Emerging Markets

Highlights Recommended Allocation Quarterly - July 2017 Quarterly - July 2017 Risk assets have continued to outperform, despite soft inflation data and falling interest rates. Either inflation will pick up again, amid decent growth, and the Fed (and, to a degree, other central banks) will tighten, or the Fed will capitulate and stay on hold. Either scenario should be good for risk assets. No indicator signals a recession on the horizon, and so we continue to expect equities to outperform bonds over the next 12 months. Within equities, we favor DM over EM; we maintain a pro-cyclical sector tilt, but rotate out of Tech into Financials, which are cheaper and should benefit from steeper yield curves. In fixed income, we prefer credit to government bonds, but trim our overweight in investment grade credit as spreads are unlikely to contract further. We are overweight TIPS and Japanese inflation-linked bonds. Feature Overview How To Square Lower Rates And Rising Equities One of the basic principles of BCA's Global Asset Allocation service is that it is highly unusual for equities to underperform bonds for any extended period except in the run-up to, and during, recessions (Chart 1). After the recent decline in long-term interest rates and softness in inflation, we find investors worldwide becoming increasingly nervous about the outlook. We see nothing in the data, however, to indicate a recession in the coming 12 months. Of the three historically most reliable recession indicators - PMIs, credit spreads, and the yield curve (Chart 2) - only the last raises some concerns, but it is still far from inverting, which is the requirement for a recession signal. None of the formal recession models is flashing a warning signal either (Chart 3). Chart 1Stocks Outperform Except Ahead Of Recession Stocks Outperform Except Ahead Of Recession Stocks Outperform Except Ahead Of Recession Chart 2Usual Recession Signals Still Absent Usual Recession Signals Still Absent Usual Recession Signals Still Absent Chart 3Recession Risk Models Not Rising Either Recession Risk Models Not Rising Either Recession Risk Models Not Rising Either Nonetheless, market action in recent months has been unusual. Bond yields have fallen (with the 10-year U.S. Treasury yield slipping to 2.2% from 2.6%), and the dollar has weakened, but risk assets have continued to perform well, with global equities giving a total return of 13% year to date and 4% in Q2. Can this desynchronization continue? We see three possible scenarios:1 Chart 4Market Expects Fed To Be Dovish Market Expects Fed To Be Dovish Market Expects Fed To Be Dovish Reflation returns. The Fed proves to be right that the recent weak inflation data is temporary. Inflation picks up and the Fed raises rates more quickly than the market is currently pricing in (which is only 25 bps over the next 12 months, Chart 4). Initially, the rebound in inflation might be a shock for risk assets but, as long as the Fed is tightening because it is confident about growth and unconcerned about global risk, over 12 months risk assets such as equities should continue to outperform. The Fed capitulates. Inflation fails to rebound and the Fed tightens only in line with what the market is currently pricing in. This could be good for risk assets, as long as the soft inflation is not accompanied by disappointing data on growth. The U.S. dollar would probably weaken further, which should be positive for EM assets and commodities. A policy mistake. The Fed pushes stubbornly ahead with tightening even though inflation fails to rebound. Bond yields fall and the yield curve moves closer to inverting. This would be negative for risk assets, which would start to price in the risk of recession. We think the first scenario is the most likely. Leading indicators of employment suggest the recent sluggish wage growth should prove temporary (Chart 5). The softness in U.S. PCE inflation probably reflects mostly the weak economic growth last year and the recent fall in commodity prices (as well as special factors in telecoms, healthcare and autos). Even if reflation pushes the Fed to tighten more quickly - followed by central banks in the euro area, U.K, and Canada, which have also sounded more hawkish recently - this should not fundamentally undermine the case for risk assets, given how easy monetary policy remains everywhere (Chart 6). It would represent merely a step towards "normalization". Chart 5Sluggish Wage Growth Should Be Temporary Sluggish Wage Growth Should Be Temporary Sluggish Wage Growth Should Be Temporary Chart 6Real Rates Still Negative Everywhere Real Rates Still Negative Everywhere Real Rates Still Negative Everywhere While scenario (2) would also probably be generally positive for risk assets, the correct portfolio allocation would be different. Under scenario (1) - our central view - the dollar would appreciate, causing commodities and EM assets to underperform, higher beta markets (such as the euro area and Japan) and cyclical sectors would perform the best, and in bond markets investors should be underweight duration and overweight TIPS. Scenario (2) would suggest a less aggressive positioning in equities, with income-generating assets outperforming as bond yields stay low at around current levels. Scenario (3), which we see only as a tail risk, would point to an outright defensive stance. What should investors watch for over the coming months? Besides the trends in inflation and wages discussed above, we would be concerned to see any slippage in global growth expectations, which have so far continued to rise despite the softness in inflation and wages (Chart 7). The most likely cause of this would be a Chinese slowdown, though recent comments by Premier Li Keqiang ("we continue to implement a proactive fiscal policy and prudent monetary policy....[but] will not resort to massive stimulative measures") seem to confirm our view that Chinese growth may slow a little further, but that the authorities will not allow it to collapse ahead of the Party Congress in the fall. As potential upside catalysts for risk assets we see: a rebound in crude oil prices (driven by a drawdown in inventories over coming months as the OPEC production cuts reduce supply, Chart 8), progress on a U.S. tax cut (which BCA's Geopolitical Strategy still expects to come into effect from early 2018), and further surprises in earnings growth (where analysts continue to revise up their forecasts, Chart 9). Chart 7No Signs Of Global Growth Slipping No Signs Of Global Growth Slipping No Signs Of Global Growth Slipping Chart 8Oil Inventories To Draw Down Oil Inventories To Draw Down Oil Inventories To Draw Down Chart 9Earnings Continue To Be Revised Up Earnings Continue To Be Revised Up Earnings Continue To Be Revised Up Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com What Our Clients Are Asking Why Haven't Inflation And Wages Picked Up? Chart 10Just A Temporary Phenomenon? Just A Temporary Phenomenon? Just A Temporary Phenomenon? Eight years into an expansion, U.S. inflation remains stubbornly below 2% on every measure and has even slowed in recent months (Chart 10, panel 1). And, despite headline unemployment of only 4.3% (below the Fed's estimate of 4.6% for the Nairu), wage growth also remains sluggish (panel 3). The Fed's view is that inflation has been pulled down by special factors: weak auto sales, the introduction of unlimited cell phone data packages (which lower hedonically-adjusted prices), and drugs companies which raised prices before last year's U.S. presidential election (panel 2). We agree that these factors are likely to be temporary. But the recent weak wage growth is more puzzling. Wages have trended up since 2012, suggesting that the Phillips Curve is not dead. But the relationship seems to have weakened. With U6 unemployment (which includes marginally attached workers and those working part-time who would like full-time jobs) currently at only 8.4%, one would have expected wage growth to be 1 ppt higher than it is (panel 4). Changes in the structure of the workforce may partly explain this (the growing proportion of low-wage service jobs, the "gig economy"). Last year's weak corporate profits may also be a factor. But, with the labor market clearly very tight, we expect wages - and therefore core inflation - to pick up again over the next 12 months. What To Do When VIX Is So Low? After two brief spikes earlier in the year, VIX has declined to 11.4, closer to the historical low of 9.3 reached in 1993, than the historical average of 19.5. In fact, asset price volatilities have been low across the board in fixed income, currencies and commodities, even though the latter two are not at the same extreme low levels as equities and fixed income (Chart 11). However, the VIX futures curve is still in steep contango, which means that getting the timing wrong would make it very costly to go long the volatility index. In addition, correlation among the index members of the S&P 500 is very low, and so are cross-market equity correlations. We do not forecast a recession until 2019, so a sharp reversal in VIX is unlikely, but brief spikes are possible, implying possible corrections in S&P 500 given the inverse correlation between the two. As such, we recommend four strategies for investors who are concerned that markets are too complacent: Focus on security selection, and rotate into cheaper sectors from expensive ones without altering the pro-cyclical bias. Our preferred way is to buy the much cheaper Financials by selling the more expensive Tech; Allocate a portion of funds to the minimum volatility style as it has been relatively oversold; Raise cash and buy a call spread on the S&P 500; Buy longer-dated VIX futures and sell shorter-dated futures to mitigate the rolling cost. Chart 11Are Investors Too Complacent? Are Investors Too Complacent? Are Investors Too Complacent? Chart 12Overweight To Neutral Overweight To Neutral Overweight To Neutral Have Technology Stock Run Too Far? Technology stocks have outperformed the broad market by 33% since April 2013 and investors are increasingly skeptical about whether the run-up can continue. In this Quarterly, we cut our weighting in the Tech sector from Overweight, but we believe it deserves no lower than a Neutral weighting for the following reasons: Sales & Earnings: New order growth is improving alongside rising consumer spending on technology (Chart 12, panel 2). Sales are growing at 5% YoY and this is likely to continue. Pricing power has also recovered over the past year. These factors should support margins and earnings growth. Valuations: Investors are worried about valuation. However, the recent rally has not led to an expansion of relative forward P/E, which is below the historical average (panel 4). Sector relative performance over the past four years has moved in line with its superior return on equity. Breadth: Improving breadth suggests that relative outperformance should be sustainable. An increasing number of firms are participating in the rally, as seen by the improving advances/declines ratio (panel 3). However, we also have some concerns. For example, a handful of large-cap technology firms have generated the bulk of the stock price performance. However, these firms currently trade at 23x.2 earnings compared to 60x.3 for the top firms at the peak of the TMT bubble in 2000. Additionally, the five largest stocks in the sector comprise only 13% of the index, compared to 16% at the peak of the 2000 bubble. Our recommendation, then, is that investors should hold this sector in line with benchmark. Are Canadian Banks At Risk Due To The Housing Bubble? Chart 13Canadian Housing Puzzle Canadian Housing Puzzle Canadian Housing Puzzle The recent problems at Home Capital Group have drawn investors' attention to the Canadian housing market. Home Capital's shares fell by 70% in April after regulators accused the mortgage lender of being slow to disclose fraud among its brokers. However, the issue is unlikely to have wider consequences: the event took place two years ago and had no impact on the lender's assets. Home Capital lends only to individuals with reliable collateral, and accounts for only 1% of total mortgage loans. We don't see imminent risks to the housing and banking sectors, since the economy is recovering and monetary policy remains loose. Vancouver and Toronto home prices have surged for almost a decade (Chart 13, panel 1). After Vancouver introduced a 15% foreign buyer tax in July 2016, house prices initially pulled back but quickly recovered. A similar tax in Ontario this April is also likely to have limited impact. Cautious macro-prudential rules should ensure banks' health: mortgage insurance is required for down-payments under 20%, and the gross debt service ratio (total housing costs over household income) cannot exceed 32%. However, the rise in house prices has caused household debt to run up (Chart 13, panel 2). Carolyn Wilkins, Senior Deputy Governor of the Bank of Canada, hinted in a speech in June that the central bank may soon raise rates. Tighter monetary policy could hurt mortgage borrowers who have enjoyed low interest payments for years (Chart 13, panel 3). Over the longer-term, therefore, we are concerned about the level of household debt, and recommend a cautious stance toward Canadian bank stocks. Global Economy Overview: Goldilocks continues, with global growth prospects still good (PMIs in developed economies generally remain around 55 - see Chart 14 panel 2 and Chart 15 panel 1), but inflation surprising on the downside in recent months. The wild card is China, where growth has slowed since Q1, when GDP reached 6.9%, and it is unclear whether the authorities will ease fiscal and monetary tightening to cushion the slowdown. Chart 14Growth Prospects Generally Remain Good Growth Prospects Generally Remain Good Growth Prospects Generally Remain Good Chart 15But Inflation Expectations Have Fallen But Inflation Expectations Have Fallen But Inflation Expectations Have Fallen U.S.: Growth has been weaker than the over-heated consensus expected, pushing down the Citigroup Economic Surprise Indexes (CESI) sharply (Chart 14, panel 1). However, prospects remain positive for the next 12 months: the Manufacturing ISM is at 54.9, retail sales are growing at 3.8% YoY, and capex has begun to reaccelerate (Chart 14, panel 5). The Fed's Nowcasts point to Q2 GDP growth at 1.9%-2.7% QoQ annualized. With expections now lowered, the CESI is likely to bottom around here. Euro Area: Growth has been stronger than in the U.S, with the PMI continuing to accelerate to 57.3. However, this is largely due to the euro area's strong cyclicality and exposure to global growth. Domestic momentum remains weak in most countries, with region-wide wage growth only 1.4% YoY. European PMIs are likely to roll over in line with the U.S. ISM. But GDP growth for the year is not likely to fall much from the 1.9% achieved in Q1. Japan remains a dual-paced economy, with international sectors doing well (exports rose by 14.9% YoY in May and industrial production by 5.7%) but domestic sectors stagnating, as wage growth remains sluggish (up just 0.5% YoY). Bank of Japan policy will remain ultra-easy, but there is scant sign of fiscal stimulus or structural reform. Emerging Markets: China is showing clear signs of slowdown, with the Caixin Manufacturing PMI falling below 50 (Chart 15, panel 3). The PBoC has tightened monetary policy, causing corporate bond yields to rise by 100 bps since the start of the year and the yield curve to invert. However, with the 19th Communist Party Conference scheduled for the fall, the authorities will prioritize stability: there are signs they are increasing fiscal spending. Elsewhere, many emerging markets are characterized by sluggish growth but falling inflation, which may allow central banks to cut rates. Interest rates: Inflation has softened recently, with U.S. core PCE inflation slowing to 1.4% and euro zone core CPI to 1.1%. We agree with the Fed that the recent weak inflation was caused by temporary factors and, with little slack in the labor market, core PCE will rise to 2% by next year, causing the Fed to hike in line with its dots. In the euro zone, however, the output gap remains around -2% of GDP and countries such as Italy could not bear tightening, so the ECB will taper only gradually next year and not raise rates soon. Chart 16Powered by Earnings and Margin Improvement! Powered by Earnings and Margin Improvement! Powered by Earnings and Margin Improvement! Global Equities In Q2 2017 the price gain in global equities was driven entirely by earnings growth, as forward earnings grew by 3.5% while the forward PE multiple barely changed. This is distinctively different from the equity rally in 2016 when multiple expansion dominated earnings growth (Chart 16). The scope of the improvement in earnings so far in 2017 has been wide. Not only are forward earnings being revised up, but 12-month trailing earnings growth has also come in very strong, with 90% of sectors registering positive earnings growth. Margins improved in both DM and EM. Equity valuation is not cheap by historical standards but, as an asset class, equities are still attractively valued compared to bonds given how low global bond yields are. We remain overweight equities versus bonds even though we are a little concerned about the extremely low volatility in all asset classes (see "What Our Clients Are Asking" on page 8). Within equities, we maintain our call to favor DM versus EM despite the 7% EM outperformance year-to-date, which was supported by attractive valuations and the weak U.S. dollar. BCA's house view is that the USD will strengthen versus EM currencies over the coming 12 months. Within EM, we have been more positive on China and remain so on a 6-9 month horizon, in spite of China's 6.7% outperformance versus EM. Our upgrade of euro area equities to overweight at the expense of the U.S. in our last Quarterly Portfolio Outlook proved to be timely as the euro area outperformed the U.S. by 641 bps in Q2. We continue to like Japan on a currency hedged basis (see next page). Sector-wise, we maintain a pro-cyclical tilt. However, we are taking profit on our overweight in Technology (downgrade to neutral) and upgrading Financials to overweight from neutral. Japanese Equities: Maintain Overweight, With Yen Hedge We upgraded Japanese equities to overweight in June 2016 (please see our Quarterly Report, dated June 30, 2016 and our Special Report, dated June 8, 2016) on a currency hedged basis. These positions have worked very well as the yen is down by 10% and MSCI Japan has gained 32% in yen term, outperforming the global benchmark by 12% in local currency terms, but in line with benchmark in USD (Chart 17). Going forward, we recommend clients continue to overweight Japanese equities in a global portfolio and hedge the JPY exposure. Reasons: First, since December 2012 when Abenomics started, MSCI Japanese equities have gained 82% in yen terms, but earnings have risen by much more, with a 180% increase. Valuation multiples have contracted, in stark contrast to other major equity markets where multiple expansion has led to stretched valuations. Second, divergent monetary policy between the BOJ and the Fed will put more downside pressure on the JPY. More importantly, weak fundamentals, as evidenced by falling inflation and a slowing in GDP growth, are likely to push the BOJ to resort to more extraordinary policy measures, such as debt monetization, which would further weaken the JPY, boosting exports and therefore the export sector dominated Japanese equity market. Note that our quant model is still underweight Japan, but has become slightly less so compared to six months ago. We have overridden the model because 1) the model is unhedged in USD terms and, more importantly, 2) the model cannot capture potential policy action such as debt monetization. Chart 17Japanese Equities: Remain Overweight Japanese Equities: Remain Overweight Japanese Equities: Remain Overweight Chart 18Financials Vs Tech: Trading Places Financials Vs Tech: Trading Places Financials Vs Tech: Trading Places Sector Allocation: Upgrade Financials to Overweight by Downgrading Tech to Neutral. We have been overweight Technology since July 2016 (please see our Monthly Update, July 29, 2016) and the sector has outperformed the global benchmark by 11.8%, of which 9% came this year. In line with our general concern on asset valuations, we are taking profit on the Tech overweight and use the proceeds to fund an overweight in the much cheaper Financials sector. As shown in Chart 18, the relative total return performance of Financials vs. Technology is back to extreme levels (panel 1), while the relative valuation of Financials measured by price to book has reached an extremely cheap level (panel 2). Also, Financial shares offer a good yield pick-up over Tech even though this advantage is in line with the historical average (panel 3). BCA's house view calls for higher interest rates and steeper yield curves over the next 9-12 months. Financial earnings benefit from a steepening yield curve. If history is any guide, we should see more aggressive analysts' earnings revisions going forward in favor of Financials (panel 4). Overall, our sector positioning retains its tilt towards cyclicals vs. defensives. (Please see Recommended Allocation table on page 1), in line with the tilt from our quant model. Within the cyclical sectors, however, we have overridden the model on Financials and Tech since the momentum factor is a major driver in the model and we judge that momentum has probably run too far. Chart 19MSCI ACW: Factor Relative Performance MSCI ACW: Factor Relative Performance MSCI ACW: Factor Relative Performance Smart Beta Update: In Q2, an equal-weighted multi-factor portfolio outperformed the global benchmark (Chart 19, top panel). Among the five most enduring factors - size, value, quality, minimum volatility, and momentum - quality and momentum factors continued the Q1 trend of outperformance, while value continued to underperform. It's worth noting that the underperformance of minimum volatility stabilized in the last two months of the quarter, indicating that the extremely low market vol has caught investor attention and some investors have started to seek protection by moving into the low vol space, albeit gradually. Value has continued to underperform growth, and small caps to underperform large caps. We maintain our neutral view on styles and prefer to use sector positioning to implement the underlying themes given the historically close correlation between styles and cyclicals versus defensives (bottom two panels). As show in Table 1, however, even though value has underperformed growth across the globe, small caps in Japan and the euro area have consistently outperformed large caps year-to-date, the opposite to that in the U.S., in line with the higher beta nature of these two markets. Table 1Divergence In Style Quarterly - July 2017 Quarterly - July 2017 Government Bonds Maintain Slight Underweight Duration. U.S. bond yields declined significantly in Q2 to below fair value levels in response to weaker "hard data" (Chart 20, top panel). But weakness in Q1 U.S. GDP was concentrated in consumer spending and inventories, both of which are likely to strengthen in the months ahead. In addition, after the June rate hike, we expect the Fed to deliver another rate hike by year end, while the market is pricing in only 14 bps of rate rise. Maintain overweight TIPS vs. Treasuries. As the nominal 10-year yield fell, so did 10-year TIPS breakeven inflation. In terms of relative valuation, now TIPS is fairly valued vs. the nominal bonds (panel 2). However, our U.S. Bond Strategy's core PCE model, which closely tracks the 10-year TIPS breakeven rate (panel 3), is sending the message that inflationary pressures are building in the economy and that core PCE should reach the Fed's 2% target later this year. This suggests that the bond markets are not providing adequate compensation for the inflationary economic backdrop. Overweight Inflation-linked JGBs (JGBi) vs. Nominal JGBs. Inflation in Japan has been falling despite strong GDP growth. However, the labor market has not been this tight since the mid-1990s, with the unemployment rate at 3.1% and jobs-to-applicants ratio at 1.49, both post-1995 extremes (Chart 21, panel 2). BCA Foreign Exchange Strategy service believes that wage pressures, in addition to the inflationary effect of a weakening yen, could lead inflation higher. Accordingly, inflation-linked JGBs offer good value relative to nominal JGBs (Chart 21, panel 1). Chart 20Inflationary Pressures Are Building Inflationary Pressures Are Building Inflationary Pressures Are Building Chart 21Overweight JGBi Vs JGB Overweight JGBi Vs JGB Overweight JGBi Vs JGB Corporate Bonds Given our expectations that global growth will remain robust over the coming 12 months, pushing the U.S. 10-year Treasury yield above 3%, we continue to favor credit over government bonds. However, U.S. corporate health has deteriorated further in the past two quarters (Chart 22) and so, when the next recession comes, returns from corporate credit may be particularly bad. We cut our double overweight in investment grade debt to single overweight. The spread over Treasuries of U.S. IG credit has fallen to around 100 bps. Given high U.S. corporate leverage currently, it is unlikely that the spread will tighten any further to reach previous lows (Chart 23), so investors will benefit only from the carry. Moreover, the ECB is likely to reduce its bond buying from January 2018 and, though it is unclear whether it will taper corporate as well as sovereign purchases, this represents a potential headwind for European credit. Remain overweight high yield debt. U.S. junk bonds have been remarkably resilient in the face of falling oil prices and the subsequent blowout in energy bond spreads. The default-adjusted spread is just over 200 bps (Chart 24), based on Moody's default assumption of 2.7% over the next 12 months and a recovery rate of 47%. Historically, a spread of this size has produced an excess return over the following year 74% of the time, for an average of 84 bps. Chart 22U.S. Corporate Health Deteriorating U.S. Corporate Health Deteriorating U.S. Corporate Health Deteriorating Chart 23IG Spreads Unlikely To Tighten Further IG Spreads Unlikely To Tighten Further IG Spreads Unlikely To Tighten Further Chart 24Junk Spreads Give Sufficient Reward Junk Spreads Give Sufficient Reward Junk Spreads Give Sufficient Reward Commodities Chart 25Mixed Feelings Towards Commodities Mixed Feelings Towards Commodities Mixed Feelings Towards Commodities Secular Perspective: Bearish: We continue to hold a negative secular outlook for commodities (Chart 25). A gradual shift towards a service-led economy in China, combined with sluggish global growth, will prevent demand from rising further. This lack of demand, together with record high inventory levels for major commodities, keep us from turning bullish. Cyclical Perspective: Neutral We are positive on oil because we believe that inventories will continue to draw. We are negative on base metals due to weak demand and excess supply. We are somewhat bullish on precious metals based on the political uncertainties ahead. Energy: Bullish OPECextended its production cuts for another nine months, carrying the cuts through to Q1, when the oil price is typically seasonally weak. We expect demand growth will increasingly outpace production growth in 2017, producing inventory drawdowns. The current weakness in the crude price is largely due to investors' concerns over shale production. However, the OPEC cut of 1.2 MMb/d, supplemented by an additional 200,000 - 300,000 b/d of voluntary restrictions on non-OPEC oil, are enough to offset any spurt in shale production. Base metals: Bearish China is slowly tightening monetary policy and, following the 19th Communist Party Congress later this year, reflationary stimulus will probably continue to wind down. We have seen a cooling in the Chinese property market along with a slowdown in the manufacturing sector. The Caixin manufacturing PMI, a key indicator for metals demand, fell below 50 in May for the first time in 11 months. At the same time, inventories for copper and iron ore have risen. Precious metals: Long-term Bullish Inflation has not picked up as we expected, which may prevent the gold price from rising further in 2017. However, we expect inflation to move higher going into 2018. As a safe haven, gold is also a good hedge against geopolitical risks. We believe that the political risks in 2018 are underestimated, especially the Italian general election (probably in March or April). Currencies Chart 26Fed Will Support The Dollar Fed Will Support The Dollar Fed Will Support The Dollar In 2017, the U.S. dollar (Chart 26) has weakened by 5% on a trade-weighted basis. However, we believe that the soft patch in inflation and wage data that caused this weakness is temporary and that underlying economic momentum remains strong. Following its rate hike in June, the Fed kept its forecast for core PCE in 2018 and 2019 at 2%. As inflation and wage pressures return, market expectations will converge with the Fed's forecast. The subsequent improvement in relative interest rates will support the dollar. Euro: The euro is up by 8% versus the dollar so far this year. The ECB is likely to continue to set policy for the weakest members of the euro zone, in the absence of a major pickup in inflation. While economic activity has improved, inflation has recently fallen back again, along with the oil price. The ECB is particularly sensitive to political uncertainty surrounding the upcoming Italian elections and the fragility of the Italian banking system. This suggests that the ECB will only gradually taper its asset purchases starting early next year, but will not move to raise rates until at least mid-2019. This is likely to cause the euro to weaken over the coming months. Yen: The yen has strengthened by 4% versus the dollar year to date. With core core inflation in Japan struggling to stay above 0%, we think it highly likely that the BOJ will continue its yield curve control policy. If, as we expect, U.S. long-term interest rate trend up in the coming months, relative rates will put downward pressure on the yen. Our FX strategists expect the USD/JPY at 125 within 12 months. EM Currencies: With Chinese growth likely to remain questionable over the coming months, emerging market currencies will lack their biggest tailwind. Terms of trade will continue to turn negative as commodity prices weaken. EM monetary authorities will mostly be easing policy in order to support growth. With rates kept low, relative monetary policy is likely to will force EM currencies, especially those for commodity exporters, to depreciate from current levels. Alternatives Chart 27Attractive Risk-Return Profile Attractive Risk-Return Profile Attractive Risk-Return Profile Return Enhancers: Favor private equity vs. hedge funds In 2016, private equity returned 9%, whereas hedge funds managed only a 3% return (Chart 27). Strong performance led to private equity funds raising $378 bn last year, the highest level of capital secured since the Global Financial Crisis. By contrast, hedge funds have underperformed global equities and private equity since the financial crisis of 2008-09. However, investors have become increasingly concerned with valuation levels in private markets. Our recommendation is that investors should continue to overweight private equity vs hedge funds, since we do not see a recession as likely over the next 12 months. Within the hedge fund space, we would recommend overweighting event-driven funds over the cycle, and macro funds heading into a recession (please see our Special Report, dated June 16, 2017). Inflation Hedges: Favor direct real estate vs. commodity futures In 2016, direct real estate returned 9%, whereas commodity futures achieved 12%. Given the structural nature of this recommendation, investors need to look past recent short-term moves in commodity prices. Low interest rates will keep borrowing cheap, making the spread between real estate and fixed income yields continue to be attractive. Moreover, with 48% of institutional investors currently below their target allocation for real estate, there is a lot of potential for further capital allocations to the asset class. With regards to the commodity complex, the long-term transition of China to a services-based economy will lead to a structural decline in commodity demand. Investors should continue to overweight direct real estate vs commodity futures on a 3-5 year target horizon. Volatility Dampeners: Favor farmland & timberland vs. structured products In 2016, farmland and timberland returned 9% and 3% respectively, whereas structured products returned 2%. Farmland and timberland will continue to benefit from favorable global demographic trends, as a growing population and improving prosperity in the developing world increase food consumption. However, increased volatility in lumber and agriculture prices have made investors concerned about cash flows. With regards to structured products, increasing rates and deteriorating credit quality in the auto loan market will slow credit origination. Given that the Fed will start unwinding its balance sheet this year, increased supply will put upward pressure on spreads. Investors can reduce the volatility of a multi-asset portfolio with the inclusion of farmland and timberland. Risks To Our View We explained the two alternative scenarios to our main view in the Overview section of this Quarterly. There are three other specific areas where our views differ notably from the consensus: Strong dollar. Our view is predicated on the Fed tightening policy more than the market currently expects, and the ECB less. Interest rate differentials (Chart 28) certainly point to a stronger USD, and speculative positions have reversed from being very dollar-long at the start of the year. But the euro momentum could continue for a while, especially given mixed messages from Mario Draghi, for example when he said in late June that "the threat of deflation is gone and reflationary forces are at play." Crude oil back at $55. Our Energy strategists believe that the oil price is currently being driven by supply, not demand. They argue that OPEC production cuts will hold and cause inventories to draw down rapidly over the coming six months. However, speculative positioning in oil has shifted from very long to significantly short since the start of the year. The risk is that U.S. oil production continues to accelerate (Chart 29), as fracking technology improves and availability of capital for oil producers remains easy. Negative on EM. Our 12-month EM view is predicated on a stronger dollar, higher U.S. interest rates, slowing Chinese growth, and falling commodity prices. We could be wrong about these drivers. Falling inflation in emerging markets such as Brazil (Chart 30) could allow central banks to cut rates aggressively, which might temporarily boost growth. Chart 28Rate Differentials Suggest Strong Dollar Rate Differentials Suggest Strong Dollar Rate Differentials Suggest Strong Dollar Chart 29Oil Bears Point To U.S. Output Oil Bears Point To U.S. Output Oil Bears Point To U.S. Output Chart 30Sharp Fall In Brazilian Inflation Sharp Fall In Brazilian Inflation Sharp Fall In Brazilian Inflation 1 Our U.S. Bond Strategists explain the detailed thinking behind these three scenarios in their Weekly Report "Three Scenarios for Treasury Yields In 2017," dated June 20, 2017, available at usbs.bcaresearch.com 2 Market-cap weighted average of Apple, Alphabet, Microsoft, Amazon and Facebook. 3 Market-cap weighted average of Microsoft, Cisco Systems, Intel, Oracle and Lucent. Recommended Asset Allocation

Highlights Economic Outlook: Global growth will remain strong over the next 12 months, but will start to slow in the second half of 2018, potentially setting the stage for a recession in 2019. Overall Strategy: Investors should overweight equities and spread product for now. However, be prepared to pare back exposure next summer. Fixed Income: Maintain below benchmark duration exposure over the next 12 months. Underweight U.S. Treasurys, stay neutral Europe, and overweight Japan. Equities: Remain overweight developed market equities relative to their EM peers. Within the DM sphere, favor the euro area and Japan over the U.S. in local-currency terms. In the EM universe, Chinese H-shares have significant upside. Currencies: The selloff in the dollar is overdone. The broad trade-weighted dollar will appreciate by 10% before peaking in mid-2018. The yen still has considerable downside against the dollar, as does the euro. Commodities: Oil will rally over the coming months as global inventories decline. Gold will continue to struggle, before exploding higher towards the end of this decade. Feature I. Global Macro Outlook End Of The Global Manufacturing Recession Global growth estimates have been trending higher over the past 12 months, having bottomed last summer. Ironically, the collapse in oil prices in late 2014 was both the main reason for the deterioration in global growth as well as its subsequent rebound. Plunging oil prices led to a massive decline in capital spending in the energy sector and associated industries. In the U.S., energy capex dropped by 70% between Q2 of 2014 and Q3 of 2016. The economic fallout was even more severe in many other economies, especially emerging markets such as Russia and Brazil. The result was a global manufacturing recession and a pronounced slump in international trade (Chart 1). When thinking about oil and the economy, the distinction between levels and rates of change is important: While rapidly falling oil prices tend to be bad for global growth, lower oil prices are good for it. By the middle of 2016, the damage from the oil crash had largely run its course. What was left was a massive windfall for households, especially poorer ones who spend a disproportionate share of their paychecks at the pump. Industries that use oil as an input also benefited. Simply put, the oil crash went from being a bane to a boon for the global economy. A Solid 12-Month Outlook We expect global growth to remain firm over the next 12 months. Financial conditions in most countries have eased substantially since the start of the year thanks to rising equity prices, lower bond yields, and narrower credit spreads (Chart 2). Our empirical analysis suggests that easier financial conditions tend to lift growth with a lag of 6-to-9 months (Chart 3). This bodes well for activity in the remainder of this year. Chart 1The Manufacturing Recession Has Ended The Manufacturing Recession Has Ended The Manufacturing Recession Has Ended Chart 2Financial Conditions Have Eased Globally Financial Conditions Have Eased Globally Financial Conditions Have Eased Globally A number of "virtuous cycles" should amplify the effects of easier financial conditions. In the U.S., a tight labor market will lead to faster wage growth, helping to spur consumption. Rising household spending, in turn, will lead to lower unemployment and even faster wage growth. Strong consumption growth will also motivate firms to expand capacity, translating into more investment spending. Chart 4 shows that the share of U.S. firms planning to increase capital expenditures has risen to a post-recession high. Chart 3Easier Financial Conditions Will Support Growth Easier Financial Conditions Will Support Growth Easier Financial Conditions Will Support Growth Chart 4U.S. Firms Plan To Boost Capex U.S. Firms Plan To Boost Capex U.S. Firms Plan To Boost Capex The euro area economy continues to chug along. The purchasing manager indices (PMIs) dipped a bit in June, but remain at levels consistent with above-trend growth. The German Ifo business confidence index hit a record high this week. Corporate balance sheets in the euro area are improving and credit growth is accelerating. This is helping to fuel a rebound in business investment (Chart 5). The fact that the ECB has no intention of raising rates anytime soon will only help matters. As inflation expectations begin to recover, short-term real rates will fall. This will lead to a virtuous circle of stronger growth, and even higher inflation expectations. The Japanese economy managed to grow by an annualized 1% in the first quarter. This marked the fifth consecutive quarter of positive sequential growth, the longest streak in 11 years. Exports are recovering and both the manufacturing and non-manufacturing PMIs stand near record-high levels (Chart 6). Chart 5Euro Area Data Remain Upbeat Euro Area Data Remain Upbeat Euro Area Data Remain Upbeat Chart 6Japanese Economy Is Rebounding Japanese Economy Is Rebounding Japanese Economy Is Rebounding Chart 7China: Slight Slowdown, But No Need To Worry China: Slight Slowdown, But No Need To Worry China: Slight Slowdown, But No Need To Worry The Chinese economy has slowed a notch since the start of the year, but remains robust (Chart 7). Real-time measures of industrial activity such as railway freight traffic, excavator sales, and electricity production are rising at a healthy clip. Exports are accelerating thanks to a weaker currency and stronger global growth. Retail sales continue to expand, while the percentage of households that intend to buy a new home has surged to record-high levels. The rebound in Chinese exports and industrial output is helping to lift producer prices. Higher selling prices, in turn, are fueling a rebound in industrial company profits (Chart 8). A better profit picture should support business capital spending in the coming months. Meanwhile, the Chinese government's "regulatory windstorm" - as the local press has called it - has largely bypassed the real economy. In fact, medium and long-term lending to nonfinancial corporations, a key driver of private-sector capital spending and physical commodity demand, has actually accelerated over the past eight months (Chart 9). Chart 8China: Higher Selling Prices Fueling A Rebound In Profits China: Higher Selling Prices Fueling A Rebound In Profits China: Higher Selling Prices Fueling A Rebound In Profits Chart 9China: Credit To The Real Economy Is Accelerating China: Credit To The Real Economy Is Accelerating China: Credit To The Real Economy Is Accelerating All Good Things Must Come To An End We remain optimistic about global growth over the next 12 months. Unfortunately, things are likely to sour in the second half of 2018, possibly setting the stage for a recession in the U.S. and several other countries in 2019. The odds of a recession rise when economies approach full employment (Chart 10). The U.S. unemployment rate now stands at 4.3% and is on track to break below its 2000 low of 3.8% next summer. A cursory look at the data suggests that the unemployment rate is usually either rising or falling (Chart 11). And once it starts rising, it keeps rising. In fact, there has never been a case in the postwar era where the three-month average of the unemployment rate has risen by more than one-third of a percentage point without a recession ensuing. Chart 10Recessions Become More Likely When The Labor Market Begins To Overheat Third Quarter 2017: Aging Bull Third Quarter 2017: Aging Bull Chart 11Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Modern economies contain numerous feedback loops. When unemployment starts increasing, this fuels a vicious cycle where rising joblessness saps confidence and incomes, leading to less spending and even higher unemployment. History suggests that it is almost impossible to break this cycle once it starts. The Fed is well aware of the risks of letting the unemployment rate fall to a level where it has nowhere to go but up. Unfortunately, calibrating monetary policy in a way that achieves a soft landing is easier said than done. Changes in monetary conditions affect the economy with a lag of about 12-to-18 months. Once it has become obvious that a central bank has either loosened or tightened monetary policy too much, it is often too late to right the ship. The risks of a policy error are particularly high in today's environment where there is significant uncertainty about the level of the long-term neutral rate. Question marks about the future stance of fiscal policy will also complicate the Fed's job. We expect the Trump administration to succeed in passing legislation that cuts both personal and corporate income taxes later this year or in early 2018. The bill will be "fully funded" in the sense that there will be offsetting spending cuts, but these will be back-loaded toward the end of the 10-year budget window, whereas the tax cuts will be front-loaded. This will generate a modest amount of fiscal stimulus over the next few years. That being said, the proposed changes to health care legislation could more than neutralize the effects of lower tax rates. The Senate bill, as currently worded, would lead to substantial cuts to Medicaid relative to existing law, as well as deep cuts to insurance subsidies for many poor and middle-class families. Our base case is that Republicans in Congress fail to pass a new health care bill, thus leaving the Affordable Care Act largely unscathed. However, if they succeed, the overall stance of federal fiscal policy would likely shift from being somewhat accommodative, on net, to somewhat restrictive. This would expedite the timing of the recession. How Deep A Recession? If the U.S. does succumb to a recession in 2019, how bad will it be? Here, there is both good news and bad news. The good news is that financial and economic imbalances are not as severe today as those that existed in the lead-up to the past few recessions. The Great Recession was preceded by a massive housing bubble, associated with overbuilding and a sharp deterioration in mortgage lending standards (Chart 12). Today, residential investment stands at 3.9% of GDP, compared to a peak of 6.6% of GDP Q1 of 2006. Lending standards, at least judging by FICO scores, have remained fairly high over the course of the recovery. In relation to income and rents, home prices are also much lower today than they were a decade ago. Likewise, the massive capex overhang that preceded the 2001 recession is largely absent at present. Chart 12No New Bubble In The U.S. Housing Sector No New Bubble In The U.S. Housing Sector No New Bubble In The U.S. Housing Sector Chart 13Consumer Credit: Making A Comeback... Consumer Credit: Making A Comeback... Consumer Credit: Making A Comeback... The bad news is that cracks in the economy are starting to form. In contrast to mortgage debt, student debt has gone through the roof and auto loans are nearly back to pre-recession levels as a share of disposable income (Chart 13). Not surprisingly, this is starting to translate into higher default rates (Chart 14). The fact that this is happening when the unemployment rate is at the lowest level in 16 years is a cause for concern. Meanwhile, the ratio of corporate debt-to-GDP has risen above 2000 levels and is closing in on its 2007 peak (Chart 15). Chart 14...With Defaults Starting To Rise In Some Categories ...With Defaults Starting To Rise In Some Categories ...With Defaults Starting To Rise In Some Categories Chart 15U.S. Corporate Sector Has Been Feasting On Credit U.S. Corporate Sector Has Been Feasting On Credit U.S. Corporate Sector Has Been Feasting On Credit We are particularly worried about the health of the commercial real estate (CRE) market. CRE prices currently stand 7% above pre-recession levels in real terms, having risen by a staggering 82% since the start of 2010 (Chart 16). U.S. financial institutions hold $3.8 trillion in CRE loans, $2 trillion of which are held by banks. As a share of GDP, the outstanding stock of CRE bank loans in most categories is near pre-recession levels (Chart 17). Chart 16Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Chart 17CRE Debt Is Rising CRE Debt Is Rising CRE Debt Is Rising The retail sector is already under intense pressure due to the shift in buying habits towards E-commerce. Vacancy rates in the apartment sector have started to tick higher and rent growth has slowed (Chart 18 and Chart 19). The number of apartment units under construction stands at a four-decade high, despite a structurally subdued pace of household formation (Chart 20). Most of these units are likely to hit the market in 2018, which will result in a further increase in vacancy rates. Vacancies in the office sector are also likely to rise, given the recent increase in the number of new projects in the pipeline. On the flipside, demand growth for new office space is set to weaken, as a tighter labor market leads to slower payroll gains. Chart 18Vacancy Rates Are Bottoming Outside The Industrial Sector... Vacancy Rates Are Bottoming Outside The Industrial Sector... Vacancy Rates Are Bottoming Outside The Industrial Sector... Chart 19...While Rent Growth Is Losing Steam ...While Rent Growth Is Losing Steam ...While Rent Growth Is Losing Steam If vacancy rates across the CRE sector start rising in earnest, real estate prices will fall, leading to a decline in the value of the collateral backing CRE loans. This could prompt lenders to pull back credit, causing prices to fall further. Seasoned real estate investors are no strangers to such vicious cycles, and if the next one begins late next year when growth is slowing because the economy is running out of spare capacity and financial conditions are tightening, it would further add to the risks of a recession. Chart 20Apartment Supply Is Surging, But Will There Be Enough Demand? Apartment Supply Is Surging, But Will There Be Enough Demand? Apartment Supply Is Surging, But Will There Be Enough Demand? Gauging The Global Spillover Effects What repercussions would a U.S. recession have for the rest of the world? Simply based on trade flows, the answer is "not much." U.S. imports account for less than 5% of global ex-U.S. GDP. Thus, even a significant decline in U.S. spending abroad would not make much of a dent in overseas growth. More worrisome are potential financial spillovers. As the IMF has documented, these have been the dominant drivers of the global business cycle in the modern era.1 Chart 21Global Debt Levels Are Still High Third Quarter 2017: Aging Bull Third Quarter 2017: Aging Bull Correlations across global markets tend to increase when risk sentiment deteriorates. Thus, if U.S. stocks buckle in the face of rising recessionary risks, risk assets in other economies are sure to suffer. The fact that valuations are stretched across so many markets only makes the problem worse. A flight towards safety could trigger a pronounced decline in global equity prices, wider credit spreads, and lower property prices. This, in turn, could lead to a sharp decline in household and corporate net worth, resulting in tighter financial conditions and more stringent lending standards. Elevated debt levels represent another major source of vulnerability. Total debt as a share of GDP is greater now than it was before the Great Recession in both advanced and emerging markets (Chart 21). High debt burdens will prevent governments from loosening fiscal policy in countries that are unable to issue their own currencies. The monetary transmission mechanism also tends to be less effective in the presence of high debt. This is especially the case in today's environment where the zero lower-bound on nominal interest rates remains a formidable challenge. The presence of these fiscal and monetary constraints implies that the severity of the next recession could be somewhat greater than one might expect based solely on the underlying causes of the downturn. II. Financial Markets Overall Strategy The discussion above implies that the investment outlook over the next few years is likely to be of the "one step forward, two steps back" variety. The global economy is entering a blow-off stage where growth will get better before it gets worse. We are bullish on global equities and spread product over the next 12 months, but expect to turn bearish on risk assets next summer. Until then, investors should position for a stronger dollar and higher bond yields. We recommend a slight overweight allocation to developed market equities over their EM peers. Within the DM sphere, we favor the euro area and Japan over the U.S. in local-currency terms. In the EM universe, Chinese H-shares stand out as offering an attractive risk-reward profile. Comparing government bonds, we are underweight U.S. Treasurys, neutral on European bonds, and overweight Japan. These recommendations are broadly in line with the output of our in-house quantitative models (Table 1 and Chart 22). Table 1BCA's Tactical Global Asset Allocation Recommendations* Third Quarter 2017: Aging Bull Third Quarter 2017: Aging Bull Chart 22Message From Our U.S. Stock Market ##br##Timing Model Third Quarter 2017: Aging Bull Third Quarter 2017: Aging Bull Equities Earnings Are Key Earnings have been the main driver of the global equity bull market. In fact, the global forward P/E ratio has actually declined slightly since February, despite a 3.9% gain in equity prices (Chart 23). Strong global growth should continue to boost corporate earnings over the next 12 months. Consensus bottom-up estimates call for global EPS to expand by 14% in 2017 and a further 11% in 2018. The global earnings revision ratio moved into positive territory earlier this year for the first time in six years (Chart 24). Chart 23Earnings Have Been The Main Driver ##br##Of The Global Equity Bull Market Earnings Have Been The Main Driver OfThe Global Equity Bull Market Earnings Have Been The Main Driver OfThe Global Equity Bull Market Chart 24Global Earnings Picture ##br##Looks Solid Global Earnings Picture Looks Solid Global Earnings Picture Looks Solid Global monetary conditions generally remain favorable. Our U.S. Financial Conditions Index has loosened significantly. Historically, this has been a bullish signal for stocks.2 Excess liquidity, which we define as M2 growth less nominal GDP growth, is also still well above the zero line, a threshold that has warned of a downturn in stock prices in the past. Chart 25Individual Investors Are Not Overly Bullish On U.S. Equities But... Individual Investors Are Not Overly Bullish On U.S. Equities But... Individual Investors Are Not Overly Bullish On U.S. Equities But... Sentiment is stretched, but not excessively so. The share of bullish respondents in the AAII's weekly poll of individual investors stood at 29.7% this week (Chart 25). This marked the 18th consecutive week that optimism has been below its long-term average. Market Vane's survey of traders and Yale's Investor Confidence index paint a more complacent picture, as do other measures such as the VIX and margin debt (Chart 26). Nevertheless, as long as earnings continue to grow and monetary policy remains in expansionary territory, sentiment can remain elevated without being a significant threat to stocks. Overweight The Euro Area And Japan Over The U.S. Regionally, earnings revisions have been more positive in Europe and Japan than in the U.S. so far this year. Net profit margins are also lower in Europe and Japan, which gives these two regions more room for catch-up. Moreover, unlike the Fed, neither the ECB nor the BoJ are likely to raise rates anytime soon. As we discuss in greater detail in the currency section of this report, this should lead to a weaker euro and yen, giving European and Japanese exporters a further leg up in competitiveness. Lastly, valuations are more favorable in the euro area and Japan than in the U.S., even if one adjusts for differing sector weights across the three regions (Chart 27). Chart 26...There Are Signs Of Complacency ...There Are Signs Of Complacency ...There Are Signs Of Complacency Chart 27U.S. Valuations Seem Stretched Relative ##br##To Other Bourses Third Quarter 2017: Aging Bull Third Quarter 2017: Aging Bull Mixed Outlook For EM Earnings growth in emerging markets has accelerated sharply. Bottom-up estimates imply EPS growth of 20% in 2017 and 11% in 2018 for the EM MSCI index. Our EM strategists believe this is too optimistic, given the prospect of a stronger dollar, high debt levels across the EM space, poor corporate governance, and the lack of productivity-enhancing structural reforms. These problems warrant a slight underweight to emerging markets in global equity portfolios. Nevertheless, considering the solid backdrop for global growth, EM stocks should still be able to deliver positive real total returns over the next 12 months. Within the EM space, we favor Russia, central Europe, Korea, Taiwan, India, Thailand, and China. Chinese H-shares, in particular, remain quite attractive, trading at only 7.1-times forward earnings and 1.0-times book value. Favor Cyclicals Over Defensives ... For Now Looking at global equity sectors, upward revisions have been largest for industrials, materials, financials, and real estate. Revisions for energy, health care, and telecom have been negative. We expect cyclical stocks to outperform defensives over the next 12 months. Energy stocks will move from being laggards to leaders, as oil prices rebound. Financials should also do well, as steeper yield curves, increased M&A activity, and falling nonperforming loans bolster profits. Equity Bear Market Will Begin Late Next Year As growth begins to falter in the second half of 2018, stocks will swoon. U.S. equities are likely to fall 20% to 30% peak to trough, marking the first sustained bear market since 2008. Other stock markets will experience similar declines. Global equities will eventually recoup most of their losses at the start of the 2020s, but the recovery will be a lackluster one. As we have argued extensively in the past, global productivity growth is likely to remain weak.3 Population aging will deplete savings, leading to higher real interest rates. The next recession could also propel more populist leaders into power. None of these things would be good for stocks. Against today's backdrop of lofty valuations, global stocks will deliver a total real return in the low single-digit range over the next decade. Fixed Income Bonds Have Overreacted To The Inflation Dip We turned structurally bearish on government bonds on July 5th, 2016. As fate would have it, this was the very same day that the U.S. 10-year Treasury yield dropped to a record closing low of 1.37%. The dramatic bond selloff that followed was too much, too fast. We warned at the start of this year that bond yields were likely to climb down from their highs. At this point, however, the pendulum has swung too far in the direction of lower yields. Chart 28 shows that almost all of the decline in bond yields has been due to falling inflation expectations. Real yields have remained resilient, suggesting that investors' views of global growth have not changed much. This helps explain why stocks have been able to rally to new highs. The fall in inflation expectations has been largely driven by the decline in commodity prices. Short-term swings in oil prices should not affect long-term inflation expectations, but in practice they do (Chart 29). If oil prices recover in the second half of this year, as we expect, inflation expectations should shift higher as well. This will translate into higher bond yields. Chart 28Inflation Expectations Declined This Year, ##br##But Real Yields Remained Resilient Inflation Expectations Declined This Year, But Real Yields Remained Resilient Inflation Expectations Declined This Year, But Real Yields Remained Resilient Chart 29Low Oil Prices Drag Down##br## Inflation Expectations Low Oil Prices Drag Down Inflation Expectations Low Oil Prices Drag Down Inflation Expectations U.S. Treasurys Are Most Vulnerable Tightening labor markets should also boost inflation expectations. This is particularly the case in the U.S., where the economy is quickly running out of surplus labor. Some commentators have argued that the headline unemployment rate understates the true amount of economic slack. We are skeptical that this is the case. Table 2 compares a wide variety of measures of labor market slack with where they stood at the height of the business cycle in 2000 and 2007. The main message from the table is that the unemployment rate today is broadly where one would expect it to be based on these collaborating indicators. Table 2Comparing Current Labor Market Slack With Past Cycles 12-MONTH Third Quarter 2017: Aging Bull Third Quarter 2017: Aging Bull If the U.S. has reached full employment, does the absence of wage pressures signal that the Phillips curve is dead? We don't think so. For one thing, wage growth is not that weak. Our wage growth tracker has risen from a low of 1.2% in 2010 to 2.4% at present (Chart 30). In fact, real wages have been rising more quickly than productivity for the past three years (Chart 31). Unit labor cost growth is now just shy of where it was at the peaks of the last two business cycles (Chart 32). Chart 30Stronger Labor Market ##br##Is Leading To Faster Wage Growth Stronger Labor Market Is Leading To Faster Wage Growth Stronger Labor Market Is Leading To Faster Wage Growth Chart 31Real Wages Now Increasing Faster##br## Than Productivity Real Wages Now Increasing Faster Than Productivity Real Wages Now Increasing Faster Than Productivity Chart 32Unit Labor Cost Growth Close ##br##To Previous Two Peaks Unit Labor Cost Growth Close To Previous Two Peaks Unit Labor Cost Growth Close To Previous Two Peaks The evidence generally suggests that the Phillips curve becomes "kinked" when the unemployment rate falls towards 4%. In plain English, this means that a drop in the unemployment rate from 10% to 8% tends to have little effect on inflation, while a drop from 4.5% to 3.5% does. The experience of the 1960s is illustrative in that regard. Chart 33 shows that much like today, inflation in the first half of that decade was well anchored at just below 2%. However, once the unemployment rate fell below 4%, inflation took off. Core inflation rose from 1.5% in early 1966 to nearly 4% in early 1967, ultimately making its way to 6% by 1970. The Fed is keen to avoid a repeat of that episode. In a recent speech, New York Fed President and FOMC vice chairman Bill Dudley warned that "If we were not to withdraw accommodation, the risk would be that the economy would crash to a very, very low unemployment rate, and generate inflation ... Then the risk would be that we would have to slam on the brakes and the next stop would be a recession." If U.S. growth remains firm and inflation rebounds in the second half of this year, as we expect, the Fed will get the green light to keep raising rates in line with the "dots." The market is not prepared for that, as evidenced by the fact that it is pricing in only 27 basis points in rate hikes over the next 12 months. We are positioned for higher rate expectations by being short the January 2018 fed funds contract. The ECB And The BoJ Will Not Follow The Fed's Lead Could better growth prospects cause the ECB and the BoJ to follow in the Fed's footsteps and take away the punch bowl? We doubt it. Investors are reading too much into Mario Draghi's allegedly more "hawkish" tone. There is a huge difference between removing emergency measures and beginning a full-fledged tightening cycle. Labor market slack is still considerably higher in the euro area than was the case in 2008. Outside of Germany, the level of unemployment and underemployment in the euro area is about seven points higher than it was before the Great Recession (Chart 34). Chart 33Inflation In The 1960s Took Off ##br##Once The Unemployment Rate Fell Below 4% Inflation In The 1960s Took Off Once The Unemployment Rate Fell Below 4% Inflation In The 1960s Took Off Once The Unemployment Rate Fell Below 4% Chart 34Euro Area: Labor Market Slack##br## Is Still High Outside Of Germany Euro Area: Labor Market Slack Is Still High Outside Of Germany Euro Area: Labor Market Slack Is Still High Outside Of Germany At this point, the market is pricing in too much tightening from the ECB. Our months-to-hike measure has plummeted from a high of 65 months in July 2016 to 25 months at present (Chart 35). Investors now expect real yields in the U.S. to be only 16 basis points higher than in the euro area in five years' time.4 This is below the 76 basis-point gap in the equilibrium rate between the two regions that Holston, Laubach, and Williams estimate (Chart 36). Chart 35ECB: Markets Are Pricing In Too Much Tighteninh ECB: Markets Are Pricing In Too Much Tighteninh ECB: Markets Are Pricing In Too Much Tighteninh Chart 36The Neutral Rate Is Lowest In The Euro Area The Neutral Rate Is Lowest In The Euro Area The Neutral Rate Is Lowest In The Euro Area As for Japan, while the unemployment rate has fallen to a 22-year low of 2.8%, this understates the true amount of slack in the economy. Output-per-hour in Japan remains 35% below U.S. levels. A key reason for this is that many Japanese companies continue to pad their payrolls with excess labor. This is particularly true in the service sector, which remains largely insulated from foreign competition. In any case, with both actual inflation and inflation expectations in Japan nowhere close to the BoJ's target, this is hardly the time to be worried about an overheated economy. And even if the Japanese authorities were inclined to slow growth, it would be fiscal policy rather than monetary policy that they would tighten first. After all, they have been keen to raise the sales tax for several years now. The Bank Of England's Dilemma Gilts are a tougher call. The equilibrium rate is higher in the U.K. than in most other developed economies. Inflation has risen, although that has largely been a function of a weaker currency. Fiscal policy is turning more accommodative, which, all things equal, would warrant a more bearish view on gilts. The big wildcard is Brexit. Chart 37 shows that the U.K. is the only major country where growth has faltered this year. Worries over Britain's future relationship with the EU have likely contributed to the slowdown. Ongoing Brexit angst will keep the Bank of England on hold, justifying a neutral weighting on gilts. Stay Short Duration ... For Now In summary, investors should keep global duration risk below benchmark levels over the next 12 months. Regionally, we recommend underweighting U.S. Treasurys, overweighting Japan, and maintaining a neutral position towards euro area and U.K. government bonds. Reflecting these recommendations, we are closing our short Japanese, German and Swiss 10-year bond trade for a gain of 5.3% and replacing it with a short 30-year U.S. Treasury bond position. As global growth begins to slow in the second half of next year, global bonds will rally. However, as we discussed at length in our Q2 Strategy Outlook, the rally will simply represent a countertrend move in what will turn out to be a structural bear market.5 The 2020s, in short, could end up looking a lot like the 1970s. Spread Product: Still A Bit Of Juice Left While we prefer equities to high-yield credit on a risk-adjusted basis over the coming months, we would still overweight spread product within a global asset allocation framework. The option-adjusted spread of the U.S. high-yield index offers 200 basis points above the Treasury curve after adjusting for expected defaults, roughly in line with the mid-point of the historical data (Chart 38). Corporate defaults are likely to trend lower over the next 12 months, spurred by stronger growth and a rebound in oil prices. Chart 37U.K. Is Lagging Its Peers U.K. Is Lagging Its Peers U.K. Is Lagging Its Peers Chart 38Default-Adjusted Junk Spreads Are At Historical Average Default-Adjusted Junk Spreads Are At Historical Average Default-Adjusted Junk Spreads Are At Historical Average As with all our other views, the picture is likely to change sharply in the second half of next year. At that point, corporate spreads will widen, warranting a much more defensive stance. Currencies And Commodities The Dollar Bull: Down But Not Out Our long-standing dollar bullish view has come under fire over the past few months. The Fed's broad trade-weighted dollar index has fallen 4.6% since December. Momentum in currency markets can be a powerful force, and so we would not be surprised if the dollar remains under pressure over the coming weeks. However, over a 12-month horizon, the greenback will strengthen, as the Fed raises rates more quickly than expected while most other central banks stand pat. When all is said and done, the broad-trade weighted dollar is likely to peak next summer at a level roughly 10% higher than where it is today. That would still leave it substantially below prior peaks in 1985 and 2000 (Chart 39). The U.S. trade deficit has fallen from a peak of nearly 6% of GDP in 2005 to 3% of GDP at present (Chart 40). Rising shale production has reduced the demand for oil imports. A smaller trade deficit diminishes the need to attract foreign capital with a cheaper currency. Chart 39The Dollar Is Below Past Peaks The Dollar Is Below Past Peaks The Dollar Is Below Past Peaks Chart 40The U.S. Trade Deficit Has Halved Since 2005 The U.S. Trade Deficit Has Halved Since 2005 The U.S. Trade Deficit Has Halved Since 2005 Sentiment and speculative positioning towards the dollar have swung from extremely bullish at the start of the year to being more neutral today (Chart 41). In contrast, long euro speculative positions and bullish sentiment have reached the highest levels in three years. Our tactical short euro/long dollar trade was stopped out this week for a loss of 1.6%. However, we continue to expect EUR/USD to fall back towards parity by the end of the year. We also expect the pound to weaken against the dollar, but appreciate slightly against the euro. Now that the Bank of Japan is keeping the 10-year JGB yield pinned to zero, the outlook for the yen will be largely determined by what happens to yields abroad. If we are correct that Treasury yields - and to a lesser extent yields in Europe - rise, the yen will suffer. Commodity Currencies Should Fare Well Higher commodity prices should benefit currencies such as the Canadian and Aussie dollars and the Norwegian krone. Our energy strategists remain convinced that crude prices are heading higher. They expect global production to increase by only 0.7 MMB/d in 2017, compared to 1.5 MMB/d growth in consumption. While shale output continues to rise, this is largely being offset by falling production from conventional oil fields. Consequently, oil inventories should fall in the remainder of this year. If history is any guide, this will lead to a rebound in oil prices (Chart 42). Chart 41USD: Sentiment And Positioning ##br##Are Not Lopsided Anymore USD: Sentiment And Positioning Are Not Lopsided Anymore USD: Sentiment And Positioning Are Not Lopsided Anymore Chart 42Falling Oil Inventories Should Lead ##br##To Higher Crude Prices Falling Oil Inventories Should Lead To Higher Crude Prices Falling Oil Inventories Should Lead To Higher Crude Prices The outlook for industrial metals is not as upbeat as for oil, but metal prices should nevertheless rebound over the coming months. We suspect that much of the recent weakness in metal prices can be attributed to the regulatory crackdown on shadow banking activity in China. Many Chinese traders had used commodities as collateral for loans. As their loans were called in, they had no choice but to liquidate their positions. Today, speculative positioning in the commodity pits has returned to more normal levels (Chart 43). This reduces the risk of a further downdraft in commodity prices. BCA's China strategists expect the Chinese authorities to relax some of their tightening measures. This is already being seen in a decline in interbank lending rates and corporate bond yields (Chart 44). Chart 43Commodities: Long Speculative Positions Returning ##br##To More Normal Levels Commodities: Long Speculative Positions Returning To More Normal Levels Commodities: Long Speculative Positions Returning To More Normal Levels Chart 44China: Some Relief##br## After Recent Tightening Action? China: Some Relief After Recent Tightening Action? China: Some Relief After Recent Tightening Action? One key reason why the authorities have been able to let interest rates come down is because capital outflows have abated. Compared to late 2015, economic growth is stronger and deflationary pressures have receded. The trade-weighted RMB has also fallen by 7.5% since then, giving the economy a competitive boost. As such, the seeming can't-lose bet on further yuan weakness has disappeared. We still expect the RMB to depreciate against the dollar over the next 12 months, but to strengthen against most other currencies, including the euro and the yen. If the yuan remains resilient, this will limit the downside risk for other EM currencies. Nevertheless, at this point, much of the good news benefiting EM currencies has been priced in. Across the EM universe, in addition to the Chinese yuan, we like the Mexican peso, Taiwan dollar, Indian rupee, Russian ruble, Polish zloty, and Czech koruna. Lastly, a few words on the most timeless of all currencies: gold. We expect bullion to struggle over the next 12 months on the back of a stronger dollar and rising bond yields. However, once the Fed starts cutting rates in 2019 and stagflationary forces begin to gather steam in the early 2020s, gold will finally have its day in the sun. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 For example, please see Box 4.1: Financial Linkages and Spillovers in "Spillovers and Cycles in the Global Economy," IMF World Economic Outlook, (April 2007). 2 Please see Global Investment Strategy Weekly Report, "The Message From Our Stock Market Timing Model," dated May 5, 2017, available at gis.bcaresearch.com. 3 Please see Global Investment Strategy Special Report, "Is Slow Productivity Growth Good Or Bad For Bonds?" dated May 31, 2017; Global Investment Strategy - Strategy Outlook, "First Quarter 2017 From Reflation To Stagflation, (Section: Supply Matters), First Quarter 2017 From Reflation To Stagflation, (Section: Supply Matters)," dated January 6, 2017; and Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 4 U.S. minus euro area 5-year/5-year forward real bond yields. Real bonds yields are calculated as a difference between nominal yields and the CPI swap rate. Euro area yields refer to a GDP-weighted average of Germany, France, the Netherlands, Belgium, Austria, Italy, and Spain. 5 Please see Global Investment Strategy, "Strategy Outlook: Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Hong Kong property prices are frothy and will continue to face headwinds. Real estate currently offers a poor risk-return trade off from an investment perspective, and will likely lag other asset classes in the medium to long run. A replay of another spectacular housing bust is highly unlikely. Several critical differences between the current environment and that of 1997 prevent a meltdown. Favor Hong Kong property developers over property owners strategically. Aim to upgrade the property sector on further decline in prices. Feature Chart 1Hong Kong Property Prices Remain Red Hot Hong Kong Property Prices Remain Red Hot Hong Kong Property Prices Remain Red Hot This coming weekend marks the 20th anniversary of Hong Kong's handover from Great Britain to the People's Republic of China - as well as the onset of the spectacular bust of a massive housing bubble that saw home prices collapsing by 70%. Fast forward 20 years and Hong Kong home prices are once again standing at bubbly highs, with growing consensus that the market is on the verge of another major crash. Some analysts are predicting a 50% decline in the coming years, and officials are also issuing stern warnings. Financial Secretary Paul Chan Mo-po has cautioned that "the risk in the property market is very high." Norman Chan Tak-lam, chief executive of the Hong Kong Monetary Authority (HKMA) has also noted that market conditions today are reminiscent of those in 1997, and has warned there are risks that the property bubble might burst again. We have been equally concerned about Hong Kong housing for a while,1 and have been surprised by its remarkable resilience (Chart 1). After a temporary dip between mid-2015 and early 2016, Hong Kong home prices bounced right back and have been touching records again, even though the authorities have significantly tightened regulations to cool off demand. Stamp duties for home sales have been raised to 15% for local households, except for first-time homebuyers, or as high as 30% for foreign buyers - both of which are draconian measures that immediately squeezed out speculative buyers. The fact that Hong Kong home prices have been able to withstand the aggressive policy crackdown suggests that fundamentals are probably stronger than commonly perceived. We maintain the view that the Hong Kong real estate market will likely continue to face downward pressure, but prevailing concerns in the marketplace appear overdone. The surprise could be that any decline in home prices will likely be smaller than many anticipate. The Anatomy Of Two Property Bubbles Chart 2Monetary Conditions Set The Broad Trend##br## In Property Prices Monetary Conditions Set The Broad Trend In Property Prices Monetary Conditions Set The Broad Trend In Property Prices At the onset, current housing market conditions in Hong Kong share some disturbing similarities with the real estate bubble 20 years ago. From a macro perspective, our fundamental concern is the tightening in monetary conditions, which have historically always boded poorly for Hong Kong asset prices in general and real estate prices in particular (Chart 2). Hong Kong's currency board system copies U.S. monetary policy in totality, and the Federal Reserve's current tightening cycle has led to a notable tightening in Hong Kong monetary conditions, especially through exchange rate appreciation. Moreover, tightening in monetary conditions often leads peaks in asset prices by a long interval. In the 1997 episode, monetary conditions began to tighten in 1993, four years ahead of the ultimate housing bubble peak. This time around, our monetary conditions index for Hong Kong has rolled over since 2012, casting a shadow on home prices from a macro standpoint. Specific to the housing market, there are also plenty of warning signs that home prices are unsustainable at current levels. Home prices have quadrupled in the past 15 years, outpacing nominal GDP as well as household income by a wide margin. In fact, the gap between home prices and household income levels has become much wider than in 1997 (Chart 3). On the surface, housing affordability does not appear as dire as during the peak of the previous bubble. A closer look, however, reveals it is almost entirely due to increasing maturities of mortgage loans over the past two decades (Chart 4). Indeed, the average contractual life of new mortgages has increased from 200 months in the early 2000s to about 320 months currently, leading to a smaller monthly payment for mortgage borrowers but an additional 10 years to pay back all the debt. If mortgage terms were held constant, our calculation shows that housing affordability would be as bad as during the 1997 bubble peak, even considering today's exceedingly low interest rates (bottom panel, Chart 4). Rental yields of Hong Kong residential properties are standing at close to record lows, only marginally higher than government bond yields. In comparison, rental yields dropped below the risk-free rate in the 1990s, but were still much higher even at the peak of the housing bubble than today's level (Chart 5). It is true that interest rates may be structurally lower than in the past, but the Hong Kong housing market is priced for "perfection," leaving no room for negative interest rate surprises. Chart 3Home Prices Massively Outpaced Income Home Prices Massively Outpaced Income Home Prices Massively Outpaced Income Chart 4Housing Affordability: Worse Than Appears Housing Affordability: Worse Than Appears Housing Affordability: Worse Than Appears Chart 5Hong Kong Property Yields: Priced For Perfection Hong Kong Property Yields: Priced For Perfection Hong Kong Property Yields: Priced For Perfection Taken together, investors should remain cautious on the Hong Kong housing sector. It offers a poor risk-return trade off from an investment perspective, and will likely lag other asset classes in the medium to long run. However, there are also some critical differences between the current environment and that of 1997 that make a replay of another spectacular housing bust highly unlikely. Five Key Differences First, there is currently much less speculative activity in the Hong Kong housing market than two decades ago, thanks to regulators' punitive measures against non-first time homebuyers and home "flippers." Overall housing transactions currently are a fraction of the overheated levels in the early 1990s. So-called "confirmor transactions," deals in which properties are re-sold before the original transaction is completed, were as high as 10% of total sales in the run-up to the 1997 housing bubble peak, while today they are practically non-existent (Chart 6). This has made home prices much less vulnerable to a self-feeding downward spiral, when speculators rush to exit when market conditions shift. Second, banks' lending practices, especially for new mortgages, are significantly tighter now than it was in the 1990s. Prior to the 1997 bust, commercial lenders were required to maintain a loan-to-value (LTV) ratio for mortgage loans at a minimum of 70%. The LTV ratio was only cut to 60% in January 1997 when home prices were already excessively high, which in hindsight may well have sown the seeds for the market collapse. This time around, the HKMA has been tightening mortgage and lending standards going as far back as 2009, and the macro-prudential supervision on housing related activity has continued to increase in recent years. Overall, banks' mortgage LTV ratio is currently hovering at 50%, underscoring a massive buffer between banks' asset quality and home prices (Chart 7). Anecdotally, some developers have been offering mortgage loans with higher LTVs for newly built projects. However, new projects account for less than a quarter of total housing transactions, and therefore such practices, even if they were widespread, would not change the situation in a meaningful way. Overall, mortgage lending in Hong Kong is fairly conservative and closely monitored by regulators. In fact, even in the previous dramatic housing downturn, Hong Kong banks' mortgage delinquency ratio peaked out at 1.5%, an extremely low number by any standard. Tightened lending regulations have made the banking sector even less vulnerable to home price declines than 20 years ago. Chart 6Much Less Speculative Housing Demand ##br##Than 20 Years Ago Much Less Speculative Housing Demand Than 20 Years Ago Much Less Speculative Housing Demand Than 20 Years Ago Chart 7Banks Have Significantly Tightened##br## Mortgage Lending Standards Banks Have Significantly Tightened Mortgage Lending Standards Banks Have Significantly Tightened Mortgage Lending Standards Third, it is important to note that another critical reason for the housing crash home prices after 1997 was a dramatic increase in new housing supply. To ease the housing shortage and rampant upward pressure on prices, then-Chief Executive Tung Chee-hwa came to office in 1997 with a promise to build 85,000 units annually for the next 10 years - 35,000 by private developers and 50,000 by the public sector. Mr. Tung was not able to reach these targets, and the housing plan was quickly suspended as home prices collapsed, but his policy still led to a sharp increase in land supply and housing starts, which in turn led to rising housing completions in the following years at a time when demand had vanished - compounding downward pressure on prices (Chart 8). In recent years, even though the Hong Kong government has acknowledged the acute housing shortage, there has been no ambitious plan to increase housing supply. The government expects a total of 96,000 new housing units in the coming three to four years, barely higher than current levels and less than a third of the early 2000s. Without oversupply, any downside in home prices will prove self-limiting. Chart 8Housing Supply: This Time Is Different Housing Supply: This Time Is Different Housing Supply: This Time Is Different Chart 9No Longer Hong Konger's Hong Kong No Longer Hong Konger's Hong Kong No Longer Hong Konger's Hong Kong Fourth, a major difference between now and 20 years ago is the dramatic wealth creation among mainland households, which will offer critical support for the Hong Kong housing market if prices drop precipitously. Chart 9 shows total value of Hong Kong residential properties as a share of local GDP has already surpassed that during the 1997 housing bubble peak, according to our estimate, but as a share of Chinese GDP it is currently standing at a record low. The point is that Hong Kong property has become a store of wealth for rich mainland investors and households. The Hong Kong authorities have been working hard to squeeze out mainland demand for local properties with punitively high taxes - homes purchased by non-Hong Kong permanent residents, mostly mainland Chinese, currently account for less than 1% of total home sales, compared with about 6% in 2012 (Chart 10). These discriminative taxes against mainland buyers can be reversed, should Hong Kong home price drop beyond the Hong Kong authorities' comfort zone. We doubt the Hong Kong government would allow home prices to drop by more than 30% from current levels. Finally, currently Hong Kong property developers' stock prices have priced in a sharp decline in home prices, while the market in general is a lot more complacent than in the previous episode. A simple regression between Hong Kong developers' stocks and property prices suggests that developers' stock prices are about 30% below some intrinsic "fair value" - roughly in line with the developers' current price-to-book ratio (Chart 11, top panel). In 1997, Hong Kong developers' PB ratio was 1.7, roughly comparable to their global peers, despite the obvious froth in underlying property prices (Chart 11, middle and bottom panel). This time around, developers' PB ratio is currently 0.7, on par with the 2003 levels, when home prices had already crashed by 70%. Hong Kong property stocks are trading at over 50% discount to their DM and EM counterparts, based on PB ratios. Chart 10Mainland Chinese Buyers ##br## Have Been Pushed Out Hong Kong Housing Bubble: A Replay Of 1997? Hong Kong Housing Bubble: A Replay Of 1997? Chart 11Hong Kong Property Stocks: ##br##Priced In A Sharp Housing Downturn Hong Kong Property Stocks: Priced In A Sharp Housing Downturn Hong Kong Property Stocks: Priced In A Sharp Housing Downturn Looking forward, our base-case scenario is that Hong Kong developers' stocks will likely remain under downward pressure along with softening home prices. Stock markets are an emotional discounting mechanism, and the Hong Kong bourse has been notoriously volatile. Therefore, periods of undershoots cannot be ruled out. However, it is noteworthy that developers' stock prices may have priced in at least a 30% decline in home prices. Strategically, we still prefer property developers over property owners and aim to upgrade the property sector on further decline in prices. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "The Fed "Lift Off", Hong Kong And The RMB," dated August 12, 2015, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

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

Highlights Trade 1: An unwinding of the Trump reflation trade... has worked exactly as expected. Take profits and switch into Trade 5. Trade 2: Short pound/euro at €1.18 and simultaneously buy call options at €1.30... is up 4%. Take profits and add to long euro/dollar. Trade 3: Underweight French OATS... has worked well both in a European bond portfolio and in a global bond portfolio. Stick with this trade. Trade 4: Long euro/yuan... is up 6%. Stick with this trade. Trade 5 (New): Underweight emerging market equities. European equity investors should underweight Poland. Feature At the mid-point of the year, we are devoting this report to appraise our top investment ideas for 2017 - as recommended in our December 22 report Five Pressing Questions (And Four Trades) For 2017. Half-time is a good moment to review the thoughts we had at the start of 2017, establish how the ideas have performed in the first half, and assess whether to stick with them or make some changes in the second half. Chart of the WeekFor EM Equities, Excessive Groupthink Is Hitting Its Natural Limit For EM Equities, Excessive Groupthink Is Hitting Its Natural Limit For EM Equities, Excessive Groupthink Is Hitting Its Natural Limit Trade 1: An Unwinding Of The Trump Reflation Trade Chart I-2The Trump Reflation Trade Has Unwound The Trump Reflation Trade Has Unwound The Trump Reflation Trade Has Unwound Our thoughts at the start of 2017: "Can a modern day King Canute1 single-handedly turn the tide of global deflation - the combined structural forces of over-indebtedness, demographics, technology, and globalization? This publication believes that the tide has not turned... Rationality and analysis will conclude that Trumponomics is not the structural game changer that the market seems to believe right now." How has the trade performed in the first half? Exactly as scripted, the Trump reflation trade - in its various guises - has unwound. Since our original report, the trade-weighted dollar is down 5%; the global bond yield is down 15bps (the 10-year T-bond yield is down 40bps); and banks have underperformed the market by 5% (Chart I-2). Our thoughts for the second half of 2017: Never forget that the financial markets are a complex ecosystem in which long-term investors jostle with short-term traders. The equilibrium of this ecosystem relies on rationality and analysis ultimately checking emotion and impulse. In February, our prescient warning in The Contrarian Case For Bonds was that as emotional and impulsive short-term traders had been left unchecked to drive markets, excessive groupthink was hitting its natural technical limit. The 6-month sell-off in bonds had reached a point of instability. And sure enough, the trend broke (Chart I-3). Chart I-3For Bonds, Excessive Groupthink Hit Its Natural Limit In February For Bonds, Excessive Groupthink Hit Its Natural Limit In February For Bonds, Excessive Groupthink Hit Its Natural Limit In February At such tipping points of excessive groupthink, a good benchmark is that the preceding trend will reverse by one third. On this basis, a large part of the gains in the Trump trade unwind have now been made. Take profits and switch into new trade 5. Trade 2: Short Pound/Euro At €1.18 And Simultaneously Buy Call Options At €1.30 Our thoughts at the start of 2017: "2017 will be an especially unpredictable year for U.K. politics and economics because Brexit creates a larger number of moving parts, complex interactions and feedback loops, both negative and positive... The pound is unlikely to stay near today's €1.18. Expect a sharp move one way or the other." How has the trade performed in the first half? For U.K. politics, "especially unpredictable" could be the understatement of the year! An unpredicted general election generated an even more unpredicted result. With pound/euro now below €1.13, the directional position is up 5% in gross terms, and up around 4% in net terms allowing for the cost of the call options (Chart I-4). Chart I-4Pound / Euro Has Underperformed In 2017 Pound / Euro Has Underperformed In 2017 Pound / Euro Has Underperformed In 2017 Our thoughts for the second half of 2017: In a hung parliament, the minority Conservative government does not have the parliamentary maths to legislate for a hard Brexit in either the House of Commons or the House of Lords. Significantly, the so-called 'Salisbury Convention' - in which the House of Lords does not oppose the second or third reading of any government legislation promised in its election manifesto - does not necessarily apply in a hung parliament. This is because, by definition, the minority Conservative government's manifesto did not secure a majority in the House of Commons. With the hard Brexit tail-risk diminished, our current preference for currencies is euro first, pound second, dollar third, based on the evolution of interest rate expectations explained below. Hence, take profits in short pound/euro and add to long euro/dollar. Trade 3: Underweight French OATS Our thoughts at the start of 2017: "2016 was the year when QE peaked... The credibility of the ECB to suppress long-term bond yields would then be severely damaged. And the greatest danger would be to those euro area bond yields closest to zero." How has the trade performed in the first half? French OATS have substantially underperformed both U.K. gilts (Chart I-5) and U.S. T-bonds (Chart I-6). So it has been correct to underweight French government bonds both in a European bond portfolio and in a global bond portfolio. Chart I-5French OATs Have Underperformed In##br## A European Bond Portfolio... French OATs Have Underperformed In A European Bond Portfolio... French OATs Have Underperformed In A European Bond Portfolio... Chart I-6...And A Global ##br##Bond Portfolio ...And A Global Bond Portfolio ...And A Global Bond Portfolio Our thoughts for the second half of 2017: Central banks' professed commitment to data-dependency means that their words - and ultimately actions - must acknowledge the hard data. No ifs, buts or maybes. Based on the latest PMIs which capture current economic sentiment, and on 6-month credit impulses, which lead activity, euro area hard data will continue to be among the best among the major economies. Combined with the supply shortages the ECB is now facing in buying German bunds, expect the ECB's words to continue becoming more hawkish. The recent relatively smooth winding down of three failing banks - Spain's Banco Popolare and Italy's Banca Popolare di Vicenza and Veneto Banca - will also hearten the ECB that the strategy for resolving its undercapitalised banks does not pose a systemic risk to the economy or markets. Hence, expect euro area interest rate expectations to continue converging with other developed economies. And stick with the underweight French OATS (or German Bunds) trade, especially in a global bond portfolio. Chart I-7Euro / Yuan Is Up 6% Euro / Yuan Is Up 6% Euro / Yuan Is Up 6% Trade 4: Long Euro/Yuan Our thoughts at the start of 2017: "The debt super cycle is over when the cost of malinvestment and misallocation of capital outweighs the benefit of good credit creation... China appears to be approaching this point. One manifestation would be continued weakness in its currency against the major developed market crosses." How has the trade performed in the first half? Euro/yuan is up 6% (Chart I-7). Our thoughts for the second half of 2017: The thoughts we expressed at the start of 2017 are still entirely valid and supported by the argument for trade 5 below. Stick with long euro/yuan. Trade 5 (New): Underweight Emerging Market Equities Just as we presciently warned of excessive negative groupthink towards bonds in February, we are now seeing similarly excessive positive groupthink towards EM equities hitting its natural technical limit. This is a strong warning that the first half 15% rally risks reversing, or fizzling, in the second half (Chart of the Week). Chart I-8If EM Underperforms DM, Poland ##br##Underperforms Europe If EM Underperforms DM, Poland Underperforms Europe If EM Underperforms DM, Poland Underperforms Europe For the detailed fundamental analysis, I refer you to the latest reports penned by my colleague, BCA's Chief Emerging Markets Strategist, Arthur Budaghyan. But in summary, Arthur says: "China's liquidity conditions have tightened, warranting a meaningful slowdown in money/credit and economic growth... the outlook for EM risk assets is extremely poor... and we continue to recommend an underweight allocation towards EM within global portfolios across stocks, credit and currencies."2 For European equity investors, this means underweighting Poland, whose relative performance tracks EM versus DM equities (Chart I-8). Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 In fact, the story of King Canute has been misinterpreted. Rather than show that he could turn the tide, he wanted to show the opposite: that he was powerless against the tide. 2 Please see the Emerging Markets Strategy Weekly Report "EM: Contradictions And A Resolution" published on June 14, 2017 and available at ems.bcaresearch.com Fractal Trading Model* As shown on page 1, this week's trade is to go short emerging markets with a corresponding long in developed markets. In this case, the trade duration is up to 6 months with a profit target and stop-loss of 3%. Amongst our other open trades, long FTSE100 / short IBEX35 is approaching its 4% profit target. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 Long FTSE100 / Short IBEX35 Long FTSE100 / Short IBEX35 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. * 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 Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights The EM carry trade - supported by a commodity price rally, falling bond yields, and a weak USD - have propped up South African assets; Investors have largely ignored politics and focused on personalities instead of political fundamentals; South Africa's socio-economic factors - governance, middle class wellbeing, productivity, and unemployment - have all regressed; The "median voter" has therefore turned more radical and left-wing; Stay short ZAR versus USD and MXN, stay underweight stocks, sovereign credit, and domestic bonds, and bet on yield-curve steepening. Feature Why do investors in Europe and the U.S. continue to invest in South Africa? - Every client in South Africa Our recent week-long trip to South Africa was revealing for two reasons. First, it reminded us of the promise and opportunity of this amazing country and its people. Second, it impressed upon us the deep pessimism of its entire financial community. As the quote at the top of this report suggests, every client we met over seven days was deeply puzzled by continued resilience of foreign inflows. Clients were surprised that foreign investors continued to find value in South Africa's fixed income and currency markets amidst a continued growth downtrend, soft commodity prices, and the ongoing political imbroglio (Chart I-1). The answer to the puzzle is simple: the main driving force behind EM risk assets, year-to-date, has been U.S. TIPS yields and the greenback (Chart I-2). Weak inflation data and policy disappointments as the pro-growth, populist, economic policy of the Trump Administration stalled have supported the ongoing EM carry trade. The actual emerging market growth fundamentals and politics are therefore unimportant. Chart I-1ZAR Rally Amidst Economic##br## And Commodity Downturn ZAR Rally Amidst Economic And Commodity Downturn ZAR Rally Amidst Economic And Commodity Downturn Chart I-2EM Carry Trade Is ##br##Alive And Well EM Carry Trade Is Alive And Well EM Carry Trade Is Alive And Well How likely is it that the carry trade can continue? BCA's Global Investment Strategy and Emerging Markets Strategy both argue that U.S. growth will soon accelerate.1 The U.S. financial conditions have eased thanks to lower Treasury yields, narrower credit spreads, a weaker dollar, and higher equity prices (Chart I-3). Historically, an easing in financial conditions has foreshadowed faster growth (Chart I-4). Meanwhile, the relative U.S. growth underperformance versus DM is late and will turn around very soon (Chart I-5). As U.S. economic growth surprises pick up, investors will bid up the 10-year Treasury yield and the greenback, ushering in the end of the carry trade. Chart I-3U.S. Financial Conditions Have Eased... U.S. Financial Conditions Have Eased... U.S. Financial Conditions Have Eased... Chart I-4...U.S. Growth Should Therefore Sharply Rebound ...U.S. Growth Should Therefore Sharply Rebound ...U.S. Growth Should Therefore Sharply Rebound Chart I-5U.S. Underperformance Is Long-In-The-Tooth U.S. Underperformance Is Long-In-The-Tooth U.S. Underperformance Is Long-In-The-Tooth How resilient are South Africa's economic fundamentals and politics? In this report, we argue that they are not resilient at all. The country is facing considerable structural problems on both economic and political fronts. Even its sole silver lining - that it retains cyclical maneuvering room, i.e., it can adopt fiscal stimulus - will only encourage its leaders to double-down on a populist growth model that has already run out of steam. Cyclical Outlook: A Dark Cloud With A Silver Lining The cyclical outlook for South Africa has darkened as of late. All the drivers that pushed the rand to appreciate over the last 12 months are now showing signs of a reversal: The rand's rally in the past six months or so - a period when it decoupled from commodities prices - is often attributed to its higher interest rates. However, Chart I-6 demonstrates that higher local interest rates historically did not prevent the rand's selloff when metal prices fell. In short, we believe the last six months is an aberration rather than a new norm. Remarkably, hedged yields in South Africa are no longer attractive within the EM space. South Africa already offers the worst hedged returns, after Turkey and China, for the U.S. dollar and euro-based investors (Chart I-7 and Chart I-8).2 The situation will only get worse as the U.S. dollar appreciates and Treasury yields rise. Chart I-6High Local Interest Rates ##br##Are No Panacea For ZAR High Local Interest Rates Are No Panacea For ZAR High Local Interest Rates Are No Panacea For ZAR Chart I-7 Chart I-8 The drop in precious metal prices will force the rand to selloff (Chart I-9). The unprecedented resilience in the rand was supported by increasing financial flows. Now that these are decreasing, the historic correlation with precious metals should reemerge. The decoupling between the ZAR and AUD since early this year is unprecedented (Chart I-10). Both economies are leveraged to industrial and precious metals as well as coal prices, making both exchange rates correlated. Needless to say, Australia commands much better governance and politics than South Africa. In fact, higher interest rates in South Africa have never precluded the rand's depreciation when the AUD dropped. Chart I-9Is The Divergence With Precious Metals... Is The Divergence With Precious Metals... Is The Divergence With Precious Metals... Chart I-10...And AUD Sustainable? ...And AUD Sustainable? ...And AUD Sustainable? Therefore, we conclude that the rand's strength has not been warranted by any of its historic drivers. It has been due to nothing else than the blind search for yield. Over the medium and long run, the outlook for the rand remains bleak. The ongoing dynamic of high wage growth and negative productivity growth will assure a lingering stagflationary environment (Chart I-11). This is bearish for the rand. Surprisingly, despite a rising currency and falling bond yields over the last 12 months, the South African economy is still showing signs of weakness. The household sector, which represents 61% of the economy, is not showing signs of a recovery yet. Credit growth to households is still falling and private consumption is abysmal. (Chart I-12). On the corporate side, the situation is not reassuring either. Firms are not investing and business confidence has not shown any signs of a significant recovery (Chart I-13). Chart I-11Productivity Is Weak But Wages Are Strong Productivity Is Weak But Wages Are Strong Productivity Is Weak But Wages Are Strong Chart I-12Household Consumption Is Declining Household Consumption Is Declining Household Consumption Is Declining Chart I-13No Confidence, No Investment No Confidence, No Investment No Confidence, No Investment The one positive is that the government has fiscal room to maneuver. South African gross government debt is at a comfortable 51% of GDP. However, we suspect that the nature of fiscal spending will likely result in transfers to appease the population - especially ahead of key elections in late 2017 and 2018 - rather than investments that can genuinely improve productivity. In fact, fiscal spending in the form of transfers could very well entice consumers to import more and consequently widen the current account deficit, putting more downward pressure on the rand. Bottom Line: The commodity price rally in 2016 and falling bond yields failed to buoy the economy. While policymakers do retain fiscal room to stimulate, the problem is that such efforts will likely merely rekindle populist policies that have failed South Africa thus far. Structural Outlook: Late Innings Of The Crisis Of Expectations South Africa is not alone in the EM universe in having failed to improve governance over the past decade. Most EM economies have squandered the commodity bull market and Chinese industrialization, allowing their governance to stagnate or even worsen during the good times (Chart I-14).3 However, South Africa does stand alone when it comes to a tepid rise in middle class, as percent of total population (Chart I-15), and continued high income inequality (Chart I-16). Chart I-14Quality Of EM Governance Declined##br## Amidst The Good Times Quality Of EM Governance Declined Amidst The Good Times Quality Of EM Governance Declined Amidst The Good Times Chart I-15Middle Class Has ##br##Barely Budged... Middle Class Has Barely Budged... Middle Class Has Barely Budged... Chart I-16 The data is clear: South Africa is as unequal overall, and its middle class unchanged relative to overall population, as it was at the end of apartheid in the early 1990s. Governance in the country has continued to deteriorate, and while it remains higher than in Sub-Saharan Africa, the gap has astonishingly begun to narrow from both ends (Chart I-17). Chart I-17Governance Gap With Sub-Saharan ##br##Africa Is Closing! Governance Gap With Sub-Saharan Africa Is Closing! Governance Gap With Sub-Saharan Africa Is Closing! A major reason for the deterioration in governance is the "state capture" thesis that has become a popular one in characterizing President Jacob Zuma's rule.4 This process began early, as the country shifted its developmental program in 1996 away from a top-down, state-led, developmental model to one that encouraged a free-market economy balanced with welfare spending. This was a natural result of the global rise of laissez-faire capitalism, the Washington Consensus, and "Third Way" politics of left-leaning parties. A commitment to laissez-faire capitalism and free markets, combined with a strong welfare state, were seen as hallmarks of a successful economy. The problem with this approach is that it confused the symptoms of developed economies with their catalysts. South Africa needed a much more state-led approach to development, one that would have harnessed the resources of the state for productivity-enhancing investments. As such, the laissez-faire approach unsurprisingly failed to address the inequalities of the apartheid system and the country saw a decline in the middle class as percent of total population under both Presidents Nelson Mandela and Thabo Mbeki. This pivot towards free-market capitalism ended with the 2007 "Polokwane moment," which saw President Mbeki's free-market, reactive, attempt to address inequality between the white and black populations replaced with the proactive policy of Jacob Zuma. Zuma's more radical approach was to complement welfare transfers and high wage growth with an activist use of state owned enterprises (SOEs) as a vehicle for redistribution. This proactive policy meant using the government's tender system to doll out lucrative contracts to well-connected insiders, under the auspices of helping enfranchise black entrepreneurs and businesses. While the media has focused on the role that the Indian-born Gupta family has played in this process, it is highly unlikely that they are the only beneficiaries. Zuma's administration has, in the name of black enfranchisement and the fight against inequality, essentially rigged the entire government tender system for the sake of its own political preservation. The results of this process are unsurprising. First, government wages have outpaced those in both manufacturing and mining sectors (Chart I-18). Meanwhile, productivity has declined precipitously since 2007 and has been negative since 2012. South Africa has a lower productivity rate than both Latin American EM economies and its neighbors in sub-Saharan Africa (Chart I-19). Chart I-18Government Wages Have Outpaced All Others Government Wages Have Outpaced All Others Government Wages Have Outpaced All Others Chart I-19South African Productivity Has No Peer South African Productivity Has No Peer South African Productivity Has No Peer Financial media and investment research have continued to focus on the intricacies of the ruling African National Congress (ANC) politics. And we do so as well below. However, investors have to understand that South Africa's ills will not be fixed by the appointment of a pro-market finance minister or even the removal of Jacob Zuma from rule. South Africa has failed to develop inclusive economic institutions that engender creative destruction, which is at the heart of all successful development stories.5 South Africa ranked 74th in the World Bank's annual Doing Business report in 2017, an astonishing fall from grace over the past decade (Chart I-20). Compared to regional averages, South Africa barely beats the Sub-Saharan "distance to frontier" scores in several World Bank categories (Chart I-21). This is not due to the gross failure of the Zuma administration to do the "right thing." Rather, it exhibits a structural failing of South African political institutions. Chart I-20 Chart I-21 This development path is not unique to South Africa. Most sub-Saharan African states experienced a similar regression within 10-20 years of decolonization. Political scientist Robert Bates famously documented how African leaders co-opted colonial-era extractive economic institutions - such as the state marketing boards that purchased all cash crops and exported them on the global market - in order to generate enough revenue to industrialize their economies.6 While their intentions may have originally been noble, if misplaced, they quickly began to use control over marketing boards for political purposes. The rent generated from marketing boards became an immense source of political power for African leaders and they held on to it to the detriment of the economic development of their state. South Africa is far more developed than its sub-Saharan peers were in the 1970s. Nevertheless, its leaders are exhibiting similar rent-seeking behavior, albeit at a much higher level of development. It is also entering a dangerous period in its post-apartheid history: it has now been twenty years since South Africa's effective decolonization and it is facing its first serious economic downturn. Bottom Line: We doubt that anyone in the current leadership elite will be able to fully abandon the rent-seeking behavior of the Zuma administration and improve South Africa's economic institutions. The crisis of expectations among the country's voters is palpable and demands for greater redistribution are rising. This is not a context for pro-market reforms that will encourage creative destruction. Instead, we would expect a doubling-down of populism and greater emphasis on proactive redistribution, which will, at the same time, encourage greater out-migration of talent out of the country and rent seeking behavior from political elites. Can Any One Man Or Woman Fix South Africa? The African National Congress (ANC) will meet in December 2017 to decide the party candidate that will contest the 2019 general election (Diagram I-1). Given the ANC's stranglehold on the country's politics, it is likely that whoever emerges at the upcoming ANC Congress will be the next president of South Africa. Chart I- BCA's Geopolitical Strategy subscribes to the idea that policymakers are price takers in the political marketplace, not price makers. This is particularly the case in democracies, but it is also the case in some authoritarian regimes where public opinion is relevant. As such, the puzzle investors have to resolve is not what policymakers stand for, but rather what the median voter wants. In South Africa, the median voter lives in a rural area, works in the agriculture or service industry, and is a black citizen. The polls indicate that the main concerns of the median voter are a high structural unemployment rate (Chart I-22), endemic corruption (Chart I-23), poor healthcare infrastructure, and a desire for aggressive, and targeted, redistributive economic policies. Chart I-22Crisis Of Expectations Structural Unemployment Is Egregious Structural Unemployment Is Egregious Chart I-23 Is this the profile of a median voter about to elect a pro-market reformer willing to pursue painful structural reforms? We do not think so. The two candidates vying for the ANC presidency are the ex-wife of Jacob Zuma and former Chair of the African Union, Nkosazana Dlamini-Zuma, and former Deputy President, Cyril Ramaphosa. Ramaphosa is the darling of the international investment community. This is because he has abandoned his previous union credentials - he founded the country's largest trade union, the National Union of Mineworkers in addition to founding the Congress of South African Trade Unions (COSATU) - and turned into a successful businessman. As such, the narrative among South Africa bulls (who are exclusively found in Europe and the U.S.) is that he would be able to bridge the divide between the demands for redistribution and pro-market reforms. To the median voter, however, Ramaphosa is alleged to be involved in the Marikana Massacre. Acting as the Deputy President, he ordered increased police presence at the mines and called for the use of force, which resulted in 47 deaths in August-September 2012. Dlamini-Zuma, on the other hand, speaks the language of the median voter while also not being seen as part of Zuma's corrupt entourage. Her credentials are bolstered by a successful tenure as Chair of the African Union and as a woman independent and strong enough to divorce President Zuma. She has not amassed personal wealth and does not hold strong loyalties to a particular faction within the ANC. However, she has begun to parrot Zuma's line that the country requires "radical economic transformation," which is a signal to left-leaning members of the ANC that she will continue much of economic policies begun under Zuma. Both the ANC Youth and Women's Leagues, which are left leaning, support her. The problem that investors face in South Africa is that there is no clear demand for pro-market reforms. Investors cheered the results of the August 2016 municipal election, for example, because the ANC lost in several key cities and saw its total vote share fall by 8%. However, few in the media or investment research community raised the obvious point that the centrist Democratic Alliance only saw its vote total rise by 3% compared to the 2011 election. It was the radically left-wing Economic Freedom Fighters, led by ex-Youth League leader Julius Malema, which saw the largest increase in vote share, by over 8%. In other words, ANC voters that did abandon Zuma most likely fell behind Malema, who is far more redistributionist. As such, we stick to our long-held view that Zuma and the ANC leadership are unlikely to do what investors want them to do given that the South African median voter is swinging further to the left. There is no demand for pro-market reforms and thus policymakers are more likely to double-down on populism. Bottom Line: Dlamini-Zuma is the likely winner of the upcoming ANC Congress, which will effectively decide the next president of South Africa. She has the sufficient left-leaning economic credentials to satisfy the demands for redistribution of the median voter. There is also a chance that she will attempt to clean up the corruption that has become endemic under Zuma, which would undoubtedly be a good thing for the country. However, it is unlikely that the macroeconomic context she will face will be positive, or that she will have the mandate to balance redistributive policies with painful pro-market reforms that would rebuild institutions required for creative destruction. Investment Implications South African assets are ultimately at the mercy of foreign inflows. When the dollar is weakening, U.S. bond yields falling, and Chinese growth stable, even the election of Julius Malema to the presidency would not dent foreign enthusiasm for yield in South African assets. Given the expected improvement in U.S. growth and the transitory nature of the drop in the U.S. inflation rate, we expect the global macro backdrop to worsen substantially for carry trades in general, and for South Africa in particular. China remains the wild card in our analysis, but its credit and fiscal impulse has rolled over, suggesting slower import growth over the next six months (Chart I-24). Even if Chinese policymakers react by re-stimulating the economy, the effects will only be felt in early 2018 given lead times. When the global carry trade reverses, it will not matter who is in charge of South Africa. Investors will realize that the country has failed to address serious socio-economic ills that have plagued South Africa since the end of apartheid. BCA's Emerging Markets Strategy continues to recommend the following investment positions: Chart I-24China Slowdown Is A Risk To EM China Slowdown Is A Risk To EM China Slowdown Is A Risk To EM Chart I-25Yield Curve Will Steepen Yield Curve Will Steepen Yield Curve Will Steepen Continue shorting ZAR versus USD and MXN. Underweight South African stocks, sovereign credit and domestic bonds relative to their respective EM benchmarks. A new trade: bet on yield-curve steepening (Chart I-25). The short end of the curve will be steady but populist politics, larger fiscal deficits/higher public debt, and an inflationary backdrop will push up long-end yields. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Beement Alemayehu, Research Assistant beementa@bcaresearch.com 1 Please see BCA Global Investment Strategy Weekly Report, "Stocks Are From Mars, Bonds Are From Venus?" dated June 23, 2017, available at gis.bcaresearch.com, and BCA Emerging Market Strategy Weekly Report, "EM: Contradictions And A Resolution," dated June 14, 2017, available at ems.bcaresearch.com. 2 Please see BCA Emerging Markets Strategy Special Report, "EM Local Bonds: Looking At Hedged Yields," dated May 10, 2017, available at ems.bcaresearch.com. 3 'Governance' is a catchall term that attempts to capture the quality of public service delivery, broadly defined. In essence, investors can consider governance as a factor that underpins the quality of political institutions. We rely on the World Bank's Development Indicators because the World Bank aggregates the work of several credible surveys on governance. These indicators are also useful because the World Bank standardizes the results in a way that allows cross-country/region comparisons. We then aggregate the scores across five different variables and look for trends and changes over time. 4 Please see State Capacity Research Project, "Betrayal Of The Promise: How South Africa Is Being Stolen," dated May 2017, available at pari.org.za. 5 Please see Daron Acemoglu and James A. Robinson, Why Nations Fail (New York: Crown Business, 2012). 6 Please see Robert H. Bates, Markets and States in Tropical Africa: The Political Basis of Agricultural Policies (Berkeley, University of California Press, 2014 edition). Geopolitical Calendar

Highlights The EM carry trade - supported by a commodity price rally, falling bond yields, and a weak USD - have propped up South African assets; Investors have largely ignored politics and focused on personalities instead of political fundamentals; South Africa's socio-economic factors - governance, middle class wellbeing, productivity, and unemployment - have all regressed; The "median voter" has therefore turned more radical and left-wing; Stay short ZAR versus USD and MXN, stay underweight stocks, sovereign credit, and domestic bonds, and bet on yield-curve steepening. Feature Why do investors in Europe and the U.S. continue to invest in South Africa? - Every client in South Africa Our recent week-long trip to South Africa was revealing for two reasons. First, it reminded us of the promise and opportunity of this amazing country and its people. Second, it impressed upon us the deep pessimism of its entire financial community. As the quote at the top of this report suggests, every client we met over seven days was deeply puzzled by continued resilience of foreign inflows. Clients were surprised that foreign investors continued to find value in South Africa's fixed income and currency markets amidst a continued growth downtrend, soft commodity prices, and the ongoing political imbroglio (Chart I-1). The answer to the puzzle is simple: the main driving force behind EM risk assets, year-to-date, has been U.S. TIPS yields and the greenback (Chart I-2). Weak inflation data and policy disappointments as the pro-growth, populist, economic policy of the Trump Administration stalled have supported the ongoing EM carry trade. The actual emerging market growth fundamentals and politics are therefore unimportant. Chart I-1ZAR Rally Amidst Economic##br## And Commodity Downturn ZAR Rally Amidst Economic And Commodity Downturn ZAR Rally Amidst Economic And Commodity Downturn Chart I-2EM Carry Trade Is ##br##Alive And Well EM Carry Trade Is Alive And Well EM Carry Trade Is Alive And Well How likely is it that the carry trade can continue? BCA's Global Investment Strategy and Emerging Markets Strategy both argue that U.S. growth will soon accelerate.1 The U.S. financial conditions have eased thanks to lower Treasury yields, narrower credit spreads, a weaker dollar, and higher equity prices (Chart I-3). Historically, an easing in financial conditions has foreshadowed faster growth (Chart I-4). Meanwhile, the relative U.S. growth underperformance versus DM is late and will turn around very soon (Chart I-5). As U.S. economic growth surprises pick up, investors will bid up the 10-year Treasury yield and the greenback, ushering in the end of the carry trade. Chart I-3U.S. Financial Conditions Have Eased... U.S. Financial Conditions Have Eased... U.S. Financial Conditions Have Eased... Chart I-4...U.S. Growth Should Therefore Sharply Rebound ...U.S. Growth Should Therefore Sharply Rebound ...U.S. Growth Should Therefore Sharply Rebound Chart I-5U.S. Underperformance Is Long-In-The-Tooth U.S. Underperformance Is Long-In-The-Tooth U.S. Underperformance Is Long-In-The-Tooth How resilient are South Africa's economic fundamentals and politics? In this report, we argue that they are not resilient at all. The country is facing considerable structural problems on both economic and political fronts. Even its sole silver lining - that it retains cyclical maneuvering room, i.e., it can adopt fiscal stimulus - will only encourage its leaders to double-down on a populist growth model that has already run out of steam. Cyclical Outlook: A Dark Cloud With A Silver Lining The cyclical outlook for South Africa has darkened as of late. All the drivers that pushed the rand to appreciate over the last 12 months are now showing signs of a reversal: The rand's rally in the past six months or so - a period when it decoupled from commodities prices - is often attributed to its higher interest rates. However, Chart I-6 demonstrates that higher local interest rates historically did not prevent the rand's selloff when metal prices fell. In short, we believe the last six months is an aberration rather than a new norm. Remarkably, hedged yields in South Africa are no longer attractive within the EM space. South Africa already offers the worst hedged returns, after Turkey and China, for the U.S. dollar and euro-based investors (Chart I-7 and Chart I-8).2 The situation will only get worse as the U.S. dollar appreciates and Treasury yields rise. Chart I-6High Local Interest Rates ##br##Are No Panacea For ZAR High Local Interest Rates Are No Panacea For ZAR High Local Interest Rates Are No Panacea For ZAR Chart I-7 Chart I-8 The drop in precious metal prices will force the rand to selloff (Chart I-9). The unprecedented resilience in the rand was supported by increasing financial flows. Now that these are decreasing, the historic correlation with precious metals should reemerge. The decoupling between the ZAR and AUD since early this year is unprecedented (Chart I-10). Both economies are leveraged to industrial and precious metals as well as coal prices, making both exchange rates correlated. Needless to say, Australia commands much better governance and politics than South Africa. In fact, higher interest rates in South Africa have never precluded the rand's depreciation when the AUD dropped. Chart I-9Is The Divergence With Precious Metals... Is The Divergence With Precious Metals... Is The Divergence With Precious Metals... Chart I-10...And AUD Sustainable? ...And AUD Sustainable? ...And AUD Sustainable? Therefore, we conclude that the rand's strength has not been warranted by any of its historic drivers. It has been due to nothing else than the blind search for yield. Over the medium and long run, the outlook for the rand remains bleak. The ongoing dynamic of high wage growth and negative productivity growth will assure a lingering stagflationary environment (Chart I-11). This is bearish for the rand. Surprisingly, despite a rising currency and falling bond yields over the last 12 months, the South African economy is still showing signs of weakness. The household sector, which represents 61% of the economy, is not showing signs of a recovery yet. Credit growth to households is still falling and private consumption is abysmal. (Chart I-12). On the corporate side, the situation is not reassuring either. Firms are not investing and business confidence has not shown any signs of a significant recovery (Chart I-13). Chart I-11Productivity Is Weak But Wages Are Strong Productivity Is Weak But Wages Are Strong Productivity Is Weak But Wages Are Strong Chart I-12Household Consumption Is Declining Household Consumption Is Declining Household Consumption Is Declining Chart I-13No Confidence, No Investment No Confidence, No Investment No Confidence, No Investment The one positive is that the government has fiscal room to maneuver. South African gross government debt is at a comfortable 51% of GDP. However, we suspect that the nature of fiscal spending will likely result in transfers to appease the population - especially ahead of key elections in late 2017 and 2018 - rather than investments that can genuinely improve productivity. In fact, fiscal spending in the form of transfers could very well entice consumers to import more and consequently widen the current account deficit, putting more downward pressure on the rand. Bottom Line: The commodity price rally in 2016 and falling bond yields failed to buoy the economy. While policymakers do retain fiscal room to stimulate, the problem is that such efforts will likely merely rekindle populist policies that have failed South Africa thus far. Structural Outlook: Late Innings Of The Crisis Of Expectations South Africa is not alone in the EM universe in having failed to improve governance over the past decade. Most EM economies have squandered the commodity bull market and Chinese industrialization, allowing their governance to stagnate or even worsen during the good times (Chart I-14).3 However, South Africa does stand alone when it comes to a tepid rise in middle class, as percent of total population (Chart I-15), and continued high income inequality (Chart I-16). Chart I-14Quality Of EM Governance Declined##br## Amidst The Good Times Quality Of EM Governance Declined Amidst The Good Times Quality Of EM Governance Declined Amidst The Good Times Chart I-15Middle Class Has ##br##Barely Budged... Middle Class Has Barely Budged... Middle Class Has Barely Budged... Chart I-16 The data is clear: South Africa is as unequal overall, and its middle class unchanged relative to overall population, as it was at the end of apartheid in the early 1990s. Governance in the country has continued to deteriorate, and while it remains higher than in Sub-Saharan Africa, the gap has astonishingly begun to narrow from both ends (Chart I-17). Chart I-17Governance Gap With Sub-Saharan ##br##Africa Is Closing! Governance Gap With Sub-Saharan Africa Is Closing! Governance Gap With Sub-Saharan Africa Is Closing! A major reason for the deterioration in governance is the "state capture" thesis that has become a popular one in characterizing President Jacob Zuma's rule.4 This process began early, as the country shifted its developmental program in 1996 away from a top-down, state-led, developmental model to one that encouraged a free-market economy balanced with welfare spending. This was a natural result of the global rise of laissez-faire capitalism, the Washington Consensus, and "Third Way" politics of left-leaning parties. A commitment to laissez-faire capitalism and free markets, combined with a strong welfare state, were seen as hallmarks of a successful economy. The problem with this approach is that it confused the symptoms of developed economies with their catalysts. South Africa needed a much more state-led approach to development, one that would have harnessed the resources of the state for productivity-enhancing investments. As such, the laissez-faire approach unsurprisingly failed to address the inequalities of the apartheid system and the country saw a decline in the middle class as percent of total population under both Presidents Nelson Mandela and Thabo Mbeki. This pivot towards free-market capitalism ended with the 2007 "Polokwane moment," which saw President Mbeki's free-market, reactive, attempt to address inequality between the white and black populations replaced with the proactive policy of Jacob Zuma. Zuma's more radical approach was to complement welfare transfers and high wage growth with an activist use of state owned enterprises (SOEs) as a vehicle for redistribution. This proactive policy meant using the government's tender system to doll out lucrative contracts to well-connected insiders, under the auspices of helping enfranchise black entrepreneurs and businesses. While the media has focused on the role that the Indian-born Gupta family has played in this process, it is highly unlikely that they are the only beneficiaries. Zuma's administration has, in the name of black enfranchisement and the fight against inequality, essentially rigged the entire government tender system for the sake of its own political preservation. The results of this process are unsurprising. First, government wages have outpaced those in both manufacturing and mining sectors (Chart I-18). Meanwhile, productivity has declined precipitously since 2007 and has been negative since 2012. South Africa has a lower productivity rate than both Latin American EM economies and its neighbors in sub-Saharan Africa (Chart I-19). Chart I-18Government Wages Have Outpaced All Others Government Wages Have Outpaced All Others Government Wages Have Outpaced All Others Chart I-19South African Productivity Has No Peer South African Productivity Has No Peer South African Productivity Has No Peer Financial media and investment research have continued to focus on the intricacies of the ruling African National Congress (ANC) politics. And we do so as well below. However, investors have to understand that South Africa's ills will not be fixed by the appointment of a pro-market finance minister or even the removal of Jacob Zuma from rule. South Africa has failed to develop inclusive economic institutions that engender creative destruction, which is at the heart of all successful development stories.5 South Africa ranked 74th in the World Bank's annual Doing Business report in 2017, an astonishing fall from grace over the past decade (Chart I-20). Compared to regional averages, South Africa barely beats the Sub-Saharan "distance to frontier" scores in several World Bank categories (Chart I-21). This is not due to the gross failure of the Zuma administration to do the "right thing." Rather, it exhibits a structural failing of South African political institutions. Chart I-20 Chart I-21 This development path is not unique to South Africa. Most sub-Saharan African states experienced a similar regression within 10-20 years of decolonization. Political scientist Robert Bates famously documented how African leaders co-opted colonial-era extractive economic institutions - such as the state marketing boards that purchased all cash crops and exported them on the global market - in order to generate enough revenue to industrialize their economies.6 While their intentions may have originally been noble, if misplaced, they quickly began to use control over marketing boards for political purposes. The rent generated from marketing boards became an immense source of political power for African leaders and they held on to it to the detriment of the economic development of their state. South Africa is far more developed than its sub-Saharan peers were in the 1970s. Nevertheless, its leaders are exhibiting similar rent-seeking behavior, albeit at a much higher level of development. It is also entering a dangerous period in its post-apartheid history: it has now been twenty years since South Africa's effective decolonization and it is facing its first serious economic downturn. Bottom Line: We doubt that anyone in the current leadership elite will be able to fully abandon the rent-seeking behavior of the Zuma administration and improve South Africa's economic institutions. The crisis of expectations among the country's voters is palpable and demands for greater redistribution are rising. This is not a context for pro-market reforms that will encourage creative destruction. Instead, we would expect a doubling-down of populism and greater emphasis on proactive redistribution, which will, at the same time, encourage greater out-migration of talent out of the country and rent seeking behavior from political elites. Can Any One Man Or Woman Fix South Africa? The African National Congress (ANC) will meet in December 2017 to decide the party candidate that will contest the 2019 general election (Diagram I-1). Given the ANC's stranglehold on the country's politics, it is likely that whoever emerges at the upcoming ANC Congress will be the next president of South Africa. Chart I- BCA's Geopolitical Strategy subscribes to the idea that policymakers are price takers in the political marketplace, not price makers. This is particularly the case in democracies, but it is also the case in some authoritarian regimes where public opinion is relevant. As such, the puzzle investors have to resolve is not what policymakers stand for, but rather what the median voter wants. In South Africa, the median voter lives in a rural area, works in the agriculture or service industry, and is a black citizen. The polls indicate that the main concerns of the median voter are a high structural unemployment rate (Chart I-22), endemic corruption (Chart I-23), poor healthcare infrastructure, and a desire for aggressive, and targeted, redistributive economic policies. Chart I-22Crisis Of Expectations Structural Unemployment Is Egregious Structural Unemployment Is Egregious Chart I-23 Is this the profile of a median voter about to elect a pro-market reformer willing to pursue painful structural reforms? We do not think so. The two candidates vying for the ANC presidency are the ex-wife of Jacob Zuma and former Chair of the African Union, Nkosazana Dlamini-Zuma, and former Deputy President, Cyril Ramaphosa. Ramaphosa is the darling of the international investment community. This is because he has abandoned his previous union credentials - he founded the country's largest trade union, the National Union of Mineworkers in addition to founding the Congress of South African Trade Unions (COSATU) - and turned into a successful businessman. As such, the narrative among South Africa bulls (who are exclusively found in Europe and the U.S.) is that he would be able to bridge the divide between the demands for redistribution and pro-market reforms. To the median voter, however, Ramaphosa is alleged to be involved in the Marikana Massacre. Acting as the Deputy President, he ordered increased police presence at the mines and called for the use of force, which resulted in 47 deaths in August-September 2012. Dlamini-Zuma, on the other hand, speaks the language of the median voter while also not being seen as part of Zuma's corrupt entourage. Her credentials are bolstered by a successful tenure as Chair of the African Union and as a woman independent and strong enough to divorce President Zuma. She has not amassed personal wealth and does not hold strong loyalties to a particular faction within the ANC. However, she has begun to parrot Zuma's line that the country requires "radical economic transformation," which is a signal to left-leaning members of the ANC that she will continue much of economic policies begun under Zuma. Both the ANC Youth and Women's Leagues, which are left leaning, support her. The problem that investors face in South Africa is that there is no clear demand for pro-market reforms. Investors cheered the results of the August 2016 municipal election, for example, because the ANC lost in several key cities and saw its total vote share fall by 8%. However, few in the media or investment research community raised the obvious point that the centrist Democratic Alliance only saw its vote total rise by 3% compared to the 2011 election. It was the radically left-wing Economic Freedom Fighters, led by ex-Youth League leader Julius Malema, which saw the largest increase in vote share, by over 8%. In other words, ANC voters that did abandon Zuma most likely fell behind Malema, who is far more redistributionist. As such, we stick to our long-held view that Zuma and the ANC leadership are unlikely to do what investors want them to do given that the South African median voter is swinging further to the left. There is no demand for pro-market reforms and thus policymakers are more likely to double-down on populism. Bottom Line: Dlamini-Zuma is the likely winner of the upcoming ANC Congress, which will effectively decide the next president of South Africa. She has the sufficient left-leaning economic credentials to satisfy the demands for redistribution of the median voter. There is also a chance that she will attempt to clean up the corruption that has become endemic under Zuma, which would undoubtedly be a good thing for the country. However, it is unlikely that the macroeconomic context she will face will be positive, or that she will have the mandate to balance redistributive policies with painful pro-market reforms that would rebuild institutions required for creative destruction. Investment Implications South African assets are ultimately at the mercy of foreign inflows. When the dollar is weakening, U.S. bond yields falling, and Chinese growth stable, even the election of Julius Malema to the presidency would not dent foreign enthusiasm for yield in South African assets. Given the expected improvement in U.S. growth and the transitory nature of the drop in the U.S. inflation rate, we expect the global macro backdrop to worsen substantially for carry trades in general, and for South Africa in particular. China remains the wild card in our analysis, but its credit and fiscal impulse has rolled over, suggesting slower import growth over the next six months (Chart I-24). Even if Chinese policymakers react by re-stimulating the economy, the effects will only be felt in early 2018 given lead times. When the global carry trade reverses, it will not matter who is in charge of South Africa. Investors will realize that the country has failed to address serious socio-economic ills that have plagued South Africa since the end of apartheid. BCA's Emerging Markets Strategy continues to recommend the following investment positions: Chart I-24China Slowdown Is A Risk To EM China Slowdown Is A Risk To EM China Slowdown Is A Risk To EM Chart I-25Yield Curve Will Steepen Yield Curve Will Steepen Yield Curve Will Steepen Continue shorting ZAR versus USD and MXN. Underweight South African stocks, sovereign credit and domestic bonds relative to their respective EM benchmarks. A new trade: bet on yield-curve steepening (Chart I-25). The short end of the curve will be steady but populist politics, larger fiscal deficits/higher public debt, and an inflationary backdrop will push up long-end yields. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Beement Alemayehu, Research Assistant beementa@bcaresearch.com 1 Please see BCA Global Investment Strategy Weekly Report, "Stocks Are From Mars, Bonds Are From Venus?" dated June 23, 2017, available at gis.bcaresearch.com, and BCA Emerging Market Strategy Weekly Report, "EM: Contradictions And A Resolution," dated June 14, 2017, available at ems.bcaresearch.com. 2 Please see BCA Emerging Markets Strategy Special Report, "EM Local Bonds: Looking At Hedged Yields," dated May 10, 2017, available at ems.bcaresearch.com. 3 'Governance' is a catchall term that attempts to capture the quality of public service delivery, broadly defined. In essence, investors can consider governance as a factor that underpins the quality of political institutions. We rely on the World Bank's Development Indicators because the World Bank aggregates the work of several credible surveys on governance. These indicators are also useful because the World Bank standardizes the results in a way that allows cross-country/region comparisons. We then aggregate the scores across five different variables and look for trends and changes over time. 4 Please see State Capacity Research Project, "Betrayal Of The Promise: How South Africa Is Being Stolen," dated May 2017, available at pari.org.za. 5 Please see Daron Acemoglu and James A. Robinson, Why Nations Fail (New York: Crown Business, 2012). 6 Please see Robert H. Bates, Markets and States in Tropical Africa: The Political Basis of Agricultural Policies (Berkeley, University of California Press, 2014 edition). Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Dear Client, We hope that you will find value in this report, a product of collaboration between BCA’s Geopolitical Strategy and EM Equity Sector Strategy. My colleagues Oleg Babanov and Matt Gertken look for investment opportunities in the recent geopolitical changes on the Korean Peninsula. The election of President Moon Jae-in will be a boon for domestic consumer sentiment and relations with China. This will produce a tailwind for the consumer-oriented South Korean stocks, which have high exposure to the country’s trade with China. We deliver this report to you both for its investment value and as an example of BCA Research commitment to seek alpha in the intersection of economics, markets, and geopolitics. Kindest Regards, Marko Papic Senior Vice President Chief Geopolitical Strategist Overweight South Korea Consumer Staples We are recommending an overweight position in select South Korean consumer staples on a long-term (one year-plus) time horizon. A decline in geopolitical tensions between South Korea and China, and a potential improvement on the Korean peninsula, will provide tailwinds to the performance of Korean consumer staples, which have high exposure to China. We expect Chinese tourist numbers to Korea to recover gradually, and sales of South Korean products in mainland China to pick up over the rest of the year. Presidential elections in South Korea and a slowly improving economy are bolstering consumer sentiment and aiding a turnaround in retail sales in the country, with companies in the consumer space displaying better earnings momentum and trading at more attractive valuations than their EM peers (Table 1). Image Sector Backdrop We are turning cautiously positive on consumer staples in South Korea. We believe the following factors will trigger a turnaround in consumer sentiment and support share price performance of consumer-oriented South Korean stocks. Geopolitics Image The election of President Moon Jae-in by a wide margin, as well as a geopolitical shift toward more accommodative policy on China, will alleviate geopolitical risks and help consumer sentiment. Moon has already kicked off his administration's tenure with considerable political capital. For one, his administration represents a return to stable and legitimate government after over a year of turmoil surrounding the scandal, impeachment and removal of former President Park Geun-hye - a relief for South Korean voters. What's more, voter turnout was higher than usual, at 77%, and Moon's margin of victory over his closest contender was over 15%, the second-highest since South Korea became a full-fledged democracy in 1987 (Chart 1). There are also institutional factors playing to Moon's advantage. He was the leading contender for the presidency even without Park being removed from office - but if she had not been removed, he would have taken office in January 2018. Now, Moon has half a year longer in office than he otherwise would have had before he faces his first serious political hurdle in the April 2020 legislative elections. This half year could make a difference. Since Korean presidents serve a single, five-year term, they often become lame ducks in the second half of their term, and therefore move rapidly on policy in the first half while their political capital is high. The only significant domestic political constraint on Moon is the rival left-of-center party, the People's Party. It holds the kingmaker position in the legislature, with the ability to give a majority to either Moon's ruling Democratic Party or to the conservative opposition (Chart 2). However, the People's Party has serious weaknesses and has been compelled by its voting base to cooperate on much of Moon's platform of expanding social spending and thawing relations with North Korea and China. Moreover, the conservative opposition is discredited and fractured. Thus, Moon has limited political constraints. Given that his administration is competent - i.e. the clear populist elements are not joined with a lack of experience or pragmatism - the key question is what policies he will prioritize while his political capital is high. Image Chart 3THAAD Deployment Hurt ##br##Bilateral China-Korea Trade THAAD Deployment Hurt Bilateral China-Korea Trade THAAD Deployment Hurt Bilateral China-Korea Trade It is our view that China-exposed companies stand to benefit in the short term as China eases sanctions over the recently deployed U.S. THAAD missile defense system (Chart 3), and as better relations with China benefit the economy more broadly (Chart 4). However, if Moon prioritizes China and North Korea excessively, he risks squandering his political capital. Korea remains stuck in the middle of U.S.-China tensions that are growing on a secular basis. Tensions with the U.S. will rise as a result of Moon's orientation, and North Korean political risks will remain elevated over the medium and long term. Moon's attempts to engage with North Korea will collide with Trump's efforts to ratchet up pressure against it. Image Therefore, Moon is likely to find the most success in his domestic agenda of increasing government spending, hiring more public workers, raising wages and instilling worker protections, expanding the social safety net and subsidizing small- and medium-sized enterprises. These measures will boost both public and private consumption. We do not have particularly high hopes for Moon's ability to reform the so-called 'chaebol', a South Korean term denoting large, typically family-owned corporate conglomerates, but his attempt to do so will add a modicum of corporate governance and competitiveness improvements that markets will likely cheer. Macroeconomics With improvement in the geopolitical situation, stabilization in the local political system following the Park Geun-hye scandal and new elections has aided in a recovery in consumer sentiment (Chart 5). Meanwhile, a rebound in total employment numbers together with a decline in household debt is providing support to consumer spending (Charts 6A, 6B, 6C). Chart 5Consumer Confidence Is ##br##Back To A Five-Year High Consumer Confidence Is Back To A Five-Year High Consumer Confidence Is Back To A Five-Year High Chart 6ANumber Of Employed ##br##Higher Than In 2015... Number Of Employed Higher Than In 2015... Number Of Employed Higher Than In 2015... Chart 6B...While The Household Debt ##br##Burden Is Slowly Declining... ...While The Household Debt Burden Is Slowly Declining... ...While The Household Debt Burden Is Slowly Declining... Chart 6C...Aiding A Recovery##br## In Retail Sales ...Aiding A Recovery In Retail Sales ...Aiding A Recovery In Retail Sales Sector Specifics From a sector perspective, South Korean consumer staples remain highly competitive, outperforming their EM peers (Chart 7). At the same time, valuations are attractive for South Korean companies (Charts 8A & 8B). Chart 7South Korean Consumer Stocks Outperforming EM Consumer Staples' Aggregate... South Korean Consumer Stocks Outperforming EM Consumer Staples' Aggregate... South Korean Consumer Stocks Outperforming EM Consumer Staples' Aggregate... Chart 8ASouth Korean Companies Trading At Cheaper ##br##Valuations Since Mid-2016... South Korean Companies Trading At Cheaper Valuations Since Mid-2016 South Korean Companies Trading At Cheaper Valuations Since Mid-2016 Chart 8B...And At One Standard Deviation Below ##br##Their Seven-Year Average ...And At One Standard Deviation Below Their Seven-Year Average ...And At One Standard Deviation Below Their Seven-Year Average Furthermore, bottom-line expansion of South Korean companies remains strong, supported by solid margin trends (Charts 9A, 9B, 9C). Chart 9A...Earnings Growth In South Korea##br## Is Outperforming EM Peers ...Earnings Growth In South Korea Is Outperforming EM Peers ...Earnings Growth In South Korea Is Outperforming EM Peers Chart 9B...With Gross Margin Nearly Twice ##br## The EM Industry Average... ...With Gross Margin Nearly Twice The EM Industry Average... ...With Gross Margin Nearly Twice The EM Industry Average... Chart 9C...And EBTIDA Margin Is Steadily ##br## Above EM Peers ...And EBTIDA Margin Is Steadily Above EM Peers ...And EBTIDA Margin Is Steadily Above EM Peers We also like the fact that the net debt level for South Korean consumer staples companies is low to negative, while companies have managed to generate excess free cash flow. One undesirable implication, however, is notoriously low dividend yields, which are discouraging investors and raising corporate governance issues (Charts 10A, 10B, 10C). Taking into account the factors listed above, we have created a portfolio of six South Korean consumer staples stocks (Table 2). Chart 10ADebt Levels Have Fallen Significantly ##br## Over The Past Seven Years... Debt Levels Have Fallen Significantly Over The Past Seven Years... Debt Levels Have Fallen Significantly Over The Past Seven Years... Chart 10B...While Cash Generation ##br## Has Recovered... ...While Cash Generation Has Recovered... ...While Cash Generation Has Recovered... Chart 10C...But Dividend Yields ##br## Remain Disappointing Low ...But Dividend Yields Remain Disappointing Low ...But Dividend Yields Remain Disappointing Low Image The Overweight Basket Chart 11Performance Since June 2016: ##br## Amorepacific Corp Vs. MSCI EM Performance Since June 2016: Amorepacific Corp Vs. MSCI EM Performance Since June 2016: Amorepacific Corp Vs. MSCI EM Amorepacific Corp (090430 KS): A leading beauty and cosmetics producer in South Korea (Chart 11). Founded in the 1940s by Yun Dok-jeong as a company distributing camellia oil for hair treatment, the company was inherited by Yun's son and later grandson, who became the second-richest man in South Korea, controlling directly 10% of the company's free float. Today, Amorepacific is the world's 14th largest cosmetics company, with oversight of some 33 brands around the world such as Etude House, Sulwhasoo and others. In terms of revenue, the bulk is generated by beauty and cosmetic products (91%), where luxury cosmetics constitute 43%, followed by premium brands with 18%. Personal care products contribute 9% to total revenue. Geographically, 70% of revenues are generated in South Korea, and another 19% in China. Amorepacific reported weaker-than-expected first-quarter 2017 financial results on April 24. Revenue increased by 5.7% year over year, with falling Chinese tourist numbers weighing on local sales, and weaker sales in mainland China. At the same time, cost of sales went up by 10.6% year over year, which resulted in gross margin compression by 100 basis points. As a result of an operating cost increase of 8.4% year over year, mainly driven by SG&A expansion (increased labor costs and one-off bonus payments), operating profit fell 6.2% year over year. Operating margin finished at 20.2% compared to 22.8% same period last year, while EBTDA margin contracted to 17.8% from 19.5% last year. Weak operating performance and disproportionate expense growth led to the bottom line falling 15% year over year. Amorepacific is currently trading at a forward P/E of 30.0x, while the market is forecasting an EPS CAGR of 13% over the next three years. We believe the share price will continue to recover strongly, taking into account that easing tensions with China will restore demand and organic volume growth as well as strong momentum in overseas sales, supporting an earnings recovery. Chart 12Performance Since June 2016: ##br## E-Mart Vs. MSCI EM Performance Since June 2016: E-Mart Vs. MSCI EM Performance Since June 2016: E-Mart Vs. MSCI EM E-Mart (139480 KS): Number one hypermarket brand in South Korea (Chart 12). E-Mart was established in 1993 and has grown into the largest hypermarket and discount store chain in South Korea, operating over 148 branch locations locally and another 16 in China. In 2006 the company also acquired its largest competitor in the country - Wal-Mart Korea - strengthening its market share. Additionally, E-Mart runs speciality shops such as "Emart" discount stores, the "Emart Mall" online store, "Emart Traders," an everyday low-price store, as well as pet and sports/outdoor stores. In terms of revenue breakdown, the flagship E-Mart brand is responsible for 78% of total revenue, followed by the food distribution and supermarket segment with 7% each respectively. From a geographic perspective, 98% of revenue originates in South Korea and only 2% in China. E-Mart reported first-quarter 2017 financial results on May 11, missing estimates. Revenue growth was solid, up 7.4% year over year, helped by 1% same-store sales growth in the main hypermarket segment, while cost of sales increased by 6.5% year over year, which resulted in gross margin falling slightly by 20 basis points to 28.2%. Operating profit increased by 2.8% year over year, weighed on by a year-on-year jump in operating expenses of 11.1%. Operating margin stood at 4.1%, down from 4.3% in 2016, while EBITDA margin finished virtually flat at 6.7%. Thanks to better operating performance, the bottom line improved by 5% year over year. The main detraction to performance came from one-off store opening expenses and a negative calendar effect. E-Mart is currently trading at a forward P/E of 14.0x, while the market is forecasting an EPS CAGR of 9% over the next three years. A store restructuring program is currently underway, and management has done well in accelerating closures of non-performing stores, which has already led to cost savings and margin turnaround. We expect this process to continue. Together with strong performance of the discount and online segments, this should warrant a further re-rating of the share price. Chart 13Performance Since June 2016: ##br## GS Retail Vs. MSCI EM Performance Since June 2016: GS Retail Vs. MSCI EM Performance Since June 2016: GS Retail Vs. MSCI EM GS Retail (007070 KS): Number one convenience store chain in South Korea (Chart 13). GS Retail is part of the GS Group, a former part of LG Group and the sixth-largest conglomerate in South Korea, which controls just under 66% of the company. GS Retail was incorporated back in 1971 and today operates GS25 - the largest convenience store brand in South Korea - as well as other brands such as GS Supermarkets, Watsons - a health and beauty chain, and Parnas Hotel. The largest contributor to total revenue is the convenience store segment, with 77%, followed by the supermarket business with 20% and the hotel operation with 3%. Geographically, all the revenue originates in South Korea. GS Retail reported first-quarter 2017 financial results on May 11. Revenue displayed strong growth, up 12.5% year over year, driven by solid performance in the convenience store segment (+21% year over year), while cost of sales increased by 12.3% year over year, which brought gross margin up by 20 basis points to 18.4%. A 15% year-over-year increase in operating costs due to the ongoing consolidation of the Watsons business brought operating income down slightly by 1.5% year over year, suppressing operating margin by 20 basis points to 1.4%. EBITDA margin stood at 5.9% compared to 6.2% a year ago. Despite weak operating performance, the bottom line grew by 18.8%, helped by a non-operating gain and lower interest expenses. GS Retail is currently trading at a forward P/E of 19.6x, while the market is forecasting an EPS CAGR of 14% over the next three years. We expect the non-convenience store segments to contribute more to performance in the second part of the year. Furthermore, non-performing supermarket store closedowns together with seasonally strong second and third quarters, where the summer weather typically helps sales, should support stock performance. Chart 14Performance Since June 2016: ##br## H&H Vs. MSCI EM Performance Since June 2016: H&H Vs. MSCI EM Performance Since June 2016: H&H Vs. MSCI EM LG Household & Healthcare (051900 KS): Producer of the very first cosmetic products in Korea (Chart 14). LG H&H was incorporated in 1947 by Koo In-Hwoi, the founder of LG Corp., and had the initial name Lucky Chemical Industrial Corp. The company produced the first-ever Korean cosmetic product, "Lucky Cream," followed by "Lucky Toothpaste." From 1995 to 2001, LG H&H was part of LG Chem before being spun off. In addition to the cosmetics and household goods businesses, the company also acquired Coca Cola Beverage in 2007, turning itself into an exclusive bottler and distributor of Coca Cola products in South Korea. In terms of revenue breakdown, the cosmetics business contributes 53% to overall revenue, followed by personal products with 27% and the soft drink division with 20%. Geographically, 84% of revenue originates in South Korea, followed by China with 8% and Japan with 4%. LG H&H reported better-than-expected first-quarter 2017 financial results on April 28. Revenue expanded by 5.3% year over year, driven by strong sales in the luxury cosmetics and beverage segments, while cost of sales grew by 4% year over year, bringing gross margin 50 basis points higher to 60.9%. Furthermore, operating income displayed strong growth, up 11.3%, helped by good management of operating expenses (+4.5% year over year). As a result, operating margin improved by 90 basis points to 16.2% and EBITDA margin finished at 16.9%, up from 15.7% last year. The bottom line increased by 11.9% year over year, helped by strong operating performance. LG H&H is currently trading at a forward P/E of 24.1x, while the market is forecasting an EPS CAGR of 8% over the next three years. As with Amorepacific, the trigger to a re-rating in the share price of LG H&H is the improving geopolitical situation. We expect tourist numbers to South Korea to gradually increase, which will aid in both sales recovery and earnings revisions, while strong momentum in the luxury cosmetics segment will contribute to further margin expansion. Chart 15Performance Since June 2016: ##br## KT&G Vs. MSCI EM Performance Since June 2016: KT&G Vs. MSCI EM Performance Since June 2016: KT&G Vs. MSCI EM KT&G Corp (033780 KS): Korea Tobacco & Ginseng (Chart 15). Initially founded as a government monopoly with the name "Korea Tobacco & Ginseng," the company was later privatized and rebranded as the "Korea Tomorrow & Global Corporation." Today, the company is the largest tobacco company in South Korea, controlling the majority of the local market. The company also has extensive exposure to Eastern European countries. In addition to the tobacco business, KT&G also has a pharma arm, the Korea Ginseng Corp. The revenue stream is broken down into the cigarette business, which contributes 60% to overall revenue, followed by the ginseng-pharma segment, adding another 30%. KT&G reported in-line first-quarter 2017 financial results on April 27. Revenue increased by a solid 8% year over year, helped by strong ginseng sales, which expanded despite a market contraction and were also alleviated by market share gain and higher prices. Cost of sales, meantime, were up 12.7%, bringing gross margin down to 59.4% from 61.1% previously. Due to a strong increase in operating costs (+11.3% year over year), driven by higher SG&A expenses, operating income edged up only 0.6% year over year. Operating margin fell 45 basis points from last year, while EBITDA margin stood at 35.5%, or 80 basis points lower compared to the same period last year. The bottom line fell by 17.5% year over year, weighted on by higher foreign exchange losses. KT&G is currently trading at a forward P/E of 12.8x, while the market is forecasting an EPS CAGR of 6.5% over the next three years. Several factors have been weighing on the company's share price recently, including the introduction of warning messages on cigarette packages and the introduction of e-cigarettes in the domestic market - making the stock one of the cheapest among its global peers (~20% discount). We believe that worries regarding e-cigarette introduction and projections of the Japanese experience are overstated due to differences in law (e.g. prohibition of smoking indoors), as well as the age composition of the market. Furthermore, we expect a strong revival in overseas sales in the second part of the year, with less headwinds from foreign exchange swings and double-digit growth due to low base effects - as well as an offset to flat local market expansion via higher selling prices. Chart 16Performance Since June 2016: ##br## Nongshim Vs. MSCI EM Performance Since June 2016: Nongshim Vs. MSCI EM Performance Since June 2016: Nongshim Vs. MSCI EM Nongshim (004370 KS): Farmer's Heart (Chart 16). Nongshim, or Farmer's Heart, was founded in 1965 under the name Lotte Food Industrial Company, and later changed its name. The company first focused on ramyun (instant noodle) production, later expanding into snacks - it was the first to introduce the "Shrimp Cracker" as well as beverages. Today, Nongshim is the largest ramyun and snack company in South Korea, selling to over 100 countries, with production facilities in Korea, China and the U.S. From a revenue perspective, ramyun products contribute 67% to total revenue, followed by other food products with 17.5% and snacks with 15.6%. Geographically, most sales occur in South Korea, with 80%, followed by the U.S. with 10% and China with 8%. Nongshim reported slightly better-than-expected first-quarter 2017 financial results on May 15. Revenue declined slightly by 2.2% year over year due to a fall in domestic ramyun sales by 9%, while cost of sales actually declined by 5% year over year, which led to a gross margin improvement by 190 basis points to 33.7% (helped by price increases.) Operating income was virtually flat year over year, as operating costs increased by 4%. Operating margin stood at 5.85% compared to 5.70% in 2016, while EBITDA margin declined to 7.9% from 9.4% last year. Nongshim is currently trading at a forward P/E of 18.5x, while the market is forecasting an EPS CAGR of 5.6% over the next three years. We expect a reversal of weak sales in China (-5% year over year) due to an easing of the geopolitical situation. Furthermore, Nongshim has already begun to claw back market share, helped by new starts and forced price hikes among its competition, which will continue to help turn around margins and improve profitability. How To Trade? The EMES team recommends gaining exposure to the sector through a basket of listed equities consisting of six overweight recommendations. The main goal is active alpha generation by excluding laggards and including out-of-benchmark plays, to avoid passive index-hugging via an ETF. Direct: Equity access through the tickers (Bloomberg): Amorepacific Corp (090430 KS); E-Mart (139480 KS); GS Retail (007070 KS); LG Household & Healthcare (051900 KS); KT&G Corp (033780 KS); Nongshim (004370 KS). ETFs: At the moment, there are no ETFs with significant consumer staples sector exposure for South Korea. Funds: At the moment, there are no funds with significant consumer staples sector exposure for South Korea. Please note this trade recommendation is long term (1Y+) and based on an overweight trade. We do not see a need for specific market timing for this call (for technical indicators please refer to our website link). For convenience, the performance of both market cap-weighted and equal-weighted equity baskets will be tracked (please see upcoming updates as well as the website link to follow performance). Risks To Our Investment Case We believe that one of the main risks is the geopolitical situation and further developments surrounding North Korea. Although the usual springtime tensions have passed, the underlying dynamic remains highly precarious. North Korea has not moderated its behavior despite President Moon's olive branch and U.S. President Trump continues to prioritize the issue and threaten bolder action. Any kind of escalation in tensions, whether they be driven by North Korea or the U.S., would negatively affect both Chinese interests and the new South Korean administration's attempts at engagement. Given that South Korea has not yet fully reversed the THAAD missile deployment, for instance, it is possible that China could maintain or intensify its informal sanctions on South Korea, such as travel and product bans, and that renewed tensions could depress overall consumer sentiment in South Korea. We are also cognizant that debt levels in the South Korean manufacturing sector as well mass layoffs in shipyards and a slowdown in exports could continue to create pressure on household disposable income levels and, in turn, spending. However, President Moon's efforts for a supplementary budget to support employment in the public sector, if approved, should alleviate some pain from layoffs. On a company level, we see increased price competition as one of the main risks to our investment case. Since many of the companies in the basket are market leaders, they will need to defend their market share aggressively in case of increased competition. Furthermore, for companies operating abroad, we see increased expansion costs as one of the risk factors for future performance. Finally, Chinese economic policy pose a risk to our view. The fiscal spending and credit impulse in China have rolled over, suggesting that demand will slow in the coming months. Moreover, the Communist Party’s ongoing “deleveraging campaign” – a crackdown on various risky financial practices and the shadow banking sector – raises the risks of a policy mistake. A slowdown in China would have negative repercussions for the South Korean companies most exposed to China and the broader Korean economy. Nevertheless, we think Chinese authorities are willing and able to meet their growth target this year. Oleg Babanov, Senior Editor obabanov@bcaresearch.co.uk Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.co.uk

Feature The BCA Corporate Health Monitor (CHM) - designed to assess the financial well-being of companies - is one of our most reliable indicators that is also extremely popular with our clients. That is no surprise, as the CHMs have a solid track record in signaling broad turning points in company credit quality. This makes them useful in determining asset allocation recommendations on Investment Grade (IG) and High-Yield (HY) corporate bonds. Chart 1U.S. Corporates Outperforming, ##br##Despite Worsening Credit Quality U.S. Corporates Outperforming, Despite Worsening Credit Quality U.S. Corporates Outperforming, Despite Worsening Credit Quality In this Weekly Report, we present the "top-down" CHMs based on corporate data from national income (i.e. "GDP") accounts for the U.S., Euro Area and the U.K. We also show the "bottom-up" CHMs constructed using the actual reported financial data of individual companies in the U.S., Euro Area and Emerging Markets (EM). The CHMs are shown in a chartbook format that allows for quick visual analysis and comparisons. Going forward, we will publish this CHM Chartbook on a quarterly basis as a regular part of Global Fixed Income Strategy. The broad conclusion from looking at the CHMs is that corporate credit quality has been steadily improving in Europe, the U.K. and in the EM universe over the past couple of years, in sharp contrast to the worsening financial health of highly-levered U.S. companies. Bond investors seem to be ignoring the relative message sent by our CHMs, however, as U.S. corporate debt has outperformed other developed credit markets since the beginning of 2016 (Chart 1). An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is an indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios similar to those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the metrics used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Top-down CHMs are now available for the U.S., Euro Area and U.K. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.1 The financial data of a broad set of individual U.S. and Euro Area companies was used to construct individual "bottom-up" CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. An EM version of the bottom-up CHM was introduced by the BCA Emerging Markets Strategy team last September, which extends the CHM analysis to EM hard-currency corporate debt.2 Table 1Definitions Of Ratios That Go Into The CHMs BCA Corporate Health Monitor Chartbook BCA Corporate Health Monitor Chartbook U.S. Corporate Health Monitors: Still Deteriorating Chart 2Top-Down U.S. CHM: Still Deteriorating Top-Down U.S. CHM: Still Deteriorating Top-Down U.S. CHM: Still Deteriorating Our top-down CHM for the U.S. has been flashing a deteriorating state of corporate health since mid-2014 (Chart 2). That trend had been showing signs of stabilization last year, but the Q1/2017 data worsened on the back of lower profit margins and returns on capital. The latter now sits just above 5% - a level last seen during the 2009 recession. Corporate leverage, as measured in our top-down CHM using the value of debt versus equity, does not look to be a problem. The story is quite different when using alternative measures like net debt/EBITDA, however, with U.S. leverage exceeding the highs from the Telecom bubble of the early 2000s. While booming equity values certainly flatter the leverage ratio in our top-down CHM, a strong stock market should, to some degree, reflect a better backdrop for growth in corporate profits and creditworthiness. Even against this positive backdrop, however, other credit indicators are flashing some warning signs that leave our top-down CHM in the "deteriorating health" zone. Interest coverage and debt coverage ratios, while still above the lows seen during past recessions, are steadily falling. This does raise concerns for U.S. corporate health if U.S. bond yields begin to climb again, as we expect. However, given the historically low interest rate backdrop for corporate debt, a bigger threat to interest coverage ratios and overall credit quality would come from an economic slump that damages company profits. That is not going to be a problem for the rest of this year, but weaker growth is a more likely outcome in 2018 as the Fed continues its monetary tightening cycle. Our bottom-up CHMs for U.S. IG (Chart 3) and U.S. HY (Chart 4) have shown a bit of improvement in recent quarters relative to the signal from our top-down CHM. This is likely related to the growing gap between corporate profits as reported in the U.S. national accounts data, which are slowing, compared to the reported earnings of publicly traded companies, which are accelerating. Also, leverage in the bottom-up CHMs uses the book value of equity, which is more readily reported by individual companies, and is thus much higher than the measure used in our top-down CHM. Return on capital is at multi-decade lows for both IG and HY corporates, although profit margins look to be in much better shape for IG names relative to HY issuers. HY margins have enjoyed a cyclical improvement, however, largely due to better earnings from HY energy companies (Chart 4, panel 4). Interest coverage and debt coverage are depressed, with HY issuers in much worse shape than IG. Chart 3Bottom-Up U.S. Investment Grade CHM: ##br##Deteriorating Bottom-Up U.S. Investment Grade CHM: Deteriorating Bottom-Up U.S. Investment Grade CHM: Deteriorating Chart 4Bottom-Up U.S. High-Yield CHM: ##br##Some Cyclical Improvement Bottom-Up U.S. High-Yield CHM: Some Cyclical Improvement Bottom-Up U.S. High-Yield CHM: Some Cyclical Improvement The cumulative message from our top-down and bottom-up U.S. CHMs is that U.S. corporate health has enjoyed some cyclical improvement over the past few quarters, but the state of balance sheets is slowly-but-steadily worsening. High corporate leverage will become a major problem during the next U.S. recession, but is not a major factor weighing on credit spreads at the moment (Chart 5). We are maintaining our overweight stance on U.S. IG and higher-rated U.S. HY, both of which should continue to outperform Treasuries over the next few months, but a repeat performance is far less likely next year. Chart 5No Signs Of Concern##br## In U.S. Corporate Credit Spreads No Signs Of Concern In U.S. Corporate Credit Spreads No Signs Of Concern In U.S. Corporate Credit Spreads Chart 6Top-Down Euro Area CHM:##br## Improving Top-Down Euro Area CHM: Improving Top-Down Euro Area CHM: Improving Euro Area Corporate Health Monitors: Solid Improvement Our top-down Euro Area CHM has been showing steady improvement since 2013, driven by strong profit margins and rising interest and debt coverage ratios (Chart 6). The ultra-stimulative monetary policies of the European Central Bank (ECB) have likely played a large role in helping lower corporate borrowing costs and boosting the interest coverage ratio. The average coupon on bonds in the Bloomberg Barclays Euro-Aggregate Investment Grade corporate index is now down to a mere 2.3% - a far cry from the 5% level that prevailed during the peak of the 2011 Euro Debt crisis or the 3.5% level just before the ECB began its asset purchase program in 2015. Return on capital has fallen over the past decade and now sits at 8%, although profit margins remain quite strong on our top-down CHM measure. Short-term liquidity is at a record high, suggesting no imminent problems for European corporate borrowers. Our bottom-up CHMs for Euro Area IG (Chart 7) and HY (Chart 8) are telling a broadly similar story to the top-down CHM. The bottom-up CHMs have steadily improved in the past couple of years, most notably for domestic issuers of Euro-denominated debt.3 Some improvement in the bottom-up aggregates for operating margins and interest coverage ratios is providing a boost to European credit quality. Chart 7Bottom-Up Euro Area Investment Grade CHMs Bottom-Up Euro Area Investment Grade CHMs Bottom-Up Euro Area Investment Grade CHMs Chart 8Bottom-Up Euro Area High-Yield CHMs Bottom-Up Euro Area High-Yield CHMs Bottom-Up Euro Area High-Yield CHMs The bottom-up measure of leverage for domestic IG issuers has been steadily declining since the 2009 recession, a sign that European companies have been much more cautious in managing their balance sheet risk than their U.S. counterparts. The same cannot be said for Euro Area domestic HY issuers, where all the individual ratios are at weak absolute levels. When splitting our bottom-up Euro Area IG company list into issuers from core Europe versus countries on the Periphery (Chart 9), the "regional" European CHMs tell broadly similar stories of improving credit quality. The fact that even Peripheral issuers are seeing rising interest coverage and liquidity ratios, despite much higher levels of leverage than in the core, is an indication of how the ECB's low interest rate policies and asset purchase programs (which include buying corporate debt) have helped support the European corporate sector. Net-net, our Euro Area CHMs are sending a signal that there are no immediate stresses on corporate balance sheets or profitability. This is already reflected in the current low level of corporate bond yields and spreads, though (Chart 10). A bigger threat to Euro Area corporates comes from monetary policy. The ECB is under increasing pressure to consider announcing a tapering of its asset purchases - likely to include slower buying of corporates - starting in 2018. There is a risk of a negative market reaction that could undermine future Euro Area corporate bond performance. Because of this, we continue to prefer U.S. corporate debt over Euro Area equivalents, despite the large gap between the U.S. and European top-down CHMs (Chart 11). Chart 9Bottom-Up Euro Area IG CHMs: ##br##Core Vs. Periphery Bottom-Up Euro Area IG CHMs: Core vs Periphery Bottom-Up Euro Area IG CHMs: Core vs Periphery Chart 10Euro Area Corporate Bonds ##br## Have Had A Great Run Euro Area Corporate Bonds Have Had A Great Run Euro Area Corporate Bonds Have Had A Great Run Chart 11Relative CHMs Starting ##br##To Turn Less Favorable For U.S. Credit Relative CHMs Starting To Turn Less Favorable For U.S. Credit Relative CHMs Starting To Turn Less Favorable For U.S. Credit U.K. Corporate Health Monitor: Solid Balance Sheet Fundamentals The top-down U.K. CHM has steadily improved over the past couple of years, led by rising profit margins, higher interest coverage and very robust liquidity (Chart 12). Return on capital is low relative to its history, which is consistent with the trends seen in the U.S. and Euro Area and likely reflects the global low productivity backdrop. Fundamental analysis of U.K. corporates may not be of much use at the moment given the extremely accommodative monetary policy environment provided by the Bank of England (BoE). Low interest rates, combined with BoE asset purchases (which include a small amount of corporate debt) and a steep fall in the Pound in the aftermath of the Brexit-driven political uncertainty, are all helping keep the U.K. economy afloat. The BoE is now having to deal with a currency-driven climb in U.K. inflation, with three members of the BoE policy committee even calling for a rate hike at the latest policy meeting. The political backdrop after last year's Brexit vote and this month's closer-than-expected U.K. election result remains too volatile for the BoE to seriously consider any imminent tightening of monetary policy. While it can be debated how much the Brexit uncertainty is truly weighing on the U.K. economy, the BoE is unlikely to take any risks on triggering a growth slowdown by becoming too hawkish, too soon - even with the relatively high level of currency-driven inflation. A combination of a strong CHM and a dovish BoE will allow U.K. corporate debt, both IG and HY, to continue to outperform Gilts. We continue to recommend an overweight allocation to U.K. corporates even though, as in the other countries shown in this report, valuations are not cheap (Chart 13). We have not yet constructed bottom-up versions of the CHM for U.K. corporates to allow us to make any additional comments on the relative merits of U.K. IG and HY debt. This is something we intend to look into for future reports. Chart 12U.K. Corporate Balance Sheets ##br##Are In Good Shape... U.K. Corporate Balance Sheets Are In Good Shape... U.K. Corporate Balance Sheets Are In Good Shape... Chart 13...Which Is Already Reflected In ##br##Tight Credit Spreads ...Which Is Already Reflected In Tight Credit Spreads ...Which Is Already Reflected In Tight Credit Spreads Emerging Market Corporate Health Monitor: Cyclically Strong, Structurally Weak The CHM for EM corporates built by our Emerging Markets Strategy team is purely a bottom-up measure. The financial data from 220 EM companies in over 30 countries is used to construct the EM CHM. Only firms that issue U.S. dollar-denominated bonds are included, with banks and other financials also omitted in a similar fashion to the CHMs for the developed economies. A shorter list of financial ratios is used in the EM CHM than the developed CHMs, including: Profit margins Free cash flow to total debt: Liquidity Leverage Unlike the developed CHMs, the ratios are not equally weighted in the construction of the EM CHM. Profit margins and cash flow/debt combined represent 75% of the EM CHM. The weightings are designed to optimize the performance of the EM CHM versus the actual spread movements in the J.P. Morgan CEMBI benchmark index for EM corporate debt. Chart 14EM Corporate Health: Cyclically Solid... EM Corporate Health: Cyclically Solid... EM Corporate Health: Cyclically Solid... The EM CHM is currently pointing to very strong fundamental underpinnings for EM corporates with the indicator at the most credit-positive level in a decade (Chart 14). That recent strength is a modest cyclical improvement after a multi-year deterioration in all the individual EM CHM components (Chart 15). The uptick in global commodity prices in 2016 played a major role in the improvement in the growth-sensitive components (top two panels). However, the biggest structural headwind for EM corporates is the unrelenting rise in balance sheet leverage (bottom panel) - a problem that could come to the forefront if the recent slump in commodity prices persists or developed market interest rates begin to rise more sharply as central banks become marginally less accommodative. For now, we continue to recommend only a neutral allocation to EM hard currency debt, as the positive message sent by the EM CHM appears fully priced into the current low level of EM yields and spreads (Chart 16). Chart 15...But Structurally More Challenged ...But Structurally More Challenged ...But Structurally More Challenged Chart 16EM Corporate Debt Is Not Cheap EM Corporate Debt Is Not Cheap EM Corporate Debt Is Not Cheap Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see Section II of The Bank Credit Analyst, "U.S. Corporate Health Gets A Failing Grade", dated February 2016, available at bca.bcaresearch.com. 2 Please see BCA Emerging Markets Strategy Special Report, "EM Corporate Health Is Flashing Red" dated September 14 2016, available at ems.bcaresearch.com. 3 Given the large share of non-European issuers in the Euro-denominated corporate debt market, we have split our sample set of companies in our bottom-up Euro Area CHMs into "domestic" and "foreign" issuer groups. This allows a more precise analysis of the corporate health of European-domiciled companies. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index BCA Corporate Health Monitor Chartbook BCA Corporate Health Monitor Chartbook

Highlights The divergence between global bond yields and equity prices is not as puzzling as it may first appear. Thus far, lower inflation has dampened the need for central banks to tighten monetary policy. This has caused bond yields to fall, lifting stocks in the process. Looking out, the combination of faster growth and dwindling spare capacity will cause inflation to rise. This is particularly the case for the U.S., where the economy has already reached full employment. The "blow-off" phase for the U.S. economy is likely to last until mid-2018. The dollar and Treasury yields will move higher over this period. The euro and the yen will suffer the most against a resurgent greenback, the pound less so. China's economy will remain resilient, helping to boost commodity prices. This will support the Canadian and Aussie dollars. Stronger global growth will provide a tailwind to emerging markets. However, at this point, most of the good news is already reflected in EM asset valuations. Feature Stocks And Bonds: A Curious Divergence Chart 1Global Growth: Increasing Optimism Global Growth: Increasing Optimism Global Growth: Increasing Optimism One could be forgiven for thinking that equity and bond investors are living on different planets. Global bond yields have been trending lower thus far this year, while stocks have been setting new highs. Are bonds signaling an imminent slowdown which equity investors are willfully ignoring? Not necessarily. Almost all of the decline in bond yields has been due to falling inflation expectations. Real yields have remained reasonably steady, suggesting that growth worries are not foremost on investors' minds. The fact that consensus global growth estimates for 2017 and 2018 have continued to grind higher is consistent with this observation (Chart 1). A quiescent inflation picture has given investors more confidence that the Fed will not need to raise rates aggressively. This has pushed down bond yields, weakened the dollar, and fueled the rally in stock prices. The decline in headline inflation, in turn, has been largely driven by lower commodity prices. In the U.S., several one-off factors - including Verizon's decision to move to unlimited data plans, a temporary lull in health care inflation, and a drop in airline fares - have helped keep core inflation in check. The U.S. Economy: It Gets Better Before It Gets Worse Looking out, global growth is likely to remain firm. This should ultimately translate into higher inflation, particularly in the U.S., where the economy has already achieved full employment. Granted, as we discussed last week,1 the U.S. business cycle expansion is getting long in the tooth. However, history suggests that the transition between boom and bust is often accompanied by a revelry of sorts where things get better before they get worse. Call it a "blow-off" phase for the business cycle. The example of the late 1990s - the last time the U.S. unemployment rate fell below NAIRU for an extended period of time - comes to mind. Chart 2 shows that final domestic demand accelerated to 8.3% in nominal terms in Q1 of 2000. Personal consumption growth surged, reaching 8.4% in nominal terms and 5.7% in real terms. Obviously, there are many differences between now and then. However, there is at least one critical similarity: The unemployment rate stood at 4.3% in January 1999. This is exactly where it stands today. And if it keeps falling at its current pace, the unemployment rate will dip below its 2000 low of 3.8% by next summer. As was the case in the past, an overheated labor market will lead to faster wage growth. In the U.S., underlying wage growth has accelerated from 1.2% in 2010 to 2.4% at present (Chart 3). Chart 2The Late 1990s: An End-Of-Cycle Blow-Off The Late 1990s: An End-Of-Cycle Blow-Off The Late 1990s: An End-Of-Cycle Blow-Off Chart 3Stronger Labor Market Is Leading To Faster Wage Growth Stronger Labor Market Is Leading To Faster Wage Growth Stronger Labor Market Is Leading To Faster Wage Growth Granted, this is still well below the levels seen in 2000 and 2007. However, productivity growth has crumbled over the past decade while long-term inflation expectations have dipped. Real unit labor costs - a measure of compensation which adjusts for shifts in productivity growth and inflation - are rising at a faster rate than in 2007 and close to the pace recorded in 2000 (Chart 4). In fact, real wage growth in the U.S. has eclipsed business productivity growth for three straight years (Chart 5). As a result, labor's share of national income is now increasing. Chart 4Real Unit Labor Cost Growth: Back To Its 2000 Peak Real Unit Labor Cost Growth: Back To Its 2000 Peak Real Unit Labor Cost Growth: Back To Its 2000 Peak Chart 5Real Wages Now Increasing Faster Than Productivity Real Wages Now Increasing Faster Than Productivity Real Wages Now Increasing Faster Than Productivity What happens to aggregate demand when the share of income going to workers rises? The answer is that at least initially, demand goes up. Companies typically spend less of every marginal dollar of income than workers. This is especially the case in today's environment where the distribution of corporate profits has become increasingly tilted towards a few winner-take-all firms which, for the most part, are already flush with cash (Chart 6). Thus, a shift of income towards workers tends to boost overall spending. In addition, an overheated labor market typically generates the biggest gains for workers at the bottom of the income distribution. Wages for U.S. workers without a college degree have been rising more quickly than those with a university education for the past few years (Chart 7). Such workers often live paycheck-to-paycheck and, hence, have a high marginal propensity to consume. Chart 6A Winner-Take-All Economy A Winner-Take-All Economy A Winner-Take-All Economy Chart 7Tighter Labor Market Boosting Wages Of Less Educated Workers Tighter Labor Market Boosting Wages Of Less Educated Workers Tighter Labor Market Boosting Wages Of Less Educated Workers Let's Get This Party Started The discussion above suggests that U.S. aggregate demand could accelerate over the next few quarters. There is some evidence that this is already happening (Chart 8). Despite a moderation in auto purchases, real PCE growth is still tracking at 3.2% in the second quarter according to the Atlanta Fed's GDPNow model. And with the personal saving rate still stuck at an elevated 5.3%, there is scope for consumer spending to grow at a faster rate than disposable income. Chart 9 shows that the current saving rate is well above the level one would expect based on the ratio of household net worth-to-disposable income. Chart 8Solid Near-Term Outlook For U.S. Consumers Solid Near-Term Outlook For U.S. Consumers Solid Near-Term Outlook For U.S. Consumers Chart 9 Financial conditions have eased over the past six months thanks to lower Treasury yields, narrower credit spreads, a weaker dollar, and higher equity prices (Chart 10). Historically, an easing in financial conditions has foreshadowed faster growth (Chart 11). This could make the coming blow-off phase even more explosive than in past business cycles. Some commentators have noted that while financial conditions have eased, bank lending has slowed significantly. If true, this would imply that easier financial conditions are not boosting credit growth in the way one might expect. The problem with this argument is that it takes a far too limited view of the U.S. financial system. Although bank lending to companies has indeed slowed, bond issuance has soared. In fact, total nonfinancial corporate debt rose by $212 billion in the first quarter according to the Fed's Financial Accounts database, the largest increase in history (Chart 12). Chart 10Financial Conditions Have Been Easing... Financial Conditions Have Been Easing... Financial Conditions Have Been Easing... Chart 11...Which Will Support Growth ...Which Will Support Growth ...Which Will Support Growth Chart 12Nonfinancial Corporate Debt Surged In Q1 Nonfinancial Corporate Debt Surged In Q1 Nonfinancial Corporate Debt Surged In Q1 All Good Things Must Come To An End Unfortunately, the burst of demand that often occurs in the late stages of business cycle expansions contains the seeds of its own demise. Initially, when consumer spending accelerates, firms tend to react by expanding capacity. This translates into higher investment spending. However, as labor's share of income keeps rising, an increasing number of firms start incurring outright losses. This causes them to dismiss workers and cut back on investment spending. Such a souring in corporate animal spirits is not an immediate risk for the U.S. economy. Hiring intentions remain solid and businesses are still signaling that they expect to increase capital spending over the coming months (Chart 13). Profit margins are also quite high by historic standards, which gives firms greater room for maneuver. This will change over time, however. Margins are already falling in the national accounts data (Chart 14). History suggests that S&P 500 margins will follow suit. This raises the risk that capex and hiring will start to slow late next year, potentially sowing the seeds for a recession in 2019. We remain overweight global equities on a cyclical 12-month horizon, but will be looking to significantly pare back exposure next summer. Chart 13Corporate America Feeling Great Again Corporate America Feeling Great Again Corporate America Feeling Great Again Chart 14Economy-Wide Margins Have Slipped Economy-Wide Margins Have Slipped Economy-Wide Margins Have Slipped The Dollar Bull Market Is Not Over Yet Chart 15Historically, A Rising Labor Share Has Pushed Up The Dollar Historically, A Rising Labor Share Has Pushed Up The Dollar Historically, A Rising Labor Share Has Pushed Up The Dollar Until U.S. growth does decelerate, the path of least resistance for bond yields and the dollar will be to the upside. Chart 15 shows the strikingly close correlation between labor's share of income and the value of the trade-weighted dollar. As noted above, the initial effect of accelerating wage growth is to put more money into workers' pockets. This results in higher aggregate demand and, against a backdrop of low spare capacity, rising inflation. Historically, such an outcome has prompted the Fed to expedite the pace of rate hikes, leading to a stronger dollar. This time is unlikely to be any different. The market is currently pricing in only 21 basis points in Fed rate hikes over the next 12 months. This seems far too low to us. Other things equal, a stronger dollar implies a weaker euro and yen. Improved export competitiveness will lead to better growth prospects and higher inflation expectations in the euro area and Japan. Unless the ECB and the BoJ respond by tightening monetary policy, short-term real rates will fall. This, in turn, could put further downward pressure on the euro and the yen. The ECB And The BoJ Will Not Follow The Fed's Lead Many commentators have argued that better growth prospects will cause the ECB and the BoJ to follow in the Fed's footsteps and take away the punch bowl. We doubt it. Labor market slack is still considerably higher in the euro area than was the case in 2008. Outside of Germany, the level of unemployment and underemployment in the euro area is about seven points higher than it was before the Great Recession (Chart 16). If anything, the market has priced in too much tightening from the ECB. Our months-to-hike measure has plummeted from a high of 65 months in July 2016 to 28 months at present (Chart 17). Investors now expect real rates in the U.S. to be only 23 basis points higher than in the euro area in five years' time. This is well below the 76 basis-point gap in the equilibrium rate between the two regions that Holston, Laubach, and Williams estimate (Chart 18). Chart 16Euro Area: Labor Market Slack Is Still High Outside Of Germany Euro Area: Labor Market Slack Is Still High Outside Of Germany Euro Area: Labor Market Slack Is Still High Outside Of Germany Chart 17ECB: Markets Are Pricing In Too Much Tightening ECB: Markets Are Pricing In Too Much Tightening ECB: Markets Are Pricing In Too Much Tightening Chart 18The Neutral Rate Is Lowest In The Euro Area The Neutral Rate Is Lowest In The Euro Area The Neutral Rate Is Lowest In The Euro Area As for Japan, while it is true that the unemployment rate has fallen to 2.8% - a 22-year low - this understates the true amount of slack in the economy. Output-per-hour in Japan remains 35% below U.S. levels. A key reason for this is that many Japanese companies continue to pad their payrolls with excess labor. This is particularly true in the service sector, which remains largely insulated from foreign competition. In any case, with both actual inflation and inflation expectations in Japan nowhere close to the BoJ's target, this is hardly the time to be worried about an overheated economy. And even if the Japanese authorities were inclined to slow growth, it would be fiscal policy rather than monetary policy that they would tighten first. After all, they have been keen to raise the sales tax for several years now. The Pound Will Rebound Against The Euro, But Weaken Further Against The Dollar Chart 19Pound: Unloved And Underappreciated Pound: Unloved And Underappreciated Pound: Unloved And Underappreciated While we continue to maintain a strong conviction view that the euro and yen will weaken against the dollar, we are more circumspect about other currencies. Bank of England Governor Mark Carney played down speculation this week that the BoE would raise rates later this year, noting in his annual speech at London's Mansion House that "now is not yet the time to begin that adjustment." U.K. growth has been the weakest in the G7 so far in 2017, partly because of growing angst over the forthcoming Brexit negotiations. Nevertheless, U.K. inflation remains elevated and fiscal policy is likely to be eased in the November budget, as Chancellor Hammond confirmed in a BBC interview on Sunday. Sterling is already quite cheap based on our metrics (Chart 19). Our best bet is that the pound will weaken against the dollar over the next 12 months but strengthen against the euro and the yen. We are currently long GBP/JPY. The trade has gained 7.2% since we initiated it in August 2016. CAD Has Upside We went long CAD/EUR in May. Despite the downdraft in oil prices, the trade has managed to gain 2.6% thus far. We are optimistic on the Canadian dollar over the coming months. Our energy strategists remain convinced that crude prices are heading higher. They expect global production to increase by only 0.7 MMB/d in 2017, compared to 1.5 MMB/d growth in consumption. Consequently, oil inventories should fall over the remainder of this year. If history is any guide, this will lead to a rebound in oil prices (Chart 20). The Bank of Canada has also turned more hawkish. Senior Deputy Governor Carolyn Wilkins suggested last week that interest rates are likely to rise later this year. The market is now pricing in a 84% chance of a rate hike in 2017, up from only 18% earlier this month. The Canadian economy continues to perform well (Chart 21). Retail sales are growing briskly, the unemployment rate is close to its lowest level in 40 years, and goods exports are recovering thanks to a weak loonie and stronger growth south of the border. While the bubbly housing market remains a source of concern, this is as much a reason to raise interest rates - to prevent further overheating - as to cut them. Chart 20Falling Oil Inventories Should Lead To Higher Crude Prices Falling Oil Inventories Should Lead To Higher Crude Prices Falling Oil Inventories Should Lead To Higher Crude Prices Chart 21Canadian Economy: Chugging Along Canadian Economy: Chugging Along Canadian Economy: Chugging Along China Will Drive The Aussie Dollar And EM Assets After a very strong start to the year, Chinese growth has slipped a notch. Housing starts slowed in May, as did gains in property prices. M2 growth decelerated to 9.6% from a year earlier, the first time broad money growth has fallen into the single-digit range since the government began publishing such statistics in 1986. Still, the economy is far from falling off a cliff, as evidenced by the fact that the IMF upgraded its full-year 2017 GDP growth forecast from 6.6% to 6.7% last week. Real-time measures of industrial activity such as railway freight traffic, excavator sales, and electricity production remain upbeat. Export growth is accelerating thanks to a weaker currency and stronger global growth. The PBoC's trade-weighted RMB basket has fallen by over 8% since it was introduced in December 2015. Retail sales continue to expand at a healthy clip. The percentage of households that intend to buy a new home has also surged to record-high levels. This should limit the fallout from the government's efforts to cool the housing market. The rebound in exports and industrial output is helping to lift producer prices. Higher selling prices, in turn, are fueling a rebound in industrial company profits (Chart 22). A better profit picture should support business capital spending in the coming months. The government also remains cognizant of the risks of tightening policy too aggressively, especially with the National Party Congress slated for this autumn. The PBoC injected 250 billion yuan into the financial system last Friday. This was the single biggest one-day intervention since January, when demand for cash was running high in the lead up to the Chinese New Year celebrations. Fiscal policy has also been eased (Chart 23). So far, the "regulatory windstorm" of measures designed to clamp down on financial speculation has largely bypassed the real economy. Medium and long-term lending to nonfinancial corporations - a key driver of private-sector capital spending - has actually accelerated over the past eight months (Chart 24). Chart 22China: Higher Selling Prices Fuelling A Rebound In Profits China: Higher Selling Prices Fuelling A Rebound In Profits China: Higher Selling Prices Fuelling A Rebound In Profits Chart 23Fiscal Spending Is On The Mend Fiscal Spending Is On The Mend Fiscal Spending Is On The Mend Chart 24China: Credit To The Real Economy Is Accelerating China: Credit To The Real Economy Is Accelerating China: Credit To The Real Economy Is Accelerating The key takeaway for investors is that Chinese growth is likely to slow over the next few quarters, but not by much. Considering that fund managers surveyed by BofA Merrill Lynch in June cited fears of a hard landing in China as the biggest tail risk facing financial markets for the second month in a row, the bar for positive surprises out of China is comfortably low. If China can clear this bar, as we expect it will, it will be good news for the Aussie dollar and other commodity plays. Strong Chinese growth should provide a tailwind for EM assets. However, EM stocks and currencies have already had a major run, which limits further upside. The fact that serial-defaulter Argentina could issue a 100-year bond this week in an offering that was three times oversubscribed is a testament to that. The fundamental problems plaguing many emerging markets - high debt levels, poor governance, and lackluster productivity growth - remain largely unaddressed. Until they are, the long-term outlook for EM assets will continue to be challenging. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," dated June 16, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades