Gold

Highlights The three deflationary anchors of the global economy have abated: The U.S. private sector deleveraging is over, the euro area economy is escaping its post crisis hangover, and the destruction of excess capacity in China is advanced. This means that global central banks are in a better position than at any point this cycle to normalize policy, pointing to higher real rates. As a result, gold prices will suffer significant downside. The populist wave in New Zealand is based on inequalities and is here to stay. This will hurt the long-term outlook for the Kiwi. However, short-term NZD has upside, especially against the AUD. The BoE hiked rates, but upside surprises to policy is unlikely now. The pound remains at risk from Brexit negotiations. Feature Chart I-1Gold Is Setting Up For A Big Move Gold Is Setting Up For A Big Move Gold Is Setting Up For A Big Move Gold is at an interesting juncture. Gold prices, once adjusted for the trend in the U.S. dollar, have been forming a giant tapering wedge since 2011 (Chart I-1). This type of chart formation does not necessarily get resolved by an up-move, nor does it indicate a clear bearish pattern either. Instead, it points toward a potential big move in either direction. For investors, the key to assess whether this wedge will be resolved with a rally or a rout is the trend in global monetary conditions and real rates. In our view, the global economic improvement witnessed in 2017 suggests the world needs less accommodation than at any point since the onset of the great financial crisis. Thus, global accommodation will continue to recede, global real rates will rise and gold will suffer. The Exit Of The Great Deflationary Forces Since the financial crisis, in order to generate any modicum of growth, global monetary authorities have been forced to maintain an incredible degree of monetary accommodation in the global financial system. Central banks' balance sheets have expanded massively, with the Federal Reserve, the European Central Bank, the Bank of Japan, the Bank of England and the Swiss National Bank all increasing their asset holdings by 16% of GDP, 26% of GDP, 70% of GDP, 17% of GDP and 97% of GDP respectively. Real rates too have been left at unfathomable levels, with average real policy rates in the U.S., the euro area, Japan and the U.K. standing at 0.13%, -1.15%, -0.19%, and -2.12%, respectively. Despite all this easing, core inflation in the OECD has only averaged 1.68% since 2010, and real growth 2.05% - well below the averages of 2.3% and 2.44%, respectively, from 2001 to 2007. Explaining this extraordinary situation have been three key anchors that have conspired to create strong deflationary forces that have necessitated all this stimulus: the first was U.S. private sector deleveraging, with at its epicenter the rebuilding of household balance sheets. The second was the euro area crisis, which also caused a forced deleveraging in the Spanish and Irish private sector as well as in the Greek and Portuguese public sectors. The third was China's purging of excess capacity in the steel and coal sectors, as well as various heavy industries. These three deflationary anchors seem to have finally passed. In the U.S., nonfinancial private credit is slowly showing signs of recovering. Households have curtailed their savings rate, suggesting a lower level of risk aversion. Even more importantly, the growth in savings deposits is sharply decelerating, which historically tends to be associated with a re-leveraging of the household sector and increasing consumption (Chart I-2). Strong new home sales point toward these developments. The corporate sector is also displaying an important change in behavior. Share buybacks are declining, and both capex intentions and actual capex are recovering smartly - powered by strong profit growth (Chart I-3). This is crucial as it suggests firms are not recycling the liquidity they generate through their operations or their borrowings in the financial markets. Thus, with banks easing their lending standards, additional debt accumulation by firms is likely to support aggregate demand, eliminating a key deflationary force in the global economy. Chart I-2Household Deleveraging Is Over Household Deleveraging Is Over Household Deleveraging Is Over Chart I-3Companies Are Borrowing To Invest Companies Are Borrowing To Invest Companies Are Borrowing To Invest Moreover, Jay Powell's nomination to helm the Fed is also important. He is a proponent of decreasing bank regulation, especially for small banks that greatly rely on loan formation for their earnings. A softening in regulatory stance on these institutions could contribute to higher credit growth in the U.S. With aggregate liquidity conditions of the private sector - shown by the ratio of liquid assets to liabilities - having already improved, and indicating that a turning point in U.S. inflation will soon be reached, more credit growth could further stoke inflation (Chart I-4). Europe as well is also escaping its own morose state. ECB President Mario Draghi's fateful words in July 2012 resulted in a compression of peripheral spreads as investors priced away the risk of a breakup of the euro area (Chart I-5). As a result, the massive policy easing associated with negative rates and the ECB's expanded asset purchase program was transmitted to the parts of the euro area that really needed that easing: the periphery. Now, Europe is booming: Monetary aggregates have regained traction, real GDP growth is growing at a 2.3% annual pace, PMIs are growing vigorously, and even the unemployment rate has fallen back below 9%. European inflation remains low, but nonetheless the nadir of -0.6% hit in 2015 has also passed (Chart I-6). Chart I-4Liquid Private Balance Sheet Point To Inflation Liquid Private Balance Sheet Point To Inflation Liquid Private Balance Sheet Point To Inflation Chart I-5Draghi Held The Key To Help Europe Draghi Held The Key To Help Europe Draghi Held The Key To Help Europe Chart I-6Europe Past The Worst Europe Past The Worst Europe Past The Worst In China too we have seen important progress. Curtailment to excess capacity in the steel and coal sectors as well as across a wide swath of industries are bearing fruit (Chart I-7). China is not the source of deflation that it was as recently as 2015. Industrial profits have stopped contracting, industrial price deflation is over, and even core consumer prices are showing signs of vigor, growing at a 2.28% pace, the highest since the 2010 to 2011 period (Chart I-8). Thanks to these developments, global export prices have stopped deflating and are now growing at a 4.64% annual pace. With the three deflationary anchors having been slain, global growth is now able to escape its lethargy, with industrial activity at its strongest since 2003, while global capacity utilization has improved (Chart I-9). This is giving global central banks room to remove their easing. The Fed has already hiked rates four times and is embarking on decreasing its balance sheet; the Bank of Canada has followed suit two times, and the BoE, one time. Even the ECB is now beginning to taper its own asset purchases. We do anticipate this trend to continue with more and more central banks, with potentially the exception of the BoJ, joining the fray as the global environment remains clement. Even the People's Bank of China is likely to keep tightening policy due to the increasingly inflationary environment being experienced. Chart I-7Chinese Excess Capacity Purge Chinese Excess Capacity Purge Chinese Excess Capacity Purge Chart I-8China Doesn't Export Deflation Anymore China Doesn't Export Deflation Anymore China Doesn't Export Deflation Anymore Chart I-9Central Banks Can Normalize Central Banks Can Normalize Central Banks Can Normalize Bottom Line: The three anchors of global deflation have been slain. Private sector deleveraging in the U.S. is over, the euro area has healed and Chinese excess capacity has declined. As a result, global economic activity is at its strongest level in 14 years, and deflationary forces are becoming more muted. This is giving global central banks an opportunity to normalize policy without yet killing the business cycle. Implications For Gold Gold is likely to fare very poorly in this environment. Gold can be thought of as a zero coupon, extremely long-maturity inflation-indexed bond. This means that gold is a function of both inflation and real rates. Currently, gold offers little protection against outright inflation, having moved out of line with prices by a very large margin (Chart I-10). This leaves gold extremely vulnerable to development in real rates and liquidity. Saying that central banks can begin to normalize policy is akin to saying that central banks are in a position where letting real rate rise is feasible. As Chart I-11 illustrates, there has been a strong negative relationship between TIPS yields and gold prices. Moreover, when one looks beyond the price of gold in U.S. dollars, one can see that gold has been negatively affected by higher bond yields (Chart I-11, bottom panel). BCA currently recommends an underweight stance on duration, one that is synonymous with lower gold prices.1 Chart I-10Gold Is Expensive Gold Is Expensive Gold Is Expensive Chart I-11Higher Interest Rates Equal Lower Gold Higher Interest Rates Equal Lower Gold Higher Interest Rates Equal Lower Gold Moreover, the Fed's own research suggests that its asset purchases have curtailed the term premium by 85 basis points. The balance sheet run-off that the U.S. central bank is engineering will weaken that impact to a more meager 60 basis points by 2024. This also points to lower gold prices, as gold prices have displayed a negative relationship with the term premium (Chart I-12). An outperformance of financials in general but banks in particular is also associated with poor returns for gold (Chart I-13). Strong financials are associated with growing loan volumes, which mean a lesser need for policy easing, which puts upward pressure on the cost of money. Anastasios Avgeriou, who heads BCA's sectoral research, has an overweight on banks both globally and in the U.S. on the basis of the stronger loan growth we are beginning to see around the world.2 This represents a dangerous environment for gold. Chart I-12Normalizing Term Premium ##br##Is Dangerous For Gold Normalizing Term Premium Is Dangerous For Gold Normalizing Term Premium Is Dangerous For Gold Chart I-13Bullish Banks Equals ##br##Bearish Gold Bullish Banks Equals Bearish Gold Bullish Banks Equals Bearish Gold Finally, there is an interesting relationship between real stock prices and real gold prices. When stocks are in a secular bull market, gold prices are typically in a secular bear market (Chart I-14). A secular bull market in stocks tends to happen in an environment where there is more confidence that growth is becoming more durable, where there is less fear that currencies will have to be debased to support economic activity, or where inflation is not a destructive force like it was in the 1970s. These are environments where real rates tend to have upside. The continued strength in global equity prices, which are again in a secular bull market, would thus contribute to an increase in currently still-depressed global real yields, and thus, create downside in gold. One key risk to our view is that the Fed falls meaningfully behind the curve and lets inflation rise violently, which would put downward pressure on real rates and cause a violent correction in global equity prices - prompting investors to price in an easing in monetary policy. Geopolitics are another key risk, particularly a ratcheting up in North Korea tensions. With our bullish stance on the dollar, we are inclined to short the yellow metal versus the greenback. Moreover, for the past eight years, when net speculative positions in gold have been as elevated as they are today relative to net wagers on the DXY, gold in U.S. dollar terms has tended to weaken (Chart I-15). However, the analysis above suggests that gold could weaken against G10 currencies in aggregate. Thus investors with a more negative dollar view than ours could elect to sell gold against the euro. Agnostic players should short gold equally against the USD and the EUR. Chart I-14Gold And Stocks Don't Like Each Other Gold And Stocks Don't Like Each Other Gold And Stocks Don't Like Each Other Chart I-15Tactical Risk To Gold Tactical Risk To Gold Tactical Risk To Gold Bottom Line: The outlook for gold is negative. As the global economy escapes its deflationary funk and global central banks begin abandoning emergency easing measures, real interest rates will rise and term premia will normalize, which will put downward pressure on gold prices. Additionally, BCA's positive stance on banks is corollary with a negative outlook on gold. The continued bull market in stocks is an additional hurdle for gold. New Zealand: A New Hot Spot Of Populism The formation of the Labour/NZ First/Green coalition has sent ripples through the kiwi. The reaction of investors is fully rational, as the Adern government is carrying a very populist torch, sporting a program of limiting foreign investments in housing, limiting immigration, increasing the minimum wage and creating a dual mandate for the Reserve Bank of New Zealand. The key question is whether this is a fad, or whether something more profound is at play in New Zealand. We worry it is the latter. New Zealand has suffered from a profound increase in inequality since pro-market reforms were implemented in the 1980s. New Zealand's gini coefficient is very elevated, but even more worrisome has been the deteriorating trend. As Chart I-16 illustrates, the ratio of income of the top 20% of households relative to the bottom 20% has been in a steady uptrend. Additionally, this trend is sharper once the cost of housing is incorporated into the equation. Moreover, as Chart I-17 shows, New Zealand has experienced one of the most pronounced increases in housing costs among the G10. Chart I-16Growing Inequalities In New Zealand Reverse Alchemy: How To Transform Gold Into Lead Reverse Alchemy: How To Transform Gold Into Lead Chart I-17Kiwi Housing Is Expensive Reverse Alchemy: How To Transform Gold Into Lead Reverse Alchemy: How To Transform Gold Into Lead It is undeniable that the impact of immigration has been real. Net migration has averaged 24 thousand a year since 2000, on a population of 4.8 million. Moreover, the labor participation rate of immigrants has been higher than that of the general population, reinforcing the perception that immigration has contributed to keeping wage growth low (Chart I-18). The effect of low wage growth - whether caused or not caused by the increase in the foreign-born population - has been to boost household credit demand, pushing the national savings rate into negative territory, something that was required if households were to keep spending. These developments suggest that kiwi populism is not a fad, and is in fact a factor that will remain present in New Zealand politics. It also implies that policies designed to limit foreign investments into housing as well as immigration are indeed popular and will be implemented. What are the economic implications of these developments? Immigration was a key source of growth for New Zealand. As Chart I-19 shows, the growth of the kiwi economy since 1985 has been driven by an increase in the labor force. In fact, over the past five years, 86% of growth has been caused by labor force growth, with a very limited contribution from productivity gains. More concerning, as Chart I-20 shows, 44% of the increase in the population growth since 2012 has been related to immigration. Chart I-18The Narrative: Foreigners Steal Our Jobs The Narrative: Foreigners Steal Our Jobs The Narrative: Foreigners Steal Our Jobs Chart I-19Kiwi Growth: Labor Force Is Key Kiwi Growth: Labor Force Is Key Kiwi Growth: Labor Force Is Key Chart I-20Labor Force Growth Could Halve Reverse Alchemy: How To Transform Gold Into Lead Reverse Alchemy: How To Transform Gold Into Lead Additionally, according to the IMF's Article IV consultation for New Zealand, immigration has boosted output significantly, contributing to total hours worked as well as forcing an increase in the capital stock, which has boosted capex (Table I-1). Hence, lower intakes of foreign-born workers is likely to push down the country's potential growth rate. Limiting immigration in New Zealand could therefore have a significantly negative impact on the country’s neutral rate. As Chart 21 demonstrates, the real neutral rate for New Zealand, as estimated using a Hodrick-Prescott filter, is around 2%. A falling potential growth rate would push down the equilibrium policy rate in New Zealand, limiting how high the RBNZ's terminal policy rate will rise in the future. This points toward downward pressure on the NZD on a long-term basis. Shorting NZD/CAD structurally makes sense at current levels, especially as Canada remains open to immigration and immune to populism, as income inequalities are much more controlled there (Chart I-22). Table I-1Impact Of Immigration On Growth Reverse Alchemy: How To Transform Gold Into Lead Reverse Alchemy: How To Transform Gold Into Lead Chart I-21Kiwi Neutral Rate Has Downside Kiwi Neutral Rate Has Downside Kiwi Neutral Rate Has Downside Chart I-22NZD/CAD: Long-Term Heavy NZD/CAD: Long-Term Heavy NZD/CAD: Long-Term Heavy Limiting immigration in New Zealand could therefore have a significantly negative impact on the country's neutral rate. As Chart I-21 demonstrates, the real neutral rate for New Zealand, as estimated using a Hodrick-Prescott filter, is around 2%. A falling potential Shorter-term, the picture is slightly brighter for the NZD. Credit growth is strong, and is pointing toward an increase in the cash rate next year. Additionally, consumer confidence is high, and the labor market is showing signs of tightness, especially as the output gap stands at 0.87% of GDP (Chart I-23). This tightness in the labor market could easily be catalyzed into higher wage growth, especially as the new government is tabulating a 4.76% increase in the minimum wage in the coming quarters. Thus, BCA continues to expect an uptick in kiwi inflation and higher kiwi rates, even if a dual mandate for the RBNZ is implemented. Our favored way to play this strength in the kiwi remains going short the AUD/NZD. Our valuation model points to a strong sell signal in this cross (Chart I-24). Moreover, speculators are very long the AUD relative to the NZD, which historically has provided a contrarian signal to short it. Additionally, the concentration of power around Chinese President Xi Jinping points towards more reform implementations in China - reforms that we estimate will be targeted at decreasing the reliance of growth on debt-fueled investment while increasing the welfare of households, which should help Chinese consumption. As a result, metals could suffer relative to consumer goods. With New Zealand being a big exporter of foodstuffs and dairy products, this should represent a positive terms-of-trade shock for the kiwi relative to the Aussie. Chart I-23Short-Term Positives In New Zealand Short-Term Positives In New Zealand Short-Term Positives In New Zealand Chart I-24Downside Risk To AUD/NZD Downside Risk To AUD/NZD Downside Risk To AUD/NZD Bottom Line: The increase in populism in New Zealand is being fueled by a sharp increase in inequalities and rising housing costs. Immigration, rightly or wrongly, has been blamed in the public narrative for these ills. The measures announced by the Adern government target these issues head on, and we expect they will be implemented. This hurts New Zealand's long-term growth profile, and thus the terminal rate hit by the RBNZ this cycle. This could hurt the NZD on a structural basis. Tactically, it still makes sense to be short AUD/NZD. A Word On The BoE The BoE increased rates this week for the first time in a decade, but now acknowledges that current SONIA pricing is correct, removing its mention that risks are skewed toward higher rates than anticipated by the market. The pound sold off sharply on the news. Consumer confidence and retailer orders point to further slowdown in consumption. Thus, we think the British OIS curve is currently well priced, limiting any potential rebound in the GBP. Brexit continues to spook markets, rightfully. The political theater is far from over, and the continued uncertainty is likely to weigh further on the U.K. economy. This is likely to generate additional downside risk in the pound over the coming months. Thus, on balance, our current assessment is that the risks are too high to make a bullish bet on the GBP for now. A progress in the negotiations between the U.K. and the EU is needed before investors can buy the GBP, a currency that is cheap on a long-term basis. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant haarisa@bcaresearch.com 1 Please see Global Fixed Income Strategy Weekly Report, titled "Follow The Fed, Ignore The Bank Of England" dated September 19, 2017, available at gfis.bcaresearch.com 2 Please see Global Alpha Sector Strategy Weekly Report, titled "Buy The Breakout" dated May 5, 2017, available at gss.bcaresearch.com and U.S. Equity Strategy Weekly Report, titled "Girding For A Breakout?" dated May 1, 2017, available at uses.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 U.S. data was mixed: Core PCE was unchanged at 1.3%, and in line with expectations; Headline PCE was also unchanged at 1.6%; ISM Prices Paid came in at 68.5, beating expectations of 68; ISM Manufacturing came in weaker than expected. In other news, Jerome Powell is President Trump's pick as the next Fed chairman to replace Janet Yellen. Market reaction was muted as Powell is expected to continue in Yellen's footsteps and hike rates at a similar pace. While the Fed decided to leave rates unchanged this month, the probability of a December rate hike went up to 98%. We expect the USD bull market to strengthen next year when inflation re-emerges. Report Links: It's Not My Cross To Bear - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Data out of Europe was mixed: German and Italian inflation underperformed expectations and weakened compared to last month, while French inflation beat expectations; Overall European headline and core inflation also mixed expectations, coming in at 1.4% and 1.1% respectively; European preliminary GDP, however, beat expectations of 2.4%, coming in at 2.5%; The unemployment rate dropped to 8.9% for the euro area; The euro was up on Thursday after the nomination of Jerome Powell as Fed chair. His nomination represents a continuity of monetary policy. Despite this, we believe the re-emergence of inflation will cause the Fed to continue hiking after the December hike, deepening downward pressure on the euro next year. Report Links: Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent Japanese data has been mixed: Housing starts yearly growth came above expectations, coming in at -2.9%. However, housing starts did accelerate their contraction from August, when they were falling by 2% year-on-year. Industrial Production yearly growth came in above expectations, at 2.5%. However the jobs-to-applicants ratio came below expectations, staying put at 1.52. On Tuesday the BoJ left rates unchanged. Additionally the committee vowed to keep 10-year government bond yield around 0% and to continue their ETF purchases. More importantly, however, was the Bank of Japan's change to its outlook for inflation, which was decreased for this year. We continue to believe that deflation is too entrenched in Japan for the BoJ to change its policy stand. Thus, we expect USD/JPY to keep grinding higher, as U.S. monetary policy becomes more hawkish vis-à-vis Japan. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has surprised to the upside: Mortgage Approvals also outperformed expectations, coming in at 66.232 thousand. Moreover Nationwide house price yearly growth also outperformed, coming at 2.5% Both Markit Manufacturing PMI and Construction PMI outperformed, coming in at 56.3 and 50.8 respectively. The BoE hiked rates yesterday by 25 basis points as expected. Moreover, the committee also voted unanimously to maintain the stock of UK government bond purchases. However, the committee also acknowledged that inflation was not be the only effect of Brexit on the economy. They highlighted that uncertainty about the exit from the European Union was hurting activity despite a positive global growth backdrop. Overall, we think that the BoE will not deviate from the interest rate path priced into the OIS curve. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Australian data was mixed: HIA New Home Sales contracted by 6.1%; AiG Performance of Manufacturing Index came in at 51.1, less than the previous 54.2; Exports increased by 3%, while imports stayed flat at 0%; The trade balance increased to AUD 1.745 bn, compared to the expected AUD 1.2 bn, and above the previous AUD 873 mn. The AUD was up on the release of the trade balance. But underlying slack in the economy, which worries RBA officials, points to a low fair value for the AUD. The AUD will be the poorest performer out of the commodity currencies, due to the relative strength of those economies and of oil relative to metals. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been positive: The unemployment rate came below expectations at 4.6%, it also decreased from last quarter's 4.8% reading. The participation rate came above expectations, at 71.1%. It also increased from 70% on the previous quarter. The Labour cost Index came in line with expectations at 1.9% yearly growth. However it increased from 1.6% in the previous quarter. Overall the New Zealand economy looks very strong. This should warrant a hike by the RBNZ. However the new government create a new set of long-term risks. The elected government is a response to the high inequality and high migration that the country had experienced in the recent years. Overall the plans to reduce immigration and install a double mandate to the RBNZ are bearish for the NZD, as the neutral rate of New Zealand would be structurally lowered. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Canadian data has been weak recently: The raw material price index contracted by 0.1%; Industrial product prices contracted at a 0.3% monthly rate; GDP also contracted at a 0.1% monthly pace; Manufacturing PMI came out at 54.3, lower than the previous 55. In addition to this, Poloz identified several issues with the Canadian economy in his speech on Tuesday. These included the deflationary effects of e-commerce, slack in the labor market, subdued wage growth, and the elevated level of household debt. The probability of a rate hike has fallen to 22% for December, and it only rises above 50% in March next year. The CAD has lost a lot of its value since the BoC began hiking, but we believe it will resume hiking next year. Increasing oil prices will also mean that that CAD will outperform other G10 currencies. Report Links: Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been positive: The SVME Purchasing Manager's Index came above expectations at 62 in October. It also increased from the September reading. The KOF leading indicator also outperformed expectations significantly, coming at 109.1. EUR/CHF continues to climb unabated and is now only 3% from where it was before the SNB let the franc appreciate in January of 2015. Overall we see little indication that the SNB would let the franc appreciate again in the near future. On Wednesday, SNB Vice President Zurbruegg continued to talk down the franc by stating that a stronger CHF would cause a growth slowdown and that the CHF is still highly valued. Thus we expect downside in EUR/CHF to be limited for the time being. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been mixed: Retail sales growth underperformed expectations, as they contracted by 0.8% in September. However Norway's credit indicator surprised to the upside, coming in at 5.8%. Since September USD/NOK has appreciated by nearly 6%. This has been in an environment where oil has rallied by nearly 20%. Although this divergence might seem counterintuitive, it confirms our previous findings: USD/NOK is much more sensitive to real rate differentials than to oil prices. Inflationary pressures are still very tepid in Norway, while inflation is set to go higher in the U.S. These factors will further amplify the monetary policy divergences between these 2 countries, and consequently propel USD/NOK higher. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Swedish Manufacturing PMI decreased to 59.3 from 63.7, below the expected 62. EUR/SEK has appreciated to June levels, implying that markets have priced out any potential hawkishness by the Riksbank. Similarly, USD/SEK has risen by 6.2% from September lows. This is due to the re-chairing of Stefan Ingves, known for negative rates and quantitative easing. On the opposite side of the trade, President Trump elected Jerome Powell as the next Fed chair who will most likely continue the rate hike path highlighted by Janet Yellen. This will add further upward pressure on USD/SEK. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

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

Yesterday, we updated our long materials/short utilities pair trade, initiated on August 21, which has delivered much faster than anticipated. However, it is behind our long U.S. energy stocks/short global gold miners, initiated on the same day. That trade has yielded a return in excess of 10% in its few short weeks; surging global trade appears to be the driver of this switch from liquidity to growth. The second panel of the chart shows Korean & Taiwanese exports as a barometer of global trade; both have been expanding at brisk rates. We recently highlighted that South Korea saw its exports grow by 16% in the first seven months this year with a 31% increase in the first three weeks of September.1 The acceleration in trade points higher for the oil/gold ratio. BCA's Global Synchronicity Indicator, which has historically been closely correlated with relative share price momentum, reaffirms this message (bottom panel), and currently points to continued upward impetus. Overall, the rationale for our pair trade remains unchanged and, if anything, our conviction level is higher than when we initiated it. Thus, despite solid returns out of the gate, we recommend investors stay long S&P energy/short global gold miners. For more details, please see our August 21, 2017 U.S. Equity Strategy Weekly Report titled "Fraying Around The Edges?," available at uses.bcaresearch.com. 1 Please see U.S. Equity Strategy Insight Report titled "Accelerating Global Manufacturing Means More Machines," dated September 22, 2017, available at uses.bcaresearch.com Black Gold Has The Upper Hand Black Gold Has The Upper Hand

Highlights Portfolio Strategy A supply/demand imbalance has created a playable opportunity in the niche refining energy sub-index. Increase exposure to overweight. Safe haven demand is supporting gold mining equities, but shifting macro forces suggest that it will soon be time to move to the sidelines. Global gold miners are now on downgrade alert. Recent Changes Lift the S&P oil & gas refining & marketing index to overweight today. Put the global gold mining equity index (ticker GDX:US) on downgrade alert. Table 1 Still Goldilocks Still Goldilocks Feature The S&P 500 moved laterally last week as sustained geopolitical uncertainty offset encouraging economic data. Synchronized global growth coupled with the related global liquidity-to-growth transition remain the dominant macro themes. Dovish Fed speeches triggered a recalibration of market rate hike expectations and a lower 10-year Treasury yield. As long as lower bond yields reflect a less hawkish Fed rather than a deflationary relapse, they should underpin stock prices. Encouragingly, the latest ISM manufacturing survey catapulted higher to a level last seen in early 2011, diverging steeply from the bond market, as manufacturing optimism reigns supreme (Chart 1). The labor market confirmed this data. The most cyclical parts of the U.S. economy are firing on all cylinders, with manufacturing and construction job creation comprising 1/3 of nonfarm payroll growth last month (Chart 2). This is the highest reading since July 2011. Chart 1Unsustainable Divergence Unsustainable Divergence Unsustainable Divergence Chart 2Manufacturing Flexing Its Muscle Manufacturing Flexing Its Muscle Manufacturing Flexing Its Muscle Meanwhile, despite the Trump administration's shortcomings, America's CEOs are going against the grain. Capex is up smartly for the second consecutive quarter adding to real GDP growth and our capital spending model remains upbeat heralding additional outlays for the remaining two quarters of the year (Chart 3). Similarly, regional Fed surveys of capex intentions point to a sustainable pickup in capital spending in the coming months (Chart 3). Still generationally low interest rates, a less hawkish sounding Fed, coupled with a tamed greenback (Chart 4) and synchronized global growth have combined to revive animal spirits. The implication is that profit growth rests on solid foundations, a message corroborated by our S&P 500 EPS growth model (Chart 5). Chart 3CapEx To The Rescue CapEx To The Rescue CapEx To The Rescue Chart 4Dollar... Dollar… Dollar… Chart 5...And EPS Model Waving Green Flag …And EPS Model Waving Green Flag …And EPS Model Waving Green Flag Adding it up, the macro backdrop remains favorable for stocks. In fact, it represents a goldilocks equity scenario. This week we continue to add some cyclicality to our portfolio by further boosting a niche energy play. We also update our view on a portfolio hedge. Buy Refiners For A Trade In early July, we lifted refiners to neutral and locked in impressive gains for our portfolio, but three reasons kept us at bay and prevented us from turning outright bullish on this niche energy sub-sector.1 Namely, all-time high refining production, high refined product stocks and breakneck pace refinery runs were offsetting the nascent recovery in gasoline consumption, rising crack spreads and a mini V-shaped recovery in industry shipments. Net, we posited that a balanced EPS outlook would prevail in coming quarters. Hurricane Harvey has significantly changed this calculus and now clearly refiners are in a sweet earnings spot for at least the remainder of the year, compelling us to lift exposure to overweight. Severe refinery shutdowns are likely to return industry production levels to what prevailed early in the decade, representing a major, albeit temporary, setback (Chart 6). This production curtailment will result in sizable petroleum products inventory drawdowns and a likely halt (if not reversal) in refined product net exports in order to satisfy domestic demand. The longer it takes for refinery production to return to normalcy, the greater the inventory whittling down. Historically, relative share price momentum has been inversely correlated with inventory growth and the Harvey-related inventory clear-out is heralding additional relative performance gains (bottom panel, Chart 7). It is notable that both industry net exports and inventories had already been receding since the beginning of 2017, suggesting that hurricane Harvey will only accelerate a downtrend that was already in place. Chart 6Hurricane Related Blues... Hurricane Related Blues… Hurricane Related Blues… Chart 7... Are A Boon For Crack Spreads … Are A Boon For Crack Spreads … Are A Boon For Crack Spreads Taken together, this represents an ultra-bullish pricing power backdrop for the U.S. refining industry, at a time when capacity additions are also likely to, at least, pause for breath (bottom panel, Chart 6). Chart 8Brisk Demand Brisk Demand Brisk Demand Indeed, refining margins have jumped recently and will likely remain elevated as the Brent/WTI spread is widening anew (middle panel, Chart 7). Surging crack spreads are synonymous with higher earnings for this extremely capital-intensive and high operating leverage industry. Nevertheless, the refining supply disruptions only tell half the story. Refined product demand is exploding higher, pushing all-time highs and signaling that a substantial supply/demand imbalance is in the works (top panel, Chart 8). Typically this gets resolved via higher gasoline prices, further boosting industry EPS prospects (third panel, Chart 8). As a result, we expect a re-rating phase in relative valuations in the coming months, reversing the year-to-date deflation in the relative price-to-sales ratio. The second panel of Chart 8 shows that relative valuations and refined product consumption move in lockstep, and the current message is to expect a catch up phase in the former. In sum, a playable rally in refiners is in the offing on the back of a budding profit recovery that has yet to filter through analysts' EPS estimates (bottom panel, Chart 8). The longer-than-usual hurricane Harvey-related refining production disruptions, along with the spike in refined product demand, have created an exploitable opportunity. Bottom Line: Boost the S&P oil & gas refining & marketing index (PSX, VLO, MPC, ANDV) to overweight. What To Do With Gold Mining Equities? Gold and gold mining equities serve as great portfolio hedges especially in times of duress. Recent geopolitical jitters surrounding North Korea along with inaction in Washington and the substantial year-to-date selloff in the U.S. dollar have served as catalysts for gold to shine anew, hitting one-year highs. So is it time to trim exposure to shiny metal equities? The short answer is not yet. Real yields are sinking courtesy of a moderately less hawkish Fed (top panel, Chart 9). The probability of a December Fed hike has now collapsed to 30%, and the 5th hike this cycle is only priced in for next June. This is keeping a bid under gold and gold miners, as zero yielding bullion and near-zero yielding gold mining equities appear at the margin relatively more appealing. The equity risk premium has also stopped falling owing largely to the lower 10-year Treasury yield (bottom panel, Chart 9), representing another source of support for global gold miners. Meanwhile, policy uncertainty in the U.S. and around the globe is hooking up especially given North Korea's unpredictability, Washington's polarization, the upcoming German elections and, most importantly, the looming Chinese Congress. Historically, the policy uncertainty index and relative performance have been joined at the hip and the current message is positive for bullion related stocks (middle panel, Chart 9). Similarly, the Philly Fed's Partisan Conflict Index2 ("The Partisan Conflict Index tracks the degree of political disagreement among U.S. politicians at the federal level by measuring the frequency of newspaper articles reporting disagreement in a given month. Higher index values indicate greater conflict among political parties, Congress, and the President.") and bullion enjoy a tight positive correlation since the early 1980s (Chart 10), likely warning that the precious metal's run has more upside in the short term. Chart 9Shining Shining Shining Chart 10Increase In Partisanship Is Bullish Gold Increase In Partisanship Is Bullish Gold Increase In Partisanship Is Bullish Gold Moreover, demand for safe haven assets remains upbeat as evidenced by recent flows into gold-related ETFs. Positioning in the commodity pits are also signaling that more gains are in store for gold and the relative share price ratio (Chart 11). Nevertheless, there are some pockets of weakness that are pointing to a more cautious stance toward this portfolio hedge. The improving U.S. economic backdrop is weighing on gold mining equities (ISM manufacturing shown inverted, middle panel, Chart 12). Not only U.S. growth, but also synchronized global growth suggests that eventually demand for bullion will subside. In fact, global growth expectations continue to perk up (GDP expectations shown inverted, Chart 12), and G10 economic surprises are also shooting higher, anchoring gold and gold related equities (economic surprise index shown inverted, top panel, Chart 12). Chart 11Safe Haven Demand Comeback Safe Haven Demand Comeback Safe Haven Demand Comeback Chart 12Not All The Glitters Is Gold Not All The Glitters Is Gold Not All The Glitters Is Gold Tack on the inevitable liquidity withdrawal once the Fed starts to wind down its balance sheet later this month, and the handoff from liquidity-to-growth represents a bearish backdrop for gold and gold mining equities. Chart 13 shows that the Fed's balance sheet is positively correlated with bullion's relative performance versus the broad commodity complex, warning that the recent push toward multi-decade highs in relative performance are on borrowed time. Finally, our relative EPS model for the global gold mining index encapsulates most of these macro forces and suggests that relative profit growth will gravitate lower in the coming months (Chart 14). Chart 13Watch The Fed's Balance Sheet Watch The Fed’s Balance Sheet Watch The Fed’s Balance Sheet Chart 14EPS Model Is Outright Bearish EPS Model Is Outright Bearish EPS Model Is Outright Bearish Bottom Line: While our confidence in maintaining the gold-related equity portfolio hedge has fallen a notch, we are staying patient before moving to the sidelines. Put the global gold mining index (ticker GDX:US) on downgrade alert. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see the July 10, 2017 U.S. Equity Strategy Report titled "SPX 3,000?", available at uses.bcaresearch.com 2 https://www.philadelphiafed.org/research-and-data/real-time-center/partisan-conflict-index Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights Financial markets have slipped into a 'risk off' phase. The upbeat second quarter earnings season in the U.S., Japan and the Eurozone was overwhelmed by a number of negative events. Equity bear markets are usually associated with recessions. On that score, we do not see any warning signs of an economic downturn. However, geopolitical risks are rising at a time when valuation measures suggest that risk assets are vulnerable. We do not see the debt ceiling or the failure of movement on U.S. tax reform as posing large risks for financial markets. However, trade protectionism and, especially, North Korea are major wildcards. We don't believe the tensions in the Korean peninsula will end the cyclical bull market in global equities. Nonetheless, investors should expect to be tested numerous times over the next year to 18 months. BCA Strategists debated trimming equity exposure to neutral. However, the majority felt that, while there will be near-term volatility, the main equity indexes are likely to be higher on a 6-12 month horizon. Riding out the volatility is a better approach than trying to time the short-term ups and downs. That said, it appears prudent to be well shy of max overweight positions and to hold some safe haven assets within diversified portfolios. On a positive note, we have upgraded our EPS growth forecasts, except in the Eurozone where currency strength will be a significant drag in the near term. The Fed faced a similar low inflation/tight labor market environment in 1999. Policymakers acted pre-emptively and began to tighten before inflation turned up. This time, the FOMC will want to see at least a small increase in inflation just to be sure. Wages may be a lagging indicator for inflation in this cycle. Watch a handful of other indicators we identify that led inflection points in inflation in previous long economic expansions. This year's euro strength is unlikely to delay the next installment of ECB tapering, which we expect in early in 2018. Investors seem to be taking an "I'll believe it when I see it" attitude toward the U.S. inflation outlook, which has led to very lopsided rate expectations. Keep duration short. Feature Chart I-1Trump Popularity Headwind For Tax Reform September 2017 September 2017 A 'risk off' flavor swept over financial markets in August. The upbeat second quarter earnings season in the U.S., Japan and the Eurozone was overwhelmed by a number of negative events, from President Trump's Charlottesville controversy to the never-ending staff changes in the White House to North Korean tensions to the Texas flood and the terror attack in Spain. Trump's popularity rating is steadily declining, even now among Republican voters (Chart I-1). This has raised concerns that none of his business-friendly policies, tax cuts or initiatives to boost growth will be successfully enacted. It is even possible that the debt ceiling will be used as a bargaining chip among the various Republican factions. The political risks are multiplying at a time when the equity and corporate bond markets are pricey. Valuation measures do not help with timing, but they do inform on the potential downside risk if things head south. At the moment, we do not see any single risk as justifying a full retreat into safe havens and a cut in risk asset allocation to neutral or below. Nonetheless, there is certainly a case to be cautious and hold some traditional safe haven assets. Timing The Next Equity Bear Market It is rare to have an equity bear market without a recession in the U.S. There have been plenty of market setbacks that did not quite meet the 20% bear-market threshold, but were nonetheless painful even in the absence of recession (Black Monday, LTCM crisis, U.S. debt ceiling showdown and euro crises). Unfortunately, these corrections are very difficult to predict. At least with recessions, investors have a fighting chance in timing the exit from risk exposure. The slope of the yield curve and the Leading Economic Indicator (LEI) are classic recession indicators, and for good reason (Chart I-2). Over the past 50 years they have both successfully called all seven recessions with just one false positive. We can eliminate the false positive signals by combining the two indicators and follow a rule that both must be in the red to herald a recession.1 Chart I-2The Traditional Recession Indicators Have Worked Well The Traditional Recession Indicators Have Worked Well The Traditional Recession Indicators Have Worked Well It will be almost impossible for the yield curve to invert until the fed funds rate is significantly higher than it is today. Thus, it may be the case that a negative reading on the LEI, together with a flattening (but not yet inverted) yield curve, will be a powerful signal that a recession is on the way. Neither of these two indicators are warning of a recession. Global PMIs are hovering at a level that is consistent with robust growth. The erosion in the Global ZEW and the drop in the diffusion index of the Global LEI are worrying signs, but at the moment are consistent with a growth slowdown at worst (Chart I-3). Financial conditions remain growth-friendly and subdued inflation is allowing central banks to proceed cautiously when tightening (in the case of the Fed and Bank of Canada) or tapering (ECB). As highlighted in last month's Overview, the global economy has entered a synchronized upturn that should persist for the next year. The U.S. will be the first major economy to enter the next recession, but that should not occur until 2019 or 2020, barring any shocks in the near term. That said, risk asset prices have been bid up sharply and are therefore vulnerable to a correction. Below, we discuss five key risks to the equity bull market. (1) Is All Lost For U.S. Tax Cuts? Our recent client meetings highlight that investors are skeptical that any fiscal stimulus or tax cuts will see the light of day in the U.S. Tax cuts and infrastructure spending appear to have been priced out of the equity market, according to the index ratios shown in Chart I-4. We still expect a modest package to eventually be passed, although time is running out for this year. Tax reform is a major component of Trump's and congressional Republicans' agenda. If it fails, Republicans will have to go to their home districts empty-handed to campaign for the November 2018 midterm elections. Chart I-3Some Worrying Signs On Growth Some Worrying Signs On Growth Some Worrying Signs On Growth Chart I-4Fiscal Stimulus Largely Priced Out Fiscal Stimulus Largely Priced Out Fiscal Stimulus Largely Priced Out One implication of Tropical Storm Harvey is that it might force Democrats and Republicans to cooperate on an infrastructure bill for rebuilding. Even a modest spending boost or tax reduction would be equity-market positive given that so little is currently discounted. The dollar should also receive a lift, especially given that the Fed might respond to any fiscally-driven growth impulse with higher interest rates. (2) Who Will Lead The Fed? There is a significant chance that either Yellen will refuse to stay on when her term expires next February or that Trump will appoint someone else anyway. In this case, we would expect the President to do everything he can to ensure that the Fed retains its dovish bias. This means that he is likely to favor a non-economist and a loyal adviser, like Gary Cohn, over any of the more traditional, and hawkish, Republican candidates. Cohn could not arrive at the Fed and change the course of monetary policy on day one. The FOMC votes on rate changes, but in reality decisions are formed by consensus (with one or two dissents). The only way Cohn could implement an abrupt change in policy is if 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. Nonetheless, it is not clear why President Trump would take a heavy hand in monetary policy when the current FOMC has been very cautious in tightening policy. The bottom line is that we would not see Cohn's appointment to the Fed Chair as signaling a major shift in monetary policy one way or the other. (3) The Debt Ceiling A more immediate threat is the debt ceiling. Recent fights over Obamacare and tax reform have pit fiscally conservative Republicans against the moderates, and it is possible that the debt ceiling is used as a bargaining chip in this battle. 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 no government could stand the popular pressure that would result from social security checks not being mailed out to seniors or a halt to other entitlement programs. Even the Freedom Caucus, the most fiscally conservative grouping in the House, is considerably divided on the issue. This augurs well for a clean bill to raise the debt ceiling as 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 in the first half of October, just before the debt ceiling is hit. 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. That said, the risk of even a shutdown has been diminished by events in Houston. It would be very difficult and damaging politically to shut down the government during a humanitarian emergency. (4) Trade And Protectionism The removal of White House Chief Strategist Stephen Bannon signals a shift in power toward the Goldman clique within the Trump Administration. National Economic Council President Gary Cohn, Treasury Secretary Steven Mnuchin, and Commerce Secretary Wilbur Ross are now firmly in charge of economic policy. The mainstream media has interpreted this shift within the Administration as reducing the risk of trade friction. We do not see it that way. President Trump still sounds hawkish on trade, particularly with respect to China. Our geopolitical experts point out that there are few constraints on the President to imposing trade sanctions on China or other countries. He could use such action to boost his popularity among his base heading into next year's midterm elections. On NAFTA, the Administration took a hard line as negotiations kicked off in August. This could be no more than a negotiating tactic. Our base case is that it will be some time before investors find out if negotiations are going off the rails. That said, the situation is volatile for both NAFTA and China, and we can't rule out a trade-related risk-off phase in financial markets over the next year. (5) North Korea North Korea's missile launch over Japan highlights that the tense situation is a long way from a resolution. The U.S. is unlikely to use military force to resolve the standoff. There are long-standing constraints to war, including the likelihood of a high death toll in Seoul. Moreover, China is unlikely to remain neutral in any conflict. However, the U.S. will attempt to establish a credible threat in order to contain Kim Jong-un. From an investor's perspective, it will be difficult to gauge whether the brinkmanship and military displays are simply posturing or evidence of real preparations for war.2 We don't believe the tensions in the Korean peninsula will end the cyclical bull market in global equities. Nonetheless, investors should expect to be tested numerous times over the next year to 18 months. Adding it all up, there is no shortage of things to keep investors awake at night. We would be de-risking our recommended portfolio were it not for the favorable earnings backdrop in the major advanced economies. Profit Outlook Update Chart I-5EPS Growth Outlook EPS Growth Outlook EPS Growth Outlook Second quarter earnings season came in even stronger than our upbeat models suggested in the U.S., Eurozone and Japan. This led to upward revisions to our EPS growth forecast, except in the Eurozone where currency strength will be a significant drag in the near term. The U.S. equity market enjoyed another quarter of margin expansion in Q2 2017 and the good news was broadly based. Earnings per share were higher versus Q2 2016 in all 11 sectors. Results were particularly strong in energy, technology and financials. Looking ahead, an update of our top-down model suggests the EPS growth will peak just under 20% late this year on a 4-quarter moving average basis, before falling to mid-single digits by the end of 2018 (Chart I-5). The peak is predicted to be a little higher than we previously forecast largely due to the feed-through of this year's pullback in the dollar. In Japan, a solid 70% of reporting firms beat estimates. Chart I-6 shows that Japan led all other major stock markets in positive earnings surprises in the second quarter. Manufacturing sectors, such as iron & steel, chemicals and machinery & electronics, were particularly impressive in the quarter, reflecting yen weakness and robust overseas demand. Japanese earnings are highly geared to the rebound in global industrial production. Moreover, Japan's nominal GDP growth accelerated in the second quarter and the latest PPI report suggested that corporate pricing power has improved. Twelve-month forward EPS estimates have risen to fresh all times highs, and have outperformed the U.S. in local currencies so far this year. Corporate governance reform - a key element of Abenomics - can take some credit for the good news on earnings. 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. We expect trailing EPS growth to peak at about 25% in the first half of 2018 on a 4-quarter moving total basis, before edging lower by the end of the year. This is one reason why we like the Japanese market over the U.S. in local currency terms. Second quarter results in the Eurozone were solid, although not as impressive as in the U.S. and Japan. The 6% rise in the trade-weighted euro this year has resulted in a drop in the earnings revisions ratio into negative territory. Our previous forecast pointed to a continued rise in the 4-quarter moving average growth rate into the first half of 2018. However, we now expect the growth rate to dip by year end, before picking up somewhat next year. If the euro is flat from today's level, our model suggests that the drag on EPS growth will hover at 3-4 percentage points through the first half of next year as the negative impact feeds through (Chart I-7, bottom panel). Chart I-6Japan Led In Q2 Earning Surprises September 2017 September 2017 Chart I-7Currency Effects On Eurozone EPS Currency Effects On Eurozone EPS Currency Effects On Eurozone EPS Our top-down EPS model highlights that Eurozone earnings are quite sensitive to swings in the currency. In Chart I-7, we present alternative scenarios based on the euro weakening to EUR/USD 1.10 and strengthening to EUR/USD 1.30. For demonstration purposes we make the extreme assumption that the trade-weighted value of the euro rises and falls by the same amount in percentage terms. Profit growth decelerates by the end of 2017 in all three scenarios because of the lagged effect of currency swings. The projections begin to diverge only in 2018. EPS growth surges to around 20% by the end of next year in the euro-bear case, as the tailwind from the weakening currency combines with continuing robust economic growth. Conversely, trailing earnings growth hovers in the 5-8% range in the euro bull scenario, which is substantially less than we expect in the U.S. and Japan over the next year. EPS growth remains in positive territory because the assumed strength in European and global growth dominates the drag from the euro. The strong euro scenario would be negative for Eurozone equity relative performance versus global stocks in local currencies, although Europe might outperform on a common currency basis. The bottom line is that 12-month forward earnings estimates should remain in an uptrend in the three major economies. This means that, absent a negative political shock, the equity bull phase should resume in the coming months. Monetary policy is unlikely to spoil the party for risk assets, although the bond market is a source of risk because investors seem unprepared for even a modest rise in inflation. FOMC Has Seen This Before The Minutes from the July FOMC meeting highlighted that the key debate still centers on the relationship between labor market tightness and inflation, the timing of the next Fed rate hike and how policy should adjust to changing financial conditions. Chart I-8The FOMC Has Been Here Before The FOMC Has Been Here Before The FOMC Has Been Here Before The majority of policymakers are willing for now to believe that this year's soft inflation readings are driven largely by temporary 'one-off' factors. The hawks worry that a further undershoot of unemployment below estimates of full employment could suddenly generate a surge of inflation. They also point to the risk that low bond yields are promoting excess risk taking in financial markets. Moreover, the recent easing in financial conditions is stimulative and should be counterbalanced by additional Fed tightening. The hawks are thus anxious to resume tightening, despite current inflation readings. Others are worried that inflation softness could reflect structural factors, such as restraints on pricing power from global developments and from innovations to business models spurred by advances in technology. In this month's Special Report beginning on page 18, we have a close look at the impact of "Amazonification" in holding down overall inflation. We do not find the evidence regarding e-commerce compelling, but the jury is still out on the impact of other technologies. If robots and new business strategies are indeed weighing on inflation, it would mean that the Phillips curve is very flat or that the full employment level of unemployment is lower than the Fed estimates (or both). Either way, the doves would like to see the whites-of-the-eyes of inflation before resuming rate hikes. The last time the Fed was perplexed by a low level of inflation despite a tight labor market was in the late 1990s (Chart I-8). The FOMC cut rates following the LTCM financial crisis in late 1998, and then held the fed funds rate unchanged at 4¾% until June 1999. Core inflation was roughly flat during the on-hold period at 1% to 1½%, even as the unemployment rate steadily declined and various measures pointed to growing labor shortages. The FOMC 's internal debate in the first half of 1999 sounded very familiar. The minutes from meetings at that time noted that some policymakers pointed to the widespread inability of firms to raise prices because of strong competitive pressures in domestic and global markets. Some argued that significant cost saving efforts and new technologies also contributed to the low inflation environment for both consumer prices and wages. 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 the absence of any clear 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%, exactly 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, but in the end patience ran out and policymakers acted pre-emptively. Inflation Warning Signs During Long-Expansions We have noted in previous research that inflation pressures are slower to emerge in 'slow burn' recoveries, such as the 1980s and 1990s. In Chart I-9, we compare the core PCE inflation rate in the current cycle with the average of the previous two long expansion episodes (the inflection point for inflation in the previous cycles are aligned with June 2017 for comparison purposes). The other panels in the chart highlight that, in the 1980s and 1990s, wage growth was a lagging indicator. Economic commentators often assume that inflation is driven exclusively by "cost push" effects, such that the direction of causation runs from wage pressure to price pressure. However, causation runs in the other direction as well. Households see rising prices and then demand better wages to compensate for the added cost of living. This is not to say that we should totally disregard wage information. But it does mean that we must keep an eye on a wider set of data. Indicators that provided some leading information in the previous two long cycles are shown in Chart I-10. To this list we would also add the St. Louis Fed's Price Pressure index, which is not shown in Chart I-10 because it does not have enough history. At the moment, the headline PPI, ISM Prices Paid and BCA's pipeline inflation pressure index are all warning that inflation pressures are gradually building. However, this message is not confirmed by the St. Louis Fed's index and corporate selling prices. We are also watching the velocity of money, which has been a reasonably good leading indicator for U.S. inflation since 2000 (Chart I-11). Chart I-9In The 80s & 90s Wage Growth ##br##Gave No Early Warning On Inflation In The 80s & 90s Wage Growth Gave No Early Warning On Inflation In The 80s & 90s Wage Growth Gave No Early Warning On Inflation Chart I-10Leading Indicators Of Inflation ##br##In "Slow Burn" Recoveries Leading Indicators Of Inflation In "Slow Burn" Recoveries Leading Indicators Of Inflation In "Slow Burn" Recoveries Chart I-11Money Velocity And Inflation Money Velocity And Inflation Money Velocity And Inflation Our Fed view remains unchanged from last month; the FOMC will announce its balance sheet diet plan in September and the next rate hike will take place in December. Nonetheless, this forecast hangs on the assumption that core inflation edges higher in the coming months. Some indicators are pointing in that direction and recent dollar weakness will help. Wake Me When Inflation Picks Up Investors seem to be taking an "I'll believe it when I see it" attitude toward the U.S. inflation outlook. They also believe that persistent economic headwinds mean that monetary policy will need to stay highly accommodative for a very long time. Only one Fed rate hike is discounted between now and the end of 2018, and implied forward real short-term rates are negative until 2022. While we do not foresee surging inflation, the risks for market expectations appear quite lopsided. We expect one rate hike by year end, followed by at least another 50 basis points of tightening in 2018. The U.S. 10-year yield is also about almost 50 basis points below our short-term fair value estimate (Chart I-12). Moreover, over the medium- and long-term, reduced central bank bond purchases will impart gentle upward pressure on equilibrium bond yields. Twenty-eighteen will be the first time in four years in which the net supply of government bonds available to private investors will rise, taking the U.S., U.K., Eurozone and Japanese markets as a group. This year's euro strength is unlikely to delay the next installment of ECB tapering, which we expect in early in 2018. The currency appreciation will keep a lid on inflation in the near term. However, we see the euro's ascent as reflective of the booming economy, rather than a major headwind that will derail the growth story. Overall financial conditions have tightened this year, but only back to levels that persisted through 2016 (Chart I-13). Chart I-12U.S. 10-year Yield Is Below Fair Value U.S. 10-year Yield Is Below Fair Value U.S. 10-year Yield Is Below Fair Value Chart I-13Financial Conditions Financial Conditions Financial Conditions It will take clear signs that the economy is being negatively affected by currency strength for the ECB to back away from tapering. Indeed, the central bank has little choice because the bond buying program is approaching important technical limits. European corporate and peripheral bond spreads are likely to widen versus bunds as a result. The implication is that global yields have significant upside potential relative to forward rates, especially in the U.S. market. Duration should be kept short. JGBs are the only safe place to hide if global yields shift up because the Bank of Japan is a long way from abandoning its 10-year yield peg. Treasury yields should lead the way higher, which will finally place a bottom under the beleaguered dollar. Nonetheless, we are tactically at neutral on the greenback. Conclusions Chart I-14Gold Loves Geopolitical Crises September 2017 September 2017 In light of rising geopolitical risk, the BCA Strategists recently debated trimming equity exposure to neutral. Some argued that the risk/reward balance has deteriorated; the upside is limited by poor valuation, while there is significant downside potential if the North Korean situation deteriorates alarmingly. However, the majority felt that, while there will be near-term volatility, the main equity indexes are likely to be higher on a 6-12 month horizon. Riding out the volatility is a better approach than trying to time the short-term ups and downs. That said, it appears prudent to be well shy of max overweight positions and to hold some safe haven assets within diversified portfolios. BCA research has demonstrated that U.S. Treasurys, Swiss bonds and JGBs have been the best performers in times of crisis (Chart I-14).3 The same is true for the Swiss franc and the Japanese yen, such that the currency exposure should not be hedged in these cases. The dollar is more nuanced. It tends to perform well during financial crises, but not in geopolitical crises or recessions. Gold has tended to perform well in geopolitical events and recessions, although not in financial crises. We continue to prefer Japanese to U.S. stocks in local currency terms, given that EPS growth will likely peak in the U.S. first. Japanese stocks are also better valued. Europe is a tough call because this year's currency strength will weigh on earnings in the next quarter or two. However, the negative impact on earnings will reverse if the euro retraces as we expect. EM stocks have seen the strongest positive earnings revisions this year. We continue to worry about some of the structural headwinds facing emerging markets (high debt levels, poor governance, etc.). However, the cyclical picture remains more upbeat. Chinese H-shares remain our favorite EM market, trading at just 7.5 times 2017 earnings estimates. Our dollar and duration positions have been disappointing so far this year. Much hinges on U.S. inflation. Investors appear to have adopted the idea that structural headwinds to inflation will forever dominate the cyclical pressures. This means that the bond market is totally unprepared for any upside surprises on the inflation landscape. Admittedly, a rise in bond yields may not be imminent, but the risks appear to us to be predominantly to the upside. Lastly, crude oil inventories are shrinking as our commodity strategists predicted. They remain bullish, with a price target of USD60/bbl. Mark McClellan Senior Vice President The Bank Credit Analyst August 31, 2017 Next Report: September 28, 2017 1 Please see BCA Global ETF Strategy, "A Guide To Spotting And Weathering Bear Markets," dated August 16, 2017, available at etf.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, available at gps.bcaresearch.com 3 Please see BCA Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com II. Did Amazon Kill The Phillips Curve? A "culture of profound cost reduction" has gripped the business sector since the GFC according to one school of thought, permanently changing the relationship between labor market slack and wages or inflation. If true, it could mean that central banks are almost powerless to reach their inflation targets. Amazon, Airbnb, Uber, robotics, contract workers, artificial intelligence, horizontal drilling and driverless cars are just a few examples of companies and technologies that are cutting costs and depressing prices and wages. In the first of our series on inflation, we will focus on the rise of e-commerce and the related "Amazonification" of the economy. In theory, positive supply shocks should not have more than a temporary impact on inflation if the price level is indeed a monetary phenomenon in the long term. But a series of positive supply shocks could make it appear for quite a while that low inflation is structural in nature. We are keeping an open mind and reserving judgement on the disinflationary impact of robotics, artificial intelligence and the gig economy until we do more research. But in terms of the impact of e-commerce, it is difficult to find supportive evidence at the macro level. The admittedly inadequate measures of online prices available today do not suggest that e-commerce sales are depressing the overall inflation rate by more than 0.1 or 0.2 percentage points. Moreover, it does not appear that the disinflationary impact of competition in the retail sector has intensified over the years. Today's creative destruction in retail may be no more deflationary than the shift to 'big box' stores in the 1990s. Perhaps lower online prices are forcing traditional retailers to match the e-commerce vendors, allowing for a larger disinflationary effect than we estimate. However, the fact that retail margins are near secular highs outside of department stores argues against this thesis. The sectors potentially affected by e-commerce make up a small part of the CPI index. The deceleration of inflation since the GFC has been in areas unaffected by online sales. High profit margins for the overall corporate sector and depressed productivity growth also argue against the idea that e-commerce represents a large positive macro supply shock. Perhaps the main way that e-commerce is affecting the macro economy and financial markets is not through inflation, but via the reduction in the economy's capital spending requirement. This would reduce the equilibrium level of interest rates, since the Fed has to stimulate other parts of the economy to offset the loss of demand in capital spending in the retail sector. Anecdotal evidence is all around us. The global economy is evolving and it seems that all of the major changes are deflationary. Amazon, Airbnb, Uber, robotics, contract workers, artificial intelligence, horizontal drilling and driverless cars are just a few examples of companies and technologies that are cutting costs and depressing prices and wages. Central banks in the major advanced economies are having difficulty meeting their inflation targets, even in the U.S. where the labor market is tight by historical standards. Based on the depressed level of bond yields, it appears that the majority of investors believe that inflation headwinds will remain formidable for a long time. One school of thought is that low inflation reflects a lack of demand growth in the post-Great Financial Crisis (GFC) period. Another school points to the supply side of the economy. A recent report by Prudential Financial highlights "...obvious examples of ... new business models and new organizational structures, whereby higher-cost traditional methods of production, transportation, and distribution are displaced by more nontraditional cost-effective ways of conducting business."1 A "culture of profound cost reduction" has gripped the business sector since the GFC according to this school, permanently changing the relationship between labor market slack and wages or inflation (i.e., the Phillips Curve). Employees are less aggressive in their wage demands in a world where robots are threatening humans in a broadening array of industrial categories. Many feel lucky just to have a job. In a highly sensationalized article called "How The Internet Economy Killed Inflation," Forbes argued that "the internet has reduced many of the traditional barriers to entry that protect companies from competition and created a race to the bottom for prices in a number of categories." Forbes believes that new technologies are placing downward pressure on inflation by depressing wages, increasing productivity and encouraging competition. There are many factors that have the potential to weigh on prices, but analysts are mainly focusing on e-commerce, robotics, artificial intelligence, and the gig economy. In the first of our series on inflation, we will focus on the rise of e-commerce and the related "Amazonification" of the economy. The latter refers to the advent of new business models that cut out layers of middlemen between producers and consumers. Amazonification E-commerce has grown at a compound annual rate of more than 9% over the past 15 years, and now accounts for about 8½% of total U.S. retail sales (Chart II-1). Amazon has been leading the charge, accounting for 43% of all online sales in 2016 (Chart II-2). Amazon's business model not only cuts costs by eliminating middlemen and (until recently) avoiding expensive showrooms, but it also provides a platform for improved price discovery on an extremely broad array of goods. In 2013, Amazon carried 230 million items for sale in the United States, nearly 30 times the number sold by Walmart, one of the largest retailers in the world. Chart II-1E-Commerce: Steady Increase In Market Share E-Commerce: Steady Increase In Market Share E-Commerce: Steady Increase In Market Share Chart II-2Amazon Dominates September 2017 September 2017 With the use of a smartphone, consumers can check the price of an item on Amazon while shopping in a physical store. Studies show that it does not require a large price gap for shoppers to buy online rather than in-store. Amazon appears to be impacting other retailers' ability to pass though cost increases, leading to a rash of retail outlet closings. Sears alone announced the closure of 300 retail outlets this year. The devastation that Amazon inflicted on the book industry is well known. It is no wonder then, that Amazon's purchase of Whole Foods Market, a grocery chain, sent shivers down the spines of CEOs not only in the food industry, but in the broader retail industry as well. What would prevent Amazon from applying its model to furniture and appliances, electronics or drugstores? It seems that no retail space is safe. A Little Theory Before we turn to the evidence, let's review the macro theory related to positive supply shocks. The internet could be lowering prices by moving product markets toward the "perfect competition" model. The internet trims search costs, improves price transparency and reduces barriers to entry. The internet also allows for shorter supply chains, as layers of wholesalers and other intermediaries are removed and e-commerce companies allow more direct contact between consumers and producers. Fewer inventories and a smaller "brick and mortar" infrastructure take additional costs out of the system. Economic theory suggests that the result of this positive supply shock will be greater product market competition, increased productivity and reduced profitability. In the long run, workers should benefit from the productivity boost via real wage gains (even if nominal wage growth is lackluster). Workers may lower their reservation wage if they feel that increased competitive pressures or technology threaten their jobs. The internet is also likely to improve job matching between the unemployed and available vacancies, which should lead to a fall in the full-employment level of unemployment (NAIRU). Nonetheless, the internet should not have a permanent impact on inflation. The lower level of NAIRU and the direct effects of the internet on consumer prices discussed above allow inflation to fall below the central bank's target. The bank responds by lowering interest rates, stimulating demand and thereby driving unemployment down to the new lower level of NAIRU. Over time, inflation will drift back up toward target. In other words, a greater degree of the competition should boost the supply side of the economy and lower NAIRU, but it should not result in a permanently lower rate of inflation if inflation is indeed a monetary phenomenon and central banks strive to meet their targets. Still, one could imagine a series of supply shocks that are spread out over time, with each having a temporary negative impact on prices such that it appears for a while that inflation has been permanently depressed. This could be an accurate description of the current situation in the U.S. and some of the other major countries. We have sympathy for the view that the internet and new business models are increasing competition, cutting costs and thereby limiting price increases in some areas. But is there any hard evidence? Is the competitive effect that large, and is it any more intense than in the past? There are a number of reasons to be skeptical because most of the evidence does not support Forbes' claim that the internet has killed inflation. (1) E-commerce affects only a small part of the Consumer Price Index As mentioned above, online shopping for goods represents 8.5% of total retail sales in the U.S. E-commerce is concentrated in four kinds of businesses (Table II-1): Furniture & Home Furnishings (7% of total retail sales), Electronics & Appliances (20%), Health & Personal Care (15%), and Clothing (10%). Since goods make up 40% of the CPI, then 3.2% (8% times 40%) is a ballpark estimate for the size of goods e-commerce in the CPI. Table II-1E-Commerce Market Share Of Goods Sector (2015) September 2017 September 2017 Table II-2 shows the relative size of e-commerce in the service sector. The analysis is complicated by the fact that the data on services includes B-to-B sales in addition to B-to-C.2 However, e-commerce represents almost 4% of total sales for the service categories tracked by the BLS. Services make up 60% of the CPI, but the size drops to 26% if we exclude shelter (which is probably not affected by online shopping). Thus, e-commerce in the service sector likely affects 1% (3.9% times 26%) of the CPI. Table II-2E-Commerce Market Share Of Service Sector (2015) September 2017 September 2017 Adding goods and services, online shopping affects about 4.2% of the CPI index at most. The bottom line is that the relatively small size of e-commerce at the consumer level limits any estimate of the impact of online sales on the broad inflation rate. (2) Most of the deceleration in inflation since 2007 has been in areas unaffected by e-commerce Table II-3 compares the average contribution to annual average CPI inflation during 2000-2007 with that of 2007-2016. Average annual inflation fell from 2.9% in the seven years before the Great Recession to 1.8% after, for a total decline of just over 1 percentage point. The deceleration is almost fully explained by Energy, Food and Owners' Equivalent Rent. The bottom part of Table II-3 highlights that the sectors with the greatest exposure to e-commerce had a negligible impact on the inflation slowdown. Table II-3Comparison Of Pre- and Post-Lehman Inflation Rates September 2017 September 2017 (3) The cost advantages for online sellers are overstated Bain & Company, a U.S. consultancy, argues that e-commerce will not grow in importance indefinitely and come to dominate consumer spending.3 E-commerce sales are already slowing. Market share is following a classic S-shaped curve that, Bain estimates, will top out at under 30% by 2030. First, not everyone wants to buy everything online. Products that are well known to consumers and purchased on a regular basis are well suited to online shopping. But for many other products, consumers need to see and feel the product in person before making a purchase. Second, the cost savings of online selling versus traditional brick and mortar stores is not as great as many believe. Bain claims that many e-commerce businesses struggle to make a profit. The information technology, distribution centers, shipping, and returns processing required by e-commerce companies can cost as much as running physical stores in some cases. E-tailers often cannot ship directly from manufacturers to consumers; they need large and expensive fulfillment centers and a very generous returns policy. Moreover, online and offline sales models are becoming blurred. Retailers with physical stores are growing their e-commerce operations, while previously pure e-commerce plays are adding stores or negotiating space in other retailers' stores. Even Amazon now has storefronts. The shift toward an "multichannel" selling model underscores that there are benefits to traditional brick-and-mortar stores that will ensure that they will not completely disappear. (4) E-commerce is not the first revolution in the retail sector The retail sector has changed significantly over the decades and it is not clear that the disinflationary effect of the latest revolution, e-commerce, is any more intense than in the past. Economists at Goldman Sachs point out that the growth of Amazon's market share in recent years still lags that of Walmart and other "big box" stores in the 1990s (Chart II-3).4 This fact suggests that "Amazonification" may not be as disinflationary as the previous big-box revolution. (5) Weak productivity growth and high profit margins are inconsistent with a large supply-side benefit from e-commerce As discussed above, economic theory suggests that a positive supply shock that cuts costs and boosts competition should trim profit margins and lift productivity. The problem is that the margins and productivity have moved in the opposite direction that economic theory would suggest (Chart II-4). Chart II-3Amazon Vs. Walmart: ##br##Who's More Deflationary? September 2017 September 2017 Chart II-4Incompatible With A Supply Shock Incompatible With A Supply Shock Incompatible With A Supply Shock By definition, productivity rises when firms can produce the same output with fewer or cheaper inputs. However, it is well documented that productivity growth has been in a downtrend since the 1990s, and has been dismally low since the Great Recession. A Special Report from BCA's Global Investment Strategy5 service makes a convincing case that mismeasurement is not behind the low productivity figures. In fact, in many industries it appears that productivity is over-estimated. If e-commerce is big enough to "move the dial" on overall inflation, it should be big enough to see in the aggregate productivity figures. Chart II-5Retail Margin Squeeze ##br##Only In Department Stores Retail Margin Squeeze Only In Department Stores Retail Margin Squeeze Only In Department Stores One would also expect to see a margin squeeze across industries if e-commerce is indeed generating a lot of deflationary competitive pressure. Despite dismally depressed productivity, however, corporate profit margins are at the high end of the historical range across most of the sectors of the S&P 500. This is the case even in the retailing sector outside of department stores (Chart II-5). These facts argue against the idea that the internet has moved the economy further toward a disinflationary "perfect competition" model. (6) Online price setting is characterized by frictions comparable to traditional retail We would expect to observe a low price dispersion across online vendors since the internet has apparently lowered the cost of monitoring competitors' prices and the cost of searching for the lowest price. We would also expect to see fairly synchronized price adjustments; if one vendor adjusts its price due to changing market conditions, then the rest should quickly follow to avoid suffering a massive loss of market share. However, a recent study of price-setting practices in the U.S. and U.K. found that this is not the case.6 The dataset covered a broad spectrum of consumer goods and sellers over a two-year period, comparing online with offline prices. The researchers found that market pricing "frictions" are surprisingly elevated in the online world. Price dispersion is high in absolute terms and on par with offline pricing. Academics for years have puzzled over high price rigidities and dispersion in retail stores in the context of an apparently stiff competitive environment, and it appears that online pricing is not much better. The study did not cover a long enough period to see if frictions were even worse in the past. Nonetheless, the evidence available suggests that the lower cost of monitoring prices afforded by the internet has not led to significant price convergence across sellers online or offline. Another study compared online and offline prices for multichannel retailers, using the massive database provided by the Billion Prices Project at MIT.7 The database covers prices across 10 countries. The study found that retailers charged the same price online as in-store in 72% of cases. The average discount was 4% for those cases in which there was a markdown online. If the observations with identical prices are included, the average online/offline price difference was just 1%. (7) Some measures of online prices have grown at about the same pace as the CPI index The U.S. Bureau of Labor Statistics does include online sales when constructing the Consumer Price Index. It even includes peer-to-peer sales by companies such as Airbnb and Uber. However, the BLS admits that its sample lags the popularity of such services by a few years. Moreover, while the BLS is trying to capture the rising proportion of sales done via e-commerce, "outlet bias" means that the CPI does not capture the price effect in cases where consumers are finding cheaper prices online. This is because the BLS weights the growth rate of online and offline prices, not the price levels. While there may be level differences, there is no reason to believe that the inflation rates for similar goods sold online and offline differ significantly. If the inflation rates are close, then the growing share of online sales will not affect overall inflation based on the BLS methodology. The BLS argues that any bias in the CPI due to outlet bias is mitigated to the extent that physical stores offer a higher level of service. Thus, price differences may not be that great after quality-adjustment. All this suggests that the actual consumer price inflation rate could be somewhat lower than the official rate. Nonetheless, it does not necessarily mean that inflation, properly measured, is being depressed by e-commerce to a meaningful extent. Indeed, Chart II-6 highlights that the U.S. component of the Billion Prices Index rose at a faster pace than the overall CPI between 2009 and 2014. The Online Price Index fell in absolute and relative terms from 2014 to mid-2016, but rose sharply toward the end of 2016. Applying our guesstimate of the weight of e-commerce in the CPI (3.2% for goods), online price inflation added to overall annual CPI inflation by about 0.3 percentage points in 2016 (bottom panel of Chart II-6). There is more deflation evident in the BLS' index of prices for Electronic Shopping and Mail Order Houses (Chart II-7). Online prices fell relative to the overall CPI for most of the time since the early 1990s, with the relative price decline accelerating since the GFC. However, our estimate of the contribution to overall annual CPI inflation is only about -0.15 percentage points in June 2017, and has never been more than -0.3 percentage points. This could be an underestimate because it does not include the impact of services, although the service e-commerce share of the CPI is very small. Chart II-6Online Price Index Online Price Index Online Price Index Chart II-7Electronic Shopping Price Index Electronic Shopping Price Index Electronic Shopping Price Index Another way to approach this question is to focus on the parts of the CPI that are most exposed to e-commerce. It is impossible to separate the effect of e-commerce on inflation from other drivers of productivity. Nonetheless, if online shopping is having a significant deflationary impact on overall inflation, we should see large and persistent negative contributions from these parts of the CPI. We combined the components of the CPI that most closely matched the sectors that have high e-commerce exposure according to the BLS' annual Retail Survey (Chart II-8). The sectors in our aggregate e-commerce price proxy include hotels/motels, taxicabs, books & magazines, clothing, computer hardware, drugs, health & beauty aids, electronics & appliances, alcoholic beverages, furniture & home furnishings, sporting goods, air transportation, travel arrangement and reservation services, educational services and other merchandise. The sectors are weighted based on their respective weights in the CPI. Our e-commerce price proxy has generally fallen relative to the overall CPI index since 2000. However, while the average contribution of these sectors to the overall annual CPI inflation rate has fallen in the post GFC period relative to the 2000-2007 period, the average difference is only 0.2 percentage points. The contribution has hovered around the zero mark for the past 2½ years. Surprisingly, price indexes have increased by more than the overall CPI since 2000 in some sectors where one would have expected to see significant relative price deflation, such as taxis, hotels, travel arrangement and even books. One could argue that significant measurement error must be a factor. How could the price of books have gone up faster than the CPI? Sectors displaying the most relative price declines are clothing, computers, electronics, furniture, sporting goods, air travel and other goods. We recalculated our e-commerce proxy using only these deflating sectors, but we boosted their weights such that the overall weight of the proxy in the CPI is kept the same as our full e-commerce proxy discussed above. In other words, this approach implicitly assumes that the excluded sectors (taxis, books, hotels and travel arrangement) actually deflated at the average pace of the sectors that remain in the index. Our adjusted e-commerce proxy suggests that online pricing reduced overall CPI inflation by about 0.1-to-0.2 percentage points in recent years (Chart II-9). This contribution is below the long-term average of the series, but the drag was even greater several times in the past. Chart II-8BCA E-Commerce Proxy Price Index BCA E-Commerce Proxy Price Index BCA E-Commerce Proxy Price Index Chart II-9BCA E-Commerce Adjusted Proxy Price Index BCA E-Commerce Adjusted Proxy Price Index BCA E-Commerce Adjusted Proxy Price Index Admittedly, data limitations mean that all of the above estimates of the impact of e-commerce are ballpark figures. Conclusions We are keeping an open mind and reserving judgement on the disinflationary impact of robotics, artificial intelligence and the gig economy until we do more research. But in terms of the impact of e-commerce, it is difficult to find supportive evidence. The available data are admittedly far from ideal for confirming or disproving the "Amazonification" thesis. Perhaps better measures of e-commerce pricing will emerge in the future. Nonetheless, the measures available today do not suggest that online sales are depressing the overall inflation rate by more than 0.1 or 0.2 percentage points, and it does not appear that the disinflationary impact has intensified by much. One could argue that lower online prices are forcing traditional retailers to match the e-commerce vendors, allowing for a larger disinflationary effect than we estimate. Nonetheless, if this were the case, then we would expect to see significant margin compression in the retail sector. The sectors potentially affected by e-commerce make up a small part of the CPI index. The deceleration of inflation since the GFC has been in areas unaffected by online sales. High corporate profit margins and depressed productivity growth also argue against the idea that e-commerce represents a large positive macro supply shock. Finally, today's creative destruction in retail may be no more deflationary than the shift to 'big box' stores in the 1990s. Perhaps the main way that e-commerce is affecting the macro economy and financial markets is not through inflation, but via the reduction in the economy's capital spending requirement. Rising online activity means that we need fewer shopping malls and big box outlets to support a given level of consumer spending. This would reduce the equilibrium level of interest rates, since the Fed has to stimulate other parts of the economy to offset the loss of demand in capital spending in the retail sector. To the extent that central banks were slow to recognize that equilibrium rates had fallen to extremely low levels, then policy was behind the curve and this might have contributed to the current low inflation environment. Mark McClellan Senior Vice President The Bank Credit Analyst 1 Robert F. DeLucia, "Economic Perspective: A Nontraditional Analysis Of Inflation," Prudential Capital Group (August 21, 2017). 2 Business to business, and business to consumer. 3 Aaron Cheris, Darrell Rigby and Suzanne Tager, "The Power Of Omnichannel Stores," Bain & Company Insights: Retail Holiday Newsletter 2016-2017 (December 19, 2016). 4 "US Daily: The Internet And Inflation: How Big Is The Amazon Effect?" Goldman Sachs Economic Research (August 2, 2017). 5 Please see Global Investment Strategy Weekly Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com 6 Yuriy Gorodnichenko, Viacheslav Sheremirov, and Oleksandr Talavera, "Price Setting In Online Markets: Does IT Click?" Journal of the European Economic Association (July 2016). 7 Alberto Cavallo, "Are Online And Offline Prices Similar? Evidence From Large Multi-Channel Retailers," NBER Working Paper No. 22142 (March 2016). III. Indicators And Reference Charts Stocks struggled in August on the back of intensifying geopolitical risks, such that equity returns slipped versus bonds in the month. The earnings backdrop remains constructive for global stocks. In the U.S., 12-month forward EPS estimates continue to climb, in line with upbeat net revisions and earnings surprises. Nonetheless, the risk/reward balance has deteriorated due to escalating risks inside and outside of the U.S. Allocation to risk assets should still exceed benchmark, but should be shy of maximum settings. It is prudent to hold some of the traditional safe haven assets, including gold. Our new Revealed Preference Indicator (RPI) remained at 100% in August, sending a bullish message for equities. We introduced the RPI in the July report. Quite simply, it combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Our Willingness-to-Pay (WTP) indicators are also bullish on stocks for the U.S., Europe and Japan. These indicators track flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The U.S. WTP topped out in June and the same occurred in August for the Japan and the Eurozone indexes. While the indicators are still bullish, they highlight that flows into the equity markets in the major countries are beginning to moderate. These indicators would have to clearly turn lower to provide a bearish signal for stocks. The VIX increased last month, but remains depressed by historical standards. This implies that the equity market is vulnerable to bad news. However, investor sentiment is close to neutral and our speculation index has pulled back from previously elevated levels. These suggest that investors are not overly long at the moment. Our monetary indicator is only slightly negative, but the equity technical indicator is close to breaking below the 9-month moving average (a negative technical sign). Bond valuation continues to hover near fair value, according to our long-standing model that is based on a simple regression of the nominal 10-year yield on short-term real interest rates and a moving average of inflation. Another model, presented in the Overview section, estimates fair value based on dollar sentiment, a measure of policy uncertainty and the global PMI. This model suggests that the 10-year yield is almost 50 basis points on the expensive side. We think that Fed rate expectations are far too benign, suggesting that bond yields will rise. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And ##br##Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And ##br##Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-10U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China

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. Positioning For The Handoff Of Liquidity To Growth Positioning For The Handoff Of Liquidity To Growth

Highlights Portfolio Strategy Execute a long S&P energy/short global gold miners pair trade to take advantage of the liquidity-to-growth handoff. Initiate another new trade, long S&P materials/short S&P utilities, to benefit from a shifting macro landscape. Synchronized global growth and commodity inflation are a boon for materials, but a bane for utilities. Recent Changes Initiate a long S&P energy/short global gold miners pair trade today. Initiate a long S&P materials/short utilities pair trade today. Table 1 Fraying Around The Edges? Fraying Around The Edges? Feature 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. Nevertheless, a less hawkish Fed should, at the margin, underpin equities with easy monetary and financial conditions complementing the goldilocks equity backdrop (Chart 1). In fact, the St. Louis Fed Financial Stress Index (comprising "18 weekly data series: seven interest rate series, six yield spreads and five other indicators"1) is probing multi-decade lows. This primarily bond market-dependent indicator, has historically done an excellent job in leading the S&P 500 at major turning points at both peaks and troughs (Chart 2A). Recently, it has been more of a coincident indicator with equities, and currently waves the all-clear sign (St. Louis Fed Financial Stress Index shown inverted, Chart 2B). Chart 1Timid Fed Is Supportive Timid Fed Is Supportive Timid Fed Is Supportive Chart 2AExcellent Leading Properties Excellent Leading Properties Excellent Leading Properties Chart 2BAll Clear All Clear All Clear Nevertheless, we do not want to sound too complacent and following up from last week's brief discussion of rising geopolitical uncertainty and equity market performance, we are examining key post-WWII geopolitical events in more detail. The first three columns of Table 2, courtesy of BCA's Geopolitical Strategy Service2, update these episodes to mid-2017. While the S&P 500's drawdown from the three-month peak prior to the event to the three-month trough following the event averages out to roughly 10%, drilling beneath the surface is instructive. Table 2Geopolitical Crises And SPX Returns Fraying Around The Edges? Fraying Around The Edges? On average, broad equity market returns are muted one and three months post the event. Interestingly, on a six- and twelve-month horizon following the geopolitical incident, the S&P clearly shoots higher rising on average 5% and 8%, respectively (Table 2). Chart 3 shows the average profile of the S&P 500's returns during all of these post-WWII events, three months prior to the incident up to one year forward. Chart 3Geopolitical Opportunity? Geopolitical Opportunity? Geopolitical Opportunity? Two key takeaways stand out from this analysis. First, the coming quarter will likely prove volatile as the dust has yet to settle from the recent North Korea escalation. As a result, tactically buying some portfolio protection when the market is near all-time highs, as we cautioned last week3, is prudent and in order, especially given the seasonally challenging months of September and October. Second, on a cyclical horizon, the S&P 500 will likely resume its advance, ceteris paribus. Thus, if history at least rhymes and barring another major flare up of geopolitical risk, the path of least resistance will be higher for the overall equity market into mid-2018. This week we are executing two market neutral pair trades, one levered to the liquidity-to-growth handoff and the other to the synchronized global growth theme. Liquidity-To-Growth Handoff: Buy Energy/Sell Gold Producers A market-neutral way to benefit from the ongoing equity overshoot phase is to go long U.S. energy stocks/short global gold miners (Chart 4). This high-octane trade would benefit most from the handoff of global liquidity to economic growth. 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 ago4 - pans out in the coming months, then relative share prices should reverse. Gold prices serve as a global fear proxy, while energy prices move with the ebb and flow of global growth. Importantly, the oil/gold ratio (OGR) hit all-time lows in early 2016 and subsequently enjoyed a V-shaped recovery. But, year-to-date the OGR has relapsed on the back of rising policy uncertainty (policy uncertainty shown inverted, Chart 5). If this geopolitical uncertainty recedes, the upshot is that the OGR will rise in response. Chart 4Ready For A Bounce Ready For A Bounce Ready For A Bounce Chart 5Prefer Black Gold To Bullion Prefer Black Gold To Bullion Prefer Black Gold To Bullion Importantly, global trade is reaccelerating, also suggesting that the OGR should resume its advance (Chart 5). Chart 6 shows a simple growth/liquidity gauge using BCA's Global Synchronicity Indicator. Historically, this metric has been closely correlated with relative share price momentum, and the current message is to expect a sharp turn in oversold relative share prices. Moreover, were the liquidity thrust to convert into significantly higher output, then real interest rates should begin to reflect better growth prospects, and further boost the allure of the pair trade. As with bullion, the relative share price ratio is also overly sensitive to changes in real rates. In fact the 10-year TIPS yield does an excellent job in explaining relative share price fluctuation. Even a modest upturn in real interest rates will go a long way for relative share prices (Chart 7). Chart 6Ample Catch Up Space Ample Catch Up Space Ample Catch Up Space Chart 7Liquidity-To-Growth Beneficiary Liquidity-To-Growth Beneficiary Liquidity-To-Growth Beneficiary Meanwhile, on the relative operating front, the tide is also turning, favoring energy stocks versus gold miners. The oil and gas rig count has recovered smartly from the depths of the global manufacturing recession of late 2015/early-2016. On the flip side, demand for safe haven assets should ebb and further weigh on global gold ETF flows. Additional capital inflows into gold ETF funds from current levels would require either a sizable flare up in global geopolitical risk or another downdraft in global growth. Taken together, this relative demand indicator has surged, signaling that a catch up phase looms for the relative share price ratio (bottom panel, Chart 8). Similarly, relative pricing power is on the verge of climbing into expansionary territory. Extremely depressed pricing power for oil & gas field machinery is unlikely to deflate further, as recent anecdotes of new capital expenditure projects provide some glimmers of light for utilization rates. Conversely, bullion prices are pushing $1,300/oz. near the upper bound of the four year trading range, warning that at least a digestion phase lies ahead. The middle panel of Chart 8 shows that relative pricing power has been an excellent leading indicator of relative earnings. Our relative EPS models do an excellent job in capturing all of these different macro forces, and at the current juncture emit an unambiguously bullish signal: energy EPS will outshine gold producers' profits as the year draws to a close (Chart 9). Finally, relative valuations and technicals are both flashing a green light. Relative value is as compelling as it was during the depths of the Great Recession (middle panel, Chart 10), while our Technical Indicator is one standard deviation below the historical mean. Every time such extreme oversold levels are hit, relative performance has catapulted higher in the subsequent 3-6 months. Chart 8Relative Demand And Price Outlooks##br##Favor Energy Stocks Over Gold Miners Relative Demand And Price Outlooks Favor Energy Stocks Over Gold Miners Relative Demand And Price Outlooks Favor Energy Stocks Over Gold Miners Chart 9Earnings-Led##br## Outperformance Looms Earnings-Led Outperformance Looms Earnings-Led Outperformance Looms Chart 10Unloved ##br##And Oversold Unloved And Oversold Unloved And Oversold 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. For investors seeking an alternative way to express this trade opportunity levered to the liquidity-to-growth theme, going long the S&P 1500 metals and mining index instead of the S&P energy sector would also produce similar results (bottom panel, Chart 9). New Pair Trade: Materials Vs. Utilities 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 cyclicals5 and also from domestic to global-exposed market areas. In fact, our relative Cyclical Macro Indicators capture the shifting macro backdrop favoring a more cyclical portfolio tilt (Chart 11). 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 (Chart 12). Chart 11Reflation Trade Reflation Trade Reflation Trade Chart 12U.S. And... U.S. And... U.S. And... Reviving global growth is typically synonymous with rising inflation expectations and bond yields. BCA's view remains that a selloff in the bond markets is the most likely scenario in the coming months. The third panel of Chart 11 shows that relative share price momentum and the bond market are joined at the hip. This makes sense as materials stocks are reflationary beneficiaries, whereas the utilities sector acts as a fixed-income proxy. Not only does the pair trade benefit from rising bond yields in isolation, but also when the stock-to-bond (S/B) ratio is on fire. Currently, a wide gap has opened between the S/B and the materials/utilities ratios that will likely narrow via a catch up phase in the latter. Synchronized global growth suggests that a relative earnings-led recovery will buttress this pair trade higher. Chart 13 highlights four different ways of depicting coordinated EM and DM economic growth, giving us confidence that materials profits will outshine utilities EPS. Materials manufacturers have a sizable export component driving both the top and bottom line. In contrast, utilities are a domestic-only play. As a result, revving global trade and the significant fall in the trade-weighted U.S. dollar will buttress relative EPS prospects (Chart 14). In fact, irrespective of where the greenback ends the year, materials profits will get a lagged bump from a positive FX translation in the back half of the year. Chart 13...Global Growth Favor ##br##Materials Over Utilities ...Global Growth Favor Materials Over Utilities ...Global Growth Favor Materials Over Utilities Chart 14Cheapened Greenback = ##br##Buy Materials At The Expense Of Utilities Cheapened Greenback = Buy Materials At The Expense Of Utilities Cheapened Greenback = Buy Materials At The Expense Of Utilities 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, Chart 14). Relative valuations and technical conditions also wave the green flag. Our valuation indicator has corrected back to the neutral zone and the technical indicator has unwound overbought conditions, offering a compelling entry point to the pair trade (Chart 15). Finally, our newly introduced relative EPS models encapsulate all of these diverging forces. Currently, the relative profit models signal that materials earnings are on track to outpace utilities profit generation for the remainder of the year (Chart 16). Chart 15Compelling Entry Point Compelling Entry Point Compelling Entry Point Chart 16Heed The Relative Profit Model Message Heed The Relative Profit Model Message Heed The Relative Profit Model Message Consequently, there is an opportunity to execute a long materials/short utilities pair trade in order to benefit from synchronized global growth and looming bond market selloff, and softening U.S. dollar and related commodity inflation. Bottom Line: Initiate a long S&P materials/short S&P utilities pair trade today. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 https://www.stlouisfed.org/news-releases/st-louis-fed-financial-stress-index/stlfsi-key 2 Please see the August 16, 2017 Geopolitical Strategy Weekly Report titled "Can Pyongyang Derail The Bull Market?", available at gps.bcaresearch.com. 3 Please see the August 14, 2017 U.S. Equity Strategy Weekly Report titled "Three Risks", available at uses.bcaresearch.com. 4 Please see July 31, 2017 U.S. Equity Strategy Weekly Report titled "Growth Trumps Liquidity", available at uses.bcaresearch.com. 5 Please see the August 14, 2017 U.S. Equity Strategy Weekly Report titled "Three Risks" for a recap of our major portfolio moves since May 1, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights Washington must establish a "credible threat" if it is to convince Pyongyang that negotiations offer the superior outcome; The process of establishing such a credible threat is volatile; U.S. Treasurys, along with Swiss and Japanese government bonds have been consistent safe haven assets; The risk of a U.S. attack against North Korea is a red herring, while the crisis itself is not; We suggest that investors hedge the risk with an equally-weighted basket of Swiss bonds and gold. Feature Brinkmanship between Pyongyang and Washington, D.C. has roiled markets over the past week. The uptick in rhetoric has not come as a surprise. Since last year, BCA's Geopolitical Strategy has stressed that souring Sino-American relations were the premier geopolitical risk to investors and that China's periphery, especially the Korean peninsula, would be the "decisive" factor for markets.1 North Korea's nuclear ambitions - which could be snuffed out immediately by a concerted and coordinated effort by China and the U.S. - are a derivative of the broader U.S.-China dynamic. The U.S. is unlikely to use military force to resolve its standoff with North Korea. There are long-standing constraints to war, ones that all of the interested parties know only too well from their experience in the Korean War of 1950-53. The first of these is that war is likely to bring a high death toll: Pyongyang can inflict massive civilian casualties in Seoul with a conventional artillery barrage; U.S. troops and Japanese troops and civilians would also likely suffer. Second, China is unlikely to remain neutral, given its behavior in the 1950s, its persistent strategic interest in the peninsula, and its huge increase in military strength relative to both the past and to the United States. However, the process by which the U.S. establishes a "credible threat" of military action is volatile.2 Such a credible threat is necessary if Washington is to convince Pyongyang that negotiations offer a superior outcome to the belligerent status quo. Viewed from this perspective - which is informed by game theory -President Donald Trump has not committed any grave mistakes so far, but has rather shrewdly manipulated the world's perception that he is mentally unhinged in order to enhance his negotiating leverage. It is unclear how long it will take Trump to convince North Korea that the threat of a U.S. preemptive strike is "credible." As such, it is unclear how long the current standoff will persist. From an investor perspective, it will be difficult to gauge whether the brinkmanship and military posturing are part of this "territorial threat display" or evidence of real preparations for an actual attack. As such, further volatility is likely. The ongoing crisis in North Korea is neither the first nor the last geopolitical crisis the world will face in today's era of paradigm shifts.3 We have long identified East Asia as the cauldron of investment-relevant geopolitical risks.4 This is a dynamic produced by the multipolar global context and the geopolitical disequilibrium in the Sino-American relationship. For now, investors have been able to ignore the rising global tensions (Chart 1) due to the ample liquidity emanating from central banks, but the day of reckoning is nigh (Chart 2). Chart 1Multipolarity Increases Conflict Frequency Multipolarity Increases Conflict Frequency Multipolarity Increases Conflict Frequency Chart 2Day Of Reckoning? Day Of Reckoning? Day Of Reckoning? Q&A On North Korea Back on April 19, we wrote a Special Report, "North Korea: Beyond Satire," which argued that North Korea had at last become a market-relevant geopolitical risk after decades of limited impact (Chart 3).5 Chart 3North Korean Provocations Rarely Affect Markets For Long North Korean Provocations Rarely Affect Markets For Long North Korean Provocations Rarely Affect Markets For Long Looking to the next steps, we introduced the "arc of diplomacy," a framework comparable to the U.S.-Iran nuclear negotiations from 2010-15 (Chart 4). We predicted that the U.S. would ultimately ramp up threats for the purpose of achieving a diplomatic solution. The U.S. was constrained and would only go to war if an act of war were committed, or appeared imminent.6 Chart 4Arc Of Diplomacy: Tensions Ramp Up As Nuclear Negotiations Begin Can Pyongyang Derail The Bull Market? Can Pyongyang Derail The Bull Market? This assessment is now playing out. But not all clients are convinced of our logic, as we have found in our travels throughout Asia Pacific and elsewhere this month. Below we offer a short Q&A based on questions we have received from clients: Q: Diplomacy has already been tried, so why won't the U.S. attack? A: The U.S. public has less appetite for war, especially a preemptive strike, in the wake of the Iraq War, and has not suffered a 9/11 or Pearl Harbor-type catalyst. The U.S. will exhaust diplomatic options before joining a catastrophic second Korean War. And the diplomatic options are far from exhausted. The latest round of sanctions are tighter and more serious than past ones, but still leave categories untouched (like fuel supplies to the North) and are still very hard to enforce (like cutting illegal North Korean labor remittances). Enforcement is always difficult, and the U.S. is currently attempting to ensure that its allies enforce the sanctions strictly, not to mention its rivals (i.e. Russia and China). While we do not think China will ever impose crippling sanctions, we do think it can tighten them up considerably, which could be enough to change the North's behavior. Q: Why doesn't China just take North Korea out? A: China is a formal political, military, and ideological ally of North Korea, and has a strategic interest in maintaining a buffer space on the Korean peninsula - which it defended at enormous human cost in the Korean War. This interest remains in place. China is far more likely to aid and abet a nuclear-armed ally in North Korea than it is to endorse (much less participate in) regime change. The fallout from a new war, such as North Korean refugees flooding into China, is extremely undesirable for China, though it could handle the problem ruthlessly. China would also prefer not to have to occupy a collapsing North, which would be an extensive and dangerous entanglement. Therefore, expect China to twist Pyongyang's arm but not to break its legs. On a more topical note, China is consumed with domestic politics ahead of the nineteenth National Party Congress. It is perhaps more likely to take action after the congress in October-November. Q: Will U.S. allies cooperate with Trump? Why not bandwagon with China to gain economic benefit? A: South Korea is the best litmus test for whether Trump is causing U.S. allies to drift. The new South Korean President Moon Jae-In, who is politically left-of-center, has played his cards very carefully and started out on good footing with President Trump. A disagreement appears to be a likely consequence of Moon's agenda, which calls for extensive engagement with the North and a review of the U.S. THAAD missile defense deployment in Korea. So far, however, Moon is reaffirming the alliance, in his own way, and Trump has not (yet) expressed misgivings about him. If this changes significantly - as in, South Korea joining with China to give North Korea significant economic aid in defiance of U.S. sanctions efforts - then it would be a sign of division among the allies that would benefit North Korea and could even increase the risk of the U.S. taking unilateral action. The odds of that are still low, however. We have been short the Korean won versus the Thai baht since March 1, and the trade is up 6.03%. We also expect greater volatility and higher prices of credit default swaps to plague South Korea while the crisis continues over the coming months. We are closing our long Korean consumer stocks trade versus Taiwanese exporters for a loss of 4.24%. Q: What is Japan's role in the current crisis? What is the impact on Japan? A: Japan is one of the few countries whose relations with the U.S. have benefited under the Trump administration. The Japanese are in lock-step so far in reacting to North Korea. The government has been sounding louder alarms about North Korea for the past year, including by conducting evacuation drills in the case of attack. Japan has long been within range of North Korea's missiles, but its successes in nuclear miniaturization pose a much greater threat. Not only does North Korea pose a legitimate security risk, but Japanese Prime Minister Shinzo Abe also stands to benefit at least marginally in terms of popular support and support for his controversial constitutional revision. This will, in turn, feed into the region's insecurities. Yen strength as a result of the crisis, however, would be a headwind to Japan's economic growth. Thus Abe has a tightrope to walk. We expect him to take actions to ensure the economy continues to reflate. Q: Is Trump rational? How do we know he won't push the nuclear button? A: Ultimately this is unknowable. It also involves one's philosophical outlook. Josef Stalin and Mao Zedong both committed atrocities by the tens of millions but did not use nuclear weapons. Nikita Khrushchev practically wrote the playbook that North Korea's Kim dynasty has used in making its belligerent nuclear threats. Yet Khrushchev ultimately agreed to détente. Kim Jong Un makes Trump look calm. The combination of Kim and Trump is worrisome; but so was the combination of Eisenhower and Khrushchev, one believing nuclear weapons should be used if needed, the other threatening wildly to use them. It may be the case that the threat of an atrocity, or (in Kim's case) of total annihilation, is enough to keep decisions restrained. As we go to press, Kim has ostensibly suspended his plan to fire missiles around Guam and U.S. officials have repeatedly stated that they would not attack unless attacked. Stairway To (Safe) Haven Revisited In expectation of increased frequency of geopolitical risks, BCA's Geopolitical Strategy has produced two quantitative analyses of safe haven assets over the past two years. The first, "Geopolitics And Safe Havens," unequivocally crowned gold as the ultimate safe haven (Table 1), while showing that the USD is not much of a defense against geopolitical events (Chart 5).7 Table 1Safe-Haven Demand Rises During Crises Can Pyongyang Derail The Bull Market? Can Pyongyang Derail The Bull Market? Table 1Safe-Haven Demand Rises During Crises Can Pyongyang Derail The Bull Market? Can Pyongyang Derail The Bull Market? As such, investors should fade the narrative that the failure of the USD to appreciate amidst the latest North Korean imbroglio is a sign of some structural weakness. The greenback continues to underperform due to weak inflation in the U.S., a fleeting condition that our macro-economist colleagues expect to reverse. Mathieu Savary, BCA's currency strategist, believes that more upside exists for the USD regardless of the geopolitical outcome: Chart 5Gold Loves Geopolitical Crises Can Pyongyang Derail The Bull Market? Can Pyongyang Derail The Bull Market? Chart 6DXY Is Cheap... DXY Is Cheap... DXY Is Cheap... Chart 7...But The Euro Is Not ...But The Euro Is Not ...But The Euro Is Not First, the dollar is currently trading at its deepest discount to the BCA Foreign Exchange Service augmented interest rate parity model since 2010 (Chart 6). The euro, which accounts for 58% of the DXY index, is its mirror image, being now overvalued by two sigma, the most since 2010 (Chart 7). Second, bullish euro bets will dissipate as Europe's economic outperformance versus the U.S. fades. Financial conditions have massively eased in the U.S., while they have tightened in Europe, resulting in the biggest upswing on euro area growth relative to the U.S. in over two years (Chart 8). Such an economic outperformance by the U.S. should lead to a strengthening greenback (Chart 9).8 Chart 8Easing Versus Tightening FCI Easing Versus Tightening FCI Easing Versus Tightening FCI Chart 9PMIs Point To USD Rally PMIs Point To USD Rally PMIs Point To USD Rally Our second attempt to quantify safe-haven assets, "Stairway To (Safe) Haven: Investing In Times Of Crisis," concluded that U.S. Treasurys, Swiss bonds, and Japanese bonds are the best performers in times of crisis.9 We considered 65 assets10 (Table 2) with five different methodologies and back-tested them empirically within the context of 25 financial and geopolitical events since January 1988. Some of these assets have been proven to perform as safe havens by previous academic research, some are commonly utilized in investment strategies, and others could provide alternatives (see Box 1 for further details). Table 2Scrutinizing The World For Safe Havens Can Pyongyang Derail The Bull Market? Can Pyongyang Derail The Bull Market? This report demystifies four key issues related to safe havens: Part I identifies what qualifies as a safe-haven asset. Unsurprisingly, the best performers are U.S. Treasurys along with Swiss and Japanese bonds due to their currency effects. Part II examines if safe havens change over time. We find that gold and Treasurys have changed places as safe havens, and that JGBs and Swiss bonds have a long history as portfolio protectors. Part III breaks down safe havens through an event analysis. We look at the country of origin, the nature of the crisis, and whether the risk is a "black swan" or "red herring" - two classifications of events that BCA's Geopolitical Strategy has established - all of which have an impact on their performance. But red herrings or black swans are only defined after the fact, thus requiring geopolitical analysis or market timing indicators to be able to act on them. Part IV demonstrates that timing plays a crucial part when investing in safe havens as their performance is coincident with that of equities. Box 1 Safe Havens - A Literature Review In a previous Geopolitical Strategy Special Report published in November 2015, it was established that shifts in economic and political regimes alter investors' preferences for safe-haven assets, and that Swiss bonds and U.S. 10-year Treasurys were at the top of that list.11 Also, statistical methods were used to demonstrate that gold had acted as a safe haven from the 1970s to the early 90s, but has since lost its status due in part to a new era of looming deflationary risks. Li and Lucey (2013) have identified a pattern in precious metals, through a series of quarterly rolling regressions testing the significance of the 1st, 5th and 10th percentile movements in U.S. equity movements against safe-haven assets, catching extreme negative events. For instance, the 1st percentile captures the very worst corrections that have occurred, the one that represent the bottom 1% of the equity performances. The 5th and 10th percentiles represent the 5% and 10% lowest returns for equities, respectively. The authors demonstrated that silver, platinum and palladium act as safe havens when gold does not.12 Similarly, Bauer and McDermott (2013) examined the 1st, 5th and 10th percentile movements in U.S. equity movements and proved that both gold and U.S. Treasurys can serve as safe havens, but that gold has the best record in times of extreme financial stress.13 Baele et al. (2015) concentrated on flight-to-safety episodes, which they characterized as events in which the VIX, TED spreads and a basket of CHF, JPY, and USD all increased drastically.14 They found that during flight-to-safety episodes, large cap stocks outperform small caps, precious metal and gold prices (measured in dollars) increase slightly, while bond returns exceed those of the equity market by 2.5-4 percentage points. Baur and Glover (2012) provide further evidence that gold can no longer be utilized as a safe haven due to increased speculation and hedging. Their main finding is that gold cannot be both an investment and a safe-haven asset. That is, gold can only be effective as a safe haven if the periods prior to the event had not generated significant investment demand for gold.15 Using high-frequency exchange rate data, Ranaldo and Soederlind (2010) conclude that the CHF, EUR and JPY have significant safe-haven characteristics, but not the GBP.16 The strongest safe havens are identified as the CHF and JPY, but the returns are partly reversed after a day of safe-haven protection. They also find that the nature of the crisis has a significant effect on safe-haven properties. For instance, a financial crisis and a natural disaster produced drastically different outcomes for the yen. Part I - Safety In Numbers Our first step in identifying safe-haven assets was to review each asset's performance against equities in times of crisis. As such, we conducted a series of threshold regressions to generate a list of true safe-haven assets - assets that have a statistically significant positive performance in times of turmoil. Our method is explained as follows: Step 1 - Percentile Dummies: Following methods from Li and Lucey (2013) and Bauer and McDermott (2013), we created dummy variables for the 1st, 5th and 10th percentile of the S&P 500 daily total returns since 1988. We then multiplied each of these dummies by their corresponding stock returns (see Box 1 for further detail). Step 2 - Regressions: Using the 64 potential safe-haven assets, we ran a series of regressions both in USD and the local currency, testing each asset's returns explained by the three percentile dummies.17 Step 3 - Identifying Safe Havens: We then quantified strong safe-havens as assets having significant coefficients for all three return thresholds (1st, 5th and 10th percentile of the S&P 500 daily total returns). Results - Seek Refuge In Currencies And Government Bonds: Our quantitative results are mainly consistent with what others have found in the past: the Japanese yen and most G10 government bonds are safe havens. Table 3 shows the safe-haven assets that generated negative coefficients versus equities for all three threshold percentiles. Table 3Seeking Protection Against Corrections Can Pyongyang Derail The Bull Market? Can Pyongyang Derail The Bull Market? In our threshold regressions expressed in USD terms, we found that the Japanese yen, Quality Stocks,18 and Japanese, Swiss and U.S. bonds acted as strong safe havens. Currencies play a crucial part in the performance of safe havens. In fact, in local-currency terms, a series of G10 government bonds (U.S., Canada, Belgium, France, Germany, Netherlands, Sweden, Switzerland, and the U.K.) proved to be the most useful safe havens. In sum, true or strong safe havens are government bonds that have currencies that add to positive returns during times of crisis. Unsurprisingly, this select group of strong safe-haven assets is comprised of U.S., Japanese, and Swiss government bonds. Quality Stocks did provide positive and statistically significant results, but the returns were very low - for this reason, we excluded them from our basket of strong safe havens. While gold, the Swiss franc, and the U.S. dollar did generate positive returns during times of crisis, they failed to generate statistically significant results at all three thresholds. Bottom Line: Based on our econometric work, most G10 government bonds can act as safe havens. But due to strong currency effects, our models favor what are already commonly known as safe havens: U.S., Japanese, and Swiss government bonds. Simply put, the difference between this select group and other G10 bonds is that their currencies rise or are stable during turmoil, while the currencies of the other G10 bonds do not. Part II - Are Safe Havens Like Fine Wines? U.S., Japanese, and Swiss government bonds were not always the top assets providing protection against the downside in equities, however. To determine whether safe-haven properties change, we examined the evolution of the relationship between safe havens and U.S. equity markets over time with the following model: Step 1 - Rolling Regressions: Considering the results obtained in Part I, we restricted our sample to G10 governments in USD and local-currency terms, Quality Stocks, gold, JPY, EUR, and USD for this statistical procedure. We put these remaining assets, both in USD and local-currency terms, through a series of 1-year rolling regressions.19 Step 2 - Identifying Trends: Each regression generated a coefficient that explained the relationship between equities and safe havens (B1). We created a new time series by collecting the coefficients for each data point and smoothing them using a five-year moving average, thus depicting a long-term pattern in the evolution of safe havens. Results - A Regime Shift In Gold And Treasurys: Our findings show that safe-haven assets fall in and out of favor through time (Charts 10A, B & C). Most striking are the changes in U.S. Treasurys and gold. Only after 2000 did Treasurys start providing a good hedge for equity corrections. The contrary is true for gold - it acted as one of the most secure investments during corrections until that time, but has since become correlated with S&P 500 total returns. That said, gold's coefficient has been falling closer to zero lately, illustrating that it could soon resurface as a proper safe haven, especially if deflation risks begin to dissipate. Given that this is precisely the conclusion stated by our colleague Peter Berezin - BCA's Chief Global Strategist - and our own political analysis, we suspect that gold may be resurrected as a safe haven very soon.20 Chart 10ASafe Havens Don't Necessarily Age Well Safe Havens Don't Necessarily Age Well Safe Havens Don't Necessarily Age Well Chart 10BSafe Havens Don't Necessarily Age Well Safe Havens Don't Necessarily Age Well Safe Havens Don't Necessarily Age Well Chart 10CSafe Havens Don't Necessarily Age Well Safe Havens Don't Necessarily Age Well Safe Havens Don't Necessarily Age Well Another important finding is that the currency effect plays a key role during recent risk-off periods (Charts 11A & B). The best protector currencies are the ones that are negatively correlated with equity returns. According to our results, the CHF and the JPY have generally been risk-off currencies, while the USD has only been one since 2007, switching places with the euro. This reinforces the case for U.S., Japanese, and Swiss government bonds, which are supported by risk-off currencies. Chart 11ACurrencies Are Difference Makers Currencies Are Difference Makers Currencies Are Difference Makers Chart 11BCurrencies Are Difference Makers Currencies Are Difference Makers Currencies Are Difference Makers Bottom Line: Safe havens change over time. Gold fell out of favor due to global deflationary dynamics. With inflation on the horizon, we will keep monitoring the relationship between gold and equities for a possible return of the yellow metal as a safe haven. Since the July 4 North Korean ICBM test, for example, gold has rallied 4.8%. Part III - Red Herrings And Black Swans Since 1988, we identified 25 economic and (geo)political events that generated instant panic or acute uncertainty in the media and financial markets.21 We analyzed the short-term reactions of the safe-haven assets, both in USD and local-currency terms. This methodology allowed for the deconstruction of the impact of the events by the following factors: Country of origin of the crisis, the nature of the crisis, and whether the event was a "red herring" or a "black swan." Generally speaking, a red herring event is a crisis of some sort with little lasting financial impact. A black swan, on the other hand, is an event that has a very low probability of occurring but has a pronounced market impact if it does. Quantitatively, our definition of a black swan is an event that produces an immediate negative response in the S&P 500 below -1%, while creating a rise in either U.S., Japanese, or Swiss government bonds above 0% (Table 4). Of course, determining which event is a red herring or a black swan is only obvious post-facto and thus requires thorough geopolitical analysis. Table 4Understanding The Crises Can Pyongyang Derail The Bull Market? Can Pyongyang Derail The Bull Market? Results - Red Herrings And Black Swans Matter: Our event analysis solidifies our findings with regards to U.S., Japanese, and Swiss government bonds, but also builds a case for some European bonds as well as gold during black swan events. Our main findings can be summarized as follows. Fade The Red Herrings: Out of the sixteen geopolitical events, ten were identified as red herrings, in which safe havens underperformed the equity market. This, then, suggests that it is not always beneficial to buy safe-haven assets when tensions are rising. What is interpreted as a major geopolitical crisis - say, Ukraine in 2014 or Greece in 2015 - often ends up being a "red herring." Geopolitical Risk = Gold: Geopolitical black swan events, on the other hand, have a significant, negative impact on the market. During these events, gold emerges as the strongest hedge against a downturn in equities. U.S. Treasurys And The Swiss Franc Provide A Baseline: Under all black swan events considered - geopolitical and non-geopolitical - U.S. Treasurys and the Swiss franc had the strongest performance, generating positive returns on the day of the stock market crash in 85% of the cases. G10 Government Bonds Will Also Do: German, Dutch, Swiss and Swedish government bonds also provided protection during black swan events in local and common-currency terms, albeit to a lesser extent. U.S. And Swiss Bonds Outperform During Financial Episodes: During black swan financial crises, Swiss and U.S. government bonds stand out as the best safe havens due to their capacity to generate positive returns both in USD and local-currency terms in eight out of the nine examined crashes. Other findings that are interesting, yet less robust due to a limited sample size, include: When the crisis originated on U.S. soil, U.S. Treasurys and the dollar performed relatively poorly compared to other safe-haven assets. This is a somewhat surprising finding, as most investors believe that U.S. assets rally even at a time of U.S.-based crises, such as the 2011 budget crisis. We show that they may perform well, but in USD, non-U.S. based assets do better. When the crisis originated in Europe, European bonds performed very well both in USD and local-currency terms. When the crisis originated in Europe, Swiss and U.K. government bonds performed poorly in USD terms, but offered strong protection in local-currency terms. When the crisis originated in Russia, precious metals acted as a poor hedge. Bottom Line: It is crucial to gain an understanding of the nature of any potential crisis. Red herrings should always be faded, not hedged against, as they produce poor results in safe-haven assets. U.S. Treasurys, Swiss and Japanese government bonds have been very consistent safe-haven assets during previous periods of acute risk. Part IV: Timing Is Everything As a final step in our quantitative approach, we put our results through numerous timing exercises to test how the assets would perform in real time. Based on our Risk Asset Spectrum (Diagram 1), which summarizes our findings, one could argue that investing in times of crisis simply boils down to buying an equal-weighted basket of U.S. Treasurys, Swiss, and Japanese government bonds. Although this is technically true, such a strategy would require perfect foresight, unparalleled timing, or dumb luck - since black swan events are, by definition, very difficult to predict. Diagram 1Risk Asset Spectrum Can Pyongyang Derail The Bull Market? Can Pyongyang Derail The Bull Market? Proof Of The Ultimate Safe Haven: The first experiment we conducted was to illustrate how powerful safe havens can be when timed perfectly in a trading strategy. We started off by comparing two baskets. The first was a benchmark portfolio comprised of 60% U.S. equities and 40% U.S. bonds. The other contained the same two assets, but with 100% allocated to a basket comprised of U.S. Treasurys, Swiss, and Japanese government bonds during times of negative returns for equities. Of course, this strategy is not realistic and would be impossible to implement, since the trading rule depends on future events. But as Chart 12 shows, if one were able to predict every single period of negative returns for global equities and hold safe-haven assets instead, the trading rule would outperform almost 10-fold. Chart 12Safe Havens Work Wonders With Perfect Information... Safe Havens Work Wonders With Perfect Information... Safe Havens Work Wonders With Perfect Information... One-Month Lag Is Already Too Late: Repeating the same exercise, but with a one-month lag in the execution, produces drastically different results. More specifically, whenever the previous month's equity return is negative (t=0), the portfolio allocates 100% to a single safe-haven asset for the current month (t=1), otherwise it keeps the allocation identical to that of the benchmark. The rationale for using such a simple rule is that average investors are generally late in identifying a crisis and only react once they have validation that the market is in a correction. Chart 13 shows that being late by one month changes the performance of the safe haven basket from astronomically outperforming the benchmark to underperforming it. Chart 13... But Timing Is Everything ... But Timing Is Everything ... But Timing Is Everything Reaction Is Key: As a final timing exercise, we analyzed the reaction function of our assets to see how quickly they react after the correction in equities begins (Chart 14). Unsurprisingly, the top assets that we identified start appreciating as soon as the crisis hits (t=0). Gold is, on average, the quickest asset to react from investors seeking refuge. Swiss bonds come in as a close second, almost mirroring gold during the first few days of the correction. But both assets start to flatten out and even roll over after a few days. Japanese bonds react slightly later than gold and Swiss bonds, but keep increasing for a longer period of time and start plateauing around the 30th day after the crisis. U.S. Treasurys and Quality Stocks, on the other hand, remain rather flat and constant over the short term. These results attest to the importance of timing the crisis using the best safe-haven assets. Chart 14Safe Havens React Instantly Can Pyongyang Derail The Bull Market? Can Pyongyang Derail The Bull Market? Bottom Line: Timing plays a crucial part in investing in safe-haven assets, as their performance is coincident to that of equities. Investment Implications: Is Pyongyang A Red Herring Or A Black Swan? The results of our quantitative analysis are clear: hedging geopolitical risk depends on whether it is persistent or fleeting. So, is Pyongyang a red herring or a black swan? From our geopolitical analysis we make three key conclusions: The U.S. is not likely to preemptively attack North Korea; However, the U.S. has an interest in signaling that it may conduct precisely such an attack; Brinkmanship could last for a long time. Even if the risk of a U.S. attack against North Korea itself is a red herring, the crisis itself is not. In fact, between now and when a negotiated solution emerges, investors may face several new crises, which may include limited military attacks or skirmishes. While markets have faded such North Korean provocations in the past, the current context is clearly different. As such, we would suggest that investors hedge the risk with an equally-weighted basket of Swiss bonds and gold. Even though a "buy and hold" strategy with such a "Doomsday Basket" will likely underperform the market if tensions with North Korea subside, we are betting that it may take time for the U.S. and North Korea to get to the negotiating table. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com David Boucher, Associate Vice President Quantitative Strategist davidb@bcaresearch.com 1 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 6, 2016, available at gis.bcaresearch.com. We upgraded North Korea to the status of a genuine market-relevant risk in "North Korea: A Red Herring No More?" in Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Client Note, "Trump Re-Establishes America's 'Credible Threat'," dated April 7, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2017 available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0," dated September 25, 2012, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. In particular, we argued, "the current saber-rattling is carefully orchestrated. But North Korea can no longer be consigned to the realm of satire. The very fact that the U.S. administration is adopting greater pressure tactics makes this year a heightened risk period. Investors should be especially wary of any missile tests that reveal North Korean long-range capabilities to be substantially better than is known to be the case today." Then, on May 13 and July 4, North Korea conducted its first ICBM launches; the UN Security Council agreed to a new round of even tighter economic sanctions on August 5; and the U.S. and North Korea engaged in an alarming war of words. 6 Specifically, we wrote: "Diplomacy is the only real option. And in fact it is already taking shape. The theatrics of the past few weeks mark the opening gestures. And theatrics are a crucial part of any foreign policy. The international context is looking remarkably similar to the lead-up to the new round of Iranian negotiations in 2012. The United States pounded the war drums and built up the potential for war before coordinating a large, multilateral sanctions-regime and then engaging in talks with real willingness to compromise." 7 Please see BCA Geopolitical Strategy Special Report, "Geopolitics And Safe Havens," dated November 11, 2015, available at gps.bcaresearch.com. 8 Please see BCA Foreign Exchange Strategy Weekly Report, "Fade North Korea, And Sell The Yen," dated August 11, 2017, available at fes.bcaresearch.com. 9 Please see BCA Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com. 10 Forty-one assets were denominated in USD only, while G10 bonds, Credit Suisse Swiss Real Estate Fund, and European 600 real estate were used both in local-currency terms and USD, for a total of 65 assets. 11 Please see Geopolitical Strategy Special Report, "Geopolitics And Safe Havens," dated November 11, 2015, available at gps.bcaresearch.com. 12 Sile Li and Brian M. Lucey, "What precious metals act as safe havens, and when? Some U.S. evidence," Applied Economic Letters, 2013. 13 Dirk G. Bauer and Thomas K.J. McDermott, "Financial Turmoil and Safe Haven Assets," 2013. 14 Lieven Baele, Geer Bekaert, Koen Inghelbrecht and Min Wei, "Flights to Safety," National Bank of Belgium Working Paper No. 230, 2015. 15 Dirk G. Baur and Kristoffer J. Glover, "The Destruction of Safe Haven Asset?,"2012. 16 Angelo Ranaldo and Paul Soederlind, "Safe Haven Currencies," Review of Finance, Vol. 10, pp. 385-407, 2010. Can Pyongyang Derail The Bull Market? Can Pyongyang Derail The Bull Market? 18 Quality stocks are defensive equity plays with high, steady earnings with an elevated return on investments. They are estimated by Deutsche Bank's Factor Index Equity Quality Excess Return in USD. Can Pyongyang Derail The Bull Market? Can Pyongyang Derail The Bull Market? 20 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation)," dated July 13, 2016, available at gps.bcaresearch.com, and BCA Global Investment Strategy Weekly Report, "A Secular Bottom In Inflation," dated July 28, 2017, available at gis.bcaresearch.com. 21 Since we were interested in the immediate, often unexpected, response to the event, we did not include economic recessions in our event analysis.

Highlights Strengthening income growth is apparent in DM and EM trade volumes, real wages in the U.S., and industrial commodity prices, chiefly oil and copper. This indicates inflation at the consumer level will move higher in the near future, most likely in 2H2018. We believe 10-year U.S. Treasury Inflation-Indexed securities (TIPS) trading below 0.52 do not reflect the risk of higher inflation and are, therefore, going long at tonight's close. Energy: Overweight. Crude oil prices rallied 4.6% this week, following the OPEC 2.0 meeting in St. Petersburg. Although ministers did not announce additional cuts to the 1.8mm b/d agreed at the end of last year, Saudi Energy Minister Khalid al-Falih said the Kingdom would reduce August exports to 6.6mm b/d, which is more than 300k b/d below May's level, the latest month for which data are available from JODI. Given strong global demand, if this export reduction persists - and if others join the Kingdom - it would speed the drawdown in global inventories. Base Metals: Neutral. Copper pushed through $2.80/lb on the COMEX, a level not seen since May 2015. Underlying strength in EM economic activity - seen most recently in global trading activity (discussed below) - and a weaker USD are supporting base metals. Precious Metals: Neutral. Gold fell below $1,257/oz earlier this week, and was trading ~ $1,250/oz going to press Wednesday. We remain long gold as a portfolio hedge; the position is up 1.7% since it was initiated on May 4, 2017. Ags/Softs: Underweight. Harsh weather is impacting grains. The USDA rated 62% of the U.S. corn crop in the 18 states comprising 92% of total output good or excellent last week, down from 76% in 2016. For beans, the split was 58% last week vs. 71% last year. Feature The expansion in global trade that began toward the end of last year continues, which, based on our modeling, indicates inflation at the consumer level likely will move higher in the short run (Chart of the Week). Trade expansion, particularly in EM economies, is consistent with rising incomes, which, all else equal, will keep industrial commodities - oil and copper, in particular - well supported, given income and demand for these commodities are closely aligned.1 These fundamentals dovetail with other indications of stronger growth, particularly in DM economies, where trade volumes also are growing (Chart 2). In the U.S., for example, wage growth continues to outpace inflation, and monetary conditions remain benign (Chart 3). Our colleagues at BCA Research's Global Investment Strategy believe the Fed actually may be behind the curve in reacting to nascent inflationary pressures emerging in the U.S.2 Chart of the WeekRising EM Trade Volumes Consistent##BR##With Higher U.S. CPI Inflation Rising EM Trade Volumes Consistent With Higher U.S. CPI Inflation Rising EM Trade Volumes Consistent With Higher U.S. CPI Inflation Chart 2DM Trade Volumes Are Expanding##BR##At ~ 5% Pace ... DM Trade Volumes Are Expanding At ~ 5% Pace ... DM Trade Volumes Are Expanding At ~ 5% Pace ... Chart 3U.S. Labor Market Tightening,##BR##Financial Conditions Remain Loose U.S. Labor Market Tightening, Financial Conditions Remain Loose U.S. Labor Market Tightening, Financial Conditions Remain Loose Trade Growth Supports Higher Inflation U.S. CPI is highly correlated with EM trade volumes (imports and exports) as shown in the Chart of the Week. In recent research into inflation and trade, we also showed EM oil demand and world base metals demand are highly correlated with EM trade volumes.3 Chart 4EM Trade Volumes##BR##Continue To Strengthen Growth EM Trade Volumes Continue To Strengthen Growth EM Trade Volumes Continue To Strengthen Growth EM import growth continues to expand at a faster pace than DM growth (Chart 4). Year-on-year (yoy) EM import growth came in at 7.7%, a full 2 percentage points above DM growth. This is not to minimize DM growth - it finally broke out of its lethargy in May with a sharp advance of close to 6%, which will lift the trend rate of growth (the 12-month moving average, or 12mma) higher going forward. EM export growth in May was only slightly above DM growth for the month - 5.4% yoy vs. 5.2% yoy. These stout monthly trade performances will, in the next few months, offset the lethargic growth seen in EM and DM prior to the expansion begun at the end of 2016, as weaker monthly performance falls off the trend calculations. Over the year ended in May, within EM markets the annual trend in imports (the 12mma to May 2017) has barely grown more than 1% yoy, dragged down by a 6% contraction in the Middle East and Africa (MEA) and a 2.1% contraction in Latin American growth. The trend in EM - Asia's imports is up, rising 3.2% over the same period. For the year ended in May, imports into central and Eastern Europe were mostly flat; however, since November 2016, the trend turned sharply positive with 3.3% yoy growth. The trend in export volumes is expanding for in MEA and Latin America economies - 3.5% yoy trend growth (12mma) in MEA, and 4.4% growth in Latin America, which is slightly higher than the overall 2.2% rate of trend growth in EM exports. Still, lower oil and commodity prices, along with reduced volumes are curtailing an income recovery in these regions. Central and Eastern Europe's rate of export expansion leads EM generally at close to 4% yoy trend growth. Favor Gold And TIPS Ahead Of Higher Inflation As the labor market tightens and real-wage growth continues to outpace productivity growth, we expect U.S. inflation to pick up. Growth in trade volumes also will support growth in EM oil demand and world base metal demand, as noted above. This will feed into U.S. core PCE, the Fed's preferred inflation gauge (Chart 5). As we've highlighted in the past, there is very strong co-movement among these variables: We've found that, all else equal, a 1% increase in the non-OECD oil demand implies an increase in the core PCE of slightly less than 50bp. If the trend in overall EM trade volumes persists, the likelihood we will be increasing our estimate of non-OECD oil consumption for 2H17 and 2018 increases. U.S. CPI and EM trade volumes show similar co-movement properties, as the Chart of the Week shows. A 1% increase in EM import volumes translates into a 0.53% increase in the U.S. CPI, while a 1% increase in EM export volumes implies a 0.49% increase in the CPI. EM import volumes over the January - May 2017 interval have been growing at slightly more than 8% yoy, while exports have been growing at slightly more than 3%. Continued strength in the EM trade data implies U.S. CPI could grow well above what's currently being priced in inflation markets and by Fed policymakers. This leads us to favour gold and TIPS as inflation hedges. If we do get a larger-than-expected move in the U.S. CPI, gold should respond well. The modelling depicted in Chart 6 shows a 1% increase in the CPI translates into a 4.1% increase in gold. Chart 5Core PCE Will Pick Up##BR##As Commodity Demand Grows Core PCE Will Pick Up As Commodity Demand Grows Core PCE Will Pick Up As Commodity Demand Grows Chart 6Gold Will Pick Up##BR##Larger-Than-Expected CPI Moves Gold Will Pick Up Larger-Than-Expected CPI Moves Gold Will Pick Up Larger-Than-Expected CPI Moves For this reason we recommend getting long U.S. Treasury Inflation-Protected Securities (TIPS), which will appreciate as the U.S. CPI moves higher.4 We will be getting long as of tonight's close. We remain long low-risk calls spreads in Dec/17 WTI and Brent - long $50/bbl strikes vs. short $55/bbl strikes. We are up 39.3% and 32.9% on the Brent and WTI positions, respectively, from last week, and 47.2% and 89.2% since inception. U.S. Monetary Policy Remains A Huge Risk To EM Trade As we've noted in the past, U.S. monetary policy can have an outsized effect on EM trade volumes. In an update of an earlier model using U.S. M2 and the broad trade-weighted USD (TWIB), we find a 1% increase in the broad trade-weighted USD translates into a 1.1% drop in EM imports, while a 1% increase in U.S. M2 (broad money) implies an 85bp increase in EM imports (Chart 7).5 Chart 7EM Trade Volumes Highly Sensitive##BR##To U.S. Monetary Policy EM Trade Volumes Highly Sensitive To U.S. Monetary Policy EM Trade Volumes Highly Sensitive To U.S. Monetary Policy This demonstrates the feedback loop we've identified between U.S. monetary policy and EM trade. EM trade volumes affect inflation at a global level. We've found inflation in the U.S., EU and China to be co-integrated - i.e., these price gauges all follow the same long-term trend. Inflation and inflation expectations drive Fed policy, which drives the price formation of the USD - i.e., the FX rates included in the USD TWIB - and affect Fed policy on M2. These U.S. monetary variables, in turn, affect EM trade volumes. And so it goes ... Too-aggressive a tightening by the Fed as it normalizes its interest-rate policy regime could destabilize EM economies - either via too-sharp an appreciation in the USD TWIB, a larger-than-expected deceleration in M2 growth, or both - and negatively affect trade flows. At the end of the day, this would redound to the detriment of the U.S. economy, as the different feedback mechanisms kick in. This says the Fed's policy doesn't just affect the U.S. economy, or that EM economies essentially are on their own in the policy tools they deploy to adjust to Fed innovations. Like it or not, the Fed has to consider these types of feedback loops in its decision-making, since the Open Market Committee will be dealing with the fallout of its earlier policies. Bottom Line: EM trade volumes continue to grow yoy, continuing the trend that began at the end of last year. This performance, coupled with a tightening labor market in the U.S. and a still-loose financial backdrop, raises the odds inflation will exceed what's currently priced into market and Fed expectations. We are getting long U.S. 10-year TIPS at tonight's close, and remain long gold as a strategic portfolio hedge. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 The income elasticity for industrial commodities in EM economies is ~ 1.0, according to the OECD. Please see "The Price of Oil - Will It Start Rising Again?" OECD Economics Department Working Paper No. 1031, p. 6 (2013). 2 Please see BCA's Global Investment Strategy Weekly Report titled "Are Central Banks Behind The Curve Or Ahead Of It?," published on July 21, 2017. It is available at gis.bcaresearch.com. Among other things, the Global Investment Strategy team notes labor-market slack is dissipating, real wages are increasing, and easier financial conditions are spurring credit growth. Our colleagues note, "The prospect of stronger growth over the next few quarters implies that the unemployment rate is likely to fall below 4% early next year, possibly breaking through the 2000 low of 3.8%." BCA's Global Investment Strategy believes U.S. inflation could move higher by 2H18. 3 Please see BCA Commodity & Energy Strategy Weekly Reports titled "EM Trade Volumes Continue Trending Higher, Supporting Metals" and "Strong EM Trade Volumes Will Support Oil," published June 29, and June 8, 2017. Both are available at ces.bcaresearch.com. 4 U.S. TIPS increase in value as the Consumer Price Index (CPI) rises, and fall in value as the index declines. Please see "TIPS: Rates & Terms" on the UST's TreasuryDirect web page (https://www.treasurydirect.gov/indiv/research/indepth/tips/res_tips_rates.htm). 5 This model covers 2000 to the present, using monthly data. The R2 for the cointegrating regression is 0.96. These variables do not explain EM exports, which are not cointegrated with U.S. monetary variables. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade And Commodity Data Point To Higher Inflation Trade And Commodity Data Point To Higher Inflation Commodity Prices and Plays Reference Table Trade And Commodity Data Point To Higher Inflation Trade And Commodity Data Point To Higher Inflation Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights Business capital spending is still trending up, adding another layer of support for the U.S. economy in the next 6-12 months. Profit growth has accelerated at a faster pace than our top-down model had projected and we expect growth to accelerate further into year end. We estimate that the delayed pass-through of previous dollar strength will remain a slight drag on U.S. EPS growth over rest of 2017. Our tactical view on gold remains bearish, but the BCA Commodity & Energy Strategy service sees strategic value in gold as a hedge. Feature The S&P 500 is attempting to break through the 2400 barrier as we go to press. This is impressive given that the flagging relative performance of infrastructure stocks and highly-taxed companies suggests that investors have given up hope of ever seeing significant tax cuts, infrastructure spending and incentives for capital spending. As we discuss below, disappointment on the policy front has thankfully been offset by solid corporate earnings figures. We believe that investors have gone too far in pricing out tax reform. True, the growing number of White House scandals will serve to delay the GOP's market-friendly policy agenda. Nonetheless, the President desperately needs a win ahead of mid-term elections, and tax reform and deregulation are two key areas where the President and congressional Republicans are on the same page. Capital spending is the part of the economy that could benefit the most from tax reform. Surprising Support From Capex Business capital spending is still trending up, adding another layer of support for the U.S. economy in the next 6-12 months. The post-election rollover in C&I loan growth worried investors that rising rates and election-related uncertainty had cut the flow of credit to the business sector, thus putting capex at risk (Chart 1, top panel). That concern was overdone, as we pointed out in a recent report.1 Business expenditures on plant, equipment and software were a surprising source of strength in first-quarter GDP, and bank lending has stabilized in the past six weeks. The FOMC minutes of the May 2-3 meeting noted that "financing conditions for large nonfinancial firms stayed accommodative." The minutes also stated that, while there was weaker demand for C&I loans in April, the weakness "pertained to customers' reduced needs for financing." The reduced need likely reflected a preference to issue corporate bonds. Chart 1Outlook For Capex Looks Solid Outlook For Capex Looks Solid Outlook For Capex Looks Solid Our BCA Capex indicator for business investment points to solid business spending in the next few quarters. (Chart 1, bottom panel) Our past research shows that sustainable capital spending cycles only get underway when businesses see evidence that consumer final demand is on the upswing. While consumer expenditures were quite soft (+0.3% annualized gain) in Q1, our view is that the weakness was transitory.2 This view was confirmed by the FOMC minutes. A rebound in consumer spending in the second quarter will boost CEO confidence that increased capital spending will be justified in terms of future sales. Our base case is that at least some tax cuts will be enacted by year end, but the risk is that political turmoil further delays a fiscal package or even totally derails the GOP legislative agenda. This scenario would be negative for stocks temporarily, but could end up being positive over the medium term by extending the expansion in the economy and corporate profits. U.S. Profits, Beats And Misses Profit growth has accelerated at a faster pace than our top-down model had projected earlier this year (Chart 2). On a 4-quarter moving total basis, S&P 500 earnings-per-share were up by more than 13% in the first quarter (84% reporting). We expect growth to accelerate further into year end, peaking at just under 20%, before moderating in 2018. The favorable profit picture reflects two key factors. First, profits are rebounding from a poor showing in 2016, when EPS was dragged down by the collapse in oil prices and a global manufacturing recession. Oil prices have since rebounded and global industrial production is recovering as expected (Chart 3). Earnings are of course leveraged to corporate sales, helping to explain why profits are highly correlated with industrial production in the major countries. BCA's U.S. Equity Strategy service estimates that operating leverage for the S&P 500 is 1.4x.3 Chart 2Impact Of Stronger Dollar Is Fading Impact Of Stronger Dollar Is Fading Impact Of Stronger Dollar Is Fading Chart 3IP On The Rebound Globally IP On The Rebound Globally IP On The Rebound Globally Second, the corporate sectors in the major economies are still in a sweet spot in which the top line is growing but there is no major wage cost pressure evident yet. This is the case even in the U.S., where labor market slack has largely been absorbed. Indeed, margins rose in Q1 2017 for the third quarter in a row. Our indicators suggest that the corporate sector has gained some pricing power at a time when wage gains are taking a breather.4 The hiatus of wage pressure may not last long, but for now our short-term EPS growth model remains upbeat for the next 3-6 months (not shown). What About The Dollar? We estimate that the delayed pass-through of previous dollar strength will remain a slight drag on U.S. EPS growth of about one percentage point for the remainder of this year, assuming no change in the dollar from today's level (Chart 2, second and third panels). However, our base case remains that the dollar will appreciate by another 10% in trade-weighted terms. A 10% appreciation would trim EPS growth by roughly 2½ percentage points, although most of this would occur in 2018 due to lagged effects. The key point is that another upleg in the dollar, on its own, should not provide a major headwind for the stock market. Indeed, the dollar would only be rising in the context of robust U.S. economic growth and an expanding corporate top line. Even though the message from our EPS model is upbeat, it still falls short of bottom-up estimates for 2017. Is this a risk for the equity market, especially since valuations are stretched? Investors are well aware that bottom-up estimates are perennially optimistic. Table 1 compares the beginning-of-year EPS growth estimate with the actual end-of-year outcome for 2007-2016. Not surprisingly, bottom-up analysts massively missed the mark in 2008, which was a recession year. But even outside of the recession, analysts significantly over-estimated earnings in seven out of nine years. Despite this, the S&P 500 rose sharply in most cases. One exception was 2015, when the S&P 500 fell by 0.7%. Plunging oil and material prices contributed to an EPS growth "miss" of seven percentage points. Chart 4 highlights that the level of the 12-month forward EPS estimate fell that year, unlike in the other years considered. Valuations are more demanding today than in the past, but the message is that attaining bottom-up EPS year-end estimates is less important for the broad market than the direction of 12-month forward estimates (which remains up at the moment). Table 1Bottom Up Estimates Are##BR##Always Too Optimistic Corporate Earnings Versus Trump Turbulence Corporate Earnings Versus Trump Turbulence Chart 4Oil Related##BR##Dip In 2015 Oil Related Dip In 2015 Oil Related Dip In 2015 The bottom line is that the backdrop is constructive for equities even if the Republicans are unable to push through any fiscal stimulus. In fact, it may be better for the stock market in the medium term if the GOP fails to pass any meaningful legislation. The U.S. economy does not need any demand stimulus at the moment (although measures to boost the supply side of the economy would help lift profits over the long term). The current long-in-the-tooth expansion is likely to stretch further in the absence of stimulus, extending the moderate growth/low inflation/low interest rate backdrop that has been positive for risk assets in recent years. Gold Update Our tactical view on gold remains bearish, but the BCA Commodity & Energy Strategy service sees strategic value in gold as a hedge against rising inflation and inflation expectations, geopolitical risk and increased equity volatility.5 Chart 5A shows that the price of gold in real terms is still very expensive. On a nominal basis, gold is at the top end of a trading channel that it has been in since early 2012 (Chart 5B). There has been a big gap between the model value and the actual price of gold for the past three years. The real price of gold remains elevated despite the fact that inflation has been well contained.6 Chart 5AModel Suggests Gold Is Overvalued Model Suggests Gold Is Overvalued Model Suggests Gold Is Overvalued Chart 5BIn A Downward Channel Since 2012 In A Downward Channel Since 2012 In A Downward Channel Since 2012 Our 6-12 month view on gold is that it will take its cues from Fed policy and policy expectations. The Fed is not behind the curve on inflation, and inflation expectations and measured inflation remain low. Our CPI and PCE models (Chart 6) show only a modest acceleration in inflation by year end, just enough to keep the Fed on track this year as it begins to shrink its balance sheet and raise rates two more times. Thus, we do not see a great need to hold gold as a hedge against inflation over the next year. Nonetheless, for those investors concerned about a pullback that turns into a correction or a bear market, we mention that gold has a 33% weight in our Protector Portfolio.7 Chart 6Core Inflation To Stay Near##BR##Fed's Target This Year Core Inflation To Stay Near Fed's Target This Year Core Inflation To Stay Near Fed's Target This Year Bottom Line: Gold is expensive in real terms relative to a set of fundamentals that have explained its real price since 1970. However, the yellow metal may have value on a strategic basis or as part of a portfolio designed to protect against falling equity prices. 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, "Earnings Rebound Will Earn Some Respect", April 10, 2017. Available at usis.bcaresearch.com. 2 Please see U.S. Investment Strategy Weekly Report, "Growth, Inflation And The Fed", May 8, 2017. Available at usis.bcaresearch.com. 3 Please see U.S. Equity Strategy Weekly Report, "Operating Leverage To The Rescue?," published April 17, 2017. Available at uses.bcaresearch.com. 4 Please see U.S. Investment Strategy Weekly Report, "Spring Snapback?," published April 24, 2017. Available at usis.bcaresearch.com. 5 Please see Commodity & Energy Strategy Weekly Report, "Go Long Gold As A Strategic Portfolio Hedge," published May 4, 2017. Available at ces.bcaresearch.com. 6 Please see U.S. Investment Strategy Weekly Report, "Gold: The Asset Allocation Dilemma," published August 1, 2011. Available at usis.bcaresearch.com. 7 Please see U.S. Investment Strategy Weekly Report, "Still Awaiting The Next Pullback," published May 15, 2017. Available at usis.bcaresearch.com.