Money Trends / Liquidity

One of BCA's long-standing clients, Ms. Mea, recently paid us a visit at our Montreal office. Ms. Mea is an experienced and successful investor who has been reading different BCA products for many years. She noted that over the years she has both agreed and disagreed with our market views, but that she appreciates our thematic approach including themes, analysis and views, as they are important to her investment process. Like many of our clients, Ms. Mea has been disappointed by the Emerging Markets Strategy (EMS) team's EM/China call, which has not been correct over the past 18 months. My team and I spent a few hours with Ms. Mea detailing our views and methodology. Despite some tough discussions, she said she found the dialogue valuable. Reflecting on our meeting, I thought it would be beneficial to share the key points with all of EMS clients. This report is a summary of that. Ms. Mea and I agreed to continue the debate as the story plays out, so I will be meeting with her occasionally in Europe when I travel there. Ms. Mea: Clearly your recommended strategy has been wrong for some time. I am aware that your negative view on EM/China and strategy was right and profitable from 2011 until early 2016. Nevertheless, since early last year EM risk assets have rallied considerably, and not participating in this rally has been painful - not to mention being short EM risk assets. For our global equity funds, underweighting EM within the global universe did not hurt performance in 2016. However, this year the EM equity benchmark has considerably outperformed the global averages (Chart I-1). So, what has gone wrong, and why haven't you changed your view already? Chart I-1EMS's Big Picture Asset Allocation Strategy: EM Relative To DM Stock Prices EMS's Big Picture Asset Allocation Strategy: EM Relative To DM Stock Prices EMS's Big Picture Asset Allocation Strategy: EM Relative To DM Stock Prices Answer: My objective today is not to dispute your comments - my view and investment strategy have clearly gone wrong. Rather, I would like to highlight what has gone wrong as well as elaborate on my methodology and thought process. Let me be clear, if I thought in 2016 or early 2017 that the market would rally for more than six months and - in the case of EM equities - by more than 20%, I would have recommended clients to play this rally regardless of my big picture themes and views. The same is true today. My general view has been based on two pillars: Chinese growth and Federal Reserve policy/the U.S. dollar. 1. The first pillar of my argument has been that China's growth improvement would prove unsustainable due to lingering credit imbalances/excesses. In the April 13, 2016 report,1 I laid out the case that China's 2015-16 fiscal stimulus of RMB 850 billion would be offset by a potential slowdown in credit growth from an annual growth rate of 11.5% to 9-9.5%. Chart I-2China: Borrowing Costs Have Been Rising China: Borrowing Costs Have Rising China: Borrowing Costs Have Rising This thesis of credit growth deceleration was based on the natural tendency of credit growth to gravitate toward nominal GDP growth, especially since the credit-to-GDP ratio had massively overshot in the preceding seven years. Besides, since 2013 high-profile policymakers in China had been talking about the need for deleveraging, containing financial excesses, and not repeating the mistakes of 2009-2010, when money and credit was allowed to run at an extremely strong pace. In first half of 2016, I downplayed the recovery in money and credit aggregates arguing that they are temporary and unsustainable. When a country has a lingering credit bubble - which has been the case in China, I am biased to downplay upticks in money and credit growth and easing in monetary policy. At the same time, I put a greater emphasis on both monetary tightening and slowdown in money/credit when the economy suffers from credit excesses. The opposite is also true in cases where there are no excesses/imbalances. Since November 2016, the People Bank of China (PBoC) has been tightening liquidity and pushing money market rates and corporate bond yields higher (Chart I-2). This has been taking place in addition to regulatory tightening on both bank and shadow banking activities. As a result, I have been predicting that regulatory and liquidity tightening amid lingering credit and speculative excesses would weigh on money, credit and capital spending. Importantly, I reckoned that financial markets would be forward-looking and would reverse their rally in anticipation of weaker growth down the road instead of reacting to robust - yet backward looking - growth data. Indeed, money and credit growth have already slowed to all-time lows (Chart I-3). Nevertheless, broad economic growth has not slowed (Chart I-4). This has also been true for China's impact on the rest of the world - the mainland's imports have remained robust (Chart I-5). Chart I-3China: Money And Credit Aggregates China: Money And Credit Aggregates China: Money And Credit Aggregates Chart I-4China: Business Cycle Perspective China: Business Cycle Perspective China: Business Cycle Perspective Chart I-5China: Money Impulses And Imports China: Money Impulses And Imports China: Money Impulses And Imports Not only have I been surprised by the mainland economy's ability to withstand the slowdown in money/credit so far, but I have also been caught off guard by how financial markets have shrugged off the rise in onshore interest rates and the deceleration in money/credit. That said, liquidity tightening works with a time lag. The fact that it has not yet had an impact on the real economy does not mean it won't going forward. 2. The second pillar of my view has been that the Fed's dovish stance would prove transitory. The global market rally began in February 2016 when the Fed sounded dovish in the face of a surging U.S. dollar, collapsing commodities prices, very weak global trade and plunging global risk assets. Remarkably, global growth and corporate profits have recovered very strongly, the U.S. dollar has weakened considerably and commodities and global tradable goods prices have rebounded. As such, I expected that U.S. interest rate expectations would move higher, dampening the carry trade. Unfortunately, markets' reactionary functions does not always follow a symmetrical logic. The decline in U.S. inflation rate amid a weak dollar, rising import prices and robust U.S. growth - especially the tight labor market and some wages pressures (Chart I-6) - has puzzled me. Ms. Mea: Why have you disregarded the clear improvements in EM profits and global trade in 2017? Answer: I have been aware of improving economic data and corporate profits. Yet, these types of data are backward looking and are not a guarantee of future trends. Even though the released economic data and corporate profits have been strong, our forward-looking indicators for both EM and China have been heralding and continue to point to a major downtrend in EM profits (Chart I-7). Chart I-6Subtle Upside Risks To U.S. Inflation Subtle Upside Risks To U.S. Inflation Subtle Upside Risks To U.S. Inflation Chart I-7EM Profits Are At Risk EM Profits Are At Risk EM Profits Are At Risk Importantly, I presume stock prices lead profits. Hence, it is dangerous to turn bullish when forward-looking indicators that lead profits are already flashing red. These are empirical indicators and have a great track record. As such, I have placed substantial weight on them rather than on backward-looking economic and profit data. Since early 2017, I have been facing the following dilemma: Should I change my view based on strong, yet backward-looking, profit data, or remain cautious based on forward-looking growth indicators as well as our big-picture themes. I chose the latter, which in retrospect was wrong. Looking back, the biggest mistake I made was putting little weight on how markets have been trading. EM and global stocks continue to trade as they would in a genuine bull market: they have looked past negative news and rallied a lot in response to positives. Ms. Mea: You mentioned big-picture themes. Can you elaborate on your framework and methodology? Answer: At the core of my analytical framework lies investment themes. I formulate these themes based on a series of in-depth research reports. These themes have multi-year relevance - I expect them to have staying power beyond one year. These themes represent an anchor to my view and strategy. Without anchor themes, I would tend to change my views back and forth based on fluctuations in economic data or swings in financial markets. Having established themes, my team and I monitor cyclical data, market dynamics/signposts and any type of evidence to prove or refute those established themes. Clients have recently been asking why I only show charts/evidence that confirm my view, and rarely entertain the alternative scenario. Indeed, there are always contradictory signals, signposts and data that I identify every week. Yet, I still choose to show those that support my ongoing themes and views. Why? Because I opt to convey a well-argued coherent message to my clients. In this context, I use the limited client-time allocated to reading our reports to highlight the reasons supporting my current themes and high-conviction views. It would also be unhelpful for readers if I demonstrate several charts that herald a bullish stance, and then conclude the opposite. If I were to utilize the alternative approach, i.e., present data and evidence on both sides of the debate, the report would be ambiguous. As a result, readers would gain little conviction and would likely be left confused. Each of these approaches has advantages and disadvantages: when the view plays out, investors see the correct angle and, thereby, develop a strong conviction on the strategy, and hopefully act upon it. Conversely, when the view goes wrong, investors typically wish they had seen the opposite side as well. Chart I-8China: No Deleveraging So Far China: No Deleveraging So Far China: No Deleveraging So Far In short, my goal is to leave clients with a clear and well-argued message when I have high conviction. As to conviction level, like all investors, I am dealing with a black box when gauging the outlook for financial markets. I am never 100% certain; I make investment recommendations only when my conviction level is somewhere around 65-75%. Generally, I do not discuss the areas where my conviction level is less than 60%. Less than 60% means "I do not know". An example of this is whether the current tech rally will persist. Importantly, I try to bring to clients' attention data and evidence that they may not be aware of and analytical points that differ from commonly known market narratives. Investors are aware of overall global financial market dynamics and ongoing narratives. My goal is to add value to their knowledge with the framework of thematic investment research, and to highlight new and potentially market moving charts, data and evidence. My major theme on China in the past several years has been the following: Chinese banks have originated too much money, and the corporate sector has taken on a large amount of leverage. This, in tandem with speculative excesses in the shadow banking and property markets, pose considerable downside risks to capital spending growth in the mainland. This is especially the case given that both liquidity and regulatory tightening of banks and non-banks already begun in late 2016. While financial markets, economic data and corporate profits have gone against this theme, this does not mean credit/money excesses in China have disappeared or do not exist. On the contrary, they have gotten even bigger now (Chart I-8, top panel). The Chinese economy has recovered and benefited commodities prices and the rest of EM due to another round of substantial money/credit injection. Broad money and broad credit have surged by about RMB 45-50 trillion since the middle of 2015 - depending on which measure one uses (Chart I-8, bottom panel). In the context of mushrooming leverage, ongoing policy tightening entails a poor risk-reward profile for bullish bets on mainland growth. This is why I am reluctant to abandon this theme and the bearish view. Ms. Mea: What would it take to change your big picture theme on China? To fundamentally reverse my view on China and commodities on a multi-year time line, I would need to reject my theme that China has meaningful credit excesses and imbalances, or buy into the view that these imbalances are a natural outcome of China's excess savings and will never correct. I have strong conviction in my big picture theme and I have not seen convincing arguments to change it. That said, if I come to the conclusion that EM risk assets and China-related plays will rally for six months or longer, I will change the investment strategy and recommend playing that rally. In this case my market strategy will change even though the big picture theme remains intact. As to the relationship between national and household savings, credit, and money, I have elaborated at great length that money creation and credit excesses do not originate from excess savings.2 Hence, it is simply not natural for a country with excess savings to experience and sustain credit bubbles. Importantly, adjustments in terms of credit excesses/deleveraging in China have not even started (Chart 8, top panel). This does not imply that investors should wait until deleveraging ends before turning positive on mainland growth. Markets are forward looking and will bottom when they see the light at the end of tunnel. But it is very dangerous to be positive when the adjustment has not yet began. It appears China's capital spending in general and construction in particular - the most vulnerable and credit-dependent segments - have in recent years been fluctuating in mini-cycles, similar to what played out in Japan during the 1990s and 2000s. I am not suggesting that China resembles Japan entirely, but comparing their mini cycles is a worthwhile exercise. Chart I-9 shows that the Japanese economy, money, credit and share prices were on a rollercoaster ride in the 1990s and 2000s. Notably, the profile of Chinese H shares fits the profile of Japan's stock market during that period (Chart I-10). On average, the recovery phase of these mini-cycles/equity rallies lasted about 20-24 months. Chart I-9Mini-Cycles In Japan In The 1990-2000s Mini-Cycles In Japan In The 1990-2000s Mini-Cycles In Japan In The 1990-2000s Chart I-10Chinese H-Shares Now And Nikkei In 1990s Chinese H-Shares Now And Nikkei In 1990s Chinese H-Shares Now And Nikkei In 1990s My judgment is that the recovery in the Chinese economy and related financial markets over the past 18 months resembles the mini cycles Japan experienced in the 1990s and 2000s. If so, after the rally in the past 18 months, forward-looking investment strategy should be focused on identifying signposts of a reversal. Consistently, given my bias stemming from our core themes and the fact that financial markets are forward looking and have already rallied a lot, I have been looking for signs of a top in China's business cycle and Asia's trade flows. It is pointless for me to change the view if my bias is that markets will reverse their trend in the next couple of months. Investors who are bullish and long but are somewhat concerned about China's growth sustainability still may want to monitor and be aware when the business cycle and markets will reverse. This is where I believe our research is helpful and relevant to investors with a bullish bias. It is hard to forecast what would be an inflection point to overturn the current financial market trend. It could be an unambiguous message from China's Communist Party Congress in the coming days that containing financial risks - a code word for deleveraging - is a major policy priority, or it could be weak economic data in China, or lower commodities prices and weaker EM currencies, being the flipside of a stronger dollar. Chart I-11China: Beware Of Rising Inflation China: Beware Of Rising Inflation China: Beware Of Rising Inflation Ms. Mea: It seems there is no silver lining in your view. Does this mean Chinese policymakers cannot do much to generate a positive outcome for the economy and financial markets? Answer: Chinese policymakers are in a very tough position. Yet it does not mean there is no silver lining. I assign a 20-25% probability that policymakers can stabilize leverage in the economy and financial system without a meaningful growth slump. If this scenario transpires, my negative view on EM and China-related plays will continue to be wrong. There is a 40-45% probability that growth will slump as the authorities focus on deleveraging and structural reforms (allowing markets to play a greater role in resource/capital allocation), and that policy tightening will begin biting. This heralds a deflationary outcome from a cyclical perspective, but it also represents a necessary adjustment to ensure efficiency gains and productivity-led growth over the long run. In fact, this would make me structurally bullish on China's growth again. There is also a 30-35% probability that policymakers - having no tolerance for any kind of growth slump - will continue to stimulate via money/credit and fiscal deficits. The outcome of this scenario will be an inflation outbreak Notably, as I argued in the October 4th 2017 report,3 underlying inflationary pressures are rising, as shown in Chart I-11. Unless growth decelerates meaningfully, inflation will need to be tackled. If not, capital outflows from residents will escalate again, and the currency will come under depreciation pressure given that the deposit rate is at a very low 1.5%. Rising inflation limits policymakers' maneuvering room: they have to tighten and cannot stimulate rapidly and considerably when growth slows. In short, a silver-lining scenario - which would include the authorities curbing out excesses while preserving overall growth, and especially capital spending growth - is always there and is a well-known narrative in the investment community. I do not write about it because I assign a 20-25% probability of it actually panning out. Why not more? Because the imbalances and excesses are currently so large that it will be difficult to contain them without jeopardizing growth. Finally, my view on China does not spread to the entire economy - our focal point has been and remains capital expenditures in general and construction in particular. These areas are being financed by credit, and consume a lot of raw materials and capital goods. Mainland imports - which are heavy in commodities and capital goods (the two account for 95% of total imports) - are the link between mainland investment expenditures and the rest of the world in general, and EM in particular. The latter will suffer if Chinese imports contract. Ms. Mea: It seems your big-picture themes have considerable influence on your views and strategy. How have your big-picture investment themes evolved over time? Last decade, my overreaching theme was that EM and China were structurally sound and that EM/China/commodities were in a bull market. So, I went from being a staunch bull to a resolute bear. I took over the EMS strategy service in 2005, and was bullish on EM, China and commodities up until 2010 (Chart I-1 on page 1). In 2005, I published an in-depth report arguing that commodities were in secular bull market due to demand from China.4 In April 2006, I pioneered a new theme that in the case of a U.S./DM recession, EM could stimulate and boost domestic demand - an out-of-consensus thesis5 at the time. Having these themes in mind, I recommended upgrading/accumulating Chinese stocks amid the Lehman crisis in the fall of 2008.6 The message was that Chinese policymakers could and would stimulate, and that such stimulus would succeed in lifting Chinese growth, corporate profits, commodities prices and EM risk assets. That was a non-consensus trade at the time, and the exact opposite of my current view. Following the credit boom in EM/China in 2009-10, excesses and imbalances emerged, and I shifted to a negative stance on EM/China in 2010 (Chart I-1 on page 1). Furthermore, in our June 8, 2010 Special Report titled, 'How to Play EM This Decade,' I made a call on a major top and forthcoming bear market in commodities arguing that the 2010-decade leaders in terms of growth and share price performance would be the healthcare and technology sectors. I speculated that during the current decade mania will unfold either in the technology or heath care sectors or some combination of both. Since 2010, the technology and healthcare equity sectors have been the best equity sectors, while commodities have been the worst performing ones within both the global and EM equity space. Consistent with this theme, I have been overweighing EM technology stocks and bourses where tech has a large weight, such as Taiwan, China and Korea. Besides, since 2010 I have maintained a pair strategy recommendation of being long tech and short materials. Ms. Mea: It seems you have been changing the goalposts lately, using new data on Chinese money and credit instead of relying on traditional ones. Our research is an ongoing effort to understand the macro landscape better. Our objective is always to find new variables and indicators that better lead business cycles and corporate profits while continuing to track the existing ones. Thus, it is not about changing goalposts but refining existing indicators or examining alternative ones that have a better track record. The following aspects have led usintroduce new broad money measures in China: Over the past two years, official M2 has been much weaker than various credit and money measures, as illustrated in the top panel of Chart I-8 on page 8. Broad money, and hence new purchasing power, is created when banks originate credit - by lending to or buying claims on non-bank entities. Therefore, properly measuring broad money is vital to assessing the new purchasing power that is created in the economy. In brief, in 2016 and early this year I relied on China's official broad money M2 measure, but it has underestimated the amount of new purchasing power created in the past two years. This was one of the reasons we misjudged the duration and magnitude of this equity rally. In addition, the regulatory clampdown on banks and non-banks may have prompted them to shift credit assets from off balance sheet to on balance sheet, or vice versa. Banks and shadow bank entities can obscure or hide credit by classifying it differently, but the banking system cannot conceal the amount of money in the system. Therefore, by tracing broad money creation, one can trail new purchasing power originated by banks. For these reasons, we have begun calculating new broad money aggregates for China - we produced our measure of M3 (M2 plus some other banks liabilities that are not included in M2) and credit-money (broad money calculated using the asset side of commercial banks' balance sheets). Chart I-3 on page 3 illustrates that all measures of money and credit have slowed in late 2016 and this year. On balance, having examined various measures of money and credit, including official M2, we have concluded that in the past 12 months money/credit creation has been slowing in China, irrespective of which aggregate we focus on (please refer to Chart I-3 on page 3). Ms. Mea: How do you explain strong September money and credit numbers out of China? Money, credit and business activity data for September were indeed strong, but they should be adjusted for working days. In China, the annual Mid-Autumn Festival fell in October this year versus September over the past several years. During this festival, business activity grinds to a halt for several days. I conjecture that money, credit and growth data out of China and Asia in general was strong in September partially due to the increase in the number of business days in September this year versus September a year ago. We need to wait for October data and average the two months to get a better picture of the trajectory of the business cycle in Asia. Chart I-12China: Velocity Of Money Has Been Declining China: Velocity Of Money Has Been Declining China: Velocity Of Money Has Been Declining Ms. Mea: Your view on China, commodities and EM is largely contingent on very weak money growth. Is it possible that the correlation between money and economic growth has diminished or completely broken down in China? The only reason why broad money growth could deviate from nominal GDP growth is due to the rising velocity of money. Let's remind ourselves: Nominal GDP = Money Supply x Velocity of Money. For nominal GDP growth to rise, a considerable decelaration in money supply growth needs to be offset by an even larger acceleration in the velocity of money. It is extremely difficult to forecast velocity of money. I assume money velocity will be steady (constant) and, consequently, nominal GDP growth to be affected primarily by changes in broad money growth. Chart I-12 demonstrates that the velocity of money in China has been declining over the past eight years. So, it would be odd for the velocity of money to suddenly rise going forward, in turn making money growth a less reliable indicator for nominal GDP growth. Overall, while it is always possible that the correlation between money growth and economic activity can break down, it is not something that one can forecast or bet on with high conviction. Chart I-13EM Ex-China, Korea And Taiwan: ##br##Broad Money And Bank Loan Growth Is Weak EM Ex-China, Korea And Taiwan: Broad Money And Bank Loan Growth Is Weak EM Ex-China, Korea And Taiwan: Broad Money And Bank Loan Growth Is Weak Ms. Mea: What about other emerging markets? How dependent are they on China? Where are they in the business cycle? The link from China to other emerging markets is via commodities and EM countries' other exports to the mainland. Even non-commodity countries like Korea and Taiwan sell a lot to China. If Chinese growth decelerates, commodities prices relapse, the U.S. dollar rallies or the RMB comes under selling pressure, the outlook for other EM countries and their risk assets will be dim. I argued that EM currencies, credit, and stocks on aggregate levels are not cheap.7 Segments that appear attractively valued are cheap for a reason, while healthy segments (countries/sectors/companies) are rather expensive. Money and bank loan growth also remain lackluster in the majority of EM, excluding China, Korea and Taiwan (Chart I-13). The reason is that the banking systems in many of these developing countries have not been restructured and remain sick following years of overextended credit and rising non-performing loans. Therefore, even though EM exports to China and the rest of the world have picked up, there has been little recovery in their domestic demand. If external conditions - exports, exchange rates and borrowing costs - deteriorate anew, EM domestic demand recovery will be derailed. Investors often refer to Russia and Brazil when they cite macro adjustments in developing economies. It is true that Russia and Brazil have already gone through a lot of pain and adjustment, including provisioning for NPLs in their respective banking systems. Nevertheless, financial markets in both countries remain dependent on commodities prices and the U.S. dollar outlook. Barring external shocks, both economies will continue to revive. That said, my big-picture view entails a negative shock to EM sentiment due to China and a rally in the greenback so I cannot turn bullish on them yet. In addition, Brazil's public debt is rising in an unsustailable manner, and political risks remain significant, particularly ahead of next year's elections. It will be hard to boost nominal growth and contain the explosion of public debt without meaningful currency depreciation that reflates the economy. That cannot not bode well for foreign investors in Brazilian markets. Credit excesses continue to linger in some other EM economies, and there has been little adjustments in their leverage even when we remove China, Korea and Taiwan from the aggregate (Chart I-14). All in all, while some EM economies have undergone necessary macro adjustments, the largest economy - China - has not. When China begins its own macro adjustments, shockwaves will likely hit Asian economies and commodities producers. There are not many large developing countries outside Asia that are not raw materials exporters. Ms. Mea: What about the technology sector? It alone has been responsible for a substantial portion of price gains in the EM equity benchmark in this rally. Does your view on China's credit cycle also influence your outlook for technology stocks? Indeed, EM tech stocks have exploded in recent years, accounting for a significant portion of EM share price appreciation. Excluding tech stocks, EM equities have not rallied nearly as much (Chart I-15). Chart I-14EM Ex-China, Korea And Taiwan: ##br##Leverage Has Not Diminished EM Ex-China, Korea And Taiwan: Leverage Has Not Diminished EM Ex-China, Korea And Taiwan: Leverage Has Not Diminished Chart I-15EM Equities: Tech Versus Non-Tech EM Equities: Tech Versus Non-Tech EM Equities: Tech Versus Non-Tech Also, Table I-1 reveals that eight out of 11 equity sectors have underperformed the benchmark. Meanwhile, a large share of tech gains has been produced by five or so companies. Table I-1EM Sectors: Only Three Out Of 11 Sectors ##br##Outperformed The Benchmark Ms. Mea Challenges The EMS View Ms. Mea Challenges The EMS View I have no strong view on the technology sector's absolute performance following the exponential price gains of past years. Overweighting the technology sector has been my recommendation since 2010, as we discussed above, and it has panned out quite well. I still maintain this overweight call, but within the technology sector we prefer semis to internet and social-media stocks. On the second part of your question, my negative view on China's credit cycle does not have direct ramifications for technology stocks, including Chinese ones. Critically, the call on internet- and social media-related companies is a bottom-up call. On the macro level, I can only state the following: It is essential to realize that in the past nine years a lot of new purchasing power in China has been created because of explosive money origination by banks. If money/credit growth structurally downshifts in China in the years ahead, nominal income growth for both households and companies will slow and the growth in their spending power will also moderate. That said, I am not in a position to assess and comment on business model viability and equity valuation levels of internet and social media-related companies like Alibaba, Tencent or Baidu. As to the other two tech heavyweights - Samsung Electronics and TSMC - I continue to recommend an overweight position in semis and other tech stocks that stand to benefit from DM growth. However, I am less certain about their absolute performance given their exponential rally. Chart I-16EMS's Fully-Invested Equity Portfolio ##br##Performance Versus The Benchmark EMS's Fully-Invested Equity Portfolio Performance Versus The Benchmark EMS's Fully-Invested Equity Portfolio Performance Versus The Benchmark Finally, regardless of my view on EM absolute performance, we always add value to dedicated EM equity and fixed-income investors by selecting countries to overweight and underweight relative to their respective benchmarks. Our country equity allocation strategy has been very successful. Chart I-16 illustrates our country fully-invested equity portfolio performance versus the EM benchmark. The portfolio is built based on our overweight and underweight recommendations on individual bourses, and is assumed to be fully invested. Our country calls have done quite well in the past nine years, producing 58% outperformance versus the benchmark with extremely low volatility. This translates into 520 basis points of annual compound outperformance for nine years. Our recommended country allocation and other equity positions as well as fixed income and currency recommendations are published at the end of each week's report. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report titled "Revisiting China's Fiscal And Credit Impulses," dated April 13, 2016, link available at ems.bcaresearch.com 2 Please refer to the Emerging Markets Strategy Special Reports from October 26, 2016, November 23, 2016 and January 18, 2017; available on ems.bcaresearch.com 3 Please refer to the Emerging Markets Strategy Weekly Report titled, " China: Deflation Or Inflation?," dated October 4, 2017; link available on page 21. 4 Please refer to the International Bank Credit Analyst Special Report titled, "Commodities: Buy On Dips," dated April 2005. 5 Please refer to the Emerging Markets Strategy Special Report titled, "Global Monetary Tightening And Emerging Markets: Is It Different This Time?"dated April 19, 2006. 6 Please refer to the Emerging Markets Strategy Special Report titled, "Upgrade/Accumulate Chinese Stocks,"dated September 29, 2008. 7 Please see Emerging Markets Strategy Weekly Report titled "Is The Dollar Expensive, And Are EM Currencies Cheap?" dated October 11, 2017, link available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Slowing global money growth, export orders, and a downgrade in earnings revisions of cyclical relative to defensive equities points to a mild slowdown in non-U.S. growth. This slowdown is not worrisome, but could become so if the U.S. dollar rallies significantly. This risk should be kept in mind by investors. Short AUD/USD at 0.79 ¢. EUR/USD is trading at a premium and is over-owned. Conditions are emerging for investors to upgrade their view of the Fed relative to the ECB. EUR/USD has downside risk. Feature Chart I-1Global Growth Is Booming Global Growth Is Booming Global Growth Is Booming The world economy is on a roll. Nearly all of the world's PMI indexes are in expansionary territory, suggesting we are experiencing a rare global synchronized expansion. A key bellwether of global trade, Korean exports, are surging at a 35% annual rate, confirming that the global economy is very strong (Chart I-1). When all looks great, it is the ideal time to wonder what could go wrong. At this point, the greatest risk to this global expansion may be the dollar. A strengthening dollar would tighten global financial conditions, especially for EM borrowers, and exacerbate the impact of yellow flags that have already emerged. Yellow Flags Investors are in an ebullient mood these days, and for good reason: global growth is strong, and global policy is still very accommodative, even if some central banks have begun removing support for their economies. However, three yellow flags have emerged that in our view warrant some caution. To be clear, these are not grave signs and we do not foresee either a U.S. or a global recession until late 2019 at the earliest. With this in mind, what are the worrying signs that investors should monitor right now? The first yellow flag comes from global money supply growth. Narrow money has decelerated from a 12% annual growth rate to 9% today. Historically, this has been a leading indicator of global industrial production, global export growth and commodity prices (Chart I-2). While the surge in money growth in 2016 and 2017 was a key reason behind the rebound in global economic activity, especially outside the U.S., its recent slowdown points to an end of the economic upswing, though admittedly not toward a cataclysm. The second yellow flag comes from the U.S. ISM release. While the general tone of the report remains extremely positive, the export component has been in a downtrend since June. The key determinant of export growth for any country tends to be the vigor of its trading partners. Hence, it is not surprising that softness in the export component of the U.S. ISM manufacturing survey tends to be associated with weakening global trade and industrial activity (Chart I-3). The third yellow flag comes from earnings revisions. The earnings revision ratios of cyclical relative to defensive equities in the U.S. and globally have sharply rolled over. While still in positive territory, this development has historically been an early signal that improvements in global growth metrics are ebbing, a signal being flashed today (Chart I-4). Chart I-2Money And Global Growth: ##br##From Tailwind To Headwind Money And Global Growth: From Tailwind To Headwind Money And Global Growth: From Tailwind To Headwind Chart I-3A Blemish In An Otherwise##br## Bright Picture A Blemish In An Otherwise Bright Picture A Blemish In An Otherwise Bright Picture Chart I-4EPS Revisions: Cyclicals Have Turned ##br##Vis-A-Vis Defensives EPS Revisions: Cyclicals Have Turned Vis-À-Vis Defensives EPS Revisions: Cyclicals Have Turned Vis-À-Vis Defensives Bottom Line: The global economy is experiencing a synchronized upswing, which has left investors in an ebullient mood. However, slowing global money growth, ebbing export sentiment and weakening earnings revisions for cyclical relative to defensive equities suggest this broad-based upswing has reached its zenith. While a mild deceleration is likely to materialize soon, these indicators constitute yellow flags, not red ones. Conditions are still not in place to expect a major global growth slowdown. The Dollar Holds The Key While the factors above point to a mild slowdown, they do not yet indicate a dearth of growth that could prompt panic among investors, especially in the EM space. For this scenario to become reality, another ingredient is needed. In our view, this ingredient is a strong dollar. To begin with, the relationship between global growth and the dollar is well known in the investor community. When global growth is strong and broad-based, the dollar depreciates; when global growth is weak, the dollar appreciates (Chart I-5). The U.S. is a relatively closed economy, and is less exposed to global growth developments than the euro area, Japan or commodities producers (Chart I-6). Thus, when the global economy is in an upswing, the U.S. garners a smaller dividend than the rest of the world. Conversely, when the global economy hits a soft patch, the U.S. suffers less. Chart I-5Strong Global Growth Coincident ##br##With A Weak Dollar Strong Global Growth Coincident With A Weak Dollar Strong Global Growth Coincident With A Weak Dollar Chart I-6The U.S. Is Less Exposed ##br##To Global Growth Factors The Best Of Possible Worlds? The Best Of Possible Worlds? But the chain of causation is not only from growth to the dollar. The trend in the dollar also affects the trend in global growth. This is because in aggregate, the world remains short the dollar. According to the BIS, there is $27 trillion dollars of foreign-currency liabilities in the world, $14 trillion of which is denominated in U.S. dollars, with an extremely large proportion issued by EM borrowers. When the dollar weakens, the cost of borrowing among companies and banks that finance themselves in USD decreases, incentivizing further borrowing. This eases global liquidity conditions and decreases the cost of financing global trade, leading to increased economic activity and profits as well as expanding global capex. Meanwhile, when the dollar rises, the balance sheet of those foreign firms and governments that have borrowed in U.S. dollars becomes increasingly illiquid, resulting in strong headwinds for additional borrowing, curtailing economic activity, profits and capex. This explains why the dollar and commodities prices, the latter being extremely sensitive to growth and global capex, have displayed such a strong negative relationship over different time periods (Chart I-7). Chart I-7Rising USD Equals Declining Liquidity And Declining Commodity Prices Rising USD Equals Declining Liquidity And Declining Commodity Prices Rising USD Equals Declining Liquidity And Declining Commodity Prices Thanks to these dynamics, the weakness in the dollar this year has been a major boost to growth for the global economy. As Chart I-8 illustrates, the large easing in EM financial conditions was indeed related to the U.S. dollar's weakness. Therefore, as growth momentum could be peaking, a period of renewed strength in the greenback might inflict further damage to a key buttress of EM growth. Moreover, this time around, Chinese policymakers are unlikely to come to the rescue of the global economy as they did in 2015 and 2016. Back then, China was experiencing a deflationary spiral: producer prices were contracting at a 6% annual pace, profits were in free fall and outflows were growing exponentially. The People's bank of China and the central government pulled all the stops, increasing lending and fiscal expenditures and tightening capital controls. Monetary conditions eased massively (Chart I-9). Chart I-8The Falling Dollar Supported Global Growth The Falling Dollar Supported Global Growth The Falling Dollar Supported Global Growth Chart I-9Tightening Chinese Monetary Conditions Tightening Chinese Monetary Conditions Tightening Chinese Monetary Conditions Last weekend, the PBoC announced targeted cuts to reserve requirement ratios for banks extending lending to small companies. According to our China Investment Strategy sister publication, this is not a major easing.1 Instead, these are targeted measures aimed at helping small firms that are currently dependent on the predatory lending rates available in the shadow banking sector. Meanwhile, access to credit by large state-owned enterprises and the real estate sector will continue to be slowly curtailed. The mutation of deflation into inflation and the recovery of profit growth imply that China does not currently need the same shot to the arm that it did in 2015 and 2016. Thus, it is unlikely the country will initiate another round of massive credit easing that will boost investment by SOEs and the construction sector, the two main sources of capex and commodities demand. In an environment where global money growth has rolled over and where China is unlikely to press on the gas pedal as hard as it did two years ago, a strong dollar would thus have a nefarious impact on global financial conditions, global growth, and, in turn, EM currencies and commodities currencies. While we remain very negative on the yen for now, the Japanese currency could benefit from a meaningful slowdown in international growth, as such a slowdown would likely exert downward pressure on global bond yields, including in the U.S. Obviously, the rally in the USD will have to be much more pronounced than what has been experienced in the past month before its negative impact on growth begins to be felt in bond yields and the yen. Thus, we remain long USD/JPY for now. The AUD could prove to be a key victim of the developments highlighted above. The AUD is highly levered to global growth and EM financial conditions. Moreover, it is now very expensive on a long-term basis, having overshot terms of trade by a very significant margin (Chart I-10). Adding to the vulnerability in the Aussie, the Australian economy has been incapable of generating any inflationary pressures. The output gap remains very deep, the level of underemployment is still at a 37-year high, and wages continue to hover near record lows, limiting the capacity of the Reserve Bank of Australia to tilt to a hawkish stance (Chart I-11). Yet, investors expect rates to be 42 basis points higher 12 months from now. Finally, speculators are currently very long the AUD. Thus, we will use any rebound above 0.79 to short the AUD/USD, setting a limit-sell at this level with a target at 0.73. Chart I-10The AUD Is Vulnerable The AUD Is Vulnerable The AUD Is Vulnerable Chart I-11Litle Inflationary Pressures In Australia Litle Inflationary Pressures In Australia Litle Inflationary Pressures In Australia Bottom Line: While the three yellow flags highlighted do not represent a terminal danger to global growth, a stronger dollar at the hands of tightening global financial conditions, especially in EM economies, would be a much bigger threat to the global economy. We do anticipate the dollar to strengthen over the coming 12 months, but it will take a significant move before the USD puts enough of a brake on global growth to hurt global yields. We therefore remain positive on the USD/JPY. However, with this risk lurking in the background, we are implementing a short position on the AUD, a currency that is both expensive and over-owned, and underpinned by an economy full of slack. An Update On EUR/USD We continue to expect some downside to EUR/USD over the remainder of the year. As we have already highlighted, the euro has greatly overshot its implied interest rate parity (IRP) relationships. Our intermediate-term time model - an enhanced IRP model accounting for short- and long-term real rate differentials, global risk aversion, commodities prices and the trend in the pair - shows that EUR/USD remains near its largest premium to fair value since 2009. Confirming this assessment, the euro has also overshot its equilibrium implied by the level of interest rates five years out (Chart I-12). Valuations offer some insight on the potential size of the euro move, but they offer very little information in terms of timing. Instead, we should rely on technical and macro considerations. On this front, we have already highlighted that speculators are currently net long the euro by the largest margin since 2011. Philosophically, we often look at the euro as the anti-dollar, a highly liquid inverse bet on the dollar. Since EUR/USD constitutes 57.6% of the DXY, a short bet on this dollar index and a long bet on the euro are similar wagers. Currently, the sum of both bets is at a level normally followed by sharp drops in EUR/USD, suggesting that euro buying is hitting exhaustion levels (Chart 13). Meanwhile, with investors having very few short bets on the euro, especially when compared to the large stock of short bets on the DXY, a short squeeze in favor of the USD could emerge if European data disappoints relative to the U.S. (Chart I-13, bottom panel). Chart I-12Downside In EUR/USD Downside In EUR/USD Downside In EUR/USD Chart I-13Tactical Risk To EUR/USD Tactical Risk To EUR/USD Tactical Risk To EUR/USD On the macro front, a few developments have caught our eye. We are entering the window where based on historical lags, the euro area's industrial production is likely to start feeling the pain of the common currency's previous strength (Chart I-14). Compounding this worry for euro longs, euro area earnings revisions are lagging those in the U.S. by the greatest margin since 2014, suggesting the euro's strength has sapped some of the euro area's vigor and is in the process of redistributing it to the U.S. economy. Historically, this has led to a period of weakness in EUR/USD (Chart I-15). Chart I-14The Strong Euro ##br##Will Soon Be Felt The Strong Euro Will Soon Be Felt The Strong Euro Will Soon Be Felt Chart I-15Falling Relative EPS Revisions ##br##Equals A Weaker EUR/USD Falling Relative EPS Revisions Equals A Weaker EUR/USD Falling Relative EPS Revisions Equals A Weaker EUR/USD Confirming this insight are relative financial conditions. Euro area financial conditions have been tightening relative to the U.S. since the beginning of 2016 - a move that has become especially pronounced this year. The euro area's inflation outperformance vis-à-vis the U.S. this year was first and foremost a reflection of the previous easing in relative European financial conditions (Chart I-16). Thanks to these strong relative inflation dynamics, investors have brought forward the first rate hike expected from the ECB, while simultaneously removing interest rate hikes out of the U.S. OIS curve. This move has been wildly euro bullish. However, the window of opportunity for this bet is closing; the tightening in European financial conditions now points to a reversal in relative inflation, with U.S. prices set to now take the lead over the euro area. This could force a repricing of the Fed relative to the ECB, implying that monetary divergences could once again play against EUR/USD. Catalonia is not a reason to be bearish on the euro. Marko Papic, BCA's Chief Political Strategist, argues that the northeastern region is unlikely to leave Spain.2 The vast majority of Catalonia still favors remaining part of Spain (Chart I-17). Moreover, the region has received immigrants from the rest of the country for many decades, reflecting its superior economic performance. As a result, only 31% of the population speaks Catalan as a first language. In aggregate, the independentists' victory last weekend only reflects a low turnout rate, as individuals who opposed leaving Spain stayed at home, like they did in 2014. Chart I-16The Fed Will Be Repriced ##br##Against The ECB The Fed Will Be Repriced Against The ECB The Fed Will Be Repriced Against The ECB Chart I-17Will Of The People: ##br##Catalonia Will Stay In Spain The Best Of Possible Worlds? The Best Of Possible Worlds? Bottom Line: The euro will exhibit downside risk in the coming months. EUR/USD is trading well above its fair value implied by its IRP relationship. Additionally, euro buying has hit nosebleed levels, and the dollar is unloved. Moreover, the euro's recent strength could begin to negatively affect growth, especially as European earnings revisions have collapsed versus the U.S. Finally, financial conditions point to a fall in euro area inflation relative to the U.S., highlighting the risk that the policy path for the Fed could be upgraded against that of the ECB. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see China Investment Strategy Special Report, titled "On A Higher Note", dated October 5, 2017, available at cis.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, titled "Is King Dollar Back?", dated October 4, 2017, and Geopolitical Strategy Monthly Report, titled "The Geopolitical Risks For The Equity Bull Market", dated May 14, 2014 at gps.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 has been strong this week: Markit and ISM Manufacturing PMIs beat expectations at 53.1 and 60.8 respectively; ISM Prices Paid rose sharply to 71.5 from 64.0; Markit Services and ISM Non-Manufacturing PMIs also beat expectations at 55.3 and 59.8 respectively; ADP employment change and continuing and initial jobless claims also came out better than expected; The DXY has rebounded meaningfully after a string of stronger data and growing hopes on the fiscal policy front recently. Bond markets have picked up on these developments, with the 10-year yield rising 30 basis points from its bottom last month. However, stronger U.S. inflation is needed in order for the greenback to meaningfully rally. 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 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 European data has been mixed: The latest headline and core inflation readings for the euro area were weaker than expected, at 1.5% and 1.1% respectively; German retail sales also underperformed expectations, however, German unemployment rate decreased; Euro area manufacturing PMI also underperformed, while the services PMI outperformed; Euro area producer prices beat expectations, coming in at 2.5%. With U.S. data outperforming, the euro has softened versus the greenback, but has not displayed similar movements against other currencies. While it is true that European inflation is higher than a year ago, it is still not near the ECB's target. A stronger euro would further restrict inflationary pressures, which would be a cause for concern for ECB officials. 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 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Japanese data has been mixed the past weeks: The jobs/applicants ratio came in at 1.52, underperforming expectations and decreasing from the previous month. Additionally, retail trade and overall housing spending yearly growth both disappointed, coming in at 1.7% and 0.6% respectively. However, on the bright side, Nikkei Manufacturing PMI outperformed expectations, coming in at 52.9. Overall, we continue to be bullish on USD/JPY, as yields in the U.S. will continue to rise vis-à-vis Japanese ones. Economic data has been tepid, and wages continue to contract or remain flat, even if some underlying pressures are slowly emerging. Furthermore we expect that the BoJ will continues its extreme measures of yield curve targeting in order to spur inflation expectations. Nevertheless, the yen could appreciate against carry currencies like the AUD or NZD if Chinese monetary conditions become tight enough. 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 been mixed: Markit services PMI outperformed expectations coming in at 53.6, and increasing from last month's reading However, Markit manufacturing PMI came in under expectations at 55.9, and decreased from last month. Moreover Construction PMI unperformed, coming in at 48.1, the lowest level since July 2016. We would lean against any further strength of the pound against the U.S. dollar. The risks associated with Brexit still looms in the background, while data has been mixed, particularly when it comes to consumption and the housing market. Additionally, the market has already fully priced a rate hike by December. Thus, it seems that any good news for the pound are already in the price, as the BoE certainly has little incentives to follow a hawkish policy beyond removing its post-Brexit emergency measures. 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: AiG Performance of Manufacturing Index decreased to 54.2 from 59.8; TD Securities Inflation came in at 2.5%, down from 2.6%; HIA New Home Sales increased by 9.1% MoM in August, up from the 15.4% contraction in July; Building permits are still contracting 15.5% annually, but better than the expected 16.2% contraction. This week, the RBA decided to leave rates unchanged at 1.5%. The monetary policy statement focused on the lack of wage pressures in the Australian economy and on the higher exchange rate, which is "expected to contribute to continued subdued price pressures in the economy", as well as "weighing on the outlook for output and employment", stating further that "an appreciating exchange rate would be expected to result in a slower pick-up in economic activity and inflation than currently forecast." 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 Last week the RBNZ decided to leave rates unchanged at 1.75%. The RBNZ continued with its dovish slant, arguing that monetary policy will remain accommodative for a considerable period. An important development, however, is that the central bank toned down its cautious tone about the kiwi. In previous instances, the RBNZ had been very aggressive in stating that the NZD was too expensive and an adjustment was needed. However, in its most recent statement the RBNZ was much less aggressive in its rhetoric, highlighting the fall in the NZD. Overall, we believe that the NZD will continue to have upside against the AUD, as domestic inflationary pressures are much stronger in New Zealand than in Australia. Meanwhile, global developments, such as a downturn in the Chinese industrial cycle would affect Australia much more than New Zealand. 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 was mixed: Industrial product price grew at a 0.3% monthly pace, less than the expected 0.5%; Raw materials increased by 1%, above the expected 0.3%; GDP stagnated in July on a monthly basis, below the expected 0.1% growth; Merchandise trade slipped even further into a deficit from CAD 2.6 bn to CAD 3.41 bn. Furthermore, Governor Poloz's September 27 speech sent the CAD tumbling, stating that "monetary policy will be particularly data dependent" and that it could be "surprised in either direction". Probability of a hike in October and December declined from 48% to 23%, and 75% to 63%, respectively. While growth is robust, inflation has been declining since January, which may be a cautious sign for the BoC. 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 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Data in Switzerland has outperformed to the upside: The KOF Leading Indicator outperformed expectations, coming in at 105.8 and increasing from last month's reading. The SVME Purchasing Manager's Index also outperformed, coming in at 61.7 Finally, headline inflation also outperformed expectations, with a reading of 0.7%, increasing from 0.5% on August. This recent strength in the Swiss economy is most likely reflective of the sharp appreciation that EUR/CHF has experienced in recent months. However, despite the increase in inflation, the Swiss economy is still too weak for the SNB to stop intervening in the foreign exchange market or to remove their ultra-dovish monetary measures. Once we see both headline and core inflation climb closer to their historical averages, we will reassess this view. 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 Data in Norway has been mixed: Register unemployment came in line with expectations at 2.5%, decreasing from last month's 2.7% reading. However the credit growth issued by national institutions in Norway, decreased since last month, coming in at 5.6%. Finally, both retail sales and real retail sales yearly growth came below expectations, coming in at -0.6% and 0.2% respectively. These few data points are interesting given that both retail and real retail sales growth dipped into contractionary territory. This shows that the Norwegian economy is still too weak to sustain a higher krone and higher rates. For this reason we continue to be bullish on USD/NOK. This cross is more correlated with rate differentials than with oil. Thus even if oil continues to rise, rising rates in the U.S. will still put upward pressure on USD/NOK. 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 The 11-year ruling governor of the world's oldest central bank, Stefan Ingves, will now sit at the helm of the Riksbank for five more years, until 31 December 2022. While Sweden's economy is still performing above par with CPIF at 2.3%, our bullish case for the SEK is under threat by the extension of the governor's term, who introduced negative interest rates to Sweden and who is consistently vigilant over the SEK's appreciation, even threatening intervention if needed. EUR/SEK appreciated 0.6% on the news, but has since given up some those gains as economic data in Sweden rebounded sharply. The Riksbank will still likely hike, but the timing is now in question. It is likely that the tightening cycle will now coincide with the ECB's tapering program, which will limit the SEK's appreciation for now. 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

Liquidity is the lifeblood of the economy and financial markets, but it is a slippery concept that means different things to different people. Liquidity falls into four categories: monetary, balance sheet, financial market transaction liquidity, and funding liquidity. Overall liquidity conditions are reasonably constructive for risk assets at the moment. Financial market and balance sheet liquidity are adequate. Monetary policy is extremely easy, although the low level of money and credit growth underscores that the credit channel of monetary policy is still somewhat impaired. Funding liquidity is as important as monetary liquidity for financial markets. It has recovered from the Great Financial Crisis (GFC) lows, but it is far from frothy. Unwinding the Fed's balance sheet represents a risk to investors because QE played such an important role in reducing risk premia in financial markets. The unwind should not affect transactions liquidity or balance sheet liquidity. It should not affect the broad monetary aggregates either. The bond market's reaction will be far more important than balance sheet shrinkage. As long as the Fed can limit the bond market damage via forward guidance, then funding liquidity should remain adequate and risk assets should take the Fed's unwind in stride. It will be a whole different story, however, if inflation lurches higher. The technical impact of balance sheet unwind on the inner workings of the credit market is very complicated. Asset sales could lead to a shortage of short-term high-quality assets, unless it is offset with increased T-bill issuance. However, a smaller balance sheet could, in fact, improve funding liquidity to the extent that it frees up space on banks' balance sheets. Liquidity has been an integral part of BCA's approach to financial markets going back to the early days of the company under the tutelage of Editor-in-Chief Hamilton Bolton from 1949 to 1968. Bolton was ahead of his time in terms of developing monetary indicators to forecast market trends. Back then, the focus was on bank flows such as the volume of checks cashed because capital markets were still developing and most credit flowed through the banking system. Times changed, monetary policy implementation evolved and financial markets became more important and sophisticated. When money targeting became popular among central banks in the 1970s, central bank liquidity analysis focused more on the broader monetary aggregates. These and other monetary data were used extensively by Anthony Boeckh, BCA's Editor-in-Chief from the 1968 to 2002, to forecast the economy and markets. He also highlighted the importance of balance sheet liquidity (holdings of liquid assets), and its interplay with rising debt levels. Martin Barnes continued with these themes when writing about the Debt Supercycle in the monthly Bank Credit Analyst. "Liquidity" is a slippery concept, and it means different things to different people. In this Special Report, we describe BCA's approach to liquidity and highlight its critical importance for financial markets. We provide a list of indicators to watch, and also outline how the pending shrinkage of the Fed's balance sheet could affect overall liquidity conditions. A Primer On Liquidity We believe there are four types of liquidity that are all interrelated: Central Bank Liquidity: Bank reserves lie at the heart of central bank liquidity. Reserves are under the direct control of the central bank, which are used as a tool to influence general monetary conditions in the economy. The latter are endogenous to the system and also depend on the private sector's desire to borrow, spend and hold cash. Bullish liquidity conditions are typically associated with plentiful bank reserves, low interest rates and strong growth in the monetary aggregates. Balance Sheet Liquidity: A high level of balance sheet liquidity means that plenty of short-term assets are available to meet emergencies. The desire of households, companies and institutional investors to build up balance sheet liquidity would normally increase when times are bad, and decline when confidence is high. Thus, one would expect strong economic growth to be associated with declining balance sheet liquidity, and vice versa when the economy is weak. Of course, deteriorating balance sheet liquidity during good times is a negative sign to the extent that households or business are caught in an illiquid state when the economy turns down, jobs are lost and loans are called. Financial Market Transaction Liquidity: This refers to the ability to make transactions in securities without triggering major changes in prices. Financial institutions provide market liquidity to securities markets through their trading activities. Funding Liquidity: The ability to borrow to fund positions in financial markets. Financial institutions provide funding liquidity to borrowers through their lending activities. The conditions under which these intermediaries can fund their own balance sheets, in turn, depend on the willingness of banks and the shadow banking system to interact with them. The BIS definition of funding liquidity is a broad concept that captures a wide range of channels. It includes the capacity of intermediaries that participate in the securitization chain to access the necessary funding to originate loans, to acquire loans for packaging into securities, and finance various kinds of guarantees. The availability and turnover of collateral for loans is also very important for generating funding liquidity, as we discuss below. These types of liquidity are interrelated in various ways, and can positively or negatively reinforce each other. It is the interaction of these factors that determines the economy's overall ease of financing. See Box II-1 for more details. BOX II-1 How Liquidity Is Inter-Related Central bank liquidity, which is exogenously determined, is the basis for private liquidity creation (the combination of market transaction and funding liquidity). The central bank determines the short-term risk-free rate and the official liquidity that is provided to the banking system. If the central bank hikes rates or provides less official liquidity, appetite for private lending begins to dry up. Private sector liquidity is thus heavily influenced by monetary policy, but can develop a life of its own, overshooting to the upside and downside with swings in investor confidence and risk tolerance. Financial market liquidity and funding liquidity are closely interrelated. When times are good, markets are liquid and funding liquidity is ample. But when risk tolerance takes a hit, a vicious circle between market transaction and funding liquidity develops. The BIS highlights the procyclical nature of private liquidity, which means that it tends to exhibit boom-bust cycles that generate credit excesses that are followed by busts.1 The Great Financial Crisis of 2008 is a perfect example. The Fed lifted the fed funds rate by 400 basis points between 2004 and 2006. Nonetheless, the outsized contraction in private liquidity, resulting from the plunge in asset prices related to U.S. mortgage debt, was a key driver of the crash in risk asset prices. Liquidity Indicators: What To Watch (1) Monetary Liquidity Key measures of central bank liquidity include the monetary base and the broad money aggregates, such as M1 and M2 (Chart II-1). Central banks control the amount of reserves in the banking system, which is part of base money, but they do not control the broad monetary aggregates. The latter is determined by the desire to hold cash and bank deposits, as well as the demand and supply of credit. Box II-2 provides some background on the monetary transmission process and quantitative easing. BOX II-2 The Monetary Transmission Process And Qe Before the Great Recession and Financial Crisis, the monetary authorities set the level of short-term interest rates through active management of the level of bank reserves. Reserves were drained as policy tightened, and were boosted when policies eased. The level of bank reserves affected banks' lending behavior, and shifts in interest rates affected the spending and investment decisions of consumers and businesses. Of course, it has been a different story since the financial crisis. Once short-term interest rates reached the zero bound, the Fed and some other central banks adopted "quantitative easing" programs designed to depress longer-term interest rates by aggressively buying bonds and thereby stuffing the banking system with an excessive amount of reserves. Many feared the onset of inflation when QE programs were first announced because investors worried that this would contribute to a massive increase in credit and the overall money supply. Indeed, there could have been hyper-inflation if banks had gone on a lending spree. But this never happened. Banks were constrained by insufficient capital ratios, loan losses and intense regulation, while consumers and businesses had no appetite for acquiring more debt. The result was that the money multiplier - the ratio of broad money to the monetary base - collapsed (top panel in Chart II-1). Bank lending standards eventually eased and credit demand recovered. Broad money growth has been volatile since 2007 but, despite quantitative easing, it has been roughly in line with the decade before. The broad aggregates lost much of their predictive power after the 1980s. Financial innovation, such as the use of debit cards and bank machines, changed the relationship between broad money on one hand, and the economy or financial markets on the other. Despite the structural changes in the economy, investors should still keep the monetary aggregates and the other monetary indicators discussed below in their toolbox. While the year-to-year wiggles in M2, for example, have not been good predictors of growth or inflation on a one or two year horizon, Chart II-2 shows that there is a long-term relationship between money and inflation when using decade averages. Chart II-1The Monetary Aggregates The Monetary Aggregates The Monetary Aggregates Chart II-2Long-Run Relationship Between M2 And Inflation October 2017 October 2017 Other monetary indicators to watch: M2 Divided By Nominal GDP (Chart II-3): When money growth exceeds that of nominal GDP, it could be interpreted as a signal that there is more than enough liquidity to facilitate economic activity. The excess is then available to purchase financial assets. Monetary Conditions Index (Chart II-3): This combines the level of interest rates and the change in the exchange rate into one indicator. The MCI has increased over the past year, indicating a tightening of monetary conditions, but is still very low by historical standards. Dollar Based Liquidity (Chart II-3): This includes Fed holdings of Treasurys and U.S. government securities held in custody for foreign official accounts. Foreign Exchange Reserves (Chart II-3): Central banks hold reserves in the form of gold, or cash and bonds denominated in foreign currencies. For example, when the People's Bank of China accumulates foreign exchange as part of its management of the RMB, it buys government bonds in other countries, thereby adding to liquidity globally. Interest Rates Minus Nominal GDP Growth (Chart II-4): Nominal GDP growth can be thought of as a proxy for the return on capital. If interest rates are below the return on capital, then there is an incentive for firms to borrow and invest. The opposite is true if interest rates are above GDP growth. Currently, short-term rates are well below nominal GDP, signaling that central bank liquidity is plentiful. Chart II-3Monetary Indicators (I) Monetary Indicators (I) Monetary Indicators (I) Chart II-4Monetary Indicators (II) Monetary Indicators (II) Monetary Indicators (II) (2) Balance Sheet Liquidity Chart II-5 presents the ratio of short-term assets to total liabilities for the corporate and household sectors. It is a measure of readily-available cash or cash-like instruments that make it easier to weather economic downturns and/or credit tightening phases. The non-financial corporate sector is in very good shape from this perspective. The seizure of the commercial paper market during the GFC encouraged firms to hold more liquid assets on the balance sheet. However, the uptrend began in the early 1990s and likely reflects tax avoidance efforts. Households are also highly liquid when short-term assets are compared to income. Liquidity as a share of total discretionary financial portfolios is low, but this is not surprising given extraordinarily unattractive interest rates. The banking system is being forced to hold more liquid assets under the new Liquidity Coverage Ratio requirement (Chart II-6). This is positive from the perspective of reducing systemic risk, but it has negative implications for funding liquidity, as we will discuss below. Chart II-5Balance Sheet Liquidity Balance Sheet Liquidity Balance Sheet Liquidity Chart II-6Bank Balance Sheet Liquidity Bank Balance Sheet Liquidity Bank Balance Sheet Liquidity (3) Financial Market Transaction Liquidity: Transactions volumes and bid-ask spreads are the main indicators to watch to gauge financial market transaction liquidity. There was a concern shortly after the GFC that the pullback in risk-taking by important market-makers could severely undermine market liquidity, leading to lower transaction volumes and wider bid-ask spreads. The focus of concern was largely on the corporate bond market given the sharply reduced footprint of investment banks. The Fed's data on primary dealer positioning in corporates shows a massive decline from the pre-crisis peak in 2007 (Chart II-7). This represents a decline from over 10% of market cap to only 0.3%. The smaller presence of dealers could create a liquidity problem for corporate debt, especially if market-making dealers fail to adequately match sellers with buyers during market downturns. Yet, as highlighted by BCA's Global Fixed Income Strategy team, corporate bond markets have functioned well since the dark days of the Lehman crisis.2 Reduced dealer presence has not resulted in any unusual widening of typical relationships like the basis between Credit Default Swaps and corporate bond spreads. Other market participants, such as Exchange Traded Funds, have taken up the slack. Daily trading volume as a percent of market cap has returned to pre-Lehman levels in the U.S. high-yield market, although this is not quite the case for the investment-grade market (Chart II-8). Chart II-7Less Market Making Less Market Making Less Market Making Chart II-8Corporate Bond Trading Volume Corporate Bond Trading Volume Corporate Bond Trading Volume That said, it is somewhat worrying that average trade sizes in corporates are smaller now compared to pre-crisis levels - perhaps as much as 20% smaller according to estimates by the New York Fed. This is likely the result of the reduced risk-taking by the dealers and the growing share of direct electronic trading. Thus, it may feel like liquidity is impaired since it now takes longer to execute a large bond trade, even though transaction costs for individual trades have not been increasing. The bottom line is that financial market liquidity is not as good as in the pre-Lehman years. This is not a problem at the moment, but there could be some dislocations in the fixed-income space during the next period of severe market stress when funding liquidity dries up. (3) Funding Liquidity: There are few direct measures of funding liquidity. Instead, one can look for its "footprint" or confirming evidence, such as total private sector credit. If credit is growing strongly, it is a sign that funding liquidity is ample. Box II-3 explains why international credit flows are also important to watch for signs of froth in lending. BOX II-3 The Importance Of International Credit Flows The BIS highlights that swings in international borrowing amplify domestic credit trends. Cross border lending tends to display even larger boom-bust cycles than domestic credit, as can be seen in the major advanced economies in the lead up to the GFC, as well as some Asian countries just before the Asian crisis in the late 1990s (Chart II-9). When times are good, banks and the shadow banking system draw heavily on cross-border sources of funds, such that international credit expansion tends to grow faster during boom periods than the credit granted domestically by banks located in the country. Since G4 financial systems intermediate a major share of global credit, funding conditions within the G4 affect funding conditions globally, as BIS research shows.3 This research also demonstrates that financial cycles have become more highly correlated across economies due to increased financial integration. Booms in credit inflows from abroad are also associated with a low level of the VIX, which is another sign of ample funding liquidity conditions (Chart II-10). These periods of excessive funding almost always end with a financial crisis and a spike in the VIX. Chart II-9International Credit Is Highly Cyclical International Credit Is Highly Cyclical International Credit Is Highly Cyclical Chart II-10International Credit Booms Lead Spikes In The VIX International Credit Booms Lead Spikes In The VIX International Credit Booms Lead Spikes In The VIX Other measures of funding liquidity to watch include: Chart II-11Market Measures Of Funding Liquidity Market Measures Of Funding Liquidity Market Measures Of Funding Liquidity Libor-OIS Spread (Chart II-11): This is a measure of perceived credit risk of LIBOR-panel banks. The spread tends to widen during periods of banking sector stress. Spreads are currently low by historical standards. However, libor will be phased out by 2021, such that a replacement for this benchmark rate will have to be found by then. Bond-CDS Basis (Chart II-11): The basis is roughly the average difference between each bond's yield spread to Treasurys and the cost of insuring the bond in the CDS market. Arbitrage should keep these two spreads closely aligned, but increases in funding costs tied to balance sheet constraints during periods of market stress affect this arbitrage opportunity, allowing the two spreads to diverge. The U.S. high-yield or investment grade bond markets are a good bellweather, and at the moment they indicate relatively good funding liquidity. FX Basis Swap (Chart II-11): This is analogous to the bond-CDS basis. It reflects the cost of hedging currencies, which is critically important for international investors and lending institutions. The basis swap widens when there is financial stress, reflecting a pullback in funding liquidity related to currencies. The FX swap basis widened during the GFC and, unlike other spreads, has not returned to pre-Lehman levels (see below). Bank Leverage Ratios (Chart II-12): The ratio of loans to deposits is a measure of leverage in the banking system. Banks boost leverage during boom times and thereby provide more loans and funding liquidity to buy securities. In the U.S., this ratio has plunged since 2007 and shows no sign of turning up. Primary Dealers Securities Lending (Chart II-13): This is a direct measure of funding liquidity. Primary dealers make loans to other financial institutions with the purpose of buying securities, thereby providing both funding liquidity and market liquidity. Historically, shifts in dealer lending have been correlated with bid-ask spreads in the Treasury market. Securities lending is also correlated with the S&P 500, although it does not tend to lead the stock market. Dealer loans soared prior to 2007, before collapsing in 2008. Total loans have recovered, but have not reached pre-crisis highs, consistent with stricter regulations that forced the deleveraging of dealer balance sheets. Chart II-12U.S. Bank Leverage U.S. Bank Leverage U.S. Bank Leverage Chart II-13Securities Lending And Margin Debt bca.bca_mp_2017_10_01_s2_c13 bca.bca_mp_2017_10_01_s2_c13 NYSE Margin Debt (Chart II-13): Another direct measure of funding liquidity. The uptrend in recent years has been steep, although it is less impressive when expressed relative to market cap. Bank Lending Standards (Chart II-14): These surveys reflect bank lending standards for standard loans to the household or corporate sectors, but their appetite for lending for the purposes of securities purchases is no doubt highly correlated. Lending standards tightened in 2016 due to the collapse in oil prices, but they have started to ease again this year. Table II-1 provides a handy list of liquidity indicators split into our four categories. Taking all of these indicators into consideration, we would characterize liquidity conditions in the U.S. as fairly accommodative, although not nearly as abundant as the period just prior to the Lehman event. Monetary conditions are super easy, while balance sheet and financial market liquidity are reasonably constructive. In contrast, funding liquidity, while vastly improved since the GFC, is still a long way from the pre-Lehman go-go years according to several important indicators such as bank leverage. Moreover, the Fed is set to begin the process of unwinding the massive amount of monetary liquidity provided by its quantitative easing program. Chart II-14Bank Lending Standards Bank Lending Standards Bank Lending Standards Table II-1Liquidity Indicators To Watch October 2017 October 2017 Fed Balance Sheet Shrinkage: What Impact On Liquidity? Given that the era of quantitative easing has been a positive one for risk assets, it is unsurprising that investors are concerned about the looming unwind of the Fed's massive balance sheet. For example, Chart II-15 demonstrates the correlation between the change in G4 balances sheets and both the stock market and excess returns in the U.S. high-yield market. Chart II-16 presents our forecast for how quickly the Fed's balance sheet will contract. Following last week's FOMC meeting we learned that balance sheet reduction will begin October 1. For the first three months the Fed will allow a maximum of $6 billion in Treasurys and $4 billion in MBS to run off each month. Those caps will increase in steps of $6 billion and $4 billion, respectively, every three months until they level off at $30 billion per month for Treasurys and $20 billion per month for MBS. Chart II-15G4 Central Bank Balance Sheets G4 Central Bank Balance Sheets G4 Central Bank Balance Sheets Chart II-16Fed Balance Sheet Fed Balance Sheet Fed Balance Sheet We have received no official guidance on the level of bank reserves the Fed will target for the end of the run-off process. However, New York Fed President William Dudley recently recommended that this level should be higher than during the pre-QE period, and should probably fall in the $400 billion to $1 trillion range.4 In our forecasts we assume that bank reserves will level-off once they reach $650 billion. In that scenario the Fed's balance sheet will shrink by roughly $1.4 trillion by 2021. The level of excess reserves in the banking system will decline by a somewhat larger amount ($1.75 trillion). In terms of the impact of balance sheet shrinkage on overall liquidity conditions, it is useful to think about the four categories of liquidity described above. (1) Monetary Liquidity The re-absorption of excess reserves will mean that base money will contract (i.e. the sum of bank reserves held at the Fed and currency in circulation). However, we do not expect this to have a noticeable impact on the broader monetary aggregates, credit growth, the economy or inflation, outside of any effect it might have on the term premium in the bond market. The reasoning is that all those excess reserves did not have a major impact on growth and inflation when they were created in the first place. This was because the credit channel of monetary policy was blocked by a lack of demand (private sector deleveraging) and limited bank lending capacity (partly due to regulation). Banks were also less inclined to lend due to rising loan losses. Removing the excess reserves should have little effect on banks' willingness or ability to make new loans. In terms of asset prices, some investors believe that when the excess reserves were created, a portion of it found its way out of the banking system and was used to buy assets directly. That is not the case. The excess reserves were left idle, sitting on deposit at the Fed. They did not "leak" out and were not used to purchase assets. Thus, fewer excess bank reserves do not imply any forced selling. Nonetheless, the QE program certainly affected asset prices indirectly via the portfolio balance effect. Asset purchases supported both the economy and risk assets in part via a weaker dollar and to the extent that the policy lifted confidence in the system. But most importantly, QE depressed long-term interest rates, which are used to discount cash flows when valuing financial assets. QE boosted risk-seeking behavior and the search for yield, partly through the signaling mechanism that convinced investors that short-term rates would stay depressed for a long time. The result was a decline in measures of market implied volatility, such as the MOVE and VIX indexes. Could Bond Yields Spike? The risk is that the portfolio balance effect goes into reverse as the Fed unwinds the asset purchases. The negative impact on risk assets will depend importantly on the bond market's response. As highlighted in the Overview section, there will be a sharp swing in the flow of G4 government bonds available to the private sector, from a contraction of US$600 billion in 2017 to an increase of US$200 billion in 2018. Focusing on the U.S. market, empirical estimates suggest that the Fed's shedding of Treasurys could boost the 10-year yield by about 80 basis points because the private sector will require a higher term premium to absorb the higher flow of bonds. However, the impact on yields is likely to be tempered by two factors: Banks are required by regulators to hold more high-quality assets than they did in the pre-Lehman years in order to meet the new Liquidity Coverage Ratio. The BCA U.S. Bond Strategy service argues that growing bank demand for Treasurys in the coming years will absorb much of the net flow of Treasurys that the Fed is no longer buying.5 As the FOMC dials back monetary stimulus it will be concerned with overall monetary conditions, including short-term rates, long-term rates and the dollar. If long-term rates and/or the dollar rise too quickly, policymakers will moderate the pace of rate hikes and use forward guidance to talk down the long end of the curve so as to avoid allowing financial conditions to tighten too quickly. Thus, the path of short-term rates is dependent on the dollar and the reaction of the long end of the curve. It is difficult to estimate how it will shake out, but the point is that forward guidance will help to limit the impact of the shrinking Fed balance sheet on bond yields. Indeed, the Fed is trying hard to sever the link in investors' minds between balance sheet policy and signaling about future rate hikes, as highlighted by Chair Yellen's Q&A session following the September FOMC meeting. The bottom line is that the impact on monetary liquidity of a smaller Fed balance sheet should be minimal, although long-term bond yields will be marginally higher as a result. That said, much depends on inflation. If the core PCE inflation rate were to suddenly shift up to the 2% target or above, then bond prices will be hit hard, the VIX will surge and risk assets will sustain some damage. The prospect of a more aggressive pace of monetary tightening would undermine funding liquidity, compounding the negative impact on risk assets. (2) Funding Liquidity Chart II-17Tri-Party Repo Market Has Shrunk Tri-Party Repo Market Has Shrunk Tri-Party Repo Market Has Shrunk By unwinding its balance sheet, the Fed will be supplying securities into the market and removing cash. This will be occurring at a time when transactions in the tri-party repo market have fallen to less than half of their peak in 2007 due to stricter regulation (Chart II-17). This market has historically been an important source of short-term funding, helping to meet the secular rise in demand for short-term, low-risk instruments, largely from non-financial corporations, asset managers and foreign exchange reserve funds. If the Fed drains reserves from the system and T-bill issuance does not increase substantially to compensate, a supply shortage of short-maturity instruments could develop. We can see how this might undermine the Fed's ability to shift short-term interest rates higher under its new system of interest rate management, where reverse repos and the interest rate paid on reserves set the floor for other short-term interest rates. However, at the moment we do not see the risk that fewer excess reserves on its own will negatively affect funding liquidity. Again, any impact on funding liquidity would likely be felt via a sharp rise in interest rates and pullback in the portfolio balance effect, which would occur if inflation turns up. But this has more to do with rising interest rates than the size of the Fed's balance sheet. Indeed, balance sheet shrinkage could actually improve funding liquidity provided via the bilateral repo market, securities-lending, derivatives and prime brokerage channels. These are important players in the collateral supply chain. A recent IMF working paper emphasizes that collateral flows are just as important in credit creation as money itself.6 Collateral refers to financial instruments that are used as collateral to fund positions, which can be cash or cash-like equivalents. Since pledged collateral can be reused over and over, it can generate significantly more total lending than the value of the collateral itself. The Fed's overnight reverse-repo facility includes restrictions that the collateral accessed from its balance sheet can only be used in the tri-party repo system. Thus, the Fed's presence in the collateral market has reduced the "velocity of collateral." Table II-2 shows that the reuse rate of collateral, or its velocity, has fallen from 3.0 in 2007 to 1.8 in 2015. Table II-2Collateral Velocity October 2017 October 2017 The combination of tighter capital regulations and Fed asset purchases has severely limited the available space on bank balance sheets to provide funding liquidity. Regulations force banks to carry more capital for a given level of assets. Fed asset purchases have forced a large portion of those assets to be held as reserves, limiting banks' activity in the bilateral repo market. There is much uncertainty surrounding this issue, but it appears that an unwind the Fed's balance sheet will free up some space on bank balance sheets, possibly permitting more bilateral repo activity and thus a higher rate of collateral velocity. It may also relieve concerns about a shortage of safe-haven assets. Nonetheless, we probably will not see a return of collateral velocity to 2007 levels because stricter capital regulations will still be in place. What About Currency Swaps? Some have argued that this removal of cash could also lead to an appreciation of the U.S. dollar. In particular, Zoltan Pozsar of Credit Suisse has observed a correlation between U.S. bank reserves and FX basis swap spreads.7 There is also a strong correlation between FX swap spreads and the U.S. dollar (Chart II-18). Chart II-18FX Basis Swap And Reserves FX Basis Swap And Reserves FX Basis Swap And Reserves One possible chain of events is that, as the Fed drains cash from the market, there will be less liquidity in the FX swap market. Basis swap spreads will widen as a result, and this will cause the dollar to appreciate. In this framework, the unwinding of the Fed's balance sheet will put upward pressure on the U.S. dollar. However, it is also possible that the chain of causation runs in the other direction. The BIS has proposed a model8 where a stronger dollar weakens the capital positions of bank balance sheets. This causes them to back away from providing liquidity to the FX swap market, leading to wider basis swap spreads. In this model, a strong dollar leads to wider basis swap spreads and not the reverse. If this is the correct direction of causation, then we should not expect any impact on the dollar from the unwinding of the Fed's balance sheet. At the moment it is impossible to tell which of the above two theories is correct. All we can do is monitor the correlation between reserves, FX basis swap spreads and the dollar going forward. Conclusions: Overall liquidity conditions are reasonably constructive for risk assets at the moment. Financial market and balance sheet liquidity are adequate. Monetary policy is extremely easy, although the low level of money and credit growth underscores that the credit channel of monetary policy is still somewhat impaired and/or constrained relative to the pre-Lehman years. Funding liquidity has recovered from the Great Financial Crisis lows, but it is far from frothy. More intense regulation means that funding liquidity will probably never again be as favorable for risk assets as it was before the crisis. But, hopefully, efforts by the authorities to reduce perceived systemic risk mean that funding liquidity may not be as quick to dry up as was the case in 2008, in the event of another negative shock. Unwinding the Fed's balance sheet represents a risk to investors because QE played such an important role in reducing risk premia in financial markets. However, we believe that the bond market's reaction will be far more important than balance sheet shrinkage. As long as the Fed can limit the bond market damage via forward guidance, then risk assets should take the Fed's unwind in stride. It will be a whole different story, however, if inflation lurches higher. The technical impact of balance sheet unwind on the inner workings of the credit market is very complicated and difficult to forecast. Asset sales could lead to a shortage of short-term high-quality assets. However, this is more a problem in terms of the Fed's ability to raise interest rates than for funding liquidity. A smaller balance sheet could, in fact, improve funding liquidity to the extent that it frees up space on banks' balance sheets. Mark McClellan Senior Vice President The Bank Credit Analyst Ryan Swift Vice President U.S. Bond Strategy 1 D. Domanski, I. Fender and P. McGuire, "Assessing Global Liquidity," BIS Quarterly Review (December 2011). 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Global Interest Rate Strategy For The Remainder Of 2017," dated July 18, 2017, available at gfis.bcaresearch.com 3 E. Cerutti, S. Claessens and L. Ratnovski, "A Primer on 'Global Liquidity'," CEPR Policy Portal (June 8, 2014). 4 William C. Dudley, "The U.S. Economic Outlook and the Implications for Monetary Policy," Federal Reserve Bank of New York (September 07, 2017). 5 Please see BCA U.S. Bond Strategy Weekly Report, "The Great Unwind," dated September 19, 2017, available at usbs.bcaresearch.com 6 M. Singh, "Collateral Reuse and Balance Sheet Space," IMF Working Paper (May 2017). 7 Alexandra Scaggs, "Where would you prefer your balance sheet: Banks, or the Federal Reserve?" Financial Times Alphaville (April 13, 2017). 8 S. Avdjiev, W. Du, C. Koch, and Hyun S.Shin, "The dollar, bank leverage and the deviation from covered interest parity," BIS Working Papers No.592 (Revised July 2017).

Highlights We highlighted last month that investors should remain slightly overweight risk assets, but should also hold safe havens given the preponderance of risks. Some of the risks have since faded and the sweet spot for equities is continuing, but the potential for a correction remains elevated. Geopolitics will no doubt remain a threat for 'risk on' trades, although we may be at peak tensions with respect to North Korea. Our models point to an acceleration in growth in the major economies. Our capital spending indicators suggest that animal spirits are stirring in the business sector. In the U.S., fiscal stimulus is back on the table and investors are looking beyond the negative short-term impact of the hurricanes to the growth-enhancing rebuilding that will follow. It is also positive for the stock-to-bond return ratio that our bullish oil scenario is playing out. Stay long oil-related plays. There is a good chance that this year's downtrend in the dollar and government bond yields is over. The rise in both may be halting, but the risks are to the upside now that disappointments on U.S. growth and inflation have likely ended (notwithstanding the hurricane-distorted economic data in the near term). The Phillips curve is not dead. We do not expect Fed balance sheet normalization on its own to be a major headwind for risk assets. The bigger threat is a sudden and sharp re-assessment of the outlook for interest rates in the major countries. Our base-case view is that inflation will only grind higher in the major countries. It should be slow enough that the associated backup in bond yields does not derail the rally in risk assets, but the danger of a sharper bond market adjustment means that investors should continue to be on the conservative side. Feature It was 'risk on' in financial markets in September, despite a less dovish tone among the major central banks. The reason is that the synchronized global growth outlook continues to gather momentum, supporting the earnings backdrop, but inflation remains dormant in the major countries outside of the U.K. Investors believe that calm inflation readings will allow central banks to proceed cautiously and avoid taking risks with growth, extending the expansion in GDP and earnings. The North Korean situation changes from day to day, but investors appear to be more comfortable with it at the margin. In the U.S., fiscal stimulus is back on the table and investors are looking beyond the negative short-term impact of the hurricanes to the growth-enhancing rebuilding that will follow. Finally, rising oil prices will lift earnings in the energy patch. These developments spurred investors to embrace risk assets and carry trades again in September. However, value is poor and signs of froth are accumulating. For example, equity investors are employing record amounts of margin debt to lever up investments. The Bank for International Settlements highlighted in its Quarterly Review that margin debt outstanding in 2015 was higher than during the dotcom boom (and it has surely increased since then). The global volume of outstanding leveraged loans continues to set new highs even as covenant standards slip. Risk assets are being supported by a three-legged stool: solid earnings growth, low bond yields and depressed bond market volatility. The latter is a reflection of current market expectations that dormant inflation will continue to constrain central bankers. We agree that the economic growth and earnings outlook is positive on a 6-12 month horizon. The main item that could upset the sweet spot for risk assets, outside of a geopolitical event, is an awakening in inflation. This would shatter the consensus view that the bond market will remain well behaved. Markets are priced for little change in the inflation backdrop even in the long term. Our base-case view is that inflation will grind higher in the major countries, although it should be slow enough that the associated backup in bond yields does not derail the rally in risk assets in the next 6-12 months. But the risk of a sharper bond market adjustment means that investors should continue to be conservative (although slightly tilted to risk-over-safety). Getting Used To North Korea It appears that investors are becoming increasingly desensitized to provocation from the rogue state. Our geopolitical experts argued that the risk of a full-out war with the U.S. was less than 10%, but they warned that there could be a market-rattling political crisis or even a military skirmish before Pyongyang returned to the negotiating table. However, we may be at peak tensions now, based on several key developments over the past month. First, both China and Russia, two North Korean allies, have turned up the pressure. China appears to be enforcing sanctions according to Chinese trade data vis-à-vis North Korea (Chart I-1). Both China and Russia have also agreed to reduce fuel supplies. And there is evidence that U.S. and North Korea have held unofficial diplomatic talks behind the scenes. The implication is that North Korea is responding to pressure now that its critical fuel supplies are at risk. Chart I-1China Getting Tougher With NK China Getting Tougher With NK China Getting Tougher With NK We cannot rule out more goading from Kim Jong Un, especially with a busy political calendar in Asia this fall: the Korean Worker's Party's anniversary on October 10, the Chinese midterm leadership reshuffle on October 11-25, Japanese elections on October 22, and Trump's visit to the region in mid-November. Nevertheless, it would require a major provocation (i.e. a direct attack on the U.S. or its allies) for Pyongyang to escalate tensions from current levels. This would require the North to be very reckless with its own strategic assets, given that the U.S. would likely conduct a proportional retaliation against any serious attack. The recent backup in Treasury yields and yen pullback suggest that investors do not think tensions will escalate that far. We agree, but obviously the situation is fluid. Trump Trades Back In Play? U.S. politics have also become more equity-friendly and bond-bearish at the margin. The risk of a debt ceiling standoff has been delayed until December following President Trump's deal with the Democrats. We do not think that this represents a radical shift toward bipartisanship, but it is warning from the President that the GOP had better get cracking on tax legislation. The House Budget committee passed a FY2018 budget resolution in late July that included "reconciliation instructions" for tax legislation. Such a budget resolution approved by the Congress as a whole would allow for tax cuts that are not fully offset by spending cuts, with the proviso that the tax reductions sunset after a defined number of years. It is difficult to see tax legislation being passed before year end, but the first quarter of 2018 is certainly possible. Markets will begin to price in the legislation well before it is passed, which means that the so-called Trump trades are likely to see a revival. In particular, the legislation should favor small caps and boost the dollar. This year's devastating hurricane activity will also lift U.S. growth in 2018. History shows that natural disasters have only a passing effect on the U.S. economy and financial markets. Following the short-term negative economic impact, rebuilding adds to growth with the Federal government footing part of the bill. A 2016 Congressional Budget Office (CBO) report found that federal spending after major hurricanes can add as much as 0.6% to GDP. CBO notes that the lion's share of the economic impact is in the first year after a storm, with most of those expenditures helping victims to obtain food and shelter, fund search and rescue operations, and protect critical infrastructure. Federal outlays for public infrastructure occur after the first year and provide a much smaller lift to GDP (Chart I-2). Chart I-2Federal Government Outlays For Hurricane Relief October 2017 October 2017 Oil: Inventories Are Correcting Chart I-3Oil Inventory Correction To Lift Prices Oil Inventory Correction To Lift Prices Oil Inventory Correction To Lift Prices It is also positive for the stock-to-bond return ratio that our bullish oil scenario is playing out. Our energy strategists highlight that global oil demand is booming, at a time when the U.S. Energy Information Administration (EIA) lowered its estimated shale oil output by 200,000 bpd for the third quarter. This confirms our contention that the EIA has overestimated the pace of the shale production response during 2017. Taken together, these factors helped to improve the global net demand/supply balance by 600,000 bpd. The drawdown in global oil inventories is thus likely to continue (Chart I-3). Looking to next year, crude prices could go even higher with an extension of the OPEC/Russian production cuts beyond March 2018 and continued strong growth in global oil demand. The synchronized global expansion is reflected in rising oil demand from all parts of the world. Soft Industrial Production Readings Won't Last We have highlighted global and regional industrial production as important indicators of both economic growth corporate earnings. It is therefore a little disconcerting that our aggregate for industrial production in the advanced economies has suddenly lost momentum (Chart I-4). We are inclined to fade the recent softening for a few reasons. First, much of it is due to weakness in the U.S. where hurricanes affected the August figures. Second, most of our leading indicators remain very constructive. Chart I-5 present a simple model for real GDP growth for the G4 economies based on our consumer and capital spending indicators. Real GDP growth will continue to accelerate for the G4 economies as a group according to the model. Our aggregate consumer indicator appears to have peaked at a high level, but the capex indicator is blasting off. The bullish capital spending reading is unanimous across the major economies (Chart I-6). Chart I-4Animal Spirits Are Stirring... Animal Spirits Are Stirring... Animal Spirits Are Stirring... Chart I-5...Contributing To Stronger G4 Economic Growth ...Contributing To Stronger G4 Economic Growth ...Contributing To Stronger G4 Economic Growth Chart I-6Capital Goods Indicators Are Surging Capital Goods Indicators Are Surging Capital Goods Indicators Are Surging The Eurozone is particularly strong on both the consumer and business fronts, suggesting that euro strength has not undermined growth. Conversely, the U.K. is at the weak end of the spectrum based on the drop in its consumer spending indicator. This is the main reason why we do not believe the Bank of England will be able to make good on its warning of a rate hike this year (see below). Robust capital goods imports for our 20-country aggregate supports the view that animal spirits are stirring in boardrooms in the advanced economies (Chart I-4, third panel). These imports and our capital spending indicators suggest that the small pullback in advanced-economy industrial production will not last, purchasing managers' indexes will remain elevated, and the acceleration in global export activity is just getting started. Even U.S. small business sector has shifted into a higher gear in terms of hiring and capital spending according to the NFIB survey. These trends will favor industrial stocks, especially versus utilities. Central Banks Shedding Dovish Feathers The synchronized global growth pickup is also reflected in our Central Bank Monitors, which are all near or above the zero line (Chart I-7). The Monitors gauge pressure on central banks to adjust policy. Current readings are consistent with the relatively more hawkish tone by central bankers in Canada, the U.S., the Eurozone and the U.K. Chart I-7Central Bank Monitors Support Less Dovish Policymakers Central Bank Monitors Support Less Dovish Policymakers Central Bank Monitors Support Less Dovish Policymakers The violent reaction in the gilt market to the Bank of England's hint that it could hike rates in the next few months highlights the vulnerability of bond markets to any shift by central bankers in a less dovish direction. In this case, we do not believe the BoE will be able to follow through with its rate hike plan. The leading economic indicators are softening and inflation is about to roll over now that the pound has bottomed. In contrast, bunds are quite vulnerable to a more hawkish tilt at the European Central Bank (ECB). Eurozone policymakers confirmed at their September meeting that they plan to announce in October a reduction in the asset purchase program, to take effect in 2018. The ECB revised up its growth forecast for 2017, and left the subsequent two years unchanged. The inflation forecast was trimmed by 0.1 percentage points in 2018 and 2019. The fact that this year's surge in the euro was not enough to move the needle much on the ECB's projections speaks volumes about the central bank's confidence in the current European economic expansion, as well as its comfort level with the rising currency. Our fixed income strategists believe that the full extent of ECB tapering is not yet fully discounted in the European bond market. Phillips Curve: It's Not Dead, Just Resting Chart I-8U.S. Inflation U.S. Inflation U.S. Inflation Turning to the Fed, the bond market did not get the dovish tone it was expecting from September's FOMC meeting. Policymakers left a December rate hike on the table, as Chair Yellen downplayed this year's lagging inflation data as well as the impact of the hurricanes on the economy. Not surprisingly, the odds of a December rate hike have since jumped to 70%. The Fed announced its plan to begin shrinking its balance sheet beginning in October. In the press conference, Yellen tried to disassociate balance sheet policy from the rate outlook. Balance sheet adjustment will be on autopilot, such that short-term interest rates will be the Fed's main policy instrument going forward. While the Fed plans to deliver another rate increase in December, it will require at least a small rise in inflation. Policymakers were no doubt pleased that annual CPI core inflation edged up in August and the 3-month rate of change has moved back to 2% (Chart I-8). The CPI diffusion index also moved above the zero line, indicating that the soft patch in the inflation data may be over, although the diffusion index for the PCE inflation data fell back to the zero line. Table I-1 presents the major contributors to the 0.9 percentage point decline in the year-over-year headline CPI inflation rate since February. Energy accounts for the majority of the decline, at 0.6 percentage points. New cars, shelter, medical services and wireless telephone services account for the remainder. The deflationary wireless price effect is now unwinding, but medical services is a wildcard and our shelter model suggests that this large part of the CPI index will probably not help to lift inflation this year. Thus, higher inflation must come largely from non-shelter core services, which is the component most closely correlated with wages. Investors remain unconvinced by Yellen's assertion that the soft patch in the inflation data reflects transitory factors. Indeed, market-based long-term inflation expectations remain well below the Fed's target, and they even fell a little following the FOMC meeting. Table I-1Contribution To Change In Headline ##br##Inflation (February -August, 2017) October 2017 October 2017 One FOMC member is becoming increasingly alarmed by the market's disbelief that the Fed will hit the 2% target even in the long run (Chart I-9). In a recent speech, Governor Brainard noted that both market-based and survey evidence on inflation expectations have drifted lower in the post-Lehman years. More recently, long-term inflation breakeven rates and CPI swaps have been surprisingly sticky in the face of the rebound in oil prices. In the Fed's view, monetary policy can be used effectively in response to shifts in the cyclical drivers of inflation. However, if inflation expectations were to become unanchored, then inflation's long-run trend would be altered and monetary policy would become less effective. Japan is a glaring example of what could be the endpoint. Brainard's fears have not yet affected the FOMC consensus, which is loath to throw the Phillips curve model into the dust bin just yet. We agree that the Phillips curve is not dead. Peter Berezin, Chief Strategist for the BCA Global Investment Strategy Service, argued in a recent Special Report that the often-cited reasons for why the Phillips curve has become defunct - decreased union bargaining power, a more globalized economy, and technological trends - are less convincing than they appear. The Fed simply has to be patient because the U.S. is only now reaching the kinked part of the Phillips Curve (Chart I-10). Chart I-9Worrying Trends For The FOMC Worrying Trends For The FOMC Worrying Trends For The FOMC Chart I-10U.S. Wage Growth Accelerates Once The Unemployment Rate Falls Below 5% (1997-2017) October 2017 October 2017 Moreover, our global fixed income team has made the case that the global output gap must be taken into consideration.1 Chart I-11 presents the percentage of OECD economies that have an unemployment rate below the NAIRU rate, along with inflation in the services and goods sectors of the developed markets. While the correlation between this global NAIRU indicator and realized inflation rates declined in the years after the recession, the linkages have improved over the past couple of years. The fact that the global NAIRU indicator is only now back to pre-Lehman levels suggests that inflationary pressure could finally be near an inflection point. Market expectations for the path of real GDP growth and the unemployment rate are roughly in line with the FOMC's central tendency forecast. However, the wide gulf between the FOMC and the market on the path of interest rates remains a potential catalyst for a correction in risk assets if market rates ratchet higher. Fed balance sheet runoff could also be problematic in this regard. QE Unwind: How Much Of A Risk? Many investors equate the surge in asset prices in the years after the Great Financial Crisis with central bank largesse. Won't a reversal of this policy be negative for both bonds and stocks? Fed balance sheet runoff, together with ECB tapering and less buying by the Bank of Japan, will certainly change the supply/demand backdrop for the G4 government bond markets in 2018. We have updated our projection for the net flow of government bonds available to the private sector, taking into consideration the supply that is absorbed by central banks and other official institutions (Chart I-12). The top panel shows that the net supply of Treasurys to the private sector never contracted in recent years, but the bottom panel highlights that the net supply of G4 government bonds as a group was negative for 2015, 2016 and 2017. Central banks and other official buyers had to bid-away bonds from the private sector during these years. Chart I-11Global Slack Matters Global Slack Matters Global Slack Matters Chart I-12Major Swing In Government ##br##Bond Supply In 2018 October 2017 October 2017 We project that the net supply will swing from a contraction of almost $600 billion in 2017 to a positive net flow of almost US$200 billion next year. The Fed's projected runoff accounts for most of the swing. The supply/demand effect might push up term premia a little. Nonetheless, as discussed in this month's Special Report beginning on page 19, the balance sheet unwind is not the key threat to bonds and stocks. Rather, the main risk is the overly benign central bank outlook that is priced into the bond market. Real 5-year bond yields, five years forward, are still extremely depressed because the market has discounted negative real short-term interest rates out to 2022 in the U.S. and 2026 in the Eurozone (Chart I-13). Chart I-13Real Forward Short-Term Rates Real Forward Short-Term Rates Real Forward Short-Term Rates Time For The Nikkei To Shine Equity bourses took September's backup in bond yields in stride. Indeed, the S&P 500 and Nikkei broke to new highs during the month. The Euro Stoxx 50 also sprang to life, although has not yet reached fresh highs in local currency terms. The solid earnings backdrop remains a key support for the market. We highlighted our EPS forecasts in last month's report. Nothing of significance has changed on this front. The latest data suggest that operating margins may be peaking, but the diffusion index does not suggest an imminent decline (Chart I-14). Meanwhile, our upbeat economic assessment discussed above means that top line expansion should keep EPS growing solidly into the first half of 2018 at the global level. EPS growth will likely decelerate toward the end of next year to mid-single digits. Chart I-14Operating Margins Approaching A Peak? Operating Margins Approaching A Peak? Operating Margins Approaching A Peak? We still see a case for the Nikkei to outperform the S&P 500, at least in local currencies. Japan is on the cheap side according to our top-down indicator (Chart I-15). Japanese earnings are highly geared to economic growth at home and abroad. Japanese EPS is in an uptrend versus the U.S. in both local and common currencies (Chart I-16). We do not expect to see a peak in EPS growth until mid-2018, a good six months after the expected top in the U.S. Moreover, an Abe win in the October 22 election would mean that policy will remain highly reflationary in absolute terms and relative to the U.S. Chart I-15Valuation: Japan Cheap To The U.S., But Not Europe Valuation: Japan Cheap To The U.S., But Not Europe Valuation: Japan Cheap To The U.S., But Not Europe Chart I-16Japanese Earnings Outperforming The U.S. Japanese Earnings Outperforming The U.S. Japanese Earnings Outperforming The U.S. European stocks are a tougher call. On the plus side, the economy is flying high and there are no warning signs that this is about to end. There is hope for structural reform in France after Macron's election win this year. We give Macron's proposed labor market reforms high marks because they compare favorably with those of Spain and Germany, which helped to diminish structural unemployment in those two countries. Many doubt that Macron's reforms will see the light of day, but our geopolitical team believes that investors are underestimating the chances. The German election in September poured cold water on recent enthusiasm regarding accelerated European integration. This is because Merkel will likely have to deal with a larger contingent of Euroskeptics in the grand coalition that emerges in the coming months. However, we do not expect political developments in Germany to be a headwind for the Eurozone stock market. On the negative side, European stocks do not appear cheap to the U.S. after adjusting for the structural discount (Chart I-15). Moreover, this year's euro bull phase will take a bite out of earnings. As noted in last month's Overview, euro strength so far this year will lop three to four percentage points off of EPS growth by the middle of next year. Our model suggests that this will be overwhelmed by the robust economic expansion at home and abroad, but profit growth could fall to 5%, which is likely to be well short of that in the U.S. and Japan (local currency). Still, a lot of the negative impact of the currency on profits may already be discounted as forward earnings have been revised down. On balance, we remain overweight European stocks versus the U.S. (currency hedged). However, it appears that Japan has more latitude to outperform. Dollar: Finally Finding A Floor? Chart I-17Has The Dollar Found Bottom? Has The Dollar Found Bottom? Has The Dollar Found Bottom? The Fed's determination to stick with the 'dot plot' may have finally placed a floor under the dollar. Before the September FOMC meeting, the market had all but priced out any rate hikes between now and the end of 2018. Both the U.S. economic surprise index and the inflation surprise index have turned up relative to the G10 (Chart I-17). The dollar has more upside if we are past the period of maximum bond market strength and moving into in a window in which U.S. economic and inflation surprises will 'catch up' with the other major economies. Technically, investors appear to be quite short the dollar, especially versus the euro. Bullish sentiment on the euro is highlighted by the fact that the currency has deviated substantially from the interest rate parity relationship. Euro positioning is thus bullish the dollar from a contrary perspective. Nonetheless, our currency experts are more bullish the dollar versus the yen. Given that inflation expectations have softened in Japan and wage growth is still lacking, the Bank of Japan will have to stick with its zero percent 10-year JGB target. The yen will be forced lower versus the dollar as the U.S. yield curve shifts up. We also like the loonie. The Bank of Canada (BoC) pulled the trigger in September for the second time this year, lifting the overnight rate to 1%. Policymakers gave themselves some "wiggle room" on the outlook, but more tightening is on the way barring a significant slowdown in growth, another spike in the C$, or a housing meltdown. The statement said that the loonie's rise partly reflected the relative strength of the Canadian economy, which implies that it is justified by the fundamentals. It does not appear that the C$ has reached a "choke point" in the eyes of the central bank. Investment Conclusions: We highlighted in our last issue that investors should remain slightly overweight risk assets, but should also hold safe haven assets given the preponderance of risks. Some of the risks have since faded and the sweet spot for risk assets is continuing. We remain upbeat on global economic growth and earnings. Nonetheless, both stocks and bonds remain vulnerable to any upside surprises on inflation, especially in the U.S. While the positive trends in stock indexes and corporate bond spreads should continue over the coming 6-12 months, there is a good chance that this year's downtrend in the dollar and government bond yields is over. The rise in both may be halting, but the risks are to the upside now that disappointments on U.S. growth and inflation have likely ended (notwithstanding the hurricane-distorted economic data in the near term). The Phillips curve is not dead, which means that it is only a matter of time before inflation begins to find a little traction. Higher oil prices will also provide a tailwind for headline inflation. Geopolitics will no doubt remain a threat for 'risk on' trades, but we may be past the worst in terms of North Korean tension. We also do not expect Fed balance sheet normalization to be a major headwind for risk assets. Nonetheless, the anticipated swing the supply of G4 government bonds to private investors would serve to add to selling pressure in the fixed-income space if inflation is rising in the U.S. and/or Europe at the same time. In other words, the risk relates more to expected policy rates than the Fed's balance sheet. Stay overweight stocks versus bonds, long oil related plays, slightly short in duration in the fixed income space, and long inflation protection. We also recommend returning to long positions on the U.S. dollar. Mark McClellan Senior Vice President The Bank Credit Analyst September 28, 2017 Next Report: October 26, 2017 1 Please see BCA Global Investment Strategy Weekly Report, "Is The Phillips Curve Dead Or Dormant?" dated September 22, 2017, available at gis.bcaresearch.com II. Liquidity And The Great Balance Sheet Unwind Liquidity is the lifeblood of the economy and financial markets, but it is a slippery concept that means different things to different people. Liquidity falls into four categories: monetary, balance sheet, financial market transaction liquidity, and funding liquidity. Overall liquidity conditions are reasonably constructive for risk assets at the moment. Financial market and balance sheet liquidity are adequate. Monetary policy is extremely easy, although the low level of money and credit growth underscores that the credit channel of monetary policy is still somewhat impaired. Funding liquidity is as important as monetary liquidity for financial markets. It has recovered from the Great Financial Crisis (GFC) lows, but it is far from frothy. Unwinding the Fed's balance sheet represents a risk to investors because QE played such an important role in reducing risk premia in financial markets. The unwind should not affect transactions liquidity or balance sheet liquidity. It should not affect the broad monetary aggregates either. The bond market's reaction will be far more important than balance sheet shrinkage. As long as the Fed can limit the bond market damage via forward guidance, then funding liquidity should remain adequate and risk assets should take the Fed's unwind in stride. It will be a whole different story, however, if inflation lurches higher. The technical impact of balance sheet unwind on the inner workings of the credit market is very complicated. Asset sales could lead to a shortage of short-term high-quality assets, unless it is offset with increased T-bill issuance. However, a smaller balance sheet could, in fact, improve funding liquidity to the extent that it frees up space on banks' balance sheets. Liquidity has been an integral part of BCA's approach to financial markets going back to the early days of the company under the tutelage of Editor-in-Chief Hamilton Bolton from 1949 to 1968. Bolton was ahead of his time in terms of developing monetary indicators to forecast market trends. Back then, the focus was on bank flows such as the volume of checks cashed because capital markets were still developing and most credit flowed through the banking system. Times changed, monetary policy implementation evolved and financial markets became more important and sophisticated. When money targeting became popular among central banks in the 1970s, central bank liquidity analysis focused more on the broader monetary aggregates. These and other monetary data were used extensively by Anthony Boeckh, BCA's Editor-in-Chief from the 1968 to 2002, to forecast the economy and markets. He also highlighted the importance of balance sheet liquidity (holdings of liquid assets), and its interplay with rising debt levels. Martin Barnes continued with these themes when writing about the Debt Supercycle in the monthly Bank Credit Analyst. "Liquidity" is a slippery concept, and it means different things to different people. In this Special Report, we describe BCA's approach to liquidity and highlight its critical importance for financial markets. We provide a list of indicators to watch, and also outline how the pending shrinkage of the Fed's balance sheet could affect overall liquidity conditions. A Primer On Liquidity We believe there are four types of liquidity that are all interrelated: Central Bank Liquidity: Bank reserves lie at the heart of central bank liquidity. Reserves are under the direct control of the central bank, which are used as a tool to influence general monetary conditions in the economy. The latter are endogenous to the system and also depend on the private sector's desire to borrow, spend and hold cash. Bullish liquidity conditions are typically associated with plentiful bank reserves, low interest rates and strong growth in the monetary aggregates. Balance Sheet Liquidity: A high level of balance sheet liquidity means that plenty of short-term assets are available to meet emergencies. The desire of households, companies and institutional investors to build up balance sheet liquidity would normally increase when times are bad, and decline when confidence is high. Thus, one would expect strong economic growth to be associated with declining balance sheet liquidity, and vice versa when the economy is weak. Of course, deteriorating balance sheet liquidity during good times is a negative sign to the extent that households or business are caught in an illiquid state when the economy turns down, jobs are lost and loans are called. Financial Market Transaction Liquidity: This refers to the ability to make transactions in securities without triggering major changes in prices. Financial institutions provide market liquidity to securities markets through their trading activities. Funding Liquidity: The ability to borrow to fund positions in financial markets. Financial institutions provide funding liquidity to borrowers through their lending activities. The conditions under which these intermediaries can fund their own balance sheets, in turn, depend on the willingness of banks and the shadow banking system to interact with them. The BIS definition of funding liquidity is a broad concept that captures a wide range of channels. It includes the capacity of intermediaries that participate in the securitization chain to access the necessary funding to originate loans, to acquire loans for packaging into securities, and finance various kinds of guarantees. The availability and turnover of collateral for loans is also very important for generating funding liquidity, as we discuss below. These types of liquidity are interrelated in various ways, and can positively or negatively reinforce each other. It is the interaction of these factors that determines the economy's overall ease of financing. See Box II-1 for more details. BOX II-1 How Liquidity Is Inter-Related Central bank liquidity, which is exogenously determined, is the basis for private liquidity creation (the combination of market transaction and funding liquidity). The central bank determines the short-term risk-free rate and the official liquidity that is provided to the banking system. If the central bank hikes rates or provides less official liquidity, appetite for private lending begins to dry up. Private sector liquidity is thus heavily influenced by monetary policy, but can develop a life of its own, overshooting to the upside and downside with swings in investor confidence and risk tolerance. Financial market liquidity and funding liquidity are closely interrelated. When times are good, markets are liquid and funding liquidity is ample. But when risk tolerance takes a hit, a vicious circle between market transaction and funding liquidity develops. The BIS highlights the procyclical nature of private liquidity, which means that it tends to exhibit boom-bust cycles that generate credit excesses that are followed by busts.1 The Great Financial Crisis of 2008 is a perfect example. The Fed lifted the fed funds rate by 400 basis points between 2004 and 2006. Nonetheless, the outsized contraction in private liquidity, resulting from the plunge in asset prices related to U.S. mortgage debt, was a key driver of the crash in risk asset prices. Liquidity Indicators: What To Watch (1) Monetary Liquidity Key measures of central bank liquidity include the monetary base and the broad money aggregates, such as M1 and M2 (Chart II-1). Central banks control the amount of reserves in the banking system, which is part of base money, but they do not control the broad monetary aggregates. The latter is determined by the desire to hold cash and bank deposits, as well as the demand and supply of credit. Box II-2 provides some background on the monetary transmission process and quantitative easing. BOX II-2 The Monetary Transmission Process And Qe Before the Great Recession and Financial Crisis, the monetary authorities set the level of short-term interest rates through active management of the level of bank reserves. Reserves were drained as policy tightened, and were boosted when policies eased. The level of bank reserves affected banks' lending behavior, and shifts in interest rates affected the spending and investment decisions of consumers and businesses. Of course, it has been a different story since the financial crisis. Once short-term interest rates reached the zero bound, the Fed and some other central banks adopted "quantitative easing" programs designed to depress longer-term interest rates by aggressively buying bonds and thereby stuffing the banking system with an excessive amount of reserves. Many feared the onset of inflation when QE programs were first announced because investors worried that this would contribute to a massive increase in credit and the overall money supply. Indeed, there could have been hyper-inflation if banks had gone on a lending spree. But this never happened. Banks were constrained by insufficient capital ratios, loan losses and intense regulation, while consumers and businesses had no appetite for acquiring more debt. The result was that the money multiplier - the ratio of broad money to the monetary base - collapsed (top panel in Chart II-1). Bank lending standards eventually eased and credit demand recovered. Broad money growth has been volatile since 2007 but, despite quantitative easing, it has been roughly in line with the decade before. The broad aggregates lost much of their predictive power after the 1980s. Financial innovation, such as the use of debit cards and bank machines, changed the relationship between broad money on one hand, and the economy or financial markets on the other. Despite the structural changes in the economy, investors should still keep the monetary aggregates and the other monetary indicators discussed below in their toolbox. While the year-to-year wiggles in M2, for example, have not been good predictors of growth or inflation on a one or two year horizon, Chart II-2 shows that there is a long-term relationship between money and inflation when using decade averages. Chart II-1The Monetary Aggregates The Monetary Aggregates The Monetary Aggregates Chart II-2Long-Run Relationship Between M2 And Inflation October 2017 October 2017 Other monetary indicators to watch: M2 Divided By Nominal GDP (Chart II-3): When money growth exceeds that of nominal GDP, it could be interpreted as a signal that there is more than enough liquidity to facilitate economic activity. The excess is then available to purchase financial assets. Monetary Conditions Index (Chart II-3): This combines the level of interest rates and the change in the exchange rate into one indicator. The MCI has increased over the past year, indicating a tightening of monetary conditions, but is still very low by historical standards. Dollar Based Liquidity (Chart II-3): This includes Fed holdings of Treasurys and U.S. government securities held in custody for foreign official accounts. Foreign Exchange Reserves (Chart II-3): Central banks hold reserves in the form of gold, or cash and bonds denominated in foreign currencies. For example, when the People's Bank of China accumulates foreign exchange as part of its management of the RMB, it buys government bonds in other countries, thereby adding to liquidity globally. Interest Rates Minus Nominal GDP Growth (Chart II-4): Nominal GDP growth can be thought of as a proxy for the return on capital. If interest rates are below the return on capital, then there is an incentive for firms to borrow and invest. The opposite is true if interest rates are above GDP growth. Currently, short-term rates are well below nominal GDP, signaling that central bank liquidity is plentiful. Chart II-3Monetary Indicators (I) Monetary Indicators (I) Monetary Indicators (I) Chart II-4Monetary Indicators (II) Monetary Indicators (II) Monetary Indicators (II) (2) Balance Sheet Liquidity Chart II-5 presents the ratio of short-term assets to total liabilities for the corporate and household sectors. It is a measure of readily-available cash or cash-like instruments that make it easier to weather economic downturns and/or credit tightening phases. The non-financial corporate sector is in very good shape from this perspective. The seizure of the commercial paper market during the GFC encouraged firms to hold more liquid assets on the balance sheet. However, the uptrend began in the early 1990s and likely reflects tax avoidance efforts. Households are also highly liquid when short-term assets are compared to income. Liquidity as a share of total discretionary financial portfolios is low, but this is not surprising given extraordinarily unattractive interest rates. The banking system is being forced to hold more liquid assets under the new Liquidity Coverage Ratio requirement (Chart II-6). This is positive from the perspective of reducing systemic risk, but it has negative implications for funding liquidity, as we will discuss below. Chart II-5Balance Sheet Liquidity Balance Sheet Liquidity Balance Sheet Liquidity Chart II-6Bank Balance Sheet Liquidity Bank Balance Sheet Liquidity Bank Balance Sheet Liquidity (3) Financial Market Transaction Liquidity: Transactions volumes and bid-ask spreads are the main indicators to watch to gauge financial market transaction liquidity. There was a concern shortly after the GFC that the pullback in risk-taking by important market-makers could severely undermine market liquidity, leading to lower transaction volumes and wider bid-ask spreads. The focus of concern was largely on the corporate bond market given the sharply reduced footprint of investment banks. The Fed's data on primary dealer positioning in corporates shows a massive decline from the pre-crisis peak in 2007 (Chart II-7). This represents a decline from over 10% of market cap to only 0.3%. The smaller presence of dealers could create a liquidity problem for corporate debt, especially if market-making dealers fail to adequately match sellers with buyers during market downturns. Yet, as highlighted by BCA's Global Fixed Income Strategy team, corporate bond markets have functioned well since the dark days of the Lehman crisis.2 Reduced dealer presence has not resulted in any unusual widening of typical relationships like the basis between Credit Default Swaps and corporate bond spreads. Other market participants, such as Exchange Traded Funds, have taken up the slack. Daily trading volume as a percent of market cap has returned to pre-Lehman levels in the U.S. high-yield market, although this is not quite the case for the investment-grade market (Chart II-8). Chart II-7Less Market Making Less Market Making Less Market Making Chart II-8Corporate Bond Trading Volume Corporate Bond Trading Volume Corporate Bond Trading Volume That said, it is somewhat worrying that average trade sizes in corporates are smaller now compared to pre-crisis levels - perhaps as much as 20% smaller according to estimates by the New York Fed. This is likely the result of the reduced risk-taking by the dealers and the growing share of direct electronic trading. Thus, it may feel like liquidity is impaired since it now takes longer to execute a large bond trade, even though transaction costs for individual trades have not been increasing. The bottom line is that financial market liquidity is not as good as in the pre-Lehman years. This is not a problem at the moment, but there could be some dislocations in the fixed-income space during the next period of severe market stress when funding liquidity dries up. (3) Funding Liquidity: There are few direct measures of funding liquidity. Instead, one can look for its "footprint" or confirming evidence, such as total private sector credit. If credit is growing strongly, it is a sign that funding liquidity is ample. Box II-3 explains why international credit flows are also important to watch for signs of froth in lending. BOX II-3 The Importance Of International Credit Flows The BIS highlights that swings in international borrowing amplify domestic credit trends. Cross border lending tends to display even larger boom-bust cycles than domestic credit, as can be seen in the major advanced economies in the lead up to the GFC, as well as some Asian countries just before the Asian crisis in the late 1990s (Chart II-9). When times are good, banks and the shadow banking system draw heavily on cross-border sources of funds, such that international credit expansion tends to grow faster during boom periods than the credit granted domestically by banks located in the country. Since G4 financial systems intermediate a major share of global credit, funding conditions within the G4 affect funding conditions globally, as BIS research shows.3 This research also demonstrates that financial cycles have become more highly correlated across economies due to increased financial integration. Booms in credit inflows from abroad are also associated with a low level of the VIX, which is another sign of ample funding liquidity conditions (Chart II-10). These periods of excessive funding almost always end with a financial crisis and a spike in the VIX. Chart II-9International Credit Is Highly Cyclical International Credit Is Highly Cyclical International Credit Is Highly Cyclical Chart II-10International Credit Booms Lead Spikes In The VIX International Credit Booms Lead Spikes In The VIX International Credit Booms Lead Spikes In The VIX Other measures of funding liquidity to watch include: Chart II-11Market Measures Of Funding Liquidity Market Measures Of Funding Liquidity Market Measures Of Funding Liquidity Libor-OIS Spread (Chart II-11): This is a measure of perceived credit risk of LIBOR-panel banks. The spread tends to widen during periods of banking sector stress. Spreads are currently low by historical standards. However, libor will be phased out by 2021, such that a replacement for this benchmark rate will have to be found by then. Bond-CDS Basis (Chart II-11): The basis is roughly the average difference between each bond's yield spread to Treasurys and the cost of insuring the bond in the CDS market. Arbitrage should keep these two spreads closely aligned, but increases in funding costs tied to balance sheet constraints during periods of market stress affect this arbitrage opportunity, allowing the two spreads to diverge. The U.S. high-yield or investment grade bond markets are a good bellweather, and at the moment they indicate relatively good funding liquidity. FX Basis Swap (Chart II-11): This is analogous to the bond-CDS basis. It reflects the cost of hedging currencies, which is critically important for international investors and lending institutions. The basis swap widens when there is financial stress, reflecting a pullback in funding liquidity related to currencies. The FX swap basis widened during the GFC and, unlike other spreads, has not returned to pre-Lehman levels (see below). Bank Leverage Ratios (Chart II-12): The ratio of loans to deposits is a measure of leverage in the banking system. Banks boost leverage during boom times and thereby provide more loans and funding liquidity to buy securities. In the U.S., this ratio has plunged since 2007 and shows no sign of turning up. Primary Dealers Securities Lending (Chart II-13): This is a direct measure of funding liquidity. Primary dealers make loans to other financial institutions with the purpose of buying securities, thereby providing both funding liquidity and market liquidity. Historically, shifts in dealer lending have been correlated with bid-ask spreads in the Treasury market. Securities lending is also correlated with the S&P 500, although it does not tend to lead the stock market. Dealer loans soared prior to 2007, before collapsing in 2008. Total loans have recovered, but have not reached pre-crisis highs, consistent with stricter regulations that forced the deleveraging of dealer balance sheets. Chart II-12U.S. Bank Leverage U.S. Bank Leverage U.S. Bank Leverage Chart II-13Securities Lending And Margin Debt bca.bca_mp_2017_10_01_s2_c13 bca.bca_mp_2017_10_01_s2_c13 NYSE Margin Debt (Chart II-13): Another direct measure of funding liquidity. The uptrend in recent years has been steep, although it is less impressive when expressed relative to market cap. Bank Lending Standards (Chart II-14): These surveys reflect bank lending standards for standard loans to the household or corporate sectors, but their appetite for lending for the purposes of securities purchases is no doubt highly correlated. Lending standards tightened in 2016 due to the collapse in oil prices, but they have started to ease again this year. Table II-1 provides a handy list of liquidity indicators split into our four categories. Taking all of these indicators into consideration, we would characterize liquidity conditions in the U.S. as fairly accommodative, although not nearly as abundant as the period just prior to the Lehman event. Monetary conditions are super easy, while balance sheet and financial market liquidity are reasonably constructive. In contrast, funding liquidity, while vastly improved since the GFC, is still a long way from the pre-Lehman go-go years according to several important indicators such as bank leverage. Moreover, the Fed is set to begin the process of unwinding the massive amount of monetary liquidity provided by its quantitative easing program. Chart II-14Bank Lending Standards Bank Lending Standards Bank Lending Standards Table II-1Liquidity Indicators To Watch October 2017 October 2017 Fed Balance Sheet Shrinkage: What Impact On Liquidity? Given that the era of quantitative easing has been a positive one for risk assets, it is unsurprising that investors are concerned about the looming unwind of the Fed's massive balance sheet. For example, Chart II-15 demonstrates the correlation between the change in G4 balances sheets and both the stock market and excess returns in the U.S. high-yield market. Chart II-16 presents our forecast for how quickly the Fed's balance sheet will contract. Following last week's FOMC meeting we learned that balance sheet reduction will begin October 1. For the first three months the Fed will allow a maximum of $6 billion in Treasurys and $4 billion in MBS to run off each month. Those caps will increase in steps of $6 billion and $4 billion, respectively, every three months until they level off at $30 billion per month for Treasurys and $20 billion per month for MBS. Chart II-15G4 Central Bank Balance Sheets G4 Central Bank Balance Sheets G4 Central Bank Balance Sheets Chart II-16Fed Balance Sheet Fed Balance Sheet Fed Balance Sheet We have received no official guidance on the level of bank reserves the Fed will target for the end of the run-off process. However, New York Fed President William Dudley recently recommended that this level should be higher than during the pre-QE period, and should probably fall in the $400 billion to $1 trillion range.4 In our forecasts we assume that bank reserves will level-off once they reach $650 billion. In that scenario the Fed's balance sheet will shrink by roughly $1.4 trillion by 2021. The level of excess reserves in the banking system will decline by a somewhat larger amount ($1.75 trillion). In terms of the impact of balance sheet shrinkage on overall liquidity conditions, it is useful to think about the four categories of liquidity described above. (1) Monetary Liquidity The re-absorption of excess reserves will mean that base money will contract (i.e. the sum of bank reserves held at the Fed and currency in circulation). However, we do not expect this to have a noticeable impact on the broader monetary aggregates, credit growth, the economy or inflation, outside of any effect it might have on the term premium in the bond market. The reasoning is that all those excess reserves did not have a major impact on growth and inflation when they were created in the first place. This was because the credit channel of monetary policy was blocked by a lack of demand (private sector deleveraging) and limited bank lending capacity (partly due to regulation). Banks were also less inclined to lend due to rising loan losses. Removing the excess reserves should have little effect on banks' willingness or ability to make new loans. In terms of asset prices, some investors believe that when the excess reserves were created, a portion of it found its way out of the banking system and was used to buy assets directly. That is not the case. The excess reserves were left idle, sitting on deposit at the Fed. They did not "leak" out and were not used to purchase assets. Thus, fewer excess bank reserves do not imply any forced selling. Nonetheless, the QE program certainly affected asset prices indirectly via the portfolio balance effect. Asset purchases supported both the economy and risk assets in part via a weaker dollar and to the extent that the policy lifted confidence in the system. But most importantly, QE depressed long-term interest rates, which are used to discount cash flows when valuing financial assets. QE boosted risk-seeking behavior and the search for yield, partly through the signaling mechanism that convinced investors that short-term rates would stay depressed for a long time. The result was a decline in measures of market implied volatility, such as the MOVE and VIX indexes. Could Bond Yields Spike? The risk is that the portfolio balance effect goes into reverse as the Fed unwinds the asset purchases. The negative impact on risk assets will depend importantly on the bond market's response. As highlighted in the Overview section, there will be a sharp swing in the flow of G4 government bonds available to the private sector, from a contraction of US$800 billion in 2017 to an increase of US$600 billion in 2018. Focusing on the U.S. market, empirical estimates suggest that the Fed's shedding of Treasurys could boost the 10-year yield by about 80 basis points because the private sector will require a higher term premium to absorb the higher flow of bonds. However, the impact on yields is likely to be tempered by two factors: Banks are required by regulators to hold more high-quality assets than they did in the pre-Lehman years in order to meet the new Liquidity Coverage Ratio. The BCA U.S. Bond Strategy service argues that growing bank demand for Treasurys in the coming years will absorb much of the net flow of Treasurys that the Fed is no longer buying.5 As the FOMC dials back monetary stimulus it will be concerned with overall monetary conditions, including short-term rates, long-term rates and the dollar. If long-term rates and/or the dollar rise too quickly, policymakers will moderate the pace of rate hikes and use forward guidance to talk down the long end of the curve so as to avoid allowing financial conditions to tighten too quickly. Thus, the path of short-term rates is dependent on the dollar and the reaction of the long end of the curve. It is difficult to estimate how it will shake out, but the point is that forward guidance will help to limit the impact of the shrinking Fed balance sheet on bond yields. Indeed, the Fed is trying hard to sever the link in investors' minds between balance sheet policy and signaling about future rate hikes, as highlighted by Chair Yellen's Q&A session following the September FOMC meeting. The bottom line is that the impact on monetary liquidity of a smaller Fed balance sheet should be minimal, although long-term bond yields will be marginally higher as a result. That said, much depends on inflation. If the core PCE inflation rate were to suddenly shift up to the 2% target or above, then bond prices will be hit hard, the VIX will surge and risk assets will sustain some damage. The prospect of a more aggressive pace of monetary tightening would undermine funding liquidity, compounding the negative impact on risk assets. (2) Funding Liquidity Chart II-17Tri-Party Repo Market Has Shrunk Tri-Party Repo Market Has Shrunk Tri-Party Repo Market Has Shrunk By unwinding its balance sheet, the Fed will be supplying securities into the market and removing cash. This will be occurring at a time when transactions in the tri-party repo market have fallen to less than half of their peak in 2007 due to stricter regulation (Chart II-17). This market has historically been an important source of short-term funding, helping to meet the secular rise in demand for short-term, low-risk instruments, largely from non-financial corporations, asset managers and foreign exchange reserve funds. If the Fed drains reserves from the system and T-bill issuance does not increase substantially to compensate, a supply shortage of short-maturity instruments could develop. We can see how this might undermine the Fed's ability to shift short-term interest rates higher under its new system of interest rate management, where reverse repos and the interest rate paid on reserves set the floor for other short-term interest rates. However, at the moment we do not see the risk that fewer excess reserves on its own will negatively affect funding liquidity. Again, any impact on funding liquidity would likely be felt via a sharp rise in interest rates and pullback in the portfolio balance effect, which would occur if inflation turns up. But this has more to do with rising interest rates than the size of the Fed's balance sheet. Indeed, balance sheet shrinkage could actually improve funding liquidity provided via the bilateral repo market, securities-lending, derivatives and prime brokerage channels. These are important players in the collateral supply chain. A recent IMF working paper emphasizes that collateral flows are just as important in credit creation as money itself.6 Collateral refers to financial instruments that are used as collateral to fund positions, which can be cash or cash-like equivalents. Since pledged collateral can be reused over and over, it can generate significantly more total lending than the value of the collateral itself. The Fed's overnight reverse-repo facility includes restrictions that the collateral accessed from its balance sheet can only be used in the tri-party repo system. Thus, the Fed's presence in the collateral market has reduced the "velocity of collateral." Table II-2 shows that the reuse rate of collateral, or its velocity, has fallen from 3.0 in 2007 to 1.8 in 2015. Table II-2Collateral Velocity October 2017 October 2017 The combination of tighter capital regulations and Fed asset purchases has severely limited the available space on bank balance sheets to provide funding liquidity. Regulations force banks to carry more capital for a given level of assets. Fed asset purchases have forced a large portion of those assets to be held as reserves, limiting banks' activity in the bilateral repo market. There is much uncertainty surrounding this issue, but it appears that an unwind the Fed's balance sheet will free up some space on bank balance sheets, possibly permitting more bilateral repo activity and thus a higher rate of collateral velocity. It may also relieve concerns about a shortage of safe-haven assets. Nonetheless, we probably will not see a return of collateral velocity to 2007 levels because stricter capital regulations will still be in place. What About Currency Swaps? Some have argued that this removal of cash could also lead to an appreciation of the U.S. dollar. In particular, Zoltan Pozsar of Credit Suisse has observed a correlation between U.S. bank reserves and FX basis swap spreads.7 There is also a strong correlation between FX swap spreads and the U.S. dollar (Chart II-18). Chart II-18FX Basis Swap And Reserves FX Basis Swap And Reserves FX Basis Swap And Reserves One possible chain of events is that, as the Fed drains cash from the market, there will be less liquidity in the FX swap market. Basis swap spreads will widen as a result, and this will cause the dollar to appreciate. In this framework, the unwinding of the Fed's balance sheet will put upward pressure on the U.S. dollar. However, it is also possible that the chain of causation runs in the other direction. The BIS has proposed a model8 where a stronger dollar weakens the capital positions of bank balance sheets. This causes them to back away from providing liquidity to the FX swap market, leading to wider basis swap spreads. In this model, a strong dollar leads to wider basis swap spreads and not the reverse. If this is the correct direction of causation, then we should not expect any impact on the dollar from the unwinding of the Fed's balance sheet. At the moment it is impossible to tell which of the above two theories is correct. All we can do is monitor the correlation between reserves, FX basis swap spreads and the dollar going forward. Conclusions: Overall liquidity conditions are reasonably constructive for risk assets at the moment. Financial market and balance sheet liquidity are adequate. Monetary policy is extremely easy, although the low level of money and credit growth underscores that the credit channel of monetary policy is still somewhat impaired and/or constrained relative to the pre-Lehman years. Funding liquidity has recovered from the Great Financial Crisis lows, but it is far from frothy. More intense regulation means that funding liquidity will probably never again be as favorable for risk assets as it was before the crisis. But, hopefully, efforts by the authorities to reduce perceived systemic risk mean that funding liquidity may not be as quick to dry up as was the case in 2008, in the event of another negative shock. Unwinding the Fed's balance sheet represents a risk to investors because QE played such an important role in reducing risk premia in financial markets. However, we believe that the bond market's reaction will be far more important than balance sheet shrinkage. As long as the Fed can limit the bond market damage via forward guidance, then risk assets should take the Fed's unwind in stride. It will be a whole different story, however, if inflation lurches higher. The technical impact of balance sheet unwind on the inner workings of the credit market is very complicated and difficult to forecast. Asset sales could lead to a shortage of short-term high-quality assets. However, this is more a problem in terms of the Fed's ability to raise interest rates than for funding liquidity. A smaller balance sheet could, in fact, improve funding liquidity to the extent that it frees up space on banks' balance sheets. Mark McClellan Senior Vice President The Bank Credit Analyst Ryan Swift Vice President U.S. Bond Strategy 1 D. Domanski, I. Fender and P. McGuire, "Assessing Global Liquidity," BIS Quarterly Review (December 2011). 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Global Interest Rate Strategy For The Remainder Of 2017," dated July 18, 2017, available at gfis.bcaresearch.com 3 E. Cerutti, S. Claessens and L. Ratnovski, "A Primer on 'Global Liquidity'," CEPR Policy Portal (June 8, 2014). 4 William C. Dudley, "The U.S. Economic Outlook and the Implications for Monetary Policy," Federal Reserve Bank of New York (September 07, 2017). 5 Please see BCA U.S. Bond Strategy Weekly Report, "The Great Unwind," dated September 19, 2017, available at usbs.bcaresearch.com 6 M. Singh, "Collateral Reuse and Balance Sheet Space," IMF Working Paper (May 2017). 7 Alexandra Scaggs, "Where would you prefer your balance sheet: Banks, or the Federal Reserve?" Financial Times Alphaville (April 13, 2017). 8 S. Avdjiev, W. Du, C. Koch, and Hyun S.Shin, "The dollar, bank leverage and the deviation from covered interest parity," BIS Working Papers No.592 (Revised July 2017). III. Indicators And Reference Charts Equity indexes in the U.S. and Japan broke out to new highs in September. European stocks surged as well. Investors embraced risk assets in the month on a solid earnings backdrop, strong economic indicators, continuing low inflation and revived hopes for fiscal stimulus in the U.S. and Japan, among other factors. Our indicators do not warn of any near-term stumbling blocks for the bull market. Our monetary indicator continues to hover only slightly on the restrictive side. Our equity composite technical indicator may be rolling over, but it must fall below zero to send a 'sell' signal. The speculation index is elevated, but bullish equity sentiment is only a little above the long-term mean. Meanwhile, the S&P 500 tends to increase whenever the 12-month forward EPS estimate is rising. The latter is in a solid uptrend that should continue based on the net revisions ratio and the earnings surprise index. Valuation remains poor, but has not yet reached our threshold of overvaluation. Our new Revealed Preference Indicator (RPI) continued on its bullish equity signal in August for the second consecutive month. We introduced the RPI in the July report. 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 provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The U.S. and Japanese WTPs are trending sideways, and Europe could be rolling over. While this is a little worrying because they indicate that flows into equity markets have moderated recently, the indicators have to clearly turn down to provide a bearish signal for stocks. Flows into the U.S. appear to be more advanced relative to Japan and the Eurozone, suggesting that there is more "dry powder" available to buy the latter two markets than for the U.S. market. Oversold conditions for the U.S. dollar are being worked off, but our technical indicator is still positive for the currency. The greenback looks expensive based on PPP, but is less so on other measures. We are positive in the near term. Our composite technical indicator for U.S. Treasurys is at neutral. Bond valuation is also at neutral based on our long-standing model. However, other models that specifically incorporate global economic factors suggest that the 10-year Treasury is still more than 30 basis points on the expensive side. Stay below benchmark in duration. 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 Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: ##br##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 Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights Industrial metals prices are signaling that China's business conditions are presently robust, but they lag the credit and money measures. The most reliable leading (forward looking) indicators of Chinese business cycle have been money and credit. Presently, all money and credit indicators forecast an imminent slowdown in the industrial sectors and a relapse in base metals prices. A new trade: short copper / long Chilean peso. Inflation in Hungary will surge. Continue betting on yield curve steepening in Hungary and stay short HUF versus PLN. Feature Copper and industrial metals prices continue to signal strong growth in China, while the majority of the country's money and credit measures forecast an imminent growth slump. Which one is correct, and which one should investors heed to when formulating their investment strategy? Chart I-1 demonstrates that our broad money measure (M3) and private and public credit impulses for China both lead copper and industrial metals prices by about nine months. Based on the historical track record, odds are that investors will be better off following these money and credit indicators rather than heeding the bullish message from copper and other industrial commodities. While copper prices are coincident with the business cycle, money and credit impulses lead not only the real economy but also industrial metals prices. Copper Copper prices have surged of late (Chart I-2), seriously challenging our negative view on Chinese capital spending, commodities and EM. In fact, the rally in industrial metals has not been confined to copper but has been broad-based, and is, at first blush, suggestive of continued strength in global and Chinese industrial cycle. Chart I-1China's Money/Credit Leads Industrial Metals Prices bca.ems_wr_2017_09_06_s1_c1 bca.ems_wr_2017_09_06_s1_c1 Chart I-2Traders Are Very Bullish On Copper: A Contrarian Signal? Traders Are Very Bullish On Copper: A Contrarian Signal? Traders Are Very Bullish On Copper: A Contrarian Signal? Consistently, China's manufacturing PMI has picked up over the past three months, as has the overall EM PMI ex-China (Chart I-3). China's aggregate imports of copper products, unwrought copper, copper ore and concentrate as well as copper scrap have been contracting since May, and interestingly, they have historically often been negatively correlated with copper prices (Chart I-4). Hence, little insight can be drawn from Chinese imports of copper, as these purchases do not correlate with the mainland's business cycle. Chart I-3China/EM PMIs Have Risen China/EM PMIs Have Risen China/EM PMIs Have Risen Chart I-4Chinese Copper Imports And ##br##Copper Prices: Negative Correlation? bca.ems_wr_2017_09_06_s1_c4 bca.ems_wr_2017_09_06_s1_c4 On the contrary, Chinese imports of copper typically rise when copper prices fall and its industrial sector is decelerating. The reason: Chinese importers time their commodities purchases when prices slump, and do not chase prices higher. In short, when attempting to predict the sustainability of Chinese economic activity, there is little to be gained in examining Chinese copper imports. Bottom Line: Industrial metals prices are signaling that China's business conditions are presently robust, but they lag the credit and money measures discussed below. Leading Indicators: Money And Credit In our experience, the best leading indicators of the Chinese business cycle have been money and credit growth, more specifically, their impulses. The latter is the change in money/credit growth, or the second derivative of outstanding money/credit. In fact, money/credit impulses lead both the leading economic indicator and the well-known Li Keqiang index (Chart I-5). The latter two are often used by analysts and investors to gauge the direction of the Chinese economy. In recent months, we have done extensive work to properly measure money and credit. This has led us to the realization that China's official M2 and total social financing have not reflected the true dynamics in money creation and leverage formation over the past two years. In particular, M2 has over the years become a less all-encompassing money measure, as the size of commercial banks' liabilities that are not counted as part of M2 has exploded in recent years. So, the gap between M2 and other measures of money and credit has in the recent years widened as depicted on the top panel of Chart I-6. Chart I-5China: Money/Credit Leads ##br##Leading Economic Indicators bca.ems_wr_2017_09_06_s1_c5 bca.ems_wr_2017_09_06_s1_c5 Chart I-6China: Money/Credit Growth Have Fallen To New Lows bca.ems_wr_2017_09_06_s1_c6 bca.ems_wr_2017_09_06_s1_c6 The bottom panel of Chart I-6 demonstrates official M2, our version of broad money M3 (calculated using commercial banks' liabilities), credit-money (computed based on banks' balance sheet assets) and aggregate of private and public credit. All these measures have slowed to new lows. The most reasonable and all-inclusive measures from the four, in our view, is our measure of broad money M3 and private and public credit. As such, this is what we use to gauge the Chinese business cycle outlook. Chart I-7A and Chart I-7B demonstrate that the impulses of both M3 and private and public credit lead various business cycle and financial variables such as nominal GDP, manufacturing PMI, total imports, imports of capital goods, the freight index and producer prices as well as industrial profits. Chart I-7AChina: Money And Credit Impulses ##br##Entail Business Cycle Slowdown (II) bca.ems_wr_2017_09_06_s1_c7a bca.ems_wr_2017_09_06_s1_c7a Chart I-7BChina: Money And Credit Impulses ##br##Entail Business Cycle Slowdown (I) China: Money And Credit Impulses Entail Business Cycle Slowdown (II) China: Money And Credit Impulses Entail Business Cycle Slowdown (II) Regardless of which money and credit measure we use, and regardless of their past track record, all of them currently suggest that China's business cycle is about to experience a considerable slump. Besides, money and credit impulses typically lead copper and industrial metals prices by about nine months, as shown in Chart I-1. These are the primary fundamental reasons why we are reluctant to alter our negative view on China's industrial cycle. Bottom Line: The most reliable leading indicators of the mainland business cycle have been money and credit. All money and credit indicators presently forecast an imminent slowdown in the industrial sectors. Financial markets are typically forward looking, and they change their direction before business cycles actually turn. Hence, from an investment strategy perspective, it makes sense to heed messages from leading indicators. Other Big Picture Considerations We have for several years argued that the rampant build-up in China's debt and credit excesses is unsustainable, and when credit growth normalizes/slows the economy will undergo a marked deceleration. Chart I-8Rising Interest Rates Herald A Further ##br##Slowdown In Money/Credit Growth Rising Interest Rates Herald A Further Slowdown in Money/Credit Growth Rising Interest Rates Herald A Further Slowdown in Money/Credit Growth Have these excesses been partially unwound, and has credit growth normalized? Not at all - the credit excesses have gotten larger. In fact, corporate and household debt and shadow banking credit have expanded enormously in the past two years. Even after the recent deceleration, broad money and credit continue growing at around 10% from a year ago (Chart I-6, bottom panel on page 5). Importantly, borrowing costs in China have recently resumed their upward move (Chart I-8, top panel) and rising interest rates will further dampen already slowed money and credit growth (Chart I-8, bottom panel) and thereby economic activity. In brief, from a big-picture standpoint, China's leverage situation has worsened, and interest rates are rising. While growth momentum is currently strong, financial markets leveraged to China's growth have already rallied a lot, and investor sentiment is quite bullish, as illustrated in Chart I-2 on page 2 in the case of copper. This makes the investment risk-reward profile of EM risk assets and commodities poor. Finally, some readers might wonder why we have been spending so much time focusing on China versus other developing economies. The basis is that China is now a major pillar of the global economy, and its cyclical economic trend materially influences those of many EM and DM countries. In short, every other developing country is too small to affect EM financial markets. But China does affect financial market dynamics in many other parts of the EM world. So, to gauge overall trends in EM financial markets, China and other global variables matter, yet individual developing countries do not. For the majority of emerging economies in Asia, Latin America and Africa, China is the dominant external force, similar to how the U.S. is for many of its trading partners. Similarly, Chinese interest rates are as important as borrowing costs in the U.S. Therefore, developments in Chinese interest rates, money/credit and economic activity are of paramount significance to many emerging markets. In particular, China's money as well as private and public credit impulses lead both EM and DM export shipments to China by about nine months (Chart I-9A and Chart I-9B). These developing nations' exports to China make up a meaningful part of their respective economies. In addition, industrial metals prices are by and large driven by China's capital spending, and hence affect commodities-producing countries. Chart I-9AExports To China Correlate ##br##With China's Money/Credit Exports To China Correlate With China's Money/Credit Exports To China Correlate With China's Money/Credit Chart I-9BExports To China Correlate ##br##With China's Money/Credit Exports To China Correlate With China's Money/Credit Exports To China Correlate With China's Money/Credit Bottom Line: In 2015 and 2016, China resorted to its standard playbook: money and credit origination, boosting capital spending and overall growth. In particular, China's broad money M3 and private and public credit both have surged by RMB 46 trillion in the past two years alone. Consequently, the excesses have become larger. That said, President Xi Jinping's ongoing campaign to control financial risks - and consequential tightening of monetary/liquidity conditions - entails considerable growth deceleration ahead. Risks Of Relying On Money And Credit There are a number of risks involved in relying on measures of money and credit. We discussed the velocity of money, the money multiplier and productivity in our last report1, and will only touch on these briefly this week: An economy can accelerate with sluggish or slowing money growth if the velocity of money rises materially. However, there is no basis to expect the velocity of money to rise in China now, given it has been declining for the past 10 years. Money and credit growth can recover quickly, despite rising interest rates, if the money multiplier spikes. However, the money multiplier is already extremely elevated in China, and the odds are low that it will surge further. This is especially true amid rising interest rates and the ongoing regulatory crackdown on off-balance sheet assets of banks and shadow banking. Real economic output can improve if productivity growth notably accelerates. Money growth and velocity of money will define nominal output, yet productivity will boost real output. However, it is unrealistic to expect productivity to improve meaningfully in China when structural reforms have not been widely implemented. Chart I-10China's Exports To The U.S. And EU Are ##br##Small Compared With Credit Origination China's Exports To The U.S. And EU Are Small Compared With Credit Origination China's Exports To The U.S. And EU Are Small Compared With Credit Origination Finally, some argue that robust exports to the U.S. and Europe can boost mainland growth, even if domestic demand slips. We disagree. China's combined annual exports to the U.S. and EU currently make up only US$ 0.77 trillion (6.6% of GDP). On the other hand, the amount of new private and public debt origination has amounted to US$ 3 trillion (25% of GDP) in the past 12 months (Chart I-10). Bottom Line: Given money and credit growth have already slumped, our negative outlook for China's capital spending and imports will be wrong if the 1) velocity of money rises considerably, 2) the money multiplier shoots up, or 3) productivity growth accelerates materially. If any one of these were to occur, relying on money growth to forecast economic growth will prove futile. That said, assumptions about a substantial increase in either the velocity of money, the money multiplier or productivity from current levels would be highly conjectural, speculative and unreasonable. Some Market Observations: The U.S. Dollar And Oil The Greenback Chart 11 demonstrates that the U.S. dollar sits on its three-year moving average. A three-year moving average sometimes marks the borderline between structural bull and bear markets, as demonstrated in the case of the S&P 500 in the bottom panel of Chart I-11. Hence, the U.S. dollar is flirting with a structural bear market. Indeed, if the greenback slides further, it would signify a breakdown into a structural bear market. That said, if the broad trade-weighted U.S. dollar finds a bottom here, a meaningful rebound will ensue. Interestingly, the U.S. dollar has plunged even though U.S. real rates have not declined much (Chart I-12). The overwhelming portion of the drop in U.S. bond yields since early this year has been due to inflation expectations. Chart I-11Will The Greenback Find ##br##Support At Current Levels? Will The Greenback Find Support At Current Levels? Will The Greenback Find Support At Current Levels? Chart I-12U.S. TIPS Yields Have Not Dropped A Lot U.S. TIPS Yields Have Not Dropped A Lot U.S. TIPS Yields Have Not Dropped A Lot Typically, stable real rates amid falling inflation expectations are neutral-to-positive for an exchange rate. This has not been the case with the dollar this year. Pessimism within the fixed income and currency markets on U.S. growth is overdone. U.S. domestic demand is strong, the labor market is tight and global disinflationary forces that have suppressed U.S. inflation are alive and rampant in other parts of the world as well. Hence, there is no basis why the U.S. dollar should be punished more than other currencies because of secular global disinflation. Odds are that the euro has seen its lows in this cycle, and any selloff will not take it anywhere close its 2015-16 lows. Nevertheless, the outlook for EM currencies is meaningfully negative. The basis is that we believe EM business cycle amelioration is not sustainable - a growth slump in China, as discussed above, lower commodities prices and the hangover from the preceding credit booms in a number of countries will cap EM growth and weigh on their currency values. Bottom Line: Our take is that the dollar has been hammered too fast too far. Unless the U.S. dollar is in a structural bear market, odds are it will likely find floor here. Oil The current bear market in oil prices is tracking the 1980s bear market in crude reasonably well (Chart I-13). Based on this profile, oil prices will relapse further. We are reiterating our trade recommendation from March 8, 2017: short the spot oil price / long the Russian ruble. While both are correlated, the ruble offers 7.8% carry and will have less downside than crude. Hence, by being long the ruble, traders are being paid to short oil (Chart I-14). Stay with this position. Chart I-13Oil Is Tracking Its 1980s Bear Market Oil Is Tracking Its 1980s Bear Market Oil Is Tracking Its 1980s Bear Market Chart I-14Maintain Short Oil / Long Ruble Position Maintain Short Oil / Long Ruble Position Maintain Short Oil / Long Ruble Position A New Trade: Short Copper / Long CLP This week we recommend replicating the above oil trading strategy in the copper market. We believe shorting copper and going long a copper-related currency such as the Chilean peso offers an attractive risk-reward profile. The rationale to short copper is the potential relapse in China's growth (Chart I-1 on page 1) and elevated bullish sentiment on copper as shown in Chart I-2 on page 2. To hedge the timing risk and earn some carry, it makes sense to complement the short copper position with a long leg in a currency exposed to industrial metals/copper prices that is not vulnerable due to domestic reasons, i.e., beside copper price effect. Such a currency is the Chilean peso, in our view. The country's macro fundamentals are fine: domestic demand seems to be bottoming out and inflation is under control (Chart I-15). The primary risk to this exchange rate is copper prices. Chart I-16 depicts the total return of the combined return of a short copper and long CLP position accounting for the carry. The CLP has lagged the recent surge in copper prices and this trade offers a good entry point. Chart I-15Signs Of Bottom In The Chilean Economy Signs Of Bottom In The Chilean Economy Signs Of Bottom In The Chilean Economy Chart I-16A New Trade: Long Chilean Peso / Short Copper A New Trade: Long Chilean Peso / Short Copper A New Trade: Long Chilean Peso / Short Copper Bottom Line: Short copper and go long the Chilean peso. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Hungary: Inflation Is Set To Surge The dovish tone following the National Bank of Hungary's (NBH) most recent monetary policy meeting has reinforced the notion that more unconventional policy tools are likely to be forthcoming. In our view, the NBH is displeased about the recent currency strength and is presently laying the groundwork for pegging/depreciating the currency. This reinforces our view that inflation is set to surge. We have been recommending a short HUF / long PLN trade since September 28, 2016 on the basis that the NBH will remain dovish far longer than the National Bank of Poland (NBP) in the face of rising genuine inflationary pressures in both economies2 (Chart II-1). Also, the NBH has much less appetite for tolerating currency appreciation than the NBP. In turn, the NBP will hike interest rates and allow the zloty to appreciate. The latest rhetoric from the NBH reinforces our conviction, and today we are reiterating our short HUF / long PLN trade. Furthermore, relative to the forint, the zloty is still cheap based on relative real effective exchange rates, calculated using unit labor costs (Chart II-2). Chart II-1Relative Swap Rates Justify Higher PLN/HUF Relative Swap Rates Justify Higher PLN/HUF Relative Swap Rates Justify Higher PLN/HUF Chart II-2Zloty Is Cheap Versus Forint Zloty Is Cheap Versus Forint Zloty Is Cheap Versus Forint When a central bank favors extremely low interest rates and a cheap currency amid an economy that is operating above full employment and a labor market that is extremely tight, inflation is set to surge. This is exactly what is happening in Hungary. The NBH has been downplaying the tight labor market, noting that so far there has been little impact on inflation. We see a major problem with this argument. Inflation is a lagging indicator; to gauge where inflation will be headed in the coming six to 12 months, one has to monitor forward-looking indicators such as labor market dynamics and money/credit conditions. Presently, the majority of these indicators point toward much higher inflation in the coming months: The labor market is definitely tight - labor shortages are widespread, the unemployment rate is making historical lows and the participation rate is high (Chart II-3). Both wages and unit labor cost growth are surging (Chart II-4). Chart II-3Labor Market Is Super Tight In Hungary Labor Market Is Super Tight In Hungary Labor Market Is Super Tight In Hungary Chart II-4Hungary: Labor Costs Are Surging Hungary: Labor Costs Are Surging Hungary: Labor Costs Are Surging While private credit growth is meager, money supply is booming at a double-digit rate (Chart II-5). Such a gap between money and credit is probably due to loan write-offs. In brief, new loan origination is much stronger than implied by private credit growth, which is being affected by loan write-offs. Besides, government spending growth is currently above 20%, and banks have been funding the government by increasing their holdings of government bonds. This has also boosted money supply and is ultimately inflationary. All in all, odds are that the NBH will allow inflation to run away. As a result, long-dated local bond yields will spike, while short-term yields will be anchored by the NBH's dovish policy. We have been recommending betting on the yield curve steepening in Hungary: receive 1-year / pay 10-year swap rates. This trade remains intact (Chart II-6). Chart II-5Money Growth Is Booming Money GRowth Is Booming Money GRowth Is Booming Chart II-6The Yield Curve Will Steepen Further The Yield Curve Will Steepen Further The Yield Curve Will Steepen Further Bottom Line: Stay short the HUF versus the PLN. Maintain a bet on yield curve steepening in Hungary: receive 1-year / pay 10-year swap rates. For other fixed-income and currency as well as equity positions in central Europe and elsewhere in the EM universe, please refer to pages 19-20. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report, titled "Making Sense Of The EM Business Cycle", dated August 30, 2017, link available on page 21. 2 Please refer to the Emerging Markets Strategy Weekly Report, titled "Central European Strategy: Two Currency Trades," dated September 28, 2016 and Emerging Markets Strategy Special Report, titled "Central Europe: Beware Of An Inflation Outbreak," dated June 21, 2017, links available on page 21. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Despite a tightening in Chinese monetary conditions, dollar bloc currencies have continued to rally. Rising global reserves and strong carry inflows into EM prompted by low global financial volatility have created plentiful liquidity conditions in EM, supporting dollar-bloc currencies. The beginning of the Fed's balance-sheet runoff could reverse these dynamics, hurting the AUD, CAD and NZD in the process. Monitor U.S. inflation, cross-currency basis swap spreads, gold, EM currencies and Chinese monetary conditions to judge when a break in dollar-bloc currencies will materialize. Feature The rally in the dollar-bloc currencies since July 2016 has been nothing short of stunning. We did highlight in April last year that commodity currencies had room to appreciate, but we did not anticipate such a prolonged move.1 In fact, the up leg that began in April 2017 caught us by surprise. At this juncture, it is essential to analyze whether or not the bull move in commodity currencies has further to run, or whether it is in its final innings. A principal component analysis of the returns of the AUD, the CAD, and the NZD shows that despite differing central bank postures in the three countries, a simple common factor explains 86% of their variability against the USD since 2010 (Chart I-1). Because of this result, our focus in this week's report are the global forces that may be driving this factor. Today, the key risk to the dollar-bloc currencies is global liquidity tightening. Behind this danger lies the removal of policy accommodation in the U.S., and the risks to carry trades created by the already-very-low volatility of risk assets. A China-Fueled Rebound, But Something Is Amiss... The key reason behind the rally in commodity currencies has been improvement in EM growth relative to DM economies since 2016 (Chart I-2). This growth outperformance has been underpinned by a few factors. Chart I-1One Factor To Drive Them All One Factor To Drive Them All One Factor To Drive Them All Chart I-2Commodity Currencies And EM Growth Commodity Currencies And EM Growth Commodity Currencies And EM Growth China has played an essential role. As the Chinese economy decelerated in 2015, Beijing implemented a large amount of fiscal stimulus, which saw government spending grow at a 25% annual rate in November 2015. Due to the lags of stimulus on the economy, the full force of that stimulus was felt in 2016. Direct fiscal goosing was not the only road taken by Beijing. The Chinese authorities also applied a considerable amount of monetary pressure on China. After tightening massively through 2015, Chinese monetary conditions eased greatly in 2016 as real borrowing costs collapsed from a peak of 10.5% in the fall of 2015 to a trough of -3.5% earlier this year (Chart I-3). Directed expansion of credit through banking channels was also used to support the economy, resulting in a surge in the Chinese credit impulse. However, in recent months these positives have dissipated. Chinese money growth has slowed, and the combined credit and fiscal impulse has been lessened. Yet EM equity prices, copper prices and commodity currencies are all continuing their rally, and are now re-testing their May 2015 levels - levels last experienced right before EM assets and related plays entered a vicious tailspin that lasted all the way until January 2016 (Chart I-4). Chart I-3China: From Tailwind ##br##To Headwind China: From Tailwind To Headwind China: From Tailwind To Headwind Chart I-4EM, Copper, Dollar Bloc: ##br##Back To May 2015 Levels EM, Copper, Dollar Bloc: Back To May 2015 Levels EM, Copper, Dollar Bloc: Back To May 2015 Levels Bottom Line: The rally in dollar-bloc currencies that begun in January 2016 was powered by improving growth performance within EM economies. The original driver behind this move was Chinese monetary and fiscal stimulus. However, even once the easing faded, EM plays, including the AUD, the CAD and the NZD continued to appreciate. Another factor is currently at play. ...And This Something Is Global Liquidity Our view is that global liquidity is now the key factor supporting EM plays in general and dollar-bloc currencies in particular. Since the end of 2016, we have seen a rebound in the Federal Reserve's custody holdings - one that has happened as foreign central banks resumed their purchases of Treasury securities (Chart I-5). Fed custodial holdings for other monetary authorities are a key component of our dollar-based liquidity indicator. A rebound in this indicator tends to be associated with a surge in high-powered money globally. The capital outflows from China have dissipated, helping high-powered money find its way into EM plays and the commodity-currency complex. Private FX settlements - a proxy for the Chinese private sector's selling of yuan - was CNY -43 billion in July, a massive improvement compared to the CNY 800 billion in outflows experienced in August 2015 (Chart I-6). Through stringent administrative controls and a lessening of deflation, China gained the upper hand over its capital account. This development has two implications: it means that China does not need to sell reserves anymore, and in fact has been accumulating Treasurys since February 2017. It also means that investors are now less afraid of a sudden devaluation in the CNY, which has heartened risk-taking globally - especially in assets most exposed to China, which includes EM, commodities and dollar-bloc currencies. Chart I-5Easing Global Liquidty In 2017 Easing Global Liquidty In 2017 Easing Global Liquidty In 2017 Chart I-6Chinese Capital Account Under Control Chinese Capital Account Under Control Chinese Capital Account Under Control The collapse in the volatility of risk assets has been an additional element helping global liquidity make its way into EM plays and commodity currencies. As Chart I-7 illustrates, there is a relationship between the realized volatility of the U.S. stock market and the performance of dollar-bloc currencies. The first hunch is to dismiss the relationship as an artifact of the fact that both stock prices and commodity currencies are "risk-on" instruments. But there is an economic underpinning behind this relationship. As we argued in a Special Report on carry trades last year, the main reason carry trades have been able generate high Sharpe ratios since the 1980s is because they offer investors a risk premium for taking on exposure to unforeseen spikes in volatility.2 As a result, when the volatility of risk assets collapses, as has been the case recently, carry currencies outperform. The opposite holds true when volatility spikes back up. Chart I-7Dollar Bloc Currencies Like Low Vol Dollar Bloc Currencies Like Low Vol Dollar Bloc Currencies Like Low Vol When carry trades do well, investors end up aggressively buying EM currencies. As a result of these purchases, they inject funds - i.e. liquidity - into these economies. These injections of liquidity end up boosting money growth and supporting their economic activity, which stimulates global trade, commodity prices, and thus commodity currencies - even if these are not currently "high-yielders." Bottom Line: Chinese monetary conditions have deteriorated, creating a handicap for EM assets and the dollar-bloc currencies. Nonetheless, an increase in high-powered money growth, a decline in the risk premium to compensate investors for the risk of sudden new Chinese devaluation, and a collapse in global financial volatility have reinforced each other to create the ideal breeding ground for a rally in the AUD, the CAD and the NZD. The Sweet Spot Is Passing At the current juncture, the sweet spot for the dollar-bloc currencies may be passing. To begin with, commodity currencies are trading at a significant premium to underlying commodity prices, suggesting they are expensive and vulnerable to a decrease in global liquidity (Chart I-8). The AUD and the NZD stand out as especially expensive, while the CAD is only trading at a small premium to its long-term fair value (Chart I-9). This suggests that the Canadian dollar is likely to continue to outperform the Australian and New Zealand currencies, as it has been doing in choppy fashion since November 2016. Chart I-8Dollar Bloc Currencies Are Expensive Dollar Bloc Currencies Are Expensive Dollar Bloc Currencies Are Expensive Chart I-9AUD And NZD Are Expensive AUD And NZD Are Expensive AUD And NZD Are Expensive Another problem for dollar-bloc currencies is that they have greatly overshot global liquidity metrics. Historically, the commodity currencies have moved in lockstep with the evolution of global central bank reserves - a key measure of global liquidity (Chart I-10). While global reserves have improved, the average of the AUD, the CAD and the NZD has over-discounted this positive, pointing to potential vulnerability once liquidity ebbs. The problem with this overshoot is that liquidity is likely to decline with the imminent reduction in the Fed's balance sheet size. As Chart I-11 shows, the USD has been closely linked to changes in the reserves of commercial banks held at the Fed. As commercial banks accumulate excess reserves, this provides fuel for the repo market and the Eurodollar market, creating a supply of globally available USD for offshore markets. However, mechanically, once the Fed lets the assets on its balance sheet run off (its holdings of Treasurys), a liability will also have to decrease. This liability is most likely to be excess reserves as banks buy the Treasurys sold by the Fed. A fall in the accumulation of reserves of commercial banks in the U.S. is also directly linked with weaker dollar-bloc currencies (Chart I-12). This is because falling reserves push up the dollar and hurt commodity prices - a negative terms-of-trade shock for the AUD, the CAD and the NZD. Moreover, less reserves point to less liquidity making its way into EM economies. This also hurts the expected returns of holding assets in dollar-bloc economies. This therefore means that not only is there less liquidity available to move into these markets, the rationale to do so also dissipates. Without this dollar-based liquidity support, the tightening in Chinese monetary conditions could finally show its true impact on commodity currencies. Chart I-10Commodity Currencies Have##br## Overshot Global Liquidity Commodity Currencies Have Overshot Global Liquidity Commodity Currencies Have Overshot Global Liquidity Chart I-11Falling Excess Bank Reserves##br## Equals Strong Greenback Falling Excess Bank Reserves Equals Strong Greenback Falling Excess Bank Reserves Equals Strong Greenback Chart I-12Falling Excess Reserves Equals##br## Falling Commodity Currencies Falling Excess Reserves Equals Falling Commodity Currencies Falling Excess Reserves Equals Falling Commodity Currencies The last worrisome development for the dollar-bloc currencies is the volatility of financial assets. When volatility falls, it creates a wonderful environment for these currencies. But today, historical volatility is near the bottom of its distribution of the past 28 years. Being a highly mean-reverting series, it is thus more likely to rise than fall further going forward. There are three fundamental factors pointing to a potential reversal. First, share buyback activity has been declining, which historically points to rising volatility. Second, the U.S. yield curve slope also points toward a higher level of volatility. Volatility tends to bottom before the stock market peaks, and the stock market tends to peak before the economy enters recession. The yield curve itself tends to invert a year or so before a recession emerges. As a result, the yield curve begins to flatten around two years before volatility picks up (Chart I-13). Third, the anticipated decline in bank reserves - an important factor that has supported risk-taking around the globe - is likely to be the key catalyst supporting the relationship between the yield curve and volatility. If volatility increases, carry trades are likely to perform poorly, which will hurt EM currencies and result in outflows from these markets. This will cause liquidity conditions in EM economies to dry out, hurting their growth outlook. EM M1 growth has already weakened considerably, and is currently pointing to problems for commodity currencies (Chart I-14). The dry out in liquidity resulting from a reversal in carry trades will only amplify this phenomenon. Chart I-13Listen To The Yield Curve: ##br##Volatility Will Pick Up Listen To The Yield Curve: Volatility Will Pick Up Listen To The Yield Curve: Volatility Will Pick Up Chart I-14EM M1 Growth Is Becoming ##br##A Headwind For The Dollar Bloc EM M1 Growth Is Becoming A Headwind For The Dollar Bloc EM M1 Growth Is Becoming A Headwind For The Dollar Bloc Bottom Line: Global liquidity conditions are set to begin to tighten. While it is probably not enough to cause the bull market in stock prices to end now, it could be enough to affect the area of the global economy most exposed to this risk factor: carry trades and the dollar-bloc currencies. Specifically, commodity currencies are likely to be negatively affected by their elevated valuations, their strong sensitivity to excess bank reserves, and their high responsiveness to changes in financial market volatility. Key Indicators To Monitor After the surge that the dollar-bloc currencies have experienced since the spring and the large increase in the long exposure of speculators to these currencies, they are naturally at risk of experiencing a period of weakness. However, what worries us is not a retracement of 3-4%, but rather a 10-15% move. We suggest monitoring the following: First, watch U.S. inflation closely. The U.S. dollar is only likely to genuinely rally once the market believes the Fed can actually increase rates. So long as inflation remains tepid, investors will continue to second-guess the Fed. The market's response to this week's release of the most recent Federal Open Market Committee minutes only confirmed this. Mentions of debate on inflation within the FOMC was enough to send bond yields and the dollar reeling. However, based on the dynamics in the U.S. velocity of money, we continue to expect inflation to pick up in the second half of 2017 (Chart I-15).3 Second, follow cross-currency basis swap spreads. The cost of hedging U.S. assets back into euro or yen has normalized somewhat after hitting record levels in early 2016 (Chart I-16). If the removal of excess bank reserves in the U.S. system does affect global liquidity conditions, this market will be one of the first to be affected. Third, scrutinize the price of gold. The yellow metal remains a key gauge of global liquidity. Moreover, it is extremely sensitive to real rates and the dollar - two major determinants of the cost of global liquidity. In the summer of 2015, EM and dollar-bloc currencies severely suffered once gold broke below 1150. Today, a break below 1200 would be a sign of danger ahead. Fourth, watch EM currencies. A breakdown in EM currencies would be a key indication that carry trades are being reversed, and that global liquidity is no longer making its way into EM and EM-related plays. Commodity currencies are currently trading at a premium to their historical relationship with EM currencies, suggesting they would be highly vulnerable to such an event (Chart I-17). Chart I-15Watch U.S. Inflation Watch U.S. Inflation Watch U.S. Inflation Chart I-16Monitor Cross-Currency Basis Swap Spreads Monitor Cross-Currency Basis Swap Spreads Monitor Cross-Currency Basis Swap Spreads Chart I-17Dollar-Bloc Currencies At The Mercy Of EM FX Dollar-Bloc Currencies At The Mercy Of EM FX Dollar-Bloc Currencies At The Mercy Of EM FX Finally, keep an eye on Chinese monetary conditions. If Chinese monetary conditions improve from here, it would alleviate some of the negative pressure exercised on dollar-bloc currencies by the upcoming deterioration in global liquidity. However, if Chinese monetary conditions deteriorate further, this would negatively affect commodity prices, EM returns and the commodity currency complex. It would also hurt expected returns on Chinese assets, re-kindling outflows out of China and thus raising the risk premium associated with what would become a growing risk of CNY depreciation. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled, "Pyrrhic Victories", dated April 29, 2016, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report titled, "Carry Trades: More Than Pennies And Steamrollers", dated May 6, 2016, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report titled, "Fade North Korea, And Sell The Yen", dated August 11, 2017, available at fes.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 has been mixed this week: The Empire State Manufacturing Index increased to 25.2, a significant jump and beat Retail Sales increased at a 0.5% monthly pace, with the ex. Autos measure increasing at 0.5%, both beating expectations; The Import Price Index increased by 1.5% since last year; Initial jobless claims dropped to 232,000, beating expectations significantly; However, housing starts and building permits both underperformed expectations. While the DXY has rebounded, the FOMC's July minutes discussed the recent shortfall of inflation, which was interpreted bearishly by markets. The Fed is likely to begin normalizing its balance sheet very soon, as well as raising rates again by the end of this year. The greenback will likely continue its ascent when firmer inflation data emerges. Report Links: Fade North Korea, And Sell The Yen - August 11, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 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 Improving euro area growth prospects have propelled the euro 12% higher since the beginning of the year. However, the market seems to begin questioning the ECB's hawkishness. In its minutes, the ECB expressed worries about a potential euro overshoot. Additionally, rumors emerged that Mario Draghi will not give much guidance in Jackson Hole. Together, these stories have reversed some of the euphoria that had engulfed the euro. The tightening in euro area financial conditions relative to the U.S. has prompted a roll over in relative economic and inflation surprises, justifying these budding doubts. Furthermore, U.S. inflation should begin to meaningfully accelerate in the fall. This is likely to add to the euro's weakness, as the greenback will resume its upward trend. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 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 Data in Japan was mixed this week: Annualized gross domestic product growth grew by 4% on an annualized basis, crushing expectations. Additionally the month-to-month growth of industrial production came in at 2.2%, also beating expectations. However both export and import growth underperformed, coming in at 13.4% and 16.3% respectively. On cue, after we placed a long USD/JPY trade last week, USD/JPY rallied half percentage point, even if it gave up some of the gain now. We continue to be bearish on the yen as we expect U.S. yields to start picking up, in an environment where market expectations are very depressed. But could a correction in EM caused by the rise in the dollar help the yen? Not in the short term, given that historically the yen only gains in very sharp EM selloffs that themselves weigh on bond yields. Report Links: Fade North Korea, And Sell The Yen - August 11, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 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 Data in the U.K. was mixed this week: Retail sales prices increased by 3.6% year-on-year, outperforming expectations. However, The trade balance not only worsened since last month but also came in below expectations, at -4.564 Billion pounds Crucially, most inflation metrics came in below expectations, with headline inflation coming in at 2.6% while PPI core output inflation came in at 2.4%. Overall, we continue to believe that the market's rate expectations for the BoE remain too hawkish. As the pass through from the currency dissipates, inflation should also start to come down. Furthermore, one has to remember that the BoE has a higher hurdle for raising rates than other central banks due to the unique situation in which the U.K. is currently in. Lowered rate expectations will be negative for cable in the short term. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 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 Despite initially weak data, a risk-on environment and increasing copper prices have fueled a rally in the AUD. Data from China has been soft, and Australian data has been neutral: Chinese retail sales increased annually by 10.4%, less than expected; Chinese industrial production also underperformed at 6.4%; Australian wages increased at a 1.9% annual pace, in line with expectations; Australian unemployment dropped to 5.6%; participation rate increased to 65.1%; and a net of 27,900 jobs were filled. However, full-time employment went down by 20,300 while part-time employment increased by 48,200, so hours worked contracted. This development is likely to comfort the RBA in its dovish stance. In its minutes, the RBA discussed its worries concerning the housing market, and that "borrowers investing in residential property had been facing higher interest rates". This further worries the RBA regarding the impact of higher interest rates, limiting the room for more hawkish speeches. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 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: Retail sales and retail sales ex-autos Quarter-on-quarter growth strengthened relatively to the previous quarter, coming in at 2% and 2.1% respectively. Moreover quarter-on-quarter inflation both for producer prices in outputs and inputs outperformed expectations, coming in at 1.3% and 1.4%. Currently, differences in perception adjustment between the dovishness of the RBNZ and the RBA have pushed Australian rate expectations to the point that the market is now pricing a hike in Australia before New Zealand. Overall, this seems like a mispricing, as the kiwi economy is on a stronger footing than the aussie one. Moreover, a slowdown in China would be more harmful for Australia as iron ore is more sensitive to the Chinese industrial cycle than dairy products. Thus we remain bearish on AUD/NZD. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 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 The CAD has regained some composure despite weak oil prices. Even with the U.S. dollar weakening and inventories drawing massively, oil dropped. This dynamic is particularly worrying for oil, as the markets are doubting the durability of the curtailment in global oil production. While this could be worrying for the CAD, we still believe the USD 40-60/bbl equilibrium price level, as postulated by the BoC, will have a limiting effect on the oil-based currency, which has been driven by interest rate differentials. Both central banks are now hiking, but we believe that markets are underpricing Fed hikes. Thus, the CAD should weaken against USD. However, it will outperform other G10 currencies. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 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 has continued to show a mixed picture for the Swiss economy: Consumer prices inflation, increased slightly from the previous month, coming in at 0.3%, in line with expectations. The unemployment rate also came in in line of expectations at 3.2%, unchanged from the previous month. However, producer prices contracted by 0.1%, underperforming expectations. EUR/CHF has been weakening since its August second overbought extreme. For the moment, we expect the SNB to stand pat in its ultra-dovish monetary policy, at least until inflation and other economic indicators start to strengthen considerably. USD/CHF however might appreciate, given that the euro might fall the ECB minutes this week showed that the ECB is concerned by a potential euro overshoot. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 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 Data in Norway this week was mixed: Headline inflation came in at 1.5% in July, outperforming expectations. However, it softened from June's 1.9% reading. Core inflation came at 1.2% in July, in line with expectations, decreasing from 1.6% in June. Moreover, manufacturing output contracted by 0.6% year-on-year. We continue to be bullish on USD/NOK, as the increasing gap in real rate differentials between the United States and Norway should outweigh any oil rally. Indeed, the recent numbers in Norway illustrate the lack of inflationary pressures in this Scandinavian country. This should keep a lid on rates, and thus help USD/NOK. On the other hand EUR/NOK should follow the path of oil. Thus, the OPEC supply cuts will ultimately support oil prices and thus, weigh on this cross. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 A Market Update: June 23, 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 The SEK has had a particularly strong week, as inflation surprised to the upside on both a monthly and a yearly basis, coming in at 0.5% and 2.2% respectively. While it initially appreciated against all currencies, the uptick in commodity currencies on Wednesday made it lose its gains against AUD, CAD, NZD and NOK. As inflationary pressures grow, the SEK is likely to appreciate further, especially against the EUR and GBP. Additionally, with current Riskbank governor Stefan Ingves' term coming to an end by the end of this year, the hawkish rhetoric is likely to only increase. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017 Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

Highlights A number forward-looking indicators for EM corporate profits point to a major deceleration in the next several months, and potentially a contraction early next year. The most reliable forward-looking indicators for EM EPS have been EM/China narrow and broad money growth and they herald a bearish outlook for EM EPS. We continue deciphering the differences between China's various money and credit aggregates. Irrespective of which money measure we use, and regardless of their past track record, all of them are currently extremely weak and point to a major and imminent slump in China's growth in the next six to 12 months. We recommend shifting the underweight EM corporate and sovereign credit position versus U.S. high-yield to underweight versus U.S. investment-grade corporate credit. Feature Chart I-1Asian Exports And EM EPS Asian Exports And EM EPS Asian Exports And EM EPS The recovery in EM earnings per share (EPS) has been instrumental to the EM stock rally this year. As such, the equity strategy at the moment hinges on the outlook for corporate profits. In this report, we revisit coincident and leading indicators for EM profits. At the moment, EM corporate profit growth still appears robust, though several forward-looking indicators point to a major deceleration in the next several months, and potentially a contraction early next year. Korean and Taiwanese exports can be used as proxy for global trade. The latest data for July reveal that the sum of Taiwanese exports and Korean total exports excluding vessels has rolled over (Chart I-1). Historically, the U.S. dollar values of both economies' exports have correlated with EM EPS, and Chart I-1 entails that EM EPS growth will roll over very soon. The reason why we exclude vessel exports in the case of Korea is because vessel shipments are one-off occurrences and when they take place, they distort export growth. This was the case in the last several months - vessel (shipbuilding) exports surged by 75% from a year ago, distorting the annual growth rate of total exports. Overall, Korea's and Taiwan's overseas shipments in the past three months have averaged about 10%, which is lower than the mid-teen growth rates recorded earlier this year. In China, export growth is close to 9% in the past three months, and it is also rolling over. On a similar note, Korea's and Taiwanese shipments-to-inventory ratios lead EM EPS cycles, and they are presently sending a downbeat message (Chart I-2). China's import growth has relapsed, as suggested by both Chinese trade data and their counterparties export data to China (Chart I-3). Chart I-2Asia's Shipment-To-Inventory Ratios And EM EPS Asia's Shipment-To-Inventory Ratios And EM EPS Asia's Shipment-To-Inventory Ratios And EM EPS Chart I-3Exports To China And Chinese Imports Exports To China And Chinese Imports Exports To China And Chinese Imports The recovery in Chinese imports has been responsible for a considerable part of the recovery in global trade. Importantly, Chinese import cycles correlate very well with EM EPS growth (Chart I-4). The key pillar of our view remains that Chinese imports will contract going forward, which will depress both advanced and developing countries' shipments to China. Exports to China are much more important for EM than DM economies, and deteriorating sales to China will weigh considerably on EM profits and currencies. The most reliable forward-looking indicators for EM EPS have been EM/China narrow and broad money growth. Chart I-5A and Chart I-5B demonstrate that both EM narrow (M1) growth and China's broad money impulse (the second derivative) - herald a major slump in EM EPS. This is the main reason behind our negative stance on EM share prices and other risk assets. Chart I-4Chinese Imports And EM EPS Chinese Imports And EM EPS Chinese Imports And EM EPS Chart I-5AChina Broad Money Impulse And EM EPS EM Narrow Money And EM EPS EM Narrow Money And EM EPS Chart I-5BEM Narrow Money And EM EPS EM Narrow Money And EM EPS EM Narrow Money And EM EPS Both narrow and broad money growth in China have already relapsed, and it is a matter of time until economic growth and imports downshift enough to produce a major selloff in EM risk assets. We discuss China's monetary aggregates in the section below. Finally, if Chinese imports and commodities prices relapse, any reasonable strength in DM domestic demand will not be sufficient to preclude a meaningful EM slowdown. The basis is that exports to the U.S. and EU only make up 7% of GDP for China, 8% for Korea and 11% for Taiwan. While exports to China account for 10% of Korean GDP and 15% of Taiwanese GDP. The same holds true for most East Asian countries. With the exceptions of India and Turkey, non-Asian EM countries are primarily commodities producers. These two have their own idiosyncratic problems. Most of our analysis is not applicable to smaller central European economies that are leveraged to the EU business cycle. That said, neither Turkey, India, nor central European markets have large enough financial markets to make a difference in the EM benchmarks. The above is the primary reason behind our bearish view on EM growth and profits. That said, there are a few other interesting considerations regarding EM corporate profits dynamics. First, EM share prices lead EM EPS by six to nine months. Therefore, to be bullish on EM stocks, it is not sufficient to expect EM EPS growth to be robust over the next three months. Rather, to be bullish on EM stocks at the current juncture, one should have a bullish view on EM EPS by the end of this year and into the early part of 2018. Consistently, we believe that EM EPS growth will decelerate materially by the end of this year and shrink in the early part of 2018. Second, the top-line shrinkage in 2015 and the consequent recovery for EM exporters has been mostly driven by prices rather than volumes. Chart I-6A illustrate that Korean, Taiwanese and Chinese manufacturing production growth is rather muted. Chart I-6ACorporate Pricing Power Asian Manufacturing Production Asian Manufacturing Production Chart I-6BAsian Manufacturing Production Corporate Pricing Power Corporate Pricing Power Price fluctuations affect profits much more than output volume changes. Therefore, if global tradable goods prices deflate - at the moment they have rolled over (Chart I-6B) - EM EPS will contract materially. Third, in EM excluding China, Korea and Taiwan, there has been little economic recovery, as evidenced by Chart I-7. Along the same lines, the latest (July) manufacturing PMI for EM ex-China, Korea and Taiwan has dropped below the crucial 50 line (Chart I-7, bottom panel). This and the majority of other economic aggregates we use are equity market-cap weighted averages, so they are relevant to investors. This corroborates the fact that outside China, Korea and Taiwan there has been little genuine growth improvement in EM domestic demand - despite the decent recovery in global trade. This challenges the prevailing widespread consensus of a synchronized global economic recovery/expansion. This is also consistent with the fact that the overwhelming EM profit recovery has occurred in technology and resource sectors while domestic sectors have not seen much of corporate earnings recovery (Chart I-8). Chart I-7EM Ex-China, Korea And Taiwan: ##br##No Strong Recovery EM Ex-China, Korea And Taiwan: No Strong Recovery EM Ex-China, Korea And Taiwan: No Strong Recovery Chart I-8EM Sectors' EPS: Exporters ##br##Have Outperformed Domestic EM Sectors' EPS: Exporters Have Outperformed Domestic EM Sectors' EPS: Exporters Have Outperformed Domestic Finally, bottom-up equity analysts have recently downgraded their EPS estimates for listed EM companies (Chart I-9). Typically, analysts alter their forecasts simultaneously with swings in share prices. Hence, the latest decoupling is puzzling. Chart I-9EM EPS And Analysts' Net Revisions EM EPS And Analysts' Net Revisions EM EPS And Analysts' Net Revisions Notably, EM net EPS revisions have failed to move into positive territory in the past 7 years. This entails that analysts' expectations have been chronically high in recent years, and/or that companies have failed to deliver profits that match these projections. Bottom Line: The EM EPS outlook is downbeat, and listed companies profits will likely contract early next year. Deciphering China's Money Puzzle Based on our assessment of multiple measures, our conclusion with respect to Chinese broad money growth is as follows: Irrespective of which measure we use, and regardless of their individual past track records, all Chinese monetary growth aggregates are currently weak (Chart 10), and point to a major and imminent slump in China's growth in the next six to 12 months. In recent weeks, we have been working to understand differences among various measures of money growth in China. Our motivation is because neither M2 nor total social financing and fiscal spending - variables that we relied on last year - did a good job of forecasting the duration and magnitude of China's economic and profit revival in the past 12 months. In our July 26 report,1 we introduced the concept of broad money calculated using commercial banks' assets. We called it credit-money. This week, we discuss a different broad money calculation based on commercial banks' liabilities, and refer to it as deposit-money. Deposit-money is an aggregate of non-financial companies' time and demand deposits, household deposits, transferable and other deposits, other liabilities, bonds issued and liabilities to non-depository financial corporations. This measure is broader than official broad money (M2) because the latter includes only non-financial companies' time and demand deposits, household deposits and some of liabilities to non-depository financial corporations. In brief, our deposit-money calculation is more comprehensive than the official broad money figures (M2). In turn, banks' credit-money is the sum of commercial banks' claims on companies, households, non-bank financial institutions and all levels of government, as well as banks' foreign assets. Also, we deduct government deposits at the central bank (see July 26 Emerging Markets Strategy report1 for more details). Chart I-10 illustrates the differences between credit-money, deposit-money, total social financing and M2. Based on our calculations, deposit-money grew faster in 2015-'16 than both M2 and total social financing. Yet its current and ongoing slowdown is as bad as that of credit-money or M2. Chart I-10Dichotomy Among Various Money And Credit Aggregates In China Dichotomy Among Various Money And Credit Aggregates In China Dichotomy Among Various Money And Credit Aggregates In China The reason why M2 growth has lagged behind deposit-money growth since the middle of 2015 until now is the fact that the latter's components that are not included in the official M2 measure have outpaced M2 growth by a wide margin since late 2015. The main components of deposit-money are shown in Chart I-11. This is one of the main reasons why we missed the latest China-play rally - we relied on the official measure of money and credit published by the PBoC that has been much tamer than the broader money and credit, as banks have originated credit and hence money in a way that official monetary aggregates have not captured. In addition, banks' credit-money and deposit-money measures should theoretically be identical, but this has not been the case in China in recent years. Deposit-money is larger and it may well be more comprehensive than credit-money (Chart I-12). Chart I-11China: Components Of Deposit-Money Aggregate China: Components Of Deposit-Money Aggregate China: Components Of Deposit-Money Aggregate Chart I-12The Outstanding Stock And Flow Of Money The Outstanding Stock And Flow Of Money The Outstanding Stock And Flow Of Money Understanding these discrepancies is an ongoing work-in-progress for us, and we will be refining these measures going forward. For now, we would say that these differences are probably due to banks' efforts to misrepresent/hide their assets and liabilities to meet the regulatory ratios and avoid penalties, as well as maximize short-term profits. All that said, the gaps between M2 and deposit-money has recently narrowed: both deposit-money and M2 growth and their impulses are at all-time lows (Chart I-13). Furthermore, we expect deposit-money to slow further because of the lagged impact of higher interest rates and regulatory tightening that is intended to curb commercial banks' ability to originate more money via shadow banking activities. Finally, as can be seen from Chart I-14A, Chart I-14B and Chart I-15, deposit-money's impulse - its second derivative - leads many cyclical economic variables such as nominal GDP, producer prices, freight index, and imports. Chart I-13China: Two Measures Of Broad Money China: Two Measures Of Broad Money China: Two Measures Of Broad Money Chart I-14ADeposit-Money Leads Real Business Cycle Deposit-Money Leads Real Business Cycle Deposit-Money Leads Real Business Cycle Chart I-14BDeposit-Money Leads Real Business Cycle Deposit-Money Leads Real Business Cycle Deposit-Money Leads Real Business Cycle There are several other data points from China's real economy that portend developing weakness. Specifically, car sales growth has almost ground to a halt, real estate floor space sold and started are decelerating (Chart I-16). Chart I-15Deposit-Money Leads Metals Prices And Construction Deposit-Money Leads Metals Prices And Construction Deposit-Money Leads Metals Prices And Construction Chart I-16China: More Signs Of Slowdown China: More Signs Of Slowdown China: More Signs Of Slowdown Bottom Line: Regardless of which money measure we use, and regardless of their past track record, all of them are currently weak and point to a major and imminent slump in China's growth in the next six to 12 months. This gives us confidence in reiterating our negative view on China plays (including commodities) and EM. Credit Markets Strategy We have been recommending a strategy of shorting/underweighting EM sovereign and corporate credit versus U.S. high-yield (HY) credit and this strategy has shown strong performance, producing 15% gains with low volatility since August 2011 (Chart I-17). However, today we recommend shifting the underweight EM corporate and sovereign credit position from U.S. HY to U.S. investment grade (IG) corporate credit. The primary reason is that credit spreads are extremely tight and odds favor credit spreads widening in both U.S. and EM. Chart I-18 shows that when U.S. TIPS yields rise U.S. IG usually outperforms U.S. HY on an excess return basis. We expect U.S. Treasurys and TIPS yields to grind higher in the near term because U.S. growth and inflation are much stronger than the bond market is currently pricing in. Chart I-17Book Gains On This Strategy Book Gains On This Strategy Book Gains On This Strategy Chart I-18Higher U.S. Bond (TIPS) Yields Warrant Rotation Higher U.S. Bond (TIPS) Yields Warrant Rotation Higher U.S. Bond (TIPS) Yields Warrant Rotation Rising U.S. bond yields also warrants EM credit underperformance versus U.S. IG because the EM credit benchmark is riskier than U.S. IG. While the two segments have similar durations, the duration times spread measure of risk is greater for EM credit. Furthermore, U.S. HY spreads have narrowed versus both EM sovereign and corporate spreads since early 2016 (Chart I-19, top panel). Hence, there is little value favoring the former versus EM credit. In contrast, U.S. IG spreads versus both EM sovereign and corporate credit are appealing historically (Chart I-19, bottom panel). Therefore, there is a valuation aspect to this strategy change. Relative spread differences have historically correlated quite well with the subsequent 12-month return. Given where relative spreads are, the subsequent 12-month return for investing in U.S. IG relative EM credit is positive (Chart I-20, top panel) but it is negative for investing in U.S. HY versus EM credit (Chart I-20, bottom panel). Chart I-19EM Credit Offers Value Relative ##br##To U.S. HY But Not Versus U.S. IG EM Credit Offers Value Relative To U.S. HY But Not Versus U.S. IG EM Credit Offers Value Relative To U.S. HY But Not Versus U.S. IG Chart I-20Projected Returns Of EM Credit ##br##To Both U.S. IG And HY Projected Returns Of EM Credit To Both U.S. IG And HY Projected Returns Of EM Credit To Both U.S. IG And HY As to the rationale of favoring U.S. credit to EM credit, this is consistent with our theme that the growth outlook, corporate leverage, and health of the banking system are in much better shape in the U.S. than in EM. Bottom Line: Book profits on the short EM sovereign and corporate credit / long U.S. HY credit position. Institute a new position: short EM sovereign and corporate credit / long U.S. IG corporate credit. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report, titled "Follow The Money, Not The Crowd", dated July 26, 2017, link available on page 18. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Feature Turkey's banking system has in recent years relied on enormous liquidity provisions by the central bank (Chart I-1) to sustain its ongoing credit boom, and hence economic growth. Since early this year, the authorities have doubled down: they have also begun using fiscal policy to prop up growth. Chart I-1Turkey: Central Bank Large Liquidity Injections Turkey: Central Bank Large Liquidity Injections Turkey: Central Bank Large Liquidity Injections On the whole, this combination of colossal credit and fiscal stimulus is indisputably bearish for the currency. Despite strong performance by Turkish stocks this year, we are maintaining our bearish call on the lira. The lira is set to depreciate by 20-25% in the next 12 months or so versus both an equally-weighted basket of the U.S. dollar and the euro. Bringing Fiscal Stimulus Into Play The Turkish authorities have recently begun using fiscal means to stimulate growth: Last summer, a sovereign wealth fund was set up by presidential decree to pool shares in companies owned by the government and use them as collateral to raise debt and initiate spending on various infrastructure projects. The target size of the fund is US$ 200 billion, compared with the government non-interest expenditure of US$ 165 billion in the last 12 months. This would effectively allow the government to issue debt and increase expenditures off-balance sheet. In addition, this past March, the government decided to recapitalize the Credit Guarantee Fund. This initiative allowed it to underwrite US$ 50 billion, or 7% of GDP, worth of credit to Turkish companies. This is considerable as it compares with US$ 93 billion worth of loan origination by commercial banks last year. By assuming credit risk on these loans, the government is effectively encouraging banks to lend, in turn boosting economic growth. In effect, this has lowered lending standards and given a green light to banks to flood the economy with credit. Even though interest rates have risen since last November, credit growth has accelerated as banks have provided loans covered by government guarantees (Chart I-2). On top of this quasi-fiscal stimulus, government expenditures excluding interest payments have accelerated (Chart I-3). Chart I-2Bank Loan Growth Has Accelerated ##br##Despite Higher Interest Rates Bank Loan Growth Has Accelerated Despite Higher Interest Rates Bank Loan Growth Has Accelerated Despite Higher Interest Rates Chart I-3Turkey: Fiscal Spending Has Surged Turkey: Fiscal Spending Has Surged Turkey: Fiscal Spending Has Surged Such a rise in government spending has been financed by commercial banks whose holdings of government bonds have risen sharply. Essentially, government spending has also been funded by commercial banks' money creation. In short, fiscal and credit stimulus have boosted domestic demand, thereby widening the country's current account deficit once again (Chart I-4A and Chart I-4B). Chart I-4AWidening Twin Deficit Widening Twin Deficit Widening Twin Deficit Chart I-4BWidening Twin Deficit Widening Twin Deficit Widening Twin Deficit Given that the starting point of the government's fiscal position is good - public debt stands at only 28% of GDP - the authorities have ample room to rely on fiscal levers to promote growth. However, a widening fiscal deficit will be bearish for the currency. Bottom Line: Widening twin (current account and fiscal) deficits (Chart I-4A and Chart I-4B) are a bad omen for the lira. Monetary Tightening? What Monetary Tightening? Chart I-5Turkey: Money/Credit Growth Is Too Strong Turkey: Money/Credit Growth Is Too Strong Turkey: Money/Credit Growth Is Too Strong Although interbank and lending rates have risen in recent months, money and credit growth have been booming (Chart I-5). This does not support the idea that monetary policy is tight. On the contrary, thriving money and credit growth suggest that the policy stance is very easy. The Central Bank of Turkey (CBT) raised various policy rates and capped the overnight liquidity facility at the beginning of this year. However, commercial banks' usage of the late liquidity window facility - the one facility that has been left uncapped - has literally gone exponential - it has risen from zero to TRY 70 billion in the past 8 months. On the whole, the central bank’s net liquidity injections into the banking system continue to make new highs, even though the price of liquidity has been rising. Adding all the liquidity facilities – the intraday, overnight and late window facilities – the CBT's outstanding funding to banks is 90 billion TRY, or 3% of GDP, more than ever recorded (Chart 1, bottom panel). This entails that monetary policy is loose rather than tight. On the whole, commercial banks are requiring more and more liquidity, and the CBT is continuously supplying it. These injections maintain liquidity in the banking system to a sufficiently high level to allow aggressive money/credit creation among commercial banks. Bottom Line: The CBT is facilitating/accommodating an economy-wide credit binge by providing copious amounts of liquidity to commercial banks. The Victim Is The Lira The lira will inevitably depreciate in the months ahead: Chart I-6Turkey: Central Bank's Foreign ##br##Reserves Have Been Depleted Turkey: Central Bank's Foreign Reserves Have Been Depleted Turkey: Central Bank's Foreign Reserves Have Been Depleted The lira's exchange rate versus an equally-weighted basket of the U.S. dollar and the euro has been mostly flat year-to-date, despite the CBT intervening in the market to support the lira by selling U.S. dollars. Aggressive selling of CBT foreign exchange reserves has so far prevented much steeper lira depreciation in Turkey. However at this stage, the central bank is literally running out of reserves and will soon lose its ability to support the currency (Chart I-6). A developing country with foreign exchange reserves worth less than three months' imports is considered vulnerable. Therefore, at 0.5 months of imports coverage, or US$ 9.7 billion, the CBT has little capacity to continue supporting the currency via interventions. Economic growth has recovered: export volumes are very strong, driven by shipments to Europe, while loan growth is supporting private domestic demand and government expenditures have mushroomed. The ongoing economic recovery will boost inflation, and strong domestic demand will assure the current account deficit widens. This will weigh on the exchange rate. Core inflation measures have subsided from 10% to 7%, but remain well above the central bank's target of 5%. Provided inflation is a lagging variable, the acceleration in money growth and domestic demand this year will lead to higher inflation in the months ahead. Wage growth remains high and our profit margin proxy for both manufacturing and service industries - calculated as core CPI divided by unit labor costs - has relapsed signifying deteriorating corporate profitability (Chart I-7). This in turn will force businesses to raise prices. Provided demand is strong, companies will likely succeed in passing through higher prices to customers. In brief, odds are that inflation will rise significantly soon. Escalating unit labor costs also offsets the benefit of nominal currency depreciation. Chart I-8 illustrates that the real effective exchange rate is not cheap based on consumer prices, or unit labor costs. Chart I-7Companies Profit Margins Are Shrinking Companies Profit Margins Are Shrinking Companies Profit Margins Are Shrinking Chart I-8The Lira Is Not Cheap At All The Lira Is Not Cheap At All The Lira Is Not Cheap At All As inflation rises, residents' desire to convert their deposits from local to foreign currency will increase. In fact, this is already happening - households' foreign currency deposit growth is accelerating. In short, lingering high inflation will continue to weigh on the currency's value. Bottom Line: The authorities have doubled down on fiscal and credit stimulus, warranting a doubling down on bearish bets on the lira. Investment Implications On the whole, the authorities will continue resorting to fiscal and monetary stimulus to sustain economic growth. According to the Impossible Trinity theory, in countries with an open capital account structure, the authorities can control either interest rates or the exchange rate, but not both simultaneously. Chart I-9Bank Stocks Have Rallied Despite ##br##Shrinking Net Interest Margins Bank Stocks Have Rallied Despite Shrinking Net Interest Margins Bank Stocks Have Rallied Despite Shrinking Net Interest Margins In Turkey, policymakers will eventually opt to control interest rates, meaning they will not have much control over the exchange rate. We suggest currency traders who are not shorting the lira do so at this time. We remain short the lira versus the U.S. dollar. A weaker lira will undermine U.S. dollar returns on Turkish stocks and domestic bonds. Dedicated EM equity investors as well as those overseeing EM fixed income and credit portfolios should continue to underweight Turkish assets within their respective EM universes. Bank stocks have rallied strongly, and have decoupled from interest rates (Chart I-9). This reflects the recent credit binge, where banks are making profits on loan originations while the government is holding responsibility for bad loans. These dynamics could persist for a while. However, both loan growth and banks' profitability will be hurt if the credit guarantee scheme is not renewed. So far, it is estimated that TRY 200 billion of an announced TRY 250 billion of this credit guarantee scheme has been utilized. Continuous credit guarantee schemes and accumulation of off-balance-sheet liabilities by the government will widen sovereign credit spreads. In many EM countries, including Turkey, bank share prices have historically correlated with sovereign spreads. Hence, rising sovereign risk will weigh on banks stocks too. Finally, as the lira begins to depreciate and inflation rises, local interest rates will have to climb. This will also weigh on bank share prices. In brief, we are reiterating our negative/underweight stance on Turkish banks. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights To shed light on the dichotomies that have surfaced in China's money and credit variables, we have calculated a new credit-money. This new measure is currently corroborating a very downbeat outlook for Chinese growth and China-related plays. We do not mean that investors should put all of their faith in this new measure. Yet, other measures of money and credit such as M1, M2 and banks' total assets all point to an impending deceleration in economic growth in China. While many global investors take for granted that the central government will underwrite credit risk in the entire economy, the top leadership in Beijing is sending the opposite message, at least for now. A new fixed income trade: pay Czech / receive Polish 10-year swap rates. Feature Chart I-1China: A Business Cycle Top Is In The Making China: A Business Cycle Top Is In The Making China: A Business Cycle Top Is In The Making Typically, the phrase 'Follow The Money' is used in the investment community to advise in favor of chasing investment flows. Today, we use this phrase in the context of not following investor crowds, per se, but money growth - especially in China. Judging from market actions and elevated inflows into EM assets and investable Chinese stocks, we can infer that investor consensus on China/EM is rather bullish. In the meantime, China's money/credit growth is sending a bearish signal. Investors should heed the downbeat message from Chinese money/credit and not chase EM risk assets higher. To reconcile the different messages from various measures of Chinese money and credit aggregates (more on the differences below), we calculated a new measure of money/credit creation - commercial banks' total credit (referred to below as banks' credit-money). Banks' credit/-oney is the sum of commercial banks' claims on companies, households, non-bank financial institutions, and all levels of government, as well as commercial banks'' and PBoC's foreign assets. Also, we deduct government deposits at the central bank (see below for the rationale). This measure, a de-facto aggregate of credit/money originated by banks and the PBoC, is computed using the asset side of banks' balance sheets. The key message from this report is that mainland banks' credit-money growth has already decelerated meaningfully, and points to a considerable slump in China's business cycle and imports in the months ahead (Chart I-1). Notably, banks' credit-money growth is at the lowest level of the past 10 years, excluding the Lehman crisis. It is also well below 2015 lows when the economy was acutely struggling. Exploring Money And Credit Dichotomies In China There has lately been a puzzling divergence between the growth rates of banks' credit-money, M2, and total social financing (TSF) (Chart I-2). Chart I-2Dichotomy Among Various Credit And Money Aggregates In China Dichotomy Among Various Credit And Money Aggregates In China Dichotomy Among Various Credit And Money Aggregates In China In 2016, banks' credit-money growth accelerated to 20%, while the pick-up in M2, and bank loan growth was modest. At the same time, TSF and corporate and household credit growth was largely flat. Lately, M1 growth has slowed, M2 and banks' total asset growth have dropped to all-time lows, while banks' loan and total social financing have remained flat. So, what is the true picture of money and credit growth in China? What are these critical variables telling us about the growth outlook? Our measure of banks' credit-money should by and large match broad money (M2) because the former is calculated by adding up various assets, and the latter by aggregation of various liabilities. Indeed, both were correlated well in the past, but decoupled in 2013 (Chart I-3, top panel). There has been another money/credit paradox: banks' credit-money on the one hand, and TSF and banks' RMB loans on the other, also have decoupled since 2013 (Chart I-3, middle and bottom panels). Overall, neither M2 nor TSF and banks' RMB loans mirrored the surge in banks' money-credit origination in 2015 and 2016, as portrayed in Chart I-3. We have been relying on the M2 and TSF aggregates published by China's central bank. Their tame readings in 2016 were the main reason we underestimated the duration and magnitude of China's economic recovery in the past year or so, as well as its impact on the rest of EM and commodities. As to components of banks' credit-money, Chart I-4 demonstrates that the deceleration has been due to the claims on non-financial organizations (companies), non-bank financial institutions and government. In brief, the slowdown has been broad-based; only claims on households continue expanding at a robust rate of 25% from a year ago (Chart I-4, bottom panel). Chart I-3M2 And Total Social Financing Have Not ##br##Reflected Money Created by Banks M2 And Total Social Financing Have Not Reflected Money Created by Banks M2 And Total Social Financing Have Not Reflected Money Created by Banks Chart I-4Individual Components Of Commercial ##br##Banks' Money Origination Individual Components Of Commercial Banks' Money Origination Individual Components Of Commercial Banks' Money Origination We suspect burgeoning financial engineering in China, credit shenanigans, and the non-encompassing nature of the People's Bank of China's broad money (M2) calculation along with the local government debt swap conducted in 2015 have all distorted credit and money data in recent years, producing the above dichotomies. To shed light on these dichotomies and calculate what has been true money/credit origination in China, we have revisited the basics of money and credit creation and have attempted to make sense of the data and the underlying trends. Overall, we have the following observations and comments: New nominal purchasing power in any economy is created by banks when they originate new loans. Hence, measuring properly the amount of new credit/money origination is of paramount importance to forecasting business cycle dynamics in any country. As we argued in our trilogy of Special Reports on Money, Credit and Savings, banks do not need savings or deposits to originate loans.1 They simultaneously create an asset (a loan) and a liability (a deposit) when extending credit to a borrower, which creates purchasing power in the economy. Importantly, there is no need for someone to save (i.e., forego consumption) in order for a bank to create a new loan / originate new money. In the case of China, commercial banks have an enormous amount of deposits - not because households and companies save a lot but because the banking system altogether has originated a lot of credit/money. The household and national savings rates quoted by economists refer to excess production/overcapacity in the real economy and not deposits in the banking system. We have discussed this issue in the past2 and will revisit it in future reports. The restraining factors for banks to originate new credit/money are their capital, regulations, loan demand, and liquidity - but not deposits. Liquidity is banks' excess reserves at the central bank. Commercial banks create deposits but they cannot engender reserves at the central bank, i.e., liquidity. Only the central bank can expand or shrink the amount of liquidity/reserves commercial banks hold with it. Finally, commercial banks do not lend their reserves; they use the reserves to settle transactions with other banks. In turn, central banks do not create new money/purchasing power unless they lend to or buy assets from governments and non-bank entities or issue currency. Central banks have a monopoly over the creation of bank reserves and currency in circulation - high-powered money. A liquidity crunch at a bank occurs when a bank runs out of excess reserves at the central bank, and it cannot borrow/attract additional reserves. Nowadays, many central banks targeting interest rates supply reserves and lend to commercial banks unlimited amounts of reserves on demand to assure interbank rates stay close to their policy target rate. Therefore, in such settings one can infer that banks are not restrained by liquidity to produce new money/expand their assets. In the case of China, the PBoC's claims on banks have skyrocketed - they have surged by 4.5-fold since 2014 (Chart I-5) - entailing that the former has supplied a lot of liquidity to commercial banks. Such liquidity expansion by the PBoC has in turn allowed banks to create tremendous amounts of new money (new purchasing power). To put the amount of money/credit originated by Chinese commercial banks in context, we have calculated the ratio of their credit/money stock to China's nominal GDP and global nominal GDP (Chart I-6). Chart I-5The PBoC Has Injected A Lot Of##br## Liquidity/Reserves Into The System The PBoC Has Injected A Lot Of Liquidity/Reserves Into The System The PBoC Has Injected A Lot Of Liquidity/Reserves Into The System Chart I-6Chinese Banks' Colossal ##br##Money Creation Chinese Banks' Colossal Money Creation Chinese Banks' Colossal Money Creation The broad measure of banks' credit/money created presently stands at 250% of Chinese GDP and 32% of global GDP, or US$29 trillion. The latter compares with the U.S. Wilshire 5000 equity market cap of US$ 26 trillion at a time when American share prices are at all-time highs, and the median P/E ratio is at a record high as well. In 2016 alone, Chinese banks' originated RMB 21 trillion, or US$1.7 trillion in new money-credit. Since January 2009, when the credit boom commenced, mainland commercial banks have cumulatively generated RMB 141 trillion, or US$21.12 trillion, of new money/credit. Banks create new money/deposits when they lend or acquire assets. Exceptions are when banks lend to the central bank or to other commercial banks. In those circumstances, a bank draws on its reserves at the central bank, and no new money - and by extension purchasing power - is created. Fluctuations in reserves/liquidity affect purchasing power in an economy indirectly rather than directly. Expanding reserves/liquidity encourage banks money/credit creation and vice versa. In China, commercial banks' excess reserves at the PBoC are presently contracting and stand at historically low level relative to outstanding stock of credit/money (Chart I-7). This is one of the reasons why banks have been scaling back their credit/money origination. Chart I-7China: Banks' Liquidity/##br##Excess Reserves Are Thin China: Banks' Liquidity/Excess Reserves Are Thin China: Banks' Liquidity/Excess Reserves Are Thin The fiscal authorities play a unique role in money creation. Because of the authorities typically have accounts at both the central bank and commercial banks, they can alter the money supply by shifting deposits back and forth between their accounts at the central bank and commercial banks. By transferring deposits from a commercial bank to the central bank, the fiscal authorities can destroy money; by the same token, they can create money by doing the opposite. This is why when computing Chinese banks' credit-money aggregate we have deducted from the credit/money aggregate government deposits at the PBoC. Finally, there is a difference between credit-money originated by banks, and non-bank credit. Non-banks are financial intermediaries that transfer existing deposits into credit. By doing so they do not create new purchasing power. When banks lend or acquire various assets, they do generate new purchasing power - i.e., they create new deposits that did not exist before. This is why banks are not financial intermediaries. This is true for any country and financial system. For more detailed analysis on the difference between banks and non-banks, please refer to the linked paper.3 When examining leverage in the system, one should consider bank and non-bank credit. Yet, when looking to gauge the outlook for growth and inflation, one should consider new credit/money originated by banks. The purpose of this report is to examine and compute new credit-money that determine nominal economic growth in China rather than discuss leverage even though they are often interlinked. Therefore, we are focused on new credit-money originated by banks, and not on the amount of and changes in leverage in the economy. Bottom Line: Whether one prefers M2, banks' total assets or our new measure of banks' credit/money, the message is by and large the same: money-credit growth is slowing and is very weak. Credit-Money And Business Cycle Chart I-8Comparing Two Impulse Indicators Comparing Two Impulse Indicators Comparing Two Impulse Indicators How good is the bank credit-money in terms of being an indicator for China's business cycle? We have one caveat to mention before we illustrate its relevance: Banks' credit-money is a stock variable, and our goal is to gauge business cycle trends - i.e., changes in flow variables such as output, capital spending, profits and imports. Also, the first derivative of a stock variable is a flow, while the second derivative of a stock variable is a change in its flow. Therefore, we have calculated credit/money impulse as the second derivative of outstanding credit/money, or a change in annual change, to align it with the growth rate of flow variables. The following illustrates that banks' credit-money impulse has been an extremely good leading indicator for many economic and financial variables. The new impulse of banks' credit-money has since 2014 diverged from the nation's credit and fiscal impulse (Chart I-8). Nevertheless, the new credit-money impulse leads numerous business cycle variables such as nominal GDP, producer prices, electricity output, machinery sales, freight volumes, and manufacturing PMI (Chart I-9A and Chart I-9B). Chart I-9AChina's Growth To Decelerate A Lot (II) China's Growth To Decelerate A Lot (I) China's Growth To Decelerate A Lot (I) Chart I-9BChina's Growth To Decelerate A Lot (I) China's Growth To Decelerate A Lot (II) China's Growth To Decelerate A Lot (II) Not surprisingly, this impulse also leads property sales and starts as well as construction nominal GDP (Chart I-10). This impulse often precedes swings in the LMEX industrial metals index and iron ore prices (Chart I-11). Further, it is also a reasonably good indicator for EM EPS growth (Chart I-11, bottom panel). As discussed above, banks' new credit-money creation determines nominal - not real - growth. Chart I-10China: Property / Construction ##br##Are At A Major Risk China: Property / Construction Are At A Major Risk China: Property / Construction Are At A Major Risk Chart I-11Downbeat Message For Industrial ##br##Metals And EM Profits Downbeat Message For Industrial Metals And EM Profits Downbeat Message For Industrial Metals And EM Profits By expanding their assets, banks generate new purchasing power, but they do not have any control over whether this new purchasing power is used to boost real output or prices. The recovery of the past 12 months have in some cases boosted prices more than volumes. It might be that China is inching closer to an inflation inflection point. We are not saying that China has runaway inflation at the moment, but persistent enormous overflow of money-credit will inevitably produce higher inflation. If inflation does indeed rise materially, policymakers will have no choice but to tighten. Monetary tightening will be devastating for an economy with already high leverage. Bottom Line: The new measure of banks' credit-money is currently corroborating a very downbeat outlook for Chinese growth and China-related plays. Beijing's Priorities And Investment Implications It is generally believed in the global investment community that China's authorities will not allow the economy to slump - they will boost credit/money growth and fiscal spending to ensure solid growth. It is true that no government wants to see their economy crumble, and China is no exception. However, there are several reasons to expect growth to slump considerably before the government responds: The central bank has been guiding interest rates higher across the entire yield curve. Short-term interbank rates (7-day Interbank Fixing Rate) and 5-year AA domestic corporate bond yields have risen by about 100 and 200 basis points, respectively, since November 2016. In addition, financial regulators are clamping down on off-balance-sheet and fancy financial engineering practices of banks and other financial institutions. Monetary policy works with a time lag, and the current tightening along with the government's regulatory clampdown will impact economic growth in the months ahead. The sharp deceleration in banks' credit/money confirms this. Even though interest rates have recently stopped rising, the damage to banks' credit/money growth has been done as shown in Chart I-12. Business activity is lagging money/credit and will be next to suffer. The central government in Beijing has largely lost control over credit creation/leverage build-up since 2009. The top leadership in Beijing did not want credit to explode and speculative behavior to profligate. Two recent articles by Caixin news agency (links are in footnote4) corroborate that Beijing is unhappy with credit creation and allocation practices prevailing in the financial system as well as among SOEs and local governments. The top leadership appears decisive, at least for now, in clamping down on ballooning credit/money growth and the ensuing misallocation of capital and bubbles. Interestingly, while many global investors take for granted that the central government will underwrite credit risk in the entire economy, or at least among state-owned companies, Beijing is sending the opposite message for now. True, when an economy and financial system crumbles, the central government will undoubtedly step in. However, investors do not want to be on the long side of China-related markets when this occurs. Buying opportunities may occur at that point, but for now the risk-reward profile is extremely poor. The authorities in Beijing tolerated colossal money/credit creation and misallocation of capital when growth in the advanced economies was extremely feeble. Now, with DM economies expanding at a solid pace and China's growth having recovered, they are comfortable tightening. As for the resulting investment strategy conclusions, it is too late to chase this rally in EM risk assets and other China-related assets. We do not mean that investors should put all of their faith in our new measure of China's credit/money. Yet, other measures of money and credit such as M1, M2 or banks' total assets all point to an impending deceleration in economic growth in China. In EM ex-China, narrow (M1), broad money and private credit growth have been and remain lackluster (Chart I-13). As China's growth and imports slump, the majority of EM economies will be materially affected. Chart I-12China: Interest Rates And Money Creation China: Interest Rates And Money Creation China: Interest Rates And Money Creation Chart I-13EM Ex-China: Subdued Money / Credit Growth EM Ex-China: Subdued Money / Credit Growth EM Ex-China: Subdued Money / Credit Growth There is no change in our overall investment strategy. Specific country recommendations and positions across all asset classes are always presented at the end of our reports, presently on pages 18-19. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Caitlynn Qi Zeng, Research Assistant caitlynnz@bcaresearch.com Central Europe: A New Fixed-Income Trade In a Special Report titled Central Europe: Beware Of An Inflation Outbreak from June 21st 2017 - the link is available on page 20, we argued that labor shortages in central Europe have been pushing up wage growth, generating genuine inflationary pressures. The Polish, Czech and Hungarian economies are overheating, warranting imminent monetary policy tightening. We elaborated on the reasons why this is happening in that report and as such we will not go through it in detail again here. Based on this theme, our primary investment recommendation was in the currency market: go long the PLN and CZK versus the euro and/or EM currencies. This recommendation remains intact. Today we recommend a new trade based on the same theme: pay Czech / receive Polish 10-year swap rates (Chart II-1). The negative 143 basis points yield gap between Czech and Polish 10-year swap rates is unsustainable and it will mostly close for the following reasons: The relative output gap between the Czech Republic and Poland is showing that the Czech economy is overheating faster than in Poland (Chart II-2). This will eventually lead to inflation rising faster in Czech Republic than in Poland as per Chart II-2. Markedly, relative trend in headline inflation warrants shrinking swap spread between Czech and Polish swap rates (Chart II-3). In effect, the Czech National Bank (CNB) will be forced to hike rates at a faster pace and more than the National Bank of Poland (NBP). The CNB has been artificially depressing the value of its exchange rate by pegging it to the euro since November 2013. Despite the fact that the CNB abandoned its peg in April of this year, the CNB continues to artificially suppress the exchange rate by printing money and accumulating foreign exchange reserves. Chart II-1Pay Czech / Receive Polish ##br##10-year Swap Rates Pay Czech / Receive Polish 10-year Swap Rates Pay Czech / Receive Polish 10-year Swap Rates Chart II-2Czech Economy Will Overheat ##br##Faster Than Poland's Czech Economy Will Overheat Faster Than Poland's Czech Economy Will Overheat Faster Than Poland's Chart II-3Inflation Dynamics Warrant ##br##Smaller Swap Spread Inflation Dynamics Warrant Smaller Swap Spread Inflation Dynamics Warrant Smaller Swap Spread Foreign exchange reserves, measured in euros, in the Czech Republic are growing at an astronomical 60% annually while growth and inflation are already in full upswing (Chart II-4, top panel). Due to the ongoing foreign currency accumulation - accompanied by insufficient sterilization - the CNB has generated an overflow of liquidity and money/credit in the Czech economy (Chart II-4, middle panels). Chart II-4Monetary Conditions Are Easier In ##br##Czech Republic Relative To Poland Monetary Conditions Are Easier In Czech Republic Relative To Poland Monetary Conditions Are Easier In Czech Republic Relative To Poland In turn, this liquidity overflow has led a real estate boom and has super-charged overall growth (Chart II-4, bottom panel). On the contrary, the NBP has been much less aggressive in easing monetary conditions. The policy rate in Poland is at 1.5% while it is 0.05% in Czech Republic. Therefore, any potential upside in inflation and bond yields will be more limited in Poland than in the Czech Republic. Even though both Czech and Polish economic growth are robust, the Czech economy is showing more imminent signs of overheating and inflationary outbreak than Poland. The CNB is further behind the curve than the NBP. When a central bank is behind the curve, its yield curve should be steeper than a central bank that is not. However, the 10/1-year swap curve is as steep in Poland as it is in the Czech Republic. With the policy rate at a mere 0.05%, the Czech economy is sitting on the verge of an inflationary precipice. The longer the CNB maintains such a low policy rate, the higher long-term bond yields will rise. The basis being that the longer policymakers wait, the more they will have to tighten to slow growth and bring down inflation. Finally, this relative trade offers a hefty 143 basis points carry and is thus very attractive. Investment Conclusions In the fixed income and currency space in central Europe, we have been and continue recommending the following relative positions: A new fixed income trade: pay Czech / receive Polish 10-year swap rates Continue betting on yield curve steepening in Hungary: Receive 1-year / paying 10-year Hungarian swap rates Long Polish and Hungarian 5-year local currency bonds / short South African and Turkish domestic bonds. Long PLN and CZK versus EM currencies and/or the euro - we are long the following crosses: PLN/HUF, PLN/IDR, CZK/EUR For dedicated EM equity investors, we continue to recommend overweighting central Europe within an EM equity portfolio. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Reports titled, "Misconceptions About China's Credit Excesses", dated October 26, 2016; "China's Money Creation Redux And The RMB", dated November 23, 2016; "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017; links available on page 20. 2 Please refer to the Emerging Markets Strategy Special Report titled, "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017; link available on page 20. 3 Werner, R. (2014b), "How Do Banks Create Money, and Why Can Other Firms Not Do the Same?", International Review of Financial Analysis, 36, 71-77. 4 Please see, "Local Officials Now Liable for Bad Debt-Management Decisions for Life", July 17th 2017, Caixin Global, available at http://www.caixinglobal.com/2017-07-17/101117307.html Please see, "Local Governments Find New Ways to Play Debt Game", July 14th 2017, Caixin Global, available at http://www.caixinglobal.com/2017-07-14/101116048.html Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights EM growth is set to falter due to budding weakness in Asia's trade, a decline in commodities prices, and the frailty of EM banking systems. U.S./DM bond yields are heading higher for now and China's money/credit growth is set to decelerate. Together, these will trigger a selloff in EM risk assets. The EM equity outperformance versus DM has been extremely narrow and, hence, it is unsustainable. The EM tech sector is unlikely to support the equity rally much further because these stocks are overbought, and the Asian semiconductor cycle is entering a soft patch. Take profits on the yield curve flattening trade in Mexico. Stay long MXN on crosses versus BRL and ZAR and continue overweighting Mexican bonds. Feature Higher bond yields within the advanced economies and policy tightening in China remain the key threats to EM risk assets in the near term (the next three months). In the medium-term (the next three to 12 months or so), the principle risk is weaker growth in EM/China, and hence contracting corporate profits in EM. While this rally has lasted longer and has gone further than we had anticipated, we find the risk-reward for EM risk assets extremely unattractive. In fact, the huge amount of money that has flown into EM equity and debt markets in the past year amid poor fundamentals suggests to us that the next move will not be a simple correction but rather a major bear market. EM Recovery To Falter Although on the surface global growth appears to be on solid footing, there are early signs of a slowdown in Asian exports. Both Taiwanese exports of electronic parts and the country's overall exports to China have rolled over - the latter two lead global export volumes by a few months, as shown in Chart I-1. The reason why Taiwanese exports of electronic parts lead global trade cycles is because these parts are used in the assembly of final products, and producers order and receive these parts before final products are made and shipped. Similarly, a lot of Taiwanese exports to China serve as inputs into final products assembled in China and shipped worldwide. This is why Taiwan's overall shipments to China lead global trade cycles. On top of this, Korea's overall manufacturing and semiconductor shipments-to-inventory ratios have relapsed. Historically, these ratios have correlated with the KOSPI (Chart I-2). Chart I-1Signs Of Slowdown ##br##In Asian Trade Signs Of Slowdown In Asian Trade Signs Of Slowdown In Asian Trade Chart I-2Korea's Manufacturing ##br##Growth Has Peaked Korea's Manufacturing Growth Has Peaked Korea's Manufacturing Growth Has Peaked Outside the manufacturing-based Asian economies, most other EMs are basically commodities plays, except for India and Turkey. The latter two countries are not only relatively small, but Indian stocks are also expensive and overbought while Turkey is sufferings from its own malaise. In short, if the Asian tech cycle rolls over, China slows down and commodities prices relapse, EM growth will falter. That is why the focus of our analysis has been and remains on China's growth, commodities prices and the Asian trade cycle. Meanwhile, many banking systems in the developing world remain frail following the credit excesses of the preceding years. BCA's Emerging Markets Strategy service remains bearish on commodities, and believes the breakdown in the correlation between commodities prices and EM risk assets since the beginning of this year is temporary and unsustainable. As for the increased importance of the technology sector in the EM equity benchmark, we offer further analysis on page 10. Our negative view on EM growth is not contingent on a relapse in U.S. and euro area growth. In fact, our current baseline scenario is that DM growth will remain solid, and government bond yields in these markets will rise further. Although growth in both the U.S. and euro area is robust, their importance for EM has become small. For example, exports to the U.S. and EU altogether account for 35% of total exports in China, 22% in Korea and 20% in Taiwan. All in all, if commodities prices continue to downshift and Asian trade slows, as we expect, EM growth will decelerate. Bottom Line: EM growth is set to falter notably, despite solid demand growth in DM. Liquidity Backdrop To Deteriorate Investors and market commentators often use the term "liquidity" loosely, and denote numerous things by it. We use the term 'liquidity' to signify the level and/or direction of interest rates as well as the level and/or direction of money/credit growth. Below we review some different perspectives of liquidity: EM narrow money (M1) growth points to both lower share prices and a relapse in EPS growth in the months ahead (Chart I-3). Chart I-3EM: Narrow Money (M1) Points To EPS Downturn And Lower Stock Prices EM: Narrow Money (M1) Points To EPS Downturn And Lower Stock Prices EM: Narrow Money (M1) Points To EPS Downturn And Lower Stock Prices This is an equity market cap-weighted aggregate of narrow money growth. M1 growth in China - the largest market cap in the EM equity benchmark - has been essential in driving aggregate EM M1 cycles in recent years. More importantly, China has been tightening liquidity, yet the majority of investors remain complacent about its impact on growth. In this regard, investors should remind themselves that monetary policy works with time lags, and the considerable rise in China's interbank rates and corporate bond yields will produce a growth slowdown in the real economy later this year. Chart I-4 demonstrates that China's broad money growth (M2) - which has in effect dropped to an all-time low - leads bank and non-bank credit origination. This suggests the odds of a slowdown in bank and non-bank credit flows are considerable. There has been no stable correlation between the size of DM central banks' balance sheets and EM stock prices, bond yields and currencies since 2011. Therefore, the Fed's move to reduce its balance sheet by itself should not matter for EM risk assets from a fundamental perspective. Nevertheless, EM risk assets have been negatively correlated with U.S. TIPS yields (Chart I-5), and the potential further rise in U.S./DM real and nominal yields will hurt EM sentiment, with flows to EM drying up. Chart I-4China: M2 Heralds ##br##Slowdown In Credit Growth China: M2 Heralds Slowdown In Credit Growth China: M2 Heralds Slowdown In Credit Growth Chart I-5EM Currencies To Depreciate ##br##As U.S. Real Yields Drift Higher EM Currencies To Depreciate As U.S. Real Yields Drift Higher EM Currencies To Depreciate As U.S. Real Yields Drift Higher Importantly, traders' bets on U.S. yield curve flattening have risen, as evidenced by large short positions in 2-year U.S. notes and considerable long positions in 10- and 30-year bonds. The unwinding of these positions will drive bond yields higher. Chart I-6Precious Metals Signal ##br##Higher Real Yields Ahead Precious Metals Signal Higher Real Yields Ahead Precious Metals Signal Higher Real Yields Ahead Notably, precious metal prices have failed to break out amid a weak U.S. dollar and have lately relapsed (Chart I-6). Precious metals prices could be sensing a further rise in U.S. real yields and/or an upleg in the U.S. dollar. Both the rise in U.S. yields and a stronger dollar will be negative for EM. Bottom Line: We maintain that U.S./DM bond yields are heading higher in the months ahead and China's money/credit growth is set to decelerate. Altogether these will trigger a selloff in EM risk assets. Underwhelming EM Technicals It is a well-known fact that flows into EM debt funds have been enormous, making EM fixed-income markets vulnerable to a reversal of these flows at the hands of tightening liquidity and EM growth disappointments, as argued above. This section focuses on a number of bearish technical signals for EM share prices. In particular: The EM equity implied volatility curve - 12-month VOL minus 1-month VOL - is at a record steep level, based on available history (Chart I-7). Periods of VOL curve flattening have historically coincided with a selloff in EM share prices, as evidenced by Chart I-7. Given that the VOL curve is record steep, the odds of flattening are substantial. Consistently, the probability of an EM selloff is considerable. Chart I-7A Sign Of Top In EM Share Prices? A Sign Of Top In EM Share Prices? A Sign Of Top In EM Share Prices? In absolute terms, EM equity implied 1-month VOL is at an all-time low and reflects enormous complacency about EM. EM equity breadth has also been poor. The MSCI EM equally weighted stock index (where each stock commands an equal weight) has considerably underperformed the EM market cap-weighted index since May 2016 (Chart I-8). This suggests the EM rally has been very narrowly driven. The same measure for DM stocks has done relatively better (Chart I-8). Remarkably, EM has underperformed DM based on equal-weighted equity indexes since July 2016 (Chart I-9). This confirms that EM outperformance against DM since early this year has been largely driven by a few stocks, namely the five companies accounting for the bulk of the EM tech index. Furthermore, EM ex-tech stocks have also failed to establish a bull market, in that the index remains below its prior low (Chart I-10). Chart I-8EM Equity Breadth ##br##Has Been Poor EM Equity Breadth Has Been Poor EM Equity Breadth Has Been Poor Chart I-9EM Versus DM: Relative ##br##Equity Performance EM Versus DM: Relative Equity Performance EM Versus DM: Relative Equity Performance Chart I-10EM Ex-Technology Stocks: ##br##Rebound But No Bull Market EM Ex-Technology Stocks: Rebound But No Bull Market EM Ex-Technology Stocks: Rebound But No Bull Market Finally, the magnitude of the EM rally this year is somewhat misleading. Only three out of 11 sectors - technology, real estate and consumer discretionary (mainly, autos) - have outperformed the EM benchmark this year. Table I-1 illustrates that these three sectors have been responsible for about 50% of the EM rally year-to-date while their market cap is only 36% of total. Table I-1EM Rally In 2017: Return Decomposition The Case For A Major Top In EM The Case For A Major Top In EM Bottom Line: The EM equity outperformance versus DM has been extremely narrow: it has been due to five tech companies that are currently very overbought (see Chart I-8 on page 7). Valuations EM equity valuations are not cheap, as most of the rally since the early 2016 bottom has been driven by a multiple expansion rather than a rise in corporate earnings (Chart I-11). We are not suggesting EM stocks are expensive, but they do not offer good value either. In fact, good companies/countries/sectors are expensive, while those, that appear "cheap", command low multiples for a reason. As for currencies, they are not cheap either. The real effective exchange rate of EM ex-China is rather elevated after the rally of the past year or so (Chart I-12). Finally, not only are EM sovereign and corporate spreads close to record lows, but also local government bond yield spreads over U.S. Treasurys are at multi-year lows (Chart I-13). Chart I-11Decomposing EM Equity ##br##Return Into P/E And EPS Decomposing EM Equity Return Into P/E And EPS Decomposing EM Equity Return Into P/E And EPS Chart I-12EM Ex-China Currencies ##br##Are Not Cheap And Vulnerable EM Ex-China Currencies Are Not Cheap And Vulnerable EM Ex-China Currencies Are Not Cheap And Vulnerable Chart I-13EM Local Bond Yields Spreads ##br##Over U.S. Treasurys Is Low EM Local Bond Yields Spreads Over U.S. Treasurys Is Low EM Local Bond Yields Spreads Over U.S. Treasurys Is Low Bottom Line: Adjusted for fundamentals, EM equity, currency and credit market valuations are rather expensive. The odds are that the reality will underwhelm expectations, and that EM risk assets will sell off. A Word On EM Tech: Is This Time Different? During our recent trip to Europe, many clients argued that the increased weight of technology in the EM equity benchmark will cause EM share prices to decouple from the traditional variables they have historically been correlated with, like commodities prices, commodities stocks and others. In brief, the argument is that EM has entered a new paradigm, and past correlations will not work. The last time we at BCA heard similar arguments was back in early 2000 at the peak of the global tech bubble. At the time, the argument was that this time was truly different - that tech stocks could drive the market higher regardless of the old indicators and the performance of other sectors. Chart I-14 portrays that in 2000 the EM equity index, for several months, decoupled from global mining and energy stocks when tech and telecom stocks went ballistic. Chart I-14EM And Commodities Stocks: Can The Recent Decoupling Persist? EM And Commodities Stocks: Can The Recent Decoupling Persist? EM And Commodities Stocks: Can The Recent Decoupling Persist? Back in 2000, the bubble was in tech and telecom stocks. These two sectors together comprised 33% of the EM benchmark as of January 2000 (Chart I-15). This compares with a 27% weighting of technology stocks alone in the EM benchmark now. The combined weight of energy and materials is currently 14% versus 19% in January 2000, as can been seen in Chart I-15. Chart I-15EM Equities Sector Composition Now And In Late 1990s The Case For A Major Top In EM The Case For A Major Top In EM To be sure, we are not suggesting that tech stocks are in a bubble as they were in 2000, and that a bust in share prices is imminent. However, several observations are noteworthy: Chart I-16EM Equities Sector ##br##Composition Now And In Late 1990s EM Equities Sector Composition Now And In Late 1990s EM Equities Sector Composition Now And In Late 1990s Just because EM tech stocks have skyrocketed in the past six months does not mean they will continue to do so. In fact, EM tech is already extremely overbought and likely over-owned (Chart I-16). As global bond yields rise, high-multiples stocks, especially social media/internet companies, could selloff. We, like all macro strategists, can add little value on how to value internet/social media companies and assess their business models. However, we can shed some light on the business cycle in the semiconductor sector that influences performance of heavyweight companies like TSMC and Samsung. As Chart I-1 and I-2 on pages 1 and 3 demonstrate, there are signs that the semi/electronics cycle in Asia has peaked. We do not mean that this sector is headed toward recession. But this is a very cyclical sector, and some slowdown is to be expected following the growth outburst of the past 18 months. This will be enough to cause a correction in semi stocks from extremely overbought levels. The tight correlation between EM share prices and energy and mining stocks has persisted for the past 20 years (Chart I-14 on page 10), and we believe it will re-establish as technology stocks' shine diminishes. Finally, we have been recommending an overweight position in Taiwanese, Korean, and Chinese stocks primarily because of their large tech exposure. For now we maintain this strategy. Bottom Line: While the technology sector could make a difference for EM economies and equity markets in the long run, it is unlikely to support the current rally and outperformance much further. Indeed, tech stocks are heavily overbought, and the Asian semiconductor cycle is entering a soft patch. In brief, the overall EM equity benchmark is at a major risk of relapse and underperformance versus the DM bourses. Stay underweight. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Mexico: Take Profits On Yield Curve Flattener And Stay Long MXN On Crosses Mexico's 10/1-year swap curve has inverted for the first time in history and we are taking a 160 basis points profit on our yield curve flattening trade recommended on June 8, 2016 (Chart II-1). Will the central bank begin cutting interest rates soon? Is it time to get bullish on stocks? We do not think so: Inflation is well above the central bank's target and is broad based (Chart II-2). Notably, wage growth is elevated (Chart II-3). Chart II-1Mexico's Yield Cruve Has Inverted: Take Profits Mexico's Yield Cruve Has Inverted: Take Profits Mexico's Yield Cruve Has Inverted: Take Profits Chart II-2Mexico: Inflation Is Above The Target Mexico: Inflation is Above The Target Mexico: Inflation is Above The Target Chart II-3Mexico: Wage Inflation Is High Mexico: Wage Inflation Is High Mexico: Wage Inflation Is High Provided productivity growth is meager in Mexico, unit labor costs - which are calculated as wage per hour divided by productivity (output per hour) - are rising. This will depress companies' profit margins and make them eager to hike selling prices. This will in turn prevent inflation from falling and, consequently, hamper Banxico's ability to cut rates for now. Meanwhile, the impact of higher interest rates will continue filtering through the economy. High interest rates entail further slowdown in money and credit growth and, hence, in domestic demand. Both consumer spending and capital expenditure by companies are set to weaken a lot (Chart II-4). This will weigh on corporate profits and share prices. Fiscal policy is not going to support growth either because policymakers will opt to consolidate the recent improvement in the fiscal deficit. This is especially true given the latest selloff in oil prices. Notably, oil accounts for about 20% of government revenues. Even though non-oil exports and manufacturing output are accelerating (Chart II-5), non-oil exports - that make about 30% of GDP - are not large enough to offset the deceleration in domestic demand from monetary tightening. Chart II-4Mexico: Domestic Demand To Buckle Mexico: Domestic Demand To Buckle Mexico: Domestic Demand to Buckle Mexico: Domestic Demand To Buckle Mexico: Domestic Demand to Buckle Chart II-5Mexico: Exports Are Robust Contracting Non-Oil Exports Signal Headwinds For Manufacturing Mexico: Exports are Robust Contracting Non-Oil Exports Signal Headwinds For Manufacturing Mexico: Exports are Robust Investment Conclusions The outlook for Mexican stocks in absolute terms is poor as domestic demand will slump, further hampering corporate profits. Meanwhile, inflation is still elevated to justify rate cuts by the central bank. Within an EM equity portfolio, we recommend neutral allocation to this bourse mainly due to our expectations of the peso outperforming other EM currencies. The Mexican peso is still cheap (Chart II-6). Therefore, we continue to recommend long positions in MXN versus ZAR and BRL. If EM currencies depreciate and oil prices drop further as we expect, it will be hard for the peso to appreciate versus the U.S. dollar. However, the peso will outperform many other EM currencies. Mexican local currency bonds and sovereign credit offer good value relative to their EM counterparts. (Chart II-7). Fixed income investors should continue to overweight Mexican local currency and sovereign credit within their respective EM benchmarks. Chart II-6Mexico: Peso Is Cheap Mexico: Peso is Cheap Mexico: Peso is Cheap Chart II-7Continue Overweighting Mexican Bonds Continue Overweighting Mexican Bonds Continue Overweighting Mexican Bonds Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations