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Equities have melted up in recent weeks, celebrating the tax bill passage, synchronized upswing in global economic data, still quiescent inflation and near vanishing tail risk. On July 10th when we penned the "SPX 3,000?" report, the S&P 500 was close to 2400.1 Over the past six months stocks have been in an uninterrupted upleg, moving to within 10% of our SPX 3,000 target. Table 1 White Paper: Introducing Our U.S. Equity Sector Earnings Models White Paper: Introducing Our U.S. Equity Sector Earnings Models Stocks have run "too far too fast" for our liking and there are increasing odds of a healthy pullback, especially now that no pundits are talking of a correction. In addition, were the selloff in the bond markets to accelerate in a short time frame, at some point it will cause equity market consternation. But, bonds still remain extremely overvalued versus stocks (Chart 1). Late last year, we began to modestly de-risk the portfolio via booking impressive gains in tactical market-neutral trades, as our upbeat cyclical view remains intact.2 Our cyclical strategy is to "buy the dip", as we do not foresee a recession in the coming 9-12 months. Importantly, profits will dictate the S&P 500's direction and the cyclical path of least resistance is higher still. Our SPX profit model continues to forecast healthy EPS growth in 2018 (Chart 2) and as we posited in the last report of 2017, earnings will do the heavy lifting at the current juncture with the forward P/E multiple likely moving laterally (Chart 3). Chart 1Simple Bond Valuation Metric Says:##br## Bonds Are Overvalued Vs. Stocks Simple Bond Valuation Metric Says: Bonds Are Overvalued Vs. Stocks Simple Bond Valuation Metric Says: Bonds Are Overvalued Vs. Stocks Chart 2All ##br##Clear All Clear All Clear Chart 3EPS Will Do The##br## Heavy Lifting In 2018 EPS Will Do The Heavy Lifting In 2018 EPS Will Do The Heavy Lifting In 2018 A simple decomposition shows that equity returns could reasonably reach a low-to-mid double digit level this year. Our assumptions are the following: nominal GDP can grow near 5% (3% real plus 2% inflation) and thus we estimate organic EPS growth that typically mimics GDP at this stage of the cycle of ~5%, ~2% dividend yield, ~2% buyback yield, ~5% tax related boost to EPS and no multiple expansion. The above assumptions are based on four key drivers: energy and financials will command a larger slice of the earnings pie,3 synchronized global capex upcycle will boost EPS,4 delayed positive translation effects from the U.S. dollar will lift profits5 and easy fiscal policy will also act as a tonic to EPS.6 On this note, this White Paper officially introduces the U.S. Equity Strategy earnings models for the eleven GICS1 equity sectors. We have identified key macro earnings drivers for each sector and incorporated them into individual sector models. The objective is to forecast the direction of earnings growth. Beyond introducing our EPS models, the purpose of this White Paper is to also compare and contrast the cyclical readings of our equity sector models with sell-side analysts' profit growth (Charts 4 & 5) and margin expectations and help clients position portfolios for the rest of 2018. The earnings models carry the most weight in determining our sector positioning, with our macro overlay and our valuation and technical indicators rounding out our methodology. Currently, our earnings models are consistent with maintaining a mostly cyclically biased portfolio structure (top panel, Chart 6), and thus participating in the broad market's overshoot. Chart 4What EPS Are Priced In... What EPS Are Priced In... What EPS Are Priced In... Chart 5...Per Sector For 2018 ...Per Sector For 2018 ...Per Sector For 2018 Chart 6Continue To Prefer Cyclicals Over Defensives Continue To Prefer Cyclicals Over Defensives Continue To Prefer Cyclicals Over Defensives Encouragingly, an equal weight of the 10 GICS1 sector model outputs (we are excluding real estate due to lack of history), accurately forecasts the S&P 500's profit growth (bottom panel, Chart 6), and currently also confirms the broad market's upbeat four factor macro EPS model (Chart 2). Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Financials (Overweight) Our financials earnings growth model comprises bank credit growth, the U.S. dollar index and net earnings revisions. The U.S. credit impulse is gaining traction, indicating that the market has digested the almost doubling in long-term rates over the past 18 months. Bankers are willing extenders of C&I credit and, with the economy humming north of 3% in real GDP terms, the outlook for loan growth is excellent. Loosening U.S. banking regulatory requirements, and pent up demand for shareholder friendly activities are all welcome news for financials profitability. Tack on BCA's higher interest rate view in 2018 and net interest margins will also get a bump, further adding to the sector's EPS euphoria. Credit quality is the third key profit driver for bank profitability and pristine credit quality is a harbinger of increased profits. The unemployment rate is plumbing generational lows and suggests that non-performing loans as a percentage of total loans will remain on a downward trajectory. Our profit model is expanding at twice the current profit growth rate (second panel, Chart 7) and 10 percentage points above the Street's 12-month forward estimates (top panel, Chart 5). In fact, the latter have gone vertical of late playing catch up to our model's estimates. The S&P financials sector remains a core portfolio overweight and we reiterate our high-conviction overweight status in the heavyweight S&P banks index. Chart 7Financials (Overweight) Financials (Overweight) Financials (Overweight) Energy (Overweight) The three drivers behind the S&P energy sector EPS growth model are oil-related currencies, the U.S. oil & gas rig count and WTI crude oil prices. A depreciating greenback, whittling down OECD oil stocks and rising global oil demand are all boosting energy profitability. OPEC 2.0 cutbacks have not only helped stabilize oil markets, but also paved the way for a breakout in oil prices above the $62.50/bbl stiff resistance level. Sustained OPEC output restraint will counterbalance U.S. shale oil production increases and coupled with rising global demand likely continue to underpin oil prices. Our synchronized global capex upcycle theme included the basic resources following a multi-year drubbing in outlays. Energy capex cannot contract at double digit rates indefinitely. Already a V-shaped capex momentum recovery is in store, as 2018 capital spending budgets are on track to at least match 2017. Our EPS growth model (second panel, Chart 8) matches sell-side analyst optimism (third panel, Chart 5). Keep in mind that only recently did the energy space become profit positive, making a solid recovery from an extremely low base. Margins are only now renormalizing above the zero line and breakneck pace EPS growth should continue in 2018. Following a negative 2017 return, the S&P energy sector is the best performing sector year-to-date, and we reiterate the high-conviction overweight stance. Chart 8Energy (Overweight) Energy (Overweight) Energy (Overweight) Industrials (Overweight) Our S&P industrials EPS model comprises the ISM manufacturing survey, raw industrials commodity prices and interest rates. It has an excellent track record in forecasting industrials EPS momentum, and sports one of the highest explanatory powers amongst all sector EPS models. While industrials EPS growth has been bouncing off the zero line for the better part of the past five years, our profit model has spoken: forecast EPS are in a V-shaped recovery since the end of the recent manufacturing recession (second panel, Chart 9). Commodity prices are recovering and increasing final demand, coupled with a soft U.S. dollar suggest that more gains are in store. Tack on the global virtuous capex upcycle, and the stars are aligned for this deep cyclical sector to break out of its multi-year trading range funk on the back of a surge in profits. China is a wild card, but signs of stability are enough to sustain the upward trajectory in the commodity-levered complex, including industrials stocks. Our industrials sector EPS model suggests that industrials profits will easily surpass the low (and below the overall market) analysts' EPS growth hurdle (third panel, Chart 4). The late-cyclical S&P industrials sector remains an overweight. Chart 9Industrials (Overweight) Industrials (Overweight) Industrials (Overweight) Consumer Staples (Overweight) The S&P consumer staples EPS growth model key drivers are: food exports, non-discretionary retail sales and analysts' net earnings revision ratio. Overall industry exports are expanding at a healthy clip as a consequence of a softening U.S. dollar and robust European and rebounding emerging markets demand. Deflating raw food commodity prices are offsetting rising energy and labor input costs, heralding a sideways move to margins. Sell side analysts are also currently penciling in a lateral profit margin move (middle panel, Chart 10). Our model is expanding at a near double digit rate, and is in line with 12-month forward EPS growth estimates (second panel, Chart 4). Investors have been vehemently avoiding staples stocks during the board market's uninterrupted run up, and have put out positioning offside. However, in the context of our cyclical over defensive portfolio bent we refrain from putting all our eggs in one basket, and prefer to keep consumer staples as our sole defensive sector overweight. This small hedge will serve our portfolio well if we do indeed get a healthy Q1/2018 pullback, as we expect. Chart 10Consumer Staples (Overweight) Consumer Staples (Overweight) Consumer Staples (Overweight) Consumer Discretionary (Neutral - Downgrade Alert) Measures of consumer confidence, consumer discretionary exports and the net earnings revisions ratio comprise BCA's global consumer discretionary EPS growth model, which has an excellent track record in forecasting the path of consumer discretionary profits. Consumer confidence is rolling over, albeit from a nose-bleed level, signaling that, at the margin, discretionary consumer outlays will remain tame. Worrisomely, rising