Valuations

Special Report

Highlights Structurally, EM corporate leverage is elevated and the interest coverage ratio is low. Cyclically, China/EM growth slowdown will lead to corporate spread widening. Rising U.S. dollar corporate bond yields in EM herald lower share prices. The recent underperformance in Mexican financial markets versus their EM peers is not sustainable. We reiterate our overweight position in Mexico. In Indonesia, the central bank is attempting to fight the Impossible Trinity, a battle that by definition cannot be won. Investors should keep underweighting this market. Feature This report focuses on the corporate health of emerging market (EM) companies, as well as the outlook for corporate bonds. We review the key drivers behind credit spreads and provide an up-to-date snapshot of overall corporate health. We also illustrate the travails in China's offshore corporate bond market, which are of high importance to the broad EM outlook. With respect to scope of coverage and data comparability, please refer to Box 1. BOX 1 Data Relevance And Its Application As there is no aggregate financial dataset for EM corporate bond issuers, we use corporate financial data provided by Worldscope for the EM equity universe - the constituents of the MSCI EM equity index. While from an individual country perspective this makes a difference, from an EM sector perspective the differences are not substantial. Excluding the technology sector, it is often the case that the same companies have both publicly traded stocks and bonds. This is especially true in sectors such as basic materials, energy, industrials, telecom, utilities and financials. This is why, in this report, we focus our attention on sectors rather than countries, and why we examine the EM companies' financial health excluding technology and banks. Banks' relevant financial ratios vary greatly from those of non-banks. For the technology sector, the largest tech names in the equity space have minimal bonds outstanding, so using financial data from the equity space for credit analysis is inappropriate. In short, the analysis below on corporate health is pertinent to both equity and corporate bond investors. However, its emphasis is on creditworthiness and ability to service debt, which is more attuned to credit investors. Drivers Of EM Credit Spreads Cyclical swings in EM corporate and sovereign credit spreads are driven by changes in borrowers' revenues, cash flow and profits. Hence, the business cycle is one of the important drivers of corporate creditworthiness. When global and EM growth accelerate, revenue and free cash flow improve, causing credit spreads to narrow (Chart I-1). The EM business cycle drives EM sovereign spreads too (Chart I-2). Chart I-1EM Corporates: Cash Flow From Operations And Credit Spreads Chart I-2EM Sovereign Spreads Move In Tandem With Business Cycle This is why we spend a lot of time gauging the global business cycle outlook and cover this topic extensively in our reports. For now, the growth outlook for China/EM and global trade remains gloomy: Chart I-3China Is A Major Risk For EM Profits China's credit and fiscal spending impulse projects further weakness in the mainland's business cycle and EM corporate earnings (Chart I-3). China's slowdown is no longer limited to the industrial sector - household spending growth has downshifted considerably since early this year, as we discussed in last week's report.1 Weakening sales of consumer goods and autos in China are one of the primary reasons behind the ongoing slump in the global technology and semiconductor sectors. Consistently, plunging growth in Taiwanese electronics exports points to both weaker global trade and EM tech earnings in the months ahead (Chart I-4). In short, even though we have excluded technology from our analysis of corporate financial health, hardware tech companies' profits remain at risk. The latter is not relevant for EM corporate bond investors, but it is critical for the EM equity space. Chart I-4Taiwanese Shipments Foreshadow A Relapse In EM Tech Earnings Other pertinent financial market indicators for EM credit spreads are commodities prices, EM exchange rates and EM local rates. The basis is as follows: (1) Energy and materials make up 25% of the J.P. CEMBI EM corporate bond index, and commodities prices drive their revenues and in turn credit spread fluctuations (Chart I-5, top panel); (2) Outside the resource sector, corporate bond issuers by and large do not feature exporters, and their capacity to service foreign currency debt is greatly affected by exchange rate movements (Chart I-5, bottom panel); (3) Financials make up 30% of the J.P. CEMBI EM corporate bond index, and their credit spreads are greatly influenced by domestic interest rates and banking system health (Chart I-6). We exclude financials from our corporate health analysis because their financial ratios differ vastly from those of non-financials. Chart I-5Drivers Of Credit Spreads: Commodities And Currencies Chart I-6EM Bank Credit Spreads Will Widen If Local Bond Yields Rise Overall, we expect global trade to weaken, commodities prices to drop further and EM currencies to depreciate. The latter will push up local interest rates. In turn, several EM banking systems remain saddled with bad assets from previous credit booms that have not been recognized, and banks have not been recapitalized. These factors point to a widening in bank credit spreads. All in all, EM corporate and sovereign spreads will widen further. A Snapshot Of EM Corporate Health The following financial ratios - which are calculated for EM companies excluding technology and financials - do not justify currently tight corporate spread. Leverage measured as net debt (total debt minus cash assets) divided either by EBITDA or cash flow from operation2 (CFO) remains elevated (Chart I-7, top panel). Among 9 sectors, only energy, basic materials and consumer discretionary have seen their leverage fall over the past two years. Chart I-7EM Corporate Health: Leverage And Interest Coverage Ratios Interest coverage ratios computed as EBITDA- or CFO- to- interest expense are well below their 2007 and 2011 levels (Chart I-7, middle panel). These figures corroborate that neither EM corporate indebtedness nor companies' ability to service debt using cash from operations is back to levels that prevailed before the global financial crisis in 2008 when EM financial markets were in a secular uptrend. Crucially, this is inconsistent with presently still-tight EM corporate spreads (Chart I-7, bottom panel). This mispricing, in our opinion, reflects the global search for yield that was induced by the crowding out of investors from DM bond markets by global central banks' QE programs. A contraction in corporate profits and cash flows from operation - for the reasons discussed above - will cause issuers' credit matrixes to deteriorate. With respect to cross-sectional analysis, Table I-1 presents interest coverage ratios (computed as an average of EBITDA- and CFO-to-interest expense ratios) for mainstream countries and all sectors. The cells in red present pockets of distress where the interest coverage ratio is below 3. The cells in blue illustrate segments where moderate financial stress is present: these are sectors with an interest coverage ratio of above 3 but below 5.5. Table I-1Interest Coverage Ratios On a positive note, the rally in commodities and cutbacks in capex have allowed energy and basic materials companies to drastically improve their leverage and interest coverage ratios in the past 2 years. However, even though their present financial health is great, their cash flow from operations is set to deteriorate again as commodities prices continue to relapse. The key motive behind our negative view on credit markets in Latin America, Russia, the Middle East and Africa - which is de facto the EM universe excluding emerging Asia - is because with the exception of Turkey, they are very exposed to commodities prices. As commodities prices drop and these nations' currencies depreciate, their sovereign and corporate credit spreads will widen. We are not implying that these issuers are facing default risks. Simply, lower revenues from commodities and higher debt servicing costs due to currency depreciation warrant a re-pricing of risk. Within credit portfolios, we recommend favoring defensive low-beta credit, excluding banks, versus riskier high-beta ones. We are underweight EM banks within the EM equity space and recommend the same strategy for the EM credit universe. Based on the matrix in Table I-1, credit portfolios should overweight consumer services, tech, energy and basic materials and underweight industrials, utilities and healthcare. China's Corporate Health And Credit Market There has been little deleveraging among Chinese companies. On the contrary, the country's massive credit and fiscal stimulus in 2016 bailed out many indebted companies, lifting corporate debt levels and augmenting the misallocation of capital. In particular: Chart I-8China's Corporate Debt Is Enormous China's corporate debt remains enormous, at $19.5 trillion, or RMB 140 trillion. It is the highest in the history of any country (Chart I-8). Some 95% of corporate debt is in local currency terms. My colleague Jonathan LaBerge from China Investment Strategy has calculated that Chinese state-owned enterprises' adjusted return on assets, has fallen below the cost of capital (Chart I-9). This indicates that these companies have for now exhausted profitable investment opportunities and should arguably scale back on their investment expenditures. Further borrowing and investing by these enterprises will augment the amount of bad assets held by Chinese banks and reduce the country's overall productivity and hence, potential growth. Yet, denying these debtors financing will result in a major slump in capex, and probably labor market weakness. Chart I-9Chinese SOEs: Capital Misallocation Chart I-10Leverage And Interest Coverage For Chinese Companies Dissecting sectoral data, indebtedness is elevated for industrials, utilities and property developers. Consistently, the interest coverage ratio is extremely low for industrials, utilities and property developers (Chart I-10). Financial health of Chinese materials has improved tremendously due to de-capacity reforms - the shutdown of excess capacity that has boosted both steel and coal prices. Interestingly, this has occurred at the expense of utilities and some other heavy consumers of steel and coal. Notably, steel and coal prices are beginning to relapse (Chart I-11). For reasons discussed in our previous report,3 these commodities prices will drop further and will hurt producers' cash flow and profits, causing their creditworthiness to deteriorate. Chart I-11Steel And Thermal Coal Prices Offshore corporate bond yields and spreads are surging, foreshadowing rising borrowing costs and reduced availability of financing (Chart I-12A). The problem is especially acute for property developers (Chart I-12B). In a nutshell, Chinese corporate U.S. dollar bond yields are at their highest levels of the past five-six years. The same is true for emerging Asian corporate bond issuers. Chart I-12AChinese Offshore Aggregate Corporate Bonds Chart I-12BChinese Offshore Property Developers Not only do Chinese corporate bonds now account for 32.5% of EM and 56% of emerging Asian corporate bond indexes, but investment expenditures by Chinese companies are also critical to companies elsewhere in Asia and globally. Chinese gross fixed capital formation accounts for 6% and 5.4% of global GDP in nominal and real terms, respectively. By contrast, these numbers are 4.6% and 4.3% for the U.S. We have deliberated at great length on why China's growth will likely continue to downshift, despite the policy stimulus, and we will not repeat our arguments today.4 The financial health of Chinese companies will worsen due to dwindling sales and cash generation. This, along with less credit/financing available onshore and offshore, will erode their capacity to undertake large investment expenditures. Consequently, capital expenditures in general and construction in particular will suffer substantially. This is the main rationale behind our negative view on resources, raw materials and industrials worldwide. Investment Observations And Conclusions Apart from Turkey and Argentina, there has been no liquidation and capitulation in EM assets in general and the credit space in particular. It would be unusual if this extended selloff ends without capitulation. EM credit markets appear technically vulnerable. In particular, the excess returns on EM sovereign and corporate bonds are splintering below their 200-day moving averages (Chart I-13). Odds are there will be more downside. Chart I-13A Bad Signal Rising U.S. dollar corporate bond yields in both EM overall and in emerging Asia herald lower share prices (Chart I-14). So long as the drop in U.S. Treasury yields is offset by widening EM credit spreads, EM corporate bond yields will continue to rise and EM share prices will sell off. However, as and when EM corporate (or sovereign) yields start falling, irrespective of whether because of declining U.S. Treasury yields or narrowing EM credit spreads, EM equity prices will rally. EM sovereign and corporate bond yields are an imperative indicator to watch for equity investors. Chart I-14Rising Corporate Yields = Lower Share Prices We continue to recommend defensive positioning in EM sovereign and corporate bonds. In terms of asset allocation, EM dollar-denominated sovereign and corporate bonds should not be compared with EM local currency bonds or equities or U.S. Treasurys.5 These are credit instruments, and they should be a part of a credit portfolio with U.S. and European corporate bonds. Credit portfolios should presently be underweight EM sovereign and corporate bonds relative to U.S. corporate bonds (Chart I-15A & Chart I-15B). Chart I-15AEM Sovereign Credit Versus U.S. Credit: Relative Excess Returns Chart I-15BEM Corporate Credit Versus U.S. Credit: Relative Excess Returns Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Analyst andrijav@bcaresearch.com Mexico: Is The Underperformance Overdone? Despite having a sound macroeconomic backdrop,6 Mexican financial markets have lately substantially underperformed their emerging market peers due in large part to domestic politics. Odds are that Mexican risk assets will continue to sell off in absolute terms, especially given the broad turmoil in the EM universe, which we expect to continue. That said, the recent underperformance of Mexican markets versus their EM peers is overdone, and odds are that Mexican stocks, local bonds and sovereign credit will outperform their EM peers over the coming six to 12 months: First, the Mexican authorities have been pursuing orthodox macro policies, including very tight monetary and fiscal policies. The central bank hiked its policy rate again last week in the face of a currency relapse, and the fiscal stance has been tight. Currently, the real policy rate is 4% and the 10-year local currency government bond yield is 5.5%, both deflated by core consumer price inflation (Chart II-1, top and middle panel). Real rates are very high by historical standards and are now above most other EMs. Chart II-1Mexico: Tight Monetary And Fiscal Policies The government's non-interest expenditures deflated by core consumer price inflation have been contracting (Chart II-1, bottom panel). Such a tight monetary and fiscal policy mix will not change considerably with AMLO taking the office and it should benefit the currency. We expect the peso to start outperforming its EM peers on a total-return basis. Second, the Mexican peso is very cheap - close to one standard deviation below fair value, according to the unit labor cost-based real effective exchange rate (Chart II-2). The latter is our favorite currency valuation measure. Chart II-2The Mexican Peso Is Cheap Third, economic growth is improving, as the effects from monetary and fiscal tightening are diminishing (Chart II-3). This should at the margin support Mexican financial markets versus their EM peers where growth is slowing. Chart II-3Mexico: A Moderate Cyclical Recovery Fourth, Mexico's business cycle is much more leveraged to the U.S. economy than to China's. In line with our view that U.S. growth will fare better than China's growth, the Mexican economy will likely outperform other EMs that are more leveraged to China. Finally, an important rationale behind our recommendation to maintain an overweight stance on Mexico is that Mexican risk assets are defensive plays within the broad EM universe. In other words, whenever there is broad EM turbulence and an ensuing flight to quality, Mexican risk assets tend to outperform their EM peers. This is even more likely to happen now that Mexican sovereign spreads are already elevated and local currency government bonds offer a very attractive yield relative to other EMs (Chart II-4). Chart II-4Mexican Domestic And U.S. Dollar Bonds Offer Value Still, a few words are warranted on the recent domestic political developments. Our view is that the latest measures announced by the incoming administration regarding the new airport and banking fees are more indicative of a strategy to test the markets before the AMLO administration takes office, rather than declaring war against both markets and investors. It is noteworthy how fast the AMLO government came out after each of these announcements to calm investors. This suggests to us that fears of Mexico taking an irreversible sharp political turn to the left are overblown. AMLO is likely to be pragmatic and deliberate in the way he pushes forward his policies. In a nutshell, our bias is that these announcements represent an attempt by the AMLO administration to promote competition and reduce rent-seeking activities in the economy. This can be negative for shareholders of incumbent large companies, as it will hurt corporate profits of oligopolies. However, in the long term these polices will be positive for overall economic growth as they will reduce the cost of doing business, appease structural inflation and boost the nation's competitiveness. From a structural perspective, these policies are positive for the currency and local bonds. One way to play this theme is to favor small-cap over large-cap companies. Given the oligopolistic structure of some industries, Mexican large-cap companies are much more likely to be hurt by the incoming administration's open competition policies than small-cap companies. As such, small-caps will likely outperform large-caps in Mexico over at least the next six to 12 months (Chart II-5). Moreover, small-caps are currently trading at a significant discount compared to large-caps, with the former trading at multiples that are half of the latter. Chart II-5Mexico: Small-Caps Will Outperform Large-Caps Investment Conclusion Dedicated EM investors should overweight Mexican equities, local currency bonds and sovereign credit within their respective universes. Concerning the exchange rate, we are maintaining our long MXN / short ZAR position. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Indonesia: Defying The Impossible Trinity? Indonesian stocks are attempting to rally and have lately outperformed the EM equity benchmark. The outlook for this bourse remains negative and we recommend investors to fade this rally and outperformance. Critically, Indonesian domestic interbank rates and corporate U.S. dollar bond yields are rising. Historically, this is a negative signal for share prices (Chart III-1, rates and yields are shown inverted). Chart III-1Rising Rates/Yields = Falling Stocks Weakening rupiah and rising interest rates are forcing the central bank (BI) into a policy dilemma: Should it defend the currency and allow interest rates to rise further or should it cap interest rates and let the currency find a market equilibrium? It appears the BI is trying to do both - to stop the currency from depreciating, while also capping or bringing down interbank rates simultaneously. This defies the Impossible Trinity thesis which stipulates that a central bank of a country with an open capital account has to choose between controlling either the exchange rate or interest rates. On the surface, it would seem that the BI has been focused on targeting a stable rupiah. The monetary authorities have sold foreign exchange reserves (Chart III-2, top panel), and raised the key policy rate. Chart III-2Aggressive Monetary Policy Tightening... Selling of foreign exchange reserves is a form of tightening as it drains the banking system's excess reserves at the central bank. Shrinking interbank liquidity, however, pushes up interbank rates and borrowing costs (Chart III-2, bottom panel). Higher borrowings costs not only make the currency more appealing to investors, but they also curb domestic demand and, thereby, improve the current account balance. This is an ultimate mechanism of how policy tightening leads to exchange rate stability. Yet the full picture of BI's policies is a lot murkier. While on the one hand, the central bank has sold its foreign exchange reserves and hiked policy rates to defend the rupiah, it has also offset some of the tightening by injecting local currency reserves into the banking system. Chart III-3 shows that the BI purchased/redeemed back central bank certificates from commercial banks, which has led to a sharp increase in commercial banks' excess reserves. Chart III-3... And Liquidity Injections By Central Bank Central bank liquidity injections are akin to monetary easing aimed at capping or even bringing down interbank rates. Hence, they come as a contradiction to the central bank's restrictive policies. If the BI chooses to stabilize the rupiah, then interbank rates and borrowing costs in general will have to rise and the economy will take a hit. Corporate earnings will then contract which will be bearish for the equity market. If the central bank opts to cap interbank rates, it has to inject as much liquidity (excess reserves) into the banking system as required. In this scenario, the currency could depreciate triggering capital flight and selloffs in equity and local bond markets. The BI can continue the muddle-through policy - offsetting or sterilizing its foreign exchange interventions by turning the backdoor liquidity taps on. These injections of local currency liquidity into the banking system could encourage speculation against the rupiah and allow banks to lend more, maintaining robust imports and a large current account deficit. It is not certain, but if the market perceives that interest rates are lower than warranted, the currency could very well depreciate amid this policy mix. In this scenario, the result could be a mix of gradual currency depreciation and somewhat higher interest rates. Financial markets will still do poorly in dollar terms. Overall, odds are high that the rupiah will resume its depreciation and interest rates will move higher. Indonesia's balance of payment dynamics remain a risk to the exchange rate. The current account deficit is still large and exports are heading south (Chart III-4). Chart III-4Current Account Deficit Is Large First, Chart III-5 illustrates that the sharp slowdown in the average manufacturing PMIs of Japan, Korea, Taiwan and Germany are pointing to an imminent contraction in Indonesian export volumes. Chart III-5Exports Are Heading South Second, thermal coal prices seem to be breaking down. Chart III-6 shows that the stock price of Adaro - a large Indonesian coal producing company - has already fallen by 45% in U.S. dollar terms since January, and is heralding a dismal outlook for coal prices. Chart III-6Coal Prices Are To Break Down Lower coal prices will shrink Indonesia's coal export revenues. The latter accounts for 12% of total Indonesian exports. In terms of the outlook for banks, which is a key equity sector, their share prices have been surprisingly resilient. Rising interest rates, however, will cause their NPLs to move higher hurting banks' profits, and pulling their share prices down (Chart III-7). Chart III-7Bank Stocks Are At Risk Finally, overall Indonesian equity valuations are still not attractive either in absolute terms or relative to the EM benchmark. Meanwhile, foreigners own 32% of the equity market and 37% of local currency bonds. As the rupiah slides, foreigners will rush to the exits, amplifying the currency depreciation. Bottom Line: The path of least resistance for the rupiah is down. Continue underweighting Indonesian equities and bonds and continue shorting the rupiah versus the U.S. dollar. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Footnotes 1 Please see Emerging Markets Strategy Weekly Report, "On Domino Effects And Portfolio Outflows," dated November 15, 2018, available at ems.bcaresearch.com. 2 Cash flow from operations represents net cash flow from operating activities & excludes net cash flow financing and investing activities. 3 Please see China Investment Strategy Special Report, "Revisiting China's De-Capacity Reforms," dated October 17, 2018, available at cis.bcaresearch.com. 4 Please see Emerging Markets Strategy Weekly Report, "China: Stimulus, Deleveraging And Growth," dated October 25, 2018, available at ems.bcaresearch.com. 5 Please see Emering Markets Strategy Weekly Report, "Strategic Asset Allocation For Emerging Markets," dated May 7 2013, available at ems.bcaresearch.com. 6 Please see Emerging Markets Strategy Special Report, "A Mexican Standoff - Markets Vs. AMLO," dated June 28 2018, available at ems.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Dear Client, Next week on November 26th instead of our regular weekly publication you will receive our flagship publication “The Bank Credit Analyst” with our annual investment outlook. Our regular publication service will resume on December 3rd with our high-conviction trades for 2019. Kind regards, Anastasios Avgeriou Highlights Portfolio Strategy We maintain our sanguine U.S. equity market view for the coming 9-12 months and reiterate our conviction that it is a good time to deploy longer-term oriented capital. The signal from our Economic Impulse Indicator represents a yellow flag and we will continue to monitor the economy for additional soft-patch signals, especially as the Fed remains committed to tighten monetary policy three more times by mid-2019. Firming pricing power on the back of recovering demand coupled with input cost deflation suggest that an earnings led recovery in the S&P airlines index is in order. Take profits and boost to an overweight stance today. Burgeoning domestic demand for freight services, healthy industry operating metrics, the recent margin boost owing to the crude oil price collapse along with compelling valuations and technicals, suggest that the path of least resistance is higher for the S&P air freight & logistics group. Recent Changes Book gains in the S&P Airlines index of 18% since inception and lift from below benchmark to overweight today. Table 1 FEATURE The SPX was rudderless last week, as the tug-of-war between bears and bulls has yet to be decided. Equities have been experiencing mini-aftershocks following October's seismic move because the Fed has injected some volatility back into the markets via raising interest rates and allowing bonds to roll off its balance sheet at an accelerating pace. While the Fed stayed pat in November, it will most definitely tighten monetary policy next month for the ninth time this cycle. Fed policy is at the epicenter of recent S&P 500 oscillations, which raises the question: is the Fed tightening monetary policy too far too fast to cause equity market consternation? To put the latest monetary tightening cycle in perspective, we examined trough-to-peak moves in the fed funds rate since the 1950s. Chart 1 shows the results of our analysis. During the past ten Fed tightening cycles, the median trough-to-peak delta in the fed funds rate heading into recession has been 495bps. The latest cycle that commenced in December 2015 is already 25bps above the median, if one uses the Wu-Xia shadow fed funds rate to capture the full quantitative easing effect (Chart 2). Were the Fed to hike three more times by the first half of 2019, as our fixed income strategists expect, this will push the current cycle 100bps above the historical median. Chart 1Too Far Too Fast? Chart 2Trough-To-Peak Tightening Cycle Already Above Historical Median While almost everyone raves about the stellar U.S. economic performance squarely focused on levels of different economic indicators (Chart 3), drilling beneath the surface reveals that small cracks are forming, as we first highlighted in the October 22nd Weekly Report when we introduced our Economic Impulse Indicator (EII).1 The EII is a second derivate equally-weighted composite of six indicators of the U.S. economy, highlighting that peak economy was likely hit this year in Q2, when nominal GDP grew 7.6% on a quarter-over-quarter annualized growth rate basis. Chart 3Do Not Focus On Levels Alone... Chart 4 shows that 5 out of the 6 indicators included in the EII are losing steam, 4 out of 6 are in outright contraction, and only capex is showing modest signs of life. While this backdrop in isolation does not portend recession, were the Fed to go ahead with three additional hikes by mid-year 2019 that would push the fed funds rate to a range of 2.75%-3% and a possible negative Q2/2019 GDP print could then easily invert the yield curve, ticking the box in one of our three recession indicators we track.2 Chart 4...Impulses Tell A Different Story The latest Fed Senior Loan Officer survey released last week also struck a nerve. While bankers are willing extenders of credit throughout most loan categories, demand for loans is declining across the board (Chart 5A); only other consumer (likely student) loans are in high demand, and subprime residential loans are also threatening to break above the zero line.3 Nevertheless, before getting too bearish, a bond valuation examination is in order. BCA's 10-year bond valuation index has been an excellent predictor of cycle ends dating back to the 1960s. It has accurately forecast 6 out of the last 7 recessions missing only the 1974 iteration. When this valuation metric swings to extremely undervalued territory - defined as at least one standard deviation above the historical mean - it signals that a recession is approaching. Why? Typically a selloff in the bond market is associated with a fed tightening cycle and such steep monetary tightening slams the breaks on the economy via the slowing housing market and the dent in consumer spending power. True, we are closing in on this level, but we are not there yet (Chart 5B). Chart 5ALoan Demand In Freefall Chart 5BWatch Bond Valuations Finally, we bought the proverbial dip on October 26th as we did not (and still do not) foresee recession in the coming 9-12 months, underscoring that likely the trough is in place.4 On that front the Minneapolis Fed's implied probability of a 20%+ correction remains tame near the 10% probability mark, corroborating our sense that the worst is behind the equity market, at least for now (Chart 6). Chart 6Risk Of A Bear Market Is Low Netting it all out, we maintain our sanguine equity market view for the coming 9-12 months and reiterate our conviction that it is a good time to deploy longer-term oriented capital. The signal from our EII represents a yellow flag and we will continue to monitor the economy for additional soft-patch signals especially as the Fed remains committed to tighten monetary policy three more times by mid-2019. This week we crystalize gains in the smallest transportation sub-index we cover and boost exposure to overweight, and reiterate our high-conviction overweight stance on a large transportation sub-index. Airlines: Up In The Air Within transports we have been advocating a barbell portfolio preferring air freight & logistics (see below for an update) to airlines (as a reminder we recently downgraded rails to neutral5). The recent carnage in oil markets has breathed a huge sigh of relief into the S&P airlines index (most of which do not hedge fuels costs) as the collapse in WTI crude oil prices has also taken down kerosene prices. Chart 7 shows that input cost relief will be a key driver of a rebound in relative airline profits in the coming months. Thus, we are compelled to trigger our upgrade alert and cement gains of 18% in our underweight and lift exposure to overweight in the niche S&P airlines index. Chart 7Energy Price Plunge Is Bullish For Airline EPS Not only will airlines get a boost from falling jet fuel prices, but also demand for travel remains upbeat. Consumer confidence is sky high and consumer spending is running at a healthy clip, at a time when job certainty is high and wage inflation is making a comeback (Chart 8). Chart 8Air Travel Demand... In fact, a larger proportion of the consumer's wallet is used for air travel, a trend that has been recently gaining steam according to national accounts. Airline load factors are pushing cyclical highs and passenger revenue per available seat mile is also gaining momentum, corroborating the U.S. government consumption expenditure data (Chart 9). Chart 9...Is Upbeat... As a result, airlines have been successful at raising selling prices and will soon exit the deflationary zone. International airfares are also in positive territory. Taken together, robust demand and higher selling prices along with declining fuel costs are a harbinger of rising margins and profits (Chart 10). Chart 10Firming Ticket Prices Is A Boon To Margins This is not yet reflected in depressed relative forward sales and profit growth estimates. Net earnings revisions have also recovered to the zero line and there is scope for additional positive EPS revisions, especially if jet fuel prices stay tamed and travel demand remains healthy. The implication is that relative share price momentum can lift off further (Chart 11). Chart 11Low Hurdle Finally, valuations are perched deeply in the undervalued zone while technicals have only recently returned to a neutral setting (Chart 12). Chart 12Unloved and Under-owned Adding it up, it no longer pays to be bearish airlines. Firming pricing power on the back of recovering demand coupled with input cost deflation suggest that an earnings led recovery in the S&P airlines index is in order. Bottom Line: Take profits in the S&P airlines index of 18% since inception and lift exposure to an above benchmark allocation. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, UAL, AAL and ALK. Air Freight & Logistics: We Have Liftoff Air freight & logistics stocks have been bouncing along the bottom for the better part of the past year and have formed a base that should serve as a launch board higher in the coming months. Firming industry operating metrics tell a positive story and suggest that relative share prices will soon take off. Air freight pricing power has been healthy, in expansionary territory and above overall inflation measures, at a time when industry executives have been showing labor restraint, with employment growth decelerating steadily over the past two years (Chart 13). This is a conducive backdrop for air freight profit margins and sell-side analysts have taken notice, penciling in higher margins in the coming 12 months. Chart 13Enticing Margin Prospects Importantly, energy costs comprise a large chunk of freight services input costs and the recent drubbing in oil markets will boost margins especially on the eve of the busiest season for courier delivery services (top panel, Chart 14). Chart 14Holiday Selling Season Beneficiary On that front, there are high odds that this holiday sales season will be another record setting one, especially given that corporations have paid out bonuses and shared part of the lowering in corporate taxes and also wage inflation is underpinning discretionary incomes. Keep in mind that the accelerating domestic manufacturing shipments-to-inventories ratio confirms that demand for hauling services is upbeat. The implication is that rising demand for freight services will buoy industry profits and lift valuations out of their recent funk (middle & bottom panels, Chart 14). With regard to the global macro and trade backdrop, while global revenue ton miles and G3 capital goods orders remain near cyclical highs (Chart 15), were Trump's trade rhetoric to re-escalate then global exports would give way. Already international and U.S. export expectations are on the verge of contracting - according to the IFO World Economic Survey and ISM manufacturing survey, respectively. Tack on the appreciating U.S. currency and the clouds darken further (bottom panel, Chart 15). The U.S./China trade tussle and the greenback are clear risks to our sanguine S&P air freight & logistics transportation subindex. Chart 15Greenback And Decelerating Global Growth Are Key Risks... Nevertheless, most of the grim news is already reflected in depressed relative forward profit estimates, bombed out valuations and washed out technicals. In sum, firming domestic demand for freight services, healthy industry operating metrics, the recent margin boost owing to the crude oil price collapse along with compelling valuations and technicals suggest that the path of least resistance is higher for the S&P air freight & logistics group (Chart 16). Chart 16...But Already Reflected In Depressed Valuations And Washed Out Technicals Bottom Line: We reiterate our high-conviction overweight status in the S&P air freight & logistics index. The ticker symbols for the stocks in this index are: BLBG: S5AIRF - FDX, UPS, EXPD and CHRW. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Report, "Icarus Moment?" dated October 22, 2018, available at uses.bcaresearch.com. 2 Ibid. 3 https://www.federalreserve.gov/data/documents/sloos-201810-charts.pdf 4 Please see BCA U.S. Equity Strategy Insight Report, “Time To Bargain Hunt” dated October 26, 2018, available at uses.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Report, "Critical Reset" dated October 29, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights Global growth has not yet bottomed, this will provide additional support for the dollar. EUR/USD will be a buy once it dips below 1.1, as slowing global growth means that European activity will continue to lag behind the U.S. The dollar is not as expensive as simple metrics suggest. Fade any Sino-U.S. détente in Buenos Aires. The best vehicle to play a dollar correction remains the NZD. GBP volatility is peaking. Feature We have been on the road for the past two weeks, in the U.S. and in the Middle East. Exchanges with clients can reveal what the key narratives driving the markets are and where the walls of worries may lie. This week, we opted to share what have been the major questions plaguing clients minds. Question 1: Has Global Growth Bottomed? The short answer is no. While there are issues affecting Europe, such as Italian budget battles and idiosyncrasies in the German auto sector, the key impetus pushing global growth downward is China. The Chinese economy is slowing as Chinese policymakers are working to force indebtedness lower, and have therefore constrained access to credit, especially in the shadow banking system (Chart I-1). This has not changed. Chart I-1Chinese Policy Tightening In Action China's Deleveraging Is Not Over Yet It is also true that Chinese policy makers have been trying to limit the downside to growth. They have injected liquidity in the banking system, let the renminbi depreciate, and allegedly, supported a stock market spiraling downward under the pressure of margin calls. Moreover, fiscal policy is being eased, with income tax cuts pointing to a desire to support household consumption, especially spending on services. But none of these policy actions seems to matter for the world economy, at least for now. China impacts global growth through its imports, and non-food commodities, investment goods, machinery equipment and transportation goods constitute 85% of total Chinese imports. These goods are levered to industrial activity and the Chinese investment cycle. The latter in turn is levered to the Chinese credit cycle (Chart I-2). Hence, as long as China tries to reign in credit growth, Chinese imports will be under pressure. Chart I-2Slowing Chinese Credit Impulse Means Slower Chinese Imports What about the recent rebound in Chinese imports? Our China Strategist posits that it has been linked to front running of orders before the Trump tariffs enter into effect. The trend in credit growth remain poor. The October's money and credit numbers show that the China's total social financing grew at its slowest pace in 12 years, and money growth as well as traditional loan growth has also relapsed (Chart I-3). Hence, China doesn't have an appetite for credit yet. Chart I-3Chinese Credit Is Not Responding To Chinese Stimulus It is hard to fully know why the country's appetite for credit is slowing despite the expanding list of small measures implemented by authorities to support economic activity. On the one hand, it seems that lenders are reluctant to lend. On the other, the private sector does not seems hungry to spend either. As BCA's Emerging Market Strategy service highlighted, even the Chinese consumer is displaying a declining marginal propensity to consume, and retail sales as well as car sales are declining (Chart I-4).1 This suggests that China will continue to act as an anchor on global growth for the time being. Chart I-4Chinese Households Are Cautious Stresses outside of China also remain problematic for global growth. Emerging market financial conditions have tightened significantly. This will continue to act as a drag on global industrial activity (Chart I-5). In fact, the recent poor GDP numbers out of Germany and Japan, two nations highly levered to the global industrial cycle, confirm that the pain originating in the EM space is spreading around the globe. Chart I-5EM Financial Conditions Suggest Continued Downward Pressure On Growth Ultimately, since the U.S. economy is a low beta economy, even if U.S. growth downshifts in response to shocks to global growth, it is likely to slow less than the rest of the world. This explains why the dollar exhibits little constant correlation with U.S. growth, but a tight negative relationship with global growth (Chart I-6). Chart I-6The Countercyclical Dollar Hence, since we see little hope for an imminent bottom in global growth, additional dollar upside remains. Thus, we re-iterate our target for DXY at 100. Nevertheless, make no mistake, the easy gains in the greenback are behind us. The remainder of the rally will likely prove volatile. Question 2: Is The Growth Divergence Between The U.S. And The Euro Area Peaking? Will This Reverse The Dollar Rally? Economic data in the U.S. has begun to weaken, especially on the durable good orders and the housing fronts. Moreover, the recent core CPI data, which came in at 2.1%, was a disappointment. The strong dollar, higher interest rates, tighter financial conditions, and the potential hit to profits from falling oil prices all suggest that U.S. capex could slow. However, as Chart I-7 illustrates, Europe is slowing more than the U.S. Despite the rollover in the U.S. Leading Economic Indicator, the gap between the U.S. and the euro area LEI is in fact growing in favor of the U.S. This is because the U.S. is a low beta economy and it outperforms Europe when global growth slows, especially when the negative impulse emanates out of China (Chart I-8). Chart I-7U.S. Growth May Be Slowing, But It Is Still Outperforming... Chart I-8...Especially If China Does Not Pick Up Nonetheless, the Fed has already increased rates eight times this cycle and the market anticipates a bit more than two interest rate hikes in the U.S. over the next 12 months, while in Europe, rate expectations are much more muted. Will this slowdown in U.S. growth cause U.S. rate and yield differentials versus the euro area - which stand near historical highs - to fall, providing a welcome fillip for EUR/USD in the process (Chart I-9)? Chart I-9U.S. Spreads Are Wide We doubt it. First, three deep structural problems still hamper Europe: Italy still faces challenging debt arithmetic if interest rates rise quickly, which means that Italy continues to teeter close to the hedge of a Eurosceptic drama. European banks are still much weaker than U.S. ones and have a large amount of EM exposure, limiting their capacity to handle higher rates. Europe is far from a true fiscal union, which means that the job of supporting growth lies much more heavily on monetary authorities than in the U.S. This forces the European Central Bank to stay more dovish than the Fed. Second, once the cost of currency hedging is taken into account, the spread between U.S. and European bonds yields becomes negative (Chart I-10)! This suggests that unhedged U.S. yields can rise further versus European ones as U.S. hedged yields are not attractive. This means that yields and interest rates in the U.S. can remain high or even rise relative to Europe, making it attractive to buy the greenback for investors willing to take on currency risk. Chart I-10U.S. Hedged Yields Are Low Hence, we do not expect that the slowdown in U.S. growth will constitutes a major problem for the dollar. Instead, we are looking for EUR/USD to fall below 1.10 before buying the common currency again. Question 3: Is The Dollar Expensive? The answer to this question seems obvious. When looking at a simple purchasing-power parity model, the dollar does look very expensive (Chart I-11). However, valuing currencies is a much more complex question than just looking at PPP metrics. Once other factors are taken into account, the dollar trades in line with its long-term drivers (Chart I-12). The dollar might not be as expensive as PPP metrics suggest because the U.S. productivity growth is higher than in most other G10 nations, because neutral interest rates in the U.S. are structurally higher than in Europe or Japan, and because the U.S. current account deficit is stable despite a strong dollar as the U.S. morphs from an energy importer to an energy exporter. Chart I-11U.S. Dollar And PPP Is The Greenback Really This Expensive?   Chart I-12Maybe Not On a short-term basis, there is no evident misalignment in the USD either. The DXY dollar index trades in line with our short-term metrics, suggesting that until now, the bulk of the dollar rally this year was a correction of its previous undervaluation (Chart I-13). Furthermore, the dollar tends to peak at higher degree of overvaluations, and, if U.S. growth continues to outperform the rest of the world, the fair value of the DXY could rise further. Chart I-13No Short-Term Misalignment Question 4: Will Sino-U.S. Relations Improve After The Buenos Aires G20 Meeting? We are skeptical that Sino-U.S. relations will improve after the Buenos Aires meeting at the end of the month. The White House could delay the imposition of a third round of tariffs as well as the increase in the current tariff rate from 10% to 25%. Such actions would likely result in a temporary bounce back in risk assets and EM related plays as well as correction in the USD. However, President Trump has no incentive to make a full-blown trade deal with China right now. The midterm elections confirmed that the U.S. electorate is not pro-free trade and that the political apparatus in the U.S. is unified in fighting China. At the end of the day, China is a great scapegoat for the income inequality problem plaguing the U.S. Question 5: Will The Dollar Correct After Its Furious 2018 Rally? Our inclination is to think that there are short-term risks building up in the dollar, a topic we discussed at length three weeks ago.2 Namely, traders are now very long the dollar, and risk-on currencies have been rallying against the dollar despite the strength in the DXY. This suggests that the corners of the FX market most levered to global growth might be sniffing out a stabilization in global conditions. Indeed, the Chinese economic surprise index has improved (Chart I-14). While Chinese data has not meaningfully picked up, expectations toward China are very depressed. As such, a slowdown in the pace of deterioration could be interpreted as good news for global growth. The countercyclical dollar may correct. Chart I-14Are Expectations Toward China Too Depressed? We have not played the dollar correction risk through selling DXY or buying EUR/USD. Instead, we have bought the NZD against both the USD and the GBP. The beaten down kiwi would be the currency most likely to rebound if global growth conditions were to surprise to the upside, even if temporarily. This has proved to be the right call. We remain positive on the NZD for the coming two months. However, from a risk management perpectives we are closing our long NZD/USD trade at 4.8% profit. However, we doubt that any dollar correction is likely to morph into a genuine bear market. If global growth conditions were indeed to improve, this would give more ammo for the Fed to hike in line with its "dots". The market knows that and would revise upward the modest 60 basis point of hikes currently anticipated over the coming 12 months. As such, the resultant increase in real rates would likely hurt the still-fragile EM economies and cause a renewed tightening in EM financial conditions. This would in turn lead to additional slowdown in global growth and would support the dollar. Hence, our current positive predisposition toward the kiwi is temporary in nature. Question 6: Has The Pound Bottomed, Will GBP-Volatility Recede Anytime Soon? In September, we warned that the pound did not compensate investors adequately for the political uncertainty surrounding Brexit risks.3 Specifically, we were most worried about British domestic politics, not the EU side of the negotiations. However, because we believed that ultimately, either soft Brexit or Bremain would ultimately prevail, we refrained from selling the pound outright. Instead, we recommended investors buy the GBP's volatility. Today, Prime Minister Theresa May is in danger as two additional ministers resigned from her cabinet after she presented the Brexit deal that was hammered out with Brussels. The risk of a new election or a hard-liner Brexit Tory replacing her is growing by the minute. Markets are once again clobbering the pound, and GBP implied volatility is trading at level last seen directly after the June 2016 referendum (Chart I-15). Chart I-15Close Long GBP Vol Bets At current levels, the pound is now an attractive play for long-term investors. Additionally, while a new election is likely to cause more tremors into the pound, we are inclined to recommend investors close long GBP volatility trades as the British public is growing more disillusioned with Brexit. Our conviction is only growing that only the softest form of Brexit will be implemented. As a result, the risk-reward ratio from selling the pound or buying its volatility has now significantly deteriorated. We are closing our short GBP/NZD trade at a 6% profit in four weeks. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1 Please see Emerging Markets Strategy Weekly Report, titled "On Domino Effects And Portfolio Outflows", dated November 15, 2018, available at ems.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "Risk To The Dollar View", dated October 26, 2018, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report, titled "Assessing the Geopolitical Risk Premium In the Pound", dated September 7, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: Both core inflation and core PCE came in below expectations, coming in at 2.1% and 1.6% respectively. However, Q3 GDP growth surprised to the upside, coming in at 3.5%. Moreover, nonfarm payrolls also came in above expectations, coming in at 250 thousand. The DXY index has been able to appreciate over the past three weeks. We maintain our bullish bias towards the dollar, given that despite its rise, this currency remains fairly valued. Moreover, we expect global growth to continue deaccelerating, as Chinese authorities continue to tighten. That being said, potential upside might be limited from current levels, as speculators are very long the dollar. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the Euro area has been mixed: Core inflation increased and outperformed expectations, coming in at 1.1%. Moreover, Markit Services PMI also surprised to the upside, coming in at 53.7. However, Markit Manufacturing PMI surprised negatively, coming in at 52. EUR/USD has depreciated over that past three weeks. We remain bearish on the euro, given that we expect global growth to keep slowing, hurting export-driven economies like the euro area. Furthermore, Italian debt dynamics will continue to plague the Eurozone. That being said, if the euro were to fall below 1.1, we would tamper our bearishness. Report Links: Evaluating The ECB's Options In December - November 6, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: The unemployment rate surprised positively, coming in at 2.3%. This measure also decreased from last month. However, housing starts yearly growth underperformed expectations, coming in at -1.5%. Moreover, overall household spending yearly growth also surprised negatively, coming in at -1.6%. Q2 GDP contracted and also came in below expectations, driven by poor capex growth. USD/JPY has also appreciated over the past three weeks. We remain positive on the trade-weighted yen, given that the continued slowdown in global growth, fueled by the dual tightening of policy by Chinese authorities and the Fed, will help safe haven currencies like the yen. Moreover, the current selloff in U.S. markets could also provide a boon for this currency if it forces the Fed to tamper its hawkishness. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 Rhetoric Is Not Always Policy - July 27, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Average hourly earnings excluding bonus yearly growth surprised to the upside, coming in at 3.2%. However, core inflation underperformed expectations, coming in at 1.9%. Moreover, retail sales yearly growth also surprised negatively, coming in at 2.2%. After rising for the last three weeks, GBP/USD fell by over 1.5% on Thursday, after two ministers quit Theresa's May cabinet. While the headline risk remains large, especially as the U.K. could soon go through an election, we do not want to be greedy and our closing our long GBP-vol bets. We are also closing our short GBP/NZD bet. At current levels, GBP is now an attractive long-term play. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been positive: Employment growth outperformed expectation, coming in at 32.8 thousand. Moreover, the participation rate also surprised to the upside, coming in at 65.6%. Finally, the unemployment rate also surprised positively, coming in at 5%. AUD/USD has risen by 3.39% the past 3 weeks. We are inclined to fade this rally as the poor outlook for the Chinese economy could soon transform these strong Australian economic results into much more disappointing numbers. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been positive: Employment growth outperformed expectations, coming in at 1.1%. Moreover, the participation rate also surprise to the upside, coming in at 71.1%. Finally, the unemployment rate also surprised positively, coming in at 3.9%. NZD/USD has risen by more than 5.5% the past 3 weeks. The NZD continues to be one of our favorite currencies in the G10, given that rate expectations continue to be very low, even though economic data has strengthened. Moreover, food prices, dairies in particular have limited downside from here, especially as they are not very exposed to China's policy tightening. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been positive: The net change in employment outperformed expectations, coming in at 11.2 thousand. Moreover, housing starts also surprised to the upside, coming in at 206 thousand. Finally, the unemployment rate also surprised positively, coming in at 5.8%. USD/CAD has risen by 1.2% these past 3 weeks. The weakness in oil prices have caused the Canadian dollar to be one of the worst performing currencies in the G10 in recent weeks. We are reticent to be too bullish on the CAD, given that markets are now pricing in a BoC that will be more hawkish than the Fed. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been negative: Real retail sales yearly growth came in significantly below expectations, coming in at -2.7%. Moreover, the SVME Purchasing Manager's Index also surprised to the downside, coming in at 57.4. Finally, the KOF leading Indicator also surprised negatively, coming in at 100.1. EUR/CHF has been flat in recent weeks. We continue to be bearish on the franc on a cyclical basis, given that inflationary forces in Switzerland remain too tepid for the SNB to hike policy rates. Moreover, the SNB will also have to intervene in currency markets if the franc becomes more expensive in response to the current risk-off environment. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data In Norway has been mixed: Both headline and core inflation underperformed expectations, coming in at 3.1% and 1.6% respectively. Moreover, manufacturing output also surprised to the downside, coming in at -0.3%. However, registered unemployment surprised positively, coming in at 79.7 thousand. USD/NOK has risen by 1.5%, as falling oil prices have weighed heavily on the krone. We are bullish on the krone relative to the Canadian dollar, given that rate expectations in Canada are much more fully priced in Canada than they are in Norway, even though the inflationary backdrop is similar. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden has been mixed: Retail sales yearly growth outperformed expectations, coming in at 2.1%. Manufacturing PMI also outperformed expectations, coming in at 55. However, headline inflation surprised to the downside, coming in at 2.3%. USD/SEK has depreciated by roughly 1% for the past 3 weeks. Overall, we are bullish on the krona on a long-term basis. After all, the Riksbank is on the verge of beginning a tightening cycle, as imbalances in the Swedish economy are only growing more dangerous. With that being said, the krona could suffer if global growth slows further, as Sweden is very exposed to the gyrations of the global economy. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Despite a stellar Q3 earnings print, the S&P 500 had a terrible October as EPS continues to do the hard work in lifting the market (Chart 1). Chart 1EPS Doing The Heavy Lifting We bought the dip,1 consistent with our view of deploying longer term oriented capital were a 10% pullback to occur, given our view of no recession for the next 9 to 12 months.2 Financials and industrials should lead the next leg up and we believe a rotation into these beaten up stocks is going to materialize in the coming months. On the flip side, as volatility is making a comeback and the fed is on a path to lift rates to 3% by June of next year, fixed income proxies and consumer discretionary stocks should be avoided and a preference for large caps over small caps should be maintained (Chart 2). Chart 2The Return Of Vol May Spoil The Party Further, a valuation reset has taken hold, pushed by the surprising rise of the equity risk premium over the course of the past two years, representing a surge in negative sentiment from investors, despite the usually tight inverse correlation with the ISM, the core sentiment indicator of the manufacturing economy (Chart 3). Chart 3ERP And The Economy Are Inversely Correlated Nevertheless, while everyone is focusing on the euphoric above trend growth of the U.S. economy, a risk lurking beneath the surface is a domestic economic soft patch.3 We have likely stolen demand from the future and brought consumption forward especially with the stock market related fiscal easing that is front loaded to 2018 and less so for next year. On that front our Economic Impulse Indicator is warning that the U.S. economy cannot grow at such a pace, unless a bipartisan divide can be crossed to deliver enough firepower to rekindle GDP growth (Chart 4). Chart 4Economic Impulse Yellow Flag Further, at least part of the blame for higher volatility rests with increasing trade uncertainty as the Trump administration has pursued an aggressive trade policy. Still, the evidence so far indicates that any trade weakness has been borne disproportionately by the rest of the world, to the U.S.' benefit (Charts 5 & 6). Chart 5U.S. Is Winning The Trade War Chart 6U.S. Has The Upper Hand We remain cognizant of a few key risks to our sanguine U.S. equity view. Principal among these is the rising U.S. dollar and its eventual infiltration into S&P 500 earnings, which has thus far been muted (Chart 7). Chart 7Watch The U.S. Dollar Further, a softening housing market bodes ill for U.S. economic growth. This is the first time since the GFC that residential investment's contribution to real GDP growth turned negative for three consecutive quarters (Chart 8). Chart 8Peak Housing Chris Bowes, Associate Editor chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Daily Insight, "Time To Bargain Hunt," dated October 26, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "The "FIT" Market," dated October 9, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Critical Reset," dated October 29, 2018, available at uses.bcaresearch.com. S&P Financials (Overweight) Unchanged from its trajectory when we updated our cyclical indicators earlier this year, the S&P financials CMI has continued to accelerate. A historically low unemployment rate, combined with unusually resilient economic growth, underpin the surge in the CMI to its highest levels post-GFC. Further goosing the indicator, particularly with respect to the core banks sub-sector, is the recent rise in Treasury yields and a modest steepening in the yield curve both of which bode well for bank profits. However, financials have not responded to this exceptionally bullish data the way we expected, with worries over future loan growth fully offsetting the positive backdrop; financials have been falling throughout 2018. Still, inflation is threatening to rise (albeit gradually) and a selloff looms in the bond market. We highlighted earlier this fall that sectors who benefit from rising interest rates while serving as inflation hedges should outperform against this backdrop. Cue the return of S&P financials. As shown in Chart 10, the S&P financials index has shown a historically strong positive correlation with interest rates and inflation expectations and we expect the recent divergence to be closed via a catch-up in the former. As noted above, bearishness has reigned in 2018 and the result has been a steep fall in our valuation indicator (VI) to more than one standard deviation below normal while our technical indicator (TI) is deep in oversold territory. Chart 9S&P Financials (Overweight) Chart 10Financials Are Trailing Rates S&P Industrials (Overweight) S&P industrials, much like their cyclical brethren S&P financials, benefit from higher interest rates and also serve as hedges against rising inflation. As we have noted in recent research, industrials are levered to the commodity cycle and thus represent an indirect inflation hedge. This hedge only becomes problematic when industrials stocks are unable to pass these rising commodity costs through to the consumer. As shown in Chart 12, pricing power is not yet an issue for these deep cyclicals. Given the positive macro backdrop for S&P industrials, the CMI has risen to new cyclical highs. Despite the forgoing, fears over trade wars and tariff-driven higher input costs, combined with slowing global demand for capital goods, have weighed on the index. The result is that S&P industrials remain deeply oversold on a technical basis while hovering around the neutral line from a valuation perspective. We reiterate our overweight recommendation. Chart 11S&P Industrials (Overweight) Cjart 12Resilient Industrials Pricing Power S&P Energy (Overweight, High-Conviction) Our energy CMI has moved horizontally since our last update of the cyclical macro indicators. However, this followed a snap-back recovery from the extremely depressed levels of 2016 and 2017. Nevertheless, the S&P energy index has moved sideways in line with the CMI. Energy stocks have significantly trailed crude oil prices since the latter broke out roughly a year ago (Chart 14). Disbelief in the longevity of the increase in oil prices is the likely culprit weighing on the index, along with a bottleneck-induced steep shale oil price discount to WTI. There are high odds that a catch up phase looms, especially if BCA's Commodity & Energy Strategy service's view of a looming oil price spike materializes, and we reiterate our overweight recommendation. Our VI has been hovering at one standard deviation below fair value, while our TI trending into oversold territory. Chart 13S&P Energy (Overweight, High-Conviction) Chart 14Crude Prices Are Still Leading The Way S&P Consumer Staples (Overweight) Unchanged from our previous update, our consumer staples CMI has moved sideways, near a depressed level. However, share prices have finally been staging the recovery we have anticipated for several years on the back of firm consumer data, solid sector profitability and an overall cyclical rotation into staples. Despite the recent outperformance, both from an earnings and market perspective, consumer staples remain a deeply unloved sector. With respect to the former, earnings growth has outstripped the market's reaction by a wide margin. This is reflected on our VI which only recently rose from one standard deviation below fair value while our TI has only just begun a retreat from oversold territory. Staples' share of retail sales have arrested their steep declines from 2014-2016, which we view as a precursor to a rebound in weak industry sales (top panel, Chart 16). Exports of consumer staples have already been staging a comeback, despite the strengthening of the U.S. dollar which has historically presaged a relative earnings outperformance (middle panel, Chart 16). Considering the already-strong industry return on equity, any relative earnings gains should result in a valuation rerating (third panel, Chart 16). We reiterate our outperform rating on this cyclically defensive index. Chart 15S&P Consumer Staples (Overweight) Chart 16Staples Are Making A Comback S&P Health Care (Neutral) In a mid-summer report , we upgraded the S&P pharma and biotech indexes to neutral which, considering their ~50% weight of the S&P health care index, took our overall recommendation on S&P health care to neutral. In the report, we proffered five reasons why the S&P pharma and biotech indexes were set for a rebound following their precipitous decline from 2016 onwards. These were: firming operating metrics, late cycle dynamics, likelihood of pricing power regulatory relief, the rising U.S. dollar and investor and analyst capitulation. Our timing has proved prescient as the S&P pharma index has been dramatically outperforming since the upgrade (top panel, Chart 18). With respect to pharma's operating metrics, our pharma productivity proxy (industrial production / employment) has been soaring, implying that earnings should surge (second panel, Chart 18). This seems particularly likely as the pace of improvement in drug shipments exceeds inventory growth by a fairly wide margin (third and bottom panels, Chart 18). Despite the upbeat backdrop for pharma, our health care CMI has declined modestly, though remains at a neutral level relative to history. Further, the pharma recovery has taken our VI from undervalued to a neutral position, a reading which is echoed by our TI. Chart 17S&P Health Care (Neutral) Chart 18Pharma Strength Is Lifting Health Care S&P Technology (Neutral) The stratospheric rise of tech profits, particularly in the past two years, have done most of the heavy lifting in pulling the S&P 500's profit margin ever higher (second panel, Chart 20) as well as pushing the index itself to new all-time highs in September. The San Francisco Fed's tech pulse index - an index of coincident indicators of technology sector activity - suggests more profit growth is in the offing (third panel, Chart 20), an intimation repeated by our technology CMI. However, we remain cognizant of three material risks to bullishness in tech. First, the tech sector garners 60% of its revenues from abroad and thus the appreciating U.S. dollar is a significant profit headwind (bottom panel, Chart 20). Second, a rising U.S. inflation backdrop along with the related looming selloff in the bond market should knock the wind out of the tech sector's sails. Third, leading indicators of emerging Asian demand are souring rapidly and were the trade war to re-escalate, EM economic data would retrench further. Lastly, neither our VI nor our TI send particularly compelling messages, as both are on the expensive side of neutral, despite the recent tech selloff. We sustain a barbell portfolio within the sector by recommending an overweight position in the late-cyclical and capex-driven technology hardware, storage & peripherals and software indexes while recommending an underweight position in the early-cyclical semi and semi equipment indexes. Chart 19S&P Technology (Neutral) Chart 20Tech Is King But Beware The U.S. Dollar S&P Materials (Neutral) Our materials CMI has recently plumbed new lows, a result of tightening monetary policy and the accompanying selloff in the bond market. As a reminder, the heavyweight chemicals component of the materials index typically sees earnings (and hence stock prices) underperform as real interest rates are moving higher. Despite this negative backdrop, chemicals fundamentals have remained surprisingly resilient. Pricing power has stayed in its multi-year uptrend (second panel, Chart 22) while productivity gains have accelerated, coinciding with an erosion of sell-side bearishness (third panel, Chart 22). Still, chemical production has clearly rolled over (bottom panel, Chart 22) which could lead to a quick reversal of the gains in our productivity proxy and a faltering in rebounding EPS estimates. Combined with BCA's view of rising real interest rates for the next year, this is enough to keep us on the fence. Our VI too shows a neutral reading, though our TI has declined steeply into an oversold position. Chart 21S&P Materials (Neutral) Chart 22Fundamentals In Chemicals Have Improved S&P Utilities (Underweight) Our utilities CMI is at a 25-year low, driven down by the ongoing backup in interest rates. Such a move is predictable, given that utilities stocks are the closest to perfect fixed income proxies in the equity space. The S&P utilities sector has been enjoying a relative resurgence recently, driven by spiking natural gas prices and a supportive electricity demand backdrop from a roaring economy (ISM survey shown inverted, bottom panel, Chart 24) and, more than anything, a general market retreat into safe haven assets. We recently trimmed our exposure to the sector from neutral to underweight because the S&P utilities sector was yielding 3.5% and the competing risk free asset was near 3.2% and investors would prefer to shed, at the margin, riskier high-yielding equities and park the proceeds in U.S. Treasurys (top panel, Chart 24). Since the run up in S&P utilities without a corresponding decline in Treasury yields, that spread has narrowed. Neither our VI nor our TI send compelling messages as both are in neutral territory, though our bearish thesis on utilities has less to do with their valuation relative to themselves or other equities than to bonds. Chart 23S&P Utilities (Underweight) Chart 24Utilities Should Still Be Avoided S&P Real Estate (Underweight) Our real estate CMI has reversed a recent recovery to set a new decade low; the only time it has shown a lower reading was during the Great Financial Crisis. Excluding the inflating of the property bubble in advance of the GFC, REITs have had a very tight inverse correlation with UST yields; the resulting downward pressure on the S&P REITs index is thus very predictable (top panel, Chart 26). Much like the S&P utilities sector in the previous section, and in the context of BCA's higher interest rate view, we continue to avoid this sector. The rate-driven downward pressure could be overlooked if all was well on an operating basis but this is not the case. Non-residential construction continues to rise (albeit more slowly than last year) in the face of higher borrowing rates (second panel, Chart 26). Further, demand looks slack as occupancy rates clearly crested at the beginning of last year (bottom panel, Chart 26). As well, on the residential front, multi-family housing starts remain elevated which should prove deflationary to rents. Our VI suggests that REITs are fairly valued, which is somewhat surprising given the negative backdrop, while our TI echoes a neutral view. Chart 25S&P Real Estate (Underweight) Chart 26A Bearish Backdrop For REITs S&P Consumer Discretionary (Underweight) While we remain constructive on financials that benefit from higher rates, we continue to recommend investors avoid the consumer discretionary sector - the other early cyclical - that suffers when interest rates rise. The second panel of Chart 28 depicts this inverse correlation consumer discretionary equities have with interest rates, especially the fed funds rate. Most discretionary equites are levered off of floating rates and thus any increase in the fed funds rates gets reflected immediately in banks' prime lending rate. Also, most consumer debt is floating rate debt and thus tighter monetary conditions, at the margin, dampen consumer debt uptake and as a knock off on effect, weigh on discretionary consumer outlays. Not only are higher interest rates anchoring consumer discretionary stocks but rising energy prices are also dealing a blow to this sector. We show our Consumer Drag Indicator (CDI, comprising mortgage rates and energy prices) in the bottom panel of Chart 28. Historically, our CDI has been an excellent leading indicator of relative share price momentum. Currently, the message is clear: the sinking CDI signals that a bear market in consumer discretionary stocks has likely commenced. All of this is captured by our CMI which has been sinking since the beginning of the year. Meanwhile, our VI has broken out to nearly its highest level ever which we believe is largely a function of the decreasing diversification of the S&P consumer discretionary index as AMZN now represents more than 30% of its market value following the redistribution of the media indexed to the new S&P communication services index. Our TI has been falling from overbought territory recently and now sends a neutral message. Chart 27S&P Consumer Discretionary (Underweight) Chart 28Higher Rates Spell Declines For Consumer Discretionary S&P Communication Services (Underweight) As the newly-minted communication services has little more than a month of existence, we do not have adequate history to create a cyclical macro indicator. However, we have created Chart 29 below with a number of valuation indicators, though we caution that they too are less reliable than the other indicators presented in the preceding pages, owing to a dearth of history. Rather, we refer readers to our still-fresh initiation of coverage on the sector and look forward to being able to deliver something more substantive in the future. Chart 29S&P Communication Services (Underweight) Size Indicator (Favor Large Vs. Small Caps) Our size CMI has been hovering near the boom/bust line, as it has for most of the last two years. Despite the neutral CMI reading, we downgraded small caps earlier this year , and moved to a large cap preference, based on the diverging (and unsustainable) debt levels of small caps vs. their large cap peers (top and second panels, Chart 31). We expect the divergence in leverage and stock price to be rationalized as it usually has: via a fall in the latter. Considering the dramatic valuation gap that has opened between large and small caps, particularly on a Shiller P/E (or cyclically adjusted P/E, CAPE) basis (bottom panel, Chart 31), no space remains for any small cap profit mishaps. Our VI is trending towards small caps being undervalued, though without conviction while our TI is hovering in the neutral zone. Chart 30Size Indicator (Favor Large Vs. Small Caps) Chart 31Too Much Debt And High Valuations Should Hurt Small Caps

As is tradition, during client visits in Europe last week, I had the pleasure of reconnecting with Ms. Mea, a long-term BCA client.1 It was our third encounter and, as always, Ms. Mea was eager to delve into our reasoning, challenge our views and strategy, as well as gauge our conviction level. We devote this week's report to key parts of our dialogue. I hope clients find it insightful and beneficial. Ms. Mea: Isn't the EM selloff and underperformance already overextended? I am afraid you will overstay your negative view on EM risk assets as happened in 2016. What are you watching to ensure you alter your stance as and when appropriate? Answer: I am very cognizant of not overstaying my negative stance on EM. I viewed the EM/China rally from their 2016 lows as a mid-cycle outperformance in a structural downtrend.2 Consequently, I argued the rally was not sustainable and that it was a matter of time before EMs and China-plays entered into a new bear market. Barring perfect timing, it was difficult to make money during that rally. Investors who averaged in EM stocks and local bonds over the past three years (including late 2015/early 2016 lows) and did not sell early this year have not made money. The current down-leg in EM financial markets may be the last phase of the bear market/underperformance that began in 2011, and it will eventually create a major buying opportunity. That said, this bear market will likely last much longer and be larger in magnitude than many investors expect. In the recent report titled EMs Are In A Bear Market, I elaborated on why this is a bear market and not just a correction. We also discussed how much further it might go.3 Big-picture macro themes - such as China/EM credit excesses and misallocation of capital - have informed my core views in recent years. Notwithstanding, I am watching various market signals that often lead economic data and are typically early in signaling a reversal in financial markets. Just a few examples of market signals and indicators I am following closely: Turns in EM corporate bond yields often coincide with reversals in EM stocks. For now, EM corporate bond yields are rising, and hence they do not signal a bottom in EM share prices (Chart I-1, top panel). Chart I-1EM/Asian Corporate Bonds Signal Downside Risks To Share Prices The same holds true for Emerging Asian markets: surging corporate bond yields are heralding further declines in Asian share prices (Chart I-1, bottom panel). Our Risk-on versus Safe-Haven (RSH) currency ratio positively correlates with EM equity prices. The RSH ratio has recently rebounded but has not broken above its 200-day moving average (Chart I-2). Hence, there is no meaningful buy signal as of yet. Chart I-2Our Market Risk Indicator The annual rate of change of this indicator leads the global trade cycles and entails further slowdown in global trade (Chart I-3). Chart I-3Global Trade Slowdown Is Not Over Finally, a number of EM equity indexes - small-caps and an equal-weighted index - have broken below their 3-year moving averages (Chart I-4). This entails that the selloff in EM stocks is very broad-based. It could also entail that the overall EM index will likely break below its 3-year moving average as well (Chart I-4, bottom panel). Chart I-4EM Equity Selloff Has Been Broad-Based Apart from market signals, I am also monitoring economic data, and so far, there are few signs of a revival in global trade or EM growth. The EM manufacturing PMI is falling (Chart I-5, top panel). Manufacturing output growth in Asia and Germany are decelerating sharply (Chart I-5, bottom panel). When global trade growth underwhelms, EM risk assets and currencies fare poorly. Chart I-5Global Growth And EM Credit Spreads Remarkably, both panels of Chart I-5 corroborate that the key reason for the EM selloff this year has not been the Federal Reserve tightening but the deceleration in global trade. We do not foresee a reversal in global trade and China/EM growth deceleration in the coming months. This heralds maintaining our negative view on EM risk assets and currencies for now. Ms. Mea: It is true that China is slowing, but policymakers are also stimulating and a lot of bad news may already be priced into China-related markets. Why do you believe there is more downside in China-related markets and EM risk assets from today's levels? Answer: Indeed, China is easing policy, but policy stimulus has so far been limited. It also works with a time lag. First, the bottoms in the money and the combined credit and fiscal spending impulses preceded the trough in EM and commodities by 6 months at the bottom in 2015 and by about 15 months at the top in 2017 (Chart I-6). Even if the money as well as credit and fiscal impulses bottom today it could take several more months before the selloff in EM financial markets and commodities prices abates. Chart I-6China: Money, Credit And Fiscal Impulses And Financial Markets Second, the stimulus has so far been limited. The recently increased issuance of special bonds by local governments was already part of this year's budget. Simply, it was delayed early this year and has been pushed into the third quarter. In addition, there are reports that 42% of this recent special bond issuance will be used for rural land purchases rather than infrastructure spending.4 The former will not boost economic activity and demand for raw materials and industrial goods. Additionally, the ongoing regulatory tightening of banks and non-bank financial institutions will hinder these institutions' willingness and ability to extend credit, despite lower interest rates. We discussed in a recent report5 that both the effectiveness of the monetary transmission mechanism and the time lag between policy easing and a bottom in the business cycle are contingent on the money multiplier (creditors' willingness to lend and borrowers' readiness to borrow) and the velocity of money (marginal propensity to spend among households and companies). On both accounts, odds are that the transmission mechanism will be slower and somewhat impaired this time around than in the past. Chart I-7 illustrates that the marginal propensity to spend/invest by companies is diminishing, and it has historically defined the primary trend in industrial metals prices. Chart I-7China: Companies Are Turning More Cautious On Capex Third, most of the fiscal stimulus - tax cuts and income tax deductions - are designed to raise household incomes. This will primarily help spending on some consumer goods and services. Yet, there will be little help for property sales, construction and infrastructure spending. These three types of spending drive most of the demand for commodities, materials and industrial goods. In turn, industrial goods, machinery, commodities and materials account for about 80% of total Chinese imports. Hence, the channels by which China affects the rest of the world are via imports of capital goods, materials and commodities. Overall, China's tax reforms will have little bearing on its imports from other countries. The latter are heavily exposed to the mainland's construction and infrastructure spending, which in turn are driven by the Chinese credit cycle. This is why we spend so much time analyzing mainland money and credit cycles. Finally, the significance of U.S. import tariffs for the Chinese economy should be put into perspective. China's exports to the U.S. make up only 3.6% of its GDP. This compares with the mainland's total exports of 20% and capital spending of 42% of GDP (Chart I-8). Chart I-8What Drives China's Growth Consequently, capital spending is much more important to the Middle Kingdom's growth than its shipments to the U.S. That said, the trade confrontation between the U.S. and China is likely already negatively affecting overall business and consumer confidence in China (Chart I-9). Chart I-9China: Service Sector Is Moderating In addition, Chart I-10 illustrates that China's manufacturing PMI for export orders have plunged, signifying an imminent slump in its exports. This could be due to its shipments not only to the U.S. but also to developing economies, which account for a larger share of total exports than shipments to the U.S. and EU combined. Considerable depreciation in EM currencies has made their imports more expensive, dampening their capacity to import. Chart I-10Chinese Exports Are At Risk In brief, China's growth will continue to disappoint, weighing on China plays in financial markets. Ms. Mea: Why has strong U.S. growth not helped global trade, China and EM in general? How do U.S. economic and financial markets enter into your analysis about the world and EM? Answer: One common mistake that many commentators make is to form a view on the U.S. growth outlook and then extrapolate it to the rest of the world. The U.S. economy is still the largest, but it is no longer the sole dominant force in the global economy. Chart I-11 shows that U.S. and EU annual imports are equal to $2.5 and $2.2 trillion, respectively. Combined annual imports of China and the rest of EM amount to $6 trillion - hence, they are much larger than the aggregate imports of U.S. and EU. This is why global trade can deviate from time to time from U.S. domestic demand cycles. Chart I-11EM Imports Are Larger Than U.S. And EU Imports Together That said, due to their sheer size, U.S. financial markets have a much larger impact on global markets than U.S. imports do on global trade. EM financial markets are greatly influenced by their counterparts in the U.S. In this respect, we have a few observations: U.S. growth is robust, the labor market is tight and core inflation is rising. Barring a major deflation shock from EM, the path of least resistance for U.S. bond yields and the fed funds rate is up. Continued rate hikes by the Fed constitute a major menace to EM risk assets. For now, the growth divergence between the U.S. and rest of the world will continue to be manifested in a stronger U.S. dollar. This is a bad omen for EMs. Chart I-12A Risk To U.S. Share Prices Rising U.S. corporate bond yields have historically been associated with lower U.S. share prices, and presently portend a further drop in American equities (Chart I-12). Finally, the surge in equity market leaders - specifically, new economy stocks - has been on par with previous bubbles, as shown in Chart I-13. Chart I-13History Of Financial Bubbles It is impossible to know whether or not this is a bubble that has already reached its top. But the magnitude and speed of the rally, at minimum, warrant a consolidation phase. On the whole, Fed tightening, rising corporate bond yields, a strong dollar and elevated valuations warrant further correction in U.S. share prices. This will reinforce the downtrend in EM risk assets. Ms. Mea: Are fundamentals in many EM countries not better today than they were amid the taper tantrum in 2013? Specifically, current account balances in many developing nations have improved and their currencies have cheapened. Answer: Your observation is correct - current account deficits have improved and currencies have become much cheaper than before. Nevertheless, these are necessary but not sufficient conditions to turn bullish: First, marginal shifts in balance of payments drive exchange rates. Even though current account deficits are currently smaller and currencies are moderately cheap in many EMs, a deterioration in their current accounts due to weakening exports in general and falling commodities prices in particular will depress their currencies. In this context, China's imports are critical. As they decelerate, EM ex-China's current account balances will deteriorate and their exchange rates will depreciate. Second, current account surpluses do not always preclude currency depreciation. Chart I-14 shows that the Korean won, the Taiwanese dollar and the Malaysian ringgit experienced bouts of depreciation, despite running current account surpluses. Chart I-14Current Account Surpluses And Exchange Rates Third, emerging Asian currencies are at a risk from another spell of RMB depreciation. Chart I-15 illustrates that CNY/USD exchange rate correlates with the interest rate differential between China and the U.S. As the Fed hikes rates further and the People's Bank of China (PBoC) keep interest rates stable, the yuan will likely depreciate against the greenback. Chart I-15CNY/USD And Interest Rates Despite capital controls, it seems the interest rate differential affects the exchange rate in China too. Given the ongoing growth slowdown and declining return on capital in China, there are rising pressures for capital to exit the country. If the authorities push up interest rates to make the yuan attractive to hold, it will hurt the already overleveraged and weak economy. If the PBoC reduces interest rates further to help the real economy, the RMB will come under depreciation pressure. Given the constraints Chinese policymakers are facing, reducing interest rates and allowing the yuan to depreciate further is the least-worst outcome for the nation. Yet, this will rattle Asian currencies and risk assets. Finally, EM currency valuations are but particularly cheap, except Argentina, Turkey and Mexico as depicted in Chart I-16A & Chart I-16B. When currency valuations are not at an extreme, they usually do not matter for the medium-term outlook. Chart I-16AEM Currency Valuations Chart I-16BEM Currency Valuations As to the EM fixed-income market, exchange rates are the key driver of their performance. Currencies depreciation causes a selloff in high-yielding local currency bonds and typically leads to credit spread widening. The latter occurs because U.S. dollar debt becomes more difficult to service when the value of local currency declines. Besides, EM currencies usually weaken amid a global trade slowdown and falling commodities prices. The latter two undermine issuers' revenues and their capacity to service debt, warranting wider credit spreads. Ms. Mea: What about equity valuations? Aren't they cheap? Chart I-17EM Equity Multiples Answer: EM stocks are not very cheap. Our composite valuation indicator based on a 20% trimmed mean of trailing and forward P/Es, PBV, price-to-cash earnings and price-to-dividend ratios denotes a slightly attractive valuation (Chart I-17). According to our cyclically-adjusted P/E ratio, EM equities are also moderately cheap (Chart I-18). Chart I-18EM Equities: Cyclically-Adjusted P/E Ratio In short, EM equity valuations are modestly cheap. As with currencies, however, unless valuations are at an extreme (say, one or two-standard deviations from their mean), they may not matter for a while. Barring extreme over- or undervaluation, share prices are typically driven by profit cycles. Importantly, EM corporate earnings are set to decelerate further and probably contract in the first half of 2019 (Chart I-19). If this scenario transpires, share prices will drop further, regardless of valuations. Chart I-19EM Corporate Earnings Are At Risk Ms. Mea: Why don't you write about risks to your view? And, I would like to use this opportunity to ask what are the risks to your view presently? Answer: The basis of why I do not write about the risks to my view is as follows: The risks to a view are often the cases when the key pillars of analysis do not play out. It follows that in these cases, the risks to the view are obvious and there is no need to write about them. To sum up our discussion today, the key pillars of my view are: China's policy stimulus has so far been moderate and the stimulus usually works with a time lag. Additionally, the combination of the regulatory tightening on banks and non-bank financial organizations and the lingering credit and property market excesses in China will generate a growth slowdown that will be longer and deeper than the markets currently expect. The Fed will continue ratcheting up rates as U.S. core inflation is grinding higher. The combination of the above three will produce weaker global growth, a stronger U.S. dollar, and lower commodities prices. All in all, these are bearish for EM risk assets. It is evident that if these themes and assumptions are incorrect, the view will be wrong. Hence, writing that the risks to my view are that my assumptions and themes are mistaken is nothing other than tautology. That said, there are seldom cases when the underlying economic themes and the assumptions are valid, yet the investment recommendations are amiss. These are, in fact, true risks to the view and they are worthy of discussion. Yet, identifying in advance what could go wrong when the analysis and assumption are accurate is very difficult. Presently, I can think of one reason why my investment recommendations could be erroneous even if my economic themes end up being largely valid: It is the shortage of investable assets worldwide relative to capital that is looking to be invested. Quantitative easing programs in the advanced economies have shrunk the size of investable assets. As a result, too much money is chasing too few assets. Consequently, the risk to my view is that EM assets never become sufficiently cheap and that fundamentals do not matter that much. In other words, investors could rush back into EM risk assets despite the poor growth backdrop and not-so-cheap valuations. This is akin to a game of musical chairs where the number of participants is greater than the number of chairs. To complicate things, some chairs are broken, i.e., some assets are of bad quality. As a result, game participants (i.e., investors) are now facing a tough choice between (1) being somewhat prudent and risking being left without a chair; or (2) rushing in and getting either a good chair or a broken chair (depending on luck). Applying this musical chairs analogy, buying EM risk assets at the current juncture is similar to rushing in and hoping to get a good chair. It is a very high-risk bet and success is contingent on luck. In my subjective assessment, there is about a 30% chance that this strategy - buying EM risk now - will be successful with 70% odds favoring being risk averse for the time being. The latter entails staying with a defensive strategy in EM and underweighting/shorting EM versus DM. Ms. Mea: What is your recommended country allocation currently? Answer: In the EM equity space, our overweights are Korea, Thailand, Brazil, Mexico, Colombia, Chile, Russia, and central Europe. Our underweights, on the other hand, are India, Indonesia, the Philippines, Hong Kong, South Africa and Peru. Chart I-20 demonstrates the performance of our fully invested EM equity portfolio versus the EM MSCI benchmark. This portfolio is constructed based on our country recommendations. Hence, it is a measure of alpha that clients could derive from our country calls and geographical equity allocations. Chart I-20EMS's Fully-Invested Model Equity Portfolio Performance This fully invested equity model portfolio has outperformed the MSCI EM equity benchmark by about 65% with very low volatility since its initiation in May 2008. This translates into 500-basis-points of compounded outperformance per year. In the currency space, we continue recommending shorting a basket of the following EM currencies versus the dollar: ZAR, IDR, MYR, KRW and CLP. The full list of our country recommendations for equity, local fixed-income, credit and currency markets are available below. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Special Reports, "Where Are EMs In The Cycle?" dated May 3, 2018 and "Ms. Mea Challenges The EMS View," dated October 19, 2018, available at ems.bcaresearch.com. 2 Please see Emerging Markets Strategy Weekly Report, "Understanding The EM/China Cycles," dated July 19, 2018, available at ems.bcaresearch.com. 3 Please see Emerging Markets Strategy Weekly Report, "EMs Are In A Bear Market," dated October 18, 2018, available at ems.bcaresearch.com. 4 Please see: https://www.bloomberg.com/news/articles/2018-10-21/china-s-195-billion-debt-splurge-has-less-bang-than-you-think 5 Please see Emerging Markets Strategy Weekly Report, "EMs Are In A Bear Market," dated October 25, 2018, available at ems.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Portfolio Strategy Frenzied software M&A activity, the ongoing capex upcycle, firming industry operating metrics and pristine balance sheets suggest that software stocks are a must have for equity portfolios. Rising interest rates along with the Fed's quantitative tightening, the return of volatility, higher gasoline prices, stretched technicals and a lack of a valuation cushion all suggest that it pays to remain bearish consumer discretionary stocks. Recent Changes We lifted the S&P Industrial Conglomerates index to overweight in a Sector Insight on Wednesday last week.1 Table 1 Feature Chart 1Stocks Are... The S&P 500 found its footing last week, but the volatility comeback assures more violent oscillations before equities resume their upward trajectory. Crash-prone October lived up to its reputation but it is now over, and once the midterm election uncertainty passes this week, investors will refocus their attention on the U.S./China trade war and U.S. economic growth. Trump's moderating approach on the former was welcome news last week, and any further de-escalation signs in the trade tussle will breathe a huge sigh of relief for equities. On the investment front, the 10% SPX drawdown triggered our "buy the dip" strategy on Friday October 26 (please see the "Time To Bargain Hunt" Sector Insight), when we put to work longer-term oriented capital. Our "buy the dip" view remains intact, as we still do not foresee a recession in the coming 9-12 months. On the volatility front, the CBOE SKEW index, a measure of tail risk,2 is sending a positive message as investors are no longer buying tail risk protection as they did in August. Interestingly, as the nominal level of the SPX has been increasing over the decades so has the price of tail risk protection (Chart 1). We view the recent collapse in the CBOE SKEW index as a positive indication that the worst may be behind the equity market. With regard to global flows to U.S. shores, the Treasury International Capital (TIC) System data revealed that global portfolio managers were not chasing U.S. equities this summer as they had been at the beginning of the year. The likely current trough in net foreign portfolio flows into U.S. equities should, at the margin, underpin U.S. stocks (Chart 2). Chart 2... Likely Out Of The Woods... On the U.S. economic front, the latest GDP release revealed that housing is indeed softening. This is the first time since the GFC that residential investment's contribution to real GDP growth turned negative for three consecutive quarters. Tack on decelerating house prices and collapsing lumber prices (Chart 3) and residential real estate confirms the yellow flag from our recently introduced Economic Impulse Indicator.3 Chart 3...But Housing Poses A Risk While house prices are decelerating, corporate pricing power remains upbeat. True, investors focused on anecdotes about input cost inflation this earnings season and all but ignored evidence that companies across different sectors have been able, and will continue, to raise selling prices by more than the rise in wage and commodity costs. Thus, corporate profit margin squeeze fears are overblown; they are likely a risk for the back half of 2019, especially if volume growth suffers a setback. This week we are updating our corporate pricing power gauge. While our overall proxy has ticked down, it is still clocking higher than wage inflation. In fact, our pricing power diffusion index shows excellent breadth (second panel, Chart 4). This firming corporate inflation backdrop suggests that businesses have been successful in passing on rising input costs down the supply chain or to the consumer, and thus suggests that investors are mistakenly fretting about a looming profit margin squeeze. Chart 4No Margin Pressures Yet While labor cost inflation is trending higher, wage growth remains contained near 3% despite a multi-decade low in the unemployment rate. According to our wage growth diffusion index, just over half of the 44 industries we track have to contend with rising wages, a visible fall from earlier in the year (middle panel, Chart 4). In addition, the Atlanta Fed Wage Growth Tracker remains tame and the switcher/stayer index recently nosedived to multi-year lows. The switcher/stayer index provides a reliable leading indication for the trend in overall labor expenses (fourth panel, Chart 4). Put differently, corporate pricing power is rising on a broadening basis while leading indicators of wage inflation suggest an easing in wage pressures in the coming months. As a result, there are rising odds that expanding forward operating margin expectations are likely, extending the two year margin expansion phase (bottom panel, Chart 4). Digging deeper into our corporate pricing power update is revealing. Table 2 summarizes the results. As a reminder, we calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. Table 2Industry Group Pricing Power 73% of the industries we cover are lifting selling prices, while another ten industries are experiencing only mild price deflation (less than a 0.6% decline). If we include those ten industries then 90% of sectors are maintaining or raising selling prices. One third of the industries are lifting prices at a faster clip than overall inflation. This is lower than our early-July report. Outright deflating sectors increased by four to sixteen since our last update but only six are deflating at 1% or more. On a slightly negative note, fourteen industries are experiencing a downtrend in selling price inflation, twice as many since our most recent report (Table 2). Deep cyclicals/commodity-related industries continue to dominate the top ranks, occupying the top 7 slots (top panel, Chart 5). Despite the ongoing global export softness, intensifying trade tussle with China and 5% year-to-date appreciation in the trade-weighted U.S. dollar, the commodity complex's ability to increase prices is impressive especially given that the base effects from the late-2015/early-2016 manufacturing recession have filtered out. On the flip side, tech industries dominate the bottom ranks of Table 2. Chart 5Cyclicals Have The Upper Hand In sum, accelerating business sector selling prices will continue to underpin top line growth into 2019. As long as wage inflation rises gradually and does not gallop higher and the corporate sector sustains its pricing power, then profit margins and earnings will remain upbeat. This week we update a high-conviction overweight tech subgroup and reiterate our below benchmark allocation to an early cyclical sector. Software Is In High Demand Despite recent tech stock ills, software stocks continue to defy gravity and remain in a multi-year uptrend, still above the dotcom bubble relative performance highs (top panel, Chart 6). We reiterate our high-conviction overweight status and within tech we continue to prefer the S&P software and S&P tech hardware, storage & peripherals indexes to the early-cyclical tech S&P semis and S&P semi equipment subgroups. Chart 6Software Fever It did not take long for the large CA acquisition to get surpassed by RHT. Inter-industry M&A activity is reaching fever pitch and this frenzy is bidding up premia to stratospheric levels (fourth panel, Chart 6). The push to the cloud, SaaS and even AI has boosted the appeal of software stocks and brought them to the forefront of potential takeout candidates. These are secular trends and will likely continue to gain steam irrespective of the different stages in the business cycle. As a result, software stocks should remain core tech holdings in equity portfolios. Chart 7Capex Gains... Beyond the positive M&A angle that we have been exploring for quite some time in our research, software stocks are particularly levered on capital spending. Chart 7 shows that relative capital outlays and the share price ratio are joined at the hip. Software upgrades offer the simplest, quickest and most effective capital deployment especially when productivity gains ground to a halt. Importantly, leading indicators of overall capex remain upbeat and should continue to underpin software profits (Chart 8). Chart 8...Say Stick With Software Moreover, industry operating metrics are on fire. Top line growth is accelerating and running at a higher clip than the broad market. The recovery in the software price deflator (middle panel, Chart 9), a proxy for industry pricing power, corroborates this bright demand backdrop. Impressively, labor additions have been muted, implying that margins can expand further and possibly challenge cyclical highs (bottom panel, Chart 9). Chart 9Operating Metrics Are Firing On All Cylinders With regard to financial statements, software stocks have pristine balance sheets with more cash on hand than debt, which sustains the net debt-to-EBITDA ratio in negative territory. Interest coverage is great at 10x and free cash flow generation is expanding smartly (Chart 10). Chart 10Pristine Balance Sheets Nevertheless, all of these positives have pushed several valuation metrics to a premium to the broad market and leave little space for any mishaps. On a forward P/E, trailing P/S, and even EV/EBITDA basis, software equities are pricey, but we think for good reason (bottom panel, Chart 10). This rerating phase will likely continue until there is evidence of an end either to the M&A frenzy, or capex upcycle or business cycle. In sum, feverish software M&A activity, the ongoing capex upcycle, firming industry operating metrics and pristine balance sheets, suggest that software stocks are a must have for equity portfolios. Bottom Line: The S&P software index remains a high-conviction overweight. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, INTU, RHT, ADSK, CA, SNPS, CTXS, ANSS, CDNS, FTNT and SYMC. Consumer Discretionary Stocks Are Still A Sell While we remain constructive on financials that benefit from higher rates, we continue to recommend investors avoid the consumer discretionary sector - the other early cyclical - that suffers when interest rates rise. Chart 11 depicts this inverse correlation consumer discretionary equities have with interest rates, especially the fed funds rate. Most discretionary equites are levered off of floating rates and thus any increase in the fed funds rates gets reflected immediately in banks' prime lending rate. Also, most consumer debt is floating rate debt and thus tighter monetary conditions, at the margin, dampen consumer debt uptake and, as a knock-on effect, weigh on discretionary consumer outlays. Chart 11Rising Fed Funds Rates... Last week we highlighted that, now that the Fed has been raising rates and allowing bonds to roll off its balance sheet, volatility is making a comeback. Unsurprisingly, the consumer discretionary share price ratio is inversely correlated with the VIX index, signaling that more pain lies ahead for this early cyclical index (VIX shown inverted, Chart 12). Chart 12...The Volatility Comeback... Money aggregates also corroborate that the time to buy consumer discretionary equities is when the money supply is galloping higher and shed exposure when both M1 and M2 are decelerating as we have shown in previous research. Importantly, the velocity of M2 money stock is inversely correlated with relative share prices and the current message is negative for consumer discretionary stocks as GDP is finally growing faster than M2 money growth (velocity of M2 money stock shown inverted, Chart 13). Chart 13...And Money Velocity Point To More Losses In Consumer Discretionary Not only are higher interest rates anchoring consumer discretionary stocks but rising energy prices are also dealing a blow to this sector. Chart 14 shows our Consumer Drag Indicator (CDI, comprising mortgage rates and energy prices). Historically, our CDI has been an excellent leading indicator of relative share price momentum. Currently, the message is clear: the sinking CDI signals that a bear market in consumer discretionary stocks has likely commenced. Chart 14Heed The Message From The Consumer Drag Indicator Sentiment and technical indicators also point to more downside ahead for this interest-rate sensitive index. Our sector advance/decline line is waning and EPS breadth has plunged (Chart 15). Worrisomely, sell-side analysts are penciling in an extremely optimistic 5-year outlook with EPS growth north of 30%/annum or twice as high as the overall market. Clearly this is not realistic as it assumes a near quadrupling of EPS in the coming 5 years. Chart 15Bad Breadth... In the near-term, analysts are more cautious (bottom panel, Chart 15). Relative EPS estimates have already given way as AMZN commands very little EPS weight, despite its massive market cap weight (30% of the S&P consumer discretionary sector), and suggests that relative share prices will converge lower (top panel, Chart 16). As a result, the 12-month forward P/E ratio is trading at a 27% premium to the broad market and significantly above the historical mean. Technicals are almost as extended as relative valuations and cyclical momentum has likely peaked, warning that a downdraft in relative share prices looms (Chart 16). Chart 16...With Poor Technicals And No Valuation Cushion Adding it up, a rising interest rate backdrop along with the Fed's quantitative tightening, the return of volatility, higher gasoline prices, stretched technicals and a lack of a valuation cushion, all suggest that it pays to remain bearish consumer discretionary stocks. Bottom Line: The path of least resistance is lower for the S&P consumer discretionary index, stay underweight. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Sector Insight, "A Rout For Conglomerates Opens A Buying Opportunity," dated October 31, 2018, available at uses.bcaresearch.com. 2 "The crash of October 1987 sensitized investors to the potential for stock market crashes and forever changed their view of S&P 500® returns. Investors now realize that S&P 500 tail risk - the risk of outlier returns two or more standard deviations below the mean - is significantly greater than under a lognormal distribution. The Cboe SKEW Index ("SKEW") is an index derived from the price of S&P 500 tail risk. Similar to VIX®, the price of S&P 500 tail risk is calculated from the prices of S&P 500 out-of-the-money options. SKEW typically ranges from 100 to 150. A SKEW value of 100 means that the perceived distribution of S&P 500 log-returns is normal, and the probability of outlier returns is therefore negligible. As SKEW rises above 100, the left tail of the S&P 500 distribution acquires more weight, and the probabilities of outlier returns become more significant. One can estimate these probabilities from the value of SKEW. Since an increase in perceived tail risk increases the relative demand for low strike puts, increases in SKEW also correspond to an overall steepening of the curve of implied volatilities, familiar to option traders as the "skew"." Source: CBOE, http://www.cboe.com/products/vix-index-volatility/volatility-indicators/skew 3 Please see BCA U.S. Equity Strategy Weekly Report, "Icarus Moment?" dated October 22, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Special Report

Dear Client, Next week, I am on the road in the Middle East visiting clients and teaching the BCA Academy Principles of Global Macro course. There will be no regular Weekly Report on November 9th. Instead, we will be sending you a Special Report on November 6th written by my colleague Rob Robis, who runs BCA's Global Fixed Income Strategy service. In this piece, Rob will be discussing the outlook for Euro Area monetary policy and its implications for rate markets and the euro. This is an especially relevant topic as the end of the ECB's Asset Purchase Program is scheduled to soon materialize. I trust you will find this report both interesting and informative. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Highlights Uncovered Interest Rate Parity still works for currencies. However, it needs to be based on a combination of short- and long-term real rates. Currencies are also affected by global risk appetite, as approximated by corporate spreads and commodity prices. Based on our timing models, the dollar is now fairly valued on short-term basis. However, slowing global growth and robust U.S. activity suggest that the dollar has room to rally further, with our models pointing to a move in the greenback's favor. These conflicting forces suggest the dollar's easy gains are behind us, and any further dollar rally will prove much more volatile. Feature In July 2016, in a Special Report titled, "In Search Of A Lost Timing Model," we introduced a set of intermediate-term models to complement our long-term fair value models for various currencies.1 These groups of models provide additional discipline - a sanity check if you will - to our regular analysis. Additionally, these models can help global equity investors manage their currency exposure, thanks to their ability to increase the Sharpe ratio of global equity portfolios vis-Ã -vis other hedging strategies, and also for a host of base-currencies.2 In this report, we review the logic underpinning these intermediate-term models and provide commentary on their most recent readings for the G10 currencies vis-Ã -vis the USD. UIP, Revisited The Uncovered Interest Rate Parity (UIP) relationship is at the core of this modeling exercise. This theory suggests that an equilibrium exchange rate is what will make an investor indifferent between holding the bonds of Country A or Country B. This means that as interest rates rise in Country A relative to Country B, the currency of Country B will fall today in order to appreciate in the future. These higher expected returns are what will drive investors to hold the lower-yielding bonds of Country B. There has long been debate as to whether investors should focus on short rates or long rates when looking at exchange rates through the prism of UIP. This debate has regained vigor in the past six months as the dollar has greatly lagged the levels implied by 2-year rate differentials (Chart 1). Research by the Federal Reserve and the IMF suggests that incorporating longer-term rates to UIP models increase their accuracy.3 This informational advantage works whether policy rates are or aren't close to their lower bound.4 Chart 1Interest Rate Parity: Generally Helpful, But... Incorporating long-term rates as an explanatory variable increases the performance of UIP models because exchange rate movements not only reflect current interest rate conditions, but currency market investors also try to anticipate the path of interest rates over many periods. By definition, long-term bonds do just that, as they are based on the expected path of short rates over their maturity - as well as a term premium, which compensates for the uncertain nature of future interest rates. There is another reason why long-term rate differential changes improve the power of UIP models. Since UIP models are based on the concept of indifference among investors between assets in two countries, changes in the spreads between 10-year bonds in these two countries will create more volatility in the currency pair than changes in the spreads between 3-month rates. This is because an equivalent delta in the 10-year spread will have a much greater impact on the relative prices of the bonds than on the short-term paper, courtesy of their much more elevated duration. To compensate for these greater changes in prices, the currency does have to overshoot its long-term PPP to a much greater extent to entice investors trading the long end of the curve. Bottom Line: The interest rate parity relationship still constitutes the bedrock of any shorter-term currency fair value model. However, to increase its accuracy, both long-term and short-term rates should be used. Real Rates Really Count Another perennial question regarding exchange rate determination is whether to use nominal or real rate differentials. At a theoretical level, real rates are what matter. Investors can look through the loss of purchasing power created by inflation. Therefore, exchange rates overshoot around real rate differentials, not nominal ones. On a practical level, there are additional reasons to believe that real rates should matter, especially when trying to explain currency moves beyond a few weeks. Indeed, various surveys and studies on models used by forecasters and traders show that FX professionals use purchasing power parity as well as productivity differential concepts when setting their forex forecasts.5 Indeed, as Chart 2 illustrates, real rate differentials have withstood the test of time as an explanatory variable for exchange rate dynamics, albeit with periods where rate differentials and the currency can deviate from one another. Chart 2Real Rates Work Better Over The Long Run It is true that very often, nominal rate differentials can be used as a shorthand for real rate differentials, as both interest rate gaps tend to move together. However, regularly enough, they do not. In countries with very depressed inflation expectations (Japan immediately comes to mind), nominal and real rate differentials can in fact look very different (Chart 3). With the informational cost of incorporating market-based inflation expectations being very low, we find the shorthand unnecessary when building UIP-based models. Chart 3Real And Nominal Rate Spreads Can Differ Finally, it is important to remark that in environments of high inflation, inflation differentials dominate any other factor when it comes to exchange rate determination. However, the currencies discussed in this report currently are not like Zimbabwe or Latin America in the early 1980s. Bottom Line: When considering an intermediate-term fair value model for exchange rates, investors should focus on real - not nominal - long-term rate differentials. Global Risk Aversion And Commodity Prices Global risk appetite is also a key factor in trying to model exchange rates. Risk-aversion shocks tend to lead to appreciation in the U.S. dollar, which benefits from its status as the global reserve currency.6 Much literature has focused on the use of the VIX as a gauge for global risk appetite. Our exercise shows stronger explanatory power with options-adjusted spreads on junk bonds (Chart 4). Chart 4The Dollar Benefits From Global Stresses Commodity prices, too, play a key role. Historically, commodity prices have displayed a very strong negative correlation with the dollar.7 This correlation is obviously at its strongest for commodity-producing nations, as rising natural resources prices constitute a terms-of-trade shock for them. However, this relationship holds up for the euro as well, something already documented by the European Central Bank.8 The Models The models for each cross rate are built to reflect the insight gleaned above. Each cross is modeled on three variables, with the model computed on a weekly timeframe. Real rates differentials: We use the average of 2-year and 10-year real rates. The rates are deflated using inflation expectations. Global risk appetite approximated by junk OAS. Commodity prices: We use the Bloomberg Continuous Commodity Index. For all countries, the variables are statistically highly significant and of the expected signs. These models help us understand in which direction the fundamentals are pushing the currency. We refer to these as Fundamental Intermediate-Term Models (FITM). We created a second set of models, based on the variables above, which also include a 52-week moving average for each cross. The real rates differentials, junk spreads and commodity prices remain statistically very significant and of the correct sign. They are therefore trend- and risk-appetite adjusted UIP-deviation models. These models are more useful as timing indicators on a three- to nine-month basis, as their error terms revert to zero much faster. We refer to these as Intermediate-Term Timing Models (ITTM). Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com The U.S. Dollar To model the dollar index (DXY), we used two approaches. In the first one, we took all the deviation from fair value for the pairs constituting the index, based on their weights in the DXY. In the second approach, we ran the model specifically for the DXY, using the three variables described above. U.S. real rates were compared to an average of euro area, Japanese, Canadian, British, Swiss and Swedish real rates, weighted by their contribution to the DXY. We then averaged both approaches, which gave us very similar results to begin with. Currently, there is no evident mispricing in the USD, as it trades near fair value when compared to both the FITM (Chart 5) and ITTM. While this means that the easy part of the dollar rally is behind us, it does not imply that the rally is over. As Chart 6 illustrates, periods of dollar strength tend to end when the dollar trades at a 5% premium to the ITTM. This would imply that a move to 102 on the DXY is likely over the coming months. Moreover, the widening interest rate differential between the U.S. and the rest of the world, as well the bout of rising volatility the world is experiencing, should continue to push the fair values of both the FITM and ITTM higher. Chart 5Fundamentals Continue To Help The Dollar Chart 6More Upside Is Possible The Euro As a mirror image to the DXY, there is no evident mispricing in EUR/USD. Currently, based on both the FITM and the ITTM, the euro trades at a small premium to fair value (Chart 7). However, the sell signal generated by the deviation from the ITTM in 2017 is still in place, as periods of overvaluation tend to be followed by periods of undervaluation (Chart 8). This indicator will only generate a buy signal for the euro once EUR/USD falls 5% below equilibrium, or to a level of 1.06. Moreover, this target is a moving one. European growth and inflation continue to disappoint, as the euro area feels the drag of a slowing China and decelerating global growth. This means that interest rate differentials are likely to continue to move in a euro-bearish fashion in the coming months. Hence, the flattening in the FITM that materialized in 2018 is at risk of becoming an outright deterioration. Chart 7Fundamentals For The Euro Are Deteriorating Chart 8EUR/USD Is Not Cheap The Yen In an environment of rising global bond yields, the FITM for the yen continues to trend south, as Japanese rates lag well behind U.S. interest rates (Chart 9). This means the yen is once again trading at a small premium to its FITM, implying that even if global risk assets sell off further, the upside for the yen against the dollar may prove limited. However, the picture for the yen against the ITTM is more benign. The yen is at equilibrium on this basis (Chart 10). However, due to the design of the ITTM, previous periods of overvaluations tend to be followed by periods of undervaluation. As a result, on the basis of this model, the yen could continue to experience downside against the dollar over the coming three to six months. This will be even truer if U.S. bond yields can continue to rise. Chart 9Rate Differentials Continue To Hurt The Yen Chart 10More Downside Ahead If U.S. Yields Keep Rising The British Pound The GBP/USD has deteriorated in recent weeks, a move that was mimicked by cable itself. As a result, the pound does not show any evident mispricing on this basis against the USD (Chart 11). The ITTM corroborates this message, as GBP/USD trades at a marginal 1% discount to this indicator (Chart 12). This upholds our analysis of September 7, which showed there was little risk premium embedded in the pound to compensate investors for the risks associated with the Brexit negotiations and the cloudy British political climate.9 Since British politics remain a minefield, this lack of valuation cushion suggests that the GBP is likely to continue to swing widely. As a result, a strategy to be long volatility in the pound, or to bet on the reversal of both large upside and downside weekly moves in the GBP, remains our preferred approach. Chart 11Cable Is At Equilibrium Chart 12Small Valuation Cushion Could Be Problem If Political Risk Increases The Canadian Dollar Despite the softening evident in the Loonie's FITM, the Canadian dollar continues to trade at a substantial discount to this fair value model (Chart 13). However, the FITM for the CAD is at risk of weakening further as oil prices have begun to be engulfed in the weakness that has gripped EM and risk assets globally. Mitigating this message, on the eve of the announcement of the USMCA trade deal, which essentially kept in place the trade relationships that existed between the U.S. and Canada under NAFTA, the Loonie was trading at a 1.5 sigma discount to the ITTM, a level normally constituting a buy signal (Chart 14). As a result, we expect the Canadian dollar to not be as sensitive to commodity price weakness as would have been the case had the CAD traded at a premium to its ITTM. This is one factor explaining why the Canadian dollar remains one of our favorite currencies outside the USD for the coming three to six months. The second favorable factor for the CAD is that the Bank of Canada is likely to hike interest rates at the same pace as the Fed. Hence, unlike with other currencies, interest rate differentials are unlikely to move against the CAD. Chart 13Loonie Trades At A Big Discount To Fundamentals... Chart 14...Which Will Help The CAD Mitigate A Fall In Oil Prices The Swiss Franc Like the euro, the Swiss franc trades in line with both its FITM and ITTM fair values (Chart 15). Moreover, the CHF has been hovering around its fair value for nearly a year now, which means there is less of a case for an undershoot of the ITTM fair value than for currencies that have experienced recent overshoot (Chart 16). Moreover, if volatility in financial markets remains elevated, and volatility within the bond market picks up, the fair value of the Swissie could experience some upside. However, this is where the positives for the Swiss franc end. The Swiss economy remains mired by underlying deflationary weaknesses, reflecting the lack of Swiss pricing power as well as the tepid growth of Swiss wages. As a result, the interest rate differential components of the models are likely to continue to represent a headwind for the CHF, especially as the Swiss National Bank remains firmly dovish and wants to keep real interest rates at low levels in order to weigh on the franc and also stimulate domestic demand. Based on these bifurcated influences, while we remain negative on the CHF against both the dollar and the euro on a cyclical basis, EUR/CHF may remain under downward pressure over the coming three to six months. Chart 15No Valuation Mismatch... Chart 16...Implies That The CHF Will Be At The Mercy Of Central Banks The Australian Dollar While the Australian dollar continues to trade at a significant premium against long-term models, it now trades at an important discount against both its FITM and ITTM equilibria (Chart 17). However, the problem for the AUD is that the FITM estimates continue to trend lower as Australian interest rates are lagging U.S. rates, especially in real terms. This is a direct consequence of the Reserve Bank of Australia maintaining the cash rate at multi-generational lows, while the Fed keeps hiking its own policy benchmark. With real estate prices sagging in both Melbourne and Sydney, as well as with a lack of wage growth and inflationary pressures, this down-under dichotomy is likely to remain in place and further weigh on the AUD. Meanwhile, while it is true that the AUD is also trading at a discount to its ITTM, historically, the Aussie has bottomed at slightly deeper levels of undervaluation (Chart 18). When all these factors are taken in aggregate, they suggest that for the AUD to fall meaningfully from current levels, we need to see more EM pain, more Chinese economic weaknesses, and commodity prices following these two variables lower. While this remains BCA's central scenario for the coming three to six months, if this scenario does not pan out the AUD could experience a sharp rebound over that timeframe. Chart 17Discount In AUD Emerging... Chart 18...But Not Yet Large Enough The New Zealand Dollar The NZD now trades at an even greater discount to both its FITM and ITTM equilibria than the AUD (Chart 19). In fact, so large is this discount that the ITTM is flashing a buy signal for the kiwi (Chart 20). This further confirms the view that we espoused 3 weeks ago that the NZD was set to rebound. As a result, we remain comfortable with our tactical recommendation of buying NZD/USD and selling GBP/NZD. The long NZD/USD position is definitely the riskier one of the two, as the NZD's upside may be limited if EM markets sell off further. In fact, NZD/USD traded at an even greater discount to its ITTM fair value when EM markets were extremely weak in late 2015 and early 2016. However, EM spreads are narrower and EM equities today trade well above the levels that prevail in those days, implying a margin of safety exists for the NZD. Meanwhile, short GBP/NZD is less likely to be challenged by weak EM asset prices, especially as in a post-Brexit environment the U.K. needs global risk aversion to stay low and global liquidity to remain ample in order to finance its large current account deficit of 3.3% of GDP. Chart 19NZD Is Now So Cheap... Chart 20...That It Is A Buy The Norwegian Krone The Norwegian krone continues to trade at a large discount to its FITM. However, this pair often experiences large and persistent deviations from this model (Chart 21). Nonetheless, it is important to note that as real interest rate differentials between the U.S. and Norway continue to widen, the fundamental drivers of the NOK are set to deteriorate further. By construction, the ITTM has proven to be a more reliable indicator for the Norwegian krone. While the NOK is currently at fair value on this metric, it is concerning that the upward trend in the ITTM has ended and that the equilibrium value for this currency has begun to deteriorate (Chart 22). As such, if oil prices are not able to find a floor at current levels, USD/NOK is likely to experience additional upside. This is because on a three- to six-month basis, there is not enough of a valuation cushion embedded in the NOK at current levels to prevent the Norwegian krone from experiencing deleterious effects in a weak energy price environment. Chart 21The NOK Fundmentals's Are Still Pointing South Chart 22...And The NOK Remains Vulnerable Versus The USD The Swedish Krona The very easy monetary policy conducted by the Riksbank is the key factor explaining why the Swedish krona remains so weak. Indeed, despite a robust economy, Swedish real interest rates are lagging well behind U.S. rates, which is putting strong downward pressure on the SEK's FITM (Chart 23). Meanwhile, despite the SEK's prodigious weakness, this currency only trades at a modest, statistically insignificant discount to its ITTM (Chart 24). This picture suggests that for the SEK to appreciate, the Riksbank needs to become much more aggressive. It is true that the Swedish central bank has flagged an imminent rise in interest rates, but the pace of increase will continue to lag far behind the Fed's own tightening. Moreover, the weakness in global trade is likely to hamper Swedish growth as Sweden is a small, open economy very influenced by gyrations in global industrial activity. As a result, the current slowdown in global trade may well give the Riksbank yet another excuse to only timidly remove monetary accommodation. This suggests that both the FITM and ITTM for the SEK have downward potential. Chart 23The Riskbank Still Hurts The SEK Chart 24...And The Krona Needs To Build A Greater Valuation Cushion 1 Please see Foreign Exchange Strategy / Global Investment Strategy Special Report titled, "Assessing Fair Value In FX Markets", dated February 26, 2016, available at fes.bcaresearch.com and gis.bcaresearch.com 2 Please see Foreign Exchange Strategy / Global Asset Allocation Special Reports titled, "Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors", dated September 29, 2017, and "Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors (Part II)", dated October 13, 2017, available at fes.bcaresearch.com and gaa.bcaresearch.com 3 Ravi Balakrishnan, Stefan Laseen, and Andrea Pescatori, "U.S. Dollar Dynamics: How Important Are Policy Divergence And FX Risk Premiums?" IMF Working Paper No.16/125 (July 2016); and Michael T. Kiley, "Exchange Rates, Monetary Policy Statements, And Uncovered Interest Parity: Before And After The Zero Lower Bound," Finance and Economics Discussion Series 2013-17, Board of Governors of the Federal Reserve System (January 2013). 