Valuations

We examined emerging market equity valuations as an asset class in Part 1 of this Special Report published on January 24; the link is available on page 18. The conclusions of the report were: That EM stocks are about one standard deviation above their fair value; Compared with DM equities, EM stocks are not cheap - their relative valuations are neutral. This follow-up report looks at individual country valuations to identify valuation opportunities within the EM equity universe. Composite Multiples Indicator (CMI) The Composite Multiples Indicator is an equal-weighted average of the following multiples: Trailing P/E ratio Forward P/E ratio Price-to-cash earnings (PCE) ratio Price-to-book value (PBV) ratio Price-to-dividend ratio. As we have argued for some time, looking at market cap-weighted equity valuation ratios for EM indexes is misleading. The basis is that some large-cap-weighted sectors optically look cheap for distinct reasons - including but not limited to low NPL provisions for banks, poor corporate governance among SOEs and high cyclicality and uncertainty over the outlook for commodities prices for energy and materials companies. Moreover, other segments such as certain technology stocks and private well-run companies command extremely high multiples. Therefore, as in Part 1, we focus on various valuation measures that are not market cap-weighted. Specifically, for each country's available sub-sectors, we calculate the following measures for each of the five multiples referred to above: 20% trimmed-mean ratio - this excludes the top 10% and bottom 10% sub-sectors - i.e., it removes outliers and then calculates an equal-weighted average. Median ratio takes the median value of sub-sectors; Equal-weighted ratio assigns an equal weight to each sub-sector regardless of market cap. Then, we standardize individual aggregates - the 20% trimmed-mean, the median and equal-weighted sub-sector ratios. Based on these three aggregates, we compute a Composite Multiples Indicator (CMI) for each country. Chart I-1 demonstrates the ranking of equity markets according to CMI. Based on these aggregate CMIs, India, Indonesia, the Philippines, Thailand and Chile are the most expensive, while Russia, Turkey, Colombia, Korea and Mexico are the cheapest. Chart I-1Equity Valuation Ranking Based On Multiples EM Equity Valuations (Part II) EM Equity Valuations (Part II) Appendix 1 on page 14 shows the aggregate CMI for the largest EM bourses in absolute terms. Among the above-mentioned five ratios, the most critical one in our opinion is the price-to-cash earnings. MSCI defines cash earnings as earnings per share including depreciation and amortization as reported by the company - i.e. depreciation and amortization expenses are added to calculate cash earnings. While this measure is not pertinent for banks, for non-financial companies it is the best proxy measure of operating cash flow. Hence, cash earnings are a superior measure of earnings power. Notably, when calculating the median, 20% trimmed-mean and equal-weighted ratios for all sub-sectors, the impact of banks is largely eliminated, as banks are just one sub-sector among about 50 others. Table I-1Ranking Based On Price-To-Cash ##br##Earnings Ratio EM Equity Valuations (Part II) EM Equity Valuations (Part II) The point is not that banks are unimportant, but rather that bank valuations should be dealt with separately. We reiterated the importance of banks and their profits in the EM universe and discussed why in certain EM countries banks' reported profits should be taken with a grain of salt in our February 14, 2018 Weekly Report; the link is available on page 18. Banks, somewhat more than other businesses, can substantially manipulate their profits by raising or lowering provisions for bad assets, leaving current multiple levels misleading. Table I-1 shows the ranking based on the average price-to-cash earnings ratio. According to this ranking, the most attractive markets are Poland, Russia, the Czech Republic, Turkey, Hungary and Korea. By contrast, the least attractive are India, Indonesia, the Philippines, South Africa, Brazil and China. A CMI can be thought of as a cyclical valuation measure, while the cyclically adjusted P/E (CAPE) ratio is a structural valuation measure. Investors with time horizons longer than three years should put meaningful weight on CAPE ratios. The latter is, however, not useful for investment horizons that are 12-18 months or less. The CAPE ratio is a structural valuation indicator because it derives the secular trend in corporate earnings and computes the P/E ratio based on the latter. Hence, the cyclical earnings trajectory is ignored. In contrast, CMIs do not incorporate such an adjustment. Hence, they can be considered as a cyclical valuation measure. By combining cyclical (CMI) and structural (CAPE) valuation measures, we produced Chart I-2. It plots each country's CAPE ratio on the X axis and CMI on the Y axis. According to these metrics, Russia, Turkey, Korea, Colombia and Mexico are cheap. On the flip side, India, Thailand, the Philippines and Indonesia are expensive. Chart I-2Cyclical Versus Structural Valuation Ratios EM Equity Valuations (Part II) EM Equity Valuations (Part II) Adjusting Multiples For Local Interest Rates Equity multiples differ across countries because of a variety of factors. One of the most crucial factors defining the equilibrium of equity multiples are domestic nominal interest rates. Chart I-3 plots local currency government bonds on the X axis and the latest values for CMI on the Y axis. As expected, there is a loose inverse relationship between bond yields and equity multiples: lower bond yields are typically consistent with relatively higher multiples, and vice versa. Chart I-3Composite Multiples & Local Interest Rates EM Equity Valuations (Part II) EM Equity Valuations (Part II) The bourses that falls outside the main cluster can be regarded as being out of equilibrium valuation. The markets that fall into the left-bottom corner of the chart are relatively cheap. These include Russia, Korea, Taiwan, Central Europe, Malaysia, Colombia and Mexico. On the other end of the spectrum, India, Indonesia, the Philippines, Brazil and South Africa stand out as expensive. As we argued above, the price-to-cash earnings ratio is somewhat superior to other multiples. This is why another useful matrix to consider is the comparison of the average price-to-cash earnings ratio with nominal local bond yields, as shown in Chart I-4. According to these metrics, central European bourses are among the cheapest. Russia, Korea, Taiwan, Thailand and Malaysia are also attractive. Chart I-4Price-To-Cash EPS & Local Interest Rates EM Equity Valuations (Part II) EM Equity Valuations (Part II) Finally, taking into account both price-to-cash earnings ratios and nominal domestic bond yields, the most expensive equity markets are India, Indonesia, the Philippines, South Africa and Brazil. Investment Conclusions Valuation of any asset class is an art rather than science. Having examined various cyclical and structural equity valuation measures and having incorporated local interest rates, we can draw the following conclusions: Chart I-5EMS's Fully-Invested Equity Portfolio ##br##Performance Versus The Benchmark EMS's Fully-Invested Equity Portfolio Performance Versus The Benchmark EMS's Fully-Invested Equity Portfolio Performance Versus The Benchmark Within the EM equity universe, Russia, central Europe and Korea stand out as the cheapest. There is also relative value in Turkey, Colombia and Mexico. India, Indonesia and Philippines are the most expensive markets. South Africa and Brazil are still somewhat expensive. Neutral valuations prevail in China, Taiwan, Peru and Chile. In China, the cheapness of banks is offset by elevated valuations of technology/new economy stocks. Our recommended country allocation within EM equities takes into consideration not only valuations but also many other parameters such as cyclical and structural outlooks for each economy, macro policies, banking system health, politics, currency and interest rate trends and other factors that we have visibility on. As such, we might recommend underweighting some markets that may look cheap, and overweighting others that appear expensive because of factors other than valuation. Our current overweights are Taiwan, Korean technology, Russia, central Europe, India, Thailand and Chile. Our underweights are Turkey, Malaysia, Brazil, South Africa and Peru. We are neutral on China, non-tech Korea, Mexico, the Philippines, Colombia and Indonesia. Finally, Chart I-5 illustrates that our fully invested EM equity model portfolio has outperformed the EM benchmark by 57% since its initiation in May 2008. This translate into 450 basis points of compounded outperformance per year. More importantly, such outperformance has been achieved with very low volatility. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com Indonesia: Weighing The Pros And Cons Chart II-1Indonesian Stock Prices: ##br##Relative & Absolute Indonesian Stock Prices: Relative & Absolute Indonesian Stock Prices: Relative & Absolute Indonesian stocks have underperformed the emerging market (EM) equity benchmark considerably since early 2016, and may well be approaching the final stages of underperformance. Yet the jury is still out on the timing of a potential reversal (Chart II-1, top panel). In absolute U.S. dollar terms, Indonesian share prices are flirting with their previous highs, which will likely become a major resistance level (Chart II-1, bottom panel). Banks hold the key for this bourse, as they account for 40% of the MSCI Indonesia index and 27% of the Jakarta Composite Index. Their earnings also make up 48% of the MSCI index's total earnings. Indonesian bank share prices have rallied significantly in the past two years, but the underpinnings of this advance are questionable for reasons we elaborate on below. Cyclical Vulnerabilities... Indonesia's macro vulnerability arises from two sources: balance of payment (BoP) dynamics and banking system health. We will review the nation's BoP vulnerability only briefly, as we have frequently discussed the outlook for commodities prices, the U.S. dollar and fund flows to EM in our weekly reports. In short, we expect Chinese growth to decelerate meaningfully this year, which will likely cause commodities prices to fall significantly (Chart II-2). Falling commodities prices will in turn create headwinds for Indonesia. Notably, commodities account for around 35% of Indonesia's total exports. Chart II-3 further illustrates that changes in Indonesia's trade balance have historically been correlated with swings in its equity market. Chart II-2Indonesia's Coal Exports ##br##To China And Coal Prices Indonesia's Coal Exports To China And Coal Prices Indonesia's Coal Exports To China And Coal Prices Chart II-3Trade Balance Is ##br##A Threat To Share Prices Trade Balance Is A Threat To Share Prices Trade Balance Is A Threat To Share Prices We now explore the vulnerability of Indonesian bank stocks in greater detail. Banks: Dubious Profit Recovery While earnings of listed Indonesian banks have rebounded, this recovery is of poor quality and is likely unsustainable. This, along with banks' elevated equity valuations, make the outlook for their share prices negative. The top panel of Chart II-4 shows that banks' net interest income - a measure of a bank's ability to grow organically - has declined. This has occurred because bank loan growth has been sluggish and net interest margins have narrowed (Chart II-4, middle and bottom panel). Yet, banks have reported dramatic acceleration in profit growth in the past six months. This has been achieved through the lowering of non-performing loan (NPL) provisions (Chart II-5). Chart II-4Strong Bank Earnings: ##br##Not From Organic Growth... Strong Bank Earnings: Not From Organic Growth... Strong Bank Earnings: Not From Organic Growth... Chart II-5...But From Lowering Provisions ...But From Lowering Provisions ...But From Lowering Provisions Lowering provisions to boost profits is an unsustainable strategy for Indonesian banks, in our opinion. Chart II-6 shows that NPLs are too low when one considers the steep rise in leverage that has occurred since 2010. Chart II-6Private Credit Has Risen A Lot ##br##Since 2010, Yet NPLs Are Still Low Private Credit Has Risen A Lot Since 2010, Yet NPLs Are Still Low Private Credit Has Risen A Lot Since 2010, Yet NPLs Are Still Low Indonesian banks have benefited meaningfully from the rally in commodities prices in the past two years. Higher resource prices have not only slowed the formation of new NPLs but have also made some old NPLs current. However, if our negative view on commodities prices plays out, these loans may become non-performing again. Further, Indonesian commercial banks were also aided by the financial authority's (OJK) decision to relax credit restructuring rules in August 2015. This relaxation allowed banks to restructure some of the troubled loans on their balance sheets in a more favorable manner, allowing them to reduce provisions. The temporary relaxation expired in August 2017, and banks now have to revert to the previous and more rigorous methods of accounting for troubled loans. Altogether, the above developments will cause NPLs and provisions to rise anew. Importantly, the sum of NPLs and special-mention loans1 (SMLs) for Indonesia's largest seven banks stand at 6.6% (2.7% NPL + 3.9% SMLs). Taking India's experience as a roadmap for Indonesia, SMLs will ultimately become non-performing, and the workout of NPLs and SMLs could drag on for years. For example, the ratio of NPLs and stressed loans in India has now reached 12.2% of total loans for the whole banking system. We also believe Indonesian banks are under-provisioned. Provisions for bad loans at Indonesia's seven largest commercial banks stand at only 3.8% of total loans. In comparison, the sum of NPLs and SMLs makes up a 6.6% share of total loans. Odds are that Indonesian commercial banks will soon be forced to raise provisions, which will materially hit their profit growth. Chart II-7 shows that if banks in Indonesia were to raise provisions by 35% in 2018 - which would take them back to early 2017 levels - then banks' annual operating profit growth would drop from 21% to zero. This is a major threat to bank share prices.2 Chart II-7As Banks' NPL Provisions Rise, ##br##Bank Stocks Could Fall As Banks' NPL Provisions Rise, Bank Stocks Could Fall As Banks' NPL Provisions Rise, Bank Stocks Could Fall Furthermore, having rallied significantly in the past two years or so, Indonesian commercial banks' valuations are elevated. The price-to-book value (PBV) for the nation's banks that are included in the MSCI equity index stands at 2.8. Bottom Line: The recent profit recovery for Indonesia's commercial banks is unsustainable, and primarily driven by opportunistic reductions in provisions. ...But Room To Pursue Accommodative Policies Despite the cyclical challenges facing the Indonesian economy and banks, the authorities have accrued enough firepower that allows them to pursue counter-cyclical policies. First, Indonesia's central bank, Bank Indonesia (BI), used strong global growth and robust trade as an opportunity to accumulate foreign exchange reserves. This has provided BI with significant ability to defend the rupiah as and when it comes under depreciation pressure from slowing exports growth and potential capital outflows. Notably, BI has bought foreign exchange reserves more rapidly than the central banks of other vulnerable economies such as South Africa, Malaysia, Turkey and Brazil (Chart II-8). As a result, the rupiah has not appreciated at all in the past 12 months, and has lagged other EM currencies. We consider this a positive sign as there will be less downside risk if the external environment worsens and EM exchange rates depreciate. Second, the Ministry of Finance has curbed government spending in the past two to three years (Chart II-9) at a time when strong global growth and rising commodities prices have been supporting Indonesia's overall growth. Chart II-8Bank Indonesia's Foreign ##br##Reserves Accumulation Bank Indonesia's Foreign Reserves Accumulation Bank Indonesia's Foreign Reserves Accumulation Chart II-9Government Has Been Prudent Indonesia's Government Has Been Prudent Indonesia's Government Has Been Prudent Consequently, the government's deposits at both the central bank and commercial banks have been rising rapidly (Chart II-10). This will allow the government to increase its expenditures without resorting to new borrowing. Because of these counter-cyclical policies, especially tight fiscal policy, the domestic demand recovery has been very muted (Chart II-11). On the flip side, and going forward, if the government raises expenditures, Indonesian domestic demand will be relatively resilient - even as and when commodities prices fall. Low inflation will also allow the authorities to stimulate when needed. Chart II-10Government Has Substantial Firepower Government Has Substantial Firepower Government Has Substantial Firepower Chart II-11Domestic Demand Recovery Has Been Muted Domestic Demand Recovery Has Been Muted Domestic Demand Recovery Has Been Muted On the whole, counter-cyclical monetary and fiscal policies will offset some of the potential external shocks that will emanate from slowing Chinese growth and falling commodities prices. This is positive for Indonesia's relative stock market performance going forward. Investment Conclusions For now, we recommend maintaining a neutral allocation to Indonesian equities. One or a combination of the following will likely lead us to upgrade this bourse to overweight: First, as and when the initial phase of commodities price declines transpires, and commodities currencies depreciate. This is a primary risk, and we will be more comfortable upgrading Indonesia if this scenario partially plays out. Second, Indonesia's relative performance vis-à-vis EM appears to be inversely related to the relative performance of Chinese stocks against that same benchmark (Chart II-12). It is hard to find scientific or even intuitive arguments behind this relationship, but it seems that portfolio flows have been rotating between Chinese and Indonesian bourses. Chart II-12Investors Rotating Between Chinese ##br##And ASEAN/Indonesian Equities Investors Rotating Between Chinese And ASEAN/Indonesian Equities Investors Rotating Between Chinese And ASEAN/Indonesian Equities Given this relationship, we would be looking for Chinese stocks to begin underperforming and equity flows rotating to Indonesia to feel confident in the potential reversal of the latter's underperformance. In short, we will be looking at the market's momentum as confirmation of our view before upgrading this bourse. Last week we reviewed our recommended allocation to EM local bonds and advocated a neutral position in Indonesian domestic bonds. This strategy remains intact. Prudent macro policies will act to offset a potential external shock to the Indonesian currency and local bonds. Indonesian sovereign credit also warrants a neutral allocation at present, with a possible upgrade on potential spread-widening. For currency traders, we continue to recommend a long PLN / short IDR trade. This is a bet on rising inflation and interest rates in central Europe on the one hand, and a negative view on commodities and fund flows to EMs on the other. As a part of our strategy of betting on depreciation in EM/commodities currencies, we are also maintaining our short IDR/long U.S. dollar position. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Special mention loans (SML) are stressed loans that are not yet non-performing. 2 Notably, annual provision growth averaged 40% between 2015 and 2016 when banks were facing declining commodities prices and rising NPLs. Appendix 1: Composite Multiples Indicators Chart III-1, Chart III-2, Chart III-3, Chart III-4 Chart III-1 CHART 1 CHART 1 Chart III-2 CHART 2 CHART 2 Chart III-3 CHART 3 CHART 3 Chart III-4 CHART 4 CHART 4 Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Dear Client, I am travelling this week meeting clients in Asia, so this report has been written by my colleagues, Billy Zicheng Huang and Sophie McGrath. Greece, the epicentre of the euro debt crisis, is finally recovering. Declining net NPLs, an upturn in investor confidence and improving employment are encouraging. But there is a risk that growth will lose some momentum amid the country's exit from the third economic adjustment program. Hence, we are recommending a neutral weighting in the Greek equity market as a whole comprising four overweight ideas counterbalanced by four underweight ideas. We expect companies with essential product focus, low debt levels and strong asset health to outperform non-essential product providers, highly leveraged players and weak asset-quality counterparts. Dhaval Joshi Best Overweight And Underweight Ideas Table I-1Single-Stock Statistics On Select Greek Companies* Greece: Investment Opportunities Are Emerging Greece: Investment Opportunities Are Emerging Greece: The Long Road To Recovery Macro indicators in Greece have improved and investors have become more confident. This is highlighted by the recent upgrade of Greece's long-term sovereign credit rating to B and an oversubscribed seven-year bond sale, confirming high investor demand. Nevertheless, there is a risk that growth will lose some momentum amid the country's exit from the third economic adjustment program. Listing the improvements, economic sentiment is approaching previous peaks (Chart I-1), the unemployment rate has dropped to its lowest level since 2011 (Chart I-2) and the youth unemployment rate has fallen around 20 percentage points from its high (Chart I-3). Chart I-1Economic Sentiment Has Improved Economic Sentiment Has Improved Economic Sentiment Has Improved Chart I-2Unemployment Is Down... Unemployment Is Down... Unemployment Is Down... Chart I-3...Youth Unemployment Even More So ...Youth Unemployment Even More So ...Youth Unemployment Even More So Furthermore, the most intense headwinds from fiscal drag are over. In the depths of the debt crisis, fiscal drag reached 7% of annual GDP. While Greece is not set to receive a sustained fiscal 'thrust' in the medium term, it appears the worst is over on the austerity front (Chart I-4). The most promising indicator is competitiveness. Greece appears to have made the necessary adjustments to unit labor costs and is no longer a euro area outlier (Chart I-5). Chart I-4Peak Fiscal Drag##br## Is Over Peak Fiscal Drag Is Over Peak Fiscal Drag Is Over Chart I-5Unit Labour Costs Are Now In Line ##br##With Euro Area Counterparts Unit Labour Costs Are Now In Line With Euro Area Counterparts Unit Labour Costs Are Now In Line With Euro Area Counterparts Recent developments in the banking system are also encouraging. Bank liquidity has improved, and the use of ECB Emergency Liquidity Assistance (ELA) has significantly diminished (Chart I-6). Net NPLs have declined sharply and are now covered by bank equity capital (Chart I-7). An unprecedented legal foundation is now in place to address the NPL stockpile. These measures include the introduction of electronic auctions to recover claims, the simplification of the out-of-court settlement process and reducing the liability of individuals involved. If net NPLs continue to fall, we can expect a healthier banking sector to support the economy, as witnessed in Spain, Ireland, and more recently in Italy. Chart I-6Banks Are No Longer Reliant ##br##On Emergency Funding Banks Are No Longer Reliant On Emergency Funding Banks Are No Longer Reliant On Emergency Funding Chart I-7Bank Equity Capital Finally ##br##Exceeds Net NPLs Bank Equity Capital Finally Exceeds Net NPLs Bank Equity Capital Finally Exceeds Net NPLs Despite these encouraging signs, the consumption recovery is fragile as households continue to delever (Chart I-8). Additionally, retail sales have dipped again recently (Chart I-9). Chart I-8Households Continue To Delever Households Continue To Delever Households Continue To Delever Chart I-9Retail Sales Have Dipped Retail Sales Have Dipped Retail Sales Have Dipped Regarding the bailout exit and debt sustainability, markets have seemingly priced in the wrapping up of the third review later this year, with the Eurogroup meeting on January 22 having recorded progress. However, what is more uncertain is whether this will take the form of a 'clean' or 'dirty' exit. The level of post-bailout monitoring that is agreed upon will ultimately dictate the pace of Greece's return to capital market normalcy. Considering the uncertainties in the overall picture, we recommend a market neutral portfolio in Greece with an overall beta of 0.15, consisting of four overweight companies versus four underweight counterparts from the consumer discretionary, telecoms, real estate, banking, consumer staples and energy sectors (Table I-2). Through our selection process we focused on companies with better growth profiles in essential sectors of the Greek economy. Table I-2Select Companies And 12-Month Beta Vs. MSCI EM Greece: Investment Opportunities Are Emerging Greece: Investment Opportunities Are Emerging Sector Specifics/Dynamics Our overweight (OW) basket performance over the past three years has been exceptionally strong relative to the underweight (UW) names. The OW basket has outperformed by 59% (Chart I-10A). However, this was primarily due to a selloff in Piraeus Bank (UW) in the second half of 2015. On a short-term horizon we see a different picture. Looking at one-year performance, the OW basket has actually just closed the underperformance gap over the past two months (Chart I-10B). Chart I-10AThree-Year Performance: ##br##Overweight Vs. Underweight Basket Three-Year Performance: Overweight Vs. Underweight Basket Three-Year Performance: Overweight Vs. Underweight Basket Chart I-10BOne-Year Performance: ##br##Overweight Vs. Underweight Basket One-Year Performance: Overweight Vs. Underweight Basket One-Year Performance: Overweight Vs. Underweight Basket Valuations favor the OW basket, especially from the second half of 2017 on, when OW and UW share prices began to diverge. Compared to historical valuations, OW names are currently trading close to their three-year average P/E, while their UW counterparts are trading at one standard deviation above historical P/E (Chart I-11A, Chart I-11B, and Chart I-11C). Chart I-11AOW Basket Displays Appealing Valuations##br## Relative To UW Basket... OW Basket Displays Appealing Valuations Relative To UW Basket... OW Basket Displays Appealing Valuations Relative To UW Basket... Chart I-11B...And Its Own ##br##Historical Average... ...And Its Own Historical Average... ...And Its Own Historical Average... Chart I-11C...While UW Basket Is Trading One Standard##br## Deviation Above Mean ...While UW Basket Is Trading One Standard Deviation Above Mean ...While UW Basket Is Trading One Standard Deviation Above Mean Non-bank OW companies display stronger operating margin dynamics, despite a recent dip, while the OW bank demonstrates superior net interest margins. Both margin trends are translating into solid profitability (Chart I-12A and Chart I-12B). Chart I-12ARobust Operational Level Performance... Robust Operational Level Performance... Robust Operational Level Performance... Chart I-12B...Feeds Into Solid Profitability ...Feeds Into Solid Profitability ...Feeds Into Solid Profitability Additionally, the OW basket displays more favorable debt dynamics, with debt remaining at low levels and trending down, whereas the debt ratio in the UW basket is already at an elevated level and continues to climb (Chart I-13). Meanwhile, free cash flow yield has favored UW players since mid-2016 when banks are excluded (Chart I-14). Chart I-13Debt Levels Remain ##br##Low In OW Companies Debt Levels Remain Low In OW Companies Debt Levels Remain Low In OW Companies Chart I-14Free Cash Flow Yield Favors ##br##UW Non-bank Names Free Cash Flow Yield Favors UW Non-bank Names Free Cash Flow Yield Favors UW Non-bank Names Specifically for banks, Alpha Bank (OW) enjoys a much healthier asset quality profile compared to Piraeus Bank (UW), with a combination of a lower NPL ratio and a higher tier-1 ratio (Chart I-15). Please also note that EPS growth is not shown as we normally do in our reports due to abrupt volatility in both baskets, which prevents us from drawing comparative conclusions. Dividend yield is also omitted due to the fact that most companies we have selected do not pay dividends. Chart I-15Alpha Bank Illustrates Healthier Asset Quality Alpha Bank Illustrates Healthier Asset Quality Alpha Bank Illustrates Healthier Asset Quality The Overweight Basket Jumbo (BELA GA) Greece: Investment Opportunities Are Emerging Greece: Investment Opportunities Are Emerging Jumbo (BELA GA) (Chart I-16) Chart I-16Performance Since February 2017: ##br##Jumbo Vs. MSCI EM Performance Since February 2017: Jumbo Vs. MSCI EM Performance Since February 2017: Jumbo Vs. MSCI EM Jumbo reported financial results for the fiscal 2017 year on October 12. Revenue increased by 7% year over year. Despite a difficult year in Greece, sales were compensated largely by organic growth in Romania and Bulgaria, with one new store open in each country respectively. EBITDA grew by 6% year over year, on the back of an effective cost management effort, while EBITDA margin remained virtually flat at 25.2%. As a result, the bottom line expanded by 8% year over year, with profit margin up 20 basis points to 19.2% Jumbo is currently trading at a forward P/E of 15.5x, while the market is forecasting an EPS CAGR of 6.3% over the next three years. The company is expected to continue its strong expansion drive in Eastern Europe, with one more store open in Romania in November 2017 (the 9th store) and one more store to be open next year in Bulgaria. At the same time, a drop in unemployment and a pick-up in household consumption will help Jumbo's recovery in the Greek market, signaling upside potential for the share price. Hellenic Telecom (HTO GA) Greece: Investment Opportunities Are Emerging Greece: Investment Opportunities Are Emerging Hellenic Telecom (HTO GA) (Chart I-17) Chart I-17Performance Since February 2017: ##br##Hellenic Telecom Vs. MSCI EM Performance Since February 2017: Hellenic Telecom Vs. MSCI EM Performance Since February 2017: Hellenic Telecom Vs. MSCI EM Hellenic Telecom (OTE) reported full-year 2017 results on February 22. Revenues declined slightly year over year by 1.3% to €3857 million, dragged down mainly by mobile operations in Albania, where revenues declined by 11.8%. Mobile operations in Romania remained positive, aided by a strong fourth-quarter performance which saw revenues increase by 14.4% year over year. Revenue growth in Greece remained solid in both mobile and fixed line, increasing by 0.7% and 1% year over year respectively. EBITDA shrank by 1.3% year over year, while EBITDA margin remained flat at 33.8%. As a result of muted top line growth on an annual basis as well as elevated operating costs, the bottom line contracted by 20% year over year, in line with market expectations. Hellenic Telecom is currently trading at a forward P/E of 86x, while the market is forecasting an EPS CAGR of 6.9% over the next three years. Management guidance indicates that free cash flow (FCF) and adjusted capex will start to return to normal levels in 2018 after heavy investments in both its fixed and mobile network capabilities in 2017. Additionally, growing confidence in the company's outlook is signalled by its announcement of a new shareholder return policy, where 100% of the FCF will be distributed through a combination of a dividend payout and share buybacks. We expect that its recent investment in mobile and fixed capabilities and an improving Greek economy should drive a positive performance in 2018. Grivalia Properties (GRIV GA) Greece: Investment Opportunities Are Emerging Greece: Investment Opportunities Are Emerging Grivalia Properties (GRIV GA) (Chart I-18) Chart I-18Performance Since February 2017: ##br##Grivalia Properties Vs. MSCI EM Performance Since February 2017: Grivalia Properties Vs. MSCI EM Performance Since February 2017: Grivalia Properties Vs. MSCI EM Grivalia Properties reported stellar full-year 2017 financial results on January 31. The top line displayed solid results, with rental income advancing 7% year over year. Furthermore, the company realized a strong net gain of EUR18.8 million from fair value adjustments on investment property, compared to a EUR13.6 million loss in 2016. This was mainly driven by new property investments. As a result, operating profit surged by 102% year over year. All this translated into 139% year-over-year net income growth. Due to loan growth, the loan-to-value ratio grew by 8 percentage points to 14%, while NAV per share expanded by 5% year over year. Grivalia Properties is trading at a forward P/E of 15x, while the market is forecasting an EPS contraction of 1% over the next three years. The company announced in February the acquisition of office space in Maroussi, which has already been leased out to multinational companies. Two more properties were acquired in Greece in the same month. We believe a stabilizing property market leaves ample room for recovery, which is expected to support Grivalia's overweight Greek real estate portfolio and its risk diversification. Alpha Bank (APLHA GA) Greece: Investment Opportunities Are Emerging Greece: Investment Opportunities Are Emerging Alpha Bank (APLHA GA) (Chart I-19) Chart I-19Performance Since February 2017: ##br##Alpha Bank Vs. MSCI EM Performance Since February 2017: Alpha Bank Vs. MSCI EM Performance Since February 2017: Alpha Bank Vs. MSCI EM Alpha Bank reported solid third-quarter 2017 financial results on November 30. Net interest income improved by 2% year over year, with net interest margin growing 20 basis points to 2.9%. However, on a quarter-over-quarter basis, growth was negative. Fee income depicted a similar picture, up 2% year over year but down 7% quarter over quarter. On the positive side, operating expenses were under control, declining by 3% year over year, effectively pushing down the cost/income ratio. With the help of a decline in impairment losses, net income surged by 386% year over year. Asset quality showed a pattern of recovery: The NPL ratio went down by 7.4 percentage points to 33.2% year over year, while the tier-1 ratio improved by 1 percentage point to 17.8%. Moreover, ELA has trended down year to date. The market is forecasting an EPS CAGR of 53.6% over the next three years. Despite uncertainty regarding stress testing and the overall trajectory of Greek economic growth, Alpha Bank has demonstrated a solid pace of recovery in terms of a better asset-liability mix, improved liquidity and steady disengagement with the ELA. As guided by management, ELA funding is expected to be further replaced by strong deposit inflows, deleveraging initiatives and an increase in interbank lending. The Underweight Basket Intralot (INLOT GA) Greece: Investment Opportunities Are Emerging Greece: Investment Opportunities Are Emerging Intralot (INLOT GA) (Chart I-20) Chart I-20Performance Since February 2017:##br## Intralot Vs. MSCI EM Performance Since February 2017: Intralot Vs. MSCI EM Performance Since February 2017: Intralot Vs. MSCI EM Intralot reported mixed third-quarter financial results on November 27. Top-line growth was solid, up 10% year over year, mainly boosted by licensed operations in Jamaica, Azerbaijan and Poland. This also drove up gross margin by 2.8 percentage points to 18.1% year over year. However, a cost hike took a bite out of profits, with operating expenses expanding by 8%. Along with a 49% surge in R&D costs, the bottom line was still in negative territory. On a year-to-date basis, cash flow grew by 23%. However, this was mainly boosted by financing activities, with operating cash flow almost unchanged. Meanwhile, long-term debt has grown by over 50% year over year, which has prompted questions on solvency and the ability to further carry the interest payment burden. The market is forecasting negative EPS over the next three years. We believe the 80% share sale of the company's Peruvian operations reflects its need for cash inflow and raises concerns on balance sheet health. Coca-Cola HBC (EEE GA) Greece: Investment Opportunities Are Emerging Greece: Investment Opportunities Are Emerging Coca-Cola HBC (EEE GA) (Chart I-21) Chart I-21Performance Since February 2017:##br## Coca-Cola HBC Vs. MSCI EM Performance Since February 2017: Coca-Cola HBC Vs. MSCI EM Performance Since February 2017: Coca-Cola HBC Vs. MSCI EM Coca-Cola HBC reported solid full-year 2017 financial results on February 14. Revenues came in strong, growing by 5% year over year. Sales volume in developed markets, developing markets and emerging markets went up 1%, 7%, and 7% respectively. Looking at product lines, Sparkling was the best seller, driven by new flavor launches (such as lime, lemon, and cucumber). Stripping out foreign exchange effects, FX-neutral revenue grew by 6% year over year. Cost of sales ticked up by 4% year over year. EBITDA expanded by 10% year over year, while EBITDA margin added 60 basis points to 14.3%. As a result, the bottom line expanded by 24% year over year, beating market expectations. Coca-Cola HBC is currently trading at a forward P/E of 20x, while the market is forecasting an EPS CAGR of 11% over the next three years. The stock price rallied in the second half of 2017 following the company's announcement that it was acquiring 54.5% of Coca-Cola Beverages Africa (CCBA), indicating market complacency toward a strong synergy effect the deal could bring. However, given its weak profitability, CCBA is not expected to be as accretive as many investors believe. With the acquisition news priced in, CCHBC's year-to-date stock price has begun reverting to its true fundamentals. Hellenic Petroleum (ELPE GA) Greece: Investment Opportunities Are Emerging Greece: Investment Opportunities Are Emerging Hellenic Petroleum (ELPE GA) (Chart I-22) Chart I-22Performance Since February 2017:##br## Hellenic Petroleum Vs. MSCI EM Performance Since February 2017: Hellenic Petroleum Vs. MSCI EM Performance Since February 2017: Hellenic Petroleum Vs. MSCI EM Hellenic Petroleum reported full-year 2017 financial results on February 22. Revenue increased by 21% year over year, driven by higher volumes (exports +12% and +14% in domestic net sales, mainly helped by aviation and bunkering) in the refining division and improved average selling prices. However, this result was offset by higher cost of sales, up 23% year over year, driven by increased input prices, sending gross margin 160 basis points lower to 13.6%. Operating income was 4.7% higher year over year, helped by lower operating expenses. EBITDA was up 14% year over year, while EBITDA margin was 200 basis points lower, finishing at 10.6%. The company secured bottom line growth of 15.7%, but came in below the market expectation by 4.5%. Hellenic Petroleum is currently trading at a forward P/E of 6.5x, while the market is forecasting an EPS CAGR of 4.6% over the next three years. The reopening of the Elefsina refinery will enable Hellenic Petroleum to return to normal capacity in 2018. However, continued maintenance work expected to end in March 2018 and higher crude prices will continue to place pressure on margins. We expect weak domestic demand to continue to impact carbon revenue, despite strong sales growth from increased tourism. Piraeus Bank (TPEIR GA) Greece: Investment Opportunities Are Emerging Greece: Investment Opportunities Are Emerging Piraeus Bank (TPEIR GA) (Chart I-23) Chart I-23Performance Since February 2017: ##br##Piraeus Bank Vs. MSCI EM Performance Since February 2017: Piraeus Bank Vs. MSCI EM Performance Since February 2017: Piraeus Bank Vs. MSCI EM Piraeus Bank delivered disappointing third-quarter 2017 financial results on November 9. Net interest income came in weak, sliding 3% year over year, with net interest margin remaining virtually flat at 2.7%. On the positive side, net fee income displayed strong growth, up 24% year over year. Operating expenses contracted by 5% year over year, pushing down the cost/income ratio by 5 percentage points to 51%. Despite robust pre-provisional income, the impairment on loans dragged down net income into negative territory, compared to a positive bottom line during the same period last year. Asset quality was a mixed bag: The NPL ratio went down by 2.6 percentage points to 48.3%, but is still the highest among its peers. The loan-to-deposit ratio declined, with ELA loan exposure trending slightly down year-to-date. The market is forecasting an EPS contraction of 8.8% over the next three years. Piraeus Bank has shown little signs of operational recovery, with most cost-savings efforts achieved through branch reductions (-8% year to date) and employee layoffs (-7% year to date). We believe the bank is still a long way away from a real turning point and prefer to monitor on the sidelines. How To Trade? The EMES team recommends gaining exposure to the sector through a basket of the listed stocks below, which would consist of overweight positions in four select Greek companies and underweight positions in the other four. The main goal is active alpha generation by excluding laggards and including out-of-benchmark plays, to avoid passive index-hugging via an ETF. Direct: Equity access through the tickers (Bloomberg): Jumbo (BELA GA) vs. Intralot (INLOT GA) Hellenic Telecom (HTO GA) vs. Coca-Cola HBC (EEE GA) Grivalia Properties (GRIV GA) vs. Hellenic Petroleum (ELPE GA) Alpha Bank (ALPHA GA) vs. Piraeus Bank (TPEIR GA) ETFs: There are no ETFs that would allow for an overweight/underweight position in the same sector. Funds: There are no funds that would allow for an overweight/underweight position in the same sector. Please note this trade recommendation is strategic and based on an overweight/underweight pair trade. We do not see a need for specific market timing for this call (for technical indicators please refer to our website link). For convenience, the performance of both market cap-weighted and equal-weighted equity baskets will be tracked (please see upcoming updates as well as the website link to follow performance). Risks To Our Investment Case Because of the overall market neutral exposure, the portfolio performance will be largely immune to the direction of Greek economic growth and political developments. Some macro risk factors stem from a slower-than-expected property market recovery, which would affect the rental income of Grivalia Properties. Other major macro risks include an oil price drop, which would benefit Hellenic Petroleum's profit margins within its refining operations. Also, a slow recovery of consumer sentiment and retail sales would put downward pressure on Jumbo's domestic top-line performance. Company specific risks worth mentioning include remarkable management efforts in CCBA's financial performance in the coming quarters. This would send the market a bullish signal on Coca-Cola HBC's stock price due to potentially strong synergies, posing upside risk to the underweight basket. Furthermore, Jumbo would be negatively affected by excessive focus on overseas markets, and thus it could miss further business development and market share expansion opportunities in the domestic market. Last but not least, asset quality remains problematic among banks, reflected by elevated NPLs, which would weigh on performance indefinitely if not properly tackled. Billy Zicheng Huang, Research Analyst billyh@bcaresearch.com Sophie McGrath, Research Assistant sophiemc@bcaresearch.co.uk

Highlights While internet retail moved to the mainstream more than a decade ago, it continues to capture the lion's share of retail growth and investors' imaginations along with it. Further, the philosophy of "profits don't matter" in pursuit of explosive growth has been replaced with more sustainable models and a convergence between bricks and mortar and online retail margins looks to be in the offing. Still, despite a market full of eye-watering valuations, the S&P internet retail index stands out as expensive; expectations appear to have overreached. Netting it out, superior growth and profit outlook have been priced in and a cautious approach is warranted. We are initiating coverage with a neutral rating. Feature Going Mainstream... A new type of story emerged last year and subsequently repeated itself a number of times: Amazon would express interest in a new segment and the existing traditional competitors would see fairly frightening share price pull backs. In Chart 1, we show the reactions of Walmart, Kroger and Costco to the acquisition of Whole Foods (top panel), Home Depot and Lowes to the announcement of a Kenmore licensing agreement (middle panel) and UPS and FedEx to the announcement that Amazon was examining creating its own last-mile logistics system (bottom panel). More examples have come this year, following Amazon's entrance into healthcare insurance and medical supply. Such is the heft of internet retailing. In fact, the meteoric rise of internet retail, particularly Amazon and Walmart, combined with the gig and sharing economies facilitated by companies like Airbnb and Uber, have been frequently blamed for the persistently low inflation of the past two years, despite a tight labor market and a roaring global economy. BCA's flagship publication, The Bank Credit Analyst, examined this last year but found scant evidence to support this assertion. Rather, BCA noted that e-commerce affects only a small part of the Consumer Price Index. Goods represent 40% of the CPI basket and, with approximately 8% of U.S. retail sales going online, the deflationary impact of online shopping is limited to just over 3% of CPI. Further, the authors note that the cost advantages for online sellers have been perennially overstated as the information technology, distribution centers, shipping, and returns processing required offset most of the advantage of not operating a brick-and-mortar retail space. Were online retailers truly deflationary, it should present itself in traditional retail's margins; as shown in Chart 2, no evidence exists of any sustainable negative impact from the rise of e-commerce. Chart 1The Amazon##br## Curse The Amazon Curse The Amazon Curse Chart 2E-Commerce Has Failed To##br## Dent Traditional Retail's Margins E-Commerce Has Failed To Dent Traditional Retail's Margins E-Commerce Has Failed To Dent Traditional Retail's Margins Still, the increasing penetration of the internet into the home should have the effect of broadening the online product portfolio, with consumer staples taking a greater share. This transition should largely be demographic in nature as millennials, who grew up shopping online are increasingly domesticated. Technology too should facilitate the change, aided by the rapid adoption into the home of smart speakers (Amazon Echo, Google Home, Apple HomePod, etc.) that, at least in the case of Amazon's offering, make ordering household items as simple as calling out into the ether. Similarly, the proliferation of smartphones is another assist to internet retail sales grabbing a larger slice of the overall retail sales pie. ...Doesn't Mean Selling Out Rather than remaining the domain of discounters, the intangible benefits of convenience and comparison information and tangible benefits including transportation and time expenses should mean that internet retail should be able to command greater pricing power than physical peers. Further, internet retailers enjoy significant advantages in scalability, both from a capital deployment and operating cost perspective. Adding it up, we expect an eventual margin convergence between traditional and online retailing as greater adoption, increasing online sales of consumer staples and demographics drive internet retail growth in excess of traditional retail for the foreseeable future. Early signs in the mature North America market support this assertion, as the representative giants of traditional and online retail, Walmart and Amazon, respectively, have seen their margin gaps closing (Chart 3). Chart 3North America Retail Operating Margins Internet Retail: Dialed Up Internet Retail: Dialed Up 'Not Cheap' Is An Understatement While internet retail remains a good news story, skyrocketing valuations mean that much of this good news is already reflected in the index. After a solid Q4 with positive revenue guidance, punctuated by a modest stumble in Walmart's competing online offering, BCA's S&P internet retail Valuation Indicator has risen more than two standard deviations above its mean (Chart 4). Chart 4Expensive By Any Measure Expensive By Any Measure Expensive By Any Measure In this context, it is difficult to make a case that the current levels make a compelling entry point. Rather, extremely high relative valuations could point to extended investor complacency in a niche sector; when complacency turns to anxiety, relative declines are likely to be amplified. Amazon Dominates We think a more granular approach to an analysis of the S&P internet retail index is appropriate. Further, some additional context is required; S&P Dow Jones Indices and MSCI have announced a shift of Netflix out of the internet retail index in September of this year and into a newly-renamed Communications Services sector. With that in mind, for all practical purposes the index is made up of Amazon and three travel-related stocks, Priceline (soon to be renamed Booking Holdings), Expedia and TripAdvisor. Accordingly, this is how we intend to analyze the group. It is also worth noting that Amazon's heft dominates both the S&P internet retail index and the GICS1 S&P consumer discretionary index, where it holds a 70% and 20% weighting, respectively. When the above-noted change is made the index (which also includes other consumer discretionary heavyweights like Comcast and Disney), these weights will be significantly magnified, further reducing the respective diversification of these indexes. A Role Reversal For David And Goliath As far as internet retailers go, Amazon is a relative dinosaur, dating back to 1995. It has since grown from a small online book retailer then to a global behemoth offering hundreds of millions of products. These products now include Amazon-developed and manufactured products, including the Kindle, Fire TV and previously mentioned Echo. The company's international and domestic segments comprise the retail consumer products operations of Amazon, which is the dominant revenue generator, the most visible part of the business and hence, the prevailing valuation driver (Chart 5). These segments include the commissions and related fulfillment and shipping fees charged to third-party sellers that now comprise roughly 20% of retail sales. Chart 5Sales Drive Amazon's Valuation But Not Profits Sales Drive Amazon's Valuation But Not Profits Sales Drive Amazon's Valuation But Not Profits Amazon Web Services (AWS) is the lesser known third segment of the Amazon empire, offering online compute and storage services to other businesses. While still relatively small (10% of 2017 sales), AWS is the fastest growing segment, averaging 50% increases in sales over the past two years. Further, the segment is by far the most profitable, yielding more operating profit than the other two segments individually and combined. Despite its incredible brand strength, Amazon remains a relatively misunderstood firm. As an example, Amazon bulls frequently quote a number of press reports stating that Amazon outspends any other company in the S&P 500 on research & development. In fact, Amazon does not disclose their R&D expense; they disclose a line item that includes R&D but also includes AWS' operating expenses, which add up to about half of that number. Further, and perhaps because of the goodwill that Amazon carries with its customers, little is made of regulatory risks to Amazon's business. However, considering the clear antipathy between Jeff Bezos, Amazon's CEO and owner of the Washington Post, and Donald Trump, nothing seems off the table. As an example, Trump tweeted that low rates charged by the U.S. Postal Service (USPS) were "making Amazon richer and the Post Office dumber and poorer". With the power to appoint the rate-setting governors of the USPS, it is not unreasonable to think that a spiteful president could impact the retailer's cost structure. Perhaps more relevant is Amazon's size. A recent report claimed that Amazon had 43.5% of U.S. e-commerce sales, larger than every other public online retailer's share combined. Considering that share grew from 38% in 2016, the trajectory suggests that Department of Justice (notably headed by a Trump surrogate, Attorney General Jeff Sessions) may be casting a wary eye, particularly in the context of domestic e-commerce sales growth that continues to vastly outpace overall retail sales growth (Chart 6). Despite these potential headwinds, the market has pushed Amazon's valuation beyond a 50% premium to the S&P 500's overall valuation (Chart 7) while at the same time making the firm one of the most valuable in the world. Chart 6E-Commerce Takes More Of The Retail Pie... E-Commerce Takes More Of The Retail Pie... E-Commerce Takes More Of The Retail Pie... Chart 7Let By Its Behemoth Let By Its Behemoth Let By Its Behemoth The recent market euphoria has only accelerated the already-high expectations for Amazon's share price, pushing it to heady levels not seen since the early 2000's. With our memories of how that story finished still relatively fresh in our minds, we think this has amplified Amazon's risk profile, causing us to take a fairly cautious stance, underpinning our overall neutral recommendation on the S&P internet retail index. Travel Has Been Fully Democratized Much like their significantly larger cap S&P internet retail peer, the travel companies (Priceline, TripAdvisor and Expedia) have been accused of being price deflators, though on a significantly narrower scale. The democratization of the travel industry, for which they are largely responsible, and the clarity of pricing and quality it has brought have mostly rendered obsolete the traditional sales force, the travel agent. Further, airlines and hotel operators have had to compete on price to a degree previously unseen, forcing a tightening of margins across both industries (Chart 8, top panel). However, declining airfares and room prices have brought a commensurate increase in travelers, which has spurred capacity increases in both industries (Chart 8, bottom panel). Chart 8Airline & Hotelier Price Declines##br## Are Offset By New Capacity Airline & Hotelier Price Declines Are Offset By New Capacity Airline & Hotelier Price Declines Are Offset By New Capacity United Airlines, for example, recently provided capacity growth guidance of 4-6% per year until 2020. Odds are other airlines will match this capacity rather than cede market share, implying more supply to travelers and cheaper prices; the airlines' loss is internet travel retail's gain (as a reminder, we remain underweight the S&P airlines index). However, as with Amazon, the internet travel stocks (particularly Priceline, by far the largest component stock) have seen significant inflation in their valuations. This makes us doubly cautious; elevated multiples should amplify a downfall in a shock scenario and these stocks are heavily exposed to a sector that is prone to shocks. Adding it up, we believe an approach at least as cautious as that for Amazon is warranted, considering the significantly greater exogenous shock risk. This further supports our neutral stance on the S&P internet retail index. Stay On The Sidelines One of BCA's themes for 2018 is higher interest rates, with our bond strategists still expecting an inflation-driven rise in the 10-year Treasury yield to 3.25% this year. With the Fed poised to increase rates at least three times this year, combined with its balance sheet unwinding, monetary conditions look set to tighten considerably. This underlies our style preference favoring value stocks over growth.1 With consumer discretionary stocks in general and internet retail in particular meeting the definition of growth stocks, we are naturally biased to a negative view for the S&P internet retail index. Tack on the aforementioned unsustainably high valuations and our negative view is confirmed. However, we believe the earnings growth trajectory for internet retail stocks, in the absence of an economic downturn, should outpace the broad market. With no recession on the horizon, we are hard pressed to find a catalyst to take the wind out of the index's sails. Bottom Line: We initiate coverage of the S&P internet retail index with a neutral weight. The ticker symbols for the stocks this index are: AMZN, NFLX, PCLN (changing to BKNG, effective February 27, 2018), EXPE, TRIP. Chris Bowes, Associate Editor chrisb@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.

Highlights The combined U.S. current account and fiscal deficits are set to rise as Trump's profligacy and higher interest rates kick in. In and of itself, this does not spell doom for the dollar. The Fed's response to the twin deficit is what will ultimately set the path for the greenback. Stimulus hitting an economy at full employment raises the likelihood that the Fed will not stand idly by. The dollar's momentum is not deteriorating anymore, global growth could hit a soft patch, and U.S. hedged yields might regain some composure versus European hedged yields. These factors are likely to precipitate a dollar rebound. The durability of this rebound remains an unknown. An opportunity to go short EUR/SEK has emerged. Feature When it comes to the U.S. dollar, the story of the day has become the twin deficits. It is now presented as the key factor that will drag the dollar lower over the course of the cycle. We do agree there are plenty of reasons to be concerned with the long-term outlook for the dollar. However, we remain unconvinced whether the twin deficits really are the much-vaunted "boogey man" that will haunt the greenback. In fact, we would argue that while they are a handicap for the dollar, the role of the Federal Reserve, global growth and hedging costs take precedence over the evil twins. The Twin Deficit Will Widen We take no offence with the assertion that the twin deficits are set to increase. According to the work of Mark McClellan, who writes The Bank Credit Analyst, the U.S. fiscal deficit is set to increase to 5.5% of GDP over the course of the next two years. U.S. President Donald Trump's tax cuts and the recent spending agreement will undeniably contribute to this.1 The current account deficit is also set to widen. Chart I-1 shows our estimate for the path of the current account. We anticipate it to move to -3.4% of GDP by late 2018 or early 2019. This is a noteworthy deterioration, but one that only brings the U.S. current account to a level last experienced in 2009. One contributor is obviously the trade balance. The Bank Credit Analyst estimates that the impact of the combined fiscal measures announced will reach 0.3% of GDP in 2018. The biggest source of deterioration will not come from trade: it will come from a fall in the net primary income balance of the U.S., which currently stands at 1.1% of GDP. Essentially, higher interest rates in the U.S. means that foreigners will receive greater income from the U.S. Based on the current level of the median long-term interest rate forecasts by the FOMC's participants, my colleague Ryan Swift estimates that a move in 10-year Treasury yields to 3.5% is likely by year end.2 Based on our estimate, this will push down the primary income balance to 0.4% of GDP. It is important to acknowledge that this forecast for the current account is likely to prove to be a worst-case scenario. To begin with, the trade balance could continue to be buffeted by the fact that U.S. energy production keeps expanding, which is slowly but surely moving the U.S. toward a positive energy trade balance (Chart I-2). Moreover, periods of weakness in the USD have been followed by improvements in the U.S. primary income balance. This is because while payments made by the U.S. to foreigners are mostly in the form of interest, 55% of U.S. income receipts are earnings on FDIs. If we add dividends received on foreign equity holdings, this share rises to 80% of U.S. gross primary income. Thus, if the dollar weakens, U.S. receipts benefit from a translation effect as corporations convert their foreign earnings back into U.S. dollars at more beneficial exchange rates. Chart I-1Higher U.S. Rates ##br##Will Hurt The Current Account Higher U.S. Rates Will Hurt The Current Account Higher U.S. Rates Will Hurt The Current Account Chart I-2U.S. Shale Oil Production Will Prevent Too Great A Deterioration In The Trade Balance U.S. Shale Oil Production Will Prevent Too Great A Deterioration In The Trade Balance U.S. Shale Oil Production Will Prevent Too Great A Deterioration In The Trade Balance But do twin deficits even matter? We would argue, it depends. Bottom Line: The U.S. twin deficits are set to increase. The U.S. fiscal deficit will move to 5.5% of GDP and the current account to -3.4% of GDP as interest owed to foreigners is set to increase. Twin Deficit, So What? It is one thing to anticipate a widening of the twin deficits, but does history suggest that twin deficits have an impact on the dollar? Here, the empirical evidence is rather mixed. As Chart I-3 illustrates, there has been no obvious link between twin deficits and the dollar. In fact, Arthur Budaghyan highlighted in BCA's Emerging Market Strategy service the following phases:3 1970s: no discernable relationship; First half of the 1980s: Substantial widening of twin deficits, but a massive dollar bull market materialized; 1985 to 1993: no reliable relationship between twin deficits and the dollar; 1994 to 2001: The dollar did rally as twin deficits narrowed on the back of the fiscal balance moving from roughly -4% of GDP to 2% of GDP; 2001 to 2011: dollar weakened as twin deficits grew deeper; 2011 to 2016: When twin deficits narrowed considerably, the dollar was stable, but when they stopped improving, the dollar rallied 25%. Chart I-3In My Time Of Dying? No Stable Relationship Between U.S. Twin Deficits And Dollar In My Time Of Dying? No Stable Relationship Between U.S. Twin Deficits And Dollar In My Time Of Dying? Let us focus on the growing twin deficits episodes. As it turns out, the missing link between twin deficits and the dollar is Fed policy. A widening in twin deficits is normally associated with a strong economy. Profligate government spending can boost domestic demand, and because imports have a high elasticity to domestic demand, a widening current account also tends to come alongside robust growth. The Volcker Fed played a high-wire act from 1979 to 1982, plunging the U.S. into a vicious double-dip recession in order to bring realized and expected inflation back to earth after the 1970s. Volcker was not about to let former President Ronald Reagan's stimulus boost growth to the point of lifting inflation expectations again, undoing all the Fed's previous good work. He elected to increase real rates sharply, which was the key factor behind the dollar's strength. The 2001 to 2011 experience needs to be broken down in parts. From 2001 to 2003, the twin deficits were expanding thanks to former President George Bush's wars and tax cuts. Yet the Fed did not play the same counterweight as it did in the mid-1980s. Instead, it kept cutting rates all the way until 2003 as then-Chairman Alan Greenspan was worried about deflation. U.S. real rates did not experience the necessary lift required to fight the negative impact of the twin deficits on the dollar. From 2003 to 2007, the twin deficits were in fact narrowing, real rates were trendless and the dollar was experiencing mild depreciation. During that time frame, global growth was extremely robust, China was growing at a double-digit pace and EM economies were booming. Money was flowing toward these destinations. From 2007 to mid-2008, while the twin deficits continued to narrow, the dollar plunged. The sharp fall in real rates as the Fed engaged in aggressive rate cutting explains this apparent inconsistency. From the second half of 2008 to 2009, the dollar surged, despite a further widening of the twin deficits. Real rates rebounded as inflation expectations melted, and risk aversion prompted investors to seek the safety of the global reserve asset and the global reserve currency - Treasurys and the greenback, respectively. From 2009 to the middle of 2011, the twin deficits stabilized, real rates stabilized, and the dollar stabilized as well, but nonetheless experienced wild gyrations as the global economy kept experiencing aftershocks from the great financial crisis. Neither the twin deficits nor real rates were offering a clear path forward, thus the dollar was also mixed. Bottom Line: A close look at various episodes of twin deficits in the U.S. pushes us toward one conclusion: if twin deficits are expanding but the Fed is trying to tighten policy and real rates are rising, the dollar ignores the twin deficits and, in fact, manages to rise. If, however, the twin deficits expand, and real rates do not experience enough upside to counterbalance this development, the dollar weakens. This means one thing for the coming years: Forecasting twin deficits is not sufficient to predict a dollar bear market. Instead, we also need a view on the Fed and the outlook for real rates. So Where Will The Dollar Go In 2018? We expect there could be some upward pressure on the Fed's dots as the year progresses. The reason is rather straightforward. The U.S. economy will receive a very large shot in the arm this year and next. Mark's calculations show that the fiscal thrust in 2018 and 2019 will morph from -0.4% of GDP to 0.8% of GDP, and from 0.3% of GDP to 1.3% of GDP, respectively (Chart I-4). While currently the fiscal thrust is expected to become a large negative in 2020, that year is an election year. There is a non-trivial probability that the fiscal cliff anticipated that year may in fact be postponed: it is not in the interest of the Republicans or Democrats to be blamed for a slowing economy in a year where Americans are hitting the voting booths! This stimulus is not happening in a vacuum either: it is materializing in an environment where the labor market seems to be at full employment, where capacity utilization is tight, and where financial conditions remain easy (Chart I-5). Stimulating when the economy is at full capacity is likely to lift prices more than it will boost real economic activity. The Fed is fully aware of this risk. Chart I-4Much Stimulus ##br##In The Pipeline Twin Deficits: Bearish Or Not, The Fed Holds The Trump Card Twin Deficits: Bearish Or Not, The Fed Holds The Trump Card Chart I-5Could Fiscal Stimulus Be Inflationary With This Backdrop?##br## We Think So Could Fiscal Stimulus Be Inflationary With This Backdrop? We Think So Could Fiscal Stimulus Be Inflationary With This Backdrop? We Think So However, it remains possible that the Fed will err on the side of caution and wait until the impact of the stimulus measures on the economy become more evident before sending a more hawkish message to the markets. Chart I-6Twin Deficits Narratives ##br##Look Like Ex-Post Explanations Because The Narrative Is Scary Twin Deficits Narratives Look Like Ex-Post Explanations Because The Narrative Is Scary Twin Deficits Narratives Look Like Ex-Post Explanations If the Fed elects to be proactive and adjusts its message regarding the future path of policy before the impact of the stimulus becomes evident, the dollar could rise as it would put upward pressure on U.S. real rates. If, however, the Fed elects to be reactive and wait until the economy responds to the stimulus package with higher wage growth and inflation, then the dollar could weaken as real rates experience little upside and the twin deficits exact their toll. BCA is currently conducting research to assess which path is more likely. In the meanwhile, there other factors to consider. First, as we highlighted three weeks ago, since 2011, spikes in the number of mentions of the twin deficits in media have historically been associated with temporary rebounds in the dollar following periods of USD weakness (Chart I-6).4 The twin deficits seem to come to the forefront of investors' minds as an ex-post explanation for previous weak-dollar periods. Second, our dollar capitulation index is not only at oversold levels, but the indicator has formed a positive divergence with the trade-weighted dollar's exchange rate (Chart I-7). Technically, this increases the probability of a meaningful rebound in the USD. Chart I-7A Positive Technical Development For The Greenback A Positive Technical Development For The Greenback A Positive Technical Development For The Greenback Third, global growth is showing signs of weakening. We have already highlighted that rollovers in the performance of EM carry trades such as the one we have been experiencing for a few months now have been very reliable leading indicators of activity slowdowns over the past 20 years.5 Korea exports are also ebbing. As Chart I-8 illustrates, when Korean exports weaken, this tends to be associated with weakness in highly pro-cyclical financial variables like EM equities, EM bonds, AUD/USD or AUD/JPY. When a slowdown in global growth materializes, especially when it does so as the U.S. economy is set to accelerate, it tends to be associated with a stronger dollar. Fourth, the super-charged strength in the euro versus the USD since the second quarter of 2017 happened as European hedged yields overtook U.S. hedged yields. Chart I-9 takes the example of a Japan-based investor. We pick Japan as an illustration because Japan is the largest creditor nation in the world, and extra-low domestic yields, Japanese investors continue to exhibit heightened yield-seeking behaviors. When the gap between European bond yields hedged into yen and U.S. bond yields hedged into yen became more negative, the euro was depreciating. Once this gap started to narrow, the euro stabilized. Once European bond yields hedged into yen became greater than U.S. bond yields hedged into yen, the euro took off. Chart I-8Growth Sensitive Assets May Be At Risk Growth Sensitive Assets May Be At Risk Growth Sensitive Assets May Be At Risk Chart I-9Are Hedged Yields The Culprit Behind The Dollar's Weakness? Are Hedged Yields The Culprit Behind The Dollar's Weakness? Are Hedged Yields The Culprit Behind The Dollar's Weakness? We expect these gaps in hedged yields to move back in the U.S.'s favor. The U.S. yield curve has some scope to begin to steepen a bit, especially as U.S. growth accelerates. Additionally, a big component of the underperformance of U.S. hedged yields has been associated with a widening of the LIBOR spread and the cross-currency basis swap spreads (Chart I-10). As we anticipated, the introduction of tax rules favoring repatriations of foreign earnings by U.S. corporations is having this effect.6 U.S. firms hold their offshore earnings in high-quality securities like bank papers or Treasurys. These securities are a vital supply of dollars in the Eurodollar market - the offshore USD market - as they are high-quality collateral that can be used to secure many transactions. As the market in December began to discount the impact of the tax changes, FRA-OIS spreads and basis swap spreads began to widen. This increased the cost of hedging U.S. bonds. Chart I-10Will The Increase In Treasurys Issuance ##br##Pull Back Down The Cost Of Hedging U.S. Assets? Will The Increase In Treasurys Issuance Pull Back Down The Cost Of Hedging U.S. Assets? Will The Increase In Treasurys Issuance Pull Back Down The Cost Of Hedging U.S. Assets? But here's one overlooked but potentially friendly outcome of the twin deficits. By increasing its current account deficit, the U.S. economy will begin to supply more USDs to Eurodollar markets, providing a relief valve to the collateral-starved offshore USD-funding markets. Moreover, because the fiscal deficit is set to mushroom, and because after many debt-ceiling debacles the Treasury's cash reserves are low, the Treasury is likely to start issuing a lot more T-Notes and T-Bills, which will also provide a source of high-quality collaterals in the system, especially as the Fed is not buying those bonds anymore. The stress in the funding market may begin to recede and hedged U.S. yields may begin to rise relative to the rest of the world. Bottom Line: While the twin deficit could become a negative for the USD, it is not yet clear that this will indeed be the case. Instead, we need to keep in mind that the U.S. government is injecting a large amount of stimulus in an economy running at full capacity. This could be inflationary. The Fed's response will dictate the USD's path. If the Fed is proactive, the USD will experience an upswing. If the Fed is reactive and waits to guide real rates higher, the dollar could remain weak. In the meanwhile, other forces are pointing toward a rebound in the dollar. The greenback is oversold and unloved; momentum indicators are forming positive divergences, raising the odds of a rebound; global growth is set to slow; and U.S. hedged yields are likely to move back in favor of the dollar. Will EUR/SEK Break Above 10? The recent inflation miss in Sweden has raised some concerns, with EUR/SEK hovering around the critical 10 level, and NOK/SEK breaking above the 1.03 handle. Headline consumer prices rose only 1.6% annually in January, while contracting by 0.8% in monthly terms. The official inflation measure tracked by the Riksbank - the CPIF - fell to 1.7% per annum. This move away from the inflation target has market participants questioning the Riksbank's willingness and ability to normalize policy this year. However, the underlying picture is not that negative. The most recent inflation figure was greatly impacted by the seasonality of Swedish CPI. As Chart I-11 shows, January tends to be a very weak number for Swedish inflation. The February data is likely to rebound significantly. Additionally, our model further highlights that based on both international and domestic factors, Swedish inflation should rise in the coming months, putting CPI much closer to the Riksbank's objective (Chart I-12). Chart I-11Seasonal Pattern In Swedish CPI Seasonal Pattern In Swedish CPI Seasonal Pattern In Swedish CPI Chart I-12Swedish Inflation Is Set To Rebound Swedish Inflation Is Set To Rebound Swedish Inflation Is Set To Rebound Reassuringly, Swedish inflation expectations have not subsided, suggesting market participants are fading the latest weak reading. As the bottom panel of Chart I-13 illustrates, CPI swap rates are still holding steady. On the macro front, consumers continue to be a source of durable strength. Real consumption is growing at a 3% annual rate, and Swedish consumer confidence is still elevated (Chart I-14). Chart I-13Swedish Inflation Expectations Are Stable Swedish Inflation Expectations Are Stable Swedish Inflation Expectations Are Stable Chart I-14The Swedish Consumer Is Still Spending The Swedish Consumer Is Still Spending The Swedish Consumer Is Still Spending Essentially, the Riksbank's extremely easy monetary policy may not have yet generated inflation in the prices of consumer goods and services, but it has generated huge debt and asset price inflation. The clearest symptom of this is Sweden's non-financial private debt, which now stands at a stunning 240% of GDP, only surpassed by Switzerland and Norway among the G10 economies. These developments imply that the positive Swedish output gap will expand further, and that inflationary pressures will only become more entrenched. Thus, we continue to anticipate a rate hike by the Riksbank this year. This is very much a consensus call. However, where we diverge from consensus is that while futures are pricing in approximately 85 basis points of interest rate hikes by March 2020, we think the scope to lift rates is greater. We also see a higher probability of hikes over that time frame than the Riksbank's own forecast. In other words, we anticipate that the Riksbank's rate forecasts will be revised to the upside. This is because inflationary pressures are growing greater and the economy is very strong. Thus, the Swedish central bank is falling behind the curve and will have to play catch up as soon as inflation moves back closer to target. This will most likely happen over the coming 12 months. As a result, selling EUR/SEK at current levels seems an interesting trade with an attractive entry point. As Chart I-15 illustrates, EUR/SEK only traded above this level during the great financial crisis. It did not manage to punch above this level during the Nordic financial crises of the early 1990s, nor did it during the 1997-'98 crisis - or directly after the September 11 attacks. Chart I-15The Line In The Sand The Line In The Sand The Line In The Sand Moreover, EUR/SEK currently trades 7.5% above its purchasing power parity equilibrium. The gap between Sweden's and the euro area's basic balance of payments is very large. While Sweden's stands at 5.1% of GDP, the euro area's is near zero. This reinforces the message that the EUR/SEK is very expensive: when the cross appreciates too much, Swedish assets become much more attractive to foreigners relative to European assets. These long-term flows end up boosting the relative basis balance in favor of Sweden. This is exactly what is happening today (Chart I-16). Chart I-16Expensive EUR/SEK Makes Swedish Assets Attractive Expensive EUR/SEK Makes Swedish Assets Attractive Expensive EUR/SEK Makes Swedish Assets Attractive From a tactical perspective, EUR/SEK also looks vulnerable. Various short-term momentum measures such as the 14-day RSI or the 13-week rate of change are diverging from actual prices. Additionally, EUR/SEK risk reversals - i.e. the implied volatility of calls versus the implied volatility of puts on this cross - have spiked up. This is true even after controlling for the rise in implied volatility that has affected the option market. It seems to suggest that investors that would have been buying EUR/SEK have already placed their bets. The marginal player is likely to now bet in the other direction. This trade is not without risks. First, a move above 10.1 could be mechanically followed by a sharp rally as stops are hit and momentum traders force the cross higher. Second, Swedish PMIs have been rolling over for six months, but so have the preliminary releases of Europe PMIs this week. What is more concerning is the weakness in Asian manufacturing production that is behind the sharp slowdown in Korean exports. This is worrisome because historically, the Swedish economy has been very sensitive to EM shocks. However, only 2008 was able to push EUR/SEK above 10. Even if EM slows, we are not anticipating a shock as large as what occurred in 2015, let alone in 2008. Moreover, while we anticipate Swedish inflation to surprise to the upside, we equally expect euro area inflation to exhibit much more limited gains. Bottom Line: Sweden's inflation report came in well below expectations, which prompted a sharp rally in EUR/SEK to near 10. However, this level has been an important resistance since the early 1990s, only breached during the great financial crisis. We are betting on it not being breached this time around. The Swedish economy is strong, and inflation is set to pick up again. As a result, we think the Riksbank will be forced to lift its interest rate forecast as time passes. Moreover, EUR/SEK is expensive, and flows are currently very much in favor of Sweden. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant HaarisA@bcaresearch.com 1 Please see The Bank Credit Analyst Monthly Report, dated February 29, 2018, available at bca.bcaresearch.com. 2 Please see U.S. Bond Strategy Weekly Report, "On the MOVE", dated February 13, 2018, available at usbs.bcaresearch.com. 3 Please see Emerging Markets Strategy Weekly Report, "EM Local Bonds and U.S. Twin Deficits", dated February 21, 2018, available at ems.bcaresearch.com. 4 Please see Foreign Exchange Strategy Weekly Report, "The Euro's Tricky Spot", dated February 2, 2018, available at fes.bcaresearch.com. 5 Please see Foreign Exchange Strategy Weekly Reports, "Canaries In The Coal Mine Alert: EM/JPY Carry Trades", dated December 1, 2017, and "Canaries In the Coal Mine Alert 2: More on EM Carry Trades And Global Growth", dated December 15, 2017, available at fes.bcaresearch.com. 6 Please see Foreign Exchange Strategy Special Report, "It's Not My Cross To Bear", dated October 27, 2017, available at fes.bcaresearch.com. Currencies U.S. Dollar U.S. data was mixed: Markit PMIs beat expectations ; Existing home sales, however, grew by less than expected at 5.38 million, a 3.2% contraction form the previous month; Continuing jobless claims outperformed expectations, coming in at 1.875 million; Initial jobless claims also outperformed with 222,000. In the meeting's minutes, FOMC members were quite positive on growth and their rhetoric suggest they intend to follow up on the current set of dot plots. Subsequently, equities sold off, the 10-year yield climbed to 2.954%, bringing them close to BCA's fair value estimate. Due to these developments, the dollar's descent seems to be taking a breather for now, and it may even experience a rebound in the coming weeks. Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2 USD Technicals 2 USD Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 A Cold Snap Doesn't Make A Winter - January 5, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Euro The tone of European data has been deteriorating: German PMIs underperformed expectations, with services coming in at 55.3, and manufacturing, at 60.3; European PMIs also underperformed anticipations with manufacturing coming in at 58.5 and services at 56.7; The Current Situation section of the ZEW Survey was also weaker than expected; German IFO underperformed expectations, with the Business Climate measure coming in at 115.4, and the Expectations measure also dropping to 105.4. The euro weakened substantially this week on poor data and a hawkish Fed, even if it managed to eke out a rebound on Thursday. We have recently published on the risks to global growth, and the weak European PMIs seem like a consequence of these developments. We expect the euro's bull market to pause until global growth picks back up. Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 The Yen Recent data in Japan has been mixed: Imports yearly growth underperformed expectations, coming in at 7.9%. It also declined significantly from the previous 14.9% pace . Moreover, Nikkei Manufacturing PMI underperformed expectations, coming in at 54. It also declined from 54.8 in the previous month, However, exports yearly growth outperformed expectations, coming in at 12.2%. It also increased from its 9.3% pace the previous month. USD/JPY has rallied by roughly 1.5% since last week. Overall, we expect that the current volatile environment will provide strength to the yen to the point that a level of 100 for USD/JPY is plausible. However, on a long term basis the yen is likely to be weak against the U.S. dollar, as the BoJ will fight tooth and nail to prevent a strengthening yen from hampering inflation. Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Report Links: The Yen's Mighty Rise Continues... For Now - February 16, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 British Pound Recent data in the U.K. has been mixed: The ILO Unemployment rate surprised negatively, coming in at 4.4%. It also increased form 4.3% the previous month. Moreover, retail sales and retail sales ex-fuel annual growth also underperformed, coming in at 1.6% and 1.5% respectively. However, average hourly earnings yearly growth excluding bonus outperformed expectations, coming in at 2.5% GBP/USD has depreciated by nearly 1.6% this week. There are currently 45 basis points of hikes by the BoE priced into the next 12-months. We believe that there is not much more upside beyond this, given that the end of the pound's collapse will weigh on inflation. Moreover, recent data has shown that although inflation is high, the economy rests on a shaky foundation. We continue to expect the pound to fall on a trade-weighted basis as well. Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Australian Dollar Data out of Australia was mixed: The Westpac Leading Index stayed steady at -0.2%; Wage growth beat expectations, growing at a 0.6% quarterly rate, and 2.1% annual rate; Construction work done slowed down severely, contacting by -19.4%, greatly surpassing the expected 10% contraction. It should also be noted that much of the wage growth was driven by the growth in public sector wages, which grew by 2.4% as opposed to the 1.9% growth experienced by the private sector. RBA members highlighted the risks created by lower than expected wage growth: weaker household consumption as a below-target inflation. The RBA is therefore likely to stay put this year, and the AUD will underperform its G10 peers. Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 New Zealand Dollar The kiwi has fallen by roughly 1% this week, in part due to dollar rebound in the greenback. Nevertheless, AUD/NZD has declined by 0.6%, and is now down almost 3% during the year, thanks to dairy prices surging by more than 13% in 2018. Overall, we expect that the NZD will outperform the AUD, given that the consumer sector in China should outperform the industrial sector, as the Chinese authorities are cracking on overcapacity. With this being said, NZD/JPY will probably see downside, as the current volatility in markets will weigh on this cross. Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Canadian Dollar Canadian data was weak: Wholesale sales contracted by 0.5% at a monthly pace; Retail sales contracted by 0.8%, underperforming expectations; Core retail sales, excluding autos, contracted by 1.8%. The CAD weakened against all currencies this week. However, even if it may not increase much against the U.S. dollar, the case for a stronger CAD against other major currencies is still firm as the BoC is likely to hike interest rates more than most central banks year. Additionally, stronger U.S. growth should support the health of the Canadian export sector. Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swiss Franc Recent data in Switzerland has been mixed: The trade balance underperformed expectation on January, coming in at CHF1.324 billion. It also declined from last month's value of CHF3.374 billion. However, industrial production yearly growth increased from last month, coming in at a stunning 19.6% pace. EUR/CHF has been relatively flat this week. Overall we believe that the franc can only rally against the euro on episodes of rising global volatility, given that the SNB will fight against any appreciation of the franc that could hurt the little progress that has been made in achieving their inflation target. Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Norwegian Krone USD/NOK has rallied by roughly 1.3% on the back of a stronger dollar. Overall, we believe that the krone should be the best performer amongst the commodity currencies, as the economic situation has improved substantially, with the Labour Survey improving last month. This will help the Norges Bank to tighten monetary policy more than the market currently expects. Investors who want to take advantage of these developments should short CAD/NOK as an oil-neutral bet. More audacious traders could short AUD/NOK or NZD/NOK as well. Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swedish Krona Swedish inflation dropped by more than expected: in monthly terms, inflation contracted by 0.8%, while in annual terms it grew by only 1.6%, less than the expected 1.8%. However, this monthly contraction was in line with the seasonal pattern historically witnessed in Swedish inflation, which also tells us that inflation is likely to pick up again in the following months. EUR/SEK hit 10, an historically very strong overhead resistance, indicating that markets may be unnerved by the Riksbank's unwillingness or inability to tighten policy. While the OIS curve is pricing in 80 bps of hikes in the next two years, we believe that the Riksbank will hike more than that, as inflation will come back to Sweden with a vengeance. Not only is the economy firing on all fronts, but the currency is also very cheap. The SEK is likely to strengthen this year. Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The euro is cheap. To cease being cheap, EUR/USD needs to approach 1.35. Euro area bonds are expensive. To cease being expensive, the yield spread between the euro area and U.S. long bond needs to compress from -135 bps to -40 bps. Never pick mainstream stock markets on the basis of seeming cheapness. Sector effects, step changes in sector valuations and currency effects make relative valuations very difficult to interpret. Always pick mainstream stock markets on the basis of the sector and currency biases you wish to express. Overweight Denmark's OMX and Ireland's ISEQ on a 6-9 month horizon. Feature A very common question we get asked is: are European investments attractively priced compared to those elsewhere in the world? To which the current answers are: yes for the euro currency; no for euro area government bonds; and highly unlikely for the aggregate European stock market. That said, we can still identify individual European stock markets that are well placed to outperform major equity indexes, including the S&P500, over the coming 6-9 months. Chart of the WeekWhen Healthcare Outperforms, Denmark's OMX Outperforms The S&P 500 When Healthcare Outperforms, Denmark"s OMX Outperforms The S&P 500 When Healthcare Outperforms, Denmark"s OMX Outperforms The S&P 500 The Euro Is Cheap... Says The ECB We can confidently claim that the euro is cheap because the ECB's own indicators say so.1 According to the ECB, the euro needs to appreciate at least 7% to cancel the euro area's over-competitiveness versus its top 19 trading partners. In terms of EUR/USD this translates to 1.32. Admittedly, 1.32 encapsulates a spectrum of fair values for the individual euro area economies: 1.45 for Germany; around 1.30 for France, Spain and Netherlands; and around 1.20 for Italy (Chart I-2). Chart I-2The Euro Needs To Appreciate 7% To Cancel The Euro Area's Over-Competitiveness The Euro Needs To Appreciate 7% To Cancel The Euro Area"s Over-Competitiveness The Euro Needs To Appreciate 7% To Cancel The Euro Area"s Over-Competitiveness The ECB indicators also assume that the euro began its life close to fair value. This seems plausible. Twenty years ago, the euro area's constituent economies were broadly in internal balance and had a lot in common. Remarkably, Germany and Italy scored identically on total debt as a share of GDP as well as on exports as a share of GDP. Furthermore, euro area trade was in external balance, and the bloc's real competitiveness versus its major trading partners was exactly in line with its long-term average. After its birth, the euro first became extremely undervalued in the dot com bubble, then extremely overvalued in the global credit boom, and most recently, extremely undervalued again. Seen in this bigger picture, the euro's current ascent is just a recovery from an extreme undervaluation, an argument that even Mario Draghi made at the last ECB press conference: "Movements in the exchange rate, to the extent that it is justified by the strengthening of the economy, is part of nature." At what level would EUR/USD cease to be cheap? Based on the average of the ECB's three competitiveness indicators, EUR/USD needs to approach 1.35. Euro Area Bonds Are Expensive The yield spread between the euro area and U.S. long bond stands at an extreme -135 bps.2 This compares with an average -40 bps through the twenty year life of the euro - indicating that euro area government bonds are very expensive relative to U.S. T-bonds. Over the completion of this cycle, this yield spread is highly likely to compress to its long-term average of -40 bps, given that the yield spread just tracks relative real GDP per head - which is itself mean-reverting (Chart I-3). Interestingly, the euro area versus U.S. annual inflation differential has also averaged -40 bps (Chart I-4), so the real interest rate differential has averaged zero. This means that the so-called 'neutral' (or mid-cycle) real interest rates in the euro area and the U.S. have been identical through the past twenty years. Growth in real GDP per head has also been identical (Chart I-5). Chart I-3Euro Area-U.S.: Average Interest ##br##Rate Differential = -40bps Euro Area-U.S.: Average Interest Rate Differential = -40bps Euro Area-U.S.: Average Interest Rate Differential = -40bps Chart I-4Euro Area-U.S.: Average Inflation ##br##Differential = -40bps Euro Area-U.S.: Average Inflation Differential = -40bps Euro Area-U.S.: Average Inflation Differential = -40bps Chart I-5The Euro Area And U.S. Have Generated##br## Identical Growth Per Head The Euro Area And U.S. Have Generated Identical Growth Per Head The Euro Area And U.S. Have Generated Identical Growth Per Head The past twenty years provide a good template for what the future holds, at least in relative terms if not in absolute terms. This is because 1999-2018 captures multiple manias and crises, some centred in Europe, some in the U.S. With no difference in neutral real rates over the past two decades, is there any reason to expect the future neutral rate to be meaningfully lower in the euro area compared to the U.S.? Our starting assumption has to be no. This assumption would be at risk if the existential threat to the euro resurfaced. Looking at the political calendar, the immediate concern might be the Italian election on March 4. Specifically, the anti-establishment Five Star Movement and Northern League could poll well enough to hold some sway in the next government and ruffle the markets. However, while both the Five Star Movement and Northern League have agendas that are unashamedly disruptive, anti-establishment and anti-austerity, neither party is standing on an anti-euro platform. Unless there is a major change in emphasis, the Italian election should not pose an existential threat to the euro. Our central expectation is that the euro area versus U.S. yield spread has the scope to compress substantially from its current -135 bps. In other words, euro area government bonds are very expensive relative to U.S. T-bonds. Never Pick Stock Markets On The Basis Of Seeming Cheapness Compared with currencies and bonds, stock markets are much less connected with their domestic economies. Mainstream stock markets are eclectic collections of multinational companies, with each stock market possessing its own unique fingerprint of sector and industry skews. Therefore, a head-to-head comparison of European stock market valuations either with each other or with non-European stock markets is a meaningless and potentially dangerous exercise. Two sectors with vastly different structural growth prospects - say, Financials and Personal Products (Chart I-6) - must necessarily trade on vastly different valuations. So the sector with the lower valuation is not necessarily the cheaper sector. By extension, a stock market with a lower valuation because of its sector fingerprint is not necessarily a cheaper stock market. Chart I-6Two Sectors With Vastly Different Growth Prospects Will Trade On Vastly Different Valuations Two Sectors With Vastly Different Growth Prospects Will Trade On Vastly Different Valuations Two Sectors With Vastly Different Growth Prospects Will Trade On Vastly Different Valuations Some people suggest comparing a valuation with its own history, and assessing how many 'standard deviations' it is above or below its norm. The problem with this standard deviation approach is that it assumes 'stationarity' - meaning, no step changes in a sector's valuation through time. Unfortunately, sector valuations can and do undergo major step changes when they enter a vastly different economic climate. For example, the structural outlook for bank profits undergoes a step change when a debt super-cycle ends. Therefore, comparing a bank valuation after a debt super-cycle with the valuation during a debt super-cycle is like comparing an apple with an orange. Another issue for stock markets that contain multinational companies is the so-called 'currency translation effect'. A multinational company will intentionally diversify its sales and profits across multiple major currencies - say, euros, dollars and yen - but of course its primary stock market listing will be in just one currency - say, euros. So when the other currencies weaken versus the euro, the company's profit growth (quoted in its home currency of euros) will necessarily weaken too. If investors anticipate this effect - because they see that the euro is structurally cheap today - they might downgrade the stock market's profit growth expectations. Thereby, they will also downgrade the stock market's valuation. Pulling together these complexities of sector effects, step changes in sector valuations and currency effects, we offer some very strong advice: picking stock markets on the basis of relative valuation is a wrong and very dangerous way to invest. The correct and safe way to invest is to pick stock markets on the basis of the sector and currency biases you wish to express (Chart I-7). This brings us to one of the major advantages of investing in Europe. The plethora of stock markets - each with their own unique fingerprint of sector and industry skews - means that there are always European bourses worth overweighting, whatever your economic outlook. Right now, two of our sector recommendations are to overweight Healthcare and to underweight Energy. Please review our report Beware The Great Moderation 2.0 for the underlying thesis, which we will not repeat here.3 If these sector recommendations pan out as we expect, Denmark's OMX is highly likely to outperform the S&P500 given the OMX's substantial overweighting to Healthcare (Chart of the Week). Likewise, Ireland's ISEQ is highly likely to outperform the S&P500 given the ISEQ's substantial underweighting to Energy via its large exposure to budget airline Ryanair (Chart I-8). Chart I-7Eurostoxx50 Vs. S&P500 Is Just 3 Banks Vs.##br## 3 Tech Stocks! Eurostoxx50 Vs. S&P500 Is Just 3 Banks Vs. 3 Tech Stocks! Eurostoxx50 Vs. S&P500 Is Just 3 Banks Vs. 3 Tech Stocks! Chart I-8When Energy Underperforms, Ireland's ##br##ISEQ Outperforms The S&P 500 When Energy Underperforms Ireland"s ISEQ Outperforms The S&P 500 When Energy Underperforms Ireland"s ISEQ Outperforms The S&P 500 Overweight Denmark's OMX And Ireland's ISEQ. A final salutary observation illustrates the importance of the sector approach to picking stock markets. As a result of favourable sector biases - overweight Healthcare, underweight Energy - a 50:50 combination of Denmark and Ireland has kept pace with the S&P500 over the past 20 years, while the Eurostoxx50 has been left a very long way behind (Chart I-9). Chart I-9Sector Biases Helped Denmark's OMX And Ireland's ISEQ, But Hindered The Eurostoxx 50 Sector Biases Helped Denmark"s OMX And Ireland"s ISEQ, But Hindered The Eurostoxx 50 Sector Biases Helped Denmark"s OMX And Ireland"s ISEQ, But Hindered The Eurostoxx 50 Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Available at https://www.ecb.europa.eu/stats. The ECB calculates three Harmonised Competitiveness Indicators for the euro area versus its top 19 trading partners based on unit labour costs (ULCs), GDP deflators, and consumer price indices (CPIs), with the latest readings referring to Q3 2017 for ULCs and GDP deflators and January 2018 for CPIs. Updating these for the euro's move to February 20 2018, the three indicators suggest that the trade-weighted euro is still undervalued by 7%, 12% and 7% respectively. 2 Calculated from the over 10-year government bond yield: euro area average, weighted by sovereign issue size, less U.S. 3 Please see the European Investment Strategy Weekly Report 'Beware The Great Moderation 2.0' published on February 1, 2018 and available at eis.bcaresearch.com. ­­ Fractal Trading Model* This week our fractal model has produced a very interesting finding. The 130-day fractal dimension for the U.S. 10-year T-bond is approaching a level which has consistently signalled a technical inflection point. This suggests that the recent sell-off in bonds might be close to running its course. We are not putting on a countertrend position yet, but expect to do so within the next few weeks. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 Long U.S. 10-Year Gov. Bond Long U.S. 10-Year Gov. Bond The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Portfolio Strategy Synchronized global capex growth and higher interest rates are two key themes that will continue to dominate this year. Three high-conviction calls are levered to the former theme and two to the latter. A special situation completes our sextet. Reinstate the S&P construction machinery & heavy truck index to the high-conviction overweight list. We also reiterate our high-conviction underweight call in the newcomer S&P telecom services sector. Recent Changes S&P Construction Machinery & Heavy Truck - Add back to high-conviction overweight list. Table 1 Semblance Of Calm Semblance Of Calm Feature Chart 1Market Bounced Smartly Market Bounced Smartly Market Bounced Smartly Equities regained their footing last week, as volatility took a breather. There are high odds that the technical, mostly-sentiment driven, pullback that we have been flagging since January 22nd is nearly over, as the market smartly bounced off the 200-day moving average (top panel, Chart 1).1 A consolidation/absorption phase is looming and, according to our "buy the dip" cycle-on-cycle analysis, a retest of the recent lows is likely before the market gets out of the woods (please refer to Chart 1 from last week's publication). While inflation expectations, crude oil prices and financial conditions are all tightly linked with and weighing on the S&P 500 (second and third panels, Chart 1), a number of tactical high-frequency financial market indicators suggest that the cyclical SPX bull market remains intact. First, SPX e-mini futures positioning is an excellent leading indicator of market momentum, and the current message is positive (net speculative positions are advanced by 40 weeks, Chart 2). Second, bond market internal dynamics suggest that this mini "risk off" episode is an isolated one and not a precursor to a real tremor. The high yield bond ETF outperformed the long dated Treasury bond ETF (bottom panel, Chart 3). It would be unprecedented for an equity market downdraft to morph into a fully blown bear market without junk bonds sinking compared with the ultimate risk free asset. Even when adjusted for its lower duration, the high yield bond ETF remained resilient versus the 3-7 year Treasury bond ETF (top panel, Chart 3). Chart 2Futures Positioning... Futures Positioning... Futures Positioning... Chart 3...Junk Bonds... ...Junk Bonds... ...Junk Bonds... Third, the calmness in the TED spread corroborates the message from the bond market. Were a systemic risk to materialize, the TED spread should have widened and not come in as it did in the past two weeks (Chart 4). Put differently, quiet interbank markets are a healthy sign. Chart 4...And TED Spread All Flashing Green Semblance Of Calm Semblance Of Calm Finally, relative valuations have corrected not only on an absolute basis (please refer to the bottom panel of Chart 2A from last week's Report), but also controlled for equity market volatility. In fact, Chart 5 shows that both the VIX-adjusted Shiller P/E and the 12-month forward P/E have returned to the neutral zone. Meanwhile, two key macro indicators we track are also flashing green. Chart 6 shows momentum in money velocity or how fast "one unit of currency is used to purchase domestically-produced goods and services".2 Historically, velocity of M2 money stock has been positively correlated with stock market momentum. The recent spike in this indicator suggests that the longevity of the business cycle remains intact, and investors with a cyclical (9-12 month) investment horizon should start "buying the dip", as we suggested on February 8th.3 Another yield curve-type macro indicator confirms this buoyant business cycle message: real GDP growth is easily outpacing real interest rates, as per the 10-year TIPS market (Chart 7). In other words, real rates are not yet restrictive enough to choke off GDP growth, despite the recent 35bps increase. Were this spread to plunge below the zero line, it would predict recession. Thus, the recent widening underscores that recession is not imminent. Chart 5Valuations Return To Earth Valuations Return To Earth Valuations Return To Earth Chart 6Money Velocity... Money Velocity... Money Velocity... Chart 7...And Yield Curve Emit Bullish Signal ...And Yield Curve Emit Bullish Signal ...And Yield Curve Emit Bullish Signal Under such a backdrop, the upshot is that earnings will remain upbeat in 2018 and continue to underpin equity prices. This week we revisit our 2018 high-conviction call list and reinstate one sector to the overweight column. Chart 8Both Themes Remains Intact Both Themes Remains Intact Both Themes Remains Intact The Themes Two key BCA themes formed the cornerstone of our 2018 high conviction call list: Synchronized global capex upcycle Higher interest rates Last autumn, we started to articulate the synchronized global capital spending macro theme4 that, despite still flying under the radar, will likely dominate this year. Both advanced and emerging economies are simultaneously expanding gross fixed capital formation (middle panel, Chart 8). As a result, we reiterate our cyclical over defensive portfolio bent,5 and continue to tie three high-conviction overweight calls to this theme. Similarly, late last year we started to highlight BCA's U.S. Bond Strategy view of a higher 10-year yield on the back of rising inflation expectations for 2018 (bottom panel, Chart 8). Back in late-November we posited that if BCA's constructive crude oil view pans out then inflation and rates may get an added boost. Two high-conviction calls remain levered to this theme. Finally, a special situation rounds up our call this year. But before we update the call list and make a small tweak, a quick housekeeping note is in order. Taking The Tally Early this year, we added trailing stops to our high-conviction call list as a risk management tool. The goal was to help protect profits as a number of our calls were showing outsized gains for such a short time span. Our tactically souring view of the overall market also compelled us to introduce this risk management metric. As a result of the recent careening in the SPX, half of our calls got stopped out with lofty double digit gains since inception a mere two and a half months ago. Namely, our speculative underweights in the S&P semi equipment and S&P homebuilders registered gains of 20% and 10%, respectively. The high-conviction underweight in the S&P utilities sector got called at an 18% gain, and our high-conviction overweight call in the S&P construction machinery & heavy truck (CMHT) index got stopped out at the 10% mark. (Please refer to page 15 for the closed trades table). Last week we added the S&P telecom services sector as a high-conviction underweight replacing the S&P utilities sector, and now that the worst is likely behind us, we are reinstating the S&P CMHT index to the high-conviction overweight list. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Construction Machinery & Heavy Truck (Overweight, Capex Theme) The capex upcycle is underpinning machinery stocks. Not only are expectations for overall capital outlays as good as they get (Chart 9), but there are also tentative signs that even the previously moribund mining and oil & gas complexes will be capex upcycle participants. While we are not calling for a return to the previous cycle's peak, even a modest renormalization of capital spending plans in these two key machinery client segments would rekindle industry sales growth. Recent news of oil majors accelerating their capex plans is a step in the right direction. This machinery end-demand improvement is not only a U.S. phenomenon, but also a global one. The middle panel of Chart 9 shows Caterpillar's global machinery sales to dealers hitting a decade high. Tack on the drubbing in the U.S. dollar and related commodity price inflation and the ingredients are in place for a global machinery export boom. While most of the countries we track enjoy a sizable rebound in machinery orders, Japan's machine tools orders have surged to an all-time high confirming that machinery global end demand is brisk (bottom panel, Chart 9). Finally, our machinery EPS model is firing on all cylinders, underscoring that the earnings-led recovery has more running room (fourth panel, Chart 9). Reinstate the S&P CMHT index to the high-conviction overweight list. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, CMI, PCAR. Energy (Overweight, Capex Theme) The S&P energy sector is a key beneficiary of our synchronized global capex theme. The Dallas Fed manufacturing outlook survey is firing on all cylinders and, given the importance of oil to the state of Texas, it serves as an excellent gauge for oil activity. Importantly, the capital expenditures part of the survey hit its highest level in a decade, and capex intentions in the coming six months are also probing multi-year highs. The overall message is that the budding recovery in energy capital budgets will likely gain steam (second panel, Chart 10). Following the late-2015/early-2016 drubbing in oil prices, energy projects ground to a halt and only now are green shoots appearing (middle panel, Chart 10). Recent news that Exxon Mobil would bump domestic capital spending up to $50bn over the next five years is encouraging. New projects/investments comprise 70% of this figure. OECD oil stocks are receding steadily and so are U.S. crude oil inventories. OPEC 2.0 remains in place and will likely balance the oil market by continuing to constrain supply. Our Commodity & Energy Strategy service is still penciling in higher oil prices for 2018. On the demand side, emerging markets/Chinese demand is the key determinant of overall oil demand, and the news on this front is encouraging and consistent with BCA's synchronized global growth theme: following the recent lull, non-OECD demand is growing anew by roughly 1.5mn bbl/day. The upshot is that S&P energy relative revenues will climb out of the recent trough (bottom panel, Chart 10). The ticker symbols for the stocks in this index are: BLBG: S5ENRS - XLE: US. Chart 9Construction Machinery & Heavy Truck ##br##(Overweight, Capex Theme) Construction Machinery & Heavy Truck (Overweight, Capex Theme) Construction Machinery & Heavy Truck (Overweight, Capex Theme) Chart 10Energy (Overweight, Capex Theme) Energy (Overweight, Capex Theme) Energy (Overweight, Capex Theme) Software (Overweight, Capex Theme) The S&P software index is another clear capex upcycle beneficiary. If software commands a larger slice of the overall capital spending pie as we expect, then industry profits should enjoy a healthy rebound (second panel, Chart 11). Small business sector plans to expand keep on hitting fresh recovery highs, underscoring that software related outlays will likely follow them higher. Rebounding bank loan growth also corroborates the upbeat spending message and signals that businesses are beginning to loosen their purse strings (Chart 11). Reviving animal spirits suggest that demand for software upgrades will stay elevated. CEO confidence is pushing decade highs (middle panel, Chart 11). Such ebullience is positive for a pickup in software outlays. It has also rekindled software M&A activity, and pushed take out premia higher. Meanwhile, the structural pull from the proliferation of cloud computing and software-as-a-service has served as a catalyst to raise the profile of this more defensive and mature tech sub-sector. Tax reform is another bonus for this group that benefits from cash repatriation, which will likely result in increased shareholder friendly activities. The ticker symbols for the stocks in this index are: BLBG: S5SOFT-MSFT, ORCL, ADBE, CRM, ATVI, INTU, EA, ADSK, RHT, SYMC, SNPS, ANSS, CDNS, CTXS, CA. Banks (Overweight, Higher Interest Rates Theme) The S&P banks index remains a core overweight portfolio holding and there are high odds of additional relative gains in the coming quarters beyond the current 10% relative return mark since the November 27th, 2017 inception. All three key drivers of bank profits, namely price of credit, loan growth and credit quality, are simultaneously moving in the right direction. On the price front, BCA expects the 10-year yield will continue to rise more quickly than is discounted in the forward curve. Our U.S. bond strategists think that inflation expectations have more room to run, likely pushing the 10-year Treasury yield close to 3.25% (top panel, Chart 12). C&I and consumer loans, two large credit categories, are both forecast to reaccelerate in the coming months. The ISM remains squarely above the 50 boom/bust line and consumer confidence is still buoyant. Our credit growth model captures these positive forces and is sending an unambiguously positive message for loan reacceleration in the coming months (third panel, Chart 12). Finally, credit quality remains pristine despite some pockets of weakness in auto loans (especially subprime) and credit card debt. At this stage of the cycle, with a closed unemployment gap, NPLs will remain muted. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT.  Chart 11Software (Overweight, Capex Theme) Software (Overweight, Capex Theme) Software (Overweight, Capex Theme) Chart 12Banks (Overweight, Higher Interest Rates Theme) Banks (Overweight, Higher Interest Rates Theme) Banks (Overweight, Higher Interest Rates Theme) Telecom Services (Underweight, Higher Interest Rates Theme) We downgraded the S&P telecom services index to underweight and added it to the high-conviction underweight list last week, filling the void left by the S&P utilities sector.6 Three main reasons are behind our dislike for this fixed income proxy sector: BCA's 2018 rising interest rate theme, both our Cyclical Macro Indicator (CMI) and our sales model send a distress signal, and a profit margin squeeze is looming. The top panel of Chart 13 shows that high dividend yielding telecom services stocks and the 10-year yield are nearly perfectly inversely correlated. In fact, telecom services stocks are prime beneficiaries of disinflation/deflation and vice versa. BCA's bond market view remains that the 10-year yield will continue to rise likely piercing through 3% and weigh heavily on this fixed income proxied sector. Our CMI has melted and relative consumer outlays on telecom services have also taken a nosedive (second & third panels, Chart 13), warning that revenue growth will be hard to come by for telecom carriers. In fact, while nearly all of the GICS1 sectors have come out of the top line growth lull of late-2015/early-2016, telecom services sales growth has relapsed. Worrisomely, our S&P telecom services revenue growth model remains deep in contractionary territory, waving a red flag (bottom panel, Chart 13). Finally, still steeply deflating selling prices are a major headwind for the sector's top and bottom line growth prospects and coupled with a still expanding wage bill, suggest that a profit margin squeeze is looming. The ticker symbols for the stocks in this index are: VZ, T, CTL. Pharmaceuticals (Underweight, Special Situation) Weak pricing power fundamentals, a soft spending backdrop, a depreciating U.S. dollar and deteriorating industry operating metrics will sustain downward pressure on pharma stocks. Industry selling prices remain soft (Chart 14). In the context of a bloated industry workforce, the profit margin outlook darkens significantly. If the Trump administration also manages to clamp down on the secular growth of pharma selling price inflation, as we expect, then industry margins will remain under chronic downward pressure. Our dual synchronized global economic and capex growth themes bode ill for this safe haven index. Nondiscretionary health care outlays jump in times of duress and underwhelm during expansions. Currently, the elevated ISM manufacturing index is signaling that pharma profits will underwhelm in the coming months as the most cyclical parts of the economy flex their muscles (the ISM survey is shown inverted, second panel, Chart 14). A depreciating currency is also synonymous with pharma profit sickness (bottom panel, Chart 14). While pharma exports should at least provide some top line growth relief during depreciating U.S. dollar phases, they are still contracting (middle panel, Chart 14), warning that global pharma demand is ill. Finally, even on the operating metric front, the outlook is dark. Pharma industrial production is nil and our productivity proxy remains muted, warning that the valuation derating phase is far from over. The ticker symbols for the stocks in this index are: BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO. Chart 13Telecom Services ##br##(Underweight, Higher Interest Rates Theme) Telecom Services (Underweight, Higher Interest Rates Theme) Telecom Services (Underweight, Higher Interest Rates Theme) Chart 14Pharmaceuticals ##br##(Underweight, Special Situation) Pharmaceuticals (Underweight, Special Situation) Pharmaceuticals (Underweight, Special Situation) 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 https://fred.stlouisfed.org/series/M2V 3 Please see BCA U.S. Equity Strategy Insight, "Buy The Dip," dated February 8, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "Invincible," dated November 6, 2017, available at uses.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Special Report, "Top 5 Reasons To Favor Cyclicals Over Defensives," dated October 16, 2017, available at uses.bcaresearch.com. 6 Please see BCA U.S. Equity Strategy Weekly Report, "Manic Depressive?" dated February 12, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).

Highlights Expectations that the BoJ's yield curve control strategy is toward its tail end, general USD weakness, and brewing EM troubles are conspiring to push the yen higher. Tactically, the yen has more upside. Global financial markets are set to remain volatile and softness in China point to a tougher environment for EM bonds and commodity prices. In the coming months, USD/JPY will fall to the 104 to 102 range, and maybe even test 100. Beyond this point, the outlook remains negative for the yen. It is too early for investors to bet on the end of YCC, especially as the current yen strength hurts Japan's inflation outlook. While EUR/JPY and USD/JPY still have tactical downside, AUD/JPY and NZD/JPY are much more vulnerable. Feature No matter what happens to U.S. asset prices, bond yields, or inflation, the yen continues to rally unabashedly. A month ago, we argued that a countertrend bounce in the yen was likely as the Bank of Japan was tweaking its bond purchases. We also thought this rally would have a limited shelf life as the BoJ's yield curve control strategy is still firmly in place.1 Considering the yen's recent strength, it is an opportune time to revisit this theme. We do believe that the yen still has room to rally on a three- to six-month basis. However, a move beyond USD/JPY 100 is unlikely as the BoJ's YCC program remains firmly entrenched, only more so now that the yen is appreciating once again. Why Is The Yen Strong? We think the yen's strength can be attributed to three factors: domestic economic conditions, the dollar's weakness, and brewing EM trouble. Domestic Conditions The strength of the Japanese economy has played an important role in the yen's appreciation. Japanese industrial production is growing at an impressive 4.4% annual pace. Also, the labor market is tight: Japan's unemployment rate is 0.8% below equilibrium, the active job openings-to-applicant ratio is at a 44-year high and job creation remains decent at 1% per annum. The output gap corroborates this picture, with GDP standing 1.1% above the OECD's estimate of potential GDP. The economic wellbeing seems generalized. Exports are growing at a brisk pace, and are strong across the board. This is a consequence of perky global growth, which always tends to help export-oriented nations. Moreover, this export boom is filtering through to the domestic economy. The share of corporate profit stands near record levels at 15% of GDP. This is incentivizing firms to invest, which should push capex higher (Chart I-1). Chart I-1Japanese Capex Is Set To Rise Japanese Capex Is Set To Rise Japanese Capex Is Set To Rise Chart I-2Japan Needs Tighter Policy? Japan Needs Tighter Policy? Japan Needs Tighter Policy? Investors are beginning to replay the story of the euro in 2017 in their minds. As the narrative goes, a booming economy is giving monetary authorities a chance to move away from extraordinarily accommodative conditions. Therefore, investors are lifting their estimates of where Japanese policy will stand in three or five years. This could be even truer in Japan than in the euro area last year: unlike Europe, Japan is at full employment and the BoJ has not achieved its bond purchase objective of JPY80 trillion per year since mid-2016. However, the BoJ is keeping a firm lid on interest rates up to 10 years ahead, making it harder to observe in interest rate derivatives whether or not investors are lifting their estimates of the Japanese terminal rate. Yet a few signs exist. For one, our Bank of Japan Monitor has moved into "tighter policy territory" (Chart I-2). While this does not guarantee that Japanese rates will rise, this indicator is comprised of variables2 that most investors follow to form their expectations of the path of Japanese monetary policy. Thus, it suggests that based on historical experience, investors are potentially in the process of re-assessing the future of Japanese monetary policy. Moreover, while interest rate markets may be artificially congealed by the BoJ, other asset prices are not. If the BoJ were indeed to lift interest rates earlier than had been previously anticipated, Japanese financials should outperform the market as a more rapid and sharper lift-off would boost Japanese banks' net interest margins. Indeed, Japanese financials experienced an expansion of their multiples relative to the broader market at the onset of the yen's most recent rally (Chart I-3). Additional fuel comes from credit conditions. Over long periods of time, easy lending standards support the yen: an improving outlook for credit growth prompt investors to expect a less accommodative BoJ stance. Today, private-sector deleveraging is over and Japanese credit standards are very loose, suggesting the yen is somewhat of a coiled spring that could easily be shocked higher. It is the dovish policy of the BoJ that has made the yen softer than normally implied by credit standards. However, any hint that easy policy could be nearing an end would once again cause investors to push the yen higher. A stronger economy is currently giving traders the justification to do exactly that (Chart I-4). Chart I-3Symptoms That Investors ##br##See Higher Rates Ahead Symptoms That Investors See Higher Rates Ahead Symptoms That Investors See Higher Rates Ahead Chart I-4Orders Are Lifting The Yen Because They ##br##Point Toward Tighter Policy Orders Are Lifting The Yen Because They Point Toward Tighter Policy Orders Are Lifting The Yen Because They Point Toward Tighter Policy Bottom Line: Not only is the Japanese labor market very tight, the economy is growing strongly. As a result, investors seem to be anticipating an earlier hawkish shift by the BoJ, which is lifting the yen. Dollar Weakness Another factor that has pushed the yen sharply higher has been the weakness in the U.S. dollar. As have other currency pairs, USD/JPY has decoupled from interest rate differentials. This weakness in the dollar can be understood under many lights. First, since the end of the Bretton Woods system, the dollar has been following an interesting pattern of 10 down years followed by five to six up years. The dollar rally from 2011 to 2016 seemed to fit this mold, suggesting we have entered a protracted period of dollar weakness (Chart I-5). Second, the dollar tends to fare poorly in the last years of an economic expansion. This is because the global economy tends to outperform the U.S. during this time frame. Today, the U.S. business cycle looks long in the tooth. Companies are reporting increasing difficulty finding qualified labor, very few are worried about the outlook for demand, and the yield curve is flattening. These developments are historically associated with the last innings of a business expansion (Chart I-6). Chart I-5USD Entering The Negative Part Of Its Cycle USD Entering The Negative Part Of Its Cycle USD Entering The Negative Part Of Its Cycle Chart I-6Late Cycle Dynamics In The U.S. Late Cycle Dynamics In The U.S. Late Cycle Dynamics In The U.S. Finally, the global economy is experiencing a synchronized boom. As we have previously highlighted, when global economic strength is robust and felt around the world, the dollar performs poorly.3 Bottom Line: The yen's strength not only reflects domestic considerations, it is also a reflection of the dollar's own weakness. The yen is feeding on this dollar depreciation. Emerging EM Strains EM economic activity seems to be ebbing at the margin. As we showed two weeks ago, EM manufacturing production has been weakening. Additionally, EM economies, which normally magnify booms in advanced economies, are currently experiencing a relative contraction in their PMIs (Chart I-7). China probably explains this strange softness. We have long argued that Chinese monetary conditions have been tightening, which has caused a sharp deceleration in the Keqiang index, a measure of industrial activity based on credit growth, electricity production and freight volumes. We are now seeing additional signs of this mini-malaise. China's orders-to-inventories ratio has begun to contract, import volumes are weak, export price growth is slowing sharply and the volume of cargo handled at seaports is decelerating (Chart I-8). This is because the tightening in Chinese monetary conditions is beginning to affect the channels through which China impacts the rest of the world. EM tends to be at the forefront of such waves; weakness in the highly sensitive Swedish PMI supports this interpretation. This development has visible market implications. EM stocks are rebounding in unison with DM equities, but EM bonds are not. This suggests that while higher U.S. bond yields are not yet causing much pain in advanced economies, EM economies, already facing headwinds from China, are more vulnerable to the tightening in financial conditions caused by higher Treasury rates. Yield-starved Japanese investors have been heavy buyers of EM bonds. Hence, the weakness in EM bonds could be prompting a closing of EM carry trades. This favors the yen; under these circumstances, Japanese investors repatriate their money home. These dynamics can become vicious. The more Japanese investors suffer losses on their EM holdings, the more they repatriate funds at home, which lifts the yen further, pushes bond prices lower and also tightens liquidity conditions in EM economies. As a result, EM/JPY carry trades tend to lead global industrial activity (Chart I-9). These dynamics seem to be playing a role in the current phase of yen strength. Chart I-7EM Growth Is Underperforming EM Growth Is Underperforming EM Growth Is Underperforming Chart I-8Chinese Slowdown Is Becoming Impactful Chinese Slowdown Is Becoming Impactful Chinese Slowdown Is Becoming Impactful Chart I-9EM Carry Trades Flashing A Slowdown EM Carry Trades Flashing A Slowdown EM Carry Trades Flashing A Slowdown Bottom Line: Not only domestic conditions in Japan and the generalized weakness in the dollar are helping the yen, but strains in EM economies are also aiding. EM manufacturing activity is slowing and EM bond prices are falling, creating an environment normally associated with a strong yen. Outlook For The Yen Tactical Outlook Over the next three to six months, we do see further upside for the yen. To begin with, the yen can get more overbought than it currently is. Peaks in the yen have historically materialized at higher levels in our capitulation index, especially as the yen tends to display strong momentum (Chart I-10).4 Moreover, the weakness of the dollar in the face of a strong CPI report and a steepening yield curve suggests that the dollar is under immense selling pressure. Additionally, even if the yen trades at a large discount of 12% relative to purchasing power parity, speculator are short a near-record 50% of the open interest. This means that as the yen strengthens, it could become very vulnerable to a short covering rally that would mechanically push the JPY significantly higher. The growing international impact of the policy induced Chinese soft patch could also gather further momentum, and support the yen in the process. As Chart I-11 illustrates, when Chinese imports of copper concentrates slow, it often leads to substantial depreciation in USD/JPY. These copper imports are currently decelerating sharply. Chart I-10More Upside For The Yen More Upside For The Yen More Upside For The Yen Chart I-11Chinese Dynamics Favor The Yen Chinese Dynamics Favor The Yen Chinese Dynamics Favor The Yen The large amount of complacency still present in the market further suggests that risks remain skewed to the upside for the yen. Not only could potential EM weakness weigh on commodity prices - a crucial component of our Complacency Index - but also volatility clustering suggests it is likely to spike again repeatedly in the coming months, despite having fallen precipitously after last week's surge. This combination would cause our Complacency Index to fall, a climate historically associated with a strong yen, unless the BoJ eases aggressively (Chart I-12). This picture is corroborated by the general positioning in the FX market. Speculators are massively long risky currencies versus safer ones. Historically, such skewed positioning tends to be followed by rallies in the yen, unless the BoJ eases aggressively (Chart I-13). Looking outside the FX market, investors still hate bonds. Sentiment toward Treasurys is very depressed, speculators are very short 10-year bonds and portfolio managers are massively underweight duration (Chart I-14). This makes bond yields vulnerable to a pullback. For this to materialize, Ryan Swift, who writes BCA's U.S. Bond Strategy service, argues that the U.S. surprise index has to fall back below zero.5 The more than 90-basis-point rise in U.S. bond yields since September will clip some momentum from U.S. growth - not enough to cause a large slowdown, but potentially enough to generate a patch of negative surprises. Chart I-12Less Complacency Equals Stronger Yen Less Complacency Equals Stronger Yen Less Complacency Equals Stronger Yen Chart I-13More Signs Of Complacency More Signs Of Complacency More Signs Of Complacency Chart I-14Duration Positioning Points To Upside Risk For The Yen Duration Positioning Points To Upside Risk For The Yen Duration Positioning Points To Upside Risk For The Yen Bottom Line: The international factors that have helped the yen over the past two months will be driving the tactical strength in the JPY. The BoJ is already trying to lean against the yen's strength, as it has recently increased its JGB purchases. While we do not think it is has done enough to weaken the yen in the short term, in our view, the BoJ will remain the biggest headwind for the yen beyond the next six months. Cyclical Outlook This naturally brings us to the cyclical outlook for the yen. We believe that USD/JPY is most likely to settle in the 104 to 102 range, and maybe even test 100. At these levels, we would buy this pair. Why? Simply, for the yen to rally durably, it will require an end to YCC. While markets are probably pricing this outcome right now, we think it is too early to do so. The rhetoric of the BoJ remains very clear: The central bank is committed to maintaining YCC until inflation overshoots its 2% target. Not only are we not there yet, but there are still many obstacles to beat in order to achieve this objective. Moreover, some of these hurdles are becoming more potent. First, while Japan's labor market seems at full employment, industrial capacity is still replete with excess slack. As Chart I-15 shows, Japanese capacity utilization may be near cycle highs, but it remains well below the levels that prevailed before the Great Financial Crisis. Moreover, since Japanese growth has been lifted by the recent EM boom, the country's own mini-boom will suffer from the EM slowdown. As the bottom panel of Chart I-15 illustrates, like China's, Japan's shipments-to-inventories ratio is falling. This is a reliable leading indicator of industrial production. So not only is Japan growth set to slow in the second half of 2018, but low capacity utilization will still be muting inflationary pressures. Second, as we highlighted one month ago, Japan's inflation is hyper sensitive to Japanese financial conditions. The recent improvement in Japan's consumer prices excluding food and energy reflects the lag impact of the previous easing in financial conditions (Chart I-16), which itself is courtesy of the prior weakness in the trade-weighted yen. However, this positive inflationary impulse is set to fade, and the stronger the yen gets, the more likely that inflation slows. The fall in money supply resulting from a strong yen only adds credence to this assertion (Chart I-17). This will reinforce the BoJ's willingness to keep YCC in place and could even incentivize the central bank to increase its asset purchases closer to target in order to clearly communicate its intentions to the market. Chart I-15Will The BoJ Stand##br## Idly By? Will The BoJ Stand Idly By? Will The BoJ Stand Idly By? Chart I-16Inflation Is Picking Up Because ##br##Financial Conditions Eased Inflation Is Picking Up Because Financial Conditions Eased Inflation Is Picking Up Because Financial Conditions Eased Third, the yen's strength could hurt Japan's competitiveness and increase domestic deflationary pressures. As the top panel of Chart I-18 illustrates, CNY/JPY has broken down through a key trend line, heralding additional weaknesses. Moreover, the yen has begun to appreciate against other Asian currencies (Chart 18, bottom panel). Our Emerging Markets Strategy service is initiating a long JPY/KRW trade this week, betting on further strength in the yen against other Asian currencies. The BoJ will pay attention to these matters. This combination suggests it is premature for investors to begin betting on an end to YCC in Japan. Thus, the domestic underpinning of the yen's rally seems flawed right now. Only once inflation is more clearly vanquished, or the yen falls substantially in value - enough to generate another outsized gain in Japanese inflation - will this bet become more justified. Chart I-17The Yen Is Already Hurting Money Supply The Yen Is Already Hurting Money Supply The Yen Is Already Hurting Money Supply Chart I-18The Yen Hurts Japan Competitiveness The Yen Hurts Japan Competitiveness The Yen Hurts Japan Competitiveness Bottom Line: While we do continue to see room for the yen to strengthen over the course of the next three to six months, we think such a move will not be durable. We will look to buy USD/JPY once it falls below 104. We believe the yen's short-term strength is more likely to be powered by external factors, as it is still too early to bet on the end of YCC. The yen will be able to embark on a clear cyclical bull market once conditions fall into place for the BoJ to abandon this policy. We are not there yet. Implementation Considerations We have recommended investors sell EUR/JPY for safety reasons. From a contrarian perspective, positioning in EUR/JPY is even more skewed than positioning in USD/JPY (Chart I-19, left panel). Moreover, EUR/JPY trades at a significant premium to our short-term fair value model, adding a significant margin of safety (Chart 19, right panel). While we still like this position, the dismal trading in the USD this week underscores that USD/JPY still offers plenty of downside as well. Chart I-19ARisks To EUR/JPY (I) Risks To EUR/JPY (I) Risks To EUR/JPY (I) Chart I-19BRisks To EUR/JPY (II) Risks To EUR/JPY (II) Risks To EUR/JPY (II) We are also very negative on commodity currencies versus the yen. Weakness in EM growth and in EM bonds should be particularly unkind to AUD/JPY and NZD/JPY. Additionally, from a valuation perspective, these two crosses represent attractive shorting opportunities (Chart I-20). Of the two, shorting AUD/JPY should be the most profitable bet. As we wrote three weeks ago, the Australian dollar seems especially vulnerable right now because nominal growth is set to fall and the labor market continues to be weak. Moreover, Australia's terms of trade is more exposed to a fall in the share of capex in China than in New Zealand.6 Chart I-20ACommodity Currencies Look Especially ##br##Vulnerable Against The Yen (I) Commodity Currencies Look Especially Vulnerable Against The Yen (I) Commodity Currencies Look Especially Vulnerable Against The Yen (I) Chart I-20BCommodity Currencies Look Especially##br## Vulnerable Against The Yen (II) Commodity Currencies Look Especially Vulnerable Against The Yen (II) Commodity Currencies Look Especially Vulnerable Against The Yen (II) Bottom Line: While shorting EUR/JPY remains a safe way to play a continuation of the tactical rebound in the yen, shorting USD/JPY may offer a potential higher reward, but at higher risk. Shorting commodity currencies versus the yen, especially the AUD, still remain the vehicles with the highest potential payoffs. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Yen: QQE Is Dead! Long Live YCC!", dated January 12, 2018, available at fes.bcaresearch.com 2 Based on output prices, overall business conditions, and consumer confidence. 3 Please see Foreign Exchange Strategy Weekly Report, titled "A Cold Snap Doesn't Make A Winter", dated January 5, 2018, available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Special Report, titled "Riding The Wave: Momentum Strategies In Foreign Exchange Markets", dated December 8, 2017, available at fes.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, titled "How Much Higher For Yields?", dated October 31, 2017, available at usbs.bcaresearch.com 6 Please see Foreign Exchange Strategy Weekly Report, titled "From Davos To Sydney, With a Pit Stop In Frankfurt", dated January 26, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 U.S. data was mixed: Inflation beat expectations, coming in at 2.1% for the headline measure and 1.8% for the core measure; Retail sales contracted by 0.3% on a monthly rate, with the core measure experiencing no growth; In line with expectations, initial jobless claims increased to 230,000; Capacity utilization came down a little at 77.5%;as Industrial production contracted by 0.1% on a monthly pace; Not even a strong inflation report was able to lift the greenback, which is a very negative sign. This could indicate that the dollar is experiencing a capitulation. A rebound in the USD is likely in the coming quarter, but this is likely to require a slowdown in global growth. Report Links: Who Hikes Again? - February 9, 2018 A Cold Snap Doesn't Make A Winter - January 5, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 European data was mixed: German 2017 Q4 GDP growth mixed expectations of 3%, coming in at 2.9%; German CPI was in line with expectations at 1.6%; European GDP in Q4 of 2017 grew by 2.7% annually, as expected; Industrial production increased by 5.2%, beating expectations; While the euro had a strong week, the long euro trade is very overcrowded. Early signs of weakening in various indicators reflect signs that tightening financial conditions could start hurting growth. The most recent selloff in risky assets further proves this point. A short-term correction is likely to come in the following months, but the euro's cyclical bull market remains intact. Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been negative: The leading economic indicator surprised to the downside, coming in at 107.9. This measure also declined from the previous month. Moreover, annualized gross domestic product growth also underperformed expectations coming in at 0.5%. Finally, machinery orders yearly growth underperformed expectations substantially, coming in at -5%. This growth rate declined from 4% in the previous month. USD/JPY has depreciated by more than 2.5% this past week. This cross is now at its lowest point since Trump's election in late 2016. Overall we think that USD/JPY has more downside, as the rise in yields, coupled with a potential slowdown in global trade, and reduced industrial activity in China should continue to weigh on EM assets. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Both core and headline inflation surprised to the upside, coming in at 2.7% and 3% respectively. However, the retail price index yearly growth underperformed expectations, coming in at 4%. This measure also declined from last month's number. Moreover, industrial production yearly growth also underperformed expectations, coming in at 0%. This measure also declined from 2.6% the previous month. GBP/USD has rallied by nearly 1% this week. This has been mostly due to the weakness in the dollar as the trade-weighted pound continued to depreciate since it texting the upper-bound of its range on tk. Overall, we expect that inflation should ease from here on out, as the pound strength should start to translate into lower prices from imported goods, this will limit the number of hikes currently priced into the SONIA curve. Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - ­February 2, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Data out of Australia was mixed: NAB Business Confidence and Business Conditions both outperformed expectations, coming in at 12 and 19, respectively; The Westpac Consumer Confidence declined to -2.3% from 1.8%. The unemployment rate declined to 5.5%, in line with expectations; Part-time employment increased by 65,900, while full-time employment declined by 49,800. At a speech on Monday, RBA Assistant Governor Luci Ellis brought forward important arguments regarding the macroeconomic situation of Australia. She highlighted the lack of wage growth and high household debt, and pointed specifically to the low household consumption growth which stand in sharp contrast to the experience of other developed countries. Recent data continues to highlight the slack in the Australian labor market, and the AUD is likely to suffer this year due to these factors and its large overvaluation. Report Links: Who Hikes Again? - February 9, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been positive: The participation rate outperformed expectations, coming in at 71%. Moreover, the unemployment came below expectations, coming in at 4.5%. It also declined from last quarter number. Finally, RBNZ inflation expectations also increased from 2% in Q3 to 2.1% in Q4. On February 8th, the RBNZ elected to keep the policy rate unchanged. In its projections, the RBNZ expects that the trade weighted exchange rate will ease over the projection period. Overall, we expect that the New Zealand dollar will outperform the Australian dollar, given that New Zealand's economy is in a much better footing to sustain rate hikes than Australia. Moreover, a slowdown in the Chinese industrial sector would affect Australia much more than New Zealand, given that New Zealand exports are geared more towards the Chinese consumer. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The CAD strengthened against the greenback by almost 1% this week. This was largely a result of the setback in the USD, and we remain neutral on the CAD for the year. That being said, Canada's superior growth position relative to most other DM commodity producers mean that the CAD is set to appreciate against the AUD. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been mixed: Producer and import price yearly growth outperformed expectations, coming in at 1.8%. Moreover, the unemployment rate came in line with expectations at 3%. However, headline inflation underperformed expectations, coming in at 0.7%. EUR/CHF has been relatively flat this past week. The recent negative inflation release is a prime example of the entrenched deflationary pressures in Switzerland in spite of a weak franc. Overall, we believe that the SNB will be maintain their ultra-dovish monetary policy as well as their currency interventions, as long as prices remain contained. This means that while bouts of risk-off sentiment will cause temporary corrections in EUR/CHF, the primary trend for this cross still points upward. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been mixed: Core inflation underperformed expectations substantially, coming in at 1.1% against anticipations of 1.5%. It also declined from 1.4% on the previous month. However, manufacturing production outperformed expectations After rallying by more than 5% in the first week of February, USD/NOK has given up some of those gains, falling by nearly 3% last week. Overall we expect that the Norwegian krone should outperform other commodity currencies, given that a slowdown in industrial activity in China will cause oil to outperform metals. Moreover, the market is only expecting roughly one rate hike in the next year by the Norges Bank, while anticipating nearly three hikes in Canada. We expect this spread in expectations to converge, putting downward pressure on CAD/NOK. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 The Riksbank's monetary policy meeting on Wednesday contradicted remarks by officials earlier this year regarding a possible policy move in early 2018. In a mild volte face, Riksbank deputy governor Per Jansson pointed to Sweden's "problem with underlying price" pressures to argue in favor of a summer hike. Riksbank officials fear that tightening ahead of the ECB may lead to too strong a currency and depress prices. They also pointed to falling wage growth despite the increasingly tightening labor market. While we are optimistic on Sweden's growth prospects, this development was highlight that Ingves' dovish inclinations still linger within the walls of this central bank. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Despite having the largest negative return of major markets during the global equity market correction, China's investable stock selloff appears to be normal after controlling for its risk characteristics. Taken together, the association between the global correction and volatility/valuation should be viewed as a sharp reduction in complacency in the market. Several factors make us cautious about China's outsized tech sector exposure in a world of reduced complacency. We recommend that investors retain cyclical exposure to investable Chinese stocks while neutralizing exposure to the tech sector. Feature Chart 1An Average Size, But Very Rapid, ##br##Global Selloff An Average Size, But Very Rapid, Global Selloff An Average Size, But Very Rapid, Global Selloff Global equities have sold off quite sharply since the end of January, having declined a total of 9% in US$ terms from their January 26 high to last Friday's close (Chart 1). BCA addressed the rout in a Special Report last week,1 and noted that strong economic growth and positive earnings surprises are likely to keep the global equity bull market intact, a view largely supported by this week's stock market behavior. Still, the report also highlighted that investors need to adjust to the fact that realized volatility is likely to sustainably rise, even if forward-looking volatility measures (such as the VIX in the U.S.) are currently too elevated. More generally, we equate the return of volatility with a reduction in complacency, and in this week's report we explore the implications of lower complacency for investors with an overweight allocation towards Chinese equities. Our judgement is that the complacency risk for China's ex-tech equity market is low, but that the same cannot be said for China's technology stocks. We conclude by recommending two trades that investors can employ to retain cyclical exposure to investable Chinese stocks, but with a neutralized exposure to the tech sector. Normal Underperformance For China Chart 2At First China Appears To Be Among ##br##The Worst Performers... After The Selloff: A View From China After The Selloff: A View From China At first blush, China's investable stock market fared quite poorly during the global stock market correction. Chart 2 lists 21 major country stock markets by the magnitude of their decline in US$ terms and highlights that China's selloff ranks at the very top of the list. But a simple comparison of stock market performance is misleading, as it fails to adjust for the different degrees of riskiness that are normally observed across global equity markets. For example, it is well known that emerging market equities have tended to be high beta relative to global stocks over the past decade, and we noted in a recent Special Report that Chinese investable stocks have become high beta even relative to emerging markets. In order to properly compare the performance of these markets during the global stock market selloff, we rely on the concept of "abnormal return" that is often employed in event study analysis. This approach involves calculating a counterfactual "normal" return for each market based on its rolling 1-year alpha and beta versus global stocks prior to the selloff, and then comparing it to the actual return. This difference, the "abnormal return" of each market, is shown in Chart 3, which highlights that China's performance during the selloff was perfectly normal after controlling for its risk characteristics. In fact, Chart 3 shows that many equity markets outperformed on a risk-adjusted basis, highlighting that the magnitude of the selloff in global stocks could actually have been worse. As for the underlying cause of the selloff, we showed in last week's Special Report that a crowded "short volatility" trade was undoubtedly a driving force: Chart 4 highlights that net long speculative positions on the VIX had fallen to a new low over the past six months, a circumstance that has now completely reversed. But Chart 5 shows that valuation also appears to have been a factor contributing to the selloff, by presenting the abnormal returns shown in Chart 3 as a function of the difference between the market's 12-month forward P/E and that of the global benchmark. While the fit is somewhat loose, the chart confirms that markets with higher (lower) forward P/E ratios were more likely to have negative (positive) abnormal returns over the two-week period. Chart 3...But Not After Adjusting##br## For Riskiness After The Selloff: A View From China After The Selloff: A View From China Chart 4The Low-Vol Trade Contributed ##br##To The Speed Of The Selloff... The Low-Vol Trade Contributed To The Speed Of The Selloff... The Low-Vol Trade Contributed To The Speed Of The Selloff... Taken together, the association between the selloff and volatility/valuation should be viewed as a sharp reduction in complacency in the market. While this does not necessarily bode poorly for global equities over the coming 6-12 months, there are some potential implications to explore for China's investable stock market. Chart 5...But Valuation Was Also A Factor After The Selloff: A View From China After The Selloff: A View From China Complacency Risk And Chinese Stocks The sharp reversal in global markets raises the question of whether Chinese equities are complacent about some looming risk. The obvious candidate for complacency risk in China would be focused on its economy, and the potential for a more substantial economic slowdown than is currently expected by market participants. However, we are unconvinced that Chinese ex-tech stocks are somehow neglecting the risks facing China's economy over the coming year. First, we have noted in previous reports that Chinese investable ex-tech stocks are extremely cheap versus global ex-tech stocks, highlighting that investors have priced in a degree of structural risk. Second, recent economic data releases from China do not suggest that the pace of the ongoing economic slowdown is accelerating, suggesting that there is no basis to expect a severe downturn over the coming year. But we acknowledge that the same cannot be said for China's tech sector. While Chinese tech stocks are not stretched on a technical basis (either versus the investable benchmark or versus global tech stocks), several observations make us cautious about China's outsized tech exposure in a world of reduced complacency: First, the growth rates of IBES 12-month trailing and forward earnings growth for global technology stocks are currently at the 80th and 85th percentiles, respectively (Chart 6). This suggests that a substantial amount of fundamental improvement has already been priced in to global tech stocks, raising the risk of earnings disappointment over the coming year. Given that China's tech sector weight (42%) is considerably above that of the global benchmark (18%), a global tech selloff would cause China's investable stock market to underperform even if Chinese tech performance is in line with that of the global tech sector. Second, relative to global technology stocks, the growth rates of China's 12-month trailing and forward earnings growth are also quite elevated, at the 80th and 70th percentiles, respectively (Chart 6 panel 2). This suggests that the tech earnings exuberance observed globally is even worse in China. Third, Chart 7 highlights that China's tech sector has been responsible for pushing our relative composite valuation indicator for China into overvalued territory over the past year. Relative to global ex-tech, China's ex-tech stocks are still significantly cheap; relative to global tech, China's tech stocks are significantly overvalued. Last, we have noted in past reports that China's tech sector appears to be a domestic consumer play, and thus unlikely to significantly underperform over the coming year. However, we also noted in last week's report on China's housing market that the optimism of the consumer sector may be somewhat unfounded if it is based on expectations of future gains in employment and/or income.2 While we do not expect a broad-based retracement in China's consumer sector, even a moderate decline in consumer confidence could spark a non-trivial selloff in Chinese tech stocks given the stretched fundamental picture highlighted above. Chart 6Tech Earnings Growth##br## Is Significantly Stretched Tech Earnings Growth Is Significantly Stretched Tech Earnings Growth Is Significantly Stretched Chart 7Tech Stocks Have Pushed China ##br##Into Overvalued Territory Tech Stocks Have Pushed China Into Overvalued Territory Tech Stocks Have Pushed China Into Overvalued Territory Investment Recommendations Given our observations about the complacency risk facing Chinese tech sector stocks, we are making the following changes to our investment recommendations: We are closing our overweight MSCI China Free versus the emerging markets benchmark trade for a 31% relative return. This has been a core trade for BCA's China Investment Strategy service and has provided investors with significant outperformance since its initiation in May 2012. We are opening two new trades as a replacement for the closed China / EM position: 1) long MSCI China investable ex-technology / short MSCI All Country World ex-technology, and 2) long MSCI China investable value / short All Country World value. These two new trades are a slight variation of a single theme, which is to retain cyclical exposure to investable Chinese stocks while neutralizing exposure to the tech sector. While style indexes such as value and growth normally do not have such a stark sector orientation, Chart 8 highlights that the relative performance of China value vs global value looks very similar to our internally-calculated ex-technology indexes for both markets. This is because MSCI's China growth index is almost entirely made up of tech sector stocks, meaning that a relative value play effectively mimics an ex-tech position. As a final point, we noted above that it is difficult to see how Chinese ex-tech equities are complacent about the ongoing slowdown in China's economy. Chart 9 supports this view by presenting a model for China's investable ex-tech 12-month trailing earnings in US$ terms, based on the Li Keqiang index. The model fit has been tight over the past decade, and is currently forecasting roughly 10% earnings growth over the coming year. This would clearly represent a significant deceleration from current levels, but it is still a decent earnings result that signals Chinese ex-tech stocks are attractive on a risk/reward basis given the sizeable valuation discount that is levied on China relative to global stocks. Chart 8China Ex-Tech And Value:##br## Similar Performance Vs Global China Ex-Tech And Value: Similar Performance Vs Global China Ex-Tech And Value: Similar Performance Vs Global Chart 9Positive Ex-Tech Earnings Growth Likely, ##br##Even With A Slowing Economy Positive Ex-Tech Earnings Growth Likely, Even With A Slowing Economy Positive Ex-Tech Earnings Growth Likely, Even With A Slowing Economy We remain alert to the possibility of a further, more pronounced slowdown in China's economy, but barring that Chinese ex-tech stocks appear to be a solid buy over the coming 6-12 months. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "The Return Of Vol", dated February 6, 2018, available at gis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Is China's Housing Market Stabilizing?", dated February 8, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights As the Fed proceeds with its policy tightening this year, higher real rates and a stronger USD will weigh on silver and platinum prices, and, to a lesser extent, palladium prices. Offsetting these downward pressures, silver, and to a lesser extent platinum, could take their lead from the gold market, and outperform on the back of increased equity volatility and understated geopolitical risks this year.1 Palladium, as always, will march to its own drummer, as this market's defining feature remains chronic physical deficits and depleted inventories, which will prevent prices from reacting too severely to tighter Fed policy this year. Energy: Overweight. Supply-demand fundamentals still are supportive of crude oil prices overall, and continued backwardation in forward curves. Our long Jul/18 WTI vs. short Dec/18 WTI calendar spread, which gains as backwardation becomes more pronounced, is up 47.4% since inception on November 2, 2017. Base Metals: Neutral. Base metals remain well supported by still-strong global growth, estimates of which were revised higher by the IMF in its most recent World Economic Outlook. Precious Metals: Neutral. Fed tightening this year will weigh on silver and platinum, less so palladium (see below). Our long gold portfolio hedge is up 7.9%. Ags/Softs: Underweight. The USDA revised down its forecast of U.S. corn ending stocks in the latest WASDE on the back of an upwards revision to U.S. corn exports. Feature The term "precious metals" is something of a misnomer: Gold, silver, and platinum-group metals (PGMs) - chiefly platinum and palladium - do not constitute a single asset class, and should not be treated as such (Chart of the Week). Nevertheless, as with most commodity markets we cover, the evolution of these markets is highly sensitive to U.S. financial variables, particularly as regards monetary policy. Palladium is something of an outlier: It behaves more like an industrial metal, while silver, and to a lesser extent platinum, are more sensitive to the fundamental drivers of gold prices - i.e., the evolution of the USD's broad trade-weighted index (USD TWIB), and real U.S. interest rates. Palladium's demand is dominated by its use in catalytic converters in gasoline-powered cars, whereas industrial applications form a more limited source of demand for platinum and silver (Chart 2). Chart of the WeekA Schism In Precious Metals A Schism In Precious Metals A Schism In Precious Metals Chart 2Industrial Uses Dominate Palladium Silver, Platinum At Risk As Fed Tightens; Palladium Less So Silver, Platinum At Risk As Fed Tightens; Palladium Less So Gold, silver, and, to a more limited extent platinum are cointegrated in the long run, meaning their prices follow their own random walks, even though they share a long-term trend. Palladium, on the other hand, is more responsive to the physical realities of the automobile market - chiefly, demand for gasoline-powered cars. In our econometric analysis of the behavior of PGMs and silver, we use the CRB Metals Index as a proxy for industrial activity. We find that while all three are sensitive to changes in the CRB Metals Index, palladium prices are significantly more responsive (i.e., elastic) to industrial activity than platinum and silver (Table 1). Table 1Palladium Behaves Like An Industrial Metal Silver, Platinum At Risk As Fed Tightens; Palladium Less So Silver, Platinum At Risk As Fed Tightens; Palladium Less So Furthermore, while gold prices impact both silver, and, to a lesser extent platinum, they are not significant when it comes to the palladium market. Bullish Fundamentals Tightened Palladium Market Palladium registered a 60% gain in 2017. Its forward curve has been backwardated since June (Chart 3). This backwardation - i.e., spot prices trade higher than deferred prices - is a symptom of a tight market. In fact, according to Thomson Reuters GFMS data, the palladium market has been in a chronic deficit since 2007, with the 2017 deficit the largest since 2000. The culprit in this case has been strong demand and stagnant supply. While supply has been growing ~ 1% year-over-year (yoy) over the past 5 years, demand growth has averaged 1.7% yoy over the same period. Palladium demand over this period has been driven by its growing use in automobile catalytic converters, most notably in China, where sales of gasoline-powered cars exceed those of diesel-powered cars, which typically use platinum in their catalytic converters (Chart 4). Chart 3Tight Fundamentals In##BR##The Palladium Market Tight Fundamentals In The Palladium Market Tight Fundamentals In The Palladium Market Chart 4Growing Demand For##BR##Autocatalysts Dominated In The Past... Silver, Platinum At Risk As Fed Tightens; Palladium Less So Silver, Platinum At Risk As Fed Tightens; Palladium Less So Growth in global demand for palladium-based autocatalysts averaged 4.8% yoy in the past 5 years. The use of palladium for autocatalysts now makes up more than 75% of global palladium demand, up from 56% 10 years ago. Chinese demand for palladium used in autocatalysts grew from 10% of global demand in 2007 to more than a quarter of global demand last year. Given autocatalysts' oversized contribution to demand growth, the palladium market is highly dependent on car sales. Our modelling highlights global car production as a significant explanatory variable when it comes to palladium prices. Most significant are the U.S. and Chinese markets, which are the largest markets for gasoline-powered cars. While vehicle sales in China were strong in 2016, they have slowed considerably and recorded yoy declines in the most recent November and December data (Chart 5). Slowing demand growth for cars in China likely comes on the back of the phasing out of tax cuts on small vehicles. This will limit the upside for palladium prices from China's industrial demand. Growth in car sales in the U.S. has been even more muted, contracting in 2017 for the first time since 2009. However, a more concerted adoption of gasoline-powered cars in Europe - largely in response to efforts by cities to reduce emissions of particulate matter from diesel engines, and the highly publicized emissions-testing scandals involving European carmakers - will, at least partially, mitigate the negative impact of slowing demand from the top two gasoline-powered markets. On the supply side, global mine supply has been relatively stagnant over the past 5 years, expanding an average 1.2% yoy during this period. Russia, South Africa and Canada account for almost 90% of total palladium mine supply. And while Russian and South African supplies have been relatively flat over the years, Canadian palladium has grown to account for ~11% of global supply in 2017, up from 4% in 2010. Global palladium supply has been supported by metal recovered from autocatalyst scrap, which has been averaging 4.8% yoy growth in supply over the past 5 years. In fact, the share of palladium recovered from autocatalyst scrap has almost doubled in the past 10 years, and now makes up almost 20% of total supply. Growth in this source of supply has come down significantly (Chart 6). However, we expect palladium's exorbitant price and elevated steel prices to incentivize an increase in the metal's recovery from scrap. Indeed, GFMS expects recycled palladium to pave record highs this year and to surpass 2 million ounces next year. Chart 5...But Beware Of Slowing Gasoline Car Sales ...But Beware Of Slowing Gasoline Car Sales ...But Beware Of Slowing Gasoline Car Sales Chart 6Palladium Needs Restocking Palladium Needs Restocking Palladium Needs Restocking Strong demand, combined with limited supply growth, has weighed on palladium inventories. Furthermore, ETF holdings of palladium have come down sharply while net speculative long positions have skyrocketed. Given that stocks are so low, we do not expect a severe fall in prices. Bottom Line: Palladium behaves like an industrial metal and is especially sensitive to changes in demand for automobiles. While the stars were aligned for palladium last year - a weak USD, low real interest rates, and bullish fundamentals - car sales in the U.S. and China have been slow recently. Even so, a physical deficit will prevent a crash in the palladium market this year. Platinum Trading At A Discount To Palladium In contrast with palladium's remarkable performance last year, platinum was up a mere 3.4% in 2017. In fact palladium, which usually trades at a discount to platinum, has been more expensive since October (Chart 7). This can be attributed to differences in fundamentals. Palladium's market conditions have been significantly tighter than platinum. Greater demand for the physical metal than supply put the market in deficit last year, which supported platinum prices. As with palladium, catalytic converters are a major demand source for platinum; however, they account for ~ 40% of platinum demand - considerably less than the roughly 80% share of palladium demand accounted for by catalytic converter demand. Europe is the largest market for diesel cars, and, while total vehicle sales in Europe have remained healthy, diesel-powered cars have been losing market share since the Volkswagen emissions-rigging scandal came to light in 2015 (Chart 8). This hit platinum use in autocatalysts particularly hard. In addition, weaker demand from its second use - jewelry - is keeping a lid on platinum