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Highlights Three factors point to stable or narrower USD cross-currency basis swap spreads: the improving health of global banks, the end of the adjustment to the regulatory change affecting prime-money market funds, and the relaxation to the Supplementary Leverage Ratio rules by the U.S. Treasury. Four factors point to wider basis swap spreads: BCA's forecast that U.S. loan growth will pick up, our view on U.S. inflation, the coming decline in the Federal Reserve's balance sheet, and the potential for U.S. repatriation. We expect USD basis swap spreads to widen again, which suggests increasing FX vol. This would hurt carry trades, EM currencies and dollar bloc currencies. Feature The rather arcane topic of cross-currency basis swap spreads has periodically surfaced in the news in the past few years. The widening in cross-currency basis swap spreads has been highlighted as one of the key factors explaining why covered interest rate parity relationships (the link between the price of FX forward, spot prices and interest rate differentials) have not held as closely after the Great Financial Crisis (GFC) as before. The widening of cross-currency basis swap spreads has also been highlighted as a factor behind the strength in the U.S. dollar in 2014 and 2015. Similarly, the recent narrowing in the cross-currency basis swap spread has been highlighted as a factor behind the weakness in the USD this year. This week we delve a little deeper into what cross-currency basis swap spread measures, and what some of its major determinants are. We ultimately expect the USD cross-currency basis swap spread to widen again, which should contribute to a stronger dollar and increased global FX volatility. What Is A Cross-Currency Basis Swap? To examine what drives cross-currency basis swap spreads, one first needs to understand what these instruments are. Let's begin with a regular FX swap. An FX swap in EUR/USD is a contract through which two counterparties agree to exchange EURs for USDs today, with a reversal of that exchange at the maturity of the contract - a reversal set at a predetermined exchange rate simply equal to the forward value of the EUR/USD. So, if counterparty A lends X million EURs to counterparty B, the former receives in U.S. dollars the equivalent of X million EURs times the prevalent EUR/USD spot rate from counterparty B today. The transaction does not end there. Simultaneously, the FX swap forces B to give back the X million EURs to counterparty A at maturity, while counterparty A gives back X million EUR times the EUR/USD forward rate in U.S. dollars to counterparty B. This forward rate is the rate prevalent when the contract was agreed upon. The transactions are illustrated in the top panel of Chart 1. Chart 1FX Swaps Vs. Cross Currency Basis Swaps It's Not My Cross To Bear It's Not My Cross To Bear The problem with regular FX swaps is that they offer little liquidity at extended maturities. If market players want to hedge long-term liabilities and assets, they tend to do so using a cross-currency basis swap, where much more liquidity is available at long maturities. A EUR/USD cross currency basis swap begins in the same way as a regular FX swap: counterparty A lends X million EURs to counterparty B, and the former receives in U.S. dollars the equivalent of X million EURs times the prevalent EUR/USD spot rate from counterparty B today. However, this is where the similarities end. A cross-currency basis swap has exchanges of cash flows through its term. Counterparty B, which provided USDs to counterparty A, receives 3-month USD Libor, while counterparty A, which provided EURs to counterparty B, received 3-month EUR Libor + a (alpha being the cross-currency basis swap spread). At the maturity of the contract, counterparty A and B both receive their regular intermediary cash flows, and also re-exchange their respective principal - but this time at the same spot rate as the one that existed at the entry of the contract (Chart 1, bottom panel). Chart 2A Bigger Funding Gap Equals##BR##A Wider Basis Swap Spread A Bigger Funding Gap Equals A Wider Basis Swap Spread A Bigger Funding Gap Equals A Wider Basis Swap Spread In both regular FX and cross-currency basis swaps, counterparties have removed their FX risks, except that in the latter, the interest differentials have been paid during the life of the contract instead of being factored through the forward premium/discount. This is fine and dandy, but it leaves a unexplained. The cross currency basis swap spread (a), is a direct function of the relative supply and demand for each currency. If investors demand a lot of EUR in the swap market relative to its supply, a will be positive. If they demand more USDs, a will be negative. A good example of this dynamic is the funding gap of banks. Let's take the Japanese example. Japanese banks have a surplus of domestic deposits (thanks to the massive savings of the Japanese corporate sector) relative to their yen lending. As a result, they have large dollar lending operations. To hedge their dollar assets, Japanese banks borrow USD in large quantities in the cross-currency swap market. This tends to result in a negative swap spread in the yen (Chart 2). This is particularly true if both the banking sector and the other actors in the economy (institutional investors and non-financial firms) also borrow dollars in the swap market to hedge dollar assets, which is the case in Japan (Chart 3). Chart 3Japanese Investors Are Accumulating Assets Abroad It's Not My Cross To Bear It's Not My Cross To Bear Additionally, if there are perceived solvency risks in the European banking sector, this should further weigh on the cross-currency basis swap spread, pushing it deeper into negative territory, as the viability of the main EUR counterparties becomes at risk. The same dance is true for any currency pair. The other factor that affects USD cross-currency basis swap spreads is the supply of U.S. dollars, especially the room on large banks' balance sheets to service these markets. The cross-currency basis swap spread could be close to zero if large arbitrageurs take offsetting positions to arbitrage the spread away, doing so until the spread disappears. However, with the imposition of Basel III and Dodd-Franks, banks have been constrained in their capacity to do this. Indeed, increased leverage ratio requirements (now banks need to post more capital behind repo transactions as well as collateralized lending and other derivatives) mean that arbitraging cross-currency basis swap spreads and deviations from covered interest rate parity has become much more expensive. Furthermore, the increase in Tier 1 capital ratios associated with these regulations has forced banks to de-lever; however, engaging in arbitrage activities still requires plenty of leverage (Chart 4). Chart 4The Structural Gap In The Basis Swap##BR##Spread Reflects Regulation The Structural Gap In The Basis Swap Spread Reflects Regulation The Structural Gap In The Basis Swap Spread Reflects Regulation Economic Factors Driving The Spread The factors that we look at essentially relate to the supply of USD available for lending in offshore markets, as well as determinants of relative counterparty risks between the U.S. and the rest of the world. Factors Arguing For Narrower Cross-Currency Basis Swap Spreads 1. Global Banks Health Chart 5Banks Perceived Health##BR##Determines Basis Swap Spreads Banks Perceived Health Determines Basis Swap Spreads Banks Perceived Health Determines Basis Swap Spreads The price-to-book ratio of global banks outside the U.S. has been largely correlated with USD cross-currency swap spreads. When global banks get de-rated, spreads widen, and it becomes more expensive to hedge USD positions in the swap market (Chart 5). This is because as investors perceive the solvency of global banks deteriorating, they impose a penalty as the Herstatt risk increases. Additionally, solvency problems can force banks to scramble to access USD funding, prompting deeper spreads. BCA is positive on global financials and sees continued improvement in European NPLs. This means that solvency risk concerns are likely to remain on the backburner for now, pointing to narrower basis swap spreads. 2. Supplementary Leverage Ratio Changes In June, the U.S. Treasury announced a relaxation of some of its rules on supplementary leverage ratios, lowering the amount of capital required to support activity in the repo market behind initial margins for centrally cleared derivatives, and behind holdings of Treasurys. This means that commercial banks in the U.S. can have bigger balance sheets and more room to engage in arbitrage activity, implying a greater supply of dollars in the USD cross-currency basis swap market. In response to last June's proposal, basis swap spreads narrowed by 11 basis points. BCA believes these changes will continue to support dollar liquidity, and will further help in narrowing cross-currency basis swap spreads. 3. Prime Money-Market Funds Debacle Is Over Chart 6More Expensive Bank Funding##BR##= Wider Basis Swap Spreads More Expensive Bank Funding = Wider Basis Swap Spreads More Expensive Bank Funding = Wider Basis Swap Spreads In October 2016, regulatory changes were implemented that allowed prime money market funds to have fluctuating net asset values. Obviously, this meant that prime money-market funds would be not-so-prime anymore. As a result, to remain the ultra-safe vehicles that they once were, prime money-market funds de-risked. As a result, they cut their exposure to risky activities in anticipation of these changes. In practice, a key source of short-term funding for banks evaporated from the market, putting upward pressure on bank financing costs. As the LIBOR-OIS spread increased, so did basis-swap spreads (Chart 6): as it became more expensive for banks to finance themselves, they had to curtail the supply of USDs provided to the swap market, an activity normally requiring intense demand on banks' balance sheets. This adjustment is now over, suggesting limited potential widening in USD basis swap spreads. Factors Arguing For Wider Cross-Currency Basis Swap Spreads 1. U.S. Loan Growth When U.S. banks increase their loan formation activity, USD cross-currency basis swap spreads widen (Chart 7). As banks increase their extension of credit through loans, they decrease the amount of securities they hold on their balance sheets (Chart 8). This means there is less supply of liquidity available for balance sheet activities, particularly providing dollar funding in the offshore market. In the Basel III / Dodd-Frank world, less-liquid bank balance sheets are synonymous with wider USD basis-swap spreads. As we argued last week, increasing U.S. capex, easing lending standards for firms and rising household income levels should result in increasing loan growth in the U.S. which will result in lower abundance of liquid assets and a widening basis swap spreads.1 Chart 7More Bank Loans Lead##BR##To Wider Swap Spreads More Bank Loans Lead To Wider Swap Spreads More Bank Loans Lead To Wider Swap Spreads Chart 8More Debt Equals Less##BR##Securities In Bank Credit More Debt Equals Less Securities In Bank Credit More Debt Equals Less Securities In Bank Credit 2. U.S. Inflation There is a fairly close relationship between U.S. inflation and the USD basis swap spread, where a higher core CPI tends to lead to a wider spread (Chart 9). The fall in U.S. inflation this year likely contributed to the narrowing in basis swap spreads. Our take on this is that as inflation falls, it gives an incentive for banks to hold low-yielding liquidity on their balance sheets as real returns on cash improve. This fuels a gigantic carry trade through the basis-swap market. We expect inflation to pick up meaningfully by mid-2018, which should widen cross-currency basis swap spreads.2 Chart 9When U.S. Inflation Increases, Swap Spreads Widen When U.S. Inflation Increases, Swap Spreads Widen When U.S. Inflation Increases, Swap Spreads Widen 3. Central Bank Balance Sheets When the Federal Reserve increases the size of its balance sheet relative to other balance sheets, this tends to lead to a narrowing of the USD basis swap spread as the global supply of dollars relative to other currencies increases. The opposite is also true. This relationship did not work after late 2016 (Chart 10). However, during that episode, as the change in prime money-market funds caused a dislocation in banks' funding, commercial banks exhibited cautious behavior and increased their reserves with the Fed. As Chart 11 illustrates, there is a tight relationship between the change in commercial banks' reserves held at the Fed and cross-currency basis swap spreads. Going forward, as the Fed lets it balance sheet run off, we expect to see a decrease in commercial banks' excess reserves. This could contribute to upward movement in the basis swap spread. Chart 10Smaller Fed Balance Sheet Leads##BR##To Wider Basis Swap Spreads Smaller Fed Balance Sheet Leads To Wider Basis Swap Spreads Smaller Fed Balance Sheet Leads To Wider Basis Swap Spreads Chart 11Fed Runoff Could Widen##BR##Basis Swap Spreads Fed Runoff Could Widen Basis Swap Spreads Fed Runoff Could Widen Basis Swap Spreads 4. U.S. Repatriations Chart 12U.s. Repatriations Support Wider##BR##Basis Swap Spreads U.s. Repatriations Support Wider Basis Swap Spreads U.s. Repatriations Support Wider Basis Swap Spreads The most revealing relationship unearthed in our study was that when U.S. entities repatriate funds at home, this tends to put strong widening pressure on the USD cross-currency basis swap spread (Chart 12). U.S. businesses hold large cash piles abroad - by some estimates more than US$2.5 trillion. However, most of these funds are held in highly liquid, high-quality U.S.-dollar assets offshore. These assets are perfect collaterals for various transactions in the interbank market. The funds held abroad by U.S. firms are a source of supply for U.S. dollars in the offshore markets. When U.S. entities bring assets back home, the widening in the basis swap spread essentially reflects a decline in the supply of USD in offshore markets, and vice versa when Americans export capital abroad. BCA's base case is that tax cuts are likely to hit the U.S. economy in 2018, even if the growing feud between Trump and the establishment Republican party members is a growing risk. BCA still views a tax repatriation as a higher-likelihood event, as it is the easiest way for the U.S. government to bring funds into its coffers. The 2004 tax repatriation under former President George W. Bush did result in substantial fund repatriation in the U.S. This time will not be different. We expect any such tax repatriation to cause a potentially large deficit of supply in the USD offshore markets, which could create a strong widening basis on the cross-currency basis swap spread in favor of the dollar. Bottom Line: Three factors argue for USD cross-currency basis swap spreads to stay at current levels, or even narrow further. These factors are the health of global banks, the easing in U.S. supplementary leverage ratios and the end of the adjustment of U.S. bank funding to new regulations affecting prime money-market funds. On the other hand four factors points to wider USD cross-currency basis swap spreads: BCA's positive outlook for U.S. credit growth; BCA's positive outlook on U.S. inflation; the run-off of the Fed's balance sheet; and the potential for U.S. entities repatriating funds from abroad. Potential Direction And Investment Implications We anticipate USD cross-currency basis swap spreads to widen over the coming 12 months. We think the easing in the Supplementary Leverage Ratios rules by the U.S. Treasury is the most important factor pointing to narrower USD cross-currency basis swap spreads. However, Basel III rules and most of Dodd-Frank are still in place, which suggest there remains large constraints on the balance-sheet activities of global banks, which will limit the potential for a narrowing of the USD basis swap spread as U.S. banks will remain constrained in their ability to supply U.S. dollars in the offshore market. Chart 13Wider Basis Swap Spreads Equals Higher Vol Wider Basis Swap Spreads Equals Higher Vol Wider Basis Swap Spreads Equals Higher Vol On the other hand many factors support wider USD cross-currency basis swap spreads, most important of which is the potential for more credit growth. This is in our view a very strong force as it requires banks to ration the use of their balance sheets, limiting their activity in the offshore market. Moreover, we do foresee a high probability of tax repatriation, which would put strong widening pressure on the swap spreads. In terms of implications, wider USD basis swap spreads tend to be associated with rising FX vols (Chart 13). As we highlighted in a Special Report last year, higher FX vols are poison for carry trades.3 As such, we think that widening swap spreads could spur a period of trouble for traditional carry currencies. This means EM and dollar-block currencies are likely to suffer in this environment. Additionally, in China, Xi Jinping is consolidating power and has taken control of the Politburo. This implies he now has more room to implement reforms. Removal of growth targets after 2020, removal of growth as a criterion for grading local officials, a focus on balanced growth, and a focus on combatting pollution all suggest that Chinese growth is unlikely to follow the same debt-fueled, capex-led model.4 This will weigh on Chinese imports of raw materials, and hurt export volumes and prices for many EM countries and commodities producers. This means these policies represent a headwind for many carry currencies. Moreover, historically, wider USD funding costs have been associated with a stronger dollar, as it makes it more expensive to hedge dollar assets. Thus, in an environment where U.S. interest rates are rising relative to the rest of the world - making U.S. assets attractive - wider basis swap spreads are an additional factor that could lift the dollar. Bottom Line: We anticipate the USD cross-currency basis swap spread to widen over the next 12 months. This will be associated with higher FX vols, which hurt carry trades, EM currencies and dollar-block currencies. Chinese reforms will reinforce these risks. Additionally, wider basis swap spreads will create support for the USD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "All About Credit", dated October 20, 2017, available at fes.bcaresearch.com. 2 Please see Foreign Exchange Strategy Weekly Report, titled "Conflicting Forces For The Dollar", dated September 8, 2017, and "Is The Dollar Expensive?", dated October 13, 2017, available at fes.bcaresearch.com. 3 Please see Foreign Exchange Strategy Special Report, titled "Carry Trades: More Than Pennies And Steamrollers", dated May 6, 2016, available at fes.bcaresearch.com. 4 Please see Geopolitical Strategy Weekly Report, titled "Xi Jinping: Chairman Of Everything", dated October 25, 2017 and Special Report, titled "How To Read Xi Jinping's Party Congress Speech", dated October 18, 2017, available at gps.bcaresearch.com. Appendix Implications For The Global Fixed Income Investor Chart A1FX Basis Swaps Boosting##BR##Hedged European Yields FX Basis Swaps Boosting Hedged European Yields FX Basis Swaps Boosting Hedged European Yields The outlook for cross-currency basis swap spreads has important implications for global fixed income investors. Chiefly, a wider (more negative) basis swap spread makes it more profitable for U.S. investors to lend U.S. dollars. For example, the top panel of Chart A1 shows that if a U.S.-based investor swaps dollars for euros on a 3-month horizon, and then invests those euros in 10-year German bunds, they will earn a hedged yield of 2.5% (annualized). This compares to a current yield of 2.3% on the 10-year U.S. Treasury note. If the basis swap spread were zero, then the U.S. investor would face a hedged German 10-year yield of only 2.1%. Conversely, a deeply negative basis swap spread works against non-U.S. investors looking to gain exposure to the U.S. bond market. If a Eurozone-based investor swaps euros for dollars on a 3-month horizon and then invests those dollars in 10-year U.S. Treasuries, he will earn a hedged yield of 0.1% (annualized). This compares to a current yield of 0.4% on 10-year German bunds. If the basis swap spread were zero, then the European investor would face a more enticing hedged U.S. 10-year yield of 0.6%. The middle three panels of Chart A1 show the 10-year yields in other Eurozone bond markets from the perspective of a U.S.-based investor who has hedged his currency risk on a 3-month horizon, as per the strategy explained above. The bottom panel of Chart A1 shows that the deviation of the EUR/USD basis swap spread from zero currently adds 42 basis points to the hedged yields faced by a U.S. investor. Charts A2, A3, A4 and A5 present the same analysis for other major bond markets, again from the perspective of a U.S. based investor.5 Chart A2FX Basis Swaps Boosting Hedged Gilt Yields FX Basis Swaps Boosting Hedged Gilt Yields FX Basis Swaps Boosting Hedged Gilt Yields Chart A3FX Basis Swaps Boosting Hedged JGB Yields FX Basis Swaps Boosting Hedged JGB Yields FX Basis Swaps Boosting Hedged JGB Yields Chart A4FX Basis Swaps Boosting##BR##Hedged Canadian Yields FX Basis Swaps Boosting Hedged Canadian Yields FX Basis Swaps Boosting Hedged Canadian Yields Chart A5FX Basis Swaps Are NOT Boosting##BR##Hedged Australian Yields FX Basis Swaps Are NOT Boosting Hedged Australian Yields FX Basis Swaps Are NOT Boosting Hedged Australian Yields The Impact Of Hedging Costs On Returns Of course, the basis swap spread is only one input to hedging costs. Once again, using the example of a U.S.-based investor looking for exposure in European bond markets, we calculate the hedging cost as: (1 + Hedging Cost) = (1 + 3-month EUR LIBOR + basis swap spread) / (1 + 3-month USD LIBOR) Right now the hedging cost in the above example is below zero. This is why German bund yields actually appear more attractive to U.S. investors after taking hedging costs into account. But what's more interesting is that total returns in 7-10 year German bunds (hedged into USD) relative to total returns in 7-10 year U.S. Treasury notes track hedging costs very closely over time (Chart A6). Chart A6Hedging Costs Will Continue To Boost Hedged German Bond Returns As The Fed Hikes Rates Hedging Costs Will Continue To Boost Hedged German Bond Returns As The Fed Hikes Rates Hedging Costs Will Continue To Boost Hedged German Bond Returns As The Fed Hikes Rates This is highly logical. As hedging costs become more negative, it means that U.S.-based investors make more money swapping U.S. dollars for euros. Therefore, a strategy of swapping dollars for euros, and then placing the proceeds in 7-10 year German bunds should continue to be a profitable one for U.S. investors as long as hedging costs continue to decline. Fortunately for U.S. investors, hedging costs should become even more negative during the next 12 months. In our base case scenario, we assume that the Federal Reserve will lift rates by 100bps by the end of 2018. We also assume that the ECB will not lift rates during this timeframe. That divergence in policy rates on its own will drive hedging costs further into negative territory, and it will only be exacerbated if the cross-currency basis swap spread widens as we anticipate. We illustrate the impact of the cross-currency basis swap spread on hedging costs in the bottom panel of Chart A6. The panel shows where hedging costs will go between now and the end of 2018, assuming policy rates move as we described above, and that the basis swap spread either widens to -100 bps or tightens back to zero. It is evident that a sharp widening in basis swap spreads would be a boon for U.S. investors in foreign bond markets. Bottom Line: Deeply negative basis swap spreads make it more profitable to lend dollars on a short-term horizon. This presents an opportunity for U.S. investors to swap dollars for foreign currencies and invest in non-U.S. bond markets. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 5 While the basis swap spread between the U.S. and most countries is negative, it is actually positive between the U.S. and Australia. So in this case the basis swap spread makes Australian bonds look less attractive to U.S. investors. Conversely, the basis swap spread makes U.S. bonds look slightly more attractive to Australian investors.

Highlights Three factors point to stable or narrower USD cross-currency basis swap spreads: the improving health of global banks, the end of the adjustment to the regulatory change affecting prime-money market funds, and the relaxation to the Supplementary Leverage Ratio rules by the U.S. Treasury. Four factors point to wider basis swap spreads: BCA's forecast that U.S. loan growth will pick up, our view on U.S. inflation, the coming decline in the Federal Reserve's balance sheet, and the potential for U.S. repatriation. We expect USD basis swap spreads to widen again, which suggests increasing FX vol. This would hurt carry trades, EM currencies and dollar bloc currencies. Feature Three factors point to stable or narrower USD cross-currency basis swap spreads: the improving health of global banks, the end of the adjustment to the regulatory change affecting prime-money market funds, and the relaxation to the Supplementary Leverage Ratio rules by the U.S. Treasury. Four factors point to wider basis swap spreads: BCA's forecast that U.S. loan growth will pick up, our view on U.S. inflation, the coming decline in the Federal Reserve's balance sheet, and the potential for U.S. repatriation. We expect USD basis swap spreads to widen again, which suggests increasing FX vol. This would hurt carry trades, EM currencies and dollar bloc currencies. The rather arcane topic of cross-currency basis swap spreads has periodically surfaced in the news in the past few years. The widening in cross-currency basis swap spreads has been highlighted as one of the key factors explaining why covered interest rate parity relationships (the link between the price of FX forward, spot prices and interest rate differentials) have not held as closely after the Great Financial Crisis (GFC) as before. The widening of cross-currency basis swap spreads has also been highlighted as a factor behind the strength in the U.S. dollar in 2014 and 2015. Similarly, the recent narrowing in the cross-currency basis swap spread has been highlighted as a factor behind the weakness in the USD this year. This week we delve a little deeper into what cross-currency basis swap spread measures, and what some of its major determinants are. We ultimately expect the USD cross-currency basis swap spread to widen again, which should contribute to a stronger dollar and increased global FX volatility. What Is A Cross-Currency Basis Swap? To examine what drives cross-currency basis swap spreads, one first needs to understand what these instruments are. Let's begin with a regular FX swap. An FX swap in EUR/USD is a contract through which two counterparties agree to exchange EURs for USDs today, with a reversal of that exchange at the maturity of the contract - a reversal set at a predetermined exchange rate simply equal to the forward value of the EUR/USD. So, if counterparty A lends X million EURs to counterparty B, the former receives in U.S. dollars the equivalent of X million EURs times the prevalent EUR/USD spot rate from counterparty B today. The transaction does not end there. Simultaneously, the FX swap forces B to give back the X million EURs to counterparty A at maturity, while counterparty A gives back X million EUR times the EUR/USD forward rate in U.S. dollars to counterparty B. This forward rate is the rate prevalent when the contract was agreed upon. The transactions are illustrated in the top panel of Chart 1. Chart 1FX Swaps Vs. Cross Currency Basis Swaps It's Not My Cross To Bear It's Not My Cross To Bear The problem with regular FX swaps is that they offer little liquidity at extended maturities. If market players want to hedge long-term liabilities and assets, they tend to do so using a cross-currency basis swap, where much more liquidity is available at long maturities. Chart 2A Bigger Funding Gap = ##br##A Wider Basis Swap Spread It's Not My Cross To Bear It's Not My Cross To Bear A EUR/USD cross currency basis swap begins in the same way as a regular FX swap: counterparty A lends X million EURs to counterparty B, and the former receives in U.S. dollars the equivalent of X million EURs times the prevalent EUR/USD spot rate from counterparty B today. However, this is where the similarities end. A cross-currency basis swap has exchanges of cash flows through its term. Counterparty B, which provided USDs to counterparty A, receives 3-month USD Libor, while counterparty A, which provided EURs to counterparty B, received 3-month EUR Libor + a (alpha being the cross-currency basis swap spread). At the maturity of the contract, counterparty A and B both receive their regular intermediary cash flows, and also re-exchange their respective principal - but this time at the same spot rate as the one that existed at the entry of the contract (Chart 1, bottom panel). In both regular FX and cross-currency basis swaps, counterparties have removed their FX risks, except that in the latter, the interest differentials have been paid during the life of the contract instead of being factored through the forward premium/discount. This is fine and dandy, but it leaves a unexplained. The cross currency basis swap spread (a), is a direct function of the relative supply and demand for each currency. If investors demand a lot of EUR in the swap market relative to its supply, a will be positive. If they demand more USDs, a will be negative. A good example of this dynamic is the funding gap of banks. Let's take the Japanese example. Japanese banks have a surplus of domestic deposits (thanks to the massive savings of the Japanese corporate sector) relative to their yen lending. As a result, they have large dollar lending operations. To hedge their dollar assets, Japanese banks borrow USD in large quantities in the cross-currency swap market. This tends to result in a negative swap spread in the yen (Chart 2). This is particularly true if both the banking sector and the other actors in the economy (institutional investors and non-financial firms) also borrow dollars in the swap market to hedge dollar assets, which is the case in Japan (Chart 3). Chart 3Japanese Investors Are Accumulating Assets Abroad It's Not My Cross To Bear It's Not My Cross To Bear Additionally, if there are perceived solvency risks in the European banking sector, this should further weigh on the cross-currency basis swap spread, pushing it deeper into negative territory, as the viability of the main EUR counterparties becomes at risk. The same dance is true for any currency pair. Chart 4The Structural Gap In The Basis Swap Spread##br## Reflects Regulation It's Not My Cross To Bear It's Not My Cross To Bear The other factor that affects USD cross-currency basis swap spreads is the supply of U.S. dollars, especially the room on large banks' balance sheets to service these markets. The cross-currency basis swap spread could be close to zero if large arbitrageurs take offsetting positions to arbitrage the spread away, doing so until the spread disappears. However, with the imposition of Basel III and Dodd-Franks, banks have been constrained in their capacity to do this. Indeed, increased leverage ratio requirements (now banks need to post more capital behind repo transactions as well as collateralized lending and other derivatives) mean that arbitraging cross-currency basis swap spreads and deviations from covered interest rate parity has become much more expensive. Furthermore, the increase in Tier 1 capital ratios associated with these regulations has forced banks to de-lever; however, engaging in arbitrage activities still requires plenty of leverage (Chart 4). Economic Factors Driving The Spread The factors that we look at essentially relate to the supply of USD available for lending in offshore markets, as well as determinants of relative counterparty risks between the U.S. and the rest of the world. Factors Arguing For Narrower Cross-Currency Basis Swap Spreads Global Banks Health The price-to-book ratio of global banks outside the U.S. has been largely correlated with USD cross-currency swap spreads. When global banks get de-rated, spreads widen, and it becomes more expensive to hedge USD positions in the swap market (Chart 5). This is because as investors perceive the solvency of global banks deteriorating, they impose a penalty as the Herstatt risk increases. Additionally, solvency problems can force banks to scramble to access USD funding, prompting deeper spreads. Chart 5Banks Perceived Health Determines ##br##Basis Swap Spreads It's Not My Cross To Bear It's Not My Cross To Bear BCA is positive on global financials and sees continued improvement in European NPLs. This means that solvency risk concerns are likely to remain on the backburner for now, pointing to narrower basis swap spreads. Supplementary Leverage Ratio Changes In June, the U.S. Treasury announced a relaxation of some of its rules on supplementary leverage ratios, lowering the amount of capital required to support activity in the repo market behind initial margins for centrally cleared derivatives, and behind holdings of Treasurys. This means that commercial banks in the U.S. can have bigger balance sheets and more room to engage in arbitrage activity, implying a greater supply of dollars in the USD cross-currency basis swap market. In response to last June's proposal, basis swap spreads narrowed by 11 basis points. BCA believes these changes will continue to support dollar liquidity, and will further help in narrowing cross-currency basis swap spreads. Prime Money-Market Funds Debacle Is Over Chart 6More Expensive Bank Funding Equals ##br##Wider Basis Swap Spreads It's Not My Cross To Bear It's Not My Cross To Bear In October 2016, regulatory changes were implemented that allowed prime money market funds to have fluctuating net asset values. Obviously, this meant that prime money-market funds would be not-so-prime anymore. As a result, to remain the ultra-safe vehicles that they once were, prime money-market funds de-risked. As a result, they cut their exposure to risky activities in anticipation of these changes. In practice, a key source of short-term funding for banks evaporated from the market, putting upward pressure on bank financing costs. As the LIBOR-OIS spread increased, so did basis-swap spreads (Chart 6): as it became more expensive for banks to finance themselves, they had to curtail the supply of USDs provided to the swap market, an activity normally requiring intense demand on banks' balance sheets. This adjustment is now over, suggesting limited potential widening in USD basis swap spreads. Factors Arguing For Wider Cross-Currency Basis Swap Spreads 1. U.S. Loan Growth When U.S. banks increase their loan formation activity, USD cross-currency basis swap spreads widen (Chart 7). As banks increase their extension of credit through loans, they decrease the amount of securities they hold on their balance sheets (Chart 8). This means there is less supply of liquidity available for balance sheet activities, particularly providing dollar funding in the offshore market. In the Basel III / Dodd-Frank world, less-liquid bank balance sheets are synonymous with wider USD basis-swap spreads. As we argued last week, increasing U.S. capex, easing lending standards for firms and rising household income levels should result in increasing loan growth in the U.S. which will result in lower abundance of liquid assets and a widening basis swap spreads.1 Chart 7More Bank Loans Lead To Wider Swap Spreads It's Not My Cross To Bear It's Not My Cross To Bear Chart 8More Debt Equals Less Securities In Bank Credit It's Not My Cross To Bear It's Not My Cross To Bear 2. U.S. Inflation There is a fairly close relationship between U.S. inflation and the USD basis swap spread, where a higher core CPI tends to lead to a wider spread (Chart 9). The fall in U.S. inflation this year likely contributed to the narrowing in basis swap spreads. Our take on this is that as inflation falls, it gives an incentive for banks to hold low-yielding liquidity on their balance sheets as real returns on cash improve. This fuels a gigantic carry trade through the basis-swap market. We expect inflation to pick up meaningfully by mid-2018, which should widen cross-currency basis swap spreads.2 3. Central Bank Balance Sheets When the Federal Reserve increases the size of its balance sheet relative to other balance sheets, this tends to lead to a narrowing of the USD basis swap spread as the global supply of dollars relative to other currencies increases. The opposite is also true. This relationship did not work after late 2016 (Chart 10). However, during that episode, as the change in prime money-market funds caused a dislocation in banks' funding, commercial banks exhibited cautious behavior and increased their reserves with the Fed. As Chart 11 illustrates, there is a tight relationship between the change in commercial banks' reserves held at the Fed and cross-currency basis swap spreads. Going forward, as the Fed lets it balance sheet run off, we expect to see a decrease in commercial banks' excess reserves. This could contribute to upward movement in the basis swap spread. Chart 9When U.S. Inflation Increases, ##br##Swap Spreads Widen It's Not My Cross To Bear It's Not My Cross To Bear Chart 10Smaller Fed Balance Sheet Leads To##br## Wider Basis Swap Spreads It's Not My Cross To Bear It's Not My Cross To Bear Chart 11Fed Runoff Could##br## Widen Basis Swap Spreads It's Not My Cross To Bear It's Not My Cross To Bear 4. U.S. Repatriations The most revealing relationship unearthed in our study was that when U.S. entities repatriate funds at home, this tends to put strong widening pressure on the USD cross-currency basis swap spread (Chart 12). U.S. businesses hold large cash piles abroad - by some estimates more than US$2.5 trillion. However, most of these funds are held in highly liquid, high-quality U.S.-dollar assets offshore. These assets are perfect collaterals for various transactions in the interbank market. The funds held abroad by U.S. firms are a source of supply for U.S. dollars in the offshore markets. When U.S. entities bring assets back home, the widening in the basis swap spread essentially reflects a decline in the supply of USD in offshore markets, and vice versa when Americans export capital abroad. Chart 12U.s. Repatriations Support Wider Basis Swap Spreads It's Not My Cross To Bear It's Not My Cross To Bear BCA's base case is that tax cuts are likely to hit the U.S. economy in 2018, even if the growing feud between Trump and the establishment Republican party members is a growing risk. BCA still views a tax repatriation as a higher-likelihood event, as it is the easiest way for the U.S. government to bring funds into its coffers. The 2004 tax repatriation under former President George W. Bush did result in substantial fund repatriation in the U.S. This time will not be different. We expect any such tax repatriation to cause a potentially large deficit of supply in the USD offshore markets, which could create a strong widening basis on the cross-currency basis swap spread in favor of the dollar. Bottom Line: Three factors argue for USD cross-currency basis swap spreads to stay at current levels, or even narrow further. These factors are the health of global banks, the easing in U.S. supplementary leverage ratios and the end of the adjustment of U.S. bank funding to new regulations affecting prime money-market funds. On the other hand four factors points to wider USD cross-currency basis swap spreads: BCA's positive outlook for U.S. credit growth; BCA's positive outlook on U.S. inflation; the run-off of the Fed's balance sheet; and the potential for U.S. entities repatriating funds from abroad. Potential Direction And Investment Implications We anticipate USD cross-currency basis swap spreads to widen over the coming 12 months. We think the easing in the Supplementary Leverage Ratios rules by the U.S. Treasury is the most important factor pointing to narrower USD cross-currency basis swap spreads. However, Basel III rules and most of Dodd-Frank are still in place, which suggest there remains large constraints on the balance-sheet activities of global banks, which will limit the potential for a narrowing of the USD basis swap spread as U.S. banks will remain constrained in their ability to supply U.S. dollars in the offshore market. On the other hand many factors support wider USD cross-currency basis swap spreads, most important of which is the potential for more credit growth. This is in our view a very strong force as it requires banks to ration the use of their balance sheets, limiting their activity in the offshore market. Moreover, we do foresee a high probability of tax repatriation, which would put strong widening pressure on the swap spreads. In terms of implications, wider USD basis swap spreads tend to be associated with rising FX vols (Chart 13). As we highlighted in a Special Report last year, higher FX vols are poison for carry trades.3 As such, we think that widening swap spreads could spur a period of trouble for traditional carry currencies. This means EM and dollar-block currencies are likely to suffer in this environment. Chart 13Wider Basis Swap Spreads Equals Higher Vol It's Not My Cross To Bear It's Not My Cross To Bear Additionally, in China, Xi Jinping is consolidating power and has taken control of the Politburo. This implies he now has more room to implement reforms. Removal of growth targets after 2020, removal of growth as a criterion for grading local officials, a focus on balanced growth, and a focus on combatting pollution all suggest that Chinese growth is unlikely to follow the same debt-fueled, capex-led model.4 This will weigh on Chinese imports of raw materials, and hurt export volumes and prices for many EM countries and commodities producers. This means these policies represent a headwind for many carry currencies. Moreover, historically, wider USD funding costs have been associated with a stronger dollar, as it makes it more expensive to hedge dollar assets. Thus, in an environment where U.S. interest rates are rising relative to the rest of the world - making U.S. assets attractive - wider basis swap spreads are an additional factor that could lift the dollar. Bottom Line: We anticipate the USD cross-currency basis swap spread to widen over the next 12 months. This will be associated with higher FX vols, which hurt carry trades, EM currencies and dollar-block currencies. Chinese reforms will reinforce these risks. Additionally, wider basis swap spreads will create support for the USD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "All About Credit", dated October 20, 2017, available at fes.bcaresearch.com. 2 Please see Foreign Exchange Strategy Weekly Report, titled "Conflicting Forces For The Dollar", dated September 8, 2017, and "Is The Dollar Expensive?", dated October 13, 2017. 3 Please see Foreign Exchange Strategy Special Report, titled "Carry Trades: More Than Pennies And Steamrollers", dated May 6, 2016. 4 Please see Geopolitical Strategy Weekly Report, titled "Xi Jinping: Chairman Of Everything", dated October 25, 2017 and Special Report, titled "How To Read Xi Jinping's Party Congress Speech", dated October 18, 2017.

Overweight We remain constructive on the S&P banks index as all three key drivers of bank profits, namely loan growth, price of credit and credit quality, are simultaneously moving in the right direction. Leading indicators of loan demand are accelerating; consumer confidence is exceptionally strong and the ISM manufacturing survey has been on fire lately (second panel). On the price of credit front, if BCA's bond view pans out in the next year and the 10-year Treasury yield veers closer to 2.8-3% range with rising inflation expectations in the driver's seat (third panel), then bank profits should continue to accelerate. Finally, credit quality remains pristine; loan loss reserves have recently crossed above non-current loans in Q2 according to the FDIC, for the first time since 2007. Historically, a rising reserve coverage ratio has been synonymous with increasing valuations and the current message is that the banks rerating phase is in the early innings. Bottom Line: We reiterate our early-May overweight stance in the S&P financials sector and continue to overweight the heavyweight S&P banks sub-index. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT. Banks Hold The Key Banks Hold The Key

Highlights Portfolio Strategy The financials sector's fortunes are linked to the path of 10-year Treasury yields. BCA's view of a selloff in the bond market bodes well for this interest rate-sensitive sector. The S&P banks index is on the cusp of flexing its earnings power muscle. Higher profits will serve as a catalyst for a valuation rerating in this key financials sub-sector. The still unloved S&P asset management & custody banks index has significant catch-up potential. We reiterate our high-conviction overweight status. Recent Changes There are no changes to our portfolio this week. Table 1 Later Cycle Dynamics Later Cycle Dynamics Feature The S&P 500 ended last week on a high note, cheering significant progress on the tax bill front and digesting early earnings beats. Given the equity market's lofty valuation starting point, substantial positive profit surprises are now necessary to move the needle in stocks. Encouragingly, IBM's mention of the fall in the U.S. dollar boosting EPS1 may morph into a broad-based theme this earnings season given the currency's mysterious absence we have been flagging in Q2. Beneath the surface, easy fiscal policy prospects coupled with synchronized global growth will likely continue to underpin equities. Importantly, later stages of the business cycle are synonymous with impressive gains in the S&P 500. The unemployment gap, defined as the unemployment rate minus the non-accelerating inflation rate of unemployment (NAIRU), is an excellent leading indicator of the yield curve. Granted, NAIRU is an estimate and we are using the CBO's long-term NAIRU quarterly forecast as an input to the unemployment gap indicator. When the unemployment gap disappears, inflation should start rearing its ugly head, eventually leading the Fed to tighten monetary policy to the point where the yield curve inverts and predicts the end of the business cycle. Empirical evidence suggests that first the unemployment gap closes then the yield curve inverts and the business cycle subsequently ends (Chart 1). However, this indicator has had one miss since the early-1970s, during the second leg of the early-1980s double dip recession. Chart 1Eliminated Unemployment Gap Is Bullish For Equities Eliminated Unemployment Gap Is Bullish For Equities Eliminated Unemployment Gap Is Bullish For Equities Table 2 shows the S&P 500 performance from when the unemployment gap clearly closes until the business cycle ends. In all five iterations that lasted, on average, 28 months, the broad market has risen, on average, by 29%. The unemployment gap has been eliminated since February 2017 and if history at least rhymes the next U.S. recession will arrive some time in 2019 as the SPX hits our peak cycle 3,000 target.2 Another later cycle phenomenon is the disappearance of volatility and the plunge in stock correlations as the Fed tightens monetary policy. While large institutional investors aggressively selling volatility this cycle is dampening vol across asset classes, there is another explanation of the non-existence of vol: synchronized global growth. Chart 2 shows that leading up to the prior three recessions, volatility was drifting lower and remained low, and the common denominator was simultaneous global growth in the late-1980s, late-1990s and mid-2000s. BCA's global (40 country) industrial production composite was expanding during the later stages of the business cycle. Similarly, our global (44 country) global EPS diffusion index and the global synchronicity indicator also depict concurrent global growth. Table 2S&P 500 Returns When##br## The Unemployment Gap Closes Later Cycle Dynamics Later Cycle Dynamics Chart 2Linking Low Vol To ##br##Synchronized Global Growth Linking Low Vol To Synchronized Global Growth Linking Low Vol To Synchronized Global Growth During the later stages of the cycle, equity sector correlations also collapse as earnings fundamentals are key performance drivers and sector differentiation generates alpha, as the broad market enters the last stage of the bull market. As we mentioned in our "SPX 3,000?" Weekly Report on July 10th, this does not mean the S&P 500's path is a linear straight line up until the next recession hits. There are high odds of a 5-10% garden variety pullback materializing which we deem a healthy development and our strategy would be to buy the dip, ceteris paribus. This week we update an early cyclical sector and two key sub-components. Financials: In The Shadows Of The Bond Market While financials stocks have cheered the prospects of a tax bill passage sometime in early 2018 (Chart 3), sell-side analysts have been brutally downgrading financials sector EPS estimates, dealing a blow to most sub-indexes net earnings revisions (Chart 4). True, hurricane-related losses may be the culprit, but such indiscriminate downgrades are unwarranted, and we would lean against such pessimism. Recent profit results corroborate our positive sector bias, but we are still early in the earnings season. Chart 3Dissecting Financials Performance Dissecting Financials Performance Dissecting Financials Performance Chart 4Extreme EPS Pessimism Extreme EPS Pessimism Extreme EPS Pessimism This early cyclical sector is a core overweight portfolio holding and there are high odds of significant relative gains in the coming quarters. Historically, financials stocks had been almost 100% positively correlated with the yield curve slope (Chart 5): a steepening yield curve gooses financials profits, while a flattening one eats into earnings via narrowing net interest margins. This rang true up until the Great Recession. Since then, unconventional monetary policies likely rendered this multi-decade correlation ineffective. In particular, the fed funds rate's zero lower bound caused a shift in the correlation from the yield curve to the 10-year Treasury yield (Chart 6). In fact, changes in the 10-year Treasury yield are now a carbon copy of relative share price momentum (Chart 6). Chart 5Shifting Correlations Shifting Correlations Shifting Correlations Chart 6Financials And UST Yield Are Joined At The Hip Financials And UST Yield Are Joined At The Hip Financials And UST Yield Are Joined At The Hip Thus, accurately forecasting long term interest rates should also dictate the direction of relative share prices, especially given the still historically low fed funds rate. On that front, the Treasury market is priced for the 10-year yield to hit 2.57% in October 2018 from roughly 2.38% currently. We expect the 10-year yield will rise more quickly than is discounted in the forward curve. Our U.S. bond strategists think core inflation will soon resume its modest cyclical uptrend. A parallel recovery in the cost of inflation protection will impart 50-60 basis points of upside to the 10-year Treasury yield by the time core inflation reaches the Fed's 2% target.3 Chart 7 plots the path of the 10-year Treasury yield discounted in the forward curve alongside a path consistent with BCA's view that inflation is poised to head higher. It also shows what this would mean for the 10-year breakeven inflation rate. If core inflation resumes its uptrend, as BCA expects, then financials will have a stellar return year in 2018, all else equal. Chart 7Lots Of Upside Lots Of Upside Lots Of Upside Meanwhile, market participants typically value financials on a price-to-book basis during calamitous times and are very slow in changing metrics once the tremors are behind the sector. We are likely on the cusp of a switch away from P/B and toward forward P/E as a key valuation metric for financials. The current 20% forward P/E discount to the broad market is highly punitive (bottom panel, Chart 5). If the key S&P banks sub-index successfully flexes its earnings power muscle, as we expect, then a valuation rerating phase looms for both banks and financials equities. Banks Hold The Key We remain constructive on the S&P banks index as all three key drivers of bank profits, namely loan growth, price of credit and credit quality, are simultaneously moving in the right direction. Tack on the increasing likelihood of a tax bill becoming law in early 2018, the continued push of the Trump administration to relax bank regulations and pent up demand for shareholder friendly activities including net share retirement and higher dividend payments/payouts, and bank stocks are well positioned to generate impressive returns in the coming quarters. Lower corporate tax rates will boost bank profits directly and indirectly. Fiscal stimulus typically translates into an economic fillip. If small and medium businesses (SME) benefit the most from lower taxes then higher SME profits will lead to a more expansionary mindset and small business owners will likely tap their bankers to finance capital spending plans. As tax certainty increases, so will animal spirits, aiding in kick-starting a virtuous economic cycle. Thus, loan growth is on an upward trajectory. Leading indicators of loan demand are also painting a bright picture for bank profits. C&I and consumer loans, two large credit categories, are both forecast to reaccelerate in the coming months. The ISM manufacturing survey has been on fire lately and consumer confidence has been following closely behind (third & fourth panels, Chart 8). Our credit growth model captures these positive forces and is sending an unambiguously positive message for loan reacceleration in the coming months (Chart 8). Moreover, residential real estate loan origination (the second largest credit category in U.S. dollar terms) should gain steam, underpinned by solid housing market's foundations: house prices are still expanding at a healthy clip (top panel, Chart 9), household formation is running higher than housing starts and mortgage rates are not prohibitive. Chart 8Bright Business And Consumer Credit Outlooks Bright Business And Consumer Credit Outlooks Bright Business And Consumer Credit Outlooks Chart 9Ongoing Valuation Rerating Ongoing Valuation Rerating Ongoing Valuation Rerating The V-shaped recovery in our U.S. credit impulse corroborates this fertile loan backdrop and is heralding an earnings outperformance phase (Chart 10). On the price of credit front, if BCA's bond view pans out in the next year and the 10-year Treasury yield veers closer to 2.8-3% range with rising inflation expectations in the driver's seat (Chart 11), then bank profits should continue to accelerate. Granted, the Fed will also raise rates next year and, at the margin, push up funding costs for the banking sector. However, our working assumption is that banks will remain linked to the 10-year UST yield's fortunes next year. At some point later in the Fed tightening cycle, the yield curve and bank correlation will likely get re-established. But, a flattening yield curve denting NIMs is a 2019 narrative. Finally, credit quality remains pristine despite some pockets of weakness in, subprime especially, auto loans. At this stage of the cycle, near or at full employment, NPLs will remain muted. Importantly, loan loss reserves have recently crossed above non-current loans in Q2 according to the FDIC, for the first time since 2007. Historically, a rising reserve coverage ratio has been synonymous with increasing valuations and the current message is that the banks rerating phase is in the early innings (Chart 12). Chart 10Heed The Positive Credit Impulse Signal Heed The Positive Credit Impulse Signal Heed The Positive Credit Impulse Signal Chart 11Price Of Credit Should Recover Price Of Credit Should Recover Price Of Credit Should Recover Chart 12Pristine Credit Quality Pristine Credit Quality Pristine Credit Quality Bottom Line: We reiterate our early-May overweight stance in the S&P financials sector and continue to overweight the heavyweight S&P banks sub-index. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT. A Few Words On Asset Management & Custody Banks The S&P asset management & custody banks (AMCB) index sits atop of our high-conviction return table (see page 15), outperforming the broad market by 7.2% since inception. While it is tempting to monetize some of these profits, we choose to remain patient. Likely more gains are in store in the coming months as this financials sub sector maintains its leadership position. If BCA's bond view of a selloff in the 10-year Treasury market transpires in 2018, then the budding rotation out of bond and into equity products will further accelerate. The stock-to-bond ratio captures this shift and it is currently flashing green (Chart 13). Overall assets under management are also rising and are a boon for the AMCB group's profit prospects, on the back of higher equity prices and also higher flows into stocks in general (bottom panel, Chart 13). Vibrant global economic sentiment, as measured by the IFO's World Economic Survey (top panel, Chart 14), and domestic (and global) manufacturing resurgence should continue to underpin M&A activity and sustain the high levels of margin debt. Both of these factors suggest that AMCB profit drivers are accelerating and will likely serve as a catalyst to unlock excellent value in this still unloved financials sub-group (middle panel, Chart 14). Chart 13Increasing AUMs... Increasing AUMs... Increasing AUMs... Chart 14...And Rising Animal Spirits Are Bullish For AMCB ...And Rising Animal Spirits Are Bullish For AMCB ...And Rising Animal Spirits Are Bullish For AMCB Adding it up, the still undervalued AMCB index has sizable catch-up potential, especially if the equity risk premium (ERP) continues to narrow in the coming quarters, as we expect (ERP shown inverted, bottom panel, Chart 14). Bottom Line: The S&P AMCB index remains a high-conviction overweight. The ticker symbols for the stocks in this index are: BLBG: S5AMGT-BK, BLK, STT, AMP, NTRS, TROW, BEN, IVZ, AMG. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report,"Dollar The Great Reflator" dated September 18, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report,"SPX 3,000?" dated July 10, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Bond Strategy Weekly Report,"Living With The Carry Trade" dated October 17, 2017, available at usbs.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights Revisiting the shadow banking system 10 years later. The September CPI data is unlikely to resolve the inflation debate at the Fed. How to invest in a late cycle environment. Wage Inflation was on the rise even before the hurricanes. Feature Chart 1September CPI And Retail Sales Keep##BR##The Fed On Track To Tighten September CPI And Retail Sales Keep The Fed On Track To Tighten September CPI And Retail Sales Keep The Fed On Track To Tighten The state of the U.S. business cycle, and what could end it, were key topics of conversation at BCA's semi-annual Research Advisory Board meeting in early October. Most participants agreed with the BCA view that the economy is in the late stages of the economic cycle, and a few suggested that another bubble in the shadow banking sector may end the expansion. With those discussions in mind, we review the state of the shadow banking in the first section of this report and then examine how key aspects of the economy and U.S. asset classes behave while the U.S. economy is in the final stages of an expansion. In the final section, we take another look at wage inflation signals from the hurricane impacted September jobs report, and conclude that wage growth has accelerated even excluding the effect of the storms. The September CPI and retail sales data were also impacted by the storm, but the message is that the underlying economy is strong enough to generate some inflation (Chart 1), although the September CPI is unlikely to resolve the inflation debate at the Fed. The minutes of last month's FOMC meeting (released last week) indicate that the upcoming inflation data could be pivotal to whether the Fed delivers another rate hike in December. There are two more CPI reports ahead of the December FOMC meeting (with the second release coming on the day of the policy announcement). While the September CPI data was hard to interpret due to the storms, the next few data prints need to affirm the Fed's forecast that core inflation is indeed recovering from the "transitory weakness" seen earlier this year. BCA's U.S. bond strategists believe that inflation will be strong enough for the Fed to justify a hike in December and recommend below-benchmark duration for fixed income portfolios. Shadow Banking Update At current levels, shadow banking activity in the U.S. is not a threat to the economic expansion. The ratio of financial sector debt to non-financial sector debt is a rough proxy of how the system can leverage existing debt into new securities and boost credit creation (Chart 2). As financial innovation and deregulation boosted system liquidity, outstanding financial debt as a percentage of non-financial debt climbed from 10% in the mid-1970s to over 50% in 2008. In Q2 2017, the shadow banking proxy stands at only 33%, because the global financial crisis and subsequent reregulation of the financial sector have reigned in excesses. The last time that the ratio was this low was in the late 1990s. Bank lending standards highlight key differences between the backdrop in the mid-2000s and today (Chart 3). In the mid-2000s, even as the Fed had boosted rates by 425 basis points, lending standards were easy and loosening. In contrast, the 100 bps increase in the Fed funds rate since late 2015 was accompanied by a tightening of lending requirements. Moreover, lending criteria were already tight when the Fed began its latest rate hikes. Chart 2The Shrinking Shadow##BR##Banking Sector The Shrinking Shadow Banking Sector The Shrinking Shadow Banking Sector Chart 3Bank Lending Standards Tighter##BR##Today Than In Mid '00s Bank Lending Standards Tighter Today Than in Mid '00s Bank Lending Standards Tighter Today Than in Mid '00s The Fed and other regulators are more attuned to financial excesses than they were a decade ago. The central bank under Yellen has raised the profile of financial stability.1 BCA views "financial stability" as a third mandate for the central bank, along with low and stable inflation, and full employment. That said, the Fed did not assess financial stability at the September FOMC meeting and the topic was only briefly mentioned by Fed staff and FOMC participants. At the July 2017 meeting, the central bank's staff characterized the "financial vulnerabilities of the U.S. financial system" as moderate on balance. BCA expects that the Fed will return to the topic at either one or both remaining FOMC meetings in 2017. The October 2017 Bank Credit Analyst Monthly Report2 provided a checklist of liquidity measures to watch as the U.S. economy enters the end of an elongated expansion. In view of these indicators, we would describe liquidity conditions in the U.S. as fairly accommodative, although not nearly as abundant as prior to the Lehman event in 2008. Monetary conditions are super easy, while balance sheet and financial market liquidity are reasonably constructive. In contrast, funding liquidity, while vastly improved since the global financial crisis, is still a long way from the pre-Lehman go-go years (as per indicators such as bank leverage). The Fed is set to begin the process of unwinding the massive amount of monetary liquidity created by its quantitative easing program. This has the potential to undermine other types of liquidity in the financial system, leading to a correction in risk assets. However, the BCA Special Report argues that the reaction of the bond market is more important for risk assets than the balance sheet adjustment itself. If inflation only edges higher and market expectations for the upward path of the Fed funds rate remain gentle, then risk assets should take the balance sheet unwind in stride. An abrupt upward shift in inflation would be an altogether different story. Bottom Line: The U.S. expansion entered a late-cycle environment near the close of 2016 as the unemployment rate dipped below NAIRU. Nonetheless, none of our recession-timing indicators warns that a downtown is imminent3 and the financial excesses in the end stage of the 2001-2007 economic expansion are not present today. If the next recession begins in the second half of 2019, then global equities will probably peak earlier that year or in late 2018. Given the starting point for valuations, U.S. equities may decline by 20% to 30% peak-to-trough. Stay overweight equities for now. The time to trim exposure could come in mid-2018. Late-Cycle Playbook Chart 4Easier Financial Conditions##BR##Will Boost U.S. Growth Easier Financial Conditions Will Boost U.S. Growth Easier Financial Conditions Will Boost U.S. Growth Easing financial conditions will lead to faster U.S. GDP growth in the next few quarters. Financial conditions have eased sharply this year due to a strengthening stock market, narrower credit spreads and a weaker dollar. Changes in financial conditions lead growth by about 6 to 9 months, implying that U.S. growth could reach 3% early next year (Chart 4). This could drop the unemployment rate to 3.5% by end-2018, more than one point below the Fed's estimate of full employment and even lower than the 2008 low of 3.8%. Rising inflation will compel the Fed to lift rates aggressively next year to cool the economy and push the unemployment rate back above NAIRU. The U.S. has never averted a recession in the post-war era when the unemployment rate has increased by more than one-third of a percentage point. BCA's stance is that the U.S. economy enters the expansion's final stage when the unemployment rate dips below NAIRU. Chart 5 shows that the unemployment rate moved below NAIRU in November 2016. In the past 45 years, the economy has spent an average of 33 months in late-cycle mode ahead of 5 recessions. The exception was 1981-82 when the unemployment rate did not dip below NAIRU ahead of the recession; we treated the separate 1980 and 1981-82 recessions as one episode. Note that several of these late-cycle intervals overlap with recessions (vertical lines on Charts 5, 6 and 7 indicate the start of recessions). Chart 5Late Cycle Performance Of Stocks, Bonds, & Commodities Late Cycle Performance Of Stocks, Bonds, & Commodities Late Cycle Performance Of Stocks, Bonds, & Commodities The late-cycle environment favors equities over Treasuries, gold and oil, but other risk assets (small caps, investment-grade and high-yield corporates) underperform (Table 1). The dollar drops by an average of 5% in late cycles and it moved lower in 4 of the 5 previous episodes. Oil is a consistent late-cycle performer, climbing in all the stages in our analysis. The average returns across all assets classes are similar, even excluding the 1973 OPEC oil embargo and the 1987 stock market crash. Nonetheless, asset class returns in the current environment have mostly run counter to history. Table 1Late Cycle Performance Of Stocks, Bonds, & Commodities The Late-Cycle View The Late-Cycle View In typical late-cycle performance, U.S. stocks have outperformed Treasuries since November 2016, the dollar has weakened and oil is up, though by far less than in an average late cycle. However, both investment-grade and high-yield corporate bonds have outpaced Treasuries, and small caps have beaten large caps. Moreover, gold prices have dropped. However, the current late-cycle period has been in place for only 10 months, which is more than two years short of the 33-month average of late cycles since 1972 (Table 1). Furthermore, the level of S&P 500 earnings, both trailing and forward, also rise uniformly in late cycles. That said, earnings growth tends to peak about halfway through each cycle, but we note that we have only forward EPS data for three of the five episodes in our analysis. Profit margins take the same course as earnings and earnings growth (Chart 6). The late-cycle climb in wages and labor compensation impacts margins. Additionally, inflation tends to escalate during late cycles (Chart 7). Chart 6S&P 500 Earnings And Margins In Late Cycle S&P 500 Earnings And Margins In Late Cycle S&P 500 Earnings And Margins In Late Cycle Chart 7Inflation And Interest Rates During Late Cycles Inflation And Interest Rates During Late Cycles Inflation And Interest Rates During Late Cycles Bottom Line: The late-cycle environment may persist for another two years or so, favoring stocks over bonds, a weaker dollar and higher oil prices. Although we are overweight both investment-grade and high-yield corporate bonds, these two asset classes tend to underperform Treasuries as the business cycle fades. We also expect wages and inflation to continue to mount, suggesting that duration should be kept short. The late-cycle pattern is at odds with BCA's view that the dollar will appreciate modestly in the next 12 months. However, the dollar's trajectory depends both on Fed policy and the direction of rates in the economies of the major U.S. trading partners. The Bank of Canada will be lifting rates in the coming quarters, but policy rates will be flat for some time in the Eurozone and Japan, such that interest rate differentials will shift in favor of the dollar on a multi-lateral basis. Another Look At Wage Inflation In last week's report4 we indicated that the September jobs report was difficult to interpret due to the impacts of Hurricanes Harvey and Irma. Specifically, we stated that the unexpected 0.5% month-over-month gain in average hourly earnings should be discounted. Employment in the low-paying leisure and hospitality sector fell by 111,000 in September, helping to boost the aggregate average hourly wage. These wages will correct lower as these workers return to their jobs post-hurricane recovery. A closer look at the wage data, however, suggests that the acceleration in wage growth in September 2017 to 2.9% from 2.7% in August and a recent low of 1.9% in 2014, has been in place for some time. Admittedly, the 2.9% year-over-year reading on wage inflation, may have overstated labor costs in September. That said, at 56% in August, the percentage of U.S. states where the year-over-year percentage change in average hourly earnings is rising has been on the upswing since mid-2014. The August reading was the highest since 2012 (Chart 8). In Chart 9, we created an "equally-weighted" AHE measure to adjust for shifts in the composition of the labor market, but we found that the recent deceleration is not linked to compositional effects. Since wage growth bottomed out in late 2012, the compositional shifts slightly lowered wage inflation on average, but the growth rates today are roughly the same. Chart 10 updates research by the Kansas City Fed5 that found only a few industries (mostly in the goods-producing sector) account for most of the rise in wages, notably manufacturing, construction and wholesale trade. Financial services, retail, professional and business services, and leisure and hospitality - all service sector industries - were the laggards. The report shows that although earnings growth has fallen behind in service-oriented industries since 2015, hours worked have increased faster than in the goods-producing sector. Chart 856% Of States Have Seen##BR##Higher Wage Inflation 56% Of States Have Seen Higher Wage Inflation 56% Of States Have Seen Higher Wage Inflation Chart 9Compositional Effects Do Not##BR##Explain Recent Wage Weakness Compositional Effects Do Not Explain Recent Wage Weakness Compositional Effects Do Not Explain Recent Wage Weakness Chart 10Acceleration In Hours Worked##BR##Should Lead To Faster Wage Growth Acceleration In Hours Worked Should Lead To Faster Wage Growth Acceleration In Hours Worked Should Lead To Faster Wage Growth Moreover, the August JOLTS data also provides evidence that the labor market began to tighten before the effects of Harvey and Irma. The quit rate matched a 15-year high in August, and job openings were at an all-time high. Job openings in the leisure and hospitality sector were at all-time highs in August, and the quit rate in that storm-impacted industry stood at 4.2% (Chart 11). Even excluding the leisure and hospitality industry from the average hourly earnings data, wage growth has unambiguously climbed in the past 1- and 3- months (Chart 12). Chart 11Overall Job Openings And Quit Rates##BR##Vs. Leisure And Hospitality Overall Job Openings And Quit Rates Vs. Leisure And Hospitality Overall Job Openings And Quit Rates Vs. Leisure And Hospitality Chart 12Wage Acceleration Evident Even##BR##Excluding Leisure And Hospitality Wage Acceleration Evident Even Excluding Leisure And Hospitality Wage Acceleration Evident Even Excluding Leisure And Hospitality Bottom Line: Wage inflation was on the upswing even before the hurricanes hit in late August and September. Persistent wage inflation will allow the Fed to raise rates again in December and three or four times next year. This supports BCA's underweight stance on duration. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate," July 24, 2017. Available at usis.bcaresearch.com. 2 Please see The Bank Credit Analyst Monthly Report, "Liquidity And The Great Balance Sheet Unwind," October 2017. Available at bca.bcaresearch.com. 3 Please see BCA's Global Investment Strategy Weekly Report, "Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear," October 4, 2017. Available at gis.bcaresearch.com. 4 Please see BCA's U.S. Investment Strategy Weekly Report, "Small Cap Surge," October 9, 2017. Available at usis.bcaresearch.com. 5 "Wage Leaders and Laggards: Decomposing The Growth In Average Hourly Earnings," Willem Van Zandweghe, Federal Reserve Bank of Kansas City, February 15, 2017.

Highlights Expect Spain's strong growth to fade somewhat as its credit impulse appears to have peaked. The Catalan independence debate is an inconvenience but not a long term tail-risk. Expect Italy's growth to pick up as the Italian banking system is repaired. Brave investors could go long Italian bonds versus Spanish bonds now. More cautious investors might wait until after the Italian election in the first half of next year. France's CAC40 is our preferred mainstream euro area equity market right now. Feature Recent history teaches us that to leave the European Union is inconvenient, but to leave the euro is disastrous. To leave the EU means redefining laws, institutions and trading relationships, but to leave the euro means redenominating the entire banking system's assets and liabilities into different currencies - leading to bank runs and chaotic insolvencies. For this reason, even tiny Greece chose to suffer an extended depression rather than to leave the euro. Chart of the WeekSpain Fixed Its Banks In 2013, Italy Is Fixing Its Banks Now Spain Fixed Its Banks In 2013, Italy Is Fixing Its Banks Now Spain Fixed Its Banks In 2013, Italy Is Fixing Its Banks Now Leaving The EU Is Inconvenient, Leaving The Euro Is Disastrous To leave the EU, there is a broadly defined process but the process is inconvenient and protracted, as the United Kingdom is now discovering. The U.K. will technically leave the EU on March 31 2019, but Prime Minister May has proposed a further transition period of "around two years." Therefore the U.K. will remain in the European single market and customs union - and fully subject to EU laws and regulations - until at least 2021, five years after the U.K. voted to leave the EU. This protraction of the exit process creates a tasty irony. Not long after the U.K. fully leaves in 2021, the Leave vote's 1.25 million majority will have disappeared - counting those who voted in 2016 who are still alive. This is because out of the 0.625 million deaths in the U.K. in each of the coming years, there is a very heavy skew to Leave's much older voters1 (Chart I-2). As the U.K is not in the euro there is no secondary issue of whether to leave the single currency. But this does raise an interesting hypothetical question. If a euro area country - or region like Catalonia - inconveniently left or was ejected from the EU, does it follow that it must also crash out of the euro? No. Several non-EU countries already use the euro. There are the European microstates of Andorra, Monaco, San Marino and Vatican City. More significantly, Montenegro and Kosovo have adopted the euro as their de facto currency. To be clear, we do not expect Catalonia to secede. Polls consistently show a significant majority in Catalonia do not want full independence (Chart I-3). The unionists mostly boycotted the independence referendum because Madrid deemed it illegal. Given the low turnout, the 89% vote for independence equalled just 37% of eligible voters. Chart I-2The Vote For Brexit Was ##br##Driven By Older Voters The Spain/Italy Conundrum The Spain/Italy Conundrum Chart I-3A Significant Minority In Catalonia##br## Do Not Want Full Independence A Significant Minority In Catalonia Do Not Want Full Independence A Significant Minority In Catalonia Do Not Want Full Independence But even if Catalonia did become independent, this hypothetical eventuality would not involve a catastrophic exit from the euro. Catalonia, in its economic interest, would want to keep the euro, and the EU would let it. The Spain/Italy Conundrum The much bigger threat would be if a major euro area country felt that the single currency was not in its economic interest, and decided to jettison the euro. In this regard, the problem - at first sight - appears to be Italy. Through the 19 years of the euro, Italy's real GDP per head has grown by just 6%, substantially less than any other major economy. If the single currency is to blame for the significant underperformance of its third largest economy with 60 million people, then the euro's long-term viability has to be in question. But it is hard to blame the euro per se for Italy's painful underperformance. For the first half of the euro's life, 1999-2007, Italian real GDP per head performed more or less in line with the United States, Canada and France (Chart I-4) - even without a substantial tailwind from a credit-fuelled boom which the other economies had. Then, in the post-2007 years, there was little to distinguish the economic performances of Italy and Spain until 2013 (Chart I-5). At which point, Spain took off, with real GDP per head subsequently expanding by 15%. Whereas Italy struggled to grow. The conundrum is: what explains this stark recent difference between Spain and Italy? Chart I-4Through 1999-2007, Italy Grew In Line ##br##With Other Major Economies Through 1999-2007, Italy Grew In Line With Other Major Economies Through 1999-2007, Italy Grew In Line With Other Major Economies Chart I-5Post-Crisis, There Was Little To Distinguish##br## Italy and Spain Until 2013 Post-Crisis, There Was Little To Distinguish Italy and Spain Until 2013 Post-Crisis, There Was Little To Distinguish Italy and Spain Until 2013 The start of Italy's underperformance in 2008 and the start of Spain's strong recovery in 2013 provide the solution to the conundrum. Following the global financial crisis in 2008, Italy has still to repair its banking system. Whereas Spain fixed its banks in 2013. Significantly, Spain ring-fenced bad assets within a bad bank while recapitalising good banks. In effect, it finally did what other economies - most notably the U.S., U.K. and Ireland - had done several years earlier in response to their own housing-related banking crises. Therefore in 2013, Spanish banks' aggressive deleveraging ended. The result was that Spain's credit impulse - which measures the change in bank credit flows - rebounded very sharply and has remained positive for four years. This explains Spain's remarkably strong recovery (Chart I-6). In contrast, Italy's still dysfunctional banking system means that its own credit impulse has been much more muted and barely positive over the past four years (Chart I-7). Begging the question: why has Italy been so slow to fix its dysfunctional banking system? One reason is that Italy's banking malaise has built up stealthily, generating frequent financial tremors but without an outright crisis. In contrast, the credit booms in the U.S., U.K., Ireland and Spain did eventually cause housing busts and full-blown banking crises, requiring urgent policymaker response. A second reason is that the Italian government is more highly indebted than other governments, making it more difficult to raise public funds to fix the banking system. The good news is that the Italian government, the EU and the ECB are now on the same page and finally progressing to repair the banking system. Italian banks' equity capital is rising (Chart I-8), their solvency is improving, and the share of non-performing loans has fallen sharply this year (Chart of the Week). Chart I-6Spain's Credit Impulse Rebounded Sharply Spain"s Credit Impulse Rebounded Sharply Spain"s Credit Impulse Rebounded Sharply Chart I-7Italy's Credit Impulse Has Been More Muted Italy"s Credit Impulse Has Been More Muted Italy"s Credit Impulse Has Been More Muted Chart I-8Italian Banks Are Raising Equity Capital Italian Banks Are Raising Equity Capital Italian Banks Are Raising Equity Capital Moreover, the recent smooth winding down of the failing Banca Popolare di Vicenza and Veneto Bank showed that the EU's new rules for resolving failing banks is working. Admittedly, the rules mean that institutional investors could still suffer losses. But a pragmatic solution will permit public funds to protect 'widows and orphans' retail investors. Some Investment Thoughts As the Italian banking system is repaired, there will be a pickup in Italy's growth just as there was in Spain. However, the strong tailwind to Spain's growth that started in 2013 is now fading given that Spain's credit impulse has peaked. This suggests that the yield spread between Italian BTPs and Spanish Bonos - which measures the extra risk premium in Italy - is at a cyclical peak from which it is likely to compress (Chart I-9). Brave investors could go long Italian bonds versus Spanish bonds now. More cautious investors might wait until after the Italian election in the first half of next year. On the face of it, a fading risk of euro breakup should also boost euro area equity relative performance. The trouble is that the relative performance of the broad Eurostoxx50 index is entirely at the mercy of its major sector skews - specifically, a huge underweighting to Technology and an overweighting to Banks (Chart I-10). The way around this dilemma - to like euro area equities but to dislike the overall sector skew - is to steer towards mainstream indexes which have less of a distorting skew. On this basis, the mainstream euro area equity market we would pick right now is France's CAC40 (Chart I-11). Chart I-9The Yield Spread Between Italian And ##br##Spanish Bonds Is At A Cyclical Peak The Yield Spread Between Italian And Spanish Bonds Is At A Cyclical Peak The Yield Spread Between Italian And Spanish Bonds Is At A Cyclical Peak Chart I-10Eurostoxx50 Relative Performance Is ##br##At The Mercy Of Its Sector Skews Eurostoxx50 Relative Performance Is At The Mercy Of Its Sector Skews Eurostoxx50 Relative Performance Is At The Mercy Of Its Sector Skews Chart I-11Prefer the CAC40 To##br## The Eurostoxx50 Prefer the CAC40 To The Eurostoxx50 Prefer the CAC40 To The Eurostoxx50 Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 In the U.K. around 625,000 people die every year and the vast majority of these are aged over 65. But in this older age cohort, 64% voted Leave (source: YouGov). So we can infer that of the 625,000 deaths, about 400,000 voted Leave and 225,000 voted Remain, eroding the Leave majority who are still alive by 175,000 every year. Fractal Trading Model This week, we note that the Canadian 10-year government bond is oversold and due a trend reversal. We prefer to express this as a new relative trade: long Canadian 10-year bond / short 10-year German bund with a profit target / stop-loss of 1% and double position size. In other trades, long USD/CAD hit its 2.5% profit target - the second success in this specific trade in the last three months. We now have three open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-12 Long Canadian 10-Year Government Bond Long Canadian 10-Year Government Bond The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights The law of the vital few states that a small number of causes have a disproportionate impact on your overall investment performance. Get the bond yield direction right and your equity sector allocation, equity country allocation and currency allocation should end up outperforming too. Expect the euro area versus U.S. bond yield spread to continue compressing. This means euro area banks will outperform U.S. banks and EUR/USD has cyclical upside. But within a European equity portfolio, banks should be at neutral weight. This implies upgrading Italy's MIB and Spain's IBEX to neutral and downgrading Germany's DAX to underweight. Feature "Less is more, and usually more effective" - Nassim Taleb The law of the vital few states that a small number of causes usually have a disproportionate impact on any overall result. Familiar examples of the law - also known as the Pareto principle or the 80/20 rule - are that a minority of bugs cause a majority of software problems; and that the top few salespeople in any company tend to be responsible for most of its sales. With investment research costs now coming under intense scrutiny, the law of the vital few has become highly significant for the investment management industry too. Every day, investors are bombarded with a seemingly endless stream of research, email alerts and newsfeeds. Yet most of the hundreds of choices that investors have to make reduce to getting just a handful of fundamental decisions right. We call this investment reductionism. The message from investment reductionism is to identify the few decisions that really matter, and to focus your time, effort and resources on these vital few rather than the trivial many. Because the vital few will have a disproportionate impact on hundreds of positions across different asset-classes in your investment portfolio. Bond Yields Are One Of The Vital Few Right now, one of the vital few decisions is the direction of high-quality government bond yields. Get bond yields right absolutely and relatively and you will get at least four investment decisions for the price of one. Not only will you get fixed income right, but your equity sector allocation, equity country allocation and currency allocation should end up outperforming too. In the most recent mini-cycle, the bond yield has driven the bank equity sector's relative performance almost tick for tick both in Europe (Chart I-2) and globally (Chart of the Week). There are two reasons. Higher bond yields fatten banks' net interest margins. They also signal an improving growth outlook and thereby a reduction in bad debts. Lower bond yields imply the exact opposite. Chart of the WeekGet Bond Yields Right And You"ll ##br##Get Banks Right Too Get Bond Yields Right And You"ll Get Banks Right Too Get Bond Yields Right And You"ll Get Banks Right Too Chart I-2Get Bond Yields Right And You"ll ##br##Get Banks Right Too Get Bond Yields Right And You"ll Get Banks Right Too Get Bond Yields Right And You"ll Get Banks Right Too In turn, the bank sector's relative performance has a major influence on equity country allocation. Investment reductionism teaches us that for most stock markets, the sector (and dominant company) skews swamp any effect that comes from the domestic economy. For example, the defining skew for Italy's MIB and Spain's IBEX is their large overweighting to banks. So unsurprisingly, MIB and IBEX relative performance reduces to: will banks outperform the market? (Chart I-3 and Chart I-4) Which itself reduces to: will bond yields head higher? The bond yield - relative to those in other economies - is also a major driver of the exchange rate (Chart I-5). As we detailed in Who's Afraid Of A Stronger Euro?1 the transmission mechanism is the so-called fixed income portfolio channel. In a nutshell, a higher bond yield in one jurisdiction relative to others attracts international fixed income portfolio flows into that jurisdiction, pushing up its currency - until a new higher level of the currency repels any further bond inflows. Chart I-3Get Banks Right And You"ll ##br##Get Italy Right Too Get Banks Right And You"ll Get Italy Right Too Get Banks Right And You"ll Get Italy Right Too Chart I-4Get Banks Right And You"ll ##br##Get Spain Right Too Get Banks Right And You"ll Get Spain Right Too Get Banks Right And You"ll Get Spain Right Too Chart I-5Get Bond Relative Performance Right And##br## You"ll Get EUR/USD Right Too Get Bond Relative Performance Right And You"ll Get EUR/USD Right Too Get Bond Relative Performance Right And You"ll Get EUR/USD Right Too Follow Your High Convictions Still, it is impossible to have a high-conviction view on a macro call at all times. A golden rule of investing is to have a big position only where and when you have a high-conviction view. Chart I-6When Unemployment Is Plunging, Real Wage ##br##Inflation Should Be Rising, But It Isn"t When Unemployment Is Plunging, Real Wage Inflation Should Be Rising, But It Isn"t When Unemployment Is Plunging, Real Wage Inflation Should Be Rising, But It Isn"t At the moment, our high-conviction view on bond yields is a relative view. Specifically, the euro area versus U.S. yield shortfall will continue to compress one way or another. This is because the polarisation of monetary policy expectations in the euro area relative to the U.S. remains at odds with growth and inflation data that have been, are, and will continue to be near-identical. Using investment reductionism, a high-conviction view that the euro area versus U.S. yield spread will compress necessarily means overweighting European banks versus U.S. banks. And it means staying cyclically long EUR/USD. On the absolute direction of bond yields we have less conviction. On the one hand, major economies are growing well and unemployment rates are coming down. Yet as we explained in Why Robots Will Kill Middle Incomes,2 the current wave of technological progress is especially disinflationary for wages, and one of the reasons why the Phillips curve relationship between unemployment and wage inflation isn't working (Chart I-6). Even the Federal Reserve Bank of Philadelphia, in a recent research paper,3 "finds no evidence for relying on the Phillips curve". The upshot is that we are cyclically neutral on bonds, but structurally positive. Using investment reductionism again, a cyclically neutral stance on bonds necessarily means a cyclically neutral weighting to European banks versus other European sectors. In turn, this means a cyclically neutral weighting to Italy's MIB and Spain's IBEX versus the Eurostoxx600. Sector Skews Are One Of The Vital Few To reiterate, the key consideration for European equity country allocation is always: how to allocate to the vital few sectors that feature most often in the skews: in addition to Banks, this means Healthcare, Energy and Materials (Box I-1 and Appendix). Box 1: The Vital Few Sector Skews That Drive Country Relative Performance For major equity indexes in the euro area, the dominant sector skews that drive relative performance are as follows: Germany (DAX) is overweight Chemicals, underweight Banks. France (CAC) is underweight Banks and Basic Materials. Italy (MIB) is overweight Banks. Spain (IBEX) is overweight Banks. Netherlands (AEX) is overweight Technology, underweight Banks. Ireland (ISEQ) is overweight Airlines (Ryanair) which is, in effect, underweight Energy. And for major equity indexes outside the euro area: The U.K. (FTSE100) is effectively underweight the pound. Switzerland (SMI) is overweight Healthcare, underweight Energy. Sweden (OMX) is overweight Industrials. Denmark (OMX20) is overweight Healthcare and Industrials. Norway (OBX) is overweight Energy. The U.S. (S&P500) is overweight Technology, underweight Banks. Within a European equity portfolio, our cyclical stance to Banks is neutral. Healthcare's cyclical relative performance reduces to its defensiveness and low beta. This means that Healthcare tends to underperform in a strongly advancing market. But it tends to outperform when the market is doing no better than advancing weakly (Chart I-7). As this is our central expectation, our cyclical stance is to remain overweight Healthcare. Chart I-7Healthcare"s Cyclical Relative Performance Reduces To Its Defensiveness And Low Beta Healthcare"s Cyclical Relative Performance Reduces To Its Defensiveness And Low Beta Healthcare"s Cyclical Relative Performance Reduces To Its Defensiveness And Low Beta Regarding Energy, Materials (and Industrials), euro area equity markets with a large exposure to these export-heavy sectors will be under pressure, given our cyclical view on the euro. Mostly, this is because the translation of multi-currency international earnings into a strengthening base currency hurts index profits. Hence, underweight these sectors. Finally, to arrive at a country allocation, combine the cyclical view on the vital few sectors with the country sector skews shown above. Even if you disagree with our sector views, the sector-based approach is the right way to pick European equity markets. If you agree with our sector views, the result is the following updated European equity market allocation: Overweight: France, Ireland, U.K., Switzerland and Denmark. Neutral: Italy, Spain, and Netherlands. Underweight: Germany, Sweden and Norway. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Published on August 3, 2017 and available at eis.bcaresearch.com 2 Published on August 10 and available at eis.bcaresearch.com 3 https://www.philadelphiafed.org/-/media/research-and-data/publications/… Chart Appendix Chart I-8Germany (DAX) Is Overweight Chemicals, ##br##Underweight Banks Germany (DAX) Is Overweight Chemicals, Underweight Banks Germany (DAX) Is Overweight Chemicals, Underweight Banks Chart I-9France (CAC) Is Underweight Banks ##br##And Basic Materials France (CAC) Is Underweight Banks And Basic Materials France (CAC) Is Underweight Banks And Basic Materials Chart I-10Italy (MIB) Is Overweight Banks Italy (MIB) Is Overweight Banks Italy (MIB) Is Overweight Banks Chart I-11Spain (IBEX) Is Overweight Banks Spain (IBEX) Is Overweight Banks Spain (IBEX) Is Overweight Banks Chart I-12Netherlands (AEX) Is Overweight Technology, ##br##Underweight Banks Netherlands (AEX) Is Overweight Technology, Underweight Banks Netherlands (AEX) Is Overweight Technology, Underweight Banks Chart I-13Ireland (ISEQ) Is Overweight Airlines (Ryanair)##br## Which Is, In Effect, Underweight Energy Ireland (ISEQ) Is Overweight Airlines (Ryanair) Which Is, In Effect, Underweight Energy Ireland (ISEQ) Is Overweight Airlines (Ryanair) Which Is, In Effect, Underweight Energy Chart I-14The U.K. (FTSE100) Is Effectively##br## Underweight The Pound The U.K. (FTSE100) Is Effectively Underweight The Pound The U.K. (FTSE100) Is Effectively Underweight The Pound Chart I-15Switzerland (SMI) Is Overweight Healthcare, ##br##Underweight Energy Switzerland (SMI) Is Overweight Healthcare, Underweight Energy Switzerland (SMI) Is Overweight Healthcare, Underweight Energy Chart I-16Sweden (OMX) Is Overweight ##br##Industrials Sweden (OMX) Is Overweight Industrials Sweden (OMX) Is Overweight Industrials Chart I-17Denmark (OMX20) Is Overweight ##br##Healthcare And Industrials Denmark (OMX20) Is Overweight Healthcare And Industrials Denmark (OMX20) Is Overweight Healthcare And Industrials Chart I-18Norway (OBX) Is##br## Overweight Energy Norway (OBX) Is Overweight Energy Norway (OBX) Is Overweight Energy Chart I-19The U.S. (S&P500) Is Overweight Technology, ##br##Underweight Banks The U.S. (S&P500) Is Overweight Technology, Underweight Banks The U.S. (S&P500) Is Overweight Technology, Underweight Banks Fractal Trading Model* Our model successfully captured the early August technical bounce in USD/CAD, and is signalling another opportunity now. The profit target / stop loss is 2.5%. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-20 Long USD/CAD Long USD/CAD The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##Br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights We estimate total Belt & Road Initiative (BRI) investment will rise from US$120 billion this year to about US$170 billion in 2020. The size of BRI investments is about 47 times smaller than China's annual gross fixed capital formation (GFCF). Therefore, a slump in domestic capital spending in China will fully offset the increase in demand for industrial goods and commodities as a result of BRI projects. Pakistan, Kazakhstan and Ghana will benefit the most among major frontier markets from BRI. Investors should consider buying these bourses in sell-off. On a positive note, BRI leads to improved global capital allocation, allows China to export its excess construction and heavy industry capacity, and boosts recipient countries' demand for Chinese exports. Feature China's 'Belt and Road' Initiative (BRI) is on an accelerating path (Chart I-1), with total investment expected to rise from US$120 billion to about US$170 billion over the next three years. Chart I-1Accelerating BRI Investment From China bca.ems_sr_2017_09_13_s1_c1 bca.ems_sr_2017_09_13_s1_c1 The BRI has been one of the central government's main priorities since late 2013. The primary objectives of the BRI are: To export China's excess capacity in heavy industries and construction to other countries - i.e., build infrastructure in other countries; To expand the country's international influence via a grand plan of funding investments into the 69 countries along the Belt and the Road (B&R) (Chart I-2); To build transportation and communication networks as well as energy supply to facilitate trade and provide China access to other regions, especially Europe and Africa; To facilitate the internationalization of the RMB; To speed up the development of China's poor (and sometimes restive) central and western regions, namely by turning them into economic hubs between coastal China and the BRI countries in the rest of Asia; To boost China's strategic position in central, south, and southeast Asia through security linkages arising from BRI cooperation, as well as from assets (like ports) that could provide military as well as commercial uses in the long run. From a cyclical investment perspective, the pertinent questions for investors are: How big is the current scale of BRI investment, and where is the funding coming from? Will rising BRI investment be able to offset the negative impact from a potential slowdown in Chinese capex spending? Which frontier markets will benefit most from Chinese BRI investment? Chart I-2The Belt And Road Program China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's BRI: Scale And Funding Scale China has been implementing its strategic BRI since 2013. To date it has invested in 69 B&R countries through two major approaches: infrastructure project contracts and outward direct investment (ODI). The first approach - investment through projects - is the main mechanism of BRI implementation. BRI projects center on infrastructure development in recipient countries, encompassing construction of transportation (railways, highways, subways, and bridges), energy (power plants and pipelines) and telecommunication infrastructure. The cumulative size of the signed contracts with B&R countries over the past three years is US$383 billion, of which US$182 billion of projects are already completed. However, the value of newly signed contracts in a year does not equal the actual project investment occurred in that year, as generally these contracts will take several years to be implemented and completed. Table I-1 shows our projection of Chinese BRI project investment over the years of 2017-2020, which will reach US$168 billion in 2020. This projection is based on two assumptions: an average three-year investing and implementation period for BRI projects from the date of signing the contract to the commercial operation date (COD) of the project, and an average annual growth rate of 10% for the total value of the annual newly signed contracts over the next three years. Table I-1Projection Of Chinese BRI Project Investment Over The Years 2017-2020 China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? The basis for the first assumption is that the majority of the completed BRI projects were by and large finished within three years, and most of the existing and future BRI projects are also expected to be completed within a three-year period.1 The second assumption of the 10% future growth rate is reasonable, given the 13.5% average annual growth rate for the past two years, but from a low base. These large-scale infrastructure projects were led mainly by Chinese state-owned enterprises (SOEs), and often in the form of BOTs (Build-Operate Transfers), Design-Build-Operate (DBOs), BOOT (Build-Own-Operate-Transfers), BOO (Build-Own-Operate) and other types of Public-Private Partnerships (PPPs). After a Chinese SOE successfully wins a bid on an infrastructure project in a hosting country, the company will typically seek financing from a Chinese source to fund the project, and then execute construction of the project. After the completion of the project, depending on the terms pre-specified in the contract, the company will operate the project for a number of years, which will generate revenues as returns for the company. The second approach - investing into the recipient countries through ODI - is insignificant, with an amount of US$14.5 billion last year. This was only 12% of BRI project investment, and only 8.5% of China's total ODI. Chinese ODI has so far been mainly focused on tertiary industries, particularly in developed countries that can educate China in technology, management, innovation and branding. Besides, most of the Chinese ODI has been in the form of cross-border M&A purchases by Chinese firms, with only a small portion of the ODI targeted at green-field projects, which do not lead to an increase in demand for commodities and capital goods. Therefore, in this report we will only focus on the analysis of project investment as a proxy of Chinese BRI investment, as opposed to ODI. The focal point of this analysis is to gauge the demand outlook for commodities and capital goods originating from BRI. The Sources Of Chinese Funding The projected US$120 billion to US$170 billion BRI investment every year seems affordable for China. This is small in comparison to about US$3-3.5 trillion of new money origination, or about US$3 trillion of bank and shadow-bank credit (excluding borrowing by central and local governments) annually in the past two years. The financing sources for China's BRI investment include China's two policy banks (China Development Bank and the Export-Import Bank of China), two newly established funding sources (Silk Road Fund and Asia Infrastructure Investment Bank), Chinese commercial banks, and other financial institutions/funds. Table I-2 shows our estimate of the breakdown of BRI funding in 2016. Table I-2BRI Funding Sources In 2016 China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China Development Bank (CDB): As the country's largest development bank, the CDB has total assets of US$2.1 trillion, translating into more than US$350 billion of potential BRI projects over the next 10 years, which could well result in US$35 billion in funding annually from the CDB. The Export-Import Bank of China (EXIM): The EXIM holds an outstanding balance of over 1,000 BRI projects, and has also set up a special lending scheme worth US$19.5 billion over the next three years. This will increase EXIM's BRI lending from last year's US$5 billion to at least US$6.5 billion per year. Silk Road Fund (SRF): The Chinese government launched the SRF in late 2014 with initial funding of US$40 billion to directly support the BRI mission. This year, Chinese President Xi Jinping pledged a funding boost to the SRF with an extra 100 billion yuan (US$15 billion). Therefore, SRF funding to BRI projects over the next three years will be higher than the US$6 billion recorded last year. The Asian Infrastructure Investment Bank (AIIB): The AIIB was established in October 2014 and started lending in January 2016. It only invested US$1.7 billion in loans for nine BRI projects last year. The BRI funding from the AIIB is set to accelerate as the number of member countries has significantly expanded from an original 57 to 80 currently. Chinese commercial banks: Chinese domestic commercial banks, the largest source of BRI funding, have been driving BRI investment momentum. Chinese commercial banks currently fund about 62% of BRI investment and the main financiers are Bank of China (BoC) and Industrial & Commercial Bank of China (ICBC). After lending about US$60 billion over the past two years, the BOC plans to provide US$40 billion this year. The ICBC has 412 BRI projects in its pipeline, involving a total investment of US$337 billion over the next 10 years, which will likely result in an annual US$34 billion in BRI investment. The China Construction Bank (CCB) also has over 180 BRI projects in its pipeline, worth a total investment of US$90 billion over the next five to 10 years. Only three commercial banks will likely fund US$80 billion of BRI projects over the next three years. A few more words about the currency used in BRI funding. The U.S. dollar and Chinese RMB will be the two main currencies employed in BRI funding. Chinese companies can get loans denominated either in RMBs or in USDs from domestic commercial banks/policy banks/special funds/multilateral international banks to buy machinery and equipment (ME) from China. For some PPP projects that involve non-Chinese companies or governments (i.e. those of recipient countries), the local presence can use either USD loans or their central bank's Chinese RMB reserves from the currency swap deal made with China's central bank. China has long looked to recycle its large current account surpluses by pursuing investments in hard assets (land, commodities, infrastructure, etc.) across the world, to mitigate its structural habit of building up large foreign exchange reserves that are mostly invested in low-interest-bearing American government securities. Risky but profitable BRI infrastructure projects are a continuation of this trend. China had so far signed bilateral currency swap agreements worth an aggregate of more than 1 trillion yuan (US$150 billion) with 22 countries or regions along the B&R. The establishment of cross-border RMB payment, clearing and settlement has been gaining momentum, and the use of RMB has been expanding gradually in global trade and investment, notwithstanding inevitable setbacks. Bottom Line: We estimate total BRI investment with Chinese financing will rise from US$120 billion this year to about US$170 billion in 2020, and Chinese financial institutions will be capable of funding it. Can BRI Offset A Slowdown In China's Capex? From a global investors' perspective, a pertinent question around the BRI program is whether the BRI-funded capital spending can offset the potential slowdown in China's domestic investment expenditure. This is essential to gauge the demand outlook for industrial commodities and capital goods worldwide. Our short answer is not likely. Table I-3 reveals that in 2016, gross fixed capital formation (GFCF) in China was estimated by the National Bureau of Statistics to be at RMB 32 trillion, or $4.8 trillion. Table I-3China's GFCF* Vs. China's BRI Investment Expenditures China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? Meantime, China-funded BRI investment expenditure amounted to US$102 billion in 2016. In a nutshell, last year GFCF in China was about 47 times larger than BRI investment expenditures. The question is how much of a drop in mainland GFCF would need to take place to offset the projected BRI investment. The latter will likely amount to US$139 billion in 2018, US$153 billion in 2019 and US$168 billion in 2020. Provided estimated sizes of Chinese GFCF in 2017 are RMB 33.5 trillion (US$4.9 trillion), it would take only 0.4% contraction in GFCF in 2018, 0.3% in 2019 and 2020 to completely offset the rise in BRI-related investment expenditure (Table 3). Chart I-3Record Low Credit Growth... bca.ems_sr_2017_09_13_s1_c3 bca.ems_sr_2017_09_13_s1_c3 We derive these results by comparing the expected absolute change in BRI capital spending expenditures with the size of China's GFCF. The expected increases in BRI in 2018, 2019 and 2020 are US$20 billion, US$14 billion and US$15 billion. Given the starting point of GFCF in 2017 was US$4.9 trillion, it will take only about 0.4% of decline in $4.9 trillion to offset the $20 billion rise in BRI. In the same way, we estimated that it would take only an annual 0.3% contraction in nominal GFCF in China to completely offset the rise in BRI capital spending in both 2019 and 2020. To be sure, we are not certain that the GFCF will contract in each of the next three years. Yet, odds of such shrinkage in one of these years are substantial. As always, investors face uncertainty, and they need to make assessments. Is an annual 0.4% decline in China's GFCF likely in 2018? In our opinion, it is quite likely, based on our money and credit growth, as illustrated in Chart I-3. Importantly, interest rates in China continue to drift higher. A higher cost of borrowing and regulatory tightening on banks and shadow banking will lead to a meaningful deterioration in China's credit origination. The latter will weigh on investment expenditures. The basis is that the overwhelming portion of GFCF is funded by credit to public and private debtors, and aggregate credit growth has already relapsed. Chart I-4 and Chart I-5 demonstrate that money and credit impulses lead several high-frequency economic variables that tend to correlate with capital expenditure cycles. Chart I-4Negative Money Credit Impulses Point To... ...Negative Money Credit Impulses Point To... ...Negative Money Credit Impulses Point To... Chart I-5...Slowing Capital Expenditure ...Slowing Capital Expenditure ...Slowing Capital Expenditure Therefore, we conclude that meaningful weakness in the GFCF is quite likely in 2018, and that it will spill out to 2019 if the government does not counteract it with major stimulus. By and large, odds are that a slump in domestic capital spending in China offset the rise in BRI-related capital expenditures. BCA's Emerging Markets Strategy service has written substantively on motives surrounding China's capital spending and how it is set to slow, and we will not cover these topics. Some reasons why investment spending is bound to slow include: considerable credit excesses/high indebtedness of companies; misallocation of capital and resultant weak cash flow position of companies; non-performing assets on banks' and other creditors' balance sheets and their weak liquidity position. To be sure, investors often ask whether or not material weakness in mainland growth will lead the authorities to stimulate. Odds are they will. Yet, before the slowdown becomes visible in economic numbers, financial markets will likely sell-off. In brief, policymakers are currently tightening and will be late to reverse their policies. Finally, should one compare the entire GFCF, or only part of it? There is a dearth of data to analyze various types of capital spending. In a nutshell, Chart I-6 reveals that installation accounts for roughly 70% of investment, while purchases of equipment account for the remaining 18%. Therefore, we guess the composition of BRI projects will be similar to structure of investment spending in China, and hence it makes sense to use overall GFCF as a comparative benchmark. In addition, the GFCF data is a better measure for Chinese capital spending over Chinese fixed asset investment (FAI) data, as the FAI number includes land values, which have risen significantly over the years and already account for about half of the FAI (Chart I-7). Chart I-6Chinese Fixed Investment Structure Chinese Fixed Investment Structure Chinese Fixed Investment Structure Chart I-7GFCF Is A Better Measure Than FAI GFCF Is A Better Measure Than FAI GFCF Is A Better Measure Than FAI Bottom Line: While it is hard to forecast and time exact dynamics over the next several years, odds are that the next 12-24 months will turn out to be a period of a slump in China's capital spending. This will more than offset the increase in demand for industrial goods and commodities as a result of BRI projects. Implication For Frontier Markets The BRI, which currently covers 69 countries, will keep expanding its coverage for the foreseeable future. Insofar as it is a way for China to create new markets for its exports, Beijing has no reason to exclude any country. In practice, however, certain countries will receive greater dedication, for the simple reason that their development fits into China's political, military and strategic interests as well as economic interests. As most of the investments are infrastructure-focused, aiming to improve transportation, energy and telecommunication connectivity as well as special economic zones, the recipient countries, especially underdeveloped frontier markets, will benefit considerably from China's BRI. Table I-4 shows that Pakistan, Kazakhstan and Ghana will benefit the most among major frontier markets, as the planned BRI investment in those countries amounts to a significant amount of their GDP. Chart I-8 also shows that, in terms of current account deficit coverage by the Chinese BRI funding, the three countries that stand to benefit most are also Pakistan, Kazakhstan and Ghana. Table I-1The B&R Countries That Benefit From ##br##China's BRI Investment (Ranged From High-To-Low) China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? Chart I-8Chinese BRI Funding's Impact On ##br##External Account Of B&R Countries China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? Of these, clearly Pakistan and Kazakhstan have the advantage of attracting China's strategic as well as economic interest: Kazakhstan offers China greater access into Central Asia and broader Eurasia; Pakistan is a large-population market that offers a means of accessing the Indian Ocean without the geopolitical complications of Southeast and East Asia. These states also neighbor China's restive Xinjiang, where Beijing hopes economic development can discourage separatist and terrorist activities. Pakistan Pakistan is a key prospect for China's exports in of itself, and in the long run offers a maritime waystation and an energy transit hub separate from China's other supply lines. For China, it is a critical alternative to Myanmar and the Malacca Strait. In April 2015, China announced a remarkable US$46.4 billion CPEC (China-Pakistan Economic Corridor) investment plan in Pakistan, equal to 16.4% of Pakistani GDP. It is expected to be implemented over five years. In particular, the planned US$33.2 billion energy investment will increase Pakistan's existing power capacity by 70% from 2017 to 2023. On the whole, China's CPEC plan will be significantly positive to economic development in Pakistan in the long run, but in the near term it is still not enough to boost the nation's competitiveness (Chart I-9A, top panel). Chart I-9AOur Calls Have Been Correct Top 3 Frontier Markets Benefiting Most From Chinese BRI Investment Top 3 Frontier Markets Benefiting Most From Chinese BRI Investment Chart I-9BTop 3 Frontier Markets Benefiting Most ##br##From Chinese BRI Investment Our Calls Have Been Correct Our Calls Have Been Correct Also, as about 40% of the investment has already been invested