Emerging Markets

Highlights By now, the Kingdom of Saudi Arabia (KSA) and Russia have figured out that if each cuts 500k b/d of production, the revenue enhancement for both will be well worth the foregone volumes. Even without additional cuts from other OPEC and non-OPEC producers - most of whom already have seen output drop as a result of OPEC's market-share war - KSA and Russia benefit. A 1mm b/d cut would accelerate the draw in oil inventories next year, allowing U.S. shale-oil producers to quickly move to replace shut-in output. Importantly, shale producers' marginal costs will then begin to set market prices. Longer term, KSA and Russia would have to manage their production in a way that keeps shale on the margin. Whether they can continue to cooperate over the long term remains to be seen. Energy: Overweight. We are recommending investors go long February 2017 $50 Brent calls vs. short $55 Brent calls, in anticipation of a production cut from KSA and Russia. Base Metals: Neutral. We remain neutral base metals, despite the better-than-expected PMIs for China reported earlier this week. Precious Metals: Neutral. We are moving our gold buy-stop to $1,250/oz from $1,210/oz, expecting higher core PCE inflation. Ags/Softs: Underweight. We are recommending a strategic long position in Jul/17 corn versus a short in July/17 sugar. Feature The options market gives a 43% probability to Brent prices exceeding $50/bbl by the end of this year (Chart of the Week). We think these odds are too low, given our expectation KSA and Russia will announce production cuts of 500k b/d each at the OPEC meeting scheduled for November 30, 2016 in Vienna. Chart of the WeekOptions Probability Brent Exceeds $50/bbl By Year-End Is Less Than 50% Raising The Odds Of A KSA-Russia Oil-Production Cut Raising The Odds Of A KSA-Russia Oil-Production Cut A production cut totaling 1mm b/d - plus whatever additional volumes are contributed by GCC OPEC members - will, in all likelihood, send Brent prices back above $50/bbl by year end. This is a fairly high-conviction call for us: We are putting the odds prices will exceed $50/bbl by year-end closer to 80%. As such, we are opening a Brent call spread, getting long February 2017 $50 Brent calls vs. short $55 Brent calls, in anticipation of this production cut from KSA and Russia.1 There are two simple facts driving our assessment: KSA and Russia are desperate for cash - they're both trying to source FDI, and will continue to need external financing for years. They can't wait for supply destruction to remove excess production from the market, given all they want to accomplish in the next two years. The vast majority of income for these states is derived from hydrocarbon sales - 70% by one estimate for Russia, and 90% for KSA - and both have seen painful contractions in their economies during the oil-price collapse, which forced them to cut social spending, raise fees, issue bonds and sell sovereign equity assets.2 With the exception of KSA, Russia, Iraq and Iran, most of the rest of the producers in the world have seen crude oil output fall precipitously - particularly poorer non-Gulf OPEC states (Chart 2), and market-driven economies like the U.S. (Chart 3). Thus, KSA's insistence that others bear the pain of cutting production has already been realized. Iran and Iraq, which together are producing ~ 8mm b/d, maintain they should be exempt from any production freeze or cut, given their economies are in the early stages of recovering from economic sanctions related to a nuclear program and years of war, respectively. Chart 2GCC OPEC Production Surges, ##br##Non-Gulf OPEC Production Collapses bca.ces_wr_2016_11_03_c2 bca.ces_wr_2016_11_03_c2 Chart 3Russia' Gains Lift Non-OPEC Production;##br## U.S. Declines Continue bca.ces_wr_2016_11_03_c3 bca.ces_wr_2016_11_03_c3 Why Would KSA And Russia Act Now? Neither trusts the other, which is why neither cut production unilaterally to accelerate storage drawdowns. Any unilateral cut would have ceded market share to the arch rival. Both states have gone to great efforts to show they can increase production even in a down market, just to make the point that they would not give away hard-won market share (Chart 4). Chart 4KSA and Russia Devoted##br## Significant Resources to Lift Production bca.ces_wr_2016_11_03_c4 bca.ces_wr_2016_11_03_c4 These states are at polar-opposite ends of the geopolitical spectrum - KSA is supporting Iran's enemies in proxy wars throughout the Middle East, while Russia is supporting Iran and its allies. In the oil markets, they are both going after the same customers in Asia and Europe. Each state had to convince the other it could endure the pain of lower prices, which brought both to the table at Algiers, and allowed their continued dialogue since then to flourish. Globally, the market rebalancing already is mostly - if not completely - done. Excess production has been removed from the market, and very shortly we will see inventory drawdowns accelerate. But, if KSA and Russia leave this process to the market, we may be looking at 2017H2 before stocks start to draw hard. By cutting production now, KSA and Russia accelerate the stock draw and hasten the day when shale is setting the marginal price in the market. While shale now is comfortably in the middle of the global cost curve, it still sits above KSA's and Russia's cost curve, which means the marginal revenue to both will be higher than if their marginal costs are driving global pricing. Both states have a lot they want to do next year and in 2018: Russia is looking to sell 19.5% of Rosneft; KSA is looking to issue more debt and IPO Aramco. Both must convince FDI that the money that's invested in their industries will not be wasted because production has not been reined in. And, they both must keep restive populations under control. Cutting production by 1mm b/d or more would push prices back above $50/bbl, perhaps higher, resulting in incremental income of some $50mm to $75mm per day for KSA and Russia. Viewed another way, the incremental revenue generated annually by higher prices brought on by lower production would service multiples of KSA's first-ever $17.5 billion global debt issue brought to market last month. Both KSA and Russia will be able to lever their production more - literally support more debt issuance - by curtailing production now. KSA will need that leverage to pull off the diversification it is attempting under its Vision 2030 initiative. Russia would be able to do more with higher revenues, as well. Balances Point To Supply Deficit Next Year The meetings - "sideline" and otherwise - in Algiers, Istanbul and Vienna over the past month or so at various producer-consumer conclaves were attended mostly by producers that already have endured painful revenue cutbacks brought on by the OPEC market-share war declared in November 2014. Even those producers that did not endure massive production cuts - e.g., Canada, where oil-sands investments sanctioned prior to the price collapse continue to come on line despite low prices - will see far lower E&P investment activity going forward, given the current price environment. Chart 5Oil Markets Will Go Into Deficit Next Year Oil Markets Will Go Into Deficit Next Year Oil Markets Will Go Into Deficit Next Year Global oil supply growth will be relatively flat this year and next (Chart 5). This will create a physical deficit in supply-demand balances, even with our weaker consumption-growth expectation: We've lowered our growth estimate to 1.30mm b/d this year, and expect 1.34mm b/d growth next year. We revised demand growth lower based on actual data from the U.S. EIA and weaker projections for global growth.3 Among the major producers, only Iran, Iraq, KSA, and Russia increased output yoy. North America considered as a whole is down despite Canada's gains, and will stay down till 2017H2, based on our balances assessments. South America is essentially flat this year and next. The North Sea's up slightly this year, down more than 5% yoy in 2017, while the Middle East ex-OPEC is flat. Lastly, we expect China's production to be down close to 7% this year, and almost 4% next year. Managing The KSA-Russia Production Cut If KSA and Russia can cut 1mm b/d of production, they'd have to actively manage global balances so that the U.S. shale barrel meets the bulk of demand increases, while conventional reserves fill in decline-curve losses. Iran and Iraq together will be up 1mm b/d this year, but only 350k b/d next year. Both states are going to have a tough time attracting FDI to accelerate production gains, although ex-North America, these states probably have a higher likelihood of attracting investment than Non-Gulf OPEC, which is in terrible shape, and will have a hard time funding projects. Recently recovered Libyan and Nigerian output likely is the best they will be able to do until additional FDI arrives.4 At low price levels, even KSA can't realize the full value of the assets it is attempting to sell and the debt it will be servicing (lower prices mean lower rating from rating agencies). This is a worry for KSA, as it looks to IPO 5% of Aramco and issue more debt.5 Without higher prices, they will need to continue to slash spending, cut defense budgets, salaries and bonuses, and begin to levy taxes and fees. Below $50/bbl Brent, Russia faces similar constraints, and cannot expect to realize the full value of the 19.5% share of Rosneft it hopes to sell into the public market. Net, if KSA and Russia can get prices up above $50/bbl by cutting 1mm from their combined production and increase their gross revenues doing so, it's a major win for them. Such a cut would bring forward the global inventory drawdown we presently see picking up steam in 2017H2 without any reductions in production. In addition, because International Oil Companies (IOCs) are limited in terms of capex they can deploy to invest in National Oil Company (NOC) projects, conventional oil reserves will not be developed in the near term due to funding constraints. That, and higher capex being devoted to the U.S. shales, will keep a lid on production growth ex-U.S. Given how we see investment in production playing out over the medium term - i.e., 3 - 5 years - it will fall to the U.S. shales and Iran-Iraq production to find the barrels to meet demand increases and to replace production lost to natural declines. Given that we expect non-Gulf OPEC yoy production in 2017 to be down close to 1.3mm b/d (or -13%), and that we expect Brazil to be flat next year, cutting 1mm b/d from KSA and Russia's near-record levels of production is a bet both states will find worth taking, in order to lift and stabilize prices over the medium term. GCC OPEC production is expected to be up ~ 1% next year, or ~ 150kb/d, so these states have some scope for reducing output, as well. Price Implications If KSA and Russia Cut If we do indeed see KSA and Russia reduce output 1mm b/d as we expect, we expect storage draws will likely accelerate next year, which will flatten WTI and Brent forward curves, and send both into backwardation (Chart 6). We also would expect prices to move toward $55/bbl in the front of the WTI and Brent forward curves, once the storage draws start backwardating these curves. This would be a boon to KSA's and Russia's gross revenues, generating ~ $75mm a day of incremental revenue post-production cuts. Chart 6Expect Backwardation With ##br##A KSA-Russia Production Cut bca.ces_wr_2016_11_03_c6 bca.ces_wr_2016_11_03_c6 Given this expected dynamic, we recommend going long a February 2017 Brent call spread: Buy the $50 Brent call and sell the $55/bbl Brent call. We also recommend getting long WTI front-to-back spreads expecting a backwardation by mid-year or thereabouts: Specifically, we recommend getting long August 2017 WTI futures vs. short November 2017 WTI futures. This scenario also will be bullish for our Energy Sector Strategy's preferred fracking Equipment services companies, HAL and SLCA. ...And if They Fail to Cut Production? If KSA and Russia fail to cut production, and instead freeze it or raise output following the November OPEC meeting, the market will quickly look through their inaction and continue to price to the actual supply destruction we've been observing for the better part of this year. In such a scenario, prices will push into the lower part of our expected $40 to $65/bbl price range for a longer period of time, which not only will prolong the financial stress of OPEC and non-OPEC producers, but will keep the probability of a significant loss of exports from poorer OPEC states elevated. Either way, global inventories will be significantly reduced by the end of 2017, either because of a production cut by KSA and Russia, or because of continued supply destruction brought about by lower prices. Bottom Line: We expect KSA and Russia to announce a 1mm b/d production cut at the upcoming OPEC meeting at the end of this month. This will rally crude oil prices above $50/bbl, and accelerate the drawdown in global storage levels, which will backwardate Brent and WTI forward curves. We recommend getting long Feb17 $50/bbl Brent calls vs. short $55/bbl Brent calls, and getting long Jul17 WTI vs. short Nov17 WTI futures in anticipation of these cuts. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com SOFTS Sugar: Downgrade To Strategically Bearish, Look To Go Long Corn Vs. Sugar We downgrade our strategic sugar view from neutral to bearish, as we expect a much smaller supply deficit next year. We also downgrade our tactical sugar view from bullish to neutral, as prices have already surged over 120% since last August. We expect corn to outperform sugar in 2017. Brazil will likely increase its imports of cheaper U.S. corn-based ethanol. We look to long July/17 corn versus July/17 sugar if the price ratio drops to 17 (current: 17.94). If the position gets filled, we suggest a 5% stop-loss to limit the downside risk. Sugar prices have rallied more than 120% since last August on large supply deficits and an extremely low global stock-to-use ratio (Chart 7). Falling acreage and unfavorable weather have reduced sugarcane supplies from major producing countries Brazil, India, China and Thailand. Chart 7Sugar Tactically Neutral, Strategically Bearish bca.ces_wr_2016_11_03_c7 bca.ces_wr_2016_11_03_c7 Tactically, We Revise Our Sugar View From Bullish To Neutral. Sugar prices are likely to stay high over next three to six months on tight supplies. The global sugar stock-to-use ratio is at its lowest level since 2010 (Chart 7, panel 3). Inventories in India and China fell to a six-year low while inventories in the European Union (EU) were depleted to all-time lows. These three regions together accounted for 36.7% of global sugar consumption last year. However, we believe prices will have limited upside over next three to six months. Despite tight inventories, India and China likely will not increase imports. India currently has a 40% tax on sugar imports, and the government also imposed a 20% duty on its sugar exports in June to boost domestic supply. China started an investigation into the country's soaring sugar imports in late September. The probe will last six months, with an option to extend the deadline. In the meantime, other sugar importers likely will reduce or delay their sugar purchases because of currently high prices. Lastly, speculative buying is running out of steam, as traders already are deeply long sugar - net speculative positions as a percentage of total open interest is sitting at record-high levels (Chart 7, panel 4). Strategically, We Downgrade Our Sugar View From Neutral To Bearish. Assuming normal weather conditions across major producing countries next year, we believe the global sugar market will have a much smaller supply deficit over a one-year time horizon. Although sugar prices in USD terms reached their highest level since July 2012, prices in other currencies actually rose to all-time highs (Chart 8). Record high sugar prices in these countries will encourage planting and investment, which will consequently result in higher sugar production, especially in Brazil, India and Thailand. This year, due to adverse weather during April-September, the USDA has revised down its sugarcane output estimates for Brazil and Thailand by 3.2% and 7.1%, respectively. Assuming a return of normal weather next year, we expect sugarcane output in these two countries to recover. Farmers in China and India have cut their sown acreage for sugarcane this year on extremely low prices late last year and early this year. With prices up significantly in the latter half of this year, we expect sugar output in these two countries to rebound on acreage recovery as well. In addition, Brazilian sugar mills have clearly preferred producing sugar over ethanol so far this year on surging global sugar prices. According to the Brazilian Sugarcane Industry Association (UNICA), for the accumulated production until October 1, 2016, 46.31% of sugarcane was used to produce sugar, a considerable increase from 41.72% for the same period of last year. We expect this trend to continue in 2017, adding more sugar supply to the global market. Moreover, as the market becomes more balanced next year, speculators will likely unwind their huge long positions, which may accelerate a price drop sometime next year (Chart 7, panel 4). Where China Stands In The Global Sugar Market? China is the world's biggest sugar importer, the third-largest consumer and the fifth-biggest producer, accounting for 14.2% of global imports, 10.3% of global consumption and 4.9% of global production, respectively (Chart 9, panel 1). Chart 8Sugar Supply Will Increase In 2017 bca.ces_wr_2016_11_03_c8 bca.ces_wr_2016_11_03_c8 Chart 9Chinese Sugar Imports May Slow Chinese Sugar Imports May Slow Chinese Sugar Imports May Slow Sugar production costs are much higher in China than in Brazil and Thailand, due to higher wages and low rates of mechanization. Falling sugar prices in 2011-2015 further reduced the profitability of Chinese sugar producers. As a result, the sugarcane-sown area in China has dropped 24% in three years, resulting in a huge supply deficit (Chart 9, panel 2). Because domestic prices are much higher than global prices, the country has boosted its imports rapidly in recent years (Chart 9, panel 3). We believe, in the near term, the recently announced investigation into surging sugar imports will slow the inflow of sugar into the country, which will be negative for global sugar prices. In the longer term, the sugarcane-sown area in China will recover on elevated sugar prices, indicating the country's production is set to rebound, which likely will reduce its sugar imports. This is in line with our strategic bearish view. Chart 10Corn Is Likely To Outperform Sugar In 2017 bca.ces_wr_2016_11_03_c10 bca.ces_wr_2016_11_03_c10 Risks To Our Sugar View In the near term, sugar prices could rally further on negative weather news or if the USDA revises down its estimates of global sugar production and inventories. Prices also could go down sharply if speculators unwind their huge long positions before the year end. We will re-evaluate our sugar view if one of these risks materializes. In the long term, if adverse weather occurs and damages the Brazilian sugarcane yield outlook for next season, which, in general starts harvesting next April, we may upgrade our bearish view to bullish. How To Profit From The Sugar Market? In the softs market, we continue to prefer relative-value trades to outright positions. With regards to sugar, we look to go long corn vs. short sugar, as we expect corn to outperform sugar in 2017. Both sugar and corn are used in ethanol production. Ethanol is also a globally tradable commodity. While sugar prices rose to four-year highs, corn prices fell to seven-year lows, resulting in a significant increase in Brazilian sugar-based ethanol production costs and a considerable drop in U.S. corn-based ethanol production costs. We believe the current high sugar/corn price ratio is unlikely to sustain itself, as Brazil will likely increase its imports of cheaper U.S. corn-based ethanol (Chart 10, panels 1, 2 and 3). In addition, global ethanol importers will also prefer buying U.S. corn-based ethanol over Brazilian sugar-based ethanol. Eventually, this should bring down the sugar/corn price ratio to its normal range. Therefore, we look to long July/17 corn versus July/17 sugar if the price ratio drops to 17 (current: 17.94) (Chart 10, panel 4). If the position gets filled, we suggest a 5% stop-loss to limit the downside risk. In addition to the risks related to the fundamentals, this pair trade also faces the risk of a steep contango in the corn futures curve, and a steep backwardation in the sugar futures curve. The July/17 corn prices are 6.2% higher than the nearest futures prices and July/17 sugar prices are 5.2% lower than the nearest sugar futures prices. Long Wheat/Short Soybeans Relative Trade On another note, our long Mar/17 wheat/short Mar/17 soybeans relative trade was stopped out at a 5% loss on October 26. We still expect wheat to outperform soybeans over next three to six months. We will re-initiate this relative trade if the ratio drops to 0.41 (current: 0.426) (Chart 10, bottom panel). Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com 1 The Feb17 options expire 22 December 2016, three weeks after the OPEC meeting. 2 Please see Commodity & Energy Strategy Weekly Report "Ignore The KSA - Russia Production Pact, Focus Instead On The Need For Cash," dated September 8, 2016, available at ces.bcaresearch.com. 3 The IMF expects slightly slower global GDP growth this year (3.1%), and a slight pick-up next year (3.4%). Please see "Subdued Demand, Symptoms and Remedies," in the October 2016 IMF World Economic Outlook. 4 Please see "OPEC Special-Case Nations Add 450,000 Barrels in Threat to Deal," by Angelina Rascouet and Grant Smith, published by Bloomberg news service November 2, 2016. 5 Please see Commodity & Energy Strategy Weekly Report "Desperate Times, Desperate Measures: Aramco And The Saudi Security Dilemma," dated January 14, 2016, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Closed Trades

Highlights The RMB will continue to drift lower against a broadly stronger dollar, but the risk of chaotic depreciation is very low. The TWD will likely remain strong in the near term, mostly due to the unyielding strength in the JPY, but it should depreciate both against the dollar and in trade-weighted terms over the medium-to-long term. Hong Kong's currency peg will not be challenged, and will rise along with the greenback, but this will prove to be deflationary for its economy and asset prices. Feature The broad trend in the U.S. dollar will remain the dominant global macro force in the near term, which in turn will dictate the performances of the three currencies in the Greater China region. Historically these currencies have had a lower "beta" - i.e. systematically lower volatility than most of their global peers. This week we review the unique driving forces behind these currencies and the cyclical dynamics of their respective economies. In a nutshell, the fundamentals of these currencies are stronger than most of their global counterparts, which diminishes the odds of outsized depreciation. Therefore, they will remain "low-beta" plays, and may even appreciate in trade-weighted terms as the dollar strengthens. The RMB: Drifting With The Flow The USD/CNY has now approached 6.8, the level at which the RMB was essentially pegged to the dollar post the global financial crisis until late 2010 (Chart 1). This has raised speculation that the People's Bank of China (PBoC) may once again soft-peg the RMB around current levels to the U.S. dollar. While there is no doubt that the PBoC will maintain tight control over the exchange rate, it is impossible to predict how the central bank intends to control it in the near term. We suspect the path of least resistance is for the RMB to continue to drift lower against a broadly stronger dollar, but the risk of chaotic depreciation is very low. First, much of the RMB's valuation froth has been cleansed through a combination of nominal depreciation and lower inflation. The RMB's 12% depreciation against the dollar since its all-time peak in January 2014 has erased all the gains since 2010 and has weakened the currency by over 10% in real effective terms since its historical high in mid-2015 - non-trivial moves for a tightly managed currency. Our models suggest that the RMB is no longer overvalued either against the dollar or in real effective terms, as discussed in recent reports.1 Similarly the trade-weighted RMB has been oscillating around a well-defined uptrend in the past decade, and it depreciation since last year has pushed the currency from a two-sigma overshoot above its long-term trend to a two-sigma undershoot (Chart 2). Chart 1Will The RMB Be Re-pegged? Will The RMB Be Re-pegged? Will The RMB Be Re-pegged? Chart 2The RMB And Long Term Trend The RMB And Long Term Trend The RMB And Long Term Trend Second, most market participants have focused squarely on the destabilizing impact of the RMB depreciation, but have ignored the reflationary benefits of a weaker currency. For a large open economy, the exchange rate matters materially. The RMB's 10% depreciation in trade-weighted terms has significantly boosted profit margins of Chinese exporters. Even though export prices measured in dollar terms are still declining, they have increased sharply in RMB terms, boosting profits as well as overall industrial activity (Chart 3). The most recent readings of purchasing managers' surveys released early this week confirm that the manufacturing sector has continued to recover, and currency weakness may be an important factor behind the regained strength (Chart 4). In the near term, the performance of the USD/CNY is largely dictated by the dollar's trend, but the downside of the RMB should be self-limiting, as the reflationary impact of a weaker exchange rate will help boost Chinese growth, which in turn will reduce downward pressure on the Chinese currency. Chart 3A Weaker RMB Helps Exporters' Profits A Weaker RMB Helps Exporters' Profits A Weaker RMB Helps Exporters' Profits Chart 4A Weaker RMB Leads Cyclical Recovery A Weaker RMB Leads Cyclical Recovery A Weaker RMB Leads Cyclical Recovery Finally, the risk of major RMB depreciation largely hinges on whether China would suffer massive capital flight that depletes its foreign exchange reserves. The risk certainly cannot be ignored, but the odds are low for now. The lion's share of China's capital outflows in the past two years have been attributable to Chinese firms paying back borrowings in foreign currencies. Therefore, the pressure for capital outflows will diminish as foreign debts are paid back (Chart 5). In addition, we expect Chinese regulators to strengthen capital account restrictions. Early this week, the authorities further tightened regulations for residents purchasing overseas insurance products. It is likely they will further crack down on administrative loopholes to hinder capital outflows. Bottom Line: Expect further weakness in the RMB/USD, but odds of material depreciation are low. The Strong TWD Will Hurt In contrast to the RMB, the Taiwanese dollar has in fact appreciated both against the dollar and in trade-weighted terms so far this year, likely due to the strong Japanese yen (Chart 6). Taiwan competes with Japan in similar value-added segments in the global supply chain, and therefore their currencies have historically been closely correlated. In this vein, the Bank of Japan's failed attempts to further weaken the yen against the dollar has also effectively boosted the Taiwanese currency. Chart 5Chinese Companies Rushed To##br## Pay Back Foreign Debt Greater China Currencies: An Overview Greater China Currencies: An Overview Chart 6TWD And JPY: Joined At The Hip TWD And JPY: Joined At The Hip TWD And JPY: Joined At The Hip From a valuation perspective, the TWD appears cheap based on standard purchasing power parity assessment. Nonetheless, with exports accounting for over 50% of Taiwan's GDP, a strong currency is neither desirable nor affordable. Similar to Japan, Taiwan's headline consumer price inflation has been uncomfortably low, rising by a mere 0.33% in September from a year ago. Meanwhile, the rising TWD will continue to depress corporate sector pricing power. Wholesale prices of manufactured goods, after briefly moving into positive territory earlier this year, have crashed back into deflation in recent months alongside the strong TWD (Chart 7, top panel). Furthermore, the untimely strength in the exchange rate may short-circuit Taiwan's nascent growth recovery that has been budding in recent months. Export orders, after rising at an above 8% annual rate in previous months, have already begun to roll over, and will likely come under further downward pressure inflicted by the exchange rate (Chart 7, bottom panel). Furthermore, overall inventory levels in the economy have been rising in recent years. Chart 8 shows that manufacturers' inventory-to-shipment ratio has increased notably since 2011. The combination of a potential slowdown in new orders and elevated inventory levels bodes poorly for industrial production and overall business activity. Chart 7A Strong TWD Is Deflationary A Strong TWD Is Deflationary A Strong TWD Is Deflationary Chart 8Inventory Level Has Been Rising Inventory Level Has Been Rising Inventory Level Has Been Rising To be sure, with its chronic current account surplus and an outsized foreign exchange reserve, Taiwan is much better equipped than most of its global and EM peers to deal with external turmoil. As a large net creditor nation, the risk of a typical balance-of-payment crisis and chaotic currency depreciation is not in the cards. The problem for Taiwan is that the TWD has become unduly strong, which could lead to quick growth deterioration and in turn sow the seeds for currency depreciation. Bottom Line: In the near term we expect the TWD to remain strong, mostly due to the unyielding strength in the JPY, but it should depreciate both against the dollar and in trade-weighted terms over the medium- to long term. We will be looking for opportunities to short the TWD/USD in the coming months. The HKD Peg Will Remain Solid The Hong Kong dollar has remained remarkably strong against the dollar in recent months, despite the broad dollar bull market (Chart 9). In the spot market, the HKD/USD has been hovering around the stronger end of the convertibility undertaking. In the forward market, the HKD non-deliverable forward (NDF) contract's premium over the dollar has widened notably in recent weeks. We suspect stronger demand for the HKD is mainly from the mainland, as it is viewed as an alternative to the greenback. Furthermore, the RMB cash accumulated in Hong Kong in previous years is being unwound (Chart 10). RMB deposits at Hong Kong banks have almost halved in the past year, but remain elevated. They may continue to be converted back into HKD supporting its exchange rate. Chart 9The HKD Still Faces Upward Pressure The HKD Still Faces Upward Pressure The HKD Still Faces Upward Pressure Chart 10HK RMB Deposits May Continue To Unwind HK RMB Deposits May Continue To Unwind HK RMB Deposits May Continue To Unwind More fundamentally, compared with the late 1990s' episode when the HKD was under furious speculative attack, the HKD's current valuation is substantially cheaper. In 1997 when the Asian crisis erupted, the Hong Kong economy had just gone through a massive inflationary boom, which dramatically pushed up its real effective exchange rate (Chart 11). This in of itself created acute deflationary pressure, which had to be corrected by either nominal exchange rate depreciation or domestic price declines. By defending the currency peg, the Hong Kong authorities opted for price deflation to realign the then-overvalued HKD. This time around, Hong Kong's real effective exchange rate is just above its all-time low, and there are no clear signs that the economy is facing strong deflationary pressures that would call for meaningful exchange rate adjustment. Similar to China and Taiwan, a strong HKD pegged to a rising USD is not ideal for the Hong Kong economy due to its heavy dependence on external demand, particularly from the mainland. Already, mainland tourism to Hong Kong has begun to moderate, and average spending among foreign tourists has dropped significantly in the past few years - at least partially attributable to the strong HKD (Chart 12). More importantly, further HKD strength will continue to tighten Hong Kong's monetary conditions, which fundamentally matters for its asset prices. As discussed in detail in previous reports,2 tightening monetary conditions are particularly bearish for real estate prices, which are already in "bubble" territory. The downside in Hong Kong stocks should be limited due to their deeply depressed valuation parameters. Chart 11The HK Dollar Is Not Expensive The HK Dollar Is Not Expensive The HK Dollar Is Not Expensive Chart 12Tourists' Spending And Exchange Rate Tourists" Spending And Exchange Rate Tourists" Spending And Exchange Rate Bottom Line: Hong Kong's currency peg will not be challenged, and the trade-weighted HKD will rise along with the greenback, but this will prove to be deflationary for its economy and asset prices. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Can The RMB Withstand More Fed Rate Hikes?", dated September 1, 2016; and China Investment Strategy Weekly Report, "The RMB's Near-Term Dilemma And Long-Term Ambition", dated October 20, 2016, available at cis.bcaresearch.com 2 Please see China Investment Strategy Weekly Report, "Hong Kong: From Politics To Political Economy", dated September 8, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Chile's economy is headed for recession. Facing strong external and domestic headwinds, any policy stimulus will be too late to prevent the impending contraction in economic activity. Investors should receive 3-year interest swaps and stay short CLP / long USD. South Africa's cyclical and structural outlook remains bleak. Banks have been selling foreign assets and repatriating capital which has helped the rand to appreciate. However, as this capital repatriation tapers, the rand will enter a renewed bear market. Stay short the rand versus the U.S. dollar and long MXN / short ZAR. Feature Chile: Stimulus Will Arrive Too Late To Prevent Recession Chart I-1Chile: From Stagflation To Recession? Chile: From Stagflation To Recession? Chile: From Stagflation To Recession? The stagflationary environment in Chile over the past two years - a combination of sluggish growth and high inflation - will give way to outright recession (Chart I-1). As economic activity downshifts further, we are doubtful that policymakers will be able to push through stimulus measures in time, and of sufficient size, to stave off recession. On the fiscal front, the government is unlikely to preemptively engage in a significant spending push. The deceleration in economic activity will soon translate into lower fiscal revenue at a time when the fiscal deficit is already quite wide, at 2.8% of GDP. Furthermore, a renewed fall in copper prices (more on this below) means mining revenue will also be weaker than currently expected, inflicting substantial damage on the government's budget. Meanwhile, monetary policy is unlikely to become stimulative in the near term. Having concluded a two-year battle to tame sticky core inflation, the central bank is unlikely cut interest rates too fast. Besides, as the current term of Central Bank President Rodrigo Vergara ends in December, chances of a new rate cut cycle before he is replaced are low. On the whole, the lack of imminent policy stimulus means economic growth is set to fall much further. Investors can profit by receiving 3-year swap rates (Chart I-2). Although the central bank will be late to cut rates, long-term interest rates will fall because Chilean growth is facing strong headwinds on several fronts: Copper prices have failed to rally amid the reflation trade of the past nine months, and are set to drop to new lows as Chinese property construction and demand for industrial metals contracts anew (Chart I-3). As a result, copper exports will continue to act as a serious drag on Chilean growth (Chart I-4). Chart I-2Receive 3-Year Interest ##br##Rate Swaps In Chile Receive 3-Year Interest Rate Swaps In Chile Receive 3-Year Interest Rate Swaps In Chile Chart I-3China's Industrial Metals ##br##Demand To Contract China's Industrial Metals Demand To Contract China's Industrial Metals Demand To Contract Chart I-4Exports Will Remain ##br##A Drag On Growth Exports Will Remain A Drag On Growth Exports Will Remain A Drag On Growth Capital expenditures will contract, partially due to very downbeat business confidence owing to the uncertain political environment created by the government's reforms agenda since 2014 (Chart I-5, top panel). As discussed in detail in our December 2014 Special Report on Chile,1 from a big-picture perspective, these reforms have shifted the structure of the economy toward higher government expenditures at the expense of the private sector. This has severely eroded business confidence. In addition, the downturn in the housing market will gain momentum, further depressing activity (Chart I-5, bottom panel). Meanwhile, employment growth has been weak and income growth has been decelerating steadily - and we foresee further downside ahead (Chart I-6). Importantly, the economy's credit impulse is now turning negative (Chart I-7). Higher delinquencies in turn will force banks to curtail lending going forward. Chart I-5Chile: Capex To Remain Weak Chile: Capex To Remain Weak Chile: Capex To Remain Weak Chart I-6Chile: Labor Market Will Weaken Further Chile: Labor Market Will Weaken Further Chile: Labor Market Will Weaken Further Chart I-7Negative Credit Impulse##br## Will Weigh On Growth Negative Credit Impulse Will Weigh On Growth Negative Credit Impulse Will Weigh On Growth Finally, narrow (M1) money supply growth, a very good leading indicator for economic activity, is now decelerating sharply (Chart I-8). Consistently, our marginal propensity to consume proxy points to weak spending and lower consumer price inflation (Chart I-9). Chart I-8Chile: Narrow Money Growth, ##br##Economic Activity And Inflation Chile: Narrow Money Growth, Economic Activity And Inflation Chile: Narrow Money Growth, Economic Activity And Inflation Chart I-9Consumption Is Set ##br##To Decelerate Further Consumption Is Set To Decelerate Further Consumption Is Set To Decelerate Further The economy has developed considerable downward momentum. Any policy stimulus is likely to come too late to prevent the economy from falling into recession. Therefore, local interest rates in Chile are headed to new lows. An economic recession and lower copper prices are clearly bearish for the Chilean peso, and we maintain that its 8.5% rally this year versus the U.S. dollar will be followed by new lows (Chart I-10). Turning to equities, lower interest rates will help only marginally as equity valuations are not cheap (Chart I-11). Moreover, as Chilean banks account for 20% of the MSCI market cap and, while they are better run and more conservative than many others in the EM, they are not immune to a decelerating credit and business cycle. Besides, this bourse's Latin American consumer plays will also likely disappoint. As such, dedicated EM investors should stay neutral on Chilean stocks relative to the EM equity benchmark (Chart I-12). Chart I-10Chilean Peso Valuation Chilean Peso Valuation Chilean Peso Valuation Chart I-11Chilean Equities Are At Fair Value Chilean Equities Are At Fair Value Chilean Equities Are At Fair Value Chart I-12Chilean Equities: Stay ##br##Neutral Relative To EM Benchmark Chilean Equities: Stay Neutral Relative To EM Benchmark Chilean Equities: Stay Neutral Relative To EM Benchmark Lastly, as highlighted in our recent in-depth Special Report on EM corporate credit,2 credit investors should stay long Chilean and Russian corporate debt versus China. Chilean corporate credit will likely outperform Chinese corporate credit, as the latter is more frothy - overbought and expensive. Bottom Line: The Chilean economy is heading into recession, and policymakers will be late with stimulus to prevent it. Fixed-income investors should receive 3-year interest rate swaps. Dedicated EM equity investors should maintain a neutral stance on the Chilean bourse versus the EM equity benchmark. Stay short CLP / long USD. Santiago E. Gomez Associate Vice President santiago@bcaresearch.com South Africa: Flows Versus Fundamentals Chart II-1Improving Trade Has Helped The ZAR Improving Trade Has Helped The ZAR Improving Trade Has Helped The ZAR The South African rand has rallied since the start of the year on the back of an improving trade balance (Chart II-1) and strong capital inflows. However, it is facing a key technical resistance level, as are many other EM assets. We expect these resistance levels to hold for EM risk assets in general and the South African rand in particular. The underlying reasons behind our outlook center around our expectations of a stronger U.S. dollar, rising U.S. and G7 bond yields and a relapse in commodities prices. This is in addition to a lack of cyclical recovery and poor structural fundamentals in South Africa. A well-known explanation as to how South Africa has been able to finance its wide current account deficit is that there have been strong foreign portfolio inflows stemming from the global search for yield. What is less known is that South African banks have in the past year been selling foreign assets and repatriating capital back into South Africa (Chart II-2). Over the past 12 months, this repatriation of capital has amounted to US$ 6.5 billion, which effectively allowed the country to fund 50% of its current account deficit. While there is no doubt that this repatriation of capital has aided the rally in the rand and domestic bonds, it remains to be seen whether these flows will continue. Our suspicion is that with South African banks' holdings of foreign bonds dropping from US$ 18 billion in December 2015 to US$ 12 billion at the end of June 2016, and G7 bond yields rising, the speed of capital repatriation will likely slow. In the meantime, fundamentals in South Africa remain weak: The household sector, which accounts for 60% of GDP, has been sluggish. Private consumption growth has been anemic and credit growth to households has been falling rapidly (Chart II-3). Chart II-2South Africa: Banks Have Been ##br##Repatriating Capital Enormously South Africa: Banks Have Been Repatriating Capital Enormously South Africa: Banks Have Been Repatriating Capital Enormously Chart II-3South African ##br##Consumption Is Anemic South African Consumption Is Anemic South African Consumption Is Anemic The corporate sector is not painting a reassuring picture either. South African firms are not investing; real gross fixed capital formation is contracting (Chart II-4, top panel) and business confidence is at an all-time low (Chart II-4, bottom panel). The ongoing dynamic of persistently high wage growth - despite negative productivity growth - only reinforces the gloomy outlook as it creates downward pressure on corporate profit margins, or upward pressure on inflation (Chart II-5). Chart II-4Contracting Capex And ##br##Record-Low Business Confidence Contracting Capex And Record-Low Business Confidence Contracting Capex And Record-Low Business Confidence Chart II-5Toxic Structural Dynamics: Contracting ##br##Productivity And High Wage Growth Toxic Structural Dynamics: Contracting Productivity And High Wage Growth Toxic Structural Dynamics: Contracting Productivity And High Wage Growth Along with renewed weakness in the rand, higher wage growth will raise interest rate expectations. The fixed-income market is currently discounting no policy rate hikes during the next 12 months making it vulnerable to potential depreciation in the rand. In addition to a poor economic backdrop, uncertainty regarding economic policy is considerable. Chart II-6South Africa's Central ##br##Bank's Liquidity Injections South Africa's Central Bank's Liquidity Injections South Africa's Central Bank's Liquidity Injections First, fiscal policy will not be market friendly. The poor performance of the ANC in the last municipal elections shows the ANC is clearly losing support from the population. This will lead President Zuma and ANC to adopt even more populist policies. This is bearish for both the fiscal accounts and the structural growth outlook. As such, this will cap the upside in the rand and put a floor under domestic bond yields. Second, the central bank will not defend the exchange rate if the latter comes under selling pressure anew. In fact, monetary policy remains somewhat unorthodox. Specifically, the Reserve Bank of South Africa continues to inject liquidity into the system to cap interbank rates (Chart II-6). This will facilitate ZAR depreciation. Investment Conclusions Stay short the rand versus the U.S. dollar. Three weeks ago we also initiated a long MXN / short ZAR trade, and this trade remains intact as the MXN is oversold and the ZAR is overbought. Dedicated EM equity investors should maintain a neutral allocation to South African stocks. On the back of a fragile and deteriorating consumer sector, we recommend staying short general retailer stocks. Their share prices seem to be breaking down despite the rebound in the rand and a drop in domestic bond yields (Chart II-7). Policy uncertainty and pressure for populist policies is still an overarching issue for South Africa, especially compared to Russia. As such we suggest fixed income investors continue to underweight South African sovereign credit within the EM sovereign credit universe (Chart II-8), and maintain the relative trade of being long South African CDS / short Russian CDS. Chart II-7Stay Short South ##br##African General Retailers Stay Short South African General Retailers Stay Short South African General Retailers Chart II-8Stay Underweight South ##br##African Credit And Short Rand Stay Underweight South African Credit And Short Rand Stay Underweight South African Credit And Short Rand Stephan Gabillard, Research Analyst stephang@bcaresearch.com 1 Please refer to the Emerging Markets Strategy & Geopolitical Strategy Special Report titled, "Chile: A New Economic Model?," dated December 3, 2014 available at ems.bcaresearch.com 2 Please refer to the Emerging Markets Strategy Special Report titled, "EM Corporate Health Is Flashing Red," dated September 14, 2016. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Recommended Allocation Monthly Portfolio Update Monthly Portfolio Update Central Banks Still In The Driving Seat Markets continue to obsess about every move from the three major DM central banks. With two of them (the Fed and the ECB) likely to withdraw accommodation cautiously over the coming 12 months, the upside for risk assets is limited. The Fed is signaling that it will probably hike in December and the futures market is pricing in a 70% probability of that happening (roughly the probability one month before the rate rise in December last year). Inflation expectations have picked up recently (Chart 1) and core PCE inflation ticked up to 1.7% in August, within "hailing distance", as Fed vice-chair Stanley Fischer put it, of the Fed's 2% target. There is a political angle, too: having forecast four rate rises for the year, the Fed would endanger its credibility (and risk an audit from Congress) if it failed to deliver even one. At the same time, with growth in the Eurozone running a little above trend, the ECB is likely to announce in December an extension to its asset purchase program beyond March 2017 but eventually at a slower pace (a "tapering"). Reflecting these factors, government bond yields have moved up in recent months (Chart 2), and the trade-weighted dollar has strengthened by 4% since mid-August. None of these moves are good for risk assets, which have consequently moved sideways since August. But neither do they presage a big selloff since central banks will err on the side of caution. Inflation in the U.S. is unlikely to jump: wage growth will be kept under control by a gradual rise in the participation rate, which will prevent unemployment falling much further (Chart 3). The Fed's leaders continue to sound dovish. Janet Yellen even raised the question in a recent speech of "whether it might be possible to reverse these adverse supply-side effects [from the 2007-9 Global Financial Crisis] by temporarily running a 'high-pressure economy'", though she emphasized this was a suggestion for further economic research not her view. More practically, the FOMC will have a more dovish tilt in 2017, as the three regional Fed presidents who voted for a hike in September rotate out. Chart 1Have Inflation Expectations Bottomed? bca.gaa_mu_2016_10_31_c1 bca.gaa_mu_2016_10_31_c1 Chart 2Bond Yields Moving Higher bca.gaa_mu_2016_10_31_c2 bca.gaa_mu_2016_10_31_c2 Chart 3Core Workers Reentering The Labor Force bca.gaa_mu_2016_10_31_c3 bca.gaa_mu_2016_10_31_c3 Meanwhile, economic data remain somewhat sluggish. The U.S. manufacturing and non-manufacturing ISMs both rebounded sharply in September, suggesting that the very weak August prints were, as we suggested, an anomaly. Q3 U.S. real GDP growth come in at 2.9%, but the New York Fed's NowCast points to a slowdown to 1.4% in Q4. The Citi Economic Surprise Index (Chart 4) has also turned down again recently, with notable weakness in consumer spending and housebuilding. We expect this sluggish pace to continue through 2017: consumption should hold up as wage rises come through, but it is hard to forecast a strong recovery in capex, given the low capacity utilization rate (Chart 5), even if investment in the mining and energy sectors bottoms out next year. Eurozone growth could stutter too. It is driven substantially by credit growth, but historically European banks have tended to curtail lending after their share prices have fallen, as has been the case recently (Chart 6). Chinese growth has stabilized (at least in the GDP data, which seems to come in regularly at 6.7%, bang in the middle of the government's target range), thanks to the government's reflation policy from earlier this year. While the Chinese authorities have now reined back a little on stimulus, given their worries about the run-up in house prices,1 they offer an option since they would undoubtedly reflate again should growth slow. Chart 4Data Surprising Negatively Again bca.gaa_mu_2016_10_31_c4 bca.gaa_mu_2016_10_31_c4 Chart 5Hard To See More CAPEX Indeed bca.gaa_mu_2016_10_31_c5 bca.gaa_mu_2016_10_31_c5 Chart 6Share Prices Influence Lending bca.gaa_mu_2016_10_31_c6 bca.gaa_mu_2016_10_31_c6 All this suggests that returns from investment assets will be low, but positive, over the coming 12 months. With economic growth anemic but stable, bond yields prone to drift up, and equities expensive (but not as expensive as bonds), we expect risk-adjusted returns from the major asset classes to be broadly similar. We continue to recommend therefore a neutral weighting between bonds and equities, and suggest that investors look to pick up extra return through tilts to investment-grade corporate credit, inflation-linked over nominal bonds, and alternative assets such as real estate and private equity. Equities: Our preference remains for U.S. equities over European ones in USD terms. The dollar is likely to strengthen further, and the worst is not over for Eurozone banks - the time to buy into them will be at the point of maximum pain, which may come if German or Italian banks have to be bailed out by their governments. We continue to recommend a small (currency-hedged) overweight on Japan. The Bank of Japan's new policy to cap 10-year government bond yields at 0% has worked so far: the yen has weakened to JPY 104 to the dollar and equities have risen moderately. We expect further fiscal or wage-control measures from the government to give inflation an extra push. We remain wary of EM equities: earnings growth is negative, loan growth has started to slow (with the credit impulse having a high correlation with earnings and economic growth), and there is still little sign of structural reform. Some sectors in EM - notably IT and Healthcare - are attractive, however. Fixed Income: U.S. Treasury bond yields are likely to rise further - our model suggests fair value is a little below 2% (Chart 7) - and so we remain underweight duration. A moderate pickup in inflation suggests that TIPs will outperform nominal bonds (as described in detail in our recent Special Report).2 We lowered our recommendation in high-yield corporate debt to neutral last month because, at 65 BPs, the default-adjusted spread no longer offers sufficient return to justify the risk. At the start of the year it was 400 BPs (Chart 8). We continue to like investment-grade debt, where the spread over government bonds is 120 BPs in the U.S. and 100 BPs in the Eurozone, higher than at any point in 2005-2006 during the last expansion. Chart 7Treasury Yields Could Rise Further bca.gaa_mu_2016_10_31_c7 bca.gaa_mu_2016_10_31_c7 Chart 8Junk No Longer Offers Enough Return Junk No Longer Offers Enough Return Junk No Longer Offers Enough Return Currencies: We expect the U.S. dollar to continue to appreciate given the differential in growth and monetary conditions between the U.S. and other developed economies. The dollar looks expensive, but is nowhere near the over-bought levels it got to at the peak of previous rallies in 1985 and 2002 (Chart 9). China seems likely to allow a further weakness of the RMB against the dollar, repegging it to a trade-weighted currency basket. This could push down other emerging market currencies too particularly if, like Brazil recently, they try to cut rates to boost growth. Chart 9USD Not As Overvalued As In The Past bca.gaa_mu_2016_10_31_c9 bca.gaa_mu_2016_10_31_c9 Commodities: Oil has probably overshot in the short-term on expectations that Saudi Arabia and Russia will cap, or even cut, production. We think this talk has been overhyped and that the OPEC meeting in November could prove a disappointment. Nonetheless, we still see the equilibrium level for crude over the next two years at USD 50 a barrel, the marginal cost for U.S. shale producers. Industrial commodities are likely to fall further (they peaked in June) if we are right that the dollar appreciates. We continue to like gold as an inflation hedge, but short-term are nervous because it, too, is negatively correlated with the dollar. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see China Investment Strategy "Housing Tightening: Now And 2010" dated October 13, 2016, available at cis.bcaresearch.com 2 Please see Global Asset Allocation Special Report "TIPS For Inflation-Linked Bonds," dated October 28, 2016, available at gaa.bcaresearch.com Recommended Asset Allocation Model Portfolio (USD Terms)

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

Highlights China's rising debt-to-GDP ratio is the mirror image of rising assets, due to a combination of rising capital intensity in the economy, falling returns on assets, falling profit margins and declining efficiency. The country's ever-rising debt-to-GDP ratio in recent years does not mean rising leverage. Rather, it is largely a reflection of the mounting difficulties in the Chinese corporate sector since the global financial crisis. The government's right choice is policy reflation via easing interest burdens, increasing aggregate demand and boosting corporate pricing power - combined with "supply-side" policies to improve corporate sector efficiency. Any harsh attempts to "delever" the broad corporate sector would amplify growth problems. Feature Of all the "China worries" among global investors, the leverage issue sits center stage. Conventional wisdom holds that China's corporate sector has become dangerously levered, which has increased broader financial fragility and economic vulnerability. The Chinese government shares similar concerns, with "deleveraging" a key policy objective for many years now. The Balance Sheet Of China Inc. However, the "debt bubble" discussion among investors and Chinese officials of late has been narrowly focused on China's debt-to-GDP ratio, particularly within the corporate sector. In a previous report, we discussed that Chinese companies' total liability-to-assets ratio, a conventional leverage measure, has not been particularly high, either from a historical perspective or compared with other countries.1 Specifically: From a micro perspective, our calculation shows that the median liability-to-assets ratio of domestically listed Chinese companies is currently 60%, or 29% for the interest-bearing debt-to-assets ratio, both of which have been little changed in the past 10 years. In fact, the leverage ratios of Chinese firms do not stand out in global comparison (Chart 1). Moreover, the median cash-to-assets ratio of Chinese firms is substantially higher than global peers, which means net debt levels are even smaller. For the macro economy, while total liabilities are hard enough to measure, measuring total assets becomes almost Mission Impossible, especially for households and the government. A reasonable proxy for the corporate sector is industrial firms' financial numbers published by the National Bureau of Statistics (NBS). Obviously industrial firms are a subset of the corporate sector, and corporate debt also includes borrowing by non-industrial firms. However, industrial firms tend to be more levered than other businesses, particularly service providers, and therefore their debt situation should be more "alarming" than the overall corporate sector. Chart 2 shows that the liabilities-to-assets ratio for all industrial firms currently stands at 57% - comparable to listed firms, a figure that has been in decline since the early 2000s. Chart 1The Balance Sheet Of China Inc. Rethinking Chinese Leverage Rethinking Chinese Leverage Chart 2The Debt-To-Asset Ratio Has Been Declining bca.cis_sr_2016_10_27_c2 bca.cis_sr_2016_10_27_c2 All of this stands in stark contrast to the consensus view of the highly indebted Chinese corporate sector, and raises some important questions. What is the true leverage situation in the Chinese corporate sector? Why has the rising "macro" leverage ratio, defined by debt-to-GDP, not been accompanied by a rising debt-to-assets ratio at the micro level? Rising Debt, Or Rising Assets? If debt-to-GDP is rising but debt-to-assets is not, then by extension assets-to-GDP is also rising. Indeed, as of 2015, liabilities of industrial firms totaled RMB 57 trillion, compared with RMB 96 trillion non-financial corporate sector debt, based on "total social financing" data, or 83% and 142% of Chinese GDP, respectively (Chart 3). As a share of GDP, both data series have been rising, but industrial firms' total liabilities have plateaued of late, while total "corporate sector" debt has continued to increase. Meanwhile, total assets of industrial firms currently amount to RMB 101 trillion (Chart 4). As a share of GDP, industrial firms' total assets have been rising much faster than liabilities, leading to a rapid decline in the liability-to-assets ratio of all industrial firms, as shown in Chart 2. Chart 3Rising Debt In The Corporate Sector... bca.cis_sr_2016_10_27_c3 bca.cis_sr_2016_10_27_c3 Chart 4... Reflects Rising Assets bca.cis_sr_2016_10_27_c4 bca.cis_sr_2016_10_27_c4 In other words, the corporate sector's rising debt-to-GDP ratio simply reflects rising assets. Therefore, the more important question is why assets as a share of GDP have also been rising. In our view, a rising assets-to-GDP ratio reflects two important developments: First, a rising assets-to-GDP ratio means the economy has become more capital intensive, which is a natural consequence of becoming more industrialized. As economic growth drives up the cost of labor, enterprises tend to invest in capital stock to replace workers, leading to a higher capital-to-labor ratio, and consequently higher productivity. Accumulating capital stock is the fundamental factor that enables lagging economies to catch up to those that are more advanced. Meanwhile, an economy with a larger industrial sector also tends to be more asset-heavy than an agriculture-based economy or a post-industrialization service-oriented economy. Second, from a national accounts point of view, GDP is the sum of total value-added at all stages of production within a country. Therefore, a rising assets-to-GDP ratio suggests that it takes more assets to generate the same unit of value-added. As far as the corporate sector is concerned, this implies that return on assets (ROA) has declined, which is confirmed by the industrial sector data: the ROAs of all industrial firms have indeed been falling since the global financial crisis (Chart 5). Further Decoding Leverage: A DuPont Approach Borrowing the wisdom of the "DuPont model" in analyzing return on equity (ROE), a country's debt-to-GDP ratio can be further broken down into the following components: Rethinking Chinese Leverage Rethinking Chinese Leverage As discussed above, if the economy's debt-to-GDP has been rising but its debt-to-assets ratio has not, then mathematically it means that the other three components, either individually or collectively, have also been rising (Chart 6). Chart 5Return On Assets Has Deteriorated bca.cis_sr_2016_10_27_c5 bca.cis_sr_2016_10_27_c5 Chart 6The DuPont Approach Of Debt-To-GDP bca.cis_sr_2016_10_27_c6 bca.cis_sr_2016_10_27_c6 Chinese companies' profits-to-GDP ratio increased in the early 2000s but has been falling since the global financial crisis, and therefore has not been a main reason behind the country's rising debt-to-GDP ratio in recent years. The assets-to-sales ratio has indeed been rising since 2011, which mathematically has contributed to the rising debt-to-GDP ratio. Assets-to-sales is the reciprocal of sales/assets, or asset turnover in textbook corporate finance (top panel, Chart 7). Falling asset turnover underscores declining efficiency with which a company is deploying its assets in generating revenue. Chart 7The Real Reasons Behind ##br## Rising Debt-To-GDP Ratio bca.cis_sr_2016_10_27_c7 bca.cis_sr_2016_10_27_c7 The sales-to-profit ratio has also been rising since 2011. Similarly, sales-to-profits is the reciprocal of profit-to-sales, or profit margin (bottom panel, Chart 7). In other words, rising sales-to-profits, or falling profit margins, has also contributed to the rising debt-to-GDP ratio in recent years. What Does All This Mean? From a balance sheet point of view, there is no clear evidence that the Chinese corporate leverage ratio has increased significantly in recent years, as widely perceived. The country's rising debt-to-GDP ratio is the mirror image of rising assets, due to a combination of rising capital intensity in the economy, falling returns on assets, falling profit margins and declining efficiency. Therefore, China's apparently ever-rising debt-to-GDP ratio in recent years does not mean rising leverage. Rather, it is largely a reflection of the mounting difficulties in the Chinese corporate sector since the global financial crisis. This is an important distinction, because it matters for policymakers on how to "delever" the economy. If the rising debt-to-GDP ratio is a true reflection of reckless borrowing and rising balance sheet leverage, then the authorities should be tightening monetary conditions and cutting credit flows. If, on the contrary, the rising debt-to-GDP ratio reflects slowing growth and deflationary damage inflicted on the corporate sector, then the right choice is policy reflation via easing interest burdens, increasing aggregate demand and boosting corporate pricing power - combined with "supply-side" policies to improve corporate sector efficiency. Any harsh attempts to "delever" the broad corporate sector would amplify growth problems, creating a vicious cycle that would lead to an even higher debt-to-GDP ratio. What the Chinese government intends to do remains to be seen. Early this month the State Council released a new document to guide the corporate sector to "delever", with several specific measures including the controversial "debt-equity" swap initiative, which allows banks to swap their corporate loans into equity holdings. There is little doubt that policymakers should not continue to feed "zombie" companies and evergreen hopeless loans. However, any efforts to help companies reduce deflationary pain should be helpful in terms of them honoring their debt obligations, and reducing overall credit risk in the system. Finally, the global investment community has been deeply troubled by China's debt situation in recent years, but the attention has been almost solely focused on the country's debt-to-GDP ratio. While this ratio is widely accepted as a leverage indicator at the macro level that allows for easier cross country comparisons, it is also well known for its major shortcomings. The ratio compares total debt in the economy, a stock concept, to economic output in a particular year, which is a flow concept and tends to be a lot more volatile. Therefore, it is necessary to take a broader view to assess the debt situation, such as on-balance-sheet debt ratios and the debt servicing capacity. Moreover, a country's debt situation should be put in context of country specific factors such as the savings rate, financial intermediation mechanisms and the current stage of the country's growth situation. We will continue to follow up on these issues in our future research. Stay tuned. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Special Report, "Chinese Deleveraging? What Deleveraging! ", dated June 15, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

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

Highlights China's abnormal credit growth has been the result of speculative, high-risk behavior among Chinese banks - and not the natural result of the country's high savings rate. Banks do not intermediate savings into credit, and they do not need deposits to lend. Banks create deposits and money by originating loans. A commercial bank is not constrained in loan origination by its reserves at the central bank if the latter supplies liquidity (reserves) to commercial banks 'on demand'. What habitually drives credit booms are the "animal spirits" of banks and borrowers. We are initiating a relative China bank equity trade: short listed medium-size banks / long large five banks. Continue shorting the RMB versus the U.S. dollar. Feature For some time, the consensus view has been that rampant credit growth in China and the resulting excesses have been the natural result of the country's high savings rate, particularly among Chinese households. We have long argued differently: abnormal credit growth has been the result of speculative, high-risk behavior among Chinese banks and other creditors and borrowers. In this vein, China's credit bubble is no different than any other credit bubble in history. Although an adjustment in China might play out differently than it has in other countries where credit excesses became prevalent, China's corporate credit bubble is an imbalance that poses a non-trivial risk to both mainland and global growth (Chart I-1). Chart I-1China's Outstanding Credit Is Large Relative To Global GDP China's Outstanding Credit Is Large Relative To Global GDP China's Outstanding Credit Is Large Relative To Global GDP In a nutshell, Chinese banks have not channelled large amounts of household deposits into credit. Without mincing words, it is our view that banks have originated loans literally from "thin air" as banks do in any other country. In turn, credit has boosted spending, income and, consequently, savings. Do Deposits Create Loans, Or Do Loans Create Deposits? It is a widely held view among academics, investors and market commentators - including some of our colleagues here at BCA - that China's enormous credit expansion over the past several years has been a natural outcome of the nation's high savings rate. The argument goes like this: China has a very high savings rate, and it is inherent that household savings flow to banks as deposits. In turn, banks have little choice but to lend out on these deposits. The upshot of this reasoning is as follows: China's abnormally strong credit growth is a consequence of the country's abundant savings rather than an unsustainable excess. This argument hails from the Intermediate Loan Funds (ILF) model, otherwise known as the Loanable Fund Theory. This model suggests that deposits create loans - i.e., banks intermediate deposits into credit. Even though the ILF model is the most widespread theory of banking within academia and in textbooks, it unfortunately has little relevance to real-life banking - i.e., banking systems around the world do not function as the model posits. An alternative but much less recognized theory, the Financing Money Creation (FMC) model, asserts that banks create deposits from "thin air" when they originate a new loan. This is the model that banking systems in almost all countries in the world subscribe to. Indeed, whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower's bank account, therefore creating new money in the process (Chart I-2). In other words, bank loans create deposits and money. Chart I-2Commercial Banks: Credit Origination Creates Deposits Misconceptions About China's Credit Excesses Misconceptions About China's Credit Excesses Herein we cite various papers that discuss this matter and delineate the key points: "Banks do not, as many textbooks still suggest, take deposits of existing money from savers and lend it out to borrowers: they create credit and money ex nihilo - extending a loan to the borrower and simultaneously crediting the borrower's money account" (Turner, 2013). "When banks extend loans, to their customers, they create money by crediting their customer's accounts" (King, 2012). "Based on how monetary policy has been conducted for several decades, banks have always had the ability to expand credit whenever they like. They don't need a pile of "dry tinder" in the form of excess reserves to do so" (Dudley, 2009). "In a closed economy (or the world as a whole), fundamentally, deposits come from only two places: new bank lending and government deficits. Banks create deposits when they create loans." (Sheard, 2013). "Just as taking out a new loan creates money, the repayment of bank loans destroys money" (McLeay, 2014). The papers cited in the bibliography on page 18 elaborate on this topic in depth and readers are encouraged to review this literature. Bottom Line: Banks do not need deposits to lend. They create deposits and money by originating loans. Do Banks Lend Their Reserves At Central Banks? Another misconception about modern banking in general and China's banking system in particular is that banks lend out their excess reserves held at the central bank. Provided that Chinese banks have plenty of required reserves at the People's Bank of China (PBoC), some economists and analysts argue it is a matter of cutting the reserve requirement ratio to free up reserves (liquidity), which will allow banks to boost their loan origination. Again, we cite several papers as well as specific views from central bankers who reject the notion that banks lend out their reserves at the central bank: This comment by William C. Dudley (President of the New York Federal Reserve Bank) states "the Federal Reserve has committed itself to supply sufficient reserves to keep the fed funds rate at its target. If banks want to expand credit and that drives up the demand for reserves, the Fed automatically meets that demand in its conduct of monetary policy. In terms of the ability to expand credit rapidly, it makes no difference whether the banks have lots of excess reserves or not" (Dudley, 2009). "In fact, the level of reserves hardly figures in banks' lending decisions. The amount of credit outstanding is determined by banks' willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans. The aggregate availability of bank reserves does not constrain the expansion directly" (Borio et al., 2009). "While the institutional facts alone provide compelling support for our view, we also demonstrate empirically that the relationships implied by the money multiplier do not exist in the data ... Changes in reserves are unrelated to changes in lending, and open market operations do not have a direct impact on lending. We conclude that the textbook treatment of money in the transmission mechanism can be rejected..." (Carpenter et al., 2010). "...reserves are, in normal times, supplied 'on demand' by Bank of England to commercial banks in exchange for other assets on their balance sheets. In no way does the aggregate quantity of reserves directly constrains the amount of bank lending or deposit creation" (McLeay 2014). "Most importantly, banks cannot cause the amount of reserves at the central bank to fall by "lending them out" to customers. Assuming that the public does not change its demand for cash and the government does not make any net payments to the private sector (two things that are both beyond the direct control of the banks and the central bank), bank reserves have to remain "parked" at the central bank" (Sheard, 2013). More detailed analysis on this topic is available in the papers cited in the bibliography on page 18. Bottom Line: Banks do not lend out their reserves at the central bank. A commercial bank is not constrained in loan origination/money creation by its reserves at the central bank if the latter supplies liquidity (reserves) to commercial banks 'on demand'. Empirical Evidence: Savings Versus Credit This section presents empirical evidence that there is no correlation between national and household savings rates and loan origination. This is true for any country, including China. Credit growth and credit penetration (the credit-to-GDP ratio) have little to do with a country's or with households' savings rates. Chart I-3 illustrates that there has been no correlation between China's national or household savings rates and the credit-to-GDP ratio. China's savings rate was high and rising before 2009, yet the credit bubble formation only commenced in January 2009 when the savings rate topped out. Looking at other countries such as Korea, Taiwan and the U.S., historically we find no correlation between their savings and credit cycles1 (Chart I-4). Chart I-3China: Credit And Savings ##br##Are Not Correlated China: Credit And Savings Are Not Correlated China: Credit And Savings Are Not Correlated Chart I-4The U.S., Korea And Taiwan:##br## Credit And Savings Are Not Correlated The U.S., Korea And Taiwan: Credit And Savings Are Not Correlated The U.S., Korea And Taiwan: Credit And Savings Are Not Correlated Importantly, a high or rising savings rate does not preclude deleveraging. There were many two- to four-year spans of deleveraging in China when the credit-to-GDP ratio was flat or falling (Chart I-5) - i.e., the growth rate of credit was at or below nominal GDP growth. This occurred despite the country's high and rising savings rate. So, not only is deleveraging not unusual for China but it has also occurred amid a high savings rate. This contradicts the commonly held view that Chinese credit has always expanded faster than nominal GDP because the nation saves a lot. Deleveraging at the current juncture will likely be very painful, because the size of credit flows is enormous and even a moderate and gradual deceleration in credit will produce a major drag on growth. Specifically, the credit impulse - the second derivative of outstanding credit that measures the impact of credit growth on GDP - will be equal to -2.2% of GDP if credit growth moderates from 11.3% now to 7.8% in the next 24 months (Chart I-6). Chart I-5There Were Periods Of ##br##Deleveraging In China Too There Were Periods Of Deleveraging In China Too There Were Periods Of Deleveraging In China Too Chart I-6China's Credit Impulse Will ##br##Likely Be Negative China's Credit Impulse Will Likely Be Negative China's Credit Impulse Will Likely Be Negative As Chart I-6 also demonstrates, China's credit impulse drives Chinese imports, the most critical variable for the rest of the world. Chart I-7China: A Growth Engine Shift Since 2009 China: A Growth Engine Shift Since 2009 China: A Growth Engine Shift Since 2009 Further, it is possible to argue that vigorous credit growth generates robust income growth. The latter, in turn, allows a nation as a whole and households in particular to save more. If Chinese banks had not originated as many loans since early 2009 as they have, many goods and services in China would not have been produced and sold, and income growth for all companies, households and even government would be much lower. Even if the savings rate were held constant, less income would entail lower absolute amounts of both national and household savings. In short, China's exponential credit growth since 2009 has helped boost both national and household income levels, and in turn the absolute level of their savings. Chart I-7 illustrates that before 2009, mainland economic and income growth were driven by exports, but since early 2009, credit has been instrumental in generating income growth and prosperity. Finally, many analysts rationalize strong loan growth among Chinese banks by their robust deposit growth. This logic is flawed: Chinese banks have substantial deposits on hand because they originate a lot of loans. Bottom Line: China's and any other country's national or household savings rate does not explain swings in credit creation. Banks do not intermediate savings into credit. Rather, banks create deposits and money. What Drives Bank Lending? If a credit boom is not driven by abundant savings, what is the foundation for a credit boom in general, and the one currently underway in China in particular? Loan origination by a bank depends on that bank's willingness to lend, as well as general demand for loans. Also, depending on policy priorities, regulators often try to encourage or limit banks' ability to lend by imposing and adjusting various regulatory ratios. Barring any regulatory constraints, so long as there is demand for loans and a bank is willing to lend, a loan will be originated. Hence, in theory, banks can lend to eternity unless shareholders and regulators constrain them. In the immediate wake of the Lehman crisis, the Chinese authorities encouraged banks to open the credit floodgates. Thus, there was a de facto deregulation in the nation's banking system in early 2009 - policymakers encouraged strong credit origination. The experience of many countries - documented by numerous academic papers on this topic - has demonstrated that banking sector deregulation typically leads to excessive risk-taking by banks, and abnormal credit growth. These episodes have not ended well, with multi-year workouts following in their wake. By and large, a credit boom often occurs when risk-taking by banks surges and shareholders and regulators do not constrain them. This has been no different in China - the credit boom since 2009 has been powered by speculative and excessive risk-taking among banks and their management teams in particular, amid complacency of regulators and shareholders. Bottom Line: What habitually drives excessive credit creation are the "animal spirits" of banks and borrowers. Banks' and borrowers' speculative behavior and reckless risk-taking typically degenerates into a credit boom that often ends in an economic and financial downturn. It has been no different in China. What Constrains Bank Lending? The following factors can limit bank credit origination: Monetary policy can limit credit growth via raising interest rates, which dampens loan demand. Also, banks can become more risk averse when interest rates rise as they downgrade creditworthiness of current and prospective borrowers. Government regulations can impose various restrictions on banks, restraining their risk-taking and ability to originate infinite amounts of credit. In China, to limit banks' ability to lend, regulators have imposed several mandatory ratios on commercial banks, and also practice 'Window Guidance'. First, the capital adequacy ratio (CAR=net capital / risk-weighted assets). This ratio limits banks' ability to originate infinite amounts of loans by imposing a minimum level CAR. In China, most banks comply comfortably with CAR. The CAR for the entire commercial banking system is currently 13.1%. While the minimum requirement is 8%. The caveat is that in China, banks' equity capital is nowadays considerably inflated because they have not provisioned for non-performing loans (NPLs). If banks were to fully provision for NPLs, their equity capital would shrink significantly, and they would probably not meet the minimum CAR. Table I-1 shows that in a scenario of 12.5% NPL ratio for banks' claims on companies and zero NPL on household loans and mortgages as well as a 20% recovery rate, a full provisioning by banks would erode 65% of their equity. In this scenario, the CAR ratio would drop a lot - probably below the required minimum of 8% and banks would be forced to raise new equity (dilute existing shareholders) or shrink their balance sheets - or a combination of both. Table I-1China: NPL Scenarios And Banks' Equity Capital Impairment Misconceptions About China's Credit Excesses Misconceptions About China's Credit Excesses Second, the leverage ratio - computed as net Tier-1 capital divided by on- and off-balance-sheet assets. According to government regulation, this ratio should be at least 4%. As of June 30, 2016, the leverage ratio for the entire commercial banking system was 6.4%, comfortably above its floor. Nevertheless, as with CAR, the leverage ratio is overstated at the moment because the numerator - net Tier-1 equity capital - is artificially inflated, as it is not adjusted for realistic levels of NPLs, as discussed above. If 65% of equity is eroded due to sensible loan-loss provisioning and write-offs (as per Table 1), the leverage ratio would drop to about 2.3%, below the required minimum of 4%. Hence, banks would need to raise new equity (dilute existing shareholders), shrink their balance sheets or do a combination of both. Equity dilution is bearish for bank stocks and, if and as banks moderate their assets/loan growth, the economy will suffer. Third, regulatory 'Window Guidance' is implemented through PBoC recommendations to banks on their annual and quarterly credit ceilings, and on their credit structures. There is no official disclosure of this measure, and it is done between the PBoC, the Chinese Banking Regulatory commission (CBRC) and banks' management. In recent years, the efficiency of 'Window Guidance' has declined dramatically. Banks have defied bank regulators' efforts to rein in credit growth by finding loopholes in regulations. What's more, they have de facto exceeded credit origination limits by moving credit risk off their balance sheets and classifying it differently than loans. The result has been mushrooming Non-Standard Credit Assets (NSCA). Table I-2 reveals that on- and off-balance-sheet NSCA stand at RMB 10 trillion and RMB 19 trillion, respectively. Furthermore, banks have lately expanded their lending to non-depositary financial organizations that include trust companies, financial leasing companies, auto financing companies and loan companies (Chart I-8). This has probably been done to circumvent government regulations. Hence, Chinese banks have taken on much more credit risk than regulators have wanted them to by reclassifying/renaming loans as NSCA, and parking these assets both on- and off-balance-sheet. Table I-2China: Five Largest Banks Hold ##br##Only 40% Of Credit Assets Misconceptions About China's Credit Excesses Misconceptions About China's Credit Excesses Chart I-8Non-Bank Financial Organizations##br## Are On A Borrowing Spree From Banks bca.ems_sr_2016_10_26_s1_c8 bca.ems_sr_2016_10_26_s1_c8 In short, regulatory measures in China have not been effective at restraining credit growth in recent years. Bank shareholders are the biggest losers when banks expand credit uncontrollably, and then their default rates rise. The reason being that banking is a business built on leverage. For example, if a bank's assets-to-equity ratio is 10 and 10% of assets go bad (default with no recovery), shareholders' equity will completely evaporate - i.e., they will lose their entire investment. Hence, it is in the best interests of bank shareholders to halt a credit expansion when they sense deteriorating credit quality ahead. Doing so will hurt the economy, but limit their losses. Why have shareholders of Chinese banks not stepped in to curb the credit boom and misallocation of capital? We believe they have either been satisfied with such a massive credit expansion, which has initially driven shareholder returns up, or weak institutional shareholder mechanisms have meant they have been unable to enforce credit discipline on their banks. All in all, if China's or any other credit system is driven by the principals of capitalism and markets, creditors are the ones who should curtail credit growth - regardless of what impact it will have on the economy. If a country's credit system in general and banks in particular do not operate on principals of capitalism and markets, banks can expand credit infinitely, thereby perpetuating capital misallocation and raising inefficiency, leading to stagnating productivity - in other words, a move to a more socialist bend. Only in a socialist system do banks expand their credit portfolios in perpetuity, since they are not run to maximize wealth for shareholders. On a related note, there is another misconception that all Chinese banks are state-owned and the government will be fast to bail them out by buying bad assets at par. Table I-3 illustrates the ownership structure of 16 Chinese banks listed the A-share market, including the large ones. The state (central and local governments) and SOEs have a large but not 100% ownership stake. In fact, foreign investors have considerable equity shares in many banks. Table I-3Chinese Banks: Shareholder Structure Is Diverse Misconceptions About China's Credit Excesses Misconceptions About China's Credit Excesses Hence, a government bail-out of these banks at no cost to shareholders would mean the Chinese government is using taxpayer money to benefit domestic private as well as foreign shareholders. Given the considerable amounts involved, this will be politically difficult to achieve unless the benefits of doing so are explicitly greater than the costs of doing nothing. Chart I-9Commercial Banks Are On ##br##Borrowing Spree From PBoC Commercial Banks Are On Borrowing Spree From PBoC Commercial Banks Are On Borrowing Spree From PBoC We are not implying that a government bailout is impossible. Our point is that it will take material pain and considerable deterioration in the economy and financial markets before the central government bails out banks at no cost to other shareholders. No wonder the authorities have not recapitalized the banks so far. In the long run, if the Chinese government is serious about improving the credit/capital allocation process, it has to allow market forces to take hold so that creditors and debtors are not bailed out but instead assume financial responsibility for their decisions. This means short-term pain but long-term gain. The lack of demand for credit is an important constraint on credit origination. If there are no borrowers, banks will have a hard time making a sizable amount of loans. Liquidity constraints also limit banks' ability to expand their assets. Let's consider an example when liquidity constraints arise. Bank A originates a loan, and Borrower A wants to transfer money to its Supplier B, which has an account at Bank B. In theory, Bank A should reduce its excess reserves at the central bank by transferring money to Bank B's reserve account at the central bank. However, if too many borrowers of Bank A try to transfer their money/deposits to other banks, Bank A will run into liquidity constraints as its excess reserves dry up. In such a case, Bank A should borrow money from the central bank or the interbank market to replenish its excess reserves. Provided many G7 central banks are nowadays committed to supplying as much liquidity (reserves) as banks require, in these countries banks do not really face liquidity constraints in lending. The focus of advanced countries' central banks is to control short-term interest rates - i.e., they manage liquidity in a way to keep policy rates at the target. In the case of China, even though the PBoC has a high required reserves ratio (RRR) for banks, it apparently supplies commercial banks with whatever amounts of liquidity they require. Chart I-9 reveals that the PBoC's claims on commercial banks have surged by fivefold in the past three years. Given the Chinese monetary authorities have in the recent years been very generous in meeting banks' demands for liquidity, the high RRR has not constrained mainland banks' ability to originate loans. This contradicts some analysts' assertions that the PBoC can boost lending by cutting the RRR. As the PBoC presently fully accommodates banks' demands for liquidity, the significance and impact of required reserves has declined. On the whole, nowadays, commercial banks in China are not facing liquidity (reserves) constraints to expand credit. High debt servicing costs could constrain bank lending. Are there limits to the credit-to-GDP ratio? It is illustrative to consider a numerical example for China. Corporate and household debt presently stands at 220% of GDP and, according to Bank of Intentional Settlement (BIS) calculations, debt servicing costs (including interest payments and amortization) account for around 20% of disposable income (Chart I-10). If credit indefinitely expands at a rate well above nominal GDP growth (Chart I-11) and interest rates do not decline, debt servicing costs will rise substantially. For example, let's assume that mainland corporate and consumer leverage reaches 400% of GDP in the next several years. If and when this happens, debt servicing costs could double, approaching 40% of income assuming constant interest rates and debt maturity. Chart I-10China's Corporate And Household##br## Credit: The Sky'S The Limit? China's Corporate And Household Credit: The Sky'S The Limit? China's Corporate And Household Credit: The Sky'S The Limit? Chart I-11Will Credit Growth Slow Toward##br## Nominal GDP Growth? Will Credit Growth Slow Toward Nominal GDP Growth? Will Credit Growth Slow Toward Nominal GDP Growth? No debtor can continue to function under such debt burden. Hence, debtors will have to cut their spending (for companies it will be a reduction in capex budgets) or these debtors will need to borrow to pay interest and retire old debt. In short, this becomes an unsustainable Ponzi scheme, where debtors borrow to service their debt obligations. Anecdotal evidence suggests this is not rare in China nowadays. One way the authorities could reduce debt servicing is to cut interest rates to zero and lengthen the maturity of debt. This is what many advanced economies have done. If Chinese credit penetration does not stop rising, the PBoC will be forced to cut rates to close to zero. This in turn will lead to large capital outflows, and the RMB will depreciate versus the U.S. dollar. Bottom Line: The following factors can restrain bank credit origination: monetary policy (higher interest rates), government regulations, bank shareholders, lack of credit demand, liquidity constraints and high debt servicing costs. Investment Implications Chart I-12Short Small Banks / Long Large##br## Banks In China Short Small Banks / Long Large Banks In China Short Small Banks / Long Large Banks In China If banks' shareholders and other creditors in China act in accordance with their self-interests to preserve the value of their assets, they will have to reduce credit origination/lending. As a result, China will experience an acute economic downturn. This would constitute a capitalist-type adjustment, which in turn will lead to more efficiency, solid productivity growth, and reasonably high economic growth over the long term. However, it will also mean significant short-term pain. If the government bails out everyone, underwrites all credit risks, and gets even more involved in capital/credit allocation, the economy will not experience an acute slump for a while. However, this would represent a shift toward socialism and the potential growth rate will collapse in the next several years. With the labor force stagnating and probably contracting in the years ahead, China's potential growth will be equal to its productivity growth. In socialism, productivity growth is low, often close to zero. The growth trajectory in this scenario will follow mini-cycles around a rapidly falling potential growth rate. In brief, China's growth rate is bound to slow further, regardless of what scenario plays out over the next several years. Today, we are initiating a relative China bank equity trade: short listed small- and medium-size banks / long large five banks in the A-share market (Chart I-12). There has been more speculative high-risk lending from the small- and medium-size banks than the large ones. As we documented in our June 15, 2016 Special Report titled Chinese Banks' Ominous Shadow,2 the largest five banks have fewer non-standard credit assets than medium and small banks. If 12.5% of banks' claims on companies turn sour and the recovery rate is 20%, 100% of the equity of 11 listed small- and medium-sized banks will be wiped out. The same number for the large five banks is 42%. Hence, these 11 listed small- and medium-sized banks are more exposed to bad loans than the large five. Finally, mushrooming leverage entails that the monetary authorities should reduce interest rates drastically. However, lower interest rates will spur more capital outflows from the mainland. Hence, the RMB is set to depreciate further. We have been shorting the RMB versus the U.S. dollar since December 9, 2015, and this position remains intact. 1 We discussed this at length in Emerging Markets Strategy Special Report, "China: Imbalances And Policy Options", dated June 12, 2012, available at ems.bcaresearch.com 2 Please refer to the Emerging Markets Strategy Special Report titled, "Chinese Banks' Ominious Shadow", June 15, 2016, link available on page 22. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com Bibliography Borio, C. and Disyatat, P. (2009), "Unconventional Monetary Policy: An Appraisal", BIS Working Papers, No. 292, November 2009. Carpenter, S. and Demiralp, S. (2010),"Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?", Finance and Economics Discussion Series, No. 2010-41, Divisions of Research & Statistics and Monetary Affairs, Washington, DC: Federal Reserve Board Dudley, W. (2009), "The Economic Outlook and the Fed's Balance Sheet: The Issue of "How" versus "When"", Remarks at the Association for a Better New York Breakfast Meeting, available at http://www.newyorkfed.org/newsevents/speeches/2009/dud090729.html Jakad, Z. and Kumhof, M. (2015), "Banks Are Not Intermediaries of Loanable Funds - and why this Matters", Bank of England, Working Paper 529, May 2015 King, M. (2012), Speech to the South Wales Chamber of Commerce at the Millenium Centre, Cardiff, October 23. Ma, G., Xiandong, Y. and Xim L. (2011), "China's evolving reserve requirements", BIS Working Papers, No. 360, November 2011. Turner, A. (2013), "Credit, Money and Leverage", September 12. Sheard, Paul (2013), "Repeat After Me: Banks Cannot And Do Not 'Lent Out' Reserves", Standard & Poor's Rating Services, August 2013, New York Werner, R. (2014b), "How Do Banks Create Money, and Why Can Other Firms Not Do the Same?", International Review of Financial Analysis, 36, 71-77. See King (2012), "Banks Are Not Intermediaries of Loanable Funds - and why this Matters", pp. 6, cited in Zoltan Jakab and Michael Kumhof, Bank of England Working Paper 529, May 2015. See Dudley (2009), "Banks Are Not Intermediaries of Loanable Funds - and why this Matters", pp. 13, cited in Zoltan Jakab and Michael Kumhof, Bank of England Working Paper 529, May 2015. See Carpenter and Demiralp (2010), "Banks Are Not Intermediaries of Loanable Funds - and why this Matters", pp. 13, cited in Zoltan Jakab and Michael Kumhof, Bank of England Working Paper 529, May 2015. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The U.S. is not yet a "high-pressure" economy, but slack is dissipating. U.S. growth, while not torrid, will remain high enough to push interest rates higher. The euro area continues to exhibit tepid domestic demand growth, and slack there remains higher than in the U.S. Monetary divergences will grow, weighing on EUR/USD. The Canadian economy displays underlying weaknesses which will prevent the BoC from hiking for an extended period of time. Stay long USD/CAD, but favor the CAD to the AUD and the NZD on a USD rally. Feature Following Janet Yellen's Boston speech last week, a new phrase has entered the lexicon of investors: "high-pressure economy". The speech was originally interpreted as a clarion call to let the economy overheat in order to absorb the slack created by the shock of 2008. However, Yellen still sees some slack in the economy. In her eyes, an easy monetary stance, at this point, will not cause an overheating, it will only bring back to the marketplace workers that had left the labor force. Chart I-1Drying Global Liquidity bca.fes_wr_2016_10_21_s1_c1 bca.fes_wr_2016_10_21_s1_c1 We have sympathy toward this view, especially when put in an international context where global capacity utilization remains depressed. Also, countries like China, Saudi Arabia, and Mexico have been intervening in the FX markets to preempt or limit downside to their currencies, tightening global liquidity conditions (Chart I-1). Nonetheless, the Fed Chair also highlighted that the FOMC did not want the U.S. economy to overheat as the domestic slack gets absorbed. Doing so would raise the risk that the Fed will have to then overcompensate by tightening rates very aggressively. This would prompt another recession. U.S.: Not High Pressure Yet, But... No indicator suggests that there is a burning need to quickly ratchet U.S. rates higher. However, domestic economic conditions are falling into place to justify a slow move toward higher rates. Our aggregate U.S. capacity utilization gauge is showing a dissipation of U.S. economic slack (Chart I-2, top panel). This is a side-effect of the tepid growth in the capital stock of U.S. businesses this cycle, which limits the expansion of the supply-side of the economy (Chart I-2, bottom panel). Meanwhile, household consumption should remain robust. Not only did 2015 register the strongest growth in the median household's real income since 1967, consumption is unlikely to slow much. In fact, vehicle-miles traveled and the Federal income tax receipts are both pointing toward healthy consumption (Chart I-3). Despite punky construction starts, housing activity shows signs of improvement. Housing inventories are near record lows and construction has underperformed household formation. Moreover, building permits are hooking upward, while housing affordability remains generous (Chart I-4). Additionally, the NAHB survey also points toward a rising share of residential activity in the economy (Chart I-4, bottom panel). Finally, capex intentions are slowly recovering. Moreover, the BCA House view is that the U.S. profit contraction is past its nadir. Going forward, capex and inventories are unlikely to subtract as much from growth as they did in 2015 and 2016. They may even become accretive to GDP growth. Chart I-2Vanishing U.S. Slack Vanishing U.S. Slack Vanishing U.S. Slack Chart I-3Positive Signs For The U.S. Consumer bca.fes_wr_2016_10_21_s1_c3 bca.fes_wr_2016_10_21_s1_c3 Chart I-4Residential Investment Will Improve bca.fes_wr_2016_10_21_s1_c4 bca.fes_wr_2016_10_21_s1_c4 Limited slack and a continued economic expansion imply a high likelihood of a Fed hike this year, and maybe two more next year if no shocks to financial conditions emerge. With markets currently pricing in 65 basis points of rate hikes by the end of 2019, this should lift rates across the curve. Higher interest rates on U.S. assets should drive private inflows into the country, pushing the U.S. dollar higher (Chart I-5). From a technical perspective, the U.S. capitulation index is breaking out to the upside following a pattern of lower highs. Since 2008, such breakouts have been followed by a significant rally in the broad trade-weighted dollar (Chart I-6). Thus, we continue to position ourselves for additional dollar strength this cycle. Chart I-5Flows Into The U.S. ##br##Are Set To Grow bca.fes_wr_2016_10_21_s1_c5 bca.fes_wr_2016_10_21_s1_c5 Chart I-6Favorable Technical ##br##Backdrop For The Greenback bca.fes_wr_2016_10_21_s1_c6 bca.fes_wr_2016_10_21_s1_c6 Bottom Line: The household sector remains healthy, and U.S. economic slack is dissipating. Hence, the Fed will try, rightfully or wrongly, to push rates higher this year and next, lifting the dollar in the process. Euro Area: Less Pressure A dollar rally could be painful for the euro. Yet, the euro is cheap and supported by a current account surplus of 3.3% of GDP (Chart I-7). What to do with this conflicting picture? For a currency to embark on a durable bull market, productivity growth needs to be stronger than that of its trading partners. A strong currency makes the tradeable-goods sector less competitive, hampering growth. A positive terms-of-trade shock, like that undergone by commodity producers during the previous decade can also do the trick. Neither of these statements currently describe the euro area. Another avenue for a country to withstand a strong currency is for growth to be domestically driven. If household consumption is the main locomotive, exporters' loss of market share do not hurt activity as much. This is true until the domestic economy enters a recession, an event usually driven by higher policy rates. This is why when the share of salaries in the U.S. economy expands, the dollar undergoes cyclical bull markets (Chart I-8). More salaries in the national income means more consumption. Chart I-7Euro ##br##Supports Euro Supports Euro Supports Chart I-8Domestically-Driven Growth##br## Is Good For A Currency Domestically-Driven Growth Is Good For A Currency Domestically-Driven Growth Is Good For A Currency In the euro area, GDP growth is above trend, but, in recent quarters, final private domestic demand has been weak (Chart I-9). In fact, last quarter, net exports were the main contributor to growth. This could explain why, since 2015, stronger European business surveys vis-à-vis the U.S. were unable to boost EUR/USD (Chart I-10). Chart I-9European Consumption##br## Isn't Strong Relative Pressures And Monetary Divergences Relative Pressures And Monetary Divergences Chart I-10If EUR/USD Could Not ##br##Rally Then, When Will It? bca.fes_wr_2016_10_21_s1_c10 bca.fes_wr_2016_10_21_s1_c10 We do expect eurozone final domestic demand to remain tepid. Yes, the credit impulse has improved, but this amelioration will prove temporary. The previous rebound in credit flows reflected the movement from a large contraction to a small expansion. Today, the dismal performance of euro area bank stocks - which have been a good leading indicator of European loan growth - points to slowing credit growth (Chart I-11). Fiscal policy is also moving from a small positive to a small negative. Work by the ECB staff shows that the cyclically adjusted budget balance in Europe fell by 0.3%, from -1.7% to -2.0% of GDP in 2016. Aggregate cyclically-adjusted budget balances are forecasted to improve to -1.8% and -1.6% of GDP in 2017 and 2018, respectively, representing a 0.2% fiscal drag each year. While a small number, we have to keep in mind that euro area trend growth is between 0.5% and 1%. This suggests that the European economy remains ill-equipped to handle a stronger euro. Moreover, the European economy exhibits much more slack than the U.S. economy. While total hours worked in the U.S. are 14% above Q1 2010 levels, in Europe, they are only 1.5% above such levels (Chart I-12), a gap much greater than demographics alone would have suggested. This means that monetary divergence will continue between Europe and the U.S. Chart I-11Euro Area Credit Impulse Will Weaken bca.fes_wr_2016_10_21_s1_c11 bca.fes_wr_2016_10_21_s1_c11 Chart I-12Less Capacity Pressures In Europe Less Capacity Pressures In Europe Less Capacity Pressures In Europe In fact, this week, the ECB did little to dispel this notion. Beyond trying to squash ideas of a sudden end to the QE program or any imminent tapering, president Draghi communicated that December will be the month when the real action occurs. Based on current trends, we expect the ECB to extend its QE program beyond March, but to hint at a tapering of purchases later in 2017. The ECB will also make it very clear that rates will remain as low as they currently are for an extremely long time. Thus, while the ECB might be slowly moving away from its hyper-stimulative stance, it will not do so as fast as the Fed. Therefore, policy divergences should continue to weigh on EUR/USD. Technicals are also pointing toward a lower euro. Not only has EUR/USD broken down its 1-year old series of higher lows, the euro's capitulation index, the intermediate-term momentum indicator, and the euro's A/D line are forming negative divergences with EUR/USD (Chart I-13). An interesting way to play the euro's weakness is to go short EUR/CZK, a position championed by our Emerging Market Strategy service.1 A floor at 27 has been set under EUR/CZK since November 2013. Yet, this floor looks increasingly untenable. Speculators are beginning to pile in. This week, 2-year Czech yields temporarily dipped below those of Swiss 2-year bonds, the current holder of the world's lowest yield. To fight appreciation pressures, the Czech National Bank (CNB) is accumulating a lot of reserves by buying euros, which is fueling a surge in the money supply (Chart I-14, top panel). Chart I-13Worrying Euro ##br##Technicals Worrying Euro Technicals Worrying Euro Technicals Chart I-14CZK: Reserves Expansion##br## Leading To Inflation bca.fes_wr_2016_10_21_s1_c14 bca.fes_wr_2016_10_21_s1_c14 This accumulation of reserves, in turn, is fanning inflationary forces in the Czech economy. The output gap is closing and core inflation already is increasing at a rate of 1.8% p.a. Easy financial conditions and expanding credit growth are likely to boost already-accelerating unit labor costs and wages (Chart I-14, bottom panel). This means that the 2% inflation target is likely to be hit as early as Q2 2017 according to the CNB. We expect this goal to be handily surpassed if the floor stays in place. Thus, we expect the CNB to abandon the floor within the next twelve months and we are shorting EUR/CZK. Finally, while we are bearish EUR/USD, we do believe that the euro will outperform the pound and commodity currencies. Moreover, despite poorer fundamentals, the euro could also temporarily outperform the SEK and the NOK if the dollar strengthens. The latter two are more sensitive to the USD than the euro is. Bottom Line: EUR/USD is at risk from the broad dollar rally. It is also likely to suffer from the tepid state of the euro area's final domestic demand, fueling monetary-policy divergences with the U.S. A speculative opportunity to short EUR/CZK is emerging, as the CNB's peg is outliving its usefulness. Canada: Falling Pressure USD/CAD has become more correlated with movements in rate differentials than with the vagaries of oil prices (Chart I-15). This puts the actions of the Bank of Canada in sharper focus. As expected, this week, the BoC left policy rates unchanged at 0.5%. More interesting was the quarterly monetary report. The economy has rebounded from the slump induced by the Q2 Alberta wildfires, and many key gauges of the Canadian economy have improved (Chart I-16). Yet, the BoC is looking the other way. Chart I-15CAD: Now More Rates Than Oil bca.fes_wr_2016_10_21_s1_c15 bca.fes_wr_2016_10_21_s1_c15 Chart I-16The BoC Is Looking The Other Way... bca.fes_wr_2016_10_21_s1_c16 bca.fes_wr_2016_10_21_s1_c16 The BoC is now forecasting the Canadian output gap to close in mid-2018; in July, this was expected to happen in the second half of 2017. This is because the BoC cut the expected Canadian growth rate by a cumulative 0.5% over the next two years. There have been some worrying developments warranting a more cautious forecast. While the Trudeau government's new childcare benefits are currently being rolled out and new infrastructure spending is to be implemented in 2017, the Canadian private sector's finances are increasingly shaky. The aggregate debt-servicing costs of the non-financial private sector is at record highs, with generous contributions from both households and the corporate sector (Chart I-17). The aggregate credit impulse has responded to this handicap, contracting by 7% of potential GDP, a move driven by the corporate sector (Chart I-18). While not as dramatic, the pace of debt accumulation by the household sector has also weakened. Recent administrative measures to cool the housing market - put in place by various provincial entities as well as the federal government - could accentuate this trend. Chart I-17...Rightfully So bca.fes_wr_2016_10_21_s1_c17 bca.fes_wr_2016_10_21_s1_c17 Chart I-18Collapsing Canadian Credit Impulse Collapsing Canadian Credit Impulse Collapsing Canadian Credit Impulse Another problem for Canada has been its loss of competitiveness. Non-oil Canadian exports have not responded as expected to the fall in the CAD. This is because many Canadian manufacturers have set up factories in Mexico and other EMs, or are competing with firms operating out of these nations. With these countries' currencies witnessing devaluations as deep as, or deeper than the loonie's, it is no wonder that Canada has lost market shares in the U.S. (Chart I-19). This means that Canadian rates will remain low for longer, making Canada another contributor to global monetary divergences vis-a-vis the U.S. The BoC is right to be worried that the Canadian economy will take longer than anticipated to close its output gap. With the pass-through to inflation of a lower CAD dissipating, the BoC expects Canadian core inflation to remain well contained for the next two years. We see little cause to disagree. This means that despite trading at a premium to PPP, USD/CAD has upside. Moreover, the Canadian dollar's A/D line is rolling over, another factor pointing to upside for USD/CAD (Chart I-20). At this point, the biggest risk to our view is oil. If WTI can breakout above $52 - perhaps in response to an as-yet negotiated OPEC/Russia oil-production cut or freeze - this could mitigate the downside for the CAD. Thus, while we like USD/CAD, we think the CAD has upside against the AUD and the NZD, especially as the loonie is less sensitive to the USD and EM spreads than the two antipodean currencies. Chart I-19Canada Is Losing Competitiveness Relative Pressures And Monetary Divergences Relative Pressures And Monetary Divergences Chart I-20Falling CAD A/D Line Falling CAD A/D Line Falling CAD A/D Line Bottom Line: The Canadian economy is showing surprising signs of underlying weakness. With the CAD having recently been more correlated to rate differentials than to oil, USD/CAD could rally on monetary divergences. That being said, on the back of a strong USD, CAD is likely to outperform the AUD and NZD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report, "Central European Strategy: Two Currency Trades", dated September 28, 2016, available at ems.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 bca.fes_wr_2016_10_21_s2_c1 bca.fes_wr_2016_10_21_s2_c1 Chart II-2USD Technicals 2 bca.fes_wr_2016_10_21_s2_c2 bca.fes_wr_2016_10_21_s2_c2 Policy Commentary: "The risks have changed in terms of overshooting what I think is full employment with implications for potential imbalances...Those imbalances might result in a reaction by the Fed that we end up having to tighten more quickly than I would like" - FOMC Voting Member Eric Rosengren (October 17, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 The Euro Chart II-3EUR Technicals 1 bca.fes_wr_2016_10_21_s2_c3 bca.fes_wr_2016_10_21_s2_c3 Chart II-4EUR Technicals 2 bca.fes_wr_2016_10_21_s2_c4 bca.fes_wr_2016_10_21_s2_c4 Policy Commentary: "An abrupt ending to bond purchases, I think, is unlikely...We remain committed to preserving a very substantial degree of monetary accommodation" - ECB President Mario Draghi (October 20, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 The Yen Chart II-5JPY Technicals 1 bca.fes_wr_2016_10_21_s2_c5 bca.fes_wr_2016_10_21_s2_c5 Chart II-6JPY Technicals 2 bca.fes_wr_2016_10_21_s2_c6 bca.fes_wr_2016_10_21_s2_c6 Policy Commentary: "Since the employment situation has continued to improve, no further easing of monetary policy may be necessary... at any rate, I would like to discuss this thoroughly with other board members at our monetary policy meeting" - BoJ Board Member Yutaka Harada (October 12, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 British Pound Chart II-7GBP Technicals 1 bca.fes_wr_2016_10_21_s2_c7 bca.fes_wr_2016_10_21_s2_c7 Chart II-8GBP Technicals 2 bca.fes_wr_2016_10_21_s2_c8 bca.fes_wr_2016_10_21_s2_c8 Policy Commentary: "Our judgment in the summer was that we could have seen another 400,000-500,000 people unemployed over the course of the next few years...So we're willing to tolerate a bit of overshoot in inflation over the course of the next few years in order to avoid that situation, to cushion the blow" - BOE Governor Mark Carney (October 14, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 bca.fes_wr_2016_10_21_s2_c9 bca.fes_wr_2016_10_21_s2_c9 Chart II-10AUD Technicals 2 bca.fes_wr_2016_10_21_s2_c10 bca.fes_wr_2016_10_21_s2_c10 Policy Commentary: "We have never thought of our job as keeping the year-ended rate of inflation between 2 and 3 percent at all times...Given the uncertainties in the world, something more prescriptive and mechanical is neither possible nor desirable" - RBA Governor Philip Lowe (October 17, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 bca.fes_wr_2016_10_21_s2_c11 bca.fes_wr_2016_10_21_s2_c11 Chart II-12NZD Technicals 2 bca.fes_wr_2016_10_21_s2_c12 bca.fes_wr_2016_10_21_s2_c12 Policy Commentary: "There are several reasons for low inflation - both here and abroad. In New Zealand, tradable inflation, which accounts for almost half of the CPI regimen, has been negative for the past four years. Much of the weakness in inflation can be attributed to global developments that have been reflected in the high New Zealand dollar and low inflation in our import prices" - RBNZ Assistant Governor John McDermott (October 11, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 bca.fes_wr_2016_10_21_s2_c13 bca.fes_wr_2016_10_21_s2_c13 Chart II-14CAD Technicals 2 bca.fes_wr_2016_10_21_s2_c14 bca.fes_wr_2016_10_21_s2_c14 Policy Commentary: "Given the downgrade to our outlook, Governing Council actively discussed the possibility of adding more monetary stimulus at this time, in order to speed up the return of the economy to full capacity" - BoC Governor Stephen Poloz (October 19, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swiss Franc Chart II-15CHF Technicals 1 bca.fes_wr_2016_10_21_s2_c15 bca.fes_wr_2016_10_21_s2_c15 Chart II-16CHF Technicals 2 bca.fes_wr_2016_10_21_s2_c16 bca.fes_wr_2016_10_21_s2_c16 Policy Commentary: "[On the effects of low interest rates on the housing market]...If you look at the recent past, the dynamics have been a bit more reassuring...[still]let's not forget, this disequilibrium that we have achieved remains very high" - SNB Vice-President Fritz Zurbruegg (October 12, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 bca.fes_wr_2016_10_21_s2_c17 bca.fes_wr_2016_10_21_s2_c17 Chart II-18NOK Technicals 2 bca.fes_wr_2016_10_21_s2_c18 bca.fes_wr_2016_10_21_s2_c18 Policy Commentary: "A period of low interest rates can engender financial imbalances. The risk that growth in property prices and debt will become unsustainably high over time is increasing. With high debt ratios, households are more vulnerable to cyclical downturns" - Norges Bank Governor Oystein Olsen (October 11, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 bca.fes_wr_2016_10_21_s2_c19 bca.fes_wr_2016_10_21_s2_c19 Chart II-20SEK Technicals 2 bca.fes_wr_2016_10_21_s2_c20 bca.fes_wr_2016_10_21_s2_c20 Policy Commentary: "[On Sweden's financial stability]...it remains an issue because we are mismanaging out housing market. Our housing market isn't under control in my view" - Riksbank Governor Stefan Ingves (October 27, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

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