Base Metals & Iron Ore

Feature Shrugging Off The Political Noise All the political noise of August (White House resignations, Charlottesville, North Korean missile launches, the looming U.S. debt ceiling) could do no more than trigger a minor market wobble: at the worst point, global equities were off only 2% from their all-time high. The reason is that global cyclical growth remains strong, earnings are accelerating, and central banks have no immediate need to turn hawkish. In such an environment, risk assets should continue to outperform over the next 12 months. The political risks will not disappear (and will no doubt produce further hair-raising moments), but they are unlikely to have a decisive impact on markets. BCA's geopolitical strategists think eventually there will be a diplomatic solution to the North Korean situation - albeit only after a significant further rise in tension forces the two sides to the negotiating table.1 It is hard to imagine the debt ceiling not being raised, since Republicans control both houses of Congress and the White House, and they would be blamed for any disruption caused by a failure to raise it. Recent personnel changes in the White House have left - for now - a more pragmatic "Goldman Sachs clique" in charge. We believe there is still a reasonable likelihood of tax cuts, not least since the Republicans are on track to lose a lot of seats in next year's mid-term elections unless they can boost the administration's popularity (Chart 1). Recent growth data has been decent. U.S. Q2 GDP growth was revised up to 3% QoQ annualized, and the regional Fed NowCasts point to 1.9-3.4% growth in Q3. If anything, growth momentum in the euro area (2.4% in Q2) and Japan (4%) is even better. Corporate earnings growth continues to accelerate too, with S&P 500 EPS growth in the second quarter coming in at 10% YoY, compared to a forecast of just 6% before the results season started. BCA's models suggest that, in all regions, earnings growth is likely to continue to accelerate for a couple more quarters (Chart 2). Chart 1Republicans Need A Popularity Boost Monthly Portfolio Update Monthly Portfolio Update Chart 2Earnings Continue To Accelerate Earnings Continue To Accelerate Earnings Continue To Accelerate The outlook for the dollar remains the key to asset allocation. The market currently assumes that the dollar will weaken further, as U.S. inflation stays low and the Fed, therefore, stays on hold. Futures markets currently price only a 38% probability of a Fed hike in December, and only 25 BP of hikes over the next 12 months. If markets are right, this scenario would be positive for emerging market equities and commodity currencies, and would mean that long-term rates would be likely to stay low, around current levels. But we think that assumption is wrong. Diffusion indexes for core inflation have begun to pick up (Chart 3). The tight labor market should start to push up wages, dollar deprecation is already coming through in the form of rising import prices, and some transitory factors (pre-election drugs price rises, for example) will fall out of the data soon. The Fed is clearly nervous that it has fallen behind the curve, especially since financial conditions have recently eased significantly (Chart 4). A moderate stabilization of inflation by December would be enough to push the Fed to hike again - and to reiterate its plan to raise rates three times next year. Chart 3Inflation To Pick Up? Inflation To Pick Up? Inflation To Pick Up? Chart 4Financial Condition: Easy In The U.S., Tight In Europe Financial Condition: Easy In The U.S., Tight In Europe Financial Condition: Easy In The U.S., Tight In Europe Meanwhile, long-term interest rates in developed economies look too low given growth prospects (Chart 5). As inflation picks up, the Fed talks more hawkishly, and the dollar begins to appreciate again, rates are likely to move up in the U.S. and in the euro zone. Our view, then, is that the Fed will tighten faster than the market expects, long-term rates will rise and the dollar will appreciate. Equities might wobble initially as they price in the tighter monetary policy but, as long as growth continues to be strong, should outperform bonds on a 12-month basis. Our scenario would be positive for euro zone and Japanese equities, but somewhat negative for EM equities. Equities: We prefer DM equities over EM. Emerging equities have been boosted over the past 12 months by the weaker dollar and Chinese reflation. With the dollar likely to appreciate (for the reasons argued above), and a slowdown in Chinese money supply growth pointing to slower growth in that economy (Chart 6), we think EM equities will struggle over coming quarters. Meanwhile, there is little sign that domestic growth momentum is improving in emerging economies (Chart 7). Within DM, our underlying preference is for euro zone and Japanese equities. Our quants model now points to an underweight for the U.S. We haven't implemented this yet because 1) of our view that the USD will strengthen, and 2) we prefer not to make too frequent changes to recommendations. We will review this in our next Quarterly. Chart 5Rates Lag Behind Global Growth Rates Lag Behind Global Growth Rates Lag Behind Global Growth Chart 6Slowing Chinese Money Growth Is A Risk For EM bca.gaa_mu_2017_09_01_c6 bca.gaa_mu_2017_09_01_c6 Chart 7EM Domestic Growth Anemic EM Domestic Growth Anemic EM Domestic Growth Anemic Text below Fixed Income: BCA's model of fair value for the 10-year U.S. Treasury yield (the model incorporates the Global Manufacturing PMI and USD bullish sentiment) points to 2.6%, almost 50 BP above the current level (Chart 8). We therefore expect G7 government bonds to produce a negative return over the next 12 months, as inflation expectations rise and monetary policy continues to "normalize". We still find some attraction in spread product, especially in the U.S. (Chart 9). While spreads are quite low compared to history, U.S. high-yield spreads remain 119 BP above historic lows, while euro area ones are only 65 BP above. Chart 8U.S. Rate Fair Value Is Around 2.6% U.S. Rate Fair Value Is Around 2.6% U.S. Rate Fair Value Is Around 2.6% Chart 9Credit Spreads Not At Record Lows Monthly Portfolio Update Monthly Portfolio Update Currencies: The euro has likely overshot. Long speculative positions are close to record levels (Chart 10) and the currency has returned to its Purchasing Power Parity level against the USD (Chart 11). An announcement of a "dovish" tapering of asset purchases by ECB President Draghi in September could persuade the market that the ECB will continue to be much more cautious about tightening than the Fed. The yen is also likely to weaken against the US dollar as global rates rise, since the BoJ will not change its yield curve control policy despite the better recent growth numbers, given how far inflation is still from its target. Chart 10There Are A Lot Of Euro Bulls There Are A Lot Of Euro Bulls There Are A Lot Of Euro Bulls Chart 11Euro Is No Longer Undervalued Euro Is No Longer Undervalued Euro Is No Longer Undervalued Commodities: Our forecast that a drawdown in crude inventories will push the WTI price back up is slowing coming about. U.S. crude inventories have fallen by 25.3 million barrels since the start of the year. The after-effects of Hurricane Harvey might affect the data for a while but, as long as global demand holds up, the crude oil price should rise further, with WTI moving over $55 a barrel by year-end. Metals prices have moved largely sideways year to date, and future movements depend mostly on the outlook for Chinese growth, which may begin to slow. In particular, the recent run-up in copper prices (which have risen by 20% since early June) seems unsustainable. The bullish sentiment was mostly due to short-term supply/demand imbalances caused by labor disruptions at some major mines. However, Chinese copper demand, especially for construction, is likely to weaken over coming months.2 Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see Geopolitical Strategy Weekly Report "Can Pyongyang Derail The Bull Market," dated 16 August 2017, available at gps.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report "Copper's Getting Out Ahead Of Fundamentals, Correction Likely," dated 24 August 2017, available at ces.bcaresearch.com Recommended Asset Allocation

Highlights Copper's impressive rally leaves prices out in front of fundamentals. We are expecting a correction going forward, given our view that reduced mine output results from transitory disruptions, and China's growth appears to be stalling: industrial output, investment, retail sales, and trade all grew less than expected last month. Energy: Overweight. Crude oil prices remain fairly well supported this week on signs U.S. production growth may not be as strong as expected, and continued production discipline by OPEC 2.0 keeps global inventories from building too rapidly. We remain long Brent and WTI $50/bbl vs. $55/bbl call spreads in Dec/17, which are up 99.1% and 18.9%, respectively. Base Metals: Neutral. Copper prices appear to be getting out ahead of fundamentals, particularly as regards Chinese demand, which could stall on the back of slower economic growth. Precious Metals: Neutral. In line with our House view, we expect the Fed to remain dovish on the inflation front, which, over time, will mean the central bank finds itself behind the curve on inflation. This means real rates remain relatively low for the foreseeable future, which will be supportive of gold. Ags/Softs: Underweight. We remain bearish, although we are not aggressively shorting any of the ags. Feature Chart of the WeekCopper 2017H1: Exceptional Performance Copper 2017H1: Exceptional Performance Copper 2017H1: Exceptional Performance Copper futures traded on COMEX rallied by almost 10% from the beginning of May, when spot was trading just under $2.50/lb, until late July, then shot up by an additional 9% on news of a potential ban on scrap imports by China; 4% of that increase was recorded on July 25 alone (Chart of the Week). Spot copper settled at $2.9865/lb Tuesday. Part of this rally can be put down to a renewed focus on China's environmental policies, which we expect to continue following the 19th National Congress of China's Communist Party later this year, and the better-than-expected performance of the Chinese economy in 2017H1. This occurred as supply side disruptions at some of the world's largest copper mines caused markets to discount possible near-term shortages, along with rumors of an import ban on so-called Category 7 scrap metals. These stories supercharged the copper market. Supply/Demand Imbalances Are Transitory While labor-related disruptions at major copper mines led to a production cutback in 2017H1, supply has, for the most part, recovered. Furthermore, these are one-off events that we do not foresee persisting or having a lasting impact on markets.1 Production of copper ores and concentrates fell a negligible 0.1% year-on-year (yoy) in H1, following a 6.7% yoy increase in global output in 2016. Year-to-date (ytd) production growth lies significantly below the 5.63% average for the same period 2013-2016 (Chart 2). Similarly, in a marked slowdown from the four-year average growth of ~ 4% yoy in refined copper production, output remained largely unchanged in the first 4 months of 2017 compared to last year. However, there is evidence of relief in May and June, which registered a 6.08% yoy increase in output. The slowdown in production is mainly driven by supply-side shocks at some of the world's largest mines in Chile, Peru, and Indonesia. Contract Renegotiations and Weather Disruptions in Chile: The respective 1% and 6.6% yoy fall in global ores and concentrates output in February and March can be attributed to a corresponding year-on-year 17% and 23% declines in production from Chile - the world's leading copper producer. At BHP Billiton's Escondida mine, the world's largest, 2,500 workers staged a 43-day strike over contract renegotiations, which ended without resolution in late March. Although the end of the strike has brought relief to copper output, talks will resume in 18 months, raising the possibility of another strike - and an accompanying production cut - in a year's time. However, President Marcelo Castillo has somewhat calmed these worries, expressing his intent to revise the mine's operating model so that it will be minimally impacted by such disputes in the future. The decline in Chilean output was compounded by heavy snow and rain in May, which forced the Caserones mine to halt production for three weeks. This was reflected in a ~ 1.7% yoy decline in national output in May. Caserones has since resumed production and is now reported to have reached 90% of capacity. Nationwide Strikes in Peru Not Expected to Show up in July Data: Labor reforms proposed at the end of July led to a three-day walk-out by unionized workers across Peru. The strike impacted operations at major deposits including Antamina, Cerro Verde, Cuajone among others. However, according to the National Society of Mining, Petroleum and Energy, absenteeism was insignificant and the impact on copper output was limited. This followed a five-day strike at Cerro Verde - Peru's second largest mine - in March due to dissatisfaction with labor conditions. Peru ramped up output by almost 25% in 2015, surpassing China as the second largest producer of copper, and accounted for 11.4% of global output in 2016. Dispute Over Export Rights and Worker Dissatisfaction at Grasberg: In an effort to promote its domestic smelting industry, Indonesian authorities imposed a temporary ban on exports of copper concentrates in January. However, in April, Freeport McMoRan was granted an eight-month license to resume exports from its Grasberg mine - the second largest in the world. Furthermore, CEO Richard Adkerson expressed confidence that Freeport will succeed in securing an agreement by October, allowing it to implement a major multi-billion-dollar underground mine development plan. Labor unrest remains a problem for the company, nonetheless. Angered by redundancies and enforced furloughs, a strike by 5,000 workers was extended for a fourth month, until the end of August. Output data until May shows production remained largely unchanged compared to last year and follows a 3.82% yoy increase in Q1. Indonesian output accounted for 3% of global copper production in 2016. This will have to be resolved for the company's development plans to proceed unchallenged. Despite these supply-side shocks and ensuing Q2 inventory draw, copper remains well stocked at the major warehouses (Chart 3). Furthermore, COMEX inventories are at their highest level since 2004. As long as the global market remains well stocked, we expect it will be capable of withstanding volatility induced by labor markets and government policy with minimal impacts on prices. Chart 2Supply Disruptions Subsiding,##BR##Copper Market Back In Balance Supply Disruptions Subsiding, Copper Market Back in Balance Supply Disruptions Subsiding, Copper Market Back in Balance Chart 3Copper Inventories##BR##Can Withstand Volatility Copper Inventories Can Withstand Volatility Copper Inventories Can Withstand Volatility Scrap Imports Kick In Amidst Elevated Prices Chart 4China Copper Demand Weakening China Copper Demand Weakening China Copper Demand Weakening A dip in Chinese demand was also partly to blame for the minimal impact of the production cutbacks on inventories. Chinese consumption single-handedly makes up ~ 50% of global copper demand. The 1.46% yoy decline in global refined copper consumption during 2017H1 is, in large part, due to a 4.57% yoy drop in Chinese consumption (Chart 4). In fact, consumption during February and April fell 10% and 11%, respectively. Weak demand is also evident in China's import of copper ores and concentrates data. Although imports grew by 2.72% yoy in 2017H1, this is a marked slowdown from the 33.66% growth rate witnessed during the same period last year, and the average H1 growth of 22.6% since 2012. Similarly, China's imports of refined copper, copper alloy, and products fell 18.32% yoy in 2017H1 before increasing by 8.33% yoy last month. However, it appears that scrap copper may have helped fill the void - China's imports of copper scraps and wastes increased by 18.56% in the first half of this year compared to the same period last year. This marks a turning point in the trend, as copper scrap imports have been on the decline since 2013, and is likely a direct result of speculation over the impact of China's environmental policies on base metals. China's Scrap Import Ban: Overplayed Last week, China confirmed intentions to ban some forms of scrap copper imports beginning as early as the end of the year. This is part of measures taken to support sustainable growth and environmental protection. While rumors swirled in late July suggesting "Category 7" (i.e. old) scrap copper would be included in the import ban, the list of banned waste imports released last week by the Ministry of Environmental protection did not include copper. However, copper scrap from automobiles, ships and electronic devices were included in a "limited import" category, with no further details of the import constraints to be imposed on these products. Scrap impacts the copper market in two main ways: It provides smelter-refineries an alternative input, in addition to ores and concentrates, thus enhancing total refined copper supply. The International Copper Study Group (ICSG) estimates global production of refined copper increased by 2% in January due to increased production from scrap, which rose by 13% yoy. It acts as a substitute for refined copper, providing first-stage manufacturers a lower-cost alternative input. This means that when prices are up, as they have been since late 2016, the impact on refined copper production is somewhat muted because scrap usage kicks in (Chart 5). Furthermore, because of this response, the effect of supply-side shocks on refined copper output are - to some extent - restrained. Chart 5Scrap Imports Kick In When Prices Are Up Scrap Imports Kick In When Prices Are Up Scrap Imports Kick In When Prices Are Up This explains why the market has been in somewhat of a frenzy since late July after hearing that the Chinese authorities will likely implement an import ban on some types of scrap copper, which caused copper prices to jump to levels last seen in 2015Q2. Copper futures traded on COMEX have rallied by 10% from the beginning of May to late July, then shot up an additional 9% on rumors of an import ban; 4% of that increase was recorded on July 25 alone. Markets are clearly buying into the news, and are optimistic the ban will hike demand for other forms of copper. However, we believe this optimism is unfounded, and that the impact on copper markets is overplayed. Although the ICSG estimates that ~ 30% of annual copper usage comes from 'secondary' or recycled sources, a much smaller ratio originates from 'old' scrap copper. This type of scrap is derived from end-of-life electronics, households, cars, and industrial products. While data on old-scrap copper supply is not readily available, researchers at Antaike estimated that out of the 3.35mm MT of scrap copper imports in 2016, old-scrap copper imports made up ~ 0.3mm MT of copper-equivalent. This accounts for a very small fraction of China's 17.05mm MT of imports of copper ores and concentrates and 4.94mm MT imports of refined copper last year. Thus, even if a ban on all old-scrap copper were to materialize, we do not believe it will create a supply deficit, or even threaten one. In addition, there has been speculation that a ban would reroute old scrap metal to other countries for dismantling and processing before being imported by China, diminishing its impact on the copper market. Given that the market's reaction to news of the ban has been favorable, we expect to see a correction as the market responds to information that the ban is less bullish than expected. Chinese Demand Will Ease As Tailwinds Die Down In 2017H1, China surprised with better-than-expected economic performance, which supported copper prices. China's infrastructure and equipment industries are especially important to the copper market, consuming, respectively, 43% and 19% of the red metal domestically. However, as our colleagues on BCA Research's China desk foresaw, recent data gives some early-warning signs of a slowdown in growth.2 Industrial output, investment and retail sales figures came in below expectations amid a cooling property market. Furthermore, restrictions on riskier types of lending will continue slowing credit growth going forward. The property market - residential and commercial construction - accounts for ~ one-third of copper consumption. After reaching three-year highs late last year, the official manufacturing PMI and the Keqiang index - both used as key measures of the state of China's economy - show evidence that the economy is stabilizing (Chart 6). In fact, the Keqiang index has come down significantly from its peak earlier this year. In particular, signs of cooling in China's property sector are playing into the possibility of weaker industrial metals generally. Steel-making commodities and base metals have been in high demand ever since China relaxed housing policies, reviving the property market. However, in an effort to cool this market, Chinese authorities announced measures to raise down payments and control speculative buying in 20 cities last September. These measures are beginning to show up in property-market construction and sales data (Chart 7). Chart 6Early Warning Signs Of China Slowdown Early Warning Signs of China Slowdown Early Warning Signs of China Slowdown Chart 7China Property Sector: Cooling China Property Sector: Cooling China Property Sector: Cooling New floor space started contracted by almost 5% yoy in July, potentially signaling early warning signs of what could come ahead. It marks a reversal of a 10.55% expansion in 2017H1. New floor space completed declined in July, registering a 13.54% fall yoy. This follows 5% growth in 2017H1 - a marked slowdown from the 20.05% pace of growth in 2016H1. Furthermore, floor space under construction has been steadily easing, growing just 3.17% yoy in July. In terms of floor space sold, July's yoy growth of 2% follows a 21.37% yoy growth rate in June, and marks a pronounced slowdown from the 15.82% average yoy growth rate in 2017H1. Chart 8China's Economic Structure##BR##Deviates From Trend China's Economic Structure Deviates From Trend China's Economic Structure Deviates From Trend While near term growth does not appear to be threatened, earlier this month the IMF warned against China's "reliance on stimulus to meet targets," and a "credit expansion path that may be dangerous," which could cause a medium-term adjustment. When this eventually weighs down on industrial activity - as we expect - it will reverberate throughout the economy, discouraging investment projects, and eventually taking its toll on commodities generally, base metals in particular. Even so, in a small change of pace, China's share of secondary sector (i.e. manufacturing) as a percent of GDP crept up in July (Chart 8). This is a deviation from the trend in the evolving structure of China's economy, where the tertiary sector (services) has been making up an increasing share of GDP. While it is still too early to determine whether this is the beginning of a change in trend, or a one-off case, this development is positive for metals short term, since manufacturing activity is industrial-metal intensive. Bottom Line: We expect a correction in copper prices near term, as markets adjust to revelations that the market impact of China's environmental policies is less than expected. Our longer-term outlook is neutral: The synchronized economic upturn in global demand will partially offset waning economic activity in China, as tailwinds from accelerating export growth and easing monetary conditions die down. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 We discuss some of these developments during 2017Q1 in BCA Research's Commodity & Energy Strategy Weekly Report "Copper's Price Supports Are Fading," published by March 23, 2017. It is available at ces.bacresearch.com. 2 Please see BCA Research's China Investment Strategy Weekly Report titled "China Outlook: A Mid-Year Revisit", dated July 13, 2017, It is available at cis.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Copper's Getting Out Ahead Of Fundamentals, Correction Likely Copper's Getting Out Ahead Of Fundamentals, Correction Likely Commodity Prices and Plays Reference Table Copper's Getting Out Ahead Of Fundamentals, Correction Likely Copper's Getting Out Ahead Of Fundamentals, Correction Likely Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights Expanding trade volumes - led by EM growth - will continue to support commodity demand, particularly for base metals. In the first four months of this year, EM import growth averaged 8.4% year-on-year (yoy), led by an expansion of almost 13% in EM Asia. This compares with yoy growth averaging just 0.3% in the DM imports over the January - April period. EM exports grew 5.1% yoy in this interval vs. 2.7% for DM outbound trade. Overall, EM growth led world trade volumes 4% higher yoy, versus 0.8% growth over the January - April interval last year. We expect trade volumes to continue to grow as long as the Fed doesn't tighten monetary conditions too much in the U.S. Energy: Overweight. Benchmark crude oil prices continue their lackluster performance, as high-frequency inventory data in the U.S. fail to convince markets OPEC 2.0 cuts are succeeding in draining global inventories. We expect this to reverse, and remain long Dec/17 $50 vs. $55/bbl call spreads in WTI and Brent. Base Metals: Neutral. Expanded global trade, led by EM Asia, will be supportive of base metals prices. However, we do not expect higher trade volumes to prompt a surge in base metals. We remain neutral base metals generally. Precious Metals: Neutral. Palladium has consistently outperformed platinum in post-GFC markets, as has gold (see below). We remain neutral the precious-metals complex, but are keeping our long gold portfolio hedge in place. Ags/Softs: Underweight. The USDA's crop report will be released Friday. Weather-related crop distress in the grains could start showing up in the data. We remain bearish, but recommend staying on the sidelines. Feature Chart of the WeekStrong Growth In Global Trade Volumes##BR##Will Be Supportive Of Base Metals EM Trade Volumes Continue Trending Higher, Supporting Metals EM Trade Volumes Continue Trending Higher, Supporting Metals Growth in EM imports and exports continues to lead the expansion of global trade volumes. This is important, as the growth in trade supports EM income growth, which, in turn, supports commodity demand. EM growth is the principal source of commodity demand growth globally, particularly for oil and base metals. Global trade volumes expanded yoy in April, with imports up 3.7% and exports up 3.2%, down slightly from the pace in 1Q17, according to the CPB World Trade Monitor (Chart of the Week). The notional value of trade for the year ended in April was $16.3 trillion. The uptrend in global trade begun in 4Q16 continues, however, which we noted earlier this month. As was the case with oil, this expansion of global trade volumes, particularly out of the EM economies, will be supportive of base metals demand generally.1 Similar to EM oil demand, we find EM exports and imports are highly correlated with world base metals demand post-GFC (Chart 2). This is not unexpected, given the prominence of Chinese base metals demand, which accounts for roughly half of base metals demand globally. Given the low level of growth in DM imports and exports, we conclude that the bulk of the increase in global trading volumes is increasingly accounted for by trade within the EM economies with each other. This can be seen in Chart 3, which shows growth of EM imports and exports surpasses DM trade performance, shown in Chart 4. Chart 2World Base Metals Demand,##BR##Highly Correlated With EM Trade Volumes World Base Metals Demand, Highly Correlated With EM Trade Volumes World Base Metals Demand, Highly Correlated With EM Trade Volumes Chart 3Increased Trade Within##BR##EM Economies Powers Global Trade Growth Increased Trade Within EM Economies Powers Global Trade Growth Increased Trade Within EM Economies Powers Global Trade Growth Chart 4DM Growth Not##BR##Keeping Up With EM Growth DM Growth Not Keeping Up With EM Growth DM Growth Not Keeping Up With EM Growth Going Through The Trade Numbers For the year ended in April 2017, yoy world import levels grew 2.5% on average each month. DM imports averaged 1.8% yoy growth, while EM imports grew at twice that level. The notional value of DM imports was $9.6 trillion for the year ended in April. EM notional imports were $6.7 trillion, with EM Asia accounting for $4.7 trillion of this. For exports, world trade volumes grew at an average rate of 2.3% yoy each month for the 12 months ending in April, with DM growth coming in at 1.6%, and EM growth clocking in at 3.1% on average, just shy of double the rate of DM growth. The notional value of DM exports was $8.8 trillion for the year ended in April. EM notional exports were $7.4 trillion, with EM Asia responsible for $4.9 trillion of this. For April alone, DM imports were up 1.8% yoy, while EM imports were up 6.5%, down from a 9.1% average rate in 1Q17. DM exports in April were up 1.7% yoy, down from a 3% average rate in 1Q17, while EM exports rose 5%, equal to the 1Q17 average rate. Import volumes for EM Asia led global growth by a wide margin vs. other EM markets, particularly in Latin America and the Middle East (Chart 5). Average yoy import growth for the year ended in April was 6.6% for EM Asia, with yoy growth for April alone registering 10.4%. EM Asia also leads export volume growth (Chart 6), with average yoy outbound trade up 7.1% yoy. Chart 5EM Asia Dominates Import Growth YoY... EM Asia Dominates Import Growth YoY... EM Asia Dominates Import Growth YoY... Chart 6...And EM Export Growth ...And EM Export Growth ...And EM Export Growth As always, the evolution of China's economy will have an outsized influence on trade and EM growth. We continue to expect China's growth to moderate but not slow sharply, in line with our colleagues at our sister publication China Investment Strategy. The recent credit tightening likely will abate, given the central bank has reversed its credit contraction and injected liquidity into the interbank system in recent weeks, according to BCA's China Investment Strategy service.2 We agree with China Investment Strategy's assessment that, "The Chinese economy will likely continue to moderate, but the downside risk appears low at the moment and overall business activity will remain buoyant."3 Update On Global Inflation Vs. EM Trade Volumes World base metals demand is highly correlated with global consumer price inflation. In fact, these variables are cointegrated, meaning they share a common long-term trend. A 1% increase in world base metals demand can be expected to produce a 0.32% increase in U.S. CPI, a 0.25% increase in the Euro Area Harmonized CPI, and a 0.43% increase in China's CPI. Like the relationships between EM oil demand and EM trade volumes, which we presented earlier this month, the relationships between world base metal demand and EM trade volumes also allows us to track EM income levels. This is because the income elasticity of base metals demand also is ~ 1.0 for EM economies, according to the OECD, meaning a 1% increase in EM income can be expected to produce an increase in base metals demand of ~ 1%.4 Likewise, consumer inflation worldwide also is highly correlated with EM trade volumes post-GFC.5 In the regressions we ran for U.S., Euro Area and China CPI as a function of EM trade volumes, we find a 1% increase in EM imports can be expected to produce a 0.51% increase in the U.S. CPI, a 0.41% increase in the Euro Area harmonized CPI, and a 0.67% increase in the China CPI. A 1% increase in EM exports produces increases of 0.47%, 0.35% and 0.65%, respectively. These relationships can be seen in Charts 7, 8, and 9. Chart 7U.S. CPI Highly Correlated##BR##With EM Trade Volumes... U.S. CPI Highly Correlated With EM Trade Volumes... U.S. CPI Highly Correlated With EM Trade Volumes... Chart 8...Along With The Euro Area##BR##Harmonized CPI... ...Along With The EMU Harmonized CPI... ...Along With The EMU Harmonized CPI... Chart 9...And##BR##China's CPI ...And China's CPI ...And China's CPI Bottom Line: World base metals demand will continue to be supported by continued growth in EM trade volumes this year. While these volumes are up nicely, the rate of growth is moderating somewhat, suggesting global base metals demand will hold up this year, but won't surge ahead. We certainly do not see base metals prices falling precipitously this year, given the growth in EM imports and exports, which started to revive toward the end of last year. We remain neutral base metals, but will be watching the interplay between base metals demand and EM trade volumes for any sign global demand is being re-ignited. Inflation appears to be quiescent globally, but we would expect it to start ticking up if we see an uptick in base metals demand and EM trade volumes. Precious Metals Update PGM Notes Price relationships within the precious-metals complex, particularly vis-à-vis Platinum Group Metals (PGMs), have undergone profound transformations since the end of the Global Financial Crisis (GFC). These changes have been bolstered by technology shifts in the automotive sector as well. Two trading relationships - palladium's relationship to platinum, and platinum's relationship to gold - best illustrate these changing fundamentals. Unlike gold and platinum prices, palladium is heavily influenced by automotive sales, in this case, gasoline-powered automobile sales. Gasoline-powered cars use palladium in their pollution-control catalysts. Such usage was up 5% last year to 7.4mm oz, according to Thomson Reuters GMFS data.6 Autocatalyst demand accounts for slightly more than three-quarters of palladium demand, according to GFMS data.7 Importantly, the two largest car markets in the world - the U.S. and China - are predominantly gasoline-powered, and sales in both have been strong, although the rate of growth has slowed (Chart 10). This is supportive of palladium prices, particularly as the metal registered a 1.2mm physical deficit last year. There is an increase in Chinese platinum-based auto catalyst demand for diesel cars, due to tightening regulation on emissions, but still is a small share of the total demand for platinum. Post-GFC, the value of palladium relative to platinum has consistently strengthened (Chart 11). Chart 10U.S. Sales Growth Down,##BR##But China Remains Strong U.S. Sales Growth Down, But China Remains Strong U.S. Sales Growth Down, But China Remains Strong Chart 11Platinum Eclipsed By##BR##Palladium And Gold Platinum Eclipsed By Palladium And Gold Platinum Eclipsed By Palladium And Gold Platinum's Discount To Gold Endures Platinum traded premium to gold until the GFC (Chart 11). Since then, gold has behaved more like a currency, with its price mostly dependent on financial variables (USD, real U.S. interest rates, and equity risk premium). Importantly, the yellow metal has traded premium to platinum since the GFC ended. While platinum prices are somewhat sensitive to the same financial factors as gold, and also can be modeled as a function of these financial variables, the metal also has a real-demand driver: diesel-powered car sales. These vehicles use platinum in their pollution-control catalysts. Autocatalysts accounted for 3.3mm oz of platinum sales last year, or 42% of demand, according to Thomson Reuters GFMS. Most of this goes to diesel catalysts, which are mainly sold in Europe. Diesel-powered car sales have been trending lower (Chart 12) in Europe, where they are the dominant type of car sold. The second largest demand segment for platinum is jewelry sales, which fell 12% last year to 2.2mm oz, following a 3.6% decline the prior year. Both gold and platinum will be responsive to the same set of financial variables, meaning a stronger USD along with higher real rates will be bearish for both, and vice versa. However, given platinum is also sensitive to the diesel-powered auto market, its price evolution has a component strongly influenced by physical platinum demand and supply. Supply comes from mines and recycling, which increases when steel prices rise. Sales of diesel-powered cars are falling in Europe partly due to the Volkswagen emissions-testing scandal and a longer-lasting trend of cities attempting to lower pollution by restricting where diesel-powered vehicles can drive (e.g., Athens, Madrid, Paris and Mexico City are eliminating diesel traffic by 2025).8 In addition, high steel prices will increase platinum recycling volumes this year (people scrap their cars more when steel prices are high). High steel prices also incentivize the scraping of gasoline-powered vehicles, which use palladium in their pollution-control catalysts. Platinum competes at the margin in the pollution-control catalyst market with palladium. The ratio between palladium and platinum is at its highest level since 2002 (Chart 11). The premium of platinum against palladium (platinum minus palladium) went from $1200/oz. in 2010 to close to parity recently (Chart 13). Chart 12EU Sales Still Growing,##BR##But Diesel Loses Share EU Sales Still Growing, But Diesel Loses Share EU Sales Still Growing, But Diesel Loses Share Chart 13Platinum's Premium To##BR##Palladium Disappears Platinum's Premium To Palladium Disappears Platinum's Premium To Palladium Disappears Continue To Favor Palladium We are more favorably disposed toward palladium than platinum. Given palladium's price is dominated by sales of gasoline-powered cars, which should, all else equal, do well relative to diesel-powered auto sales, even with a globally synchronized economic upturn. With the U.S. Fed expected to continue tightening, gold and platinum will face financial headwinds that will restrain price appreciation. Palladium, on the other hand, will be less sensitive to these headwinds, although higher interest rates in the U.S. relative to the rest of the world will restrain demand for goods purchased on credit like autos. While we remain neutral the precious metals complex generally, we recently recommended a long spot-gold position as a portfolio hedge against rising inflation and inflation expectations.9 Even though inflation has remained quiescent, and markets are trading as if the odds of a return of inflation are extremely low, BCA's Global Investment Strategy argues "the combination of faster growth and dwindling spare capacity will cause inflation to rise. This is particularly the case for the U.S., where the economy has already reached full employment."10 We believe the strengthening of household incomes resulting from the tight U.S. labor market likely will keep the Fed on track to continue with its rates-normalization policy, vs. market expectations of a mere 21 basis points in cumulative Fed rate hikes over the next 12 months. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Strong EM Trade Volumes Will Support Oil," published June 8, 2017, available at ces.bcaresearch.com. The CPB World Trade Monitor is published monthly by the CPB Netherlands Bureau for Economic Policy Analysis. Please see https://www.cpb.nl/en/worldtrademonitor for data and documentation. We use CPB's volumetric data for imports and exports in our analysis, which are indexed to 2010 = 100; we converted these data to USD values to see how the composition of imports and exports is changing so as to better see how the relative shares of EM and DM are evolving. 2 Please see BCA Research's China Investment Strategy Weekly Report "Chinese Financial Tightening: Passing The Phase Of Maximum Strength," published by on June 22, 2017, available at cis.bcaresearch.com. 3 Please see BCA Research's China Investment Strategy Weekly Report "A Chinese Slowdown: How Much Downside," published on June 8, 2017, available at cis.bcaresearch.com. 4 As we noted in our research earlier this month, the read-through on this is EM trade volumes are closely tied to income levels, given this income elasticity in non-OECD economies. Please see "The Price of Oil - Will It Start Rising Again?" OECD Economics Department Working Paper No. 1031, p. 6 (2013). In our modeling, we assume the GFC ended in 2010. Our oil results vis-à-vis EM income elasticities can be found in BCA Research's Commodity & Energy Strategy Weekly Report "Strong EM Trade Volumes Will Support Oil," published June 8, 2017, available at ces.bcaresearch.com. 5 We originally published these results for EM oil demand vs. EM trade volumes in the June 8, 2017 article referenced above in footnote 1, in BCA Research's Commodity & Energy Strategy Weekly Report "Strong EM Trade Volumes Will Support Oil," available at ces.bcaresearch.com. The average R2 coefficient of determination for the regressions on imports was 0.89, while the average for the regressions on exports was 0.89. 6 Palladium supply totalled 8.6mm oz, while demand came in at 9.8mm oz, according to the Thomson Reuters - GFMS Platinum Group Metals Survey 2017. 7 In our modelling, we treat palladium as an industrial metal, given the overwhelming influence auto demand - particularly gasoline-powered vehicles - has on its price. Please see BCA Research's Commodity & Energy Strategy Weekly Report "2016 Commodity Outlook: Precious Metals," published by December 3, 2015, available at ces.bcaresearch.com. 8 A number of cities are looking to ban diesel cars entirely from their central districts. Please see https://www.theguardian.com/environment/2016/dec/02/four-of-worlds-biggest-cities-to-ban-diesel-cars-from-their-centres. 9 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Go Long Gold As A Strategic Portfolio Hedge," published May 4, 2017, available at ces.bcaresearch.com. 10 Please see BCA Research's Global Investment Strategy Weekly Report "Stocks Are From Mars, Bonds Are From Venus?," published June 23, 2017, available at gis.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016 EM Trade Volumes Continue Trending Higher, Supporting Metals EM Trade Volumes Continue Trending Higher, Supporting Metals

Highlights Markets have gone too far in pricing out the Republican's market-friendly policy agenda. The President desperately needs a win ahead of mid-term elections. A bill that at least cuts taxes should be forming by year end. The risk is that continued political turbulence, now including the possibility of impeachment, distracts Congress and delays or completely derails tax reform plans. Fortunately for the major global equity markets, corporate profits are providing solid support. We expect U.S. EPS growth to accelerate further into year end, peaking at just under 20%. The projected profit acceleration is even more impressive in the Eurozone and Japan. Corporations are still in a sweet spot in which the top line is growing but there is no major wage cost pressure evident yet. U.S. EPS growth is well ahead of both Japan and the Eurozone at the moment, but we expect some "catch up" by year end that will favor the latter two bourses in local currency terms. EPS growth will fall short of bottom-up estimates for 2017, but what is more important for equity indexes is the direction of 12-month forward EPS expectations, which remain in an uptrend. The positive earnings backdrop means that stocks will outperform bonds for the remainder of the year even if Congress fails to pass any market-friendly legislation. The FOMC is "looking through" the recent soft economic data and slower inflation, and remains on track to deliver two more rate hikes this year. The impact of the Fed's balance sheet runoff on the Treasury market will be limited by several factors, but a shrinking balance sheet and Fed rate hikes will force bond yields to rise faster than is currently discounted. Policy divergence will push the dollar higher. The traditional relationship between the euro/USD and short-term yield differentials should re-establish following the French election. The euro could reach parity before the next move is done. "Dr. Copper" is not signaling that global growth will soften significantly this year. Chinese growth has slowed but the authorities are easing policy, which will stabilize growth and support base metals. That said, we remain more upbeat on oil prices than base metals. Feature Investors have soured on the prospects for U.S. tax reform in recent weeks, but the latest travails in Washington inflicted only fleeting damage on U.S. and global bourses. The S&P 500 appears to have broken above the 2400 technical barrier as we go to press. Market expectations for a more tepid Fed rate hike cycle, lower Treasury yields and related dollar softness undoubtedly provided some support. But, more importantly, corporate profits are positively surprising in the major economies and this is not just an energy story. The good news on company earnings should continue to drive stock prices higher this year in absolute terms and relative to bond prices. It is a tougher call on the dollar and the direction of bond yields. We remain short duration and long the dollar, but much depends on the evolution of U.S. core inflation and fiscal policy. A Death Knell For U.S. Tax Reform? Chart I-1 highlights that the market now sees almost a zero chance that the Republicans will ever be able to deliver any meaningful tax cuts or infrastructure spending. Many believe that mushrooming political scandals encumbering President Trump will distract the GOP and delay or derail tax reform. Indeed, impeachment proceedings would be a major distraction, although this outcome would not necessarily lead to an equity bear market. The historical record shows that the economy is much more important than politics for financial markets. BCA's geopolitical strategists looked at three presidential impeachments, covering the Teapot Dome Scandal (April 1922 to October 1927), Watergate (February 1973 to August 1974) and the President Clinton's Lewinsky Affair (January 1998 to February 1999).1 Watergate was the only episode that coincided with a bear market, but it is difficult to pin the market downturn on Nixon's impeachment since the U.S. economy entered one of the worst post-war recessions in 1973 that was driven by tight Fed policy and an oil shock. Impeachment would require that Trump loses support among the Republican base, which so far has not happened. The President still commands the support of 84% of Republican voters (Chart I-2). Investors should monitor this support level as an indicator of the President's political capital and the risk of impeachment. Chart I-1Fading Hopes For Tax Reform Fading Hopes For Tax Reform Fading Hopes For Tax Reform Chart I-2 We believe that markets have gone too far in pricing out Trump's market-friendly policy agenda. The President desperately needs a win ahead of mid-term elections, and tax reform and deregulation are two key areas where the President and congressional Republicans see eye to eye. The odds are good that an agreement to cut taxes will be formed by year end. Congressional leaders want tax reform to be revenue neutral, but finding sufficient areas to cut spending will be extremely difficult. They may simply require that tax cuts are paid for in a 10-year window. This makes it possible to lower taxes upfront and promise non-specific spending cuts and revenue raising measures down the road. Or, Congress may pass tax reform that is not revenue neutral through the reconciliation process, which would require that tax cuts sunset at some point in the future. Tax cuts would give stocks a temporary boost either way but, as we discuss below, it may be better for corporate profits in the medium term if Congress fails to deliver any fiscal stimulus. Profits, Beats And Misses While economists fret over the soft U.S. economic data so far this year, profit growth is quietly accelerating in the background (Chart I-3). On a 4-quarter moving total basis, S&P 500 earnings-per-share were up by more than 13% in the first quarter (84% reporting). We expect growth to accelerate further into year end, peaking at about 18%, before moderating in 2018. Profit growth is accelerating outside of the energy sector. The projected acceleration in EPS growth is equally impressive in the Eurozone and Japan. The favorable profit picture in the major economies reflects two key factors. First, profits are rebounding from a poor showing in 2015/16, when EPS was dragged down by the collapse in oil prices and a global manufacturing recession. Oil prices have since rebounded and global industrial production is recovering as expected (Chart I-4). Our short-term forecasting models for real GDP, based on a mixture of hard data and surveys, continue to flag a pickup in economic growth in the major economies (Chart I-5). Chart I-3Top-Down Profit Projection Top-Down Profit Projection Top-Down Profit Projection Chart I-4EPS Highly Correlated With Industrial Production EPS Highly Correlated With Industrial Production EPS Highly Correlated With Industrial Production Chart I-5GDP Growth Poised To Accelerate GDP Growth Poised To Accelerate GDP Growth Poised To Accelerate The U.S. model's forecast paints an overly rosy picture, but it does support our view that Q1 softness in the hard data reflected temporary factors that will give way to a robust rebound in the second and third quarters. The Eurozone economy is really humming at the moment, as highlighted by our model and recent readings from the IFO and purchasing managers' surveys. Indeed, these indicators are consistent with real GDP growth of nearly 3%! Our GDP models are also constructive for Japan and the U.K., although not nearly as robust as in the U.S. and Eurozone. Chart I-6Profit Margins On The Rise Profit Margins On The Rise Profit Margins On The Rise Second, the corporate sectors in the major economies are still in a sweet spot in which the top line is growing but there is no major wage cost pressure evident yet. This is the case even in the U.S., where labor market slack has largely been absorbed. Indeed, margins rose in Q1 2017 for the third quarter in a row (Chart I-6). Our indicators suggest that the corporate sector has gained some pricing power at a time when wage gains are taking a breather.2 The hiatus of wage pressure may not last long, and we expect the "mean reversion" in profit margins to resume next year. But for now, our short-term EPS growth model remains upbeat for the next 3-6 months (not shown). Profit margins are also on the rise in Japan and the Eurozone. Margins in the latter appear to have the most upside potential of the three major markets, given the fact that current levels are still depressed by historical standards, and that there remains plenty of slack in the European labor market. We are not incorporating any margin expansion in Japan because they are already very high. Nonetheless, we do not expect any "mean reversion" in margins over the next year either, because the business sector is going to great lengths to avoid any increase in the wage bill despite an extremely tight labor market. U.S. EPS growth is well ahead of both Japan and the Eurozone at the moment, but we expect some "catch up" by year end: The U.S. is further ahead in the global profit mini recovery and year-ago EPS comparisons will become more difficult by the end of the year. The drag on corporate profits in 2017 from previous dollar strength will be larger than the currency drag in the Eurozone according to our models, assuming no change in trade-weighted exchange rates in the forecast period (Chart I-7). The pass-through of past yen movements will be a net boost to EPS growth for Japanese companies this year.3 Currency shifts would favor the Japanese and the Eurozone markets versus the U.S. even more if the dollar experiences another upleg. We expect the dollar to appreciate by 10% in trade-weighted terms. A 10% broad-based dollar appreciation would trim EPS growth by 2½ percentage points, although most of this would occur in 2018 due to lags (Chart I-8). Eurozone and Japanese EPS growth would receive a lift of 2 and ½ percentage points, respectively, as their currencies depreciate versus the dollar. Chart I-7Currency Impact On EPS Growth Currency Impact On EPS Growth Currency Impact On EPS Growth Chart I-8A 10% Dollar Rise Would Trim Profits A 10% Dollar Rise Would Trim Profits A 10% Dollar Rise Would Trim Profits Finally, the fact that profits in Japan and the Eurozone are more leveraged to overall economic growth than in the U.S. gives the former two markets the edge as global industrial production continues to recover this year and into 2018. Japanese and Eurozone equity market indexes also have a higher beta with respect to the global equity index. The implication is that we remain overweight these two markets relative to the U.S. on a currency hedged basis. Lofty Expectations Even though the message from our EPS models is upbeat, our forecasts still fall short of bottom-up estimates for 2017. Is this a risk for the equity market, especially in the U.S. where valuations are stretched? Investors are well aware that bottom-up estimates are perennially optimistic. Table I-1 compares the beginning-of-year EPS growth estimate with the actual end-of-year outcome for 2007-2016. Not surprisingly, bottom-up analysts massively missed the mark in the recession. But even outside of 2008, analysts significantly over-estimated earnings in seven out of nine years. Despite this, the S&P 500 rose sharply in most cases. One exception was 2015, when the S&P 500 fell by 0.7%. Plunging oil and material prices contributed to an EPS growth "miss" of seven percentage points. Chart I-9 highlights that the level of the 12-month forward EPS estimate fell that year, unlike in the other years since the Great Recession. Valuations are more demanding today than in the past, but the message is that attaining bottom-up EPS year-end estimates is less important for the broad market than the trend in 12-month forward estimates (which remains up at the moment). Chart I- Chart I-9S&P 500 Follows ##br##12-month Forward EPS S&P 500 Follows 12-month Forward EPS S&P 500 Follows 12-month Forward EPS The bottom line is that the backdrop is constructive for equities even if the Republicans are unable to push through any fiscal stimulus. In fact, it may be better for the stock market in the medium term if the GOP fails to pass any meaningful legislation. The U.S. economy does not need any demand stimulus at the moment (although measures to boost the supply side of the economy would help lift profits over the long term). The current long-in-the-tooth U.S. expansion is likely to stretch further in the absence of stimulus, extending the moderate growth/low inflation/low interest rate backdrop that has been positive for risk assets in recent years. The Fed's Balance Sheet: It's Diet Time The minutes from the May FOMC meeting reiterated that policymakers plan to begin scaling back on reinvesting the proceeds of its maturing securities of Treasurys and MBS by the end of the year. The Fed is leaning toward a gradual tapering of reinvestment in order to avoid shocking the bond market. Still, investors are rightly concerned about the potential impact of the balance sheet runoff, especially given that memories of the 2013 "taper tantrum" are still fresh. Chart I-10 Chart I-10 presents a forecast for the flow of Treasurys available to the private sector, taking into consideration the supply that is absorbed by foreign official institutions and by the Fed. The bottom panel shows a similar calculation for the aggregate supply of government bonds from the U.S., Japan, the Eurozone and the U.K. While the supply of Treasurys has been positive since 2012, the net flow has been negative for these four economies as a whole because of aggressive quantitative easing programs. This year will see the largest contraction in the supply of government bonds available to the private sector, at US$800 billion. The flow will become less negative in 2018 even if the Fed were to keep its balance sheet unchanged (mostly due to assumed ECB tapering). If the Fed goes ahead with its balance sheet reduction plan, the net supply of government bonds from the major economies will move slightly into positive territory for the first time since 2014. There is disagreement among academics about whether quantitative easing (QE) directly depressed bond yields by restricting the supply of high-quality fixed income assets, or whether the impact on yields was solely via the "signaling effect" for the path of future short rates. Either way, balance sheet runoff will likely have some impact on bond yields. A good starting point is to employ an empirical estimate of the impact of QE. The IMF has modeled long-term Treasury yields based on a number of economic and financial variables and the stock of assets held by the Fed as a share of GDP. Just for exposition purposes, let us take an extreme example and assume that the Fed simply terminates all re-investment as of January 2018 (i.e. the runoff is not tapered). In this case, the amount of bank reserves held at the Fed would likely evaporate by 2021. This represents a contraction of roughly 10 percentage points of GDP (Chart I-11). Applying the IMF interest rate model's coefficient of -0.09, it implies that long-term Treasury yields and mortgage rates would rise by 90 basis points from the "portfolio balance" effect alone. Chart I-11Fed Balance Sheet Runoff Scenario Fed Balance Sheet Runoff Scenario Fed Balance Sheet Runoff Scenario However, it is more complicated than that. The impact on yields is likely to be tempered by two factors: The balance sheet may never fully revert to historic norms relative to GDP. Some academic experts are recommending that the Fed maintain a fairly large balance sheet by historical standards because of the need in financial markets for short-term, risk-free assets that would diminish if there are fewer excess bank reserves available. Banks, for example, are required by regulators to hold more high-quality assets than they did in the pre-Lehman years. As the FOMC dials back monetary stimulus it will be concerned with overall monetary conditions, including short-term rates, long-term rates and the dollar. If long-term rates and/or the dollar rise too quickly, policymakers will moderate the pace of rate hikes and use forward guidance to talk down the long end of the curve so as to avoid allowing financial conditions to tighten too quickly. Thus, the path of short-term rates is dependent on the dollar and the reaction of the long end of the curve. It is difficult to estimate how it will shake out, but a recent report from the Federal Reserve Bank of Kansas City estimated that a $675 billion reduction in the size of the Fed's balance sheet is equivalent to a 25 basis point increase in the fed funds rate (although the authors admit that the confidence band around this estimate is extremely wide).4 We expect that the impact of runoff alone will be much less than the 90 basis point estimate discussed above. Still, the combination of balance sheet shrinkage and Fed rate hikes will lead to higher bond yields than are currently discounted in the market. Fed Outlook: Mostly About Inflation The May FOMC minutes confirmed that the FOMC is "looking through" the soft economic data in the first quarter, chalking it up to temporary factors such as shifts in inventories. They are also inclined to believe that the moderation in core CPI inflation in recent months is temporary. The message is that policymakers remain on track to deliver two more rate hikes this year, in line with the 'dot plot' forecast. The market is pricing almost a 100% chance of a June rate hike. However, less than two full rate hikes are expected over the next year, which is far too benign in our view. Investors have been quick to conclude that recent economic data have convinced Fed officials to shift from a "gradual" pace of rate hikes to a "glacial" pace. Treasurys rallied on this shift in Fed expectations and a decline in long-term inflation expectations. The 10-year TIPS breakeven inflation rate has dropped to about 1.8%, the lowest level since before the U.S. election. This appears to us that the bond market over-reacted to the drop in core CPI inflation from 2.2% in February to 1.9% in April. The evolution of actual inflation will be critical to the outlook for the Fed and Treasury yields in the coming months. Our U.S. fixed-income strategists have simulated a traditional Phillips Curve model of inflation (Chart I-12).5 The model projects that core PCE inflation will reach 2.1% by December, even assuming no change in the unemployment rate or the trade-weighted dollar. Inflation ends the year not far below the 2% target even in an alternative scenario in which we assume that the dollar appreciates and that the full-employment level of unemployment is lower than the Fed currently assumes. Chart I-12U.S. Inflation Should End Year At 2% U.S. Inflation Should End Year At 2% U.S. Inflation Should End Year At 2% Thus, the trend in inflation should reinforce the FOMC's bias to keep tightening policy, forcing the bond market to reassess the pace of rate hikes discounted in the curve. That said, if we are wrong and inflation does not trend higher in the next 3-4 months, then it is the FOMC that will be forced to reassess and our short duration recommendation will probably not pan out on a six month horizon. Longer-term, last month's Special Report highlighted that we have reached an inflection point in some of the structural forces that have depressed bond yields. This month's Special Report, beginning on page 20, builds on that theme with a look at the impact of technological progress on equilibrium bond yields. With respect to credit spreads, the state of nonfinancial corporate sector balance sheets and the overall stance of monetary policy will continue to be the main drivers of the credit cycle. If unwinding the balance sheet leads to a premature tightening of financial conditions, then the Fed will proceed more slowly on rate hikes. The crucial indicator to watch is core PCE inflation. Credit spreads will remain fairly well contained until core PCE inflation reaches the Fed's 2% target. At that point, the pace of monetary normalization will ramp up, putting spreads at risk of widening. Stay overweight corporate bonds within fixed income portfolios for now. While the Fed's balance sheet reduction by itself may not have a big impact on the dollar, we still believe the currency has more upside because of the divergence in the overall monetary policy stance between the U.S. on one side and the ECB and Bank of Japan (BoJ) on the other. The BoJ will hold the 10-year JGB near to zero for quite some time. The ECB will also not be in a position to tighten policy for an extended period, outside of removing negative short rates and tapering QE purchases a bit further in 2018. The euro has appreciated versus the dollar even as two-year real interest rate differentials have moved in favor of the dollar since the end of March. This divergence probably reflects euro short-covering following the market-friendly French election outcome. Next up are the two rounds of French legislative elections in June. Polls support the view that Macron's En Marche and the center-right Les Republicains will capture the vast majority of seats in the legislature. Such an election outcome would make possible the passage of genuine structural reforms that would suppress wage growth and make French exports more competitive. Investors may be shocked into pricing greater odds of Euro Area dissolution when Italy comes back into focus. In the meantime, we do not see any risk factors emanating from the Eurozone that could upset the global equity applecart in the near term. Moreover, the traditional relationship between the euro/USD exchange rate and 2-year real yield differentials should now re-establish. The implication is that the euro could reach parity before the next move is done. Dr. Copper? The recent setback in the commodity pits has added to investor angst regarding global growth momentum. The LMEX base metals index is up almost 25% on a year-ago basis, but has fallen by 5% since February (Chart I-13). From their respective peaks earlier this year, zinc and copper are down about 7-10%, nickel has dropped by 18% and iron ore has lost almost half of its value. Is the venerable "Dr. Copper" sending an important warning about world growth? Chart I-13What Are Commodities Telling Us? What Are Commodities Telling Us? What Are Commodities Telling Us? Some of our global leading economic indicators have edged lower this year, as we have discussed in previous reports. Nonetheless, the decline in base metals prices likely has more to do with other factors, such as an unwinding of the surge in speculative demand that immediately followed the U.S. election last autumn. Speculators may be disappointed by the lack of progress on Republican promises to cut taxes and boost infrastructure spending. The main story for base metals demand and prices, however, is the Chinese real estate sector. China accounts for roughly 50% of world consumption for each of the major metals. The Chinese authorities are trying to cool the property market and transition to a more consumer spending-oriented economy, thereby reducing the dependence on exports, capital spending and real estate as growth drivers. Fiscal policy tightened last year and new regulations were introduced to limit housing speculation. The effect of policy tightening can be seen in our Credit and Fiscal Spending Impulse indicator, which has been softening since mid-2016 (Chart I-14). The economy held up well last year, but the policy adjustment resulted in a peaking of the PMI at year-end. Growth in housing starts also appears to be rolling over. Both the PMI and housing starts are correlated with commodity prices. The good news is that BCA's China Investment Strategy service does not expect a major downshift in Chinese real GDP growth this year, which means that commodity import demand should rebound: The authorities wish to slow credit growth, but there is no incentive for the authorities to crunch the economy given that consumer price inflation is still low and the surge in producer price inflation appears to have peaked. Monetary conditions have tightened a little in recent months, but overall conditions are not restrictive. Both direct fiscal spending and infrastructure investment have picked up noticeably this year (Chart I-15). Finally, the PBoC re-started its Medium-Term Lending Facility and recently made the largest one-day cash injection into the financial system in nearly four months. Chart I-14China Is The Main Story ##br##For Base Metals Demand China Is The Main Story For Base Metals Demand China Is The Main Story For Base Metals Demand Chart I-15Direct Fiscal Spending And ##br##Infrastructure Have Picked Up Recently Direct Fiscal Spending And Infrastructure Have Picked Up Recently Direct Fiscal Spending And Infrastructure Have Picked Up Recently Export growth will continue to accelerate based on our model (not shown). The upturn in the profit cycle and firming output prices should boost capital spending. Robust demand will ensure that housing construction will continue to grow at a healthy pace. Households' home-buying intentions jumped to an all-time high last quarter. Tighter housing policies in major cities will prevent a massive boom, but this will not short-circuit the recovery in housing construction. Fading fears about a China meltdown may give commodities a lift later this year. Our commodity strategists are particularly positive on crude oil, as extended production cuts from OPEC and Russia outweigh the impact of surging shale production, allowing bloated inventories to moderate. In contrast, the backdrop is fairly benign for base metals. Our commodity strategists do not see the conditions for a major bull or bear phase on a 6-12 month horizon. Within commodity portfolios, they recommend a benchmark allocation to base metals, an underweight in agricultural products and an overweight in oil. From a broader perspective, our key message is that "Dr. Copper" is not signaling that global growth will soften significantly this year. Investment Conclusions: Accelerating corporate profit growth in the major advanced economies provides a healthy tailwind and suggests that stocks could perform well under a couple of different scenarios in the second half of 2017. If the rebound in U.S. economic growth from the poor first quarter is unimpressive and it appears that Congress will be sidetracked by political turmoil in the White House, then the S&P 500 should benefit from the 'goldilocks' combination of healthy profit growth, low bond yields, an accommodative Fed and a soft dollar. If, instead, U.S. growth rebounds strongly and Congress makes progress on the broad outline of a tax reform bill over the summer months, then stocks should benefit from the prospect of stronger growth in 2018. Rising bond yields and a firmer dollar would provide some offset for stocks, but would not derail the equity bull market as long as inflation remains below the Fed's target. Our model suggests that U.S. inflation will remain below-target for the next several months, but could be near 2% by year end. This scenario would set the stage for a more aggressive Fed in 2018, a surge in the dollar and possibly a bear market in risk assets next year. We are therefore comfortable in predicting that the stock-to-bond total return ratio will continue to rise for at least the remainder of this year. The tough part relates to bond yields and the dollar, since the above two scenarios have very different implications for these two asset classes. Our base case is closer to the second scenario, such that we remain below benchmark in duration and long the dollar. That said, much depends on the evolution of U.S. core inflation and U.S. politics. Both are particularly difficult to forecast. A failure for core PCE inflation to pick up in the next 3-4 months and/or continuing political scandals in Washington would force us to reconsider our asset allocation. Of course, there are other risks to consider, including growing mercantilism in the U.S., Sino-American tensions and North Korea. At the top of the list are China and Italy. (1) China China remains our geopolitical strategists' top pick as the catalyst most likely to scuttle our upbeat view on global risk assets in 2017.6 Our base case assumption is that policymakers will not enact wide-scale financial sector reform, which would entail a surge in realized non-performing loans and bankruptcies and defaults, ahead of the Fall Party Congress. The regulatory crackdown so far seems merely to keep the financial sector in check for a while. The government has already stepped back somewhat in the face of the liquidity squeeze, and fiscal policy has been loosened (as mentioned above). All of the key Communist Party statements have emphasized that stability remains a priority. Nonetheless, it may be difficult for the authorities to manage the deleveraging process given nose-bleed levels of private-sector leverage. Politicians could misjudge the fragility of the financial system and investors might front-run the reform process, sending asset prices down well in advance of policy implementation. (2) Italy We have flagged the next Italian election as a key risk for markets because of polls showing that voters have become disillusioned with the euro. It appeared that an election would not take place until 2018, and we have downplayed European elections as a risk factor for 2017. However, the 5-Star Movement has now backed a proportional electoral system, which raises the chances of an autumn election in Italy. This would obviously spark turbulence in financial markets in the months leading up to the event. Turning to emerging markets, the pickup in global growth and a modest bounce in commodity prices would support this asset class. However, our view that the dollar is headed higher on the back of Fed rate hikes keeps us from getting too excited about EM stocks, bonds or currencies. Our other recommendations include the following: Within global government bond portfolios, overweight JGBs and underweight Treasurys. Gilts and core Eurozone bonds are at benchmark. Underweight the periphery of Europe. Overweight European and Japanese equities versus the U.S. on a currency-hedged basis. Overweight the dollar versus the other major currencies. Overweight small caps stocks versus large in the U.S. market. Stay exposed to oil-related assets, and favor oil to base metals within commodity portfolios. Mark McClellan Senior Vice President The Bank Credit Analyst May 31, 2017 Next Report: June 29, 2017 1 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 7, 2017, available at gps.bcaresearch.com 2 Please see The Bank Credit Analyst, "Overview," April 017, available at bca.bcaresearch.com 3 Currency shifts affect earnings with a lag, which in captured by our models. 4 Forecasting the Stance of Monetary Policy Under Balance Sheet Adjustments. The Macro Bulletin, Federal Reserve Bank of Kansas City. Troy Davig and A. Lee Smith. May 10, 2017. 5 Please see BCA U.S. Bond Strategy Weekly Report, "Two Challenges For U.S. Policymakers," dated May 23, 2017, available at usbs.bcaresearch.com 6 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets ," dated May 24, 2017, available at gps.bcaresearch.com II. Is Slow Productivity Growth Good Or Bad For Bonds? This month's Special Report was written by Peter Berezin, Chief Global Strategist for BCA's Global Investment Strategy Service. The report is a companion piece to last month's Special Report, which argued that some of the structural factors that have depressed global interest rates are at an inflection point. These factors include demographic trends and the integration of China's massive labor supply into the global economy. Peter's report focuses on technology's impact on bond yields. He presents the non-consensus view that slow productivity growth likely depresses interest rates at the outset, but will lead to higher rates later on. Not only could sluggish productivity growth lead to higher inflation, it could also deplete national savings. Both factors would be bond bearish, reinforcing the other factors discussed in last month's Special Report. I trust that you will find the report as insightful and educational as I did. Mark McClellan Productivity growth has declined in most countries. This appears to be a structural problem that will remain with us for years to come. In theory, slower productivity growth should reduce the neutral rate of interest, benefiting bonds in the process. In reality, countries with chronically low productivity growth typically have higher interest rates than faster growing economies. The passage of time helps account for this seeming paradox: Slower productivity growth tends to depress interest rates at the outset, but leads to higher rates later on. The U.S. has reached an inflection point where weak productivity growth is starting to push up both the neutral real rate and inflation. Other countries will follow. The implication for investors is that government bond yields have begun a long-term secular uptrend. The market is not at all prepared for this. Slow Productivity Growth: A Structural Problem Productivity growth has fallen sharply in most developed and emerging economies (Chart II-1). As we argued in "Weak Productivity Growth: Don't Blame The Statisticians," there is little compelling evidence that measurement error explains the productivity slowdown.1 Yes, the unmeasured utility accruing from free internet services is large, but so was the unmeasured utility from antibiotics, indoor plumbing, and air conditioning. No one has offered a convincing explanation for why the well-known problems with productivity calculations suddenly worsened about 12 years ago. Chart II-1 If mismeasurement is not responsible for the productivity slowdown, what is? Cyclical factors have undoubtedly played a role. In particular, lackluster investment spending has curtailed the growth in the capital stock (Chart II-2). This means that today's workers have not benefited from the improvement in the quality and quantity of capital to the same extent as previous generations. Chart II-2The Great Recession Hit ##br##Capital Stock Accumulation The Great Recession Hit Capital Stock Accumulation The Great Recession Hit Capital Stock Accumulation However, the timing of the productivity slowdown - it began in 2004-05 in most countries, well before the financial crisis struck - suggests that structural factors have been key. These include: Waning gains from the IT revolution. Recent innovations have focused more on consumers than businesses. As nice as Facebook and Instagram are, they do little to boost business productivity - in fact, they probably detract from it, given how much time people waste on social media these days. The rising share of value added coming from software relative to hardware has also contributed to the decline in productivity growth. Chart II-3 shows that productivity gains in the latter category have been much smaller than in the former. Slower human capital accumulation. Globally, the fraction of adults with a secondary degree or higher is increasing at half the pace it did in the 1990s (Chart II-4). Educational achievement, as measured by standardized test scores in mathematics and science, is edging lower in the OECD, and is showing very limited gains in most emerging markets (Chart II-5). Test scores tend to be much lower in countries with rapidly growing populations (Chart II-6). Consequently, the average level of global mathematical proficiency is now declining for the first time in modern history. Chart II-3The Shift Towards Software ##br##Has Dampened IT Productivity Gains The Shift Towards Software Has Dampened IT Productivity Gains The Shift Towards Software Has Dampened IT Productivity Gains Chart II-4 Chart II-5 Chart II-6 Decreased creative destruction. The birth rate of new firms in the U.S. has fallen by half since the late 1970s and is now barely above the death rate (Chart II-7). In addition, many firms in advanced economies are failing to replicate the best practices of industry leaders. The OECD reckons that this has been a key reason for the productivity slowdown.2 Chart II-7Secular Decline In U.S. Firm Births Secular Decline In U.S. Firm Births Secular Decline In U.S. Firm Births Productivity Growth And Interest Rates Investors typically assume that long-term interest rates will converge to nominal GDP growth. All things equal, this implies that faster productivity growth should lead to higher interest rates. Most economic models share this assumption - they predict that an acceleration in productivity growth will raise the rate of return on capital and incentivize households to save less in anticipation of faster income gains.3 Both factors should cause interest rates to rise. The problem is that these theories do not accord with the data. Chart II-8 shows that interest rates are far higher in regions such as Africa and Latin America, which have historically suffered from chronically weak productivity growth. In contrast, rates are lower in regions such as East Asia, which have experienced rapid productivity growth. One sees the same negative correlation between interest rates and productivity growth over time in developed economies. In the U.S., for example, interest rates rose rapidly during the 1970s, a decade when productivity growth fell sharply (Chart II-9). Chart II-8 Chart II-9U.S. Interest Rates Soared In The ##br##1970s While Productivity Swooned U.S. Interest Rates Soared In The 1970s While Productivity Swooned U.S. Interest Rates Soared In The 1970s While Productivity Swooned Two Reasons Why Slower Productivity Growth May Lead To Higher Interest Rates There are two main reasons why slower productivity growth may lead to higher nominal interest rates over time: Slower productivity growth may eventually lead to higher inflation; Slower productivity growth may deplete national savings, thereby raising the neutral real rate of interest. We discuss each reason in turn. Reason #1: Slower Productivity Growth May Fuel Inflation Most economists agree that chronically weak productivity growth tends to be associated with higher inflation. Even Janet Yellen acknowledged as much, noting in a 2005 speech that "the evidence suggests that the predominant medium-term effect of a slowdown in trend productivity growth would likely be higher inflation."4 In theory, the causation between productivity and inflation can run in either direction: Weak productivity gains can fuel inflation while high inflation can, in turn, undermine growth. With respect to the latter, economists have focused on three channels: First, higher inflation may make it difficult for firms to distinguish between relative and absolute price shocks, leading to suboptimal resource allocation. Second, higher inflation may stymie capital accumulation because investors typically pay capital gains taxes even when the increase in asset values is entirely due to inflation. Third, high inflation may cause households and firms to waste time and effort on economizing their cash holdings. There are also several ways in which slower productivity growth can lead to higher inflation. For example, sluggish productivity growth may increase the likelihood that a country will be forced to inflate its way out of any debt problems. In addition, central banks may fail to recognize structural declines in productivity growth in real time, leading them to keep interest rates too low in the errant belief that weak GDP growth is due to inadequate demand when, in fact, it is due to insufficient supply. There is strong evidence that this happened in the U.S. in the 1970s. Chart II-10 shows that the Fed consistently overestimated the size of the output gap during that period. Chart II-10The Fed Continuously Overstated The ##br##Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s Reason #2: Slower Productivity Growth May Deplete National Savings, Leading To A Higher Neutral Real Rate Imagine that you have a career where your real income is projected to grow by 2% per year, but then something auspicious happens that leads you to revise your expected annual income growth to 20%. How do you react? If you are like most people, your initial inclination might be to celebrate by purchasing a new car or treating yourself to a lavish vacation. As such, your saving rate is likely to fall at the outset. However, as the income gains pile up, you might find yourself running out of stuff to buy, resulting in a higher saving rate. This is particularly likely to be true if you grew up poor and have not yet acquired a taste for conspicuous consumption. Now consider the opposite case: One where you realize that your income will slowly contract over time as your skills become increasingly obsolete. The logic above suggests that your immediate reaction will be to hunker down and spend less - in other words, your saving rate will rise. However, as time goes by and the roof needs to be changed and the kids sent off to college, you may find it hard to pay the bills - your saving rate will then fall. The same reasoning applies to economy-wide productivity growth. When productivity growth increases, household savings are likely to decline as consumers spend more in anticipation of higher incomes. Meanwhile, investment is likely to rise as firms move swiftly to expand capacity to meet rising demand for their products. The combination of falling savings and rising investment will cause real rates to increase. As time goes by, however, it may become increasingly difficult for the economy to generate enough incremental demand to keep up with rising productive capacity. At that point, real rates will begin falling. The historic evidence is consistent with the notion that higher productivity growth causes savings to fall at the outset, but rise later on. Chart II-11 shows that East Asian economies all had rapid growth rates before they had high saving rates. China is a particularly telling example. Chinese productivity growth took off in the early 1990s. Inflation accelerated over the subsequent years, while the country flirted with current account deficits - both telltale signs of excess demand. It was not until a decade later that the saving rate took off, pushing the current account into a large surplus, even though investment was also rising at the time (Chart II-12). Chart II-11Asian Tigers: Growth Took Off First, ##br##Followed By Higher Savings Asian Tigers: Growth Took Off First, Followed By Higher Savings Asian Tigers: Growth Took Off First, Followed By Higher Savings Chart II-12China: Productivity Growth Accelerated, ##br##Then Savings Rate Took Off China: Productivity Growth Accelerated, Then Savings Rate Took Off China: Productivity Growth Accelerated, Then Savings Rate Took Off Today, Chinese deposit rates are near rock-bottom levels, and yet the household sector continues to save like crazy. This will change over time. The working-age population has peaked (Chart II-13). As millions of Chinese workers retire and begin to dissave, aggregate household savings will fall. Meanwhile, Chinese youth today have no direct memory of the hardships that their parents endured. As happened in Korea and Japan, the flowering of a consumer culture will help bring down the saving rate. Meanwhile, sluggish income growth in the developed world will make it difficult for households to save much. Population aging will only exacerbate this effect. As my colleague Mark McClellan pointed out in last month's edition of the Bank Credit Analyst, elderly people in advanced economies consume more than any other age cohort once government spending for medical care on their behalf is taken into account (Chart II-14).5 Our estimates suggest that population aging will reduce the household saving rate by five percentage points in the U.S. over the next 15 years (Chart II-15). The saving rate could fall as much as ten points in Germany, leading to the evaporation of the country's mighty current account surplus. As saving rates around the world begin to fall, real interest rates will rise. Chart II-13China's Very High Rate Of National Savings ##br##Will Face Pressure From Demographics China's Very High Rate Of National Savings Will Face Pressure From Demographics China's Very High Rate Of National Savings Will Face Pressure From Demographics Chart II-14 Chart II-15Aging Will Reduce ##br##Aggregate Savings Aging Will Reduce Aggregate Savings Aging Will Reduce Aggregate Savings The Two Reasons Reinforce Each Other The discussion above has focused on two reasons why chronically low productivity growth could lead to higher interest rates: 1) weak productivity growth could fuel inflation; and 2) weak productivity growth could deplete national savings, leading to higher real rates. There is an important synergy between these two reasons. Suppose, for example, that weak productivity growth does eventually raise the neutral real rate. Since central banks cannot measure the neutral rate directly and monetary policy affects the economy with a lag, it is possible that actual rates will end up below the neutral rate. This would cause the economy to overheat, resulting in higher inflation. Thus, if the first reason proves to be true, it is more likely that the second reason will prove to be true as well. The Technological Wildcard So far, we have discussed productivity growth in very generic terms - as basically anything that raises output-per-hour. In reality, the source of productivity gains can have a strong bearing on interest rates. Economists describe innovations that raise the demand for labor relative to capital goods as being "capital saving." Paul David and Gavin Wright have argued that the widespread adoption of electrically-powered processes in the early 20th century serves as "a textbook illustration of capital-saving technological growth."6 They note that "Electrification saved fixed capital by eliminating heavy shafts and belting, a change that also allowed factory buildings themselves to be more lightly constructed." In contrast, recent technological innovations have tended to be more of the "labor saving" than "capital saving" variety. Robotics and AI come to mind, but so do more mundane advances such as containerization. Marc Levinson has contended that the widespread adoption of "The Box" in the 1970s completely revolutionized international trade. Nowadays, huge cranes move containers off ships and place them onto waiting trucks or trains. Thus, the days when thousands of longshoremen toiled in the great ports of Baltimore and Long Beach are gone.7 If technological progress is driven by labor-saving innovations, real wages will tend to grow more slowly than overall productivity (Chart II-16). In fact, if technological change is sufficiently biased in favour of capital (i.e., if it is extremely "labor saving"), real wages may actually decline in absolute terms (Chart II-17). Owners of capital tend to be wealthier than workers. Since richer people save more of their income than poorer people, the shift in income towards the former will depress aggregate demand (Chart II-18). This will result in a lower neutral rate. Chart II-16U.S.: Real Wages Have Been ##br##Lagging Productivity Gains U.S.: Real Wages Have Been Lagging Productivity Gains U.S.: Real Wages Have Been Lagging Productivity Gains Chart II-17 Chart II-18Savings Heavily Skewed ##br##Towards Top Earners Savings Heavily Skewed Towards Top Earners Savings Heavily Skewed Towards Top Earners It is difficult to know if the forces described above will dissipate over time. Productivity growth is largely a function of technological change. We like to think that we are living in an era of unprecedented technological upheavals, but if productivity growth has slowed, it is likely that the pace of technological innovation has also diminished. If so, the impact that technological change is having on such things as the distribution of income and global savings - and by extension on interest rates - could become more muted. To use an analogy, the music might remain the same, but the volume from the speakers could still drop. Capital In A Knowledge-Based Economy Chart II-19Falling Capital Goods Prices Have Allowed ##br##Companies To Slash Capex Budgets Falling Capital Goods Prices Have Allowed Companies To Slash Capex Budgets Falling Capital Goods Prices Have Allowed Companies To Slash Capex Budgets Labor-saving technological change has not been the only force pushing down interest rates. Modern economies are transitioning away from producing goods towards producing knowledge. Companies such as Google, Apple, and Amazon have thrived without having to undertake massive amounts of capital spending. This has left them with billions of dollars in cash on their balance sheets. The price of capital goods has also tumbled over the past three decades, allowing companies to cut their capex budgets (Chart II-19). In addition, technological advances have facilitated the emergence of "winner-take-all" industries where scale and network effects allow just a few companies to rule the roost (Chart II-20). Such market structures exacerbate inequality by shifting income into the hands of a few successful entrepreneurs and business executives. As noted above, this leads to higher aggregate savings. Market structures of this sort could also lead to less aggregate investment because low profitability tends to constrain capital spending by second- or third-tier firms, while the worry that expanding capacity will erode profit margins tends to constrain spending by winning companies. The combination of higher savings and decreased investment results in a lower neutral rate. As with labor-saving technological change, it is difficult to know how these forces will evolve over time. The growth of winner-take-all industries has benefited greatly from globalization. Globalization, however, may be running out of steam. Tariffs are already extremely low in most countries, while the gains from further breaking down the global supply chain are reaching diminishing returns (Chart II-21). Perhaps more importantly, political pressures for greater income distribution, trade protectionism, and stronger anti-trust measures are likely to intensify. If that happens, it may be enough to reverse some of the downward pressure on the neutral rate. Chart II-20 Chart II-21The Low-Hanging Fruits Of ##br##Globalization Have Been Picked The Low-Hanging Fruits Of Globalization Have Been Picked The Low-Hanging Fruits Of Globalization Have Been Picked Investment Conclusions Is slow productivity growth good or bad for bonds? The answer is both: Slow productivity growth is likely to depress interest rates at the outset, but is liable to lead to higher rates later on. The U.S. has likely reached the inflection point where slow productivity is going from being a boon to a bane for bonds. Chart II-22 shows that the U.S. output gap would be over 8% of GDP had potential GDP grown at the pace the IMF projected back in 2008. Instead, it is close to zero and will likely turn negative if growth remains over 2% over the next few quarters. Other countries are likely to follow in the footsteps of the U.S. Chart II-22Output Gap Has Narrowed ##br##Thanks To Lower Potential Growth Output Gap Has Narrowed Thanks To Lower Potential Growth Output Gap Has Narrowed Thanks To Lower Potential Growth To be clear, productivity is just one of several factors affecting interest rates - demographics, globalization, and political decisions being others. However, as we argued in our latest Strategy Outlook, these forces are also shifting in a more inflationary direction.8 As such, fixed-income investors with long-term horizons should pare back duration risk and increase allocations to inflation-linked securities. Peter Berezin, Chief Global Strategist Global Investment Strategy 1 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 2 Dan Andrews, Chiara Criscuolo, and Peter N. Gal,"The Best versus the Rest: The Global Productivity Slowdown, Divergence across Firms and the Role of Public Policy," OECD Productivity Working Papers, No. 5 (November 2016). 3 Consider the widely-used Solow growth model. The model says that the neutral real rate, r, is equal to (a/s) (n + g + d), where a is the capital share of income, s is the saving rate, n is labor force growth, g is total factor productivity growth, and d is the depreciation rate of capital. All things equal, an increase in g will result in a higher equilibrium real interest rate. The same is true in the Ramsey model, which goes a step further and endogenizes the saving rate within a fully specified utility-maximization framework. In this model, consumption growth is pinned down by the so-called Euler equation. Assuming that utility can be described by a constant relative risk aversion utility function, the Euler equation states that consumption will grow at (r-d)/h where d is the rate at which households discount future consumption and h is a measure of the degree to which households want to smooth consumption over time. In a steady state, consumption increases at the same rate as GDP, n+g. Rearranging the terms yields: r=(n+g)h+d. Notice that both models provide a mechanism by which a higher g can decrease r. In the Solow model, this comes from thinking about the saving rate not as an exogenous variable, but as something that can be influenced by the growth rate of the economy. In particular, if s rises in response to a higher g, r could fall. Likewise, in the Ramsey model, a higher g could make households more willing to forgo consumption today in return for higher consumption tomorrow (equivalent to a decrease in the rate of time preference, d). This, too, would translate into a lower neutral rate. 4 Janet L. Yellen, "The U.S. Economic Outlook," Presentation to the Stanford Institute of Economic Policy Research, February 11, 2005. 5 Please see The Bank Credit Analyst, "Beware Inflection Points In The Secular Drivers Of Global Bonds," April 28, 2017, available at bca.bcaresearch.com. 6 Paul A. David, and Gavin Wright,"General Purpose Technologies And Surges In Productivity: Historical Reflections On the Future Of The ICT Revolution," January 2012. 7 Marc Levinson, "The Box: How the Shipping Container Made the World Smaller and the World Economy Bigger," Princeton University Press, 2006. 8 Please see Global Investment Strategy, "Strategy Outlook Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. III. Indicators And Reference Charts The breakout in the S&P 500 above 2400 in May has further stretched valuation metrics. Measures such as the Shiller P/E and price/book are elevated relative to past equity cycles. The price/sales ratio is in a steep rise too. However, our U.S. Composite valuation metric, which takes into consideration 11 different measures of value, is still a little below the one sigma level that marks significant overvaluation. This is because our composite indicator includes valuation measures that take into account the low level of interest rates. Of course, these measures will not look as favorable when rates finally rise. Technically, the U.S. equity market has upward momentum. Our Equity Monetary Indicator has remained around the zero line, meaning that it is not particularly bullish or bearish at the moment. Our Speculation Index is high, pointing to froth in the market. The high level of our Composite Sentiment Index and low level of the VIX speaks to the level of investor complacency. The U.S. net revisions ratio jumped higher this month, and it is bullish that the earnings surprise index advanced again. Our U.S. Willingness-to-Pay (WTP) indicator continues to send a positive message for the S&P 500, although it is now so elevated that it suggests that there could be little "dry powder" left to buy the market. This indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. The widening gap between the U.S. WTP and that of Japan and Europe highlights that recent flows have favored the U.S. market relative to the other two. Looking forward, this means that there is more "dry powder" available to buy the Japanese and European markets. A rise in the WTPs for these two markets in the coming months would signal that a rotation into Europe and Japan is taking place. It is disconcerting that our Europe WTP suffered a pull-back over the past month. Nonetheless, we believe that accelerating corporate profit growth in the major advanced economies provides a strong tailwind and suggests that stocks remain in a window in which they will outperform bonds. U.S. bond valuation is hovering close to fair value. However, we believe that fair value itself is moving higher as we have reached an inflection point in some of the structural forces that have depressed bond yields. We also believe that the combination of Fed balance sheet shrinkage and rate hikes will lead to higher bond yields than are currently discounted in the market. Technically, our composite indicator has touched the zero line, clearing the way for the next leg of the bond bear market. The dollar is very expensive on a PPP basis, although it is less so by other measures. Technically, the dollar has shifted down this year, crossing the 200-day moving average. That said, according to our dollar technical indicator, overbought conditions have been totally worked off, suggesting that the currency is clear to move higher if Fed rate expectations shift up as we expect. Moreover, we believe that policy divergence in the overall monetary policy stance between the U.S. on one side and the ECB and BoJ on the other will push the dollar higher. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-5U.S. Earnings U.S. Earnings U.S. Earnings Chart III-6Global Stock Market And ##br##Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-7Global Stock Market And ##br##Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-8U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-9U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-12U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-18Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-19Euro Technicals Euro Technicals Euro Technicals Chart III-20Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-21Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-23Commodity Prices Commodity Prices Commodity Prices Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-26Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-27U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-28U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-29U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-30U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-31U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-32U.S. Consumption U.S. Consumption U.S. Consumption Chart III-33U.S. Housing U.S. Housing U.S. Housing Chart III-34U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:

Highlights EM EPS has recovered, supporting the current rally. However, forward-looking indicators portend a reversal and potential renewed contraction in EM EPS. BCA's Emerging Markets Strategy team has a more pessimistic outlook than the BCA house view, which is upbeat on the prospects for China's capex growth and commodity prices. The ongoing liquidity tightening in China amid lingering credit excesses is bound to produce major negative growth surprises. The authorities will reverse the ongoing monetary tightening only if the pain on the ground becomes visible or the economic data deteriorates significantly. Financial markets will sell off considerably in advance. In Chile, take profits on the receiving 3-year swap rate trade; stay neutral on this bourse within an EM equity portfolio. Feature EM Profit Recovery: How Enduring? EM equities have not only advanced in absolute terms but have also outperformed developed market (DM) share prices considerably since early this year. This outperformance has been rationalized by a recovery in EM earnings per share (EPS). Indeed, EM EPS has revived briskly in recent months (Chart I-1A). Chart I-1AEM/China Profits Growth To Roll Over (I) EM/China Profits Growth To Roll Over (I) EM/China Profits Growth To Roll Over (I) Chart I-1BEM/China Profits Growth To Roll Over (II) EM/China Profits Growth To Roll Over (II) EM/China Profits Growth To Roll Over (II) For this rally to continue, EM EPS would need to continue to expand further. We do not expect this. On the contrary, our bet is that EM EPS growth will slow considerably later this year and most likely contract in early 2018. Our basis is that the growth (first derivative) and impulse (second derivative) of EM & Chinese narrow money (M1) has in the past led their respective profit cycle (Chart I-1A and Chart I-1B). If these relationships hold and EM EPS growth dwindles later this year, EM share prices should begin to sense it now, and start falling back very soon. Interestingly, EM EPS net revisions have failed to rise above the zero line despite the recent rebound in profits (Chart I-2, top panel). This is in contrast to DM EPS net revisions, which have surged well above zero (Chart I-2, middle panel). As a result, recent EM relative outperformance against their DM peers has occurred despite the drop in relative net EPS revisions (Chart I-2, bottom panel). This presages EM equity analysts are not revising upward their forward estimates for EM EPS, despite the ongoing rally in share prices. This is extremely puzzling (and rare) and may be a reflection of recent weakness in commodities prices - or the fact that expectations for EM EPS growth were already elevated. We do not place much emphasis on analysts' EPS revisions because the latter swing with stock prices - they have zero forecasting power for share prices. We highlight this fact simply to counter the common market narrative that EM corporate earnings growth expectations are improving, driving EM bourses higher. Bottom Line: EM EPS has recovered, supporting the current rally. However, forward-looking indicators portend a reversal and potential renewed contraction in EM EPS nine months ahead. Importantly, EM equity prices relative to DM shares are at a major technical juncture (Chart I-3). A decisive breakout would be a very bullish technical signal, whereas a failure to break out would be an important warning sign. We continue to bet on the latter. Chart I-2EPS Net Revisions: EM And DM EPS Net Revisions: EM And DM EPS Net Revisions: EM And DM Chart I-3Relative Equity Performance: EM Versus DM Relative Equity Performance: EM Versus DM Relative Equity Performance: EM Versus DM China's Credit Cycle And Commodities Redux Our overarching theme has been and remains that China is tightening liquidity amid a lingering credit bubble. This cannot end well for financial markets that are exposed China's growth. Here we revisit our rationale for a credit slowdown in China and its impact on EM. Chinese interest rates have risen dramatically since last November across the entire yield curve. The 3-month interbank rate and AA- on-shore corporate bond yields both have risen by about 200 basis points since November 1, 2016. Monetary policy works with a time lag, and higher interest rates warrant a slowdown in credit growth (Chart I-4). In turn, it takes only a deceleration in credit growth for the credit impulse - the second derivative of outstanding credit - to turn negative. The falling credit and fiscal impulse will consequently lead to a relapse in Chinese import volumes and EM EPS (Chart 5), in turn weighing on commodity prices and non-commodity producing countries like Korea and partially Taiwan. Mainland import volumes contracted mildly in the second half of 2015, as demonstrated in Chart I-5. De facto, from the perspective of the rest of the world, China was in mild recession in late 2015. Not surprisingly, global risk assets in general, and particularly those exposed to China, tumbled. Chart I-4China: Higher Rates Point To##br## Negative Credit Impulse China: Higher Rates Point To Negative Credit Impulse China: Higher Rates Point To Negative Credit Impulse Chart I-5China's Credit Impulse Heralds ##br##Slowdown In Its Imports China's Credit Impulse Heralds Slowdown In Its Imports China's Credit Impulse Heralds Slowdown In Its Imports We expect China import volumes to shrink again by the end of this year or early next. Some sort of replay of 2015 is a real possibility. The broad-based yet mild selloff in commodities since early this year (Chart I-6) amid weakness in the U.S. dollar exchange rate gives us confidence in our view. Chart I-6ABroad-Based Selloff In Commodities (I) Broad-Based Selloff In Commodities (I) Broad-Based Selloff In Commodities (I) Chart I-6BBroad-Based Selloff In Commodities (II) Broad-Based Selloff In Commodities (II) Broad-Based Selloff In Commodities (II) Our colleagues at BCA have attributed the selloff in commodities this year to deleveraging in China's shadow banking system, and to traders worldwide closing their long positions. They expect an improving commodities supply-demand balance to support prices going forward. It makes sense to us to explain the selloff in commodities as having been caused by deleveraging in China's shadow banking system. Yet to be consistent, we should also acknowledge that the rally in commodities last year was to a large extent driven by the same forces in reverse: non-commercial buyers (investors) buying commodities both in China and elsewhere. In short, this signifies there was little improvement in worldwide commodities demand last year. In 2016, rising commodities prices provided a significant boost to commodity-producing countries and underlying corporate profits - and ultimately EM risk assets. The drop in commodities prices this year, if sustained, should lead to the opposite dynamic: income/profits among commodities countries/companies will drop. As such, falling commodities prices amid diminishing investor demand for commodities is bearish for EM risk assets. Where we differ from the majority of our colleagues at BCA is that we expect Chinese credit growth to decelerate, thereby weighing on its capital spending and depressing demand for commodities (please refer to Chart I-5). We have written extensively1 on this topic and will not fully rehash our view that China's annual credit growth will decelerate from the current 12% to somewhere around 8% in the next 12-18 months. In short, China's corporate and household credit-to-GDP ratio cannot rise indefinitely from an already high level of 225% of GDP. Credit growth will likely downshift to a level of sustainable nominal GDP growth, which is probably around 8%. Our main disagreement with our colleagues on structural issues is as follows: we believe China's credit excesses are not a natural outcome of the nation's high savings rate but rather the outcome of a speculative credit boom driven by high-risk behavior among creditors and debtors.2 Tightening liquidity amid such speculative excesses creates a very bearish backdrop for risk assets exposed to China's credit cycle. The bullish camp on China has recently pointed to a strong recovery in mainland nominal GDP growth, which in their view suggests that double-digit credit growth in China is not excessive (Chart I-7). However, such a surge in nominal GDP growth has been due to the GDP deflator rising from zero in the fourth quarter of 2015 to 5% in the first quarter of this year. Importantly, the swings in the GDP deflator almost perfectly correlate with the fluctuation in commodities prices (Chart I-8). This proves how much China's economy is exposed to commodities cycles and how much of nominal GDP swings are stipulated by resource price swings. Chart I-7China: Credit And ##br##Nominal GDP Growth China: Credit And Nominal GDP Growth China: Credit And Nominal GDP Growth Chart I-8China's GDP Deflator Is Very Sensitive##br## To Commodities Prices China's GDP Deflator Is Very Sensitive To Commodities Prices China's GDP Deflator Is Very Sensitive To Commodities Prices As commodities prices decline, China's GDP deflator, producer prices and nominal GDP growth will all dwindle. Thereby, China's underlying steady state nominal GDP growth is probably around 8% at best (5.5-6% real growth), with inflation of 2-2.5% (assuming flat commodities prices). If this is indeed the case, corporate and household credit growth of 12% entails a further build-up of leverage and an escalating non-public credit-to-GDP ratio, which already stands at 225% of GDP: corporate debt is 180% and household debt is at 45% of GDP. Bank loans account for 70%, while shadow (non-bank) funding channels (corporate bonds, trust products, entrusted loans, and banker's acceptance) constitute 30% of outstanding non-public credit or 65% of GDP. Both are growing at an annual rate of 11-12.5% (Chart I-9). On the whole, the share of shadow banking is non-trivial and its current growth pace is unsustainable amid ongoing regulatory tightening and rising interest rates. Furthermore, banks are themselves exposed to shadow banking as their claims on non-depository financial institutions have risen exponentially from RMB 3 trillion to RMB 27 trillion over the past five years. In regard to non-standard credit assets,3 our estimates are that banks' off-balance-sheet exposure is RMB 10 trillion compared with RMB 18.3 trillion of their balance-sheet non-standard credit assets. The off-balance-sheet credit exposure to non-standard credit assets is much larger for medium and small banks than the largest five (Table I-1). We discussed these issues in greater detail in our June 15, 2016 Special Report titled "Chinese Banks' Ominous Shadow". Chart I-9Bank Loans And Non-Bank (Shadow) Credit Growth Bank Loans And Non-Bank (Shadow) Credit Growth Bank Loans And Non-Bank (Shadow) Credit Growth Chart I- With banks being forced by regulators to bring off-balance-sheet assets onto their balance sheets, their capital adequacy ratios will drop and their ability to sustain double-digit credit growth will be curtailed. Chart I-10Stay With Short Small / Long Large ##br##Banks Equity Trade Stay With Short Small / Long Large Banks Equity Trade Stay With Short Small / Long Large Banks Equity Trade The risks to medium and small banks is greater than to the large five banks. That is why we reiterate our recommendation from October 26, 2016 to short small banks versus large ones (Chart I-10). As a final note, we are often asked whether the government will provide a bail out if things deteriorate. Yes, we concur that policymakers will step in and backstop a financial system to preclude a systemic crisis. However, they are tightening now, and like the rest of us have little visibility. The authorities will meaningfully reverse the ongoing monetary tightening only if the pain on ground becomes visible or economic data deteriorate considerably. Financial markets will sell off materially in advance. Bottom Line: Investors should not be long China-plays, commodities and EM risk assets when mainland policy tightening is occurring amid lingering speculative credit excesses. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Strategy For Chilean Markets We recommended receiving 3-year swap rates on November 2, 2016 and this position has panned out with rates dropping by 30 basis points. We now recommend booking profits. The following has led us to conclude that the risk-reward profile of this position is no longer attractive: The improvement in narrow money (M1) growth points in a bottom in the economic activity indicator (Chart II-1). Mining production plunged amid the strikes in the world's largest copper producer Codelco (Chart II-2, top panel) and manufacturing production has also been contracting (Chart II-2, bottom panel). A period of improvement in mining and manufacturing output from a very low base is likely. Chart II-1Book Profits On Receiving ##br##3-Year Swap Rate Position Book Profits On Receiving 3-Year Swap Rate Position Book Profits On Receiving 3-Year Swap Rate Position Chart II-2Chile: Money And Economic##br## Activity Are Bottoming Out Chile: Money And Economic Activity Are Bottoming Out Chile: Money And Economic Activity Are Bottoming Out This will ameliorate overall business conditions and cause the central bank, at least for the time being, to halt the easing cycle. The pace of expansion in employment, wage growth, and consumer credit remains decent (Chart II-3). This will put a floor under household spending growth for now. Odds are that copper prices will decline meaningfully in the next nine months or so, which will cause the Chilean peso to depreciate. Although a depreciating currency will not to lead to materially higher interest rates in Chile, it will limit downside in local rate expectations. Finally, local 3-year swap rates and their spread over U.S. 3-year bond yields are extremely low from a historical perspective (Chart II-4). At this point, there is little value left in Chilean local rates. Chart II-3Chile's Mining And Manufacturing ##br##A Period Of Stabilization Ahead Chile's Mining And Manufacturing A Period Of Stabilization Ahead Chile's Mining And Manufacturing A Period Of Stabilization Ahead Chart II-4Chile: Consumer Spending##br## Is Holding Up Chile: Consumer Spending Is Holding Up Chile: Consumer Spending Is Holding Up Investment Conclusions Chart II-5Chilean Local Rates Spreads Over ##br##U.S. Treasurys: Not Much Value Left Chilean Local Rates Spreads Over U.S. Treasurys: Not Much Value Left Chilean Local Rates Spreads Over U.S. Treasurys: Not Much Value Left We do not expect the central bank to hike but the downside in local rates is limited for the time being. Take profits on the receiving 3-year swap rate trade. As to equities, the outlook for relative performance is balanced; we continue recommending a benchmark weight in Chile for dedicated EM equity portfolios. For absolute return investors, the risk-reward profile is not attractive because our profit margin proxy points to a relapse in corporate earnings (Chart II-5). Unit labor costs are rising faster than the core inflation rate, producing a profit margin squeeze (Chart II-5, bottom panel). Finally, we continue shorting the peso versus the U.S. dollar as a bet on lower copper prices. 1 Please refer to the Emerging Markets Strategy Special Reports titled, "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017, Misconceptions About China's Credit Excesses", dated October 26, 2016 and "China's Money Creation Redux And The RMB", dated November 23, 2016, available at ems.bcaresearch.com 2 Please refer to the Emerging Markets Strategy Special Reports titled, "The Great Debate: Does China Have Too Much Debt Or Too Much Savings?", dated March 23, 2017, "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017, "Misconceptions About China's Credit Excesses", dated October 26, 2016 and "China's Money Creation Redux And The RMB", dated November 23, 2016, available at ems.bcaresearch.com 3 Non-standard credit assets are banks' claims on corporates that are not classified as loans. For more details please refer to the Emerging Markets Strategy Special Report titled, "Chinese Banks' Ominous Shadow", dated June 15, 2016, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The risk asset friendly outcomes in the French and South Korean elections are the latest examples of fading geopolitical risk, and we expect that to continue over the remainder of 2017. Although it has been well over a year since the last 10% pullback, the U.S. equity market is not "due" for a correction. For many investors, the drop in commodity prices has replaced geopolitics as the most likely cause of the next equity market correction. What is Dr. Copper's diagnosis? We re-examine our Yield and Protector portfolios to find out which assets will hold up best if there is a correction. Many investors cite the monthly report on average hourly earnings as evidence that the Fed has it wrong on the economy and the labor market. We disagree. Feature U.S. stock prices remain within striking distance of their all-time highs and many investors continue to worry about the next correction. The risk asset friendly outcomes in the French and South Korean elections are the latest examples of fading geopolitical risk, and we expect that to continue over the remainder of 2017. The market has all but ignored the recent political turmoil in Washington. For many investors, the drop in commodity prices has replaced geopolitics as the most likely cause of the next equity market correction, while others note that it's been more than 15 months since the last 10%+ correction and that we are "due" for one. But is Dr. Copper still a reliable indicator of equity market tops? And if a correction is at hand, which assets would hold up best on the way down? We also review yet another disconnect between the Fed and the market: average hourly earnings. Geopolitical Risk Continues To Fade As A Market Concern Emmanuel Macron's victory was a resounding one as French voters rejected Le Pen's anti-Europe message in last week's election. Removing the possibility of a French President that is dedicated to exiting the eurozone is obviously positive for European stocks and investor risk appetite the world over. Next up are the two rounds of legislative elections in June. Polls are sparse, but they support the view that Macron's En Marche and the center-right Les Republicains will capture the vast majority of seats in the legislature. A Macron presidency supported by Les Republicains in the National Assembly would be a bullish outcome for investors, according to our geopolitical strategists. On the international stage - where the president has few constraints - France will be led by a committed Europhile willing to push Germany towards a more proactive policy. On the domestic stage - where the National Assembly dominates - Macron's cautiously pro-growth agenda will be pushed further to the right by Les Republicains. Such an election outcome would make possible the passage of genuine structural reforms that would suppress wage growth and make French exports more competitive. The presidential election result in South Korea last week was exactly what the market expected, and should help to reduce tensions on the Korean peninsula. For now, the situation in Washington around President Trump's firing of FBI Director Comey has not had a major impact on markets. If the Democrats win the House of Representatives in 2018, our geopolitical team believes that impeachment proceedings will begin against Trump. On one hand, this means that polarization in the U.S. is about to reach record-high levels. On the other, it should motivate the GOP to get tax reform done before it is too late. Bottom Line: Investors may be shocked into pricing greater odds of Euro Area dissolution when Italy comes back into focus, but that is a risk for 2018. We expect market-friendly policies emerging from Washington this year, although the Comey affair highlights that the road will be anything but smooth. Corrections And Pullbacks In Context Geopolitical risk appear to have faded for now, but with U.S. equities at or close to all-time highs, talk of a correction is hard to avoid. We continue to favor stocks over bonds this year and suggest that any sell-off in equities will be bought not sold. A hard landing in China, major disappointment on the Trump legislative agenda, a prolonged spell of weakness in the U.S. economic data1, and an overly aggressive Fed in 2017 may all serve as catalysts for a pullback. Above average PE ratios and measures of market volatility that are at cycle lows have only added to the chorus of those saying we are "due" for a correction. History suggests otherwise. From the end of WWII through 2009, the S&P 500 has experienced, on average, two 10% corrections and 10 corrections of 5% of more during equity bull markets. Since the start of the current bull market in March 2009 we've had 22 pullbacks of 5% or more and six corrections of more than 10% (using market closing prices) Table 1. This suggests that the market has seen its fair share of pullbacks and corrections since 2009, and isn't really "due". Chart 1 takes a different approach, but reaches the same conclusion. At 15 months (325 days) since the end of the last 10% correction, the current bull market is right of the middle of the pack of all bull markets since 1932. Table 1Six S&P 500 Corrections Of 10% Or More Since March 2009: We're Not "Due" Still Awaiting The Next Pullback Still Awaiting The Next Pullback Chart 1Current Equity Bull Market Is Not Long In The Tooth Still Awaiting The Next Pullback Still Awaiting The Next Pullback Our view remains that any pullback in U.S. equities will be bought, not sold, and we favor stocks over bonds in 2017. There are few notable imbalances in the U.S. or global economies and we see an acceleration in both over the remainder of 2017. The Fed will raise rates gradually this year, and there is general agreement between the Fed and the market on the pace of hikes at least for 2017. The Fed and the market remain far apart on hikes in 2018. Our view of the economy and labor market suggests that the market will ultimately move toward the Fed's view. The U.S. corporate earnings outlook remains solid, after a very good Q1 earnings season and favorable guidance for Q2 2017 and beyond. Bottom Line: Equity pullbacks - even during bull markets - are normal and healthy. We do not believe that the market is especially "overdue" for a pullback, but when the inevitable pullback or correction occurs, we expect that investors will take the opportunity to add to equity positions and not turn the pullback into a bear market. Dr. Copper? Chart 2Metals Prices Are Rolling Over...##BR##But Is It A Signal? Metals Prices Are Rolling Over... But Is It A Signal? Metals Prices Are Rolling Over... But Is It A Signal? The recent setback in the commodity pits has added to investor angst regarding global growth momentum. The LMEX base metals index is up almost 20% on a year-ago basis, but has fallen by 8% since February (Chart 2). From their respective peaks earlier this year, zinc and copper are down about 10%, nickel has dropped by 22% and iron ore has lost almost half of its value. Is the venerable "Dr. Copper" sending an important warning about world growth? Some of our global leading economic indicators have edged lower this year, as we have discussed in recent Weekly Reports. Nonetheless, the decline in base metals prices likely has more to do with other factors, such as an unwinding of the surge in speculative demand that immediately followed the U.S. election last autumn. Speculators may be disappointed by the lack of progress on Republican promises to cut taxes and boost infrastructure spending. The main story for base metals demand and prices, however, is the Chinese real estate sector. China accounts for roughly 50% of world consumption for each of the major metals. The Chinese authorities are trying to cool the property market and transition to a more consumer spending-oriented economy, thereby reducing the dependence on exports, capital spending and real estate as growth drivers. Fiscal policy tightened last year and new regulations were introduced to limit housing speculation. The effect of policy tightening can be seen in our Credit and Fiscal Spending Impulse indicator, which has been softening since mid-2016 (Chart 3). The economy held up well last year, but the policy adjustment resulted in a peaking of the PMI at year-end. Growth in housing starts also appears to be rolling over (annual growth is shown on a 12-month moving-average basis in Chart 4 because of the extreme volatility in the series). Both the PMI and housing starts are correlated with commodity prices. Chart 3China is The Main Story##BR##For Base Metals Demand China is The Main Story For Base Metals Demand China is The Main Story For Base Metals Demand Chart 4Direct Fiscal Spending And Infrastructure##BR##Have Picked Up Recently Direct Fiscal Spending And Infrastructure Have Picked Up Recently Direct Fiscal Spending And Infrastructure Have Picked Up Recently The good news is that BCA's China Investment Strategy service does not expect a major downshift in Chinese real GDP growth this year, which means that commodity import demand should rebound: Chart 5Dr. Copper Is Not Signaling##BR##A Slowdown in Global Growth Dr. Copper Is Not Signaling A Slowdown in Global Growth Dr. Copper Is Not Signaling A Slowdown in Global Growth There is no incentive for the authorities to crunch the economy given that consumer price inflation is still low and the surge in producer price inflation appears to have peaked. Monetary conditions have tightened a little in recent months, but overall conditions are not restrictive. Moreover, both direct fiscal spending and infrastructure investment have picked up noticeably in recent months (Chart 4). Export growth will continue to accelerate based on our model (not shown). The upturn in the profit cycle and firming output prices should boost capital spending. Robust demand will ensure that housing construction will continue to grow at a healthy pace. Households' home-buying intentions jumped to an all-time high last quarter. Tighter housing policies in major cities will prevent a massive boom, but this will not short-circuit the recovery in housing construction. This all adds up to a fairly benign outlook for base metals. Our commodity strategists do not see the conditions for a major bull or bear phase on a 6-12 month horizon. Within commodity portfolios, they recommend a benchmark allocation to base metals, an underweight in agricultural products and an overweight in oil. We intend to update our view on oil prices in the May 22, 2017 edition of this report. Bottom Line: From a broader perspective, our key message is that "Dr. Copper" is not signaling that global growth will soften significantly this year. Chart 5 highlights that the LMEX base metals index has a high positive correlation with the U.S. stock-to-bond total return ratio on a daily change basis. However, in terms of trends and turning points, base metals are far from a reliable indicator for the stock-to-bond ratio. Where To Hide In A Stock Market Correction Over the past several years, BCA's U.S. Investment Strategy service has periodically recommended that investors add a variety of investments as portfolio "insurance" to help guard against the possibility of a material correction in equities. More recently, we have highlighted two specific forms of insurance: our yield and protector portfolios. We last discussed the protector portfolio in the October 17, 2016 and November 7, 2016 Weekly Reports2, and in today's report we revisit the issue by comparing both portfolios to a more common form of insurance: shifting from cyclical to defensive stocks within an equity allocation. Charts 6, 7, and 8 show a breakdown of the relative performance of S&P 500 defensives along with our yield and protector portfolios. Panels 2 and 3 of Charts 6, 7 and 8 present the rolling 1-year beta and alpha of each strategy vs. the S&P 500. Here, we present alpha as the difference between the actual year-over-year excess return of the portfolio (vs. short-term Treasury bills) and what would have been expected given the portfolio's beta. This measure is sometimes referred to as "Jensen's alpha". Chart 6A Modestly Low-Beta Option A Modestly Low-Beta Option A Modestly Low-Beta Option Chart 7A Lower Beta Than Defensives A Lower Beta Than Defensives A Lower Beta Than Defensives Chart 8A Negative Beta, And Positive Alpha A Negative Beta, And Positive Alpha A Negative Beta, And Positive Alpha There are several noteworthy observations from the charts: Based on the historical beta of the three portfolios vs. the S&P 500, defensive stocks are the most correlated with the overall equity market. Our protector portfolio has a negative correlation to the broad market, and our yield portfolio is somewhere in between, with a positive but relatively low beta. This is consistent with the equity composition of the three portfolios (shown in Table 2); with our protector portfolio composed entirely of non-equity assets. Table 2A Breakdown Of Three##BR##Portfolio Insurance Options Still Awaiting The Next Pullback Still Awaiting The Next Pullback After accounting for their lower beta, all three portfolios have tended to outperform the S&P in risk-adjusted terms since the onset of the global economic recovery. But this outperformance has been more significant for our yield and protector portfolios: the top panel of Charts 7 and 8 highlight that both portfolios have generated essentially the same return as equities have since the end of the recession (since the relative profile has been flat), despite exhibiting considerably less volatility than stocks. All three portfolios have experienced a relative decline vs. the S&P 500 since the election, but this has largely occurred due to passive rather than active underperformance. In other words, they have underperformed due to a failure to keep up with the S&P 500 rather than because of losses in absolute terms. There are two important conclusions from Charts 6, 7 and 8 for U.S. multi-asset investors. First, the lower beta of our yield and protector portfolios compared with S&P defensives means that the former represent a better insurance bet against a sell-off in the equity market than the latter. Second, the persistently positive volatility-adjusted returns for our insurance portfolios highlights an investor preference for these assets over the past few years, which is likely to persist over the coming 6-12 months. But investors should also recognize that this preference could eventually be subject to a reversal if the long-term economic outlook significantly improves, an event that could be catalyzed either by organic economic developments or policy decisions by the Trump administration. For now, our investment bias towards equities over government bonds makes us less inclined to favor a low beta position within a balanced portfolio. But our analysis suggests that clients who anticipate the need for portfolio insurance over the coming year should favor our yield and protector portfolios over a defensive sector allocation within an equity portfolio, and we are likely to recommend an allocation to these portfolios for all clients were we to see any material progression towards the sell-off triggers that we identified earlier in the report. Bottom Line: Investors seeking some protection against a potential equity market sell-off should favor our yield and protector portfolios over defensive sector positioning. We do not currently recommend these portfolios for all clients, but we are likely to do so if our key sell-off trigger "red lines" are breached. What's Up With Wage Growth? On the surface, the April jobs report-released in early May seemed to send mixed signals to investors and the Fed about the health of the labor market3. Our view remains that the economy is growing fast enough to tighten the labor market, push up wages and ultimately inflation, which will lead the Fed to raise rates twice more in 2017. But even though the economy is very close to full employment and the output gap has nearly closed, patience is required. Although it's a close call, the next hike is likely to come next month. Markets remain somewhat skeptical of this view, and have only priced in 39 bps of tightening by the end of the year, and have not yet fully priced in a June rate hike. The lack of wage growth (up just 2.5% year-over-year in April according to average hourly earnings (AHE)) remains a key source of the market's skepticism about the pace and timing of Fed rate hikes. Many investors cite the monthly report on average hourly earnings as evidence that the Fed has it wrong on the economy and the labor market. Does the Fed see something the market does not? Or is it the other way around? Markets tend to focus on data that are timely. That requirement certainly fits the AHE. The monthly wage measure is the most timely data point on labor compensation. While timeliness is an important factor when assessing the health of the labor market, it is also critically important to watch what the Fed watches. Investors should note that the AHE data is only one of at least four measures of labor compensation the Fed mentions in its Semi Annual Monetary Report to Congress. Since Fed Chair Yellen took office in 2014, the Fed has specifically referenced (and charted together) three measures of labor compensation in the report: Average hourly earnings Employment Cost Index and Compensation per Hour in the nonfarm business sector, and Chart 9The Fed Tracks All Four Of##BR##These Compensation Measures The Fed Tracks All Four Of These Compensation Measures The Fed Tracks All Four Of These Compensation Measures The Atlanta Fed's Wage Tracker was mentioned in the June 2016 Monetary Policy Report, and the Fed added it to the chart of the other three metrics in the most recent report, released in February 2017. As Chart 9 shows, all have moved higher in recent years, although it is clear that AHE has lagged the others. Given the attention it receives in the financial news media on and just after "Employment Friday" each month, it may surprise investors to learn that neither AHE nor wages were directly mentioned in any of the FOMC statements since Yellen took charge. However, wage growth (or lack thereof) has been a topic of discussion at all but a few of the 13 post FOMC press conferences Yellen has held. When asked about wages, she is careful to note that the Fed watches a wide range of indicators of labor compensation, but has lamented the lack of progress on wages. In her most recent press conference, Yellen noted that "I would describe some measures of wage growth as having moved up some. Some measures haven't moved up, but there's some evidence that wage growth is gradually moving up, which is also suggestive of a strengthening labor market." Average hourly earnings are routinely mentioned in the FOMC minutes, but only alongside mentions of the other metrics noted above. On balance, average hourly earnings are viewed by the Fed - and therefore should be viewed by the market - as one of several indicators of the health of the labor market, but not the only indicator. Chart 10 shows that only a third of industries have seen an acceleration in wage increases over the past year, which supports the market's view that the economy is not growing quickly enough to push up wages and inflation. A recent report by the Kansas City Fed4 takes a different view. Using a bottom-up approach, the author points out that only a few industries (mostly in the goods producing sector of the economy) have accounted for much of the rise in wages, notably manufacturing, construction and wholesale trade. Financial services, retail trade, professional and business services and leisure and hospitality - all service sector industries - have been the laggards. The study done by the economists at the Kansas City Fed shows that although earnings growth has lagged in those more service-oriented industries since 2015, hours worked have seen faster growth than in the mainly goods producing sector (chart not shown). This suggests to the author - and we concur - that labor demand has been strong in the past few years in areas that have not seen much wage growth. As the labor market continues to tighten, wages in these industries may accelerate, but patience may be required. Chart 11 shows that it takes two to three years after a bottom in the output gap for a decisive turn higher in ECI or AHE. While this cycle has seen a more shallow recovery - especially in AHE - both have moved higher since the output gap bottomed out in 2009/2010. Chart 10Only 33% Of Industries Have Seen##BR##Wage Acceleration Over The Past 12 Months Only 33% Of Industries Have Seen Wage Acceleration Over The Past 12 Months Only 33% Of Industries Have Seen Wage Acceleration Over The Past 12 Months Chart 11Measures Of Labor Compensation Move##BR##Higher After Output Gap Bottoms Out Measures Of Labor Compensation Move Higher After Output Gap Bottoms Out Measures Of Labor Compensation Move Higher After Output Gap Bottoms Out Bottom Line: Investors are always wise to watch what the Fed watches. The evolution of wage growth will be critical to FOMC policymakers, because a clear acceleration will confirm that the economy is truly at full employment and, thus, at risk of overheating. We do not expect a surge in wages, but a steady upward trend will keep the Fed on a gradual tightening path. 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 Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report "Growth, Inflation And The Fed", dated May 8, 2017, available at usis.bcaresearch.com. 2 Please see U.S. Investment Strategy Weekly Reports "Portfolio Insurance: What, How, When?", dated October 17, 2016 and "Policy, Polls, Probability", dated November 7, 2016, both available at usis.bcaresearch.com. 3 Please see U.S. Investment Strategy Weekly Report "Growth, Inflation And The Fed" dated May 8, 2017, available at usis.bcaresearch.com. 4 See "Wage Leaders and Laggards; Decomposing the Growth in Average Hourly Earnings" The Macro Bulletin, February 15, 2017; Federal Reserve Bank of Kansas City.

Highlights Chart of the WeekCopper Term Structure, Inventories##br## Are Not Reflecting Scarcity Copper Term Structure, Inventories Are Not Reflecting Scarcity Copper Term Structure, Inventories Are Not Reflecting Scarcity Transitory supply disruptions and financial demand have kept copper prices buoyant, but these influences will wane. A surge in inventories (Chart of the Week), coupled with slower Chinese demand growth as reflationary policies wind down, will prevent a sharp rally in copper prices. A stronger USD also will weigh on base metals in general, copper in particular. Energy: Overweight. We continue to expect oil inventories to draw throughout the rest of this year and next and are positioned for a backwardated forward curve in WTI. We are adding to our long Dec/17 vs. short Dec/18 WTI spread, which, as of our Tuesday mark to market, is up 183.33% since it was elected on Mar 13/17, and going long Dec/17 Brent vs. short Dec/18 Brent position basis tonight's close, as a strategic position. We also are adding a tactical position in WTI, buying $50/bbl calls vs. selling $55/bbl calls for July, August and September delivery basis tonight's close. Base Metals: Neutral. We remain neutral base metals longer term. Transitory supply disruptions in copper markets will subside, while reflationary stimulus in China will wane, keeping a lid on prices near term (see below). Precious Metals: Neutral. Gold rallied 3.7% following the Fed's rate hike last week. We expect this to reverse as the Fed ratchets up its hawkish rhetoric. Our long volatility position in gold - i.e., long a June put spread vs. long a June call spread - is down 27.5%, following the post-FOMC meeting rally. Ags/Softs: Underweight. We remain bearish, and are comfortable on the sidelines going into the month-end planting-intentions report from the USDA. Higher output of corn and beans in South America and a well-supported USD keep us bearish. Feature Actions taken by Chinese policymakers to slow the property market, wind down reflationary policies, and resume the pivot to services- and consumer-led growth will be critical to the evolution of copper demand, hence prices. Near term, we expect transitory supply disruptions in key mines in Chile, Peru and Indonesia will be addressed, and ore output will be restored. A stronger USD will present a headwind to copper demand, and will lower local production costs in Chile, Peru, Indonesia and elsewhere. Supply And Demand Shocks In the short-term (i.e. 2-3, months), copper prices should remain supported by the disruptions at Escondida in Chile, Grasberg in Indonesia, and more recently at Peru's biggest mine, Cerro Verde. Additionally, flooding in Peru is disrupting copper mining and transport operations beyond Cerro Verde, forcing the declaration of force majeure. BHP Billiton's third meeting with union officials at its Escondida mine failed to end to the strike. This is the world's largest mine - producing ~ 1.1mm MT/yr, or 5% of world supply. Escondida hasn't produced any copper since the strike began on Feb 9/17. This has reduced Chilean copper output 12% yoy as of February, and reduced Chile's GDP by ~ 1%. Unions this week showed interest in resuming talks with management, however. A settlement between PT Freeport Indonesia (PT-FI) and the Indonesian government re export permitting for Grasberg output has yet to materialize. PT-FI produced ~ 500k MT last year. As of this week, PT-FI restarted producing around 40% of its capacity. Lastly, strike action at the Cerro Verde mine is set to end today by order of the Peruvian government, but union officials said the strike would resume Friday if no agreement is reached with management. Cerro Verde produced ~ 500k MT of copper last year; the mine currently produces 50% of its capacity, after replacement workers were hired by the company. The lost output of these three mines accounts for ~ 10% of the global copper mine output. These developments clearly represent a transitory, albeit unexpected, supply shock with effects that should start to dissipate as these issues are resolved. It is worthwhile noting that copper is trading lower in the wake of this news, suggesting markets either prepared for labor action ahead of time - building precautionary inventories ahead of the labor-contract negotiations now underway - or that demand growth is slowing. We think a combination of both likely explains the price weakness following the transitory supply disruptions noted above. On the demand side, any optimism about rising copper prices due to an expected $1 trillion fiscal package in the U.S. is misplaced. Indeed, increased U.S. infrastructure spending - a largely unknown demand-side factor in terms of its details and dimensions - does not figure prominently in our assessment of future copper and based metals prices. The U.S contribution to global copper demand, and to base metals consumption in general, remains limited and has been decreasing in the last decades. U.S. copper demand now represents ~ 7.5% of world copper demand. Therefore, the U.S. market has a relatively small influence on copper prices compared to China, which accounts for close to 50% of global demand (Chart 2A and Chart 2B). Chart 2AU.S. Copper Consumption Pales Relatively To China U.S. Copper Consumption Pales Relatively To China U.S. Copper Consumption Pales Relatively To China Chart 2B U.S. Copper Consumption Pales Relatively To China U.S. Copper Consumption Pales Relatively To China We believe recent run-up in copper prices mainly was due to financial demand rather than physical demand (Chart 3). This elevated demand from financial investors could elevate price volatility, as any new fundamental information that provokes a sudden change in the copper outlook - e.g., faster restart to once-sidelined production, say, at Glencore's Katanga Mining facilities in the DRC, which are scheduled to be back on line later this year and next - could lead to an exodus of investors out of their long positions. Copper ETF holdings and copper open interest have been elevated in past weeks, and can have a significant effect on the evolution of copper prices (Chart 4).1 Prices have started to trend lower, a development that bears watching, given the still-high speculative holdings of the red metal. Chart 3Speculators Are Exiting Copper, ##br##Even As Supply Disruptions Mount Speculators Are Exiting Copper, Even As Supply Disruptions Mount Speculators Are Exiting Copper, Even As Supply Disruptions Mount Chart 4China PMI Vs. Copper Net Speculative Positions: ##br##Spec Positioning Matters For The Red Metal China PMI Vs. Copper Net Speculative Positions: Spec Positioning Matters For The Red Metal China PMI Vs. Copper Net Speculative Positions: Spec Positioning Matters For The Red Metal Global Copper Fundamentals Keep Us Neutral Looking at the next 6 to 12 months, we see no clear evidence to be bullish copper given supply-demand fundamentals. On the supply side, Australia's Department of Industry, Innovation and Science (DIIS) estimates mine output will be up 3.1% this year to 21mm MT - roughly in line with our estimates - and 4.1% next year to 21.8mm MT. Refined output hit a record high of almost 23.6mm MT last year, and is expected to increase 2.5% next year to 24mm MT. By 2018, the DIIS expects refined output to be up 4%, at 25mm MT. Large production gains were reported by the International Copper Study Group (ICSG) for Peru, where mine output was up 38% at 650k MT last year, offsetting lower mine production in Chile, where output was down 3.8% to 220k MT. Global production estimates by the DIIS for 2016 were in line with ICSG estimates for both mine production and world refined production. The ICSG estimates were released earlier this week. Global demand was up 3% last year at 23.4mm MT, and is expected to increase 2% this year to 24mm MT and 3% next year to 24.6mm MT, based on DIIS's estimates. These estimates also are in line with the ICSG's assessment of global sage. The ICSG estimated global demand last year was up ~ 2%. As is apparent, global supply and demand for copper have been, and will remain, relatively balanced this year and next (Chart 5).2 This will be supported by countervailing fundamentals: Global economic activity is picking up, especially in the manufacturing sectors of major economies, which will be supportive for copper prices (Chart 6); and, running counter to that, A strong USD, coupled with inventories at close to 3-year-high levels, will keep copper prices from escalating dramatically.3 Chart 5Global Copper Market Is Balanced Global Copper Market Is Balanced Global Copper Market Is Balanced Chart 6Global Growth Synchronization Is Underway Global Growth Synchronization Is Underway Global Growth Synchronization Is Underway China's Reflationary Policies Will Wind Down While reflationary policies launched over the past couple of years will continue to stimulate the Chinese economy in 2017, the fiscal and monetary impulses from them are waning. China's manufacturing sector, fixed-asset investment and the property sector are expected to stay strong during the first half of the year, which will support copper demand (Chart 7). However, this stimulus is winding down, and, following the 19th National Congress of the Communist Party in the autumn, we expect it to decline at a faster pace: These lagged effects of the wind-down of fiscal and monetary stimulus will be apparent - particularly in the property markets. Policymakers likely will reduce and re-direct policy stimulus to support consumer- and services-led growth, and continue to invest in the country's electricity grid, which accounts for about a third of China's copper demand. Net, demand likely will grow, but at a slower pace. Global copper inventories are now at an elevated level, which suggests there is no alarming scarcity in the market. This is corroborated by the contango observed in the copper futures market (Chart of the Week). An important takeaway from last week's People's Congress is that the main objective of Premier Li's work plan is to maintain economic and social stability. This primary objective is now more important than the Communist's Party's growth objective, and can be seen in the lower GDP growth target approved by policymakers (6.5%) going forward. The Chinese fiscal impulse already has started to roll over - government expenditures are now growing at a rate of close to 7.5% versus a peak of 29% in Nov/15 (Chart 8). This poses a risk to the downside for base metals prices, given that much of China's base-metals demand is dependent on government expenditures. Chart 7Fixed Asset Investments Are Resilient Fixed Asset Investments Are Resilient Fixed Asset Investments Are Resilient Chart 8Expansionary Chinese Fiscal Policy Is Slowing Down Expansionary Chinese Fiscal Policy Is Slowing Down Expansionary Chinese Fiscal Policy Is Slowing Down Chart 9China Might Have Reached A Sustainable Growth Path China Might Have Reached A Sustainable Growth Path China Might Have Reached A Sustainable Growth Path That said, recent data from China showing resilient industrial activity and fixed-asset investments despite the roll-over in government expenditures gives hope the economy reached a sustainable growth path and that it will stay buoyant throughout the year (Chart 9). China's Red-Hot Property Market Will Cool China's housing sector has, since the economy's liberalization in the late 1990s, grown into one of the most important drivers of its GDP. Most of the 2002 - 2010 increase in base metal prices - nearly 85% - can be explained by the spectacular growth in the Chinese housing sector.4 Building construction accounts for close to 45% of total copper consumption in China (Chart 10). Within that, residential construction makes up 70% of China's real estate investment, according to Australia's DIIS.5 Globally, China accounts for a third of the copper used in construction, according to the CME Group.6 This equates to ~ 10% of global copper usage. Chart 10Building Construction Is Crucial For Copper Demand Copper's Price Supports Are Fading Copper's Price Supports Are Fading In 2016, the Chinese real estate sector experienced extremely high growth, which was mainly fueled by easy access to credit, interest-rate cuts, easing of mortgage rules and an income effect from reflationary policies. This tendency reversed in late 2016 - early 2017, as can be seen in Chart 11. Looking forward, the evolution of the housing market will rely heavily on the policy path taken by the Chinese government. In the second half of 2016, the high level of speculative demand apparent in the property market red-flagged Chinese authorities that a price bubble was developing, producing an inflated debt load that posed a risk to future economic growth. President Xi repeatedly affirmed that China's priority going forward will be to keep the economy stable. This implies keeping the property market stable by nudging investment behavior and expectations to control the supply-side of the market. This is reflected in President Xi statement: "houses are for living in, not for speculating" during the recent Peoples Congress.7 Chinese authorities will maintain loan restrictions and stricter selling conditions implemented late last year, for first- and second-tier cities, where prices increased dramatically. First-tier newly constructed residential building prices were up on average by 18% year-on-year in February 2017, and the National Bureau of Statistics of China's sales price index of residential buildings in 70 large and medium-sized cities was up 11.3% in 2016. For other cities - where home inventories are still elevated and prices are relatively stable - the government could keep its facilitating policies in place, to encourage consumption and to draw down inventories of unsold homes. These developments will introduce downside risk to copper prices, given the importance of Chinese residential construction. Still, the Chinese government cannot allow real estate prices to drop suddenly, or even to slow too much, given that housing remains the main savings vehicle - directly or indirectly - for households. According to Xi and Jin (2015), Chinese citizens save around 70-80% of their wealth via the property market. It is true that financial innovation and the opening of Chinese financial markets should help households save using alternative strategies. However, changing households' savings behavior is not an instantaneous process. Moreover, we believe reflationary policies in other sectors of the economy will remain accommodative during the first half of the year, as headline and core inflation are still at relatively low levels (Chart 12). And, as mentioned previously, we expect continued investment in China's power grid, which will support copper prices this year and next. As the consumer economy grows, we would expect demand for electricity to continue to grow. Chart 11China's Property Market Peaked In 2016 China's Property Market Peaked In 2016 China's Property Market Peaked In 2016 Chart 12Inflation Close To Six-Year Lows Inflation Close To Six-Year Lows Inflation Close To Six-Year Lows Bottom Line: Combining these opposing effects, Chinese demand should remain high enough to maintain copper prices at a relatively stable level in 2017. However, following the 19th Communist Party later this year, we expect reflationary stimulus to wind down and for fiscal and monetary policy to be directed to supporting consumer- and services-led growth, which is less commodity intensive than heavy industrial and investment-led growth. We strongly believe the Communist Government will strengthen its focus on stronger enforcement of environmental regulations, which will introduce new supply-demand dynamics to the copper market. We will be exploring the "greening" of China in subsequent research, and its implications for base metals demand. Hugo Bélanger, Research Assistant Commodity & Energy Strategy hugob@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 We found that year-on-year variations in copper prices and in speculative long open interest exhibit a feedback loop - there is two-way Granger causality between them (i.e., they are endogenously related and each of their lagged values explain variation in the other's current price). The causality is stronger from copper prices to speculative long open interest; however, it also is significant the other way around. This means that in period of high speculative interest in copper - similar to what we experienced following the U.S. presidential election in late 2016 - the open interest variable is actually driving copper prices in the short term. We have also been able to explain copper prices by modeling year-on-year percentage change in the broad U.S trade-weighted index (TWI), Chinese PMI and in speculative long open interest. We find a 1% increase in the yoy speculative long open interest leads to a 0.19% increase in yoy copper prices. The adjusted R2 of the regression is 0.84. 2 The ICSG estimated there was a 50k MT deficit last year, trivial in a 23.4mm MT market. 3 We estimated the long-term relationship between copper prices, china PMI, world copper consumption and the U.S. TWI using a cointegrating regression. Interestingly, we found that, in equilibrium, a 1% increase in the China PMI variable translates to a 1.17% increase in copper prices. This relation can obviously be thrown out of equilibrium following an exogenous shock to the fundamentals of any of the variables in the model. The adjusted R2 of the regression is 0.71. 4 Please see "The Evolution of The Chinese Housing Market and Its Impact on Base Metal Prices," published by the Bank of Canada, March, 2016. It is available at http://www.bankofcanada.ca/wp-content/uploads/2016/03/sdp2016-7.pdf. Using an approach that accounts for the uncertainty around the official data, the lack of consistency in the data and the high level of seasonality and volatility in the data, the authors concluded that the Chinese GDP would have been around 9% lower at the end of 2010 in a scenario in which the housing market did not grow after 2002. Following this, they estimated two vector-error-correction models (VECM), one with the actual level of global activity, and one where the Chinese activity is 9% lower. 5 Please see "China Resources Quarterly" published by Australia's DIIA. It is available at https://industry.gov.au/Office-of-the-Chief Economist/Publications/Documents/crq/China-Resources-Quarterly-Southern-autumn-Northern-spring-2016.pdf 6 Please see "Copper: Supply and Demand Dynamics," published by the CME Group January 27, 2016. 7 Please see "Xi says China must 'unswervingly' crackdown on financial irregularities" published by Reuters. It is available at http://ca.reuters.com/article/businessNews/idCAKBN1671A0 Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016

Highlights Global manufacturing inventories are low but this does not guarantee higher share prices for global cyclical stocks. If an increase in inventories is accompanied by strengthening final demand, it will be very bullish for the global business cycle. If final demand growth falters, global cyclical plays will relapse amid rising inventories. China's inventory depletion has been due to the large fiscal and credit impulse in the past 12 months - i.e., improving final demand has been instrumental to inventory shedding. Looking forward, the mainland's aggregate credit and fiscal impulse seems to have topped out raising the odds of a reversal in EM/China plays sooner than later. The risk/reward of EM/China plays remains unattractive. Feature Global Manufacturing Inventories Global manufacturing inventories have been depleted over the past 12 months, and inventory levels are generally low (Chart I-1 and Chart I-2). Chart I-1Global Manufacturing Inventories Are Low Global Manufacturing Inventories Are Low Global Manufacturing Inventories Are Low Chart I-2Global Manufacturing Inventories Are Low Global Manufacturing Inventories Are Low Global Manufacturing Inventories Are Low Could inventory re-stocking extend the current manufacturing cycle recovery worldwide? Will low inventories and re-stocking in China lengthen the nation's business cycle upswing? Chart I-3 demonstrates inventory cycles and manufacturing production within manufacturing-intensive economies. The correlation is not stable. Currently, this entails that low manufacturing inventories and a potential rise in inventories over the course of this year do not guarantee acceleration in industrial output growth. Having reviewed manufacturing inventory cycles and their correlation with share prices, we conclude that the key to share prices is final demand - not inventory swings. Manufacturing inventories have dropped in the past 12 months because final demand has been robust (Chart I-4). Historically, periods of re-stocking have often coincided with poor equity market performance. Indeed, Taiwanese, Korean, Japanese and German non-financial share prices have no stable correlation with their respective manufacturing inventory cycles (Chart I-5). In short, manufacturing inventories could rise in the months ahead, but this does not guarantee higher share prices in cyclical industries. Chart I-3Inventories And Production ##br##Are Not Always Correlated Inventories And Production Are Not Always Correlated Inventories And Production Are Not Always Correlated Chart I-4Robust Demand Has Led ##br##To Inventory Depletion Robust Demand Has Led To Inventory Depletion Robust Demand Has Led To Inventory Depletion Chart I-5Non-Financial Share Prices And##br## Inventories: Little Correlation Non-Financial Share Prices And Inventories: Little Correlation Non-Financial Share Prices And Inventories: Little Correlation By and large, the outlook for corporate profits is contingent on final demand rather than re-stocking. All of the above confirms that inventories are a residual of demand and supply. Stronger-than-expected demand is bullish for share prices, though it also often coincides with declining inventories. By contrast, rising inventories typically reflect demand falling behind output growth (one can define it as involuntary re-stocking) and these periods are not favorable for share price gains in cyclical industries. One caveat is that there could be a re-stocking cycle amid strengthening demand or, in other words, voluntary re-stocking. If this transpires in the coming months, it will be extremely bullish for share prices as it will supercharge output growth. While the latter scenario - inventory re-stocking amid strengthening final demand - could very well occur within the advanced economies this year, odds of such positive dynamics are low in EM/China. Bottom Line: Share prices in global cyclical sectors are driven by swings in final demand - not in inventories. Going forward, global manufacturing inventories will rise. If this rise is accompanied by strengthening demand, it will be very bullish for the global business cycle. Otherwise, global cyclical plays will relapse as inventories rise. What Drives China's Inventory Cycles Chart I-6 shows that China's manufacturing inventories typically deplete when the credit and fiscal impulse is rising, and vice versa. China's manufacturing inventories have been exhausted because demand has been strong in the past 12 months. In turn, demand strength has originated from the country's massive fiscal and credit stimulus push from the first half of 2016. Chart I-6China: Strong Policy Stimulus Led To Manufacturing Inventories Reduction China: Strong Policy Stimulus Led To Manufacturing Inventories Reduction China: Strong Policy Stimulus Led To Manufacturing Inventories Reduction That said, China's aggregate fiscal and credit impulse seems to have recently rolled over, pointing to a top in its manufacturing mini-cycle and commodities prices (Chart I-7). This signals a potential deceleration in final demand. On the whole, the ongoing modest tightening by the People's Bank of China and by the bank regulator (the China Banking Regulatory Commission) amid a lingering credit bubble is raising the odds of a moderate credit slowdown in the months ahead. Even modest credit growth deceleration will result in a negative credit impulse (Chart I-8, top panel). Meanwhile, the mainland's fiscal impulse has already dropped (Chart I-8, bottom panel). Chart I-7China: Aggregate Credit And Fiscal##br## Stimulus Has Topped Out China: Aggregate Credit And Fiscal Stimulus Has Topped Out China: Aggregate Credit And Fiscal Stimulus Has Topped Out Chart I-8China: A Breakdown Of Credit ##br##And Fiscal Impulses China: A Breakdown Of Credit And Fiscal Impulses China: A Breakdown Of Credit And Fiscal Impulses On the whole, these developments are leading us to maintain our negative bias toward EM risk assets and China plays. What has gone wrong in our view/analysis on China in the past 12 months is that the nation's credit growth has stayed much stronger than we expected. In our April 13, 2016 report,1 we did a scenario analysis and argued that China's large fiscal stimulus push would be offset by a negative credit impulse if credit growth slowed from 11.5% to below 10%. In reality, credit growth has been between 11.5-12.5%, producing a positive credit impulse. Barring tightening by the central bank or bank regulators, mainland banks can continue originating loans/money at a double-digit pace, as they have been doing for many years (Chart I-9). In general, commercial banks do not need savings to create money/loans and there are few limits on Chinese banks originating loans "out of thin air," as we argued in our Trilogy of Special Reports on money/loan creation, savings and investment.2 Chart I-9China's Credit/Money Growth##br## Remains Rampant China's Credit/Money Growth Remains Rampant China's Credit/Money Growth Remains Rampant Therefore, if credit growth does not slow, our negative view on China's growth will be off-the-mark again. The pressure point in such a case will be the exchange rate. Unlimited money creation/oversupply of local currency is bearish for the value of the RMB. The RMB will continue depreciating, but it is not certain if it will hurt EM risk assets. It is a major consensus view nowadays that the Chinese authorities will not allow growth to suffer ahead of the Party Congress in autumn of this year. Yet, the PBoC and bank regulators are modestly tightening to "normalize" credit growth. Some clients may wonder why we are placing so much emphasis on the rollover of credit and fiscal impulses now, while placing little emphasis on these same indicators in 2016 when they were recovering. The rationale is as follows: when there is a credit bubble - as there is in China now - we tend to downplay the importance of policy easing and put more significance on policy tightening. The opposite also holds true: when the credit/banking system is healthy, we tend to downplay the impact of moderate policy tightening and put greater emphasis on policy easing. In a credit bubble, it does not take much tightening to trigger a downtrend that unwinds excesses. Similarly, moderate tightening in a healthy credit system should not be feared. From a big picture perspective, we turned bearish on China's growth several years ago due to the formation of a credit bubble. The bubble has only gotten larger and an adjustment has not yet even started. This does not justify altering our fundamental assessment of China's growth outlook. It would have been ideal to turn positive tactically on EM/China plays a year ago. Unfortunately, we did not do that. Presently, chasing the market higher might not be the best investment idea. Based on all this and given: the sharp rally in EM/China plays and widespread investor complacency and consensus that "everything" will be fine before the end of this year; modest tightening in Chinese monetary policy amid lingering credit and asset (property and the corporate bond market) bubbles; our outlook for higher U.S. bond yields and a stronger U.S. dollar; the fact that financial markets are forward looking, and timing is impossible; We believe the risk/reward of EM/China plays remains unattractive. In regard to EM ex-China, as we documented in last week's report, domestic demand in the developing economies has not recovered at all, or is mixed at best. DM final demand strength and global manufacturing inventory rebuilding will certainly help Korea and Taiwan, but not other emerging economies. The most important variables for other EM economies including China are domestic demand and/or commodities prices. If commodities prices relapse along with China's credit and fiscal impulse (Chart I-7, bottom panel), EM financial markets will suffer regardless of the growth trends within advanced economies. In fact, strong U.S. growth could lead to higher U.S. interest rate expectations and prop up the U.S. dollar. This will also be a bad omen for EM and commodities. Bottom Line: China's inventory depletion has been due to the large fiscal and credit impulse in the past 12 months - i.e., improving final demand has been instrumental to inventory shedding. Looking forward, the mainland's aggregate credit and fiscal impulse seems to have topped out, raising the odds of a reversal in EM/China plays sooner than later. Industrial Metals Inventories And Prices There is no good data reflecting industrial metals inventories globally. London Metal Exchange and Shanghai Futures Exchange data are likely not indicative of global metals stockpiles. China accounts for close to 50% of global demand for industrial metals, and its demand is critical to prices. Given that the large spike in metals prices in the past several months has coincided with improving Chinese economic data, one would expect the mainland to be the driving force behind the rally. However, Chart I-10 demonstrates that China's imports of industrial metals actually contracted in 2016. This is puzzling, but we have to take it at face value. The top panel of Chart I-11 depicts that traders' net long positions in copper are at a six-year high. This might partially explain the rally in copper in the recent months. Chart I-10China's Import Of Base Metals##br## And Base Metals Prices China's Import Of Base Metals And Base Metals Prices China's Import Of Base Metals And Base Metals Prices Chart I-11Traders Are Long ##br##Copper And Oil Traders Are Long Copper And Oil Traders Are Long Copper And Oil Clearly, China has been depleting its stock of industrial metals, and is likely primed to increase its imports. Nevertheless, periods of metals re-stocking by the mainland have historically not entailed higher industrial metals prices (Chart I-10). On the contrary, rising Chinese imports of metals have actually coincided with falling prices. One can interpret this relationship as China buying industrial metals when prices are falling. This is consistent with China attempting to buy commodities on dips. As to metals inventories in China, the picture is as follows: Steel inventories have plummeted and are low (Chart I-12). One can safely argue that there will be an inventory re-stocking cycle in China. Nevertheless, it is highly uncertain if this will be bullish for steel prices and steel stocks. In fact, there has been a mild negative correlation between steel prices and inventories; historically, when inventories have risen, prices declined (Chart I-12, top panel). This confirms that inventory levels are a residual of demand and supply, and prices are often driven by final demand - not inventories. This is also corroborated by the bottom panel of Chart I-12, which illustrates that share prices of global steel companies are sometimes negatively correlated with China's steel inventories. Stock prices occasionally sell off when inventories rise, and rally when inventories are shrinking. In contrast to steel and steel products, iron ore inventories have risen, and it seems the re-stocking cycle is well advanced (Chart I-13). Chart I-12China: Steel Inventories And Prices China: Steel Inventories And Prices China: Steel Inventories And Prices Chart I-13China: Iron Ore Inventories And Prices China: Iron Ore Inventories And Prices China: Iron Ore Inventories And Prices Yet, again there is no strong correlation between inventories and prices of iron ore (Chart I-13). In our discussions with clients, investors often attribute the rally in industrial metals in general and steel prices in particular over the past 12 months to supply cutbacks in China. While supply reductions have helped in the case of certain metals, it is also evident that the rally in industrial commodities has been driven by rising demand globally and in China. First, China's aggregate credit and fiscal impulse was positive until very recently, implying strengthening demand and thereby higher metals prices. Second, if there were only production cutbacks in steel and other commodities and not demand recovery, the mainland's manufacturing PMI would not have risen (Chart I-14). Finally, steel production has risen both in China and the rest of the world (Chart I-15). Hence, world steel supplies have expanded in the past 12 months. Given this has coincided with rising steel prices, it confirms there has been notable improvement in demand for steel. Chart I-14China: Steel Prices Are Up ##br##Because Of Strong Demand China: Steel Prices Are Up Because Of Strong Demand China: Steel Prices Are Up Because Of Strong Demand Chart I-15Chinese And Global ##br##Steel Production Chinese And Global Steel Production Chinese And Global Steel Production We are not experts in the ebbs and flows of commodities supplies, but it seems the Chinese government's mandated steel capacity cutbacks have not prevented rising steel output in China. In the meantime, rising prices amid rising production and falling inventories are indicative of robust final demand for many metals. Bottom Line: Industrial metals prices have risen because demand in the real economy and among financial investors has been strong. That said, a rollover in China's fiscal and credit impulse and a strong U.S. dollar will likely create headwinds for industrial metals prices over the course of this year. A Word About Oil Inventories OECD oil product inventories have continued to rise, despite supply cuts (Chart I-16, top panel). At the same time, our proxy for change in China's oil inventories has been very elevated for a while, depicting strategic and/or commercial inventory building on the mainland (Chart I-16, bottom panel). It is true that supply curtailments have been instrumental to the rally in oil prices, but the continued inventory buildup also indicates that supply is still outpacing demand. Besides, traders' net long positions in crude have spiked close to their 2014 highs (Chart I-11, bottom panel). This corroborates that demand for crude, like for copper, has partially been financial rather than from final consumers. Finally, U.S. rig counts have recovered somewhat, which may be indicative of a continued rise in America's oil output (Chart I-17). Chart I-16Oil Inventories Keep On Rising Oil Inventories Keep On Rising Oil Inventories Keep On Rising Chart I-17U.S. Rig Counts And Oil Production U.S. Rig Counts And Oil Production U.S. Rig Counts And Oil Production Bottom Line: While we do not have expertise to follow or forecast oil supply dynamics, we are biased in believing that the risk-reward for oil prices is unattractive because of a strong U.S. dollar and potentially weak EM/China asset prices, which could trigger a reduction in net long positions in crude. Investment Conclusions Complacency reigns in the global financial markets. EM equity volatility has fallen close to its cycle lows, the U.S. VIX is depressed, U.S. equity investor sentiment is very elevated and EM corporate credit spreads have plummeted to a ten-year low (Chart I-18). While the timing of a reversal is impossible, the risk-reward profile of EM financial markets is greatly unattractive. The U.S. trade-weighted dollar has consolidated recently, and might be primed for another upleg. As the U.S. dollar resumes its uptrend, EM risk assets will likely sell off. Finally, EM share prices have failed to outperform the developed bourses much, despite the rally in commodities and amelioration in Chinese growth (Chart I-19). Chart I-18Complacency Reigns Complacency Reigns Complacency Reigns Chart I-19EM Equities Have Not Yet Outperformed EM Equities Have Not Yet Outperformed EM Equities Have Not Yet Outperformed Remarkably, analysts' net earnings revisions for EM stocks have so far failed to turn positive (Chart I-20). Either analysts' EPS expectations were originally still too high, or companies are failing to deliver profits. Whatever the reason, the implication is that the consensus is more bullish on EM than is suggested by the underlying fundamentals. Within an EM equity portfolio, our overweights remain Taiwan, Korea, India, China, Thailand, Russia and central Europe. Our underweights are Malaysia, Indonesia, Turkey, Brazil and Peru. We are neutral on other bourses. Finally, the EM equity benchmark is at a critical technical resistance level (Chart I-21) but odds do not favor a sustainable breakout. Chart I-20EM EPS Net Revisions Are Still Negative EM EPS Net Revisions Are Still Negative EM EPS Net Revisions Are Still Negative Chart I-21EM Stocks: A Breakout Attempt EM Stocks: A Breakout Attempt EM Stocks: A Breakout Attempt Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Report titled, "Revisiting China's Fiscal And Credit Impulses", dated April 13, 2016, available at ems.bcaresearch.com 2 Trilogy of Special Reports on money/loan creation, savings and investment, titled, "Misconceptions About China's Credit Excesses" dated October 26, 2016, "China's Money Creation Redux And The RMB", dated November 23, 2016 and "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights China's supply-side structural reforms will focus mainly on its coal and steel markets this year. In addition, environmental policies will become stricter in 2017, as Beijing puts more weight on environmental protection than economic development. As as result, supply growth will slow, particularly in steel markets, which will be good news for global steel producers and bad news for iron ore exporters in Australia and Brazil. While we are more bearish on iron ore than steel due to supply-side reforms and stricter environmental policies, we remain cautious getting short iron ore, given the Dalian Commodity Exchange's iron-ore futures are backwardated (prompt prices exceed deferred prices). This indicates buyers are willing to pay more for prompt delivery (e.g., next week) than they are for deferred delivery (e.g., next year). Energy: Overweight. The Saudi-Russia production deal will slow the rate of growth in supply relative to demand, which will tighten physical markets. This will cause inventories to draw, and the backwardation in crude to deepen. Our long Dec/17 vs. short Dec/18 WTI recommendation is up 700%. We are long at +$0.04/bbl, and will risk the spread going to -$0.05/bbl. We will take profits at $0.50/bbl. Base Metals: Neutral. Supply-side reforms, coupled with environmental restrictions will slow the growth of steel production in China this year, benefiting producers ex-China. Precious Metals: Neutral. Gold markets will become increasing volatile, with the Fed likely to keep any rate-hike decision on hold until it has greater clarity re the incoming Trump administration's fiscal policy intentions. Ags/Softs: Underweight. The USDA's most recent supply-demand balances continue to paint a bearish picture for grains, with global ending stocks expected to grow. Feature China will continue its supply-side structural reforms this year, focusing mainly on its coal and steel markets. China environmental policies will become stricter in 2017. This year will mark the first time the central government puts more weight on environmental protection over economic development in evaluating officials' performance since 1949, when the People's Republic of China was established. Supply growth will be slower than last year due to continuing reforms, and stricter environmental policies in the country. Among base metals and bulks, the steel and iron ore markets will be most affected. This will be good news for global steel producers and bad news for global iron ore producers. We are more bearish on iron ore than steel strategically, due to these supply-side reforms, stricter environmental policies, scrap steel substitution, and rising global iron ore supply. That said, we remain cautious getting short iron ore, given the Dalian Commodity Exchange's iron-ore futures are backwardated (prompt prices exceed deferred prices). This indicates buyers are willing to pay more for prompt delivery (e.g., next week) than they are for deferred delivery (e.g., next year). We are downgrading nickel from bullish to neutral, both tactically and strategically. We also are downgrading our tactically bullish stance on aluminum to neutral, as the Indonesian government on January 12 unexpectedly allowed exports of nickel ore and bauxite under certain conditions. China's Supply-Side Reforms In 2017 In 2016, steel prices rallied more than 90% from year-end 2015 levels, but Chinese crude steel and steel products production rose a mere 0.4% and 1.3% yoy, respectively. Back in 2009, when steel prices rose about 30% from November 2008 to August 2009, production grew 12.9% and 17.8% yoy for Chinese crude steel and the output of steel products, respectively (Chart 1). Chart 1China: A Slower Steel Production##br## Recovery Than In 2009 China: A Slower Steel Production Recovery Than In 2009 China: A Slower Steel Production Recovery Than In 2009 One reason for these disparate performances can be found in the massive production cuts made in China last year to crude steel capacity. In February 2016, China's central government announced that it planned to cut 100 to 150 million metric tons (mmt) of crude steel capacity over the five-year period of 2016-2020. While the country aimed to cut 45 mmt in 2016, the actual reduction accelerated in 2016H2 making the full year decrease much larger. According to the China Iron and Steel Association (CISA), 70 mmt of crude steel capacity was taken off line last year, equivalent to 6.2% of total crude steel production capacity in China. This explains, in part, the much slower crude steel production recovery last year when compared to the post-Global Financial Crisis (GFC) recovery in 2009. How much crude steel production capacity will China cut in 2017? Even though last year's 70 mmt capacity cut means about half of the five-year 100-150 mmt capacity-cut target was already achieved, the Chinese government does not show any sign of moderating its desire to see additional cuts. The Chinese Central Economic Work Conference (December 14-16, 2016) emphasized that 2017 will be a year to deepen supply-side structural reforms. Although the central government still has not finalized its 2017 target, we believe a further 40-50 mmt cut in 2017 is possible. For example, China's largest steel producing province - Hebei - has already announced its 2017 crude steel capacity reduction target, which will be 14.39 mmt, similar to its 2016 target of 14.22 mmt. We would note here that the actual cut for the Hebei province in 2016 was 16.24 mmt, much higher than the target, indicating officials will seek to err on the high side when it comes to taking production off line. In December 2016, the country launched a nationwide crackdown on production of so-called shoddy steel, also known as ditiaogang in Chinese - low-quality crude steel made from scrap metal, which is commonly used to produce substandard construction steel products. This material accounts for about 4% of Chinese crude steel output. Last week, the Chinese government ordered a full ban on "shoddy steel" production to be completed before June 30, 2017. This month, 12 inspection groups were sent to major shoddy steel producing provinces to oversee the implementation of the directive. In 2017, the Chinese government also plans to: rein in new steel production capacity; scrutinize new projects; push for more mergers; and generally tighten supervision in the steel sector. In early January, China's top economic planner - the National Development and Reform Commission (NDRC) - toughened its tiered electricity pricing to limit availabilities to outdated steel producers, and to advance its goal of capacity cuts. According to the NRDC website, the new measures raised the price paid by "outdated" steelmakers by 66.7% to 0.5 yuan per kWh, effective on Jan. 1, 2017. Outdated steelmakers, in the government's reckoning, are those scheduled to be phased out - for example, those shoddy steel producers - most of which are privately owned small- or medium- scale mills. Bottom Line: A further capacity cut will limit Chinese steel production growth in 2017. China's Environmental Policies In 2017 In 2016, the Chinese government increased the frequency at which it sent environmental inspection teams to major metal-producing provinces and cities, to ensure the smelters and refiners comply with state environmental rules. Factories that failed to meet environmental standards were ordered to permanently or temporarily shut down, depending on the severity of their violations. This year, with persistent and intensifying smog becoming a greater threat to the health of China's population, environmental policies will only get stricter, resulting in more frequent supply disruptions, especially in its steel industry. In addition to plant-specific environmental measures, in late 2016, China rolled out rules to evaluate the "green" efforts of local governments. For the first time since 1949, when the People's Republic of China was established, the central government indicated it would put more weight on environmental protection than on economic development, as measured by GDP, in evaluating local government officials' performance. This likely will reduce the local governments' incentive to support unqualified or unprofitable steel/aluminum production. Bottom Line: China's stricter environmental policies will cause more supply disruptions and increase production costs for the Chinese metal sector, especially the steel industry. Our Views On Iron Ore And Steel In 2017 We are strategically neutral on steel prices and bearish on iron ore prices. Supply-side reforms and stricter environmental policies in China likely will result in zero growth or even a small contraction in Chinese steel production, which may well support steel prices while reducing iron ore demand. This will be good news for global steel producers ex-China, and bad news for global iron ore producers. China is determined to cull all "shoddy steel" production by the end of June, which will make considerable volumes of scrap steel available to be used in good-quality steel production. Chinese steel producers are currently willing to replace iron ore with scrap steel in their steel production, given scrap steel prices are cheap versus iron ore and steel product prices (Chart 2). In addition, using scrap as an input to produce crude steel will save steel producers money on coking coal, the price of which has surged over the past year. Chinese steel demand growth may remain robust in 2017H1. Last year's stimulus still has not run out of steam, and this year's fiscal and monetary policy will stay accommodative.1 Raw-material costs in the form of iron ore, coking coal and oil soared versus levels seen last year, which means the production costs of steel now are much higher than last year. This will support steel prices (Chart 3). Chart 2More Scrap Steel Will Replace##br## Iron Ore In Steel Production More Scrap Steel Will Replace Iron Ore In Steel Production More Scrap Steel Will Replace Iron Ore In Steel Production Chart 3Cost Push Will Support ##br##Steel Prices Cost Push Will Support Steel Prices Cost Push Will Support Steel Prices Steel product inventories at the major cities in China are still low; producers' inventory holdings have declined to levels last seen in 2014, which also will be supportive of steel prices (Chart 4). China's iron ore inventories are high, while domestic iron ore production is recovering (Chart 5, panels 1 and 2). With slowing domestic steel production, Chinese iron ore import growth likely will be subdued this year (Chart 5, panel 3). Global iron ore supplies are increasing. The "Big Three" producers - Vale, Rio Tinto, and BHP - all plan to boost production in response to profitable iron ore prices this year. Indeed, this month, Vale started its first iron-ore shipments from the giant new S11D mine. Chart 4Low Inventory Supports Steel Prices As Well Low Inventory Supports Steel Prices As Well Low Inventory Supports Steel Prices As Well Chart 5Limited Chinese Iron Ore Import Growth In 2017 Limited Chinese Iron Ore Import Growth In 2017 Limited Chinese Iron Ore Import Growth In 2017 Bottom Line: The outlook for steel prices this year is brighter relative to iron ore in 2017, although, the backwardation in the Dalian Commodity Exchange's iron-ore futures suggests markets may be pricing in tighter iron-ore supply in the near term. We will explore this in future research. Downgrading Our Nickel And Aluminum Views We are downgrading nickel from bullish to neutral, both tactically and strategically. Chart 6Downgrading Nickel And Aluminum View Downgrading Nickel And Aluminum View Downgrading Nickel And Aluminum View In November, we expected the global nickel supply deficit to widen on rising stainless steel demand and falling nickel ore supply. One major reason we were bullish nickel was that there was no sign Indonesia's export ban - imposed in January 2014 - would be removed. With elevated global nickel output, surging Chinese nickel pig iron (NPI) imports, and rebounding Indonesian nickel ore exports, Chinese NPI production will recover in 2017, which will reduce the country's need for refined nickel imports (Chart 6). Our long Dec/17 LME nickel contract versus Dec/17 LME zinc contract was stopped out for a 5.1% loss this week. We are no longer bullish nickel versus zinc. We also are downgrading our tactically bullish stance on aluminum to neutral, after the Indonesian government unexpectedly allowed exports of nickel ore and bauxite under certain conditions earlier this month. We are removing our buy limit order to go long Mar/17 aluminum contracts if it falls to $1,640/MT from our shopping list. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report "China Commodity Focus: How China's Monetary And Fiscal Policy Will Affect Metal Markets," dated January 12, 2017, available at ces.bcaresearch.com Grains/Softs Global Grain Stocks Set To Rise Overall: Despite some positive developments in the U.S. - where corn supplies are falling faster than demand - we remain underweight grains. This is largely because of the continued growth of production relative to consumption globally, which looks like it will lift global stocks by the end of the 2016-17 crop year in September. While we do expect a slight decrease in output this year, it is difficult to upgrade our view at this point (Table 1). Table 1World Grains Estimates - January 2017 China Commodity Focus: Supply Cuts, Environmental Restrictions Will Hit Metals China Commodity Focus: Supply Cuts, Environmental Restrictions Will Hit Metals Wheat: Worldwide, output growth in Argentina, Russia and the EU added 1.3mm tons of production to global supplies. In the U.S., ending stocks are projected to reach levels not seen since the late 1980s, according to the USDA. Global consumption, meanwhile, is projected to increase a mere 100k tons, according to the USDA, which will lift ending stocks 1.2mm tons by the end of the crop year to a record 253.3mm tons. Corn: U.S. production is expected to fall, which, along with higher usage in the ethanol market, will contribute to lower stocks. However, on a global basis, production is set to outstrip consumption resulting in higher ending stocks at the end of the crop year. Soybeans: Same story here: Production growth outstripping consumption, leaving ending stocks higher by close to 7% yoy, based on the USDA's estimates. Rice: In relative terms, the rice market has the most bullish fundamentals - global production and consumption are roughly balanced, leaving expected ending stocks slightly above last year's level. We continue to favor rice over the other grains (save wheat) for this reason. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 China Commodity Focus: Supply Cuts, Environmental Restrictions Will Hit Metals China Commodity Focus: Supply Cuts, Environmental Restrictions Will Hit Metals

Highlights China's monetary and fiscal policy in 2017 will likely remain accommodative, in order to achieve the goal of an average 6.5% GDP growth over the next five years. China's policies related to its property market will be much more restrictive than the previous two years. Chinese metal demand will grow at a slower pace than last year, as reflationary policies are throttled back. Feature Base metals and bulk markets had a fantastic year in 2016, a complete reversal of their miserable performance in 2015 (Chart 1, panels 1 and 2). Last year, the LMEX base metal index, steel prices and iron ore prices were up 30%, 75%, and 91%, respectively (using average prices in January and December). In comparison, during the same period of 2015, the LMEX index, steel and iron ore were down 22%, 30%, and 41%, respectively. Massive supply reductions, and recovering demand caused by China's reflationary fiscal and monetary policies, were the driving forces behind these sharp rallies in bulks and base metals prices last year. Both the official manufacturing PMI and Keqiang index, which are broadly used as key measures of Chinese economic conditions, reached a three-year high in late 2016 (Chart 1, panels 3 and 4). Clearly, metal prices had already discounted a positive outlook vis-a-vis Chinese economic growth, which was boosted by a series of reflationary policy initiatives in the past two years. The question now is: will reflationary monetary and fiscal policies continue into 2017? If so, on how large a scale will it be? What factors could limit or even prevent reflationary policies in China? A look back China's reflationary policies actually started in late 2014, when the property market and overall economy showed signs of weakness. The country accelerated its reflationary policies throughout 2015 and maintained a moderate reflationary stance in 2016, in order to spur domestic economic growth. Monetary policy: China cut its central-bank directed policy rate five times in 2015 from 5.6% to 4.35%, the lowest level since the data started in 1980 (Chart 2, panel 1). The People's Bank of China (PBoC), the country's central bank, also lowered the reserve requirement ratio at banks - the amount of reserves banks must keep on hand - four times in 2015 and once in 2016 from 18% to 15%, the lowest level since May 2010 (Chart 2, panel 2). Chart 1China Reflationary Policy Drove ##br##Metal Price Rallies In 2016 China Reflationary Policy Drove Metal Price Rallies In 2016 China Reflationary Policy Drove Metal Price Rallies In 2016 Chart 2Both Monetary and Fiscal Policies ##br##Were Reflationary Last Year Both Monetary and Fiscal Policies Were Reflationary Last Year Both Monetary and Fiscal Policies Were Reflationary Last Year Fiscal policy: China halved its 10% sales tax on passenger cars with engines up to 1.6 liters in October 2015, which boosted auto sales and production significantly last year (Chart 2, panel 3). The country also maintained its high-growth infrastructure investment last year (Chart 2, panel 4). Real estate-related policy: China loosened its housing-related policies extensively since September 2014, by among other things, reducing down-payment requirements for first-time home buyers, and reducing down payments needed to finance second homes. The goal of the policies was to reduce elevated housing inventories. Indeed, those policies, along with the combination of falling mortgage rates, revived the Chinese property market in 2016, and sparked a massive rally in steel-making commodities - metallurgical coal and iron ore - and in base metals. For the first 11 months of last year, the average selling prices of 70 cities and the total floor-space-sold area rose 13.6% and 24.3% yoy, respectively, which considerably improved from the 2015 same period's 6% and 7.4% yoy growth. The floor-space-started area had an even more significant improvement - a growth of 7.6% for the first 11 months of last year versus a deep contraction of 14.7% yoy for the same period of 2015 (Chart 3). What now? This year, we continue to expect accommodative monetary and fiscal policy in China. "Stability" was the key word during the three-day Central Economic Work Conference (December 14-16, 2016), an annual meeting that set out economic targets and policy priorities for next year. "Stability" means the country's leaders will try to implement policies designed to keep the country's GDP growth around 6.5% this year, the average GDP growth target for the five years between 2016 and 2020, under China's five-year plan. China's economic growth is on a downtrend, coming in at 6.9% in 2015, and a predicted 6.7% in 2016 (for the first three quarters of 2016, China's GDP growth was all 6.7%) (Chart 4, panel 1). Chart 3Property Market Policy: ##br##Greatly Loosened In 2015 And 2016 Property Market Policy: Greatly Loosened In 2015 And 2016 Property Market Policy: Greatly Loosened In 2015 And 2016 Chart 4We Expect Chinese Monetary And Fiscal Policies ##br##To Stay Accommodative This Year We Expect Chinese Monetary and Fiscal Policies To Stay Accommodative This Year We Expect Chinese Monetary and Fiscal Policies To Stay Accommodative This Year The market's expectation for China's 2017 GDP growth currently is 6.5%. Even though President Xi has stated he is open to growth in China falling below 6.5%, too far below this level - for example, below 6% - could cause widespread disappointment in the country and trigger the "instability" leaders are trying to avoid. Hence, monetary accommodation likely will persist in 2017. As both headline inflation and core inflation in China still are not elevated, we do not expect any rate hikes or increases in the reserve requirement ratio to be announced by the PBoC this year (Chart 4, panel 2). In addition, the RMB depreciated considerably last year, which helps the country's exports and, to some extent, stimulates domestic economic growth (Chart 4, panel 3). In mid-December last year, Chinese policymakers raised the tax on small-engine autos slightly - from 5% last year to 7.5% this year - but this is still below its normal 10% level. This also indicates the country wants to maintain a moderate, but not too expansionary, level of fiscal stimulus In 2017. In 2016, most of Chinese automobile production growth came from small-engine passenger cars, which clearly benefited from this policy (Chart 4, panel 4). This year, we still expect positive growth in Chinese vehicle production but at a much slower rate than last year. Curbing Property Market Exuberance Regarding the Chinese property market, our take-away from the Central Economic Work Conference was that "curbing the speculative home purchases, containing asset bubbles and financial risks" will be among the country's top 2017 priorities. In comparison, back in 2016, reducing housing inventories was the focus. Indeed, with property sales recovering, inventory has fallen from its 2015 peak. Inventories still are elevated, but most of the overhang is in third- and fourth-tier cities, with some of it in even smaller cities (Chart 4, panel 5). A continuation of stricter housing policies deployed since last September to cool the over-heated domestic property market is expected. For example, Beijing raised the down payment for first-time homebuyers from 30% to 35%. Down payments for second homes rose from 30% to a minimum of 50%. For a second home larger than 140 square meters, the down payment is now 70%. So far, more than 20 cities have declared similarly strict policies to control speculative buying in property markets. Currently, a record high 20% of people surveyed plan to buy a new house in the next three months, which indicates further cooling measures are needed for the property market (Chart 5, panel 1). In the meantime, new mortgage loans as a share of home sales in value also reached a record high of 49%, and real estate-related loans as a share of total new bank loans now stand at a 6-year high, signaling financial risk in these markets is rising (Chart 5, panels 2 and 3). All of these factors signal that the Chinese authorities will maintain their restrictive property market policies in 2017. This will be negative for the country's bulk and base metals demand, as the property market accounts for some 35% of demand for these commodities. In conclusion, China's monetary and fiscal policies are likely to stay accommodative in 2017, while the country's housing market is facing restrictive policies. Shifting Economic Drivers For Bulk and Base Metal Demand We would like to remind our clients that China's economic structure is shifting: Services (also known as the "tertiary sector") account for a rising share of GDP, and are not big users of bulks or metals, while manufacturing (i.e., the "secondary sector) demand for these commodities is slowing. Services now account for 51.4% of GDP, while manufacturing now accounts for 39.8% (Chart 6). The GDP weight of services is up from 42% ten years ago, while the GDP weight of manufacturing is down 8 percentage points over the same period. Chart 5Property Market Policy Will Remain ##br##Restrictive in 2017 Property Market Policy Will Remain Restrictive in 2017 Property Market Policy Will Remain Restrictive in 2017 Chart 6China's Economic Structure Shift Is ##br##Negative To Metals Demand China's Economic Structure Shift Is Negative To Metals Demand China's Economic Structure Shift Is Negative To Metals Demand This shift is negative for metal demand growth, as the related manufacturing activity growth slows faster than the overall GDP growth. Overall, we believe Chinese bulk and base metal demand growth in 2017 will slow as a result of less expansionary policies than prevailed last year, and a more restrictive domestic housing market. Next week The Chinese Central Economic Work Conference also emphasized that 2017 will be a year to deepen supply-side structural reforms, which we will discuss in our next week's pub. We also will address the impact of Chinese environmental policy on Chinese metal output. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com ENERGY Chart 7Evidence Of Production Cuts Will Lift Oil Prices Evidence Of Production Cuts Will Lift Oil Prices Evidence Of Production Cuts Will Lift Oil Prices Oil Production Expected To Fall Reports of production cuts and reduced volumes being made available to U.S. and Asian refiners have been trickling out since the start of the year, lending underlying support to prices globally (Chart 7). The Kingdom of Saudi Arabia (KSA) is reducing exports of heavy-sour crudes favored by U.S. Gulf refiners, and boosting light-sweet sales, which will compete with North Sea volumes and U.S. shale production. This should tighten the spread between the light-sweet benchmarks Brent and WTI vs. Dubai (medium/heavy-sour). Reduced volumes being shipped by KSA to Asian refiners - particularly to Chinese refiners - will support Brent prices. We continue to expect the production cuts negotiated under the leadership of KSA and Russia to become apparent next month, and for inventories to draw in response. Continued high output by Iraq likely will be reduced in the near future. U.S. shale-oil output most likely will increase in 2H17 by ~ 200k to 300k b/d on average, given higher prices supporting drilling economics. Our expectation for global demand growth remains ~ 1.4mm b/d this year, roughly in line with 2016 growth. Given these underlying fundamentals, we expect inventories will begin showing sharp draws, causing backwardation in crude-oil markets to re-emerge in 2H17. As such, we are re-establishing our Dec/17 vs. Dec/18 WTI front-to-back spread - i.e., buying Dec/17 WTI and selling Dec/18 WTI against it. This spread was in contango going to press, making it particularly compelling. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 China Commodity Focus: How China's Monetary And Fiscal Policy Will Affect Metal Markets China Commodity Focus: How China's Monetary And Fiscal Policy Will Affect Metal Markets