Currencies

Special Report

Highlights China's abnormal credit growth has been the result of speculative, high-risk behavior among Chinese banks - and not the natural result of the country's high savings rate. Banks do not intermediate savings into credit, and they do not need deposits to lend. Banks create deposits and money by originating loans. A commercial bank is not constrained in loan origination by its reserves at the central bank if the latter supplies liquidity (reserves) to commercial banks 'on demand'. What habitually drives credit booms are the "animal spirits" of banks and borrowers. We are initiating a relative China bank equity trade: short listed medium-size banks / long large five banks. Continue shorting the RMB versus the U.S. dollar. Feature For some time, the consensus view has been that rampant credit growth in China and the resulting excesses have been the natural result of the country's high savings rate, particularly among Chinese households. We have long argued differently: abnormal credit growth has been the result of speculative, high-risk behavior among Chinese banks and other creditors and borrowers. In this vein, China's credit bubble is no different than any other credit bubble in history. Although an adjustment in China might play out differently than it has in other countries where credit excesses became prevalent, China's corporate credit bubble is an imbalance that poses a non-trivial risk to both mainland and global growth (Chart I-1). Chart I-1China's Outstanding Credit Is Large Relative To Global GDP In a nutshell, Chinese banks have not channelled large amounts of household deposits into credit. Without mincing words, it is our view that banks have originated loans literally from "thin air" as banks do in any other country. In turn, credit has boosted spending, income and, consequently, savings. Do Deposits Create Loans, Or Do Loans Create Deposits? It is a widely held view among academics, investors and market commentators - including some of our colleagues here at BCA - that China's enormous credit expansion over the past several years has been a natural outcome of the nation's high savings rate. The argument goes like this: China has a very high savings rate, and it is inherent that household savings flow to banks as deposits. In turn, banks have little choice but to lend out on these deposits. The upshot of this reasoning is as follows: China's abnormally strong credit growth is a consequence of the country's abundant savings rather than an unsustainable excess. This argument hails from the Intermediate Loan Funds (ILF) model, otherwise known as the Loanable Fund Theory. This model suggests that deposits create loans - i.e., banks intermediate deposits into credit. Even though the ILF model is the most widespread theory of banking within academia and in textbooks, it unfortunately has little relevance to real-life banking - i.e., banking systems around the world do not function as the model posits. An alternative but much less recognized theory, the Financing Money Creation (FMC) model, asserts that banks create deposits from "thin air" when they originate a new loan. This is the model that banking systems in almost all countries in the world subscribe to. Indeed, whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower's bank account, therefore creating new money in the process (Chart I-2). In other words, bank loans create deposits and money. Chart I-2Commercial Banks: Credit Origination Creates Deposits Herein we cite various papers that discuss this matter and delineate the key points: "Banks do not, as many textbooks still suggest, take deposits of existing money from savers and lend it out to borrowers: they create credit and money ex nihilo - extending a loan to the borrower and simultaneously crediting the borrower's money account" (Turner, 2013). "When banks extend loans, to their customers, they create money by crediting their customer's accounts" (King, 2012). "Based on how monetary policy has been conducted for several decades, banks have always had the ability to expand credit whenever they like. They don't need a pile of "dry tinder" in the form of excess reserves to do so" (Dudley, 2009). "In a closed economy (or the world as a whole), fundamentally, deposits come from only two places: new bank lending and government deficits. Banks create deposits when they create loans." (Sheard, 2013). "Just as taking out a new loan creates money, the repayment of bank loans destroys money" (McLeay, 2014). The papers cited in the bibliography on page 18 elaborate on this topic in depth and readers are encouraged to review this literature. Bottom Line: Banks do not need deposits to lend. They create deposits and money by originating loans. Do Banks Lend Their Reserves At Central Banks? Another misconception about modern banking in general and China's banking system in particular is that banks lend out their excess reserves held at the central bank. Provided that Chinese banks have plenty of required reserves at the People's Bank of China (PBoC), some economists and analysts argue it is a matter of cutting the reserve requirement ratio to free up reserves (liquidity), which will allow banks to boost their loan origination. Again, we cite several papers as well as specific views from central bankers who reject the notion that banks lend out their reserves at the central bank: This comment by William C. Dudley (President of the New York Federal Reserve Bank) states "the Federal Reserve has committed itself to supply sufficient reserves to keep the fed funds rate at its target. If banks want to expand credit and that drives up the demand for reserves, the Fed automatically meets that demand in its conduct of monetary policy. In terms of the ability to expand credit rapidly, it makes no difference whether the banks have lots of excess reserves or not" (Dudley, 2009). "In fact, the level of reserves hardly figures in banks' lending decisions. The amount of credit outstanding is determined by banks' willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans. The aggregate availability of bank reserves does not constrain the expansion directly" (Borio et al., 2009). "While the institutional facts alone provide compelling support for our view, we also demonstrate empirically that the relationships implied by the money multiplier do not exist in the data ... Changes in reserves are unrelated to changes in lending, and open market operations do not have a direct impact on lending. We conclude that the textbook treatment of money in the transmission mechanism can be rejected..." (Carpenter et al., 2010). "...reserves are, in normal times, supplied 'on demand' by Bank of England to commercial banks in exchange for other assets on their balance sheets. In no way does the aggregate quantity of reserves directly constrains the amount of bank lending or deposit creation" (McLeay 2014). "Most importantly, banks cannot cause the amount of reserves at the central bank to fall by "lending them out" to customers. Assuming that the public does not change its demand for cash and the government does not make any net payments to the private sector (two things that are both beyond the direct control of the banks and the central bank), bank reserves have to remain "parked" at the central bank" (Sheard, 2013). More detailed analysis on this topic is available in the papers cited in the bibliography on page 18. Bottom Line: Banks do not lend out their reserves at the central bank. A commercial bank is not constrained in loan origination/money creation by its reserves at the central bank if the latter supplies liquidity (reserves) to commercial banks 'on demand'. Empirical Evidence: Savings Versus Credit This section presents empirical evidence that there is no correlation between national and household savings rates and loan origination. This is true for any country, including China. Credit growth and credit penetration (the credit-to-GDP ratio) have little to do with a country's or with households' savings rates. Chart I-3 illustrates that there has been no correlation between China's national or household savings rates and the credit-to-GDP ratio. China's savings rate was high and rising before 2009, yet the credit bubble formation only commenced in January 2009 when the savings rate topped out. Looking at other countries such as Korea, Taiwan and the U.S., historically we find no correlation between their savings and credit cycles1 (Chart I-4). Chart I-3China: Credit And Savings ##br##Are Not Correlated Chart I-4The U.S., Korea And Taiwan:##br## Credit And Savings Are Not Correlated Importantly, a high or rising savings rate does not preclude deleveraging. There were many two- to four-year spans of deleveraging in China when the credit-to-GDP ratio was flat or falling (Chart I-5) - i.e., the growth rate of credit was at or below nominal GDP growth. This occurred despite the country's high and rising savings rate. So, not only is deleveraging not unusual for China but it has also occurred amid a high savings rate. This contradicts the commonly held view that Chinese credit has always expanded faster than nominal GDP because the nation saves a lot. Deleveraging at the current juncture will likely be very painful, because the size of credit flows is enormous and even a moderate and gradual deceleration in credit will produce a major drag on growth. Specifically, the credit impulse - the second derivative of outstanding credit that measures the impact of credit growth on GDP - will be equal to -2.2% of GDP if credit growth moderates from 11.3% now to 7.8% in the next 24 months (Chart I-6). Chart I-5There Were Periods Of ##br##Deleveraging In China Too Chart I-6China's Credit Impulse Will ##br##Likely Be Negative As Chart I-6 also demonstrates, China's credit impulse drives Chinese imports, the most critical variable for the rest of the world. Chart I-7China: A Growth Engine Shift Since 2009 Further, it is possible to argue that vigorous credit growth generates robust income growth. The latter, in turn, allows a nation as a whole and households in particular to save more. If Chinese banks had not originated as many loans since early 2009 as they have, many goods and services in China would not have been produced and sold, and income growth for all companies, households and even government would be much lower. Even if the savings rate were held constant, less income would entail lower absolute amounts of both national and household savings. In short, China's exponential credit growth since 2009 has helped boost both national and household income levels, and in turn the absolute level of their savings. Chart I-7 illustrates that before 2009, mainland economic and income growth were driven by exports, but since early 2009, credit has been instrumental in generating income growth and prosperity. Finally, many analysts rationalize strong loan growth among Chinese banks by their robust deposit growth. This logic is flawed: Chinese banks have substantial deposits on hand because they originate a lot of loans. Bottom Line: China's and any other country's national or household savings rate does not explain swings in credit creation. Banks do not intermediate savings into credit. Rather, banks create deposits and money. What Drives Bank Lending? If a credit boom is not driven by abundant savings, what is the foundation for a credit boom in general, and the one currently underway in China in particular? Loan origination by a bank depends on that bank's willingness to lend, as well as general demand for loans. Also, depending on policy priorities, regulators often try to encourage or limit banks' ability to lend by imposing and adjusting various regulatory ratios. Barring any regulatory constraints, so long as there is demand for loans and a bank is willing to lend, a loan will be originated. Hence, in theory, banks can lend to eternity unless shareholders and regulators constrain them. In the immediate wake of the Lehman crisis, the Chinese authorities encouraged banks to open the credit floodgates. Thus, there was a de facto deregulation in the nation's banking system in early 2009 - policymakers encouraged strong credit origination. The experience of many countries - documented by numerous academic papers on this topic - has demonstrated that banking sector deregulation typically leads to excessive risk-taking by banks, and abnormal credit growth. These episodes have not ended well, with multi-year workouts following in their wake. By and large, a credit boom often occurs when risk-taking by banks surges and shareholders and regulators do not constrain them. This has been no different in China - the credit boom since 2009 has been powered by speculative and excessive risk-taking among banks and their management teams in particular, amid complacency of regulators and shareholders. Bottom Line: What habitually drives excessive credit creation are the "animal spirits" of banks and borrowers. Banks' and borrowers' speculative behavior and reckless risk-taking typically degenerates into a credit boom that often ends in an economic and financial downturn. It has been no different in China. What Constrains Bank Lending? The following factors can limit bank credit origination: Monetary policy can limit credit growth via raising interest rates, which dampens loan demand. Also, banks can become more risk averse when interest rates rise as they downgrade creditworthiness of current and prospective borrowers. Government regulations can impose various restrictions on banks, restraining their risk-taking and ability to originate infinite amounts of credit. In China, to limit banks' ability to lend, regulators have imposed several mandatory ratios on commercial banks, and also practice 'Window Guidance'. First, the capital adequacy ratio (CAR=net capital / risk-weighted assets). This ratio limits banks' ability to originate infinite amounts of loans by imposing a minimum level CAR. In China, most banks comply comfortably with CAR. The CAR for the entire commercial banking system is currently 13.1%. While the minimum requirement is 8%. The caveat is that in China, banks' equity capital is nowadays considerably inflated because they have not provisioned for non-performing loans (NPLs). If banks were to fully provision for NPLs, their equity capital would shrink significantly, and they would probably not meet the minimum CAR. Table I-1 shows that in a scenario of 12.5% NPL ratio for banks' claims on companies and zero NPL on household loans and mortgages as well as a 20% recovery rate, a full provisioning by banks would erode 65% of their equity. In this scenario, the CAR ratio would drop a lot - probably below the required minimum of 8% and banks would be forced to raise new equity (dilute existing shareholders) or shrink their balance sheets - or a combination of both. Table I-1China: NPL Scenarios And Banks' Equity Capital Impairment Second, the leverage ratio - computed as net Tier-1 capital divided by on- and off-balance-sheet assets. According to government regulation, this ratio should be at least 4%. As of June 30, 2016, the leverage ratio for the entire commercial banking system was 6.4%, comfortably above its floor. Nevertheless, as with CAR, the leverage ratio is overstated at the moment because the numerator - net Tier-1 equity capital - is artificially inflated, as it is not adjusted for realistic levels of NPLs, as discussed above. If 65% of equity is eroded due to sensible loan-loss provisioning and write-offs (as per Table 1), the leverage ratio would drop to about 2.3%, below the required minimum of 4%. Hence, banks would need to raise new equity (dilute existing shareholders), shrink their balance sheets or do a combination of both. Equity dilution is bearish for bank stocks and, if and as banks moderate their assets/loan growth, the economy will suffer. Third, regulatory 'Window Guidance' is implemented through PBoC recommendations to banks on their annual and quarterly credit ceilings, and on their credit structures. There is no official disclosure of this measure, and it is done between the PBoC, the Chinese Banking Regulatory commission (CBRC) and banks' management. In recent years, the efficiency of 'Window Guidance' has declined dramatically. Banks have defied bank regulators' efforts to rein in credit growth by finding loopholes in regulations. What's more, they have de facto exceeded credit origination limits by moving credit risk off their balance sheets and classifying it differently than loans. The result has been mushrooming Non-Standard Credit Assets (NSCA). Table I-2 reveals that on- and off-balance-sheet NSCA stand at RMB 10 trillion and RMB 19 trillion, respectively. Furthermore, banks have lately expanded their lending to non-depositary financial organizations that include trust companies, financial leasing companies, auto financing companies and loan companies (Chart I-8). This has probably been done to circumvent government regulations. Hence, Chinese banks have taken on much more credit risk than regulators have wanted them to by reclassifying/renaming loans as NSCA, and parking these assets both on- and off-balance-sheet. Table I-2China: Five Largest Banks Hold ##br##Only 40% Of Credit Assets Chart I-8Non-Bank Financial Organizations##br## Are On A Borrowing Spree From Banks In short, regulatory measures in China have not been effective at restraining credit growth in recent years. Bank shareholders are the biggest losers when banks expand credit uncontrollably, and then their default rates rise. The reason being that banking is a business built on leverage. For example, if a bank's assets-to-equity ratio is 10 and 10% of assets go bad (default with no recovery), shareholders' equity will completely evaporate - i.e., they will lose their entire investment. Hence, it is in the best interests of bank shareholders to halt a credit expansion when they sense deteriorating credit quality ahead. Doing so will hurt the economy, but limit their losses. Why have shareholders of Chinese banks not stepped in to curb the credit boom and misallocation of capital? We believe they have either been satisfied with such a massive credit expansion, which has initially driven shareholder returns up, or weak institutional shareholder mechanisms have meant they have been unable to enforce credit discipline on their banks. All in all, if China's or any other credit system is driven by the principals of capitalism and markets, creditors are the ones who should curtail credit growth - regardless of what impact it will have on the economy. If a country's credit system in general and banks in particular do not operate on principals of capitalism and markets, banks can expand credit infinitely, thereby perpetuating capital misallocation and raising inefficiency, leading to stagnating productivity - in other words, a move to a more socialist bend. Only in a socialist system do banks expand their credit portfolios in perpetuity, since they are not run to maximize wealth for shareholders. On a related note, there is another misconception that all Chinese banks are state-owned and the government will be fast to bail them out by buying bad assets at par. Table I-3 illustrates the ownership structure of 16 Chinese banks listed the A-share market, including the large ones. The state (central and local governments) and SOEs have a large but not 100% ownership stake. In fact, foreign investors have considerable equity shares in many banks. Table I-3Chinese Banks: Shareholder Structure Is Diverse Hence, a government bail-out of these banks at no cost to shareholders would mean the Chinese government is using taxpayer money to benefit domestic private as well as foreign shareholders. Given the considerable amounts involved, this will be politically difficult to achieve unless the benefits of doing so are explicitly greater than the costs of doing nothing. Chart I-9Commercial Banks Are On ##br##Borrowing Spree From PBoC We are not implying that a government bailout is impossible. Our point is that it will take material pain and considerable deterioration in the economy and financial markets before the central government bails out banks at no cost to other shareholders. No wonder the authorities have not recapitalized the banks so far. In the long run, if the Chinese government is serious about improving the credit/capital allocation process, it has to allow market forces to take hold so that creditors and debtors are not bailed out but instead assume financial responsibility for their decisions. This means short-term pain but long-term gain. The lack of demand for credit is an important constraint on credit origination. If there are no borrowers, banks will have a hard time making a sizable amount of loans. Liquidity constraints also limit banks' ability to expand their assets. Let's consider an example when liquidity constraints arise. Bank A originates a loan, and Borrower A wants to transfer money to its Supplier B, which has an account at Bank B. In theory, Bank A should reduce its excess reserves at the central bank by transferring money to Bank B's reserve account at the central bank. However, if too many borrowers of Bank A try to transfer their money/deposits to other banks, Bank A will run into liquidity constraints as its excess reserves dry up. In such a case, Bank A should borrow money from the central bank or the interbank market to replenish its excess reserves. Provided many G7 central banks are nowadays committed to supplying as much liquidity (reserves) as banks require, in these countries banks do not really face liquidity constraints in lending. The focus of advanced countries' central banks is to control short-term interest rates - i.e., they manage liquidity in a way to keep policy rates at the target. In the case of China, even though the PBoC has a high required reserves ratio (RRR) for banks, it apparently supplies commercial banks with whatever amounts of liquidity they require. Chart I-9 reveals that the PBoC's claims on commercial banks have surged by fivefold in the past three years. Given the Chinese monetary authorities have in the recent years been very generous in meeting banks' demands for liquidity, the high RRR has not constrained mainland banks' ability to originate loans. This contradicts some analysts' assertions that the PBoC can boost lending by cutting the RRR. As the PBoC presently fully accommodates banks' demands for liquidity, the significance and impact of required reserves has declined. On the whole, nowadays, commercial banks in China are not facing liquidity (reserves) constraints to expand credit. High debt servicing costs could constrain bank lending. Are there limits to the credit-to-GDP ratio? It is illustrative to consider a numerical example for China. Corporate and household debt presently stands at 220% of GDP and, according to Bank of Intentional Settlement (BIS) calculations, debt servicing costs (including interest payments and amortization) account for around 20% of disposable income (Chart I-10). If credit indefinitely expands at a rate well above nominal GDP growth (Chart I-11) and interest rates do not decline, debt servicing costs will rise substantially. For example, let's assume that mainland corporate and consumer leverage reaches 400% of GDP in the next several years. If and when this happens, debt servicing costs could double, approaching 40% of income assuming constant interest rates and debt maturity. Chart I-10China's Corporate And Household##br## Credit: The Sky'S The Limit? Chart I-11Will Credit Growth Slow Toward##br## Nominal GDP Growth? No debtor can continue to function under such debt burden. Hence, debtors will have to cut their spending (for companies it will be a reduction in capex budgets) or these debtors will need to borrow to pay interest and retire old debt. In short, this becomes an unsustainable Ponzi scheme, where debtors borrow to service their debt obligations. Anecdotal evidence suggests this is not rare in China nowadays. One way the authorities could reduce debt servicing is to cut interest rates to zero and lengthen the maturity of debt. This is what many advanced economies have done. If Chinese credit penetration does not stop rising, the PBoC will be forced to cut rates to close to zero. This in turn will lead to large capital outflows, and the RMB will depreciate versus the U.S. dollar. Bottom Line: The following factors can restrain bank credit origination: monetary policy (higher interest rates), government regulations, bank shareholders, lack of credit demand, liquidity constraints and high debt servicing costs. Investment Implications Chart I-12Short Small Banks / Long Large##br## Banks In China If banks' shareholders and other creditors in China act in accordance with their self-interests to preserve the value of their assets, they will have to reduce credit origination/lending. As a result, China will experience an acute economic downturn. This would constitute a capitalist-type adjustment, which in turn will lead to more efficiency, solid productivity growth, and reasonably high economic growth over the long term. However, it will also mean significant short-term pain. If the government bails out everyone, underwrites all credit risks, and gets even more involved in capital/credit allocation, the economy will not experience an acute slump for a while. However, this would represent a shift toward socialism and the potential growth rate will collapse in the next several years. With the labor force stagnating and probably contracting in the years ahead, China's potential growth will be equal to its productivity growth. In socialism, productivity growth is low, often close to zero. The growth trajectory in this scenario will follow mini-cycles around a rapidly falling potential growth rate. In brief, China's growth rate is bound to slow further, regardless of what scenario plays out over the next several years. Today, we are initiating a relative China bank equity trade: short listed small- and medium-size banks / long large five banks in the A-share market (Chart I-12). There has been more speculative high-risk lending from the small- and medium-size banks than the large ones. As we documented in our June 15, 2016 Special Report titled Chinese Banks' Ominous Shadow,2 the largest five banks have fewer non-standard credit assets than medium and small banks. If 12.5% of banks' claims on companies turn sour and the recovery rate is 20%, 100% of the equity of 11 listed small- and medium-sized banks will be wiped out. The same number for the large five banks is 42%. Hence, these 11 listed small- and medium-sized banks are more exposed to bad loans than the large five. Finally, mushrooming leverage entails that the monetary authorities should reduce interest rates drastically. However, lower interest rates will spur more capital outflows from the mainland. Hence, the RMB is set to depreciate further. We have been shorting the RMB versus the U.S. dollar since December 9, 2015, and this position remains intact. 1 We discussed this at length in Emerging Markets Strategy Special Report, "China: Imbalances And Policy Options", dated June 12, 2012, available at ems.bcaresearch.com 2 Please refer to the Emerging Markets Strategy Special Report titled, "Chinese Banks' Ominious Shadow", June 15, 2016, link available on page 22. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com Bibliography Borio, C. and Disyatat, P. (2009), "Unconventional Monetary Policy: An Appraisal", BIS Working Papers, No. 292, November 2009. Carpenter, S. and Demiralp, S. (2010),"Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?", Finance and Economics Discussion Series, No. 2010-41, Divisions of Research & Statistics and Monetary Affairs, Washington, DC: Federal Reserve Board Dudley, W. (2009), "The Economic Outlook and the Fed's Balance Sheet: The Issue of "How" versus "When"", Remarks at the Association for a Better New York Breakfast Meeting, available at http://www.newyorkfed.org/newsevents/speeches/2009/dud090729.html Jakad, Z. and Kumhof, M. (2015), "Banks Are Not Intermediaries of Loanable Funds - and why this Matters", Bank of England, Working Paper 529, May 2015 King, M. (2012), Speech to the South Wales Chamber of Commerce at the Millenium Centre, Cardiff, October 23. Ma, G., Xiandong, Y. and Xim L. (2011), "China's evolving reserve requirements", BIS Working Papers, No. 360, November 2011. Turner, A. (2013), "Credit, Money and Leverage", September 12. Sheard, Paul (2013), "Repeat After Me: Banks Cannot And Do Not 'Lent Out' Reserves", Standard & Poor's Rating Services, August 2013, New York 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. See King (2012), "Banks Are Not Intermediaries of Loanable Funds - and why this Matters", pp. 6, cited in Zoltan Jakab and Michael Kumhof, Bank of England Working Paper 529, May 2015. See Dudley (2009), "Banks Are Not Intermediaries of Loanable Funds - and why this Matters", pp. 13, cited in Zoltan Jakab and Michael Kumhof, Bank of England Working Paper 529, May 2015. See Carpenter and Demiralp (2010), "Banks Are Not Intermediaries of Loanable Funds - and why this Matters", pp. 13, cited in Zoltan Jakab and Michael Kumhof, Bank of England Working Paper 529, May 2015. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Duration: Treasury yields will continue to rise as a December Fed rate hike is priced in. A surge in bullish dollar sentiment between now and December would cause us to back away from our below-benchmark duration stance. Spread Product: Maintain a neutral allocation to spread product, favoring convexity over credit risk. A surge in bullish dollar sentiment between now and December would cause us to downgrade spread product relative to Treasuries. TIPS: The increased sensitivity of TIPS breakevens to core inflation argues for a continued overweight position in TIPS relative to nominal Treasuries. Sovereign Debt: Continue to favor U.S. corporate credit over USD-denominated sovereign government debt within a neutral allocation to spread product. Feature About one month ago, we outlined how we expected our investment strategy to evolve over the remainder of this year and into 2017.1 Our continued expectation that the Fed will lift rates in December leads us to maintain below-benchmark portfolio duration and a neutral allocation to spread product2 until a December rate hike has been fully discounted by the market. Chart 1Dollar Sentiment: A Key Indicator Beyond December, our investment strategy will depend largely on how the dollar responds to an upward re-rating of rate expectations. Strong dollar appreciation would likely cause us to reverse our below-benchmark duration stance and become even more cautious on spread product. Conversely, a tame dollar could mean that the sell-off in bonds and rally in spreads have further to run. The dollar has appreciated by close to +2% since early September and bullish sentiment toward the dollar has also edged higher (Chart 1). However, so far the increases appear muted compared to the rapid dollar appreciation that occurred in the run-up to last December's rate hike. The reason we care about the dollar is that a stronger currency represents a tightening of financial conditions that acts to depress expectations of future economic growth. This can spell trouble for risk assets and also lower the market-implied odds of future rate hikes. For example, spread product was performing well last year until rate hike expectations started to move higher in late October. As the market began to anticipate a December Fed rate hike, it did not take long for the combination of higher rate expectations and increasingly bullish dollar sentiment to weigh on risk assets (Chart 2). The Market Vane survey of bullish sentiment toward the dollar surged above 80% last December, and this tightening of financial conditions is what prompted the sell-off in spread product and sharp decline in Treasury yields that kicked off 2016. Chart 2More Bullish Dollar Sentiment Is A Risk For Spread Product With last year's example in mind, the relevant question for current investment strategy is: How much dollar appreciation can the market tolerate before Treasury yields reverse their uptrend and credit spreads start to widen? To answer that question we make an assessment of U.S. and global growth relative to this time last year. All else equal, if U.S. growth is improved compared to last year, then it should require a greater dollar appreciation to have a similar impact on yields and spreads. Relatedly, if the growth outlook outside of the U.S. is improved, then it would mean that the dollar's reaction to rising U.S. rate expectations might not be as strong. On this note, there is some evidence pointing toward a more resilient U.S. and global economy than at this time last year. In the U.S., our preferred leading indicators suggest that growth contributions from capital spending, housing, net exports, government spending and inventories should all move higher in the coming quarters (Chart 3). This should act to offset a likely moderation in consumer spending growth (Chart 4). All in all, the domestic U.S. growth outlook appears similar to - if not slightly better than - what was seen at this time last year. There is more cause for optimism in the global growth indicators. The aggregate global PMI and LEI are tracking close to levels seen last year, but rising diffusion indexes suggest that further increases are likely (Chart 5). Already, manufacturing PMIs in all the major economic blocs have entered clear uptrends (Chart 5, bottom two panels). This suggests that the global growth outlook is actually much brighter than at this time last year, and improved diffusion indexes suggest that the global recovery has also become more synchronized. Chart 3U.S. Growth Outlook Improving... Chart 4...Outside Of Consumer Spending Chart 5Global Growth On The Upswing The implication of a U.S. economic outlook that is broadly similar to last year and an improved outlook for global growth is that the U.S. dollar may not react as strongly to rising Fed rate hike expectations in 2016 as it did in 2015. If this turns out to be the case, then the performance of spread product should also be more resilient and the uptrend in Treasury yields is less likely to reverse. Bottom Line: We continue to track the dollar and dollar sentiment closely to inform our near-term investment strategy. While dollar sentiment has edged higher, it has not yet reached the elevated levels seen last year. A more synchronized global growth recovery makes such a spike in bullish dollar sentiment less likely this time around. What Is A High Pressure Economy? Chart 6What A "High Pressure Economy" Looks Like Fed Chair Janet Yellen introduced a new buzzword to the market two weeks ago when she suggested in a speech3 that "it might be possible to reverse the adverse supply-side effects [of the financial crisis] by temporarily running a 'high-pressure economy' with robust aggregate demand and a tight labor market." Some investors took this to mean that the Fed would be increasingly tolerant of inflation overshooting its 2% target. We think this interpretation is incorrect, although we do think that Yellen's description of a "high pressure economy" provides a lot of information about the Fed's reaction function. More than anything, Yellen's speech was a response to recent trends in the labor market. The downtrend in the unemployment rate started to abate late last year, even though the economy has continued to add jobs at an average pace of just under +200k per month. A sharp rebound in the labor force participation rate has prevented the unemployment rate from falling, despite robust job growth (Chart 6). It is this dynamic that Yellen refers to when she talks about a "high pressure economy". Essentially, her theory suggests that, despite the low unemployment rate, the economy might be able to continue to add jobs without inflation spiking higher. Put differently, the unemployment rate might be less useful as an input to the Fed's forecast of future inflation than in past cycles. The key implication for investors is that if the Fed doesn't trust the unemployment rate to provide a signal about future inflation, then it is forced to rely on the actual inflation data for guidance. In our view, core PCE and core CPI inflation are now the two most important inputs to the Fed's reaction function. On that note, while last week's September core CPI release was soft, both core CPI and core PCE remain in uptrends that began in early 2015. Further, diffusion indexes suggest that these uptrends will persist (Chart 7). The Fed's increased focus on core inflation also has implications for our TIPS call. The sensitivity of TIPS breakevens to realized core inflation has shifted higher since the Great Recession (Chart 8). In our view, this has occurred because of how the zero-lower-bound on interest rates has constrained the Fed's ability to influence investor expectations. Chart 7The Inflation Uptrend Is Intact Chart 8TIPS Breakevens & Core Inflation When the fed funds rate was well above the zero-lower-bound, investors could reasonably assume that the Fed would act to offset any temporary price shocks. As such, long-maturity TIPS breakevens remained in a relatively narrow range and were mostly influenced by perceptions about the stance of Fed policy. In a zero-lower-bound world, investors can reasonably question whether the Fed has the ability to offset a deflationary price shock. As such, inflation expectations are increasingly driven by the actual inflation data rather than the Fed. With the Fed and the market both increasingly taking their cues from the actual inflation data, it means that the Fed will likely remain sufficiently accommodative for core PCE to return to target and also that TIPS breakevens will move higher alongside the trend in realized inflation. Bottom Line: The increased sensitivity of TIPS breakevens to core inflation argues for a continued overweight position in TIPS relative to nominal Treasuries. Sovereign Credit: A Dollar Story Chart 9Sovereign Debt & The Dollar As noted above, in the current environment the path of the U.S. dollar takes on increased importance for our entire portfolio strategy. However, there is one sector of the fixed income market where the dollar is always paramount - USD-denominated sovereign debt. Specifically, we refer to the Barclays Sovereign index which consists of the U.S. dollar denominated debt of foreign governments, mostly emerging markets.4 In the long-run, the performance of sovereign debt relative to equivalently-rated and duration-matched U.S. corporate credit tends to track movements in the dollar and bullish sentiment toward the dollar (Chart 9). When the dollar appreciates it makes USD-denominated debt more expensive to service from the perspective of a foreign issuer, and therefore causes sovereign debt to underperform domestic alternatives. As stated above, we do not anticipate a near-term spike in the dollar, like what was witnessed near the end of last year. However, given that the Fed is much further along in its tightening cycle than other major central banks, the long-run bull market in the U.S. dollar should remain intact. This will continue to be a major headwind for sovereign debt. Further, the recent performance of sovereign debt relative to U.S. credit has bucked its traditional correlations with the dollar. Notice that the beta between sovereign excess returns and the dollar has moved into positive territory (Chart 9, bottom two panels). Historically, the correlation does not remain at these levels for long and sovereign debt should underperform as the more typical negative correlation is re-established. At present, there is not even an attractive valuation argument for sovereign debt relative to U.S. credit. The spread differential between the Sovereign index and an equivalently-rated, duration-matched U.S. credit index is well below zero (Chart 10), and only the USD-debt of Hungary, South Africa, Colombia and Uruguay offer spreads that appear attractive relative to the U.S. Credit index (Chart 11). Chart 10No Spread Pick-Up In Sovereigns Chart 11USD-Denominated Sovereign Debt By Issuing Country Bottom Line: Continue to favor U.S. corporate credit over USD-denominated sovereign government debt within a neutral allocation to spread product. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching", dated September 13, 2016, available at usbs.bcaresearch.com 2 We favor negatively convex assets (MBS) over credit within a neutral allocation to spread product, on the view that negatively convex assets will outperform as yields head higher in advance of a December rate hike. In anticipation of a December Fed rate hike we are also maintain a short position in the December 2017 Eurodollar futures contract as well as positions in 2/10 and 10/30 curve flatteners. The three trades have returned: +20bps, -23bps and +4bps respectively. 3 http://www.federalreserve.gov/newsevents/speech/yellen20161014a.htm 4 The largest issuers in the Barclays Sovereign Index are: Mexico (22%), Philippines (14%) and Colombia (11%). Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Portfolio Strategy Boost restaurant stocks to neutral, as same-store sales should improve next year. A further upgrade requires evidence of top-line traction. The exodus from health care stocks represents an overreaction rather than a downshift in fundamental forces. Stay long. Recent Changes S&P Restaurants Index - Upgrade to neutral for a profit of 9%. Table 1 Feature Equity market buoyancy remains a liquidity rather than an earnings story. Fed commentary and the trend in global bond yields, a reflection of the global central bank narrative, continue to exert an outsize influence on short-term price action and momentum. In the background, earnings are a wildcard. Companies may be surpassing beaten down third quarter estimates, but the path of profits over the next several quarters is by no means assured and will determine the durability of any stock market advance. Even excluding the persistent drag from narrowing profit margins, courtesy of falling productivity and increasing unit labor costs, it is dangerous to look at the corporate profit outlook through rose colored glasses. The low level of economic growth, both at home and abroad, represents a major hurdle to the corporate sector. Total business sales have climbed back up to zero, but it is premature to forecast meaningful growth ahead based on moribund global export growth (Chart 1), and/or leading economic indicators. After all, sales growth has been virtually non-existent for years, reinforcing that earnings per share have been driven by cost cutting and buybacks. While measured consumer price inflation has crept higher, corporate sector pricing power remains virtually non-existent. The producer price index is still deflating, despite the rally in oil prices. U.S. import prices are very weak (Chart 1). The negative global credit impulse warns that there is still no impetus to reinvigorate final demand, and by extension, global profits (Chart 1). It is hard to envision an economic reacceleration as long as the corporate sector is more inclined to retrench than expand, as heralded by stressed balance sheets and weak durable goods orders (Chart 2). Chart 3 shows BCA's two U.S. profit models. The first one is based on reflationary variables, such as the dollar, bond yields and oil prices. It is designed to predict the trend in forward earnings momentum. This model has troughed, but is not signaling any upside ahead in already exuberant analyst earnings estimates (Chart 3, second panel). Chart 1Without Sales Growth... Chart 2... And Rising Costs... Chart 3... How Much Can Profits Improve? The second model looks at macro data such as new orders, labor costs and productivity growth to forecast the trend in actual operating earnings. This model is slightly more optimistic (Chart 3, bottom panel), and signals a decisive end to the profit contraction, albeit not a growth rate sufficient to satisfy double-digit analysts forecasts or rich valuations. The U.S. dollar is a major wildcard, as any sustained strength would compromise earnings. Typically, major profit expansions only occur after the currency begins to depreciate and labor cost inflation ebbs (Chart 2). The late-1990s was an exception, as profits climbed alongside the currency and amidst rising wage inflation (Chart 2). However, that was during an economic and credit boom, two key factors that are conspicuously absent at the moment. Nevertheless, as discussed in past Weekly Reports, the flood of central bank liquidity could sustain the overshoot in equity prices for a while longer. Investors have demonstrated a willingness to look through soggy profits as long as the liquidity taps remain open. Despite the possibility of a stubbornly resilient broad market, we do not recommend interpreting it as a sign of economic vitality, and consider it high risk. Our portfolio strategy is based on expected sectoral earnings trends, as liquidity is subject to the whims of central bankers. We recommend a largely defensive sector portfolio, with some exceptions, as discussed in last week's Special Report. Our cyclical exposure remains confined to consumption-oriented plays; this week we are lifting our view on restaurants. Restaurants: Buying Into Weakness Investors have gravitated toward washed out deep cyclical sectors rather than consumption-oriented plays in recent months. However, we doubt this trend has staying power, as outlined in our Special Report last week. Consequently, it is time to revisit the outlook for shunned consumer sectors, such as restaurants. This year's exodus from casual dining stocks has been justified on the basis of overvaluation and deteriorating industry performance. The National Association of Restaurants (NAR) survey of current performance has dipped into negative territory (Chart 4), as restaurant operators have reported a decrease in traffic. One of the major drags on restaurant same-store sales has been the gap in restaurant inflation compared with the cost of food inflation for eating at home. Relative inflation has soared (Chart 5). That has caused relative spending growth at restaurants vs. at home dining to drop sharply, in real (volumes) terms. However, next year could be different. If the inflation gap falls, as predicted by the decline in relative spending (Chart 5), then restaurant traffic should stabilize. Importantly, the odds of budgets for dining out being pruned even further are low. As long as wages and salaries growth is decent and consumer income expectations are firm, consumers should still allocate a rising share to restaurants relative to eating at home (Chart 5). There is plenty of scope for relative restaurant spending to rise on a secular basis (Chart 5, bottom panel). Clearly, if relative spending were to reaccelerate too quickly, then the inflation gap would stay wide, and same-store sales growth would stay punk. That is a risk to an optimistic view of future restaurant traffic. But the good news is that cost structures are being realigned to a more subdued sales run rate. The NAR survey shows that staffing plans are on the wane. That leads restaurant labor cost inflation (Chart 4). As the largest source of expenses, any decline in headcount would be welcome given that minimum wages in a number of states are set to climb next year. In any case, the most potent profit elixir would be a recovery in top-line growth, sourced both domestically and from abroad. Restaurant sales growth has been unimpressive for the past several years. Subdued pricing power gains, and until recently, lackluster income growth among lower income consumers have weighed on revenue growth. The good news is that consumer confidence among low income earners is on the upswing (Chart 6), which bodes well for casual dining out in the coming quarters. If our bearish view on refiners and gasoline prices continues to pan out, then a windfall from lower fuel prices may further bolster the outlook. Chart 4Expenses Set To Ease Chart 5Inflation Gap Should Narrow Chart 6Sales Set To Stabilize... In addition, restaurant retail sales often follow the trend in the wealth effect (Chart 7). The latter has pulled back this year, owing to the equity market consolidation and house price correction. However, financial wealth gains are rebounding, and provided the stock market does not suffer a sustained swoon, consumers' feeling of affluence may soon be bolstered. Even marginal improvements in store traffic should be impactful to same-store sales. Restaurant chains have been in retrenchment mode since the Great Recession. Construction activity is historically low, which implies limited capacity expansion (Chart 7). Contribution from abroad may become less of a drag. The industry garners roughly 67% of sales from overseas. The strong U.S. dollar, particularly against emerging market currencies, has deprived the industry of sales strength. Moreover, even in domestic currency terms, emerging markets consumption has been through a difficult period, as the Asian Hotel and Restaurant Activity Proxy spent most of the last year in negative territory (Chart 8). But EM currencies have stabilized and Asian restaurant activity has climbed back into positive territory in recent months. The upshot is that foreign revenue could make up any lingering domestic sales slack. All of this suggests that leaning into share price weakness in anticipation of improved prospects next year makes sense. Nevertheless, the S&P restaurants index does not warrant a full shift from underweight to overweight. There could still be earnings/headline risk given lackluster readings in coincident activity indicators, despite McDonald's earnings beat last week. Valuations are not cheap. On a normalized basis, the relative forward P/E ratio has dropped below its average, but still trades at a premium to the broad market. A return to above average levels is possible if operating margins expand on the back of sales improvement (Chart 9), thereby sparking higher return on equity, but it may be too soon to position for such an outcome. Chart 7... Or Even Improve In 2017 Chart 8End Of Foreign Drag Chart 9Still Not Dirt Cheap Bottom Line: Lift the S&P restaurant index (BLBG: S5REST - MCD, SBUX, YUM, CMG, DRI) to neutral from underweight, locking in a profit of 9% since our underweight recommendation last November. Health Care Crunch: Buying Opportunity Or Trend Change? The speed at which the health care sector has sunk toward the bottom end of this year's trading range has unnerved many investors. In fact, the sector has dropped back down to the levels where we added it to our high conviction overweight list. The question now is whether our positive views still hold, and whether would we add here if we weren't long already, or if something more sinister is at work? The hit to health care stocks reflects a rise in risk premiums related to concerns that the U.S. government will exert more control over price setting if the Democrats win the election rather than any immediate downshift in relative forward earnings drivers. While it is impossible to forecast with any precision to what extent pricing models may or may not change, the political appetite may be low for another overhaul of the sector so soon after the Affordable Care Act was implemented. Regardless, several observations suggest that the sector may already be undershooting, i.e. a Democratic victory is already discounted. Relative performance has experienced a clear uptrend over the last forty years, with cyclical swings oscillating around its upward sloping trend-line (Chart 10). It would be extremely rare for a bull phase to peak prior to hitting at least one standard deviation above trend. Instead, the price ratio hit trend and is now not far above one standard deviation below trend, a level one would normally equate with an economic boom when capital flowed to high-beta sectors. Cyclical technical measures also point to an undershoot. Our Technical Indicator has hit an oversold extreme (Chart 11), signaling that the sell-off is in the late stages. Our relative advance/decline line has also stayed firm, suggesting that the decline in the overall sector has not been broad-based (Chart 11). Chart 10Time To Buy, Not Sell Chart 11Buying Opportunity Whether a wholesale flight from the sector, and all defensives in general, looms is largely contingent on the path of inflation expectations, which have been in a multiyear decline. This trend reflects anemic global final demand and the repercussions from over-indebtedness. Lately, inflation expectations have firmed, but that may largely reflect the rebound in oil prices courtesy of hopes for an OPEC production cut, given the lack of confirming indicators of growth acceleration and renewed strength in the U.S. dollar. The latter is testing the top end of its recent range (Chart 11, shown inverted, bottom panel), and it would be highly unusual for inflation expectations to rise concurrent with the U.S. dollar. In a world of zero interest rates and limited aggregate demand strength, a strong currency is deflationary, especially for corporate profits. Those conditions keep bond yields low, and push capital into long duration sectors. Once the election is over, attention will refocus on the relative forward earnings outlook. Our Indicators suggest that earnings momentum will stay positive. Our health care sector pricing power proxy has rebounded after cooling from red-hot levels, and is still much stronger than overall corporate sector pricing (Chart 12, second panel). That is confirmed by the pharmaceuticals producer price index, and employment cost index for health insurance, i.e. pricing strength is broad-based. There is still scant evidence of a downshift in consumer spending patterns in reaction to rising health care sector inflation. Real (volumes) personal spending on health care goods and services continues to grow at a mid-single digit rate, well in excess of the rate of overall consumption (Chart 12). That is consistent with ongoing earnings outperformance. As noted in past research, the time to forecast negative relative earnings momentum is when consumers balk at higher prices. So far, a few high profile cases of exorbitant drug price increases have grabbed the spotlight, but in aggregate, consumers are not voting with their wallets. The biggest tangible negative for the health care sector may be that shares outstanding are no longer falling (Chart 13). That mirrors overall buyback activity, which has cooled markedly on the back of balance sheet deterioration and waning free cash flow. We doubt the supply of health care stocks is going to rise much, however, because the sector is in good financial shape, earning healthy returns and is not dependent on external financing. Chart 12Demand Driven Pricing Power Gains Chart 13Buybacks Are Dwindling Bottom Line: Health care sector risk premiums have climbed in response to polling results, but an apolitical check on relative earnings drivers and valuations points to a buying opportunity. Current Recommendations Current Trades Size And Style Views Favor small over large caps and growth over value.

Highlights The path of the least resistance for the U.S. dollar is up; this has far-reaching implications for monetary policy, global growth dynamics and asset prices. Dollar strength reinforces our view to overweight defensives vs. cyclicals and is a headwind to overall S&P 500 profits. Most of the gap between core CPI and core PCE can be explained by the medical care component. Overall, core PCE is likely to reach 2% over the next several months; a strong dollar means core goods PCE deflation will be sustained, but rising wage costs will put upward pressure on service sector inflation. Feature Amid the ongoing U.S. elections and Q3 earnings uncertainty, one of our higher conviction views is the likelihood of U.S. dollar appreciation. Our reasoning is straightforward: interest-rate differentials are the strongest 12-18 month predictor of currency trends,1 and relative economic performance between the U.S. and the rest of the world suggests that the gap between U.S. monetary policy and elsewhere will stay wide, and perhaps even widen (Chart 1). Chart 1Interest Rates And The Dollar Moreover, as we showed last week, the trade-weighted dollar provides good insurance against a variety of downside equity risks, even when a financial calamity occurs on U.S. soil. We remain dollar bulls. However, that does not mean that the outlook is without risk. The implications of further dollar strength are wide-ranging: How does dollar strength impact inflation expectations and monetary policy? How does the rest of the world cope with a rising U.S. dollar? How does the S&P 500 stand up to further dollar appreciation? Monetary Policy And The Dollar We have discussed the ramifications of the Fed Policy Loop, the interplay between Fed policy and financial conditions, since September 2015 (Chart 2). Since last year, each hawkish move from the Fed has been met by a sharp upward adjustment in the trade-weighted dollar and a sell-off in equities and credit spreads. Tighter-than-expected financial conditions have then forced the Fed to lower its outlook for future economic growth and adopt a more dovish policy stance. A more dovish Fed then caused financial conditions to ease and the dollar to fall, and this easing eventually emboldened Fed policymakers to move in a more hawkish direction. The loop then repeats itself. The reason this loop has been in place is because U.S. monetary policy is so far in advance of other central banks. For example, the ECB and BoJ continue to try to find ways to stimulate their economies, while the Fed is gearing up for a second rate hike. The point is that this feedback mechanism means that monetary conditions tighten in the form of a rising dollar, even without the Fed hiking interest rates by very much (Chart 3). The implication for investors is also clear: for equities, even though overall monetary conditions can tighten, rate-sensitive, domestically-exposed sectors such as telecoms can still perform well, because the tightening is coming mainly through the currency, rather than interest rates. For bonds, the policy loop means that sell-offs are likely to happen in fits and starts: the Fed knows that the process of normalizing interest rates will trigger bouts of volatility, because their actions are being exaggerated by movements in the dollar. This is one reason why we are not more eager to move aggressively underweight duration. Chart 2The Fed Policy Loop Chart 3Dollar To Do The Fed's Lifting? ROW And The Dollar Dollar strength, in the context of a robust U.S. economy, can be a good thing for some parts of the world. For example, a strong dollar means that European and Japanese exports will be more competitive. In this benign context, currency strength acts a growth re-distributor, taking growth away from the U.S., but transferring it to others, where the currency has been devalued. Our concerns focus squarely on emerging markets. Since the early 1980s, there have been no periods when EM share prices rallied amid strength in the real broad trade-weighted U.S. dollar (Chart 4). Chart 4EM Stocks Don't Like Dollar Strength It is significant that financial markets panicked in August, 2015 when the RMB was devalued by 2% ahead of the Fed's warning about a rate rise, and amid broad based U.S. dollar strength. True, the RMB has weakened periodically since then, without any real fallout for risk assets. Nonetheless, it is hard to say that the global economy - and China for that matter - is in significantly better shape than when the Fed began televising the last rate hike. We do not offer a forecast on the likelihood of further RMB devaluation. However, recent history is a reminder that dollar strength risks creating volatility in global markets. The latter would be especially true if worries about the EM credit cycle resurface. S&P 500 And The Dollar In the last major dollar bull market (1994-2002), U.S. stocks strengthened alongside the rise in the currency, offering some historical support that dollar strength does not necessarily hinder stock market performance. However, the global backdrop during that era was distinctly different from today. During the last half of the 1990s, the entire global economy experienced a supply-side, disinflationary expansion and credit binge. The U.S. was at the forefront of that expansion, and pulled the rest of the world (ROW) along for the ride. In other words, the U.S. and ROW were all moving broadly in the same direction. Today, the global economic backdrop is starkly different. Europe, Japan and China are all battling deflation and the major distinguishing trait of this business cycle is deficient demand and the need to de-lever. As we highlighted above, the U.S. has embarked on a gradual rate hike path, but most other central banks are trying new ways to reflate. In this world, currency movements act to re-distribute growth: a stronger currency can become a headwind to externally sourced profits, rather than a reflection of strong domestic demand. Indeed, the S&P 500 may become even more vulnerable to dollar strength: globally sourced profits as a share of overall S&P 500 profits has been in a steady climb over the past twenty years. Chart 5 shows that net earnings revisions are especially sensitive to currency moves, suggesting that further dollar appreciation would undermine already very lofty earnings expectations and would be a headwind for the broad market. Chart 5Beware The Dollar Drag From a sector perspective, dollar strength has already become problematic and is a main reason why we continue to advocate for defensive stocks relative to cyclical plays. Our U.S. Equity Strategy service published a Special Report on this topic last week.2 The Report outlined a seven item checklist of factors needed before tilting positions in favor of cyclicals. The first item on the list is dollar weakness. The full checklist is here: Chart 6Stick With Defensives Broad-based U.S. dollar weakness, particularly against emerging market currencies in countries with large current account deficits. An end to Chinese manufacturing sector deflation. A decisive upturn in global manufacturing purchasing manager's indexes. A return to growth in global export volumes and prices. A resynchronization in global profitability such that U.S. profits were not the only locomotive. A rebound in global inflation expectations. China credibly addressing banking sector weakness to the point where economic growth can reaccelerate rather than move laterally. Most of the items remain unfulfilled and our U.S. equity strategists believe that over the past several weeks, a technical adjustment has occurred in equity markets, rather than a fundamentally-driven trend change. In fact, the cyclical vs. defensive share price ratio appears to now be overshooting after having undershot. We expect leadership to revert back to non-cyclical sectors once the current rotational correction has run its course, given the lack of confirmation from the bulk of the macro variables on our checklist (Chart 6). The bottom line is that the U.S. dollar's path of least resistance is to trend higher. Dollar strength has already become restrictive for some U.S. industries, and unlike the late 1990s, we are concerned that further currency appreciation will act to restrain profit growth, rather than be reflective of a stellar domestic backdrop. Still, the Fed and other central banks' actions have proven to so far be a powerful antidote to earnings concerns: as long as the liquidity taps remain open, investors are willing to look through profit disappointment. We continue to recommend benchmark weightings to equities, but are highly attuned to this profit risk. What Is The True Inflation Rate? The Fed's target is 2% inflation. Core CPI has been above this rate for eleven months, implying that if the Fed's target was based on this measure, policymakers would have been much more aggressive in hiking interest rates. But the Fed's preferred measure, core PCE, is still stuck below the target. The CPI and PCE usually move together. The correlation between the two series is about 98% and divergences tend to be short-lived (Chart 7). Thus, the choice between the two series is often irrelevant, although the recent gap raises an issue for the Fed and the bond market: which measure is currently telling the right story? First, there are many alternative measures of inflation and in Chart 8, we show a selection of them. The median CPI uses the middle or median price change as its estimate of the underlying rate of inflation, irrespective of its share of the overall basket. The trimmed mean CPI removes the most volatile components of the index. The market-based PCE measure of inflation addresses concerns about using "imputed" prices (such as financial services furnished without payment) by leaving them out. Incidentally, this latter series, which is currently somewhat weaker than core PCE, is giving a similar inflation signal to our corporate price deflator. Together, these two measures suggest that the business sector is faced with a much tougher pricing backdrop than the core PCE and core CPI suggest. Chart 7Core CPI And Core PCE Usually Say The Same Thing Chart 8Various Alternative Measures Unfortunately, none of these alternative measures offer reliable leading information and do not help in understanding the divergence between core CPI or core PCE. However, understanding how the indexes are constructed does uncover important differences. Core CPI And Core PCE Explained The core CPI is a fixed-weight index while the personal consumption expenditure is chain-weighted. A fixed-weight index uses a constant basket of goods and tries to determine how much more an individual pays for an identical basket today versus a base year. A chain-type index measures how much it costs to a constantly evolving basket. The latter should be more representative of consumers' evolving buying habits. Historically, the different weighting methodology explains most of the gap between CPI and PCE inflation rates. The remainder of the gap is accounted for largely by the difference in the size of the weights used for the medical and housing components. Housing accounts for 40% of core CPI and only 17% of core PCE. Medical care accounts for 7% of core CPI versus 18% of core PCE. Currently, the gap between core PCE and core CPI is mostly explained by the medical care component (both the relative weights, but also the underlying prices used). In the CPI, only the portion that consumers spend on health care is taken into account, but the PCE also includes the amount that government agencies spend on consumers' behalf. The pricing information on the government funded portion is estimated from the PPI, which sometimes gives a different signal than the data supplied to the CPI from the consumer expenditure survey. The gap between medical care PCE and CPI has become particularly pronounced in the past few years. There is a lot of confusion about what is driving the spike in CPI medical care costs, with some pundits trying to find a political angle. Some blame higher insurance rates, while others blame drug costs. In fact, as Chart 9 shows, all elements of medical care CPI have contributed to the surge. Meanwhile, core PCE shows that medical care inflation has in fact been contained, some say, due to the enactment of the Affordable Care Act (a.k.a. Obamacare). It is not clear that this is the full story and forecasting future rates of inflation specifically in this sector is beyond the scope of this report. Over the next six to twelve months, we would expect some convergence between the two inflation gauges, as CPI medical care inflation peaks. More specifically, we would not be surprised to see the core PCE move slightly above 2%, but we think it is unlikely that much of an overshoot of the Fed's target can occur. Chart 10 shows the major components of CPI and we note the following: Chart 9Medical Care##br## Inflation Is Tricky Chart 10Major Components Of##br## Inflation At Crosscurrents Goods prices continue to fall. If our strong dollar view proves correct, deflation in this sector may persist for years. Recall that throughout the economic recovery in the first half of the previous decade, core goods price deflation persisted; that was during a dollar bear market. This time, dollar strength is likely to keep an even tighter lid on imported prices. Non-shelter service price inflation appears to be rolling over, after a surge earlier this year. The key for core service price inflation is wage pressures, since labor costs are the most significant input cost to U.S. service businesses. For core service price inflation to sustainably break above 3%, i.e. to return to the pre-Great Recession range, recent wage trends will need to be sustained, if not accelerate. Shelter prices are the most difficult segment to forecast. Our model for shelter inflation has flattened out, owing to a decline in market-tightness in multi-family properties. A reasonable working assumption is that shelter inflation stays around 3%, which is roughly the rate of shelter inflation that persisted prior to the housing bubble of the previous decade. Adding it up, core inflation is likely to drift gradually up: service sector inflation will likely trend higher with wage growth, but deflation in the goods sector will provide somewhat of an offset. The Fed has initiated interest rate hikes in the past when core PCE was under 1.5%, so there is historic precedent for policymakers to hike rates before the 2% target is achieved. Of course, this cycle is very different and there has been much talk of the need for policymakers to err on the side of ease for even longer, i.e. allow inflation to run much higher than 2%. Recent Fed communication suggests that a December rate hike is most likely, unless the data significantly worsen in the meantime. Thereafter, if our inflation view is correct, the Fed will find little reason to hike more than twice in 2017. Note: Last week, I had the pleasure of participating in our Geopolitical Strategy service's webcast on the upcoming U.S. Elections. In addition to a well-rounded debate on the U.S. political situation, we also discussed the present economic and investment landscape. To listen to the replay, please go here: www.bcaresearch.com/webcasts/index/131 Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report "Dollar: The Great Redistributor", dated October 7, 2016, available at fes.bcaresearch.com 2 Please see U.S. Equity Strategy Special Report "Defensive Dominance Has Bent, But Will Not Break", dated October 17, 2016, available at uses.bcaresearch.com Appendix Monthly Asset Allocation Model Update Our Asset Allocation (AA) model provides an objective assessment of the outlook for relative returns across equities, Treasuries and cash. It combines valuation, cyclical, monetary and technical indicators. The model was constructed as a capital preservation tool, and has historically outperformed the benchmark in large part by avoiding major equity bear markets. Please note that our official cyclical asset allocation recommendations deviate at times from the model's recommendation. The model is just one input to our decision process. The model's recommended weightings for the major asset classes remained unchanged this month: neutral equity exposure at 60% (benchmark 60%), slightly overweight Treasury allocation at 40% (benchmark 30%) and underweight cash at 0% (benchmark 10%). The neutral portfolio recommendation for equities is in line with our qualitative defensive stance, in place since August 2015. Although the technical and monetary components of the equity model are still favorable, the earnings-driven component continues to warn that profits are likely to remain lackluster, especially relative to expectations. The allocation for a slight overweight in Treasuries continues to be supported by all three components of the bond model: valuation, cyclical and technical. While the valuation component continues trending towards expensive territory, a "buy signal" still exists for now. The cyclical and technical components of the bond model have retraced some of their bullish signals, but both still maintain a preference for Treasuries, especially relative to cash. Chart 11Portfolio Total Returns Chart 12Current Model Recommendations Note: The asset allocation model is not necessarily consistent with the weighting recommendations of the Cyclical Investment Stance. For further information, please see our Special Report "Presenting Our U.S. Asset Allocation Model", February 6, 2009. Market Calls

Highlights The U.S. is not yet a "high-pressure" economy, but slack is dissipating. U.S. growth, while not torrid, will remain high enough to push interest rates higher. The euro area continues to exhibit tepid domestic demand growth, and slack there remains higher than in the U.S. Monetary divergences will grow, weighing on EUR/USD. The Canadian economy displays underlying weaknesses which will prevent the BoC from hiking for an extended period of time. Stay long USD/CAD, but favor the CAD to the AUD and the NZD on a USD rally. Feature Following Janet Yellen's Boston speech last week, a new phrase has entered the lexicon of investors: "high-pressure economy". The speech was originally interpreted as a clarion call to let the economy overheat in order to absorb the slack created by the shock of 2008. However, Yellen still sees some slack in the economy. In her eyes, an easy monetary stance, at this point, will not cause an overheating, it will only bring back to the marketplace workers that had left the labor force. Chart I-1Drying Global Liquidity We have sympathy toward this view, especially when put in an international context where global capacity utilization remains depressed. Also, countries like China, Saudi Arabia, and Mexico have been intervening in the FX markets to preempt or limit downside to their currencies, tightening global liquidity conditions (Chart I-1). Nonetheless, the Fed Chair also highlighted that the FOMC did not want the U.S. economy to overheat as the domestic slack gets absorbed. Doing so would raise the risk that the Fed will have to then overcompensate by tightening rates very aggressively. This would prompt another recession. U.S.: Not High Pressure Yet, But... No indicator suggests that there is a burning need to quickly ratchet U.S. rates higher. However, domestic economic conditions are falling into place to justify a slow move toward higher rates. Our aggregate U.S. capacity utilization gauge is showing a dissipation of U.S. economic slack (Chart I-2, top panel). This is a side-effect of the tepid growth in the capital stock of U.S. businesses this cycle, which limits the expansion of the supply-side of the economy (Chart I-2, bottom panel). Meanwhile, household consumption should remain robust. Not only did 2015 register the strongest growth in the median household's real income since 1967, consumption is unlikely to slow much. In fact, vehicle-miles traveled and the Federal income tax receipts are both pointing toward healthy consumption (Chart I-3). Despite punky construction starts, housing activity shows signs of improvement. Housing inventories are near record lows and construction has underperformed household formation. Moreover, building permits are hooking upward, while housing affordability remains generous (Chart I-4). Additionally, the NAHB survey also points toward a rising share of residential activity in the economy (Chart I-4, bottom panel). Finally, capex intentions are slowly recovering. Moreover, the BCA House view is that the U.S. profit contraction is past its nadir. Going forward, capex and inventories are unlikely to subtract as much from growth as they did in 2015 and 2016. They may even become accretive to GDP growth. Chart I-2Vanishing U.S. Slack Chart I-3Positive Signs For The U.S. Consumer Chart I-4Residential Investment Will Improve Limited slack and a continued economic expansion imply a high likelihood of a Fed hike this year, and maybe two more next year if no shocks to financial conditions emerge. With markets currently pricing in 65 basis points of rate hikes by the end of 2019, this should lift rates across the curve. Higher interest rates on U.S. assets should drive private inflows into the country, pushing the U.S. dollar higher (Chart I-5). From a technical perspective, the U.S. capitulation index is breaking out to the upside following a pattern of lower highs. Since 2008, such breakouts have been followed by a significant rally in the broad trade-weighted dollar (Chart I-6). Thus, we continue to position ourselves for additional dollar strength this cycle. Chart I-5Flows Into The U.S. ##br##Are Set To Grow Chart I-6Favorable Technical ##br##Backdrop For The Greenback Bottom Line: The household sector remains healthy, and U.S. economic slack is dissipating. Hence, the Fed will try, rightfully or wrongly, to push rates higher this year and next, lifting the dollar in the process. Euro Area: Less Pressure A dollar rally could be painful for the euro. Yet, the euro is cheap and supported by a current account surplus of 3.3% of GDP (Chart I-7). What to do with this conflicting picture? For a currency to embark on a durable bull market, productivity growth needs to be stronger than that of its trading partners. A strong currency makes the tradeable-goods sector less competitive, hampering growth. A positive terms-of-trade shock, like that undergone by commodity producers during the previous decade can also do the trick. Neither of these statements currently describe the euro area. Another avenue for a country to withstand a strong currency is for growth to be domestically driven. If household consumption is the main locomotive, exporters' loss of market share do not hurt activity as much. This is true until the domestic economy enters a recession, an event usually driven by higher policy rates. This is why when the share of salaries in the U.S. economy expands, the dollar undergoes cyclical bull markets (Chart I-8). More salaries in the national income means more consumption. Chart I-7Euro ##br##Supports Chart I-8Domestically-Driven Growth##br## Is Good For A Currency In the euro area, GDP growth is above trend, but, in recent quarters, final private domestic demand has been weak (Chart I-9). In fact, last quarter, net exports were the main contributor to growth. This could explain why, since 2015, stronger European business surveys vis-à-vis the U.S. were unable to boost EUR/USD (Chart I-10). Chart I-9European Consumption##br## Isn't Strong Chart I-10If EUR/USD Could Not ##br##Rally Then, When Will It? We do expect eurozone final domestic demand to remain tepid. Yes, the credit impulse has improved, but this amelioration will prove temporary. The previous rebound in credit flows reflected the movement from a large contraction to a small expansion. Today, the dismal performance of euro area bank stocks - which have been a good leading indicator of European loan growth - points to slowing credit growth (Chart I-11). Fiscal policy is also moving from a small positive to a small negative. Work by the ECB staff shows that the cyclically adjusted budget balance in Europe fell by 0.3%, from -1.7% to -2.0% of GDP in 2016. Aggregate cyclically-adjusted budget balances are forecasted to improve to -1.8% and -1.6% of GDP in 2017 and 2018, respectively, representing a 0.2% fiscal drag each year. While a small number, we have to keep in mind that euro area trend growth is between 0.5% and 1%. This suggests that the European economy remains ill-equipped to handle a stronger euro. Moreover, the European economy exhibits much more slack than the U.S. economy. While total hours worked in the U.S. are 14% above Q1 2010 levels, in Europe, they are only 1.5% above such levels (Chart I-12), a gap much greater than demographics alone would have suggested. This means that monetary divergence will continue between Europe and the U.S. Chart I-11Euro Area Credit Impulse Will Weaken Chart I-12Less Capacity Pressures In Europe In fact, this week, the ECB did little to dispel this notion. Beyond trying to squash ideas of a sudden end to the QE program or any imminent tapering, president Draghi communicated that December will be the month when the real action occurs. Based on current trends, we expect the ECB to extend its QE program beyond March, but to hint at a tapering of purchases later in 2017. The ECB will also make it very clear that rates will remain as low as they currently are for an extremely long time. Thus, while the ECB might be slowly moving away from its hyper-stimulative stance, it will not do so as fast as the Fed. Therefore, policy divergences should continue to weigh on EUR/USD. Technicals are also pointing toward a lower euro. Not only has EUR/USD broken down its 1-year old series of higher lows, the euro's capitulation index, the intermediate-term momentum indicator, and the euro's A/D line are forming negative divergences with EUR/USD (Chart I-13). An interesting way to play the euro's weakness is to go short EUR/CZK, a position championed by our Emerging Market Strategy service.1 A floor at 27 has been set under EUR/CZK since November 2013. Yet, this floor looks increasingly untenable. Speculators are beginning to pile in. This week, 2-year Czech yields temporarily dipped below those of Swiss 2-year bonds, the current holder of the world's lowest yield. To fight appreciation pressures, the Czech National Bank (CNB) is accumulating a lot of reserves by buying euros, which is fueling a surge in the money supply (Chart I-14, top panel). Chart I-13Worrying Euro ##br##Technicals Chart I-14CZK: Reserves Expansion##br## Leading To Inflation This accumulation of reserves, in turn, is fanning inflationary forces in the Czech economy. The output gap is closing and core inflation already is increasing at a rate of 1.8% p.a. Easy financial conditions and expanding credit growth are likely to boost already-accelerating unit labor costs and wages (Chart I-14, bottom panel). This means that the 2% inflation target is likely to be hit as early as Q2 2017 according to the CNB. We expect this goal to be handily surpassed if the floor stays in place. Thus, we expect the CNB to abandon the floor within the next twelve months and we are shorting EUR/CZK. Finally, while we are bearish EUR/USD, we do believe that the euro will outperform the pound and commodity currencies. Moreover, despite poorer fundamentals, the euro could also temporarily outperform the SEK and the NOK if the dollar strengthens. The latter two are more sensitive to the USD than the euro is. Bottom Line: EUR/USD is at risk from the broad dollar rally. It is also likely to suffer from the tepid state of the euro area's final domestic demand, fueling monetary-policy divergences with the U.S. A speculative opportunity to short EUR/CZK is emerging, as the CNB's peg is outliving its usefulness. Canada: Falling Pressure USD/CAD has become more correlated with movements in rate differentials than with the vagaries of oil prices (Chart I-15). This puts the actions of the Bank of Canada in sharper focus. As expected, this week, the BoC left policy rates unchanged at 0.5%. More interesting was the quarterly monetary report. The economy has rebounded from the slump induced by the Q2 Alberta wildfires, and many key gauges of the Canadian economy have improved (Chart I-16). Yet, the BoC is looking the other way. Chart I-15CAD: Now More Rates Than Oil Chart I-16The BoC Is Looking The Other Way... The BoC is now forecasting the Canadian output gap to close in mid-2018; in July, this was expected to happen in the second half of 2017. This is because the BoC cut the expected Canadian growth rate by a cumulative 0.5% over the next two years. There have been some worrying developments warranting a more cautious forecast. While the Trudeau government's new childcare benefits are currently being rolled out and new infrastructure spending is to be implemented in 2017, the Canadian private sector's finances are increasingly shaky. The aggregate debt-servicing costs of the non-financial private sector is at record highs, with generous contributions from both households and the corporate sector (Chart I-17). The aggregate credit impulse has responded to this handicap, contracting by 7% of potential GDP, a move driven by the corporate sector (Chart I-18). While not as dramatic, the pace of debt accumulation by the household sector has also weakened. Recent administrative measures to cool the housing market - put in place by various provincial entities as well as the federal government - could accentuate this trend. Chart I-17...Rightfully So Chart I-18Collapsing Canadian Credit Impulse Another problem for Canada has been its loss of competitiveness. Non-oil Canadian exports have not responded as expected to the fall in the CAD. This is because many Canadian manufacturers have set up factories in Mexico and other EMs, or are competing with firms operating out of these nations. With these countries' currencies witnessing devaluations as deep as, or deeper than the loonie's, it is no wonder that Canada has lost market shares in the U.S. (Chart I-19). This means that Canadian rates will remain low for longer, making Canada another contributor to global monetary divergences vis-a-vis the U.S. The BoC is right to be worried that the Canadian economy will take longer than anticipated to close its output gap. With the pass-through to inflation of a lower CAD dissipating, the BoC expects Canadian core inflation to remain well contained for the next two years. We see little cause to disagree. This means that despite trading at a premium to PPP, USD/CAD has upside. Moreover, the Canadian dollar's A/D line is rolling over, another factor pointing to upside for USD/CAD (Chart I-20). At this point, the biggest risk to our view is oil. If WTI can breakout above $52 - perhaps in response to an as-yet negotiated OPEC/Russia oil-production cut or freeze - this could mitigate the downside for the CAD. Thus, while we like USD/CAD, we think the CAD has upside against the AUD and the NZD, especially as the loonie is less sensitive to the USD and EM spreads than the two antipodean currencies. Chart I-19Canada Is Losing Competitiveness Chart I-20Falling CAD A/D Line Bottom Line: The Canadian economy is showing surprising signs of underlying weakness. With the CAD having recently been more correlated to rate differentials than to oil, USD/CAD could rally on monetary divergences. That being said, on the back of a strong USD, CAD is likely to outperform the AUD and NZD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report, "Central European Strategy: Two Currency Trades", dated September 28, 2016, available at ems.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Policy Commentary: "The risks have changed in terms of overshooting what I think is full employment with implications for potential imbalances...Those imbalances might result in a reaction by the Fed that we end up having to tighten more quickly than I would like" - FOMC Voting Member Eric Rosengren (October 17, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Policy Commentary: "An abrupt ending to bond purchases, I think, is unlikely...We remain committed to preserving a very substantial degree of monetary accommodation" - ECB President Mario Draghi (October 20, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Policy Commentary: "Since the employment situation has continued to improve, no further easing of monetary policy may be necessary... at any rate, I would like to discuss this thoroughly with other board members at our monetary policy meeting" - BoJ Board Member Yutaka Harada (October 12, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Policy Commentary: "Our judgment in the summer was that we could have seen another 400,000-500,000 people unemployed over the course of the next few years...So we're willing to tolerate a bit of overshoot in inflation over the course of the next few years in order to avoid that situation, to cushion the blow" - BOE Governor Mark Carney (October 14, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Policy Commentary: "We have never thought of our job as keeping the year-ended rate of inflation between 2 and 3 percent at all times...Given the uncertainties in the world, something more prescriptive and mechanical is neither possible nor desirable" - RBA Governor Philip Lowe (October 17, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Policy Commentary: "There are several reasons for low inflation - both here and abroad. In New Zealand, tradable inflation, which accounts for almost half of the CPI regimen, has been negative for the past four years. Much of the weakness in inflation can be attributed to global developments that have been reflected in the high New Zealand dollar and low inflation in our import prices" - RBNZ Assistant Governor John McDermott (October 11, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Policy Commentary: "Given the downgrade to our outlook, Governing Council actively discussed the possibility of adding more monetary stimulus at this time, in order to speed up the return of the economy to full capacity" - BoC Governor Stephen Poloz (October 19, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Policy Commentary: "[On the effects of low interest rates on the housing market]...If you look at the recent past, the dynamics have been a bit more reassuring...[still]let's not forget, this disequilibrium that we have achieved remains very high" - SNB Vice-President Fritz Zurbruegg (October 12, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Policy Commentary: "A period of low interest rates can engender financial imbalances. The risk that growth in property prices and debt will become unsustainably high over time is increasing. With high debt ratios, households are more vulnerable to cyclical downturns" - Norges Bank Governor Oystein Olsen (October 11, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Policy Commentary: "[On Sweden's financial stability]...it remains an issue because we are mismanaging out housing market. Our housing market isn't under control in my view" - Riksbank Governor Stefan Ingves (October 27, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Special Report

Dear Client, I am on the road visiting clients in Toronto, Chicago, and Wisconsin this week, and as such there will be no regular Weekly Report. Instead, we are sending you a Special Report written by my colleague Marko Papic, Chief Strategist of BCA's Geopolitical Strategy service. In this report, Marko argues that Hillary Clinton has not yet sealed the election, despite her high odds of winning. I hope you will find this report both interesting and informative. Best regards, Peter Berezin, Senior Vice President Global Investment Strategy Highlights Clinton has a 65.5% chance of winning the presidency. A Trump win requires a surprise - such as in voter turnout. Still, we doubt Trump can punch more than 3% above his polling. Regardless of the outcome, multinational corporate profits will suffer. Go long the USD. Feature With the conclusion of the final presidential debate on October 19, the U.S. election is now in its final inning. Donald Trump's chances of mounting a comeback are slipping away (Chart 1). Could there be a Brexit-like surprise for the markets on November 8? And what are the investment implications of this year's unprecedented election? How Trump Can Still Win... Paddy Power, one of the world's biggest bookies, has begun to pay out bets to people who had wagered on Secretary Hillary Clinton winning the election. Meanwhile, according to Nate Silver, America's statistical Geek-in-Chief, Donald Trump has a meager 13.7% chance of winning the election.1 While our own model gives Clinton a 65.5% chance of winning, we have not forgotten Yogi Berra's wisdom: "It ain't over till it's over." There are three reasons why we would have held onto the pay-outs if we ran Paddy Power: Turnout assumptions could be wrong: Silver's quant model - and ours - is based on the assumption that the publically available opinion polls are high-quality data points. To iron-out the noise of an occasional bad poll, political analysts aggregate the polls to create a "poll-of-polls." The problem is that this method is mathematically the same as combining bad mortgages into securities. The idea is that each individual object (mortgage or poll) may be flawed, but if you get enough of them together, the problems will all average out and you have a very low risk of something bad happening.2 If there is a bias that is common to a large part of the data, then you are in real trouble. And why would there be a bias in election polls? For one, polling is not a science. It is an art. To extrapolate the results of an opinion survey of ~1,000 individuals to the general election of ~130 million people, polling professionals have to make turnout assumptions that are based partly on previous elections and partly on guesswork. This year, these assumptions are notoriously difficult to make as both candidates are extremely unpopular (Chart 2). This is bound to throw off pollsters' assumptions and may partially explain the regular gyrations that can be gleaned in Chart 1. For Secretary Hillary Clinton, the problem is compounded by the fact that she requires a high turnout to win. She needs the "Obama Coalition" of minorities and Millennial voters to show up as they did for President Barack Obama in 2008 and 2012. But we know that she struggled with the latter, with Senator Bernie Sanders picking up 70% of the youth vote in the Democratic primaries (Chart 3). If the 2016 turnout resembles the turnout from mid-term elections - which Republicans have generally won this century - then Trump could still have a chance. People may be lying: Another concern for Clinton is that she may be the 21st century Tom Bradley. Bradley was an African-American Mayor of Los Angeles who lost the 1982 California governor's race despite being ahead in the polls right up until election day. The "Bradley effect" theory goes that white voters lied when answering the polls in 1982 for fear of appearing racially prejudiced. Today, voters may be telling pollsters what they think is "politically correct," thus favoring Clinton in the polls. In the same vein - but ideologically opposite - the former Imperial Wizard of the Knights of the Ku Klux Klan, David Duke, outperformed expectations in both the 1996 U.S. Senate election and the 1999 special election for Louisiana's First Congressional District. He lost both elections, but he managed to garner double-digit support both times. More recently, the June 23 Brexit vote surprised markets. In our view, investors and betting markets underestimated Brexit largely in spite of polls, which had been close throughout the campaign stage (Charts 4 and 5). BCA's Geopolitical Strategy outlined the case for why the probability of Brexit was much higher than the market assumption as early as March.3 Our concerns began to manifest in the polls with the "Leave" camp comfortably ahead throughout June. And then, from June 16 (one week before the vote) to June 23, the "Stay" vote surged ahead in the polls, garnering a 4% lead the day before the election. This surge in the last week was clearly false, as the "Leave" camp won by a 3.8% margin, a 7.8% swing on the day of the election. So, what happened? The vertical line in Chart 5 shows the day that Member of Parliament Jo Cox was murdered by a British ultra-nationalist. Our guess is that the stunning political assassination - an extremely rare event in the U.K. - created a "Cox effect" in the Brexit polling. Those who were polled may have mourned for Cox, or resisted being associated with the extreme views of a self-professed neo-Nazi, yet they silently stuck to their legitimate concerns regarding EU membership on the day of the referendum. Chart 4Online Betting Got Brexit Wrong... Chart 5...So Did Prominent Opinion Polls The Brexit example illustrates that lying to pollsters is not something that only happens in the past. It has happened as recently as June. Given Donald Trump's controversial statements - and particularly his misogynist rants going back to 2005 - American voters may be lying to pollsters when it comes to their choice for president. Chart 6Media Narratives Are Cyclical Media narratives: As our geopolitical team has stressed throughout this election, the news media work through narratives (Chart 6). These narratives appear to have influenced polls, leading to regular gyrations in support levels for the two candidates. Will the media have another "comeback kid" narrative for Trump in store ahead of the election? It cannot be discounted. And if the polls tighten to the 0-3% range again, the turnout concerns and the "Bradley/Cox effect" from above could be enough to swing the election for Trump. Bottom Line: Clinton remains the favorite to win the election, but her probability of winning is closer to 65.5% than the 85% that appears to be "priced in the market." ...And Why He Will Not Win While we are not comfortable calling the election a "done deal," we do believe that Clinton is a favorite. The BCA Geopolitical Strategy quantitative model predicts that she has about a 65.5% probability of winning.4 And the team's qualitative analysis of Trump's electoral strategy suggests that the hurdles to his victory are considerable, particularly in swing states Virginia and Colorado. Before we introduce the quantitative and qualitative models that underpin our election forecast, let us address the above concerns about turnout and the "Bradley/Cox effect" head on. In our view, the polls are telling the truth. We concede that Trump's support level may be underestimated by approximately 3%, which would not be out of line with the last five presidential elections (Chart 7). However, a Clinton lead greater than ~3% the day of the election will be insurmountable for four reasons: GOP primary: It was not the polling that got Trump wrong during the Republican primary race, but the pundits. The polls were generally accurate, particularly those in the swing states where polls tend to be frequent and sophisticated (Chart 8). Polls only underestimated Trump by more than 3% in Illinois, Massachusetts, New York and Pennsylvania. Some of Trump's most controversial statements were made in late 2015 and early 2016 and yet they prompted no shame from his supporters when answering pollsters' questions. Turnout seesaw: Trump's strategy - which we dubbed "The Great White Hype" back in March - is a serious and mathematically viable electoral strategy.5 The effort focuses on boosting the GOP share and overall turnout of the white, blue-collar voter. The problem with this strategy, as executed by Trump, is that its effect could be a seesaw. Trump's rhetoric and policy proposals may appeal to less-educated, lower-income white voters, but may also reduce his support among well-educated, upper-income voters. This is a serious problem for Trump given that the 2012 exit polls indicate that Romney won college graduates by 4 points and voters earning $100k or above by 10 points. In other words, upper-income, well-educated voters are a key constituency of the Republican Party. And just as Clinton may have trouble getting Millennials and minorities to vote for her by the same margin as they did for Obama, Trump could be struggling to get key conservative constituencies out as well. Debates: All scientific polls taken after the debates have Hillary Clinton as a clear winner (Chart 9). This may seem surprising given the reaction of many pundits that Trump outperformed the very low expectations for him in the debates. Many analysts scored the debates close, but voters did not. Why? Because independent and undecided voters are just now tuning into the election and want to see candidates discuss serious policy issues and show leadership. Political science research shows that the direct influence of party identification decreases in presidential elections over time, but issues gain importance, especially after the presidential debates.6 As such, voters tuning into the debates were not discounting Trump's fiery rhetoric and behavior, they were appalled by it. We can't say we were surprised, as we have been showing Chart 10 to clients since February. Senate: If voters are hiding their true support level for Donald Trump, then their genuine preference should be revealed in Senate races where less controversial Republicans are contesting close elections. Instead, Republicans are on a path to lose four of their Senate seats, with another three in play (Democrats need four to take the Senate, assuming that Clinton wins the presidency, since Vice-President Tim Kaine would then cast the tie-breaking vote in that body). Democrats are ahead in Indiana, Illinois, Wisconsin, and Colorado. Nevada is also expected to stay blue. Missouri, New Hampshire, North Carolina, and Pennsylvania are all still in contention, despite the GOP incumbent advantage in all three. Bottom Line: Despite the challenges that this election presents - two highly disliked candidates, questions about turnout, and concerns about polling quality - we doubt that Donald Trump can surprise his poll numbers by more than ~3%. With Hillary Clinton up by 6.4% in the latest RealClearPolitics poll of polls, this means that Trump has to start rallying now if he is going to have a chance on November 8. What Do Our Quantitative & Qualitative Models Say? Our geopolitical team's quantitative model predicts that Hillary Clinton will win the election with 335 electoral votes. The model, built using historical macroeconomic and election data since 1980, has been projecting a strong Clinton victory for some time.7 It currently shows that Clinton already has 279 electoral votes from states where she has more than a 70% chance of winning (Chart 11). These results mean that even under the unlikely scenario in which the GOP wins all the remaining swing states (North Carolina, Arizona, Florida, Ohio, and Iowa), Clinton will still win the election, all other things being equal. Meanwhile, our qualitative model relies on testing Trump's electoral strategy - boosting the share of the white vote accruing to the GOP - in the real world. We concluded in March that Trump did have a path to victory, albeit a very narrow one. Our research showed that Trump's strategy is mathematically viable, at least in 2016 when the white share of the total population remains large enough. We specifically showed that Trump would only need to increase white voters' support by 1.7% and 2.9% in Florida and Ohio, respectively, to flip those states, which seems quite reasonable. We also pointed out that getting a 5.7% swing in Iowa could be feasible. On the other hand, we showed that "flipping" Midwest states like Michigan, Pennsylvania, and Wisconsin would require a very large swing of white voters in Trump's favor: 13.9%, 7.8%, and 8.1%, respectively. With those numbers, Trump would have to win nearly 70% of Michigan's white voters, 65% of Pennsylvania's, and 58% of Wisconsin's. Of the three, Wisconsin looks the most achievable. On the other hand, the GOP only managed to pick up 52% of the state's white share in 2004, the last time a Republican candidate for president won an actual majority of the popular vote since 1988. So, getting to 58% is a high bar given Wisconsin's recent electoral history. How did our qualitative model hold up in terms of state-by-state polling? It did really well! As we predicted, Trump has led the race or nearly led the race in Iowa, Florida, and Ohio (Chart 12). In Michigan, Pennsylvania, and Wisconsin, Clinton's lead has remained higher than 5% through most of the election cycle, even when the media narrative shifted against her (Chart 13). Chart 12The 'White Hype' Model Works Here Chart 13White Hype' Does Not Work Here If Trump were to win all the states that our White Hype model predicts as competitive, he would still be short of the necessary 270 electoral votes. Map 1 shows the ideal distribution of states for Trump, one that ignores the polls and assigns swing states to Trump or Clinton based on whether the White Hype model is feasible or not. Notice that the two remaining major states are Virginia and Colorado. For Trump to win this election, we believe that he needs to win one of the two (Colorado in combination with either Nevada or New Hampshire), in addition to all of Florida, Ohio, North Carolina, and Iowa. This is a tall order! Particularly given that his polling in Virginia and Colorado is poor (Chart 14). Chart 14Two Critical Swing States Bottom Line: BCA's Geopolitical Strategy quantitative and qualitative models both show that Hillary Clinton is a clear favorite to win the election, a view we have held since December 2015.8 Investment Implications: MNCs Vs. SMEs Our colleague Peter Berezin has already discussed the implications of a Trump victory: a stronger USD and a sell-off in stocks.9 We agree and would add that a rally in Treasurys would be likely in the event of a surprise Trump win (Chart 15). Chart 15Trump's Success Helps Safe-Haven Assets The rally in safe-haven assets would eventually give way, however, to a bear market in Treasurys as investors realized that Trump has no intention of controlling public spending or reining in the (already growing) budget deficit. Growth, and likely inflation, would surprise to the upside, allowing the Fed to hike rates beyond the 48 bps expected by the market through the end of 2018. We do not foresee that a Republican-held Congress would stand in Trump's way, despite the clear dislike between the Speaker of the House, Representative Paul Ryan, and Trump. Ryan would not go against a sitting president from the same party who just pulled off a revolutionary election. The entire House will face re-election in 2018 and moderate Republicans will be wary of standing up to Trump, lest he campaign against them in GOP primaries in a short two years. Investors are putting way too much faith in America's checks-and-balances to keep Trump from enacting his policies, at least in the short term. These are constitutional, legal, and technical checks, and political expediency often overrules all three. In case of a Clinton win, we would expect the House to remain controlled by the GOP. There are only about 38 truly competitive electoral districts in this race, according to The Cook Political Report.10 Given that the Republicans have a 60-seat majority in the House, a Democratic takeover would require Democratic candidates to defeat Republican Representatives in 30 out of 38 competitive districts. At best, this means that the current, market- bullish status quo of divided government will continue. With the House remaining in Republican hands, and Democrats clinging to a potential razor-thin control of the Senate (vulnerable to a post-Trump Republican comeback in 2018), the Clinton White House would be constrained on some of its most left-leaning policies.11 And what are the chances of cooperation on modest reforms? We think they are actually quite good. Unlike Obama, Clinton's victory will not be a popular sweep. She will not control Congress, she will likely receive less than 50% of the popular vote (due to the presence of two notable third-party candidates), and she will be the first candidate ever elected that has more voters saying they dislike her than like her. Therefore, the odds are slim that Clinton will come to power with the same level of confidence and agenda-setting vision as Obama did in 2008. Instead, we see two potential avenues for modest cooperation with the GOP-controlled House: Chart 16Corporate Taxes Have Bottomed Corporate tax reform: It is unlikely that we will see reform that lowers the already historically-low effective tax rates (Chart 16). However, broadening the tax base by closing various loopholes could be feasible. This will hurt S&P 500 multi-national corporations that have been able to lobby for special treatment over the past three decades. However, it will benefit America's SMEs, which are the backbone of employment and growth. Fiscal spending: Paul Ryan and moderate Republicans understand that there is a paradigm shift in America and that the median voter is moving to the left.12 After all, Donald Trump won the GOP primary with an unorthodox economic message that combined both left- and right-wing economic policies. As such, we would expect House Republicans to give in to a modest infrastructure spending plan from Clinton, in exchange for corporate tax reform. Even a modest plan could make a substantive difference for the economy given the high fiscal multipliers of infrastructure spending in an economy with low interest rates. This in turn would allow the Fed to surprise the markets with more than two rate hikes by the end of 2018 and thus sustain the USD bull market. If there is one trend that we are certain will end with the 2016 U.S. election, it is the dominance of American economic policy by the S&P 500, or perhaps the S&P 100. What Trump and Senator Bernie Sanders have shown is that challenging for the presidency no longer requires a cozy relationship with either Wall Street or the large multinational corporations (MNCs). We therefore do not expect a Clinton-Ryan coalition to care as much about the concerns of America's large corporations as otherwise might be the case. Policies that lead to higher effective corporate tax rates on major S&P 500 corporations, a dollar bull market, and higher wages are likely over the course of the next four years. The political pendulum is shifting in the U.S. and it should marginally favor growth, inflation, the USD, and SMEs.13 Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com 1 Please see FiveThirtyEight, "Who Will Win The Presidency?" dated October 20, 2016, available at fiverthirtyeight.com. 2 "You mean like the 2008 Global Financial Crisis?" Yes. Like that. 3 Please see BCA Geopolitical Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Final Forecast & Implications," dated October 12, 2016, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "U.S. Election: The Great White Hype," dated March 9, 2016, available at gps.bcaresearch.com. 6 Please see Andreas Graefe, "Issues and Leader Voting in U.S. Presidential Elections,"Electoral Studies 32:4 (2013), pp.644-657. 7 For the assumptions underpinning our model, we encourage clients to read BCA Geopolitical Strategy Special Report, "U.S. Election: Final Forecast & Implications," dated October 12, 2016, available at gps.bcaresearch.com. 8 Please see The Bank Credit Analyst Strategy Outlook, "Stuck In A Rut," dated December 17, 2015, available at bca.bcaresearch.com. 9 Please see BCA Global Investment Strategy Special Report, "Three (New) Controversial Calls," dated September 30, 2016, available at gis.bcaresearch.com. 10 Please see "House: Recent Updates," accessed October 20, 2016, available at cookpolitical.com 11 We believe that it will be very difficult, if not impossible, for the Democrats to retain a razor-thin majority in the Senate if they get one in November. First, Democrats will have to defend 25 Senate seats (including two allied independent seats) out of 33 in contention in 2018. Second, Democrats always see a drop-off in voter turnout and enthusiasm in mid-term elections. 12 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Monthly Report, "King Dollar: The Agent Of Righteous Retribution," dated October 12, 2016, available at gps.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The resilience of EM industrial commodity demand, which is helping to lift inflation and inflation expectations in the U.S., will be tested over the next few months, as markets gear up for a possible oil-production deal between OPEC and Russia, and the first of perhaps three Fed rate hikes in December and next year. Any indication Janet Yellen has persuaded her colleagues to run a "high-pressure economy" will provoke us to get long gold, given its sensitivity to the Fed's preferred inflation gauge. We remain wary, however, given the higher-rates stance favored by some Fed officials, which, our modeling suggests, would reverse the pick-up in inflation and inflation expectations in the U.S. by depressing EM growth. Energy: Overweight. We continue to favor U.S. shale-oil producers at this stage in the cycle, and continue to look for opportunities to take commodity price exposure. Base Metals: Neutral. We downgraded copper to neutral from bullish last week, expecting prices to trade sideways over the next three months. Precious Metals: Neutral. We continue to be buyers of gold at $1,210/oz. If we continue to see the Fed's preferred inflation gauge increase, we will raise that target. Ags/Softs: Underweight. We are recommending a tactical long position in Mar/17 wheat versus a short in Mar/17 soybeans. Feature In her Boston Fed speech last week, Fed Chair Janet Yellen dangled catnip in front of commodity markets by discussing the possibility of "temporarily running a 'high-pressure economy,' with robust aggregate demand and a tight labor market" as a means of countering the prolonged hysteresis in the U.S. economy.1 Any indication Dr. Yellen has succeed in convincing her colleagues to pursue such a strategy would compel us to get long gold, given the sensitivity of the yellow metal to core PCE, the Fed's preferred inflation gauge (Chart of the Week).2 Indeed, we find there is a long-term equilibrium between spot gold prices and the core PCEPIand U.S. financial variables, which is extremely robust over time.3 Core PCEPI has been ticking up this year, most recently in March and appears to be leading 5-year/5-year inflation expectations tracked by the St. Louis Fed, which bottomed in June and have been trending higher since (Chart 2).4 In our modeling, we find a 1% increase in core PCE translates into a 4% increase in gold prices, suggesting gold would provide an excellent hedge against rising inflation. Chart of the WeekGet Long Gold If Pressure ##br##Builds in U.S. Economy Chart 2Core PCE ##br##Ticking Up Core PCE And EM Commodity Demand There is an enduring long-term relationship between inflation generally and EM commodity demand, which we have highlighted in previous research.5 This week we are exploring long-term equilibrium relationships between EM industrial commodity demand and core PCE, given the obvious interest among commodity investors. The big driver of core PCE is EM industrial commodity demand, as can be seen in Chart 3, which shows the output of two regressions we ran using non-OECD oil demand - our proxy for EM oil demand - and world base metals demand, which is dominated by China's roughly 50% share of global base metals demand. Core PCE is cointegrated with these measures of industrial-commodity demand, which makes perfect sense considering most - sometimes, all - of the demand growth for industrial commodities (oil and base metals, in this instance) is coming from EM economies.6 For example, of the total growth in oil demand since 2013, non-OECD demand accounted for 1.1mm b/d of an average 1.2mm b/d global demand growth. Within other markets, China accounts for more than 50% of global iron ore, copper ore, metallurgical and thermal coal demand.7 At the margin, prices in the real economy are being set by EM demand, not by DM demand. This, in turn, feeds into core and headline PCE and other inflation gauges. Feedback Between Fed Policy And EM Commodity Demand Leading economic indicators for EM growth are turning up, which is supportive for commodity demand near term (Chart 4). This has been aided by accommodative monetary policy in the U.S., which has kept the USD relatively tame after peaking in January 2016.8 Chart 3EM Industrial Commodity Demand,##br## Core PCE Share Common Trend Chart 4EM Leading Indicators ##br##Point to Growth Upturn The single biggest risk to commodity demand and commodity prices remains U.S. monetary policy. The longer-term cointegrating relationships highlighted in this week's research are consistent with earlier results we reported on the impact of U.S. financial variables on commodity demand.9 When we model EM oil demand as a function of U.S. financial variables, we find a 1% increase (decrease) in the USD broad trade-weighted index (TWI) is consistent with a 22bp decrease (increase) in consumption using these longer-dated models. For global base metals, a 1% increase (decrease) in the USD TWI corresponds with a 27bp drop (increase) in demand. As a general rule, each 1% increase (decrease) in the USD TWI is accompanied by a 25bp drop (increase) in EM demand for oil and global base metals (Charts 5 and 6). Chart 5EM Oil Demand Will Fall If ##br##The Fed Gets Too Aggressive... Chart 6...As Will##br## Base Metals Demand As mentioned above, we continue to expect a 25bp hike by the Fed at its December meeting, followed by two additional hikes next year. Our House view continues to maintain this round of rate hikes will cause the USD to appreciate by 10% over the next 12 months. If this is fully passed through, we expect this gauge to register a ~ 2.5% decline in EM demand for industrial commodities. This would reduce the core PCE's yoy rate of change to ~ 1%, vs. the current level of 1.7% yoy growth. Walking A Tightrope Chair Yellen's speech makes it clear the Fed is well aware of how its monetary policy affects the global economy and the feedback loop this creates. This is of particular moment right now, given the Fed is the only systemically important central bank even considering tightening its monetary policy. As she notes, "Broadly speaking, monetary policy actions in one country spill over to other economies through three main channels: changes in exchange rates; changes in domestic demand, which alter the economy's imports; and changes in domestic financial conditions - such as interest rates and asset prices - that, through portfolio balance and other channels, affect financial conditions abroad." The other major threat to EM commodity demand is the oil-production deal being negotiated by OPEC, led by the Kingdom of Saudi Arabia (KSA), and non-OPEC, led by Russia. Should these negotiations result in an actual cut in oil production, it would accelerate the tightening of global oil markets - likely increasing the rate at which global inventories of crude oil and refined products are drained - and put upward pressure on prices. While we do not expect a material agreement to emerge from these negotiations - KSA and Russia already are producing at or close to maximum capacity at present. A freeze in production by these states would result in no change in production globally. The risk here is KSA actually cuts production beyond its seasonal decline by adding, say, a 500k b/d cut to the expected 500k b/d seasonal decline, and Russia agrees to something similar. This would be offset by continued production increases in Iran, and possibly in Libya and Nigeria, but would, nonetheless, surprise the market and rally prices. All else equal, higher prices would weaken EM demand growth at the margin, and feed back into lower inflation expectations. We do not believe it is in KSA's or non-OPEC producers' interest to try to tighten markets sharply, since a price spike would re-energize conservation efforts by consumers, particularly in DM economies, and incentivize alternative transportation technologies like electric cars, as happened when oil prices were above $100/bbl from 2010 to mid-2014. Nonetheless, KSA, Russia, and other parties to any production-management agreement will have to balance this risk against the likelihood U.S. shale producers step in to fill the production cutbacks before any meaningful increase in revenues accrues to these states. Bottom Line: It still is too early to discuss the implications of a production cut, given negotiations between the KSA and Russia camps ahead of OPEC's November meeting continue. However, this could become a material issue next year, just as the Fed is considering whether to hike rates two more times, as we expect. A combined oil-production cut emerging from the KSA - Russia negotiations, which is a non-trivial risk, coupled with two Fed rate hikes could set off a new round of disinflation or even deflation, just as EM commodity demand was starting to enliven inflation and inflations expectations in the U.S.10 This could force the Fed to back off further rate hikes, or even walk back previous rate hikes. If on, the other hand, Chair Yellen is successful in persuading her colleagues to run a "high-pressure economy" we would look to get long commodities generally, gold in particular, given our expectation core PCE inflation and inflation expectations will move higher. As our research has shown, the yellow metal is particularly sensitive to the Fed's preferred inflation gauge. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com SOFTS China Commodity Focus: Softs Grains: Focus On Relative-Value Trade We remain strategically bearish grains, but we are upgrading our tactical view for wheat from bearish to neutral. We believe most of the negative news already is reflected in wheat prices. Over next three to six months, we expect wheat to outperform soybeans. Wheat prices could move up on reduced U.S. acreage, rising Chinese imports, or any unfavorable winter weather in major producing countries while expanding area-sown in Brazil, Argentina, China and the U.S. will likely pressure down soybean prices. We recommend a tactical long position in March/17 wheat versus March/17 soybeans. We suggest a 5% stop-loss to limit the downside risk. Grain prices have already rebounded 10.3% since August 30, when prices collapsed to a 10-year low (Chart 7, panel 1). There were three main reasons behind the precipitous price drop from early June to late August. 1.The 25% rally grain prices in 2016H1 encouraged global planting of spring wheat, soybeans, corn and rice. 2.Favorable weather lifted yields of all grains to record highs. 3.Extremely cheap Russian, Ukraine, Argentine and Brazilian currencies boosted exports from these major grain producing countries. In addition, grain-related policy changes in Argentine and Russia also have stimulated their grain exports (wheat benefited most and corn next). Given a 10% rebound recently, as the USDA expects global grain stocks to rise 3% to a new high next year, we remain a strategical bearish view on grain. Looking forward, we will continue to focus on relative-value trades in grain markets. Tactically, we are interested in long wheat versus soybeans. Wheat: Tactically Neutral Wheat has underperformed other grains so far in 2016 (Chart 7, panel 2). Prices fell to 361 cents per bushel on August 31, which was the lowest level since June 2006 (Chart 7, panel 3). Wheat prices have already recovered 16.7% from their August bottom. We believe, over the next three to six months, wheat prices may have limited downside due to one or a combination of the following factors. U.S. farmers are currently in the process of planting winter wheat. According to the USDA, as of October 9, 59% of winter wheat acreage has been planted. As U.S. wheat production costs are well above current market prices, U.S. farmers likely will further cut their wheat acreage over the next several weeks. This year, U.S. wheat-planted acreage has already dropped to the lowest since 1971 (Chart 8, panel 1). Global wheat yields improved 2.8% this year, with 13.4% and 20.8% increases in Russian and U.S. yields, respectively. Even though Russia will raise its wheat-sown area for next season, the country's wheat crop still faces plenty of risks during its development period. Too cold a winter or too hot a summer, which may not even result in a considerable drop in yields, still could spur a temporary rally in wheat prices. Similarly, U.S. wheat yields are also likely to retreat from the record high in 2017H1. In addition, extremely low wheat prices will encourage global farmers to plant other more profitable crops instead. As a result, both global wheat acreage and yields will likely go down next year (Chart 8, panel 2). Speculators are currently holding sizable net short positions. Market sentiment is also extremely bearish. Given this backdrop, any short-covering also would drive prices up (Chart 8, panels 3 and 4). Chart 7Wheat: Cautiously Bullish Chart 8Wheat: Upgrade To Tactically Neutral ##br##On Supportive Factors Soybeans: Tactically Bearish Soybeans have outperformed other grains significantly this year (Chart 7, panel 2). As planting soybeans general is more profitable than planting corn, wheat and rice, global farmers are likely to expand their soybean acreage for the next harvest season. According Conab, Brazil's national crop agency, Brazil's soybean production next spring will increase 6.7% to 9%. Record high U.S. soybean production is likely to weigh down the market as well. According to the USDA, 7.1% jump in the yields will bring U.S. soybean crop to a record high, an 8.7% increase from last year. As of October 9, 2016, only 44% U.S. soybean has been harvested, 12 percentage points behind last year. Chart 9China Grain Imports Will Continue Rising How does China contribute to our grain view? As the world's largest grain producer and also the largest consumer, China is an important player in global grain market. Last year the country accounted for 20.7% of global aggregate grain production and 23% of global consumption. In terms of grain imports, as we predicted in our January 2011 Special Report "China-related Ag Winners For The Long Term," China's grain imports have been on the uptrend, despite the depreciating RMB in the most recent two years (Chart 9). In terms of individual grain markets, China has been the most significant player in the global soybean market, accounting for 62.7% of global imports last year. China is also the world's largest rice importer, accounting for 12.5% of global rice trade. However, for corn and wheat markets, China only accounted for about 2% of global trade. In late March, the Chinese government announced an end to its price-support program for corn, but the government maintained price-support policies for wheat and rice. The government also announced its temporary reserve policy will be replaced by a new market-oriented purchase mechanism for the domestic corn market. In addition, the policy of giving direct subsidies to soybean farmers will continue in the 2016-17 market year. What Are The Implications Of China's Grain-Related Policy? Domestic corn prices fell sharply with global prices, while the gap between domestic soybean prices and the international ones remains large (Chart 10, panels 1 and 2). This will discourage domestic corn sowing and encourage soybean production, which is positive to global corn markets, but negative for global soybean markets. China's imports of wheat and rice are set to rise, given a widening price gap (Chart 10, panels 3 and 4). The country's demand for high-quality wheat and rice are rising as household incomes have greatly improved. China will likely liquidate its elevated grain inventories, which account for about 45% of global stocks. This will be bearish for all grains. However, as most of the domestic grain stocks are low-quality grains, inventory liquidation may affect animal feed market rather than the good-quality grain market. Overall, China's grain policy is positive for international corn, wheat and rice prices, but negative for global soybean prices. Investment strategy As we expect wheat to outperform soybeans over the next three to six months, we recommend a tactical long position in March/17 wheat versus short March/17 soybeans with a 5% stop-loss (Chart 11). Chart 10Implications Of China Grain Related Policy Chart 11Go Long Wheat Versus Soybeans With Stops Downside risks To Our Relative-Value Trade Position Currently, global wheat inventories still are at a record highs, and almost all the major wheat exporting countries continue to hold considerable inventory for sale. If farmers in Russia, Ukraine and Argentina rush to sell to take advantage of recent price rally, wheat prices will fall. Also, a strengthening USD will put a downward pressure on grain (including wheat and soybeans) prices. For this reason, it will be important to monitor U.S. dollar strength against the currencies of these countries - too-strong a USD will keep grains from being exported, which will keep domestic U.S. prices under pressure. However, our relative-value trade may weather this risk well as a strengthening dollar affects both wheat and soybeans. Moreover, if weather continues to be favorable during the winter, wheat prices may drop below the August lows. On the other side, if unfavorable weather reappears in South America next spring like this year, soybean prices may quickly go up. To limit our downside risk, we suggest putting a 5% stop-loss to our long wheat/short soybeans trade. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com 1 Please see "Macroeconomic Research After the Crisis," Dr. Yellen's speech delivered at the October 14, 2016, Boston Fed 60th annual economic conference in Boston. She highlighted hysteresis - "the idea that persistent shortfalls in aggregate demand could adversely affect the supply side of the economy" - in her discussion on how demand affects aggregate supply. She noted, "interest in the topic has increased in light of the persistent slowdown in economic growth seen in many developed economies since the crisis. Several recent studies present cross-country evidence indicating that severe and persistent recessions have historically had these sorts of long-term effects, even for downturns that appear to have resulted largely or entirely from a shock to aggregate demand." 2 Core PCE is the Personal Consumption Expenditures (PCE) price index, which excludes food and energy prices 3 The relationship shown in the Chart Of The Week covers the period March 2000 to present. The adjusted R2 of the cointegrating regression we estimated is 0.97; the price elasticity of gold with respect to a 1% change in the core PCE is close to 4%. The model is dominated by real rates, however: a 1% increase in real rates translates to a 15% decrease in gold prices, while a 1% increase in the broad trade-weighted USD implies a decrease in gold prices of just under 2.5%. Data and modeling constraints took the last observation to August 2016, when the model suggested the "fair value" of gold was close to $1,200/oz. At the time, gold was trading at just below $1,310/oz. Prices subsequently fell into the low to mid $1,200s, and were trading at ~ $1,270/oz as we went to press). 4 For this chart, we use the St. Louis Fed's 5y5y U.S. TIPS inflation index. Please see Federal Reserve Bank of St. Louis, 5-Year, 5-Year Forward Inflation Expectation Rate [T5YIFR], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/T5YIFR , October 19, 2016. 5 Please see "Memo To Fed: EM Oil, Metals Demand Key To U.S. Inflation" and "Commodities Could Be Hit Hard By Fed Rate Hikes," in the August 4, 2016, and September 1, 2016, issues of BCA Research's Commodity & Energy Strategy. Both are available at ces.bcaresearch.com. See also "China's Evolving Demand for Commodities," by Ivan Roberts, Trent Saunders, Gareth Spence and Natasha Cassidy," presented at the Reserve Bank of Australia's Conference focused on "Structural Change in China: Implications for Australia and the World," 17 - 18 March 2016. 6 The adjusted-R2 statistics for cointegrating regressions we ran for core PCE as a function of non-OECD oil demand and world base metals demand were 0.99 and 0.98 from 2000 to present. 7 Please see discussion beginning on p. 4 of "China's Evolving Demand for Commodities," by Ivan Roberts, Trent Saunders, Gareth Spence and Natasha Cassidy," presented at the Reserve Bank of Australia's Conference focused on "Structural Change in China: Implications for Australia and the World," 17 - 18 March 2016. 8 The Fed's broad trade-weighted USD index post-Global Financial Crisis peaked in January at just under 125 and currently stands at 122.6. Please see Board of Governors of the Federal Reserve System (US), Trade Weighted U.S. Dollar Index: Broad [TWEXBMTH], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/TWEXBMTH, October 18, 2016. 9 Please see p. 3 of "Commodities Could Be Hit Hard By Fed Rate Hikes," in the September 1, 2016, issue of BCA Research's Commodity & Energy Strategy, available at ces.bcaresearch.com. 10 We define a non-trivial risk as a 1-in-6 chance of occurrence - i.e., the same odds as Russian roulette. Investment Views and Themes Recommendations Tactical Trades Commodity Prices and Plays Reference Table Closed Trades

Highlights The near-term RMB outlook is entirely dictated by the movement of the dollar. We expect the CNY/USD to weaken alongside broad dollar strength, which could rekindle financial market volatility and cap the upside in Chinese stocks. The Chinese currency is better prepared for a stronger dollar than a year ago, and therefore the authorities should be able to maintain exchange rate stability. Joining the SDR does not automatically award the RMB international currency status. However, raising the relevance of the SDR as well as the RMB is part of China's long-term strategic plan. Feature The resumption of the dollar bull market has once again generated downward pressure on the RMB. How long the dollar bull run will last remains to be seen, but the broader global backdrop supports its continued strength against other major currencies, at least in the near term, including the yuan. Renewed downward pressure on the RMB may be perceived as a sign of domestic economic troubles, which could expedite capital outflows, creating a self-feeding vicious circle. The saving grace is that the Chinese currency is better prepared for a stronger dollar than a year ago, and therefore the authorities should be able to maintain exchange rate stability. Interestingly, the RMB's renewed weakness came in the wake of its official inclusion in the IMF's Special Drawing Right (SDR) basket early this month. While joining the SDR bears no near-term relevance from both an economic and financial market point of view, it marks an important milestone in the internationalization process of the RMB, with potential longer term implications. The RMB: From Goldilocks To Gridlock Chart 1The RMB: Stronger Or Weaker? The relapse of the CNY/USD of late is entirely driven by the strong dollar. While the RMB has weakened against the greenback, it has strengthened in trade-weighted terms (Chart 1). This is undoubtedly bad news for China, as it has very quickly pushed the RMB from a goldilocks scenario to essentially a gridlock. The goldilocks scenario that prevailed over the past several months was ushered in primarily by the weak dollar. It allowed the RMB to stay largely stable against the dollar but weaken substantially in trade-weighted terms - an ideal combination for both the market and the economy. Investors took comfort in a stable CNY/USD, while the Chinese economy benefited from the reflationary impact of a weaker trade-weighted exchange rate. In this vein, the reversal of the dollar trend will also lead to a reversal of this positive dynamic that prevailed over the past several months. Financial markets and investors will once again pay attention to the weakening CNY/USD, while the "stealth" depreciation of the trade-weighted RMB will also be halted, removing its reflationary impact. In other words, a weaker CNY/USD and a stronger trade-weighted RMB is the least desirable combination for both financial markets and the economy. To break this gridlock, the People's Bank of China (PBoC) could either "peg" the currency to the dollar, or weaken it substantially enough to achieve a weaker RMB in trade-weighted terms, neither of which is likely in our view. The path of least resistance is for the PBoC to bear it out, with managed CNY/USD depreciation together with tightened capital account controls to prevent capital flight. This is far from optimal and may still stoke financial market volatility, similar to the several episodes last year when a weakening RMB stoked fears of Chinese financial instability. However, a few factors suggest that this time the PBoC may be better prepared: Frist, the Chinese authorities have been paying much more attention to "open-mouth" operations in communicating their intention to market participants. Overall, investors are less 'spooked" by China's foreign exchange rate policy than a year ago. Second, pressure from capital outflows from the corporate sector will likely subside going forward. Paying down foreign debt has been one of the biggest sources of capital outflows in the past year, which has substantially reduced the domestic corporate sector's foreign currency liabilities (Chart 2).1 Moreover, despite dwindling foreign debt obligations, the corporate sector still holds near-record-high foreign currency deposits (Chart 3), which should further reduce its incentive to hoard the dollar. Chart 2Corporate Sector Foreign ##br##Debt Has Dropped Substantially... Chart 3... But Still Hoards ##br##Lots Of Dollar Deposits Further, Chinese growth is a tad stronger than last year, due largely to the reflationary impact of previous easing measures, including a weaker trade-weighted RMB. Even though the headline third quarter GDP growth figures reported this week remained essentially unchanged, the industrial sector has recovered notably, with improving activity, strengthening pricing power and accelerating profits. As economic variables typically respond to policy thrusts with a time lag, we expect the economy will continue to build momentum in the coming months, even if the reflationary impact of the RMB begins to diminish. More importantly, the Chinese government appears more willing to engage in fiscal pump-priming than last year, with a focus on infrastructure and private-public-partnership projects. Improving growth momentum and expansionary fiscal policy should be supportive for the exchange rate. Finally, the CNY/USD is already 12% lower than its peak in early 2014, and is no longer significantly overvalued, according to our valuation models (Chart 4). This means that additional CNY/USD weakness will further boost market share of Chinese products in the U.S., helping China to reflate while at the same time acting as an increasingly heavier drag on the U.S (Chart 5). It is therefore in the mutual interests of both the Chinese and U.S. authorities to maintain a steady RMB exchange rate. The U.S. Treasury once again cleared China from being currency manipulator in its last week's semi-annual review, and acknowledged the PBoC's efforts in preventing rapid RMB depreciation as beneficial for both the Chinese and global economies. To be sure, the U.S. and China will not explicitly coordinate monetary policy to regulate exchange rate movements. However, a weaker CNY/USD will lead to much quicker dollar appreciation in trade-weighted terms than otherwise, which in of itself will prove self-limiting. Chart 4RMB/USD Is No Longer Overvalued Chart 5A Weaker RMB/USD Is ##br##Boosting Chinese Exports To The U.S. The bottom line is that the near-term RMB outlook is entirely dictated by the movement of the dollar. We expect the CNY/USD to weaken alongside broad dollar strength in the near term, but unless the dollar massively overshoots the downside will not be substantial. This could rekindle financial market volatility and cap the upside in Chinese stocks. We tactically downgraded our "bullishness" rating on Chinese H shares from "overweight" to "neutral" last week,2 and this view remains unchanged. At the same time, we continue to argue against being outright bearish, because of the deeply depressed valuation matrix of this asset class, especially H shares. When Will The RMB Float? We expect Chinese regulators will tighten capital account controls significantly in the coming months in order to slow capital outflows in the wake of renewed CNY/USD depreciation. The impossible trinity of international finance dictates that a country cannot target its exchange rate with independent monetary policy and simultaneously allow free capital flows. Among these three conditions, "free capital flows" is the least-costly sacrifice. There is no way the PBoC will raise interest rates to defend the currency. Tightening capital account controls goes against the long-term objective of China's foreign exchange rate reforms, but it is not only justified but necessary in the near term. Pointing at the dilemma the PBoC faces today, some pundits are now singing the "I-told-you-so" song, claiming the country should have moved to a much greater degree of exchange-rate flexibility "back when the going was good", as they had advised. In our view, this argument is completely flawed. In previous years when "the going was good", China was facing massive foreign capital inflows, unleashed by extremely aggressive monetary easing by other central banks in the wake of the global financial crisis. If the PBoC indeed took this advice back then and did not intervene to slow down RMB appreciation by hoarding massive foreign reserves, it would simply have led to a dramatic overshoot of the RMB. By the same token, when the tide turned, capital outflows would have proven overwhelming, leading to an RMB collapse. In fact, without the massive foreign reserves accumulated in previous years during the PBoC's RMB intervention, the Chinese authorities' ability to maintain exchange rate stability would have been much more seriously challenged, particularly in the past year. Chart 6Lopsided Expectations On The RMB ##br##Drive One-Way Moves Of Capital Flows In other words, the key problem with China's exchange rate is that expectations on the RMB have been lopsided in recent years (Chart 6). Consequently, the RMB has long been a one-way bet, accompanied by one-way moves of capital flows. The unanimous view on a rising RMB in previous years drove capital inflows; expectations completely reversed in 2015, leading to persistent outflows. In this environment, without the PBoC's intervention, a "greater degree of exchange rate flexibility" as advised by some would simply mean extreme RMB moves, inevitably leading to much greater financial and economic volatility. Therefore, the RMB should only be allowed to float when there is a healthy divergence of views among market participants, so that there are enough "buyers" and "sellers" to collectively price the RMB exchange at a market-determined "equilibrium" level. Until then, any premature and imprudent capital account deregulation would prove catastrophic, and should be avoided at all cost. We are hopeful the Chinese authorities will remain pragmatic enough not to hasten this process. The RMB's SDR Debut: Playing The Long Game The RMB has officially joined the SDR basket since the beginning of October, the first emerging country currency to join this "elite club". The RMB's SDR debut has little economic relevance in the near term. If anything, officially joining the SDR means that the RMB, under China's prevailing capital account regulations, meets the IMF's criteria as a "freely usable" currency. Therefore, it implies that the IMF endorses China's capital control measures currently in place. Some analysts suggest that the Chinese government's determination to join the SDR is largely to show off national pride. In our view, it serves more pragmatic purposes both at the private and official level. Chart 7The RMB's Rising Importance As ##br##An International Payment Currency At the private level, an important function of an international currency is for trade invoicing - an area where the RMB has witnessed remarkable progress in recent years. The RMB currently ranks fifth among world payment currencies, accounting for a mere 2% of world payments, which pales in comparison with the dollar's 40% and the euro's 30%. However, an increasingly large share of China-related trade has been settled directly with the RMB. Currently, the RMB accounts for about 13% for all international payments sent and received by value with China and Hong Kong (Chart 7), up from practically zero a few years ago. Moreover, RMB settlement already accounts for over half of Chinese trade with specific regions such as the Middle East and African countries. For Example, the use of the RMB in the United Arab Emirates (UAE) and Qatar accounted for 74% and 60% of their respective payments to China/Hong Kong in 2015. As the largest trade partner with a growing number of countries, China should have no problem continuing to promote RMB settlement, especially in the emerging world. At the official level, the Chinese government is certainly intent on having the RMB act as an international reserve currency, but not in such a way as to challenge the dollar's mighty dominance. Rather, the government appears to be following dual mandates in its purse. Domestically, it is aiming to use the SDR inclusion as a catalyst to reform its financial system, much like what joining the World Trade Organization (WTO) in the early 2000s did to its manufacturing sector. Globally, it is seeking to play a more active role in reforming the international monetary system. After witnessing the dramatic liquidity crunch during the global financial crisis, the Chinese authorities see the necessity to reduce the world's heavy reliance on the dollar by creating credible alternatives. Neither of these dual mandates can be easily accomplished, but it is important to keep the big picture in mind in understanding China's policy initiatives going forward. The bottom line is that joining the SDR does not automatically award the RMB international currency status, and it is naïve to expect the RMB to challenge the U.S. dollar anytime soon, if at all. However, raising the relevance of the SDR as well as the RMB is part of China's long-term strategic plan. Its determination to internationalize the RMB should not be underestimated. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Special Report, "Mapping China's Capital Outflows: A Balance Of Payment Perspective", dated February 3, 2016, available at cis.bcaresearch.com 2 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010", dated October 13, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights When interest rates are ultra-low, central banks have no margin for policy error. A small loosening or tightening has the potential to produce either a stall or catastrophic turbulence. The analogy is flying a plane at high altitude. Bond investors should have a strong preference for U.S. T-bonds over German bunds (currency hedged). Currency investors should prefer the euro over the dollar. For equity investors, valuations do not appear structurally attractive anywhere, once a sufficient equity risk premium is factored in. But a setback in the region of 5-10% could create a tactical entry point. Feature As the ECB Governing Council convenes for its October monetary policy meeting, an experience familiar to pilots1 provides a perfect analogy for central banks' very limited margin for error. Pilots call the experience "flying in coffin corner." Chart of the WeekUnusually High Turbulence For The German 30-Year Bund Next time you're in a plane climbing to 35,000 feet, here's something to think about; or perhaps, not to think about. As the plane gains altitude, its stall speed increases while its upper speed limit simultaneously decreases. For the pilot, this means less and less margin for error (Figure I-1). The plane's stall speed is the minimum speed to generate sufficient lift. At higher altitude, as the air gets thinner, the stall speed increases. Meanwhile, the plane's upper speed limit is set by the speed of sound. Airliners cannot fly too close to the speed of sound because the sonic shockwave produces violent and catastrophic turbulence. At higher altitude, as the air temperature drops, so does the speed of sound. Which means the plane's upper speed limit decreases. By the time the plane has reached the rarefied atmosphere of 35,000 feet, these lower and upper speed limits are barely 25 knots (30mph) apart,2 leaving almost no room for flight data misinterpretation or pilot error.3 Hence, at high altitude pilots morbidly say they are "flying in coffin corner." Analogously, in the rarefied atmosphere of zero or near-zero interest rates, central bank policy is also in coffin corner. When short-term and long-term interest rates approach the zero bound, there is no room for economic data misinterpretation or policy error. A small loosening or tightening of monetary policy has the potential to produce either a stall or catastrophic turbulence (Figure I-2 and Chart of the Week). Figure I-1Flying At High Altitude ##br## Has No Margin For Error Figure I-2Monetary Policy At Ultra-Low Rates ##br##Has No Margin For Error Avoiding A Stall At today's zero or near-zero interest rates in the euro area, a small loosening of monetary policy risks stalling the banking system, and thereby stalling the economy. A bank's core business is simple. Take in deposits, and lend them out at a higher interest rate than the deposit-rate - with the difference in the two defining the bank's net interest margin. A part of the net interest margin is a compensation for the risk of non-performing loans. This should be profit-neutral if correctly priced. The other large part of the net interest margin comes from the interest rate term-structure, as loans tend to be long-term while deposits are short-term. Hence, all else being equal, the bank's profitability suffers as the term-structure flattens. For a while, the bank can protect its profitability by cutting the interest rate paid on short-term deposits to well below the policy rate. However, once the policy rate hits zero, this profit-protection strategy hits a wall - because a negative deposit rate would risk an exodus of deposits into cash or cash-substitutes. Alternatively, the bank could charge a higher rate to borrowers, but this would tighten credit conditions. The third possibility is for the bank to suffer a hit to its already-thin net lending margin, but this would also tighten credit conditions. The pressure on the bank's profitability and share price would increase the cost of equity, making it harder to raise capital (Chart I-2). Given that an insufficient capital buffer is a major constraint to euro area bank lending, this would be a de facto tightening of credit conditions. The paradox is that at the zero bound, the smallest additional monetary loosening - via interest rate cuts or QE - risks stalling euro area bank credit creation (Chart I-3). Thereby it risks stalling economic growth. Chart I-2The ECB's QE Has Hurt Bank Valuations Chart I-3The Interplay Between Bank Profits And Bank Credit Creation Avoiding Violent Turbulence An extended period of ultra-low interest rates, and a commitment to keep them structurally low, has compressed the yields on government bonds pushing up their prices. As competing asset classes, the prices of corporate bonds and equities have also increased. This phenomenon is called the Portfolio Balance Effect. The big problem is that the prices of riskier assets have increased by more than is justified by the portfolio balance effect alone. This distortion is the result of a behavioural finance phenomenon called Mental Accounting Bias. Mental Accounting Bias describes the irrational distinction between the return from an investment's yield and that from its capital growth. The distinction is irrational because the money that comes from yield and the money that comes from capital growth is perfectly fungible.4 Rationally, what should matter is an investment's total return. But psychologically, the distinction between yield and capital is very stark. Fears about self-control cause people to compartmentalise yield as spending money and capital as saving money. Hence, people who want their investments to generate spending money - say, retirees - have an irrational focus on yield. Traditionally, the safe income from cash and government bonds satiates the people who irrationally focus on yield. However, in recent years, central banks' extended experiments with ZIRP, NIRP and QE have forced these yield-focussed investors out of cash and government bonds into risky investments. And just like every distortion, this phenomenon has generated memes to justify the act: 'reach for yield', 'search for yield', and 'there is no alternative' (TINA). But the irrational focus on yield instead of total return has artificially bid up the prices of risky investments. To the point that they no longer offer a sufficient risk premium5 for the very real possibility of substantial losses over a 5-10 year horizon (Chart I-4 and Chart I-5). The unfortunate thing is that as central bankers have little expertise in psychology or behavioural finance, they have been blind to the very dangerous behavioural distortion that their monetary policy experiments have unwittingly unleashed. Chart I-4A Positive Yield On Equities##br## Can Produce A Negative 5-Year Return... Chart I-5...And Even A Negative ##br##10-Year Return The risk is that the smallest monetary tightening could trigger an aggressive unwinding of this behavioural distortion. Recall the violent turbulence in global financial markets at the start of the year after just one 25bps rate hike from the Federal Reserve. Now consider what might happen if the Fed hiked again and the ECB simultaneously announced a rapid tapering of its QE program. How Must The Pilots Fly? In a rarefied atmosphere, pilots have very little margin to alter speed without inducing a stall or violent turbulence. The same applies to central banks today. The ECB has the hardest piloting task. It is becoming difficult to justify the current aggressive pace of QE given the danger of stalling the euro area banking system; and given that the euro area's nominal GDP and nominal wage bill are both growing at a very respectable 3% (Chart I-6). But an abrupt end to the ECB's QE could create violent turbulence in QE-distorted financial markets. Chart I-6What Deflation Threat? Euro Area Nominal GDP And The Wage Bill Growing At 3% Hence, the ECB's best course of action is to hint at a very gradual deceleration of QE to start at some point in the second half of 2017. Turning to developed economy central banks in general, we remind readers of a very powerful observation. Since 2008, no major central bank has been able to hike interest rates by more than 1.75%. And every central bank that has hiked rates has had to start unwinding those hikes within a year, ultimately taking the policy rate to a new all-time low (Chart I-7 and Chart I-8). Chart I-7Since 2008, All Rate Hikes ##br##Have Been Quickly Reversed Chart I-8Will The U.S. Be ##br##Any Different? No Given the turbulence that rate hikes will generate in the financial markets and/or the economy, we fully expect the Federal Reserve to go through exactly the same experience. The important upshot is that global central bank policy through 2017-18 will be considerably less divergent than is discounted. Bond yields could creep higher in the short term. But on a 1-year horizon, bond investors should have a strong preference for U.S. T-bonds over euro area bonds, and especially over German bunds (currency hedged). Over the same horizon, currency investors should prefer the euro over the dollar. For equity investors, valuations do not appear structurally attractive anywhere once a sufficient equity risk premium is factored in. Moreover, the potential for ECB QE-tapering combined with expectations for a Fed rate hike could generate some near-term turbulence. That said, a setback in the region of 5-10% could create an excellent entry point for a 3-month trade. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com Fractal Trading Model* There are no new trades this week. Last week's long silver/short lead pair trade has bounced sharply. And the short U.K. A-rated corporate bonds trade has achieved its 4% profit target. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. 1 Your author is a former pilot in the Royal Air Force reserve. 2 For an Airbus A330. 3 Tragically, a combination of flight data misinterpretation and pilot error at 35,000 feet was disastrous for Air France flight AF447 flying from Rio de Janeiro to Paris in June 2009. Going through a storm, the airspeed indicator started giving a false reading and the pilot took the wrong corrective action, resulting in a catastrophic stall. 4 Assuming no difference in tax treatment of income and capital gains. 5 Please see the European Investment Strategy Weekly Report "The Great Distortion... And How It will End" dated September 15, 2016 available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations

Highlights EM tech stocks are overbought while banks are fundamentally vulnerable due to bad-loan overhang. EM stocks have never decoupled from the U.S. dollar and commodities prices. There has been no recovery in EM corporate profitability and EPS. We reiterate two equity trades: short EM banks / long U.S. banks, and short Chinese property developers / long U.S. homebuilders. Upgrade Thai stocks to overweight within the EM equity benchmark and go long THB versus KRW. Feature Our Reflation Confirming Indicator - an equal-weighted aggregate of platinum prices (a proxy for global reflation), industrial metals prices (a proxy for China growth) and U.S. lumber prices (a proxy for U.S. reflation) - has decisively rolled over, and is spelling trouble for emerging market (EM) equities (Chart I-1). In particular, platinum prices have relapsed after hitting a major resistance at their 800-day moving average (Chart I-2). Such a technical pattern often leads to new lows. If so, it could presage a major selloff in EM markets in the months ahead. Chart I-1A Red Flag From ##br##Reflation Confirming Indicator Chart I-2Platinum: A Canary##br## In A Coal Mine? The rationale behind using platinum rather than gold or silver prices is because platinum is a precious metal that also has industrial uses. Besides, we have found that platinum prices correlate with EM stocks better than gold or silver. The latter two sometimes rally due to global demand for safety, even as EM markets tank. Finally, platinum seems to be the most high-beta precious metal in the sense that it "catches a cold" sooner and, thus, might be leading other reflationary plays. In short, EM share prices have been flat since August 15, and odds are that they are topping out and the next large move will be to the downside. Can EM De-Couple From The U.S. Dollar? Many investors are asking whether EM risk assets can rally if the greenback continues to rebound. Chart I-3 illustrates that since the early 1980s, there have been no periods when EM share prices rallied amid strength in the real broad trade-weighted U.S. dollar (the dollar is shown inverted on this and the proceeding charts). The same holds true if one uses the nominal narrow trade-weighted U.S. dollar1 (Chart I-4). Chart I-3Real Trade-Weighted ##br##U.S. Dollar And EM Stocks Chart I-4Nominal Trade-Weighted ##br##U.S. Dollar And EM Stocks One could disregard these charts and argue that this time around is different. We don't quite see it that way. Chart I-5Nominal Trade-Weighted ##br##U.S. Dollar And Commodities Notably, the narrative behind the EM rally since February's lows has been based on the Federal Reserve backing off from rate hikes and the U.S. dollar weakening - with the latter propelling a rally in commodities prices. These arguments appear to be reversing: the U.S. dollar is already firming up and commodities prices are at best mixed. The broad index for commodities prices always drops when the U.S. dollar rallies (Chart I-5). In recent months, the advance in commodities prices has been uneven and narrow based. While oil prices have spiked substantially, industrial metals prices have advanced very little. The current oil price rally is proving a bit more durable and lasting than we thought a few months ago. Nevertheless, China's apparent consumption of petroleum products is beginning to contract (Chart I-6). Consequently, resurfacing worries about EM/China's demand for commodities will lead to a meaningful pullback in crude prices in the months ahead, especially since the likelihood that oil producers act to restrain supply at the current prices is very low. As for commodities trading in China such as steel, iron ore, rubber, plate glass and others, they have been on a roller-coaster ride in recent months (Chart I-7). Chart I-6China's Demand For Oil Products Is Very Weak Chart I-7Commodities Prices In China Bottom Line: There are reasonably high odds that as the U.S. dollar strengthens and commodities prices roll over, EM risk assets (stocks, currencies and credit markets) will start to relapse. EM Beyond Commodities: Still Shrinking Profits Table I-1EM Sectors Weights: In 2011 And Now Another question that many investors have been asking is as follows: Is there not a positive story in EM beyond commodities? Given that the weight of the EM equity market benchmark in commodities stocks - energy and materials - has drastically declined in recent years, from 29.2% in 2011 to 13.7% now (Table I-1), and the weight in technology stocks has risen substantially (from 12.9% in 2011 to 23.9% now), couldn't non-commodities stocks drive the index higher? In this regard, we have the following observations: Information technology stocks are overbought. The EM information technology equity index has surged to its previous highs (Chart I-8, top panel). This sector is dominated by five companies that have a very large weight also in the overall EM benchmark: Samsung (3.6% weight in the EM equity benchmark), TMSC (3.5%), Alibaba (2.9%), Hon Hai Precision (1%) and Tencent (3.8%). Their share price performance has been spectacular, and some of them have gone ballistic (Chart I-9). TMSC and to a lesser extent Samsung have benefited from the rising prices of semiconductors (Chart I-9, second panel from top). However, it is not assured that semiconductor prices will continue soaring from these levels as global aggregate demand remains very weak. In short, the outlook for semi stocks is by and large a semiconductor industry call, not a macro one. As for Alibaba and Tencent, they are bottom-up stories - not macro bets at all. At the macro level, we reassert that EM/China demand for technology goods and services as well as for health care will stay robust. Hence, from a revenue perspective, technology and health care companies will outperform other EM sectors. This still warrants an overweight allocation to technology and health care stocks, a recommendation that we have had in place since June 2010 (Chart I-8, bottom panel). Odds are that tech outperformance will persist, but we are not sure about absolute performance, given overbought conditions and not-so-cheap valuations. Excluding information technology, the EM benchmark is somewhat weaker (Chart I-10). Chart I-8EM Technology Stocks: Sky Is Limit? Chart I-9Individual Tech Names Are Overbought Chart I-10EM Equities: Overall And Excluding Tech There is no improvement in EM corporate profitability The return on equity (RoE) for EM non-financial listed companies has stabilized at very low levels, but it has not improved at all (Chart I-11, top panel). The reason we use non-financials' RoE rather than overall RoE is because in EM the latter is artificially inflated at the moment, as banks are originating a lot of new loans but are not sufficiently provisioning for bad loans. Among the three components of non-financials RoE, net profit margins have stabilized but asset turnover is falling and leverage continues to mushroom (Chart I-11, bottom two panels). Remarkably, the relative performance between EM and U.S. stocks has historically been driven by relative RoE. When non-financial RoE in EM is above that of the U.S., EM stocks outperform U.S. ones, and vice-versa (Chart I-12). This relationships argues for EM stocks underperformance versus the S&P 500. Chart I-11EM Non-Financials: ##br##RoE And Its Components Chart I-12EM Versus U.S.: ##br##Relative RoE And Share Prices Overall EM EPS is still contracting in both local currency and U.S. dollar terms (Chart I-13). Even though the rate of contraction is easing for EPS in U.S. dollar terms, it is due to EM exchange rate appreciation versus the greenback this year. Furthermore, EPS in U.S. dollars is contracting in a majority of non-commodities sectors (Chart I-13A, Chart I-13B). The exceptions are utilities and industrials, which both exhibit strong EPS growth despite poor share price performance. The latter could be a sign that strong industrials and utilities EPS have been due to temporary factors and are not sustainable. Chart I-13AEM EPS Growth: Overall And By Sector Chart I-13BEM EPS Growth: Overall And By Sector Banks hold the key. Apart from commodities/the U.S. dollar and tech stocks, EM banks' share prices are probably the most important precursor to the direction of the overall EM benchmark. Financials are the second-largest sector in the EM equity benchmark (26.4% weight), so if bank share prices break down, the broader EM index will likely relapse. Our analysis of bank health in various EM countries leads us to believe that banks are under-provisioned for non-performing loans (NPL) (Chart I-14A, Chart I-14B). As EM growth disappointments resurface, investors will question the quality of banks' balance sheets and push down bank equity valuation. Hence, odds are bank share prices will drop sooner than later. Chart I-14AEM NPLs Are Unrecognized ##br##And Under-Provisioned Chart I-14BEM NPLs Are Unrecognized ##br##And Under-Provisioned In turn, concerns about EM banks will heighten doubts about overall EM growth and the EM equity benchmark will sell off. Bottom Line: EM tech stocks are overbought, while banks are fundamentally vulnerable due to the bad-loan overhang. As commodities prices relapse anew and worries about the EM credit cycle resurface, the EM benchmark will drop considerably. An Update On Two Relative Equity Trades We reiterate two relative equity trades: short EM banks / long U.S. banks, and short Chinese property developers / long U.S. homebuilders. For investors who do not have these positions, now is a good time to initiate them. Short EM banks / long U.S. banks (Chart I-15). The credit cycle in EM/China will undergo a further downturn: credit growth is set to decelerate as banks recognize NPLs and seek to raise capital. Even if a crisis is avoided, the need to raise substantial amounts of equity will considerably erode the value of EM bank shares. Meanwhile, risks to U.S. banks such as a flat yield curve and a possible spillover effect from European banking tremors are considerably less severe than the problems faced by EM banks. Importantly, unlike EM banks, U.S. banks' balance sheets are very healthy. Short Chinese property developers / long U.S. homebuilders (Chart I-16). Chart I-15Stay Short EM Banks##br## Versus U.S. Banks Chart I-16Stay Short Chinese Property ##br##Developers Versus U.S. Homebuilders Chinese property developers are on the verge of another downturn, as the authorities have tightened policy surrounding housing. Residential and non-residential property sales have boomed in the past 12 months, but starts have been less robust (Chart I-17). The upshot could still be high shadow inventories. Going forward, as speculative demand for housing cools off, property developers' chronic malaise - high leverage and lack of cash flow - will come back to play. Remarkably, property stocks trading in Hong Kong have failed to break out amid the buoyant residential market frenzy in the past 12 months, and are likely to break down as demand growth falters in the coming months (Chart I-18). Chart I-17China's Real Estate: ##br##Sales And Starts Will Contract Chart I-18Chinese Property Developers: ##br##On A Verge Of Breakdown? Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com Thailand: Upgrade Stocks To Overweight And Go Long THB Versus KRW The death of King Bhumibol Adulyadej marks the end of an era not only because he symbolized national unity but also because his entire generation is passing. This generational shift has far-reaching consequences for Thailand's political establishment: in the long run it could hurt the Thai military's - and its allies' - attempt to cement their dominance over parliament. However, as Box II-1 (on page 17) explains, there is a low probability of serious domestic instability over the next 12 months2 - although beyond that risks will be heating up. For now, the military junta faces no major political or economic constraints: The junta has already consolidated control over all major organs of government and has purged or intimidated political enemies. The military will have to turn power back to parliament, or make a major policy mistake, for the opposition movement to rise again. The government's fiscal deficit has been stable (around 3% of GDP) over the past few years, public debt is at 33% of GDP, government bond yields are low and debt servicing costs are at 5% of total expenditures (Chart II-1). Hence, the military government can ramp up expenditures further to appease the disaffected. Indeed, the military junta has already accelerated public capital expenditures (Chart II-2) and investments have poured into the Northeast, a populous base of opposition to the junta. Chart II-1Thailand: More Room ##br##For Fiscal Stimulus Chart II-2Thailand: Government ##br##Capex Has Been Booming Likewise, fiscal expenditure has also accelerated in areas such as general public services, defense, and social protection (Chart II-3). Additionally, the Bank of Thailand (BoT) has scope to cut interest rates as the policy rate is still above a very low inflation rate (Chart II-4). This will limit the downside for credit growth and contribute to economic and political stability. Chart II-3Rising Public Spending Chart II-4Thailand: No Inflation; Room To Cut Rates The large current account surplus - standing at 11% of GDP - provides the authorities with plenty of fiscal and monetary maneuverability without having to worry about a major depreciation in the Thai baht (Chart II-5). Amid this sensitive political transition, the central bank will likely defend the currency if downward pressure on the baht emerges due to U.S. dollar strength. Therefore, we recommend traders to go long the Thai baht versus the Korean won (Chart II-6). Despite Korea's enormous current account, the won is at risk from depreciation in the RMB and the Japanese yen. Chart II-5Enormous Current Account ##br##Surplus Will Support The Baht Chart II-6Go Long THB Against KRW On the whole, although the Thai economy has been stagnant (Chart II-7), fiscal spending and low interest rates will limit the downside in growth. Bottom Line: We expect relative calm on the political surface in Thailand over the next 12 months and a stable macro backdrop. Therefore, we are using the latest weakness to upgrade this bourse from neutral to overweight within an EM equity portfolio (Chart II-8). Chart II-7Thai Growth Has Been Stagnant Chart II-8Upgrade Thai Stocks ##br##From Neutral To Overweight In addition, currency traders should go long THB versus KRW. Ayman Kawtharani, Research Analyst aymank@bcaresearch.com Matt Gertken, Associate Editor mattg@bcaresearch.com BOX 1 The Military Coup In 2014 Pre-empted The King's Death... The May 2014 military coup was timed to pre-empt this event. The king's health had been declining for years and it was only a matter of time until he died. This raised the prospect of an intense political struggle that could have escalated into a full-blown succession crisis. Thus the military moved preemptively so that it would be in control of the country ahead of the king's death and could reshape the constitutional system in the military's favor before his death, as it has done. ... And This Means Stability For Now If the populist, anti-royalist faction had been in control of government at the time of the king's death, it could have attempted to manipulate the less popular new king and take advantage of the vacuum of royal authority in order to reduce the role of the military and their allies. That in turn could have sparked a wave of mass protests from royalists, pressuring the government to collapse, or a military coup that would not have carried the king's implicit approval like the 2014 coup. That would have fed the narrative that a final showdown between the factions was finally emerging, and would have been highly alarming to foreign investors. But Risks Still Linger Make no mistake: a new long-term cycle of political instability is now emerging. Potential military mistakes and the return to parliamentary rule are potential dangers. The country's deep divisions - between (1) the Bangkok-centered royalist bureaucratic and military establishment and (2) the provincial opposition -have not been healed but aggravated since the 2014 coup and the new pro-military constitution: The junta's constitutional and electoral reforms will weaken the representation of the largest opposition party, the Pheu Thai Party, and will marginalize a large share of the 65% of the country's population that lives in the opposition-sympathetic provinces. It is also conceivable that the new king could trigger conflict by lending support to the populist opposition. For instance, he could pardon the exiled leader of the rural opposition movement, or he could transform the powerful Privy Council. However, we do not expect discontent to flare up significantly until late 2017 or 2018 when the military steps back and a new election cycle begins.3 We will reassess and alert investors if we foresee a rapid deterioration in the palace-military network, or in the military's ability to prevent seething resistance in the provinces. 1 The narrow U.S. dollar is a trade-weighted exchange rate versus the euro, Canadian dollar, Japanese yen, British pound, Swiss franc, Australian dollar, and Swedish krona. Source: The Federal Reserve. 2 The exception is that isolated acts of terrorism remain likely and could well strike key areas in Bangkok, signaling the reality that the underground opposition to military dictatorship remains alive and well. 3 The junta will use the one-year national period of mourning to its advantage and opposition forces will not want to be targeted for causing any trouble during a time of mourning. The junta could very easily delay the transition to nominal civilian rule, including the elections slated for November 2017. Equity Recommendations Fixed-Income, Credit And Currency Recommendations