interest rates coupled with a breakout in crude oil prices are net negatives for consumer spending. Our consumer drag indicator captures these consumer headwinds and warns that the sector is not out of the woods yet (bottom panel, Chart 11). The Fed is on track to raise rate three more times in 2018 and continue to mop up liquidity via renormalizing its balance sheet. This dual tightening backdrop bodes ill for early cyclical discretionary stocks as we highlighted in the September 25th Weekly Report. Our consumer discretionary EPS growth model is making an effort to bounce, signaling that contracting earnings will likely reverse course and come out of their recent funk (second panel). But, analysts are overly optimistic penciling in a near double-digit profit growth backdrop for the consumer discretionary sector (fourth panel, Chart 5). Netting it all out, the anemic message from our profit model along with the ongoing Fed tightening cycle and spiking energy prices warrant a downgrade alert. Stay tuned. Chart 11Consumer Discretionary (Neutral-Downgrade Alert) Consumer Discretionary (Neutral-Downgrade Alert) Consumer Discretionary (Neutral-Downgrade Alert) Telecom Services (Neutral) Telecom pricing power and capital expenditures expectations comprise our S&P telecom services EPS growth model. Telecom capital expenditures have bounced off the zero line and are growing at 4% per annum while sector sales growth has been nil. This capital-intensive industry must continually invest to stay relevant. A push by telecom carriers into TV offerings as part of a quad-play (internet, wireline, wireless and TV) has rekindled an M&A boom, and capex is slated to increase. However, margins will suffer if increased investment fails to translate into new sales (bottom panel, Chart 12). Steeply contracting pricing power is a bad omen both for top and bottom line growth prospects (fourth panel). Hopefully, industry consolidation will lead to a better pricing backdrop, but the jury is still out. Our EPS model has sunk into the contraction zone (second panel). Analysts are a little bit more sanguine, penciling in low single-digit profit growth (bottom panel, Chart 4). Industry deflation is not alone as a headwind as the bond market selloff is weighing on the high dividend yielding telecom services stocks. Despite all the bearish news, near all-time lows in relative valuation and washed out technicals are keeping us on the sidelines. Chart 12Telecom Services (Neutral) Telecom Services (Neutral) Telecom Services (Neutral) Materials (Neutral) Materials EPS growth is a far cry from the near 100% year-over-year mark hit during the commodity super-cycle the mid-2000s and the reflex rebound following the Great Recession (second panel, Chart 13). Our S&P materials EPS model inputs include the U.S. currency, metals commodity prices and a measure of borrowing costs. The model has been steadily decelerating recently, and moving in the opposite direction compared with sell-side analysts' optimistic estimates (bottom panel, Chart 5). Consequently, there is scope for downward revisions. Materials stocks are reflationary beneficiaries and also high fixed cost high operating leverage deep cyclicals that benefit most during the later stages of the business cycle when a virtuous capex/EPS upcycle takes root. A number of both developed and developing central banks have recently embarked on tightening monetary policy following in the Fed's footsteps. Global liquidity is on the verge of getting mopped up as even the ECB and the BoJ have started to hint that they would remove some of their ultra-accommodative and unconventional policy measures. These opposing forces keep us at bay and we continue to recommend a benchmark allocation in the S&P materials index. Chart 13Materials (Neutral) Materials (Neutral) Materials (Neutral) Real Estate (Neutral) Commercial real estate loan demand, a labor market measure and the EUR/USD comprise our S&P real estate profit growth model (second panel, Chart 14). The 10-year Treasury yield and real estate relative performance have been nearly perfectly inversely correlated since the GFC as REITs sport a hefty dividend yield and thus are considered a fixed income proxy. BCA's higher interest rate 2018 theme suggests that more downside looms for this rate-sensitive sector. Similarly, a firming EUR/USD reflecting the nearly 100% domestic exposure of the sector weighs on real estate relative performance. Our EPS model has recently sunk into the contraction zone and is in sync with sell-side analysts' negative profit growth figures for calendar 2018 (second panel, Chart 5). While all this signals that an underweight stance is appropriate, we would rather stay on the sidelines for three reasons: First, sector pricing power (mostly rents) has not eroded yet, despite the surge in multi-family housing construction. Second, most of the bad news is likely already discounted in sinking valuations and extremely oversold technicals. Finally, we would rather concentrate our interest rate related underweight in the pure play fixed income proxy, the utilities sector (please see page 15). Stick with a benchmark allocation in the S&P real estate index. Chart 14Real Estate (Neutral) Real Estate (Neutral) Real Estate (Neutral) Health Care (Underweight) Our S&P health care EPS growth model consists of health care pricing power, labor costs and a measure of health care outlays. Health care demand is fairly inelastic, signaling that health care spending prospects remain upbeat, especially given the aging population. However, the industry's up-to-recently structurally robust pricing power backdrop is under intense scrutiny. Medical commodity cost inflation is melting and drug pricing power has nearly halved since early 2016. Democrats and Republicans alike, despise the pharmaceutical/biotech industry's pricing tactics and drug price containment is on nearly every legislator's agenda. Add on the generic drug inroads, and Big Pharma/biotech resilient profits appear vulnerable, weighing heavily on the sector's relative performance. From a secular perspective, there is scope for health care sector profit gains. Developing countries are only just starting to institute social "safety nets" that the developed world already has in place. Our profit model is decelerating (second panel, Chart 15) and forecasting single digit EPS growth, in line with the Street's 12-month forward profit estimates (fourth panel, Chart 4). The S&P health care sector is a core underweight portfolio holding and we reiterate the high-conviction underweight status in the heavy weight S&P pharma sub index. Chart 15Health Care (Underweight) Health Care (Underweight) Health Care (Underweight) Utilities (Underweight) Utilities pricing power, the yield curve and analysts' net earnings revisions are the key inputs in our S&P utilities EPS growth model (second panel, Chart 16). While natgas prices, the industry's marginal price setter, have been stuck in a trading range between $2.6 and $3.4/mmbtu over the past 18 months, they are currently contracting and weighing heavily on industry pricing power. The U.S. economy is firing on all cylinders (bottom panel, Chart 16) and a selloff in the 10-year Treasury market near 3% is BCA's base-case scenario for 2018. Under such a backdrop, fixed income proxied defensive equities lose their luster, and thus utilities stocks will likely remain under intense downward pressure, Our S&P utilities EPS growth model is expanding at a mid-single digit growth rate, broadly in line with sell-side analysts' forecasts (fifth panel, Chart 4) and roughly 700bps below the broad market. The S&P utilities sector is a high-conviction underweight. Chart 16Utilities (Underweight) Utilities (Underweight) Utilities (Underweight) Technology (Underweight - Upgrade Alert) Our three-factor global technology EPS growth model includes capex intentions, the trade-weighted U.S. dollar and sell-side analysts' net earnings revision ratio. While the tech sector is still largely considered a deep cyclical, we view it as more defensive. The majority of large capitalization tech companies are mature, cash rich, cash flow generating, dividend paying and high margin. Tech firms thrive in a deflationary backdrop as business models have been built to withstand the inherently disinflationary "creative destruction" process. BCA's interest rate view calls for an inflationary driven sell off in bonds for 2018, suggesting that investors avoid high-flying tech stocks. Weakness in basic resources explains most of the delta in cyclical capital outlays. Encouragingly, technology's share of the U.S. capex pie is making inroads rising to roughly 10% (bottom panel, Chart 17). Tech investment has been so abysmal for so long that it is hard to get any worse. In fact, it has started to improve both on an absolute and relative basis, as pent-up tech demand is being unleashed. Our synchronized global capex upcycle theme is gaining traction and the tech sector will continue to make gains at the expense of resource-related spending. Our global tech EPS model is forecasting modest double-digit growth in the coming quarters (second panel, Chart 17), largely aligned with sell-side analysts' profit growth expectations (fifth panel, Chart 5). On balance, we are putting the S&P tech sector on upgrade alert reflecting the capex tailwind offsetting the rising interest rate backdrop, and reiterate our capex-related high-conviction overweight in the S&P software sub-index. Chart 17Technology (Underweight-Upgrade Alert) Technology (Underweight-Upgrade Alert) Technology (Underweight-Upgrade Alert) 1 Please see BCA U.S. Equity Strategy Weekly Report, "SPX 3,000?," dated July 10, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "EPS And "Nothing Else Matters"," dated December 18, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Dissecting Profit Composition," dated July 24, 2017, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "Invincible," dated November 6, 2017, available at uses.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Weekly Report, "Dollar The Great Reflator," dated September 18, 2017, available at uses.bcaresearch.com. 6 Please see BCA U.S. Equity Strategy Weekly Report, "Can Easy Fiscal Offset Tighter Monetary Policy?," dated October 9, 2017, available at uses.bcaresearch.com.

Dear Client, This is our final publication for the year. We will be back on January 5th. On behalf of the entire Global Investment Strategy team, I would like to wish you a Merry Christmas, Happy Holidays, and a Prosperous New Year! Best regards, Peter Berezin, Chief Global Strategist Highlights Global bonds have sold off in recent days, but the spread between long-term and short-term Treasury yields remains well below where it was at the start of the year. A flatter Treasury yield curve suggests that the ongoing U.S. business-cycle expansion is getting long in the tooth. Nevertheless, three factors dilute the potentially bearish message from the curve. First, the yield curve has flattened largely because short-term rate expectations have risen thanks to better economic data. Second, both the 10-year/2-year and 10-year/3-month spreads are still above levels that have foreshadowed poor returns for risk assets in the past. This is particularly true for equities. Third, a structurally low term premium has distorted the signal from the yield curve. The U.S. yield curve is likely to steepen over the next six months, before flattening again in the lead-up to a recession in late-2019. We reveal the One Number that will kill bitcoin. Feature A Harbinger Of Recession? The U.S. yield curve has steepened in recent days, but is still much flatter than it was at the start of the year. The 10-year/3-month spread currently stands at 113 bps, down 84 bps year-to-date. The 10-year/2-year spread has fallen from 125 bps to 62 bps. Numerous academic studies have highlighted the importance of the yield curve as a leading indicator of recessions.1 In fact, every U.S. recession over the past 50 years has been preceded by an inverted yield curve (Chart 1). Chart 1An Inverted Yield Curve Has Often Been A Harbinger Of A Recession An Inverted Yield Curve Has Often Been A Harbinger Of A Recession An Inverted Yield Curve Has Often Been A Harbinger Of A Recession The converse has generally been true as well: Most inversions in the yield curve have coincided with a recession. The only two exceptions were in 1967 - when credit conditions tightened and industrial production decelerated, but the U.S. still managed to avoid succumbing to a recession - and in 1998, when the yield curve briefly inverted during the LTCM crisis. Considering that recessions and equity bear markets typically overlap (Chart 2), it is not surprising that investors have begun to fret about what a flatter yield curve may mean for their portfolios. Chart 2Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Don't Worry... Yet Chart 3U.S. Growth Expectations Revised Higher U.S. Growth Expectations Revised Higher U.S. Growth Expectations Revised Higher We would not be as dismissive of a flatter yield curve as Fed Chair Yellen was during her December press conference. Policymakers and investors alike have been too quick to downplay the signal from the yield curve in the past. In 2006, they blamed the "global savings glut" for dragging down long-term yields. In 2000, they argued that the federal government's budget surplus was reducing the supply of long-term bonds. In both cases, the bond market turned out to be seeing something more ominous than they were. That said, there are three reasons why we would discount some of the more bearish interpretations of what a flatter yield curve is telling us. First, the flattening of the yield curve has occurred mainly because of an increase in short-term rate expectations, rather than a decrease in long-term bond yields. The increase in rate expectations has been largely driven by stronger growth data. The economic surprise index has surged far into positive territory and analysts are now scrambling to revise up their 2018 and 2019 U.S. GDP growth projections (Chart 3). The Fed now sees growth of 2.5% in 2018 and an unemployment rate of 3.9% by the end of next year. Back in September, the Fed expected growth of 2.1% and an unemployment rate of 4.1%. Second, our research suggests that the slope of the yield curve only becomes worrisome for the economy when it falls to extremely low levels. This conclusion is reinforced by the New York Fed's Yield Curve Recession Model, which uses the difference between 10-year and 3-month Treasury rates to estimate the probability of a U.S. recession twelve months ahead.2 The model's current recession probability stands at a modest 11% (Chart 4). The last three recessions all began when the implied probability was over 25%. Chart 4NY Fed's Yield Curve Model Suggests That The Probability Of A Recession Is Still Quite Low NY Fed's Yield Curve Model Suggests That The Probability Of A Recession Is Still Quite Low NY Fed's Yield Curve Model Suggests That The Probability Of A Recession Is Still Quite Low Third, the slope of the yield curve is weighed down by a structurally low term premium. The term premium measures the additional return investors can expect to receive by locking in their money in a 10-year Treasury note instead of rolling over a short-term Treasury bill for an entire decade. Historically, the term premium has been positive. Over the past few years, however, it has often been negative - meaning that investors have been willing to pay a premium to take on duration risk. Many commentators have attributed this peculiar state of affairs to central bank asset purchases, which they claim have artificially depressed long-term bond yields. There is some truth to this, but we think there is an even more important reason: Bonds today provide a good hedge against bad economic news. When fears of an economic slowdown mount, equities tend to sell off, while bond prices rise. This differs from the circumstances that existed in the 1970s and 1980s, when bad economic news usually meant higher inflation. To the extent that long-term bonds now serve as insurance policies against recessions, investors are more willing to accept the lower yields that they offer. Empirically, one can see this in the shift of the correlation between equity returns and bond yields. It was strongly negative up until the mid-1990s. Now it is strongly positive (Chart 5). A low term premium implies that the slope of the yield curve should be structurally flatter. That is exactly what we see today. Chart 6 shows that the 10-year/3-month spread would be well above its long-term average if the term premium were removed from the picture. This implies that investors have little to fear from the shape of today's yield curve, at least over the next six-to-twelve months. Chart 5Bond Prices Now Tend To Rise When Equity Prices Go Down Bond Prices Now Tend to Rise When Equity Prices Go Down Bond Prices Now Tend to Rise When Equity Prices Go Down Chart 6Stripping Out The Term Premium,##BR##The Yield Curve Is Not So Flat Stripping Out The Term Premium, The Yield Curve Is Not So Flat Stripping Out The Term Premium, The Yield Curve Is Not So Flat Rising Odds Of A Recession In Late-2019 Beyond then, things start to get dicey. The Fed's end-2018 unemployment rate projection of 3.9% is 0.7 percentage points below its long-term estimate of the unemployment rate. This means that at some point in the future, the Fed will need to lift interest rates above their "neutral" level in order to push the unemployment rate up to its equilibrium level. That's a risky gambit. There has never been a case in the post-war era where the unemployment rate has risen by more than one-third of a percentage point without a recession ensuing (Chart 7). Modern economies are subject to feedback loops. Once economic conditions begin to deteriorate, households cut back on spending. This leads to less hiring and even less spending. Bad economic news begets worse news. Chart 7Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Implications For Equities And Credit A flatter Treasury yield curve suggests that the U.S. business cycle is entering the home stretch. Nevertheless, as we pointed out two weeks ago, the 7th-to-8th innings of business-cycle expansions are often the juiciest for equity investors (Table 1).3 Table 1Too Soon To Get Out Don't Fear A Flatter Yield Curve Don't Fear A Flatter Yield Curve Chart 8 shows that the term spread today is still at levels that have signaled positive equity returns in the past. In fact, today's term spread is close to levels that prevailed in the second half of the 1990s, a period that coincided with the greatest bull market in American history. This message is echoed by our forthcoming MacroQuant model, which continues to flag upside risks for stocks over the next 6-to-12 months (Chart 9). Chart 8Current Term Spread Is Still Pointing##BR##To Positive Equity Returns Don't Fear A Flatter Yield Curve Don't Fear A Flatter Yield Curve Chart 9MacroQuant Still Positive##BR##On The Stock Market Don't Fear A Flatter Yield Curve Don't Fear A Flatter Yield Curve Globally, we favor euro area and Japanese equities (in local-currency terms) in the developed market sphere due to our expectation that the euro and yen will depreciate somewhat next year. Both the euro area and Japan also have greater exposure to cyclical sectors. This fits with our bias towards owning cyclicals over defensive stocks. Today's term spread is a bit more worrying for corporate credit. As our bond strategists have noted, a flatter yield curve is consistent with lower, though still positive, monthly excess returns for high-yield bonds (Chart 10).4 Again, the second half of the 1990s provides a potentially useful template: Despite a sizzling stock market, high-yield spreads actually widened as corporations loaded up on debt (Chart 11). The deterioration in our Corporate Health Monitor over the past five years suggests that a similar dynamic may be afoot (Chart 12). Chart 10Junk Monthly Excess Returns##BR##And The Yield Curve Don't Fear A Flatter Yield Curve Don't Fear A Flatter Yield Curve Chart 11Second Half Of 1990s: When High-Yield Spreads##BR##Rose With Stock Prices Second Half Of 1990s: When High-Yield Spreads Rose With Stock Prices Second Half Of 1990s: When High-Yield Spreads Rose With Stock Prices Chart 12Corporate Health Has##BR##Been Deteriorating Corporate Health Has Been Deteriorating Corporate Health Has Been Deteriorating Yield Curve Should Steepen Over The Coming Months Of course, much depends on what happens to the yield curve going forward. We suspect that it will flatten again towards the end of next year. However, it is likely to steepen over the next six months. U.S. GDP growth will remain above trend next year, as wages start to rise more briskly and firms boost capital spending to meet rising demand for their products. Fiscal policy should also help. Tax cuts will lift growth by 0.2%-to-0.3% in 2018. Higher disaster relief efforts following the hurricanes and a pending agreement to raise caps on discretionary spending will also translate into increased federal government spending. Investors have largely overlooked this source of fiscal stimulus, but increased spending will contribute almost as much to growth next year as lower taxes. Unfortunately, all this additional growth, coming at a time when the output gap is all but closed, is likely to stoke inflationary pressures. Our Pipeline Inflation Pressure Index has risen sharply since early 2016, while the ISM prices paid index has shot up. The New York Fed's Underlying Inflation Gauge has accelerated to an 11-year high of 3% (Chart 13). Historically, rising inflation expectations have led to a steeper yield curve (Chart 14). The implication is that investors should favor inflation-linked securities over government bonds. Chart 13U.S. Inflation Pressure Are Building U.S. Inflation Pressure Are Building U.S. Inflation Pressure Are Building Chart 14Rising Inflation Expectations Lead To A Steeper Yield Curve Don't Fear A Flatter Yield Curve Don't Fear A Flatter Yield Curve The One Number That Will Kill Bitcoin In a normal world, most reasonable people would regard a flatter yield curve and continued weak inflation readings as evidence that fiat money was, if anything, doing too good a job as a store of value. However, nothing is normal or reasonable about bitcoin.5 Chart 15Governments Will Want Their Cut:##BR##U.S. Seigniorage Revenue Governments Will Want Their Cut: U.S. Seigniorage Revenue Governments Will Want Their Cut: U.S. Seigniorage Revenue No one knows when the bitcoin bubble will burst. Only a tiny fraction of the public owns the virtual currency. The value of all bitcoin in circulation represents 0.35% of global GDP. At its peak in 1996, the value of all pyramid scheme assets in Albania amounted to almost half of GDP. Never underestimate the lure of easy money. While we do not know where the price of bitcoin will be ten months from now, we do have a good guess of where it will be ten years from today. And that price is zero, or thereabouts. When the U.S. Treasury issues a $100 bill, it gains the ability to buy $100 of goods and services with it. The government's cost is whatever it pays to print the bill, which is next to nothing. This so-called "seigniorage revenue" is set to reach $100 billion this year (Chart 15). That is the number that will kill bitcoin. There is no way the U.S. government will forsake this revenue in order to make room for bitcoin and other cryptocurrencies. Not when there are entitlements to pay and gaping budget deficits to finance. A variety of other countries have a love-hate relationship with bitcoin, partly because of their "the enemy of my enemy is my friend" attitude towards the dollar. But that will change when they see their tax bases eroding as more commerce gets done in the anonymous world of cryptocurrencies. Bitcoin's days are numbered. The only question is who will be holding the bag when the party ends. Peter Berezin, Chief Global Strategist peterb@bcaresearch.com 1 Please see Jonathan H. Wright, "The Yield Curve And Predicting Recessions," FEDs Working Paper No. 2006-7, May 3, 2006; Michael Owyang, "Is the Yield Curve Signaling a Recession?"Federal Reserve Bank Of St. Louis, March 24, 2016; and Arturo Estrella and Mishkin, Frederic S., "The Yield Curve as a Predictor of U.S. Recessions," Federal Reserve Bank Of New York, (2:7), June 1996. 2 Please see "The Yield Curve As A Leading Indicator: Probability of U.S. Recession Charts," Federal Reserve Bank Of New York. 3 Please see Global Investment Strategy Weekly Report, "When To Get Out," dated December 8, 2017. 4 Please see U.S. Bond Strategy, "Proactive, Reactive Or Right?" dated December 12, 2017. 5 Please see European Investment Strategy Weekly Report, "Bitcoins And Fractals," dated December 21, 2017; Technology Sector Strategy Special Report, "Cyber Currencies: Actual Currencies Or Just Speculative Assets?" dated December 12, 2017; Global Investment Strategy Special Report, "Bitcoin's Macro Impact," dated September 15, 2017; and Technology Sector Strategy Special Report, "Blockchain And Cryptocurrencies," dated May 5, 2017. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights As bitcoin has developed into a fledgling form of money, the best valuation framework for it is the quantity theory of money. This states that the bitcoin money supply (in dollars) times bitcoin's velocity of circulation = the amount of world GDP carried out in bitcoin. In the short term, excessive herding signals a likely countertrend reversal, and implies that the bitcoin price will retest $12,750 at some point in the next 130 days. In the long term, the wholesale acceptance of cryptocurrencies in the global economy will be deflationary. Feature Bitcoin's near-vertical price ascent to $19,000 has left many commentators crying "bubble!" The problem with this is that you cannot define an asset bubble simply from the behaviour of a price. You need to assess fundamental value, and the extent of deviation above this fundamental value. Conceivably, bitcoin's near-vertical price ascent could be a correction from an "anti-bubble", in which the price was a long way below its fundamental value and rapidly corrected upwards. Which begs the question: what is the best way to assess the fundamental value of bitcoin and other cryptocurrencies? Chart of the WeekCryptocurrencies Will Prevent Inflation, Just Like The Gold Standard Cryptocurrencies Will Prevent Inflation, Just Like The Gold Standard Cryptocurrencies Will Prevent Inflation, Just Like The Gold Standard A Valuation Framework For Bitcoin As bitcoin has developed into a fledgling form of money, one potential valuation framework is the quantity theory of money. This states that the money supply times its velocity of circulation equals nominal GDP. Given that the supply of bitcoin will not exceed an upper limit of 21 million coins, we can say that the bitcoin money supply (in dollars) is the bitcoin price times 21 million. We can then use the quantity theory to deduce: Bitcoin price times 21 million times bitcoin's velocity of circulation = Amount of world GDP carried out in bitcoin. If we additionally assume that bitcoin's velocity is similar to that of the stock of broad fiat money, 1.5, then we can rearrange and simplify the equation to approximately: Bitcoin price = Amount of world GDP carried out in bitcoin divided by 30 million So if the market was discounting that $0.5 trillion of world GDP would be carried out in bitcoin, then its price should be $16,700. Given the purported nefarious uses of cryptocurrencies at the moment, and an estimated size of the world's shadow economy at around $16 trillion, an assumption of $0.5 trillion of bitcoin use in the world economy does not seem excessive. On the other hand, nefarious use might make bitcoin's velocity of circulation a lot higher than conventional money. Which would pull bitcoin's fair price much lower. Suffice to say, the above assumptions are broad-brush and open to challenge. Nevertheless, despite the many caveats, the above framework is probably the most valid for valuing a cryptocurrency once it gains acceptance as a fledgling form of money. Putting Bitcoin Through Fractal Analysis The behaviour of price alone cannot gauge an asset bubble. But the behaviour of price alone can gauge a shortage of liquidity in the asset which implies a potential countertrend reversal. Liquidity is plentiful when the market is split between short-term momentum traders and longer-term value investors. This is because the two herds generally disagree with each other. If the price fluctuates up, the momentum trader wants to buy while the value investor wants to sell; and vice-versa. So the herds trade with each other with plentiful liquidity and little movement in price. This raises an obvious question. Can there really be any value investors in cryptocurrencies? The answer is potentially yes, if these investors believe that cryptocurrency acceptance will increase over time. And if they apply the aforementioned valuation framework from the quantity theory of money. Still, liquidity will periodically evaporate if too many value investors join the short-term momentum herd. Instead of dispassionately investing on the basis of a valuation framework, value investors get lured into participating in a strong rally, and their buy orders add fuel to the rally. A tipping point comes when all the value investors have joined the momentum herd. If a value investor then suddenly reverts to type and puts in a sell order, he will find that there are no buyers left. Liquidity has evaporated, and finding new liquidity might require a substantial reversal in the price to attract a buy order from an ultra-long-term deep value investor. As regular readers know, fractal analysis measures whether the herding behaviour in any financial instrument has reached its tipping point, signalling a likely end of its price trend. Today, the 130-day herding indicator for bitcoin is at a level which has indicated three previous countertrend reversals of at least one fifth of the preceding 130-day move (Chart I-2, Chart I-3, Chart I-4). Chart I-2Bitcoin: The 130 Day Fractal Dimension Signalled A Reversal In 2015 Bitcoin: The 130 Day Fractal Dimension Signalled A Reversal In 2015 Bitcoin: The 130 Day Fractal Dimension Signalled A Reversal In 2015 Chart I-3Bitcoin: The 130 Day Fractal Dimension Signalled Two Reversals In 2017 Bitcoin: The 130 Day Fractal Dimension Signalled Two Reversals In 2017 Bitcoin: The 130 Day Fractal Dimension Signalled Two Reversals In 2017 Chart I-4Bitcoin: The 65 Day Fractal Dimension Also Signalled Two Previous Reversals Bitcoin: The 65 Day Fractal Dimension Also Signalled Two Previous Reversals Bitcoin: The 65 Day Fractal Dimension Also Signalled Two Previous Reversals If this herding indicator signals a fourth countertrend reversal, it implies that the bitcoin price will retest $12,750 at some point in the next 130 days. Are Cryptocurrencies Inflationary Or Deflationary? On the face of it, the emergence of cryptocurrencies sounds inflationary. After all, if the general acceptance of cryptocurrencies for commercial transactions increases, there will be new money supply. And this new money supply will increase the nominal demand for goods and services. However, the truth is more nuanced. Unlike fiat money supply - which can expand without limit - each cryptocurrency has a defined limit to its supply. Although new cryptocurrencies can emerge, there seems to be a limit to the aggregate amount of cryptocurrency supply. The limiting factor is that it takes energy to create cryptocurrency through so-called 'mining'. Miners must compete to validate transactions that occur in a cryptocurrency. The competition takes the form of solving a mathematical problem - for example, finding the prime factors of a very large number. And the computational demands are energy sapping. Furthermore, the computational demands - known as 'proof of work' - get progressively more difficult for each additional new coin mined. Given that the computational resources in the world are finite and growing at a gentle and predictable rate, the implication is that the growth in the total amount of cryptocurrency is also limited. So while the emergence of cryptocurrencies does increase the money supply in the near-term (Chart I-5), a large-scale rejection of fiat money would make it impossible for uncouth policymakers to spike the overall money supply over the longer-term. Chart I-5Cryptocurrencies: Market Cap Is Now Non-Trivial Bitcoins And Fractals Bitcoins And Fractals Here's a further thought. Imagine if the proof of work computations, instead of being random mathematical calculations, solved useful problems that expanded the envelope of knowledge. This could boost real productivity, which is ultimately just a function of the stock of human ingenuity. In which case, any increase in money supply would be matched by an increase in potential real output. Interestingly, a recent paper from the Bank of Canada proposes that a wholesale acceptance of cryptocurrencies in the global economy could act as a new gold standard, whose effect would be mildly deflationary1 (Chart of the Week) and Table I-1). We fully agree with the Bank of Canada analysis. Table I-1No Persistent Inflation For 700 Years! Bitcoins And Fractals Bitcoins And Fractals The sting in the tail is that the analysis describes prices denominated in cryptocurrency terms. In fiat currency terms, the quantity theory of money implies that prices would rise2 - unless central banks reacted to the emergence of cryptocurrencies by shrinking the supply of fiat money. Would they? Very likely yes. If they didn't, the demise of fiat money would accelerate as people voted with their wallets and switched to superior stores of purchasing power. Nevertheless, we suspect that any central bank response would just delay the inevitable. As Larry Summers puts it: I am much more confident that the world of payments will look very different 20 years from now than I am about how it will look. And with that observation, I am signing off for 2017. I do hope you have enjoyed our provocative and counterintuitive insights this year. In the vast majority of cases, these insights have led to highly profitable investment recommendations. We promise to continue the success in 2018! Early next year, we will also unveil a major enhancement to our proprietary fractal trading strategy. So stay tuned. It just remains for me to wish you all a very enjoyable Festive Season and a prosperous 2018. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Bank of Canada Staff Working Paper, A Bitcoin Standard: Lessons from the Gold Standard https://www.bankofcanada.ca/2016/03/staff-working-paper-2016-14/ 2 Please see the Global Investment Strategy Special Report titled "Bitcoin's Macro Impact", dated September 15, 2017 available at gis.bcaresearch.com and Technology Sector Strategy Special Report titled "Cyber Currencies: Actual Currencies Or Just Speculative Assets?", dated December 12, 2017 available at tech.bcaresearch.com. Fractal Trading Model* As discussed in the main body of this report, this week's trade is to expect a countertrend reversal in bitcoin. Go short with a profit target at $12750 and stop-loss at $28000. In other trades, long silver has had a strong 1-week bounce while long U.K. personal products / short U.K. food and beverages reached the end of its 65 day maximum holding period and closed with a small profit. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-6 Long Silver Long Silver The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Overweighting Eurostoxx50 versus S&P500 is just a sector play - you must believe that banks are going to outperform technology. It is categorically not a relative economic growth or relative valuation play. The best expression of euro area economic outperformance - as we believe is likely - is not through mainstream equity indexes. It is through the euro. Could Spain in 2014-17 be Italy in 2018-21? If so, the cleanest play is through Italian bonds: long Italian BTPs versus French OATs. Play the lottery for free: when the price gap between the second and first month VIX future is greater than that between the first month and VIX spot - as it is now - it signals a potentially free lottery ticket. Feature Don't Play The Euro Area Economy Through The Stock Market The fallacy of division is a logical fallacy. It occurs when somebody falsely infers that what is true for the whole is also true for the parts that make up the whole. For example, somebody might see that their computer screen appears purple, and infer that the pixels that make up the screen are also purple. In fact, pixels are never purple. They are either red or blue. The fallacy of division is that the property of the whole - purpleness - does not translate to the property of the parts - redness or blueness. Chart of the WeekEuro Area Vs. U.S. Equities Is Just A Sector Play: Banks Vs. Technology Euro Area Vs. U.S. Equities Is Just A Sector Play: Banks Vs. Technology Euro Area Vs. U.S. Equities Is Just A Sector Play: Banks Vs. Technology The fallacy of division also affects investors. Since global equities are a play on the global economy, some investors infer that major equity indexes such as the Eurostoxx50 are relative plays on their regional economies. In fact, this is a fallacy of division: the property of the equity market as a global aggregate does not translate to the relative property of an equity market as a regional or national part. Through the past three years, the euro area economy has comfortably outperformed the U.S. economy1 (Chart I-2). Yet the Eurostoxx50 has substantially underperformed the S&P500 (Chart I-3). Why? Because the Eurostoxx50 has a major 14% weighting to banks and a minor 7% weighting to technology. The S&P500 is the mirror image; a minor 7% weighting to banks and a major 24% weighting to technology. Chart I-2The Euro Area Economy ##br##Has Outperformed... The Euro Area Economy Has Outperformed... The Euro Area Economy Has Outperformed... Chart I-3...But The Eurostoxx50 ##br##Has Underperformed ...But The Eurostoxx50 Has Underperformed ...But The Eurostoxx50 Has Underperformed Hence, for the Eurostoxx50 the distinguishing property is 'bank'; for the S&P500 it is 'technology'. And as banks have underperformed technology, the Eurostoxx50 has underperformed the S&P500. This large difference in sector exposure also means that a head-to-head comparison of equity market valuation is misleading. The euro area, trading on a forward price to earnings (PE) multiple of 15, appears considerably cheaper than the U.S., trading on a forward PE of 19. But this head-to-head difference just reflects the forward PEs of banks at 11 and technology at 19. As banks will likely generate less long-term growth than technology, banks are rightfully cheaper than technology and the Eurostoxx50 is rightfully cheaper than the S&P500. Some people suggest sector-adjusting stock market valuations to allow for the sector biases. The problem is that this suggestion cannot avoid the inescapable end-result. The bank-heavy Eurostoxx50 versus the tech-heavy S&P500 relative performance will still depend on banks versus technology (Chart of the Week). Remarkably, this overarching driver is captured in just the three largest euro area banks versus the three largest U.S. tech stocks. This means that relative performance simply reduces to whether Banco Santander, BNP Paribas and ING outperform Apple, Microsoft and Google,2 or vice-versa (Chart I-4). Chart I-4Eurostoxx50 Vs. S&P500 Reduces To: Santander, BNP & ING Vs. Apple, Microsoft & Google Eurostoxx50 Vs. S&P500 Reduces To: Santander, BNP & ING Vs. Apple, Microsoft & Google Eurostoxx50 Vs. S&P500 Reduces To: Santander, BNP & ING Vs. Apple, Microsoft & Google Everything else is largely irrelevant. Hence, the counterintuitive conclusion is that overweight Eurostoxx50 versus S&P500 is actually a sector play. You must hold the view that banks are going to outperform technology. At the moment, we are agnostic on this view. The best expression of euro area economic outperformance - as we believe is likely - is not through mainstream equity indexes. It is through bond yield spread compression and through exchange rates. Our preferred expression is structurally long EUR/USD. Could Spain In 2014-17 Be Italy In 2018-21? In 2013, Spain seemed to be on its knees. The economy had slumped by almost 10%, unemployment stood at 27%, and the stock of bank loans which were non-performing exceeded 13%. Doomsayers abounded. Standard and Poor's downgraded Spain's sovereign credit rating to BBB-, one notch above junk, and esteemed Wall Street strategists predicted the unemployment rate would remain above 25% for the rest of the decade. But the esteemed strategists were completely wrong. Through 2014-17, Spanish real GDP per head has grown by almost 15% (Chart I-5) - making it one of the top performing developed economies; unemployment has plunged by 10% (Chart I-6); and non-performing loans have declined sharply. What suddenly transformed Spain from zero to hero? The answer is that Spain recapitalised its banks. Chart I-5Through 2014-17 Spanish Real GDP ##br##Per Head Is Up Almost 15%... Through 2014-17 Spanish Real GDP Per Head Is Up Almost 15%... Through 2014-17 Spanish Real GDP Per Head Is Up Almost 15%... Chart I-6...And Unemployment##br## Is Down 10% ...And Unemployment Is Down 10% ...And Unemployment Is Down 10% After a financial crisis, the golden rule of recovery is to repair the banking system as soon as possible. In the aftermath of housing-related banking crises in 2008, the U.S. and U.K. quickly recapitalised their damaged banking systems; Ireland followed a couple of years later; Spain waited until 2013. But in each case, the economies rebounded very strongly as soon as the banks' aggressive deleveraging ended. Which brings us to Italy. Many people claim that Italy's long-standing economic underperformance is due to deep-seated structural problems. We do not dispute that such problems exist, but they cannot be the main cause of the economic underperformance. After all, through 1999-2007, Italian real GDP per head performed more or less in line with the U.S., Canada and France (Chart I-7), even without a private sector credit boom which the other economies had. Italy's underperformance really started after the 2008 financial crisis. And the most plausible explanation is that its dysfunctional banking system has been left broken for so long. Italy has procrastinated because its government is more indebted than other sovereigns and its banking problems have not caused an outright crisis - yet. But now policymakers in Rome, Brussels and Frankfurt realise that a hamstrung economy carries risks of a populist backlash against the European project. Finally, Italian banks' equity capital is rising, their solvency is improving and the share of non-performing loans appears to have peaked at the same level as in Spain in 2013 (Chart I-8). Chart I-7Through 1999-2007 Italy Performed In##br## Line With Other Major Economies Through 1999-2007 Italy Performed In Line With Other Major Economies Through 1999-2007 Italy Performed In Line With Other Major Economies Chart I-8Spanish NPLs Peaked In 2013, ##br##Italian NPLs Are Peaking Now Spanish NPLs Peaked In 2013, Italian NPLs Are Peaking Now Spanish NPLs Peaked In 2013, Italian NPLs Are Peaking Now So could Spain in 2014-17 be Italy in 2018-21? Once again, doomsayers abound and the counterintuitive thought could pay off. The cleanest way to play this is through Italian bonds: long Italian BTPs versus French OATs. Play The Lottery For Free As everybody knows, playing the lottery is not a good investment strategy. Most of the time your Lotto ticket brings zero reward, though occasionally you do win a prize. In fact, the U.K. National Lottery has said that the expected win per £1 played averages £0.47. Meaning the long-term return on this strategy is -53%. In the financial markets, the equivalent of a Lotto ticket is to buy volatility. In practice, this means buying a future on a volatility index such as the VIX. The problem is that the VIX futures curve usually slopes upwards. So if the curve doesn't change, a future bought above the spot price loses value when it expires at the spot price (Chart I-9). The upshot is that most of the time, the future 'rolls down the curve', and you lose money, though occasionally when volatility spikes you win. But counterintuitively, sometimes you can play the lottery for free. Look at the VIX futures curve: when the price gap between the second and first month is greater than that between the first month and spot - as it is now (Chart I-10) - it signals a potentially free lottery ticket. Chart I-9VIX Futures "Roll Down The Curve" VIX Futures "Roll Down The Curve" VIX Futures "Roll Down The Curve" Chart I-10Spotting A Free Lottery Ticket Spotting A Free Lottery Ticket Spotting A Free Lottery Ticket Under these circumstances, the strategy is to go long the first month future and short the second month future. If the futures curve stays broadly as it is - and both futures contracts roll down the curve - the loss on the first month long position will be made up by the gain on the second month short position. Effectively, the combined position becomes costless. Yet this potentially costless position is still playing the lottery. Because if volatility does spike, the volatility futures curve tends to invert sharply (go into backwardation). Hence, the gain on the first month long position substantially outweighs the loss on the second month short position. Now might be a good time to play the lottery for free. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 On a real GDP per capita basis. 2 Listed as Alphabet. Fractal Trading Model* Silver's 65-day fractal dimension is at a level which has previously indicated four tradeable trend reversals. Go long silver with a profit target / stop-loss of 4.5% In other trades, we are pleased to report that short basic materials versus market and short copper / long tin both hit their respective profit targets. This leaves us with six open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 Long Silver Long Silver The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

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

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

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

Semiconductor stocks in general and semi equipment in particular have gone parabolic over the last year, prompting us to add the S&P semi equipment index on our speculative high-conviction underweight list earlier this week. The move looks prescient as the index, as of publishing, has fallen by more than 9% this week. A global M&A frenzy and the bitcoin/ICO mania (bottom panel) have pushed chip equipment stocks to the stratosphere. In absolute terms this index is near the tech bubble peak, and relative share prices are following close behind (top panel). Worrisomely five year EPS growth forecasts recently surpassed the 25% mark, an all-time high. Both the tech sector's (in 2000) and the biotech index's (2001 and 2014) long term growth estimates hit a wall near such breakneck pace (second panel). This indefinite profit euphoria is unwarranted and we would lean against it. Accordingly, we are reiterate our speculative high-conviction underweight recommendation; see Monday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5SEEQ-AMAT, LRCX, KLC. 2018 Key Views: High-Conviction Calls - Semiconductor Equipment 2018 Key Views: High-Conviction Calls - Semiconductor Equipment

Highlights China stands out as the most likely candidate to send negative shock waves through EM and commodities in 2018. Granted the ongoing policy tightening in China will likely dampen money growth further, the only way mainland nominal GDP growth can hold up is if the velocity of money rises meaningfully, offsetting the drop in money growth. Assigning equal probabilities to various scenarios of velocity of money, the outcome is as follows: one-third probability of robust nominal growth (continuation of the rally in China-related plays) and two-third odds of a non-trivial slowdown in nominal growth with negative ramifications for China-related plays. Hence, we reiterate our negative stance on EM risk assets Feature The key question for emerging markets (EM) in 2018 is whether a slowdown in Chinese money growth will translate into a meaningful growth deceleration in this economy, and in turn produce a reversal in EM risk assets. This week we address the above question in detail elaborating on what could make China's business cycle defy the slowdown in its monetary aggregates and how investors should approach such uncertainty. Before this, we review the status of financial markets going into 2018. Priced To Perfection Or A New Paradigm? Several financial markets are at extremes. Our chart on the history of financial market manias reveals that some parts of technology/new concept stocks may be entering uncharted territory (Chart I-1). Tencent's share price, for instance, has surged 11-fold since January 2010. Chart I-1History Of Financial Markets Manias: They Lasted A Decade History Of Financial Markets Manias: They Lasted A Decade History Of Financial Markets Manias: They Lasted A Decade This is roughly on par with the prior manias' average 10-year gains. As this chart indicates, the manias of previous decades run wild until the turn of the decade. It is impossible to know whether technology/new concept stocks will peak in 2018 or run for another two years. Regardless whether or not the mania in tech/new concept stocks endures up until 2020, some sort of mean reversion in their share prices is likely next year. This has relevance to EM because the magnitude of the EM equity rally in 2017 has been enormously boosted by four large tech/concept stocks in Asia. Our measure of the cyclically-adjusted P/E (CAPE) ratio for the U.S. market suggests that equity valuations are reaching their 2000 overvaluation levels (Chart I-2, top panel). The difference between our measure and Shiller's measure of CAPE is that Shiller's CAPE is derived by dividing share prices by the 10-year moving average of EPS in real terms (deflated by consumer price inflation). Our measure is calculated by dividing equity prices by the time trend in real EPS (Chart I-2, bottom panel). Our CAPE measure assumes that in the long run, U.S. EPS in real terms will revert to its time trend. Meanwhile, the Shiller CAPE is based on the assumption that real EPS will revert to its 10-year mean. Hence, the assumptions behind our CAPE model are quite reasonable if not preferable to those of Shiller's P/E. Remarkably, the U.S. (Wilshire 5000) market cap-to-GDP ratio is close to its 2000 peak (Chart I-3). With respect to EM equity valuations, the non-financial P/E ratio is at its highest level in the past 15 years (Chart I-4). EM banks have low multiples and seem "cheap" because many of them have not provisioned for NPLs. Hence, their profits and book values are artificially inflated. In short, excluding financials, EM stocks are not cheap at all, neither in absolute terms nor relative to DM bourses. Chart I-2A Perspective On U.S. Equity Valuation A Perspective On U.S. Equity Valuation A Perspective On U.S. Equity Valuation Chart I-3The U.S. Market Cap-To-GDP ##br##Ratio Is Close To 2000 Peak The U.S. Market Cap-To-GDP Ratio Is Close To 2000 Peak The U.S. Market Cap-To-GDP Ratio Is Close To 2000 Peak Chart I-4EM Non-Financial Equities Are Not Cheap EM Non-Financial Equities Are Not Cheap EM Non-Financial Equities Are Not Cheap Such elevated DM & EM stock market valuations might be justified by currently low global long-term bond yields. Yet, if and when long-term bond yields rise, multiples will likely shrink. The latter will overpower the profit growth impact on share prices, as multiples are disproportionately and negatively linked to interest rates - especially when interest rates are low - but are proportionately and positively linked to EPS.1 As a result, a small rise in long-term bond yields will lead to a meaningful P/E de-rating. Despite very high equity valuations, U.S. advisors and traders are extremely bullish on American stocks. Their sentiment measures are at all time and 11-year highs, respectively. So are copper traders on red metal prices (Chart I-5). The mirror image of the strong and steady rally in global stocks is record-low implied volatility. The aggregate financial markets' implied volatility index is at a multi-year low (Chart I-6). Finally, yields on junk (high-yield) EM corporate and sovereign bonds are at all-time lows (Chart I-7). They are priced for perfection. Chart I-5Bullish Sentiment On Copper Is Very Elevated Bullish Sentiment On Copper Is Very Elevated Bullish Sentiment On Copper Is Very Elevated Chart I-6Aggregate Global Financial Markets ##br##Implied VOL Is At Record Low Aggregate Global Financial Markets Implied VOL Is At Record Low Aggregate Global Financial Markets Implied VOL Is At Record Low Chart I-7EM Junk Bond Yields Are At Record Low EM Junk Bond Yields Are At Record Low EM Junk Bond Yields Are At Record Low Are we in a new paradigm, or are we witnessing financial market extremes that are unsustainable? In regard to the timing, can these dynamics last throughout 2018 or at least the first half of next year, or will they reverse in the coming months? We have less conviction on the durability of the U.S. equity rally, but our bet is that EM risk assets will roll over in absolute terms and begin underperforming their DM peers very soon. What could cause such a reversal in EM risk assets? China stands out as the most likely candidate to send negative shock waves through emerging markets and commodities. China: "Financial Stability" Priority Entails Tighter Policy The Chinese authorities are facing unprecedented challenges: The outstanding value of broad money in China (measured in U.S. dollars) is now larger than the combined U.S. and euro area broad money supply (Chart I-8, top panel). Chart I-8Beware Of Money Excesses In China Beware Of Money Excesses In China Beware Of Money Excesses In China As a share of its own GDP, broad money in China is much higher compared to any other nation in history (Chart I-8, bottom panel). In brief, there is too much money in China and most of it - $21 trillion out of $29 trillion - has been created by the banking system since early 2009. We maintain that the enormous overhang of money and credit in China represents major excess/imbalances and has nothing to do with the nation's high savings rate.2 Rather, it is an outcome of animal spirits running wild among bankers and borrowers over the past nine years. Easy money often flows into real estate and China has not been an exception. Needless to say, property prices are hyped and expensive relative to household income. Policy tightening amid lingering excesses and imbalances makes us negative on China's growth outlook. In a nutshell, we place more weight on tightening when there are excesses in the system, and downplay the importance of tightening in a healthy system without excesses. Importantly, excessive money creation seems to finally be pushing inflation higher. Consumer price services and core consumer price inflation rates are on a rising trajectory (Chart I-9, top and middle panels). As a result, banks' deposit rates in real terms (deflated by core CPI) have plunged into negative territory for the first time in the past 12 years (Chart I-9, bottom panel). Remarkably, the People's Bank of China's existing $3 trillion of international reserves is sufficient to "back up" only 13% and 11% of official M2 and our measure of M3, respectively (Chart I-10). If Chinese households and companies decide to convert 10-15% of their deposits into foreign currency and the PBoC takes the other side of the trade, its reserves will be exhausted. Chart I-9China: Inflation Is Rising And ##br##Real Deposit Rate Is Negative China: Inflation Is Rising And Real Deposit Rate Is Negative China: Inflation Is Rising And Real Deposit Rate Is Negative Chart I-10China: Low Coverage Of ##br##Money Supply By FX Reserves bca.ems_wr_2017_11_29_s1_c10 bca.ems_wr_2017_11_29_s1_c10 Therefore, reining money and credit expansion is of paramount importance to China's long-term financial and economic stability. "Financial stability" has become the key policy priority. "Financial stability" is policymakers' code word for containing and curbing financial imbalances and bubbles. Having experienced the equity bubble bust in 2015, policymakers are determined to preclude another bubble formation and its subsequent bust. Consequently, the ongoing tightening campaign will not be reversed in the near term unless damage to the economy becomes substantial and visible. By the time the authorities and investors are able to identify such damage in the real economy, China-related plays in financial markets will be down substantially. Chart I-11China: Corporate Bond Yields And Yield Curve China: Corporate Bond Yields And Yield Curve China: Corporate Bond Yields And Yield Curve Faced with significant excesses in money, leverage and property markets, the Chinese authorities have been tightening - and have reinforced their policy stance following the Party's Congress in October. There is triple tightening currently ongoing in China: 1. Liquidity tightening: Money market rates have climbed, and onshore corporate bond yields are rising (Chart I-11, top panel). Remarkably, the yield curve is flat, pointing to weaker growth ahead (Chart I-11, bottom panel). 2. Regulatory tightening: The China Banking Regulatory Commission (CBRC) is forcing banks to bring off-balance-sheet assets onto their balance sheets, and is reining banks' involvement in shadow banking activities. In addition, financial regulators are trying to remove the government's implicit "put" from the financial system, and thereby curb speculative and irresponsible investment behavior. Finally, many local governments are tightening investors' participation in the real estate market. 3. Anti-corruption campaign is embracing the financial institutions: The powerful anti-corruption commission is planning to dispatch groups of inspectors to examine financial institutions' activities. This could dampen animal spirits among bankers and shadow banking organizations. The Outlook: The "Knowns"... In China, broad money growth has already slumped to an all-time low (Chart I-12). The money as well as the credit plus fiscal spending impulses both point to a considerable slowdown in the mainland's industrial cycle and overall economic activity (Chart I-13). Chart I-12China: Broad Money ##br##Growth Is At All-Time Low bca.ems_wr_2017_11_29_s1_c12 bca.ems_wr_2017_11_29_s1_c12 Chart I-13China: Money And Credit & ##br##Fiscal Impulses Are Negative bca.ems_wr_2017_11_29_s1_c13 bca.ems_wr_2017_11_29_s1_c13 The slowdown is not limited to money growth; there are a few real business cycle indicators that are already weakening. For example, the growth rate of property floor space sold and started has slumped to zero (Chart I-14). Electricity output and aggregate freight volume growth have both decisively rolled over (Chart I-15). Chart I-14China: Property Starts Are Set To Contract Again China: Property Starts Are Set To Contract Again China: Property Starts Are Set To Contract Again Chart I-15China: A Few Signs Of Slowdown China: A Few Signs Of Slowdown China: A Few Signs Of Slowdown That said, based on the past correlation between money and credit impulses on the one hand and the business cycle on the other, China's economy should have slowed much more, and its negative impact on the rest of the world should have already been felt (Chart I-13, on page 9). This has been the key pillar of our view on EM, but it has not yet transpired. Is it possible that the relationship between money/credit impulses and the business cycle has broken down? If so, why? And how should investors handle such uncertainty? Bottom Line: China's ongoing policy tightening will ensure that money and credit impulses remain negative for some time. Can the country's industrial sectors de-couple from its past tight correlation with money and credit? ...And The "Unknowns" By definition, the only way to sustain nominal economic growth in the face of a decelerating money supply is if the velocity of money increases. This is true for any economy. Nominal GDP = Money Supply x Velocity of Money Provided China's policy tightening will likely further dampen money growth, the only way nominal GDP growth can hold up is if the velocity of money rises meaningfully, offsetting the drop in money growth. This is the main risk to our view and strategy. Chart I-16 portrays all three variables. Chart I-16China: Money, Nominal GDP ##br##And Velocity Of Money China: Money, Nominal GDP And Velocity Of Money China: Money, Nominal GDP And Velocity Of Money Even though the velocity of money has fallen structurally over the past nine years (Chart I-16, bottom panel), it has risen marginally in 2017, allowing the mainland's nominal economic growth to hold up despite a considerable relapse in money supply growth. Notably, this has been the reason why our view has not worked this year. What is the velocity of money, and how can we forecast its fluctuations and, importantly, the magnitude of its variations? The velocity of money is one of the least understood concepts in economic theory. The velocity of money is anything but stable. In our opinion, the velocity of money reflects animal spirits of households and businesses as well as government spending decisions. Forecasting animal spirits and the magnitude of their variations is not very a reliable exercise. In a nutshell, the banking system (commercial banks and the central bank) creates money via expanding its balance sheet - making loans to or acquiring assets from non-banks. However, commercial banks have little direct influence on the velocity of money. The latter is shaped by non-banks' decisions to spend or not (i.e., save). Significantly, non-banks' spending and saving decisions do not alter the amount of money in the system. Yet they directly impact the velocity of money. The banking system creates money, and non-banks churn money (make it circulate). At any level of money supply, a rising number of transactions will boost nominal output, and vice versa. Further, there is a great deal of complexity in the interaction between money supply and its velocity. Both are sometimes independent, i.e. they do not influence one another, but in some other cases one affects the other. For example, with the ongoing triple tightening in China and less money being originated by the banking system, will households and businesses increase or decrease their spending? Our bias is that they will not increase spending. This is especially true for the corporate sector, which has record-high leverage and where access to funding has been tightening. It is also possible that rising velocity will lead to more money creation as more spending leads to higher loan demand and banks accommodate it - i.e., originating more loans/money. These examples corroborate that money supply and the velocity of money are not always independent of each other. On the whole, it is almost impossible to reliably forecast the magnitude of changes in velocity of money. In the same vein, it is difficult to forecast animal spirit dynamics in any economy. Chart I-17U.S.: The Rise In Velocity Of Money ##br##Overwhelmed Slowdown In Money U.S.: The Rise In Velocity Of Money Overwhelmed Slowdown In Money U.S.: The Rise In Velocity Of Money Overwhelmed Slowdown In Money One recent example where nominal GDP has decoupled from broad money growth is the U.S. Chart I-17 demonstrates that in the past 12 months, U.S. nominal GDP growth has firmed up even though broad money (M2) growth has slumped. This decoupling can only be explained by a spike in the velocity of M2. In other words, soaring confidence and animal spirits among U.S. households and businesses have boosted their willingness to spend, even as the banking system has created less money and credit growth has slowed considerably over the past 12 months. Going back to China, how should investors consider such uncertainty in changes in the velocity of money? Investing is about the future, which is inherently uncertain. Hence, an investment process is about assigning probabilities to various scenarios. Provided the velocity of money is impossible to forecast, we assign equal probabilities to each of the following scenarios for China in 2018 (Figure I-1): One-third odds that the velocity of money rises more than the decline in broad money growth, producing robust nominal GDP growth; One-third probability that the velocity of money stays broadly flat - the outcome being meaningful deceleration in nominal GDP growth; A one-third chance that the velocity of money declines - the result being a severe growth slump. Figure I-1How Investors Can Consider Uncertainty Related To Velocity Of Money Questions For Emerging Markets Questions For Emerging Markets In short, a positive outcome on China-related plays has a one-third probability of playing out, while a negative outcome carries a two-thirds chance. This is why we continue to maintain our negative view on EM and commodities. Commodities Our view on commodities and commodity plays is by and large shaped by our view on China's capital spending. Given the credit plus fiscal spending impulse is already very weak, the path of least resistance for capital expenditures is down. Besides, the government is clamping down on local governments' off-balance-sheet borrowing and spending (via Local Government Financing Vehicles). A deceleration in capital expenditures in general and construction (both infrastructure and property development) in particular is bearish for industrial metals (Chart I-18). Money and credit impulses herald a major downturn in Chinese imports values and volumes (Chart I-19). Chart I-18Industrial Metals / Copper Are At Risk bca.ems_wr_2017_11_29_s1_c18 bca.ems_wr_2017_11_29_s1_c18 Chart I-19China Will Be A Drag On Its Suppliers bca.ems_wr_2017_11_29_s1_c19 bca.ems_wr_2017_11_29_s1_c19 As to China's commodities output reductions, last week we published a Special Report3 on China's "de-capacity" reforms in steel and coal. The report concludes the following: The path of least resistance for steel, coal and iron ore prices is down over the next 12-24 months. China's "de-capacity" reforms in steel and coal will continue into 2018 and 2019, but the scale and pace of "de-capacity" will diminish. Importantly, the mainland's steel and coal output will likely rise going forward as new capacity using more efficient and ecologically friendly technologies come on stream. The capacity swap policy introduced by the authorities has been allowing steel and coal producers to add new capacity in order to replace almost entirely obsolete capacity. The combination of demand slowdown and modest production recovery will weigh on non-oil raw materials. As for oil, the picture is much more complicated. Oil prices have been climbing in reaction to declining OECD inventories as well as on expectations of an extension to oil output cuts into 2018. One essential piece of missing information in the bullish oil narrative is China's oil inventories. In recent years, China has been importing more crude oil than its consumption trend justifies. Specifically, the sum of its net imports and domestic output of crude oil has exceeded the amount of refined processed oil. This difference between the sum of net imports and production of crude oil and processed crude oil constitutes our proxy for the net change of crude oil inventories. Chart I-20 shows that our proxy for mainland crude oil inventories has risen sharply in recent years. This includes both the nation's strategic oil reserves as well as commercial inventories. There is no reliable data on the former. Therefore, it is impossible to estimate the country's commercial crude oil inventories. Chart I-20China: Beware Of High Chinese Oil Inventories China: Beware Of High Chinese Oil Inventories China: Beware Of High Chinese Oil Inventories Nevertheless, whether crude oil inventories have risen due to a build-up of strategic petroleum reserves or commercial reserves, the fact remains that crude oil inventories in China have surged and appear to be reaching the size of OECD total crude and liquid inventories (Chart I-20). In short, China has been a stabilizing force for the oil market over the past three years by buying more than it consumes. Without such excess purchases from China, oil prices would likely have been much weaker. Going forward, the pace of Chinese purchases of crude oil will likely slow due to several factors: (a) China prefers buying commodities on dips, especially when it is for strategic inventory building. With crude oil prices having rallied to around $60, the authorities might reduce their purchases temporarily, creating an air pocket for prices, and then accelerate their purchases at lower prices; (b) Commercial purchases of oil will likely decelerate due to tighter money/credit, possibly high inventories and a general slowdown in industrial demand for fuel. Bottom Line: Raw materials and oil prices4 are at risk from China and overly bullish investor sentiment. Beyond Commodities The slowdown in China will impact not only commodities but also non-commodity shipments to the mainland (Chart I-21). In fact, 47% of the nation's imports are commodities and raw materials and 45% are industrial/capital goods - i.e., China's imports are heavily exposed to investment expenditures, not consumer spending. This is why money/credit impulses correlate so well with this country's imports. Consistently, China's broad money (M3) impulse leads EM corporate profit growth by 12 months - and currently heralds a major EPS downtrend (Chart I-22). In addition, aggregate EM narrow money (M1) growth also points to a material slump in EM EPS (Chart I-23). Chart I-21China Is A Risk To ##br##Non-Commodity Economies Too bca.ems_wr_2017_11_29_s1_c21 bca.ems_wr_2017_11_29_s1_c21 Chart I-22Downside Risk To EM EPS bca.ems_wr_2017_11_29_s1_c22 bca.ems_wr_2017_11_29_s1_c22 The only EM countries that are not materially exposed to China and commodities are Turkey and India. The former is a basket case on its own. Indian stocks are expensive and will have a difficult time rallying in absolute terms when the EM equity benchmark relapses. As for Korea and Taiwan, their largest export destination is not advanced economies but China. China accounts for 25% of Korea's exports and 28% of Taiwan's. This compares to a combined 22% of total Korean exports and 20% of total Taiwanese exports going to the U.S. and EU combined Can robust growth in the U.S. and EU derail the growth slowdown in China when capital spending slows? This is very unlikely, in our view. Chart I-24 portends that China's shipments to the U.S. and EU account for only 6.6% of Chinese GDP, while capital spending and credit origination constitute 45% and 25% of GDP, respectively. Chart I-23EM M1 And EM EPS EM M1 And EM EPS EM M1 And EM EPS Chart I-24What Drives Chinese Growth? What Drives Chinese Growth? What Drives Chinese Growth? A final word on tech stocks. EM's four large-cap tech stocks (Tencent, Ali-Baba, Samsung and TSMC) have gone exponential and are extremely overbought. At this juncture, any strong opinion on tech stocks is not warranted because they can sell off or continue advancing for no fundamental reason. We have been recommending an overweight position in tech stocks, and continue recommending overweighting them, especially Korean and Taiwanese semiconductor companies. As for Tencent and Alibaba, these are concept stocks, and as a top-down house we have little expertise to judge whether or not they are expensive. These are bottom-up calls. Investment Strategy EM Stocks: Asset allocators should continue to underweight EM versus DM, and absolute-return investors should stay put. Our overweights are Taiwan, China, Korean tech stocks, Thailand, Russia and central Europe. Our underweights are Turkey, South Africa, Brazil, Peru and Malaysia. Chart I-25EM Currencies: A Canary In ##br##Coal Mine For EM Credit? EM Currencies: A Canary In Coal Mine For EM Credit? EM Currencies: A Canary In Coal Mine For EM Credit? Stay short a basket of the following EM currencies: ZAR, TRY, BRL, IDR and MYR. We are also shorting the COP and CLP. Unlike in 2014-2015, EM currencies will depreciate not only versus the U.S. dollar but also the euro. For traders who prefer a market neutral currency portfolio, our recommended longs (or our currency overweights) are TWD, THB, SGD, ARS, RUB, PLN and CZK. INR and CNH will also outperform other EM currencies. Continue underweighting EM sovereign and corporate credit relative to U.S. investment grade bonds. The mix of weaker EM/China growth, lower commodities prices and EM currency depreciation bode ill for already very tight EM credit spreads (Chart I-25). Within the sovereign credit space, our underweights are Brazil, Venezuela, South Africa and Malaysia and our overweights are Russia, Argentina and low beta defensive credits. The main risk to EM local currency bonds is EM currency depreciation. With foreign ownership of EM domestic bonds at all-time highs, exchange rate depreciation could trigger non-trivial selling pressure. Among local currency bond markets, the most vulnerable are Turkey, South Africa, Indonesia and Malaysia. The least vulnerable are Korea, Russia, China, India, Argentina and Central Europe. Other high-conviction market-neutral recommendations: Long U.S. banks / short EM banks. Long U.S. homebuilders / short Chinese property developers. Long the Russian ruble / short oil. Long the Chilean peso / short copper. Long Big Five state-owned Chinese banks / short small- and medium-sized banks. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 For example, given that interest rates are in the denominator of the Gordon Growth model, a one percentage point change in interest rates from a low level can have a significant impact on the fair value P/E ratio. 2 Please refer to the Emerging Markets Strategy Special Reports from October 26, 2016, November 23, 2016 and January 18, 2017; available on ems.bcaresearch.com 3 Please refer to the Emerging Markets Strategy Special Report titled "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017, link available on page 22. 4 This is the Emerging Markets Strategy team's view and is different from BCA's house view on commodities. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Overweight - High Conviction Synchronized global capex growth, a derivative of BCA's synchronized global growth thesis, will be a dominant theme next year, benefiting cyclicals over defensives. The S&P software index is a clear capex upcycle beneficiary and we recommend an upgrade to a high-conviction overweight stance today. If software commands a larger slice of the overall capital spending pie as we expect, then industry profits should enjoy a healthy rebound (second panel). Recovering bank loan growth signals that businesses are beginning to loosen their purse strings anew (third panel). CEO confidence is pushing decade highs, pointing to a pickup in software investments and rekindling software M&A activity, with the number of industry deals jumping in recent months. Our newly introduced S&P software EPS model encapsulates this sanguine industry backdrop and heralds a bright profit outlook (bottom panel). Overall, we recommend moving to an overweight position; see yesterday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5SOFT-MSFT, ORCL, ADBE, CRM, ATVI, INTU, EA, ADSK, RHT, SYMC, SNPS, ANSS, CDNS, CTXS, CA. 2018 Key Views: High-Conviction Calls - Software 2018 Key Views: High-Conviction Calls - Software