Financial Markets

Highlights The sharp rally in Chinese developer stocks this year reflects a combination of the unwinding of "doomsday" bets and notable improvement in fundamentals rather than a bubble formation. The positive re-rating has further to run. Tighter policy imposed by local governments will probably keep developers in dormancy, but a major downturn is highly unlikely simply because there is not much excess to begin with. Urbanization still provides a powerful tailwind for residential construction from a long-term perspective. Chinese housing market will continue to experience cyclical swings, but the powerful structural tailwind will make the cyclical downturn shallow and fleeting. Feature Chart 1A Sharp Re-Rating Of Developer Stocks Chinese real estate developer stocks have more than doubled so far this year, making them the best performing sector in the investable universe - easily outpacing even the world-beating Chinese technology sector (Chart 1). The recent moves in developer stock prices have become parabolic, which combined with recent measures by some major cities to further tighten housing transactions raises the odds of profit-taking and a technical correction in the near term. However, the sharp rally since the beginning of the year has largely been a mean-reverting positive re-rating process rather than an overshoot. Moreover, the latest housing tightening measures are unlikely to have a long-lasting impact on housing demand. Therefore developer stocks should continue to advance after a period of consolidation. Beyond the cyclical horizon, residential development will remain a long-term growth driver for Chinese business activity. Positive Re-Rating Has Further To Run Chart 2Improvement In Developers' Fundamentals It is tempting to dismiss this year's sharp rally in developer stocks as a speculative frenzy, as the dramatic boom in stock price has been accompanied by cooling property sales and moderating home prices amid regulatory tightening in various cities. In our view, the sharp rally in property stocks has been a powerful positive re-rating in multiples after being deeply depressed for several consecutive years. The bottom panel of Chart 1 shows strong multiples expansion of developer stocks since the beginning of 2017. The message here is that China's cyclical improvement in the past two years has led to an aggressive repricing of Chinese equities, particularly in some of the hardest hit sectors. Investors' overwhelming bearishness towards China's macro situation in previous years took a heavy toll on Chinese investable stocks. The market had essentially priced in a chaotic hard-landing scenario, which is now being reversed due to growth improvement. In recent years we have consistently argued that the risk premium embedded in Chinese equities was exceptionally high and ultimately unsustainable, and one of our major investment themes has been a "positive re-rating in Chinese equities" - a view that has been quickly validated. Moreover, developers' stock prices have also reflected some notable improvements in earnings and balance sheet fundamentals, which can also be observed among their domestically listed peers (Chart 2): Deleveraging: The median liabilities-to-assets ratio of developers has dropped notably from the peak of 2015. Destocking: Developers have been focusing on selling inventories, and have been cautious on new projects. The median inventory-to-assets ratio has dropped from a peak of 63% in late 2015 to below 50% currently. Stronger cash positions: Aggressive de-stocking and conservative expansion have also significantly improved developers' cash flows. Cash position as a share of total assets has improved significantly, returning to the all-time highs reached in 2010. Total profits have also recovered strongly with strengthening margins.1 In short, the rally in developer stocks reflects a combination of the unwinding of "doomsday" bets and notable improvement in fundamentals rather than a bubble formation. There is little froth in the marketplace just yet. In fact, property stocks still remain quite cheap based on some conventional valuation indicators - even after this year's sharp rally. Property stocks are trading at 13 times trailing earnings and nine times forward earnings, and are still trading at hefty discounts to bottom-up net-asset-value (NAV) estimates. This means the bull market should have more legs in the coming months. Will Policy Constraints Lead To Another Major Downturn? Recent policy tightening on the residential market clearly creates some headwinds for the sector, and policy risk has been a key factor driving developer stock prices in previous tightening cycles. Historically, the government's tightening campaigns have typically restricted land supplies and bank credit to developers, and have been combined with tighter lending standards and higher interest rates for mortgage borrowers - and even outright bans on household investment demand for residential properties in major cities. In the current tightening cycle that began early last year, regulations on developers have remained largely unchanged, while the rein on households has been much tighter. Mortgage interest rates have also begun to inch higher (Chart 3). In the latest round of tightening measures announced late last week, eight major cities tightened controls on home sales, with a ban on reselling of homes within two to five years of purchase. The government's tightening measures have already led to a moderation in both home sales and prices, as shown in Chart 3, and the impact needs to be closely monitored. For now, our view is that policy constraints will not lead to major negative surprises both for developer stock prices and overall construction activity. On the demand side, household residential demand has been exceptionally strong of late. The central bank's most recent survey showed that a record high percentage of households intend to buy a home in the near future, a dramatic turnaround since the beginning of 2016 (Chart 4). The reason for the surge in home-buying intentions is not clear - we suspect it is the combination of pent-up demand accumulated in previous years and the herd-following mentality that typically follows a period of rapid increase in home prices. On the supply side, developers' inventory de-stocking and stronger cash positions have improved their ability to deal with sales slowdowns. In fact, home sales have significantly outpaced housing completions since 2015, leading to a sharp decline in inventories. Even including floor space under construction, the sellable inventories-to-sales ratio has dropped to its lowest level since 2010 (Chart 5). In our view, the sharp decline in inventories has been a key reason for the rampant increase in home prices since early last year. Chart 3Housing Market Has Been Moderating Chart 4Booming Demand For Home Purchases Taken together, with no inventory overhang and strong demand, we expect the impact of the current episode of housing tightening to be limited. In fact, real estate investment has been pretty subdued in recent years, despite surging home sales and improvement in business confidence among developers (Chart 6). Previous housing tightening measures were often implemented after a prolonged period of construction boom, leading to a sudden halt in investment and construction activity. This time around, tighter policy will probably keep developers in dormancy, but a major downturn is highly unlikely simply because there is not much excess to begin with. Chart 5Housing Destocking Becomes Advanced Chart 6Real Estate Investment Will Unlikely Slump Anew It's The Supply Side, Stupid! It appears that Chinese policymakers as well as global investors have perpetual fears of a "housing bubble" in China. The authorities are deeply worried about potential housing excesses and the negative impact on macro stability. Investors share similar concerns, and chronically worry about the global repercussions of a Chinese housing bust. Some have taken aggressive bets against Chinese developers and other asset classes that are leveraged on Chinese construction activity. While there are some idiosyncrasies in the motives of every tightening cycle in recent years, there is one common theme: the authorities' repeated attempts to cool off the housing sector are deeply rooted in the belief that both residential supplies and home prices were excessive, and therefore tighter controls on both supply and demand were warranted. Remarkably, concerns about housing excesses began to emerge almost immediately after the residential sector was privatized and a housing "market" began to develop in the early 2000s. In a special report dated April 29th 2004 titled, "What Housing Bubble?",2 I disputed for the first time the then-prevailing view on Chinese housing excesses. Fast forwarded 13 years and China's urban landscape has changed profoundly - yet the arguments for a "housing bubble" have remained essentially unchanged: speculative demand, excess supply, parabolic price increases and extreme unaffordability. To some China watchers, the housing sector's remarkable resilience despite repeated policy attacks from the early 2000s was simply an accumulation of a bigger accident waiting to eventually happen. In our analysis in recent years, we have repeatedly emphasized that the supply side shortages have been a key reason for the massive increase in Chinese home prices. While the government's various tightening measures to restrict speculators and cool off demand are well warranted, harsh supply side restrictions during various tightening campaigns have proven counterproductive, as they have amplified supply shortages, creating even more upward pressure on prices. Indeed, the supply-side restrictions are fairly easy to observe. China's leadership is fundamentally concerned about self-sufficiency of agricultural products, and therefore is reluctant to sacrifice farmland for urban development. Moreover, land supplies zoned for residential construction have accounted for an increasingly smaller share of total land supply, due to competition from infrastructure, industrial and commercial projects (Chart 7). Similarly, land purchased by developers plateaued in the early 2000s, and has dropped substantially in recent years. As a highly levered business by nature, developers have also been constantly challenged by limited access to bank loans due to regulatory restrictions. Loans to developers account for about 7% of banks' total loan book, largely unchanged in the past decade despite the massive construction boom. Tight credit controls have forced developers to other "shadow" financing options, which are both costlier and less reliable than formal bank loans, further limiting their ability to bring new housing projects to market. The prevailing heightened concerns on residential excesses and tougher regulations have pushed real estate companies to increasingly shift to commercial and industrial property development. Residential accounted for almost 80% of total real estate development in the early 2000s; the share has dropped to below 70% in recent years (Chart 8). Finally, the government's ill-informed judgement on the degree of excessive supply and speculative demand in the residential sector also prevented them from formulating a multi-tier residential market. Rental residential properties owned by professional institutional investors are rare, and "renters" often suffer discrimination for some public services, making homeownership essentially the only way for new families to establish themselves in urban areas. Chart 7Residential Land Supply Has Been Shrinking Chart 8Residential Construction's Dwindling Importance From a big-picture point of view, China is still in the midst of a spectacular urbanization process. Residential development is not only part of the growth process, but also an essential component to accommodating the massive increase in the urban population. Mainstream media often hype about "ghost towns" but ignore the fact that millions of young migrant workers still reside in dorm rooms provided by employers in sub-standard living conditions. Adjusting for the increase in the urban population, China's new residential construction in recent years has been a lot smaller than in other countries such as Japan and Korea at the prime stage of their respective urbanization process, according to our calculations (Chart 9) - likely the critical reason why Chinese home prices have remained stubbornly high, despite numerous rounds of government crackdowns. Chart 9China's Construction Boom In Perspective Since last year it appears the Chinese authorities have been paying more attention to increasing residential housing supply by providing more funding for social housing projects and shanty town reconstruction, as well as increasing land supply for residential projects. Meanwhile, there are recent proposals to develop rental markets in some major cities, allowing developers to build solely for rental, rather than for sales. In our view, policies boosting residential supplies will be a lot more effective in improving housing affordability for urban citizens. All in all, after the massive boom in recent years, home prices in certain major cities certainly feel a lot more "bubbly" than any time before, and it is easy to make a bearish structural case, as many have been doing over the past decade. However, urbanization still provides a powerful tailwind for residential construction from a long-term perspective. The Chinese housing market will continue to experience cyclical swings, but powerful structural tailwinds will make the cyclical downturn shallow and fleeting, as repeatedly demonstrated in previous policy tightening cycles. Looking forward, construction will remain an important growth driver for China for decades to come. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China: Earnings Scorecard And Market Tea Leaves", dated September 7, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Special Report, "What Housing Bubble?" dated April 29, 2004, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Special Report

Liquidity is the lifeblood of the economy and financial markets, but it is a slippery concept that means different things to different people. Liquidity falls into four categories: monetary, balance sheet, financial market transaction liquidity, and funding liquidity. Overall liquidity conditions are reasonably constructive for risk assets at the moment. Financial market and balance sheet liquidity are adequate. Monetary policy is extremely easy, although the low level of money and credit growth underscores that the credit channel of monetary policy is still somewhat impaired. Funding liquidity is as important as monetary liquidity for financial markets. It has recovered from the Great Financial Crisis (GFC) lows, but it is far from frothy. Unwinding the Fed's balance sheet represents a risk to investors because QE played such an important role in reducing risk premia in financial markets. The unwind should not affect transactions liquidity or balance sheet liquidity. It should not affect the broad monetary aggregates either. The bond market's reaction will be far more important than balance sheet shrinkage. As long as the Fed can limit the bond market damage via forward guidance, then funding liquidity should remain adequate and risk assets should take the Fed's unwind in stride. It will be a whole different story, however, if inflation lurches higher. The technical impact of balance sheet unwind on the inner workings of the credit market is very complicated. Asset sales could lead to a shortage of short-term high-quality assets, unless it is offset with increased T-bill issuance. However, a smaller balance sheet could, in fact, improve funding liquidity to the extent that it frees up space on banks' balance sheets. Liquidity has been an integral part of BCA's approach to financial markets going back to the early days of the company under the tutelage of Editor-in-Chief Hamilton Bolton from 1949 to 1968. Bolton was ahead of his time in terms of developing monetary indicators to forecast market trends. Back then, the focus was on bank flows such as the volume of checks cashed because capital markets were still developing and most credit flowed through the banking system. Times changed, monetary policy implementation evolved and financial markets became more important and sophisticated. When money targeting became popular among central banks in the 1970s, central bank liquidity analysis focused more on the broader monetary aggregates. These and other monetary data were used extensively by Anthony Boeckh, BCA's Editor-in-Chief from the 1968 to 2002, to forecast the economy and markets. He also highlighted the importance of balance sheet liquidity (holdings of liquid assets), and its interplay with rising debt levels. Martin Barnes continued with these themes when writing about the Debt Supercycle in the monthly Bank Credit Analyst. "Liquidity" is a slippery concept, and it means different things to different people. In this Special Report, we describe BCA's approach to liquidity and highlight its critical importance for financial markets. We provide a list of indicators to watch, and also outline how the pending shrinkage of the Fed's balance sheet could affect overall liquidity conditions. A Primer On Liquidity We believe there are four types of liquidity that are all interrelated: Central Bank Liquidity: Bank reserves lie at the heart of central bank liquidity. Reserves are under the direct control of the central bank, which are used as a tool to influence general monetary conditions in the economy. The latter are endogenous to the system and also depend on the private sector's desire to borrow, spend and hold cash. Bullish liquidity conditions are typically associated with plentiful bank reserves, low interest rates and strong growth in the monetary aggregates. Balance Sheet Liquidity: A high level of balance sheet liquidity means that plenty of short-term assets are available to meet emergencies. The desire of households, companies and institutional investors to build up balance sheet liquidity would normally increase when times are bad, and decline when confidence is high. Thus, one would expect strong economic growth to be associated with declining balance sheet liquidity, and vice versa when the economy is weak. Of course, deteriorating balance sheet liquidity during good times is a negative sign to the extent that households or business are caught in an illiquid state when the economy turns down, jobs are lost and loans are called. Financial Market Transaction Liquidity: This refers to the ability to make transactions in securities without triggering major changes in prices. Financial institutions provide market liquidity to securities markets through their trading activities. Funding Liquidity: The ability to borrow to fund positions in financial markets. Financial institutions provide funding liquidity to borrowers through their lending activities. The conditions under which these intermediaries can fund their own balance sheets, in turn, depend on the willingness of banks and the shadow banking system to interact with them. The BIS definition of funding liquidity is a broad concept that captures a wide range of channels. It includes the capacity of intermediaries that participate in the securitization chain to access the necessary funding to originate loans, to acquire loans for packaging into securities, and finance various kinds of guarantees. The availability and turnover of collateral for loans is also very important for generating funding liquidity, as we discuss below. These types of liquidity are interrelated in various ways, and can positively or negatively reinforce each other. It is the interaction of these factors that determines the economy's overall ease of financing. See Box II-1 for more details. BOX II-1 How Liquidity Is Inter-Related Central bank liquidity, which is exogenously determined, is the basis for private liquidity creation (the combination of market transaction and funding liquidity). The central bank determines the short-term risk-free rate and the official liquidity that is provided to the banking system. If the central bank hikes rates or provides less official liquidity, appetite for private lending begins to dry up. Private sector liquidity is thus heavily influenced by monetary policy, but can develop a life of its own, overshooting to the upside and downside with swings in investor confidence and risk tolerance. Financial market liquidity and funding liquidity are closely interrelated. When times are good, markets are liquid and funding liquidity is ample. But when risk tolerance takes a hit, a vicious circle between market transaction and funding liquidity develops. The BIS highlights the procyclical nature of private liquidity, which means that it tends to exhibit boom-bust cycles that generate credit excesses that are followed by busts.1 The Great Financial Crisis of 2008 is a perfect example. The Fed lifted the fed funds rate by 400 basis points between 2004 and 2006. Nonetheless, the outsized contraction in private liquidity, resulting from the plunge in asset prices related to U.S. mortgage debt, was a key driver of the crash in risk asset prices. Liquidity Indicators: What To Watch (1) Monetary Liquidity Key measures of central bank liquidity include the monetary base and the broad money aggregates, such as M1 and M2 (Chart II-1). Central banks control the amount of reserves in the banking system, which is part of base money, but they do not control the broad monetary aggregates. The latter is determined by the desire to hold cash and bank deposits, as well as the demand and supply of credit. Box II-2 provides some background on the monetary transmission process and quantitative easing. BOX II-2 The Monetary Transmission Process And Qe Before the Great Recession and Financial Crisis, the monetary authorities set the level of short-term interest rates through active management of the level of bank reserves. Reserves were drained as policy tightened, and were boosted when policies eased. The level of bank reserves affected banks' lending behavior, and shifts in interest rates affected the spending and investment decisions of consumers and businesses. Of course, it has been a different story since the financial crisis. Once short-term interest rates reached the zero bound, the Fed and some other central banks adopted "quantitative easing" programs designed to depress longer-term interest rates by aggressively buying bonds and thereby stuffing the banking system with an excessive amount of reserves. Many feared the onset of inflation when QE programs were first announced because investors worried that this would contribute to a massive increase in credit and the overall money supply. Indeed, there could have been hyper-inflation if banks had gone on a lending spree. But this never happened. Banks were constrained by insufficient capital ratios, loan losses and intense regulation, while consumers and businesses had no appetite for acquiring more debt. The result was that the money multiplier - the ratio of broad money to the monetary base - collapsed (top panel in Chart II-1). Bank lending standards eventually eased and credit demand recovered. Broad money growth has been volatile since 2007 but, despite quantitative easing, it has been roughly in line with the decade before. The broad aggregates lost much of their predictive power after the 1980s. Financial innovation, such as the use of debit cards and bank machines, changed the relationship between broad money on one hand, and the economy or financial markets on the other. Despite the structural changes in the economy, investors should still keep the monetary aggregates and the other monetary indicators discussed below in their toolbox. While the year-to-year wiggles in M2, for example, have not been good predictors of growth or inflation on a one or two year horizon, Chart II-2 shows that there is a long-term relationship between money and inflation when using decade averages. Chart II-1The Monetary Aggregates Chart II-2Long-Run Relationship Between M2 And Inflation Other monetary indicators to watch: M2 Divided By Nominal GDP (Chart II-3): When money growth exceeds that of nominal GDP, it could be interpreted as a signal that there is more than enough liquidity to facilitate economic activity. The excess is then available to purchase financial assets. Monetary Conditions Index (Chart II-3): This combines the level of interest rates and the change in the exchange rate into one indicator. The MCI has increased over the past year, indicating a tightening of monetary conditions, but is still very low by historical standards. Dollar Based Liquidity (Chart II-3): This includes Fed holdings of Treasurys and U.S. government securities held in custody for foreign official accounts. Foreign Exchange Reserves (Chart II-3): Central banks hold reserves in the form of gold, or cash and bonds denominated in foreign currencies. For example, when the People's Bank of China accumulates foreign exchange as part of its management of the RMB, it buys government bonds in other countries, thereby adding to liquidity globally. Interest Rates Minus Nominal GDP Growth (Chart II-4): Nominal GDP growth can be thought of as a proxy for the return on capital. If interest rates are below the return on capital, then there is an incentive for firms to borrow and invest. The opposite is true if interest rates are above GDP growth. Currently, short-term rates are well below nominal GDP, signaling that central bank liquidity is plentiful. Chart II-3Monetary Indicators (I) Chart II-4Monetary Indicators (II) (2) Balance Sheet Liquidity Chart II-5 presents the ratio of short-term assets to total liabilities for the corporate and household sectors. It is a measure of readily-available cash or cash-like instruments that make it easier to weather economic downturns and/or credit tightening phases. The non-financial corporate sector is in very good shape from this perspective. The seizure of the commercial paper market during the GFC encouraged firms to hold more liquid assets on the balance sheet. However, the uptrend began in the early 1990s and likely reflects tax avoidance efforts. Households are also highly liquid when short-term assets are compared to income. Liquidity as a share of total discretionary financial portfolios is low, but this is not surprising given extraordinarily unattractive interest rates. The banking system is being forced to hold more liquid assets under the new Liquidity Coverage Ratio requirement (Chart II-6). This is positive from the perspective of reducing systemic risk, but it has negative implications for funding liquidity, as we will discuss below. Chart II-5Balance Sheet Liquidity Chart II-6Bank Balance Sheet Liquidity (3) Financial Market Transaction Liquidity: Transactions volumes and bid-ask spreads are the main indicators to watch to gauge financial market transaction liquidity. There was a concern shortly after the GFC that the pullback in risk-taking by important market-makers could severely undermine market liquidity, leading to lower transaction volumes and wider bid-ask spreads. The focus of concern was largely on the corporate bond market given the sharply reduced footprint of investment banks. The Fed's data on primary dealer positioning in corporates shows a massive decline from the pre-crisis peak in 2007 (Chart II-7). This represents a decline from over 10% of market cap to only 0.3%. The smaller presence of dealers could create a liquidity problem for corporate debt, especially if market-making dealers fail to adequately match sellers with buyers during market downturns. Yet, as highlighted by BCA's Global Fixed Income Strategy team, corporate bond markets have functioned well since the dark days of the Lehman crisis.2 Reduced dealer presence has not resulted in any unusual widening of typical relationships like the basis between Credit Default Swaps and corporate bond spreads. Other market participants, such as Exchange Traded Funds, have taken up the slack. Daily trading volume as a percent of market cap has returned to pre-Lehman levels in the U.S. high-yield market, although this is not quite the case for the investment-grade market (Chart II-8). Chart II-7Less Market Making Chart II-8Corporate Bond Trading Volume That said, it is somewhat worrying that average trade sizes in corporates are smaller now compared to pre-crisis levels - perhaps as much as 20% smaller according to estimates by the New York Fed. This is likely the result of the reduced risk-taking by the dealers and the growing share of direct electronic trading. Thus, it may feel like liquidity is impaired since it now takes longer to execute a large bond trade, even though transaction costs for individual trades have not been increasing. The bottom line is that financial market liquidity is not as good as in the pre-Lehman years. This is not a problem at the moment, but there could be some dislocations in the fixed-income space during the next period of severe market stress when funding liquidity dries up. (3) Funding Liquidity: There are few direct measures of funding liquidity. Instead, one can look for its "footprint" or confirming evidence, such as total private sector credit. If credit is growing strongly, it is a sign that funding liquidity is ample. Box II-3 explains why international credit flows are also important to watch for signs of froth in lending. BOX II-3 The Importance Of International Credit Flows The BIS highlights that swings in international borrowing amplify domestic credit trends. Cross border lending tends to display even larger boom-bust cycles than domestic credit, as can be seen in the major advanced economies in the lead up to the GFC, as well as some Asian countries just before the Asian crisis in the late 1990s (Chart II-9). When times are good, banks and the shadow banking system draw heavily on cross-border sources of funds, such that international credit expansion tends to grow faster during boom periods than the credit granted domestically by banks located in the country. Since G4 financial systems intermediate a major share of global credit, funding conditions within the G4 affect funding conditions globally, as BIS research shows.3 This research also demonstrates that financial cycles have become more highly correlated across economies due to increased financial integration. Booms in credit inflows from abroad are also associated with a low level of the VIX, which is another sign of ample funding liquidity conditions (Chart II-10). These periods of excessive funding almost always end with a financial crisis and a spike in the VIX. Chart II-9International Credit Is Highly Cyclical Chart II-10International Credit Booms Lead Spikes In The VIX Other measures of funding liquidity to watch include: Chart II-11Market Measures Of Funding Liquidity Libor-OIS Spread (Chart II-11): This is a measure of perceived credit risk of LIBOR-panel banks. The spread tends to widen during periods of banking sector stress. Spreads are currently low by historical standards. However, libor will be phased out by 2021, such that a replacement for this benchmark rate will have to be found by then. Bond-CDS Basis (Chart II-11): The basis is roughly the average difference between each bond's yield spread to Treasurys and the cost of insuring the bond in the CDS market. Arbitrage should keep these two spreads closely aligned, but increases in funding costs tied to balance sheet constraints during periods of market stress affect this arbitrage opportunity, allowing the two spreads to diverge. The U.S. high-yield or investment grade bond markets are a good bellweather, and at the moment they indicate relatively good funding liquidity. FX Basis Swap (Chart II-11): This is analogous to the bond-CDS basis. It reflects the cost of hedging currencies, which is critically important for international investors and lending institutions. The basis swap widens when there is financial stress, reflecting a pullback in funding liquidity related to currencies. The FX swap basis widened during the GFC and, unlike other spreads, has not returned to pre-Lehman levels (see below). Bank Leverage Ratios (Chart II-12): The ratio of loans to deposits is a measure of leverage in the banking system. Banks boost leverage during boom times and thereby provide more loans and funding liquidity to buy securities. In the U.S., this ratio has plunged since 2007 and shows no sign of turning up. Primary Dealers Securities Lending (Chart II-13): This is a direct measure of funding liquidity. Primary dealers make loans to other financial institutions with the purpose of buying securities, thereby providing both funding liquidity and market liquidity. Historically, shifts in dealer lending have been correlated with bid-ask spreads in the Treasury market. Securities lending is also correlated with the S&P 500, although it does not tend to lead the stock market. Dealer loans soared prior to 2007, before collapsing in 2008. Total loans have recovered, but have not reached pre-crisis highs, consistent with stricter regulations that forced the deleveraging of dealer balance sheets. Chart II-12U.S. Bank Leverage Chart II-13Securities Lending And Margin Debt NYSE Margin Debt (Chart II-13): Another direct measure of funding liquidity. The uptrend in recent years has been steep, although it is less impressive when expressed relative to market cap. Bank Lending Standards (Chart II-14): These surveys reflect bank lending standards for standard loans to the household or corporate sectors, but their appetite for lending for the purposes of securities purchases is no doubt highly correlated. Lending standards tightened in 2016 due to the collapse in oil prices, but they have started to ease again this year. Table II-1 provides a handy list of liquidity indicators split into our four categories. Taking all of these indicators into consideration, we would characterize liquidity conditions in the U.S. as fairly accommodative, although not nearly as abundant as the period just prior to the Lehman event. Monetary conditions are super easy, while balance sheet and financial market liquidity are reasonably constructive. In contrast, funding liquidity, while vastly improved since the GFC, is still a long way from the pre-Lehman go-go years according to several important indicators such as bank leverage. Moreover, the Fed is set to begin the process of unwinding the massive amount of monetary liquidity provided by its quantitative easing program. Chart II-14Bank Lending Standards Table II-1Liquidity Indicators To Watch Fed Balance Sheet Shrinkage: What Impact On Liquidity? Given that the era of quantitative easing has been a positive one for risk assets, it is unsurprising that investors are concerned about the looming unwind of the Fed's massive balance sheet. For example, Chart II-15 demonstrates the correlation between the change in G4 balances sheets and both the stock market and excess returns in the U.S. high-yield market. Chart II-16 presents our forecast for how quickly the Fed's balance sheet will contract. Following last week's FOMC meeting we learned that balance sheet reduction will begin October 1. For the first three months the Fed will allow a maximum of $6 billion in Treasurys and $4 billion in MBS to run off each month. Those caps will increase in steps of $6 billion and $4 billion, respectively, every three months until they level off at $30 billion per month for Treasurys and $20 billion per month for MBS. Chart II-15G4 Central Bank Balance Sheets Chart II-16Fed Balance Sheet We have received no official guidance on the level of bank reserves the Fed will target for the end of the run-off process. However, New York Fed President William Dudley recently recommended that this level should be higher than during the pre-QE period, and should probably fall in the $400 billion to $1 trillion range.4 In our forecasts we assume that bank reserves will level-off once they reach $650 billion. In that scenario the Fed's balance sheet will shrink by roughly $1.4 trillion by 2021. The level of excess reserves in the banking system will decline by a somewhat larger amount ($1.75 trillion). In terms of the impact of balance sheet shrinkage on overall liquidity conditions, it is useful to think about the four categories of liquidity described above. (1) Monetary Liquidity The re-absorption of excess reserves will mean that base money will contract (i.e. the sum of bank reserves held at the Fed and currency in circulation). However, we do not expect this to have a noticeable impact on the broader monetary aggregates, credit growth, the economy or inflation, outside of any effect it might have on the term premium in the bond market. The reasoning is that all those excess reserves did not have a major impact on growth and inflation when they were created in the first place. This was because the credit channel of monetary policy was blocked by a lack of demand (private sector deleveraging) and limited bank lending capacity (partly due to regulation). Banks were also less inclined to lend due to rising loan losses. Removing the excess reserves should have little effect on banks' willingness or ability to make new loans. In terms of asset prices, some investors believe that when the excess reserves were created, a portion of it found its way out of the banking system and was used to buy assets directly. That is not the case. The excess reserves were left idle, sitting on deposit at the Fed. They did not "leak" out and were not used to purchase assets. Thus, fewer excess bank reserves do not imply any forced selling. Nonetheless, the QE program certainly affected asset prices indirectly via the portfolio balance effect. Asset purchases supported both the economy and risk assets in part via a weaker dollar and to the extent that the policy lifted confidence in the system. But most importantly, QE depressed long-term interest rates, which are used to discount cash flows when valuing financial assets. QE boosted risk-seeking behavior and the search for yield, partly through the signaling mechanism that convinced investors that short-term rates would stay depressed for a long time. The result was a decline in measures of market implied volatility, such as the MOVE and VIX indexes. Could Bond Yields Spike? The risk is that the portfolio balance effect goes into reverse as the Fed unwinds the asset purchases. The negative impact on risk assets will depend importantly on the bond market's response. As highlighted in the Overview section, there will be a sharp swing in the flow of G4 government bonds available to the private sector, from a contraction of US$600 billion in 2017 to an increase of US$200 billion in 2018. Focusing on the U.S. market, empirical estimates suggest that the Fed's shedding of Treasurys could boost the 10-year yield by about 80 basis points because the private sector will require a higher term premium to absorb the higher flow of bonds. However, the impact on yields is likely to be tempered by two factors: Banks are required by regulators to hold more high-quality assets than they did in the pre-Lehman years in order to meet the new Liquidity Coverage Ratio. The BCA U.S. Bond Strategy service argues that growing bank demand for Treasurys in the coming years will absorb much of the net flow of Treasurys that the Fed is no longer buying.5 As the FOMC dials back monetary stimulus it will be concerned with overall monetary conditions, including short-term rates, long-term rates and the dollar. If long-term rates and/or the dollar rise too quickly, policymakers will moderate the pace of rate hikes and use forward guidance to talk down the long end of the curve so as to avoid allowing financial conditions to tighten too quickly. Thus, the path of short-term rates is dependent on the dollar and the reaction of the long end of the curve. It is difficult to estimate how it will shake out, but the point is that forward guidance will help to limit the impact of the shrinking Fed balance sheet on bond yields. Indeed, the Fed is trying hard to sever the link in investors' minds between balance sheet policy and signaling about future rate hikes, as highlighted by Chair Yellen's Q&A session following the September FOMC meeting. The bottom line is that the impact on monetary liquidity of a smaller Fed balance sheet should be minimal, although long-term bond yields will be marginally higher as a result. That said, much depends on inflation. If the core PCE inflation rate were to suddenly shift up to the 2% target or above, then bond prices will be hit hard, the VIX will surge and risk assets will sustain some damage. The prospect of a more aggressive pace of monetary tightening would undermine funding liquidity, compounding the negative impact on risk assets. (2) Funding Liquidity Chart II-17Tri-Party Repo Market Has Shrunk By unwinding its balance sheet, the Fed will be supplying securities into the market and removing cash. This will be occurring at a time when transactions in the tri-party repo market have fallen to less than half of their peak in 2007 due to stricter regulation (Chart II-17). This market has historically been an important source of short-term funding, helping to meet the secular rise in demand for short-term, low-risk instruments, largely from non-financial corporations, asset managers and foreign exchange reserve funds. If the Fed drains reserves from the system and T-bill issuance does not increase substantially to compensate, a supply shortage of short-maturity instruments could develop. We can see how this might undermine the Fed's ability to shift short-term interest rates higher under its new system of interest rate management, where reverse repos and the interest rate paid on reserves set the floor for other short-term interest rates. However, at the moment we do not see the risk that fewer excess reserves on its own will negatively affect funding liquidity. Again, any impact on funding liquidity would likely be felt via a sharp rise in interest rates and pullback in the portfolio balance effect, which would occur if inflation turns up. But this has more to do with rising interest rates than the size of the Fed's balance sheet. Indeed, balance sheet shrinkage could actually improve funding liquidity provided via the bilateral repo market, securities-lending, derivatives and prime brokerage channels. These are important players in the collateral supply chain. A recent IMF working paper emphasizes that collateral flows are just as important in credit creation as money itself.6 Collateral refers to financial instruments that are used as collateral to fund positions, which can be cash or cash-like equivalents. Since pledged collateral can be reused over and over, it can generate significantly more total lending than the value of the collateral itself. The Fed's overnight reverse-repo facility includes restrictions that the collateral accessed from its balance sheet can only be used in the tri-party repo system. Thus, the Fed's presence in the collateral market has reduced the "velocity of collateral." Table II-2 shows that the reuse rate of collateral, or its velocity, has fallen from 3.0 in 2007 to 1.8 in 2015. Table II-2Collateral Velocity The combination of tighter capital regulations and Fed asset purchases has severely limited the available space on bank balance sheets to provide funding liquidity. Regulations force banks to carry more capital for a given level of assets. Fed asset purchases have forced a large portion of those assets to be held as reserves, limiting banks' activity in the bilateral repo market. There is much uncertainty surrounding this issue, but it appears that an unwind the Fed's balance sheet will free up some space on bank balance sheets, possibly permitting more bilateral repo activity and thus a higher rate of collateral velocity. It may also relieve concerns about a shortage of safe-haven assets. Nonetheless, we probably will not see a return of collateral velocity to 2007 levels because stricter capital regulations will still be in place. What About Currency Swaps? Some have argued that this removal of cash could also lead to an appreciation of the U.S. dollar. In particular, Zoltan Pozsar of Credit Suisse has observed a correlation between U.S. bank reserves and FX basis swap spreads.7 There is also a strong correlation between FX swap spreads and the U.S. dollar (Chart II-18). Chart II-18FX Basis Swap And Reserves One possible chain of events is that, as the Fed drains cash from the market, there will be less liquidity in the FX swap market. Basis swap spreads will widen as a result, and this will cause the dollar to appreciate. In this framework, the unwinding of the Fed's balance sheet will put upward pressure on the U.S. dollar. However, it is also possible that the chain of causation runs in the other direction. The BIS has proposed a model8 where a stronger dollar weakens the capital positions of bank balance sheets. This causes them to back away from providing liquidity to the FX swap market, leading to wider basis swap spreads. In this model, a strong dollar leads to wider basis swap spreads and not the reverse. If this is the correct direction of causation, then we should not expect any impact on the dollar from the unwinding of the Fed's balance sheet. At the moment it is impossible to tell which of the above two theories is correct. All we can do is monitor the correlation between reserves, FX basis swap spreads and the dollar going forward. Conclusions: Overall liquidity conditions are reasonably constructive for risk assets at the moment. Financial market and balance sheet liquidity are adequate. Monetary policy is extremely easy, although the low level of money and credit growth underscores that the credit channel of monetary policy is still somewhat impaired and/or constrained relative to the pre-Lehman years. Funding liquidity has recovered from the Great Financial Crisis lows, but it is far from frothy. More intense regulation means that funding liquidity will probably never again be as favorable for risk assets as it was before the crisis. But, hopefully, efforts by the authorities to reduce perceived systemic risk mean that funding liquidity may not be as quick to dry up as was the case in 2008, in the event of another negative shock. Unwinding the Fed's balance sheet represents a risk to investors because QE played such an important role in reducing risk premia in financial markets. However, we believe that the bond market's reaction will be far more important than balance sheet shrinkage. As long as the Fed can limit the bond market damage via forward guidance, then risk assets should take the Fed's unwind in stride. It will be a whole different story, however, if inflation lurches higher. The technical impact of balance sheet unwind on the inner workings of the credit market is very complicated and difficult to forecast. Asset sales could lead to a shortage of short-term high-quality assets. However, this is more a problem in terms of the Fed's ability to raise interest rates than for funding liquidity. A smaller balance sheet could, in fact, improve funding liquidity to the extent that it frees up space on banks' balance sheets. Mark McClellan Senior Vice President The Bank Credit Analyst Ryan Swift Vice President U.S. Bond Strategy 1 D. Domanski, I. Fender and P. McGuire, "Assessing Global Liquidity," BIS Quarterly Review (December 2011). 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Global Interest Rate Strategy For The Remainder Of 2017," dated July 18, 2017, available at gfis.bcaresearch.com 3 E. Cerutti, S. Claessens and L. Ratnovski, "A Primer on 'Global Liquidity'," CEPR Policy Portal (June 8, 2014). 4 William C. Dudley, "The U.S. Economic Outlook and the Implications for Monetary Policy," Federal Reserve Bank of New York (September 07, 2017). 5 Please see BCA U.S. Bond Strategy Weekly Report, "The Great Unwind," dated September 19, 2017, available at usbs.bcaresearch.com 6 M. Singh, "Collateral Reuse and Balance Sheet Space," IMF Working Paper (May 2017). 7 Alexandra Scaggs, "Where would you prefer your balance sheet: Banks, or the Federal Reserve?" Financial Times Alphaville (April 13, 2017). 8 S. Avdjiev, W. Du, C. Koch, and Hyun S.Shin, "The dollar, bank leverage and the deviation from covered interest parity," BIS Working Papers No.592 (Revised July 2017).

Highlights We highlighted last month that investors should remain slightly overweight risk assets, but should also hold safe havens given the preponderance of risks. Some of the risks have since faded and the sweet spot for equities is continuing, but the potential for a correction remains elevated. Geopolitics will no doubt remain a threat for 'risk on' trades, although we may be at peak tensions with respect to North Korea. Our models point to an acceleration in growth in the major economies. Our capital spending indicators suggest that animal spirits are stirring in the business sector. In the U.S., fiscal stimulus is back on the table and investors are looking beyond the negative short-term impact of the hurricanes to the growth-enhancing rebuilding that will follow. It is also positive for the stock-to-bond return ratio that our bullish oil scenario is playing out. Stay long oil-related plays. There is a good chance that this year's downtrend in the dollar and government bond yields is over. The rise in both may be halting, but the risks are to the upside now that disappointments on U.S. growth and inflation have likely ended (notwithstanding the hurricane-distorted economic data in the near term). The Phillips curve is not dead. We do not expect Fed balance sheet normalization on its own to be a major headwind for risk assets. The bigger threat is a sudden and sharp re-assessment of the outlook for interest rates in the major countries. Our base-case view is that inflation will only grind higher in the major countries. It should be slow enough that the associated backup in bond yields does not derail the rally in risk assets, but the danger of a sharper bond market adjustment means that investors should continue to be on the conservative side. Feature It was 'risk on' in financial markets in September, despite a less dovish tone among the major central banks. The reason is that the synchronized global growth outlook continues to gather momentum, supporting the earnings backdrop, but inflation remains dormant in the major countries outside of the U.K. Investors believe that calm inflation readings will allow central banks to proceed cautiously and avoid taking risks with growth, extending the expansion in GDP and earnings. The North Korean situation changes from day to day, but investors appear to be more comfortable with it at the margin. In the U.S., fiscal stimulus is back on the table and investors are looking beyond the negative short-term impact of the hurricanes to the growth-enhancing rebuilding that will follow. Finally, rising oil prices will lift earnings in the energy patch. These developments spurred investors to embrace risk assets and carry trades again in September. However, value is poor and signs of froth are accumulating. For example, equity investors are employing record amounts of margin debt to lever up investments. The Bank for International Settlements highlighted in its Quarterly Review that margin debt outstanding in 2015 was higher than during the dotcom boom (and it has surely increased since then). The global volume of outstanding leveraged loans continues to set new highs even as covenant standards slip. Risk assets are being supported by a three-legged stool: solid earnings growth, low bond yields and depressed bond market volatility. The latter is a reflection of current market expectations that dormant inflation will continue to constrain central bankers. We agree that the economic growth and earnings outlook is positive on a 6-12 month horizon. The main item that could upset the sweet spot for risk assets, outside of a geopolitical event, is an awakening in inflation. This would shatter the consensus view that the bond market will remain well behaved. Markets are priced for little change in the inflation backdrop even in the long term. Our base-case view is that inflation will grind higher in the major countries, although it should be slow enough that the associated backup in bond yields does not derail the rally in risk assets in the next 6-12 months. But the risk of a sharper bond market adjustment means that investors should continue to be conservative (although slightly tilted to risk-over-safety). Getting Used To North Korea It appears that investors are becoming increasingly desensitized to provocation from the rogue state. Our geopolitical experts argued that the risk of a full-out war with the U.S. was less than 10%, but they warned that there could be a market-rattling political crisis or even a military skirmish before Pyongyang returned to the negotiating table. However, we may be at peak tensions now, based on several key developments over the past month. First, both China and Russia, two North Korean allies, have turned up the pressure. China appears to be enforcing sanctions according to Chinese trade data vis-à-vis North Korea (Chart I-1). Both China and Russia have also agreed to reduce fuel supplies. And there is evidence that U.S. and North Korea have held unofficial diplomatic talks behind the scenes. The implication is that North Korea is responding to pressure now that its critical fuel supplies are at risk. Chart I-1China Getting Tougher With NK We cannot rule out more goading from Kim Jong Un, especially with a busy political calendar in Asia this fall: the Korean Worker's Party's anniversary on October 10, the Chinese midterm leadership reshuffle on October 11-25, Japanese elections on October 22, and Trump's visit to the region in mid-November. Nevertheless, it would require a major provocation (i.e. a direct attack on the U.S. or its allies) for Pyongyang to escalate tensions from current levels. This would require the North to be very reckless with its own strategic assets, given that the U.S. would likely conduct a proportional retaliation against any serious attack. The recent backup in Treasury yields and yen pullback suggest that investors do not think tensions will escalate that far. We agree, but obviously the situation is fluid. Trump Trades Back In Play? U.S. politics have also become more equity-friendly and bond-bearish at the margin. The risk of a debt ceiling standoff has been delayed until December following President Trump's deal with the Democrats. We do not think that this represents a radical shift toward bipartisanship, but it is warning from the President that the GOP had better get cracking on tax legislation. The House Budget committee passed a FY2018 budget resolution in late July that included "reconciliation instructions" for tax legislation. Such a budget resolution approved by the Congress as a whole would allow for tax cuts that are not fully offset by spending cuts, with the proviso that the tax reductions sunset after a defined number of years. It is difficult to see tax legislation being passed before year end, but the first quarter of 2018 is certainly possible. Markets will begin to price in the legislation well before it is passed, which means that the so-called Trump trades are likely to see a revival. In particular, the legislation should favor small caps and boost the dollar. This year's devastating hurricane activity will also lift U.S. growth in 2018. History shows that natural disasters have only a passing effect on the U.S. economy and financial markets. Following the short-term negative economic impact, rebuilding adds to growth with the Federal government footing part of the bill. A 2016 Congressional Budget Office (CBO) report found that federal spending after major hurricanes can add as much as 0.6% to GDP. CBO notes that the lion's share of the economic impact is in the first year after a storm, with most of those expenditures helping victims to obtain food and shelter, fund search and rescue operations, and protect critical infrastructure. Federal outlays for public infrastructure occur after the first year and provide a much smaller lift to GDP (Chart I-2). Chart I-2Federal Government Outlays For Hurricane Relief Oil: Inventories Are Correcting Chart I-3Oil Inventory Correction To Lift Prices It is also positive for the stock-to-bond return ratio that our bullish oil scenario is playing out. Our energy strategists highlight that global oil demand is booming, at a time when the U.S. Energy Information Administration (EIA) lowered its estimated shale oil output by 200,000 bpd for the third quarter. This confirms our contention that the EIA has overestimated the pace of the shale production response during 2017. Taken together, these factors helped to improve the global net demand/supply balance by 600,000 bpd. The drawdown in global oil inventories is thus likely to continue (Chart I-3). Looking to next year, crude prices could go even higher with an extension of the OPEC/Russian production cuts beyond March 2018 and continued strong growth in global oil demand. The synchronized global expansion is reflected in rising oil demand from all parts of the world. Soft Industrial Production Readings Won't Last We have highlighted global and regional industrial production as important indicators of both economic growth corporate earnings. It is therefore a little disconcerting that our aggregate for industrial production in the advanced economies has suddenly lost momentum (Chart I-4). We are inclined to fade the recent softening for a few reasons. First, much of it is due to weakness in the U.S. where hurricanes affected the August figures. Second, most of our leading indicators remain very constructive. Chart I-5 present a simple model for real GDP growth for the G4 economies based on our consumer and capital spending indicators. Real GDP growth will continue to accelerate for the G4 economies as a group according to the model. Our aggregate consumer indicator appears to have peaked at a high level, but the capex indicator is blasting off. The bullish capital spending reading is unanimous across the major economies (Chart I-6). Chart I-4Animal Spirits Are Stirring... Chart I-5...Contributing To Stronger G4 Economic Growth Chart I-6Capital Goods Indicators Are Surging The Eurozone is particularly strong on both the consumer and business fronts, suggesting that euro strength has not undermined growth. Conversely, the U.K. is at the weak end of the spectrum based on the drop in its consumer spending indicator. This is the main reason why we do not believe the Bank of England will be able to make good on its warning of a rate hike this year (see below). Robust capital goods imports for our 20-country aggregate supports the view that animal spirits are stirring in boardrooms in the advanced economies (Chart I-4, third panel). These imports and our capital spending indicators suggest that the small pullback in advanced-economy industrial production will not last, purchasing managers' indexes will remain elevated, and the acceleration in global export activity is just getting started. Even U.S. small business sector has shifted into a higher gear in terms of hiring and capital spending according to the NFIB survey. These trends will favor industrial stocks, especially versus utilities. Central Banks Shedding Dovish Feathers The synchronized global growth pickup is also reflected in our Central Bank Monitors, which are all near or above the zero line (Chart I-7). The Monitors gauge pressure on central banks to adjust policy. Current readings are consistent with the relatively more hawkish tone by central bankers in Canada, the U.S., the Eurozone and the U.K. Chart I-7Central Bank Monitors Support Less Dovish Policymakers The violent reaction in the gilt market to the Bank of England's hint that it could hike rates in the next few months highlights the vulnerability of bond markets to any shift by central bankers in a less dovish direction. In this case, we do not believe the BoE will be able to follow through with its rate hike plan. The leading economic indicators are softening and inflation is about to roll over now that the pound has bottomed. In contrast, bunds are quite vulnerable to a more hawkish tilt at the European Central Bank (ECB). Eurozone policymakers confirmed at their September meeting that they plan to announce in October a reduction in the asset purchase program, to take effect in 2018. The ECB revised up its growth forecast for 2017, and left the subsequent two years unchanged. The inflation forecast was trimmed by 0.1 percentage points in 2018 and 2019. The fact that this year's surge in the euro was not enough to move the needle much on the ECB's projections speaks volumes about the central bank's confidence in the current European economic expansion, as well as its comfort level with the rising currency. Our fixed income strategists believe that the full extent of ECB tapering is not yet fully discounted in the European bond market. Phillips Curve: It's Not Dead, Just Resting Chart I-8U.S. Inflation Turning to the Fed, the bond market did not get the dovish tone it was expecting from September's FOMC meeting. Policymakers left a December rate hike on the table, as Chair Yellen downplayed this year's lagging inflation data as well as the impact of the hurricanes on the economy. Not surprisingly, the odds of a December rate hike have since jumped to 70%. The Fed announced its plan to begin shrinking its balance sheet beginning in October. In the press conference, Yellen tried to disassociate balance sheet policy from the rate outlook. Balance sheet adjustment will be on autopilot, such that short-term interest rates will be the Fed's main policy instrument going forward. While the Fed plans to deliver another rate increase in December, it will require at least a small rise in inflation. Policymakers were no doubt pleased that annual CPI core inflation edged up in August and the 3-month rate of change has moved back to 2% (Chart I-8). The CPI diffusion index also moved above the zero line, indicating that the soft patch in the inflation data may be over, although the diffusion index for the PCE inflation data fell back to the zero line. Table I-1 presents the major contributors to the 0.9 percentage point decline in the year-over-year headline CPI inflation rate since February. Energy accounts for the majority of the decline, at 0.6 percentage points. New cars, shelter, medical services and wireless telephone services account for the remainder. The deflationary wireless price effect is now unwinding, but medical services is a wildcard and our shelter model suggests that this large part of the CPI index will probably not help to lift inflation this year. Thus, higher inflation must come largely from non-shelter core services, which is the component most closely correlated with wages. Investors remain unconvinced by Yellen's assertion that the soft patch in the inflation data reflects transitory factors. Indeed, market-based long-term inflation expectations remain well below the Fed's target, and they even fell a little following the FOMC meeting. Table I-1Contribution To Change In Headline ##br##Inflation (February -August, 2017) One FOMC member is becoming increasingly alarmed by the market's disbelief that the Fed will hit the 2% target even in the long run (Chart I-9). In a recent speech, Governor Brainard noted that both market-based and survey evidence on inflation expectations have drifted lower in the post-Lehman years. More recently, long-term inflation breakeven rates and CPI swaps have been surprisingly sticky in the face of the rebound in oil prices. In the Fed's view, monetary policy can be used effectively in response to shifts in the cyclical drivers of inflation. However, if inflation expectations were to become unanchored, then inflation's long-run trend would be altered and monetary policy would become less effective. Japan is a glaring example of what could be the endpoint. Brainard's fears have not yet affected the FOMC consensus, which is loath to throw the Phillips curve model into the dust bin just yet. We agree that the Phillips curve is not dead. Peter Berezin, Chief Strategist for the BCA Global Investment Strategy Service, argued in a recent Special Report that the often-cited reasons for why the Phillips curve has become defunct - decreased union bargaining power, a more globalized economy, and technological trends - are less convincing than they appear. The Fed simply has to be patient because the U.S. is only now reaching the kinked part of the Phillips Curve (Chart I-10). Chart I-9Worrying Trends For The FOMC Chart I-10U.S. Wage Growth Accelerates Once The Unemployment Rate Falls Below 5% (1997-2017) Moreover, our global fixed income team has made the case that the global output gap must be taken into consideration.1 Chart I-11 presents the percentage of OECD economies that have an unemployment rate below the NAIRU rate, along with inflation in the services and goods sectors of the developed markets. While the correlation between this global NAIRU indicator and realized inflation rates declined in the years after the recession, the linkages have improved over the past couple of years. The fact that the global NAIRU indicator is only now back to pre-Lehman levels suggests that inflationary pressure could finally be near an inflection point. Market expectations for the path of real GDP growth and the unemployment rate are roughly in line with the FOMC's central tendency forecast. However, the wide gulf between the FOMC and the market on the path of interest rates remains a potential catalyst for a correction in risk assets if market rates ratchet higher. Fed balance sheet runoff could also be problematic in this regard. QE Unwind: How Much Of A Risk? Many investors equate the surge in asset prices in the years after the Great Financial Crisis with central bank largesse. Won't a reversal of this policy be negative for both bonds and stocks? Fed balance sheet runoff, together with ECB tapering and less buying by the Bank of Japan, will certainly change the supply/demand backdrop for the G4 government bond markets in 2018. We have updated our projection for the net flow of government bonds available to the private sector, taking into consideration the supply that is absorbed by central banks and other official institutions (Chart I-12). The top panel shows that the net supply of Treasurys to the private sector never contracted in recent years, but the bottom panel highlights that the net supply of G4 government bonds as a group was negative for 2015, 2016 and 2017. Central banks and other official buyers had to bid-away bonds from the private sector during these years. Chart I-11Global Slack Matters Chart I-12Major Swing In Government ##br##Bond Supply In 2018 We project that the net supply will swing from a contraction of almost $600 billion in 2017 to a positive net flow of almost US$200 billion next year. The Fed's projected runoff accounts for most of the swing. The supply/demand effect might push up term premia a little. Nonetheless, as discussed in this month's Special Report beginning on page 19, the balance sheet unwind is not the key threat to bonds and stocks. Rather, the main risk is the overly benign central bank outlook that is priced into the bond market. Real 5-year bond yields, five years forward, are still extremely depressed because the market has discounted negative real short-term interest rates out to 2022 in the U.S. and 2026 in the Eurozone (Chart I-13). Chart I-13Real Forward Short-Term Rates Time For The Nikkei To Shine Equity bourses took September's backup in bond yields in stride. Indeed, the S&P 500 and Nikkei broke to new highs during the month. The Euro Stoxx 50 also sprang to life, although has not yet reached fresh highs in local currency terms. The solid earnings backdrop remains a key support for the market. We highlighted our EPS forecasts in last month's report. Nothing of significance has changed on this front. The latest data suggest that operating margins may be peaking, but the diffusion index does not suggest an imminent decline (Chart I-14). Meanwhile, our upbeat economic assessment discussed above means that top line expansion should keep EPS growing solidly into the first half of 2018 at the global level. EPS growth will likely decelerate toward the end of next year to mid-single digits. Chart I-14Operating Margins Approaching A Peak? We still see a case for the Nikkei to outperform the S&P 500, at least in local currencies. Japan is on the cheap side according to our top-down indicator (Chart I-15). Japanese earnings are highly geared to economic growth at home and abroad. Japanese EPS is in an uptrend versus the U.S. in both local and common currencies (Chart I-16). We do not expect to see a peak in EPS growth until mid-2018, a good six months after the expected top in the U.S. Moreover, an Abe win in the October 22 election would mean that policy will remain highly reflationary in absolute terms and relative to the U.S. Chart I-15Valuation: Japan Cheap To The U.S., But Not Europe Chart I-16Japanese Earnings Outperforming The U.S. European stocks are a tougher call. On the plus side, the economy is flying high and there are no warning signs that this is about to end. There is hope for structural reform in France after Macron's election win this year. We give Macron's proposed labor market reforms high marks because they compare favorably with those of Spain and Germany, which helped to diminish structural unemployment in those two countries. Many doubt that Macron's reforms will see the light of day, but our geopolitical team believes that investors are underestimating the chances. The German election in September poured cold water on recent enthusiasm regarding accelerated European integration. This is because Merkel will likely have to deal with a larger contingent of Euroskeptics in the grand coalition that emerges in the coming months. However, we do not expect political developments in Germany to be a headwind for the Eurozone stock market. On the negative side, European stocks do not appear cheap to the U.S. after adjusting for the structural discount (Chart I-15). Moreover, this year's euro bull phase will take a bite out of earnings. As noted in last month's Overview, euro strength so far this year will lop three to four percentage points off of EPS growth by the middle of next year. Our model suggests that this will be overwhelmed by the robust economic expansion at home and abroad, but profit growth could fall to 5%, which is likely to be well short of that in the U.S. and Japan (local currency). Still, a lot of the negative impact of the currency on profits may already be discounted as forward earnings have been revised down. On balance, we remain overweight European stocks versus the U.S. (currency hedged). However, it appears that Japan has more latitude to outperform. Dollar: Finally Finding A Floor? Chart I-17Has The Dollar Found Bottom? The Fed's determination to stick with the 'dot plot' may have finally placed a floor under the dollar. Before the September FOMC meeting, the market had all but priced out any rate hikes between now and the end of 2018. Both the U.S. economic surprise index and the inflation surprise index have turned up relative to the G10 (Chart I-17). The dollar has more upside if we are past the period of maximum bond market strength and moving into in a window in which U.S. economic and inflation surprises will 'catch up' with the other major economies. Technically, investors appear to be quite short the dollar, especially versus the euro. Bullish sentiment on the euro is highlighted by the fact that the currency has deviated substantially from the interest rate parity relationship. Euro positioning is thus bullish the dollar from a contrary perspective. Nonetheless, our currency experts are more bullish the dollar versus the yen. Given that inflation expectations have softened in Japan and wage growth is still lacking, the Bank of Japan will have to stick with its zero percent 10-year JGB target. The yen will be forced lower versus the dollar as the U.S. yield curve shifts up. We also like the loonie. The Bank of Canada (BoC) pulled the trigger in September for the second time this year, lifting the overnight rate to 1%. Policymakers gave themselves some "wiggle room" on the outlook, but more tightening is on the way barring a significant slowdown in growth, another spike in the C$, or a housing meltdown. The statement said that the loonie's rise partly reflected the relative strength of the Canadian economy, which implies that it is justified by the fundamentals. It does not appear that the C$ has reached a "choke point" in the eyes of the central bank. Investment Conclusions: We highlighted in our last issue that investors should remain slightly overweight risk assets, but should also hold safe haven assets given the preponderance of risks. Some of the risks have since faded and the sweet spot for risk assets is continuing. We remain upbeat on global economic growth and earnings. Nonetheless, both stocks and bonds remain vulnerable to any upside surprises on inflation, especially in the U.S. While the positive trends in stock indexes and corporate bond spreads should continue over the coming 6-12 months, there is a good chance that this year's downtrend in the dollar and government bond yields is over. The rise in both may be halting, but the risks are to the upside now that disappointments on U.S. growth and inflation have likely ended (notwithstanding the hurricane-distorted economic data in the near term). The Phillips curve is not dead, which means that it is only a matter of time before inflation begins to find a little traction. Higher oil prices will also provide a tailwind for headline inflation. Geopolitics will no doubt remain a threat for 'risk on' trades, but we may be past the worst in terms of North Korean tension. We also do not expect Fed balance sheet normalization to be a major headwind for risk assets. Nonetheless, the anticipated swing the supply of G4 government bonds to private investors would serve to add to selling pressure in the fixed-income space if inflation is rising in the U.S. and/or Europe at the same time. In other words, the risk relates more to expected policy rates than the Fed's balance sheet. Stay overweight stocks versus bonds, long oil related plays, slightly short in duration in the fixed income space, and long inflation protection. We also recommend returning to long positions on the U.S. dollar. Mark McClellan Senior Vice President The Bank Credit Analyst September 28, 2017 Next Report: October 26, 2017 1 Please see BCA Global Investment Strategy Weekly Report, "Is The Phillips Curve Dead Or Dormant?" dated September 22, 2017, available at gis.bcaresearch.com II. Liquidity And The Great Balance Sheet Unwind Liquidity is the lifeblood of the economy and financial markets, but it is a slippery concept that means different things to different people. Liquidity falls into four categories: monetary, balance sheet, financial market transaction liquidity, and funding liquidity. Overall liquidity conditions are reasonably constructive for risk assets at the moment. Financial market and balance sheet liquidity are adequate. Monetary policy is extremely easy, although the low level of money and credit growth underscores that the credit channel of monetary policy is still somewhat impaired. Funding liquidity is as important as monetary liquidity for financial markets. It has recovered from the Great Financial Crisis (GFC) lows, but it is far from frothy. Unwinding the Fed's balance sheet represents a risk to investors because QE played such an important role in reducing risk premia in financial markets. The unwind should not affect transactions liquidity or balance sheet liquidity. It should not affect the broad monetary aggregates either. The bond market's reaction will be far more important than balance sheet shrinkage. As long as the Fed can limit the bond market damage via forward guidance, then funding liquidity should remain adequate and risk assets should take the Fed's unwind in stride. It will be a whole different story, however, if inflation lurches higher. The technical impact of balance sheet unwind on the inner workings of the credit market is very complicated. Asset sales could lead to a shortage of short-term high-quality assets, unless it is offset with increased T-bill issuance. However, a smaller balance sheet could, in fact, improve funding liquidity to the extent that it frees up space on banks' balance sheets. Liquidity has been an integral part of BCA's approach to financial markets going back to the early days of the company under the tutelage of Editor-in-Chief Hamilton Bolton from 1949 to 1968. Bolton was ahead of his time in terms of developing monetary indicators to forecast market trends. Back then, the focus was on bank flows such as the volume of checks cashed because capital markets were still developing and most credit flowed through the banking system. Times changed, monetary policy implementation evolved and financial markets became more important and sophisticated. When money targeting became popular among central banks in the 1970s, central bank liquidity analysis focused more on the broader monetary aggregates. These and other monetary data were used extensively by Anthony Boeckh, BCA's Editor-in-Chief from the 1968 to 2002, to forecast the economy and markets. He also highlighted the importance of balance sheet liquidity (holdings of liquid assets), and its interplay with rising debt levels. Martin Barnes continued with these themes when writing about the Debt Supercycle in the monthly Bank Credit Analyst. "Liquidity" is a slippery concept, and it means different things to different people. In this Special Report, we describe BCA's approach to liquidity and highlight its critical importance for financial markets. We provide a list of indicators to watch, and also outline how the pending shrinkage of the Fed's balance sheet could affect overall liquidity conditions. A Primer On Liquidity We believe there are four types of liquidity that are all interrelated: Central Bank Liquidity: Bank reserves lie at the heart of central bank liquidity. Reserves are under the direct control of the central bank, which are used as a tool to influence general monetary conditions in the economy. The latter are endogenous to the system and also depend on the private sector's desire to borrow, spend and hold cash. Bullish liquidity conditions are typically associated with plentiful bank reserves, low interest rates and strong growth in the monetary aggregates. Balance Sheet Liquidity: A high level of balance sheet liquidity means that plenty of short-term assets are available to meet emergencies. The desire of households, companies and institutional investors to build up balance sheet liquidity would normally increase when times are bad, and decline when confidence is high. Thus, one would expect strong economic growth to be associated with declining balance sheet liquidity, and vice versa when the economy is weak. Of course, deteriorating balance sheet liquidity during good times is a negative sign to the extent that households or business are caught in an illiquid state when the economy turns down, jobs are lost and loans are called. Financial Market Transaction Liquidity: This refers to the ability to make transactions in securities without triggering major changes in prices. Financial institutions provide market liquidity to securities markets through their trading activities. Funding Liquidity: The ability to borrow to fund positions in financial markets. Financial institutions provide funding liquidity to borrowers through their lending activities. The conditions under which these intermediaries can fund their own balance sheets, in turn, depend on the willingness of banks and the shadow banking system to interact with them. The BIS definition of funding liquidity is a broad concept that captures a wide range of channels. It includes the capacity of intermediaries that participate in the securitization chain to access the necessary funding to originate loans, to acquire loans for packaging into securities, and finance various kinds of guarantees. The availability and turnover of collateral for loans is also very important for generating funding liquidity, as we discuss below. These types of liquidity are interrelated in various ways, and can positively or negatively reinforce each other. It is the interaction of these factors that determines the economy's overall ease of financing. See Box II-1 for more details. BOX II-1 How Liquidity Is Inter-Related Central bank liquidity, which is exogenously determined, is the basis for private liquidity creation (the combination of market transaction and funding liquidity). The central bank determines the short-term risk-free rate and the official liquidity that is provided to the banking system. If the central bank hikes rates or provides less official liquidity, appetite for private lending begins to dry up. Private sector liquidity is thus heavily influenced by monetary policy, but can develop a life of its own, overshooting to the upside and downside with swings in investor confidence and risk tolerance. Financial market liquidity and funding liquidity are closely interrelated. When times are good, markets are liquid and funding liquidity is ample. But when risk tolerance takes a hit, a vicious circle between market transaction and funding liquidity develops. The BIS highlights the procyclical nature of private liquidity, which means that it tends to exhibit boom-bust cycles that generate credit excesses that are followed by busts.1 The Great Financial Crisis of 2008 is a perfect example. The Fed lifted the fed funds rate by 400 basis points between 2004 and 2006. Nonetheless, the outsized contraction in private liquidity, resulting from the plunge in asset prices related to U.S. mortgage debt, was a key driver of the crash in risk asset prices. Liquidity Indicators: What To Watch (1) Monetary Liquidity Key measures of central bank liquidity include the monetary base and the broad money aggregates, such as M1 and M2 (Chart II-1). Central banks control the amount of reserves in the banking system, which is part of base money, but they do not control the broad monetary aggregates. The latter is determined by the desire to hold cash and bank deposits, as well as the demand and supply of credit. Box II-2 provides some background on the monetary transmission process and quantitative easing. BOX II-2 The Monetary Transmission Process And Qe Before the Great Recession and Financial Crisis, the monetary authorities set the level of short-term interest rates through active management of the level of bank reserves. Reserves were drained as policy tightened, and were boosted when policies eased. The level of bank reserves affected banks' lending behavior, and shifts in interest rates affected the spending and investment decisions of consumers and businesses. Of course, it has been a different story since the financial crisis. Once short-term interest rates reached the zero bound, the Fed and some other central banks adopted "quantitative easing" programs designed to depress longer-term interest rates by aggressively buying bonds and thereby stuffing the banking system with an excessive amount of reserves. Many feared the onset of inflation when QE programs were first announced because investors worried that this would contribute to a massive increase in credit and the overall money supply. Indeed, there could have been hyper-inflation if banks had gone on a lending spree. But this never happened. Banks were constrained by insufficient capital ratios, loan losses and intense regulation, while consumers and businesses had no appetite for acquiring more debt. The result was that the money multiplier - the ratio of broad money to the monetary base - collapsed (top panel in Chart II-1). Bank lending standards eventually eased and credit demand recovered. Broad money growth has been volatile since 2007 but, despite quantitative easing, it has been roughly in line with the decade before. The broad aggregates lost much of their predictive power after the 1980s. Financial innovation, such as the use of debit cards and bank machines, changed the relationship between broad money on one hand, and the economy or financial markets on the other. Despite the structural changes in the economy, investors should still keep the monetary aggregates and the other monetary indicators discussed below in their toolbox. While the year-to-year wiggles in M2, for example, have not been good predictors of growth or inflation on a one or two year horizon, Chart II-2 shows that there is a long-term relationship between money and inflation when using decade averages. Chart II-1The Monetary Aggregates Chart II-2Long-Run Relationship Between M2 And Inflation Other monetary indicators to watch: M2 Divided By Nominal GDP (Chart II-3): When money growth exceeds that of nominal GDP, it could be interpreted as a signal that there is more than enough liquidity to facilitate economic activity. The excess is then available to purchase financial assets. Monetary Conditions Index (Chart II-3): This combines the level of interest rates and the change in the exchange rate into one indicator. The MCI has increased over the past year, indicating a tightening of monetary conditions, but is still very low by historical standards. Dollar Based Liquidity (Chart II-3): This includes Fed holdings of Treasurys and U.S. government securities held in custody for foreign official accounts. Foreign Exchange Reserves (Chart II-3): Central banks hold reserves in the form of gold, or cash and bonds denominated in foreign currencies. For example, when the People's Bank of China accumulates foreign exchange as part of its management of the RMB, it buys government bonds in other countries, thereby adding to liquidity globally. Interest Rates Minus Nominal GDP Growth (Chart II-4): Nominal GDP growth can be thought of as a proxy for the return on capital. If interest rates are below the return on capital, then there is an incentive for firms to borrow and invest. The opposite is true if interest rates are above GDP growth. Currently, short-term rates are well below nominal GDP, signaling that central bank liquidity is plentiful. Chart II-3Monetary Indicators (I) Chart II-4Monetary Indicators (II) (2) Balance Sheet Liquidity Chart II-5 presents the ratio of short-term assets to total liabilities for the corporate and household sectors. It is a measure of readily-available cash or cash-like instruments that make it easier to weather economic downturns and/or credit tightening phases. The non-financial corporate sector is in very good shape from this perspective. The seizure of the commercial paper market during the GFC encouraged firms to hold more liquid assets on the balance sheet. However, the uptrend began in the early 1990s and likely reflects tax avoidance efforts. Households are also highly liquid when short-term assets are compared to income. Liquidity as a share of total discretionary financial portfolios is low, but this is not surprising given extraordinarily unattractive interest rates. The banking system is being forced to hold more liquid assets under the new Liquidity Coverage Ratio requirement (Chart II-6). This is positive from the perspective of reducing systemic risk, but it has negative implications for funding liquidity, as we will discuss below. Chart II-5Balance Sheet Liquidity Chart II-6Bank Balance Sheet Liquidity (3) Financial Market Transaction Liquidity: Transactions volumes and bid-ask spreads are the main indicators to watch to gauge financial market transaction liquidity. There was a concern shortly after the GFC that the pullback in risk-taking by important market-makers could severely undermine market liquidity, leading to lower transaction volumes and wider bid-ask spreads. The focus of concern was largely on the corporate bond market given the sharply reduced footprint of investment banks. The Fed's data on primary dealer positioning in corporates shows a massive decline from the pre-crisis peak in 2007 (Chart II-7). This represents a decline from over 10% of market cap to only 0.3%. The smaller presence of dealers could create a liquidity problem for corporate debt, especially if market-making dealers fail to adequately match sellers with buyers during market downturns. Yet, as highlighted by BCA's Global Fixed Income Strategy team, corporate bond markets have functioned well since the dark days of the Lehman crisis.2 Reduced dealer presence has not resulted in any unusual widening of typical relationships like the basis between Credit Default Swaps and corporate bond spreads. Other market participants, such as Exchange Traded Funds, have taken up the slack. Daily trading volume as a percent of market cap has returned to pre-Lehman levels in the U.S. high-yield market, although this is not quite the case for the investment-grade market (Chart II-8). Chart II-7Less Market Making Chart II-8Corporate Bond Trading Volume That said, it is somewhat worrying that average trade sizes in corporates are smaller now compared to pre-crisis levels - perhaps as much as 20% smaller according to estimates by the New York Fed. This is likely the result of the reduced risk-taking by the dealers and the growing share of direct electronic trading. Thus, it may feel like liquidity is impaired since it now takes longer to execute a large bond trade, even though transaction costs for individual trades have not been increasing. The bottom line is that financial market liquidity is not as good as in the pre-Lehman years. This is not a problem at the moment, but there could be some dislocations in the fixed-income space during the next period of severe market stress when funding liquidity dries up. (3) Funding Liquidity: There are few direct measures of funding liquidity. Instead, one can look for its "footprint" or confirming evidence, such as total private sector credit. If credit is growing strongly, it is a sign that funding liquidity is ample. Box II-3 explains why international credit flows are also important to watch for signs of froth in lending. BOX II-3 The Importance Of International Credit Flows The BIS highlights that swings in international borrowing amplify domestic credit trends. Cross border lending tends to display even larger boom-bust cycles than domestic credit, as can be seen in the major advanced economies in the lead up to the GFC, as well as some Asian countries just before the Asian crisis in the late 1990s (Chart II-9). When times are good, banks and the shadow banking system draw heavily on cross-border sources of funds, such that international credit expansion tends to grow faster during boom periods than the credit granted domestically by banks located in the country. Since G4 financial systems intermediate a major share of global credit, funding conditions within the G4 affect funding conditions globally, as BIS research shows.3 This research also demonstrates that financial cycles have become more highly correlated across economies due to increased financial integration. Booms in credit inflows from abroad are also associated with a low level of the VIX, which is another sign of ample funding liquidity conditions (Chart II-10). These periods of excessive funding almost always end with a financial crisis and a spike in the VIX. Chart II-9International Credit Is Highly Cyclical Chart II-10International Credit Booms Lead Spikes In The VIX Other measures of funding liquidity to watch include: Chart II-11Market Measures Of Funding Liquidity Libor-OIS Spread (Chart II-11): This is a measure of perceived credit risk of LIBOR-panel banks. The spread tends to widen during periods of banking sector stress. Spreads are currently low by historical standards. However, libor will be phased out by 2021, such that a replacement for this benchmark rate will have to be found by then. Bond-CDS Basis (Chart II-11): The basis is roughly the average difference between each bond's yield spread to Treasurys and the cost of insuring the bond in the CDS market. Arbitrage should keep these two spreads closely aligned, but increases in funding costs tied to balance sheet constraints during periods of market stress affect this arbitrage opportunity, allowing the two spreads to diverge. The U.S. high-yield or investment grade bond markets are a good bellweather, and at the moment they indicate relatively good funding liquidity. FX Basis Swap (Chart II-11): This is analogous to the bond-CDS basis. It reflects the cost of hedging currencies, which is critically important for international investors and lending institutions. The basis swap widens when there is financial stress, reflecting a pullback in funding liquidity related to currencies. The FX swap basis widened during the GFC and, unlike other spreads, has not returned to pre-Lehman levels (see below). Bank Leverage Ratios (Chart II-12): The ratio of loans to deposits is a measure of leverage in the banking system. Banks boost leverage during boom times and thereby provide more loans and funding liquidity to buy securities. In the U.S., this ratio has plunged since 2007 and shows no sign of turning up. Primary Dealers Securities Lending (Chart II-13): This is a direct measure of funding liquidity. Primary dealers make loans to other financial institutions with the purpose of buying securities, thereby providing both funding liquidity and market liquidity. Historically, shifts in dealer lending have been correlated with bid-ask spreads in the Treasury market. Securities lending is also correlated with the S&P 500, although it does not tend to lead the stock market. Dealer loans soared prior to 2007, before collapsing in 2008. Total loans have recovered, but have not reached pre-crisis highs, consistent with stricter regulations that forced the deleveraging of dealer balance sheets. Chart II-12U.S. Bank Leverage Chart II-13Securities Lending And Margin Debt NYSE Margin Debt (Chart II-13): Another direct measure of funding liquidity. The uptrend in recent years has been steep, although it is less impressive when expressed relative to market cap. Bank Lending Standards (Chart II-14): These surveys reflect bank lending standards for standard loans to the household or corporate sectors, but their appetite for lending for the purposes of securities purchases is no doubt highly correlated. Lending standards tightened in 2016 due to the collapse in oil prices, but they have started to ease again this year. Table II-1 provides a handy list of liquidity indicators split into our four categories. Taking all of these indicators into consideration, we would characterize liquidity conditions in the U.S. as fairly accommodative, although not nearly as abundant as the period just prior to the Lehman event. Monetary conditions are super easy, while balance sheet and financial market liquidity are reasonably constructive. In contrast, funding liquidity, while vastly improved since the GFC, is still a long way from the pre-Lehman go-go years according to several important indicators such as bank leverage. Moreover, the Fed is set to begin the process of unwinding the massive amount of monetary liquidity provided by its quantitative easing program. Chart II-14Bank Lending Standards Table II-1Liquidity Indicators To Watch Fed Balance Sheet Shrinkage: What Impact On Liquidity? Given that the era of quantitative easing has been a positive one for risk assets, it is unsurprising that investors are concerned about the looming unwind of the Fed's massive balance sheet. For example, Chart II-15 demonstrates the correlation between the change in G4 balances sheets and both the stock market and excess returns in the U.S. high-yield market. Chart II-16 presents our forecast for how quickly the Fed's balance sheet will contract. Following last week's FOMC meeting we learned that balance sheet reduction will begin October 1. For the first three months the Fed will allow a maximum of $6 billion in Treasurys and $4 billion in MBS to run off each month. Those caps will increase in steps of $6 billion and $4 billion, respectively, every three months until they level off at $30 billion per month for Treasurys and $20 billion per month for MBS. Chart II-15G4 Central Bank Balance Sheets Chart II-16Fed Balance Sheet We have received no official guidance on the level of bank reserves the Fed will target for the end of the run-off process. However, New York Fed President William Dudley recently recommended that this level should be higher than during the pre-QE period, and should probably fall in the $400 billion to $1 trillion range.4 In our forecasts we assume that bank reserves will level-off once they reach $650 billion. In that scenario the Fed's balance sheet will shrink by roughly $1.4 trillion by 2021. The level of excess reserves in the banking system will decline by a somewhat larger amount ($1.75 trillion). In terms of the impact of balance sheet shrinkage on overall liquidity conditions, it is useful to think about the four categories of liquidity described above. (1) Monetary Liquidity The re-absorption of excess reserves will mean that base money will contract (i.e. the sum of bank reserves held at the Fed and currency in circulation). However, we do not expect this to have a noticeable impact on the broader monetary aggregates, credit growth, the economy or inflation, outside of any effect it might have on the term premium in the bond market. The reasoning is that all those excess reserves did not have a major impact on growth and inflation when they were created in the first place. This was because the credit channel of monetary policy was blocked by a lack of demand (private sector deleveraging) and limited bank lending capacity (partly due to regulation). Banks were also less inclined to lend due to rising loan losses. Removing the excess reserves should have little effect on banks' willingness or ability to make new loans. In terms of asset prices, some investors believe that when the excess reserves were created, a portion of it found its way out of the banking system and was used to buy assets directly. That is not the case. The excess reserves were left idle, sitting on deposit at the Fed. They did not "leak" out and were not used to purchase assets. Thus, fewer excess bank reserves do not imply any forced selling. Nonetheless, the QE program certainly affected asset prices indirectly via the portfolio balance effect. Asset purchases supported both the economy and risk assets in part via a weaker dollar and to the extent that the policy lifted confidence in the system. But most importantly, QE depressed long-term interest rates, which are used to discount cash flows when valuing financial assets. QE boosted risk-seeking behavior and the search for yield, partly through the signaling mechanism that convinced investors that short-term rates would stay depressed for a long time. The result was a decline in measures of market implied volatility, such as the MOVE and VIX indexes. Could Bond Yields Spike? The risk is that the portfolio balance effect goes into reverse as the Fed unwinds the asset purchases. The negative impact on risk assets will depend importantly on the bond market's response. As highlighted in the Overview section, there will be a sharp swing in the flow of G4 government bonds available to the private sector, from a contraction of US$800 billion in 2017 to an increase of US$600 billion in 2018. Focusing on the U.S. market, empirical estimates suggest that the Fed's shedding of Treasurys could boost the 10-year yield by about 80 basis points because the private sector will require a higher term premium to absorb the higher flow of bonds. However, the impact on yields is likely to be tempered by two factors: Banks are required by regulators to hold more high-quality assets than they did in the pre-Lehman years in order to meet the new Liquidity Coverage Ratio. The BCA U.S. Bond Strategy service argues that growing bank demand for Treasurys in the coming years will absorb much of the net flow of Treasurys that the Fed is no longer buying.5 As the FOMC dials back monetary stimulus it will be concerned with overall monetary conditions, including short-term rates, long-term rates and the dollar. If long-term rates and/or the dollar rise too quickly, policymakers will moderate the pace of rate hikes and use forward guidance to talk down the long end of the curve so as to avoid allowing financial conditions to tighten too quickly. Thus, the path of short-term rates is dependent on the dollar and the reaction of the long end of the curve. It is difficult to estimate how it will shake out, but the point is that forward guidance will help to limit the impact of the shrinking Fed balance sheet on bond yields. Indeed, the Fed is trying hard to sever the link in investors' minds between balance sheet policy and signaling about future rate hikes, as highlighted by Chair Yellen's Q&A session following the September FOMC meeting. The bottom line is that the impact on monetary liquidity of a smaller Fed balance sheet should be minimal, although long-term bond yields will be marginally higher as a result. That said, much depends on inflation. If the core PCE inflation rate were to suddenly shift up to the 2% target or above, then bond prices will be hit hard, the VIX will surge and risk assets will sustain some damage. The prospect of a more aggressive pace of monetary tightening would undermine funding liquidity, compounding the negative impact on risk assets. (2) Funding Liquidity Chart II-17Tri-Party Repo Market Has Shrunk By unwinding its balance sheet, the Fed will be supplying securities into the market and removing cash. This will be occurring at a time when transactions in the tri-party repo market have fallen to less than half of their peak in 2007 due to stricter regulation (Chart II-17). This market has historically been an important source of short-term funding, helping to meet the secular rise in demand for short-term, low-risk instruments, largely from non-financial corporations, asset managers and foreign exchange reserve funds. If the Fed drains reserves from the system and T-bill issuance does not increase substantially to compensate, a supply shortage of short-maturity instruments could develop. We can see how this might undermine the Fed's ability to shift short-term interest rates higher under its new system of interest rate management, where reverse repos and the interest rate paid on reserves set the floor for other short-term interest rates. However, at the moment we do not see the risk that fewer excess reserves on its own will negatively affect funding liquidity. Again, any impact on funding liquidity would likely be felt via a sharp rise in interest rates and pullback in the portfolio balance effect, which would occur if inflation turns up. But this has more to do with rising interest rates than the size of the Fed's balance sheet. Indeed, balance sheet shrinkage could actually improve funding liquidity provided via the bilateral repo market, securities-lending, derivatives and prime brokerage channels. These are important players in the collateral supply chain. A recent IMF working paper emphasizes that collateral flows are just as important in credit creation as money itself.6 Collateral refers to financial instruments that are used as collateral to fund positions, which can be cash or cash-like equivalents. Since pledged collateral can be reused over and over, it can generate significantly more total lending than the value of the collateral itself. The Fed's overnight reverse-repo facility includes restrictions that the collateral accessed from its balance sheet can only be used in the tri-party repo system. Thus, the Fed's presence in the collateral market has reduced the "velocity of collateral." Table II-2 shows that the reuse rate of collateral, or its velocity, has fallen from 3.0 in 2007 to 1.8 in 2015. Table II-2Collateral Velocity The combination of tighter capital regulations and Fed asset purchases has severely limited the available space on bank balance sheets to provide funding liquidity. Regulations force banks to carry more capital for a given level of assets. Fed asset purchases have forced a large portion of those assets to be held as reserves, limiting banks' activity in the bilateral repo market. There is much uncertainty surrounding this issue, but it appears that an unwind the Fed's balance sheet will free up some space on bank balance sheets, possibly permitting more bilateral repo activity and thus a higher rate of collateral velocity. It may also relieve concerns about a shortage of safe-haven assets. Nonetheless, we probably will not see a return of collateral velocity to 2007 levels because stricter capital regulations will still be in place. What About Currency Swaps? Some have argued that this removal of cash could also lead to an appreciation of the U.S. dollar. In particular, Zoltan Pozsar of Credit Suisse has observed a correlation between U.S. bank reserves and FX basis swap spreads.7 There is also a strong correlation between FX swap spreads and the U.S. dollar (Chart II-18). Chart II-18FX Basis Swap And Reserves One possible chain of events is that, as the Fed drains cash from the market, there will be less liquidity in the FX swap market. Basis swap spreads will widen as a result, and this will cause the dollar to appreciate. In this framework, the unwinding of the Fed's balance sheet will put upward pressure on the U.S. dollar. However, it is also possible that the chain of causation runs in the other direction. The BIS has proposed a model8 where a stronger dollar weakens the capital positions of bank balance sheets. This causes them to back away from providing liquidity to the FX swap market, leading to wider basis swap spreads. In this model, a strong dollar leads to wider basis swap spreads and not the reverse. If this is the correct direction of causation, then we should not expect any impact on the dollar from the unwinding of the Fed's balance sheet. At the moment it is impossible to tell which of the above two theories is correct. All we can do is monitor the correlation between reserves, FX basis swap spreads and the dollar going forward. Conclusions: Overall liquidity conditions are reasonably constructive for risk assets at the moment. Financial market and balance sheet liquidity are adequate. Monetary policy is extremely easy, although the low level of money and credit growth underscores that the credit channel of monetary policy is still somewhat impaired and/or constrained relative to the pre-Lehman years. Funding liquidity has recovered from the Great Financial Crisis lows, but it is far from frothy. More intense regulation means that funding liquidity will probably never again be as favorable for risk assets as it was before the crisis. But, hopefully, efforts by the authorities to reduce perceived systemic risk mean that funding liquidity may not be as quick to dry up as was the case in 2008, in the event of another negative shock. Unwinding the Fed's balance sheet represents a risk to investors because QE played such an important role in reducing risk premia in financial markets. However, we believe that the bond market's reaction will be far more important than balance sheet shrinkage. As long as the Fed can limit the bond market damage via forward guidance, then risk assets should take the Fed's unwind in stride. It will be a whole different story, however, if inflation lurches higher. The technical impact of balance sheet unwind on the inner workings of the credit market is very complicated and difficult to forecast. Asset sales could lead to a shortage of short-term high-quality assets. However, this is more a problem in terms of the Fed's ability to raise interest rates than for funding liquidity. A smaller balance sheet could, in fact, improve funding liquidity to the extent that it frees up space on banks' balance sheets. Mark McClellan Senior Vice President The Bank Credit Analyst Ryan Swift Vice President U.S. Bond Strategy 1 D. Domanski, I. Fender and P. McGuire, "Assessing Global Liquidity," BIS Quarterly Review (December 2011). 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Global Interest Rate Strategy For The Remainder Of 2017," dated July 18, 2017, available at gfis.bcaresearch.com 3 E. Cerutti, S. Claessens and L. Ratnovski, "A Primer on 'Global Liquidity'," CEPR Policy Portal (June 8, 2014). 4 William C. Dudley, "The U.S. Economic Outlook and the Implications for Monetary Policy," Federal Reserve Bank of New York (September 07, 2017). 5 Please see BCA U.S. Bond Strategy Weekly Report, "The Great Unwind," dated September 19, 2017, available at usbs.bcaresearch.com 6 M. Singh, "Collateral Reuse and Balance Sheet Space," IMF Working Paper (May 2017). 7 Alexandra Scaggs, "Where would you prefer your balance sheet: Banks, or the Federal Reserve?" Financial Times Alphaville (April 13, 2017). 8 S. Avdjiev, W. Du, C. Koch, and Hyun S.Shin, "The dollar, bank leverage and the deviation from covered interest parity," BIS Working Papers No.592 (Revised July 2017). III. Indicators And Reference Charts Equity indexes in the U.S. and Japan broke out to new highs in September. European stocks surged as well. Investors embraced risk assets in the month on a solid earnings backdrop, strong economic indicators, continuing low inflation and revived hopes for fiscal stimulus in the U.S. and Japan, among other factors. Our indicators do not warn of any near-term stumbling blocks for the bull market. Our monetary indicator continues to hover only slightly on the restrictive side. Our equity composite technical indicator may be rolling over, but it must fall below zero to send a 'sell' signal. The speculation index is elevated, but bullish equity sentiment is only a little above the long-term mean. Meanwhile, the S&P 500 tends to increase whenever the 12-month forward EPS estimate is rising. The latter is in a solid uptrend that should continue based on the net revisions ratio and the earnings surprise index. Valuation remains poor, but has not yet reached our threshold of overvaluation. Our new Revealed Preference Indicator (RPI) continued on its bullish equity signal in August for the second consecutive month. We introduced the RPI in the July report. It combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Our Willingness-to-Pay (WTP) indicators are also bullish on stocks for the U.S., Europe and Japan. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The U.S. and Japanese WTPs are trending sideways, and Europe could be rolling over. While this is a little worrying because they indicate that flows into equity markets have moderated recently, the indicators have to clearly turn down to provide a bearish signal for stocks. Flows into the U.S. appear to be more advanced relative to Japan and the Eurozone, suggesting that there is more "dry powder" available to buy the latter two markets than for the U.S. market. Oversold conditions for the U.S. dollar are being worked off, but our technical indicator is still positive for the currency. The greenback looks expensive based on PPP, but is less so on other measures. We are positive in the near term. Our composite technical indicator for U.S. Treasurys is at neutral. Bond valuation is also at neutral based on our long-standing model. However, other models that specifically incorporate global economic factors suggest that the 10-year Treasury is still more than 30 basis points on the expensive side. Stay below benchmark in duration. 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-10U.S. Treasury Indicators 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

Highlights Duration: As long as inflation shows signs of stabilizing during the next couple of months the Fed will lift rates again in December. Stay at below-benchmark duration and remain overweight TIPS versus nominal Treasuries. Credit Cycle: The process of corporate sector re-leveraging is well underway, but the corporate bond trade still has further to run. In fact, the second quarter decline in net leverage likely prolongs the length of time that overweight corporate bond positions will be profitable. Economy & Inflation: While households are no longer paying down debt, the pace of re-leveraging has so far been slow. With delinquency rates already starting to rise for certain classes of consumer credit, we see household debt growth as remaining tepid at best. Feature Janet Yellen struck a somewhat hawkish tone in her press conference following last week's FOMC meeting, as did the post-meeting statement and Summary of Economic Projections (SEP). Predictably, the bond market sold off and is now priced for 39 bps of rate hikes between now and the end of 2018 (Chart 1). While this is still well below the 100 bps predicted in the SEP, it proved sufficient to send the 2-year Treasury yield to a new cycle high (Chart 1, bottom panel). The Fed also announced the unwind of its balance sheet, as had been widely anticipated, and Yellen took great pains to stress that the pace of balance sheet reduction will not be altered unless the economy encounters a shock severe enough to send the fed funds rate back to zero. As was discussed in last week's report,1 this is a calculated move by the Fed meant to sever the link between the balance sheet and expectations about the future path of rate hikes. The SEP showed that most FOMC participants still expect to lift rates once more this year, and that only four out of 16 believe the Fed should stand pat, the same number as in June. However, expectations for one more hike this year are most likely contingent on inflation showing some further signs of strength. To see this, we note that the real fed funds rate is very close to at least one popular estimate of its equilibrium level (Chart 2). With inflation still below the Fed's target it is imperative that an accommodative monetary policy stance is maintained. Practically, this means keeping the real fed funds rate below equilibrium so that economic slack can be absorbed and inflation can rise. If inflation stays flat and the Fed hikes in December, then the real fed funds rate will move above the Laubach-Williams estimate of equilibrium. Chart 1Fed Pushes Yields Higher Chart 2Funds Rate Must Stay Below Neutral We calculate that if the Fed delivers a 25 basis point hike in December, then year-over-year core PCE inflation must rise from its current 1.41% to 1.63% for the real fed funds rate to stay below its neutral level (Chart 2, bottom panel). This squares with the Fed's central tendency forecast that calls for core PCE inflation between 1.5% and 1.6% by the end of the year. In our view, as long as inflation shows further signs of stabilizing and moves toward the Fed's central tendency range during the next couple of months, then the Fed will likely lift rates again in December. However, if inflation resumes its recent downtrend, then the Fed will take a pass. Inflation Expectations: Yellen vs. Brainard Perhaps the most interesting detail to emerge from last week's FOMC meeting is that the committee is so far rejecting Governor Lael Brainard's claim that inflation expectations have become unanchored to the downside. As we discussed in a recent report,2 inflation expectations are critical to the Fed's way of thinking about inflation. In the Fed's view, monetary policy can be used effectively in response to shifts in the cyclical drivers of inflation. However, if inflation expectations were to become unanchored, it would suggest that inflation's long run trend had been altered. This would make monetary policy much less effective, and a timely return of inflation to target much less likely. Governor Brainard views the recent weakness in inflation as suggesting that inflation expectations have in fact become unmoored. As evidence she points to the low levels of: TIPS breakeven inflation rates (Chart 3, top panel) Chart 3Inflation Expectations Household inflation expectations from the University of Michigan survey (Chart 3, panel 2) 5-year, 5-year forward CPI forecasts derived from the Survey of Professional Forecasters (SPF) (Chart 3, panel 3) In contrast, at her post-meeting press conference Chair Yellen pointed to median 10-year forecasts from the SPF as evidence that inflation expectations remain well-anchored (Chart 3, bottom panel). Although, she also admitted that she is unable to explain why inflation has fallen this year: I can't say I can easily point to a sufficient set of factors that explain this year why inflation has been this low. I've mentioned a few idiosyncratic things, but frankly, the low inflation is more broad-based than just idiosyncratic things. What matters for bond investors is that TIPS breakeven inflation rates, a measure of the compensation for inflation protection embedded in nominal bond yields, are well below levels that are usually seen when core inflation is well anchored around the Fed's target. At present, the 10-year TIPS breakeven inflation rate is 1.84%. We expect it will return to a range between 2.4% and 2.5% by the time that year-over-year core PCE inflation reaches 2%. In Yellen's view, inflationary pressures are strong enough for this process to play out with the Fed still being able to gradually lift rates, once more this year and then three more times in 2018. But the longer that inflation fails to rebound as Yellen expects, the more likely it becomes that the committee will come around to Brainard's view and scale back the pace of hikes. A slower expected pace of rate hikes will lend support to inflation and TIPS breakevens, and in either scenario we would expect TIPS breakevens to reach the 2.4% to 2.5% range by the end of the cycle. The uncertainty surrounds what level of real rates will be required to achieve that outcome. In that regard we are more inclined toward Yellen's view. Inflation will soon follow growth indicators higher,3 and the Fed will be able to deliver a pace of rate hikes similar to what it currently projects. But with so few rate hikes priced into the curve, we think the investment implications are the same in either scenario. Investors should stay at below-benchmark duration and remain overweight TIPS versus nominal Treasuries. Bonds In The Long-Run? The Fed's median projection for the level of longer-run interest rates also declined last week, from 3% to 2.75%. It is now only 8 bps above the 5-year, 5-year forward Treasury yield (Chart 4). Chart 4Fed Slowly Embracing A Low Neutral Rate In general, we think the 5-year, 5-year Treasury yield should be equal to the nominal interest rate expected to prevail in the longer-run plus a small risk premium. In that respect, the yield still looks a tad low compared to the Fed's forecast, although the gap has narrowed considerably. While we would not want to hinge our investment strategy on the accuracy of the Fed's longer-run interest rate forecast, it is notable that the Fed continues to price-in a future where the equilibrium interest rate remains depressed. Please see the Economy & Inflation section (below) for a discussion of the longer-run outlook for the fed funds rate. Corporate Credit Cycle Prolonged Second quarter Financial Accounts (formerly Flow of Funds) data were released last week, allowing us to update some of our credit cycle indicators. Chart 5 shows that, historically, three conditions must be met before the credit cycle turns and we experience a period of sustained corporate bond underperformance. Our Corporate Health Monitor (CHM) must be in "deteriorating health" territory, signaling that the corporate sector is aggressively taking on debt (Chart 5, panel 2). Monetary policy must be restrictive. This can be signaled by the real federal funds rate crossing above its equilibrium level (Chart 5, panel 3), or an inversion of the yield curve (Chart 5, panel 4). Banks must be tightening standards on commercial & industrial loans (Chart 5, bottom panel). So far this cycle only the first criterion has been met and while the CHM remains firmly in "deteriorating health" territory, it actually took a sizeable turn toward zero in Q2. The marginal improvement in corporate health was broad based across all six of our monitor's components (Chart 6). Even return on capital, which had been in free fall, managed to move higher (Chart 6, panel 3). Chart 5Credit Cycle Indicators Chart 6Corporate Health Monitor Components Box 1Corporate Health Monitor Components The slower pace of deterioration in corporate health can mostly be chalked up to surging profit growth. EBITD4 growth outpaced debt growth in Q2, sending our measure of net leverage lower (Chart 7). Year-over-year EBITD growth is now within striking distance of corporate debt growth for the first time since 2015 (Chart 7, bottom panel). Chart 7Can Leverage Reverse Its Uptrend? It is rare for corporate spreads to tighten while leverage is rising. So in that regard the tick lower in leverage probably extends the period of time we can remain overweight corporate bonds in a U.S. fixed income portfolio. Chart 8Profit Outlook Still Positive Since 1973, we calculate that investment grade corporate bonds have outperformed duration-equivalent Treasuries in 62% of six month periods, for an average annualized excess return of 45 bps. In prior research5 we showed that, during the same timeframe, when leverage rose for two consecutive quarters corporate bonds outperformed in only 45% of the following six month periods, for an average annualized excess return of -190 bps. This quarter's decline in leverage breaks a streak of two consecutive increases. But what about going forward? Further declines in leverage will depend on whether profit growth can sustain its recent strength. While some moderation is likely, our leading profit indicators suggest that growth will remain firm for the remainder of the year (Chart 8). Total business sales less inventories have hooked a tad lower, but are still consistent with solid profit growth (Chart 8, panel 1). Industrial production growth also rolled over last month, but that reflects temporary weakness related to Hurricane Harvey. Continued elevated readings from the ISM manufacturing index suggest that underlying demand is strong (Chart 8, panel 2). Meanwhile, dollar weakness continues to provide a tailwind for profit growth (Chart 8, panel 3), and our profit margin proxy has also ticked higher (Chart 8, bottom panel). Our profit margin proxy has risen due to weakness in unit labor costs. While tightening labor markets should cause the corporate wage bill to increase, a late-cycle rebound in productivity growth will ensure that unit labor cost growth stays muted compared to other wage growth measures. We made the case for a late-cycle rebound in productivity growth driven by stronger non-residential investment in a recent report.6 That being said, mounting wage pressures will likely cause margins to narrow next year, although a sharp margin-driven hit to profit growth is not likely in the next few quarters. Bottom Line: The process of corporate sector re-leveraging is well underway, but the corporate bond trade still has further to run. In fact, the second quarter decline in net leverage likely prolongs the length of time that overweight corporate bond positions will be profitable. Economy & Inflation: Household Re-leveraging Still A Slog As was noted above, both model-driven estimates and FOMC forecasts posit that the real equilibrium fed funds rate is very low by historical standards. One school of thought, secular stagnation, views the low equilibrium rate as a permanent state of affairs. While another, the "headwinds" thesis, claims that the fall-out from the financial crisis is keeping the equilibrium rate low for now, but that it will rise as the vestiges of the crisis start to fade. In this second theory, the major headwind keeping the equilibrium rate temporarily low would be the slow pace of household re-leveraging. Chart 9 shows the correlation between the Laubach-Williams estimate of the real equilibrium fed funds rate and growth in household debt. Household debt has only recently started to increase, and even today it is growing at a historically slow pace. So far this has not translated into strong enough growth to push the equilibrium interest rate higher, perhaps because the modest debt growth is occurring off quite a low base. Overall household debt is no longer falling relative to disposable income, but it has also not yet started to rise (Chart 9, panel 2). Whether you fall into the secular stagnation or headwinds camp, we would argue that the pace of household re-leveraging will remain tepid, keeping a lid on the equilibrium interest rate for quite some time. Household debt is dominated by housing, where still-tight lending standards and a lack of savings on the part of potential first-time homebuyers remain semi-permanent features of the economic landscape that will take a long time to disappear. Outside of housing, consumers have been adding debt fairly aggressively, especially in the non-revolving (auto loan and student loan) spaces (Chart 9, bottom panel). The problem is that in those areas where consumers have been adding debt (credit cards, auto loans and student loans), we are also seeing delinquency rates start to rise (Chart 10). Chart 9Household Debt & The Neutral Rate Chart 10Consumer Credit Delinquency Rates Delinquency rates are elevated compared to pre-crisis levels for both auto loans and student loans. For credit cards, where the re-leveraging is not as far advanced, delinquency rates remain low but have started to increase. It is only in the mortgage market, where re-leveraging has not occurred, that delinquencies remain low. The fact that delinquency rates have already started to increase for auto loans, student loans and credit cards suggests that there is limited scope to add further debt in those areas. Bottom Line: While households are no longer paying down debt, the pace of re-leveraging has so far been slow. With delinquency rates already starting to rise for certain classes of consumer credit, we see household debt growth as remaining tepid at best. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Great Unwind", dated September 19, 2017, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Open Mouth Operations", dated September 12, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Open Mouth Operations", dated September 12, 2017, available at usbs.bcaresearch.com 4 Earnings before interest, taxes and depreciation. 5 Please see U.S. Bond Strategy Weekly Report, "Low Inflation And Rising Debt", dated June 13, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Open Mouth Operations", dated September 12, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The Fed will shrink its balance and is determined to raise rates. Implications of synchronized global growth and global NAIRU. Consumers are upbeat and ready to spend. What's the signal from record high consumer expectations for equities? Feature Risk assets and Treasury yields rose up to and after last week's Fed meeting, but late-week saber-rattling by North Korea left most asset classes little changed on the week. The U.S. economic data released last week continued to be impacted by Hurricanes Harvey and Irma, but the Fed notes that the storms are "unlikely to materially alter the course of the national economy beyond the next few months". The backdrop has turned more bearish for bonds even before the Fed's recommitment last week to raising rates gradually and shrinking its balance sheet. The Fed's hawkish stance short term and dovish stance long term will allow risk assets to outperform Treasury bonds and cash, but a sudden move higher in inflation would challenge that view. FOMC: Short Term Hawkish... The Fed sent a hawkish short-term signal on the outlook for monetary policy at its meeting last week. The vast majority of FOMC members, 12 out of 16, expect to raise rates again by December (Chart 1). A 0.2% downward revision to the Fed's 2017 core PCE inflation forecast was offset by an equal 0.2% upward revision to its GDP growth forecast. Moreover, Fed Chair Janet Yellen downplayed this year's soft inflation figures and stressed that inflation expectations remain "reasonably well anchored". Although the relationship may have weakened somewhat recently, the Fed is loath to throw the Phillips curve model into the dust bin just yet. The unemployment rate forecasts were lowered from 4.2% to 4.1% for 2018 and 2019, while the Fed kept its NAIRU estimate at 4.6%. The tightening labor market is expected to place upward pressure on wage inflation and push PCE inflation to the 2% target by 2019. Chart 1Market Expects A Hike In December Incoming data on actual inflation and inflation expectations will determine whether the Fed will be able to pull the trigger in December. Further softness in the core PCE inflation and CPI will raise doubts as to whether the inflation undershoot is indeed transitory. And especially worrisome will be a decline in inflation expectations. It is noteworthy that 10-year inflation breakevens fell nearly 4bps immediately following yesterday's FOMC announcement. At 1.85%, 10-year breakevens are already running below the 2.4-2.5% range that is consistent with the Fed's 2% target for PCE inflation. Any further decline in breakevens will call into question the Fed's view that inflation expectations remain well anchored. Further, with the decline in inflation expectations, the 2/10-year yield curve flattened following the Fed's announcement. This is could be considered a sign of a slight lowering in growth expectations. Finally, there was little surprise on the Fed's balance sheet announcement. For now, the Fed is committed to slowly unwinding its bond holdings. Janet Yellen said that the Fed will only resume full reinvestment of maturing bonds after it had cut the policy rate back to the zero bound. In other words, the Fed funds rate is now the primary tool to set monetary policy. The odds of another Fed rate hike by year-end have certainly increased (Chart 1). This need not upset risk assets if the incoming data justify higher rates. Only a policy error, where the Fed hikes rates even as inflation expectations decline and the yield curve flattens, will trigger a sizeable pullback in risk assets. This is not our baseline scenario. Softness in inflation and inflation expectations will force the Fed to back down. ...But Long Term Dovish Although the Fed signaled a greater probability of an interest rate hike in the near-term, it lowered the long-run outlook for policy rates. First, the median FOMC member now expects only two rate increases in 2019, down from three in the June forecast (not shown). Second, the estimate for the terminal rate was lowered to 2.75% from 3.0% (Chart 2, panel 4). With the long-run inflation target being 2% (Chart 2, panel 3), this means that the FOMC collectively believes the long-term neutral real Fed funds rate to be just 0.75%. Currently, the Laubach-Williams estimate of the neutral real Fed funds rate is near zero (Chart 3). Therefore, the FOMC sees it rising only modestly from current levels over the coming years. Chart 2The FOMC's "Long Run" Forecasts Since 2012 Chart 3Neutral Real Rate Near Zero For any given term premium, a lower short-term interest rate path will mean a lower 10-year yield. If estimates for the terminal policy rate outside the U.S. remain unchanged, the Fed's lower projection will mean narrower interest rate differentials, reducing the relative attractiveness of the dollar. As for equities, a lower estimate for the long-run policy rate would be a wash if it also reflected a lower estimate for long-term GDP growth. However, the Fed kept its longer run real GDP growth estimate unchanged at 1.8% (Chart 2, panel 1). If that proves accurate, lower interest rates and a weaker dollar will be more supportive for U.S. equities over the long-term. Notably, the Fed did not adjust its view of NAIRU, keeping it at 4.6%, where it has been since April (Chart 2, panel 2). Bottom Line: In terms of investment implications, the lower estimate of the long-run neutral rate is supportive for 10-year Treasuries, negative for the dollar and positive for equities. Stay overweight stocks versus bonds and short duration. Don't Downplay NAIRU Synchronous global growth remains in place in 2017 and will persist into 2018, but this growth alone may not be enough to push up inflation. BCA's OECD Real GDP Diffusion Index is at 100% after it dipped to 14% during the financial crisis. The index was also above 90% from 1994 through 1998, and then again from 2001 through 2007. Moreover, the OECD expects that GDP growth will climb above zero in all the member countries in BCA's diffusion index again in 2018. The broad-based global GDP growth has historically been associated with a rising stock-to-bond ratio, rising global trade flows, a narrowing output gap and accelerating industrial production (Chart 4). However, there is no consistent pattern on the dollar, the unemployment rate, or core inflation. Chart 5 shows that during prior periods of robust global growth, equities beat bonds, the U.S. output gap tightened and industrial production increased. U.S. exports tend to contribute more to GDP growth during these phases, but not in a uniform way. Meantime, the Fed has both raised and lowered rates during these periods. Chart 4Widespread##BR##Global Growth... Chart 5... Supports Risk Assets,##BR##Trade And A Narrower Output Gap Nonetheless, while the dollar jumped in the 1990s when BCA's OECD growth index was above 90%, it fell from 2001 to 2007, and it's performance since 2015 has been mixed. The unemployment rate declined in the mid-to-late 1990s, but initially rose in the 2001-2007 period and has dropped since 2010. The Fed both raised and lowered rates during the previous episodes, but has only boosted rates in the current phase. Core inflation slowed in the 1990s when 90% of countries saw positive GDP growth, but accelerated in the early 2000s. Since 2015, core inflation has both climbed and decelerated. What will trigger higher inflation if more than 90% of the globe is experiencing positive economic growth? BCA's Global Fixed Income Strategy service notes that1 67% of OECD nations have unemployment rates under the organization's assessment of "global NAIRU", a level not seen since before the Great Recession when inflation expanded in both the goods and service sectors (Chart 6). However, the link between inflation and NAIRU waned during and just after the 2007-2009 recession and only reconnected lately. The implication for investors is that there is a global NAIRU level (or global output gap), which is more important in determining worldwide inflation rates than individual country NAIRU measures. Chart 6The NAIRU Concept Is Not Dead Yet Bottom Line: Surging global growth is a precondition for higher inflation, but sustained improvement in the labor market is needed to drive up inflation and prompt more action from the Fed. Investors may be downplaying the NAIRU concept at a time when it is finally set to bite. If that is the case, inflation expectations around the world are too low, although it will take some evidence of faster realized inflation (especially in the U.S. and Europe) before the markets begin to discount that view in bond yields. Stay underweight duration. Flow Of Funds Update On Consumer And Corporate Health The latest readings on the health of household and corporate balance sheets from the Fed's flow of funds accounts reinforce BCA's stance that consumer spending will provide strong support for the U.S. economy through 2017 and 2018. Household net worth continues to rise and is well above average at this point in a long expansion (Chart 7). The total wealth effect for consumer spending is still lagging prior cycles, but remains supportive. Debt-to-income ratios are at multi-decade lows. The ongoing repair of consumer balance sheets has led to an all-time high in FICO scores (Chart 7, panel 4). Last week's U.S. flow of funds report also allows us to update BCA's Corporate Health Monitor (CHM) (Chart 8). The level of the CHM improved slightly between Q1 and Q2, but the overall level still suggests corporate balance sheets are deteriorating. The progress in Q2 was broadbased, as all the components improved, notably the net leverage component. Profit growth surged while debt moved up modestly in Q2, modestly reducing leverage. The Monitor has been a reliable indicator of the trend in corporate bond spreads. The upswing in the CHM in Q2 - and particularly the dip in leverage - supports our corporate bond overweight. On the consumer front, while the recent weakness in vehicle sales and overall retail sales are noteworthy, they do not signal the end of the business cycle. We found2 that a peak in vehicle sales leads the end of the economic cycle by two years. Moreover, Hurricane Harvey weighed on August's retail sales report and Irma will have the same impact on September's sales.3 Instead, the backdrop for consumer spending remains strong. For example, the most recent Fed Senior Loan Officer's Survey suggests that the banking sector is willing to lend to households and that consumers are open to borrowing, although household demand for loans has weakened in recent quarters (Chart 9). Chart 7Support For The Consumer##BR##Remains In Place Chart 8Improved A Bit In Q2##BR##But Still Deteriorating Chart 9Senior Loan Officers##BR##Survey Still Supportive In addition, consumer spending intentions remain in an uptrend and the decade-high readings on "plans to buy" a house and a car are telling (Chart 10, panels 1 and 2). Overall measures of consumer confidence remain at 16-year peaks (Chart 10, panel 3). Furthermore, the sturdy labor market, modest wage growth and low inflation are all factors that support a solid pace of real income growth, which reinforces the spending backdrop (Chart 10, panel 4). Student loan debt increased again in Q2 and investors are concerned by the risks posed by the upswing. The Bank Credit Analyst covered the topic in a comprehensive report in November 2016.4 The key message was that student debt is a modest drag on economic growth, but is not a threat to U.S. government finances and does not represent the next subprime crisis. Nearly a year later, BCA's conclusions remain unchanged. A recent report5 by the Federal Reserve Bank of New York provides data on student loans through Q2 2017. The report noted that while student debt levels were little changed between Q1 and Q2 2017, they are up $85B from a year ago and at record highs (Chart 11). Although student loan delinquencies ticked higher in Q2, and remain elevated by historical standards, they have moved sideways in recent years. We will continue to monitor all types of consumer indebtedness as we assess hazards in the U.S. economy. Student loans are only a mild economic headwind and do not represent a source of systemic financial risk. Chart 10Consumers Upbeat And Ready To Spend Chart 11Student Loan Debt Is Elevated Bottom Line: The consumer - a key driver of the U.S. economy and corporate earnings - will provide a solid backdrop for the economy through 2017 and beyond. This climate will allow the Fed to boost rates one more time this year and begin paring its balance sheet starting next month. The solid underpinnings for the consumer will sustain corporate earnings growth and, ultimately, higher stock prices. However, favorable consumer attitudes toward U.S. equity prices are a mild concern. Signals From Stock Sentiment Surveys Record U.S. consumer optimism - as measured by the University of Michigan (UM) - on forward stock returns does not necessarily signal a market top. On the other hand, it supports BCA's view that investors be prudent with risk allocations. Respondents to the UM Survey of Consumers assign a 65% probability that the U.S. stock market will move higher in the next 12 months, surpassing the previous zenith in mid-2004. Interestingly, before the 2014 high (60%), the top reading was in mid-2007 (62%), only three months prior to the October 2007 equity market peak. A cursory look at Chart 12, panel 1 shows that peaks on this metric line up with those in equities. We view it another way. Investors should not assume that stocks are peaking based on the UM data. The bottom panel of Chart 12 shows that at just 5.6%, the annual change in the percentage of respondents who expect stocks to move higher in the next 12 months is not at an extreme. The 12-month change was as high as 18% in early 2004 and again in March 2010. Stock returns in the 12 months after these peaks in sentiment were lower than in the 12 months prior. However, we are not yet in the danger zone based on this indicator. Furthermore, BCA's Investor Sentiment Composite Index (not shown) is not at an extreme, although it is at the top end of its bull market range. We expect the stock-to-bond ratio to move higher in the next 6-to-12 months, despite the elevated readings on households' expected return on stocks. Our position is driven more by our bearish stance on Treasury bond prices than on an overly bullish call on equity returns. Chart 13 illustrates this point across three time horizons given our view of fair value on the 10-year Treasury yield (2.67%).6 Our analysis assumes a 2% annualized dividend yield on the S&P 500. Panel 1 shows the ratio between now and year end will remain positive if U.S. equities dip by 5%. Looking ahead 6 and 12 months (Panels 2 and 3), the S&P 500 will have to drop by between 5% and 10% to signal a localized peak in the stock-to-bond ratio. Chart 12Consumers' Expectations For Equity Returns Are Elevated Chart 13Scenarios For Stock-To-Bond Ratio Bottom Line: Despite heightened consumer sentiment toward equities, we expect the stock-to-bond ratio to move higher in the next 6 to 12 months. Nonetheless, investors should be prudent with risk assets, paring back any maximum overweight positions and holding some safe-haven assets within diversified portfolios. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA's Global Fixed Income Strategy Weekly Report, "Have Bond Yields Peaked For The Cycle? No.", September 12, 2017. Available at gfis.bcaresearch.com. 2 Please see BCA's U.S. Investment Strategy Weekly Report, "Disconnected," September 11, 2017. Available at usis.bcaresearch.com. 3 Please see BCA's U.S. Investment Strategy Weekly Report, "Shelter From The Storm, "September 5, 2017. Available at usis.bcaresearch.com. 4 Please see The Bank Credit Analyst Special Report, "Student Loan Blues: Can't Replay What I Borrowed", November 2016. Available at bca.bcaresearch.com. 5 https://www.newyorkfed.org/medialibrary/interactives/householdcredit/data/pdf/HHDC_2017Q2.pdf 6 Please see BCA's U.S. Bond Strategy Portfolio Allocation Summary, "The Cyclical Sweet Spot Rolls On," September 5, 2017. Available at usbs.bcaresearch.com.

Highlights Portfolio Strategy A more balanced cable & satellite and movies & entertainment industry profit backdrop is signaling that only a neutral stance is warranted in both these media sub-indexes. Trim to neutral. These moves also push our S&P consumer discretionary sector weight to a benchmark allocation. Recent Changes S&P Consumer Discretionary - Downgrade to neutral. S&P Cable & Satellite - Trim to equal weight. S&P Movies & Entertainment - Downgrade to a benchmark allocation. Table 1 Feature Equities sustained recent gains last week, largely ignoring the mildly hawkish Fed. The S&P 500 is undeterred by the prospect of another interest rate hike later this year with investors focused squarely on synchronized reaccelerating global growth. Highly-sensitive growth indicators are surging: South Korean exports are on fire, the Baltic Dry Index, lumber prices and a long forgotten global growth barometer, Brent oil prices, are breaking out (Chart 1). This suggests that S&P 500 profits are well positioned to continue expanding at a healthy clip, underpinning prices. Firming economic growth will eventually show up in inflation. In the U.S., empirical evidence signals that expanding real output growth usually does lead to a pickup in core CPI, albeit with an 18 month lag (top panel, Chart 2). A tightening labor market also corroborates this data. As the year-over-year change in the unemployment rate recedes, inflation typically rises, again with a 6 quarter lag (unemployment rate shown inverted, second panel, Chart 2). Finally, the bottom two panels of Chart 2 show the Cleveland Fed's Inflation Nowcasting1 series as a 3-month annualized rate of change in core CPI and core PCE. Both point to a continued rise in inflation. This inflation backdrop is significant as it will likely sustain the corporate sector's pricing power gains. Chart 3 updates our corporate sector pricing power proxy and the related diffusion index. We also update the business sector's overall wage inflation and associated diffusion index from the latest BLS employment report. Selling prices are recovering at a time when wages remain stable. Taken together, out margin proxy indicator suggests that the ongoing profit margin expansion phase has more legs (bottom panel, Chart 3). Chart 1Vibrant Global Growth Chart 2Inflation Comeback? Chart 3Margins Should Expand Table 2 shows our updated industry group pricing power gauges, which are calculated from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. The table also highlights shorter term pricing power trends and each industry's spread to overall inflation in order to identify potential profit winners and losers. Table 2Industry Group Pricing Power This analysis shows that 75% of the industries we cover are able to raise selling prices, and 45% are doing so at a faster clip than overall inflation. Importantly, inflation rates have increased since our late-June update. The outright deflating sectors dropped by one to 15 since our last update, but are still up from the 14 figure registered in April. Encouragingly, only 12 industries are experiencing a downtrend in selling price inflation, a decrease of 7 since our late-June and April reports. Chart 4Cyclicals Have The Pricing Power Advantage Moreover, 9 out of the top 12 industries with the highest selling price inflation are deep cyclicals/commodity-related (Chart 4), highlighting that the fall in the U.S. dollar is aiding the commodity complex to increase prices. The bottom of the table is equally split between 5 deflating tech industries and 5 consumer discretionary sectors. In sum, corporate sector pricing power is recovering painting a positive sales growth backdrop for the coming months. This will also prop up operating leverage, as we have been suggesting,2 as will still modest wage inflation. All in all, we envision a sound profit margin and EPS growth outlook for the back half of the year. This week we are executing a further early cyclical downshift to our portfolio. Consumer Discretionary Juggernaut Is Over Since the fed funds rate hit the zero line in December 2008, the S&P consumer discretionary index is not only the best performing GICS1 sector, but it is also the best performing asset class globally. In fact, it has risen by over 384% since December 1, 2008, nearly double the S&P 500's return. Even if one recalculates the GICS1 sector returns since the March 2009 broad market trough, U.S. consumer discretionary stocks still come out on top. Interestingly, relative performance bottomed in July 2008 (Chart 5), roughly two months before Lehman's collapse and in advance of that autumn's trough in deep cyclicals/China & EM levered equity plays. Simply put, U.S. discretionary equities sniffed out a massive reflationary impulse. This sector is extremely sensitive to interest rate changes and the quick slashing of the fed funds rate to zero and undertaking of unconventional monetary policies worked in their favor. Fast forward to today and our sense is that there are high odds that the consumer discretionary juggernaut is over and thus we are downgrading exposure to neutral. The Fed last week announced the commencement of the renormalization of its balance sheet. If consumer discretionary stocks are the ultimate beneficiaries of zero interest rate policy and the quantitative easing experiment, the unwinding of these emergency policies should also work in reverse (Chart 5). In other words, a winding down of the Fed's balance sheet and a rising fed funds rate should eat into consumer discretionary relative returns (top panel, Chart 6). Chart 5Mind The Fed's Balance Sheet Chart 6Rates, Money Growth... Money growth has also taken a backseat. M1 money supply is decelerating and so is M2 growth. Historically, money creation and relative performance have been joined at the hip and the current message is to lighten up on discretionary stocks (bottom panel, Chart 6). Beyond tighter, at the margin, monetary policy capping this early cyclical sectors future returns, energy inflation is also working against the S&P consumer discretionary index. The recent knee-jerk jump in retail gasoline prices will dent consumer disposable incomes as higher prices at the pump act as a tax on consumers. Our consumer drag indicator, capturing both rising interest rates and gasoline prices, is weighing on relative performance momentum (bottom panel, Chart 7). Nevertheless, there are some sizable positive offsets preventing us from downgrading exposure all the way to underweight. Recovering household net worth has historically been a boon for discretionary consumer outlays (second panel, Chart 8). Consumers feeling more flush, coupled with the jump in confidence, typically underpin real PCE growth. Tack on the fresh all-time highs in real median incomes, with the latest two year period registering the highest income gains since the history of the data, and the ingredients are in place for sustained gains in consumer spending (third & bottom panels, Chart 8). Finally, relative valuations and technicals have unwound previously expensive and overbought conditions, respectively. The S&P consumer discretionary forward P/E currently trades at a mild discount to the broad market and below the historical mean, and our Technical Indicator still hovers near washed out levels (Chart 9). Chart 7...And Energy Prices Weigh##br## On Consumer Discretionary Chart 8Positive ##br##Offsets... Chart 9...With Washed##br## Out Technicals Bottom Line: Adding it up, the Fed's historic exit from unconventional monetary policies, coupled with higher interest rates and gasoline prices, which are all income sapping, signal that only a benchmark allocation is warranted in the S&P consumer discretionary sector. We are executing this downgrade to neutral by trimming the media heavyweight sub-index (comprising cable & satellite and movies & entertainment) to a benchmark exposure. Intermittent Cable Signal Similar to the broad consumer discretionary index, cable & satellite stocks have been on a tear since troughing at the onset of the Great Recession. The more defensive in nature cable-related spending served as a catalyst to push up relative performance to all-time highs (Chart 10). This defensive industry backdrop is also evident in the positive correlation between the U.S. dollar and relative share prices. Empirical evidence shows that over the past three decades cable stocks outperform during dollar bull markets and suffer during periods of U.S. dollar weakness (Chart 10). Synchronized global growth is allowing other G10 central banks to play catch up to the Fed, which raised rates for the first time this cycle in December 2015. As a result, this looming coordinated G10 tightening monetary policy backdrop has forced investors out of the greenback. Given that the cable & satellite index sources nearly 100% of its revenues domestically, in a relative sense, the year-to-date U.S. softness is negative for sales/profits (Chart 10). On the industry operating front, there are some demand cracks forming. Cable outlays are trailing overall PCE and are anchoring relative share price momentum (middle panel, Chart 11). This message is corroborated by the softness in the ISM services survey that has been negatively diverging from ISM manufacturing. Waning services demand has historically been a bad omen for relative profit growth. At a minimum, a leveling off in the V-shaped recovery in sell-side analysts relative EPS expectations is in order (bottom panel, Chart 11). Chart 10Dollar Blues Chart 11Demand Softening Worrisomely, recent comments from Comcast that subscriber losses in the current quarter will likely erase all of last year's gains are disconcerting. This anecdote also confirms that demand for cable services is failing. The second panel of Chart 12 shows that real cable spending peaked in early 2014 and since then has been continually losing traction. If it were not for the successful offset from price hikes, cable companies would be in dire straits. The cable operators' ability to lift selling prices is undeniable and unmatched with a multi-decade track record, and remains solid despite the plethora of industry woes of late (Chart 13).Recent chatter that Charter Communications is about to be gobbled up is another factor underpinning cable pricing power. Additional industry M&A activity will take supply out of the market; recall that Charter bought out Time Warner Cable last year with positive industry pricing power results. The implication is that industry sales will remain resilient. Chart 12Margin Squeeze Alert Chart 13But Pricing Power And Valuations Are Tailwinds Tack on compelling relative valuations with the relative price-to-cash flow ratio probing 5-year lows and the industry's threats are likely well reflected following the recent derating phase (bottom panel, Chart 13). Netting it all out, a more balanced cable industry profit backdrop is signaling that only a neutral stance is warranted in this media sub-index. Bottom Line: Downgrade the S&P cable & satellite index to neutral and lock in gains of 5% since inception. The ticker symbols for the stocks in this index are: BLBG: S5CBST - CMCSA, CHTR, DISH. Movies & Entertainment: Intermission Similar to the S&P cable & satellite downgrade to neutral, the S&P movies & entertainment media sub-index no longer deserves an overweight and we recommend trimming exposure to neutral. Cord cutting is not a new phenomenon and content providers have been regrouping in order to fend off cutthroat competition from Netflix and similar outfits. This is a secular industry force that traditional media outlets must embrace and adapt to rather than be ground down by inertia. M&A activity has been a key defense mechanism for this sector and share count retirement explains a sizable part of the torrid relative performance since the Great Recession (Chart 14). This source of industry support is in late stages on the eve of the mega deal involving Time Warner. Demand for movies and entertainment has also come under pressure lately as depicted by the deceleration in recreation PCE. The softness in the ISM services survey is a yellow flag (Chart 15). The hurricane catastrophe is disquieting in the near-term, especially given the unintended consequence of the spike in gasoline prices. Historically, rising prices at the pump eat into demand for recreation activities (third panel, Chart 15). Chart 14End Of Share Retirement? Chart 15Decreasing Demand... In a broader context, when overall media-related consumer outlays suffer a setback, as is currently the case, relative forward profit estimates tend to follow suit and vice versa. The implication is that the earnings-led decline in relative share prices likely has more room to fall (bottom panel, Chart 15). All of this is transpiring in softening industry pricing power. While selling prices are still expanding, the growth rate has been cut in half since peaking early last year. Input cost inflation is not offering any positive offsets. Chart 3 showed that our broad based wage inflation diffusion index is plunging, but movies & entertainment executives have been fighting for talent, boosting industry wage growth. Taken together, they are sending a negative signal for sky high margins that appear vulnerable to a squeeze (Chart 16). Nevertheless, there is some light at the end of the tunnel for this media sub-group. Disney recently announced that it would pull content out of Netflix and start its own streaming service, disintermediating its core movie and sports (ESPN) content. Content providers in general are also working on introducing/beefing up their own streaming services options in order to better compete with online-only rivals. Live television (news and sports in particular) are still a near-monopoly that traditional media content providers are working hard to preserve. Moreover, diversified business models also assist in cushioning the cord cutting secular decline in the content business segments. Importantly, consumer confidence is pushing decade highs and will likely make all-time highs prior to the end of the business cycle. Historically, relative performance and consumer sentiment have been positively correlated for the better part of the past 22 years. Currently, a wide gap has opened and there are good odds of a catch up phase in the former (top panel, Chart 17). Chart 16...Showing Up In Loss Of Pricing Power Chart 17Cheap With Low EPS Growth Hurdle Finally, we refrain from turning very negative on this index as we deem that most of the bearish news is already reflected in historically inexpensive valuations on below par relative sales and EPS 12-month forward expectations (middle & bottom panels, Chart 17). Bottom Line: Downgrade the S&P movies & entertainment index to a benchmark allocation. The ticker symbols for the stocks in this index are: BLBG: S5MOVI - DIS, TWX, FOXA, FOX, VIAB. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 https://www.clevelandfed.org/our-research/indicators-and-data/inflation-nowcasting.aspx 2 Please see BCA U.S. Equity Strategy Weekly Report, "Operating Leverage To The Rescue?" dated April 17, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights The Fed still wants to hike in December and thrice next year, but euro area inflation could roll-over versus the U.S. This could cause some weakness in EUR/USD. Long USD/JPY remains a cleaner way to capitalize on the Fed and on higher U.S. bond yields. U.K. trend growth is falling, this will limit how high the BoE will push interest rates up. While the pound can rebound further until year-end, it is not as cheap as it may currently look. AUD/NZD could move back toward parity, but be patient before shorting this cross. Feature The Fed Is On, The Dollar Will Strengthen The dollar bear market is likely over for now, but in our view, U.S. inflation still needs to bottom meaningfully for the DXY to be able to move above 95, and for EUR/USD to trade below 1.15. We expect inflation to bottom late in the fourth quarter, and noticeably re-accelerate in 2018. For now, markets will have to fully price a December rate hike from the Federal Reserve and handle the fallout of a potential slowdown in euro area inflation in the coming months. Moreover, the European Central Bank's tapering announcement next month has been well telegraphed, and is likely to be fully priced in a euro already trading well above levels implied by interest rate differentials. Fed Chair Janet Yellen and the Fed's economic projections have been unequivocal: Governor Lael Brainard has not convinced the rest of the FOMC that U.S. inflation expectations are becoming unmoored to the downside. As a result, the Fed still plans to hike in December and still expects to lift U.S. interest rates thrice next year. The committee also continues to foresee inflation returning to 2% in 2019. The market got the message: on Wednesday, the dollar experienced its strongest rally in eight months, and bond yields moved higher. New evidence is also accumulating that U.S. core CPI will soon trough. This week, U.S. non-oil import prices, a key input to non-oil goods prices continued to increase and the Philly Fed survey's prices-paid and price-received components both showed improvement - corroborating the message from the ISM price paid, which has shot up to 62. This should give Wednesday's message from the Fed more credence among investors. Meanwhile, euro area growth remains very strong, but there are early signs that core inflation may be peaking. BCA's euro area core CPI diffusion index has rolled over and fallen below 50%, normally a precursor sign to a top in core CPI (Chart I-1). Moreover, the strength in EUR/USD is redistributing previous U.S. deflationary pressures into the euro area. As Chart I-2 illustrates, the tightening in euro area financial conditions relative to the U.S. points to a rollover in relative inflation trends. Chart I-1Euro Area CPI Peaking? Chart I-2Euro Area Core CPI Peaking Against The U.S. The market is still pricing far too little in the way of rate hikes in the U.S. over the next two years, while it is pricing the ECB appropriately, anticipating a 2019 lift-off of euro area policy rates (Chart I-3). This leaves the EUR/USD quite vulnerable if the market reassesses the Fed's capacity to lift rates, as this pair continues to trade at a level of premium to interest rate parity models last recorded in 2009 (Chart I-4) - premia that have historically been followed by declines over the following six months, averaging 6%. Chart I-3The Potential For A Repricing Of The ##br##Fed Relative To The ECB... Chart I-4..Will Hurt ##br##EUR/USD The yen too remains at risk. The yen might be cheaper than the euro, trading in line with its interest rate-implied fair value, but it is also burdened by a central bank inclined to leave policy as easy as possible for as long as possible. In fact, new Bank of Japan board member Goshi Kataoka dissented this week because, in his view, Japan needs more easing, both fiscal and monetary. Thus, in an environment where the Fed is trying to lift interest rates and where U.S. Treasury yields trade well below fair value (Chart I-5), the yen could suffer greatly as interest rate differentials move in favor of the USD, since the BoJ will still cap JGB yields for an extended period. Moreover, on the political front, an October election is becoming increasingly possible. Japanese Prime Minister Shinzo Abe's popularity has rebounded, and the opposition is in disarray, pointing to a very likely win for the LDP. Abe is seeking a new mandate as he wants to set a referendum to amend the Japanese constitution, removing its pacifist bias in order to increase military spending, which has greatly lagged that of rival China (Chart I-6). The North Korean crisis is obviously beneficial to this goal, and Abe wants to capitalize on it. Chart I-5Biggest Problem For The Yen Chart I-6Abe Wants To Rectify This Gap In order to increase the likelihood of a successful referendum, we anticipate Abe to push for more stimulus to goose the economy. Additionally, when Japanese wages are adjusted for the change in the breakdown between full-time and part-time positions, wage growth has already picked up significantly - well above 3% compared to a paltry 0.4% annual rate for the headline measure. This combination of potential fiscal stimulus, improving underlying wage growth and a staunchly dovish central bank could ultimately put upward pressure on inflation expectations, and thus downward pressure on Japanese real yields. This could further augment the negative impact of rising U.S. bond yields on the yen. Bottom Line: The dollar is set to appreciate against the euro and the yen in the coming weeks. The Fed has not deviated from its message and it still intends to follow the path set in the "dot plot." Meanwhile, euro area inflation could roll over, limiting how close to today markets can bring forward the first hike from the ECB. The euro is too expensive to withstand this eventuality. The BoJ in unwilling to abandon its current extremely dovish policy, setting the stage for additional yen weakness in the face of higher U.S. bond yields. GBP: As Cheap As It Seems? GBP/USD is currently trading at a large 20% discount to its purchasing parity equilibrium rate, and the trade-weighted pound is 10% below our long-term fair value estimate (Chart I-7). Since valuations have been strong predictors of currency returns on a two- to five-year horizon, this begs the following question: Is the pound a buy? Tactically, yes, the GBP still offers upside for the next three months or so, especially vis-à-vis the euro. The Brexit negations are likely to lead to long transition periods for FTAs after the U.K. leaves the EU. Moreover, interest rate markets currently assign a 65% probability of a hike by the Bank of England in November. However, recent communications from BoE Governor Mark Carney and his colleagues suggest the British central bank will hike that month. House prices have regained some composure and wage growth has rebounded to 2.2% after hitting a low of 1.7% six months ago, explaining some of the recent strength in retail sales. Inflation remains sticky at 2.9% per annum, and even the non-tradeable sector, where the pound's movements should bear little influence, continues to experience elevated inflation readings. This would support Carney's recent assertion that the U.K.'s output gap is closing faster than the BoE originally anticipated. It also raises question marks as to whether long-term inflation expectations in the private sector are beginning to become unanchored - something that would justify removing monetary accommodation from the system. Beyond this time horizon, the picture becomes more complex. The problem for the pound arises from the fact that the earlier-than-expected closure of the output gap is first and foremost a reflection of falling trend growth, a phenomenon that will continue well into the future. It is one of the inevitable consequences of last year's Brexit vote. Brexit principally impacts trend growth by depressing the U.K.'s labor force growth. As Chart I-8 illustrates, pre-Brexit, the U.K. experienced much more robust labor force growth than its EU peers thanks to a steady inflow of immigrants. However, at its core, the Brexit vote was a referendum on immigration. The U.K. government's hard stance on rejecting free movement of people going forward demonstrates that the Conservatives understand this, and it will remain a key pillar of their strategy going forward. Chart I-7Is The Pound Really That Cheap? Chart I-8U.K. Trend Growth Will Fall Problematically, leaving the EU will not improve the British trade balance, despite the fall in the pound. It may even hurt it. The fall in the pound can marginally help the U.K.'s goods balance with the EU, which currently stands at a deficit of 5% of GDP. However, this deficit is structural and reflects the U.K.'s lack of competitive advantage in manufacturing vis-à-vis the rest of the EU. Thus, a fall in the pound will do little to fully redress this gap. Meanwhile, the U.K. runs a surplus of 1.3% of GDP in the services balance (Chart I-9). However, by leaving the EU, the U.K.'s service sector is likely to lose much access to the continent as trade in services is heavily regulated, and creating new trade deals on services between the U.K. and the EU will prove a difficult process. Moreover, this services balance seems insensitive to the gyrations in EUR/GBP. Thus, while leaving the EU might marginally help the goods balance thanks to a lower pound, this exchange rate benefit will be nullified by a loss of access to EU markets by U.K. service sector firms. Why does a lower trend growth matter for the pound in the long run? The U.K. has been running a large current account deficit for 20 years. Even at 3.9% of GDP, this deficit does not have to be a problem if it can be financed. Thankfully, the U.K. has benefited from a higher level of neutral interest rates, itself a function of Britain's higher trend GDP growth. This higher neutral rate means the U.K. has been able to enjoy higher interest rates in general than the EU or the U.S. (Chart I-10). These higher returns have attracted the necessary capital to finance the current account. Chart I-9A Lower Pound Will Not Undo##br## The Pain Of Leaving The EU Chart I-10Lower Trend Growth Equals##br## Lower Terminal Rate Going forward, lower trend growth will lower the neutral interest rate, which will limit both the terminal rate hit by the BoE this cycle as well as the average level of rates in the U.K. In this context, the U.K. will need a permanently cheaper pound to finance its current account deficit. As a result, the apparent cheapness of the pound on long-term valuation metrics may prove to be nothing more than an illusion. Chart I-11Will Higher GBP Volatility Hurt London? The other problem that could negatively affect the pound is that the U.K. remains a global financial center. Historically, having low exchange rate volatility has helped financial centers achieve the pre-requisite level of stability needed to attract foreign capital (Chart I-11). However, the pound's volatility has increased in the aftermath of Brexit. If realized volatility was computed from 2000 to 2015, the standard deviation of the pound's returns rank below that of the Swiss franc and the Norwegian krone; if the sample is expanded to today, its volatility ranks above that of the CHF and the NOK. Not only does this point to a large increase in the relative volatility of the pound in the interim two years, but this trend could continue in the future, especially if as our Geopolitical Strategy sister service argues, the leftward-shift in the U.K.'s median voter could lead to a Corbyn Premiership down the road.1 Bottom Line: The pound still has upside in the short-term as markets re-assess the path of the BoE toward a rate hike this year, removing the emergency easing implemented in the wake of the last year's referendum. However, the long-term outlook for the pound is trickier. The GBP's apparent cheapness is warranted. The U.K.'s potential growth rate is falling, which will drag down the country's neutral interest rates. As a result, the BoE will not be able to increase interest rates much over the course of the cycle. This means that financing the U.K.'s current account deficit will require the pound to remain cheap for an extended period of time. AUD/NZD: The RBNZ Can Tighten More Than The RBA The AUD/NZD is likely to experience a move toward parity over the next six months. Currently, AUD/NZD trades approximately 10% above its long-term fair value (Chart I-12, left panels), a level that has historically resulted in sharp reversals. This cross is also trading at a significant premium to our Intermediate-Term timing model (Chart I-12, right panels), further highlighting the medium-term downside risk for the aussie/kiwi. Chart I-12AAUD/NZD Is Expensive Chart I-12BAUD/NZD Is Expensive Valuations are not the only consideration raising a red flag for AUD/NZD. Relative monetary policy dynamics could also weigh on this cross going forward. As the Reserve Bank of New Zealand has been trying to talk down the kiwi, interest rate markets are pricing in 34 basis points of hikes over the next 12 months, while they expect the Reserve Bank of Australia's Cash Rate to increase by 41 basis points over the same timeframe. We think the RBNZ has more room to tighten policy than the RBA, especially as our central bank monitor is much more hawkish on New Zealand than Australia (Chart I-13). Corroborating the message of this indicator, the New Zealand output gap is now at 0.9% of potential GDP while it stands at -1.6% in Australia, suggesting more pronounced underlying inflationary pressures in the smaller economy. Moreover, New Zealand's growth is outpacing Australia's by nearly 1%, and relative LEIs suggest no end in sight for this trend. Thus, the relative output gap between the two countries will continue to move in favor of a tighter RBNZ than RBA. Additionally, Australia house prices have been in a cyclical downtrend versus New Zealand, depreciating nearly 15% in relative terms since 2011. This is resulting in a large underperformance of Australia's credit growth against New Zealand, which points to downside risk in AUD/NZD (Chart I-14). Mirroring these two factors, Aussie retail sales are lagging their neighbors by a near-record 3% annual pace. Beyond domestic conditions, terms-of-trade dynamics are also a negative for AUD/NZD. This cross tends to mimic movements in the prices of metals relative to dairy prices, reflecting the composition of the two nations' exports. Since May this year, metals have been outperforming milk, but AUD/NZD has massively overshot this driver (Chart I-15), exposing the cross to a reversal in relative commodities prices. Going forward, with Chinese monetary conditions tightening, with Chinese fiscal stimulus waning, and with EM money growth sharply decelerating, metals prices, which are much more sensitive to global industrial activity, are likely to underperform the less growth-sensitive dairy prices. Chart I-13The RBNZ Needs To be More##br## Hawkish Than The RBA Chart I-14Disconnect Between AUD/NZD##br## And Relative Credit Growth Chart I-15AUD/NZD Out Of Line ##br##With Terms Of Trade Technically, it is too early to enter this bet with any degree of certainty. Short-term momentum metrics are deeply oversold, and AUD/NZD, currently trading at 1.085, could rebound once it moves to 1.08 - the next key support level and slightly above the 50% retracement of the rally begun in June. This rebound could lift AUD/NZD close to the 1.11 neighborhood. Thus, we will wait for a better entry point to begin shorting this cross, especially as this weekend's election remains too close to call despite a recent rebound in the National Party. A Labour/NZ First coalition could cause a temporary sell-off in the NZD. Bottom Line: AUD/NZD is very expensive, and the market is underestimating the risk that the RBNZ will tighten policy more than the RBA over the next 12 months. The New Zealand economy has much less slack and is growing more strongly than Australia's, pointing to greater inflation risk. Additionally, metals prices are likely to underperform dairy prices, which will hurt Australian terms of trade relative to New Zealand. Technically, a better opportunity to short AUD/NZD is likely to emerge in the coming weeks. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The highlight of this week was the Fed's Monetary Policy meeting, where the FOMC announced the unwinding of the Fed's US$4.5 trillion balance sheet in October. It also intend to boost in interest rates in December, with the probability of a hike that month now at 63%. This is likely to move to 100%. While data continued to be mixed this week - existing home sales slowed but the Philly Fed survey was very strong, the Fed decided to ignore this as well as the potential impact of hurricanes, instead concentrating on the strong fundamentals underpinning the U.S. economy. Interest rates will therefore increase alongside inflation, providing a fillip for the greenback. On the fiscal side, tax cuts seem increasingly likely to be implemented. As investors begin to price out fiscal policy disappointments, the dollar will rally. Nevertheless, inflation is likely to pick up some time in 2018, and the dollar will fully bloom then. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Fade North Korea, And Sell The Yen - August 11, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Euro area data continues to outperform expectations: Core CPI, unchanged at 1.3%, beat expectations of 1.2%; Headline CPI also remained unchanged at 1.5%; German ZEW Economic Sentiment outperformed greatly coming out at 17.0, while the Current Situation also outperformed at 87.9; German producer prices grew at 2.6% annually, outperforming expectations of 2.5%. While the euro traded positively on the news, it lost most of this week's gains due to the Fed policy decision. We believe that sustained growth in the euro area will sustain the euro between 1.15 and 1.20. However, a pickup in U.S. inflation in 2018 could push EUR/USD toward 1.10. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Machinery orders yearly growth underperformed to the downside, contracting by 7.5%. The contraction also accentuated from July to August. Domestic corporate goods price yearly growth also underperformed, coming in at 2.9%. However both export and import growth outperformed expectations, coming in at 18.1% and 15.2% respectively. Additionally the merchandise trade balance in August also outperformed, coming in at 113.6 Billion yen. The Bank of Japan decided to leave their policy rate unchanged at -0.1% on Wednesday on an 8 to 1 vote, with dissenter Goshi Kataoka presenting an even more dovish slant. The BoJ highlighted that the economy continues to expand moderately, and that inflation should continue to slowly grind higher. Overall we are more bearish on the ability of the BoJ to spur inflation without a meaningful depreciation in the yen. Continue to long USD/JPY. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Fade North Korea, And Sell The Yen - August 11, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has surprised to the upside: Retail sales growth and retail sales ex-fuel growth outperformed expectations coming in at 2.4% and 2.8% respectively. Manufacturing production yearly growth came in at 2.9%, also outperforming expectations. Furthermore the ILO unemployment rate came in at 4.3%, outperforming expectations. The BoE left rates unchanged in their latest interest rate decision by a majority of 7 to 2. The BoE was more hawkish than expected, commenting that monetary policy could need to be "tightened by a somewhat greater extent over the forecast period than current market expectations". Overall we continue to be positive on the pound relatively to the euro. However on a longer term basis, the outlook for the pound remains tricky, as Brexit could result in a lower neutral rate in the U.K., and thus a lower pound. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 AUD fell sharply following RBA Governor Philip Lowe's speech. Lowe stated that "a rise in global interest rates has no automatic implications for us here in Australia", prompting a repricing of Aussie rates. The high level of household debt was also brought to light, with Governor Lowe highlighting that "household spending could be quite sensitive to increases in interest rates, something the Reserve Bank will be paying close attention to." He also surmised that "there are risks on the horizon, with the Chinese economy going through some difficult adjustments". This speech largely confirms are bearish view on the Australian dollar. While the AUD did rally this summer, this was mostly due to disappointing U.S. inflation. When inflation re-emerges, which we believe will be in early 2018, the AUD could give up most of its gains. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been positive: Electronic card retail sales yearly growth increased to 4.4% from 2% the month before. Gross Domestic product yearly growth came at 2.5%, in line with expectations. Meanwhile the current account outperformed to the upside, coming in at a deficit of 2.8% of GDP, compared to expectations of 3%. Finally the Business NZ PMI came in at 57.9, increasing significantly from last month's reading of 55.4. The kiwi has appreciated in the past 2 weeks, as a weak dollar coupled with positive data in New Zealand and falling political risk in that country have helped the currency. At the present, we are bearish on AUD/NZD, as the inflationary backdrop continues to be more positive in New Zealand than in Australia. Meanwhile iron ore prices seem to have peaked. These factors should weigh on this cross. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The Canadian consumer sector remains strong, with wholesale sales increasing at a 1.5% monthly pace in July, beating the expected 0.9% contraction. Higher rates are also increasing portfolio inflows, as foreign portfolio investment in Canadian securities jumped to CAD 23.95 bn in July, from the previous outflow of CAD 0.86 bn, also larger than the expected CAD 4.46 bn. While the CAD depreciated against the USD following the Fed's monetary policy meeting, it remained largely flat against other G10 currencies. The CAD will continue to fight headwinds against the USD but to rally on its crosses. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: Producer price inflation came in at 0.6%, beating expectations. The trade balance came in at 2.713 billion CHF for the month of August, underperforming expectations. A week ago the SNB left rates unchanged as expected. Most importantly, there was a slight upward revision in the inflation forecast, with the SNB anticipating an inflation rate of 0.4% in 2018 and 1.1% in 2019 compared to the previous forecast of 0.3% and 1%. These forecast assume a 3-month LIBOR of -0.75% through the forecast period. Moreover, the central bank also expects the modest recovery in Switzerland to continue. However, it seems that the floor under EUR/CHF will stay for the time being, as the SNB said that the Swiss Franc continues to be "highly valued" and that that continued intervention in the FX market will continue to be necessary. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Despite a rebound in Norway's economic surprise index, Norway continues to experience a marked lack of inflation: Headline inflation came in at 1.3%, decreasing from last month's reading of 1.5% and underperforming expectations. Core inflation also underperformed expectations, falling from 1.2% last month to 0.9% in the latest data point. Yesterday the Norges Bank decided to keep rates unchanged at 0.5%. The bank released a statement highlighting that capacity utilization is "on the rise, and higher than previously assumed", however they also highlighted that "wage growth will remain moderate". More importantly they signaled that they would likely increase rates somewhat earlier than previously expected. Overall we continue to be bullish on USD/NOK, as interest rate expectations should help the dollar against the krone. That being said, higher oil prices should help the krone outperform its commodity peers and the euro. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 USD/SEK has remained flat for a month, as markets are assessing the situation between the two hawkish central banks. Data in Sweden has disappointed recently: Manufacturing PMI went down to 54.7 from 60.4; The current account decreased by SEK 39.5 bn; Industrial production also grew by 5.3% annually, lower than the previous 8.9% figure; New orders are also growing by less than before at 2.1%; Inflation also underperformed the expected 2.2%, coming in at 2.1%; However, the unemployment rate dropped significantly from 6.6% to 6%. While inflation disappointed, it still remains in the target range and the upward trend is still intact. The Swedish economy is performing very well, and the Riksbank is likely to join the Fed and the BoC in hiking rates next year. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

Special Report

Highlights A shares are under-owned and under-researched beyond Chinese borders. Global investors' interest on Chinese A shares will inevitably increase. The A-share market historically has been a low-beta play, and the Chinese domestic sectors tend to move together with one another rather than with their respective global sector benchmarks. The superior long-term performance of Chinese equities has been accompanied with much greater volatility in both earnings and prices compared with EM and DM benchmarks. Some larger-weight sectors, particularly banks, have significantly dragged down the valuation matrix of the broad A-share market, while some smaller-weight sectors are more dearly valued. Overall A shares are still more expensive compared with other global bourses. Feature The MSCI's decision of partial inclusion of Chinese domestic A shares in its widely followed EM and world equity indices has put this asset class on global investors' radar screens. The A-share market, which only began to develop some 30 years ago as a trial balloon for capitalism, has already become the world's second-largest by market capitalization. Yet it remains decisively mysterious outside Chinese borders. Not only is the market notoriously volatile, alternately driven by euphoria and panics, it has also been largely isolated from the outside world thanks to China's capital account controls. All of this has made global investors either unable or unwilling to commit to this asset class, which also means it is both under-owned and under-researched from global investors' perspective. This trend will inevitably change, as the Chinese economy continues to gain global significance and as Chinese regulators continue to liberalize capital account control measures. The People's Bank of China is reportedly drafting a policy package to further open up the country's financial sector to foreigners. This week's report intends to shed light on this obscure asset class. A Class Of Its Own The A-share market's juvenile and isolated nature has generated some unique features that are not only different from global and EM bourses, but also from their overseas-listed investable peers. First, Chinese A shares have a systemically lower correlation with other major global bourses, which is not surprising due to the market's isolation from global fund flows. The three-year moving beta of the market with the S&P 500 is slightly over 0.5, according to our calculation - much lower than both EM and Chinese investable equities.1 A shares' correlation with the rest of the world, however, has been steadily rising in the past 10 years (Chart 1). Foreign capital has indeed been given increasing access to A shares in the past decade through various channels such as qualified foreign institutional investors (QFIIs), the RMB Qualified Foreign Institutional Investors (RQFIIs) and more recently the "connect" programs linking Hong Kong Exchange with mainland bourses (Chart 2). However, we doubt A shares' rising beta has much to do with China's capital account liberation, as foreign ownership is still negligible. Rather, we suspect it is more due to China's rising importance in the global economy. In other words, global markets have become increasingly sensitive to the "China factor" that is also driving A shares. Chart 1A Shares' Low And Rising Beta Chart 2Rising Foreign Access To A shares Moreover, A shares' low correlation with other global markets can also be observed at the sector level. Table 1 summarizes A-share sectors' correlations with their respective EM and DM sector benchmarks as well as their China investable counterparts, which are categorically lower than the cross-sector correlations among other markets. For example, A-share energy stocks' correlations with their sector counterparts in the China investable universe, EM and DM are 0.58, 0.48 and 0.36, respectively. In comparison, China investable energy stocks have a correlation of 0.84 and 0.72, respectively with the EM and DM sector benchmarks, and the EM energy sector's correlation with its DM counterpart is 0.8. In other words, sector selection rather than country selection matters fundamentally for the performances of DM and EM focused portfolios, including investable China funds. A-share sector performances, however, have shown much greater idiosyncrasy from the general sector trends in global markets. Table 1A shares Sectors Are Less Correlated With Global Peers... Instead, there have been much stronger correlations among the performances of A-share sectors compared with their investable peers and other global bourses. Appendix 1 provides a detailed breakdown of cross-sector correlations of these major markets. Taken together, the average cross-sector correlation among A shares is 0.75, compared with about 0.55 in all other markets (Chart 3). This, in our view, is likely due to exceptionally high retail investor participation in the A-share market. Unlikely other markets that are largely driven by sophisticated institutional investors with research capabilities, Chinese A shares are to a much greater extent driven by herd-following retail investors, who put little emphasis on fundamentals. Anecdotal evidence abounds that investors buy or sell a stock based on price per share rather than per share earnings metrics, and naively chase laggards in anticipation of a catchup, even without clear fundamental catalysts. This could change as institutional investors take a greater share in A-share market trading and ownership, but the process will be slow and gradual. Chart 3... But Are Closely Correlated ##br##Among Each Other In short, the A-share market historically has been a low-beta play, and the Chinese domestic sectors tend to move together with one another rather than with their respective global sector benchmarks. From a portfolio management of view, including A shares should provide diversification benefits in managed global and EM portfolios. Greater Returns... Since its inception in the early 1990s, Chinese A shares have been on a powerful and volatile uptrend (Chart 4). The market has followed a well-defined central trendline, but with extreme price moves on both sides, alternating between massive overshoots and undershoots. Measured by the Shanghai Stock Exchange (SSE) Composite Index, launched in 1991 with the longest price history, stock prices have increased by over 20-fold since 1991 in RMB terms. Since 2000, A-shares' total return index, price appreciation and dividend income combined has rallied by about five-fold in U.S. dollar terms - massively outperforming both global and EM benchmarks as well as investable Chinese stocks (Chart 5). A-shares' outperformance against global bourses is largely due to faster earnings growth rather than multiples expansion. Earnings of Chinese domestic and investable shares have risen by seven- and 10-fold respectively since 2000, both outpacing their EM and DM peers (Chart 5, middle panel). Importantly, while DM has been the bright spot in the ongoing multi-year bull market, it has been a chronic laggard over a more extended time horizon - both earnings and total returns of DM have significantly lagged EM in general and Chinese shares in particular since 2000. It is commonly argued that economic growth has little to do with stock market performance, and therefore a country's superior growth outlook does not necessarily lead to superior equity returns for investors. We find this view plausible. There is no question that the near-term correlation between a country's economic growth and stock prices is low empirically. However, economic growth should be a defining factor for asset returns over the long run. After all, stock prices are ultimately driven by earnings, which in turn are driven by economic growth. Granted, stock markets are an emotional discounting mechanism, and prices can and do deviate from earnings fundamentals from time to time - they will inevitably mean-revert over the long run. Chinese GDP has expanded by a staggering 10-fold since 2000 in dollar terms, which is the fundamental driving force behind China's long-term earnings growth and stock market returns (Chart 5, bottom panel). Chart 4A shares Powerful And Volatile Long-term Uptrend Chart 5GDP, Earnings And Stocks Prices ... With Greater Risks The superior long-term performance of Chinese equities, however, has been accompanied with much greater volatility in both earnings and prices compared with EM and DM benchmarks. This is easy to observe in the dramatic fluctuations in A-share prices; from its inception, the market has been routinely characterized by massive boom-bust cycles. Table 2 summarizes the historical returns of A shares in comparison with their investable and EM/DM peers. A few points are worth highlighting. Table 2Statistical Summary Chart 6A Shares' volatility Is High... First, the A-share market has historically yielded much greater dispersion of returns compared with other bourses, including Chinese investable stocks, as shown in the box-and-whisker plot (Chart 6).2 Since 2000, the A-share market has achieved the highest cumulative returns among all markets, but it has also recorded the biggest monthly gain and deepest monthly loss. It has the widest gap between first-quartile and third quartile returns, the greatest risk of loss and the biggest historical value at risk (VaR)(See Appendix 2 for return distributions of various markets). Overall, the standard deviation of A-share monthly returns historically is 8.4%, compared with 7.7% for the Chinese investable market and 6.4% and 4.4% respectively for the EM and DM benchmarks. On a risk-adjusted basis, A shares have delivered the highest risk-adjusted returns since 2000, but the risk-return profile has been decisively poorer evaluated in both a five- and 10-year horizon (Table 3). The Sharpe ratio of A shares since 2000 is 0.39, compared with 0.35 and 0.23 for EM and DM benchmarks.3 Over a five-year and 10-year period, however, A shares' Sharpe ratios were significantly lower than other markets. Similarly, A shares' Sortino ratio since 2000 was superior, but inferior over shorter-term horizons. In contrast, DM has delivered the highest risk-adjusted returns in the past five years and 10 years, but has lagged since 2000. Indeed, DM stocks, particularly the U.S. market, have delivered stellar performance since the aftermath of the global financial crisis with very low volatility, while Chinese equities and EM stocks in general have been plagued with numerous macro concerns. It remains to be seen, however, whether this divergence can be sustained going forward. Table 3Risk And Return Characteristics Chart 7...But Declining Finally, although A shares historically have been structurally more volatile than other markets, the gap has been gradually narrowing - a sign of A shares' growing maturity (Chart 7). As the market continues to institutionalize, we expect price volatility will likely continue to decline. A shares, dubbed as a highly speculative "virtual casino" in the early 1990s, will become an increasingly important venue for Chinese households to park their wealth, with more moderate risk-return tradeoffs. Sector Composition And Valuation Perspective From the humble start of a handful of listed firms in the early 1990s to the world's second-largest equity market by capitalization, A shares have experienced a dramatic expansion and significant changes. Along with the two mainboards in Shanghai and Shenzhen stock exchanges dominated by large-cap stocks, several "peripheral" boards have also been established to cater to the funding needs of small and medium-sized companies and high-tech startups. Chart 8 shows the sector components of A shares - as in most equity markets, banks and financial firms account for a disproportionally large weight in the A-share index. However, compared with the Chinese investable universe,4 A shares are more diversified and are a closer representation of the sectoral structure of the broader Chinese economy. Chart 8A Shares Sector Breakdown On an aggregate level, A shares currently look cheap compared with historical norms (Chart 9). Our composite valuation indicator, an average of conventional valuation indicators such as price-to-trailing earnings, price-to-book and dividend yield, shows that A shares are currently trading at close to one standard deviation below its historical average. Under the surface, however, the market-cap weighted aggregate valuation indicators disguise some significant differences among different sectors: large-cap A-shares, mainly banks, are trading at large discounts to their respective historical means, but smaller-weight sectors, particularly technology, consumer staples and healthcare, are trading at higher multiples. Chart 10 shows a simple average of various valuation ratios of the 10 Global Industry Classification Standard (GICS) sectors.5 With the exception of price-to-cash, the equal-weighted valuation indicators are more expensive than their respective market weight-based versions, according to our calculation. This means some larger-weight sectors, particularly banks, have significantly dragged down the valuation matrix of the broad market, while some smaller-weight sectors are more dearly valued. However, none of the valuation ratios appear extreme in a historical context. Chart 9A Shares Appear Cheap... Chart 10...But With Big Sector Gaps Summary And Conclusions Compared with other bourses, Chinese A shares currently are still more expensive (Table 4). A-shares' valuation premium may be justified from a long-term point of view, given its stronger earnings growth outlook. However, investable Chinese stocks currently are still much more attractively valued, and thus remain our favored "China play" at the moment. Table 4Valuation Ratio: Market Rate Vs. Sector Average Nonetheless, global investor interest in A shares will inevitably increase going forward, as the Chinese economy continues to gain global significance and regulators continue to deregulate the country's capital account controls. A shares' relatively low correlation with other global bourses also provides unique diversification benefits to managed global and EM portfolios, and foreigners' extremely low ownership in this asset class also generates constant tailwinds. In addition, as the market continues to mature, volatility will abate, further improving its attractiveness for global long-term investors. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com Stella Peng, Research Assistant stellap@bcaresearch.com 1 All based on weekly returns. China Shanghai A share index is used for A share index, and MSCI China Free USD total index is used for the China investable market. All other markets are calculated using U.S. dollar total return MSCI indexes, unless otherwise specified. 2 A box and whisker chart shows the degrees of returns concentration in a given time frame. The top and bottom lines of the box indicate the first and third quartiles of the return distribution respectively; the horizontal line inside the box is the median; and the tips of the vertical lines stand for the maximum and minimum returns. 3 The Sharpe ratio is calculated as monthly returns minus one-month U.S. dollar LIBOR (as risk free rate for dollar-denominated investors) divided by the standard deviation of returns. The Sortino ratio is a variation of the Sharpe ratio, which measures the excess returns divided by the standard deviation of negative asset returns (or the downside deviation). 4 Please see China Investment Strategy Weekly Report, "A Closer Look At Chinese Equity Valuations," dated August 31, 2017, available at cis.bcaresearch.com. 5 Includes Consumer Discretionary, Consumer Staples, Energy, Financials, Health Care, Industrials, Information Technology, Materials, Telecommunication Services and Utilities. Real Estate is included in Financials, due to its limited data availability as a stand-alone GICS sector. Appendix 1 Cross-Sector Correlations Of Major Markets China A China Investable Emerging Markets Developed Markets All Country World Appendix 2 Distribution Of Market Returns Cyclical Investment Stance Equity Sector Recommendations

Highlights Dear Client, We will not be publishing next week, as BCA Research's Investment Conference is being held in New York City. We will be back the following week with a Special Report on global agricultural markets, and a recap on the performance of our 3Q17 recommendations. Kind regards, Robert P. Ryan, Chief Commodity Strategist Commodity & Energy Strategy Our new supply-demand balances indicate OPEC 2.0 will have to extend its production cuts to June 2018 to meaningfully reduce global oil inventories, even with demand growth exceeding 1.60mm b/d this year and 1.70mm b/d next year. This will lift average Brent prices to ~ $59/bbl and WTI to just under $57.50/bbl next year. We continue to expect Brent to trade to $60/bbl by year-end 2017, and for WTI to trade ~ $3.00/bbl under that. Higher prices will incentivize higher production from U.S. shale operators. This is a risk OPEC 2.0 will have to manage, as it develops a modus operandi that allows it to co-exist with shale and still maintain adequate revenues for its member states. Energy: Overweight. We are taking profit on our Brent options positions at today's close, since December options will have only three weeks to trade when we return. These positions, recommended in May and June, were up 116.3% on average by Tuesday's close. We will initiate positions in May and December 2018 Brent call spreads, going long the $55/bbl strike vs. short the $60/bbl strike at tonight's close. Base Metals: Neutral. Our tactical COMEX copper short is up 5.5% since inception on September 7. Precious Metals: Neutral. Our long COMEX Gold hedge is up 6.2% since it was initiated May 4, 2017. We are retaining the position as a strategic portfolio hedge. Ags/Softs: Underweight. Corn is having a tough time holding a bid following last week's USDA's Crop Report, which called for higher production and ending stocks, and lower prices. We will be updating our global ags assessment in a Special Report October 5. Feature OPEC 2.0 will have to extend its 1.8mm b/d production cuts to end-June 2018, in order to bring global inventories closer to levels it considered necessary to clear the market when it embarked on its 1.8mm b/d production-cutting Agreement at the end of last year, based on our most recent supply-demand balances modeling (Chart of the Week). Chart of the WeekOPEC 2.0 Needs To Extend Cuts,##BR##To Reduce Global Inventories As a result, our base case for balances reflects the OPEC 2.0 Agreement being extended to end-June (Chart 2). As we noted in our assessment last week, compliance with the OPEC 2.0 production-cutting Agreement remains high.1 All told, we see global production growing 0.83mm b/d this year, and 2.13mm b/d next year, based on our expectation of the OPEC 2.0 Agreement being extended to end-June. On the demand side, our most recent assessment of global demand leads us to expect growth of 1.62mm b/d this year and 1.72mm b/d in 2018 (Table 1). Chart 2Base Case For BCA Oil Supply-Demand Balances Reflects June 2018 Expiry Of OPEC 2.0 Cuts Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Fundamentals Point To Higher Oil Prices Based on our latest assessment of the global oil market, we believe OPEC 2.0 will fall short of reducing visible inventories back to their 5-year average levels if the coalition's production-cutting agreement expires at end-March 2018 (Chart of the Week, top panel). In fact, we believe that the Agreement will have to be extended to at least June 2018 - assuming no change in OPEC 2.0 country-specific production quotas - in order to draw OECD inventories down to their 5-year average levels (Chart of the Week, middle panel). An extension of the cuts to December 2018 would push OECD commercial inventories closer to levels originally targeted by OPEC 2.0 when its Agreement was reached at the end of last year. There is a higher risk prices will exceed the upper end of the range we assume WTI will trade in - $45/bbl to $65/bbl - with greater frequency next year, given we expect WTI prices will average slightly less than $57.50/bbl and Brent prices will average just under $59.00/bbl. Given the draws we expect in global inventories, the likelihood the WTI forward curve trades in backwardation next year also is elevated. We expect Brent to continue to trade in backwardation next year, which we believe will benefit OPEC 2.0 member states, since it allows them to realize higher spot prices - against which term contracts mostly are written - and will limit the volume of hedging U.S. shale producers can effect. Given our updated balances, we re-estimated our oil fundamentals models, accounting for the higher demand we expect (Chart 3), and continued production restraint by OPEC 2.0 on the supply side (Chart 4). These are markedly different to the EIA's estimates. Chart 3BCA Expecting Stronger Oil Demand Than EIA Chart 4Oil Supply Evolution Under Different Scenarios Using these fundamental inputs, we derived forecasts for the WTI and Brent prices.2 The four scenarios we analyzed are: Expiry of OPEC 2.0 Agreement in March 2018; Expiry of OPEC 2.0 Agreement in June 2018; Expiry of OPEC 2.0 Agreement in December 2018; The U.S. EIA Short-term Energy Outlook (STEO) supply-demand assumptions. The estimated results are presented in Table 2 and Chart 5. Table 2Fundamentally Derived##BR##Price Expectations Chart 5Oil Prices Will Lift As OPEC 2.0##BR##Agreement Restricts Supply Interestingly, the 4Q17 WTI futures curve appears to be priced much closer to Scenario No. 4, the EIA's assumptions. This is something we have observed in the past - i.e., the market has a tendency to price to the EIA's supply-demand balances, in the short term. As far as we can tell, the EIA's estimates assume less steep cuts than we do, and appear to be projecting visible inventories will begin to rise starting next month - (Chart 6). Chart 6EIA Assumes OECD Inventories Will Rise Under the EIA scenario, the average WTI futures price for 4Q17 is $50.40/bbl. Under BCA Base Case Scenario, which assumes the OPEC 2.0 Agreement will be extended to end-June, we estimated WTI prices would average $54.00/bbl over the same period. For 2018, the divergence between the EIA and BCA base cases is even more dramatic: Under the EIA's assumptions, our fundamental model estimates WTI prices will average $45.55/bbl in 2018, while under our new base case scenario, which projects the OPEC 2.0 deal will be extended through June, we estimate WTI prices will average $57.44/bbl next year. In its September Short-Term Energy Outlook (STEO), the EIA substantially lowered its U.S. shale production growth estimates for this year. Our colleagues at BCA's Energy Sector Strategy highlight this revision in this week's report, noting that 3Q17 U.S. onshore production levels will be 540k b/d higher yoy, versus an earlier expectation of a 730k b/d increase. This represents a ~ 25% reduction in the yoy growth rate. In addition, EIA's forecasted 3Q17 quarter-on-quarter oil production growth was cut by 40%, with sequential production growth now estimated at 197k b/d.3 The EIA's estimate now is more in line with BCA's assessment. These revisions will be supportive of prices, once market participants realize the EIA's scaling back on its growth expectations. BCA Lifts Estimate Of Demand Growth In our revised supply-demand balances, we expect 2017 global oil consumption will increase 1.62mm b/d, while 2018 demand will be up 1.72mm b/d. This reflects the strong growth reported by the OECD, which we noted last week, and the IMF.4 Strong growth momentum also can be seen in the continued performance of world trade volumes (Chart 7). The trade expansion is led by EM economies, with EM Asia, Latin America and Central Europe all posting yoy growth of ~ 10% at mid-year. EM also drives most of global oil-demand growth (Chart 8).5 Chart 7Global Growth Reflected##BR##In Increased Trade Volumes Chart 8EM Import Volumes##BR##Remain Strong Our expectation is EM oil demand will grow 1.20mm b/d this year and 1.30mm next year, accounting for the bulk of the 1.62mm and 1.72mm of overall demand growth we expect in 2017 and 2018, respectively. We will continue to follow demand trends in EM closely, particularly China and India, given its importance to overall global oil demand growth. Backwardation Will Persist In Brent, Arrive Sooner In WTI The direct implication of our results is backwardation will become more pronounced going forward. In the Brent market, the forward curve is backwardated to the end of 1Q18 then pretty much flattens out, based on mid-week settlements. In the WTI curve forwards, WTI futures carry to June 2018 then backwardate slightly to the beginning of 4Q19. We expect both to backwardate next year as storage draws and markets tighten. We have maintained OPEC 2.0 member states would benefit from a strategy under which they manage production and storage in such a way as to backwardate Brent and WTI curves. This would allow member states to realize higher revenues from spot prices, which are referenced in long-term supply contracts and are received on outright spot sales, and limit the amount of hedging U.S. shale producers can do: Lower deferred prices are not as profitable for producers, since they result in less revenue per barrel hedge in the future. Upward-sloping forward curves - i.e., contango market structures - allow producers to hedged at higher prices in the future, providing higher revenues, assuming the starting point is the same as in a backwardated market. We expect that as 2017 winds down and we approach the end of 1Q18, it will become apparent to OPEC 2.0's leadership their production-cutting agreement needs to be extended in order to drain global storage and get prices to lift. This is particularly true for the Kingdom of Saudi Arabia (KSA), which most likely will IPO Saudi Aramco, the state-owned oil company toward the end of next year. If OPEC 2.0's production-management agreement is not extended and inventories do not draw sufficiently to lift prices and backwardate the Brent forward curve, KSA most likely will have to push its IPO into 2019. Given the country's keen desire to raise funds to support its diversification away from its oil dependency, we believe its leaders would prefer to get the funds raised by the IPO in the door and begin allocating them. Bottom Line: OPEC 2.0 will extend the expiry of its production-cutting agreement from end-March to end-June 2018. This will force global inventories to fall to levels closer to those expected when the coalition agreed to jointly manage production at the end of last year. Demand growth will exceed 1.60mm b/d this year and 1.70mm b/d next year. This, along with the extension of the OPEC 2.0 cuts to end-June, will lift average Brent prices to ~ $59/bbl and WTI to just under $57.50/bbl next year. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Hurricane Recovery Obscures OPEC 2.0's Forward Guidance," published September 14, 2017. It is available at ces.bcaresearch.com. 2 We estimate WTI and Brent prices for the balance of 2017 and 2018 with respect to their fundamentals. The adjusted R2 for the WTI and the Brent regressions are 0.89 and 0.92, respectively. 3 Please see BCA Research's Energy Sector Strategy Weekly Report "A Funny Thing Happened On The Way To The "Shalepocalypse," published September 20, 2017. It is available at nrg.bcaresearch.com. 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Hurricane Recovery obscures OPEC 2.0's Forward Guidance," published September 14, 2017. It is available at ces.bcaresearch.com. See also "A Firming Recovery," in the IMF's World Economic Outlook Update published July 24, 2017. We use IMF global GDP growth estimates as an input to our oil-demand modelling. 5 We have found EM imports to be a good explanatory variable for oil and base metals demand, as well as inflation in the U.S. and EU. Please see, e.g., BCA Research's Commodity & Energy Strategy Weekly Report "Trade And Commodity Data Point To Higher Inflation," published July 27, 2017. It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights EM EPS growth is set to decelerate significantly and will likely turn negative in 2018 based on the China/EM money/credit indicators. All measures of Chinese broad money growth have fallen to a record low signifying a major growth slump. The two pillars of the EM currency rally - strong growth in China that manifests in higher commodities prices and lower U.S. bond yields- are set to reverse. EM equities and credit markets relative performance versus their DM peers is about to relapse. A new fixed-income trade: receive 2-year swap rates in Mexico / pay 2-year swap rates in the U.S. Feature Last week we were on the road, meeting with some of our U.S. East Coast clients. This week we address some of the common questions we received. Q: Why do you think EM profits will relapse in the next six-to-nine months, given both global and EM growth continue to show strength? A: Our reluctance to change our view on EM risk assets in general and equities in particular has to do with EM/China business cycle/corporate profit indicators. Several indicators for EM profits - which have exhibited very good track records - presently forecast a material slowdown and possibly a contraction in EM EPS starting late this year and well into next year. In particular, China's broad and narrow money impulses lead EM EPS by about nine months, and are currently signaling that EPS growth is set to peak and begin to decline in the next nine months (Chart I-1). What's more, a few business cycle indicators from Korea and Taiwan, such as nominal manufacturing production and manufacturing shipments-to-inventory ratios, corroborate a peak in EM EPS growth (Chart I-2). Chart I-1EM EPS Is Set to Decelerate ##br##And Probably Contract Chart I-2More Signs Of Relapse##br## In EM EPS Growth Importantly, the EM corporate earnings slowdown will not occur in a vacuum. It will transpire amid a slowdown in Asian trade and lower commodities prices. In particular: China's broad money M3 impulse leads domestic industrial orders, nominal manufacturing production and imports (Chart I-3). Even though Asian export data were strong in August, China's container freight index signals a slowdown in Asian trade lies ahead (Chart I-4). Chart I-3China: M3 Impulse And Domestic Demand Chart I-4Asian Export Growth To Slow The Chinese broad money impulse also points to a rollover in Korean, Taiwanese, other EM as well as DM countries' shipments to the mainland (Chart I-5). This is how the slowdown in China's money/credit will hurt corporate profits in EM as well as in DM sectors with substantial exposure to Chinese growth. Besides, China's broad money impulse leads industrial metals prices in general and iron ore prices in particular (Chart I-6). This signifies downside risks to commodities producers. Finally, China's yield curve suggests that mainland manufacturing PMI will roll over after its recent ascent (Chart I-7). Chart I-5Shipments To China Are At Risk Chart I-6Industrial Metals Prices Have Peaked Chart I-7China: The Yield Curve And Manufacturing PMI In short, China has been gradually tightening monetary policy, which has already manifested in record-low broad money growth. The next phase is evidence of a material deterioration in sales and profits among China-exposed plays. The EM stock markets are unlikely to ignore it. Q: It seems you are putting a lot of emphasis on China's broad money M3 measure. Why do you look at your version of Chinese broad money M3 and not at official M2 and total social financing (TSF)? A: Over the past several months we have done a lot of research and analysis on China's money and credit, and believe that our broad money M3 measure and private and public credit aggregate calculated by BIS are presently better measures of money and credit than official broad money M2 and TSF: First, the TSF data have become distorted because of the local government financing vehicles (LGFV) debt swap program. Specifically, according to the LGFV debt swap mechanics, starting in 2015 provincial governments began issuing bonds that have been purchased by banks. The amount of bonds issued was RMB 3.2 trillion in 2015, RMB 4.9 trillion in 2016 and expected to be RMB 4.8 trillion in 2017. This amounts to total issuance of RMB 12.9 trillion since the commencement of the program. As the next step, local governments were supposed to transfer the proceeds from these bond issuances to their LGFVs, with the latter using the money to pay down their debt. The ultimate goal of the program is to shift the debt from LGFVs to provincial governments, as the latter's creditworthiness is much better than the former. This has also reduced interest rates on the debt as provincial governments borrow at lower interest rates than LGFVs. All that said, it is unclear how much of their debt LGFVs have repaid. The main problem with using TSF data is knowing the amount of proceeds from the issued debt swap bonds that were used to pay down LGFV debt. If the entire amount of these bonds issued by provincial governments was used to pay down LGFV debt, there would not be an impact on economic activity, and only a very short-term impact on money supply. When banks buy bonds from non-banks (including governments), they create new money. When debtors (including governments and their entities) pay down debt to banks, money is destroyed. Nevertheless, both official M1 growth and our measure of broad money (M3) were too strong in 2015 and 2016 – i.e., they remained strong much longer than would have been justified by the LGFV debt swap. Furthermore, private and public credit, M2 and M3 money measures have decoupled from TSF since the middle of 2015 (Chart I-8A). TSF adjusted for the LGFV debt swap – the latter is added to TSF – has also diverged from official M2, our broad money M3 and BIS’s private and public credit measures (Chart I-8B). This corroborates that TSF data can no longer serve as a reliable measure of credit/money origination. Chart I-8AChina: TSF Has Diverged From ##br##Other Money/Credit Measures Chart I-8BChina: TSF Adjusted For LGFV Debt Swap Has Also Decoupled From Money/Credit Measures Markedly, paying down debt by LGFVs should have reduced corporate debt outstanding by RMB 12.9 trillion, which would represent a 12% drop from the RMB 112 trillion outstanding at the end of 2015. However, corporate debt has continued to expand rapidly, even as government debt has surged. Given all of the above, we doubt all of the proceeds from bonds issued within the LGFV debt swap program were immediately used to repay LGFV debt. Instead, we suspect the proceeds from the bond issuance might have been at least partially invested into the economy in 2016, in defiance of the rules of LGFV debt swap operation. We played down the rise in M1 in late 2015 and early 2016 because we regarded it as temporary, reflecting the LGFV debt swap program. In retrospect, it was a mistake - this was one of the main reasons we did not heed the message from recovering money growth in early 2016 to turn cyclically positive on China's growth, and consequently on commodities and broader EM. Provided we do not know what portion of LGFV debt was repaid and when, corporate credit and total social financing data have become difficult to interpret. Chart I-8A and Chart I-8B demonstrate that TSF with and without the LGFV debt swap has diverged from private and public debt since the middle of 2015 when the LGFV debt swap program commenced. Apparently, one no longer can rely on TSF or adjust it by the amount of LGFV debt swap to gauge money and credit creation in China. In this context, the aggregate of private and public credit is a much more appropriate measure of credit provision and debt creation than TSF. The basis is because it includes both private and public debt. Indeed, the reshuffling of debt between local governments and LGFVs (the latter are treated as enterprises in China's banking statistics), does not affect either aggregate borrowing or amount of debt held in the economy. Second, when credit numbers are distorted, one needs to resort to money supply measures to judge credit dynamics. The reason is because financial engineering and, in the case of China, the LGFV debt swap program, can obscure the amount of outstanding credit, but they cannot conceal the amount of money banks create when they lend or purchase bonds or any other asset. Money is created when a bank originates claims on non-banks, and money is destroyed when a debt is paid back to the bank. Accordingly, money traces debt creation by banks. Banks can disguise their assets, and corporations and governments can conceal their liabilities, but none of them can camouflage the amount of money in circulation. In short, we trace money to gauge the amount of private and public sector borrowing from banks. This is why we have calculated various measures of money in China to overcome the shortcomings of the TSF. Specifically, we have calculated broad money M3 (see details of our calculation below) and credit-money. The latter is the sum of commercial banks' assets such as claims on non-financial institutions, claims on other financial institutions, claims on government and claim on other resident sectors and commerical banks' as well as the central bank's foreign currency assets. Chart I-9 demonstrates various measures of broad money and outstanding credit: official M2, our measure of broad money M3, our credit-money measure, and private and public debt (source BIS). Importantly, all measures of money and private and public credit suggest that credit origination/money creation was very strong in 2015 and 2016, and that it has slowed substantially in 2017. In brief, the message from various measures of money/credit is consistent. Chart I-9China: Money/Credit Growth Has Decelerated To New Lows Interestingly, broad money M3 rose by RMB 21 trillion in 2015, RMB 20 trillion in 2016 and by only RMB 16.5 trillion in the past 12 months through end of August. This is why the M3 impulse - a change in money flows - has turned negative since early this year. Third, we prefer our broad money measure M3 to official M2 because it is more consistent with the BIS's measure of private and public credit. It has also served as a better tool in forecasting the 2016-2017 recovery in Chinese growth. As can be seen in Chart 1, 3, 4, 5 and 6 on previous pages, the M3 impulse - its second derivative - has a great track record in forecasting China's business cycle dynamics. The acceleration in M2 growth in 2015-16 was milder than one would expect in order to achieve meaningful acceleration in nominal economic activity. M2 growth was more subdued than a rise in both private and public debt (Chart I-9). We suspect that M2 is no longer an encompassing measure of broad money in China, and therefore we have calculated other measures of broad money to gauge true money/credit creation. Chart I-10China: Consumer Price Inflation Is Rising Broad money consists of various liabilities of commercial banks. While the official M2 includes many of their liabilities such as corporate demand deposits, corporate time deposits and personal deposits. It does not include some others. We have added the following commercial banks' liabilities - transferable deposits and other deposits which are not included in M2, liabilities to other financial corporations and other liabilities - to M2 to produce a more all-inclusive measure of broad money M3. Q: Why can't the Chinese authorities stimulate and revive growth again, like they have done many times in the past? A: Of course, they can. However, if the authorities begin easing monetary/credit and fiscal policies now, it will affect growth six to nine months down the road. Based on money and credit indicators shown in the charts above, growth is set to slow over the next nine months because of the time lag that money/credit has on the economy. In the next six to nine months, economic activity and corporate profits are likely to decelerate considerably, based on the monetary/credit tightening that has already occurred in China. Provided China-related financial markets in general and EM risk assets in particular have so far not discounted the slowdown suggested by China's money/credit indicators, they are very vulnerable. Finally, the magnitude of the impending growth slump is likely to be large, as evidenced by the substantial decline in these money and credit indicators that has already occurred. In brief, policymakers have been tightening credit/money creation, and it has not yet impacted financial markets. Furthermore, inflation is rising in China (Chart I-10) and policymakers are unlikely to start easing before they witness a major growth slump. Until the latter becomes visible in economic data and on the ground, financial markets leveraged to mainland growth will sell off notably. Q: There is no indication that the Federal Reserve will turn hawkish. This will be especially true if global growth slows - as you argue it will because of China. Why do you expect the EM currency rally to peter out amid a dovish Fed? Historical empirical evidence suggests that EM currencies are often driven by commodities prices, not the interest rate differential over U.S. rates. Let's take the BRL and the ZAR as examples. Charts I-11A and Chart I-11B illustrate that the BRL and ZAR exchange rates versus the U.S. dollar have historically been closely correlated with commodities prices, not the level of or change in their interest rate differential over the U.S. Chart I-11ABrazil: What Drives The Currency? Chart I-11BSouth Africa: What Drives The Currency? This has also been true over the past 18 months. The rally in EM currencies since early 2016 can be largely attributed to the rise in commodities prices. As and when commodities prices roll over - as we expect to occur - the trade balances of commodities-producing nations will deteriorate, as will their currencies. Remarkably, there are tentative signs that the drop in U.S. bond yields and the greenback's depreciation are late and overdone. Two-year U.S. bond yields have bounced from their 200-day moving average (please refer to the middle panel of Chart II-1 in the Mexican section). Typically, such a technical profile leads to new highs. Our sense is that U.S. bond yields will rebound in the coming months, which will also weigh on EM currencies. Importantly, one of the drivers behind the U.S. dollar selloff since early this year has been the rise in banks' excess reserves at the Fed (Chart I-12). The latter was due to the debt ceiling, as the U.S. Treasury was running down its account at the Fed by issuing less paper. In short, since the beginning of this year the U.S. Treasury did not issue bonds/bills and deposit them at its Treasury General Account (TGA) at the Fed - meaning it was not destroying banking system reserves as it typically does. This boosted the supply of U.S. dollars - banks' excess reserves at the Fed rose by US$ 300 billion. More dollar supply depressed both the exchange rate and U.S. interest rates. Chart I-12 demonstrates that in the post-QE era, banks' excess reserves at the Fed have correlated with the U.S. dollar's exchange rate. The debt ceiling has been resolved for now, and the Treasury will now begin accumulating dollars in its TGA account again. It has already announced that its TGA will rise from $73 billion now to $400 billion at the end of this year. The Treasury will issue more paper, and deposit U.S. dollars in the TGA. This will shrink banks' excesses reserves. This, in tandem with the reduction in the Fed's balance sheet, will diminish banks' excess reserves. The latter will reduce U.S. dollar supply in off-shore markets and will likely trigger a U.S. dollar rebound. On the whole, the two pillars of the EM currency rally - strong growth in China that manifests in higher commodities prices and lower U.S. bond yields - are set to reverse. In turn, a potential EM currency selloff along with deteriorating EM corporate profits will likely weigh on EM equities and EM sovereign and corporate debt. Q: Does this mean EM stocks will relapse in absolute terms, or simply underperform the DM equity markets? Our strongest conviction at the moment is on EM relative equity performance versus DM equity markets. Odds are that a relapse in relative performance is imminent as and if U.S. bond yields rise (Chart I-13). Chart I-12U.S. Banks' Excess Reserves ##br##And The U.S. Dollar Chart I-13U.S. Stocks Outperform EM Ones When ##br##U.S. Bond Yields Are Rising In addition, U.S. stocks' underperformance versus the global equity index in common currency terms is at a technical support (Chart I-14, top panel), and will likely reverse as the dollar firms up. Historically, when U.S. stocks outperform the global benchmark in common currency terms - denoted by shaded periods in Chart I-14, EM stocks typically underperform the global equity index. The dynamics of EM equity absolute performance depends on investor's risk appetite. It will be hard for EM share prices to drop meaningfully as the DM rally persists. Global stocks are still trading well, and it is very difficult to pinpoint any trigger that will lead to a reversal. As our readers well know, we do not forecast triggers for the simple reason that the chances of getting it right are much lower than a coin toss. That said, in the medium term, the reason for a correction in DM stocks could well be EM/China growth, as it was in 2015. In such a scenario, EM risk assets will sell off first. As to timing, it is hard to find indicators that lead share prices, but aggregate EM narrow (M1) money growth has historically been coincident or leading with EM share prices - and it presently points to a considerable drop in EM equity prices (Chart I-15). This EM M1 aggregate is equity market-cap weighted making it relevant to investors. Chart I-14EM And U.S. Equites Typically Do Not Outperform Global Stocks Simultaneously Chart I-15EM M1 Growth And EM Share Prices Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com A New Trade: Receive Mexican / Pay U.S. 2-Year Swap Rates Mexico's 2-year bond yield has recently fallen through a technical support line while the U.S. 2-year bond yield has recently bounced off a major support level (Chart II-1). Our bias is that the 2-year yield in Mexico will fall relative to 2-year U.S. yield (Chart II-1, bottom panel). We recommend a new trade: receive 2-year swap rates in Mexico and pay U.S. 2-year swap rates. Historically, the domestic demand cycle in Mexico was synchronized with the business cycle in the U.S., mainly due to the fact these two economies are heavily integrated. However, the two economies have recently become desynchronized. This is evident by the fact that the Mexican export sector - which is leveraged to U.S. - is booming while the domestic demand in Mexico is slowing down (Chart II-2). Chart II-12-Year Bond Yields: Mexico And U.S. Chart II-2Divergence Within Mexican Economy The culprit behind this desynchronization is the previous collapse in the peso. Falling oil prices and excessive money/credit expansion in Mexico led to a major peso depreciation in 2014 and 2015. The election of Trump pushed it off the cliff in 2016. Inflation in Mexico spiked due to the massive currency depreciation. Consequently, the Mexican central bank has hiked interest rates by 400 basis points since the end of 2015. This, along with fiscal tightening, has choked domestic demand growth in Mexico. At this point, our bias is that the short-term interest rate differential between Mexico and the U.S. is unjustifiably wide and is about to narrow. Going forward, we expect inflation to fall in Mexico and interest rate expectations will at minimum not rise. Inflation in Mexico will roll over soon and moderate because of the following: A large part of the rise in inflation was caused by the depreciation in the peso. The peso's material appreciation this year will reduce the inflation rate (Chart II-3). Consumer spending and capital expenditure are set to continue slumping as the impact of higher interest rates continues filtering through the economy (Chart II-4, top and bottom panel). Chart II-3Mexico: Exchange Rate And Core Inflation Chart II-4Mexico: Domestic Demand To Disappoint Further Domestic vehicle sales are shrinking signifying no revival in interest rate-dependent sectors. Fiscal policy has been tightening and this will continue to be a headwind on economic growth (Chart II-5). Hence, despite flourishing exports to the U.S., very weak domestic demand will dampen inflation in Mexico. Finally, there were several one-off effects to inflation such as the gasoline subsidy removal that took place at the end of last year, and the minimum wage hike that was implemented at the beginning of the year. As the base effect of these fade, the inflation rate will moderate. In the U.S., our bias is that interest rate expectations are too low given the tight labor market, reasonably strong growth, and the U.S. dollar depreciation this year. Odds are that the U.S. interest rate expectations will rise as core inflation moves up (Chart II-6). Chart II-5Mexico: A Major Improvement In Fiscal Position Chart II-6U.S. Core Inflation To Rise Investment Recommendations We recommend fixed-income traders to receive Mexican / pay U.S. 2-year swap rates. The main risk to this trade lies in the event of an abrupt sell-off in the peso against the U.S dollar that could push up the 2-year swap rate differential. While we expect EM currencies, including the peso, to depreciate, this trade is still favorable in terms of risk-reward because of the starting point in interest rate differential and peso valuations: Despite the rally this year, the peso is still cheap (Chart II-7). Furthermore, its current account and fiscal balances have improved dramatically. So, the peso should depreciate less than many other EM currencies. Chart II-7The MXN Is Still Cheap In fact, the interest rate spread between Mexico and the U.S. is already historically high, and the peso depreciation might not push it much higher. We would not be recommending this trade if the peso was fairly or overvalued, or if interest rates in Mexico were not this high. Entering this position under these current circumstances reduces the downside risk and, therefore, makes the risk-reward attractive. As to Mexican financial markets in general, we remain constructive on the peso versus other EM currencies. More specifically, we continue to recommend long positions in MXN versus ZAR and BRL. Mexican local currency bonds and sovereign credit offer good value relative to their EM counterparts. Fixed income investors should continue to overweight Mexican local currency and sovereign credit within their respective EM benchmarks. Finally, the outlook for Mexican stocks in absolute terms is poor as domestic demand will slump, further hampering corporate profits. Within an EM equity portfolio we recommend neutral allocation to this bourse mainly due to our expectations of the peso outperforming other EM currencies. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations