Market Returns

Special Report

One of BCA's long-standing clients, Ms. Mea, recently paid us a visit at our Montreal office. Ms. Mea is an experienced and successful investor who has been reading different BCA products for many years. She noted that over the years she has both agreed and disagreed with our market views, but that she appreciates our thematic approach including themes, analysis and views, as they are important to her investment process. Like many of our clients, Ms. Mea has been disappointed by the Emerging Markets Strategy (EMS) team's EM/China call, which has not been correct over the past 18 months. My team and I spent a few hours with Ms. Mea detailing our views and methodology. Despite some tough discussions, she said she found the dialogue valuable. Reflecting on our meeting, I thought it would be beneficial to share the key points with all of EMS clients. This report is a summary of that. Ms. Mea and I agreed to continue the debate as the story plays out, so I will be meeting with her occasionally in Europe when I travel there. Ms. Mea: Clearly your recommended strategy has been wrong for some time. I am aware that your negative view on EM/China and strategy was right and profitable from 2011 until early 2016. Nevertheless, since early last year EM risk assets have rallied considerably, and not participating in this rally has been painful - not to mention being short EM risk assets. For our global equity funds, underweighting EM within the global universe did not hurt performance in 2016. However, this year the EM equity benchmark has considerably outperformed the global averages (Chart I-1). So, what has gone wrong, and why haven't you changed your view already? Chart I-1EMS's Big Picture Asset Allocation Strategy: EM Relative To DM Stock Prices Answer: My objective today is not to dispute your comments - my view and investment strategy have clearly gone wrong. Rather, I would like to highlight what has gone wrong as well as elaborate on my methodology and thought process. Let me be clear, if I thought in 2016 or early 2017 that the market would rally for more than six months and - in the case of EM equities - by more than 20%, I would have recommended clients to play this rally regardless of my big picture themes and views. The same is true today. My general view has been based on two pillars: Chinese growth and Federal Reserve policy/the U.S. dollar. 1. The first pillar of my argument has been that China's growth improvement would prove unsustainable due to lingering credit imbalances/excesses. In the April 13, 2016 report,1 I laid out the case that China's 2015-16 fiscal stimulus of RMB 850 billion would be offset by a potential slowdown in credit growth from an annual growth rate of 11.5% to 9-9.5%. Chart I-2China: Borrowing Costs Have Been Rising This thesis of credit growth deceleration was based on the natural tendency of credit growth to gravitate toward nominal GDP growth, especially since the credit-to-GDP ratio had massively overshot in the preceding seven years. Besides, since 2013 high-profile policymakers in China had been talking about the need for deleveraging, containing financial excesses, and not repeating the mistakes of 2009-2010, when money and credit was allowed to run at an extremely strong pace. In first half of 2016, I downplayed the recovery in money and credit aggregates arguing that they are temporary and unsustainable. When a country has a lingering credit bubble - which has been the case in China, I am biased to downplay upticks in money and credit growth and easing in monetary policy. At the same time, I put a greater emphasis on both monetary tightening and slowdown in money/credit when the economy suffers from credit excesses. The opposite is also true in cases where there are no excesses/imbalances. Since November 2016, the People Bank of China (PBoC) has been tightening liquidity and pushing money market rates and corporate bond yields higher (Chart I-2). This has been taking place in addition to regulatory tightening on both bank and shadow banking activities. As a result, I have been predicting that regulatory and liquidity tightening amid lingering credit and speculative excesses would weigh on money, credit and capital spending. Importantly, I reckoned that financial markets would be forward-looking and would reverse their rally in anticipation of weaker growth down the road instead of reacting to robust - yet backward looking - growth data. Indeed, money and credit growth have already slowed to all-time lows (Chart I-3). Nevertheless, broad economic growth has not slowed (Chart I-4). This has also been true for China's impact on the rest of the world - the mainland's imports have remained robust (Chart I-5). Chart I-3China: Money And Credit Aggregates Chart I-4China: Business Cycle Perspective Chart I-5China: Money Impulses And Imports Not only have I been surprised by the mainland economy's ability to withstand the slowdown in money/credit so far, but I have also been caught off guard by how financial markets have shrugged off the rise in onshore interest rates and the deceleration in money/credit. That said, liquidity tightening works with a time lag. The fact that it has not yet had an impact on the real economy does not mean it won't going forward. 2. The second pillar of my view has been that the Fed's dovish stance would prove transitory. The global market rally began in February 2016 when the Fed sounded dovish in the face of a surging U.S. dollar, collapsing commodities prices, very weak global trade and plunging global risk assets. Remarkably, global growth and corporate profits have recovered very strongly, the U.S. dollar has weakened considerably and commodities and global tradable goods prices have rebounded. As such, I expected that U.S. interest rate expectations would move higher, dampening the carry trade. Unfortunately, markets' reactionary functions does not always follow a symmetrical logic. The decline in U.S. inflation rate amid a weak dollar, rising import prices and robust U.S. growth - especially the tight labor market and some wages pressures (Chart I-6) - has puzzled me. Ms. Mea: Why have you disregarded the clear improvements in EM profits and global trade in 2017? Answer: I have been aware of improving economic data and corporate profits. Yet, these types of data are backward looking and are not a guarantee of future trends. Even though the released economic data and corporate profits have been strong, our forward-looking indicators for both EM and China have been heralding and continue to point to a major downtrend in EM profits (Chart I-7). Chart I-6Subtle Upside Risks To U.S. Inflation Chart I-7EM Profits Are At Risk Importantly, I presume stock prices lead profits. Hence, it is dangerous to turn bullish when forward-looking indicators that lead profits are already flashing red. These are empirical indicators and have a great track record. As such, I have placed substantial weight on them rather than on backward-looking economic and profit data. Since early 2017, I have been facing the following dilemma: Should I change my view based on strong, yet backward-looking, profit data, or remain cautious based on forward-looking growth indicators as well as our big-picture themes. I chose the latter, which in retrospect was wrong. Looking back, the biggest mistake I made was putting little weight on how markets have been trading. EM and global stocks continue to trade as they would in a genuine bull market: they have looked past negative news and rallied a lot in response to positives. Ms. Mea: You mentioned big-picture themes. Can you elaborate on your framework and methodology? Answer: At the core of my analytical framework lies investment themes. I formulate these themes based on a series of in-depth research reports. These themes have multi-year relevance - I expect them to have staying power beyond one year. These themes represent an anchor to my view and strategy. Without anchor themes, I would tend to change my views back and forth based on fluctuations in economic data or swings in financial markets. Having established themes, my team and I monitor cyclical data, market dynamics/signposts and any type of evidence to prove or refute those established themes. Clients have recently been asking why I only show charts/evidence that confirm my view, and rarely entertain the alternative scenario. Indeed, there are always contradictory signals, signposts and data that I identify every week. Yet, I still choose to show those that support my ongoing themes and views. Why? Because I opt to convey a well-argued coherent message to my clients. In this context, I use the limited client-time allocated to reading our reports to highlight the reasons supporting my current themes and high-conviction views. It would also be unhelpful for readers if I demonstrate several charts that herald a bullish stance, and then conclude the opposite. If I were to utilize the alternative approach, i.e., present data and evidence on both sides of the debate, the report would be ambiguous. As a result, readers would gain little conviction and would likely be left confused. Each of these approaches has advantages and disadvantages: when the view plays out, investors see the correct angle and, thereby, develop a strong conviction on the strategy, and hopefully act upon it. Conversely, when the view goes wrong, investors typically wish they had seen the opposite side as well. Chart I-8China: No Deleveraging So Far In short, my goal is to leave clients with a clear and well-argued message when I have high conviction. As to conviction level, like all investors, I am dealing with a black box when gauging the outlook for financial markets. I am never 100% certain; I make investment recommendations only when my conviction level is somewhere around 65-75%. Generally, I do not discuss the areas where my conviction level is less than 60%. Less than 60% means "I do not know". An example of this is whether the current tech rally will persist. Importantly, I try to bring to clients' attention data and evidence that they may not be aware of and analytical points that differ from commonly known market narratives. Investors are aware of overall global financial market dynamics and ongoing narratives. My goal is to add value to their knowledge with the framework of thematic investment research, and to highlight new and potentially market moving charts, data and evidence. My major theme on China in the past several years has been the following: Chinese banks have originated too much money, and the corporate sector has taken on a large amount of leverage. This, in tandem with speculative excesses in the shadow banking and property markets, pose considerable downside risks to capital spending growth in the mainland. This is especially the case given that both liquidity and regulatory tightening of banks and non-banks already begun in late 2016. While financial markets, economic data and corporate profits have gone against this theme, this does not mean credit/money excesses in China have disappeared or do not exist. On the contrary, they have gotten even bigger now (Chart I-8, top panel). The Chinese economy has recovered and benefited commodities prices and the rest of EM due to another round of substantial money/credit injection. Broad money and broad credit have surged by about RMB 45-50 trillion since the middle of 2015 - depending on which measure one uses (Chart I-8, bottom panel). In the context of mushrooming leverage, ongoing policy tightening entails a poor risk-reward profile for bullish bets on mainland growth. This is why I am reluctant to abandon this theme and the bearish view. Ms. Mea: What would it take to change your big picture theme on China? To fundamentally reverse my view on China and commodities on a multi-year time line, I would need to reject my theme that China has meaningful credit excesses and imbalances, or buy into the view that these imbalances are a natural outcome of China's excess savings and will never correct. I have strong conviction in my big picture theme and I have not seen convincing arguments to change it. That said, if I come to the conclusion that EM risk assets and China-related plays will rally for six months or longer, I will change the investment strategy and recommend playing that rally. In this case my market strategy will change even though the big picture theme remains intact. As to the relationship between national and household savings, credit, and money, I have elaborated at great length that money creation and credit excesses do not originate from excess savings.2 Hence, it is simply not natural for a country with excess savings to experience and sustain credit bubbles. Importantly, adjustments in terms of credit excesses/deleveraging in China have not even started (Chart 8, top panel). This does not imply that investors should wait until deleveraging ends before turning positive on mainland growth. Markets are forward looking and will bottom when they see the light at the end of tunnel. But it is very dangerous to be positive when the adjustment has not yet began. It appears China's capital spending in general and construction in particular - the most vulnerable and credit-dependent segments - have in recent years been fluctuating in mini-cycles, similar to what played out in Japan during the 1990s and 2000s. I am not suggesting that China resembles Japan entirely, but comparing their mini cycles is a worthwhile exercise. Chart I-9 shows that the Japanese economy, money, credit and share prices were on a rollercoaster ride in the 1990s and 2000s. Notably, the profile of Chinese H shares fits the profile of Japan's stock market during that period (Chart I-10). On average, the recovery phase of these mini-cycles/equity rallies lasted about 20-24 months. Chart I-9Mini-Cycles In Japan In The 1990-2000s Chart I-10Chinese H-Shares Now And Nikkei In 1990s My judgment is that the recovery in the Chinese economy and related financial markets over the past 18 months resembles the mini cycles Japan experienced in the 1990s and 2000s. If so, after the rally in the past 18 months, forward-looking investment strategy should be focused on identifying signposts of a reversal. Consistently, given my bias stemming from our core themes and the fact that financial markets are forward looking and have already rallied a lot, I have been looking for signs of a top in China's business cycle and Asia's trade flows. It is pointless for me to change the view if my bias is that markets will reverse their trend in the next couple of months. Investors who are bullish and long but are somewhat concerned about China's growth sustainability still may want to monitor and be aware when the business cycle and markets will reverse. This is where I believe our research is helpful and relevant to investors with a bullish bias. It is hard to forecast what would be an inflection point to overturn the current financial market trend. It could be an unambiguous message from China's Communist Party Congress in the coming days that containing financial risks - a code word for deleveraging - is a major policy priority, or it could be weak economic data in China, or lower commodities prices and weaker EM currencies, being the flipside of a stronger dollar. Chart I-11China: Beware Of Rising Inflation Ms. Mea: It seems there is no silver lining in your view. Does this mean Chinese policymakers cannot do much to generate a positive outcome for the economy and financial markets? Answer: Chinese policymakers are in a very tough position. Yet it does not mean there is no silver lining. I assign a 20-25% probability that policymakers can stabilize leverage in the economy and financial system without a meaningful growth slump. If this scenario transpires, my negative view on EM and China-related plays will continue to be wrong. There is a 40-45% probability that growth will slump as the authorities focus on deleveraging and structural reforms (allowing markets to play a greater role in resource/capital allocation), and that policy tightening will begin biting. This heralds a deflationary outcome from a cyclical perspective, but it also represents a necessary adjustment to ensure efficiency gains and productivity-led growth over the long run. In fact, this would make me structurally bullish on China's growth again. There is also a 30-35% probability that policymakers - having no tolerance for any kind of growth slump - will continue to stimulate via money/credit and fiscal deficits. The outcome of this scenario will be an inflation outbreak Notably, as I argued in the October 4th 2017 report,3 underlying inflationary pressures are rising, as shown in Chart I-11. Unless growth decelerates meaningfully, inflation will need to be tackled. If not, capital outflows from residents will escalate again, and the currency will come under depreciation pressure given that the deposit rate is at a very low 1.5%. Rising inflation limits policymakers' maneuvering room: they have to tighten and cannot stimulate rapidly and considerably when growth slows. In short, a silver-lining scenario - which would include the authorities curbing out excesses while preserving overall growth, and especially capital spending growth - is always there and is a well-known narrative in the investment community. I do not write about it because I assign a 20-25% probability of it actually panning out. Why not more? Because the imbalances and excesses are currently so large that it will be difficult to contain them without jeopardizing growth. Finally, my view on China does not spread to the entire economy - our focal point has been and remains capital expenditures in general and construction in particular. These areas are being financed by credit, and consume a lot of raw materials and capital goods. Mainland imports - which are heavy in commodities and capital goods (the two account for 95% of total imports) - are the link between mainland investment expenditures and the rest of the world in general, and EM in particular. The latter will suffer if Chinese imports contract. Ms. Mea: It seems your big-picture themes have considerable influence on your views and strategy. How have your big-picture investment themes evolved over time? Last decade, my overreaching theme was that EM and China were structurally sound and that EM/China/commodities were in a bull market. So, I went from being a staunch bull to a resolute bear. I took over the EMS strategy service in 2005, and was bullish on EM, China and commodities up until 2010 (Chart I-1 on page 1). In 2005, I published an in-depth report arguing that commodities were in secular bull market due to demand from China.4 In April 2006, I pioneered a new theme that in the case of a U.S./DM recession, EM could stimulate and boost domestic demand - an out-of-consensus thesis5 at the time. Having these themes in mind, I recommended upgrading/accumulating Chinese stocks amid the Lehman crisis in the fall of 2008.6 The message was that Chinese policymakers could and would stimulate, and that such stimulus would succeed in lifting Chinese growth, corporate profits, commodities prices and EM risk assets. That was a non-consensus trade at the time, and the exact opposite of my current view. Following the credit boom in EM/China in 2009-10, excesses and imbalances emerged, and I shifted to a negative stance on EM/China in 2010 (Chart I-1 on page 1). Furthermore, in our June 8, 2010 Special Report titled, 'How to Play EM This Decade,' I made a call on a major top and forthcoming bear market in commodities arguing that the 2010-decade leaders in terms of growth and share price performance would be the healthcare and technology sectors. I speculated that during the current decade mania will unfold either in the technology or heath care sectors or some combination of both. Since 2010, the technology and healthcare equity sectors have been the best equity sectors, while commodities have been the worst performing ones within both the global and EM equity space. Consistent with this theme, I have been overweighing EM technology stocks and bourses where tech has a large weight, such as Taiwan, China and Korea. Besides, since 2010 I have maintained a pair strategy recommendation of being long tech and short materials. Ms. Mea: It seems you have been changing the goalposts lately, using new data on Chinese money and credit instead of relying on traditional ones. Our research is an ongoing effort to understand the macro landscape better. Our objective is always to find new variables and indicators that better lead business cycles and corporate profits while continuing to track the existing ones. Thus, it is not about changing goalposts but refining existing indicators or examining alternative ones that have a better track record. The following aspects have led usintroduce new broad money measures in China: Over the past two years, official M2 has been much weaker than various credit and money measures, as illustrated in the top panel of Chart I-8 on page 8. Broad money, and hence new purchasing power, is created when banks originate credit - by lending to or buying claims on non-bank entities. Therefore, properly measuring broad money is vital to assessing the new purchasing power that is created in the economy. In brief, in 2016 and early this year I relied on China's official broad money M2 measure, but it has underestimated the amount of new purchasing power created in the past two years. This was one of the reasons we misjudged the duration and magnitude of this equity rally. In addition, the regulatory clampdown on banks and non-banks may have prompted them to shift credit assets from off balance sheet to on balance sheet, or vice versa. Banks and shadow bank entities can obscure or hide credit by classifying it differently, but the banking system cannot conceal the amount of money in the system. Therefore, by tracing broad money creation, one can trail new purchasing power originated by banks. For these reasons, we have begun calculating new broad money aggregates for China - we produced our measure of M3 (M2 plus some other banks liabilities that are not included in M2) and credit-money (broad money calculated using the asset side of commercial banks' balance sheets). Chart I-3 on page 3 illustrates that all measures of money and credit have slowed in late 2016 and this year. On balance, having examined various measures of money and credit, including official M2, we have concluded that in the past 12 months money/credit creation has been slowing in China, irrespective of which aggregate we focus on (please refer to Chart I-3 on page 3). Ms. Mea: How do you explain strong September money and credit numbers out of China? Money, credit and business activity data for September were indeed strong, but they should be adjusted for working days. In China, the annual Mid-Autumn Festival fell in October this year versus September over the past several years. During this festival, business activity grinds to a halt for several days. I conjecture that money, credit and growth data out of China and Asia in general was strong in September partially due to the increase in the number of business days in September this year versus September a year ago. We need to wait for October data and average the two months to get a better picture of the trajectory of the business cycle in Asia. Chart I-12China: Velocity Of Money Has Been Declining Ms. Mea: Your view on China, commodities and EM is largely contingent on very weak money growth. Is it possible that the correlation between money and economic growth has diminished or completely broken down in China? The only reason why broad money growth could deviate from nominal GDP growth is due to the rising velocity of money. Let's remind ourselves: Nominal GDP = Money Supply x Velocity of Money. For nominal GDP growth to rise, a considerable decelaration in money supply growth needs to be offset by an even larger acceleration in the velocity of money. It is extremely difficult to forecast velocity of money. I assume money velocity will be steady (constant) and, consequently, nominal GDP growth to be affected primarily by changes in broad money growth. Chart I-12 demonstrates that the velocity of money in China has been declining over the past eight years. So, it would be odd for the velocity of money to suddenly rise going forward, in turn making money growth a less reliable indicator for nominal GDP growth. Overall, while it is always possible that the correlation between money growth and economic activity can break down, it is not something that one can forecast or bet on with high conviction. Chart I-13EM Ex-China, Korea And Taiwan: ##br##Broad Money And Bank Loan Growth Is Weak Ms. Mea: What about other emerging markets? How dependent are they on China? Where are they in the business cycle? The link from China to other emerging markets is via commodities and EM countries' other exports to the mainland. Even non-commodity countries like Korea and Taiwan sell a lot to China. If Chinese growth decelerates, commodities prices relapse, the U.S. dollar rallies or the RMB comes under selling pressure, the outlook for other EM countries and their risk assets will be dim. I argued that EM currencies, credit, and stocks on aggregate levels are not cheap.7 Segments that appear attractively valued are cheap for a reason, while healthy segments (countries/sectors/companies) are rather expensive. Money and bank loan growth also remain lackluster in the majority of EM, excluding China, Korea and Taiwan (Chart I-13). The reason is that the banking systems in many of these developing countries have not been restructured and remain sick following years of overextended credit and rising non-performing loans. Therefore, even though EM exports to China and the rest of the world have picked up, there has been little recovery in their domestic demand. If external conditions - exports, exchange rates and borrowing costs - deteriorate anew, EM domestic demand recovery will be derailed. Investors often refer to Russia and Brazil when they cite macro adjustments in developing economies. It is true that Russia and Brazil have already gone through a lot of pain and adjustment, including provisioning for NPLs in their respective banking systems. Nevertheless, financial markets in both countries remain dependent on commodities prices and the U.S. dollar outlook. Barring external shocks, both economies will continue to revive. That said, my big-picture view entails a negative shock to EM sentiment due to China and a rally in the greenback so I cannot turn bullish on them yet. In addition, Brazil's public debt is rising in an unsustailable manner, and political risks remain significant, particularly ahead of next year's elections. It will be hard to boost nominal growth and contain the explosion of public debt without meaningful currency depreciation that reflates the economy. That cannot not bode well for foreign investors in Brazilian markets. Credit excesses continue to linger in some other EM economies, and there has been little adjustments in their leverage even when we remove China, Korea and Taiwan from the aggregate (Chart I-14). All in all, while some EM economies have undergone necessary macro adjustments, the largest economy - China - has not. When China begins its own macro adjustments, shockwaves will likely hit Asian economies and commodities producers. There are not many large developing countries outside Asia that are not raw materials exporters. Ms. Mea: What about the technology sector? It alone has been responsible for a substantial portion of price gains in the EM equity benchmark in this rally. Does your view on China's credit cycle also influence your outlook for technology stocks? Indeed, EM tech stocks have exploded in recent years, accounting for a significant portion of EM share price appreciation. Excluding tech stocks, EM equities have not rallied nearly as much (Chart I-15). Chart I-14EM Ex-China, Korea And Taiwan: ##br##Leverage Has Not Diminished Chart I-15EM Equities: Tech Versus Non-Tech Also, Table I-1 reveals that eight out of 11 equity sectors have underperformed the benchmark. Meanwhile, a large share of tech gains has been produced by five or so companies. Table I-1EM Sectors: Only Three Out Of 11 Sectors ##br##Outperformed The Benchmark I have no strong view on the technology sector's absolute performance following the exponential price gains of past years. Overweighting the technology sector has been my recommendation since 2010, as we discussed above, and it has panned out quite well. I still maintain this overweight call, but within the technology sector we prefer semis to internet and social-media stocks. On the second part of your question, my negative view on China's credit cycle does not have direct ramifications for technology stocks, including Chinese ones. Critically, the call on internet- and social media-related companies is a bottom-up call. On the macro level, I can only state the following: It is essential to realize that in the past nine years a lot of new purchasing power in China has been created because of explosive money origination by banks. If money/credit growth structurally downshifts in China in the years ahead, nominal income growth for both households and companies will slow and the growth in their spending power will also moderate. That said, I am not in a position to assess and comment on business model viability and equity valuation levels of internet and social media-related companies like Alibaba, Tencent or Baidu. As to the other two tech heavyweights - Samsung Electronics and TSMC - I continue to recommend an overweight position in semis and other tech stocks that stand to benefit from DM growth. However, I am less certain about their absolute performance given their exponential rally. Chart I-16EMS's Fully-Invested Equity Portfolio ##br##Performance Versus The Benchmark Finally, regardless of my view on EM absolute performance, we always add value to dedicated EM equity and fixed-income investors by selecting countries to overweight and underweight relative to their respective benchmarks. Our country equity allocation strategy has been very successful. Chart I-16 illustrates our country fully-invested equity portfolio performance versus the EM benchmark. The portfolio is built based on our overweight and underweight recommendations on individual bourses, and is assumed to be fully invested. Our country calls have done quite well in the past nine years, producing 58% outperformance versus the benchmark with extremely low volatility. This translates into 520 basis points of annual compound outperformance for nine years. Our recommended country allocation and other equity positions as well as fixed income and currency recommendations are published at the end of each week's report. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report titled "Revisiting China's Fiscal And Credit Impulses," dated April 13, 2016, link available at ems.bcaresearch.com 2 Please refer to the Emerging Markets Strategy Special Reports from October 26, 2016, November 23, 2016 and January 18, 2017; available on ems.bcaresearch.com 3 Please refer to the Emerging Markets Strategy Weekly Report titled, " China: Deflation Or Inflation?," dated October 4, 2017; link available on page 21. 4 Please refer to the International Bank Credit Analyst Special Report titled, "Commodities: Buy On Dips," dated April 2005. 5 Please refer to the Emerging Markets Strategy Special Report titled, "Global Monetary Tightening And Emerging Markets: Is It Different This Time?"dated April 19, 2006. 6 Please refer to the Emerging Markets Strategy Special Report titled, "Upgrade/Accumulate Chinese Stocks,"dated September 29, 2008. 7 Please see Emerging Markets Strategy Weekly Report titled "Is The Dollar Expensive, And Are EM Currencies Cheap?" dated October 11, 2017, link available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Special Report

Highlights On Black Monday, October 19, 1987, equity bourses around the world plunged amid cascading bouts of selling, recording some of their largest single-day losses of the twentieth century. The plunge, exacerbated by derivatives transactions, and transmitted swiftly around the world, marked the first contemporary global financial crisis. BCA clients were well prepared. The Bank Credit Analyst steadily warned of increasing stock market vulnerabilities across all of 1987 even as it correctly predicted that the S&P 500 would most likely soar before eventually cracking. The Federal Reserve's immediate all-out effort to contain the damage ushered in a new central bank template for responding to quaking markets and helped give rise to the Greenspan put. While we do not fear a repeat of Black Monday, the U.S. equity market's long-term prospects are dramatically less appealing than they were in 1987. Investors should be prepared for an extended stretch of public market returns that pale beside the ones earned over the last 30-plus years. Feature 30 years ago today, Black Monday erupted around the world, reaching its nadir in New York, where relentless waves of selling drove the major indexes down 20%. The contagion had spread in a rapid relay from Hong Kong to Europe and then to New York, before fetching up in Auckland and other Asia-Pacific exchanges as Black Tuesday. The event was the centerpiece of what turned out to be sharp, albeit relatively brief, bear markets around the world (Charts 1 and 2). Confounding nearly every observer, however, the crash did not amount to much in a broader economic context and financial markets quickly regained their footing, with global equities vaulting to new highs in the '90s1 amidst speculative excesses that made the '80s' mania look demure. Chart 1Great Runs... Chart 2...And Sudden Stops Like all serious investors, BCA researchers are students of history. Black Monday was the first modern global financial crisis, and its 30th anniversary affords us the chance to study its run-up and aftermath for insights into future dives. It also gives us the chance to return to BCA's extensive archives and see how our forebears assessed conditions in real time. Their ex-ante analysis and forecasts were stellar, and reinforce the robustness of our approach. Their lagging ex-post performance highlights the need for investors to maintain a flexible mindset that can accommodate all possibilities. From Fear To Greed Black Monday marked the definitive end of a historically potent bull market (Table 1) that began, as the best ones do, in revulsion. Business Week's August 1979 cover story trumpeting the death of equities has become notorious, but the S&P 500 didn't bottom for three more years, during which it lost a quarter of its inflation-adjusted value. All told from the end of September 1968 to the end of July 1982, the S&P tumbled 62.5% in real terms (Chart 3). Inflation took a heavy toll on real growth over the 55 quarters of U.S. stocks' lost decade and a half (Chart 4, top panel), but the economy had expanded nonetheless, and stocks emerged from the ashes of the Volcker double-dip recession with a lot of ground to make up. Table 1A Bull With Speed And Stamina Chart 3A Lost Decade And A Half ... Chart 4...Despite Steady, If Unspectacular, Real Growth The ensuing five-year bull market (Chart 5, top panel) unfolded in two phases: the first, which burst out of the gate on a sudden repricing before taking a full year to catch its breath, had the support of earnings growth (Chart 5, middle panel) and re-rating; the second, which went on without pause for two and a half years, was all about re-rating (Chart 5, bottom panel). It finally ended in late August 1987, when skeptical investors could no longer stomach big gains derived entirely from multiple expansion, and stocks began to retreat in earnest in October, sliding 5% and 9% in the two weeks before Black Monday. Proximate triggers included sickly trade data, a competitive devaluation threat and proposed tax legislation that stood to make corporate takeovers a good deal more costly. The first two factors pushed the dollar down and yields up, as investors fretted that the Fed would be forced to raise rates (Chart 6), and the last pulled the plug on runaway speculation in takeover targets. Chart 5A Two-Act Bull Market Chart 6Be Careful What You Wish For The Echo Chamber, ... There is career safety in numbers, but portfolio danger. As the late Barton Biggs put it, there's no investment so good that it can't be destroyed by too much capital. Portfolio insurance may not have even been a good idea, as it didn't amount to anything more than a portfolio-sized stop-loss order, souped up with computer software and derivatives contracts. But by the fall of 1987, its widespread adoption had turned it into a very bad one. Portfolio insurance was developed in the late '70s by two finance professors who sought a method that would allow investors to participate in equity market gains while limiting their downside exposure. When stocks began to decline in the direction of a set downside limit, the portfolio insurance program would reduce net equity exposure via the sale of index futures. Once the market recovered and the program determined the coast was clear, it would unwind the futures positions. Although the technique had its flaws on a micro scale - futures trading wasn't costless, and there was considerable potential for whipsawing - it was doomed at the aggregate level because the index futures market wasn't deep enough to accommodate all the selling pressure that would be unleashed by a significant correction. ... Or, From Wall Street To LaSalle Street And Back Again There was more to Black Monday than portfolio insurance - the event was global, and the technique was not a factor on other bourses - but it helped to create a self-reinforcing spiral between the cash market in New York and the futures market in Chicago. Heavy selling of stocks in New York triggered heavy selling of index futures in Chicago, as insured portfolios sold futures to mitigate their direct cash exposures. The selling redounded back to New York as the futures buyers on the other side of the trade sold the underlying stocks to balance out their long futures positions2 and opportunistic investors seized the chance to front-run the mechanical portfolio insurers.3 The new sales pushed share prices even lower in New York, triggering more index futures selling in Chicago, and cinching the vicious circle. The View From Peel Street BCA, safely removed from the madding crowd in Montreal, foresaw something quite like the crash. The September 1986 and 1987 editions of our annual New York conferences bore the respective titles, "The Escalation in Debt and Disinflation: Prelude to Financial Mania and Crash?" and "Phase II in the Escalation of Debt, Disinflation and Market Mania: Prelude to Financial Crash?" Throughout all of 1987, the monthly Bank Credit Analyst warned of the U.S. equity market's increasing vulnerability and recommended that investors reduce exposure in a disciplined fashion ahead of the inevitable bust. The investment policy recommendation, issued in accord with prudent money management principles, differed from BCA's market forecast, which was for robust, potentially parabolic, gains before the bull market ended. BCA was not trying to have it both ways: it has long been a central tenet of our work that one's investment strategy can - and regularly should - be distinct from one's market forecast. We do not attempt to squeeze every last drop out of a bull or a bear market. Empirical evidence makes it abundantly clear that no one can consistently call tops or bottoms. In the words of turn-of-the-century trading legend Jesse Livermore: "One of the most helpful things that anybody can learn is to give up trying to catch the last eighth - or the first. These two are the most expensive eighths in the world.4" The opening paragraph of the March 1987 Bank Credit Analyst, published six months before the market peak, summarizes our ongoing advice: [I]nvestors who are overexposed should reduce positions to a level comfortable to ride out what will likely become a much more volatile phase of the secular bull market in stocks. ... At some point, it is likely that the U.S. stock market will experience a 1962-type correction - a sharp decline which comes out of the blue as a result of extreme overvaluation and excessive speculation. As then, it is unlikely to be associated with a credit crunch, as almost all post-war bear markets have been. ... At present, there is nothing in the data, either fundamental or technical, which suggests that such a shakeout is imminent. However, the key for investors in this bull market is to have positions which are sufficiently comfortable so that they can ride out sudden, dramatic corrections and participate in the long upward rise, which we feel has much further to go. (pp. 3-4) Eighteen months before the August 25th peak, the March 1986 Bank Credit Analyst's Section III was titled, "The Coming Financial Mania," and its strategy prescriptions were much more aggressive, even as it acknowledged the risks: Increasing volatility should be expected both because of the still lingering risks prevailing and the dramatic price movements in recent months. Hence, conservative investors should not overtrade. To fully capitalize on the ongoing revaluation of financial assets, it is important not to lose positions as a result of the necessary sharp corrections which will be experienced along the way. The stock and bond market potential over the next 2-3 years remains extraordinary. (p.11) The great dilemma for investors is, of course, how aggressively to play the game during the latter stages. The fascination, excitement and danger is the knowledge that vast fortunes are easily made right up to the end, but there is no reliable method to get out just before the crash. [...] Frequently the bubble goes on much longer and prices go far higher than anyone can imagine [...]. Yet, the vulnerabilities grow proportionately to the power of the manic phase. (p.26) Investment strategy in [a manic] environment must be based on the historically observed phenomenon that price appreciation generally accelerates to a climax or blowoff and that the hidden risks grow exponentially with price rises. Therefore, investors must constantly guard against the natural tendency to become increasingly greedy and careless in valuation standards as prices rise. (p.41) As good as BCA's near- and intermediate-term calls were in the run-up to the '87 crash, our longer-term calls were even better. We repeatedly argued that disinflation would be a secular trend, and that it would power secular bull markets in bonds and equities. Three decades on, with the Barclays Aggregate Index, the Barclays High Yield Index and the S&P 500 having produced real annualized total returns of 5%, 9.3% and 7.6%, respectively, the call has been vindicated (Table 2). As BCA foresaw, the harsh monetary medicine administered by the Volcker Fed to slay the inflation dragon has paid hefty market dividends. Table 2A Great Three Decades For Financial Assets The Trouble With The Austrians For all that BCA achieved ahead of Black Monday, and as correct as our long-term calls from the '80s turned out to be, it must be acknowledged that we missed the boat on getting back into equities after the crash. Part of the miss is understandable: one wouldn't expect the strategist with the most prescient call ahead of a downturn to be the first one to identity the beginning of the subsequent rally. The best investors are the ones with the supplest minds, however, and the BCA archives reveal a bias that may have gotten in the way of embracing more bullish near-term outcomes. To wit, one cannot read the 1988 and 1989 Bank Credit Analysts, and indeed, our original leaders' output, without detecting strong sympathies for the Austrian School of Economics (Box 1). BOX 1 An Austrian's Lonely Lot The Austrian School of Economics most saliently parts company with neoclassical economics in its adamant opposition to government intervention and its fraught relationship with credit. Instead of intervening to counter business cycles, Austrians would prefer to let busts run their course so as to cleanse the economy of the excesses embedded in booms. They occupy the Mellonian, purge-the-rottenness-out-of-the-system end of the continuum in opposition to the Debt Supercycle's unconditional forgiveness. Austrians regard banking and credit with some measure of suspicion, as Austrian Business Cycle Theory holds that artificially low interest rates are the raw material of destabilizing booms. Encouraged by central bankers seeking to steer an economy out of recession with a bare minimum of discomfort, borrowers take on debt to invest in projects that may not be able to pay their own way were it not for intervention. Once rates rise after policy accommodation fades, the economy slows and the extent of the malinvestment is revealed. The Debt Supercycle prescribes more of the hair of the dog to alleviate the suffering from malinvestment. The debt overhang is thereby never eliminated; it instead continues to silt up, requiring larger and larger interventions. Unchecked, the degree of intervention required to keep the plates spinning will eventually exceed capacity. This analysis is logically sound, but it so thoroughly contradicts the reigning orthodoxy that an investor who becomes emotionally invested in it is at risk of serially tilting at windmills. There is nothing wrong with the Austrian School per se. We rather like its outsider status, and actively seek heterodox inputs and perspectives so as to stay out of the ruts of the well-worn consensus path. Even its pessimistic bent has its uses; investors are surely exposed to enough cheerleading. Its prescriptions are so bracing, however, that a little goes a long way and real-world users should handle them with care. A popular pair of You Tube videos of actors portraying Keynes and Hayek issuing dueling raps about their respective ideologies (Keynes: I want to steer markets/Hayek: I want them set free!) provide an entertaining example of the Austrian-inspired investor's dilemma. Keynes, drink after drink in hand, is the exuberant life of the party, while the sallow Hayek stares into the bottom of his glass, unable to capture any other partygoers' attention. The simple conceit animating the video - Keynesianism is fun; Austrians are dour scolds - resonates deeply with elected officials. Voters love free drinks, but hate being told to eat their vegetables. The Austrian School, therefore, is a poor guide to the path that policy is likely to take. It also has the problematic effect of introducing an element of moral judgment into what should be a purely objective sphere. Investors should have a laser-like focus on what is most likely to happen and should strive to suppress extraneous notions about what should happen. The Debt Supercycle is a brilliantly incisive way of viewing the interaction between constituents' desires and officials' incentives, and has predicted the long-run direction of policy to a T. Only someone with a focus on money flows, informed by exposure to Austrian Business Cycle Theory, could have come up with it. In the hands of BCA editors in the late '80s, however, it seemed to feed a desire to see the American economy get its comeuppance. Setting aside that desire for punishment - and value judgments altogether - is the clearest way that we could have done better in the aftermath of the crash 30 years ago, when BCA essentially sat out the December '87 - July '90 equity bull market. We should strive to be dispassionate and unbiased observers of the economy and markets. After all, the process illustrated by the Debt Supercycle concept has surely helped put the wind at equities' back throughout the postwar era (Chart 7). Making sense of it without decrying it could help us to provide even better counsel. Chart 7Equity Investing Is An Optimists' Game Then And Now Does 2017 look like 1987? Is another crash lurking just around the corner? Our answers are "no," and "no." We think the resemblances between then and now are merely superficial. The good news is that the probability of a Black Monday-style crash is remote, and we think that even a run-of-the-mill bear market is not likely until our most reliable recession leading indicators, which are still dormant, begin to flash red.5 While that view may come as a short-term relief, 1987's long-term market outlook was vastly superior. While both today's bull market and the '82-'87 bull market began with forward earnings multiples at multi-year lows, the trough multiple in 1982 was in the low sixes, nearly two standard deviations below the mean (Chart 8). Even though it more than doubled by the August '87 peak, it only just reached what is now the mean level for the entire series. This bull market has seen the S&P 500's forward multiple rise to a full standard deviation above the mean. Valuation is not everything, of course. It is a lousy short-term indicator and only issues a reliable intermediate-term signal at extremes. Long-term returns correlate closely with the cyclically-adjusted P/E ("CAPE"), however, and it is currently at levels only previously reached ahead of the 1929 and 2000 peaks (Chart 9). The frothy CAPE portends a tepid long-run U.S. equity outlook. Chart 8Not A Lot Of Room To Grow Chart 9Not The Stuff Of Secular Rallies Both of the bull markets emerged from the ashes of nasty recessions (Chart 10), but the periods' primary economic threats were polar opposites, as were the policy settings adopted to counteract them. The Volcker Fed tightened monetary conditions to the point of pain in the early '80s, plunging the economy into a double-dip recession for the express purpose of eradicating the scourge of double-digit inflation (Chart 11). After the financial crisis, on the other hand, the clear and present danger was the potential for the credit bust to trigger a deflationary spiral. The Bernanke Fed pursued unprecedentedly accommodative policy in response. Chart 10Similarly Nasty Recessions ... Chart 11... But Opposite Inflation Backdrops The policy measures of the early '80s were an example of swapping near-term pain for long-term gain, and they set the stage for secular rallies in financial assets that continue to this day. Once inflation was removed from the equation, interest rates had to fall, and they did so for 35 years. The extraordinary accommodation in the wake of the crisis was an attempt to stave off hysteresis, which boils down to mitigating near-term pain as an insurance policy against long-term pain.6 It may well have worked, but there is no such thing as a free lunch, and the Fed's exertions have likely pulled forward much of the bond and stock markets' future returns. Black Monday And The Fed Put Before the October 20th open, the Fed issued the following statement: The Federal Reserve, consistent with its responsibilities as the Nation's central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system. Although it was only 30 words long, the statement packed a punch. It signaled the Fed's willingness to fulfill its function as the lender of last resort and may also have prodded skittish banks into fulfilling their responsibilities as intermediaries. Behind the scenes, the Federal Reserve Banks of New York and Chicago were doing their utmost to keep the system functioning. New York Fed president Corrigan was twisting lenders' arms to keep credit flowing so the crash would not infect the banking system and the real economy.7 Meanwhile, the Chicago Fed wasn't letting the letter of the law keep it from "help[ing to] engineer a solution" when one of the biggest derivatives market participants "ran short of cash.8" The statement, and the vigorous offstage exertions, countered the Fed's determinedly low profile. These were the days, after all, when monetary policy actions were still regarded as something akin to state secrets. Wall Street firms employed "Fed watchers," who were charged with studying the tea leaves to determine if the Fed had adjusted policy. As late as January 1990, the Bank Credit Analyst could devote an entire Section III to the question, "Has the Federal Reserve Eased?" Some of Alan Greenspan's comments in his memoir may reflect after-the-fact boasting or burnishing, but Black Monday can be viewed as a policy watershed. After it, the Fed's conduct of monetary policy has become transparent to the point of oversharing. More meaningfully for investors, it marked the origin of the "Greenspan Put," the widespread notion among market participants that the Fed would do its best to ward off or mitigate financial market downdrafts. Are ETFs The New Portfolio Insurance? Responsibility for the crash cannot be precisely apportioned among factors, but all post-mortem analyses agree that portfolio insurance played a leading role. While it may well have proven harmless if pursued on a modest scale by a limited number of players, it morphed into a destabilizing force once a critical mass of investors embraced it. On Black Monday, it became a paradox of safety akin to the paradox of thrift: prudent and rational when practiced by one individual, but a metastasizing disaster when followed by a crowd. A reasonable roadmap for someone trying to spot parallels between then and now is to identify market products that may have become overly popular. Wall Street's tendency to wring every last drop out of financing innovations, coupled with investors' tendency to move in herds, can lead to excesses. The latest innovation to achieve wild popularity is the ETF. Is it possible that ETFs could exert the same destabilizing influence as portfolio insurance if investors' ardor for them suddenly cools? We think not. As our Global ETF Strategy service has argued, the claims about passive investing's dangers are overheated.9 The notion that index tracking is undermining price discovery disregards the power of incentives. Passive investing strikes us as the best cure for passive investing: if so many people are pursuing it that index-trackers begin to drown out active investors, the prospective returns to active investing will soar and money will rotate out of index-tracking strategies in sufficient quantity to correct the imbalance. Chatter about a passive bubble also fails to consider the source of fund flows into index-tracking ETFs. The oft-repeated statement, "so much money is flowing into ETFs that it's distorting prices across the board," does not hold up to scrutiny. Away from Japan and Switzerland, where QE purchases of ETFs are being funded with new yen and franc notes, ETFs are not being purchased with new investment capital that has materialized out of thin air. They are being purchased with existing investment capital that has merely been reallocated away from actively managed mutual funds (Chart 12). Chart 12Mirror Image Bubbles are always the result of speculative, excess-profit-seeking activity. Index-tracking ETFs are vehicles intended to deliver market returns. They are the opposite of a get-rich-quick scheme; they're the instrument investors turn to when they give up on quick riches. We do not worry that ETFs are the object of a bubble, or that they are in any way analogous to portfolio insurance in the fall of 1987. Investment Implications Black Monday was a one-off event that remained contained within the financial markets despite widespread fears that it would spread to constrict the broader financial system and the real economy. A lot has changed in 30 years, but the collision of algorithms, derivatives and global pressures squarely places it in our time. It is entirely possible that its elements could come together to create another massive single-day drop. A key difference between future single- or intra-day swoons, and the ones that have already occurred since the crisis, is that they will arrive while the Fed is tightening policy at the margin. The future swoons, then, may not be as likely to disappear quickly without leaving much of a mark. It may go too far to say that market infrastructure is vulnerable, but it would be too optimistic to assume that it has kept pace with the advances in rapid-fire trading and the increasing prevalence of algorithms. It may make sense for investors with less tolerance for risk to maintain an extra cash buffer to protect against swoons and to ensure that they have dry powder to exploit them when they materialize. We remain constructive on the global economy, however, and our house view recommends overweighting risk assets while maintaining below-benchmark duration within bond portfolios. We sympathize with investors who lament that nothing in the public markets is cheap, but synchronized global acceleration remains intact. None of our models are warning of imminent danger. We therefore remain fully invested but vigilant, seeking out signs that the long bull market may be running out of steam. After reviewing our shortcomings in the aftermath of Black Monday, however, we will seek with an open mind and will not attenuate our efforts by awaiting the rapture of a final reckoning, when the sheep and the goats will be separated according to their virtue. The whole point of policy makers' efforts to engineer a rising tide is to keep the goats, and the broader economy, from harm. Doug Peta, Senior Vice President Global ETF Strategy dougp@bcaresearch.com 1 Except in New Zealand, where Black Tuesday popped a bubble of such notable excess that the MSCI New Zealand Index today trades at less than two-thirds of its September 1987 high, and Japan, where the mania lasted until December 1989 and the MSCI Japan Index is still nearly 40% below its all-time high. 2 Index arbitrageurs would have followed the same pattern, but they were sidelined by delayed price quotes and the failure of the NYSE's automated order execution system, which kept them from accurately identifying and exploiting true arbitrage opportunities. 3 Portfolio insurance was no secret - it was estimated that $90 billion of assets were following the strategy - and its potential to amplify selling pressures in a vicious circle had been the subject of a widely followed Wall Street Journal column published a week before the crash. 4 Lefevre, Edwin. Reminiscences of a Stock Operator, John Wiley & Sons, Inc.: Hoboken (NJ), pp. 57-8. Until 1997, the prices of NYSE-listed stocks were quoted in eighth-of-a-dollar increments. 5 For details on the interaction between recessions and equity bear markets, please see the August 16, 2017 Global ETF Strategy Special Report, "A Guide to Spotting and Weathering Bear Markets," available at etf.bcaresearch.com. 6 Hysteresis is the process by which a negative cyclical phenomenon, if left unchecked, can evolve into a secular phenomenon. 7 Greenspan, Alan. The Age of Turbulence: Adventures in a New World, Penguin (New York): 2007, p.108. Greenspan disavowed knowledge of the details, but suggested that Corrigan, "the Fed's chief enforcer," "bit off a few earlobes" while encouraging bankers to keep in mind that, "'if you shut off credit to a customer just because you're a little nervous about him, but with no concrete reason, he's going to remember that'." 8 Greenspan, p. 110.

Highlights The uptick in world oil demand in the wake of a strengthening global upturn - the first since the Global Financial Crisis (GFC) - coupled with continued production discipline by OPEC 2.0, will accelerate inventory draws, and lift prices above our previous expectation. Even though we expect - and model for - U.S. shale producers to step up drilling as a result, we are lifting our base case forecast for 2018 Brent and WTI to $65.15/bbl and $62.95/bbl, respectively. These estimates are up $5.51 and $5.98/bbl from our forecast last month.1 Energy: Overweight. Given our view (discussed below), we are taking profits on the long Dec/17 WTI call spread we recommended June 15 - long $50/bbl calls vs. short $55/bbl calls - on the close tonight. This position was up 116% Tuesday. We will replace this spread with long $55/bbl WTI calls vs. short $60/bbl WTI calls in Jul/18 and Dec/18. Base Metals: Neutral. We closed our short Dec 2016 copper trade last week, after our trailing-stop of $3.10/lb was elected, with a 0.75% return. Our trade was up 6% by the end of September, however bullish data in October - including an earthquake in Chile and worries over a potential metal shortage in China - lifted prices back up. Chinese copper import data showed a 26.5% year-on-year (yoy) jump in September. Even so, we expect copper imports to end 2017 with a yoy decline. Precious Metals: Neutral. Palladium continues to trade premium to platinum following its breakout at the end of September. We expect this to continue, given the supply-demand fundamentals we highlighted in June.2 Ags/Softs: Neutral. The USDA's latest World Agricultural Supply and Demand Estimates (WASDE) is supportive of our grains view - projections for 2017/18 wheat ending inventories were revised upward, while corn and soybeans stock estimates were lowered. Our long corn vs. short wheat position recommended October 5 is up 1.5% (please see p. 8 for further discussion.) Feature The global uptick in GDP growth noted this month by the IMF, along with continued production discipline from OPEC 2.0 - the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia - will lift 2018 average Brent and WTI prices to $65.15/bbl and $62.95/bbl, respectively. These estimates are up $5.51 and $5.98/bbl from our forecast last month (Chart of the Week). Chart of the WeekHigher Demand, Lower Supply,##BR##Tighter Inventories Lift Prices We expect the fortuitous combination of fundamentals - for oil producers, that is - to accelerate the drawdown in oil inventories globally, which also will be supportive for prices (Chart 2). This, in turn, will set off a new round of U.S. shale-oil production, which will temper the price rise we expect, but still force inventories to draw harder than expected (Chart 3). Our base case calls for OPEC 2.0 to extend its 1.8mm b/d production cutting deal to end-June 2018, and for compliance within the KSA-Russia-led coalition to remain strong. OPEC 2.0 member states compliance with self-imposed quotas stood at 106% of agreed cuts, according to a state-by-state tally published by S&P's Global Platts earlier this month.3 Iraq continues to flaunt its OPEC 2.0 production quota, at 4.54mm b/d by our estimate, or 153k b/d over its quota. OPEC as a whole is producing 32.74mm b/d of crude oil, by our reckoning, vs. Platts' estimate of 32.66mm b/d. We have Libya and Nigeria, which are not parties to the OPEC 2.0 Agreement, producing 930k b/d and 1.71mm b/d last month, vs. Platts' estimates of 910k b/d and 1.84mm b/d, respectively (Table 1). KSA and Russia continue to lead OPEC 2.0 by example, with the former's crude oil production coming in at 9.97mm b/d in September, vs. 9.95mm b/d in August; the latter's total liquids production was 11.12mm b/d, vs. 11.13mm in August (Chart 4). Chart 2Market Will Get##BR##Tighter Sooner Chart 3BCA Expects Sharper##BR##Inventory Draw Than EIA Chart 4KSA And Russia Continue##BR##Providing Leadership To OPEC 2.0 Global GDP, Oil Demand Growth Strengthens The IMF earlier this month raised its forecast for global GDP growth this year to 3.6% and to 3.7% for next year, up 0.1% for each year vs. previous forecasts. In its analysis, the Fund drew attention to: Notable pickups in investment, trade, and industrial production, coupled with strengthening business and consumer confidence, are supporting the recovery. With growth outcomes in the first half of 2017 generally stronger than expected, upward revisions to growth are broad based, including for the euro area, Japan, China, emerging Europe, and Russia. These more than offset downward revisions for the United States, the United Kingdom, and India.4 On the back of the IMF's revised global growth estimates, we lifted our 2017 and 2018 oil demand expectation to just under 47.5mm b/d on average for the OECD and to just under 52mm b/d for non-OECD economies (Table 1). This translates into global demand growth of 1.65mm b/d in 2017 and 1.69mm b/d in 2018. Notably, we expect global demand to exceed 100mm b/d on average next year in our base case. Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Our estimated demand is driven by global growth projections, particularly for EM economies, which make up the bulk of demand and growth in our balances estimates (Table 1). And, as before, our estimates remain above the EIA's (Chart 5). The indicators we look at to confirm or refute our demand assessment - global trade, particularly EM imports, and manufacturing - remain strong. Global trade continues to expand, particularly in EM ex-Middle East and Africa, as does manufacturing globally, both of which supports the IMF's assessment of growth generally (Charts 6 and 7). Rising incomes lead to rising trade, and also to increased oil and base metals consumption in EM economies. Chart 5We Continue To##BR##Estimate Higher Demand Than The EIA Chart 6Rising Trade Volumes##BR##Support Growth Story ... Chart 7... Expanding Manufacturing##BR##Does, Too Higher Prices, Greater USD Risk Expected In 2018 Given the upward revisions to global growth and our expectation OPEC 2.0 compliance will remain fairly stout, our baseline forecast now calls for WTI prices to average $56.40/bbl in 4Q17 and $62.95/bbl in 2018. Brent is expected to average $58.40/bbl in 4Q17 and $65.15/bbl next year (Chart 1 and Table 2). These estimates are up from last month's averages of $54.89 and $57.44/bbl for 4Q17 and 2018 WTI, and $56.67 and $59.17/bbl for 4Q17 and 2018 Brent.5 Our increasing bullishness is tempered by the risk of a stronger USD, particularly the broad trade-weighted USD index, which captures EM currency weakness. With the Fed set on a course to lift rates - our House view anticipates a Dec/17 rate hike and two or three hikes next year - and the oil market getting fundamentally tighter, we have seen the oil-USD linkage being re-established recently (Chart 8). Table 2Upgrading Our##BR##Price Forecasts Chart 8Expect The USD To Be Less##BR##Determinant For Oil Prices The persistent negative correlation between oil prices and the USD broke down following the global asset sell-off in 1Q16. However, this relationship converged to its long-term equilibrium in recent months. In our view, this reflects market participants' increasing conviction - expressed in market-cleared prices - that OPEC 2.0 will maintain its supply-management accord for an extended period, and that supply is now stabilizing. With demand remaining robust as the global synchronized upturn continues, the fundamental side of price determination has stabilized, and financial variables once again will strongly influence oil prices at the margin. Given our view the USD will trade off interest-rate differentials going forward, and our expectation that U.S. rates are set to increase relative to other systemically important rates, the USD likely will appreciate over the next 12 months. This will be a headwind for oil prices, and may be an additional factor OPEC 2.0 member states have to account for in 2018. Bottom Line: We are raising our price forecast for 4Q17 and 2018 in line with our expectation for stronger global growth and continued strong compliance from OPEC 2.0. With markets getting tighter, we expect the USD to become more important to the evolution of oil prices in 2018. Ag Update: Stay Long Corn, Short Wheat Global grain fundamentals continue to be supportive to our long corn vs. short wheat position, recommended October 5. The USDA's latest WASDE are projecting higher 2017/18 ending wheat inventories, while corn and soybeans stock estimates were lowered (Chart 9).6 Chart 9Fundamentals Support Long Corn##BR##Vs. Short Wheat Trade The USDA lowered its expected global corn stocks-to-use ratio, and increased its wheat stocks-to-use ratio for the current crop year. Revisions to the estimates for the 2016/17 crop year also reflect similar dynamics. We expected this going into the WASDE report at the beginning of the month when we published our Special Report on the Ag markets, and got long corn vs. short wheat. December 2017 corn futures traded on CME are up 0.14% since October 5, while wheat futures are down 1.36%. This brings the return on our long corn/short wheat trade to 1.5%, to date. Highlights from the current WASDE include: Upward revisions to wheat production from India, the EU, Russia, Australia, and Canada more than offset greater projected global demand, most notably from India and the EU. Overall, global ending stocks were revised up by 4.99mm MT, and are projected to stand at 268mm MT by the end of the 2017/18 marketing year. Greater projected corn demand, most notably from the U.S. and China, more than offset the ~ 6mm MT upward revision to global production in the USDA's estimates. Higher projected Chinese demand reflects greater food and seed demand, and higher expected industrial use. Corn stocks are expected to end 2017/18 at 200.96mm MT - 1.51mm MT below September projections. Similarly, in its October Chinese Agricultural Supply and Demand Estimates, China's Agriculture Ministry increased its forecast for the 2017/18 corn deficit to 4.31mm MT from 0.89mm MT projected last month. The Ministry expects lower output and greater consumption on the back of stronger demand from ethanol plants.7 Furthermore, in a move towards market pricing, Heilongjiang - China's top corn province - will be reducing the subsidy it gives corn farmers from 153.92 yuan/mu last year to 133.46 yuan/mu. The province will reorient its subsidies to incentivize more soybean production.8 In soybean markets, USDA projections for ending stocks were reduced by 1.48mm MT to 96.05mm MT by end-2017/18, largely on the back of lower expected U.S. and Brazilian inventories in 2016/17. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com Hugo Bélanger, Research Assistant HugoB@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report "OPEC 2.0 Will Extend Cuts To June 2018," published September 21, 2017. It is available at ces.bcaresearch.com. 2 Please see "Precious Metals Update," in the June 29, 2017 issue of BCA Research's Commodity & Energy Strategy Weekly Report "EM Trade Volumes Continue Trending Higher, Supporting Metals". It is available at ces.bcaresearch.com. 3 Please see S&P Global Platts OPEC Guide published October 6, 2017. 4 Please see Chapter 1 of the IMF's World Economic Outlook for October 2017, which is available online at https://www.imf.org/en/Publications/WEO/Issues/2017/09/19/world-economic-outlook-october-2017. 5 Our base case continues to call for an end-June 2018 extension of the OPEC 2.0 production deal. Should the deal be extended to end-December 2018, we estimate 2018 WTI prices would average $67.35/bbl, while Brent prices would average just under $70.00/bbl. We are becoming increasingly confident OPEC 2.0 will become a durable production-management coalition, given the increasing cooperation and mutual investment between KSA and Russia. We will be exploring this further in future research. Please see "King Salman Goes To Moscow, Bolsters OPEC 2.0," published October 11, 2017, by BCA Research's Energy Sector Strategy. It is available at nrg.bcaresearch.com. 6 Please see Commodity & Energy Strategy Special Report titled "Ags In 2017/18: Move To Neutral," dated October 5, 2017, available at ces.bcaresearch.com. 7 Please see "China Raises Forecast For 2017/18 Corn Deficit On Lower Output," dated October 12, 2017, available at reuters.com. 8 Please see "Top China Corn Province Cuts Subsidy For Farmers Growing the Grain," dated October 16, 2017, available at reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights This week, we are reviewing all our current active trades in our Tactical Overlay. As a reminder, these positions (Table 1) are meant to complement our strategic GFIS Model Fixed Income Portfolio, typically with shorter holding periods and occasionally in smaller or less liquid markets outside our usual core bond market coverage (i.e. U.S. TIPS or Swedish interest rate swaps). This report includes a short summary of the rationale behind each position, as well as a decision on whether to continue holding the trade, close it out or switch to a new position that may more efficiently express our view. The trades are grouped together by the country/region that is most relevant for the performance of each trade. Table 1GFIS Tactical Overlay Trades Feature U.S. Short July 2018 Fed Funds futures (HOLD). Long 5-year U.S. Treasury (UST) bullet vs. 2-year/10-year duration-matched UST barbell (HOLD). Long U.S. TIPS vs. nominal USTs (HOLD). Short 10-year USTs vs. 10-year German Bunds (HOLD). The tactical trades that we have been recommending within U.S. markets all have a common theme - positioning for an expected rebound in U.S. inflation that will push up U.S. bond yields. We are maintaining all of them. The drift lower in realized inflation rates since the spring has been a surprise given the backdrop of above-potential growth, low unemployment and a weakening U.S. dollar. On the back of this, markets have priced out several of the Fed rates hikes that had been expected over the next year, leaving U.S. Treasury yields at overly-depressed levels. Back on July 11th, we initiated a recommendation to short the July 2018 fed funds futures contract (Chart 1). This was a position that would turn a profit if the market moved to once again discount multiple Fed rate hikes by mid-2018. The trade has a modest profit of 9bps, but with scope for additional gains if the market moves to discount 2-3 hikes by the middle of next year. Our base case scenario is that the Fed will lift rates again this December, and deliver additional increases next year amid healthy growth and with inflation likely to grind higher towards the Fed's 2% target. With the market discounting 46bps of rate hikes over the next year, there is scope for additional profits in our fed funds futures trade. Another tactical position that we've been recommending is a butterfly trade within the U.S. Treasury (UST) curve, long a 5-year UST bullet versus a duration-matched 2-year/10-year UST barbell. This is a position that would benefit from a bearish steepening of the UST curve as the market priced in higher longer-term inflation expectations (Chart 2). We have held that trade for a much longer period than a typical tactical trade, going back nearly a full year to December 20th, 2016. Yet while the UST curve has flattened since that date, our trade has delivered a return of +18bps. This outperformance can be attributed to the undervalued level of the 5-year bullet at the initiation of the trade. Chart 1Stay Short July 2018##BR##Fed Funds Futures Chart 2Stay Long The 5yr UST Bullet Vs.##BR##The 2yr/10yr UST Barbell While that valuation cushion no longer exists (bottom panel), longer-term TIPS breakevens are back to the levels seen last December (middle panel), thanks in no small part to much higher energy prices (top panel). This leaves the UST curve at risk of a bearish re-steepening on the back of rising inflation expectations. Add in a U.S. dollar that is -2.5% weaker from year-ago levels (Chart 3, middle panel), and a solid U.S. economic expansion that should eventually translate into rising core inflation momentum (bottom panel), and the case for a steeper UST curve over the next 3-6 months is a strong one. The above logic also supports our trade recommendation to go long U.S. TIPS vs. nominal USTs, which is up +248bps since inception on August 23, 2016. We have been holding this trade for much longer than our usual tactical recommendations, but we will not look to take profits until we see the 10-year breakeven (now at 186bps) return back to levels consistent with the Fed's 2% PCE inflation target (i.e. headline U.S. CPI inflation back to 2.5%). One final tactical trade that will benefit from higher UST yields is our recommendation to position for a wider spread between 10-year USTs and 10-year German Bunds. This trade was initiated on August 9th of this year, and has delivered a profit of +9bps. Yet the UST-Bund spread still looks too low relative to shorter-term interest rate differentials that favor the U.S. (Chart 4, top panel). With U.S. data starting to surprise more on the upside than Euro Area data (middle panel), and with UST positioning still quite long (bottom panel), there is potential for additional near-term UST-Bund spread widening. The upcoming decision by the European Central Bank (ECB) on potential tapering of its asset purchases next year represents a potential risk for the long Bund leg of our recommended trade. Any hawkish surprises on that front would be a likely catalyst for us to close out this position. Chart 3Stay Long U.S. TIPS Vs. Nominal USTs Chart 4Stay Short 10yr USTs Vs. German Bunds Euro Area Long 10yr Euro Area CPI swaps (HOLD). Long 5-year Spain vs. 5-year Italy in government bonds (HOLD). We have two recommended tactical trades that are specifically focused on developments in the Euro Area. We are maintaining both of them. As a way to position for an eventual pickup in European inflation, we entered a long position in 10-year Euro Area CPI swaps back on December 20th, 2016. That trade is now estimated to have a profit of +29bps, as market-based inflation expectations have drifted higher in the Euro Area. The simple reason for that increase is that realized inflation has moved higher on the back of rising energy costs, as there is a very robust correlation between the annual growth rate of oil prices (denominated in euros) and headline Euro Area inflation (Chart 5). More importantly, the booming Euro Area economy, which has eaten up much of the spare capacity in the Europe, has boosted wage growth and core inflation to levels seen prior to the disinflation shock from the 2014/15 collapse in oil prices (bottom panel). With no signs of any imminent slowing of Euro Area growth that could raise unemployment and slow underlying inflation pressures, the trend for inflation expectations in Europe is still upward. The current 10-year Euro Area CPI swap at 1.5% is still well beneath the ECB's inflation target of "just below" 2% on headline CPI, so there is room for inflation expectations to continue drifting higher. ECB tapering of asset purchases is not an immediate threat to this trade, as the central bank is still likely to keep buying bonds next year (at a slower pace), while holding off on any interest rate increases until late 2019. In other words, the ECB will not be looking to act to slow economic growth to bring down Euro Area inflation anytime soon. Our other tactical trade recommendation in Europe is a relative value spread trade, long 5-year Spanish government debt versus 5-year Italian bonds. This trade was initiated on December 13th, 2016 and currently has only a modest gain of +9bps, although the profits were much larger earlier this year. Italian bonds have been outperforming on the back of improving Italian economic growth (Chart 6, top panel) and, recently, a generalized sell-off in Spanish financial assets on the back of the political uncertainty in Catalonia. Chart 5Stay Long 10yr##BR##Euro Area CPI Swaps Chart 6Stay Long 5yr Spanish Government Bonds Vs.##BR##5-Year Italian Debt Our colleagues at BCA Geopolitical Strategy have been downplaying the threat to Spanish political stability from the Catalonian independence movement, given that the polling data shows only 35% for outright independence from Spain. At the same time, the poll numbers in Italy for the upcoming parliamentary elections are much closer, with parties favoring less integration with Europe holding a slight lead over more "establishment" parties (bottom two panels). With the bulk of the cyclical convergence between Italian and Spanish growth now largely completed, and with a greater potential for future political instability in Italy compared to Spain, we expect that Spain-Italy spreads will tighten further back to the lows seen at the beginning of 2017 (-64bps on the 5-year spread). That is a level we are targeting on our current tactical trade recommendation. Canada Short 10-year Canadian government bonds vs. 10-year USTs (TAKE PROFITS). Long Canada/U.K. 2-year/10-year government bond yield curve box, positioning for a relatively flatter Canadian curve (TAKE PROFITS). Short 5-year Canada government bond versus a duration-matched 2-year/10-year barbell (TAKE PROFITS). We have three different Canadian fixed income trades in our Tactical Overlay, all of which were biased towards tighter monetary policy in Canada: a Canada-U.S. bond spread widener, a yield curve box trade versus the U.K. and a curve flattener expressed as a barbell trade (Chart 7) All three positions are in the money, but we now recommend taking profits. We had initiated these recommendations in a very timely fashion earlier in the year at a time when the Bank of Canada (BoC) was sending a relative dovish message. In our view, the Canadian economy was building significant upward momentum that would eventually force the central bank to shift its policy bias. This would especially be true with the Fed also in a tightening cycle, given the typical tendency for the BoC to follow the Fed's policy actions. Several members of the BoC monetary policy committee began to sing a more hawkish tune over the summer, particularly after the release of the Q2 BoC Business Outlook Survey. That robust report, which was confirmed by a 2nd quarter GDP growth rate of nearly 4% (Chart 8), led the BoC to deliver not one by two unexpected interest rate hikes in July and September. Markets reacted accordingly, driving Canadian bond yields higher and flattening the yield curve. Chart 7Take Profits On Bearish Canadian Bond Trades Chart 8Canadian Growth Set To Cool Off A Bit Now, we see the market pricing as having gone a bit too far, too quickly. The Q3 Business Outlook Survey, released yesterday, was still positive but with readings softer than the booming Q2 report. Meanwhile, the commentary from the BoC has become more balanced, with BoC Governor (and BCA alumnus) Stephen Poloz describing the central bank as being more "data dependent" after the recent rate hikes. Markets are now pricing in another 72bps of rate hikes over the next year, even with our own BoC Monitor off the peak (Chart 9). Chart 9Our BoC Monitor Is Peaking From a tactical perspective, the repricing of the BoC that we expected earlier this year is now largely complete. Thus, we are taking profits on all three Canadian trades: Canada-U.S. spread trade: initiated on January 17th, profit of +43bps. Canada/U.K. box trade: initiated on May 16th, profit of +67bps. Canada 2yr/5yr/10yr butterfly trade: initiated on December 6th, 2016, profit of +95bps. From a strategic perspective, we still see a case where the BoC can deliver additional rate hikes and keep upward pressure on Canadian bond yields. The output gap in Canada is now closed, according to BoC estimates, and additional strength in the economy now has a greater chance in translating to higher inflation. Strong global growth, especially in the U.S., will also support Canadian export growth and feed into rising capital spending. While the rate hikes have help boost the value of the Canadian dollar (CAD), the exchange rate (on a trade-weighted basis) also largely reflects a rising value of energy prices and is, therefore, should provide an additional boost to growth via stronger terms-of-trade (bottom panel). In other words, the rising CAD will not prevent additional BoC rate hikes if oil prices remain strong. Thus, we are maintaining our underweight recommendation on Canadian government bonds in our strategic model bond portfolio, even as we take profits on our bearish Canadian tactical trades. Australia Long a 2-year/10-year Australia government bond curve flattener (SELL AND SWITCH TO NEW TRADE). On July 25th of this year, we entered into a 2-year/10-year curve flattener trade for Australia. Though employment was improving and house prices were booming in Australia, the wide output gap, high level of consumer indebtedness and lack of real wage growth was keeping the Reserve Bank of Australia (RBA) inactive. In our view, nothing has changed since then; the RBA remains in a very difficult position. While the yield curve flattened substantially following the initiation of our trade, the global rise in long-term yields since mid-September lifted Australian longer-maturity yields, and the yield curve with it (Chart 10). Now, Australian long-term yields are not reflecting domestic fundamentals but are instead driven by improving global growth. As such, we are closing the trade and initiating a new position - long Dec 2018 Australian Bank Bill futures - as a more focused way to express the view that the RBA will stay on hold for longer than markets expect. Markets are currently pricing in 30bps of RBA rate hikes over the next twelve months. We believe this will be unlikely, for several reasons. Macroprudential measures on the Australian housing market will continue to dampen credit growth. Core inflation is slowly rising but still far below the central bank's target. Additionally, there is plenty of slack in the labor market despite the spike in employment growth. This is evidenced in anemic real wage growth, stubbornly high underemployment rate, low hours worked and high percentage of part-time to full-time workers (Chart 11). Chart 10Close Australian Government##BR##Bond 2yr/10yr Flattener Chart 11RBA Unlikely To Deliver##BR##Discounted Rate Hikes The biggest risk to our new trade would if signs of a tighter Australian labor market started to feed through into faster wage growth, which would likely coincide with faster underlying price inflation and a more hawkish turn by the RBA. New Zealand Long 5-year NZ government bonds vs. 5-year USTs (currency hedged). Long 5-year NZ government bonds vs. 5-year Germany (currency unhedged). Chart 12Stay Long 5yr NZ Government Bonds##BR##Vs. U.S, & Germany We entered two New Zealand (NZ) tactical bond trades on May 30th, going long 5-year government bonds vs. U.S. and Germany (Chart 12). We expected NZ spreads to tighten faster than the forwards based on our more hawkish views on the Fed and, to a lesser extent, the ECB relative to the more dovish view on the Reserve Bank of New Zealand (RBNZ). The outright bond spreads have tightened and, on a currency-hedged basis, both trades are in the money. Our dovish view on the RBNZ came from the central bank's own forecasts, which called for slowing headline inflation on the back of softer "tradeables" inflation and a sharp cooling of domestic "non-tradeables" inflation through a slowing housing market (Chart 13, bottom two panels). Our own RBNZ Monitor has been calling for the need for higher interest rates in NZ, mostly from the strength in the labor market. Yet we have been ignoring that signal, as has the market which has priced out one full expected RBNZ rate hike since the beginning of the year. With business confidence rolling over, and with the trade-weighted NZ dollar still staying at stubbornly strong levels, the case for the RBNZ to deliver even a single rate hike is not a strong one - especially given the soft inflation forecasts of the central bank. Thus, we are sticking with our tactical spread trades for NZ versus the U.S. and Germany. We are maintaining the currency hedge on the U.S. version of the trade, as we typically do for the vast majority of our cross-country spread trade recommendations. Occasionally, however, we will make an active decision to do a spread trade UN-hedged if we felt very strongly about a currency move. We did that for our NZ-Germany spread trade and this has cost us in the performance of the trade, which is down -3.4%. This is because of a surprisingly large decline in the New Zealand dollar (NZD) versus the euro since the inception of our trade. Yet a review of the technical indicators on the NZD/EUR currency cross shows that the currency pair is now very stretched versus its medium-term trend (the 40-week moving average), with price momentum also at some of the most negative levels of the past decade (Chart 14). These measures suggest that the worst of the downturn in the currency is likely over. The relative positioning on the two individual currencies is now neutral, as long positions on the NZD have been reduced (bottom panel). Chart 13RBNZ Dovishness Is Justified Chart 14Keep NZ/Germany Position Currency Unhedged Given these technical indicators, and from these current levels, we see greater upside potential for NZD/EUR in the months ahead. This leads us to maintain our unhedged currency position on the NZ-Germany spread trade so as not to realize the current mark-to-market losses on the trade. Sweden Pay 18-month Sweden Overnight Index Swap (OIS) rate (TAKE PROFITS). We entered into a bearish Swedish rates position back on November 22nd, 2016, paying Sweden 18-month Overnight Index swap rates (Chart 15). At the time, we expected the Riksbank to begin hiking interest rates earlier than what was priced in the markets IF inflation reached the central bank target faster due to a weaker Swedish krona. We also believed that the economy would continue to expand at a robust pace when the economy had no spare capacity, creating additional upside inflation surprises. According to the Riksbank's latest Monetary Policy Statement (MPS), the central bank will likely keep the repo rate at -0.5% until mid-2018, while continuing its asset purchase program until the end of this year - even with an overheating economy. This is because realized inflation has remained below the Riksbank target for a long period of time and, although current inflation is above target, it was not necessary to immediately tighten conditions. More likely, the Riskbank is worried about the potential for the krona to appreciate - especially versus the euro - if rate hikes are delivered. It will only be a matter of time before the central bank is forced to tighten policy with the economy likely to strengthen further, led by solid domestic demand, strong productivity growth, and improving exports. Consumption is also expected to increase as households have scope to cut back their high level of savings. Combining the Riksbank's easing policy with the current strength of the economy and the tightness of the labor market, inflation is very likely to return to the 2% target in the next year or two (Chart 16). Chart 15Close Sweden OIS Trade Chart 16Riksbank More Worried About SEK Than Inflation However, if the Riskbank remains too concerned about the currency versus the euro, as we suspect, then this will prevent any shift to a more hawkish stance before any change from the ECB. That is unlikely to happen over the next year, at least, even if the ECB slows the pace of asset purchases as we expect. Thus, we are closing out our Sweden 18-month Overnight Index Swap position at a small profit of 12bps. We have already kept this trade for longer than the typical investment horizon for one of our tactical overlay trades. We will investigate the potential for more profitable trade opportunities in the Swedish fixed income markets in a future report. Korea Long a 2-year/10-year Korean government bond yield curve steepener (HOLD). We recommended entering into a 2-year/10-year steepening trade in the Korean government bond yield curve on May 30th, 2017. Since then, the yield curve has flattened by 7bps, which was mainly caused by an unexpected rise in the 2-year yield, rather than a decline in 10-year yield (Chart 17). Korea is currently enjoying a solid business cycle upturn. Leading economic indicators are rising, the year-over-year growth in exports has risen to a 7-year high and previously sluggish private consumption has also rebounded recently. The Bank of Korea (BoK) is of the view that the recovery will continue and consumer price inflation will stabilize at the target level over the medium-term. This recovery should cause the 2/10 curve to steepen as longer-term inflation expectations rise. Based on South Korean President Moon's aggressive fiscal plans to increase welfare spending and create jobs in the public sector, at a time when the economy is good shape, we still believe that long-end of the curve (10-year) will rise. In addition, as shown in Chart 18, the 26-week rolling beta of changes in the 10-year UST yield and Korean 10-year bond is very high, nearly 1. Given our bearish view on USTs, this implies Korean yields can follow suit. On the other hand, the correlation between the 2-year UST yield and equivalent maturity Korean yields is much lower (4th panel), as Korean rate expectations have not been following those of the U.S. higher - even with a stronger Korean economy. Most likely, this is due to investors downplaying the potential for the BoK to match Fed rate hikes tick-for-tick given the heightened tensions between the U.S. and North Korea. Chart 17Stay In Korea 2yr/10yr##BR##Government Bond Steepener Chart 18Long-Term Korean##BR##Yields Are Too Low We still believe the Korean curve can steepen as longer-term yields rise, although we will be monitoring the behavior of shorter-dated Korean yield as the situation between D.C. and Pyongyang evolves. If investors begin to demand a higher risk premium on Korean assets, particularly the Korean won, then 2-year Korean yields may rise much faster and our curve trade may not go our way. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Patrick Trinh, Associate Editor Patrick@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Year One Performance: The GFIS recommended model bond portfolio returned 1.1% (hedged into USD) in its first year of existence, slightly underperforming the custom benchmark index by -2bps. Our bearish duration tilts were a drag on performance, while our overweights to U.S. corporate debt were a major contributor. Risk Management Lessons: The maximum overweight to low-beta, but low-yielding, Japanese Government Bonds was a drag on performance by reducing the portfolio yield. This highlights the classic bond management trade-off between controlling portfolio risks, like duration or tracking error, and maximizing sources of return, like interest income. Future Drivers Of Returns: Over the next 6-12 months, we expect the model portfolio returns to again benefit mostly from our below-benchmark duration stance (as global bond yields grind higher) and from our overweight stance on U.S. corporates (as the U.S. economy maintains a solid pace of growth). Feature In September of 2016, we introduced a new element to the BCA Global Fixed Income Strategy (GFIS) service - our recommended model bond portfolio.1 This represented a bit of a departure from the usual macroeconomic analysis and forecasting of financial markets that has been the hallmark of BCA. Yet we felt that it was important to add an actual portfolio, with specific allocations and weightings, given the needs and constraints faced by our readers. With so many of our clients being traditional fixed income managers (or multi-asset managers) who measure investment performance versus benchmark indices, we felt that it was important to have a way to communicate our views within a framework akin to what they deal with each day. Even for clients who are not professional bond managers, the model portfolio can be useful as a way to express how much we prefer one bond market (or sector) versus others. It also gives us a forum to discuss portfolio management issues as an addition to the macro analysis. So far, the reception from clients to this new addition to the GFIS service has been a warm one, and we look forward to additional feedback in the months and years ahead. With the model portfolio just passing its first birthday, we are dedicating this Weekly Report to an overview of the final Year One performance numbers. We will evaluate our winning and losing recommendations, look back at the lessons learned as the model portfolio framework has evolved, and identify what we expect will be the biggest drivers of performance in Year Two based on our current views. Year One Model Portfolio Performance: Winners & Losers Chart 1GFIS Model Portfolio Performance The GFIS model portfolio produced a total return of 1.09% (hedged into U.S. dollars) over first full year since inception on September 20, 2016 (Chart 1). This essentially matched the performance of our custom benchmark index, with the model portfolio lagging by a mere -2bps.2 In terms of the breakdown between government bonds and credit (spread product), the former underperformed the benchmark by -18bps while the latter outperformed by +16bps. A more traditional period to evaluate investment performance is on a calendar year-to-date basis. We also show the 2017 year-to-date (YTD) numbers in Chart 1, measured from January 1st to October 3rd. Over that time period, the total returns are much higher - the model portfolio has returned 2.78%, lagging the index by -6bps. This higher absolute return is mostly due to the strong outperformance of corporate bond markets and the decline in government bond yields seen since March. Broadly speaking, that breakdown of returns lines up with what were our largest strategic market calls: to be underweight overall portfolio duration and overweight U.S. corporate bond exposure (bottom panel). This is obviously a welcome property to see in our returns, which we hope will always line up with our desired tilts! When looking at the detailed decomposition of the returns on the government bond side of the portfolio (Table 1), however, a few points stand out: Table 1A Detailed Breakdown Of The GFIS Model Portfolio The underperformance on the government bond side of the portfolio (Chart 2) came from underweight positions at the long-end (maturities beyond seven years) of yield curves in the U.S. (-4bps), U.K. (-5bps), Germany (-5bps) and, most notably, France (-18bps). Chart 2GFIS Model Portfolio Government Bond Performance Attribution By Country The underweight position in Italy, across the curve, generated another -7bps of underperformance, although this was paired against an overweight to Spanish government bonds that positively contributed to returns (+3bps). Overweights to bonds in the middle and shorter ends of yields curves (maturities less than seven years) positively contributed to returns in the U.S. (+6bps), Germany (+2bps) and France (+2bps). Our significant overweight to Japanese government bonds, intended as a way to reduce portfolio duration by increasing exposure to a market with a low beta to global bond yields, also helped boost performance (+8bps). The conclusion? By concentrating our recommended duration underweights on longer-maturity bonds, and raising the weightings on shorter-maturity government debt, we imparted a bearish curve steepening bias on top of the reduced duration exposure. It is no surprise that our recommended government bond allocations underperformed during the bull-flattening move in global yield curves seen earlier this year. By contrast, the returns on the credit (spread) product allocations within the GFIS model portfolio tell a more positive story (Chart 3): Chart 3GFIS Model Portfolio Spread Product Performance Attribution The outperformance came from our overweight allocations to U.S. Investment Grade (IG) corporate debt, focused on Financials (+14bps) and Industrials (+4bps), and U.S. High-Yield (HY), concentrated on Ba-rated (+13bps) and B-rated (+8bps) bonds. U.S. Mortgage-Backed Securities (MBS) were a laggard during the first year of the model bond portfolio (-12bps), which largely came from an ill-timed tactical move to overweight in the 4th quarter of 2016. More recently, our underweight stance on MBS has been only a modest drag on the total return of the portfolio since the peak in U.S. bond yields back in March. Our decisions to reduce exposure to Euro Area IG (-5bps) and HY (-2bps) corporate debt earlier in the year, and our more recent decision to downgrade Emerging Market (EM) sovereign (-1bp) and corporate debt (-4bps), were both small negative contributors to performance. Summing it all up, our spread product allocations performed well because of the overweight to U.S. IG and HY corporates. The underweights in Euro Area and EM credit were set up as relative value allocations versus U.S. equivalents, so the underperformance versus the benchmark should be viewed against the substantial outperformance from U.S. corporates. The MBS underperformance was small on a YTD basis, but we see an opportunity for that to soon turn around, as we discuss later. Bottom Line: The GFIS recommended model bond portfolio returned 1.1% (hedged into USD) in its first year of existence, slightly underperforming the custom benchmark index by -2bps. Our bearish duration tilts were a drag on performance, while our overweights to U.S. corporate debt were a major contributor. Lessons Learned On Risk Management As the first year of the GFIS model portfolio progressed, we added elements to the framework to help us manage the overall risk of the portfolio. Specifically, we began to include a tracking error calculation to show the relative volatility of the portfolio to its benchmark.3 When we first introduced that tracking error back in April, we were running far too little risk in the portfolio given the relatively modest position sizes (Chart 4). Rather than be an "index hugger", we decided to increase the sizes of all our relative tilts (Chart 5), and the tracking error rose accordingly from a mere 25bps to over 60bps. This is still below the 100bps limit that we decided to impose on the relative volatility of the model portfolio, but we were comfortable not running less-than-maximum risk given that valuations on many spread products were not extraordinarily cheap. The time to max out a risk budget is early in the credit cycle when spreads are wide, not when the cycle is far advanced and spreads are relatively tight. Yet one lesson that was learned in Year One was that too much focus on tracking error can result in lost opportunities to boost the performance of the portfolio. As part of our strategic call to maintain a below-benchmark overall duration stance, we upgraded Japan to maximum overweight in the model portfolio back on July 4th.4 With Japanese Government Bonds (JGBs) having such a low beta to yield changes in the overall Developed Markets (Chart 6), adding more Japan exposure was a way to get more defensive on duration in a way that would also boost our desired tracking error (since we were adding more of an asset less correlated to the other government bonds in the portfolio). Chart 4Tracking Error Of##BR##The Model Portfolio Chart 5Allocations Between##BR##Government Bonds & Spread Product Chart 6Are JGBs The##BR##Optimal Duration Hedge? Yet by increasing the allocation to low-beta JGBs, we were also adding exposure to "no-yield" JGBs. The overall yield of the model portfolio suffered as a result, fully offsetting the bump to the portfolio yield from the increase in allocations to spread product in April (Charts 7 & 8). With the benefit of hindsight, increasing the allocation even more to something like U.S. HY corporate bonds would have a been a more prudent way to redirect government bond exposure to a low-beta market that would have boosted the overall portfolio yield (Chart 9). Chart 7Too Much Japan##BR##In The Portfolio ... Chart 8... Offsetting The Yield Pick-Up##BR##From Spread Product Chart 9There Is Not Enough Yield##BR##In The Model Portfolio Going forward, we will pay more attention to managing the portfolio yield more actively as another piece of our model bond portfolio framework that can help boost expected returns. Bottom Line: The maximum overweight to low-beta, but low-yielding, Japanese Government Bonds was a drag on performance by reducing the portfolio yield. This highlights the classic bond management trade-off between controlling portfolio risks, like duration or tracking error, and maximizing sources of return, like interest income. The Outlook For The Next Year Looking towards the next twelve months, the biggest expected drivers of returns in our model bond portfolio are expected to come from the following allocations: Below-benchmark overall duration exposure: We are sticking to our guns on the future direction of global bond yields, which have more room to rise over the next 6-12 months. The coordinated global economic upturn is showing little sign of slowing, with leading indicators still rising and pointing to upward pressure on real bond yields (Chart 10). At the same time, inflation expectations in the developed economies remain too low relative to current levels of inflation (bottom panel). Thus, we expect government bond yield curves to bear-steepen as central banks will respond slowly to the rise in inflation. This will benefit the steepening bias we have in the model portfolio from the underweights in longer maturity buckets in the U.S., Europe and the U.K. (Chart 11). Chart 10Future Drivers Of Performance:##BR##Below-Benchmark Duration Chart 11An Unexpected##BR##Bull Flattening This Year Overweight U.S. corporate bonds (both IG and HY): Looking over the indicators from our U.S. Corporate Bond Checklist, the backdrop is not yet pointing to a period of expected underperformance for U.S. corporates (Chart 12). While balance sheet fundamentals do appear stretched, as indicated by our Corporate Health Monitor (2nd panel), the overall stance of U.S. monetary conditions is neutral (3rd panel), while bank lending standards are not yet restrictive (4th panel). We expect the Fed to deliver another 25bp rate hike in December, and at least another 2-3 hikes in 2018, which will shift monetary conditions into more restrictive territory. A very rapid rise in the U.S. dollar would worsen this trend, but we expect only a moderate grind higher in the greenback as the Fed slowly delivers additional rate hikes and non-U.S. growth remains robust. While the solid global economic backdrop should benefit all growth-sensitive assets like corporate debt, we see more attractive relative valuations on U.S. corporates versus Euro Area or EM equivalents. The upcoming tapering of asset purchases by the European Central Bank (ECB) also represents a major risk to Euro Area corporate debt, as the ECB will be slowing the pace of its corporate bond buying. One other sector that can potentially boost the portfolio performance in Year Two versus Year One is U.S. MBS. Our colleagues at our sister service, U.S. Bond Strategy, now see MBS valuations as looking attractive to other U.S. spread product like IG corporates (Chart 13).5 The relative option-adjusted spreads (OAS) on MBS and U.S. IG are a good leading indicator of the relative performance of the two asset classes and current spread levels should lead to a better return profile for MBS over IG. Another factor benefitting MBS is the continued rising trend in U.S. bond yields (and mortgage rates) that we expect over the next 6-12 months, which will reduce mortgage prepayments that would weigh on MBS returns (bottom panel). Chart 12Future Drivers Of Performance:##BR##Overweight U.S. Corporates Chart 13Upgrade U.S. MBS##BR##To Neutral This week, we are upgrading our MBS allocation to neutral from underweight in our model portfolio. However, given that our allocations to U.S. corporates are already fairly significant, we are choosing to "fund" the MBS upgrade by lowering our weighting on U.S. Treasuries (see the model portfolio allocations on Page 14). Bottom Line: Over the next 6-12 months, we expect the model portfolio returns to again benefit mostly from our below-benchmark duration stance (as global bond yields grind higher) and from our overweight stance on U.S. corporates (as the U.S. economy maintains a solid pace of growth). We are also now more constructive on valuations on U.S. MBS, thus we are upgrading our allocation to neutral at the expense of U.S. Treasuries. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Model Special Report, "Introducing Our Recommended Global Fixed Income Portfolio", dated September 20th, 2016, available at gfis.bcaresearch.com. 2 The GFIS model portfolio custom benchmark index can most simply be described as the Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very highly-rated spread product. We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 3 Please see BCA Global Fixed Income Strategy Special Report, "Adding A Risk Management Framework To Our Model Bond Portfolio", dated June 20th 2017, available at gfis.bcareseach.com. 4 Please see BCA Global Fixed Income Strategy Weekly Report, "Central Banks Are Now Playing Catch-Up", dated July 4th 2017, available at gfis.bcaresearch.com. 5 Please see BCA U.S. Bond Strategy Weekly Report, "Dollar Watching: Yet Another Debate", dated October 10th 2017, available at usbs.bcaresearch.com. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Appendix - Selected Sectors From The GFIS Model Portfolio Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

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

Special Report

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

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

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

Special Report

Dear Client, We are sending you a Special Report prepared by my colleague Matt Gertken, associate vice president of our Geopolitical Strategy team. This report focuses on the upcoming 19th Party congress and discusses its implications on China’s economic and political outlook, as well as its impact on financial markets. I trust you will find this report insightful. Best regards, Yan Wang, Senior Vice President China Investment Strategy Highlights The Communist Party will hold its nineteenth National Congress on Oct. 18. This is the "midterm election" for President Xi Jinping, whose political capital will be replenished; Recent Chinese leaders have a greater impact in their second term than their first; Base case: Xi consolidates power while preserving a balance on the Politburo Standing Committee; Stay long Chinese equities versus emerging market peers. Feature China's Communist Party will hold the nineteenth National Party Congress on October 18-25. This is a critical "midterm" leadership reshuffle that will also mark the halfway point of General Secretary Xi Jinping's term in office. Investors around the world will watch closely to see what insight can be gained about the political trajectory of the world's second-largest economy. This report serves as a "primer" for readers to understand the party congress and its investment takeaways. Why Is The Party Congress Important? Because it rotates China's political leaders! Chart 1So Long To The 18th Central Committee In a political system without popular representation, the rotation of personnel according to promotion and retirement is the only way to rejuvenate the policy process. The average rate of turnover on the Communist Party's Central Committee at each five-year congress has been 62%, which is a remarkably high rate (Chart 1). It reveals an underrated dynamism in Chinese politics. This leadership rotation also allows the top leader (Xi Jinping) to consolidate power by putting his supporters into key positions. This in turn alters the policymaking environment and the way in which China formulates policies and responds to external events. China has a "parallel" political system in which the ruling Communist Party operates alongside (and above) the state. Xi Jinping is "General Secretary" of the party, president of the People's Republic of China, and (not least) chairman of the Central Military Commission. The party maintains supremacy by independently controlling the state and the army. Since fall 2016, Xi has been dubbed the "core" of the Communist Party, putting him on a par with previous core leaders Mao Zedong, Deng Xiaoping and Jiang Zemin.1 The party's nearly 90 million members convene large congresses of about 2,000 members every five years to select the membership of the key decision-making bodies (Diagram 1), a practice known as "intra-party democracy."2 The key body is the Central Committee, which consists of about 200 full members and another 100-some alternative members. The Central Committee then "elects" the General Secretary, Political Bureau (a.k.a. "Politburo," the top 25 or so leaders) and Politburo Standing Committee (the "PSC," the top five-to-nine leaders) - though in reality the Politburo and the PSC are chosen through intense negotiations among the incumbent PSC and former leaders. Diagram 1National Party Congress Of The Communist Party Of China The handful of men on the PSC are the chief decision-makers in China, often in league with the broader Politburo (and former PSC members who exercise some power through the back door). Most of the key personnel decisions will have been made before the Central Committee votes.3 Hence the current top leaders have a chance to put their loyalists and supporters in key positions, potentially improving the implementation of their agenda. The outgoing eighteenth Central Committee will meet for its last session on October 11, and then the nineteenth party congress will meet on October 18 to elect a new Central Committee. It will in turn ratify the new Politburo and PSC. At the beginning of the party congress, Xi Jinping will deliver a keynote political report on the state of the party and nation, reviewing the progress of the past five years and mapping out a vision for the next five. The party congress will also amend the Communist Party constitution.4 By the end of the week, the members of the new PSC will step out to meet the press together for the first time. Only later will the party's key decisions be incorporated by the state, i.e. China's central government, including key personnel appointments and policy initiatives. This will occur when the legislature, the National People's Congress ("NPC," not to be confused with party congress), convenes at its annual "Two Sessions" in early March 2018. Chart 2Bold Action Can Follow Midterm Congresses Any NPC session following a five-year party congress carries more weight than usual not only because it approves of the party congress's leadership decisions but also because it kicks off major new policy initiatives. For instance, Premier Zhu Rongji was appointed to launch the "assault stage" of President Jiang Zemin's reforms of state-owned enterprise at the NPC in March 1998 (Chart 2). Similarly, Hu Jintao's Premier Wen Jiabao launched extensive administrative reforms at the NPC meeting in early 2008.5 How does a "midterm" party congress differ from others? Typically, in even-numbered years, the top two leaders change over, as with Xi Jinping and Premier Li Keqiang in 2012. These transitions are highly significant as they mark a leadership succession, a transfer of power to a new general secretary in a heavily centralized, authoritarian system that does not have a codified succession process. By contrast, in odd-numbered years like 2017, the Communist Party promotes, demotes, and retires a large number of other top leaders. Thus Xi Jinping's place is assured, and Li Keqiang's place is probably assured as well, but most likely the other five members of the PSC will be gone.6 This year's transition is also significant because the total turnover on the Central Committee is expected to be higher than usual (perhaps 70%) as a result of President Xi's aggressive anti-corruption campaign and other factors (see Chart 1 above).7 Leaders often spend the bulk of their first five years consolidating power and the second five years pushing forward their true policy agenda. Even President Hu Jintao, who failed to see his preferred social safety-net policies fully implemented, had a vastly more influential second term than first term in office: the 2007-12 period saw the 4 trillion RMB stimulus package to thwart the Global Recession. Moreover, Chinese leaders do not normally become "lame ducks" toward the end of their last term: Deng Xiaoping recommitted the country to pro-market reforms in 1992, after having stepped down as general secretary, while Jiang Zemin reached the height of his power at the end of his term in 2002, when he chose to hang onto the position of top military leader for two extra years. Many observers suspect that Xi Jinping will hold onto power beyond 2022. Bottom Line: The National Party Congress coincides with a sweeping rotation of the Chinese political elites, which is a critical way of ensuring that China, unlike a monarchy or personalized "dictatorship," has an orderly way of updating its policy-makers and (hopefully) policies. Midterm reshuffles allow top leaders to promote supporters and re-energize the implementation of their policy agenda. The past two Chinese leaders were more consequential in their second term than their first. How Is The Nineteenth Congress Unique? Chart 3Xi Jinping's Generation Taking Command The most important change this year is the passing of a generation.8 China's political elites are classified into "leadership generations," with Mao Zedong symbolizing the first generation, Deng Xiaoping the second, Jiang Zemin the third, Hu Jintao the fourth, and Xi Jinping the fifth generation. The current reshuffle will see the following generational trends: The End of the Jiang Zemin Era: The key figures retiring on the PSC are those who were born before 1950 and put in place by Jiang Zemin. Thus in a very real sense, Jiang Zemin's influence is coming to a close (Chart 3).9 This generational shift is likely to force the retirement of 11 of the 25-member Politburo, and five of the seven PSC members (Table 1), as well as other major figures, such as the long-serving central bank Governor Zhou Xiaochuan. Table 1Chinese Leaders Set To Retire On Politburo And Politburo Standing Committee Jiang-era leaders are defined by certain characteristics that are now fading. As Chart 4 demonstrates, these leaders came of age in the early, idealistic days of the Revolution, leading them to have a conservative streak in ideological matters. Yet they are well-known pragmatists in economic matters. They studied engineering and natural sciences in answer to the call for the young to develop the country's heavy industry. They tended to hail from capitalist-leaning coastal provinces, and often gained first-hand experience operating China's state-owned enterprises. This last point became especially important when they pioneered pro-market corporate reforms in the 1990s. By contrast, fewer of them served as government ministers on the State Council (China's cabinet) than subsequent generations. Chart 4Leadership Characteristics Of The Politburo Standing Committee The Middle of the Hu Jintao Era: The passing of Jiang's cohort will necessarily give his successor Hu Jintao's cohort a boost in relative influence at the top levels. Hu's generation is marked by leaders who studied the "soft sciences" (like law and economics). Several of them (including Hu and Premier Wen Jiabao) have links with the politically liberal wing of the party. They have far less experience in the military or state-owned business, but are more likely to have governing experience in the central government and especially the provinces (Chart 4 above). This includes the interior provinces from which they often hail. They are thus highly attuned to the problem of maintaining social stability, arguably to the neglect of economic dynamism. Hu Jintao's influence may be underrated. Xi's administration has shown important continuities with Hu's, and Hu's followers are well positioned in the Central Committee, the Politburo, and the provincial governments (though not the current PSC). If Xi does not take decisive moves to replace some of Hu's acolytes on the PSC at the coming party congress, then Hu's men will likely outnumber Xi's on the PSC as they graduate up the ladder from the Politburo.10 A strong showing by Hu's faction could affect China's policy priorities, given that Xi showed different preferences from Hu in the first few years of his rule (Table 2). However, the factions do not maintain consistent policy platforms. The bottom line is that Hu's faction could act as more or less of a constraint on Xi regardless of what policies the latter pursues. Table 2Fiscal Priorities Of Recent Chinese Presidents The True Beginning of the Xi Jinping Era: Xi's generation has yet to reveal its full character - the demographics of the new Central Committee will help determine it. So far it is a continuation of the trends above: more likely than not to come from interior than coastal provinces, to have studied the humanities, to have governed in the provinces or central ministries, and to lack military or business experience (Chart 4 above). The coming reshuffle could initiate a change in some of these trends, given some of Xi's revealed preferences, but that will not become clear until this fall.11 Xi is not stereotypical when it comes to China's political cycles: he consolidated power rapidly in his first term.12 The question, then, is whether Xi can continue to accrue power at the party congress, or whether his second term will become complicated by an infusion of Hu Jintao supporters into top party posts. Thus the success of Hu's supporters (particularly on the PSC) is the critical moving part that could determine the political constraints on Xi Jinping from 2017-22. Will Xi be able to arrange a favorable power-sharing agreement? Or will he go further and try to remove this political constraint entirely, even at the risk of political instability? The above points raise two critical questions: Will Chinese politics become more institutionalized? Investors should expect China to maintain a stridently informal political system. Rules and norms can and will be bent, but key principles will be upheld. In other words, the goal posts can be moved, but not too far. Going beyond certain limits would be destabilizing for China's political, institutional, and factional balances, and so far Xi has exhibited poise and the desire to maintain stability that is characteristic of post-1978 Chinese leaders.13 We think there is a low probability that Xi will overthrow all the norms of leadership selection and overturn the balance of power on the Politburo and PSC. If he does, it will raise alarms that he is setting up a new "cult of personality" like Mao, which could cause domestic economic and market instability. Rather, we expect him to modify the rules to maintain control of the PSC without excluding Hu Jintao's faction from power. Will Xi initiate the succession process for 2022? Some commentators suspect that Xi will use the party congress to pave the way for him to cling to power beyond 2022. Clearly Xi could retain the top military post and stay within recent precedent. But any hints at altering recent succession patterns, despite the fact that they are informal, are dangerous for investors in the long run because they raise deep uncertainty about the range of possibilities and political conflicts that could occur upon the actual change of power in 2022. Nevertheless, bear in mind the following points: The question of succession will not be resolved this October. If Xi plans to hang on beyond 2022, then he will continue amassing power and positioning loyalists over the next five years so that he will have full institutional support at the critical moment in 2022 - like Jiang Zemin did when he chose to hang onto the military chairmanship from 2002-04. Thus while Xi may lay some groundwork that makes political observers uneasy, the question will not be resolved either way this fall. Xi's tenure will be an ongoing topic for investors to monitor. Xi is already set to be the most powerful Chinese leader well into the 2020s. Xi's anti-corruption campaign is remarkable evidence of his strength as a ruler. Significantly, this campaign has focused on rooting out Jiang Zemin's influence. Yet Jiang stepped down way back in 2004! In other words, Jiang wielded massive influence between 2004 and 2017. Indeed, Xi's boldest move this year so far was to remove Sun Zhengcai, a Jiang acolyte. It stands to reason that, even if Hu Jintao's faction pulls off a relative victory this year, Xi Jinping's faction will likely be well positioned for a victory in 2022. And if Hu loses out this year, Xi's followers will be better positioned in 2027, as well as 2022. In short, market participants are unlikely to be able to tell the difference this October between (1) Xi getting a boost of political capital for his second term and (2) Xi getting such a big boost that he is on track to overstay his second term.14 Xi might intend to become a dictator and cling to power for longer, but all the market will know for certain is that he has maintained control of the PSC and his general policy framework will be more or less continuous, which is likely a relief in the near term. Finally, investors may not initially care if Xi seizes additional power at the expense of party norms and the succession process. A-shares sold off, but H-shares rallied, when Jiang Zemin decided not to step down entirely in 2002 (Chart 5). Russian stocks and the RUB/USD only fleetingly sold off when Vladimir Putin made clear his intention to return to the presidency yet again in 2011 (Chart 6). Chart 5Foreign Investors Cheered Jiang's Clinging To Power Chart 6Russian Investors Cheered Putin's Second Presidency While it is impossible to know whether markets will cheer any signs of "Papa Xi" doing away with term limits, it is bad for China's governance in the long run if Xi does not clearly begin grooming a successor with this fall's promotions. An heir-apparent for 2022 would reduce the risks of disruptive power-struggle and would impose a personal deadline on Xi Jinping's reform agenda. That is, a deadline above and beyond the 2020 deadline in the 13th Five Year Plan and the 2021 deadline for the 100th anniversary of the Communist Party's founding. That reform agenda, in turn, is essential for improving China's long-term productivity.15 Bottom Line: The Chinese political system is informal, which means that rules and norms can be bent without altering the underlying principles of balance among the key factions and stability of the regime and society as a whole. Our baseline scenario is a market-positive one: that Xi Jinping will win a victory at the party congress, but that he will not overthrow Hu Jintao's followers and abandon the "collective leadership" model, since that would destroy the overall balance of power and heighten domestic political risks. If Xi loses out to the Hu faction, then we would expect Chinese and China-exposed risk assets to sell off, at least initially. If Xi romps to total victory, excluding Hu's clique from power, we would fade any market rally. Such a development would heighten political risks for the foreseeable future. Investment Conclusions The prospect of a Xi-dominated, yet stable, PSC in China is promising because it suggests that China will have at least a marginally improved policy framework for managing the immense challenges it faces. On the economic front, the loss of the demographic dividend threatens to make China old before it gets rich (Chart 7). Xi will need a unified party, as well as loyal supporters in key posts, if he is to re-energize his productivity-enhancing reforms. On the socio-political front, China's intensifying focus on domestic security is symbolized by draconian media censorship ahead of the party congress and, more broadly, a faster rate of spending on public security than national defense in recent years (Chart 8). Such trends suggest that policy makers are concerned about public support. Income inequality and regional disparities are burning issues in an authoritarian country with a larger and more connected middle class and an incipient civil rights movement. Chart 7Rising Participation Boosted Euro Area Labor Force Growth China's Demographic Challenge Chart 8Social Stability A Major Concern In China In terms of the likely economic and market response, we have highlighted in the past that larger macro-economic trends tend to swamp any effects of China's five-year party congresses. There is no observable correlation between these events and the deviations of China's nominal GDP, credit, or fixed investment from long-term averages going back to 1992 (Chart 9). Chart 9No Clear Policy Impact From Past Party Congresses Moreover, China only has two midterm party congresses to compare to today's party congress, and both occurred in the thick of global financial crises (1997, 2007). This makes it difficult to draw firm conclusions about any impact on Chinese risk assets. A-shares were mostly flat after the 1997 congress but fell after 2007, while H-shares broadly fell after both meetings, as one might expect given the crises raging around them (Chart 10 A&B). Chart 10AChinese Stocks Were Flat Or Down ... Chart 10B... After Past Midterm Party Congresses H-shares, being highly responsive to global financial market turmoil, fell relative to emerging market (EM) equities as well in 1997 and 2007. A-shares were more insulated and outperformed EM stocks during the 1997 crisis, though not in the 2007 crisis (Chart 11 A&B). What is clear - for Chinese domestic investors - is that A-shares outperformed H-shares after the party congresses in 1997 and 2007 (Chart 12). Chart 11AChinese Stocks Sold Off In Relative Terms... Chart 11B...Except A-Shares During The Asian Crisis Chart 12A-Shares Outperformed H-Shares After Midterm Congresses This fall, it would not be surprising to see Chinese and global risk-on attitudes prevail in the immediate aftermath of China's party congress: in the broadest sense, the meeting represents a political recapitalization for the Xi administration. Moreover, the backdrop is positive: global and Chinese growth are on a synchronized upswing, Chinese industrial profits have improved, the Fed is on hold, and China's growth risks and capital outflow pressures have diminished.16 This suggests a marginal positive impact for H-shares as well as A-shares. However, Chinese stocks are no longer trading at a discount relative to peers. Moreover, BCA's Geopolitical Strategy believes that the Xi administration's reform reboot will likely bring tougher financial and environmental regulation that will slow credit growth and cut into corporate profits.17 It also seems likely that 2018 will see the dollar stage a comeback as inflation recovers and the Fed resumes hiking rates.18 For all these reasons, we recommend staying long Chinese stocks relative to EM, on the basis that China's reform efforts will be positive for China's productivity outlook but negative for commodities and EM in 2018. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Mao's successor Hua Guofeng, and Xi's predecessor Hu Jintao, are the two leaders who did not obtain "core" status. 2 The current norms developed mostly in the 1980s and have evolved since. The list of candidates is mostly pre-arranged by the top leaders. The party congress then votes on which candidates to include, leaving a remainder of about 10% who do not take seats in the Central Committee. 3 Nevertheless, the Central Committee could produce a few surprises. It is almost inevitable that a few major personalities will fail to get promoted into key positions, while others will be catapulted to higher places. There will also be some tea leaves to read about the share of negative votes or abstentions and the implications for different candidates. 4 The political report is filled with arcane Communist Party jargon but is very important. It is a consensus document that takes multiple committees a year or more to draft, though Xi Jinping will give the finishing touches. It will cover a comprehensive range of policies and will be scrutinized closely by experts for slight changes of terminology, emphasis, or omission. Key things to watch for are whether Xi adds or removes entire sections; whether he alters developmental goals outlined in previous administrations; and whether he inserts new concepts or revises party ideology to make way for contentious reforms. As for the party's constitution, the main question of any change is whether Xi's leadership philosophy is incorporated into the Communist Party's guiding thought, and if so, whether Xi's name is explicitly attached to it. The latter in particular would be a sign that Xi's political capital within the party is massive. For additional commentary, please see Alice Miller, "How To Read Xi Jinping's 19th Party Congress Political Report," China Leadership Monitor 53 (2017), available at www.hoover.org. 5 For the "assault stage" of reform, see Robert Lawrence Kuhn, The Man Who Changed China: The Life And Legacy Of Jiang Zemin (NY: Crown, 2004). Jiang had first targeted SOE reform in 1996 in a speech, he launched the policy itself at the party congress in September 1997, and the state began to implement it at the NPC in March 1998. For Hu Jintao's and Wen Jiabao's administrative reforms after the seventeenth party congress, see Willy Wo Lap Lam, "Beijing Unveils Plan For Super Ministries," China Brief, Jamestown Foundation, February 4, 2008. These reforms, which were only part of the overall agenda after the congress, included restructuring the State Council, empowering the National Development and Reform Commission, and setting up "Super-Ministries" to streamline cabinet-level functions. 6 Rumor has it that Xi will keep his anti-corruption chief, Wang Qishan, on the PSC beyond the 69-year mandatory retirement age, and that he could even replace Premier Li Keqiang. We do not expect either to happen, but both are well within the realm of political possibility - particularly retaining Wang. 7 For this estimate, please see Cheng Li, Chinese Politics In The Xi Jinping Era: Reassessing Collective Leadership (Washington, D.C.: Brookings, 2016), chapter 9. 8 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 9 Traces of Jiang's power will persist here and there, especially if Wang Qishan remains on the PSC, but the overall effect will be a diminishment of this powerful leadership cohort. Symbolically, just as Deng Xiaoping's death loomed over the fifteenth party congress in 1997, Jiang's impending death will loom over the nineteenth party congress today. 10 Indeed judging solely by the cyclical rotation of Chinese leaders according to generation and faction, Hu Jintao's acolytes are favored to outnumber Jiang Zemin's and Xi Jinping's in the 2017 reshuffle. Please see BCA Geopolitical Strategy, "China: Two Factions, One Party," dated September 2012, available at gps.bcaresearch.com. However, Xi's effectiveness and good luck since coming to power lead us to believe that he will secure his followers on the PSC and Politburo this year: please see BCA Geopolitical Strategy Strategic Outlook 2017, "We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 11 For example, Xi Jinping's recent promotions have re-emphasized SOE managers and his policies have supported large "state champion" SOEs. Please see Cheng Li and Lucy Xu, "The rise of state-owned enterprise executives in China's provincial leadership," Brookings, February 22, 2017, available at www.brookings.edu. 12 He came to the top office at a time of significant public dissatisfaction (2012), which meant that he received a kind of "mandate" to make big changes. His faction dominated the PSC, and his sweeping anti-corruption campaign purged the party and state of formidable rivals. In the fall of 2016 he clinched his status as the "core" of the party. 13 As to specific rules, no one should be surprised if they are altered. Take the age limit, which is hotly debated: Jiang Zemin introduced a hard age limit into the PSC in 1997, specifically in a way that prevented the promotion of a heavy-hitting politician, Qiao Shi, while allowing Jiang to continue in power. Now, assume Xi alters the rules to preserve Wang Qishan: this would not necessarily mean that Xi plans to overstay his term limits, though some observers will take it that way. For market participants, the important point is that slight tweaks to informal rules are unlikely to have a big market impact. Consider that Wang has overseen a massive crackdown on corruption, helping clean up the party's image, and is known to be competent in financial regulation as well. If he is retained, will the market really protest? We doubt it. Having said that, we expect him to retire according to the existing rule of thumb. 14 The exception to this statement is if Xi reforms Communist Party political institutions, as some commentators suspect he might, in order to allow the Central Committee to elect the Politburo and PSC directly from its members, thus expanding "intra-party democracy" while also giving Xi a higher likelihood of staying in power. Please see Bo Zhiyue, "Commentary: Sweeping Reforms Expected At Party Congress, But Will Xi Jinping Get All He Wants?" Channel News Asia, August 20, 2017, available at www.channelnewsasia.com. 15 Please see BCA Geopolitical Strategy Monthly Report, "Reflections On China's Reforms," in "The Great Risk Rotation - December 2013," dated December 11, 2013; and Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. Please also see BCA China Investment Strategy, "Understanding China's Master Plan," dated November 20, 2013, available at cis.bcaresearch.com. 16 Please see BCA China Investment Strategy Weekly Reports, "China: Earnings Scorecard And Market Tea Leaves," dated September 7, 2017, and "Monitoring Chinese Capital Outflows And The RMB Internationalization Process," dated August 24, 2017, available at cis.bcaresearch.com. 17 Please see BCA China Investment Strategy Weekly Report, "A Closer Look At Chinese Equity Valuations," dated August 31, 2017, available at cis.bcaresearch.com. For the reform agenda, please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 18 Please see BCA Global Investment Strategy Weekly Report, "Central Bank Showdown," dated September 8, 2017, available at gis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations