Corporate

Highlights Portfolio Strategy Boost restaurant stocks to neutral, as same-store sales should improve next year. A further upgrade requires evidence of top-line traction. The exodus from health care stocks represents an overreaction rather than a downshift in fundamental forces. Stay long. Recent Changes S&P Restaurants Index - Upgrade to neutral for a profit of 9%. Table 1 Profits: Is Less Bad Good Enough? Profits: Is Less Bad Good Enough? Feature Equity market buoyancy remains a liquidity rather than an earnings story. Fed commentary and the trend in global bond yields, a reflection of the global central bank narrative, continue to exert an outsize influence on short-term price action and momentum. In the background, earnings are a wildcard. Companies may be surpassing beaten down third quarter estimates, but the path of profits over the next several quarters is by no means assured and will determine the durability of any stock market advance. Even excluding the persistent drag from narrowing profit margins, courtesy of falling productivity and increasing unit labor costs, it is dangerous to look at the corporate profit outlook through rose colored glasses. The low level of economic growth, both at home and abroad, represents a major hurdle to the corporate sector. Total business sales have climbed back up to zero, but it is premature to forecast meaningful growth ahead based on moribund global export growth (Chart 1), and/or leading economic indicators. After all, sales growth has been virtually non-existent for years, reinforcing that earnings per share have been driven by cost cutting and buybacks. While measured consumer price inflation has crept higher, corporate sector pricing power remains virtually non-existent. The producer price index is still deflating, despite the rally in oil prices. U.S. import prices are very weak (Chart 1). The negative global credit impulse warns that there is still no impetus to reinvigorate final demand, and by extension, global profits (Chart 1). It is hard to envision an economic reacceleration as long as the corporate sector is more inclined to retrench than expand, as heralded by stressed balance sheets and weak durable goods orders (Chart 2). Chart 3 shows BCA's two U.S. profit models. The first one is based on reflationary variables, such as the dollar, bond yields and oil prices. It is designed to predict the trend in forward earnings momentum. This model has troughed, but is not signaling any upside ahead in already exuberant analyst earnings estimates (Chart 3, second panel). Chart 1Without Sales Growth... bca.uses_wr_2016_10_24_c1 bca.uses_wr_2016_10_24_c1 Chart 2... And Rising Costs... bca.uses_wr_2016_10_24_c2 bca.uses_wr_2016_10_24_c2 Chart 3... How Much Can Profits Improve? ... How Much Can Profits Improve? ... How Much Can Profits Improve? The second model looks at macro data such as new orders, labor costs and productivity growth to forecast the trend in actual operating earnings. This model is slightly more optimistic (Chart 3, bottom panel), and signals a decisive end to the profit contraction, albeit not a growth rate sufficient to satisfy double-digit analysts forecasts or rich valuations. The U.S. dollar is a major wildcard, as any sustained strength would compromise earnings. Typically, major profit expansions only occur after the currency begins to depreciate and labor cost inflation ebbs (Chart 2). The late-1990s was an exception, as profits climbed alongside the currency and amidst rising wage inflation (Chart 2). However, that was during an economic and credit boom, two key factors that are conspicuously absent at the moment. Nevertheless, as discussed in past Weekly Reports, the flood of central bank liquidity could sustain the overshoot in equity prices for a while longer. Investors have demonstrated a willingness to look through soggy profits as long as the liquidity taps remain open. Despite the possibility of a stubbornly resilient broad market, we do not recommend interpreting it as a sign of economic vitality, and consider it high risk. Our portfolio strategy is based on expected sectoral earnings trends, as liquidity is subject to the whims of central bankers. We recommend a largely defensive sector portfolio, with some exceptions, as discussed in last week's Special Report. Our cyclical exposure remains confined to consumption-oriented plays; this week we are lifting our view on restaurants. Restaurants: Buying Into Weakness Investors have gravitated toward washed out deep cyclical sectors rather than consumption-oriented plays in recent months. However, we doubt this trend has staying power, as outlined in our Special Report last week. Consequently, it is time to revisit the outlook for shunned consumer sectors, such as restaurants. This year's exodus from casual dining stocks has been justified on the basis of overvaluation and deteriorating industry performance. The National Association of Restaurants (NAR) survey of current performance has dipped into negative territory (Chart 4), as restaurant operators have reported a decrease in traffic. One of the major drags on restaurant same-store sales has been the gap in restaurant inflation compared with the cost of food inflation for eating at home. Relative inflation has soared (Chart 5). That has caused relative spending growth at restaurants vs. at home dining to drop sharply, in real (volumes) terms. However, next year could be different. If the inflation gap falls, as predicted by the decline in relative spending (Chart 5), then restaurant traffic should stabilize. Importantly, the odds of budgets for dining out being pruned even further are low. As long as wages and salaries growth is decent and consumer income expectations are firm, consumers should still allocate a rising share to restaurants relative to eating at home (Chart 5). There is plenty of scope for relative restaurant spending to rise on a secular basis (Chart 5, bottom panel). Clearly, if relative spending were to reaccelerate too quickly, then the inflation gap would stay wide, and same-store sales growth would stay punk. That is a risk to an optimistic view of future restaurant traffic. But the good news is that cost structures are being realigned to a more subdued sales run rate. The NAR survey shows that staffing plans are on the wane. That leads restaurant labor cost inflation (Chart 4). As the largest source of expenses, any decline in headcount would be welcome given that minimum wages in a number of states are set to climb next year. In any case, the most potent profit elixir would be a recovery in top-line growth, sourced both domestically and from abroad. Restaurant sales growth has been unimpressive for the past several years. Subdued pricing power gains, and until recently, lackluster income growth among lower income consumers have weighed on revenue growth. The good news is that consumer confidence among low income earners is on the upswing (Chart 6), which bodes well for casual dining out in the coming quarters. If our bearish view on refiners and gasoline prices continues to pan out, then a windfall from lower fuel prices may further bolster the outlook. Chart 4Expenses Set To Ease bca.uses_wr_2016_10_24_c4 bca.uses_wr_2016_10_24_c4 Chart 5Inflation Gap Should Narrow bca.uses_wr_2016_10_24_c5 bca.uses_wr_2016_10_24_c5 Chart 6Sales Set To Stabilize... bca.uses_wr_2016_10_24_c6 bca.uses_wr_2016_10_24_c6 In addition, restaurant retail sales often follow the trend in the wealth effect (Chart 7). The latter has pulled back this year, owing to the equity market consolidation and house price correction. However, financial wealth gains are rebounding, and provided the stock market does not suffer a sustained swoon, consumers' feeling of affluence may soon be bolstered. Even marginal improvements in store traffic should be impactful to same-store sales. Restaurant chains have been in retrenchment mode since the Great Recession. Construction activity is historically low, which implies limited capacity expansion (Chart 7). Contribution from abroad may become less of a drag. The industry garners roughly 67% of sales from overseas. The strong U.S. dollar, particularly against emerging market currencies, has deprived the industry of sales strength. Moreover, even in domestic currency terms, emerging markets consumption has been through a difficult period, as the Asian Hotel and Restaurant Activity Proxy spent most of the last year in negative territory (Chart 8). But EM currencies have stabilized and Asian restaurant activity has climbed back into positive territory in recent months. The upshot is that foreign revenue could make up any lingering domestic sales slack. All of this suggests that leaning into share price weakness in anticipation of improved prospects next year makes sense. Nevertheless, the S&P restaurants index does not warrant a full shift from underweight to overweight. There could still be earnings/headline risk given lackluster readings in coincident activity indicators, despite McDonald's earnings beat last week. Valuations are not cheap. On a normalized basis, the relative forward P/E ratio has dropped below its average, but still trades at a premium to the broad market. A return to above average levels is possible if operating margins expand on the back of sales improvement (Chart 9), thereby sparking higher return on equity, but it may be too soon to position for such an outcome. Chart 7... Or Even Improve In 2017 bca.uses_wr_2016_10_24_c7 bca.uses_wr_2016_10_24_c7 Chart 8End Of Foreign Drag bca.uses_wr_2016_10_24_c8 bca.uses_wr_2016_10_24_c8 Chart 9Still Not Dirt Cheap bca.uses_wr_2016_10_24_c9 bca.uses_wr_2016_10_24_c9 Bottom Line: Lift the S&P restaurant index (BLBG: S5REST - MCD, SBUX, YUM, CMG, DRI) to neutral from underweight, locking in a profit of 9% since our underweight recommendation last November. Health Care Crunch: Buying Opportunity Or Trend Change? The speed at which the health care sector has sunk toward the bottom end of this year's trading range has unnerved many investors. In fact, the sector has dropped back down to the levels where we added it to our high conviction overweight list. The question now is whether our positive views still hold, and whether would we add here if we weren't long already, or if something more sinister is at work? The hit to health care stocks reflects a rise in risk premiums related to concerns that the U.S. government will exert more control over price setting if the Democrats win the election rather than any immediate downshift in relative forward earnings drivers. While it is impossible to forecast with any precision to what extent pricing models may or may not change, the political appetite may be low for another overhaul of the sector so soon after the Affordable Care Act was implemented. Regardless, several observations suggest that the sector may already be undershooting, i.e. a Democratic victory is already discounted. Relative performance has experienced a clear uptrend over the last forty years, with cyclical swings oscillating around its upward sloping trend-line (Chart 10). It would be extremely rare for a bull phase to peak prior to hitting at least one standard deviation above trend. Instead, the price ratio hit trend and is now not far above one standard deviation below trend, a level one would normally equate with an economic boom when capital flowed to high-beta sectors. Cyclical technical measures also point to an undershoot. Our Technical Indicator has hit an oversold extreme (Chart 11), signaling that the sell-off is in the late stages. Our relative advance/decline line has also stayed firm, suggesting that the decline in the overall sector has not been broad-based (Chart 11). Chart 10Time To Buy, Not Sell bca.uses_wr_2016_10_24_c10 bca.uses_wr_2016_10_24_c10 Chart 11Buying Opportunity Buying Opportunity Buying Opportunity Whether a wholesale flight from the sector, and all defensives in general, looms is largely contingent on the path of inflation expectations, which have been in a multiyear decline. This trend reflects anemic global final demand and the repercussions from over-indebtedness. Lately, inflation expectations have firmed, but that may largely reflect the rebound in oil prices courtesy of hopes for an OPEC production cut, given the lack of confirming indicators of growth acceleration and renewed strength in the U.S. dollar. The latter is testing the top end of its recent range (Chart 11, shown inverted, bottom panel), and it would be highly unusual for inflation expectations to rise concurrent with the U.S. dollar. In a world of zero interest rates and limited aggregate demand strength, a strong currency is deflationary, especially for corporate profits. Those conditions keep bond yields low, and push capital into long duration sectors. Once the election is over, attention will refocus on the relative forward earnings outlook. Our Indicators suggest that earnings momentum will stay positive. Our health care sector pricing power proxy has rebounded after cooling from red-hot levels, and is still much stronger than overall corporate sector pricing (Chart 12, second panel). That is confirmed by the pharmaceuticals producer price index, and employment cost index for health insurance, i.e. pricing strength is broad-based. There is still scant evidence of a downshift in consumer spending patterns in reaction to rising health care sector inflation. Real (volumes) personal spending on health care goods and services continues to grow at a mid-single digit rate, well in excess of the rate of overall consumption (Chart 12). That is consistent with ongoing earnings outperformance. As noted in past research, the time to forecast negative relative earnings momentum is when consumers balk at higher prices. So far, a few high profile cases of exorbitant drug price increases have grabbed the spotlight, but in aggregate, consumers are not voting with their wallets. The biggest tangible negative for the health care sector may be that shares outstanding are no longer falling (Chart 13). That mirrors overall buyback activity, which has cooled markedly on the back of balance sheet deterioration and waning free cash flow. We doubt the supply of health care stocks is going to rise much, however, because the sector is in good financial shape, earning healthy returns and is not dependent on external financing. Chart 12Demand Driven Pricing Power Gains Demand Driven Pricing Power Gains Demand Driven Pricing Power Gains Chart 13Buybacks Are Dwindling bca.uses_wr_2016_10_24_c13 bca.uses_wr_2016_10_24_c13 Bottom Line: Health care sector risk premiums have climbed in response to polling results, but an apolitical check on relative earnings drivers and valuations points to a buying opportunity. Current Recommendations Current Trades Size And Style Views Favor small over large caps and growth over value.

Highlights The near-term RMB outlook is entirely dictated by the movement of the dollar. We expect the CNY/USD to weaken alongside broad dollar strength, which could rekindle financial market volatility and cap the upside in Chinese stocks. The Chinese currency is better prepared for a stronger dollar than a year ago, and therefore the authorities should be able to maintain exchange rate stability. Joining the SDR does not automatically award the RMB international currency status. However, raising the relevance of the SDR as well as the RMB is part of China's long-term strategic plan. Feature The resumption of the dollar bull market has once again generated downward pressure on the RMB. How long the dollar bull run will last remains to be seen, but the broader global backdrop supports its continued strength against other major currencies, at least in the near term, including the yuan. Renewed downward pressure on the RMB may be perceived as a sign of domestic economic troubles, which could expedite capital outflows, creating a self-feeding vicious circle. The saving grace is that the Chinese currency is better prepared for a stronger dollar than a year ago, and therefore the authorities should be able to maintain exchange rate stability. Interestingly, the RMB's renewed weakness came in the wake of its official inclusion in the IMF's Special Drawing Right (SDR) basket early this month. While joining the SDR bears no near-term relevance from both an economic and financial market point of view, it marks an important milestone in the internationalization process of the RMB, with potential longer term implications. The RMB: From Goldilocks To Gridlock Chart 1The RMB: Stronger Or Weaker? The RMB: Stronger Or Weaker? The RMB: Stronger Or Weaker? The relapse of the CNY/USD of late is entirely driven by the strong dollar. While the RMB has weakened against the greenback, it has strengthened in trade-weighted terms (Chart 1). This is undoubtedly bad news for China, as it has very quickly pushed the RMB from a goldilocks scenario to essentially a gridlock. The goldilocks scenario that prevailed over the past several months was ushered in primarily by the weak dollar. It allowed the RMB to stay largely stable against the dollar but weaken substantially in trade-weighted terms - an ideal combination for both the market and the economy. Investors took comfort in a stable CNY/USD, while the Chinese economy benefited from the reflationary impact of a weaker trade-weighted exchange rate. In this vein, the reversal of the dollar trend will also lead to a reversal of this positive dynamic that prevailed over the past several months. Financial markets and investors will once again pay attention to the weakening CNY/USD, while the "stealth" depreciation of the trade-weighted RMB will also be halted, removing its reflationary impact. In other words, a weaker CNY/USD and a stronger trade-weighted RMB is the least desirable combination for both financial markets and the economy. To break this gridlock, the People's Bank of China (PBoC) could either "peg" the currency to the dollar, or weaken it substantially enough to achieve a weaker RMB in trade-weighted terms, neither of which is likely in our view. The path of least resistance is for the PBoC to bear it out, with managed CNY/USD depreciation together with tightened capital account controls to prevent capital flight. This is far from optimal and may still stoke financial market volatility, similar to the several episodes last year when a weakening RMB stoked fears of Chinese financial instability. However, a few factors suggest that this time the PBoC may be better prepared: Frist, the Chinese authorities have been paying much more attention to "open-mouth" operations in communicating their intention to market participants. Overall, investors are less 'spooked" by China's foreign exchange rate policy than a year ago. Second, pressure from capital outflows from the corporate sector will likely subside going forward. Paying down foreign debt has been one of the biggest sources of capital outflows in the past year, which has substantially reduced the domestic corporate sector's foreign currency liabilities (Chart 2).1 Moreover, despite dwindling foreign debt obligations, the corporate sector still holds near-record-high foreign currency deposits (Chart 3), which should further reduce its incentive to hoard the dollar. Chart 2Corporate Sector Foreign ##br##Debt Has Dropped Substantially... bca.cis_wr_2016_10_20_c2 bca.cis_wr_2016_10_20_c2 Chart 3... But Still Hoards ##br##Lots Of Dollar Deposits bca.cis_wr_2016_10_20_c3 bca.cis_wr_2016_10_20_c3 Further, Chinese growth is a tad stronger than last year, due largely to the reflationary impact of previous easing measures, including a weaker trade-weighted RMB. Even though the headline third quarter GDP growth figures reported this week remained essentially unchanged, the industrial sector has recovered notably, with improving activity, strengthening pricing power and accelerating profits. As economic variables typically respond to policy thrusts with a time lag, we expect the economy will continue to build momentum in the coming months, even if the reflationary impact of the RMB begins to diminish. More importantly, the Chinese government appears more willing to engage in fiscal pump-priming than last year, with a focus on infrastructure and private-public-partnership projects. Improving growth momentum and expansionary fiscal policy should be supportive for the exchange rate. Finally, the CNY/USD is already 12% lower than its peak in early 2014, and is no longer significantly overvalued, according to our valuation models (Chart 4). This means that additional CNY/USD weakness will further boost market share of Chinese products in the U.S., helping China to reflate while at the same time acting as an increasingly heavier drag on the U.S (Chart 5). It is therefore in the mutual interests of both the Chinese and U.S. authorities to maintain a steady RMB exchange rate. The U.S. Treasury once again cleared China from being currency manipulator in its last week's semi-annual review, and acknowledged the PBoC's efforts in preventing rapid RMB depreciation as beneficial for both the Chinese and global economies. To be sure, the U.S. and China will not explicitly coordinate monetary policy to regulate exchange rate movements. However, a weaker CNY/USD will lead to much quicker dollar appreciation in trade-weighted terms than otherwise, which in of itself will prove self-limiting. Chart 4RMB/USD Is No Longer Overvalued RMB/USD Is No Longer Overvalued RMB/USD Is No Longer Overvalued Chart 5A Weaker RMB/USD Is ##br##Boosting Chinese Exports To The U.S. A Weaker RMB/USD Is Boosting Chinese Exports To The U.S. A Weaker RMB/USD Is Boosting Chinese Exports To The U.S. The bottom line is that the near-term RMB outlook is entirely dictated by the movement of the dollar. We expect the CNY/USD to weaken alongside broad dollar strength in the near term, but unless the dollar massively overshoots the downside will not be substantial. This could rekindle financial market volatility and cap the upside in Chinese stocks. We tactically downgraded our "bullishness" rating on Chinese H shares from "overweight" to "neutral" last week,2 and this view remains unchanged. At the same time, we continue to argue against being outright bearish, because of the deeply depressed valuation matrix of this asset class, especially H shares. When Will The RMB Float? We expect Chinese regulators will tighten capital account controls significantly in the coming months in order to slow capital outflows in the wake of renewed CNY/USD depreciation. The impossible trinity of international finance dictates that a country cannot target its exchange rate with independent monetary policy and simultaneously allow free capital flows. Among these three conditions, "free capital flows" is the least-costly sacrifice. There is no way the PBoC will raise interest rates to defend the currency. Tightening capital account controls goes against the long-term objective of China's foreign exchange rate reforms, but it is not only justified but necessary in the near term. Pointing at the dilemma the PBoC faces today, some pundits are now singing the "I-told-you-so" song, claiming the country should have moved to a much greater degree of exchange-rate flexibility "back when the going was good", as they had advised. In our view, this argument is completely flawed. In previous years when "the going was good", China was facing massive foreign capital inflows, unleashed by extremely aggressive monetary easing by other central banks in the wake of the global financial crisis. If the PBoC indeed took this advice back then and did not intervene to slow down RMB appreciation by hoarding massive foreign reserves, it would simply have led to a dramatic overshoot of the RMB. By the same token, when the tide turned, capital outflows would have proven overwhelming, leading to an RMB collapse. In fact, without the massive foreign reserves accumulated in previous years during the PBoC's RMB intervention, the Chinese authorities' ability to maintain exchange rate stability would have been much more seriously challenged, particularly in the past year. Chart 6Lopsided Expectations On The RMB ##br##Drive One-Way Moves Of Capital Flows bca.cis_wr_2016_10_20_c6 bca.cis_wr_2016_10_20_c6 In other words, the key problem with China's exchange rate is that expectations on the RMB have been lopsided in recent years (Chart 6). Consequently, the RMB has long been a one-way bet, accompanied by one-way moves of capital flows. The unanimous view on a rising RMB in previous years drove capital inflows; expectations completely reversed in 2015, leading to persistent outflows. In this environment, without the PBoC's intervention, a "greater degree of exchange rate flexibility" as advised by some would simply mean extreme RMB moves, inevitably leading to much greater financial and economic volatility. Therefore, the RMB should only be allowed to float when there is a healthy divergence of views among market participants, so that there are enough "buyers" and "sellers" to collectively price the RMB exchange at a market-determined "equilibrium" level. Until then, any premature and imprudent capital account deregulation would prove catastrophic, and should be avoided at all cost. We are hopeful the Chinese authorities will remain pragmatic enough not to hasten this process. The RMB's SDR Debut: Playing The Long Game The RMB has officially joined the SDR basket since the beginning of October, the first emerging country currency to join this "elite club". The RMB's SDR debut has little economic relevance in the near term. If anything, officially joining the SDR means that the RMB, under China's prevailing capital account regulations, meets the IMF's criteria as a "freely usable" currency. Therefore, it implies that the IMF endorses China's capital control measures currently in place. Some analysts suggest that the Chinese government's determination to join the SDR is largely to show off national pride. In our view, it serves more pragmatic purposes both at the private and official level. Chart 7The RMB's Rising Importance As ##br##An International Payment Currency The RMB's Near-Term Dilemma And Long-Term Ambition The RMB's Near-Term Dilemma And Long-Term Ambition At the private level, an important function of an international currency is for trade invoicing - an area where the RMB has witnessed remarkable progress in recent years. The RMB currently ranks fifth among world payment currencies, accounting for a mere 2% of world payments, which pales in comparison with the dollar's 40% and the euro's 30%. However, an increasingly large share of China-related trade has been settled directly with the RMB. Currently, the RMB accounts for about 13% for all international payments sent and received by value with China and Hong Kong (Chart 7), up from practically zero a few years ago. Moreover, RMB settlement already accounts for over half of Chinese trade with specific regions such as the Middle East and African countries. For Example, the use of the RMB in the United Arab Emirates (UAE) and Qatar accounted for 74% and 60% of their respective payments to China/Hong Kong in 2015. As the largest trade partner with a growing number of countries, China should have no problem continuing to promote RMB settlement, especially in the emerging world. At the official level, the Chinese government is certainly intent on having the RMB act as an international reserve currency, but not in such a way as to challenge the dollar's mighty dominance. Rather, the government appears to be following dual mandates in its purse. Domestically, it is aiming to use the SDR inclusion as a catalyst to reform its financial system, much like what joining the World Trade Organization (WTO) in the early 2000s did to its manufacturing sector. Globally, it is seeking to play a more active role in reforming the international monetary system. After witnessing the dramatic liquidity crunch during the global financial crisis, the Chinese authorities see the necessity to reduce the world's heavy reliance on the dollar by creating credible alternatives. Neither of these dual mandates can be easily accomplished, but it is important to keep the big picture in mind in understanding China's policy initiatives going forward. The bottom line is that joining the SDR does not automatically award the RMB international currency status, and it is naïve to expect the RMB to challenge the U.S. dollar anytime soon, if at all. However, raising the relevance of the SDR as well as the RMB is part of China's long-term strategic plan. Its determination to internationalize the RMB should not be underestimated. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Special Report, "Mapping China's Capital Outflows: A Balance Of Payment Perspective", dated February 3, 2016, available at cis.bcaresearch.com 2 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010", dated October 13, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights When interest rates are ultra-low, central banks have no margin for policy error. A small loosening or tightening has the potential to produce either a stall or catastrophic turbulence. The analogy is flying a plane at high altitude. Bond investors should have a strong preference for U.S. T-bonds over German bunds (currency hedged). Currency investors should prefer the euro over the dollar. For equity investors, valuations do not appear structurally attractive anywhere, once a sufficient equity risk premium is factored in. But a setback in the region of 5-10% could create a tactical entry point. Feature As the ECB Governing Council convenes for its October monetary policy meeting, an experience familiar to pilots1 provides a perfect analogy for central banks' very limited margin for error. Pilots call the experience "flying in coffin corner." Chart of the WeekUnusually High Turbulence For The German 30-Year Bund Unusually High Turbulence For The German 30-Year Bund Unusually High Turbulence For The German 30-Year Bund Next time you're in a plane climbing to 35,000 feet, here's something to think about; or perhaps, not to think about. As the plane gains altitude, its stall speed increases while its upper speed limit simultaneously decreases. For the pilot, this means less and less margin for error (Figure I-1). The plane's stall speed is the minimum speed to generate sufficient lift. At higher altitude, as the air gets thinner, the stall speed increases. Meanwhile, the plane's upper speed limit is set by the speed of sound. Airliners cannot fly too close to the speed of sound because the sonic shockwave produces violent and catastrophic turbulence. At higher altitude, as the air temperature drops, so does the speed of sound. Which means the plane's upper speed limit decreases. By the time the plane has reached the rarefied atmosphere of 35,000 feet, these lower and upper speed limits are barely 25 knots (30mph) apart,2 leaving almost no room for flight data misinterpretation or pilot error.3 Hence, at high altitude pilots morbidly say they are "flying in coffin corner." Analogously, in the rarefied atmosphere of zero or near-zero interest rates, central bank policy is also in coffin corner. When short-term and long-term interest rates approach the zero bound, there is no room for economic data misinterpretation or policy error. A small loosening or tightening of monetary policy has the potential to produce either a stall or catastrophic turbulence (Figure I-2 and Chart of the Week). Figure I-1Flying At High Altitude ##br## Has No Margin For Error Flying At The Edge Flying At The Edge Figure I-2Monetary Policy At Ultra-Low Rates ##br##Has No Margin For Error Flying At The Edge Flying At The Edge Avoiding A Stall At today's zero or near-zero interest rates in the euro area, a small loosening of monetary policy risks stalling the banking system, and thereby stalling the economy. A bank's core business is simple. Take in deposits, and lend them out at a higher interest rate than the deposit-rate - with the difference in the two defining the bank's net interest margin. A part of the net interest margin is a compensation for the risk of non-performing loans. This should be profit-neutral if correctly priced. The other large part of the net interest margin comes from the interest rate term-structure, as loans tend to be long-term while deposits are short-term. Hence, all else being equal, the bank's profitability suffers as the term-structure flattens. For a while, the bank can protect its profitability by cutting the interest rate paid on short-term deposits to well below the policy rate. However, once the policy rate hits zero, this profit-protection strategy hits a wall - because a negative deposit rate would risk an exodus of deposits into cash or cash-substitutes. Alternatively, the bank could charge a higher rate to borrowers, but this would tighten credit conditions. The third possibility is for the bank to suffer a hit to its already-thin net lending margin, but this would also tighten credit conditions. The pressure on the bank's profitability and share price would increase the cost of equity, making it harder to raise capital (Chart I-2). Given that an insufficient capital buffer is a major constraint to euro area bank lending, this would be a de facto tightening of credit conditions. The paradox is that at the zero bound, the smallest additional monetary loosening - via interest rate cuts or QE - risks stalling euro area bank credit creation (Chart I-3). Thereby it risks stalling economic growth. Chart I-2The ECB's QE Has Hurt Bank Valuations The ECB's QE Has Hurt Bank Valuations The ECB's QE Has Hurt Bank Valuations Chart I-3The Interplay Between Bank Profits And Bank Credit Creation Flying At The Edge Flying At The Edge Avoiding Violent Turbulence An extended period of ultra-low interest rates, and a commitment to keep them structurally low, has compressed the yields on government bonds pushing up their prices. As competing asset classes, the prices of corporate bonds and equities have also increased. This phenomenon is called the Portfolio Balance Effect. The big problem is that the prices of riskier assets have increased by more than is justified by the portfolio balance effect alone. This distortion is the result of a behavioural finance phenomenon called Mental Accounting Bias. Mental Accounting Bias describes the irrational distinction between the return from an investment's yield and that from its capital growth. The distinction is irrational because the money that comes from yield and the money that comes from capital growth is perfectly fungible.4 Rationally, what should matter is an investment's total return. But psychologically, the distinction between yield and capital is very stark. Fears about self-control cause people to compartmentalise yield as spending money and capital as saving money. Hence, people who want their investments to generate spending money - say, retirees - have an irrational focus on yield. Traditionally, the safe income from cash and government bonds satiates the people who irrationally focus on yield. However, in recent years, central banks' extended experiments with ZIRP, NIRP and QE have forced these yield-focussed investors out of cash and government bonds into risky investments. And just like every distortion, this phenomenon has generated memes to justify the act: 'reach for yield', 'search for yield', and 'there is no alternative' (TINA). But the irrational focus on yield instead of total return has artificially bid up the prices of risky investments. To the point that they no longer offer a sufficient risk premium5 for the very real possibility of substantial losses over a 5-10 year horizon (Chart I-4 and Chart I-5). The unfortunate thing is that as central bankers have little expertise in psychology or behavioural finance, they have been blind to the very dangerous behavioural distortion that their monetary policy experiments have unwittingly unleashed. Chart I-4A Positive Yield On Equities##br## Can Produce A Negative 5-Year Return... bca.eis_wr_2016_10_20_s1_c4 bca.eis_wr_2016_10_20_s1_c4 Chart I-5...And Even A Negative ##br##10-Year Return bca.eis_wr_2016_10_20_s1_c5 bca.eis_wr_2016_10_20_s1_c5 The risk is that the smallest monetary tightening could trigger an aggressive unwinding of this behavioural distortion. Recall the violent turbulence in global financial markets at the start of the year after just one 25bps rate hike from the Federal Reserve. Now consider what might happen if the Fed hiked again and the ECB simultaneously announced a rapid tapering of its QE program. How Must The Pilots Fly? In a rarefied atmosphere, pilots have very little margin to alter speed without inducing a stall or violent turbulence. The same applies to central banks today. The ECB has the hardest piloting task. It is becoming difficult to justify the current aggressive pace of QE given the danger of stalling the euro area banking system; and given that the euro area's nominal GDP and nominal wage bill are both growing at a very respectable 3% (Chart I-6). But an abrupt end to the ECB's QE could create violent turbulence in QE-distorted financial markets. Chart I-6What Deflation Threat? Euro Area Nominal GDP And The Wage Bill Growing At 3% bca.eis_wr_2016_10_20_s1_c6 bca.eis_wr_2016_10_20_s1_c6 Hence, the ECB's best course of action is to hint at a very gradual deceleration of QE to start at some point in the second half of 2017. Turning to developed economy central banks in general, we remind readers of a very powerful observation. Since 2008, no major central bank has been able to hike interest rates by more than 1.75%. And every central bank that has hiked rates has had to start unwinding those hikes within a year, ultimately taking the policy rate to a new all-time low (Chart I-7 and Chart I-8). Chart I-7Since 2008, All Rate Hikes ##br##Have Been Quickly Reversed bca.eis_wr_2016_10_20_s1_c7 bca.eis_wr_2016_10_20_s1_c7 Chart I-8Will The U.S. Be ##br##Any Different? No bca.eis_wr_2016_10_20_s1_c8 bca.eis_wr_2016_10_20_s1_c8 Given the turbulence that rate hikes will generate in the financial markets and/or the economy, we fully expect the Federal Reserve to go through exactly the same experience. The important upshot is that global central bank policy through 2017-18 will be considerably less divergent than is discounted. Bond yields could creep higher in the short term. But on a 1-year horizon, bond investors should have a strong preference for U.S. T-bonds over euro area bonds, and especially over German bunds (currency hedged). Over the same horizon, currency investors should prefer the euro over the dollar. For equity investors, valuations do not appear structurally attractive anywhere once a sufficient equity risk premium is factored in. Moreover, the potential for ECB QE-tapering combined with expectations for a Fed rate hike could generate some near-term turbulence. That said, a setback in the region of 5-10% could create an excellent entry point for a 3-month trade. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com Fractal Trading Model* There are no new trades this week. Last week's long silver/short lead pair trade has bounced sharply. And the short U.K. A-rated corporate bonds trade has achieved its 4% profit target. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 Long Silver / Short Lead Long Silver / Short Lead * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. 1 Your author is a former pilot in the Royal Air Force reserve. 2 For an Airbus A330. 3 Tragically, a combination of flight data misinterpretation and pilot error at 35,000 feet was disastrous for Air France flight AF447 flying from Rio de Janeiro to Paris in June 2009. Going through a storm, the airspeed indicator started giving a false reading and the pilot took the wrong corrective action, resulting in a catastrophic stall. 4 Assuming no difference in tax treatment of income and capital gains. 5 Please see the European Investment Strategy Weekly Report "The Great Distortion... And How It will End" dated September 15, 2016 available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields bca.eis_wr_2016_10_20_s2_c2 bca.eis_wr_2016_10_20_s2_c2 Chart II-3Indicators To Watch - Bond Yields bca.eis_wr_2016_10_20_s2_c3 bca.eis_wr_2016_10_20_s2_c3 Chart II-4Indicators To Watch - Bond Yields bca.eis_wr_2016_10_20_s2_c4 bca.eis_wr_2016_10_20_s2_c4 Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations bca.eis_wr_2016_10_20_s2_c5 bca.eis_wr_2016_10_20_s2_c5 Chart II-6Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_10_20_s2_c6 bca.eis_wr_2016_10_20_s2_c6 Chart II-7Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_10_20_s2_c7 bca.eis_wr_2016_10_20_s2_c7 Chart II-8Indicators To Watch ##br##- Interest Rate Expectations bca.eis_wr_2016_10_20_s2_c8 bca.eis_wr_2016_10_20_s2_c8

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

Highlights Global liquidity conditions are set to tighten in the months ahead. This could add some fire to a dollar rally, especially against EM and commodity currencies. The GBP has become the new anti-dollar, reflected by its strong sensitivity to the greenback. Financing the U.K.'s large current-account deficit is a difficult task when global liquidity tightens, the layer of political uncertainty now makes it a herculean labor. While the pound is now attractive as a long-term play, it still possesses plenty downside risk. A quick look at EUR/SEK, NOK/SEK, GBP/CAD, and AUD/JPY. Feature Global liquidity conditions have begun to tighten. This development is likely to send the dollar higher and inflict serious damage on EM and commodity currencies. The pound's weakness fits nicely into this larger story. Not only is the current political climate in the British Isles prompting investors to think twice about buying British assets, but a tightening in global liquidity makes financing the U.K. current account deficit even more onerous. This adjustment demands a cheaper GBP. Global Yields: A Step Forward, Half A Step Backward The main reason why global liquidity conditions are tightening is the recent back up in global bond yields. In normal circumstances, a 39 basis-point (bp), a 24bp, and a 16bp back-up in 10-year Treasury yields, JGB yields, and bund yields, respectively, would not represent much of a problem. But today is anything but normal. The shift in global monetary policy has been behind the back-up in yields. In aggregate, global central banks are about to begin decreasing their purchases of securities. This will not only lift interest rates on government paper, but it will also raise rates for private-sector borrowing, especially as global risk premia have been depressed by an effect known as TINA - or "There Is No Alternative" (Chart I-1). The Fed too is in the process of lifting global bond yields. For one thing, U.S. labor market slack is dissipating and we are starting to witness rising wage pressures (Chart I-2). As such, we expect the Fed to raise its policy rate in December, and to further push rates higher in 2017 and 2018. Given that only 62 basis points of hike are priced in until the end of 2019, there is scope for U.S. bond yields to rise. Chart I-1Central Banks Are Contributing##br## To Tightening Liquidity Central Banks Are Contributing To Tightening Liquidity Central Banks Are Contributing To Tightening Liquidity Chart I-2U.S. Labor Market Is ##br##Showing Signs Of Tightening U.S. Labor Market Is Showing Signs Of Tightening U.S. Labor Market Is Showing Signs Of Tightening In terms of investor sentiment, despite the recent back-up in long bond yields, investors remain surprisingly upbeat on the outlook for T-bonds (Chart I-3). This, combined with their still-poor valuations, is another reason to be worried about the outlook for U.S. and global bonds for the remainder of the year. Finally, we expect U.S. real rates to have more upside than non-U.S. rates. Why? The U.S. output gap is arguably narrower than that of Europe or Japan. Moreover, the U.S. economy has deleveraged more than the rest of the G10. With U.S households enjoying strong real income growth, strong balance sheet positions, and with banks easing their lending standards to households, U.S. private-sector debt levels can expand vis-à-vis those of other developed economies. This will lift U.S. relative real rates (Chart I-4). Chart I-3Upside For ##br##Yields Upside For Yields Upside For Yields Chart I-4Real Rate Differentials Should ##br##Move In The Dollar's Favor Real Rate Differentials Should Move In The Dollar's Favor Real Rate Differentials Should Move In The Dollar's Favor What does this all mean for currency markets? As we highlighted last week, we expect the U.S. dollar to display more upside, potentially rising by around 10% over the next 18 months. We also expect more tumultuous times to re-emerge in the EM space. Rising real rates have been a bane for EM assets in this cycle. This is because EM growth has been dependent on EM financial conditions, which themselves, have been a function of global liquidity conditions (Chart I-5). Exacerbating our fear, the recent narrowing in EM spreads has not been reflective of EM corporate health. This suggests that EM borrowing costs and financial conditions are at risk of a shakeout (Chart I-6). Chart I-5Global Liquidity Conditions Will Hurt EM Global Liquidity Conditions Will Hurt EM Global Liquidity Conditions Will Hurt EM Chart I-6EM Spreads Are Priced For Perfection EM Spreads Are Priced for Perfection EM Spreads Are Priced for Perfection This obviously leads us to worry about commodity currencies as well. For one, they remain tightly linked with EM equities, displaying a 0.82 correlation with that asset class since 2000. Moreover, as Chart I-7 and Table I-1 illustrate, commodity currencies are tightly linked with the dollar and EM spreads. Thus, a combo of a higher dollar and deteriorating EM financial conditions could do great harm to the AUD, the NZD, and the NOK. Interestingly, SEK and GBP are also two potential big casualties of any such development. Chart I-7The GBP Has Become The Anti-Dollar The Pound Falls To The Conquering Dollar The Pound Falls To The Conquering Dollar Table I-1Currency Sensitivities To Key Factors, Since 2014 The Pound Falls To The Conquering Dollar The Pound Falls To The Conquering Dollar That being said, these dynamics contain the seeds of their own demise. As they are deflationary shocks, EM and commodity sell-offs are likely to elicit a dovish response from global policymakers. This will limit the upside for yields, implying that any tightening in global liquidity conditions is likely to prompt another reflationary push early in 2017. Bottom Line: Global rates still have more upside from here. U.S. real rates could rise the most as the Fed is now confronted with an increasingly tight labor market. Moreover, the U.S. economy possesses the strongest structural fundamentals in the G10. Together, this set of circumstances is likely to boost the dollar, especially at the expense of EM, commodity currencies, and the pound. GBP: Another Arrow In The Eye Nine hundred and fifty years ago to this day, King Harold, the last Anglo-Saxon King of England, died on the battlefield at Hastings from an arrow to the eye.1 The kingship of Norman William the Conqueror ushered a long and complex relationship between the British Isles and the rest of the continent. Over the past two weeks, the fall in the pound has been a dramatic story. The collapse of the nominal effective exchange rate to a nearly 200-year low, is a clear indication that the battle between the U.K. and the rest of the EU is inflicting long-term damage on the kingdom (Chart I-8). The key shock to the pound remains political. PM May made it clear that Brexit means Brexit. Additionally, elements of her discourse, such as wanting firms to list their foreign-born employees, are raising fears among the business community that the Conservatives are taking a very populist, anti-business slant that could weigh on the long-term prospects for British growth. True, these policies may never see the light of day. But across the Channel, the EU partners are taking a hardline approach to Brexit negations. Investors cheered the announcement on Wednesday that PM Theresa May will allow deeper scrutiny from parliament before triggering Brexit. Altogether, this mostly means that the cacophony over the future of the U.K. will only grow louder. Thus, we expect political headline risks to remain a strong source of uncertainty. These political games are poisonous for the pound. The U.K. is highly dependent on FDI inflows to finance it large current account deficit of nearly 6% of GDP (Chart I-9). Not knowing the status of the U.K. vis-à-vis the common market heightens any risk premium on investments in the U.K. Also, any shift of rhetoric toward a more populist discourse increases the risk that regulations could be implemented that either hurt the future profitability of British firms or increase their cost of capital. At the margin, this makes the U.K. less attractive to foreign investors. Chart I-8Something Evil This Way Comes bca.fes_wr_2016_10_14_s1_c8 bca.fes_wr_2016_10_14_s1_c8 Chart I-9The U.K. Needs Capital The U.K. Needs Capital The U.K. Needs Capital This has multiple implications. The pound remains highly sensitive to global liquidity trends, a fact highlighted by its extremely elevated sensitivity to EM spreads. The pound will also remain correlated with EM equity prices. This suggests that if a rising dollar acts as a lever to tighten global liquidity conditions, the pound will continue to be the currency with the largest beta to USD. In other words, investors will continue to express bullish-dollar views through the pound. Domestic dynamics are also problematic. The recent fall in the pound is lifting British inflationary pressures, a reality picked up by our Inflation Pressure Gauge (Chart I-10). In normal times, this could have lifted the pound as investors would have expected a response by the BoE. Today, however, the British credit impulse is very weak, in part reflecting the lack of confidence toward the future of the U.K. (Chart I-10, bottom panel). Hence, the BoE is not responding to these inflationary pressures. This combo is very bearish for the pound. It means that British real rates are falling, especially vis-à-vis the U.S. (Chart I-11). The U.K. is now in a vicious circle where the more the pound falls, the higher British inflation expectations go, which depresses British real rates and puts additional selling pressure on the pound. In other words, the U.K. is in the opposite spot of where Japan was in the spring of 2016. Chart I-10Stagflation Light! Stagflation Light! Stagflation Light! Chart I-11A Vicious Circle For GBP A Vicious Circle For GBP A Vicious Circle For GBP What is the downside for the pound? On a 52-week rate of change basis, the pound is not as oversold as it was at long-term bottoms like in 1985, 1993, or 2009. More concerning, long-term bottoms are also characterized by the 2-year rate of change staying oversold for a prolonged period, which again, has yet to be the case (Chart I-12). On the valuation front, GBP/USD is cheap, trading at a 25% discount to its PPP. However, in 1985, the pound was trading at a 36% discount to PPP (Chart I-13). The uncertainty around the future of the British economy is much higher today than in 1985. A move away from the pro-business Thatcherite policies of the 1980s, could result in a GBP discount similar to that of 1985. The sensitivity of the pound to the dollar amplifies the probability that such a scenario materializes. This could imply a GBP/USD toward 1.1-1.05 at its bottom. Chart I-12GBP/USD: Not Oversold Enough GBP/USD: Not Oversold Enough GBP/USD: Not Oversold Enough Chart I-13GBP/USD Valuation GBP/USD Valuation GBP/USD Valuation When is that bottom likely to emerge? With the strong downward momentum currently weighing on the pound, and the progressive un-anchoring of market based inflation expectations in the U.K., the bottom in the pound is a moving target. Moreover, Dhaval Joshi, who runs our European Investment Strategy service, has written about the fractal dimension as a tool to identify turning points in a trend. When the fractal dimension hits 1.25, a reversal in the trend is likely. Essentially, this metric measures group-think. When both short-term and long-term investors end up uniformly expressing the same views, liquidity dries up as there are fewer and fewer sellers for each buyer (or vice-versa).2 Currently GBP/USD's fractal dimension has not yet hit that stage. While the 3-6 months risk-reward ratio for the pound remains poor, the pound is now attractive as a long-term buy. The recent collapse in real rates and sterling has massively eased monetary conditions in the U.K. (Chart I-14). Also, even if valuations are a poor guide of near term returns, the 25% discount currently experienced by the pound suggests that on a one- to two-year basis, holding the GBP will be a rewarding bet. What about EUR/GBP? EUR/GBP has moved out of line with its historical link to real-rate differentials (Chart I-15). However, the pound's beta to the dollar is twice as high as that of the euro. Moreover, the pound is many times more sensitive to EM spreads than the euro. This suggests that our view of a strong dollar and tightening EM liquidity conditions are likely to weigh on GBP more than on the EUR for the next few months. Thus we believe it is still too early to short EUR/GBP. In fact EUR/GBP could flirt with 0.95. Chart I-14A Glimmer of Hope For The Long-Term A Glimmer of Hope For The Long-Term A Glimmer of Hope For The Long-Term Chart I-15EUR/GBP Has Overshot Fundamentals EUR/GBP Has Overshot Fundamentals EUR/GBP Has Overshot Fundamentals Bottom Line: While the pound is cheap, it can cheapen further. Not only is the pound being hampered by the political quagmire surrounding Brexit, but the strong sensitivity of the pound to the dollar and EM spreads are two additional potent headwinds for the British currency. Altogether, while the pound is most likely a long-term buy at current levels, it could still experience significant downside in the near term. We remain long gold in GBP terms. Four Chart Reviews Four long-term price charts caught our eye this week. First is EUR/SEK. As Chart I-16 shows, despite the valuation, economic momentum, and balance of payments advantages for the SEK, EUR/SEK broke out. We think this reflects the SEK's strong sensitivity to the dollar and brewing EM risks. A move to slightly above 10 on this cross is likely. Second, while we remain positive on NOK/SEK, the next few weeks may prove challenging. As Chart I-17 illustrates, NOK/SEK is about to test a potent downward sloping trend line, exactly as it is becoming overbought. With NOK being slightly more sensitive to the dollar than SEK, punching above this trend line will require much firmer oil prices. While our energy strategists see oil in the mid- to upper-$50s for next year, they worry that the recent rally to $52/bbl may have been too violent and is already eliciting a supply response from U.S. shale producers. Chart I-16EUR/SEK Can Rise Higher EUR/SEK Can Rise Higher EUR/SEK Can Rise Higher Chart I-17Big Ceiling Above Big Ceiling Above Big Ceiling Above Third, since the early 1980s, GBP/CAD has formed long-term bottom in the 1.5 region, a zone we expect to be tested again (Chart I-18). While CAD is more sensitive to commodity prices than the GBP, it is much less sensitive to the USD and EM spreads than the British currency. Also, the loonie does not suffer from a massive political handicap. That being said, each time the 1.5 zone has been hit, GBP/CAD slingshots higher. We recommend buying GBP/CAD at that level. Finally, since 1991, AUD/JPY has been strongly mean-reverting in a trading band between 60 and 110 (Chart I-19). Any blow-up in EM in the next few months is likely to prompt this cross to hit the low end of this band once again. Chart I-18GBP/CAD: Target 1.5 GBP/CAD: Target 1.5 GBP/CAD: Target 1.5 Chart I-19AUD/JPY: A Model Of Mean Reversion AUD/JPY: A Model Of Mean Reversion AUD/JPY: A Model Of Mean Reversion Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 This story of his death is now considered more a legend than an historical event, but we like this story. 2 Please see European Investment Strategy Special Report, "Fractals, Liquidity & A Trading Model", dated December 11, 2014, available at eis.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Policy Commentary: "We're at a point where the economic expansion has plenty of room to run. Inflation's a little bit below our target, rather than above our target... so, I think we can be quite gentle as we go in terms of gradually removing monetary policy accommodation" - Federal Reserve Bank of New York President William Dudley (October 12, 2016) Report Links: The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Policy Commentary: "Due to the role of global inflation, more stimulus is needed than in the past to deliver their domestic mandates; and where, due to the falling equilibrium interest rates, their ability to deliver that stimulus is more constrained" - ECB Executive Board Member Yves Mersch (October 12, 2016) Report Links: The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Clashing Forces - July 29, 2016) The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Policy Commentary: "Since the employment situation has continued to improve, no further easing of monetary policy may be necessary... at any rate, I would like to discuss this thoroughly with other board members at our monetary policy meeting" - BoJ Board Member Yutaka Harada (October 12, 2016) Report Links: The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 How Do You Say "Whatever It Takes" In Japanese? - September 23, 2016 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Policy Commentary: "If the MPC and other monetary authorities hadn't eased policy - if they had failed to accommodate the forces pushing down on the neutral real rate - the performance of the economy and equity markets, and the long-term prospects for pension funds, would probably have been worse" - BoE Deputy Governor Ben Broadbent (October 5, 2016) Report Links: The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Messages From Bali - August 5, 2016 Australian Dollar Chart II-9AUD Technicals 1 bca.fes_wr_2016_10_14_s2_c9 bca.fes_wr_2016_10_14_s2_c9 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Policy Commentary: "Inflation remains quite low. Given very subdued growth in labor costs and very low cost pressures elsewhere in the world, this is expected to remain the case for some time" - RBA Monetary Policy Statement (October 3, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Messages From Bali - August 5, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Policy Commentary: "Interest rates are at multi-decade lows, and our current projections and assumptions indicate that further policy easing will be required to ensure that future inflation settles near the middle of the target range" - Reserve Bank Assistant Governor John McDermott (October 11, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Policy Commentary: "Policy is having its effects. And obviously we have room to maneuver but its not a great deal of room to maneuver and fortunately we have a different mix of policy today and the fiscal effects we talked about should be showing up in the data any time now" - BoC Governor Stephen Poloz (October 8, 2016) Report Links: The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Policy Commentary: "We feel [negative interest rates and currency market interventions] is actually how we can ensure our mandate, namely by making the Swiss franc less attractive" - SNB Vice President Fritz Zurbruegg (October 12, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Policy Commentary: "Review [of the monetary policy framework] is in order... I would, however, emphasise that our experience of the current framework is positive. This suggests a need for adjustments rather than a regime change" - Norgest Bank Governor Oeystein Olsen (October 11, 2016) Report Links: The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Policy Commentary: "We have all the tools but there are limits since the repo rate and additional bond purchases can produce undesired side-effects... We don't really know for how long future interest rate cuts will work in an effective way." - Riksbank Deputy Governor Cecila Skingsley (October 7, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Grungy Times - A Replay Of The Early 1990s? - June 10, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

We are pleased to share this <i>Special Report</i> rolling out our Global ETF Strategy (GETF) service's model ETF portfolios.
We are in the latter stages of developing the digital interface that will serve as the central nervous system for the GETF service and are excited to be rolling it out next month. In the meantime, the GETF team has embarked on its regular bi-weekly publication schedule. An ETF Primer <i>Special Report</i> will follow on October 26. It will discuss ETF architecture, operation and trading, and is meant to help investors determine how they can best deploy ETFs to accomplish their tactical and strategic goals.

The mini-consolidation in equities reflects the ongoing tension between market-supportive liquidity and a sketchy corporate profit backdrop.

When earnings growth negatively diverges from GDP growth, the gap rarely closes <i>via</i> a rebound in profit growth. The most notable feature of prior episodes is weak corporate pricing power and the current period is no different; an ongoing profit margin squeeze means earnings in the next few months risk being a disappointment.

Stocks are flirting with new highs, courtesy of a gradualist Fed and the reduced threat
of incremental near-term U.S. dollar strength.

Consumer products stocks are likely to move to an even larger valuation premium before the cyclical outperformance phase ends.