4 Michael T. Kiley (January 2013). 5 Please see Yin-Wong Cheung and Menzie David Chinn, "Currency Traders and Exchange Rate Dynamics: A Survey of the U.S. Market," CESifo Working Paper Series No. 251 (February 2000); and David Hauner, Jaewoo Lee, and Hajime Takizawa, "In which exchange rate models do forecasters trust?" IMF Working Paper No.11/116 (May 2010) for revealed preference approach based on published forecasts from Consensus Economics. 6 Ravi Balakrishnan, Stefan Laseen, and Andrea Pescatori (July 2016) 7 Ravi Balakrishnan, Stefan Laseen, and Andrea Pescatori (July 2016) 8 Francisco Maeso-Fernandez, Chiara Osbat, and Bernd Schnatz, "Determinants Of The Euro Real Effective Exchange Rate: A BEER/PEER Approach," Working Paper No.85, European Central Bank (November 2001). 9 Please see Foreign Exchange Strategy Special Report, titled "Assesing The Geopolitical Risk Premium In the Pound", dated September 7, 2018, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights After tumbling more than 20% between June and August, copper prices have remained largely static. This reflects the tug-of-war between the near-term bullish physical market fundamentals, and the cloudier macro headwinds ahead, arising from a stronger U.S. dollar. Furthermore, Chinese policymakers are unlikely to abandon their reform agenda and stimulate massively, which will put downside pressure on copper prices further down the road. Despite our negative 12-month outlook, we do not rule out the potential for some upside going into year-end, on the back of falling inventories. Energy: Overweight. News leaked earlier this week indicates the Trump administration is divided over whether to grant waivers on Iranian crude oil imports to big importers like China, India and Turkey, following the re-imposition of sanctions on November 4.1 The U.S. State Department, in particular, appears worried the sanctions will produce a price spike that could derail growth in the U.S. and its allies. This suggests the Administration will be less determined to enforce its Iranian export sanctions, until it has been assured Saudi Arabia and Russia will be able to bring enough production on line in 1H19 to cover the lost Iranian exports, and possible deeper Venezuelan losses. Markets will remain focused on actual export losses from Iran - if they come in at the high end of expectations (i.e., greater than 1.5mm b/d), we expect higher prices; if it becomes apparent the U.S. will go soft on enforcing sanctions, prices would fall. Expect higher volatility. Base Metals: Neutral. Copper prices could rally over the short term, on the back of lower inventories. However, longer term, we see no catalysts to push prices toward recent highs of ~ $3.30/lb on the COMEX. Precious Metals: Neutral. Gold's break above $1,200/oz is holding, but it continues to grind in a $1,210 to $1,240/oz range. Ags/Softs: Underweight. The USDA will report on export sales of grains and oil seeds today. Soybean exports were down 21% y/y for the current crop year, based on the Department's October 18 report. Feature Tight Market Conditions Suggest A Brief Upswing ... After remaining in the $2.90-$3.30/lb trading range for the better part of 1H18, copper prices plunged ~20% since their June peak. The trigger? The escalation of the U.S.-China trade war. The increasingly acrimonious trade relationship acted as a reality check. Investors betting on strike-induced mine supply shortfalls earlier this year were forced to adjust expectations regarding the resilience of the global, and, more specifically, the Chinese business cycles.2 The negative impact of the trade war is clear: copper prices moved to the downside with each escalation in the dispute (Chart of the Week). While current market fundamentals do not necessarily warrant such drastic declines, we see these developments as a wake-up call to market participants. Copper sentiment - previously buoyed by expectations of mine strikes (which failed to materialize) - has come crashing down (Chart 2). Chart of the WeekCopper Down On Trade War Chart 2Sentiment Has Come Crashing Down However, the outlook in the very near term is not so bleak. The evidence below suggests tight physical conditions, indicating copper's next move could be to the upside: Chinese copper imports came in strong in September (Chart 3). While unwrought copper imports reached a 2.5-year high, ores and concentrates forged new record highs. Chart 3Chinese Imports Came In Strong The resilience of Chinese purchases comes on the back of restrictions on scrap imports, which account for a significant share global copper supply (Chart 4). As we have been highlighting, Chinese restrictions on the purity of scrap imports require other forms of the metal to fill the supply gap.3 At the same time, the 25% tariff imposed on Chinese imports of U.S. scrap since August also manifests itself in greater demand for other forms of the metal. This is evident in weak scrap copper imports (Chart 5). Chart 4A Dependable Secondary Market Is Essential For Global Supply Chart 5Scrap Import Restrictions Raise Need For Other Forms Of Copper Copper inventories at the three major global exchange warehouses have been declining steadily and together now stand at half their late April peak (Chart 6). This is their lowest level since late 2016. Chart 6Exchange Inventories At Two Year Low The above evidence of a tight market is in line with copper's futures curve, which is recently pricing a premium for physical delivery (Chart 7). Chart 7Markets Pricing A Premium For Physical Delivery Going into the winter, smelter disruptions may lend further upside support amid these tight conditions: The Vedanta copper smelter in the Indian state of Tamil Nadu was forced to shut down in May due to violent protests. The smelter has an annual production of over 400k MT. In Chile, Codelco gave notice to the market that two of its four smelters will undergo weeks-long outages, in order to comply with tightening of emissions rules - requiring smelters to capture 95% of emissions - due to take effect in December. This will halt production from smelters at the Chuquicamata and Salvador mines for 75 days and 45 days, respectively. Furthermore, in mid-October BHP Billiton reduced its 2018 copper production forecast by 3% to between 1.62mm MT and 1.7mm MT, due to shutdowns at its Olympic Dam facility in Australia and Spence in Chile. Bottom Line: Dynamics at the scrap level in China and disruptions at major smelters in India, Chile and Australia justify tight copper market conditions. This offers potential for a minor rebound in copper prices in the very near term. ... Ahead Of Macro Headwinds In the medium term, macro headwinds will dominate the physical market, capping gains in copper prices. Most notably, fall-out from the U.S.-China trade war in absence of aggressive traditional forms of stimulus, will weigh on demand there. Furthermore, U.S. dollar strength on the back of economic and monetary policy divergences, will make the red metal more expensive for global consumers. Ex-U.S. Growth Unpromising Given the stimulative fiscal policies in the U.S., our House View still does not expect a recession before late-2020. However in the meantime, the global economy will be characterized by divergence in favor of the U.S. (Chart 8). Chart 8Global Economic Divergence Favors U.S. Of utmost importance is, of course, China - where roughly half of global refined copper is consumed. The trade dispute with the U.S. has raised concerns over the resilience of the Chinese economy. Recent data releases have done little to ease fears of a manufacturing slowdown. The Li Keqiang Index and our China construction proxy - both of which are strongly correlated with copper prices - are on a slight downtrend (Chart 9). Chart 9Ominous Signs From China China's 3Q18 GDP data indicate the Chinese economy grew by the slowest pace in nearly a decade (Chart 10). At the same time, PMI's have fallen to or near the 50 level - the boom-bust line - reflecting pessimism in the manufacturing sector. The real estate market - where 45% of China's copper is consumed - also looks gloomy. Home sales rolled over, boding ill for future housing starts. Chart 10Weak Q3 GDP Mirrors Manufacturing And Property Sectors What's more, we are not betting on a flood of stimulus to rescue China's ailing economy. As our colleagues at BCA's Geopolitical Strategy service have been highlighting, the drive to combat vulnerabilities in financial markets raised the pain threshold of Chinese policymakers.4 As such, they are not likely to abandon their reform agenda at the first sign of weakness, as they traditionally have. Although some measures have already been implemented to ease policy, the current response is not yet as promising for commodity markets as has historically been the case. For one, credit growth is constrained by China's de-leveraging campaign. Although there is some evidence that the clampdown on shadow financing is easing, it is not yet at simulative levels (Chart 11). And while the money impulse is rebounding thanks to Reserve Requirement Ratio cuts, the credit impulse is still falling deeper into negative territory. Chart 11Shadow Banking Restrained By Reform Agenda Additionally, as Peter Berezin who heads BCA's Global Investment Strategy highlights, China's more recent forms of (consumption-based) stimulus such as income tax reforms do not boost commodity demand. The same goes for the other way in which Chinese authorities are trying to stabilize their economy: by depreciating the RMB. This is in clear contrast to traditional measures such as fixed asset investment, which stimulate demand for raw materials and capital goods.5 Overall, the current level of stimulus is not sufficient to boost the Chinese economy. Nor, by extension, is it enough to lift EMs, and commodity prices in the process. In fact, copper markets have been oblivious to various announcements by Chinese authorities that they are easing policy (Chart 12). Chart 12Copper Markets Oblivious To Chinese Stimulus Our Geopolitical Strategists warn that the U.S.-China trade war could get worse before it improves. Thus, while policymakers are not yet compelled to throw in the towel with their reform agenda, they are pragmatic and will likely intensify their response if conditions deteriorate further. If authorities were to deploy massively stimulative fiscal and monetary policy by propping up infrastructure and the real estate sector - as they traditionally have done - chances are that we would be able to escape further price weakness in copper markets. For now, the evidence points at a more modest policy approach. Green Dollar, Red Metal As a counter-cyclical currency, the U.S. dollar will shine in the current weaker ex-U.S. growth environment. What's more, limited spare capacity in the U.S. and a strong labor market foreshadow rising U.S. inflation readings. This will justify continued tightening by the Fed. Economic divergences favoring the U.S. economy will amplify the impact. Rising U.S. borrowing costs will be painful for debt-laden EM economies. Their Central Banks will struggle to keep the pace with the Fed. Similarly, the European Central Bank - conscious of turmoil in Italy - will be forced to maintain a more dovish stance. This will weigh down on the EUR/USD. A stronger dollar generally dents demand by making commodities - priced in U.S. dollars - more expensive for foreign consumers. While energy markets dominated by supply risks remain disconnected from their long-term negative correlation with the U.S. dollar, the relationship with metals has re-converged (Chart 13).6 This leaves copper more vulnerable to the downside amid dollar strengthening. The impact will be magnified for Chinese consumers as the RMB weakens further, forcing the top consumer to cut down on imports of the red metal. Chart 13USD-Copper Relationship Re-converged Bottom Line: Headwinds from weakness in China and a stronger dollar will be a drag on demand next year. Unless Chinese policymakers temporarily abandon their reform agenda and stimulate massively, medium term copper prices will face pressures to the downside. Model Updates Given the macro headwinds outlined above, we revised our copper demand forecast. Our balances now point to a slight surplus in 2019 (Chart 14). In the context of 24mm MT of consumption p.a., a 100k MT surplus can be characterized as a balanced market. This makes prices vulnerable to upside or downside surprises, which can easily tip the scale. Chart 14Broadly Balanced Market In line with our market assessment, we simulated forecasts for copper prices based on a 5% and 10% appreciation in the USD over the coming 12 months (Chart 15). Chart 15Macro Headwinds In 2019   Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Reuters published an interesting analysis containing the apparently leaked information re the internal disputes in the Trump administration entitled "Trump's sanctions on Iran tested by oil-thirsty China, India" on October 29, 2018. 2 In the Commodity & Energy Strategy Weekly Report published January 25, 2018, we highlighted the risk to mine supply in 2018 on the back of an unusually large number of labor contract renegotiations taking place this year - representing ~ 5 mm MT worth of mined copper. Most noteworthy was the risk of a strike at the Escondida copper mine in Chile. These have been largely resolved with minimal impact on supply. Please see "Stronger USD, Slower China Growth Threaten Copper," available at ces.bcaresearch.com. 3 Please see BCA Research Commodity & Energy Strategy Weekly Report titled "Copper: A Break Out, Or A Break Down?" dated May 17, 2018. Available at ces.bcaresearch.com. 4 Please see BCA Research Geopolitical Strategy Special Report titled "China Sticks To The Three Battles," dated October 24, 2018. Available at gps.bcaresearch.com. 5 Please see BCA Research Global Investment Strategy Weekly Report "Chinese Stimulus: Not So Stimulating" dated October 26, 2018, available at gis.bcaresearch.com. 6 Please see BCA Research Commodity & Energy Strategy Weekly Report titled "Correlations Vs. USD Weaken," dated June 14, 2018. Available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Highlights Portfolio Strategy Overbought technicals, pricey valuations, decelerating global growth, declining capex, rising indebtedness and softening operating metrics argue for hopping off the S&P railroads index. Rising refined product stocks, ebbing gasoline demand, and excessive analyst profit optimism underscore that more pain lies ahead for refiners. Recent Changes Book profits of 15% in the S&P railroads index and downgrade to neutral today. TABLE 1 FEATURE Equities continue to digest the recent healthy pullback, and should remain range-bound before building a base in order to resume their bull market run. As we highlighted in our October 9thWeekly Report, "stock market crash-prone October is upon us, and thus a pick-up in volatility would not come as a surprise".1 Simply put, the difference between perception and reality propagates as volatility. Volatility has indeed come roaring back. There are high odds that vol will settle at a higher level, and bouts of volatility will be more frequent. The most important determinant of vol is interest rates, as we first highlighted on March 5th this year.2 For almost a decade, the Fed kept the fed funds rate close to zero in order to suppress volatility. QE and excess liquidity injections into the financial system and in the economy also aided in bringing down volatility across assets classes. Now this process is working in reverse. Not only is the Fed tightening monetary policy by increasing the fed funds rate, but it is also allowing maturing bonds to fall off its balance sheet (what some market participants have defined as quantitative tightening). In other words, as the Fed is mopping up excess liquidity, volatility is making a comeback (Chart 1). Chart 1VIX The Comeback Kid A relatively flat yield curve also points to higher volatility in the months ahead. This relationship is intuitive, given that a flat curve signals that the cycle is long in the tooth and a recession may be approaching. While both of these interest rate relationships with vol have a long lead time, the message is clear: investors should get accustomed to higher volatility at this stage of the cycle (yield curve shown on inverted scale, Chart 2). Chart 2Yield Curve And Vol Joined At The Hip Following up from last week, our Economic Impulse Indicator (EII) caught the attention of a number of our clients, igniting a healthy exchange. One criticism is that this Indicator has had some big misses in the past. This is true, but the recent history (since mid-1990s) has enjoyed an extremely high correlation. Importantly, if we show SPX profits as an impulse, the fit with the EII increases considerably (bottom panel, Chart 3). In addition, the EII moves in lockstep with the impulse of S&P 500 momentum (second panel, Chart 3). Chart 3Economic Impulse Yellow Flag Nevertheless, our worry remains intact and the risk of modest economic disappointment sometime early next year is rising (Chart 4). On that front, another indicator that continues to show signs of stress is the credit card chargeoff rate of U.S. commercial banks, excluding the 100 largest outfits. According to the Fed, both delinquencies and chargeoffs are near recessionary levels, a message large banks do not corroborate, at least not yet (Chart 5). Chart 4Economic Growth Trouble Chart 5Watch Credit Quality True, we do not think the consumer is at the cusp of retrenching as a tight labor market and rising wage inflation should boost disposable income, but rising interest rates are a clear headwind. Importantly, the fact that regional banks are sniffing out some credit quality trouble is disconcerting especially given the recent anecdote of commercial real estate (CRE) chargeoffs at Bank OZK, a regional bank that epitomizes the CRE excesses of the current cycle. We will continue to monitor our Indicators for further evidence of deteriorating credit quality. While all these risks are worrisome, and a surge in the U.S. dollar is a key EPS risk for 2019, last Friday we triggered our "buy the dip" strategy for long-term oriented capital that we have been touting recently - as the SPX hit the 10% drawdown mark since the late-September peak - predicated on BCA's view of no recession in the coming 12 months.3 In fact, none of the boxes in the three signposts we track to call the end of the cycle have been checked yet (please refer to last week's report for a recap).4 In addition, the multiple has reset significantly lower (down 20% from the cyclical peak set in January) flirting with the late-2015/early-2016 lows (Chart 6), leaving the onus on EPS to do the heavy lifting. Chart 6Wholesale Liquidation Should Bring Out Bargain Hunters On that front, Q3 earnings season has been solid, despite the input cost inflation worries that MMM and CAT rekindled recently (please look forward to reading next week's pricing power update where we gauge if the U.S. corporate sector will be in a position to pass on input cost inflation down the supply chain or to the consumer). This week we downgrade a transportation sub-group that has been on fire, and update our view on an energy index we continue to dislike. Time To Get Off The Rails We have been riding the rails juggernaut for roughly 16 months, but the time has come to get off board. Chart 7 shows that technical conditions are overbought and relative valuations are pricey, hovering near previous extremes as investors are extrapolating good times far into the future. Such euphoric readings have historically been synonymous with a high relative performance mark for this key transportation sub-index and are a cause for concern. Chart 7Overvalued And Overbought We do not want to overstay our welcome on the S&P rails index for a number of reasons. First, its is quite perplexing why this capital intensive industry has been cutting capex as the rest of the non-financial corporate sector has been growing gross fixed capital formation at near double-digit rates (second panel, Chart 8). Chart 8Capex Blues Adding insult to injury, railroad CEOs have been changing the capital structure of their respective firms by borrowing extensively in order to retire equity (in order to satisfy shareholders) and thus artificially massaging EPS higher. Going through the recent history of the constituents' financial statements is worrying. Net debt-to-EBITDA is up 75% since early-2015 near 2.2x and higher than the overall market, largely driven by rising indebtedness (Chart 8). Taken together, lack of investment and a higher debt burden are painting a grim backdrop, especially if cash flow growth suffers a mishap. Second, the global manufacturing outlook has downshifted on the back of Trump's trade rhetoric and China's larger than anticipated slowdown. Tack on our souring margin proxy and relative EPS euphoria resting mostly on equity retirement is under attack (second panel, Chart 9). Chart 9Warning Signals... Third, two of our key industry Indicators have suddenly turned south. Our Railroad Indicator has dropped into the contraction zone and our Rail Shipment Diffusion Indicator has fallen off a cliff lately (Chart 10). The implication is that rail freight demand is likely on the verge of cresting. Chart 10...Abound... Fourth, industry operating metrics are deteriorating, at the margin. Intermodal rail shipments have rolled over. In fact, toppy consumer confidence alongside decreasing traffic at the Port of Los Angeles signal that the path of least resistance is lower for this key rail freight category, comprising 50% of total carloads (Chart 11). In addition, coal shipments are moribund, despite the recent slingshot recovery in natural gas prices that should have enticed utilities to switch out of nat gas and into coal for electricity generation (not shown). Chart 11...Even In Intermodel... However, there are some positive offsets that prevent us from turning outright bearish on the S&P rails index. This transportation sub group is an oligopoly and is in the driver's seat with regard to pricing power (middle panel, Chart 12). In other words, it has the ability to pass rising diesel costs through to its clients as a fuel surcharge. Alternative modes of transportation like air freight and trucking are available, at least for some rail categories, but the switching costs are typically prohibitive and the relative price advantages few and far between. Chart 12...But There Are Offsets Further, rail pricing power is a key input to our railroad EPS model and the message from our model is that EPS have more upside, at least until Q1/2019. Thus, we refrain from swinging all the way to a below benchmark allocation. Adding it up, overbought technicals, pricey valuations, declining capex rising indebtedness and softening operating metrics argue for hopping off the rails. Bottom Line: Lock in gains of 15% since inception in the S&P rails index and downgrade to neutral. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. Refiners Crack Under Pressure Pure-play refiners remain our sole underweight within the energy space, and despite recent M&A activity, they have trailed the broad market by 9% since the early-July inception. More downside looms, and we continue to recommend a below benchmark allocation in the S&P oil & gas refining & marketing index. We remain puzzled with sell-side analysts' extreme long-term EPS euphoria in this niche energy space. Historically, when an index catapults to a 25%/annum 5-year forward EPS growth rate, it is time to run for cover: the tech sector in the late 1990s, biotech stocks in the early-2000s and in 2014 and, most recently, semi equipment stocks in late-2017 all painfully demonstrate that stocks hit a wall when profit euphoria is so elevated (bottom panel, Chart 13). Chart 13Too Good To Be True Refiners are currently trading at a 45%/annum long-term EPS growth rate. While at first we thought base effects were the culprit, a closer inspection reveals that those effects were filtered out late last year and the recent increase in expected growth rate from 20% to north of 45% defies logic (middle panel, Chart 13). We expect a sharp revision to a rate below the broad market in the coming months, as refining stocks also continue to correct lower. There are a few reasons why we anticipate such a gravitational pull back down to earth. Refined product consumption is falling and that exerts a downward pull on refining profitability. This letdown in demand is materializing at a time when gasoline inventories are rising at a high mid-single digit rate (gasoline inventories shown inverted, bottom panel, Chart 14). Chart 14Bearish Supply Demand Backdrop Not only have light vehicle sales crested, but also vehicle miles driven are flirting with the contraction zone, weighing heavily on gasoline demand prospects (second panel, Chart 15). Chart 15No Valuation Cushion Ultimately, pricing discovery resolves any supply/demand imbalances and most evidence currently points to at least an easing in crack spreads. Chart 16 highlights that crude oil inventories are trailing the buildup in refined products stocks and that is pressuring refining margins. Chart 16Mixed Signals... The implication is that refining industry profits will underwhelm, which will catch investors and analysts by surprise given their near and long-term optimistic EPS assessment. If our weak profit backdrop pans out, then a lack of a valuation cushion suggests that relative share prices will likely suffer a significant drawdown (bottom panel, Chart 15). Nevertheless, there are two related positive offsets. And, if they were to persist then our bearish view on refiners would be offside. The widening Brent-WTI crude oil spread suggests that crack spreads could reverse course if it stays stubbornly elevated. This wide oil price differential has pushed refining net exports close to all-time highs and represents a profit relief valve as the energy space has, up to now, escaped the trade wars unscathed (Chart 17). Chart 17...On Crack Spreads Netting it out, rising refined product stocks, softening gasoline demand, and excessive analyst profit optimism underscore that more pain lies ahead for refiners. Bottom Line: Continue to avoid the S&P oil & gas refining & marketing index. The ticker symbols for the stocks in this index are: BLBG: S5OILR - PSX, VLO, MPC and HFC. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Report, "The "FIT" Market" dated October 9, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Special Report, "Top 10 Reasons We Still Like Banks" dated March 5, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Insight, "Time To Bargain Hunt" dated October 26, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Report, "Icarus Moment?" dated October 22, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights Portfolio Strategy Debt saddled small caps have to wrestle with rising interest rates at a time when they lack a valuation cushion. Tack on their high beta status and investors should continue to avoid small caps and instead prefer large caps. Upbeat global demand for U.S. defense goods, firming defense industry operating metrics and a flurry of M&A will more than offset the defense contractors' valuation overshoot. Stay structurally overweight. Recent Changes There are no changes to the portfolio this week. Table 1 Feature In Greek mythology, Daedalus warned his son Icarus not to fly too close to the sun when the pair of them were escaping from Crete, as his wax-made wings would melt. Icarus ignored his father's warning and soared toward the sun that eventually led to his drowning in the Aegean Sea when his wings melted. Is the equity market experiencing an Icarus moment? The S&P 500 is undergoing a healthy reset during crash-prone October, but post-midterms it should make an attempt to vault to fresh all-time highs into year-end. The selloff in the bond market (largely driven by the real component) most likely caused the consternation in stocks, but our sense is that the backup in yields is reflective and not yet restrictive both for stocks and, most importantly, the economy. In the coming weeks we expect a retest, and hold, of the recent lows before waving the all clear sign. Nevertheless, the latest bout of volatility is a cause for concern especially given that the SPX pullback is not sentiment/technical driven as it was earlier in the year when on January 221 and again on January 292 we cautioned clients that the equity market advance was too good to be true and complacency reigned supreme. As a reminder in late-January, equities looked extremely stretched on a number of sentiment and technical indicators. This was not the case, however, heading into October (Charts 1 & 2), and it raises the question: what are stocks discounting with regard to the economic backdrop? Chart 1Leading Into The Recent Pullback Sentiment And Technicals... Chart 2...Were Not As Extended As In Late-January Our biggest worry is that the 2018 goosing of the economy will soon fall flat as President Trump runs out of firepower to further buoy the economy. In other words, we have likely brought demand/consumption forward which should get reflected in softer 2019 output data, especially if there is gridlock in Congress post the midterms. Keep in mind, that most of the fiscal easing that pertains to stocks is front loaded to this year. The drop in corporate taxes is a one-off EPS boost for 2018, as is the surge in buybacks that was driven by cash repatriation. Buybacks are on pace to reach $1tn in 2018, but are likely to fall back to the more typical $400bn/annum rate next year. The U.S. economy and stock market will have to grapple with both of these fading tailwinds in 2019. One simple way to depict this is our newly conceived BCA Economic Impulse Indicator (EII). Chart 3 shows six economic indicators gauging the state of the U.S. economy. The EII comprises housing, capex, manufacturing, confidence, employment and credit; it is equally weighted shown as a Z-score. At present it is wobbling and diverging negatively from euphoric SPX EPS growth rates. Chart 3 Mind The Gap Not only is the economy humming at an unsustainable pace, but the Fed is also tightening monetary policy and letting maturing securities run off its balance sheet at approximately $50bn/month. If the Fed hikes rates three more times by June 2019, as both the bond market and our fixed income strategists expect, the fed funds rate will reach a range of 2.75%-3%. It then becomes plausible that any letdown in economic data could cause the yield curve to invert. The elimination of the unemployment gap increases the probability of curve inversion (see Chart 1 from the October 23, 2017 Weekly Report), as does another indicator of labor market tightness that recently dropped below zero (Chart 4). Chart 4Full Employment And Yield Curve Joined At The Hip But, we are not there yet and want to be systematic in calling the end of the business cycle, and thus equity bull market, using the three signposts we deemed most important earlier in the year: a yield curve inversion (leading indicator), doubling in year-over-year oil prices based on monthly dataset (coincident indicator) and a mega-merger announcement either in tech or biotech space (confirming anecdotal indicator). With regard to the latter, the rumored Uber IPO fetching a valuation of $120bn may also qualify as an end of cycle anecdotal indicator. Still, none of these three boxes have yet been ticked. Moreover, two other catalysts may assist in prolonging the cycle and breathe a sigh of relief not only in U.S. equities, but also in global bourses: a trade deal with China, and/or a reversal in U.S. dollar strength that would boost global ex-U.S. growth. Netting it all out, while the recent equity market swoon is worrisome it is still too early to call the end of the cycle and we do not think we are in an "Icarus moment". Our broad equity market strategy is to "buy the dip" as we expect EPS to do all the heavy lifting next year with the multiple drifting lower, and we continue to recommend a cyclical over defensive portfolio bent. This week we highlight a deep cyclical capital goods subsector and revisit our size bias. The Bigger The Better The days in the sun are over for small cap stocks. Similar to the double top formation in the early 1980s, small cap stocks have hit a wall and are giving in to their larger brethren. There are high odds that the small over large multi-year ascendancy is over and a reversion, at least, to the historical time trend mean is in order (Chart 5). Chart 5Double Top Since changing our size bias to a large cap bias on May 10, 2018, the S&P 500 has bested the S&P 600 index by over 300bps. Small caps however remain fully valued using different metrics and are extremely overvalued versus the SPX according to the Shiller P/E (or cyclically adjusted P/E, CAPE) methodology of smoothing the earnings cycle over a decade (Chart 6). In fact, this 40% CAPE premium leaves no space for any small cap profit mishaps. Chart 6Small Caps Valuations Are Stretched... Unfortunately, on a number of fronts small cap EPS will underwhelm and significantly trail SPX EPS, the opposite of what optimistic sell-side analysts expect. First, small caps are severely debt saddled as we have highlighted in our recent research. Sustained small cap balance sheet degradation is worrying, with S&P 600 net debt-to-EBITDA close to 4 (compared with 1.5 for the SPX, middle panel, Chart 7). Such gearing is fraught with danger as the default rate has nowhere to go but higher. Chart 7...Amidst Balance Sheet Degradation... Second, small and medium businesses have a higher dependency on bank credit as opposed to the bond market access that mega caps enjoy. Most bank credit is floating rate debt and so are lines of credit, and as the Fed remains firm on tightening monetary policy, interest expense costs are skyrocketing for SMEs. In a relative sense this will weigh on net profits. More generally, given the high indebtedness, small caps are a lot more sensitive to interest rates, and the selloff in the 10-year Treasury note heralds more pain in 2019 (10-year Treasury yield shown inverted, Chart 8). Chart 8 ...And With Rates Rising... Third, relative wage costs are flashing red for small caps. Small cap margins are thin - roughly mid-single digits or 800bps below large caps, and rising labor costs (according to the latest NFIB survey) are warning that this delta will widen, further suppressing relative margins and profitability as large cap wage costs are still well contained (Chart 9). Chart 9...And Labor Costs Perking Up, A Margin Squeeze Looms Fourth, small caps are high(er) beta stocks and when volatility spikes they underperform large caps. When the Fed ballooned its balance sheet and dropped the fed funds rate to zero it suppressed volatility. Now that the Fed has been decreasing the size of its balance sheet and raising interest rates, this is working in reverse and volatility is making a comeback as we have been highlighting in our research, and will continue to weigh on small caps (VIX shown inverted, top panel, Chart 10). Chart 10Large Caps Have The Upper Hand Another way to showcase small caps' riskier status is the close correlation they have with the relative EM equity share price ratio. When EMs outperform the SPX, small caps follow suit and vice versa. Importantly a wide gap has opened recently and we suspect that it will narrow via small caps following the EM higher beta stocks lower (SPX vs. EM ratio shown inverted, bottom panel, Chart 10). Adding it up, a high small cap debt burden, rising interest rates, lack of a valuation cushion, and their high beta status all signal that investors should continue to avoid small caps and instead prefer large caps. Bottom Line: Stick with a large cap bias. Stay With Defense Stocks For The Long-Term We have been overweight the pure-play BCA defense index since late-2015 and there are high odds that this juggernaut that really commenced with the George Walker Bush presidency remains in a secular growth trajectory (top panel, Chart 11). Our strategy is to add exposure on any meaningful pullbacks and keep this index as a structural overweight within the GICS1 S&P industrials index. Chart 11Defense Stocks Are A Secular Growth Play The rise of global "multipolarity" - or competition between the world's great nations - and the decline of globalization, along with a global arms race and increased risk of cyber-attacks, have been documented in our "Brothers In Arms" Special Report. These trends all signal that global defense related spending will remain upbeat in the coming decade.3 In the U.S. in particular, where military spending in absolute terms is greater that the rest of the world put together, defense spending and investment have bottomed and will continue to accelerate. In fact, the CBO continues to project that defense outlays will jump further next year (middle panel, Chart 12). While such a breakneck pace is clearly unsustainable, President Trump is serious about upgrading and updating the U.S. military in order to keep China's geopolitical and military ascendancy in check (as well as to deal with Russia and Iran).4 The upshot is that defense outlays will continue to expand into the 2020s. Chart 12Upbeat Defense Outlays... Such a buoyant demand backdrop is music to the ears of defense contractor CEOs, and represents a boost to defense equity revenue growth prospects. This capital goods sub-industry has extremely high fixed costs and thus any increase in top line growth flows straight to the bottom line. Put differently, defense contractors enjoy high operating leverage. No wonder M&A activity is robust: at least four large deals have been announced in the past year that are underpinning both takeout premia and relative share prices (bottom panel, Chart 13). Chart 13 ...And A Flurry Of M&A Is A Boon For Defense Stocks A closer look at operating metrics corroborates that defense goods manufacturers are firing on all cylinders. New orders recently jumped to fresh all-time highs and the industry's shipments-to-inventories ratio is rising, on track to surpass the 2008 peak. Unfilled orders are also running at a high rate, signaling that factories will keep on humming at least for the next few quarters (Chart 14). Chart 14Firming Operating Metrics Importantly, the industry is not standing still and is making significant investments. U.S. defense capex as reported in the financial statements of constituent firms is growing at roughly 20%/annum or twice as fast as overall capex (Chart 15). Chart 15Industry Is Not Standing Still True, industry indebtedness is also on the rise as some of the expansion has been debt financed, but net debt-to-EBITDA trails the overall market (ex-financials). Similarly, interest coverage has been modestly deteriorating, but is twice as high as the overall market. Impressively, defense ROE is running near 30%, again roughly double the rate of the broad market (Chart 16). Chart 16Healthy B/S With High ROE... Nevertheless, undoubtedly valuations are on the expensive side. Not only is recent M&A fever the culprit, but global investors' insatiable appetite for pure-play defense stocks has also driven valuations into overshoot territory (Chart 17). This is a clear risk to our secular overweight view, however, if our thesis pans out, then these stocks will grow into their pricey valuations as happened in the back half of the 1960s.5 Chart 17 ...But Valuations Are Expensive In sum, upbeat global demand for U.S. defense goods, firming industry operating metrics and a flurry of M&A will more than offset the defense contractors' valuation overshoot. Bottom Line: The secular advance in pure-play defense stocks remains in place. We continue to recommend an above benchmark allocation. The ticker symbols for the stocks in the BCA defense index are: LMT, LLL, NOC, GD and RTN. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Too Good To Be True?" dated January 22, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Corporate Pricing Power Update," dated January 29, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "A Global Show Of Force?" dated October 10, 2018, available at gps.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps