Sectors

Highlights To shed light on the dichotomies that have surfaced in China's money and credit variables, we have calculated a new credit-money. This new measure is currently corroborating a very downbeat outlook for Chinese growth and China-related plays. We do not mean that investors should put all of their faith in this new measure. Yet, other measures of money and credit such as M1, M2 and banks' total assets all point to an impending deceleration in economic growth in China. While many global investors take for granted that the central government will underwrite credit risk in the entire economy, the top leadership in Beijing is sending the opposite message, at least for now. A new fixed income trade: pay Czech / receive Polish 10-year swap rates. Feature Chart I-1China: A Business Cycle Top Is In The Making Typically, the phrase 'Follow The Money' is used in the investment community to advise in favor of chasing investment flows. Today, we use this phrase in the context of not following investor crowds, per se, but money growth - especially in China. Judging from market actions and elevated inflows into EM assets and investable Chinese stocks, we can infer that investor consensus on China/EM is rather bullish. In the meantime, China's money/credit growth is sending a bearish signal. Investors should heed the downbeat message from Chinese money/credit and not chase EM risk assets higher. To reconcile the different messages from various measures of Chinese money and credit aggregates (more on the differences below), we calculated a new measure of money/credit creation - commercial banks' total credit (referred to below as banks' credit-money). Banks' credit/-oney is the sum of commercial banks' claims on companies, households, non-bank financial institutions, and all levels of government, as well as commercial banks'' and PBoC's foreign assets. Also, we deduct government deposits at the central bank (see below for the rationale). This measure, a de-facto aggregate of credit/money originated by banks and the PBoC, is computed using the asset side of banks' balance sheets. The key message from this report is that mainland banks' credit-money growth has already decelerated meaningfully, and points to a considerable slump in China's business cycle and imports in the months ahead (Chart I-1). Notably, banks' credit-money growth is at the lowest level of the past 10 years, excluding the Lehman crisis. It is also well below 2015 lows when the economy was acutely struggling. Exploring Money And Credit Dichotomies In China There has lately been a puzzling divergence between the growth rates of banks' credit-money, M2, and total social financing (TSF) (Chart I-2). Chart I-2Dichotomy Among Various Credit And Money Aggregates In China In 2016, banks' credit-money growth accelerated to 20%, while the pick-up in M2, and bank loan growth was modest. At the same time, TSF and corporate and household credit growth was largely flat. Lately, M1 growth has slowed, M2 and banks' total asset growth have dropped to all-time lows, while banks' loan and total social financing have remained flat. So, what is the true picture of money and credit growth in China? What are these critical variables telling us about the growth outlook? Our measure of banks' credit-money should by and large match broad money (M2) because the former is calculated by adding up various assets, and the latter by aggregation of various liabilities. Indeed, both were correlated well in the past, but decoupled in 2013 (Chart I-3, top panel). There has been another money/credit paradox: banks' credit-money on the one hand, and TSF and banks' RMB loans on the other, also have decoupled since 2013 (Chart I-3, middle and bottom panels). Overall, neither M2 nor TSF and banks' RMB loans mirrored the surge in banks' money-credit origination in 2015 and 2016, as portrayed in Chart I-3. We have been relying on the M2 and TSF aggregates published by China's central bank. Their tame readings in 2016 were the main reason we underestimated the duration and magnitude of China's economic recovery in the past year or so, as well as its impact on the rest of EM and commodities. As to components of banks' credit-money, Chart I-4 demonstrates that the deceleration has been due to the claims on non-financial organizations (companies), non-bank financial institutions and government. In brief, the slowdown has been broad-based; only claims on households continue expanding at a robust rate of 25% from a year ago (Chart I-4, bottom panel). Chart I-3M2 And Total Social Financing Have Not ##br##Reflected Money Created by Banks Chart I-4Individual Components Of Commercial ##br##Banks' Money Origination We suspect burgeoning financial engineering in China, credit shenanigans, and the non-encompassing nature of the People's Bank of China's broad money (M2) calculation along with the local government debt swap conducted in 2015 have all distorted credit and money data in recent years, producing the above dichotomies. To shed light on these dichotomies and calculate what has been true money/credit origination in China, we have revisited the basics of money and credit creation and have attempted to make sense of the data and the underlying trends. Overall, we have the following observations and comments: New nominal purchasing power in any economy is created by banks when they originate new loans. Hence, measuring properly the amount of new credit/money origination is of paramount importance to forecasting business cycle dynamics in any country. As we argued in our trilogy of Special Reports on Money, Credit and Savings, banks do not need savings or deposits to originate loans.1 They simultaneously create an asset (a loan) and a liability (a deposit) when extending credit to a borrower, which creates purchasing power in the economy. Importantly, there is no need for someone to save (i.e., forego consumption) in order for a bank to create a new loan / originate new money. In the case of China, commercial banks have an enormous amount of deposits - not because households and companies save a lot but because the banking system altogether has originated a lot of credit/money. The household and national savings rates quoted by economists refer to excess production/overcapacity in the real economy and not deposits in the banking system. We have discussed this issue in the past2 and will revisit it in future reports. The restraining factors for banks to originate new credit/money are their capital, regulations, loan demand, and liquidity - but not deposits. Liquidity is banks' excess reserves at the central bank. Commercial banks create deposits but they cannot engender reserves at the central bank, i.e., liquidity. Only the central bank can expand or shrink the amount of liquidity/reserves commercial banks hold with it. Finally, commercial banks do not lend their reserves; they use the reserves to settle transactions with other banks. In turn, central banks do not create new money/purchasing power unless they lend to or buy assets from governments and non-bank entities or issue currency. Central banks have a monopoly over the creation of bank reserves and currency in circulation - high-powered money. A liquidity crunch at a bank occurs when a bank runs out of excess reserves at the central bank, and it cannot borrow/attract additional reserves. Nowadays, many central banks targeting interest rates supply reserves and lend to commercial banks unlimited amounts of reserves on demand to assure interbank rates stay close to their policy target rate. Therefore, in such settings one can infer that banks are not restrained by liquidity to produce new money/expand their assets. In the case of China, the PBoC's claims on banks have skyrocketed - they have surged by 4.5-fold since 2014 (Chart I-5) - entailing that the former has supplied a lot of liquidity to commercial banks. Such liquidity expansion by the PBoC has in turn allowed banks to create tremendous amounts of new money (new purchasing power). To put the amount of money/credit originated by Chinese commercial banks in context, we have calculated the ratio of their credit/money stock to China's nominal GDP and global nominal GDP (Chart I-6). Chart I-5The PBoC Has Injected A Lot Of##br## Liquidity/Reserves Into The System Chart I-6Chinese Banks' Colossal ##br##Money Creation The broad measure of banks' credit/money created presently stands at 250% of Chinese GDP and 32% of global GDP, or US$29 trillion. The latter compares with the U.S. Wilshire 5000 equity market cap of US$ 26 trillion at a time when American share prices are at all-time highs, and the median P/E ratio is at a record high as well. In 2016 alone, Chinese banks' originated RMB 21 trillion, or US$1.7 trillion in new money-credit. Since January 2009, when the credit boom commenced, mainland commercial banks have cumulatively generated RMB 141 trillion, or US$21.12 trillion, of new money/credit. Banks create new money/deposits when they lend or acquire assets. Exceptions are when banks lend to the central bank or to other commercial banks. In those circumstances, a bank draws on its reserves at the central bank, and no new money - and by extension purchasing power - is created. Fluctuations in reserves/liquidity affect purchasing power in an economy indirectly rather than directly. Expanding reserves/liquidity encourage banks money/credit creation and vice versa. In China, commercial banks' excess reserves at the PBoC are presently contracting and stand at historically low level relative to outstanding stock of credit/money (Chart I-7). This is one of the reasons why banks have been scaling back their credit/money origination. Chart I-7China: Banks' Liquidity/##br##Excess Reserves Are Thin The fiscal authorities play a unique role in money creation. Because of the authorities typically have accounts at both the central bank and commercial banks, they can alter the money supply by shifting deposits back and forth between their accounts at the central bank and commercial banks. By transferring deposits from a commercial bank to the central bank, the fiscal authorities can destroy money; by the same token, they can create money by doing the opposite. This is why when computing Chinese banks' credit-money aggregate we have deducted from the credit/money aggregate government deposits at the PBoC. Finally, there is a difference between credit-money originated by banks, and non-bank credit. Non-banks are financial intermediaries that transfer existing deposits into credit. By doing so they do not create new purchasing power. When banks lend or acquire various assets, they do generate new purchasing power - i.e., they create new deposits that did not exist before. This is why banks are not financial intermediaries. This is true for any country and financial system. For more detailed analysis on the difference between banks and non-banks, please refer to the linked paper.3 When examining leverage in the system, one should consider bank and non-bank credit. Yet, when looking to gauge the outlook for growth and inflation, one should consider new credit/money originated by banks. The purpose of this report is to examine and compute new credit-money that determine nominal economic growth in China rather than discuss leverage even though they are often interlinked. Therefore, we are focused on new credit-money originated by banks, and not on the amount of and changes in leverage in the economy. Bottom Line: Whether one prefers M2, banks' total assets or our new measure of banks' credit/money, the message is by and large the same: money-credit growth is slowing and is very weak. Credit-Money And Business Cycle Chart I-8Comparing Two Impulse Indicators How good is the bank credit-money in terms of being an indicator for China's business cycle? We have one caveat to mention before we illustrate its relevance: Banks' credit-money is a stock variable, and our goal is to gauge business cycle trends - i.e., changes in flow variables such as output, capital spending, profits and imports. Also, the first derivative of a stock variable is a flow, while the second derivative of a stock variable is a change in its flow. Therefore, we have calculated credit/money impulse as the second derivative of outstanding credit/money, or a change in annual change, to align it with the growth rate of flow variables. The following illustrates that banks' credit-money impulse has been an extremely good leading indicator for many economic and financial variables. The new impulse of banks' credit-money has since 2014 diverged from the nation's credit and fiscal impulse (Chart I-8). Nevertheless, the new credit-money impulse leads numerous business cycle variables such as nominal GDP, producer prices, electricity output, machinery sales, freight volumes, and manufacturing PMI (Chart I-9A and Chart I-9B). Chart I-9AChina's Growth To Decelerate A Lot (II) Chart I-9BChina's Growth To Decelerate A Lot (I) Not surprisingly, this impulse also leads property sales and starts as well as construction nominal GDP (Chart I-10). This impulse often precedes swings in the LMEX industrial metals index and iron ore prices (Chart I-11). Further, it is also a reasonably good indicator for EM EPS growth (Chart I-11, bottom panel). As discussed above, banks' new credit-money creation determines nominal - not real - growth. Chart I-10China: Property / Construction ##br##Are At A Major Risk Chart I-11Downbeat Message For Industrial ##br##Metals And EM Profits By expanding their assets, banks generate new purchasing power, but they do not have any control over whether this new purchasing power is used to boost real output or prices. The recovery of the past 12 months have in some cases boosted prices more than volumes. It might be that China is inching closer to an inflation inflection point. We are not saying that China has runaway inflation at the moment, but persistent enormous overflow of money-credit will inevitably produce higher inflation. If inflation does indeed rise materially, policymakers will have no choice but to tighten. Monetary tightening will be devastating for an economy with already high leverage. Bottom Line: The new measure of banks' credit-money is currently corroborating a very downbeat outlook for Chinese growth and China-related plays. Beijing's Priorities And Investment Implications It is generally believed in the global investment community that China's authorities will not allow the economy to slump - they will boost credit/money growth and fiscal spending to ensure solid growth. It is true that no government wants to see their economy crumble, and China is no exception. However, there are several reasons to expect growth to slump considerably before the government responds: The central bank has been guiding interest rates higher across the entire yield curve. Short-term interbank rates (7-day Interbank Fixing Rate) and 5-year AA domestic corporate bond yields have risen by about 100 and 200 basis points, respectively, since November 2016. In addition, financial regulators are clamping down on off-balance-sheet and fancy financial engineering practices of banks and other financial institutions. Monetary policy works with a time lag, and the current tightening along with the government's regulatory clampdown will impact economic growth in the months ahead. The sharp deceleration in banks' credit/money confirms this. Even though interest rates have recently stopped rising, the damage to banks' credit/money growth has been done as shown in Chart I-12. Business activity is lagging money/credit and will be next to suffer. The central government in Beijing has largely lost control over credit creation/leverage build-up since 2009. The top leadership in Beijing did not want credit to explode and speculative behavior to profligate. Two recent articles by Caixin news agency (links are in footnote4) corroborate that Beijing is unhappy with credit creation and allocation practices prevailing in the financial system as well as among SOEs and local governments. The top leadership appears decisive, at least for now, in clamping down on ballooning credit/money growth and the ensuing misallocation of capital and bubbles. Interestingly, while many global investors take for granted that the central government will underwrite credit risk in the entire economy, or at least among state-owned companies, Beijing is sending the opposite message for now. True, when an economy and financial system crumbles, the central government will undoubtedly step in. However, investors do not want to be on the long side of China-related markets when this occurs. Buying opportunities may occur at that point, but for now the risk-reward profile is extremely poor. The authorities in Beijing tolerated colossal money/credit creation and misallocation of capital when growth in the advanced economies was extremely feeble. Now, with DM economies expanding at a solid pace and China's growth having recovered, they are comfortable tightening. As for the resulting investment strategy conclusions, it is too late to chase this rally in EM risk assets and other China-related assets. We do not mean that investors should put all of their faith in our new measure of China's credit/money. Yet, other measures of money and credit such as M1, M2 or banks' total assets all point to an impending deceleration in economic growth in China. In EM ex-China, narrow (M1), broad money and private credit growth have been and remain lackluster (Chart I-13). As China's growth and imports slump, the majority of EM economies will be materially affected. Chart I-12China: Interest Rates And Money Creation Chart I-13EM Ex-China: Subdued Money / Credit Growth There is no change in our overall investment strategy. Specific country recommendations and positions across all asset classes are always presented at the end of our reports, presently on pages 18-19. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Caitlynn Qi Zeng, Research Assistant caitlynnz@bcaresearch.com Central Europe: A New Fixed-Income Trade In a Special Report titled Central Europe: Beware Of An Inflation Outbreak from June 21st 2017 - the link is available on page 20, we argued that labor shortages in central Europe have been pushing up wage growth, generating genuine inflationary pressures. The Polish, Czech and Hungarian economies are overheating, warranting imminent monetary policy tightening. We elaborated on the reasons why this is happening in that report and as such we will not go through it in detail again here. Based on this theme, our primary investment recommendation was in the currency market: go long the PLN and CZK versus the euro and/or EM currencies. This recommendation remains intact. Today we recommend a new trade based on the same theme: pay Czech / receive Polish 10-year swap rates (Chart II-1). The negative 143 basis points yield gap between Czech and Polish 10-year swap rates is unsustainable and it will mostly close for the following reasons: The relative output gap between the Czech Republic and Poland is showing that the Czech economy is overheating faster than in Poland (Chart II-2). This will eventually lead to inflation rising faster in Czech Republic than in Poland as per Chart II-2. Markedly, relative trend in headline inflation warrants shrinking swap spread between Czech and Polish swap rates (Chart II-3). In effect, the Czech National Bank (CNB) will be forced to hike rates at a faster pace and more than the National Bank of Poland (NBP). The CNB has been artificially depressing the value of its exchange rate by pegging it to the euro since November 2013. Despite the fact that the CNB abandoned its peg in April of this year, the CNB continues to artificially suppress the exchange rate by printing money and accumulating foreign exchange reserves. Chart II-1Pay Czech / Receive Polish ##br##10-year Swap Rates Chart II-2Czech Economy Will Overheat ##br##Faster Than Poland's Chart II-3Inflation Dynamics Warrant ##br##Smaller Swap Spread Foreign exchange reserves, measured in euros, in the Czech Republic are growing at an astronomical 60% annually while growth and inflation are already in full upswing (Chart II-4, top panel). Due to the ongoing foreign currency accumulation - accompanied by insufficient sterilization - the CNB has generated an overflow of liquidity and money/credit in the Czech economy (Chart II-4, middle panels). Chart II-4Monetary Conditions Are Easier In ##br##Czech Republic Relative To Poland In turn, this liquidity overflow has led a real estate boom and has super-charged overall growth (Chart II-4, bottom panel). On the contrary, the NBP has been much less aggressive in easing monetary conditions. The policy rate in Poland is at 1.5% while it is 0.05% in Czech Republic. Therefore, any potential upside in inflation and bond yields will be more limited in Poland than in the Czech Republic. Even though both Czech and Polish economic growth are robust, the Czech economy is showing more imminent signs of overheating and inflationary outbreak than Poland. The CNB is further behind the curve than the NBP. When a central bank is behind the curve, its yield curve should be steeper than a central bank that is not. However, the 10/1-year swap curve is as steep in Poland as it is in the Czech Republic. With the policy rate at a mere 0.05%, the Czech economy is sitting on the verge of an inflationary precipice. The longer the CNB maintains such a low policy rate, the higher long-term bond yields will rise. The basis being that the longer policymakers wait, the more they will have to tighten to slow growth and bring down inflation. Finally, this relative trade offers a hefty 143 basis points carry and is thus very attractive. Investment Conclusions In the fixed income and currency space in central Europe, we have been and continue recommending the following relative positions: A new fixed income trade: pay Czech / receive Polish 10-year swap rates Continue betting on yield curve steepening in Hungary: Receive 1-year / paying 10-year Hungarian swap rates Long Polish and Hungarian 5-year local currency bonds / short South African and Turkish domestic bonds. Long PLN and CZK versus EM currencies and/or the euro - we are long the following crosses: PLN/HUF, PLN/IDR, CZK/EUR For dedicated EM equity investors, we continue to recommend overweighting central Europe within an EM equity portfolio. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Reports titled, "Misconceptions About China's Credit Excesses", dated October 26, 2016; "China's Money Creation Redux And The RMB", dated November 23, 2016; "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017; links available on page 20. 2 Please refer to the Emerging Markets Strategy Special Report titled, "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017; link available on page 20. 3 Werner, R. (2014b), "How Do Banks Create Money, and Why Can Other Firms Not Do the Same?", International Review of Financial Analysis, 36, 71-77. 4 Please see, "Local Officials Now Liable for Bad Debt-Management Decisions for Life", July 17th 2017, Caixin Global, available at http://www.caixinglobal.com/2017-07-17/101117307.html Please see, "Local Governments Find New Ways to Play Debt Game", July 14th 2017, Caixin Global, available at http://www.caixinglobal.com/2017-07-14/101116048.html Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Chemicals stocks comprise over 73% of the S&P materials index, and this bump to a neutral stance also moves the broad materials index to a benchmark allocation. The key Chinese economy, the largest commodity consumer, appears to have turned a corner. Historically, the Keqiang Index has been positively correlated with materials revenue growth and the current message is positive (second panel). Further, the recently surging Australian dollar suggests that China is at least not relapsing (third panel). Not only are emerging markets reviving, but also advanced economies are in excellent shape. Synchronized global growth and the coordinated brewing tightening cycle should lead to a selloff in most G7 bond markets. At a minimum, this implies that relative materials performance has put in a cyclical trough. Our newly introduced S&P materials relative EPS model captures this positive macro backdrop for the sector and signals that the relative EPS recovery still has breathing room (bottom panel). Bottom Line: Lift the S&P materials sector to a benchmark allocation, and lock in profits of 12.8% since inception.

In the summer of 2014 we went underweight the S&P chemicals index, anticipating an earnings underperformance phase, driven by weak revenues as chemicals manufacturers were furiously adding capacity to benefit from lower domestic feedstocks. This view has largely panned out, and now three factors underpin our more neutral bias: synchronized global growth, receding global capacity and improving domestic operating conditions. The global manufacturing PMI has recently reaccelerated and jumped to a six year high. Similarly, the U.S. ISM manufacturing survey also vaulted higher. Synchronized global growth suggests that final demand is on the upswing and should bode well for chemical top- and bottom-line growth (second panel). This has driven a relative weakening of the U.S. dollar, much to the benefit of U.S. chemical producers, whose exports appear to be displacing German exports (third panel). Finally, domestic operating conditions have taken a turn for the better. This improving domestic final demand backdrop is reflected in higher resource utilization rates and solid pricing power gains have staying power (bottom panel). Net, evidence is emerging that the bear market in chemicals producers is over; upgrade the S&P chemicals index to neutral (see the next Insight).

Special Report

Highlights The RBA will not hike as quickly as markets expect. Weak wage growth and high underemployment suggest plenty of spare capacity. Inflation is only barely at the bottom of the central bank's range. Massive household debt levels will make it difficult for consumers to handle higher interest rates. Australian banks, although relatively healthy, are still enormously exposed to Australian housing and interest-only mortgages. House prices have nearly quadrupled since 2000 and exhibit the characteristics of a bubble. Still, it will likely take considerable monetary tightening before the bubble bursts. We do not think this will occur anytime soon. Maintain a neutral exposure to Australian government bonds, but enter into a 2-year/10-year Australian government bond yield curve flattener. Feature Chart 1Diverging Trends In##BR##The Australian Economy Australia remains one of the more difficult bond markets on which to take a decisive investment stance at the moment. The recent Moody's downgrade of Australian banks has put the spotlight back on the housing boom Down Under. With home prices continuing to climb - despite the introduction of macro-prudential measures on mortgage lending and with household indebtedness reaching exorbitant levels - investors are becoming increasingly concerned over a potential housing crash that could have spillover effects on the Australian banking system (Chart 1). At the same time, the domestic economy continues to suffer a hangover from the end of the mining boom earlier this decade, with excess capacity keeping inflation pressures subdued. Naturally, this has put the Reserve Bank of Australia (RBA) in a difficult position. Interest rate cuts in response to low inflation would add further fuel to the housing bubble. On the other hand, any attempt to try and normalize the current accommodative monetary policy settings with rate hikes could trigger an unwanted surge in the Australian dollar and prompt a correction in house prices. The latter could lead to financial instability and raise recession risks with consumers already dealing with negative real wage growth, low savings and massive debt loads. In this Special Report, we examine Australia's monetary policy trajectory, analyze its concentrated banking sector and the potential risks from a downturn in house prices, and revisit our positioning on Australian government debt. Our conclusions still lead us to stick with a neutral duration stance and country allocation on Australian debt, but with a bias towards a flatter government bond yield curve. RBA On Hold... For Now Chart 2Aussie Bonds Caught##BR##In The Global Selloff Earlier this month, the RBA decided to leave the cash rate unchanged at 1.5%. The central bank maintained its fairly neutral rhetoric, though they did cite that the "broad-based pick-up in the global economy is continuing." The central bank upgraded its economic forecasts, with real GDP growth now projected to reach slightly above 3% over the next two years. The minutes from that July 4 monetary policy meeting revealed that a discussion over the ideal level of the real cash rate took place.1 The conclusion was that equilibrium inflation-adjusted rate is now around 1%, meaning that the "neutral" nominal rate is 3.5% after adding an inflation expectation of 2.5% (the middle of the RBA inflation target band). That implies that the RBA has lots of catching up to do on interest rates once the next tightening cycle begins. The timing of that discussion on real rates came shortly after the rebound in global bond yields that began after policymakers in other countries, most notably the European Central Bank and the Bank of Canada, began hinting that a move to dial back the emergency monetary easings of 2015/16 was about to begin (Chart 2). With the RBA possibly sending a similar message, investors responded by raising interest rate expectations and bidding up the Australian dollar (AUD). 30bps of RBA hikes are now priced in over the next year, while our proxy for the market-implied pricing of the terminal (i.e. equilibrium) cash rate - the 5-year AUD overnight index swap rate, 5-years forward - shot up to just over 3%. We believe that this market repricing of potential RBA rate hikes is too optimistic. Australian monetary policy must remain highly accommodative for some time. Our more dovish case is based on our assessment of the RBA's policy mandates, which include full employment, price stability and the 'welfare of the Australian people'. Because of Australia's heavy economic exposure to iron ore prices, its largest export, we also include an outlook on the commodity to aid in our forecast of RBA policy. Employment: The latest readings on the Australian labor market have shown marked improvement so far in 2017 (Chart 3). The unemployment rate now sits at 5.6%. Employment growth is accelerating while the participation rate has edged higher in recent months. The National Australia Bank business confidence index is steadily improving, while job vacancies are at a five-year high. In the statement released after the June monetary policy meeting, RBA governor Philip Lowe stated that "forward-looking indicators point to continued growth in employment in the period ahead." Chart 3Labor Demand##BR##Picking Up... Chart 4...But All Signs Point To Lots##BR##Of Spare Labor Capacity While Governor Lowe also noted that the overall employment picture is 'mixed' in some aspects, we are far more pessimistic (Chart 4). The underemployment rate has been rising and now sits only slightly below its almost 50-year high of 8.8%.2 Part-time workers as a percentage of total employment has experienced a structural increase to nearly 33%, while hours worked have declined. Additionally, nominal wages have been flat and real wages are declining. This suggests that there is plenty of slack in labor markets and that Australia is still far from full employment, even with the headline jobless rate sitting slightly below the OECD's current NAIRU estimate of 5.9%.3 Inflation: Core inflation has been slowing since 2014 and only reached an anemic 1.45% in the first quarter of 2017 (Chart 5). Although headline inflation has rebounded over the past year, at 2.1% it remains only at the bottom of the RBA's 2-3% target range. Additionally, the downtrend in inflation expectations for 2017 appears to be intact. Chart 5Inflation Staying Within The RBA 2-3% Target Chart 6Australian Consumer Spending Slowing Weak productivity growth, leading to lackluster wage growth, is keeping overall inflation subdued. The trade-weighted currency has rallied since June, presenting an additional headwind for consumer prices. Even if the recovery in headline inflation persists and starts to pass through to core readings, policymakers will likely err on the side of caution. A higher realized inflation rate will be tolerated in the near term to ensure expectations stay well within the 2-3% target band - the RBA's definition of "price stability" - before any interest rate increases are considered. Consumer: Australian households face a challenging environment. Real wages are declining, with the wage cost index in a downtrend since 2011. Real retail spending growth has been slowing and is nearing negative territory, while consumer sentiment is quite pessimistic (Chart 6). As income growth is lacking, consumers have had to dip into savings to maintain consumption, with the savings rate collapsing from 10% to 5% over the last few years. Part of that decline is likely due to the rising cost of "essentials" spending, such as utilities, health care, education and transportation. The inflation rates for those sectors have been outpacing overall headline and core readings (Chart 7), suggesting that Australian households are saving less just to "make ends meet." Chart 7Spending More On The "Essentials" Overall, Australian consumers remain incredibly indebted. The household debt-to-income ratio is nearing 200% - the fourth highest figure among the OECD countries.4 Households have been able to handle the massive debt loads (so far) due to record-low interest rates, which have allowed debt service ratios to fall in line with long-term averages. However, hiking interest rates against this backdrop of highly leveraged consumers - especially given the huge exposure of Australian household balance sheets to overvalued house prices - could severely test the 'economic prosperity and welfare of the Australian people' element of the RBA's mandates. In other words, the RBA would need to see decisive signs that the economy was pushing up against inflationary capacity constraints before embarking on a tightening cycle, for fear of the spillover effects of pricking the housing bubble too soon (as we discuss later in this report). Iron Ore: Historically, Australia's growth has been tightly linked to the performance of industrial commodities, in particular iron ore which represents nearly 20% of total Australian exports. Our commodity strategists are neutral on iron ore on a cyclical horizon and bearish on a strategic basis. Chinese iron ore import growth has recently ticked up, but should remain subdued as Chinese inventories are still high (Chart 8). Chinese property construction activity, which accounts for roughly 35% of total Chinese steel demand, remains depressed. Globally, iron ore supply is set to increase throughout the year as many mining projects will come on stream. On a longer-term basis, Chinese demand for metals will likely slow due to the ongoing structural economic shift away from excessive reliance on infrastructure investment and house-building to an economy based on consumption and services. Summing it all up, none of the RBA's policy mandates is being threatened in a way that should force policymakers to begin shifting to a less dovish stance. There is little evidence that Australia has reached full employment, inflation and inflation expectations remain within the RBA target band, growth momentum remains moderate and the housing bubble remains an existential risk to the future health of the economy. Additionally, Australian policymakers will want to keep rates as low as possible to ensure that a weaker currency helps prop up exports, support the economy in its transition away from the heavy reliance on mining investment. Real GDP growth fell below 2% and the output gap is still far in negative territory, suggesting plenty of slack (Chart 9). Our own Australian Central Bank Monitor has rolled over and is now barely in the "tight policy required" zone (bottom panel). Projected fiscal drag over the next few years will also dampen growth. RBA growth forecasts appear highly optimistic relative to median economist estimates. All of these factors point to a delay in rate hikes. Chart 8No Big Boost To Iron Ore Prices From China Chart 9No Pressure On The RBA To Hike Rates Bottom Line: Markets are overpricing the potential for RBA tightening. There is still spare capacity in labor markets, inflation is subdued and consumers cannot handle higher rates. Monitoring The Banks In June, Moody's downgraded all Australian banks, citing a "rise in household leverage and the rising prevalence of interest-only and investment loans" (Chart 10). The downgrade raised concern among investors, with banks being the largest component of the Australian equity market, and short positions have noticeably risen. Despite subdued income growth and enormous household debt levels, escalating house prices have supported consumption through the wealth effect, but this is clearly unsustainable. Political pressures are also building, as evidenced by the introduction of a bank levy in South Australia. Chart 10A Relentless Climb In Household Debt The Chairman of the Australian Prudential Regulation Authority (APRA), Wayne Byres, wants to make bank capital levels "unquestionably strong." His recent comments indicate that Australian banks will need to raise capital before 2020 to adhere to global standards, with some estimates reaching as high as $20bn (in USD). This process is crucial for instilling confidence in markets that banks can meet these targets through organic capital generation or dividend re-investment plans. As the increased capital required is relatively small - only 2% of the capital base of the Australian banks - it should not be difficult to raise that amount. The greatest risk to the financial system is still the exposure to Australian housing. For the four major banks, Australian housing loans make up slightly over 50% of their lending mix, far greater than for U.S. banks prior to the Great Financial Crisis of 2008 (Chart 11). Of those loans, approximately 40% are non-traditional (interest-only, sub-prime, reverse mortgages). Several macro-prudential measures have been implemented by Australian financial regulators to decrease risks within the banking sector. The regulations have been focused on interest-only loans, which are more vulnerable to rate rises. Such loans are riskier, typically shorter in maturity and requiring larger deposit amounts. Banks are tightening their lending standards for these loans and risk weights will likely be increased, thereby requiring more capital. Additionally, the standard variable rate on interest-only loans has increased by 30-35bps and APRA has imposed a 30% cap on interest-only loans as a percentage of new loans. This will cause a meaningful decline in the risk profile of banks' mortgage books, as consumers with interest-only loans will shift to less expensive principal-plus-interest loans. Another source of risk is the Australian banks' increasing reliance on offshore short-term wholesale funding. When credit growth outpaces deposit growth, which has been the case, banks need to balance the equation through increased wholesale funding. This raises the potential for a liquidity crunch, as capital may be unavailable during a crisis. Credit growth to the private sector is slowing, though, reducing the immediate need for this type of funding. Additionally, authorities are prompting banks to substitute away from the heavy reliance on short-term wholesale funding through the implementation of a net stable funding ratio. This is defined as the available amount of stable funding (i.e. core deposits, equity and long-term wholesale funding) over the required regulatory level of stable funding. Banks will have until 2018 to increase this ratio above 100%. As a result, long-term wholesale debt issuance rose sharply in 2016 and that amount is projected to be relatively similar for 2017. Overall, current metrics suggest that Australian banks are fairly healthy, even before the additional capital requirements. Tier 1 capital ratios have gradually increased since 2007 and are fairly strong, non-performing loans are subdued and net interest margins are rising (Chart 12). In fact, Tier 1 ratios are substantially higher in Australia than they were in the U.S. prior to the Global Financial Crisis. Return-on-assets and return-on-capital have bounced slightly, although increasing capital will certainly dampen the earnings prospects for the Australian banks. Chart 11Australian Banks Heavily Exposed##BR##To Risky Mortgage Lending Chart 12Aussie Banks In##BR##Good Shape Right Now... Since the Moody's downgrade, credit default swap spreads for Australian banks have actually declined to near the 2014 lows, suggesting markets are not concerned about the risk of future bank stresses. We remain concerned, however. Macro-prudential measures on mortgage loan sizes and higher capital requirements are certainly welcome and will reduce perceived risks within the banking sector. However, these measures have done little to curb the rise in Australian house prices. Given their huge exposure to Australian housing, the banks will likely not be able to withstand a meaningful decline in house values - the outlook for which depends critically on the RBA's future monetary policy path. Bottom Line: Australia bank metrics are fairly healthy but they will need to raise more capital. This should not be too problematic. However, the banks' massive exposure to Australian housing, elevated number of interest-only mortgage loans and heavy reliance on short-term wholesale funding present substantial risks. Even if the bank capital levels are 'unquestionably strong,' they will not be enough to withstand a meaningful downturn in house prices. When Will The Housing Bubble Burst? House prices in Australia have nearly quadrupled since 2000. With the exception of Perth, house prices in the other major cities have continued their massive run-up over the last year, suggesting macro-prudential measures have done little to cool the market (Chart 13). Price gains have been supported by robust demand, both domestic and foreign. However, the steady rise in debt-fueled speculation (i.e. loans for investment purposes), the magnitude of the price increases, and the lack of any correction in over 25 years, suggest Australian housing is indeed in the midst of a bubble. On the supply side, steadily rising completions over the past decade have not curbed price gains (Chart 14). While construction has slowed since its peak at the end of 2016 and building approvals have declined, we find the argument that there has been a shortage in supply to be fairly weak. In fact, the rate of dwelling completions has outpaced population growth since 2012 and dwelling completions per 1,000 people are much higher in Australia than its G7 counterparts. Chart 13...Just Don't Prick##BR##The Housing Bubble Chart 14Supply Not Rising Enough To##BR##Slow House Price Growth History teaches us that bubbles never deflate calmly. Nevertheless, we view the likelihood of a systemic crash over the next 6-12 months as highly unlikely. While growth estimates may not meet the RBA's lofty goals, Australia will also not experience its first recession in over 25 years, which would crimp housing demand. The two most likely candidates to act as a catalyst for a housing downturn are therefore: a slowdown in capital inflows from Chinese property buyers and/or a shift to restrictive monetary policy from the RBA. It will not require a complete halt in capital inflows from China, simply a considerable slowdown, for the Australian housing market to come under pressure. While there is always a possibility for Chinese authorities to clamp down on outflows, particularly if the RMB comes under pressure, we view this as fairly unlikely. Current capital outflows have eased a bit and a long-term goal is to deregulate the capital account. Continued capital liberalization in China will aid in maintaining capital flows into Australian housing. Additionally, the millionaire class in China is growing and the private sector wants to diversify its assets. While Australian house prices are expensive, prices are far more affordable than those metropolitan areas such as Hong Kong, indicating Chinese money will continue to drift into Australian real estate. Chart 15A Long Way From Restrictive Policy Rates The more likely candidate for a bursting of the housing bubble is through the monetary policy channel. In the case of the U.S., multiple Fed rate hikes in the mid-2000s pushed monetary conditions into restrictive territory, prompting the housing crash. As we previously argued, the RBA will likely stay on hold for an extended period due to a lack of serious inflation pressures. Yet even if the RBA were to begin tightening sooner than we expect, it will take multiple rate hikes before monetary conditions become even close to restrictive. Using a simple measure of the equilibrium RBA cash rate, like a combination of Australian potential GDP growth and a five-year moving average of headline CPI inflation or the Taylor Rule formulation that we introduced in a recent Weekly Report, it is clear that the RBA is a long way from a restrictive policy stance (Chart 15).5 Bottom Line: Australian house prices have nearly quadrupled since 2000 and exhibit the characteristics of a bubble. Still, it will likely take considerable monetary tightening before the bubble bursts. We do not think this will occur anytime soon. Investment Implications We currently hold a neutral recommended stance on Australian government debt, both in terms of duration exposure and country allocation in global fixed income portfolios. Australian bond yields are above the lows seen in 2016 but have yet to break out of the structural downtrend with the benchmark 10-year now at 2.67% (Chart 16). We hesitate to go outright overweight on Australian debt in our model bond portfolio, however, even with our relatively dovish view on the RBA's future policy moves. Without any slowing in house prices, and with realized and expected inflation having clearly bottomed after last year's downturn, a big move lower in Australian bond yields is unlikely. At best, Australian yields will not rise by as much as we expect to see in the U.S. or Euro Area over the next 6-12 months. At the same time, if that view pans out, the Australian currency will likely underperform which will erode into the returns of an overweight Australian bond position (either through currency hedging costs or the outright losses on unhedged currency exposure). We do, however, see an opportunity to enter into an Australian 2-year/10-year yield curve flattening position (Chart 17). As previously mentioned, the short end of the curve will be anchored by an inactive central bank. The long end, however, faces multiple downward pressures. Macro-prudential measures and political pressures will continue to dampen credit growth. While we believe there is scope for realized inflation to grind a bit higher in the coming quarters, longer-term inflation expectations are likely to remain well-anchored. Additionally, the economic surprise index is elevated after several positive data releases and has plenty of scope for disappointment, which will limit any rise in longer-dated bond yields. Chart 16No Bear Market##BR##In Australian Bonds Chart 17Enter A 2yr/10yr##BR##Australian Curve Flattener The added benefit of entering a curve flattener is that the trade will likely work if our RBA view turns out to be wrong in a hawkish direction. If the RBA does indeed begin to hike rates sooner than we expect to deal with an improving economy or to begin deflating the housing bubble, this should put flattening pressure on the curve as the market prices in additional future rate increases. Only in the case of a breakout in longer-term inflation expectations that bear-steepens the curve, or a severe economic downturn that prompts RBA rate cuts and bull-steepens the curve, will a flattening trade underperform. Given our views on Australian growth and inflation, we see more likely scenarios where the curve flattens than steepens, particularly versus the only modest amount of flattening currently priced in the forwards. Bottom Line: Enter into a 2-year/10-year Australian government bond yield curve flattener. The short end of the curve will be anchored by an inactive central bank. On the long end, slowing credit growth, fiscal drag and an elevated economic surprise index will put downward pressure on yields. Patrick Trinh, Associate Editor Patrick@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 http://www.rba.gov.au/monetary-policy/rba-board-minutes/2017/2017-07-04.html 2 The "underemployed" is defined as full-time workers on reduced hours for economic reasons and part-time workers who would like, and are available, to work more hours. 3 NAIRU = Non-Accelerating Inflation Rate Of Unemployment. 4 https://data.oecd.org/hha/household-debt.htm 5 Please see BCA Global Fixed Income Strategy Weekly Report, "Dangerous Duration", dated July 11 2017. Available at gfis.bcaresearch.com.

Highlights Portfolio Strategy The chemicals bear market is over. Synchronized global growth, receding global capacity and improving domestic operating conditions compel us to lift exposure to neutral. As a result, our materials sector exposure also moves to the neutral column. While chemicals and materials are beneficiaries of an upgrade in global economic expectations, utilities sit at the opposite end of the table, and thus warrant a downgrade to a below benchmark allocation. Recent Changes S&P Chemicals - Upgrade to neutral, lock in profits of 10.2%. S&P Materials - Lift to neutral, take profits of 12.8%. S&P Utilities - Trim to underweight. Table 1 Feature Equities broke out last week. While still early, earnings season served as a catalyst and outweighed political/reform uncertainty and the budding global tightening interest rate cycle. Barring any unforeseen surprises, profits will remain the focal point in the coming weeks and sustain the equity blow-off phase. Two weeks ago we highlighted three ways to SPX 3,0001, and posited that this was a reasonable peak cycle level before the next recession hits. This week we dissect GICS1 sector profit composition and conclude that low double-digit EPS growth is attainable in 2018. Table 2 shows sector contribution to the S&P 500's profit growth in calendar 2017 and 2018, sector earnings weights for these two years and current market cap weights using Standard & Poor's data. Table 2Earnings Decomposition Charts 1 & 2 portray the high sector profit contribution concentration, with four sectors comprising 82% of the earnings growth year-over-year in 2017. For calendar 2018 such concentration still exists, but the same four sectors' profit contribution weight falls to 70% (based on bottom up estimates). Chart 1Sector Contribution To 2017 Profit Growth Chart 2Sector Contribution To 2018 Profit Growth Charts 3-5 show the sector earnings weight minus their market capitalization weight. Energy is the clear standout, but keep in mind that this resource sector is coming off a very depressed absolute profit level. As of Q1/2017, energy stocks have the widest gap of -574bps among the 11 sectors, with tech, real estate and staples also registering a small negative gap of roughly -100bps. The upshot is that even on modest assumptions, the energy sector's profit weight can renormalize close to its market cap weight (bottom panel, Chart 4). Chart 3Profit Weight... Chart 4... VS. Market Cap Weight... Financials is another standout sector. This early cyclical sector has consistently delivered a positive profit/market cap weight differential with the exception of the GFC. In fact, the 12-year average gap up to end-2007 has been over 700bps with a range of 425-1140bps, despite a rising financials market cap weight (second panel, Chart 3). Financials now sit near the bottom of the pre-crisis profit/market cap gap range. If our bullish thesis on financials (please see the May 1st Weekly Report) pans out, then this sector should command a larger share of the S&P 500's earnings pie with the profit/market cap gap widening closer to the pre-GFC average, assuming a cyclical earnings recovery. In sum, while sector profit contribution composition is highly concentrated in both 2017 and 2018, the earnings recovery is broad based with over three quarters of the 63 S&P 500 sector indexes we cover registering expanding forward EPS growth (Chart 6). Energy and financials profits will likely continue to surprise to the upside, and suggest that low double-digit EPS growth is realistic for the broad market. Our S&P 500 macro based profit model also corroborates this message. Chart 5... Across Sectors Chart 6Broad Based EPS Recovery One risk to our forecast is an oil price relapse that would put our energy profit assumptions offside. However, our Commodity & Energy strategists continue to expect higher crude oil prices into 2018. This week we continue to tweak our portfolio and add cyclical exposure by upgrading a deep cyclical sector, while simultaneously downgrading a defensive one. Chemicals No Longer Deserve An Underweight In the summer of 2014 we went underweight the S&P chemicals index, anticipating an earnings underperformance phase. We were expecting a deflationary industry impulse on the back of a slipup in global growth at a time when the chemicals manufacturers were furiously adding capacity to benefit from lower domestic feedstocks. This view has largely panned out, and it no longer pays to remain bearish on this highly cyclical industry. In line with our recent tweaks in our U.S. equity portfolio toward a more cyclical bent, we recommend locking in gains of 10.2% and upgrading the S&P chemicals index to a benchmark allocation. Three factors underpin our more neutral bias: synchronized global growth, receding global capacity and improving domestic operating conditions. The global manufacturing PMI has recently reaccelerated and jumped to a six year high. Similarly, the U.S. ISM manufacturing survey also vaulted higher. Synchronized global growth suggests that final demand is on the upswing and should bode well for chemical top- and bottom-line growth (Chart 7). Such synchronized global growth is giving way to a coordinated G10 Central Bank (CB) tightening cycle. Already, the BoC lifted rates recently and likely other CBs will take cover under the Fed's leadership and follow suit. Given that U.S. CPI continues to surprise to the downside, this implies that the U.S. dollar will remain under pressure as the Fed's next hike is penciled in only for December. This is significant for the export relief valve of U.S. chemical producers. As the euro shoots higher, U.S. exports become more competitive in the global chemicals market place and result in market share gains versus their Eurozone competitors (top panel, Chart 8). Currently, it seems as if U.S. chemicals exports are displacing German exports: German chemicals factory orders have plummeted on a short-term rate of change basis opening a wide gap with rebounding U.S. chemical exports (bottom panel, Chart 8). Chart 7Levered To Global Gross Chart 8Global Market Share Gains Global chemicals M&A supports our expectation of demand-driven pricing power gains. The current wave of mega-mergers started at the end of 2015 with the historic tie-up of Dow Chemical and DuPont. It has since grown to include more than half of the S&P chemicals sector by market cap and has a value greater than the previous seven years combined (Chart 9). We think the benefits of consolidation are twofold: First, reduced revenues of the past decade have left the industry with outsized cost structures; consolidation should sweep that away under the guise of synergy, driving margins higher. Second, industry overcapacity has historically impaired profitability due to soaring overhead and more competitive pricing; greater scale should impose greater capital discipline. Finally, domestic operating conditions have taken a turn for the better. Industry shipments have staged a 10 percentage point recovery from the 2015 trough and are now rising at a healthy clip. Chemical production has troughed and the firming U.S. leading economic indicator signals that output is on the verge of expanding. This improving domestic final demand backdrop is reflected in higher resource utilization rates. The upshot is that pricing power gains have staying power (Chart 10). Nevertheless, there are also three headwinds that merit close attention and prevent us from turning outright bullish. U.S. capacity additions are worrisome and, if not held in check, risk sabotaging the nascent pricing power recovery. Moreover, a wholesale and manufacturing inventory channel check suggests that there is a modest supply buildup. If there is any demand mishap it could also prove deflationary for chemical manufacturers. Tack on the recent spike in our chemicals wage bill proxy, and a profit margin squeeze could rapidly materialize (Chart 11). Chart 9M&A Boom Is Pricing Power Positive Chart 10Firming Domestic Backdrop Chart 11Three Risks To Monitor Bottom Line: There is tentative evidence that the bear market in chemicals producers is over. Take profits of 10.2% since inception and upgrade the S&P chemicals index to neutral. This will also move the S&P materials index to a benchmark allocation. Upgrade Materials To Neutral Chemicals stocks comprise over 73% of the S&P materials index, and this bump to a neutral stance also moves the broad materials index to a benchmark allocation, resulting in 12.8% profits for our portfolio since inception. Chinese economic data have been in a broad based recovery mode, and real GDP troughed mid-year 2016. Wholesale manufacturing and raw materials prices are climbing steadily (Chart 12), with core and services CPI also accelerating in marked contrast with the developed markets. This is impressive given the current dual Chinese monetary tightening via the currency and interest rate channels and modest deceleration in the fiscal thrust. China matters to materials producers as it is the largest commodity consumer. Thus, China's fortunes are closely aligned with the overall materials sector. Historically, the Keqiang Index has been positively correlated with materials revenue growth and the current message is positive. Similarly, the firming Chinese pricing backdrop also bodes well for materials EPS prospects (third & fourth panels, Chart 12). While we take Chinese data with a pinch of salt, the recently surging Australian dollar suggests that China is at least not relapsing (middle panel, Chart 13). Beyond China, the emerging markets are also in a cyclical recovery mode. The emerging Asia leading economic indicator (EALEI) has enjoyed a V-shaped recovery in the aftermath of the late-2015/early-2016 global manufacturing recession. Appreciating EM currencies corroborate the EALEI message, and should continue to underpin materials exports (top & bottom panels, Chart 13). Chart 12Recovering China... Chart 13... And EM Are A Boon For Materials Not only are emerging markets reviving, but also advanced economies are in excellent shape. Synchronized global growth and the coordinated brewing tightening cycle should lead to a selloff in most G7 bond markets. At a minimum, this implies that relative materials performance has put in a cyclical trough (top panel, Chart 14). Importantly, materials producers have made significant headway in improving their finances. The sector's interest coverage ratio (EBIT/interest expense) has bounced smartly and net debt/EBITDA has also dropped by a full turn. Bond investors have taken notice and this balance sheet improvement is reflected in the collapse in junk materials bond yields (yield shown inverted, middle panel, Chart 14). Our newly introduced S&P materials relative EPS model captures this positive macro backdrop for the sector and signals that the relative EPS recovery still has breathing room (Chart 15). However, a few risks hold us back from getting overly excited about materials stocks. First, Chinese money supply growth is not responsive. M1 growth is decelerating and M2 growth is plumbing all-time lows. Second, commodity inflation is also showing signs of fatigue. Similarly, U.S. core PCE and CPI inflation are stalling (Chart 16). This is significant because basic materials are synonymous with hard assets and excel in times of inflation, but falter in times if disinflation/deflation (please refer to our early December inflation-related Special Report). Finally, from a domestic operating perspective, our materials wage bill proxy has sharply reaccelerated giving us cause for concern, especially if there is a pricing power letdown. Under such a backdrop, profit margins would suffer a squeeze, and thereby profits would underwhelm (wage bill shown inverted, bottom panel, Chart 16). Chart 14Improving Finances Chart 15EPS Recovery Has Breathing Room Chart 16Three Risks Keep Us At Bay Netting all out, the S&P materials outlook has brightened a notch, but not sufficiently to turn us into bulls. Bottom Line: Lift the S&P materials sector to a benchmark allocation, and lock in profits of 12.8% since inception. Trim Utilities To Underweight Chart 17Blackout Warning While chemicals and materials are beneficiaries of an upgrading in global economic expectations, utilities sit at the opposite end of the table (global manufacturing PMI shown inverted, top panel, Chart 17), and therefore warrant a downgrade to a below benchmark allocation. Now that the Fed is ready to start unwinding its balance sheet, the ECB is preparing the waters for QE tapering and a slew of CBs are on the cusp of a new tightening interest rate cycle, there are high odds that still overvalued fixed income proxies will continue to suffer. Synchronized global growth and coordinated tightening in monetary policy spells trouble for bonds. Our sister publication U.S. Bond Strategy expects a bond selloff for the remainder of the year. Given that utilities essentially trade as a proxy for bonds, this macro backdrop leaves them vulnerable to a significant underperformance phase (Treasury yield shown inverted, bottom panel, Chart 17). Importantly, the stock-to-bond (S/B) ratio and utilities sector relative performance also has a tight inverse correlation (S/B shown inverted, second panel, Chart 17). The implication is that downside risks remain acute. Without the support of continued declines in bond yields, or of indiscriminate capital flight from all riskier assets, utilities advances depend on improving fundamentals. The news on the domestic operating front is grim. Contracting natural gas prices, the marginal price setter for the industry, suggest that recent utilities pricing power gains are running on empty (Chart 18). Tack on waning productivity, with labor additions handily outpacing electricity production, and the ingredients for a margin squeeze are in place (Chart 18). Importantly, industry utilization rates are probing multi-decade lows and overcapacity is negative for pricing power. Chart 18 confirms that utilities construction is relentless at a time when turbine and generator inventories have been hitting all-time highs. This is a deflationary backdrop, and suggests that sell-side analyst optimism is wrong footed. Put differently, it is unreasonable to expect profits to grow fast enough to support continued overvaluation (Chart 19). Chart 18Pricing Power Blues Chart 19Valuation Crunch Ahead Bottom Line: We are making room for the niche S&P materials upgrade to neutral by downgrading the equally small S&P utilities sector to a below benchmark allocation. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see the July 10th, 2017 U.S. Equity Strategy Service Report titled "SPX 3,000?", available at www.bcaresearch.com Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

The country's top 5 banks, collectively representing 80% of the S&P 500 bank index all reported Q2 EPS ahead of analyst expectations. The story was no different with investment banks as heavyweights GS and MS both reported solid earnings beats. As one would expect, both indexes responded by...falling? A couple of factors are at play in the market moves. First, market volatility, especially debt market volatility, has been subdued and that has decreased trading revenues across the board. Second, growth expectations are very high and a flattened yield curve is making investors worried about the achievability of top line estimates. We expect both of these to be transitory. As global monetary policy tightens, a bond selloff should gain momentum and inject a more normal level of volatility into markets. Coincidentally, the U.S. dollar will likely remain under downward pressure and inflation expectations should rise, driving a steepening of the yield curve. Bank earnings should continue to outpace the broad market as a result, especially given the nascent recovery in credit growth, making any near-term weakness an excellent entry point. Stay overweight.

Highlights China's strong second-quarter growth numbers released early this week confirmed the synchronized global growth upturn within the major economies. Our model is predicting an imminent increase in the PBoC's benchmark lending rate. Higher rates in China are reflective rather than restrictive. The PBoC will likely maintain a tightening bias, but this should not lead to major growth disappointments. The latest MFWC pledges "re-regulation" of the financial industry and remains committed to developing capital markets. Increasing supplies of equities through IPOs will put some downward pressure on stock prices - especially in the domestic small cap space. Feature The Bank of Canada hiked its policy rate by 25 basis points last week, the second major central bank to tighten after the Federal Reserve in the current cycle. While it is unclear whether central bankers maintain secret communication channels, effectively there appears to be a "coordinated recalibration" of monetary policies among major central banks, due largely to a synchronized growth upturn within the major economies. China's strong second-quarter growth numbers released early this week fit with this broad theme. There are rising odds that the People's Bank of China (PBoC) will join the proverbial global party with rate hikes. In addition, the Chinese authorities have pledged a tougher stance on the financial industry. Reflective Or Restrictive? China's latest data have shown across-the-board strength of late. Most indicators have surprised to the upside, rectifying our positive assessment.1 With the latest growth numbers, our model is predicting an imminent increase in the PBoC's benchmark lending rate (Chart 1). The model follows a modified version of "Taylor's Rule," in which external factors are also considered for open economies. In China's case, both improvement in growth and the Fed's interest rate hikes have played a strong role in setting the stage for higher policy rates in China. The model currently predicts 50 to 75 basis points in rate hikes by the PBoC. Historically, our interest rate model has done a reasonably good job in capturing the major turning points in China's policy rate cycles. This time around, the country's interest rate reforms may have complicated the model's predicting power. In short, the PBoC is in the process of diminishing the importance of the benchmark lending rate, while promoting market-based interest rates. The central bank has theoretically fully liberalized commercial bank interest rates since 2015, and therefore it is unclear whether it will abandon benchmark policy rates, which is viewed as an outdated tool. Instead, the PBoC has been trying to build an interest rate "corridor" in which it uses monetary and liquidity measures to guide market interest rates. The upper band of the interest rate corridor appears to be the interest rates of the PBoC's lending facilities - the cost for financial institutions to borrow from the central bank - while the lower band is the interest rate the PBoC pays on commercial banks' excess reserves (Chart 2). In this vein, the 6-month Medium Term Lending Facilities (MLF) interest rate has already been raised by 20 basis points since late last year, and interbank rates have been guided higher. Chart 1Rising Odds Of PBoC Rate Hikes Chart 2Interest Rate Corridor' ##br##Has Been Lifted Higher Chart 3Bank Loan Rate Is On The Rise Nonetheless, the upturn in our interest rate model justifies higher rates engineered by the PBoC. Regardless of whether the PBoC explicitly raises its policy lending rate, interest rates in China have already moved higher (Chart 3). Tighter liquidity and higher bond yields since late 2016 suggest that average bank lending rates should have increased by probably 50 basis points in recent months. Higher rates in China are a reflection of stronger growth rather than policy tightening to tame business activity, at least for now. After all, China's nominal GDP growth has rebounded from 6.4% in late 2015 to 11.1% in the second quarter of 2017 - a sharp turnaround in nominal business activity that calls for higher interest rates. Similarly, recent hawkish - or less dovish - rhetoric from other central banks all reflect improving growth where "emergency" levels of monetary accommodation are no longer needed (Chart 4). With the exception of Japan, BCA Central Bank Monitors, which measure pressure on central bankers to raise or reduce interest rates, have mostly climbed above zero of late, underscoring the need for tighter money among most developed countries. By the same token, it is premature to conclude that any policy tightening by the PBoC will lead to major growth problems in China. Chart 4Emergency' Levels Of Accommodation No Longer Needed Where does the RMB fit in? The PBoC's tightening bias suggests there is less incentive to target a lower exchange rate, both against the dollar and in trade-weighted terms. The central bank will continue to intervene to smooth out volatility. From investors' perspectives, the risk-return profile of taking a direct bet on the RMB is not attractive in either direction: we doubt there is meaningful upside in the RMB against the dollar in the near term, but the odds of significant RMB/USD depreciation have been further reduced. In other words, the RMB/USD exchange rate is still largely dominated by broader dollar performance, and the RMB is not a "high beta" currency to play the dollar. In short, we maintain our positive view on China's growth outlook, as discussed in greater detail in last week's bulletin. The PBoC will likely maintain a tightening bias, but this should not lead to major growth disappointments. Financial Reforms And Markets As growth has mostly surprised to the upside, policymakers' focus appears to have shifted to controlling financial risks, as highlighted by the key messages from the 5th National Financial Work Conference (NFWC) this past weekend. The NFWC convenes twice a decade, and usually sets the policy tone for the following years. Compared with the previous meeting five years ago that featured "deepening reforms and promoting development" as the key theme of the financial industry, the current session clearly strikes a more conservative tone. Top leadership declared that the financial sector must serve the needs of the "real economy," and that preventing systemic financial risks is the government's "eternal theme." Importantly, a cabinet level committee has been established to coordinate regulatory oversight on the financial industry - a task currently shared between the central bank and three regulators. The overall message from the latest NFWC is consistent with the regulatory crackdown on financial excesses since late last year.2 Overall, we share policymakers' sentiment that China's financial sector deregulation in recent years has gone too far.3 The dramatic leverage-fueled equity market boom-bust cycle in 2015 offered a crude awakening to the authorities against imprudent financial deregulation. Meanwhile, reform measures also ushered in a proliferation of institutions that prolonged financial intermediation channels. Without proper regulatory coordination, the authorities' attempts to reduce excesses has typically pushed speculative activity off the books of financial institutions, making it even more difficult to monitor and regulate. In fact, regulations on the financial sector have already been tightened of late. Derivatives, internet-based financing firms and asset-backed securities have all been put under much tighter regulatory scrutiny. The macro-prudential assessment (MPA) on financial institutions has been adopted since earlier this year - the latest MFWC suggests that "re-regulation" of the financial industry will continue in the coming years. The long-term impact of tighter control over the financial sector on the economy and financial markets remains to be seen. On one hand, imprudent financial deregulation and prolonged financial intermediation channels have done little to address the financing needs of small private enterprises, but have amplified risks and raised funding costs for the overall corporate sector - a suboptimal outcome that needs to be corrected. On the other hand, China's vast domestic savings need to be properly intermediated to the economy. We have long held the view that so long as the banking sector and debt instruments play the dominant role in financial intermediation, the accumulation of debt in the overall economy is all but inevitable.4 In this vein, any attempt to block financial intermediation aimed at "deleveraging" will prove both ineffective and counterproductive, with unintended consequences. An easier bet is that the authorities will remain committed to developing capital markets, both equities and corporate bonds, to provide alternative funding sources for the corporate sector. Procedures for initial public offerings (IPOs) and debt issuances will be simplified. The share of debt and equities in total social financing will continue to grow from a structural point of view (Chart 5). From investors' perspective, increasing supplies of equities through IPOs will put some downward pressure on stock prices - especially in the domestic small cap space, where multiples are unsustainably high and will continue to be de-rated (Chart 6). There are certainly some compelling growth stories among small caps that are worth cherry-picking, but overall investors should remain cautious for this asset class. Chart 5Debt And Equity Issuance##br## On A Structural Uptrend Chart 6Domestic Small Caps##br## Will Continue To Derate Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China Outlook: A Mid-Year Revisit," dated July 13, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China: Financial Crackdown And Market Implications," dated May 18, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "Legacies Of 2015," dated December 16, 2015, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Special Reports, "Chinese Deleveraging? What Deleveraging!" dated June 15, 2016, and "The Great Debate: Does China Have Too Much Debt Or Too Much Savings?" dated March 23, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

When Hunter Harrison took over the reins at CSX, the expectation was a repetition of his slashing of costs with the deployment of his Precision Scheduled Railroading. In his first full quarter as CEO, he appears to have done just that. However, the real surprise (and the one with direct read-through to the sector as a whole) was the pricing gains on the already-known strong quarterly volume; this bodes exceptionally well for the sector. Our upgrade of the sector to overweight last month was based on firming pricing driven by rising volumes (including coal); the CSX results confirm that expectation. In fact, the industry appears to be enjoying the best pricing power of the past 5 years, according to the latest PPI release (middle panel). Our rails EPS model captures this pricing strength and continues to indicate a surge in profit growth relative to the S&P 500. We reiterate our overweight position. The ticker symbols for the stocks in this index are: BLBG: S5RAIL -UNP, CSX, NSC, KSU.

The Fed will likely start renormalizing the balance sheet later this year and the ECB is preparing to taper asset purchases. In the G10, the BoC recently tightened monetary policy and more central banks are lining up to lift generationally low policy rates (see Chart 3 of our Cyclical Indicator Update published this week). This global liquidity hand-off to global growth is a boon to early-cyclical financials equities. The industrial metals/precious metals ratio moves with the ebb and flow of global growth, and is an excellent growth/liquidity indicator. Currently, this gauge has jumped on the back of a synchronized global growth backdrop. The upshot is that the financials sector outperformance phase is in the early stages, and we reiterate our early-May upgrade to an above benchmark allocation.

Our Consumer Discretionary Cyclical Macro Indicator (CMI) has snapped back after a tough year, driven by improving real wage growth. Higher home prices, a tighter labor market and increasing disposable income have consumers feeling flush, which should boost discretionary outlays. Importantly, consumer deleveraging is far advanced with the debt service ratio hovering near decade lows. Further, our Consumer Drag Indicator remains near its modern high, suggesting EPS gains will prove resilient. Although somewhat expensive from a historical perspective, our Valuation Indicator (shown in this week's Cyclical Indicator Update) remains close to the neutral zone, underscoring that profits will be the primary sector price driver. Our Technical Indicator (shown in this week's Cyclical Indicator Update) has fully recovered from oversold levels, and is flirting with the buy zone, underscoring additional recovery potential. We continue to recommend an overweight position, favoring the media-oriented sub-indices.