Correlations

Highlights The basic conditions that the U.S. Treasury utilizes to evaluate its major trade partners do not justify labeling China as a currency manipulator. Even if China were officially declared as a manipulator, the remedial measures that the Treasury must follow under the existing legal framework are materially insignificant for a country like China. Trade friction between the U.S. and China may increase with product-specific tariffs, but that a broader escalation in protectionism is unlikely, at least in the near term. The changing correlation between the RMB and Chinese stocks suggests that investors may be becoming less worried about the RMB and China's foreign exchange policy. Over the long run, the "normal" negative correlation between the performance of exchange rate and that of the stock market should also emerge with regards to the RMB and Chinese stocks. Feature Financial markets will continue to grapple with what U.S. President-elect Donald Trump will bring to the global economy as we head into the final trading weeks of 2016. His signature policy proposals - fiscal stimulus, a more restrictive immigration policy, and trade protectionism - have already led to a significant repricing of risk asset, and will continue to unsettle investors. As far as China is concerned, the upshot is that more fiscal stimulus under President Trump will generate stronger American demand, which could spill over to China. The downside risk is undoubtedly protectionism, which will cast a long shadow on an economy that is still heavily dependent on overseas markets.1 President-elect Trump declared on the campaign trail that he would name China a currency manipulator on his first day in office, accompanied by punitive tariffs on Chinese imports that could reach 45%. This adds a major uncertainty to the growth outlook for China next year. Conditions And Remedies For A Currency Manipulator For now, it is impossible to predict what President Trump will do. He has become notably more pragmatic since his election victory. In his first policy statement, he declared his intentions to withdraw the U.S. from the Trans-Pacific Partnership (TPP) negotiations as his top priority on trade, while avoiding further China-bashing. However, the true color of his trade policy remains unclear. What is more certain is that the basic conditions that the U.S. Treasury utilizes to evaluate its major trade partners do not justify labeling China as a currency manipulator. The existing Treasury review process of foreign exchange practices is a formal process laid out in statutory law that governs the reporting process, the need for negotiations in cases of manipulation, and the recommended trade remedies if negotiations fail. Specifically, there are three conditions a nation must meet to be labeled a currency manipulator: It runs a significant bilateral trade surplus with the U.S.; It has a material current account surplus; and It has engaged in persistent one-sided intervention in the foreign exchange market. In China's case, the country does run a significant bilateral trade surplus with the U.S., but its current account surplus as a share of GDP has declined from a peak of 10% in 2007 to 2.5% currently (Chart 1). More importantly, while China's foreign exchange market intervention has indeed been one-sided since 2014, the effort has been to prop up the RMB against the dollar. Without the PBoC's intervention, the RMB would have fallen further, potentially substantially. The RMB may have met all three criteria for currency manipulation before the global financial crisis, but the case is a lot harder to make at the moment. Chart 1Conditions For A Currency Manipulator Conditions For A Currency Manipulator Conditions For A Currency Manipulator Moreover, even if China were officially declared as a manipulator, the remedial measures that the Treasury must follow under the existing legal framework are materially insignificant for a country like China. The U.S. Treasury is required to negotiate with alleged currency manipulators, utilizing several "sticks" if negotiations fail: Prohibit the Overseas Private Investment Corporation from financing (including providing insurance to) new projects in that country; Prohibit the federal government from procuring from that country; Seek additional surveillance of the macroeconomic and exchange rate policies of that country through the International Monetary Fund; Take into account the currency practices in negotiating new bilateral or regional trade agreements with that country. While these "sticks" may be intimidating enough for small open economies, for a country like China, they are largely irrelevant. There is no ongoing negotiation for bilateral trade agreement between the two countries, and on a federal level the U.S. government rarely procures in China, if at all. Therefore, labeling China a currency manipulator may be a highly symbolic move aimed at satisfying Trump supporters, but the real economic consequences are rather small. To be sure, the U.S. president has enough administrative authority to bypass existing legal constraints and take unilateral action on trade issues. However, that would require extraordinary political capital. Barring this rather "extreme" scenario, we expect trade frictions between the U.S. and China to increase in the form of product-specific tariffs. A broader escalation in protectionism is unlikely, at least in the near term. The Impact On Investment Flows From a balance-of-payment point of view, a country running a trade deficit should not be viewed as a sign that it is losing in bilateral trade. Rather, it reflects capital flows from a surplus country to a deficit country in the form of exported domestic savings. In this vein, China running a chronic current account surplus with the U.S. implies that the country as a whole has been accumulating U.S. assets. By the same token, so long as China runs a current account surplus, it means it is still a net creditor to the rest of the world, and the nation's foreign asset holdings, official and private sector combined, continue to increase. In previous years, it was the Chinese central bank that had increased its holdings of foreign assets, primarily in the form of U.S. Treasurys and other low-risk liquid assets. More recently, as the RMB has been depreciating against the dollar, the Chinese domestic private sector been accumulating foreign assets, particularly denominated in U.S. dollars. In fact, the private sector has taken over as the main source of demand for foreign assets, primarily in risker asset classes such as corporate equities, bonds and real estate. The official sector, on the other hand, has been selling foreign asset holdings, as reflected in China's declining official reserves. In other words, rather than experiencing an exodus of capital, there has been a gigantic "swap" of foreign assets between private and public sector in China. Indeed, Chart 2 shows China's official reserves have dropped significantly in the past two years. Chinese official holdings of Treasurys currently stand at USD 1157 billion, down from USD 1315 billion in 2011. Meanwhile, anecdotal evidence suggests that buoyant demand among Chinese households for foreign assets, particularly real estate. For the corporate sector, there has been a dramatic increase in overseas mergers and acquisitions (M&A) and other investment activity by Chinese companies, particularly in the U.S. (Chart 3). So far this year, total announced M&A deals by Chinese firms in the U.S. have already tripled compared to last year, however, most are still in progress and pending. Chart 2The Official Sector Is##br## Shedding Foreign Assets... The Official Sector Is Shedding Foreign Assets... The Official Sector Is Shedding Foreign Assets... Chart 3... While The Private ##br##Sector Accumulates China As A Currency Manipulator? China As A Currency Manipulator? Looking forward, if the business environment in the U.S. under President Trump becomes less foreign-friendly, it may impact Chinese enterprises' confidence in acquiring U.S. assets, and complicate Chinese companies' M&A deals. At a minimum, the massive increase in Chinese M&A interest in the U.S. will pause until policy visibility improves, while the outlook for many already announced pending deals will remain murky. This may deter further capital flows to the U.S. by the Chinese private sector. Changing Correlation Between The RMB And Stocks? The RMB has continued to drift lower against the dollar in the past week in both the onshore and offshore markets. Interestingly, Chinese stocks have appeared to have largely ignored the RMB's slide and have continued to move higher. This is in stark contrast to last year's panic selloffs that happened whenever RMB appreciation against the dollar appeared to quicken (Chart 4). In August 2015 and January 2016, the RMB's outsized moves against the dollar caused major disruptions in both A shares and H shares, sending shockwaves across the globe. It is too soon to draw definitive conclusions from very short-term moves. However, the changing correlation between the RMB and Chinese stocks suggests that investors may have become less worried about the RMB and China's foreign exchange policy. First, investors may be getting more accustomed to the RMB's rising volatility. The trade-weighted RMB in recent days has been stable, a sign that the RMB's weakness against the dollar is mainly a reflection of the strong dollar. The People's Bank of China and other relevant authorities have also been paying more attention when communicating to market participants, which may also help anchor investors' expectations. Second, in previous episodes of "sharper" RMB depreciation, the Chinese economy was clearly decelerating, and the RMB weakness further amplified investors' anxiety on China's macro conditions. Currently the Chinese economy is showing notable signs of improvement, particularly in the industrial sector, which also lessens investors' concerns. Chart 4The RMB Is Less Troubling ##br##To Market bca.cis_wr_2016_11_24_c4 bca.cis_wr_2016_11_24_c4 Chart 5The Mirror Image Between Yen ##br##And Japanese Stocks The Mirror Image Between Yen And Japanese Stocks The Mirror Image Between Yen And Japanese Stocks Finally, the market may be starting to reflect the reflationary impact of a weaker currency rather than the negative consequences of RMB depreciation. China's growth improvement is in no small part attributable to the falling exchange rate. This in and of itself limits the RMB's downside, rather than leading to an endless downward spiral. It remains to be seen whether Chinese stocks will stay calm as the RMB continues to depreciate against a surging dollar. Our hunch is that global equity markets, particularly in the U.S., have become complacent with a strong dollar and rising U.S. interest rates, both of which tighten global liquidity conditions. Therefore, global equities are vulnerable to downside risk, which could spill over to the Chinese market. For now, we are staying on the sidelines and do not suggest investors chase the rally in Chinese equities. However, over the long run, we expect investors will eventually come to terms with the "new normal" for the RMB as it becomes an important macro factor for the economy and stock market. Chart 5 shows that the performance of Japanese stocks has almost been a mirror image of the yen/dollar exchange rate, in which a weaker yen boosts Japan's growth profile as well as stock prices, and vice versa. Barring a crisis scenario, such a correlation will also emerge between the RMB and Chinese stocks over the long run. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China-U.S. Trade Relations: The Big Picture", dated November 17, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Eurostoxx600 outperformance versus the FTSE100 reduces to: will the euro weaken against the pound? Stay neutral in the Eurostoxx600 versus the FTSE100. Eurostoxx600 outperformance versus the Nikkei225 reduces to: will the euro weaken against the yen? Overweight the Eurostoxx600 versus the Nikkei 225. Eurostoxx600 outperformance versus the S&P500 reduces to: will European Banks outperform U.S. Technology? Underweight the Eurostoxx600 versus the S&P500. Feature 2016 is the year of the political shock. But for investors, some things have stayed faithfully the same. Chart of the WeekEurostoxx Vs. Nikkei Reduces To: Will Euro/Yen Weaken? Eurostoxx Vs. Nikkei Reduces To: Will Euro/Yen Weaken? Eurostoxx Vs. Nikkei Reduces To: Will Euro/Yen Weaken? Last week's report From Berlin Wall To Mexican Wall explained how the fall of the Berlin Wall in 1989 ushered in a great era of globalization - an era in which goods, services, capital and people have moved around the world more and more freely. Chart I-2The Globalization Of Stock Markets bca.eis_wr_2016_11_24_s1_c2 bca.eis_wr_2016_11_24_s1_c2 For investors, one major upshot is that the world's biggest companies have also become more and more globalized. The leading European stock market indexes - Eurostoxx600, FTSE100, DAX30, CAC40 and many other national indexes - are now just a collection of multinational companies with a global footprint. The same applies to major indexes outside Europe, such as the Nikkei225 and S&P500. Before the era of globalization, many companies had little exposure to economies outside their country or region of domicile. Unsurprisingly, in the 1980s, a German bank share price was more correlated with the rest of the German stock market than it was with a U.S. bank share price. But today, a large proportion of sales and profits are sourced globally. The German bank share price is now more correlated with the U.S. bank share price than it is with the rest of the German stock market! (Chart I-2) This begs the question: if Brexit and President-elect Trump are ushering in a great era of anti-globalization, will the major indexes become parochial once again? The answer is perhaps, but it will be a slow process - even assuming that the anti-globalization rhetoric does fully materialize. Sometimes, Stock Market Allocation Reduces To A Currency View For the time being, one obvious distinction between the major indexes will remain instrumental in driving performance differences. The Eurostoxx600 is denominated in euros, the FTSE100 in pounds, the Nikkei225 in yen, and the S&P500 in dollars. However, the constituent companies' sales and profits are denominated in a mixture of major global currencies, or in dollars. So all else being equal, if the local currency weakens - in other words, if other global currencies strengthen versus the local currency - then index profits will rise in local currency terms. Meaning the index value must go up. And if the local currency strengthens, the index value must go down. Simplistic as it sounds, some important asset allocation decisions just reduce to a bi-lateral currency view. Chart I-3 clearly shows that Eurostoxx600 versus FTSE100 relative performance reduces to a simple question: will the euro weaken against the pound? If so, the Eurostoxx600 will outperform the FTSE100. And vice-versa. Clearly, the outlook for euro/pound has been an important question this year, and will be an equally important question next year. Chart I-3Eurostoxx Vs. FTSE Reduces To: Will Euro/Pound Weaken? bca.eis_wr_2016_11_24_s1_c3 bca.eis_wr_2016_11_24_s1_c3 Likewise, the Chart of the Week clearly shows that Eurostoxx600 versus Nikkei225 relative performance reduces to a similar simple question: will the euro weaken against the yen? If so, the Eurostoxx600 will outperform the Nikkei225. And vice-versa. Sometimes, Stock Market Allocation Reduces To A Sector View But in the case of the Eurostoxx600 versus the S&P500, relative performance does not reduce to the direction of euro/dollar. Since mid-2014, the euro has weakened substantially versus the dollar, yet the Eurostoxx600 has underperformed the S&P500. This is because another factor drives this relative performance pair (Chart I-4 and Chart I-5). Chart I-4Eurostoxx Vs. S&P500 Does Not ##br##Depend On Euro/Dollar... bca.eis_wr_2016_11_24_s1_c4 bca.eis_wr_2016_11_24_s1_c4 Chart I-5...Eurostoxx Vs. S&P500 Does Depend ##br##On Banks Vs. Technology bca.eis_wr_2016_11_24_s1_c5 bca.eis_wr_2016_11_24_s1_c5 Although major indexes are a collection of multinational companies, it doesn't follow that the sector exposures of these indexes will be the same. Comparing the Eurostoxx600 with the S&P500, the Eurostoxx600 has a marked overexposure to Banks and an especially marked underexposure to Technology (Table I-1). Table I-1Eurostoxx Vs. S&P500 = Overweight##br## Banks, Underweight Technology More Investment Reductionism More Investment Reductionism Banks comprise 13% of the Eurostoxx600 market capitalization but only 6% of the S&P500. On the flipside, Technology comprises just 4% of the Eurostoxx600 market capitalization but a very substantial 21% of the S&P500. To repeat, multinational company share prices today are more correlated with their global sector than with their domestic stock market of listing. Recently, this has been true even for U.S. Banks - which amazingly have shown a higher correlation with European Banks than with the rest of the U.S. stock market. It follows that when two indexes are distinguished by large sector skews, these sector skews will drive relative performance. Our Special Reports Picking Countries The Right Way 1 Parts 1, 2 and 3 showed that this is the case for most head to head stock market comparisons within Europe. It is also the case for the Eurostoxx600 versus the S&P500. Put simply, for the Eurostoxx600 to outperform the S&P500 on a sustained basis, Banks must outperform Technology on a sustained basis. Or to be more precise, European Banks must outperform U.S. Technology (Chart I-6). Chart I-6Eurostoxx Vs. S&P500 Reduces To: Will European Banks Outperform U.S. Technology? Eurostoxx Vs. S&P500 Reduces To: Will European Banks Outperform U.S. Technology? Eurostoxx Vs. S&P500 Reduces To: Will European Banks Outperform U.S. Technology? Applying Reductionism To The Eurostoxx600 We can now apply investment reductionism to position the Eurostoxx600 against three other major indexes: the FTSE100, the Nikkei225 and the S&P500. 1. Eurostoxx600 outperformance versus the FTSE100 reduces to: will the euro weaken against the pound? For the foreseeable future, the euro/pound exchange rate hinges on the perceived severity of Brexit. In this regard, there is unlikely to be meaningful new information until the U.K. Supreme Court delivers its verdict on the legal process that the U.K. government must follow. The verdict is due in January. So for the time being, it is appropriate to stay neutral in the Eurostoxx600 versus the FTSE100. Eurostoxx600 outperformance versus the Nikkei225 reduces to: will the euro weaken against the yen? 2. The euro/yen exchange rate hinges on ECB/BoJ relative monetary policy. Given that the BoJ made its bold policy move a few months ago, the focus now is on whether the ECB will continue with QE beyond March 2017. Chart I-7European Banks Do Not Offer An Especially##br## Large Discount To U.S. Technology European Banks Do Not Offer An Especially Large Discount To U.S. Technology European Banks Do Not Offer An Especially Large Discount To U.S. Technology The minutes of the ECB's most recent policy meeting provide some clues. On the one hand, the central bank cautioned on the unintended consequences of extended QE: "The possible side effects of the low interest rate environment and the range of non-standard measures in place on the longer-term intermediation capacity of banks and other financial institutions had to be further examined" On the other hand, the ECB emphasised: "(QE) was set to run... in any case until the ECB saw a sustained adjustment in the path of inflation consistent with its inflation aim... underlying inflation, however, continued to lack clear signs of a convincing upward trend." On this basis, it seems that the ECB will extend its QE program beyond March 2017, as well as give a strong commitment to keep policy rates anchored. But the recent underperformance of the Eurostoxx600 versus Nikkei225 has discounted a sizable strengthening of euro/yen. It is appropriate to lean against this and overweight the Eurostoxx600 versus the Nikkei225. Eurostoxx600 outperformance versus the S&P500 reduces to: will European Banks outperform U.S. Technology? Again, the minutes of the ECB's most recent policy meeting perfectly summarized the environment for European banks: "Ongoing structural challenges to banks' balance sheets, notably arising from still high levels of non-performing loans (NPLs) in parts of the euro area banking sector, in conjunction with regulatory challenges (BRRD), and the weakness in profitability were seen to pose a risk to the transmission of monetary policy and a further recovery in credit dynamics" Or as we recently put it,2 European bank investors are fighting three long-term headwinds: BRRD, NPLs and NIRP. Yet on a price to forward earnings multiple, European Banks do not offer an especially large discount to U.S. Technology (Chart I-7). Therefore, investment reductionism says it is appropriate to underweight the Eurostoxx600 versus the S&P500. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Please see the three European Investment Strategy Special Reports 'Picking 5 European Countries The Right Way' November 13, 2014, 'Picking Countries The Right Way: Part 2' March 26, 2015 and 'Picking Countries The Right Way: Part 3' November 12, 2015, available at eis.bcaresearch.com 2 Please see the European Investment Strategy Weekly Report "All Roads Lead To Banks", dated October 6, 2016, available at eis.bcaresearch.com Fractal Trading Model* The recent sharp moves in markets offer another opportunity for a long plantinum / short palladium pair-trade. A similar opportunity on October 6 successfully signaled a 13% countertrend move. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-8 bca.eis_wr_2016_11_24_s1_c8 bca.eis_wr_2016_11_24_s1_c8 * 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 bca.eis_wr_2016_11_24_s2_c1 bca.eis_wr_2016_11_24_s2_c1 Chart II-2Indicators To Watch - Bond Yields bca.eis_wr_2016_11_24_s2_c2 bca.eis_wr_2016_11_24_s2_c2 Chart II-3Indicators To Watch - Bond Yields bca.eis_wr_2016_11_24_s2_c3 bca.eis_wr_2016_11_24_s2_c3 Chart II-4Indicators To Watch - Bond Yields bca.eis_wr_2016_11_24_s2_c4 bca.eis_wr_2016_11_24_s2_c4 Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations bca.eis_wr_2016_11_24_s2_c5 bca.eis_wr_2016_11_24_s2_c5 Chart II-6Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_11_24_s2_c6 bca.eis_wr_2016_11_24_s2_c6 Chart II-7Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_11_24_s2_c7 bca.eis_wr_2016_11_24_s2_c7 Chart II-8Indicators To Watch ##br##- Interest Rate Expectations bca.eis_wr_2016_11_24_s2_c8 bca.eis_wr_2016_11_24_s2_c8

Highlights The blistering dollar rally has mimicked the selloff in U.S. and global bonds. The dollar and bonds may have gotten ahead of themselves. A short-term reversal or a pause in the recent trend is becoming our base-case scenario for the rest of the year. If a dollar correction materializes, USD/CNY will also retreat, temporarily diminishing pressures on EM currencies. The yen weakness illustrates the importance of the September policy change by the BoJ. AUD/SEK is a short. We are re-introducing our back sections, but now covering all the G10 currencies. Feature In recent weeks, we have developed the view that a Trump victory would embolden our cyclically bullish stance on the dollar. We re-iterated this sentiment last week.1 Since then, we have received many questions about the very short-term outlook for FX markets. Our view is that from now to the end of the year, the dollar is likely to stabilize and may even weaken somewhat. This should create a buying opportunity for investors that have missed the dollar rocket. It's All About Bonds The dollar rally since Trump's election has been so torrid that the broad trade-weighted dollar has made new highs. DXY is now flirting with the top of the trading range established since March 2015 (Chart I-1). If the dollar can significantly punch above this resistance, or EUR/USD falls below 1.055, another violent dollar rally could ensue. While we do ultimately expect such a move to materialize, we do not expect it to happen just yet. The main reason for our skepticism is the bond market. Much of the appreciation in the dollar has been explained by the sharp rally in U.S. bonds, which has caused interest rates differentials to move massively in favor of the greenback (Chart I-2). For DXY to meaningfully punch above 100, bonds have to sell-off further. Chart I-1The Return Of The King The Return Of The King The Return Of The King Chart I-2Dollar And Bond Yields: Same Fight Dollar And Bond Yields: Same Fight Dollar And Bond Yields: Same Fight Our U.S. Bond Strategy service remains cyclically underweight duration, but the short-term outlook is murky. The move in bonds has been extremely one-sided. The bond market's behavior displays the hallmark of groupthink, where long-term and short-term traders have uniformly been selling Treasurys. The fractal dimension for bonds, a measure of groupthink developed by Dhaval Joshi, our European Chief Strategist, rests at 1.25, a level at which a trend reversal - even if a temporary one - tends to emerge (Chart I-3).2 Chart I-3Groupthink In The Bond Market Groupthink In The Bond Market Groupthink In The Bond Market Additionally, our composite sentiment indicator, based on the 13-week rate of change of prices, investor sentiment, and net speculative positions, is deeply oversold, highlighting the risk of a backup in prices (Chart I-4). Fundamentals also warrant a careful stance. A December Fed hike is fully priced in, and the expected Fed funds rates 12-months from now is already near the levels hit before the Fed raised rates in 2015 (Chart I-5). A catalyst is now needed to push rate expectations materially higher. Chart I-4Bond Sentimen##br##t Is Depressed Bond Sentiment Is Depressed Bond Sentiment Is Depressed Chart I-5Interest Rates Priced In A Lot##br## In A Short Time Span Interest Rates Priced In A Lot In A Short Time Span Interest Rates Priced In A Lot In A Short Time Span However, the recent backup in yields and the dollar has massively hit EM currencies (Chart I-6). EM currencies are falling because investors are taking funds out of these economies. Consequently, EM liquidity and financial conditions are tightening, a dark omen for economic activity in that space (Chart I-7). The more than 10% fall in gold prices since July 8, also paints a picture of deteriorating global liquidity conditions. Chart I-6Bond Yields Are Hurting##br## EM Financial Conditions Bond Yields Are Hurting EM Financial Conditions Bond Yields Are Hurting EM Financial Conditions Chart I-7A Dark ##br##Omen A Dark Omen A Dark Omen An EM correction may compel the Fed to worry about the short-term outlook. This development, along with the tightening in U.S. financial conditions resulting from the 7% back up in the broad trade-weighted dollar and 77 basis points in bond yields since mid-August, heighten the risk of a correction in risk assets. The Fed is aware of this and the market knows it. Chart I-8CPI Swaps Can Rebound More bca.fes_wr_2016_11_18_s1_c8 bca.fes_wr_2016_11_18_s1_c8 Additionally, U.S. 5y/5y forward CPI swaps have backed up 60 basis points from their lows to 2.4%, but they still remain below their historical norm of 2.5% to 3.3% (Chart I-8). The Fed probably wants to see them closer to these levels before aggressively ramping up its rhetoric and "dot-plot" forecasts. A Trump presidency will result in a large dose of fiscal stimulus, but we still have little clarity regarding the size of any packages, their composition, or their timing. Neither does the Fed. If there was any clarity, the Fed would likely be in a position to increase its "dot-plot" even without inflation expectations being in their normal range. Additionally, this week, the Bank of Japan put actions behind its words and announced an unlimited bond buying program at fixed prices, a process that should cap the upside on this anchor for global yields. Thus, in the very near term, the burden of proof is now elevated for rates to rise higher without the Fed's rhetoric becoming clearly more hawkish. While we expect this outcome to ultimately materialize, the next few weeks are not when we see it happening. This implies that the dollar's rip-roaring rally is likely to take a pause and even retrace some of its exceptional gains. However, a key risk remains, and that is China. Since Trump's victory, the Chinese RMB has accelerated its downward path, depreciating 1.7% in nine days. This move reflects the fear that Trump will impose large tariffs on Chinese-made goods. In the process, the fall in the yuan has dragged Asian currencies lower than the DXY appreciation would have warranted (Chart I-9). If these moves were to continue, EM currencies, the yen, and the AUD would fall further even without U.S. bond yields rising much. In the short-term this remains more a risk rather than a base-line scenario. While USD/CNY has rallied, the yuan has been stable relative to the currency basket targeted by the PBoC (Chart I-10). Therefore, if our view that the U.S. bond sell-off pauses temporarily is correct, the USD/CNY rally will also take a breather. Chart I-9Tariff Risk Weighing On Asian Forex bca.fes_wr_2016_11_18_s1_c9 bca.fes_wr_2016_11_18_s1_c9 Chart I-10Mind The Gap! Mind The Gap! Mind The Gap! The currencies most likely to benefit from any dollar bull-market pause are JPY, SEK, and EUR as they have become hyper-sensitive to U.S. bond yields. EM currencies too could see a temporary rally, especially if USD/CNY stops appreciating in line with the DXY. Bottom Line: The dollar bull market is intact. However, the tactical outlook points toward a pause in the greenback's upswing. In light of the fast repricing of the market's expectations for Fed policy, and the lack of clarity regarding Trump's plans, bond yields and interest-rate expectations have gotten ahead of themselves. Even the rally in USD/CNY, which has contributed to devaluation pressures on other Asian currencies, could pause if DXY stops rallying for a period of time. Why is the Yen So Weak? We have articulated a very bearish view on the yen since September 23.3 To our way of thinking, the Bank of Japan pegging 10-year JGB yields to 0% until Japanese inflation significantly overshoots 2% was a sea-change. However, we have been surprised by the violence of the recent yen sell-off. After all, wouldn't a selloff in EM currencies support the yen? A few factors have been at play. First, Japanese preliminary Q3 GDP numbers have come in at 2.2% on a year-on-year basis, handily beating expectations of 0.9%. Moreover, industrial production has picked up, and our model forecasts further acceleration, despite the recent strength in the yen (Chart I-11). With the employment market being tight - the unemployment rate stands at 3.1% and the active-job-openings-to-applicants ratio is at a 25-year high - this raises the risk that inflation begins to emerge. With nominal bond yields pegged at zero, this would weigh on Japanese real rates, and thus the yen, which continues to closely correlate with Japanese real rates differentials. Second, the recent global sell off in bonds has been an additional weight on the yen. In our communications with clients, we are often reminded how USD/JPY and bond yields are essentially one and the same, a heuristic borne by the facts (Chart I-12). Chart I-11Japanese IP Is ##br##Picking Up Japanese IP Is Picking Up Japanese IP Is Picking Up Chart I-12USD/JPY And Bond Yields ##br##Are One And The Same USD/JPY And Bond Yields Are One And The Same USD/JPY And Bond Yields Are One And The Same But right now, there is more to the relationship with bond yields than in previous episodes. The September promise of a cap on 10-year JGB yields is causing Japanese yield differentials to stand at mid-2015 levels, despite global yields being lower than they were then (Chart I-13). Also, the sell-off in global bonds has caused 10-year JGB yields to move slightly above 0%. However, having announced unlimited bond purchases at capped yields, the BoJ is about to begin purchasing JGBs to prevent yields from punching above 0% meaningfully. This will result in growing Japanese liquidity, compounding already existing JPY weaknesses. Chart I-13The BoJ Policy In Action The BoJ Policy In Action The BoJ Policy In Action Finally, the government is talking up fiscal stimulus. The third revision of the second supplementary budget has been passed, and the executive is already pushing for a third supplementary budget. Additionally, both Abe and Kuroda are ramping up their rhetoric regarding next year's wage negotiations, highlighting the growing risk that the government will implement wage policies in 2017.4 Short-term risks are skewed toward a yen rebound. When the BoJ announced its new policy in September, USD/JPY was 7% undervalued according to our short-term model. This is not the case anymore. Also, if global bond yields stop their ascension until year end, the BoJ will not purchase any bonds. Moreover, falling global bond yields will push Japanese rate differentials in favor of the yen, supporting the currency further. Finally, a continuation of EM stresses could prompt Japanese investors to repatriate funds into the country, putting upward pressures on the yen. Bottom Line: The extraordinary weakness in the yen reflects the improvement in Japanese economic activity. Also, the change in monetary policy executed earlier this year is limiting the upside for JGB yields, and the BoJ is now setting up an unlimited purchase program to back its words. However, a short term pull-back in USD/JPY grows increasingly likely if the global bond implosion takes a breather. Going Short AUD/SEK Shorting AUD/SEK here makes sense. To begin with, AUD/SEK is trading 16% above its long-term fair value as well as 5.2% above its short-term equilibrium (Chart I-14). Additionally, the current account differential is 9.4% of GDP in favor of Sweden. In terms of the economy, the Swedish consumer is displaying stronger resilience than the Australian one, powered by an outperforming Swedish labor market (Chart I-15). Additionally, Swedish house prices are growing 5% faster than in Australia. With Swedish consumer confidence outperforming that of Australia, and Swedish household credit overtaking Australian household credit growth, inflationary forces could emerge, resulting in a tightening of Swedish policymakers' rhetoric relative to Australia. On this front, the recent pick up in Swedish inflation is telling. Having rebounded to 1.2% annually, Swedish headline CPI is at a four-and-a-half-year high, suggesting that the emergency measures put in place by the Riksbank are beginning to outlive their usefulness. Meanwhile, Australia is moving away from its easing bias. But a move toward less accommodation is still not in the cards, especially as employment growth underperformed and total hours worked contracted at a 1% annual pace. Financial market dynamics also favor a weaker AUD/SEK. This cross has moved much ahead of nominal interest rate differentials, and real-interest-rate differentials have moved in the opposite direction, pointing to a lower AUD/SEK. Additionally, the Swedish broad market as well as financial equities have been outperforming Australian stocks. This suggests that Swedish financial conditions are too easy relative to Australia. Finally, technicals point to a negative short-term outlook for this cross. AUD/SEK is massively overbought on a 52-week-rate-of-change measure. On a shorter-term basis, the MACD indicates an overbought condition and is forming a negative divergence with prices, exactly as the stochastic indicator has broken down (Chart I-16). Chart I-14Poor Risk/Reward Tradeoff ##br##For Holding AUD/SEK Poor Risk/Reward Tradeoff For Holding AUD/SEK Poor Risk/Reward Tradeoff For Holding AUD/SEK Chart I-15The Swedish Labor ##br##Market Is On Fire The Swedish Labor Market Is On Fire The Swedish Labor Market Is On Fire Chart I-16AUD/SEK:##br## Poised For A Shakeout AUD/SEK: Poised For A Shakeout AUD/SEK: Poised For A Shakeout Bottom Line: The outlook for AUD/SEK is problematic. This cross is pricey and the Swedish consumer is outperforming that of Australia. This is happening exactly as the Riksbank may begin moving away from its hyper-accommodative stance, as inflation is hitting four-and-a-half year highs. Finally, financial market dynamics and currency technicals are flagging a short in this cross. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "Raeganomics 2.0?", dated November 11, available at fes.bcaresearch.com 2 Please see European Investment Strategy Special Report, "Fractals, Liquidity & A Trading Model", dated December 11, 2014, available at eis.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, "How Do You Say "Whatever It Takes" In Japanese?", dated September 23, 2016 available at fes.bcaresearch.com 4 Ibid. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Last week, equities and the dollar rallied as Trump's unexpected victory was taken as a positive for the U.S. economy in the hopes of promised fiscal stimulus. Both the market and Fed officials therefore remain tenacious on the prospects of a 25bps hike in December, with a 98% probability currently priced in. In a speech on Thursday, Yellen confirmed the gradual normalization of policy and acknowledged the strength of the U.S. labor market. Initial jobless claims declined to 235,000 from 254,000 and continuing jobless claims declined to 1.977 million from 2.043 million. This has further solidified our bullish stance on the dollar. On a technical basis, the DXY Index has hit a key resistance level of 100, which suggests a temporary halt to last week's surge. However, longer-term momentum is indicating a possible break-out from the key 100 level in the near future. Report Links: Reaganomics 2.0? - November 11, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Euro Chart II-3EUR Technicals 1 bca.fes_wr_2016_11_18_s2_c3 bca.fes_wr_2016_11_18_s2_c3 Chart II-4EUR Technicals 2 bca.fes_wr_2016_11_18_s2_c4 bca.fes_wr_2016_11_18_s2_c4 The Euro continues to mirror the U.S. Dollar, losing more than 3% in a week since the U.S. Presidential Election. This move seems to be a function of the election only, as European data has come out reasonably strong this week: Economic sentiment from the ZEW Survey shot up to 15.8, beating expectations, while current conditions declined to 58.8 from 59.5. The trade balance increased by €8.2bn to €26.5bn. European GDP growth remains solid at 1.6%. Data points to EUR strength, so the Euro should remain somewhat neutral on a trade-weighted basis as its economy remains strong. Monetary policy divergence and technicals, however, should continue to weigh on EUR/USD in the short term, suggesting that cross-currency plays are the best way to capture any Euro strength. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Yen Chart II-5JPY Technicals 1 bca.fes_wr_2016_11_18_s2_c5 bca.fes_wr_2016_11_18_s2_c5 Chart II-6JPY Technicals 2 bca.fes_wr_2016_11_18_s2_c6 bca.fes_wr_2016_11_18_s2_c6 The yen has been one of the worst performing currencies in the G10 following Trump's election, with USD/JPY appreciating by about 5%. After this down-leg, we will not be surprised if the yen recovers some ground in the short-term. USD/JPY has already reached overbought technical levels and the sell-off in EM caused by the rising dollar may eventually trigger a risk-off period from which the yen will benefit. However, past the short term, we continue to be yen bears. Although the policies that the BoJ implemented in September did not seem as radical back then, a cap on Japanese 10-year rates takes a whole different meaning for the yen in the recent environment where interest rates are rising in the U.S, since it exerts considerable pressure on Japanese real rates vis-à-vis the rest of the world. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 British Pound Chart II-7GBP Technicals 1 bca.fes_wr_2016_11_18_s2_c7 bca.fes_wr_2016_11_18_s2_c7 Chart II-8GBP Technicals 2 bca.fes_wr_2016_11_18_s2_c8 bca.fes_wr_2016_11_18_s2_c8 An interesting trend has caught our attention: the British economy continues to be very resilient, beating not only market expectations but also projections by the BoE. Recent October data confirms this view: Retail sales and retail sales ex-fuel grew at an annual rate of 7.4% and 7.6% respectively, blowing past expectations. Additionally Markit Services PMI was 54.5, also beating expectations. This is particularly surprising given that the service sector is likely getting very little support from the weak pound. We are reticent to be bullish on the pound, at least on the short term, given that political risks continue to dominate the movements of this currency. Nevertheless, the cable is very cheap from a valuation standpoint, and if the British economy continues to beat expectations, the pound could become an attractive buy. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 bca.fes_wr_2016_11_18_s2_c9 bca.fes_wr_2016_11_18_s2_c9 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The RBA left its cash rate unchanged at 1.5% at their November meeting, and clarified that their easing cycle has come to an end. Recent data, however, is showing signs of weakness in the Australian economy: the Westpac Consumer Confidence Index came in last week at -1.1%; wage pressures remain subdued at 1.9% yoy in Q3 from 2.1% in Q2; employment change was weaker than expected at 9,800 with the unemployment rate unchanged at 5.6% in October. Labor market slack remains a fundamental concern for the Australian economy, something the RBA also pointed out in their November statement. Inflationary pressures, if any, will likely emanate only from commodity prices, for which the outlook remains questionable due to a rising USD. Deteriorating consumer confidence and continued labor market slack will translate into deflationary tendencies, which will cap rates and add downward pressure on the AUD. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 In line with expectations, The RBNZ cut rates by 25 basis points to 1.75% at its latest policy meeting. Shortly after, a speech by Governor Wheeler lifted the NZD, as he appeared to signal that the RBNZ might be done easing by stating that "at this stage we think that we won't need another cut". We are unfazed by this change of rhetoric, and continue to be bearish on the kiwi. The NZD has formed a head-and-shoulders pattern which, along with fading momentum, foretells a downside leg for this antipodean currency. Moreover, a sell-off in Asian currencies and deteriorating financial conditions in Emerging markets following Trump's election should put further downward pressure on the kiwi, given that the NZD is the most sensitive currency to Asian spreads in the G10. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data points south for CAD: The merchandise trade deficit increased to CAD 4.1bn in September, with imports rising 4.7% to a record CAD 47.6 bn, and exports only up 0.1% to CAD 43.5 bn. The housing market continues to display warning signs as housing starts decreased in October to 192,900 and building permits declined by 7% in September from August, showing signs of supply decreases and rising prices. Although the labor market seems to be picking up, with net change in employment increasing by 43,900 and the participation rate at 65.8%, the setback in growth from the commodity slump and the Q2 Alberta wildfires will keep the BoC from raising rates. Nevertheless, we remain bullish on oil in the commodity space, and the CAD will likely display strength against the antipodeans. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 The rally in USD/CHF should subside, at least in the short term. Not only has the swissie reached technical overbought levels, but the continued tightening in EM financial conditions caused by the rising dollar increased the probability of a risk off period where the CHF would rally. EUR/CHF on the other hand is likely to have limited downside from here on. Since August 2015, this cross had traded within a tight range of 1.075 to 1.110, breaking down only after the Brexit vote, when all risk-off assets rallied. However it has recently broken down again, an unwelcomed development for the SNB, who will likely intervene in the currency market in order to keep a rising franc from adding additional deflationary pressures to the Swiss economy. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 The Krone was another victim of Trump's election, with USD/NOK rising by 4%. Although we expect that the dollar bull market will ultimately weigh on the krone, we remain positive on the outlook for this currency compared to its commodity peers. Inflation is currently at 3.7%, significantly above the Norges Bank target. Additionally house prices are rising at almost 20%, while household debt as a percentage of disposable income has surpassed the 200% mark. The Norges Bank has not overlooked this developments, as their rhetoric has recently become more hawkish. All these factors along with rebalancing energy markets, should provide strong tailwinds for the NOK, particularly against its crosses. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 The Swedish economy looks strong according to recent data: Manufacturing PMI ticked up last month from 54.9 to 58.4. Industrial production increased in September by 1.5% annually. Inflation in October came in at 1.2% yoy. Inflation in the near future also looks quite upbeat, as per the uptick in 1-, 2-, and 5-year Prospera inflation expectation numbers to 1.4%, 1.7%, and 1.9% respectively. The Riksbank has therefore lifted their easing bias, which is also reflected by an increase in the 12-month market expectations of the repo rate to -0.4%. All is not perfect though. New orders decreased by 16.4% annually, indicating possible fragility in the manufacturing sector. Additional medium-term risk to the SEK will be dictated by bullish moves in the USD, as SEK remains one of the currencies with the highest sensitivity to the dollar. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The 50bps spike in the JPM global government bond yield since August constitutes one of the most aggressive tightenings since the Great Recession. Higher bond yields weaken credit growth, and weaker credit growth almost always depresses subsequent GDP growth. Maintain at most a neutral weighting to equities. Lean against the aggressive sell-offs in Healthcare, Consumer Goods, Telecoms and government bonds. Lean against the aggressive rally in Financials. Feature November 9 is an important date in the annals of history. November 9, 1989 was the day that the Berlin Wall came down. Chart of the WeekGlobalization Has Been Good For Profits, Bad For Wages Globalization Has Been Good For Profits, Bad For Wages Globalization Has Been Good For Profits, Bad For Wages Through 1961-89, the Berlin Wall divided a city. More significantly, it symbolized a divided world. So when the wall came down on November 9, 1989, it marked a new era of globalization. Goods, services, capital and people started to move around the world much more freely, resulting in greater efficiencies and lower costs. In developed economies, profits surged. Using the United States as an example, in the 27 years since the Berlin Wall came down, stock market real earnings per share have gone up 200% (Chart I-2). Chart I-2The Backdrop For Populism bca.eis_wr_2016_11_17_s1_c2 bca.eis_wr_2016_11_17_s1_c2 But globalization has exacted a heavy price: the pressure on wages means that in the 27 years since the Berlin Wall came down, U.S. median household real income has gone up just 10%. By comparison, in the 28 years that the Berlin Wall stood, the median household real income went up 60% (Chart of the Week). November 9 is also the date that Donald Trump won the presidency of the United States. So exactly 27 years after one symbolic wall fell, is another one about to go up? Will Mr. Trump's promised wall with Mexico symbolize a new era of anti-globalization, and a reversal of the economic and financial trends since the Berlin Wall came down? Flaws In The Trump Plan Economists are almost unanimous that protectionism, trade barriers and tariffs - in other words, "building walls" - depresses long-term global growth. It is conceivable that protectionism could help some parts of the U.S. economy, though other parts might lose out as trading partners retaliated. It is inconceivable that protectionism would be good for the world economy as a whole. Chart I-3One Of The Most Aggressive Tightenings ##br##Since The Great Recession bca.eis_wr_2016_11_17_s1_c3 bca.eis_wr_2016_11_17_s1_c3 But what about Trump's noise about fiscal stimulus, and specifically infrastructure spending - why would anybody not get excited about that? The two word answer is: crowding out. If a dollar that is borrowed and spent by the government (or even forecast to be borrowed and spent by the government) pushes up the bond yield (Chart I-3), it makes it more expensive for the private sector to borrow and spend. If, as a result, the private sector scales back its borrowing by a dollar, the dollar of government spending would have no impact on GDP. This is because the dollar of government spending has crowded out a dollar of private sector spending. The fiscal multiplier would be zero. But doesn't the euro area debt crisis provide compelling evidence of the power of fiscal thrust and a very high fiscal multiplier? No, not exactly. The fiscal multiplier was high through the debt crisis because euro area austerity - a fiscal tightening - very unusually coincided with sharply rising bond yields - which killed private sector borrowing. In other words, fiscal tightening and private sector tightening were reinforcing each other. Through 2009-12, when the euro area debt crisis escalated, the relationship between fiscal tightening and growth in GDP per capita in 13 sampled economies had a near-perfect explanatory power (r-squared of 0.9); and its slope of 1.5 indicated an extremely high average fiscal multiplier (Chart I-4). But through 2012-15, after Mario Draghi "did whatever it takes" the unusual combination of fiscal tightening and higher bond yields no longer existed, and both the explanatory power of the relationship and fiscal multiplier collapsed (Chart I-5). Chart I-4A Very Strong Connection Between Fiscal Policy And Growth Through 2009-12... From Berlin Wall To Mexican Wall From Berlin Wall To Mexican Wall Chart I-5...But No Connection Between Fiscal Policy And Growth Through 2012-15 From Berlin Wall To Mexican Wall From Berlin Wall To Mexican Wall The lesson is that the efficacy of fiscal stimulus and infrastructure spending crucially depends on its impact on the bond yield - and thereby on private sector borrowing. Now note that the 6-month increase in the U.S. (and global) 10-year bond yield constitutes one of the sharpest tightenings since the Great Recession. Higher borrowing costs depress credit growth as captured in the 6-month credit impulse (Chart I-6). A weaker 6-month credit impulse then almost always depresses subsequent 6-month GDP growth (Chart I-7). Chart I-6Higher Borrowing Costs Depress##br## Credit Growth... bca.eis_wr_2016_11_17_s1_c6 bca.eis_wr_2016_11_17_s1_c6 Chart I-7...And Weaker Credit Growth Depresses ##br##Subsequent GDP Growth bca.eis_wr_2016_11_17_s1_c7 bca.eis_wr_2016_11_17_s1_c7 So yes, fiscal stimulus and infrastructure spending could be effective as long as the bond yield is anchored, as it is in Japan. But if the bond yield goes up sharply, the consequent drag from the private sector will partly or entirely negate any putative boost from the government. Explaining Market Shocks And Electoral Shocks In his seminal book Thinking, Fast And Slow psychologist and Nobel Laureate Daniel Kahneman1 proposed that the human brain has evolved two separate and independent systems for decision making: a fast, rapid-response, associative way of thinking which he calls "System 1" and a slow, analytical, measured way of thinking which he calls "System 2". The two ways of thinking, fast and slow, have evolved to protect us from two types of threat to our survival: immediate, and long-term. Thousands of years ago, the immediate threat to survival might have been a sudden noise in the bushes suggesting that a predator was stalking. Today, for a bond investor, the immediate threat might be a sudden noise about aggressive U.S. fiscal stimulus, suggesting that the end of deflationary pressures is nigh. Faced with this immediate but uncertain threat, using the slow and measured thinking of System 2 could be fatal. So we obey the fast-thinking, associative, emotional System 1 and run for cover - or sell bonds. Thousands of years ago, a long-term threat might have been a war of attrition against an enemy tribe. Today, for the bond investor, the long-term threat might be the end of the debt super cycle, suggesting that deflationary pressures will persist. Faced with this long war of attrition, an over-reliance on the impulsive decisions of System 1 could also be fatal. We must use the measured analysis and strategies of slow-thinking System 2. Kahneman's System 1 and 2 is also an excellent framework to help explain how the simple messages of the Brexiteers and Donald Trump led to stunning success at the ballot box. Faced with job destruction and stagnant real wages, many people intuitively believe that less globalization, less competition and less immigration must mean more jobs and a better standard of living. Associative and emotional System 1 immediately identifies with simple messages such as "take back control" or "build a wall". The success of the Brexiteers and Donald Trump was to acknowledge the deep malaise that many people are feeling and offer simple and intuitive cures. To be absolutely clear, this is neither an endorsement nor a criticism of the Brexiteers or Donald Trump, but simply an explanation of why their message hit home. Still, as we have argued, the more analytical and measured System 2 will find that the simple and intuitive cures that the Brexiteers and Donald Trump offer are not the panaceas that they might first seem. The Immediate Investment Decision Short-term traders generally use the rapid-response, associative, emotional System 1 for their decision making. Long-term investors generally use the slow, analytical, measured System 2. But after a shock, disoriented long-term investors may also switch from System 2 to System 1 and just follow the herd. Eventually though, System 2 switches back on, and the excessive herding and trend-following reverses. At the moment, several sector trends are at or near such a point of reversal according to our excessive groupthink indicator (Chart I-8, Chart I-9, Chart I-10, Chart I-11, Chart I-12). Chart I-8Healthcare Reversals After Excessive Trend-Following Healthcare Reversals After Excessive Trend-Following Healthcare Reversals After Excessive Trend-Following Chart I-9Consumer Goods Reversals After Excessive Trend-Following bca.eis_wr_2016_11_17_s1_c9 bca.eis_wr_2016_11_17_s1_c9 Chart I-10Telecoms Reversals After Excessive Trend-Following Telecoms Reversals After Excessive Trend-Following Telecoms Reversals After Excessive Trend-Following Chart I-11Financials Reversals After Excessive Trend-Following Financials Reversals After Excessive Trend-Following Financials Reversals After Excessive Trend-Following Chart I-12Government Bond Reversals After Excessive Trend-Following Government Bond Reversals After Excessive Trend-Following Government Bond Reversals After Excessive Trend-Following Specifically, on a 3-month trading view, we would lean against the aggressive sell-offs in Healthcare, Consumer Goods, Telecoms and government bonds; and we would lean against the aggressive rally in Financials. More generally, what does the Trump victory mean for European equities? In today's highly-connected financial markets, mainstream investments in Europe overwhelmingly depend on global developments, and not on parochial issues. The dominant components of the Eurostoxx600, FTSE100, DAX30, CAC40, AEX, SMI, and other major indices, are multinationals with a truly global footprint. So the answer rests on two subsidiary questions: What does the Trump victory mean for global monetary conditions? What does the Trump victory mean for global growth? As already mentioned, global monetary conditions have tightened significantly in recent months, and in accelerated fashion after the Trump victory. The 50bps tightening in the JPM global government bond yield since August constitutes one of the sharpest 3-month spikes since the Great Recession. But as in previous cases, the spike may be self-limiting given its squeeze on credit sensitive sectors and emerging markets. Since August, the dividend yield on equities is little changed - meaning that equities have become more expensive relative to bonds. But this is hard to justify as short-term growth prospects have, if anything, worsened. To repeat the powerful messages from Chart 6 and Chart 7, higher bond yields weaken credit growth; and weaker credit growth almost always depresses subsequent GDP growth. Putting all this together, asset allocators should maintain at most a neutral weighting to equities. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Daniel Kahneman won the Nobel Prize in economics in 2002 for his work on decision making. Fractal Trading Model* There are no new trades this week. After the big recent moves in markets, four open positions were closed at their trading-rule limits, two at profit targets, two at stop-losses. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart 1-13 Copper Vs. Tin Copper Vs. Tin * 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 bca.eis_wr_2016_11_17_s2_c1 bca.eis_wr_2016_11_17_s2_c1 Chart II-2Indicators To Watch - Bond Yields bca.eis_wr_2016_11_17_s2_c2 bca.eis_wr_2016_11_17_s2_c2 Chart II-3Indicators To Watch - Bond Yields bca.eis_wr_2016_11_17_s2_c3 bca.eis_wr_2016_11_17_s2_c3 Chart II-4Indicators To Watch - Bond Yields bca.eis_wr_2016_11_17_s2_c4 bca.eis_wr_2016_11_17_s2_c4 Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_11_17_s2_c5 bca.eis_wr_2016_11_17_s2_c5 Chart II-6Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_11_17_s2_c6 bca.eis_wr_2016_11_17_s2_c6 Chart II-7Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_11_17_s2_c7 bca.eis_wr_2016_11_17_s2_c7 Chart II-8Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_11_17_s2_c8 bca.eis_wr_2016_11_17_s2_c8

Highlights EM risk assets will continue to plunge as U.S. bond yields and the U.S. dollar have more upside. Asset allocators should maintain an underweight allocation to EM within global equity and credit portfolios. Upgrade Russian stocks from neutral to overweight within an EM equity portfolio. Reinstate the long Russia ruble / short Malaysian ringgit trade. Feature The rout in emerging markets (EM) risk assets will persist, regardless of the direction of the U.S. equity market. While president-elect Donald Trump's potential fiscal stimulus will boost U.S. growth, it will not be sufficient to offset the negative impact on EM from rising U.S. Treasury yields and a stronger U.S. dollar. On a broader scale, risks of protectionist measures from the incoming U.S. administration are non-trivial, which will make investors even more jittery on EM. Notably, from a historical perspective, firm U.S. growth has not been a panacea for EM, particularly when the latter's domestic fundamentals were poor and commodities prices were falling. For example, EM in general and emerging Asia in particular collapsed in 1997- '98 when U.S. real GDP growth was averaging 4.5%, and European real GDP growth was 3.5%. In particular, U.S. import volumes were booming at double-digit rates, but this was insufficient to circumvent the crisis in Asia (Chart I-1). Importantly, U.S. bond yields were falling during the 1997-'98 period. Chart I-1Strong U.S. Growth Is No Panacea For EM Stocks bca.ems_wr_2016_11_16_s1_c1 bca.ems_wr_2016_11_16_s1_c1 It is hard to expect similar U.S. growth nowadays, even with Trump's potential fiscal impetus. Meanwhile, any fiscal boost in Europe so far remains a forecast. Besides, back in the 1990s, the U.S. and Europe were dominant sources of global demand - and China was not at all an economic power. Since the late 1990s, the significance of China and the rest of EM has grown enormously, while the importance of the U.S. and Europe with respect to global demand in general and EM in particular has fallen. In short, the outlook for stronger growth in the U.S. is not a reason to turn bullish on EM because the latter's fundamentals are poor. The U.S. dollar rally will persist. The greenback is close to being fairly valued, or only slightly expensive (Chart I-2). Typically, major cycles run until a market becomes considerably expensive or very cheap. It is not often that markets bottom or peak at their fair value. Odds are that the U.S. dollar will become more expensive before this bull market is over. In effect, the U.S. dollar rally is reflective of America sucking in capital. This will leave EM current account deficit countries exposed. As the currencies of these countries plummet and their local bond yields rise, their share prices will plunge and credit spreads will widen. Importantly, Trump's trade protectionist rhetoric could accelerate the depreciation in the Chinese RMB. If and when America imposes import tariffs on China, the latter will compensate via further yuan depreciation. In fact, Chinese residents will "assist" the People's Bank of China in devaluing the currency by converting their RMBs into U.S. dollars. As the RMB weakens further, probably at a faster speed, other Asian currencies will plummet (Chart I-3). In fact, odds are high that EM financial markets will once again become sensitive to the RMB. Chart I-2The U.S. Dollar Is Not Expensive bca.ems_wr_2016_11_16_s1_c2 bca.ems_wr_2016_11_16_s1_c2 Chart I-3RMB And Emerging Asian Currencies RMB And Emerging Asian Currencies RMB And Emerging Asian Currencies Apart from shorting the RMB versus the U.S. dollar, on October 19 we recommended shorting the KRW against the THB because the Korean won was one of most vulnerable EM currencies to continued RMB depreciation and renewed JPY weakness. We reiterate this trade today. Consistent with U.S. dollar appreciation, commodities prices will drop. One unsustainable post-U.S. presidential election move has been the rally in industrial metals in general, and copper in particular. Traders have bid up copper prices as the metal had lagged the rally in risk assets since February (Chart I-4). Nevertheless, expectations that U.S. infrastructure spending will considerably boost world demand for industrial metals are misplaced. The U.S. accounts for a very small portion of global industrial metals demand, including copper. Chart I-5 demonstrates that U.S. demand for copper is seven times smaller than that of China. On average, China accounts for about 50% of global demand for industrial metals, while the U.S. accounts for slightly less than 10%. Chart I-4The Rally In Copper ##br##Prices Is Unsustainable The Rally In Copper Prices Is Unsustainable The Rally In Copper Prices Is Unsustainable Chart I-5Industrial Metals ##br##Consumption: U.S. Versus China EM Got "Trumped" EM Got "Trumped" Hence, any reasonable rise in U.S. demand will not be sufficient to offset a single-digit percentage drop in China's intake of industrial metals, which we expect to occur in 2017. Finally, the Chilean mining firm Codelco - the largest copper producer in the world - in recent weeks has cut its premiums on copper shipped to Asia and Europe.1 This is a move to reduce prices - and a sign that demand is weak relative to supply. This leads us to believe that a rally driven by financial investors at a time of inferior demand-supply balance will prove short-lived. Investors should consider shorting copper on any further price strength. The selloff in U.S. and global bonds will likely persist well into December, which in turn will unravel the turmoil in bond proxies and high-multiples stocks (Chart I-6). In our July 13 Weekly Report,2 we argued that U.S. bond yields had bottomed and a selloff would prove painful as lower yields increases their duration. As a result, even a small rise in yields would lead to considerable bond price declines. Since then, while G7 bond yields initially grinded higher, they have surged over the past week. U.S. 10-year and 30-year bond yields have risen by 40 and 36 basis points, respectively since November 1. This translates into a 3.5% and 7.5% price decline for 10-year and 30-year bonds, accordingly. A similar scenario has also played out with EM bonds - both U.S. dollar and local-currency denominated. Accumulating considerable losses will force further bond liquidation. Our feeling is that many bond proxies and markets that benefited from lower yields will be seriously damaged in the coming weeks. Consistently, EM carry trades are at risk of further unraveling. Interestingly, Chart I-7 demonstrates that many high-yielding EM local bond markets are at a critical technical juncture. Odds are that their yields are heading considerably higher after troughing at their long-term moving averages. Chart I-6U.S. Bond Yields ##br##And Bond Proxies bca.ems_wr_2016_11_16_s1_c6 bca.ems_wr_2016_11_16_s1_c6 Chart I-7AEM Local-Currency Bonds Are ##br##At Critical Technical Resistance Levels bca.ems_wr_2016_11_16_s1_c7a bca.ems_wr_2016_11_16_s1_c7a Chart I-7BEM Local-Currency Bonds Are##br## At Critical Technical Resistance Levels bca.ems_wr_2016_11_16_s1_c7b bca.ems_wr_2016_11_16_s1_c7b Bottom Line: EM risk assets will continue to plunge. Stay put and remain defensive. Asset allocators should maintain an underweight allocation to EM within both global equity and credit portfolios. Currency traders who are not already short should consider shorting a basket of the following EM currencies: BRL, CLP, ZAR, TRY, IDR and MYR. In addition, we recommend maintaining our short RMB versus USD trade, as well as our short KRW / long THB position. Today, we are also reinstating the long RUB / short MYR trade (see section on Russia below). For more details on other currency, fixed-income, credit and equity positions, please refer to our Open Position Tables on pages 12-13. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com 1 Please see: Codelco cuts 2017 China copper premium by 27% to $72/t.- sources (2016, November 14). Retrieved from https://www.metalbulletin.com/Article/3601613/Latest-news/Codelco-cuts-2017-China-copper-premium-by-27-to-72-sources.html 2 Please refer to the Emerging Markets Strategy Weekly Report, titled "Risks To Our Negative EM View," dated July 13, 2016; a link is available on page 14. Russia: Overweight Equities; Reinstate Long RUB / Short MYR Trade Chart II-1Overweight Russian Stocks ##br##Versus The EM Equity Benchmark Overweight Russian Stocks Versus The EM Equity Benchmark Overweight Russian Stocks Versus The EM Equity Benchmark Russia stands out as one of the few EM countries that will likely benefit from Trump's presidency. As such, we recommend dedicated EM investors overweight Russia within both EM equity and credit portfolios. The energy and financial equity sectors together account for 75% of the Russian MSCI equity index, and we think they will continue to outperform their EM peers for the following reasons: With the ruble serving as a shock absorber, Russia's oil and gas sector has been able to weather the volatility in energy prices. If it wasn't for the ruble's massive devaluation in 2014-15, Russian energy companies would have struggled to stay solvent. While we expect oil prices to drop toward $35 per barrell, Russian energy stocks will still perform better than their EM counterparts. Furthermore, going forward, oil prices will outpace industrial metals prices. This should help Russian stocks, credit, and the currency outperform their EM peers (Chart II-1). As we argued above (please refer to page 3), the latest rally in industrial metals prices - based on expectations of U.S. infrastructure spending - does not make sense to us. In fact, the U.S. is a much more important consumer of oil than industrial metals in total world aggregate demand. Hence, strong U.S. growth and weaker Chinese growth (our baseline assumption) should be associated with oil prices outperforming base metals prices. Russia is much more advanced in its deleveraging cycle than most other EM economies. This will help banks and consumer stocks outperform their EM peers. In March 2016 we highlighted our preference for Russia's banking system relative to Malaysia's, and initiated a relative equity trade: long Russian stocks / short Malaysian stocks. This trade has already returned 30% and we believe it still has further to go. Today, we extend this positive view on Russia's banking system vis-à-vis Malaysia, to one versus the entire EM bank universe. In contrast to other emerging markets, Russian banks have been recognizing NPLs and have increased their provisions significantly (Chart II-2). Russia has now been in recession for two years and its banks have increased their NPL provisions and their credit growth has already slowed down significantly. This stands in stark contrast to other emerging markets, where banks are failing to realize NPLs and increase provisions adequately, despite substantially slower economic growth and elevated debt levels. In fact, Russia's domestic credit impulse is already starting to head into positive territory (Chart II-3), while the same indicator for the overall EM aggregate will be negative over the next 12 months or so. Russia's financial market outperformance will be aided by orthodox macro policies. This stands in contrast to unorthodox measures in many other developing countries. In terms of monetary policy, the Central Bank of Russia has refrained from injecting excess liquidity into the system or intervening in the foreign exchange market. Moreover, the central bank has been canceling the licenses of smaller banks. This is bullish for listed banks, as their market share will increase (Chart II-4). Chart II-2Russian Banks Have Recognized ##br##NPLs And Raised Provisions Russian Banks Have Recognized NPLs And Raised Provisions Russian Banks Have Recognized NPLs And Raised Provisions Chart II-3Russia's Credit Impulse ##br##Is Turning Positive Russia's Credit Impulse Is Turning Positive Russia's Credit Impulse Is Turning Positive Chart iI-4Russia: Banking Sector Consolidation ##br##Is Bullish For Listed Banks Russia: Banking Sector Consolidation Is Bullish For Listed Banks Russia: Banking Sector Consolidation Is Bullish For Listed Banks With respect to fiscal policy, although the government has exceeded its planned budget deficit of 3% of GDP for 2016, we believe this is not an issue given that Russia's total government debt is very low at only 16.5% of GDP. Lastly, our bias is that the recent victory of President-elect Trump will be marginally positive for the Russian economy relative to other EM. While the U.S. is not a major importer of Russian exports, investors will begin to price in sanction relief. European sanctions are particularly important for Russia and a substantive improvement in U.S.-Russia relations could lead some relatively pro-Russia European governments (Italy, Hungary, Greece, etc.) to demand that EU sanctions be either rolled back fully or significantly modified. Therefore, since Russia does not export as many goods to the U.S. compared to other emerging markets and sanctions may be easing soon, the nation is much more insulated from potential U.S. protectionist measures than many other EM countries. Investment Recommendations The Russian economy is further along its necessary adjustment path compared to the rest of the EM world, and there is less downside at the moment. Furthermore, Russian monetary and fiscal policymakers have undertaken orthodox policy measures in the face of an economic crisis - which cannot be said of many other EM countries. As such, we recommend dedicated EM investors upgrade Russia from neutral to overweight within an EM equity portfolio. We reiterate an overweight stance on Russian sovereign and corporate credit and recommend holding the following trades: Short Russian CDS / long South African CDS Long Russian and Chilean corporate credit / Short Chinese offshore corporate credit. We also recommend currency traders reinstate the long RUB / short MYR trade (Chart II-5). The two currencies are sensitive to energy prices, but the Russian economy is likely to recover soon, while the Malaysian economy has much more downside ahead. Excessive liquidity injections in Malaysia relative to somewhat tighter monetary conditions in Russia will lead to ringgit depreciation versus the ruble (Chart II-6). Lastly, the ruble offers a higher carry than the ringgit. Consistent with the currency trade, we are maintaining our long Russian / short Malaysian equity trade. Chart II-5Reinstate Long RUB / ##br##Short MYR Trade bca.ems_wr_2016_11_16_s2_c5 bca.ems_wr_2016_11_16_s2_c5 Chart II-6Malaysia And Russia: ##br##Non-Orthodox Versus Orthodox bca.ems_wr_2016_11_16_s2_c6 bca.ems_wr_2016_11_16_s2_c6 Stephan Gabillard, Research Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Most narratives surrounding G7 bond yields, the U.S. dollar, Chinese credit/fiscal impulses, and the RMB exchange rate - which justified the EM rally from February's lows - have been overturned. To be consistent, this warrants a relapse in EM risk assets. In China, recent property market and marginal credit policy tightening will weigh on growth. Feature The more recent strength in Chinese and emerging markets' (EM) manufacturing PMI indexes as well as the bounce in industrial metals prices have gone against our negative view on EM/China growth and related markets. While it is hard to predict market patterns over the next several weeks, we maintain that the EM rally is on borrowed time, and that the risk-reward profile for EM risk assets (stocks, credit markets and currencies) remains very unfavorable. Tracking Correlations And Indicators The overwhelming majority of indicators and variables that supported the rally in EM since February have reversed in recent months. Specifically: China's credit and fiscal spending impulses have rolled over (Charts I-1 and Chart I-2, on page 1). This will likely lead to a rollover in mainland industrial activity early next year (Chart 1, top panel). Similarly, this bodes ill for much-followed Chinese ex-factory producer prices - i.e., producer price deflation will probably recommence early next year (Chart I-1, bottom panel). Chart I-1China: Industrial Sectors To Retreat? bca.ems_wr_2016_11_09_s1_c1 bca.ems_wr_2016_11_09_s1_c1 Chart I-2China: Credit And Fiscal Impulses China: Credit And Fiscal Impulses China: Credit And Fiscal Impulses In a nutshell, the strong credit and fiscal impulses of late 2015 and early 2016 explain the stabilization and mild improvement in the Chinese economy during the past few months. However, these same impulses project renewed weakness/rollover in the economy in early 2017. If financial markets are forward looking, they should begin pricing-in deteriorating growth momentum sooner than later - especially as Chinese policymakers are announcing marginal tightening policies (see below for more details). One of the narratives that triggered the EM and global equity rally in February was speculation that there was a "Shanghai accord" between global central banks. According to this narrative, the People's Bank of China (PBoC) promised not to devalue the RMB in exchange for the Federal Reserve not hiking rates. Since then, the RMB has continued to depreciate, both versus the greenback and the CFETS1 basket. Yet EM and global stocks have completely disregarded the RMB depreciation (Chart I-3). We do not have good explanation as to why. Indeed, the RMB has weakened meaningfully, despite the PBoC's massive currency defense: the latter's foreign exchange reserves have shrunk further since then (Chart I-4), as capital flight has exceeded the enormous current account surplus by a large margin. Chart I-3Investors Are ##br##Complacent About RMB bca.ems_wr_2016_11_09_s1_c3 bca.ems_wr_2016_11_09_s1_c3 Chart I-4China: Foreign Exchange ##br##Reserves Still Shrinking bca.ems_wr_2016_11_09_s1_c4 bca.ems_wr_2016_11_09_s1_c4 Chart I-5PBoC Liquidity Injections ##br##Have Been Enormous bca.ems_wr_2016_11_09_s1_c5 bca.ems_wr_2016_11_09_s1_c5 The PBoC's selling of U.S. dollars to prop up the yuan has drained domestic currency liquidity and one would expect interbank rates to rise. However, the PBoC has been re-injecting RMBs into the system to keep interest rates low (Chart I-5). Such RMB liquidity proliferation makes further declines in the currency's value all the more likely. We expect the RMB to continue depreciating. Yet global financial markets have become extremely complacent about the potential for additional RMB depreciation. After having been bullish on U.S./G7 bonds for the past several years, in our July 13 Weekly Report,2 we highlighted that U.S./G7 bond yields would rise and closed our strategic short EM equities/long 30-year U.S. Treasurys position. Even though U.S./G7 bond yields have risen since July, EM equities have not declined. Given that falling G7 bond yields were used as justification for the EM rally, the opposite should also hold true. We expect U.S. bond yields to rise further. Our EM Corporate Health Monitor - constructed using bottom-up financial variables of companies with outstanding U.S. dollar corporate bonds - points to a reversal in the EM corporate credit market rally (Chart I-6). Furthermore, EM sovereign and corporate credit spreads have tightened considerably and are now very overbought and expensive. As we argued in our Special Report titled EM Corporate Health Is Flashing Red3 that introduced the EM Corporate Financial Health (CFH) Monitor, EM corporate credit spreads are as expensive as they were before they began widening in 2013 and 2014 (Chart I-7). Chart I-6EM Corporate Bond Rally To Reverse? EM Corporate Bond Rally To Reverse? EM Corporate Bond Rally To Reverse? Chart I-7EM Corporate Spreads Are Too Tight EM Corporate Spreads Are Too Tight EM Corporate Spreads Are Too Tight Finally, the U.S. dollar sold off early this year, but it has held firm in recent months. Nevertheless, EM risk assets have not retreated, despite the greenback's strength (Chart I-8). Few would argue that sharp U.S. dollar appreciation is negative for EM risk assets, but there is a debate among investors and analysts about whether EM risk assets can rally amidst a gradual appreciation in the U.S. dollar. Turning to the empirical evidence, Chart I-9 reveals that in the past 30 years any U.S. dollar appreciation - whether gradual or not - even versus DM currencies has coincided with weakness in EM share prices. Chart I-8EM Investors Have ##br##Ignored U.S. Dollar Strength bca.ems_wr_2016_11_09_s1_c8 bca.ems_wr_2016_11_09_s1_c8 Chart I-9EM Equities And ##br##U.S. Dollar: A 30 Year History EM Equities And U.S. Dollar: A 30 Year History EM Equities And U.S. Dollar: A 30 Year History Bottom Line: The majority of narratives that justified the EM rally from February's lows have been overturned. To be consistent, this warrants a relapse in EM risk assets. China's Credit And Property Tightening In recent weeks, there have been numerous policy tightening efforts in China. In particular: At the annual World Bank/IMF meetings in Washington last month, PBoC Governor Zhou Xiaochuan stated that once markets stabilized there would no longer be additional large increases in bank credit. His exact words were: "With the gradual recovery of the global economy, China will control its credit growth".4 As U.S. and European PMIs have firmed up and U.S. employment and wage growth is robust, Chinese policymakers will be emboldened to moderate unsustainable credit growth and not to repeat the massive fiscal push of early this year. In a bid to curb excessive bank credit growth and discourage "window dressing" accounting, the PBoC announced on October 255 that going forward it will include off-balance-sheet wealth management products (WMPs) in the calculation of banks' quarterly Marco Prudential Assessment ratios, starting from the third quarter. The clampdown on WMP accounting will reduce banks' capital adequacy ratios (CARs). One key reason that banks had aggressively boosted the size of their off-balance-sheet WMP assets was that they were not required to have capital charges against them, helping banks extend more credit while complying with CARs. In short, Chinese banks' CARs are inflated. This policy measure along with provisioning and writing-off non-performing loans, if reinforced, could meaningfully reduce the CARs of all Chinese banks, especially small- and medium-sized ones, as well as force them to reduce the pace of credit expansion. Given that the majority of medium and small banks have been more aggressive than the country's five biggest banks in expanding credit in recent years, this may have a damping effect on credit growth in 2017. In fact, the 110 medium and small banks retain 60% of on- and off-balance-sheet credit claims on companies, while the five largest banks hold 40% (Table I-1). Hence, credit trends in small and medium banks are at least as important as those among large banks. Table I-1China: Five Largest Banks Hold Only 40% Of Credit Assets EM: Defying Gravity? EM: Defying Gravity? Finally, a number of cities have announced various tightening measures on property markets of late, including the re-launch of house purchasing restrictions and increases in minimum down payments. Similar restrictions on home purchases served as an efficient tool for curbing property purchases in 2013-14, and there is no reason why it will be different this time around. This is especially true given the market is more expensive than it was back in 2013. In addition, the government has curbed financing for property developers. The biggest economic risk remains construction activity. Even though housing sales and prices have skyrocketed by 20-40% in the past 12 months (Chart I-10, top and middle panels), residential floor space started has been very timid - it has in fact failed to recover (Chart I-10, bottom panel). As residential property sales contract again due to new purchasing restrictions, property developers will certainly curtail new investment, and housing construction activity will shrink anew. The same is true for commercial properties (Chart I-11). Chart I-10China's Residential Market: ##br##Demand, Prices And Starts China's Residential Market: Demand, Prices And Starts China's Residential Market: Demand, Prices And Starts Chart I-11China's Non-Residential ##br##Market: Demand And Starts China's Non-Residential Market: Demand And Starts China's Non-Residential Market: Demand And Starts An interesting question is why property starts have been so weak, as indicated in the bottom panels of Chart I-10 and Chart I-11 - particularly when both floor space sold (units) and property prices have surged exponentially in the past 12 months. Our view is that there is a large hidden inventory overhang in the Chinese property market. For example, government data on residential floor space started, completed and under construction attest that there is still a large gap between floor space started versus completed (Chart I-12). From these data/charts and the enormous leverage carried by property developers, we infer the latter have been accumulating / carrying on their balance sheets vast amounts of inventory in excess of what market-based sources suggest, and what is widely followed by analysts. It is very hard to make sense of the Chinese property inventory data, but we suspect these market-based data sources may track only inventories that have been completed and released to the market - and do not account for inventories classified as "under construction". For residential housing, according to government data the "under construction floor space" is 5 billion square meters (Chart I-13, top panel), which is equal to 3.5-4 years of sales at the fervent pace of the past 12 months (Chart I-13, bottom panel). Another way to assess this is as follows: Assuming an average construction cycle of three years, there will be supply of new housing in amounts of 16.7 units in each of the next three years. This compares with sales of 13.3 million units in the past 12 months that occurred amid a buying frenzy and booming mortgage lending. Faced with a potential drop in sales due to the recent purchasing restrictions, elevated inventories, enormous leverage (Chart I-14), and tighter financing, property developers will most likely curtail new starts. In turn, a reduction in property starts means less construction activity next year, and weak demand for commodities. Consistent with the rollover in the fiscal spending impulse, infrastructure spending will likely also lose its potency in early 2017. Chart I-12China's Residential ##br##Market: Hidden Inventories bca.ems_wr_2016_11_09_s1_c12 bca.ems_wr_2016_11_09_s1_c12 Chart I-13Chinese Real Estate: Massive ##br##Volumes Under Construction Chinese Real Estate: Massive Volumes Under Construction Chinese Real Estate: Massive Volumes Under Construction Chart I-14Leverage Of Chinese ##br##Listed Property Developers bca.ems_wr_2016_11_09_s1_c14 bca.ems_wr_2016_11_09_s1_c14 Bottom Line: Recent property market and marginal credit policy tightening will weigh on construction activity and depress Chinese demand for commodities and industrial goods next year. Confirmation Bias, Or Bias Based On Fundamentals? Why did we not follow the indicators discussed above from February through June, when the EM rally emerged and these indicators bottomed? Do we have a confirmation bias? We did not recommend playing the EM rebound early this year because we did not believe the rally would last this long or go this far. If we had had conviction about the duration and magnitude of the rally, we would have changed our strategy - tactically upgrading EM risk assets despite our negative structural and cyclical views. Simply put, we were wrong on strategy. In our April 13, 2016 Weekly Report,6 we argued that based on China's injection of massive amounts of fiscal and credit stimulus, growth would marginally improve in the months ahead. Yet, we stopped short of recommending chasing the EM rally given the menace of numerous cyclical and structural negatives surrounding the EM/China growth outlook. As to the reasons why we put more emphasis on some indicators and less on others at various times, we have the following points: We are biased in so far as our assessment and analysis of EM/China is based on fundamentals. In this sense, we are biased towards centering our investment strategy on fundamentals. Specifically, given our view/analysis that EM/China have credit bubbles/excesses, rapidly falling or weak productivity growth and record-low return on capital (Chart I-15), we cannot help but to have a fundamentally bearish bias on EM. This, in turn, means that we view any rally in EM risk assets or uptick in EM/China economic indicators with suspicion and likely as unsustainable. The opposite also holds true. All in all, if we are wrong on our fundamental view and analysis, we will be wrong on financial markets. When investors expect a bear market, they are better off selling rallies and not buying dips. When an asset class is in a multiyear bull market, it pays off to buy dips rather not sell rallies. Unless one can time market swings well, it is hard to make money on the long sides of bear markets. Similarly, it is difficult to profit from short positions in bull markets. In brief, countertrend moves are about timing. Timing does not depend on fundamentals. It is often a coin toss. Typically we do not recommend clients invest based on a coin toss. For example, it is impossible to rationalize why the EM rally did not begin following the August 2015 selloff, but instead started in February 2016. In late August 2015, with carnage in EM risk assets pervasive, it was clear that Chinese policymakers would stimulate and in fact the massive fiscal stimulus was initiated in August/September 2015 not in 2016. Similarly, China's manufacturing PMI bottomed in September 2015, not in 2016 (Chart I-16). Chart I-15EM Non-Financial Return ##br##On Equity Is At All Time Low EM Non-Financial Return On Equity Is At All Time Low EM Non-Financial Return On Equity Is At All Time Low Chart I-16China's Manufacturing PMI ##br##Bottomed In October 2015 China's Manufacturing PMI Bottomed In October 2015 China's Manufacturing PMI Bottomed In October 2015 In September 2015, EM and global equities rebounded, but chasing momentum at that time did not pay off as risk assets cratered in the following months. This is all to say that timing markets is often a random walk. We do attempt to time market moves that go along with our fundamental bias, but prefer not to time market moves that go against the primary trend. We assume any countertrend move is typically short-lived and unsustainable. That said, we also realize these moves can be very painful for investors if they last long enough, like this EM rally. Finally, we often get questions on fund flows. We do not make investment recommendations based on fund flows - even though we recognize they are very important in driving markets. The reason is that there is no comprehensive data on global fund flows that one can analyze and make reasonably educated bets. The often-cited EPRF dataset only tracks inflows and outflows of mutual funds and ETFs. It does not account for flows and positioning of various asset managers, sovereign funds, pension funds, insurance companies, hedge funds and private wealth managers, among many others. What's more, the EPRF dataset only covers the funds located in advanced countries and offshore jurisdictions, but not emerging countries where investment pools have become large and important. In brief, the available investment flow and portfolio positioning data are not comprehensive at all, and they cannot be relied upon too much to make investment recommendations. In this vein, a question arises: Why can't flows into EM sustain the current rally for a while even though it is not based on fundamentals? In this context, let's consider the case of the rally in euro area share prices when markets sensed the arrival of the European Central Bank's quantitative easing efforts at the beginning of 2015. There was a fervent rush to buy/overweight euro area stocks heading into the QE announcement by the ECB. European bourses surged. Nevertheless, euro area equity prices have been sliding and massively underperforming the global equity benchmark since March 2015 (Chart I-17). The reason the ECB's QE has not helped euro area stocks is because their fundamentals were bad - profits have been shrinking despite the ECB's QE. We suspect EM stocks and currencies will have a similar destiny: EM profits will disappoint considerably, and the current rally will prove unsustainable. Notably, net EPS revisions have so far failed to move into the positive territory (Chart I-18). Chart I-17Euro Area Stocks And EPS: ##br##Why The QE Rally Proved To Be Bogus Euro Area Stocks And EPS: Why The QE Rally Proved To Be Bogus Euro Area Stocks And EPS: Why The QE Rally Proved To Be Bogus Chart I-18EM Stocks And EPS: ##br##Earning Revisions Are Still Contracting bca.ems_wr_2016_11_09_s1_c18 bca.ems_wr_2016_11_09_s1_c18 Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com 1 China Foreign Exchange Trading System. 2 Please refer to the Emerging Markets Strategy Weekly Report, titled "Risks To Our Negative EM View," dated July 13, 2016; a link is available on page 15. 3 Please refer to the Emerging Markets Strategy Special Report, titled "EM Corporate Health Is Flashing Red," dated September 14, 2016; a link is available on page 15. 4 Please see http://www.pbc.gov.cn/goutongjiaoliu/113456/113469/3155686/index.html 5 Please see http://www.pbc.gov.cn/goutongjiaoliu/113456/113469/3183204/index.html 6 Please refer to the Emerging Markets Strategy Weekly Report titled, "Revisiting China's Fiscal And Credit Impulses," dated April 13, 2016; a link is available on page 15. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights There is an eternal duality between bulls and bears on the Chinese economy. We prefer to stay away from the debate, and simply monitor the situation while adjusting our portfolio recommendations as the situation evolves. From the perspective of BCA Global Fixed Income Strategy (GFIS), and in the short term, five key questions on China influence our duration stance and our core bond portfolio allocation recommendations. To answer these questions, we are following specific indicators, laid out in this Special Report. Together, those form the "GFIS China Checklist". Several of our financial stress indicators reveal the possibility that China's macro stability could be starting to fray a bit at the edges. These trends could become worrisome if they linger or re-appear. China's cyclical growth impulses are positive, suggesting a tailwind for the global economy, and upward pressure on inflation and bond yields in the near-term. At the moment, the "China Factor" reinforces our below-benchmark portfolio duration stance and our bias towards underweighting bond markets that are most exposed to Chinese demand and higher commodity prices (i.e. Australian government debt), while also favoring inflation-linked bonds over nominals across the developed world. Table 1The GFIS China Checklist How To Assess The "China Factor" For Global Bonds How To Assess The "China Factor" For Global Bonds Feature Chart 1Getting China Right Is Crucial Getting China Right Is Crucial Getting China Right Is Crucial At the macro level, several factors have a disproportionate impact on the direction of global bond yields. The evolution of monetary policies in the developed economies, globalization, new technologies, demographic changes and productivity trends are among the themes that top our list. A positive or negative shift in these factors could significantly alter the path of global growth and inflation and, by the same token, bond yields. In this Special Report, we will address the "China factor". Through its massive aggregate demand, this huge country can tip the global macro landscape into equilibrium or disequilibrium (Chart 1).1 As such, closely monitoring its developments is crucial for investors to correctly position for/against the cyclical drivers of bond markets. Unfortunately, understanding China's dynamics and seeing through the opacity of its policy-setting process is extremely challenging. Experts on the matter often disagree (even here at BCA!) on the complex issues, and sometimes even the most basic assumptions, underlying a view on China. In this Special Report, our goal is not to try to untangle the ultimate truth about China. Instead, we will cut through the fog and offer a simple framework to monitor its economy and associated risks. From an investment perspective, getting China right comes down to answering five keys questions: Is China's macro stability starting to deteriorate? Are China's growth impulses positive? Is Chinese economic momentum accelerating? Are China's business fundamentals evolving positively? Is the outlook for Chinese household consumption improving? To answer those, we follow simple indicators, laid out in this Report. Together, they form the BCA Global Fixed Income Strategy (GFIS) "China Checklist" (Table 1). The Eternal Duality In Chinese philosophy, the Yin - the dark swirl - represents shadows, the moon and the trough of a wave. In the investment world, members of the Yin camp view China's great accomplishments of the last 30 years with a doubtful eye. In its economic miracle, they see fragility and unsustainability. Those doubters are quick to raise the multiple structural problems such as regional disparities, income inequality, pollution, workers' dissatisfaction, and the unfair hukou2 system, among others. China' high debt levels and widespread, institutionalized misallocation of capital usually anchor their gloomy view. On the other end of the spectrum, the Yang - the light swirl - represents the sun and growth. For members of the Yang camp, China's policymakers have a grand master plan that will lead China to dominate economically and geopolitically for decades to come. Discarding the potential credit addiction problem, they believe that China should continue to invest at a record pace, arguing that investments will eventually lead to faster productivity, which will lift potential growth and overall prosperity. They posit that leveraging is simply a natural process for a fast-growing country with massive excess savings. To their despondency, China bears fail to recognize the merits of the country's un-paralleled meritocratic political system and the communal dynamic that makes it unique. Where does GFIS stand in this debate? Both camps have legitimate arguments and could be right in the end. The key thing about the Yin/Yang symbol is that both the black and white contain a little bit of each other. In the end, this duality might just be a healthy dynamic where one cannot exist without its opposite. For us, it leaves an important dilemma. On one hand, betting on a Chinese hard landing that never materializes could turn out to be a widow-maker trade.3 On the other hand, ignoring China's structural issues and assuming that everything will be all right is a strategy that can be prone to devastating disappointments. Instead of trying to predict the end game, we will focus our efforts on assessing how the economic momentum and the risks are evolving at each particular moment. This will inform our overall views on global growth and inflation and, in the end, the direction of bond yields and credit spreads. Bottom Line: There is eternal debate between the Yin and Yang camp in regards to China's future. We prefer to stay away from the debate, and will monitor the situation through specific indicators and adjust our investment recommendations accordingly. Is China's Macro Stability Starting To Deteriorate? Maybe Nobody knows for sure when or if China will go through an acute period of turbulence related to stresses in its financial system. Nonetheless, to properly calibrate our duration call and the pro-cyclical bets in our recommended fixed income portfolio, we need to assess if the stress points are flashing red, and to what degree. Below, we propose a set of indicators that could eventually signal a bubbling credit-related event (Chart 2 & Chart 3). Chart 2Is China's Macro Stability Deteriorating? Part I bca.gfis_sr_2016_11_08_c2 bca.gfis_sr_2016_11_08_c2 Chart 3Is China's Macro Stability Deteriorating? Part II Is China's Macro Stability Deteriorating? Part II Is China's Macro Stability Deteriorating? Part II In aggregate, they warn that China has been experiencing some instability lately. This should be taken seriously and temper any China optimism. The Renminbi If China goes through a period of instability, its currency, the Renminbi (RMB), would deteriorate as money tries to escape through any cracks in the financial system or real economy. The RMB has had several episodes of rapid depreciation (by China's standards) over the past 18 months which could be a bad omen. That said, since China's policymakers still largely have the capacity to control the evolution of its currency, the RMB could end up reflecting a serious capital outflow problem only far after the fact. Nonetheless, it is still something to follow closely. Hibor/Shibor rates When a financial system goes through episodes of turbulence, lenders tend to freeze operations until the cause is clear. Banks stop lending to each other and overnight interest rates tend to spike. It is possible that the RMB-based Hong Kong Interbank Offered rate (Hibor) or the Shanghai Interbank Offered Rate (Shibor) can offer such a signal. Since mid-2015, the Hibor has experienced three such episodes. In each case, they proved to be temporary - rates came down shortly after each spike - but we still view this with a wary eye. Since China has a closed capital account and maintains a stable currency through several interlinked instruments, it is possible that the overnight lending market might not be as relevant a signal as it would be for countries with open capital accounts. Our colleagues at the BCA China Investment Strategy have recently been sanguine about the significance of those spikes.4 Regardless, we will keep this indicator on our list of possible China stress points. Equity prices of global banks with heavy links to China & Emerging Markets Capital market data are often the first to hint that financial stress is rising. In China's case, the stock prices of major global banks that are highly exposed to China and, more broadly, emerging markets might play that role. Two such banks are Standard Chartered and HSBC. If China's internal dynamic eventually becomes shaky, the relative equity performance of those banks could quickly erode.5 For now, this does not seem to be the case, as their stocks are performing well; the stress appears to be contained. Capital outflows If China's economy is about to crumble under a pile of debt, money will leak through the cracks. Part of the money flowing out will eventually trickle through to safe assets in the rest of the world, like U.S. Treasuries and non-Chinese property markets. Since mid-2014, China capital flight has been large and clearly represents a potential source of worry. Official Holdings of U.S. Treasuries If the Chinese economy were to deteriorate meaningfully, or if there were potential undercapitalization issues stemming from any buildup of bad loans within the Chinese banking system, the authorities might be driven to sell some of China's enormous stock of U.S. Treasuries and "invest" the money domestically. Lately, China has been a net seller of U.S. Treasuries, which could be a potential sign of trouble but could also simply be the result of China having less of a need to accumulate U.S. dollar assets to fight inherent appreciation pressures on the RMB. Policy Uncertainty Capital flight out of China could be related to many factors. Pessimism towards the future or lack of domestic investment opportunities could force savings outward. Another possibility is increasing policy uncertainty and/or brewing political instability among China's leadership. Lately, China's Policy Uncertainty Index has skyrocketed.6 Before pushing the panic button, however, one has to consider mitigating factors. It is possible, considering the after-effects of the shocking U.K. Brexit referendum and the increased odds of a Donald Trump U.S. Presidency, that this jump in the China uncertainty index has been more externally than domestically driven. Bottom Line: Several of our financial stress indicators reveal the possibility that China's macro stability could be starting to fray a bit at the edges. These trends could become worrisome if they linger or re-appear. Are China's Growth Impulses Positive? Yes Economic momentum can develop as a result of several growth impulses. Below, we propose five of them (Chart 4 & Chart 5). Currently, they are trending favorably, for the most part, and suggest that China is in the expansionary phase of its economic cycle. If sustained, this tendency should have a considerable impact on global growth, inflation and bond yields. Chart 4Are The Growth Impulses Positive? Part I bca.gfis_sr_2016_11_08_c4 bca.gfis_sr_2016_11_08_c4 Chart 5Are The Growth Impulses Positive? Part II Are The Growth Impulses Positive? Part II Are The Growth Impulses Positive? Part II The monetary conditions index Both the movement in policy interest rates and the currency can influence a country's monetary conditions, which in turn impact the backdrop for growth. Since the beginning of 2015, China's policy interest rate and the reserve requirement ratio for banks have been cut several times. The Renminbi has also depreciated during the same period. Combined, these factors have eased monetary conditions, which has been a positive development for the Chinese economy. Money supply growth In most countries, a more rapidly growing money supply usually leads to greater credit expansion, which eventually leads to faster economic growth. Again, since the beginning of 2015, Chinese money supply growth has shot up markedly. This should sustain credit/growth expansion in the coming months. Corporate bond yields An abundance of money can be of little help to an economy if corporations cannot finance themselves at a reasonable yield. Historically, the average Chinese corporate bond yield has been a leading indicator of industrial output growth. As the corporate yield decreases, financing becomes more attractive and a credit boom could follow, resulting in increased economic activity. Since 2015, Chinese corporate bond yields have literally collapsed, seemingly following the trend in non-Chinese corporate bond yields. If history is any guide, this should be setting the stage for accelerating output growth. One caveat: China's private sector debt servicing ratio might have reached too high a level, such that it has reduced the ability for companies to benefit from lower corporate bond yields moving forward. This could explain why industrial output growth has not gained ground as corporate bond yields have fallen. The credit impulse Credit origination has been a vital part of China's economic success since 2000 and even more so since the 2008 global financial crisis. Our Emerging Markets Strategy team has created the credit impulse indicator - which is the second derivative of credit growth - to assess the condition of the credit impulse.7 This simple indicator has proven to be one of our more reliable leading indicators of economic growth (for China and for many other countries) Of late, this indicator has moved into positive territory. Possibly, easy monetary conditions, stronger money supply growth and lower corporate bond yields have helped push the impulse upward. We interpret that as a very powerful signal for future Chinese growth. Again, a cautionary note is warranted. For a while now, Chinese credit growth has been faster than nominal GDP growth, potentially representing an unsustainable dynamic. Hence, it is likely that the latest surge proves to be only temporary, as credit growth slows to a more desirable pace.8 So, we won't get too excited just yet. Fiscal thrust Outside the credit channel, the Chinese government embodies another major contributor to the growth impulse. Considering its relatively low debt levels, the government has the means to sustain the economy via increased fiscal expenditures, especially via infrastructure investments. Lately, to alleviate the pain from the reforms and restructuring of certain parts of the economy,9 the government has engineered a decent fiscal thrust. Many infrastructure projects have been laid out, growing at a rate up of 15% in the last four years. As long as China continues along a long-term restructuring path, reducing that rapid pace of government spending will prove to be difficult. Bottom Line: Chinese growth impulses are currently positive. Is Chinese Economic Momentum Accelerating? Yes An open liquidity tap and a positive fiscal thrust should lead to increased Chinese demand. Below, we provide six indicators showing that this occurred lately (Chart 6 and Chart 7). The synchronicity of their upward acceleration reinforces our optimism about the Chinese cyclical outlook. Chart 6Is Chinese Economic Momentum Accelerating? Part I Is Chinese Economic Momentum Accelerating? Part I Is Chinese Economic Momentum Accelerating? Part I Chart 7Is Chinese Economic Momentum Accelerating? Part II Is Chinese Economic Momentum Accelerating? Part II Is Chinese Economic Momentum Accelerating? Part II Keqiang index Since Chinese economic growth data could be described as "man-made" and potentially unreliable, an index of Premier Li Keqiang's favorite economic indicators has been used, since it was leaked to the press several years ago, to appraise the true state of the economy. Cargo volumes, electricity consumption and loans disbursed by banks comprise this indicator. In the last twelve months, the Keqiang index has hooked decisively higher. The index has a flaw - the declining role of banks loans in overall new credit - but it is still useful, and it corroborates the positive signal sent by the growth impulses mentioned previously in this report. Excavator sales Traditionally, the construction sector has been at the core of China's growth miracle. To gauge the evolution of this sector, the growth rate of excavator sales has been very reliable. After being negative since mid-2011, it has surged in 2016. With a lift off of such magnitude, one could doubt the validity of this data. However, it has followed a similar spurt seen in money supply and a burst in the "projects started" capital spending growth rate. Residential floor space sold The state of the construction sector can also be assessed through the time series of residential floor space sold, which tends to lead new housing starts by several months. Again, since the beginning of the year, this indicator has been trending higher, echoing the message sent by excavator sales growth. Import volume growth No other time series better expresses the state of China's demand than its import volume growth. If the global growth and inflation outlook were to get a boost, Chinese imports would need to gain positive momentum. Lately, they have accelerated; this constitutes a very positive sign. CRB Raw Industrials prices Since China is by far the biggest consumer of commodities globally (see Chart 1, on page 2), China's demand indicators should be correlated with global commodity prices. In theory, both should move in a similar fashion to validate one another. This year, the CRB Raw Industrials price index has indeed stabilized and confirmed the positive growth dynamic observed through other indicators. The Chinese yield curve The yield curve has traditionally been recognized as an excellent leading indicator for most economies. It usually signals slowing growth when it flattens and steepens when growth gains momentum. China's yield curve has been especially well correlated with the Chinese PMI data, for example. Lately, China's yield curve has flattened a bit, which is not a good sign. However, until it inverts, like in 2011, 2013 and 2015, we will treat its message as neutral. Bottom Line: Chinese economic momentum is accelerating. A flattening yield curve tempers our optimism to some degree, however. Chart 8Are The Business Fundamentals Evolving Positively? Are The Business Fundamentals Evolving Positively? Are The Business Fundamentals Evolving Positively? Are The Business Fundamentals Evolving Positively? Yes If Chinese economic momentum truly accelerates, domestic businesses should reap the benefits and their internal dynamics should improve. As per the business indicators presented below, this is currently the case (Chart 8). Final goods producer prices Producer pricing power is crucial and it has been lacking over the last few years on a global scale. Without pricing power, capital investment and employment growth tend to stay depressed, and vice versa. Since 2012, China's final goods producer prices have been contracting. This started before the beginning of the commodities collapse in 2014 and has been hugely deflationary for the rest of the world. But this might be a story of the past; final goods producer prices have turned positive lately. This could prove a major development, if it lasts. The risk here is that the U.S. dollar appreciates - due to a Fed hike and/or a more hawkish tone going forward - pushing global commodity prices lower, which has historically depressed global producer prices. However, if the Fed treads carefully after the December rate hike that we expect, waiting for the rest of the global economy to catch up to a U.S. acceleration, the dollar could end up trending sideways. Commodity prices could then continue on the current upward trend, preventing producer price growth from relapsing back into negative territory. Cash flow ratio Leveraging during the 2009-2011 period has left many Chinese firms highly indebted, especially in the industrials, materials and real estate sectors. As debts increased, debt servicing cash flows substantially shrank during the 2011-2014 period. Fortunately, since mid-2015, this situation has reversed, with the cash flow/total liabilities ratio having increased steadily. Net earnings revisions In the end, strong profits are necessary for a healthy economy. This has been lacking globally, but even more so in China; most China MSCI equity index sectors suffer from contracting earnings per share, except consumer staples. Nonetheless, the jump higher in net earnings revisions seen this year is encouraging. Bottom Line: China's business fundamentals are evolving positively. Chart 9 Is Chinese Consumption Outlook Improving? Is Chinese Consumption Outlook Improving? Is Chinese Consumption Outlook Improving? Is the Outlook For Chinese Household Consumption Improving? Yes Ultimately, improved business conditions should lead to better job creation, strong workers' income and more robust final consumer spending. Lately, the virtuous cycles in credit, demand and the business sector have indeed trickled down to the consumers. Employment and consumption are synchronously accelerating (Chart 9). PMI Employment Index Despite the questionable quality of China's employment data - making it difficult to assess the true picture of the labor market - the employment sub-index of the overall China Purchasing Managers Index (PMI) gives a relatively reasonable reading. Since 2012, it has been trending downward. However, the fact that the latest data point rose sharply above the 12-month moving average is a good sign, perhaps indicating the cyclical downtrend in Chinese employment growth truly bottomed in 2015. Auto sales If employment growth and wages are indeed in a cyclical upturn, Chinese retail consumption growth should be thriving. This has been the case in 2016, with auto sales growth shooting up sharply. Bottom Line: The outlook for Chinese household consumption is improving. Investment Implications Chart 10Investment Implications Investment Implications Investment Implications In the analysis above, we concluded that: The possibility of eroding Chinese macro stability cannot be discarded, as financial stress points are rising. This needs close monitoring. Chinese growth impulses are, for the most part, positive. Chinese economic momentum is accelerating, but a flattening yield curve tempers our optimism. China's business fundamentals are evolving positively. The outlook for Chinese household consumption is improving. In sum, despite the reigning policy uncertainty and persistent capital outflows, the current short-term dynamics are surprisingly positive. Accordingly, and taking the overall "China factor" in isolation, the following fixed income investment recommendations should be implemented (Chart 10): Maintain a below-benchmark duration bias. There is a meaningful positive contribution to global growth and inflation from China. If the Chinese economy gathers more steam, global bond yields and inflation will also move higher. Maintain low exposure to bond markets most negatively exposed to faster Chinese growth & rising commodity prices. Our positive cyclical view on China has an impact on our core recommended bond portfolio allocation. We have been underweight Australian government bonds versus global hedged benchmarks since the summer, and China's improving demand constitutes a definite plus to this view, as it is Australia's largest export destination. We have also maintained a bias to favor inflation-linked bonds versus nominals in the major developed markets. A faster pace of Chinese goods inflation should translate into an acceleration in global traded goods prices (and inflation rates) in the coming months, to the benefit of the relative performance of linkers. Maintain a neutral stance on Emerging Market hard currency bonds. Due to a very unappealing structural backdrop, we have a negative longer-term bias towards Emerging Markets sovereign and corporate bonds. However, in July, we turned neutral, from underweight, due to the improving global cyclical outlook, especially based on what was happening in China. This move has paid off so far and the position should be maintained, even if there is some upward pressure on the U.S. dollar from a Fed rate hike next month.10 Overweight Australian Semis. Since March 2016, we have had a positive bias towards Australian Semi-government debt.11 Semis outperform Australia federal government debt during global expansionary phases, and China will continue to support the current cyclical growth upturn. Finally, the biggest risk to our view is that China's structural fragilities won't allow the current cyclical recovery to be sustained beyond the next year. Our GFIS China Checklist will help us to detect any downturn if and when it becomes apparent. Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com 1 Furceri, Jalles, and Zdzienicka (2016) perform time-varying coefficient analysis using local projection methods on a sample of 148 countries over 1990-2014, and show that spillovers from a 1 percentage point shock to China's final demand growth now have a cumulative impact on global GDP of about 0.25 percent, after one year. Source: http://www.imf.org/external/pubs/ft/weo/2016/02/pdf/c4.pdf 2 The hukou system was originally introduced to register China's households as part of an effort to gather population statistics. It has morphed into a government tool to control rural-urban migration flows that has made it more difficult for migrant workers to access health care or education services in China's cities. For more information, please see: http://thediplomat.com/2016/02 chinas-plan-for-orderly-hukou-reform/ 3 Here we have a thought for all those who have bet on the demise of the Japanese bond market over the years without glory. 4 For details on this issue, please see BCA China Investment Strategy Weekly Report, "HIBOR, Liquidity And Chinese Stocks", dated September 22, 2016, available at cis.bcaresearch.com 5 For details on this issue, please see http://www.imf.org/~/media/files/publications/spillovernotes/spillovernote5 6 This is part of a global suite of indicators produced by researchers Baker, Bloom and Davis, designed to measure economic policy uncertainty for the major economies. For more information, please go to www.policyuncertainty.com. 7 Please see BCA Emerging Markets Strategy Special Report, "Gauging EM/China Credit Impulses", dated August 31, 2016, available at ems.bcaresearch.com 8 For more perspective on this idea, please see BCA Emerging Market Strategy Special Report "Misconceptions About China's Credit Excesses", dated October 26, 2016, available at ems.bcaresearch.com 9 Massively decreased output and increased employee layoffs in the steel industry, for example. 10 Please see BCA Global Fixed Income Strategy Special Report, "Emerging Markets Hard Currency Debt: Time For More Optimism?", dated July 12, 2016, available at gfis.bcaresearch.com 11 Please see BCA Global Fixed Income Strategy Special Report, "Australian Credit: Time To Test The Waters", dated March 29, 2016, available at gfis.bcaresearch.com

Highlights Lesson 1: Don't fear the end of the debt super cycle. Lesson 2: The ECB will ultimately target the long-term bond yield. Lesson 3: Financials will structurally underperform. Lesson 4: Personal Products (Beauty) will structurally outperform. Feature Striking similarities exist between the post debt super cycle economies in the euro area and Japan. Feature ChartPersonal Products Will Outperform Structurally... Financials Will Not bca.eis_sr_2016_11_03_s1_c1 bca.eis_sr_2016_11_03_s1_c1 In many regards, the euro area looks remarkably like Japan with a 17 year lag. Line up the 2007 peak in the euro area credit boom with the 1990 peak in the Japan credit boom - and the subsequent evolutions of many economic and financial metrics also line up almost perfectly: for example, the policy interest rate; the 10-year bond yield; inflation; and nominal GDP (Chart I-2, Chart I-3, Chart I-4, Chart I-5). Chart 2Striking Similarities Between The Euro Area... bca.eis_sr_2016_11_03_s1_c2 bca.eis_sr_2016_11_03_s1_c2 Chart 3...And Japan, Advanced By 17 Years ...And Japan, Advanced By 17 Years ...And Japan, Advanced By 17 Years Chart I-4Striking Similarities Between The Euro Area... Striking Similarities Between The Euro Area... Striking Similarities Between The Euro Area... Chart I-5...And Japan, Advanced By 17 Years bca.eis_sr_2016_11_03_s1_c5 bca.eis_sr_2016_11_03_s1_c5 This is very useful because if the euro area continues in Japan's footsteps, Japan's experience can teach us several important lessons about the euro area economy and financial markets out to the year 2034. Lesson 1: Don't Fear The End Of The Debt Super Cycle Does the euro area economy have "lost decades" ahead of it? Not exactly. Japan's so-called lost decades describe its stagnant nominal GDP since the mid-1990s. But this emphasis on nominal income is misleading (Chart I-6). The average citizen's standard of living does not depend on nominal GDP or even on real GDP. What truly matters is real GDP per head combined with the absence of extreme income inequality. Real incomes must grow and the growth must be reasonably distributed across society. On both counts, the euro area can be encouraged by Japan's experience. Since the late 1990s, Japan's real GDP per head has averaged close to 1% growth a year, broadly in line with the expected real productivity growth in a developed economy. This is exactly the real growth rate to be expected when there is no artificial and unsustainable tailwind from credit expansion. It is an economy's natural state of growth when the debt super cycle comes to an end, as it did in Japan more than 20 years ago.1 And it is good growth because it comes entirely from productivity improvements. Mankind's persistent ability to learn, experiment, and innovate produces more and/or better output from a fixed set of inputs. Furthermore, unlike other major economies, income inequality in Japan has not increased through the past 20 years and remains amongst the lowest in the developed world (Chart I-7). Again, this is not surprising. It is credit expansions that inflate bubbles in financial assets and exacerbate income and wealth inequalities. Therefore, unlike bad growth fuelled by credit booms, real growth that comes from productivity improvements is sustainable and unpolarising. The first lesson from Japan is that the euro area can expect structural growth in real GDP per head of around 1% a year. Chart I-6What ##br##"Lost Decades"? bca.eis_sr_2016_11_03_s1_c6 bca.eis_sr_2016_11_03_s1_c6 Chart I-7Income Inequality In Japan ##br##Has Not Increased bca.eis_sr_2016_11_03_s1_c7 bca.eis_sr_2016_11_03_s1_c7 Lesson 2: The ECB Will Ultimately Target The Long-Term Bond Yield One objection to Lesson 1 is that in a highly indebted economy, nominal GDP growth does matter. As debt is a nominal amount, it is nominal incomes that determine the ability to service and repay the high level of debt. So given a free choice, policymakers would prefer to have inflation at 2% or 4% rather than at -1%; and nominal GDP growth at 3% or 5% rather than zero. Unfortunately, policymakers do not have this free choice. Contrary to what central bankers promise, inflation and nominal GDP growth cannot be dialled up or down at will to hit a point-target. As we explained in The Case Against Helicopters,2 inflation is a notoriously non-linear phenomenon which is extremely difficult, if not impossible, to control. As a reminder, look at the standard identity of monetary economics: MV = PT M is the broad money supply, V is its velocity of circulation, P is the price level and T is the volume of transactions. PT is effectively nominal GDP. The big problem is that both the broad money supply M and its velocity V - whose product determines nominal GDP - are highly non-linear. M is non-linear because the commercial banking system money multiplier - the ratio of loans to reserves - is non-linear (Chart I-8). At a tipping point of inflation, the onus suddenly flips from lending as little as possible to lending as much as possible. Chart I-8The Money Multiplier Is Non-Linear bca.eis_sr_2016_11_03_s1_c8 bca.eis_sr_2016_11_03_s1_c8 Admittedly, the central bank (in cahoots with the government) could by-pass the commercial banking system to control the money supply M directly. But it can do nothing to change the extreme non-linearity of the other driver of nominal GDP, the velocity of money V. Again, at a tipping point of inflation, the onus suddenly flips to spending money - both newly created and pre-existing balances - as fast as possible. At which point, nominal GDP growth and inflation suddenly and uncontrollably phase-shift from ice to fire with little in between. Therefore in the highly indebted euro area economy with near-zero inflation, the prudent course of action is not to risk uncontrolled inflation with so-called "helicopter money". Instead, the second lesson from Japan is to expect the ECB ultimately to emulate the BoJ and target the long-term bond yield. But which bond yield? Most likely, it would be the euro area synthetic 10-year yield, which the ECB already calculates and publishes, or a close proxy. In combination with the ECB's (as yet unused) OMT program - whose mere presence limits individual sovereign yield spreads - expect euro area government bond yields to remain structurally well anchored. Lesson 3: Financials Will Structurally Underperform Japanese financial sector profits today stand at less than half their level in 1990. For euro area financial sector profits, the concerning thing is that their evolution is tracking the Japanese experience with a 17 year lag. If euro area financial profits continue to follow in Japan's footsteps, expect no sustained growth over the next 17 years (Chart I-9). Chart I-9Euro Area Financial Profits May Experience No Sustained Growth bca.eis_sr_2016_11_03_s1_c9 bca.eis_sr_2016_11_03_s1_c9 In a post debt super cycle world, banks lose the lifeblood of their business: credit creation. And this becomes a multi-decade headwind to financial sector profit growth and share price performance. Euro area financials face two other headwinds similar to those in post debt super cycle Japan. As explained in Lesson 2, high indebtedness makes the economy hyper-sensitive to rising bond yields. The upshot is that the interest rate term-structure, which drives banks' net lending margins, cannot sustainably steepen. Also, just like Japan's 'zombie' banks, many European banks will take a long time to fully recognise the extent of their non-performing loans. The consequent squeeze on new lending combined with a requirement for additional capital further weighs down banks' return on equity. So the third lesson from Japan is that euro area financials is not a sector to buy and hold for the long term. Rather, it is a sector to play for periodic strong countertrend rallies. Now is not the time for such a play. Lesson 4: Personal Products (Beauty) Will Structurally Outperform Over the past 20 years, Japan's nominal GDP has gone sideways. But over this same period, the sales of skin cosmetics and beauty products have almost tripled (Chart I-10). This has helped the personal products sector to outperform very strongly. While Japanese financial profits have halved since 1990, Japanese personal products profits have quintupled (Feature Chart). Once again, the useful thing is that euro area personal product profits are uncannily tracking the Japanese experience with a 17 year lag. If euro area personal product profits continue to follow in Japan's footsteps, expect them to almost triple over the next 17 years (Chart I-11). Chart I-10Beauty Sales Have Boomed In Japan bca.eis_sr_2016_11_03_s1_c10 bca.eis_sr_2016_11_03_s1_c10 Chart I-11Euro Area Personal Products Profits Might Triple bca.eis_sr_2016_11_03_s1_c11 bca.eis_sr_2016_11_03_s1_c11 The very strong growth in beauty sales and profits in Japan is an extended example of the phenomenon known as the lipstick effect. Our Special Report Buy Beauty: The Lipstick Effect Stays Put3 provides the detail. But in a nutshell, the demand for beauty products and cosmetics - epitomised by lipstick - experiences a surge when the economic environment feels harsh. For many people, the post debt super cycle world of 1% real income growth with high indebtedness and no more bingeing on credit does feel like an extended hangover - at least compared to the spendthrift era that preceded it. Hence, it creates the ideal backdrop for an extended play of the lipstick effect, as witnessed in Japan. The fourth lesson from Japan is that euro area personal products is a sector to buy and hold for the long term. Expect profits to trend up at around 6% a year, and the sector to strongly outperform the broader market. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Admittedly, after the debt super cycle ended in Japan, government levering was needed to counter the impact of aggressive de-levering in the private sector. But in the euro area, this will not be needed to the same extent as the de-levering in the private sector is not as aggressive. 2 Please see the European Investment Strategy Weekly Report 'The Case Against Helicopters' published on May 5, 2016, available at eis.bcaresearch.com 3 Please see the European Investment Strategy Special Report 'Buy Beauty: The Lipstick Effect Stays Put' published on April 14, 2016, available at eis.bcaresearch.com Fractal Trading Model This week's recommended trade is to go short French banks versus the CAC40. 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 bca.eis_sr_2016_11_03_s2_c1 bca.eis_sr_2016_11_03_s2_c1 Chart II-2Indicators To Watch - Bond Yields bca.eis_sr_2016_11_03_s2_c2 bca.eis_sr_2016_11_03_s2_c2 Chart II-3Indicators To Watch - Bond Yields bca.eis_sr_2016_11_03_s2_c3 bca.eis_sr_2016_11_03_s2_c3 Chart II-4Indicators To Watch - Bond Yields bca.eis_sr_2016_11_03_s2_c4 bca.eis_sr_2016_11_03_s2_c4 Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations bca.eis_sr_2016_11_03_s2_c5 bca.eis_sr_2016_11_03_s2_c5 Chart II-6Indicators To Watch - Interest Rate Expectations bca.eis_sr_2016_11_03_s2_c6 bca.eis_sr_2016_11_03_s2_c6 Chart II-7Indicators To Watch - Interest Rate Expectations bca.eis_sr_2016_11_03_s2_c7 bca.eis_sr_2016_11_03_s2_c7 Chart II-8Indicators To Watch - Interest Rate Expectations bca.eis_sr_2016_11_03_s2_c8 bca.eis_sr_2016_11_03_s2_c8

Highlights A poor fundamental backdrop for high yield is being offset by easy monetary conditions. A prolonged shallow uptrend in corporate defaults - and therefore spreads - is most likely. The relative performance of equities versus corporate credit has not been distorted by monetary policy: the high-yield debt market will remain a reliable indicator for equity market vulnerability. A December rate hike will not be problematic for the residential real estate market. Plenty of pent-up demand for housing exists, and this will provide long-term support, so long as the labor market remains robust. Feature High-yield (HY) corporate bond spreads have dramatically narrowed throughout 2016 (Chart 1). This trend should not go unnoticed, since beyond being an important asset class in its own right, we have long viewed the high-yield debt market as an early warning system for equities. The current message suggests an all-clear for stocks. Chart 1Dramatic Spread Narrowing In 2016, But... bca.usis_wr_2016_10_31_c1 bca.usis_wr_2016_10_31_c1 We have had a cautious stance on U.S. high yield since August 2015, based on the view that corporate balance sheet health has deteriorated to the point where defaults would continue to rise on a cyclical basis. This week, we explore whether this remains the right strategy, and also whether junk bond spreads are still a relevant leading indicator for the equity market. Our answer to both questions is: Yes. In our view, the HY comeback can be explained by three main factors. First, the recovery in energy-related junk bonds has led the rally, as rising oil prices have helped diminish the default risks among U.S. shale issuers. Second, the 2015 spike in junk bond yields - mainly due to contagion from energy-sector bankruptcy fears - created tactical value in high-yield. Throughout most of 2016, we have seen an unwinding of these previously oversold positions. And third, the high-yield market benefits from an ongoing and intense search for yield in a world of unattractive higher-quality interest rates. Looking ahead, the first two forces are unlikely to play much of a role in the outcome for junk bonds. Oil prices are likely to trade in narrow range, allowing energy-related company fundamentals to stabilize. The rally in junk bonds over the past several months has removed any perceived value in this sector. Thus, it is only the search for yield/accommodative monetary policy that still supports a narrowing in spreads. Over time, we believe junk bond performance will once again be aligned with balance sheet fundamentals, i.e. high-yield spreads will gradually widen. A Review Of Our HY Indicators Our fixed income strategists have developed three key indicators to gauge major turning points in corporate spreads (Chart 2): Corporate Health Monitor (CHM): An aggregate indicator of non-financial corporate balance sheet health. The CHM deteriorated further in the second quarter, and has reached levels that historically tend to only be seen during recessions. Of the indicator's six components, most of the weakness has occurred in measures of corporate profitability (Chart 3). One caveat is that our measure of leverage in the CHM remains low, but this understates the risks because it measures total debt as a percent of market value of equity. Leverage looks decidedly worse if measured using net debt/book value. Chart 2Key Corporate Credit Indicators Key Corporate Credit Indicators Key Corporate Credit Indicators Chart 3Corporate Health Monitor Components Corporate Health Monitor Components Corporate Health Monitor Components C&I bank lending standards: A Fed survey that measures how easy/difficult it is for the corporate sector to access bank loans. According to this gauge, banks have already been tightening credit conditions for the past three quarters. Deviation in monetary conditions from equilibrium: We use our Monetary Conditions Index (MCI), which incorporates movements in both the dollar and interest rates. Due to a very accommodative Fed, monetary conditions remain very easy according to this measure. At present, two of these three indicators are sending negative signals for corporate spreads. Our corporate health monitor is decidedly bearish, as are lending standards. Indeed, focusing on corporate balance sheets and fundamental credit quality metrics would almost unanimously lead investors to recognize that the credit cycle is in its late stages and to expect spreads to move wider. After all, spreads have widened in every episode of deteriorating balance sheet health since the mid-1990s. Or to put it more simply, a default cycle - leading to spread widening - has occurred each time that year-on-year profit growth has gone negative since 1984 (Chart 4). Chart 4Profit Contraction Spells Trouble For Junk Bonds Profit Contraction Spells Trouble For Junk Bonds Profit Contraction Spells Trouble For Junk Bonds Our Bank Credit Analyst service came to the same conclusion earlier this year. In a Special Report, our colleagues analyzed financial ratios for 770 companies from across the industrial and quality spectrum. Their work uncovered that the corporate re-leveraging cycle is far more advanced than is widely believed and that key financial ratios and overall corporate health look only mildly better excluding the troubled energy and materials sectors. Of course, there is an important salve this cycle at work and it is captured in our third indicator - monetary policy. As shown in Chart 2, easy monetary conditions have never persisted for this long and low rates have driven a colossal search for yield, causing high-yield bonds to become ever more divorced from fundamentals. This divergence between corporate bond spreads and balance sheet fundamentals is likely to persist for as long as monetary conditions remain supportive. Adding it up, a poor fundamental backdrop for high-yield is being offset by easy monetary conditions. This combination argues for a cautious long-term bias toward lower-quality corporate credit because a prolonged shallow uptrend in corporate defaults (and spreads) is most likely. Nimble investors may look to tactically buy junk bonds when spreads overshoot our forecast of default losses, although such an opportunity is not present at the moment (Chart 5). The equity market is suffering from the same dynamic. Chart 5No Value Here No Value Here No Value Here Will Junk Bond Yields Still Warn Of Stock Bear Markets? Junk bond yields have long been one of our early warning indicators for equity bear markets. Since the 1980s, junk yields (shown inverted in Chart 6) have consistently broken out to new highs 3-6 months before stock bear markets take hold. This is because in a typical cycle, junk yields tend to respond more quickly to an erosion in corporate health fundamentals and/or a credit event. Chart 6Junk Bonds Provide Early Warning For Stocks Junk Bonds Provide Early Warning For Stocks Junk Bonds Provide Early Warning For Stocks Chart 7Typical Behavior Here bca.usis_wr_2016_10_31_c7 bca.usis_wr_2016_10_31_c7 But, as we note above, in the current cycle, the reaction to worsening corporate health fundamentals has been far more subdued than historical relationships would have predicted, due to the salve effect of easy monetary policy. If corporate bonds are in a "bubble", does it mean that the behavior of junk bond spreads will no longer be an early predictor of stocks returns? We believe corporate bonds will still be a useful timing tool for equities. If equities are experiencing the same divorcing from fundamentals, courtesy of central bank largesse, then it stands to reason that what pops the bond bubble will also burst the equity balloon. The search for yield has affected the behavior of investors, and therefore returns, in a fairly systematic way. Due to the current extended period of ultra-low interest rates and central bank asset purchases, government bond prices have been pushed sky high (yields have sunk to rock-bottom lows). As a shortage of government bonds has taken hold, investors have sought to invest in "Treasury-like" products, first seeking out the safest corporate bonds, but eventually reaching further out on the risk spectrum to include high-yield bonds and (dividend yielding) stocks. Indeed, asset prices of all stripes have been distorted by the search for yield, which has fueled a broad inflation in all asset classes. The behavior of stocks relative to corporate bonds is telling (Chart 7). Since 2010, and until very recently, stocks outperformed junk bonds on a total return basis. Junk bonds outperformed investment-grade bonds over roughly the same period (although junk underperformed investment-grade in most of 2015 due to the collapse in energy prices and related energy company defaults). This is exactly what has occurred during every recovery phase since the 1980s. Over the past forty years, investment-grade bonds tended to outperform junk bonds and equities during economic recessions. Junk bonds beat equities during the early phases of recovery (i.e. when economic growth turns positive) and for as long as companies continue to repair balance sheets. And equity returns trump both investment-grade and high-yield corporate bonds when our Corporate Health Monitor is deteriorating, i.e. in the latter half of the economic cycle, such as now. This suggests that the relative performance of equities versus corporate credit has not been distorted by monetary policy. One key takeaway is that, although very easy monetary conditions mean that corporate credit performance is becoming divorced from fundamentals, monetary policy has had a similar effect on equity prices (we have written at length in past reports about equity market performance diverging from profit indicators). As in past cycles, once the monetary cover fades, it is most likely that corporate credit markets will once again respond most quickly to balance sheet fundamentals. The bottom line is that we believe the high-yield debt market will remain a reliable indicator for equity market vulnerability. The current message is that a bear market in stocks will be averted, although as we have written in recent reports, earnings disappointments amid dollar strength represent a potential trigger for a near-term correction. Housing Outlook: Room To Expand Over the past quarter, residential real estate data has been slightly disappointing. September housing starts slipped to the bottom end of the range that has held this year and are only marginally above year-ago levels. House price inflation, as measured by the Case Shiller index, is negative on a 3-month basis. Despite this mild disappointment, we continue to believe the housing market is a relative bright light and will continue to be a significant positive contribution to GDP growth. Most indicators show that the housing market continues to recover along the typical path of the classic boom/bust real estate cycle (Chart 8). Chart 8Housing And Its History bca.usis_wr_2016_10_31_c8 bca.usis_wr_2016_10_31_c8 Chart 9First-Time Homebuyers Entering The Market First-Time Homebuyers Entering The Market First-Time Homebuyers Entering The Market Moreover, both supply and demand conditions are supportive of further construction activity and upward pressure on house prices over the next several quarters. On the demand side, household formation and a pick-up in interest from first-time buyers are the largest positives. Household formation: The number of households being formed is the most basic measure of marginal new demand for housing units. Household formation was suppressed during the Great Recession and early recovery years, because very poor job prospects and restricted access to credit sorely limited prospective new households from entering both the rental and ownership market. From 2007-2013, the annual household formation rate was 625,000, compared to over 1.1 million in the pre-crisis period.1 Now that the unemployment rate is at 5% and job security is improving, household formation rates are accelerating, particularly among young adults who have hitherto delayed moving out on their own. Monthly numbers are choppy, but household formation could easily run on average at 1.1 million per year for the next few years, simply to make up for muted rates post-housing crisis. First-time buyers: After years of putting off purchases, first-time buyers appear to be finally coming back to the housing market (Chart 9). According to the National Association of Realtors, the proportion of first-time homebuyers for existing home sales has reached its highest mark since July 2012 (34%). But there is still room for this share to improve, as prior to 2007, first-time homebuyers averaged about 40% of total purchases. Once again, persistent income gains and job security will be the driving factors behind first-time homebuyers' decisions. Could a Fed interest rate rise slow housing demand? We don't think so. Mortgage payments relative to income will remain well below their long-term average even if rates are increased by 200bps, an extreme case scenario. Even under this scenario, housing affordability would still be above average, conservatively assuming that income is held constant (Chart 10). Income and employment prospects will continue to trump mortgage rates for consumers making housing decisions; the current employment backdrop is positive for continued housing market activity. Chart 10December Rate Hike Won't Bother The Housing Market bca.usis_wr_2016_10_31_c10 bca.usis_wr_2016_10_31_c10 Chart 11Supply Is Tight bca.usis_wr_2016_10_31_c11 bca.usis_wr_2016_10_31_c11 From a supply perspective, conditions remain ripe for more robust construction activity. As Chart 11 shows, the supply of new homes remains low both in absolute, and in terms of months of supply. The bottom line is that we do not fear that a December rate hike will be particularly onerous for the residential real estate market. Plenty of pent-up demand for housing still exists, and this will provide long-term support, so long as the labor market remains robust, as we expect. The recent soft patch in housing will give way to stronger home building activity in the coming months, helping to boost real GDP growth in 2017. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 The State Of the Nation's Housing 2016, Joint Centre For Housing Studies of Harvard University http://jchs.harvard.edu/research/publications/state-nations-housing-2016

Highlights With inflation probably having bottomed, especially in the U.S., investors are starting to worry about inflation tail-risk and wonder whether inflation-linked bonds (ILBs) are an efficient way to hedge this risk. This Special Report explains how ILBs work in different countries and analyzes their performance characteristics over time. We find that ILBs, a rapid growing asset class, can be a beneficial addition to a balanced global portfolio even though recent history does not show as strong portfolio diversification benefits as a longer history. The lower nominal duration of ILBs is a useful feature for portfolio duration management. ILBs have proven to be a good inflation hedge in a rising inflationary environment, but they underperform nominal bonds in a disinflationary environment. As such, the balance between ILBs and nominal bonds should be managed tactically based on an investor's views on inflation dynamics and valuation. Overweight U.S. TIPS; avoid U.K. linkers. Australian TIBS are a cheap yield enhancer, but higher yielding Mexican Udibonos are a dangerous yield trap. Feature BCA's view is that the 35-year bull market in bonds is ending and that the path of least resistance for bond yields globally is up.1 Even though the level of inflation in the U.S. is still below the Fed's target of 2%, we think it's clear that U.S. inflation has bottomed for this cycle. Globally, loose monetary policy together with the likelihood of more fiscal stimulus, present the risk of higher inflation down the road. Global Asset Allocation has recommended investors to overweight U.S. TIPS (Treasury Inflation Protected Securities) relative to nominal U.S. government bonds throughout 2016. Many clients have asked for details on how TIPS work, whether there are similar securities in other countries, and how ILBs fit into a balanced global portfolio. In this Special Report, we take a detailed look at inflation-linked bond markets globally and recommend some strategies for asset allocators to use them to help navigate a world of low returns and possibly higher inflation. 1. What Are Inflation-Linked bonds (ILBs)? Inflation Protection: Inflation-linked bonds are designed to hedge inflation risk by indexing the bonds' principal to the official inflation index in the issuer country. While the methodology and what the bonds are called differ from country to country, the underlying concept is the same: the holders of ILBs will get the stated real return even in an inflationary environment since both the nominal face value and the nominal coupon payments change based on an official inflation measure. Deflation Floor: In the case of sustained deflation such that the final nominal face value falls below the initial face value, however, the repayment of principal at maturity is guaranteed in the majority of the countries, but not, for example, in the U.K., Canada, Brazil, or Mexico (Table 1). Table 1Basic Information Of Global ILB Markets TIPS For Inflation-Linked Bonds TIPS For Inflation-Linked Bonds Inflation Measure: ILBs are linked to actual inflation with a time lag. As shown in Table 1, the inflation measure used varies slightly by country: in the U.S. it's the non-seasonally adjusted CPI; in the U.K. it's the retail price index (RPI); while in the euro area, France and Italy both have ILBs linked to local CPI ex tobacco and EU HICP ex tobacco, with the former primarily for domestic retail investors. The time lag is three months in most countries, but can vary from one to eight months as shown in Table 1. A Rapidly Growing Asset Class: The earliest recorded ILBs were issued by the Commonwealth of Massachusetts in 17802 during the Revolutionary War. Finland introduced indexed bonds in 1945, Israel and Iceland in 1955. Brazil introduced its indexed bonds in 1964 and has become the largest ILB market in the emerging markets and the third largest globally. When the U.K. issued its first "linkers", it originally used eight months of inflation lag to make sure the next coupon payment is known at the current coupon payment date. In 1991 Canada issued its first ILBs and the "Canadian Model", which uses a three-month lag to the inflation index and calculates a daily index ratio using linear extrapolation, has been adopted widely since; even the U.K. adopted it in 2005. The largest ILB market now is the U.S. TIPS with a market cap of USD 1.2 trillion. TIPS were first issued in 1997, using the Canadian model. Chart 1 shows the evolution of the ILB markets globally. Since the Bloomberg Barclays Universal Government Inflation-linked Bond Index was constructed in July 1997, the market cap has increased to over USD 3.2 trillion from a mere USD 145 million at the end of 1997. It's worth noting that the actual amount of ILBs outstanding globally is slightly larger than this because not all debts are included in the index.3 Even though many countries have issued ILBs, and emerging markets (EM) grew very fast in the 2000s, the global market is still dominated by the top three countries (the U.S., U.K., and Brazil) with a combined share of 70% of global market cap. Chart 1ILBs: A Fast Growing Asset Class bca.gaa_sr_2016_10_28_c1 bca.gaa_sr_2016_10_28_c1 Chart 2U.S. BEI Vs. Inflation Expectations bca.gaa_sr_2016_10_28_c2 bca.gaa_sr_2016_10_28_c2 Country Differentiation: Nominal government bonds come with different features in different countries, and the same is true with ILBs. Table 2 shows that even though the U.S. accounts for 43.6% of the developed markets (DM) index in terms of market cap, it contributes only 28.8% to overall duration while the U.K. accounts for 53% of the overall duration, because the U.K. linkers have much longer duration than the U.S. TIPS. The Canadian real return bonds (RRBs) have the second longest average duration at 16 years. Table 2Key Features of the Bloomberg Barclays Government ILB Indexes* TIPS For Inflation-Linked Bonds TIPS For Inflation-Linked Bonds 2. How Do ILBs Compare To Nominal Bonds? Break-Even Inflation (BEI) And Inflation Expectations: The difference between the yield on a nominal bond and the yield on a comparable ILB (a comparator) is defined as the BEI, the market-based inflation rate at which an investor is indifferent between holding a real or a nominal bond. If realized inflation over an ILB's life turns out to be higher than the BEI at purchase, then holding the ILB is better than holding its nominal counterpart. BEI on its own is not an accurate gauge of inflation expectations, because it is the sum of inflation expectations, the inflation risk premium, and the liquidity premium. One of the long-term inflation expectation measures that the U.S. Fed keeps track of is the five-year forward five-year inflation calculated using the Fed's own fitted yield curves.4 Even this measure, however, contains the inflation term premium and the relative supply/demand of 10-year BEI vs 5-year BEI. Three important observations from Chart 2 for investors to pay attention to when assessing the inflation outlook are: U.S. breakeven inflation rates have been consistently below the Fed's inflation target of 2% since 2014 (panel 4); The CPI swaps markets priced in a much higher inflation rate than the TIPS market and the Fed's measure derived from fitted curves (panels 2 & 3), largely caused by the supply and demand imbalance in the inflation swaps market: there is excess demand to receive inflation, but no natural regular payer of inflation other than the U.S. Treasury via TIPS, therefore a higher fixed rate has to be paid to receive inflation; The 10-year inflation expectation from the Cleveland Fed's model5 (panel 1), exhibits very different behavior from the other measures. It has been below the 2% target since 2011. This model attempts to combine survey-based inflation expectations and that derived from the CPI swaps market. It's intended to be a "superior" measure of inflation expectations from a monetary policy perspective.6 For investors, however, it's advisable to take into account all these measures when assessing inflation dynamics. Duration and Yield Beta: Duration is measured as the bond price change in relation to the yield change. Chart 3 shows that ILBs have higher duration than their nominal counterparts. These two durations, however, are not directly comparable because ILB duration is related to "real yield" while nominal bond duration is related to "nominal yield". The conversion from one to another is not straightforward because the relationship between real and nominal yields can be complex.7 In practice, however, we can run a simple regression to get ILB's yield beta to change in nominal yield.8 Some practitioners simply assume 0.5 in the emerging market.9 Our research shows that in the developed market the relationship between real yield and nominal yield can vary over different time periods and in different countries, but the moving 3-year and 5-year yield betas are always less than 1 and mostly above 0.5, which is the full sample average.(Chart 4). This is a useful feature for duration management and curve positioning. For example, everything else being equal, 1) replacing nominal government bonds with comparable ILBs can reduce portfolio duration, and 2) replacing a short-dated nominal bond with a longer-dated ILB could maintain the same duration. Chart 3Average Government Bond Duration Average Government Bond Duration Average Government Bond Duration Chart 4ILBs' Yield Beta TIPS For Inflation-Linked Bonds TIPS For Inflation-Linked Bonds Total Return: By design, ILBs should do well in an inflationary environment and they should outperform their nominal bonds when realized inflation is higher than the break-even inflation rate. How have ILBs performed in the real world? Unfortunately, we do not have a long enough data history to cover different inflation cycles. Chart 5 confirms that in nominal terms ILBs outperform their nominal counterparts when inflation rate trends higher. What's interesting, however, is that it is disinflation, rather than deflation, that hurts ILBs the most. Within the available data history, only 2009 experienced a brief deflation scare globally, yet the rebound in ILBs actually led economies out of the deflationary environment. Over the long run, U.K. linkers have underperformed nominal gilts since their first issuance in 1981 when inflation was running at 12%. Since 1997 when the Bloomberg/Barclays ILB indexes were constructed, however, ILBs have performed slightly better than their nominal comparable bonds in most countries, with the exception of the euro area where ILBs have fared slightly worse (Chart 5). Risk-Adjusted Return: On a risk-adjusted basis, the available data history shows that ILBs performed slightly better in the U.S. and Australia, and also the DM aggregate on a hedged basis, but slightly worse in the euro area, the U.K. and Canada. It's worth emphasizing, however, that in either case the difference is not significant (Table 3). Chart 5ILB Performance Vs Inflation ILB Performance Vs Inflation ILB Performance Vs Inflation Table 3ILBs Approximately Equal To Nominal Bonds TIPS For Inflation-Linked Bonds TIPS For Inflation-Linked Bonds 3. What's The Role Of ILBs In A Balanced Portfolio? Bridgewater Associate showed that adding ILBs to a balanced euro zone stock/bond portfolio significantly improved the efficient frontier over the very long run, from 1926 to 2010.10 Since there were no ILBs in the early part of that history, ILB returns were calculated based on inflation. Our research, based on data from the Bloomberg/Barclays Inflation-Linked Government Bond Index with a much shorter history, however, does not yield the same results, probably because the much shorter recent history does not include any highly inflationary periods from which ILBs benefit the most. Table 4 shows the statistics of replacing a certain portion of the nominal bonds with comparable ILBs in a DM 60/40 stocks/bonds portfolio. On a standalone basis, the hedged USD DM ILBs are less volatile and have the best risk-adjusted return of 1.3 in the sample period (Portfolio 8). When combined with equities, however, the nominal bonds are a slightly better diversifier than the ILBs. Why? The answer lies in the correlation. Chart 6 shows that the ILBs have much higher correlation with equities than the nominal bonds do with equities. This makes sense because equities could rise in an inflationary environment if the higher inflation were driven by stronger growth, while inflation is always bad for nominal bonds. Again, the differences in risk-adjusted returns are not significant, varying from 0.77 to 0.7 (Portfolios 2-6) in line with the findings in Section 2. Table 4Balanced Global Portfolio Statistics* TIPS For Inflation-Linked Bonds TIPS For Inflation-Linked Bonds Chart 6Global Stocks-Bonds Correlations bca.gaa_sr_2016_10_28_c6 bca.gaa_sr_2016_10_28_c6 4. Inflation Has Bottomed BCA's Fixed Income Strategy team has written extensively about the outlook for U.S. and global inflation.11 We concur with their view that, even though inflation in most DM countries is still below the targets set by their central banks (Chart 7), in most countries it has probably bottomed (top three panels in Chart 7), and especially in the U.S., where all indicators point to rising wage pressures as labor market slack diminishes (Chart 8). Chart 7Inflation Still Below Target Inflation Still Below Target Inflation Still Below Target Chart 8Accelerating Wage Pressure bca.gaa_sr_2016_10_28_c8 bca.gaa_sr_2016_10_28_c8 5. Investment Implications Overweight U.S. TIPS Over Nominal Treasuries: We have shown that ILBs outperform comparable nominal bonds in a rising inflation environment and have argued that inflation has bottomed in the U.S. These views support our recommendation to overweight U.S. TIPS relative to nominal U.S. Treasuries. In addition, our TIPS valuation models (Chart 9) show that breakeven inflation rates in the U.S. are still below fair values based on underlying economic and financial drivers. Being the largest ILB market with a market cap of over USD 1.2 trillion, TIPS are very easy to trade. Currently, only five-year TIPS have a negative yield, so there are plenty of opportunities for investors to preserve real purchasing power by holding longer maturity TIPS. Avoid U.K. Linkers: The U.K. linkers market is the second largest after the U.S., with a market cap of about USD 810 billion. Unfortunately, these linkers are among the most expensively priced real return bonds, with negative yields at all maturities (Chart 10, panel 3). For example, 10-year linkers are currently yielding -1.98%, which means that investors are guaranteed to lose 18% of real purchasing power in 10 years by holding the bonds to maturity. Granted, the U.K. linkers have always traded at a premium to U.S. TIPS and many other ILB markets due to the nature of the U.K. pension schemes which link pension liabilities to inflation (CPI or RPI). With insatiable appetite from pension funds, demand greatly exceeds what the linkers and inflation swaps markets can supply. U.K. real yields have been driven lower and lower, causing an increasing funding gap which in turns drives yield further down.12 In addition, our fair value model (Chart 10, panels 1 and 2) shows that the U.K. linkers' current breakeven rates are above fair value. The collapse in the linkers' yields after the Brexit vote is also consistent with a skyrocketing in the CPI swaps rate, indicating that the probable rise in inflation due to the collapse of the GBP has now largely been priced in (panel 4). Investors who are not constrained by U.K. pension regulations should avoid U.K. linkers. Chart 9Overweight U.S. TIPS bca.gaa_sr_2016_10_28_c9 bca.gaa_sr_2016_10_28_c9 Chart 10Avoid U.K. Linkers bca.gaa_sr_2016_10_28_c10 bca.gaa_sr_2016_10_28_c10 Yield Enhancement From Australia, Not From Mexico: The U.S. TIPS market is liquid but yields are low, albeit higher than U.K. linkers. Among the smaller markets with higher yields, we prefer Australian Treasury Indexed Bonds (TIBS) over Mexican Udibonos, even though the 10-year Udibonos have a higher yield of 2.8% compared to the 10-year TIBS yield of 0.62%. As shown in Chart 11 and Chart 12, the Australian TIBS are very cheap while the Mexican Udibonos are very expensive. The BEI in Mexico is above the central bank's target of 3% while in Australia it's still at the lower end of the target range of 2-3%. Chart 11 Australian TIBS: A Cheap Yield Enhancer bca.gaa_sr_2016_10_28_c11 bca.gaa_sr_2016_10_28_c11 Chart 12 Mexico ILBS: Too Expensive Mexico ILBS: Too Expensive Mexico ILBS: Too Expensive 6. ETFs Some of our clients always want to know if there are ETFs for the asset classes we cover. For ILBs, the most liquid ETF is the iShares TIPS Bond ETF with an AUM of USD 19 billion and an expense ratio (ER) of 20 bps. For non-U.S. global ILBs, the SPDR Citi International Government Inflation-Protected Bond ETF has an AUM of USD 620 million and an expense ratio of 50bps. The Appendix on page 14 gives a sample list of the exchange traded ILB funds. For more information about ETFs, please see BCA's newly launched Global ETF Strategy service. AppendixSample List Of ILB ETFs*** TIPS For Inflation-Linked Bonds TIPS For Inflation-Linked Bonds Xiaoli Tang Associate Vice President xiaolit@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "The End of the 35-year Bond Bull Market," July 5, 2016, available at gis.bcaresearch.com. 2 Robert Shiller, "The Invention of Inflation-Linked Bonds in Early America," NBER Working Paper 10183, December 2003. 3 Barclays Index Methodology, July 17, 2014. 4 Refet S. Gurkaynak et al., "The TIPS Yield Curve and Inflation Compensation," May 2008, Federal Reserve publication. 5 Joseph G Haubrich et al., "Inflation Expectations, Real Rates, and Risk Premia: Evidence from Inflation Swaps," Working Paper 11-07, March 2011, Federal Reserve Bank Of Cleveland. 6 Joseph G. Haubrich And Timothy Bianco, "Inflation: Nose, Risk, and Expectations," Economic Commentary, June 28, 2010, Federal Reserve Bank Of Cleveland. 7 Francis E. Laatsch and Daniel P. Klein, "The nominal duration of TIPS bonds," Review of Financial Economics 14 (2005). 8 Mattheu Gocci, "Understanding the TIPS Beta," University of Pennsylvania, 2013. 9 Thor Schultz Christensena and Eva Kobeja, "Inflation-Linked Bond from emerging markets provide attractive yield opportunities," Danske Capital, May 2015. 10 Werner Kramer, "Introduction to Inflation-Linked Bonds," Lazard Asset Management, 2012.