over the previous two years, odds are that China's CPEC investment will go slower and smaller this year and over the next few years. BCA's Frontier Markets Strategy service's recent tactical bearish call on Pakistani stocks has been correct, with a 25% decline in the MSCI Pakistan Index in U.S. dollar terms since our recommendation in March (Chart I-9B, top panel).2 We remain tactically cautious for now. Kazakhstan Kazakhstan is a key transit corridor for Chinese goods to enter Europe and the Middle East. In June 2017, Chinese and Kazakh enterprises and financial institutions signed at least 24 deals worth more than US$8 billion. China's BRI investment in Kazakhstan facilitated the country's accelerated economic growth (Chart I-9A, middle panel). BCA's Frontier Markets Strategy service reiterates its positive view on Kazakhstan equities because of a recuperating economy, considerable fiscal stimulus and rising Chinese BRI investment (Chart I-9B, middle panel).3 Ghana Ghana is not strategic for China (it is a minor supplier of oil). Instead, it illustrates the fact that BRI is not always relevant to China's strategic or geopolitical interests. Sometimes it is simply about China's need to invest its surplus U.S. liquidity into hard assets around the world. Of course, Ghana itself will benefit considerably from the committed US$19 billion BRI investment, which was announced only a few months ago. This is a huge amount for the country, equaling 45% of Ghana's 2016 GDP. This massive fresh investment will boost Ghana's economic growth in both the near and long term (Chart I-9A, bottom panel). BCA's Frontier Markets Strategy service upgraded its stance on the Ghanaian equity market from negative to neutral in absolute terms at the end of July, and we also recommended overweighting the bourse relative to the broader MSCI EM universe (Chart I-9B, bottom panel).4 Our positive view on Ghana remains unchanged for now and we are looking to establish a long position in the absolute terms in this bourse amid a potential EM-wide sell-off. Other Macro Ramifications Industrial goods and commodities/materials are vulnerable. BRI will not change the fact that a potential relapse in capital spending in China will lead to diminishing growth in commodities demand. If there is a massive slowdown in property market like China experienced in 2015, which is very likely due to lingering excesses, Chinese commodity and industrial goods demand could even contract (Chart I-10). Notably, mainland's imports of base metals have been flat since 2010, and imports of capital goods shank in 2015 even though GDP and GFCF growth were positive (Chart I-11). The point is that there could be another cyclical contraction in Chinese imports of commodities and industrial goods, even if headline GDP and GFCF do not contract. Chart I-10Chinese Capital Goods Imports Could Contract Again bca.ems_sr_2017_09_13_s1_c10 bca.ems_sr_2017_09_13_s1_c10 Chart I-11Imports Of Metals Could Slow Further Imports Of Metals Could Slow Further Imports Of Metals Could Slow Further As China accounts for 50% of global demand of industrial metals and it imports about US$ 589 billion of industrial goods and materials annually, either decelerating growth or outright demand contraction will be negative news for global commodities markets and industrial goods producers. China's Exports Have A Brighter Outlook China's machinery and equipment (ME) exports account for 47% of total exports, and 9% of its GDP (Table I-5). The BRI investment will boost Chinese ME exports directly through large infrastructure projects. Table I-5Structure Of Chinese Exports (2016) China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? Meantime, robust income growth in the recipient countries will boost their demand for household goods (Chart I-12). China has a very strong competitive advantage in white and consumer goods production, especially in low-price segments that are popular in developing economies. Therefore, not only is China exporting its excess construction and heavy industry capacity, but the BRI is also boosting recipient countries' demand for Chinese household and other goods exports. Adding up dozens of countries like Ghana can result in a meaningful augmentation in China's customer base. Notably, Chinese total exports have exhibited signs of improvement as Chinese ME exports and exports to the major B&R countries have contributed to a rising share of total Chinese exports since 2015 (Chart I-13). Chart I-12BRI Will Lift Chinese Exports Of ##br##Capital And Consumer Goods BRI Will Lift Chinese Exports Of Capital And Consumer Goods BRI Will Lift Chinese Exports Of Capital And Consumer Goods Chart I-13Signs Of Improvement In Chinese Exports ##br##Due To Rising BRI Investment Signs Of Improvement In Chinese Exports Due To Rising BRI Investment Signs Of Improvement In Chinese Exports Due To Rising BRI Investment BRI Leads To Improved Global Capital Allocation BRI is one of a very few global initiatives that improves the quality of global capital allocation. Therefore, it is bullish for global growth from a structural perspective. By shifting capital spending from a country that has already invested a lot in the past 20 years (China) to the ones that have been massively underinvested, BRI boosts the marginal productivity of capital. One billion dollars invested in the underinvested recipient countries will generate more benefits than the same amount invested in China. Risks To BRI Projects Notable deterioration in the health of Chinese banks may meaningfully curtail BRI funding, as Chinese non-policy banks will likely need to provide 60% of BRI projects' funding. Political stability/changes in destination countries: As most infrastructure projects have been authorized by the top government and need their cooperation, any changes in the recipient countries' governments or regimes may slow down or deter BRI projects. China already has a checkered past with developing countries where it has invested heavily. This is because of its employment of Chinese instead of local labor, its pursuit of flagship projects seen as benefiting elites rather than commoners, its allegedly corrupt ties with ruling parties, and perceived exploitation of natural resources to the neglect of the home nation. As China's involvement grows, local politics will be more difficult to manage, requiring China to suffer occasional losses due to political reversals or to defend its assets through aggressive economic sanctions, or even expeditionary force. For now, as there are no clear signs that any these risks are imminent, we remain positive on the further implementation of China's BRI program. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 China has long been known to use three-year periods - as distinct from its better known "five year plans" - for major domestic initiatives. In 2016, the National Development and Reform Commission re-emphasized three-year planning periods for "continuous, rolling" implementation. 2 Please see BCA's Frontier Markets Strategy Special Report "Pakistani Stocks: A Top Is At Hand", published March 13, 2017. Available at fms.bcaresearch.com. 3 Please see BCA's Frontier Markets Strategy Special Report "Kazakhstan: A Touch Less Dependent On Oil Prices", published March 28, 2017. Available at fms.bcaresearch.com. 4 Please see BCA's Frontier Markets Strategy Special Report "Ghana: Sailing On Chinese Winds", published July 31, 2017. Available at fms.bcaresearch.com.

Feature The Brazilian economy is finally improving following a devastating depression of about 3 years, where real GDP dropped by a whopping 7.4%. Does the current economic revival warrant a bullish stance on its financial markets? If the global risk-on trade persists among EM risk assets and commodities and there are no domestic political blunders in Brazil, the country's financial markets will continue to rally as economic growth improves. If the EM and commodities rallies wane and an EM risk-off cycle develops, Brazilian risk assets will sell off, regardless of domestic economic recovery. Provided economies around the world have become interconnected, it is often difficult to separate global economic and financial market impact from domestic economic dynamics. Yet, it is possible to do so in Brazil in the latest cycle. Chart I-1 demonstrates that the Brazilian real bottomed with iron ore prices on December 21, 2015 - not with the bottom in the Brazilian economy in early Q1 2017 (Chart I-1, bottom panel). In turn, the currency's rally amid the collapse in domestic demand has led to a material drop in inflation and allowed the central bank to cut interest rates aggressively. The exchange rate is the main variable driving financial markets in many developing countries, including Brazil. In these countries, it is the exchange rate that causes swings in interest rate expectations, not the other way around. Furthermore, other important variables that led to the bottom in iron ore prices and the BRL were the Chinese manufacturing PMI and money growth, both of which bottomed in the second half of 2015 (Chart I-2). Chart 1BRL Correlates With Commodities ##br##Not Domestic Demand BRL Correlates With Commodities Not Domestic Demand BRL Correlates With Commodities Not Domestic Demand Chart 2Chinese Data Led##br## The Bottom In BRL Chinese Data Led The Bottom In BRL Chinese Data Led The Bottom In BRL In short, economic recovery arrived much later in Brazil, and so far it has been exceptionally tame and tentative (Chart I-3). Brazil's domestic demand performance has in no way justified the rally in its financial markets since January 2016. If anything, it is the opposite: the domestic economic recovery emerged too late, and has been extremely subdued compared with the sizable gains in share prices. For example, banks' EPS bottomed only in May 2017, while their share prices troughed in January 2016 (Chart I-4). Similarly, Brazil's fiscal outlook and debt profile has continued to deteriorate, even though the country's sovereign spreads have tightened substantially (Chart I-5). Chart 3Brazil: Economic Recovery Is Exceptionally Tame Brazil: Economic Recovery Is Exceptionally Tame Brazil: Economic Recovery Is Exceptionally Tame Chart 4Brazil: Bank Share Prices And EPS Brazil: Bank Share Prices And EPS Brazil: Bank Share Prices And EPS Chart 5Brazil's Fiscal And Debt Profiles Have Deteriorated Brazil's Fiscal And Debt Profiles Have Deteriorated Brazil's Fiscal And Debt Profiles Have Deteriorated Hence, one can safely argue that economic growth and domestic fundamentals were not the basis behind why Brazilian financial markets found a bottom and rallied starting January 2016. Rather, the critical driving force has been commodities prices, China, the U.S. dollar and global risk appetite. This is consistent with the defining features of bull and bear markets: In a bull market, liquidity lifts all boats, and all flaws are overlooked or discharged while minor positives are magnified by the market. In a bear market, even marginal negatives are overblown, and the market punishes severely for minor missteps. In short, global risk assets have been in a genuine bull market since early 2016, and that has overridden Brazil's poor domestic fundamentals. Going forward, we recommend avoiding Brazilian risk assets - not because we do not expect an economic recovery in Brazil to progress, but because our view on China's impact on commodities and the potential U.S. dollar rebound will curb overall risk appetite toward EM. We discussed this EM/China/commodities outlook at length in last week's report.1 Timing a shift in financial market regimes is always a difficult task, but our sense is that a top in EM risk assets will likely occur between now and the end of October, as China's Communist party Congress reiterates its focus on containing financial risk and leverage, as well as the authorities' marginal tolerance for slightly slower growth. Furthermore, our broad money (M3) impulse for China suggests an imminent relapse in Goldman Sach's current economic activity indicator for the mainland economy (Chart I-6). Our assumption is that commodities prices will drop due to potential weakness in China, and that the U.S. dollar and U.S. bond yields are oversold and will recover, respectively. Altogether, these views warrant a cautious stance on EM currencies. The real has historically been correlated with commodities prices, and this positive correlation will likely continue. As and when the Brazilian currency resumes its depreciation, the risk-on trade in Brazilian equities and credit markets will end. As for Brazilian financial markets, a few relationships are worth highlighting: Since early this year, iron ore prices have been inversely correlated with Chinese money market rates (Chart I-7). A possible explanation is that iron ore and other commodities prices trading on Chinese exchanges have been driven by meaningful speculative buying that negatively correlates with borrowing costs on the mainland. Chart 6China's Growth Is Set To Slow bca.ems_wr_2017_09_13_s1_c6 bca.ems_wr_2017_09_13_s1_c6 Chart 7Iron Ore Prices Are Vulnerable Iron Ore Prices Are Vulnerable Iron Ore Prices Are Vulnerable Given the latest relapse in Brazil's nominal GDP growth, the pace of amelioration in private banks' NPL and NPL provisions could stall (Chart I-8). In turn, Brazilian banks' share prices seem to move inversely with the rate of change in private banks' NPL and NPL provisions (Chart I-9A & Chart I-9B). If these relationships hold, we might be close to a peak in Brazilian bank share prices. Chart 8Brazil: Is The Improvement In NPL Cycle Over? Brazil: Is The Improvement In NPL Cycle Over? Brazil: Is The Improvement In NPL Cycle Over? Chart 9ABrazil: NPL Cycles and Bank Stocks Brazil: NPL Cycles and Bank Stocks Brazil: NPL Cycles and Bank Stocks Chart 9BBrazil: Provisions Cycles And Bank Stocks Brazil: Provisions Cycles And Bank Stocks Brazil: Provisions Cycles And Bank Stocks Finally, the pace of economic recovery will likely disappoint because the Brazilian economy is facing numerous headwinds: High borrowing costs - the real prime lending rate is 12.5% and the policy rate in the real terms is 6.8%, while public banks' lending rates are set to rise due to the TJLP reform that will remove the government budget's subsidy for borrowers. With 50% of outstanding credit being earmarked credit (previously subsidized by the government and provided by public banks), the impact on economic activity will be non-trivial; Lower government spending, as 2018 government expenditure growth cannot exceed the 2017 June headline inflation rate of 3%. Besides, the fiscal balance is so disastrous that risks to taxes are to the upside, not downside. Furthermore, the recently augmented 2017 year-end fiscal primary deficit target of BRL 159 billion is smaller than the deficit of BRL 182 billion for the past 12 months. This entails government spending cuts are likely this year, which will weigh on growth. The Brazilian exchange rate is not cheap. The nation needs a cheaper currency to reflate its economy. Lingering political uncertainty amid the corruption scandals and upcoming presidential elections in fall 2018 will continue to weigh on capital spending and employment, which have not yet recovered. Bottom Line: Our overarching negative view on EM, China and commodities heralds staying cautious on Brazil's financial markets despite the early signs of domestic economic recovery. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report, titled "Copper Versus Money/Credit In China - Which One Is Right?", dated September 6,. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

The latest FDIC Quarterly Banking Profile paints a rosy picture for bank earnings growth. A surge in net interest income drove the industry Q2 net interest margin (NIM) to its highest level in 4 years, and the return on assets to the highest level in 10 years (second and third panels). Should inflation pick up in the back half of the year as we expect, it should be accompanied by a steeper yield curve and further NIM expansion. Encouragingly, noncurrent C&I loans have peaked (bottom panel), a strong signal that the credit cycle has turned positive. Improving credit quality in this largest category of bank credit should have the double impact of raising earnings and encouraging increasing loan growth. In short, this report reinforces our expectation that soaring consumer and business confidence, rising corporate profits and a potential capital spending revival will support the relative outperformance of banks. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT. Banking On Growth Banking On Growth