Sectors

Highlights Growth in the Taiwanese economy has trended sideways this year, but a budding turnaround in weak domestic demand suggests that growth should improve in 2018. The appreciation of the TWD from its 2016 low reflects investor inflows rather than bullish fundamentals. The risk of a protectionist backlash means that monetary authorities are reluctant to intervene aggressively to limit the rise. We recommend that investors stick with our existing long MSCI China / short Taiwan trade, for now. A breakout in relative Taiwanese tech sector performance coupled with a weakening TWD would likely be a sufficient basis to close the trade at a healthy profit. Feature We last wrote about Taiwan in February of this year,1 when the risk of protectionist action from the Trump administration loomed large. While there have been no negative trade actions levied against Taiwan this year, macro factors, particularly the strength of the currency, continue to argue for an underweight stance within the greater China bourses (China, Hong Kong, and Taiwan). Our long MSCI China / short Taiwan trade has generated an impressive 19% return since its inception in February. The trade has become significantly overbought, but we recommend that investors stick with it, for now. A material easing in pressure on Taiwan's trade-weighted exchange rate appears to be the most likely catalyst to close the trade and to upgrade Taiwan within a portfolio of greater China equities. The Taiwanese Economy In 2017: What Has Changed? Real GDP growth in Taiwan has generally trended sideways in 2017, decelerating in the first half of the year and then recovering in the third quarter (Chart 1). While these fluctuations in its growth profile have been somewhat muted, overall GDP growth has masked a sizeable divergence between domestic demand and export growth. Taiwan is a highly trade-oriented economy, with exports of goods & services accounting for nearly 65% for its GDP, and a recent acceleration in real export volume has positively contributed to overall growth. Over 50% of Taiwan's exports are tech-based, and Chart 1 panel 2 highlights the close link between global semiconductor sales (which have risen sharply over the past year) and Taiwanese nominal exports. But as Chart 1 panel 3 shows, growth in real domestic demand has fallen back into contractionary territory, driven largely by a sharp decline in gross fixed capital formation. This decline in investment is somewhat surprising, given the close historical relationship between Taiwan's real exports and investment (Chart 2, panel 1). But the sharp drop may have been a lagged response to the export shock that occurred during the synchronized global growth slowdown in 2015, as it led to a non-trivial accumulation of inventory (Chart 2, panel 2). The recent acceleration of export growth and a renewed draw in inventories suggests that the severe pullback in investment is likely to reverse in the coming year. Chart 1A Divergence Between Domestic Demand##br## And Exports A Divergence Between Domestic Demand And Exports A Divergence Between Domestic Demand And Exports Chart 2Investment Likely To Rebound Over ##br##The Coming Year Investment Likely To Rebound Over The Coming Year Investment Likely To Rebound Over The Coming Year The evolution of Taiwanese capital goods imports is likely to provide an important confirming signal about the trend in real investment, given the close historical correlation between the two series. For now, the growth in capital goods imports is rebounding from negative territory (Chart 3), which is consistent with the view that investment is set to recover. Finally, while real consumer spending growth also decelerated in the first half of the year, the acceleration in Q3 has brought consumption back to its 5-year moving average. More importantly, Chart 4 highlights that the consumer confidence index in Taiwan is closely correlated with real spending, with the former heralding a rise in the latter over the coming months. Chart 3Capital Goods Signal An Investment Recovery Capital Goods Signal An Investment Recovery Capital Goods Signal An Investment Recovery Chart 4Consumption Also Set To Improve Consumption Also Set To Improve Consumption Also Set To Improve Bottom Line: Growth in the Taiwanese economy has trended sideways this year, but a budding turnaround in weak domestic demand suggests that growth should improve in 2018. The Taiwanese Dollar: Driven By Flows, Not Fundamentals Taiwanese stock prices have underperformed Greater China bourses since the beginning of the year (Chart 5), despite the recent improvement in real export growth and signs of an impending improvement in domestic demand. To us, this underperformance has been largely caused by the strength in the Taiwanese currency. The Taiwanese dollar has appreciated since early-2016, both against the U.S. dollar and in trade-weighted terms (Chart 6). Although the currency retreated from May to August of this year, it has since resumed its uptrend and currently stands between 8-9% higher than last year's low in trade-weighted terms. Chart 5Significant Underperformance Of ##br##Taiwan Vs Greater China Significant Underperformance Of Taiwan Vs Greater China Significant Underperformance Of Taiwan Vs Greater China Chart 6Material Currency Appreciation##br## Since Early-2016 Material Currency Appreciation Since Early-2016 Material Currency Appreciation Since Early-2016 Crucially, Chart 7 highlights that the rise in the TWD cannot be explained by relative monetary policy or by an improvement in the terms of trade. The chart shows how the USD/TWD began to decouple from the relative 2-year swap rate spread in early-2016, and how the trend in Taiwan's export price index has been negatively correlated with the trade-weighted exchange rate. The best explanation for the recent strength in Taiwan's currency appears to be a surge in capital inflows oriented towards Taiwan's equity market (Chart 8). Foreign ownership of Taiwanese stocks has increased significantly over the past few years and is currently at a record high of 43%. Given that Taiwan's equity market is enormously tech-focused, it appears that global investors have been attracted to Taiwanese stocks as part of a play on the global tech rally. As we will discuss below, this has become somewhat of a self-defeating strategy, at least in terms of Taiwan's relative performance vs Greater China bourses. While it is possible that monetary authorities will attempt to combat the appreciation of the Taiwanese dollar, Chart 9 highlights that there is little room to maneuver. First, Taiwan's policy rate of 1.375% is already extremely low, and is only 12.5 bps above the level that prevailed during the worst of the global financial crisis. Second, panels 2 and 3 suggests that while past central bank intervention was successful at depreciating the TWD, monetary authorities also seem reluctant to allow Taiwan to be labeled as a currency manipulator. Our proxy for central bank intervention is the rolling 3-month average daily depreciation in TWD/USD in the first 30 minutes of aftermarket trading, a period that the central bank has historically used to intervene in the foreign exchange market. The chart shows that periods of intervention have been associated with a subsequent decline in TWD/USD, but that intervention durably ended once Taiwan was added to the U.S. Treasury's watch list of potential currency manipulators (first vertical line). Taiwan was removed from the watch list in October of this year (second vertical line), after central bank intervention ceased. Chart 7Currency Strength Not Supported ##br##By Fundamentals Currency Strength Not Supported By Fundamentals Currency Strength Not Supported By Fundamentals Chart 8Equity-Oriented Capital Inflows##br## Are Pushing Up The TWD Equity-Oriented Capital Inflows Are Pushing Up The TWD Equity-Oriented Capital Inflows Are Pushing Up The TWD Chart 9Little Room For Policy ##br##To Push Down The Exchange Rate Little Room For Policy To Push Down The Exchange Rate Little Room For Policy To Push Down The Exchange Rate Bottom Line: The appreciation of the TWD from its 2016 low reflects investor inflows rather than bullish fundamentals. While there is scope for further central bank intervention to help depreciate the currency, the risk of a protectionist backlash means that monetary authorities are reluctant to act. The Relative Outlook For Taiwanese Equities Table 1 presents a simple performance attribution analysis for Taiwan's year-to-date stock returns relative to Greater China bourses,2 in an attempt to answer the following question: Has Taiwan underperformed because it is underweight sectors that have outperformed, or because its highly-weighted sectors underperformed? To test this question we calculate a "hypothetical" return for the Taiwanese stock market, which shows what would have occurred if Taiwan's tech and ex-tech sectors had earned the benchmark return instead of their own. Table 1Taiwan's Poor Performance This Year Is Due To Its Tech Sector Taiwan: Awaiting A Re-Rating Catalyst Taiwan: Awaiting A Re-Rating Catalyst The table clearly shows that Taiwan would have substantially outperformed Greater China in this hypothetical scenario, underscoring that its sector weighting is not the source of the underperformance. While both Taiwan's tech and ex-tech indexes underperformed those of Greater China, it is apparent that most of the gap in performance can be linked to Taiwan's tech sector. Tech accounts for roughly 60% of Taiwan's equity market capitalization, and the sector significantly underperformed Greater China tech this year. Chart 10 highlights that Taiwan's tech sector underperformance is significantly explained by the rise in Taiwan's trade-weighted currency. Panels 2 & 3 of the chart shows Taiwan's rolling 1-year tech sector beta and alpha vs Greater China tech, both compared with the (inverted) year-over-year percent change in the trade-weighted exchange rate. Here, we define alpha using Jensen's measure, which is the difference between Taiwan's tech sector price return and what would have been expected given its beta and Greater China's tech sector performance. The chart clearly shows that the sharp rise in Taiwan's trade-weighted exchange rate caused both a decline in Taiwan's tech sector beta (from a historical average of about 1) as well as a significantly negative alpha over the past year. Chart 10, in combination with the currency-driven downtrend in Taiwan's export prices shown in Chart 7, suggests that Taiwan's equity market has suffered in relative terms due to the outsized appreciation in its currency. This is somewhat ironic, as we noted above that the currency appreciation itself appears to be caused by capital inflow oriented towards Taiwan's tech sector, meaning that global investors have inadvertently contributed to Taiwan's equity market underperformance relative to Greater China bourses. Looking forward, there are cross-currents affecting the outlook for Taiwanese stock prices. Chart 11 shows that technical conditions and relative valuation argue against maintaining an underweight stance; Taiwanese stocks are heavily oversold vs Greater China, and have de-rated in relative terms since the beginning of the year. Taiwanese tech in particular is quite cheap in relative terms. In addition, panel 1 of Chart 10 suggests that Taiwanese tech (in relative terms) may have undershot the appreciation in the currency. Chart 10Taiwan's Tech Underperformance Is Explained By Currency Appreciation Taiwan's Tech Underperformance Is Explained By Currency Appreciation Taiwan's Tech Underperformance Is Explained By Currency Appreciation Chart 11Taiwan Vs China: Oversold, And Cheaper Than Usual Taiwan Vs China: Oversold, And Cheaper Than Usual Taiwan Vs China: Oversold, And Cheaper Than Usual However, Taiwan's tech sector is mostly made up of the semiconductors & semiconductor equipment industry group, and there are signs that the growth rate in global semiconductor sales is in the process of peaking. Chart 12 illustrates the close correlation between the growth of global semi sales and Taiwan's absolute 12-month forward earnings per share, with the recent gap likely having occurred due to the currency impact noted above. The chart suggests that earnings expectations for Taiwan are highly unlikely to accelerate if semi sales growth slows, meaning that Taiwanese stocks, particularly the tech sector, currently lack a catalyst to re-rate. Chart12Taiwan Is Lacking A Re-Rating Catalyst Taiwan Is Lacking A Re-Rating Catalyst Taiwan Is Lacking A Re-Rating Catalyst From our perspective, a lasting depreciation in the currency appears to be the most likely catalyst for a re-rating, as it would increase the odds that the relationship shown in Chart 10 would durably recouple. Until then, any exogenous rebound in relative tech sector performance is likely to be met with a self-limiting TWD appreciation. Bottom Line: We recommend that investors, for now, stick with our existing long MSCI China / short Taiwan trade. However, a breakout in relative Taiwanese tech sector performance coupled with a weakening TWD would likely cause us to close the trade, and upgrade Taiwanese stocks to at least neutral within a greater China equity portfolio. Stay tuned. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Lin Xiang, Research Assistant linx@bcaresearch.com 1 Pease see China Investment Strategy Weekly Report "Taiwan's 'Trump' Risk", dated February 2, 2017, available at cis.bcaresearch.com. 2 We use MSCI's Golden Dragon index to represent Greater China, which includes China investable, Hong Kong, and Taiwanese stocks. Cyclical Investment Stance Equity Sector Recommendations

Highlights The stellar performance in metals over the past year resulted from a combination of favorable demand- and supply-side developments, propelled along, as always, by China's outsized effect on fundamentals. On the demand side, robust global growth is keeping metals consumption strong. On the supply side, environmental reforms in China and the shuttering of mills - as well as supply-side shocks in individual markets - continues to bolster prices. A weak U.S. dollar - which lost 6% of its value in broad trade-weighted terms - further supports these bullish conditions for metal markets. We expect China's winter supply cuts to dominate 1Q18 market fundamentals. As we move toward mid-year, we expect a soft and controlled slowdown in China, brought about by the Communist Party's goals of reducing industrial pollution and pivoting toward consumer-led growth. Although this will moderate demand from the world's top metal consumer, strong growth from the rest of the world will neutralize the impact of this slowdown. Energy: Overweight. Pipeline cracks in the critical Forties system in the North Sea highlight the unplanned-outage risk to oil prices we flagged in recent reports. We remain long Brent and WTI $55/bbl vs. $60/bbl call spreads in 2018, which are up an average of 47%, respectively, since they were recommended in September and October 2017. Base Metals: Neutral. Following a strong 1Q18, a moderate slowdown in China will be offset by growth in the rest of the world (see below). Precious Metals: Neutral. We continue to recommend gold as a strategic portfolio hedge, even though we expect as many as three additional Fed rate hikes next year. Ags/Softs: Underweight. The U.S. undersecretary for trade and foreign agricultural affairs warned farmers this week they "need to have a backup plan in the event the U.S. exits the North American Free Trade Agreement," in an interview with agriculture.com's Successful Farming. No specifics were offered. Canada and Mexico - the U.S.'s NAFTA partners - are expected to account for $21 billon and $19 billion of exports, respectively, based on USDA estimates for FY 2018. These exports largely offset imports of $22 billion and $23 billion, respectively, from both countries. The U.S. runs an ag trade surplus of ~ $23.5 billion annually. Feature Metals had another extraordinary year in 2017. The LME base metal index rallied more than 20% year-to-date (ytd) bringing the index up more than 50% since it bottomed in mid-January 2016 (Chart Of The Week). Chart of the WeekA Great Year For Metals A Great Year For Metals A Great Year For Metals Steel, zinc, copper, and aluminum led the gains. In fact, of the metals we track, iron ore is the only one in negative territory - having lost almost 8% ytd. Nonetheless, it has been on the uptrend recently - gaining ~ 24% since it bottomed at the end of October. Capacity reductions in China, where policymakers mandated inefficient and highly polluting mills and smelters in steel- and aluminum-producing provinces be taken offline, continue to affect the supply side in those metals most. As China churns out less of these commodities, competition for the more limited supply will pull prices for them higher. Nevertheless, a stronger USD - brought about by a more hawkish Fed - likely will cap significant upside gains, and prevent a repeat of this year's exceptional performance. Strong Global Demand Will Neutralize China Slowdown The Chinese economy is beginning to show signs of a slowdown. The Li Keqiang Index - a proxy for China's economic activity - has rolled over. Furthermore, the manufacturing PMI has plateaued following last year's rapid ascent (Chart 2). This deceleration is also evident in China's infrastructure data. Annual growth in infrastructure spending in the first three quarters of the year are below the four-year average. And, although spending grew 15.9% year-on-year (yoy) in the first 10 months of this year, the rate of growth is slower than the four-year average of 19.6% (Chart 3). Chart 2A China Slowdown Is In The Cards... A China Slowdown Is In The Cards... A China Slowdown Is In The Cards... Chart 3...Threatening A Pull Back In Metals Demand ...Threatening A Pull Back In Metals Demand ...Threatening A Pull Back In Metals Demand That said, it is important to point out that this is due to a significant decline in utilities spending growth, which accounts for ~ 20% of infrastructure investments. Investment in utilities grew a mere 2.3% in the first ten months of the year, in contrast with the average 15.7% yoy increase of the previous four years. In any case, the slowdown in China's reflation reflects President Xi Jinping's resolve to shift gears and emphasize quality over quantity in future growth strategies. Now that Xi has consolidated his power, we expect policymakers to build on the momentum from the National Communist Party Congress, and be more effective in implementing reforms going forward. As such, Beijing should be more willing to tolerate slower growth than it has in the past. Nonetheless, we do not anticipate a significant slowdown. More likely than not, policymakers will resort to fiscal stimulus if the economy is faced with notable risks. Consequently, a hard landing in China is not our base case scenario. In any case, strong global demand will neutralize a slowdown in China's metal consumption in 2018. Despite a deceleration in China, the IMF expects global growth to pick up in 2018 (Table 1). The Global PMI is at its highest level since early 2011, supported by strong readings in the Euro Area and the U.S. (Chart 4). In all likelihood, conditions for global metal demand will remain favorable in 2018. Table 1IMF Economic Forecasts China's Supply Cuts Will Tighten Metals In 1Q18; Global Demand Offsets 2H18 Slowdown In China China's Supply Cuts Will Tighten Metals In 1Q18; Global Demand Offsets 2H18 Slowdown In China Chart 4Strong Global Demand Will Neutralize##BR##Impact Of China Slowdown Strong Global Demand Will Neutralize Impact Of China Slowdown Strong Global Demand Will Neutralize Impact Of China Slowdown China Real Estate Will Slow; Major Downturn Not Expected Chart 5Slowing Real Estate Investment Is A Mild Risk Slowing Real Estate Investment Is A Mild Risk Slowing Real Estate Investment Is A Mild Risk We do not foresee significant risks to China's real estate market, which is the big driver of base-metals demand in that economy. Total real estate investment is up 7.8% in the first 10 months of the year - the strongest growth for the period since 2014 (Chart 5). Even so, it is important to note the slowdown in that sector. After growing 9% yoy in 1Q17, growth rates fell to 8% and 7% in 2Q and 3Q17, respectively. In fact, growth in October, the latest month for which data are available, came in at 5.6% yoy - significantly slower than the average monthly yoy rate of 8% in the first nine months of the year. The slowdown in floor-space-started is more pronounced. The area of floor space started grew 5% in the first 10 months of the year, down from an 8% expansion in the same period in 2016. October data showed a yoy as well as month-on-month contraction - 4.2% for the former, and 12.1% for the latter. This is the second yoy contraction in 2017, with July experiencing a 4.9% reduction in floor area started. Similarly, quarterly data shows a significant slowdown from almost 12% yoy growth rates registered in 4Q16 and 1Q17 to the mere 0.4% yoy growth in 3Q17. In addition, the growth rate in commodity building floor-space-under-construction has slowed down to 3.1% yoy in the first 10 months of 2017, down from almost 5% for the same period in the previous two years. Although the data are a reflection of Xi's resolve to tighten control of the real estate market, we do not expect a major downturn that will weigh on metal demand. As BCA Research's China Investment Strategy desk notes, strong demand in the real estate sector, coupled with declining inventories, will prevent a major slowdown in construction activity, even in face of tighter policies.1 A Stronger Dollar Moderates Upside Price Pressures In our modeling of the LME Base Metal Index, we find that currency movements are important determinants of the evolution of metals prices. More specifically, the U.S. dollar is inversely related to the LME base metal index. While U.S. inflation has remained stubbornly low, we expect inflation to start its ascent sometime before mid-2018, allowing the Fed to proceed with its rate-hiking cycle. Given our view that too few hikes are currently priced in for 2018, there remains some upside to the USD. Thus, while dollar weakness has been supportive for metal prices in 2017, a stronger dollar will be a headwind in 2018. A Look At The Fundamentals In terms of supply/demand dynamics in individual metal markets, idiosyncrasies in their current states, and variations in how China's environmental reforms manifest themselves will mean the different metals will follow different trajectories next year. Muted Consumption Mitigated Impact Of Supply Disruptions In Copper Copper production had a bumpy 2017, rocked by sporadic supply disruptions in some of the world's top mines.2 This led to a contraction in world refined production ex-China, which was offset by an increase in Chinese output (Chart 6). Although Chinese refined copper output grew a healthy 6% yoy in the first three quarters, this was nonetheless a slowdown from the 8% yoy expansion for the same period in 2016. Even so, increased Chinese copper production more than offset declines from other top producers. Refined copper production in the rest of the world contracted by 1.5% in the first three quarters, bringing world production growth to 1.3% - significantly slower than the average 2.6% yoy increase witnessed in the same period in the previous two years. The supply-side impact on the overall market was mitigated by a slowdown in consumption. Chinese consumption, which accounts for 50% of global refined copper demand, remained largely unchanged in the first three quarters of the year compared to last year. This follows a yoy increase of ~ 8% in Chinese demand vs. the same period in 2016. Demand from the rest of the world contracted by 0.6% yoy, down from a 2.5% yoy expansion in the same period last year. So, despite supply disruptions, the copper market remained balanced - registering a 20k MT surplus in the first three quarters of this year, following a 230k MT deficit in the same period in 2016. Recently, there is news of capacity cuts in Anhui province - where China's second-largest copper smelter will be eliminating 20 to 30% of its capacity during the winter.3 If the copper market is the next victim of China's environmental reforms, global balances may be pushed to a deficit. Although copper remains well stocked at the major warehouses, an adoption of these winter cuts by other copper producing provinces would weaken refined copper supply and support prices (Chart 7). Chart 6Copper Rallied On Back Of Supply-Side Fears Copper Rallied On Back Of Supply-Side Fears Copper Rallied On Back Of Supply-Side Fears Chart 7Copper Warehouses Are Well Stocked Copper Warehouses Are Well Stocked Copper Warehouses Are Well Stocked Steel Prices Will Remain Elevated Throughout Q1 China's steel sector has undergone significant reforms this year. In addition to the 100-150 mm MT of capacity cuts to be implemented between 2016 and 2020, Beijing has also eliminated steel produced by intermediate frequency furnaces (IFF).4 Even so, Chinese steel production - paradoxically - is at record highs. This comes down to the nature of IFFs, which are illegal and thus not reflected in official crude steel production data. However, growth in steel products - which reflect output from both official as well as illegal steel mills - has been flat (Chart 8). In addition, China's steel exports have come down significantly since last year, reflecting a domestic shortage in the steel industry. November data shows a 34% yoy contraction, and exports for the first 11 months of the year are down more than 30% from the same period last year. We expect Chinese steel production to remain anemic until the end of 1Q18, as mandated winter capacity cuts cap production in major steel-producing provinces. The near-term cutback in production will keep steel prices elevated. The spread between steel and iron ore prices during this period will remain wide as lower steel production translates into muted demand for the ore. This is also consistent with China's inventory data which shows that after falling since August, iron ore stocks have been building up since mid-October - in conjunction with the start of winter steel-capacity cuts. Indonesian Nickel Exports Bearish In Long Run, Not So Much In Near Term Ever since Indonesia's ban on nickel ore exports in 2014, worldwide production has been on the downtrend. In the previous two years, shrinking supply from China - which makes up about a quarter of global output - was the culprit of reduced world output, offsetting increases from the rest of the globe, and causing global production to contract by 0.2% and 0.5%, respectively (Chart 9). Chart 8Falling Exports And Flat Steel Products##BR##Output Reflect Closures In Steel Falling Exports And Flat Steel Products Output Reflect Closures In Steel Falling Exports And Flat Steel Products Output Reflect Closures In Steel Chart 9Deficit And Inventory##BR##Drawdowns Dominate Nickel... Deficit And Inventory Drawdowns Dominate Nickel... Deficit And Inventory Drawdowns Dominate Nickel... However, at 2.5%, the contraction in global output is significantly larger for the first three quarters of this year. What is noteworthy is that it is caused by shrinking production both from China - down ~ 7.5% - as well as from the rest of the world, where output is down ~ 1%. Nevertheless, a decline in demand from China - which accounts for almost half of global consumption - has softened the impact of withering production. Chinese demand for semi refined nickel shrunk 22% in the first three quarters of the year, more than offsetting the 9% growth in demand from the rest of the world. However, there has been a recovery in global demand since June. A 15% yoy growth in the third quarter from consumers ex-China drove a 5% yoy gain in global growth. Despite weak demand in 1H17, the nickel market recorded a deficit in the first three quarters of the year. In fact, nickel has been in deficit for the past two years. Going forward, Indonesia's gradual lifting of the export ban will prop up production. In fact, global yoy production growth has been in the green since June. However, while Indonesian ores are slowly returning to the global market, they remain a fraction of their pre-ban levels. Thus, prices will likely remain under upside pressure in the near term. Record Deficit And Significant Inventory Drawdowns Dominate Aluminum... Aluminum has been in deficit for the past three years. In fact, at 100k MT, the deficit in the first three quarters of 2017 is the largest on record for that period. This is reflected in LME inventory data which has been experiencing drawdowns since April 2014 - Falling from more than 5mm MT to ~ 1mm MT (Chart 10). Strong growth from Chinese producers - which account for more than half the world's primary production - kept global output growth strong, despite a decline from other top producers. However, falling Chinese production in August and September compounded the fall in output from the rest of the world, leading to a 3.5% yoy decline for those two months. In fact, September's Chinese output data marks the lowest production figure since February 2016. On the demand side, global consumption is up 6.2% yoy in the first seven months of 2017, reflecting a general uptrend in both Chinese consumption and, to a lesser extent, a greater appetite for the metal from the rest of the world. However, there has been some weakness from China recently. Chinese demand contracted by 2.9% and 9.6% yoy in August and September. While an 8.2% yoy increase in consumption from the rest of the world offset the August weakness from China, global demand shrunk by 5.8% in September. As with steel, supply-side reforms will dominate and keep aluminum prices elevated in the near term. ... Along With Zinc Demand Global zinc production has been more or less flat this year. The 2.7% decline from Chinese producers, which supply 46% of global zinc slab, was offset by a 2.4% increase in production from the rest of the world. On the demand side, although Chinese consumption - which accounts for almost half of global zinc slab demand - has been flat, strength from the rest of the world supported global demand, which is up 2.3% yoy for the first three quarters of the year (Chart 11). Chart 10...As Well As Aluminum... ...As Well As Aluminum... ...As Well As Aluminum... Chart 11...And Zinc ...And Zinc ...And Zinc Static supply coupled with increased demand has led the zinc market to a deficit of 500k MT - a record for the first three quarters of 2017. The deficit has continued to eat up zinc stocks, which have been in free-fall, since early 2013.   Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see BCA Research's China Investment Strategy Weekly Report titled "Chinese Real Estate: Which Way Will The Wind Blow?," dated September 28, 2017, available at cis.bcaresearch.com. 2 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "Copper's Getting Out Ahead Of Fundamentals, Correction Likely," dated August 24, 2017, available at ces.bcaresearch.com. 3 Please see "Chinese Copper Smelter Halts Capacity to Ease Winter Pollution," published on December 7, 2017, available at Bloomberg.com. 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "Slow-Down in China's Reflation Will Temper Steel, Iron Ore in 2018,' dated September 7, 2017, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades China's Supply Cuts Will Tighten Metals In 1Q18; Global Demand Offsets 2H18 Slowdown In China China's Supply Cuts Will Tighten Metals In 1Q18; Global Demand Offsets 2H18 Slowdown In China Commodity Prices and Plays Reference Table China's Supply Cuts Will Tighten Metals In 1Q18; Global Demand Offsets 2H18 Slowdown In China China's Supply Cuts Will Tighten Metals In 1Q18; Global Demand Offsets 2H18 Slowdown In China Trades Closed in 2017 Summary of Trades Closed in 2016

Overweight The Stockholm International Peace Research Institute (SIPRI) released data earlier this week showing that global arms sales (as measured by the revenues of the largest 100 defense companies) had arrested their 6-year long decline last year, rising by 1.9%. The key driver appears to be Lockheed Martin (LMT), which saw rising sales for the international F-35 program and also purchased helicopter producer Sikorsky, thus cementing its position as the number one defense firm. Importantly, 2016 saw arms sales for South Korean companies surge by 20.6% in response to the rising tensions on the Korean peninsula, both to meet domestic demand and for international exports. There are two implications from this statistic: first, rising South Korean arms production means overall demand is increasing and second, defense demand is becoming heterogeneous. In conjunction with growth in domestic armed forces (second panel), the demand environment for U.S. defense firms remains bright and while valuations are lofty on a P/E and P/CF basis, they are not out of line with the broad market measured by EV/EBITDA (third panel); stay overweight. The ticker symbols for the stocks in the BCA Defense index are: LMT, GD, RTN, NOC, LLL. Rising Global Threats Are A Boon To Defense Stocks Rising Global Threats Are A Boon To Defense Stocks

Highlights Yield Curve & Fed: The yield curve will not invert until inflation has first recovered to the Fed's target. This means that a period of curve steepening is likely, driven either by rising inflation or a more dovish Fed. Corporate Sectors: Expect less extra compensation from increasing the riskiness of corporate bond portfolios in 2018. The Energy, Communications, Basic Industry, Financial and Technology sectors offer the best risk-adjusted value. Economy & Inflation: All signs are that economic growth has accelerated in recent months. Decelerating consumer credit growth and rising consumer delinquency rates do not yet pose a risk to future spending. Feature Long-term interest rates have trended lower in recent months even as the Federal Reserve has raised the level of the target federal funds rate by 150 basis points. This development contrasts with most experience, which suggests that, other things being equal, increasing short-term interest rates are normally accompanied by a rise in longer-term yields. [...] The broadly anticipated behavior of world bond markets remains a conundrum. - Alan Greenspan, February 20051 By the end of the week the Fed will have raised interest rates by 125 basis points since December 2015, yet the 10-year Treasury yield has risen only 7 bps (Chart 1). But unlike in 2005, there is no bond conundrum. On the contrary, the reason for low long-maturity Treasury yields is easily understood. Chart 1What Conundrum? What Conundrum? What Conundrum? Quite simply, the Federal Reserve has been lifting interest rates in-line with its projections for rising inflation, but markets are trading off the fact that this inflation has yet to materialize. The compensation for inflation protection embedded in 10-year yields is only 1.88%. Historically, when core inflation is close to the Fed's 2% target, compensation for inflation protection has traded in a range between 2.4% and 2.5%. Essentially, Fed rate hikes have lifted short-maturity yields but low inflation is keeping long-maturity yields depressed. The result is that the 2/10 Treasury slope has flattened all the way down to 58 bps from 128 bps in December 2015 (Chart 1, bottom panel). What should be clear is that the current paths of inflation and the yield curve are unsustainable. If the Fed continues to hike rates but inflation fails to rise, then the yield curve will invert in the coming months - a signal that bond investors anticipate a recession - and the Fed will have not achieved its inflation target. Such an obvious policy error will not be permitted to occur, which leaves us with three possible outcomes for Fed policy and the Treasury curve during the next six months. 1) The Fed Is Right In this scenario inflation starts to rebound in the coming months, pushing the compensation for inflation protection embedded in long-dated bond yields higher (Chart 2). This would certainly cause long-maturity nominal yields to increase and would probably impart a steepening bias to the yield curve, depending on how quickly the Fed lifts rates.2 BCA's Outlook for 2018 makes the case for why inflation is likely to bottom in the coming months, and we view the "Fed is Right" scenario as the most likely outcome.3 Chart 2Fed Expects Higher Inflation Fed Expects Higher Inflation Fed Expects Higher Inflation 2) The Fed Is Proactive In this scenario the Fed recognizes there is a risk of tightening the yield curve into inversion - and the economy into recession - if inflation stays low. It therefore proactively adopts a more dovish policy stance to prevent the yield curve from inverting. The likely first step would be signaling a slower pace of rate hikes in this week's Summary of Economic Projections. The yield curve would also steepen in this scenario, but this time a bull-steepening where short-maturity yields fall more than long-maturity yields. At least one FOMC member already seems worried enough to take this sort of action. St. Louis Fed President James Bullard said two weeks ago that: "Given below-target U.S. inflation, it is unnecessary to push normalization to such an extent that the yield curve inverts".4 But other policymakers are less concerned. Cleveland Fed President Loretta Mester downplayed the flat yield curve in a recent interview.5 We view this outcome as the least likely of our three scenarios. With economic growth accelerating (see Economy & Inflation section below), the Fed will likely cling to its forecast that inflation will move higher. If inflation fails to respond, then risky assets will eventually sell off. This brings us to the final scenario. 3) The Fed Is Reactive The Fed does not have a strong track record of proactively responding to low inflation readings, but it does have a strong track record of reacting to tighter financial conditions and risk off periods in equities and credit markets. What's more, if the yield curve continues to flatten, then we are very likely to see credit spreads widen and equities sell off quite soon. At that point the Fed would almost certainly respond by signaling a slower pace of rate hikes. That would steepen the curve and ease the pressure on risky assets. We view this third scenario as more likely than the one where the Fed is proactive. In fact, we observe that the yield curve is already flat enough that the chances of a sell-off in High-Yield corporate bonds relative to Treasuries are high. Using monthly data going back to 1988, we see that a flatter 2/10 Treasury slope is consistent with lower monthly excess returns from High-Yield (Chart 3). We also see that a flatter yield curve is consistent with more frequent risk-off periods (Chart 4). Chart 3Junk Monthly Excess Returns & ##br##Yield Curve (1988-Present) Proactive, Reactive Or Right? Proactive, Reactive Or Right? Chart 4% Of Months With Negative High-Yield ##br##Excess Returns (1988- Present) Proactive, Reactive Or Right? Proactive, Reactive Or Right? This makes sense intuitively. An inverted yield curve is a well-known recession indicator. This means that when the yield curve is very flat investors are obviously nervous that any new piece of bad news could tip the curve into inversion and signal an end to the economic recovery. In other words, a risk-off episode in junk bonds, like the one witnessed in early November, would be less likely to occur if the yield curve were steeper.6 We would recommend buying the dips on any near-term correction in junk bonds, because the Fed would then be forced to get more dovish and support the credit markets. But unless inflation returns and steepens the Treasury curve from current levels, the risk of just such an episode is high. Corporate Sector Year-In-Review With 2017 nearly in the books, this week we take a quick look back at the performance of the 10 main investment grade corporate bond sectors during the year. Chart 5 shows the excess return for each sector relative to its duration-times-spread (DTS) from the beginning of the year. DTS is a common measure of risk for corporate bonds, and can be thought of much like an equity's beta. When the overall corporate bond market is rallying, then high-DTS sectors tend to perform better. Conversely, when corporate bonds underperform Treasuries, then high-DTS sectors tend to lose more than the low-DTS alternatives. As can be seen in Chart 5, given that 2017 was a risk-on year, high-DTS sectors tended to outperform low-DTS sectors with a few exceptions. The Basic Industry sector and Financials performed much better than their DTS alone would have predicted, while the Communications sector performed much worse than its DTS would have predicted. Looking ahead into 2018, we make the following observations: Excess returns for investment grade corporate bonds are likely to be lower in 2018 than in 2017.7 In turn, this means that the Credit Risk Premium - the extra return earned for taking an additional unit of DTS risk - will also be lower. We calculated the Credit Risk Premium for each year since 2000 by performing a regression of annual excess returns for each of the 10 major sectors versus their beginning-of-year DTS. The beta from that regression represents the additional return earned that year from taking an extra unit of DTS risk. Chart 6 shows that this Credit Risk Premium is an increasing function of excess returns for the overall corporate sector. Logically, if the year ahead is likely to deliver lower excess returns for the overall index, then we should also expect less additional return from increasing the DTS risk of our corporate bond portfolios. Chart 52017 Corporate Sectors ##br##Excess Returns* Vs DTS** Proactive, Reactive Or Right? Proactive, Reactive Or Right? Chart 6Excess Returns* Vs ##br##Credit Risk Premium Proactive, Reactive Or Right? Proactive, Reactive Or Right? Second, we use our corporate sector model - a model that adjusts each sector's spread by its average credit rating and duration - to identify sectors that have the potential to outperform their DTS in the coming months. This model is updated each month in our Portfolio Allocation Summary.8 The most recent update shows that the high-DTS Energy, Basic Industry and Communications sectors are all attractively valued. The most attractive low-DTS sectors are Financials and Technology (Chart 7). Chart 7Risk-Adjusted Value In Corporate Sectors* Proactive, Reactive Or Right? Proactive, Reactive Or Right? Bottom Line: Expect less extra compensation from increasing the riskiness of corporate bond portfolios in 2018. The Energy, Communications, Basic Industry, Financial and Technology sectors offer the best risk-adjusted value. Economy & Inflation Does Consumer Credit Growth Put The Recovery At Risk? Last week's employment report showed a sharp increase in aggregate hours worked and suggests that U.S. economic growth has indeed shifted into a higher gear. We use a combination of year-over-year growth in aggregate hours worked and average quarterly productivity growth since 2012 to get a rough tracking estimate for U.S. real GDP growth. After last Friday's report this proxy is up to a healthy 3.1% (Chart 8). Last Friday's Consumer Sentiment data also suggest that consumer spending, the largest component of U.S. GDP, will stay firm in the coming months (Chart 9). While consumer credit growth has started to slow (Chart 9, panel 2) and consumer delinquencies are starting to rise (Chart 9, bottom panel), we are not yet inclined to view those trends as risks to the economic recovery. Chart 8Growth Tracking Well Above Trend Growth Tracking Well Above Trend Growth Tracking Well Above Trend Chart 9Credit Growth Falling & Delinquencies Rising Credit Growth Falling & Delinquencies Rising Credit Growth Falling & Delinquencies Rising First, notice that prior to the onset of recession, consumer spending growth tends to decline while consumer credit growth accelerates. It is only well after the recession begins that consumer credit growth follows spending growth lower. This chain of events is highly logical. In the late stages of the recovery households first start to see their incomes decline and then turn to credit to support their spending needs. Eventually, banks make consumer credit less available and consumer credit growth also decelerates, but we are already well into the recession by then. Chart 10Bank Lending Standards Bank Lending Standards Bank Lending Standards In fact, judging by the patterns observed in the lead up to the last two recessions, the warning sign for the economic recovery would be if consumer credit growth is rising while consumer spending growth is falling. So far this pattern has not been observed. Potentially more troubling is the increase in the consumer credit delinquency rate. Delinquencies do tend to rise prior to the onset of recession, although at the moment delinquencies are rising off an extremely low base. It is possible that after having kept lending standards very stringent for several years after the Great Recession, an uptick in delinquencies off historically low levels simply reflects a return to "business-as-usual" for banks. In fact, the Federal Reserve's Senior Loan Officer Survey showed a large tightening of consumer lending standards during the crisis, but then a moderate easing from 2010 until quite recently (Chart 10). Further, the most recent Senior Loan Officer Survey showed an increase in banks' willingness to extend consumer installment loans. Historically, this has been associated with falling consumer delinquency rates (Chart 10, bottom panel). Bottom Line: All signs are that economic growth has accelerated in recent months. Decelerating consumer credit growth and rising consumer delinquency rates do not yet pose a risk to future spending. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 https://www.federalreserve.gov/boarddocs/hh/2005/february/testimony.htm 2 For a look at what different combinations of Fed rate hikes and long-maturity yields mean for the slope of the yield curve please see U.S. Bond Strategy Special Report, "2018 Key Views: Implications For U.S. Fixed Income", dated November 28, 2017, available at usbs.bcaresearch.com 3 Please see BCA Special Report, "Outlook 2018: Policy And The Markets: On A Collision Course", dated November 20, 2017, available at www.bcaresearch.com 4 https://www.stlouisfed.org/from-the-president/speeches-and-presentations/2017/assessing-yield-curve 5 https://www.bloomberg.com/news/articles/2017-12-01/fed-s-mester-shrugs-off-flattening-yield-curve-in-call-for-hikes 6 Please see U.S. Bond Strategy Special Report, "Junk Bond Jitters", dated November 21, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Special Report, "2018 Key Views: Implications For U.S. Fixed Income", dated November 28, 2017, available at usbs.bcaresearch.com 8 For the most recent update please see U.S. Bond Strategy Portfolio Allocation Summary, "A Higher Gear", dated December 5, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

With the Senate Republicans passing their version of the bill on December 2, the odds that a final version of the bill will pass into law are now very high, though investors remain skeptical that there will be any stimulative economic effect from tax cuts. While we admit that the direct effect on the economy will be moderate, tax cuts have the potential to sustain the healthy sector rotation and supercharge the ongoing capex cycle. The bulk of the media's analysis to date of the impact of the impending tax reform has been focused on the reduction of the corporate tax rate and the repatriation of foreign earnings. While those are obviously critical, we think more attention should be paid to the provision allowing the immediate expensing of capital investment. Our analysis suggests that the impact of bringing forward the tax shield could, at the margin, change spending behavior for firms and drive the next up-leg for the capex cycle in 2018. We expect S&P industrials (overweight) to be the greatest beneficiary from the ongoing capex boom, considering the tight correlation between capital goods orders and EPS growth (second and third panels), followed by S&P financials (overweight) via a step function higher in loan growth to finance the outsized demand for capital. Please see this week's Special Report for more details. Tax Cuts Are Here: Equity Sector Implications Tax Cuts Are Here: Equity Sector Implications

Highlights The House and Senate have passed similar tax cut bills; passage of a compromise version seems all but certain; Combined with the Trump administration's de-regulation efforts, fundamentals point ever higher for U.S. earnings; The under-reported change, in both versions of the bill, to the expensing of capital investments could have far-reaching implications; All of these support the ongoing healthy sector rotation; The lion's share of upside from the capex upcycle should go to industrials, followed closely by financials. Feature Chart 1Republicans Are Not Fiscally Responsible Republicans Are Not Fiscally Responsible Republicans Are Not Fiscally Responsible BCA's Geopolitical Strategy has maintained a high-conviction view since November 9, 2016 that Congress would pass budget-busting tax cuts.1 With the Senate Republicans passing their version of the bill on December 2, the odds that a final version of the bill will pass into law are now very high. What should investors expect from the new tax legislation? Much as our geopolitical team faced considerable resistance to their political forecast, investors are now skeptical that there will be any stimulative economic effect from tax cuts. While we admit that the direct effect on the economy will be moderate, tax cuts have the potential to sustain the healthy sector rotation and supercharge the ongoing capex cycle. In this Special Report, we explain why. Why Did We Get Tax Cuts Right? What did our geopolitical team get right about tax cuts? First, in November 2016, right after the election, we reminded clients that the Republican Party has a spotty record on fiscal conservativism. There is no empirical evidence that GOP policymakers are actually fiscally conservative (Chart 1), nor that Republican voters have a stable preference for fiscally conservative policies (Chart 2). As such, there was not going to be a popular revolt against tax cuts. Second, in April 2017, we saw that Obamacare repeal's failure actually increased the probability of tax cuts passing. Put simply, tax cuts are about motivating the Republican base to come out and vote in the upcoming midterms, not about satisfying the median American voter. Polling currently suggests that Republicans face an uphill battle to retain majority in the House of Representatives (Chart 3). Should investors fear that the ongoing Mueller investigation will scuttle tax cuts? The short answer is no. First, former National Security Adviser Michael Flynn lied to the FBI and has been charged with that offense, but what he did for the Trump administration in the interim between the election and the inauguration is likely not illegal. Chart 2Republican Desire For Smaller Government Wanes When In Power Republican Desire For Smaller Government Wanes When In Power Republican Desire For Smaller Government Wanes When In Power Chart 3Republicans Losing Popular Support Republicans Losing Popular Support Republicans Losing Popular Support Second, White House scandals and intrigue have rarely mattered to the market. Chart 4A and Chart 4B show that both the Tea Pot Dome scandal (the greatest in U.S. history at the time) and the Lewinsky affair occurred amidst the two greatest bull markets. While the Watergate scandal appears to have shaken the markets, it also escalated simultaneously with the historic 1973 oil shock and the onset of the 1973-75 recession. Besides, why would investors turn negative on the S&P 500 if President Trump - a highly unorthodox, unpredictable, and impulsive politician - looked to be replaced by Vice President Mike Pence? Earnings fundamentals drive the market, not political intrigue. Thus, we would fade impeachment risk and stick to getting the fundamentals right. Chart 4AMassive Bull Markets... Massive Bull Markets... Massive Bull Markets... Chart 4B...Attended Massive Scandals ...Attended Massive Scandals ...Attended Massive Scandals What about upside potential? Is there any left now that the market has begun to fully price in tax cuts, or will it be a reason to sell and crystalize profits? It is difficult to say, but our sense is that the healthy rotation out of tech (U.S. Equity Strategy is underweight) and into financials (overweight) and industrials (overweight) will gain steam. Also high-effective-tax-rate stocks and mostly domestically focused small caps have likely turned the corner (Chart 5), and the "Fed Spread" (2-year yield minus the fed funds rate) continues to point toward brisk economic growth in coming quarters (Chart 6). While the S&P 500 is up 18% year-to-date, synchronized global economic growth and robust earnings explain half the rise, the other half is forward multiple expansion. Were a 5%-10% pullback to materialize after all the tax-related dust settled, we would deem it a healthy development and a reset that would propel equities higher on the back of firm EPS growth next year. Furthermore, the market has cheered Trump's de-regulation drive, which, unlike tax cuts, has been concrete policy from day one of his administration (Chart 7). Chart 5Market Has Doubted Tax Reform Market Has Doubted Tax Reform Market Has Doubted Tax Reform Chart 6Growth Prospects Still Good Growth Prospects Still Good Growth Prospects Still Good Chart 7Market Has Cheered De-Regulation Market Has Cheered De-Regulation Market Has Cheered De-Regulation De-regulation is likely to continue in parallel with lower taxes. For example, in a potentially huge blow to the enforcement powers of the federal bureaucracy, Trump's Justice Department has switched sides in a lawsuit that may shortly come before the Supreme Court (Lucia v Securities and Exchange Commission). The DOJ is now backing the plaintiffs instead of supporting the SEC as the Obama administration had. If the plaintiffs win their argument that the SEC's "administrative law judges" were unconstitutionally appointed by bureaucrats (instead of by the president, the courts, or the head of an executive department), then all of the prior decisions and penalties enforced by these judges (and their peers in other bureaucracies) may be legally invalidated, weakening the enforcement mechanisms of the federal bureaucracy.2 Bottom Line: Tax cuts are coming while the deregulation drive is set to continue. Both are bullish for the market from a cyclical time perspective. What about the economy and equity-sector-specific winners? To this question we now turn. Lighting The Afterburners On The Capex Cycle With the eye-popping numbers involved, it is no surprise that the media's analysis to date of the impact of the impending tax reform has been focused on the reduction of the corporate tax rate and the repatriation of foreign earnings. However, the impact of those headline-grabbing reforms on changing consumption behavior and, as a result, delivering real economic growth remains hotly debated. We think more attention should be paid to the provision in the versions from both chambers of Congress allowing the immediate expensing of capital investment. Unlike the reductions in tax rate (Table 1), U.S. firms only benefit from this change when they deploy capital on qualified property and equipment at home, an unambiguously stimulative change. Table 1Sector Tax Rates And Pro Forma EPS Changes From Tax Reform Tax Cuts Are Here - Equity Sector Implications Tax Cuts Are Here - Equity Sector Implications We believe most market observers have overlooked this reform as it is simply a "time value of money" shift. The IRS already allows significantly accelerated depreciation of capex (please see the Appendix on page 12 for more detailed information); this reform merely brings it forward. Our analysis suggests that the impact of bringing it forward could, at the margin, change spending behavior for firms and drive the next up-leg for the capex cycle in 2018. In our analysis, we use the example of a railroad. The current tax code allows the firm to depreciate the cost of a locomotive over 7 years, roughly the average for all assets under the depreciation schedule published by the IRS. This already incents the firm to deploy capex aggressively because fleet ages are well in excess of 7 years. Further, as long as the asset is new and to be used in the U.S., the company can depreciate a bonus 40% in the first year.3 Assume this railroad is paying the new marginal tax rate in the U.S. of 20% and has the same cost of capital as the U.S. government, approximating 2.4%. If the railroad purchases a locomotive for $10,000, the current regime offers a present value tax benefit of $1,919 (Table 2). The proposed tax reform allows the railroad to collect that benefit immediately (at least for the next 5 years), yielding a present value 4.2% greater than the current regime. Using an estimate of the S&P 500's weighted average cost of capital (8.5%) as a discount rate (an obviously more realistic scenario), and this advantage climbs to 14.2% (Table 3). Table 2Tax Shield Implications Are Modest With A Low Discount Rate... Tax Cuts Are Here - Equity Sector Implications Tax Cuts Are Here - Equity Sector Implications Table 3...But Grow Substantially As Discount Rates Rise Tax Cuts Are Here - Equity Sector Implications Tax Cuts Are Here - Equity Sector Implications In theory, any profit maximizing firm should alter their capital budgets such that returns are adjusted to incorporate a significantly higher tax shield. We, thus, expect tax reform to drive significant new order growth in the near term as foreseeable capex is pulled forward. A case could be made that this reform changes the math sufficiently that U.S. firms will add capacity that is incremental to existing plans, hinging on a positive feedback loop from the new order growth the pull-forward effect noted above. Who Wins? While our cyclical view of an ongoing EPS upcycle morphing into a virtuous broad-based capex upcycle remains intact (Chart 8)4, there are two sectors that will almost immediately benefit from the tax bill getting signed into law. The greatest, and perhaps most obvious, beneficiary of any capital largesse that will follow this reform will be S&P industrials (overweight) as the principal destination for increases in capital deployment. We expect higher capex to lead to higher sales growth courtesy of firm end-demand and high operating leverage, flow-through to the bottom line, which boosts EPS and sustains the virtuous upcycle. True, wage growth would also get a bump mildly denting profit margins. However, at this stage of the business cycle and given accelerating pricing power (Chart 9), capital goods producers will likely succeed in passing through wage inflation. S&P financials (overweight) too should be significant beneficiaries via a step function higher in loan growth to finance the outsized demand for capital and generalized lift in animal spirits (Chart 10), though they have a partial offset arising from the reduction in value of their net operating loss (NOL) tax assets. A sustained push for more bank deregulation, along with shareholder-friendly activities will also boost the allure of financials equities. Chart 8Earnings Are The Critical Capex Driver Earnings Are The Critical Capex Driver Earnings Are The Critical Capex Driver Chart 9Capex Upcycles Drive Industrial EPS... Capex Upcycles Drive Industrial EPS... Capex Upcycles Drive Industrial EPS... Chart 10...And Boost Loan Demand ...And Boost Loan Demand ...And Boost Loan Demand Bottom Line: S&P industrials and financials sectors get an early Christmas present in the form of demand-enhancing tax reform, combined with corporate tax cuts that allow them to keep their profits. The result should be outstanding EPS growth and rising stock prices. The S&P industrials and financials sectors remain core portfolio overweights. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Chris Bowes, Associate Editor U.S. Equity Strategy chrisb@bcaresearch.com Anastasios Avgeriou, Vice President U.S. Equity Strategy & anastasios@bcaresearch.com 1 Please see BCA Geopolitical Strategy, "U.S. Election: Outcomes & Investment Implications," dated November 9, 2016, and "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 We thank our colleague Matt Conlan, of BCA's Energy Sector Strategy, for the tip on this crucial court case. 3 First year depreciation is set to step down to 40% from 50% in 2018, according to the phasing out of the bonus depreciation under the 2015 PATH Act. 4 Please see BCA U.S. Equity Strategy, "Top 5 Reasons To Favor Cyclicals Over Defensives," dated October 16, 2017, and "Later Cycle Dynamics," dated October 23, 2017, available at uses.bcaresearch.com. Appendix: Why Does Accelerated Depreciation Matter? Accelerated depreciation is a tax incentive for firms to invest in capital assets. In essence, the IRS provides depreciable lives of assets that are shorter than useful lives, allowing firms to gain the tax benefit of the depreciation expense earlier in the asset's life. Assuming tax reforms are passed as currently written, firms will be able to deduct 100% of the capital cost of new equipment in the first year. Using our railroad example from earlier in this report, the capital cost was $10,000 and, with a tax rate of 20%, the tax shield is thus $2,000. Continuing with that example, imagine the locomotive has an estimated useful life of 10 years. In the absence of any accelerated depreciation (including that which is already on the books), the tax shield would be roughly half of what accelerated depreciation allows (Table 4). Note that the gross tax benefit is unchanged, it is merely shifted from the future to the present. Table 4Straight Line Depreciation Halves Tax Shield Tax Cuts Are Here - Equity Sector Implications Tax Cuts Are Here - Equity Sector Implications

We downgraded the S&P homebuilders index to underweight last week, owing to three factors: higher interest rates on the back of a pickup in inflation expectations, the threat to mortgage deductibility in pending tax reform and sky-high lumber prices. Weak earnings from Toll Brothers (TOL, not a member of the index but still a proxy) suggest that our move was well-timed as the index has fallen since hitting its 10-year peak last Monday. The first two of our reasons for downgrading homebuilders were because of a darkened affordability outlook. A red-hot economy should stoke inflation expectations, which our bond strategists anticipate will take the 10-year Treasury yield and mortgage rates higher (second panel). Further, the House version of the pending tax plan includes a reduction in deductibility of mortgage interest to the first $500,000 of the loan. Both of these point to ever-decreasing new home demand; TOL announced their slowest order growth since early-2015. Similarly, the S&P homebuilding index's new orders and the NAHB sales expectations survey have clearly rolled over (third panel). At the same time as top lines look under threat, still elevated lumber prices (bottom panel) appear to be biting into margins. In its earnings call, TOL pointed to declining gross margins next year, implying industry pricing power is insufficient to pass through rising costs. Sector EPS should be trending downward as a result; we reiterate our recent downgrade to underweight. The ticker symbols for the stocks in this index are: BLBG: S5HOME-DHI, LEN, PHM, LEN / B. S&P Homebuilding S&P Homebuilding

Highlights The growth momentum of China's recent mini-cycle has peaked, but the ongoing slowdown is likely to continue to remain benign in nature. A return to 2015-like conditions is not the most likely outcome over the coming year. Chinese policymakers are likely to increase their focus on reform efforts next year, but the pace will have to be modulated to avoid a repeat of the significant slowdown that occurred in 2014/2015. The risk of a policy mistake is a key theme to watch for 2018. Chinese ex-tech stocks have room to re-rate next year in a benign slowdown scenario. Investors should stay overweight Chinese investable equities vs EM and global stocks. Feature BCA recently published its special year end Outlook report for 2018,1 which described the macro themes that are likely to drive global financial markets over the coming year. In this week's China Investment Strategy report we expand on the Outlook, by reviewing our three key themes for China over the coming year. Key Theme # 1: A Benign End To China's Recent Mini-Cycle We presented our case that the cyclical slowdown of the Chinese economy will likely be benign in our October 12 Weekly Report. Chart 1 presents a stylized view of the Chinese economy over the past three years that was published in that report, which illustrated our framework of how cyclical growth conditions have evolved over this "mini-cycle". It also highlighted three possible scenarios for the coming 6-12 months, and noted that our bet was on scenario 2: A re-acceleration of the economy and a continuation of the V-shaped rebound profile A benign, controlled deceleration and settling of growth into the "stable" growth range, and An uncontrolled and sharp deceleration in the economy that threatens a return to the conditions that prevailed in early-2015 (or worse) Chart 1A Stylized View Of China's Recent "Mini-Cycle" Three Themes For China In The Coming Year Three Themes For China In The Coming Year Since we presented this framework, incoming evidence has been consistent with our call. Chart 2 shows that the Li Keqiang index has now decisively rolled over, but that economic conditions remain well away from their mid-2015 lows. We sketched out the basis for our benign slowdown view in our October 12 piece, but we followed up more formally in a two-part report that addressed the main factors arguing against a return to 2015-like conditions.2 Our view is grounded in the perspective that economic conditions in 2015 were not "normal", and we showed in these reports how a sharp slowdown in the economy was caused by an extremely weak external demand environment and overly tight monetary policy. On the trade front, Chart 3 highlights how Chinese export growth is likely to moderate over the coming several months, which argues against the re-acceleration scenario described above. Since mid-2011, Chinese export growth has lagged what most economic indicators would have predicted, and we noted in part I of our 2015 vs today comparison that this can be traced largely to two factors: a decline in global import intensity and, to a lesser extent, a decline in China's export "market share". Chart 2An Economic Slowdown In China##br## Is Now Underway An Economic Slowdown In China Is Now Underway An Economic Slowdown In China Is Now Underway Chart 3Chinese Export Growth Likely To##br## Converge To Global IP Growth Chinese Export Growth Likely To Converge To Global IP Growth Chinese Export Growth Likely To Converge To Global IP Growth Our analysis in that report suggested that China's 2018 export growth will converge to that of global industrial production, which implies a modest deceleration in the months ahead. Still, export growth of +4% would be a far cry from the significant contraction of exports that occurred in late-2015 / early-2016, which is consistent with a benign growth slowdown. On the monetary policy front, we showed how a monetary conditions approach captured the tightness of China's policy stance from 2012 to early-2015, which led to a material decline in China's industrial sector (Chart 4). Our Special Report last week further supported the view that monetary conditions matter enormously for China's economy; out of 40 macro data series that we tested to reliably predict the Chinese business cycle, only measures of money & credit passed our criteria.3 An aggregate indicator of these 6 series has a similar profile to the Bloomberg Monetary Conditions Index that we have shown in the past (Chart 4, panel 2), and neither suggests that a sharp further slowdown in China's economy is imminent. We will be watching these indicators closely in 2018 for signs of a more aggressive decline than we currently expect. Recently, some investors have pointed to a sharp rise in China's corporate bond yields as a sign that the monetary policy stance is, in fact, tighter than a standard monetary conditions approach would imply. Indeed, China's 5-year AA corporate bond yield has risen 230 bps since late-October 2016, from 3.6% to 5.9%, with most of this rise having occurred due to a rise in government bond yields. Corporate bond spreads have also risen, but relative to spreads on similarly-rated U.S. credit, the rise appears to reflect a rebound from extremely low levels late last year and is not (yet) symptomatic of major concerns over defaults (Chart 5). Chart 4The Ongoing Slowdown Is Likely ##br##To Be Benign The Ongoing Slowdown Is Likely To Be Benign The Ongoing Slowdown Is Likely To Be Benign Chart 5China's Corporate Bond Spreads ##br##Do Not Yet Look Onerous China's Corporate Bond Spreads Do Not Yet Look Onerous China's Corporate Bond Spreads Do Not Yet Look Onerous We are not complacent of the potential risk posed by rising corporate bond yields, and a further significant rise in 2018 could change our view that a benign economic slowdown is the most likely outcome. But for now, the fact that the stock of corporate bond issuance accounts for only 10% of ex-equity social financing suggests that the rise in yields this year is not likely to have an outsized impact on the economy in 2018, beyond the impact that monetary tightening has had on overall average interest rates (which, for now, is material but has not returned rates back to their 2015 levels). Chart 6The Rise In CPI Will Likely Soon Peak The Rise In CPI Will Likely Soon Peak The Rise In CPI Will Likely Soon Peak Finally, the 85 bps rise in Chinese core consumer price inflation that has occurred over the past year has also fed investor concerns that monetary policy will become even tighter next year. To us, this risk is probably overblown, given that demand-driven inflation lags growth (which has clearly peaked). Chart 6 shows the year-over-year change in Chinese core CPI vs that of the Li Keqiang index, and clearly suggests that the acceleration in core prices is likely to soon abate. Poor communication from the PBOC means that it is not clear how prominently core inflation features into the central bank's reaction function, but given that tighter monetary conditions have already caused a peak in both house prices and growth momentum, we doubt that policymakers will see the recent rise in consumer prices as a basis to aggressively tighten further. Bottom Line: The growth momentum of China's recent mini-cycle has peaked, but a return to 2015-like conditions is not the most likely outcome over the coming year. Key Theme # 2: Monitoring The Pace Of Renewed Structural Reforms We have written several reports concerning China's 19th Communist Party Congress over the past three months, both in the lead-up to the event and as a post-mortem.4 The Congress was significant because it likely heralds stepped-up reform efforts in 2018 and beyond. By "reforms", our Geopolitical Strategy team specifically means deleveraging in the financial sector accompanied by a more intense anti-corruption campaign focused on the shadow-banking sector, as well as ongoing restructuring in the industrial sector. Table 1 presents our geopolitical team's assessment of the likely reform scenarios and probabilities over the coming year. It should be clearly noted that the "reform reboot" scenario as described in Table 1 is likely negative for emerging market equities and other plays on China's industrial sector (such as industrial metals). Table 1Post-Party Congress Scenarios And Probabilities Three Themes For China In The Coming Year Three Themes For China In The Coming Year We agree that the "status quo" scenario of no significant reforms is highly unlikely given that President Xi has succeeded in amassing tremendous political capital and that he has an agenda for reform. But the intensity of reforms pursued over the coming year will have to be closely monitored by policymakers, to avoid a repeat of the significant slowdown that occurred in 2014/2015. As such, the view of BCA's China Investment Strategy service is that the reform efforts over the coming year will be structured at a pace that is sufficient to avoid a meaningful deceleration in China's industrial sector and is conducive to the outperformance of Chinese ex-technology stocks. However, the potential for a brisk pace of reforms to cause a more acute decline in industrial activity in 2018 is a risk to our view that China's ongoing economic slowdown is likely to be benign and controlled. We presented our framework for monitoring this risk in our November 16 Weekly Report,5 specifically our BCA China Reform Monitor (Chart 7). The monitor is calculated as an equally-weighted average of four "winner" sectors that outperformed the investable benchmark in the month following the Party Congress relative to an equally-weighted average of the remaining seven sectors. Significant underperformance of "loser" sectors could become a headwind for broad MSCI China outperformance (especially ex-tech), and we will be watching in 2018 for signs that our monitor is rising largely due to outright declines in the denominator. Chart 7Our Reform Monitor Will Help Us Judge ##br##Whether The Pace Of Reforms Becomes Too Burdensome Our Reform Monitor Will Help Us Judge Whether The Pace Of Reforms Becomes Too Burdensome Our Reform Monitor Will Help Us Judge Whether The Pace Of Reforms Becomes Too Burdensome For now, there is no indication that reform risk is affecting the performance of the MSCI China index. Panel 2 of Chart 7 highlights that recent movements in our Reform Monitor have been driven by the "winner" sectors, with the recent selloff largely reflecting a modest correction in global technology stocks sparked by the passage of the U.S. Senate's tax reform plan.6 But we will be watching the monitor closely in 2018, and will adjust it as needed in reaction to additional reform announcements over the coming months. Finally, next year's reform announcements will be highly significant not just because of the "what", but also the "how". It is difficult to see how China's leadership can aggressively pare back heavy-polluting industry and deleverage the financial sector without destabilizing the economy in the near term, but their goal to significantly raise China's per capita GDP and escape the "middle income trap" over the long-term is equally nebulous. We have noted in previous reports that a country's income level is fundamentally determined by its productivity, which is in turn determined by the level and sophistication of its capital stock. Chart 8 shows a clear positive correlation between a country's per capita output, a measure of productivity, and its per capita capital stock. In general, industrialized countries enjoy much higher levels of per capita capital stock than developing economies, leading to much higher productivity, income, and living standards. Therefore, the process of industrialization is fundamentally a process of accumulation of capital stock through investment. As shown in Chart 9, despite some remarkable achievements, the productivity level of the average Chinese worker is still just a fraction of the level in more advanced countries. Conventional economics would suggest that if China wishes to keep progressing on the productivity and income ladder, that it should remain on the path of growing the capital stock through savings and investment. If, however, it abandons its current growth model and "rebalances" towards a consumption-driven one, the risk that the country will stagnate and fail to advance beyond the "middle income trap" looms large. Chart 8Productivity Is Positively Correlated ##br##With Capital Stock Three Themes For China In The Coming Year Three Themes For China In The Coming Year Chart 9China's Catchup Process ##br## Has A Lot Further To Run Three Themes For China In The Coming Year Three Themes For China In The Coming Year Chart 10 makes this point from a different perspective. At root, China's leadership is describing the desire to rapidly transition towards an economy with a much higher level of tertiary industry (services) as a share of GDP, but the U.S. experience suggests that this is a long process that is not investment-oriented. The chart shows the evolution of U.S. investment in private services excluding real estate as a share of total private fixed assets since 1947, when the U.S. had only a slightly higher level of real per capita GDP than China today. It has taken almost 70 years for the share of private services ex real estate to rise by 16 percentage points in the U.S., and it has yet to account for the majority of private fixed investment.7 Services activity/investment also typically requires a highly educated workforce as an input, and rate of China's post-secondary educational attainment appears to be too low to fit the bill (Chart 11). In short, crucial details about China's reform plan should hopefully emerge in 2018, which are likely to have both near-term and multi-year implications. Bottom Line: Chinese policymakers are likely to increase their focus on reform efforts next year, but the pace will have to be modulated to avoid a repeat of the significant slowdown that occurred in 2014/2015. The risk of a policy mistake is a key theme to watch for 2018. Chart 10China Cannot Easily Replace 'Hard' Investment China Cannot Easily Replace 'Hard' Investment China Cannot Easily Replace 'Hard' Investment Chart 11China's Workforce Is Not Well Equipped To Transition To Services Three Themes For China In The Coming Year Three Themes For China In The Coming Year Key Theme # 3: The Relative Re-Rating Of Chinese Investable Ex-Tech Stocks Over the past several years, this publication argued strongly that the valuation discount applied to Chinese equities was unjustified. For the investable benchmark, the past two years of material outperformance vs emerging market and global stocks has removed a significant portion of this discount, and we noted in our August 31 Weekly Report that Chinese equities are no longer "exceptionally cheap".8 However, a good portion of this revaluation has been isolated to the tech sector. Chart 12 shows that while the 12-month forward P/E ratio for Chinese tech stocks is 70% higher than the global average, ex-tech shares still trade at a 37% relative discount. Chart 13 echoes this conclusion by showing the ex-tech price-to-book ratio for every country in MSCI's All Country World index; by this metric China's ex-tech cheapness currently ranks in the 85th percentile, behind only Israel, Colombia, Italy, Jordan, Korea, Russia, and Greece. Chart 12China: Expensive Tech, Extremely Cheap Ex-Tech China: Expensive Tech, Extremely Cheap Ex-Tech China: Expensive Tech, Extremely Cheap Ex-Tech Chart 13China's Ex-Tech P/B Ratio Among The Lowest In The World Three Themes For China In The Coming Year Three Themes For China In The Coming Year Charts 12 and 13 are weighted simply by the remaining market capitalization in each country's market after excluding the technology sector, meaning that the deep discount applied to Chinese banks wields a disproportionate influence (financials would make up 40% of China's MSCI ex-tech "index", if one officially existed). Although we agree that the magnitude of the rise in debt over the past several years warrants somewhat of a P/B discount, we would argue that the risk is more earnings and dilution-related rather than solvency-related. It is highly unlikely that the Chinese government would allow large banks to fail outright in the event of a serious financial crisis, but the potential for a rise in provisioning and significant new capital raising suggests that the risk premium for these stocks should be somewhat higher than what would otherwise be normal. Chart 14China's Banks Can Re-Rate ##br##In A Benign Slowdown Scenario China's Banks Can Re-Rate In A Benign Slowdown Scenario China's Banks Can Re-Rate In A Benign Slowdown Scenario Still, either the Chinese bank risk premium is excessive, or the banking sectors of several major DM countries are significantly overvalued. For example, Chinese investable banks trade at a P/B ratio of 0.8, but Canadian, Australian, and Swedish banks trade at an average P/B ratio of 1.7. If the concern over credit excesses is the source of the higher risk premium applied to Chinese banks, Chart 14 suggests that there is a major inconsistency in pricing; an equally-weighted average of Canadian, Australian, and Swedish private sector debt-to-GDP is higher than that of China's, at 214% vs 211% as of Q2 this year. Our bet is the former: In a world where outsized returns are scarce and U.S. equities are overvalued, a benign growth deceleration and a modulated pace of reforms favor a lessening of the substantial valuation discount currently applied to China's investable ex-tech stocks. Barring a more pronounced slowdown in China's economy than we currently expect, investors should stay overweight the MSCI China investable index in 2018, within both an emerging markets and global equity portfolio. Bottom Line: Chinese ex-tech stocks have room to re-rate in a benign slowdown scenario. Investors should stay overweight Chinese investable stocks in 2018. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see BCA Special Report, "2018 Outlook - Policy And The Markets: On A Collision Course," dated November 20, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Reports "China's Economy - 2015 Vs Today (Part I): Trade", dated October 26, 2017, and "China's Economy - 2015 Vs Today (Part II): Monetary Policy", dated November 9, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle", dated November 30, 2017, available at cis.bcaresearch.com. 4 Please see China Investment Strategy and Geopolitical Strategy Special Reports, "China's Nineteenth Party Congress: A Primer", dated September 14, 2017, "How To Read Xi Jinping's Party Congress Speech", dated October 18, 2017, and BCA Special Report "China: Party Congress Ends ... So What?", dated November 2, 2017, available at cis.bcaresearch.com. 5 Please see China Investment Strategy Weekly Report, "Messages From The Market, Post-Party Congress", dated November 16, 2017, available at cis.bcaresearch.com. 6 The Senate bill that was passed this week unexpectedly retained 20% alternative minimum tax (AMT) for corporations, which would disproportionately impact U.S. technology companies. Indications currently suggest that the final tax cut bill to be approved by both houses of Congress will repeal the AMT. 7 In 2016, real estate investment accounted for roughly 29% of total private investment in fixed assets, and the sum of primary and secondary industry (agriculture, mining, utilities, construction, and manufacturing) accounted for about 28%. 8 Please see China Investment Strategy Weekly Report, "A Closer Look At Chinese Equity Valuations", dated August 31, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Neutral Cable & satellite stocks received a much-needed boost last week when it was announced that the head of the U.S. Federal Communications Commission planned to scrap the landmark 2015 rules to guarantee net neutrality. Such a move was unsurprisingly championed by the largest internet service providers (ISP) as it allows them significantly more flexibility in pricing. While this news is certainly positive for the profit outlook of the S&P cable & satellite index, we remain outside the bullish camp. Consumer spending on cable services have fallen behind overall PCE, despite sustained price increases (second panel); incremental price hikes would be contrary to increasing demand. Further, cable & satellite companies have been spending heavily on infrastructure (third panel) while margins have been declining (bottom panel). This implies declining return on invested capital and valuation contraction. On balance, the net neutrality change may be a positive for earnings but with so much uncertainty, we prefer a more cautious approach; stay neutral. The ticker symbols for the stocks in this index are: BLBG: S5CBST - CMCSA, CHTR, DISH. Net Neutrality Rollback May Lift Cable & Satellite Fortunes Net Neutrality Rollback May Lift Cable & Satellite Fortunes