Equities

The latest FDIC Quarterly Banking Profile paints a rosy picture for bank earnings growth. A surge in net interest income drove the industry Q2 net interest margin (NIM) to its highest level in 4 years, and the return on assets to the highest level in 10 years (second and third panels). Should inflation pick up in the back half of the year as we expect, it should be accompanied by a steeper yield curve and further NIM expansion. Encouragingly, noncurrent C&I loans have peaked (bottom panel), a strong signal that the credit cycle has turned positive. Improving credit quality in this largest category of bank credit should have the double impact of raising earnings and encouraging increasing loan growth. In short, this report reinforces our expectation that soaring consumer and business confidence, rising corporate profits and a potential capital spending revival will support the relative outperformance of banks. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT.

Highlights Yellen sidesteps monetary policy at Jackson Hole. The Fed raised rates in late 1990s before seeing any inflation. Tax cut deal is still likely... ..but a prolonged debt ceiling battle or government shutdown is not. Inflation surprise has not yet followed economic surprise higher. Earnings and earnings guidance matters more than politics. Feature Fed Chair Yellen's speech on financial stability at the Jackson Hole symposium on Friday, August 25 shed little light on the timing of the central bank's next policy move. Some investors were fearing that Yellen would give a nod to the hawks in her speech. Yellen did no such thing. She simply noted "that the core reforms we have put in place have substantially boosted resilience without unduly limiting credit availability or economic growth". Yellen made no comments to suggest that monetary policy needs to tighten in order to reduce financial froth and foster greater stability. Financial stability1 matters to the Fed almost as much as maintaining low and stable inflation, and full employment. In this week's report, we discuss the FOMC's deliberations when the economy was at full employment in the late 1990s, and note that the Fed was willing to raise rates even before inflation accelerated. Gary Cohn, a potential replacement for Yellen, suggested in an interview last week that tax cut legislation is on the way. We agree and discuss below. The economic surprise index is rebounding, but that has not yet led to positive surprises on inflation as it has in the past. We also examine what history says about earnings guidance, U.S. equities and the stock-to-bond ratios during and after earnings reporting season. Fed Deliberations At Full Employment Chart 1The Fed And Inflation At Full Employment Minutes from FOMC meetings in the late 1990s are instructive in understanding the central bank's reaction function due to a lack of inflation as the economy moves beyond full employment (Chart 1). The Fed cut rates following the LTCM financial crisis in late 1998 and subsequently held the fed funds rate at 4¾% until June 1999. Core inflation was roughly flat during the on-hold period, even as the unemployment rate steadily declined and various measures pointed to significant labor market tightness. The FOMC discussion in the late 1990s of why inflation was still quiescent sounds very familiar. Policymakers pointed to the widespread inability of firms to raise prices because of strong competitive pressures in domestic and global markets. In the Fed's view, significant cost-saving efforts and new technologies also contributed to the low inflation environment for both consumer prices and wages. Moreover, rapid increases in imports and a drawdown in the pool of available workers was also seen as satisfying growing demand and avoiding upward pressure on inflation. One difference from today is that productivity growth was solid at that time. The FOMC decided to hike rates in June 1999 by a quarter point, despite any indication that inflation had turned up. Policymakers described the tightening as "a small preemptive move... (that) would provide a degree of insurance against worsening inflation later". The Fed went on to lift the fed funds rate to 6½% by May 2000. Interestingly, the unemployment rate in June 1999 was 4.3%, the same as the current rate. There are undoubtedly important differences in today's macro backdrop. The Fed is also more fearful of making a policy mistake in the aftermath of the Great Recession and financial crisis. Nonetheless, the point is that the Fed has faced a similar low inflation / tight labor market environment before. Question marks regarding the structural headwinds to inflation will remain in place, but it will not take much of a rise in core inflation in the coming months for the Fed to deliver the next rate hike (most likely in December). Any fiscal stimulus, were it to occur, would reinforce the FOMC's bias to normalize interest rates. Is All Lost For U.S. Tax Cuts? Although tax reform was a major component of President Trump's legislative agenda, investors are skeptical that any fiscal stimulus or tax cuts will succeed (Chart 2). In our view, there is a high probability that at least a modest package will be passed. The reason is that, if it fails, Republicans will return empty-handed to their home districts to campaign for the November 2018 mid-term elections. Historically, Republican Presidents who have low approval ratings ahead of mid-term elections tend to lose a larger number of seats to Democrats (Chart 3). Chart 2Market Has Priced Out Trump's Economic Agenda Chart 3GOP Is Running Out Of Time Now that the border adjustment tax is officially dead, the GOP must either significantly moderate its tax cuts or add to the deficit. BCA's geopolitical strategists argue that regardless of which bill is passed by the GOP, the legislation will expire after a "budget window" of around 10 years.2 Tax cut plans ultimately will be watered down, but even a modest cut would be positive for the equity market. The dollar should also receive a boost, especially given that the Fed would have to respond to any fiscally driven growth impulse with higher interest rates. We expect Trump to ensure that the Fed retains its dovish bias when Chair Janet Yellen's term expires on February 3, 2018. He may favor a non-economist and a loyal adviser, such as Gary Cohn, over any of the more traditional and hawkish Republican candidates. Cohn could not single-handedly affect the course of monetary policy. The FOMC votes on rate changes, but decisions are formed by consensus (with one or two dissents). Cohn could implement an abrupt change in policy in the unlikely event that the Administration stacks the Fed Governors with appointees that are prepared to "toe the line." (The Administration does not appoint Regional Fed Presidents). Stacking the Governorships would take time. The FOMC has been very cautious in tightening policy and we do not see Trump taking an active role in monetary policy. The bottom line is that Cohn's possible appointment to the Fed Chair would not signal a major shift in monetary policy. Raising The Debt Ceiling Recent fights over Obamacare and tax reform have pitted fiscally conservative Republicans against moderates, with the debt ceiling used as a bargaining chip in the battles. While government shutdowns have occurred in the past, the debt ceiling has never been breached. At the end of the day, the debt ceiling will always be raised because government could not withstand the public pressure. Democrats can't be blamed because the Republicans control both chambers of Congress and the White House. Even the Freedom Caucus, the most fiscally conservative grouping in the House, is divided on the issue. This augurs well for a clean bill to raise the debt ceiling because the Republican majority in the House is 22 and the Freedom Caucus has 31 members. Democrats will not stand in the way of passage in the Senate. The worst-case scenario for the market would be a two-week shutdown, between October 1 when the current funding for the government will expire, and mid-October when the CBO predicts that the debt ceiling will be reached. Odds of such a scenario are probably around 25%. We would not expect a shutdown to have any lasting impact on the economy, although it could provide an excuse for the equity market to correct. The good news is that at least the economy is cooperating. Economic Surprise Versus Inflation Surprise Economic expectations are now low enough for the still-tepid activity data to beat, but this trend has not yet spilled over into the inflation data. Elevated economic expectations post-election led to a four-month period (early March-mid June) when the Citi Economic surprise index rolled over3 (Chart 4). In mid-July, the data began to top washed-out expectations and the surprise index accelerated. In the past two months, readings across a wide spectrum of economic indicators (consumer and business sentiment, consumer spending, home prices, manufacturing sentiment, and employment) have outpaced lowered expectations. Even so, inflation readings continue to disappoint relative to forecasts. Chart 4Inflation Surprise Usually Follows Economic Surprise Higher... But Not This Time After briefly moving above zero in early 2017 - indicating that inflation data was stronger than analysts projected- the Citi inflation surprise index rolled over again (Chart 4, bottom panel). Reports on the CPI, PPI, and average hourly earnings continued to fall short of consensus forecasts. This despite the rebound in the economic surprise index and the tightening of labor and product markets. The disappointment on price data relative to consensus forecasts is not new. Although there were brief periods where prices exceeded forecasts in 2010 and 2011, the last time that inflation exceeded market consensus in this business cycle was in late 2009 and early 2010. In the last few years of the 2001-2007 economic expansion through early 2009, the price data eclipsed forecasts more than half of the time. During this interval, economists underestimated the impact of surging energy prices on inflation readings. Moreover, the disconnect between economic surprise and inflation surprise has never been wider, but the inflation surprise index should follow the economic surprise index upward. In the past 13 years, there have been 15 periods when economic surprise has climbed after a trough. The inflation surprise index has temporarily increased in 13 of those episodes. For example, in the aftermath of the oil price peak in the U.S. in mid-2014, both economic surprise and inflation surprise diminished through early 2015 and then began moving up. However, today's inflation surprise index has rolled over while economic surprise has gained, but remember that inflation is a lagging indicator.4 Asset class performance since the economic surprise index formed a bottom in mid-June has run counter to history as risk assets have underperformed (Table 1). Returns on the S&P 500 have lagged Treasuries since the June 14 trough, driving down the stocks-to-bond ratio. U.S. large cap equities have outperformed Treasuries by an average of 290 basis points in the 11 prior episodes in this expansion as economic surprise climbed. Similarly, both high yield and investment-grade corporate bond returns have lagged Treasuries since mid-June. During previous episodes when the surprise index was climbing, credit outperformed Treasuries. Small caps have also lagged large caps, which is counter to the historical pattern, although oil and gold have both gained since the trough in economic surprise. The evidence is mixed for these two commodities after a bottom in economic surprise. Table 1Performance Of Risk Assets As Economic Surprise Rises BCA's view5 is that a Fed-led recession will begin in 2019. Nonetheless, markets were concerned about a recession occurring this year as the economic data underwhelmed in the first part of the year. Despite market fears, reliable leading indicators of a recession such as the LEI, the yield curve and the 26-week change in claims, are not signaling a recession (Chart 5). BCA does not expect the buildup of the types of imbalances that led to economic downturns in the past. Instead, a recession may be triggered by a Fed policy mistake, or a terrorist attack that disrupts economic activity over large area for an extended time, or a widespread natural disaster. Chart 5Data Suggest Low Odds Of A##BR##Recession In Next 12 Months Bottom Line: There are few imbalances in the economy and a recession in the U.S. is more than a year away. Although risk assets have not outperformed as is typical after a trough in economic surprise, we anticipate that stocks will beat bonds in the next 12-18 months. Inflation will surprise to the upside in the coming months, pressuring the Fed and the bond market. Stay short duration. Is Trump To Blame For The Stalled Stock Market Rally? Corporate earnings, not politics, drive equity prices. The S&P 500 has retreated from its all-time highs in early August despite another terrific earnings reporting season.6 Investors are concerned that Trump's erratic presidency may be to blame, but we take a different view Since the start of the economic expansion, the S&P 500 rose in 83% of the periods when large U.S. corporations provide results for the prior quarter and guidance on subsequent periods. (Table 2, bottom panel) U.S. equities increased only 66% of the time when managements were silent on profitability and future prospects (Table 3, bottom panel). However, there are periods when exogenous events like the 2011 U.S. debt downgrade and the 2015 Chinese devaluation that can disrupt the normal pattern, and we have excluded those from our calculations. Nevertheless, with the Q2 earnings reporting season over, the odds are less favorable for a rising U.S. equity market in the next few months. Table 2S&P 500, Stock-Bond-Ratio And Guidance During Earnings Season Table 3S&P 500, Stock-Bond-Ratio And Guidance Outside Of Earnings Season The stock-to-bond ratio also fares better during earnings season than during corporate quiet periods, and moves higher more often. When companies report profits, the stock-to-bond ratio increases 73% (Table 2, bottom panel) of the time versus just 65% outside of earnings season (Table 3, bottom panel). Since the start of 2010, the median return for the stock-to-bonds ratio is 0.046% per day during reporting season (Table 2, top panel) and 0.037% when it is not earnings season (Table 3, top panel). The implication is that the stock-to-bond ratio over the next two months may move higher, and at a faster rate than it did during the just completed Q2 earnings reporting season. Counter-intuitively, earnings guidance increases more often outside of earnings season (90% of the time and 0.04% per day, Table 3) than during it (77% of the time and 0.019% per day, Table 2). The top panels of Tables 3 and 2 respectively also show that the median daily return on stocks is higher outside of earnings reporting season (0.074% per day) than it is as earnings are being reported (0.054% per day). This is also somewhat counter-intuitive, as over the long term, earnings trends drive stock prices. We intend to examine the shorter term relationship between stock prices, the stocks to bond ratio and earnings guidance in a future Weekly Report. Bottom Line: The path of corporate earnings and not politics, ultimately drive stock prices. In the past eight years, the stocks to bond ratio during earnings season rises more and more often than when there was no new information on earnings. We remain upbeat on the earnings outlook for at least the remainder of this year, which will help the equity market weather the ongoing turbulence emanating from Washington. Next year, the earnings backdrop will not be as supportive. Stay overweight stocks versus bonds. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate", dated July 24, 2017. It is available at usis.bcaresearch.com. 2 Please see Geopolitical Strategy Weekly Report, "Is The Trump Put Over" dated August 23, 2017. It is available at gps.bcaresearch.com. 3 Please see BCA's U.S. Investment Strategy Weekly Report, "Global Monetary Policy Recalibration", published July 17, 2017. It is available at usis.bcaresearch.com. 4 Please see Global Investment Strategy Weekly Report, "From Slow Burn Recovery To Retro-Recession?," August 18, 2017. It is available at gis.bcaresearch.com. 5 Please see BCA's Global Investment Strategy Weekly Report, "The Timing Of The Next Recession" published June 16, 2017. It is available at gis.bcaresearch.com. 6 Please see BCA's U.S. Investment Strategy Weekly Report, "The Stage Is Set For Jackson Hole", August 21, 2017. It is available at usis.bcaresearch.com.

Cisco Systems, the communications equipment index heavyweight, reported tough quarterly results that highlighted the issues continuing to strain the industry. Revenues have continued to fall as telecom carriers, the key customer group, remain engaged in a deflationary price war (second panel) which has been exacerbated by U.S. federal government spending uncertainty; management guided to more of the same next quarter. Encouragingly, margins have improved despite sliding sales, evidence of solid cost control. This should (eventually) result in outsized profits when revenues turn the corner. On that front, telecom services providers have made significant progress in slowing the rate of decline in sales (third panel). Still, inventories & production have been diverging in an unhealthy direction (bottom panel) which could herald a liquidation phase, rendering the progress on margins unsustainable. We think the risks to profitability, combined with ongoing top line shrinkage, will keep investors away. Stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5COMM - CSCO, HRS, MSI, JNPR, FFIV.

Highlights Mario Draghi will signal the ECB's intention to further taper asset purchases during his Jackson Hole address later today, while cautioning that rate hikes remain a way away. The spread between long-term U.S. and euro area bond yields is not especially wide considering that trend growth is higher in the U.S. and fiscal policy will add 4% of GDP more to U.S. aggregate demand over the next few years than it will in the euro area. The upswing in Japanese growth is unlikely to prompt the BoJ to abandon its yield- curve targeting regime. Japanese stocks are cheap and corporate profits are rebounding smartly. Stay overweight Japanese equities in currency-hedged terms for the next 12 months. As one looks further ahead to the next decade, Japanese inflation will likely break out as labor shortages intensify. This will be part of a broad-based increase in global inflation. Stay long Japanese inflation protection and go short 20-year JGBs relative to their 5-year counterparts. Feature Mario Draghi: Action Jackson, The Sequel? Mario Draghi made shockwaves the last time he spoke at Jackson Hole on August 22, 2014. Draghi used that occasion to lay out the case for additional monetary easing. This paved the way for the ECB's own QE program. From that fateful speech to March 2015, EUR/USD fell from 1.33 to 1.05. Three years later, investors are anxious to hear what Draghi has to say, but this time around the expectation is that he will discuss plans for winding down QE. We agree that Draghi will signal the ECB's intent to further taper asset purchases. Growth is currently strong and the risk of a euro area breakup has all but disappeared. Nevertheless, although he may not publicly admit it, Draghi is cognizant of the fact that euro area financial conditions have tightened on the back of a strong euro, while U.S. financial conditions have continued to ease (Chart 1). Mario Draghi also knows that both inflation and wage growth remain depressed across the euro area, and that labor market slack outside Germany is still 6.7 percentage points higher than in 2008 (Chart 2). In addition, Draghi is undoubtedly aware of the likelihood that the neutral rate of interest is extremely low in the euro area, implying that the ECB would be constrained in raising rates even if the region were close to full employment.1 The spread between the 30-year U.S. Treasury yield and the 30-year GDP-weighted euro area bond yield - a reasonable proxy for the market's estimate of the difference in neutral rates between the two regions - currently stands at 86 basis points in nominal terms and 56 basis points in real terms. This is not especially wide considering that trend growth is higher in the U.S. and fiscal policy will add 4% of GDP more to U.S. aggregate demand over the next few years than it will in the euro area (Chart 3).2 Chart 1Diverging Financial Conditions Favor U.S. Over The Euro Area Chart 2Draghi Is Paying Attention Chart 3The State Of Fiscal Policy In The G4 We expect EUR/USD to pare back its gains, dropping to $1.05 by the end of 2018. However, most of the dollar's rebound is likely to occur next year, when it becomes apparent that the U.S. unemployment rate will fall well below the Fed's 2018 projection of 4.2%. This will force the Fed to step up the pace of rate hikes. For the time being, we see EUR/USD fluctuating within a broad range of $1.10-to-$1.20. BoJ: Time To Remove The Sake Bowl? Could the Bank of Japan follow in the Fed's and ECB's footsteps by signaling the desire to slowly withdraw monetary accommodation? On the surface, there are certainly some reasons to think so. Japanese growth has picked up recently, with real GDP rising at a blistering annualized pace of 4% in the second quarter (Chart 4). The acceleration in growth was driven entirely by stronger domestic demand. Consumer spending increased by 3.7%, while private nonresidential investment jumped by 9.9%. Inflation appears to be bottoming. The national core CPI index, which excludes fresh food prices but includes energy costs, rose for the seventh straight month in June to 0.4% on a year-over-year basis. Corporate goods inflation has reached 2.6%, up from a low of -4.6% in May 2016. Corporate service inflation moved to 0.8% this spring, the highest rate since 1993 (Chart 5). Nominal wage growth has also accelerated. Our Wage Trend Indicator, which uses statistical techniques applied to three separate data series to extract the underlying trend in Japanese wages, is now close to its 2007 highs (Chart 6). Chart 4GDP Growth Has Perked Up In Japan Chart 5Corporate Pricing Power Has Improved Chart 6Japanese Wages Are In An Uptrend The recovery in Japanese wage growth has occurred alongside a tightening of the labor market. The latest Economy Watchers Survey featured a litany of companies complaining of worsening labor shortages (Table 1). This is confirmed by the job openings-to-applicants ratio, which has surged to the highest level since 1974 (Chart 7). Table 1Japan: Evidence Of Shortages Of Workers, Part I Chart 7Japan: Evidence Of Shortages Of Workers, Part II Easy Does It, Kuroda-san Despite the good news on the economy, it is highly unlikely that the Bank of Japan will abandon its ultra-accommodative stance any time soon. There are a number of reasons for this: While inflation is rising, it is coming off a very low base, and is nowhere near the BoJ's 2% target. A deflationary mindset also remains firmly entrenched, as highlighted by both survey data and market expectations (Chart 8). Much of the recent pickup in inflation is attributable to higher energy prices and the lagged effects of a weaker yen. Excluding energy prices, core inflation has barely risen. The increase in corporate goods prices has also closely tracked the price of imports. Considering that the trade-weighted yen has appreciated of late, it is reasonable to assume that import price inflation will dissipate. This spring's annual shunto wage negotiations yielded smaller wage hikes among large companies than in 2016. This suggests that further near-term gains in wages will be hard to come by. Fiscal policy may turn less accommodative. The government passed a supplementary budget last summer (worth 1.5% of GDP according to the IMF). The effects of this package are being felt now. Public fixed investment surged by 21.9% in Q2. Under current law, however, fiscal policy is set to turn contractionary again over the next few years. Leading economic indicators are pointing to a modest slowdown in growth over the coming months (Chart 9). Chart 8Deflationary Mindset Has Been Hard To Shake Off Chart 9LEIs Pointing To Modest Slowdown The BoJ is not the same central bank that it was five years ago. The last two hawkish dissenters, Takehiro Sato and Takehide Kiuchi, both stepped down in July when their terms expired. They were replaced by Goshi Kataoka and Hitoshi Suzuki, neither of whom are expected to oppose Governor Haruhiko Kuroda's dovish approach. As such, it is highly likely that the BoJ will continue to anchor the 10-year yield at close to zero for at least the next 12 months. If bond yields elsewhere rise over this period - as we expect will be the case - the yen will weaken. Good News For Japanese Stocks... For Now A weaker yen is, of course, good news for Japanese stocks. Japanese equities are currently trading at a 16% discount to the MSCI World index based on forward earnings (Chart 10). Moreover, unlike in the past, both earnings and dividend growth have been strong, averaging 19% and 9%, respectively, over the last five years (Chart 11). Corporate governance reform - a key element of Abenomics - can take some credit for this. The share of companies with at least two independent directors rose from 18% in 2013 to 78% in 2016. The number of companies with performance-linked pay increased from 640 to 941, while the number that publish disclosure policies jumped from 679 to 1055. Analysts have been slow to factor in these positive developments. Chart 12 shows that Japan leads all other major stock markets in positive earnings surprises in the second quarter. We remain overweight Japanese equities in currency-hedged terms. Chart 10Good Value In Japanese Stocks Chart 11Solid Earnings And Dividend Growth Chart 12Japan And Positive Earnings Revisions: Follow The Leader . The Longer-Term Outlook: Japan (Eventually) Escapes Deflation As we discussed last week, it is likely that the U.S. will fall into recession in 2019 or 2020, dragging the rest of the world down with it.3 As a risk-off currency, the yen will strengthen, potentially reigniting deflationary forces. This will make it impossible for the BoJ to abandon its yield-curve targeting regime. Does that mean that Japan is condemned to a never-ending cycle of reflation/deflation? Not necessarily. As one looks at a longer-term horizon of 5-to-10 years, it is likely that Japan will finally escape deflation. This is because many of the structural forces that have sustained deflation will have either receded or reversed course by then. The simultaneous bursting of Japan's real estate and stock market bubbles in the early 1990s ushered in a prolonged period of falling property prices and corporate deleveraging. This suppressed both household consumption and business investment, leading to a persistent shortfall in aggregate demand. The latest data suggests that property prices are bottoming and corporate balance sheets have finally improved to the point where further aggressive cost-cutting is no longer necessary (Chart 13). Demographic trends are also likely to fuel higher inflation over the long haul. The deceleration in population growth in the early 1990s reduced the need for everything from new homes to new cars, shopping malls, and factories. This weighed on business capex and consumer durable spending, thereby exacerbating the deflationary forces that were already in place. In addition, a surge in the share of the population in their peak saving years - ages 30 to 50 - led to an increase in desired savings throughout the economy. More savings means less spending, so this also contributed to deflation. Looking out, population growth will remain anemic. However, two important developments will occur. First, the biggest cohort of Japanese baby boomers - those born in 1947-52 - will hit 70, the age at which most Japanese workers retire. Second, the secular rise in female labor force participation will plateau. Chart 14 shows that a larger percentage of Japanese women between the ages of 25 and 54 are employed than in the U.S., a massive shift from 20 years ago. Both these changes will exacerbate labor shortages, while further reducing national savings. Chart 13Deflationary Headwinds Are Abating Chart 14Female Employment In Japan Has Surpassed The U.S. Concluding Thoughts Contrary to popular belief, the Phillips curve remains intact, even in Japan (Chart 15). The market is not at all prepared for the prospect of higher Japanese inflation, as evidenced by the fact that CPI swaps are pricing in inflation of only 0.5% over the next two decades. As inflation picks up in the 2020s, nominal GDP will rise (even if real GDP growth remains anemic due to a shrinking labor force). The Bank of Japan will keep nominal rates low during the first half of the 2020s, ensuring that real rates sink further into negative territory. This will be the way by which Japan reduces its debt burden. Older savers may not like it, but the alternative of pension and health care cuts will be seen as even worse. We are currently long Japanese inflation protection through the CPI swaps market. As of today, we are adding a new long-term trade recommendation: Go short 20-year JGBs relative to their 5-year counterparts. The potential upside from this trade easily compensates for the negative carry of 66 bps. An upswing in Japanese inflation in the 2020s is very much in line with our secular view that global inflation will trend higher over the long haul, as articulated in a recent report.4 This will have a profound impact on fixed-income markets. While Japan's demographic transition has been and will continue to be more extreme than elsewhere, population aging is something that will affect all major economies. Chart 15Japan's Phillips Curve Is Alive And Well Chart 16Demographic Shifts: From Highly Deflationary To Highly Inflationary Chart 16 shows the IMF's estimate of how projected changes in the age structure of the population will affect inflation over the next few decades. The Fund's calculations suggest that demographic shifts will go from being very deflationary to very inflationary in every major economy. This will translate into significantly higher long-term nominal bond yields. Peter Berezin, Global Chief Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "The Future Of The Neutral Rate," dated August 4, 2017. 2 We calculate this number by taking the difference between the structural primary budget balance in the euro area (roughly 1.5% of GDP) and the U.S. (roughly -2.5% of GDP). The claim that this will translate into 4% more in aggregate demand in the U.S. implicitly assumes a fiscal multiplier of one. A larger multiplier would generate an even bigger gap in demand. 3 Please see Global Investment Strategy Weekly Report, "From Slow Burn Recovery To Retro-Recession?" dated August 18, 2017. 4 Please see Global Investment Strategy Weekly Report, "A Secular Bottom In Inflation," dated July 28, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Neutral Wal-Mart's (WMT) second quarter earnings provided some insight into a retail landscape that is in the midst of upheaval at the hands of Amazon. While a still-strong consumer (second panel) helped drive a 1.8% same-store sales increase, the real story was the 60% surge in online sales. The retail giant's acquisition of jet.com (and a host of smaller sites) and the recent partnering with Google Home to deliver an Alexa-like offering are clear signals that WMT is committed to the online path; the third panel suggests they have little choice. An increasing share of online sales will dilute margins for two reasons: first, with the visibility and comparability of online shopping, the spike in sales will be biased towards the most heavily discounted items, driving an erosion of gross margins. Second, the online platforms are still being built up, with significant overhead expenses that will impact operating margins. Both of these impacts were evident in the second quarter. Net, while WMT looks reasonably strong gearing up for a fight with Amazon from a sales perspective, profitability is the clear loser in the near term. We prefer to sit on the sidelines until margins can stage a recovery (which may take considerable time); stay neutral. The ticker symbols for the stocks in this index are: BLBG: S5HYPC - WMT, COST.

Highlights Your portfolio cash weighting should be at least in the middle of its range, until the observed volatility of risk assets rises meaningfully from its record low. Cyclically add long SEK/USD to long EUR/USD. Within a European equity portfolio, this implies going cyclically underweight Sweden's OMX, given its high exposure to exporters. Go underweight Swedish real estate equities; overweight Spanish real estate equities. Within a global equity portfolio, overweight euro area banks versus U.S. banks. Feature Great expectations for Mario Draghi's appearance at the Jackson Hole Symposium have been dampened, and understandably so. After the last monetary policy meeting, Draghi emphasised that ECB discussions about policy direction would take place in the autumn. It would undermine this decision making process if Draghi's Jackson Hole speech front ran the ECB discussions. Nonetheless, twitchy markets will inevitably read the tone of Draghi's observations on the global and euro area economies. Chart of the WeekSwedish House Prices Are Up 50% In Just Four Years...Thanks To Negative Interest Rates But the more market-relevant presentation might come five hours earlier on Friday at 3pm London time, when Janet Yellen gives a keynote speech on the market's latest meme - financial stability. Three months ago in Madrid, Draghi delivered a keynote speech1 on the very same topic - The interaction between monetary policy and financial stability - available here https://www.ecb.europa.eu/press/key/date/2017/html/ecb.sp170524_1.en.html and well worth reading as a prelude to Yellen's presentation. Draghi explained that ultra-accommodative monetary policy endangers financial stability through three potential channels: Distorting investor behaviour. Generating credit-fuelled bubbles, especially in real estate. Squeezing bank profitability. Do any of these three channels give ground for concern today? Yes. Distorting Investor Behaviour In our view, central banks' distortive impact on investor behaviour is the single biggest source of financial instability today. Yet Draghi devoted only a cursory mention of this danger, noting that investors "could be prone to engage in search-for-yield behaviour and take on excessive risks." The difficulty is that the psychological and behavioural finance biases creating the current distortions lie outside central bankers' natural area of expertise. Nevertheless, we hope that Yellen develops this topic much further at Jackson Hole. Specifically, the behavioural finance distortion known as Mental Accounting Bias describes the irrational distinction between the part of an investment's return that comes from its income, and the part that comes from its capital growth. Rationally, people should not care about this distinction because the money that comes from income and the money that comes from capital growth is perfectly fungible.2 But in practice, many people want a minimum investment income - because they wish to match their known spending outlays with their known income. While they could meet their spending needs by crystalizing capital growth, many people create psychologically separate 'mental accounts': spending from investment income and saving from capital growth. This is especially true for retirees whose main or only income might come from accumulated assets. Traditionally, this psychological mental accounting bias would be unnoticeable because investors could easily match their spending needs with the safe income generated by cash and government bonds. But in recent years, central banks' extended experiments with zero and negative interest rates and QE have forced the 'income mental account' to chase the higher but much more risky income streams from high-yield bonds and equities (Chart I-2 and Chart I-3). To the point where these risk assets no longer offer a sufficient risk premium. Chart I-2A Positive Yield On Equities Can Produce##br## A Negative 5-Year Return... Chart I-3...And Even A Negative##br## 10-Year Return The search-for-yield pushed up the prices of these risk assets. Now add to the mix the phenomenon known as negative skew.3 Risk asset advances tend to be gradual and gentle, and the longer and more established the advance becomes, the lower the observed volatility goes. Some investors then mistakenly interpret lower observed volatility as justification for a lower risk premium, which warrants a further price advance. And so on, in a self-reinforcing feedback. Today, this has left us with a bizarre and unprecedented situation in which the observed volatility of the Eurostoxx50 equity index is a fraction of the observed volatility of the long-dated German bund! (Chart I-4) Chart I-4Unprecedented: The Observed Volatility Of The Eurostoxx50 ##br## Is Now Lower Than That On The German Bund! But given the strong inverse relationship between observed volatility and price, record low observed volatility categorically does not mean that prospective risk of a drawdown is low. Quite the reverse, the lower the observed volatility, the higher the prospective risk. And vice-versa. Investment bottom line: Your portfolio cash weighting should always be inversely proportional to the observed volatility of risk assets. Today, with observed volatility still near a record low, your cash weighting should be at least in the middle of its range. Generating Credit-Fuelled Bubbles... In Sweden Turning to the second channel of financial instability, the ECB sees no evidence of credit-fuelled bubbles. Banks are extending credit, but at a fraction of the rate seen prior to 2007 (Chart I-5). And although house prices are rising, the ECB claims that its ultra-accommodative monetary policy has not created imbalances in real estate markets in the euro area. Taken at face value, this claim might be true. Chart I-5Euro Area Banks Are Extending Credit... But At A Modest Rate But look across the Baltic Sea. Chart I-6Swedish House Prices Accelerated##br## After ZIRP And NIRP Sweden's Riksbank has had to shadow the ECB's ultra-loose policy, to prevent a sharp appreciation of the Swedish krona versus the euro. The trouble is that negative interest rates have been wholly inappropriate for an economy that has recently been growing at 4.5%. One worrying consequence is that Swedish house prices have gone up by 50% in just four years (Chart of the Week), with the bulk of the boom happening after ZIRP and NIRP (Chart I-6). Also, bear in mind that the Swedish real estate market did not suffer a meaningful setback in either 2008 or 2011, meaning the recent boom is not a corrective rebound - like say, in Spain and Ireland. So the ECB's ultra-loose policy may indeed have generated a credit-fuelled bubble... albeit in Sweden! Fortunately, as the ECB ends its ultra-accommodation, it will also liberate the Riksbank to end its incongruous and dangerous NIRP policy. Investment bottom line: Cyclically add long SEK/USD to long EUR/USD. For European equity investors, this implies going cyclically underweight Sweden's OMX, given its high exposure to exporters. Also, go underweight Swedish real estate equities which are now approaching peak price-to-book multiples (Chart I-7). Prefer to overweight Spanish real estate equities which offer much more attractive valuations (Chart I-8). Chart I-7Swedish Real Estate Equities ##br##Are Close To Peak Valuation Chart I-8Spanish Real Estate Equities ##br##Offer Better Value Squeezing Bank Profitability For the third channel of financial instability, the ECB concedes that ultra-loose monetary policy compresses banks' net interest margins and thus exerts pressure on their profitability. "Since banks carry out maturity transformation by borrowing short and lending long-term, both the slope of the yield curve and its level matter for profitability." In turn, lower retained profits means lower accumulation of capital, making banks more fragile. The evidence strongly supports this logic. Since the start of the ECB's asset-purchase program, euro area bank valuations - a good proxy for profitability - have formed a perfect mirror-image of the expected intensity of QE (Chart I-9). Chart I-9Bank Valuations Have Been A Mirror-Image Of QE It follows that as the ECB dials back accommodation, the valuations of euro area banks will continue to recover - at the very least, in relative terms versus banks elsewhere in the world. Investment bottom line: Global equity investors should stay overweight euro area banks versus U.S. banks. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 At the First Conference on Financial Stability, May 24 207. 2 Assuming the tax treatment of income and capital growth is equal. 3 Please see the European Investment Strategy Weekly Report titled 'Negative Skew: A Ticking Time-Bomb' dated July 27, 2017 available at eis.bcaresearch.com Fractal Trading Model* We are monitoring the Italian stock Tenaris which is approaching a point of being technically oversold. We are also monitoring a commodity pair-trade, short nickel / long silver which is also approaching a potential entry point in the coming days. But we have not yet opened either trade. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations

Macro conditions are ripe to initiate a market neutral trade: long materials/short utilities. This trade provides exposure to the budding shift in underlying portfolio strength away from defensives toward cyclicals1 and also from domestic to global-exposed market areas. The balance of macro evidence is skewing increasingly toward robust manufacturing growth at home and abroad. The ISM manufacturing and global PMI indexes have maintained their recent gains, signaling that the path of least resistance for the relative share price ratio is higher (top panel). Synchronized global growth suggests that a relative earnings-led recovery will buttress this pair trade higher. The second and third panels highlight different ways of depicting coordinated EM and DM economic growth, giving us confidence that materials profits will outshine utilities EPS. The depreciating U.S. dollar is also a boon for commodity prices in general and base metals prices in particular. While natural gas prices are the marginal price setter for utilities pricing power, they represent an input feedstock cost to chemicals producers that dominate the materials sector. Taken together, a relative pricing power proxy suggests that materials stocks have the upper hand (bottom panel). Bottom Line: Initiate a long S&P materials/short S&P utilities pair trade. 1 For a recap of our major portfolio moves since May 1, please see U.S. Equity Strategy Weekly Report "Three Risks" dated August 14, 2017, available at uses.bcaresearch.com

Highlights Beware of asset managers' and leveraged funds' large net long positions in EM currencies. Overextended net long positions in EM and commodities currencies signify overbought conditions in EM risk assets in general. This in tandem with the poor outlook for EM/China growth makes the risk-reward of EM financial markets unattractive. Downgrade Korean equities from overweight to neutral, but continue to overweight Korean technology stocks relative to the EM benchmark. Also, maintain the short KRW / long THB trade. Take profits on the long Indian / short Indonesian stocks position. Consistently, downgrade Indian stocks to neutral and upgrade Indonesian bourses to neutral within an EM equity portfolio. Feature Investor positioning in EM currencies is elevated. From a contrarian perspective, this at minimum warrants a correction. Chart I-1 illustrates that asset managers' and leveraged funds' combined net long positions in the Mexican peso, the Brazilian real, the Russian ruble and South African rand are very elevated.1 This aggregate is weighted by notional value of outstanding open interest of each currency, and is shown as a percentage of open interest. Importantly, we have refined positioning data to separate asset managers and leveraged funds from other non-commercial and commercial institutions. Asset managers and leveraged funds reflect investment community sentiment the best. Besides, they are the most inclined to scale back their net long positions if and when these currencies begin to depreciate, i.e., they are more momentum driven. By doing so, they will reinforce the selloff. Currently bullish sentiment on EM and commodities is corroborated by the fact that asset managers' and leveraged funds' aggregate net long positions in non-EM commodities currencies such as the CAD, the AUD and the NZD are at the highest level since 2011 (Chart I-2). Typically, these currencies are at risk of a correction when positioning reaches such excessive levels. Chart I-1Asset Manager's And Leveraged Funds' Net Long Positions In EM Currencies Are Large Chart I-2Asset Manager's And Leveraged Funds' Net ##br##Long Positions In Commodities Currencies Chart I-3A and Chart I-3B show the same for individual currencies such as the MXN, the BRL, the RUB, the ZAR, the CAD, the AUD and the NZD. The overarching message is that investors' net long exposure to both EM and commodities currencies is large and depreciation risk for these exchange rates is substantial, at least in the near term. Chart I-3AAsset Managers And Leveraged Funds' Net ##br##Long Positions In Select Currencies Chart I-3BAsset Managers And Leveraged Funds' Net ##br##Long Positions In Select Currencies Yet, these positioning data do not reveal whether potential weakness will be a bull market correction or the beginning of bear market. Our bias remains that the potential selloff will evolve into a new phase of the bear market in EM currencies that began in 2011. In turn, as EM currencies depreciate, they will erode foreign investors' returns and trigger a selloff in other EM risk assets such as stocks, domestic bonds and credit markets. In short, investor sentiment on EM risk assets correlates with sentiment toward both EM and commodities currencies. Hence, bullish sentiment and overextended net long positions in EM and commodities currencies signify overbought conditions in EM risk assets in general. The Cyclical Outlook Chart I-4EM Currency Valuations Are Close To Neutral We are negative on the cyclical outlook for EM currencies for the following reasons: With a few minor exceptions, EM currencies are not cheap; their valuations are close to neutral Chart I-4 demonstrates the real effective exchange rate for aggregate EM excluding China, Korea and Taiwan. This is an equity market cap-weighted aggregate. It shows that EM exchange rate valuations are not depressed. The reason why we remove China, Korea and Taiwan from the calculation is because their respective bourses have large equity market-cap weights in the MSCI EM stock index, and thereby dominate the EM aggregate. Excluding these three markets, we get a less skewed perspective on EM currency valuations and assign higher weight to the high-yielding ones. Importantly, the best measure of currency valuation is, in our opinion, the real effective exchange rate based on unit labor costs (ULC). The rationale is that this measure captures changes in wages and productivity. The latter two are critical to competitiveness and, hence, reveal the true valuation of currencies. Unfortunately, there is no available ULC-based real effective exchange rate data for all individual EM currencies. Chart I-5A and Chart I-5B presents the measure for countries where data from reputable sources are available. By and large, the message is that, with the exception of the Mexican peso, EM currencies are not particularly cheap. Chart I-5AReal Effective Exchange Rates ##br##Based On Unit Labor Costs Chart I-5BReal Effective Exchange Rates ##br##Based On Unit Labor Costs The outlook for EM exchange rates has historically been contingent on growth and corporate profitability in developing economies. That said, EM exchange rate fluctuations have in recent years become dependent on U.S. real interest rates as the importance of portfolio fixed-income flows into EM has dramatically surged. Both drivers - EM growth and U.S. real yields - are likely to become headwinds for EM exchange rates going forward. EM growth will relapse anew as Chinese growth slows and EM shipments to China decline. Our new money impulse for China2 has historically been a good leading indicator for EM exchange rates, and it points to potentially considerable EM currency depreciation in the next six to nine months (Chart I-6). Meanwhile, U.S. interest rate expectations are very depressed. It will take only slightly stronger U.S. growth and inflation readings or some non-dovish guidance from the Federal Reserve for U.S. interest rate expectations to move higher. The latter will support the U.S. dollar and hurt EM currencies. Although industrial metals prices have recently spiked to new cyclical highs, we believe commodities prices - both for energy and industrial materials - will be lower in the medium term. Global oil stocks are breaking to new cyclical lows, heralding weakness in crude prices (Chart I-7). The fact that oil has failed to post gains amid a notable rally in the euro could be a sign of fundamental vulnerability. Chart I-6China's Money Impulse And EM Currencies Chart I-7Oil Prices Are Vulnerable As for industrial metals prices, our analysis has not changed: the considerable slowdown in China's broad money heralds a major top in industrial metals prices, as per Chart I-8. The mainland accounts for 50% of global industrial metals consumption, and its capex cycle is of critical importance. What explains the latest spike in base metals prices? Chart I-9 reveals that since early this year, iron ore prices have been negatively correlated with Chinese money market rates (interest rates are shown inverted and are advanced by 30 days Chart I-9). This year's correction and subsequent rebound in iron ore prices might be attributed to changes in mainland traders' positioning due to swings in domestic interest rates. Chart I-8China-Plays Are At Risk Chart I-9Chinese Interest Rates And Iron Ore Prices Going forward, either China's growth will decelerate sufficiently enough to weigh on industrial metals prices, or the authorities will resume policy tightening to rein in financial excesses. All in all, the risk-reward for iron ore and other industrial metals is negative. On the whole, lower energy and industrial metals prices will weigh on EM commodities currencies. As for Asian currencies, they are sensitive to global trade. We expect global trade and tradable goods prices to relapse due to the resumption of a slowdown in China/EM demand. Manufacturing-based Asian currencies will depreciate amid budding weakness in their manufacturing sector (Chart I-10). In addition, Chart I-11 shows global auto sales lead global semiconductor sales by several months. The basis for this correlation is that autos nowadays use a lot of semiconductors, and therefore auto cycles affect semiconductor demand. The boom in semi-cycle has been one of the pillars of Asian exports recovery. As the former moderates, the latter will relapse weighing on Asian non-commodities currencies. Chart I-10Asian Manufacturing ##br##And Exchange Rates Chart I-11Global Auto Sales Lead ##br##Global Semiconductor Sales Bottom Line: Our bet remains that EM currencies will depreciate versus both the U.S. dollar and the euro - and regardless of euro/U.S. dollar exchange rate fluctuations. We recommend a short position in a basket of the following EM currencies: ZAR, TRY, COP, CLP, BRL, IDR, MYR and KRW. For market-neutral portfolios, our currency overweights are MXN, RUB, PLN, CZK, TWD, INR and THB. Korean Equities: Downgrading To Neutral We recommend downgrading Korea to neutral from overweight within EM equity portfolios. North Korea will likely remain a source of uncertainty and volatility. BCA's Geopolitical Strategy service does not expect war on the Korean peninsula as long-standing constraints to conflict are still in place, starting with Pyongyang's ability to cause massive civilian casualties north of Seoul via an artillery barrage. As such, the ultimate resolution to the conflict will be a peaceful one. However, getting from here (volatility) to there (negotiated resolution) requires more tensions. The U.S. has to establish a "credible threat" of war in order to move China and North Korea towards a negotiated resolution.3 And that process could take more time, which means more volatility in the markets.4 The overwhelming portion of Korea's equity rally has been driven by a phenomenal surge in one company's share price: Samsung. Excluding technology companies, the performance of MSCI Korea stock prices and their EPS has been mediocre. Samsung's explosive rally has been partially due to the exponential surge in DRAM prices (Chart I-12). On a macro level, we cannot forecast prices of individual semiconductors (such as DRAM). Nevertheless, our assessment is that the global semi cycle is entering a soft patch as per Chart I-11 above. Furthermore, Korea's cyclical growth has already peaked, and will slow going forward (Chart I-13). Broad money growth is still decelerating, entailing that no turnaround is in the cards (Chart I-13, bottom panel). Chart I-12Samsung Share Prices And DRAM Chart I-13Korea: Cyclical Profile Importantly, the new government has enacted a law to boost minimum wages by 16% in January 2018 and would need to increase by a similar rate annually to reach its 2020 target. Even though there are fiscal subsidies for businesses and minimum wages affect smaller businesses much more than larger ones, odds are that this will still boost overall wage growth, and hence weigh on companies' profit margins. Chart I-14Korean Won Is Expensive Versus The Yen Finally, the Korean won is modestly expensive, based on the unit labor costs-based real effective exchange rate (Chart I-14, top panel). The won is especially expensive versus the yen (Chart I-14, bottom panel). This is negative for Korean manufacturers and the currency. Investment Recommendations Downgrade Korean stocks from overweight to neutral, but continue to overweight Korean technology stocks relative to the EM benchmark. Close long Korea / short EM equities and long Korean banks / short Indonesian banks positions. These positions have produced small gains since their initiation (details on all our open positions are available at the end of each week's report on page 17). Maintain a short KOSPI / long Nikkei in common currency terms trade: Either the won will depreciate substantially versus the yen or the KOSPI will underperform the Nikkei in local currency terms. In both cases, this trade will be profitable. Continue to bet on lower bond yields in Korea via receiving 10-year swap rates. Deflationary pressures from weaker exports - that make up 35% of GDP - will weigh on economic growth, and the central bank will be forced to cut rates. Maintain a short Korean won / long Thai baht position. The won is a high-beta currency and will underperform the Thai baht in a selloff / Asian exports slowdown. The Thai currency will likely trade in a low beta fashion due to the country's large current account surplus and low exposure to both China and commodities. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Take Profits On Long Indian / Short Indonesian Equities Position This recommendation has generated 8.4% gain since its initiation on July 30, 2014, and we recommend booking profits. Indian share prices have outperformed their Indonesian peers over the past year (Chart II-1) but the outlook for top line growth appears to be slightly better in Indonesia than in India. Specifically: We have combined bank credit to businesses and households with government expenditures to calculate a credit and fiscal spending impulse for both countries. Chart II-2 illustrates that this impulse heralds a more positive outlook for listed companies' revenues in the case of Indonesia than India. Chart II-1Book Profits On Long Indian / ##br##Short Indonesian Stocks Position Chart II-2Credit And Fiscal Spending ##br##Impulse Favor Indonesia Over India Other cyclical variables are mixed in both economies: vehicle and two-wheeler sales are sluggish, manufacturing PMIs have rolled over, but imports of capital goods are improving (Chart II-3). In regard to valuation and profitability, both bourses are expensive in absolute terms (Chart II-4, top panel) but India's return on equity (RoE) is well below Indonesia's (Chart II-4, bottom panel). Such a 14% premium of Indian stocks over Indonesian ones along with a poor revenue outlook and lower RoE might prevent further share price outperformance by India. Chart II-3Mixed Cyclical Growth Dynamics Chart II-4India And Indonesian Equities: P/E Ratios And RoEs Although our negative outlook for commodities prices and expensive equity valuations entail a negative stance on Indonesian risk assets in absolute terms, we believe this bourse's underperformance versus the EM overall equity index and Indian stocks is late. It makes sense to reduce/eliminate an underweight allocation to Indonesian equities. Bottom Line: We recommend booking gains on the long Indian / short Indonesia equity position initiated on July 30, 2014. Consistently, we downgrade Indian stocks from overweight to neutral and upgrade Indonesian ones from underweight to neutral within an EM equity portfolio. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 CFTC is the U.S. Commodity Futures Trading Commission. The data on South African rand is available from May 2015. 2 Presented and discussed in detail in July 26, 2017 and August 16, 2017 reports; the links are available on page 18. 3 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," April 19, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?," August 16, 2017, available at gps.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

The S&P 500 failed to hold on to gains and drifted lower last week succumbing to Washington-related uncertainty. The transition from liquidity-to-growth remains the dominant macro theme which is prone to bouts of volatility. A market-neutral way to benefit from the ongoing equity overshoot phase is to go long U.S. energy stocks/short global gold miners. This high-octane trade would benefit most from the handoff of global liquidity to economic growth (top and middle panels). Relative share prices have plummeted since the mid-December 2016 peak, collapsing 34%. The selloff in oil prices along with a more accommodative Fed have propelled global gold miners and punished U.S. energy stocks. More recently, increasing geopolitical risks have also boosted flows into bullion and gold-related equities. However, if our thesis that growth will trump liquidity - posited three weeks ago1 - pans out in the coming months, then relative share prices should reverse. Our relative EPS models do an excellent job in capturing the different macro forces that drive this trade; at the current juncture, they emit an unambiguously bullish signal: energy EPS will outshine gold producers' profits as the year draws to a close (bottom panel). Bottom Line: Initiate a long S&P energy/short global gold miners pair trade to benefit from the passing of the baton from liquidity to growth. 1 Please see August 21, 2017 U.S. Equity Strategy Weekly Report titled "Fraying Around The Edges?", available at uses.bcaresearch.com.