Valuations

Highlights Portfolio Strategy The financials sector's fortunes are linked to the path of 10-year Treasury yields. BCA's view of a selloff in the bond market bodes well for this interest rate-sensitive sector. The S&P banks index is on the cusp of flexing its earnings power muscle. Higher profits will serve as a catalyst for a valuation rerating in this key financials sub-sector. The still unloved S&P asset management & custody banks index has significant catch-up potential. We reiterate our high-conviction overweight status. Recent Changes There are no changes to our portfolio this week. Table 1 Later Cycle Dynamics Later Cycle Dynamics Feature The S&P 500 ended last week on a high note, cheering significant progress on the tax bill front and digesting early earnings beats. Given the equity market's lofty valuation starting point, substantial positive profit surprises are now necessary to move the needle in stocks. Encouragingly, IBM's mention of the fall in the U.S. dollar boosting EPS1 may morph into a broad-based theme this earnings season given the currency's mysterious absence we have been flagging in Q2. Beneath the surface, easy fiscal policy prospects coupled with synchronized global growth will likely continue to underpin equities. Importantly, later stages of the business cycle are synonymous with impressive gains in the S&P 500. The unemployment gap, defined as the unemployment rate minus the non-accelerating inflation rate of unemployment (NAIRU), is an excellent leading indicator of the yield curve. Granted, NAIRU is an estimate and we are using the CBO's long-term NAIRU quarterly forecast as an input to the unemployment gap indicator. When the unemployment gap disappears, inflation should start rearing its ugly head, eventually leading the Fed to tighten monetary policy to the point where the yield curve inverts and predicts the end of the business cycle. Empirical evidence suggests that first the unemployment gap closes then the yield curve inverts and the business cycle subsequently ends (Chart 1). However, this indicator has had one miss since the early-1970s, during the second leg of the early-1980s double dip recession. Chart 1Eliminated Unemployment Gap Is Bullish For Equities Eliminated Unemployment Gap Is Bullish For Equities Eliminated Unemployment Gap Is Bullish For Equities Table 2 shows the S&P 500 performance from when the unemployment gap clearly closes until the business cycle ends. In all five iterations that lasted, on average, 28 months, the broad market has risen, on average, by 29%. The unemployment gap has been eliminated since February 2017 and if history at least rhymes the next U.S. recession will arrive some time in 2019 as the SPX hits our peak cycle 3,000 target.2 Another later cycle phenomenon is the disappearance of volatility and the plunge in stock correlations as the Fed tightens monetary policy. While large institutional investors aggressively selling volatility this cycle is dampening vol across asset classes, there is another explanation of the non-existence of vol: synchronized global growth. Chart 2 shows that leading up to the prior three recessions, volatility was drifting lower and remained low, and the common denominator was simultaneous global growth in the late-1980s, late-1990s and mid-2000s. BCA's global (40 country) industrial production composite was expanding during the later stages of the business cycle. Similarly, our global (44 country) global EPS diffusion index and the global synchronicity indicator also depict concurrent global growth. Table 2S&P 500 Returns When##br## The Unemployment Gap Closes Later Cycle Dynamics Later Cycle Dynamics Chart 2Linking Low Vol To ##br##Synchronized Global Growth Linking Low Vol To Synchronized Global Growth Linking Low Vol To Synchronized Global Growth During the later stages of the cycle, equity sector correlations also collapse as earnings fundamentals are key performance drivers and sector differentiation generates alpha, as the broad market enters the last stage of the bull market. As we mentioned in our "SPX 3,000?" Weekly Report on July 10th, this does not mean the S&P 500's path is a linear straight line up until the next recession hits. There are high odds of a 5-10% garden variety pullback materializing which we deem a healthy development and our strategy would be to buy the dip, ceteris paribus. This week we update an early cyclical sector and two key sub-components. Financials: In The Shadows Of The Bond Market While financials stocks have cheered the prospects of a tax bill passage sometime in early 2018 (Chart 3), sell-side analysts have been brutally downgrading financials sector EPS estimates, dealing a blow to most sub-indexes net earnings revisions (Chart 4). True, hurricane-related losses may be the culprit, but such indiscriminate downgrades are unwarranted, and we would lean against such pessimism. Recent profit results corroborate our positive sector bias, but we are still early in the earnings season. Chart 3Dissecting Financials Performance Dissecting Financials Performance Dissecting Financials Performance Chart 4Extreme EPS Pessimism Extreme EPS Pessimism Extreme EPS Pessimism This early cyclical sector is a core overweight portfolio holding and there are high odds of significant relative gains in the coming quarters. Historically, financials stocks had been almost 100% positively correlated with the yield curve slope (Chart 5): a steepening yield curve gooses financials profits, while a flattening one eats into earnings via narrowing net interest margins. This rang true up until the Great Recession. Since then, unconventional monetary policies likely rendered this multi-decade correlation ineffective. In particular, the fed funds rate's zero lower bound caused a shift in the correlation from the yield curve to the 10-year Treasury yield (Chart 6). In fact, changes in the 10-year Treasury yield are now a carbon copy of relative share price momentum (Chart 6). Chart 5Shifting Correlations Shifting Correlations Shifting Correlations Chart 6Financials And UST Yield Are Joined At The Hip Financials And UST Yield Are Joined At The Hip Financials And UST Yield Are Joined At The Hip Thus, accurately forecasting long term interest rates should also dictate the direction of relative share prices, especially given the still historically low fed funds rate. On that front, the Treasury market is priced for the 10-year yield to hit 2.57% in October 2018 from roughly 2.38% currently. We expect the 10-year yield will rise more quickly than is discounted in the forward curve. Our U.S. bond strategists think core inflation will soon resume its modest cyclical uptrend. A parallel recovery in the cost of inflation protection will impart 50-60 basis points of upside to the 10-year Treasury yield by the time core inflation reaches the Fed's 2% target.3 Chart 7 plots the path of the 10-year Treasury yield discounted in the forward curve alongside a path consistent with BCA's view that inflation is poised to head higher. It also shows what this would mean for the 10-year breakeven inflation rate. If core inflation resumes its uptrend, as BCA expects, then financials will have a stellar return year in 2018, all else equal. Chart 7Lots Of Upside Lots Of Upside Lots Of Upside Meanwhile, market participants typically value financials on a price-to-book basis during calamitous times and are very slow in changing metrics once the tremors are behind the sector. We are likely on the cusp of a switch away from P/B and toward forward P/E as a key valuation metric for financials. The current 20% forward P/E discount to the broad market is highly punitive (bottom panel, Chart 5). If the key S&P banks sub-index successfully flexes its earnings power muscle, as we expect, then a valuation rerating phase looms for both banks and financials equities. Banks Hold The Key We remain constructive on the S&P banks index as all three key drivers of bank profits, namely loan growth, price of credit and credit quality, are simultaneously moving in the right direction. Tack on the increasing likelihood of a tax bill becoming law in early 2018, the continued push of the Trump administration to relax bank regulations and pent up demand for shareholder friendly activities including net share retirement and higher dividend payments/payouts, and bank stocks are well positioned to generate impressive returns in the coming quarters. Lower corporate tax rates will boost bank profits directly and indirectly. Fiscal stimulus typically translates into an economic fillip. If small and medium businesses (SME) benefit the most from lower taxes then higher SME profits will lead to a more expansionary mindset and small business owners will likely tap their bankers to finance capital spending plans. As tax certainty increases, so will animal spirits, aiding in kick-starting a virtuous economic cycle. Thus, loan growth is on an upward trajectory. Leading indicators of loan demand are also painting a bright picture for bank profits. C&I and consumer loans, two large credit categories, are both forecast to reaccelerate in the coming months. The ISM manufacturing survey has been on fire lately and consumer confidence has been following closely behind (third & fourth panels, Chart 8). Our credit growth model captures these positive forces and is sending an unambiguously positive message for loan reacceleration in the coming months (Chart 8). Moreover, residential real estate loan origination (the second largest credit category in U.S. dollar terms) should gain steam, underpinned by solid housing market's foundations: house prices are still expanding at a healthy clip (top panel, Chart 9), household formation is running higher than housing starts and mortgage rates are not prohibitive. Chart 8Bright Business And Consumer Credit Outlooks Bright Business And Consumer Credit Outlooks Bright Business And Consumer Credit Outlooks Chart 9Ongoing Valuation Rerating Ongoing Valuation Rerating Ongoing Valuation Rerating The V-shaped recovery in our U.S. credit impulse corroborates this fertile loan backdrop and is heralding an earnings outperformance phase (Chart 10). On the price of credit front, if BCA's bond view pans out in the next year and the 10-year Treasury yield veers closer to 2.8-3% range with rising inflation expectations in the driver's seat (Chart 11), then bank profits should continue to accelerate. Granted, the Fed will also raise rates next year and, at the margin, push up funding costs for the banking sector. However, our working assumption is that banks will remain linked to the 10-year UST yield's fortunes next year. At some point later in the Fed tightening cycle, the yield curve and bank correlation will likely get re-established. But, a flattening yield curve denting NIMs is a 2019 narrative. Finally, credit quality remains pristine despite some pockets of weakness in, subprime especially, auto loans. At this stage of the cycle, near or at full employment, NPLs will remain muted. Importantly, loan loss reserves have recently crossed above non-current loans in Q2 according to the FDIC, for the first time since 2007. Historically, a rising reserve coverage ratio has been synonymous with increasing valuations and the current message is that the banks rerating phase is in the early innings (Chart 12). Chart 10Heed The Positive Credit Impulse Signal Heed The Positive Credit Impulse Signal Heed The Positive Credit Impulse Signal Chart 11Price Of Credit Should Recover Price Of Credit Should Recover Price Of Credit Should Recover Chart 12Pristine Credit Quality Pristine Credit Quality Pristine Credit Quality Bottom Line: We reiterate our early-May overweight stance in the S&P financials sector and continue to overweight the heavyweight S&P banks sub-index. 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. A Few Words On Asset Management & Custody Banks The S&P asset management & custody banks (AMCB) index sits atop of our high-conviction return table (see page 15), outperforming the broad market by 7.2% since inception. While it is tempting to monetize some of these profits, we choose to remain patient. Likely more gains are in store in the coming months as this financials sub sector maintains its leadership position. If BCA's bond view of a selloff in the 10-year Treasury market transpires in 2018, then the budding rotation out of bond and into equity products will further accelerate. The stock-to-bond ratio captures this shift and it is currently flashing green (Chart 13). Overall assets under management are also rising and are a boon for the AMCB group's profit prospects, on the back of higher equity prices and also higher flows into stocks in general (bottom panel, Chart 13). Vibrant global economic sentiment, as measured by the IFO's World Economic Survey (top panel, Chart 14), and domestic (and global) manufacturing resurgence should continue to underpin M&A activity and sustain the high levels of margin debt. Both of these factors suggest that AMCB profit drivers are accelerating and will likely serve as a catalyst to unlock excellent value in this still unloved financials sub-group (middle panel, Chart 14). Chart 13Increasing AUMs... Increasing AUMs... Increasing AUMs... Chart 14...And Rising Animal Spirits Are Bullish For AMCB ...And Rising Animal Spirits Are Bullish For AMCB ...And Rising Animal Spirits Are Bullish For AMCB Adding it up, the still undervalued AMCB index has sizable catch-up potential, especially if the equity risk premium (ERP) continues to narrow in the coming quarters, as we expect (ERP shown inverted, bottom panel, Chart 14). Bottom Line: The S&P AMCB index remains a high-conviction overweight. The ticker symbols for the stocks in this index are: BLBG: S5AMGT-BK, BLK, STT, AMP, NTRS, TROW, BEN, IVZ, AMG. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report,"Dollar The Great Reflator" dated September 18, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report,"SPX 3,000?" dated July 10, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Bond Strategy Weekly Report,"Living With The Carry Trade" dated October 17, 2017, available at usbs.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights On Black Monday, October 19, 1987, equity bourses around the world plunged amid cascading bouts of selling, recording some of their largest single-day losses of the twentieth century. The plunge, exacerbated by derivatives transactions, and transmitted swiftly around the world, marked the first contemporary global financial crisis. BCA clients were well prepared. The Bank Credit Analyst steadily warned of increasing stock market vulnerabilities across all of 1987 even as it correctly predicted that the S&P 500 would most likely soar before eventually cracking. The Federal Reserve's immediate all-out effort to contain the damage ushered in a new central bank template for responding to quaking markets and helped give rise to the Greenspan put. While we do not fear a repeat of Black Monday, the U.S. equity market's long-term prospects are dramatically less appealing than they were in 1987. Investors should be prepared for an extended stretch of public market returns that pale beside the ones earned over the last 30-plus years. Feature 30 years ago today, Black Monday erupted around the world, reaching its nadir in New York, where relentless waves of selling drove the major indexes down 20%. The contagion had spread in a rapid relay from Hong Kong to Europe and then to New York, before fetching up in Auckland and other Asia-Pacific exchanges as Black Tuesday. The event was the centerpiece of what turned out to be sharp, albeit relatively brief, bear markets around the world (Charts 1 and 2). Confounding nearly every observer, however, the crash did not amount to much in a broader economic context and financial markets quickly regained their footing, with global equities vaulting to new highs in the '90s1 amidst speculative excesses that made the '80s' mania look demure. Chart 1Great Runs... bca.bcasr_sr_2017_10_19_c1 bca.bcasr_sr_2017_10_19_c1 Chart 2...And Sudden Stops ...And Sudden Stops ...And Sudden Stops Like all serious investors, BCA researchers are students of history. Black Monday was the first modern global financial crisis, and its 30th anniversary affords us the chance to study its run-up and aftermath for insights into future dives. It also gives us the chance to return to BCA's extensive archives and see how our forebears assessed conditions in real time. Their ex-ante analysis and forecasts were stellar, and reinforce the robustness of our approach. Their lagging ex-post performance highlights the need for investors to maintain a flexible mindset that can accommodate all possibilities. From Fear To Greed Black Monday marked the definitive end of a historically potent bull market (Table 1) that began, as the best ones do, in revulsion. Business Week's August 1979 cover story trumpeting the death of equities has become notorious, but the S&P 500 didn't bottom for three more years, during which it lost a quarter of its inflation-adjusted value. All told from the end of September 1968 to the end of July 1982, the S&P tumbled 62.5% in real terms (Chart 3). Inflation took a heavy toll on real growth over the 55 quarters of U.S. stocks' lost decade and a half (Chart 4, top panel), but the economy had expanded nonetheless, and stocks emerged from the ashes of the Volcker double-dip recession with a lot of ground to make up. Table 1A Bull With Speed And Stamina Black Monday, Thirty Years On: Revisiting The First Modern Global Financial Crisis Black Monday, Thirty Years On: Revisiting The First Modern Global Financial Crisis Chart 3A Lost Decade And A Half ... A Lost Decade And A Half ... A Lost Decade And A Half ... Chart 4...Despite Steady, If Unspectacular, Real Growth ...Despite Steady, If Unspectacular, Real Growth ...Despite Steady, If Unspectacular, Real Growth The ensuing five-year bull market (Chart 5, top panel) unfolded in two phases: the first, which burst out of the gate on a sudden repricing before taking a full year to catch its breath, had the support of earnings growth (Chart 5, middle panel) and re-rating; the second, which went on without pause for two and a half years, was all about re-rating (Chart 5, bottom panel). It finally ended in late August 1987, when skeptical investors could no longer stomach big gains derived entirely from multiple expansion, and stocks began to retreat in earnest in October, sliding 5% and 9% in the two weeks before Black Monday. Proximate triggers included sickly trade data, a competitive devaluation threat and proposed tax legislation that stood to make corporate takeovers a good deal more costly. The first two factors pushed the dollar down and yields up, as investors fretted that the Fed would be forced to raise rates (Chart 6), and the last pulled the plug on runaway speculation in takeover targets. Chart 5A Two-Act Bull Market A Two-Act Bull Market A Two-Act Bull Market Chart 6Be Careful What You Wish For Be Careful What You Wish For Be Careful What You Wish For The Echo Chamber, ... There is career safety in numbers, but portfolio danger. As the late Barton Biggs put it, there's no investment so good that it can't be destroyed by too much capital. Portfolio insurance may not have even been a good idea, as it didn't amount to anything more than a portfolio-sized stop-loss order, souped up with computer software and derivatives contracts. But by the fall of 1987, its widespread adoption had turned it into a very bad one. Portfolio insurance was developed in the late '70s by two finance professors who sought a method that would allow investors to participate in equity market gains while limiting their downside exposure. When stocks began to decline in the direction of a set downside limit, the portfolio insurance program would reduce net equity exposure via the sale of index futures. Once the market recovered and the program determined the coast was clear, it would unwind the futures positions. Although the technique had its flaws on a micro scale - futures trading wasn't costless, and there was considerable potential for whipsawing - it was doomed at the aggregate level because the index futures market wasn't deep enough to accommodate all the selling pressure that would be unleashed by a significant correction. ... Or, From Wall Street To LaSalle Street And Back Again There was more to Black Monday than portfolio insurance - the event was global, and the technique was not a factor on other bourses - but it helped to create a self-reinforcing spiral between the cash market in New York and the futures market in Chicago. Heavy selling of stocks in New York triggered heavy selling of index futures in Chicago, as insured portfolios sold futures to mitigate their direct cash exposures. The selling redounded back to New York as the futures buyers on the other side of the trade sold the underlying stocks to balance out their long futures positions2 and opportunistic investors seized the chance to front-run the mechanical portfolio insurers.3 The new sales pushed share prices even lower in New York, triggering more index futures selling in Chicago, and cinching the vicious circle. The View From Peel Street BCA, safely removed from the madding crowd in Montreal, foresaw something quite like the crash. The September 1986 and 1987 editions of our annual New York conferences bore the respective titles, "The Escalation in Debt and Disinflation: Prelude to Financial Mania and Crash?" and "Phase II in the Escalation of Debt, Disinflation and Market Mania: Prelude to Financial Crash?" Throughout all of 1987, the monthly Bank Credit Analyst warned of the U.S. equity market's increasing vulnerability and recommended that investors reduce exposure in a disciplined fashion ahead of the inevitable bust. The investment policy recommendation, issued in accord with prudent money management principles, differed from BCA's market forecast, which was for robust, potentially parabolic, gains before the bull market ended. BCA was not trying to have it both ways: it has long been a central tenet of our work that one's investment strategy can - and regularly should - be distinct from one's market forecast. We do not attempt to squeeze every last drop out of a bull or a bear market. Empirical evidence makes it abundantly clear that no one can consistently call tops or bottoms. In the words of turn-of-the-century trading legend Jesse Livermore: "One of the most helpful things that anybody can learn is to give up trying to catch the last eighth - or the first. These two are the most expensive eighths in the world.4" The opening paragraph of the March 1987 Bank Credit Analyst, published six months before the market peak, summarizes our ongoing advice: [I]nvestors who are overexposed should reduce positions to a level comfortable to ride out what will likely become a much more volatile phase of the secular bull market in stocks. ... At some point, it is likely that the U.S. stock market will experience a 1962-type correction - a sharp decline which comes out of the blue as a result of extreme overvaluation and excessive speculation. As then, it is unlikely to be associated with a credit crunch, as almost all post-war bear markets have been. ... At present, there is nothing in the data, either fundamental or technical, which suggests that such a shakeout is imminent. However, the key for investors in this bull market is to have positions which are sufficiently comfortable so that they can ride out sudden, dramatic corrections and participate in the long upward rise, which we feel has much further to go. (pp. 3-4) Eighteen months before the August 25th peak, the March 1986 Bank Credit Analyst's Section III was titled, "The Coming Financial Mania," and its strategy prescriptions were much more aggressive, even as it acknowledged the risks: Increasing volatility should be expected both because of the still lingering risks prevailing and the dramatic price movements in recent months. Hence, conservative investors should not overtrade. To fully capitalize on the ongoing revaluation of financial assets, it is important not to lose positions as a result of the necessary sharp corrections which will be experienced along the way. The stock and bond market potential over the next 2-3 years remains extraordinary. (p.11) The great dilemma for investors is, of course, how aggressively to play the game during the latter stages. The fascination, excitement and danger is the knowledge that vast fortunes are easily made right up to the end, but there is no reliable method to get out just before the crash. [...] Frequently the bubble goes on much longer and prices go far higher than anyone can imagine [...]. Yet, the vulnerabilities grow proportionately to the power of the manic phase. (p.26) Investment strategy in [a manic] environment must be based on the historically observed phenomenon that price appreciation generally accelerates to a climax or blowoff and that the hidden risks grow exponentially with price rises. Therefore, investors must constantly guard against the natural tendency to become increasingly greedy and careless in valuation standards as prices rise. (p.41) As good as BCA's near- and intermediate-term calls were in the run-up to the '87 crash, our longer-term calls were even better. We repeatedly argued that disinflation would be a secular trend, and that it would power secular bull markets in bonds and equities. Three decades on, with the Barclays Aggregate Index, the Barclays High Yield Index and the S&P 500 having produced real annualized total returns of 5%, 9.3% and 7.6%, respectively, the call has been vindicated (Table 2). As BCA foresaw, the harsh monetary medicine administered by the Volcker Fed to slay the inflation dragon has paid hefty market dividends. Table 2A Great Three Decades For Financial Assets Black Monday, Thirty Years On: Revisiting The First Modern Global Financial Crisis Black Monday, Thirty Years On: Revisiting The First Modern Global Financial Crisis The Trouble With The Austrians For all that BCA achieved ahead of Black Monday, and as correct as our long-term calls from the '80s turned out to be, it must be acknowledged that we missed the boat on getting back into equities after the crash. Part of the miss is understandable: one wouldn't expect the strategist with the most prescient call ahead of a downturn to be the first one to identity the beginning of the subsequent rally. The best investors are the ones with the supplest minds, however, and the BCA archives reveal a bias that may have gotten in the way of embracing more bullish near-term outcomes. To wit, one cannot read the 1988 and 1989 Bank Credit Analysts, and indeed, our original leaders' output, without detecting strong sympathies for the Austrian School of Economics (Box 1). BOX 1 An Austrian's Lonely Lot The Austrian School of Economics most saliently parts company with neoclassical economics in its adamant opposition to government intervention and its fraught relationship with credit. Instead of intervening to counter business cycles, Austrians would prefer to let busts run their course so as to cleanse the economy of the excesses embedded in booms. They occupy the Mellonian, purge-the-rottenness-out-of-the-system end of the continuum in opposition to the Debt Supercycle's unconditional forgiveness. Austrians regard banking and credit with some measure of suspicion, as Austrian Business Cycle Theory holds that artificially low interest rates are the raw material of destabilizing booms. Encouraged by central bankers seeking to steer an economy out of recession with a bare minimum of discomfort, borrowers take on debt to invest in projects that may not be able to pay their own way were it not for intervention. Once rates rise after policy accommodation fades, the economy slows and the extent of the malinvestment is revealed. The Debt Supercycle prescribes more of the hair of the dog to alleviate the suffering from malinvestment. The debt overhang is thereby never eliminated; it instead continues to silt up, requiring larger and larger interventions. Unchecked, the degree of intervention required to keep the plates spinning will eventually exceed capacity. This analysis is logically sound, but it so thoroughly contradicts the reigning orthodoxy that an investor who becomes emotionally invested in it is at risk of serially tilting at windmills. There is nothing wrong with the Austrian School per se. We rather like its outsider status, and actively seek heterodox inputs and perspectives so as to stay out of the ruts of the well-worn consensus path. Even its pessimistic bent has its uses; investors are surely exposed to enough cheerleading. Its prescriptions are so bracing, however, that a little goes a long way and real-world users should handle them with care. A popular pair of You Tube videos of actors portraying Keynes and Hayek issuing dueling raps about their respective ideologies (Keynes: I want to steer markets/Hayek: I want them set free!) provide an entertaining example of the Austrian-inspired investor's dilemma. Keynes, drink after drink in hand, is the exuberant life of the party, while the sallow Hayek stares into the bottom of his glass, unable to capture any other partygoers' attention. The simple conceit animating the video - Keynesianism is fun; Austrians are dour scolds - resonates deeply with elected officials. Voters love free drinks, but hate being told to eat their vegetables. The Austrian School, therefore, is a poor guide to the path that policy is likely to take. It also has the problematic effect of introducing an element of moral judgment into what should be a purely objective sphere. Investors should have a laser-like focus on what is most likely to happen and should strive to suppress extraneous notions about what should happen. The Debt Supercycle is a brilliantly incisive way of viewing the interaction between constituents' desires and officials' incentives, and has predicted the long-run direction of policy to a T. Only someone with a focus on money flows, informed by exposure to Austrian Business Cycle Theory, could have come up with it. In the hands of BCA editors in the late '80s, however, it seemed to feed a desire to see the American economy get its comeuppance. Setting aside that desire for punishment - and value judgments altogether - is the clearest way that we could have done better in the aftermath of the crash 30 years ago, when BCA essentially sat out the December '87 - July '90 equity bull market. We should strive to be dispassionate and unbiased observers of the economy and markets. After all, the process illustrated by the Debt Supercycle concept has surely helped put the wind at equities' back throughout the postwar era (Chart 7). Making sense of it without decrying it could help us to provide even better counsel. Chart 7Equity Investing Is An Optimists' Game Equity Investing Is An Optimists' Game Equity Investing Is An Optimists' Game Then And Now Does 2017 look like 1987? Is another crash lurking just around the corner? Our answers are "no," and "no." We think the resemblances between then and now are merely superficial. The good news is that the probability of a Black Monday-style crash is remote, and we think that even a run-of-the-mill bear market is not likely until our most reliable recession leading indicators, which are still dormant, begin to flash red.5 While that view may come as a short-term relief, 1987's long-term market outlook was vastly superior. While both today's bull market and the '82-'87 bull market began with forward earnings multiples at multi-year lows, the trough multiple in 1982 was in the low sixes, nearly two standard deviations below the mean (Chart 8). Even though it more than doubled by the August '87 peak, it only just reached what is now the mean level for the entire series. This bull market has seen the S&P 500's forward multiple rise to a full standard deviation above the mean. Valuation is not everything, of course. It is a lousy short-term indicator and only issues a reliable intermediate-term signal at extremes. Long-term returns correlate closely with the cyclically-adjusted P/E ("CAPE"), however, and it is currently at levels only previously reached ahead of the 1929 and 2000 peaks (Chart 9). The frothy CAPE portends a tepid long-run U.S. equity outlook. Chart 8Not A Lot Of Room To Grow Not A Lot Of Room To Grow Not A Lot Of Room To Grow Chart 9Not The Stuff Of Secular Rallies Not The Stuff Of Secular Rallies Not The Stuff Of Secular Rallies Both of the bull markets emerged from the ashes of nasty recessions (Chart 10), but the periods' primary economic threats were polar opposites, as were the policy settings adopted to counteract them. The Volcker Fed tightened monetary conditions to the point of pain in the early '80s, plunging the economy into a double-dip recession for the express purpose of eradicating the scourge of double-digit inflation (Chart 11). After the financial crisis, on the other hand, the clear and present danger was the potential for the credit bust to trigger a deflationary spiral. The Bernanke Fed pursued unprecedentedly accommodative policy in response. Chart 10Similarly Nasty Recessions ... Similarly Nasty Recessions ... Similarly Nasty Recessions ... Chart 11... But Opposite Inflation Backdrops ... But Opposite Inflation Backdrops ... But Opposite Inflation Backdrops The policy measures of the early '80s were an example of swapping near-term pain for long-term gain, and they set the stage for secular rallies in financial assets that continue to this day. Once inflation was removed from the equation, interest rates had to fall, and they did so for 35 years. The extraordinary accommodation in the wake of the crisis was an attempt to stave off hysteresis, which boils down to mitigating near-term pain as an insurance policy against long-term pain.6 It may well have worked, but there is no such thing as a free lunch, and the Fed's exertions have likely pulled forward much of the bond and stock markets' future returns. Black Monday And The Fed Put Before the October 20th open, the Fed issued the following statement: The Federal Reserve, consistent with its responsibilities as the Nation's central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system. Although it was only 30 words long, the statement packed a punch. It signaled the Fed's willingness to fulfill its function as the lender of last resort and may also have prodded skittish banks into fulfilling their responsibilities as intermediaries. Behind the scenes, the Federal Reserve Banks of New York and Chicago were doing their utmost to keep the system functioning. New York Fed president Corrigan was twisting lenders' arms to keep credit flowing so the crash would not infect the banking system and the real economy.7 Meanwhile, the Chicago Fed wasn't letting the letter of the law keep it from "help[ing to] engineer a solution" when one of the biggest derivatives market participants "ran short of cash.8" The statement, and the vigorous offstage exertions, countered the Fed's determinedly low profile. These were the days, after all, when monetary policy actions were still regarded as something akin to state secrets. Wall Street firms employed "Fed watchers," who were charged with studying the tea leaves to determine if the Fed had adjusted policy. As late as January 1990, the Bank Credit Analyst could devote an entire Section III to the question, "Has the Federal Reserve Eased?" Some of Alan Greenspan's comments in his memoir may reflect after-the-fact boasting or burnishing, but Black Monday can be viewed as a policy watershed. After it, the Fed's conduct of monetary policy has become transparent to the point of oversharing. More meaningfully for investors, it marked the origin of the "Greenspan Put," the widespread notion among market participants that the Fed would do its best to ward off or mitigate financial market downdrafts. Are ETFs The New Portfolio Insurance? Responsibility for the crash cannot be precisely apportioned among factors, but all post-mortem analyses agree that portfolio insurance played a leading role. While it may well have proven harmless if pursued on a modest scale by a limited number of players, it morphed into a destabilizing force once a critical mass of investors embraced it. On Black Monday, it became a paradox of safety akin to the paradox of thrift: prudent and rational when practiced by one individual, but a metastasizing disaster when followed by a crowd. A reasonable roadmap for someone trying to spot parallels between then and now is to identify market products that may have become overly popular. Wall Street's tendency to wring every last drop out of financing innovations, coupled with investors' tendency to move in herds, can lead to excesses. The latest innovation to achieve wild popularity is the ETF. Is it possible that ETFs could exert the same destabilizing influence as portfolio insurance if investors' ardor for them suddenly cools? We think not. As our Global ETF Strategy service has argued, the claims about passive investing's dangers are overheated.9 The notion that index tracking is undermining price discovery disregards the power of incentives. Passive investing strikes us as the best cure for passive investing: if so many people are pursuing it that index-trackers begin to drown out active investors, the prospective returns to active investing will soar and money will rotate out of index-tracking strategies in sufficient quantity to correct the imbalance. Chatter about a passive bubble also fails to consider the source of fund flows into index-tracking ETFs. The oft-repeated statement, "so much money is flowing into ETFs that it's distorting prices across the board," does not hold up to scrutiny. Away from Japan and Switzerland, where QE purchases of ETFs are being funded with new yen and franc notes, ETFs are not being purchased with new investment capital that has materialized out of thin air. They are being purchased with existing investment capital that has merely been reallocated away from actively managed mutual funds (Chart 12). Chart 12Mirror Image Mirror Image Mirror Image Bubbles are always the result of speculative, excess-profit-seeking activity. Index-tracking ETFs are vehicles intended to deliver market returns. They are the opposite of a get-rich-quick scheme; they're the instrument investors turn to when they give up on quick riches. We do not worry that ETFs are the object of a bubble, or that they are in any way analogous to portfolio insurance in the fall of 1987. Investment Implications Black Monday was a one-off event that remained contained within the financial markets despite widespread fears that it would spread to constrict the broader financial system and the real economy. A lot has changed in 30 years, but the collision of algorithms, derivatives and global pressures squarely places it in our time. It is entirely possible that its elements could come together to create another massive single-day drop. A key difference between future single- or intra-day swoons, and the ones that have already occurred since the crisis, is that they will arrive while the Fed is tightening policy at the margin. The future swoons, then, may not be as likely to disappear quickly without leaving much of a mark. It may go too far to say that market infrastructure is vulnerable, but it would be too optimistic to assume that it has kept pace with the advances in rapid-fire trading and the increasing prevalence of algorithms. It may make sense for investors with less tolerance for risk to maintain an extra cash buffer to protect against swoons and to ensure that they have dry powder to exploit them when they materialize. We remain constructive on the global economy, however, and our house view recommends overweighting risk assets while maintaining below-benchmark duration within bond portfolios. We sympathize with investors who lament that nothing in the public markets is cheap, but synchronized global acceleration remains intact. None of our models are warning of imminent danger. We therefore remain fully invested but vigilant, seeking out signs that the long bull market may be running out of steam. After reviewing our shortcomings in the aftermath of Black Monday, however, we will seek with an open mind and will not attenuate our efforts by awaiting the rapture of a final reckoning, when the sheep and the goats will be separated according to their virtue. The whole point of policy makers' efforts to engineer a rising tide is to keep the goats, and the broader economy, from harm. Doug Peta, Senior Vice President Global ETF Strategy dougp@bcaresearch.com 1 Except in New Zealand, where Black Tuesday popped a bubble of such notable excess that the MSCI New Zealand Index today trades at less than two-thirds of its September 1987 high, and Japan, where the mania lasted until December 1989 and the MSCI Japan Index is still nearly 40% below its all-time high. 2 Index arbitrageurs would have followed the same pattern, but they were sidelined by delayed price quotes and the failure of the NYSE's automated order execution system, which kept them from accurately identifying and exploiting true arbitrage opportunities. 3 Portfolio insurance was no secret - it was estimated that $90 billion of assets were following the strategy - and its potential to amplify selling pressures in a vicious circle had been the subject of a widely followed Wall Street Journal column published a week before the crash. 4 Lefevre, Edwin. Reminiscences of a Stock Operator, John Wiley & Sons, Inc.: Hoboken (NJ), pp. 57-8. Until 1997, the prices of NYSE-listed stocks were quoted in eighth-of-a-dollar increments. 5 For details on the interaction between recessions and equity bear markets, please see the August 16, 2017 Global ETF Strategy Special Report, "A Guide to Spotting and Weathering Bear Markets," available at etf.bcaresearch.com. 6 Hysteresis is the process by which a negative cyclical phenomenon, if left unchecked, can evolve into a secular phenomenon. 7 Greenspan, Alan. The Age of Turbulence: Adventures in a New World, Penguin (New York): 2007, p.108. Greenspan disavowed knowledge of the details, but suggested that Corrigan, "the Fed's chief enforcer," "bit off a few earlobes" while encouraging bankers to keep in mind that, "'if you shut off credit to a customer just because you're a little nervous about him, but with no concrete reason, he's going to remember that'." 8 Greenspan, p. 110.

Feature It was an honour and privilege to welcome Professor Daniel Kahneman to our New York Conference this year. Professor Kahneman was the 2002 winner of the Nobel Prize in Economics, though the great irony is that he hasn't taken a single economics class in his life! That said, he did have a great informal mentor in the form of Richard Thaler who, coincidentally, has just become the 2017 winner of the Nobel Prize in Economics. Professor Kahneman's lifetime work demonstrates that our economic and financial decisions are often highly irrational - flying in the face of most mainstream economic models which assume fully rational behaviour. His research culminated in a school of thought called Prospect Theory, for which he ultimately won the Nobel Prize. Feature ChartBonds Become Much More Risky At Ultra-Low Yields The Mystery Of The Risk Premium...Finally Solved The Mystery Of The Risk Premium...Finally Solved Over lunch, Professor Kahneman summarised Prospect Theory to us. And as he spoke, the penny suddenly dropped. Prospect Theory's rich findings may have solved some of the most pressing mysteries of finance. Why do equities typically outperform bonds? Why has QE boosted equity prices so much? What happens next to financial markets? Why Do Equities Typically Outperform Bonds? Let's begin by debunking a popular myth. Many people believe that equities typically outperform bonds because equity income streams grow in line with the economy whereas bond income streams are fixed and do not grow. This reasoning is false. Any income stream can be made to generate any return depending on the price you pay for the income stream upfront. A rapidly growing income stream can still generate a deeply negative return if you overpay for it. And a fixed, or shrinking, income stream can still generate a strongly positive return if you underpay for it. It follows that equities generate a higher return than bonds simply because the financial markets typically price them to deliver this higher return. The question is: why? Prospect Theory provides an answer. One of its great insights is that we significantly overestimate the probabilities of rare but sizeable gains and losses. Indeed, this overestimation of rare events provides the entire foundation of the lottery and insurance industries. We overpay for a lottery ticket to buy the tiny possibility of a large gain, which is called positive skew. And we overpay for insurance to remove the tiny possibility of a large loss, which is called negative skew. We do this because creating the tiny possibility of immense wealth lets us dream pleasant thoughts. While removing the tiny possibility of losing our home lets us sleep soundly. The upshot from Prospect Theory is that income streams with positive skew tend to be overvalued, and so generate poor returns - like the lottery ticket. Whereas income streams with negative skew tend to be undervalued, and so generate high returns. This brings us to the first key point. Equity returns possess negative skew (Chart I-2). On rare occasions, they suffer deep losses. Because of this negative skew, it is our contention that the markets price equities to generate an excess return - a risk premium - over investments that do not have a negative skew. Chart I-2Equity Markets Have Negative Skew: "Equity Markets Walk Up The Stairs But Jump Out Of The Window" Equity Markets Have Negative Skew: "Equity Markets Walk Up The Stairs But Jump Out Of The Window" Equity Markets Have Negative Skew: "Equity Markets Walk Up The Stairs But Jump Out Of The Window" To illustrate the point, bear with us as we do some simple maths. Say an equity price could end up at 102 with probability 90%, but could plunge to 82 in a rare event with probability 10%. This makes its expected value 100 (because 102*0.9 + 82*0.1 = 100). But if, as Professor Kahneman suggests, the market overestimates the rare event probability to, say, 20%, it will underprice the equity at 98 (because 102*0.8 + 82*0.2 = 98). Clearly, this pricing will generate an excess return - a risk premium of 2% - because the correct expected value is 100. Next consider a bond price which could end up at 101 or 99 with equal probability, giving it an expected value also at 100. As it does not have negative skew, the market will just price it at 100. Observe that the equity price and bond price have exactly the same expected value of 100, but the financial markets have underpriced the equity at 98 to generate an excess return over the bond - because the equity has negative skew while the bond does not. Why Has QE Boosted Equity Prices So Much? When bond yields fall to very low levels, things get more complicated. Bond returns also exhibit extreme negative skew (Chart I-3 and Chart I-4). And the reasons are obvious. At very low bond yields, the prospects for capital appreciation rapidly disappear, while the prospects for large-scale capital losses suddenly increase ( Feature Chart). Chart I-3When Bond Yields Are Ultra-Low Bond Markets Have Negative Skew Too When Bond Yields Are Ultra-Low Bond Markets Have Negative Skew Too When Bond Yields Are Ultra-Low Bond Markets Have Negative Skew Too Chart I-4When Bond Yields Are Ultra-Low Bond Markets Have Negative Skew Too When Bond Yields Are Ultra-Low Bond Markets Have Negative Skew Too When Bond Yields Are Ultra-Low Bond Markets Have Negative Skew Too One simple way to quantify an investment's negative skew is to pick an extended period of time - say several years - when the price has gone sideways, and then to calculate the worst 3-month loss as a multiple of the best 3-month gain.1 On this metric, equities typically show a negative skew of around 1.5. Meaning that the worst loss is about 1.5 times the size of the best gain. But for bonds, negative skew varies with the bond yield. At yields above 2.5%, bonds show no skew. Worst losses broadly equal best gains. However, when yields drop below 2%, the negative skew approaches the same level as for equities. And at yields around 1%, the negative skew can even exceed that on equities (Table 1 and Chart I-5). Table 1At Low Bond Yields, ##br##Bonds Have Extreme Negative Skew The Mystery Of The Risk Premium...Finally Solved The Mystery Of The Risk Premium...Finally Solved Chart I-5Bonds Become Much More Risky##br## At Ultra-Low Yields The Mystery Of The Risk Premium...Finally Solved The Mystery Of The Risk Premium...Finally Solved This brings us to a crucial conclusion. At very low bond yields, the equity risk premium must compress, and potentially disappear, because both bonds and equities now have the same undesirable negative skew. Is there any empirical evidence for this? The prospective equity risk premium is hard to capture as it requires an accurate forecast of the prospective excess return from equities over bonds. But the realised equity risk premium is easy to measure as it is just the annualised outperformance of equities over bonds. This shows a clear downtrend in Germany, the U.K. and the U.S. Meanwhile, in Japan where bond yields have been near zero for years, the realised equity risk premium is non-existent (Charts I-6, Chart I-7, Chart I-8, Chart I-9). Chart I-6The Equity Risk Premium ##br##Has Trended Lower In Germany... The Equity Risk Premium Has Trended Lower In Germany... The Equity Risk Premium Has Trended Lower In Germany... Chart I-7...And In The U.K. ...And The U.K. ...And The U.K. Chart I-8The Equity Risk Premium ##br##Has Trended Lower In The U.S. The Equity Risk Premium Has Trended Lower In The U.S. The Equity Risk Premium Has Trended Lower In The U.S. Chart I-9The Equity Risk Premium Is Non-Existent ##br##In Japan The Equity Risk Premium Is Non-Existent In Japan The Equity Risk Premium Is Non-Existent In Japan One important takeaway is that central banks, perhaps unwittingly, have driven up equity valuations exponentially. This is because QE has simultaneously compressed both the bond yield and the equity risk premium, giving equity valuations a double shot in the arm. Let's reasonably say that central bank policy depressed the 10-year bond yield by 2%. The resulting increased negative skew on bonds might then reasonably depress the 10-year equity risk premium by 2%. In combination, this would reduce the 10-year required return from equities by 4% a year for ten years. Under these assumptions, central bank policy might well have boosted equity valuations by 50%.2 What Happens Next To Financial Markets? The double shot in the arm to developed market equity valuations may have boosted them by 50%, but they are broadly in the right ballpark as long as bond yields remain ultra-low. However, the conditionality on bond yields is crucial. This is because the process that exponentially boosted equity valuations can also work viciously in reverse. To reiterate, the negative skew on bond returns starts to fade when the bond yield is at 2% and completely disappears at 3%, at which point the equity risk premium must fully re-emerge. Given the tendency of equities to exhibit negative skew and to move en masse in the developed markets, we can infer that the current valuation of equities would be in jeopardy if a mainstream bond yield broke well north of 2.5%. Whereupon the reassessment of equity valuations is likely to catalyse a correction, at the very least. Chart I-10Bond Yields Can Rise More In Europe ##br##Than In The U.S. Bond Yields Can Rise More In Europe Than In The U.S. Bond Yields Can Rise More In Europe Than In The U.S. But one important investment implication is that the subsequent flight to investment havens means that no mainstream bond yield can realistically rise beyond 3% in the foreseeable future. We can also infer that European 10-year bond yields have the potential to rise more than their equivalents in the U.S., given that European yields are much further from the 2.5%-3% 'red zone'(Chart I-10). So an excellent structural position is to underweight European government bonds versus U.S. T-bonds. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Using log returns. 2 Because 1.04^10 = 1.48 Fractal Trading Model* This week we observe that Norwegian equities are technically overbought. A market neutral trade is to go short Norway/long Switzerland with a profit target/stop loss of 2%. We now have five open trades. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 Short Norway / Long Switzerland Short Norway / Long Switzerland Fractal Trading Model 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. 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 - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights High-Yield: High-Yield spreads are 149 bps away from being more expensive than they have ever been. But in the absence of inflation it is difficult to pinpoint a catalyst for sharp spread widening. We expect excess high-yield returns between 2% and 5% (annualized) during the next 6-12 months. EM Sovereigns: There is no compelling valuation argument in favor of hard currency EM Sovereign debt versus U.S. corporate bonds. We will look to shift into EM once the pace of Fed rate hikes starts to slow later in the cycle. Economy & Inflation: Core inflation disappointed expectations in September, but the details of the report showed some silver linings. Inflation looks to be past the worst of its downtrend and should be strong enough during the next two months for the Fed to lift rates in December. Feature Chart 110-Year Treasury Yield Breakdown 10-Year Treasury Yield Breakdown 10-Year Treasury Yield Breakdown Just past the three quarter mark of 2017 and stubbornly low inflation remains the story of the year in U.S. bond markets. Quite simply, if inflation rebounds during the next two-and-a-half months, as the Federal Reserve expects, then Treasury yields will move sharply higher and Treasury total returns for 2017 will be close to zero. Otherwise, yields are likely to remain near current levels and 2017 Treasury total returns will approximate carry, in the range of 2.5%. Our valuation framework for the 10-year Treasury yield underscores the importance of inflation for the duration call. The real 10-year Treasury yield (currently 0.43%) is consistent with market expectations for just under two Fed rate hikes during the next 12 months (Chart 1). With the median Fed member calling for 3-4 hikes during that period, the potential remains for somewhat higher real yields in the near-term. But with all but one Fed member forecasting a terminal fed funds rate of 3% or below (1% or below in real terms), the long-run upside in real yields appears limited. On the other hand, the compensation for inflation embedded in 10-year bond yields is still far too low. At 1.85%, the 10-year TIPS breakeven inflation rate is well below the 2.4% to 2.5% range consistent with the Fed hitting its inflation target. This continues to be the case even as our Pipeline Inflation Indicator has accelerated in recent weeks (Chart 1, bottom panel). Bond investors are waiting for inflation to show up in the core CPI and PCE data before liquidating their positions. We retain our below-benchmark duration bias on a 6-12 month horizon on the view that inflation will soon resume its cyclical uptrend. 10-year inflation compensation has 55-65 bps of upside in this scenario, while 10-year real yields will probably stay close to current levels. The outlook for core inflation is discussed in more detail in the Economy & Inflation section below. High-Yield: Just A Carry Trade At this late stage of the credit cycle, low inflation is also the key support for excess returns in both investment grade and high-yield corporate bonds. We see limited scope for further spread tightening but think it's likely that the carry trade will continue until inflation turns the corner and long-maturity TIPS breakevens settle into the 2.4% to 2.5% range consistent with the Fed's target.1 In this week's report we explore what this carry trade means for excess high-yield returns, and put those returns into context with what the asset class has typically delivered for bond investors. Table 1 shows historical annual excess returns for the Bloomberg Barclays High-Yield index since 1995.2 On average High-Yield has returned 3.42% over Treasuries each year, but with significant variation. Most of that variation results from years when the default rate is either rising quickly during a recession or falling fast in the early stages of economic recovery. Since neither of those scenarios is likely during the next 6-12 months we filter out those periods by looking at years when the average index option-adjusted spread (OAS): Widened by more than 100 bps Tightened by more than 100 bps Was range bound between -100 bps and +100 bps The average excess return is 4.9% in years when the spread is confined to a -100 bps to +100 bps range. High-Yield has returned 5.46% in excess of Treasuries so far this year, and the OAS has tightened 61 bps. It is unlikely that junk spreads will tighten by 100 bps or more during the next 12 months. The average index OAS is currently 348 bps, only 115 bps above its all-time low (Chart 2). However, to properly assess current spread levels we also need to consider that the average index duration has declined during the past fifteen years. All else equal, the same spread level is more attractive today because index duration is lower. Table 1Historical Annual High-Yield##br## Excess Returns* (%) Living With The Carry Trade Living With The Carry Trade Chart 2Junk Spreads Not Far ##br##From All-Time Tights Junk Spreads Not Far From All-Time Tights Junk Spreads Not Far From All-Time Tights We adjust for index duration by looking at the 12-month breakeven spread.3 At 93 bps, the breakeven spread is currently 40 bps above its all-time low (Chart 2, bottom panel). In other words, at current duration levels, the junk OAS can tighten another 149 bps before the sector is more expensive than it has ever been. Either way, what's clear from Chart 2 is that we should probably not expect much more than 100 bps of further tightening this cycle. Or, put differently, it would definitely make sense to reduce high-yield exposure as we approach all-time expensive valuations. But we can get even more specific about our expectations for high-yield excess returns. Excess junk returns can be approximated using the following formula: Excess return = Starting OAS - Default Losses - Duration*(Change in OAS) The expected return from carry during the next 12 months can be thought of as today's index spread less our expectation for default losses. Capital gains and losses can be approximated using today's index duration and the expected change in spreads. For simplicity we ignore convexity effects. This excess return approximation is shown in the second panel of Chart 3, where the dashed line assumes a base case scenario where default losses fall in line with our expectation and the OAS remains flat. Table 2 shows what 12-month excess returns would be in this base case scenario, as well as in several other scenarios. Chart 3High-Yield ##br##Expected Returns High-Yield Expected Returns High-Yield Expected Returns Table 2High-Yield 12-Month Excess ##br##Return* Projections Living With The Carry Trade Living With The Carry Trade In a base case scenario, where default losses are 1.09% and the OAS is flat, we would expect excess junk returns of 2.39% during the next 12 months. In a more bullish scenario where the OAS tightens by another 100 bps - bringing it to within striking distance of all-time tights - we would expect excess returns of 6.15%. We also consider scenarios where default losses differ from our forecast of 1.09%. For context, that 1.09% forecast is derived from Moody's baseline default rate forecast of 2.26% and our own model-based recovery rate forecast of 51%. For example, in a scenario where default losses are somewhat higher than expected (2%) but where the OAS stays flat, we would expect excess returns of only 1.48%. We should note that 12-month high-yield default losses have never been lower than 0.5%. So we present that optimistic scenario as an upper-bound on potential excess returns to junk. Notice that even in the most optimistic scenario we can envision, default losses reaching all-time lows and spreads contracting to within a hair of all-time tights, expected excess high-yield returns still only reach 6.74%. We would view that as the absolute best case scenario for high-yield. Realistically, default losses will probably fall into a range between 1% and 2% during the next 12 months. Assuming also that spreads come under neither strong upward nor downward pressure, we would expect excess high-yield returns between 2% and 5% (annualized) during the next 6-12 months. Bottom Line: High-Yield spreads are 149 bps away from being more expensive than they have ever been. But in the absence of inflation it is difficult to pinpoint a catalyst for sharp spread widening. We expect excess high-yield returns between 2% and 5% (annualized) during the next 6-12 months. Is Hard Currency EM Debt A Substitute For Junk? Chart 4Favor U.S. Corporates Over EM Sovereigns Favor U.S. Corporates Over EM Sovereigns Favor U.S. Corporates Over EM Sovereigns With relatively feeble expected returns from U.S. high-yield bonds, it's logical to explore whether there are any more attractively valued alternatives in the U.S. bond universe. One potential candidate is the U.S. dollar denominated debt of Emerging Market governments. Unfortunately, valuation in that space does not look much better than in U.S. corporates. In an effort to control for differences in both credit rating and index duration, we compare 12-month breakeven spreads between the Bloomberg Barclays EM USD Sovereign Index and a credit rating matched benchmark consisting of a combination of U.S. investment grade and high-yield corporate bond indexes. We notice that hard currency EM Sovereigns and similarly rated U.S. corporate bonds offer almost exactly the same breakeven spread, and also that EM Sovereigns have been getting comparatively cheaper since early last year (Chart 4). At the moment there is no compelling argument to favor one sector over the other on pure valuation grounds. We therefore also consider the main macro drivers of relative excess returns between EM Sovereigns and U.S. corporates (Chart 4, bottom 2 panels). The last two significant periods of EM outperformance coincided with falling U.S. rate hike expectations - as evidenced by our declining fed funds discounter - and a weaker U.S. dollar. With our 24-month fed funds discounter at only 62 bps - meaning the market expects less than three rate hikes during the next 24 months - we think it is likely to move higher from here. This should lead to one more bout of EM cheapening relative to U.S. corporates. At that point, once we are past peak rate hike expectations for the cycle, we will likely get a more attractive entry point to move into EM. Interestingly, an examination of country level spreads also does not identify any clear pockets of cheapness in EM (Chart 5). Mexico and Turkey both offer similar breakeven spreads to equivalently rated U.S. corporates, but our Emerging Markets Strategy service has a dim view of both the Turkish Lira and Mexican peso versus the U.S. dollar.4 The higher-rated EM countries: Saudi Arabia, UAE and Qatar offer the most attractive relative spreads. But, at least for Qatar, that elevated spread is most likely compensation for a highly volatile currency (Chart 6).5 Chart 5Breakeven Spreads: USD EM Sovereign Vs. U.S. Corporates Living With The Carry Trade Living With The Carry Trade Chart 6USD EM Sovereign Breakeven Spread Differentials Vs. Exchange Rate Volatility Living With The Carry Trade Living With The Carry Trade Bottom Line: There is no compelling valuation argument in favor of hard currency EM Sovereign debt versus U.S. corporate bonds. We will look to shift into EM once the pace of Fed rate hikes starts to slow later in the cycle. Economy & Inflation Some Silver Linings In September's CPI The September CPI report was released last week and it disappointed expectations with core CPI rising only 0.13% month-over-month. For context, an environment where inflation is well anchored around the Fed's target would be consistent with core CPI prints of 0.2% every month, roughly 2.4% annualized. However, despite the disappointing month-over-month figure, we continue to see evidence that inflation is past the worst of its recent downtrend. First, while year-over-year core CPI was roughly flat in September, the 3-month rate of change increased for the fourth consecutive month. The year-over-year rate of change tends to converge toward the 3-month rate of change (Chart 7). Second, a look at the underlying components of core CPI shows the following (Chart 8): Chart 7CPI Inflation CPI Inflation CPI Inflation Chart 8Core CPI Components Core CPI Components Core CPI Components Shelter inflation fell from 3.30% to 3.24% year-over-year in September. This mild deceleration is consistent with the reading from our model, and will persist going forward (Chart 8, panel 1). Chart 9Wireless No Longer A Drag Wireless No Longer A Drag Wireless No Longer A Drag Core goods inflation also fell in September, but should soon start to rise as the weaker dollar and rising import prices pass through to overall core goods prices (Chart 8, panel 2). Core services inflation, excluding shelter and medical care, increased for the third consecutive month (Chart 8, panel 3). This component of inflation is most sensitive to wage growth, and it is where we would expect most of the inflation to come from going forward. Medical care inflation continues to decelerate sharply (Chart 8, bottom panel), but as we have discussed previously, this mostly reflects a convergence between CPI and PCE inflation.6 The Fed's 2% target refers to PCE inflation. The acceleration in core services inflation (excluding shelter and medical care) is particularly important as it is yet another signal that tight labor markets are starting to pressure wages higher. This is the dynamic that must continue to play out if inflation is to return to the Fed's target, and we would tend to view increases in inflation as more sustainable if they are driven by this component. Additionally, the critical core services inflation (excluding shelter and medical care) component has been depressed in recent months by an incredibly sharp decline in cellular service (aka wireless) inflation (Chart 9). The decline occurred when both Verizon and AT&T unveiled unlimited data plans in the same month, but that drop has since reversed. When we exclude wireless from core services inflation, in addition to shelter and medical care, we see that the resulting series tracks wage growth much more closely in recent months. This underscores our conviction that core services inflation will respond to tightening labor markets and mounting wage pressure going forward. Consumer Sentiment Is Sky High There was one other notable datapoint released last week, and that was the University of Michigan's Consumer Sentiment survey which surged to its highest level since 2004 (Chart 10)! This should lend support to consumer spending (and hence GDP growth) in Q3 and Q4 and is consistent with the message from the New York Fed's GDP tracking estimate which projects GDP growth to average 2.3% in the second half of 2017. This is well above the Fed's 1.8% estimate of trend. Chart 10Consumer Spending & Sentiment Consumer Spending & Sentiment Consumer Spending & Sentiment With growth coming in solidly above trend, it is unlikely that September's disappointing month-over-month CPI print will be enough to prevent the Fed from lifting rates in December. As long as inflation is flat or higher during the next two months, then another rate hike this year is probably in the cards. Bottom Line: Core inflation disappointed expectations in September, but the details of the report showed some silver linings. Inflation looks to be past the worst of its downtrend and should be strong enough during the next two months for the Fed to lift rates in December. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com 2 Excess returns are calculated relative to a duration-matched position in Treasury securities. 3 The 12-month breakeven spread is the spread widening required on a 12-month investment horizon to deliver zero excess returns. For simplicity we ignore convexity effects and calculate the breakeven spread as OAS divided by duration. 4 For Turkey please see Emerging Markets Strategy Weekly Report, "Is The Dollar Expensive, And Are EM Currencies Cheap?" dated October 11, 2017. For Mexico please see Emerging Markets Strategy Weekly Report, "Questions From The Road", dated September 20, 2017. Both available at ems.bcaresearch.com 5 Both Saudi Arabia and UAE have pegged exchange rates and are not shown in Chart 6. 6 Please see U.S. Bond Strategy Weekly Report, "The Great Unwind", dated September 19, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Dear Client, There is no regular report this week. Instead, I am sending you a Special Report written by colleague Mark McClellan, who examines global equity valuations from a bottom-up perspective using our Equity Trading Strategy (ETS) platform. I discussed the intellectual underpinnings for the ETS model in 2015. In addition, if you haven't done so already, please take a moment to listen to our latest webcast, where I survey the global macro landscape, drawing on the material published in our Quarterly Strategy Outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights The performance of Japanese stocks relative to the U.S. has been dismal over the past couple of decades, and the same is true for Europe in the post-Lehman period. However, both the Japanese and European economies are performing impressively this year, profit growth is accelerating and margins are rising. This suggests that there could be some "catch up" for both markets, at least in local-currency terms. Standard valuation measures based on index data also suggest that Eurozone and Japanese stocks are cheap compared to the U.S. Nonetheless, these markets almost always trade at a discount, due to a persistent lackluster profit performance. In this Special Report, we approach the issue from a bottom-up perspective, utilizing the powerful analytics provided by BCA's exciting new Equity Trading Strategy (ETS) platform. The ETS software allows us to compare companies across markets on a head-to-head basis and rank them based on a wide range of characteristics. The bottom-up approach adjusts for structural valuation gaps between these markets and avoids the problems of index construction. Investors can have greater confidence that they will make money on a 12-month horizon by taking a position when the new bottom-up indicators reach +/-1 standard deviations over- or under-valued, although technical information should be taken on board to sharpen the timing. The +/-2 sigma level gives clear buy/sell signals irrespective of fundamental or technical factors. The bottom-up valuation indicators will not replace our top-down versions that are based on index data, but rather will be considered together when evaluating relative value. European stocks are near fair value relative to the U.S. at the moment, while Japan is modestly cheap. We favor the European and, especially, Japanese markets over the U.S., due to policy divergence and the view that EPS has more room to expand in the former two economies. Feature Chart 1European And Japanese Stocks Have Lagged... European And Japanese Stocks Have Lagged... European And Japanese Stocks Have Lagged... Japanese equities have been perennial underperformers versus the U.S. for most of the past 2-3 decades in both local- and common-currency terms (Chart 1). The simultaneous bursting of the equity and land bubbles in the 1990s ushered in a prolonged period of deflation in wages and consumer prices. There was a ray of light in the early years of Abenomics, when the aggressive three-arrow approach appeared to be finally lifting the Japanese economy out of a Secular Stagnation. Yen weakness contributed to a surge in earnings-per-share (EPS) in absolute terms and relative to the U.S. Equity multiples rose between 2012 and 2015. Unfortunately, Abe's honeymoon with equity markets faded in 2016 (Chart 2). A bout of yen strength, collapsing inflation expectations, weakening business confidence and a lack of progress on structural reforms caused investors to question the upside potential for Japanese corporate top-line growth. While European indexes have fared better than Japanese stocks relative to the U.S. over the past 25 years as a whole, the post-Lehman period has been particularly tough for European corporate profitability and relative equity market performance. The U.S. total return index has more than doubled its pre-recession peak according to Thomson Reuters/Datastream data, while the Eurozone total return index is only 10% above the previous high-water mark when expressed in U.S. dollars (Chart 2). The yawning return gap between the two equity markets was almost entirely due to earnings as market multiples have moved largely in sync. Earnings-per-share generated by U.S. companies now exceed the pre-recession peak by about 23%. In contrast, earnings produced by their Eurozone peers are a whopping 42% below their peak (common-currency). That said, the earnings backdrop now appears to be shifting. The strengthening global recovery is turbocharging EPS growth in Europe and Japan, where the corporate sector is more leveraged to global growth than is the case in the U.S. Eurozone domestic demand is also hot. Japan is still struggling with deflation, but the economy is performing well and the corporate sector is benefiting from this year's yen pullback. Japanese EPS is surging in both yen and dollar terms. Finally, both Europe and Japan appear cheap versus the U.S. by traditional valuation metrics. Based on index data, these two markets trade at a hefty discount across most of the main valuation measures (Chart 3). This is the case even for normalized measures such as price-to-book. However, these two markets have almost always traded at a discount to the U.S. Chart 2...Due To Depressed Fundamentals ...Due To Depressed Fundamentals ...Due To Depressed Fundamentals Chart 3Europe And Japan Trade At A Discount Europe And Japan Trade At A Discount Europe And Japan Trade At A Discount There are many possible explanations for the persistent valuation gap, including differences in accounting standards, discount rates and sector weights. The wider use of stock buybacks in the U.S. also favors American equity valuations. But most important are historical differences in underlying corporate fundamentals. U.S. companies on the whole have been significantly more profitable over the years based on return on equity and operating margins (Charts 4 and 5). Until recently, U.S. companies have also tended to have lower leverage relative to Europe and Japan, and a higher interest coverage ratio than Europe. Better profitability metrics in the U.S. are not solely an artifact of sector weighting either. Operating margins are lower in Europe and Japan even after applying U.S. sector weights to the other two markets (Chart 6). Chart 4RoE Is Consistently Lower In Japan And Europe RoE Is Consistently Lower In Japan And Europe RoE Is Consistently Lower In Japan And Europe Chart 5U.S./Europe/Japan Comparison U.S./Europe/Japan Comparison U.S./Europe/Japan Comparison Chart 6U.S./Europe/Japan Comparison (U.S. Sector Weights) U.S./Europe/Japan Comparison (U.S. Sector Weights) U.S./Europe/Japan Comparison (U.S. Sector Weights) Why the European and Japanese corporate sectors have been profit underachievers is beyond the scope of this paper. U.S. companies reaped most of the benefit from productivity gains over the past 25 years, with the result that the capital share of income soared while the labor share collapsed. European and Japanese companies were less successful in squeezing down labor costs. This raises the question of whether European and Japanese stocks are, in fact, cheap relative to the U.S. Measuring Value Our monthly Bank Credit Analyst publication developed top-down valuation indicators that adjust for different sector weights and persistent differences in the underlying profit fundamentals. These indicators are based on index data, and have a good track record for providing profitable buy/sell signals.1 In this Special Report, we take a bottom-up approach that utilizes the powerful analytics provided by BCA's Equity Trading Strategy (ETS) platform.2 The software allows us to compare companies on a head-to-head basis and rank them based on a wide range of characteristics. The bottom-up approach avoids the problems of index construction when trying to gauge valuation across countries. The web-based platform uses over 27 quantitative factors to rank approximately 10,000 individual stocks in 23 countries, allowing clients to find stocks with winning characteristics at the global level. Users can rank and score individual equities to support a broad set of investment strategies and apply macro and sector views to single-name investments. The ETS approach has an impressive track record.3 Historically, the top-decile of stocks ranked using the "BCA Score" methodology has outperformed stocks in the bottom decile by over 25% a year. The BCA Score includes 27 factors when ranking stocks, including sentiment and momentum. However, since we are interested in developing a valuation metric in this paper, we focus on five valuation measures in the ETS database: trailing P/E, forward P/E, price-to-book, price-to-sales and price-to-cash flow. We combined all of the Eurozone and U.S. companies that have total assets of greater than $1 billion into one dataset. The ETS platform then ranked the stocks from best to worst on a daily basis (i.e., cheapest to most expensive), using an equally-weighted average of the five valuation measures. The average score for U.S. stocks is subtracted from the average score for European stocks, and then divided by the standard deviation of the series. This provides a valuation metric that fluctuates roughly between +/- 2 standard deviations. This approach inherently adjusts for structural valuation gaps. We then used the same methodology to construct bottom-up valuation indicators for Japan relative to the U.S. Chart 7 presents the resulting bottom-up indicators for Europe and Japan, along with our top-down valuation measure. A high reading indicates that European or Japanese stocks are cheap relative to the U.S., while the opposite is true for low readings. Chart 7Top-Down And Bottom-Up Valuation Indicators Top-Down And Bottom-Up Valuation Indicators Top-Down And Bottom-Up Valuation Indicators The underlying bottom-up data extend back to 2000. However, the bursting of the tech bubble in the early 2000's caused major shifts in relative valuation among sectors that skew the indicator when constructed using the entire data set. A cleaner indicator emerges when using only the data from 2005. As with any valuation indicator, it is only useful when it reaches extremes. We calculated the historical track record for a trading rule that is based on critical levels of over- and under-valuation. For example, we calculated the (local-currency basis) excess returns over 3-, 6-, 12- and 24-month horizons generated by (1) overweighting European or Japanese stocks when that market was one and two standard deviations cheap versus the U.S. market, and (2) overweighting the U.S. when the European or Japanese market was one and two standard deviations expensive (Tables 1 and 2). Table 1Eurozone Vs. U.S. Value Indicator: Trading Rule Returns And Batting Average Valuing Stocks Using The BCA Equity Trading Strategy Platform Valuing Stocks Using The BCA Equity Trading Strategy Platform Table 2Japan Vs. U.S. Value Indicator: Trading Rule Returns And Batting Average Valuing Stocks Using The BCA Equity Trading Strategy Platform Valuing Stocks Using The BCA Equity Trading Strategy Platform The trading rule returns are best in the case of Europe when the indicator reached two standard deviations cheap or expensive, providing average returns of almost 11 percent over 12 months. The trading rule returns when the indicator reached +/-1 standard deviation are lower, but still respectable at roughly 3% on 12- and 24-month horizons. The results are even better for the Japan trading rule (Table 2). Excess returns are 14% and 35%, respectively, over 12 and 24-month horizons after the indicator reaches +/-2 standard deviations. The results are very impressive even when using +/-1 standard deviation as the trigger point. Tables 1 and 2 also present the trading rules' batting average. That is, the number of positive excess returns generated by the trading rule as a percent of the total number of signals. For the European indicator, the batting average ranged from 50% on a 3-month horizon to 68% over 12 months when buy/sell signals are triggered at +/- 1 standard deviation. The batting average is much higher (80-100%) using +/- 2 standard deviations as a trigger point, although there were only five months over the entire sample when the indicator reached this level. The batting average is even better for the Japanese indicator. Sharpening The Buy/Sell Signals We then augmented the valuation analysis by adding information on company fundamentals, such as EPS growth and profit margins, among others. The ETS software ranked the companies after equally-weighting the valuation and fundamental factors. However, this approach yielded poor results in terms of the trading rule. This is because, for example, when European stocks reached undervalued levels relative to the U.S., it is usually because the European earnings fundamentals have underperformed those of the U.S. companies. Thus, favorable value is offset by poor fundamentals when scored by the ETS model, muddying the message provided by valuation alone. We also tried including some technical indicators to see if they could add information on timing. Chart 8 compares the valuation indicator discussed above to an enhanced indicator that includes both value and technical factors. Tables 3 and 4 provide the excess returns and batting averages for a trading rule based on the enhanced indicator. Chart 8Bottom-Up Indicators: Value, And Value Plus Technical Bottom-Up Indicators: Value, And Value Plus Technical Bottom-Up Indicators: Value, And Value Plus Technical Table 3Eurozone Vs. U.S. Value And Technical Indicator: Trading Rule Returns And Batting Average Valuing Stocks Using The BCA Equity Trading Strategy Platform Valuing Stocks Using The BCA Equity Trading Strategy Platform Table 4Japan Vs. U.S. Value And Technical Indicator: Trading Rule Returns And Batting Average Valuing Stocks Using The BCA Equity Trading Strategy Platform Valuing Stocks Using The BCA Equity Trading Strategy Platform It turns out that including some technical information does add value, but only in the case of Europe when using +/-1 standard deviation as the trigger point for trades. Both the excess returns and batting average to the trading rule improve. However, this is not the case when using +/-2 sigma. In the case of Japan, including technical information detracts from excess returns for both trigger points. Investment Conclusions Our new ETS platform provides investors with a unique way of picking stocks by combining top-down macro themes with company-specific information. It also allows us to develop valuation tools that avoid some of the pitfalls of index data by comparing stocks on a head-to-head basis. Investors can be fairly confident that they will make money on a 12-month horizon by taking a position when the bottom-up valuation indicators reach +/-1 sigma over- or under-valued. The +/-2 sigma valuation level gives clear buy/sell signals irrespective of fundamental or technical factors for both Europe and Japan. The bottom-up valuation indicators will not replace our top-down versions, but rather will be considered together when evaluating relative value. At the moment, both the top-down and bottom-up versions suggest that European stocks are roughly fairly valued relative to the U.S. market. Japanese stocks are on the cheap side based on both indicators, but neither one exceeds +1 sigma. This means that investors cannot make the allocation decision based on value alone. Valuation indicators need to be at extremes to have any predictive power. Our global equity strategists recommend overweighting Eurozone stocks versus the U.S. on a currency-hedged basis, although not because of valuation. On the plus side, the economy is flying high and there are no warning signs that this is about to end. There is hope for structural reform in France after Macron's election win this year. We give Macron's proposed labor market reforms high marks. Many doubt that these reforms will see the light of day, but our geopolitical team believes that investors are underestimating the chances. The German election in September poured cold water on recent enthusiasm regarding accelerated European integration. This is because Merkel will likely have to deal with a larger contingent of Euroskeptics in the grand coalition that emerges in the coming months. However, we do not expect political developments in Germany to be a headwind for the Eurozone stock market. On the negative side, this year's euro bull phase will take a bite out of earnings. Euro strength so far this year will lop three to four percentage points off of EPS growth by the middle of next year. Our model suggests that this will be overwhelmed by the robust economic expansion at home and abroad, but profit growth will diminish heading into year-end and will likely trail that in the U.S. and Japan over the next six months (local-currency basis). Still, a lot of the negative impact of the currency on profits may already be discounted. The bullish case versus the U.S. is more compelling for the Nikkei, at least in local-currency terms. Valuation is modestly attractive and Japanese earnings are highly geared to economic growth at home and abroad. Japanese EPS is in an uptrend versus the U.S. in both local and common currencies. We do not expect to see a peak in EPS growth until mid-2018, a good six months after the expected top in the U.S. Moreover, an Abe win in the October 22 election would mean that policy will remain highly reflationary in absolute terms and relative to the U.S. However, overweight positions in both the European and Japanese bourses should be currency hedged because the dollar is likely to appreciate over the next 6-12 months due to monetary policy divergences. Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see The Bank Credit Analyst Special Report, "Are Eurozone Stocks Really That Cheap?" dated July 2016. 2 Please see Equity Trading Strategy Special Report, "Introducing ETS: A Top Down Approach To Bottom-Up Stock Picking," dated December 2, 2015. 3 For more information, please see Equity Trading Strategy Special Report, "Making Money with ETS," dated January 20, 2016 Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights It is often argued that the U.S. dollar is expensive, but models do not offer a unanimous picture. The U.S. current account, exports share, and cyclical inflation do not point to an obvious dollar overvaluation either. Without a clear valuation signal, the dollar will continue to trade off rate differentials. An increasing body of evidence points toward a rebound in U.S. inflation. As such, U.S. rates are likely to move up relative to the rest of the world, lifting the USD over the next 12 months. Feature We are sending you a shorter regular bulletin this week as we are also publishing a follow up to our joint Special Report titled, "Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors," released with the Global Asset Allocation team two weeks ago. In this follow-up, my colleague Xiaoli Tang expands on the same methodology, testing various FX-hedging strategies for international investors - but this time looking at portfolios based in the CHF, the SEK, and the NOK. In this week's regular bulletin, we take a closer look at the U.S. dollar's valuations. The consensus view is that the dollar is expensive. We explore how this claim stacks up against the facts. At this juncture, the U.S. economy is not exhibiting some of the key consequences typical of an economy burdened by an expensive currency. Valuation Models The main argument used by some investors to show that the U.S. dollar is expensive is the traditional purchasing power parity model. This indicator does indeed flag a large 17% overvaluation for the greenback (Chart I-1). However, this is only one metric based on producer price indices. We also like to look at measures that focus on the true determinant of competitiveness: the cost of labor. When we deflate the U.S. dollar's exchange rate using unit labor costs, the dollar is neither a screaming sell nor a screaming buy. It is in line with its long-term average (Chart I-2). The same IMF real effective exchange rate model based on unit labor costs also shows the euro as fairly valued. Thus, on this metric, valuations do not seem to provide a compelling argument to go long or short the dollar, which challenges the universally bearish take on the dollar's perceived overvaluation. Chart I-1An Argument For An###br## Expensive USD An Argument For An Expensive USD An Argument For An Expensive USD Chart I-2But Not All Valuation Approaches ##br##Are That Clearcut But Not All Valuation Approaches Are That Clearcut But Not All Valuation Approaches Are That Clearcut We can also double-check the result of this metric using our own long-term fair value model, which incorporates long-term relative productivity trends. This model tries to capture the so-called Balassa-Samuelson effect. This effect is an empirical observation that countries with superior long-term labor productivity trends tend to experience a secular upward bias on their real exchange rates. The perceived overvaluation of the U.S. dollar may in fact be an illusion, because when the Balassa-Samuelson effect is taken into account, the dollar currently trades in line with its fair value (Chart I-3). Chart I-3Another Global Approach With USD At Fair Value Another Global Approach With USD At Fair Value Another Global Approach With USD At Fair Value Bottom Line: Valuing currencies is always an exercise to be approached with plenty of circumspection. It is easy to look at simple PPP models and argue that the dollar looks very expensive. However, when one takes into account labor market costs and productivity trends, the dollar seems fairly valued. A Look At The Symptoms Chart I-4The U.S. Current Account##br## Shows Little Dollar Strain The U.S. Current Account Shows Little Dollar Strain The U.S. Current Account Shows Little Dollar Strain Models are only as good as their inputs. It is important to try to corroborate their insights with economic reality. An expensive currency should produce three major outcomes: the country's current account position should be deteriorating, its market share of global exports should be falling, and it should be experiencing deep deflationary pressures relative to the rest of the world. Let's begin with the current account. Despite a 17% increase in the U.S. dollar since 2014, the U.S. current account has remained stable (Chart I-4). It is undeniable that this reflects an improvement in the energy trade balance of the U.S., itself a byproduct of the shale revolution. Nonetheless, it also highlights that there is little balance-of-payments strains in the U.S. In fact, the move away from energy imports in itself should point to a higher level of equilibrium for the dollar. The export share of the U.S. also does not point to too much stress created by the dollar bull market. As Chart I-5 illustrates, in contrast to the early 1980s or late 1990s-early 2000s, U.S. exports has been faring well when compared to the rest of the world. This exercise needs to be conducted by comparing U.S. exports to the rest of the world excluding China. China has been grabbing global market share from everyone for 30 years. As an aside, the continued rise of China, as well as its still-large current account surplus of more than US$155 billion, supports the idea that the RMB is indeed cheap and remains attractive on a long-term basis - a message also flagged by our long-term fair value model for the CNY (Chart I-6). Chart I-5Growing U.S. Market Share Growing U.S. Market Share Growing U.S. Market Share Chart I-6The Yuan Is Clearly Cheap The Yuan Is Clearly Cheap The Yuan Is Clearly Cheap Finally, there is little evidence that the U.S. dollar is depressing U.S. inflation on a cyclical basis. Changes in financial conditions can temporarily redistribute inflationary pressures between the U.S. and the rest of the world, but an expensive dollar should depress U.S. inflation for an extended period of time on a global relative basis. An expensive U.S. dollar makes the U.S. uncompetitive, and should force some degree of internal adjustment on the U.S. economy. So far, the two-year moving average of U.S. core inflation relative to the OECD does not show the same kind of swoon as in the 1980s or late 1990s. In fact, even after this year's inflation slowdown in the U.S., American inflation remains in an uptrend relative to the rest of the OECD (Chart I-7). One source of worry remains the U.S. net international investment position (NIIP). The U.S.'s NIIP currently stands at -41% of GDP, and despite stabilizing for the past two years, has been in a pronounced downtrend over the past 35 years. Historically, countries like Switzerland or Japan with strong NIIPs have tended to experience long-term upward pressure on their exchange rates, while those with poor NIIPs such as South Africa tend to experience negative secular trends, even in real terms. For the time being, what keeps the negative impact of the NIIP on the USD at bay is that the U.S. continues to earn a positive net income - despite negative net assets abroad (Chart I-8). This reflects the willingness of investors to hold the U.S. dollar for its reserve currency status. For the time being, with a lack of alternative to challenge the U.S. dollar's reserve status, the NIIP should not represent a key hurdle for a few more years. Chart I-7The U.S. is Not Experiencing##br## An Internal Devaluation The U.S. is Not Experiencing An Internal Devaluation The U.S. is Not Experiencing An Internal Devaluation Chart I-8The Exorbitant ##br##Privilege The Exorbitant Privilege The Exorbitant Privilege Bottom Line: The U.S. economy is currently exhibiting few of the signals that would be associated with an expensive dollar: the current account remains well behaved, the country is not losing export market shares to its main competitors, and U.S. inflation remains well behaved relative to the rest of the OECD on a cyclical basis. A key risk remains the U.S.'s net international investment position, but so long as the USD can maintain its unchallenged role as the key reserve in the global financial system, the U.S. is likely to continue to run an income surplus vis-à-vis the rest of the world. So What? When it comes to the FX space, long-term valuations only become binding constraints when they are in the extreme. Right now, there is enough conflicting evidence to suggest that if the dollar is indeed expensive, it is not expensive enough to flash a bright sell signal. In this case, the U.S. dollar's dynamics are likely to be dominated by interest rate differentials. Interest rate curves outside of the U.S. seem currently fairly priced, but this is not the case in the U.S. Thus, with only two full hikes priced in over the next 24 months, one needs to see upside for U.S. interest rates if one is to be bullish on the greenback. Despite last month's very poor employment numbers, a consequence of hurricanes Harvey and Irma, the labor market remains strong enough to justify the Federal Reserve's desire to hike rates. The ISM surveys also remains very strong, with the headline numbers and new order components pointing toward robust growth. The only factor that could impede the Fed is inflation. On this front, we remain optimistic that inflation will not deteriorate much further and that, in fact, it is likely to pick up over the next six months, giving the Fed a green light to increase rates in line with its own forecast: First, in the past, we have highlighted that velocity of money - based on the money of zero maturity and nominal GDP - has been a very reliable leading indicator of inflation over the past 20 years, and is pointing toward a rebound in core inflation measures toward year-end.1 Moreover, the easing in U.S. financial conditions over the past 18 months also points toward upside risks to both U.S. growth and inflation. Second, the strength in the Prices-Paid component of both ISM surveys further increases our optimism. Moreover, the recent vigor of the Supplier Delivery subcomponent - a measure of bottlenecks in the system - also points to pipeline inflationary pressures. It is true that some of the recent spike is most likely skewed by the devastating impact of the hurricanes, but this improving trend began much earlier this year. Historically, a combined improvement in both the Prices-Paid and the Supplier Delivery components of the ISM survey tends to provide long leads on core inflation (Chart I-9). Third, the New York Fed has recently started publishing an underlying inflation trend estimate. This measure has also been rebounding sharply, hitting its highest level in 10 years, also pointing toward higher core inflation (Chart I-10). Chart I-9Pipeline Inflationary Pressures##br## Are Growing In The U.S. Pipeline Inflationary Pressures Are Growing In The U.S. Pipeline Inflationary Pressures Are Growing In The U.S. Chart I-10Underlying Inflationary ##br##Pressures Are Growing Underlying Inflationary Pressures Are Growing Underlying Inflationary Pressures Are Growing Fourth, the behavior of inflation itself is somewhat encouraging. While the recent core PCE year-over-year numbers have been disheartening, the three-month annualized rate of change has picked up robustly. Historically, this has also led to turning points in the year-on-year number (Chart I-11). Finally, there are signs of underlying vigor in wages. Last week's U.S. average hourly earnings number clicked in at 2.9%.It was likely overinflated by the effect of the hurricanes, which have temporarily dropped workers in low-paid industries out of the sample used by the U.S. Bureau of Labor Statistics to compute this data. However, the median average hourly earnings across the key sectors covered by the BLS has been in an uptrend since the beginning of the year (Chart I-12), pointing to some faint but real early signs of rising underlying wage growth. Moreover, while much ink has been spilled regarding whether or not the Philips curve is flat, there remain a well-defined tight relationship between the U.S. employment cost index (ECI) and the level of employment-to-population ratio in the U.S. (Chart I-13). Our view that employment growth will likely continue to tick in north of 120,000 jobs for the next 12 months, implies further improvement in the employment-to-population ratio, and thus a growing ECI. This will both support household income and consumption as well as our inflation view. Chart I-11Sequential Inflation Pointing ##br##To A Turning Point Sequential Inflation Pointing To A Turning Point Sequential Inflation Pointing To A Turning Point Chart I-12Cross-Sectional Median ##br##Of Wages Improving The Cross-Sectional Median Of Wages Improving The Cross-Sectional Median Of Wages Improving Chart I-13The Cross-Sectional Median##br## Of Wages Improving Is The Dollar Expensive? Is The Dollar Expensive? Bottom Line: With no clear message from long-term valuation, the key driver of the dollar is likely to remain interest rate differentials. At this point, U.S. interest rates need U.S. inflation to be able to rise by more than what is implied in the OIS curve and lift the dollar. Signs continue to accumulate that U.S. inflation is likely to turn the corner over the next six months, thanks to an easing in U.S. financial conditions and the pick-up in the velocity of money: the Prices-Paid and Supplier Deliveries components of the ISM have hooked up significantly, the NY Fed's underlying inflation measure is strong, the sequential growth rate in core inflation is improving, and there are growing signs that wage growth in the U.S. is picking up. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled "Fade North Korea, And Sell The Yen", dated August 11, 2017, or Foreign Exchange Strategy Weekly Report, titled "Conflicting Forces For The Dollar", dated September 8, 2017, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

Highlights EM currencies are fairly valued at the moment - they are neither cheap nor expensive. Unit labor cost-based REER is a superior currency valuation measure to those based on consumer and producer prices. Based on this measure, the U.S. dollar is not expensive - rather its valuation is neutral. When valuations are neutral, directional market indicators are more imperative than valuations. We expect directional indicators to favor the U.S. dollar and the euro versus EM currencies. In Turkey, inflation is breaking out - the currency, stocks and bonds will be under assault (page 9). The Philippines economy is overheating warranting policy tightening. Share prices are at risk (page 16). Feature EM currencies have recently begun to sell off. Does this represent a major reversal, or just a pause in a bull market? Our bias is that it is the former. In this week's report, we discuss the valuation aspect of foreign exchange markets. One of the oft-cited bullish arguments for EM currencies is that they are cheap. Similarly, the contention goes that the U.S. dollar is expensive. Our exchange rate valuation measures do not support these claims. According to our most favored currency valuation measure - the real effective exchange rate (REER) based on unit labor costs - the U.S. dollar is currently fairly valued (Chart I-1). More specifically, the greenback is not cheap, per se, but it is not expensive either. Meanwhile, the euro is at its fair value and the yen is undervalued (Chart I-2). The source of this data is the IMF. Below we elaborate in detail why we believe the unit labor cost-based REER valuation measure is superior to those based on consumer or producer prices. Chart I-1The U.S. Dollar Is Neither Cheap Nor Expensive The U.S. Dollar Is Neither Cheap Nor Expensive The U.S. Dollar Is Neither Cheap Nor Expensive Chart I-2The Euro Is Fairly Valued, The Yen Is Cheap The Euro Is Fairly Valued, The Yen Is Cheap The Euro Is Fairly Valued, The Yen Is Cheap As to EM currencies, there is no data on REER based on unit labor costs across all EM countries. The IMF and OECD have data for only a few developing countries, shown in Chart I-3A and Chart I-3B. With the exception of the Mexican peso and the Polish zloty, EM currencies shown in these charts are not cheap. Chart I-3AEM Currencies Are Not Universally Cheap EM Currencies Are Not Universally Cheap EM Currencies Are Not Universally Cheap Chart I-3BEM Currencies Are Not Universally Cheap EM Currencies Are Not Universally Cheap EM Currencies Are Not Universally Cheap In the absence of unit labor cost-based REER for EM, we deduce EM currency valuations in a number of ways: First, if the U.S. dollar, the euro and yen are not expensive, EM currencies by definition cannot be cheap. Second, provided exchange rates of commodities-producing advanced countries such as Australia, New Zealand, Canada and Norway are still expensive, according to unit labor cost-based REER (Chart I-4A and Chart I-4B), it is fair to argue that currencies of commodities-producing EM economies probably are not cheap as well given they move in tandem with their advanced countries peers. Chart I-4ACAD Is At Fair Value, NOK Is Slightly Expensive AUD & NZD Are Expensive AUD & NZD Are Expensive Chart I-4BAUD & NZD Are Expensive CAD Is At Fair Value, NOK Is Slightly Expensive CAD Is At Fair Value, NOK Is Slightly Expensive Third, Chart I-5 illustrates consumer and producer prices-based REER for EM. Excluding China, Korea and Taiwan, the equity market cap-weighted EM REER based on the average of consumer and producer prices is at its historical mean (Chart I-5). This denotes that EM currencies are by and large fairly valued. Notably, the BRL is slightly above its fair value, according to the REER based on average of consumer and producer prices (Chart I-6, top panel). Similarly, the same measure for the RUB and ZAR is no longer depressed after the appreciation witnessed in both currencies over the past 18 months (Chart I-6, middle and bottom panels). Chart I-5EM Ex-China, Korea And Taiwan: ##br##Exchange Rates Valuations Are Neutral EM Ex-China, Korea And Taiwan: Exchange Rates Valuations Are Neutral EM Ex-China, Korea And Taiwan: Exchange Rates Valuations Are Neutral Chart I-6EM High-Yielding ##br##Currencies Are Not Cheap EM High-Yielding Currencies Are Not Cheap EM High-Yielding Currencies Are Not Cheap All in all, we conclude that EM currencies are fairly valued at the moment - they are neither cheap nor expensive. This message is also corroborated by current account profiles across EM economies. In many developing countries, current account balances have improved, but are still in deficit. Consistently, the U.S. current account deficit excluding oil is at 1.75%, and with oil is at 2.4% of GDP - not wide at all. So, the current account does not presage that the greenback is expensive. Importantly, when valuations are neutral, they do not necessarily prevent the market from either rallying or selling off. Neutral valuations in any market have little impact on the market outlook. Thereby, we conclude that valuations are not an impediment for both EM currencies and the U.S. dollar to move in any given direction. When valuations are neutral, directional market indicators are more imperative than valuations. The best directional indicators for EM currencies have been commodities prices and the EM business cycle. Chart I-7 illustrates the EM aggregate currency index has historically correlated with commodities prices and EM industrial production. If commodities prices relapse and the EM business cycle slows down, as we expect, EM currencies will depreciate. As to U.S. bond yields and the greenback, we believe U.S. interest rate expectations will rise and the U.S. dollar will strengthen, at least, relative to EM currencies. That said, there has been no historical correlation between high-yielding exchange rates such as the BRL and ZAR and their interest rate differential over the U.S. (Chart I-8). Chart I-7These Factors Drive ##br##EM Exchange Rates These Factors Drive EM Exchange Rates These Factors Drive EM Exchange Rates Chart I-8Interest Rate Differential And ##br##Exchange Rates: No Correlation Interest Rate Differential And Exchange Rates: No Correlation Interest Rate Differential And Exchange Rates: No Correlation The euro and European currencies have the least downside versus the U.S. dollar. Hence, we expect EM currencies to weaken materially versus both the dollar and the euro (Chart I-9). Bottom Line: EM currencies are neither cheap nor expensive. We expect commodities prices to relapse and U.S. interest rate expectations to rise. This warrants a material down leg in EM currencies. We continue recommending a short position in a basket of the following currencies: ZAR, TRY, BRL, MYR and IDR versus the U.S. dollar. Investors, who are not comfortable being long the U.S. dollar, can short these same EM currencies versus the euro. Our overweights within the EM currency space are the TWD, THB, RMB, RUB, MXN, PLN and CZK. The Superior Currency Valuation Measure Unit labor cost-based REER is a superior currency valuation measure to those based on consumer and producer prices. The key idea behind currency valuation measures in general is to gauge competitiveness. Rising consumer and producer prices relative to trading partners signifies deteriorating competitiveness, and usually entails more expensive currency valuations. However, nowadays, labor costs in many economies, especially advanced ones, represent the largest cost component, even for manufacturing businesses. Therefore, it makes sense to compare wages across trading partners, not consumer and producer prices. However, rising wages in a country relative to its trading partners do not always signify worsening competitiveness. Wages might be rising, but productivity of employees may well be growing faster than wages. Therefore, true labor costs for businesses are not wages, but unit labor costs. Unit labor costs equal wages divided by productivity. They show the labor cost per unit of output. To estimate an economy's true competitiveness, one should compare its unit labor costs relative to its trading partners. REER based on unit labor cost does that. Hence, this measure captures two critical variables to competitiveness: wages and productivity. On the whole, unit labor costs measure competitiveness better than consumer and producer prices. Therefore, we argue that REER based on unit labor costs is superior to those based on consumer and producer prices. For comparison purposes, Chart I-10 illustrates the two REER measures for the U.S. dollar. Chart I-9EM Currencies Versus The USD And Euro EM Currencies Versus The USD And Euro EM Currencies Versus The USD And Euro Chart I-10U.S. Dollar: Two Valuation Measures bca.ems_wr_2017_10_11_s1_c10 bca.ems_wr_2017_10_11_s1_c10 Based on the above analysis, we conclude that the greenback and the euro are fairly valued, while the Japanese yen is cheap. In addition, EM currency valuations are neutral and currencies of commodities producing advanced countries are modestly expensive. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Turkey: Ride The Sell-Off Turkish stocks were among the best performing equity markets worldwide in the January-August period of this year before relapsing by 16% in U.S. dollar terms since September 1st (Chart II-1). We remain bearish/underweight Turkish financial markets. A Genuine Inflation Breakout Despite the currency being stable since the beginning of the year, inflation has been rising. Core consumer price inflation has surpassed 10% for the first time in the past 14 years (Chart II-2). Chart II-1Turkish Stocks Have More Downside Turkish Stocks Have More Downside Turkish Stocks Have More Downside Chart II-2Turkey: Inflation Is Breaking Out Turkey: Inflation Is Breaking Out Turkey: Inflation Is Breaking Out The country's double-digit wage growth is not supported by productivity gains. The latter has been stagnant (Chart II-3, top panel). Consequently, unit labor costs have surged in both the manufacturing and services sectors (Chart II-3, bottom panel). This combination of strong wage growth paired with low productivity growth depresses companies' profit margins. This in turn will force businesses to raise prices. Provided stimulus-propelled domestic demand is robust, businesses will succeed in raising their prices leading to escalating inflation. Typically, when a country is witnessing heightening inflationary pressures, the natural policy response should be monetary and/or fiscal tightening. However, Turkish authorities have been doing the opposite - running loose monetary and fiscal policies: Government expenditure excluding interest payments have accelerated significantly (Chart II-4). The rise in government spending has been partially funded by commercial banks - the latter's holdings of government bonds have been growing, boosting money supply, as a result. Chart II-3Turkey: Surging Unit Labor Costs Turkey: Surging Unit Labor Costs Turkey: Surging Unit Labor Costs Chart II-4Turkey: Fiscal Expenditures Are Booming Turkey: Fiscal Expenditures Are Booming Turkey: Fiscal Expenditures Are Booming This year the Turkish authorities have been able to generate growth through the recapitalization of the Credit Guarantee Fund. The aim of this fund is to incentivize banks to lend by essentially assuming credit risk on loans extended to small and medium enterprises. Under this scheme, the government has effectively given a green light to flood the economy with credit, in turn, boosting economic growth. So far, the scheme has been responsible for the creation of TRY 200 billion, or 7% of GDP, worth of new credit out of the TRY 250 billion limit. This TRY 250 billion is considerable as it compares with a total of TRY 367 billion worth of loan origination by commercial banks last year. Turkey's banking system has been relying on enormous amounts of liquidity provisions by the central bank (Chart II-5, top panel) to sustain its ongoing credit boom and strong economic growth. On the whole, the central bank's net liquidity injections into the banking system continue to increase rapidly. Interestingly, the nature of the central bank's funding of commercial banks has increasingly shifted away from open market operations and more towards direct lending to banks (Chart II-5, bottom panel). Adding all the liquidity facilities - the intraday, overnight and late window facilities - the Central Bank Of Turkey's outstanding funding to banks is TRY 86 billion, or 3% of GDP, abnormally elevated relative to the data series' history. This entails that monetary policy is loose even though the price of liquidity provided by the central bank to banks has been rising. Consistently, local currency bank loan growth stands at 25% (Chart II-6, top panel). Chart II-5Central Bank Of Turkey's Liquidity Injections Central Bank Of Turkey's Liquidity Injections Central Bank Of Turkey's Liquidity Injections Chart II-6Turkey Is Experiencing A Credit Binge Turkey Is Experiencing A Credit Binge Turkey Is Experiencing A Credit Binge On the whole, commercial banks are requiring more and more liquidity, and the CBT is continuously supplying it. These injections maintain liquidity in the banking system to a sufficiently high level that allow money/credit creation by commercial banks to continue mushrooming (Chart II-6, bottom panel). Fiscal and monetary policies are overly simulative and the country's twin - fiscal and current account - deficit is widening (Chart II-7). The widening current account deficit - which is a form of hidden inflation - substantiates the case of an inflation outbreak in Turkey. Remarkably, despite extremely strong exports due to the robust growth in the Euro Area, Turkey's current account deficit has been unable to narrow at all. This confirms excessive growth in domestic demand. In regard to currency valuation, Chart II-8 demonstrates that the lira is not cheap, especially according to unit labor cost-based REER. It is therefore questionable how long Turkish exports can remain competitive if unit labor costs continue mushrooming at a rapid pace. Chart II-7Turkey: Widening Twin Deficit Turkey: Widening Twin Deficit Turkey: Widening Twin Deficit Chart II-8The Lira Is Not Cheap The Lira Is Not Cheap The Lira Is Not Cheap Bottom Line: Despite high inflation, the Turkish authorities have opted to stimulate the economy further, aiming to boost short-term growth at all costs. The outcome will be an inevitable inflation outbreak. The Monetary Regime And Exchange Rate Chart II-9Excessive Money Printing Is Bearish For Lira Excessive Money Printing Is Bearish For Lira Excessive Money Printing Is Bearish For Lira The monetary regime in Turkey will lead to a major lira depreciation: The money multiplier - calculated as broad local currency money divided by banks' excess reserves at the central bank - has been rising sharply since 2012 (Chart II-9, top panel). This measure illustrates the degree of leverage banks have assumed. Also, the money multiplier reveals how much broad money/purchasing power banks have created per unit of liquidity provided by the central bank. To put into perspective the vast amount of money that has been created, the bottom panel of Chart II-9 demonstrates that the current net level of foreign exchange reserves (currently US$ 32 billion) covers only 11% of broad local currency money M3. Not only is excessive money creation bearish for the currency but it is also highly inflationary. As inflation rises, residents' desire to convert their deposits from local to foreign currency will increase, further exerting downward pressure on the lira. In fact, this is already happening - households' foreign currency deposits - measured in U.S. dollars - are growing at rapid annual pace of 13%. Given this inflationary backdrop and the risk of further depreciation, interest rates will have to rise. This will inevitably trigger another NPL cycle. Banks are very under-provisioned for non-performing loans (NPL). NPLs have not risen, and NPL provisions are also very low (Chart II-10). Both are set to rise considerably, and banks' capital and ability to expand credit will be severely undermined. Lastly, higher interest rates will be negative for loan growth and bank's profitability. Bank stocks are starting to roll-over. Given the extent to which they have decoupled from interest rates, we believe there is much more downside (Chart II-11). Chart II-10Turkey: A New NPL Cycle Will Start Turkey: A New NPL Cycle Will Start Turkey: A New NPL Cycle Will Start Chart II-11Turkish Bank Stocks Have Considerable Downside Turkish Bank Stocks Have Considerable Downside Turkish Bank Stocks Have Considerable Downside The current monetary policy stance is unsustainable. Inflation is breaking out and this is bearish for Turkish financial markets. Box 1 on page 15 addresses the geopolitical dimension of Turkey's recent spat with the U.S. Investment Conclusions We expect policy makers to remain behind the curve amid rising inflation and this will weigh on the lira. As such, we suggest currency traders who are not shorting the lira to do so at this time. We remain short the lira versus the U.S. dollar but the lira will continue to plummet versus the euro too. A weaker lira will undermine U.S. dollar and euro returns on Turkish stocks and domestic bonds. Dedicated EM equity investors as well as those overseeing EM fixed income and credit portfolios should continue to underweight Turkish assets within their respective EM universes. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com BOX 1 Turkey's Unstable Geopolitical Position On the political front, the recent spat with the U.S. over visas is just another sign of how far Turkey has descended into the geopolitical unknown. The U.S. has closed its visa offices as a response to the detention of a Turkish national working for the U.S. consulate in Istanbul by the local authorities. The arrest was made over alleged links to Fethullah Gulen, the cleric that Turkish authorities blame for the July 2016 botched coup. That Gulen remains the obsession of Turkish authorities is a clear sign that President Recep Tayyip Erdogan continues to feel threatened. Whether the Gulen threat is real or imagined is not for us to determine. But it is clear that Turkey remains a deeply divided country. The April 2017 constitutional referendum giving the president greater powers barely passed, despite numerous reports of irregularities. As BCA's Geopolitical Strategy posited following the vote, the referendum did nothing to reinforce Erdogan's power or reduce domestic tensions.1 It would only deepen his instinct to use "rally-around-the-flag" strategy by emphasizing external threats to quell domestic opposition. Now Turkey finds itself at the crossroad on three different fronts: Iraq: Neighboring Kurdistan Regional Government (KRG) has just held an independence referendum, prompting Erdogan to threaten military action against the Iraqi Kurds. Although no regional or global power overtly supports KRG's moves towards independence, Turkey is under pressure to respond in order to snuff out any secessionist ambitions by the Kurds in Turkey and Syria. Syria: President Erdogan has also threatened invasion of the self-declared Kurdish canton of Afrin in northwestern Syria. The enclave is held by the U.S.-allied People's Protection Units (YPG), which fought against the Islamic State in Syria. According to various news reports, Turkish troops are amassing on the border with Syria for the intervention. This could put the Turkish military in direct contact with Russian troops, which have a presence in Afrin. The West: Relations with the West, with whom Turkey remains in a formal military alliance (NATO) remain in the doldrums. Aside from the visa spat with the U.S., Turkey's relations with Europe, and Germany in particular, are at their lowest point in years. Bottom Line: In a month's time, Turkey may have invaded both Syria and Iraq while simultaneously hitting a low point in its relationship with traditional Western allies. At the very least, this complicated geopolitical environment will make it difficult for Ankara to focus on the economy. At its greatest, it is a recipe for geopolitical overreach, military disaster, domestic crisis, or any combination of all three. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "What About Emerging Markets?," dated May 3, 2017, available at gps.bcaresearch.com. The Philippines: An Overheating Economy Requires Policy Tightening Since early 2016, the Philippine stock market has been massively lagging the EM benchmark (Chart III-1, top panel). Similarly, the Philippine peso has been extremely weak, recording new lows versus the U.S. dollar, despite the broad-based EM currency rally (Chart III-1, bottom panel). In fact, the symptoms of this economy and its financial markets are consistent with an overheating economy that is expanding above potential, and where inflationary pressures are heightening. Going forward, inflation will keep rising and the central bank will have to tighten monetary policy meaningfully. These developments will weigh on Philippine growth and financial markets. Consumer price inflation, both headline and core, are rising briskly and currently stand at 3% - in the middle of the central bank's 2-4% target (Chart III-2). With the policy rate at 3%, this entails that real rates have dropped to zero. Chart III-1Philippine Stocks Relative ##br##To EM Have Underperformed Philippine Stocks Relative To EM Have Underperformed Philippine Stocks Relative To EM Have Underperformed Chart III-2Philippine Inflation ##br##Is Creeping Higher Philippine Inflation Is Creeping Higher Philippine Inflation Is Creeping Higher The Central Bank of the Philippines (BSP) has kept monetary policy too easy for too long. It injected liquidity into the banking system on various occasions in 2013-2014 and 2016-2017 via its banking liquidity management tool - the Special Deposit Account (Chart III-3, top panel). These liquidity injections incentivized commercial banks to create enormous amounts of credit in the economy (Chart III-3, middle and bottom panels). Booming credit growth in turn is creating excessive purchasing power in the economy, resulting in a current account deficit for the first time since 2000. In addition, the fiscal deficit is now widening (Chart III-4). Chart III-3Credit Growth Is Rampant Credit Growth Is Rampant Credit Growth Is Rampant Chart III-4Philippines Twin Deficit Philippines Twin Deficit Philippines Twin Deficit On the wage front, non-agriculture workers' salaries are accelerating, pushing unit labor costs higher (Chart III-5). Remarkably, despite real GDP growth of about 6.5% since 2014, consumer staples EPS growth is on the verge of contracting. It seems that costs (including wages) have been mushrooming while productivity gains have been lagging. This also corroborates the overheating thesis. With Philippines' inflationary dynamics intensifying, the BSP will have to tighten monetary policy. In fact, the top panel of Chart III-3 shows that the BSP has already begun its tightening cycle by withdrawing some banking liquidity via its Special Deposit Account. In addition, interest rate hikes by the central bank are also an option. Monetary tightening amid very strong loan growth will lead a meaningful slowdown in the economy. Loan growth deceleration will affect primarily capital spending and the property market. Both segments are cooling off (Chart III-6). Chart III-5Philippines: Wages Are Accelerating Philippines: Wages Are Accelerating Philippines: Wages Are Accelerating Chart III-6Cyclical Slowdown On The Horizon Cyclical Slowdown On The Horizon Cyclical Slowdown On The Horizon Importantly, banks' net interest margins have been falling - a trend that will likely continue due to potential liquidity tightening and higher policy rates (Chart III-7, top panel). This, along with slow loan growth and rising NPL provisions, will intensify banks' EPS contraction (Chart III-7, bottom panel). Chart III-8 illustrates that both NPL and NPL provisions as a percent of total loans are at their lowest level since 1997. Higher borrowing costs following a decade-long lending boom, necessitates higher NPL provisions. Chart III-7Banks' Interest Rate Margins And Profits Banks' Interest Rate Margins And Profits Banks' Interest Rate Margins And Profits Chart III-8Bank NPLs To Rise Along With Provisions Bank NPLs To Rise Along With Provisions Bank NPLs To Rise Along With Provisions NPLs are likely to emanate from the real estate and construction sectors. Loans to these two sectors account for 20% of total bank loans. Hence, higher interest rates are negative for banks and real estate stocks which, together, account for 40% of the Philippines MSCI index market cap. If the central bank decides not to tighten, however, the economy will continue to overheat and bond yields - as well as the currency - will sell-off. Such a scenario is equally bearish for the equity market. Philippines equity valuations are elevated and, hence, are not priced for any of these scenarios. For dedicated EM equity investors, we continue recommending a neutral allocation to this bourse. We are reluctant to underweight this stock market because the Philippines remains less leveraged to China and the commodities cycle vis-à-vis other emerging markets (EM). Besides, it has already considerably underperformed the EM equity benchmark. Therefore, it might not underperform substantially relative to other EM countries - if and when commodities start selling off as a result of a growth slowdown in China. Within ASEAN, we favor Thailand, underweight Malaysia and are neutral on the Philippines, Indonesia, and India relative to the EM equity benchmark. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Portfolio Strategy Go long industrials/short discretionary. Leading indicators of interest rates, relative sentiment, relative demand and relative exports all signal that industrials stocks will outperform their consumer discretionary peers. A price war is gripping airlines anew, and it will suck the air out of the industry. Recent Changes Long S&P Industrials/Short S&P Consumer Discretionary - Initiate this pair trade today. Table 1 Can Easy Fiscal Offset Tighter Monetary Policy? Can Easy Fiscal Offset Tighter Monetary Policy? Feature Tax relief euphoria propelled the S&P 500 to fresh all-time highs last week. While such exuberance has rekindled the "Trump trade" with small caps outshining mega caps and banks soaring (as a reminder we have a small cap size bias and are overweight financials/banks1), it will likely prove fleeting unless the tax bill becomes law. BCA's Geopolitical Strategy service believes that a tax bill passage is likely in Q1/2018.2 Were that to materialize, it would serve as a catalyst to further fuel the blow off phase in equities. Why? Empirical evidence suggests that easy fiscal policy outweighs the drag from Fed interest rate tightening. Filtering the post WWII era for periods of easing fiscal and tightening monetary policies during expansions is revealing. We define easy fiscal policy as increasing fiscal thrust (year-over-year change in cyclically-adjusted fiscal balance as a percentage of potential GDP, shown inverted, bottom panel, Chart 1) and tight monetary policy as a rising fed funds rate. Chart 1Easy Fiscal + Tight Money = Buy SPX Easy Fiscal + Tight Money = Buy SPX Easy Fiscal + Tight Money = Buy SPX While this is a rare occurrence, it has clearly happened seven times since the mid-1950s (shaded areas, Chart 1). As a clarification, we omitted the brief periods in the early-1960s, early-1970s and twice in the early-1980s as they were very close to the end of those recessions and positively skewed the results. All iterations resulted in positive stock returns with the SPX rising on average by over 16%. Table 2 details all seven periods that have an average duration of 16 months. There are high odds that a tax bill enactment coupled with a potential infrastructure spending bill will more than cushion the blow from the Fed's interest rate hikes in 2018, and sustain the overshoot phase in equities. As we recently showed in our equity market indicator White Paper, the business cycle stays intact during Fed tightening cycles, and historically a peak in the fed funds rate presages a recession.3 Importantly, the highly cyclical part of the U.S. economy is humming. The latest ISM manufacturing survey showed that new orders are running 20% higher than inventories, with the headline number soaring to a 13 year high (third panel, Chart 2). Prices paid also spiked to above 70, signaling that commodity inflation is looming. And, were the capex revival to gain steam as most of the leading indicators we track suggest (see Chart 8 from the October 2nd Weekly Report), then late cyclicals will continue to benefit from end-demand resurgence. Table 2SPX Returns During Periods Of Loose##br## Fiscal And Tight Monetary Policy Can Easy Fiscal Offset Tighter Monetary Policy? Can Easy Fiscal Offset Tighter Monetary Policy? Chart 2It's Deep##br## Cyclicals' Time It's Deep Cyclicals' Time It's Deep Cyclicals' Time As a result, we reiterate last week's upgrade of the S&P industrials sector to overweight, and this week we add more deep cyclical exposure to our portfolio by initiating a market-neutral pair trade to benefit from this enticing macro backdrop. Industrials Will Outmuscle Consumer Discretionary In the past few weeks, we have tweaked our cyclical portfolio exposure by downgrading early-cyclical consumer discretionary stocks to a benchmark allocation and lifting the late cyclical industrials complex to overweight. In fact, a once-in-a-generation opportunity to buy industrials at the expense of discretionary stocks has surfaced, and we recommend a new long S&P industrials/short S&P consumer discretionary sector pair trade to exploit this tradable opportunity. Chart 3 shows that relative share prices recently bounced near the early-1970s all-time lows and a mini V-shaped recovery is taking root. The industrials/discretionary price ratio has been in a downtrend for the better part of the past decade and the most recent peak-to-trough collapse has been a 4 standard deviation move (Chart 3). Even a modest relative performance renormalization near the historical mean would translate into impressive returns. Chart 3Compelling Entry Point Compelling Entry Point Compelling Entry Point Four key drivers underpin our warming up to this late over early cyclical pair trade: interest rates, relative sentiment, relative demand and relative export backdrop. The Fed embarked on a fresh tightening interest rate cycle almost two years ago and is on track to lift the fed funds rate another 100bps by the end of 2018 according to the FOMC's median dot forecast. Interest rate-sensitive stocks suffer when the Fed tightens monetary policy, whereas deep cyclicals disproportionately benefit from accelerating economic growth. Chart 4 confirms that over the past four decades a rising fed funds rate has been synonymous with an increase in the relative share price ratio and vice versa. Chart 4Tight Money Is Good For Industrials But Weighs On Discretionary Tight Money Is Good For Industrials But Weighs On Discretionary Tight Money Is Good For Industrials But Weighs On Discretionary The framework we use on the interest rate front is that higher interest rates represent a sizable hindrance to consumer spending (top and second panel Chart 5). Not only does the price of housing-related credit rise in lockstep with fed hikes, but also auto and credit card interest rates, two major consumer loan categories, increase on the back of the Fed's tighter monetary backdrop. True, C&I loan pricing also suffers a setback, but capital goods producers can bypass banks and raise debt in the bond markets. In fact, this cycle, the global hunt for yield and unconventional monetary policies have suppressed interest rates to the benefit of corporate borrowers. One final relative advantage industrials outfits have this cycle is rising pricing power in the form of firming commodity prices (third panel, Chart 5), while wage growth/median income (a proxy for consumer pricing power) has been subpar. Taken together, higher interest rates and rising commodity prices should continue to underpin relative share price momentum (Chart 5). Relative sentiment readings also suggest that industrials manufacturers have the upper hand versus consumer discretionary companies (Chart 6). The overall ISM manufacturing survey is easily outpacing consumer confidence readings. Importantly, the ISM survey and most of the subcomponents are making multi-year highs, while both the University of Michigan's consumer sentiment survey and The Conference Board's consumer confidence reading peaked in early 2017. Chart 5Commodity Inflation Is A Boon For##br## Industrials But Bane For Discretionary Commodity Inflation Is A Boon For Industrials But Bane For Discretionary Commodity Inflation Is A Boon For Industrials But Bane For Discretionary Chart 6Manufacturing Flexing ##br##Its Muscles Manufacturing Flexing Its Muscles Manufacturing Flexing Its Muscles With regard to the relative demand landscape, a sustained capital expenditure upcycle is promising for capital goods producers (second panel, Chart 7), at a time when personal consumption expenditures (PCE) are anemic at best. Notably, real capital outlays have been rising at a faster clip than real PCE, signaling that the upward trajectory in relative forward EPS estimates is sustainable (middle panel, Chart 7). Our relative pricing power gauge has recently come out of its funk reflecting this improving relative demand backdrop. The implication is that a rerating phase is likely in the coming months (bottom panel, Chart 7). Finally, the relative export backdrop suggests that industrials come out on top of discretionary stocks (top panel, Chart 8). According to FactSet the S&P consumer discretionary sector's foreign revenue exposure stands at 24% of total sales, and it is roughly 60% higher for the S&P industrials sector at 38% of revenues.4 While the year-to-date breakdown in the greenback is stimulative for industrials exporters, it is, at the margin, restrictive for the more domestically oriented consumer discretionary companies (trade-weighted dollar shown inverted, bottom panel, Chart 8). Our relative EPS growth models best capture all of these moving parts and suggest that the path of least resistance for relative profit growth is higher in the coming quarters (Chart 9). Chart 7Capex##br## Upcycle... Capex Upcycle... Capex Upcycle... Chart 8... And Export Markets Benefit Industrials##br## At The Expense Of Discretionary ... And Export Markets Benefit Industrials At The Expense Of Discretionary ... And Export Markets Benefit Industrials At The Expense Of Discretionary Chart 9Relative Profit Growth Models Also Say##br## Buy The Relative Share Price Ratio Relative Profit Growth Models Also Say Buy The Relative Share Price Ratio Relative Profit Growth Models Also Say Buy The Relative Share Price Ratio Adding up, all four key macro variables (interest rates, relative sentiment, relative demand and relative export exposure) signal that the time is ripe for a new industrials versus discretionary pair trade. Bottom Line: Initiate a long S&P industrials/short S&P consumer discretionary sector pair trade. Airlines Update: Mayday While we have turned positive on the broad industrials complex and remain constructive on most transports, we continue to recommend investors avoid the S&P airlines index. This decade has seen a huge recovery in consumer confidence, rising from the depths of the Great Recession. The consumer's revival has been matched by equally steep growth in airline passenger traffic (Chart 10). However, the resurgence in passenger demand has not had the expected uplift in pricing. Rather, the opposite has happened; consumers have not seen a sustainable price increase in years and airline pricing power has collapsed, even in the face of soaring jet fuel costs that eat into profits (Chart 11). The costly price war between the low cost carriers and the largely-restructured legacy airlines the industry is currently embroiled in explains deflating airfares (Chart 12). Chart 10More Passengers... More Passengers... More Passengers... Chart 11... But Higher Fuel Costs... ... But Higher Fuel Costs... ... But Higher Fuel Costs... Chart 12... And Price Concessions Crash Profits ... And Price Concessions Crash Profits ... And Price Concessions Crash Profits The industry has been here before, and recently too. 2015 was a tumultuous year that saw pricing collapse as the ultra-low cost carriers entered the traditional hubs, triggering a scramble for market share. Brave airline investors have been whipsawed as the industry recovered and then stumbled again earlier this year. From a profit perspective, airlines have been able to hide poor pricing with efficiency gains (Chart 13). Industry load factors have been steadily moving upward, though those gains appear to have plateaued at peak levels. The implication is that this current price war will hit profit margins and thus the bottom line worse than in the past (Chart 13). Expanding international air travel could provide some relief to the besieged legacy carriers as international airfares look to have pulled out of deflation (Chart 14). However, the sustainability of positive pricing is questionable as international no-frills carriers are gaining greater penetration and often have significantly lower cost structures. Once unheard of trans-Atlantic travel for below $200 is now widely available. Chart 13Masking Poor Pricing Backdrop Masking Poor Pricing Backdrop Masking Poor Pricing Backdrop Chart 14Analysts Ignore Positives Analysts Ignore Positives Analysts Ignore Positives At the same time as cash generation appears most threatened, the industry is in the midst of an expensive fleet renewal as airlines seek to replace declining prices and aging fleets with higher volume and more efficient aircraft. In fact, capex as a percentage of sales has nearly tripled since 2012. The result is predictable; the hard deleveraging work the industry put in over the course of this decade is being unwound (Chart 13). An increasingly geared balance sheet, combined with weakening margins should translate directly into a higher risk premium and lower valuation multiples. However, while multiples have fallen from the sky-high levels earlier this decade, they remain well above the lows of 2015-16 (Chart 14). This implies further downside risk should risk premiums expand as we expect. With sell-side analysts jumping on board the bear story, as evidenced by net forward earnings revisions falling off a cliff (Chart 14), this should probably happen sooner rather than later. Bottom Line: With no end in sight to the price war and outsized capacity additions likely to throw fuel on the fire, we think investors should stay away from the S&P airlines index. Accordingly, we reiterate our underweight recommendation. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, AAL, UAL, ALK. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report,"Girding For A Breakout?" dated May 1, 2017, available at uses.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report,"Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 3 Please see Chart 55 of BCA U.S. Equity Strategy Special Report, "White Paper: U.S. Equity Market Indicators (Part I)", dated August 7, 2017, available at uses.bcaresearch.com. 4 https://www.factset.com/earningsinsight Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.