Sectors

Overweight We remain constructive on the S&P banks index as all three key drivers of bank profits, namely loan growth, price of credit and credit quality, are simultaneously moving in the right direction. Leading indicators of loan demand are accelerating; consumer confidence is exceptionally strong and the ISM manufacturing survey has been on fire lately (second panel). On the price of credit front, if BCA's bond view pans out in the next year and the 10-year Treasury yield veers closer to 2.8-3% range with rising inflation expectations in the driver's seat (third panel), then bank profits should continue to accelerate. Finally, credit quality remains pristine; loan loss reserves have recently crossed above non-current loans in Q2 according to the FDIC, for the first time since 2007. Historically, a rising reserve coverage ratio has been synonymous with increasing valuations and the current message is that the banks rerating phase is in the early innings. Bottom Line: We reiterate our early-May overweight stance in the S&P financials sector and continue to overweight the heavyweight S&P banks sub-index. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT. Banks Hold The Key Banks Hold The Key

Highlights Storms set a low bar for Q3 EPS. BCA's Beige Book Monitor near cycle highs despite storms. Investors should fade the Q3 housing weakness. Latest Survey Of Consumer Finances highlights student loan debt issue. Feature Chart 1Q3 GDP Growth Has Held Up##BR##Remarkably Well Despite Hurricane Impact Q3 GDP Growth Has Held Up Remarkably Well Despite Hurricane Impact Q3 GDP Growth Has Held Up Remarkably Well Despite Hurricane Impact U.S. equities hit fresh all-time highs again last week, undeterred by the downward adjustment in Q3 earnings estimates in part due to Hurricanes Harvey and Irma. Investors appear to be looking through any near-term hit to economic growth and profits. Trump's tax plan cleared a key hurdle in Congress and tax cuts would surely give the market a boost if they are eventually passed. Bond yields and the dollar edged higher on speculation that President Trump will choose John Taylor as the next Fed Chair, who many believe will be a hawk. While we agree that investors should look through the hurricane effects, we worry that equity markets appear increasingly frothy. While the storms will cast a shadow over the Q3 earnings reports, the economic data has held up remarkably well. At 2.7% and 1.5%, the Atlanta Fed GDP Now and New York Fed's Nowcast for Q3 have recouped nearly all the ground they lost in the immediate aftermath of the storms (Chart 1). The Fed's Beige Book revealed a stout underlying economy despite the most weather related disruptions since superstorm Sandy in 2012. The Beige Book and most of the other economic data released in the past few weeks, aside from the inflation data, support a December rate hike. Markets are pricing in a near 100% chance of a 25bps hike at the December 12-13 FOMC meeting. The impact of Harvey and Irma have also lowered expectations for housing and residential investment in Q3, but housing is poised to rebound in the coming quarters even if the Fed raises rates once this year and three more times as we expect next year. The Fed's latest Survey of Consumer Finances will raise more concern over student loan debt, but also show that households' low cash balances and elevated allocation to equities match consumers' elevated confidence readings. Q3 Earnings Outlook Clouded By Storms Hurricanes Harvey and Irma may temporarily undermine corporate profits in a few industries in the third quarter. The annual growth rate of the 4-quarter moving total was poised to peak anyway, given more demanding year-ago comparisons (Chart 2). Still, EPS growth is peaking at a high level and should decelerate only slowly through 2018 toward a level more commensurate with 3.5-4% nominal GDP growth. We thus expect the earnings backdrop to remain a tailwind for the equity market, albeit a smaller tailwind. This forecast excludes any positive impact on growth from tax cuts. The announcement of tax cuts would be positive for EPS and the S&P 500 price index in the short term, although this would also bring forward Fed rate hikes. Rising oil prices are turbocharging earnings in the energy patch and we expect this to continue. Indeed, BCA's Commodity & Energy Strategy service raised its 2018 target price for both Brent and WTI last week to $65.15/bbl and $62.95/bbl, respectively. These estimates are up by $5.51 and $5.98/bbl from our forecast last month.1 The soft industrial production readings in September would be a concern for BCA's profit forecast, absent the storms' impact (industrial production is included in our top-down EPS model). However, the Fed noted that "the continued effects of Hurricane Harvey and, to a lesser degree, the effects of Hurricane Irma combined to hold down the growth in total production in September by 1/4 percentage point. For the third quarter as a whole, industrial production fell 1.5 percent at an annual rate; excluding the effects of the hurricanes, the index would have risen at least 1/2 percent." Moreover, strong readings in September and October on both the New York and Philadelphia Fed's manufacturing indices imply that the aftermath of the storms did not extend beyond Texas and Florida, and suggest a rebound in IP in Q4. The elevated readings on the Cass Freight index in recent months support that view (Chart 3). Chart 2Strong EPS Growth Ahead,##BR##Will Start To Slow Soon Strong EPS Growth Ahead, Will Start To Slow Soon Strong EPS Growth Ahead, Will Start To Slow Soon Chart 3Storms Impacted IP In Q3 Storms Impacted IP In Q3 Storms Impacted IP In Q3 Bottom Line: The earnings season is underway and forecasts have collapsed to a mere 4.2% year-over-year growth rate for Q3. They were as high as 5.5% at the start of Q3. Financials are heavily weighing on the outlook and the sector's profits are expected to contract by 9%. While the insurance sub-sector may be behind the bulk of the negative EPS revisions owing to the hurricanes, such extreme pessimism is unwarranted and the bar is set extremely low for both financials and the overall market. Based on the September and October Beige Books, corporate managements will not be too concerned with the dollar during this earnings reporting season. The Beige Book: Beyond The Storms The Beige Book released on October 18 supports the Fed's stance that the hurricanes will not alter the U.S. economy's medium-term trajectory and will keep the Fed on track to boost rates by another 25 basis points in December. BCA's quantitative approach2 to the Beige Book's qualitative data points to underlying strength in GDP and a tighter labor market, but there is still a disconnect between the Beige Book's view of inflation and the market's stance. Moreover, the stronger dollar has disappeared from the Beige Book and despite the lack of progress in Washington on Trump's pro-business agenda, business uncertainty is down. In addition, the prospects for commercial and residential real estate remain bright. Chart 4Beige Book Monitors Support Fed's Outlook##BR##On Economy And Inflation Beige Book Monitors Support Fed's Outlook On Economy And Inflation Beige Book Monitors Support Fed's Outlook On Economy And Inflation At 63%, BCA's Beige Book Monitor stayed near its cycle highs in October, providing more confirmation that the underlying economy remained upbeat in Q3 despite Hurricanes Harvey and Irma (Chart 4). The latest Beige Book covered the period from mid-September to October 6. Hurricane Harvey hit Texas and Louisiana in late August while Irma made landfall in Florida in early September and moved on to neighboring southeastern states through mid-month. While there were only four mentions of "weather", "hurricane" was used 58 times and "storm" nine times. The total 71 puts the weather impact on the Beige Book at its highest since superstorm Sandy struck the northeastern U.S. in Q4 2012 (Chart 4, panel 2). Based on the Beige Book, the dollar should not be an issue in the Q3 or Q4 earnings seasons. The greenback is no longer a concern for small businesses and bankers, which is in sharp contrast to 2015 and early 2016 when there was a surge in Beige Book mentions of a strong dollar (Chart 4, panel 4). In October, there were no remarks at all. The past three Beige Books (July, September and October) have seen only a single reference to a stronger dollar. The last time that three consecutive Beige Books had so few mentions was in late 2014. Remarkably, business uncertainty over government policy (fiscal, regulatory and health) has moved lower in 2017. The implication is that the business community is ignoring the lack of progress by Washington policymakers on Trump's agenda (Chart 4, panel 5). Echoing the market's disagreement with the Fed on inflation, a significant discrepancy in the Beige Book was evident in the number of inflation words (Chart 4, panel 3). Expressions of inflation dipped to a 7-month low in October. However, a disconnect persists between the still-elevated mentions of inflation and the soft readings on CPI and PCE. In the past, increased references to inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may soon turn up. Bottom Line: The recent Beige Book backs BCA's view that the hurricanes will not derail the economy. Indeed, the September reading on our Beige Book monitor in early October suggests that the economy rebounded smartly as the effects of the storms waned in late Q3 and early Q4. However, the Beige Book has done little to resolve the debate around why an economy growing above potential and a tightening labor market have not boosted inflation. Moreover, the October Beige Book all but warned investors to fade the Q3 weakness in the housing data. Housing Woes Continue In Q3 The weakness in residential investment in Q3 is temporary and housing has not peaked for the cycle. The monthly data on housing in August and September were affected by Hurricanes Harvey and Irma. Housing starts for September were weaker than anticipated and below August's readings. Specifically, the 9% m/m drop in September's starts in the South followed the 5% drop in August. Existing home sales posted a modest month-over-month gain in September after a three month decline. Nonetheless, October's 68 reading on homebuilder sentiment was four points above September's reading and the highest since May (Chart 5). Rising rates are not a threat to housing affordability, even if the Fed is able to lift rates in line with its dot plot. Chart 6 shows the influence of higher rates on housing affordability and effective mortgage rates under two scenarios. A 200-basis point increase in mortgage rates (Chart 6, panel 1) would push the housing affordability index below its long-term average for the first time in nine years. BCA assigns a low probability to a rate jump given the Fed's commitment to gradually increase rates. A more plausible path for mortgage rates in the next year is a 100bps rise (Chart 6, panel 3). Under this scenario, the affordability index would deteriorate, but remain a tailwind for housing. Chart 5Solid Housing##BR##Fundamentals In Place Solid Housing Fundamentals In Place Solid Housing Fundamentals In Place Chart 6Housing Affordability Under##BR##Various Rate Assumptions Housing Affordability Under Various Rate Assumptions Housing Affordability Under Various Rate Assumptions The historically low reading on Bloomberg's Housing and Real Estate Surprise Index also suggests that housing is poised to rebound in the coming quarters (Chart 7). The last time that the index was as low as the -1.2 reading in mid-October was in late 2013 amid the taper tantrum, and prior to that in late 2008/early 2009. Moreover, the gap between Bloomberg's overall Economic Surprise Index and the Housing Surprise index has never been wider. Therefore, the weakness in the housing data is a weather-related anomaly. Chart 7Big Disconnect Between Housing Surprise And Economic Surprise Big Disconnect Between Housing Surprise And Economic Surprise Big Disconnect Between Housing Surprise And Economic Surprise It is important to assess whether residential investment has peaked for the cycle. Since the early 1960s, a crest in housing provided seven quarters of warning before a downturn commenced.3 While housing's contribution to overall economic growth plunged in Q2 and Q3, we expect housing to provide fuel for the next few years as pent up demand is worked off from the depressed household formation rate since the 2008 financial crisis. Moreover, BCA does not anticipate that rising rates will be a serious threat to housing in the next 12 months. The implication from our upbeat view on housing is that the next recession is still several years away. Reliable leading indicators of a recession such as the LEI, the yield curve and the 26-week change in claims, are not signaling a downturn (Chart 8). BCA's recession model puts the probability in the next 12 months at a meager 2%. Only one of the eight components signal a downturn. Furthermore, neither the St. Louis Fed's nor the Atlanta Fed's recession indicators is in the danger zone. BCA does not expect a buildup in the types of imbalances that previously led to economic declines. Instead, a recession may be triggered by a Fed policy mistake,4 a terrorist attack that disrupts economic activity over a large area for an extended time, or a widespread natural disaster. Chart 8Odds Of A Recession In Next Year Remain Low Odds Of A Recession In Next Year Remain Low Odds Of A Recession In Next Year Remain Low Bottom Line: In the next 12 months, investors should remain positioned for stocks to outperform bonds and rising rates. While markets have entered a more dangerous late-cycle "blow off" phase,5 housing's contribution to GDP has not peaked for the cycle, which means that recession is still more than a year away. Housing will rebound in Q4 after an appalling performance in Q2 and Q3. A healthy housing market will continue to support the consumer. Surveying The Consumer Table 1Household Balance Sheets Prior##BR##To Recessions And Today Lowered Expectations Lowered Expectations The Fed's latest triennial Survey of Consumer Finances (SCF) shows that the consumer is less sensitive to housing, holds less cash and more equities than in the past. However, the report also shows that households that own interests in small businesses may disproportionately benefit from the GOP's corporate tax cut proposal. The SCF data supply a detailed examination of consumer health, not provided by the macro data. Nonetheless, key household- and consumer-related spending, which are saving- and balance sheet-related concepts in the SCF, closely track similar statistics in the macro datasets such as the Flow of Funds and the NIPA accounts.6 Table 1 shows household balance sheets in 1989, 1998, 2007, a year or two before the recessions and bear markets of 1990, 2001 and 2008-2009. The latest (2016) is also shown. Households are more sensitive to business conditions than ever before. Households in 2016 hold less cash (as a percentage of financial assets) than in any other pre-recession year, while consumers' equity holdings are the highest on record. Consumers' mix of nonfinancial assets showed that while housing was still the largest single asset (42.4% in 2016), the share of household assets devoted to primary residences was the lowest on record. Vehicles were only 4.8% of a household's nonfinancial assets in 2016, a new low. In contrast, individuals' equity in business (34%) was the highest ever. The implication is that a plunge in housing prices would be as detrimental to consumers today as it was in the mid-2000s. Hence, households' higher exposure to business ventures suggests that a tax cut that favors small businesses over individuals may shore up household finances. Despite improvement in many areas of consumer finances, the household exposure to student loans in 2016 was alarmingly high (Table 2). On the surface, the SCF data do little to ease fears that student loans will compromise household balance sheets and lead to the next recession. The mean student loan debt per household in 2016 was $34,200, 37% higher than in 2007, and more than triple the 1989 level. While 22% of families had student debt in 2016, a slight improvement from 2013, only 9% of families had student debt in 1989. Moreover, educational debt accounts for 8% of household debt. While that figure is dwarfed by the 67% of family debt in housing, a scant 4% of family debt was related to student loans prior to the last recession in 2007.7 Furthermore, 42.6% of families with education debt report that they have student loan debt of more than $25,000, a sharp upsurge from 2007 and more than double the percentage reporting $25,000 or more in 1989.8 Table 2Nearly Half Of All Families With Education Debt Have Student Loan Debt Of At Least $25,000 Lowered Expectations Lowered Expectations That said, BCA's view remains that student debt is a modest drag on economic growth, and is not a threat to U.S. government finances nor does it represent the next subprime crisis.9 John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Oil Forecast Lifted As Markets Tighten," October 19, 2017. Available at ces.bcaresearch.com. 2 Please see BCA Research's U.S. Investment Strategy Weekly Report "The Great Debate Continues", dated April 17, 2017. Available at usis.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Disconnected," September 11, 2017. Available at usis.bcaresearch.com. 4 Please see BCA Research's Global Investment Strategy Weekly Report, "Strategy Outlook Fourth Quarter 2017: Goldilocks and the Recession Bear," October 4, 2017. Available at gis.bcaresearch.com. 5 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View," October 16, 2017. Available at usis.bcaresearch.com. 6 https://www.federalreserve.gov/econresdata/feds/2015/files/2015086pap.pdf 7 Sourced from 1989-2016 Survey of Consumer Finances Database at https://www.federalreserve.gov/econres/scfindex.htm. Historic Tables - Table 16 - Amount of debt of all families, distributed by purpose of debt. 8 Jeffrey P. Thompson and Jesse Bricker, "Does Education Loan Debt Influence Household Financial Distress? An Assessment Using The 2007-09 SCF Panel," October 16, 2014, Federal Reserve. 9 Please see The Bank Credit Analyst Special Report, "Student Loan Blues: Can't Replay What I Borrowed," November 2016. Available at bca.bcaresearch.com.

Highlights Portfolio Strategy The financials sector's fortunes are linked to the path of 10-year Treasury yields. BCA's view of a selloff in the bond market bodes well for this interest rate-sensitive sector. The S&P banks index is on the cusp of flexing its earnings power muscle. Higher profits will serve as a catalyst for a valuation rerating in this key financials sub-sector. The still unloved S&P asset management & custody banks index has significant catch-up potential. We reiterate our high-conviction overweight status. Recent Changes There are no changes to our portfolio this week. Table 1 Later Cycle Dynamics Later Cycle Dynamics Feature The S&P 500 ended last week on a high note, cheering significant progress on the tax bill front and digesting early earnings beats. Given the equity market's lofty valuation starting point, substantial positive profit surprises are now necessary to move the needle in stocks. Encouragingly, IBM's mention of the fall in the U.S. dollar boosting EPS1 may morph into a broad-based theme this earnings season given the currency's mysterious absence we have been flagging in Q2. Beneath the surface, easy fiscal policy prospects coupled with synchronized global growth will likely continue to underpin equities. Importantly, later stages of the business cycle are synonymous with impressive gains in the S&P 500. The unemployment gap, defined as the unemployment rate minus the non-accelerating inflation rate of unemployment (NAIRU), is an excellent leading indicator of the yield curve. Granted, NAIRU is an estimate and we are using the CBO's long-term NAIRU quarterly forecast as an input to the unemployment gap indicator. When the unemployment gap disappears, inflation should start rearing its ugly head, eventually leading the Fed to tighten monetary policy to the point where the yield curve inverts and predicts the end of the business cycle. Empirical evidence suggests that first the unemployment gap closes then the yield curve inverts and the business cycle subsequently ends (Chart 1). However, this indicator has had one miss since the early-1970s, during the second leg of the early-1980s double dip recession. Chart 1Eliminated Unemployment Gap Is Bullish For Equities Eliminated Unemployment Gap Is Bullish For Equities Eliminated Unemployment Gap Is Bullish For Equities Table 2 shows the S&P 500 performance from when the unemployment gap clearly closes until the business cycle ends. In all five iterations that lasted, on average, 28 months, the broad market has risen, on average, by 29%. The unemployment gap has been eliminated since February 2017 and if history at least rhymes the next U.S. recession will arrive some time in 2019 as the SPX hits our peak cycle 3,000 target.2 Another later cycle phenomenon is the disappearance of volatility and the plunge in stock correlations as the Fed tightens monetary policy. While large institutional investors aggressively selling volatility this cycle is dampening vol across asset classes, there is another explanation of the non-existence of vol: synchronized global growth. Chart 2 shows that leading up to the prior three recessions, volatility was drifting lower and remained low, and the common denominator was simultaneous global growth in the late-1980s, late-1990s and mid-2000s. BCA's global (40 country) industrial production composite was expanding during the later stages of the business cycle. Similarly, our global (44 country) global EPS diffusion index and the global synchronicity indicator also depict concurrent global growth. Table 2S&P 500 Returns When##br## The Unemployment Gap Closes Later Cycle Dynamics Later Cycle Dynamics Chart 2Linking Low Vol To ##br##Synchronized Global Growth Linking Low Vol To Synchronized Global Growth Linking Low Vol To Synchronized Global Growth During the later stages of the cycle, equity sector correlations also collapse as earnings fundamentals are key performance drivers and sector differentiation generates alpha, as the broad market enters the last stage of the bull market. As we mentioned in our "SPX 3,000?" Weekly Report on July 10th, this does not mean the S&P 500's path is a linear straight line up until the next recession hits. There are high odds of a 5-10% garden variety pullback materializing which we deem a healthy development and our strategy would be to buy the dip, ceteris paribus. This week we update an early cyclical sector and two key sub-components. Financials: In The Shadows Of The Bond Market While financials stocks have cheered the prospects of a tax bill passage sometime in early 2018 (Chart 3), sell-side analysts have been brutally downgrading financials sector EPS estimates, dealing a blow to most sub-indexes net earnings revisions (Chart 4). True, hurricane-related losses may be the culprit, but such indiscriminate downgrades are unwarranted, and we would lean against such pessimism. Recent profit results corroborate our positive sector bias, but we are still early in the earnings season. Chart 3Dissecting Financials Performance Dissecting Financials Performance Dissecting Financials Performance Chart 4Extreme EPS Pessimism Extreme EPS Pessimism Extreme EPS Pessimism This early cyclical sector is a core overweight portfolio holding and there are high odds of significant relative gains in the coming quarters. Historically, financials stocks had been almost 100% positively correlated with the yield curve slope (Chart 5): a steepening yield curve gooses financials profits, while a flattening one eats into earnings via narrowing net interest margins. This rang true up until the Great Recession. Since then, unconventional monetary policies likely rendered this multi-decade correlation ineffective. In particular, the fed funds rate's zero lower bound caused a shift in the correlation from the yield curve to the 10-year Treasury yield (Chart 6). In fact, changes in the 10-year Treasury yield are now a carbon copy of relative share price momentum (Chart 6). Chart 5Shifting Correlations Shifting Correlations Shifting Correlations Chart 6Financials And UST Yield Are Joined At The Hip Financials And UST Yield Are Joined At The Hip Financials And UST Yield Are Joined At The Hip Thus, accurately forecasting long term interest rates should also dictate the direction of relative share prices, especially given the still historically low fed funds rate. On that front, the Treasury market is priced for the 10-year yield to hit 2.57% in October 2018 from roughly 2.38% currently. We expect the 10-year yield will rise more quickly than is discounted in the forward curve. Our U.S. bond strategists think core inflation will soon resume its modest cyclical uptrend. A parallel recovery in the cost of inflation protection will impart 50-60 basis points of upside to the 10-year Treasury yield by the time core inflation reaches the Fed's 2% target.3 Chart 7 plots the path of the 10-year Treasury yield discounted in the forward curve alongside a path consistent with BCA's view that inflation is poised to head higher. It also shows what this would mean for the 10-year breakeven inflation rate. If core inflation resumes its uptrend, as BCA expects, then financials will have a stellar return year in 2018, all else equal. Chart 7Lots Of Upside Lots Of Upside Lots Of Upside Meanwhile, market participants typically value financials on a price-to-book basis during calamitous times and are very slow in changing metrics once the tremors are behind the sector. We are likely on the cusp of a switch away from P/B and toward forward P/E as a key valuation metric for financials. The current 20% forward P/E discount to the broad market is highly punitive (bottom panel, Chart 5). If the key S&P banks sub-index successfully flexes its earnings power muscle, as we expect, then a valuation rerating phase looms for both banks and financials equities. Banks Hold The Key We remain constructive on the S&P banks index as all three key drivers of bank profits, namely loan growth, price of credit and credit quality, are simultaneously moving in the right direction. Tack on the increasing likelihood of a tax bill becoming law in early 2018, the continued push of the Trump administration to relax bank regulations and pent up demand for shareholder friendly activities including net share retirement and higher dividend payments/payouts, and bank stocks are well positioned to generate impressive returns in the coming quarters. Lower corporate tax rates will boost bank profits directly and indirectly. Fiscal stimulus typically translates into an economic fillip. If small and medium businesses (SME) benefit the most from lower taxes then higher SME profits will lead to a more expansionary mindset and small business owners will likely tap their bankers to finance capital spending plans. As tax certainty increases, so will animal spirits, aiding in kick-starting a virtuous economic cycle. Thus, loan growth is on an upward trajectory. Leading indicators of loan demand are also painting a bright picture for bank profits. C&I and consumer loans, two large credit categories, are both forecast to reaccelerate in the coming months. The ISM manufacturing survey has been on fire lately and consumer confidence has been following closely behind (third & fourth panels, Chart 8). Our credit growth model captures these positive forces and is sending an unambiguously positive message for loan reacceleration in the coming months (Chart 8). Moreover, residential real estate loan origination (the second largest credit category in U.S. dollar terms) should gain steam, underpinned by solid housing market's foundations: house prices are still expanding at a healthy clip (top panel, Chart 9), household formation is running higher than housing starts and mortgage rates are not prohibitive. Chart 8Bright Business And Consumer Credit Outlooks Bright Business And Consumer Credit Outlooks Bright Business And Consumer Credit Outlooks Chart 9Ongoing Valuation Rerating Ongoing Valuation Rerating Ongoing Valuation Rerating The V-shaped recovery in our U.S. credit impulse corroborates this fertile loan backdrop and is heralding an earnings outperformance phase (Chart 10). On the price of credit front, if BCA's bond view pans out in the next year and the 10-year Treasury yield veers closer to 2.8-3% range with rising inflation expectations in the driver's seat (Chart 11), then bank profits should continue to accelerate. Granted, the Fed will also raise rates next year and, at the margin, push up funding costs for the banking sector. However, our working assumption is that banks will remain linked to the 10-year UST yield's fortunes next year. At some point later in the Fed tightening cycle, the yield curve and bank correlation will likely get re-established. But, a flattening yield curve denting NIMs is a 2019 narrative. Finally, credit quality remains pristine despite some pockets of weakness in, subprime especially, auto loans. At this stage of the cycle, near or at full employment, NPLs will remain muted. Importantly, loan loss reserves have recently crossed above non-current loans in Q2 according to the FDIC, for the first time since 2007. Historically, a rising reserve coverage ratio has been synonymous with increasing valuations and the current message is that the banks rerating phase is in the early innings (Chart 12). Chart 10Heed The Positive Credit Impulse Signal Heed The Positive Credit Impulse Signal Heed The Positive Credit Impulse Signal Chart 11Price Of Credit Should Recover Price Of Credit Should Recover Price Of Credit Should Recover Chart 12Pristine Credit Quality Pristine Credit Quality Pristine Credit Quality Bottom Line: We reiterate our early-May overweight stance in the S&P financials sector and continue to overweight the heavyweight S&P banks sub-index. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT. A Few Words On Asset Management & Custody Banks The S&P asset management & custody banks (AMCB) index sits atop of our high-conviction return table (see page 15), outperforming the broad market by 7.2% since inception. While it is tempting to monetize some of these profits, we choose to remain patient. Likely more gains are in store in the coming months as this financials sub sector maintains its leadership position. If BCA's bond view of a selloff in the 10-year Treasury market transpires in 2018, then the budding rotation out of bond and into equity products will further accelerate. The stock-to-bond ratio captures this shift and it is currently flashing green (Chart 13). Overall assets under management are also rising and are a boon for the AMCB group's profit prospects, on the back of higher equity prices and also higher flows into stocks in general (bottom panel, Chart 13). Vibrant global economic sentiment, as measured by the IFO's World Economic Survey (top panel, Chart 14), and domestic (and global) manufacturing resurgence should continue to underpin M&A activity and sustain the high levels of margin debt. Both of these factors suggest that AMCB profit drivers are accelerating and will likely serve as a catalyst to unlock excellent value in this still unloved financials sub-group (middle panel, Chart 14). Chart 13Increasing AUMs... Increasing AUMs... Increasing AUMs... Chart 14...And Rising Animal Spirits Are Bullish For AMCB ...And Rising Animal Spirits Are Bullish For AMCB ...And Rising Animal Spirits Are Bullish For AMCB Adding it up, the still undervalued AMCB index has sizable catch-up potential, especially if the equity risk premium (ERP) continues to narrow in the coming quarters, as we expect (ERP shown inverted, bottom panel, Chart 14). Bottom Line: The S&P AMCB index remains a high-conviction overweight. The ticker symbols for the stocks in this index are: BLBG: S5AMGT-BK, BLK, STT, AMP, NTRS, TROW, BEN, IVZ, AMG. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report,"Dollar The Great Reflator" dated September 18, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report,"SPX 3,000?" dated July 10, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Bond Strategy Weekly Report,"Living With The Carry Trade" dated October 17, 2017, available at usbs.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

A recovery in asset values, employment and savings over the past eight years has taken household net worth steadily higher; it now exceeds pre-GFC levels. Historically, household net worth and the consumer finance index have moved hand-in-hand, though this relationship has broken down of late as the former has soared and the latter has lagged. The gap has widened despite consistently healthy industry revenue growth (second panel) and a steady decline in loss ratios (third panel). The upshot of improving earnings and the absence of market appreciation has been a decline in valuations to well-below average levels. With no signs yet of a consumer wobble, this looks like an excellent buying opportunity. We reiterate our overweight position. The ticker symbols for the stocks in the S&P consumer finance index are: BLBG: S5CFINX-AXP, COF, DFS, SYF, NAVI. Charging Higher Charging Higher

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

Earlier this week, CSX led off railroad Q3 earnings, managing to beat expectations while overcoming hurricanes and derailments. Of particular note was solid pricing gains despite somewhat lagging domestic inflation and CSX-specific service issues. Even modest growth bodes exceptionally well for the industry as pricing moves have historically been good indicators of margin gains (second panel). Further, firming in intermodal shipping specifically portends ongoing EPS improvements. Intermodal is broadly a reflection of global production & trade, which is tightly correlated with profit growth (third panel). Our rails EPS model captures all this, and it continues to indicate a surge in profit growth relative to the S&P 500 (bottom panel). We reiterate our overweight position. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. Stay On The Rails Stay On The Rails

In this week's Weekly Report, we are highlighting what we expect to be the key macro theme we see dominating markets in 2018: the nascent recovery in capital outlays transforming into a full blown capex upcycle. The second panel shows that the recent V-shaped recovery in operating EPS should morph into a sizable capex upcycle. Vibrant capex then feeds back into profits, leading to a virtuous cycle. Empirical evidence suggests that a lagged relationship exists between these two variables: since the early 1980s capex growth has typically trailed profit growth by one year. Intuitively, as earnings recover, CEOs have more confidence in the outlook for final demand and choose to deploy longer-term oriented capital. National accounts data also confirm the positive correlation between capex1 and corporate non-financial operating earnings2 growth, albeit with a shorter lag. Our chart shows that since the 1980s recession, all four recessions were preceded by stock market reported capex soaring to roughly a 20% annual growth rate. At the current juncture, capex is merely on the cusp of entering expansion territory and, if history at least rhymes, a significant capex upcycle is looming and higher beta/higher operating leverage deep cyclicals sectors are going to be in the driver's seat. Please see Monday's Weekly and Special Reports for more details. Underappreciated Capex Underappreciated Capex 1 Source: National Income and Product Accounts 2 Source: Financial Accounts of the United States - Z.1

We have been shifting our portfolio toward a cyclical over defensive tilt recently and in this week's Special Report, we are highlighting five compelling reasons to buy cyclicals at the expense of defensives. Capital expenditures upcycle. The capex upcycle will disproportionately benefit capital goods producers versus their defensive brethren. Leading indicators of capital outlays have taken off (top panel), suggesting both capex and the relative share price ratio will surge higher. Synchronized global growth in general and emerging markets (EM) growth in particular. Synchronized global growth typically boosts global final demand and is also conducive to a coordinated global capex upcycle. The resurgent global manufacturing PMI suggests that cyclicals have the upper hand (second panel). U.S. dollar softness. The U.S. dollar has a critical influence on the relative share price ratio. The currency remains in the red year-to-date, on a trade-weighted basis, representing a bullish backdrop for cyclical compared with defensive EPS prospects as a lagged currency effect should boost relative profitability (third panel). Bottom Line: Shift to a cyclical over defensive portfolio bent. Please see yesterday's Special Report for more details and our other reasons for the portfolio shift. Top 5 Reasons To Favor Cyclicals Over Defensives Top 5 Reasons To Favor Cyclicals Over Defensives

Highlights Revisiting the shadow banking system 10 years later. The September CPI data is unlikely to resolve the inflation debate at the Fed. How to invest in a late cycle environment. Wage Inflation was on the rise even before the hurricanes. Feature Chart 1September CPI And Retail Sales Keep##BR##The Fed On Track To Tighten September CPI And Retail Sales Keep The Fed On Track To Tighten September CPI And Retail Sales Keep The Fed On Track To Tighten The state of the U.S. business cycle, and what could end it, were key topics of conversation at BCA's semi-annual Research Advisory Board meeting in early October. Most participants agreed with the BCA view that the economy is in the late stages of the economic cycle, and a few suggested that another bubble in the shadow banking sector may end the expansion. With those discussions in mind, we review the state of the shadow banking in the first section of this report and then examine how key aspects of the economy and U.S. asset classes behave while the U.S. economy is in the final stages of an expansion. In the final section, we take another look at wage inflation signals from the hurricane impacted September jobs report, and conclude that wage growth has accelerated even excluding the effect of the storms. The September CPI and retail sales data were also impacted by the storm, but the message is that the underlying economy is strong enough to generate some inflation (Chart 1), although the September CPI is unlikely to resolve the inflation debate at the Fed. The minutes of last month's FOMC meeting (released last week) indicate that the upcoming inflation data could be pivotal to whether the Fed delivers another rate hike in December. There are two more CPI reports ahead of the December FOMC meeting (with the second release coming on the day of the policy announcement). While the September CPI data was hard to interpret due to the storms, the next few data prints need to affirm the Fed's forecast that core inflation is indeed recovering from the "transitory weakness" seen earlier this year. BCA's U.S. bond strategists believe that inflation will be strong enough for the Fed to justify a hike in December and recommend below-benchmark duration for fixed income portfolios. Shadow Banking Update At current levels, shadow banking activity in the U.S. is not a threat to the economic expansion. The ratio of financial sector debt to non-financial sector debt is a rough proxy of how the system can leverage existing debt into new securities and boost credit creation (Chart 2). As financial innovation and deregulation boosted system liquidity, outstanding financial debt as a percentage of non-financial debt climbed from 10% in the mid-1970s to over 50% in 2008. In Q2 2017, the shadow banking proxy stands at only 33%, because the global financial crisis and subsequent reregulation of the financial sector have reigned in excesses. The last time that the ratio was this low was in the late 1990s. Bank lending standards highlight key differences between the backdrop in the mid-2000s and today (Chart 3). In the mid-2000s, even as the Fed had boosted rates by 425 basis points, lending standards were easy and loosening. In contrast, the 100 bps increase in the Fed funds rate since late 2015 was accompanied by a tightening of lending requirements. Moreover, lending criteria were already tight when the Fed began its latest rate hikes. Chart 2The Shrinking Shadow##BR##Banking Sector The Shrinking Shadow Banking Sector The Shrinking Shadow Banking Sector Chart 3Bank Lending Standards Tighter##BR##Today Than In Mid '00s Bank Lending Standards Tighter Today Than in Mid '00s Bank Lending Standards Tighter Today Than in Mid '00s The Fed and other regulators are more attuned to financial excesses than they were a decade ago. The central bank under Yellen has raised the profile of financial stability.1 BCA views "financial stability" as a third mandate for the central bank, along with low and stable inflation, and full employment. That said, the Fed did not assess financial stability at the September FOMC meeting and the topic was only briefly mentioned by Fed staff and FOMC participants. At the July 2017 meeting, the central bank's staff characterized the "financial vulnerabilities of the U.S. financial system" as moderate on balance. BCA expects that the Fed will return to the topic at either one or both remaining FOMC meetings in 2017. The October 2017 Bank Credit Analyst Monthly Report2 provided a checklist of liquidity measures to watch as the U.S. economy enters the end of an elongated expansion. In view of these indicators, we would describe liquidity conditions in the U.S. as fairly accommodative, although not nearly as abundant as prior to the Lehman event in 2008. Monetary conditions are super easy, while balance sheet and financial market liquidity are reasonably constructive. In contrast, funding liquidity, while vastly improved since the global financial crisis, is still a long way from the pre-Lehman go-go years (as per indicators such as bank leverage). The Fed is set to begin the process of unwinding the massive amount of monetary liquidity created by its quantitative easing program. This has the potential to undermine other types of liquidity in the financial system, leading to a correction in risk assets. However, the BCA Special Report argues that the reaction of the bond market is more important for risk assets than the balance sheet adjustment itself. If inflation only edges higher and market expectations for the upward path of the Fed funds rate remain gentle, then risk assets should take the balance sheet unwind in stride. An abrupt upward shift in inflation would be an altogether different story. Bottom Line: The U.S. expansion entered a late-cycle environment near the close of 2016 as the unemployment rate dipped below NAIRU. Nonetheless, none of our recession-timing indicators warns that a downtown is imminent3 and the financial excesses in the end stage of the 2001-2007 economic expansion are not present today. If the next recession begins in the second half of 2019, then global equities will probably peak earlier that year or in late 2018. Given the starting point for valuations, U.S. equities may decline by 20% to 30% peak-to-trough. Stay overweight equities for now. The time to trim exposure could come in mid-2018. Late-Cycle Playbook Chart 4Easier Financial Conditions##BR##Will Boost U.S. Growth Easier Financial Conditions Will Boost U.S. Growth Easier Financial Conditions Will Boost U.S. Growth Easing financial conditions will lead to faster U.S. GDP growth in the next few quarters. Financial conditions have eased sharply this year due to a strengthening stock market, narrower credit spreads and a weaker dollar. Changes in financial conditions lead growth by about 6 to 9 months, implying that U.S. growth could reach 3% early next year (Chart 4). This could drop the unemployment rate to 3.5% by end-2018, more than one point below the Fed's estimate of full employment and even lower than the 2008 low of 3.8%. Rising inflation will compel the Fed to lift rates aggressively next year to cool the economy and push the unemployment rate back above NAIRU. The U.S. has never averted a recession in the post-war era when the unemployment rate has increased by more than one-third of a percentage point. BCA's stance is that the U.S. economy enters the expansion's final stage when the unemployment rate dips below NAIRU. Chart 5 shows that the unemployment rate moved below NAIRU in November 2016. In the past 45 years, the economy has spent an average of 33 months in late-cycle mode ahead of 5 recessions. The exception was 1981-82 when the unemployment rate did not dip below NAIRU ahead of the recession; we treated the separate 1980 and 1981-82 recessions as one episode. Note that several of these late-cycle intervals overlap with recessions (vertical lines on Charts 5, 6 and 7 indicate the start of recessions). Chart 5Late Cycle Performance Of Stocks, Bonds, & Commodities Late Cycle Performance Of Stocks, Bonds, & Commodities Late Cycle Performance Of Stocks, Bonds, & Commodities The late-cycle environment favors equities over Treasuries, gold and oil, but other risk assets (small caps, investment-grade and high-yield corporates) underperform (Table 1). The dollar drops by an average of 5% in late cycles and it moved lower in 4 of the 5 previous episodes. Oil is a consistent late-cycle performer, climbing in all the stages in our analysis. The average returns across all assets classes are similar, even excluding the 1973 OPEC oil embargo and the 1987 stock market crash. Nonetheless, asset class returns in the current environment have mostly run counter to history. Table 1Late Cycle Performance Of Stocks, Bonds, & Commodities The Late-Cycle View The Late-Cycle View In typical late-cycle performance, U.S. stocks have outperformed Treasuries since November 2016, the dollar has weakened and oil is up, though by far less than in an average late cycle. However, both investment-grade and high-yield corporate bonds have outpaced Treasuries, and small caps have beaten large caps. Moreover, gold prices have dropped. However, the current late-cycle period has been in place for only 10 months, which is more than two years short of the 33-month average of late cycles since 1972 (Table 1). Furthermore, the level of S&P 500 earnings, both trailing and forward, also rise uniformly in late cycles. That said, earnings growth tends to peak about halfway through each cycle, but we note that we have only forward EPS data for three of the five episodes in our analysis. Profit margins take the same course as earnings and earnings growth (Chart 6). The late-cycle climb in wages and labor compensation impacts margins. Additionally, inflation tends to escalate during late cycles (Chart 7). Chart 6S&P 500 Earnings And Margins In Late Cycle S&P 500 Earnings And Margins In Late Cycle S&P 500 Earnings And Margins In Late Cycle Chart 7Inflation And Interest Rates During Late Cycles Inflation And Interest Rates During Late Cycles Inflation And Interest Rates During Late Cycles Bottom Line: The late-cycle environment may persist for another two years or so, favoring stocks over bonds, a weaker dollar and higher oil prices. Although we are overweight both investment-grade and high-yield corporate bonds, these two asset classes tend to underperform Treasuries as the business cycle fades. We also expect wages and inflation to continue to mount, suggesting that duration should be kept short. The late-cycle pattern is at odds with BCA's view that the dollar will appreciate modestly in the next 12 months. However, the dollar's trajectory depends both on Fed policy and the direction of rates in the economies of the major U.S. trading partners. The Bank of Canada will be lifting rates in the coming quarters, but policy rates will be flat for some time in the Eurozone and Japan, such that interest rate differentials will shift in favor of the dollar on a multi-lateral basis. Another Look At Wage Inflation In last week's report4 we indicated that the September jobs report was difficult to interpret due to the impacts of Hurricanes Harvey and Irma. Specifically, we stated that the unexpected 0.5% month-over-month gain in average hourly earnings should be discounted. Employment in the low-paying leisure and hospitality sector fell by 111,000 in September, helping to boost the aggregate average hourly wage. These wages will correct lower as these workers return to their jobs post-hurricane recovery. A closer look at the wage data, however, suggests that the acceleration in wage growth in September 2017 to 2.9% from 2.7% in August and a recent low of 1.9% in 2014, has been in place for some time. Admittedly, the 2.9% year-over-year reading on wage inflation, may have overstated labor costs in September. That said, at 56% in August, the percentage of U.S. states where the year-over-year percentage change in average hourly earnings is rising has been on the upswing since mid-2014. The August reading was the highest since 2012 (Chart 8). In Chart 9, we created an "equally-weighted" AHE measure to adjust for shifts in the composition of the labor market, but we found that the recent deceleration is not linked to compositional effects. Since wage growth bottomed out in late 2012, the compositional shifts slightly lowered wage inflation on average, but the growth rates today are roughly the same. Chart 10 updates research by the Kansas City Fed5 that found only a few industries (mostly in the goods-producing sector) account for most of the rise in wages, notably manufacturing, construction and wholesale trade. Financial services, retail, professional and business services, and leisure and hospitality - all service sector industries - were the laggards. The report shows that although earnings growth has fallen behind in service-oriented industries since 2015, hours worked have increased faster than in the goods-producing sector. Chart 856% Of States Have Seen##BR##Higher Wage Inflation 56% Of States Have Seen Higher Wage Inflation 56% Of States Have Seen Higher Wage Inflation Chart 9Compositional Effects Do Not##BR##Explain Recent Wage Weakness Compositional Effects Do Not Explain Recent Wage Weakness Compositional Effects Do Not Explain Recent Wage Weakness Chart 10Acceleration In Hours Worked##BR##Should Lead To Faster Wage Growth Acceleration In Hours Worked Should Lead To Faster Wage Growth Acceleration In Hours Worked Should Lead To Faster Wage Growth Moreover, the August JOLTS data also provides evidence that the labor market began to tighten before the effects of Harvey and Irma. The quit rate matched a 15-year high in August, and job openings were at an all-time high. Job openings in the leisure and hospitality sector were at all-time highs in August, and the quit rate in that storm-impacted industry stood at 4.2% (Chart 11). Even excluding the leisure and hospitality industry from the average hourly earnings data, wage growth has unambiguously climbed in the past 1- and 3- months (Chart 12). Chart 11Overall Job Openings And Quit Rates##BR##Vs. Leisure And Hospitality Overall Job Openings And Quit Rates Vs. Leisure And Hospitality Overall Job Openings And Quit Rates Vs. Leisure And Hospitality Chart 12Wage Acceleration Evident Even##BR##Excluding Leisure And Hospitality Wage Acceleration Evident Even Excluding Leisure And Hospitality Wage Acceleration Evident Even Excluding Leisure And Hospitality Bottom Line: Wage inflation was on the upswing even before the hurricanes hit in late August and September. Persistent wage inflation will allow the Fed to raise rates again in December and three or four times next year. This supports BCA's underweight stance on duration. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate," July 24, 2017. Available at usis.bcaresearch.com. 2 Please see The Bank Credit Analyst Monthly Report, "Liquidity And The Great Balance Sheet Unwind," October 2017. Available at bca.bcaresearch.com. 3 Please see BCA's Global Investment Strategy Weekly Report, "Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear," October 4, 2017. Available at gis.bcaresearch.com. 4 Please see BCA's U.S. Investment Strategy Weekly Report, "Small Cap Surge," October 9, 2017. Available at usis.bcaresearch.com. 5 "Wage Leaders and Laggards: Decomposing The Growth In Average Hourly Earnings," Willem Van Zandweghe, Federal Reserve Bank of Kansas City, February 15, 2017.

Overweight - High-Conviction The S&P asset management and custody banks (AMCB) index has outperformed both the S&P 500 and the broad financials index since we lifted it to a high-conviction overweight in mid-February. The tight correlation between Treasury yields and relative share prices explain a large part of the outperformance (top panel). Given BCA's underweight duration bond view, we still think the outperformance phase is in early days. Historically, the index has also been positively correlated with both the stock-to-bond ratio and the equity risk premium, but has deviated significantly from both in the last four years (second and third panels). The index has also diverged negatively from its own earnings profile, creating a persistent state of undervaluation since 2015. Even modest mean reversion in any of these measures implies substantial outperformance as animal spirits remain upbeat. Bottom Line: The undervalued S&P AMCB index has significant catch-up potential with earnings momentum pointing in the right direction. Stay overweight. The ticker symbols for the stocks in the S&P asset manager & custody banks index are: BLBG: S5AMGT-BK, BLK, STT, AMP, NTRS, TROW, BEN, IVZ, AMG. Banking On Mean Reversion Banking On Mean Reversion