Sectors

"That as the only possible policy in our day for a conqueror to pursue is to leave the wealth of a territory in the complete possession of the individuals inhabiting that territory, it is a logical fallacy and an optical illusion in Europe to regard a nation as increasing its wealth when it increases its territory, because when a province or state is annexed, the population, who are the real and only owners of the wealth therein, are also annexed, and the conqueror gets nothing." 1 Norman Angell's "The Great Illusion" posited in the early 1910s that war would be futile for developed nations, especially given the rising importance of economic and financial ties. Nevertheless, the arms race from the late-1800s gained momentum and eventually led to the Great War, dealing a devastating blow to his arguments. The European armament dynamics of the late-19th century/early 20th century are eerily reminiscent of the current post-Great Recession global arms race. Back then Germany, Austria-Hungary and Italy on one side, and Britain, France and Russia on the other, were fiercely trying to outpace each other in military expenditures. The crumbling Ottoman Empire along with the newly created smaller states in Greece, Serbia, Bulgaria and Romania were also eager weapons purchasers. Today, a fresh military expenditure-related development pops up almost daily. Not only are the U.S. and China boosting military spending, but also Japan, Australia, India, Vietnam, Saudi Arabia, Turkey, Russia, etc (Chart 1).2 The list goes on and on. The driving factor is "multipolarity," i.e. the emergence of multiple competing great powers, which BCA's Geopolitical Strategy service has shown to be a key investment theme.3 Chart 1U.S. Defense Spending Is More Than The Rest Of The World Combined Brothers In Arms Brothers In Arms While we are not arguing that WWIII will erupt in the coming years, the purpose of this Special Report is to identify the winning global equity sectors from the intensifying global arms race (Chart 2): global defense stocks come atop of our list, but also global space-related equities and cyber security firms would be beneficiaries of the secular increase in military outlays. On a regional basis, the U.S. defense stocks are the only game in town, but undiscovered Chinese, and to a lesser extent Russian, defense stocks are intriguing as are Israeli defense and tech stocks (please refer to the Appendix below for ticker symbols). Chart 2Intensifying Global Arms Race bca.gtss_sr_2016_10_28_c2 bca.gtss_sr_2016_10_28_c2 Late 19th/Early 20th Century: Militarism, Globalization & Finance Back in the late-1800s, the ascendancy of Germany was challenging the hegemony of Britain, fueling a European-wide arms race. Smaller newly formed states were also on the hunt for the latest and greatest weaponry. During the Balkan Wars of 1912-13 airplanes were deployed in combat for the very first time, highlighting the importance of new technology. Behind this explosive European rearmament were a few large British companies (Vickers Sons & Maxim Ltd, Armstrong and Whitworth, and Coventry Ordnance Works). "By 1905, its capital of £7.4 million ranked Vickers sixth amongst British companies; Armstrong Whitworth, with 5.3 million pounds capital was eleventh".4 Basil Zaharoff, who acted as general representative for business abroad for Vickers,5 was reputedly one of the richest men in the world.6 Moreover, globalization was on the rise in the late 19th century, as evidenced by global imports as a percentage of GDP (Chart 3). Industrialization coupled with imperialism and the colonization of Asia and sub-Saharan Africa along with population growth and rising demand for commodities were key drivers behind the jump in 19th century globalization. Finally, all of this was made possible by cross-boarder finance. Trade finance and credit growth skyrocketed in the late-1800s and the rising interconnectedness of global financial centers was most evident in the 1907 stock market panic that originated in the U.S., but spread like wildfire to the rest of the world. Chart 3Twin Peaks Of Globalization? Twin Peaks Of Globalization? Twin Peaks Of Globalization? Chart 4Heeding The Early 1960s Parallel bca.gtss_sr_2016_10_28_c4 bca.gtss_sr_2016_10_28_c4 What About The 1960s? The idea of militarily outspending opponents was very evident in the early-1960s when U.S. defense spending surged by 20% on a year-over-year basis (Chart 4), bolstering demand once again for military contractors. The mutually assured destruction (MAD) doctrine of military strategy and national security policy declared overtly in the early-1960s by U.S. defense secretary Robert McNamara and the Space Race competition between the Cold War rivals also have striking similarities with today, as far as investment implications are concerned. Parallels With Today China's ascendency to a world power large enough to challenge the hegemony of the U.S. is a sea change.7 The rearmament of East Asia is reminiscent of late 19th and early 20th century Europe and involves Japan, Australia, South Korea, Vietnam and India. All of the Middle East, along with Turkey and Russia, are on a structural military spending spree. European NATO fringe states are also arming furiously (Chart 5), trying to thwart Russia's regional ambitions. In the U.S., despite the Budget Control Act of 2011 (sequestration), the CBO projects that defense spending will rise gradually from $586 billion in 2015 to $739 billion by 2026 (Chart 6). This is before any push for a fiscal spending thrust that both presidential candidates have proposed, which would include increased defense outlays. While as a percentage of GDP defense spending may drift sideways, in absolute terms it will likely rise, and thus boost demand for defense contractors. Chart 5Stealthy Rise In Defense Outlays bca.gtss_sr_2016_10_28_c5 bca.gtss_sr_2016_10_28_c5 Chart 6CBO Estimates New Defense Spending Highs bca.gtss_sr_2016_10_28_c6 bca.gtss_sr_2016_10_28_c6 Globalization has hit an apex recently (Chart 3).8 The world is still licking its wounds from the recent GFC, where U.S. financials stocks were so intertwined with their global peers that the crisis effectively brought down to its knees the global financial system and gave birth to unorthodox monetary policy that Central Banks are still currently deploying. Global Rearmament Beneficiaries If our hypothesis that a global arms race will continue to heat up in coming years pans out, then owning global defense stocks as a structural bet will pay handsome dividends. The global push away from austerity and toward more fiscal spending should also support aggregate defense demand. Thus, there are high odds that global defense stocks are primed to deliver absolute positive returns, irrespective of where the broad global equity market drifts in the next five years. Similar to Vickers and Armstrong and Whitworth making impressive stock market strides early last century, global defense stocks should continue to be high flyers. The early-1960s U.S. aerospace & defense (A&D) stocks are the only close stock market parallel we have come across in our analysis (given data constraints) and comparing this index's available metrics of that era with today is in order. A big pushback to the U.S. Equity Strategy service's constructive view on the U.S. defense index (since the late-2015 inception) has been that the valuations of these stocks are already full, leaving no valuation cushion for any mishaps (Chart 7). True, defense stocks are on the expensive side, but not if they manage to grow into their valuations, as we expect. Relative performance was up over 100% in a span of four years in the 1960s (Chart 8), as U.S. aerospace & defense industrial production (IP) swelled to a 20% per annum clip with utilization rates running at 95% (Chart 8). A&D factories were humming, racing to fulfill orders as U.S. military expenditures were thriving (Chart 4). Chart 7Buy Global Defense Stocks Buy Global Defense Stocks Buy Global Defense Stocks Chart 8In The 1960s A&D Factories Were Humming... bca.gtss_sr_2016_10_28_c8 bca.gtss_sr_2016_10_28_c8 This demand surge translated into a jump in sector sales momentum (Chart 4), and given the industry's high operating leverage, earnings and book values soared. From trough to peak, sector EPS rose more than 400%, margins expanded from sub 2% to nearly 8%, and book value doubled (Chart 9). That stellar performance justified initial valuation premiums at the time. Using that period as a guide would imply that there is ample upside left for relative performance of the global defense index (that is a pure play on global defense spending). For comparison consistency, we use U.S. A&D figures. Currently, U.S. A&D IP is contracting, with resource utilization running at 80%. U.S. A&D relative performance has risen a mere 30% since the Great Recession (Chart 10). Chart 9...Boosting The Allure Of ##br## A&D Stocks bca.gtss_sr_2016_10_28_c9 bca.gtss_sr_2016_10_28_c9 Chart 10If History At Least Rhymes, ##br## There Is Still Ample Upside... bca.gtss_sr_2016_10_28_c10 bca.gtss_sr_2016_10_28_c10 Likely, the advance is still in the early innings, and analysts have been very slow to upgrade their EPS estimates accentuating the apparent overvaluation. Importantly, 5-year forward relative EPS growth estimates are deep in negative territory which is very perplexing given the upward trajectory of industry demand (Chart 11). Given that we only have access to data for MSCI All-Country World aerospace & defense long-term EPS expectations the caveat is that some of the poor expectations and performance could be because of the waning aerospace delivery cycle. Unlike the deteriorating health of the broad corporate sector, profit margins are expanding and net debt-to-EBITDA is a comfortable 1.2x. Similarly, interest coverage ratio is near an all-time high of 8x (Chart 12), while the overall markets EBIT/interest expense ratio is half that. Chart 11...Especially ##br## Given Depressed Analysts' Expectations ...Especially Given Depressed Analysts' Expectations ...Especially Given Depressed Analysts' Expectations Chart 12Defense ##br## Wins Championships Defense Wins Championships Defense Wins Championships Global defense sector return on equity (ROE) is almost 30% and rising (Chart 13), whereas global non-financial corporate (NFC) ROE is hitting multi-year lows, with the U.S. NFC ROE plumbing all-time lows (Chart 14). Free cash flow is also growing briskly and the industry is making greenfield investments, with capex growing 9.5% year-over-year, the mirror image of the global NFC sector that is pruning capital outlays (middle and bottom panels, Chart 13). Chart 13Defense Flexing ##br## Its Muscles... Defense Flexing Its Muscles... Defense Flexing Its Muscles... Chart 14...Vs. The Atrophy In The U.S. ##br## Non-Financial Corporate Sector bca.gtss_sr_2016_10_28_c14 bca.gtss_sr_2016_10_28_c14 On the valuation front, modest overvaluation exists, as portrayed by the high relative price-to-cash flow and price-to-book multiples. However, the global defense stocks forward P/E ratio and EV/EBITDA multiple are on an even keel with the broad market (Chart 15), and if our thesis that a secular uptrend in defense-related demand looms proves accurate, then these stocks are not expensive, but on the contrary still represent a buying opportunity. Chart 15Mixed Signals On The Relative Valuation Front Mixed Signals On The Relative Valuation Front Mixed Signals On The Relative Valuation Front Chart 16Defense Is The Best Offense bca.gtss_sr_2016_10_28_c16 bca.gtss_sr_2016_10_28_c16 The Rise In Terrorism, Global Space Race And Cyber Security Threat The unfortunate structural increase in terrorist activity will also embolden governments around the world to step up defense spending (top panel, Chart 16).9 The latter tends to move in long cycles. U.S. defense industry revenues have already begun to outpace those of the overall S&P 50010, and a prolonged upturn lies ahead, based on the message from the previous upcycle. From a cyclical perspective, the defense capital goods shipments-to-inventories ratio is outpacing the overall manufacturing sector (second panel. Chart 16), reinforcing the case for ongoing earnings outperformance. The same also holds true in Europe. Western European terrorist attacks have increased, heralding further relative gains for the euro area aerospace & defense index (bottom panel, Chart 16). Beyond the disastrous spike in terrorism, the global space race is also gaining traction, with China spearheading the charge. There is a good chance that China will attain geosynchronous orbit satellites (residing more than 20,000 miles above the earth), challenging U.S. space dominance. India's space aspirations are grand and it is slowly and stealthily rising up the ranks on the space race. Moreover, as more countries aim to have manned space missions, that translates into higher space budgets and thus firming demand for space-related expenditures (Chart 17). Chart 17Space, The Final Frontier Brothers In Arms Brothers In Arms Finally, the number of cyber-attacks is also on the rise globally. Defending against attacks is a challenge. Not only does the cyber space domain definition remain elusive, but tracking hackers down is also increasingly difficult given the vastest of the internet, lack of global uniform policing methods and physical country borders. Crudely put, it is a lot easier for a Chinese or Russian hacker to deal a blow, for example, to U.S. nuclear infrastructure rather than physically deliver an attack. All of this suggests that investment in anti-hacking and counter cyber-attack capabilities is necessary around the globe in order to thwart cyber-terrorism. Risks To Our View While there is conceivably a risk that China will abruptly halt its intense militarization and make a U turn in its long-term strategy of becoming a military superpower, we assign a very low probability to such a turn of events. The global push for more fiscal spending may not materialize, which would be a risk to our sanguine global defense spending view. As Paul Volcker and Peter Peterson recently opined in a NY Times article11 - offering a different view from the always-articulate Larry Summers - prudent and fiscally responsible spending is in order given the excessive debt-to-GDP ratio that is probing war-like levels (Chart 18). This excessive debt overhang is not only a U.S. phenomenon, but also a global one spanning both advanced and emerging economies. Chart 18Excessive Debt Is A Risk To Bullish View On Global Defense Stocks Excessive Debt Is A Risk To Bullish View On Global Defense Stocks Excessive Debt Is A Risk To Bullish View On Global Defense Stocks One final risk is that the world will enter a prolonged peace phase and global terrorism will get quashed, with conflicts dying down in the Middle East, Russia reining in its imperialistic ambitions and China ceasing to stir the waters in the South and East China Seas. We would also assign low odds to this optimistic "no conflict phase" scenario, but it would indeed be welcome. Investment Conclusion Factors are falling into place for a structural outperformance period in the global defense index. The early-1900s and early-1960s parallels, coupled with the trifecta of terrorism, space race and cyber security all point to upbeat demand for defense-related goods and services. Expressing this buoyant view can be done from a bottom up perspective. The Appendix below highlights all the companies in the global defense index we track from Datastream and the alternative one from Bloomberg. An investable proxy is the U.S. aerospace & defense index as the U.S. dominates global A&D indexes and aerospace outfits also sport significant defense corporate segments (please see the Appendix below for relevant tickers). There are also three fairly liquid ETFs mimicking the U.S. A&D index: ITA:US, PPA:US & XAR:US. Moreover, below are a few more speculative investment ideas. Given China's dominance of global defense spending (ex-U.S.) we are confident that Chinese A&D stocks will also be eagerly sought after and deliver alpha in the coming years (please refer to the Appendix below for a list of China plays). If one has the resilience and the stomach to invest in Russian equities given high political and currency risk, then Russian A&D stocks may be a desirable vehicle. Russia remains a massive weapons exporter with a large sphere of influence. We would not underestimate the returns in local currency of some Russian A&D stocks (the Appendix below lists some Russian A&D listed firms). Finally, Israel A&D and IT companies either listed on NASDAQ or domestically in Tel Aviv offer some great opportunities for investors that can handle riskier investments. Not only Israel's geography, but also its intense IT/military focus and entrepreneurial culture imply that a number of these companies will be long-term winners (please see the Appendix below for relevant tickers). While most of the drones, space-related, and highly specialized IT companies are private, there is a drone and an anti-hacking ETF (IFLY:US & HACK:US). On the space front, we are tracking an index that comprises a number of space-related constituents that we show in the Appendix below. Nevertheless, most of these companies are categorized under A&D. Bottom Line: We are initiating a structural overweight in the global defense index with a longer-than-usual five year secular investment horizon. The re-rating phase in this index is still in the early innings. The re-rating phase in this index is still in the early innings. We also reiterate our overweight in the BCA U.S. defense index (LMT, GD, RTN, NOC, LLL). Anastasios Avgeriou, Vice President Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Angell, Norman (1911), The Great Illusion: A Study of the Relation of Military Power in Nations to their Economic and Social Advantage, (3 ed.), New York and London: G.P. Putnam’s & Sons. 2 Please see BCA Geopolitical Strategy Monthly Report, “The Great Risk Rotation,” dated December 11, 2013, available at gps.bcaresearch.com 3 Please see BCA Geopolitical Strategy Monthly Report, “Multipolarity And Investing,” dated April 9, 2014, available at gps.bcaresearch.com 4 Angell, Warren, Kenneth (1989), Armstrongs of Elswick: Growth In Engineering And Armaments To The Merger with Vickers, London, The Macmillan Press Ltd. 5 http://www.oxforddnb.com/index/38/101038270/ 6 https://www.britannica.com/biography/Basil-Zaharoff 7 Please see BCA Geopolitical Strategy Special Report, “Sino-American Conflict: More Likely Than You Think, Part II,” dated November 6, 2015, available at gps.bcaresearch.com 8 Please see BCA Geopolitical Strategy, “The Apex Of Globalization - All Downhill From Here,” in Monthly Report, “Winter Is Coming,” dated November 12, 2014, available at gps.bcaresearch.com 9 Please see BCA Geopolitical Strategy Special Report, “A Bull Market For Terror,” dated August 5, 2016, available at gps.bcaresearch.com 10 Please see U.S. Equity Strategy Weekly Report, “Wobbling,” dated December 7, 2015, available at uses.bcaresearch.com 11 http://www.nytimes.com/2016/10/22/opinion/ignoring-the-debt-problem.html?_r=0 Appendix Table A1BI Global Defense Primes Competitive Peers Brothers In Arms Brothers In Arms Table A2World Defense Index (DS: DEFENWD) Brothers In Arms Brothers In Arms Table A3S&P 500 Aerospace & Defense Index ##br## (S5AERO Index) Brothers In Arms Brothers In Arms Table A4China ##br## Aerospace & Defense Brothers In Arms Brothers In Arms Table A5Russia & Israel Aerospace & Defense Brothers In Arms Brothers In Arms Table A6Kensho Space Index Brothers In Arms Brothers In Arms

Highlights Clinton has a 65% chance of victory. She wins the election with 334 electoral votes. Trump has low odds of winning key swing states Virginia and Colorado. A Trump win requires a shock; it is not impossible by the historical record. A Clinton win is initially bullish and could bring some compromise. However, the median voter is moving to the left. The 1990s are gone. Feature BCA's Geopolitical Strategy made its initial U.S. general election forecast thirteen months ago in September 2015.1 We argued that the two most likely outcomes were: GOP Sweep Scenario: a Republican sweep (presidency and Congress) with a moderate candidate at the head of the party ticket; Democratic President / GOP Sweep of Congress: a Democrat win in the White House and a GOP that holds onto the House and Senate. Both outcomes would be positive for the markets given that (1) a GOP sweep would entail pro-market reforms (corporate taxes, de-regulation, entitlement reform, and modest fiscal spending) and (2) a divided government has historically produced a market-positive outcome. In December, we updated our forecast with a call that Hillary Clinton was a clear frontrunner given that a Trump nomination would greatly reduce the probability of a GOP sweep.2 Our reasoning then was that an anti-establishment Republican would fail to gather enough votes in the ideological middle of the American electorate. Although Trump has given Clinton a hardly believable run for her money, we continue to believe that misogynistic, racist, and narcissistic rhetoric are off-putting to the median American voter and distract from Trump's policy message (such as it is).3 In this final extended forecasting effort ahead of the election, our intention is to add value on three fronts: Get the final forecast right. Introduce the investment implications of our forecast. Ask what we have learned from this election so far. Quant Election Model: Trump Is A Red Herring Until very recently, the electoral polls showed a close race between Secretary Hillary Clinton and Mr. Donald Trump (Chart 1). However, our "Polls-plus" model, built using historical macroeconomic and election data since 1980, has been projecting a strong Clinton victory for some time. Based on our latest forecast, Hillary Clinton will win the 2016 presidential election in a landslide, with a projected electoral vote count of 334 (Chart 2). bca.gps_mp_2016_10_12_s2_c1 bca.gps_mp_2016_10_12_s2_c1 King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution In the following section, we introduce our model, its results, and explain why the predicted Clinton victory is so comfortable. To be clear, our model has favored Clinton well before the most recent series of gaffes by Mr. Trump. Part I: Structural Econometric Model Our econometric work combines state-level election and economic data as well as trends in national politics and opinion. The model's dependent variable is the difference in the share of the vote received by the Republicans and Democrats in each state. The explanatory variables break down into the following categories: Voting Patterns: Each state's previous election results, back to 1980, are computed as the differential between Republican and Democratic vote share, and used to gauge voter predisposition. We also include a momentum variable which measures the change in the differential between the two previous elections. Economic Variables: We use changes in state and national economic conditions prior to the elections to capture the macroeconomic context. These include national GDP, oil prices, and state-level disposable income. Political Intangibles: We include three different qualitative variables to capture political attitudes. "Polarization" is computed to factor in the likelihood that the incumbent party will be voted out after staying in power for multiple terms. The "alternative choice" measures the presence of a prominent third party. We also include current presidential approval ratings. Using these variables, and strictly avoiding any advantage of hindsight, our model correctly predicted the winner of every election since 1984 (Table 1 and Appendix 1): King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution 2012 - Obama v. Romney: The model slightly overestimated President Obama's support in West Virginia, Arizona, Arkansas, Louisiana, Missouri, and Tennessee. 2008 - Obama v. McCain: The model produced an accurate forecast on an aggregate level, but again underestimated Obama's support. It misallocated electoral votes in 7 states. 2004 - Bush v. Kerry: Our analysis was only off by giving two extra electoral votes to Bush, but once more misallocated votes in 7 states. The Third Party Vote In 1992, 1996, and 2000: The model accurately predicted the winner in each contest but produced more volatile results as our sample started to shrink. In addition, the strong third-party candidacy in 1992 and 1996 distorted the results. These two elections were a key bellwether for the success of our model in 2016, as this year also features prominent third-party choices. Gary Johnson of the Libertarian Party is currently polling around 6.3%. 1984 and 1988: Our earliest set of elections produced results that were quite close to reality despite a limited sample size. Although this is somewhat surprising, it is to be expected given the landslide victories that occurred in both instances. Part II: Econometric Modeling Meets Polls Most of the components from our econometric model are slow-moving structural factors. Opinion polls, on the other hand, change based on periodical surveys. They are more volatile, but provide a good indication of the day-to-day pulse of the electorate. For this reason, we created an augmented version of our econometric model using probabilities constructed from polls. First, we transformed our econometric forecasts into probabilities by using two scenarios and the historical volatility of our estimates. The two scenarios are based on the potential impact of the third parties: one in which they gather 5-10% of the popular vote, and the other in which they fail to reach that threshold. From there, we calculated the historical standard deviations for each scenario, getting the lower and upper limits of the election forecasts. Giving the two limits equal chances of occurring, we calculated the GOP's chances to win each state. We then added opinion polls to this model. We used the election probabilities from FiveThirtyEight, which are computed using simulations from a collection of weighted and adjusted polls, to add a shorter-term dimension to our forecast.4 We give a 60% weight to the probabilities from the polls and 40% to our structural econometric model to ensure that we capture the momentum effect. Part III: 2016 Election - All Hype, No Fight Our polls-plus model suggests that Clinton has a 65.4% chance of winning the election (Table 2). This is somewhat lower than the probability derived by other polls-plus models - such as FiveThirtyEight and the New York Times. Further, our model shows that Clinton already has 279 electoral votes in states where she has more than a 70% chance of winning (Chart 3). By the same standards, Trump has secured only 170 votes. These results mean that even under the unlikely scenario where the GOP wins all the remaining swing states (North Carolina, Arizona, Florida, Ohio, and Iowa), if all else stays the same, the Democrats still win with 279 electoral votes. King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution Intriguingly, our "White Hype" model back in March produced the same result using an entirely different method (it asked simply what share of the white vote Trump needed to win the swing states). At that time we argued that Trump had a very good chance to win Florida, Ohio, and Iowa, but that it would still be insufficient to win the election.5 In other words, our White Hype model correctly forecast in March the ultimate probabilities that our polls-plus model is now gauging from the combination of econometric results and opinion polls in October. Put differently, after winning the swing states (North Carolina, Arizona, Florida, Ohio, and Iowa), where the odds of winning are between 32% and 57%, the GOP would still need to steal the electoral votes in Virginia or Colorado (the latter in combination with Nevada or New Hampshire), away from the Democrats, where they are favored to win at 71.6% and 79.7%, respectively.6 This remains as unlikely now as it was in March.7 Bottom Line: Given the structural economic and political dynamics currently in place, our quantitative estimates show that Clinton is the clear favorite. Clinton has a 65.4% chance of winning the 2016 election, with an expected 334 electoral votes. Qualitative Election Model: Time To Dump Trump Thanks largely to the analysis of our colleague Peter Berezin, Chief Strategist of the BCA Global Investment Strategy, we took Donald Trump seriously long before most.8 We analyzed his electoral strategy - boosting the share of the white vote accruing to the GOP and away from the Democratic Party - and concluded that Trump did have a path to victory, albeit a very narrow one. Our research showed that Trump's strategy of increasing the Republican share of the white vote was mathematically the correct strategy for a GOP candidate to pursue, at least in 2016 when the white share of the total population remained large enough. We specifically showed that Trump would only need to increase white voters' support by 1.7% and 2.9% in Florida and Ohio, respectively, to flip those states, which seems quite reasonable and feasible.9 We also pointed out that getting a 5.7% swing in Iowa could be feasible. On the other hand, we showed that "flipping" Midwest states like Michigan, Pennsylvania, and Wisconsin would require a very large swing of white voters in Trump's favor: 13.9%, 7.8%, and 8.1% respectively. At those numbers, Trump would have to win nearly 70% of Michigan's white voters, 65% of Pennsylvania's, and 58% of Wisconsin's. Of the three, Wisconsin looks the most feasible. On the other hand, the GOP only managed to pick up 52% of the state's white share in 2004, the last time a Republican candidate for president won an actual majority of the popular vote since 1988. So, getting to 58% is a high bar given Wisconsin's recent electoral history. How did our model hold up in terms of state-by-state polling? It did quite well! As we predicted, Trump has been doing relatively well in Iowa, Florida, and Ohio (Chart 4). In Michigan, Pennsylvania, and Wisconsin, Clinton's lead has remained higher than 5% through most of the election cycle and even through the periods where the media narrative shifted against her (Chart 5). bca.gps_mp_2016_10_12_s2_c4 bca.gps_mp_2016_10_12_s2_c4 bca.gps_mp_2016_10_12_s2_c5 bca.gps_mp_2016_10_12_s2_c5 Bottom Line: Despite a narrowing in the polls in mid-September - particularly following Clinton's September 11 health scare - we still concluded in our September Monthly Report that "the presidential race is Clinton's to lose."10 This is because both our quant (polls-plus) and qualitative (White Hype) models have correctly predicted that Trump's path to victory is extremely narrow. He would have to hold all of the swing-states where the White Hype model makes him competitive, and then also win either Virginia or Colorado plus Nevada, where he has struggled in the polls. Risks To Our View - A Trump Surprise! What scenario could occur between now and November 8 that throws off our forecast of a Hillary Clinton victory? As we have claimed from the beginning of the contest, Trump requires an exogenous factor to push him over the finish line. Given that Clinton's lead is now 6% in the polls, and that Trump is running out of time, he may need an act of God. That said, Trump has come a lot closer to winning the election than our polls-plus model suggests. Were it not for his idiosyncratic personality, the Democrats would have been a lot more vulnerable in 2016 than our predicted election outcome indicates. Why? Research by Professor Allan Lichtman, who has accurately predicted every U.S. presidential election since 1984, is instructive. Lichtman has called the election for Trump.11 His so-called "Keys" method - first outlined in a 1981 article and in his 1990 book, The Thirteen Keys To The Presidency - is a simple true or false quiz with thirteen propositions. If six or more of the answers are "false," the incumbent party loses the Oval Office (Table 3). King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution For instance, if it is true that the average GDP growth per capita is higher in the past four years than the preceding four years, then that fact favors the incumbent. Today, this "long-term economic key" favors Hillary (Chart 6). bca.gps_mp_2016_10_12_s2_c6 bca.gps_mp_2016_10_12_s2_c6 In 2016, at least five of Lichtman's keys clearly favor the GOP: In the House of Representatives, the incumbent Democrats lost seats in the 2014 midterm elections, relative to the 2010 midterms (Chart 7). The Democrats do not have an incumbent candidate advantage. Obama achieved no major policy initiative in the second term. There was nothing comparable in effect to the Affordable Care Act, his signature legislation (Chart 8). Obama achieved no major foreign policy success. The Iran nuclear deal is too controversial to satisfy this key, although we suspect that history will judge it as a major success. Instead, the public focus has been on the disastrous intervention in Libya and the dithering in Syria. Hillary Clinton is not charismatic, which is an understatement (Chart 9). In addition, Gary Johnson, of the Libertarian Party, is a third-party candidate who could garner more than 5% of the vote (Chart 10). Under Lichtman's methodology, this is a key that hurts the incumbent. Of course, Libertarians may suck more votes away from Trump than Clinton. But Lichtman has signaled this issue as a crux of the election, and thinks it favors Trump. King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution bca.gps_mp_2016_10_12_s2_c10 bca.gps_mp_2016_10_12_s2_c10 Moreover, in our view, Lichtman's keys could predict an even worse outcome for Clinton than Lichtman himself admits. Lichtman is very forthright about the fact that the keys require subjective judgment of the sort that professional historians make all the time. We would note, first, that the contest in the Democratic primary was serious. Sanders performed nearly as well as Clinton herself did in 2008, and better than other second-rank Democratic contenders going back to 1984 (Chart 11). Second, social unrest has likely risen in Obama's second term, or at least is perceived to have done so (Chart 12). King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution Thus the primary contest and social unrest could trigger two more strikes against the incumbent party, without even debating whether Obama administration scandals or Trump's charisma qualify as keys against the Democrats.12 We think that Lichtman's model speaks volumes about the built-in vulnerability that the Democratic Party has faced throughout 2016. It also supports our initial September 2015 forecast, which gave largely even odds to both a moderate GOP presidential candidate and Hillary Clinton. As such, Trump's defeat will be a disaster for the Republican Party and will initiate a period of introspection - if not civil war - within the organization. Bottom Line: Trump does have good odds of winning the election if Clinton's lead in the polls drops below 3% between now and Election Day. If Trump gets back within striking distance, it will suggest that Clinton cannot shake him even after the media narrative and GOP establishment turned against him. With a 3% gap in the polls, the "turnout thesis" would become a lot more cogent. This is the thesis that Clinton will struggle to get members of the "Obama coalition" (millennials and minorities) to come out and vote, while Trump will motivate the registered but non-voting white population to turn out for him. At this point in the cycle, however, we doubt that Trump will re-test this level of competitiveness. Investment Implications: More Bullish Than Priced-In A Trump surprise would trigger a correction in equity markets, which is already due based on valuations, earnings, and other factors. We would expect the USD, as a key safe haven, to rally sharply both on Trump policy uncertainty and heightened geopolitical risk. We would also expect bond yields to fall initially, as part of a broad risk-off move, but then sell off due to the implication of more inflationary fiscal policies. Trump's policy proposals suggest a budget deficit blowout at least comparable to that under George W. Bush, which went from 2% to almost -4% of GDP. A combination of more spending and less tax revenue would blow the top off the bond market. What about the expected Clinton victory? First, markets love divided government (Table 4). Why? Because spending remains in check and no new onerous policies are likely. This will likely be the case if the GOP keeps the House of Representatives. However, we also think a Republican House could be conducive to dealing with Clinton, particularly on a modest fiscal stimulus: King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution Clinton is not Obama: She will enter the Oval Office unpopular and without a strong mandate. She may not win over 50% of the popular vote. The Senate is in play, with polls at RealClearPolitics suggesting that the Democrats would win at least the four seats they need (leaving Vice-President Tim Kaine to cast the tie-breaking vote on legislation). The House is unlikely to be in play. Thus, unlike Obama in 2009, she will have a slim Senate majority at best (not filibuster-proof) and a GOP-held House. She will have to cut deals to advance her agenda. The Grand Coalition Lives: In the past few years, Congress has passed a number of important bills because establishment Republicans voted alongside Democrats (Chart 13). This coalition would remain in place, cemented by the populist threat to both camps represented by Trump and Sanders. The Knives Will Be Out For The Tea Party: Trump's rise and fall would be seen as an infamous debacle that cost the Republicans a highly significant election well within their reach. The Republican establishment will be determined to regain the reins of the party apparatus and brand. The Tea Party and other populist or anti-establishment Republicans will be blamed not only for giving Clinton the keys to the White House but also for giving the Democrats the advantage on the Supreme Court for a generation. True, Republicans could take away a narrow reading of the election results. They could blame the entire loss on Trump, not the party, given that Trump and the party had a bad relationship and Trump endorsed various positions at odds with conservative platforms and principles. They could therefore draw the conclusion that the correct strategy for the future is not to change policies or compromise with Democrats, but simply avoid running inexperienced, flamboyant mavericks for president. This view would be supported by the fact that, with a Clinton victory, moderate Republicans in more competitive districts, not arch-conservatives in bright red ones, are more likely to lose seats in the House. Ironically, this means that House Republicans could be just as zealous in opposition as they were under Obama, or more, and thus poised to resume the game of obstruction. This is possible, but we think the anti-establishment will be on the defensive, at least initially. Clinton will receive some kind of honeymoon period after dealing a devastating blow to the GOP. There will be Republicans ready to compromise, under the leadership of Paul Ryan, who did not accept the House speakership in order not to compromise. And the far-right will have at least some waverers in their midst. As such, we can see the potential for modest corporate tax reform (broadening the tax base without lowering the effective corporate tax rate). Even though such reform is not extraordinary, it should boost economic growth by helping small and medium-sized businesses grow. We can also see the GOP under Paul Ryan agreeing to modest increases in fiscal spending in return. Our colleague Anastasios Avgeriou, Chief Strategist of BCA's Global Alpha Sector Strategy, cogently argues that fiscal spending only comes amidst recessions. Chart 14 shows that mentions of "fiscal stimulus" in the news media are positively correlated with junk bonds and VIX, and negatively correlated with the yield curve. As such, fiscal stimulus only begins being contemplated when the pain of a recession hits. King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution bca.gps_mp_2016_10_12_s2_c14 bca.gps_mp_2016_10_12_s2_c14 Could this time be different? Yes. 55% of Americans think the economy has not recovered from the Great Recession, and some polls suggest that over half think the U.S. is still in recession. As such, while a recession may not be occurring in reality, it may as well be as far as politicians are concerned. Moreover, the public apparently cares less about the deficit and debt than in the recent past: the number of Americans naming deficits as the "top priority" has fallen from 72% to 56% in the past few years. And again, the populist groundswell will reinforce the need to lift growth through policy. Beyond an immediate relief rally, we would fade any idea that Clinton's victory means a return to the Bill Clinton-environment for corporate profits and stock performance. A structural shift to the left is underway in American politics, both generational and economic, as we argued in June.13 Clinton will not be able to betray her pledges to Bernie Sanders supporters if she wants to be a two-term president. Thus, on a sectoral basis, we would expect Clinton to have quite a few negatives (Table 5). First, she would portend greater state involvement in healthcare, especially Big Pharma, despite the idea that repealing the Affordable Care Act would cause more uncertainty than keeping and changing it. We also would not expect her to be as favorable to the financial community as her list of donors suggests, given the challenges she faces on her left regarding financial regulation. On energy, she will benefit renewable energy companies more so than conventional ones, given her commitment to turning the U.S. into a "twenty-first century clean energy superpower." King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution We would expect her to be good for defense stocks, both because she has a lifetime of foreign policy hawkishness and because of the global trend of multipolarity, which increases both the number of global conflicts and the risks of additional conflicts.14 For Trump, there is little reason to speculate - he has no experience governing, has flip-flopped on many policy stances, and is generally unorthodox and impossible to predict (e.g. his healthcare "plan"). If we had to venture a guess, we would say that, like Clinton, he will be positive for defense stocks. His aggressively anti-regulatory positions on the financial and energy sectors should be a boon for both. A critical thing to remember is that recent American presidents do not have a bad track record of getting what they want (Box 1). Like all leaders, they are at the mercy of constraints and structural factors, whether political, military, economic, or social. Yet they also command a powerful (and increasingly so) executive branch of government in the world's most powerful country. If Clinton wants higher taxes on the wealthy and a stronger state hand in healthcare, she will most likely get them. If Trump wants tougher border security and deep corporate tax cuts, he will likely get those as well. Congress is a check, but only that. BOX 1 U.S. Presidents: Promises And Performance Over the past 28 years, each new president has generally succeeded in passing the signature items on his agenda. George Bush Sr. is the major exception. He took office in 1988 with a pledge of keeping growth rates constant, creating 30 million new jobs over eight years, keeping the peace abroad, and improving the budget deficit without raising taxes. Instead, after only one year in office, he faced a recession that caused a 1.2 percentage point drop in the growth rate from Reagan's average, resulting in only 2.6 million increase in the civilian labor force his first term, 12.4 million wide of the mark. He was famously forced to raise taxes, despite saying "read my lips: no new taxes," and the budget deficit expanded from 2.7% to 4.5%. Finally, Saddam Hussein's invasion of Kuwait drew him into the Gulf War. Bill Clinton got luckier. His chief pledge was to raise wages, shift government investment from defense to the domestic economy, make healthcare more affordable, and reform welfare. He failed in healthcare, but generally succeeded in other initiatives. Wages admit of some debate - average earnings grew faster than under Reagan-Bush, though median earnings did not. Still, Clinton presided over a longer more stable period of wage growth than his predecessors (Chart 1). Non-defense investment rose 19% (defense barely grew) and its share in federal spending rose from 10% to 12%. The participation rate in cash assistance and food stamp programs declined sharply, as did the length of time on the dole. George W. Bush came to power on the promise of reforming social policy - health, education, social security - and essentially transferring the Clinton budget surplus to voters through tax cuts. He succeeded in taxes, education (No Child Left Behind Act), and health (Medicare expansion), aided by Republican majorities and popular support after the September 11 attacks. He failed to partially privatize social security, however. Barack Obama promised to make the tax code more progressive, make healthcare accessible and affordable, reduce energy dependency on the Middle East, and phase out the wars in Iraq and Afghanistan. He has generally achieved these goals: the number of uninsured adults fell from 18% to 11%, healthcare price inflation has slowed from about 4% under Clinton and Bush to 3% per year, and U.S. energy imports have fallen from 33% to 25% of total consumption. However, while Obama succeeded broadly in withdrawing troops from the Middle East (Chart 2), he has failed to "finish" the war in Afghanistan. bca.gps_mp_2016_10_12_s2_c15 bca.gps_mp_2016_10_12_s2_c15 bca.gps_mp_2016_10_12_s2_c16 bca.gps_mp_2016_10_12_s2_c16 There are three chief takeaways: First, circumstances can overrule any president's plans, as occurred with George Bush Sr. Second, winning an election in reaction to a recession, as did Clinton and Obama, or suffering a crisis early in one's term, like Bush Jr., provides a tailwind for a president's initiatives. The flipside is that inheriting strong economic growth on the coattails of a popular two-term president may put an administration at risk of a cyclical downturn or general failure to meet expectations. (Warning for a Hillary Clinton administration!) Third, Congress can block some but probably not all of a president's plans. Clinton, Bush, and Obama each began with their own party controlling the legislature, which gave an early advantage that was later reversed. Clinton lost on healthcare but achieved bipartisan welfare reform. For Obama, legislative obstructionism halted various initiatives, but his core objectives were either already met (healthcare), not reliant on Congress (foreign policy), or achieved through compromise after his reelection (expiration of Bush tax cuts for upper income levels). For Bush Jr., the legislature switched after six years of his administration, yet social security had already proved to be the "third rail" of politics that he feared - he failed to reform it despite his own party's control of Congress. Final Thoughts: Lessons From 2016 The 2016 election has taught us some critical lessons. First, the world never would have believed, in the immediate aftermath of the global financial crisis, that populism would be more disruptive in the Anglo-Saxon countries than in continental Europe. But that is what has happened. The United States and the United Kingdom have both seen an explosion of pent-up forces as a result of decades - particularly the past 16 years in the U.S. - of declining middle classes, rising inequality, and weak median incomes.15 The consequences are only just beginning to be felt, and are of far greater global significance coming from the U.S. than the relatively small U.K. The chief of these is that, in the U.S., the median voter has clearly moved to the left on economic policy. Trump's victory over an army of seasoned, relatively orthodox GOP contenders in the primary exposed the fact that the party's grassroot voters no longer care deeply about fiscal austerity and no longer wish to tolerate the corporate incentive for importing cheap labor. Rather, they want government to give them more goodies and protections. This fact, taken along with the demographic trends favoring millennials and minorities (who tend to vote left on economic policies), portends a shift by which the GOP attempts to capture left-leaning voters in a way that Bill Clinton and the "New Democrats" shifted to capture right-leaning centrist voters in the wake of Ronald Reagan and the collapse of the USSR. Part of this process will involve a political alignment in the U.S., now that the GOP's deep fractures have been exposed for all the world to see. Trump's candidacy could never have occurred if there had not first been a power vacuum at the center of the party. If Trump wins, it will be a veritable revolution for both parties. Fiscal conservatism (and social conservatism, for that matter) will have little to show by way of official party machinery. The global consequences will be highly disruptive as well since the executive branch has extensive power over all actions of the federal bureaucracy, trade, and foreign policy, and since the GOP will not obstruct Trump initially (whatever happens in the aftermath of any radical policy changes). If Trump loses, as mentioned above, the anti-establishment trend in the Republican Party will suffer the brunt of the blame - whether Tea Party or other. Though messy, this result could in fact be bullish for the U.S. in the long run, since it would discredit populism in the party and give a boost to reformers who seek to re-brand and redesign the party to respond to changes in the electorate. Thus, in 2020, either Clinton's policies will be working and Americans will not be demanding change, or they will not be working, and Americans will have a reformed GOP as an alternative. Alternatively, Trump's loss could fuel populism by showing the way for a similar candidate with similar policies yet who does not lack in charisma, oratory, and party backing. Trump's strategy of boosting white support for the GOP is demographically and mathematically possible at least until 2024. Or perhaps a different kind of Republican (or Democratic) candidate could attempt to capture aspects of Trumpism, given his left-tilt on economic policy, while appealing to the Democratic coalition of women, millennials, and minorities. The GOP shakeup should be watched closely. Lastly, the 2016 election has amplified a point that we have long emphasized: the news media works in narratives. These narratives work as a filter that preempts and distorts the presentation and, to some extent, reception of facts. This phenomenon was influential in Trump's rise - the first "Twitter" candidacy - as well as his recent decline. Similarly, it made the race competitive when Clinton's various scandals were "trending." As a result, investors cannot be too wary of what the mainstream press or financial "smart money" says about any particular political trend or event. It is essential to separate the wheat from the chaff by using empirics and looking at macro and structural factors to identify the constraints rather than the preferences of candidates or politicians. Trump's constraints, as we have contended, are too high. Appendix 1 shows the state-by state performance of the econometric model (without polls) for each of the past 8 elections. It compares the model's forecast (no hindsight bias) with actual results. APPENDIX 1 Back-testing GPS's Econometric Election Model Image Image Image Image 1 Please see BCA Geopolitical Strategy Special Report, "U.S. Election - Forecast & Investment Implications," dated September 9, 2015, available at gps.bcaresearch.com. 2 Please see Bank Credit Analyst Strategic Outlook, "Stuck In A Rut," dated December 17, 2015, available at gps.bcaresearch.com. 3 #shocker. 4 For a more detailed explanation of FiveThirtyEight's methodology, please see "A User's Guide To FiveThirtyEight's 2016 General Election Forecast," dated June 29, 2016, available at http://www.fivethirtyeight.com. 5 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: The Great White Hype," dated March 9, 2016, available at gps.bcareseach.com. 6 The Democrats' probability of winning Nevada and New Hampshire are 74.4% and 80% respectively. 7 Please see BCA Geopolitical Strategy, "U.S. Election: Is The Election Over?" in Monthly Report, "Who's Afraid Of Big Bad Trump?" dated August 10, 2016, available at gps.bcaresearch.com. 8 Please see BCA Global Investment Strategy Special Report, "Trumponomics: What Investors Need To Know," September 4, 2015, available at gis.bcaresearch.com. 9 The assumption being that the turnout, non-white vote share, and white turnout do not change from 2012. In other words, our model only focuses on the white share of the vote for the Republican candidate. We assume that Clinton will not benefit from an anti-Trump tailwind among minorities, which is a big assumption given the pernicious effects of the "White Hype" strategy on the minority support of a Republican candidate. On the other hand, we also do not change the white voter turnout, which is unfair to Trump as he would likely be able to boost the white turnout as he increases the GOP share of the vote. 10 Please see BCA Geopolitical Strategy, "U.S. Election Update - The Home Stretch," in Monthly Report, "Transformative Vs. Transactional Leadership," dated September 14, 2016, available at gps.bcaresearch.com. 11 Please see our book review below for a discussion of Lichtman's latest book. See also Peter W. Stevenson, "Trump Is Headed For A Win, Says Professor Who Has Predicted 30 Years Of Presidential Outcomes Correctly," Washington Post, September 23, 2016, available at www.washingtonpost.com. 12 Lichtman addresses the issues of Sanders, scandals, and Trump's charisma in Peter W. Stevenson, "This Professor Has Predicted Every Presidential Election Since 1984. He's Still Trying To Figure Out 2016," Washington Post, May 12, 2016, available at www.washingtonpost.com. 13 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, and "Annus Horribilis," dated January 20, 2016, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com.

The technology sector has spiked higher of late, supported by the merger premium in semiconductor stocks. However, the fundamental justification for the recent valuation expansion remains shaky. Tech sales growth remains non-existent. A dearth of new order growth and the ongoing contraction in Asian exports warn that it is premature to position for a recovery in top-line performance. That is confirmed by the impending corporate sector retrenchment, as the steady narrowing in the gap between the return on and cost of capital warns that business investment on tech goods will stay sluggish. Consumer spending on tech has been the lone bright spot, but even that has mostly been moving in line with overall consumption in recent years, not enough to deliver sales outperformance. As a result, fading recent tech strength makes sense, given vulnerability to a valuation squeeze. bca.uses_in_2016_10_27_002_c1 bca.uses_in_2016_10_27_002_c1

While the corporate sector has run up debt levels and is struggling to generate profit growth, consumers have rebuilt their savings and are enjoying the benefits of a positive wealth effect. The increase in real wage and salaries growth is supporting consumer income expectations, according to the latest consumer confidence survey (top panel). The implication is that consumption-oriented plays should be well positioned to deliver profit outperformance. Consumer finance stocks provide an attractively valued play on this theme, as does the S&P data processing index. The latter is levered to total transaction volumes, and a healthy consumer should translate into positive sales momentum. We are overweight both indexes. bca.uses_in_2016_10_27_001_c1 bca.uses_in_2016_10_27_001_c1

Highlights Dear Client, The growth of the electric-vehicle market, particularly re its implications for hydrocarbons as the primary transportation fuel in the world, will remain a key issue for energy markets, particularly oil. The IEA estimates transportation accounted for 64.5% of oil demand in 2014, the latest data available, compared to natural gas's 7% share and electricity's 1.5% share.1 Last week, Fitch Ratings published a report concluding, "Widespread adoption of battery-powered vehicles is a serious threat to the oil industry." For example, the agency contends that "in an extreme scenario, where electric cars gained a 50 per cent market share over 10 years about a quarter of European gasoline demand could disappear." This is not a widespread view in the energy markets. IHS Energy published a report in 2014 finding, "Past energy transitions took decades to unfold and were driven by a combination of market factors: cost, scarcity of supply, utility and flexibility, technology development, geopolitical developments, consumer trends, and policy.2" While our view is more aligned with IHS's, it is undeniable electric vehicles are a growing market. For this reason, we are publishing an analysis by BCA Research's EM Equity Sector Strategy written by our colleague Oleg Babanov, which explores the lithium-battery supply chain and how investors can gain exposure to this critical element of the fast-growing global electric-vehicle market. Separately, we are downgrading our strategic zinc view from neutral to bearish, and recommending a Dec/17 short if it rallies. Robert P. Ryan Senior Vice President, Commodity & Energy Strategy Lithium is a rare metal with a costly production process and a high concentration in a small number of countries. Difficulty in production is comparable to deep-sea oil drilling. Lithium is the key element in lithium-ion batteries. Demand is rapidly increasing as more countries adopt environment-protection policies and electric-car production is on the rise. We recommend an overweight on the lithium battery supply chain (Table 1), on a long-term perspective (one year plus). We estimate demand for the raw material to rise by approximately 30% over the coming years, driven by the main electric vehicle production clusters in Asia and the U.S. Table 1Single Stock Statistics For Companies##br## In The Lithium Battery Supply Chain (Oct 2016)* The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market What Is Powering Your Battery? Being a relatively rare and difficult to produce metal, lithium demand is rapidly increasing due to the metal's unique physical characteristics, which are utilized in long-life or rechargeable batteries. Rapidly rising demand from portable electronics manufacturers, and the push of the auto industry to develop new fuel-efficient technology, backed by the widespread support of many governments to reduce transportation costs and improve CO2 emissions, are driving prices for the metal higher. We believe that companies in the electric vehicle (EV) supply chain, from miners to battery producers and down to EV manufacturers, will benefit from the change in environmental policies and the growing need for more portable devices with larger energy storage. As the focus of the wider investment community remains tilted towards the U.S. (and Tesla in particular), many companies in the lithium battery supply chain, as well as EV producers, remain overlooked and undervalued. EV Production Expected To Surge We expect a continuation of the push towards energy-saving vehicles among car manufacturers, driven by government incentives and new tougher regulations (EU regulations for CO2 emissions in 2020 will be the strictest so far). Over one million EV vehicles of different types were sold in 2015. In countries such as Norway, the penetration of PEVs is reaching up to 23% (Chart 1). Based on the current growth rates (Chart 2), the compound annual growth rate of EV production is estimated at 30% to 35% over the next 10 years. Japan will remain in top spot in EV penetration (the current HEV rate is around 20% of the overall market). Japan's market (controlled by Toyota and Honda) is dominated by the HEV type of vehicles, and we expect it to remain this way. Chart 1PEV Penetration By Country The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market Chart 2EV Sales By Country The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market We expect the largest boost in market share gains to happen on the European market, based on very stringent CO2 emissions regulation (Chart 3) and ambitious EV targets set by the larger countries. EV market share is set to reach 20% (from the current 5%) in the coming seven to 10 years. The EU is closely followed by South Korea. The Ministry of Trade, Industry and Energy (MOTIE) has developed an ambitious plan of growth, by which EV market share should reach 20% by 2020 and 30% by 2025. New EVs will receive special license plates, fuel incentives, and new charging stations. MOTIE wants the auto industry to be able to produce 920,000 NEVs per year, of which 70% should be exported. Among other large markets, the U.S. and China will remain the two countries with lowest EV penetration rates, although growth rates will be impressive. This will be due to low incentives from the government and cheap traditional fuel supply (in the U.S.), or a low base, some subsidy cuts, and infrastructure constraints (in China). Especially in China's case, the numbers remain striking (Chart 4). According to statistics published by the China Association of Automobile Manufacturers (CAAM), EV sales in 2015 grew 450% YOY. The market is estimated to grow at an average rate of 25% over the next 10 years. Chart 3EU CO2 Emission Targets bca.ces_wr_2016_10_27_c3 bca.ces_wr_2016_10_27_c3 Chart 4Monthly NEV Sales China Monthly NEV Sales China Monthly NEV Sales China In this report we will highlight companies from the raw material production stage: Albermarle (ALB US), Gangfeng Lithium (002460 CH), Tianqi Lithium Industries (002466 CH), and Orocobre (ORE AU); to added-value battery producers: BYD (1211 HK), LG Chem (051910 KS), and Samsung SDI (006400 KS); down to some electric vehicle companies: Geely Automobile Holdings (175 HK) and Zhengzhou Yutong Bus Company (600066 CH). The Supply Side Driven by demand from China and the U.S., the raw material base for lithium has shifted in the past 20 years from subsurface brines to more production-intensive hard-rock ores. Brine operations are mostly found in the so-called LatAm "triangle" - Argentina, Chile and Bolivia - while China and Australia produce lithium from spodumene (a mineral consisting of lithium aluminium inosilicate) and other minerals. The U.S. Geological Survey estimates world reserves at 14 million tonnes in 2015, with Bolivia and Chile on top of the table (Chart 5). The main lithium producing countries, according to the U.S. Geological Survey, are Australia, Chile, and Argentina (Chart 6). Chart 5Lithium Reserves Concentrated In LatAm The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market Chart 6Lithium Production Dynamics By Country The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The lithium mining process starts with pumping lithium-containing brine to subsurface reservoirs and leaving the water to evaporate (from 12 to 24 months) until the brine reaches a 6% lithium content. From here there are three ways to process the concentrate, or the hard-rock in mineral form: Treatment with sulfuric acid (acidic method) Sintering with CaO or CaCO3 (alkali method) Treatment with K2SO4 (salt method) Further, lithium carbonate (Li2CO3), a poorly soluble solution, is isolated from the received concentrate and transferred into lithium chloride, which is purified in a vacuum distillation process. Storage is also difficult: as lithium is highly corrosive and can damage the mucous membrane, it is most commonly stored in a mineral oil lubricant. Due to the rare nature of the metal, lithium comes mainly as a by-product of other metals and comprises only a small part of the production portfolio. This is the reason why the underlying metal price and the share prices of the largest producers of lithium have low correlation (Chart 7). Albermarle, SQM, and FMC Corp currently control as much as three-quarters of global lithium production, but price performance is not keeping up with the price of the underlying metal. For best exposure to the metal, we concentrate on companies with a large degree of dedication to mining lithium and close ties to the end-users. We recommend one established market leader (by volume) - Albermarle (ALB US); one company that just started operations - Orocobre (ORE AU), whose assets are concentrated in Argentina; and two lithium miners from China - Jiangxi Ganfeng Lithium (002460 CH) and Tianqi Lithium (002466 CH). These companies display much higher correlation to the metal price (Chart 8). Chart 7FMC Corp., SQM And ##br##Albermarle Vs. Lithium Price bca.ces_wr_2016_10_27_c7 bca.ces_wr_2016_10_27_c7 Chart 8Orocorbe, Jiangxi Ganfeng And##br## Tianqi Lithium Vs. Lithium Price bca.ces_wr_2016_10_27_c8 bca.ces_wr_2016_10_27_c8 Albermarle (ALB US): U.S. company with EM exposure (Chart 9). After the acquisition of Rockwood Holdings in 2015, Albermarle became one of the largest producers of lithium and lithium derivatives. Lithium accounts for more than 35% of the company's revenue stream (+20% YOY), which compares favourably to the 20% of the Chilean producer SQM and the 8% of another large US producer FMC Corp. Chile comprises 31% of global production. Albermarle's 2Q16 results on 3 August came broadly in line with market expectations. Some deviation from expectations occurred because of discontinued operations in the Surface Treatment segment. Group sales contracted by 7%, due to divestures started in previous quarters (Chemetal). Positively, lithium sales grew 10% YOY due to both better pricing and higher volumes, and EBITDA in the segment improved by 20%. Group EBITDA (adjusted) grew by 5% YOY and the bottom-line (adjusted) expanded by 11% YOY. Management appears confident about FY16 operations, guiding 1% improvement in EBITDA, as well as 3% in FY EPS and aims to maintain EBITDA margins in the lithium segment at over 40%. We see high growth potential due to Albermarle's portfolio composition. The market is currently expecting an EPS CAGR of 9% over the next four years. Albermarle is trading at a forward P/E of 23.1x. Orocobre (ORE AU): An Australian company mining in Argentina (Chart 10). Orocobre is an Australian resource company, based in Brisbane. As in the case with Albermarle, the majority of operations are located in EM, so we see it as appropriate to include the company into our portfolio. Chart 9Performance Since October 2015: ##br##Albermarle vs MXEF Index bca.ces_wr_2016_10_27_c9 bca.ces_wr_2016_10_27_c9 Chart 10Performance Since October 2015: ##br##Orocobre vs MXEF Index bca.ces_wr_2016_10_27_c10 bca.ces_wr_2016_10_27_c10 Orocobre is at an initial stage in the lithium production process. The only division working at full capacity is Borax Argentina (acquired from Rio Tinto in 2012), an open-pit borate mining operation (producing 40 kilotonnes per annum (ktpa)). The flagship project (65% share), launched in a JV with Toyota Tsusho Corp, is the Olaroz lithium facility, a salt lake with an estimated 6.5 million tonnes of lithium carbonate (LCE) reserves. The planned capacity is at 17.5 ktpa. Due to the geological structure, it comes with one of the lowest operational costs ($3500 per tonne). The production ramp-up to 2,971 tonnes of lithium, reported on 19 July together with the 4Q16 results, came a notch below market expectations. The management lowered the production guidance, delaying full operational capacity by two months until November (realistically it might take even longer). Positive points in guidance included an LCE price exceeding $10,000/tonne in the upcoming quarter and confirmation that the company turned cash flow positive in the first half of this year.3 Orocobre is already planning capacity expansion at the Olaroz facility to 25 ktpa, with diversification into lithium hydroxide. Further exploration drilling is underway in the Cauchari facility, just south of Olaroz. The market forecasts the company to produce a positive bottom-line in FY17 and grow EPS by a CAGR of 25% for the next four years. Orocobre is currently trading at a forward P/E of 36.1x. Jiangxi Ganfeng Lithium (002460 CH): one of the largest lithium producers in China (Chart 11). Gangfeng is a unique company in the lithium space in the sense that it is a raw material producer with added processing capabilities. The main trigger for our OW recommendation was the acquisition of a 43% stake in the Mt Marion project in Australia. From 3Q16 onwards the bottleneck in raw material supply will be removed and the company can count on approximately 20 thousand tonnes (kt) of lithium spodumene. On the back of this news, the company announced a production expansion into lithium hydroxide (20 kt) from which 15 kt will be battery grade and 5 kt industry grade. This has the potential to lift Ganfeng to one of the top five producers in the world. Ganfeng reported stellar 2Q16 results on 22 August. The top-line grew two times YOY, while operating profit increased by 7.8x. Operating margin jumped from 9.8% to 35.9%, and the bottom-line expanded five-fold YOY. The profit margin also improved from 8.55% to 25.3%. We expect less strong, but still robust, YOY growth for the upcoming quarters. Market projects EPS CAGR of over 50% during the next four years, as the production run-up will continue. The company is currently trading at a forward P/E of 36.8x. Tianqi Lithium Industries (002466 CH): Making the move (Chart 12). Tianqi is the third largest producer in the world (18% of global capacity). Recently the company got into the news on rumors of its attempted expansion by taking a controlling stake in the world's largest lithium producer, Chile's SQM. Chart 11Performance Since October 2015:##br## Jiangxi Ganfeng Lithium vs MXEF Index bca.ces_wr_2016_10_27_c11 bca.ces_wr_2016_10_27_c11 Chart 12Performance Since October 2015: ##br##Tianqi Lithium vs MXEF Index bca.ces_wr_2016_10_27_c12 bca.ces_wr_2016_10_27_c12 SQM has an intricate shareholding structure, with the involvement of the Chilean government and a rule that no shareholder is currently allowed to own more than a 32% stake in the company (this rule can be changed only through an extraordinary shareholder meeting). At the moment the largest shareholder is Mr. Ponce Lerou (son-in-law of former President Augusto Pinochet), who owns just under 30% and has a strategic agreement with a Japanese company, Kowa, which makes the combined holding 32%. During the last week of September Tianqi acquired a 2% stake (for USD209 m) from US-based fund SailtingStone Capital Partners, which held a 9% stake, with the option to buy the remaining 7%. In a further step, Tianqi is trying to negotiate a deal with one of Mr. Ponce Lerou's companies which holds a 23% stake. It is said that Mr. Ponce Lerou has got into a political stalemate with the Chilean government on a production increase at one of its deposits and is looking to exit the company. Tianqi reported strong Q2 results on 22 August. Revenues grew by 2.4x YOY, and operating profit improved by 3.9x YOY. Operating margin grew from 42.99% in 2015 to 69.35% in 2Q16, and bottom-line increased twofold QOQ as production ramp-up continued. At the same time profit margin reached 48.9%, up from 2.8% a year ago. The company is currently trading at a forward P/E of 23.4x, and the market is forecasting an EPS CAGR of 13% over the next three years. The Demand Side4 Lithium is used in a wide range of products, from electronics to aluminium production and special alloys, down to ceramics and glass. But battery production takes the largest share of utilization (Charts 13A & 13B). Chart 13ALithium Usage The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market Chart 13BLithium Batteries Most Widely Used The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market As confirmed by import statistics (from the U.S. Geological Survey), demand in many Asian countries, as well as the U.S., has been constantly rising. Among the main importers, South Korea is in fourth place with the largest number of new lithium-related projects started. In top position is the U.S., where we expect a strong demand increase, once the Tesla battery mega-factory in Nevada is completed, followed by Japan, which has the highest penetration of electric vehicles (EV), and China (Chart 14). Chart 14Composition Of Lithium Imports By Country The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market Because of its low atomic mass, lithium has a high charge and power-to-mass ratio (a lithium battery generates up to 3V per cell, compared to 2.1V for lead-acid or 1.5V for zinc-carbon), which makes it the metal-of-choice for battery electrolytes and electrodes, and makes it difficult to replace with other metals, due to its unique physical features. Lithium is used in both disposable batteries (as an anode) and re-chargeable ones (Li-ion or LIB batteries, where lithium is used as an intercalated compound). Li-ion batteries are used in: Portable electronics, such as mobile phones (lithium cobalt oxide based); Power tools / household appliances (lithium iron phosphate or lithium manganese oxide); EVs (lithium nickel manganese cobalt oxide or NMC). The most produced battery is the cylindrical 18650 battery. Tesla's Model S uses over 7000 of these type of batteries for its 85 kWh battery pack (the largest on the market until mid-August, when Tesla announced a 100 kWh battery pack). The amount of lithium used in a battery pack depends on the kW output. Rockwood Lithium (now Albermarle), estimated in one of its annual presentations that: A hybrid electric vehicle (HEV) uses approximately 1.6kg of lithium A plug-in hybrid (PHEV) uses 12kg An electric vehicle (EV) uses more than 20kg (but all depends on make, model, and technology). An average car battery (PHEV/EV) would use over 10kg of lithium, assuming 450g per kWh (please note that real-life calculations suggest a usage of up to 800g per kWh of lithium. We have used the lower end of the range for our estimates), with Tesla's battery consuming around 70kg of lithium. Simple math suggests that with the completion of the mega-factory (estimated production of 35 GWh or 500k batteries p.a.), Tesla alone will be consuming at least half of world lithium production by 2020, and create a large overhang in demand. Among car battery producers, we like global players with dominant market positions and strong ties to end-users, such as LG Chem, Samsung SDI in Korea, and BYD in China. Those three companies together control more than half of global battery production (Chart 15) and will most likely maintain market share in the foreseeable future, as barriers to entry are high due the amount of investment required into technology and production facilities, and the end-product is difficult to differentiate on the market. BYD Corp (1211 HK): Build Your Dreams, it's in the name (Chart 16). Founded in 1995 and based in Shenzhen, BYD covers the whole value chain, from R&D and production of batteries (phone and car batteries) to automobile production and energy storage solutions. It is currently the largest battery and PHEV producer in China. The total revenues stream consists of 55% from auto and auto components sales, 33% portable electronics battery, and 12% car battery sales. Chart 15Largest Lithium ##br##Battery Producers The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market Chart 16Performance Since October 2015: ##br##BYD Corp vs MXEF Index bca.ces_wr_2016_10_27_c16 bca.ces_wr_2016_10_27_c16 We believe the company is best positioned to reap multi-year rewards from the recent drive of the Chinese government to promote new electronic vehicle (NEV) growth through subsidies, support of charging infrastructure, and changes in legislation. The introduction of carbon trading in August (carbon credit will be measured on the number of gasoline-powered vehicles in the producer's fleet) will give BYD a benefit over other car manufacturers. BYD's model pipeline and battery manufacturing capacity (expected to reach 20 GWh by FY17), as well as favourable pricing ($200 kWh compared to over $400 kWh for Tesla) put the company into a leadership position. BYD reported 2Q16 results on 28 August, which came out very strong. Revenues grew by 52.5% YOY and 384% on a semi-annual perspective, driven by all three business segments and especially strong in EV sales (+29% YOY). This came with a significant beat of consensus estimates and later we saw a 68% upwards adjustment. As a result operating margin and profit margin improved from 3.8% and 2.2% in 2Q15 to 8.5% and 5.8% in 2Q16. Bottom-line was up 4x YOY. The market is currently pricing in an EPS CAGR of 12% over the next three years. BYD is trading at a forward P/E of 23.9x. LG Chem (051910 KS): Catering for the US market (Chart 17). LG Chem is the largest chemical company in South Korea, operating in three different divisions: petrochemicals (from basic distillates to polymers), which account for 71% of total revenues, information technology and electronics (displays, toners etc.), which represent 13% of total revenues, and energy solutions, 16% of total revenues. LG Chem is the third largest battery producer in the world, manufacturing a pallet from small watch and mobile phone batteries down to auto-packs. LG's North American operations in Holland, Michigan produce battery packs for the whole range of GM (Chevrolet, Cadillac) EVs (including the most popular Volt range), as well as for the Ford Focus. In Europe, customers include Renault; in Asia, LG is working with Hyundai, SAIC, and Chery. The company reported better-than-expected 2Q16 results on 21 July. Revenues grew by 3% YOY and operating profit by 8.5% YOY, driven solely by the petrochem division (up 10% YOY). Bottom-line expanded by a healthy 8% YOY. LG Chem trades at deeply discounted levels (forward P/E of 11.6x) due to the remaining negative profitability in the battery segment (partly due to licensing issues in China, which represents 32% of total revenues), but we estimate that the trend will turn in the following quarters, as Chevrolet is ramping up demand with new product lines and management is guiding for a resolution in China. Furthermore, plans released by the Korean government in June/July (renewable energy plan and EV expansion plan) will increase demand for batteries by more than 30% CAGR in the next five years. The market is forecasting an EPS CAGR of 9% over the upcoming four years. Samsung SDI (006400 KS): Investing into the future (Chart 18). In contrast to LG Chem, Samsung SDI is fully focused on Li-ion battery production, with 66.5% of total revenues coming from this division (BMW and Fiat among clients). The company also produces semiconductors and LCD displays, which account for 35.5% of total revenue. Chart 17Performance Since October 2015: ##br##LG Chem vs MXEF Index bca.ces_wr_2016_10_27_c17 bca.ces_wr_2016_10_27_c17 Chart 18Performance Since October 2015: ##br##Samsung SDI vs MXEF Index bca.ces_wr_2016_10_27_c18 bca.ces_wr_2016_10_27_c18 Samsung SDI is currently in a reorganization phase, as the company is spinning off "Samsung SDI Chemicals" and has announced it will invest $2.5 bn into further development of its car battery business. The proceeds from the sale of Samsung SDI Chemicals (taken over by Lotte Chemicals in April for around $2.6 bn) will also be directed towards the car battery segment. Samsung SDI reported weak 2Q16 results on 28 July, as expected. Revenues continued to contract on a YOY basis, although the rate of decline slowed compared to Q1 and even registered 2% QOQ growth. The bottom-line was positive due to a one-off gain (the sale of the chemical business). The main headwinds came from delays in licensing Chinese factory production and a strong Japanese yen. On the positive side, Li-ion batteries in portable devices performed well, due to better than expected Galaxy S7 sales, as well as OLED sales, due to increased demand and capacity constraints in the mobile phone and large panel spaces. Due to the high concentration of EV battery-related revenues in its portfolio, we believe that Samsung SDI will be the largest beneficiary of government's renewable energy and EV expansion plans. The company is also ideally positioned to take advantage of the fast-growing Chinese market (35% of revenues coming from China), once the issue with licensing is resolved (which management guided will happen in Q3). The recent problems with overheating or exploding batteries, reported by users of the new Samsung phones, have sent the share price lower. We believe that this offers an excellent entry point, as ultimately the company will replace/improve the technology, and, at the same time, there are no alternatives which could threaten Samsung SDI's leadership in the portable battery space. The temporary issue in China has weighted on valuations, as Samsung SDI is trading at a forward P/E of 27.7x, while the market expects EPS to increase fivefold in the coming four years. Accessing The Chinese EV Market Best access to the fast growing Chinese market is through local car manufacturers, such as Geely (Chart 19). The subsidy schemes, put in place by the National Development and Reform Commission (NDRC), currently cover only domestic-made models (except the BMW i3). Furthermore, import duties are making foreign-made vehicles uncompetitive in terms of price. We recommend to overweight Geely (0175 HK) and electric bus producer Yutong Bus (600066 CH) on the 30% NEV rule for public transport procurement. Chart 19Accessing The Chinese EV Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market Geely ("Lucky" in Mandarin) Automobile Holdings (175 HK): A company with large ambitions (Chart 20). Probably best known for its two foreign car holdings, Volvo and the London Taxi Company, Geely grew from a small appliances manufacturer to the second largest EV producer in China, with an ambitious goal to manufacture 2 mn units by 2020. We see the main positive driver in Geely's big push into the EV market. The goal set by management is to have 90% of its fleet powered by electricity by 2020. The so called "Blue Geely" initiative is based on a revamp of Geely's current fleet into HEVs/PHEVs (65% as per plan) and EVs (35%). In May the company raised $400 mn in "green bonds" in a first for a Chinese car company, to support its R&D and manufacturing project, Ansty, to produce the first zero-emission TX5 black cabs in the U.K. The company reported strong 1H16 results on 18 August. Revenues were up 30% YOY, driven by higher production volume (up 10% YOY) and a sales price hike of around 15% YOY. The co-operation with Volvo seems to be working well (Volvo's design, Geely's production capabilities). The average waiting time for new models in China is approximately two months. The bottom-line expanded by 37.5% YOY despite a high density of new model launches, and we expect to see some margin improvement in the coming quarters. The market forecasts an EPS growth CAGR of 25% over the coming four years. Geely is currently trading at a forward P/E of 15.6x. Zhengzhou Yutong Bus Company (600066 CH): An unusual bus manufacturer (Chart 21). Yutong Bus Company is the world's largest, and technologically most advanced, producer of medium and large-sized buses (over 75k units produced in FY15, 10% global market share), with its own R&D and servicing capabilities. Even more important, Yutong is one of the largest producers of electric-powered buses in China and globally. Chart 20Performance Since October 2015: ##br##Geely Automobile Holdings vs MXEF Index bca.ces_wr_2016_10_27_c20 bca.ces_wr_2016_10_27_c20 Chart 21Performance Since October 2015:##br## Yutong Bus Company vs MXEF Index bca.ces_wr_2016_10_27_c21 bca.ces_wr_2016_10_27_c21 Due to the 30% EV procurement rule for local governments, the number of electric buses produced in 2015 soared 15 times to 90,000, a quarter of which were produced by Yutong. We expect this number to grow further with the introduction of the new carbon emission trading scheme. We see Yutong as best positioned in the bus manufacturers' space to take advantage of the new trading rules. Yutong reported 2Q16 results on 23 August, which came in broadly in line with market expectations. Revenue expanded by 34% YOY, driven by volume growth (7400 NEV units sold, +100% YOY). The push into EVs came with higher cost-of-sales (warranty and servicing). This did not affect gross margin (up 1% to 25%). Bottom-line grew by 50% YOY. Management maintained an upbeat outlook, guiding 25,000 units of NEV sales in FY16, with an average sales price increase due to higher sales in the large-bus segment. Management also expects to receive the national subsidy for FY15 in 3Q16 and for 2016 in 1Q17. The market currently factors in an EPS CAGR growth of 8% over the next four years. Yutong is trading at a forward P/E of 12.3x. How To Trade? The EMES team recommends gaining exposure to the sector through a basket of the listed equities, which would consist of four mining companies, three car battery pack producers, and two EV manufacturers. The main goal is active alpha generation by excluding laggards and including out-of-benchmark plays, to avoid passive index hugging via an ETF. Direct: Equity access through the tickers (Bloomberg): Albermarle (ALB US), Gangfeng Lithium (002460 CH), Orocobre (ORE AU), Tianqi Lithium Industries (002466 CH), BYD (1211 HK), LG Chem (051910 KS), Samsung SDI (006400 KS), Geely Automobile Holdings (175 HK), Zhengzhou Yutong Bus Company (600066 CH). ETFs: Global X Lithium ETF (LIT US) Funds: There are currently no funds available, which invest directly into lithium or lithium-related stocks. Please note that the trade recommendation is long-term (1Y+) and based on an OW call. We don't see a need for specific market timing for this call (for technical indicators please refer to our website link). Trades can also be implemented through our recommendation versus MXEF index either directly through equities in the recommended list or through ETFs. For convenience, the performance of both the ETFs and market cap-weighted equity baskets will be tracked (please see upcoming updates as well as the website link to follow performance). Risks To Our Investment Case Because of the broad diversification, we see our portfolio exposed to idiosyncratic risk factors, which could affect single-stock performance, as well as the following macro factors: Mining: Falling lithium prices due to lower demand or a ramp-up in production on some of the Australian projects, could hurt profitability or delay new projects (especially in case of Orocobre). We also see some political risk stemming from the region of operations (Argentina, Chile), especially taking into account the weak performance of Chile's own lithium producer SQM and its role in a Brazil-like political scandal. Battery and EV production. We identify the main risk in drastic changes to governments' environmental and subsidy policies, which would hit the whole supply chain. A slowdown in economic development can make green or power-saving initiatives too expensive and governments will have to rethink their subsidy policies or production/penetration goals. This will hurt profitability through either a negative impact on sales or through smaller subsidies, which producers and end-users are receiving from their governments. One further risk is the dramatic increase in demand for lithium after the completion of Tesla's factory in Nevada, but may also come from other large players such as BYD. We currently see this risk as muted. As with all large Tesla initiatives, you have to take them with a pinch of salt, as the exact end numbers and the time the factory will be working at full capacity are unclear. Furthermore, Tesla, unlike many Chinese competitors, has no supply of lithium of its own, so there is little chance that it can protect supply or control prices. In any case, we see the overall portfolio as balanced, as the mining companies' performance should compensate for a negative impact on the end producers. Oleg Babanov, Editor/Strategist obabanov@bcaresearch.co.uk BASE METALS China Commodity Focus: Base Metals Zinc: Downgrade To Strategically Bearish We downgrade our strategic zinc view from neutral to bearish. We believe zinc supply (both ore and refined) will rise in response to current high prices, resulting in a 10-15% decline in zinc prices over next 9-12 months. Tactically, we still remain neutral on zinc prices as we believe the market will remain in supply deficit over the near term. Chinese zinc ore production will recover in 2017, while the country's zinc demand growth will slow. China is the world's biggest zinc ore miner, refined zinc producer, and zinc consumer. We recommend selling Dec/17 zinc if it rises to $2,400/MT (current: $2,373.5/MT). If the sell order gets filled, put on a stop-loss level at $2,500/MT. Zinc has been the best-performing metal in the base-metals complex, beating copper, aluminum and nickel this year. After bottoming at $1,456.50/MT on January 12, zinc prices have rallied 64.7% to $2,399/MT on October 3 (Chart 22, panel 1). The Rally The rally was supercharged by a widening supply deficit, which was mainly due to a record shortage of zinc ores globally (Chart 22, panels 2, 3 and 4). Late last October our research showed the output loss from the closure of Australia's Century mine, the closure of Ireland's Lisheen mine and Glencore's production cuts would reduce global zinc supply by 970 - 1,020 KT in 2016, which would be equivalent to a 7.1 - 7.5% drop in global zinc ore output.5 Moreover, a 16% price decline during the November-January period spurred additional production cut worldwide. According to the WBMS data, for the first seven months of 2016, global zinc ore production declined 11.9% versus the same period of last year, a reduction never before seen in the zinc market. In comparison, there was no decline in global zinc demand (Chart 22, panel 4). As a result, the global supply deficit reached 152-thousand-metric-tons (kt) for the first seven months of 2016, versus the 230kt supply surplus during the same period last year. What Now? Tactically, We Remain Neutral. On the supply side, we do not see much new ore supply coming on stream over the next three months. On the demand side, both monetary and fiscal stimulus in China has pushed Chinese zinc demand higher. For the first seven months of 2016, the country's zinc consumption increased 209 kt, the biggest consumption gain worldwide. Because of China, global zinc demand did not fall this year. China will continue lifting global zinc demand as its auto production, highway infrastructure investment, and overseas demand for galvanized steel sheet will likely remain elevated over the near term (Chart 23, panels 1, 2 and 3). Inventories at the LME are still hovering around the lowest level since August 2009, while SHFE inventories also have been falling (Chart 23, bottom panel). Speculators seem to be running out of steam, as the open interest has dropped from the multi-year high on futures exchanges. Chart 22Zinc: Strategically Bearish, Tactically Neutral bca.ces_wr_2016_10_27_c22 bca.ces_wr_2016_10_27_c22 Chart 23Positive Factors In The Near Term bca.ces_wr_2016_10_27_c23 bca.ces_wr_2016_10_27_c23 The aforementioned factors militate against zinc prices dropping sharply in the near term. However, with prices near the 2014 and 2015 highs, and facing strong technical resistance, we do not see much upside. Strategically, We Downgrade Our Strategic Zinc View From Neutral To Bearish We believe zinc supply (both ore and refined) will rise in response to current high prices, resulting in a 10-15% decline in zinc prices over next 9-12 months. Chart 24High Prices Will Boost Supply In 2017 bca.ces_wr_2016_10_27_c24 bca.ces_wr_2016_10_27_c24 Zinc prices at both LME and China's SHFE markets are high (Chart 24, panel 1). Last year, many miners and producers cut their ore and refined production due to extremely low prices. If zinc prices stay high over next three to six months, we expect to see an increasing amount of news stories on either production cutbacks coming back or new supply being added to the market, which will clearly be negative to zinc prices (Chart 24, panels 2 and 3). So far, even though Glencore, the world's biggest ore producing company, is still sticking firmly to its output reduction plan, there have been some news reports about other producers raising their output, all of which will increase zinc ore supply in 2017. The CEO of the Peruvian Antamina mine said on October 10 the mine operator will aim to double its zinc output in 2017 to 340 - 350 kt, up from an estimated 170 kt - 180 kt this year, as the open pit operation transitions into richer zinc areas. This alone will add 170 kt - 180 kt new zinc supply to the market. Vedanta said last week that its zinc ore output from its Hindustan Zinc mine located in India will be significantly higher over next two quarters versus the last two quarters. Nyrstar announced in late September that it is reactivating its Middle Tennessee mines in the U.S., expecting ore production to resume during 2017Q1 and to reach full capacity of 50 kt per year of zinc in concentrate by November 2017. Red River Resource is also restarting its Thalanga zinc project in Australia, and expects to resume producing ore in early 2017. Glencore may not produce more than its 2016 zinc production guidance over next three months. But it will likely set its 2017 guidance higher, if zinc prices stay elevated. After all, the company has massive mothballed zinc mines, which are available to bring back to the market quickly. In comparison to the high probability of more supply coming on stream, global demand growth is likely to stay anemic in 2017, as the stimulus in China, which was implemented in 2016H1, will eventually run out of steam. How Will China Affect The Global Zinc Market? Chart 25Look To Short Dec/17 Zinc bca.ces_wr_2016_10_27_c25 bca.ces_wr_2016_10_27_c25 China is the world's largest zinc ore producing country, the world's largest refined zinc producing country, and the world's largest zinc consuming country. Last year, the country produced 35.9% of global zinc ore, 43.8% of global refined zinc, and consumed 46.7% of global zinc. Over the near term, China is a positive factor to global zinc prices. Domestic refiners are currently willing to refining zinc ores as domestic zinc prices are near their highest levels since February 2011. With inventories running low and domestic ore output falling 7.8% during the first seven months of 2016, the country may increase its zinc ore imports in the near term, further tightening global zinc ore supply. Domestic zinc demand and overseas galvanized steel demand are likely to stay strong in the near term. However, over the longer term, China will become a negative factor to global zinc prices. China's ore output the first seven months of 2016 was 221 kt lower than the same period of last year as low prices in January-March forced widespread mine closures. The country's mine output may not increase much, as the government shut 26 lead and zinc mines in August in Hunan province (the 3rd largest zinc-producing province in China) due to safety and environmental concerns. The ban will be in place until June 2017. Looking forward, elevated zinc prices and a removal of the ban will boost Chinese zinc ore output in 2017. Regarding demand, we expect much weaker Chinese zinc demand growth next year as this year's stimulus should run out of steam by then. Risks If global zinc ore supply does not increase as much as we expect, or global demand still have a robust growth next year, global zinc supply-demand balance may be more tightened, resulting in further zinc price rallies. If Chinese authorities resume their reflationary policies next year during the lead-up to the 19th National Congress of the Communist Party of China in the fall, which may increase Chinese and global zinc demand considerably, we will re-evaluate our bearish strategic zinc view. Investment Ideas As we are strategically bearish zinc, we recommend selling Dec/17 zinc if it rises to $2,400/MT (current: $2,373.5/MT) (Chart 25). If the sell order gets filled, put on a stop-loss level at $2,500/MT. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com 1 Please see p. 32 of the 2016 edition of the International Energy Agency's "Key World Energy Statistics." The IEA reckons global oil demand in 2014 averaged just over 93mm b/d. 2 Please see the Financial Times, p. 12, "Warning on electric vehicle threat to oil industry," in the October 9, 2016, re the Fitch Ratings report, and IHS Energy's Special Report, "Deflating the 'Carbon Bubble,' Reality of oil and gas company valuation," published in September 2014. 3 Because of the early stage of the project, a conventional equity analysis is not yet applicable. 4 Please see Technology Sector Strategy Special Report "Electric Vehicle Batteries", dated September 20, 2016, available at tech.bcaresearch.com 5 Please see Commodity & Energy Strategy Weekly Report for Base Metal section, "Global Oil Market Rebalancing Faster Than Expected", dated October 22, 2015, available at ces.bcaresearch.com Investment Views and Themes Recommendations Tactical Trades Commodity Prices and Plays Reference Table Closed Trades

As third quarter earnings reports trickle in for companies in the industrial sector, it is becoming increasingly clear that achieving meaningful sales growth will remain a daunting task. There is little incentive to bet on upside surprises. Commodity-related industries remain hamstrung by poor balance sheets and a dearth of free cash flow, which will limit capital availability needed for investment. Banks are tightening standards on business loans, a leading indicator for industrial sales growth (second panel). The ongoing contraction in core durable goods orders confirms that industrial sector earnings momentum remains negative. Now that sector labor costs are back on the upswing, the need for a sales recovery becomes even more urgent, otherwise profit margins will continue to get squeezed. We remain underweight the S&P industrials sector. bca.uses_in_2016_10_26_002_c1 bca.uses_in_2016_10_26_002_c1

Consumer product stocks have had a tough few weeks, as renewed strength in the U.S. dollar threatens to undermine sales prospects. However, there are reasons to be cautiously optimistic, especially in relative terms. Consumption has a lower economic beta than capital spending, particularly among consumer staples vendors. Consumer goods exports have started to rebound, even prior to renewed strength in emerging market currencies. The latter heralds at least a mild recovery in consumer product top-line growth. Domestically, retail sales at non-discretionary stores are outpacing sales at discretionary stores by a wide margin, another indication that in relative terms, profit conditions favor non-cyclical consumer goods vendors. We are overweight the S&P household products and S&P soft drink indexes. bca.uses_in_2016_10_26_001_c1 bca.uses_in_2016_10_26_001_c1

Highlights China's abnormal credit growth has been the result of speculative, high-risk behavior among Chinese banks - and not the natural result of the country's high savings rate. Banks do not intermediate savings into credit, and they do not need deposits to lend. Banks create deposits and money by originating loans. A commercial bank is not constrained in loan origination by its reserves at the central bank if the latter supplies liquidity (reserves) to commercial banks 'on demand'. What habitually drives credit booms are the "animal spirits" of banks and borrowers. We are initiating a relative China bank equity trade: short listed medium-size banks / long large five banks. Continue shorting the RMB versus the U.S. dollar. Feature For some time, the consensus view has been that rampant credit growth in China and the resulting excesses have been the natural result of the country's high savings rate, particularly among Chinese households. We have long argued differently: abnormal credit growth has been the result of speculative, high-risk behavior among Chinese banks and other creditors and borrowers. In this vein, China's credit bubble is no different than any other credit bubble in history. Although an adjustment in China might play out differently than it has in other countries where credit excesses became prevalent, China's corporate credit bubble is an imbalance that poses a non-trivial risk to both mainland and global growth (Chart I-1). Chart I-1China's Outstanding Credit Is Large Relative To Global GDP China's Outstanding Credit Is Large Relative To Global GDP China's Outstanding Credit Is Large Relative To Global GDP In a nutshell, Chinese banks have not channelled large amounts of household deposits into credit. Without mincing words, it is our view that banks have originated loans literally from "thin air" as banks do in any other country. In turn, credit has boosted spending, income and, consequently, savings. Do Deposits Create Loans, Or Do Loans Create Deposits? It is a widely held view among academics, investors and market commentators - including some of our colleagues here at BCA - that China's enormous credit expansion over the past several years has been a natural outcome of the nation's high savings rate. The argument goes like this: China has a very high savings rate, and it is inherent that household savings flow to banks as deposits. In turn, banks have little choice but to lend out on these deposits. The upshot of this reasoning is as follows: China's abnormally strong credit growth is a consequence of the country's abundant savings rather than an unsustainable excess. This argument hails from the Intermediate Loan Funds (ILF) model, otherwise known as the Loanable Fund Theory. This model suggests that deposits create loans - i.e., banks intermediate deposits into credit. Even though the ILF model is the most widespread theory of banking within academia and in textbooks, it unfortunately has little relevance to real-life banking - i.e., banking systems around the world do not function as the model posits. An alternative but much less recognized theory, the Financing Money Creation (FMC) model, asserts that banks create deposits from "thin air" when they originate a new loan. This is the model that banking systems in almost all countries in the world subscribe to. Indeed, whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower's bank account, therefore creating new money in the process (Chart I-2). In other words, bank loans create deposits and money. Chart I-2Commercial Banks: Credit Origination Creates Deposits Misconceptions About China's Credit Excesses Misconceptions About China's Credit Excesses Herein we cite various papers that discuss this matter and delineate the key points: "Banks do not, as many textbooks still suggest, take deposits of existing money from savers and lend it out to borrowers: they create credit and money ex nihilo - extending a loan to the borrower and simultaneously crediting the borrower's money account" (Turner, 2013). "When banks extend loans, to their customers, they create money by crediting their customer's accounts" (King, 2012). "Based on how monetary policy has been conducted for several decades, banks have always had the ability to expand credit whenever they like. They don't need a pile of "dry tinder" in the form of excess reserves to do so" (Dudley, 2009). "In a closed economy (or the world as a whole), fundamentally, deposits come from only two places: new bank lending and government deficits. Banks create deposits when they create loans." (Sheard, 2013). "Just as taking out a new loan creates money, the repayment of bank loans destroys money" (McLeay, 2014). The papers cited in the bibliography on page 18 elaborate on this topic in depth and readers are encouraged to review this literature. Bottom Line: Banks do not need deposits to lend. They create deposits and money by originating loans. Do Banks Lend Their Reserves At Central Banks? Another misconception about modern banking in general and China's banking system in particular is that banks lend out their excess reserves held at the central bank. Provided that Chinese banks have plenty of required reserves at the People's Bank of China (PBoC), some economists and analysts argue it is a matter of cutting the reserve requirement ratio to free up reserves (liquidity), which will allow banks to boost their loan origination. Again, we cite several papers as well as specific views from central bankers who reject the notion that banks lend out their reserves at the central bank: This comment by William C. Dudley (President of the New York Federal Reserve Bank) states "the Federal Reserve has committed itself to supply sufficient reserves to keep the fed funds rate at its target. If banks want to expand credit and that drives up the demand for reserves, the Fed automatically meets that demand in its conduct of monetary policy. In terms of the ability to expand credit rapidly, it makes no difference whether the banks have lots of excess reserves or not" (Dudley, 2009). "In fact, the level of reserves hardly figures in banks' lending decisions. The amount of credit outstanding is determined by banks' willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans. The aggregate availability of bank reserves does not constrain the expansion directly" (Borio et al., 2009). "While the institutional facts alone provide compelling support for our view, we also demonstrate empirically that the relationships implied by the money multiplier do not exist in the data ... Changes in reserves are unrelated to changes in lending, and open market operations do not have a direct impact on lending. We conclude that the textbook treatment of money in the transmission mechanism can be rejected..." (Carpenter et al., 2010). "...reserves are, in normal times, supplied 'on demand' by Bank of England to commercial banks in exchange for other assets on their balance sheets. In no way does the aggregate quantity of reserves directly constrains the amount of bank lending or deposit creation" (McLeay 2014). "Most importantly, banks cannot cause the amount of reserves at the central bank to fall by "lending them out" to customers. Assuming that the public does not change its demand for cash and the government does not make any net payments to the private sector (two things that are both beyond the direct control of the banks and the central bank), bank reserves have to remain "parked" at the central bank" (Sheard, 2013). More detailed analysis on this topic is available in the papers cited in the bibliography on page 18. Bottom Line: Banks do not lend out their reserves at the central bank. A commercial bank is not constrained in loan origination/money creation by its reserves at the central bank if the latter supplies liquidity (reserves) to commercial banks 'on demand'. Empirical Evidence: Savings Versus Credit This section presents empirical evidence that there is no correlation between national and household savings rates and loan origination. This is true for any country, including China. Credit growth and credit penetration (the credit-to-GDP ratio) have little to do with a country's or with households' savings rates. Chart I-3 illustrates that there has been no correlation between China's national or household savings rates and the credit-to-GDP ratio. China's savings rate was high and rising before 2009, yet the credit bubble formation only commenced in January 2009 when the savings rate topped out. Looking at other countries such as Korea, Taiwan and the U.S., historically we find no correlation between their savings and credit cycles1 (Chart I-4). Chart I-3China: Credit And Savings ##br##Are Not Correlated China: Credit And Savings Are Not Correlated China: Credit And Savings Are Not Correlated Chart I-4The U.S., Korea And Taiwan:##br## Credit And Savings Are Not Correlated The U.S., Korea And Taiwan: Credit And Savings Are Not Correlated The U.S., Korea And Taiwan: Credit And Savings Are Not Correlated Importantly, a high or rising savings rate does not preclude deleveraging. There were many two- to four-year spans of deleveraging in China when the credit-to-GDP ratio was flat or falling (Chart I-5) - i.e., the growth rate of credit was at or below nominal GDP growth. This occurred despite the country's high and rising savings rate. So, not only is deleveraging not unusual for China but it has also occurred amid a high savings rate. This contradicts the commonly held view that Chinese credit has always expanded faster than nominal GDP because the nation saves a lot. Deleveraging at the current juncture will likely be very painful, because the size of credit flows is enormous and even a moderate and gradual deceleration in credit will produce a major drag on growth. Specifically, the credit impulse - the second derivative of outstanding credit that measures the impact of credit growth on GDP - will be equal to -2.2% of GDP if credit growth moderates from 11.3% now to 7.8% in the next 24 months (Chart I-6). Chart I-5There Were Periods Of ##br##Deleveraging In China Too There Were Periods Of Deleveraging In China Too There Were Periods Of Deleveraging In China Too Chart I-6China's Credit Impulse Will ##br##Likely Be Negative China's Credit Impulse Will Likely Be Negative China's Credit Impulse Will Likely Be Negative As Chart I-6 also demonstrates, China's credit impulse drives Chinese imports, the most critical variable for the rest of the world. Chart I-7China: A Growth Engine Shift Since 2009 China: A Growth Engine Shift Since 2009 China: A Growth Engine Shift Since 2009 Further, it is possible to argue that vigorous credit growth generates robust income growth. The latter, in turn, allows a nation as a whole and households in particular to save more. If Chinese banks had not originated as many loans since early 2009 as they have, many goods and services in China would not have been produced and sold, and income growth for all companies, households and even government would be much lower. Even if the savings rate were held constant, less income would entail lower absolute amounts of both national and household savings. In short, China's exponential credit growth since 2009 has helped boost both national and household income levels, and in turn the absolute level of their savings. Chart I-7 illustrates that before 2009, mainland economic and income growth were driven by exports, but since early 2009, credit has been instrumental in generating income growth and prosperity. Finally, many analysts rationalize strong loan growth among Chinese banks by their robust deposit growth. This logic is flawed: Chinese banks have substantial deposits on hand because they originate a lot of loans. Bottom Line: China's and any other country's national or household savings rate does not explain swings in credit creation. Banks do not intermediate savings into credit. Rather, banks create deposits and money. What Drives Bank Lending? If a credit boom is not driven by abundant savings, what is the foundation for a credit boom in general, and the one currently underway in China in particular? Loan origination by a bank depends on that bank's willingness to lend, as well as general demand for loans. Also, depending on policy priorities, regulators often try to encourage or limit banks' ability to lend by imposing and adjusting various regulatory ratios. Barring any regulatory constraints, so long as there is demand for loans and a bank is willing to lend, a loan will be originated. Hence, in theory, banks can lend to eternity unless shareholders and regulators constrain them. In the immediate wake of the Lehman crisis, the Chinese authorities encouraged banks to open the credit floodgates. Thus, there was a de facto deregulation in the nation's banking system in early 2009 - policymakers encouraged strong credit origination. The experience of many countries - documented by numerous academic papers on this topic - has demonstrated that banking sector deregulation typically leads to excessive risk-taking by banks, and abnormal credit growth. These episodes have not ended well, with multi-year workouts following in their wake. By and large, a credit boom often occurs when risk-taking by banks surges and shareholders and regulators do not constrain them. This has been no different in China - the credit boom since 2009 has been powered by speculative and excessive risk-taking among banks and their management teams in particular, amid complacency of regulators and shareholders. Bottom Line: What habitually drives excessive credit creation are the "animal spirits" of banks and borrowers. Banks' and borrowers' speculative behavior and reckless risk-taking typically degenerates into a credit boom that often ends in an economic and financial downturn. It has been no different in China. What Constrains Bank Lending? The following factors can limit bank credit origination: Monetary policy can limit credit growth via raising interest rates, which dampens loan demand. Also, banks can become more risk averse when interest rates rise as they downgrade creditworthiness of current and prospective borrowers. Government regulations can impose various restrictions on banks, restraining their risk-taking and ability to originate infinite amounts of credit. In China, to limit banks' ability to lend, regulators have imposed several mandatory ratios on commercial banks, and also practice 'Window Guidance'. First, the capital adequacy ratio (CAR=net capital / risk-weighted assets). This ratio limits banks' ability to originate infinite amounts of loans by imposing a minimum level CAR. In China, most banks comply comfortably with CAR. The CAR for the entire commercial banking system is currently 13.1%. While the minimum requirement is 8%. The caveat is that in China, banks' equity capital is nowadays considerably inflated because they have not provisioned for non-performing loans (NPLs). If banks were to fully provision for NPLs, their equity capital would shrink significantly, and they would probably not meet the minimum CAR. Table I-1 shows that in a scenario of 12.5% NPL ratio for banks' claims on companies and zero NPL on household loans and mortgages as well as a 20% recovery rate, a full provisioning by banks would erode 65% of their equity. In this scenario, the CAR ratio would drop a lot - probably below the required minimum of 8% and banks would be forced to raise new equity (dilute existing shareholders) or shrink their balance sheets - or a combination of both. Table I-1China: NPL Scenarios And Banks' Equity Capital Impairment Misconceptions About China's Credit Excesses Misconceptions About China's Credit Excesses Second, the leverage ratio - computed as net Tier-1 capital divided by on- and off-balance-sheet assets. According to government regulation, this ratio should be at least 4%. As of June 30, 2016, the leverage ratio for the entire commercial banking system was 6.4%, comfortably above its floor. Nevertheless, as with CAR, the leverage ratio is overstated at the moment because the numerator - net Tier-1 equity capital - is artificially inflated, as it is not adjusted for realistic levels of NPLs, as discussed above. If 65% of equity is eroded due to sensible loan-loss provisioning and write-offs (as per Table 1), the leverage ratio would drop to about 2.3%, below the required minimum of 4%. Hence, banks would need to raise new equity (dilute existing shareholders), shrink their balance sheets or do a combination of both. Equity dilution is bearish for bank stocks and, if and as banks moderate their assets/loan growth, the economy will suffer. Third, regulatory 'Window Guidance' is implemented through PBoC recommendations to banks on their annual and quarterly credit ceilings, and on their credit structures. There is no official disclosure of this measure, and it is done between the PBoC, the Chinese Banking Regulatory commission (CBRC) and banks' management. In recent years, the efficiency of 'Window Guidance' has declined dramatically. Banks have defied bank regulators' efforts to rein in credit growth by finding loopholes in regulations. What's more, they have de facto exceeded credit origination limits by moving credit risk off their balance sheets and classifying it differently than loans. The result has been mushrooming Non-Standard Credit Assets (NSCA). Table I-2 reveals that on- and off-balance-sheet NSCA stand at RMB 10 trillion and RMB 19 trillion, respectively. Furthermore, banks have lately expanded their lending to non-depositary financial organizations that include trust companies, financial leasing companies, auto financing companies and loan companies (Chart I-8). This has probably been done to circumvent government regulations. Hence, Chinese banks have taken on much more credit risk than regulators have wanted them to by reclassifying/renaming loans as NSCA, and parking these assets both on- and off-balance-sheet. Table I-2China: Five Largest Banks Hold ##br##Only 40% Of Credit Assets Misconceptions About China's Credit Excesses Misconceptions About China's Credit Excesses Chart I-8Non-Bank Financial Organizations##br## Are On A Borrowing Spree From Banks bca.ems_sr_2016_10_26_s1_c8 bca.ems_sr_2016_10_26_s1_c8 In short, regulatory measures in China have not been effective at restraining credit growth in recent years. Bank shareholders are the biggest losers when banks expand credit uncontrollably, and then their default rates rise. The reason being that banking is a business built on leverage. For example, if a bank's assets-to-equity ratio is 10 and 10% of assets go bad (default with no recovery), shareholders' equity will completely evaporate - i.e., they will lose their entire investment. Hence, it is in the best interests of bank shareholders to halt a credit expansion when they sense deteriorating credit quality ahead. Doing so will hurt the economy, but limit their losses. Why have shareholders of Chinese banks not stepped in to curb the credit boom and misallocation of capital? We believe they have either been satisfied with such a massive credit expansion, which has initially driven shareholder returns up, or weak institutional shareholder mechanisms have meant they have been unable to enforce credit discipline on their banks. All in all, if China's or any other credit system is driven by the principals of capitalism and markets, creditors are the ones who should curtail credit growth - regardless of what impact it will have on the economy. If a country's credit system in general and banks in particular do not operate on principals of capitalism and markets, banks can expand credit infinitely, thereby perpetuating capital misallocation and raising inefficiency, leading to stagnating productivity - in other words, a move to a more socialist bend. Only in a socialist system do banks expand their credit portfolios in perpetuity, since they are not run to maximize wealth for shareholders. On a related note, there is another misconception that all Chinese banks are state-owned and the government will be fast to bail them out by buying bad assets at par. Table I-3 illustrates the ownership structure of 16 Chinese banks listed the A-share market, including the large ones. The state (central and local governments) and SOEs have a large but not 100% ownership stake. In fact, foreign investors have considerable equity shares in many banks. Table I-3Chinese Banks: Shareholder Structure Is Diverse Misconceptions About China's Credit Excesses Misconceptions About China's Credit Excesses Hence, a government bail-out of these banks at no cost to shareholders would mean the Chinese government is using taxpayer money to benefit domestic private as well as foreign shareholders. Given the considerable amounts involved, this will be politically difficult to achieve unless the benefits of doing so are explicitly greater than the costs of doing nothing. Chart I-9Commercial Banks Are On ##br##Borrowing Spree From PBoC Commercial Banks Are On Borrowing Spree From PBoC Commercial Banks Are On Borrowing Spree From PBoC We are not implying that a government bailout is impossible. Our point is that it will take material pain and considerable deterioration in the economy and financial markets before the central government bails out banks at no cost to other shareholders. No wonder the authorities have not recapitalized the banks so far. In the long run, if the Chinese government is serious about improving the credit/capital allocation process, it has to allow market forces to take hold so that creditors and debtors are not bailed out but instead assume financial responsibility for their decisions. This means short-term pain but long-term gain. The lack of demand for credit is an important constraint on credit origination. If there are no borrowers, banks will have a hard time making a sizable amount of loans. Liquidity constraints also limit banks' ability to expand their assets. Let's consider an example when liquidity constraints arise. Bank A originates a loan, and Borrower A wants to transfer money to its Supplier B, which has an account at Bank B. In theory, Bank A should reduce its excess reserves at the central bank by transferring money to Bank B's reserve account at the central bank. However, if too many borrowers of Bank A try to transfer their money/deposits to other banks, Bank A will run into liquidity constraints as its excess reserves dry up. In such a case, Bank A should borrow money from the central bank or the interbank market to replenish its excess reserves. Provided many G7 central banks are nowadays committed to supplying as much liquidity (reserves) as banks require, in these countries banks do not really face liquidity constraints in lending. The focus of advanced countries' central banks is to control short-term interest rates - i.e., they manage liquidity in a way to keep policy rates at the target. In the case of China, even though the PBoC has a high required reserves ratio (RRR) for banks, it apparently supplies commercial banks with whatever amounts of liquidity they require. Chart I-9 reveals that the PBoC's claims on commercial banks have surged by fivefold in the past three years. Given the Chinese monetary authorities have in the recent years been very generous in meeting banks' demands for liquidity, the high RRR has not constrained mainland banks' ability to originate loans. This contradicts some analysts' assertions that the PBoC can boost lending by cutting the RRR. As the PBoC presently fully accommodates banks' demands for liquidity, the significance and impact of required reserves has declined. On the whole, nowadays, commercial banks in China are not facing liquidity (reserves) constraints to expand credit. High debt servicing costs could constrain bank lending. Are there limits to the credit-to-GDP ratio? It is illustrative to consider a numerical example for China. Corporate and household debt presently stands at 220% of GDP and, according to Bank of Intentional Settlement (BIS) calculations, debt servicing costs (including interest payments and amortization) account for around 20% of disposable income (Chart I-10). If credit indefinitely expands at a rate well above nominal GDP growth (Chart I-11) and interest rates do not decline, debt servicing costs will rise substantially. For example, let's assume that mainland corporate and consumer leverage reaches 400% of GDP in the next several years. If and when this happens, debt servicing costs could double, approaching 40% of income assuming constant interest rates and debt maturity. Chart I-10China's Corporate And Household##br## Credit: The Sky'S The Limit? China's Corporate And Household Credit: The Sky'S The Limit? China's Corporate And Household Credit: The Sky'S The Limit? Chart I-11Will Credit Growth Slow Toward##br## Nominal GDP Growth? Will Credit Growth Slow Toward Nominal GDP Growth? Will Credit Growth Slow Toward Nominal GDP Growth? No debtor can continue to function under such debt burden. Hence, debtors will have to cut their spending (for companies it will be a reduction in capex budgets) or these debtors will need to borrow to pay interest and retire old debt. In short, this becomes an unsustainable Ponzi scheme, where debtors borrow to service their debt obligations. Anecdotal evidence suggests this is not rare in China nowadays. One way the authorities could reduce debt servicing is to cut interest rates to zero and lengthen the maturity of debt. This is what many advanced economies have done. If Chinese credit penetration does not stop rising, the PBoC will be forced to cut rates to close to zero. This in turn will lead to large capital outflows, and the RMB will depreciate versus the U.S. dollar. Bottom Line: The following factors can restrain bank credit origination: monetary policy (higher interest rates), government regulations, bank shareholders, lack of credit demand, liquidity constraints and high debt servicing costs. Investment Implications Chart I-12Short Small Banks / Long Large##br## Banks In China Short Small Banks / Long Large Banks In China Short Small Banks / Long Large Banks In China If banks' shareholders and other creditors in China act in accordance with their self-interests to preserve the value of their assets, they will have to reduce credit origination/lending. As a result, China will experience an acute economic downturn. This would constitute a capitalist-type adjustment, which in turn will lead to more efficiency, solid productivity growth, and reasonably high economic growth over the long term. However, it will also mean significant short-term pain. If the government bails out everyone, underwrites all credit risks, and gets even more involved in capital/credit allocation, the economy will not experience an acute slump for a while. However, this would represent a shift toward socialism and the potential growth rate will collapse in the next several years. With the labor force stagnating and probably contracting in the years ahead, China's potential growth will be equal to its productivity growth. In socialism, productivity growth is low, often close to zero. The growth trajectory in this scenario will follow mini-cycles around a rapidly falling potential growth rate. In brief, China's growth rate is bound to slow further, regardless of what scenario plays out over the next several years. Today, we are initiating a relative China bank equity trade: short listed small- and medium-size banks / long large five banks in the A-share market (Chart I-12). There has been more speculative high-risk lending from the small- and medium-size banks than the large ones. As we documented in our June 15, 2016 Special Report titled Chinese Banks' Ominous Shadow,2 the largest five banks have fewer non-standard credit assets than medium and small banks. If 12.5% of banks' claims on companies turn sour and the recovery rate is 20%, 100% of the equity of 11 listed small- and medium-sized banks will be wiped out. The same number for the large five banks is 42%. Hence, these 11 listed small- and medium-sized banks are more exposed to bad loans than the large five. Finally, mushrooming leverage entails that the monetary authorities should reduce interest rates drastically. However, lower interest rates will spur more capital outflows from the mainland. Hence, the RMB is set to depreciate further. We have been shorting the RMB versus the U.S. dollar since December 9, 2015, and this position remains intact. 1 We discussed this at length in Emerging Markets Strategy Special Report, "China: Imbalances And Policy Options", dated June 12, 2012, available at ems.bcaresearch.com 2 Please refer to the Emerging Markets Strategy Special Report titled, "Chinese Banks' Ominious Shadow", June 15, 2016, link available on page 22. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com Bibliography Borio, C. and Disyatat, P. (2009), "Unconventional Monetary Policy: An Appraisal", BIS Working Papers, No. 292, November 2009. Carpenter, S. and Demiralp, S. (2010),"Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?", Finance and Economics Discussion Series, No. 2010-41, Divisions of Research & Statistics and Monetary Affairs, Washington, DC: Federal Reserve Board Dudley, W. (2009), "The Economic Outlook and the Fed's Balance Sheet: The Issue of "How" versus "When"", Remarks at the Association for a Better New York Breakfast Meeting, available at http://www.newyorkfed.org/newsevents/speeches/2009/dud090729.html Jakad, Z. and Kumhof, M. (2015), "Banks Are Not Intermediaries of Loanable Funds - and why this Matters", Bank of England, Working Paper 529, May 2015 King, M. (2012), Speech to the South Wales Chamber of Commerce at the Millenium Centre, Cardiff, October 23. Ma, G., Xiandong, Y. and Xim L. (2011), "China's evolving reserve requirements", BIS Working Papers, No. 360, November 2011. Turner, A. (2013), "Credit, Money and Leverage", September 12. Sheard, Paul (2013), "Repeat After Me: Banks Cannot And Do Not 'Lent Out' Reserves", Standard & Poor's Rating Services, August 2013, New York Werner, R. (2014b), "How Do Banks Create Money, and Why Can Other Firms Not Do the Same?", International Review of Financial Analysis, 36, 71-77. See King (2012), "Banks Are Not Intermediaries of Loanable Funds - and why this Matters", pp. 6, cited in Zoltan Jakab and Michael Kumhof, Bank of England Working Paper 529, May 2015. See Dudley (2009), "Banks Are Not Intermediaries of Loanable Funds - and why this Matters", pp. 13, cited in Zoltan Jakab and Michael Kumhof, Bank of England Working Paper 529, May 2015. See Carpenter and Demiralp (2010), "Banks Are Not Intermediaries of Loanable Funds - and why this Matters", pp. 13, cited in Zoltan Jakab and Michael Kumhof, Bank of England Working Paper 529, May 2015. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

The speed at which the health care sector has sunk toward the bottom end of this year's trading range has unnerved many investors. The hit to health care stocks reflects a rise in risk premiums related to concerns that the U.S. government will exert more control over price setting if the Democrats win the election rather than any immediate downshift in relative forward earnings drivers. The sector is extremely oversold, and once the election is over, attention will refocus on the relative forward earnings outlook. Our Indicators suggest that earnings momentum will stay positive. Our health care sector pricing power proxy has rebounded after cooling from red-hot levels, and is still much stronger than overall corporate sector pricing (second panel). That is confirmed by the pharmaceuticals producer price index, and employment cost index for health insurance, i.e. pricing strength is broad-based. There is still scant evidence of a downshift in consumer spending patterns in reaction to rising health care sector inflation. Real (volumes) personal spending on health care goods and services continues to grow at a mid-single digit rate, well in excess of the rate of overall consumption. That is consistent with ongoing earnings outperformance. Stay overweight. bca.uses_in_2016_10_25_002_c1 bca.uses_in_2016_10_25_002_c1