Correlations

Highlights Should the U.S. 10-year T-bond yield approach 3% it would be a red flag, and a trigger to downgrade equities. Equity investors should stay overweight defensive-heavy Switzerland and Denmark. Contrary to what the consensus is expecting, global growth will lose steam in the first half of 2018. EUR/USD will continue to trend higher through 2018 as long-term interest rate differentials converge further. The multi-year prognosis for GBP/USD is higher. U.K. parliamentary arithmetic simply does not support a hard Brexit. Furthermore, a hard Brexit would require either a North/South or East/West hard border in Ireland, which will be politically impossible to deliver. Feature A happy and prosperous 2018 to you all! In this first report of the year, we describe some investment outcomes in 2017 that at first glance seemed odd or unexpected; but that on deeper reflection provide valuable insights for 2018. Some of these insights deviate substantially from the BCA house view. Bonds Became More Risky Than Equities The first oddity of 2017 concerns the 'drawdowns' suffered by bonds and equities. A drawdown is defined as an investment's peak to trough decline. In 2017, the odd thing was that the drawdowns suffered by government bonds - a supposedly safe asset-class - were equal to or worse than those suffered by equities - a supposedly risky asset-class (Chart of the Week, Chart I-2 and Chart I-3). Chart of the WeekBonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Chart I-2Bonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Chart I-3Bonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Contrary to classical theory, empirical evidence now proves that investors do not define an investment's risk in terms of its volatility, the fluctuations of its return around a mean. Instead, investors define risk as the ratio of large and sudden drawdowns versus potential gains. This unattractive asymmetry in an investment's return is technically known as negative skew. And it is as compensation for this negative skew that investors demand an excess return, the so-called 'risk premium'. Significantly, at low bond yields, the mathematics of bond returns necessarily means that their negative skew increases. The risk of large and sudden drawdowns rises while the prospect for price gains diminishes. But if bond risk becomes 'equity-like', it follows that equities' prospective long-term return should become 'bond-like'. Meaning, equities should no longer offer a meaningful risk premium over bonds. Is this the case? According to my colleague Martin Barnes, BCA Chief Economist, the answer appears to be yes - at least in certain major markets. In BCA's Outlook 2018, Martin projects that from current valuations U.S. equities are set to deliver a total nominal return of 2.6% a year to 2028 - almost indistinguishable from the 2.5% a year that a U.S. 10-year T-bond will deliver over the same period. But the mathematics of bond pricing tells us that the negative skew on bond returns fully disappears when a yield approaches 3%. At which point the risk of bonds once again declines to become 'bond-like', and the required return on equities should once again rise to become 'equity-like'. This higher required return would necessarily require today's equity prices to drop, perhaps substantially. Admittedly in Europe there is a bigger gap between the expected returns from equities and bonds than there is in the U.S. The trouble is that global capital markets move together and a chain is only as strong as its weakest link. Hence, one lesson for 2018 is that investors should downgrade equities to neutral should the U.S. 10-year T-bond yield approach 3%. In this event, investors should redeploy the funds into U.S. T-bonds, because any substantial adjustment in risk-asset prices would trigger supportive flows into haven bonds, reversing the spike in yields. Euro/Dollar Hit A 3-Year High EUR/USD ended 2017 touching 1.21, a 3-year high. At first glance, this might seem odd given that the ECB has committed to maintaining its zero and negative interest rate policy for at least another year while the Federal Reserve has already hiked interest rates five times. But EUR/USD is not tracking short-term rate differentials. It is tracking long-term rate differentials, and EUR/USD at a 3-year high is fully consistent with the 30-year T-bond/German bund yield spread converging to its narrowest for several years (Chart I-4). Chart I-4Further Convergence In Long-Term Interest Rate Differentials Will Support EUR/USD Further Convergence In Long-Term Interest Rate Differentials Will Support EUR/USD Further Convergence In Long-Term Interest Rate Differentials Will Support EUR/USD Where will this yield spread go from here? Let's consider both sides of the spread. On the ECB side, policy is at the realistic limit of ultra-looseness, so policy rate expectations cannot go significantly lower, but they can go higher. On the Federal Reserve side, long-term policy rate expectations are not far from our upper bound of the 'high 2s' at which risk-assets become vulnerable to a sell-off, perhaps substantial. So these interest rate expectations cannot go sustainably higher, but they can go lower. Considering this strong asymmetry, the most likely outcome is that the 30-year T-bond/German bund yield spread will continue to converge. The upshot is that EUR/USD will continue to trend higher through 2018. No Connection Between Economic Outperformance And Stock Market Outperformance Chart I-5The Eurostoxx50 Underperformed Even Though##br## The Euro Area Economy Outperformed The Eurostoxx50 Underperformed Even Though The Euro Area Economy Outperformed The Eurostoxx50 Underperformed Even Though The Euro Area Economy Outperformed 2017 proved that there is no positive correlation between relative economic performance and relative equity market performance. For example, the euro area was one of the best performing developed economies, yet the Eurostoxx50 was one of the worst performing stock market indexes (Chart I-5). This seems odd, until you realise that major stock market indexes are dominated by multinational rather than domestic stocks. And that when stock markets have vastly different sector weightings, the sector effect completely swamps the domestic economy effect. Therefore the first decision for international equity investors should never be which regions to own. The first decision should always be which sectors to own, and above all whether to tilt to cyclicals or defensives. The regional and country allocation then just drops out automatically. At the moment, our mini-cycle framework for global growth suggests tilting to defensives rather than to cyclicals. Global growth experiences remarkably consistent - and therefore predictable - 'mini-cycles', with half-cycle lengths averaging 8 months. As the current mini-upswing started last May we can infer that it is likely to end at some point in early 2018 (Chart I-6 and Chart I-7). So one surprise could be that global growth will lose steam in the first half of 2018 rather than in the second half - contrary to what the consensus is expecting. Chart I-6The Current Mini-Upswing##br## Is Long In The Tooth The Current Mini-Upswing Is Long In The Tooth The Current Mini-Upswing Is Long In The Tooth Chart I-7China Has Driven The Global 6-Month##br## Credit Impulse Higher China Has Driven The Global 6-Month Credit Impulse Higher China Has Driven The Global 6-Month Credit Impulse Higher We will provide further ammunition for our mini-cycle thesis in next week's report. In the meantime, we will leave you with one ramification of paring back equity exposure to cyclicals and redeploying to defensives. Stay overweight defensive-heavy Switzerland and Denmark. Realpolitik Will Prevent A Hard Brexit For the FTSE100, the paradox is that its relative performance is negatively correlated with relative economic performance. When the U.K. economy outperforms, the FTSE100 underperforms. And vice-versa (Chart I-8). Chart I-8FTSE 100 Relative Performance Is The Inverse ##br##Of U.K. Economic Relative Performance FTSE 100 Relative Performance Is The Inverse Of U.K. Economic Relative Performance FTSE 100 Relative Performance Is The Inverse Of U.K. Economic Relative Performance The simple explanation is that FTSE100 multinational sales and profits tend to be denominated in dollars and euros, whereas the FTSE100 index is denominated in pounds. The upshot is that an outperforming U.K. economy weighs on the U.K. stock market because a strengthening pound diminishes the FTSE100's multi-currency profits in pound terms. And vice-versa. Compared to a year ago, investors can be more optimistic about the long-term prospects for the U.K. economy and the pound (and therefore expect long-term underperformance from the FTSE100). This is because after the unexpectedly disastrous 2017 election for Theresa May, the parliamentary arithmetic simply does not support a hard Brexit. Furthermore, a hard Brexit would require either a North/South or East/West hard border in Ireland, which will be politically impossible to deliver. The constraints that come from this realpolitik means that Brexit's endpoint will retain much of the current trading relationship with the EU, albeit the journey to that eventual destination is likely to be a wild roller coaster ride. Therefore, the multi-year prognosis for GBP/USD is higher. But investors who want to optimize their timing into 'cable' can wait for one of the inevitable roller coaster dips in 2018. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* We are delighted to say that three of our recent trades quickly hit their profit targets: short bitcoin 29%, long silver 4.5% and long NZD/USD 3%. Against this, short Nikkei/long Eurostoxx50 hit its 3% stop-loss. This week's trade recommendation is to go short palladium. Set a profit target of 6% with a symmetrical stop-loss. This leaves us with three open trades. Chart I-9 Short Palladium Short Palladium 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. * 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. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights The Li Keqiang Index (LKI) is particularly relevant for global investors, who are most concerned with China's investable stock performance and the country's impact on global exports. BCA's view is that the LKI will retrace about 50% of its rise from late-2015 to early-2017. This is consistent with our call that China's economy will experience a benign, controlled deceleration. U.S. financial assets tend to perform better when the LKI is rising, than when it is decelerating. Correlations between China's economy and the S&P 500 have increased in the past few decades. Feature In the past three months, BCA's China Investment Strategy team has significantly heightened its focus on the cyclical condition of China's economy. Our colleagues presented their framework for tracking the end of China's mini-cycle in an October Weekly Report.1 This was followed by a two-part report that examined the key differences between China today and mid-20152 when the economy operated below what investors and market participants considered a stable pace of growth. These articles were anchored by BCA's view that in 2015 China's economy suffered from a double whammy: a weak external demand environment and overly tight monetary conditions. In a Special Report released in late November, BCA's China Investment Strategy took a different approach to gauge the slowdown in China's economy. The strategist tested a wide range of commonly watched macro data series for signs that reliably lead economic activity.3 The study surprisingly showed that measures of money and credit have been the most reliable predictors of China's economy since 2010. A composite leading indicator of these predictors suggests that the country's economy will continue to slow in the coming months. However, the pace and magnitude of the decline are consistent with BCA's view that China will experience a benign, controlled deceleration, and will not repeat its 2015 uncontrolled slowdown. A Brief Methodological Overview We provide a brief overview of our approach and address two questions: what are we trying to predict and what series do we use as predictors,4 to explain the Chinese business cycle? What are we trying to predict? We use the Li Keqiang Index (LKI) as a proxy for China's business cycle for three reasons: Despite the potential to become a consumer-oriented society, the economy remains highly geared to investment (and the industrial sector). Investors are familiar with the LKI since a 2007 U.S. diplomatic cable (leaked in late-2010) quoted Li, then Communist Party Secretary of Liaoning, telling U.S. Ambassador Randt that China's GDP figures were man-made and unreliable. Li's focus on electricity consumption, rail cargo volume and bank loans subsequently became a standard metric for China analysts. Most importantly, we use the LKI as a proxy because it continues to provide key information about China's economy. Chart 1 highlights that LKI leads China's nominal import growth. The index is particularly relevant for global investors who are concerned with China's investable stock performance and the country's impact on global exports. Chart 1The Li Keqiang Index Predicts Chinese Import Growth The Li Keqiang Index Predicts Chinese Import Growth The Li Keqiang Index Predicts Chinese Import Growth What series were used in our approach? To test the predictability of China's business cycle, we compiled a list of 40 highly tracked macroeconomic variables (presented in Appendix Table 1) and grouped them into six categories: Economy-wide measures, such as composite LEIs and models of GDP growth. Measures related to investment and the corporate sector, such as PMIs, fixed-asset investment and industrial production. Variables related to the consumer sector, such as consumer confidence, retail sales and the employment component of official PMIs. Housing indicators, such as house price indexes and residential floor space sold. Government spending. A variety of measures including money, credit and financial conditions. All series, including the LKI, were smoothed with a three-month moving average. The exception was government spending, which was smoothed with a six-month average. Chart 2Measures Of Money & Credit Are ##br## The Best Predictors Of The LKI Measures Of Money & Credit Are The Best Predictors Of The LKI Measures Of Money & Credit Are The Best Predictors Of The LKI Money And Credit: Results From The Data Lab Chart 2 presents the average correlation profiles for the six data categories described above, alongside the ideal profile. The chart allows us to draw several important conclusions: First, it highlights that while economy-wide measures and those related to investment and the corporate sector tended to have a high correlation with the LKI, their correlation profiles lag rather than lead. In other words, the LKI predicts these variables, not vice versa. The Markit/Caixin and NBS manufacturing PMIs are notable exceptions. Furthermore, variables related to both consumer spending and government expenditures appear to have little ability to predict China's business cycle. In the case of government spending, the evidence suggests that the LKI reliably leads expenditures by approximately a year. This implies that fiscal policy in China is responsive and countercyclical (but not leading). Finally, measures of money and credit, and housing to a lesser degree, appear to fulfill our first two criteria to be good leading indicators of the LKI. Both profiles peak in advance of t=0, and at least in the case of money and credit, have a strong relationship (Chart 2). BCA's results show that it is more accurate to state that money supply measures cause the LKI than vice versa, which means that money growth should be closely watched as an economic indicator. Chart 3 presents a composite leading indicator for the LKI based on the six variables presented above. The indicator is advanced by four months and suggests that the LKI will retrace about 50% of its rise from late-2015 to early-2017. This is consistent with our call that China's economy will experience a benign, controlled deceleration. An additional factor that strengthens our conviction is that the weakest components of the indicator on a year-over-year basis, M2 and M3 (as defined by BCA's Emerging Markets Strategy service), have increased more rapidly in the past three months (Chart 4). Chart 3Our Composite LKI Indicator Suggests ##br## A Benign Slowdown In Growth bca.usis_sr_2018_01_02_c3 bca.usis_sr_2018_01_02_c3 Chart 4Money Supply Growth ##br## Has Recently Rebounded Money Supply Growth Has Recently Rebounded Money Supply Growth Has Recently Rebounded BCA's stance is that investors should remain overweight Chinese investable stocks relative to the EM and global benchmarks. However, what does a retracement of the LKI and a slowdown in China's economy mean for U.S. asset classes? Charts 5 and 6 and Tables 1 and 2 show how several key financial markets have performed in periods when the LKI decelerated and accelerated. Chart 5Performance Of U.S. Financial Assets As The LKI Decelerates Performance Of U.S. Financial Assets As The LKI Decelerates Performance Of U.S. Financial Assets As The LKI Decelerates Chart 6Performance Of U.S. Financial Assets As The LKI Accelerates Performance Of U.S. Financial Assets As The LKI Accelerates Performance Of U.S. Financial Assets As The LKI Accelerates Table 1Performance Of U.S. Financial Assets As The LKI Decelerates China: Critical For U.S. Portfolio Allocation? China: Critical For U.S. Portfolio Allocation? Table 2Performance Of U.S. Financial Assets As The LKI Accelerates China: Critical For U.S. Portfolio Allocation? China: Critical For U.S. Portfolio Allocation? The Implications For U.S. Assets U.S. risk assets tend to perform better when the LKI accelerates. BCA has identified seven episodes since 1988 when the LKI slowed (Table 1) and an equal number when the LKI climbed (Table 2). The median returns for the S&P 500, high-yield and investment-grade corporates, small caps, gold, and oil, are all higher when the LKI speeds up. However, the dollar is apt to fall when the LKI accelerates and S&P 500 EPS growth is only one third as fast when the LKI gathers speed versus when the LKI is decelerating. The improved performance of U.S. risk assets when the LKI climbs is noteworthy, given that three U.S. recessions overlap with intervals of escalating LKI, and only one of seven phases of falling LKI intersects with an economic downturn in the U.S. There are pitfalls using LKI data before 2000. The basic structure of China's economy has shifted several times since the late 1980s. This first occurred during the early-to-mid-2000s as China transitioned from its rural roots to a manufacturing and export-led economy. In 2010, Chinese growth slowed as the government guided the economy toward a more consumer-led profile. Nonetheless, even if we exclude the pre-2000 interval, we draw the same conclusions about the performance of U.S. assets as the LKI picks up the pace and slows down. The LKI provided an excellent roadmap for U.S. assets from 2013-2017. The LKI index lost speed as the dollar rose, and oil prices peaked and then rolled over in late 2013 through September 2015. Then it began to reaccelerate in September 2015, five months before oil prices and U.S. equities prices bottomed in early 2016, and moved higher through early 2017. BCA's stock-to-bond ratio, the S&P 500, investment-grade and high-yield bonds, all performed better from September 2015 through early 2017 than in the 2013-2016 episode. As the LKI picked up pace between 2015 and 2017, the performance of small caps, gold, S&P 500 earnings growth and oil were also better than during the 2013-2015 timeframe when the LKI was in a lull. Rising Correlations The S&P 500 has become more sensitive to China's economy over time. Chart 7 presents the relationship between year-over-year shifts in the LKI and annual changes in the S&P 500 in three different eras: Chart 7Correlations Between LKI And S&P 500 Since 2000 China: Critical For U.S. Portfolio Allocation? China: Critical For U.S. Portfolio Allocation? 2000-2005, as China entered the world stage as an economic power after joining the WTO in the early 2000s; 2005 through 2007, after China revalued the yuan, but before the onset of the Great Recession; and 2007-2009, during and immediately following the Great Recession. It is difficult to find any positive correlation between the LKI and the S&P 500 in the early 2000s. However, a relationship began unfolding between 2005 and 2007, and from 2007 to 2009, the positive connection became even more defined. Many asset classes were highly correlated during and just after 2009, but the jump in the correlation between 2005-2007 and 2007-2009 is unmistakable. More recently (2009-present) the link weakened slightly, but it remains stronger than in the 2000-2007 period (not shown). The rise in foreign earnings as a share of total S&P 500 profits in recent years helps to explain the stronger link between China and U.S. equities. China has become a key driver of globally-sourced earnings as China share of global GDP has risen in the past two decades. Bottom Line: China's economy and financial markets play a much more critical role in the performance of U.S. financial assets than in the recent past. History suggests that U.S. assets perform better when the LKI picks up speed. However, BCA's stance is that the LKI is poised to decelerate modestly. This is consistent with our view that China's economy will experience a benign, controlled slowdown and not a sudden downturn, such as in late 2015 and early 2016. History suggests that U.S. assets perform better when the LKI is accelerating, not decelerating. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Appendix Appendix Table 1List Of Macroeconomic Data Series Included In Our Study China: Critical For U.S. Portfolio Allocation? China: Critical For U.S. Portfolio Allocation? 1 Please see China Investment Strategy Weekly Report, "Tracking The End Of China's Mini-Cycle," published October 12, 2017. Available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China's Economy - 2015 Vs. Today (Part II): Monetary Policy", published November 9, 2017. Available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report, "The Data Lab: Testing the Predictability Of China's Business Cycle," published November 30, 2017. Available at cis.bcaresearch.com. 4 The original China Investment Strategy Special Report also explains how we judge which series are "useful" in explaining the Chinese business cycle.

Dear Client, This is our final publication for the year. We will be back on January 5th. On behalf of the entire Global Investment Strategy team, I would like to wish you a Merry Christmas, Happy Holidays, and a Prosperous New Year! Best regards, Peter Berezin, Chief Global Strategist Highlights Global bonds have sold off in recent days, but the spread between long-term and short-term Treasury yields remains well below where it was at the start of the year. A flatter Treasury yield curve suggests that the ongoing U.S. business-cycle expansion is getting long in the tooth. Nevertheless, three factors dilute the potentially bearish message from the curve. First, the yield curve has flattened largely because short-term rate expectations have risen thanks to better economic data. Second, both the 10-year/2-year and 10-year/3-month spreads are still above levels that have foreshadowed poor returns for risk assets in the past. This is particularly true for equities. Third, a structurally low term premium has distorted the signal from the yield curve. The U.S. yield curve is likely to steepen over the next six months, before flattening again in the lead-up to a recession in late-2019. We reveal the One Number that will kill bitcoin. Feature A Harbinger Of Recession? The U.S. yield curve has steepened in recent days, but is still much flatter than it was at the start of the year. The 10-year/3-month spread currently stands at 113 bps, down 84 bps year-to-date. The 10-year/2-year spread has fallen from 125 bps to 62 bps. Numerous academic studies have highlighted the importance of the yield curve as a leading indicator of recessions.1 In fact, every U.S. recession over the past 50 years has been preceded by an inverted yield curve (Chart 1). Chart 1An Inverted Yield Curve Has Often Been A Harbinger Of A Recession An Inverted Yield Curve Has Often Been A Harbinger Of A Recession An Inverted Yield Curve Has Often Been A Harbinger Of A Recession The converse has generally been true as well: Most inversions in the yield curve have coincided with a recession. The only two exceptions were in 1967 - when credit conditions tightened and industrial production decelerated, but the U.S. still managed to avoid succumbing to a recession - and in 1998, when the yield curve briefly inverted during the LTCM crisis. Considering that recessions and equity bear markets typically overlap (Chart 2), it is not surprising that investors have begun to fret about what a flatter yield curve may mean for their portfolios. Chart 2Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Don't Worry... Yet Chart 3U.S. Growth Expectations Revised Higher U.S. Growth Expectations Revised Higher U.S. Growth Expectations Revised Higher We would not be as dismissive of a flatter yield curve as Fed Chair Yellen was during her December press conference. Policymakers and investors alike have been too quick to downplay the signal from the yield curve in the past. In 2006, they blamed the "global savings glut" for dragging down long-term yields. In 2000, they argued that the federal government's budget surplus was reducing the supply of long-term bonds. In both cases, the bond market turned out to be seeing something more ominous than they were. That said, there are three reasons why we would discount some of the more bearish interpretations of what a flatter yield curve is telling us. First, the flattening of the yield curve has occurred mainly because of an increase in short-term rate expectations, rather than a decrease in long-term bond yields. The increase in rate expectations has been largely driven by stronger growth data. The economic surprise index has surged far into positive territory and analysts are now scrambling to revise up their 2018 and 2019 U.S. GDP growth projections (Chart 3). The Fed now sees growth of 2.5% in 2018 and an unemployment rate of 3.9% by the end of next year. Back in September, the Fed expected growth of 2.1% and an unemployment rate of 4.1%. Second, our research suggests that the slope of the yield curve only becomes worrisome for the economy when it falls to extremely low levels. This conclusion is reinforced by the New York Fed's Yield Curve Recession Model, which uses the difference between 10-year and 3-month Treasury rates to estimate the probability of a U.S. recession twelve months ahead.2 The model's current recession probability stands at a modest 11% (Chart 4). The last three recessions all began when the implied probability was over 25%. Chart 4NY Fed's Yield Curve Model Suggests That The Probability Of A Recession Is Still Quite Low NY Fed's Yield Curve Model Suggests That The Probability Of A Recession Is Still Quite Low NY Fed's Yield Curve Model Suggests That The Probability Of A Recession Is Still Quite Low Third, the slope of the yield curve is weighed down by a structurally low term premium. The term premium measures the additional return investors can expect to receive by locking in their money in a 10-year Treasury note instead of rolling over a short-term Treasury bill for an entire decade. Historically, the term premium has been positive. Over the past few years, however, it has often been negative - meaning that investors have been willing to pay a premium to take on duration risk. Many commentators have attributed this peculiar state of affairs to central bank asset purchases, which they claim have artificially depressed long-term bond yields. There is some truth to this, but we think there is an even more important reason: Bonds today provide a good hedge against bad economic news. When fears of an economic slowdown mount, equities tend to sell off, while bond prices rise. This differs from the circumstances that existed in the 1970s and 1980s, when bad economic news usually meant higher inflation. To the extent that long-term bonds now serve as insurance policies against recessions, investors are more willing to accept the lower yields that they offer. Empirically, one can see this in the shift of the correlation between equity returns and bond yields. It was strongly negative up until the mid-1990s. Now it is strongly positive (Chart 5). A low term premium implies that the slope of the yield curve should be structurally flatter. That is exactly what we see today. Chart 6 shows that the 10-year/3-month spread would be well above its long-term average if the term premium were removed from the picture. This implies that investors have little to fear from the shape of today's yield curve, at least over the next six-to-twelve months. Chart 5Bond Prices Now Tend To Rise When Equity Prices Go Down Bond Prices Now Tend to Rise When Equity Prices Go Down Bond Prices Now Tend to Rise When Equity Prices Go Down Chart 6Stripping Out The Term Premium,##BR##The Yield Curve Is Not So Flat Stripping Out The Term Premium, The Yield Curve Is Not So Flat Stripping Out The Term Premium, The Yield Curve Is Not So Flat Rising Odds Of A Recession In Late-2019 Beyond then, things start to get dicey. The Fed's end-2018 unemployment rate projection of 3.9% is 0.7 percentage points below its long-term estimate of the unemployment rate. This means that at some point in the future, the Fed will need to lift interest rates above their "neutral" level in order to push the unemployment rate up to its equilibrium level. That's a risky gambit. There has never been a case in the post-war era where the unemployment rate has risen by more than one-third of a percentage point without a recession ensuing (Chart 7). Modern economies are subject to feedback loops. Once economic conditions begin to deteriorate, households cut back on spending. This leads to less hiring and even less spending. Bad economic news begets worse news. Chart 7Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Implications For Equities And Credit A flatter Treasury yield curve suggests that the U.S. business cycle is entering the home stretch. Nevertheless, as we pointed out two weeks ago, the 7th-to-8th innings of business-cycle expansions are often the juiciest for equity investors (Table 1).3 Table 1Too Soon To Get Out Don't Fear A Flatter Yield Curve Don't Fear A Flatter Yield Curve Chart 8 shows that the term spread today is still at levels that have signaled positive equity returns in the past. In fact, today's term spread is close to levels that prevailed in the second half of the 1990s, a period that coincided with the greatest bull market in American history. This message is echoed by our forthcoming MacroQuant model, which continues to flag upside risks for stocks over the next 6-to-12 months (Chart 9). Chart 8Current Term Spread Is Still Pointing##BR##To Positive Equity Returns Don't Fear A Flatter Yield Curve Don't Fear A Flatter Yield Curve Chart 9MacroQuant Still Positive##BR##On The Stock Market Don't Fear A Flatter Yield Curve Don't Fear A Flatter Yield Curve Globally, we favor euro area and Japanese equities (in local-currency terms) in the developed market sphere due to our expectation that the euro and yen will depreciate somewhat next year. Both the euro area and Japan also have greater exposure to cyclical sectors. This fits with our bias towards owning cyclicals over defensive stocks. Today's term spread is a bit more worrying for corporate credit. As our bond strategists have noted, a flatter yield curve is consistent with lower, though still positive, monthly excess returns for high-yield bonds (Chart 10).4 Again, the second half of the 1990s provides a potentially useful template: Despite a sizzling stock market, high-yield spreads actually widened as corporations loaded up on debt (Chart 11). The deterioration in our Corporate Health Monitor over the past five years suggests that a similar dynamic may be afoot (Chart 12). Chart 10Junk Monthly Excess Returns##BR##And The Yield Curve Don't Fear A Flatter Yield Curve Don't Fear A Flatter Yield Curve Chart 11Second Half Of 1990s: When High-Yield Spreads##BR##Rose With Stock Prices Second Half Of 1990s: When High-Yield Spreads Rose With Stock Prices Second Half Of 1990s: When High-Yield Spreads Rose With Stock Prices Chart 12Corporate Health Has##BR##Been Deteriorating Corporate Health Has Been Deteriorating Corporate Health Has Been Deteriorating Yield Curve Should Steepen Over The Coming Months Of course, much depends on what happens to the yield curve going forward. We suspect that it will flatten again towards the end of next year. However, it is likely to steepen over the next six months. U.S. GDP growth will remain above trend next year, as wages start to rise more briskly and firms boost capital spending to meet rising demand for their products. Fiscal policy should also help. Tax cuts will lift growth by 0.2%-to-0.3% in 2018. Higher disaster relief efforts following the hurricanes and a pending agreement to raise caps on discretionary spending will also translate into increased federal government spending. Investors have largely overlooked this source of fiscal stimulus, but increased spending will contribute almost as much to growth next year as lower taxes. Unfortunately, all this additional growth, coming at a time when the output gap is all but closed, is likely to stoke inflationary pressures. Our Pipeline Inflation Pressure Index has risen sharply since early 2016, while the ISM prices paid index has shot up. The New York Fed's Underlying Inflation Gauge has accelerated to an 11-year high of 3% (Chart 13). Historically, rising inflation expectations have led to a steeper yield curve (Chart 14). The implication is that investors should favor inflation-linked securities over government bonds. Chart 13U.S. Inflation Pressure Are Building U.S. Inflation Pressure Are Building U.S. Inflation Pressure Are Building Chart 14Rising Inflation Expectations Lead To A Steeper Yield Curve Don't Fear A Flatter Yield Curve Don't Fear A Flatter Yield Curve The One Number That Will Kill Bitcoin In a normal world, most reasonable people would regard a flatter yield curve and continued weak inflation readings as evidence that fiat money was, if anything, doing too good a job as a store of value. However, nothing is normal or reasonable about bitcoin.5 Chart 15Governments Will Want Their Cut:##BR##U.S. Seigniorage Revenue Governments Will Want Their Cut: U.S. Seigniorage Revenue Governments Will Want Their Cut: U.S. Seigniorage Revenue No one knows when the bitcoin bubble will burst. Only a tiny fraction of the public owns the virtual currency. The value of all bitcoin in circulation represents 0.35% of global GDP. At its peak in 1996, the value of all pyramid scheme assets in Albania amounted to almost half of GDP. Never underestimate the lure of easy money. While we do not know where the price of bitcoin will be ten months from now, we do have a good guess of where it will be ten years from today. And that price is zero, or thereabouts. When the U.S. Treasury issues a $100 bill, it gains the ability to buy $100 of goods and services with it. The government's cost is whatever it pays to print the bill, which is next to nothing. This so-called "seigniorage revenue" is set to reach $100 billion this year (Chart 15). That is the number that will kill bitcoin. There is no way the U.S. government will forsake this revenue in order to make room for bitcoin and other cryptocurrencies. Not when there are entitlements to pay and gaping budget deficits to finance. A variety of other countries have a love-hate relationship with bitcoin, partly because of their "the enemy of my enemy is my friend" attitude towards the dollar. But that will change when they see their tax bases eroding as more commerce gets done in the anonymous world of cryptocurrencies. Bitcoin's days are numbered. The only question is who will be holding the bag when the party ends. Peter Berezin, Chief Global Strategist peterb@bcaresearch.com 1 Please see Jonathan H. Wright, "The Yield Curve And Predicting Recessions," FEDs Working Paper No. 2006-7, May 3, 2006; Michael Owyang, "Is the Yield Curve Signaling a Recession?"Federal Reserve Bank Of St. Louis, March 24, 2016; and Arturo Estrella and Mishkin, Frederic S., "The Yield Curve as a Predictor of U.S. Recessions," Federal Reserve Bank Of New York, (2:7), June 1996. 2 Please see "The Yield Curve As A Leading Indicator: Probability of U.S. Recession Charts," Federal Reserve Bank Of New York. 3 Please see Global Investment Strategy Weekly Report, "When To Get Out," dated December 8, 2017. 4 Please see U.S. Bond Strategy, "Proactive, Reactive Or Right?" dated December 12, 2017. 5 Please see European Investment Strategy Weekly Report, "Bitcoins And Fractals," dated December 21, 2017; Technology Sector Strategy Special Report, "Cyber Currencies: Actual Currencies Or Just Speculative Assets?" dated December 12, 2017; Global Investment Strategy Special Report, "Bitcoin's Macro Impact," dated September 15, 2017; and Technology Sector Strategy Special Report, "Blockchain And Cryptocurrencies," dated May 5, 2017. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

As we near the end of an impressive year for equities, the relationship between price growth and earnings growth and how to best position a portfolio for 2018 bears some reflection. The purpose of this report, rather than take a position on inflation or growth, is to create a roadmap such that investors can allocate according to their expectations for both and also avoid potential pitfalls and embrace likely winners. Diagram 1Four Quadrants Of Earnings And Inflation Equity Sector Winners And Losers When Inflation Climbs; A Deeper Dive Equity Sector Winners And Losers When Inflation Climbs; A Deeper Dive In framing our analysis, we will focus on the top half of a well-known growth/inflation matrix presented in Diagram 1 below (stay tuned for a follow-up Special Report when we examine the sector impacts of deflation). We have used S&P 500 earnings as our measure of growth for two reasons: first, they lead GDP and IP growth and second, they are most relevant in a discussion of S&P 500 sector allocations. While inflation and earnings growth tend to move together, this has not always been the case. We have identified six time periods in which inflation has been visibly rising (shaded in Chart 1) and compared it with S&P 500 EPS growth. The mean reverting nature of S&P 500 earnings growth makes discerning a pattern difficult but, more often than not, there is a positive correlation with rising inflation. Over the last 60 years S&P 500 earnings growth has averaged 7.6%, while core PCE prices increased on average by 3.3%. As shown in Table 1 below, S&P 500 earnings outpaced core inflation in four periods (indeed, they grew much faster) and fell behind in two periods. We thus place 1965-1971 and 1998-2002 in the top-left quadrant of our matrix (Stagflation) and 1973-1975, 1976-1981, 1987-1989 and 2003-2006 in the top-right (Boom Times). It is important to qualify that, for the purposes of this report, we are considering all periods in which inflation is increasing, not necessarily periods when it is elevated on an absolute basis. Chart 1Earnings And Inflation Usually Move Together... Earnings And Inflation Usually Move Together... Earnings And Inflation Usually Move Together... Table 1...But Not Always Equity Sector Winners And Losers When Inflation Climbs; A Deeper Dive Equity Sector Winners And Losers When Inflation Climbs; A Deeper Dive In our examination of inflation and sector winners last year1, we presented Table 2 below, now modified to tie sector earnings growth to relative share price performance. Breaking down sector performance in boom and bust periods is revealing. The first and most obvious observation is that stock performance tracks earnings growth in all periods, implying that fundamentals lead valuation, as they should. The second observation is that empirical evidence supports sector allocation theory in inflationary boom/bust periods. Table 2Sector Performance When Inflation Rises Equity Sector Winners And Losers When Inflation Climbs; A Deeper Dive Equity Sector Winners And Losers When Inflation Climbs; A Deeper Dive In theory, the best performing stocks in a stagflation environment would have low economic sensitivity but high pricing power. This is borne out with S&P health care being the top performing sector both from an earnings growth and, predictably, relative stock performance perspective. By contrast, the top performing boom time stocks should be the most economically sensitive yet still stores of value. In these periods, the top overall performer was energy which checks all the boxes. This year, we are expanding our analysis to the GICS2 sectors which have shared the same cyclical return profile as their GICS1 peers (Table 3). In the inflationary busts, defensive stocks including healthcare equipment and food & beverage outperformed. As expected, the inflationary booms saw traditional cyclical indices including energy and transportation outperform. Table 3GICS2 Sector Performance When Inflation Rises Equity Sector Winners And Losers When Inflation Climbs; A Deeper Dive Equity Sector Winners And Losers When Inflation Climbs; A Deeper Dive In the next section, we will take a deeper look at three of the GICS2 top and two bottom quartile performers when inflation is rising. Energy - (Currently Overweight) The S&P energy index has been a stellar performer in all six high inflation periods we have examined and has the highest average return of all GICS2 sectors. This is logical, considering the sector's revenue, profit and share price leverage to the underlying commodity. During periods of high inflation, all stores of value tend to increase and oil is no exception. An additional tailwind for energy prices with inflation is the associated elevated industrial production; the current synchronized global growth backdrop should sustain a healthy level of demand for energy. Keep in mind oil prices are an excellent gauge of global growth. In the context of a falling rig count and contracting oil stocks (Chart 2), energy prices and stocks seem likely to remain well bid, underpinning our overweight recommendation on the S&P energy index. Transportation - (Currently Overweight) Transportation can largely be summarized as S&P railroads (currently overweight) and S&P air freight & logistics (currently overweight) which together comprise 75% of the index. The index has been a very strong performer in periods of rising inflation, driven by coincident accelerating global trade volumes (Chart 3). Historically, global industrial production and both rail and air freight EPS have moved in tandem as relatively fixed supply drives pricing power firmly on the side of logistics providers (Chart 3). This pricing power allows the transportation to mitigate the usually coincidentally highly volatile energy price via oil surcharges, offsetting what is typically the largest input cost. Together, firming volumes and pricing gains support an outsized earnings outlook and our overweight recommendation in transportation. Chart 2Inflation, IP And Oil Prices Move Together Inflation, IP And Oil Prices Move Together Inflation, IP And Oil Prices Move Together Chart 3Rising Inflation Is A Boon To Global Trade Volume Rising Inflation Is A Boon To Global Trade Volume Rising Inflation Is A Boon To Global Trade Volume Health Care Equipment - (Currently Neutral) The S&P health care equipment index has consistently been an outperformer in each of the six high inflation impulse periods we analyzed. This is all the more interesting, considering it is the least cyclical of the top quartile relative performers. Health care equipment sales are largely driven by new facility construction which is, in turn, driven at least in part by consumer spending on health care. Consumer health care expenditure has a demonstrated propensity to follow (with significantly greater amplitude) overall inflation (Chart 4). Further, health care equipment is highly levered to global demand; the latter clearly rises hand in hand with inflation and should be EPS accretive to the former. Elevated relative valuations offsetting the positive operating environment keep us on the sidelines. Chart 4Health Care Spending Tracks Inflation Health Care Spending Tracks Inflation Health Care Spending Tracks Inflation Automotive - (Currently Underweight) Returns in the S&P automotive index are by far the most consistently negative when inflation is rising. Rising interest rates driving the costs of ownership higher, combined with the rational avoidance of a depreciating asset when stores of value are preferable, have historically impaired light vehicle sales as inflation climbs. In fact, the two have a tight negative correlation (Chart 5). In an industry where margins are razor thin at the best of times and fixed costs are relatively high, a shrinking top line implies significant profit contraction. Add on a highly geared balance sheet in a rising rate environment and the ingredients are all in place for underperformance. The current environment echoes this analysis; inventories are still elevated despite manufacturer incentives hitting their highest level in history and seven-year auto loans becoming the norm, something unheard of in previous cycles. Chart 5Inflation And Auto Sales Are Inversely Correlated Inflation And Auto Sales Are Inversely Correlated Inflation And Auto Sales Are Inversely Correlated Utilities - (Currently Underweight) Utilities, as the prototypical defensive sector, have unsurprisingly performed poorly as inflation is rising. Rising inflation expectations go hand in hand with rising bond yields (Chart 6); as a fixed-income proxy, utilities are likely to be subject to the same drubbing as the bond market when yields rise. Further, surging global trade is a notable boon to the three outperformers previously highlighted with their exceptional international exposure; utilities are a domestic-only investment and are bound to underperform. Overall, we recommend an underweight position in utilities. Chart 6Inflation Is A Headwind To Fixed Income Proxies Inflation Is A Headwind To Fixed Income Proxies Inflation Is A Headwind To Fixed Income Proxies Chris Bowes, Associate Editor U.S. Equity Strategy chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Equity Sector Winners And Losers When Inflation Climbs," dated December 5, 2016, available at uses.bcaresearch.com.

Highlights Agricultural markets are informationally efficient for the most part, which is to say that at any given time, prices already reflect most public information available to traders, and a lot of private information as well. Even so, we believe markets are underestimating the Fed's resolve in normalizing interest-rate policy next year - particularly when it comes to the number of rate hikes we are likely to see - and thus are underestimating the likelihood of lower grain prices in 2018. Energy: Overweight. Oil markets will emerge from their suspended animation following OPEC 2.0's Vienna meeting today. Our Brent and WTI call spreads in May, July and December 2018 - long $55/bbl calls vs. short $60/bbl calls - are up an average 50.2%. Our long Jul/18 WTI vs. short Dec/18 WTI trade anticipating steepening backwardation is up 13.3%. Base Metals: Neutral. China's refined zinc imports were up 145% yoy to 61,355 MT in October, based on customs data. Metal Bulletin noted tight domestic supplies accounted for the increase. Precious Metals: Neutral. Gold is breaking away from its attachment to $1,280/oz., as the USD weakens. Our long gold portfolio hedge is up 5.2% since inception May 4, 2017. Ags/Softs: Neutral. Global financial conditions will become increasingly important to grain prices going forward, a trend we explore below. Feature Record output and ending stocks will ensure that ag markets remain well supplied globally next year. While we see risks as balanced in the upcoming year, and remain neutral ags generally, we believe markets are underestimating the Fed's resolve when it comes to normalizing interest rates, and thus underestimate upside USD potential. This means the likelihood of lower grain prices also is being underestimated. Weather will add volatility to the mix, as well. We believe the fundamentals supporting the assessment of record output and season-ending stocks-to-use ratios are fully reflected in prices. However, financial conditions - particularly USD strength next year - are not being fully priced by markets. This makes grains, in particular, vulnerable to the downside. Financial conditions driving ag markets: Fed policy & real rates: we expect U.S. financial conditions to tighten, and for the Fed to hike rates once more this year, and up to three more times in 2018.1 FX rates: With higher U.S. policy rates next year, the USD is likely to strengthen. This will weaken grain prices generally. Wheat, in particular, is most vulnerable to a strengthening USD and a weakening of the currencies of some of the commodity's top exporters - the European Union, Russia, and Australia. We've narrowed down the fundamental factors to look out for in 2018 as follows: Strong demand amid an extension of supply cuts by the OPEC 2.0 coalition will support oil prices in 2018. Higher energy prices will increase profit-margin pressure in ag markets through input and shipping costs. Weather risks from La Nina threaten to curb yields this winter, especially in Argentina and Brazil, which will add volatility to prices. Policy shifts in Argentina, China, and Brazil will influence farmers' planting decisions in the upcoming crop year. A Look Back At 2017 Chart of the WeekGrains Outperformed Softs This Year Grains Outperformed Softs This Year Grains Outperformed Softs This Year As predicted in our 2017 outlook, grains reversed their 2016 underperformance vis-à-vis softs this year, and outperformed them.2 While prices for sugar, coffee, and cotton were up 28%, 8%, and 12% in 2016, they have since declined by 21%, 8%, and 2%, respectively. In fact, sugar - our top ag in 2016 - took the biggest hit this year (Chart of the Week). On the other hand, as a complex, grains currently stand at largely the same level as the beginning of last year. However, there are some idiosyncrasies within the class. The two worst performing grains last year - rice and wheat - have been the strongest performers so far this year. Rice rallied 30% year-to-date (ytd) on the back of tighter supplies, completely reversing its 19% decline in 2016. Similarly, wheat, which lost 13% of its value last year, is up a modest 3% ytd. On the other hand, soybeans surrendered its title as the most profitable grain in 2016. After gaining 14% last year, its fate turned and it fell 3% ytd. Finally, out of the lot, corn is the only ag we cover that has fallen in both years consecutively, by a minor 1.9% in 2016, and an additional 4.4% so far this year. A Recap Of Long Term Trends According to the International Grains Council's November estimates, grains production is projected to come down this crop year. With an increase in consumption, this will ultimately lead to a 5.2% decline in ending stocks - the first drawdown in five years. Despite the year-on-year (y-o-y) decline, grain inventories are expected to stand at their second highest level on record (Table 1). Table 1Grain Production Down While Consumption Inches Higher Global Financial Conditions Will Drive Grain Prices In 2018 Global Financial Conditions Will Drive Grain Prices In 2018 The decline in expected grain ending stocks is mainly driven by corn, which - despite a large upwards revision to U.S. yields in the most recent WASDE - is expected to experience a 3.6% decline in production. This, together with a boost in consumption, leads to a 13.6% fall in ending stocks - the first drawdown since the 2010/11 crop year. The decline in corn expectations reflects a shift in the planting preferences of some of the major producers. The U.S., Brazil, Argentina, and China are the top soybean and corn exporters - accounting for 78% and 49% of global soybean and corn area harvested in the 2016/17 crop year, respectively. What is significant in the current cycle is that farmers in these countries are moving away from planting corn and towards more soybeans (Chart 2). China, which accounted for 19% of global corn area harvested and 6% of global soybean area harvested in 2016/17, is leading this change. While corn area harvested fell by an average 4.2% in the 2015 and 2016 crop years, soybean area harvested gained 9.8% during that period. Similarly, in Brazil, which accounted for 10% and 28% of global corn and soybean area harvested in 2016/17, respectively, corn area harvested by farmers has been growing at a much slower rate than soybean area harvested, with the former expanding by 16.4% and the latter by 39.6% since 2010/11. Likewise, harvested area in the U.S., which accounted for 18% and 29% of global corn and soybean area harvested, respectively, shrunk by 0.9% in the case of corn, and expanded by 21.3% in the case of soybeans since 2010/11. The exception to this rule is Argentina. Argentine farmland accounted for 3% and 15% of global corn and soybean area harvested in 2016/17, respectively. Since 2010/11, both corn area harvested as well as soybean area harvested increased by roughly the same level - 1.6 Mn Ha for the former and 1.5 Mn Ha for the latter - representing a 44.4% and 8.6% increase in area harvested for corn and soybeans, respectively. However, this is due to export policies, which in effect, encourage corn production over soybeans. As we discuss below, soybean export tariffs will be phased out in the coming years, likely changing the incentives structure for Argentine farmers. This trend is mirrored in production data, with global soybean output gaining 32% since 2010/11, compared to a 25% increase in global corn production. However, this shift is in large part due to demand patterns which also favor soybeans to corn. Over the same period, global soybean consumption increased by 36%, compared to 24% in the case of corn (Chart 3). Chart 2Farmers Favor Soybeans Over Corn... Farmers Favor Soybeans Over Corn... Farmers Favor Soybeans Over Corn... Chart 3...As Do Consumers ...As Do Consumers ...As Do Consumers In fact, at 28%, global soybean stock-to-use ratios are significantly more elevated than that of corn, which stand at 19%. Furthermore, while soybeans are expected to record a 3.9mm MT surplus by the end of the current crop year, corn is projected to experience a 17.7mm MT deficit. Powell's Fed And Dollar Movements Our modelling of ags reveals that U.S. financial factors are important determinants of agriculture commodity price developments.3 Fed policy decisions and their impact on real rates have a direct effect on ag commodity prices, as well as an indirect effect through the exchange rate channel (Chart 4). Chart 4Fed Policy Drives Ag Markets Fed Policy Drives Ag Markets Fed Policy Drives Ag Markets While U.S. inflation has remained stubbornly low, forcing the Fed to slow down their interest rate normalization process, the anticipation - and eventual acceleration - of the Fed tightening cycle will weigh on ag prices. However, thanks in part to softer-than-expected inflation readings coming out of the U.S. this year, the USD broad trade-weighted index (TWIB) has weakened by 6.8% since the beginning of the year. In terms of the impact of real rates, monetary policy impacts agriculture markets through the following channels: The Fed's interest-rate normalization process will, all else equal, increase borrowing costs for farmers, and discourage investments in general - impacting both agricultural investments as well as outlays in research and development. Tighter credit also leads to a slowdown in growth which - ceteris paribus - depresses consumption and demand for goods and services generally, and agricultural commodities specifically. Finally, real rates have an indirect effect on agricultural commodity prices through its effect on the U.S. dollar. Higher U.S. rates encourage investment in U.S. bonds and entail a strengthening of the U.S. dollar making U.S. exports less competitive vis-à-vis those of its international competitors. Since commodities are priced in U.S. dollars while costs are priced in local currencies, a weakening of the domestic currency vis-à-vis the dollar would increase profitability for farmers selling in international markets. This can incentivize farmers to plant more, despite depressed global ag prices, which increases supply. As our modelling reveals, the net effect is an inverse relationship, whereby easier monetary policy is generally more favorable for agriculture markets. The Fed Will Remain Behind The Inflation Curve Our U.S. Bond Strategy team expects the Fed to remain behind inflation, in which case the USD will remain weak in the beginning of next year. The 2/10 Treasury curve is flat highlighting the market's belief that the Fed will continue with interest rate normalization despite below target levels of inflation.4 Since this would be a huge error on the part of new Chairman Powell, our U.S. bond strategists believe that the Fed will avoid such a policy mistake. Consequently, if inflation does not pick up soon, the Fed will be forced to turn dovish. In any case, U.S. monetary policy will "fall behind the curve." This means that the U.S. dollar will remain weak until inflation starts to tick higher, and the Fed can resume its interest rate normalization process. In fact, our bond strategists find that there is a resemblance between the current cycle and that of the late 1990s where the unemployment rate significantly undershot its natural level before inflation started to accelerate. Thus, they find it significant that most of the indicators that predicted the 1999 increase in inflation are now positive. This reinforces our faith that inflation will soon rebound, allowing the Fed to fall behind the curve and simultaneously hike rates at a pace of one more hike this year, and three more in 2018.5 In terms of the future path of the U.S. dollar, our foreign exchange strategists argue interest rate differentials will be a more significant determinant of dollar dynamics going forward. They expect inflation will start its ascent sometime before the end of 1H2018, which would lift the interest rate curve and the dollar. Our expectation is that inflation will bottom towards the end of this year/beginning of next, giving room for the Fed to proceed with its anticipated rate-hiking cycle, resulting in two to three hikes next year. Markets are pricing one to two rate hikes next year, which means our out-of-consensus rates call could cause the USD to rally far more than what markets have priced in to the USD TWIB. Following a 4.4% appreciation in trade weighted terms in 2016, the U.S. dollar has depreciated by 6.8% so far this year. The U.S. accounts for a larger share of global exports of corn and soybeans than rice and wheat, which means a strengthening of the USD TWIB will likely have a bigger impact on wheat and rice, in which the U.S. faces greater international competition for market share (Table 2). Table 2Wheat & Rice Vulnerable To USD Dynamics Global Financial Conditions Will Drive Grain Prices In 2018 Global Financial Conditions Will Drive Grain Prices In 2018 This is, in fact, in line with the price behavior that we have observed. Wheat and rice prices fell the most in 2016 as the U.S. dollar appreciated, and have outperformed soybeans and corn so far this year, as the U.S. dollar depreciated. Thus, in the absence of supply shocks that affect a particular grain, changes in the U.S. dollar going forward will have a greater impact on rice and wheat than on corn and soybeans. Keep An Eye On The Brazilian Real Of the major ag exporters, Brazil is most vulnerable to USD depreciation risk. Poor productivity trends have made our foreign exchange strategists single out the Brazilian Real (BRL) as one of the most expensive currencies they track. While they expect the BRL to depreciate over a one- to two-year horizon, the current strength in EM asset prices means that the BRL is likely to remain at its current level in the near term. However, given that the BRL provides an high carry, it will likely move sideways until U.S. interest rate expectations adjust to a rebound in inflation - which we expect toward the end of this year, or beginning of next. Brazil is a major ag producer - making up 45%, 44%, 27%, 23% and 12% share of the global export pies for soybeans, sugar, coffee, corn and cotton, respectively. Thus, a weaker BRL vis-à-vis the USD is a major downside risk to these commodity prices. Downside FX Risks Will Keep Wheat Prices Depressed Chart 5Downside FX Risks For Wheat Exporters Downside FX Risks For Wheat Exporters Downside FX Risks For Wheat Exporters In addition to the risks from an overvalued BRL, our foreign exchange strategists have highlighted the EUR, RUB, and AUD as currencies that are at risk of falling back to their fair value in the near term. Given that these regions are major wheat exporters, this would weigh on the grain's price as exports increase (Chart 5).6 On the back of expectations that the European Central Bank will adopt a significantly less aggressive monetary policy than the Fed, our foreign exchange strategists expect the EUR to weaken toward the end of the year and beginning of next. Given that Europe is a major wheat exporter - making up ~20% of global exports - a weaker EUR would make European wheat more attractive, weighing on prices in 2018. The currencies of other major exporters could be drawn in different directions in the near term. Our FX strategists see the Russian Rouble (RUB) as overvalued and at risk of weakening when U.S. inflation starts accelerating late this year or early next. However, higher oil prices would push up the ruble's fair value, correcting some of its overvaluation. As with the EUR, the wheat market is most vulnerable to a weaker RUB since Russia accounts for 14% of global wheat exports. Likewise, Australia - another major wheat exporter which accounts for 10% of world exports - has been identified as having an expensive currency. It is at risk of a depreciation over the next 24 months, but could rally if iron ore markets turn higher. Some Additional (Potential) Fundamental Forces Among the news and noise in the ags sphere, we see higher oil prices and La Nina as the most significant near-term risks to current supply/demand dynamics. Longer term, shifting policies in China, Argentina, and Brazil will become more relevant in determining the trajectory of ag markets. Our Out-Of-Consensus Call On Oil Is Bullish For Ags Chart 6Higher Energy Prices Upside Risk Higher Energy Prices Upside Risk Higher Energy Prices Upside Risk We expect oil prices will tread higher next year - averaging $65/bbl for Brent and $63/bbl for WTI - on the back of stronger demand and an extension of the OPEC 2.0 coalition's supply restrictions.7 This will support ag commodity prices. Higher oil prices affect ags by increasing input costs and global shipping prices. In addition, the supply of ocean-going transport for grains is tight. The Baltic Dry index, a measure of the global cost of shipping dry goods, and has been on the uptrend this year, as freight costs have more than doubled since mid-February, mostly on the back of a slowdown in shipping transportation supply (Chart 6). La Nina: A Literal Tailwind? Against a backdrop of falling stocks-to-use ratios in the corn and soybean markets, weather will add volatility to prices into 1H2018. In the near term La Nina, which is predicted to continue through the 2017-18 Northern Hemisphere winter, threatens to curb agricultural output. This phenomenon affects weather and rainfall, causing floods and droughts, by cooling the Pacific Ocean. Australia's Bureau of Meteorology recently pegged the chance of a La Nina at 70%, expecting it to last from December to at least February. However, this season's La Nina is forecast to be weak and weather conditions are expected to neutralize in 1Q2018.8 In the case of ags, the greatest threat from La Nina is the risk of droughts in Brazil and Argentina which could hurt the regions soybean, corn, sugar, and cotton harvests. Furthermore, excess rainfall in Australia and Colombia threaten wheat, cotton, and sugar yields in the former and coffee output in the latter. Furthermore, the weather phenomenon raises chances of a potential drought in the U.S. Midwest.9 However, it is noteworthy that by the time La Nina hits, much of the harvest in the Northern Hemisphere will have been completed. So the main risk will be to harvests in the Southern Hemisphere. Gradualismo In Argentina, Stockpiling In China, And Ethanol In Brazil 1. Since taking office late 2015, Argentine President Mauricio Macri has reversed his predecessor's unfavorable agricultural policies - allowing the Argentine peso to float, and eliminating export taxes on wheat and corn. Marci's Gradualismo reforms have been successful - incentivizing plantings and leading to record harvests (Chart 7). While a 30% export tax remains on soybeans - Argentina's main cash crop - it is down from 35% under the presidency of Macri's predecessor. Further cuts to soybean export taxes have been delayed in order to finance the country's fiscal deficit, however they are expected to resume next year with a 0.5pp reduction/month for the next two years. This would stimulate soybean plantings, if it materializes. Argentine farmers produce 18% of global soybean output, and account for 9% of global soybean exports. The change in export policy, as it unfolds, will thus weigh on soybean prices as Argentine farmers increase their soybean acreage in the coming crop years. 2. Although we will likely get more clarity regarding Chinese ag policies with the release of China's Number 1 Central document - which for the past 14 years has focused on agriculture - in February, we expect Beijing to continue incentivizing soybean farming over corn. China's soybean inventory levels stand significantly lower than its notoriously massive stocks of corn, wheat, and cotton (Chart 8). Chart 7Argentine Reforms Will Raise Soybean Exports Argentine Reforms Will Raise Soybean Exports Argentine Reforms Will Raise Soybean Exports Chart 8China's Soybean Stocks Are Relatively Low China's Soybean Stocks Are Relatively Low China's Soybean Stocks Are Relatively Low As such, China's top corn producing province - Heilongjian - cut the subsidy for corn farmers by 13 percent this year. Farmers there now receive 8.90 yuan/hectare of corn, down from the 10.26 yuan/hectare they received last year. This compares with subsidies for soybean farmers which at 11.56 yuan/hectare is much higher. According to the China National Grain and Oils Information Center, corn acreage in Heilongjiang is down 9.3 percent in 2016/17. However, with corn prices in China increasing, the higher subsidy for soybeans may not be sufficient. Nonetheless, according to a report by the Brazilian state Mato Grosso's official news agency, over the next five years the Chinese commodities trader COFCO intends to almost double its soybean imports from the Brazilian grains state. This means that China's demand for soybeans will drive the market in the near term as they look to buildup soybean reserves and bring down their corn stocks.10 Chart 9Higher Oil Prices Incentivize Ethanol Over Sugar Higher Oil Prices Incentivize Ethanol Over Sugar Higher Oil Prices Incentivize Ethanol Over Sugar 3. Ethanol Demand will raise the opportunity costs of bringing sugar and corn to market. In addition to the direct effect of higher oil prices on ag commodities in general, our forecast of increasing prices will pressure sugar prices indirectly through the ethanol channel in Brazil. Since July, Brazil's state-controlled oil company, Petrobras, has shifted its pricing policy allowing gasoline and diesel prices to follow those of international oil markets. As a result, the gasoline-ethanol price gap is widening.11 This will revive demand for the biofuel, which will cause mills to divert sugarcane away from the sweetener in favor of producing more ethanol (Chart 9). In fact, according to UNICA - the Brazilian sugarcane industry association - mills in the country's center-south region - from which 90% of Brazil's sugar output is derived - are favoring ethanol production over sugar. Data for the first half of October shows that 46.5% of sugarcane was diverted to producing sugar, down from 49.6% in the same period last year. However, in the near term, increased production from the EU amid their scrapping of domestic sugar production quotas will likely keep the global market in balance.12 Global sugar supply is forecast to remain strong on the back of supplies from Thailand, Europe and India. There are reports that ethanol producers in Brazil are evaluating the adoption of "corn-cane flex" ethanol plants.13 However this is a longer run risk which would increase demand for corn, and reduce demand for sugar. Bottom Line: Financial conditions will drive ag prices in 2018. The Fed's resolve to normalize interest rates - more so than markets expect - will keep a lid on prices. This will offset risks from higher energy prices. Nonetheless, some weather induced volatility is likely into 1Q2018. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 In fact, our Global Investment Strategists expect the Fed to hike rates in December 2017, and again four more times in 2018. Please see BCA Research's Global Investment Strategy Weekly Report titled "A Timeline For the Next Five Years: Part I," dated November 24, 2017, available at gis.bcaresearch.com. 2 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "2017 Commodity Outlook: Grains & Softs," dated December 22, 2016, available at ces.bcaresearch.com. 3 A 1% move in the USD TWI is associated with a 1.4% change in the CCI Grains & Oilseed Index, in the opposite direction. Similarly, a 1pp move in 5-year real rates is associated with a 18% change in the CCI Grains & Oilseed Index, in the opposite direction. The adjusted R2 is 0.84. 4 Please see BCA Research's U.S. Bond Strategy Portfolio Allocation Summary titled "Into The Fire," dated November 7, 2017, available at usbs.bcaresearch.com. 5 Please see BCA Research's U.S. Bond Strategy Weekly Report titled "The Fed Will Fall Behind The Curve," dated October 24, 2017, available at usbs.bcaresearch.com. 6 Please see BCA Research's Foreign Exchange Strategy Weekly Report titled "Updating Our Long-Term Fair Value Models," dated September 15, 2017, available at fes.bcaresearch.com. 7 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "Oil Balances Continue To Point To Higher Prices," dated November 23, 2017, available at ces.bcaresearch.com. 8 El Nino/Southern Oscillation (ENSO) alternates between warm ("El Nino") and cool ("La Nina") phases, impacting global precipitation and temperatures. These episodes are identified by looking at temperatures in the "Nino region 3.4" whereby readings of at least 0.5 degrees Celsius above or below seasonal average for several months would qualify as an El Nino or La Nina. 9 La Nina is often associated with wet conditions in eastern Australia, Indonesia, the Philippines, Thailand, and South Asia. It usually leads to increased rainfall in northeastern Brazil, Colombia, and other northern parts of South America, and drier than normal conditions in Uruguay, parts of Argentina, coastal Ecuador and northwestern Peru. The effect on the U.S. and Canada tends to be milder since they are located further away from the heart of ENSO, on the other hand it has the greatest impact on countries around the Pacific and Indian Oceans. 10 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "Ags in 2017/18: Move To Neutral," dated October 5, 2017, available at ces.bcaresearch.com. 11 Flex-fuel vehicles in Brazil means that ethanol demand is not constrained by a "blending wall". Thus ethanol is a substitute for gasoline- rather than a complement to, as in the U.S. 12 France, Belgium, Germany and Poland reportedly have the capacity to ramp up sugar beet production. 13 Please see "Brazil mills eye corn-cane flex plant to extend production cycle," dated November 7, 2017, available at reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Global Financial Conditions Will Drive Grain Prices In 2018 Global Financial Conditions Will Drive Grain Prices In 2018 Commodity Prices and Plays Reference Table Trade Recommendation Performance In 3Q17 Global Financial Conditions Will Drive Grain Prices In 2018 Global Financial Conditions Will Drive Grain Prices In 2018 Trades Closed in 2017 Summary of Trades Closed in 2016

Feature When things get ultra-small, the laws that describe the universe change radically. Classical physics breaks down and we have to turn to quantum physics to explain behaviour that seems strange and counterintuitive. In this short Special Report, we would like to extend the quantum principle into the financial world. When interest rates get ultra-low, the laws that describe the behaviour of financial markets also change radically. Classical financial theory breaks down and we have to turn to what we will call the quantum theory of finance. Figure I-1AThe Quantum Theory Of Physics The Quantum Theory Of Finance The Quantum Theory Of Finance Figure I-2BThe Quantum Theory Of Finance The Quantum Theory Of Finance The Quantum Theory Of Finance Some Interest Rates Are Not Allowed Somebody once said the test of a good theory is that you should be able to write it on the front of a T-shirt. What would the T-shirt for the quantum theory of physics say? Probably this: "For a physical system, energies take discrete values and some energies are not allowed." What would the T-shirt for the quantum theory of finance say? Probably this (Figure I-1): "For a financial system, interest rates take discrete values, and some interest rates are not allowed." At large scales, the granularity that defines the energy of all physical system and the interest rates in a financial system is not apparent. Allowable values seem a continuum, and all values are allowed. Chart I-1A Promise To Keep The Policy Interest Rates##br## Ultra-Low Pulls Down Bond Yields A Promise To Keep The Policy Interest Rates Ultra-Low Pulls Down Bond Yields A Promise To Keep The Policy Interest Rates Ultra-Low Pulls Down Bond Yields But at ultra-small scales for both energy and interest rates, the granularity of the values becomes very apparent and this granularity becomes the dominant driver of physical systems and, we would argue, financial systems too. Policy interest rates do not have to take discrete values, but in practice they do move in steps. More importantly, some policy interest rates are not allowed. Policymakers accept that there exists a 'lower bound' to interest rates - perhaps slightly negative - below which there would be an exodus of bank deposits. Hence, this lower bound marks the limit of allowable interest rates. When policy interest rates approach this lower bound, central banks can turn to a second strategy: they can promise to keep rates at this lower bound for an extended period of time. Thereby they can pull down long-term interest rates towards the lower bound too (Chart I-1). To do this, they must convince the market that their promise is genuine. Enter quantitative easing (QE). In the words of ECB Chief Economist Peter Praet, "the credibility of promises to follow a certain course for policy rates in the future is enhanced by asset purchases." QE is nothing more than "a signalling channel which reinforces the credibility of forward guidance on (ultra-low) policy rates." Once bond yields approach ultra-low levels, we begin to see some of the strange effects of the quantum theory of finance. When bond yields cannot fall much further, they can only stabilize or rise, leaving the bond investor with a highly asymmetric payoff (Chart I-2 and Chart I-3) - technically known as negative skew. Chart I-2When Bond Yields Become Ultra-Low, Potential Losses Become Larger Than Potential Gains When Bond Yields Become Ultra-Low, Potential Losses Become Larger Than Potential Gains When Bond Yields Become Ultra-Low, Potential Losses Become Larger Than Potential Gains Chart I-3Bonds Become Much More Risky At Ultra-Low Yields The Quantum Theory Of Finance The Quantum Theory Of Finance Put simply, a distribution with negative skew produces values that usually turn out to be slightly higher than the mean and rarely, values substantially lower than the mean (Figure I-2). For financial returns negative skew means frequent small gains and infrequent large losses. The opposite is true for positive skew. Figure I-2Distributions With Negative And Positive Skew The Quantum Theory Of Finance The Quantum Theory Of Finance This brings us to an important point. Empirical and theoretical evidence now proves that investors are not concerned about small fluctuations around an investment's mean return. Instead, they are concerned about large and sudden losses. Hence, the classical use of volatility1 σ as a standard measure of risk is wrong.2 The truth is that risk premiums are a compensation for holding assets that provide positive cash flows but may occasionally suffer very large losses, erasing a large proportion of wealth. In other words, assets with negative skew. Hope And Fear Move In Quanta Too There is compelling theoretical evidence linking risk premiums to negative skew. It comes from a branch of behavioural finance developed by Daniel Kahneman and Amos Tversky, called prospect theory. In their seminal 1979 paper in Econometrica,3 Kahneman and Tversky proposed that "choices among risky prospects exhibit several pervasive effects that are inconsistent with the basic tenets of (classical) utility theory." Contrary to classical utility theory, people do not think in terms of final wealth (utility). In practice, people think in terms of gains and losses. And within these gains and losses, people tend to overweight low probability events by very large amounts - contributing to the attractiveness of both gambling and insurance. In prospect theory, the value of any gain or loss is multiplied by a 'decision weight'. Decision weights measure the impact on the investor of a specific prospect. Prospect theory finds that people tend to ascribe large decision weights to low probability events. Why? Remarkably, Kahneman and Tversky found the answer comes from quantum theory (what they called a quantal effect). "There is a limit to how small a decision weight can be attached to an event, if it is given any weight at all. Because people are limited in their ability to comprehend and evaluate extreme probabilities, highly unlikely events are either ignored or overweighted." Just like the energies of a physical system, or policy interest rates, the feelings of hope and fear occur in quanta and not in a continuum. You move stepwise from 'no hope' to 'some hope' to 'a lot of hope'. You move stepwise from 'no fear' to 'some fear' to 'a lot of fear'. Furthermore, the step from no hope to some hope and the step from some fear to no fear are especially large. You significantly overpay for a lottery ticket versus your expected gain because it takes you from no hope to some hope of winning a life-changing fortune. Likewise, you overpay for the insurance on your home versus your expected loss because it takes you from some fear to no fear of a ruinous loss. In exactly the same way, investment risk premiums are the return compensation for holding assets that may occasionally suffer ruinous losses - in other words, investments that exhibit negative skew (Table I-1 and Chart I-4). Table I-1At Low Bond Yields, Bonds Have ##br## Extreme Negative Skew The Quantum Theory Of Finance The Quantum Theory Of Finance Chart I-4Bonds Become Much More Risky##br## At Ultra-Low Yields The Quantum Theory Of Finance The Quantum Theory Of Finance Applying The Quantum Theory To Markets So now let's pull together what the quantum theory of finance tells us: A lower bound to interest rates - perhaps slightly negative - defines the 'quantum limit' of allowable interest rates. When bond yields approach this lower bound, prospective returns from bonds suffer strong negative skew, meaning the prospect of a rare but ruinous loss. The quantum step from 'no fear' to 'some fear' means that negative skew requires a risk premium. Therefore, at low bond yields the valuation relationship between bonds and equities changes radically. Given that equity returns always possess negative skew, we can say that at low bond yields, bond risk becomes equity-like. So the excess return demanded on equities relative to bonds - the equity risk premium - should compress, or indeed fully disappear (Chart I-5). This means that at low bond yields equity prospective returns should become bond-like. Justifying much richer equity valuations today. Chart I-5At Low Bond Yields, The Excess Prospective Return On Equities Over Bonds Disappears At Low Bond Yields, The Excess Prospective Return On Equities Over Bonds Disappears At Low Bond Yields, The Excess Prospective Return On Equities Over Bonds Disappears However, the conditionality on the negative skew of bonds is crucial. The negative skew on a 10-year bond starts to fade when the bond yield is at 2% and completely disappears at 3%, at which point the equity risk premium must fully re-emerge. Removing the justification for the richer equity valuations. Markets tend to move en masse, so we infer that the rich valuation of equity markets would be at risk of correction if a mainstream 10-year bond yield broke well north of 2.5%. At current yields, the 10-year bond closest to the 2.5%-3% 'red zone' is the U.S. T-bond. And a breach into the 'high 2s' would trigger us to de-risk our portfolio. However, the flight to investment havens that would follow a sell-off in risk assets would also curtail the rise in bond yields. No mainstream bond yield can realistically rise beyond 3% - and stay there - in the foreseeable future. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Root mean squared 2 Please see Quantitative Finance, Risk premia: asymmetric tail risks and excess returns, by Y. Lemperiere et al. 3 Please see Econometrica Volume 47 Number 2 March 1979, Prospect theory: an analysis of decision under risk, by Daniel Kahneman and Amos Tversky.

Highlights Emerging Market (EM) hard currency debt, both sovereign and corporate, has consistently outperformed the broad global bond index. However, investors should steer clear of always maintaining maximum overweights to EM given its weak volatility reduction benefits and a much higher-than normal tendency of experiencing outsized, negative returns. Our long-term analysis suggests a structural 5% allocation offers the best risk/reward potential. The Fed is still in the early stages of rate normalization. At this point in the Fed policy cycle, where the Fed is hiking rates but monetary conditions are still stimulative, EM hard currency debt has historically performed well both on a relative and absolute basis. Looking ahead, EM returns should begin to suffer in latter half of 2018 as the Fed moves to more restrictive policy stance. While global growth will remain supportive of EM credit next year, renewed U.S. dollar strength and a re-convergence to the downside with commodity prices present considerable headwinds. Maintain an underweight stance on EM hard currency debt. Favor DM spread product due to more supportive relative growth trends and valuations. Feature Emerging market (EM) sovereign and corporate debt returns have surged in 2017, returning 9.4% and 7.5%, respectively (Chart 1). Investor interest has been renewed, with the latest IMF Financial Stability Report indicating that non-resident inflows of portfolio capital to EM countries have recovered since early 2016 and reached $205 billion for 2017 through August. Against a backdrop of above-trend global economic growth, monetary policy settings from the major central banks that are still accommodative, and some diminished risks from the world's geopolitical hotspots, the current uptrend for EM debt performance could continue. Nevertheless, we urge caution. We moved to a moderate underweight stance on EM hard currency debt back in August, while at the same time increasing our current recommended overweight to U.S. investment grade (IG) corporate debt on the other side of the trade.1 Even with synchronized global growth boosting both EM export demand and industrial commodity prices, we prefer U.S. credit exposure over EM at this point in the cycle, for several reasons: The massive flow-driven EM rally has resulted in not only outsized returns but stretched valuations, with EM debt spreads now back to post-2008-crisis low (or even through those levels for EM hard currency corporates) without any major improvement in EM fundamentals; The previously reliable correlation between EM debt and commodity prices, a long-time driver of EM performance, has broken down, bullishly, for EM - potentially another sign of flow-driven overvaluation; Growing uncertainty over the near-term China growth outlook raises risks on further gains in industrial commodity demand and EM exports; The USD will appreciate once again on the back of additional Fed interest rate hikes beyond levels currently discounted by markets, which could trigger some reversal of the sharp inflows into EM seen this year. Over a strategic horizon, however, it remains difficult to argue against owning a core structural allocation of EM hard currency debt within global fixed income portfolios, given the higher yields that are typically on offer and the fairly consistent historical outperformance over Developed Market (DM) debt. Although the benefits of EM in a portfolio context are slightly overstated given its skewed risk profile (i.e. fat negative tails) and high correlation with DM spread product, specifically U.S. high-yield corporates (Chart 2). Chart 1How Much Longer Can This Rally Last? How Much Longer Can This Rally Last? How Much Longer Can This Rally Last? Chart 2EM Debt Offers Little Diversification Benefits EM Debt Offers Little Diversification Benefits EM Debt Offers Little Diversification Benefits In this Special Report, we examine the long-term role of EM hard currency debt within a fixed-income portfolio, and re-iterate our case for being underweight EM debt on a cyclical basis. The Long-Run Case For Owning EM Debt: A Moderate Core Allocation Makes Sense It is not a stretch to say that EM debt has become the most important part of global bond portfolios in the 21st century. Having a significant EM allocation at the right time can make a bond manager's year, while having it at the wrong time can end a bond manager's career. But what is the "right" allocation to optimize the long-run contribution to returns in a global fixed income portfolio? To answer this question, we took a look at the historical performance of a global bond portfolio that consisted of both DM and EM debt (sovereign and corporate), looking for the combination that would maximize the risk-adjusted return of the portfolio. In our analysis, we ran calculations for two different time periods as the available index data for EM sovereign debt goes back to 1994, while EM corporate debt indices begin in 2002. For DM debt, we used a single index - the Bloomberg Barclays Global Aggregate - as this has a long history and is a common benchmark used by global bond managers that includes both DM sovereign and corporate debt. Though the sample size of our combined global portfolio is limited due to the shorter history of the EM corporates asset class, the findings generally align with our intuition. On a standalone basis, modern portfolio theory proposes that an individual asset should be included within a portfolio if its excess return divided by its standard deviation is higher than the excess return of the portfolio divided by the portfolio's standard deviation, multiplied by the correlation between the portfolio and the asset. Examining The Role Of EM Hard Currency Debt In Global Bond Portfolios Examining The Role Of EM Hard Currency Debt In Global Bond Portfolios Though the correlation to the DM portfolio from 2004 was fairly high for both assets at over 0.6, when we applied this formula, both EM sovereign and corporate debt warranted an allocation in a standard global fixed-income portfolio. EM sovereign debt scored higher, by offering a considerably better Sharpe ratio with only a minimally higher correlation to DM fixed income. While EM hard currency debt has fairly consistently outperformed the DM benchmark on a 12-month rolling basis, investors must be careful not to simply maintain large positions at all times. Obviously, the majority of fixed-income investors have volatility constraints that impose limits on credit allocations. Additionally, apart from simple volatility measures, EM debt has a "hidden" risk profile when looking at the higher moments of return distributions. Table 1EM Debt Returns Are##BR##Negatively Skewed Examining The Role Of EM Hard Currency Debt In Global Bond Portfolios Examining The Role Of EM Hard Currency Debt In Global Bond Portfolios Both EM sovereign and corporate credit historical returns have exhibited significant negative skewness and excess kurtosis, indicating a much higher-than-normal tendency of experiencing outsized, negative returns (Table 1). This is confirmed through Historical Value-at-Risk (VaR) analysis, where the 5% worst returns far eclipsed those of DM investment grade and government debt. Nevertheless, it is important to view EM from a holistic perspective. For example, an asset with a high standard deviation may be less desirable as a standalone investment, but can be highly beneficial if it enhances overall the returns of a portfolio while also reducing its volatility. We tested these "portfolio effects" of EM debt by creating 21 hypothetical portfolios. We began with a DM-only portfolio (consisting of the Global Aggregate index) and increased the weighting toward EM debt by one percentage point in each portfolio, with the last portfolio having a 20% weighting toward EM. The breakdown within EM was 62% corporates and 38% sovereigns based on the market capitalizations of the relevant benchmark indices. Our calculations indicate that the highest portfolio Sharpe ratio was achieved with a 5% EM debt allocation, which also happens to be the "neutral" weighting of EM debt in the BCA Global Fixed Income Strategy model portfolio benchmark index (Chart 3).2 Global bond investors should hover around this weighting on EM hard currency debt, absent a high conviction view on EM. Chart 3The Optimal EM Hard Currency Debt Allocation Is 5% Examining The Role Of EM Hard Currency Debt In Global Bond Portfolios Examining The Role Of EM Hard Currency Debt In Global Bond Portfolios So while the data suggests that EM hard currency debt warrants a long-term allocation, its beneficial impact on a fixed-income portfolio is at least slightly exaggerated. Portfolio managers are typically seeking out assets that can both improve return and decrease overall volatility, thereby increasing the efficiency of their portfolios. This was not the case with EM debt. In our study, increasing the EM allocation consistently raised both returns and volatility. Chart 4EM/DM Correlations Should Decline In 2018 EM/DM Correlations Should Decline In 2018 EM/DM Correlations Should Decline In 2018 This lack of diversification benefit is a result of the high correlation between EM hard currency debt and DM fixed income. Currently, the correlation between EM and DM (the Global Aggregate) is 0.90, near the upper end of its range, indicating that diversification benefits over the last year were essentially non-existent (Chart 4). Nevertheless, this relationship clearly exhibits a mean reversion tendency. That EM/DM correlation in recent years has been itself correlated to global growth and monetary policy changes. As we show in Chart 4, our diffusion index of OECD Leading Economic Indicators (LEI) - the number of countries with a rising LEI relative to those with a declining LEI - does tend to lead the EM/DM correlation and is currently pointing to a lower correlation as global growth becomes a little less synchronized in 2018. The same goes for the growth rate of major central bank balance sheets which is already slowing and will decelerate even more in 2018 on the back of a diminished pace of bond buying by the ECB and the Fed runoff of maturing bonds on its balance sheet. The conclusion is this - the EM/DM correlation should decline in 2018 but, as we discuss below, we think that happens through relative underperformance of EM credit. Bottom Line: EM hard currency debt, both sovereign and corporate, has consistently outperformed the broad global index. However, investors should steer clear of always maintaining maximum overweights given its weak volatility reduction benefits and a much higher-than normal tendency of experiencing outsized, negative returns. Our long-term analysis suggests a structural 5% allocation offers the best risk/reward potential. The Shorter-Run Case For Owning EM Debt: Will Macro Drivers Remain Supportive? So far in 2017, EM sovereign and corporate debt have been beneficiaries of robust global growth, a declining USD and a decoupling from a broader index of commodity prices. While we expect global growth will remain strong over the medium term, our outlook for the USD is still bullish and there is a risk that commodity prices and EM debt performance re-converge to the downside. Global growth will remain strong. Outside of a major global growth slowdown, which we currently view as a low probability event, a mass flight out of EM assets anytime soon is highly unlikely. Indicators such as the global PMI index, industrial production growth and the OECD leading economic indicator are all booming (Chart 5). Inflation will head higher on the back of rising oil prices, but the increase is likely to be gradual. Importantly, this is happening alongside global monetary conditions that remain generally accommodative, even with the Fed in a tightening cycle. Credit, both DM & EM, has historically performed well against this backdrop, as we discuss in the next section of this report. A renewed upleg in the USD bull market is already underway. The correlation between EM currencies and EM debt performance has recovered after breaking down during 2013-15 (Chart 6). Year-to-date, EM currency strength - the flipside of the weaker U.S. dollar - has been a major driver of EM relative performance. Using the IMF's measure real effective exchange rates based on unit labor costs, the U.S. dollar is fairly valued.3 Neutral valuations suggest that directional market indicators are driving currency movements. As the EM business cycle slows and the Fed ramps up its rate hikes in response to rising inflation, the USD cyclical bull market should resume. Chart 5Robust Global Growth##BR##Is Supportive For EM bca.gfis_sr_2017_11_01_c5 bca.gfis_sr_2017_11_01_c5 Chart 6Can EM Ignore Another##BR##Round Of USD Strength? Can EM Ignore Another Round Of USD Strength? Can EM Ignore Another Round Of USD Strength? The de-coupling between EM debt and commodity price movements is unsustainable. EM debt has experienced a strong rally since 2016 with only a moderate rise in commodity prices compared to past periods of EM strength. We view this decoupling to be temporary (Chart 7). Many sovereign EM issuers are commodity producers, suggesting that this divergence is unsustainable. EM sovereign and corporate debt will not be able to continue their massive rallies if commodity prices relapse. We maintain a bullish view on oil prices, but there are signals that base metal prices are at risk over the next 6-12 months. Chinese monetary authorities have tightened policy and the resulting sharp slowdown in money supply growth is a worrisome sign for Chinese demand for commodities (Chart 8).4 Chart 7EM-Commodity Divergence##BR##Is Unsustainable EM-Commodity Divergence Is Unsustainable EM-Commodity Divergence Is Unsustainable Chart 8China Downside Risks For##BR##Industrial Commodity Prices bca.gfis_sr_2017_11_01_c8 bca.gfis_sr_2017_11_01_c8 Bottom Line: While global growth will remain supportive of EM credit, currency weakness and a re-convergence with commodity prices present considerable headwinds. EM Debt Performance & The Fed Policy Cycle Chart 9The Fed Policy Cycle Examining The Role Of EM Hard Currency Debt In Global Bond Portfolios Examining The Role Of EM Hard Currency Debt In Global Bond Portfolios As more central banks are shifting to a tightening bias, investors are becoming increasingly concerned over policy normalization and its potential impact on credit market performance. Given the strong historical linkages between EM debt performance and Fed policy changes, the current U.S. tightening cycle looms as a major potential problem for EM assets. We have found it most useful to think about changes in Fed monetary policy and asset market performance in terms of breaking up the Fed policy into four distinct phases (Chart 9).5 These are characterized by both the level of interest rates (whether they are above or below "equilibrium") and the direction of policy changes (whether the Fed is raising or cutting rates):6 Phase 1 - the Fed is hiking while the fed funds rate is below equilibrium (i.e. monetary conditions are stimulative). Phase 2 - the Fed is hiking or keeping policy on hold while the fed funds rate is above equilibrium (i.e. monetary conditions are restrictive). Phase 3 - the Fed is cutting while the fed funds rate is above equilibrium (i.e. monetary conditions are restrictive). Phase 4 - the Fed is cutting rates while the fed funds rate is below equilibrium (i.e. monetary conditions are stimulative). For EM sovereign debt where we have index data going back to 1994, there have been four episodes of Phase 1 and three episodes of the other phases. For EM corporate debt, where the index data begins in 2002, there have been two episodes of Phases 1 and 4 and only one occurrence of Phases 2 and 3. We present the excess returns of EM debt relative to other major fixed income classes by phase in Table 2. In the limited sample, EM sovereign debt and corporate debt consistently outperformed the Global Aggregate index and most individual bond classes. However, relative to DM high-yield debt, which has the most comparable risk profile, EM sovereign bonds underperformed in Phase 1 and EM corporate debt underperformed in all phases. Table 2Relative EM Debt Performance Worsens As Fed Policy Tightens Examining The Role Of EM Hard Currency Debt In Global Bond Portfolios Examining The Role Of EM Hard Currency Debt In Global Bond Portfolios Excess returns for both EM debt classes were highest in Phase 4, where the central bank is easing while conditions are stimulative. Similar to other risk assets, EM debt also outperformed in Phase 1, where the central bank is tightening while rates are below equilibrium. This makes sense, as the early stages of monetary tightening typically occur in conjunction with stable, above-trend growth. Liquidity conditions are still stimulative in Phase 1, which provides a substantial tailwind for spread product performance. On the other end of the spectrum, EM debt excess returns were relatively low during Phase 2 and Phase 3, and even negative in the case of EM corporate debt for Phase 3. Surprisingly, EM debt has been less affected by the direction of U.S. interest rates than what we would have expected. Monetary easing in Phase 3 was not enough to substantially boost EM relative returns and tightening in Phase 1 did not derail growth or lift the USD enough for EM debt to underperform. In fact, because EM debt still offers robust excess returns during Phase 1 when the central bank is tightening, while also suffering during Phase 3 during central bank easing, we can conclude that the level of policy rates relative to equilibrium has a greater impact on returns than the direction of rates. The severity of the Global Financial Crisis and the relatively subdued pace of recovery for both growth and inflation led to one of the longest Phase 4s in history. Given the low level of starting yields, indicating a large gap to equilibrium, and the 'gradual' pace of normalization, the current Phase 1 should also last longer than it typically has. This bodes well for all credit sectors, including EM sovereign and corporate debt, if history is any guide. However, there are still reasons to be concerned about the impact of U.S. monetary policy on EM assets next year. If the Fed follows through with the interest rate hikes it is currently projecting - another 100bps in total by the end of 2018 - the funds rate will be much closer to equilibrium. If the U.S. dollar rallies alongside that Fed tightening, as we expect, overall U.S. monetary conditions could end up being much closer to a restrictive level than implied by strictly looking at our Fed Policy Cycle (which only looks at the funds rate to determine monetary conditions). Also, the equilibrium funds rate may now be lower than the levels we are assuming in the Fed Policy Cycle framework, suggesting that policy could turn restrictive more quickly in the current tightening cycle. Bottom Line: The Fed is still in the early stages of rate normalization. At this point in the Fed policy cycle, where the Fed is hiking rates but monetary conditions are still stimulative, EM hard currency debt has historically performed well both on a relative and absolute basis. Looking ahead, EM returns should begin to suffer in latter half of 2018 as the Fed moves to more restrictive policy stance. Another Reason For Caution: Our EM Corporate Health Monitor The BCA EM Corporate Health Monitor (CHM) is a directional indicator aimed at modeling the path of EM corporate spread movements. Financial data from 220 emerging market companies in over 30 countries is aggregated. Only firms that issue USD-denominated bonds are included, with banks and other financials also omitted in a similar fashion to the CHMs we have constructed for DM corporates. The indicator is made up of four financial ratios: profit margins, free cash flow to total debt, liquidity and leverage. Unlike the DM CHMs, the ratios are not equally weighted in the construction of the EM CHM. Profit margins and free cash flow to debt combined represent 75% of the EM CHM. The latest available reading is from Q2 2017, showing a large decrease, with the indicator now only barely in 'Improving Health' territory (Chart 10). This has occurred in tandem with EM corporate spreads narrowing to post-crisis lows, leaving EM debt at potentially overvalued levels on a fundamental basis. While this slowdown in the EM CHM is not yet a cause for concern, if this became an extended trend of financial health deterioration, the divergence with EM corporate debt performance would be unsustainable and leave EM corporates highly vulnerable to a correction. Chart 10The BCA EM Corporate Health Monitor Has Rolled Over EM Corporate Health Monitor Is Sending A 'Sell' Signal The BCA EM Corporate Health Monitor Has Rolled Over EM Corporate Health Monitor Is Sending A 'Sell' Signal The BCA EM Corporate Health Monitor Has Rolled Over EM Corporate Health Monitor Is Sending A 'Sell' Signal Bottom Line: Our EM Corporate Health Monitor has declined drastically and is barely in 'Improving Health' territory. This alone is not cause for concern yet, but further deterioration in our Monitor combined with additional credit spread narrowing would be a worrisome divergence. Investment Implications Emerging market debt is facing conflicting forces. While continued robust global growth and accommodative monetary policy provide a substantial tailwind for credit performance, extended valuations, the turn in the USD and a potentially worsening commodities outlook present difficult hurdles for EM to overcome. Given the mixed messages, we prefer owning cyclical credit exposure through DM corporate debt, particularly U.S. investment grade. EM debt yields have collapsed and are expensive relative to DM investment grade debt (Chart 11). Combined with a higher risk profile in EM, elevated valuations indicate that EM sovereign and corporate debt are vulnerable to larger corrections. From a return perspective, the difference in the corporate option-adjusted spreads (OAS) has been an excellent leading indicator for relative total returns (Chart 12). This differential indicates that there is considerable relative upside potential for U.S. investment grade over EM hard currency debt. Additionally, while global growth should support credit-related plays, relative growth dynamics are more supportive of U.S. investment grade because the next phase of the global growth upturn will be driven by DM countries and not EM. The difference between the manufacturing PMIs in the U.S. and EM has historically been a good directional indicator for the spread between U.S. corporate bond spreads and EM debt spreads (Chart 13). The gap between the relative manufacturing PMI readings is at a post-crisis high, and could widen further if EM economies suffer on the back of any pullback in Chinese growth in 2018. Chart 11EM Yields & Spreads Look Full Valued EM Yields & Spreads Look Full Valued EM Yields & Spreads Look Full Valued Chart 12Favor U.S. IG Over EM Corporates... Favor U.S. IG Over EM Corporates... Favor U.S. IG Over EM Corporates... Chart 13...Because Of Stronger U.S. Growth ...Because Of Stronger U.S. Growth ...Because Of Stronger U.S. Growth What are the risks to our view? Our recommended position would suffer in the event that inflation in the U.S. slows, keeping the Fed on hold and maintaining this year's USD downtrend. Also, if China were to ease up on its policy tightening, industrial commodity prices could strengthen once again. Under these scenarios, EM hard currency debt would likely outperform DM spread product. Bottom Line: Maintain moderate underweight positions in EM hard currency debt. Favor DM spread product (especially U.S. investment grade corporates) due to more supportive relative valuations and growth trends. Patrick Trinh, Associate Editor Global Fixed Income Strategy patrick@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 This “EM versus IG” trade was implemented in both our Emerging Markets Strategy and Global Fixed Income Strategy services. Please see BCA Emerging Markets Strategy Weekly Report, “EM: The Focus Is On Profits”, dated August 16th 2017, available at ems.bcaresearch.com, as well as the BCA Global Fixed Income Strategy Weekly Report, “A Lack Of Leadership”, dated August 22nd 2017, available at gfis.bcaresearch.com. 2 The weighting to EM debt in the Global Fixed Income Strategy model bond portfolio benchmark is based on market capitalizations of all the fixed income sectors we wanted to have in the benchmark, which includes non-investment grade debt like global high-yield corporates. It is reassuring to see that our benchmark weighting is also the desired weighting from a long-run portfolio optimization perspective. 3 Please see BCA Emerging Markets Strategy Weekly Report, "Is The Dollar Expensive, And Are EM Currencies Cheap?", dated October 11th, 2017, available at ems.bcaresearch.com. 4 Please see the joint BCA Global Asset Allocation/Emerging Markets Strategy Special Report, "Global Equity Allocation: The Underwhelming Case For EM", dated August 9th 2017, available at ems.bcaresearch.com & gaa.bcaresearch.com. 5 Please see BCA U.S. Bond Strategy Special Report, "Bonds And The Fed Funds Rate Cycle", dated May 27th 2014, available at usbs.bcaresearch.com. 6 The equilibrium policy rate is a BCA calculation based on long-run real potential GDP growth and long run inflation expectations.

Highlights Emerging Market (EM) hard currency debt, both sovereign and corporate, has consistently outperformed the broad global bond index. However, investors should steer clear of always maintaining maximum overweights to EM given its weak volatility reduction benefits and a much higher-than normal tendency of experiencing outsized, negative returns. Our long-term analysis suggests a structural 5% allocation offers the best risk/reward potential. The Fed is still in the early stages of rate normalization. At this point in the Fed policy cycle, where the Fed is hiking rates but monetary conditions are still stimulative, EM hard currency debt has historically performed well both on a relative and absolute basis. Looking ahead, EM returns should begin to suffer in latter half of 2018 as the Fed moves to more restrictive policy stance. While global growth will remain supportive of EM credit next year, renewed U.S. dollar strength and a re-convergence to the downside with commodity prices present considerable headwinds. Maintain an underweight stance on EM hard currency debt. Favor DM spread product due to more supportive relative growth trends and valuations. Feature Emerging market (EM) sovereign and corporate debt returns have surged in 2017, returning 9.4% and 7.5%, respectively (Chart 1). Investor interest has been renewed, with the latest IMF Financial Stability Report indicating that non-resident inflows of portfolio capital to EM countries have recovered since early 2016 and reached $205 billion for 2017 through August. Against a backdrop of above-trend global economic growth, monetary policy settings from the major central banks that are still accommodative, and some diminished risks from the world's geopolitical hotspots, the current uptrend for EM debt performance could continue. Nevertheless, we urge caution. We moved to a moderate underweight stance on EM hard currency debt back in August, while at the same time increasing our current recommended overweight to U.S. investment grade (IG) corporate debt on the other side of the trade.1 Even with synchronized global growth boosting both EM export demand and industrial commodity prices, we prefer U.S. credit exposure over EM at this point in the cycle, for several reasons: The massive flow-driven EM rally has resulted in not only outsized returns but stretched valuations, with EM debt spreads now back to post-2008-crisis low (or even through those levels for EM hard currency corporates) without any major improvement in EM fundamentals; The previously reliable correlation between EM debt and commodity prices, a long-time driver of EM performance, has broken down, bullishly, for EM - potentially another sign of flow-driven overvaluation; Growing uncertainty over the near-term China growth outlook raises risks on further gains in industrial commodity demand and EM exports; The USD will appreciate once again on the back of additional Fed interest rate hikes beyond levels currently discounted by markets, which could trigger some reversal of the sharp inflows into EM seen this year. Over a strategic horizon, however, it remains difficult to argue against owning a core structural allocation of EM hard currency debt within global fixed income portfolios, given the higher yields that are typically on offer and the fairly consistent historical outperformance over Developed Market (DM) debt. Although the benefits of EM in a portfolio context are slightly overstated given its skewed risk profile (i.e. fat negative tails) and high correlation with DM spread product, specifically U.S. high-yield corporates (Chart 2). Chart 1How Much Longer Can This Rally Last? How Much Longer Can This Rally Last? How Much Longer Can This Rally Last? Chart 2EM Debt Offers Little Diversification Benefits EM Debt Offers Little Diversification Benefits EM Debt Offers Little Diversification Benefits In this Special Report, we examine the long-term role of EM hard currency debt within a fixed-income portfolio, and re-iterate our case for being underweight EM debt on a cyclical basis. The Long-Run Case For Owning EM Debt: A Moderate Core Allocation Makes Sense It is not a stretch to say that EM debt has become the most important part of global bond portfolios in the 21st century. Having a significant EM allocation at the right time can make a bond manager's year, while having it at the wrong time can end a bond manager's career. But what is the "right" allocation to optimize the long-run contribution to returns in a global fixed income portfolio? To answer this question, we took a look at the historical performance of a global bond portfolio that consisted of both DM and EM debt (sovereign and corporate), looking for the combination that would maximize the risk-adjusted return of the portfolio. In our analysis, we ran calculations for two different time periods as the available index data for EM sovereign debt goes back to 1994, while EM corporate debt indices begin in 2002. For DM debt, we used a single index - the Bloomberg Barclays Global Aggregate - as this has a long history and is a common benchmark used by global bond managers that includes both DM sovereign and corporate debt. Though the sample size of our combined global portfolio is limited due to the shorter history of the EM corporates asset class, the findings generally align with our intuition. On a standalone basis, modern portfolio theory proposes that an individual asset should be included within a portfolio if its excess return divided by its standard deviation is higher than the excess return of the portfolio divided by the portfolio's standard deviation, multiplied by the correlation between the portfolio and the asset. Examining The Role Of EM Hard Currency Debt In Global Bond Portfolios Examining The Role Of EM Hard Currency Debt In Global Bond Portfolios Though the correlation to the DM portfolio from 2004 was fairly high for both assets at over 0.6, when we applied this formula, both EM sovereign and corporate debt warranted an allocation in a standard global fixed-income portfolio. EM sovereign debt scored higher, by offering a considerably better Sharpe ratio with only a minimally higher correlation to DM fixed income. While EM hard currency debt has fairly consistently outperformed the DM benchmark on a 12-month rolling basis, investors must be careful not to simply maintain large positions at all times. Obviously, the majority of fixed-income investors have volatility constraints that impose limits on credit allocations. Additionally, apart from simple volatility measures, EM debt has a "hidden" risk profile when looking at the higher moments of return distributions. Table 1EM Debt Returns Are##BR##Negatively Skewed Examining The Role Of EM Hard Currency Debt In Global Bond Portfolios Examining The Role Of EM Hard Currency Debt In Global Bond Portfolios Both EM sovereign and corporate credit historical returns have exhibited significant negative skewness and excess kurtosis, indicating a much higher-than-normal tendency of experiencing outsized, negative returns (Table 1). This is confirmed through Historical Value-at-Risk (VaR) analysis, where the 5% worst returns far eclipsed those of DM investment grade and government debt. Nevertheless, it is important to view EM from a holistic perspective. For example, an asset with a high standard deviation may be less desirable as a standalone investment, but can be highly beneficial if it enhances overall the returns of a portfolio while also reducing its volatility. We tested these "portfolio effects" of EM debt by creating 21 hypothetical portfolios. We began with a DM-only portfolio (consisting of the Global Aggregate index) and increased the weighting toward EM debt by one percentage point in each portfolio, with the last portfolio having a 20% weighting toward EM. The breakdown within EM was 62% corporates and 38% sovereigns based on the market capitalizations of the relevant benchmark indices. Our calculations indicate that the highest portfolio Sharpe ratio was achieved with a 5% EM debt allocation, which also happens to be the "neutral" weighting of EM debt in the BCA Global Fixed Income Strategy model portfolio benchmark index (Chart 3).2 Global bond investors should hover around this weighting on EM hard currency debt, absent a high conviction view on EM. Chart 3The Optimal EM Hard Currency Debt Allocation Is 5% Examining The Role Of EM Hard Currency Debt In Global Bond Portfolios Examining The Role Of EM Hard Currency Debt In Global Bond Portfolios So while the data suggests that EM hard currency debt warrants a long-term allocation, its beneficial impact on a fixed-income portfolio is at least slightly exaggerated. Portfolio managers are typically seeking out assets that can both improve return and decrease overall volatility, thereby increasing the efficiency of their portfolios. This was not the case with EM debt. In our study, increasing the EM allocation consistently raised both returns and volatility. Chart 4EM/DM Correlations Should Decline In 2018 EM/DM Correlations Should Decline In 2018 EM/DM Correlations Should Decline In 2018 This lack of diversification benefit is a result of the high correlation between EM hard currency debt and DM fixed income. Currently, the correlation between EM and DM (the Global Aggregate) is 0.90, near the upper end of its range, indicating that diversification benefits over the last year were essentially non-existent (Chart 4). Nevertheless, this relationship clearly exhibits a mean reversion tendency. That EM/DM correlation in recent years has been itself correlated to global growth and monetary policy changes. As we show in Chart 4, our diffusion index of OECD Leading Economic Indicators (LEI) - the number of countries with a rising LEI relative to those with a declining LEI - does tend to lead the EM/DM correlation and is currently pointing to a lower correlation as global growth becomes a little less synchronized in 2018. The same goes for the growth rate of major central bank balance sheets which is already slowing and will decelerate even more in 2018 on the back of a diminished pace of bond buying by the ECB and the Fed runoff of maturing bonds on its balance sheet. The conclusion is this - the EM/DM correlation should decline in 2018 but, as we discuss below, we think that happens through relative underperformance of EM credit. Bottom Line: EM hard currency debt, both sovereign and corporate, has consistently outperformed the broad global index. However, investors should steer clear of always maintaining maximum overweights given its weak volatility reduction benefits and a much higher-than normal tendency of experiencing outsized, negative returns. Our long-term analysis suggests a structural 5% allocation offers the best risk/reward potential. The Shorter-Run Case For Owning EM Debt: Will Macro Drivers Remain Supportive? So far in 2017, EM sovereign and corporate debt have been beneficiaries of robust global growth, a declining USD and a decoupling from a broader index of commodity prices. While we expect global growth will remain strong over the medium term, our outlook for the USD is still bullish and there is a risk that commodity prices and EM debt performance re-converge to the downside. Global growth will remain strong. Outside of a major global growth slowdown, which we currently view as a low probability event, a mass flight out of EM assets anytime soon is highly unlikely. Indicators such as the global PMI index, industrial production growth and the OECD leading economic indicator are all booming (Chart 5). Inflation will head higher on the back of rising oil prices, but the increase is likely to be gradual. Importantly, this is happening alongside global monetary conditions that remain generally accommodative, even with the Fed in a tightening cycle. Credit, both DM & EM, has historically performed well against this backdrop, as we discuss in the next section of this report. A renewed upleg in the USD bull market is already underway. The correlation between EM currencies and EM debt performance has recovered after breaking down during 2013-15 (Chart 6). Year-to-date, EM currency strength - the flipside of the weaker U.S. dollar - has been a major driver of EM relative performance. Using the IMF's measure real effective exchange rates based on unit labor costs, the U.S. dollar is fairly valued.3 Neutral valuations suggest that directional market indicators are driving currency movements. As the EM business cycle slows and the Fed ramps up its rate hikes in response to rising inflation, the USD cyclical bull market should resume. Chart 5Robust Global Growth##BR##Is Supportive For EM bca.gfis_sr_2017_11_01_c5 bca.gfis_sr_2017_11_01_c5 Chart 6Can EM Ignore Another##BR##Round Of USD Strength? Can EM Ignore Another Round Of USD Strength? Can EM Ignore Another Round Of USD Strength? The de-coupling between EM debt and commodity price movements is unsustainable. EM debt has experienced a strong rally since 2016 with only a moderate rise in commodity prices compared to past periods of EM strength. We view this decoupling to be temporary (Chart 7). Many sovereign EM issuers are commodity producers, suggesting that this divergence is unsustainable. EM sovereign and corporate debt will not be able to continue their massive rallies if commodity prices relapse. We maintain a bullish view on oil prices, but there are signals that base metal prices are at risk over the next 6-12 months. Chinese monetary authorities have tightened policy and the resulting sharp slowdown in money supply growth is a worrisome sign for Chinese demand for commodities (Chart 8).4 Chart 7EM-Commodity Divergence##BR##Is Unsustainable EM-Commodity Divergence Is Unsustainable EM-Commodity Divergence Is Unsustainable Chart 8China Downside Risks For##BR##Industrial Commodity Prices bca.gfis_sr_2017_11_01_c8 bca.gfis_sr_2017_11_01_c8 Bottom Line: While global growth will remain supportive of EM credit, currency weakness and a re-convergence with commodity prices present considerable headwinds. EM Debt Performance & The Fed Policy Cycle Chart 9The Fed Policy Cycle Examining The Role Of EM Hard Currency Debt In Global Bond Portfolios Examining The Role Of EM Hard Currency Debt In Global Bond Portfolios As more central banks are shifting to a tightening bias, investors are becoming increasingly concerned over policy normalization and its potential impact on credit market performance. Given the strong historical linkages between EM debt performance and Fed policy changes, the current U.S. tightening cycle looms as a major potential problem for EM assets. We have found it most useful to think about changes in Fed monetary policy and asset market performance in terms of breaking up the Fed policy into four distinct phases (Chart 9).5 These are characterized by both the level of interest rates (whether they are above or below "equilibrium") and the direction of policy changes (whether the Fed is raising or cutting rates):6 Phase 1 - the Fed is hiking while the fed funds rate is below equilibrium (i.e. monetary conditions are stimulative). Phase 2 - the Fed is hiking or keeping policy on hold while the fed funds rate is above equilibrium (i.e. monetary conditions are restrictive). Phase 3 - the Fed is cutting while the fed funds rate is above equilibrium (i.e. monetary conditions are restrictive). Phase 4 - the Fed is cutting rates while the fed funds rate is below equilibrium (i.e. monetary conditions are stimulative). For EM sovereign debt where we have index data going back to 1994, there have been four episodes of Phase 1 and three episodes of the other phases. For EM corporate debt, where the index data begins in 2002, there have been two episodes of Phases 1 and 4 and only one occurrence of Phases 2 and 3. We present the excess returns of EM debt relative to other major fixed income classes by phase in Table 2. In the limited sample, EM sovereign debt and corporate debt consistently outperformed the Global Aggregate index and most individual bond classes. However, relative to DM high-yield debt, which has the most comparable risk profile, EM sovereign bonds underperformed in Phase 1 and EM corporate debt underperformed in all phases. Table 2Relative EM Debt Performance Worsens As Fed Policy Tightens Examining The Role Of EM Hard Currency Debt In Global Bond Portfolios Examining The Role Of EM Hard Currency Debt In Global Bond Portfolios Excess returns for both EM debt classes were highest in Phase 4, where the central bank is easing while conditions are stimulative. Similar to other risk assets, EM debt also outperformed in Phase 1, where the central bank is tightening while rates are below equilibrium. This makes sense, as the early stages of monetary tightening typically occur in conjunction with stable, above-trend growth. Liquidity conditions are still stimulative in Phase 1, which provides a substantial tailwind for spread product performance. On the other end of the spectrum, EM debt excess returns were relatively low during Phase 2 and Phase 3, and even negative in the case of EM corporate debt for Phase 3. Surprisingly, EM debt has been less affected by the direction of U.S. interest rates than what we would have expected. Monetary easing in Phase 3 was not enough to substantially boost EM relative returns and tightening in Phase 1 did not derail growth or lift the USD enough for EM debt to underperform. In fact, because EM debt still offers robust excess returns during Phase 1 when the central bank is tightening, while also suffering during Phase 3 during central bank easing, we can conclude that the level of policy rates relative to equilibrium has a greater impact on returns than the direction of rates. The severity of the Global Financial Crisis and the relatively subdued pace of recovery for both growth and inflation led to one of the longest Phase 4s in history. Given the low level of starting yields, indicating a large gap to equilibrium, and the 'gradual' pace of normalization, the current Phase 1 should also last longer than it typically has. This bodes well for all credit sectors, including EM sovereign and corporate debt, if history is any guide. However, there are still reasons to be concerned about the impact of U.S. monetary policy on EM assets next year. If the Fed follows through with the interest rate hikes it is currently projecting - another 100bps in total by the end of 2018 - the funds rate will be much closer to equilibrium. If the U.S. dollar rallies alongside that Fed tightening, as we expect, overall U.S. monetary conditions could end up being much closer to a restrictive level than implied by strictly looking at our Fed Policy Cycle (which only looks at the funds rate to determine monetary conditions). Also, the equilibrium funds rate may now be lower than the levels we are assuming in the Fed Policy Cycle framework, suggesting that policy could turn restrictive more quickly in the current tightening cycle. Bottom Line: The Fed is still in the early stages of rate normalization. At this point in the Fed policy cycle, where the Fed is hiking rates but monetary conditions are still stimulative, EM hard currency debt has historically performed well both on a relative and absolute basis. Looking ahead, EM returns should begin to suffer in latter half of 2018 as the Fed moves to more restrictive policy stance. Another Reason For Caution: Our EM Corporate Health Monitor The BCA EM Corporate Health Monitor (CHM) is a directional indicator aimed at modeling the path of EM corporate spread movements. Financial data from 220 emerging market companies in over 30 countries is aggregated. Only firms that issue USD-denominated bonds are included, with banks and other financials also omitted in a similar fashion to the CHMs we have constructed for DM corporates. The indicator is made up of four financial ratios: profit margins, free cash flow to total debt, liquidity and leverage. Unlike the DM CHMs, the ratios are not equally weighted in the construction of the EM CHM. Profit margins and free cash flow to debt combined represent 75% of the EM CHM. The latest available reading is from Q2 2017, showing a large decrease, with the indicator now only barely in 'Improving Health' territory (Chart 10). This has occurred in tandem with EM corporate spreads narrowing to post-crisis lows, leaving EM debt at potentially overvalued levels on a fundamental basis. While this slowdown in the EM CHM is not yet a cause for concern, if this became an extended trend of financial health deterioration, the divergence with EM corporate debt performance would be unsustainable and leave EM corporates highly vulnerable to a correction. Chart 10The BCA EM Corporate Health Monitor Has Rolled Over EM Corporate Health Monitor Is Sending A 'Sell' Signal The BCA EM Corporate Health Monitor Has Rolled Over EM Corporate Health Monitor Is Sending A 'Sell' Signal The BCA EM Corporate Health Monitor Has Rolled Over EM Corporate Health Monitor Is Sending A 'Sell' Signal Bottom Line: Our EM Corporate Health Monitor has declined drastically and is barely in 'Improving Health' territory. This alone is not cause for concern yet, but further deterioration in our Monitor combined with additional credit spread narrowing would be a worrisome divergence. Investment Implications Emerging market debt is facing conflicting forces. While continued robust global growth and accommodative monetary policy provide a substantial tailwind for credit performance, extended valuations, the turn in the USD and a potentially worsening commodities outlook present difficult hurdles for EM to overcome. Given the mixed messages, we prefer owning cyclical credit exposure through DM corporate debt, particularly U.S. investment grade. EM debt yields have collapsed and are expensive relative to DM investment grade debt (Chart 11). Combined with a higher risk profile in EM, elevated valuations indicate that EM sovereign and corporate debt are vulnerable to larger corrections. From a return perspective, the difference in the corporate option-adjusted spreads (OAS) has been an excellent leading indicator for relative total returns (Chart 12). This differential indicates that there is considerable relative upside potential for U.S. investment grade over EM hard currency debt. Additionally, while global growth should support credit-related plays, relative growth dynamics are more supportive of U.S. investment grade because the next phase of the global growth upturn will be driven by DM countries and not EM. The difference between the manufacturing PMIs in the U.S. and EM has historically been a good directional indicator for the spread between U.S. corporate bond spreads and EM debt spreads (Chart 13). The gap between the relative manufacturing PMI readings is at a post-crisis high, and could widen further if EM economies suffer on the back of any pullback in Chinese growth in 2018. Chart 11EM Yields & Spreads Look Full Valued EM Yields & Spreads Look Full Valued EM Yields & Spreads Look Full Valued Chart 12Favor U.S. IG Over EM Corporates... Favor U.S. IG Over EM Corporates... Favor U.S. IG Over EM Corporates... Chart 13...Because Of Stronger U.S. Growth ...Because Of Stronger U.S. Growth ...Because Of Stronger U.S. Growth What are the risks to our view? Our recommended position would suffer in the event that inflation in the U.S. slows, keeping the Fed on hold and maintaining this year's USD downtrend. Also, if China were to ease up on its policy tightening, industrial commodity prices could strengthen once again. Under these scenarios, EM hard currency debt would likely outperform DM spread product. Bottom Line: Maintain moderate underweight positions in EM hard currency debt. Favor DM spread product (especially U.S. investment grade corporates) due to more supportive relative valuations and growth trends. Patrick Trinh, Associate Editor Global Fixed Income Strategy patrick@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 This “EM versus IG” trade was implemented in both our Emerging Markets Strategy and Global Fixed Income Strategy services. Please see BCA Emerging Markets Strategy Weekly Report, “EM: The Focus Is On Profits”, dated August 16th 2017, available at ems.bcaresearch.com, as well as the BCA Global Fixed Income Strategy Weekly Report, “A Lack Of Leadership”, dated August 22nd 2017, available at gfis.bcaresearch.com. 2 The weighting to EM debt in the Global Fixed Income Strategy model bond portfolio benchmark is based on market capitalizations of all the fixed income sectors we wanted to have in the benchmark, which includes non-investment grade debt like global high-yield corporates. It is reassuring to see that our benchmark weighting is also the desired weighting from a long-run portfolio optimization perspective. 3 Please see BCA Emerging Markets Strategy Weekly Report, "Is The Dollar Expensive, And Are EM Currencies Cheap?", dated October 11th, 2017, available at ems.bcaresearch.com. 4 Please see the joint BCA Global Asset Allocation/Emerging Markets Strategy Special Report, "Global Equity Allocation: The Underwhelming Case For EM", dated August 9th 2017, available at ems.bcaresearch.com & gaa.bcaresearch.com. 5 Please see BCA U.S. Bond Strategy Special Report, "Bonds And The Fed Funds Rate Cycle", dated May 27th 2014, available at usbs.bcaresearch.com. 6 The equilibrium policy rate is a BCA calculation based on long-run real potential GDP growth and long run inflation expectations.

Highlights The uptick in world oil demand in the wake of a strengthening global upturn - the first since the Global Financial Crisis (GFC) - coupled with continued production discipline by OPEC 2.0, will accelerate inventory draws, and lift prices above our previous expectation. Even though we expect - and model for - U.S. shale producers to step up drilling as a result, we are lifting our base case forecast for 2018 Brent and WTI to $65.15/bbl and $62.95/bbl, respectively. These estimates are up $5.51 and $5.98/bbl from our forecast last month.1 Energy: Overweight. Given our view (discussed below), we are taking profits on the long Dec/17 WTI call spread we recommended June 15 - long $50/bbl calls vs. short $55/bbl calls - on the close tonight. This position was up 116% Tuesday. We will replace this spread with long $55/bbl WTI calls vs. short $60/bbl WTI calls in Jul/18 and Dec/18. Base Metals: Neutral. We closed our short Dec 2016 copper trade last week, after our trailing-stop of $3.10/lb was elected, with a 0.75% return. Our trade was up 6% by the end of September, however bullish data in October - including an earthquake in Chile and worries over a potential metal shortage in China - lifted prices back up. Chinese copper import data showed a 26.5% year-on-year (yoy) jump in September. Even so, we expect copper imports to end 2017 with a yoy decline. Precious Metals: Neutral. Palladium continues to trade premium to platinum following its breakout at the end of September. We expect this to continue, given the supply-demand fundamentals we highlighted in June.2 Ags/Softs: Neutral. The USDA's latest World Agricultural Supply and Demand Estimates (WASDE) is supportive of our grains view - projections for 2017/18 wheat ending inventories were revised upward, while corn and soybeans stock estimates were lowered. Our long corn vs. short wheat position recommended October 5 is up 1.5% (please see p. 8 for further discussion.) Feature The global uptick in GDP growth noted this month by the IMF, along with continued production discipline from OPEC 2.0 - the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia - will lift 2018 average Brent and WTI prices to $65.15/bbl and $62.95/bbl, respectively. These estimates are up $5.51 and $5.98/bbl from our forecast last month (Chart of the Week). Chart of the WeekHigher Demand, Lower Supply,##BR##Tighter Inventories Lift Prices Higher Demand, Lower Supply, Tighter Inventories Lift Prices Higher Demand, Lower Supply, Tighter Inventories Lift Prices We expect the fortuitous combination of fundamentals - for oil producers, that is - to accelerate the drawdown in oil inventories globally, which also will be supportive for prices (Chart 2). This, in turn, will set off a new round of U.S. shale-oil production, which will temper the price rise we expect, but still force inventories to draw harder than expected (Chart 3). Our base case calls for OPEC 2.0 to extend its 1.8mm b/d production cutting deal to end-June 2018, and for compliance within the KSA-Russia-led coalition to remain strong. OPEC 2.0 member states compliance with self-imposed quotas stood at 106% of agreed cuts, according to a state-by-state tally published by S&P's Global Platts earlier this month.3 Iraq continues to flaunt its OPEC 2.0 production quota, at 4.54mm b/d by our estimate, or 153k b/d over its quota. OPEC as a whole is producing 32.74mm b/d of crude oil, by our reckoning, vs. Platts' estimate of 32.66mm b/d. We have Libya and Nigeria, which are not parties to the OPEC 2.0 Agreement, producing 930k b/d and 1.71mm b/d last month, vs. Platts' estimates of 910k b/d and 1.84mm b/d, respectively (Table 1). KSA and Russia continue to lead OPEC 2.0 by example, with the former's crude oil production coming in at 9.97mm b/d in September, vs. 9.95mm b/d in August; the latter's total liquids production was 11.12mm b/d, vs. 11.13mm in August (Chart 4). Chart 2Market Will Get##BR##Tighter Sooner Market Will Get Tighter Sooner Market Will Get Tighter Sooner Chart 3BCA Expects Sharper##BR##Inventory Draw Than EIA BCA Expects Sharper Inventory Draw Than EIA BCA Expects Sharper Inventory Draw Than EIA Chart 4KSA And Russia Continue##BR##Providing Leadership To OPEC 2.0 KSA And Russia Continue Providing Leadership To OPEC 2.0 KSA And Russia Continue Providing Leadership To OPEC 2.0 Global GDP, Oil Demand Growth Strengthens The IMF earlier this month raised its forecast for global GDP growth this year to 3.6% and to 3.7% for next year, up 0.1% for each year vs. previous forecasts. In its analysis, the Fund drew attention to: Notable pickups in investment, trade, and industrial production, coupled with strengthening business and consumer confidence, are supporting the recovery. With growth outcomes in the first half of 2017 generally stronger than expected, upward revisions to growth are broad based, including for the euro area, Japan, China, emerging Europe, and Russia. These more than offset downward revisions for the United States, the United Kingdom, and India.4 On the back of the IMF's revised global growth estimates, we lifted our 2017 and 2018 oil demand expectation to just under 47.5mm b/d on average for the OECD and to just under 52mm b/d for non-OECD economies (Table 1). This translates into global demand growth of 1.65mm b/d in 2017 and 1.69mm b/d in 2018. Notably, we expect global demand to exceed 100mm b/d on average next year in our base case. Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Oil Forecast Lifted As Markets Tighten Oil Forecast Lifted As Markets Tighten Our estimated demand is driven by global growth projections, particularly for EM economies, which make up the bulk of demand and growth in our balances estimates (Table 1). And, as before, our estimates remain above the EIA's (Chart 5). The indicators we look at to confirm or refute our demand assessment - global trade, particularly EM imports, and manufacturing - remain strong. Global trade continues to expand, particularly in EM ex-Middle East and Africa, as does manufacturing globally, both of which supports the IMF's assessment of growth generally (Charts 6 and 7). Rising incomes lead to rising trade, and also to increased oil and base metals consumption in EM economies. Chart 5We Continue To##BR##Estimate Higher Demand Than The EIA We Continue To Estimate Higher Demand Than The EIA We Continue To Estimate Higher Demand Than The EIA Chart 6Rising Trade Volumes##BR##Support Growth Story ... Rising Trade Volumes Support Growth Story ... Rising Trade Volumes Support Growth Story ... Chart 7... Expanding Manufacturing##BR##Does, Too .. Expanding Manufacturing Does, Too .. Expanding Manufacturing Does, Too Higher Prices, Greater USD Risk Expected In 2018 Given the upward revisions to global growth and our expectation OPEC 2.0 compliance will remain fairly stout, our baseline forecast now calls for WTI prices to average $56.40/bbl in 4Q17 and $62.95/bbl in 2018. Brent is expected to average $58.40/bbl in 4Q17 and $65.15/bbl next year (Chart 1 and Table 2). These estimates are up from last month's averages of $54.89 and $57.44/bbl for 4Q17 and 2018 WTI, and $56.67 and $59.17/bbl for 4Q17 and 2018 Brent.5 Our increasing bullishness is tempered by the risk of a stronger USD, particularly the broad trade-weighted USD index, which captures EM currency weakness. With the Fed set on a course to lift rates - our House view anticipates a Dec/17 rate hike and two or three hikes next year - and the oil market getting fundamentally tighter, we have seen the oil-USD linkage being re-established recently (Chart 8). Table 2Upgrading Our##BR##Price Forecasts Oil Forecast Lifted As Markets Tighten Oil Forecast Lifted As Markets Tighten Chart 8Expect The USD To Be Less##BR##Determinant For Oil Prices Expect The USD To Be Less Determinant For Oil Prices Expect The USD To Be Less Determinant For Oil Prices The persistent negative correlation between oil prices and the USD broke down following the global asset sell-off in 1Q16. However, this relationship converged to its long-term equilibrium in recent months. In our view, this reflects market participants' increasing conviction - expressed in market-cleared prices - that OPEC 2.0 will maintain its supply-management accord for an extended period, and that supply is now stabilizing. With demand remaining robust as the global synchronized upturn continues, the fundamental side of price determination has stabilized, and financial variables once again will strongly influence oil prices at the margin. Given our view the USD will trade off interest-rate differentials going forward, and our expectation that U.S. rates are set to increase relative to other systemically important rates, the USD likely will appreciate over the next 12 months. This will be a headwind for oil prices, and may be an additional factor OPEC 2.0 member states have to account for in 2018. Bottom Line: We are raising our price forecast for 4Q17 and 2018 in line with our expectation for stronger global growth and continued strong compliance from OPEC 2.0. With markets getting tighter, we expect the USD to become more important to the evolution of oil prices in 2018. Ag Update: Stay Long Corn, Short Wheat Global grain fundamentals continue to be supportive to our long corn vs. short wheat position, recommended October 5. The USDA's latest WASDE are projecting higher 2017/18 ending wheat inventories, while corn and soybeans stock estimates were lowered (Chart 9).6 Chart 9Fundamentals Support Long Corn##BR##Vs. Short Wheat Trade Fundamentals Support Long Corn Vs. Short Wheat Trade Fundamentals Support Long Corn Vs. Short Wheat Trade The USDA lowered its expected global corn stocks-to-use ratio, and increased its wheat stocks-to-use ratio for the current crop year. Revisions to the estimates for the 2016/17 crop year also reflect similar dynamics. We expected this going into the WASDE report at the beginning of the month when we published our Special Report on the Ag markets, and got long corn vs. short wheat. December 2017 corn futures traded on CME are up 0.14% since October 5, while wheat futures are down 1.36%. This brings the return on our long corn/short wheat trade to 1.5%, to date. Highlights from the current WASDE include: Upward revisions to wheat production from India, the EU, Russia, Australia, and Canada more than offset greater projected global demand, most notably from India and the EU. Overall, global ending stocks were revised up by 4.99mm MT, and are projected to stand at 268mm MT by the end of the 2017/18 marketing year. Greater projected corn demand, most notably from the U.S. and China, more than offset the ~ 6mm MT upward revision to global production in the USDA's estimates. Higher projected Chinese demand reflects greater food and seed demand, and higher expected industrial use. Corn stocks are expected to end 2017/18 at 200.96mm MT - 1.51mm MT below September projections. Similarly, in its October Chinese Agricultural Supply and Demand Estimates, China's Agriculture Ministry increased its forecast for the 2017/18 corn deficit to 4.31mm MT from 0.89mm MT projected last month. The Ministry expects lower output and greater consumption on the back of stronger demand from ethanol plants.7 Furthermore, in a move towards market pricing, Heilongjiang - China's top corn province - will be reducing the subsidy it gives corn farmers from 153.92 yuan/mu last year to 133.46 yuan/mu. The province will reorient its subsidies to incentivize more soybean production.8 In soybean markets, USDA projections for ending stocks were reduced by 1.48mm MT to 96.05mm MT by end-2017/18, largely on the back of lower expected U.S. and Brazilian inventories in 2016/17. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com Hugo Bélanger, Research Assistant HugoB@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report "OPEC 2.0 Will Extend Cuts To June 2018," published September 21, 2017. It is available at ces.bcaresearch.com. 2 Please see "Precious Metals Update," in the June 29, 2017 issue of BCA Research's Commodity & Energy Strategy Weekly Report "EM Trade Volumes Continue Trending Higher, Supporting Metals". It is available at ces.bcaresearch.com. 3 Please see S&P Global Platts OPEC Guide published October 6, 2017. 4 Please see Chapter 1 of the IMF's World Economic Outlook for October 2017, which is available online at https://www.imf.org/en/Publications/WEO/Issues/2017/09/19/world-economic-outlook-october-2017. 5 Our base case continues to call for an end-June 2018 extension of the OPEC 2.0 production deal. Should the deal be extended to end-December 2018, we estimate 2018 WTI prices would average $67.35/bbl, while Brent prices would average just under $70.00/bbl. We are becoming increasingly confident OPEC 2.0 will become a durable production-management coalition, given the increasing cooperation and mutual investment between KSA and Russia. We will be exploring this further in future research. Please see "King Salman Goes To Moscow, Bolsters OPEC 2.0," published October 11, 2017, by BCA Research's Energy Sector Strategy. It is available at nrg.bcaresearch.com. 6 Please see Commodity & Energy Strategy Special Report titled "Ags In 2017/18: Move To Neutral," dated October 5, 2017, available at ces.bcaresearch.com. 7 Please see "China Raises Forecast For 2017/18 Corn Deficit On Lower Output," dated October 12, 2017, available at reuters.com. 8 Please see "Top China Corn Province Cuts Subsidy For Farmers Growing the Grain," dated October 16, 2017, available at reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Oil Forecast Lifted As Markets Tighten Oil Forecast Lifted As Markets Tighten Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights Looking into 2018, the major risk factors driving gold - inflation and inflation expectations; fiscal and monetary policy; and geopolitics - will, on balance, continue to favor gold as a strategic portfolio hedge. We expect gold will provide a good hedge against rising inflation. However, this will be partially mitigated by Fed rate hikes next year. On the back of tighter U.S. monetary policy, our macroeconomists expect a recession by 2H19, possibly earlier in 2019, which likely would be sniffed out by equity markets as early as 2H18. Our analysis indicates gold will provide a good hedge against this expected recession and the associated equity bear market.1 Lastly, geopolitical risks from (1) U.S.-North Korea tensions, (2) trade protectionism of the Trump administration and (3) ongoing conflicts in the Middle East will support gold prices next year, given the metal's safe-haven properties. Energy: Overweight. At the end of 3Q17, our open energy recommendations were up 45%, led by our long Dec/17 WTI $50/bbl vs. $55/bbl Call spread. We closed out our long Brent recommendations in 3Q17 for an average gain of 116%. (Please see p. 13 for a summary of trades closed in 3Q17). Base Metals: Neutral. Our tactical short Dec/17 copper position ended 3Q17 up 6%. We are placing a trailing stop at $3.10/lb. Precious Metals: Neutral. Our long gold portfolio hedge ended 3Q17 up 4.3%. The balance of risks continues to favor this as a strategic position, which we discuss below. Ags/Softs: Neutral. We lifted our weighting on ags - particularly grains - to neutral last week. Our long corn/short wheat position is up 1.2%. Feature Chart of the WeekInflation And U.S. Financial Variables##BR##Explain Gold Prices Inflation And U.S. Financial Variables Explain Gold Prices Inflation And U.S. Financial Variables Explain Gold Prices Inflation and U.S. financial variables - particularly the USD broad trade-weighted index (TWIB), and real rates - are the main factors explaining the evolution of gold prices (Chart of the Week).2 Subdued inflation and low unemployment - a decoupling of the so-called Phillips Curve relationship that drives central-bank models of the macroeconomy - have dominated the macro landscape this year (Chart 2). We expect that current low inflation, positive growth, and low interest rates will remain in place for the next 12 months (Chart 3). Although economies such as the U.S. are growing above trend, inflation has remained weak due to a redistribution of demand through imports from countries with spare capacity, according to BCA's Global Investment Strategy.3 This is expected to continue in the near term to end-2018. However, we expect the USD to gradually strengthen, as the Fed cautiously normalizes policy rates, while other systemically important central banks remain accommodative relative to the U.S. central bank (Chart 4). Further falls in the unemployment rate will push the U.S. economy into the steep end of the Phillips Curve. Weak capex in the post-Global Financial Crisis (GFC) era means demand for labor will increase as low unemployment - and associated higher wages - encourage higher consumer spending. This will cause inflation to lift next year or early 2019. Chart 2A Decoupling Of The Phillips Curve Relationship? Balance Of Risks Favors Holding Gold Balance Of Risks Favors Holding Gold In such an environment, any U.S. tax cuts - which we still expect by the end of 1Q18 - will simply add fuel to the inflationary fire, and lift inflation expectations for next year and beyond. As BCA's Geopolitical Strategy team puts it, the tax cuts are a "form of modest stimulus ... (which), this far into the economic cycle, could have a significant effect."4 With unemployment at or below levels consistent with full employment in the U.S. and little slack of any sort, it would not take much in the way of fiscal stimulus to further pressure inflation. Chart 3No Pressure From Inflation Or U.S. Financial##BR##Variables...For Now No Pressure From Inflation Or U.S. Financial Variables...For Now No Pressure From Inflation Or U.S. Financial Variables...For Now Chart 4A Strengthening U.S. Dollar Will##BR##Keep The Pressure Off Gold A Strengthening U.S. Dollar Will Keep The Pressure Off Gold A Strengthening U.S. Dollar Will Keep The Pressure Off Gold Inflation vs. Fed Hikes In the face of the rising inflation we expect next year, gold's appeal will increase. As our previous research reveals, gold's correlation with inflation is strengthened during periods of low real rates, i.e., the difference between nominal rates and inflation. This is a perfect context for gold. However, gold's ability to hedge inflation risks to portfolios will be partially hampered by a more-hawkish Fed. As inflation finally takes off, the Fed will feel confident to hike rates more aggressively. More than anything, this will put a bid under the USD, as U.S. interest-rate differentials vs. other currencies rise in favor of the dollar. In addition, real rates will rise as the Fed gains confidence it can lift policy rates without doing serious harm to the U.S. economy, and follows thru with its normalization. Thus, the gold market will be facing two opposing forces: On the one hand, gold will be an attractive inflation hedge as inflationary pressures build up. On the other, as the Fed begins to tighten to respond to those inflationary pressures, gold will lose its appeal in the face of rising real rates and a strong dollar. Chart 5Fed Will Ease Pressure Off Gold##BR##If It Gets Ahead Of Inflation Fed Will Ease Pressure Off Gold If It Gets Ahead Of Inflation Fed Will Ease Pressure Off Gold If It Gets Ahead Of Inflation The timing of the Fed's rate hikes will be critical to the evolution of gold prices next year and beyond. We previously assumed that rate hikes will remain behind wage growth, which would be supportive of gold prices as inflation picks up. However, if the Fed begins hiking ahead of any realized uptick in inflation, this would create a stronger-than-expected headwind for gold (Chart 5). While we expect inflation to take off in 2H18, our House view calls for 2 to 3 hikes by then. This is a risk to our gold view. Longer term, Fed rate hikes could trigger a feedback loop that will make it difficult for the U.S. central bank policy to support low unemployment rates. As real rates rise, increased unemployment will lead households to spend less. Lower demand will force firms to reduce hiring. The accompanying slowing of U.S. growth will disseminate to the rest of the world, pushing the global economy into a shallow recession as early as 2H19. In all likelihood, this higher-inflation/higher-policy-rate period will be sniffed out by equity markets before the economy actually enters a recession, leading to a bear market. Somewhat counterintuitively, this will favor gold as a portfolio hedge, as we discuss below. Bottom Line: As U.S. unemployment continues falling, inflation will re-emerge, as predicted by the Philips Curve trade-off so important to central-bank policy. Gold then will face two opposing forces. Its inflation hedging properties will be partially hamstrung by rising real U.S. rates and a strengthening USD. Nevertheless, we will turn bullish gold towards the end of next year as signs of an equity bear market emerge. Gold Will Outperform In An Equity Bear Market Our modelling indicates gold is an exceptional safe-haven during downturns in equity markets.5 It is especially attractive in equity bear markets because its returns during such episodes are negatively correlated with the U.S. stock market. This relationship with equities does not hold in bull markets -- gold prices typically rise during such periods, but at a slower rate than equities (Table 1). Table 1Gold's Ability To Hedge U.S. Equities Balance Of Risks Favors Holding Gold Balance Of Risks Favors Holding Gold In a Special Report titled "Safe Havens: Where To Hide Next Time?" BCA's Global Asset Allocation Strategy team looked at the performance of nine safe-haven assets and found, on average, they are negatively correlated with equities in every bear market since 1972.6 Although the current equity bull market still has room to run, recessions and bear markets tend to coincide (Chart 6). If the economy goes into recession in 2H19, equities could peak as early as the end of next year.7 Chart 6Bear Markets Usually Precede Recessions Bear Markets Usually Precede Recessions Bear Markets Usually Precede Recessions Gold's role as a global portfolio hedge during bear markets would thus support the hypothesis that the metal could enter a bull market as soon as end-2018 when equity markets start pricing in a recession (Chart 7). Things could get interesting at this point, since a clear indication the economy is entering into a recession likely will cause "traumatized" central bankers to turn overly dovish. This would add support to the gold market longer term.8 Chart 7Gold Outperforms During Recessions##BR##And Geopolitical Crises Balance Of Risks Favors Holding Gold Balance Of Risks Favors Holding Gold Correlations between safe havens decline during bear markets, as our GAA strategists found when they compared correlations by dividing the assets into three "buckets": currencies, inflation hedges, and fixed-income instruments. In this analysis, our GAA team found that gold outperformed TIPS and Farmland in the inflation-hedge bucket.9 Bottom Line: Gold is an exceptional hedge against downturns in equity markets. The bear market preceding the late-2019 recession we expect will put a bid under gold. The eventual turn to the dovish side by central bankers will further support the metal. Gold Will Hedge Geopolitical Risks A confluence of elevated geopolitical risks next year will drive part of gold's performance. BCA's Geopolitical Strategy (GPS) group has highlighted the following three themes investors need to track going into next year: U.S.-China Tensions: Our geopolitical strategists believe that the Korean conflict is a derivative of a more important secular trend of U.S.-China tensions. They estimate the risk of total war on the Korean peninsula at less than 3% and believe that the market impact of North Korea's provocations has peaked in the late summer. Nevertheless, they warn against complacency, as the underlying tensions over Pyongyang's nuclear program remain unresolved and North Korea could break with its past patterns.10 If the North stages attacks against U.S. or Japanese assets, or international shipping or aircraft, for instance, it could cause a larger safe-haven rally than what we witnessed earlier this year. At the very least, geopolitically induced volatility may return as U.S. President Trump tries to convince the world that war is a real option - a critical condition for establishing a "credible threat" of war with which to influence North Korean behavior - and as the U.S. and China spar over other issues. Trump's protectionism: Trump's campaign promised significant trade-protectionism. While he has not yet acted on those promises, the risk is that he returns to them next year.11 These policies could impact the gold market by: a. Feeding fears that the United States is abandoning the global liberal order; b. Intensifying U.S. trade tensions and strategic distrust with China; c. Pressuring U.S. domestic inflation via higher import prices. This risk will become even more elevated if the Trump administration and Congress fail to pass any tax legislation this year. Our geopolitical strategists believe that such a failure, while not their baseline scenario, would drive Trump to focus on his foreign policy and trade agenda more intently, especially ahead of the midterm elections in November next year, which would increase safe-haven flows. 3. Mideast Troubles: While we are not alarmist about the Middle East, the risk of market-relevant conflicts will be higher over the coming 12 months than over the previous year, following the fall of ISIS. The latter gave reason for various regional powers to cooperate, while its absence will revive their grievances with each other. Kurdish assertiveness is a key consequence, highlighted by last month's Kurdish independence referendum.12 Iraqi forces have pushed ISIS out of major Iraqi cities and the slowdown in the fight against ISIS could push Iraqi forces to focus on regaining the province of Kirkuk. Kirkuk, which is home to major oil fields and reserves, has been under Kurdish control since 2014 when the Peshmerga forces there captured it from ISIS. As ISIS ceases to be a threat, Baghdad will try to regain control of these precious oil fields. The Kurdish conflict, as well as Trump's pressure tactics against Iran, will increase geopolitical risks in oil-producing (hence market-relevant) areas. Chart 82017 Risks Were Overstated 2017 Risks Were Overstated 2017 Risks Were Overstated In a recent study investigating how different "safe-havens" assets react to political and financial events, our GPS colleagues found that gold provides the best average returns following a major geopolitical event (Chart 7).13 Our House geopolitical view has maintained that political risks in 2017 were overstated. This was particularly the case in Europe, where much of the risk was exaggerated and merely the product of linear extrapolation from the outcomes of the U.K. referendum on EU membership and the U.S. presidential election. As such, we do not expect any European break-up risk to support gold prices next year. Although elevated Italian Euroscepticism is one lingering European risk that could impact gold markets, we see this as a long-term risk rather than a market catalyst arising from the Italian general election in May next year. Reflecting our view, the policy uncertainty index has fallen drastically in the last two months (Chart 8). Bottom Line: Elevated political risks in 2018 will further support the gold market. Most notable on our geopolitical strategists' minds are continued U.S.-China tensions (most notably over Korea), Trump's protectionist policies, and potential conflicts in the Middle East. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com Hugo Bélanger, Research Assistant HugoB@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report "Go Long Gold As A Strategic Portfolio Hedge," dated May 4, 2017, available at ces.bcaresearch.com. 2 Our results show 1% increase in U.S. YoY CPI, 5 year real rates, and USD TWI are associated with a 4% increase, 0.18% decline and a 0.21% decline in gold prices, respectively. The adjusted R2 is 0.88. 3 Please see the Global Investment Strategy Outlook "Fourth Quarter 2017: Goldilocks And The Recession Bear," dated October 4, 2017, available at gis.bcaresearch.com. 4 Please see Geopolitical Strategy Weekly Report "Is King Dollar Back," dated October 4, 2017, available at gps.bcaresearch.com. 5 We use the S&P 500 Total Return (TR) index as a proxy for U.S. equities. 6 Please see Global Asset Allocation Special Report "Safe Havens: Where To Hide Next Time?," dated April 21, 2017, available at gaa.bcaresearch.com. 7 Please see Global Asset Allocation Quarterly Portfolio Outlook, dated October 2, 2017, available at gaa.bcaresearch.com. 8 Please see the Global Investment Strategy Outlook "Fourth Quarter 2017: Goldilocks And The Recession Bear," dated October 4, 2017, available at gis.bcaresearch.com. 9 Please see Global Asset Allocation Special Report "Safe Havens: Where To Hide Next Time?," dated April 21, 2017, available at gaa.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Weekly Report, "Insights From The Road - The Rest Of The World," dated September 6, 2017, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 12 Armed conflict in the Middle East usually lead to a sharp rally in gold prices. Please see Table 1 from Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?," dated August 16, 2017, available at gps.bcaresearch.com. 13 Please see Geopolitical Strategy Special Report, "Geopolitics And Safe Havens," dated November 11, 2015, available at gps.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Balance Of Risks Favors Holding Gold Balance Of Risks Favors Holding Gold Trades Closed in 2017 Summary of Trades Closed in 2016