Regarding the first of these, the Trump administration has a legitimate gripe when it comes to automotive production. A tracing list was written in the early-1990's to define automotive components such that the rules of origin (ROO) could be easily met; anything not on the list is deemed originating in North America. As anyone who has driven a vehicle of early-1990's vintage and one of late-2010's vintage can attest, high tech components (largely not included on the tracing list) have grown exponentially as a percentage of the cost of the vehicle and, at least with respect to electronic and display components, are sourced mostly from overseas. Updating the tracing list would force auto makers to source a significantly greater amount of components domestically, almost certainly raising the cost of the vehicle and either hurting margins or hurting competitiveness through higher prices. The current NAFTA ROO require that 62.5% of the content of a vehicle must be sourced in North America, with no distinction between any of the member nations. The result of this legislation has been the creation of a highly integrated supply base that sees components move back and forth across borders through each stage of the manufacturing process. Early proposals from the Trump administration for a NAFTA rework included a country of origin provision for as much as 50% U.S. content. Such a provision would certainly cause a massive disruption in the automotive supply chain with components manufacturers forced to relocate or automakers electing to source overseas and pay the 2.5% MFN tariff on exports within North America. Either scenario presents a headwind to the tightly woven auto components base, underscoring BCA's U.S. Equity Strategy's underweight recommendation on the sector. The recently announced bilateral trade deal with Mexico raises the ROO content requirements to 75% from the 62.5% contemplated under NAFTA but, importantly, no country of origin provisions appear in the new deal. Still, given how quickly this is evolving, a final NAFTA deal could be significantly different. Chart II-4 presents a scatter diagram that compares import tariff exposure (horizontal axis) with foreign revenue exposure (vertical axis). The industries in the north-east corner of the diagram are the most exposed to NAFTA failure. The problem is that there are so many in this region that it is difficult to choose the top two or three, although Metals & Mining stands out from the rest. It is easier to identify the industries that face less risk in relative terms: Pharmaceuticals, Construction Materials, Health Care & Supplies, Leisure Products and, perhaps, Machinery. The rest rank highly in terms of both foreign revenue exposure and import tariff exposure. Chart II-4Foreign Revenue And Import Tariff Exposure Conclusions: By itself, a total cancelation of NAFTA would not be devastating for any particular U.S. industry because the size of the tariff increases would be fairly small as long as all parties stick with MFN tariff levels. That said, the impact would not be trivial, especially for those industries that have extensive supply lines that run between the three countries involved. The negative impact on GDP growth would likely be worse for Canada (and Mexico if its bilateral somehow fell through), but U.S. exporters would see some loss of business. We approached the issue from four different perspectives; international supply chains, a model-based approach, and an analysis of foreign revenue exposure and import tariff exposure. The broad conclusion is that there are no winners from a NAFTA cancelation for the U.S. manufacturing GICs industries. Pharmaceuticals, Health Care Equipment & Supplies, Personal Products and Construction Materials are lower on the risk scale, but cannot be considered beneficiaries of a NAFTA collapse. The remaining industries are all moderately-to-highly exposed. Considering the four perspectives as a group, the most vulnerable industries are Automobiles, Automobile Components, Metals & Mining, Food Products, Beverages, and Textiles & Apparel. Our U.S. equity sector specialists recommend overweight positions in Defense and Financials; while neither stands to benefit from a NAFTA abrogation, they should at least be relative outperformers. They recommend underweight positions on Auto Components, Steel and Electrical Components & Equipment as relative (and probably absolute) underperformers should NAFTA disappear. As we go to press, rapid developments are taking place in the NAFTA negotiations. The U.S. and Mexico have completed a bilateral agreement in principle and a Canadian team is looking into whether to sign onto the agreement by a U.S.-imposed August 31 deadline. This deadline would enable the current U.S. Congress to proceed to ratification before turning over its seats in January, though it is not a hard deadline. It is possible that the negotiations will conclude this week and the crisis will be averted. But the lack of constraints on President Trump's trade authority gives reason for pause. If Canada demurs, Trump could move to raise the cost through auto tariffs or announcements that he intends to withdraw from existing U.S.-Canada agreements in advance of November 6. While Mexico has now tentatively secured bilaterals with both countries through the new U.S. deal and the Trans-Pacific Partnership (which includes Canada), it still stands to suffer if a trilateral agreement is not in place. Moreover it is technically possible that Canada's refusal to join the U.S.-Mexico bilateral could delay the latter's ratification well into next year. Therefore, we treat Mexico the same as Canada in our analysis, despite the fact that Mexican assets stand to benefit in relative terms from having a floor put under them by the Trump Administration's more constructive posture and this week's framework deal. If Trump does not pursue a hard line with Canada, then it will be an important sign that he is adjusting his trade policy to contain the degree of confrontation with the developed nations and allies and instead focus squarely on China, where we expect trade risks to increase in the coming months. Mark McClellan Senior Vice President The Bank Credit Analyst Matt Gertken Associate Vice President Geopolitical Strategy Chris Bowes Associate Editor U.S. Equity Strategy APPENDIX TABLE II-1 U.S. Imports From Canada (2017) APPENDIX TABLE II-2 U.S. Exports To Canada (2017) APPENDIX TABLE II-3 U.S. Imports From Mexico (2017) APPENDIX TABLE II-4 U.S. Exports To Mexico (2017) 1 Please see BCA Geopolitical Strategy Special Report, "A Mexican Standoff - Markets Vs. AMLO," dated June 28, 2018, and Weekly Report, "Are You 'Sick Of Winning' Yet?" dated June 20, 2018, available at gps.bcaresearch.com 2 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com 3 Working Together: Economic Ties Between the United States and Mexico. Christopher E. Wilson, November 2011. 4 The NAFTA Renegotiation: What if the U.S. Walks Away? The C.D. Howe Institute Working Paper. November 2017. III. Indicators And Reference Charts Our equity indicators continue to signal that caution is warranted, but U.S. profits have been so strong recently as to dominate any negative market forces. Our Monetary Indicator is hovering at a low level by historical standards, suggesting that liquidity conditions have tightened. It is constructive that our Composite Technical Indicator has hooked up, narrowly avoiding a technical break below the zero line. It is also positive that our Composite Sentiment Indicator is rising, but not yet to a level that would signal trouble for stocks from a contrary perspective. However, our U.S. Willingness-to-Pay (WTP) indicator continues to erode, and the Japanese WTP appears to be rolling over. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Flows into the U.S. stock market are waning, and those into the Japanese market are wavering. Flows into European stocks have flattened off. Moreover, our Revealed Preference Indicator (RPI) for stocks remained on a 'sell' signal in August. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive 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. These indicators are not aligned at the moment, further supporting the view that caution is warranted. Our indicators thus suggest that the underlying health of the U.S. equity bull market is fraying at the edges. Nonetheless, robust U.S. profits figures have sparked a euphoric late-cycle blow-off phase. The net revisions ratio is still in positive territory, and the net earnings surprises index has surged to an all-time high. Not much has changed on the U.S. Treasury front. The 10-year bond is slightly on the cheap side according to our model, and oversold conditions have not yet been worked off. This month's Overview section discusses the potential for upside inflation surprises in the U.S. that will place the FOMC "behind the curve". The term premium and long-term inflation expectations are still too low. This year's dollar rally has taken it to very expensive levels according to our purchasing power parity estimate. The long-term trend in the dollar is down, but economic and policy divergences vis-à-vis the U.S. and the other major economies suggests that the dollar is likely to continue moving higher in the near term. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Special Report

Highlights Since 2010, China's private sector has accounted for the majority of the country's increase in the debt-to-GDP ratio, most of which has been on the balance sheets of state-owned enterprises (SOEs) and the household sector. While policymakers achieved their goal of maintaining aggregate demand in the decade following the global financial crisis, the financial condition of SOEs has been greatly sacrificed as a result. An analysis of SOE return on equity highlights a sharp decline in return on assets, which has occurred due to both declining profit margins and a falling asset turnover ratio. Even worse, a comparison of adjusted SOE ROA to borrowing costs suggests that the marginal operating gain from debt has become negative. This has profound implications for policymakers, as it suggests that further leveraging of SOEs could push them into a debt trap and/or shackle the monetary authority's ability to meaningfully raise interest rates. We can envision a modest releveraging scenario over the coming 12-18 months, but even that scenario is not consistent with a surge in investment-driven economic activity. Policymakers face a clear choice between growth and leveraging, and our bet is that they will choose just enough of the latter to prevent the former from decelerating significantly. This implies that the typical beneficiaries of Chinese reflation are not likely to outperform global risk assets, and that China's contribution to global growth is not set to rise sharply. However, over the coming 6-12 months, we acknowledge that domestic stocks are significantly oversold, and we are watching closely for an opportunity to time a reversal. Feature Global investors have paid considerable attention to China over the past month, focusing on the likely stimulative response of policymakers to an upcoming, tariff-induced export shock. We recently presented our view of the likely character and magnitude of upcoming Chinese stimulus in a two-part joint special report with our geopolitical team,1 and concluded that an acceleration in fiscal spending was far more likely than a sharp pickup in credit growth. In this report, we further examine the constraints facing Chinese policymakers and again conclude that they are likely to remain committed to preventing a significant releveraging of the economy. The financial condition of Chinese state-owned enterprises features prominently in our argument, and we highlight how the damage caused by China's post-2008 "business model" is a serious roadblock to further credit excesses. Whereas most modern central banks characterize their monetary policy decisions within the context of a trade-off between growth and inflation, Chinese policymakers now appear to understand that they face a trade-off between growth and leveraging. While we agree that economic stability will always remain the paramount objective of policymakers and a major policy mistake is not likely in the cards, reflationary efforts are likely to be carefully calibrated to avoid a dramatic overshoot of credit growth. This means that there is both limited downside and upside to Chinese economic activity, implying that expectations of a material, credit-driven reacceleration in growth are not likely to be met. A Brief Review Of Chinese Private Sector Debt Chart 1A Now Familiar Concern After several years of intense concern about China's elevated debt, Chart 1 should be familiar to most investors. It highlights the significant rise in Chinese credit to the non-financial sector (i.e. total credit to governments, households, and non-financial corporations) based on data from the Bank for International Settlements (BIS), most of which has occurred in the private sector (non-financial firms and households). But Charts 2-4 presents a different breakdown of credit to the non-financial sector, based on IMF data, that includes a separation of corporate debt into private and state-owned enterprises (SOEs). The data shown in Charts 2-4 covers the 2010-2016 period; for reference, private non-financial sector debt continued to rise relative to GDP in 2017, in large part due to households (see Table A1 in Appendix 1 for the most recent IMF estimate of China's non-financial sector debt, absent the breakdown in corporate debt by ownership that the fund previously provided). Chart 2 presents the IMF's version of the rise in total non-financial debt (akin to Chart 1 from the BIS), and Charts 3 and 4 attribute the rise in debt to different sectors. Chart 3 shows that the increase in private sector debt accounts for 70% of the increase in leverage since 2010, and Chart 4 shows that the rise in SOE debt has accounted for nearly half of the rise in private sector debt. Within the private sector, household leverage has also risen substantially, accounting for roughly 40% of the rise from 2010-2016. Non-SOE corporates accounted for only 12% of the total rise in private leverage, the smallest of all sectors. Chart 2Another Perspective On Chinese Leveraging, With A Breakdown Of Corporate Debt By Ownership   Chart 3The Private Sector Has Accounted For ##br##Most Of Chinese Leveraging... Chart 4...Due Mostly To State-Owned ##br##Enterprises And Households     When considering the potential economic impact of a sharp rise in leverage, BCA's view is that the focus should usually be on the increase in private sector debt rather than government debt. Public sector deleveraging is fundamentally a political choice in countries that have control over their own monetary policy, and simply will not occur in China over the coming year given the headwinds facing the economy. Given this, Chart 4 suggests that to understand any constraints facing policymakers from excessive leverage, investors should primarily devote their attention towards China's SOEs. China's State-Owned Enterprises: The Sacrifice Of Profitability For Stability Chart 5Within SOEs, Industrial And Construction Firms ##br##Account For Half Of The Increase In Debt When assessing the risk of a potential private sector debt crisis in China, many investors have a sanguine view. The common refrain is that Chinese corporations, particularly state-owned enterprises, will be bailed out by the government if debt problems arise. Ultimately, we agree with this view, although we would note that the market pressure required to force the government to act could be quite severe. Still, there is a more pressing concern for investors: an analysis of the financial condition of China's state-owned enterprises suggests that the country may have reached the limit of how much SOEs can be further leveraged by policymakers in an attempt to rescue the economy, without significantly increasing the ultimate cost to the public. Our sense is that the campaign to control debt growth over the past two years reflects this economic reality, suggesting that the motivation behind the campaign will not be easily abandoned. Chart 2 showed that non-financial SOE debt-to-GDP rose by 20 percentage points from 2010-2016, a change in the stock of debt of roughly RMB33 trillion. Chart 5 shows that roughly half of this amount can be accounted for by the change in liabilities of state-owned industrial and construction enterprises over the same period. To the extent that they broadly reflect the condition of all non-financial SOEs, the availability of income statement and balance sheet data for these two industries allows us to make some inferences about the debt sustainability of China's state-owned firms.   Table 1 presents a breakdown of return on equity (ROE) for state-owned/state-holding companies in these industries, using the DuPont approach. Several points are noteworthy: Industrial & construction SOEs are highly leveraged entities, with an assets to equity ratio of 2.7. This explains the substantial difference between return on equity, which has been decently high, and a low single-digit return on assets (ROA). From 2010-2016, the ROE for industrial & construction SOEs fell from 14% to 8%, entirely because of a substantial decline in ROA. The decline in ROA occurred because of a roughly equal combination of declining profit margins and a falling asset turnover ratio. Based on the DuPont approach to expressing leverage,2 SOEs in the industrial and construction industries increased their leverage only very modestly during the period. But when leverage is expressed as liabilities relative to net income, a considerably more relevant measure when considering the potential to service debt, leverage nearly doubled. Table 1A Meaningful Decline In SOE Efficiency And Profitability We presented Chart 6 in our last weekly report of 2017,3 and used it to represent a stylized timeline of China's economic history over the past 15 years. The chart describes how China's extremely rapid growth phase from 2002-2008 was followed by the global financial crisis and a normal, counter-cyclical rise in the debt-to-GDP ratio from 2008 to 2010. Chart 6A Stylized Timeline Of China's Recent Economic History However, amidst the Great Recession, it became clear that China's export-enabled catchup growth phase was durably over, and policymakers were faced with a hard choice. They could either replace exports with debt-fueled domestic demand as a growth driver in order to buy time to transition to a services-led economy (the "reflate" path), or allow the labor market to suffer the consequences of a sharp slowdown in export growth while preserving fiscal and state-owned firepower for some uncertain future opportunity (the "stagnate" path). The picture that emerges from the combination of this narrative and our analysis of the evolution of SOE financial health is straightforward, but sobering. State-owned enterprises, already highly indebted at the onset of the global economic recovery, were levered even further in order to pursue the "reflate" path described above. While policymakers achieved their goal of maintaining aggregate demand, the consequence of their choice is that both the profitability and efficiency of SOEs have declined significantly. Avoiding An SOE Debt Trap A significant deterioration in SOE efficiency against the backdrop of a sharp rise in leverage speaks to the existence of capital misallocation, i.e. investment that has been funded by debt but cannot produce sufficient income to repay the debt. This suggests that SOEs are likely to have a bad debt problem at some point that will need to be resolved with government support. But in our view, the decline in profitability is a more immediate problem for policymakers, because it does not appear that SOEs can be leveraged any further without pushing them dangerously towards a self-reinforcing debt trap. Chart 7 illustrates why. The chart shows SOE ROA adjusted for interest expenses (a proxy for EBIT/Assets) versus a market-based proxy for SOE borrowing rates.4 Adjusted ROA fell below borrowing rates in 2013, suggesting that some of the observed decline in SOE profitability has occurred because the marginal operating gain from debt for Chinese state-owned enterprises has become negative. If so, this has profound implications for Chinese policymakers. Chart 8 illustrates how the process of perpetually leveraging an entity with a negative marginal operating gain from new borrowing eventually leads to a debt trap. An initial increase in debt causes interest costs to rise and profits to fall, as the return on new assets fails to exceed the interest rate on the debt used to acquire the assets. The process repeats itself as the entity is directed to leverage further, although management may choose to raise the entity's debt in this situation regardless of policy objectives (e.g. to cover a working capital deficit) if they mistakenly believe that the decline in ROA below debt costs is temporary. In addition, the existence of a negative marginal gain from new borrowing for a significant portion of the private sector would imply that China's natural rate of interest may have fallen. Chart 9 shows some evidence in support of this notion: the rise in the weighted average lending rate since late-2016 was relatively minor compared with levels that have prevailed over the past decade, and yet it is clear that it succeeded in materially slowing the investment-driven sectors of China's economy. This suggests that further leveraging of SOEs could tighten the shackles on the PBOC in terms of its ability to meaningfully raise interest rates, potentially fueling credit excesses in other sectors of the economy Chart 7SOEs Now Appear To Have A Negative ##br##Financial Gain From Debt Chart 8A Stylized Example Of ##br## Debt Trap Dynamics Chart 9Has SOE Leveraging Caused China's ##br##Natural Rate Of Interest To Fall?         In short, the financial condition of China's state-owned enterprises appears to represent a proximate constraint preventing policymakers from responding to economic weakness with a significant acceleration in credit growth. It is not just that SOEs are highly levered and there is "a lot of debt in the system"; material further leveraging of these entities risks deteriorating what is already very poor profitability, which may push SOEs into an outright debt trap. That would precipitate a crisis and necessitate a bailout from the government, the cost of which will increase directly in line with the amount of additional debt taken. We agree that economic stability will always remain the paramount objective of policymakers, and we fully expect a policy response to address the upcoming export shock from the U.S. But whereas most modern central banks characterize their monetary policy decisions within the context of a trade-off between growth and inflation, our analysis of China's state-owned enterprises suggests that Chinese policymakers now seem to understand that they face a trade-off between growth and leveraging. This implies that current reflationary efforts from policymakers are likely to be carefully calibrated to avoid a dramatic overshoot of credit growth. Envisioning Modest Releveraging Chart 10Modest Releveraging Is Ok, As Long As ##br##Its Pace Continues To Slow What is a carefully calibrated credit response likely to look like, and what does it mean for private sector debt growth? As noted above, my colleague Matt Gertken addressed this question by presenting three scenarios in part 1 of the recent joint special report with our geopolitical team.5 His base-case view, to which he assigned 70% odds, implied that there would be a very modest reacceleration in total social financing (on the order of 1% or so). In this report we take a second approach to estimating the potential magnitude of a modest reacceleration scenario using the BIS private sector credit data, primarily to incorporate different growth rates for the corporate and household sectors. Using the BIS data, Chart 10 shows the growth rate in Chinese total private sector debt, nominal GDP, and the difference between the two. The significant leveraging period from 2010-2016 is evidenced by the persistently positive gap between credit and GDP growth (it was only briefly negative in 2011).   But the chart also shows that there has been a downtrend in the gap since 2013, with 2017 representing a major overshoot (to the downside). Given that the trend shown in Chart 10 points downward and reflects policy efforts to control debt growth, we could envision Chinese policymakers tolerating some acceleration in credit growth relative to GDP, as long as it does not materially overshoot the trendline to the upside. Using this framework as a guide, we can calculate what modest releveraging might mean for corporate sector debt, assuming the following: Chinese policymakers, through a combination of fiscal spending and modest releveraging, succeed in stabilizing nominal GDP growth at current levels. Policymakers tolerate total non-financial private sector credit growth that is 4% in excess of nominal GDP growth. Household credit growth remains well in excess of GDP growth, in-line with its average of the past 5 years. Given the significant leveraging of the household sector and the recent uptick in home sales, this appears to be a reasonable assumption barring a major crackdown on the property market by Chinese officials. Chart 11 presents the result of these assumptions, which shows non-financial corporation credit growth accelerating to roughly 12% by the end of 2019. At first blush, the chart appears to show a meaningful acceleration, as the annual change in year-over-year credit growth based on this measure would meet or exceed that of the past two credit cycles. But there are two important caveats for investors: Even as depicted in Chart 11, non-financial corporate credit growth would still be extremely weak relative to its recent history. At the end of 2019, the chart shows that corporate credit growth would be almost two percentage points lower than its weakest point in 2015. Chart 11 illustrates a scenario where the level of credit to the total private non-financial sector grows by RMB36 trillion by the end of 2019. Chart 12 shows that when compared to our estimate of the stock of adjusted total social financing, this rise barely even registers as an acceleration. Chart 11A Rebound, But Weak Relative To History Chart 12Barely Even Registers As An Acceleration In Adjusted TSF In short, while the degree of acceleration in credit growth as implied in our scenario varies depending on the definition of credit employed, the bottom line for investors is that a modest releveraging scenario is not consistent with a surge in investment-driven economic activity. Policymakers face a clear choice between growth and leveraging, and our bet is that they will choose just enough of the latter to prevent the former from decelerating significantly. This cautious, contingent attitude towards an acceleration in private sector credit growth would be in marked contrast to previous episodes of reflation, suggesting that investors who are following China's "old stimulus rulebook" are likely to be disappointed. Implications For Investment Strategy Chart 13No Signs Yet Of A Heavy, Credit-Based Response There are two clear implications of our analysis for investment strategy. First, in ironic reference to Reinhart & Rogoff's book that coined the term, "this time" is likely to be different for China because policymakers seem resolute in their intention to prevent a financial crisis (as opposed to the term having been used in the past by those who have ended up contributing to one). Our analysis shows that the debt burden for state-owned enterprises is already extreme, and that further, material, forced leveraging of the sector risks a possible debt trap. This implies that the typical beneficiaries of Chinese reflation are not likely to outperform global risk assets, and that China's contribution to global growth is not set to rise sharply. For now, our BCA China Play Index and the relative performance of infrastructure stocks seem to support our conclusion (Chart 13). Second, if this time is not different, i.e. if policymakers allow a significant further releveraging of the private sector, either intentionally or by accident, investors should recognize that the longer-term outlook for China may darken considerably if the country is not capable of quickly shifting away from its old growth model over the next few years. Unfortunately for officials in China, the reality of economics is that positive NPV projects for SOEs to invest in cannot simply be willed into existence. The significant decline in profitability and asset turnover that we have observed in state-owned enterprises since 2010 speaks to the poor use of credit, and policymaker reliance on the traditional methods of stimulus is likely to achieve the country's short-term goals at the expense of making the already large debt problem (and the cost of the eventual bailout by the public sector) much worse. This would raise both the political and economic risks facing the country, at a time when a U.S. and/or global recession appears likely within the next 2-3 years. As a final point, despite our caution against over-optimism concerning China's stimulative response, we acknowledge that policymakers are likely to succeed in preventing a significant deceleration in their economy over the coming 6-12 months. Given how materially Chinese stock prices have declined, it remains a debate whether a mere stabilization of economic activity at a modest pace will be enough for domestic or investable equities to meaningfully rally in absolute or relative terms. For now, we have highlighted that the relative selloff in domestic stocks appears to be quite late, particularly in common currency terms, and we are watching closely for an opportunity to time a reversal.   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com   Appendix 1 Appendix A-1Chinese Non-Financial Sector Debt 1 Pease see China Investment Strategy Special Reports "China: How Stimulating Is The Stimulus?", dated August 8, 2018, and "China: How Stimulating Is The Stimulus? Part Two", dated August 15, 2018 available at cis.bcaresearch.com 2 The DuPont approach breaks down return on equity into the product of profit margins (profits / revenue), asset turnover (revenue / assets), and financial leverage (assets / equity). 3 Pease see China Investment Strategy Weekly Report "Legacies Of 2017", dated December 21, 2017, available at cis.bcaresearch.com 4 We use the yield-to-maturity of the ChinaBond Corporate Bond Index as our proxy for the interest rate paid by state-owned firms, given that the index includes bonds issued by central and local government SOEs. Importantly, our proxy is closely aligned with the weighted average bank loan borrowing rate paid by SOEs from 2014-2016, as per a 2017 report from the China Academy of Fiscal Science ("Cost reduction: 2017 survey and analysis", August 28, 2017). 5 Pease see China Investment Strategy Special Reports "China: How Stimulating Is The Stimulus?", dated August 8, 2018, and "China: How Stimulating Is The Stimulus? Part Two", dated August 15, 2018 available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Special Report

Highlights The Golden Rule: During the next 12 months, will the Federal Reserve move interest rates by more or less than what is currently priced into the market? In this report we demonstrate that an investor who can correctly answer that question will very likely make the right bond market call. We call this framework for market analysis the golden rule of bond investing. Exceptions: We identify a few periods when applying the golden rule correctly would not have led to the right market call. Such periods are rare, but they tend to occur when the market "fights the Fed". One such episode occurred as recently as 2017. Total Return Forecasts: We use the golden rule framework to generate total return forecasts for Treasury indexes of all different maturities and many different spread product indexes. Feature Dear Client, This week, we are sending you a Special Report written by Ryan Swift, Chief Strategist of our sister publication, U.S. Bond Strategy. The report introduces an intriguing framework that directly links market expectations of changes in short-term interest rates to bond market returns for both U.S. Treasuries and U.S. spread product. We will extend the analysis to non-U.S. bond markets in a future Special Report to be published in late September. I trust you will find this report to be interesting and insightful. Best Regards, Rob Robis It's easy to get lost in the sea of financial market news. Last week alone saw the suggestion of additional tariffs, weak housing data, strong consumer data, falling commodity prices and steep Chinese currency depreciation. It's not always obvious what's important for bond markets and what isn't. While there is no miracle solution to this problem, we propose one helpful question that investors should always ask themselves to help discern the signal from the noise. During the next 12 months, will the Federal Reserve move interest rates by more or less than what is currently priced into the market? If you are able to answer that question correctly you will make the correct bond market call most of the time, and any new piece of information should be judged on how it impacts your answer. In fact, the framework of viewing everything through the lens of answering the above question works so well that we call it the golden rule of bond investing. In this Special Report we illustrate the empirical success of the golden rule. We also draw on historical evidence to consider periods when the rule failed. Finally, we translate the golden rule into a method for forecasting total returns, and we generate total return forecasts for many different bond indexes, encompassing both Treasuries and spread product. Testing The Golden Rule's Performance Chart 1 shows how well the golden rule has worked during the past 28 years. The top panel shows the 12-month fed funds rate surprise - the difference between the expected change in the fed funds rate that was priced into the market at the beginning of the 12-month investment horizon and the change in the fed funds rate that was ultimately delivered. A reading above zero indicates that the market expected a larger increase (or smaller decrease) than actually occurred, a reading below zero indicates that the market expected a smaller increase (or larger decrease) than actually occurred. The bottom panel shows 12-month excess returns from the Bloomberg Barclays Treasury Master Index relative to a position in cash. Chart 1The Golden Rule's Track Record If the golden rule works, then dovish fed funds rate surprises (positive values in Chart 1, shown shaded) will coincide with positive Treasury excess returns, and vice-versa. Chart 1 shows that this has indeed generally been the case. Digging a little deeper, we find a strong positive relationship between 12-month Treasury excess returns and the 12-month fed funds rate surprise (Chart 2) and a similarly strong relationship using Treasury index price return instead of the excess return versus cash (Chart 3). Dovish fed funds rate surprises coincide with positive 12-month Treasury excess returns 87% of the time for an average excess return of +3.9%. They also coincide with positive Treasury price returns 76% of the time for an average price return of +2.1%. Hawkish surprises coincide with negative 12-month Treasury excess returns 61% of the time for an average excess return of -0.3%. They also coincide with negative Treasury price returns 72% of the time for an average price return of -1.9% (Table 1). Chart 2Treasury Index Excess Return &##BR##Fed Funds Rate Surprises (1990 - Present) Chart 3Treasury Index Price Return &##BR##Fed Funds Rate Surprises (1990 - Present) Table 112-Month Treasury Index Returns And Fed Funds Rate Surprises (1990 - Present) Total Treasury returns also factor in coupon income, and are therefore often positive even when the price return is negative. Still, Table 1 shows that Treasury index total returns average +7.1% in periods with a dovish fed funds rate surprise and only +3.4% in periods with a hawkish surprise. Further, 65% of negative total return periods occurred when there was a hawkish fed funds rate surprise. Of course, the golden rule is no panacea. The results presented above are impressive, but they assume that investors are able to correctly predict whether the market is over- or under-pricing the Fed. Making that determination remains a tall order. The key insight to be gleaned from the golden rule is that if a piece of information does not alter your opinion about the future path of the fed funds rate relative to expectations, then it should probably be ignored. The golden rule is certainly not the "be all and end all", but it is a very useful first step. Learning From Failures While Table 1 shows that correctly determining the 12-month fed funds rate surprise allows us to make the correct bond market call most of the time, it also shows that it doesn't always work. To understand why the golden rule might fail, it is useful to think about why it works in the first place. To do this, let's first consider that any Treasury yield can be thought of as consisting of three components: Treasury Yield = Fed Funds Rate + Expectations For Future Change In The Fed Funds Rate + Term Premium Based on this formula, it is obvious that if rate expectations and the term premium are held constant, a higher fed funds rate translates directly into a higher Treasury yield, and vice-versa. This is one reason why the fed funds rate surprise correlates with Treasury returns. The second reason that the fed funds rate surprise correlates with Treasury returns is that the expectations component of the above formula also tracks the fed funds rate surprise. In other words, investors are more likely to revise their rate expectations higher when the Fed is already in the process of delivering hawkish surprises. They are also more likely to revise their rate expectations lower when the Fed is delivering dovish surprises. This dynamic is illustrated in Chart 4. The top panel shows the correlation between the 12-month fed funds rate surprise and changes in rate expectations as measured by our 12-month fed funds discounter. The two lines are mostly positively correlated, though they do occasionally diverge. The largest divergences appear near inflection points in monetary policy - e.g. when the Fed switches from hiking rates to cutting. Such inflection points are often prompted by economic recession. Chart 4When The Golden Rule Doesn't Work The bottom panel of Chart 4 shows the much tighter correlation between the 12-month fed funds rate surprise and the change in the average yield on the Treasury Master index. These two lines also occasionally diverge, but only during periods when rate expectations move strongly in the opposite direction of what is suggested by the rate hike surprise. Crucially, the abnormal change in rate expectations has to be so large that it more than offsets the impact from the change in the fed funds rate itself. Such periods are rare, though we did experience one as recently as last year. The 2017 Episode Treasury returns in 2017 provide a textbook example of one of the rare periods when the golden rule failed. The Treasury Master Index returned +1.5% in excess of cash, even though the Fed lifted rates 25 bps more than the market expected at the beginning of the year. The reason for the divergence is that even though the Fed was in the process of lifting rates by more than what the market anticipated, the market continued to doubt the Fed's resolve and revised its expectations lower. At the beginning of 2017 the market was priced for 51 bps of rate hikes for the year. Then, just as the Fed started to lift rates more quickly than that expectation would suggest, core inflation plunged (Chart 5). The market started to price-in that the Fed would react to falling inflation by turning more dovish, but as it revised its expectations lower the Fed continued to hike. Chart 5The 2017 Example The end result is that the impact of the downward revision to rate hike expectations more than offset the upward pressure on yields from Fed rate hikes, and the Treasury index outperformed cash for the year. Forecasting Total Returns One final application of the golden rule is that it can be used as a framework for generating total return forecasts for different bond indexes. To illustrate how this is achieved we will walk through how we calculate such a forecast for the Treasury Master Index. Chart 6Market Has Underestimated##BR##The Fed In Recent Years First, we note that the current reading from our 12-month fed funds discounter is 79 bps. This means that the market expects 79 bps of Fed rate hikes during the next 12 months. If we assume that the Fed will lift rates by 100 bps during the next 12 months, then we have a hawkish fed funds rate surprise of 21 bps. As an aside, Chart 6 shows that we have consistently witnessed hawkish fed funds rate surprises since mid-2017, and our 12-month discounter has increased, as is typically the case. But this also means that the bar for further hawkish rate surprises is now much higher. We already demonstrated the strong correlation between the 12-month fed funds rate surprise and the 12-month change in the average yield from the Treasury index (see Chart 4). This allows us to translate our assumed fed funds rate surprise into an expected change in the index yield. In this case, that expected change in yield is +19 bps. With an expected yield change in hand, it is relatively simple to calculate an expected total return using the index's yield, duration and convexity: Expected Total Return = Yield - (Duration*Expected Change In Yield) + 0.5*Convexity*E(DY2) E(DY2) = 1-year trailing estimate of yield volatility In our scenario where we assume the Fed lifts rates by 100 bps during the next 12 months, the above formula spits out an expected total return of +1.59% for the Treasury Master Index. Table 2 shows total return forecasts using this same method but with many different rate hike assumptions. For example, if we assume only 50 bps of Fed rate hikes during the next 12 months we get an expected Treasury Index total return of +3.36%. Table 2Treasury Index Total Return Forecasts Table 2 also displays total return forecasts for different maturity buckets within the Treasury Master index. These forecasts are all generated using the same method, but we correlate the 12-month fed funds rate surprise with different Treasury yields in each case. One caveat here is that the correlation between the fed funds rate surprise and the change in Treasury yield declines as we move into longer maturities (Appendix A). This is because long-dated yields are less directly connected to near-term changes in the fed funds rate. As such, there is more uncertainty surrounding the total return forecasts for long maturity sectors. Spread Product Total Return Forecasts With one additional assumption we can also apply our return forecasting method to different spread product indexes. That additional assumption is for the expected change in the average index spread. Using Table 3, you can simply pick a column based on the number of Fed rate hikes you expect during the next 12 months and pick a row based on whether you think spreads will remain flat, widen or tighten. Table 3Spread Product Total Return Forecasts For example, if the Fed lifts rates by 100 bps during the next 12 months and investment grade corporate bond spreads stay flat, we would expect investment grade corporate bond index total returns of +2.79%. For each sector, the spread widening scenario assumes that the average index spread widens to its highest level since the beginning of 2016 and the spread tightening scenario assumes the average index spread tightens to its lowest level since the beginning of 2016. All the spread scenarios are depicted graphically in Appendix B. For the High-Yield sector we make the additional adjustment of subtracting expected 12-month default losses from the average index yield. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Appendix A Chart 7Change In 1-Year Yield Vs.##BR##12-Month Fed Funds Rate Surprise Chart 8Change In 2-Year Yield Vs.##BR##12-Month Fed Funds Rate Surprise Chart 9Change In 3-Year Yield Vs.##BR##12-Month Fed Funds Rate Surprise Chart 10Change In 5-Year Yield Vs.##BR##12-Month Fed Funds Rate Surprise Chart 11Change In 7-Year Yield Vs.##BR##12-Month Fed Funds Rate Surprise Chart 12Change In 10-Year Yield Vs.##BR##12-Month Fed Funds Rate Surprise Chart 13Change In 30-Year Yield Vs.##BR##12-Month Fed Funds Rate Surprise Appendix B Chart 14Corporate Bond Spread Scenarios Chart 15Government-Related Spread Scenarios Chart 16Structured Product Spread Scenarios

Special Report

Highlights Chart 1Corporate Health: Improving Everywhere, ##br##Down In The U.S. Dollar bull markets are often accompanied by positive returns for the S&P 500. While a strong dollar hurts the earnings outlook for the S&P 500, it supports an expansion of multiples by putting downward pressure on rates and elongating the U.S. business cycle. The dollar and stocks are most positively correlated when the U.S. yield curve slope is between zero and 50-basis points, and flattening. Today's environment fits this bill. BCA is neutral on U.S. in a balanced portfolio. While the USD's strength should be associated with rising U.S. equity prices, the quality of U.S. stock returns is deteriorating. This warrants a certain degree of de-risking relative to our former overweight stance. Feature For the past two weeks, we have warned investors that the dollar rally was over-extended, and that a correction was likely to ensue. However, we also argued that this correction was likely to prove a countertrend move, and that the dollar was likely to end the year at higher levels. BCA has a neutral stance on equities on both a cyclical and tactical horizon. BCA is also neutral on U.S. equities within a global equity portfolio. For investors, it becomes important to understand whether a stronger dollar constitutes an additional downside risk for stocks. This is especially relevant in the U.S., where equity valuations are comparatively elevated, and where corporate health is deteriorating relative to the rest of the world (Chart 1). In this report, we built on the research of our colleague Anastasios Avgeriou, who spearheads BCA's U.S. Equity Sector Strategy service, who has shown that the dollar and the S&P often do rise in unison.1 Ultimately, while the dollar can have an impact on the relative performance of the U.S., it is generally not a strong determinant of the trend in the S&P 500. Strong Dollar And The S&P: Good Friends Indeed A picture is worth a thousand words. As Chart 2 illustrates, a strong dollar has never really been enough to slay a bull run in the S&P 500. Between late 1978 and early 1985, the real trade-weighted dollar rallied by 45%, yet the S&P 500 was able to advance by 102%. Between 1995 and 2002, the real trade-weighted dollar increased by 33% but rallied by nearly 92%. If one were to confine their observations to 1995 to August 2000 window, the dollar would have been up 16.5% and the S&P an outstanding 223%. Finally, from its most recent cyclical bottom in 2011 to the end of 2016, the trade-weighted dollar rallied by 22%, but the S&P 500 managed to rise by another impressive 68%. It is true that the magnitude of the strength of U.S. equities in the face of a strong dollar has decreased over time. This essentially reflects the fact that in the early 1980s, 20% of S&P 500 revenues were garnered outside the U.S. versus roughly 40% today, which in turn has increased the drag on earnings created by a stronger dollar. This problem is illustrated by the negative relationship present between the dollar and U.S. earnings revisions (Chart 3). Chart 2Strong Dollar, No Problem Chart 3Dollar Is Dangerous For The Earnings Outlook Yet, despite this negative link between earnings revisions and the dollar, the S&P can still rise when the dollar increases. What explains this seeming paradox? The answer is almost tautological: It is multiples. A strong dollar tends to be associated with a rising P/E ratio. This is because a strong dollar has a dampening impact on inflation. As a result, when the dollar rises, the Federal Reserve can keep interest rates lower than would otherwise be the case, fomenting periods of declining bond yields (Chart 4). Thanks to lower bond yields, not only do multiples get a boost, but additionally the domestically driven U.S. economic cycle also gets elongated. This further helps stocks in the process. Another more international dimension helps explain the positive correlation between stocks and the dollar. The dollar tends to experience its strongest rallies when U.S. growth is superior to that of the rest of the G-10. As Chart 5 illustrates, the bulk of the early 1980s dollar rally, of the late 1990s rally, and of the 2011 to early 2017 rally materialized when U.S. economic activity was outperforming. In all these instances, the relative strength of the U.S. economy attracted funds from abroad. This also meant that foreign funds flowing into the U.S. economy bolstered liquidity in the U.S. economy. Not only did this liquidity support economic activity, thereby counterbalancing the drag created by a stronger dollar, these funds also found their way into asset markets, generating higher multiples in the U.S. in the process. Chart 4Strong Dollar Hurts Yields Chart 5Growth Differentials Matter For The Dollar Bottom Line: A strong dollar in and of itself has never been enough to derail a bull market in the S&P 500. While a strong dollar creates a hurdle for foreign earnings accruing to U.S. firms, higher multiples often compensate for this negative. Essentially, a higher dollar causes downside to bond yields, warranting lower hurdle rates and higher valuations. Moreover, a stronger dollar diminishes inflationary pressures in the U.S., warranting easier Fed policy than would otherwise be the case. Since the U.S. economy is domestically driven, this elongates the business cycle, helping stocks in the process. Correlation And The Yield Curve Slope While a strong dollar does not seem to be a death threat for the equity market, are there environments when the dollar and the S&P 500 are more correlated than others? Table 1Dollar Versus S&P 500 Correlation: ##br##A Function Of The Yield Curve The answer to this question is yes. As Table 1 illustrates, the correlation between the dollar and the S&P 500 fluctuates significantly based on both the slope of the yield curve and whether the yield curve is flattening or not. Interestingly, when the yield curve is steep (defined as greater than a 50-basis-point spread between 10-year and 2-year Treasury yields), the dollar and U.S. stock prices tend to move in opposite directions. However, when the yield curve is flatter but before it has yet to invert (a yield curve slope of between zero and 50 basis points), the correlation between the dollar and the S&P 500 changes: it becomes positive. In fact, the time at which the correlation between stocks and the dollar is the highest is when the yield curve slope is in that zone and is also flattening. This is surprising, but at the same time it makes sense. We know that when the yield curve is flat but not inverted, the stock market tends to still rally (Chart 6). However, this flattening yield curve indicates that monetary conditions are not as accommodative as they once were. Interestingly, while the dollar performs poorly in the early innings of a monetary tightening campaign, it performs much better when monetary conditions are not so easy anymore that they juice up global growth, but they are not yet tight enough to cause an imminent recession in the U.S.2 This corresponds to a an environment with a flatter yield curve that has yet to invert, such as the one in place today. In light of these observations, the close correlation between the S&P 500 and the dollar in this environment should not be very surprising. Chart 6Flat And Flattening: No Problem For Stocks Bottom Line: The dollar and the stock market are not always positively correlated. However, when the U.S. yield curve slope stands between zero and 50 basis points and is flattening, the positive correlation between the S&P 500 and the dollar is at its strongest. This defines today's environment. Investment Implications BCA thinks the U.S. dollar has ample downside on a long-term basis. After all, the U.S. dollar trades at a significant premium to its PPP fair value, and this kind of overvaluation historically indicates significant downside for the greenback on a multi-year time horizon (Chart 7). Moreover, the Trump administration's fiscal policy is likely to result in a widening of both the fiscal and current account deficits. While a twin deficit rarely impacts the dollar negatively, so long as U.S. real rates rise relative to the rest of the world, it nonetheless often ends up being a harbinger of long-term weakness in the greenback.3 It is hard to make any inference for the S&P 500 based on a bearish long-term dollar view as historically, during a structural dollar bear market, the relationship between the greenback and the S&P has been rather ambiguous. However, BCA also thinks the 2018 dollar rally is not over. As Chart 8 shows, when U.S. rates are in the top of the distribution of interest rates among G-10 economies, the dollar tends to perform well. The U.S.'s status as the global high-yielder is currently unchallenged. This suggests the dollar has a natural advantage over other currencies through the remainder of the year. Chart 7Long-Term Downside For The Dollar... Chart 8...But 2018 Rally Is Not Over Moreover, as the U.S. economy is less exposed to the global industrial cycle than the rest of the world is, the U.S. dollar will benefit from the softening global economic environment. This is even truer, given that the U.S. economy was already set to outperform other G-10 economies even before the soft patch in global trade began. As a result, long-term flows into the U.S. are strong, which is generating a basic balance-of-payments surplus (Chart 9). American investors are not blind to this reality; the higher expected rate of returns on U.S. projects along with U.S. corporations bringing earnings back home to take advantage of the Trump tax cuts is generating outsized repatriation flows into the country, historically a good correlate of a strong dollar (Chart 10). This phenomenon is likely to remain alive through the remainder of the year. Chart 9Money Is Making Its Way Into The U.S. Chart 10Americans Like Their Dollar Since the U.S. yield curve slope currently stands between zero and 50 basis points while it is flattening in response to the Fed's interest rate hikes, we are in the part of the cycle where the dollar and stocks are positively correlated, and where they in fact often rise together. This suggests the S&P 500 has more upside ahead for the rest of the year as well. It is important to note that the tech sector is now the most at risk from the dollar strength as it has the largest percentage of foreign sales (Chart 11). However, BCA is neutral on stocks on a cyclical horizon. This is not because stocks will not be able to eke out some positive returns; it is because we are acutely aware that we stand close to the end of the bull market. Moreover, the end of an equity bull market is often marked by a pick-up in volatility. Accordingly, risk-adjusted returns for U.S. equities are declining. Hence, while an underweight stance on stocks is not yet warranted, a neutral stance is appropriate as we believe that it is better to be early and leave some money on the table than to be late.4 There remains a big risk that could cause the dollar to rally and stocks to fall, despite where we stand in the cycle: trade disputes. As Chart 12 illustrates, since May, tariff announcements and protectionist pronouncements have buoyed the dollar. However, the same announcements ultimately represent a real risk to profits as they create a real danger for global supply chains and imply higher cost of goods sold by U.S. corporations. Investors should monitor these risks closely. Chart 11S&P 500: Aggregate Sector International Revenue Exposure (%) Chart 12While Tariffs Can Help The Dollar, ##br##They Will Not Help Stocks Bottom Line: BCA anticipates the dollar to be able to rise over the course of the next six to nine months, as U.S. rates are in favor of the greenback and domestic growth outperformance will continue to favor inflows into the U.S. This bullish view on the U.S. dollar currently does not constitute a reason to downgrade stocks to underweight. In fact, at this stage of the cycle, U.S. stocks and the dollar tend to rise in unison. However, since the quality of the equity gains is likely to deteriorate as equity volatility is on an uptrend, BCA prefers to maintain a neutral cyclical stance on equities within a balanced portfolio rather than an overweight stance. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see U.S. Equity Sector Strategy Insight Report, titled "Can the S&P 500 Continue Rising Alongside the U.S. Dollar?", dated October 13, 2016, available at uses.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "This Time Is NOT Different," dated May 25 2018, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "Twin Deficits: Bearish Or Not, The Fed Holds The Trump Card," dated February 23 2018, available at fes.bcaresearch.com 4 Please see The Bank Credit Analyst Special Report, titled "U.S. Fiscal Policy: An Unprecedented Macro Experiment," dated June 28, 2018 available at bcaresearch.com.

Highlights The indicators that led the EM selloff continue to point to more downside. Meanwhile, broader EM valuation and positioning indicators have not yet bombed out to warrant bottom fishing. In China, policymakers are not yet embracing stimulus of the same magnitude as in 2015-2016. Consequently, the odds for now favor staying put on China-leveraged plays. Feature Calling market bottoms and tops is an art -not a science - as there is no formula that works at all times, in all markets. The fundamental case for EM/China remains negative, as credit excesses of previous years have not been unwound, and commodities prices remain at risk. However, to avoid being part of a herd and to maintain investment discipline, it is vital to re-visit market indicators from time to time. In this week's report, we explore directional market indicators and valuations, and offer some thoughts on investor sentiment and positioning in EM. Putting all of these together with our fundamental analysis, we still see meaningful downside in EM risk assets, and continue recommending a defensive strategy. A Review Of Indicators The indicators that led this EM selloff continue to point to additional downside. Meanwhile, valuation and positioning indicators have not yet bombed out. Chart I-1 illustrates that EM corporate U.S. dollar bond yields continue to rise (shown inverted on the chart), entailing lower EM share prices. The message is the same whether we consider EM high-yield or investment-grade corporate or EM sovereign U.S. dollar bond yields. Chart I-1EM Share Prices Always Decline When EM Corporate Bond Yields Rise We have repeatedly highlighted1 that EM share prices correlate with EM borrowing costs rather than risk-free rates. So long as the rise in U.S. bond yields is offset by compressing EM credit spreads, EM corporate bond yields decline and EM share prices rally. But when EM corporate (or sovereign) yields rise, irrespective of whether this is due to rising U.S. Treasury yields or widening EM credit spreads, EM equity prices come under selling pressure. Chart I-2 illustrates that a similar relationship exists between China's onshore AA- corporate bond yields and A share prices. AA- corporate bond yields have not yet dropped, and, thereby, they still point to lower share prices ahead. Even though risk-free and interbank rates have plummeted on the mainland, corporate borrowing costs have not. If the Chinese authorities do indeed eradicate the perception of implicit government guarantees for the majority of corporate borrowers - one of the most important items on the government's structural reforms agenda - the odds are that corporate bond yields will rise further to price in higher risk of defaults. This would be a bad omen for corporate borrowing costs, capital spending and share prices. Our risky to safe-haven currency ratio is making new lows. Given it has historically been highly correlated with EM stocks, odds are that EM share prices will continue to drop (Chart I-3). Chart I-2China: On-Shore Corporate Bond (AA-) ##br##Yields And A-Share Market Chart I-3Risky To Safe-Haven Currencies ##br##Ratio And EM Stocks Notably, this ratio is also agnostic to the dollar's direction - it swings between risk-on versus risk-off regimes in financial markets, regardless of the greenback's general trend. Hence, it addresses the question of the direction of EM equity prices, irrespective of the dollar's trajectory. Industrial metals prices correlate with EM corporate earnings growth as demonstrated in Chart I-4. The basis is that both are affected by global growth. Presently, falling metals prices are signaling further deceleration in EM non-financials corporate EBITDA growth. We want to emphasize again that the EM selloff this year has primarily been due to the growth slowdown in EM/China rather than higher U.S. bond yields. If anything, the opposite has been occurring: the EM turmoil and growth slowdown have capped U.S. bond yields since April. Moreover, the currency selloff in EM ex-China has led to rising local currency interest rates in many developing economies. Looking forward, higher local rates entail a capital spending slump, which will weigh on EM and global growth. EM risk assets are highly sensitive to global trade growth. The poor performance of global cyclical equity sectors corroborates weakening world trade. In particular, global mining, steel, chemicals, industrials and semiconductor stocks have all broken below their 200-day moving averages (Chart I-5). Chart I-4More Deceleration In EM Corporate Profits Chart I-5Global Equities: Cyclical Sectors Have Broken Down EM equity valuations are currently roughly neutral, down from being one standard deviation above fair value in January (Chart I-6). Hence, EM stocks are not expensive, but they are not cheap either. When equity valuations are neutral rather than at extremes, the market can either rally or sell off. In brief, when equity valuations are not at extremes, the direction of share prices is contingent on the profit cycle. The outlook for EM corporate earnings at the moment is downbeat (as shown in Chart I-4 on page 3), presaging a market selloff. With respect to high-yielding EM currencies, Chart I-7 demonstrates that the aggregate real effective exchange rate for EM ex-China, Korea and Taiwan has dropped quite a bit, but still stands above its historical lows. Chart I-6EM Stocks Are Not Cheap Chart I-7EM Currencies Are Only Moderately Cheap Regarding credit market valuations, EM corporate credit spreads are still below their post-2009 mean (Chart I-8, top panels). EM sovereign spreads are above their post-2009 mean, but this is due to crisis-stricken outliers. Some pockets of EM, such as Argentina or Turkey,2 might be undervalued for a reason. However, sovereign spreads for EM ex-Venezuela, Argentina and Turkey are still at their post-2009 mean (Chart I-8, bottom panel). On the whole, EM market valuations have improved, but EM assets are not yet cheap to warrant bottom-fishing. Finally, investor sentiment towards EM is no longer wildly bullish as it was last year, but our sense is that the average investor believes this EM selloff will not develop into an extended major bear market. Consistent with this, investors may have hedged some of their bets, or are reducing their exposure, but they have not capitulated or gone bearish/underweight on EM assets. For example, Chart I-9 illustrates that leveraged investors - who have little tolerance for volatility - have substantially reduced their net long positions in EM ETF equity futures, yet asset managers are still very long. Chart I-8EM Credit Spreads Do Not Yet Offer Value Chart I-9EM Stock Futures: Leveraged Funds Have Sold, ##br##But Asset Managers Have Not Besides, investor sentiment on copper - a proxy for EM - is not yet depressed (Chart I-10). As can be seen on this chart, EM share prices bottom when the net bullish sentiment on copper typically drops close to 25%. That is not the case at the moment. Chart I-10Bullish Sentiment On Copper And EM Share Prices Bottom Line: Investors should stay put on EM and underweight EM assets relative to their DM counterparts in general, and the U.S. in particular. China: Juggling Contradictory Objectives China's central bank has substantially eased liquidity in the banking system, as evidenced by the 200-basis-point plunge in interbank rates. In addition, the authorities have instructed local governments to accelerate issuance of the remaining quota of their bonds. What's more, the banking regulator has urged banks to lend more to infrastructure development and to the export sector. We offer several comments and observations regarding China's current round of policy stimulus: First, there has so far been no additional fiscal stimulus announced. General government spending growth for 2018 is planned at 3%, and managed funds spending at 24.1%. Altogether public (fiscal and quasi-fiscal) spending in 2018 is projected to be 8% compared to 8.6% in 2017 and 8.1% in 2016 (Table I-1). Table I-1China: Fiscal And Quasi-Fiscal Spending (Annual Nominal Growth Rates) With no new announced public spending, front-loading previously planned spending could alter the near-term growth trajectory, but it will not affect the economy's cyclical outlook. Second, the key risk to our downbeat view is an acceleration in credit origination.3 Our baseline scenario is that regulatory tightening for banks and shadow banking as well as the ongoing anti-corruption campaign in the financial sector - both components of the broader structural reforms agenda - will continue, and will curb credit growth despite more liquidity provision by the People's Bank of China and lower interbank rates. Importantly, so far there has been little deleveraging. If the authorities allow a credit acceleration, it would negate their adherence to structural reforms in general, and deleveraging in particular. In such a case, China's growth will revive and the negative view on China-leveraged markets will prove to be wrong. Furthermore, a revival in credit growth would go against the policy priority of containing financial risks - code for not allowing bubbles to inflate further. In fact, property sales and starts have recently accelerated (Chart I-11). Stimulating money and credit now would mean inflating the real estate bubble further. Third, broad money (official M2 and our measure of M3) impulses have ticked up, but the credit impulse has not (Chart I-12, top panel). Chart I-11China: Housing Is Proving Resilient Chart I-12China: Money/Credit Impulses Importantly, the broad money impulses rolled over in the second half of 2016, yet EM/China markets and commodities prices remained resilient until early 2018 (Chart I-12, bottom panel). There was roughly an 12-month plus time lag between the rollover in the money/credit impulses and the peak in China-related financial markets. Hence, there will likely be an interval of at least six months before financial markets react to the recent improvement in the money impulses. As such, it is probably too early to bottom-fish EM/China plays. There could be considerable downside in financial markets in the next six months or so, notwithstanding short-term rebounds. Finally, the PBoC's ability to keep money market rates down will be constrained by its appetite for further weakness in the RMB exchange rate. Chart I-13 illustrates that the drop in the interest rate differential between China and the U.S. has coincided with the latest down-leg in the RMB's value. Chart I-13China: Lower Interest Rate Differential = Weaker RMB The interest rate differential between China and the U.S. is now only 100 basis points. Given that U.S. short interest rates are bound to rise further, we expect one of the following scenarios to unfold: If the PBoC opts to lower rates further or keep them at current levels, the yuan will continue to depreciate versus the U.S. dollar. This will be negative for China/EM financial markets; If the PBoC prefers to stabilize the RMB exchange rate versus the dollar, it will need to push up money market rates, thereby undoing its liquidity easing of the past several months. If this takes place, the odds of a credit revival will drop considerably and chances of an economic growth recovery will diminish. Given the above and the fact that EM financial markets have reacted poorly to the RMB's recent depreciation, staying negative on EM risk assets appears to be the more prudent course. We are not sure which option the PBoC will choose in the near term, but in the long run China will have to drop interest rates to soften the deleveraging process. Bottom Line: Chinese policymakers are attempting to simultaneously achieve contradictory objectives: On one hand, they want to deleverage the system and contain the property and credit bubbles. On the other hand, they are not ready to tolerate weaker growth, and have lately opted for stimulus as soon as growth has downshifted. It will be very hard to achieve these contradictory objectives at the same time. For now, policymakers are not yet embracing stimulus of the magnitude that was implemented in 2015-2016. Consequently, the odds for now favor staying put on China-leveraged plays. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "On EM Blues, Brazil And Malaysia," dated May 17, 2018, a link available on page 13. 2 Please see Emerging Markets Strategy Special Alert "Turkey: Booking Profits On Shorts," dated August 15, 2018, a link available on page 13. 3 Underestimating the recovery in credit growth was the reason why we misjudged the magnitude and duration of 2016-17 recovery in China. Equity Recommendations Fixed-Income, Credit And Currency Recommendations