Banks

Highlights Dear Client, The Global Fixed Investment Strategy will not be publishing next week. Our regular publishing schedule will resume on September 12, 2017. Jackson Hole: Last week's Fed conference did not produce any signals on policy shifts from the Fed or ECB. Yet the outlook for either central bank over the next year has not changed. The Fed will deliver more hikes than currently discounted by the market, while the ECB will taper the pace of its asset purchases. A below-benchmark duration stance is warranted on a 6-12 month horizon. IG Sector Performance: Our Investment Grade (IG) corporate sector allocations for the U.S., Euro Area and U.K., taken from our relative value models, have generated outperformance versus the regional benchmarks since the beginning of the year, led by overweights to Banks. The alpha of sector selection should start to outweigh the beta of owning corporates in the next 6-12 months, given the tight overall level of spreads and flat credit curves. Feature Markets Were Too Jacked Up For Jackson Hole Well, so much for that. The highly anticipated Federal Reserve symposium in Jackson Hole last weekend provided little in the way of guidance on the future monetary policy moves in the U.S. or Europe. The speakers at Jackson Hole, including Fed Chair Janet Yellen and ECB President Mario Draghi, instead chose to focus more on factors that they cannot directly control, such as trade protectionism, income inequality and technological change. Chart of the WeekTougher Regulations Or Just Easy Money? Tougher Regulations Or Just Easy Money? Tougher Regulations Or Just Easy Money? The market reaction was interesting. Bond yields and equities were essentially unchanged on the day last Friday, but the U.S. dollar ended softer, especially versus the euro. Perhaps this was simply a function of very short-term positioning in currency markets. The speculation prior to Jackson Hole was that Yellen might talk up another Fed rate hike to offset to stimulative effects of booming financial asset prices, perhaps in the absence of any renewed pickup in U.S. inflation. At the same time, there were expectations that Draghi could use his speech to dial back expectations of a reduction in ECB asset purchases, which have helped fuel the strong rally in the euro. With both central bankers delivering a big "nothing burger" with regards to policy changes, speculators likely covered their positions. The speeches from Yellen and Draghi were not totally without meaningful content, however. They both warned about the potential risks from dialing back some of the post-crisis regulatory changes to the infrastructure of the global financial system. Both of them went as far as stating that the stronger regulatory backdrop has been a major factor behind the current health of the global economy: Yellen: "Our more resilient financial system is better prepared to absorb, rather than amplify, adverse shocks, as has been illustrated during periods of market turbulence in recent years." Draghi: "[...] lax regulation runs the risk of stoking financial imbalances. By contrast, the stronger regulatory regime that we now have has enabled economies to endure a long period of low interest rates without any significant side-effects." This is an interesting way to spin the events of the past decade. Yes, regulatory reforms have forced global banks to hold higher levels of capital. This should, in theory, help mitigate the spillover effects on the real economy from periodic financial market sell-offs that could make banks more risk-averse. Yet central banks have, at the same time, maintained incredibly loose monetary policies that have helped support both global growth and bull markets in risk assets (Chart of the Week). It is, at best, complacency and, at worst, hubris for Yellen or Draghi to say that the financial system can handle market shocks better when their own hyper-easy monetary policies are a big reason why asset markets have avoided protracted sell-offs. "Buy the dip" is an easy investment strategy when central banks are providing a liquidity tailwind while keeping risk-free interest rates at unattractive levels. Yet market valuations are now at the point where the payoff to buying the dips will be much lower than in recent years, presenting a challenge to financial stability for policymakers looking to incrementally become less accommodative. In Charts 2A & 2B, we show the range of asset prices and valuations for key fixed income and equity markets since 1990. The blue dots in each panel represent the latest reading, while the historical ranges are the thick lines. The benchmark 10-year government bond yields for the U.S., Germany, Japan and the U.K. are shown in Chart 2A, both in nominal and inflation-adjusted terms.1 In Chart 2B, the trailing price-earnings multiples for global equity markets and option-adjusted spreads for the major global credit sectors (corporate bonds and Emerging Market debt) are displayed. Chart 2AGlobal Asset Valuations, 1990-2017 A "Hole" Lot Of Nothing A "Hole" Lot Of Nothing Chart 2BGlobal Asset Valuations, 1990-2017 A "Hole" Lot Of Nothing A "Hole" Lot Of Nothing Within fixed income, nominal government bond yields and credit spreads are trading at the low end of the historical ranges. Equity valuations are not yet at the stretched extremes seen during the late 1990s dot-com bubble, although longer-term measures like the CAPE (cyclically-adjusted price earnings) ratio are much closer to all-time highs. By any measure, most financial assets are not cheap, thanks in large part to the easy monetary backdrop. Right now, the current tranquil market backdrop is increasingly at risk from a shift in monetary policies. The Fed and ECB are still confronted with the problem of tight labor markets alongside tame inflation (Chart 3). While there has been a much more vigorous debate among central bankers on the effectiveness of using a Phillips Curve framework for forecasting inflation, the plain truth is that policymakers do not have any reliable alternative. The best they can do is stick with the unemployment-versus-inflation trade-off and go more slowly on policy adjustments when inflation undershoots levels suggested by strong labor markets. At the moment, there is no immediate need for either the Fed or ECB to tighten monetary policy. Realized inflation rates on both sides of the Atlantic are still below the 2% target. Our Central Bank Monitors for the U.S. and Euro Area are both hovering around the zero line (Chart 4), also indicating that no imminent changes in the policy stance are required. Chart 3Fed & ECB Facing The Same##BR##Phillips Curve Dilemma Fed & ECB Facing The Same Phillips Curve Dilemma Fed & ECB Facing The Same Phillips Curve Dilemma Chart 4Bond & FX Markets Look Fully##BR##Priced For A Stronger Europe Bond & FX Markets Look Fully Priced For A Stronger Europe Bond & FX Markets Look Fully Priced For A Stronger Europe The improvement in the Euro Area Monitor is related to both faster domestic economic growth and a slow-but-steady rise in inflation, trends that are likely to be maintained over at least the next 6-12 months given the strength of European leading economic indicators. However, the decline in the U.S. Monitor is largely a function of the recent surprising dip in U.S. inflation (both prices and wages) over the past few months. We expect that to soon begin to reverse on the back of reaccelerating U.S. growth and a rebound in inflation fueled in part by the lagged impact of the weaker U.S. dollar. The greenback's decline this year versus the euro has been a reflection of a more rapid improvement in European economic growth (3rd panel). Although this looks to have overshot with the EUR/USD exchange rate rising far more rapidly than implied by interest rate differentials between the U.S. and Europe (bottom panel). This either suggests that European bond yields must rise relative to U.S. yields to justify the current level of EUR/USD (a UST-Bund spread close to 100bs based on the relationship over the past three years), or that the currency must pull back to valuations more consistent with interest rate differentials (around 1.10, also based on the post-2014 correlations). The easier path is for the currency to soften up rather than European bond yields rising faster than U.S. Treasuries. The ECB is still far from contemplating an actual interest rate hike, and is only debating the need to continue buying European bonds at the current pace. At the same time, there is now barely one full 25bp Fed rate hike discounted by the market, which makes Treasuries more vulnerable to the rebound in U.S. growth and inflation that we expect. That outcome is not conditional on any easing of U.S. fiscal policy, but any success by the Trump White House in delivering tax cuts would only force the Fed to hike rates to offset the stimulus to an economy already at full employment. In other words, we see more reasons for both U.S. Treasury yields and the U.S. dollar to go up from current levels versus European equivalents. Bottom Line: Last week's Fed conference at Jackson Hole did not produce any signals on policy shifts from the Fed or ECB. Yet the outlook for either central bank over the next year has not changed. The Fed will deliver more hikes than currently discounted by the market, while the ECB will taper the pace of its asset purchases. A below-benchmark duration stance is warranted on a 6-12 month horizon. A Brief Update On The Performance Of Our Corporate Bond Sector Allocation Recommendations Chart 5Performance Of Our IG Sector Allocations A "Hole" Lot Of Nothing A "Hole" Lot Of Nothing We last published an update of our Investment Grade (IG) sector valuation models for the U.S., Euro Area and U.K. back on June 6th.2 This followed up on our report from January 24th of this year where we added our IG sector recommendations to our model bond portfolio.3 That meant putting actual weightings to each sub-sector within the overall IG index for each region, rather than a more nebulous "overweight", "underweight" or "neutral" recommendation. This was in keeping with the spirit of our overall model bond portfolio framework, which is to present a more transparent measure of how our recommended tilts would perform as a hypothetical fully-invested fixed income portfolio. Our IG sector allocations come from our IG relative value model, which is designed to measure the valuation of each sector relative to the overall Barclays Bloomberg corporate bond index for each region. The latest output of the model can be found in the Appendix on page 14. The current valuations have not changed material from that June 6th report, suggesting that the rally in corporate bond markets has been more about beta driving the valuations of all sectors. In other words, the sectors have maintained their value relative to each other and to the overall IG index over the past few months. Having said that, our sector allocations have still been able to deliver some extra return versus the regional benchmarks since we started putting specific weights to our sector tilts back in January. Since then, our sector tilts have added +3bps of "active" excess return (i.e. returns over duration-matched government bonds) versus the IG benchmark in the U.S., +9bps in the Euro Area and an impressive +32bps in the U.K. (Chart 5). Most of that outperformance came between January and our last update, with only the U.K. showing gains since June. The specifics of the returns can be found in Table 1 for the U.S., Table 2 for the Euro Area and Table 3 for the U.K. For all three regions, the biggest source of the outperformance of our allocations has come from the overweight positions in Financials, specifically Banks. As any corporate bond portfolio manager will attest, the large weighting of Financials in IG bond indices makes the Financials versus Non-Financials decision the most important one to make. Our model bond portfolio is no different. Table 1U.S. Investment Grade Performance A "Hole" Lot Of Nothing A "Hole" Lot Of Nothing Table 2Euro Area Investment Grade Performance A "Hole" Lot Of Nothing A "Hole" Lot Of Nothing Table 3U.K. Investment Grade Performance A "Hole" Lot Of Nothing A "Hole" Lot Of Nothing Looking ahead, we expect that sector allocations may soon begin to have a greater impact on the performance of IG corporate bond portfolios, given how flat credit curves have become (Chart 6). The spread between BBB-rated corporates and A-rated corporates is at historically narrow levels in all regions. The flattening of credit curves may be reaching a resistance level in the U.S. and U.K., but not so in the Euro Area where the gap between BBB-rated and A-rated corporates is now a mere 34bps. Chart 6Credit Quality Curves Are Very Flat Credit Quality Curves Are Very Flat Credit Quality Curves Are Very Flat The combination of a solid Euro Area economic upturn and persistent ECB buying of corporates as part of its asset purchase program has driven a reduction of risk premiums throughout the Euro Area credit markets. Given our expectation that the ECB will be forced to begin tapering its asset purchase program in 2018, including the pace of corporate buying, we continue to maintain an underweight allocation to Euro Area IG corporates in our overall model portfolio. We are also seeking to limit our overall recommended spread risk to around index levels using our preferred metric, Duration Times Spread (DTS). At the same time, we are maintaining our recommended overweights to U.S. IG and U.K. IG, sticking with above-benchmark tilts in the Banks, while maintaining a portfolio DTS close to the overall index DTS. In the U.S., we are also keeping an overweight bias on Energy-related sectors, which offer the most attractive valuations despite having a higher DTS than the overall benchmark index. Our underweights in higher DTS U.S. sectors, specifically in the Consumer Non-Cyclicals and Utilities groupings, offset the DTS exposure from our recommended Energy overweight. Bottom Line: Our Investment Grade (IG) corporate sector allocations for the U.S., Euro Area and U.K., taken from our relative value models, have generated outperformance versus the regional benchmarks since the beginning of the year, led by overweights to Banks. The alpha of sector selection should start to outweigh the beta of owning corporates in the next 6-12 months, given the tight overall level of spreads and flat credit curves. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 In the bottom panel of Chart 2A, we deflate nominal 10-year bond yields by a 3-year moving average of realized headline inflation to smooth out the fluctuations in inflation. 2 Please see BCA Global Fixed Income Strategy Special Report, "Updating Our Investment Grade Corporate Bond Sector Allocations", dated June 6th 2017, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Special Report, "Adding Investment Grade Corporate Bond Sectors To Our Model Portfolio Framework", dated January 24th 2017, available at gfis.bcaresearch.com. Appendix Appendix Table 1U.S. Corporate Sector Valuation And Recommended Allocation* A "Hole" Lot Of Nothing A "Hole" Lot Of Nothing Appendix Chart 1U.S. Corporate Sector Risk Vs. Reward* A "Hole" Lot Of Nothing A "Hole" Lot Of Nothing Appendix Table 2Euro Area Corporate Sector Valuation And Recommended Allocation* A "Hole" Lot Of Nothing A "Hole" Lot Of Nothing Appendix Chart 2Euro Area Corporate Sector Risk Vs. Reward* A "Hole" Lot Of Nothing A "Hole" Lot Of Nothing Appendix Table 3U.K. Corporate Sector Valuation And Recommended Allocation* A "Hole" Lot Of Nothing A "Hole" Lot Of Nothing Appendix Chart 3U.K. Corporate Sector Risk Vs. Reward* A "Hole" Lot Of Nothing A "Hole" Lot Of Nothing A "Hole" Lot Of Nothing A "Hole" Lot Of Nothing Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index A "Hole" Lot Of Nothing A "Hole" Lot Of Nothing

Highlights Your portfolio cash weighting should be at least in the middle of its range, until the observed volatility of risk assets rises meaningfully from its record low. Cyclically add long SEK/USD to long EUR/USD. Within a European equity portfolio, this implies going cyclically underweight Sweden's OMX, given its high exposure to exporters. Go underweight Swedish real estate equities; overweight Spanish real estate equities. Within a global equity portfolio, overweight euro area banks versus U.S. banks. Feature Great expectations for Mario Draghi's appearance at the Jackson Hole Symposium have been dampened, and understandably so. After the last monetary policy meeting, Draghi emphasised that ECB discussions about policy direction would take place in the autumn. It would undermine this decision making process if Draghi's Jackson Hole speech front ran the ECB discussions. Nonetheless, twitchy markets will inevitably read the tone of Draghi's observations on the global and euro area economies. Chart of the WeekSwedish House Prices Are Up 50% In Just Four Years...Thanks To Negative Interest Rates Swedish House Prices Are Up 50% In Just Four Years...Thanks To Negative Interest Rates Swedish House Prices Are Up 50% In Just Four Years...Thanks To Negative Interest Rates But the more market-relevant presentation might come five hours earlier on Friday at 3pm London time, when Janet Yellen gives a keynote speech on the market's latest meme - financial stability. Three months ago in Madrid, Draghi delivered a keynote speech1 on the very same topic - The interaction between monetary policy and financial stability - available here https://www.ecb.europa.eu/press/key/date/2017/html/ecb.sp170524_1.en.html and well worth reading as a prelude to Yellen's presentation. Draghi explained that ultra-accommodative monetary policy endangers financial stability through three potential channels: Distorting investor behaviour. Generating credit-fuelled bubbles, especially in real estate. Squeezing bank profitability. Do any of these three channels give ground for concern today? Yes. Distorting Investor Behaviour In our view, central banks' distortive impact on investor behaviour is the single biggest source of financial instability today. Yet Draghi devoted only a cursory mention of this danger, noting that investors "could be prone to engage in search-for-yield behaviour and take on excessive risks." The difficulty is that the psychological and behavioural finance biases creating the current distortions lie outside central bankers' natural area of expertise. Nevertheless, we hope that Yellen develops this topic much further at Jackson Hole. Specifically, the behavioural finance distortion known as Mental Accounting Bias describes the irrational distinction between the part of an investment's return that comes from its income, and the part that comes from its capital growth. Rationally, people should not care about this distinction because the money that comes from income and the money that comes from capital growth is perfectly fungible.2 But in practice, many people want a minimum investment income - because they wish to match their known spending outlays with their known income. While they could meet their spending needs by crystalizing capital growth, many people create psychologically separate 'mental accounts': spending from investment income and saving from capital growth. This is especially true for retirees whose main or only income might come from accumulated assets. Traditionally, this psychological mental accounting bias would be unnoticeable because investors could easily match their spending needs with the safe income generated by cash and government bonds. But in recent years, central banks' extended experiments with zero and negative interest rates and QE have forced the 'income mental account' to chase the higher but much more risky income streams from high-yield bonds and equities (Chart I-2 and Chart I-3). To the point where these risk assets no longer offer a sufficient risk premium. Chart I-2A Positive Yield On Equities Can Produce##br## A Negative 5-Year Return... A Positive Yield On Equities Can Produce A Negative 5-Year Return... A Positive Yield On Equities Can Produce A Negative 5-Year Return... Chart I-3...And Even A Negative##br## 10-Year Return ...And Even A Negative 10-Year Return ...And Even A Negative 10-Year Return The search-for-yield pushed up the prices of these risk assets. Now add to the mix the phenomenon known as negative skew.3 Risk asset advances tend to be gradual and gentle, and the longer and more established the advance becomes, the lower the observed volatility goes. Some investors then mistakenly interpret lower observed volatility as justification for a lower risk premium, which warrants a further price advance. And so on, in a self-reinforcing feedback. Today, this has left us with a bizarre and unprecedented situation in which the observed volatility of the Eurostoxx50 equity index is a fraction of the observed volatility of the long-dated German bund! (Chart I-4) Chart I-4Unprecedented: The Observed Volatility Of The Eurostoxx50 ##br## Is Now Lower Than That On The German Bund! Unprecedented: The Observed Volatility Of The Eurostoxx50 Is Now Lower Than That On The German Bund! Unprecedented: The Observed Volatility Of The Eurostoxx50 Is Now Lower Than That On The German Bund! But given the strong inverse relationship between observed volatility and price, record low observed volatility categorically does not mean that prospective risk of a drawdown is low. Quite the reverse, the lower the observed volatility, the higher the prospective risk. And vice-versa. Investment bottom line: Your portfolio cash weighting should always be inversely proportional to the observed volatility of risk assets. Today, with observed volatility still near a record low, your cash weighting should be at least in the middle of its range. Generating Credit-Fuelled Bubbles... In Sweden Turning to the second channel of financial instability, the ECB sees no evidence of credit-fuelled bubbles. Banks are extending credit, but at a fraction of the rate seen prior to 2007 (Chart I-5). And although house prices are rising, the ECB claims that its ultra-accommodative monetary policy has not created imbalances in real estate markets in the euro area. Taken at face value, this claim might be true. Chart I-5Euro Area Banks Are Extending Credit... But At A Modest Rate Euro Area Banks Are Extending Credit... But At A Modest Rate Euro Area Banks Are Extending Credit... But At A Modest Rate But look across the Baltic Sea. Chart I-6Swedish House Prices Accelerated##br## After ZIRP And NIRP Swedish House Prices Accelerated After ZIRP And NIRP Swedish House Prices Accelerated After ZIRP And NIRP Sweden's Riksbank has had to shadow the ECB's ultra-loose policy, to prevent a sharp appreciation of the Swedish krona versus the euro. The trouble is that negative interest rates have been wholly inappropriate for an economy that has recently been growing at 4.5%. One worrying consequence is that Swedish house prices have gone up by 50% in just four years (Chart of the Week), with the bulk of the boom happening after ZIRP and NIRP (Chart I-6). Also, bear in mind that the Swedish real estate market did not suffer a meaningful setback in either 2008 or 2011, meaning the recent boom is not a corrective rebound - like say, in Spain and Ireland. So the ECB's ultra-loose policy may indeed have generated a credit-fuelled bubble... albeit in Sweden! Fortunately, as the ECB ends its ultra-accommodation, it will also liberate the Riksbank to end its incongruous and dangerous NIRP policy. Investment bottom line: Cyclically add long SEK/USD to long EUR/USD. For European equity investors, this implies going cyclically underweight Sweden's OMX, given its high exposure to exporters. Also, go underweight Swedish real estate equities which are now approaching peak price-to-book multiples (Chart I-7). Prefer to overweight Spanish real estate equities which offer much more attractive valuations (Chart I-8). Chart I-7Swedish Real Estate Equities ##br##Are Close To Peak Valuation Swedish Real Estate Equities Are Close To Peak Valuation Swedish Real Estate Equities Are Close To Peak Valuation Chart I-8Spanish Real Estate Equities ##br##Offer Better Value Spanish Real Estate Equities Offer Better Value Spanish Real Estate Equities Offer Better Value Squeezing Bank Profitability For the third channel of financial instability, the ECB concedes that ultra-loose monetary policy compresses banks' net interest margins and thus exerts pressure on their profitability. "Since banks carry out maturity transformation by borrowing short and lending long-term, both the slope of the yield curve and its level matter for profitability." In turn, lower retained profits means lower accumulation of capital, making banks more fragile. The evidence strongly supports this logic. Since the start of the ECB's asset-purchase program, euro area bank valuations - a good proxy for profitability - have formed a perfect mirror-image of the expected intensity of QE (Chart I-9). Chart I-9Bank Valuations Have Been A Mirror-Image Of QE Bank Valuations Have Been A Mirror-Image Of QE Bank Valuations Have Been A Mirror-Image Of QE It follows that as the ECB dials back accommodation, the valuations of euro area banks will continue to recover - at the very least, in relative terms versus banks elsewhere in the world. Investment bottom line: Global equity investors should stay overweight euro area banks versus U.S. banks. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 At the First Conference on Financial Stability, May 24 207. 2 Assuming the tax treatment of income and capital growth is equal. 3 Please see the European Investment Strategy Weekly Report titled 'Negative Skew: A Ticking Time-Bomb' dated July 27, 2017 available at eis.bcaresearch.com Fractal Trading Model* We are monitoring the Italian stock Tenaris which is approaching a point of being technically oversold. We are also monitoring a commodity pair-trade, short nickel / long silver which is also approaching a potential entry point in the coming days. But we have not yet opened either trade. 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-10 Nickel Vs. Silver Nickel Vs. Silver 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 Portfolio Strategy We reiterate our recent overweight calls in banks/financials and energy. Chemicals/materials and telecom services no longer deserve a below benchmark allocation. Pharma/health care and utilities are now in the underweight column. Recent Changes There are no changes to our portfolio this week. Table 1Sector Performance Returns (%) Three Risks Three Risks Feature Equities poked higher early last week on the eve of a robust earnings season as quarterly EPS vaulted to all-time highs (Chart 1), only to give up those gains and then some as North Korea jitters spoiled the party and ignited a mini selloff later in the week. While geopolitical uncertainty is dominating the news flow and an escalation is possible, we doubt North Korea tensions in isolation can significantly derail the stock market. With regard to the SPX's future return composition, our view remains intact that the onus falls on earnings to do the heavy lifting. In other words, the multiple expansion phase has mostly run its course, and explains the bulk of the board market's return since the 2011 trough (Chart 2). Now it is time for profits to shine. Chart 1Earnings-Led Advance Earnings-Led Advance Earnings-Led Advance Chart 2EPS Has To Do The Heavy Lifting EPS Has To Do The Heavy Lifting EPS Has To Do The Heavy Lifting Low double-digit EPS growth is likely in calendar 2018. Three key factors drive our sanguine profit view. First, as we posited three weeks ago, financials and energy will command a larger slice of the earnings pie, a backdrop not yet discounted in sell-side analysts' estimates (please see Table 2 from the July 24th Weekly Report). Second, irrespective of where the U.S. dollar heads in the coming months, SPX earnings will benefit from positive FX translation gains in Q3 and Q4. Finally, as the corporate sector flexes its operating leverage muscle, even modest sales growth will go a long way in terms of profit growth generation. Operating profit margins are poised to expand especially given muted wage inflation (Chart 3). Nevertheless, lack of profit validation is a key risk to our bullish S&P 500 thesis. Considering the post-GFC period, global growth scares (and resulting anemic earnings follow through) were the primary catalysts for the 2010, 2011 and late-2015/early-2016 equity corrections. The SPX fell 16%, 19% and 14% in each of those episodes, respectively. As a reminder, early in 2010 the Fed's QE ended and the ECB was scrambling to contain the government debt crisis as the Eurozone and the IMF bailed out Greece, Portugal and Ireland. In 2011, recession fears gripped the world economy, when then ECB President Jean-Claude Trichet tightened monetary policy twice in the euro area, while in the U.S. QE2 ended (Chart 4) and the debt ceiling fiasco spiraled out of control in the late-summer. More recently, a global manufacturing recession took hold in late-2015/early-2016 and the commodity drubbing re-concentrated investor's minds. Chart 3Margin Expansion Phase Margin Expansion Phase Margin Expansion Phase Chart 4Liquidity Removal = Market Turmoil Liquidity Removal = Market Turmoil Liquidity Removal = Market Turmoil A persistent flare up in geopolitical risk (i.e. in addition to the possible escalation of North Korea tensions) may lead consumers and CEOs alike to pull in their horns and short circuit the synchronized global economic recovery. Putting this risk in perspective is instructive. Table 2 documents the historical precedent of geopolitical crises since the mid-1950s, the maximum SPX drawdowns, and bid up of safe haven assets courtesy of our Geopolitical Strategy Service.1 Under such a backdrop, low-double digit EPS growth would be at risk, also causing some equity market consternation. Table 2Safe-Haven Demand Rises During Crises Three Risks Three Risks Table 2Safe-Haven Demand Rises During Crises, Continued Three Risks Three Risks Importantly, the Chinese Congress is quickly approaching in October and the dual tightening in Chinese monetary conditions (rising currency and interest rates) is unnerving. A related Chinese/EM relapse represents a risk to our bullish overall equity market thesis. Commodity producers/sectors would suffer a setback, jeopardizing the broad-based earnings recovery. Chart 5Mini Capex Upcycle Mini Capex Upcycle Mini Capex Upcycle Second, lack of tax reform is another risk we are closely monitoring that could put our upbeat SPX view offside. Lack of traction on this front as the year draws to a close will likely sabotage business confidence and put capex plans on the backburner anew. Moreover, this would shatter the confidence of small and medium businesses, especially given their greatest bugbears: high taxes and big government. Finally, repatriation tax holiday blues would cast a double dark shadow primarily over the tech and health care sectors: not only would shareholder-friendly activities like dividends and buybacks get postponed, but so would capex plans (Chart 5). One final risk worth monitoring is the handoff of liquidity to growth. Historically, there has been significant turmoil every time the Fed has removed balance sheet accommodation in the post-GFC era. We are in uncharted territory and the unwinding of the Fed's balance sheet, likely to be announced next month, may have unintended consequences. Unlike QE and QE2 ending, this time around the ECB is also on the cusp of removing balance sheet liquidity, at the margin. Chart 6A shows that the equity market may come under pressure if history at least rhymes. While we doubt that a larger than 10% correction is in the cards -- in line with the historical S&P 500 average drawdown during geopolitical crises (middle panel, Chart 6B)2 -- and our strategy will be to "buy the dip", the time to purchase portfolio insurance is now when the S&P 500 is near all-time highs, especially given the seasonally-weak and accident-prone months of September and October. Chart 6ADay Of Reckoning? Day Of Reckoning? Day Of Reckoning? Chart 6BAsset Class Returns During Crises Three Risks Three Risks We are comfortable with our overall early-cyclical portfolio exposure, while simultaneously maintaining a bit of defense in the form of our overweight consumer staples and underweight tech positions. This week we are recapping and reiterating all the major portfolio moves we have made since early May. Banking On Faster Growth Bank profit growth is supported by three main pillars: the quantity, price and quality of credit. All three are set to improve. Solid house price inflation and a tight labor market should ensure that consumer credit growth also firms (Chart 7A), pointing to the potential for a broad-based bank balance sheet expansion. Our U.S. bank loan growth model suggests that banks could enjoy the largest upswing in credit growth of the past 30 years (Chart 7B). Soaring consumer and business confidence, rising corporate profits and a potential capital spending revival are the key model drivers. BCA's view is that a better economy and rising inflation will materialize in the back half of the year, and serve as a catalyst to higher interest rates and a steeper yield curve. Banks profit from overall rising interest rates in two ways: reinvesting at higher yields and assets repricing at a faster pace than deposits. Thus, a steepening yield curve would signal that bank profit estimates should experience a re-rating, provided the yield lift at the long end of the curve was gradual and did not choke off growth via a sudden spike (Chart 7A). Chart 7ABanks Flexing Their Muscle Banks Flexing Their Muscle Banks Flexing Their Muscle Chart 7BBCA Bank Loans & Leases Growth Model BCA Bank Loans & Leases Growth Model BCA Bank Loans & Leases Growth Model In terms of credit quality, non-performing loans and charge-offs are sinking from already low levels. It would take a significant deterioration in the labor market to warn that credit quality was about to become a profit drag. Importantly, the reserve coverage ratio has climbed to near 100%, as non-current loans have fallen faster than banks have released reserves. Historically, credit quality improvement has been positively correlated with rising valuations (Chart 7A). Finally, even a modest easing in the regulatory backdrop along with a more shareholder friendly outlook now that the banks aced the Fed's stress test should help unlock excellent value in bank equities. Bottom Line: We reiterate our overweight stance in the S&P banks index that also lifted the S&P financials sector to overweight. Buy Energy Stocks Chart 8Energy EPS Model Says Buy Energy EPS Model Says Buy Energy EPS Model Says Buy Energy equities are down roughly 20% year-to-date versus the broad market, driven by rising U.S. shale oil production, inventory accumulation, and investor doubts about whether all nations will comply with OPEC's mandated production cuts. There are tentative signs that this relative performance bear phase is drawing to a close. Three main drivers support our modestly sanguine view of energy stocks. First, the long term inverse correlation between the U.S. dollar and the commodity complex has been reestablished; global growth suggests that a tightening interest rate cycle is brewing which should be supportive to energy stocks (top panel, Chart 8). Second, the steepest drilling upcycle in recent memory is showing signs of fatigue with Baker Hughes reporting flattening growth in domestic oil rig count; At least a modest deceleration in shale oil production is likely (Chart 8). Finally, our S&P energy sector Valuation Indicator has gravitated back to the neutral zone. Technicals are also washed out with our Technical Indicator breaching one standard deviation below its historical mean, a level that typically heralds a reversal. Recent anecdotes that the sell-side is throwing in the towel on their bullish oil forecasts for the remainder of the year are also contrarily positive. Bottom Line: Our newly introduced S&P energy sector relative EPS model encapsulates this cautiously optimistic industry backdrop (Chart 8), and gave us comfort to lift the S&P energy sector to a modest overweight position. DeREITing Chart 9Lighten Up On REITs Lighten Up On REITs Lighten Up On REITs REITs have marked time year-to-date, but recently operating conditions have downshifted a notch. Three key drivers argue for lightening up exposure on this newly formed S&P GICS1 sector. First, REITs had been unable to materially benefit from the 50bps fall in the 10-year Treasury yield from the mid-December peak to the mid-June trough. As the economy recovers from the first half lull, Treasury yields will resume their advance. This is a net negative for the fixed income proxy real estate sector (Chart 9). Second, real estate occupancy rates have crested and generationally high supply additions in the apartment space are all but certain to push vacancies higher still. The implication is that rental inflation will remain under intense downward pressure (Chart 9). Finally, according to the Fed's latest Senior Loan Officer Survey, bankers are less willing to extend CRE credit. If banks continue to close the credit taps, CRE prices will suffer a setback. Bottom Line: We reiterate our downgrade of the niche S&P real estate sector to a benchmark allocation. Positive Chemical Reaction? Chart 10Chemicals Are No Longer Toxic Chemicals Are No Longer Toxic Chemicals Are No Longer Toxic In the summer of 2014 we went underweight the S&P chemicals index, anticipating an earnings underperformance phase, driven by weak revenues as chemicals manufacturers were furiously adding capacity to benefit from lower domestic feedstocks. This view has largely panned out, and now three factors underpin our more neutral bias: synchronized global growth, receding global capacity and improving domestic operating conditions. The global manufacturing PMI has recently reaccelerated and jumped to a six year high. Similarly, the U.S. ISM manufacturing survey also vaulted higher. Synchronized global growth suggests that final demand is on the upswing and should bode well for chemical top- and bottom-line growth (Chart 10). This has driven a relative weakening of the U.S. dollar, much to the benefit of U.S. chemical producers, whose exports appear to be displacing German exports. Global chemicals M&A supports our expectation of demand-driven pricing power gains. We think the benefits of consolidation are twofold: First, reduced revenues of the past decade have left the industry with outsized cost structures; consolidation should sweep that away under the guise of synergy, driving margins higher. Second, industry overcapacity has historically impaired profitability due to soaring overhead and more competitive pricing; greater scale should impose greater capital discipline. Finally, domestic operating conditions have taken a turn for the better. This improving domestic final demand backdrop is reflected in higher resource utilization rates and solid pricing power gains have staying power (Chart 10). Bottom Line: Tentative evidence suggests that the bear market in chemicals producers is over. We reiterate our recent upgrade to neutral. Given that chemicals stocks comprise over 73% of the broad materials index, this bump also moved the S&P materials sector to a benchmark allocation. Utilities: Blackout Warning Chart 11Utilities Get Short Circuited Utilities Get Short Circuited Utilities Get Short Circuited While chemicals and materials are beneficiaries of an upgrading in global economic expectations, utilities sit at the opposite end of the table (global manufacturing PMI shown inverted, top panel, Chart 11), and therefore warrant a downgrade to a below benchmark allocation. Now that the Fed is ready to start unwinding its balance sheet, the ECB is preparing the waters for QE tapering and a slew of CBs are on the cusp of a new tightening interest rate cycle, there are high odds that still overvalued fixed income proxies will continue to suffer. Synchronized global growth and coordinated tightening in monetary policy spells trouble for bonds. Our sister publication U.S. Bond Strategy expects a bond selloff for the remainder of the year. Given that utilities essentially trade as a proxy for bonds, this macro backdrop leaves them vulnerable to a significant underperformance phase (Treasury yield shown inverted, bottom panel, Chart 11). Importantly, the stock-to-bond (S/B) ratio and utilities sector relative performance also has a tight inverse correlation (S/B shown inverted, second panel, Chart 11). The implication is that downside risks remain acute. Without the support of continued declines in bond yields, or of indiscriminate capital flight from all riskier assets, utilities advances depend on improving fundamentals. The news on the domestic operating front is grim. Contracting natural gas prices, the marginal price setter for the industry, suggest that recent utilities pricing power gains are running on empty. Tack on waning productivity, with labor additions handily outpacing electricity production, and the ingredients for a margin squeeze are in place. Bottom Line: We reiterate our recent downgrade to underweight. Pharma: Tough Pill To Swallow Chart 12Pharma Relapse Pharma Relapse Pharma Relapse Pharma stock profits have moved in lockstep with consumer spending on pharmaceuticals and both have roughly doubled over the past decade. However, relative pharma consumer outlays have crested recently, causing a significant pharma profit underperformance (Chart 12). If our cautious drug pricing power thesis pans out as we portrayed in the July 31st Weekly Report, then pharma earnings will suffer and exert downward pressure on relative share prices (Chart 12). Industry balance sheet deterioration represents another warning signal. Net debt/EBITDA is skyrocketing at a time when the broad non-financial corporate (NFC) sector has been in balance sheet rebuilding mode (bottom panel). While this metric does not suggest that pharma stocks are in deep financial trouble, the deterioration in finances is undeniable, and, at the margin, a rising interest rate backdrop will likely slow down debt issuance for equity retirement and dividend payout purposes. Bottom Line: We recently trimmed the S&P pharmaceuticals index to underweight, which also took the S&P health care index to underweight. Telecom Services: Signs Of Life Chart 13Telecom: Climbing Out Of Deflation2 Telecom: Climbing Out Of Deflation Telecom: Climbing Out Of Deflation Investors have shunned telecom services stocks vehemently year-to-date (YTD) on the back of an abysmal profit showing. We had been fortunate enough to underweight this niche sector since late January, adding alpha to our portfolio. Nevertheless, we did not want to overstay our welcome and recently booked profits of 12% and lifted the S&P telecom services sector to the neutral column. Our Cyclical Macro Indicator has arrested its fall giving us comfort that at least a lateral move in relative share prices is likely in coming months (Chart 13). The steep recalibration of cost structures to the new pricing reality is buttressing our CMI, offsetting the sector's plummeting share of the consumer's wallet (Chart 13). Encouragingly, selling prices cannot contract at 10% per annum indefinitely, and on a three month-rate of change basis, pricing power has staged a V-shaped recovery (Chart 13). Anecdotally, Verizon's first full quarter post the new pricing plans was solid and suggests that the peak deflationary impulse is likely behind the industry. Impressive labor cost discipline along with even a modest pricing power rebound signal that a grinding higher margin backdrop is likely in the coming months, in line with our margin proxy reading. This will also stabilize relative profitability. In sum, the bearish S&P telecom services narrative is more than discounted in ultra-depressed relative valuations on cyclically quashed profit estimates. Green shoots on the industry's pricing power front and impressive management focus on cost structures argue against being bearish this niche sector. Bottom Line: We reiterate the recent bump to neutral in the S&P telecom services sector. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Geopolitics And Safe Havens," dated November 11, 2015, available at gps.bcaresearch.com. 2 Ibid. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Feature Turkey's banking system has in recent years relied on enormous liquidity provisions by the central bank (Chart I-1) to sustain its ongoing credit boom, and hence economic growth. Since early this year, the authorities have doubled down: they have also begun using fiscal policy to prop up growth. Chart I-1Turkey: Central Bank Large Liquidity Injections Turkey: Central Bank Large Liquidity Injections Turkey: Central Bank Large Liquidity Injections On the whole, this combination of colossal credit and fiscal stimulus is indisputably bearish for the currency. Despite strong performance by Turkish stocks this year, we are maintaining our bearish call on the lira. The lira is set to depreciate by 20-25% in the next 12 months or so versus both an equally-weighted basket of the U.S. dollar and the euro. Bringing Fiscal Stimulus Into Play The Turkish authorities have recently begun using fiscal means to stimulate growth: Last summer, a sovereign wealth fund was set up by presidential decree to pool shares in companies owned by the government and use them as collateral to raise debt and initiate spending on various infrastructure projects. The target size of the fund is US$ 200 billion, compared with the government non-interest expenditure of US$ 165 billion in the last 12 months. This would effectively allow the government to issue debt and increase expenditures off-balance sheet. In addition, this past March, the government decided to recapitalize the Credit Guarantee Fund. This initiative allowed it to underwrite US$ 50 billion, or 7% of GDP, worth of credit to Turkish companies. This is considerable as it compares with US$ 93 billion worth of loan origination by commercial banks last year. By assuming credit risk on these loans, the government is effectively encouraging banks to lend, in turn boosting economic growth. In effect, this has lowered lending standards and given a green light to banks to flood the economy with credit. Even though interest rates have risen since last November, credit growth has accelerated as banks have provided loans covered by government guarantees (Chart I-2). On top of this quasi-fiscal stimulus, government expenditures excluding interest payments have accelerated (Chart I-3). Chart I-2Bank Loan Growth Has Accelerated ##br##Despite Higher Interest Rates Bank Loan Growth Has Accelerated Despite Higher Interest Rates Bank Loan Growth Has Accelerated Despite Higher Interest Rates Chart I-3Turkey: Fiscal Spending Has Surged Turkey: Fiscal Spending Has Surged Turkey: Fiscal Spending Has Surged Such a rise in government spending has been financed by commercial banks whose holdings of government bonds have risen sharply. Essentially, government spending has also been funded by commercial banks' money creation. In short, fiscal and credit stimulus have boosted domestic demand, thereby widening the country's current account deficit once again (Chart I-4A and Chart I-4B). Chart I-4AWidening Twin Deficit Widening Twin Deficit Widening Twin Deficit Chart I-4BWidening Twin Deficit Widening Twin Deficit Widening Twin Deficit Given that the starting point of the government's fiscal position is good - public debt stands at only 28% of GDP - the authorities have ample room to rely on fiscal levers to promote growth. However, a widening fiscal deficit will be bearish for the currency. Bottom Line: Widening twin (current account and fiscal) deficits (Chart I-4A and Chart I-4B) are a bad omen for the lira. Monetary Tightening? What Monetary Tightening? Chart I-5Turkey: Money/Credit Growth Is Too Strong Turkey: Money/Credit Growth Is Too Strong Turkey: Money/Credit Growth Is Too Strong Although interbank and lending rates have risen in recent months, money and credit growth have been booming (Chart I-5). This does not support the idea that monetary policy is tight. On the contrary, thriving money and credit growth suggest that the policy stance is very easy. The Central Bank of Turkey (CBT) raised various policy rates and capped the overnight liquidity facility at the beginning of this year. However, commercial banks' usage of the late liquidity window facility - the one facility that has been left uncapped - has literally gone exponential - it has risen from zero to TRY 70 billion in the past 8 months. On the whole, the central bank’s net liquidity injections into the banking system continue to make new highs, even though the price of liquidity has been rising. Adding all the liquidity facilities – the intraday, overnight and late window facilities – the CBT's outstanding funding to banks is 90 billion TRY, or 3% of GDP, more than ever recorded (Chart 1, bottom panel). This entails that monetary policy is loose rather than tight. On the whole, commercial banks are requiring more and more liquidity, and the CBT is continuously supplying it. These injections maintain liquidity in the banking system to a sufficiently high level to allow aggressive money/credit creation among commercial banks. Bottom Line: The CBT is facilitating/accommodating an economy-wide credit binge by providing copious amounts of liquidity to commercial banks. The Victim Is The Lira The lira will inevitably depreciate in the months ahead: Chart I-6Turkey: Central Bank's Foreign ##br##Reserves Have Been Depleted Turkey: Central Bank's Foreign Reserves Have Been Depleted Turkey: Central Bank's Foreign Reserves Have Been Depleted The lira's exchange rate versus an equally-weighted basket of the U.S. dollar and the euro has been mostly flat year-to-date, despite the CBT intervening in the market to support the lira by selling U.S. dollars. Aggressive selling of CBT foreign exchange reserves has so far prevented much steeper lira depreciation in Turkey. However at this stage, the central bank is literally running out of reserves and will soon lose its ability to support the currency (Chart I-6). A developing country with foreign exchange reserves worth less than three months' imports is considered vulnerable. Therefore, at 0.5 months of imports coverage, or US$ 9.7 billion, the CBT has little capacity to continue supporting the currency via interventions. Economic growth has recovered: export volumes are very strong, driven by shipments to Europe, while loan growth is supporting private domestic demand and government expenditures have mushroomed. The ongoing economic recovery will boost inflation, and strong domestic demand will assure the current account deficit widens. This will weigh on the exchange rate. Core inflation measures have subsided from 10% to 7%, but remain well above the central bank's target of 5%. Provided inflation is a lagging variable, the acceleration in money growth and domestic demand this year will lead to higher inflation in the months ahead. Wage growth remains high and our profit margin proxy for both manufacturing and service industries - calculated as core CPI divided by unit labor costs - has relapsed signifying deteriorating corporate profitability (Chart I-7). This in turn will force businesses to raise prices. Provided demand is strong, companies will likely succeed in passing through higher prices to customers. In brief, odds are that inflation will rise significantly soon. Escalating unit labor costs also offsets the benefit of nominal currency depreciation. Chart I-8 illustrates that the real effective exchange rate is not cheap based on consumer prices, or unit labor costs. Chart I-7Companies Profit Margins Are Shrinking Companies Profit Margins Are Shrinking Companies Profit Margins Are Shrinking Chart I-8The Lira Is Not Cheap At All The Lira Is Not Cheap At All The Lira Is Not Cheap At All As inflation rises, residents' desire to convert their deposits from local to foreign currency will increase. In fact, this is already happening - households' foreign currency deposit growth is accelerating. In short, lingering high inflation will continue to weigh on the currency's value. Bottom Line: The authorities have doubled down on fiscal and credit stimulus, warranting a doubling down on bearish bets on the lira. Investment Implications On the whole, the authorities will continue resorting to fiscal and monetary stimulus to sustain economic growth. According to the Impossible Trinity theory, in countries with an open capital account structure, the authorities can control either interest rates or the exchange rate, but not both simultaneously. Chart I-9Bank Stocks Have Rallied Despite ##br##Shrinking Net Interest Margins Bank Stocks Have Rallied Despite Shrinking Net Interest Margins Bank Stocks Have Rallied Despite Shrinking Net Interest Margins In Turkey, policymakers will eventually opt to control interest rates, meaning they will not have much control over the exchange rate. We suggest currency traders who are not shorting the lira do so at this time. We remain short the lira versus the U.S. dollar. A weaker lira will undermine U.S. dollar returns on Turkish stocks and domestic bonds. Dedicated EM equity investors as well as those overseeing EM fixed income and credit portfolios should continue to underweight Turkish assets within their respective EM universes. Bank stocks have rallied strongly, and have decoupled from interest rates (Chart I-9). This reflects the recent credit binge, where banks are making profits on loan originations while the government is holding responsibility for bad loans. These dynamics could persist for a while. However, both loan growth and banks' profitability will be hurt if the credit guarantee scheme is not renewed. So far, it is estimated that TRY 200 billion of an announced TRY 250 billion of this credit guarantee scheme has been utilized. Continuous credit guarantee schemes and accumulation of off-balance-sheet liabilities by the government will widen sovereign credit spreads. In many EM countries, including Turkey, bank share prices have historically correlated with sovereign spreads. Hence, rising sovereign risk will weigh on banks stocks too. Finally, as the lira begins to depreciate and inflation rises, local interest rates will have to climb. This will also weigh on bank share prices. In brief, we are reiterating our negative/underweight stance on Turkish banks. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Return on Equity (ROE) has historically driven bank share performance, with the yield curve being the key driver for earnings growth. Since the 2008-2009 Global Financial Crisis (GFC), however, the recovery in ROE has been anemic, largely due to a sharp reduction in leverage. Now that the Trump administration has moved towards unwinding parts of Dodd-Frank, this could be the start of a deregulation trend for U.S. banks. Return on Assets (ROA), meanwhile, has recovered to close to pre-crisis levels. Profit margin has been the main driver behind the ROA recovery, as asset utilization has been in a downtrend since the 1980s. Profit margins in the U.S. have been making new highs, while they are rolling over in Japan, and improving from low levels in the euro area. Global economic growth together with policy normalization will support banks' profit-making ability and share outperformance in the next nine-to-twelve months. Maintain an overweight stance in global Financials, with particular favor toward European banks. Feature We recently upgraded Financials to overweight from neutral in our global equity portfolio on attractive valuations and improving profit prospects (see GAA Quarterly Portfolio Outlook, July 3, 2017). As the largest sector in the MSCI ACWI, Financials account for 19.5% of the MSCI global equity universe. It is, therefore, a key sector investors need to have a view on. Banks account for 56% of the global Financial sector market cap, and bank share performance has lagged the broader market by 10% since March 2009, when global equities hit their post-GFC bottom. In this report, we delve into the main drivers that have historically supported bank profits and share-price outperformance, with a view to confirming whether now is a good time to overweight. Return On Equity (ROE) Return on equity, the ratio of a bank's earnings to its book value, measures how much profit each dollar of common shareholders' equity generates. Based on Dupont analysis, ROE is linked to a bank's return on assets (ROA) together with leverage, while ROA is linked to profit margins and asset utilization.1 As such, ROE has been a very important target for banks - despite the fact that it does not take into consideration the riskiness of capital, and has therefore received various forms of criticism.2,3 History has shown that ROE has been correlated with bank share performance, especially on a relative-to-the-broad-market basis (Chart 1 and Chart 2). Chart 1Global Bank Share Performance Vs. ROE Global Bank Share Performance VS. ROE Global Bank Share Performance VS. ROE Chart 2Regional Bank Performance Vs. ROE Regional Bank Performance VS. ROE Regional Bank Performance VS. ROE Chart 1 also shows that global bank ROE has averaged about 11.3% since the fourth quarter of 1980, about 10 basis point higher than that of the overall market. In the two decades before the GFC, bank ROE was mostly higher than that of the broad market. Since the GFC, however, bank ROE has been in a very different regime after an initial sharp rebound. Over the past few years, global bank ROE has been in a range of 8-10%, way lower than the historical average. On a relative basis, bank ROE has rebounded faster than bank stock prices. On a regional basis, Chart 2 shows some very interesting divergences: Unlike banks in the U.S. and euro area, banks in Canada, Australia and emerging markets have consistently outperformed their respective broad markets since the GFC, supported by rising ROE spreads. Even in absolute terms, ROE in these countries/regions are at much higher levels, with a long-term average of 15% in Canada, 14% in Australia and 13.5% in emerging markets. This could be due to 1) a less competitive environment in these countries where a handful of large banks hold the majority of domestic banking assets; 2) less risky mortgage lending practices and a lower share of shadow banking;4 and 3) the dominance of banks in the local equity indices. In Japan, banks have consistently underperformed the broader market, despite relative improvement in ROE. This could be due to the low ROE nature of Japanese banks, with an average of only 5%. So, going forward, how will ROE evolve, and how differently will banks perform in various countries/regions? To determine this, we disaggregate ROE. Return On Assets (ROA) And Leverage ROE is the product of ROA and leverage,1 which is defined as total assets divided by common shareholders' equity. ROA and ROE have historically been closely correlated, though they have diverged in the past few years. (Chart 3, panel 1). ROA has recovered to above its historical average, while ROE has been gradually declining after its initial sharp post-GFC rebound - and is still currently below its historical average (top panel). The culprit behind the anemic ROE recovery is the leverage ratio (panel 2), which has gone through three distinctive phases: It declined from very high levels (over 25 times) in the early 1980s to a two decade-low of 18.5 times during the 2001 recession, which was largely the result of the Basel Accord for minimum capital requirements published in 1988 by the Basel Committee on Banking Supervision, and fully implemented in 1992. It then started to rise, and hit a high of 20.7 times just ahead of the GFC; since that time, however, it has plummeted to 14.3 times, a historical low since the 1980s, as Basel III came into effect in 2010. In the U.S., the current level of 9.7 times leverage ratio is the lowest in history, and also the lowest compared to other countries. Recently, the U.S. Federal Reserve Board announced the results of the Comprehensive Capital Analysis and Review (CCAR) of the nation's largest banks, with a 100% pass rate. This is of particular note as it is the largest test (34 financial institutions versus 14 in 2013) and the first perfect score in the CCAR's history, implying that the balance sheets of U.S. banks have been fully repaired. The top panel of Chart 4 shows that U.S. bank leverage has been in a downtrend since the 1980s. Any increase in the leverage ratio would translate into a higher ROE. Now that the Trump administration has moved towards unwinding parts of Dodd-Frank, this could be the start of a deregulation trend for U.S. banks after over 30 years of tough regulation. Chart 3Global Bank ROA, ROE And Leverage Global Bank ROA, ROE And Leverage Global Bank ROA, ROE And Leverage Chart 4Regional Dynamics Of Bank ROA And Leverage Regional Dynamics Of Bank ROA And Leverage Regional Dynamics Of Bank ROA And Leverage The euro area bank leverage ratio has oscillated lower over time, currently at 18.2 times, also the lowest in its own history but still in line with that of Japan, Canada and Australia - and a lot higher than the U.S. and emerging markets. With a low and rising ROA - currently at 0.2% - EMU banks' ROA should have further room to improve (Chart 4, panel 2) as the euro area economy continues to recover. On July 4, 2017, the European Commission approved Italy's plan to support a precautionary recapitalization of Italian bank Monte dei Paschi di Siena under EU rules, on the basis of an effective restructuring plan. This will help ensure the bank's long-term viability, while limiting competition distortions. We view this as a very positive development in the European banking sector. Profit Margin And Asset Utilization The recovery in ROA has been impressive, but how sustainable is it going forward? Let's look at the two components that jointly determine ROA: profit margin (defined as net profit divided by revenue) and asset utilization,1 which is defined as total revenue divided by total assets. The correlation between ROA and profit margin has been very close, even though profit margin made new highs after the GFC, while ROA is still lower than its pre-GFC peak. (Chart 5, panel 1). The cause lies in the asset utilization ratio, a ratio that measures how much assets are needed to generate $1 of revenue. As Chart 5 panel 2 shows, asset efficiency has been on a consistent downtrend since the 1980s. Should we be concerned about elevated profit margin levels among global banks? Where are they coming from? Chart 6 shows the regional dynamics of profit margin and asset utilization. Chart 5Net Profit Margin Vs. Asset Utilization Net Profit Margin VS. Asset Utilization Net Profit Margin VS. Asset Utilization Chart 6Regional Profit Margin Vs. Asset Utilization Regional Profit Margin VS. Asset Utilization Regional Profit Margin VS. Asset Utilization Profit margins have been strong across the board, with the U.S. and Canada making historical new highs and Japanese, Australian and emerging market banks' profit margins near their historical peaks. Only EMU banks' profit margins are slightly above their historical average. In absolute terms, EMU banks also have the lowest profit margins, currently standing at around 6%, versus banks in other regions which have profit margins in the mid-to-high teens. Canadian, Australian and EM banks have high profit margins, supporting their consistent outperformance relative to their respective broader markets. U.S. banks also have comparable profit margins, yet they have underperformed their broader market due to lower ROE (see Chart 2 panel 1 on page 2). How can ROE be lower while profit margins are at similar levels? Because ROE is a function of profit margins, asset utilization and leverage. The U.S. leverage ratio is much lower than those in Canada, Australia and emerging markets (Chart 4 on page 5). Japan is another interesting case where high profit margins have not led to superior share performance - because assets are least efficient in terms of generating revenue. Net Interest Margin, Yield Curve and Earnings Growth Banks obtain fees (such as commitment fees or trust fees) from a vast number of different types of transactions. Interest revenue is generated principally from loans but also from repos, investment securities (bonds), and other products. On the funding side, banks pay interest expenses on bank deposits, Federal Funds, other borrowed funds, and debt. As such, net interest margin (NIM), defined as net interest income divided by interest-bearing assets - is an important driver of a bank's net profit. Chart 7 shows the close relationship between EPS growth and net interest margins. Even though data on NIM globally from the World Bank come annually and with a long time lag, the U.S. data proves the point. Because NIM is a function of the yield curve, it makes sense that the yield curve should be a driving force for earnings growth. In fact, the intuitive relationship between EPS growth and the yield curve is empirically robust across the globe, as shown in Chart 8. BCA's profit models for the global Financial Sector incorporates yield curve, 10-year yield changes and credit impulse (defined as the change in loan growth), as well as earnings revisions. They have a reasonably good correlation with actual earnings growth, both trailing and forward, as shown in Chart 9. Chart 7Bank EPS Growth Vs. Net Interest Margin Bank EPS Growth VS. Net Interest Margin Bank EPS Growth VS. Net Interest Margin Chart 8Bank EPS Growth Vs. Yield Curve Bank EPS Growth VS Yield Curve Bank EPS Growth VS Yield Curve Chart 9Global Financial Earnings Growth Global Financial Earnings Growth Global Financial Earnings Growth The current readings from our profit growth models are in line with our assessment based on BCA's house view of better economic growth leading to better loan growth, higher interest rates and steeper yield curves. Investment Implications We upgraded global financials in our most recent Quarterly Portfolio Strategy published July 3, 2017 - based on our house view calling for better global growth, higher interest rates and steeper yield curves over the next nine to twelve months, together with attractive valuations and a favorable technical backdrop. This was financed by a reduction in our allocation to the Technology sector, the second-largest in the global universe (Chart 10). Chart 10Remain Overweight Global Financials Remain Overweight Global Financials Remain Overweight Global Financials Chart 11Favor Euro Area Banks Favor Euro Area Banks Favor Euro Area Banks Within the Financial sector, we suggest clients favor banks in the euro area, in agreement with the view of BCA's Global Alpha Sector Strategy dated May 5, 2017. European banks have lost 74% from their peak relative to the MSCI ACWI Index on a U.S. dollar basis (Chart 11, panel 1). Their recent outperformance should be just the start of a more sustainable uptrend because valuations are very attractive, with a 61% discount to the MSCI ACWI based on price to book (Chart 11 panel 4), and economic growth is gaining traction, with better employment prospects (Chart 11, panel 2) and in turn higher demand for loans. An improving loan-performance ratio (Chart 11, panel 3) combined with the prospect for higher interest rates bodes well for bank profits in the region, while profit margins have room to the upside (Chart 6 on page 6). Xiaoli Tang, Associate Vice President xiaolit@bcaresearch.com 1 ROE = Net Income (NI) /Common Shareholders' Equity (E) = NI/ Total Assets (TA) * TA/E = Return on Assets (ROA)* leverage; ROA = NI/Sales * Sales/TA = Net Profit Margin * Asset Utilization 2 "Beyond ROE - How to measure bank performance,"European Central Bank, September 2010. 3 "Why Banks Come Back To Return On Equity,"Financial Times, November 15, 2015. 4 Neville Arjani and Graydon Paulin, “Lessons from the Financial Crisis: Bank Performance and Regulatory Reform,” Discussion Paper, Bank Of Canada, 2013.

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

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

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

Highlights Duration: Investor optimism about U.S. growth and inflation will return in the coming months. Remain at below-benchmark duration and enter a short position in the July fed funds futures contract. Close short positions in the January contract for a small gain. Credit Spreads: Spreads are at risk of widening as Fed rate hike expectations ramp up in the second half of the year, though we would be inclined to view a Fed-driven back-up in spreads as a buying opportunity. Bank Bonds: Banks continue to shore up their balance sheets and are likely to see rising profits in the coming months. Bank bonds also offer a spread advantage compared to other similarly risky sectors. Feature Chart 1Synchronized Global Selloff Synchronized Global Selloff Synchronized Global Selloff The bond selloff is now two weeks old. What began as a reaction to perceived hawkish policy shifts from central banks outside of the U.S. - the European Central Bank in particular - is now morphing into a selloff built on optimism about U.S. growth. Needless to say, we think the recent bearish price action has further to run. Global participation makes it more likely that the weakness in U.S. Treasuries will persist because it prevents the dollar from strengthening as yields move higher (Chart 1). In recent years, most U.S. bond selloffs have been met with an appreciating exchange rate. The stronger dollar then caused investors to lower their U.S. growth expectations, and capped the upside in yields. We view the dollar's current stability as a bearish signal for U.S. bonds. But it has not just been non-U.S. factors driving the uptrend in yields. Last week's positive ISM and employment figures are ushering in renewed optimism about U.S. growth. We also think that U.S. growth is poised to bounce back in the second half of the year, and the Fed is inclined to agree. The Fed's median projection calls for one more 25 basis point rate hike before the end of the year, and we also expect the committee to announce the run-off of the balance sheet in September. With the market still only priced for 15 bps of hikes between now and year-end, there remains scope for further upside surprises. Of course, this forecast for balance sheet run-off in September and another rate hike in December hinges on a second-half snapback in growth, continued strength in labor markets and a rebound in core inflation. Growth Is On The Way Although GDP growth averaged just 1.75% during past two quarters, all signs suggest that the next two quarters will be much stronger. As was mentioned above, both the manufacturing and non-manufacturing ISM surveys delivered strong readings in June. The manufacturing ISM came in at 57.8 and the non-manufacturing survey came in at 57.4, both signal stronger GDP growth in the coming months (Chart 2). The crucial new orders-to-inventories figure calculated from the manufacturing survey is also displaying remarkable strength (Chart 2, bottom panel). We can also infer the current trend in growth from the employment and productivity data. In fact, aggregate hours worked - a combination of total employment and average weekly hours - plus labor productivity growth is more or less equivalent to GDP (Chart 3). After last week's payrolls report, aggregate hours worked are now growing at 1.99% year-over-year. If we combine that growth rate with quarterly productivity growth of 0.7%, the average since 2012, we get a tracking estimate of just below 2.7% for GDP growth. The Atlanta Fed's GDPNow model also currently expects that second quarter growth will be 2.7%. Chart 2PMIs Point To Stronger Growth... PMIs Point To Stronger Growth... PMIs Point To Stronger Growth... Chart 3...As Does The Labor Market ...As Does The Labor Market ...As Does The Labor Market Labor Markets: Watching The Participation Rate Last week's jobs report showed that the economy added 222k jobs in June, and that the prior two months were also revised higher. This pushed the 3-month moving average up to +180k jobs per month, right in line with the +187k jobs per month averaged in 2016. However, despite robust payroll gains, the unemployment rate actually ticked higher in June. This is because many previously sidelined workers re-entered the labor force, pushing the labor force participation rate up to 62.8%. Going forward, for the Fed to have confidence that wage growth and inflation will continue to rise, the unemployment rate will have to remain under downward pressure (Chart 4). As long as the labor force participation rate remains flat (or declines) this should be relatively easy to achieve. We calculate that the economy needs to add just above 117k jobs per month for the unemployment rate to continue falling. However, if we assume a higher labor force participation rate of 63.2%, we would need to add 195k jobs per month, a much higher hurdle.1 We detailed the main drivers of the labor force participation rate in a recent report,2 and while we do not see much potential for a significant increase in the participation rate, its trend is critical for the monetary policy outlook and should be monitored closely going forward. Inflation: Is The Fed Too Sanguine? The most important question for policymakers is whether inflation will rebound in the second half of the year. While the Fed will probably start winding down its balance sheet in September no matter what, another rate hike in December is likely contingent on core inflation showing some signs of strength in the next few months. We have previously written3 that if the Fed were to proceed with a December rate hike in the face of low and falling inflation, the market would start to price in a "policy mistake" scenario. The yield curve would flatten, credit spreads would widen, TIPS breakevens would narrow and long-dated Treasury yields could even decline. However, we do expect that core inflation will trend higher in the coming months, mostly driven by strength in the core services (excluding shelter and medical care) component. That component is historically the most sensitive to tight labor markets and rising wage growth (Chart 5). Chart 4Falling Unemployment Rate = ##br##Rising Inflation Falling Unemployment Rate = Rising Inflation Falling Unemployment Rate = Rising Inflation Chart 5A Boost From Import##br## Prices Is Coming A Boost From Import Prices Is Coming A Boost From Import Prices Is Coming Although it is unlikely to be a long-run driver of inflation, the core goods component also has some upside in the coming months in response to recent dollar weakness and rising non-oil import prices (Chart 5, bottom 2 panels). Investment Strategy Chart 6Too Few Hikes In The Price Too Few Hikes In The Price Too Few Hikes In The Price We think U.S. growth and inflation are poised to snap back during the second half of the year, probably by enough for the Fed to deliver another hike before year-end. We therefore continue to recommend that investors maintain below-benchmark portfolio duration. We have also been advising clients to hold short positions in the January 2018 fed funds futures contract since March 21.4 That contract is now priced for the fed funds rate to increase 15 bps between now and the end of the year. Given that even an optimistic economic scenario would likely only result in a 25 bps increase in the funds rate, there is not much potential for further gains in this trade. We close this position, booking a small profit of +1 bp. Looking further out, we now see an attractive opportunity to short the July 2018 fed funds futures contract. That contract is currently priced for 32 bps of rate hikes between now and next June (Chart 6), and would therefore turn a profit in the event of two or more rate hikes during that timeframe. Bottom Line: Investor optimism about U.S. growth and inflation will return in the coming months. Remain at below-benchmark duration and enter a short position in the July fed funds futures contract. Close short positions in the January contract for a small gain. Credit Spreads: When Good News Is Bad News Chart 7High Risk Of A Near-Term Selloff High Risk Of A Near-Term Selloff High Risk Of A Near-Term Selloff Renewed optimism on U.S. growth and inflation could ironically pose a problem for credit spreads, at least in the very short term. As we have often discussed in the context of our Fed Policy Loop,5 hawkish shifts in Fed policy tend to result in wider credit spreads and tighter financial conditions more broadly. Fortunately, these periods are usually short lived. Once financial conditions tighten, the Fed backs away from its hawkish stance, allowing financial conditions to ease once again. An extreme example of this dynamic is the 2014/15 selloff in credit markets. Of course, the plunge in oil prices and related stress in the energy sector was the chief catalyst, but what is often overlooked is that Fed rate hike expectations were also quite elevated during that period (Chart 7). It is the combination of stress in the energy sector and unsupportive Fed policy that resulted in the prolonged rise in spreads. A more benign example is the price action from this past March. Junk spreads widened from 344 bps on March 2 to 406 bps on March 22, as rate hike expectations ramped up heading into the March FOMC meeting. Ultimately, this period of spread widening represented a buying opportunity in credit markets. It is a March 2017 style selloff that we see as quite likely in the coming months as growth recovers by just enough to give the Fed cover for another rate increase. Bottom Line: Credit spreads are at risk of widening as Fed rate hike expectations ramp up in the second half of the year. But with inflation and inflation expectations still well below target, the Fed will ultimately be forced to remain supportive. We would therefore view any period of Fed-driven weakness in credit markets as a buying opportunity. Bank Bonds: Still A Strong Buy The Federal Reserve released the results of its annual bank stress tests last month and for once it did not object to the capital plans of any of the 34 participating bank holding companies, a recognition of the fact that banks have dramatically boosted their capital ratios since the first round of stress tests in 2009 (Chart 8). For the most part bank profit growth has also outpaced debt growth during this period, with the exception of last year when profit growth turned negative and debt growth surged (Chart 8, panel 2). A large portion of last year's increase in debt growth was likely a response to the new Total Loss Absorbing Capital (TLAC) regulations which require banks to issue a specified minimum amount of securities that can be easily written off in case of bankruptcy. This includes capital and long-term unsecured debt. Regardless, bank debt growth has already fallen back close to zero and we see upside for bank profits in the next 6-12 months. Meanwhile, non-financial corporate profits have had a much more difficult time outpacing debt growth in recent years (Chart 8, bottom panel). Bank Profits On The Rise A number of forward looking loan growth indicators suggest that credit and capital formation are on an upward trajectory (Chart 9). Our U.S. Equity Strategy service's proprietary Capex Indicator,6 consumer and business confidence, manufacturing new orders and our own C&I loan growth model all point to accelerating loan growth in the coming months. Net interest margins also have scope to widen. A recent blog post from the Federal Reserve Bank of New York7 showed that net interest margins are sensitive to both the level of interest rates and the slope of the yield curve (Chart 10). Lower rates and a flatter curve have both compressed margins in recent years. In addition, net interest margins tend to narrow when banks take less risk on the asset side of their balance sheets, we proxy this by showing banks' risk-weighted assets as a percent of total assets (Chart 10, bottom panel). Chart 8Bank Health Still Improving Bank Health Still Improving Bank Health Still Improving Chart 9Loan Growth Will Accelerate Loan Growth Will Accelerate Loan Growth Will Accelerate Chart 10A Higher, Steeper Curve Will Help NIMs A Higher, Steeper Curve Will Help NIMs A Higher, Steeper Curve Will Help NIMs Going forward, higher rates and a steeper yield curve8 will apply widening pressure to net interest margins. Similarly, risk-weighted assets have already risen considerably as a fraction of total assets and will increase further as the Fed starts to drain reserves from the banking system. Bank Bonds Are Still Cheap The truly remarkable thing is that even though banks have been raising capital while the non-financial sector has been taking on leverage, bank spreads still look attractive compared to most non-financial sectors after adjusting for credit rating and duration (Chart 11). This is true for both senior and subordinated bank debt. As can be seen in Chart 11, senior bank debt has a low duration-times-spread (DTS) compared to the overall index. This means that it acts as a "low-beta" sector, underperforming the investment grade benchmark during rallies and outperforming during selloffs. Conversely, subordinate bank bonds are a high-DTS sector. They tend to outperform during rallies and underperform during selloffs (Chart 12). Chart 11Corporate Sector Risk Vs. Reward* Summer Snapback Summer Snapback LegendCorporate Sector Abbreviations Summer Snapback Summer Snapback Chart 12Add "Beta" With Subordinate Bank Debt Add "Beta" With Subordinate Bank Debt Add "Beta" With Subordinate Bank Debt While we strongly recommend grabbing the extra spread available in both senior and subordinate bank debt relative to other similarly risky alternatives, subordinate bank bonds look particularly attractive in the current environment. This is because they both add some pro-cyclical risk ("beta") to a corporate bond portfolio and offer a spread advantage compared to other similarly risky bonds. Bottom Line: Banks continue to shore up their balance sheets and are also likely to see rising profits in the coming months. Meanwhile, bank bonds still offer a spread advantage compared to other similarly risky sectors. Remain overweight both senior and subordinate bank debt. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 These calculations assume population growth of 0.08% per month, or 1% per year. 2 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Equity Strategy Weekly Report, "Unfazed", dated June 12, 2017, available at uses.bcaresearch.com 7 http://libertystreeteconomics.newyorkfed.org/2017/06/low-interest-rates-and-bank-profits.html 8 For further details on the case for a bear-steepening yield curve please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The Q2 earnings season will be above average and the BCA Earnings model predicts EPS growth to hit 18% later this year before moderating in 2018. Are the NIPA and S&P profit measures sending different signals? Business capital spending remains in an uptrend despite businesses' reluctance to spend ahead of changes in corporate tax policy. The commercial real estate sector (CRE) is beginning to show early signs of stress. Repealing Dodd-Frank faces procedural hurdles and would yield few political benefits, even for Republicans in an environment of populism. Feature Q2 Earnings Season Is Here Chart 1Strong Earnings Growth##BR##In 2017 Will Support Equities Strong Earnings Growth In 2017 Will Support Equities Strong Earnings Growth In 2017 Will Support Equities The Q2 earnings season will be above average and the BCA Earnings model predicts EPS growth to hit roughly 18% later this year on a 4-quarter moving total basis, before moderating in 2018 (Chart 1). The consensus is anticipating an 8% year-over-year increase in EPS in Q2 2017 versus Q2 2016, and 11% for 2017. Energy, technology, and financials, all are forecast to lead the way in earnings growth in Q2, but utilities and telecom will be the laggards. The favorable profit picture for Q2 and the rest of the year reflects the rebound in oil prices, which are expected to boost energy sector EPS by 671%. The positive picture also mirrors the sweet spot of rising top-line growth and still muted labor costs, which are driving a countercyclical rally in profit margins. The focus in Q2 for investors and corporate executives will be on the improving economic conditions in Europe and EM, the U.S. dollar and the sustainability of margins. Guidance from CEOs and CFOs on trends in 2H 2017 and beyond are more important than the actual Q2 results. Note that guidance can be tracked using Chart 2. Investors should guard against managements' over-optimism because earnings growth forecasts almost always move lower over time. Chart 22017 EPS Estimates Rebounding And 2018 Stable 2017 EPS Estimates Rebounding And 2018 Stable 2017 EPS Estimates Rebounding And 2018 Stable In Q2, firms with high overseas sales should benefit from the improved growth profile in Europe and Japan. Global GDP growth projections for this year and next have steadily escalated, in sharp contrast with prior years when forecasters have relentlessly lowered GDP estimates. On the other hand, the U.S. dollar should be a modest drag on earnings in Q2; the dollar is up 2% versus a year ago against a broad basket of currencies. Moreover, in the most recent Beige Book (May 31) mentions of a "strong dollar" were unchanged compared with a year ago, indicating that the stronger currency has faded as a primary concern of managements in recent months. Our view is that the dollar will appreciate by another 10%. This appreciation would trim EPS growth by roughly 2.5 percentage points, although most of this would occur in 2018 due to lagged effects. Another upleg in the dollar, on its own, should not provide a substantial headwind for the stock market. Indeed, the dollar would only climb in the context of robust U.S. economic growth and an expanding corporate top line. Investors are skeptical that margins can advance for the fourth consecutive quarter in Q2. Our view is that we are in a temporary sweet spot for margins and that should continue for the next quarter or two, but the secular "mean reversion" of margins will resume beyond that time. Bottom Line: Look for another solid performance for earnings and margins in Q2 and the rest of 2017, supporting our stocks-over-bonds stance for this year. However, investors should position their portfolios for decelerating earnings and compressed profit margins in 2018. Will The Real Profit Margin Stand Up While the markets focus on Q2 earnings, margins and corporate guidance for the next month or so, we take a broader view. For some time we have highlighted the importance of the mini-cycle in U.S. earnings growth; the corporate sector is in a catch-up phase following last year's profit recession, a trend that extends beyond the energy patch. EPS growth has surged this year on the back of slightly stronger sales and rising S&P 500 margins. The National Accounts (NIPA) data, on the other hand, paint a different picture. Earnings growth for the entire corporate sector fell sharply in the first quarter and margins continued to slide. If the NIPA data are telling the true story, then the equity market is in trouble because it suggests that the earnings outlook is much weaker than what is discounted in stock prices. There are many definitional differences that make it difficult to reconcile the NIPA and S&P data.1 Nonetheless, we can make some general observations. Chart 3 presents the four-quarter growth rate of NIPA profits2 and a proxy for aggregate S&P earnings. For the latter, we multiplied earnings-per-share by the divisor to obtain an estimate of the level of aggregate earnings in dollar terms (i.e. not on a per-share basis). The bottom panel of Chart 3 compares the level of profits, each indexed to be 100 in 2011 Q1. The charts highlight that while there have been marked differences in annual growth rates between the two measures, the levels were close to the same point in the first quarter of 2017. The dip in NIPA profit growth in Q1 was not reflected in the S&P measure. It appears that this is partly due to different profiles for profit growth in the energy and financials sectors. However, it does not appear that the difference in margins is linked to a significant divergence in aggregate profits. Most of the margin divergence is related to the denominator of the calculation (Chart 4). The NIPA denominator is corporate sector Gross Domestic Product (GDP). This is a value-added concept that is different from sales. It is not clear why, but GDP has grown much faster than sales since the end of 2014. We believe that the S&P data are painting a more accurate picture because sales are straight forward to measure, while value-added is complicated to construct. The slow growth of sales is not a bullish point for stocks. Nonetheless, it does not appear that financial engineering has distorted bottom-up company data to such an extent that the S&P data are falsely signaling strong profit growth. We expect the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning early in 2018. Nonetheless, the profit backdrop remains positive for stocks for now. The same is true in the Eurozone and Japan, where margins are also rising. It is worrying that a much of this year's advance in U.S. equity markets has been concentrated in only a few stocks, but that belies the breadth of the profit recovery (Chart 5). The proportion of S&P industry groups with rising earnings estimates is 75%, reflecting broad-based upgrades. Chart 3S&P And NIPA##BR##Profit Comparison S&P And NIPA Profit Comparison S&P And NIPA Profit Comparison Chart 4Denominator Explains##BR##S&P/NIPA Margin Divergence Denominator Explains S&P/NIPA Margin Divergence Denominator Explains S&P/NIPA Margin Divergence Chart 5Positive Earnings Revisions##BR##Are Broadly Based Positive Earnings Revisions Are Broadly Based Positive Earnings Revisions Are Broadly Based Such widespread participation is consistent with ongoing upward revisions to 12-month forward earnings estimates. Bottom Line: The solid earnings backdrop is why we remain overweight stocks versus bonds and cash. Stay extra vigilant for warning signs of a bear market in view of the poor valuations. Valuation has never been good leading indicator for bear markets, but it may provide information on the risks. Capital Spending Check Up Business capital spending remains in an uptrend. Investors are concerned that the below expectations readings on capex in recent months may be the start of a new trend for a significant part of the economy. We look at it another way. Managements are postponing investment decisions until they get more clarity on federal tax policy. In short, corporations are struggling with how much and when spend, rather than whether to invest at all. The key supports for sustained corporate spending remain despite the tepid May durable goods report. C&I loan growth has ticked back up and our model (based on non-residential fixed investment, small business optimism and the speculative-grade default rate) suggests lending is poised to move higher on a 12-month basis (Chart 6). Our research shows that sustainable capital spending cycles get underway only when businesses see evidence that consumer final demand is on the upswing. While consumer expenditures were soft (+1.1% annualized gain) in Q1, household spending in Q2 accelerated and is on track to post 3%+ growth. We expect household spending to continue to improve in the second half of 2017.3 Moreover, the recent readings on core durable goods orders and shipments show that the uptrend that began in mid-2016 persists, despite the recent monthly wiggles in the data (Chart 7). Chart 6Model Points To##BR##Further Improvement Model Points To Further Improvement Model Points To Further Improvement Chart 7Capital Spending##BR##Remains In An Uptrend Capital Spending Remains In An Uptrend Capital Spending Remains In An Uptrend CEO confidence recently soared to a 13-year high in Q1, adding to the positive backdrop for capex. The last reading on this survey was taken in the first quarter of 2017 when managements eagerly anticipated that business-friendly legislation was pending. The next survey (due in mid-July) may show a bit more restraint from CEOs given the lack of legislative progress in Washington (Chart 7, top panel). Bottom Line: The fundamentals supporting solid business spending remain in place. However, our positive capex outlook in the U.S. could be blemished if the Republicans fail to deliver on their promises to cut taxes and boost infrastructure spending. Stressing The Commercial Real Estate Market The commercial real estate sector (CRE) is beginning to show early signs of stress. The recent softening in CRE does not suggest that recession is imminent, but investors should understand whether a sustained drop in CRE prices poses a risk to the global financial system. At best, business spending on construction is coincident with the overall economy, but most often lags due to long lead times required on projects (Chart 8). Chart 8Commercial Real Estate Lags Commercial Real Estate Lags Commercial Real Estate Lags Our colleagues in the Global Investment Strategy service4 highlighted the risks to the CRE market, noting that CRE-related debt is rising, prices have surpassed pre-recessionary levels, vacancy rates outside of the industrial sector are bottoming, and rent growth is losing steam (Chart 9). Likewise, we share Boston Fed President Rosengren's5 concern that if CRE's recent tailwinds (muted inflation, low financing rates, declining unemployment rate, robust economic growth in the U.S. relative to overseas developed economies, and favorable demographics) turn to headwinds, then the impact on the market and the wider economy may have a disproportionate impact on CRE. The BCA Beige Book Real Estate Monitor corroborates a softening in recent quarters. The monitor takes the real estate (both commercial and residential) comments from each Beige Book and uses the approach outlined in our April 17 publication6 (Chart 10). Chart 9Commercial Real Estate##BR##Indicators Softening Commercial Real Estate Indicators Softening Commercial Real Estate Indicators Softening Chart 10Introducing The##BR##Beige Book CRE Monitor Introducing The Beige Book CRE Monitor Introducing The Beige Book CRE Monitor Stretched CRE valuations may exacerbate any price declines in CRE if the markets sense that the tide is turning. Falling prices may lead to a drop in the value of collateral-backing CRE loans, which in turn, could cause lenders to restrict credit in the sector and spark an additional downturn in prices. Moreover, Table 1 highlights the risk that GSE reform may cause two large holders of CRE debt to begin to curtail lending. Small banks have more absolute exposure to CRE loans than large banks, according to the table, and overall, banks' share of CRE lending (53%) is nearly four times as high as GSE's exposure. Table 1Holders Of Commercial Real Estate Loans Summer Stress Out Summer Stress Out CRE's risks are evident in the latest round of bank CCAR stress tests. The Fed modeled a 15% drop in CRE prices through Q4 2018 in its "adverse" scenario and a 35% drop in the same period in its "severely adverse" scenario. The Fed7 found that under these scenarios, common equity Tier 1 capital ratio at the participating firms would drop from 12.5% (Q4 2016) to 9.2% and 7.2% respectively by Q1 2019. Bottom Line: Commercial real estate has benefitted from a Fed-led tailwind since the end of the 2007-2009 recession. That said, some of the tailwinds are turning to headwinds and investors should be prepared for a reversal in this sector sometime in the second half of 2018 as economic and earnings growth slows, which could set the stage for a recession in 2019. That said, it is a positive sign for the economy that the commercial real estate sector is one of the few areas showing any signs of stress, implying that the conditions for a recession in the next 6 to 12 months remain low. Is Dodd-Frank Dead? The Republicans' Financial CHOICE Act, which would roll back key aspects of the landmark Dodd-Frank Wall Street reform, has hurdles to overcome before its passage through the U.S. Senate. Two of BCA's publications have examined the impact on consumers, investors and financial markets. BCA's Geopolitical Strategy8 service noted that Republicans want to overturn Dodd-Frank to increase the financial sector's profits, credit growth, economic growth and animal spirits. A repeal would also satisfy the Republicans' ideological goal to reduce state involvement, which grew due to the law. Also, the CBO estimates that the proposed rewrite would cut the budget deficit by a net $22.3 billion over 10 years, in line with the GOP's political bent. The CHOICE Act would create an "escape hatch" to allow banks to maintain a capital-to-asset ratio of over 10% to bypass Dodd-Frank regulations. Financial companies that do not meet the 10% leverage ratio could either raise funds or remain subject to Dodd-Frank oversight, including required capital ratios, stress tests, living wills and other regulations. Critically, the 10% leverage ratio for those banks that opt out of Dodd-Frank would not be calculated using risk-weightings for different assets (whereas Dodd-Frank requires both risk-weighted and non-risk-weighted capital ratios to be maintained). Therefore, banks that opt out would be able to take on greater risk while still fulfilling minimum capital requirements. The intent is to boost lending, earnings and growth. According to the Geopolitical Strategy, if the bill becomes law, U.S. banks comprising an estimated $1.5 trillion in assets would become less restricted and eligible to adopt riskier trading practices. The greatest impact will be in areas with a higher concentration of small community banks and credit unions. These banks, with under $10 billion in assets, face the most difficulty in meeting Dodd-Frank's requirements and yet tend to meet the 10% leverage ratio (Chart 11). Chart 11Banks With $1.5 Trillion Could Gain Risk Appetite Summer Stress Out Summer Stress Out Other aspects of the bill would: Repeal the FDIC's liquidation fund: The private sector would take over responsibility for managing liquidations. Eliminate the Volcker Rule: Banks would be able to trade riskier assets on their own accounts and forge closer relationships with private equity and hedge funds. Audit the Fed: The Government Accountability Office (GAO) would audit the Fed's board of governors and regional banks, including their handling of monetary policy. Reshape the Consumer Financial Protection Board: The agency would have its powers neutered and funding dependent on the Congress, rather than transfers from the Fed. Cut penalties for violating regulations. Chart 12Small Banks Benefit##BR##From Bank Deregulation Small Banks Benefit From Bank Deregulation Small Banks Benefit From Bank Deregulation Investors could capitalize on financial sector reform by favoring small U.S. bank equities over large bank stocks. The share price of small banks relative to large banks, which rallied in the aftermath of Trump's election only to subsequently fall back, has recently perked up (Chart 12). Relative earnings have been flat in the same period. If Dodd-Frank is partially watered down, then these banks should see earnings improve, and drive up their share prices. BCA's U.S. Equity Strategy is positive on global bank equities. In particular, U.S. banks have better fundamentals than their counterparts in Europe and Japan - more capital, higher net interest margins, lower or equal NPL ratios. They also stand to benefit from relatively faster rising interest rates. BCA's Fiscal Note Financial Sector Index suggests that the flow of legislative and regulatory proposals is becoming less onerous on the financial sector. Chart 13 is an aggregation of the favorability scores, which assess whether the bill would be favorable to the financial sector. It provides a snapshot of the regulatory environment for the financial sector at any point. Chart 13Financial Sector Scrutiny Softening Financial Sector Scrutiny Softening Financial Sector Scrutiny Softening Bottom Line: Repealing Dodd-Frank faces procedural hurdles and would yield few political benefits, even for Republicans in an environment of populism. However, a bill focused on lightening the regulatory load on small banks has a chance of passing if tacked on to the budget process. Large banks would remain subject to closer scrutiny and stricter international standards. The post-election rally for bank stocks is mostly over. Investors have an opportunity to favor small banks versus large ones. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 The first problem is that the S&P data are expressed on a per-share basis. Moreover, the NIPA data adjusts for inventory and depreciation allowance. S&P margins are calculated using sales in the denominator, while we generally use GDP as the denominator for calculating NIPA profits. 2 The NIPA data shown include financials and profits earned overseas, as is the case for the S&P. 3 Please see BCA's U.S. Investment Strategy Weekly Report, "Still In The Sweet Spot", June 19, 2017, available at usis.bcaresearch.com. 4 Please see BCA's Global Investment Strategy Weekly Report "The Timing Of The Next Recession," published June 16, 2017, available at gis.bcaresearch.com. 5 "Trends In Commercial Real Estate", Eric S. Rosengren, at Risk Management for Commercial Real Estate Financial Markets Conference, NYU Stern School of Business, May 9, 2017. 6 Please see BCA's U.S. Investment Strategy Weekly Report, "The Great Debate Continues", published April 17, 2017, available at usis.bcaresearch.com. 7 https://www.federalreserve.gov/publications/files/2017-ccar-assessment-framework-results-20170628.pdf 8 Please see BCA's Geopolitical Strategy Weekly Report "How Long Can The "Trump Put" Last?," published June 14, 2017, available at gps.bcaresearch.com.