Economy

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

Highlights The economic momentum of China's "mini-cycle" appears to have peaked earlier this year. A benign moderation in growth is the most likely outcome, but this report reviews some factors to watch over the coming year to track the character of the slowdown. This month's Party Congress will hopefully provide investors with some clues whether policymakers have learned from their past mistakes of failing to combine any painful structural reforms with an appropriate amount of fiscal support. Shorter-term measures of money & credit in China are hooking up, and most measures of global growth are still signaling robust export demand. An eventual stabilization in the housing market will be an important signal confirming the benign nature of China's economic slowdown. Investors should remain overweight the MSCI China Free index versus the emerging market benchmark. Feature We reiterated the case for a benign cyclical slowdown of the Chinese economy in last week's report, by highlighting several forces that are working to support stable economic activity.1 Specifically, we noted that: There is presently little risk of aggressive policy tightening on the horizon. There is likely to be reduced downside cyclicality in China's industrial and real estate sectors, owing to the past imposition of "supply side" constraints. External demand will continue to support the Chinese economy, even if global growth momentum moderates. Chart 1 presents a stylized view of the Chinese economy over the past three years, which illustrates our framework of how cyclical growth conditions have evolved over this "mini-cycle". It also highlights three possible outcomes for the coming 6-12 months. Chart 1A Stylized View Of China's Recent 'Mini-Cycle' The chart shows how the Chinese economy began to operate below what investors and market participants considered to be a "stable" pace of growth in early-2015, owing to a "double whammy" of excessively tight monetary conditions and a synchronized global downturn. Policy easing succeeded in sparking a V-shaped rebound in some sectors of the economy (particularly housing), and caused an attendant rally in Chinese relative equity performance (vs EM), emerging market relative performance (vs global), and industrial metals prices. However, based on a number of "hard" growth indicators, the economic momentum of the "mini-cycle" appears to have peaked earlier this year. This raises the question of what is likely to be the character of Chinese economic growth over the coming year, with Chart 1 presenting three distinct scenarios: 1) a re-acceleration of the economy and a continuation of the V-shaped rebound profile, 2) a benign, controlled deceleration and settling of growth into the "stable" growth range, and 3) an uncontrolled and sharp deceleration in the economy that threatens a return to the conditions that prevailed in early-2015 (or worse). Our bet is clearly on scenario 2, but this week's report reviews some factors to watch over the coming year in order to monitor the end of China's mini-cycle and its implications for investment strategy. Policy Risk And The Party Congress China's 19th Party Congress is likely to dominate media headlines about China over the coming two weeks. While it is unlikely that a major, explicit policy announcement will emerge from the Congress, investors are likely to focus on the policy implications of the leadership rotation, as well as any signals from President Xi Jinping's opening speech. Indeed, the next two reports of this publication will be devoted to the Party Congress and our assessment of the economic and financial market impact of the event. Chart 2Bold Action Can Follow ##br##Midterm Congresses We recently published a primer explaining the Party Congress,2 and noted that major new policy initiatives can emerge during the March National People's Congress that follows a "midterm" Party Congress. For instance, Premier Zhu Rongji was appointed to launch the "assault stage" of President Jiang Zemin's reforms of state-owned enterprise at the National People's Congress in March 1998 (Chart 2). Similarly, Hu Jintao's Premier Wen Jiabao launched extensive administrative reforms at the NPC meeting in early 2008. When forecasting the character of Chinese economic growth over the coming year, the relevance of the Party Congress comes into play when assessing whether policymakers have learned from their past mistakes by combining any painful structural reforms with the appropriate amount of fiscal support to manage demand in the economy during the adjustment phase. In the past, policymakers have been preoccupied with the idea that the economy needs painful but eventually rewarding economic reforms, and have viewed short term policy easing as endangering reforms and as a contributor to further structural imbalances. In essence, authorities have in the past cornered themselves into a self-imposed 'either/or' choice between supply-side reforms and demand-side countercyclical policies, rather than pursuing a sensible balance between structural reforms and policy easing to mitigate headwinds. For example, the main pillars of "Likonomics", named after the Chinese premier, were touted as "deleveraging, structural reforms and no stimulus", in stark contrast to the three arrows of Japan's "Abenomics", including fiscal stimulus, monetary easing and structural reforms. For now, our view is that policymakers will provide the fiscal support required for the economy to avoid a potentially sharp downturn were they to aggressively pursue structural reform initiatives, given what occurred in 2015. But this assessment remains a key risk to our view of a benign cyclical slowdown, and we will be watching the Party Congress closely for any indications to the contrary. Domestic Demand Momentum Chart 3Shorter-Term Measures Of ##br##Money & Credit Growth Are Positive We noted above that China's domestic growth momentum is unlikely to decelerate materially, owing to the lack of aggressive policy tightening and the fact that some of China's industries have not experienced a major cyclical upswing (and thus are less likely to experience a major downswing). Supporting this view, shorter-term measures of money & credit in China are hooking up, suggesting that year-over-year measures may soon stabilize (or even accelerate modestly). Chart 3 presents the growth in M2 and two measures of credit, both on a year-over-year and 3-month annualized basis.3 While the latter measure is highly volatile and dependent on a seasonal-adjustment process that may not perfectly capture the seasonal component of Chinese economic data, it should be noted that all three shorter-term measures are at or above their year-over-year rates of change. Despite this, an outsized slowdown in non-supply constrained industries cannot be ruled out, even if it is far from our base case scenario. At a minimum, the potential for severe data disappointments exists, as Chart 4 highlights that the Chinese economy has already been surprising modestly to the downside over the past three months. Disappointing readings from industrial production, retail sales, and fixed-asset investment were particularly noticeable last month, which is in contrast to the steady uptrend in the surprise index that has prevailed since mid-2015. One recent trend that bears particular attention over the coming months is that of a weakening housing market. Chart 5 shows that house prices are beginning to decelerate on a year-over-year basis, and the pace of appreciation in home sales continues to decline. Worryingly, a 70-city diffusion index of house prices is also falling sharply, and to a level that would tend to imply a significant further deceleration in aggregate prices. A moderation in house price appreciation was all but inevitable given the magnitude of the boom over the past 2 years, and is not concerning in isolation (in fact, it reduces risk of escalating tightening measures). But given that home sales and prices were a key bellwether of the efficacy of policymakers' reflationary efforts over the past two years, and given the sharp decline in a broadly measured diffusion index, an eventual stabilization will be an important signal confirming the benign nature of China's economic slowdown. Chart 4Recently Surprising Modestly To The Downside Chart 5A Warning Sign From House Prices Trade, And Global Growth In last week's Foreign Exchange Strategy Weekly Report, our colleague Mathieu Savary explored the potential for "yellow flags" that may herald a slowdown in global growth. A slowdown in global narrow money growth was the most notable of the potential warning signs that he highlighted, which historically has been a leading indicator of global industrial production (Chart 6). It is possible that the deceleration in narrow money growth may correctly forecast a mild slowdown in global trade, which would be negative for Chinese economic growth at the margin. Still, it is very unlikely that a gentle pullback in global growth momentum would be sufficient for China's "mini-cycle" to end in the 3rd scenario highlighted in Chart 1 above (an uncontrolled and sharp deceleration in activity). In addition, narrow money growth is but one global growth indicator among many, several of which are still painting a rosy picture for China's external demand outlook: A GDP-weighted average of our consumer and capital spending indicators for the U.S., U.K., euro area, and Japan are suggesting that global GDP growth will continue to accelerate over the coming year (Chart 7). Barring a decline in global import intensity, this would imply that the acceleration in global export activity is just getting started. Chart 6A 'Yellow Flag' From Narrow Money Growth Chart 7Stronger G4 Growth Will Support China's Export Sector A recent update of our global LEI diffusion index suggests that the LEI itself is unlikely to significantly moderate (Chart 8). This is a notable development, as it somewhat reverses the concerning loss of momentum in the diffusion index that had occurred over the past year. Excluding the U.S., the improvement in the LEI diffusion index is still present, and the uptrend since late-2013 / early-2014 is more clearly defined (panel 2). Finally, both the EM and global PMIs remain in an uptrend, and are either at or near multi-year highs (Chart 9). The resilience of the EM PMI is particularly noteworthy, as much of the improvement in the index reflects the strength of the Caixin China PMI (despite the most recent tick down in the index). In addition, it is an underappreciated point among global investors that the EM PMI correctly forecast the onset of China's "mini-cycle" in 2015, and bottomed several months before the global PMI. The improvement of the EM PMI was sufficient to help catalyze a synchronized global economic recovery, despite having persistently lagged the global PMI in level terms. Chart 8A Positive Sign From Our Global LEIs Chart 9Manufacturing PMIs Are Not Heralding ##br##A Sharp Decline In Activity The Investment Strategy Implications Of A Benign Slowdown In China Taken together, the evidence noted above is more consistent with a benign end of China's mini-cycle than an uncontrolled and sharp deceleration in the economy. We will continue to track the pace of moderating economic activity, and will adjust our investment recommendations accordingly if China slows more aggressively than we expect. But for now, we see no reason to alter our constructive view on Chinese equities, suggesting that investors should remain overweight the MSCI China Free index versus the emerging market benchmark. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Pease see China Investment Strategy Special Report "On A Higher Note," dated October 5, 2017, available at cis.bcaresearch.com 2 Pease see China Investment Strategy Special Report "China's Nineteenth Party Congress: A Primer," dated September 14, 2017, available at cis.bcaresearch.com 3 For the latter measure we use a seasonal-adjustment methodology employed by the U.S. Census Bureau to adjust all three series prior to calculating the 3-month annualized rate of change. Cyclical Investment Stance Equity Sector Recommendations

Highlights Looking into 2018, the major risk factors driving gold - inflation and inflation expectations; fiscal and monetary policy; and geopolitics - will, on balance, continue to favor gold as a strategic portfolio hedge. We expect gold will provide a good hedge against rising inflation. However, this will be partially mitigated by Fed rate hikes next year. On the back of tighter U.S. monetary policy, our macroeconomists expect a recession by 2H19, possibly earlier in 2019, which likely would be sniffed out by equity markets as early as 2H18. Our analysis indicates gold will provide a good hedge against this expected recession and the associated equity bear market.1 Lastly, geopolitical risks from (1) U.S.-North Korea tensions, (2) trade protectionism of the Trump administration and (3) ongoing conflicts in the Middle East will support gold prices next year, given the metal's safe-haven properties. Energy: Overweight. At the end of 3Q17, our open energy recommendations were up 45%, led by our long Dec/17 WTI $50/bbl vs. $55/bbl Call spread. We closed out our long Brent recommendations in 3Q17 for an average gain of 116%. (Please see p. 13 for a summary of trades closed in 3Q17). Base Metals: Neutral. Our tactical short Dec/17 copper position ended 3Q17 up 6%. We are placing a trailing stop at $3.10/lb. Precious Metals: Neutral. Our long gold portfolio hedge ended 3Q17 up 4.3%. The balance of risks continues to favor this as a strategic position, which we discuss below. Ags/Softs: Neutral. We lifted our weighting on ags - particularly grains - to neutral last week. Our long corn/short wheat position is up 1.2%. Feature Chart of the WeekInflation And U.S. Financial Variables##BR##Explain Gold Prices Inflation and U.S. financial variables - particularly the USD broad trade-weighted index (TWIB), and real rates - are the main factors explaining the evolution of gold prices (Chart of the Week).2 Subdued inflation and low unemployment - a decoupling of the so-called Phillips Curve relationship that drives central-bank models of the macroeconomy - have dominated the macro landscape this year (Chart 2). We expect that current low inflation, positive growth, and low interest rates will remain in place for the next 12 months (Chart 3). Although economies such as the U.S. are growing above trend, inflation has remained weak due to a redistribution of demand through imports from countries with spare capacity, according to BCA's Global Investment Strategy.3 This is expected to continue in the near term to end-2018. However, we expect the USD to gradually strengthen, as the Fed cautiously normalizes policy rates, while other systemically important central banks remain accommodative relative to the U.S. central bank (Chart 4). Further falls in the unemployment rate will push the U.S. economy into the steep end of the Phillips Curve. Weak capex in the post-Global Financial Crisis (GFC) era means demand for labor will increase as low unemployment - and associated higher wages - encourage higher consumer spending. This will cause inflation to lift next year or early 2019. Chart 2A Decoupling Of The Phillips Curve Relationship? In such an environment, any U.S. tax cuts - which we still expect by the end of 1Q18 - will simply add fuel to the inflationary fire, and lift inflation expectations for next year and beyond. As BCA's Geopolitical Strategy team puts it, the tax cuts are a "form of modest stimulus ... (which), this far into the economic cycle, could have a significant effect."4 With unemployment at or below levels consistent with full employment in the U.S. and little slack of any sort, it would not take much in the way of fiscal stimulus to further pressure inflation. Chart 3No Pressure From Inflation Or U.S. Financial##BR##Variables...For Now Chart 4A Strengthening U.S. Dollar Will##BR##Keep The Pressure Off Gold Inflation vs. Fed Hikes In the face of the rising inflation we expect next year, gold's appeal will increase. As our previous research reveals, gold's correlation with inflation is strengthened during periods of low real rates, i.e., the difference between nominal rates and inflation. This is a perfect context for gold. However, gold's ability to hedge inflation risks to portfolios will be partially hampered by a more-hawkish Fed. As inflation finally takes off, the Fed will feel confident to hike rates more aggressively. More than anything, this will put a bid under the USD, as U.S. interest-rate differentials vs. other currencies rise in favor of the dollar. In addition, real rates will rise as the Fed gains confidence it can lift policy rates without doing serious harm to the U.S. economy, and follows thru with its normalization. Thus, the gold market will be facing two opposing forces: On the one hand, gold will be an attractive inflation hedge as inflationary pressures build up. On the other, as the Fed begins to tighten to respond to those inflationary pressures, gold will lose its appeal in the face of rising real rates and a strong dollar. Chart 5Fed Will Ease Pressure Off Gold##BR##If It Gets Ahead Of Inflation The timing of the Fed's rate hikes will be critical to the evolution of gold prices next year and beyond. We previously assumed that rate hikes will remain behind wage growth, which would be supportive of gold prices as inflation picks up. However, if the Fed begins hiking ahead of any realized uptick in inflation, this would create a stronger-than-expected headwind for gold (Chart 5). While we expect inflation to take off in 2H18, our House view calls for 2 to 3 hikes by then. This is a risk to our gold view. Longer term, Fed rate hikes could trigger a feedback loop that will make it difficult for the U.S. central bank policy to support low unemployment rates. As real rates rise, increased unemployment will lead households to spend less. Lower demand will force firms to reduce hiring. The accompanying slowing of U.S. growth will disseminate to the rest of the world, pushing the global economy into a shallow recession as early as 2H19. In all likelihood, this higher-inflation/higher-policy-rate period will be sniffed out by equity markets before the economy actually enters a recession, leading to a bear market. Somewhat counterintuitively, this will favor gold as a portfolio hedge, as we discuss below. Bottom Line: As U.S. unemployment continues falling, inflation will re-emerge, as predicted by the Philips Curve trade-off so important to central-bank policy. Gold then will face two opposing forces. Its inflation hedging properties will be partially hamstrung by rising real U.S. rates and a strengthening USD. Nevertheless, we will turn bullish gold towards the end of next year as signs of an equity bear market emerge. Gold Will Outperform In An Equity Bear Market Our modelling indicates gold is an exceptional safe-haven during downturns in equity markets.5 It is especially attractive in equity bear markets because its returns during such episodes are negatively correlated with the U.S. stock market. This relationship with equities does not hold in bull markets -- gold prices typically rise during such periods, but at a slower rate than equities (Table 1). Table 1Gold's Ability To Hedge U.S. Equities In a Special Report titled "Safe Havens: Where To Hide Next Time?" BCA's Global Asset Allocation Strategy team looked at the performance of nine safe-haven assets and found, on average, they are negatively correlated with equities in every bear market since 1972.6 Although the current equity bull market still has room to run, recessions and bear markets tend to coincide (Chart 6). If the economy goes into recession in 2H19, equities could peak as early as the end of next year.7 Chart 6Bear Markets Usually Precede Recessions Gold's role as a global portfolio hedge during bear markets would thus support the hypothesis that the metal could enter a bull market as soon as end-2018 when equity markets start pricing in a recession (Chart 7). Things could get interesting at this point, since a clear indication the economy is entering into a recession likely will cause "traumatized" central bankers to turn overly dovish. This would add support to the gold market longer term.8 Chart 7Gold Outperforms During Recessions##BR##And Geopolitical Crises Correlations between safe havens decline during bear markets, as our GAA strategists found when they compared correlations by dividing the assets into three "buckets": currencies, inflation hedges, and fixed-income instruments. In this analysis, our GAA team found that gold outperformed TIPS and Farmland in the inflation-hedge bucket.9 Bottom Line: Gold is an exceptional hedge against downturns in equity markets. The bear market preceding the late-2019 recession we expect will put a bid under gold. The eventual turn to the dovish side by central bankers will further support the metal. Gold Will Hedge Geopolitical Risks A confluence of elevated geopolitical risks next year will drive part of gold's performance. BCA's Geopolitical Strategy (GPS) group has highlighted the following three themes investors need to track going into next year: U.S.-China Tensions: Our geopolitical strategists believe that the Korean conflict is a derivative of a more important secular trend of U.S.-China tensions. They estimate the risk of total war on the Korean peninsula at less than 3% and believe that the market impact of North Korea's provocations has peaked in the late summer. Nevertheless, they warn against complacency, as the underlying tensions over Pyongyang's nuclear program remain unresolved and North Korea could break with its past patterns.10 If the North stages attacks against U.S. or Japanese assets, or international shipping or aircraft, for instance, it could cause a larger safe-haven rally than what we witnessed earlier this year. At the very least, geopolitically induced volatility may return as U.S. President Trump tries to convince the world that war is a real option - a critical condition for establishing a "credible threat" of war with which to influence North Korean behavior - and as the U.S. and China spar over other issues. Trump's protectionism: Trump's campaign promised significant trade-protectionism. While he has not yet acted on those promises, the risk is that he returns to them next year.11 These policies could impact the gold market by: a. Feeding fears that the United States is abandoning the global liberal order; b. Intensifying U.S. trade tensions and strategic distrust with China; c. Pressuring U.S. domestic inflation via higher import prices. This risk will become even more elevated if the Trump administration and Congress fail to pass any tax legislation this year. Our geopolitical strategists believe that such a failure, while not their baseline scenario, would drive Trump to focus on his foreign policy and trade agenda more intently, especially ahead of the midterm elections in November next year, which would increase safe-haven flows. 3. Mideast Troubles: While we are not alarmist about the Middle East, the risk of market-relevant conflicts will be higher over the coming 12 months than over the previous year, following the fall of ISIS. The latter gave reason for various regional powers to cooperate, while its absence will revive their grievances with each other. Kurdish assertiveness is a key consequence, highlighted by last month's Kurdish independence referendum.12 Iraqi forces have pushed ISIS out of major Iraqi cities and the slowdown in the fight against ISIS could push Iraqi forces to focus on regaining the province of Kirkuk. Kirkuk, which is home to major oil fields and reserves, has been under Kurdish control since 2014 when the Peshmerga forces there captured it from ISIS. As ISIS ceases to be a threat, Baghdad will try to regain control of these precious oil fields. The Kurdish conflict, as well as Trump's pressure tactics against Iran, will increase geopolitical risks in oil-producing (hence market-relevant) areas. Chart 82017 Risks Were Overstated In a recent study investigating how different "safe-havens" assets react to political and financial events, our GPS colleagues found that gold provides the best average returns following a major geopolitical event (Chart 7).13 Our House geopolitical view has maintained that political risks in 2017 were overstated. This was particularly the case in Europe, where much of the risk was exaggerated and merely the product of linear extrapolation from the outcomes of the U.K. referendum on EU membership and the U.S. presidential election. As such, we do not expect any European break-up risk to support gold prices next year. Although elevated Italian Euroscepticism is one lingering European risk that could impact gold markets, we see this as a long-term risk rather than a market catalyst arising from the Italian general election in May next year. Reflecting our view, the policy uncertainty index has fallen drastically in the last two months (Chart 8). Bottom Line: Elevated political risks in 2018 will further support the gold market. Most notable on our geopolitical strategists' minds are continued U.S.-China tensions (most notably over Korea), Trump's protectionist policies, and potential conflicts in the Middle East. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com Hugo Bélanger, Research Assistant HugoB@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report "Go Long Gold As A Strategic Portfolio Hedge," dated May 4, 2017, available at ces.bcaresearch.com. 2 Our results show 1% increase in U.S. YoY CPI, 5 year real rates, and USD TWI are associated with a 4% increase, 0.18% decline and a 0.21% decline in gold prices, respectively. The adjusted R2 is 0.88. 3 Please see the Global Investment Strategy Outlook "Fourth Quarter 2017: Goldilocks And The Recession Bear," dated October 4, 2017, available at gis.bcaresearch.com. 4 Please see Geopolitical Strategy Weekly Report "Is King Dollar Back," dated October 4, 2017, available at gps.bcaresearch.com. 5 We use the S&P 500 Total Return (TR) index as a proxy for U.S. equities. 6 Please see Global Asset Allocation Special Report "Safe Havens: Where To Hide Next Time?," dated April 21, 2017, available at gaa.bcaresearch.com. 7 Please see Global Asset Allocation Quarterly Portfolio Outlook, dated October 2, 2017, available at gaa.bcaresearch.com. 8 Please see the Global Investment Strategy Outlook "Fourth Quarter 2017: Goldilocks And The Recession Bear," dated October 4, 2017, available at gis.bcaresearch.com. 9 Please see Global Asset Allocation Special Report "Safe Havens: Where To Hide Next Time?," dated April 21, 2017, available at gaa.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Weekly Report, "Insights From The Road - The Rest Of The World," dated September 6, 2017, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 12 Armed conflict in the Middle East usually lead to a sharp rally in gold prices. Please see Table 1 from Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?," dated August 16, 2017, available at gps.bcaresearch.com. 13 Please see Geopolitical Strategy Special Report, "Geopolitics And Safe Havens," dated November 11, 2015, available at gps.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016

Dear Client, This week, in addition to this regular Geopolitical Strategy Weekly Report, we decided to send you a collaborative report we penned with BCA's Energy Sector Strategy. My colleague Matt Conlan runs the service, which blends BCA's macroeconomic framework with his bottom-up expertise in the energy sector. Matt's service is one of the few that our firm publishes with specific company recommendations. In the report titled "King Salman Goes To Moscow, Bolsters OPEC 2.0," Matt argues that the emerging détente between Russia and Saudi Arabia will strengthen OPEC 2.0 and provide a structural tailwind for BCA's bullish view on energy. I highly recommend that you check out the research Matt and his team produce at nrg.bcaresearch.com. All the very best, Marko Papic Senior Vice President, Geopolitical Strategy Highlights Easier fiscal policy and tighter monetary policy is bullish for U.S. equities; The Dec. 12 Alabama Senate race could be a game changer in U.S. politics; Trump's anti-immigration policies could boost inflation; Our Catalan view is bearing out. Go long Spain's IBEX 35 / short Eurostoxx 50. Separately, book profits on our China volatility trade and our long China big bank trade. Feature "Buy In May And Enjoy Your Day!" has been our mantra throughout the summer. Despite the doom and gloom in the media surrounding the Mueller investigation, North Korea, Trump's legislative agenda, the French elections, Brexit, and so on, the S&P 500 is up 16% and global equities are up 10.8%. Our April 23 Weekly Report bearing the same cheery title focused on three overstated risks:1 European politics - massively overstated; U.S. politics - all noise, no signal; Brexit - irrelevant for global investors. We have also cautioned investors throughout the year to worry, but not to obsess, about North Korea. Yes, it is a risk.2 Yes, it will continue to buoy safe haven assets on occasion.3 But it is extremely unlikely to produce total war and therefore has lost some market relevance as assets have adjusted to the higher geopolitical volatility on the Korean Peninsula under the Trump regime.4 We are not reiterating these calls just to pat ourselves on the back. Rather, our point is to emphasize that there is nothing supernatural about the ongoing bull market. It has not "ignored" geopolitical risks. Rather, geopolitical risks on hand have not developed in a market-relevant way. The bottom line here is that geopolitics is not voodoo. It is not an "error term," a disturbance in an elegant model that can go awry at any moment because "one cannot forecast politics." Investors can systematically analyze geopolitics just as they do the economy or the markets. When geopolitical risks are overstated, as they have been since the beginning of the year, recognizing the mispricing can generate significant alpha. Going forward, however, geopolitics will likely play a headwind for the market. We are particularly concerned with three dynamics: The upcoming party congress in China may signal a shift towards more growth-stalling reforms, as we have been writing all year. The Trump administration could make a hard turn towards a more populist agenda, particularly on trade, if it fails to enact any legislative successes this year. A plethora of political risks in emerging markets (EM) - with the usual suspects of Brazil, South Africa, and Turkey on top of our list - could re-surface in 2018 if China is not firing on all cylinders. We will be focusing on these three risks to markets until the end of 2017 and beyond. This week, however, we focus on upcoming tax legislation in the U.S. First, a reason to be optimistic ("easier fiscal policy, tighter monetary policy" is a winning policy combination). Then, a reason to be pessimistic (Alabama). Finally, a few words about inflation from a political perspective and a quick word on Catalonia. Easy Fiscal, Tighter Monetary Policy Mix - What Does It Mean? If our base case view on tax legislation is correct, U.S. equities should gain double-digit returns from current levels. Our colleague Anastasios Avgeriou, Chief Strategist of BCA's U.S. Equity Strategy, believes that the passage of stimulative tax legislation would serve as a catalyst to further fuel the blow-off phase in equities. In his latest Weekly Report, Anastasios presents empirical evidence suggesting that easy fiscal policy outweighs the drag from Fed interest rate tightening.5 Filtering the post-World War Two era for periods of easing fiscal and tightening monetary policies during economic expansions is revealing. Anastasios defines easy fiscal policy as periods with a positive fiscal thrust and tight monetary policy as a rising fed funds rate. Fiscal thrust is the year-over-year change in the cyclically-adjusted fiscal balance as a percentage of potential GDP (shown inverted on the bottom panel of Chart 1). While such a policy mix is a rare occurrence, it has happened seven times since the mid-1950s (shaded areas, Chart 1).6 All iterations resulted in positive returns, with the SPX rising on average by over 16%. Table 1 details all seven periods that have an average duration of 16 months. For sectoral implications of such an "easier fiscal, tighter monetary" policy mix, we encourage our clients to peruse the work of BCA's U.S. Equity Strategy. On the other hand, the demand for fiscal stimulus usually rises during times of high volatility, unlike today (Chart 2). Investors have become acutely aware of the political difficulties of stimulating the economy late in the economic cycle. We now turn to some emerging risks to our sanguine view on tax policy. Chart 1Easy Fiscal + Tight Money##br## = Buy SPX Table 1SPX Returns During Periods Of Loose##br## Fiscal And Tight Monetary Policy Chart 2Fiscal Stimulus Usually##br## Comes With High Volatility Bottom Line: If our base case view holds, and Republicans pass mildly stimulative tax legislation, the blow-off phase in equities should continue. "Alabama, You Got The Weight On Your Shoulders" The market continues to doubt that the Trump administration can pass significant tax legislation over the next six-to-nine months. The gap in the probabilities assigned to such an outcome by the market and ourselves has narrowed over the past two weeks, generating alpha on several of our "Trump Reflation" trades (Chart 3). But skepticism abounds. Chart 3Signs Of Life For 'Trump Reflation' Trades We have spent the entire year pushing against the skepticism, but there is now an actual reason to worry. The December 12 Alabama Senate special election - being held to elect a replacement for former Senator Jeff Sessions, now the U.S. Attorney General - has become a premier league event. Former Alabama Chief Justice Roy Moore won the Republican primary against a candidate backed by the Republican establishment and President Trump. The reason the Alabama special election is of global significance is because the Republicans are already down to essentially 50 votes in the Senate. The rhetorical war between President Donald Trump and Senator Bob Corker (R - Tennessee) has reached epic proportions, with the latter insinuating via twitter that the president was an adult baby. Corker has announced his retirement from the Senate, which increases the probability that he will go out by refusing to support the president's agenda across all fronts.7 This now makes two GOP senators that want nothing to do with President Trump's agenda. John McCain (R - Arizona) has harbored ill will since the presidential campaign and has twice played the spoiler in the effort to repeal Obamacare. Further complicating matters is the role of former White House Chief Strategist Steve Bannon, who strongly backed Moore when nobody in the Republican establishment would. If Moore should remain loyal to Bannon beyond the election, it would mean that Trump's former campaign strategist would become the kingmaker on tax legislation. Bannon's departure from the White House was cheered by the markets, as it signaled victory for the "Goldman Sachs clique" and the trio of generals managing President Trump's foreign policy over Bannon's populist "Breitbart clique." We do not think that Bannon is opposed to stimulative tax policy. Yes, he has branded his ideology "economic nationalism," but his media empire, Breitbart, has so far stayed away from attacking the Republican tax plan. Instead, Bannon and Moore could hold out on supporting tax policy until they see movement on other pillars of the populist agenda, namely on immigration policy. As such, Moore's Alabama victory would complicate the horse-trading surrounding tax legislation, and elevate Bannon's standing on Capitol Hill, but it would not be a death knell for stimulus. The actual death knell for tax reform would be if Moore actually lost the December 12 Alabama special election. Moore's views are generally considered to be staunchly conservative, even for Alabama, and therefore a shock defeat cannot be ignored.8 Polls are limited, but most show Moore leading the Democratic candidate Doug Jones by only 5%-8%. This in a state where Republican Senate candidates have defeated their Democrat counterparts by an astounding average of 36% in the last decade! If Jones were to win, Republicans would be down to 51 Senators. Given the staunch opposition to Trump by Corker and McCain, this would effectively end the tax legislation push. Not all is negative for the tax push in Washington. The U.S. House of Representatives has passed a budget resolution that includes steep spending cuts as well as reconciliation instructions for tax legislation. This now sets in motion the reconciliation process by which Republicans can pass tax legislation with merely 51 votes in the Senate. Of the 18 GOP representatives who voted against the budget resolution, only three were from the 31-member Freedom Caucus, which is rhetorically committed to fiscal conservativism. This is very bullish for tax cuts as it means that the Freedom Caucus is toeing the line of its Chair Mark Meadows (R - North Carolina) who has been hinting since the spring that he would have no problem with budget-busting tax cuts. The majority of Republicans who voted against the budget resolution were from highly-taxed "Blue States," suggesting that the real point of contention for Republicans in the House was the proposal to end the state and local tax deduction. Treasury Secretary Steven Mnuchin has already signaled that the White House is willing to compromise on this particular revenue offset. Bottom Line: The December 12 Alabama special election now has global market relevance. A defeat for GOP candidate Roy Moore would be a massive game changer. It would reduce the Republican majority in the Senate to 51 votes, putting in danger President Trump's tax agenda given the staunch opposition from Senators Corker and McCain. What Can Politics Do To Inflation? The greatest surprise to the markets this year has been lackluster inflation data in the U.S. Both headline and core data have been disappointing (Chart 4). This is particularly puzzling as the U.S. has closed its output gap and unemployment has fallen below the low reached in 2007 (Chart 5). Chart 4U.S. Inflation Has Disappointed... Chart 5...Which Is Puzzling At Full Employment One possible explanation is that the U.S. has been importing deflation from abroad. The U.S. imports around 12.5% of GDP worth of goods and 2.8% of GDP worth of services (Chart 6). However, the import price deflator has been growing at 2.7% so far this year and yet inflation has been nonexistent (Chart 6, bottom panel). Export prices have grown by 5% in 2017, from the lows of -15% amidst the commodity bust in 2015 (Chart 7). Chart 6The U.S. Is Not Importing Deflation Chart 7Global Export Prices Are Rising Another explanation is that structural changes in the labor market - globalization and the fall in the unionization rate - have eroded the bargaining power of workers (Chart 8). When combined with the shock of the 2008 Great Recession, workers may simply be happy to have a job and are therefore delaying asking of a raise or switching to a higher-paying, but higher-risk, job. As a result, the economy may have closed its output gap, but with no inflationary effects coming from the low unemployment figures. Chart 8Globalization Suppressed U.S. Wages Further restricting wage gains may be the high number of migrants - legal or illegal (Chart 9). The foreign born population in the U.S. is at an all-time high of 43.2 million, although unauthorized migration has come down from around 12 million prior to the GFC to 11.3 million in 2016. The conventional wisdom is that most immigrants are uneducated, competing with blue collar laborers and suppressing wages at the lower income levels. However, this is a stereotype stuck in the 1980s. Today's migrants are as educated as Americans: 29.7% have a Bachelor's degree or higher, compared with just over 30% Americans in general (Chart 10). Chart 9Immigration Helps Explain Weak Wage Growth Chart 10Immigrants Not Stealing Low-Skill Jobs The point is that immigration has evolved along with the U.S. economy. With 78% of the U.S. economy based in services, the modern migrant has had to keep up with the educational requirements of the American job market. The Trump administration could be a game-changer for the skilled, legal immigration into the U.S. First, President Trump ordered a full review of the high-skilled, H-1B immigration visa in April. Second, President Trump asked Congress in August to curb legal migration by sharply curtailing family reunification while keeping immigration based on job skills roughly the same. Third, anti-immigrant rhetoric - as well as restrictions to family reunification down the line - could influence highly-skilled migrants to choose job opportunities in countries like Australia, Canada, and New Zealand, instead of in the U.S. Bottom Line: Investors often think of fiscal policy as the main vehicle through which politicians can influence inflation. However, the U.S. economy has been enjoying, since the 1980s, the combined effect of rapidly expanding immigration and a parallel increase in the educational attainment of incoming migrants. In a way, the influx of skilled migrants has been an important supply side reform for the U.S. economy. The Trump administration could influence immigration either directly, through policies to curb it, or indirectly, through creating a general atmosphere that redirects some of the flows to other developed economies. Spain: Fade Catalan Risks As we have expected since 2014, the prospects for Catalan independence remain slim.9 As we go to press, Catalan President Carles Puigdemont has backed away from his earlier hints toward a unilateral declaration of independence. Instead, he has succumbed to domestic and international pressure and told the regional parliament that he has "suspended" any declaration in order to begin negotiations with Madrid. Puigdemont's decision to suspend something that has not happened is not only illogical but also ineffectual. The Catalan pro-independence government is trying to force Madrid to be the "bad guy" and refuse negotiations; Spain has refused any discussion of independence. But slight narrative shifts and "gotcha" politics will not work in this case. While Puigdemont is playing checkers with Spanish Prime Minister Mariano Rajoy, the rest of Europe is playing chess. International recognition of Catalan independence is not forthcoming. And without it, Catalonia will not become independent. As we have extensively written, we strongly believe that investors should fade secessionism risk in Spain. First, the independence process in Catalonia falls far short of the democratic ideals established in similar referendums in the developed world, particularly in Scotland (2014), Montenegro (2006), and Quebec (1980 and 1995) (Table 2). The pro-independence government has been unable to significantly boost turnout figures from 2014, no doubt due to interference by the federal authorities. However, even if the pro-independence Catalans were to receive mediation from the EU, the outcome would likely be to strengthen Madrid's hand. For example, when the EU negotiated the 2006 divorce between Serbia and Montenegro, it required a supermajority of 55% in order to recognize the result of the Montenegro independence referendum. As an integrationist project, the EU has an anti-secession bias. Table 2Catalan Independence Demand Exaggerated By Low Voter Turnout Second, the French government has come out forcefully against Catalan independence, as we suspected it would. This is particularly important for Catalonia as it is nestled between Spain and France.10 It is quite likely that, were Catalans somehow to enforce their independence, both European powers would close their borders to Catalan travel and trade. In addition, French European Affairs Minister Nathalie Louiseau has repeated Madrid's assertion that by choosing independence Catalonia would automatically be kicked out of the EU. Third, Madrid is unlikely to make another mistake as the disastrous attempt to disrupt the independence referendum. Images of civilians being dragged through the streets of an advanced European economy while attempting to vote - even if the referendum was constitutionally illegal - shocked the world. Spanish officials have already offered rather tepid apologies for the police action, suggesting that a re-run of the heavy-handed actions is not to be expected. For investors who disagree with us, we suggest an empirical way to test our thesis. Chart 11 shows that only 34.7% of Catalans support independence. These are not pro-Madrid polls. They are the product of the Centre d'Estudis d'Opinió, which is affiliated with the Catalan (currently staunchly pro-independence) government and has been conducting polls on the issue of independence since 2005. Even if the level of support for independence is off in this data, the direction gives us valuable insight into the support for secession. The data clearly suggests that (A) the majority of Catalans have never supported independence and that (B) support for independence peaked in 2013, at the height of Spain's economic crisis, and has been in steady decline since then. That said, Chart 11 also shows that the other 57.5% of Catalans are not necessarily "pro-Spain." In fact, 30.5% support Catalonia remaining in its current form of an autonomous region, with considerable sovereignty devolved to the province. Another 21.7% favor a federal state, which would be a step in the direction of even greater sovereignty. Investors should watch the polls to see whether voters who previously favored federal or autonomous status have begun to shift towards independence, especially in light of the crackdown against the referendum by Madrid. Centre d'Estudis d'Opinió normally releases its third series of polls in October, which would mean that investors will have an update from the official polling agency soon. That said, we are willing to put our geopolitical views on the line. An unwarranted selloff in Spanish equities on the back of increased Catalonia-related geopolitical risk has created an opportunity for a market neutral trade: long Spanish IBEX 35/short Eurostoxx 50. This is a market neutral way to express our view that Catalonia does not pose a grand geopolitical risk as it will remain an integral part of Spain and thus the EU. Importantly, adding a hedge to this pair trade would also make sense for certain investors. Chart 12 shows that EUR/USD and relative Spanish equity performance are joined at the hip. Currently an uncharacteristically wide gap has opened. Thus, putting on this equity pair trade and simultaneously going short EUR/USD on the expectation of a convergence, should generate alpha, as the geopolitical dust settles. Chart 11The Silent Majority Fears Independence Chart 12Expect A Convergence Bottom Line: Fade geopolitical risks in Spain. For those with risk appetite, buy Spanish equities at any sign of geopolitical risk premium. Housekeeping With the Communist Party convening for the nineteenth National Party Congress over the next week, we think the time is opportune to book profits on two trades: our long China ETF volatility index, for a gain of 17.72%, and our long Chinese Big Five state-owned banks versus small and medium-sized banks, for a gain of 11.63%. We will revisit these trades in an upcoming report. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day," dated April 26, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Insights From The Road - The Rest Of The World," dated September 6, 2017, available at gps.bcaresearch.com. 5 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. 6 Omitted from the sample are brief periods in the early-1960s, early-1970s, and twice in the early-1980s as they were very close to the end of recessions. 7 We suspect that Senator Corker is planning a centrist challenge to President Trump in the 2020 GOP presidential primaries. 8 "Staunchly conservative" does not do justice to Moore's ideological orientation. He was removed from his position as Chief Justice of the Alabama Supreme Court twice for failing to follow federal law. In both cases, Moore chose to inform his actions as the Chief Justice through Biblical scripture, rather than the U.S. Constitution. 9 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014, available at gps.bcaresearch.com. 10 Yes, we are aware that Catalonia also borders Andorra. However, given that French President Emmanuel Macro is the co-prince of Andorra, and that Andorra is a microstate, this fact is largely irrelevant and would in no way aid Catalan independence. However, you have now learned that the French President is automatically a co-prince of another country. And that there is such a thing as a "co-prince." Therefore, this footnote has not been a complete waste of your time.

Highlights Duration: The global economic recovery is more synchronized than at any time since 2011. This suggests that foreign demand will be less of an impediment to the bond bear market and that Treasury yields will rise once U.S. data start to surprise on the upside. Stay at below-benchmark duration. MBS: Agency MBS option-adjusted spreads have widened significantly and no longer look expensive. With Treasury yields moving higher and mortgage refinancings likely to stay depressed, we advise upgrading MBS from underweight to neutral. Economy & Inflation: The U.S. economic data are starting to outperform beaten-down expectations. Survey data point to further GDP acceleration in the second half of this year and we expect inflation will soon follow growth higher. Feature Chart 12-Factor Treasury Model The relationship between the global breadth of economic growth, the value of the dollar and the outlook for Treasury yields has been a running theme in this publication.1 To summarize, stronger global growth pressures bond yields higher (and vice-versa). But how that growth is distributed across different countries matters as well. For example, if global growth is mostly concentrated in the U.S., then yield spreads will widen between the U.S. and the rest of the world and the dollar will appreciate as money pours in from overseas. Investors then respond to a stronger dollar by downgrading their U.S. growth and rate hike expectations. This caps the upside in long-dated U.S. Treasury yields. Conversely, if global growth is more evenly spread out throughout the world, then the dollar will come under less upward pressure when U.S. growth accelerates and Treasury yields can rise further. We developed a simple two-factor model to show how the trade-off between global growth and the exchange rate impacts the U.S. 10-year Treasury yield (Chart 1). The model uses the Global Manufacturing PMI as its proxy for global growth and a survey of bullish sentiment toward the dollar as its proxy for growth synchronization. So far this year, the Global PMI has moved higher and sentiment toward the dollar has become less bullish. Both developments have bond-bearish implications and our model now pegs fair value for the 10-year Treasury yield at 2.65%, 28 bps above the current 10-year yield. In Sync The Global PMI came in at 53.2 in September, the same as in August, but still a strong reading compared to recent history (Chart 2). But the most stunning detail of the September PMI releases is that 33 out of the 36 countries we track had PMIs above the 50 boom/bust line. As a result, our Global PMI Diffusion Index hit 90% for only the second time since 2011 (Chart 2, panel 1). The elevated reading of our diffusion index leads us to two market related observations. First, stronger growth outside of the U.S. explains why the 10-year Treasury yield is only 8 bps lower than at the start of the year despite U.S. economic data that have severely undershot expectations (Chart 2, bottom panel). Second, it suggests that when U.S. economic data inevitably start to surprise on the upside - a process which is only now beginning (see Economy & Inflation section below) - the dollar will appreciate by less than it would have when our PMI diffusion index was near 50. This removes a huge impediment from the bond bear market. In Chart 3 we see that the recent peak in 7-10 year U.S. bond yields occurred at 2.54% on Dec 16th. On that same date the spread between 7-10 year U.S. bond yields and average 7-10 year yields in the rest of the world was 178 bps, and bullish sentiment toward the dollar was above 80%. With the global recovery now more synchronized than it was last year, we anticipate that by the time U.S. yields take out that prior peak, the yield spread and dollar bullish sentiment will still be lower than they were last December. This means that less foreign capital will be encouraged into the U.S. and yields will rise even further. Chart 2Broad Based Recovery Chart 3Spreads Less Of A Constraint Where Is Growth Coming From? Considering the major economic blocs, the biggest change during the past year has been the surging Eurozone PMI (Chart 4). The U.S. PMI is still firmly above the 50 boom/bust line but has actually moderated in 2017. The Japanese PMI is similarly entrenched above 50 and while the Chinese PMI was weak earlier this year, it has rebounded during the past four months. At roughly 20%, China carries the largest weight in the Global PMI. The outlook for the Chinese economy is therefore crucial for the path of bond yields. On that note, while the Chinese PMI has been strong in recent months, a couple of warning signs are beginning to flash (Chart 5). Chart 4Global Manufacturing PMIs Chart 5Chinese Monetary Conditions Commodity prices - which correlate strongly with Chinese PMI - have declined since early September, although they remain above levels seen last year and do not yet pose a major risk. What's more important is that monetary conditions are starting to tighten (Chart 5, panel 2). If tighter monetary conditions persist, then we should expect growth to slow. The mild tightening in monetary conditions that has already occurred will probably lead to some near-term moderation in Chinese growth. But our China Investment Strategy service thinks it's unlikely that monetary conditions will tighten enough to cause a meaningful slowdown.2 Our China strategists note that with GDP growth within the government's target range, inflation exceedingly low and signs that financial excesses have been reigned in, there should not be much appetite for draconian policy tightening. We would also add that the causes of this year's tightening in monetary conditions have been relatively benign. The monetary conditions index shown in Chart 5 has fallen because the trade-weighted RMB is no longer depreciating and because real interest rates have moved a tad higher. Crucially, the RMB has only stabilized, it is not appreciating in trade-weighted terms. Also, the nominal policy rate remains flat at a low level. The increase in real interest rates resulted purely from weaker consumer price inflation. Bottom Line: The global economic recovery is more synchronized than at any time since 2011. This suggests that foreign demand will be less of an impediment to the bond bear market and that Treasury yields will rise once U.S. data start to surprise on the upside. Stay at below-benchmark duration. Buy The News In MBS Last week we upgraded our allocation to Agency MBS from underweight to neutral, noting that spreads had become more attractive during the past few months. In all likelihood this is the result of the market pricing in the wind-down of the Fed's balance sheet.3 With the Fed's plans now well known (and unlikely to change), there is an opportunity to increase MBS exposure from a more attractive starting point. After having sold the rumor, we think it's time to buy the news. The Value Proposition Chart 6OAS Look Attractive To be clear, we are not forecasting stellar excess returns from Agency MBS. But with spreads compressed across the entire U.S. fixed income universe, we would note that the option-adjusted spread (OAS) differential between conventional 30-year Agency MBS and investment grade corporate bonds (in duration-matched terms) has risen back to levels last seen in 2014 (Chart 6). The lagged OAS differential is a decent predictor of relative returns between MBS and corporate credit, and at current levels it suggests that MBS could even outperform corporate bonds at some point during the next 12 months (Chart 6, panel 2). This year's decline in Treasury yields has also biased OAS differentials between MBS and corporate bonds wider. Because of negative convexity, MBS duration is positively correlated with yields (Chart 6, bottom panel). If yields rise from here, as we expect they will, then MBS duration will also extend. This means that MBS OAS will start to appear less and less attractive relative to duration-matched comparables. In other words, MBS are less likely to cheapen relative to other spread product in an environment of rising Treasury yields. The Drivers Of MBS Spreads A simplified formula for excess MBS returns, relative to duration-matched Treasuries, could be written as follows: Excess Return = Starting OAS - Duration*(Change in nominal spread) + 0.5*Convexity*(Change in yield) 2 That is, OAS is the correct measure of MBS carry because it adjusts for expected losses due to prepayments. However, it is the change in the nominal spread (not the OAS) that will determine capital gains and losses during the investment horizon. On that note, we observe that nominal MBS spreads have rarely been tighter during the past 30 years (Chart 7). However, it is also hard for us to see a catalyst for significantly wider nominal spreads during the next 6-12 months. The two factors that correlate most closely with nominal MBS spreads are credit spreads and mortgage refinancings. Chart 7Nominal MBS Spreads Are Driven By Credit Spreads And Refinancings On credit spreads, we have repeatedly outlined why they are unlikely to widen materially in the absence of more significant inflationary pressure.4 As for refis, we are also hard pressed to see much upside for three main reasons: First, changes in mortgage rates are the number one driver of refinancings (Chart 8). Refis only increase when mortgage rates fall, making the proposition of refinancing more attractive. As yields rise during the next 6-12 months, refis will stay low. Second, the distribution of outstanding mortgages across the coupon stack impacts how sensitive refis are to changes in rates. The second panel of Chart 8 shows our measure of "moneyness", aka the dispersion of outstanding mortgages around the current coupon rate.5 Given today's dispersion levels we can calculate that even if the current coupon mortgage rate falls back to its recent low of 2.24%, our measure of moneyness would not get back to its late-2016 peak. For our moneyness indicator to rise back to 2013 levels the current coupon mortgage rate would have to fall all the way to 1.68%. Needless to say, we would characterize that risk as low. Third, the final factor that can impact the pace of mortgage refinancing is the seasoning of outstanding mortgages. Typically, we think of mortgages between 30 and 60 months old as being the most likely to refinance. Given that net mortgage origination was close to zero between 30 and 60 months ago and that mortgage purchase applications were at multi-year lows (Chart 9), most of the outstanding mortgage universe probably falls outside of this zone. Chart 8Refis Will Stay Low Chart 9Most Mortgages Are Not Yet Seasoned Bottom Line: Agency MBS option-adjusted spreads have widened significantly and no longer look expensive. With Treasury yields moving higher and mortgage refinancings likely to stay depressed, we advise upgrading MBS from underweight to neutral. Economy & Inflation Bring On The Upside Surprises As was alluded to in the opening section of this report, after have disappointed expectations year-to-date, we are just now starting to see U.S. economic data surprise to the upside (see Chart 2). The most recent datapoints that caught our eye were the ISM manufacturing and non-manufacturing PMIs.6 Our inclination is to mostly ignore last Friday's employment report as an outlier due to the recent hurricanes.7 The ISM non-manufacturing survey jumped to 59.8 in September, its highest level since 2005. Taken together with other survey indicators that tend to track GDP growth - the BCA Beige Book Indicator and the BCA Composite New Orders Indicator - the case is quite strong for further GDP acceleration in the third and fourth quarters (Chart 10). Of course the pressing issue for bond markets is whether that growth acceleration translates into higher inflation. On that note, we would suggest that the weak inflation we have seen during the past six months was a reaction to the growth slowdown witnessed in 2015 and the first half of 2016. The stronger ISM manufacturing index, in particular, sends a powerful signal that inflation is poised to put in a bottom (Chart 11). Chart 10Survey Indicators Of U.S. Growth Chart 11Inflation Lags Growth Bottom Line: The U.S. economic data are starting to outperform beaten-down expectations. Survey data point to further GDP acceleration in the second half of this year and we expect inflation will soon follow growth higher. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: Another Update", dated January 31, 2017, available at usbs.bcaresearch.com 2 Please see China Investment Strategy Special Report, "On A Higher Note", dated October 5, 2017, available at cis.bcaresearch.com 3 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Return Of The Trump Trade", dated October 3, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Won't Back Down", dated September 26, 2017, available at usbs.bcaresearch.com 5 For each coupon bucket in the Bloomberg Barclays Conventional 30-year Agency MBS index we calculate the squared deviation between its coupon and the current coupon rate. We then weight those squared differences by the market capitalization of each coupon bucket. 6 These are different than the Markit PMI that is included in our 2-factor Treasury model. 7 Please see BCA Daily Insights, "U.S. Jobs Report: All Noise, No Signal", dated October 6, 2017, available at din.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights It's ok to ignore the September jobs report. Is the small cap comeback sustainable? Assessing the threat to the consumer from higher rates and oil prices. The ISM is over 60, now what? Feature Risk assets outperformed again last week, as the S&P 500, the dollar, and the 10 year- Treasury yield all moved higher. Oil was an exception, as WTI dipped back below $50 per barrel, but BCA's Commodity & Energy Strategy service expects WTI to end the year over $55/bbl. Small-cap stocks outperformed as well and conditions are in place for the rise in small caps to continue. The rise in risk assets in recent weeks occurred alongside a marked improvement in the Citi Economic Surprise Index (Chart 1), which moved into positive territory last week for the first time since April, despite the impacts of Hurricanes Harvey and Irma. Chart 1S&P And 10 Year Treasury Yield Tracks Economic Surprise The lack of impact from the hurricanes on the economic data is surprising. Before Hurricane Harvey made landfall, the Atlanta Fed GDP Now reading for Q3 was 3.4%, but moved as low as 2.1% in late September as the August economic data was reported. The most recent Atlanta Fed forecast pegged Q3 GDP at 2.5%. The 60+ readings on September's manufacturing ISM composite and 70+ reading on prices were notably strong, as was the 18.6 million reading on September vehicle sales, the strongest in 12 years. That said, the impact of the storms was evident in the employment data released last week (See below). U.S. Jobs Report: All Noise, No Signal U.S. nonfarm payrolls fell 33,000 in September, which was entirely due to the hurricanes. According to the BLS, 1.47 million workers could not show up for their jobs due to the weather. Because this data series is not seasonally adjusted, one cannot simply add it back to the headline payrolls number. Unfortunately, the separate household survey does not help to shed any better light on the state of the labor market. The household survey is known to be much more volatile than the establishment survey. This was quite apparent with the 906,000 surge in jobs, which followed a 74,000 decline in the previous month. The outsized and unbelievable surge in household employment was the main reason for the decline in the jobless rate to 4.2% from 4.4%. The labor force actually grew by a hefty 575,000 and the participation rate rose to 63.1%, the highest since March 2014 (Chart 2). The 0.5% m/m gain in average hourly earnings needs to be discounted as well. Employment in the low-paying leisure and hospitality sector fell by 111,000 in September, helping to boost the aggregate average hourly wage. As these workers return to their jobs, average hourly wages will correct lower. Bottom Line: Investors should ignore the September jobs report. The 3-month average of payrolls growth from June to August was 172K. This is probably the best gauge of underlying jobs growth and this pace is above the trend growth in the labor force. To the extent that the Fed believes the tightening labor market will push inflation to its 2% target, the calculus for the December FOMC should not change after today's report. Small Caps Make A Comeback Rising prospects for tax cuts have lifted the Trump trades, including small-cap equities. We first initiated an overweight to small caps on November 14, 20161 (Chart 3). Since then, small caps have underperformed large by 162 bps, but not uniformly. The trade was successful from the start through to late January, but faded by late summer along with the prospects for Trump's tax cuts. Starting in mid-August, small cap made a comeback as odds of the tax cut troughed. Chart 2The September Jobs Report Is More Noise Than Signal Chart 3The Trump Trades Are Back On Several factors support our overweight view. According to BCA's U.S. Equity Strategy service S&P 600 valuation indicator, small caps are even more undervalued today than when we last discussed them in June2 (Chart 4). Moreover, the Cyclical Capitalization Indicator (CCI) moved sharply into positive territory following the U.S. election despite a modest dip in subsequent months (Chart 5). In addition, small cap stocks have been a reliably high-beta segment of U.S. capital markets since the middle of the last economic cycle (Chart 5, panel 2). That characteristic of small caps argues for a bullish stance given our upbeat view on growth and our overweight positions in U.S. equities versus bonds. BCA's outlook for regulation, inflation, the dollar, the Fed and the consumer also favor small over large caps. Trump has already made significant progress in slowing the pace of new regulations,3 which has long been a concern for small businesses. We expect inflation to move back to 2% in the coming quarters and then begin to climb higher in 2018. Chart 6 shows that small caps often thrive when inflation accelerates. BCA's outlook is that the dollar will see modest appreciation over the next 12 months. Small-cap stocks are less sensitive to dollar movements than large caps. Gradually rising rates will not impede small caps and credit conditions remain favorable. Finally, small caps are more closely linked to the consumer than the S&P 500, and BCA's view on household spending remains upbeat. Chart 4Small Caps Are Cheap, But Not Historically Cheap Chart 5Our CCI Supports Small Caps Chart 6Accelerating Inflation Usually Supports Small Caps Despite the upbeat prospects for small caps, some risks linger. Tighter credit conditions for consumers and businesses, an abrupt pullback in housing that would trigger a consumer retrenchment, persistent weakness in the dollar, and a "risk off" environment would see small caps underperform large caps. Bottom Line: It is too early to abandon our bullish bias toward small caps. Conditions remain in place for small caps to outpace large caps. Favorable valuation and encouraging prospects for Trump's pro-small business platform are key to BCA's view, as our favorable outlook for the U.S. consumer. Will Higher Rates And Oil Prices Crush The Consumer? Supports remain in place for continued strength in U.S. consumer spending despite rising interest rates and oil prices. That support was confirmed by September's reports on employment and vehicle sales, and August's personal income and spending data, all released in the past two weeks. However, investors should be aware of hurricane-related distortions in the August and September figures.4 Moreover, BCA's position is reinforced by elevated readings on consumer confidence and booming household net worth statistics, and record high FICO scores (Chart 7). The conditions that crushed the consumer ahead of the 2007-2008 recession are not in place and will not be for some time. Chart 8 shows that at 41%, household purchases of essentials as a percentage of disposable income are near an all-time low and have dropped by 1.3 percentage points since 2012. In contrast, spending on necessities rose by a record 3.5% in the five years ending in 2008, matching the bruising impact of higher rates, surging inflation and soaring oil prices seen by the end of 1980. Wrenching consumer-driven economic downturns ensued after both episodes. We see gradual increases ahead for both oil prices and interest rates, but nothing that would trigger the collapse of the consumer.5 Furthermore, BCA forecasts only a modest rise in inflation and an acceleration in wage growth; both will provide a boost to disposable income. Personal tax cuts as part of the plan Trump proposed last month would also enhance incomes. Chart 7Plenty Of Support For The Consumer Chart 8Consumer In Good Shape Despite Rise In Oil, Rates BCA's research shows that sustainable capital spending cycles get underway only when businesses see evidence that consumer final demand is on the upswing. The latest reading on the manufacturing ISM composite and the 60+ readings on the new orders component of ISM since February suggest that managements are starting to note the robust pace of consumer spending. Signals From Elevated ISM Readings September's numbers on the ISM manufacturing index support BCA's case for accelerating corporate profits in the coming quarters. The ISM is a good proxy for industrial production, which in turn tracks S&P 500 sales. The recent strong data on ISM suggests that IP should pick up in the next six months (Chart 9). A rollover in the 12-month change in IP would challenge our constructive stance on earnings. While a decline is possible given that the index is already lofty, the leading components of the ISM, including the new orders index and the new orders-to-inventory ratio, indicate that the ISM will remain above 50 in the months ahead (Chart 10). Chart 9Favorable Macro Backdrop For Earnings And Sales Chart 10ISM Components Suggest IP Poised To Accelerate Some investors question how long the composite and new orders indices will remain beyond 60 and what that will mean for risk assets. Additionally, the second 70+ reading on the ISM Prices index this year challenges the notion that inflation is dormant. Other investors are concerned about what will happen after these ISM components are so elevated. Others may fear that the index will soon fall below 50. We analyze the historical periods when the ISM and its sub-indexes were above the 60 threshold, and then what happens to the returns of risk assets 12 months after they fall below the 60 threshold (Chart 11A, Chart 11B and Chart 11C). Chart 11AComposite ISM And Risk Assets Chart 11BISM New Orders And Risk Assets Chart 11CISM Prices And Risk Assets Historically, the relative performance of large cap equities to Treasuries is typically poor when the ISM Manufacturing Composite Index is over 60, but investment-grade credit outperforms and both gold and oil usually gain. The performance of these assets is similar even excluding the period around the 1973 OPEC oil embargo and the 1987 stock market crash (Chart 11A and Appendix Table 1). The ISM Manufacturing Composite Index ticked up to 60.8 in September, the first 60+ reading since 2004. The indicator also reached 60 three times in the 1970s and twice in the 1980s, and it stayed above 60 on average for 8 months. The last time it breached 60, it remained at that level for 6 months (December 2003 through June 2004). That interval, along with most of the others, was accompanied by tightening monetary policy and accelerating inflation late in the latter half of economic cycles. Gold and oil perform strongly in the 12 months after ISM Composite Index goes below 60, large-cap equities barely do better than Treasuries, while investment-grade credit underperforms. Surprisingly, high-yield bonds and small-cap stocks outperform 12 months after the ISM falls back below 60, although the sample size is limited. In 1974-1975, the economy was in recession. In all but one other instance (the mid- 1980s), the economy was in a late stage of the cycle, nearing full employment and inflation was on the rise. Risk assets also are strong performers when the New Orders component of the ISM exceeds the 60 threshold (Chart 11B and Appendix Table 2). Moreover, the episodes are more numerous (14 since 1971 versus only 6 for the composite) but, on average, they persist as long as the signal from the ISM Composite. New Orders have been above 60 since February 2017 (7 months), just shy of the 46-year average (8 months). Large cap equities and credit (both investment-grade and high-yield) have outperformed Treasuries, and gold has climbed since February. This performance matches the historical pattern when the New Orders index exceeds 60. In the past 8 months, the underperformance of small caps and the drop in oil prices in that span runs counter to history. The performance of risk assets in the year after the new orders index moves below 60 is mixed, at best. In these periods, while the S&P 500 outperforms Treasuries on average, and small caps outperform large caps, credit underperforms. The big winners when the New Orders index is falling from over 60 are gold (average 14% gain) and oil (22%). Chart 11C and Appendix Table 3 shows the performance of risk assets when the ISM Prices index is greater than 70 and then 12 months after the index crosses below 70. Gold and oil are standouts in the first case, and small cap tends to outperform large. Note that 3 of these 11 episodes coincided with recessions (early 1970s, 1980 and 2008) and 1 occurred during the 1987 stock market crash. Small-cap equities continue to outperform as the Prices index fades, and returns on gold and oil are muted. High-yield bonds underperform Treasuries when the ISM Prices index dips back below 70, and the total return on investment-grade corporate struggles, but it beats Treasuries. Moreover, 3 of these 11 occurred during recessions (early 1980s, 2001, 2008-2009). Separately, there has been a tight relationship between the 12-month change in the 10-year Treasury yield and both the overall ISM, the New Orders and Prices component of the ISM in the past 25 years (Chart 12). Nonetheless, the relationship between the ISM Prices component and the 10-year Treasury has broken down since oil prices peaked in 2014. The 12-month jump in ISM Prices surge in 2016 was met with a decline in Treasury yields. Prior to that, a rise in Prices index was almost always accompanied by a move higher in bond yields. BCA's view is that the ISM manufacturing Composite will remain elevated (although not necessarily more than 60 in the months ahead), supporting our bullish stance on corporate sales and earnings. However, if we are wrong and the ISM dips below 60 and then down to 50, would that signal a downturn and concomitant selloff in risk assets? The ISM has a mixed track record as a leading indicator of recessions (Chart 13). Since 1948, the ISM has provided 9 false signals, using 3 consecutive months below 50 as the indication of an economic decline. Furthermore, 5 of the 9 examples occurred since 1985, as the U.S. economy became less reliant on manufacturing. In the 6 instances that the ISM warned of contractions, the average lead time was 4 months. In the 4 other economic slumps, the ISM moved and stayed below 50 for 3 consecutive months only after the start of recession. The lag averaged 4 months. This was the case in the 2007-2009 episode when the ISM did not send a recession signal until May 2008, 5 months after the official start of the downturn. Chart 1210 Year Treasury Vs. ISM Chart 13The Rocky Relationship Between ISM And Recessions Bottom Line: Elevated readings on ISM support BCA's view that profit growth will accelerate for a few more quarters while the recent rise in the ISM Prices index confirms the move higher in Treasury yields. Stay overweight stocks versus bonds and underweight duration. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA's U.S. Investment Strategy Weekly Report, "Easier Fiscal, Tighter Money?," November 14, 2016. Available at usis.bcaresearch.com. 2 Please see BCA's U.S. Investment Strategy Weekly Report, "Waiting For The Turn," June 26, 2017. Available at usis.bcaresearch.com. 3 Please see BCA's U.S. Investment Strategy Weekly Report, "Still Waiting for Inflation, "August 14, 2017. Available at usis.bcaresearch.com. 4 Please see BCA's U.S. Investment Strategy Weekly Report, "Shelter From the Storm," September 5, 2017. Available at usis.bcaresearch.com. 5 Please see The Bank Credit Analyst Monthly Report, "Global Debt Titanic Collides With Fed Iceberg?," February 2017. Available at bca.bcaresearch.com. Appendix: Table 1 Table 2 Table 3

Highlights Slowing global money growth, export orders, and a downgrade in earnings revisions of cyclical relative to defensive equities points to a mild slowdown in non-U.S. growth. This slowdown is not worrisome, but could become so if the U.S. dollar rallies significantly. This risk should be kept in mind by investors. Short AUD/USD at 0.79 ¢. EUR/USD is trading at a premium and is over-owned. Conditions are emerging for investors to upgrade their view of the Fed relative to the ECB. EUR/USD has downside risk. Feature Chart I-1Global Growth Is Booming The world economy is on a roll. Nearly all of the world's PMI indexes are in expansionary territory, suggesting we are experiencing a rare global synchronized expansion. A key bellwether of global trade, Korean exports, are surging at a 35% annual rate, confirming that the global economy is very strong (Chart I-1). When all looks great, it is the ideal time to wonder what could go wrong. At this point, the greatest risk to this global expansion may be the dollar. A strengthening dollar would tighten global financial conditions, especially for EM borrowers, and exacerbate the impact of yellow flags that have already emerged. Yellow Flags Investors are in an ebullient mood these days, and for good reason: global growth is strong, and global policy is still very accommodative, even if some central banks have begun removing support for their economies. However, three yellow flags have emerged that in our view warrant some caution. To be clear, these are not grave signs and we do not foresee either a U.S. or a global recession until late 2019 at the earliest. With this in mind, what are the worrying signs that investors should monitor right now? The first yellow flag comes from global money supply growth. Narrow money has decelerated from a 12% annual growth rate to 9% today. Historically, this has been a leading indicator of global industrial production, global export growth and commodity prices (Chart I-2). While the surge in money growth in 2016 and 2017 was a key reason behind the rebound in global economic activity, especially outside the U.S., its recent slowdown points to an end of the economic upswing, though admittedly not toward a cataclysm. The second yellow flag comes from the U.S. ISM release. While the general tone of the report remains extremely positive, the export component has been in a downtrend since June. The key determinant of export growth for any country tends to be the vigor of its trading partners. Hence, it is not surprising that softness in the export component of the U.S. ISM manufacturing survey tends to be associated with weakening global trade and industrial activity (Chart I-3). The third yellow flag comes from earnings revisions. The earnings revision ratios of cyclical relative to defensive equities in the U.S. and globally have sharply rolled over. While still in positive territory, this development has historically been an early signal that improvements in global growth metrics are ebbing, a signal being flashed today (Chart I-4). Chart I-2Money And Global Growth: ##br##From Tailwind To Headwind Chart I-3A Blemish In An Otherwise##br## Bright Picture Chart I-4EPS Revisions: Cyclicals Have Turned ##br##Vis-A-Vis Defensives Bottom Line: The global economy is experiencing a synchronized upswing, which has left investors in an ebullient mood. However, slowing global money growth, ebbing export sentiment and weakening earnings revisions for cyclical relative to defensive equities suggest this broad-based upswing has reached its zenith. While a mild deceleration is likely to materialize soon, these indicators constitute yellow flags, not red ones. Conditions are still not in place to expect a major global growth slowdown. The Dollar Holds The Key While the factors above point to a mild slowdown, they do not yet indicate a dearth of growth that could prompt panic among investors, especially in the EM space. For this scenario to become reality, another ingredient is needed. In our view, this ingredient is a strong dollar. To begin with, the relationship between global growth and the dollar is well known in the investor community. When global growth is strong and broad-based, the dollar depreciates; when global growth is weak, the dollar appreciates (Chart I-5). The U.S. is a relatively closed economy, and is less exposed to global growth developments than the euro area, Japan or commodities producers (Chart I-6). Thus, when the global economy is in an upswing, the U.S. garners a smaller dividend than the rest of the world. Conversely, when the global economy hits a soft patch, the U.S. suffers less. Chart I-5Strong Global Growth Coincident ##br##With A Weak Dollar Chart I-6The U.S. Is Less Exposed ##br##To Global Growth Factors But the chain of causation is not only from growth to the dollar. The trend in the dollar also affects the trend in global growth. This is because in aggregate, the world remains short the dollar. According to the BIS, there is $27 trillion dollars of foreign-currency liabilities in the world, $14 trillion of which is denominated in U.S. dollars, with an extremely large proportion issued by EM borrowers. When the dollar weakens, the cost of borrowing among companies and banks that finance themselves in USD decreases, incentivizing further borrowing. This eases global liquidity conditions and decreases the cost of financing global trade, leading to increased economic activity and profits as well as expanding global capex. Meanwhile, when the dollar rises, the balance sheet of those foreign firms and governments that have borrowed in U.S. dollars becomes increasingly illiquid, resulting in strong headwinds for additional borrowing, curtailing economic activity, profits and capex. This explains why the dollar and commodities prices, the latter being extremely sensitive to growth and global capex, have displayed such a strong negative relationship over different time periods (Chart I-7). Chart I-7Rising USD Equals Declining Liquidity And Declining Commodity Prices Thanks to these dynamics, the weakness in the dollar this year has been a major boost to growth for the global economy. As Chart I-8 illustrates, the large easing in EM financial conditions was indeed related to the U.S. dollar's weakness. Therefore, as growth momentum could be peaking, a period of renewed strength in the greenback might inflict further damage to a key buttress of EM growth. Moreover, this time around, Chinese policymakers are unlikely to come to the rescue of the global economy as they did in 2015 and 2016. Back then, China was experiencing a deflationary spiral: producer prices were contracting at a 6% annual pace, profits were in free fall and outflows were growing exponentially. The People's bank of China and the central government pulled all the stops, increasing lending and fiscal expenditures and tightening capital controls. Monetary conditions eased massively (Chart I-9). Chart I-8The Falling Dollar Supported Global Growth Chart I-9Tightening Chinese Monetary Conditions Last weekend, the PBoC announced targeted cuts to reserve requirement ratios for banks extending lending to small companies. According to our China Investment Strategy sister publication, this is not a major easing.1 Instead, these are targeted measures aimed at helping small firms that are currently dependent on the predatory lending rates available in the shadow banking sector. Meanwhile, access to credit by large state-owned enterprises and the real estate sector will continue to be slowly curtailed. The mutation of deflation into inflation and the recovery of profit growth imply that China does not currently need the same shot to the arm that it did in 2015 and 2016. Thus, it is unlikely the country will initiate another round of massive credit easing that will boost investment by SOEs and the construction sector, the two main sources of capex and commodities demand. In an environment where global money growth has rolled over and where China is unlikely to press on the gas pedal as hard as it did two years ago, a strong dollar would thus have a nefarious impact on global financial conditions, global growth, and, in turn, EM currencies and commodities currencies. While we remain very negative on the yen for now, the Japanese currency could benefit from a meaningful slowdown in international growth, as such a slowdown would likely exert downward pressure on global bond yields, including in the U.S. Obviously, the rally in the USD will have to be much more pronounced than what has been experienced in the past month before its negative impact on growth begins to be felt in bond yields and the yen. Thus, we remain long USD/JPY for now. The AUD could prove to be a key victim of the developments highlighted above. The AUD is highly levered to global growth and EM financial conditions. Moreover, it is now very expensive on a long-term basis, having overshot terms of trade by a very significant margin (Chart I-10). Adding to the vulnerability in the Aussie, the Australian economy has been incapable of generating any inflationary pressures. The output gap remains very deep, the level of underemployment is still at a 37-year high, and wages continue to hover near record lows, limiting the capacity of the Reserve Bank of Australia to tilt to a hawkish stance (Chart I-11). Yet, investors expect rates to be 42 basis points higher 12 months from now. Finally, speculators are currently very long the AUD. Thus, we will use any rebound above 0.79 to short the AUD/USD, setting a limit-sell at this level with a target at 0.73. Chart I-10The AUD Is Vulnerable Chart I-11Litle Inflationary Pressures In Australia Bottom Line: While the three yellow flags highlighted do not represent a terminal danger to global growth, a stronger dollar at the hands of tightening global financial conditions, especially in EM economies, would be a much bigger threat to the global economy. We do anticipate the dollar to strengthen over the coming 12 months, but it will take a significant move before the USD puts enough of a brake on global growth to hurt global yields. We therefore remain positive on the USD/JPY. However, with this risk lurking in the background, we are implementing a short position on the AUD, a currency that is both expensive and over-owned, and underpinned by an economy full of slack. An Update On EUR/USD We continue to expect some downside to EUR/USD over the remainder of the year. As we have already highlighted, the euro has greatly overshot its implied interest rate parity (IRP) relationships. Our intermediate-term time model - an enhanced IRP model accounting for short- and long-term real rate differentials, global risk aversion, commodities prices and the trend in the pair - shows that EUR/USD remains near its largest premium to fair value since 2009. Confirming this assessment, the euro has also overshot its equilibrium implied by the level of interest rates five years out (Chart I-12). Valuations offer some insight on the potential size of the euro move, but they offer very little information in terms of timing. Instead, we should rely on technical and macro considerations. On this front, we have already highlighted that speculators are currently net long the euro by the largest margin since 2011. Philosophically, we often look at the euro as the anti-dollar, a highly liquid inverse bet on the dollar. Since EUR/USD constitutes 57.6% of the DXY, a short bet on this dollar index and a long bet on the euro are similar wagers. Currently, the sum of both bets is at a level normally followed by sharp drops in EUR/USD, suggesting that euro buying is hitting exhaustion levels (Chart 13). Meanwhile, with investors having very few short bets on the euro, especially when compared to the large stock of short bets on the DXY, a short squeeze in favor of the USD could emerge if European data disappoints relative to the U.S. (Chart I-13, bottom panel). Chart I-12Downside In EUR/USD Chart I-13Tactical Risk To EUR/USD On the macro front, a few developments have caught our eye. We are entering the window where based on historical lags, the euro area's industrial production is likely to start feeling the pain of the common currency's previous strength (Chart I-14). Compounding this worry for euro longs, euro area earnings revisions are lagging those in the U.S. by the greatest margin since 2014, suggesting the euro's strength has sapped some of the euro area's vigor and is in the process of redistributing it to the U.S. economy. Historically, this has led to a period of weakness in EUR/USD (Chart I-15). Chart I-14The Strong Euro ##br##Will Soon Be Felt Chart I-15Falling Relative EPS Revisions ##br##Equals A Weaker EUR/USD Confirming this insight are relative financial conditions. Euro area financial conditions have been tightening relative to the U.S. since the beginning of 2016 - a move that has become especially pronounced this year. The euro area's inflation outperformance vis-à-vis the U.S. this year was first and foremost a reflection of the previous easing in relative European financial conditions (Chart I-16). Thanks to these strong relative inflation dynamics, investors have brought forward the first rate hike expected from the ECB, while simultaneously removing interest rate hikes out of the U.S. OIS curve. This move has been wildly euro bullish. However, the window of opportunity for this bet is closing; the tightening in European financial conditions now points to a reversal in relative inflation, with U.S. prices set to now take the lead over the euro area. This could force a repricing of the Fed relative to the ECB, implying that monetary divergences could once again play against EUR/USD. Catalonia is not a reason to be bearish on the euro. Marko Papic, BCA's Chief Political Strategist, argues that the northeastern region is unlikely to leave Spain.2 The vast majority of Catalonia still favors remaining part of Spain (Chart I-17). Moreover, the region has received immigrants from the rest of the country for many decades, reflecting its superior economic performance. As a result, only 31% of the population speaks Catalan as a first language. In aggregate, the independentists' victory last weekend only reflects a low turnout rate, as individuals who opposed leaving Spain stayed at home, like they did in 2014. Chart I-16The Fed Will Be Repriced ##br##Against The ECB Chart I-17Will Of The People: ##br##Catalonia Will Stay In Spain Bottom Line: The euro will exhibit downside risk in the coming months. EUR/USD is trading well above its fair value implied by its IRP relationship. Additionally, euro buying has hit nosebleed levels, and the dollar is unloved. Moreover, the euro's recent strength could begin to negatively affect growth, especially as European earnings revisions have collapsed versus the U.S. Finally, financial conditions point to a fall in euro area inflation relative to the U.S., highlighting the risk that the policy path for the Fed could be upgraded against that of the ECB. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see China Investment Strategy Special Report, titled "On A Higher Note", dated October 5, 2017, available at cis.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, titled "Is King Dollar Back?", dated October 4, 2017, and Geopolitical Strategy Monthly Report, titled "The Geopolitical Risks For The Equity Bull Market", dated May 14, 2014 at gps.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S data has been strong this week: Markit and ISM Manufacturing PMIs beat expectations at 53.1 and 60.8 respectively; ISM Prices Paid rose sharply to 71.5 from 64.0; Markit Services and ISM Non-Manufacturing PMIs also beat expectations at 55.3 and 59.8 respectively; ADP employment change and continuing and initial jobless claims also came out better than expected; The DXY has rebounded meaningfully after a string of stronger data and growing hopes on the fiscal policy front recently. Bond markets have picked up on these developments, with the 10-year yield rising 30 basis points from its bottom last month. However, stronger U.S. inflation is needed in order for the greenback to meaningfully rally. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data has been mixed: The latest headline and core inflation readings for the euro area were weaker than expected, at 1.5% and 1.1% respectively; German retail sales also underperformed expectations, however, German unemployment rate decreased; Euro area manufacturing PMI also underperformed, while the services PMI outperformed; Euro area producer prices beat expectations, coming in at 2.5%. With U.S. data outperforming, the euro has softened versus the greenback, but has not displayed similar movements against other currencies. While it is true that European inflation is higher than a year ago, it is still not near the ECB's target. A stronger euro would further restrict inflationary pressures, which would be a cause for concern for ECB officials. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Japanese data has been mixed the past weeks: The jobs/applicants ratio came in at 1.52, underperforming expectations and decreasing from the previous month. Additionally, retail trade and overall housing spending yearly growth both disappointed, coming in at 1.7% and 0.6% respectively. However, on the bright side, Nikkei Manufacturing PMI outperformed expectations, coming in at 52.9. Overall, we continue to be bullish on USD/JPY, as yields in the U.S. will continue to rise vis-à-vis Japanese ones. Economic data has been tepid, and wages continue to contract or remain flat, even if some underlying pressures are slowly emerging. Furthermore we expect that the BoJ will continues its extreme measures of yield curve targeting in order to spur inflation expectations. Nevertheless, the yen could appreciate against carry currencies like the AUD or NZD if Chinese monetary conditions become tight enough. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Markit services PMI outperformed expectations coming in at 53.6, and increasing from last month's reading However, Markit manufacturing PMI came in under expectations at 55.9, and decreased from last month. Moreover Construction PMI unperformed, coming in at 48.1, the lowest level since July 2016. We would lean against any further strength of the pound against the U.S. dollar. The risks associated with Brexit still looms in the background, while data has been mixed, particularly when it comes to consumption and the housing market. Additionally, the market has already fully priced a rate hike by December. Thus, it seems that any good news for the pound are already in the price, as the BoE certainly has little incentives to follow a hawkish policy beyond removing its post-Brexit emergency measures. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data was mixed: AiG Performance of Manufacturing Index decreased to 54.2 from 59.8; TD Securities Inflation came in at 2.5%, down from 2.6%; HIA New Home Sales increased by 9.1% MoM in August, up from the 15.4% contraction in July; Building permits are still contracting 15.5% annually, but better than the expected 16.2% contraction. This week, the RBA decided to leave rates unchanged at 1.5%. The monetary policy statement focused on the lack of wage pressures in the Australian economy and on the higher exchange rate, which is "expected to contribute to continued subdued price pressures in the economy", as well as "weighing on the outlook for output and employment", stating further that "an appreciating exchange rate would be expected to result in a slower pick-up in economic activity and inflation than currently forecast." Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Last week the RBNZ decided to leave rates unchanged at 1.75%. The RBNZ continued with its dovish slant, arguing that monetary policy will remain accommodative for a considerable period. An important development, however, is that the central bank toned down its cautious tone about the kiwi. In previous instances, the RBNZ had been very aggressive in stating that the NZD was too expensive and an adjustment was needed. However, in its most recent statement the RBNZ was much less aggressive in its rhetoric, highlighting the fall in the NZD. Overall, we believe that the NZD will continue to have upside against the AUD, as domestic inflationary pressures are much stronger in New Zealand than in Australia. Meanwhile, global developments, such as a downturn in the Chinese industrial cycle would affect Australia much more than New Zealand. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canadian data was mixed: Industrial product price grew at a 0.3% monthly pace, less than the expected 0.5%; Raw materials increased by 1%, above the expected 0.3%; GDP stagnated in July on a monthly basis, below the expected 0.1% growth; Merchandise trade slipped even further into a deficit from CAD 2.6 bn to CAD 3.41 bn. Furthermore, Governor Poloz's September 27 speech sent the CAD tumbling, stating that "monetary policy will be particularly data dependent" and that it could be "surprised in either direction". Probability of a hike in October and December declined from 48% to 23%, and 75% to 63%, respectively. While growth is robust, inflation has been declining since January, which may be a cautious sign for the BoC. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Data in Switzerland has outperformed to the upside: The KOF Leading Indicator outperformed expectations, coming in at 105.8 and increasing from last month's reading. The SVME Purchasing Manager's Index also outperformed, coming in at 61.7 Finally, headline inflation also outperformed expectations, with a reading of 0.7%, increasing from 0.5% on August. This recent strength in the Swiss economy is most likely reflective of the sharp appreciation that EUR/CHF has experienced in recent months. However, despite the increase in inflation, the Swiss economy is still too weak for the SNB to stop intervening in the foreign exchange market or to remove their ultra-dovish monetary measures. Once we see both headline and core inflation climb closer to their historical averages, we will reassess this view. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Data in Norway has been mixed: Register unemployment came in line with expectations at 2.5%, decreasing from last month's 2.7% reading. However the credit growth issued by national institutions in Norway, decreased since last month, coming in at 5.6%. Finally, both retail sales and real retail sales yearly growth came below expectations, coming in at -0.6% and 0.2% respectively. These few data points are interesting given that both retail and real retail sales growth dipped into contractionary territory. This shows that the Norwegian economy is still too weak to sustain a higher krone and higher rates. For this reason we continue to be bullish on USD/NOK. This cross is more correlated with rate differentials than with oil. Thus even if oil continues to rise, rising rates in the U.S. will still put upward pressure on USD/NOK. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The 11-year ruling governor of the world's oldest central bank, Stefan Ingves, will now sit at the helm of the Riksbank for five more years, until 31 December 2022. While Sweden's economy is still performing above par with CPIF at 2.3%, our bullish case for the SEK is under threat by the extension of the governor's term, who introduced negative interest rates to Sweden and who is consistently vigilant over the SEK's appreciation, even threatening intervention if needed. EUR/SEK appreciated 0.6% on the news, but has since given up some those gains as economic data in Sweden rebounded sharply. The Riksbank will still likely hike, but the timing is now in question. It is likely that the tightening cycle will now coincide with the ECB's tapering program, which will limit the SEK's appreciation for now. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

Special Report

Highlights China's growth momentum is unlikely to continue to accelerate, but the downside risk is low. Some more recent developments suggest economic momentum remains fairly robust. The heated debate on a "soft or hard landing" in recent years has disproportionally diverted investors' attention to China's cyclical growth fluctuations, while some larger picture changes have gone unnoticed. The Chinese economy will undoubtedly continue to experience cyclical swings; it is equally important to keep in mind some mega trends that hold the potential to reshape the world in profound ways. Feature The Chinese economy has likely ended the third quarter on a slightly higher note, according to "nowcast" types of models using high-frequency data (Chart 1). The latest PMI surveys, focusing on both the manufacturing and service sectors, accelerated in September from the prior month, and remain comfortably in expansionary territory, heralding positive surprises in the macro numbers to be released in the coming weeks. China's mini-cycle acceleration since early last year has been fairly modest by historical standards, but it has been a key component driving synchronized improvement in global growth. Moreover, the resilience of the Chinese economy has led to a quick repricing of risk assets that were deeply depressed in previous years due to China "hard landing" concerns. Stock prices of both Chinese investable equities and the emerging market benchmark have rallied massively since the 2016 bottom. Total returns of Chinese equities and EM stocks, price appreciation and dividend payments combined, have both broken out to all-time highs (Chart 2). Chart 1Chinese Q3 GDP Should Have Remained Strong Chart 2Breakout In China And EM Equities Looking forward, Chinese growth momentum is unlikely to continue to accelerate, but the downside risk remains low in the near term, as we have argued in recent months. In fact, some more recent developments suggest economic momentum remains fairly robust. More importantly, the heated debates among investors and analysts in recent years on China's macro stability have disguised some dramatic changes in the Chinese economy, which will have a profound and long-lasting impact on the global economy and financial markets from a big-picture standpoint. Given China's rising economic significance, getting China right will become all the more important for investors going forward. Near-Term Growth Outlook Remains Solid The Chinese economy will likely continue to surprise to the upside in the coming months. First, there is little risk of aggressive policy tightening that would prematurely choke off the economy, as economic growth is within the government's target, consumer price inflation is exceedingly low and financial excesses have been reined in.1 The latest decision of the People's Bank of China (PBoC) to lower reserve requirement ratios (RRR) for banks offering loans to small-sized enterprises should not be confused as a broad attempt to boost credit and growth. The move certainly reflects the authorities' preference for offering credit to smaller private borrowers, but it also reflects the PBoC's continued fine-tuning of its liquidity management.2 The PBoC has significantly ramped up direct lending to banks since 2015 to offset the liquidity drainage from capital outflows from the country's financial sector - the pace of PBoC direct lending has slowed since early this year (Chart 3, top panel). This means that the central bank will need to resort to other tools to manage interbank liquidity should stress increase - releasing required reserves being one of them. Taken together, the PBoC's liquidity injection has almost precisely matched the liquidity withdrawal due to capital outflows, as can be seen in the bottom panel of Chart 3. The key point here is that the PBoC's latest decision is not to encourage a lending spree, but it certainly does not indicate intentions of aggressive tightening. Second, some view China's lukewarm industrial activity as a sign of weak growth momentum, and argue for a pending relapse. In fact, some sectors have been under strict government scrutiny to cut capacity and production in recent years - a key reason behind the exceptional weakness in these industries despite massive improvement in their sales, pricing power and profits. In other words, these sectors have not been responding to market signals due to government restrictions of "supply side reforms" to cut excess capacity and reduce pollution. For example, some sectors that are subject to "supply side" constraints such as coal, base metals and cement producers have chronically underperformed in recent years, and have also hurt the overall performance of the industrial sector (Chart 4). Similarly, capital spending in the mining sector, historically highly sensitive to moves in global metals prices, have continued to contract, despite the sharp increase in metals prices since 2016. Without these regulations, the performance of the industrial sector should have been a lot stronger. In addition, without aggressive expansion in the "good times," the odds of another major relapse in these highly cyclical industries when the "bad times" do come are also lower. Chart 3The PBoC Liquidity Operation Chart 4Policy Constraints Weigh Heavy On Some Sectors Third, the Chinese authorities' tightening measures on the real estate sector pose a growth risk, and should continue to be monitored; the impact is unlikely to be significant, as discussed in detail in last week's report.3 Developers have also been subject to "supply side" constraints and have not increased construction in this cycle, despite rising home prices, increasing transactions and booming profits (Chart 5). Tighter policies imposed by local governments will probably keep developers in dormancy, but a major downturn is highly unlikely, simply because there is not much excess to begin with. Finally, while China has been a key component of the synchronized global growth improvement, the country has also benefited from a pickup in global demand.4 Korean exports, a harbinger of global trade, jumped by a whopping 35% in dollar terms in September versus a year ago. It is certainly unrealistic to expect such strong momentum to last, but the benign global demand situation is unlikely to immediately falter without some sort of extreme external shock. Similarly, our model expects Chinese export growth to moderate, but there are no signs of a sharp contraction anytime soon (Chart 6). Chart 5Real Estate Investment May Surprise To The Upside Chart 6Exports: Moderating, Not Relapsing Bottom Line: China's near-term growth outlook will remain resilient, providing a supportive macro backdrop for global risk assets. The China Debate: Seven Years On Ever since the Chinese economy recovered from the aftermath of the global financial crisis, with the help of a massive government stimulus package, investors' opinions on China's macro situation have been deeply divided.5 To be sure, sensational predictions of an imminent China collapse have always existed, ever since the country's economic reform, but they were mostly rooted in ideological bashing and were largely ignored by global investors. In recent years, however, predictions of a Chinese "hard landing" have been taken much more seriously by the mainstream media, as well as investors and policymakers. Amid mounting doubts about its long term sustainability, the Chinese economy has experienced some remarkable achievements and dramatic changes in the past several years. The Chinese economy continues to gain global significance, accounting for 16% of global economic output currently versus 9% in 2010. More importantly, its contribution to global economic growth is far larger, given its faster growth rate (Chart 7). China's nominal GDP currently stands at about US$11.5 trillion, a distant second to the mighty US$19.2 trillion U.S. economy. However, 7% of nominal growth in China feasibly amounts to an increase of US$800 billion in gross output, compared with US$770 billion for the U.S., assuming the latter is to grow by 4% in nominal terms. Although China's growth rate has downshifted since the global financial crisis, the increase in the country's total output in value terms has become even greater, given the economy's much larger size. China remains the dominant factor in driving global commodities demand, especially base metals. China's base metals consumption accounts for over 50% of the global total, higher than the rest of the world combined (Chart 8). More importantly, China's base metal consumption has continued to climb in recent years, while demand from the rest of the world has stagnated. In recent years, "sluggish" Chinese metals consumption has been blamed for commodities woes by some analysts; in reality, the country has been the only source of demand increase for base metals. China's role in driving the supply/demand balance of raw materials has increased significantly since the global financial crisis. Chart 7China's Growing Significance In World Economy Chart 8China And Base Metals The country's heavy investment on infrastructure has massively changed its urban landscape, leading to a significant improvement in the country's transportation system, with massive expansion in high-speed railway, urban metro and light-rail system, and further extensions of the highway network (Chart 9). This has significantly narrowed the country's infrastructure gap with more advanced countries, facilitating both international trade and domestic demand (Chart 10). Chinese car sales have jumped from about 10 million per year in 2010 to 25 million currently, by far the largest car market in the world. Without improvement in logistical infrastructure, there is little doubt the country's growth trajectory would have faced severe bottlenecks. Chart 9Massive Expansion Of ##br##Transportation Infrastructure... Chart 10...Has Narrowed The Gap ##br##With Developed Economies Finally, the impact of Chinese consumers has become all the more visible on the global stage. Even though China still ranks as a middle-income country with a per-capita GDP of about US$8000, a fraction of the US$57,000 in the U.S., the sheer size of the Chinese population, the rapid increase in household income and the country's very high savings rate have fundamentally shifted the wealth distribution of the global population. Currently, only about 20% of the world population has a per-capita GDP higher than China, a rapid change within a short period of time (Chart 11). This dramatic shift has profoundly redefined the global economic landscape, affecting the spectrum of essentially all businesses, from manufacturers' cost structures to luxury goods markets to tourism and education to financial services. Chart 11China's Rising Income In Perspective The list can easily be extended, but the point here is that the heated debate on a "soft or hard landing" in recent years has disproportionally diverted investors' attention to China's cyclical growth fluctuations, while some larger picture changes have gone unnoticed. Of course, financial markets are an emotional discounting mechanism, and stock prices always exaggerate any subtle changes in growth fundamentals, which can in turn impact economic reality through a complex web of reflexivity relationships. Chinese equities lagged significantly behind developed markets, particularly the U.S. bourses, between 2011 and 2015, which apparently validated the bears' views. In reality, however, multiples of Chinese equities, and emerging market in general, were deeply compressed compared with their developed market peers (Chart 12). In other words, it is largely multiples compression associated with heightened risk aversion and greater risk premium that was behind the woes of Chinese and EM markets before 2015. Since 2016, China's mini-cycle upturn has progressively raised investors' risk appetite towards China and EM, lifting their multiples and prices - essentially a positive re-rating of these markets. Chart 12Positive Rerating Of China ##br##And EM Has Further To Run The debate on China's growth sustainability will likely remain firmly in place in the coming years, which will continue to create cross-currents and outsized volatility. As an investor, it is futile to argue with "Mr. Market." Even with strong convictions on the fundamental case, investors should be nimble and avoid standing in front of an oncoming train - however ill-informed the market consensus could be. For now, Chinese and EM equities are still much more attractively valued compared with the developed world, and the train of the positive re-rating of these bourses will likely have further to run. It is too soon to bet on a trend reversal. Whither China: The Big Picture Fundamentally the China debate boils down to the country's growth model, which invests a much greater share of its output than most other major economies. The "bears" conclude this amounts to capital misallocation and propose a "rebalancing" towards consumption. Some even claim China's massive savings, essential for financing domestic capital spending, are byproducts of banks' "out of thin air" money printing - to me, if "thin air" money was indeed such a magical silver bullet, the world would have solved its poverty problems a long time ago. Over the years I have argued firmly against these assertions. In economics, it is well known that a country's income level is fundamentally determined by its productivity, which is in turn determined by the level and sophistication of its capital stock. Chart 13 shows a clear positive correlation between a country's per capita output, a measure of productivity, and its per capita capital stock. In general, industrialized countries enjoy much higher levels of per capita capital stock than developing economies, leading to much higher productivity, income as well as living standards. Therefore, the industrialization process, by definition, is the process of accumulation of capital stock through investment, which has been proven by many economies that have successfully industrialized. China's growth path in the past several decades is simply repeating these success stories. As shown in Chart 14, despite some remarkable achievements, the productivity level of the average Chinese worker is still just a fraction of the level in more advanced countries. If China remains on the path of accumulation of capital stock through savings and investment, the country will continue to progress on the productivity and income ladder. If, however, it abandons its current growth model and "rebalances" towards a consumption-driven one, odds are much higher that the country will stagnate and fail to advance beyond the "middle income trap." Chart 13Productivity Is Positively ##br##Correlated With Capital Stock Chart 14China's Catchup Process ##br##Has A Lot Further To Run In my 15 years of covering China for BCA, the country has dramatically shifted beyond recognition - the pace of changes are still accelerating. Looking forward, the Chinese economy will undoubtedly continue to experience cyclical swings; it is equally important to keep in mind some mega trends that hold the potential to reshape the world in profound ways. The following are a few worth highlighting. Chart 15China's Tech Boom The first mega trend is the explosive growth of the Chinese technology sector, which will increasingly challenge players in more advanced economies. The tech boom is reflected in the dramatic expansion of e-commerce and mobile payments, spectacular price gains in the BAT giants (Baidu, Alibaba and Tencent) and surging patent applications among the corporate sector (Chart 15). With a massive and homogenous domestic market and increasingly affluent consumers, China has rapidly become the testing ground of all new high-tech sectors - from big data and artificial intelligence to industrial robotics and additive manufacturing, to genetic analysis and quantum computing - with numerous startups and venture capitalists as well as government support on basic research and development. This is bound to create exciting investment opportunities with winners and losers far beyond Chinese borders. The second major development is the "Belt & Road Initiative" (BRI), also known as "One Belt One Road," or OBOR, that links China with some less developed nations. The project, initially proposed by President Xi Jinping in 2013 but met with heavy doubts, has been quietly gaining momentum. Some commentators have viewed the BRI as an attempt by the Chinese authorities to export excess domestic industrial capacity and have tried to quantify the impact, which is shortsighted and likely useless. China's vision of the BRI is an ambitious open-ended geo-strategic, economic and social undertaking to promote globalization with distinct "Chinese characteristics." There is no doubt that BRI will face tremendous challenges, and its ultimate destiny is simply an "unknowable unknown" at the moment. However, some solid progress has been made, and foreign authorities are increasingly taking the BRI seriously. Even with limited success, the BRI holds the promise of redefining the balance of geopolitics, global trade and international finance. The role of the RMB in international finance will inevitably grow at the expense of other majors, particularly the dollar. Investors will be well served to closely follow this mega development. Finally, how China's governance and political system will evolve remains a major question mark for investors, especially from a long-term perspective. Democracy has increasingly become the norm of world politics since the early 1990s, with over half of the global population currently living in democratic regimes, while China's political system is decisively foreign (Chart 16). Investors are ideologically skeptical on the long-term sustainability of China's essentially meritocratic authoritarian regime. Investors mostly see democracy as China's ultimate future, and expect the country to progressively move in this direction, along with rising economic prosperity. In reality, however, the ruling Communist Party has tightened its grip over the country in recent years, apparently reverting the trend of political liberalization that was underway in previous years. Chart 16Is Democracy China's Future? In essence, China, with over 20% of the world population, is conducting a mega-political experiment by searching for an alternative to open democracy, the prospect of which remains unknown. The majority of the Chinese population have been content with the existing system, and have been adapting to drastic social and economic changes with ease in the past several decades. Numerous previous predictions of an imminent collapse of the Chinese regime have repeatedly proven wrong, but the underlying anxiety will remain, especially when China's economic growth further downshifts. Political and social stability is crucial for the country's continued economic development. A major social upheaval, on the other hand, would have devastating consequences, not only for China but also for the entire world. Stay tuned. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report "Chinese Financial Tightening: Passing The Phase Of Maximum Strength," dated June 22, 2017, available at cis.bcaresearch.com 2 Please see China Investment Strategy Special Report "More On The Chinese Debt Debate," dated April 20, 2017, available at cis.bcaresearch.com 3 Please see China Investment Strategy Weekly Report "Chinese Real Estate: Which Way Will The Wind Blow?" dated April 20, 2017, available at cis.bcaresearch.com 4 Please see China Investment Strategy Weekly Report "China Outlook: A Mid-Year Revisit," dated July 13, 2017, available at cis.bcaresearch.com 5 Please see China Investment Strategy Weekly Report "The China Debate," dated April 14, 2010, and China Investment Strategy Weekly Report "The China Debate: Four Years On," dated April 30, 2014, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Economic Outlook: Global growth will stay strong over the next 12 months, with the U.S. surprising on the upside. Unfortunately, the global economy will succumb to a recession in 2019. Stagflation will become a major problem in the 2020s. Portfolio Strategy: We are sticking with our pro-risk stance for the time being, but are trimming our overweight recommendations to global equities and high-yield credit. Fixed Income: Maintain below benchmark duration exposure over the next 12 months. Underweight U.S., euro area, and Canadian government bonds; stay neutral the U.K., Australia, and New Zealand; overweight Japan. Equities: Favor cyclicals over defensives, but look to turn outright bearish on stocks late next year. For now, stay overweight the euro area and Japan relative to the U.S. in local-currency terms. In the EM universe, Chinese H-shares will outperform. Currencies and Commodities: While the recent dollar rebound has further to run, oil-sensitive currencies and the yuan will hold their ground against the greenback. It is too early to buy gold. Feature I. Global Macro Outlook: Reflation, Recession, And Stagflation The economic outlook over the coming years can be summarized in three words: reflation, recession, and stagflation. Reflation A Broad-Based Recovery Global growth is firing on all cylinders. The OECD estimates that all 46 of the economies that it tracks will see positive growth this year, the first time this has happened since 2007. Most leading economic indicators remain upbeat (Chart 1). This has left analysts scrambling to revise up their global GDP growth forecasts (Chart 2). Chart 1Most Leading Economic Indicators Remain Upbeat Chart 2Global Growth Has Accelerated The acceleration in global growth has occurred against the backdrop of tame inflation, which has allowed most central banks to keep interest rates at exceptionally low levels. Not surprisingly, risk assets have reacted positively. These goldilocks conditions should remain in place for the next 12 months. While most economies are growing at an above-trend pace, there is still plenty of spare capacity around the world. This means that inflation in countries such as the U.S. - where the labor market has returned to full employment - is likely to rise only gradually, as excess demand is satiated through higher imports. Such a redistribution of demand from countries with low levels of spare capacity to those with high levels is a win-win outcome for the global economy. Recession Running Out Of Room Unfortunately, all good things must come to an end. Weak productivity growth across most of the world is likely to cause bottlenecks to emerge over time, and this will cause inflation to move higher (Chart 3). Output gaps in the main developed economies would actually be higher today than at the height of the Great Recession had potential GDP grown at the rate the IMF projected back in 2008 (Chart 4). This is a testament to just how exceptionally weak potential growth has been. Chart 3Productivity Growth Has Slowed Across The Globe Chart 4Weak Supply Growth Has Narrowed Output Gaps U.S. growth will surprise to the upside over the next 12 months, leading to an unwelcome burst of inflation in late 2018 or early 2019. Financial conditions have eased sharply this year thanks to lower bond yields, narrower credit spreads, a weaker dollar, and a surging stock market. Changes in financial conditions lead growth by around 6-to-9 months, implying that U.S. growth could reach 3% early next year (Chart 5). This could take the unemployment rate down to 3.5% by end-2018, more than a full point below the Fed's estimate of full employment and even lower than the 2008 low of 3.8%. The unemployment rate could fall even further if Congress succeeds in passing legislation to cut taxes, as we expect it will. Our geopolitical team estimates that the GOP proposal would reduce federal revenues by $1.1-to-$1.2 trillion over ten years, or about 0.5% of GDP.1 In order to appease moderates, the final bill is likely to scale back the size of the tax cuts and shift more of the benefits to middle class households. Under the current proposal, the top 1% of taxpayers would receive 50% of the tax benefits (Chart 6). Our best bet is that the legislation will be enshrined into law in early 2018. Chart 5Easier Financial Conditions Will Boost U.S. Growth Chart 6Republican Tax Would Disproportionately Benefit The Top 1% Welcome To The Steep Side Of The Phillips Curve The so-called Phillips curve, which depicts the relationship between unemployment and inflation, tends to become quite steep once unemployment falls to very low levels (Chart 7). It is easy to see why: When spare capacity is high, a modest decline in slack will still leave many workers idle. In such a setting, inflation is unlikely to rise. However, once the output gap is fully closed, any further decline in slack will cause bottlenecks to emerge, pushing wages and prices higher. The 1960s provide a useful lesson in that regard. Just like today, inflation hovered below 2% during the first half of that decade, even though unemployment was trending downward over this period. To most observers back then, the Phillips curve would have also seemed defunct. However, once the unemployment rate fell below 4%, core inflation took off, rising from 1.5% in early 1966 to nearly 4% in 1967 (Chart 8). The kink in the Phillips curve had been reached. Inflation ultimately made its way to 6% in 1970, four years before the first oil shock struck. Chart 7U.S. Economy Has Moved Into The 'Steep' Side Of The Phillips Curve Chart 8Inflation In The 1960s Took Off Once The Unemployment Rate Fell Below 4% Many commentators have questioned the relevance of the sixties template on the grounds that the U.S. economy was less open to the rest of the world back then, trade unions had greater bargaining power, inflation expectations were not as well anchored, and the deflationary effects of new technologies were not as pervasive. We discussed these arguments in a report published earlier this month, concluding that they are not nearly as persuasive as one might think.2 The Difficulty Of Achieving A Soft Landing Rising inflation will compel the Fed to hike rates aggressively starting late next year in order to push the unemployment rate back towards NAIRU. A turn towards hawkishness is especially likely if Janet Yellen is replaced by someone such as former Fed Governor Kevin Warsh, whom betting markets now think has a 40% chance of becoming the next Fed chair (Chart 9). The problem for whoever ends up running the Fed is that it is very difficult to raise the unemployment rate by just a little bit. Modern economies are subject to massive feedback loops. When unemployment begins rising, households lose confidence and reduce spending. This prompts firms to slow hiring, leading to even less spending. The U.S. has never averted a recession in the post-war era whenever the unemployment rate has increased by more than one-third of a percentage point (Chart 10). Chart 9Who Will The Next Fed Chair Be? Chart 10Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Lofty valuations are likely to exacerbate the adverse feedback loop described above during the next downturn. As growth slows, risk asset prices will tumble. This will cause business investment spending to dry up. Given America's dominant role in global financial markets, the U.S. recession will spread like wildfire to the rest of the world. Stagflation The Doves Reassert Control The next recession will probably be more painful for Wall Street than for Main Street. Fed-induced downturns tend to be swift but short-lived. The subsequent recoveries are usually V-shaped, rather than the elongated U-shaped recoveries that follow financial crises. Nevertheless, central banks around the world will undoubtedly start slashing rates again, perhaps even restarting their QE programs. Traumatized by the Great Recession, central bankers will overreact. The hawks will be blamed for the recession and forced to turn tail. The doves will reassert control. Fiscal policy will be significantly eased. This will be particularly the case if the next recession coincides with Trump's re-election campaign, brewing populism in Europe, and the spectre of military conflict in a variety of hotspots around the planet. Structural Forces Will Boost Inflation Meanwhile, millions of baby boomers will be in the process of leaving the workforce. This will lead to slower income growth, but not to slower spending growth - spending actually rises late in life due to spiraling health care costs (Chart 11). An increase in spending relative to income tends to push up prices. A recent IMF research report estimated that population aging has been highly deflationary over the past few decades, but will be very inflationary over the coming years (Chart 12). Chart 11Savings Over The Life Cycle Chart 12Demographic Shifts: From Highly Deflationary To Highly Inflationary All this suggests that the dip in inflation during the next recession will be fleeting. As the recovery from the shallow recession unfolds, inflation will reaccelerate. Of course, at that point, central banks could step in to aggressively quell inflationary pressures. However, they are unlikely to do so. After the next recession-induced burst of fiscal stimulus, debt levels will be even higher than they are now. The temptation to inflate away this debt will intensify. And, in an environment of anemic real potential GDP growth, the means to generate inflation will become available: Central banks will simply need to keep rates below their "neutral" level. Central bankers will rationalize their actions on the grounds that higher inflation will allow them to bring real interest rates deeper into negative territory in the event of another economic downturn. A growing chorus of eminent economists has begun to argue that a 2% inflation target is too low. For example, just this week, Larry Summers stated that "I think we probably need to adjust our monetary policy framework ... to [one] that provides for higher nominal rates during normal times, so there's more room to cut rates during downturns."3 II. Financial Markets As with the economic outlook, the three words reflation, recession, and stagflation guide our views of where financial markets are heading over the coming years. We continue to maintain a pro-risk stance, but are trimming our overweight recommendation to equities and high-yield credit due to the fact that valuations have gotten stretched and we are entering the last innings of the business-cycle expansion (Table 1). Table 1BCA's Tactical Global Asset Allocation Recommendations* Equities Sticking With Bullish ... For Now Recessions and bear markets tend to go hand-in-hand (Chart 13). None of our recession timing indicators are warning of an imminent downturn, suggesting that the cyclical global equity bull market has further room to run (Chart 14). Chart 13Recessions And Bear Markets Usually Overlap Chart 14AThis Business Cycle Has Further To Run Chart 14BThis Business Cycle Has Further To Run Strong growth in corporate earnings continues to underpin the rally in equities. The MSCI All-Country World index has increased by 11.9% in the first 9 months of the year, only slightly more than the 9.1% gain in earnings. As a result, the forward P/E ratio has only risen from 15.7 at the start of the year to 16.1 (Table 2). Table 2Earnings-Backed Price Appreciation Favor Cyclicals Over Defensives Above-trend global growth should boost profits over the next 12 months. We favor cyclical sectors over defensives, and are expressing this view through our long global industrial stocks/short utilities trade recommendation. The trade is up 0.9% since we initiated it last Friday and up 2.3% since I previewed it at BCA's annual New York Investment Conference earlier the same week. Capital spending tends to accelerate in the mature phase of business-cycle expansions, as a growing number of firms realize that they have insufficient capacity to meet rising demand. Our model predicts that global capex will grow at the fastest pace in six years (Chart 15). This should benefit industrial stocks. On the flipside, rising global yields will hurt rate-sensitive utilities (Chart 16). Chart 15Global Capex On The Upswing Chart 16Higher Bond Yields Will Hurt Utilities Financials should also outperform. Banks, in particular, will benefit from steeper yield curves, faster credit growth, and ongoing declines in nonperforming loans. Energy stocks are also attractive. As discussed below, we continue to maintain a generally upbeat view on the direction of oil prices. Prefer DM Over EM, Europe And Japan Over The U.S. While it is a close call, we see more upside for DM than EM stocks, as the former are less vulnerable to a dollar rebound and an increasingly hawkish Fed. Emerging market equities have had a good run over the past year, and are due for a breather. Our favorite EM equity idea for the fourth quarter is to be long Chinese H-shares. H-shares are heavily tilted toward financials and deep cyclicals, two sectors that we like. They also trade at a mere seven-times forward earnings and one-times book value (Chart 17). Within the DM space, European and Japanese equities should outperform U.S. stocks in currency-hedged terms. The sector composition of both the European and Japanese market is tilted toward stocks that will gain the most from strong global growth and increased capital spending. As our European strategists have documented, the European stock market is dominated by large multinationals whose fortunes are tied more to the global economy than to domestic prospects. This is largely true for the Japanese stock market as well. If our prediction for a somewhat weaker euro and yen comes to pass, profits in both regions will benefit from the currency translation effect. Valuations in Europe and Japan are also generally more attractive than in the U.S, even if one adjusts for different sector weights (Chart 18). Chart 17Chinese H-Shares: A Valuation Snapshot Chart 18U.S. Stocks Look Pricey Small Cap Value Trumps Large Cap Growth Style-wise, we prefer small cap value over large cap growth. Value stocks generally do better in environments where cyclicals are outperforming defensives, while small caps tend to be high-beta bets on global growth (Chart 19). U.S. small caps will disproportionately benefit from cuts to statutory corporate taxes, since smaller companies typically have less ability to game the tax code in their favor. Timing The Next Bear Market As one looks beyond the next 12 months, the skies begin to darken for global equities. The stock market usually sniffs out recessions before they happen, but the lead time is quite variable and generally not that long (Table 3). For example, the S&P 500 peaked only two months before the start of the Great Recession in December 2007. Chart 19Favor Cyclicals And Value Plays Table 3Stocks And Recessions: Case-By-Case Chart 20Stagflation Was Devastating For Stocks Stagflation Is Not A Stock-Friendly Environment If the next recession begins in the second half of 2019, global equities will probably peak earlier that year or in late 2018. Given the starting point for valuations, U.S. equities are likely to fall 20%-to-30% peak-to-trough. While other global bourses are generally not as expensive, their higher-beta nature means that they will probably face similar if not worse declines. The fact that correlations tend to rise during risk-off episodes will only add to the bloodshed. Stocks And Stagflation If the experience of the 1970s is any guide, equities perform poorly in stagflationary environments (Chart 20). Investors tend to see stocks as a riskier substitute for bonds. When nominal bond yields rise, the dividend yield offered by stocks becomes less attractive. In theory, the increase in the nominal value of corporate net worth resulting from higher inflation should generate enough capital gains over time to compensate for the wider gap between dividend yields and bond yields. In practice, due to "money illusion" and other considerations, that does not fully occur, requiring that stocks become cheaper so that their expected return can rise. The Long-Term Outlook For Profit Margins A complicating factor going into the next decade will be what happens to profit margins. S&P 500 operating margins are close to their all-time highs (Chart 21). While margins will undoubtedly fall during the next recession, their subsequent recovery is likely to be encumbered by a number of shifting structural forces. A slew of labor-saving technological innovations depressed labor's share of income over the past few decades. So did the entry of over one billion new workers into the global labor force following the collapse of the Berlin Wall and China's transition to a capitalist economy. The fixation of central banks on bringing down inflation may have led to higher unemployment than what would otherwise have been the case, thereby undermining the bargaining power of workers. All this may change during the next decade. China's labor force has peaked and is on track to decline by over 400 million workers by the end of the century - a larger decline than the entire U.S. population (Chart 22). A shift towards persistently more expansionary monetary policy could also keep the labor market fairly tight. Chart 21U.S. Profit Margins Are Close To All-Time Highs Chart 22China On Course To Lose More Than 400 Million Workers Technological innovation will persist, but the firms that benefit from it are likely to attract more scrutiny from regulators. Republican voters - the traditional defenders of corporate America's God-given right to make a buck - are growing increasingly wary of big business. Wall Street, Silicon Valley, and the rest of the corporate establishment tend to be liberal on social issues and conservative on economic ones. Very few voters actually share this configuration of views (Chart 23). The Democratic Party's "Better Deal" moves it to the left on many economic issues. This runs the risk of leaving the U.S. without any major party actively pushing a pro-business agenda. That can't be good for profit margins. Bottom Line: Investors should stay overweight global equities, but trim exposure from moderate overweight to small overweight due to rising business-cycle risk, and look to get outright bearish late next year. The long-term outlook for equities is poor, especially in the U.S. where valuations are highly stretched. Chart 24 presents a stylized sketch of how we think the major stock market indices will evolve over the coming years. Chart 23An Absence Of Libertarians Chart 24Market Outlook: Equities Fixed Income Above-trend GDP growth and rising inflation are likely to push up long-term bond yields in most economies over the next few quarters, as flagged by our Central Bank Monitors (Chart 25). Bond yields will fall during the next recession and then begin to inexorably rise higher as stagflationary forces intensify (Chart 26). Looking out over the next 12 months, our regional allocation recommendations are as follows: Chart 25Our Central Bank Monitors Point To Growing Pressures To Tighten Chart 26Market Outlook: Bonds Underweight The U.S., Euro Area, And Canada Chart 27Canada Enjoys Robust Growth We remain underweight U.S. Treasurys in a global fixed-income portfolio. The market is pricing in only 44 basis points in Fed hikes between now and the end of next year, well below the 100 basis points of hikes implied by the dots in the Summary of Economic Projections. The U.S. yield curve has flattened since the start of the year. This should change over the next 12 months, as inflation expectations rebound from currently depressed levels. The yield curve in the euro area should steepen more than in the U.S., since the ECB has pledged not to raise rates until well after its asset purchase program is complete - something that is unlikely to happen until the end of next year. This implies that the 2-year spread between the two regions will widen in favor of the U.S., which should be bullish for the dollar. Canadian bond yields are likely to rise further (Chart 27). The unemployment rate has fallen to a nine-year low and the Bank of Canada expects the output gap to be fully closed by the end of this year. The economy grew by 3.7% year-over-year in the second quarter, well above the BoC's estimate of potential real GDP growth of 1.5%. The Bank's most recent Business Outlook Survey points to continued robust growth ahead. The bubbly housing market remains a concern, but delaying withdrawal of monetary accommodation risks exacerbating the problem. Neutral On Gilts And Aussie And Kiwi Bonds In contrast to most other developed economies, leading indicators point to slower U.K. growth in the months ahead (Chart 28). This undoubtedly reflects the ongoing uncertainty over Brexit negotiations, which are likely to drag on for quite some time. Core inflation has surged to 2.7% on the back of the sharp depreciation of the pound, but market expectations suggest that it is about to roll over. Nevertheless, with 10-year gilts fetching just 1.35%, the downside for yields is limited. The cheap pound should also prop up exports, partly offsetting the impact of diminished market access to the rest of the EU. The unemployment rate stands at 4.3%, slightly below the Bank of England's estimate of NAIRU. One way or another, the uncertainty over Brexit will fade, allowing gilt yields to move higher. As with gilts, the outlook for Australian and New Zealand bonds is mixed. Strong global growth should boost commodity prices. This will help the Australian economy. The unemployment rate in Australia has fallen to 5.6%, but involuntary part-time employment is high and wage growth has been stagnant. Industrial capacity utilization remains low, as reflected in a fairly large output gap (Chart 29). The market expects the RBA to deliver 38 basis points in rate hikes over the next 12 months. We think that's about right. New Zealand's 10-year yield stands at a relatively generous 2.96%, which makes it difficult to be too bearish on kiwi bonds. However, we do not see much scope for yields to fall from current levels. Nominal GDP is growing at over 5% and retail sales are expanding at nearly 7% (Chart 30). The terms of trade have risen to their highest level since the 1970s. The output gap is now fully closed and core inflation is edging higher. Despite this good news, the policy rate remains at a record low of 1.75%. We concur with market expectations that the RBNZ will start raising rates next year. Chart 28U.K. Growth Is Slowing Chart 29There Is Still Slack In The Australian Economy Chart 30New Zealand: Upbeat Indicators Overweight JGBs CPI swaps predict that inflation in Japan will average only 0.5% over the next twenty years. As we argued last week, this is far too low.4 The secular drivers of deflation are fading and inflation will begin to surprise to the upside over the coming years (Chart 31). However, the path between here and there will be a choppy one. Considering that deflationary expectations remain deeply entrenched, the Bank of Japan is unlikely to abandon its yield curve targeting regime for at least the next few years. As government bond yields rise elsewhere in the world, 10-year JGBs will be the default winners. Investors thinking of going short Japanese government bonds should focus on 20-year or 30-year maturities, which are not subject to the BoJ's cap. Credit: Still Overweight, But Trimming Back Exposure High-yield credit spreads have fallen back near their post-recession lows after widening in the wake of the global manufacturing recession (Chart 32). We see little scope for further spread compression. Our U.S. Corporate Health Monitor remains in deteriorating territory (Chart 33), and higher Treasury yields will put downward pressure on corporate bond prices even if spreads remain constant. Nevertheless, the default-adjusted spread on U.S. high-yield debt of 212 basis points is still large enough to warrant a modest overweight to credit, especially since banks have started to loosen lending standards again. Chart 31Japan: Fading Deflationary Forces Chart 32High-Yield Spreads Have Narrowed Chart 33U.S. Corporate Health Continues To Deteriorate Our Global Fixed Income Strategists prefer U.S. over European credit, given that spreads are lower in Europe, and the tapering of ECB asset purchases could reduce the demand for spread product. Currencies And Commodities The Dollar: Comeback Kid? Charts 34 and 35 show our expectations about the future path of the major currencies and commodities. Chart 34Market Outlook: Currencies Chart 35Market Outlook: Commodities BCA's Global Investment Strategy service went long the dollar in October 2014. We reiterated our bullish stance before the U.S. presidential elections, controversially arguing that "Trump Will Win And The Dollar Will Rally."5 Unfortunately, we remained long the dollar over the course of this year, which turned out to be a mistake. Strong growth abroad, weaker-than-expected inflation readings in the U.S., and the fizzling of the "Trump Trade" all contributed to dollar weakness. Technicals also played a role. Sentiment was extremely bullish towards the dollar at the start of the year, but extremely bearish towards the euro (Chart 36). The reversal of these technical trends helps explain why the euro appreciated a lot more than what one would have expected based simply on changes in interest rate differentials (Chart 37). Chart 36Euro: Long Positions Are Getting Stretched Chart 37The Euro Has Overshot Interest Rate Spreads Of course, if the spread between U.S. and euro area interest rates continues to narrow, it is likely that EUR/USD will strengthen. We are skeptical that it will. For one thing, financial conditions have eased sharply in the U.S. since the start of the year, but have tightened in the euro area (Chart 38). This suggests that U.S. growth will surprise on the upside whereas euro area growth could begin to disappoint. Chart 38U.S. Versus Euro Area Diverging Financial Conditions The five-year, five-year forward OIS spread between the two regions stands at 87 basis points in nominal terms, and 25 basis points in real terms. The five-year forward spread is even lower if one calculates a GDP-weighted bond yield for the euro area rather than looking at the expected path of interbank rates. Such a small spread is inconsistent with the fact that the neutral rate is substantially higher in the U.S.6 We expect EUR/USD to fall to $1.15 by the end of 2017, and potentially decline further in 2018 as the Fed picks up the pace of rate hikes. The dollar is also likely to strengthen against the yen, as Treasury yields rise relative to JGB yields. We see less downside for the British pound and the Swedish krona against the greenback. This is reflected in our long GBP/EUR and long SEK/CHF trade recommendations, both of which remain in the black. Upside For Oil-Sensitive Currencies Our energy strategists still see further upside for crude oil prices, owing to favorable supply and demand conditions. They point to the fact that official forecasts by the EIA have consistently underestimated oil demand. They also note that compliance with OPEC 2.0 production cuts has been remarkably good, and that estimates of how much new shale output will hit the market over the next 12 months are too optimistic. Additionally, they believe that the decline in production from conventional oil fields around the world - especially offshore fields, where there has been a dearth of new investment in recent years - could be larger than expected.7 Geopolitical risks in Iraq, Libya, and Venezuela could also adversely affect supply. Firmer demand and lackluster supply will lead to further drawdowns in OECD oil inventories, which should be supportive of prices (Chart 39). We recently took profits of 13.8% on our recommendation to go long the December-2017 Brent oil futures contract, but are maintaining exposure to oil through our long CAD/EUR and RUB/EUR positions, as well as through our bias towards cyclical equities. Resilient Chinese Economy Should Support Metal Prices And The RMB Recent Chinese data have been on the soft side, giving rise to fears that the economy is heading towards a major slowdown. We are more optimistic. While growth has clearly slowed since the start of the year, it remains at an above-trend pace, as evidenced by numerous real-time measures of economic activity (Chart 40). Chart 39Falling Oil Inventories Should Lead To Higher Crude Prices Chart 40Chinese Economy: No Need To Be Pessimistic Even the housing market has managed to stay resilient, despite widespread predictions of imminent doom (Chart 41). The share of households planning to buy a new home remains close to all-time highs. The amount of land purchased by developers - a good leading indicator for housing starts - is accelerating. Reflecting these developments, property stocks are surging. Financial conditions have tightened, but so far this has largely bypassed the real economy. In fact, long-term bank lending to nonfinancial institutions has accelerated since the start of the year (Chart 42). The recently announced cuts to reserve requirements for small business loans should facilitate this trend. Chart 41Chinese Housing Market Remains Resilient Chart 42Credit To Real Economy And Profit Rebound Bode Well For Capex Meanwhile, industrial profits have rebounded, as rampant producer price deflation last year has given way to modest price gains this year. Increased retained earnings will give Chinese companies the wherewithal to spend more on capital equipment. A recovery in global trade should also help stoke export growth. (Chart 43). Despite strengthening this year, our indicators suggest the yuan is still in undervalued territory (Chart 44). Buoyant economic growth should alleviate capital flight and reduce the pressure on the authorities to engineer a further depreciation of the currency. This, in turn, should help support metal prices and other EM currencies, even in a setting where the dollar remains well bid. Chart 43Positive Global Trade Momentum: A Tailwind For Chinese Exports Chart 44The Chinese Yuan Is Undervalued Chart 45Gold: Waiting For Drivers Of Sustained Price Appreciation Buy Gold ... But Not Yet Lastly, a few words on gold. Gold does well in situations where real rates are falling and the dollar is weakening (Chart 45). That's not the environment we find ourselves in today. Gold will have its day in the sun, but probably not before the stagflationary era begins in earnest after the next recession. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 This revenue loss is measured against a baseline where a number of tax breaks, which are currently set to expire, are extended. Please see BCA Geopolitical Strategy Weekly Report, "Is King Dollar Back?" dated October 4, 2017, available at gps.bcaresearch.com. 2 Please see Global Investment Strategy Weekly Report, "Is The Phillips Curve Dead Or Dormant?" dated September 22, 2017. 3 Summers, Lawrence, H. (@LHSummers). "Great piece by @jasonfurman in today's @WSJ: The U.S. can no longer afford deficit-increasing tax cuts." 01 Oct 2017. Tweet. 4 Please see Global Investment Strategy Weekly Report, "Three Tantalizing Trades," dated September 29, 2017. 5 Please see Global Investment Strategy Special Report, "Three (New) Controversial Calls," dated September 30, 2016. 6 Please see Global Investment Strategy Weekly Report, "Central Bank Showdown," dated September 8, 2017. 7 Please see Commodity & Energy Strategy, "OPEC 2.0 Will Extend Cuts to June 2018," dated September 21, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Either China's growth will slump soon, capping budding inflationary pressures, or policymakers will have to hike interest rates meaningfully to tackle inflation. If the PBoC drags its feet and does not hike interest rates amid rising inflation, the RMB will come under major selling pressure. EM/China corporate profits have expanded predominantly due to price increases. However, rapid price increases warrant higher interest rates. The latter is a formidable risk to share prices. The U.S. dollar has made a major bottom. Stay short select EM currencies. The EM equity rally momentum remains strong but the risk-reward is quite unfavorable. We expect the external backdrop - metals prices and portfolio flows to EM - to deteriorate inhibiting the current easing cycle in Peru. Stay underweight this bourse within the EM universe (page 13). Feature A key question for investors at the current juncture is whether the global economic backdrop is moving toward inflation or deflation - or whether it will remain in its present "goldilocks" state. One can cite numerous examples that support each of the three scenarios. Proponents of deflation cite low consumer price inflation in the U.S., euro area and Japan, as well as very weak money growth in China and the U.S. as being leading indicators of budding deflationary pressures. Advocates of goldilocks - improving growth with low inflation - point to robust global trade and low consumer price inflation, as well as benign financial market dynamics in the form of higher share prices and low bond yields. Last but not least, inflationists can cite very tight labor markets among advanced economies as well as rising core and services consumer price inflation rates in China (Chart I-1). Chart I-1China: Inflation Is Grinding Higher At BCA's annual conference in New York held last week, the broad consensus was that there is a lack of considerable inflationary pressures worldwide amid improving global growth. This is consistent with the goldilocks outcome currently priced by the financial markets - i.e., a combination of robust growth and low inflation. Given the current pricing in financial markets, one economic variable that could disturb benign global financial dynamics is inflation. This report examines inflationary dynamics in China and briefly touches on the U.S. and euro area inflation outlooks. Our take is as follows: Unless China's money and credit growth slow further and generate another deflationary slump in China and world trade, the odds are that the balance both globally and within China will tilt toward inflation in the next 12 months. To be clear, our main theme remains that a material slowdown in China's growth will dampen China/EM growth, derail the EM corporate profit recovery and cap inflationary pressures in China, at least. Therefore, to some extent, this report is counter-factual - it examines what may happen if a meaningful growth deceleration in China does not transpire. Our analysis also addresses the question of what may happen if policymakers in China allow money/credit to accelerate again, without permitting the economy to slow too much. The short response: Inflation is already slowly but surely rising in China and it will soon become a constraint, limiting Chinese policymakers' options. China/Asia Recovery: Prices Or Volumes? China's industrial revival, as well as Asia's export recovery over the past 12-18 months, has largely been due to price increases amid modest volume growth. In particular: China's manufacturing production volume growth has not improved at all, but manufacturing producer prices have surged, producing substantial recovery in nominal output growth (Chart I-2). This is strictly within manufacturing, and does not include mining and ferrous metal production, where output cuts have led to surging prices for raw materials. In brief, one can observe higher inflation beyond the steel and coal industries. Furthermore, producer price inflation has improved for consumer goods (Chart I-3, top panel), and for the first time in 17 years ex-factory producer price deflation has ended in durable consumer goods as well as in electronics goods and communication equipment (Chart I-3, middle and bottom panels). Chart I-2China's Industrial Recovery: Surging ##br##Prices Amid Subdued Volume Growth Chart I-3China: Producer Price ##br##Inflation Is Broad-Based Notably, China's core (ex-food and energy) consumer price inflation has moved above 2%, and consumer services price inflation has risen to 3% (Chart I-1 on page 1). Importantly, these consumer inflation measures have risen, even though food prices are deflating in China and energy prices are stable. This entails that consumer price inflation pressures are genuine and reasonably broad-based. In Asian trade, the dichotomy between prices and volumes is especially apparent in the case of Korea's exports. The U.S. dollar value of Korean exports has mushroomed, but there has been only modest revival in export volumes (Chart I-4). Remarkably, both the 2014-'15 slump and the 2016-'17 recovery in Korean exports were largely due to prices, not volumes. The latter have been expanding modestly in recent years, while prices crashed in 2013-'15 and surged in 2016-'17. Finally, Korean and Taiwanese export prices as well as U.S. import prices from Asia have risen in the past 12-18 months, following years of deflation (Chart I-5). Chart I-4Korean Export Recovery: Prices Versus Volumes Chart I-5Asian Export Prices: A Reversal? Beyond higher prices for steel and other commodities, Korea's export prices are climbing because of skyrocketing DRAM semiconductor prices (Chart I-6). Price changes are much more important to corporate profits than volume changes. For example, a 5% rise in prices boosts corporate profits by much more than a 5% gain in output volume. By the same token, profits decline more when prices drop by 2% than when volumes fall by 2%. We discussed this phenomenon and illustrated an example in our January 28, 2016 report.1 Rising prices across various commodities and manufactured goods have allowed Chinese and Asian companies to deliver strong profits in the past 12 months. China's industrial profits have ballooned, even though output volume growth has been modest. On the whole, the enormous money/credit injection in China in the past two years has hindered lingering price deflation and led to rising prices for various goods and services. Chart I-7 illustrates that the recovery in corporate pricing power and, hence, mushrooming industrial corporate earnings can be attributed to the mainland's credit/money impulses. Chart I-6DRAM Semi Price Has ##br##Surged 4-Fold In Last 12 Months Chart I-7China: A Peak In Producer ##br##Prices And Industrial Profits? If pricing power deteriorates, as the money/credit impulse is signaling, corporate earnings will be at risk. In such a scenario, inflation will not be a problem, as deflationary pressures will resurface. However, corporate profits will shrink. Bottom Line: EM/China corporate profits have expanded predominantly due to price increases. Investors have celebrated it by flocking into EM/Chinese stocks. However, rapid price increases warrant higher interest rates. The latter is a formidable risk to share prices. Barring a material growth deceleration in China, which is our baseline view, odds are that inflation will rise further. Why Now? Inflation is rising in China because of rampant money/credit creation complemented with a weak productivity growth rate. In addition, policymakers have engineered a reversal in raw materials price deflation since early 2016. It is impossible to know if the Chinese economy has reached a point where growth rates of 6-6.5% and above will lead to inflation. It is hard to estimate potential GDP growth rates and output gaps for advanced countries, but it is practically impossible to do so in the case of China. Its economy has undergone multiple dramatic structural transformations in the past 30 years, changes that continue today. That said, it is possible to argue that China may have reached a point where further rampant money and credit creation leads to higher inflation. The key thesis is that productivity growth has slowed because of the following: Channeling credit to SOEs - which often misallocate capital - and to property markets does not boost productivity. Infrastructure projects will take years to produce productivity gains, even if they are well thought out. Chart I-8 illustrates that in recent years an increasing share of investment has been on structures and installations rather than equipment and new technologies. Investment in structures does not boost productivity as much as equipment purchases. Meanwhile, private capital spending has been in the doldrums over the past four years, as has been the case for manufacturing investment (Chart I-9). This argues for less efficiency/productivity and, thereby, diminished potential growth. Chart I-8Unfavorable Mix For Productivity Growth Chart I-9Private And Manufacturing Capex Remain Weak Historically, it was private investment and manufacturing capacity expansion that fostered productivity gains in China. Private projects are often more efficient than public investment, and it is much easier to achieve higher productivity in manufacturing than in the service sector. This is not to argue that there are no innovation and rapid technological changes in China. A lot of innovation and technological advancement is happening but it might not be sufficient to boost productivity growth above 6% (Chart I-10). China's extremely fast productivity gains in the past 20 years have largely been due to rapid expansion of manufacturing and construction. Manufacturing cannot rise fast because it is hard for China to gain more market share in global trade without causing political backslashes. In turn, construction has been driven by excessive credit expansion and property market speculation and policymakers want to reduce this. It is imperative to understand that in any country productivity is much lower in the service sector than in manufacturing and construction. A shift away from manufacturing and construction toward services will surely lead to much lower productivity and, hence, potential economic growth. If policymakers allow/encourage rapid money/credit expansion to achieve growth rates above 6-6.5% or so, the outcome will be inflation. Implications For Chinese Policymakers If economic growth does not slow, odds are that inflation will continue to rise in China due to a lower potential GDP growth rate. As such, policymakers will have to tackle inflation by raising interest rates. The deposit rate in China is at 1.5%, and is presently negative when deflated by core consumer price inflation (Chart I-11). This is occurring for the first time in ten years. Chart I-10Potential Growth = Labor Force + ##br##Productivity Growth Chart I-11China: Deposit Rate In ##br##Real Terms Is Negative If inflationary pressures continue building up and policymakers do not hike interest rates, households will become even more dissatisfied by negative deposit rates and opt for converting their RMB deposits into foreign currency, or buying real estate. Both scenarios will eventually lead to financial instability, which policymakers are trying to avoid. Chart I-12 demonstrates that the current level of foreign exchange reserves of US$ 3.3 trillion is equal to only 34% of household deposits and 15% of total (corporate and household) deposits, and 10% of our broad M3 money measure. In brief, the failure to proactively hike deposit rates will likely lead to capital flight. Policymakers realize that the Chinese banking system has created so much money that even the sheer size of foreign currency reserves is insufficient to defend the currency if and when households and companies choose to convert their liquid savings into foreign currency. This argues for higher interest rates in China, unless growth downshifts very soon and caps inflation. Bottom Line: Either China's growth will slump soon, capping budding inflationary pressures, or policymakers will have to hike interest rates meaningfully to avoid another run on the exchange rate. What About DM And Non-Asian EM? In the majority of non-Asian EM economies, inflation is either muted or under control. The exceptions are Turkey and central European economies. We have discussed the inflation outbreak in central Europe in detail in past reports (also see Chart I-13 below), and will be revisiting Turkey next week.2 Chart I-12Too Much Money Has Been Created Chart I-13Inflation Outbreak In Central Europe The basis is that there has been little recovery in Latin American economies as well as Russia and South Africa for inflationary pressures to transpire. While some may be prone to structural inflation, cyclical business conditions are still too weak to warrant rising pricing power. In the Euro Area, investors should closely monitor German wage dynamics. Manufacturing wages and core consumer price inflation in central Europe are ramping up (Chart I-13). If and when labor shortages and rising wages in central Europe discourage German manufacturing companies from relocating/outsourcing production to the former, it will put more pressure on the already very tight German labor market and will lead to higher wages. As a result, genuine inflation in the largest European economy will heighten. In the U.S., the tight labor market and vibrant growth argue for higher inflation ahead. The Trump administration's proposed tax cuts amid robust growth will boost demand and rekindle inflation. Bottom Line: Inflation expectations are very depressed worldwide, and it will not take much in the way of upward inflation surprises to re-price interest rate expectations and, consequently, financial assets. Financial Markets Ramifications The Foreign Exchange Market: The U.S. dollar has probably made a major bottom and will stage a multi-month rally (Chart I-14). Chart I-14Will The Greenback Find ##br##Support At Current Levels? The Federal Reserve will be the first central bank to hike interest rates if global inflation or inflation expectations rise. In turn, the European Central Bank and the People's Bank of China will likely move slower in tightening policy. Such a proactive policy stance of the Fed, especially relative to its peers, will benefit the greenback. Furthermore, the potential appointment of Kevin Warsh as Fed Chairman could lead to higher interest rate expectations in the U.S., and will be currency bullish. In short, the potential mix of tight monetary policies and easy fiscal policies is bullish for the dollar. In the interim, U.S. bond yields are likely to move higher. This is true in the near term, even if Chinese growth disappoints. It will take time until China's growth deceleration caps the upside in U.S./global bond yields. Consistent with our U.S. dollar view, we believe commodities prices have reached a major peak. In sum, the path of least resistance for the U.S. dollar is up. Stay long the U.S. dollar versus a basket of EM currencies: ZAR, TRY, MYR, IDR, BRL and CLP. Local Currency Bonds: As and when EM currencies depreciate versus the greenback and U.S. bond yields grind higher, EM high-yielding local currency bonds could sell off. Chart I-15 reveals that the spread between the EM-GBI local currency benchmark yield and five-year U.S. Treasurys has fallen to a 10-year low. The risk-reward is not attractive for U.S. dollar- and euro-based investors. EM credit versus U.S. investment grade bonds. On August 16, 2017, we advised shifting our underweight EM sovereign bonds recommendation away from U.S. high yield to U.S. investment grade corporate credit. This strategy remains intact. This is consistent with EM currencies depreciating versus the U.S. dollar, U.S. bond yields moving higher and commodities prices softening. Continue underweighting EM stocks versus DM: A stronger U.S. dollar and rising U.S. bond yields will reverse EM equities' relative outperformance versus DM. In fact, manufacturing PMIs certify that EM manufacturing growth remains subdued relative to DM (Chart I-16). Chart I-15EM Local Currency Bonds: Little Yield Advantage Chart I-16EM Equities Versus DM: A Sign Of Reversal? If this coincides with inflation or growth concerns in China, it will create a perfect storm for all EM risk assets. As to EM stocks' absolute performance, we are approaching a major top, even though the exact timing of a major relapse is uncertain. Flows into EM equities remain robust, but they will reverse if one or more of the following transpires: rising U.S. interest rate expectations, a stronger U.S. dollar, high and rising inflation in China and policy tightening, or the opposite - an imminent growth slump in China and a relapse in commodities prices. All in all, the EM equity rally momentum remains strong but the risk-reward is quite unfavorable. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Peru: External Backdrop Holds The Key The external environment has been and will remain key to the performance of Peruvian financial markets. The Peruvian bourse has rallied massively, outperforming the EM equity benchmark over the past year, even as domestic demand in Peru has been weakening. Despite stronger global growth and higher commodities prices, GDP growth along with consumer and capital growth have not recovered at all (Chart II-1). Meanwhile, bank loan growth remains very weak (Chart II-2). Chart II-1Peru: Weak Domestic Demand... Chart II-2...Corroborated By Weak Credit Growth If metals prices stay firm and strong capital flows in EM persist, Peru's currency will remain under appreciation pressure. This will provide the central bank with more room to ease policy by cutting interest rates and adding liquidity to the banking system as it accumulates foreign exchange reserves (Chart II-3). Continued policy easing by the central bank will in turn revive bank loan growth, and the economy will recover. Chart II-3FX Reserve Accumulation = Liquidity Easing Our baseline scenario, however, is that industrial metals prices in general and copper prices in particular will relapse materially in the next 12 months. Furthermore, odds are that U.S. bond yields will drift higher and the U.S. dollar will strengthen (as discussed on pages 11-12). Under such a scenario: The Peruvian sol would come under depreciation pressure if and when metals prices relapse (Chart II-4). With precious and industrial metals representing 60% of total exports, a drop in metals prices will lead to considerable deterioration in Peru's trade balance and FDI inflows will slump. The central bank is committed to maintaining a stable exchange rate due to high foreigner ownership of government local currency bonds and a still-partially dollarized economy. Hence, if the currency comes under attack, the central bank will defend the sol by selling its international reserves, which will deplete local currency liquidity (Chart II-3). Consequently, local rates will rise and banks will curtail bank loan growth, which in turn will preclude any recovery in domestic demand. Overall, the external environment and its impact on the exchange rate holds the key for a domestic-led recovery. A relapse in industrial metals and copper prices and ensuing depreciation pressure on the currency will undo the recent loosening in monetary policy and stall a potential domestic demand recovery. In terms of financial markets strategy, we recommend the following: Despite domestic demand weakness, the Peruvian equity market has been on a tear, led by banking and mining stocks. Given our negative view on industrial metals and copper prices, we recommend staying underweight Peruvian equities relative to the EM benchmark (Chart II-5). Chart II-4Terms Of Trade Dictate The Currency Chart II-5Has Peru's Relative Equity Performance Peaked? With respect to our absolute call on bank stocks and our relative trade versus Colombian banks, we recommend closing both trades with large losses. Finally, we recommend being long Peru credit relative to Brazilian sovereign credit. Public debt burden is much lower in Peru (24% of GDP) than in Brazil (74% of GDP). Andrija Vesic, Research Assistant andrijav@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "Corporate Profits: Recession Is Bad, Deflation Is Worse," dated January 28, 2016, link available at ems.bcaresearch.com 2 Please see Emerging Markets Strategy Special Report "Central Europe: Beware Of An Inflation Outbreak," dated June 21, 2017, and Emerging Markets Strategy Weekly Report, dated September 6, 2017; pages 15-18; links are available on page 18. Equity Recommendations Fixed-Income, Credit And Currency Recommendations