Sectors

President-elect Trump and the specter of his spendthrift policy proposals have generated significant client interest/inquiries on equities and inflation - not asset price, but of the more traditional kind: consumer price inflation. Accelerating inflation is a modest risk, but not our base case forecast. Nevertheless, for investors that are more worried about the prospect of higher inflation, the purpose of yesterday's Special Report is to serve as an equity sector positioning roadmap if inflationary pressures become more acute sooner than we anticipate. Historically, inflation has been synonymous with an aggressive Fed and hard asset outperformance, suggesting that deep cyclical sectors would be primary beneficiaries. The table shows that over the last six major inflationary cycles, energy, materials, real estate and health care have been consistent outperformers. Utilities, tech and telecom have been clear underperformers. The remaining sectors have been a mixed bag (please see the next Insight). (Part I) Equity Sector Winners And Losers When Inflation Climbs (Part I) Equity Sector Winners And Losers When Inflation Climbs

Highlights The rise in both bond yields and the U.S. dollar represents significant tightening in monetary conditions, which will be difficult for stock prices to digest. Technical indicators suggest that the rally could persist in the near term, but investors should nonetheless prepare a shopping list once prices correct. Both consumer discretionary and health care stocks are appealing longer-term plays that are less expensive than the broad market. Feature The current rally in equity prices is high risk. Since the summer, our main worry for the stock market has been the likelihood of profit disappointments, given that corporations lack pricing power and that the outlook for top-line growth is lackluster. That worry has not gone away, but now the more pressing issue has become the impact on equity prices of the swift and aggressive tightening in monetary conditions via both the bond market sell-off and rise in the dollar (Chart 1). The 10-year Treasury yield is now trading above fair value. True, in the past, equity prices have sustained gains until yields rose much further into undervalued territory, but the big difference this time is that the dollar is rising in tandem. Simultaneous powerful rises in the currency and yields are rare, and typically result in steep market pullbacks. Investors should be on high-alert for this outcome. The possibility that equity market euphoria persists for another month or two should not be ruled out, i.e. until the Fed's next meeting and until there is more clarity on the course of fiscal and trade policy. Indeed, a simple read of technical indicators and market sentiment suggest that the rally could continue, but the risk/reward balance is poor (Chart 2). Chart 1Monetary Conditions Have Changed bca.usis_wr_2016_12_05_c1 bca.usis_wr_2016_12_05_c1 Chart 2Technicals: Not Flashing A Warning Yet Technicals: Not Flashing A Warning Yet Technicals: Not Flashing A Warning Yet With that in mind, one of the most frequently asked (and difficult) questions we receive is, Where is the value in U.S. equities? Presently, this is akin to looking for deals on New York's Upper 5th Avenue.1 As Chart 3 shows, U.S. equity multiples remain near or at historic (ex. TMT mania) highs. This is true for both small and large caps. And relative to global equity valuations, U.S. stocks appear even more expensive. There are few sectors that we believe offer compelling absolute value today. However, on a relative basis, the Trump rally has caused a flight out of traditional safe havens that has gone too far. For instance, consumer products stocks (household products, beverages and packaged food) are now trading below the broad market P/E multiple, in aggregate, on a trailing 12-month basis (Chart 4). According to our U.S. Equity Strategy service, forward relative returns are typically very robust when the group trades at a discount to the market. Importantly, consumer products stocks have a positive correlation with the U.S. dollar, which means that recent share price weakness represents a buying opportunity. Chart 3No Deals Here bca.usis_wr_2016_12_05_c3 bca.usis_wr_2016_12_05_c3 Chart 4Good Entry Point To Consumer Products? bca.usis_wr_2016_12_05_c4 bca.usis_wr_2016_12_05_c4 As highlighted above, we are on high-alert for an equity shakeout, triggered by the rapid rise in bond yields, and reinforced by profit disappointment. Still, we have assembled a short shopping list of sectors that we believe offer long-term upside. Health care and consumer discretionary stocks already offer better value than other areas of the market. Consumer Discretionary Will Last Longer This Cycle We have recommended favoring domestic over global exposure within U.S. equities and, in-line with our U.S. Equity Strategy service, we have favored non-cyclical holdings. But the cyclical interest rate-sensitive consumer discretionary sector deserves more attention, especially given good relative valuations. The recent back-up in bond yields has sent the relative performance of consumer discretionary stocks to a four-year low, once heavyweight Amazon is excluded (Chart 5). Admittedly, this comes on the back of an almost uninterrupted run higher since 2010. Still, since we believe it unlikely that the current back-up in yields can continue much longer, any cooling in bond yields could start a rotation back into consumer discretionary stocks. In last week's Special Report,2 we outlined the case as to why structural headwinds make it highly unlikely that the Fed will need to aggressively tighten in the coming year. In our view, the interest rate backdrop is unlikely to be an insurmountable headwind for this sector. Most importantly, fundamentals for consumer spending have been slowly improving. The labor market is now tight enough that consumers have job security (Chart 6). Incidentally, consumer confidence is now back to historically buoyant levels. The greatest ramification of this is that higher job security historically goes hand in hand with greater demand for credit. Until this point of the cycle, consumption growth has been capped by income growth trends because there has been no appetite to borrow in the aftermath of the Great Recession. We highly doubt that a new debt-fuelled spending spree will get underway, but rising job security should help fuel some credit growth. Chart 5Consumer Discretionary Stocks##br## Should Resume Outperformance bca.usis_wr_2016_12_05_c5 bca.usis_wr_2016_12_05_c5 Chart 6Consumers: The Future##br## Is Brighter Consumers: The Future Is Brighter Consumers: The Future Is Brighter Alongside improved job security, consumers are enjoying a tailwind from a historically light drag on their finances (Chart 6). Consumer spending on essential items, which includes energy costs, interest expense, insurance, taxes, etc. is at multi-decade lows. If BCA's benign forecast for energy prices (around $50 per barrel) and rate backdrop pans out, then there should continue to be ample spending room on discretionary items. The bottom line is that consumer discretionary stocks are one of the few sectors that are trading at historically reasonable valuations. We believe that a combination of a benign rate backdrop, better consumer confidence and a strong dollar will help this sector outperform late into the business cycle. Particular emphasis should be placed on industry groups and companies that can maintain positive pricing power. This includes movie & entertainment and restaurant stocks. Retailers should be de-emphasized until deflationary pressures ease, as we discuss on page 9. Follow The Baby Boomers To...Health Care Stocks In our Special Report last week, we explained how the aging population will continue to have implications for the labor market and wages. We also believe that demographics will eventually have important implications for equity sector outperformance. BCA Research periodically puts forward investment mania candidates. Charles Kindleberger described three conditions that must be met in order to create a financial mania and bubble: a powerful theme that captures the imagination of investors which is often the result of a major economic displacement; low interest rates; and finally, investment vehicles that allow rampant speculation (Chart 7). We believe that the aging of the population and the need for increased resources to service that population could be a powerful theme that captures investors' attention in the coming years. Chart 7A History Of Manias A History Of Manias A History Of Manias Since the baby boomers came of age (in the 1960s), their massive numbers relative to other age cohorts has given this generation an outsized influence on political, social and economic trends. Put simply, the baby boom generation has had the most clout because of their sheer numbers. And what do baby boomers want now? This age cohort is now focused on prolonging good health for as long as possible! It makes sense, then, any coming pent-up demand for goods and services will focus on health-related spending. As Chart 8 shows, spending on health care increases significantly for the 65-year and over cohort. This massive increase in health care spending has already begun but is likely to increase much more in the coming years. Chart 8Spending On Health Care Accelerates With Age Bargain Hunting Bargain Hunting To further highlight this point, in a Special Report last year,3 we made the case that health care will be one of the greatest sources of innovation this cycle. As we highlighted then, government R&D spending on basic research tends to lead practical applications, such as in the 1950s innovation boom after WWII (Chart 9). Currently, government R&D spending is growing much faster in healthcare than in tech. The private sector is also in agreement with tech VC investment still well below its 2000 peak, whereas healthcare is hitting new highs. Chart 9Health Care R&D Spending Is An Outlier bca.usis_wr_2016_12_05_c9 bca.usis_wr_2016_12_05_c9 Health care relative valuations are significantly below their post-2008 mean (Chart 10). We will explore the potential for health care as a mania candidate in an upcoming Special Report, but our preliminary work suggests that health care stocks should be on the top of investors' shopping lists. Chart 10Long-Term Value In Health Care Stocks bca.usis_wr_2016_12_05_c10 bca.usis_wr_2016_12_05_c10 Economic Momentum Heating Up? The surprising election results have stolen the financial media's focus away from economic and profit fundamentals in the past few weeks. Admittedly, investors who were focused on the elections did not miss much: the overall picture of economic growth has not changed in recent weeks. Indeed, the Fed's Beige Book of anecdotes on the state of the U.S. economy, released last week, indicates that growth remains mediocre, although sufficient enough for the Fed to raise rates later this month. Nevertheless, we have been monitoring consumer and business confidence closely, as we believe that this will be a key gauge to the likelihood that a more virtuous economic cycle is underway. There is some improvement: Consumer Confidence: A missing ingredient thus far in the recovery has been optimism among households. But that may be finally changing. Surveys of consumer sentiment ticked up markedly in November. As discussed above, this appears mainly to be attributed to better job security as the labor market tightens. If sustained, we view this as a very positive development, since a rising confidence in the outlook allows consumers to take on debt - or at least reduce their savings rate (Chart 6). Business Confidence: Business confidence has mirrored - and even lagged - soggy consumer confidence throughout this cycle. This makes sense, since optimism about a company's future hinges on prospects for demand for its products. In an economy where 70% of GDP is consumption, it is rational that businesses take their cue from consumer sentiment. The most recent ISM manufacturing survey was positive; new orders are rising. Respondent comments were particularly sunny. The bulk of survey responses were collected after the November 8 election and so should be reflective of business attitudes toward the new political administration. Consumer Spending: Black Friday/Cyber Monday sales were reported as lackluster relative to last year, according to the National Retail Federation (NRF). Apparently, about 3 million more shoppers than in 2015 were enticed into stores and onto their computers, but they spent about 3.5% less, while overall sales were down about 1.5% over last year. But the survey also picked up on one of our critical themes: deflation in the retailing sector is still rampant. Price discounting remains a dominant tactic to entice shoppers and over half of the NRF survey respondents reported that deals were "too good to pass up." In real terms, annual consumer spending growth has trended sideways at 2.5%. We see little risk of a slowdown, and in fact as highlighted above, now that consumer confidence has improved, any modest wage gains could lead to an improved spending outlook. All in all, the modest growth backdrop that has characterized the economic recovery since to date is still intact. We are closely watching consumer and business confidence for signs that the economy can or cannot handle the rise in bond yields and dollar: if recent optimism can be maintained, the odds of a more virtuous economic cycle will improve. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 According to Cushman & Wakefield, New York's Upper 5th Avenue had the highest average rents of any shopping street in the world in 2015. A square foot of retail space cost $3,500. 2 Please see U.S. Investment Strategy Special Report "U.S. Wage Growth: Paid In Full?," dated November 28, 2016, available at usis.bcaresearch.com 3 Please see U.S. Investment Strategy Special Report "The Next Big Thing: How To Profit From Disruptive Innovation," dated March 9, 2015, available at usis.bcaresearch.com

Highlights We update the long-term structural themes that we expect will be key drivers of financial market performance over the next one to five years, drawing investment conclusions from each. Debt Supercycle. The final stage of a debt supercycle is often marked by an increase in public debt, which we may now see in the U.S. Meanwhile, the eurozone and emerging markets are still at an early stage of post-debt deleveraging. Technological Disruption. The IT revolution has reached the mature phase, and behind it is a new wave of technologies including artificial intelligence and biotech. The first and last stages of tech waves are the only times where investors typically make profits. Emerging Market Deleveraging. EM assets will continue to underperform until these countries complete structural reforms and deal with the consequences of a decade of credit excesses. Multipolar Geopolitics. The end of American hegemony raises the risk of military conflicts and will make the world less globalized. End Of The Bond Bull Market. Interest rates have been in structural decline since the early 1980s. With a rotation to fiscal policy and (eventually) higher inflation, the path of least resistance for yields is upwards. Subpar Long-Run Returns. With bond yields low and equities expensive, investors will find it hard to achieve the returns they have become accustomed to over the past 30 years. Substantially more risk will be required to achieve the same level of return. Bear Market In Commodities. Weak demand growth (as China reengineers its economy), excess resource capacity, and an appreciating dollar make this a very different environment to the 2000s. Mal-Distribution Of Income. The backlash from stagnant incomes in Anglo-Saxon economies will continue. Populism is likely to cause the labor share of GDP to rise, hurting profits and lowering investment returns. Feature I. Introduction Chart 1Major Market Cycles Major Market Cycles Major Market Cycles The key views in Global Asset Allocation (GAA), as in other BCA services, center on the cyclical time-horizon, six to 12 months. This means analyzing principally where we are in the business cycle, the impact of liquidity and monetary conditions, and the current outlook for economic and earnings growth. But it is also important to understand the long-term picture: the structural trends in asset prices, debt, demographics, technology, and other "long wave" factors that have profound and protracted impacts on investment performance. Specifically, investors need to get right long-term shifts in things such as economic growth, the U.S. dollar, commodity prices, interest rates, and the relative performance of stocks and bonds (Chart 1). Such long-term themes, therefore, represent the road-map around which GAA develops its cyclical views. Ever since the service began in 2011 (and indeed in its predecessor, the BCA Premium Service), we have published a list of Major Themes, that "should be key drivers of financial market performance over the next 1-5 years." This Special Report updates and fleshes out these major themes. We have retained five of our current themes: The End of The Debt Supercycle The End of The 35-Year Global Bond Bull Market Subpar Long-Run Returns Bear Market in Commodities The Mal-Distribution of Income &Social Unrest And have added three new themes: Technological Disruption EM in A Multi-Year Deleveraging Multipolar Geopolitics In the report we describe each of these themes and draw investment conclusions from them. The descriptions are relatively brief (since most of these themes will be familiar to BCA clients), but we spend more time on analyzing the new themes and on the Debt Supercycle, which is central to our world view. We have dropped two of our earlier themes: Financial Sector Re-Regulation: Bank regulation has indeed been drastically tightened in the years since the Global Financial Crisis. As a result, banks have deleveraged significantly in most regions (Chart 2), their profitability has declined (Chart 3), and share price performance has been poor. But this phase may be over. Bank loan growth has recovered in the U.S. and the new Trump administration may both boost demand for borrowing and ease regulation. In Europe and Japan, bank stock performance will henceforth be driven more by shifts in loan demand and the shape of the yield curve than by regulation. Chart 2Banks Have Deleveraged... bca.gaa_sr_2016_12_05_c2 bca.gaa_sr_2016_12_05_c2 Chart 3... And Become Much Less Profitable bca.gaa_sr_2016_12_05_c3 bca.gaa_sr_2016_12_05_c3 Chart 4The Lowest Interest Rates Ever bca.gaa_sr_2016_12_05_c4 bca.gaa_sr_2016_12_05_c4 A Generational Shift: Our concept was that Millennials (usually defined as those who came of age after 2000 - so born between 1977 and 1994) would behave differently: they would own less (preferring to Uber and couch-surf), depend on social media, and be less focused on their careers. Arguably, this has not been the case. Like previous generations, Millennials have started to acquire possessions. In the U.S. last year, one-half of homebuyers were under 36; Millennials bought 4 million cars (making them the second largest group of purchasers behind baby-boomers). Moreover, this is a hard theme to draw investment conclusions from. Every generation is slightly different - but how concretely does this affect asset prices? One final thought. A common thread running through our themes is that there is little new under the sun. Most phenomena in economics and markets are cyclical. Many of the charts in this report show that the same environment comes round time and again, after five, 10 or 50 years. Much analysis in investment theory is based on this (think of Kontratiev waves, "the fourth turning," Dow Theory etc.) But what is fascinating about today's world is that there are trends we are experiencing for the first time in history: Zero or negative interest rates: never in history have governments, companies, and individuals been able to borrow so cheaply (Chart 4), sometimes even being paid for the privilege. Demographics: The world population has grown continuously since the Black Death in 1350. Indeed the fastest population growth on record was as recent as the 1960s (Chart 5). But growth has slowed sharply since, and is expected to be only 0.1% a year by the end of the century. As a result, we are seeing an unprecedented slowdown - and even decline - in the size of the workforce in many countries (Chart 6). Chart 5Population Growth Has Slowed Drastically bca.gaa_sr_2016_12_05_c5 bca.gaa_sr_2016_12_05_c5 Chart 6The Workforce In Some Countries Is Shrinking bca.gaa_sr_2016_12_05_c6 bca.gaa_sr_2016_12_05_c6 The impacts of these two trends will be profound - but they won't be found by looking at historical precedents. II. Debt Supercycles One of the key ways in which BCA has long looked at the world is through the concept of debt supercycles. Our founder, Hamilton Bolton, wrote in 1967 of "the possibilities inherent in an intensive study of changes in bank credit as a major cyclical and supercyclical investment tool....History shows period after period of excessive bank credit inflation. It also shows a number of periods in which bank credit deflation has been allowed to erode the whole economic and investment structure."1 Simply put, when credit in the economy expands (and these days one needs to look more broadly than at just bank credit) it tends to boost growth, raise asset prices, and underpin the effectiveness of monetary policy. At some point, the level of credit becomes unsustainable and the subsequent deleveraging causes financial conservatism as borrowers focus on repairing their balance-sheets. This makes monetary policy relatively ineffective, and has negative effects on growth and asset prices. The two biggest debt supercycles over the past 50 years were in Japan from 1970 to 1990, and in the U.S. and parts of Europe starting in the early 1980s and culminating with the Global Financial Crisis in 2007 (Chart 7). The fallout from the end of Japan's debt supercycle has been stark: since 1990, Japanese nominal GDP has grown by only 0.4% a year (compared to 6% a year over the previous 10 years) and even today the Nikkei index is 55% below its peak. In the U.S., the early 1980s' financial deregulation and the fiscal policies of the Reagan government caused both private and government debt to begin to rise as a percentage of GDP (Chart 8). From the late 1990s, monetary policy was kept too easy, which culminated in the housing bubble of 2004-7. After that bubble burst, households reduced debt (partly through defaults) and government spending rose sharply for a few years to cushion the recession. Chart 7Debt Supercycles Everywhere Debt Supercycles Everywhere Debt Supercycles Everywhere Chart 8U.S. Debt Started To Rise From 1980 bca.gaa_sr_2016_12_05_c8 bca.gaa_sr_2016_12_05_c8 Since 2009, BCA has been talking about a "post debt supercycle" in the U.S.2 The household savings rate rose (Chart 9), as consumers became cautious, preferring to save rather than spend (Chart 10). This has meant that consumption growth has been lower than wage growth, whereas the opposite was the case up to 2007. Monetary policy also became ineffective since, in such a weak growth environment, companies were not inclined to spend on capital investment despite ultra-low interest rates (Chart 11). Chart 9Household Savings Rate Has Risen Since The Crisis bca.gaa_sr_2016_12_05_c9 bca.gaa_sr_2016_12_05_c9 Chart 10Consumers Prefer To Save Than Spend Consumers Prefer To Save Than Spend Consumers Prefer To Save Than Spend Chart 11Companies Not Spending Despite Low Rates Companies Not Spending Despite Low Rates Companies Not Spending Despite Low Rates There are two competing theories to explain the sub-trend growth of the current expansion. Larry Summers' theory of secular stagnation3 describes a world in which, even with ultra-low interest rates, desired levels of saving exceed desired levels of investment, leading to chronic shortfall in demand. BCA's debt supercycle explanation is closer to that of economists such as Kenneth Rogoff, who argues that once deleveraging and borrowing headwinds subside, growth trends might rise again.4But the two theories may not be so incompatible: secular factors, such as demographics, play a role in both. The final stage of a debt supercycle is often an increase in public debt. That has certainly been the case in Japan: while the private sector has deleveraged aggressively since 1990, government debt to GDP has risen from 67% to 250% - without having much discernible effect on boosting growth. In the U.S., government debt has stabilized as a percentage of GDP over the past two years, and the baseline projection made by the Congressional Budget Office in March this year forecasts it to increase by only 10 percentage points over the next decade. But the election of President Trump might change that. His campaign promised tax cuts and infrastructure spending amounting to about USD6 Trn which, all else being equal, would increase government debt/GDP by another 30 percentage points over a decade. There are two other regions where we see the debt supercycle being an important factor over the coming years: the Eurozone and emerging markets. In Europe, some of the most indebted countries, notably the U.K. and Spain, have made progress in deleveraging since the Global Financial Crisis - although the balance-sheet repair is likely to remain a drag on the economy for a while longer. But France and Italy have hardly delevered at all, and some smaller countries such as Belgium have seen a substantial increase in private debt/GDP (Chart 12). The Eurozone remains generally a very heavily bank-dependent economy, with total bank credit almost back to a historical peak (Chart 13). Germany, by contrast, has long had an aversion to debt: private sector debt/GDP has never been above 130% and is currently only around 100%. This unwillingness to borrow and spend by the world's fourth largest economy has been a drag on European growth. Chart 12Deleveraging In Europe Has Been Patchy Deleveraging In Europe Has Been Patchy Deleveraging In Europe Has Been Patchy Chart 13Eurozone Bank Loans Have Not Declined Eurozone Bank Loans Have Not Declined Eurozone Bank Loans Have Not Declined Emerging markets delevered after the Asian crisis in 1997-8 but the wave of global liquidity created in 2009-12 flowed into EMs, triggering excessively high credit growth. Private-sector EM debt has reached an average of 140% of GDP (Chart 14), and a higher percentage of global GDP than was U.S. debt at the peak of the housing bubble in 2006. Although the debt buildup is most extreme in China, where private-sector debt/GDP has risen by 70 percentage points over the past seven years, the same phenomenon is apparent in many other emerging markets, notably Brazil, Turkey, Russia and Malaysia (Chart 15). Chart 14The EM Debt Supercycle May Be Ending The EM Debt Supercycle May Be Ending The EM Debt Supercycle May Be Ending Chart 15And It's Not Just About China And It's Not Just About China And It's Not Just About China BCA's Emerging Markets Strategy has argued for a while that this is unsustainable and that a period of deleveraging will cause growth to slow in many emerging markets and that the strains from the excessive lending, such as rising NPL ratios, will become apparent.5 The deleveraging has already started to happen, with loan growth in Brazil, Malaysia and Turkey - but not yet China - slowing sharply (Charts 16 & 17). Chart 16EM Bank Lending Now Slowing... EM Bank Lending Now Slowing... EM Bank Lending Now Slowing... Chart 17...Almost Everywhere ... Almost Everywhere ... Almost Everywhere We draw a number of conclusions for long-term asset allocation from this analysis. The post debt supercycle is likely to remain a drag on global growth, and therefore on returns from risk assets, for some years to come. But the U.S. is likely to be less affected than the eurozone since the household sector there has already substantially deleveraged and the Trump administration is more likely to use government spending to fill the gap. Emerging markets will underperform for some years to come as they too go through a period of deleveraging. III. Disruptive Technology Technological change is a key driving force of economies and markets. As Joseph Schumpeter said, capitalism is a "process of industrial mutation...that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one." Nikolai Kondratiev described 45-60 year waves that were triggered by "the irruption of a technological revolution and the absorption of its effects." Understanding where we are in the technological cycle, then, is very important for investors wanting to catch deep trends. But it is particularly hard at the moment because, at the same time as the world is still seeing ramifications coming through from personal computing (which began as long ago as 1971, with Intel's announcement of the first microprocessor) and from the internet (which started as Arpanet in 1969), there is a new wave of revolutionary technologies still mainly on the drawing-board, including robotics, artificial intelligence, and genetic engineering. The best framework for thinking about technological cycles is provided by economist Carlota Perez.6 She describes five "surges of development" starting with the Industrial Revolution, which she dates from the opening of Arkwright's cotton spinning mill in Cromford in 1771 (Table 1). Her key argument is that these revolutionary technologies have powerful and long drawn-out effects on the financial, social, institutional, and organizational framework and therefore tend to move through a similar pattern of four phases (Chart 18) lasting around 50 years in all. The fifth wave, Information Technology, for example, started in its installation phase with development of the microprocessor, PCs, and mobile phones in the 1970s and 1980s, reached frenzy in the 1990s, hit a turning-point (which often triggers a stock market crash) in 2000-2, before reaching the deployment phase in the 2000s, and may now be at maturity (growth in computers and smart phones is slowing). Table 1The Five Historic Technology ##br##'Surges Of Development' Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes Chart 18The Four Stages Of Technology Waves Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes But Perez wrote her book in 2002, and we could now be close to the beginning of the sixth wave. Think about the situation 30 years ago, in 1986. It would not have been hard to extrapolate how technology might develop over the coming years since some people already used PCs, mobile phones, and the internet but, as William Gibson said at the time, "the future is already, here - it's just not very evenly distributed." Today there are still a few further developments to come in these fifth-wave technologies (we've listed some in Table 2). But there is a whole further set of technologies (self-driving cars, graphene, distributed energy generation) which almost nobody uses now, but which could become important. Many of these build on the developments of the fifth wave (ubiquitous connectivity, cheap and powerful computing) in the same way that previous revolutions grew from their predecessors (cars wouldn't have been possible without steel, for example). Table 2Fifth And Sixth Wave Technologies Still To Come Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes The implications of these new technologies are hard to predict, and many have undoubtedly been over-hyped. As Bill Gates said: "We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten." So how should investors deal with this? The macro implications are enormous. Every new wave of technologies has a large impact on employment, as jobs in dying industries disappear. U.S. farm workers, for example, fell from over half of the labor force in 1880 to only 12% by 1950 (Chart 19). But perhaps more relevant - given that self-driving vehicles may replace taxi, truck, and delivery drivers - is that the number of horses in the U.S. fell from 26 million to 4 million over the 50 years starting in 1915 (Chart 20). These jobs, of course, were replaced by new opportunities in manufacturing or services. And the number of drivers in the U.S. is only 3.8 million currently, or less than 3% of the workforce. Nonetheless, in the maturity phase of the technology wave (where we are now for the IT revolution), Perez points out, there is often popular unrest as "workers organize and demand...the benefits that have been promised and not delivered." Chart 19Farm Workers Were Disrupted ##br##In The Late 19th Century Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes Chart 20...And So ##br##Were Horses Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes Investing in new technologies is naturally appealing to investors, but often tricky to get right. Alastair Nairn7 identifies five similar phases for investing in technology but concludes that investors can usually make money only in the first stage, when initial skepticism reigns, and in the final stage, when the technology has matured and the surviving handful of leading players can now make good profit. Analysis by economists at the Atlanta Fed showed (Table 3) that, of the 24 U.S. PC manufacturers listed on the U.S. stock market between 1983 and 2006, only 10 made a positive return for shareholders.8 Of these, only five beat the overall index. The picture is similar for other technology waves, except perhaps for the nascent auto industry when 12 of 23 listed manufacturers outperformed the index in 1912-1928. Table 3Investments In New Technology Companies Rarely Beat The Market Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes Nairn also argues that it is easier to spot losers than winners: "The winners take many years to emerge and...it is well-nigh impossible to identify them early. ...Conversely, the losers tend to be more obvious, and more obvious at an early stage." Think back to the early days of the internet. Investors would have struggled to pick the eventual winners (Apple, Amazon, Google - but many might have guessed Yahoo or even Pets.com) but should have understood that the media, travel, retailing, and film-camera industries would all be disrupted. Chart 21IT And Healthcare Sectors ##br##Are Likely To Continue To Outperform IT And Healthcare Sectors Are Likely To Continue To Outperform IT And Healthcare Sectors Are Likely To Continue To Outperform So how should investors apply these conclusions? If we are in the mature phase of the Fifth Wave and the skepticism phase of the Sixth, this is a time when investors can benefit from tilts towards sectors where technological changes are taking place, most notably IT and Healthcare, which are likely to continue to outperform over the long run (Chart 21). Exposure to what our colleague Peter Berezin calls BRAIN stocks - biotech, robotics, artificial intelligence, nanotech - makes sense.9 This can be captured through venture capital funds. Potential losers might include energy companies and utilities, as improvements in solar energy lead to more distributed power. Even oil company BP reckons that renewables will provide 16% of power generation in 2035 - and 35% in the EU - up from 4% today, with the cost of solar power expected to fall by 40% over the time. Other sectors that could be disrupted include automakers, which could be challenged by developments in electric vehicles, and financial institutions, whose business model could be under threat from peer-to-peer lending, robo-advisers and other developments in fintech. IV. Emerging Markets In A Multi-Year Deleveraging BCA has recommended a structural underweight on emerging market (EM) equities relative to developed markets (DM) since 2010.10 This call worked well until the end of last year. So far this year, however, EM equities have outperformed DM by 5%, despite their sharp selloff (Chart 22) after the U.S. election. Our view is that emerging markets remain structurally challenged and that their long-run underperformance is likely to continue. We view the outperformance this year as simply a counter-trend move driven largely by two factors: a) the extreme relative undervaluation of EM vs. DM at the beginning of the year; and b) unconventional quantitative easing from the ECB and BoJ, and massive back-door liquidity injections (Chart 23) by EM central banks, such as in China and Turkey. Chart 22Counter-Trend Rally Largley Driven By... bca.gaa_sr_2016_12_05_c22 bca.gaa_sr_2016_12_05_c22 Chart 23QE / Massive Liquidity Injection By PBoC bca.gaa_sr_2016_12_05_c23 bca.gaa_sr_2016_12_05_c23 After the bounce, however, EM equities are no longer especially cheap relative to their DM counterparts, with the relative forward PE ratio now at its five-year average. Going forward, the poor profit outlook - due to persistent structural problems in the EM economies - will continue to weigh on the relative performance of EM assets. We maintain our structural underweight call on EM equities in a global portfolio. First, the factors that drove the massive outperformance of emerging markets in 2002-2010 have disappeared: the once-in-a-generation debt-fueled consumption binge in DM, and the investment-fueled double-digit growth in China which triggered a bull market in commodities (Chart 24). But EM countries did not take full advantage of these exogenous forces to reform their economies: to foster domestic demand, and optimize resource allocation and industrial structure. When China slowed and U.S. consumers went through a much-needed deleveraging after the Great Recession, exports to DM slowed and even contracted, and commodities prices declined sharply. As a result, the export-driven economic model of EM countries has broken down. The structural drivers of economic growth in the EM, both productivity and capital efficiency (Chart 25), have been in a downtrend, while debt (Chart 26) has continued to soar. Chart 24Regime Has Shifted bca.gaa_sr_2016_12_05_c24 bca.gaa_sr_2016_12_05_c24 Chart 25Structural Drivers Have Weakened bca.gaa_sr_2016_12_05_c25 bca.gaa_sr_2016_12_05_c25 Chart 26Debt Has Soared Debt Has Soared Debt Has Soared Structural problems require structural solutions. These solutions vary by country, but in general require less state intervention in the economy, flexible labor markets, and better incentive structures to encourage innovation and entrepreneurship. But structural reforms are a painful process and take strong political will to implement. A case in point is China, which delayed its announced supply-side reforms and reverted to monetary and fiscal stimulus when growth slowed. Second, history shows that no credit boom can last forever. Chart 27 shows private non-financial credit-to-GDP ratios in major developed economies. They have experienced periods of deleveraging of various magnitudes and durations, even though these nations have deep and sophisticated banking, credit, and financial markets, and some have plenty of domestic savings. Similar patterns have been observed in EM economies, although their deleveraging episodes have tended to be more frequent and of larger magnitude (Chart 28). Chart 27No Credit Boom Lasts ##br##Forever In DM Economies No Credit Boom Lasts Forever In DM Economies No Credit Boom Lasts Forever In DM Economies Chart 28Asian Economies: Many Interruptions During Structural Leveraging Process bca.gaa_sr_2016_12_05_c28 bca.gaa_sr_2016_12_05_c28 The main reason for these boom-bust credit cycles is the burden of debt servicing. As the private credit-to-GDP ratio rises, if interest rates are held constant, a larger share of income needs to be allocated to paying interest. At some point, debt service eats too much into debtors' incomes, causing debtors to default and creditors to reduce credit provision. This causes the economy to slow, followed by a painful but necessary restructuring to work off the excess leverage before a new cycle can start. We see no reason see why EM countries, China in particular, can sustain their current high and rising leverage levels. Deleveraging is inevitable. Third, this deleveraging in EM is at a very early stage, since credit in most EM countries continues to grow faster than nominal GDP (Chart 29). After years of booming corporate and household debt, a period of consolidation is inevitable. Hence, credit growth is set to slow to at least the level of nominal GDP growth. The credit impulse - the change in the rate of credit growth - is a key factor influencing GDP and profit growth. Chart 30 shows that if credit growth converges to nominal GDP growth within the next 12-24 months, the credit impulse will turn negative, ensuring a slowdown in the EM economies and a further contraction in corporate earnings, thus putting downside pressure on asset prices. Chart 29A Break In LEveraging Cycle Is Overdue bca.gaa_sr_2016_12_05_c29 bca.gaa_sr_2016_12_05_c29 Chart 30Negative Credit Impulse Bodes Ill For Profit And Equities Prices Negative Credit Impulse Bodes Ill For Profit And Equities Prices Negative Credit Impulse Bodes Ill For Profit And Equities Prices Chart 31Dismal Return on Equity Dismal Return on Equity Dismal Return on Equity Bottom Line: EM economies are at a very early stage of a multi-year deleveraging to work off credit excesses. Despite their year-to-date outperformance, we expect EM equities will continue to underperform their DM counterparts over the long run until their return on equity (Chart 31) improves significantly. V. Geopolitical Multipolarity Since the end of the Cold War, geopolitics has mostly remained in the background for investors. This is because the collapse of the Soviet Union ushered in an era of American hegemony that lasted for roughly two decades. During this period, the global concentration of economic, trade, and military power increased as the U.S. became the only true superpower (Chart 32). The world entered a period of "hegemonic stability," an era during which regional powers dared not pursue an independent foreign policy for fear of U.S. retaliation and during which the "Washington consensus" of laissez-faire capitalism and free trade was adopted by policymakers in both developed and emerging markets. Chart 32The End Of American Hegemony bca.gaa_sr_2016_12_05_c32 bca.gaa_sr_2016_12_05_c32 A central thesis of BCA's Geopolitical Strategy is that the world has entered a multipolar phase.11 Multipolarity implies that the number of states powerful enough to pursue an independent and globally-relevant foreign policy is greater than one (unipolarity) or two (bipolarity). Today, multipolarity is the product of America's decaying unipolar moment. The U.S. remains, by far, the most powerful country in the absolute sense, but it is experiencing a relative decline as regional powers become more capable on both the economic and geopolitical fronts (Chart 33). Multipolarity is not a popular theme with investors. It augurs uncertainty, rising risk premia, and unanticipated "Black Swan" events. In addition, some of our clients take issue with the thesis that the U.S. is in "decline." Although we can measure hard power and illustrate the relative decline of the U.S. empirically, perhaps the greatest evidence of global multipolarity are recent events that were unimaginable just five or ten years ago: Russia's annexation of Crimea; China's military expansion in South China Sea; Turkey's disregard for U.S. interests in Syria; U.S.-Iran détente (with little evidence that Tehran has actually curbed its nuclear capabilities); Dramatic withdrawal of U.S. troops in the Middle East. The point of a multipolar world is not that Russia, China, Turkey, Iran, and other powers seek to challenge America's global reach, but rather that each is more than capable of pursuing an independent foreign policy within their own spheres of influence. As the number of "veto players" in the global "Great Game" increases, however, equilibrium becomes more difficult to achieve. Uncertainty rises and conflicts emerge where none were expected. So what does multipolarity mean for investors? First, we know from formal modeling in political science, and from history, that a multipolar world is unstable and more likely to produce military conflict (Chart 34).12 There are three reasons: Chart 33U.S. Experiencing Relative Decline U.S. Experiencing Relative Decline U.S. Experiencing Relative Decline Chart 34Geopolitical Risk Is The Outcome Of Global Multipolarity bca.gaa_sr_2016_12_05_c34 bca.gaa_sr_2016_12_05_c34 During periods of multipolarity, more states can effectively pursue foreign policies that lead to war, thus creating more potential "conflict dyads" in the parlance of International Relations theory. In fact, evidence shows that this has already happened (and continues to happen), with the number of international or internationalized conflicts rising since 2010 dramatically (Chart 35). Power imbalances between states are more likely if there are more states that matter geopolitically. And power imbalances invite conflict as they are more likely to produce a situation in which one country's rising capabilities threaten another. During the Cold War, it didn't matter that Iran was more powerful than Saudi Arabia because the U.S. was present in the Middle East and willing to balance against Tehran. In a multipolar world, the weaker states are on their own. The probability of miscalculation rises due to the number of relevant states making geopolitical decisions simultaneously. For example, last year's shooting down of a Russian jet by the Turkish air force over Syria is an example of an incident that is mathematically more likely in a multipolar world. During the Cold War, the chances that Turkey would independently make the decision to shoot down a Soviet jet was far smaller as its foreign policy was closely aligned with that of its NATO ally the U.S. Chart 35Multipolarity Increases ##br##The Frequency Of Conflict Multipolarity Increases The Frequency Of Conflict Multipolarity Increases The Frequency Of Conflict There are a number of derivatives from the multipolarity thesis that will be relevant for investors. For example, despite Brexit, a multipolar world will support European integration.13 With geopolitical uncertainty rising in Europe's neighborhood - particularly in the Middle East and with Russia reasserting itself - Europe's core countries will not follow down the "exit" path that the U.K. pursued. On the other hand, the geopolitical disequilibrium in East Asia is deepening, with China's pursuit of a sphere of influence in the South and East China Seas likely to continue to raise tensions in the region. But the overarching concern for investors should be how multipolarity impacts the global economy. Global macroeconomic imbalances - such as the current combination of insufficient demand and excessive capacity - can be overcome either by unilateral policy from the hegemon or through coordination among the major economic and political powers. A multipolar world, however, lacks such coordination. Globalization is therefore at risk from multipolarity.14 Not only are regional powers pursuing spheres of influence, which is by definition incompatible with a globalized world, but the world lacks the hegemon that normally provides the expensive, and hard to come by, global public goods: namely economic coordination and geopolitical stability. History teaches us that the ebb and flow of trade globalization has been closely associated in the past with the shifting global balance of power (Chart 36). Trade globalization collapsed right around 1880, when the rise of a unified Germany and the ascendant U.S. undermined the century-old Pax Britannica. This trend ushered in a rise of competitive tariffs as the laggards of industrialization attempted to catch up with the established powers. Trade globalization recovered and began to grown again in the early twentieth century and immediately after the First World War, but both attempts were aborted by the lack of a clear hegemon willing to undertake the coordinating role necessary for globalization to take root and persevere. Chart 36Back To The 1930's? bca.gaa_sr_2016_12_05_c36 bca.gaa_sr_2016_12_05_c36 The lack of a clear hegemon and the diffusion of geopolitical power amongst multiple states can act as a headwind to global coordination. In the late nineteenth and early twentieth century, the U.K. was too weak to enforce global rules and norms, and the surging U.S. was unwilling to do so. Today, the U.S. is (relatively) too weak and unwilling to do the job of a hegemon, while China is understandably unwilling to coordinate its economic policy with a strategic rival. The investment implications of multipolarity center on three broad themes: Apex globalization: Going forward, the world is going to be less, not more, globalized. This will favor domestic over global sectors and consumer-oriented economies over the export-oriented ones. Globalization is also a major deflationary force, which would suggest that, on the margin, a world that is less globalized should be more inflationary. DM over EM: Multipolarity is more likely to produce a number of conflicts, some of which lay dormant throughout the Cold War and subsequent era of American hegemony. These conflicts tend to be in emerging or frontier markets. Safe Havens: With the frequency of geopolitical conflict on the rise, safe haven assets like the U.S. Treasurys, U.S. dollar, gold, and Swiss and Japanese government bonds, should continue to hold an important place in investors' asset allocation. VI. End Of The 35-Year Global Bond Bull Market Since the early 1980s, interest rates have been in a structural decline on the back of falling inflation expectations. Thirty-five years later, the global bond bull market has reached its end (Chart 37). Importantly, this is not to suggest that a secular bear market in bonds is beginning. The global economy is still suffering from significant spare capacity and markets usually go through a volatile bottoming process before a new secular trend is established. Nevertheless, the path of least resistance for yields is upwards. Chart 37Long-Term Yields Have Bottomed Long-Term Yields Have Bottomed Long-Term Yields Have Bottomed The most significant shift regarding sovereign yields is the global transition from monetary to fiscal stimulus. Over the next few years, central bank asset purchases will be negligible at best, with normalization in central bank balance sheets being far more likely, albeit at a muted pace. From the fiscal perspective, the rotation has already occurred in several regions, with the liberal government in Canada promising to increase infrastructure spending, Japanese Prime Minister Shinzo Abe postponing next year's planned VAT tax hike, and incoming U.S. President Donald Trump expected to ramp up fiscal spending. Sovereign bond yields have been weighed down by the rise in inequality. IMF studies found that this increase in inequality has had substantial negative effects on real GDP growth and therefore the real component. Populism is growing, as evidenced by the surprising outcome of the Brexit vote, the rise of anti-establishment parties in Europe, and the highly polarizing candidates in the U.S. elections. However, as populism continues to mount, policymakers will be further pressured to take on additional reflationary measures, inevitably leading to higher inflation. Anemic productivity growth has dampened aggregate demand and applied downward pressure to bond yields. Initially, weak productivity gains are deflationary as they reduce the incentive for firms to invest and consumers to reduce their spending. The longer term effect however, is that the supply side catches up, causing the economy to overheat and inflation to rise (Chart 38). This was the case in low productivity economies in Africa and Latin America. Chart 38A Decline In Productivity Growth Is Deflationary In The Short Run, But Inflationary In The Long Run Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes Nevertheless, not all factors are pointing to higher yields. Demographic trends have been unfavorable, as working age population growth in the major countries has decelerated sharply since 2007. Conditions will likely worsen, with the UN forecasting growth to reach zero in the latter half of the next decade. The effect is further compression in the real component of bond yields as slower labor force growth reduces the incentive for firms to build new factories, shopping malls and office towers. Overall, while the global economy has been plagued by deflation, these signs suggest that the tide is finally turning. Higher consumer prices will not only lead to an increase in the inflation expectations component, but also the inflation risk premium, which compensates investors over the inflation outlook. As the majority of the rise in bond yields will come via the inflation component and not the real component, we advocate a long-term allocation to TIPS. VII. Subpar Long-Run Returns Asset prices have surged following the global financial crisis and have reached fairly expensive valuations. While this not to say that a bear market is imminent, it certainly makes financial assets more vulnerable to correction and it does suggest that long-term return prospects are bleak. Lower future returns will shift the efficient frontier inward, requiring substantially more risk to achieve the same level of returns. Investors will find it far more difficult to achieve returns they have become accustomed to over the past 30 years. Sovereign Bonds: After 35 years, the structural decline in interest rates is at an end. While we do not expect an outright bond bear market, the path of least resistance for yields is up (Chart 39). Across all major countries and regions, starting long-term real yields have been an excellent predictor for future five-year returns. Given that yields are at multi-century lows, and even negative in some regions, future returns will be meager. Investors should reduce their long-term allocation to sovereign debt. Chart 39Yields: The Path Of Least Resistance Is Up Yields: The Path Of Least Resistance Is Up Yields: The Path Of Least Resistance Is Up Corporate Bonds: Corporate debt is also priced expensively relative to its long-term history. The credit cycle is in its late stages, and while accommodative monetary policy will extend this phase, defaults will eventually grind higher and low starting yields will limit long-term returns. Investment grade real returns can be mostly explained by their starting real yields. In fact, real yields have been an even better predictor for investment grade returns than they have for sovereigns. Investment grade spreads are less important as they have historically been stable, and defaults are fairly rare in this space. For high yield, while starting real yields are important, spreads and defaults are also crucial determinants for performance. All valuation metrics suggest that both future investment grade and high-yield returns will fall far short of investors' ingrained expectations (Chart 40). Equities: The relationship between cyclically-adjusted price-to-earnings ratios (CAPEs) and real returns is well established, as a simple regression generates a high r-squared (Chart 41). Current valuations are expensive, suggesting low to mid single digit returns. However, there is reason to believe that this scenario is overly optimistic. First, global equities have benefitted from the structural decline in interest rates. Going forward however, the end of the bond bull market removes a substantial tailwind. Secondly, the Debt Supercycle, in which each cycle begins with more indebtedness than the one that preceded it, is played out in the developed world. The implication is that household credit demand will be weak and businesses are less likely to spend on capex, thereby dampening economic growth. Chart 40Low Starting Yields = Low Future Returns bca.gaa_sr_2016_12_05_c40 bca.gaa_sr_2016_12_05_c40 Chart 41Shiller P/E Suggests Below-Average Long-Run Equity Returns Shiller P/E Suggests Below-Average Long-Run Equity Returns Shiller P/E Suggests Below-Average Long-Run Equity Returns In order for investors to reach their return targets, we recommend several options. The end of the structural decline in interest rates does not bode well for sovereign bond returns. Instead, allocators should increase their structural exposure to equities. Investors should also focus more on bottom-up analysis and differentiating at lower levels, i.e. industry groups (GICS level 2). Finally, we advocate a long-term allocation to alternative assets. Alternatives provide downside protection through volatility reduction and substantial return enhancement potential given their active management and an illiquidity premium. VIII. Structural Bull Market In Resources Is Over Commodities experienced an unusually strong bull market in the 2000s, driven by very supportive global economic and financial conditions (Chart 42): 1) the U.S. dollar spent the decade in decline; 2) investment in mining capacity was depressed following the bear market of the 1990s; 3) rapid industrialization and double-digit growth in China. The bull market of 2000s lasted longer than its predecessors and was driven more by demand growth than by supply shortages. Commodities have never been a long-term buy. While there have been cyclical bull markets, the commodity complex in real terms has been in a structural downtrend for the past two centuries (Chart 43). This is despite a 20-fold increase in real GDP, a sign that rapid economic growth and weaker commodity prices can go hand in hand. The simple reason is that humans constantly find ways to extract commodities from the ground more cheaply and use them more efficiently. The current cyclical downturn is likely to continue for some years. Demand: A number cyclical and structural factors (Chart 44) will weigh on marginal demand for commodities in the long run: Chart 42Very SUpportive Backdrop In The 1990s bca.gaa_sr_2016_12_05_c42 bca.gaa_sr_2016_12_05_c42 Chart 43Not A Good Long-Term Investment Not A Good Long-Term Investment Not A Good Long-Term Investment Chart 44Shaky Demand Outlook bca.gaa_sr_2016_12_05_c44 bca.gaa_sr_2016_12_05_c44 Anemic Global Growth: Despite rising incomes, per capita consumption of base metals has been flat in most developed nations. With growth in the working age population slowing to 0.7% in 2010 - 2050, down from 1.7% in 1970 - 2010, the long-term outlook for consumer demand is poor. China: China consumes more zinc, aluminium and copper than the U.S., Japan, and Europe combined. It comprises more than 40% of global base metal demand, while it has only a 15% share of global GDP. With China's plans to transition into a consumer-driven services economy, this magnitude of incremental demand is highly unlikely in the future. Alternatives & Technological Advancements: Improved energy efficiency, the transition to renewable sources, and growth in electric-hybrid vehicles will weigh on demand for traditional sources of energy. A large-scale push towards nuclear energy, led by China's plans for 80GW of installed capacity by 2020, will pose a serious threat to marginal demand. Supply: Coordinated production cuts are a thing of the past. Underutilization (Chart 45) and market share-wars by countries that need to finance rising fiscal deficits have changed supply dynamics: Excess Capacity: Following the Global Financial Crisis, completion of projects which had been previously committed to, led to enormous capacity expansion when global growth was struggling. Both mining and oil & gas extraction capacity have reached new highs led by the U.S. This will continue to put downward pressure on both metals and energy prices until excess capacity has been removed. Proven Reserves: Known reserves of most metals have risen over the past decade and reached new highs: for example, in the case of copper, nearly three tons have been added to reserves for every ton consumed. In the crude oil market, technological progress has led to discovery of unconventional deposits, the best-known being Canadian oil sands, which by some estimates contain more than twice Saudi Arabia's crude oil reserves. Price Elasticity: The shale revolution brought with it leaner drilling operations which have a much shorter supply response time. The key to the price of crude is how quickly U.S. shale oil producers respond once the oil price rises above their current average cash cost of $50. This will limit the upside potential to crude oil for the next few years. U.S. Dollar & Real Rates: The dollar (Chart 46) has much more explanatory power for commodity prices than Chinese demand does. Given monetary policy and growth divergence between the U.S. and the rest of the world, the U.S. dollar will continue to appreciate. When real rates are low, the opportunity cost of keeping resources in the ground is also low. As growth starts to stabilize, rising real rates will add downward pressure on prices. Chart 45Relentless Supply Response bca.gaa_sr_2016_12_05_c45 bca.gaa_sr_2016_12_05_c45 Chart 46U.S. Dollar Vs Chinese Growth bca.gaa_sr_2016_12_05_c46 bca.gaa_sr_2016_12_05_c46 We remain structurally bearish on the overall commodity complex, but expect short-lived divergences within the group. As more nations agree on production cuts in oil, we expect energy markets to outperform metals. Precious metals will continue to stage mini-rallies on the back of heightened equity market volatility. Agricultural commodities will continue to bear the brunt of poor global demographics. IX. Mal-Distribution Of Income And Social Unrest The decision by the U.K. in June's referendum to leave the EU and Donald Trump's victory in the U.S. presidential election suggest a high degree of dissatisfaction with the status quo in Anglo-Saxon economies. This is hardly surprising given the stagnation of median wages in developed economies since the early 1980s, especially among the less educated (Chart 47), and growing inequality. The middle class (defined as those with disposable income between 25% below and 25% above the median) in the U.S. has fallen to 27% of the population from 33% in the early 1980s, and in the U.K. to 33% from 40% (Chart 48). Note that the decline in the middle class is much less prominent in continental Europe and Canada. Chart 47Wages For Less Educated Have Stagnated bca.gaa_sr_2016_12_05_c47 bca.gaa_sr_2016_12_05_c47 Chart 48Middle Class Has Shrunk In U.S. And U.K. But Not In Continental Europe Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes The Gini coefficient in the U.S. has risen to as high a level as during the 1920s (Chart 49). Branko Milanovic, the leading academic working on global inequality, explains the reasons are follows: "The forces that pushed U.S. inequality up in the roaring twenties were, in many ways, similar to the forces that pushed it up in the 1990s: downward pressure on wages (from immigration and/or increased trade), capital-based technological change (Taylorism and the Internet), monopolization of the economy (Standard Oil and large banks), suppression or decreasing attractiveness of trade unions, and a shift toward plutocracy in government."15 Chart 49U.S. Inequality Back To 1920's Level Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes The backlash has begun. BCA's Geopolitical Strategy service has described how the median voter in the Anglo-Saxon world is shifting to the left.16 Around the world governments are abandoning austerity and moving to fiscal stimulus and spending to improve infrastructure. Many, for example, are raising the minimum wage. In the U.K., it is due to go up from GBP7.20 to 60% of the median wage (about GBP9.35) by 2020, and in California from $10 to $15 by 2022. The 40 years of a falling labor share of GDP and rising capital share have started to reverse in the U.S. over the past two or three years (Chart 50). These shifts also threaten growth of global trade. Trump opposes the Trans-Pacific Partnership (TPP) trade agreement and says he will renegotiate or scrap the North America Free Trade Agreement (NAFTA). Global trade, after continuous growth as a percentage of GDP since World War Two, has slowed since the Great Recession (Chart 51). The WTO reports an increase in trade-restrictive measures and a fall in trade-facilitating measures over the past 12 months (Chart 52). Chart 50Fall In Labor Share ##br##Of GDP Starting To Reverse Fall In Labor Share Of GDP Starting To Reverse Fall In Labor Share Of GDP Starting To Reverse Chart 51Trade Globalization* bca.gaa_sr_2016_12_05_c51 bca.gaa_sr_2016_12_05_c51 Chart 52Trade Measures Are Getting ##br##Increasingly Restrictive Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes Chart 53Populism Could Cause ##br##Profit Margins To Mean Revert Populism Could Cause Profit Margins To Mean Revert Populism Could Cause Profit Margins To Mean Revert These trends have significant implications for investors. The shift to populist politics is likely to be inflationary, as governments increasingly fall back on stimulative fiscal policy. A faster rise in wages will hurt corporate profit margins which, in the U.S., are likely to mean-revert from their current near-record highs (Chart 53). The popular discontent (and the growing unreliability of opinion polls) will make election results more unpredictable, as witnessed in the Brexit vote and the U.S. presidential election. A further pullback in global trade will hurt exporting sectors and export-dependent countries. All these factors lead to the conclusion that returns from investment assets over coming years are likely to be lower, and volatility higher, than has been the case over the past 40 years. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Patrick Trinh, Senior Analyst patrick@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com 1 Money And Investment Profits, A. Hamilton Bolton, Dow-Jones-Irwin Inc, 1967, pp74, 304. 2 For our most recent detailed analysis of this, please see BCA Special Report, "The End Of The Debt Supercycle, An Update," dated May 11, 2016, available at reports.bcaresearch.com 3 Please see, for example, Summers' article in Foreign Affairs, "The Age of Secular Stagnation," dated February 15, 2016. 4 Please see, for example, Rogoff's article, "Debt Supercycle, not secular stagnation," Centre for Economic Policy Research, dated April 22, 2015. 5 Please see, for example, Emerging Markets Strategy Special Report, "Gauging EM/China Credit Impulses," dated August 31, 2016, available at ems.bcaresearch.com 6 Please see, for example, her book Technological Revolutions and Financial Capital, published in 2002. 7 Please see Alasdair Nairn, "Engines That Move Markets," Wiley, dated January 4, 2002. 8 Measured either over the whole period, or between the dates that they were listed during the period. 9 Please see The Bank Credit Analyst, "Human Intelligence And Economic Growth," March 2013, available at bca.bcaresearch.com. 10 Please see Emerging Markets Strategy Weekly Report, "EM Equities: Downgrade To Underweight," dated April 20, 2010, available at ems.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, and Geopolitical Strategy Strategic Outlook, "Stay The Course: EM Risk - DM Reward," dated January 23, 2014, available at gps.bcaresearch.com. 12 Please see Mearsheimer, John "The Tragedy Of Great Power Politics," New York: W.W. Norton & Company (2001). 13 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-Exit?," dated July 13, 2016, available at gps.bcaresearch.com, and BCA The Bank Credit Analyst, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 2011, available at bca.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization: All Downhill From Here," dated November 12, 2014. 15 Please see Branco Milanovic, "Global Inequality: A New Approach for the Age of Globalization," Harvard University Press, 2016. 16 Please see Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com.

President-elect Trump and the specter of his spendthrift policy proposals have generated significant client interest/inquiries on equities and inflation - not asset prices, but of the more traditional kind: consumer price inflation. Chart 1 shows that a little bit of inflation would be positive for the broad equity market, further fueling the high-risk, liquidity-driven blow off phase. However, when inflation has reached 3.7%-4% in the past, the broad equity market has stumbled (Chart 2). Sizeable tax cuts, increased infrastructure and defense spending (i.e. loose fiscal policy), protectionism and a tougher stance on immigration are inherently inflationary policies (and bond price negative) ceteris paribus. Chart 1A Whiff Of Inflation##br## Is Good For Stocks... bca.uses_sr_2016_12_05_c1 bca.uses_sr_2016_12_05_c1 Chart 2...But Too Much ##br##Is Restrictive ...But Too Much Is Restrictive ...But Too Much Is Restrictive However, our working assumption is that in the next 9-12 months, CPI headline inflation will only renormalize, rather than surge. Importantly, the magnitude and timing of the implementation of Trump's policy pledges is unknown. Moreover, the Fed's reaction function is also uncertain, and the resulting economic growth and U.S. dollar impact will be critical in determining whether any lasting inflation acceleration occurs. Table 1 Equity Sector Winners And Losers When Inflation Climbs Equity Sector Winners And Losers When Inflation Climbs For global inflation to take root beyond the short term, Europe and Japan would also have to follow Canada's and America's fiscal largesse to swing the global deflation/inflation pendulum toward sustained inflation. The Fed's Reaction Function Our sense is that a Yellen-led Fed will allow for some inflation overshoot to materialize. This view was originally posited in her 2012 "optimal control"1 speech and more recently reiterated with her mid-October speech emphasizing "temporarily running a "high-pressure economy," with robust aggregate demand and a tight labor market."2 The Fed has credible tools to deal with inflation. If economic growth does not soar, but rather sustains its post-GFC steady 2-2.5% real GDP growth profile as we expect, then taking some inflation risk is a high-probability. The implication is that the Fed will likely not rush to abruptly tighten monetary policy, a view confirmed by the bond market , which is penciling in only 40bps for 2017 (Chart 3). A sustainable breakout in bond yields would require inflation (and to a lesser extent real GDP growth) to significantly surprise to the upside and thus compel the Fed to aggressively raise the fed funds rate. Is that on the horizon? While wage inflation has perked up, unit labor cost inflation has a spotty track record in terms of leading core consumer goods prices. Why? About 20% of the CPI and PCE inflation baskets are produced abroad, underscoring that domestic costs are not a factor in setting prices. There is a tighter correlation between unit labor costs and service sector inflation, but even here there is not a consistent relationship (Chart 4). Consequently, there is minimal pressure on the Fed to get aggressive, suggesting that most of the cyclical back up in long-term yields may have already occurred. Chart 3Fed Will Be Late, As Always bca.uses_sr_2016_12_05_c3 bca.uses_sr_2016_12_05_c3 Chart 4Wage And CPI Inflation Often Diverge Wage And CPI Inflation Often Diverge Wage And CPI Inflation Often Diverge The 1960s Analogy The 1960s period provides an instructive guide for today. Then, an extremely tight labor market and a positive output gap was initially ignored by the Fed, i.e. the economy was allowed to overheat (Chart 5). This ultimately led to the surge of inflation in the 1970s, especially given the then highly unionized labor market (see appendix Chart A1). While there are similarities between the current backdrop and the 1960s, namely an extended business cycle, full employment, narrowing output gap, easy monetary and a path to easing fiscal policies, and rising money multiplier, there are also striking differences. At the current juncture, wage inflation is half of what it was in the mid-1960s. Even unit labor costs heated up to over 8% back then, nearly four times the current level. Chart 5The 1960's... bca.uses_sr_2016_12_05_c5 bca.uses_sr_2016_12_05_c5 Chart 6... And Today bca.uses_sr_2016_12_05_c6 bca.uses_sr_2016_12_05_c6 Full employment has only been recently attained (Chart 6) and in order to pose a long-term inflation worry, it would have to stay near 5% for another three years. True, the output gap is almost closed, and is forecast to turn marginally positive in 2017/2018, but much will depend on the timing of fiscal stimulus. Industrial production has diverged negatively from the output gap of late, suggesting that excess capacity still lingers in some parts of the economy (Chart 7). The upshot is that inflationary pressures may stay contained for some time, especially if the U.S. dollar continues to firm. The global environment remains marked by deficient demand, not scarce resources. Chart 8 shows that the NFIB survey of the small business sector has a good track record in leading core inflation. The survey shows that businesses are still finding it difficult to lift selling prices. That is confirmed by deflation in the retail price deflator. Chart 7Divergent Economic Slack Messages bca.uses_sr_2016_12_05_c7 bca.uses_sr_2016_12_05_c7 Chart 8Pricing Power Trouble bca.uses_sr_2016_12_05_c8 bca.uses_sr_2016_12_05_c8 Finally, while the money multiplier has troughed, it would have to jump to a level of 4.9 to parallel the 1960s (Chart 9). This is a tall order and it would really require the Fed to very aggressively wind down its balance sheet. Chart 9Monitoring The Money Multiplier bca.uses_sr_2016_12_05_c9 bca.uses_sr_2016_12_05_c9 Therefore, a 1960s repeat would be a tail risk, and not our base case forecast. What About The Greenback? Chart 10 shows that inflation decelerates during U.S. dollar bull markets. Our Foreign Exchange Strategy service believes that the currency has more cyclical upside3, given that it has not yet overshot on a valuation basis and interest rate differentials will favor the U.S. for the foreseeable future. Accordingly, it may be difficult for inflation to rise on a sustained basis. Chart 10Appreciating Dollar Is##br## Always Disinflationary Appreciating Dollar Is Always Disinflationary Appreciating Dollar Is Always Disinflationary So What? Accelerating inflation is a modest risk, but not our base case forecast. Nevertheless, for investors that are more worried about the prospect of higher inflation, the purpose of this Special Report is to serve as an equity sector positioning roadmap if inflationary pressures become more acute sooner than we anticipate. Historically, inflation has been synonymous with an aggressive Fed and hard asset outperformance, suggesting that deep cyclical sectors would be primary beneficiaries. Table 1 on Page 2 shows that over the last six major inflationary cycles, energy, materials, real estate and health care have been consistent outperformers. Utilities, tech and telecom have been clear underperformers. The remaining sectors have been a mixed bag. However, this cycle, potential growth is much lower than in the past, underscoring that the hit to overall profits from tighter monetary policy could be pronounced, potentially undermining equity market risk premiums. If inflation rises too quickly and the Fed hits the economic brakes, then it is hard to envision cyclical sectors putting in a strong market performance, especially given their high debt loads and shaky balance sheets, i.e. they are at the epicenter of corporate sector vulnerability if interest rates rise too quickly. Owning shaky balance sheets in a sluggish global economy is a strategy fraught with risk. On the flipside, the recent knee jerk sell off in more defensive sectors represents a reversal of external capital flows, and is not representative of an underlying vulnerability in their earnings prospects. As a result of this shift, valuations now favor more defensive sectors by a wide margin. Ultimately, we expect relative profit trends to dictate relative performance on a cyclical investment horizon, and are not rushing to position our portfolio for accelerating inflation. Anastasios Avgeriou, Vice President Global Alpha Sector Strategy anastasios@bcaresearch.com 1 https://www.federalreserve.gov/newsevents/speech/yellen20120411a.htm 2 https://www.federalreserve.gov/newsevents/speech/yellen20161014a.htm 3 https://fes.bcaresearch.com/articles/view_report/20812 Health Care (Overweight) Health care stocks have consistently outperformed during the six inflationary periods we studied. Over the long haul it has paid to overweight this sector given the structural uptrend in relative share prices. Spending on health care services is non-cyclical and demand for such services is also on a secular rise around the globe: in the developed markets driven largely by the aging population and in the emerging markets by the adoption of health care safety nets (Chart 11). Health care pricing power is expanding at a healthy clip, outshining overall CPI. Importantly, recent geopolitical uncertainty had cast a shadow on the sector's pricing power prospects that suffered from a constant derating. Now that political and pricing power uncertainty is lifting, a rerating looms. Finally, the health care sector's dividend yield allure is the lowest among defensive sectors and remains 44bps below the broad market, somewhat insulating the sector from the inflation driven selloff in the bond market (Chart 12). Chart 11Health Care bca.uses_sr_2016_12_05_c11 bca.uses_sr_2016_12_05_c11 Chart 12Health Care bca.uses_sr_2016_12_05_c12 bca.uses_sr_2016_12_05_c12 Consumer Staples (Overweight) Similar to the health care sector, consumer staples stocks have been stellar outperformers over the past 55 years. The sector's track record during the six inflationary periods we studied is split down the middle. Most consumer staples companies are global conglomerates and their efforts have been focused on building global consumer brands, allowing them to implement a stickier pricing strategy. As a result, overall inflation/deflation pressures are more benign (Chart 13). Relative consumer staples pricing power is expanding and has been in an uptrend for the past five years. As the U.S. dollar has been in a bull market since 2011, short-circuiting the commodity super cycle, consumer staples manufacturers have been beneficiaries of falling commodity input costs. The implication is that profit margins have been expanding due to both rising pricing power and lower input costs (Chart 14). Chart 13Consumer Staples bca.uses_sr_2016_12_05_c13 bca.uses_sr_2016_12_05_c13 Chart 14Consumer Staples bca.uses_sr_2016_12_05_c14 bca.uses_sr_2016_12_05_c14 Telecom Services (Overweight - High Conviction) Relative telecom services performance and inflation appear broadly inversely correlated since the early 1970s, underperforming 60% of the time when core PCE prices accelerate. Importantly, in two of the periods we studied (during the late-70s and the TMT bubble) the drawdowns were massive, skewing the mean results portrayed in Table 1 on page 2. This fixed income proxy sector tends to suffer in times of inflation as competing assets dilute its yield appeal and vice versa (Chart 15). Telecom services pricing power has been declining over time as the government deregulated this once monopolistic industry. As more entrants forayed into the sector boosting competition, pricing power erosion accelerated. While relative sector pricing power has been mostly mired in deflation with a few rare expansionary spurts, there is an offset as the industry has entered a less volatile selling price backdrop: communications equipment costs are also constantly sinking (they represent a major input cost), counterbalancing the industry's profit margin outlook (Chart 16). Chart 15Telecom Services bca.uses_sr_2016_12_05_c15 bca.uses_sr_2016_12_05_c15 Chart 16Telecom Services bca.uses_sr_2016_12_05_c16 bca.uses_sr_2016_12_05_c16 Consumer Discretionary (Overweight) While the overall trend in consumer discretionary stocks has been higher since the mid-1970s, relative performance mostly declines during inflationary times. Consumer spending takes the backseat as a performance driver when interest rates rise on the back of higher inflation. In addition, previous inflationary periods have also coincided with surging energy prices, representing another source of diminishing consumer discretionary purchasing power (Chart 17). Consumer discretionary selling prices are expanding relative to overall wholesale price inflation, but they have been losing some steam of late. Were energy prices to sustain their recent cyclical advance, as BCA's Commodity & Energy Strategy service expects, that would represent a minor headwind to discretionary outlays. True, the tightening in monetary conditions could also be a risk, but we doubt the Yellen-led Fed would slam on the brakes at a time when the greenback is close to 15 year highs. The latter continues to suppress import prices and act as a tailwind to consumer spending and more than offsetting the energy and interest rate headwinds (Chart 18). Chart 17Consumer Discretionary bca.uses_sr_2016_12_05_c17 bca.uses_sr_2016_12_05_c17 Chart 18Consumer Discretionary bca.uses_sr_2016_12_05_c18 bca.uses_sr_2016_12_05_c18 Real Estate (Overweight) REITs have been outperforming the overall market during the five inflationary periods we analyzed, exemplifying their hard asset profile. While the 1976-81 iteration skewed the mean results, REITs still come out with the third best showing among the top eleven sectors even on median return basis (see Table 1 on page 2). Real estate prices tend to appreciate when inflation is accelerating, because landlords have consistently raised rents at least on a par with inflation (Chart 19). REITs pricing power has outpaced overall CPI. Apartment REITs rental inflation has been on a tear since the GFC, and the multi-family construction boom will eventually act as a restraint. The selloff in the bond market represents another risk to REITs relative returns as this index falls under the fixed income proxied equity basket, but the sector is now attractively valued (Chart 20). Chart 19Real Estate bca.uses_sr_2016_12_05_c19 bca.uses_sr_2016_12_05_c19 Chart 20Real Estate Real Estate Real Estate Energy (Neutral) The energy sector comes out on top of the median relative return results in times of inflation, and second best in average terms (Table 1 on page 2). Oil price surges are typically synonymous with other forms of inflation. During the six inflationary periods we analyzed, all but one period were associated with relative share price outperformance. Oil producers in particular benefit from the increase in the underlying commodity almost immediately (assuming little to no hedging), which also serves as an excellent inflation hedge (Chart 21). While relative energy pricing power had stabilized following the tumultuous GFC, Saudi Arabia's decision in late 2014 to refrain from balancing the oil market triggered a plunge in oil prices, similar to the mid-1980s collapse. The OPEC deal reached last week to curtail oil production should rebalance the market more quickly, assuming OPEC cheating will be limited, removing downside price risks. Nevertheless, any oil price acceleration to the $60/bbl level will likely prove self-limiting, as supply will come to the market and producers would rush to lock in prices by hedging forward (Chart 22). Chart 21Energy Energy Energy Chart 22Energy Energy Energy Financials (Neutral) Financials relative returns are neither hot nor cold when inflation rears its ugly head. In fact they sit in the middle of the pack in terms of relative median and mean returns. This lack of consistency reflects different factors that exerted significant influence in some of these inflationary periods. Moreover, Chart 23 shows that relative share prices have been mean reverting since the 1960s, likely blurring the inflation influence. Ultimately, the yield curve, credit growth and credit quality determine the path of least resistance for the relative share price ratio of this early cyclical sector. Financials sector pricing power has jumped by about 400bps over the past 18 months. Given the recent steepening of the yield curve, the odds are high that sector pricing power will remain firm via rising net interest margins. Any easing in the regulatory backdrop could also provide a fillip to margins (Chart 24). Chart 23Financials Financials Financials Chart 24Financials Financials Financials Utilities (Neutral) Utilities relative returns during inflationary bouts are the second worst among the top eleven sectors on an average basis and dead last on a median return basis. In five out of the six inflationary phases we examined, utilities stocks suffered a setback. The industry's lack of economic leverage and fixed income attributes anchor the relative share price ratio during inflationary times (Chart 25). Our utilities sector pricing power proxy has sprung to life recently moderately outpacing overall inflation. Natural gas prices, the industry's marginal price setter, have experienced a V-shaped recovery since the March trough, as excess inventories have been whittled down, signaling that recent pricing power gains have more upside. Nevertheless, the recent inflation driven jack up in interest rates has dealt a blow to this high dividend yielding defensive sector. Barring a sustained selloff in the bond market at least a technical rebound in relative share prices is looming (Chart 26). Chart 25Utilities Utilities Utilities Chart 26Utilities Utilities Utilities Tech (Underweight) Technology stocks have underperformed every time inflation has accelerated with two exceptions, in the mid-to-late 1960s and mid-to-late 1970s. Creative destruction forces in the tech industry are inherently deflationary. As a result, tech business models have evolved to thrive during disinflationary periods. Moreover, tech stocks have become more mature than typically perceived, having more stable cash flows and paying dividends. The implication is that the negative correlation with inflation will likely remain in place (Chart 27). Tech companies are constantly mired in deflation. While relative pricing power has been in an uptrend since 2011, it has recently relapsed into the deflationary zone. Worrisomely, deflation pressures are likely to intensify as the U.S. dollar appreciates, eating into the sector's earnings growth prospects. Finally, as a reminder, among the top eleven sectors tech stocks have the highest international sales exposure (Chart 28). Chart 27Tech Tech Tech Chart 28Tech Tech Tech Industrials (Underweight - High Conviction) The industrials sector tends to outperform during inflationary periods. In fact, relative share prices have risen 50% of the time since the mid-1960s when inflation was accelerating. The two oil shocks in the 1970s raised the profile of all commodity-related sectors as investors were scrambling to find reliable inflation hedges (Chart 29). Industrials pricing power is sinking steadily, weighed down by the multi-year commodity plunge on the back of China's economic growth deceleration, rising U.S. dollar and increasing supplies. While infrastructure spending is slated to increase at some point in late-2017 or early-2018, we doubt a lot of shovel ready projects will get off the ground quickly enough to satisfy the recent spike in expectations. We are in a wait and see period and remain skeptical that all this fiscal spending enthusiasm will translate into a sustainable earnings driven outperformance phase (Chart 30). Chart 29Industrials Industrials Industrials Chart 30Industrials bca.uses_sr_2016_12_05_c30 bca.uses_sr_2016_12_05_c30 Materials (Underweight) Materials equities have a tight positive correlation with accelerating inflation. Resource-related stocks are the closest representation of hard assets, given their ability to store value among the eleven GICS1 sectors. As inflation takes root and commodity prices rise, materials sales and EPS growth get a boost with relative share prices following right behind (Chart 31). From peak-to-trough relative materials prices collapsed by over 35 percentage points and only recently have managed to stage a modest comeback. Our relative pricing power gauge is flirting with the zero line, but may not move much higher. Deleveraging has not even commenced in the emerging markets, and the soaring U.S. dollar is highly deflationary. It will be extremely difficult for materials prices to advance sustainably if EM financial stress intensifies, given the inevitable backlash onto regional economic growth (Chart 32). Chart 31Materials bca.uses_sr_2016_12_05_c31 bca.uses_sr_2016_12_05_c31 Chart 32Materials bca.uses_sr_2016_12_05_c32 bca.uses_sr_2016_12_05_c32 Appendix Chart A1 bca.uses_sr_2016_12_05_c33 bca.uses_sr_2016_12_05_c33 Chart A2 bca.uses_sr_2016_12_05_c34 bca.uses_sr_2016_12_05_c34 Chart A3 bca.uses_sr_2016_12_05_c35 bca.uses_sr_2016_12_05_c35 Chart A4 bca.uses_sr_2016_12_05_c36 bca.uses_sr_2016_12_05_c36 Chart A5 bca.uses_sr_2016_12_05_c37 bca.uses_sr_2016_12_05_c37 Chart A6 bca.uses_sr_2016_12_05_c38 bca.uses_sr_2016_12_05_c38

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of November 30, 2016. The model further augmented the overweight to the U.S. despite the fact that the U.S. had already been the largest overweight, at the expenses of the Euro Area. Japan's underweight is reduced again, albeit slightly. The model continues to dislike Canada and Australia even though the two countries have outperformed year to date. U.K. remains the largest underweight (Table 1). Table 1Model Allocation Vs. Benchmark Weights GAA Model Updates GAA Model Updates As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the large overweight of the U.S. versus the non-U.S. (Level 1 model) worked well in November with 49 bps of outperformance versus the MSCI World benchmark, the level 2 (allocation within the 11 non-U.S. countries), however, underperformed significantly, resulting the overall model to underperform by 16 bps. Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. Table 2Performance (Total Returns In USD) GAA Model Updates GAA Model Updates Chart 1GAA DM Model Vs. MSCI World bca.gaa_sa_2016_12_01_c1 bca.gaa_sa_2016_12_01_c1 Chart 2GAA U.S. Vs. Non U.S. Model (Level1) bca.gaa_sa_2016_12_01_c2 bca.gaa_sa_2016_12_01_c2 Chart 3GAA Non U.S. Model (Level 2) bca.gaa_sa_2016_12_01_c3 bca.gaa_sa_2016_12_01_c3 For more details on the models, please see the January 29th, 2016 Special Report "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of November 30, 2016. Table 3Allocations GAA Model Updates GAA Model Updates Table 4Performance Since Going Live GAA Model Updates GAA Model Updates Chart 4Overall Model Performance bca.gaa_sa_2016_12_01_c4 bca.gaa_sa_2016_12_01_c4 The momentum component has shifted Consumer Discretionary from underweight to overweight. For mode details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Patrick Trinh, Senior Analyst patrick@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

Highlights Dear Client, This issue of BCA's Commodity & Energy Strategy features our 2017 Outlook for Bulks and Base Metals. The evolution of China's economy will, as always, be critical to these markets, given that country's outsized role in iron ore, steel and base metals. We are broadly neutral the complex, and, with the exception of the nickel market, see supply and demand relatively balanced. That said, the potential for price spikes - e.g., copper, where spare capacity is shrinking - and for monetary and fiscal policy errors to spill into these markets keeps downside price risk elevated. Next week, we will publish our 2017 Outlook for Energy Markets, with special attention to the oil market. As expected, OPEC and Russia agreed to cut production. As we went to press, WTI and Brent crude oil prices were up ~ 8.5% on the news. We will take profits today on our Long February 2017 Brent $50/bbl Calls vs. Short February 2017 $55/bbl Calls, which was up 73.6% basis Wednesday's close when we went to press. We remain long August 2017 WTI vs. Short November 2017 WTI futures in anticipation of a backwardated forward curve in 2017H2; as of Wednesday's close, this position returned 76.39% since November 3, when we recommended the exposure. Our 2017 Precious Metals and Agricultural outlooks will be published in the following weeks. We will finish with an outlook for commodities as an asset class in 2017 at year-end. We trust you will find these reports informative and useful for your investing and year-ahead planning. Kindest regards, Robert P. Ryan, Senior Vice President The monetary and fiscal stimulus that massively boosted China's housing market this year will wind down, bringing an end to the run-up in iron ore, steel and base metals prices. While we expect "reflationary" policies to continue going into the Communist Party Congress next fall, when new leadership roles will be announced, we do not expect anything along the lines of the surge in policy stimulus seen earlier this year: Unwinding and controlling property-market excesses and high debt levels will limit policymakers' desire to turbo-charge the housing market again, limiting the boost such policies provide. We are downgrading our tactically bullish view on iron ore to neutral. Our out-of-consensus bullish call was proven correct with a 43% rally in iron ore prices within the past eight weeks.1 Strategically, we retain a bearish bias, as rising iron ore supply may overwhelm the market again in 2017H2. We remain tactically neutral and strategically bearish steel. Low steel inventories and production disruptions caused by China's recently launched environmental inspection program likely will continue to support steel prices in the near term. However, persistently high steel output and falling demand from the Chinese property sector should eventually knock down prices in 2017H2. We remain neutral copper going into 2017, expecting Chinese reflationary stimulus to continue along with a concerted effort to slow the housing boom in that country. This will still support real demand for copper, but will reduce demand from new construction. Manufacturing will play a larger role on the demand side next year, while a stronger USD could limit price appreciation. We still believe nickel will outperform zinc over a one-year time horizon. We are bullish nickel prices, both tactically and strategically, as we expect a supply deficit to widen on rising stainless steel demand and falling nickel ore supply in 2017. For zinc, we remain tactically neutral and strategically bearish. We expect zinc supply to rise considerably in response to current high prices. For the global aluminum market, we remain tactically bullish and strategically neutral. Supply shortages will likely persist ex-China over the next three to six months. We have three investment strategies, including long iron ore/short steel futures, long nickel/short zinc futures, and buying aluminum on weaknesses. Feature Iron Ore & Steel: Limited Upside In 2017 A Quick Recap Back in early October, we wrote an in-depth report on global iron ore and steel markets in which we made an out-of-consensus tactically bullish call on iron ore, expecting the price to reach the April high of $68.70/MT in 2016Q4. Our prediction was realized, with iron ore prices surging 43% to a two-year high of $79.81/MT on November 11 (Chart 1, panel 1). Although the steel market has been much stronger than the assessment driving our tactically neutral stance indicated earlier in the quarter, our call that iron ore would outperform steel in the near term was correct: Steel prices rose 21% during the same period of time - only half of the iron ore price rally (Chart 1, panel 1). Over the past two months, the rally occurred in both futures and spot markets, and in the markets globally (Chart 1, panels 2 and 3). Chart 1Iron Ore: Downgrade To Tactically Neutral Iron Ore: Downgrade To Tactically Neutral Iron Ore: Downgrade To Tactically Neutral Chart 2Steel: Remain Tactically Neutral Steel: Remain Tactically Neutral Steel: Remain Tactically Neutral The 2017 Outlook First, we downgrade our tactically bullish view on iron ore to neutral, as China likely will import less iron ore in 2017Q1 (Chart 2, panel 1). China has imposed stricter environmental regulations on its domestic metals industry since 2014 to control pollution. The government currently is sending environmental inspection teams to major steel-producing provinces to check how well the steel producers are complying with state environment rules. Many steel-producing factories were closed this year, due to environmental violations. This will constrain growth in Chinese steel output in the near term (Chart 2, panel 2). Between 2011 - 15, the state-owned Xinhua news agency states Chinese steel capacity has been reduced by 90 million MT; authorities want to cut as much as 150 million MT by 2020, including 45 million MT this year.2 Chinese steel production generally falls in January and February as workers are celebrating the Chinese Spring Festival - the most important festival for the Chinese. Iron ore inventories at major Chinese ports are still high (Chart 2, panel 3). Given iron ore prices have already rallied more than 100% since last December and steel demand outlook remains uncertain next year, most steel producers likely will choose to push off purchases into 2017Q2 or later. While China may slow its iron ore purchases next year, global iron ore supply is set to increase in 2017 as many projects will come on stream. The world's biggest iron ore project, Vale's S11D, which has a capacity of 90 million metric tons (mmt) per year, is expected to ship its first ore in January 2017. Moreover, with iron ore prices above $70/MT, global top iron ore companies with low production costs can be expected to sell as much as they can to maximize their profit, given their all-in production costs for high-quality iron ore (62% Fe) typically are between $30 and $35/MT.3 That said, we are not bearish on iron ore prices in the near term. We prefer to be neutral. Iron ore prices will have pullbacks, but the downside may be also limited in 2017H1. Chinese domestic iron ore production is still in a deep contraction (Chart 2, panel 4). Plus, most steel producing companies prefer high-quality ore from overseas over the domestic low-quality ore. In addition, almost all steel companies in China are profitable at present, which means Chinese steel production will rise after the Spring Festival holidays. All of these factors will support iron ore prices. Chart 3Iron Ore & Steel: Strategically Bearish Iron Ore & Steel: Strategically Bearish Iron Ore & Steel: Strategically Bearish Second, we retain our tactically neutral view on steel. Chinese steel demand was lifted by China's expansionary monetary and fiscal policies this year - which we have dubbed China's "reflationary" policy - which included reductions in its central bank's policy rate and reserve requirement ratio, and implementation of additional infrastructure projects (Chart 3). This was the driving force for the sharp steel price rally this year. The big question is how sustainable Chinese steel demand growth will be? This will be highly dependent on the Chinese government's decisions and actions. More than a third of steel demand is accounted for by the property market, of which some 70% is residential property.4 Mortgages accounted for approximately 71% of all new loans in August of this year, down from 90% in July, according to Reuters.5 This loan growth powered the iron ore and steel markets this past 12 - 18 months and China's credit-to-GDP ratio to extremely high levels. The OECD recently observed, "The high pace of debt accumulation was sustained despite weaker domestic demand growth. This raises concerns about the underlying quality of new credit, disorderly corporate defaults and the possible extent to which it has been used to support financial asset prices. Residential property prices in some of the largest cities have risen by over 30% year-on-year, although price growth in smaller cities has been much more modest. The price gains have been partly driven by loose monetary policy and ample credit availability as well as reduced land supply."6 Based on our calculations, Chinese steel demand started showing positive yoy growth in July and, so far, had posted four consecutive months of positive yoy growth from July to October. In September and October, the growth was accelerated to 8.3% and 6.6%, respectively, a clear improvement from the 0.8% yoy growth registered in July. The growth may last another three to six months but could peak sooner, if there are no new stimulus plans announced by the government. In addition to the housing sector, China's auto industry also saw significant demand growth. As China cut the sale taxes on small passenger vehicles from 10% to 5% this year, Chinese car sales jumped 13.6% yoy for the first 10 months of 2016, a significant improvement from a 5.7% yoy contraction in the same period of last year. If the government lets the tax cut expire at year-end, Chinese auto production may decline in 2017, which will weaken Chinese steel demand. In the meantime, Chinese steel producers will keep boosting production next year, which likely will limit the upside for steel prices. That said, current steel inventories in China are still low. According to the China Iron and Steel Association (CISA), steel inventories at large and medium steel enterprises fell 9% from mid-September to late October. This probably will limit the downside for steel prices. Third, we retain a strategic bearish view on both iron ore and steel. If there is no additional reflationary stimulus deployed in 2017, we expect Chinese steel demand to weaken. In the meantime, Chinese steel producers will keep boosting their production. Let these two factors run nine to 12 months, and we believe they will be sufficient to knock down both steel and iron ore prices. Our research last year concluded the Chinese property sector is structurally down-trending.7 Given that the property market is the biggest end user of steel in China, accounting for about 35% of total steel demand, we are strategically bearish on steel and iron ore prices. How To Make Money In The Iron Ore & Steel Market? Chart 4Take Profit On Long ##br##Iron Ore/ShortSteel Rebar Trade Take Profit On Long Iron Ore/Short Steel Rebar Trade Take Profit On Long Iron Ore/Short Steel Rebar Trade We went long May/17 iron ore futures in Dalian Futures Exchange in China and short May/17 steel rebar futures in Shanghai Futures Exchange on October 6 (Chart 4). Both contracts are denominated in RMB. The relative trade gives us a return of 18.1% in two months. We are taking profits with this publication, but we may re-initiate this pair trade on pullbacks. Risks If China deploys additional fiscal and monetary stimulus next year, similar in scope to this year's stimulus, we will re-evaluate our view accordingly. If global iron ore production is less than the market expects we could see further rallies in iron ore prices. Should this occur, we will re-examine our market call, as well. Copper: Market Is Balanced; Little Flex On Supply Side The reflationary stimulus that powered China's property markets - and drove demand for iron ore and steel higher - also propelled copper prices to dizzying heights in 2016H2. We do not expect this juggernaut to continue, and instead expect copper to trade sideways next year as global supply and demand stay relatively balanced (Chart 5). China accounts for roughly half of global refined copper demand (Chart 6). Manufacturing activity has the greatest impact on prices: A 1% increase in China's PMI translates to a 1.8% increase in LME copper prices (Chart 7). Chart 5Copper Market Is In Balance Copper Market Is In Balance Copper Market Is In Balance Chart 6World Copper Markets Are Balanced World Copper Markets Are Balanced World Copper Markets Are Balanced Chart 7China Demand Will Remain Key For Copper China Demand Will Remain Key For Copper China Demand Will Remain Key For Copper China's property market accounts for about a third of global copper demand in used in construction, according to the CME Group, which trades copper on its COMEX exchange. A 1% increase floor-space started in China leads to a 0.3% increase in LME copper prices (Chart 8). The surge in demand from the housing market lifted China's copper demand over the past 12 - 18 months, as credit creation in the form of home-mortgage loans expanded at a rapid clip (Chart 9). We expect the Chinese government to continue to try to rein in a booming property market, which has seen mortgage-loan growth of 90% p.a. recently. If the government is successful, this will limit price gains for copper next year. If not, the bubble will continue to expand in large tier-1 and -2 cities in China, making the copper rally's fundamental support tenous to say the least. Chart 8China PMIs and USD TWI Drive LME Prices China PMIs and USD TWI Drive LME Prices China PMIs and USD TWI Drive LME Prices Chart 9Mortgage Growth Likely Slows in 2017 Mortgage Growth Likely Slows in 2017 Mortgage Growth Likely Slows in 2017 This drives our expectation that the real economic activity in China - chiefly manufacturing - will be the dominant fundamental on the demand side for copper next year. On the supply side, we expect 2.65% yoy growth in refined copper production, just slightly above the International Copper Study Group's 2% estimate. Company and press reports cite a reduced mine capacity additions, lower ore content in mined output, and labor unrest as reasons supply side growth is slowing. Our balances reflect a convergence of supply and demand for next year, and also highlight the reduced flexibility in the system to respond to unplanned outages. For this reason, the global copper market could be prone to upside price risk in the event of a major unplanned production outage. Watch Out For USD Strength Copper, like all of the base metals, is sensitive to the path taken by the USD. We continue to expect the Fed to lift rates next month and a couple of times next year. This most likely will lift the USD 10% or so over the next 12 months. This would be bearish for base metals, particularly copper, since 92% of global demand for the red metal occurs outside the U.S. Our modeling indicates a 1% increase in the broad USD trade-weighted index leads to a 3.5% decrease in LME copper prices. A stronger USD will raise the local-currency cost of commodities ex-U.S. EM demand would suffer, which would slow the principal source of growth for base metals. Metals producers' ex-U.S. with little or no exposure to USD debt-service obligations would see local-currency operating costs fall. At the margin, this will lead to increased supply. These effects would combine to push commodity prices lower, producing a deflationary blowback to the U.S. Nickel & Zinc: Going Different Ways In 2017? Zinc has outperformed nickel significantly for the past six years. This year alone, zinc prices have shot up over 90% since January, almost doubling the 50% rally in nickel prices for the same period of time (Chart 10, panel 1). The nickel/zinc price ratio has declined to its lowest level since 1998 (Chart 10, panel 2). Will nickel continue underperforming zinc into 2017? Or will the trend reverse next year? We believe the latter has a higher probability. Tactically, we are bullish nickel and neutral zinc. Strategically, we are bullish nickel and bearish zinc.8 Zinc's bull story has been well-known for the past several years, and nickel's oversupplied bear story also has been commented on in the news. However, both markets' fundamentals are changing. Based on World Bureau of Metal Statistics (WBMS) data, for the first nine months of this year, the supply deficit in the global nickel market was at its highest level since 1996. Meanwhile, the global zinc market was already in balance (Chart 10, panels 3 and 4). Chart 10Nickel Likely To Outperform Zinc In 2017 Nickel Likely To Outperform Zinc In 2017 Nickel Likely To Outperform Zinc In 2017 Chart 11Nickel Has More Positive Fundamentals Than Zinc Nickel Has More Positive Fundamentals Than Zinc Nickel Has More Positive Fundamentals Than Zinc Both nickel and zinc markets are experiencing ore shortages (Chart 11, panels 1 and 2). For the nickel market, the ore shortage was mainly due to the Indonesian ore export ban, and Philippines' suspension of nickel miners for violating that country's environmental laws. For the zinc market, the ore shortage arose because of several big mines' depletion, years of underinvestment, and mine suspensions due to low prices late last year. The nickel ore shortage will become acute as the Indonesian ban remains in place and the Philippines' government becomes stricter on domestic mining operations. However, for zinc, most of the output loss occurred last year, and actually may be restored to the market in the near future. Zinc prices reached $2,811/MT last year as the market was adjusting to lost supply - the highest level since March 2008. In terms of demand, nickel exhibits much stronger demand growth versus zinc (Chart 11, panels 3 and 4). In addition, China's auto sales tax-cut policy will expire at year-end, which may cause Chinese auto production to fall in 2017. This will affect zinc much more than nickel, as less galvanized steel will be needed next year if Chinese car production falls. Investment Strategies We sold Dec/17 zinc at $2,400/MT on November 3, and the trade was stopped out at $2,500/MT with a 4% loss (Chart 12, panel 1). Zinc prices jumped 11.5% in four trading days in late November, which we believe was mainly driven by speculative buying. Nonetheless, in the near term, global zinc supply is still on the tight side, and zinc inventories are low (Chart 12, panel 2). Zinc prices could rally more in the near term. We were looking to go Long Dec/17 LME nickel vs. Short Dec/17 LME zinc if the ratio drops to 4.3 since mid-November (Chart 13, panel 1). We also suggested that if the order gets filled, put a stop-loss for the ratio at 4.15. Chart 12Zinc: Stay Tactically Neutral Zinc: Stay Tactically Neutral Zinc: Stay Tactically Neutral Chart 13Risks To Long Nickel/Short Zinc Risks To Long Nickel/Short Zinc Risks To Long Nickel/Short Zinc On November 25, the order was filled at the closing price ratio of 4.17. But unfortunately the ratio declined to 4.08 on the next trading day (November 28), based on the closing price ratio, which triggered our predefined stop-loss level with a 2.2% loss. The ratio was trading at 4.17 again as of November 29. As the market is so volatile, we recommend initiating this relative trade if it drops below 4.05 to compensate the risk. If the order gets filled, we suggest putting a 5% stop-loss level for the relative trade. After all, nickel prices could still have pullbacks, as global nickel inventories still are elevated (Chart 13, panel 2). Risks Our strategically bearish view on zinc will be wrong if global zinc ore supply does not increase as much as we expect, or global zinc demand still has robust growth in 2017. Our strategically bullish view on nickel will be wrong if Indonesian refined nickel output increases quickly, resulting in a smaller supply deficit than the market expects. However, due to power shortages, poor infrastructure and funding problems, development on many of the smelters and stainless steel plants once envisioned for the nickel market have been delayed. We believe these problems will continue to be headwinds for Indonesian nickel output growth, and will continue to restrict supply growth going forward. Aluminum: Cautiously Bullish In 2017 Chart 14Aluminum: Remain Tactically Bullish ##br## And Strategically Neutral Aluminum: Remain Tactically Bullish And Strategically Neutral Aluminum: Remain Tactically Bullish And Strategically Neutral Sharp supply cuts combined with tight inventories have pushed aluminum prices higher this year. Prices in China have rallied more than 50% so far this year, which was more than double the 20% rise in the global aluminum market (Chart 14, panel 1). This probably indicates a tighter Chinese domestic market than the global (ex-China) market. Looking forward, we remain tactically bullish on LME aluminum prices and neutral on SHFE aluminum prices.9 The supply shortage will likely persist ex-China over next three to six months. Global aluminum production has declined faster than demand so far this year. Based on the WBMS data, global aluminum output was still in a deep contraction in September (Chart 14, panel 2). Even though China's operating capacity has been rising every month so far this year, Chinese total aluminum output for the first 10 months was still 1.1% less than the same period last year. In addition, considering the possible output loss due to the Spring Festival in late January, we believe it will take another three to six months for China to meet its own domestic demand and inventory restocking. Extremely tight domestic inventories should limit the downside of SHFE aluminum prices (Chart 14, panel 3) as the market adjusts on the supply side. We think there is more upside for LME aluminum prices, as the supply shortage will likely persist ex-China over next three to six months. Currently, Chinese aluminum prices are about 18% higher than the LME prices (both are in USD terms), which will likely limit the supply coming from China's exports to the rest of world. Strategically, we are neutral LME aluminum prices and bearish on SHFE aluminum prices. Currently, about 85% of the China's aluminum operating capacity is making money. With new low-cost capacity and more idled capacity coming back on line, profitable Chinese smelters will continue boosting their aluminum production to maximize profits. This, over a longer term like nine months to one year, should eventually spill over to the global market. Investment strategy Chart 15Still Look To Buy Aluminum Still Look To Buy Aluminum Still Look To Buy Aluminum We recommended buying the Mar/17 LME aluminum contract (Chart 15) if it falls to $1,640/MT (current: $1,721/MT). We expect the contract price to rise to $1,900/MT over the next three to five months. If our order is filled, we suggest a 5% stop-loss. Risks Prices at both the SHFE and LME may come under intense pressure if aluminum producers in China increases their output quickly, even at a small loss, in order to create jobs and revenue for local governments. If global aluminum demand falters in 2017 while supply is rising, we will revisit our strategically neutral view on LME aluminum prices. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com Robert P. Ryan, Senior Vice President rryan@bcaresearch.com 1 Please see Commodity & Energy Strategy Special Report for iron ore and steel "Global Iron Ore And Steel Markets: Is The Rally Over?," dated October 6, 2016, available at ces.bcaresearch.com. In this report, we are using Metal Bulletin iron ore price delivered to Qingdao port in China as our iron ore reference price. 2 Please see "N. China city cuts 32 mln tonnes of steel capacity" published October 30, 2016, by Xinhua's online service, xinhuanet.com. 3 Please see "CHART: The breakeven iron ore prices for major miners in 2016," published June 7, 2016, by Business Insider Australia. 4 Please see "China Resources Quarterly, Southern spring ~ Northern autumn 2016," published by the Australian Department of Industry, Innovation and Science and Westpac, particularly this discussion on p. 4, "The real estate sector." 5 Please see "China August new loans well above expectations on mortgage boom," published by Reuters September 14, 2016. 6 Please see the OECD Economic Outlook, Volume 2016 Issue 2, Chapter 1, entitled "General Assessment of the Macroeconomic Situation," p. 44, under the sub-head "Rapid debt accumulation risks instability in EMEs." The IMF also expressed concern over rising debt levels supporting the real-estate boom in China, particularly in the larger cities, noting, "Credit and financial sector leverage continue to rise faster than GDP, and state-owned enterprises in sectors with excess capacity and real estate continue to absorb a major share of credit flow. The deviation of credit growth from its long-term trend, the so-called credit overhang--a key cross-country indicator of potential crisis--is estimated somewhere in the range of 22-27 percent of GDP..., which is very high by international comparison." Please see the IMF's Global Financial Stability Report for October 2016, "Fostering Stability in a Low-Growth, Low-Rate Era," p. 35, under the sub-heading "China: Growing Credit and Complexities." 7 Please see Commodity & Energy Strategy Special Report "Chinese Property Market: A Structural Downtrend Just Started," dated June 4, 2015 and "China Property Market Q&As," dated July 2, 2015, available at ces.bcaresearch.com 8 Please see Commodity & Energy Strategy Weekly Report "Oil Production Cut, Trump Election Will Stoke Inflation Expectations," dated November 17, 2016 and "The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market," dated October 27, 2016, available at ces.bcaresearch.com 9 Please see Commodity & Energy Strategy Weekly Report "Market Saturation Likely In Asia, If KSA - Russia Fail To Curb Oil Production," dated November 10, 2016, available at ces.bcaresearch.com Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Closed Trades

Highlights Despite the static headline GDP figures, most of our indicators suggest Chinese growth momentum has improved since the second quarter, particularly in the industrial sector. A dollar overshoot, domestic housing policy tightening and potential policy mistakes by the Chinese authorities need to be monitored for potential growth disappointments. The rally in commodity prices reflects improving Chinese demand, but it has ignored the surging dollar. Chinese H shares are a safer play on Chinese reflation and growth improvement. Feature Our recent conversations with clients suggest that global investors' concerns over China have slightly abated, as various economic numbers have shown improvement. Nonetheless, investors remain highly sceptical about China's macro situation, raising questions ranging from "traditional" distrust of China's economic data to the latest worries of a "trade war" with the U.S. under President Donald Trump. We dedicate this week's report to addressing some common issues that we have been discussing with clients of late. What Is The Actual GDP Growth In China? In Recent Quarters, It Seems To Be Holding In A "Too-Good-To-Be-True" Tight Range? Chinese real GDP growth has been 6.7% for the past three consecutive quarters, right in the middle of the government's official target of 6.5-7%. This seemingly incredible stability has stoked long-held suspicions among investors about the reliability of Chinese economic data. While we do not claim to have the ultimate insider story on official Chinese statistics, and it is certainly possible that the macro numbers are "smoothed out" to hide otherwise greater volatility in economic reality, it is also possible that stable headline numbers overshadow bigger underlying fluctuations among different sectors (Chart 1). Chart 1Greater Volatility Underneath ##br##Stable GDP Greater Volatility Underneath Stable GDP Greater Volatility Underneath Stable GDP For example, while real GDP growth has stayed at 6.7% since Q1 this year, there has been some fluctuations in both the industrial and service sectors. Within the service sector, the financial industry has had a major downturn, with nominal growth falling from 10.9% in Q1 to 8.2% in the last quarter, partly due to last year's base effect of the stock market boom-bust. The real estate sector, on the other hand, has been on the mend, with growth strengthening from 14% in Q1 to 16.3%. Regardless, the exact GDP growth figures rarely matter from an investor's perspective. What is more important is the growth trajectory and policy implications. On this front, most of our indicators suggest growth momentum has improved since the second quarter of the year, particularly in the industrial sector. A strong recovery in manufacturing-sensitive indicators such as railway freight, heavy machine sales and electricity consumption (Chart 2). Continued acceleration in profit growth, in both the overall industrial sector and among listed firms.1 Further improvement in pricing power and producer prices. Producer price deflation that lasted for over four years ended in September, compared with 5.3% deflation in January. Looking forward, we expect the economy to continue to improve, even though some of the high-flying variables may begin to moderate. On the policy front, the authorities will likely enter a wait-and-see mode, especially on interest rates. Our model signals that the central bank's interest rate cuts have likely come to an end, unless the economy relapses again (Chart 3). This is also reflected in the pickup in interest rates in the bond market. We will further explore China's growth outlook, policy orientation and investment implications for the New Year in the first week of 2017. Chart 2Broad Improvement In##br## Industrial Indicators bca.cis_wr_2016_12_01_c2 bca.cis_wr_2016_12_01_c2 Chart 3No More Rate Cuts, ##br##For Now bca.cis_wr_2016_12_01_c3 bca.cis_wr_2016_12_01_c3 There Appears To Be Growing Acceptance In The Market That China Will Not Suffer A Hard Landing. What Are You Monitoring To Gauge The Growth Risk? We have not been in the "hard landing" camp, and have been anticipating a "rocky bottoming" process in Chinese growth for the year.2 Despite enormous financial volatility in January associated with the domestic stock market and the RMB, growth has largely played out as we anticipated. We expect the economy to remain resilient, but are watching some pressure points that could lead to disappointments. The first is the RMB, which has been depreciating notably against the dollar in recent weeks, as the dollar uptrend has resumed with vigour. In our view, a strong dollar is one of the key risks, as it not only generates downward pressure on the CNY/USD cross rate, on which the market tends to focus closely, but also halts the "stealth" depreciation of the RMB in trade-weighted terms, which reduces the reflationary benefits of a weaker exchange rate on the Chinese economy (Chart 4). In other words, a weak CNY/USD and a strong trade-weighted RMB is a poor combination for both financial markets and the macro economy.3 So far, the CNY/USD decline appears orderly, and we doubt the greenback will massively overshoot against all major currencies within a short period without causing growth difficulties in the U.S. However, the situation should be closely monitored and continuously assessed. The second is housing policy tightening, which the authorities have re-imposed since October to check rapid gains in home prices. So far, the tightening measures have not led to a significant slowdown in home sales in major cities: Daily home sales in the major cities that we track have broken out to new record highs (Chart 5). However, new housing supply has already been very weak, which together with robust sales could lead to even lower housing inventory and a further spike in home prices. We maintain guarded optimism on China's housing construction, as we discussed in detail in our previous report.4 The risk is that unyielding home price gains will force the Chinese authorities to up the ante on tightening, which could lead to a sudden deterioration in housing activity. In this vein, price moderation should be good news from policymakers' perspectives, as well as for the overall economy. Chart 4The RMB: Weak Or Strong? bca.cis_wr_2016_12_01_c4 bca.cis_wr_2016_12_01_c4 Chart 5Monitor Housing Activity bca.cis_wr_2016_12_01_c5 bca.cis_wr_2016_12_01_c5 Finally, as we have argued repeatedly, China's growth difficulties in recent years have had a lot to do with the excessively tight policy environment post the global financial crisis - a policy mistake that compounded deflationary pressures in the economy, which had already been suffering from weak external demand. Despite budding improvement in the economy, China's overall macro environment remains highly challenging, and policy mistakes that undermine aggregate demand will prove extremely costly. In this vein, any broader attempt to tighten policies, hasten administrative enforcement to de-lever or prematurely withdraw fiscal support on infrastructure construction will prove counterproductive. A more recent risk is how China deals with the potential protectionist threat from the U.S. under President Donald Trump.5 Our view is that China should avoid escalating trade tensions with tic-for-tac retaliations that could further complicate the growth outlook. As far as the markets are concerned, Chinese equities appear to have begun to price in a lower "China risk premium." Forward P/E ratios for both A shares and H shares have been rising since early this year, likely a reflection of investors' easing anxiety on China's macro conditions (Chart 6). Nonetheless, Chinese stocks' forward P/E ratios remain well below other major markets and the global average, and the risk premium in Chinese equities is still substantially higher than historical norms. Beyond near-term volatility, we expect the risk premium in Chinese stocks to continue to revert to the mean, leading to multiples expansion and further price gains. At minimum, Chinese equities should outpace global and EM benchmarks. There Has Been A Massive Rally In Some Industrial Commodity Prices In China. Is This Driven By Speculative Frenzy? How Much Does The Commodities Rally Reflect Chinese Demand? Industrial commodity prices have rebounded sharply in both the Chinese domestic spot markets and various derivatives exchanges. For some products, prices have gone parabolic, and there is little doubt that these extreme moves cannot be fully explained by fundamental factors (Chart 7). Nonetheless, it is also well known that commodities in general are subject to volatile price fluctuations, as they are extremely sensitive to marginal shifts in the supply-demand balance due to very low price elasticity among both producers and end users. Therefore, it is impossible, and rather meaningless, to precisely detangle speculative forces and fundamental factors. Chart 6Risk Premium Will Continue ##br##To Mean Revert Risk Premium Will Continue To Mean Revert Risk Premium Will Continue To Mean Revert Chart 7No Clear Evidence Of Commodity ##br## Speculative Frenzy bca.cis_wr_2016_12_01_c7 bca.cis_wr_2016_12_01_c7 That said, from a macro perspective, a few observations are in order: There does not appear to be a particularly high level of over-trading and speculative activity involved this time around compared with historical norms. Futures transactions this year have been hovering at close to record low levels, despite sharp prices gains in numerous products. Even if prices decline sharply, the impact on the financial system should be negligible because of very low investor participation. Broad-based improvement in numerous industry-sensitive indicators shown in Chart 2 on page 2 suggest the gains in commodity prices are at least partially attributable to improving demand rather than purely driven by speculative frenzy. In fact, improving Chinese demand is also reflected in a firmer global shipping rate. The Baltic Dry Index has almost quadrupled since its February lows, which hardly has anything to do with Chinese retail speculators (Chart 8, top panel). Massive price gains in some commodities such as steel and coal have been partially driven by the Chinese authorities' attempts early this year to "de-capacity" the two sectors, with aggressive efforts to cut idle capacity and reduce domestic production. The self-imposed restrictions together with improving demand have led to sharp price gains and a significant rebound in imports of related products (Chart 8, bottom panel). This confirms our view that the overcapacity issue in the Chinese industrial sector has been overestimated.6 Moreover, regulators' control on domestic supply has been relaxed, which will likely lead to rising domestic production in due course - this bodes well for Chinese domestic business activity, but poorly for the prices of related products. Historically, commodity prices have been positively correlated with China's growth trajectory, and negatively correlated with the trade-weighted dollar (Chart 9). Currently, the commodities rally clearly reflects regained strength in Chinese industrial activity, but has ignored the recent strength of the greenback, leading to a glaring divergence that has been very rare in recent history. Chart 8More Signs Of ##br## Improving Demand bca.cis_wr_2016_12_01_c8 bca.cis_wr_2016_12_01_c8 Chart 9Macro Drivers And Commodity Prices: ##br##Mind The Gap bca.cis_wr_2016_12_01_c9 bca.cis_wr_2016_12_01_c9 It remains to be seen how such a divergence will eventually converge. Our hunch is that the dollar will likely continue to rally in the near term, which means commodity prices could converge to the downside. Our commodities team has upgraded base metals from underweight earlier this year on China's reflation efforts, and is currently neutral on the asset class. What is more certain, however, is that China's reflation efforts and growth improvement should also lift Chinese H shares, but the price gains of H shares so far have been much more muted. Earlier this year we recommended going long Chinese H shares against the CRB index, which so far has been flat. We are still comfortable holding this position. The bottom line is that we do not advocate chasing the current rally in base metals. Chinese H shares are a safer play on Chinese reflation and growth improvement. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Chinese Stocks: Between Domestic Improvement And External Uncertainty", dated November 10, 2016, available at cis.bcaresearch.com 2 Please see China Investment Strategy Weekly Report, "2016: A Choppy Bottoming", dated January 6, 2016, available at cis.bcaresearch.com 3 Please see China Investment Strategy Weekly Report, "The RMB's Near-Term Dilemma And Long-Term Ambition", dated October 20, 2016, available at cis.bcaresearch.com 4 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010", dated October 13, 2016, available at cis.bcaresearch.com 5 Please see China Investment Strategy Weekly Report, "China As A Currency Manipulator?", dated November 24, 2016; and "China-U.S. Trade Relations: The Big Picture", dated November 17, 2016, available at cis.bcaresearch.com 6 Please see China Investment Strategy Special Report, "The Myth Of Chinese Overcapacity", dated October 6, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

The S&P health care equipment index has underperformed alongside most other long-duration sectors, but the share price ratio has reached a point where buying interest should emerge. Sales have been running at a healthy double-digit clip, and new order growth remains firm, providing conviction that the outlook remains bright. Even exports are contributing positively, despite the high level of the U.S. dollar. The IFO survey of German medical equipment demand suggests that a solid undercurrent of foreign uptake exists. The recent contraction in valuation multiples suggests that sales are expected to disappoint in the coming year, an outlook that appears overly cautious, especially within the context of the nascent improvement in industry return on equity. We reiterate our overweight allocation. The ticker symbols for the stocks in this index are: BLBG: S5HCEP - MDT, ABT, DHR, SYK, BDX, BSX, BAX, ISRG, EW, STJ, ZBH, BCR, HOLX, VAR. Buy Weakness In Health Care Equipment Buy Weakness In Health Care Equipment

The sudden economic exuberance following the Trump election victory has caused a flight out of traditional safe havens that looks to have gone too far. For instance, consumer products stocks (household products, beverages and packaged food) are now trading below the broad market P/E multiple, in aggregate, on a trailing 12-month basis. The chart shows that forward relative returns have typically been very robust when the group trades at a discount to the market. What could go wrong? History shows that a period of stable and strong GDP growth can cause discounted valuations to persist. Pricing in such an outlook at this juncture is overly optimistic, given the unknown fallout from a strong U.S. dollar on the rest of the world, trade uncertainty, and potential financial strains in the heavily indebted corporate sector as a consequence of rising bond yields. Keep in mind that the consumer products has a positive correlation with the U.S. dollar (top panel). We would be buyers on recent share price weakness. bca.uses_in_2016_11_30_001_c1 bca.uses_in_2016_11_30_001_c1

The S&P hotels index had been in a relative performance bear market since late last year when we reduced it to underweight, but downside risks have diminished even though a number of players have lowered 2017 guidance and revenue per room (REVPAR) expectations. A variety of valuation metrics show that the price ratio is plumbing recessionary-type levels. REVPAR should be supported by decent consumer spending. Wage growth, and thus aggregate income, is perking up, job security has risen and income expectations are on the upswing. Consumers are behaving as if income gains will be permanent, given the increase in consumer loan demand. Low fuel prices and the surge in vehicle miles driven are consistent with solid lodging outlays. The latter have recently reaccelerated, and are supporting better than market hotel pricing power. Now that wage inflation has rolled over, the margin squeeze should go on hiatus. The bottom line is that an upgrade to neutral is now in order, locking in a profit of 3% on our underweight recommendation. Please see yesterday's Weekly Report for additional charts and analysis. The ticker symbols for the stocks in this index are: BLBG: S5HOTL - MAR, CCL, RCL, WYN. bca.uses_in_2016_11_29_002_c1 bca.uses_in_2016_11_29_002_c1 bca.uses_in_2016_11_29_002_c1 bca.uses_in_2016_11_29_002_c1