Commodities & Energy Sector

Highlights Duration: Economic fundamentals indicate that TIPS breakeven inflation rates have further cyclical upside and this will drive nominal bond yields higher on a 6-12 month horizon. In the near term, however, positioning data suggest that the uptrend in bond yields is due for a pause. Maintain a below-benchmark duration stance. Oil & Bonds: The cost of inflation compensation is an important driver of bond yields and the oil price is an important driver of the cost of inflation compensation. This will continue to be true until long-maturity TIPS breakeven inflation rates settle into a range between 2.4% and 2.5%. At that point the oil price will become a less important driver of yields. Fed: The Fed will start actively discussing alternative monetary policy frameworks in 2018. While we think the Fed will eventually adopt a policy framework that tolerates higher inflation, this shift probably won't occur this year. Feature There was certainly no shortage of possible catalysts for last week's bond rout (Chart 1). The Bank of Japan (BoJ) reduced its buying of long-dated JGBs, there was a rumor that China plans to slow or stop its purchases of U.S. Treasury debt, and U.S. inflation expectations started to ramp back up - driven by a combination of higher oil prices and a strong December core CPI print. But of all these factors we think it is only the third that merits much attention. Once the BoJ started targeting the level of the yield curve in September 2016 its quantity targets became irrelevant. A reduction in the pace of BoJ buying only matters if it foreshadows a shift to a higher yield curve target. Our foreign exchange strategists don't think such a move is likely in the next 12-18 months.1 China, for its part, still has a highly managed currency and now that capital is no longer flowing out of the country it will start to rebuild its foreign exchange reserves. Given that the U.S. Treasury market remains the world's most liquid, it is hard to see how China can avoid having to park much of its excess foreign capital in the United States (Chart 2). Chart 1Higher Yields, Driven By Inflation Chart 2China's Forex Reserves Are Rising The compensation for 10-year U.S. inflation protection broke above 2% last week, after having been as low as 1.66% as recently as last June. This 34 basis point increase in inflation compensation coincided with a 36 basis point increase in the nominal 10-year yield and a Brent crude oil price that rose from $45 per barrel last June to $70 per barrel as of last Friday. We think these correlations will continue to be the most important factors driving bond yields during the next 6-12 months, and the bulk of this report is dedicated to disentangling the linkages between oil prices, inflation, inflation expectations and nominal bond yields. But first we reiterate our cyclical investment stance. Last week's CPI report provided further evidence that core inflation is in the process of bottoming-out (Chart 3). The 10-year TIPS breakeven inflation rate will settle into a range between 2.4% and 2.5% by the time that core inflation returns to the Fed's target. By that time the nominal 10-year yield will be in a range between 2.8% and 3.25%. Likewise, our energy strategists anticipate that an ongoing steady decline in commercial inventories will keep crude prices well supported on a 6-12 month horizon. Chart 3U.S. Inflation Turns The Corner Chart 4Net Speculative Positioning For Oil And Bonds However, on a shorter time horizon (3 months or less), recent shifts in speculative positioning signal that the uptrends in bond yields and the oil price might be due for a pause (Chart 4). After having been solidly "net long" since the middle of last year, net speculative positions in the 10-year U.S. Treasury futures contract have just dipped into "net short" territory. Historically, net speculative positions have been a decent indicator of 3-month changes in the 10-year U.S. Treasury yield, and at current levels they signal that the 10-year yield could decline modestly during the next three months (Chart 5). Similarly, speculators in the oil futures market are now more "net long" than at any time since last February. While this positioning indicator does not work quite as well for the oil market as for the Treasury market, net longs at more than 20% of open interest (most recent reading is 26%) have more often than not been met with 3-month price declines since 2010 (Chart 6). Chart 5Net Speculative Positions & 10-Year Treasury Yield Chart 6Net Speculative Positions & WTI Oil Price Bottom Line: The outlook for U.S. inflation suggests that TIPS breakeven rates have further cyclical upside and this will drive nominal bond yields higher. However, positioning data in both bond and oil markets suggest that the recent run-up in yields might be due for a near-term pause. Maintain a below-benchmark duration stance on a 6-12 month horizon. Oil, TIPS, Inflation And Bond Yields: Sorting Out The Mess During the post-financial crisis period two relationships have been both (i) incredibly robust and (ii) unlike relationships observed in prior periods. They are: The cost of inflation protection has been an unusually important determinant of nominal U.S. bond yields The oil price has shown a very strong correlation with the cost of inflation protection Both relationships can be explained by the Federal Reserve's asymmetric ability to control inflation. We consider each relationship in turn. The Importance Of Inflation Chart 7TIPS Beta Declines When ##br##Breakevens Are Low A common rule of thumb is to estimate the TIPS beta - the proportion of movement in U.S. nominal bond yields that is explained by movement in TIPS (real) yields - at around 0.8. In other words, this assumes that 80% of the movement in nominal bond yields is explained by the real component. However, we observe that since the financial crisis the 10-year TIPS beta has been a much lower 0.68, and at times it has been closer to 0.5 on a 12-month rolling basis (Chart 7). We also observe that the TIPS beta tends to be lower when TIPS breakeven inflation rates are un-anchored to the downside. There is a very good reason for this. The reason is that the Fed's ability to influence inflation is asymmetric. The Fed has a strong track record of successfully tightening to bring inflation down, but has been less successful at easing to drive it up. This asymmetric ability to influence prices is due in no small part to the zero-lower bound on interest rates. Because the Fed's ability to cut rates is constrained by the zero-bound while its ability to lift rates is not, bond market participants may at times question the Fed's ability to ease and revise their inflation expectations lower. It is also during these periods that inflation expectations become more volatile and a more important determinant of nominal bond yields. This is because they are increasingly driven by the swings in the economic data and less by the Fed's policy bias. The Importance Of Oil This is where the oil price comes in. Oil and other commodities are crucial inputs to the production process. As such, not only do these prices rise in response to stronger aggregate demand, but higher prices also signal mounting cost-push inflationary pressures. But despite this obvious truth, there is not always a strong correlation between oil prices and inflation expectations. This is because the Fed's reaction function influences the relationship. Consider the pre-crisis (2004-2008) period. Long-maturity TIPS breakeven inflation rates stayed range-bound between 2.4% and 2.5% even as the oil price increased dramatically (Chart 8). Since investors perceived that the Fed would simply tighten policy to tamp out any inflationary pressures that might arise, there was no desire to demand greater compensation for inflation. However, this logic does not work in reverse. When commodity prices fell in 2014, inflation expectations declined alongside. In fact we observe that the correlations between long-maturity TIPS breakeven inflation rates and both oil and commodity prices have been much stronger in the post-crisis period, when inflation expectations have been un-anchored (Table 1). Chart 8The Unstable Correlation Breakevens & Oil Table 1Correlations Between TIPS Breakeven Inflation And Commodities Investment Conclusions The Fed's asymmetric reaction function leads to two crucial investment conclusions. First, long-maturity inflation expectations (as measured by the TIPS breakeven inflation rate) can fall when deflationary pressures mount, but their upside is capped in the 2.4% to 2.5% range. This is because the market has no reason to question the Fed's ability to lower inflation by lifting rates. The upside limit of 2.4% to 2.5% will remain in place unless the Fed changes its inflation target. A change to the inflation target that allows for higher inflation is an idea that is quickly gaining traction among policymakers, but is unlikely to be implemented this year (see section titled "The Fed In 2018: Contemplating A Major Change" below). Second, when long-maturity inflation expectations are below their 2.4% to 2.5% upper-bound they become both (i) a more important driver of nominal yields - as evidenced by the lower TIPS beta - and (ii) more sensitive to swings in commodity prices. For this reason, the oil price will continue to be an important driver of inflation expectations and nominal bond yields for the next few months, but will decrease in importance as TIPS breakevens move back to their 2.4% to 2.5% range. Once inflation expectations are re-anchored, nominal bond yields will once again be predominantly driven by the real component and swings in the price of oil will be less important for bond markets. The dynamics described above are not merely theoretical. Consider the evidence from five developed countries presented in Charts 9 & 10. Chart 9 shows that the oil price is tightly correlated with inflation expectations in the U.S., Eurozone and Japan, but also that inflation expectations in the U.K. and Australia did not respond to the recent increase in oil prices. The reason is that core inflation in the U.K. and Australia is already relatively close to the central bank's target (Chart 10). It is only where core inflation is far below target (in the U.S., Eurozone and Japan) that the oil price remains an important driver of bond yields. Chart 9Oil & Inflation Expectations Highly Correlated... Chart 10...But Only When Inflation Is Low The U.K. in particular presents an interesting case study. U.K. core inflation was quite far below target throughout 2015 and 2016, and during this time period U.K. inflation expectations were tightly linked with the oil price. It is only in the past few months that U.K. core inflation has moved back above target, and not surprisingly the correlation between the U.K. 10-year CPI swap rate and the price of oil has started to break down. Bottom Line: At present, the cost of inflation compensation is an important driver of bond yields and the oil price is an important driver of the cost of inflation compensation. Both of these dynamics will continue to be true for the next few months, but will decline in importance as TIPS breakeven inflation rates rise. When long-maturity TIPS breakeven inflation rates settle into a range between 2.4% and 2.5%, then the oil price will become a less important driver of bond yields. The Fed In 2018: Contemplating A Major Change? As was alluded to in the prior section, the biggest potential change for bond markets in 2018 would be if the Fed changed its monetary policy framework to one that tolerated higher levels of inflation. For example, let's imagine that the Fed suddenly lifted its inflation target from 2% to 3%. This would likewise shift the upper-bound range for long-maturity TIPS breakeven inflation rates to approximately 3.4% to 3.5%. It would mean that nominal bond yields have further upside over the course of the cycle, and also that oil and commodity prices would play an important role in bond markets for much longer. It would also lengthen the period where spread product can outperform Treasuries since the Fed would not be so quick to choke off the recovery. We still think it is unlikely that such a change will be implemented this year, but recent weeks have seen a marked increase in the number of Fed policymakers either advocating for a different policy framework or saying that the Fed should start researching alternative frameworks. What's crucial to remember is that the reason policymakers are unsatisfied with the current 2% inflation target is that it brings the zero-lower bound on interest rates into play too often. So any potential change in policy framework would be to one that tolerates higher inflation rates. Bernanke's Idea Chart 11The Implications Of A Price Level Target One potential new policy approach was put forward by ex-Fed Chairman Ben Bernanke in a recent blog post.2 Bernanke made the case for "Temporary Price Level Targeting", a policy where the Fed continues to use a 2% inflation target when the fed funds rate is sufficiently far from zero, but then switches to a price-level target when the fed funds rate is close to the zero bound. In his own words, the strategy would be communicated as follows: The Committee therefore agrees that, in future situations in which the funds rate is at or near zero, a necessary condition for raising the funds rate will be that average inflation since the date at which the federal funds rate first hit zero be at least 2 percent. Chart 11 provides an illustration of this example. Under the current framework the Fed targets 2% PCE inflation and forecasts that it will achieve this target sometime in 2019. In Bernanke's proposed framework the Fed would not target 2% inflation, but rather a price level that is consistent with 2% trend growth in prices since the zero-lower bound was hit in December 2008. In order to achieve this goal by the end of 2019 the Fed would need to tolerate a significant overshoot of inflation during the next two years (bottom panel). Who's On Board? The Appendix to this report is a list of all Fed Governors and Regional Fed Presidents. It also shows our own assessment of each committee member's policy bias. We noted from the most recent Summary of Economic Projections that 6 FOMC participants expect three rate hikes in 2018, 6 expect fewer than three rate hikes and 4 expect more than three hikes. From recent speeches we attempted to discern which member owns which forecast and then we attributed a "dovish" policy bias to those with a forecast for fewer than three hikes, a "neutral" bias to those expecting three hikes, and a "hawkish" bias to those expecting more than three hikes. We also show which FOMC participants are voters in 2018, although we do not think that distinction carries much practical importance. The Committee tends to arrive at decisions by consensus anyways, and all participants voice their opinions at every meeting whether or not it is their turn to vote. But it is the "notes" column of the Appendix that is most striking. There we highlighted all the FOMC participants who have recently made comments regarding the exploration of alternative policy frameworks. A general consensus seems to be forming that alternative frameworks should be studied this year, and a few policymakers (San Francisco Fed President John Williams, in particular) have strongly made the case that the Fed should switch to some sort of price level targeting regime. The Appendix also identifies the biggest source of uncertainty for the Fed this year. Namely that there are four vacant Governor positions that need to be filled. The New York Fed will also need a new President when William Dudley retires later this year. Who is nominated to fill those vacant positions will go a long way toward determining how aggressively the Fed pursues alternative policy frameworks. Bottom Line: The Fed will start actively discussing alternative monetary policy frameworks in 2018. While we think the Fed will eventually adopt a policy framework that tolerates higher inflation, this shift probably won't occur this year. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "Yen: QQE Is Dead! Long Live YCC!", dated January 12, 2018, available at fes.bcaresearch.com 2 https://www.brookings.edu/blog/ben-bernanke/2017/10/12/temporary-price-level-targeting-an-alternative-framework-for-monetary-policy/ Appendix Table 2Composition Of The FOMC Fixed Income Sector Performance Recommended Portfolio Specification

Highlights An increase in the "synthetic" supply of bitcoins via financial derivatives, along with the launch of bitcoin-like alternatives by large established tech companies, will cause the cryptocurrency market to collapse under its own weight. Other areas that could see supply-induced pressures over the coming years include oil, high-yield debt, global real estate, and low-volatility trades. In contrast, the U.S. stock market has seen an erosion in the supply of shares due to buybacks and voluntary delistings. Investors should consider going long U.S. equities relative to high-yield credit, while positioning for higher volatility. Such an outcome would be similar to what happened in the late 1990s, a period when the VIX and credit spreads were trending higher, while stocks continued to hit new highs. A breakdown in NAFTA talks remains the key risk for the Canadian dollar and Mexican peso. Feature Bubbles Burst By Too Much Supply The "cure" for higher prices is higher prices. The dotcom and housing bubbles did not die fully of their own accord. Their demise was expedited by a wave of new supply hitting the market. In the case of the dotcom bubble, a flood of shares from initial and secondary public offerings inundated investors in 2000 (Chart 1). This put significant downward pressure on the prices of internet stocks. The housing boom was similarly subverted by a slew of new construction - residential investment rose to a 55-year high of 6.6% of GDP in 2006 (Chart 2). Chart 1Burst By Too Much Supply: Example 1 Chart 2Burst By Too Much Supply: Example 2 Is bitcoin about to experience a similar fate? On the surface, the answer may seem to be "no." As more bitcoins are "mined," the computational cost of additional production rises exponentially. In theory, this should limit the number of bitcoins that can ever circulate to 21 million, about 80% of which have already been created (Chart 3). Yet if one looks beneath the surface, bitcoin may also be vulnerable to a variety of "supply-side" factors. Chart 3Bitcoin: Most Of It Has Been Mined First, the expansion of financial derivatives tied to the value of bitcoin threatens to create a "synthetic" supply of the cryptocurrency. When someone writes a call option on a stock, the seller of the option is effectively taking a bearish bet while the buyer is taking a bullish bet. The very act of writing the option creates an additional long position, which is exactly offset by an additional short position. Moreover, to the extent that a decision to sell a particular call option will depress the price of similar call options, it will also depress the underlying price of the stock. This is simply because one can have long exposure to a stock either by owning it outright or owning a call option on it. Anything that hurts the price of the latter will also hurt the price of the former. As bitcoin futures begin to trade, investors who are bearish on bitcoin will be able to create short positions that cause the effective number of bitcoins in circulation to rise. This will happen even if the official number of bitcoins outstanding remains the same. Imitation Is The Sincerest Form Of Flattery An increase in synthetic forms of bitcoin supply is one worry for bitcoin investors. Another is the prospect of increased competition from bitcoin-like alternatives. There are now hundreds of cryptocurrencies, most of which use a slight variant of the same blockchain technology that underpins bitcoin. Chart 4Governments Will Want Their Cut So far, the proliferation of new currencies has been largely driven by technologically savvy entrepreneurs working out of their bedrooms or garages. But now companies are getting in on the act. The stock price of Kodak, which apparently is still in business, tripled earlier this week when it announced the launch of its own cryptocurrency. That's just a small taste of what's to come. What exactly is stopping giants such as Facebook, Amazon, Netflix, and Google from issuing their own cryptocurrencies? After all, they already have secure, global networks. Amazon could start giving out a few coins with every sale, and allow shoppers to purchase goods from the online retailer using its new currency. It's simple.1 The only plausible restriction is a legal one: The threat that governments will quash upstart cryptocurrencies for fear that will drive down demand for their own fiat monies. As we noted several weeks ago, the U.S. government derives $100 billion per year in seigniorage revenue from its ability to print currency and use that money to buy goods and services (Chart 4).2 As large companies get into the cryptocurrency arena, governments are likely to respond harshly - sooner rather than later. This week's news that the South Korean government will consider banning the trading of cryptocurrencies on exchanges is a sign of what's to come. Who Else? What other areas are vulnerable to an eventual tsunami of new supply? Four come to mind: Oil: BCA's bullish oil call has paid off in spades. Brent has climbed from $44 last June to $69 currently. Further gains may not be as easily attainable, however. Our energy strategists estimate that the breakeven cost of oil for U.S. shale producers is in the low-$50 range.3 We are now well above this number, which means that shale supply will accelerate. This does not mean that prices cannot go up further in the near term, but it does limit the long-term potential for crude. Real estate: Ultra-low interest rates across much of the world have fueled sharp rallies in home prices. Inflation-adjusted home prices in Canada, Australia, New Zealand, and parts of Europe are well above their pre-Great Recession levels (Chart 5). U.S. real residential home prices are still below their 2006 peak, but commercial real estate (CRE) prices have galloped to new highs (Chart 6). Rent growth within the U.S. CRE sector is starting to slow, suggesting that supply is slowly catching up with demand (Chart 7). Chart 5Where Low Rates Have ##br##Fueled House Prices Chart 6Commercial Real Estate Prices Have ##br##Surpassed Pre-Recession Levels Chart 7Rent Growth Is Cooling Corporate debt: Low rates have also encouraged companies to feast on credit. The ratio of corporate debt-to-GDP in the U.S. and many other countries is close to record-high levels (Chart 8A and Chart 8B). Credit spreads remain extremely tight, but that may change as more corporate bonds reach the market. Chart 8ACorporate Debt-To-GDP ##br##Is Close To Record Highs Chart 8BCorporate Debt-To-GDP ##br##Is Close To Record Highs Low-volatility trades: A recent Bloomberg headline screamed "Short-Volatility Funds Are Being Flooded With Cash."4 The number of volatility contracts traded on the Cboe has increased more than tenfold since 2012. Net short speculative positions now stand at record-high levels (Chart 9). Traders have been able to reap huge gains over the past few years by betting that volatility will decline. The problem is that if volatility starts to rise, those same traders could start to unload their positions, leading to even higher volatility. In contrast to the aforementioned areas, the stock market has seen an erosion in the supply of shares due to buybacks and voluntary delistings. The S&P divisor is down by over 8% since 2005. The number of U.S. publicly-listed companies has nearly halved since the late 1990s (Chart 10). This trend is unlikely to reverse any time soon, given the elevated level of profit margins and the temptation that many companies will have to use corporate tax cuts to step up the pace of share repurchases. Chart 9Low Volatility Is In High Demand Chart 10Erosion Of Supply In The Stock Market Bet On Higher Equity Prices, But Also Higher Volatility And Higher Credit Spreads The discussion above suggests that the relationship between equity prices and both volatility and credit spreads may shift over the coming months. This would not be the first time. Chart 11 shows that the VIX and credit spreads began to trend higher in the late 1990s, even as the S&P 500 continued to hit new record highs. We may be entering a similar phase now. Continued above-trend growth in the U.S. and rising inflation will push up Treasury yields. We declared "The End Of The 35-Year Bond Bull Market" on July 5, 2016 - the exact same day that the 10-year Treasury yield hit a record closing low of 1.37%.5 Higher interest rates will punish financially-strapped borrowers, leading to wider credit spreads. Equity volatility is also likely to rise as corporate health deteriorates and the timing of the next downturn draws closer. Our baseline expectation is that the U.S. and the rest of the world will fall into a recession in late 2019. Financial markets will sniff out a recession before it happens. However, if history is any guide, this will only happen about six months before the start of the recession (Table 1). This suggests that global equities can continue to rally for the next 12 months. With this in mind, we are opening a new trade going long the S&P 500 versus high-yield credit. Chart 11Volatility Can Increase And Spreads ##br##Can Widen As Stock Prices Rise Table 1Too Soon To Get Out Four Currency Quick Hits Four items buffeted currency and fixed-income markets this week. The first was a news story suggesting that China will slow or stop its purchases of U.S. Treasury debt. China's State Administration of Foreign Exchange (SAFE) decried the report as "fake news." Lost in the commotion was the fact that China's holdings of Treasurys have been largely flat since 2011 (Chart 12). China still has a highly managed currency. Now that capital is no longer pouring out of the country, the PBoC will start rebuilding its foreign reserves. Given that the U.S. Treasury market remains the world's largest and most liquid, it is hard to see how China can avoid having to park much of its excess foreign capital in the United States. The second item this week was the Bank of Japan's announcement that it will reduce its target for how many government bonds it buys. This just formalizes something that has already been happening for over a year. The BoJ's purchases of JGBs have plunged over the past twelve months, mainly because its ¥80 trillion target is more than double the ¥30-35 trillion annual net issuance of JGBs (Chart 13). Chart 12China's Holdings Of Treasurys: ##br##Largely Flat Since 2011 Chart 13BoJ Has Been Reducing ##br##Its Bond Purchases Ultimately, none of this should matter that much. The Bank of Japan can target prices (the yield on JGBs) or it can target quantities (the number of bonds it owns), but it cannot target both. The fact that the BoJ is already doing the former makes the latter irrelevant. And with long-term inflation expectations still nowhere near the BoJ's target, the former is unlikely to change. What does this mean for the yen? The Japanese currency is cheap and its current account surplus has swollen to 4% of GDP (Chart 14). Speculators are also very short the currency (Chart 15). This increases the likelihood of a near-term rally, as my colleague Mathieu Savary flagged this week.6 Nevertheless, if global bond yields continue to rise while Japanese yields stay put, it is hard to see the yen moving up and staying up a lot. On balance, we expect USD/JPY to strengthen somewhat this year. Chart 14Yen Is Already Cheap... Chart 15...And Unloved The third item was the revelation in the ECB's December meeting minutes that the central bank will be revisiting its communication stance in early 2018. The speculation is that the ECB will renormalize monetary policy more quickly than what the market is currently discounting. If that were to happen, EUR/USD would strengthen further. All this is possible, of course, but it would likely require that euro area growth surprise on the upside. That is far from a done deal. The euro area economic surprise index has begun to edge lower, and in relative terms, has plunged against the U.S. (Chart 16). Unlike in the U.S., the euro area credit impulse is now negative (Chart 17). Euro area financial conditions have also tightened significantly relative to the U.S. (Chart 18). Chart 16Euro Area Economic ##br##Surprises Edging Lower Chart 17Negative Credit Impulse In The Euro ##br##Area Will Weigh On Growth Chart 18Diverging Financial Conditions ##br##Favor U.S. Over The Euro Area Meanwhile, EUR/USD has appreciated more since 2016 than what one would expect based on changes in interest rate differentials (Chart 19). Speculative positioning towards the euro has also gone from being heavily short at the start of 2017 to heavily long today (Chart 20). Reasonably cheap valuations and a healthy current account surplus continue to work in the euro's favor, but our best bet is that EUR/USD will give up some of its gains over the coming months. Chart 19The Euro Has Strengthened More Than ##br##Justified By Interest Rate Differentials Chart 20Euro Positioning: From Deeply ##br##Short To Record Long Lastly, the Canadian dollar and Mexican peso came under pressure this week on news reports that the U.S. will be pulling out of NAFTA negotiations. Of the four items discussed in this section, this is the one that worries us most. The global supply chain has become highly integrated. Anything that sabotages it would be greatly disruptive. At some level, Trump realizes this, but he also knows that his base wants him to get tough on trade, and unless he does so, his chances of reelection will be even slimmer than they are now. Ultimately, we expect a new NAFTA deal to be reached, but the path from here to there will be a bumpy one. Housekeeping Notes Our long global industrials/short utilities trade is up 12.4% since we initiated it on September 29. We are raising the stop to 10% to protect gains. We are also letting our long 2-year USD/Saudi Riyal forward contract trade expire for a loss of 2.9%. Given the recent improvement in Saudi Arabia's finances, we are not reinstating the trade. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 My thanks to Igor Vasserman, President of SHIG Partners LLC, for his valuable insights on this topic. 2 Please see Global Investment Strategy Special Report, "Bitcoin's Macro Impact," dated September 15, 2017; and Global Investment Strategy Weekly Report, "Don't Fear A Flatter Yield Curve," dated December 22, 2017. 3 Please see Energy Sector Strategy Weekly Report, "Breakeven Analysis: Shale Companies Need ~$50 Oil To Be Self-Sufficient," dated March 15, 2017. 4 Dani Burger, "Short-Volatility Funds Are Being Flooded With Cash," Bloomberg, November 6, 2017. 5 Please see Global Investment Strategy Special Alert, "End Of The 35-year Bond Bull Market," dated July 5, 2016. 6 Please see Foreign Exchange Strategy, "Yen: QQE Is Dead! Long Live YCC!" dated January 12, 2018. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Environmental reforms in China continue to reduce steelmaking capacity. The shuttering of illegal induction facilities in China also is tightening markets. Although official Chinese steel output is higher, this likely reflects the fact that output from illegal induction mills went unreported - and thus uncounted - while production from legal mills is increasing to fill the gap left by closures. Steelmakers' profits are surging, which means demand for iron ore in China will remain stout at least through 1H18. Copper has been well bid since June 2017, following supply disruptions and strong demand growth driven by the global economic upturn. We expect it will get an additional lift in 1H18, as wiring and plumbing in construction projects now absorbing steel in China get underway. Later, global growth will make up for any slowdown in China. Our analysis indicates the global steel market will be tightening in 1H18, as it already is doing in China. Consistent with this, we are opening a tactical long position in Mar/18 steel rebar futures on the Shanghai Futures Exchange, which are quoted in RMB/ton. We are including a 10% stop loss on this recommendation. Energy: Overweight. Our once-out-of-consensus oil view is now the consensus, so we are taking profits on Brent and WTI $55 vs. $60/bbl call spreads on May- and July-delivery oil at tonight's close. These positions were up 109.2% and 123.5% at Tuesday's close. Any sell-offs will present an opportunity to re-establish length along these forward curves. Base Metals: Neutral. Copper will remain well bid this year as the global economic recovery rolls on. A large number of contract renegotiations at mines is an additional upside risk to copper prices this year. Precious Metals: Neutral. Given our expectation of four rate hikes by the Fed, it is difficult to get too bullish gold. However, any indication the central bank is tilting dovish - particularly if we fail to see higher inflation this year - will rally the metal. Ags/Softs: Underweight. Markets will tread water until Friday's USDA WASDE. We remain underweight, except for corn. Feature Chart of the WeekIron Ore And Steel Prices Diverged In 2017 China's environmental policy actions have reduced world steel-making capacity by 100 mm MT between 1H16 and 1H18. This is most visible in Chinese steel prices, which gained more than 30% in 2017, following an almost 80% increase in 2016. The total gain in steel prices since the start of Beijing's focus on steel-market reforms is a resounding 135%. Iron ore prices posted similar gains to steel in 2016 but diverged sharply in 2017, slumping more than 40% between mid-March and mid-June - ending almost 8% lower year-on-year (yoy) (Chart of the week). Soaring steel prices pushed profit margins at Chinese mills higher, which, of course, fed through to demand for iron ore, the critical steel-making ingredient in China, toward year-end: Iron ore prices were up 20% in the last two months of 2017. How Did We Get Here? A Recap Of China's Steel Sector Reforms As part of its reforms aimed at reducing air pollution by eliminating outdated, excess industrial capacity, Beijing pledged to eliminate 100-150 mm MT of steel capacity over the 2016-2020 period. To date it has shuttered an estimated 100 mm MT of capacity. In addition to these reforms Beijing pledged to shut down smaller induction furnaces in China, which melt scrap steel, and produce steel of shoddy quality. These induction furnaces are estimated to account for 80-120 mm MT worth of annual capacity, although their actual output is far less: They produced an estimated 30-50 mm MT in 2016, according to S&P Global Platts.1 This is less than 7% of China's total crude-steel output. Production cuts from induction mills are not evident in official data - China's crude steel production figures have continued to rise amid these cuts, as we discussed in previous research (Chart 2).2 Data from the International Iron and Steel Institute shows global steel output was at a record high for the first 11 months of 2017, increasing by more than 5% yoy. Likewise, crude steel output from China - which accounts for 50% of global output - peaked in August: Output over the same period was the highest on record, increasing by 5.28% compared to the same period in 2016. This production paradox can be put down to the fact that many Chinese induction furnaces are illegal, and, as a result their output is not accounted for in official production data. As legal steelmakers ramped up their output to offset declines from the closed down induction furnaces, official crude production figures climbed. In fact, further examination of Chinese steel data makes it clear that China's steel market is in fact tighter than what can be inferred from the crude production figures (Chart 3). The following observations point to a strained market: While China's crude steel production has been paving new record highs, China Stat Info data reveals a contradictory picture about steel products. Output of steel products in the March to November period of 2017 came in 3.46% lower yoy, marking the first yoy decline for that period since 1995! While crude steel produced by induction furnaces would not be included in official crude steel figures, the metal would eventually be used to manufacture steel products - wires, rods, rails and bars, and are represented in this data. Thus the decline in steel products indicates that lower crude supply has weighed down on the output of steel products. China's steel exports have been on a downtrend. In theory, this can be due to either an increase in domestic demand or a decrease in foreign demand. Given the healthy state of the global economy, and what we know about steel production in China, we are believers in the former theory. China's exports of steel products are down 30% yoy in the first 11 months of 2017. Aside from the 3.04% yoy decline in 2016, these mark the first annual declines in exports since 2009. In face of lower domestic supply, China has likely reduced its exports in order to satisfy demand from local steel users. China's scrap steel imports fell in 2H17. Unlike blast furnaces which use iron ore as the main input in steelmaking, the shuttered illegal steelmakers use scrap steel which they melt in an induction furnace. Coincident with the elimination of these furnaces, China's imports of scrap steel fell 14.35% yoy in 2H17. This is further evidence of reduced demand for the scrap steel from these furnaces. China steel inventories are falling. In fact steel product inventories in major industrial cities are at record lows (Chart 4). This is a symptom of a tight market with demand outpacing supply, contradicting China's crude steel production figures. Chart 2Record Chinese Production Of Crude Steel##BR##Amid Falling Steel Products Output Chart 3China Trade Data Evidence##BR##Of Tight Market Chart 4Steel Inventories##BR##In China Are Falling Furthermore, according to World Steel Association (WSA), capacity utilization in the 66 countries for which they collect data increased by 3.12 percentage points yoy for the July to November 2017 period to average 72.64%, up from the 69.52% average in the same period of 2016. These observations are evidence that despite the increase in official crude steel production figures, the actual output has in fact fallen and supply is tighter. Whether steel prices will remain buoyed by tight supply hinges on whether China is successful in permanently shuttering excess capacity and shoddy steel producers, or if induction furnace operators are able to circumvent these policies and bring illegal steel back to the market. China's Reforms To Dominate Steel Market, At Least This Winter Following the conclusion of the mid-December Central Economic Work Conference, Chinese authorities announced the "three tough battles" for the next three years, which they see as crucial for future economic prosperity. These battles are summarized as (1) preventing major risks, (2) targeted poverty alleviation, and (3) pollution control. The International Energy Agency (IEA) estimates that air pollution has led to ~1 million premature deaths while household air pollution caused an additional 1.2 million premature deaths in China annually.3 Because of this, improving China's air quality is a chief social and health target for China. Chart 5Lower Chinese Steel Production##BR##Will Impact Global Output This will mean that measures to reduce pollution and clear China's skies will be critically important to the steel sector. According to the Ministry of Environmental Protection, China has pledged a 15% yoy reduction in the concentration of airborne particles smaller than 2.5 microns in diameter - known as PM2.5 - in 28 smog-prone northern cities. The steel industry, which is mostly concentrated in the northern China region of Beijing-Tianjin-Hebei, is one of the top sources of air polluting emissions in that region. In fact, industrial emissions - most notably from the steel and cement sectors - are reportedly responsible for 40-50% of these small airborne particles. China's winter smog "battle plan" will target these polluting industries by mandating cuts on steel, cement, and aluminum production during the smog-prone mid-November to mid-March months, as well as restricting household coal use, diesel trucks and construction projects. Steel production cuts target a range between 30-50%, which, according to Platts estimates, will take 33 mm MT of steel production - equivalent to ~3.9% of China's projected 2017 crude steel output - offline during the winter. In fact, according to China's environment minister, Li Ganjie, "these special campaigns are not a one-off, instead it is an exploration of long-term mechanisms."4 Thus, these cuts may become a recurring event in China's steel sector. China's official crude steel figures are beginning to show the impact of these cuts with November crude production falling 8.6% month-on-month (mom) and growing by just 2.2% yoy - significantly slower than the 7.6% yoy average experienced since July. As a consequence, although crude production in the rest of the world grew in line with previous months, global steel output fell almost 6% month-on-month in November, while yoy production grew 3.7% – a significant deceleration from the average 6.6% yoy rate witnessed since the beginning of 2H17 (Chart 5). Risks to this outlook come from weak compliance with these cuts. There are recent reports of evasions by aluminum and steel producers in Shandong. Nonetheless, given China's focus on these reforms, we do not foresee widespread violations. Another risk comes from the demand side. As part of its environmental agenda, Beijing announced plans put off the construction of major public projects in the city - road and water projects - until springtime. The suspension is not intended to impact "major livelihood projects" such as railways, airports, and affordable housing. Construction is the largest end user for steel - according to WSA more than half of global steel is used for buildings and infrastructure - a slowdown in the construction sector would weigh on steel demand.5 If other major construction zones adopt a similar policy, the impact of lower steel supply will be offset by weak demand, muting the overall effect on the steel market. Bottom Line: We expect to see lower steel production and exports from China in the coming months. Given Xi Jinping's resolve to improve air quality, we expect compliance to environmental reforms among steelmakers to be strong this winter. This, along with lower output from induction furnaces in China, indicates the market could be tighter than is commonly supposed at least in 1H18. The likelihood the global economic recovery and expansion persists through 2018 suggests steel markets could remain well bid in 2H18, particularly if, as we expect, growth ex-China picks up the slack resulting from any slowdown in China. However, we will need to see what the actual reforms for the industry look like following the National People's Congress in March 2018.6 Steel Profit Margins Spur Iron Ore Demand Given steel's exceptional price gains over the past two years, and iron ore's lackluster performance in 2017, profit margins at China's steel producers reached multi-year highs (Chart 6). Ordinarily, this would normally encourage steel production, which would flood the market with supply and push prices down. However, China's environmental reforms will cap output from the country's most productive steelmaking region in coming months. Consequently, unless there are mass policy violations by steel producers this winter, we do not anticipate a swift price adjustment lower. Instead, steel producers are preparing to run on all cylinders when production restrictions are lifted in the spring. As such, they are filling iron ore inventories and taking advantage of weaker iron ore prices, before the iron ore market catches up with steel. China's iron ore imports reached an all-time record in September, while the latest data shows a 19% month-on-month (mom) jump in imports, corresponding with a 2.8% yoy increase (Chart 7). Chart 6Healthy Steel##BR##Profit Margins Chart 7Steel Producers Stocking Up On Iron Ore##BR##In Preparation For Spring This runs counter to what we expect during a period of muted steel production. Especially in an environment of healthy iron ore inventories, as China is in currently. Although Chinese inventories came down from mid-year peaks, they resumed their upward trend in 4Q17. This coincides with the steel winter capacity cuts, and is likely due to reduced demand for the ore from steel mills. There are two theories to explain this phenomenon: 1. Chinese steelmakers are taking advantage of lower iron ore prices and locking in higher profit margins, in anticipation of higher iron ore prices once steel production picks up again in the spring. 2. Amid the winter cuts, China's steelmakers are demanding high-grade iron ore, imported from Brazil and Australia. This will help them ensure that they are able to maximize their output without violating environmental policies. Environmental Consciousness Widens Iron Ore Spreads A consequence of the steel winter capacity cuts is stronger demand for higher grade raw materials to cut down on the most polluting phases of steel production. Higher-grade iron ore, which is defined by its purity or iron content, is more efficient for blast furnaces to use, allowing them to produce more steel from each tonne of iron ore they consume, maximizing output and profit. This is especially true in a tight steel market, with healthy profit margins: Steelmakers are able to afford the higher grades and are favoring productive efficiency. The discount for lower grade iron ore fines - 58% iron content - as well as the premium for higher grade 65% iron content have widened (Chart 8). This is because mills have found a way to legally circumvent the winter environmental restrictions, and still remain compliant. Furthermore, purer ores are less polluting, which helps serve China's environmental agenda. In addition, the premiums for iron ore pellets and iron ore lumps have also widened. Unlike lumps and pellets which can be fed directly into blast furnaces, fines require a sintering process which is highly polluting. Thus, China's environmental reforms have increased demand for higher grade, less polluting ores. An additional factor that could be driving up spreads is higher metallurgical coke prices (Chart 6). Higher grade iron ore contains less silica and thus requires less met coke to purify the ores. According to anecdotal evidence from China, Carajas fines from Brazil - which have the highest iron ore content and lowest silica content- are reportedly in high demand.7 Furthermore, China's imports show a decline in iron ore from India - which is of the lower grades. In the July to October period, imports fell 11.26% yoy with October imports falling almost 25% yoy and 30% mom. This is consistent with the theory that steel makers are shunning lower grade ores. On the other hand, imports from Brazil and Australia are expected to remain strong (Chart 9). The latest Australian Resources and Energy Quarterly forecasts Australian and Brazilian iron ore exports to grow 5.4% and 4.2% respectively in 2018, while Indian exports are projected to fall 57.5% yoy. Chart 8Wide Iron Ore##BR##Price Spreads Chart 9Environmental Concerns Will Support##BR##Demand For High Grade Iron Ore Bottom Line: In an effort to keep production high and profit from strong steel prices in face of the winter production cuts, steel producers are turning to higher-grade iron ore, pushing up the spread between high vs. low grade ores. The extent to which steel producers are able to successfully keep production going on the back of higher-grade ores will dampen the impact of the winter production cuts on the steel sector. Given that China's environmental focus is a long term plan, we expect these spreads to remain wide, rather than reverting back to their historic average. Steel Prices And Copper Markets Chart 10Steel Consumption Helps##BR##Predict Copper Prices The copper market had a roller coaster fourth quarter. Prices for the red metal were on a general uptrend since May, and first peaked in early September at $3.13/lb before bottoming at $2.91/lb by the second half of that month. Shortly thereafter, copper prices peaked at a new high of $3.22/lb by mid October - their highest in more than three years. Fears of a slowdown in China following messaging from the 19th Communist Party Congress caused the metal to lose almost 10% of its value, when it bottomed for the second time in early December. In fact, this coincided with a 4.65% decline in the price on December 5. While there is no clear justification for this fall, it can be put down to a mix of factors including a ~10 th MT increase in LME inventories, worries about a China slowdown, as well as a liquidation of positions ahead of the new year. Nonetheless, copper has since regained these losses to end the year at $3.28/lb. In our modelling of copper, we find that steel consumption is significant in forecasting future copper price behavior. More specifically, China's steel consumption has a significant positive relationship with copper prices 6 months into the future (Chart 10). This can be explained by the importance of the construction sector as an end user of both materials. However, each metal goes into the construction site at different time frames. While steel products are used in the construction of the structures, and thus are needed at the beginning of the project, copper is used in the electrical wiring and plumbing, and is thus needed later (6 months or so) in the project. This is in line with our findings that steel is most significant with a six-month lag - reflecting the average time period between which the structure is built and the plumbing and wiring are needed. Steel consumption in China is a useful leading indicator of copper markets when demand side fundamentals are dominating steel and copper markets. Government stimulus and a solid construction sector boosted China's steel demand in 2017. However, according to the WSA Short Range Outlook, demand for steel will moderate this year on the back of reflation in China, partially offset by strong global growth. WSA notes that the closure of induction furnaces skewed up steel demand growth figures to 12.4% yoy, and instead cite a more reasonable estimate along the lines of 3% yoy steel demand growth from China in 2017, bringing the global steel demand growth rate to 2.8%. While steel demand outside of China grew by an estimated 2.6% in 2017, they foresee it reaching 3% in 2018. In contrast, they expect flat demand from China in 2018, bringing world steel demand growth to 1.6% in 2018 (Table 1). Table 1Steel Demand (yoy Growth Rates) Moderating demand from China and the stability (or lack thereof) of the supply-side will dominate the copper market this year. On the demand side, China's steel market offers insight about the future direction of the red metal. Bottom Line: Given China's appetite for steel has remained healthy to date and is projected to maintain its 2017 level this year, we do not expect a demand-induced plunge in copper prices in the 6 month horizon. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see "Will China's induction furnace steel whac-a-mole finally come to an end?" published by S&P Global Platts March 6, 2017. 2 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Slow-Down In China's Reflation Will Temper Steel, Iron Ore In 2018," published September 7, 2017, available at ces.bcaresearch.com. 3 Please see IEA World Energy Outlook 2016 Special Report titled "Energy and Air Pollution," available at iea.org. 4 Please see "Provincial China officials used fake data to evade aluminium, steel capacity curbs - China Youth Daily," published on December 26, 2017, available at reuters.com. 5 Please see "Steel Markets" at worldsteel.org. 6 For additional discussion, please see "Shifting Gears in China: The Impact On Base Metals," in the November 9, 2017, issue of BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 7 Please see "High-medium grade iron ore fines spread widens to all-time high of $23.55/dmt," published August 22, 2017, available at platts.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017

Overweight - High Conviction A cyclical over defensive sector preference is consistent with a capex upcycle and a simultaneous bond market selloff (please see the next Insight), both of which are our key 2018 investment themes. Our overweight recommendation on the S&P energy index is predicated on our cyclical preference, aided by much better fundamentals. The index has caught fire recently, lifted by a recovery in the price of oil (second panel) which has, in turn, been responding to a revving global economy and a sell-off in the US$ (top panel). However, the index has been diverging sharply from falling oil stocks (third panel), which are typically a harbinger of much better performance. This has created a buying opportunity as the energy index still sports a below-market valuation (a hard to find criteria in these heady times) that we expect to mean revert, driven by ongoing improvements in operating fundamentals. We reiterate our high conviction overweight recommendation.

Highlights Before re-capping the performance of our recommendations last year - up 77%, led by oil calls, which posted an average gain of 111% - we take a look at what the re-emergence of financial and monetary factors will mean for commodities this year. Fundamentals - supply, demand, inventories - drove the evolution of industrial commodity prices over the past two years, and will remain supportive for oil and, to a lesser degree, base metals in 1H18. Thereafter, in 2H18, we believe financial and monetary variables will begin to re-assert their importance in the evolution of commodity prices. Forecasting commodity prices becomes more difficult, as a result, as it is not clear the Fed or other systematically important central banks, understand what is driving their principal policy variables - particularly inflation - or how they are evolving. Despite these central-bank uncertainties, we remain long broad commodity exposure via the S&P GSCI (up 6.4% since it was recommended in Dec/17), long call spreads in Brent and WTI across 2018 deliveries (up 78%); and long gold (up 6.7%). 2018 Weightings Energy: Overweight. WTI and Brent crude oil forward curves will become more backwardated as the combination of OPEC 2.0 production discipline and continued strength in demand draws inventories lower. This will boost S&P GSCI returns.1 Base Metals: Neutral. Base metals will continue to be supported through 1Q18 by China's environmental reforms, which are reducing supply in the face of continued strength in global demand. Strong demand ex-China will offset weaker Chinese growth, supporting metals prices. Precious Metals: Neutral. While we expect four rate hikes by the Fed this year, we are wary of policy errors at systemically important central banks, which makes forecasting monetary policy highly uncertain. We remain long gold as a portfolio hedge. Ags/Softs: Underweight. Still-high supplies outside the corn market; policy uncertainty re NAFTA; and uncertainty over Fed policy likely keep grain prices weak. A stronger USD would weaken demand for U.S.-sourced grains and softs. Feature Chart of the WeekFundamentals Continue To##BR##Support Commodities That was quick! Oil prices are closely hewing to fundamentals as the year opens. We revised our Brent forecast to $67/bbl in early December (up from a $65/bbl forecast in mid-October 2017), based on our fundamental assessment of the market - supply, demand and inventories - and, voilà, contracts for Mar/18 delivery got there by the end of 2017. Our $63/bbl forecast for WTI is still ~ $2.50/bbl from being realized, but we continue to expect this gap to close. At the moment, fundamentals for industrial commodities - oil and, to a slightly lesser extent, base metals - will support firmer prices in 1H18 (Chart of the Week). For oil, this will be an extension of the fundamental realignment initiated by OPEC 2.0 at the end of 2016. The producer coalition agreed to remove ~ 1.1mm b/d from the market, which, along with another 300k to 400k barrels of natural declines, tightened the supply side considerably. On the demand side, the synchronized global economic upturn that powered consumption up by 1.65mm b/d last year, by our estimation, will push demand higher by 1.67mm b/d this year. Supply-side adjustments in base metals, particularly copper, where strikes and natural disasters combined to tighten markets, will be augmented by the ongoing environmental reforms in China (Chart 2). These supply-side effects in industrial commodities occurred against a backdrop of stronger-than-expected economic growth worldwide last year - the first such upturn since the Global Financial Crisis (GFC) in 2008 (Chart 3). Chart 2Fundamentals Supported Metals Chart 3Global Upturn Powers Commodity Demand We expect this to continue. Part of the recovery in aggregate demand worldwide can be attributed to the massive monetary stimulus by systematically important central banks - led by the Fed, the ECB and BoJ. Lower energy prices last year, which acted like a tax cut, put more discretionary income in consumers' hands and also boosted aggregate demand.2 Monetary Policy Will Re-Assert Itself Chart 4The USD Will Re-Emerge As A##BR##Driver Of Commodity Prices The influence of monetary policy - chiefly how the Fed's actions affect the USD - has been de minimis over the past two years relative to fundamentals, which have driven price formation in industrial commodities (Chart 4). While the Fed raised its policy rate 3 times last year, monetary conditions remained relatively loose in the U.S., which was supportive of commodity prices. Looser monetary conditions kept the USD better offered than other major currencies in 4Q17, which allowed gold prices to recover late in the year. A weaker USD also supported grain markets, which also have staged a somewhat subdued recovery following a mid-2017 sell-off. For at least 1H18, we see commodities generally continuing to be supported by strong fundamentals and relatively accommodative monetary policy globally, even with the Fed lifting its policy rate as many as four times this year, per our House view. Inflation Pressures Could Start Building By 2H18, inflationary pressures could start to build: In the U.S., tax cuts coupled with fiscal stimulus from the federal government in the form of disaster relief and higher discretionary spending - could add ~ 0.5% to GDP growth this year, based on calculations by BCA's Global Investment Strategy team (Chart 5).3 This should, all else equal, increase demand for labor and push the U.S. unemployment rate lower, lifting wages, inflation and inflation expectations in turn (Chart 6). At least that's how it's supposed to work. Our colleagues in BCA Research's U.S. Bond Strategy note, the "dichotomy between stronger growth and a tight labor market on the one hand and low inflation on the other gets to the heart of the first big challenge that incoming Fed Chairman Jay Powell will face next year. Specifically, how much faith should the Fed have in its framework for forecasting inflation? Chart 5U.S. Inflation Is Ticking Higher Chart 6Still Waiting On The Phillips Curve "... Janet Yellen's Phillips Curve model of core inflation does not explain this year's decline.1 It also shows that inflation is close to 0.5% below fair value, almost the largest deviation since 1995."4 We're inclined to agree with former Fed Chair Ben Bernanke on this. In 2016, he noted that, given the years-long stretch of errors in forecasting key economic variables - output, unemployment and the Fed funds rate - "Fed-watchers should probably focus on incoming data and count a bit less on Fed policymakers for guidance."5 This is a mixed blessing (or curse) for commodity markets: Increased economic activity raises demand for commodities, so at least in 1H18, and most likely for the second half as well, commodity demand will remain well supported globally. If we do get higher inflation, the Fed likely would feel it could lean into its rate-normalization with greater vigor, and start guiding to more frequent or bigger rate hikes. If we don't see higher inflation - if, as Chicago Fed President Charles Evans fears, inflation expectations have been marked down in a meaningful way - and the Fed cannot justify further rate hikes, we could see the real side of the global economy take another leg higher, lifting commodity demand in the process.6 This is the big issue for the coming year. We cannot say at this point how it plays out, which is why we recommend commodity investors remain in tactical mode, as we did a year ago. Recapping 2017's Recommendations Our trade recommendations were up an average of 77% last year, led by a 111% gain in our oil calls. This was a touch better than the 95% average gain we posted on our oil recommendations in 2016 (Table 1). Table 1Average Quarterly Returns 2017 Without a doubt, most of our recommendations were in the oil markets, as the accompanying tables show, and we maintained an exposure of one sort or another in oil throughout the year (Table 2). Table 2Trades Closed In 2017 The big drivers of our view in oil markets were fundamentals: On the supply side, we maintained the view OPEC 2.0 would not waver in its commitment to draining global storage levels, particularly in the OECD commercial inventories via supply reductions. On the demand side, by mid-2017, it became apparent to us the big data providers - the U.S. EIA and the IEA in Paris - and most of the sell-side analysts were underestimating demand. Information flows during 1H17 were often contradictory, which injected enormous volatility in crude-oil spread markets - particularly the calendar spreads trading markets employ to take a view on the shape of the forward curve (e.g., long a near-term futures contract like Dec/17 Brent, vs. short a deferred delivery contract like Dec/18). This intense volatility drove us toward the relative safety of call-option spreads in 2H17, where the risk of loss is limited to the net premium paid for the call spread. As we did last year, we constructed an information ratio (IR) to determine whether the additional volatility produced by our recommendations was adequately compensated for by the returns (simple percent changes of the opening level for a recommendation vs. the closing level). Our IR uses the S&P GSCI as a benchmark, given it has a relatively high weight in energy-related exposures. Our ratio looks at the average excess return of the active portfolio against this benchmark. This average excess return is divided by its standard deviation (also referred to as the tracking error volatility) in order to generate a risk-adjusted metric to measure returns on our recommendations relative to the risk we took to generate them. BCA's IR thus is calculated as: The higher the IR, the better the risk-adjusted relative performance of the portfolio. Three elements can explain a high IR: High returns in the portfolio; low returns in the benchmark, or low tracking error volatility. Hence, this measure provides a numeric value to analyze the risk-reward trade-off; it tells us whether or not the risk assumed in our trades was compensated for by larger returns. Viewing our energy recommendations as a portfolio over the course of 2017, our average return was 111%, while the GSCI return was 5.8%. The tracking error volatility was 112%.7 Using these inputs, the IR of our recommendations was 0.94. While not as stellar as our 2016 IR of 1.47, this risk-adjusted return is still stout, and indicates the consistent positive excess returns of our portfolio relative to passive GSCI exposure compensated for the high volatility of those returns. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 OPEC 2.0 is the name we've given the OPEC + non-OPEC producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. 2 For a summary of our 2018 outlooks, please see BCA Research's Commodity & Energy Strategy Weekly Report "Oil Fundamentals Remain Bullish Heading Into 2018," published on December 21, 2017, and "Opposing Forces: Stay Neutral Metals In 2018" in the same issue. It is available at ces.bcaresearch.com. 3 Please see BCA Research's Global Investment Strategy Weekly Report, "Don't Fear A Flatter Yield Curve," published December 22, 2017. It is available at gis.bcaresearch.com. 4 Please see BCA Research's U.S. Bond Strategy Weekly Report, "Ill Placed Trust?," published December 19, 2017. It is available at usbs.bcaresearch.com. 5 Please see "The Fed's shifting perspective on the economy and its implications for monetary policy," by Ben S. Bernanke, published by the Brookings Institution on its website August 8, 2016. 6 Please see "All Talk, Few Answers From FOMC for Yellen's Long Inflation Miss," published by bloomberg.com on January 3, 2018. 7 Note: In order to find the standard deviation of the portfolio's excess returns (tracking error volatility), we averaged the daily percentage change in each trade's underlying assets. Any given trade only weighed in the daily average return if it was open during that day of the year. We are not accounting for the type of trades (spreads, pairs or single trades), we only track the underlying asset returns. From these daily average returns we subtracted the daily return of the preferred benchmark to obtain the daily excess return. Using this, we computed an historical standard deviation (based on 20-day periods) for every day during which a trade was open in our portfolio (we had 224 days with at least one energy trade opened). Lastly, we annualized this standard deviation to obtain our tracking-error volatility. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017

Dear Client, This is our last report of 2017. We will be back on January 4, 2018, with our customary recap of recommendations made this year. We wish you and your loved ones the very best this lovely season has to offer. Sincerely, Robert P. Ryan, Chief Commodity Strategist Commodity & Energy Strategy Highlights With GDP growth accelerating in ~ 75% of countries monitored by the IMF, we expect commodity demand - particularly for crude oil and refined products - to remain strong in 2018. On the supply side, OPEC 2.0 - the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia - will maintain its production discipline, which will force commercial oil inventories lower in 2018. As a result, we expect oil markets to continue to tighten in 2018, keeping upside risk to prices from unplanned production outages acute. This was clearly demonstrated in separate incidents in the U.S. and North Sea in the past two months, which removed more than 400k b/d from markets since November. Geopolitical risk will remain elevated, particularly in Venezuela, where operations at the state oil company were paralyzed after senior military officers assumed leadership positions there. Beyond 2018, we believe OPEC 2.0 will endure as a coalition. It will manage production and provide forward guidance consistent with a strategy to keep WTI and Brent forward curves backwardated. This will provide a supportive backdrop for the Saudi Aramco IPO, expected toward the end of next year, and will limit the volume of hedging U.S. shale-oil producers are able to effect. In turn, this will limit the number of rigs U.S. E&Ps can profitably deploy. Energy: Overweight. Our Brent and WTI call spreads in 2018 - long $55/bbl calls vs. short $60/bbl calls - are up an average 53.8%. We will retain these exposures into 2018. Base Metals: Neutral. We expect base metals to be supported through 1Q18, after which reform measures in China could crimp supply and demand, as we discuss below. Precious Metals: Neutral. We remain long gold as a strategic portfolio hedge against inflation and geopolitical risk, even though inflation remains quiescent (see below). Ags/Softs: Underweight. Fed policy will be critical to ag markets in 2018. We expect as many as four rate hikes next year, as the Fed continues with rates normalization (see below). Feature Our updated balances model indicates global oil markets will continue to tighten in 2018, as demand growth accelerates and OPEC 2.0 - the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia - maintains production discipline (Chart of the Week). Earlier this week, IMF noted improving employment conditions globally, which will continue to support aggregate demand and the synchronized global expansion in manufacturing and trade (Chart 2 and Chart 3).1 This acceleration of GDP growth rates globally will continue to support income growth and commodity demand generally. Oil-exporters have not participated in the global economic expansion to the extent of other economies, according to the Fund, which can be seen in the trade data (Chart 3). However, imports by Middle East and African countries are moving higher, and look set to post year-on-year (yoy) growth in the near future. Chart of the WeekOil Balances Will Continue to Tighten In 2018 Chart 2Global Upturn Boosts Manufacturing, ##br##Commodity Demand... The combination of continued production discipline from OPEC 2.0 and expanding incomes boosting demand will force crude and product inventories lower, particularly those in the OECD, which are the primary target of the producer coalition (Chart 4). Chart 3...And Global Trade Chart 4OECD Inventories Will Fall Below 5-year ##br##Average In BCA's Supply-Demand Assessment Unplanned Outages Mounting; Risk Remains Acute Unlike many forecasters, we continue to expect inventories to draw in 1Q18. This expectation is the direct result of our supply-demand modelling, and also is supported by our expectation that the risk of unplanned outages is increasing. This already has been demonstrated in the U.S. and U.K. North Sea, where more than 400k b/d of pipeline flows in November and December were lost. Of far greater moment, however, is the potential for unplanned outages in Venezuela. We believe the state-owned oil company there is one systemic malfunction away from shutting down exports entirely - e.g., a breakdown in pumping stations - as happened in 2002. Reuters reports the government of Nicolas Maduro appears to be consolidating power via an "anti-corruption" campaign, and is installing senior military officials with little or no industry experience in leadership roles inside PDVSA.2 Reuters notes, "The ongoing purge, in which prosecutors have arrested at least 67 executives including two recently ousted oil ministers, now threatens to further harm operations for the OPEC country, which is already producing at 30-year-lows and struggling to run PDVSA units including Citgo Petroleum, its U.S. refiner." The news service goes on to report, "Executives that remain, meanwhile, are so rattled by the arrests that they are loathe to act, scared they will later be accused of wrongdoing." We have Venezuela output at just under 1.90mm b/d, and expect it to decline to a little more than 1.70mm b/d by the end of 2018. Brent Expected To Average $67/bbl In 2018 We continue to forecast average Brent prices of $67/bbl and WTI at $63/bbl next year, given our assessment of global supply-demand balances, which drive our fundamental price forecasts: We expect global crude and liquids supply to average 100.23mm b/d in 2018, vs 100.01mm b/d expected by the U.S. EIA, while we have global demand coming in at 100.29mm b/d on average next year, vs the 99.97mm b/d expected by EIA (Chart 5 and Chart 6). Chart 5BCA's Expected Crude Oil Supply Vs. EIA's Chart 6BCA's Expected Demand Exceeds EIA's In 2018 Our expectations translate into a 2.55mm b/d increase in supply next year, vs a 1.67mm b/d increase in demand yoy (Table 1). Running the EIA's supply-demand assessments through our fundamental pricing models produces average Brent and WTI prices of $49/bbl and $47/bbl, respectively. EIA is expecting a 2.04mm b/d increase in supply next year, vs a 1.63mm b/d increase in demand. Table 1BCA Global Oil Supply - Demand Balances (mm b/d) In line with our House view, we are expecting some USD strengthening on the back of as many as four interest-rate hikes by the Federal Reserve in the U.S. (Chart 7). As we've noted in the past, we expect these effects to be felt more in 2H18. Along with higher U.S. shale-oil production driven by higher prices - we expect shale output to go up 0.97mm b/d next year to 6.64mm b/d - a stronger USD will keep Brent and WTI prices below $70/bbl next year. Oil Beyond 2018: OPEC 2.0 Endures OPEC 2.0 will remain an enduring feature of the oil market going forward, in our view. Allowing the coalition to fade away, and returning the global oil market to a production free-for-all once again serves neither KSA's nor Russia's interests. Following the IPO of Saudi Aramco toward the end of 2018, KSA will, we believe, want to maintain stability in the market, by demonstrating to capital markets that OPEC 2.0 can manage crude-oil supplies in a way that is not disruptive to its new-found investors. It is important to remember the Aramco IPO is only the beginning of the process of transforming KSA from a crude resource exporter into a vertically integrated global refining and marketing colossus. To eclipse Exxon as the world's largest refiner, Aramco would benefit from continued access to capital markets throughout the following decades, as well reliable cash flows to lower its cost of capital, service debt, and maintain whatever dividends it envisions. This cannot occur if oil markets are continually at risk of collapsing because production cannot be managed in a business-like manner. While Russia has not embarked on the same sort of transformation of its resource industry as KSA, it still has a very strong interest in maintaining stability in the crude oil markets, given its dependence on hydrocarbon exports. The Russian rouble moves in near-lock-step with Brent prices - since 2010, Brent prices explain ~80% of the movement in the rouble (Chart 8). It is obvious a collapse in global crude oil prices would, once again, have devastating effects on Russia's economy, as it did in 2009 and 2014. Such a collapse would trigger inflation domestically, as the cost of imports skyrockets, and threaten civil unrest as incomes and GDP are hobbled and foreign reserves evaporate. Chart 7Stronger USD Limits Oil-Price Appreciation In 2018 Chart 8Russia Cannot Afford An Oil Price Collapse Both KSA and Russia have a deep interest in maintaining oil's pre-eminent position as a transportation fuel for as long as possible. For this reason, neither wants to encourage prices that are too high - $100/bbl+ prices greatly encouraged the development of shale technology in the U.S. - nor too low, given the dire consequences such an outcome would have for both their economies. The common goals of KSA and Russia cannot be achieved by allowing OPEC 2.0 to dissolve, leaving member states to produce at will in the sort of production free-for-all that characterized the OPEC market-share war of 2014 - 15. To the extent possible, OPEC 2.0 must continue to manage member states' production in a manner that does not permit inventories to once again fill to the point where the only way to moderate over-production is to push prices through cash costs, so that enough output is shut in to clear the market. The most obvious way for these goals to be accomplished is by keeping markets relatively tight. This can be done by keeping commercial oil inventories worldwide low enough to keep Brent and WTI forward curves backwardated - particularly in highly visible OECD and U.S. storage facilities. A backwardated forward curve means the average price over a typical 2- or 3-year hedge horizon is lower than the spot price received by OPEC 2.0 producers. The deeper the backwardation, the lower the average price a U.S. shale producer can lock in by hedging. This limits the number of rigs that can be deployed by shale producers. This will require continual communication with markets to assure them sufficient spare capacity and easily developed production can be brought to market to alleviate any temporary shortage. In the meantime, OPEC 2.0 members with flexible storage will need to communicate these barrels will be readily available to the market. This management and forward-guidance should be easier for OPEC 2.0 to execute on, following its recent success in keeping some 1.0mm b/d of production off the market - largely in KSA and Russia - and member states' existing spare capacity and storage. We continue to expect the daily working dialogue of the OPEC 2.0 member states - most especially KSA and Russia - to deepen as time goes by, and for tactics and strategy to evolve as each gains comfort operating with the other. Whether OPEC 2.0 can pull this off remains to be seen. However, given the success of the coalition over the past two years, we are inclined to believe they will continue to develop a durable modus operandi supporting this outcome. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com Opposing Forces: Stay Neutral Metals In 2018 Chart 9Strong Global Demand Will Neutralize ##br##Impact of China Slowdown While we expect more upside to metal prices in the first half of 2018, slowing growth in China and a stronger USD will prevent a repeat of this year's stellar performance. While a deceleration in China is - ceteris paribus - most definitely a headwind to metal prices, we believe the impact may pan out differently this time around. The silver lining comes from the Communist Party's commitment to environmental reforms, which, in many cases, will manifest themselves in the form of less supply of the refined product, or demand for the ores. Either way, this alone is a positive for metals. China's Environmental Reforms Will Dominate in 1Q18 China's commitment to cleaning its air is currently shaping up in the form of winter cuts in major steel- and aluminum-producing provinces. While policies are hard to predict, we will keep monitoring the development and implementation of reforms from within China to assess how they will impact the markets. Outcomes from the Annual National People's Congress in March will give us a clearer indication of what to expect in terms of policy. For now, we see these reforms putting a floor under metal prices, at least in the beginning of 2018. Robust Global Demand Offsets Stronger USD & Slower Chinese Growth Xi's reforms will turn into a headwind for metal prices as they begin to impact the real economy in 2H18. Signs of weakness have already emerged in measures of industrial activity such as the Li Keqiang and Chinese PMI (Chart 9). In addition, the real estate sector has been showing some weakness since the beginning of the year. Annual growth rates in real estate investment and floor-space started are decelerating - a worrisome sign. Nonetheless, domestic demand remains robust, and policymakers in Beijing are approaching economic reforms gradually and with caution. Consequently we do not expect a major policy mistake to derail the Chinese economy. While Chinese growth will likely slow from above trend levels, a hard landing is most probably not in the cards. Another bearish risk comes from a stronger USD. We see the Fed as more committed to interest-rate normalization than markets expect, and consequently would not be surprised to see up to four rate hikes next year. Inverting the yield curve is a policy mistake incoming Chair Jerome Powell will try to avoid; however, we expect inflation to bottom in the first half of next year, giving the Fed room to accelerate its path of rate hikes. This will result in a stronger USD, which is bearish for commodities priced in U.S. dollars. In any case, these bearish factors will likely be offset by strong global growth, supported by a robust U.S. economy. Bottom Line: Xi's reforms will dominate metal markets in 2018 as bullish supply side environmental reforms duel against bearish demand-side economic reforms. Robust global growth will neutralize the impact of downside pressures. Stay neutral, but beware of modest USD strength. Low Inflation Retards Gold's Advance Once again, reality confounded theory: Inflation failed to emerge this year, even as systematically important central banks remained massively accommodative, and some 70% of the economies tracked by the OECD reported jobless rates below the commonly used estimate of the natural rate of unemployment (Chart 10). Chart 10Massive Monetary Accommodation Failed ##br##To Spur Inflation In The U.S. These fundamentals should be inflationary and supportive of gold. To date, they haven't been. We Expect Inflation To Revive The global economy has endured decades of low inflation going back at least to the 1990s. This has been driven by numerous factors. First, the expansion of the global value chain (GVC) over the past three decades has synchronized inflation rates worldwide, as our research and that of the BIS has found. As a result, U.S. wages and goods' inflation are now more dependent on global spare capacity. With the global output gap now almost closed, this disinflationary force will dissipate.3 Second, most measures of labor-market slack are now pointing toward tighter conditions, which, we expect, will strengthen the Phillips curve trade-off between inflation and unemployment next year. Inflation is a lagging indicator: Wage inflation lags the unemployment rate, and CPI inflation lags wage inflation. Investors should expect inflation to show up in 2018.4 Lastly, one-off technical factors, which depressed inflation last year - e.g. drop in cellphone data charges and prescription drug prices - also will fade. Once these big one-offs are no longer in annual percent-change calculations, inflation rates will rise. The Fed's Choppy Waters Against this backdrop, the Fed is embarking on a rates-normalization policy, which we believe will result in U.S. central bank's policy rate being increased up to four times next year. The risk of a policy error is high. Should the Fed proceed with its rate hikes while inflation remains quiescent, real interest rates will increase. This would depress gold prices, and, at the limit, threaten the current economic expansion by tightening monetary conditions well beyond current levels, potentially lifting unemployment levels. If, on the other hand, the Fed deliberately keeps rate hikes below the rate of growth in prices - i.e., it stays "behind the curve" - it risks being forced to implement steeper rate hikes later in 2018 or in 2019 to get stronger inflation under control. This could tighten monetary conditions suddenly, and threaten the expansion, pushing the U.S. economy into recession. There's a lot riding on how the Fed navigates these difficult conditions. Geopolitical Risks Will Support Gold On the geopolitical side, the risks we've identified in our October 12, 2017 publication - i.e. (1) U.S.-North Korea tensions, (2) trade protectionism of the Trump administration, and (3) ongoing conflicts in the Middle East-- will add a geopolitical risk premium to gold prices, supporting the metal's role as a safe haven.5 Bottom Line: We remain neutral precious metals, but still recommend investors allocate to gold as a strategic portfolio hedge against inflation and geopolitical risk. U.S. Policies Will Weigh On Ags In 2018 U.S. monetary and trade policy will dominate ags next year. Our modelling reveals that U.S. financial factors - real rates and the USD - are significant in explaining ag price behavior (Chart 11).6 Given that we expect the Fed to hike interest rates more aggressively than what the market is currently pricing in, we see grains as vulnerable to the downside. In addition, the risk that NAFTA is abrogated by the U.S. would weigh on ag markets, as Canada and Mexico are among the U.S.'s top three ag export destinations. Chart 11Bearish U.S. Monetary And Trade Policies ##br##Amid Healthy Inventories Will Weigh On Ags We expect ag markets will remain well supplied next year, and inventories will moderate the impact of supply-side shocks - most notably in the form of a La Nina event. The probability of a La Nina currently stands above 80%, and is expected to last until mid-to-late spring. U.S. Monetary Policy Is Relevant With U.S. inflation rates still subdued, there has been much talk about how soon the Fed will be able embark on its tightening cycle. A weaker-than-expected USD has been favorable for ag markets this year, and thus kept U.S. ag exports competitive. However, if and when the economy reaches the kink in the Philipps Curve, and inflation begins its ascent, the Fed will be able to proceed with its rate-hiking cycle. With the New York Fed's Underlying Inflation Gauge at a cycle high, we expect this scenario to unfold in the first half of 2018. This would give incoming Fed Chairman Jerome Powell ample room to hike rates which would - ceteris paribus - bear down on ag prices. FX Developments In Other Major Exporters Will Also Be Bearish The effects of higher U.S. interest rates are translated to ag markets via the exchange-rate channel. Commodities are priced in USD, thus a stronger USD vis-à-vis the currency of a major ag exporter will, all else equal, increase the profitability of farmers competing against U.S. exporters in international markets. Among the ag-relevant currencies, we highlight the Brazilian Real, EUR, Russian Rouble, and Australian Dollar as most likely to depreciate vis-à-vis the USD in 2018. Termination Of NAFTA Is A Risk For American Farmers U.S. farmers are keeping a close eye on NAFTA renegotiations, and rightly so. Canada and Mexico are the U.S.'s second and third largest agricultural export markets - accounting for 15% and 13% of U.S. agricultural exports in 2016, respectively. In fact, corn, rice, and wheat exports to Mexico accounted for 26%, 15%, and 11% share of U.S. exports of those commodities, respectively. However, as BCA Research's Geopolitical Strategy service points out, the long-run impact depends on the underlying reason for the termination of the trade agreement. If Trump is merely a "pluto-populist" - as they expect - NAFTA will simply be replaced by bilateral trade agreements, with no lasting economic disturbance. The risk is that Trump is a genuine populist. If this turns out to be the case, tariffs and a rejection of the WTO would make U.S. exports less competitive, and would become a bearish force in ag markets.7 The risk of a collapse in the NAFTA trade deal would be devastating for U.S. farmers. In fact, in a bid to reduce reliance on the U.S., Mexican Economic Minister Ildefonso Guajardo recently announced that they are working on a Mexico-European Union trade deal.8 In addition, Mexico signed the world's largest free trade agreement with Japan, and is currently exploring the opportunity to join Mercosur. Bottom Line: Weather-induced volatility is possible in the near term, as a La Nina event threatens to reduce yields. Nevertheless, U.S. financial conditions and trade policy will dominate ag markets in 2018. With markets underestimating the Fed's resolve regarding interest rate hikes, we see some upside to the USD. This will keep a lid on ag prices next year. 1 Please see "The year in Review: Global Economy in 5 Charts," published on the IMF Blog December 18, 2017. https://blogs.imf.org/2017/12/17/the-year-in-review-global-economy-in-5-charts/ 2 Please see "Paralysis at PDVSA: Venezuela's oil purge cripples company," published by reuters.com December 15, 2017. 3 The IMF estimates the median output gap for 20 advanced economies reached -0.1% in 2017 and will rise to +0.3% in 2018. Please see BIS https://www.bis.org/publ/work602.htm. The Bank for International Settlements in Basel describes the GVC as "cross-border trade in intermediate goods and services." 4 The U.S. unemployment has been under its estimated NAIRU for 9 consecutive months now. 5 Please see Commodity and Energy Strategy Weekly Report titled "Balance Of Risks Favors Holding Gold," dated October 12, 2017, available at ces.bcaresearch.com. 6 Our modelling indicates that U.S. financial factors are important determinants of agriculture commodity price developments. More specifically, a 1% move in the USD TWI and a 1pp change in 5 year real rates are associated with a 1.4%, and an 18% change in the CCI Grains & Oilseed Index, in the opposite direction. 7 Please see Global Investment Strategy Special Report titled "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gis.bcaresearch.com. 8 Please see "Mexico sees possible EU trade deal as NAFTA talks drag on," dated December 13, 2017, available at reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trade Recommendation Performance In 3Q17 Trades Closed in Summary of Trades Closed in

Feature It has been a Geopolitical Strategy tradition, since our launch in 2012, to include our best and worst forecasts of the year in our end-of-year Strategic Outlook monthly reports.1 Since we have switched over to a weekly publication schedule, we are making this section of our Outlook an individual report.2 It will also be the final publication of the year, provided that there is no global conflagration worthy of a missive between now and January 10, when we return to our regular publication schedule. The Worst Calls Of 2017 A forecasting mistake is wasted if one learns nothing from the error. Alternatively, it is an opportunity to arm oneself with wisdom for the next fight. This is why we take our mistakes seriously and why we begin this report card with the zingers. Overall, we are satisfied with our performance in 2017, as the successes below will testify. However, we made one serious error and two ancillary ones. Short Emerging Markets Continuing to recommend an overweight DM / underweight EM stance was the major failure this year (Chart 1). More specifically, we penned several bearish reports on the politics of Brazil, South Africa, and Turkey throughout the year to support our view.3 What did we learn from our mistake? The main driving forces behind EM risk assets in 2017 have been U.S. TIPS yields and the greenback (Chart 2). Weak inflation data and policy disappointments as the pro-growth, populist economic policy of the Trump Administration stalled mid-year supported the EM carry trade throughout the year. The post-election dollar rally dissipated, while Chinese fiscal and credit stimulus carried over into 2017 and buoyed demand for EM exports. Chart 1The Worst Call Of 2017: Long DM / Short EM Chart 2How Long Can The EM Carry Trade Survive? Our bearish call was based on EM macroeconomic and political fundamentals. On one hand, our fundamental analysis was genuinely wrong. Emerging markets were buoyed by Chinese stimulus and a broad-based DM recovery. On the other hand, our fundamental analysis was irrelevant, as the global "search-for-yield" overwhelmed all other factors. Chart 3The Dollar Ought ##br##To Rebound Chart 4Chinese Monetary Conditions Point##br## To Slowing Industrial Activity Going forward, it is difficult to see this combination of factors emerge anew. First, the U.S. economy is set to outperform the rest of the world in 2018, particularly with the stimulative tax cut finally on the books, which should be dollar bullish (Chart 3). Second, downside risks to the Chinese economy are multiplying (Chart 4) as policymakers crack down on the shadow financial sector and real estate (Chart 5). BCA's Foreign Exchange Strategy has shown that EM currencies are already flagging risks to global growth. Their "carry canary indicator" - EM currencies vs. the JPY - is forecasting a sharp deceleration in global growth within the next two quarters (Chart 6). Chart 5Chinese Growth ##br##Slowing Down? Chart 6After Carry Trades Lose Momentum,##br## Global IP Weakens That said, we have learned our lesson. We are closing all of our short EM positions and awaiting January credit numbers from China. If our view on Chinese financial sector reforms is correct, these figures should disappoint. If they do not, the EM party can continue. "Trump, Day One: Let The Trade War Begin" In our defense, the title of our first Weekly Report of the year belied the nuanced analysis within.4 We argued that the Trump administration would begin its relationship with China with a "symbolic punitive measure," but that it would then "seek high-level negotiations toward a framework for the administration's relations with China over the next four years." This was largely the script followed by the White House. We also warned clients that it would be the "lead up to the 2018 or 2020 elections" that truly revealed President Trump's protectionist side. Nonetheless, we were overly bearish about trade protectionism throughout 2017. First, President Trump did not name China a currency manipulator. Second, the border adjustment tax (BAT), which we thought had a 55% chance of being included in tax reform, really was dead-on-arrival. Third, the "Mar-A-Lago Summit" consensus lasted through the summer, buoying companies with relative exposure to China relative to the S&P 500 (Chart 7).5 Chart 7Second Worst Call Of 2017:##br## Alarmism On Protectionism Why did we get the Trump White House wrong on protectionism? There are three possibilities: Constraints error: We strayed too far from our constraints-based model by focusing too much on preferences of the Trump Administration. While we are correct that the White House lacks constraints when it comes to trade, tensions with North Korea this year - which we forecast correctly - were a constraint on an overly punitive trade policy against China. Preferences error: We got the Trump administration preferences wrong. Trade protectionism is the wool that Candidate Trump pulled over his voters' eyes. He is in fact an establishment Republican - a pluto-populist - with no intention of actually enacting protectionist policies. Timing error: We were too early. Year 2018 will see fireworks. Unfortunately for our clients, we have no idea which error we committed. But Trump's national security speech on Dec. 18 maintained the protectionist threat, and there are several key deadlines coming up that should reveal which way the winds are blowing: New Year: Trump will have to decide on January 12 and February 3 whether to impose tariffs on solar panels and washing machines, respectively, under Section 201 of the U.S. Trade Act of 1974. This ruling will have implications for other trade items. End of Q1: NAFTA negotiations have been extended through the end of Q1 2018. As we recently posited, the abrogation of NAFTA by the White House is a 50-50 probability.6 The question is whether the Trump administration follows this up with separate bilateral talks with Canada and Mexico, or whether it moves beyond NAFTA to clash directly with the WTO instead.7 The U.K. Election (Although We Got Brexit Right!) Our forecasting record of U.K. elections is abysmal. We predicted that Theresa May would preserve her majority in the House of Commons, although in our defense we also noted that the risks were clearly skewed to the downside given the movement of the U.K. median voter to the left.8 We are now 0 for 2, having also incorrectly called the 2015 general election (we expected the Tories to fail to reach the majority in that election).9 On the other hand, we correctly sounded the alarm on Brexit, noting that the probability was much closer to 50% than what the market was pricing at the time.10 What gives? The mix of U.K.'s first-past-the-post system and the country's unique party distribution makes forecasting elections difficult. Because the Tories are essentially the only right-of-center party in England, they tend to outperform their polls and win constituencies with a low-plurality of votes. As such, in 2017, we ignored the strong Labour momentum in the polls, expecting that it would stall. It did not (Chart 8). That said, our job is not to call elections, but to generate alpha by focusing on the difference between what the market is pricing in and what we believe will happen. If elections are a catalyst for market performance - as was the case with the French one this year - we track them closely in a series of publications and adjust our probabilities as new data comes in. For U.K. assets this year, by contrast, getting the Brexit process right was far more relevant than the general election. Our high conviction view that the EU would not be punitive, that the U.K. would accept all conditions, and that the May administration would essentially stick to the "hard Brexit" strategy it defined in January ended up being correct.11 This allowed us to call the GBP bottom versus the USD in January (Chart 9). Chart 8Third Worst Call Of 2018: The U.K. Election Chart 9But We Got Brexit - And Cable! - Right What did we learn from our final error? Stop trying to forecast U.K. elections! The Best Calls Of 2017 The best overall call in 2017 was to tell clients to buy the S&P 500 in April and never look back. Our "Buy In May And Enjoy Your Day!" missive on April 26 was preceded by our analysis of global geopolitical risks and opportunities.12 In these, we concluded that "Political Risks Are Overstated In 2017" and "Understated In 2018."13 As such, the combination of strong risk asset performance and low volatility did not surprise us. It was our forecast (Chart 10). U.S. Politics: Tax Cuts & Impeachment Not only did we forecast that President Trump would manage to successfully pass tax reform in 2017, but we also correctly called the GOP's fiscal profligacy.14 We get little recognition for the latter in conversations with clients and colleagues, but it was a highly contentious call, especially after seven years of austere rhetoric from the fiscal conservatives supposedly running the Republican Party. We were also correct that impeachment fears and the ongoing Mueller Investigation would have little impact on U.S. assets.15 Chart 11 shows that the U.S. dollar and S&P 500 barely moved with each Trump-related scandal (Table 1). Chart 10The Best Call Of 2017: Getting The Market Right Chart 11No Real Impact From Trump Imbroglio By correctly identifying the ongoing "Trump Put" in the market, we were able to remain bullish on U.S. equities throughout the year and avoid calling any pullbacks. Table 1An Eventful Year 1 Of The Trump Presidency Europe (All Of It) Our performance forecasting European politics and markets has been stellar this year. Instead of reviewing each call, the list below simply summarizes each report: "After Brexit, N-Exit?" - Although technically a call made in 2016, our view that Brexit would cause a surge in support for the EU was a view for 2017.16 Several anti-establishment populists failed to perform in line with their 2015-2016 polling, particularly Geert Wilders in the Netherlands. "Will Marine Le Pen Win?" - We definitely answered this question in the negative, going back to November 2016.17 This allowed us to recommend clients go long the euro vs. the U.S. dollar (Chart 12). Moreover, we argued that regardless of who won the election, the next French government would embark on structural reforms.18 As a play on our bullish view of France, we recommended that clients overweight French industrials vs. German ones (Chart 13). "Europe's Divine Comedy: Italy In Purgatorio" - We correctly assessed that Italian Euroskpetics would migrate towards the center on the question of the euro. However, we missed recommending the epic rally in Italian equities and bonds that should have naturally flowed from our political view.19 "Fade Catalan Risks" - Based on our 2014 net assessment, we concluded that the Catalan independence drive would be largely irrelevant for the markets.20 This proved to be correct this year. "Can Turkey Restart The Immigration Crisis?" - Earlier in the year, clients became nervous about a potential diplomatic breakdown between the EU and Turkey leading to a renewal of the immigration crisis.21 We reiterated our long-held view that the immigration crisis did not end because of Turkish intervention, but because of tighter European enforcement. Throughout the year, we were proven right, with Europeans becoming more and more focused on interdiction. Chart 12Second Best Call Of 2017: The Euro... Chart 13...And France In Particular China: Policy-Induced Financial Tightening Throughout 2016-17, in the lead-up to China's nineteenth National Party Congress, we argued that the stability imperative would ensure an accommodative-but-not-too-accommodative policy stance.22 In particular, we highlighted the ongoing impetus for anti-pollution controls.23 This forecast broadly proved to be correct, as the government maintained stimulus yet simultaneously surprised the markets with financial and environmental regulatory crackdowns throughout the year. Once these regulatory campaigns took off, we argued that they would remain tentative, since the truly tough policies would have to wait until after the party congress. At that point, Xi Jinping could re-launch his structural reform agenda, primarily by intensifying financial sector tightening.24 Over the course of the year, this political analysis began to be revealed in the data, with broad money (M3) figures suggesting that money growth decelerated sharply in 2017 (Chart 14). In addition, we correctly called several moves by President Xi Jinping at the party congress.25 Chart 14Third Best Call Of 2017:##br## Chinese Reforms? (We Will See In 2018!) Our view that Chinese policymakers will restart reforms after the party congress is now becoming more widely accepted, given Xi's party congress speech Oct. 18 and the news from the December Politburo meeting.26 Where we differ from the market is in arguing that Beijing's bite will be worse than its bark. We are concerned that there is considerable risk to the downside and that stimulus will come much later than investors think this time around. Our China view was largely correct in 2017, but the real market significance will be felt in 2018. There are still several questions outstanding, including whether the crackdown on the financial sector will be as growth-constraining as we think. As such, this is a key view that will carry over into 2018. Thankfully, we should know whether we are right or wrong by the March National People's Congress session and the data releases shortly thereafter. North Korea - Both A Tail Risk And An Overstated Risk We correctly identified North Korea as a key 2017 geopolitical risk in our Strategic Outlook and began signaling that it was no longer a "red herring" as early as April 2016.27 In April 2017, we told clients to prepare for safe haven flows due to the likelihood that tensions would increase as the U.S. established a "credible threat" of war, a playbook that the Obama administration most recently used against Iran.28 While we flagged North Korea as a risk that would move the markets, we also signaled precisely when the risk became overstated. In September, we told clients that U.S. Treasury yields would rise from their lows that month as investors realized that the North Korean regime was constrained by its paltry military capability.29 At the same time, we gave President Trump an A+ for his performance establishing a credible threat, a bet that worked not only on Pyongyang, but also on Beijing. Since this summer, China has begun to ratchet up economic pressure against North Korea (Chart 15). Chart 15Fourth Best Call Of 2017: North Korea Middle East And Oil Prices BCA Research scored a big win this year with our energy call. It would be unfair for us to take credit for that view. Our Commodity & Energy Strategy as well as our Energy Sector Strategy deserve all the credit.30 Nonetheless, we helped our commodity teams make the right calls by: Correctly forecasting that Saudi-Iranian and Russo-Turkish tensions would de-escalate, allowing OPEC and Russia to maintain the production-cut agreement;31 Emphasizing risks to Iraqi production as tensions shifted from the Islamic State to the Kurdish Regional Government; Highlighting the likely continued decline, but not sharp cut-off, of Venezuelan production, due to the regime's ability to cling to power even as the conditions of production worsened.32 In addition, we were correct to fade various concerns regarding renewed tensions in Qatar, Yemen, and Lebanon throughout the year. Despite the media narrative that the Middle East has become a cauldron of instability anew, our long-held view that all the players involved are constrained by domestic and material constraints has remained cogent. In particular, our view that Saudi Arabia would engage in serious social reforms bore fruit in 2017, with several moves by the ruling regime to evolve the country away from feudal monarchy.33 Going forward, a major risk to our view is the Trump administration policy towards Iran, our top Black Swan risk for 2018. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Ekaterina Shtrevensky, Research Assistant ekaterinas@bcaresearch.com 1 Due to the high volume of footnotes in this report, we have decided to include them at the end of the document. For a review of our past Strategic Outlooks, please visit gps.bcaresearch.com. 2 For the rest of our 2018 Outlook, please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, and "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy, "Turkey: Military Adventurism And Capital Controls," dated December 7, 2016, "South Africa: Back To Reality," dated April 5, 2017, "Brazil: Politics Giveth And Politics Taketh Away," dated May 24, 2017, "South Africa: Crisis Of Expectations," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "G19," dated July 12, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 7 The outcome at the WTO Buenos Aires summit last week offered a possible way out of confrontation between the Trump administration and the WTO. It featured Europe and Japan taking a tougher line on trade violations, namely China, to respond to the Trump administration grievances that, unaddressed, could escalate into a full-fledged Trump-WTO clash. 8 Please see BCA Geopolitical Strategy Weekly Report, "How Long Can The 'Trump Put' Last?" dated June 14, 2017 and "U.K. Election: The Median Voter Has Spoken," dated June 9, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "U.K. Election Preview," dated February 26, 2015, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me?' World?" dated January 25, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017 and "Political Risks Are Understated In 2017," dated April 12, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, "The French Revolution," dated February 3, 2017 and "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014 and "Why So Serious?" dated October 11, 2017, available at gps.bcaresearch.com. 21 Please see BCA Geopolitical Strategy Weekly Report, "Five Questions On Europe," dated March 22, 2017, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation)," dated July 13, 2016, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 24 Please see BCA Geopolitical Strategy We," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 25 We argued in our 2017 Strategic Outlook that while Xi's faction would gain a majority on the Politburo Standing Committee, he would maintain a reasonable balance and refrain from excluding opposing factions from power. We expected that factional struggle would flare back up into the open (as with the ouster of Sun Zhengcai), and that Xi would retire anti-corruption chief Wang Qishan, but not that Xi would avoid promoting a successor for 2022 to the Politburo Standing Committee. 26 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 27 Please see BCA Geopolitical Strategy "North Korea: A Red Herring No More?" in Monthly Report, "Partem Mirabilis," dated April 13, 2016 and "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 28 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 29 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 30 If you are an investor with even a passing interest in commodities and oil, you must review the work of our colleagues Robert Ryan and Matt Conlan. 31 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com. 32 Please see BCA Geopolitical Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 33 Please see BCA Geopolitical Strategy Special Report, "The Middle East: Separating The Signal From The Noise," dated November 15, 2017, available at gps.bcaresearch.com.

Special Report

Feature It has been a Geopolitical Strategy tradition, since our launch in 2012, to include our best and worst forecasts of the year in our end-of-year Strategic Outlook monthly reports.1 Since we have switched over to a weekly publication schedule, we are making this section of our Outlook an individual report.2 It will also be the final publication of the year, provided that there is no global conflagration worthy of a missive between now and January 10, when we return to our regular publication schedule. The Worst Calls Of 2017 A forecasting mistake is wasted if one learns nothing from the error. Alternatively, it is an opportunity to arm oneself with wisdom for the next fight. This is why we take our mistakes seriously and why we begin this report card with the zingers. Overall, we are satisfied with our performance in 2017, as the successes below will testify. However, we made one serious error and two ancillary ones. Short Emerging Markets Continuing to recommend an overweight DM / underweight EM stance was the major failure this year (Chart 1). More specifically, we penned several bearish reports on the politics of Brazil, South Africa, and Turkey throughout the year to support our view.3 What did we learn from our mistake? The main driving forces behind EM risk assets in 2017 have been U.S. TIPS yields and the greenback (Chart 2). Weak inflation data and policy disappointments as the pro-growth, populist economic policy of the Trump Administration stalled mid-year supported the EM carry trade throughout the year. The post-election dollar rally dissipated, while Chinese fiscal and credit stimulus carried over into 2017 and buoyed demand for EM exports. Chart 1The Worst Call Of 2017: Long DM / Short EM Chart 2How Long Can The EM Carry Trade Survive? Our bearish call was based on EM macroeconomic and political fundamentals. On one hand, our fundamental analysis was genuinely wrong. Emerging markets were buoyed by Chinese stimulus and a broad-based DM recovery. On the other hand, our fundamental analysis was irrelevant, as the global "search-for-yield" overwhelmed all other factors. Chart 3The Dollar Ought ##br##To Rebound Chart 4Chinese Monetary Conditions Point##br## To Slowing Industrial Activity Going forward, it is difficult to see this combination of factors emerge anew. First, the U.S. economy is set to outperform the rest of the world in 2018, particularly with the stimulative tax cut finally on the books, which should be dollar bullish (Chart 3). Second, downside risks to the Chinese economy are multiplying (Chart 4) as policymakers crack down on the shadow financial sector and real estate (Chart 5). BCA's Foreign Exchange Strategy has shown that EM currencies are already flagging risks to global growth. Their "carry canary indicator" - EM currencies vs. the JPY - is forecasting a sharp deceleration in global growth within the next two quarters (Chart 6). Chart 5Chinese Growth ##br##Slowing Down? Chart 6After Carry Trades Lose Momentum,##br## Global IP Weakens That said, we have learned our lesson. We are closing all of our short EM positions and awaiting January credit numbers from China. If our view on Chinese financial sector reforms is correct, these figures should disappoint. If they do not, the EM party can continue. "Trump, Day One: Let The Trade War Begin" In our defense, the title of our first Weekly Report of the year belied the nuanced analysis within.4 We argued that the Trump administration would begin its relationship with China with a "symbolic punitive measure," but that it would then "seek high-level negotiations toward a framework for the administration's relations with China over the next four years." This was largely the script followed by the White House. We also warned clients that it would be the "lead up to the 2018 or 2020 elections" that truly revealed President Trump's protectionist side. Nonetheless, we were overly bearish about trade protectionism throughout 2017. First, President Trump did not name China a currency manipulator. Second, the border adjustment tax (BAT), which we thought had a 55% chance of being included in tax reform, really was dead-on-arrival. Third, the "Mar-A-Lago Summit" consensus lasted through the summer, buoying companies with relative exposure to China relative to the S&P 500 (Chart 7).5 Chart 7Second Worst Call Of 2017:##br## Alarmism On Protectionism Why did we get the Trump White House wrong on protectionism? There are three possibilities: Constraints error: We strayed too far from our constraints-based model by focusing too much on preferences of the Trump Administration. While we are correct that the White House lacks constraints when it comes to trade, tensions with North Korea this year - which we forecast correctly - were a constraint on an overly punitive trade policy against China. Preferences error: We got the Trump administration preferences wrong. Trade protectionism is the wool that Candidate Trump pulled over his voters' eyes. He is in fact an establishment Republican - a pluto-populist - with no intention of actually enacting protectionist policies. Timing error: We were too early. Year 2018 will see fireworks. Unfortunately for our clients, we have no idea which error we committed. But Trump's national security speech on Dec. 18 maintained the protectionist threat, and there are several key deadlines coming up that should reveal which way the winds are blowing: New Year: Trump will have to decide on January 12 and February 3 whether to impose tariffs on solar panels and washing machines, respectively, under Section 201 of the U.S. Trade Act of 1974. This ruling will have implications for other trade items. End of Q1: NAFTA negotiations have been extended through the end of Q1 2018. As we recently posited, the abrogation of NAFTA by the White House is a 50-50 probability.6 The question is whether the Trump administration follows this up with separate bilateral talks with Canada and Mexico, or whether it moves beyond NAFTA to clash directly with the WTO instead.7 The U.K. Election (Although We Got Brexit Right!) Our forecasting record of U.K. elections is abysmal. We predicted that Theresa May would preserve her majority in the House of Commons, although in our defense we also noted that the risks were clearly skewed to the downside given the movement of the U.K. median voter to the left.8 We are now 0 for 2, having also incorrectly called the 2015 general election (we expected the Tories to fail to reach the majority in that election).9 On the other hand, we correctly sounded the alarm on Brexit, noting that the probability was much closer to 50% than what the market was pricing at the time.10 What gives? The mix of U.K.'s first-past-the-post system and the country's unique party distribution makes forecasting elections difficult. Because the Tories are essentially the only right-of-center party in England, they tend to outperform their polls and win constituencies with a low-plurality of votes. As such, in 2017, we ignored the strong Labour momentum in the polls, expecting that it would stall. It did not (Chart 8). That said, our job is not to call elections, but to generate alpha by focusing on the difference between what the market is pricing in and what we believe will happen. If elections are a catalyst for market performance - as was the case with the French one this year - we track them closely in a series of publications and adjust our probabilities as new data comes in. For U.K. assets this year, by contrast, getting the Brexit process right was far more relevant than the general election. Our high conviction view that the EU would not be punitive, that the U.K. would accept all conditions, and that the May administration would essentially stick to the "hard Brexit" strategy it defined in January ended up being correct.11 This allowed us to call the GBP bottom versus the USD in January (Chart 9). Chart 8Third Worst Call Of 2018: The U.K. Election Chart 9But We Got Brexit - And Cable! - Right What did we learn from our final error? Stop trying to forecast U.K. elections! The Best Calls Of 2017 The best overall call in 2017 was to tell clients to buy the S&P 500 in April and never look back. Our "Buy In May And Enjoy Your Day!" missive on April 26 was preceded by our analysis of global geopolitical risks and opportunities.12 In these, we concluded that "Political Risks Are Overstated In 2017" and "Understated In 2018."13 As such, the combination of strong risk asset performance and low volatility did not surprise us. It was our forecast (Chart 10). U.S. Politics: Tax Cuts & Impeachment Not only did we forecast that President Trump would manage to successfully pass tax reform in 2017, but we also correctly called the GOP's fiscal profligacy.14 We get little recognition for the latter in conversations with clients and colleagues, but it was a highly contentious call, especially after seven years of austere rhetoric from the fiscal conservatives supposedly running the Republican Party. We were also correct that impeachment fears and the ongoing Mueller Investigation would have little impact on U.S. assets.15 Chart 11 shows that the U.S. dollar and S&P 500 barely moved with each Trump-related scandal (Table 1). Chart 10The Best Call Of 2017: Getting The Market Right Chart 11No Real Impact From Trump Imbroglio By correctly identifying the ongoing "Trump Put" in the market, we were able to remain bullish on U.S. equities throughout the year and avoid calling any pullbacks. Table 1An Eventful Year 1 Of The Trump Presidency Europe (All Of It) Our performance forecasting European politics and markets has been stellar this year. Instead of reviewing each call, the list below simply summarizes each report: "After Brexit, N-Exit?" - Although technically a call made in 2016, our view that Brexit would cause a surge in support for the EU was a view for 2017.16 Several anti-establishment populists failed to perform in line with their 2015-2016 polling, particularly Geert Wilders in the Netherlands. "Will Marine Le Pen Win?" - We definitely answered this question in the negative, going back to November 2016.17 This allowed us to recommend clients go long the euro vs. the U.S. dollar (Chart 12). Moreover, we argued that regardless of who won the election, the next French government would embark on structural reforms.18 As a play on our bullish view of France, we recommended that clients overweight French industrials vs. German ones (Chart 13). "Europe's Divine Comedy: Italy In Purgatorio" - We correctly assessed that Italian Euroskpetics would migrate towards the center on the question of the euro. However, we missed recommending the epic rally in Italian equities and bonds that should have naturally flowed from our political view.19 "Fade Catalan Risks" - Based on our 2014 net assessment, we concluded that the Catalan independence drive would be largely irrelevant for the markets.20 This proved to be correct this year. "Can Turkey Restart The Immigration Crisis?" - Earlier in the year, clients became nervous about a potential diplomatic breakdown between the EU and Turkey leading to a renewal of the immigration crisis.21 We reiterated our long-held view that the immigration crisis did not end because of Turkish intervention, but because of tighter European enforcement. Throughout the year, we were proven right, with Europeans becoming more and more focused on interdiction. Chart 12Second Best Call Of 2017: The Euro... Chart 13...And France In Particular China: Policy-Induced Financial Tightening Throughout 2016-17, in the lead-up to China's nineteenth National Party Congress, we argued that the stability imperative would ensure an accommodative-but-not-too-accommodative policy stance.22 In particular, we highlighted the ongoing impetus for anti-pollution controls.23 This forecast broadly proved to be correct, as the government maintained stimulus yet simultaneously surprised the markets with financial and environmental regulatory crackdowns throughout the year. Once these regulatory campaigns took off, we argued that they would remain tentative, since the truly tough policies would have to wait until after the party congress. At that point, Xi Jinping could re-launch his structural reform agenda, primarily by intensifying financial sector tightening.24 Over the course of the year, this political analysis began to be revealed in the data, with broad money (M3) figures suggesting that money growth decelerated sharply in 2017 (Chart 14). In addition, we correctly called several moves by President Xi Jinping at the party congress.25 Chart 14Third Best Call Of 2017:##br## Chinese Reforms? (We Will See In 2018!) Our view that Chinese policymakers will restart reforms after the party congress is now becoming more widely accepted, given Xi's party congress speech Oct. 18 and the news from the December Politburo meeting.26 Where we differ from the market is in arguing that Beijing's bite will be worse than its bark. We are concerned that there is considerable risk to the downside and that stimulus will come much later than investors think this time around. Our China view was largely correct in 2017, but the real market significance will be felt in 2018. There are still several questions outstanding, including whether the crackdown on the financial sector will be as growth-constraining as we think. As such, this is a key view that will carry over into 2018. Thankfully, we should know whether we are right or wrong by the March National People's Congress session and the data releases shortly thereafter. North Korea - Both A Tail Risk And An Overstated Risk We correctly identified North Korea as a key 2017 geopolitical risk in our Strategic Outlook and began signaling that it was no longer a "red herring" as early as April 2016.27 In April 2017, we told clients to prepare for safe haven flows due to the likelihood that tensions would increase as the U.S. established a "credible threat" of war, a playbook that the Obama administration most recently used against Iran.28 While we flagged North Korea as a risk that would move the markets, we also signaled precisely when the risk became overstated. In September, we told clients that U.S. Treasury yields would rise from their lows that month as investors realized that the North Korean regime was constrained by its paltry military capability.29 At the same time, we gave President Trump an A+ for his performance establishing a credible threat, a bet that worked not only on Pyongyang, but also on Beijing. Since this summer, China has begun to ratchet up economic pressure against North Korea (Chart 15). Chart 15Fourth Best Call Of 2017: North Korea Middle East And Oil Prices BCA Research scored a big win this year with our energy call. It would be unfair for us to take credit for that view. Our Commodity & Energy Strategy as well as our Energy Sector Strategy deserve all the credit.30 Nonetheless, we helped our commodity teams make the right calls by: Correctly forecasting that Saudi-Iranian and Russo-Turkish tensions would de-escalate, allowing OPEC and Russia to maintain the production-cut agreement;31 Emphasizing risks to Iraqi production as tensions shifted from the Islamic State to the Kurdish Regional Government; Highlighting the likely continued decline, but not sharp cut-off, of Venezuelan production, due to the regime's ability to cling to power even as the conditions of production worsened.32 In addition, we were correct to fade various concerns regarding renewed tensions in Qatar, Yemen, and Lebanon throughout the year. Despite the media narrative that the Middle East has become a cauldron of instability anew, our long-held view that all the players involved are constrained by domestic and material constraints has remained cogent. In particular, our view that Saudi Arabia would engage in serious social reforms bore fruit in 2017, with several moves by the ruling regime to evolve the country away from feudal monarchy.33 Going forward, a major risk to our view is the Trump administration policy towards Iran, our top Black Swan risk for 2018. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Ekaterina Shtrevensky, Research Assistant ekaterinas@bcaresearch.com 1 Due to the high volume of footnotes in this report, we have decided to include them at the end of the document. For a review of our past Strategic Outlooks, please visit gps.bcaresearch.com. 2 For the rest of our 2018 Outlook, please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, and "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy, "Turkey: Military Adventurism And Capital Controls," dated December 7, 2016, "South Africa: Back To Reality," dated April 5, 2017, "Brazil: Politics Giveth And Politics Taketh Away," dated May 24, 2017, "South Africa: Crisis Of Expectations," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "G19," dated July 12, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 7 The outcome at the WTO Buenos Aires summit last week offered a possible way out of confrontation between the Trump administration and the WTO. It featured Europe and Japan taking a tougher line on trade violations, namely China, to respond to the Trump administration grievances that, unaddressed, could escalate into a full-fledged Trump-WTO clash. 8 Please see BCA Geopolitical Strategy Weekly Report, "How Long Can The 'Trump Put' Last?" dated June 14, 2017 and "U.K. Election: The Median Voter Has Spoken," dated June 9, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "U.K. Election Preview," dated February 26, 2015, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me?' World?" dated January 25, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017 and "Political Risks Are Understated In 2017," dated April 12, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, "The French Revolution," dated February 3, 2017 and "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014 and "Why So Serious?" dated October 11, 2017, available at gps.bcaresearch.com. 21 Please see BCA Geopolitical Strategy Weekly Report, "Five Questions On Europe," dated March 22, 2017, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation)," dated July 13, 2016, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 24 Please see BCA Geopolitical Strategy We," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 25 We argued in our 2017 Strategic Outlook that while Xi's faction would gain a majority on the Politburo Standing Committee, he would maintain a reasonable balance and refrain from excluding opposing factions from power. We expected that factional struggle would flare back up into the open (as with the ouster of Sun Zhengcai), and that Xi would retire anti-corruption chief Wang Qishan, but not that Xi would avoid promoting a successor for 2022 to the Politburo Standing Committee. 26 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 27 Please see BCA Geopolitical Strategy "North Korea: A Red Herring No More?" in Monthly Report, "Partem Mirabilis," dated April 13, 2016 and "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 28 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 29 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 30 If you are an investor with even a passing interest in commodities and oil, you must review the work of our colleagues Robert Ryan and Matt Conlan. 31 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com. 32 Please see BCA Geopolitical Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 33 Please see BCA Geopolitical Strategy Special Report, "The Middle East: Separating The Signal From The Noise," dated November 15, 2017, available at gps.bcaresearch.com.

In late-August we initiated a liquidity-to-growth handoff levered market-neutral trade: long S&P energy/short global gold miners. Over the past four months this trade is up 18.3% and we think the easy money has already been made in this market-neutral trade, despite the still favorable relative macro backdrop. The Fed and other G7 central banks are simultaneously tightening monetary policy, either through rate hikes or reduced asset purchases or a combination thereof. This is de facto negative for the shiny metal and gold mining equities as interest rates are headed higher (second panel). Meanwhile, on the relative operating front, energy stocks have the upper hand versus gold miners as global oil majors have returned to profitability in the new era of $50/bbl oil, suggesting that the worst is behind the industry. Notwithstanding the still-supportive context, this was a tactical three-to-six month pair trade that has mostly played out and we would not like to overstay our welcome. Should a broad market pullback to occur in the upcoming quarter, and the ratio to trade significantly lower, we would not hesitate to reinstate this pair trade. Our cyclical strategy is to "buy the broad market dip" and remain opportunistic on a tactical basis. Bottom Line: Lock in 18.3% profits in the long S&P energy/short global gold miners pair trade and move to the sidelines for now; see Monday's Weekly Report for more details.

Highlights Portfolio Strategy The easy money has already been made in the liquidity-to-growth theme-levered long S&P energy/short global gold miners pair trade. Lock in profits and move to the sidelines, for now. Similarly, book gains in the long S&P materials/short S&P utilities market-neutral trade. A stealthy macro shift, at the margin, suggests that a more challenging phase lies ahead for this relative share price ratio. Recent Changes Book 18.3% profits in the long S&P energy/short global gold miners pair trade today. Take profits in excess of 8.6% in the long materials/short utilities pair trade today. Table 1 Feature Equities continued to defy gravity last week, vaulting to fresh all-time highs. Seasonality (or the pending Santa rally) appears to have trumped any "buy on rumor sell the tax news" jitters, at a time when macro data continue to surprise to the upside. Heading into 2018, easier fiscal policy will likely offset some of the uneasiness of the Fed's ongoing tightening cycle as we postulated in early October.1 Synchronized global economic and capex growth remain the key macro themes that dominate markets. The latest GDP revisions in the G3 confirm our global capex upcycle bias: U.S., euro area and, especially, Japanese gross fixed capital formation are on fire (Chart 1). Importantly, once the tax bill related dust settles, profits will come back to the forefront as a key stock market driver. In that regard, the news on the EPS front is ebullient and, along with the forward multiple, all that matters. Table 2 shows annual SPX returns going back to 1979, and breaks down the composition of the capital (not total) return into two components: forward earnings growth and the forward P/E multiple (January 1979 is the first IBES data point for forward EPS SPX estimates). Chart 1Synchronized Global Capex Table 2Disentangling SPX Returns Currently, sell side analysts expect 11% EPS growth for 2018, and our sense is that 8-12% EPS growth is achievable next year, a message that our SPX EPS macro model corroborates (Chart 2). Keep in mind that there is no tax cut penciled into our EPS model's numbers. Chart 2SPX EPS Macro Model Flashing Green What is interesting from the multiple/EPS analysis is that over the last four decades when forward profit growth was in this high single-digit / low double-digit range (ten iterations), the multiple expanded modestly (on average, adding 2.6 percentage points to the market's return) and EPS did the heavy lifting (explaining, on average, roughly 80% of the S&P 500's 12.9% average annual return, Table 3). If we consider periods when EPS growth was positive but below 8% (eleven iterations), SPX returns are close to 10%, on average, with EPS and the multiple contributing almost equally to the market's return. One caveat is that two recessionary years and the dot com bust are part of this segment skewing the results to the downside (Table 3).2 Table 3Disentangling SPX Returns Continued Nevertheless, if history at least rhymes, were EPS growth to stay positive next year and hit the 8-12% mark, then a profit driven low double-digit broad equity market return is likely. If profits disappoint and grow between 0-8%, barring recession, empirical evidence suggests that equity returns will still prove healthy. Adding it up, the path of least resistance is higher for equities on a cyclical 9-12 month horizon. Granted, since Brexit the SPX has rallied in a near straight line up and a healthy and temporary pause for breath is likely in Q1/2018. As a result, this week we are booking impressive gains in two tactical market-neutral trades we initiated in late-August and mildly de-risking our portfolio. Lock In Profits In The Long Energy/Short Gold Producers Trade In late-August we initiated a liquidity-to-growth handoff levered market-neutral trade: long S&P energy/short global gold miners. Over the past four months this trade is up 18.3%. It also sports a positive annual dividend carry of 200bps. With the equity market overshoot phase likely going on hiatus sometime in early 2018 is it still prudent to hold this high-octane intra-commodity and market-neutral trade? The short answer is no. Nothing in terms of macro data has changed to trip up this pair trade. If anything, the handoff of global liquidity to economic growth has gained steam in the past few months. Global GDP, IP, manufacturing PMIs, global trade (Chart 3) and gross capital formation are all growing simultaneously across all of the G7 and most of the EMs. Even China's economy seems to have stabilized. The Fed announced its plans to wind down its balance sheet as expected in September and the BoE and BoC have both tightened monetary policy. Even the ECB announced a halving of the size of its monthly purchases in late-October (but extended it for nine months). All these central bank (CB) moves suggest that, at the margin, the global liquidity injection is reversing, with CBs actually mopping up liquidity. This is de facto negative for the shiny metal and gold mining equities as interest rates are headed higher (Chart 4). Chart 3Brisk Global Growth... Chart 4...Higher Rates... Moreover, geopolitical uncertainty is steadily receding, especially now that the Senate also passed a tax bill, and a final bill will likely soon be signed into law.3 Historically in times of duress, safe haven assets are bid up and vice versa, and the current low policy uncertainty backdrop is conducive to additional gains in the relative share price ratio (policy uncertainty shown inverted, Chart 5). Meanwhile, on the relative operating front, energy stocks have the upper hand versus gold miners. The oil and gas rig count has resumed its advance and remains 150% clear of the lows hit during the depths of the global manufacturing recession of late-2015/early-2016. Anecdotes of global oil majors comfortably registering positive EPS, in the new era of $50/bbl oil, and reinstating stock buybacks and eliminating scrip dividends (RDS, BP & ENI) suggest that the worst is behind the industry. In contrast, safe haven asset demand is in retreat and will continue to weigh on global gold ETF flows. Anecdotally, the BITCOIN/ICO/cryptocurrency mania may also steal some of bullion's thunder, as this mania is capturing investor's imagination. Either a flare up in global geopolitical risk or a global growth scare could cause investors to start shifting capital into gold ETFs. Our relative EPS models do an excellent job in capturing this energy positive/gold negative backdrop and continue to suggest that energy profits will outpace gold mining EPS (Chart 6). Chart 5...And Diminishing Uncertainty##br## Still Bode Well For The Trade Chart 6But We Do Not Want To##br## Overstay Our Welcome If these different macro and operational forces all emit an unambiguously bullish signal for S&P energy shares compared with global gold miners, why book profits? Our sense is that there are high odds of a pullback in Q1/2018 and from a portfolio management and risk perspective it is prudent to lock in handsome profits in excess of 18.3% in a four month period. There are high odds that most of these key drivers are reflected in relative share prices versus late-August. Relative valuations are pricier today and technicals are also flashing yellow (bottom panel, Chart 4). We deem that the easy money has already been made in this market-neutral trade, despite the still favorable relative macro backdrop. This was a tactical three-to-six month pair trade that has mostly played out and we would not like to overstay our welcome. Were the broad market pullback to occur in the upcoming quarter, and the ratio to trade significantly lower, we would not hesitate to reinstate this pair trade. Our cyclical strategy is to "buy the broad market dip" and remain opportunistic on a tactical basis. Bottom Line: Lock in 18.3% profits in the long S&P energy/short global gold miners pair trade and move to the sidelines for now. Take Profits In Materials Vs. Utilities Similar to booking gains in the liquidity-to-growth levered market-neutral long S&P energy/short global gold miners pair trade, we also recommend taking profits in the reflation levered long S&P materials/short S&P utilities pair trade. Since its late-August inception this market-neutral trade has generated returns in excess of 8.6% and added alpha to our portfolio. While overall macro conditions continue to underpin the relative share price ratio, some cracks are appearing on the surface. Global reflation has matured and synchronized global growth is as good as it gets. The ISM manufacturing and services surveys have ticked down in sympathy recently, warning that the easy gains are behind this market neutral trade (Chart 7). Worrisomely, our relative sector Cyclical Macro Indicators are sniffing out this marginal shift in the macro backdrop and suggest that a more challenging phase lies ahead for the relative share price ratio (Chart 8). BCA's view remains that a sizable selloff in the bond markets is the most likely scenario in 2018. This is one of our key themes for next year, and given that this trade typically moves in lockstep with interest rates, the path of least resistance is higher. Nevertheless, the fact that this ratio has not kept up with the slingshot recovery in the stock-to-bond (S/B) ratio is slightly disconcerting. The top panel of Chart 9 shows that the gap between the S/B and the materials/utilities ratios has widened further since late-August. Chart 7As Good As It Gets? Chart 8Fatigue Signs Chart 9More Balanced Backdrop=Move To The Sidelines On the operating front, our relative EPS models are also showing signs of fatigue. Materials profits cannot expand indefinitely at the breakneck pace observed since the 2016 trough, at a time when utilities EPS have stabilized. Currently, the relative earnings models suggest that materials are on an even keel with utilities (Chart 9). Tack on rising odds of a healthy broad market pullback in Q1/2018, and from a risk management perspective we would rather de-risk the portfolio a notch by locking in near double-digit gains since inception in this volatile pair trade. Bottom Line: Book gains of 8.6% in the long S&P materials/short S&P utilities pair trade. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Can Easy Fiscal Offset Tighter Monetary Policy?" dated October 9, 2017, available at uses.bcaresearch.com. 2 For reference and completion purposes Table 3 also tabulates the results during EPS contractions (nine iterations) and in profit boom times, i.e. forward EPS growth north of 12% (nine iterations). 3 Please see BCA U.S. Equity Strategy & Geopolitical Strategy Special Report, "Tax Cuts Are Here - Equity Sector Implications," dated December 11, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.