Base Metals & Iron Ore

Highlights The tactical environment is dynamic, chaotic and unpredictable. ...Chaos also brings opportunity. We must recognize and exploit opportunities when chance presents them. Look for recurring patterns to exploit.1 Feature Highlights Strategically, major commodity markets are balanced with the exception of ags, where we remain underweight on the back of record grain harvests and high stock-to-use ratios. Otherwise, broad exposure to the asset class is warranted. However, within the larger investment context, we believe tactical positioning once again will produce higher returns than strategic index exposure to commodities. Chart of the WeekTactical Positioning ##br##Rewarded In Oil Markets Tactical Positioning Rewarded In Oil Markets Tactical Positioning Rewarded In Oil Markets Supply-driven price volatility and erratic monetary policy presented commodity markets strategic and tactical opportunities in 2016, particularly in oil, where our recommendations returned an average of 95% (Chart of the Week). We remain overweight oil, expecting continued opportunities from volatile markets. Going forward, the contribution of demand-side risk to price volatility will increase. This will be evident in iron ore, steel and base metals, where the opacity of China's fiscal and monetary policy - especially re heavily indebted state-owned enterprises (SOEs) and the banks that support them - in the lead-up to the Communist Party's Congress abounds. Continued adjustments by the U.S. Fed to random-walking data will again contribute to volatility, particularly in oil and gold markets. A stronger dollar resulting from continued Fed tightening will hit U.S. ag exports, and benefit competitors such as Argentina and the EU. However, uncertainty re the Trump administration's fiscal and trade policies could keep the Fed looser for longer, particularly if border-adjusted taxation favoring exports over imports is realized. Geopolitics - particularly vis-à-vis U.S. and China trade and military policy - will become more important if America tilts toward dirigisme, i.e., actively managing its economy by adjusting taxation and policy to support favored industries. Governments typically allocate resources inefficiently, which distorts fundamentals. If border-adjusted taxation becomes law in the U.S. we will look to get long volatility across commodity markets: Such legislation likely would rally the USD, which would lower global demand for commodities generally and lift supply by lowering local costs. This would run smack into higher U.S. inflation arising from the increasing cost of imported goods. This is a recipe for heightened uncertainty and price volatility. Russia lurks in the background: U.S. sanctions in the wake of alleged interference in American presidential elections, and Russia's response, will keep oil markets on edge. 2017 Weightings Energy: Overweight. The OPEC-Russia co-operation pact to limit production could evolve into a durable modus operandi for managing oil supply. Markets will judge the pact effective if tanker chartering out of the Persian Gulf falls, and global inventories draw by mid- to end-February. Base Metals: Neutral. Bulks and base metals prices will remain rangebound, until greater clarity on China's fiscal and monetary policy emerges. Fiscal stimulus in the U.S. will have a marginal effect on demand toward year-end. Precious Metals: Neutral. Gold will remain sensitive to shifts in U.S. fiscal and monetary policy expectations. The possibility of border-adjusted taxes in the U.S. will hang like the proverbial Sword of Damocles over the gold market. Should it pass, the Fed could be forced to keep interest rates lower for longer to offset the massive tightening in financial conditions such a tax would impose. Ags/Softs: Underweight. We see limited downside for grains, despite record harvests. We favor wheat and rice over corn and beans. A stronger USD will be bearish for grain exports. Feature Commodities as an asset class remain attractive. However, constantly changing information flows affecting these markets compel us once again to favor tactical positioning over a broad strategic exposure to the asset class. Fundamentals - supply, demand, inventories - and financial variables remain in a state of flux. In the oil market, the durability of the OPEC-Russia co-operation pact to reduce oil production will be tested, following a year-end surge in global production. Markets will closely follow shipping activity - particularly out of the Persian Gulf - and global oil inventory levels for signs the production cuts engineered late last year by OPEC, led by the Kingdom of Saudi Arabia (KSA), and non-OPEC producers, led by Russia, are taking hold. Uncertainty regarding the incoming Trump administration's tax and trade policies - and responses from states targeted by such policies (e.g., China and Mexico) - will keep decisions affecting supply and demand fluid. The incoming Trump administration's trade policies could alter global oil flows: e.g., a re-working of NAFTA that reduces U.S. refined-product exports to Latin America would result in lower demand for crude at American refineries, and present an opening to Chinese refiners. In addition, as mentioned above, legislation authorizing border-adjusted taxes favoring exports and penalizing imports likely will be taken up this year in the U.S. Congress. If we did see tax policy favouring U.S. exports over imports, we believe it would prompt a USD rally via reducing America's current account deficit. This would, all else equal, send commodity prices sharply lower, as EM commodity demand will contract, owing to higher USD prices for commodities, and production ex U.S. will increase, due to lower local costs. That said, border-adjusted taxation in the U.S. also would increase the price of imports, and lift realized and expected inflation. How this plays out is highly uncertain at present. A border-adjusted tax bill likely will be taken up in the current session. If it passes, it would have major implications for pricing relationships globally - chiefly WTI vs. Brent, and Brent vs. Dubai crudes, along with product differentials that drive shipping economics. If such a bill looks like it will pass, we expect a sharp increase in commodity-price volatility globally. If the odds do favor such a tax regime shift, we would look to get long WTI and short Brent further out the curve, expecting higher U.S. exports and lower imports. In addition, we would look to get long gold volatility - buying puts and calls - as policy uncertainty effects resolve themselves. Heightened Uncertainty Means Tactical Positioning Once Again Trumps Passive Commodities Allocation The primacy of tactical positioning was demonstrated in 2016 in the oil market, when strategic positions quickly became tactical, either because they were stopped out or reached their P&L targets quicker than expected. Supply destruction dominated price formation last year, following OPEC's decision to abandon its strategy to support prices via production management in November 2014. This destruction occurred mostly in non-Gulf OPEC, which was down 7.0% yoy in 2016 (Chart 2), and non-OPEC producers, particularly the U.S. shale-oil fields, where yoy production was down 12.0% by year-end 2016 (Chart 3). Chart 2Low Prices Crushed Non-Gulf Production... Low Prices Crushed Non-Gulf Production ... Low Prices Crushed Non-Gulf Production ... Chart 3...And U.S. Production ... and U.S. Production ... and U.S. Production Even in states where production increased - chiefly KSA and Russia (Chart 4) - domestic finances crumbled, leaving them in dire straits. By our estimates, between July 2014, just prior to its decision to launch OPEC's market-share war, and December 2016, KSA had burned through $220 billion of it foreign reserves, equivalent to 30% of its central-bank holdings. Russia had drawn down its official reserves by $77 billion over the same period, or 16% of its holdings; its burn rate was reduced by allowing its currency to depreciate, which lowered the local cost of producing oil and boosted profitability of exports priced in USD. This was the background that forced OPEC, led by KSA, and non-OPEC, led by Russia, to negotiate the year-end pact that resulted in an agreement to cut production by up to 1.8 mm b/d. The stated volumes to be cut are comprised of 1.2 mm from OPEC, 300k b/d from Russia, and another 300 from other non-OPEC producers. The goal of this agreement is to reduce global oil inventories to more normal levels (Chart 5). Chart 4KSA, Russia Production Ramp ##br##Exacerbated Price Weakness KSA, Russia Production Ramp Exacerbated Price Weakness KSA, Russia Production Ramp Exacerbated Price Weakness Chart 5KSA-Russia Production Pact Aimed ##br##At Lowering Inventories KSA-Russia Production Pact Aimed at Lowering Inventories KSA-Russia Production Pact Aimed at Lowering Inventories Throughout 2016, as the supply-destruction drama was unfolding, numerous opportunities opened up to investors to fade market overshoots, brought about by over-reactions to fast-moving news flows. Unrestrained output by OPEC and non-OPEC producers strained oil-storage facilities early in the year, taking markets to the brink of breaking down entirely. Unexpected shifts in U.S. monetary policy - driven by random-walking data - also contributed to oil price volatility and opened numerous trading opportunities. Markets essentially ignored the cumulating right-tail price risks last year, following the supply destruction wrought by OPEC's declaration of a market-share war, and Russian overtures to OPEC seeking a production-allocation dialogue, which were very much in evidence in January 2016. The continual OPEC-Russia dialogue, which appeared to be bearing fruit in Doha before it was scuppered by KSA at the last minute in April, was the underlying geopolitical driver last year, and kept the odds of a production deal elevated. Based on our modeling, the supply surge following OPEC's decision made getting long contingent upside price exposure extremely compelling, particularly as it imperiled the finances of all oil producers - rich and poor, but mostly the poorer states like Venezuela and Nigeria. Our reasoning was lower prices would accelerate rebalancing of global markets and raise the odds of a major supply disruption at one of these failing states.2 Our modeling consistently indicated global oil markets would rebalance in 2016H2.3 Ultimately, this is how things played out, aided in no small measure by mid-year wildfires in Canada, which temporarily removed move than 1mm b/d from global markets, and sabotage of pipelines and loading facilities in Nigeria. Even with that, markets remained under pressure as Canadian barrels returned, and foreign reserves in KSA and Russia were rapidly depleted. These fundamentals, along with constantly changing Fed guidance, provided numerous opportunities to exploit recurring patterns thrown up by chance, as is evident in the returns on recommendations we made - averaging 95.1% last year - that naturally followed from our analysis (Table 1). Our favored exposure was getting long contingent exposure (i.e., options), using deferred call spreads in WTI and Brent, given our assessment the odds of higher prices exceeded the market's. Later in the year, following the OPEC-Russia pact, we got long a front-to-back crude oil spread (Dec/17 WTI vs. Dec/18 WTI) expecting the goal of the deal - reducing global inventories - stood a good chance of being realized. We got lucky putting the trade on as the market was correcting, but just ahead of the statement by KSA's oil minister that the Kingdom would do "whatever it takes" to make the deal work. This transformed a strategic position - one we expected to hold for months - into a one-week exposure that returned 493% (Table 1). Table 1Energy Trades Closed In 2016 Tactical Focus Again Required In 2017 Tactical Focus Again Required In 2017 In order to obtain a more detailed assessment of our energy portfolio's performance, we built an information ratio (IR) to evaluate how our energy recommendations performed compared to a selected benchmark, the S&P GS Commodity Index (GSCI). Essentially, our IR is used to assess whether an active portfolio has outperformed the selected benchmark in a consistent manner during the period of analysis, given the risk it incurred. To that end, our ratio looks at the average excess return of the active portfolio against the benchmark. This average excess return is then divided by its standard deviation (also referred to as the tracking error volatility) in order to get a risk-adjusted metric to evaluate whether the risk we took were compensated by the returns we generated. Our IR thus is calculated as: Formula Tactical Focus Again Required In 2017 Tactical Focus Again Required In 2017 The higher the IR, the better the risk-adjusted relative performance of the portfolio. Three elements can explain a high IR: high returns in the portfolio, low returns in the benchmark, or low tracking error volatility. Hence, this measure helps analyzing the notion of risk-reward tradeoff; it tells us whether or not the risk assumed in our trades was compensated by larger returns. In our case, to get the risk-adjusted returns of the energy portfolio, we selected the GSCI as a benchmark, as it is heavily skewed towards Energy commodities (around 60% of its composition). We believe this is a plausible benchmark alternative to our energy trade recommendations for an investor, whose choice is passive index exposure with a significant energy weighting. Our portfolio's average return in 2016 was 95%, while the GSCI return was 11%. The tracking error volatility was 56%.4 Using these inputs, we calculated the IR of our recommendations was 1.47. This is an excellent risk-adjusted return, and indicates the high volatility of our returns was more than compensated for by consistent positive excess returns our recommendations generated relative to passive GSCI exposure, which also can be used as a benchmark for energy-heavy commodity index exposure (i.e., "commodity beta"). Remain Overweight Oil We expect the combination of production cuts and natural declines will remove enough production from the market this year to restore global oil stocks to five-year average levels toward the end of 2017Q2 or early Q3 (Chart 5), even with cheating by OPEC and non-OPEC producers capable of increasing production. As a result, in 2017, we expect the OPEC-Russia deal to result in inventory draws of ~ 10% by 2017Q3. On the demand side, we continue to expect global growth of ~ 1.3 to 1.5mm b/d. Given these expectations, we expect U.S. benchmark WTI crude prices to average $55/bbl, up $5 from our 2016 forecast, on the back of the end-year OPEC-Russia pact. We are moving the bottom of the range in which we expect WTI prices to trade most of the time to $45/bbl and keeping the upside at $65/bbl. Markets already are pricing in a normalization of global inventories by year end (Chart 6 and Chart 7). We will look for opportunities to re-establish our long front-to-back positions, expecting the backwardation further out the curve will steepen. Chart 6Backwardation Steepening Near Term... Backwardation Steepening Near Term ... Backwardation Steepening Near Term ... Chart 7...And Further Out the Curve ... And Further Out the Curve ... And Further Out the Curve Further out the curve - i.e., mid-2018 and beyond - our conviction is lower: The massive capex cuts seen in the industry for projects expected between 2015 - 2020 will place an enormous burden on shale producers and conventional oil producers, chiefly Gulf Arab producers and Russia. It will be difficult to offset natural decline-curve losses - which will increase as U.S. shales account for a larger share of global supply - and meet increasing demand. As we've often noted, any indication U.S. shales or conventional supplies (Gulf states and Russian production) will not be able to move quickly enough to meet growing demand and replace natural declines could spike prices further out the curve. We expect U.S. oil exports to increase this year, which means the international benchmark, Brent crude oil, will increasingly price to move WTI into global markets. We expect U.S. WTI exports to increase from an average ~ 500k b/d, which should keep the price differential roughly around +$1.50/bbl differential (Brent over) for 2017. If we see border-adjusted taxation laws take effect, we would look to get long WTI vs. short Brent, and long U.S. products (e.g., U.S. Gulf gasoline and distillate exposure) vs. short Brent exposure. Remain Neutral Bulks, Base Metals Over in the bulks and base metals markets, a full-fledged iron-ore market-share war at the beginning of last year threatened to take prices to $30/ton. Then, seemingly out of the blue, an unexpected pivot by Chinese policymakers toward stimulating the "old economy" caught many bulks and base-metals traders and analysts - ourselves included - flat-footed. Powerful rallies in iron ore, steel and base metals early in the year on Chinese exchanges were dismissed as irrational exuberance on the part of retail investors. But, at the end of the day, these market participants were responsible for well-informed price signals that fully reflected low inventories and surging demand.5 The -0.5% average return in our bulks and base metals recommendations last year attests to how difficult we found these markets to read and anticipate (Table 2). Table 2Base Metals Trades Closed In 2016 Tactical Focus Again Required In 2017 Tactical Focus Again Required In 2017 As always, the evolution of China's economy will, as always, be critical to these markets, given that country's outsized role in iron ore, steel and base metals. We are broadly neutral the complex, and, with the exception of the nickel market, see supply and demand relatively balanced to slightly oversupplied globally and in China. Production globally and in China is growing yoy, while consumption shows signs of slowing. (Chart 8 and Chart 9). Chart 8World Base Metals Consumption Slowing,##br## Relative to Production... World Base Metals Consumption Slowing, Relative to Production ... World Base Metals Consumption Slowing, Relative to Production ... Chart 9...As Is ##br##China's ... As Is China's ... As Is China's Uncertainty re the direction of China's fiscal and monetary policy - chiefly, whether policymakers will, once again, resort to stimulating the "old economy" - will keep us broadly neutral bulks and base metals until we get further clarity on the direction of policy. We expect the monetary and fiscal stimulus that massively boosted China's housing market this year will wind down, bringing an end to the run-up in iron ore, steel and base metals prices. Odds favor "reflationary" policies to continue going into the Communist Party Congress next fall, but we do not expect anything along the lines of the surge in policy stimulus seen earlier this year: Unwinding and controlling property-market excesses and high debt levels will limit policymakers' desire to turbo-charge the housing market again, limiting the boost such policies provide. The fate of border-adjusted taxation in the U.S. Congress is critically important to bulk and base-metals markets, since it would encourage exports and discourage imports (along with raising their prices). Tax policy favouring U.S. exports over imports likely would prompt a USD rally, which would send commodity prices generally sharply lower. It would boost U.S. steel production and base metals exports, while raising the cost of imports. A border-adjusted tax bill likely will be taken up in the current session of Congress. We are downgrading our tactically bullish view on iron ore to neutral. Strategically, we retain a bearish bias, as rising iron ore supply may overwhelm the market again in 2017H2. We remain tactically neutral and strategically bearish steel. Low steel inventories and production disruptions caused by China's recently launched environmental inspection program likely will continue to support steel prices in the near term. However, persistently high steel output and falling demand from the Chinese property sector will eventually knock down prices in 2017H2. Manufacturing will play a larger role in copper markets, and will drive the demand side this year. However, if we see a stronger USD - either as a result of Fed policy or U.S. fiscal policy - price appreciation will be limited. We remain neutral copper, expecting a concerted effort to slow the housing boom in China. Reflationary policies will still support real demand for copper, but will reduce demand from new construction. The supply deficit in nickel will widen on the back of rising stainless steel demand and falling nickel ore supply in 2017, which will support prices. We expect nickel will outperform zinc over a one-year time horizon. For zinc, we remain tactically neutral and strategically bearish. We expect zinc supply to rise considerably in response to current high prices. Aluminum supply - for the moment - will lag demand globally, which keeps us tactically bullish and strategically neutral. Supply shortages will likely persist ex-China over the next three to six months. Stay Neutral Precious Metals Precious metals, gold in particular, staged an impressive rally on the back of unexpected easing by the U.S. Fed in response to weaker-than-expected sub-1% GDP growth in 1Q16 GDP. Markets had been pricing in as many as four interest-rate hikes earlier in the year into short-term expectations, which were quickly dashed. Markets lowered their expectations for multiple rate hikes last year, which weakened the USD and U.S. real rates, setting the stage for the gold rally. Nonetheless, gold proved a difficult commodity to trade last year, as our results indicate - the average return on our precious metals recommendations amounted to a paltry -0.65% (Table 3). For the near term - i.e., until greater clarity on Fed policy and the incoming Trump administration's fiscal policy direction becomes clear - we remain neutral precious metals, and will avoid taking any further exposure other than perhaps getting long gold volatility - i.e., buying puts and calls in the gold market - if the odds of border-adjusted taxation legislation passing increase. Such legislation likely would rally the USD, which would lower global demand and increase supply ex U.S. at the margin for commodities generally, oil and base metals in particular. This would be deflationary, given the high correlations between oil and base metals consumption and U.S. inflation (Chart 10).6 However, such a taxation scheme also would raise U.S. inflation by increasing the cost of imported goods, sending the U.S. core PCE, the Fed's preferred inflation gauge, higher. The global disinflationary impulse from a stronger USD would run headlong into higher U.S. inflation, which would be a recipe for heightened uncertainty and price volatility. Table 3Precious Metals Trades ##br##Closed In 2016 Tactical Focus Again Required In 2017 Tactical Focus Again Required In 2017 Chart 10Risk of Deflation Will Rise If Border-Adjusted ##br##Taxes Prove Deflationary Risk of Deflation Will Rise If Border-Adjusted Taxes Prove Deflationary Risk of Deflation Will Rise If Border-Adjusted Taxes Prove Deflationary This will complicate U.S. monetary policy. We believe the Fed also will be waiting on such direction, and that interest-rate policy will, therefore, remain pretty much be on hold, keeping precious metals - gold, in particular - rangebound. For the moment, the possibility of border-adjusted taxes in the U.S. will hang like the proverbial Sword of Damocles over the gold market. We are taking profits on the tactical long gold position we opened December 15, 2016, as of today's close. Remain Underweight AGS Lastly, Ag markets provided us no joy, as the El Nino wreaked havoc on our recommendations. Our average -1.0% return for the year amply demonstrates the difficulty of trading markets so heavily influenced by weather (Table 4). Going into 2017, we believe there is a limited downside for grains. The downtrend since August 2012 like forms a bottom this year, if, as we are modeling, we see a return to normal weather conditions. That said, the principal upside risk remains unfavorable weather in major grain-producing countries, which could send badly battered grain prices surging as they did in 2016H1. Among grains, we favor wheat and rice over corn and soybeans. Global soybean acreage is likely to expand as the crop provides higher returns than other grains. South American corn output will continue rising on favorable policies and weak currencies, adding further pressure to already-high U.S. corn inventories, in particular, and global inventories globally (Chart 11). Table 4AGS Trades Closed In 2016 Tactical Focus Again Required In 2017 Tactical Focus Again Required In 2017 Chart 11Global Grain Inventories Remain High Global Grain Inventories Remain High Global Grain Inventories Remain High Softs - cotton and sugar - likely will underperform grains in 2017, reversing their outperformance this year. We are tactically bearish cotton, as U.S. cotton acreage is likely to increase next spring. Strategically, we are neutral cotton. For the global sugar market, barring extremely unfavorable weather, we are tactically and strategically bearish. This year's extreme rally in prices may result in a small supply surplus in 2017. Our Ag strategies will continue to focus on relative-value investments. Robert P. Ryan, Senior Vice President Commodities & Energy Strategy rryan@bcaresearch.com Hugo Belanger, Research Assistant hugob@bcaresearch.com 1 Please see "Tactics Cliff Notes; A Synopsis of MCDP 1-3 Tactics," published by the United States Marine Corps, Marine Corps Warfighting Lab, Marine Corps Combat Development Command, Quantico, Virginia. 10 May 1998 (pp. 2, 3. sf). 2 In our January 7, 2016, publication we noted investors were ignoring growing upside price risk and suggested they get long a Dec/16 $50/$55 WTI call spread to gain exposure to higher volatility. We also recommended remaining long Dec/16 and Dec/17 WTI vs. Brent following passage of legislation to allow U.S. crude exports. We ultimately took profits on these recommendations of 172% on the call spread in June, and 97% on the Dec/16 WTI vs. Brent spread in June, and 88% on the Dec/17 WTI vs. Brent spread in July, respectively (Table 1). Please see "Oil Market Ignores Right-Tail Saudi Risks" in the January 7, 2016, issue of BCA Research's Commodity & Energy Strategy, which is available at ces.bcaresearch.com. 3 In our January 21, 2016, Commodity & Energy Strategy article entitled "Global Oil Sell-off Will Accelerate Rebalancing," we noted, "We expect oil markets to rebalance by late 2016Q3 or early Q4. We remain long Dec/16 $50 calls vs. $55 calls, in anticipation of rebalancing and as a hedge against geopolitical risk." 4 Note: In order to find the standard deviation of the portfolio's excess returns (tracking error volatility), we averaged the daily percentage change in each trade's underlying assets. Any given trade only weighed in the daily average return if it was open during that day of the year. We are not accounting for the type of trades (spreads, pairs or single trades), we only track the underlying asset returns. From these daily average returns we subtracted the daily return of the preferred benchmark to obtain the daily excess return. Using this, we computed an historical standard deviation (based on 20-day periods) for every day during which a trade was open in our portfolio (we had 203 days with at least one energy trade opened). Lastly, we annualized this standard deviation to obtain our tracking error volatility. 5 Please see "Dead-Cat Bounces Notwithstanding, Iron Ore Will Trade Lower" in the January 21, 2016 issue of BCA Research's Commodity & Energy Strategy, and "Fade The Copper Rally" in the February 25, 2016 issue. Both are available at ces.bcaresearch.com. 6 In earlier research, we've shown U.S. core PCE inflation is highly correlated with EM oil and base metals demand. Please see "2017 Commodity Outlook: Precious Metals" published December 15, 2016. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Tactical Focus Again Required In 2017 Tactical Focus Again Required In 2017

Highlights The U.S. dollar will continue to appreciate while the RMB will depreciate further. This is a bad omen for EM risk assets, commodities, and global late cyclical equity sectors. Gold often leads oil and copper prices. Investors should heed the current downbeat message from gold. EM credit spreads have become detached from fundamentals and are unreasonably tight. Continue overweighting the Indian bourse within an EM equity portfolio. A new equity trade: long Indian software stocks / short the EM overall index. Feature There are several major discrepancies in financial markets that in our view are unsustainable. 1. The gap between EM equity breadth, USD, RMB and EM share prices One way to measure equity market breadth is to compare performance of equal-weighted versus market cap-weighted stock price indexes. Based on this measure, EM stock market breadth has been deteriorating. Poor breadth often heralds a major selloff (Chart I-1). Chart I-1Poor EM Equity Breadth Heralds A Major Selloff Poor EM Equity Breadth Heralds A Major Selloff Poor EM Equity Breadth Heralds A Major Selloff Remarkably, the same measure for the U.S. stock market shows improving breadth. The relative performance of equally-weighted EM stocks against U.S. equity indexes - a measure of breadth in relative performance - can also be a reliable marker for the relative performance of market cap-weighted indexes. It has plummeted to a new low pointing to new lows in EM versus U.S. relative share prices. In addition, a surging U.S. dollar has historically meant lower EM share prices (Chart I-2). We doubt this time is different. Finally, EM risk assets have decoupled from the RMB/USD exchange rate as well. The RMB has been depreciating and China's domestic corporate and government bond yields have spiked. As a result, the on-shore bond prices in RMB terms have plummeted (Chart I-3). Chart I-2A Rising U.S. Dollar Is ##br##A Bad Omen For EM A Rising U.S. Dollar Is A Bad Omen For EM A Rising U.S. Dollar Is A Bad Omen For EM Chart I-3China's On-Shore Corporate Bond##br## Prices Have Crashed bca.ems_wr_2016_12_21_s1_c3 bca.ems_wr_2016_12_21_s1_c3 Experiencing considerable losses on their favorite financial investment of the past year, bonds, Chinese investors, as well as households and companies, could opt to switch into U.S. dollars. The stampede into the U.S. dollar could start as early as January when the annual US$ 50,000 quota per person becomes available. It is hard to see what the government will do to preclude this rush and massive flight towards U.S. dollars. In China, households' and corporates' RMB deposits in the banking system amount to RMB 122 tn or US$17.5 tn. Hence, the PBoC's foreign exchange reserves including gold at US$ 3.2 tn are only equal to 18.5% of these deposits at the current exchange rate. Bottom Line: The U.S. dollar will appreciate and the RMB will depreciate. This is a bad omen for EM share prices and other risk assets. 2. Oil and copper prices deviating from gold prices Historically, when gold and oil prices have diverged, gold in most cases has proven more forward looking, with oil prices ultimately converging toward gold prices. Chart I-4A and Chart I-4B illustrate past episodes of gold and oil decoupling (in the 1980, 1990s and 2008), each of which were resolved via oil prices gravitating toward gold prices. Chart I-4AGold Led Oil Prices bca.ems_wr_2016_12_21_s1_c4a bca.ems_wr_2016_12_21_s1_c4a Chart I-4BGold Led Oil Prices Gold Led Oil Prices Gold Led Oil Prices In short, if history is any guide, the current gap between gold and oil prices will likely close via lower oil prices (Chart I-5, top panel). The same holds true for the recent divergence between gold and copper prices (Chart 5, bottom panel). We identified four historical periods when gold and copper prices diverged. In each case, it was copper prices that amended their trajectory and aligned with the direction of gold prices (Chart I-6A and 6B). Chart I-5Divergence Between Oil, Copper And Gold Divergence Between Oil, Copper And Gold Divergence Between Oil, Copper And Gold Chart I-6AGold Led Copper Prices Too bca.ems_wr_2016_12_21_s1_c6a bca.ems_wr_2016_12_21_s1_c6a Chart I-6BGold Led Copper Prices Too bca.ems_wr_2016_12_21_s1_c6b bca.ems_wr_2016_12_21_s1_c6b In sum, historically there have been a number of episodes when gold has led both oil and copper prices. Investors should heed the current downbeat message from gold. Chart I-7China: Dichotomies bca.ems_wr_2016_12_21_s1_c7 bca.ems_wr_2016_12_21_s1_c7 The underlying rationale could be that gold responds to monetary/liquidity conditions (gold is very sensitive to U.S. TIPS (real) yields) while oil and copper are more sensitive to growth conditions. Tightening in monetary/liquidity conditions often precedes a growth relapse. This could be the reason why gold has led oil and copper prices on several occasions in the past. 3. Dichotomies in China's industrial economy There are two types of dichotomies underway within China's industrial economy: The first is between industrial activity and industrial commodities prices. Commodities prices have surged, but the pace of manufacturing production has not improved at all (Chart I-7). There have been major discrepancies among various segments of China's industrial economy, with utilities surging and the technology sector remaining robust, and many others stagnating. The decoupling between industrial activity and industrial commodities prices can be explained by financial speculation and supply cutbacks. The former is unsustainable, while the latter is reversing as the government is gradually lifting restrictions on supply for coal and steel. The second is between the private- and state-owned parts of the industrial sector. The state-owned segment has experienced a meaningful improvement in output, while private companies in the industrial sector have seen their output growth weaken, albeit the growth rate is higher than in the SOE sector. (Chart I-7, bottom panel). As China's fiscal and credit impulses wane,1 activity in the state-owned industrial segment will relapse anew. 4. EM credit spreads diverging from EM currencies and credit fundamentals EM sovereign and corporate credit spreads (credit markets) are once again proving very resilient, despite the renewed selloff in EM currencies (Chart I-8). EM credit markets have defied deteriorating EM credit fundamentals in the past several years. Below we identify several divergences and anomalies within the EM credit space that give us confidence that EM credit markets have become detached from fundamentals, and that their risk-reward profile is poor. Chart I-8EM Credit Markets And EM Currencies:##br## A Widening Dichotomy EM Credit Markets And EM Currencies: A Widening Dichotomy EM Credit Markets And EM Currencies: A Widening Dichotomy Chart I-9EM Corporate Financial Health:##br## Not Much Improvement bca.ems_wr_2016_12_21_s1_c9 bca.ems_wr_2016_12_21_s1_c9 The EM Corporate Financial Health (CFH) Indicator has stabilized, but remains at a very depressed level (Chart I-9, top panel). This amelioration is largely due to the profit margin component. The other three components have not improved (Chart I-9, second panel). The valuation model based on the EM CFH indicator shows that EM corporate spreads are far too tight (Chart I-10). Chart I-10EM Corporate Bonds Are Expensive EM Corporate Bonds Are Expensive EM Corporate Bonds Are Expensive The strong performance of EM credit markets in recent years has been justified by the persistence of low bond yields in developed markets (DM). Yet the latest spike in DM bond yields has so far not caused EM credit spreads to widen. We expect U.S./DM government bond yields to rise further, and the U.S. dollar to continue to strengthen. This, along with potential broad-based declines in commodities prices, should lead to material widening in EM sovereign and corporate credit spreads in early 2017. With respect to unsustainable discrepancies, the case in point is Brazil. The country's sovereign and corporate spreads have tightened a lot this year, even though economic activity continues to shrink. The country has had numerous boom-bust cycles in the past 100 years, yet this depression is the worst on record. In fact, the nation's economic growth and public debt dynamics are worse than at any time during the past 20 years. Yet, at 300 basis points, sovereign spreads are well below the 1000-2500 basis point trading range that prevailed in the second half of 1990s and early 2000s (Chart I-11). Remarkably, the economy's pace of contraction has lately intensified (Chart I-12). This will likely worsen government revenues and lead to further widening in the fiscal deficit - making debt dynamics unsustainable. Another absurd credit market divergence is between China's sovereign CDS and Chinese offshore corporate spreads. Sovereign CDS spreads have been widening, but corporate credit spreads remain very tight (Chart I-13). Chart I-11Brazil: Dichotomy Between Sovereign ##br##Spreads And Fundamentals Brazil: Dichotomy Between Sovereign Spreads And Fundamentals Brazil: Dichotomy Between Sovereign Spreads And Fundamentals Chart I-12Brazil's Economy: ##br##No Improvement At All Brazil's Economy: No Improvement At All Brazil's Economy: No Improvement At All Chart I-13Chinese Sovereign CDS And ##br##Off-Shore Corporate Spreads Chinese Sovereign CDS And Off-Shore Corporate Spreads Chinese Sovereign CDS And Off-Shore Corporate Spreads Yet there is much more risk in Chinese corporates than in government debt. The corporate sector commands record leverage of 165% of national GDP, while public debt stands at 46% of GDP. Besides, the central government in China will always have immediate access to domestic or foreign debt markets, while some corporations could lose access to financing if creditors question their creditworthiness and decide to tighten credit. There is no rational case to support the rise in sovereign CDS when corporate spreads are tame. The only feasible explanation is that investors - who are invested in Chinese corporate bonds, and are not interested in selling them - are buying sovereign CDS to tactically hedge their credit exposure. If and when market sentiment sours sufficiently, and credit spread widening is perceived durable and lasting, real money will sell corporate bonds, resulting in a major spike in corporate spreads. 5. Divergence between global late cyclicals and the U.S. dollar Another area where we detect that financial markets have lately become overly optimistic is in global late cyclicals - materials, machinery and energy stocks. Typically, the absolute share prices in these sectors correlate with the U.S. dollar exchange rate but they have lately diverged (Chart I-14). Furthermore, global machinery stocks in general, and Caterpillar's share price in particular, have lately staged significant gains, while their EPS and sales continue to plunge (Chart I-15). Notably, Caterpillar's sales have not improved, even on a rate-of-change basis. Chart I-14Global Late Cyclicals And The U.S. Dollar: ##br##Unsustainable Decoupling Global Late Cyclicals And The U.S. Dollar: Unsustainable Decoupling Global Late Cyclicals And The U.S. Dollar: Unsustainable Decoupling Chart I-15Global Machinery Sales And##br## Profits Continue Plunging Global Machinery Sales And Profits Continue Plunging Global Machinery Sales And Profits Continue Plunging EM including China capital spending in real terms is as large as the U.S. and EU capital spending combined (Chart I-16). If the EM and China capex cycle does not post a recovery, which is our baseline view, it will be hard for global late cyclical stocks to continue rallying based solely on the positive outlook for U.S. infrastructure spending and potential U.S. tax reforms. In short, global late cyclicals such as machinery, materials and energy stocks that performed quite well in 2016 are vulnerable to a major pullback as EM/Chinese capital spending disappoints on the back of credit growth deceleration. Notably, these global equity sectors have reached a major technical resistance that will likely become a ceiling for their share prices (Chart I-17). Chart I-16EM/China's Capex Is As Large As ##br##U.S. And Euro Area Combined EM/China's Capex Is As Large As U.S. And Euro Area Combined EM/China's Capex Is As Large As U.S. And Euro Area Combined Chart I-17Global Late Cyclicals Are ##br##Facing Technical Resistance Global Late Cyclicals Are Facing Technical Resistance Global Late Cyclicals Are Facing Technical Resistance 6. Decoupling between the South African rand and precious metals prices The South African rand's recent resilience - despite the considerable drop in precious metal prices - is unprecedented (Chart I-18, top panel). Similarly, the rand has also decoupled from the exchange rate of another major metals producer: Australia (Chart I-18, bottom panel). We cannot think of any reason why these discrepancies can or should persist. Rising global bond yields and a broadening selloff in commodities prices should hurt the rand. In fact, the trade-weighted rand is facing a major technical resistance (Chart I-19) and will likely relapse sooner than later. Chart I-18Rand, AUD And ##br##Precious Metals Rand, AUD And Precious Metals Rand, AUD And Precious Metals Chart I-19Trade-Weighted Rand Is ##br##Facing Technical Resistance Trade-Weighted Rand Is Facing Technical Resistance Trade-Weighted Rand Is Facing Technical Resistance We reiterate our structural short position in the rand versus the U.S. dollar, and on October 12, 2016 initiated a short ZAR / long MXN trade. Traders should consider putting on these trades. Investment Strategy Chart I-20EM Relative Equity Performance ##br##Is Heading To New Lows EM Relative Equity Performance Is Heading To New Lows EM Relative Equity Performance Is Heading To New Lows Emerging markets share prices and currencies have been doing poorly since October, despite U.S. equity shares breaking out to new highs. In fact, almost all relative outperformance has been wiped out (Chart I-20). BCA's Emerging Markets Strategy team expects further declines in EM share prices and currencies, as well as a selloff in domestic bonds and a widening of sovereign and corporate spreads. Absolute return investors should stay put, while asset allocators should maintain underweight positions in EM risk assets within respective global portfolios. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com India: Demonetization And Opportunities In Equities On November 8, India launched a demonetization program with the goal of removing the two most used banknotes - the 500 INR and 1000 INR banknotes - from circulation. Both banknotes accounted for roughly 85% of currency in circulation, which itself accounts for 13% of India's broad money supply. Moreover, almost 90%2 of retail transactions in India are cash-reliant. While around INR 13 trillion of notes (US$ 190 billion) have been deposited in the banking system as of December 10, only INR 5 trillion of new notes have been issued by the Reserve Bank of India (RBI). India is unlikely to turn cashless overnight. According to a Harvard Business Review article,3 less than 10% of Indians have ever used non-cash payment instruments. Likewise, less than 2% of Indians have used a cellular phone to receive a payment. This implies cash shortages could persist for a while and will have a significant impact on short-term economic activity. There are numerous reports that layoffs and business shutdowns have ensued in several industries, particularly in the informal economy (Chart II-1). The service sector PMI already dipped below 50 in November and the manufacturing PMI fell as well (Chart II-2). Chart II-1Very Weak Employment Outlook Very Weak Employment Outlook Very Weak Employment Outlook Chart II-2Indian PMIs Are Sinking Indian PMIs Are Sinking Indian PMIs Are Sinking Having boomed over the past year, motorcycle sales growth is now waning. Similarly, passenger and commercial vehicle sales - that have been anemic - will now dip. However, the consumption slowdown should not continue beyond the next couple of months. As more currency is supplied by the RBI, economic activity will rebound - particularly household spending. Pent-up demand will be unleashed as money circulation is restored. Nevertheless, investment expenditures are the key factors for improving productivity and, hence, as non-inflationary growth potential. Capital spending had been anemic in India well before the demonetization program was announced (Chart II-3). The reason for such lackluster investment expenditure lies in the fact that past investment projects taken on by highly leveraged Indian conglomerates have delivered poor performance. This translated into ever rising non-performing loans (NPLs) at state banks. Without debt restructuring and public bank recapitalization, a new capex cycle is unlikely in India. Consistently, credit to large industries is now contracting (Chart II-4) and foreign lending to Indian companies is declining. Chart II-3Indian Capex Is Anemic Indian Capex Is Anemic Indian Capex Is Anemic Chart II-4Banks Prefer Consumers bca.ems_wr_2016_12_21_s2_c4 bca.ems_wr_2016_12_21_s2_c4 We expect the demonetization program to hurt capital spending only mildly in the coming months, but do not expect a material bounce in investment afterward, unlike the one slated for household consumption. Indian share prices have more downside in absolute terms, as the market is still expensive and growth is slumping. Nevertheless, India will likely outperform the EM equity benchmark going forward (Chart II-5). Chart II-5Indian Share Prices: A Tapering Wedge Indian Share Prices: A Tapering Wedge Indian Share Prices: A Tapering Wedge The rationale for our overweight on Indian equities within the EM stock universe is due to the nation's much better macro fundamentals relative to those in many other EM. In particular, deleveraging and NPL write-offs are more advanced, the current account deficit is small, and India will benefit from potentially lower commodities prices. Within the Indian bourse, we recommend overweighting software stocks that will benefit from a revival in advanced economies' growth and a weaker currency. Besides, Indian software stocks are not exposed to the currently weak domestic consumption cycle and in fact might benefit from the push toward digitalization in banking. Bottom Line: Indian consumption will weaken in the coming three months or so, but will rebound thereafter. The capex cycle is weak and will remain subdued. Continue overweighting the Indian bourse within an EM equity portfolio. A new equity recommendation: long Indian software stocks / short the EM overall index. Ayman Kawtharani, Research Analyst aymank@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report, titled "Key EM Issues Going Into 2017," dated December 14, 2016, available at ems.bcaresearch.com 2 Chakravorti, B., Mazzotta, B., Bijapurkar, R., Shukla, R., Ramesha, K., Bapat, D., &Roy, D. (2013). The cost of cash in India. Institute of Business in the Global Context, Fletcher School, Tufts University. 3 Chakravorti, B. (2016, December 14). India's Botched War on Cash. Retrieved from https://hbr.org Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Recommendation Allocation Quarterly - December 2016 Quarterly - December 2016 Highlights Growth was picking up before the election of President Trump. His election merely accelerates the rotation from monetary to fiscal policy. This is likely to cause yields to rise, the Fed to tighten and the dollar to strengthen further. That will be negative for bonds, commodities and emerging market assets, and equivocal for equities. Short term, markets have overshot and a correction is likely. But the 12-month picture (higher growth and inflation) suggests risk assets such as equities will outperform. Our recommendations mostly have cyclical tilts. We are overweight credit versus government bonds, underweight duration and, in equity sectors, overweight energy, industrials and IT (and healthcare for structural reasons). Among alts, we prefer real estate and private equity over hedge funds and structured products. We limit beta through overweights (in common currency terms) on U.S. equities versus Europe and emerging markets. We also have a (currency-hedged) overweight on Japanese stocks. Feature Overview A Shift To Reflation The next 12 months are likely to see stronger economic growth, particularly in the U.S., and higher inflation. That will probably lead to higher long-term interest rates, the Fed hiking two or three times in 2017, and further dollar strength. The consequences should be bad for bonds, but mixed for equities - which would benefit from a better earnings outlook, but might see multiples fall because of a higher discount rate. The election of Donald Trump merely accelerates the rotation from monetary policy to fiscal policy that had been emerging globally since the summer. Trump's fiscal plans are still somewhat vague,1 but the OECD estimates they will add 0.4 percentage points to U.S. GDP growth in 2017 and 0.8 points in 2018, and 0.1 and 0.3 points to global growth. Growth was already accelerating before the U.S. presidential election. Global leading indicators have picked up noticeably (Chart 1), and the Q3 U.S. earnings season surprised significantly on the upside, with EPS growth of 3% (versus a pre-results expectation of -2%) - the first YoY growth in 18 months (Chart 2). Chart 1Global Growth Picking Up bca.gaa_qpo_2016_12_15_c1 bca.gaa_qpo_2016_12_15_c1 Chart 2U.S. Earnings Growing Again bca.gaa_qpo_2016_12_15_c2 bca.gaa_qpo_2016_12_15_c2 The problem with the shift to fiscal, then, is that it comes at a time when slack in U.S. economy has already largely disappeared. The Congressional Budget Office estimates the output gap is now only -1.5%, which means it is likely to turn positive in 2017 (Chart 3). Unemployment, at 4.6%, is below NAIRU2 (Chart 4). Historically, the output gap turning positive has sown the seeds of the next recession a couple of years later, as the Fed tightens policy to choke off inflation. Chart 3Output Gap Will Close In 2017 bca.gaa_qpo_2016_12_15_c3 bca.gaa_qpo_2016_12_15_c3 Chart 4Will This Trigger Inflation Pressures? bca.gaa_qpo_2016_12_15_c4 bca.gaa_qpo_2016_12_15_c4 As the Fed signaled at its meeting on December 14, it is likely to raise rates two or three times more in 2017. But we don't see it getting any more hawkish than that. Janet Yellen has made it clear that she will not preempt Trump's fiscal stimulus but rather wait to see it passed by Congress. The market is probably about right in pricing in an 80% probability of two rate hikes in 2017, and a 50% probability of three. With the Atlanta Fed Wage Growth Tracker rising 3.9% YoY and commodity prices (especially energy) starting to add to headline inflation, the Fed clearly wants to head off inflation before it sets in. We do not agree with the argument that the Fed will deliberately allow a "high-pressure economy." The result is likely to be higher long-term rates. The 10-year U.S. yield has already moved a long way (up 100 BP since July), and our model suggests fair value currently is around 2.3% (Chart 5). Short term, then, a correction is quite possible (and would be accompanied by moves in other assets that have overshot since November 9). But stronger global growth and an appreciating dollar over the next 12 months could easily push fair value up to 3% or beyond. The relationship between nominal GDP growth (which is likely to be 4.5-5% in 2017, compared to 2.7% in 1H 2016) and long-term rates implies a rise to a similar level (Chart 6). Accordingly, we recommend investors to be underweight duration and prefer TIPs over nominal bonds. Chart 5U.S. 10-Year At Fair Value U.S. 10-Year At Fair Value U.S. 10-Year At Fair Value Chart 6Rise In Nominal GDP Could Push It Up To 3% Rise In Nominal GDP Could Push It Up To 3% Rise In Nominal GDP Could Push It Up To 3% Global equities, on a risk-adjusted basis, performed roughly in line with sovereign bonds in 2016 - producing a total return of 9.2%, compared to 3.3% for bonds (though global high yield did even better, up 15.1%). If our analysis above is correct, the return on global sovereign bonds over the next 12 months is likely to be close to zero. Chart 7Will Investors Reverse The Move##br## from Equities To Bonds? Will Investors Reverse The Move from Equities To Bonds? Will Investors Reverse The Move from Equities To Bonds? The outlook for equities is not unclouded. Higher rates could dampen growth (note, for example, that 30-year fixed-rate mortgages in the U.S. have risen over the past two months from 3.4% to 4.2%, close to the 10-year average of 4.6%). The U.S. earnings recovery will be capped by the stronger dollar.3 And a series of Fed hikes may lower the PE multiple, already quite elevated by historical standards. Erratic behavior by President Trump and the more market-unfriendly of his policies could raise the risk premium. But we think it likely that equities will produce a decent positive return in this environment. Portfolio rebalancing should help. Since the Global Financial Crisis investors have steadily shifted allocations from equities into bonds (Chart 7). They are likely to reverse that over the coming quarters if bond yields continue to trend up. Accordingly, we moved overweight equities versus bonds in our last Monthly Portfolio Update.4 Our recommended portfolio has mostly pro-cyclical tilts: we are overweight credit versus government bonds, overweight most cyclical equity sectors, and have a preference for risk alternative assets such as real estate and private equity. But our portfolio approach is to pick the best spots for taking risk in order to make a required return. We, therefore, balance this pro-cyclicality by some lower beta stances: we prefer investment grade debt over high yield, and U.S. and Japanese equities over Europe and emerging markets. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com What Our Clients Are Asking What Will Trump Do? Trump made several speeches in September with details of his tax plan. He promised to (1) simplify personal income tax, cutting seven brackets to three, with 12%, 25% and 33% tax rates; (2) cut the headline corporate tax rate to 15% (from 35%); and (3) levy a 10% tax on the $3 trillion of corporate retained earnings held offshore. He was less specific on infrastructure spending, but Wilbur Ross, the incoming Commerce Secretary, mentioned $550 billion, principally financed through public-private partnerships. The Tax Policy Center estimates the total cost of the tax plan at $6 trillion (with three-quarters from the business tax cut). But it is not clear how much will be offset by reduced deductions. Incoming Treasury Secretary Steven Mnuchin, for example, said that upper class taxpayers will get no absolute tax cut. TPC estimates the tax plan alone will increase federal debt to GDP by 25 percentage points over the next 10 years (Chart 8). The OECD, assuming stimulus of 0.75% of GDP in 2017 and 1.75% in 2018, estimates that this will raise U.S. GDP growth by 0.4 percentage points next year and by 0.8 points in 2018, with positive knock-on effects on the rest of the world (Chart 9). While there are questions on the timing (and how far Trump will go with trade and immigration measures), BCA's geopolitical strategists sees few constraints on getting these plans passed.5 Republications in Congress like tax cuts (and will compromise on the public spending element) and it is wrong to assume that Republican administrations reduce the fiscal deficit - historically the opposite is true (Chart 10). Chart 8Massive Increase In Debt Quarterly - December 2016 Quarterly - December 2016 Chart 9GDP Impact Of U.S. Fiscal Stimulus Quarterly - December 2016 Quarterly - December 2016 Chart 10A Lot of Stimulus, And Extra Debt bca.gaa_qpo_2016_12_15_c10 bca.gaa_qpo_2016_12_15_c10 Implications for markets? Short term positive for growth and inflation; longer-term a worry because of crowding out from the increased government debt. How Will The Strong USD Impact Global Earnings? We have a strong U.S. dollar view and also favor U.S. equities over the euro area and emerging markets. Some clients question our logic because conceptually a strong USD should benefit earnings growth in the non-U.S. markets, and therefore non-U.S. equities should outperform. Chart 11USD Impact On Global Earnings bca.gaa_qpo_2016_12_15_c11 bca.gaa_qpo_2016_12_15_c11 Currency is just one of the factors that we consider when we make country allocation decisions, and our weights are expressed in USD terms unhedged. We will hedge a currency only when we have very high conviction, such as our current Japan overweight with a yen hedge, which is based on our belief that the BOJ will pursue more unconventional policies to stimulate the economy. This is undoubtedly yen bearish but positive for Japanese stocks. As shown in Chart 11, a stronger USD has tended to weaken U.S. earnings growth (panel 1). However, what matters to country allocation is relative earnings growth. Panels 3 and 5 show that in local currency terms, earnings growth in emerging markets and the euro area did not always outpace that in the U.S. when their currencies depreciated against the USD. In fact, when their currencies appreciated, earnings growth in USD terms tended to outpace that in the U.S. (panels 2 and 4), suggesting that the translation impact plays a very important role. This is consistent with what we have found for relative equity market returns (see Global Equity section on page 13). Currency affects revenues and costs in different proportions. If both revenues and costs are in same currency, then only net profit is affected by the currency. But, since many companies manage their forex exposure, at the aggregate level the currency impact will always be "weaker than it should be". What Is The Outlook For Brexit And The Pound? The U.K. shocked the world on 24 June 2016 with its vote to leave the European Union. However, the process and terms of exit are yet to be finalized pending the Supreme Court's decision on the role of parliament in invoking Article 50 of the Lisbon Treaty. Depending on this decision, there is a spectrum of possible outcomes for the U.K./EU relationship. At the two ends of the spectrum are: 1) a hard Brexit - complete separation from the EU, in which case the pound will plunge further; 2) a soft Brexit - with a few features of the current relationship retained, in which case the pound will rally. Chart 12What's Up Brexit? What's Up Brexit? What's Up Brexit? The fall in the nominal effective exchange rate to a 200-year low (Chart 12) is a clear indication of the potential serious long-term damage. With the nation's dependence on foreign direct investment (FDI) to finance its large current account deficit (close to 6% of GDP), more populist policies and increased regulation will hurt corporate profitability, making local assets less profitable to foreigners. The pound is currently caught up in a vicious circle of more depreciation, leading to higher inflation expectations and depressed real rates, which adds further selling pressure. This is the likely path of the pound in the case of a hard Brexit. For U.K. equities, under a hard Brexit that adds downward pressure to the pound, investors should favor firms with global revenues (FTSE 100) and underweight firms exposed more to domestic business and a potential recession (FTSE 250). The opposite holds true in the case of a soft Brexit. Investors should also underweight U.K. REITs because of cyclical and structural factors that will affect commercial real estate. In the case of a hard Brexit, structural long-term impacts to the British economy include: 1) a decline in the financial sector - the EU will introduce regulations that will force euro-denominated transactions out of London; 2) a slowdown in FDI - the U.K. will cease to be a platform for global companies to access the EU, triggering a long-term decline in foreign inflows; 3) weaker growth - with EU immigration into the U.K. expected to fall by 90,000 to 150,000 per year, estimates.6 point to a 3.4% to 5.4% drop in per capita GDP by the year 2030. What Industry Group Tilts Do You Recommend? In October 2015, we advocated that, because long-term returns for major asset classes would fall short of ingrained expectations, investors should increase alpha by diving down into the Industry Group level.7 How have these trades fared, and which would we still recommend? Long Household And Personal Products / Short Energy. We closed the trade for a profit of 12.2% in Q12016. This has proven to be quite timely as oil prices, and Energy stocks along with it, have rallied substantially since. Long Insurance / Short Banks. The early gains from this trade reversed in Q2 as long yields have risen rapidly, leading to yield curve steepening. However, our cyclical view is still intact. Relative performance is still holding its relationship with the yield curve (Chart 13). Historically, Fed tightening has almost always led to bear flattening. We expect the same in this cycle, which should lead to Insurance outperformance. Long Health Care Equipment / Short Materials. This trade generated early returns but has since underperformed as Materials bounced back sharply. Nevertheless, we remain bearish on commodities and EM-related plays, viewing this rise in Materials stocks as more of a technical bounce from oversold valuations (Chart 14). Commodities remain in a secular bear market. On health care, we maintain our structural bullish outlook given aging demographics, increased spending on health care and attractive valuations. Short Retail / Global Broad. We initiated trade in January after the Fed initiated liftoff. Consumer Discretionary stocks collapsed after, and this trade has provided a gain of 2.01%. We maintain this view as the recent hike and 2017 hikes will continue to dampen Retail performance (Chart 15). Additionally, Retail has only declined slightly while other Consumer Discretionary stocks have falling drastically, suggesting downside potential from convergence. Chart 13Flatter Yield Curve Is Bullish bca.gaa_qpo_2016_12_15_c13 bca.gaa_qpo_2016_12_15_c13 Chart 14An Oversold Bounce bca.gaa_qpo_2016_12_15_c14 bca.gaa_qpo_2016_12_15_c14 Chart 15Policy Tightening = Underperformance bca.gaa_qpo_2016_12_15_c15 bca.gaa_qpo_2016_12_15_c15 Global Economy Overview: The macro picture looks fairly healthy, with growth picking up in developed economies and China, though not in most emerging markets. The weak patch from late 2015 through the first half of 2016, with global industrial and profits recessions, appears to be over. The biggest threat to growth now is excessive dollar strength, which would slow U.S. exports and harm emerging markets. U.S.: U.S. growth was surprising on the upside (Chart 16) even before the election. Q2 real GDP growth came in at 3.2% and the Fed's Nowcasting models indicate 2.6-2.7% in Q4. After rogue weak ISMs in August, the manufacturing indicator has recovered to 53.2 and the non-manufacturing ISM to 57.2. However, growth continues to be driven mainly by consumption, with capex as yet showing few signs of recovery. A key question is whether a Trump stimulus will be enough to reignite "animal spirits" and push corporates to invest more. Euro Area: Eurozone growth has also been surprisingly robust. PMIs for manufacturing and services in November came in at 53.7 and 53.8 respectively; the manufacturing PMI has been accelerating all year. This is consistent with the ECB's forecasts for GDP growth of 1.7% for both this year and next. However, risk in the banking system could derail this growth. Credit growth, highly correlated with economic activity, has picked up to 1.8% YOY but could slow if banks turn cautious. Japan: Production data has reacted somewhat to Chinese stimulus, with IP growth positive (Chart 17) for the past three months and the Leading Economic Index inching higher since April. But the strength of the yen until recently and disappointing inflation performance (core CPI -0.4% YOY) have depressed exports and consumer sentiment. The effectiveness of the BoJ's 0% yield cap on 10-year government bonds, which has weakened the yen by 14% in two months, should trigger a mild acceleration of growth in coming quarters. Chart 16U.S. Economy Surprising ##br##On The Upside bca.gaa_qpo_2016_12_15_c16 bca.gaa_qpo_2016_12_15_c16 Chart 17Growth Picks Up In##br## Most DMs And China bca.gaa_qpo_2016_12_15_c17 bca.gaa_qpo_2016_12_15_c17 Emerging Markets: China has continued to see positive effects from its reflation of early 2016, with the manufacturing PMI close to a two-year high. The effects of the stimulus will last a few more months, but the authorities have reined back now and the currency is appreciating against its trade basket. The picture is less bright in other emerging markets, as central banks struggle with weak growth and depreciating currencies. Credit growth is slowing almost everywhere (most notably Turkey and Brazil) which threatens a further slowdown in growth in 2017. Interest rates: Inflation expectations have risen sharply in the U.S. following the election, but less so in the eurozone and Japan. They may rise further - pushing U.S. bond yields close to 3% - if the Trump administration implements a fiscal stimulus anywhere close to that hinted at. This could, in turn, push the Fed to raise rates at least twice more in 2017. The ECB has announced a reduction in its asset purchases starting in April 2017, too, but the Bank of Japan will allow inflation to overshoot before tightening. Chart 18Earnings Bottoming But##br## Valuation Stretched bca.gaa_qpo_2016_12_15_c18 bca.gaa_qpo_2016_12_15_c18 Global Equities Cautiously Optimistic: Global markets have embraced the "hoped for" pro-growth and inflationary policies from the new U.S. administration since Trump's win on November 8. In the latest GAA Monthly Update published on November 30,8 we raised our recommendation for global equities relative to bonds to overweight from neutral on a 6-12 month investment horizon. However, the call was driven more by underweighting bonds than by overweighting equities, given the elevated equity valuations and declining profit margins.(Chart 18) The hoped-for U.S. pro-growth policies would, if well implemented, be positive for earnings growth, but the "perceived" earnings boost has not yet shown up in analysts' earnings revisions (panel 3). In fact, only three sectors (Financials, Technology and Energy) currently have positive earnings revisions, because analysts had already been raising forward earnings estimates since early 2016. According to I/B/E/S data as of November 2016, about 80% of sectors are forecast to have positive 12-month forward earnings growth, while only about 20% have positive 12-month trailing earnings growth (panel 3). Within global equities, we continue to favor developed markets over emerging market on the grounds that most EMs are at an early stage of a multi-year deleveraging.9 We also favor the U.S. over the euro area (see more details on the next page). The Japan overweight (currency hedged) is an overwrite of our quant model: we believe that the BoJ will pursue increasingly unconventional monetary policy measures over the coming 12 months. The quant model (in USD and unhedged) has suggested a large underweight in Japan but has gradually reduced the underweight over the past two months. Our global sector positioning is more pro-cyclical than our more defensively-oriented country allocations. In line with our asset class call, we upgrade Financials to neutral and downgrade Utilities to underweight, and continue to overweight Energy, Technology, Industrials, and Healthcare while underweighting Telecom, Consumer Discretionary and Consumer Staples. Country Allocation: Still Favor U.S. Over Euro Area GAA's portfolio approach is to take risk where it is likely to be best rewarded. Having taken risk at the asset class level (overweight equities vs. bonds), at the global equity sector level with a pro-cyclical tilt, and at the bond class level with credit and inflation tilts, we believe it's appropriate to maintain our more defensive equity tilt at the country level by being market weight in euro area equities on an unhedged USD basis while maintaining a large overweight in the U.S. Chart 19Uninspiring profit Outlook bca.gaa_qpo_2016_12_15_c19 bca.gaa_qpo_2016_12_15_c19 It's true that the euro area PMI has been improving. Relative to the U.S., however, the euro area's cyclical improvement, driven by policy support, has lost momentum. It's hard to envision what would reverse this declining growth momentum, suggesting European earnings growth will remain at a disadvantage to the U.S. (Chart 19, panel 1) It's also true that the underperformance of eurozone equities versus the U.S. has reached an historical extreme in both local and common currency terms, and that euro equities are trading at significant discount to the U.S. But Europe has always traded at a discount, and the current discount is only slightly lower than its historical average. Our work has shown that valuation works well only when it is at extremes, which is not the case currently. Conceptually, a weak euro should boost euro area equity performance at least in local currency terms, yet empirical evidence does not strongly support such a claim: the severe underperformance since 2007 has been accompanied by a 43% drop in the euro versus the USD (Chart 19 panel 2). In fact, in USD terms, the euro area tended to outperform the U.S. when the euro was strong (panel 3), suggesting that currency translation plays a more dominant role in relative performance. Our currency house view is that the euro will depreciate further against the USD, given divergences in monetary and fiscal policy between the two regions. As such, we recommend clients to continue to favor U.S. equities versus the euro area, but not be underweight Europe given that it is technically extremely oversold. Sector Allocation: Upgrade Financials To Neutral Our sector quant model shifted global Financials to overweight in December from underweight, largely driven by the momentum factor. We agree with the direction of the quant model as the interest rate environment has changed (Chart 20, panel 1) and valuation remains very attractive (panels 2), but we are willing to upgrade the sector only to market weight due to our concern on banks in the euro area and emerging markets. Within the neutral stance in the sector, we still prefer U.S. and Japanese Financials to eurozone and emerging market ones. Despite the poor performance of the Financials sector relative to the global benchmark, U.S. and Japanese financials have consistently outperformed eurozone financials, driven by better relative earnings without any valuation expansion (panel 3). U.S. banks have largely repaired their balance sheets since the Great Recession, and the "promised" deregulation by the new U.S. administration will probably help U.S. banks. In the euro area, however, banks, especially in Italy, are still plagued with bad loans (panel 4). We will watch banking stress in the region very closely for signs of contagion (panel 5) The upgrade of financials is mainly financed by downgrading the bond proxy Utilities to underweight from neutral, in line with our asset class view underweighting fixed income. Chart 20Global Financials: Regional Divergence bca.gaa_qpo_2016_12_15_c20 bca.gaa_qpo_2016_12_15_c20 Chart 21Global Equities: No Style Bet bca.gaa_qpo_2016_12_15_c21 bca.gaa_qpo_2016_12_15_c21 Smart Beta Update: No Style Bet In a Special Report on Smart Beta published on July 8 2016,10 we showed that it is very hard to time style shifts and that an equal-weighted composite of the five most enduring factors (size, value, quality, minimum volatility and momentum) outperforms the broad market consistently on a risk-adjusted basis. Year-to-date, the composite has performed in line with the broad market, but over the past three months there have been sharp reversals in the performance of the different factors, with Min Vol, Quality and Momentum sharply underperforming Value and Size (Chart 21 panel 1). We showed that historically the Value/Growth tilt has been coincident with the Cyclical/Defensive sector tilt (panel 3). Panel 2 also demonstrates that the Min Vol strategy's relative performance can also be well explained by the Defensives/Cyclicals sector tilt. Sector composition matters. Compared to Growth, Value is now overweight Financials by 25.6%, Utilities by 13.2%, Energy by 8.3% and Materials by 2.5%, while underweight Tech by 23%, Healthcare by 12.7%, and Consumer Discretionary by 10%. REITs is in pure Growth, while Utilities and Telecom are in pure Value, and Energy has very little representation in Growth. In our global sector allocation, we favor Tech, REITs, Energy, and Healthcare, while underweight Utilities, Consumer Discretionary and Telecoms, and neutral on Financials and Materials. As such, maintaining a neutral stance on Value vs. Growth is consistent with our sector positioning. Government Bonds Maintain slight underweight duration. After 35 years, the secular bull market in government bonds is over. Even with Treasury yields skyrocketing since the Trump victory, the path of least resistance for yields is upward (Chart 22). Yields should grind higher slowly as inflation rises and growth indicators continue to improve. Bullish sentiment has dropped considerably, but there is further downside potential. Additionally, fiscal stimulus from Japan and further rate hikes from the Fed will provide considerable tailwinds. Overweight TIPS vs. Treasuries. Despite still being below the Fed's target, with headline and core CPI readings of 1.6% and 2.2% respectively, U.S. inflation has clearly bottomed for the cycle (Chart 23). This continued rise is a result of cost-push inflation driven by faster wage growth. Trump's increased spending and protectionist trade policies are both inflationary. As real GDP growth should remain around 2% annualized and the labor market continues to tighten, this effect will only intensify. Valuations have become less attractive but very gradual Fed hikes will not be enough to derail the upward momentum in consumer prices. Overweight JGBs. The BoJ has ramped up its commitment to exceeding 2% inflation by expanding its monetary base and locking in 10-year sovereign yields at zero percent. Additionally, the end of the structural decline in interest rates suggests global bonds will perform poorly going forward. During global bond bear markets, low-beta Japanese government debt has typically outperformed (Chart 24). This will likely hold true again as global growth improves and Japanese authorities increase fiscal stimulus while maintaining their cap on bond yields. Chart 22Maintain Slight Underweight Duration bca.gaa_qpo_2016_12_15_c22 bca.gaa_qpo_2016_12_15_c22 Chart 23Inflation Uptrend Intact bca.gaa_qpo_2016_12_15_c23 bca.gaa_qpo_2016_12_15_c23 Chart 24Overweight JGBs bca.gaa_qpo_2016_12_15_c24 bca.gaa_qpo_2016_12_15_c24 Corporate Bonds The BCA Corporate Health Monitor remains deeply in "Deteriorating Health" territory, indicating weakness within corporate balance sheets (Chart 25). Over the last quarter, the rate of deterioration actually slowed, with all six ratios improving slightly. Nevertheless, the trend toward weaker corporate health has been firmly established over the past eleven quarters. This is consistent with the very late stages of past credit cycles. Maintain overweight to Investment Grade debt. In the absence of a recession, spread product will usually outperform. U.S. growth should accelerate in 2017, with consumer confidence being resilient, fiscal spending expected to increase, and the drag from inventories unwinding. Monetary conditions are still accommodative and the potential sell-off from the rate hike should be milder than it was in December 2015 (Chart 26). Additionally, credit has historically outperformed in the early stages of the Fed tightening cycle. However, there are two key risks to our view. The end of the structural decline in interest rates presents a substantial headwind to investment grade performance. Since 1973, median and average returns were slightly negative during months where long-term yields rose. During the blow-off in yields in the late 1970s, corporate debt performed very poorly. However, yields had reached very high levels. Secondly, valuations are unattractive, with OAS spreads at their lowest in about one and a half years (Chart 27). Chart 25Balance Sheets Deteriorating Balance Sheets Deteriorating Balance Sheets Deteriorating Chart 26Still Accommodative bca.gaa_qpo_2016_12_15_c26 bca.gaa_qpo_2016_12_15_c26 Chart 27Expensive Valuations bca.gaa_qpo_2016_12_15_c27 bca.gaa_qpo_2016_12_15_c27 Commodities Secular Perspective: Bearish We reiterate our negative long-term outlook on the commodity complex on the back of a structural downward shift in global demand led primarily by China's transition to a services-driven economy. With this slack in demand, global excess capacity has sent deflationary impulses across the globe, limiting upside in commodity prices.11 Chart 28OPEC To The Rescue bca.gaa_qpo_2016_12_15_c28 bca.gaa_qpo_2016_12_15_c28 Cyclical Perspective: Neutral A divergent outlook for energy and base metals gives us a neutral view for aggregate commodities over the cyclical horizon (Chart 28). Last month's OPEC deal supports our long-standing argument of increasing cuts in oil supply, which will support energy prices. However, metal markets suffer from excess supply. A stronger U.S. dollar will continue to be a major headwind over the coming months. Energy: OPEC's agreement to cut production by 1.2 mb/d has spurred a rally in the crude oil price, as prospects for tighter market conditions next year become the base case. However, with the likelihood that the dollar will strengthen further in coming months, oil will need more favorable fundamentals to rise substantially in price from here. Base Metals: The U.S. dollar has much greater explanatory power12 than Chinese demand in price formation for base metals. The recent rally in base metals is overdone with metals prices decoupling from the dollar; we expect a correction in the near-term driven by further dollar strength. Metal markets remain oversupplied as seen by rising iron ore and copper inventories. We remain bearish on industrial and base metals. Precious Metals: Gold, after decoupling from forward inflation expectations in H1 2016 - rising while inflation expectations were weak - has converged back in line with the long-term inflation gauge. Our expectation of higher inflation, coupled with rising geopolitical uncertainties, remain the two key positives for the gold price. However, our forecast of U.S. dollar appreciation will limit upside potential for the precious metal. Currencies Key Themes: USD: Much of the post-Trump rally in the dollar can be explained by the sharp rally in U.S. bond yields (Chart 29). We expect more upside in U.S. real rates relative to non-U.S. rates, driven by the U.S.'s narrower output gap and the stronger position of its household sector. As labor market slack continues to lessen and wage pressures rise, the Fed will be careful not to fall behind the curve; this will add upward pressure to the dollar. Chart 29Dollar Continues It's Dominance bca.gaa_qpo_2016_12_15_c29 bca.gaa_qpo_2016_12_15_c29 Euro: Since the euro area continues to have a wider output gap than the U.S., the euro will face additional downward pressure on the back of diverging monetary policy. As the slack diminishes, the ECB will respond appropriately - we believe the euro has less downside versus the dollar than does the yen. Yen: Although the Japanese economy is nearing fully employment, the Abe administration continues to talk about additional stimulus. As inflation expectations struggle to find a firm footing despite the stimulus, the BOJ is explicitly aiming to stay behind the curve. Additionally, with the BOJ pegging the 10-year government bond yield at 0% for the foreseeable future, we expect further downward pressure on the currency. EM: We expect more tumult for this group as rising real rates have been negative for EM assets in this cycle. EM spreads have widened in response to rising DM yields which has led to more restrictive local financial conditions. The recovery in commodity prices has been unable to provide any relief to EM currencies - a clear sign of continued weak fundamentals (rising debt, excess capacity and low productivity). Commodity currencies will face more downside driven by their tight correlation with EM equities (0.82) and with EM spreads. Alternatives Overweight private equity / underweight hedge funds. Global growth is fairly stable and has the potential to surprise on the upside. In the absence of a recession, private equity typically outperforms as the illiquidity premium should provide a considerable boost to returns. Hedge funds, on the other hand, have displayed a negative correlation with global growth. Historically, they have outperformed private equity only during recessions or periods of high credit market stress (Chart 30). Overweight direct real estate / underweight commodity futures. Commercial real estate (CRE) assets are in a "goldilocks" scenario: Growth is sufficient to generate sustainable tenant demand without triggering a new supply cycle. Favor Industrials for its income potential and Retail given resilient consumer spending. Overweight trophy markets, as demand remains robust given multiple macro risks. Commodities have bounced, but remain in a secular bear market caused by a supply glut and exacerbated by a market-share war (Chart 31). Overweight farmland & timberland / underweight structured products. The trajectory of Fed policy, the run-up in equity prices and the weak earnings backdrop have increased the importance of volatility reduction. Favor farmland & timberland. Substantial portfolio diversification benefits, resulting from low correlations with traditional assets, coupled with a positive skew, make these assets highly attractive. As the most bond-like alternative, structured products tend to outperform during recessions, which is not our base case (Chart 32). Chart 30PE: Tied To Real Growth bca.gaa_qpo_2016_12_15_c30 bca.gaa_qpo_2016_12_15_c30 Chart 31Commodities: A Secular Bear Market bca.gaa_qpo_2016_12_15_c31 bca.gaa_qpo_2016_12_15_c31 Chart 32Structured Products Outperform In Recessions bca.gaa_qpo_2016_12_15_c32 bca.gaa_qpo_2016_12_15_c32 Risks To Our View Our main scenario is for stronger growth, higher inflation and an appreciating dollar in 2017, leading to equities outperforming bonds. Where could this go wrong? Growth stagnates. U.S. growth could fail to pick up as expected: the stronger dollar will hurt profits, which might lead to companies cutting back on hiring; higher interest rates could affect the housing market and consumer discretionary spending; companies may fail to increase capex, given their low capacity utilization ratio (Chart 33). In Europe, systemic banking problems could push down credit growth which is closely correlated to economic growth. Emerging markets might see credit events caused by the stronger dollar and weaker commodities prices. Political risks. An unconventional new U.S. President raises uncertainty. How much will Trump emphasize his more market-unfriendly policies, such as tougher immigration control, tariffs on Chinese and Mexican imports, and interference in companies' decisions on where to build plants? His more confrontational foreign policy stance risks geopolitical blow-ups. Elections in France, the Netherland and Germany in 2017 could produce populist government. The Policy Uncertainty Index currently is high and this historically has been bad for equities (Chart 34). Chart 33Maybe Companies Won't Increase Capex bca.gaa_qpo_2016_12_15_c33 bca.gaa_qpo_2016_12_15_c33 Chart 34Policy Uncertainty Is High bca.gaa_qpo_2016_12_15_c34 bca.gaa_qpo_2016_12_15_c34 Synchronized global growth. If the growth acceleration were not limited to the U.S. but were to spread, this might mean that the dollar would depreciate, particularly as it is already above fair value (Chart 35). In this environment, given their inverse correlation with the dollar (Chart 36), commodity prices and EM assets might rise, invalidating our underweight positions. Chart 35Dollar Already Above##br## Fair Value Dollar Already Above Fair Value Dollar Already Above Fair Value Chart 36How Would EM And Commodities Move##br## If USD Weakens? bca.gaa_qpo_2016_12_15_c36 bca.gaa_qpo_2016_12_15_c36 1 We discuss them in the "What Our Clients Are Asking," section of this Quarterly Portfolio Outlook. 2 Non-accelerating inflation rate of unemployment - the level of unemployment below which inflation tends to rise. 3 Please see "How Will The Strong USD Impact Global Earnings," in the What Our Clients Are Asking section of this Quarterly Portfolio Outlook. 4 Please see Global Asset Allocation, "Monthly Portfolio Update: The Meaning of Trump," dated November 30, 2016, available at gaa.bcaresearch.com. 5 Please see Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency", dated November 30, 2016, available at gps.bcaresearch.com. 6 According to National Institute of Economic Research.com. 7 Please see Global Asset Allocation Strategy Special Report, "Asset Allocation In A Low-Return World, Part IV: Industry Groups," dated October 25, 2015, available at gaa.bcaresearch.com. 8 Please see Global Asset Allocation,"Monthly Portfolio Update," dated November 30, 2016 available at gaa.bcaresearch.com 9 Please see Global Asset Allocation Special Report,"Refreshing Our Long-Term Themes," dated December 5, 2016 available at gaa.bcaresearch.com 10 Please see Global Asset Allocation Strategy Special Report, "Is Smart Beta A Useful Tool In Global Asset Allocation?," dated July 8, 2016, available at gaa.bcaresearch.com. 11,12 Please see Global Asset Allocation Special Report, "Refreshing Our Long-Term Themes," dated December 5, 2016 available at gaa.bcaresearch.com Recommended Asset Allocation

Highlights Dear Client, This issue of BCA's Commodity & Energy Strategy features our 2017 Outlook for Bulks and Base Metals. The evolution of China's economy will, as always, be critical to these markets, given that country's outsized role in iron ore, steel and base metals. We are broadly neutral the complex, and, with the exception of the nickel market, see supply and demand relatively balanced. That said, the potential for price spikes - e.g., copper, where spare capacity is shrinking - and for monetary and fiscal policy errors to spill into these markets keeps downside price risk elevated. Next week, we will publish our 2017 Outlook for Energy Markets, with special attention to the oil market. As expected, OPEC and Russia agreed to cut production. As we went to press, WTI and Brent crude oil prices were up ~ 8.5% on the news. We will take profits today on our Long February 2017 Brent $50/bbl Calls vs. Short February 2017 $55/bbl Calls, which was up 73.6% basis Wednesday's close when we went to press. We remain long August 2017 WTI vs. Short November 2017 WTI futures in anticipation of a backwardated forward curve in 2017H2; as of Wednesday's close, this position returned 76.39% since November 3, when we recommended the exposure. Our 2017 Precious Metals and Agricultural outlooks will be published in the following weeks. We will finish with an outlook for commodities as an asset class in 2017 at year-end. We trust you will find these reports informative and useful for your investing and year-ahead planning. Kindest regards, Robert P. Ryan, Senior Vice President The monetary and fiscal stimulus that massively boosted China's housing market this year will wind down, bringing an end to the run-up in iron ore, steel and base metals prices. While we expect "reflationary" policies to continue going into the Communist Party Congress next fall, when new leadership roles will be announced, we do not expect anything along the lines of the surge in policy stimulus seen earlier this year: Unwinding and controlling property-market excesses and high debt levels will limit policymakers' desire to turbo-charge the housing market again, limiting the boost such policies provide. We are downgrading our tactically bullish view on iron ore to neutral. Our out-of-consensus bullish call was proven correct with a 43% rally in iron ore prices within the past eight weeks.1 Strategically, we retain a bearish bias, as rising iron ore supply may overwhelm the market again in 2017H2. We remain tactically neutral and strategically bearish steel. Low steel inventories and production disruptions caused by China's recently launched environmental inspection program likely will continue to support steel prices in the near term. However, persistently high steel output and falling demand from the Chinese property sector should eventually knock down prices in 2017H2. We remain neutral copper going into 2017, expecting Chinese reflationary stimulus to continue along with a concerted effort to slow the housing boom in that country. This will still support real demand for copper, but will reduce demand from new construction. Manufacturing will play a larger role on the demand side next year, while a stronger USD could limit price appreciation. We still believe nickel will outperform zinc over a one-year time horizon. We are bullish nickel prices, both tactically and strategically, as we expect a supply deficit to widen on rising stainless steel demand and falling nickel ore supply in 2017. For zinc, we remain tactically neutral and strategically bearish. We expect zinc supply to rise considerably in response to current high prices. For the global aluminum market, we remain tactically bullish and strategically neutral. Supply shortages will likely persist ex-China over the next three to six months. We have three investment strategies, including long iron ore/short steel futures, long nickel/short zinc futures, and buying aluminum on weaknesses. Feature Iron Ore & Steel: Limited Upside In 2017 A Quick Recap Back in early October, we wrote an in-depth report on global iron ore and steel markets in which we made an out-of-consensus tactically bullish call on iron ore, expecting the price to reach the April high of $68.70/MT in 2016Q4. Our prediction was realized, with iron ore prices surging 43% to a two-year high of $79.81/MT on November 11 (Chart 1, panel 1). Although the steel market has been much stronger than the assessment driving our tactically neutral stance indicated earlier in the quarter, our call that iron ore would outperform steel in the near term was correct: Steel prices rose 21% during the same period of time - only half of the iron ore price rally (Chart 1, panel 1). Over the past two months, the rally occurred in both futures and spot markets, and in the markets globally (Chart 1, panels 2 and 3). Chart 1Iron Ore: Downgrade To Tactically Neutral Iron Ore: Downgrade To Tactically Neutral Iron Ore: Downgrade To Tactically Neutral Chart 2Steel: Remain Tactically Neutral Steel: Remain Tactically Neutral Steel: Remain Tactically Neutral The 2017 Outlook First, we downgrade our tactically bullish view on iron ore to neutral, as China likely will import less iron ore in 2017Q1 (Chart 2, panel 1). China has imposed stricter environmental regulations on its domestic metals industry since 2014 to control pollution. The government currently is sending environmental inspection teams to major steel-producing provinces to check how well the steel producers are complying with state environment rules. Many steel-producing factories were closed this year, due to environmental violations. This will constrain growth in Chinese steel output in the near term (Chart 2, panel 2). Between 2011 - 15, the state-owned Xinhua news agency states Chinese steel capacity has been reduced by 90 million MT; authorities want to cut as much as 150 million MT by 2020, including 45 million MT this year.2 Chinese steel production generally falls in January and February as workers are celebrating the Chinese Spring Festival - the most important festival for the Chinese. Iron ore inventories at major Chinese ports are still high (Chart 2, panel 3). Given iron ore prices have already rallied more than 100% since last December and steel demand outlook remains uncertain next year, most steel producers likely will choose to push off purchases into 2017Q2 or later. While China may slow its iron ore purchases next year, global iron ore supply is set to increase in 2017 as many projects will come on stream. The world's biggest iron ore project, Vale's S11D, which has a capacity of 90 million metric tons (mmt) per year, is expected to ship its first ore in January 2017. Moreover, with iron ore prices above $70/MT, global top iron ore companies with low production costs can be expected to sell as much as they can to maximize their profit, given their all-in production costs for high-quality iron ore (62% Fe) typically are between $30 and $35/MT.3 That said, we are not bearish on iron ore prices in the near term. We prefer to be neutral. Iron ore prices will have pullbacks, but the downside may be also limited in 2017H1. Chinese domestic iron ore production is still in a deep contraction (Chart 2, panel 4). Plus, most steel producing companies prefer high-quality ore from overseas over the domestic low-quality ore. In addition, almost all steel companies in China are profitable at present, which means Chinese steel production will rise after the Spring Festival holidays. All of these factors will support iron ore prices. Chart 3Iron Ore & Steel: Strategically Bearish Iron Ore & Steel: Strategically Bearish Iron Ore & Steel: Strategically Bearish Second, we retain our tactically neutral view on steel. Chinese steel demand was lifted by China's expansionary monetary and fiscal policies this year - which we have dubbed China's "reflationary" policy - which included reductions in its central bank's policy rate and reserve requirement ratio, and implementation of additional infrastructure projects (Chart 3). This was the driving force for the sharp steel price rally this year. The big question is how sustainable Chinese steel demand growth will be? This will be highly dependent on the Chinese government's decisions and actions. More than a third of steel demand is accounted for by the property market, of which some 70% is residential property.4 Mortgages accounted for approximately 71% of all new loans in August of this year, down from 90% in July, according to Reuters.5 This loan growth powered the iron ore and steel markets this past 12 - 18 months and China's credit-to-GDP ratio to extremely high levels. The OECD recently observed, "The high pace of debt accumulation was sustained despite weaker domestic demand growth. This raises concerns about the underlying quality of new credit, disorderly corporate defaults and the possible extent to which it has been used to support financial asset prices. Residential property prices in some of the largest cities have risen by over 30% year-on-year, although price growth in smaller cities has been much more modest. The price gains have been partly driven by loose monetary policy and ample credit availability as well as reduced land supply."6 Based on our calculations, Chinese steel demand started showing positive yoy growth in July and, so far, had posted four consecutive months of positive yoy growth from July to October. In September and October, the growth was accelerated to 8.3% and 6.6%, respectively, a clear improvement from the 0.8% yoy growth registered in July. The growth may last another three to six months but could peak sooner, if there are no new stimulus plans announced by the government. In addition to the housing sector, China's auto industry also saw significant demand growth. As China cut the sale taxes on small passenger vehicles from 10% to 5% this year, Chinese car sales jumped 13.6% yoy for the first 10 months of 2016, a significant improvement from a 5.7% yoy contraction in the same period of last year. If the government lets the tax cut expire at year-end, Chinese auto production may decline in 2017, which will weaken Chinese steel demand. In the meantime, Chinese steel producers will keep boosting production next year, which likely will limit the upside for steel prices. That said, current steel inventories in China are still low. According to the China Iron and Steel Association (CISA), steel inventories at large and medium steel enterprises fell 9% from mid-September to late October. This probably will limit the downside for steel prices. Third, we retain a strategic bearish view on both iron ore and steel. If there is no additional reflationary stimulus deployed in 2017, we expect Chinese steel demand to weaken. In the meantime, Chinese steel producers will keep boosting their production. Let these two factors run nine to 12 months, and we believe they will be sufficient to knock down both steel and iron ore prices. Our research last year concluded the Chinese property sector is structurally down-trending.7 Given that the property market is the biggest end user of steel in China, accounting for about 35% of total steel demand, we are strategically bearish on steel and iron ore prices. How To Make Money In The Iron Ore & Steel Market? Chart 4Take Profit On Long ##br##Iron Ore/ShortSteel Rebar Trade Take Profit On Long Iron Ore/Short Steel Rebar Trade Take Profit On Long Iron Ore/Short Steel Rebar Trade We went long May/17 iron ore futures in Dalian Futures Exchange in China and short May/17 steel rebar futures in Shanghai Futures Exchange on October 6 (Chart 4). Both contracts are denominated in RMB. The relative trade gives us a return of 18.1% in two months. We are taking profits with this publication, but we may re-initiate this pair trade on pullbacks. Risks If China deploys additional fiscal and monetary stimulus next year, similar in scope to this year's stimulus, we will re-evaluate our view accordingly. If global iron ore production is less than the market expects we could see further rallies in iron ore prices. Should this occur, we will re-examine our market call, as well. Copper: Market Is Balanced; Little Flex On Supply Side The reflationary stimulus that powered China's property markets - and drove demand for iron ore and steel higher - also propelled copper prices to dizzying heights in 2016H2. We do not expect this juggernaut to continue, and instead expect copper to trade sideways next year as global supply and demand stay relatively balanced (Chart 5). China accounts for roughly half of global refined copper demand (Chart 6). Manufacturing activity has the greatest impact on prices: A 1% increase in China's PMI translates to a 1.8% increase in LME copper prices (Chart 7). Chart 5Copper Market Is In Balance Copper Market Is In Balance Copper Market Is In Balance Chart 6World Copper Markets Are Balanced World Copper Markets Are Balanced World Copper Markets Are Balanced Chart 7China Demand Will Remain Key For Copper China Demand Will Remain Key For Copper China Demand Will Remain Key For Copper China's property market accounts for about a third of global copper demand in used in construction, according to the CME Group, which trades copper on its COMEX exchange. A 1% increase floor-space started in China leads to a 0.3% increase in LME copper prices (Chart 8). The surge in demand from the housing market lifted China's copper demand over the past 12 - 18 months, as credit creation in the form of home-mortgage loans expanded at a rapid clip (Chart 9). We expect the Chinese government to continue to try to rein in a booming property market, which has seen mortgage-loan growth of 90% p.a. recently. If the government is successful, this will limit price gains for copper next year. If not, the bubble will continue to expand in large tier-1 and -2 cities in China, making the copper rally's fundamental support tenous to say the least. Chart 8China PMIs and USD TWI Drive LME Prices China PMIs and USD TWI Drive LME Prices China PMIs and USD TWI Drive LME Prices Chart 9Mortgage Growth Likely Slows in 2017 Mortgage Growth Likely Slows in 2017 Mortgage Growth Likely Slows in 2017 This drives our expectation that the real economic activity in China - chiefly manufacturing - will be the dominant fundamental on the demand side for copper next year. On the supply side, we expect 2.65% yoy growth in refined copper production, just slightly above the International Copper Study Group's 2% estimate. Company and press reports cite a reduced mine capacity additions, lower ore content in mined output, and labor unrest as reasons supply side growth is slowing. Our balances reflect a convergence of supply and demand for next year, and also highlight the reduced flexibility in the system to respond to unplanned outages. For this reason, the global copper market could be prone to upside price risk in the event of a major unplanned production outage. Watch Out For USD Strength Copper, like all of the base metals, is sensitive to the path taken by the USD. We continue to expect the Fed to lift rates next month and a couple of times next year. This most likely will lift the USD 10% or so over the next 12 months. This would be bearish for base metals, particularly copper, since 92% of global demand for the red metal occurs outside the U.S. Our modeling indicates a 1% increase in the broad USD trade-weighted index leads to a 3.5% decrease in LME copper prices. A stronger USD will raise the local-currency cost of commodities ex-U.S. EM demand would suffer, which would slow the principal source of growth for base metals. Metals producers' ex-U.S. with little or no exposure to USD debt-service obligations would see local-currency operating costs fall. At the margin, this will lead to increased supply. These effects would combine to push commodity prices lower, producing a deflationary blowback to the U.S. Nickel & Zinc: Going Different Ways In 2017? Zinc has outperformed nickel significantly for the past six years. This year alone, zinc prices have shot up over 90% since January, almost doubling the 50% rally in nickel prices for the same period of time (Chart 10, panel 1). The nickel/zinc price ratio has declined to its lowest level since 1998 (Chart 10, panel 2). Will nickel continue underperforming zinc into 2017? Or will the trend reverse next year? We believe the latter has a higher probability. Tactically, we are bullish nickel and neutral zinc. Strategically, we are bullish nickel and bearish zinc.8 Zinc's bull story has been well-known for the past several years, and nickel's oversupplied bear story also has been commented on in the news. However, both markets' fundamentals are changing. Based on World Bureau of Metal Statistics (WBMS) data, for the first nine months of this year, the supply deficit in the global nickel market was at its highest level since 1996. Meanwhile, the global zinc market was already in balance (Chart 10, panels 3 and 4). Chart 10Nickel Likely To Outperform Zinc In 2017 Nickel Likely To Outperform Zinc In 2017 Nickel Likely To Outperform Zinc In 2017 Chart 11Nickel Has More Positive Fundamentals Than Zinc Nickel Has More Positive Fundamentals Than Zinc Nickel Has More Positive Fundamentals Than Zinc Both nickel and zinc markets are experiencing ore shortages (Chart 11, panels 1 and 2). For the nickel market, the ore shortage was mainly due to the Indonesian ore export ban, and Philippines' suspension of nickel miners for violating that country's environmental laws. For the zinc market, the ore shortage arose because of several big mines' depletion, years of underinvestment, and mine suspensions due to low prices late last year. The nickel ore shortage will become acute as the Indonesian ban remains in place and the Philippines' government becomes stricter on domestic mining operations. However, for zinc, most of the output loss occurred last year, and actually may be restored to the market in the near future. Zinc prices reached $2,811/MT last year as the market was adjusting to lost supply - the highest level since March 2008. In terms of demand, nickel exhibits much stronger demand growth versus zinc (Chart 11, panels 3 and 4). In addition, China's auto sales tax-cut policy will expire at year-end, which may cause Chinese auto production to fall in 2017. This will affect zinc much more than nickel, as less galvanized steel will be needed next year if Chinese car production falls. Investment Strategies We sold Dec/17 zinc at $2,400/MT on November 3, and the trade was stopped out at $2,500/MT with a 4% loss (Chart 12, panel 1). Zinc prices jumped 11.5% in four trading days in late November, which we believe was mainly driven by speculative buying. Nonetheless, in the near term, global zinc supply is still on the tight side, and zinc inventories are low (Chart 12, panel 2). Zinc prices could rally more in the near term. We were looking to go Long Dec/17 LME nickel vs. Short Dec/17 LME zinc if the ratio drops to 4.3 since mid-November (Chart 13, panel 1). We also suggested that if the order gets filled, put a stop-loss for the ratio at 4.15. Chart 12Zinc: Stay Tactically Neutral Zinc: Stay Tactically Neutral Zinc: Stay Tactically Neutral Chart 13Risks To Long Nickel/Short Zinc Risks To Long Nickel/Short Zinc Risks To Long Nickel/Short Zinc On November 25, the order was filled at the closing price ratio of 4.17. But unfortunately the ratio declined to 4.08 on the next trading day (November 28), based on the closing price ratio, which triggered our predefined stop-loss level with a 2.2% loss. The ratio was trading at 4.17 again as of November 29. As the market is so volatile, we recommend initiating this relative trade if it drops below 4.05 to compensate the risk. If the order gets filled, we suggest putting a 5% stop-loss level for the relative trade. After all, nickel prices could still have pullbacks, as global nickel inventories still are elevated (Chart 13, panel 2). Risks Our strategically bearish view on zinc will be wrong if global zinc ore supply does not increase as much as we expect, or global zinc demand still has robust growth in 2017. Our strategically bullish view on nickel will be wrong if Indonesian refined nickel output increases quickly, resulting in a smaller supply deficit than the market expects. However, due to power shortages, poor infrastructure and funding problems, development on many of the smelters and stainless steel plants once envisioned for the nickel market have been delayed. We believe these problems will continue to be headwinds for Indonesian nickel output growth, and will continue to restrict supply growth going forward. Aluminum: Cautiously Bullish In 2017 Chart 14Aluminum: Remain Tactically Bullish ##br## And Strategically Neutral Aluminum: Remain Tactically Bullish And Strategically Neutral Aluminum: Remain Tactically Bullish And Strategically Neutral Sharp supply cuts combined with tight inventories have pushed aluminum prices higher this year. Prices in China have rallied more than 50% so far this year, which was more than double the 20% rise in the global aluminum market (Chart 14, panel 1). This probably indicates a tighter Chinese domestic market than the global (ex-China) market. Looking forward, we remain tactically bullish on LME aluminum prices and neutral on SHFE aluminum prices.9 The supply shortage will likely persist ex-China over next three to six months. Global aluminum production has declined faster than demand so far this year. Based on the WBMS data, global aluminum output was still in a deep contraction in September (Chart 14, panel 2). Even though China's operating capacity has been rising every month so far this year, Chinese total aluminum output for the first 10 months was still 1.1% less than the same period last year. In addition, considering the possible output loss due to the Spring Festival in late January, we believe it will take another three to six months for China to meet its own domestic demand and inventory restocking. Extremely tight domestic inventories should limit the downside of SHFE aluminum prices (Chart 14, panel 3) as the market adjusts on the supply side. We think there is more upside for LME aluminum prices, as the supply shortage will likely persist ex-China over next three to six months. Currently, Chinese aluminum prices are about 18% higher than the LME prices (both are in USD terms), which will likely limit the supply coming from China's exports to the rest of world. Strategically, we are neutral LME aluminum prices and bearish on SHFE aluminum prices. Currently, about 85% of the China's aluminum operating capacity is making money. With new low-cost capacity and more idled capacity coming back on line, profitable Chinese smelters will continue boosting their aluminum production to maximize profits. This, over a longer term like nine months to one year, should eventually spill over to the global market. Investment strategy Chart 15Still Look To Buy Aluminum Still Look To Buy Aluminum Still Look To Buy Aluminum We recommended buying the Mar/17 LME aluminum contract (Chart 15) if it falls to $1,640/MT (current: $1,721/MT). We expect the contract price to rise to $1,900/MT over the next three to five months. If our order is filled, we suggest a 5% stop-loss. Risks Prices at both the SHFE and LME may come under intense pressure if aluminum producers in China increases their output quickly, even at a small loss, in order to create jobs and revenue for local governments. If global aluminum demand falters in 2017 while supply is rising, we will revisit our strategically neutral view on LME aluminum prices. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com Robert P. Ryan, Senior Vice President rryan@bcaresearch.com 1 Please see Commodity & Energy Strategy Special Report for iron ore and steel "Global Iron Ore And Steel Markets: Is The Rally Over?," dated October 6, 2016, available at ces.bcaresearch.com. In this report, we are using Metal Bulletin iron ore price delivered to Qingdao port in China as our iron ore reference price. 2 Please see "N. China city cuts 32 mln tonnes of steel capacity" published October 30, 2016, by Xinhua's online service, xinhuanet.com. 3 Please see "CHART: The breakeven iron ore prices for major miners in 2016," published June 7, 2016, by Business Insider Australia. 4 Please see "China Resources Quarterly, Southern spring ~ Northern autumn 2016," published by the Australian Department of Industry, Innovation and Science and Westpac, particularly this discussion on p. 4, "The real estate sector." 5 Please see "China August new loans well above expectations on mortgage boom," published by Reuters September 14, 2016. 6 Please see the OECD Economic Outlook, Volume 2016 Issue 2, Chapter 1, entitled "General Assessment of the Macroeconomic Situation," p. 44, under the sub-head "Rapid debt accumulation risks instability in EMEs." The IMF also expressed concern over rising debt levels supporting the real-estate boom in China, particularly in the larger cities, noting, "Credit and financial sector leverage continue to rise faster than GDP, and state-owned enterprises in sectors with excess capacity and real estate continue to absorb a major share of credit flow. The deviation of credit growth from its long-term trend, the so-called credit overhang--a key cross-country indicator of potential crisis--is estimated somewhere in the range of 22-27 percent of GDP..., which is very high by international comparison." Please see the IMF's Global Financial Stability Report for October 2016, "Fostering Stability in a Low-Growth, Low-Rate Era," p. 35, under the sub-heading "China: Growing Credit and Complexities." 7 Please see Commodity & Energy Strategy Special Report "Chinese Property Market: A Structural Downtrend Just Started," dated June 4, 2015 and "China Property Market Q&As," dated July 2, 2015, available at ces.bcaresearch.com 8 Please see Commodity & Energy Strategy Weekly Report "Oil Production Cut, Trump Election Will Stoke Inflation Expectations," dated November 17, 2016 and "The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market," dated October 27, 2016, available at ces.bcaresearch.com 9 Please see Commodity & Energy Strategy Weekly Report "Market Saturation Likely In Asia, If KSA - Russia Fail To Curb Oil Production," dated November 10, 2016, available at ces.bcaresearch.com Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Closed Trades

Highlights Tighter global oil markets resulting from the production cut we expect to be announced November 30 at OPEC's Vienna meeting, along with fiscal stimulus from the incoming Trump administration in the U.S., will continue to stoke inflation expectations. We believe gold is well suited for hedging investors' medium-term inflation exposure, given its sensitivity to 5-year/5-year CPI swaps in the U.S. and eurozone. If the Fed decides to get out ahead of this expected pick-up in inflation and inflation expectations by raising rates aggressively next year, we would expect any increase in gold prices - and oil prices, for that matter - to be challenged. For OPEC and non-OPEC producers, a larger production cut may be required to offset a stronger USD next year. Near term, we still like upside oil exposure, given our expectation that production will be cut. Energy: Overweight. We remain long Brent call spreads expiring at year-end, and long WTI front-to-back spreads in 2017H2, in anticipation of an oil-production cut. Base Metals: Neutral. We expect nickel to outperform zinc in 2017. Precious Metals: Neutral. We are long gold at $1,227/oz after our buy-stop was elected on November 11. We are including a 5% stop-loss for this position. Ags/Softs: Underweight. Our long Mar/17 wheat vs. beans order was filled on November 14. We still look to go long corn vs. sugar. Feature Chart of the WeekBrent, WTI Curves Will Flatten, ##br##Then Backwardate Following Oil-Production Cut bca.ces_wr_2016_11_17_c1 bca.ces_wr_2016_11_17_c1 Continuing production increases from sundry sources outside OPEC, which the International Energy Agency estimates will lift output almost 500k b/d in 2017, are turning the heat up on the Kingdom of Saudi Arabia (KSA) and Russia to agree a production cut at the Cartel's meeting in Vienna later this month. It's either that or risk another downdraft that takes prices closer to the bottom of our long-standing $40-to-$65/bbl price range that defines U.S. shale-oil economics. The unexpected strength in production growth outside OPEC likely will require KSA and Russia to come up with a production cut that exceeds the 1mm b/d we projected earlier this month would be required to lift prices into the mid-$50s/bbl range. On the back of the expected cuts, we recommended getting long a February 2017 Brent call spread - long the $50/bbl strike vs. short the $55/bbl strike at $1.21/bbl. As of Tuesday's close, when we mark our positions to market every week, the position was up 9.09%. Reduced output from KSA and Russia - and, most likely, Gulf allies of KSA - will force refiners globally to draw down crude in storage, and for refined product inventories to draw as well. This will lift the forward curves for Brent and WTI futures (Chart of the Week). We expect oil prices will increase by approximately $10/bbl, following the joint cuts of 500k b/d each we expect KSA and Russia, which will be announced November 30. This also will lift 3-year forward WTI futures prices, which, as we showed in previous research, share a common trend with 5y5y CPI swaps. As stocks continue to draw next year, we expect the forward Brent and WTI curves to flatten, and, in 2017H2, to backwardate - that is to say, prompt-delivery prices will trade above the price of oil delivered in the future. For this reason, we are long August 2017 WTI futures vs. short November 2017 WTI futures, expecting the price difference between the two, which favors the deferred contract at present (i.e., a contango curve), to flip in favor of the Aug/17 contract. Chart 2Longer-dated WTI Futures, ##br##Inflation Expectations Rising bca.ces_wr_2016_11_17_c2 bca.ces_wr_2016_11_17_c2 Fiscal Stimulus Expected in the U.S. The election of Donald J. Trump as the 45th president of the U.S. likely will usher in significant fiscal stimulus beginning next year, particularly as Republicans now control the Presidency and Congress for the first time since 2005 - 06, when George W. Bush was president. Trump campaigned on a promise of significant fiscal stimulus, which likely will, among other things, stoke inflation expectations as money starts to flow to infrastructure projects and tax cuts toward the end of next year. Even before Trump's election 5-year/5-year (5y5y) CPI swaps were ticking higher, as oil markets rebalanced and started to discount the drawdown in global inventories this year and next (Chart 2). As the outlines of the Trump administration's fiscal policy take shape and money starts to flow to infrastructure projects, we expect inflation expectations to continue to rise. In previous research, we showed 5y5y CPI swaps and 3-year forward WTI futures are cointegrated, meaning they follow the same long-term trend. Indeed, we can specify 5y5y CPI swaps in the U.S. and eurozone directly as a function of 3-year forward WTI futures.1 Gold Will Lift With Rising Inflation Expectations... In the post-Global Financial Crisis (GFC) markets, gold prices have shared a common trend with U.S. CPI 5y5y swaps and real interest rates, which we show in a new model (Chart 3A, top panel).2 Using this specification, we find a 1% increase in the U.S. 5y5y CPI swaps increases gold prices by slightly more than 9%. Similarly, we find a 1% increase in EMU 5y5y CPI swaps increases gold prices by slightly more than 10% (Chart 3B, top panel).3 Of course, investors always can go straight to Treasury Inflation Protected Securities (TIPS) for inflation protection, given the evolution of the respective CPIs in the U.S. and eurozone drives returns for these securities (Chart 4). However, we believe gold gives investors higher leverage to actual inflation and expected inflation. Chart 3AGold Prices Ticking Higher With ##br##U.S. CPI Inflation Expectations Gold Prices Ticking Higher With U.S. CPI Inflation Expectations Gold Prices Ticking Higher With U.S. CPI Inflation Expectations Chart 3BEMU Inflation Expectations ##br##Vs. 3-year Forward WTI bca.ces_wr_2016_11_17_c3b bca.ces_wr_2016_11_17_c3b Chart 4Inflation Expectations And TIPS ##br##Are Highly Correlated, As Well Inflation Expectations And TIPS Are Highly Correlated, As Well Inflation Expectations And TIPS Are Highly Correlated, As Well ...But The USD's Evolution Matters, Too The combination of tighter oil markets and fiscal stimulus in the U.S. will continue to push inflation and inflation expectations higher. The Fed will not sit idly by and just watch inflation expectations move higher next year. Indeed, prior to the election, we expected two rate hikes next year, following a likely rate increase at the FOMC's meeting next month. With expectations of a tightening oil market, and a fresh round of fiscal stimulus from the incoming Trump administration, the odds of an even stronger USD increase. We had been expecting the USD will appreciate 10% over the next year or so, as a result of the upcoming December rate hike and two additional hikes next year. This could change, since, as, our Foreign Exchange Strategy service noted, "Trump's electoral victory only re-enforces our bullish stance on the dollar."4 A stronger USD, all else equal, is bearish for commodities generally, since it raises the cost of dollar-denominated commodities ex-U.S., and lowers the costs of commodity producers in local-currency terms. The former effect depresses demand at the margin, while the latter raises supply at the margin. Both effects would combine to reduce oil prices at the margin (Chart 5). This would, in turn, lower inflation expectations, which would feed into lower gold prices (Chart 6). Chart 5A Stronger USD Would Be Bearish For Oil bca.ces_wr_2016_11_17_c5 bca.ces_wr_2016_11_17_c5 Chart 6And Gold Prices As It Would Lower Inflation Expectations bca.ces_wr_2016_11_17_c6 bca.ces_wr_2016_11_17_c6 Our FX view, is complicated by the possibility the Fed might want to run a "high-pressure economy" next year, and the potential for additional Chinese fiscal stimulus going into the 19th Communist Party Congress next fall. If both the U.S. and China deploy significant fiscal stimulus next year, the growth in these economies could overwhelm the negative effects of a stronger USD, and industrial commodities - chiefly base metals, iron ore and steel - could rally as demand picks up. Oil demand also would be expected to pick up as a result of the combined fiscal stimulus coming out of the U.S. and China, both from infrastructure build-outs and income growth. KSA - Russia Oil-Production Cut Gets Complicated These considerations will complicate the calculus of KSA and Russia and their respective oil-producing allies as the November 30 OPEC meeting in Vienna draws near. If the Fed moves to get out ahead of increasing inflation expectations by adding another rate hike or two next year, oil prices will encounter a significant headwind. OPEC and non-OPEC producers could very well find themselves back at the bargaining table negotiating additional cuts, as prices come under pressure next year from higher U.S. interest rates. It is too early to act on any speculation regarding fiscal policy in the U.S. or China next year. However, given our expectation for an oil-production cut announcement later this month at OPEC's Vienna meeting, we are confident staying long the Brent $50/$55 call spread, and the long Jul/17 vs. short Nov/17 WTI spread position we recommended earlier this month. As greater clarity emerges on U.S. and Chinese fiscal policy going into next year, we will update our assessments. Bottom Line: We expect global oil markets to tighten as KSA and Russia engineer a production cut, which will be announced at OPEC's Vienna meeting later this month. Fiscal stimulus from the incoming Trump administration in the U.S., and possible fiscal stimulus in China next year could put a bid under commodities. However, if the Fed gets out ahead of the expected pick-up in inflation and inflation expectations by raising rates aggressively next year, any increase in commodity prices - oil and gold, in particular - will be challenged. KSA and Russia could find themselves back at the bargaining table, negotiating yet another production cut to offset a stronger USD. That said, we are retaining our upside oil exposure via a Brent $50/$55 call spread expiring at the end of this year, and our long Jul/17 WTI vs. short Nov/17 WTI futures, which will go into the money as the forward curve flattens and then goes into a backwardation. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com BASE METALS China Commodity Focus: Base Metals Nickel: A Good Buy, Especially Versus Zinc Chart 7Nickel: More Upside Ahead Nickel: More Upside Ahead Nickel: More Upside Ahead We are bullish on nickel prices, both tactically and strategically. Its supply deficit is likely to widen on rising stainless steel demand and falling nickel ore supply in 2017. China will continue to increase its refined nickel imports to meet strong domestic stainless steel production growth. We remain strategically bearish zinc even though our short Dec/17 LME zinc position got stopped out at $2500/MT with a 4% loss. We expect nickel to outperform zinc considerably in 2017. We recommend buying Dec/17 LME nickel contract versus Dec/17 LME zinc contract at 4.3 (current level: 4.38). If the order gets filled, we suggest putting a stop-loss level for the ratio at 4.15. Nickel prices have gone up over 50% since bottoming in February (Chart 7, panel 1). The global nickel supply deficit reached a record high of 75 thousand metric tons (kt) for the first eight months of this year, based on the World Bureau of Metal Statistics (WBMS) data (Chart 7, panel 2). More upside for nickel in 2017 On the supply side, the outlook is not promising in 2017. Global nickel ore and refined nickel production fell 5.2% and 1.1% yoy for the first eight months of this year, respectively, according to the WBMS data (Chart 7, panel 3). The newly elected Philippine government is clearly aiming for "responsible mining," and has been highly restrictive on domestic nickel mining activities, actions that likely will reduce the country's nickel ore production in 2017. The Philippines became the world's biggest nickel ore producer and exporter after Indonesia banned nickel ore exports in January 2014. The Philippines has implemented a national audit on domestic mines from July to September and has halted 10 mines for their environmental violations since July. Eight of them are nickel producers, which account for about 10% of the country's total nickel output. In late September, the government further declared that 12 more mines (mostly nickel) were recommended for suspension, and 18 firms are also subject to a further review. Stringent policy oversight will be the on-going theme for Philippine mines. We expect more suspensions in the country next year. There is no sign the export ban will be removed by the Indonesian government. Since Indonesia banned nickel ore exports in January 2014, the country's nickel ore output has declined 84% from 2013 to 2015. This occurred even though smelters were built locally, which will allow more nickel ore output in Indonesia. However, the incremental Indonesian output is unlikely to make up for the global nickel ore shortage next year. Global nickel demand is on the rise again (Chart 7, panel 4). According to the International Stainless Steel Forum (ISSF), global stainless steel production grew by 11.5% in 2016Q2 from only 3.7% yoy in 2016Q1. Comparatively, in 2015, the growth was a negative 0.3%. Due to fiscal and monetary stimulus in China this year, we expect continued growth in global stainless steel production in 2017. Why China Is Important To Global Nickel Markets China is the world's biggest nickel producer, consumer and importer. Its primary effect on nickel prices is through refined nickel imports. It also influences global stainless steel prices through stainless steel exports. In comparison to the global supply deficit of 75 kt, the deficit in China widened to 346 kt for the first eight months of this year - the highest physical shortage ever (Chart 8, panel 1). China has driven the global growth of both refined nickel production and nickel consumption since 2010 (Chart 8, panels 2 and 3). During the first eight months of this year, Chinese nickel production dropped sharply to 40.5 kt, nearly three times the global nickel output loss of 13.6 kt. For the same period, China's nickel demand growth accounted for 67% of global growth. In addition, the country produces about 53% of global stainless steel and exports about 10% of domestic-made stainless steel products to the rest of world (Chart 8, panel 4). Clearly, China is extremely important to both the global stainless steel and nickel markets. China Needs To Import More Nickel in 2017 Looking forward, China is likely to continue increasing its nickel imports to meet a growing domestic supply deficit (Chart 9, panel 1). The country's ore imports have been declining because of Indonesia's ban since 2014, and further dropped this year on the Philippine's suspensions (Chart 9, panel 2). Scarcer ore supply drove down Chinese refined nickel and nickel pig iron (NPI) output every year for the past three consecutive years (including this year). Chart 8China: A Key Factor For Nickel Market China: A Key Factor For Nickel Market China: A Key Factor For Nickel Market Chart 9Chinese Nickel Imports Are Set To Rise bca.ces_wr_2016_11_17_c9 bca.ces_wr_2016_11_17_c9 Prior to 2014, China imported nickel ores from Indonesia to produce NPI, which is used in its domestic stainless steel production. In 2013, only 20% of domestic nickel demand was met by unwrought nickel imports. After 2014, China's higher nickel ore imports from the Philippines were not able to make up the import losses from Indonesia (Chart 9, panel 3). As a result, in 2015, the percentage of domestic nickel demand met by unwrought nickel imports jumped to 47%. Furthermore, for the first eight months of this year, imports accounted for 57% of Chinese demand. Before the Indonesian ban in 2014, Chinese stainless steel producers and NPI producers built up mammoth nickel ore inventories for their stainless steel ore NPI production (Chart 9, panel 4). Now, Chinese laterite ore inventories are much lower than three years ago. Plus, most of the inventories likely are low nickel-content Philippines ore. Besides the tight ore inventory, China's stainless-steel output is accelerating. According to Beijing Antaike Information Development Co., a state-backed research firm, for the first nine months of 2016, Chinese nickel-based stainless steel output grew 11.3% yoy, a much stronger growth rate than the 4% seen during the same period last year. Given falling domestic nickel output and increasing nickel demand from the stainless steel sector, China seems to have no other choice but to import more refined nickel or NPI from overseas. Downside Risks Nickel prices could fall sharply in the near term if massive LME inventories are released to the global market. After all, global nickel inventories currently are at a high level of more than 350 kt, which is more than enough to meet the supply deficit of 75 kt (Chart 10, panel 1). However, as prices are still at the very low end of the range over the past 13 years, we believe that the odds of a massive, sudden inventory release is small. Inventory holders will be hesitant to sell their precious inventory too quickly, therefore the inventory release will likely be gradual, especially given the continuing export ban in Indonesia and a likely increase in the suspension of mines in the Philippines. In the longer term, if Indonesian refined nickel output continues growing at the pace registered in the past two years, the global nickel supply deficit may be much less than the market expects (Chart 10, panel 2). In that scenario, nickel prices will also fall. Due to power supply shortages, poor infrastructure and funding problems, many of the smelters and stainless steel plants' development have got delayed, so we believe these problems will continue to be headwinds for Indonesian nickel output growth. A five-million capacity stainless steel project, funded by three Chinese companies, potentially making Indonesia the world's second biggest stainless steel producer, will only be in production by 2018. Therefore, we believe next year is still a good window for a further rally in nickel prices. In addition, global stainless steel output may weaken again after this year's stimulus from China runs out of steam, which will also weigh on nickel prices (Chart 10, panel 3). We will monitor these risks closely. Investment strategy We expect nickel to outperform zinc considerably in 2017. Nickel has underperformed zinc massively since 2010 with the nickel/zinc price ratio tumbling to a 17-year low (Chart 11, panel 1). Chart 10Downside Risks To Watch bca.ces_wr_2016_11_17_c10 bca.ces_wr_2016_11_17_c10 Chart 11Nickel Likely To Outperform Zinc In 2017 bca.ces_wr_2016_11_17_c11 bca.ces_wr_2016_11_17_c11 Even though our short Dec/17 LME zinc position was stopped out at $2500/MT with a 4% loss due to the short-term turbulence, we remain strategically bearish zinc, as we expect supply to rise in 2017 (Chart 11, panel 2).5 Given our assessments of the nickel and zinc markets, we recommend buying Dec/17 LME nickel contract versus Dec/17 LME zinc contract at 4.3 (current level: 4.38) (Chart 11, panel 3). If the order gets filled, we suggest putting a stop-loss level for the ratio at 4.15. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com 1 Our updated estimates of the cointegrating regressions for U.S. and eurozone 5y5y CPI swaps indicate 3-year forward WTI futures explain close to 87% of the U.S. swap levels and 82% of the eurozone swaps, in the post-GFC period (January 2010 to present). Please see Commodity & Energy Strategy Weekly Report "Inflation Expectations Will Lift As Oil Rebalances," dated March 31, 2016, available at ces.bcaresearch.com. 2 We also found that, over a longer period encompassing pre-GFC markets, gold prices shared a common trend with U.S. 5y5y CPI swaps, as well. Indeed, the evolution of 5y5y CPI swaps explained 84% of gold's price from 2004, when the 5y5y CPI swap time series begins, to present. 3 Previously, we estimated a gold model using the Fed's core PCE and the St. Louis Fed's 5y5y U.S. TIPS inflation index and found a 1% increase in the core PCE translates to a 4% increase in gold prices. Please see Commodity & Energy Strategy Weekly Report "A 'High-Pressure Economy' Would Be Bullish For Gold," dated October 20, 2016, available at ces.bcaresearch.com. 4 Please see Foreign Exchange Strategy Weekly Report "Reaganomics 2.0?," dated November 11, 2016, available at fes.bcaresearch.com. 5 Please see Commodity & Energy Strategy Weekly Report for zinc section "The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market," dated October 27, 2016, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Closed Trades

Highlights The inexorable shift of refining eastward would be accelerated if the Kingdom of Saudi Arabia (KSA) and Russia fail to curb crude oil production as we expect. Prolonging the crude oil market-share war - particularly between opposing camps led by KSA and Iran within OPEC, and Russia's campaign outside the Cartel - will advantage Asian refiners in the short term. Over the longer term, the expansion of oil refining in Asia and the Middle East likely will accelerate, as these warring camps invest directly in refining capacity in Asia and expand their domestic and regional refining and trading capacity. The risk Asian product markets will become super-saturated over the next 3 - 5 years remains elevated, as local refining capacity outgrows local demand and export markets are used to dispose of product surpluses. Like their upstream counterparts, refiners can be expected to fight for market share, leading to a compression in margins. Energy: Overweight. We continue to expect a production cut by KSA and Russia to be announced at the OPEC meeting this month. Base Metals: Neutral. LME aluminum prices still have upside as the market will likely remain supply deficit in the short term. We look to buy aluminum on weakness. Precious Metals: Neutral. We remain on the sidelines ahead of the Fed's December meeting. Ags/Softs: Underweight. We still look to go long wheat versus soybeans. We also look to go long corn versus sugar. Feature We continue to expect an announcement from KSA and Russia of a net 1mm b/d production cut at this month's OPEC meeting in Vienna, after accounting for the 400k b/d or so of seasonal production declines in KSA. A failure to follow through on a cut will prolong the global market-share war among OPEC and Russian oil producers seeking long-term customers in Asian refining markets, particularly in China. China's so-called teapots, which refine 60k to 70k b/d, only started importing crude oil for their own accounts late last year. These refiners represent about one-third of China's 14.3 mm b/d refining capacity as of 2015. It's been a slow ramp - some of these teapots only got started on importing their own crude this year - but they're definitely on a growth trajectory and should catch up with KSA and India in the near future. Some of them already are using hedge markets and setting up their own trading operations, according to media reports. Also, we're expecting to see increased investment in refining in China by KSA and others in the very near future, which will bring state of the art technology to the sector. In and of itself, a failure of KSA and Russia to agree a production cut would be bullish for the growth potential of Asian refiners, as Middle Eastern and Russian crude oil supplies continue to be aggressively marketed to them, allowing them to build capacity and grow their share of global exports (Chart of the Week). Chart of the Week (A)Asia/Middle East Refining Inputs Continue to ##br##Grow As OPEC Market-Share War Drags On bca.ces_wr_2016_11_10_c1a bca.ces_wr_2016_11_10_c1a Chart of the Week (B)Asia/Middle East Refiners' Market Share Of ##br##Gasoline Exports Is Growing bca.ces_wr_2016_11_10_c1b bca.ces_wr_2016_11_10_c1b Chart of the Week (C)...As Are ##br##Diesel/Gasoil Exports bca.ces_wr_2016_11_10_c1c bca.ces_wr_2016_11_10_c1c Our expectation for crude production cuts by KSA and Russia, perhaps with sundry cuts from their allies in the market-share war, would accelerate the draws in crude and product inventories globally. Absent a cut, inventories will continue to draw slowly, based on an assessment of data provided by the Joint Oil Data Initiative (JODI), a transnational oil-data service (Chart 2). The current cycle of supply destruction is being prolonged by high global inventory levels. High inventories keep prices under pressure, which, as we have often noted, raise the odds of civil unrest in cash-strapped states. The odds of unplanned production outages and loss of exports thus remains elevated. A price spike in such a scenario cannot be ruled out. Chart 2Inventories Will Continue To Fall Slowly ##br##If KSA-Russia Don't Cut Crude Output bca.ces_wr_2016_11_10_c2 bca.ces_wr_2016_11_10_c2 Chart 3Asia/Middle East Diesel Output##br## Growth Will Continue bca.ces_wr_2016_11_10_c3 bca.ces_wr_2016_11_10_c3 Global Refining and Storage Markets Continue Transformation Longer term, we see an inexorable shift in refining eastward, as local refiners expand their capacity in China and India, and financially stronger crude and product exporters expand their refining and trading operations by investing in existing or new Asian refining capacity - e.g., KSA in China and South Korea, and Russia's Rosneft in India alongside a major trading company. This will keep high-valued-added exports growing in Asia (Chart 3 and Chart 4), and will take market share from traditional processing centers - e.g., northwest Europe, and Singapore's processing refineries (Chart 5). Chart 4Along With ##br##Gasoline Output bca.ces_wr_2016_11_10_c4 bca.ces_wr_2016_11_10_c4 Chart 5Asia/Middle East Refiners ##br##Displace Traditional Processors bca.ces_wr_2016_11_10_c5 bca.ces_wr_2016_11_10_c5 With or without a production cut by KSA and Russia, the incidence of crude-oil supply destruction will continue to fall on the poorer OPEC producers outside the Gulf Cooperation Council (GCC), which lack the wherewithal to invest in higher crude-oil output domestically, or in refining and trading capacity domestically or abroad. These cash-strapped states also will be unable to make direct investments in refining assets in end-use markets, depriving them of assured outlets for crude production enjoyed by exporters like KSA with substantial refining investments domestically and worldwide.1 This means that, unlike KSA, where refined-product sales and trading will constitute a greater share of revenues over the medium term (out to 10 years), these cash-strapped producers will continue to depend on crude oil sales alone. Chart 6U.S. Product Exports Hold Up Well bca.ces_wr_2016_11_10_c6 bca.ces_wr_2016_11_10_c6 Given its technological edge and nearby crude supplies - Canadian heavy shipped south via pipeline, conventional and light-tight oil (LTO) from shale fields, and increasing volumes of Mexican crude following the sale of deep-water acreage next month - we do not expect U.S. refiners to lose export-market share in the high-value-added light-product markets (diesel and gasoline/aviation fuels) (Chart 6). Indeed, on a 5-year seasonal basis, U.S. refined-product exports actually are increasing, as nearby refiners - e.g., Mexico - continue to find it difficult to maintain operations. Even as Asia and the Middle East refining and trading markets develop, we continue to expect a deepening of crude and product flows among North and South American producers and refiners.2 China Policy Put Could Spur Refining Output In our earlier research, we noted the implicit put provided to Chinese refiners, after the National Development and Reform Commission mandated products be sold at a minimum crude oil reference price of $40/bbl. This was done to encourage conservation and to support domestic refiners and producers.3 So, if crude oil prices go below $40/bbl for Chinese refiners, this regulation incentivizes them to refine as much as possible, then store or export output surplus to domestic needs. Unless the government steps in to tax away the refining windfall resulting from this put whenever the reference crude price falls below $40/bbl, this policy will, at the margin, pressure global refined-product prices, and keep refining margin growth potential limited as Chinese capacity increases. This pattern was seen in Chinese agricultural markets, where crop price supports resulted in a massive accumulation of corn in storage, as farmers bought cheap corn on the international market and sold it into the government storage market. The crop price supports are being unwound, but it does illustrate the Ironclad Law of Regulation - markets always find a way to game regulations to their advantage. Refining Margins Will Remain Under Pressure Chart 7Refining Margins Will Remain Under Pressure bca.ces_wr_2016_11_10_c7 bca.ces_wr_2016_11_10_c7 The rapid expansion of refining capacity in Asia and the Middle East - driven by increased domestic and foreign investment in refining and trading capacity - suggests to us refined-product markets could be in for an extended period of oversupply, which will limit refiner margins going forward. OPEC's market-share war, and the massive supplies produced by U.S. shale-oil producers made it abundantly clear that crude oil is a super-abundant resource, particularly with shale-oil production ready to come on line as soon as prices move above $50/bbl. The buildout in refining capacity by KSA and other OPEC members, along with plans to expand Asian and Middle East refining capacity and, critically, to supply that capacity with aggressively priced crude charging stock, will keep refining margins under pressure going into 2017 (Chart 7). The risk of super-saturating Asian markets in the near future with unsold refined products as crude supplies and production are ramped up in the near future, therefore, poses a risk for refiners generally, since, at the right prices, crude and product can be moved anywhere on the globe. This poses a particular risk for KSA as it readies the IPO of is state-owned oil company Aramco. KSA is simultaneously attempting to grow its own refining capacity worldwide - from a current level of ~ 6mm b/d to as much as 10mm b/d - and retain and secure long-term customers for its crude. In effect, as a refiner it will be competing with the very customers to which it provides crude oil. This doubly compounds the difficulty of IPOing Aramco, as well, since investors will want to be assured the refining side of the enterprise is not being disadvantaged by the crude-oil supply side of the enterprise. However, for KSA as a sovereign state, this expansion of revenues earned from a massive refining presence worldwide is clearly a boon. KSA could, at the end of the day, refine, export and trade product volumes that equal or surpass its current crude export volumes, as it continues to invest and build out its global refining presence. This will further distance it from its OPEC brethren and other crude oil producers worldwide, making it less a crude exporter and more a global vertically integrated portfolio manager. Bottom Line: We see an inexorable shift of refining eastward, with or without a production cut by KSA and Russia. Failure to agree and implement a production cut would prolong the crude oil market-share and provide a tailwind to Asian refiners in the short term. With or without a production cut, we see the expansion of oil refining in Asia and the Middle East continuing apace, as direct investment flows to refining and trading. The risk that Asian product markets will become super-saturated over the next 3 - 5 years remains elevated, as local refining capacity outgrows local demand and exports from Asian and Middle East refineries grow. Like their upstream counterparts, refiners can be expected to fight for market share, leading to a compression in margins. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com BASE METALS China Commodity Focus: Base Metals Aluminum: Buy On Weakness Tactically, we are bullish on LME aluminum prices and neutral on SHFE aluminum prices.4 Supply shortages will likely persist in the ex-China world over next three to six months. Strategically, we are neutral on LME aluminum prices and bearish on SHFE aluminum prices. Profitable Chinese smelters will continue boosting their aluminum production, which will eventually spill over into the global market. We recommend buying Mar/17 LME aluminum contract if it falls to $1,580/MT (current: $1,727/MT). We expect the contract price to rise to $1,900/MT over next three to five months. If the order gets filled, we suggest putting a stop-loss at $1,500/MT. Aluminum prices have gone up considerably this year (Chart 8, panel 1). Global aluminum producers cut their production sharply while global consumption only contracted slightly, reversing a deep supply-surplus market in 2015 to a significant supply-deficit market in 2016 (Chart 8, panel 2). Moreover, aluminum inventories in both LME and SHFE markets also have fallen to multi-year lows (Chart 8, panel 3). However, aluminum prices went nearly vertical in China with a 48% rally since late last November, while LME prices have been only up 21% during the same period of time (Chart 8, panel 1). Why have prices in China gone up much more than the global LME prices? Will the rallies in aluminum prices in both LME and SHFE markets continue? The answer is mainly in China. China: The Most Important Factor In The Global Aluminum Market As the world's largest aluminum producer and consumer, China accounts more than 50% of global aluminum production and consumption (Chart 9, panel 1). The country has also been the major contributor to the growth of both global supply and demand for at least the past 10 years (Chart 9, panels 2 and 3). Chart 8Aluminum: Still More ##br##Upside Ahead? bca.ces_wr_2016_11_10_c8 bca.ces_wr_2016_11_10_c8 Chart 9China: The Most Important Factor ##br##In Aluminum Market China: The Most Important Factor In Aluminum Market China: The Most Important Factor In Aluminum Market China And The Price Collapse In 2015 In November 2015, while LME aluminum prices plunged to their lowest levels since February 2009, aluminum prices in China (SHEF) collapsed to their lowest levels since at least 1994. There were four main factors driving for the price drop. Chinese aluminum output increased more than 3 million metric tons (Mn MT), which accounted 87% of global supply growth, and resulted in excessive global supply. At the same time, global aluminum demand growth experienced a sharp slowdown -- yoy growth was 6% in 2015, versus 16.1% in 2014. This was mainly led by China, where, last year, aluminum demand growth slowed from 27.5% in 2014 to 10.9% in 2015. Inventories at SHFE were boosted by about 68% in 2015, while inventories at LME remained elevated. With China producing much more than it consumed, the country started to encourage exports of semi-manufactured aluminum products last year to reduce the domestic supply surplus (Chart 9, panel 4). In April 2015, the country removed the export tariff on several major aluminum semi-manufactured products. In November 2015, the country implemented a policy of giving a 13-15% value-added tax rebate to exporters of semi-manufactured products. As a result, last year net Chinese unwrought aluminum exports increased 16.7% yoy, which have weighed on global LME aluminum prices. China And The Price Rally In 2016 Chart 10Positive Factors To Aluminum Prices Positive Factors To Aluminum Prices Positive Factors To Aluminum Prices Similarly, China was the major driving factor behind this year's rally as well. Global supply was cut massively for the last two months of 2015 and the first eight months of 2016, as extremely low aluminum prices resulted in huge losses for most global aluminum producers. According to the World Bureau of Metal Statistics (WBMS), for the first eight months of this year, China accounted for 55% of the global aluminum supply cuts, as the country suspended its high-cost producing capacity and started industry-wide coordinated production cutbacks in last December (Chart 10, panel 1). Extremely low inventory levels also spurred the price rally. Inventories at SHFE warehouses fell 76.5% from mid-March to late-September (Chart 10, panel 2). In addition, the social inventory at major cities (Wuxi, Shanghai, Hangzhou, Gongyi and Foshan) also fell to record lows. Surging coal prices and rising alumina prices have also pushed up domestic aluminum production costs (Chart 10, panel 3). In addition, China implemented its newly promulgated Road Traffic Management Regulations regarding overloaded and oversized trucks, and unsafe vehicles on September 21. It was common before these regulations were implemented for drivers to overload shipments of commodities in order to increase profits. This raised road transportation costs for commodities like steel, coal, aluminum, aluminum products and other metals. It also created a bottleneck for timely transporting of coal to aluminum smelters, which own self-generated power plants, and transporting primary aluminum from major producing provinces Xinjiang, Inner Mongolia and Ningxia to some inner-land provinces like Henan for further manufacturing. As China cut its aluminum production this year, the country's exports of semi-manufactured aluminum products also fell 1.9% yoy for the first nine months of this year. As for Chinese aluminum demand, the data are confusing: The WBMS data showed a contraction for the first eight months of 2016, but the domestic industry association reported a decent increase in Chinese aluminum demand so far this year. Based on domestic auto output and construction activity data, we are inclined to believe Chinese aluminum demand rose moderately on the back of this year's fiscal stimulus. Other Factors For The Price Rally In 2016 There are two factors besides China for this year's aluminum rally. U.S. aluminum output fell nearly 50% yoy this year as Alcoa and Century Aluminum massively cut capacity late last year in response to lower prices (Chart 10, panel 4). For the ex-China world, while its supply fell 1.2%, consumption actually grew 0.4% for the first eight months of this year. This increased the supply deficit for the world excluding China, which is positive for LME aluminum prices (Chart 10, panel 5). So, What's Next? Tactically, we are bullish on LME aluminum prices and neutral on SHFE aluminum prices. Chart 11Aluminum: Buy On Weakness bca.ces_wr_2016_11_10_c11 bca.ces_wr_2016_11_10_c11 Most of the aforementioned positive factors are still in place. Even though China has enough capacity to oversupply both its domestic market and global markets again, the key factor will be how fast China boosts its aluminum output. With new added capacity and idled capacity returned to service, China's operating capacity for aluminum has been rising every month so far this year. According to the data provided by Sublime China Information Group, as of the end of October, China's aluminum operating capacity was 35.1 MMt/y (million metric tons per year), a rise of 0.575 MMt/y from the previous month, and an increase of 2.034 mtpy from the end of 2015. Based on our calculations, so far, total aluminum output from January to September is still much lower than the same period last year. In addition, considering the possible output loss due to the Spring Festival in late January, we believe it will take another three to six months for China to meet its own domestic demand and inventory restocking. Therefore, as domestic supply becomes more ample, China's domestic prices - including SHFE aluminum prices - should have limited upside. At the same time, the downside also should be limited by low inventory and rebounding demand. We expect more upside for LME aluminum prices as the supply shortage will likely persist in the ex-China world over next three to six months. Currently, Chinese aluminum prices are about 20% higher than the LME prices (both are in USD terms), which will likely limit the supply coming from China's exports to the rest of the world. Strategically, we are neutral on LME aluminum prices and bearish on SHFE aluminum prices. Currently, about 85% of the China's aluminum operating capacity is profitable. With new low-cost capacity and more idled capacity coming back line, profitable Chinese smelters will continue boosting their aluminum production to maximize profits. This, over a longer term such as nine months to one year, should eventually spill over into the global market. Risks China has imposed stricter environmental regulations on the domestic metal smelting and refining process since 2014 to control domestic pollution. The government currently is sending environmental inspection teams to major aluminum producing provinces to check how well the smelters and refiners comply with state environment rules. Some unqualified factories may be ordered to close. If this occurs, domestic SHFE aluminum prices may go up further in the near term. On the other side, if unprofitable aluminum producers in China also increase their output quickly, in order to creating jobs and revenue for local governments, prices at both SHFE and LME may face a big drop. We will monitor these risks closely. Investment Strategy We probably will see increasing Chinese aluminum production in 2016Q4, which may induce price corrections in both LME and SHFE prices. We prefer to buy LME aluminum on weakness. We recommend buying the Mar/17 LME aluminum contract if it falls to $1,580/MT (current: $1,727/MT) (Chart 11). We expect the contract price to rise to $1,900/MT over next three to five months. If the order gets filled, we suggest putting a stop-loss level at $1,500/MT. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report for an extended discussion of increasing Asian and Middle Eastern refining capacity "KSA, China, India Ramping Oil Product Exports," dated July 28, 2016, available at ces.bcaresearch.com. 2 We will be exploring inter-American crude and product flows - and the potential for expanding this trade - in future research. 3 Please see Commodity & Energy Strategy Weekly Report p. 6 of the earlier-referenced "KSA, China, India Ramping Oil Product Exports," dated July 28, 2016, available at ces.bcaresearch.com. 4 LME denotes London Metals Exchange and SHFE denotes Shanghai Futures Exchange. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Closed Trades

Highlights Dear Client, The growth of the electric-vehicle market, particularly re its implications for hydrocarbons as the primary transportation fuel in the world, will remain a key issue for energy markets, particularly oil. The IEA estimates transportation accounted for 64.5% of oil demand in 2014, the latest data available, compared to natural gas's 7% share and electricity's 1.5% share.1 Last week, Fitch Ratings published a report concluding, "Widespread adoption of battery-powered vehicles is a serious threat to the oil industry." For example, the agency contends that "in an extreme scenario, where electric cars gained a 50 per cent market share over 10 years about a quarter of European gasoline demand could disappear." This is not a widespread view in the energy markets. IHS Energy published a report in 2014 finding, "Past energy transitions took decades to unfold and were driven by a combination of market factors: cost, scarcity of supply, utility and flexibility, technology development, geopolitical developments, consumer trends, and policy.2" While our view is more aligned with IHS's, it is undeniable electric vehicles are a growing market. For this reason, we are publishing an analysis by BCA Research's EM Equity Sector Strategy written by our colleague Oleg Babanov, which explores the lithium-battery supply chain and how investors can gain exposure to this critical element of the fast-growing global electric-vehicle market. Separately, we are downgrading our strategic zinc view from neutral to bearish, and recommending a Dec/17 short if it rallies. Robert P. Ryan Senior Vice President, Commodity & Energy Strategy Lithium is a rare metal with a costly production process and a high concentration in a small number of countries. Difficulty in production is comparable to deep-sea oil drilling. Lithium is the key element in lithium-ion batteries. Demand is rapidly increasing as more countries adopt environment-protection policies and electric-car production is on the rise. We recommend an overweight on the lithium battery supply chain (Table 1), on a long-term perspective (one year plus). We estimate demand for the raw material to rise by approximately 30% over the coming years, driven by the main electric vehicle production clusters in Asia and the U.S. Table 1Single Stock Statistics For Companies##br## In The Lithium Battery Supply Chain (Oct 2016)* The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market What Is Powering Your Battery? Being a relatively rare and difficult to produce metal, lithium demand is rapidly increasing due to the metal's unique physical characteristics, which are utilized in long-life or rechargeable batteries. Rapidly rising demand from portable electronics manufacturers, and the push of the auto industry to develop new fuel-efficient technology, backed by the widespread support of many governments to reduce transportation costs and improve CO2 emissions, are driving prices for the metal higher. We believe that companies in the electric vehicle (EV) supply chain, from miners to battery producers and down to EV manufacturers, will benefit from the change in environmental policies and the growing need for more portable devices with larger energy storage. As the focus of the wider investment community remains tilted towards the U.S. (and Tesla in particular), many companies in the lithium battery supply chain, as well as EV producers, remain overlooked and undervalued. EV Production Expected To Surge We expect a continuation of the push towards energy-saving vehicles among car manufacturers, driven by government incentives and new tougher regulations (EU regulations for CO2 emissions in 2020 will be the strictest so far). Over one million EV vehicles of different types were sold in 2015. In countries such as Norway, the penetration of PEVs is reaching up to 23% (Chart 1). Based on the current growth rates (Chart 2), the compound annual growth rate of EV production is estimated at 30% to 35% over the next 10 years. Japan will remain in top spot in EV penetration (the current HEV rate is around 20% of the overall market). Japan's market (controlled by Toyota and Honda) is dominated by the HEV type of vehicles, and we expect it to remain this way. Chart 1PEV Penetration By Country The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market Chart 2EV Sales By Country The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market We expect the largest boost in market share gains to happen on the European market, based on very stringent CO2 emissions regulation (Chart 3) and ambitious EV targets set by the larger countries. EV market share is set to reach 20% (from the current 5%) in the coming seven to 10 years. The EU is closely followed by South Korea. The Ministry of Trade, Industry and Energy (MOTIE) has developed an ambitious plan of growth, by which EV market share should reach 20% by 2020 and 30% by 2025. New EVs will receive special license plates, fuel incentives, and new charging stations. MOTIE wants the auto industry to be able to produce 920,000 NEVs per year, of which 70% should be exported. Among other large markets, the U.S. and China will remain the two countries with lowest EV penetration rates, although growth rates will be impressive. This will be due to low incentives from the government and cheap traditional fuel supply (in the U.S.), or a low base, some subsidy cuts, and infrastructure constraints (in China). Especially in China's case, the numbers remain striking (Chart 4). According to statistics published by the China Association of Automobile Manufacturers (CAAM), EV sales in 2015 grew 450% YOY. The market is estimated to grow at an average rate of 25% over the next 10 years. Chart 3EU CO2 Emission Targets bca.ces_wr_2016_10_27_c3 bca.ces_wr_2016_10_27_c3 Chart 4Monthly NEV Sales China Monthly NEV Sales China Monthly NEV Sales China In this report we will highlight companies from the raw material production stage: Albermarle (ALB US), Gangfeng Lithium (002460 CH), Tianqi Lithium Industries (002466 CH), and Orocobre (ORE AU); to added-value battery producers: BYD (1211 HK), LG Chem (051910 KS), and Samsung SDI (006400 KS); down to some electric vehicle companies: Geely Automobile Holdings (175 HK) and Zhengzhou Yutong Bus Company (600066 CH). The Supply Side Driven by demand from China and the U.S., the raw material base for lithium has shifted in the past 20 years from subsurface brines to more production-intensive hard-rock ores. Brine operations are mostly found in the so-called LatAm "triangle" - Argentina, Chile and Bolivia - while China and Australia produce lithium from spodumene (a mineral consisting of lithium aluminium inosilicate) and other minerals. The U.S. Geological Survey estimates world reserves at 14 million tonnes in 2015, with Bolivia and Chile on top of the table (Chart 5). The main lithium producing countries, according to the U.S. Geological Survey, are Australia, Chile, and Argentina (Chart 6). Chart 5Lithium Reserves Concentrated In LatAm The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market Chart 6Lithium Production Dynamics By Country The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The lithium mining process starts with pumping lithium-containing brine to subsurface reservoirs and leaving the water to evaporate (from 12 to 24 months) until the brine reaches a 6% lithium content. From here there are three ways to process the concentrate, or the hard-rock in mineral form: Treatment with sulfuric acid (acidic method) Sintering with CaO or CaCO3 (alkali method) Treatment with K2SO4 (salt method) Further, lithium carbonate (Li2CO3), a poorly soluble solution, is isolated from the received concentrate and transferred into lithium chloride, which is purified in a vacuum distillation process. Storage is also difficult: as lithium is highly corrosive and can damage the mucous membrane, it is most commonly stored in a mineral oil lubricant. Due to the rare nature of the metal, lithium comes mainly as a by-product of other metals and comprises only a small part of the production portfolio. This is the reason why the underlying metal price and the share prices of the largest producers of lithium have low correlation (Chart 7). Albermarle, SQM, and FMC Corp currently control as much as three-quarters of global lithium production, but price performance is not keeping up with the price of the underlying metal. For best exposure to the metal, we concentrate on companies with a large degree of dedication to mining lithium and close ties to the end-users. We recommend one established market leader (by volume) - Albermarle (ALB US); one company that just started operations - Orocobre (ORE AU), whose assets are concentrated in Argentina; and two lithium miners from China - Jiangxi Ganfeng Lithium (002460 CH) and Tianqi Lithium (002466 CH). These companies display much higher correlation to the metal price (Chart 8). Chart 7FMC Corp., SQM And ##br##Albermarle Vs. Lithium Price bca.ces_wr_2016_10_27_c7 bca.ces_wr_2016_10_27_c7 Chart 8Orocorbe, Jiangxi Ganfeng And##br## Tianqi Lithium Vs. Lithium Price bca.ces_wr_2016_10_27_c8 bca.ces_wr_2016_10_27_c8 Albermarle (ALB US): U.S. company with EM exposure (Chart 9). After the acquisition of Rockwood Holdings in 2015, Albermarle became one of the largest producers of lithium and lithium derivatives. Lithium accounts for more than 35% of the company's revenue stream (+20% YOY), which compares favourably to the 20% of the Chilean producer SQM and the 8% of another large US producer FMC Corp. Chile comprises 31% of global production. Albermarle's 2Q16 results on 3 August came broadly in line with market expectations. Some deviation from expectations occurred because of discontinued operations in the Surface Treatment segment. Group sales contracted by 7%, due to divestures started in previous quarters (Chemetal). Positively, lithium sales grew 10% YOY due to both better pricing and higher volumes, and EBITDA in the segment improved by 20%. Group EBITDA (adjusted) grew by 5% YOY and the bottom-line (adjusted) expanded by 11% YOY. Management appears confident about FY16 operations, guiding 1% improvement in EBITDA, as well as 3% in FY EPS and aims to maintain EBITDA margins in the lithium segment at over 40%. We see high growth potential due to Albermarle's portfolio composition. The market is currently expecting an EPS CAGR of 9% over the next four years. Albermarle is trading at a forward P/E of 23.1x. Orocobre (ORE AU): An Australian company mining in Argentina (Chart 10). Orocobre is an Australian resource company, based in Brisbane. As in the case with Albermarle, the majority of operations are located in EM, so we see it as appropriate to include the company into our portfolio. Chart 9Performance Since October 2015: ##br##Albermarle vs MXEF Index bca.ces_wr_2016_10_27_c9 bca.ces_wr_2016_10_27_c9 Chart 10Performance Since October 2015: ##br##Orocobre vs MXEF Index bca.ces_wr_2016_10_27_c10 bca.ces_wr_2016_10_27_c10 Orocobre is at an initial stage in the lithium production process. The only division working at full capacity is Borax Argentina (acquired from Rio Tinto in 2012), an open-pit borate mining operation (producing 40 kilotonnes per annum (ktpa)). The flagship project (65% share), launched in a JV with Toyota Tsusho Corp, is the Olaroz lithium facility, a salt lake with an estimated 6.5 million tonnes of lithium carbonate (LCE) reserves. The planned capacity is at 17.5 ktpa. Due to the geological structure, it comes with one of the lowest operational costs ($3500 per tonne). The production ramp-up to 2,971 tonnes of lithium, reported on 19 July together with the 4Q16 results, came a notch below market expectations. The management lowered the production guidance, delaying full operational capacity by two months until November (realistically it might take even longer). Positive points in guidance included an LCE price exceeding $10,000/tonne in the upcoming quarter and confirmation that the company turned cash flow positive in the first half of this year.3 Orocobre is already planning capacity expansion at the Olaroz facility to 25 ktpa, with diversification into lithium hydroxide. Further exploration drilling is underway in the Cauchari facility, just south of Olaroz. The market forecasts the company to produce a positive bottom-line in FY17 and grow EPS by a CAGR of 25% for the next four years. Orocobre is currently trading at a forward P/E of 36.1x. Jiangxi Ganfeng Lithium (002460 CH): one of the largest lithium producers in China (Chart 11). Gangfeng is a unique company in the lithium space in the sense that it is a raw material producer with added processing capabilities. The main trigger for our OW recommendation was the acquisition of a 43% stake in the Mt Marion project in Australia. From 3Q16 onwards the bottleneck in raw material supply will be removed and the company can count on approximately 20 thousand tonnes (kt) of lithium spodumene. On the back of this news, the company announced a production expansion into lithium hydroxide (20 kt) from which 15 kt will be battery grade and 5 kt industry grade. This has the potential to lift Ganfeng to one of the top five producers in the world. Ganfeng reported stellar 2Q16 results on 22 August. The top-line grew two times YOY, while operating profit increased by 7.8x. Operating margin jumped from 9.8% to 35.9%, and the bottom-line expanded five-fold YOY. The profit margin also improved from 8.55% to 25.3%. We expect less strong, but still robust, YOY growth for the upcoming quarters. Market projects EPS CAGR of over 50% during the next four years, as the production run-up will continue. The company is currently trading at a forward P/E of 36.8x. Tianqi Lithium Industries (002466 CH): Making the move (Chart 12). Tianqi is the third largest producer in the world (18% of global capacity). Recently the company got into the news on rumors of its attempted expansion by taking a controlling stake in the world's largest lithium producer, Chile's SQM. Chart 11Performance Since October 2015:##br## Jiangxi Ganfeng Lithium vs MXEF Index bca.ces_wr_2016_10_27_c11 bca.ces_wr_2016_10_27_c11 Chart 12Performance Since October 2015: ##br##Tianqi Lithium vs MXEF Index bca.ces_wr_2016_10_27_c12 bca.ces_wr_2016_10_27_c12 SQM has an intricate shareholding structure, with the involvement of the Chilean government and a rule that no shareholder is currently allowed to own more than a 32% stake in the company (this rule can be changed only through an extraordinary shareholder meeting). At the moment the largest shareholder is Mr. Ponce Lerou (son-in-law of former President Augusto Pinochet), who owns just under 30% and has a strategic agreement with a Japanese company, Kowa, which makes the combined holding 32%. During the last week of September Tianqi acquired a 2% stake (for USD209 m) from US-based fund SailtingStone Capital Partners, which held a 9% stake, with the option to buy the remaining 7%. In a further step, Tianqi is trying to negotiate a deal with one of Mr. Ponce Lerou's companies which holds a 23% stake. It is said that Mr. Ponce Lerou has got into a political stalemate with the Chilean government on a production increase at one of its deposits and is looking to exit the company. Tianqi reported strong Q2 results on 22 August. Revenues grew by 2.4x YOY, and operating profit improved by 3.9x YOY. Operating margin grew from 42.99% in 2015 to 69.35% in 2Q16, and bottom-line increased twofold QOQ as production ramp-up continued. At the same time profit margin reached 48.9%, up from 2.8% a year ago. The company is currently trading at a forward P/E of 23.4x, and the market is forecasting an EPS CAGR of 13% over the next three years. The Demand Side4 Lithium is used in a wide range of products, from electronics to aluminium production and special alloys, down to ceramics and glass. But battery production takes the largest share of utilization (Charts 13A & 13B). Chart 13ALithium Usage The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market Chart 13BLithium Batteries Most Widely Used The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market As confirmed by import statistics (from the U.S. Geological Survey), demand in many Asian countries, as well as the U.S., has been constantly rising. Among the main importers, South Korea is in fourth place with the largest number of new lithium-related projects started. In top position is the U.S., where we expect a strong demand increase, once the Tesla battery mega-factory in Nevada is completed, followed by Japan, which has the highest penetration of electric vehicles (EV), and China (Chart 14). Chart 14Composition Of Lithium Imports By Country The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market Because of its low atomic mass, lithium has a high charge and power-to-mass ratio (a lithium battery generates up to 3V per cell, compared to 2.1V for lead-acid or 1.5V for zinc-carbon), which makes it the metal-of-choice for battery electrolytes and electrodes, and makes it difficult to replace with other metals, due to its unique physical features. Lithium is used in both disposable batteries (as an anode) and re-chargeable ones (Li-ion or LIB batteries, where lithium is used as an intercalated compound). Li-ion batteries are used in: Portable electronics, such as mobile phones (lithium cobalt oxide based); Power tools / household appliances (lithium iron phosphate or lithium manganese oxide); EVs (lithium nickel manganese cobalt oxide or NMC). The most produced battery is the cylindrical 18650 battery. Tesla's Model S uses over 7000 of these type of batteries for its 85 kWh battery pack (the largest on the market until mid-August, when Tesla announced a 100 kWh battery pack). The amount of lithium used in a battery pack depends on the kW output. Rockwood Lithium (now Albermarle), estimated in one of its annual presentations that: A hybrid electric vehicle (HEV) uses approximately 1.6kg of lithium A plug-in hybrid (PHEV) uses 12kg An electric vehicle (EV) uses more than 20kg (but all depends on make, model, and technology). An average car battery (PHEV/EV) would use over 10kg of lithium, assuming 450g per kWh (please note that real-life calculations suggest a usage of up to 800g per kWh of lithium. We have used the lower end of the range for our estimates), with Tesla's battery consuming around 70kg of lithium. Simple math suggests that with the completion of the mega-factory (estimated production of 35 GWh or 500k batteries p.a.), Tesla alone will be consuming at least half of world lithium production by 2020, and create a large overhang in demand. Among car battery producers, we like global players with dominant market positions and strong ties to end-users, such as LG Chem, Samsung SDI in Korea, and BYD in China. Those three companies together control more than half of global battery production (Chart 15) and will most likely maintain market share in the foreseeable future, as barriers to entry are high due the amount of investment required into technology and production facilities, and the end-product is difficult to differentiate on the market. BYD Corp (1211 HK): Build Your Dreams, it's in the name (Chart 16). Founded in 1995 and based in Shenzhen, BYD covers the whole value chain, from R&D and production of batteries (phone and car batteries) to automobile production and energy storage solutions. It is currently the largest battery and PHEV producer in China. The total revenues stream consists of 55% from auto and auto components sales, 33% portable electronics battery, and 12% car battery sales. Chart 15Largest Lithium ##br##Battery Producers The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market Chart 16Performance Since October 2015: ##br##BYD Corp vs MXEF Index bca.ces_wr_2016_10_27_c16 bca.ces_wr_2016_10_27_c16 We believe the company is best positioned to reap multi-year rewards from the recent drive of the Chinese government to promote new electronic vehicle (NEV) growth through subsidies, support of charging infrastructure, and changes in legislation. The introduction of carbon trading in August (carbon credit will be measured on the number of gasoline-powered vehicles in the producer's fleet) will give BYD a benefit over other car manufacturers. BYD's model pipeline and battery manufacturing capacity (expected to reach 20 GWh by FY17), as well as favourable pricing ($200 kWh compared to over $400 kWh for Tesla) put the company into a leadership position. BYD reported 2Q16 results on 28 August, which came out very strong. Revenues grew by 52.5% YOY and 384% on a semi-annual perspective, driven by all three business segments and especially strong in EV sales (+29% YOY). This came with a significant beat of consensus estimates and later we saw a 68% upwards adjustment. As a result operating margin and profit margin improved from 3.8% and 2.2% in 2Q15 to 8.5% and 5.8% in 2Q16. Bottom-line was up 4x YOY. The market is currently pricing in an EPS CAGR of 12% over the next three years. BYD is trading at a forward P/E of 23.9x. LG Chem (051910 KS): Catering for the US market (Chart 17). LG Chem is the largest chemical company in South Korea, operating in three different divisions: petrochemicals (from basic distillates to polymers), which account for 71% of total revenues, information technology and electronics (displays, toners etc.), which represent 13% of total revenues, and energy solutions, 16% of total revenues. LG Chem is the third largest battery producer in the world, manufacturing a pallet from small watch and mobile phone batteries down to auto-packs. LG's North American operations in Holland, Michigan produce battery packs for the whole range of GM (Chevrolet, Cadillac) EVs (including the most popular Volt range), as well as for the Ford Focus. In Europe, customers include Renault; in Asia, LG is working with Hyundai, SAIC, and Chery. The company reported better-than-expected 2Q16 results on 21 July. Revenues grew by 3% YOY and operating profit by 8.5% YOY, driven solely by the petrochem division (up 10% YOY). Bottom-line expanded by a healthy 8% YOY. LG Chem trades at deeply discounted levels (forward P/E of 11.6x) due to the remaining negative profitability in the battery segment (partly due to licensing issues in China, which represents 32% of total revenues), but we estimate that the trend will turn in the following quarters, as Chevrolet is ramping up demand with new product lines and management is guiding for a resolution in China. Furthermore, plans released by the Korean government in June/July (renewable energy plan and EV expansion plan) will increase demand for batteries by more than 30% CAGR in the next five years. The market is forecasting an EPS CAGR of 9% over the upcoming four years. Samsung SDI (006400 KS): Investing into the future (Chart 18). In contrast to LG Chem, Samsung SDI is fully focused on Li-ion battery production, with 66.5% of total revenues coming from this division (BMW and Fiat among clients). The company also produces semiconductors and LCD displays, which account for 35.5% of total revenue. Chart 17Performance Since October 2015: ##br##LG Chem vs MXEF Index bca.ces_wr_2016_10_27_c17 bca.ces_wr_2016_10_27_c17 Chart 18Performance Since October 2015: ##br##Samsung SDI vs MXEF Index bca.ces_wr_2016_10_27_c18 bca.ces_wr_2016_10_27_c18 Samsung SDI is currently in a reorganization phase, as the company is spinning off "Samsung SDI Chemicals" and has announced it will invest $2.5 bn into further development of its car battery business. The proceeds from the sale of Samsung SDI Chemicals (taken over by Lotte Chemicals in April for around $2.6 bn) will also be directed towards the car battery segment. Samsung SDI reported weak 2Q16 results on 28 July, as expected. Revenues continued to contract on a YOY basis, although the rate of decline slowed compared to Q1 and even registered 2% QOQ growth. The bottom-line was positive due to a one-off gain (the sale of the chemical business). The main headwinds came from delays in licensing Chinese factory production and a strong Japanese yen. On the positive side, Li-ion batteries in portable devices performed well, due to better than expected Galaxy S7 sales, as well as OLED sales, due to increased demand and capacity constraints in the mobile phone and large panel spaces. Due to the high concentration of EV battery-related revenues in its portfolio, we believe that Samsung SDI will be the largest beneficiary of government's renewable energy and EV expansion plans. The company is also ideally positioned to take advantage of the fast-growing Chinese market (35% of revenues coming from China), once the issue with licensing is resolved (which management guided will happen in Q3). The recent problems with overheating or exploding batteries, reported by users of the new Samsung phones, have sent the share price lower. We believe that this offers an excellent entry point, as ultimately the company will replace/improve the technology, and, at the same time, there are no alternatives which could threaten Samsung SDI's leadership in the portable battery space. The temporary issue in China has weighted on valuations, as Samsung SDI is trading at a forward P/E of 27.7x, while the market expects EPS to increase fivefold in the coming four years. Accessing The Chinese EV Market Best access to the fast growing Chinese market is through local car manufacturers, such as Geely (Chart 19). The subsidy schemes, put in place by the National Development and Reform Commission (NDRC), currently cover only domestic-made models (except the BMW i3). Furthermore, import duties are making foreign-made vehicles uncompetitive in terms of price. We recommend to overweight Geely (0175 HK) and electric bus producer Yutong Bus (600066 CH) on the 30% NEV rule for public transport procurement. Chart 19Accessing The Chinese EV Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market Geely ("Lucky" in Mandarin) Automobile Holdings (175 HK): A company with large ambitions (Chart 20). Probably best known for its two foreign car holdings, Volvo and the London Taxi Company, Geely grew from a small appliances manufacturer to the second largest EV producer in China, with an ambitious goal to manufacture 2 mn units by 2020. We see the main positive driver in Geely's big push into the EV market. The goal set by management is to have 90% of its fleet powered by electricity by 2020. The so called "Blue Geely" initiative is based on a revamp of Geely's current fleet into HEVs/PHEVs (65% as per plan) and EVs (35%). In May the company raised $400 mn in "green bonds" in a first for a Chinese car company, to support its R&D and manufacturing project, Ansty, to produce the first zero-emission TX5 black cabs in the U.K. The company reported strong 1H16 results on 18 August. Revenues were up 30% YOY, driven by higher production volume (up 10% YOY) and a sales price hike of around 15% YOY. The co-operation with Volvo seems to be working well (Volvo's design, Geely's production capabilities). The average waiting time for new models in China is approximately two months. The bottom-line expanded by 37.5% YOY despite a high density of new model launches, and we expect to see some margin improvement in the coming quarters. The market forecasts an EPS growth CAGR of 25% over the coming four years. Geely is currently trading at a forward P/E of 15.6x. Zhengzhou Yutong Bus Company (600066 CH): An unusual bus manufacturer (Chart 21). Yutong Bus Company is the world's largest, and technologically most advanced, producer of medium and large-sized buses (over 75k units produced in FY15, 10% global market share), with its own R&D and servicing capabilities. Even more important, Yutong is one of the largest producers of electric-powered buses in China and globally. Chart 20Performance Since October 2015: ##br##Geely Automobile Holdings vs MXEF Index bca.ces_wr_2016_10_27_c20 bca.ces_wr_2016_10_27_c20 Chart 21Performance Since October 2015:##br## Yutong Bus Company vs MXEF Index bca.ces_wr_2016_10_27_c21 bca.ces_wr_2016_10_27_c21 Due to the 30% EV procurement rule for local governments, the number of electric buses produced in 2015 soared 15 times to 90,000, a quarter of which were produced by Yutong. We expect this number to grow further with the introduction of the new carbon emission trading scheme. We see Yutong as best positioned in the bus manufacturers' space to take advantage of the new trading rules. Yutong reported 2Q16 results on 23 August, which came in broadly in line with market expectations. Revenue expanded by 34% YOY, driven by volume growth (7400 NEV units sold, +100% YOY). The push into EVs came with higher cost-of-sales (warranty and servicing). This did not affect gross margin (up 1% to 25%). Bottom-line grew by 50% YOY. Management maintained an upbeat outlook, guiding 25,000 units of NEV sales in FY16, with an average sales price increase due to higher sales in the large-bus segment. Management also expects to receive the national subsidy for FY15 in 3Q16 and for 2016 in 1Q17. The market currently factors in an EPS CAGR growth of 8% over the next four years. Yutong is trading at a forward P/E of 12.3x. How To Trade? The EMES team recommends gaining exposure to the sector through a basket of the listed equities, which would consist of four mining companies, three car battery pack producers, and two EV manufacturers. The main goal is active alpha generation by excluding laggards and including out-of-benchmark plays, to avoid passive index hugging via an ETF. Direct: Equity access through the tickers (Bloomberg): Albermarle (ALB US), Gangfeng Lithium (002460 CH), Orocobre (ORE AU), Tianqi Lithium Industries (002466 CH), BYD (1211 HK), LG Chem (051910 KS), Samsung SDI (006400 KS), Geely Automobile Holdings (175 HK), Zhengzhou Yutong Bus Company (600066 CH). ETFs: Global X Lithium ETF (LIT US) Funds: There are currently no funds available, which invest directly into lithium or lithium-related stocks. Please note that the trade recommendation is long-term (1Y+) and based on an OW call. We don't see a need for specific market timing for this call (for technical indicators please refer to our website link). Trades can also be implemented through our recommendation versus MXEF index either directly through equities in the recommended list or through ETFs. For convenience, the performance of both the ETFs and market cap-weighted equity baskets will be tracked (please see upcoming updates as well as the website link to follow performance). Risks To Our Investment Case Because of the broad diversification, we see our portfolio exposed to idiosyncratic risk factors, which could affect single-stock performance, as well as the following macro factors: Mining: Falling lithium prices due to lower demand or a ramp-up in production on some of the Australian projects, could hurt profitability or delay new projects (especially in case of Orocobre). We also see some political risk stemming from the region of operations (Argentina, Chile), especially taking into account the weak performance of Chile's own lithium producer SQM and its role in a Brazil-like political scandal. Battery and EV production. We identify the main risk in drastic changes to governments' environmental and subsidy policies, which would hit the whole supply chain. A slowdown in economic development can make green or power-saving initiatives too expensive and governments will have to rethink their subsidy policies or production/penetration goals. This will hurt profitability through either a negative impact on sales or through smaller subsidies, which producers and end-users are receiving from their governments. One further risk is the dramatic increase in demand for lithium after the completion of Tesla's factory in Nevada, but may also come from other large players such as BYD. We currently see this risk as muted. As with all large Tesla initiatives, you have to take them with a pinch of salt, as the exact end numbers and the time the factory will be working at full capacity are unclear. Furthermore, Tesla, unlike many Chinese competitors, has no supply of lithium of its own, so there is little chance that it can protect supply or control prices. In any case, we see the overall portfolio as balanced, as the mining companies' performance should compensate for a negative impact on the end producers. Oleg Babanov, Editor/Strategist obabanov@bcaresearch.co.uk BASE METALS China Commodity Focus: Base Metals Zinc: Downgrade To Strategically Bearish We downgrade our strategic zinc view from neutral to bearish. We believe zinc supply (both ore and refined) will rise in response to current high prices, resulting in a 10-15% decline in zinc prices over next 9-12 months. Tactically, we still remain neutral on zinc prices as we believe the market will remain in supply deficit over the near term. Chinese zinc ore production will recover in 2017, while the country's zinc demand growth will slow. China is the world's biggest zinc ore miner, refined zinc producer, and zinc consumer. We recommend selling Dec/17 zinc if it rises to $2,400/MT (current: $2,373.5/MT). If the sell order gets filled, put on a stop-loss level at $2,500/MT. Zinc has been the best-performing metal in the base-metals complex, beating copper, aluminum and nickel this year. After bottoming at $1,456.50/MT on January 12, zinc prices have rallied 64.7% to $2,399/MT on October 3 (Chart 22, panel 1). The Rally The rally was supercharged by a widening supply deficit, which was mainly due to a record shortage of zinc ores globally (Chart 22, panels 2, 3 and 4). Late last October our research showed the output loss from the closure of Australia's Century mine, the closure of Ireland's Lisheen mine and Glencore's production cuts would reduce global zinc supply by 970 - 1,020 KT in 2016, which would be equivalent to a 7.1 - 7.5% drop in global zinc ore output.5 Moreover, a 16% price decline during the November-January period spurred additional production cut worldwide. According to the WBMS data, for the first seven months of 2016, global zinc ore production declined 11.9% versus the same period of last year, a reduction never before seen in the zinc market. In comparison, there was no decline in global zinc demand (Chart 22, panel 4). As a result, the global supply deficit reached 152-thousand-metric-tons (kt) for the first seven months of 2016, versus the 230kt supply surplus during the same period last year. What Now? Tactically, We Remain Neutral. On the supply side, we do not see much new ore supply coming on stream over the next three months. On the demand side, both monetary and fiscal stimulus in China has pushed Chinese zinc demand higher. For the first seven months of 2016, the country's zinc consumption increased 209 kt, the biggest consumption gain worldwide. Because of China, global zinc demand did not fall this year. China will continue lifting global zinc demand as its auto production, highway infrastructure investment, and overseas demand for galvanized steel sheet will likely remain elevated over the near term (Chart 23, panels 1, 2 and 3). Inventories at the LME are still hovering around the lowest level since August 2009, while SHFE inventories also have been falling (Chart 23, bottom panel). Speculators seem to be running out of steam, as the open interest has dropped from the multi-year high on futures exchanges. Chart 22Zinc: Strategically Bearish, Tactically Neutral bca.ces_wr_2016_10_27_c22 bca.ces_wr_2016_10_27_c22 Chart 23Positive Factors In The Near Term bca.ces_wr_2016_10_27_c23 bca.ces_wr_2016_10_27_c23 The aforementioned factors militate against zinc prices dropping sharply in the near term. However, with prices near the 2014 and 2015 highs, and facing strong technical resistance, we do not see much upside. Strategically, We Downgrade Our Strategic Zinc View From Neutral To Bearish We believe zinc supply (both ore and refined) will rise in response to current high prices, resulting in a 10-15% decline in zinc prices over next 9-12 months. Chart 24High Prices Will Boost Supply In 2017 bca.ces_wr_2016_10_27_c24 bca.ces_wr_2016_10_27_c24 Zinc prices at both LME and China's SHFE markets are high (Chart 24, panel 1). Last year, many miners and producers cut their ore and refined production due to extremely low prices. If zinc prices stay high over next three to six months, we expect to see an increasing amount of news stories on either production cutbacks coming back or new supply being added to the market, which will clearly be negative to zinc prices (Chart 24, panels 2 and 3). So far, even though Glencore, the world's biggest ore producing company, is still sticking firmly to its output reduction plan, there have been some news reports about other producers raising their output, all of which will increase zinc ore supply in 2017. The CEO of the Peruvian Antamina mine said on October 10 the mine operator will aim to double its zinc output in 2017 to 340 - 350 kt, up from an estimated 170 kt - 180 kt this year, as the open pit operation transitions into richer zinc areas. This alone will add 170 kt - 180 kt new zinc supply to the market. Vedanta said last week that its zinc ore output from its Hindustan Zinc mine located in India will be significantly higher over next two quarters versus the last two quarters. Nyrstar announced in late September that it is reactivating its Middle Tennessee mines in the U.S., expecting ore production to resume during 2017Q1 and to reach full capacity of 50 kt per year of zinc in concentrate by November 2017. Red River Resource is also restarting its Thalanga zinc project in Australia, and expects to resume producing ore in early 2017. Glencore may not produce more than its 2016 zinc production guidance over next three months. But it will likely set its 2017 guidance higher, if zinc prices stay elevated. After all, the company has massive mothballed zinc mines, which are available to bring back to the market quickly. In comparison to the high probability of more supply coming on stream, global demand growth is likely to stay anemic in 2017, as the stimulus in China, which was implemented in 2016H1, will eventually run out of steam. How Will China Affect The Global Zinc Market? Chart 25Look To Short Dec/17 Zinc bca.ces_wr_2016_10_27_c25 bca.ces_wr_2016_10_27_c25 China is the world's largest zinc ore producing country, the world's largest refined zinc producing country, and the world's largest zinc consuming country. Last year, the country produced 35.9% of global zinc ore, 43.8% of global refined zinc, and consumed 46.7% of global zinc. Over the near term, China is a positive factor to global zinc prices. Domestic refiners are currently willing to refining zinc ores as domestic zinc prices are near their highest levels since February 2011. With inventories running low and domestic ore output falling 7.8% during the first seven months of 2016, the country may increase its zinc ore imports in the near term, further tightening global zinc ore supply. Domestic zinc demand and overseas galvanized steel demand are likely to stay strong in the near term. However, over the longer term, China will become a negative factor to global zinc prices. China's ore output the first seven months of 2016 was 221 kt lower than the same period of last year as low prices in January-March forced widespread mine closures. The country's mine output may not increase much, as the government shut 26 lead and zinc mines in August in Hunan province (the 3rd largest zinc-producing province in China) due to safety and environmental concerns. The ban will be in place until June 2017. Looking forward, elevated zinc prices and a removal of the ban will boost Chinese zinc ore output in 2017. Regarding demand, we expect much weaker Chinese zinc demand growth next year as this year's stimulus should run out of steam by then. Risks If global zinc ore supply does not increase as much as we expect, or global demand still have a robust growth next year, global zinc supply-demand balance may be more tightened, resulting in further zinc price rallies. If Chinese authorities resume their reflationary policies next year during the lead-up to the 19th National Congress of the Communist Party of China in the fall, which may increase Chinese and global zinc demand considerably, we will re-evaluate our bearish strategic zinc view. Investment Ideas As we are strategically bearish zinc, we recommend selling Dec/17 zinc if it rises to $2,400/MT (current: $2,373.5/MT) (Chart 25). If the sell order gets filled, put on a stop-loss level at $2,500/MT. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com 1 Please see p. 32 of the 2016 edition of the International Energy Agency's "Key World Energy Statistics." The IEA reckons global oil demand in 2014 averaged just over 93mm b/d. 2 Please see the Financial Times, p. 12, "Warning on electric vehicle threat to oil industry," in the October 9, 2016, re the Fitch Ratings report, and IHS Energy's Special Report, "Deflating the 'Carbon Bubble,' Reality of oil and gas company valuation," published in September 2014. 3 Because of the early stage of the project, a conventional equity analysis is not yet applicable. 4 Please see Technology Sector Strategy Special Report "Electric Vehicle Batteries", dated September 20, 2016, available at tech.bcaresearch.com 5 Please see Commodity & Energy Strategy Weekly Report for Base Metal section, "Global Oil Market Rebalancing Faster Than Expected", dated October 22, 2015, available at ces.bcaresearch.com Investment Views and Themes Recommendations Tactical Trades Commodity Prices and Plays Reference Table Closed Trades

Highlights The resilience of EM industrial commodity demand, which is helping to lift inflation and inflation expectations in the U.S., will be tested over the next few months, as markets gear up for a possible oil-production deal between OPEC and Russia, and the first of perhaps three Fed rate hikes in December and next year. Any indication Janet Yellen has persuaded her colleagues to run a "high-pressure economy" will provoke us to get long gold, given its sensitivity to the Fed's preferred inflation gauge. We remain wary, however, given the higher-rates stance favored by some Fed officials, which, our modeling suggests, would reverse the pick-up in inflation and inflation expectations in the U.S. by depressing EM growth. Energy: Overweight. We continue to favor U.S. shale-oil producers at this stage in the cycle, and continue to look for opportunities to take commodity price exposure. Base Metals: Neutral. We downgraded copper to neutral from bullish last week, expecting prices to trade sideways over the next three months. Precious Metals: Neutral. We continue to be buyers of gold at $1,210/oz. If we continue to see the Fed's preferred inflation gauge increase, we will raise that target. Ags/Softs: Underweight. We are recommending a tactical long position in Mar/17 wheat versus a short in Mar/17 soybeans. Feature In her Boston Fed speech last week, Fed Chair Janet Yellen dangled catnip in front of commodity markets by discussing the possibility of "temporarily running a 'high-pressure economy,' with robust aggregate demand and a tight labor market" as a means of countering the prolonged hysteresis in the U.S. economy.1 Any indication Dr. Yellen has succeed in convincing her colleagues to pursue such a strategy would compel us to get long gold, given the sensitivity of the yellow metal to core PCE, the Fed's preferred inflation gauge (Chart of the Week).2 Indeed, we find there is a long-term equilibrium between spot gold prices and the core PCEPIand U.S. financial variables, which is extremely robust over time.3 Core PCEPI has been ticking up this year, most recently in March and appears to be leading 5-year/5-year inflation expectations tracked by the St. Louis Fed, which bottomed in June and have been trending higher since (Chart 2).4 In our modeling, we find a 1% increase in core PCE translates into a 4% increase in gold prices, suggesting gold would provide an excellent hedge against rising inflation. Chart of the WeekGet Long Gold If Pressure ##br##Builds in U.S. Economy bca.ces_wr_2016_10_20_c1 bca.ces_wr_2016_10_20_c1 Chart 2Core PCE ##br##Ticking Up bca.ces_wr_2016_10_20_c2 bca.ces_wr_2016_10_20_c2 Core PCE And EM Commodity Demand There is an enduring long-term relationship between inflation generally and EM commodity demand, which we have highlighted in previous research.5 This week we are exploring long-term equilibrium relationships between EM industrial commodity demand and core PCE, given the obvious interest among commodity investors. The big driver of core PCE is EM industrial commodity demand, as can be seen in Chart 3, which shows the output of two regressions we ran using non-OECD oil demand - our proxy for EM oil demand - and world base metals demand, which is dominated by China's roughly 50% share of global base metals demand. Core PCE is cointegrated with these measures of industrial-commodity demand, which makes perfect sense considering most - sometimes, all - of the demand growth for industrial commodities (oil and base metals, in this instance) is coming from EM economies.6 For example, of the total growth in oil demand since 2013, non-OECD demand accounted for 1.1mm b/d of an average 1.2mm b/d global demand growth. Within other markets, China accounts for more than 50% of global iron ore, copper ore, metallurgical and thermal coal demand.7 At the margin, prices in the real economy are being set by EM demand, not by DM demand. This, in turn, feeds into core and headline PCE and other inflation gauges. Feedback Between Fed Policy And EM Commodity Demand Leading economic indicators for EM growth are turning up, which is supportive for commodity demand near term (Chart 4). This has been aided by accommodative monetary policy in the U.S., which has kept the USD relatively tame after peaking in January 2016.8 Chart 3EM Industrial Commodity Demand,##br## Core PCE Share Common Trend bca.ces_wr_2016_10_20_c3 bca.ces_wr_2016_10_20_c3 Chart 4EM Leading Indicators ##br##Point to Growth Upturn bca.ces_wr_2016_10_20_c4 bca.ces_wr_2016_10_20_c4 The single biggest risk to commodity demand and commodity prices remains U.S. monetary policy. The longer-term cointegrating relationships highlighted in this week's research are consistent with earlier results we reported on the impact of U.S. financial variables on commodity demand.9 When we model EM oil demand as a function of U.S. financial variables, we find a 1% increase (decrease) in the USD broad trade-weighted index (TWI) is consistent with a 22bp decrease (increase) in consumption using these longer-dated models. For global base metals, a 1% increase (decrease) in the USD TWI corresponds with a 27bp drop (increase) in demand. As a general rule, each 1% increase (decrease) in the USD TWI is accompanied by a 25bp drop (increase) in EM demand for oil and global base metals (Charts 5 and 6). Chart 5EM Oil Demand Will Fall If ##br##The Fed Gets Too Aggressive... bca.ces_wr_2016_10_20_c5 bca.ces_wr_2016_10_20_c5 Chart 6...As Will##br## Base Metals Demand bca.ces_wr_2016_10_20_c6 bca.ces_wr_2016_10_20_c6 As mentioned above, we continue to expect a 25bp hike by the Fed at its December meeting, followed by two additional hikes next year. Our House view continues to maintain this round of rate hikes will cause the USD to appreciate by 10% over the next 12 months. If this is fully passed through, we expect this gauge to register a ~ 2.5% decline in EM demand for industrial commodities. This would reduce the core PCE's yoy rate of change to ~ 1%, vs. the current level of 1.7% yoy growth. Walking A Tightrope Chair Yellen's speech makes it clear the Fed is well aware of how its monetary policy affects the global economy and the feedback loop this creates. This is of particular moment right now, given the Fed is the only systemically important central bank even considering tightening its monetary policy. As she notes, "Broadly speaking, monetary policy actions in one country spill over to other economies through three main channels: changes in exchange rates; changes in domestic demand, which alter the economy's imports; and changes in domestic financial conditions - such as interest rates and asset prices - that, through portfolio balance and other channels, affect financial conditions abroad." The other major threat to EM commodity demand is the oil-production deal being negotiated by OPEC, led by the Kingdom of Saudi Arabia (KSA), and non-OPEC, led by Russia. Should these negotiations result in an actual cut in oil production, it would accelerate the tightening of global oil markets - likely increasing the rate at which global inventories of crude oil and refined products are drained - and put upward pressure on prices. While we do not expect a material agreement to emerge from these negotiations - KSA and Russia already are producing at or close to maximum capacity at present. A freeze in production by these states would result in no change in production globally. The risk here is KSA actually cuts production beyond its seasonal decline by adding, say, a 500k b/d cut to the expected 500k b/d seasonal decline, and Russia agrees to something similar. This would be offset by continued production increases in Iran, and possibly in Libya and Nigeria, but would, nonetheless, surprise the market and rally prices. All else equal, higher prices would weaken EM demand growth at the margin, and feed back into lower inflation expectations. We do not believe it is in KSA's or non-OPEC producers' interest to try to tighten markets sharply, since a price spike would re-energize conservation efforts by consumers, particularly in DM economies, and incentivize alternative transportation technologies like electric cars, as happened when oil prices were above $100/bbl from 2010 to mid-2014. Nonetheless, KSA, Russia, and other parties to any production-management agreement will have to balance this risk against the likelihood U.S. shale producers step in to fill the production cutbacks before any meaningful increase in revenues accrues to these states. Bottom Line: It still is too early to discuss the implications of a production cut, given negotiations between the KSA and Russia camps ahead of OPEC's November meeting continue. However, this could become a material issue next year, just as the Fed is considering whether to hike rates two more times, as we expect. A combined oil-production cut emerging from the KSA - Russia negotiations, which is a non-trivial risk, coupled with two Fed rate hikes could set off a new round of disinflation or even deflation, just as EM commodity demand was starting to enliven inflation and inflations expectations in the U.S.10 This could force the Fed to back off further rate hikes, or even walk back previous rate hikes. If on, the other hand, Chair Yellen is successful in persuading her colleagues to run a "high-pressure economy" we would look to get long commodities generally, gold in particular, given our expectation core PCE inflation and inflation expectations will move higher. As our research has shown, the yellow metal is particularly sensitive to the Fed's preferred inflation gauge. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com SOFTS China Commodity Focus: Softs Grains: Focus On Relative-Value Trade We remain strategically bearish grains, but we are upgrading our tactical view for wheat from bearish to neutral. We believe most of the negative news already is reflected in wheat prices. Over next three to six months, we expect wheat to outperform soybeans. Wheat prices could move up on reduced U.S. acreage, rising Chinese imports, or any unfavorable winter weather in major producing countries while expanding area-sown in Brazil, Argentina, China and the U.S. will likely pressure down soybean prices. We recommend a tactical long position in March/17 wheat versus March/17 soybeans. We suggest a 5% stop-loss to limit the downside risk. Grain prices have already rebounded 10.3% since August 30, when prices collapsed to a 10-year low (Chart 7, panel 1). There were three main reasons behind the precipitous price drop from early June to late August. 1.The 25% rally grain prices in 2016H1 encouraged global planting of spring wheat, soybeans, corn and rice. 2.Favorable weather lifted yields of all grains to record highs. 3.Extremely cheap Russian, Ukraine, Argentine and Brazilian currencies boosted exports from these major grain producing countries. In addition, grain-related policy changes in Argentine and Russia also have stimulated their grain exports (wheat benefited most and corn next). Given a 10% rebound recently, as the USDA expects global grain stocks to rise 3% to a new high next year, we remain a strategical bearish view on grain. Looking forward, we will continue to focus on relative-value trades in grain markets. Tactically, we are interested in long wheat versus soybeans. Wheat: Tactically Neutral Wheat has underperformed other grains so far in 2016 (Chart 7, panel 2). Prices fell to 361 cents per bushel on August 31, which was the lowest level since June 2006 (Chart 7, panel 3). Wheat prices have already recovered 16.7% from their August bottom. We believe, over the next three to six months, wheat prices may have limited downside due to one or a combination of the following factors. U.S. farmers are currently in the process of planting winter wheat. According to the USDA, as of October 9, 59% of winter wheat acreage has been planted. As U.S. wheat production costs are well above current market prices, U.S. farmers likely will further cut their wheat acreage over the next several weeks. This year, U.S. wheat-planted acreage has already dropped to the lowest since 1971 (Chart 8, panel 1). Global wheat yields improved 2.8% this year, with 13.4% and 20.8% increases in Russian and U.S. yields, respectively. Even though Russia will raise its wheat-sown area for next season, the country's wheat crop still faces plenty of risks during its development period. Too cold a winter or too hot a summer, which may not even result in a considerable drop in yields, still could spur a temporary rally in wheat prices. Similarly, U.S. wheat yields are also likely to retreat from the record high in 2017H1. In addition, extremely low wheat prices will encourage global farmers to plant other more profitable crops instead. As a result, both global wheat acreage and yields will likely go down next year (Chart 8, panel 2). Speculators are currently holding sizable net short positions. Market sentiment is also extremely bearish. Given this backdrop, any short-covering also would drive prices up (Chart 8, panels 3 and 4). Chart 7Wheat: Cautiously Bullish bca.ces_wr_2016_10_20_c7 bca.ces_wr_2016_10_20_c7 Chart 8Wheat: Upgrade To Tactically Neutral ##br##On Supportive Factors bca.ces_wr_2016_10_20_c8 bca.ces_wr_2016_10_20_c8 Soybeans: Tactically Bearish Soybeans have outperformed other grains significantly this year (Chart 7, panel 2). As planting soybeans general is more profitable than planting corn, wheat and rice, global farmers are likely to expand their soybean acreage for the next harvest season. According Conab, Brazil's national crop agency, Brazil's soybean production next spring will increase 6.7% to 9%. Record high U.S. soybean production is likely to weigh down the market as well. According to the USDA, 7.1% jump in the yields will bring U.S. soybean crop to a record high, an 8.7% increase from last year. As of October 9, 2016, only 44% U.S. soybean has been harvested, 12 percentage points behind last year. Chart 9China Grain Imports Will Continue Rising China Grain Imports Will Continue Rising China Grain Imports Will Continue Rising How does China contribute to our grain view? As the world's largest grain producer and also the largest consumer, China is an important player in global grain market. Last year the country accounted for 20.7% of global aggregate grain production and 23% of global consumption. In terms of grain imports, as we predicted in our January 2011 Special Report "China-related Ag Winners For The Long Term," China's grain imports have been on the uptrend, despite the depreciating RMB in the most recent two years (Chart 9). In terms of individual grain markets, China has been the most significant player in the global soybean market, accounting for 62.7% of global imports last year. China is also the world's largest rice importer, accounting for 12.5% of global rice trade. However, for corn and wheat markets, China only accounted for about 2% of global trade. In late March, the Chinese government announced an end to its price-support program for corn, but the government maintained price-support policies for wheat and rice. The government also announced its temporary reserve policy will be replaced by a new market-oriented purchase mechanism for the domestic corn market. In addition, the policy of giving direct subsidies to soybean farmers will continue in the 2016-17 market year. What Are The Implications Of China's Grain-Related Policy? Domestic corn prices fell sharply with global prices, while the gap between domestic soybean prices and the international ones remains large (Chart 10, panels 1 and 2). This will discourage domestic corn sowing and encourage soybean production, which is positive to global corn markets, but negative for global soybean markets. China's imports of wheat and rice are set to rise, given a widening price gap (Chart 10, panels 3 and 4). The country's demand for high-quality wheat and rice are rising as household incomes have greatly improved. China will likely liquidate its elevated grain inventories, which account for about 45% of global stocks. This will be bearish for all grains. However, as most of the domestic grain stocks are low-quality grains, inventory liquidation may affect animal feed market rather than the good-quality grain market. Overall, China's grain policy is positive for international corn, wheat and rice prices, but negative for global soybean prices. Investment strategy As we expect wheat to outperform soybeans over the next three to six months, we recommend a tactical long position in March/17 wheat versus short March/17 soybeans with a 5% stop-loss (Chart 11). Chart 10Implications Of China Grain Related Policy bca.ces_wr_2016_10_20_c10 bca.ces_wr_2016_10_20_c10 Chart 11Go Long Wheat Versus Soybeans With Stops bca.ces_wr_2016_10_20_c11 bca.ces_wr_2016_10_20_c11 Downside risks To Our Relative-Value Trade Position Currently, global wheat inventories still are at a record highs, and almost all the major wheat exporting countries continue to hold considerable inventory for sale. If farmers in Russia, Ukraine and Argentina rush to sell to take advantage of recent price rally, wheat prices will fall. Also, a strengthening USD will put a downward pressure on grain (including wheat and soybeans) prices. For this reason, it will be important to monitor U.S. dollar strength against the currencies of these countries - too-strong a USD will keep grains from being exported, which will keep domestic U.S. prices under pressure. However, our relative-value trade may weather this risk well as a strengthening dollar affects both wheat and soybeans. Moreover, if weather continues to be favorable during the winter, wheat prices may drop below the August lows. On the other side, if unfavorable weather reappears in South America next spring like this year, soybean prices may quickly go up. To limit our downside risk, we suggest putting a 5% stop-loss to our long wheat/short soybeans trade. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com 1 Please see "Macroeconomic Research After the Crisis," Dr. Yellen's speech delivered at the October 14, 2016, Boston Fed 60th annual economic conference in Boston. She highlighted hysteresis - "the idea that persistent shortfalls in aggregate demand could adversely affect the supply side of the economy" - in her discussion on how demand affects aggregate supply. She noted, "interest in the topic has increased in light of the persistent slowdown in economic growth seen in many developed economies since the crisis. Several recent studies present cross-country evidence indicating that severe and persistent recessions have historically had these sorts of long-term effects, even for downturns that appear to have resulted largely or entirely from a shock to aggregate demand." 2 Core PCE is the Personal Consumption Expenditures (PCE) price index, which excludes food and energy prices 3 The relationship shown in the Chart Of The Week covers the period March 2000 to present. The adjusted R2 of the cointegrating regression we estimated is 0.97; the price elasticity of gold with respect to a 1% change in the core PCE is close to 4%. The model is dominated by real rates, however: a 1% increase in real rates translates to a 15% decrease in gold prices, while a 1% increase in the broad trade-weighted USD implies a decrease in gold prices of just under 2.5%. Data and modeling constraints took the last observation to August 2016, when the model suggested the "fair value" of gold was close to $1,200/oz. At the time, gold was trading at just below $1,310/oz. Prices subsequently fell into the low to mid $1,200s, and were trading at ~ $1,270/oz as we went to press). 4 For this chart, we use the St. Louis Fed's 5y5y U.S. TIPS inflation index. Please see Federal Reserve Bank of St. Louis, 5-Year, 5-Year Forward Inflation Expectation Rate [T5YIFR], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/T5YIFR , October 19, 2016. 5 Please see "Memo To Fed: EM Oil, Metals Demand Key To U.S. Inflation" and "Commodities Could Be Hit Hard By Fed Rate Hikes," in the August 4, 2016, and September 1, 2016, issues of BCA Research's Commodity & Energy Strategy. Both are available at ces.bcaresearch.com. See also "China's Evolving Demand for Commodities," by Ivan Roberts, Trent Saunders, Gareth Spence and Natasha Cassidy," presented at the Reserve Bank of Australia's Conference focused on "Structural Change in China: Implications for Australia and the World," 17 - 18 March 2016. 6 The adjusted-R2 statistics for cointegrating regressions we ran for core PCE as a function of non-OECD oil demand and world base metals demand were 0.99 and 0.98 from 2000 to present. 7 Please see discussion beginning on p. 4 of "China's Evolving Demand for Commodities," by Ivan Roberts, Trent Saunders, Gareth Spence and Natasha Cassidy," presented at the Reserve Bank of Australia's Conference focused on "Structural Change in China: Implications for Australia and the World," 17 - 18 March 2016. 8 The Fed's broad trade-weighted USD index post-Global Financial Crisis peaked in January at just under 125 and currently stands at 122.6. Please see Board of Governors of the Federal Reserve System (US), Trade Weighted U.S. Dollar Index: Broad [TWEXBMTH], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/TWEXBMTH, October 18, 2016. 9 Please see p. 3 of "Commodities Could Be Hit Hard By Fed Rate Hikes," in the September 1, 2016, issue of BCA Research's Commodity & Energy Strategy, available at ces.bcaresearch.com. 10 We define a non-trivial risk as a 1-in-6 chance of occurrence - i.e., the same odds as Russian roulette. Investment Views and Themes Recommendations Tactical Trades Commodity Prices and Plays Reference Table Closed Trades

Highlights EM tech stocks are overbought while banks are fundamentally vulnerable due to bad-loan overhang. EM stocks have never decoupled from the U.S. dollar and commodities prices. There has been no recovery in EM corporate profitability and EPS. We reiterate two equity trades: short EM banks / long U.S. banks, and short Chinese property developers / long U.S. homebuilders. Upgrade Thai stocks to overweight within the EM equity benchmark and go long THB versus KRW. Feature Our Reflation Confirming Indicator - an equal-weighted aggregate of platinum prices (a proxy for global reflation), industrial metals prices (a proxy for China growth) and U.S. lumber prices (a proxy for U.S. reflation) - has decisively rolled over, and is spelling trouble for emerging market (EM) equities (Chart I-1). In particular, platinum prices have relapsed after hitting a major resistance at their 800-day moving average (Chart I-2). Such a technical pattern often leads to new lows. If so, it could presage a major selloff in EM markets in the months ahead. Chart I-1A Red Flag From ##br##Reflation Confirming Indicator A Red Flag From Reflation Confirming Indicator A Red Flag From Reflation Confirming Indicator Chart I-2Platinum: A Canary##br## In A Coal Mine? bca.ems_wr_2016_10_19_s1_c2 bca.ems_wr_2016_10_19_s1_c2 The rationale behind using platinum rather than gold or silver prices is because platinum is a precious metal that also has industrial uses. Besides, we have found that platinum prices correlate with EM stocks better than gold or silver. The latter two sometimes rally due to global demand for safety, even as EM markets tank. Finally, platinum seems to be the most high-beta precious metal in the sense that it "catches a cold" sooner and, thus, might be leading other reflationary plays. In short, EM share prices have been flat since August 15, and odds are that they are topping out and the next large move will be to the downside. Can EM De-Couple From The U.S. Dollar? Many investors are asking whether EM risk assets can rally if the greenback continues to rebound. Chart I-3 illustrates that since the early 1980s, there have been no periods when EM share prices rallied amid strength in the real broad trade-weighted U.S. dollar (the dollar is shown inverted on this and the proceeding charts). The same holds true if one uses the nominal narrow trade-weighted U.S. dollar1 (Chart I-4). Chart I-3Real Trade-Weighted ##br##U.S. Dollar And EM Stocks Real Trade-Weighted U.S. Dollar And EM Stocks Real Trade-Weighted U.S. Dollar And EM Stocks Chart I-4Nominal Trade-Weighted ##br##U.S. Dollar And EM Stocks Nominal Trade-Weighted U.S. Dollar And EM Stocks Nominal Trade-Weighted U.S. Dollar And EM Stocks One could disregard these charts and argue that this time around is different. We don't quite see it that way. Chart I-5Nominal Trade-Weighted ##br##U.S. Dollar And Commodities Nominal Trade-Weighted U.S. Dollar And Commodities Nominal Trade-Weighted U.S. Dollar And Commodities Notably, the narrative behind the EM rally since February's lows has been based on the Federal Reserve backing off from rate hikes and the U.S. dollar weakening - with the latter propelling a rally in commodities prices. These arguments appear to be reversing: the U.S. dollar is already firming up and commodities prices are at best mixed. The broad index for commodities prices always drops when the U.S. dollar rallies (Chart I-5). In recent months, the advance in commodities prices has been uneven and narrow based. While oil prices have spiked substantially, industrial metals prices have advanced very little. The current oil price rally is proving a bit more durable and lasting than we thought a few months ago. Nevertheless, China's apparent consumption of petroleum products is beginning to contract (Chart I-6). Consequently, resurfacing worries about EM/China's demand for commodities will lead to a meaningful pullback in crude prices in the months ahead, especially since the likelihood that oil producers act to restrain supply at the current prices is very low. As for commodities trading in China such as steel, iron ore, rubber, plate glass and others, they have been on a roller-coaster ride in recent months (Chart I-7). Chart I-6China's Demand For Oil Products Is Very Weak China's Demand For Oil Products Is Very Weak China's Demand For Oil Products Is Very Weak Chart I-7Commodities Prices In China Commodities Prices In China Commodities Prices In China Bottom Line: There are reasonably high odds that as the U.S. dollar strengthens and commodities prices roll over, EM risk assets (stocks, currencies and credit markets) will start to relapse. EM Beyond Commodities: Still Shrinking Profits Table I-1EM Sectors Weights: In 2011 And Now The EM Rally: Running Out Of Steam? The EM Rally: Running Out Of Steam? Another question that many investors have been asking is as follows: Is there not a positive story in EM beyond commodities? Given that the weight of the EM equity market benchmark in commodities stocks - energy and materials - has drastically declined in recent years, from 29.2% in 2011 to 13.7% now (Table I-1), and the weight in technology stocks has risen substantially (from 12.9% in 2011 to 23.9% now), couldn't non-commodities stocks drive the index higher? In this regard, we have the following observations: Information technology stocks are overbought. The EM information technology equity index has surged to its previous highs (Chart I-8, top panel). This sector is dominated by five companies that have a very large weight also in the overall EM benchmark: Samsung (3.6% weight in the EM equity benchmark), TMSC (3.5%), Alibaba (2.9%), Hon Hai Precision (1%) and Tencent (3.8%). Their share price performance has been spectacular, and some of them have gone ballistic (Chart I-9). TMSC and to a lesser extent Samsung have benefited from the rising prices of semiconductors (Chart I-9, second panel from top). However, it is not assured that semiconductor prices will continue soaring from these levels as global aggregate demand remains very weak. In short, the outlook for semi stocks is by and large a semiconductor industry call, not a macro one. As for Alibaba and Tencent, they are bottom-up stories - not macro bets at all. At the macro level, we reassert that EM/China demand for technology goods and services as well as for health care will stay robust. Hence, from a revenue perspective, technology and health care companies will outperform other EM sectors. This still warrants an overweight allocation to technology and health care stocks, a recommendation that we have had in place since June 2010 (Chart I-8, bottom panel). Odds are that tech outperformance will persist, but we are not sure about absolute performance, given overbought conditions and not-so-cheap valuations. Excluding information technology, the EM benchmark is somewhat weaker (Chart I-10). Chart I-8EM Technology Stocks: Sky Is Limit? bca.ems_wr_2016_10_19_s1_c8 bca.ems_wr_2016_10_19_s1_c8 Chart I-9Individual Tech Names Are Overbought Individual Tech Names Are Overbought Individual Tech Names Are Overbought Chart I-10EM Equities: Overall And Excluding Tech EM Equities: Overall And Excluding Tech EM Equities: Overall And Excluding Tech There is no improvement in EM corporate profitability The return on equity (RoE) for EM non-financial listed companies has stabilized at very low levels, but it has not improved at all (Chart I-11, top panel). The reason we use non-financials' RoE rather than overall RoE is because in EM the latter is artificially inflated at the moment, as banks are originating a lot of new loans but are not sufficiently provisioning for bad loans. Among the three components of non-financials RoE, net profit margins have stabilized but asset turnover is falling and leverage continues to mushroom (Chart I-11, bottom two panels). Remarkably, the relative performance between EM and U.S. stocks has historically been driven by relative RoE. When non-financial RoE in EM is above that of the U.S., EM stocks outperform U.S. ones, and vice-versa (Chart I-12). This relationships argues for EM stocks underperformance versus the S&P 500. Chart I-11EM Non-Financials: ##br##RoE And Its Components EM Non-Financials: RoE And Its Components EM Non-Financials: RoE And Its Components Chart I-12EM Versus U.S.: ##br##Relative RoE And Share Prices EM Versus U.S.: Relative RoE And Share Prices EM Versus U.S.: Relative RoE And Share Prices Overall EM EPS is still contracting in both local currency and U.S. dollar terms (Chart I-13). Even though the rate of contraction is easing for EPS in U.S. dollar terms, it is due to EM exchange rate appreciation versus the greenback this year. Furthermore, EPS in U.S. dollars is contracting in a majority of non-commodities sectors (Chart I-13A, Chart I-13B). The exceptions are utilities and industrials, which both exhibit strong EPS growth despite poor share price performance. The latter could be a sign that strong industrials and utilities EPS have been due to temporary factors and are not sustainable. Chart I-13AEM EPS Growth: Overall And By Sector EM EPS Growth: Overall And By Sector EM EPS Growth: Overall And By Sector Chart I-13BEM EPS Growth: Overall And By Sector EM EPS Growth: Overall And By Sector EM EPS Growth: Overall And By Sector Banks hold the key. Apart from commodities/the U.S. dollar and tech stocks, EM banks' share prices are probably the most important precursor to the direction of the overall EM benchmark. Financials are the second-largest sector in the EM equity benchmark (26.4% weight), so if bank share prices break down, the broader EM index will likely relapse. Our analysis of bank health in various EM countries leads us to believe that banks are under-provisioned for non-performing loans (NPL) (Chart I-14A, Chart I-14B). As EM growth disappointments resurface, investors will question the quality of banks' balance sheets and push down bank equity valuation. Hence, odds are bank share prices will drop sooner than later. Chart I-14AEM NPLs Are Unrecognized ##br##And Under-Provisioned EM NPLs Are Unrecognized And Under-Provisioned EM NPLs Are Unrecognized And Under-Provisioned Chart I-14BEM NPLs Are Unrecognized ##br##And Under-Provisioned EM NPLs Are Unrecognized And Under-Provisioned EM NPLs Are Unrecognized And Under-Provisioned In turn, concerns about EM banks will heighten doubts about overall EM growth and the EM equity benchmark will sell off. Bottom Line: EM tech stocks are overbought, while banks are fundamentally vulnerable due to the bad-loan overhang. As commodities prices relapse anew and worries about the EM credit cycle resurface, the EM benchmark will drop considerably. An Update On Two Relative Equity Trades We reiterate two relative equity trades: short EM banks / long U.S. banks, and short Chinese property developers / long U.S. homebuilders. For investors who do not have these positions, now is a good time to initiate them. Short EM banks / long U.S. banks (Chart I-15). The credit cycle in EM/China will undergo a further downturn: credit growth is set to decelerate as banks recognize NPLs and seek to raise capital. Even if a crisis is avoided, the need to raise substantial amounts of equity will considerably erode the value of EM bank shares. Meanwhile, risks to U.S. banks such as a flat yield curve and a possible spillover effect from European banking tremors are considerably less severe than the problems faced by EM banks. Importantly, unlike EM banks, U.S. banks' balance sheets are very healthy. Short Chinese property developers / long U.S. homebuilders (Chart I-16). Chart I-15Stay Short EM Banks##br## Versus U.S. Banks Stay Short EM Banks Versus U.S. Banks Stay Short EM Banks Versus U.S. Banks Chart I-16Stay Short Chinese Property ##br##Developers Versus U.S. Homebuilders Stay Short Chinese Property Developers Versus U.S. Homebuilders Stay Short Chinese Property Developers Versus U.S. Homebuilders Chinese property developers are on the verge of another downturn, as the authorities have tightened policy surrounding housing. Residential and non-residential property sales have boomed in the past 12 months, but starts have been less robust (Chart I-17). The upshot could still be high shadow inventories. Going forward, as speculative demand for housing cools off, property developers' chronic malaise - high leverage and lack of cash flow - will come back to play. Remarkably, property stocks trading in Hong Kong have failed to break out amid the buoyant residential market frenzy in the past 12 months, and are likely to break down as demand growth falters in the coming months (Chart I-18). Chart I-17China's Real Estate: ##br##Sales And Starts Will Contract China's Real Estate: Sales And Starts Will Contract China's Real Estate: Sales And Starts Will Contract Chart I-18Chinese Property Developers: ##br##On A Verge Of Breakdown? Chinese Property Developers: On A Verge Of Breakdown? Chinese Property Developers: On A Verge Of Breakdown? Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com Thailand: Upgrade Stocks To Overweight And Go Long THB Versus KRW The death of King Bhumibol Adulyadej marks the end of an era not only because he symbolized national unity but also because his entire generation is passing. This generational shift has far-reaching consequences for Thailand's political establishment: in the long run it could hurt the Thai military's - and its allies' - attempt to cement their dominance over parliament. However, as Box II-1 (on page 17) explains, there is a low probability of serious domestic instability over the next 12 months2 - although beyond that risks will be heating up. For now, the military junta faces no major political or economic constraints: The junta has already consolidated control over all major organs of government and has purged or intimidated political enemies. The military will have to turn power back to parliament, or make a major policy mistake, for the opposition movement to rise again. The government's fiscal deficit has been stable (around 3% of GDP) over the past few years, public debt is at 33% of GDP, government bond yields are low and debt servicing costs are at 5% of total expenditures (Chart II-1). Hence, the military government can ramp up expenditures further to appease the disaffected. Indeed, the military junta has already accelerated public capital expenditures (Chart II-2) and investments have poured into the Northeast, a populous base of opposition to the junta. Chart II-1Thailand: More Room ##br##For Fiscal Stimulus Thailand: More Room For Fiscal Stimulus Thailand: More Room For Fiscal Stimulus Chart II-2Thailand: Government ##br##Capex Has Been Booming bca.ems_wr_2016_10_19_s2_c2 bca.ems_wr_2016_10_19_s2_c2 Likewise, fiscal expenditure has also accelerated in areas such as general public services, defense, and social protection (Chart II-3). Additionally, the Bank of Thailand (BoT) has scope to cut interest rates as the policy rate is still above a very low inflation rate (Chart II-4). This will limit the downside for credit growth and contribute to economic and political stability. Chart II-3Rising Public Spending bca.ems_wr_2016_10_19_s2_c3 bca.ems_wr_2016_10_19_s2_c3 Chart II-4Thailand: No Inflation; Room To Cut Rates bca.ems_wr_2016_10_19_s2_c4 bca.ems_wr_2016_10_19_s2_c4 The large current account surplus - standing at 11% of GDP - provides the authorities with plenty of fiscal and monetary maneuverability without having to worry about a major depreciation in the Thai baht (Chart II-5). Amid this sensitive political transition, the central bank will likely defend the currency if downward pressure on the baht emerges due to U.S. dollar strength. Therefore, we recommend traders to go long the Thai baht versus the Korean won (Chart II-6). Despite Korea's enormous current account, the won is at risk from depreciation in the RMB and the Japanese yen. Chart II-5Enormous Current Account ##br##Surplus Will Support The Baht Enormous Current Account Surplus Will Support The Baht Enormous Current Account Surplus Will Support The Baht Chart II-6Go Long THB Against KRW bca.ems_wr_2016_10_19_s2_c6 bca.ems_wr_2016_10_19_s2_c6 On the whole, although the Thai economy has been stagnant (Chart II-7), fiscal spending and low interest rates will limit the downside in growth. Bottom Line: We expect relative calm on the political surface in Thailand over the next 12 months and a stable macro backdrop. Therefore, we are using the latest weakness to upgrade this bourse from neutral to overweight within an EM equity portfolio (Chart II-8). Chart II-7Thai Growth Has Been Stagnant bca.ems_wr_2016_10_19_s2_c7 bca.ems_wr_2016_10_19_s2_c7 Chart II-8Upgrade Thai Stocks ##br##From Neutral To Overweight Upgrade Thai Stocks From Neutral To Overweight Upgrade Thai Stocks From Neutral To Overweight In addition, currency traders should go long THB versus KRW. Ayman Kawtharani, Research Analyst aymank@bcaresearch.com Matt Gertken, Associate Editor mattg@bcaresearch.com BOX 1 The Military Coup In 2014 Pre-empted The King's Death... The May 2014 military coup was timed to pre-empt this event. The king's health had been declining for years and it was only a matter of time until he died. This raised the prospect of an intense political struggle that could have escalated into a full-blown succession crisis. Thus the military moved preemptively so that it would be in control of the country ahead of the king's death and could reshape the constitutional system in the military's favor before his death, as it has done. ... And This Means Stability For Now If the populist, anti-royalist faction had been in control of government at the time of the king's death, it could have attempted to manipulate the less popular new king and take advantage of the vacuum of royal authority in order to reduce the role of the military and their allies. That in turn could have sparked a wave of mass protests from royalists, pressuring the government to collapse, or a military coup that would not have carried the king's implicit approval like the 2014 coup. That would have fed the narrative that a final showdown between the factions was finally emerging, and would have been highly alarming to foreign investors. But Risks Still Linger Make no mistake: a new long-term cycle of political instability is now emerging. Potential military mistakes and the return to parliamentary rule are potential dangers. The country's deep divisions - between (1) the Bangkok-centered royalist bureaucratic and military establishment and (2) the provincial opposition -have not been healed but aggravated since the 2014 coup and the new pro-military constitution: The junta's constitutional and electoral reforms will weaken the representation of the largest opposition party, the Pheu Thai Party, and will marginalize a large share of the 65% of the country's population that lives in the opposition-sympathetic provinces. It is also conceivable that the new king could trigger conflict by lending support to the populist opposition. For instance, he could pardon the exiled leader of the rural opposition movement, or he could transform the powerful Privy Council. However, we do not expect discontent to flare up significantly until late 2017 or 2018 when the military steps back and a new election cycle begins.3 We will reassess and alert investors if we foresee a rapid deterioration in the palace-military network, or in the military's ability to prevent seething resistance in the provinces. 1 The narrow U.S. dollar is a trade-weighted exchange rate versus the euro, Canadian dollar, Japanese yen, British pound, Swiss franc, Australian dollar, and Swedish krona. Source: The Federal Reserve. 2 The exception is that isolated acts of terrorism remain likely and could well strike key areas in Bangkok, signaling the reality that the underground opposition to military dictatorship remains alive and well. 3 The junta will use the one-year national period of mourning to its advantage and opposition forces will not want to be targeted for causing any trouble during a time of mourning. The junta could very easily delay the transition to nominal civilian rule, including the elections slated for November 2017. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

The volte-face being attempted by OPEC and non-OPEC producers in an attempt to keep oil prices above a pure-competition market-clearing level arises from the dire financial circumstances key states in both camps find themselves. Now begins the arduous process of determining just how much the Gulf Arab states within OPEC, led by the Kingdom of Saudi Arabia (KSA); and non-OPEC states, chiefly Russia, can cut oil production without giving shale-oil producers in the U.S. a huge windfall.