FOREIGNEXCHANGE OUTLOOK FOR FOURTH QUARTER 2018 FOREIGNEXCHANGE

Disclaimer: This material has been prepared by Brown Brothers Harriman & Co. (“BBH”) and is intended for information purposes only. This communication should not be relied upon as financial, investment, tax or legal advice. This communication should not be construed as a recommendation to invest or not to invest in any country or to undertake any specific position or transaction in any . This infor- mation may not be suitable for all investors depending on their financial sophistication and investment objectives. The services of an appropriate professional should be sought in connection with such matters. The information contained herein has been obtained from sources believed to be reliable, but is not necessarily complete in its accuracy and cannot be guaranteed. Sources used are available upon request. Any opinions expressed are subject to change without notice. Please contact your BBH representative for additional information. BBH’s partners and employees may own in the subject of this communication and/or may make purchases or sales while this communication is in circulation. This communication has been prepared for use by the intended recipient(s) only.

BBH Foreign Exchange | 2018 Fourth Quarter Outlook CONTENTS

Global Overview: Thorny Issues Threaten in Q4...... 2

Further Delays Increase the Probability of a No-Deal Brexit...... 6

Emerging Market Country Profiles ...... 8

Trade Tension Timeline ...... 11

Currency Forecasts...... 12

2018 Fourth Quarter Outlook | 1 GLOBAL OVERVIEW: THORNY ISSUES THREATEN IN Q4 By: Dr. Win Thin

2 | BBH Foreign Exchange Around the world, the process of normalization is running its course. The Fed is the most obvious example and has been the leader in this process. One by one, other central banks have followed the Fed in removing extraordinary stimulus. This process is expected to continue into 2019.

The FOMC just delivered the eighth rate hike of its tightening cycle, moving the Fed Funds target range to 2.25-2.50%. It left its “dot plot” steady, which points to another hike in December, followed by three in 2019 and one in 2020. Growth and inflation forecasts were tweaked. As of this writing, the market has priced in a nearly 75% chance of a December hike, and has fully priced in two more hikes in 2019.

Meanwhile, the ECB is sticking to its forward guidance. That means it will taper its purchases in Q4, halt its purchases at year-end and start hiking rates after next summer. However, ECB officials have been stressing that the pace of tightening will be modest and very much data-dependent. They also have not given guidance on when the balance sheet would start shrinking.

To its credit, the Fed has provided the ECB with a pitch-perfect blueprint on how to exit unconventional policies with limited market turmoil. Recall that the Fed first GLOBAL OVERVIEW: tapered its asset purchases, then ended them altogether in October 2014. The proceeds of any maturing securities were reinvested to keep the size of the Fed’s balance sheet steady. Only after rate hikes began did the Fed start shrinking its balance sheet. THORNY ISSUES THREATEN IN Q4 Benoît Cœuré, member of the Executive Board of the European (ECB), prefers not to set an expected rate path, favoring instead the identification of the By: Dr. Win Thin economic conditions needed for rate hikes. Peter Praet, also an Executive Board member and the chief economist of the ECB, similarly prefers some sort of verbal forward guidance. Both want to prevent market turmoil and both favor modest adjustments. At the other end of the spectrum is Austrian central bank governor Ewald Nowotny, who wants to normalize policy more quickly than what’s currently planned. ECB President Draghi clearly prefers the more cautious approach.

There continues to be much speculation about who will replace Draghi when his term ends in November 2019. Cœuré, Praet and Nowotny are often mentioned, but other pos- sibilities include Bundesbank President Jens Weidmann and Banque de France Governor François Villeroy de Galhau. Press reports suggest that having a German fill the top spot at the ECB is no longer a priority for Chancellor Angela Merkel, as she focuses instead on getting a German to lead the .

2018 Fourth Quarter Outlook | 3 Italy has thrown a spanner in the works. The populist government Other major central banks have tightened, albeit modestly. led by the Five Star and League coalition has proposed a 2019 budget Norway’s Norges Bank recently started a tightening cycle with a 25 that seeks to follow through on their campaign spending promises. The bp hike, but the rate path that it signaled was fairly modest. The Bank draft budget deficit is seen at -2.4% of GDP, higher than what Finance of Canada (BOC) has been the most aggressive, hiking rates four Minister Tria wanted. That Tria caved to the populists is not a good sign times from 0.5% to 1.5% currently. It is widely expected to hike going forward. Italy must submit its draft budget to the European another 25 bp to 1.75% at its October 24 meeting. Now that NAFTA Commission for approval by mid-October, and critical comments from uncertainty has ended, we think the BOC has even more confidence the finance ministers already suggest conflicts ahead. in its policy path.

The Bank of England (BOE) will remain on its cautious tightening Elsewhere, Sweden’s Riksbank signaled that it is likely to start cycle, which amounts to roughly one hike per year. It last hiked its tightening cycle in either December or February. We favor rates in August. That was only the second hike in this cycle and comes December, as the underlying economy remains strong. The Riksbank after the first hike in November 2017. Recent signs of strength in the is concerned about the housing market, and so we suspect the tight- UK economy have boosted the implied yields in the longer-dated short ening path will start off very modest. Elsewhere, with the mainland sterling contracts. A third hike has been fully priced in by March 2019, Chinese economy slowing, we believe policymakers in Australia and and a fourth by December 2019. New Zealand will maintain a dovish stance. Consensus sees neither the Reserve Bank of Australia (RBA) nor the Reserve Bank of New Yet offsetting this more hawkish BOE outlook is continued Brexit Zealand (RBNZ) hiking rates until H2 2019. uncertainty. As of this writing, the Irish border issue remains a sticking point. Prime Minister May’s so-called “Chequers plan” was Most emerging market (EM) central banks have started tightening resoundingly rejected by the EU, and there does not appear to be a cycles. Those that haven’t are likely to begin in 2019. Just as ultra-low plan B. Add to this a potential Tory leadership challenge to May as well developed market (DM) rates allowed EM rates to fall sharply, so too as risks of snap elections, and one can understand why political risks should higher DM rates feed into rising EM rates. As the developed are trumping the BOE with regards to sterling. world moves to a more normal state of affairs regarding monetary policy, so too should EM. The Bank of Japan (BOJ) has signaled QE will continue in the foreseeable future. There have been several tweaks to its uncon- The People’s Bank of China (PBOC) is the major exception. With ventional policies, but the BOJ has pushed back against any market the mainland economy slowing, the PBOC enacted another round perceptions of “stealth tapering.” Recently, the BOJ lowered its of monetary and fiscal stimulus back in July. It has pledged to keep purchase range for securities with maturities longer than 25 years liquidity ample. In another special case, the Hong Kong Monetary to between JPY10-100 bln for each operation in October, down from Authority has been hiking rates in lockstep with the Fed because of JPY50-150 bln in September. It kept the indicative buying ranges for the HKD peg. Liquidity has tightened in Hong Kong money markets in all other maturities unchanged. Under its Yield Curve Control (YCC) recent weeks, lifting the HK dollar off the weak end of its trading band. policy, the BOJ seems to be encouraging a slightly steeper curve. As a result, yields at the long end have moved higher and this will be welcomed by Japanese insurers.

4 | BBH Foreign Exchange Tighter global liquidity is one major headwind for global growth. All in all, investors will Another is ongoing trade tensions. As of this writing, the US and China have announced several tit for tat rounds of tariffs. Even more tariffs continue to face a difficult appear likely, and Chinese officials have said no talks will take place in global environment in Q4. the current environment of threats. Because China is such a large part of the global supply chain, these tariffs will likely have spillover effects Economic and political on the regional trading powerhouses like Korea, Taiwan and Singapore.

uncertainty remain high.” To its credit, Chinese policymakers have stressed that they will not weaponize the yuan. That is, they will not devalue the currency in order to regain competitiveness. As such, we see the yuan trading in line with wider EM FX. China will continue with its efforts to inter- Elsewhere in Asia, India, Indonesia and the Philippines are already nationalize the yuan, albeit cautiously. The most recent IMF COFER in their respective tightening cycles. Korea and Malaysia have each data show the yuan’s share of global reserves rising to a record high hiked only once, taking back the emergency cut in the wake of Brexit. 1.84% of the total. The Monetary Authority of Singapore tightened policy modestly in April by adjusting the slope of its S$NEER trading band. Taiwan and Thailand For the most part, we see ongoing weakness remaining concen- have yet to hike rates and are unlikely to do so until well into 2019. trated in the new “Fragile Five” countries of Argentina, Brazil, Russia, South Africa and Turkey. All five have idiosyncratic risks that In EMEA, the started a tightening cycle last are likely to persist well into 2019. Elsewhere, Mexico continues to summer and has continued hiking rates this year. The Central bask in the recent rebranding of NAFTA into USMCA. While the eco- Bank of Russia just started its tightening cycle, while Turkey is in the nomic benefits are yet to be determined, USMCA takes the focus off midst of a protracted tightening cycle. The South African Reserve Mexico and puts it squarely on China. Bank delivered a hawkish hold in September, and the 4-3 vote with 3 dissents in favor of an immediate hike suggests the start of tightening All in all, investors will continue to face a difficult global environ- will be seen sooner rather than later. Israel is likely to hike in Q4, while ment in Q4. Economic and political uncertainty remain high. Delivering has started to lay the groundwork for exiting unconventional a speech in Washington, D.C. on October 1, IMF Managing Director policies. In this , Poland stands out for its ultra-dovish forward Christine Lagarde warned of growing downside risks to the global guidance of steady rates through 2020. economy, pinning much of it on rising trade tensions.

In Latin America, Argentina and Mexico have already tightened. “Six months ago, I pointed to clouds of risk on the horizon. Today, With inflation still high in both countries, neither is expected to ease some of those risks have begun to materialize,” she said. anytime soon. Brazil is likely to start hiking rates in October, while Chile is likely to in Q4. Both Colombia and Peru are likely to hike rates in Q1 2019.

2018 Fourth Quarter Outlook | 5 Further Delays Increase Probability of No-Deal Brexit By: Adrian Whelan

6 | BBH Foreign Exchange Another day, another delay: EU summit in October will no longer be a place to agree on post-Brexit plans.

An October EU summit was supposed to mark a key date in the Brexit timeline, a time for the EU and UK to agree on their post-Brexit relationship. However, there are widespread media reports that the ambitious self-imposed deal deadline will be pushed to mid-November at the earliest. The EU will now have to facilitate an unplanned emergency summit. This was always a likely outcome, but it does fundamentally alter the entire Brexit timeline.

More importantly, this latest delay is further indication that the EU and UK diplomats and negotiators are not making the requisite headway on substan- tive issues, primarily the Irish border problem, thus greatly increasing the probability of a no-deal Brexit.

Here is a timeline of key Brexit dates:

26 June 2018 The (Withdrawal) Bill The bill is now an act of parliament

November 2018 Rescheduled EU ‘first agreement’ emergency summit Pushed back from October, meeting with the purpose to agree on post-Brexit relationship 18 October – 31 December 2018 Window to ratify Brexit outline UK Parliament will need to agree to relationship terms

31 December 2018 EU ‘second’ summit Second meeting if agreement is not ratified by EU Member States and 31 December – 29 March 2019 the UK Parliament (1) The UK House of Lords and the House of Commons both need to pass a vote on the EU withdrawal treaty (2) The UK Parliament will vote on an implementation bill There is currently no clarity as to what would happen If the votes fail to pass 29 March 2019 Brexit Day The UK will no longer be part of the EU as of 11 p.m. GMT

29 March 2018 – 31 December 2020 Transition Period Grace period in which businesses and individuals will prepare and implement the post-Brexit agreed terms

2018 Fourth Quarter Outlook | 7 EMERGING MARKET Country Profiles By: Dr. Win Thin

We believe weakness in the EM space will remain concentrated in the five problem countries of Argentina, Brazil, Russia, South Africa and Turkey. All have idiosyncratic risks that are likely to persist into 2019. However, India and Indonesia are also likely to remain under pressure, albeit to a lesser extent, due to their high financing needs.

8 | BBH Foreign Exchange An initial Further economic $50 bln IMF program and massive and financial sanctions by the US are rate hikes to 65% have yet to fully already in the pipeline. stabilize the situation in Argentina. These will weigh on an already sluggish economy. Relations with the West and the US remain poor, and the upcoming US elections could As a result of fiscal and monetary tightening, the economy is likely be another flashpoint if further Russian interference is detected. The to experience its second recession in three years. What’s worse, so-called “Sanctions Bill from Hell” will be debated by the Senate, inflation is running close to 35% and is likely to continue accelerating. with some believing that US entities may be prohibited from buying This outcome is all the more disappointing since President Mauricio Russian government bonds. The Russian Finance Ministry is report- Macri has for the most part done all the right things. edly looking into alternative means of financing.

This backdrop does not bode well for President Macri as he faces The central bank just started a tightening cycle in September, an election in October 2019. The Peronists would like nothing bet- adding to the headwinds. The budget numbers will be boosted ter than to get back in power and reverse Macri’s orthodox policies. by high oil prices, giving the government some leeway to use fiscal Argentina approached the IMF and was able to increase its credit stimulus. However, inflation has clearly bottomed and is likely to line to $57 bln, a bit less than the rumored $70 bln. It will come with breach the 4% target in the coming months. With the ruble remain- even greater conditionality, but austerity will be difficult to enact in ing vulnerable, we think tightening will continue into 2019. an election year.

The economy is The economy remains sluggish, growing, albeit sluggishly. putting upward pressure on the Yet price pressures are rising and the central bank’s Monetary Policy Committee (COPOM) appears likely to embark on a tightening cycle budget deficit. as early as October 31. The budget numbers have improved modestly due to the cyclical recovery, but the lack of structural reforms during The mid-term budget statement in October will be very important Temer’s lame duck administration points to more fiscal woes ahead. for the nation’s efforts to stave off further rating downgrades. High If the real continues to weaken, there will be significant fiscal costs unemployment remains persistent even as the economy is stuck due to the $68.9 bln stock of outstanding FX swaps. in a low growth cycle. President Cyril Ramaphosa faces a host of issues as we approach elections next spring, which may push the As of this writing, the October 7 election remains too close ANC toward a more populist stance. to call. It appears that Jair Bolsonaro and Fernando Haddad are likely to be the top two vote-getters in the first round. However, the most The South African Reserve Bank (SARB) delivered a hawkish recent polls show a toss-up in the second round on October 28. To hold in September. The 4-3 vote with dissents favoring an immedi- state the obvious, markets would not like to see Haddad, Lula’s heir ate hike suggests that a consensus to tighten will be seen sooner apparent, win. Amongst other things, many believe Haddad would rather than later. Inflation is drifting toward the top of the 3-6% target be a figurehead, with Lula pulling the strings behind the scenes. On band. While the SARB does not forecast a breach of that band, we the other hand, there are signs that Bolsonaro’s market-friendly eco- see upside risks to inflation. nomic advisor, Paulo Guedes, may have limited influence on policies.

2018 Fourth Quarter Outlook | 9 While the central The rupee has come bank belatedly took aggressive under pressure this year. action, we do not think the crisis Markets are increasingly focused on countries that have outsized financing needs (both domestic and external) in this period of tight- is by any means over. ening global liquidity. India has a growing current account deficit as well as persistent budget deficits. The recently announced New Economic Plan was woefully short on details, suggesting that policymakers still do not have a handle on Price pressures are rising, spurred in part by higher energy costs. what needs to be done. Inflation is likely to accelerate to the 25% The Reserve Bank of India (RBI) started a tightening cycle but has area, which would make the current policy rate of 24% inadequate. since taken a more neutral stance. We believe pressure on the rupee will force the RBI to tighten further in the coming months. This will The longer the adjustment is put off, the greater the economic come at a cost to growth, and at an uncomfortable time for Prime costs. We believe the economy will undergo a hard landing next Minister Modi. General elections are due next year, and polls sug- year. With no plan yet in place to deal with corporate FX exposure, gest support for him is already slipping. we think the situation could develop into a much deeper banking and financial crisis. Despite significant tightening from Bank Indonesia,the rupiah continues  Markets are increasingly to weaken.

focused on countries that USD/IDR rose above 15000 for the first time since 1998. Given have outsized financing the sharp moves seen during the Asian Crisis, there really aren’t any major chart points between current levels and the all-time high needs (both domestic and near 16950 from June 1998. The next policy meeting is on October “ 23 and another 25 bp hike appears likely then. Like India, markets external) in this period of are focusing on Indonesia’s growing current account and budget deficits. Indonesia’s Net International Investment Position (NIIP) of tightening global liquidity.” -34% is the biggest in Asia, which represents another vulnerability.

10 | BBH Foreign Exchange TRADE TENSION TIMELINE v. China

UNITED STATES DATE CHINA Safeguard tariffs imposed on washing machines and solar cell imports Jan 22 Feb 4 Start of one-year anti-subsidy investigation into U.S. sorghum imports Trump signs tariffs on imported steel and aluminum Mar 9 Trump signs tariffs on imported steel and aluminum Tariffs on $50-$60 bln of Chinese goods proposed in response to China’s Mar 22 Tariffs on $50-$60 bln of Chinese goods proposed in response to “unfair trade practices” China’s “unfair trade practices” Formal complaint filed to WTO about China’s Intellectual Property rights Mar 23 Tariffs on $3 bln on U.S. imports announced, in retaliation to the U.S.’s steel/aluminum tariffs Apr 2 Trade talks break down after U.S. rejects offer to cut bilateral trade deficit by $50 bln; Start of the tariffs on $3 bln USTR announces list targeting high-tech industrial products for the Apr 3 USTR announces list targeting high-tech industrial products for the $50 bln of Chinese goods $50 bln of Chinese goods Apr 4 Plan to impose 25% tariffs on $50 bln of U.S. goods (spanning from produce to aircrafts) announced Trump orders USTR to consider tariffs on an additional $100 bln of Apr 5 Formal complaint filed to WTO about U.S.’s steel and aluminum tariffs Chinese goods (Retaliation for China’s retaliatory tariffs) Apr 17 Collection of anti-dumping tariffs on U.S. sorghum imports announced (Around a $1 bln value) U.S. demands a $200 bln cut in trade deficit ($150 bln more than China’s May 3-4 No statement is released following trade talks, China demands an end original offer) to WTO’s investigation Trade talks start in Washington May 17 May 18 China ends anti-dumping & anti-subsidy investigation into Sorghum U.S. agrees to temporarily hold-off on tariffs May 20 China offers to significantly increase U.S. imports of farm and agricultural products May 22 Import duties on cars cut from 25% to 15% Trump backs away from the trade talks in DC as the two sides appeared May 23 to be approaching a deal White House said a final tariff list on $50 bln of goods will be published May 29 by June 15th May 30 Cuts to tariffs on some consumer goods announced, starting July 1st Jun 2-4 Officials meet in Beijing for trade talks Jun 3 Declares previous deals off the table if new tariffs imposed by U.S. Jun 6 Offers to buy $25 bln more of U.S. goods in 2018 The final list of 25% tariffs on $34 bln of Chinese goods is published; Jun 15 Announces 25% tariffs on the 1st set of $34 bln of U.S. goods; A second round of tariffs on $16 bln will undergo review The second set of $16 bln will undergo review U.S. threatens an additional 10% tariff on $200 bln of Chinese goods, Jun 18 if China retaliates Tariffs on $34 bln of Chinese goods begin Jul 6 Tariffs on $34 bln of U.S. goods begin Resulting from China’s retaliation, USTR releases list of additional Jul 10 $200 bln of Chinese goods to tariff USTR confirms considering increasing proposed tariff on $200 bln Aug 2 of Chinese goods from 10% to 25% Tariffs on $16 bln of Chinese goods begin Aug 23 Retaliatory tariffs on $16 bln of U.S. goods begin USDA to make $4.7 bln in payments to U.S. Farmers to offset trade losses Aug 27 Commerce Department announces U.S.’s trade deficit increased to Sep 5 $50.1 bln in July End of comment period for Tariffs of 25% on $200 bln of Chinese goods Sep 6 China threatens to retaliate in kind U.S. Midterm Elections Nov 6

2018 Fourth Quarter Outlook | 11 CURRENCY FORECASTS* Major Markets In US Dollar Terms Current Q4 2018 Q1 2019 Q2 2019 Q3 2019 1. 15 1. 12 1. 10 1.08 1. 10 Ye n 114 116 118 120 118 Sterling 1.30 1.28 1.26 1.24 1.22 Canadian $ 1.28 1.29 1.30 1.32 1.30 Australian $ 0.72 0.70 0.68 0.66 0.68 New Zealand $ 0.66 0.65 0.63 0.61 0.63 9.00 9.11 9.09 9.07 9.09 Norwegian 8.18 8.26 8.18 8.10 8.18 Swiss 0.98 1. 0 0 1.02 1.05 1.02 In EuroTerms Current Q4 2018 Q1 2019 Q2 2019 Q3 2019 Ye n 131 130 130 130 130 Sterling 0.89 0.88 0.87 0.87 0.90 Swiss 1. 13 1. 12 1. 12 1. 13 1. 12 Swedish Krona 10.39 10.20 10.00 9.80 10.00 9.44 9.25 9.00 8.75 9.00 Emerging Markets In US Dollar Terms Current Q4 2018 Q1 2019 Q2 2019 Q3 2019 Chinese Yuan 6.87 6.95 7.05 7. 1 5 7.05 Hong Kong $ 7.83 7.85 7.83 7.80 7.80 72.91 74.00 75.00 76.00 75.00 Korean Won 1119 1125 1150 1175 1150 15043 15250 15500 15750 15500 Malaysian Ringgit 4.14 4.20 4.25 4.30 4.25 Philippine Peso 54.32 55.00 56.00 57.00 56.00 1.37 1.40 1.42 1.45 1.40 New Taiwan $ 30.65 31.00 31.50 32.00 31.50 32.35 32.50 33.00 33.50 33.00 3.96 4.00 4.25 4.50 4.25 Mexican Peso 18.75 19.00 19.25 19.50 19.25 22.35 23.21 24.09 25.00 24.09 280 295 305 315 305 Polish Zloty 3.72 3.93 4.09 4.26 4.09 65.33 67.50 70.00 72.50 70.00 S. African Rand 14.35 14.50 15.00 15.50 15.00 Turkish 6.01 6.25 6.50 7. 0 0 6.50 Israeli Shekel 3.65 3.70 3.75 3.80 3.75 In EuroTerms Current Q4 2018 Q1 2019 Q2 2019 Q3 2019 Czech Koruna 25.78 26.00 26.50 27.00 26.50 Hungarian Forint 323 330 335 340 335 Polish Zloty 4.30 4.40 4.50 4.60 4.50 *There is no assurance that future forecasts will be attained.

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