prices (Chart 9). In fact, Chinese demand for the white metal, which accounts for more than 50% of global platinum jewelry demand, has been falling. Despite weakening demand, global balances remained in deficit on the back of muted supply. Chart 7Platinum Now Cheaper Than Palladium Platinum Now Cheaper Than Palladium Platinum Now Cheaper Than Palladium Chart 8EU Diesel Car Market Losing Momentum EU Diesel Car Market Losing Momentum EU Diesel Car Market Losing Momentum Chart 9Platinum Jewelry Losing Its Appeal Silver, Platinum At Risk As Fed Tightens; Palladium Less So Silver, Platinum At Risk As Fed Tightens; Palladium Less So Platinum's market balance could be at risk if carmakers start using more of it in catalytic converters, now that it trades at a discount to palladium. Platinum is a superior material for autocatalysts, but palladium has been traditionally favored on a cost basis. Platinum's lower price incentivizes carmakers to switch to this metal. According to Johnson Matthey, it will be two years before the impact of such substitution begins to affect the palladium market. Bottom Line: Subdued demand for platinum jewelry combined with the loss of market share for diesel-powered cars in Europe will keep a lid on the platinum market this year. However, platinum follows gold, and this could support prices if equity investors hedge market volatility and future corrections by purchasing the metal. Silver Follows Gold Silver, and, to a lesser extent, platinum are not as exposed to the industrial business cycle as palladium. These metals' prices instead move in line with gold (Chart 10). Our modeling reveals that a 1% increase in gold prices is associated with a 0.76 pp increase in silver prices. Thus gold's spillovers to the silver market are significant. Even so, there are periods when this relationship disconnects. This is because, although industrial uses do not account for as large a share of silver demand as they do for palladium, such fundamentals do account for a significant source of demand. Thus, in addition to the financial factors which drive gold, silver's industrial applications give it some exposure to economic activity. In fact, a 1% increase in the CRB Metals Index is associated with a 0.17pp increase in silver prices. This explains why, in some instances, silver's cointegration with gold weakens. As a practical matter, gold is a superior hedge against equity downfalls than silver (Chart 11). While gold month-on-month (mom) returns outperform S&P 500 mom returns almost 80% of the time in periods of decreasing equity returns, the ratio for silver comes in at a lower 67%. On the other hand, gold mom returns outperform S&P 500 returns less than 30% of the time during periods when equities are increasing, while silver outperforms the stock market almost 40% of the time. Chart 10Silver And Gold##BR##Move In Tandem Silver And Gold Move In Tandem Silver And Gold Move In Tandem Chart 11Gold Outperforms Amid Equity Downfalls,##BR##Not During Rising Stocks Silver, Platinum At Risk As Fed Tightens; Palladium Less So Silver, Platinum At Risk As Fed Tightens; Palladium Less So In addition, although both gold's and silver's correlations with the S&P 500 become large and negative when the S&P 500 decreases in yoy terms, this negative correlation in the case of gold is significantly larger than for silver (Chart 12). In fact, along with silver's relatively weaker negative correlation with the S&P 500 during periods of negative equity returns, silver also exhibits a relatively stronger positive correlation with equities during periods of positive returns. While silver is an effective hedge against geopolitical and economic crises, gold's hedging ability remains superior (Chart 13). Silver and gold post similar returns during geopolitical crises; however, gold returns are significantly higher during economic crisis. Chart 12Negative Correlations More##BR##Pronounced During Equity Downfalls Negative Correlations More Pronounced During Equity Downfalls Negative Correlations More Pronounced During Equity Downfalls Chart 13Gold Is A##BR##Superior Protection Silver, Platinum At Risk As Fed Tightens; Palladium Less So Silver, Platinum At Risk As Fed Tightens; Palladium Less So This supports the finding that silver's hedging ability is hampered by its use in industrial applications, which make it more responsive to the business cycle than gold. Bottom Line: Gold and silver prices are cointegrated. However, given silver's industrial applications, it is more sensitive to business activity. This explains the periods of divergence in the two precious metals, and limits silver's ability to hedge against economic crises and falling equities. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 For a discussion of the gold market fundamentals, please see Commodity & Energy Strategy Weekly Report titled "Gold Still Shines Despite Threat Of Higher Rates," dated February 1, 2018. Available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Silver, Platinum At Risk As Fed Tightens; Palladium Less So Silver, Platinum At Risk As Fed Tightens; Palladium Less So Trades Closed in 2018 Summary of Trades Closed in 2017 Silver, Platinum At Risk As Fed Tightens; Palladium Less So Silver, Platinum At Risk As Fed Tightens; Palladium Less So

Highlights The trajectory of EM bank profits and share prices will be critical to sustain the EM equity rally. Rising U.S. bond yields will push up EM local bond yields. This, along with poor quality of banks' earnings, will likely halt EM banks' stock rally. We reiterate our strategic equity position: short EM banks / long U.S. banks. The same strategy can be replicated in credit markets. In China, bank loan data are no longer indicative of aggregate lending to all segments of the economy. Banks' total claims, total assets, and money aggregates have all slowed. The Korean won is making a major top. Short it against an equal-weighted basket of the U.S. dollar and yen. Feature Chart I-1Rising U.S. Bond Yields = Higher EM Local ##br##Bond Yields And Lower Bank Stocks Rising U.S. Bond Yields = Higher EM Local Bond Yields And Lower Bank Stocks Rising U.S. Bond Yields = Higher EM Local Bond Yields And Lower Bank Stocks The key financial market variables with respect to the outlook for emerging markets (EM) are commodities prices, the U.S. dollar and EM bank share prices. We have written extensively on the former two, and today we elaborate on the third pillar: the importance of banks/financial stocks to the EM aggregate equity index. First, surging U.S. Treasurys yields point to higher EM local currency bond yields (Chart I-1, top panel). In turn, EM banks' share performance inversely correlates with EM local bond yields (Chart I-1, bottom panel). Altogether, this heralds lower EM bank share prices. Second, financials make up 24.4% of the MSCI EM equity market cap, with banks accounting for 18% out of the 24.4%. Hence, financials/banks' price fluctuations are critical to the EM equity benchmark. Importantly, financials' earnings accounts for 33.6% of EM listed companies earnings. By contrast, technology accounts for 27.6% of the EM market cap, but only 23.3% of EM total earnings (Table I-1). As to the EM technology sector, it is heavily skewed toward four large companies: Tencent, Alibaba, Samsung and TSMC. The latter two have already shown considerable weakness, with Samsung breaking down below its 200-day moving average (Chart I-2). Analyses on the former two companies are beyond the realm of macro research. What's more, these stocks are extremely overbought and probably expensive. If the rest of EM goes down, these two stocks are not likely to preclude it from happening. Third, banks in China, Turkey, Indonesia, Malaysia and Brazil have been boosting their reported EPS by reducing their provisions outright or the pace of provisioning. Table I-1EM Equity Sectors: Earnings & Market Cap Weights EM Bank Stocks Hold The Key EM Bank Stocks Hold The Key Chart I-2Is EM Tech Hardware Breaking Down? Is EM Tech Hardware Breaking Down? Is EM Tech Hardware Breaking Down? For various reasons, we believe these reductions in provisions are unjustified. In China, Turkey and Malaysia, NPLs are too low to begin with: the more accurate measures of NPLs are probably much higher in these banking systems given the magnitude and duration of the preceding credit boom (Chart I-3 and Chart I-4). Chart I-3China: Banks' Provisions Are Inadequate bca.ems_wr_2018_02_14_s1_c3 bca.ems_wr_2018_02_14_s1_c3 Chart I-4Turkey And Malaysia: ##br##Falling Provisions Are Untenable Turkey And Malaysia: Falling Provisions Are Untenable Turkey And Malaysia: Falling Provisions Are Untenable In Brazil and Indonesia, the recent weakness in nominal GDP growth - shown inverted on the chart - does not justify the outright reduction in the level of net new NPL provisions (Chart I-5). In short, some EM banks have inflated their EPS in recent quarters by reducing provisioning for bad loans. This suggests that their EPS quality is poor, and their profit recovery is unsustainable. Bottom Line: EM bank share prices have reached their previous high but are unlikely to break above that level, in our opinion (Chart I-6). Chart I-5Brazil And Indonesia: Declining ##br##Provisions Are Unsustainable Brazil And Indonesia: Declining Provisions Are Unsustainable Brazil And Indonesia: Declining Provisions Are Unsustainable Chart I-6EM Bank Share Prices ##br##Are Facing Resistance EM Bank Share Prices Are Facing Resistance EM Bank Share Prices Are Facing Resistance We reiterate our strategic call of being short EM banks and long U.S. bank stocks. The relative share price performance of EM versus U.S. banks has been inversely correlated with U.S. bond yields (Chart I-7). Chart I-7Rising U.S. Bond Yields = ##br##EM Banks Underperformance Rising U.S. Bond Yields = EM Banks Underperformance Rising U.S. Bond Yields = EM Banks Underperformance If our view on higher U.S. bond yields materializes, odds are that EM bank share prices will relapse considerably versus U.S. banks. Traders should consider implementing this trade. Credit investors can replicate the same strategy in credit markets. Strategy Considerations Investor sentiment remains bullish on risk assets in general and emerging markets in particular. The buy-on-dips mentality is well entrenched. Amid such investor consensus, it is important to consider alternative scenarios. Presently, the relative performance of Swiss versus global non-financial stocks is sitting on its long-term moving average (Chart I-8). Odds of a rebound in the relative performance of Swiss non-financial stocks from such oversold levels are fairly high. As and when the latter begin outperforming their global peers, it might entail a negative outlook for global bourses in general and cyclical equity sectors in particular. The basis is that Swiss non-financial stocks are defensive in nature, as pharmaceuticals and consumer staples account for a large portion of the total market cap. Not surprisingly, the previous bottoms in Swiss non-financials' relative performance versus global non-financials coincided with major tops in global equity bull markets. For now, the risk-reward for global stocks is unattractive, and the outlook for EM relative performance is extremely poor. Notably, relative manufacturing PMI trends favor DM over EM stocks (Chart I-9). Chart I-8Swiss Stocks Are At Critical Juncture: ##br##What Does It Mean For Global Equities? Swiss Stocks Are At Critical Juncture: What Does It Mean For Global Equities? Swiss Stocks Are At Critical Juncture: What Does It Mean For Global Equities? Chart I-9EM Relative To DM: PMIs And Share Prices EM Relative To DM: PMIs And Share Prices EM Relative To DM: PMIs And Share Prices Besides, as we discussed at great length in our recent report,1 EM equity valuations are on par with DM when adjusted for sector weights and sub-sectors with outlier valuation ratios. Our stance remains that EM risk assets will face a perfect storm this year for two reasons: Strong U.S. growth will cause U.S. inflation to rise, and the selloff in U.S. bonds has further to run. Higher U.S. interest rates should support the U.S. dollar and weigh on EM risk assets that have benefited disproportionally from the search for yield; While China's growth has slowed only moderately, our forward-looking leading indicators continue to point to further deceleration. A combination of these two tectonic shifts will amount to a perfect storm for EM risk assets in 2018. We explore these two issues in greater detail below. U.S. Inflation, The Fed And The U.S. Dollar We have the following observations on current U.S. economic dynamics: Fiscal stimulus is arriving at a time when growth is already robust, and the labor market is tight. This will likely produce higher inflation. Inflation does not need to surge to make a difference in financial markets. It would be fair to say investors have become complacent and financial markets are still pricing in a goldilocks scenario. Therefore, even a moderate rise in core inflation readings along with some anecdotal evidence that companies are able to raise prices will lead to further re-pricing in U.S. interest rate expectations. Higher U.S. interest rates pose a risk to EM, which have benefited considerably from the search for yield. EM currencies, domestic bonds and credit markets have so far held up well, despite the considerable rise in U.S. bond yields (see Chart I-1 on page 1). Based on this, it is tempting to argue that EM will be immune to rising U.S. interest rate expectations. Nevertheless, we believe this EM resilience has occurred because fund flows to EM remain very robust. These flows are often backward looking. Odds are that 10-year U.S. Treasury yields will move well north of 3%. Such a considerable rise in yields will weigh on EM risk assets. It is essential to realize that the positioning in EM stocks, local bonds and credit is more elevated today than it was before the 2015 downturn. Finally, Chart I-10 illustrates that U.S. banks' excess reserves at the Federal Reserve have started to drop. In recent years the periods of reserve declines have coincided with a strong U.S. dollar, yet the latest drop in banks' excess reserves has not yet produced a meaningful rally in the greenback (the dollar is shown inverted in Chart I-10). The Fed's ongoing tapering efforts and the U.S. Treasury's replenishment of its account at the Fed are bound to produce further reductions in banks' excess reserves. Based on the latter's correlation with the exchange rate, this should support the greenback. Notably, the U.S. dollar is fairly valued, according to our most favored valuation measure: the unit labor cost-based real effective exchange rate (Chart I-11). This takes into account both wages and productivity, and hence gauges competitiveness much better than real effective exchange rate measures that rely on consumer and producer prices. Chart I-10Shrinking U.S. Banks Excess ##br##Reserves = Stronger U.S. Dollar Shrinking U.S. Banks Excess Reserves = Stronger U.S. Dollar Shrinking U.S. Banks Excess Reserves = Stronger U.S. Dollar Chart I-11The U.S. Dollar Is Not Expensive The U.S. Dollar Is Not Expensive The U.S. Dollar Is Not Expensive Finally, tax cuts are supply side reforms, and they are typically bullish for the currency. Bottom Line: A combination of stronger growth, rising interest rate expectations, neutral valuations and oversold conditions should help the U.S. dollar to rebound. The rally in the U.S. exchange rate versus EM currencies will be pronounced if China's growth slows, as we expect it to. Making Sense Of Chinese Data China's slowdown has so far been moderate. However, in any economy a downturn almost always begins with a moderation in growth. That, however, is not sufficient reason to conclude that the growth slump will be benign or short-lived. Judgement on the duration and magnitude of a slowdown should be based on the existence of major macro imbalances, or lack thereof. Given that China has enormous money, credit and property market excesses/imbalances and policy has been tightening, we believe that growth disappointments will be non-trivial and more substantive than the market consensus currently expects. The following corroborate the case for a deepening growth slump ahead: The annual change in the manufacturing new orders-to-inventory ratio from the National Bureau of Statistics points to a relapse in Caixin's manufacturing PMI as well as steel, iron ore and coal prices (Chart I-12). This indicator also heralds a decline in analysts' EPS net revisions for all Chinese stocks (Chart I-13). Chart I-12China: An Impending Slowdown China: An Impending Slowdown China: An Impending Slowdown Chart I-13China: EPS Net Revisions Have Peaked China: EPS Net Revisions Have Peaked China: EPS Net Revisions Have Peaked While some economic data like imports for January were strong, it is important to realize that this January had a few more working days compared with January 2017 due to the Chinese New Year falling in February this year. Although the same seasonal adjustment should be applied to money and credit data, there are other critical dimensions specific to the credit data that investors should be aware of. Banks' loans to companies and households - widely watched by the investment community - was very strong in January relative to the previous month. However, loan and most of other data in China should be seasonally adjusted. The annual growth rate in RMB bank loans is still very robust at 13.2% (Chart I-14, top panel). However, the growth rates of banks' total assets, total claims and broad money have all dropped close to 10% or below (Chart I-14). The disparity between bank loans on the one hand and their claims and assets on the other is due to the following: In China's banking statistics, banks' loans to non-bank financial institutions - such as financial trusts, investment corporations, insurance, financial leasing companies and auto-financing companies, and loan companies - are not included in banks' loan data. Hence, bank loan data do not reveal the banks' full impact on the economy. By extending credit to non-bank financial institutions, banks have expanded their balance sheets without exceeding their loan quotas. In short, banks have funded shadow banking and by extension the real economy and speculative investment schemes but have done so via non-bank financial institutions. In addition, banks have also bought a lot of corporate and local government bonds that are not considered loans. Overall, bank loans have been understating the degree of the banking system's credit expansion. In the past year, regulators have been forcing banks to reduce their lending to non-bank financial institutions. With this channel of balance sheet expansion restricted (Chart I-15, top panel), banks are probably resorting to more traditional loans to expand their balance sheets and earn income. Chart I-14China: Bank Loans, ##br##Assets And Total Claims China: Bank Loans, Assets And Total Claims China: Bank Loans, Assets And Total Claims Chart I-15China: Bank Lending To Shadow ##br##Banking Is Being Curtailed China: Bank Lending To Shadow Banking Is Being Curtailed China: Bank Lending To Shadow Banking Is Being Curtailed In short, one needs to look at banks' aggregate claims on all entities - companies, households, non-bank financial institutions and governments - to assess whether their lending to the economy is slowing or accelerating. Chart I-16China: Structure Of Bank Assets China: Structure Of Bank Assets China: Structure Of Bank Assets Consistent with the ongoing regulatory clampdown, banks' claims on non-bank financial institutions - so called shadow banking - have plummeted in the past 12 months after expanding 50-70% annually for several years in a row (Chart I-15, top panel). The bottom three panels of Chart I-15 indicate that the annual growth rates of banks' claims on companies, household and the government have either already decelerated or are slowing now. Their respective shares in banks' total assets are displayed in Chart I-16. While banks' RMB loans remain the largest category of assets, the importance of other claims has risen. Bottom Line: Several leading indicators continue pointing to an impending slowdown in the mainland's economy. Bank loan data is no longer indicative of total bank assets expansion/aggregate lending to all segments in the economy. Broader measures - such as banks' total claims, assets and money aggregates - have decelerated considerably. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Korea: A Major Top In The Won The Korean won is vulnerable on several fronts: Its real effective exchange rate based on unit labor costs is well above its historical mean (Chart II-1, top panel). Importantly, based on this same measure, the won is very expensive versus the Japanese yen (Chart II-1, bottom panel). The manufacturing cycle has already weakened in Korea (Chart II-2). Chart II-1The Won Is Expensive The Won Is Expensive The Won Is Expensive Chart II-2Korea's Manufacturing Is Weakening Korea's Manufacturing Is Weakening Korea's Manufacturing Is Weakening Japanese exports in U.S. dollar terms are starting to outperform Korean ones (Chart II-3), suggesting that Korean exporters might be losing market share to their Japanese rivals. Furthermore, manufacturing inventories are rising sharply in Korea but not in Japan (Chart II-4). Relative manufacturing inventory trends also favor the yen versus the won (Chart II-4, bottom panel). Chart II-3Relative Exports: Korea Versus Japan Relative Exports: Korea Versus Japan Relative Exports: Korea Versus Japan Chart II-4Manufacturing Inventories: Korea And Japan Manufacturing Inventories: Korea And Japan Manufacturing Inventories: Korea And Japan The won's appreciation has depressed Korea's export prices in local-currency terms. In Japan, on the other hand, local-currency export prices are holding better. Interestingly, the relative export price trend in U.S. dollars points to the won's depreciation versus the yen (Chart II-5). Korean non-financial stocks have broken below their 200-day moving average, which corroborates that corporate profitability is deteriorating (Chart II-6). Korean equities have been among the world's worst-performing bourses year-to-date. Chart II-5Export Prices: Korea And Japan Export Prices: Korea And Japan Export Prices: Korea And Japan Chart II-6Korean Non-Financial Stocks Are Cracking Korean Non-Financial Stocks Are Cracking Korean Non-Financial Stocks Are Cracking In addition, the correction in Korean stocks commenced before the recent plunge in the S&P 500. This highlights that the relapse in Korean share prices was not only due to the contagion from the U.S. equity selloff. Finally, the technical profile of the won points to a major top. Chart II-7 shows that the won is facing multi-year technical resistance versus the U.S. dollar. Chart II-7KRW/USD Exchange Rate: ##br##A Long-Term Technical Profile KRW/USD Exchange Rate: A Long-Term Technical Profile KRW/USD Exchange Rate: A Long-Term Technical Profile Investment Conclusions We have been short the Korean won versus the Thai baht since October 19, 2016 and this trade has produced a 7.3% gain. We recommend closing this trade and shorting the won versus an equally-weighted basket of the U.S. dollar and yen. The rationale to short the KRW versus this basket is to hedge against a possible near-term U.S. dollar selloff if China is forced to revalue the RMB further, as we discussed in February 7, 2018 report.2 In regards to equities, we are closing our long KOSPI / short Nikkei trade with a 1% loss since April 26, 2017. Within the EM universe, we continue recommending a neutral allocation to Korean stocks excluding technology. Despite their recent underperformance, EM-dedicated managers should continue overweighting Korean tech stocks. The reasoning behind this is that the potential currency depreciation will help their corporate profitability as tech shipments are not exposed to Chinese capital spending. The latter will be the epicenter of negative growth surprises in our opinion. Finally, Korean local bond yields will soon top out as the deflationary pressures from a stronger currency become more evident in the economy. Korean bonds will outperform U.S. Treasurys on a currency-hedged basis. 1 Please refer to Emerging Markets Strategy Special Report, titled "EM Equity Valuations (Part I)," dated January 24, 2018, the link is available on page 19. 2 Please refer to Emerging Markets Strategy Weekly Report, titled "A Regime Shift?," dated February 7, 2018, the link is available on page 19. Equity Recommendations Fixed-Income, Credit And Currency Recommendations