Capex

Highlights U.S. credit growth is set to improve as capex has more upside and households benefits from a positive backdrop. The U.S. has substantially more room to increase leverage than the rest of the G10, pointing toward further monetary divergences. The euro is not very cheap and is trading at a significant premium to forward rate differentials. It is thus at risk if U.S. rates can rise vis-à-vis Europe. Chinese underlying inflation is becoming elevated, which could prompt additional tightening by the PBoC. Moreover, Xi Jinping's speech this week suggests a move away from the debt-fueled, investment-led growth model. The AUD is at risk. Feature A general lack of credit growth has been one of the key factors hampering both broader growth and inflation in the U.S. Not only has this muted activity and weak pricing pressure kept the Federal Reserve on the easier side of policy, the absence of lending growth has further depressed real rates as demand for loanable funds remains low. Can credit pick up from here, and what are the implications for the USD? Room For Optimism There are good reasons to lean a bit more on the positive side regarding the U.S. credit growth outlook. As Chart I-1 illustrates, U.S. commercial and industrial loan growth seems to be rebounding. Confirming that this impulse could gain momentum, it follows an easing in lending standards and a pick-up in durable goods orders - two leading indicators of business borrowings. Household debt is also showing some signs of revival. While the annual growth rate of household borrowings from banks has yet to trough, the annualized quarterly growth rate has picked up significantly - a development that tends to precede accelerations in the yearly measure. Moreover, this improvement is broad based among all the key components of household borrowings (Chart I-2). Chart I-1Upside For U.S. C&I Loans... Upside For U.S. C&I Loans… Upside For U.S. C&I Loans… Chart I-2... And For Household Debt As Well ... And For Household Debt As Well ... And For Household Debt As Well This has positive implications for U.S. nonfinancial private credit, which has been in the process of forming a shallow bottom relative to GDP. Moreover, based on the low level of debt servicing costs for both households and businesses, this trend has room to develop (Chart I-3). However, most of the increase in the debt-to-GDP since 1994 has been caused by financial engineering, with firms swapping equity for debt in their capital structure, and has therefore not lifted domestic demand nor created inflationary pressures. However, we posit that this phenomenon is toward its tail end, and that additional debt accretion could have a meaningful impact on growth. Why? On the business front, capex - an essential but volatile component of aggregate demand - is set to accelerate further. Business investment is led by firms' capex intentions, a series that has surged since the summer of 2016 (Chart I-4, top panel). Confirming the message from this indicator, profits from U.S.-listed businesses have also sharply rebounded, a signal that leads capex by a year, as highlighted last Monday by Anastasios Avgeriou, who heads BCA's U.S. Equity Sector Strategy service (Chart I-4, bottom panel).1 Chart I-3The U.S. Has Room To Relever The U.S. Has Room To Relever The U.S. Has Room To Relever Chart I-4Capex Outlook Looks Good Capex Outlook Looks Good Capex Outlook Looks Good On the household front, three factors support our assessment: First, household nominal and real wages and salaries should enjoy further upside as the labor market remains very healthy. This means more consumption and more capacity to accumulate debt, especially as household financial obligations remain near multi-generational lows (Chart I-5). In fact, U.S. real median household income already hit an all-time high in 2016. Chart I-5Supports To Household Consumption Supports To Household Consumption Supports To Household Consumption Second, household confidence is still near record-high levels, a factor which tends to lead credit growth and consumption. Optimistic households are more likely to spend their income gains and buy durable goods like houses or apartments, especially as the household formation rate has regained vigor. Third, U.S. net wealth has hit 430% of disposable income, a record, which will keep supporting consumption. As households see their net worth increase, they can boost consumption and debt as their leverage ratios improve, especially when financial obligation ratios are as low as they are today. These factors point toward a continued increase in the indebtedness of the U.S. private sector, one which this time we anticipate will add to demand through investments, real estate purchases and general consumption. This also means that real rates are likely to experience upside. More debt-fueled aggregate demand implies more demand for loanable funds, and thus higher real rates. In an economy operating near full capacity, it can also lift inflation. Tax cuts and fiscal stimulus would only be a bonus in this environment. This should give the Fed room to increase interest rates in line with its dot plot, or more than the two-and-a-half hikes priced into the OIS curve over the next two years. However, as 2017 has vividly demonstrated, movements in U.S. rates alone are not enough to make a call on the U.S. dollar. One needs to have a sense of how U.S. rates could evolve vis-à-vis the rest of the world. In the context of debt accumulation, we are optimistic that the U.S. could experience a re-leveraging relative to the rest of the G10, putting upward pressures on U.S. real rates relative to the rest of the world. To begin with, U.S. non-financial private credit stands at 150% of GDP, a drop of 20% of GDP since its peak in 2009. The rest of the G10 has not experienced the same extent of post-financial crisis deleveraging, and nonfinancial private credit there still hovers around 175% of GDP (Chart I-6). Today, the indebtedness of the U.S. relative to other advanced economies is near its lowest levels of the past 50 years. Debt levels are obviously not the only consideration; the ability to service that debt also must enter the equation to judge the capacity of an economy to accumulate debt relative to the rest of the world. Currently, according to the BIS, the debt-service ratios of the U.S. nonfinancial private sector still stand well below the GDP-weighted average of the rest of the G10 (Chart I-7). This also highlights that the U.S. has plenty of room to have both higher debt accumulation and higher real rates than the rest of the G10. Chart I-6U.S. Vs. G10: Debt Upside U.S. vs. G10: Debt Upside U.S. vs. G10: Debt Upside Chart I-7Lower Private Sector Debt-Servicing Costs In The U.S. Lower Private Sector Debt-Servicing Costs In The U.S. Lower Private Sector Debt-Servicing Costs In The U.S. This should support the dollar in 2018. As Chart I-8 shows, 10-year bond yield differentials between the U.S. and other large advanced economies lead tops in the dollar by one year. To highlight this relationship, this chart de-trends the DXY by plotting it as a deviation from its 10-year moving average. Not only does the current trend in real rate differentials already point to a higher dollar, but room for more debt accumulation in the U.S. relative to the rest of the G10 supports the notion that the elevated level of spreads could even expand, implying the era of monetary divergence has yet to end. As we highlighted last week, the dollar may not be as expensive as seems at first glance. We have expanded on our 'modelization' exercise this week, using methods employed by the Swiss National Bank to incorporate the Balassa -Samuelsson effect.2, 3 This metric, which incorporates the relative price of manufactured goods in each economy, further confirm our assessment from last week that the dollar is not expensive enough to warrant a sell-signal (Chart I-9). Thus, with competitiveness a non-issue for the dollar for now, the USD is likely to be able to take advantage of potentially supportive real interest rate spreads. Chart I-8Real Rates Point To A Higher Peak For The USD Real Rates Point To A Higher Peak For The USD Real Rates Point To A Higher Peak For The USD Chart I-9U.S. Only Sightly Expensive U.S. Only Sightly Expensive U.S. Only Sightly Expensive On the technical side, our U.S. Dollar Capitulation Index hit very depressed levels earlier this year, but is now rebounding. Crucially, it has moved meaningfully back above its 13-week moving average, an event which normally characterizes uptrends in the dollar (Chart I-10). Chart I-10Dollar: From Bearish To Bullish Mood Dollar: From Bearish To Bullish Mood Dollar: From Bearish To Bullish Mood Bottom Line: The U.S. economy looks set to enjoy an episode of rising debt supporting increasing economic activity and higher rates as capex should grow further and a supportive backdrop continues to emerge for households - whether or not tax cuts happen. Because the U.S. private sector has comparatively healthy balance sheets relative to the rest of the G10, this means that U.S. re-leveraging should outpace the rest of the world. Even if this U.S. re-leveraging is only a cyclical phenomenon and not a resumption of the debt super-cycle, it would imply that monetary policy divergences have yet to reach their apex, and thus the dollar could experience additional upside. Even Against The Euro? We tend to view the euro as the anti-dollar. It is the main vehicle to play both uptrends and downtrends in the dollar and it is also the most liquid instrument, backed with an economy similarly sized as the U.S. Thus, the views expressed above would imply a negative slant on EUR/USD. Such a framework can give an impetus to a EUR/USD view, but is also not enough. Indeed, factors more specific to this pair argue that EUR/USD does have downside. When it comes to valuations, using the SNB's methodology, the EUR/USD is more or less the mirror image of the DXY. This pair is slightly cheap, essentially within the statistical definition of fairly valued (Chart I-11). Thus, valuations alone are fully neutral for the euro. This means EUR/USD remains prisoner to relative interest rate dynamics. On this front, a key driver of this pair paints a risky picture for euro bulls. The 1-year/1-year forward risk-free rate spread between the euro area and the U.S. has been a reliable guide of the EUR/USD's trend for the past 12 years. Yet, the euro's rally has not been matched by a similar move in this spread. As a result, the gap between the currency pair and its rates-implied fair value is at its highest since the summer of 2014 (Chart I-12). Chart I-11Euro: Not That Cheap Euro: Not That Cheap Euro: Not That Cheap Chart I-12Forward Interest Rates Point To Euro Risk Forward Interest Rates Point To Euro Risk Forward Interest Rates Point To Euro Risk But then again, the differential between the European and U.S. 1-year/1-year forward risk-free rate is at its lowest ever over the time frame of this chart. However, it was even lower than current levels in 1999 and 1997. This suggests that if the U.S. can re-leverage relative to the rest of the G10, the spread could grow as negative as it was in these two previous instances. Supporting this assessment, we anticipate U.S. inflation to outperform euro area measures going forward. Last week, we explored the reasons why we see an upcoming uptick in U.S. inflation next year: U.S. financial conditions have eased, American velocity of money has increased, pipeline inflationary pressures are growing and underlying wage growth seems to be improving.4 Meanwhile, European financial conditions have tightened, especially against the U.S., which historically leads to an underperformance of European inflation measures. Very importantly, the euro area core CPI diffusion index has rolled over and is now below 50%, suggesting that euro area core CPI has limited upside (Chart I-13). This means potential downside vis-à-vis the U.S. and room for upside in U.S. rates relative to the euro area, especially as the European Central Bank is likely to craft its message carefully next week when it announces the tapering of its asset purchases, to prevent quick upward movement in interest rate expectations. Additionally, the dollar is still quite under-owned by speculators relative to the euro. Our favorite positioning measure, which sums long bets in the euro with short bets on the DXY - two equivalent wagers - continues to hover near record-high levels, suggesting potential downside in EUR/USD (Chart I-14). This continues to highlight the risks to the euro created by a repricing of the Fed. Chart I-13Euro Area CPI Peaking? Euro Area CPI Peaking? Euro Area CPI Peaking? Chart I-14Excess Bullishness In Euro Intact Excess Bullishness In Euro Intact Excess Bullishness In Euro Intact Bottom Line: The euro is obviously at risk if the dollar gets lifted by rising economic activity and indebtedness in the U.S., even if this cyclical upswing in debt does not represent a resumption of the debt super-cycle. Moreover, 1-year/1-year forward rates differentials point to heightened EUR/USD vulnerability, especially if U.S. inflation bottoms relative to the euro area. Moreover, long euro bets have yet to be washed out, deepening the EUR/USD's vulnerability. A Few Words On China Chart I-15China: Good Reasons For Policy Tightening China: Good Reasons For Policy Tightening China: Good Reasons For Policy Tightening Despite a marginal slowdown in Chinese real GDP growth and slightly disappointing industrial production and fixed asset investment numbers for the third quarter, some key Chinese economic activity metrics have been very robust. Imports are growing at a 19% annual pace, credit growth continues to outperform expectations and electricity production and excavator sales remain robust. Should this make investors bullish on China plays? In our view, two key risks lurk on the horizon. The first is monetary tightening. Pricing pressures in China are growing and are looking increasingly genuine. As Chart I-15 shows, core CPI is clocking in at 2.3%, the highest level since 2010-2011, a level which in the past prompted monetary tightening by the Chinese authorities. Additionally, services inflation - a purely domestic sector and thus one reflective of domestic inflationary pressures - is now above 3% and accelerating. Also, PPI has re-accelerated to 6.9%, pointing to a paucity of deflationary forces in the Chinese economy that could potentially give the People's Bank of China the green light to tighten further. We would expect the rise in the Shibor 7-day rate to continue and monetary conditions, which have been tightening since the end of 2016, to become an even bigger handicap in the future. The second risk lies around the Communist Party Congress underway in Beijing. Xi Jinping's marathon speech highlighted his vision for Chinese socialism in a new era. Xi is very clearly dedicated to the primacy of the Chinese communist party. He did highlight, however, that the new principal problem for the Chinese population is the need for a better life, with less imbalances, less inequalities. This fits with his previously revealed policy preferences. As Matt Gertken, who heads the Asian efforts on our Geopolitical Strategy team, has shown, Xi's administration has massively increased spending to protect the environment and increased financial regulation (Table 1).5 These preferences fit in the optic of addressing China's new principal problems: too much pollution and too much debt. Table 1Fiscal Priorities Of Recent Chinese Presidents All About Credit All About Credit Moreover, the continued fight against corruption also fits into that mold. It is a key tool to maintain the legitimacy of the Communist party, and a popular way to address some of the inequalities and imbalances plaguing China today. What does this mean? China has continued to accumulate debt over the past 10 years, with debt to GDP increasing by nearly 120% between 2008 and 2017 (Chart I-16). If a window is opening to tighten monetary policy because inflationary pressures are growing while there is political will to combat inflation and imbalances, it is likely that investment - which pollutes heavily - and debt - a byproduct of large capex programs - could be curtailed. Moreover, the Chinese government still has the wherewithal to support aggregate economic activity through fiscal stimulus. In addition, in the context of the above, much fiscal stimulus could be deployed to fight pollution and decrease inequalities by supporting households. This means that while Chinese GDP growth is unlikely to weaken substantially, the capex intensity of the economy could decrease. So would imports of raw materials and capital goods. As a result, this could be a very negative environment for metals. Metals prices have rebounded sharply since 2016 as Chinese investment has increased. But now that policy could be tightened further and that Xi's new administration has more freedom to move away from an investment-heavy, deeply polluting growth model, the rally in metals could be at risk. Copper, a bellwether for the metals complex, has surged nearly 70% since 2016, and bullish sentiment on the red metal is now at levels historically associated with imminent corrections (Chart I-17). Chart I-16Is This What Deleveraging Looks Like? All About Credit All About Credit Chart I-17Tighter Policy And A Reform Push Put Metal At Risk Tighter Policy And A Reform Push Put Metal At Risk Tighter Policy And A Reform Push Put Metal At Risk This means that currencies for which metals prices are a key driver of terms of trade are at great risk, specifically the BRL, the CLP and the AUD. Moreover, the latter is expensive, having recently been buoyed by some positive economic numbers, and is now widely owned by very bullish investors. We have a short sell AUD/USD at 0.79 and our short AUD/NZD trade at 1.11 was triggered following the Labor/NZ First/Green coalition announced Thursday in New Zealand. Bottom Line: Chinese authorities are set to tighten monetary conditions further as domestic inflationary pressures are growing. Moreover, while short on details, this week's speech by Xi Jinping at the opening of the 19th Communist Party Congress in Beijing seemed to confirm that addressing imbalances, inequalities, and environmental problems will be a key objective of this administration. This points toward a less debt-/investment-driven economic model - at least until deflationary problems re-emerge. While overall GDP growth could be supported by targeted fiscal support, investment plays linked to Chinese capex and real estate could suffer. The AUD is at risk, and we are entering our proposed short AUD/NZD trade. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see U.S. Equity Strategy Special Report, titled “Top 5 Reasons To Favor Cyclicals Over Defensives” dated October 16, 2017, available at uses.bcaresearch.com 2 The Balassa Samuelson effect is an empirical observation that countries with higher productivity tend to experience an appreciating trend in there real exchange rate. Please see Foreign Exchange Strategy Weekly Report, titled “Is The Dollar Expensive?”, dated October 13, 2017, available at fes.bcaresearch.com 3 Samuel Reynard, “What Drives the Swiss Franc?” Swiss National Bank Working Papers (2008 – 14). 4 Please see Foreign Exchange Strategy Weekly Report, titled “Is The Dollar Expensive?”, dated October 13, 2017, available at fes.bcaresearch.com 5 Please see Geopolitical Strategy Weekly Report, titled “How To Read Xi Jinping’s Party Congress Speech”, dated October 18, 2017, available at gps.bcaresearch.com Currencies U.S. Dollar Chart II-1 USD Technicals 1 USD Technicals 1 Chart II-2 USD Technicals 2 USD Technicals 2 U.S. data was mixed: Last week's CPI releases showed that inflation disappointed in September, with headline CPI increasing by only 2.2%, below the expected 2.3%; and Core CPI coming in at 1.7%, in line with expectations; However, long-term TIC data showed a large inflow of funds of USD 67.2 bn, much larger than the expected USD 14.3 bn. The labor market continues to tighten with initial jobless claims and continuing claims dropping to 222,000 and 1.888 million respectively. The DXY has rebounded this week on this news, and also helped by a somewhat disappointing ZEW survey from the euro area, but pared its gains on Wednesday. Regardless, positive developments in the U.S. fiscal space and disappearing slack will provide a tailwind for the greenback. 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-3 EUR Technicals 1 EUR Technicals 1 Chart II-4 EUR Technicals 2 EUR Technicals 2 Data from the euro area has been mixed: Industrial production grew at an annual rate of 3.8% in August; The trade balance contracted to EUR 16.1 bn from EUR 23.2 bn on a non-seasonally-adjusted basis, but improved on a seasonally-adjusted basis. The final estimate for core CPI hit 1.1%, in line with expectations; The ZEW Survey dropped and underperformed expectations; Despite largely weak data, the euro has pared all of last week's losses. Markets may be pricing in Catalan developments as a bullish case. The Spanish government has threatened to enact Article 155 of the constitution if Catalonia does not comply, which will give Spain the authority to take measures to ensure compliance by the rogue region. 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-5 JPY Technicals 1 JPY Technicals 1 Chart II-6 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: Bank lending outperformed expectations, growing at a 3% year-on-year pace. Machinery orders yearly growth also outperformed to the upside, coming in at 4.4% However, the annual growth of both imports and exports underperformed expectations and declined significantly from last month, coming in at 12% and 14.1% respectively. The yen has remained relatively flat these past two weeks. Overall, we expect USD/JPY to have additional upside, given that the U.S. OIS curve is not pricing in enough rate hike over the next 2-years. Ultimately, the driver of USD/JPY will simply be U.S. rates as Japanese 10-year rates are capped near 0%. This situation is not likely to change any time soon, as the Japanese economy is still hampered by very low inflation. 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-7 GBP Technicals 1 GBP Technicals 1 Chart II-8 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Average hourly earnings outperformed expectations, growing at a 2.2% pace from a year ago. Both headline and core inflation came in line with expectations at 3% and 2.7% respectively. However, both retail sales and retail sales ex-fuel growth underperformed expectations, coming in at 1.2% and 1.6% respectively. Overall, we do not expect much more upside for the pound relative to the U.S. dollar, given that there is already a hike priced for November. At this point, the economic situation does not warrant any more hikes beyond just removing the emergency measures implemented after the Brexit fallout. Furthermore inflation has stopped climbing, and could start to come down in the coming months as the effects of the currency dissipate. Finally, Brexit negotiations have hit a bit of a temporary impass. 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-9 AUD Technicals 1 AUD Technicals 1 Chart II-10 AUD Technicals 2 AUD Technicals 2 The AUD has not seen much action this week. The RBA minutes highlighted that "slow growth in real wages and high levels of household debt were likely to be constraining influences". This is largely in line with our argument that spare capacity is limiting wage growth and inflation in the economy. Going forward, China remains a risk to our view, with the most recent import figures having provided a welcomed fillip to the AUD. Nevertheless, remarks by RBA Governors will limit the upside in the AUD. Expectations of a rate hike by the RBA depend upon growth numbers, which are unlikely to be achieved given the current trajectory of wages and consumer spending. Furthermore, high underemployment in the economy also remains a drag on spending, dampening the positive effect of a strong job report. 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-11 NZD Technicals 1 NZD Technicals 1 Chart II-12 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been mixed: Electronic card retail sales year-on-year growth declined form 4.4$ to 2.9%. Business NZ PMI softened from 57.9 to 57.5. However, headline inflation came in at 1.9%, rising from the previous month reading of 1.7% and outperforming expectations. The kiwi sold off by almost 2% yesterday, as Jacinda Ardern was elected as the new prime minister of New Zealand. The market is now pricing the risk that the Labor party, which Ardern leads, could change the mandate of the central bank from just targeting inflation to also seeking full employment. Moreover, Labor and its coalition partner, NZ First, want to curtail immigration, one of the tailwind to New Zealand growth. These development would structurally limit the upside for kiwi rates, acting as a headwinds to the New Zealand dollar. 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-13 CAD Technicals 1 CAD Technicals 1 Chart II-14 CAD Technicals 2 CAD Technicals 2 The CAD has been somewhat strong recently due to developments in the oil market. KSA-Russia support for an extension of supply cuts to OPEC 2.0, as well as developments in Iraq, have pointed to an increase in prices. While the path for Canadian interest rates seem fairly priced, oil prices could buoy the CAD. Risks surrounding NAFTA remain, as President Trump stays inflexible with regards to tariffs, although this is likely to have a greater effect on Mexico than on Canada. Furthermore, albeit still in its infancy Morneau's tax plan, which is anticipated to mostly affect the richest of small business, could have an effect on investment intentions. 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-15 CHF Technicals 1 CHF Technicals 1 Chart II-16 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has surprised to the upside: The unemployment rate decreased from 3.2% and 3.1%, outperforming expectations. Producer and import prices yearly growth came in at 0.8%, also surprising to the upside. Finally, the trade balance also outperformed, coming in at 2.918 billion dollars for September. It seems that the fall in the franc has been very positive to the Swiss economy. Overall, it would be difficult to see much more upside in EUR/CHF, as the euro already reflects euro area positives. That being said, we are reticent to be outright bearish on this cross as the economic data is still too weak for the SNB to change its monetary policy stance. 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-17 NOK Technicals 1 NOK Technicals 1 Chart II-18 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been negative: Manufacturing yearly output growth underperformed expectations, contracting at 5.7%. Both core and headline inflation also surprised to the downside, coming in at 1% and 1.6% against expectations of 1.2% and 1.7% respectively. Finally, the Norwegian trade balance declined from 12.4 billion dollars to 9.2 billion dollars USD/NOK has risen 3% since September, even as oil prices have continued their path upward. This was first and foremost reflective of the higher probability of rate hikes in the U.S. in December. Additionally, the recent Norwegian inflation and trade balance numbers are showing that the krone rebounds has tightened monetary conditions in this Scandinavian economy. Overall, we remain bullish on USD/NOK and bearish on EUR/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-19 SEK Technicals 1 SEK Technicals 1 Chart II-20 SEK Technicals 2 SEK Technicals 2 The most recent inflation data was slightly weak, with CPI increasing by 0.1% monthly, and 2.1% yearly. Unemployment worsened as the rate rose to 6.2% from 6%. The krona depreciated against the euro on the news, but was flat against the dollar. Despite this temporary setback, PMIs are still perky across the board, and credit is hooking up. China and Europe's recent performance has likely provided a tailwind for growth, which should translate into higher inflation as capacity utilization is extremely tight. Furthermore, the depreciation of the SEK since the beginning of September has eased monetary conditions, making way for the central bank to begin a tightening process in the wake of the ECB's tapering program. 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 Tactical Trades Closed Trades

In this week's Weekly Report, we are highlighting what we expect to be the key macro theme we see dominating markets in 2018: the nascent recovery in capital outlays transforming into a full blown capex upcycle. The second panel shows that the recent V-shaped recovery in operating EPS should morph into a sizable capex upcycle. Vibrant capex then feeds back into profits, leading to a virtuous cycle. Empirical evidence suggests that a lagged relationship exists between these two variables: since the early 1980s capex growth has typically trailed profit growth by one year. Intuitively, as earnings recover, CEOs have more confidence in the outlook for final demand and choose to deploy longer-term oriented capital. National accounts data also confirm the positive correlation between capex1 and corporate non-financial operating earnings2 growth, albeit with a shorter lag. Our chart shows that since the 1980s recession, all four recessions were preceded by stock market reported capex soaring to roughly a 20% annual growth rate. At the current juncture, capex is merely on the cusp of entering expansion territory and, if history at least rhymes, a significant capex upcycle is looming and higher beta/higher operating leverage deep cyclicals sectors are going to be in the driver's seat. Please see Monday's Weekly and Special Reports for more details. Underappreciated Capex Underappreciated Capex 1 Source: National Income and Product Accounts 2 Source: Financial Accounts of the United States - Z.1

Underappreciated Capex Table 1Evolution Of S&P 500 Q3 2017 Estimates Top 5 Reasons To Favor Cyclicals Over Defensives Top 5 Reasons To Favor Cyclicals Over Defensives Equities moved laterally last week, consolidating recent gains. Loosening fiscal policy coupled with synchronized global growth remain the dominant macro themes. Earnings season got underway and since our early October Q3 EPS analysis, overall forecasts have collapsed further to a mere 4.3% year-over-year growth rate trailing even expected revenue growth (Table 1). Importantly, the financials sector (which we are overweight) is heavily weighing on the overall profit picture and is expected to contract profits by 9% (Table 1). While the insurance sub-sector (which we are underweight) may be behind the bulk of the negative EPS revisions owing to the recent hurricane catastrophes, such extreme pessimism is unwarranted and the bar is set extremely low both for the financials sector and the overall market. While still early in the season, better than expected bank reports are hinting that surprises will be to the upside. If bank cash has already been put to work following the late-June mega buyback announcements, then profits will most certainly overwhelm. Following up from last week's easy fiscal/tight money analysis1, the ongoing capex upcycle (and any assistance from a possible infrastructure bill) is likely to add fuel to the fire and propel equities deeper into overshoot territory. This nascent recovery in capital outlays transforming into a full blown capex upcycle is the key macro theme we see dominating markets in 2018. Investors and pundits alike are dismissing the potential positive thrust from a capital spending upturn that is not only a common late-cycle phenomenon, but also the result of a virtuous EPS cycle. Chart 1 shows that the recent V-shaped recovery in operating EPS should morph into a sizable capex upcycle. Vibrant capex then feeds back into profits, leading to a virtuous cycle. Empirical evidence suggests that a lagged relationship exists between these two variables: since the early 1980s capex growth has typically trailed profit growth by one year. Intuitively, as earnings recover, CEOs have more confidence in the outlook for final demand and choose to deploy longer-term oriented capital. Granted, this also works in reverse: when profits contract, all spending ceases and preservation of cash takes center stage. This is the nature of animal spirits, and currently they are in takeoff mode. National accounts data also confirm the positive correlation between capex2 and corporate non-financial operating earnings3 growth, albeit with a shorter lag. Bear in mind that one key difference between the stock market reported capex data and the national accounts is the energy/basic resource sectors' unusually large slice of the stock market-reported overall capex pie (Chart 2). Chart 1Virtuous Cycle Virtuous Cycle Virtuous Cycle Chart 2Resources Retrenchment Is Over Resources Retrenchment Is Over Resources Retrenchment Is Over Nevertheless, the message is clear and consistent from both data sets and most importantly from forward looking indicators of cyclical spending: a sustainable capex upcycle is brewing (Chart 3). It would be unprecedented if the current business cycle ended without a visible capex upcycle. The bottom panel of Chart 1 shows that since the 1980s recession, all four recessions were preceded by stock market reported capex soaring to roughly a 20% annual growth rate. At the current juncture, capex is merely on the cusp of entering expansion territory and, if history at least rhymes, a significant capex upcycle is looming. Drilling beneath the surface on sector capex composition is revealing. Chart 4 shows that basic resources (energy, industrials & materials) reported financial statement capex is still contracting. The rest of the eight sectors combined are also experiencing a sizable capex deceleration, signaling a wide-ranging capex slowdown (Charts 5, 6 & 7 break down the top eleven sector capex growth rate). Chart 3Expect A Capex... Expect A Capex… Expect A Capex… Chart 4...Recovery... …Recovery… …Recovery… Chart 5... Across... …Across… …Across… Similar to the recent 2015/16 broad-based EPS contraction phase that was not limited to the three resource related industries but permeated most GICS1 sectors, all segments of the market have been in capex retrenchment mode, suffering the aftermath of the recent profit recession. If our thesis of a virtuous EPS-to-capex cycle takes root in the coming quarters, then a synchronized capex upcycle is in the cards, and higher beta/higher operating leverage deep cyclicals sectors are going to be in the driver's seat (Chart 7). Chart 6... All... …All… …All… Chart 7...Sectors …Sectors …Sectors Our October 2nd S&P industrials sector boost to overweight4 shifted our portfolio to a modest cyclical over defensive tilt, and this week's Special Report highlights five key reasons to prefer cyclicals over defensives (please see below). Top 5 Reasons To Favor Cyclicals Over Defensives Following last November's Trump election victory euphoria, the S&P cyclicals/defensives ratio has been marking time, oscillating in a tight 5% trading range, and digesting the impressive run up. Factors are now falling into place for a playable breakout in the cyclical/defensive ratio. Five key macro drivers outline our warming up to a cyclical over defensive portfolio tilt: Capital expenditures upcycle Synchronized global growth in general and emerging markets (EM) growth in particular U.S. dollar softness Risk premia suppression Diverging operating metrics Capex Upcycle The capex upcycle, which should take root globally, not just in the U.S. (second panel, Chart 8), will disproportionately benefit capital goods producers versus their defensive brethren. Basic resources manufacturers are extremely capital intensive/high operating leverage businesses that flex their earnings power muscle when capex is on the upswing. In fact, if our thesis of a generalized capex upcycle materializes, then even defensive sector manufacturers will boost spending (Chart 6) and reinforce capital goods producers' top and bottom line growth prospects. Chart 8Capital Expenditures Upcycle... Capital Expenditures Upcycle… Capital Expenditures Upcycle… The worst for deep cyclicals-related capex is likely over and as confidence returns, purse strings will loosen and lead to fresh investment decisions in order to satisfy upbeat final demand. Keep in mind that capex is starting from an historically low point for the complex, and there are high odds that the recent tick up in capex will gain traction (Chart 2) as resource companies are now more flush with cash. As a reminder, the most opportune time to buy cyclicals at the expense of defensives is in full expansion mode during a virtuous cycle and not in retrenchment mode. Leading indicators of capital outlays have taken off at full throttle (top panel, Chart 8), and the reviving global credit impulse (courtesy of the Bank for International Settlements) suggests that bankers will continue to extend credit and fulfil loan demand. This credit fuel will likely propel both capex and the relative share price ratio higher (bottom panel, Chart 8) or, at the very least, remove the critical constraint to firms growing their balance sheets. Synchronized Global Growth Synchronized global growth typically boosts global final demand and is also conducive to a coordinated global capex upcycle. The resurgent global manufacturing PMI and buoyancy in most of its subcomponents suggests that cyclicals have the upper hand (fourth panel, Chart 9). Importantly, the IMF's most recent World Economic Outlook upgraded global growth, penciling in 2.1% and 5.3% real GDP growth for the back half of 2018 for advanced and developing economies, respectively. Historically, this growth differential has been positively correlated with relative share prices and the recent IMF upgrade of forward output growth should add impetus to the upswing in the relative share price ratio (top panel, Chart 9). Indeed, emerging markets economies are gaining steam and EM assets reflect recent resiliency: EM stock prices in particular both in local currency and U.S. dollars are at multi year highs painting a bright picture for the cyclical/defensive ratio (third panel, Chart 9). Within the EMs, China remains a key source of uncertainty. The economy has likely passed the point of peak growth momentum, and economic data surprises have recently turned negative. Still, shorter-term measures of money & credit growth have turned positive, and global growth indicators continue to point to a robust external demand (which will, in turn, support Chinese import growth). All told, while China is likely to decelerate from current levels, the slowdown is likely to be benign and will cause the economy to settle into a stable growth range. This is a positive outcome for trades that are sensitive to the potential for a sharp decline in Chinese economic activity, such as cyclicals versus defensives. Soft U.S. Dollar The U.S. dollar has a critical influence on the relative share price ratio. The currency remains in the red year-to-date, on a trade-weighted basis, and cyclical momentum will likely linger in negative territory at least for the remainder of the year given that the greenback peaked in late 2016. This represents a bullish backdrop for cyclical compared with defensive EPS prospects as a lagged currency effect should boost relative profitability (Chart 10). Chart 9...Synchronized Global Growth... …Synchronized Global Growth… …Synchronized Global Growth… Chart 10...The Dollar's Softness... …The Dollar’s Softness… …The Dollar’s Softness… The S&P cyclicals sectors sport, on average, 47% foreign sales exposure, whereas defensives garner a mere 14% of total revenue from abroad according to FactSet.5 The implication is that a depreciating U.S. dollar gooses cyclicals EPS three times more than defensives, ceteris paribus. Our relative export proxy corroborates this profit advantage that cyclicals enjoy at the expense of defensives (third panel, Chart 10). One final way that the U.S. currency depreciation benefits cyclicals is via the commodity channel. In general, commodities are priced in U.S. dollars, thus any drop in the currency is almost immediately mirrored in rising commodity prices and vice versa. In contrast, fluctuating commodity prices represent an input cost for select defensives and commodity inflation tends to eat into profit margins. Our relative pricing power gauges do an excellent job capturing these pricing dynamics and the forward looking ISM manufacturing prices paid sub-index signals additional relative pricing power gains (fourth panel, Chart 10). Low Risk Premia Chart 11...Suppressed Risk Premia... …Suppressed Risk Premia… …Suppressed Risk Premia… The fall in the greenback has historically been correlated with reviving global real output, "risk on" phases and a decline in risk premia. The opposite is also true. Currently, investor euphoria reigns supreme and the suppression in risk premia across asset classes is flashing green for a cyclical over defensive portfolio tilt. All four major asset volatilities we track have collapsed of late (Chart 11), and there are high odds they will remain depressed as long as coordinated global economic growth chugs along. Financial conditions remain easy both in DM and across most of EM. The St. Louis Fed Financial Stress Index6 is also plumbing multi year lows. Similarly, globally, junk bond spreads are narrow and even the level of junk yields is no longer "high yield", especially in the Eurozone. Finally, the Bloomberg calculated soft versus hard data surprise index is at all-time highs and will likely rekindle relative share price momentum. The upshot is that the runway is clear for the cyclical/defensives ratio (Chart 11). Diverging Operating Metrics Turning to operating metrics, cyclicals clearly have the upper hand. The top panel of Chart 12 shows that the overall business sales-to-inventories ratio troughed in early 2016 and reflects a brighter final demand backdrop for cyclicals relative to defensives. This pickup in end demand is conducive to a further widening of relative operating margins, a message corroborated by the multi-year highs in the ISM manufacturing survey (second panel, Chart 12). The most important development exiting the late-2015/early-2016 global manufacturing recession is that deep cyclicals have made major strides in deleveraging balance sheets and significantly improving their liquidity while in massive retrenchment mode (Chart 12). That era is now over and cyclical cost structures are adjusting, albeit slowly, to higher revenue run rates. The commodity price recovery since early 2016 has considerably improved net debt-to-EBITDA and interest coverage for cyclicals versus defensives. Moreover, relative free cash flow growth generation in isolation is also expanding for the first time in three years and should sustain the valuation rerating phase (middle panel, Chart 13). Our relative Cyclical Macro Indicators best encapsulate the shifting macro landscape: the current message is to expect more gains in the relative share price ratio (top panel, Chart 13). Chart 12...Divergent Operating Metrics... …Divergent Operating Metrics… …Divergent Operating Metrics… Chart 13...And Cyclical Macro Indicators, All Support Cyclicals Over Defensives …And Cyclical Macro Indicators, All Support Cyclicals Over Defensives …And Cyclical Macro Indicators, All Support Cyclicals Over Defensives Risks Most of the indicators we track point to additional gains in relative share prices, however, three risks bear close attention. While relative valuations are slightly on the expensive side and cash flow generation should sustain the cyclical valuation premium, if cyclicals compared with defensives profits disappoint in the coming quarters, then the lack of a valuation cushion is a key risk to our constructive cyclicals over defensives view. Related to this profit mishap risk, any severe Chinese/EM slowdown or global growth scare would put our view offside as relative EPS growth would underwhelm. A spike in the U.S. dollar is the final risk to our thesis. Any surge in the U.S. dollar would short circuit relative performance and a relapse to the 2016 lows could materialize. Either a more hawkish than expected Fed or a destabilizing Chinese currency devaluation (similar to August 11, 2015) can cause tremors in global markets that would reverberate via a soaring greenback. Such an outcome would deal a blow to commodity prices and cyclicals profits and, as a result, cyclicals share prices would bear the brunt of the U.S. dollar's might. Investment Implications Adding it up, the revving capital expenditures upcycle, synchronized global growth in general and firming EM growth in particular, U.S. dollar softness, risk premia suppression and diverging operating metrics all favor cyclicals at the expense of defensives. Bottom Line: Shift to a cyclical over defensive portfolio bent. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Can Easy Fiscal Offset Tighter Monetary Policy?"dated October 9, 2017, available at uses.bcaresearch.com. 2 Source: National Income and Product Accounts 3 Source: Financial Accounts of the United States - Z.1 4 Please see BCA U.S. Equity Strategy Weekly Report, "Earnings Take Center Stage,"dated October 2, 2017, available at uses.bcaresearch.com. 5 https://www.factset.com/earningsinsight 6 https://fred.stlouisfed.org/series/STLFSI

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 Chinese Q3 GDP Should Have Remained Strong Chinese Q3 GDP Should Have Remained Strong Chart 2Breakout In China And EM Equities Breakout In China And EM Equities Breakout 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 The PBoC Liquidity Operation The PBoC Liquidity Operation Chart 4Policy Constraints Weigh Heavy On Some Sectors Policy Constraints Weigh Heavy On Some Sectors Policy 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 Real Estate Investment May Surprise To The Upside Real Estate Investment May Surprise To The Upside Chart 6Exports: Moderating, Not Relapsing Exports: Moderating, Not Relapsing Exports: 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 China's Growing Significance In World Economy China's Growing Significance In World Economy Chart 8China And Base Metals China And Base Metals China 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... Massive Expansion Of Transportation Infrastructure... Massive Expansion Of Transportation Infrastructure... Chart 10...Has Narrowed The Gap ##br##With Developed Economies On A Higher Note On A Higher Note 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 On A Higher Note On A Higher Note 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 Positive Rerating Of China And EM Has Further To Run Positive Rerating Of China 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 On A Higher Note On A Higher Note Chart 14China's Catchup Process ##br##Has A Lot Further To Run On A Higher Note On A Higher Note 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 China's Tech Boom China'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? On A Higher Note On A Higher Note 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 Oil prices have hit our target, but more upside is likely. President Trump's tax proposal has arrived and the Trump trades have responded. Surging M&A activity is not a sign of a market top. The supports are all in place for a robust period of U.S. capital spending. We expect another solid earnings season in Q3, with little impact from the hurricanes. Feature The S&P 500, Treasury yields and the dollar all rose last week, with the S&P hitting a new all-time high, even as 10-year Treasury yields hit a 2-month high. The sweet spot for risk assets has been extended by the rise in oil prices and rising prospects for tax cuts in the U.S. M&A activity will continue, which is market bullish because it has not yet reached frothy levels. Moreover, capex is blasting off, which will give growth (and EPS) another boost. The downtrends in both Treasury yields and the dollar this year are over, and they both have more upside given that economic growth and underlying inflation are both improving. Moreover, the FOMC is still in a position to deliver on a December rate hike with 2-3 additional hikes in 2018, which will be a wake-up call for bonds and will reverse this year's dollar weakness. More Upside In Oil Prices Last week, both Brent ($57.50/bbl) and WTI ($51.60/bbl) hit the midpoints of the ranges set by our commodity and energy strategists earlier this year. This milestone provides us with an opportunity to revisit BCA's stance on the oil market. OPEC's deal to cut production will be extended to at least June 2018. Based on BCA's latest assessment of the global oil market,1 OPEC 2.0 will fall short of reducing visible inventories to their 5-year average if the coalition's production cut agreement expires which was initially agreed upon in March 2018. Extending OPEC 2.0's cuts through December 2018 would nudge OECD commercial inventories closer to levels originally targeted by OPEC 2.0 at the end of last year (Chart 1). Therefore, in 2018 we expect WTI to average slightly less than $57.50/bbl and Brent to average just under $59/bbl. Accordingly, there is a higher risk that prices will exceed the upper end of our WTI range ($45/bbl to $65/bbl) with greater frequency next year. Furthermore, BCA's Commodity & Energy Strategy team has raised its global oil demand forecasts for both 2017 and 2018; increased demand will support prices in the next 12 months (Chart 2). Chart 1OPEC 2.0 Needs To Extend Cuts,##BR##To Reduce Global Inventories OPEC 2.0 Needs To Extend Cuts, To Reduce Global Inventories OPEC 2.0 Needs To Extend Cuts, To Reduce Global Inventories Chart 2Base Case For BCA Oil Supply-Demand Balances##BR##Reflects June 2018 Expiry Of OPEC 2.0 Cuts Base Case For BCA Oil Supply-Demand Balances Reflects June 2018 Expiry Of OPEC 2.0 Cuts Base Case For BCA Oil Supply-Demand Balances Reflects June 2018 Expiry Of OPEC 2.0 Cuts Geopolitical risks in Iraq and an escalation in supply disruptions add to BCA's bullish view. The Kurd's vote for independence from Iraq last week will elevate tensions in the region and could trigger a civil war. If a war breaks out over Kirkuk, it will lead to production cuts. Furthermore, civil war in Iraq would reduce the flow of FDI into Iraq's oil infrastructure, further crimping output. Moreover, Russia, which supports the Kurd's fight, would also benefit from high oil prices. Oil production wildcards in 2017 mostly favored more oil output. However, in 2018, supply disruptions will curtail global oil output. Bottom Line: Additional supply cuts, higher demand, elevated tensions in Iraq and a normal spate of supply disruptions, all suggest that there is upside risk to our $45-$65 stance on WTI. A risk to this forecast is a sharply higher dollar linked to expansionary fiscal policy. Tax Cuts Imminent Chart 3Trump Trades Making A Comeback Trump Trades Making A Comeback Trump Trades Making A Comeback As BCA's Geopolitical Strategy service predicted last month, President Trump's long-awaited tax plan will likely be enacted in Q1 2018. Trump and the Republicans in Congress, still desperate for a legislative win after again failing to repeal and replace Obamacare, introduced the proposal last week. However, the plan must clear several hurdles before it becomes law. First, the proposals may run afoul of both deficit hawks and moderates in the Congress' Republican caucus. The initial framework has tax decreases, but no revenue or spending offsets. The implication is that the package would blow out the deficit, alienating the fiscal conservatives. Moderates may not like the lack of cuts for the middle class. Democrats have not yet had their say. The CBO still must score the legislation, and even with dynamic scoring2 which counts on stronger economic growth to boost revenues and reduce outlays for automatic stabilizers and some social programs, it will add to the deficit. This may also cause an uproar in Congress. Nonetheless, on a positive note, Trump has the support of the influential House Ways and Means Committee, as well as the Senate Finance Committee. This was not the case with the Obamacare repeal and replace when the President and his GOP allies were at odds. First and foremost, the GOP-led Congress needs to pass a budget resolution, expected by the end of October. Congress considers the President's request as it formulates a budget resolution, which both houses of Congress must pass. Bottom Line: Investors should watch the response of Congressional Republicans to Trump's tax proposals. A lukewarm reception would indicate that investors' renewed optimism may be premature. The Trump trades have made a comeback in the past two weeks and will continue to be profitable if the current proposal (or something similar) is signed into law in Q1 2018 (Chart 3). If Trump and the GOP could extend the tax cuts into broader tax reform, it would provide a lift to corporate M&A activity. Little Froth From M&A Market U.S. merger and acquisition (M&A) volume peaked along with U.S. equity prices in the late 1990s and mid-2000s, but another top in the current deal market does not signal a top in equity prices. Deal volume (in dollars) and relative to market cap peaked in 1999, again in 2007, and more recently in mid-2015, before a 13% pullback in the S&P 500 in late 2015 and early 2016 (Chart 4). Although not shown on the chart, deal volume surpassed its late 1980s' pinnacle in 1995, five years before equity markets reached record highs in 2000. Through August, corporate takeovers relative to GDP matched those prior heights, but remained below the 1999, 2007 and 2015 tops as a percentage of market cap. Furthermore, global or cross-border M&A, a better indicator of market zest than U.S.-only activity, has not eclipsed the peaks in 2007. Measured against both global GDP and market cap, worldwide corporate combinations are below their 2015 zenith and well below the 2007 peak. At just 7% in 2016, the GDP-based metric was significantly under the mid-2000s pinnacle of 10%. That said, it is difficult to analyze this in context as the time series does not reach back to the late 1990s, which were the boom years for M&A. Bottom Line: Booming M&A activity is not a sign of froth in equity markets but it is a sign that animal spirts are stirring. Overall net equity withdrawal (which includes the net impact of IPOs, share buybacks, and M&A) has not been out of line with previous economic expansions (Chart 5). Stay overweight stocks versus bonds. The uptrend in capital spending is another sign of a shift in animal spirits. Chart 4Roaring M&A Volume Not##BR##A Sign Of A Market Peak Roaring M&A Volume Not A Sign Of A Market Peak Roaring M&A Volume Not A Sign Of A Market Peak Chart 5Comparison Of Corporate Outlays Across Four Economic Expansion Phases Managing The Risks Managing The Risks Capital Spending Blasting Off The capital spending outlook remains bright despite the recent loss of momentum in industrial production, as indicated by BCA's aggregate for IP in the advanced economies (Chart 6). This is disconcerting because global and regional industrial production are important indicators of both economic growth and corporate earnings. The recent softening is due to a few factors. Much of it is linked to weakness in the U.S. where hurricanes affected the August figures. However, most of our leading indicators remain constructive. Chart 7 presents simple models for real GDP growth for the G4 economies based on our household and capital spending indicators. Real GDP growth will continue to accelerate for the G4 economies, according to the model. BCA's aggregate consumer indicator for the G4 appears to have peaked, but the capex indicator is blasting off. The bullish capital spending reading is unanimous across the major economies. Robust capital goods imports for our 20-country aggregate supports the view that "animal spirits" are stirring in boardrooms in the advanced economies. These imports and BCA's capital spending indicators suggest that the small pullback in advanced-economy industrial production will not last, purchasing managers' indexes will remain elevated, and the acceleration in global export activity is only starting (Chart 7). Despite the lack of progress in Washington on repealing Obamacare and enacting tax cuts, even the U.S. small business sector has shifted into a higher gear in terms of hiring and capital spending, according to the NFIB survey (not shown). Moreover, both BCA's real and nominal U.S. capex models, driven by sturdy capital goods orders, elevated ISM readings and surging sentiment on capex, point to strong business spending in the next few quarters (Chart 8). Chart 6Animal Spirits Are Stirring... Animal Spirits Are Stirring... Animal Spirits Are Stirring... Chart 7...Contributing To Stronger G4 Economic Growth ...Contributing To Stronger G4 Economic Growth ...Contributing To Stronger G4 Economic Growth Chart 8Prospects For U.S. Capex Are Good Prospects For U.S. Capex Are Good Prospects For U.S. Capex Are Good Bottom Line: Business capital spending remains sturdy and it will lift overall GDP in 2H despite the recent severe weather. BCA's U.S. Equity Strategy strategists note3 that U.S. industrial machinery manufacturers should be particularly well positioned to see earnings growth outpace the rest of the S&P 500. Stay overweight industrials. Moreover, above-potential GDP growth will keep the Fed on track for gradual tightening this year, and supports BCA's position of stocks over bonds. Stout capital spending will be a theme as the Q3 earnings season unfolds in the next six weeks. Will Hurricanes Impact Q3 Earnings? Chart 9Strong EPS Growth Ahead,##BR##Will Start To Slow Soon Strong EPS Growth Ahead, Will Start To Slow Soon Strong EPS Growth Ahead, Will Start To Slow Soon The Q3 earnings season will be above average and the BCA Earnings model predicts EPS growth will hit roughly 20% later this year on a 4-quarter moving total basis, before moderating in 2018 (Chart 9). The consensus anticipates a 6% year-over-year increase in EPS in Q3 2017 versus Q3 2016, and 12% for 2017. Energy and technology will likely lead the way in earnings growth in Q3, and utilities and telecom will again be the laggards. The favorable profit picture for Q3 and the rest of the year partly reflects the rebound in oil prices, which are expected to swell the energy sector's EPS by 134%. The positive picture also mirrors the sweet spot of rising top-line growth and still muted labor costs, which are driving a countercyclical rally in profit margins. Investors and corporate executives will focus in Q3 on the improving economic conditions in Europe and the EM, the U.S. dollar, the sustainability of margins, and the impact of Hurricanes Harvey and Irma. President Trump's tax proposal will also be vetted during conference call Q&A's, as investors drill managements on the implications of tax cuts on their operations. Rising interest rates may also demand attention from some analysts because the 10-year Treasury yield in Q3 2017 was 45 bps above Q2 2016 and rose sharply in the final weeks of the third quarter. Guidance from CEOs and CFOs on trends in Q4 2017 and beyond are more important than the actual Q3 results (Chart 10). Investors should guard against managements' over-optimism because earnings growth forecasts almost always move lower over time. Chart 10Unusual Stability In '17 And '18 EPS Estimates Unusual Stability In '17 And '18 EPS Estimates Unusual Stability In '17 And '18 EPS Estimates In Q3, as in Q2, firms with elevated overseas sales should benefit from the improved growth profile in Europe, Japan and the EM. Global GDP growth projections for this year and next have steadily perked up, in sharp contrast with prior years when forecasters have relentlessly lowered GDP estimates. The U.S. dollar, which has been only a small drag on EPS in recent quarters, should become a modest plus in Q3; the dollar is down by 3% versus a year ago against a broad basket of currencies. Moreover, in the most recent Beige Book (September 6), mentions of a "strong dollar" declined by 4% compared with a year ago, indicating that the stronger currency has faded as a primary concern of managements in recent months. Nonetheless, BCA's view is that the dollar will appreciate by another 10% in the next 12-18 months. The appreciation would trim EPS growth by roughly 2.5 percentage points, although most of this would occur next year due to lagged effects. Another up leg in the dollar, on its own, should not provide a substantial headwind for the stock market. Indeed, the dollar would only climb in the context of robust U.S. economic growth and an expanding corporate top line. The timely enactment of Trump's tax proposal would boost the greenback. Investors are skeptical that margins can advance in Q3 for the fifth consecutive quarter. BCA's view is that we are in a temporary sweet spot for margins, which should continue for the next quarter or two, but the secular "mean reversion" of margins will resume beyond that time. The effect of Harvey and Irma on Q3 results will be muted for the S&P 500 and most sectors, but several weather-sensitive industries (insurance, airlines, chemicals, refining, leisure, etc.) will see significant disruptions. Charts 11A and 11B show that the impact of major hurricanes does not alter the pre-landfall trajectory of S&P 500 earnings forecasts. Earnings estimates for the energy, industrial and utilities sectors (relative to the S&P) tend to move higher after storms, while relative EPS growth in the materials and staples sectors lag behind. Chart 11AImpact Of Major Hurricanes##BR##On Forward EPS Estimates... Impact Of Major Hurricanes On Forward EPS... Impact Of Major Hurricanes On Forward EPS... Chart 11B...Is Muted For S&P 500##BR##And Most Sectors ...Is Muted For S&P 500 And Most Sectors ...Is Muted For S&P 500 And Most Sectors Bottom Line: Look for another solid performance for earnings and margins in Q3 and the rest of 2017, supporting our stocks-over-bonds stance for this year. However, it may be tougher sledding in 2018 when earnings growth begins to moderate and margins begin to "mean revert". Higher inflation, a more active Fed and a stronger dollar will be headwinds for earnings starting in the early part of 2018. FOMC Unified Yet Divided Chart 12Recent Inflation Readings##BR##Challenge The Fed's View Recent Inflation Readings Challenge The Fed's View Recent Inflation Readings Challenge The Fed's View U.S. inflation is likely to trend higher over the coming months as a variety of one-off factors that depressed inflation earlier this year fall out of the equation. That said, the August PCE deflator challenges that view (Chart 12). Core PCE inflation slowed further to 1.3%, down from 1.4% last month. In fact, core PCE inflation of 1.3% is at the exact same level as when the Fed delivered its first rate hike in December 2015. Moreover, the diffusion index dipped back to zero, implying the price weakness was widespread. The rollover in the PCE this year is consistent with the soft CPI readings. However, Fed officials highlight the trend in underlying inflation (Chart 12, panel 4) as they make the case for gradual rate hikes. Risk assets are unlikely to suffer if inflation rises towards the Fed's target against the backdrop of stronger growth. However, if inflation moves above the Fed's target due to brewing supply bottlenecks, the Fed will have little choice but to pick up the pace of rate hikes. This could unsettle markets and sow the seeds for the next recession, which we tentatively expect to occur in the second half of 2019. The market is pricing in only 42 basis points of hikes between now and the end of next year. FOMC voting members agree that the path for the normalization of monetary policy should be gradual. However, the path of inflation has provoked squabbling in the past month (Diagram 1) in the Fed and regional branches. Even though the Fed is path-dependent rather than data-dependent, the consensus remains that low inflation is due to temporary factors and higher consumer prices should soon rebound, justifying a December 2017 rate hike. FRBNY President William Dudley remains committed to further gradual rate hikes, although he has been recently surprised by the shortfall of inflation from the FOMC's 2% long-run objective. Fed Chair Janet Yellen confidently backed Dudley's optimism, stating that "low inflation likely reflects factors whose influence should fade over time." But she also struck a cautious tone by highlighting the risks around the uncertainty for the inflation outlook. Yellen even conceded that the Fed would not rule out pausing its gradual rate hike cycle given that they "may have misjudged the strength of the labor market, the degree to which longer-run inflation expectations are consistent with the inflation objective, or even fundamental forces driving inflation". Diagram 1Unified On Gradual Path But Divided On Inflation Path Managing The Risks Managing The Risks To manage risks, Chair Yellen offered a prescription of scenarios to strengthen the case for a gradual path: "Moving too quickly risks over adjusting policy to head off projected developments that may not come to pass. A gradual approach is particularly appropriate in light of subdued inflation and a low neutral real interest rate, which imply that the FOMC will have only limited scope to cut the federal funds rate should the economy be hit with an adverse shock. But we should also be wary of moving too gradually. Without further modest increases in the federal funds rate over time, there is a risk that the labor market could eventually become overheated, potentially creating an inflationary problem down the road that might be difficult to overcome without triggering a recession." In contrast, dovish FOMC members are apprehensive about the outlook for higher inflation. Governor Lael Brainard, known for her influence on the consensus at the FOMC, needs more confirmation that inflation is moving towards the 2% objective. FRB Chicago President Charles Evans, a dove, but mostly in line with the FOMC consensus, also is skeptical about inflation overshooting its 2% target and is worried about a potential policy mistake. Even FRB Minneapolis President Kashkari, the most dovish and a known dissenter, does not see inflation spiraling out of control given that the economy is unlikely to overheat anytime soon. Not surprising, FOMC hawks Esther George (Kansas City) and Patrick Harker (Philadelphia) noted in speeches late last week that policy was still accommodative and that gradual rate hikes are in order. Ultimately, a pickup in inflation is required to convince the doves at the Fed that even gradual rate hikes are required. BCA's stance is that inflation will pick up over the next year as the unemployment rate falls further and the output gap closes. Bottom Line: The Fed is likely to raise rates in December and three or four more times in 2018. We recommend investors remain underweight duration. Nonetheless, the Treasury market remains unconvinced about the Fed's view on rates and inflation. The implication for investors is that although 10-year Treasury bond yields have risen sharply in recent weeks, we see more upside in yields. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Will Extend Cuts To June 2018," September 21, 2017. Available at ces.bcaresearch.com. 2 Please see BCA Research's Geopolitical Strategy Weekly Report, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," May 31, 2017. Available at gps.bcaresearch.com. 3 Please see BCA Research's U.S. Equity Strategy Insight "Accelerating Global Manufacturing Means More Machines", dated September 22, 2017. Available at uses.bcaresearch.com.

Highlights We estimate total Belt & Road Initiative (BRI) investment will rise from US$120 billion this year to about US$170 billion in 2020. The size of BRI investments is about 47 times smaller than China's annual gross fixed capital formation (GFCF). Therefore, a slump in domestic capital spending in China will fully offset the increase in demand for industrial goods and commodities as a result of BRI projects. Pakistan, Kazakhstan and Ghana will benefit the most among major frontier markets from BRI. Investors should consider buying these bourses in sell-off. On a positive note, BRI leads to improved global capital allocation, allows China to export its excess construction and heavy industry capacity, and boosts recipient countries' demand for Chinese exports. Feature China's 'Belt and Road' Initiative (BRI) is on an accelerating path (Chart I-1), with total investment expected to rise from US$120 billion to about US$170 billion over the next three years. Chart I-1Accelerating BRI Investment From China bca.ems_sr_2017_09_13_s1_c1 bca.ems_sr_2017_09_13_s1_c1 The BRI has been one of the central government's main priorities since late 2013. The primary objectives of the BRI are: To export China's excess capacity in heavy industries and construction to other countries - i.e., build infrastructure in other countries; To expand the country's international influence via a grand plan of funding investments into the 69 countries along the Belt and the Road (B&R) (Chart I-2); To build transportation and communication networks as well as energy supply to facilitate trade and provide China access to other regions, especially Europe and Africa; To facilitate the internationalization of the RMB; To speed up the development of China's poor (and sometimes restive) central and western regions, namely by turning them into economic hubs between coastal China and the BRI countries in the rest of Asia; To boost China's strategic position in central, south, and southeast Asia through security linkages arising from BRI cooperation, as well as from assets (like ports) that could provide military as well as commercial uses in the long run. From a cyclical investment perspective, the pertinent questions for investors are: How big is the current scale of BRI investment, and where is the funding coming from? Will rising BRI investment be able to offset the negative impact from a potential slowdown in Chinese capex spending? Which frontier markets will benefit most from Chinese BRI investment? Chart I-2The Belt And Road Program China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's BRI: Scale And Funding Scale China has been implementing its strategic BRI since 2013. To date it has invested in 69 B&R countries through two major approaches: infrastructure project contracts and outward direct investment (ODI). The first approach - investment through projects - is the main mechanism of BRI implementation. BRI projects center on infrastructure development in recipient countries, encompassing construction of transportation (railways, highways, subways, and bridges), energy (power plants and pipelines) and telecommunication infrastructure. The cumulative size of the signed contracts with B&R countries over the past three years is US$383 billion, of which US$182 billion of projects are already completed. However, the value of newly signed contracts in a year does not equal the actual project investment occurred in that year, as generally these contracts will take several years to be implemented and completed. Table I-1 shows our projection of Chinese BRI project investment over the years of 2017-2020, which will reach US$168 billion in 2020. This projection is based on two assumptions: an average three-year investing and implementation period for BRI projects from the date of signing the contract to the commercial operation date (COD) of the project, and an average annual growth rate of 10% for the total value of the annual newly signed contracts over the next three years. Table I-1Projection Of Chinese BRI Project Investment Over The Years 2017-2020 China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? The basis for the first assumption is that the majority of the completed BRI projects were by and large finished within three years, and most of the existing and future BRI projects are also expected to be completed within a three-year period.1 The second assumption of the 10% future growth rate is reasonable, given the 13.5% average annual growth rate for the past two years, but from a low base. These large-scale infrastructure projects were led mainly by Chinese state-owned enterprises (SOEs), and often in the form of BOTs (Build-Operate Transfers), Design-Build-Operate (DBOs), BOOT (Build-Own-Operate-Transfers), BOO (Build-Own-Operate) and other types of Public-Private Partnerships (PPPs). After a Chinese SOE successfully wins a bid on an infrastructure project in a hosting country, the company will typically seek financing from a Chinese source to fund the project, and then execute construction of the project. After the completion of the project, depending on the terms pre-specified in the contract, the company will operate the project for a number of years, which will generate revenues as returns for the company. The second approach - investing into the recipient countries through ODI - is insignificant, with an amount of US$14.5 billion last year. This was only 12% of BRI project investment, and only 8.5% of China's total ODI. Chinese ODI has so far been mainly focused on tertiary industries, particularly in developed countries that can educate China in technology, management, innovation and branding. Besides, most of the Chinese ODI has been in the form of cross-border M&A purchases by Chinese firms, with only a small portion of the ODI targeted at green-field projects, which do not lead to an increase in demand for commodities and capital goods. Therefore, in this report we will only focus on the analysis of project investment as a proxy of Chinese BRI investment, as opposed to ODI. The focal point of this analysis is to gauge the demand outlook for commodities and capital goods originating from BRI. The Sources Of Chinese Funding The projected US$120 billion to US$170 billion BRI investment every year seems affordable for China. This is small in comparison to about US$3-3.5 trillion of new money origination, or about US$3 trillion of bank and shadow-bank credit (excluding borrowing by central and local governments) annually in the past two years. The financing sources for China's BRI investment include China's two policy banks (China Development Bank and the Export-Import Bank of China), two newly established funding sources (Silk Road Fund and Asia Infrastructure Investment Bank), Chinese commercial banks, and other financial institutions/funds. Table I-2 shows our estimate of the breakdown of BRI funding in 2016. Table I-2BRI Funding Sources In 2016 China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China Development Bank (CDB): As the country's largest development bank, the CDB has total assets of US$2.1 trillion, translating into more than US$350 billion of potential BRI projects over the next 10 years, which could well result in US$35 billion in funding annually from the CDB. The Export-Import Bank of China (EXIM): The EXIM holds an outstanding balance of over 1,000 BRI projects, and has also set up a special lending scheme worth US$19.5 billion over the next three years. This will increase EXIM's BRI lending from last year's US$5 billion to at least US$6.5 billion per year. Silk Road Fund (SRF): The Chinese government launched the SRF in late 2014 with initial funding of US$40 billion to directly support the BRI mission. This year, Chinese President Xi Jinping pledged a funding boost to the SRF with an extra 100 billion yuan (US$15 billion). Therefore, SRF funding to BRI projects over the next three years will be higher than the US$6 billion recorded last year. The Asian Infrastructure Investment Bank (AIIB): The AIIB was established in October 2014 and started lending in January 2016. It only invested US$1.7 billion in loans for nine BRI projects last year. The BRI funding from the AIIB is set to accelerate as the number of member countries has significantly expanded from an original 57 to 80 currently. Chinese commercial banks: Chinese domestic commercial banks, the largest source of BRI funding, have been driving BRI investment momentum. Chinese commercial banks currently fund about 62% of BRI investment and the main financiers are Bank of China (BoC) and Industrial & Commercial Bank of China (ICBC). After lending about US$60 billion over the past two years, the BOC plans to provide US$40 billion this year. The ICBC has 412 BRI projects in its pipeline, involving a total investment of US$337 billion over the next 10 years, which will likely result in an annual US$34 billion in BRI investment. The China Construction Bank (CCB) also has over 180 BRI projects in its pipeline, worth a total investment of US$90 billion over the next five to 10 years. Only three commercial banks will likely fund US$80 billion of BRI projects over the next three years. A few more words about the currency used in BRI funding. The U.S. dollar and Chinese RMB will be the two main currencies employed in BRI funding. Chinese companies can get loans denominated either in RMBs or in USDs from domestic commercial banks/policy banks/special funds/multilateral international banks to buy machinery and equipment (ME) from China. For some PPP projects that involve non-Chinese companies or governments (i.e. those of recipient countries), the local presence can use either USD loans or their central bank's Chinese RMB reserves from the currency swap deal made with China's central bank. China has long looked to recycle its large current account surpluses by pursuing investments in hard assets (land, commodities, infrastructure, etc.) across the world, to mitigate its structural habit of building up large foreign exchange reserves that are mostly invested in low-interest-bearing American government securities. Risky but profitable BRI infrastructure projects are a continuation of this trend. China had so far signed bilateral currency swap agreements worth an aggregate of more than 1 trillion yuan (US$150 billion) with 22 countries or regions along the B&R. The establishment of cross-border RMB payment, clearing and settlement has been gaining momentum, and the use of RMB has been expanding gradually in global trade and investment, notwithstanding inevitable setbacks. Bottom Line: We estimate total BRI investment with Chinese financing will rise from US$120 billion this year to about US$170 billion in 2020, and Chinese financial institutions will be capable of funding it. Can BRI Offset A Slowdown In China's Capex? From a global investors' perspective, a pertinent question around the BRI program is whether the BRI-funded capital spending can offset the potential slowdown in China's domestic investment expenditure. This is essential to gauge the demand outlook for industrial commodities and capital goods worldwide. Our short answer is not likely. Table I-3 reveals that in 2016, gross fixed capital formation (GFCF) in China was estimated by the National Bureau of Statistics to be at RMB 32 trillion, or $4.8 trillion. Table I-3China's GFCF* Vs. China's BRI Investment Expenditures China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? Meantime, China-funded BRI investment expenditure amounted to US$102 billion in 2016. In a nutshell, last year GFCF in China was about 47 times larger than BRI investment expenditures. The question is how much of a drop in mainland GFCF would need to take place to offset the projected BRI investment. The latter will likely amount to US$139 billion in 2018, US$153 billion in 2019 and US$168 billion in 2020. Provided estimated sizes of Chinese GFCF in 2017 are RMB 33.5 trillion (US$4.9 trillion), it would take only 0.4% contraction in GFCF in 2018, 0.3% in 2019 and 2020 to completely offset the rise in BRI-related investment expenditure (Table 3). Chart I-3Record Low Credit Growth... bca.ems_sr_2017_09_13_s1_c3 bca.ems_sr_2017_09_13_s1_c3 We derive these results by comparing the expected absolute change in BRI capital spending expenditures with the size of China's GFCF. The expected increases in BRI in 2018, 2019 and 2020 are US$20 billion, US$14 billion and US$15 billion. Given the starting point of GFCF in 2017 was US$4.9 trillion, it will take only about 0.4% of decline in $4.9 trillion to offset the $20 billion rise in BRI. In the same way, we estimated that it would take only an annual 0.3% contraction in nominal GFCF in China to completely offset the rise in BRI capital spending in both 2019 and 2020. To be sure, we are not certain that the GFCF will contract in each of the next three years. Yet, odds of such shrinkage in one of these years are substantial. As always, investors face uncertainty, and they need to make assessments. Is an annual 0.4% decline in China's GFCF likely in 2018? In our opinion, it is quite likely, based on our money and credit growth, as illustrated in Chart I-3. Importantly, interest rates in China continue to drift higher. A higher cost of borrowing and regulatory tightening on banks and shadow banking will lead to a meaningful deterioration in China's credit origination. The latter will weigh on investment expenditures. The basis is that the overwhelming portion of GFCF is funded by credit to public and private debtors, and aggregate credit growth has already relapsed. Chart I-4 and Chart I-5 demonstrate that money and credit impulses lead several high-frequency economic variables that tend to correlate with capital expenditure cycles. Chart I-4Negative Money Credit Impulses Point To... ...Negative Money Credit Impulses Point To... ...Negative Money Credit Impulses Point To... Chart I-5...Slowing Capital Expenditure ...Slowing Capital Expenditure ...Slowing Capital Expenditure Therefore, we conclude that meaningful weakness in the GFCF is quite likely in 2018, and that it will spill out to 2019 if the government does not counteract it with major stimulus. By and large, odds are that a slump in domestic capital spending in China offset the rise in BRI-related capital expenditures. BCA's Emerging Markets Strategy service has written substantively on motives surrounding China's capital spending and how it is set to slow, and we will not cover these topics. Some reasons why investment spending is bound to slow include: considerable credit excesses/high indebtedness of companies; misallocation of capital and resultant weak cash flow position of companies; non-performing assets on banks' and other creditors' balance sheets and their weak liquidity position. To be sure, investors often ask whether or not material weakness in mainland growth will lead the authorities to stimulate. Odds are they will. Yet, before the slowdown becomes visible in economic numbers, financial markets will likely sell-off. In brief, policymakers are currently tightening and will be late to reverse their policies. Finally, should one compare the entire GFCF, or only part of it? There is a dearth of data to analyze various types of capital spending. In a nutshell, Chart I-6 reveals that installation accounts for roughly 70% of investment, while purchases of equipment account for the remaining 18%. Therefore, we guess the composition of BRI projects will be similar to structure of investment spending in China, and hence it makes sense to use overall GFCF as a comparative benchmark. In addition, the GFCF data is a better measure for Chinese capital spending over Chinese fixed asset investment (FAI) data, as the FAI number includes land values, which have risen significantly over the years and already account for about half of the FAI (Chart I-7). Chart I-6Chinese Fixed Investment Structure Chinese Fixed Investment Structure Chinese Fixed Investment Structure Chart I-7GFCF Is A Better Measure Than FAI GFCF Is A Better Measure Than FAI GFCF Is A Better Measure Than FAI Bottom Line: While it is hard to forecast and time exact dynamics over the next several years, odds are that the next 12-24 months will turn out to be a period of a slump in China's capital spending. This will more than offset the increase in demand for industrial goods and commodities as a result of BRI projects. Implication For Frontier Markets The BRI, which currently covers 69 countries, will keep expanding its coverage for the foreseeable future. Insofar as it is a way for China to create new markets for its exports, Beijing has no reason to exclude any country. In practice, however, certain countries will receive greater dedication, for the simple reason that their development fits into China's political, military and strategic interests as well as economic interests. As most of the investments are infrastructure-focused, aiming to improve transportation, energy and telecommunication connectivity as well as special economic zones, the recipient countries, especially underdeveloped frontier markets, will benefit considerably from China's BRI. Table I-4 shows that Pakistan, Kazakhstan and Ghana will benefit the most among major frontier markets, as the planned BRI investment in those countries amounts to a significant amount of their GDP. Chart I-8 also shows that, in terms of current account deficit coverage by the Chinese BRI funding, the three countries that stand to benefit most are also Pakistan, Kazakhstan and Ghana. Table I-1The B&R Countries That Benefit From ##br##China's BRI Investment (Ranged From High-To-Low) China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? Chart I-8Chinese BRI Funding's Impact On ##br##External Account Of B&R Countries China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? Of these, clearly Pakistan and Kazakhstan have the advantage of attracting China's strategic as well as economic interest: Kazakhstan offers China greater access into Central Asia and broader Eurasia; Pakistan is a large-population market that offers a means of accessing the Indian Ocean without the geopolitical complications of Southeast and East Asia. These states also neighbor China's restive Xinjiang, where Beijing hopes economic development can discourage separatist and terrorist activities. Pakistan Pakistan is a key prospect for China's exports in of itself, and in the long run offers a maritime waystation and an energy transit hub separate from China's other supply lines. For China, it is a critical alternative to Myanmar and the Malacca Strait. In April 2015, China announced a remarkable US$46.4 billion CPEC (China-Pakistan Economic Corridor) investment plan in Pakistan, equal to 16.4% of Pakistani GDP. It is expected to be implemented over five years. In particular, the planned US$33.2 billion energy investment will increase Pakistan's existing power capacity by 70% from 2017 to 2023. On the whole, China's CPEC plan will be significantly positive to economic development in Pakistan in the long run, but in the near term it is still not enough to boost the nation's competitiveness (Chart I-9A, top panel). Chart I-9AOur Calls Have Been Correct Top 3 Frontier Markets Benefiting Most From Chinese BRI Investment Top 3 Frontier Markets Benefiting Most From Chinese BRI Investment Chart I-9BTop 3 Frontier Markets Benefiting Most ##br##From Chinese BRI Investment Our Calls Have Been Correct Our Calls Have Been Correct Also, as about 40% of the investment has already been invested over the previous two years, odds are that China's CPEC investment will go slower and smaller this year and over the next few years. BCA's Frontier Markets Strategy service's recent tactical bearish call on Pakistani stocks has been correct, with a 25% decline in the MSCI Pakistan Index in U.S. dollar terms since our recommendation in March (Chart I-9B, top panel).2 We remain tactically cautious for now. Kazakhstan Kazakhstan is a key transit corridor for Chinese goods to enter Europe and the Middle East. In June 2017, Chinese and Kazakh enterprises and financial institutions signed at least 24 deals worth more than US$8 billion. China's BRI investment in Kazakhstan facilitated the country's accelerated economic growth (Chart I-9A, middle panel). BCA's Frontier Markets Strategy service reiterates its positive view on Kazakhstan equities because of a recuperating economy, considerable fiscal stimulus and rising Chinese BRI investment (Chart I-9B, middle panel).3 Ghana Ghana is not strategic for China (it is a minor supplier of oil). Instead, it illustrates the fact that BRI is not always relevant to China's strategic or geopolitical interests. Sometimes it is simply about China's need to invest its surplus U.S. liquidity into hard assets around the world. Of course, Ghana itself will benefit considerably from the committed US$19 billion BRI investment, which was announced only a few months ago. This is a huge amount for the country, equaling 45% of Ghana's 2016 GDP. This massive fresh investment will boost Ghana's economic growth in both the near and long term (Chart I-9A, bottom panel). BCA's Frontier Markets Strategy service upgraded its stance on the Ghanaian equity market from negative to neutral in absolute terms at the end of July, and we also recommended overweighting the bourse relative to the broader MSCI EM universe (Chart I-9B, bottom panel).4 Our positive view on Ghana remains unchanged for now and we are looking to establish a long position in the absolute terms in this bourse amid a potential EM-wide sell-off. Other Macro Ramifications Industrial goods and commodities/materials are vulnerable. BRI will not change the fact that a potential relapse in capital spending in China will lead to diminishing growth in commodities demand. If there is a massive slowdown in property market like China experienced in 2015, which is very likely due to lingering excesses, Chinese commodity and industrial goods demand could even contract (Chart I-10). Notably, mainland's imports of base metals have been flat since 2010, and imports of capital goods shank in 2015 even though GDP and GFCF growth were positive (Chart I-11). The point is that there could be another cyclical contraction in Chinese imports of commodities and industrial goods, even if headline GDP and GFCF do not contract. Chart I-10Chinese Capital Goods Imports Could Contract Again bca.ems_sr_2017_09_13_s1_c10 bca.ems_sr_2017_09_13_s1_c10 Chart I-11Imports Of Metals Could Slow Further Imports Of Metals Could Slow Further Imports Of Metals Could Slow Further As China accounts for 50% of global demand of industrial metals and it imports about US$ 589 billion of industrial goods and materials annually, either decelerating growth or outright demand contraction will be negative news for global commodities markets and industrial goods producers. China's Exports Have A Brighter Outlook China's machinery and equipment (ME) exports account for 47% of total exports, and 9% of its GDP (Table I-5). The BRI investment will boost Chinese ME exports directly through large infrastructure projects. Table I-5Structure Of Chinese Exports (2016) China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? Meantime, robust income growth in the recipient countries will boost their demand for household goods (Chart I-12). China has a very strong competitive advantage in white and consumer goods production, especially in low-price segments that are popular in developing economies. Therefore, not only is China exporting its excess construction and heavy industry capacity, but the BRI is also boosting recipient countries' demand for Chinese household and other goods exports. Adding up dozens of countries like Ghana can result in a meaningful augmentation in China's customer base. Notably, Chinese total exports have exhibited signs of improvement as Chinese ME exports and exports to the major B&R countries have contributed to a rising share of total Chinese exports since 2015 (Chart I-13). Chart I-12BRI Will Lift Chinese Exports Of ##br##Capital And Consumer Goods BRI Will Lift Chinese Exports Of Capital And Consumer Goods BRI Will Lift Chinese Exports Of Capital And Consumer Goods Chart I-13Signs Of Improvement In Chinese Exports ##br##Due To Rising BRI Investment Signs Of Improvement In Chinese Exports Due To Rising BRI Investment Signs Of Improvement In Chinese Exports Due To Rising BRI Investment BRI Leads To Improved Global Capital Allocation BRI is one of a very few global initiatives that improves the quality of global capital allocation. Therefore, it is bullish for global growth from a structural perspective. By shifting capital spending from a country that has already invested a lot in the past 20 years (China) to the ones that have been massively underinvested, BRI boosts the marginal productivity of capital. One billion dollars invested in the underinvested recipient countries will generate more benefits than the same amount invested in China. Risks To BRI Projects Notable deterioration in the health of Chinese banks may meaningfully curtail BRI funding, as Chinese non-policy banks will likely need to provide 60% of BRI projects' funding. Political stability/changes in destination countries: As most infrastructure projects have been authorized by the top government and need their cooperation, any changes in the recipient countries' governments or regimes may slow down or deter BRI projects. China already has a checkered past with developing countries where it has invested heavily. This is because of its employment of Chinese instead of local labor, its pursuit of flagship projects seen as benefiting elites rather than commoners, its allegedly corrupt ties with ruling parties, and perceived exploitation of natural resources to the neglect of the home nation. As China's involvement grows, local politics will be more difficult to manage, requiring China to suffer occasional losses due to political reversals or to defend its assets through aggressive economic sanctions, or even expeditionary force. For now, as there are no clear signs that any these risks are imminent, we remain positive on the further implementation of China's BRI program. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 China has long been known to use three-year periods - as distinct from its better known "five year plans" - for major domestic initiatives. In 2016, the National Development and Reform Commission re-emphasized three-year planning periods for "continuous, rolling" implementation. 2 Please see BCA's Frontier Markets Strategy Special Report "Pakistani Stocks: A Top Is At Hand", published March 13, 2017. Available at fms.bcaresearch.com. 3 Please see BCA's Frontier Markets Strategy Special Report "Kazakhstan: A Touch Less Dependent On Oil Prices", published March 28, 2017. Available at fms.bcaresearch.com. 4 Please see BCA's Frontier Markets Strategy Special Report "Ghana: Sailing On Chinese Winds", published July 31, 2017. Available at fms.bcaresearch.com.

Highlights The Q2 earnings season will be above average and the BCA Earnings model predicts EPS growth to hit 18% later this year before moderating in 2018. Are the NIPA and S&P profit measures sending different signals? Business capital spending remains in an uptrend despite businesses' reluctance to spend ahead of changes in corporate tax policy. The commercial real estate sector (CRE) is beginning to show early signs of stress. Repealing Dodd-Frank faces procedural hurdles and would yield few political benefits, even for Republicans in an environment of populism. Feature Q2 Earnings Season Is Here Chart 1Strong Earnings Growth##BR##In 2017 Will Support Equities Strong Earnings Growth In 2017 Will Support Equities Strong Earnings Growth In 2017 Will Support Equities The Q2 earnings season will be above average and the BCA Earnings model predicts EPS growth to hit roughly 18% later this year on a 4-quarter moving total basis, before moderating in 2018 (Chart 1). The consensus is anticipating an 8% year-over-year increase in EPS in Q2 2017 versus Q2 2016, and 11% for 2017. Energy, technology, and financials, all are forecast to lead the way in earnings growth in Q2, but utilities and telecom will be the laggards. The favorable profit picture for Q2 and the rest of the year reflects the rebound in oil prices, which are expected to boost energy sector EPS by 671%. The positive picture also mirrors the sweet spot of rising top-line growth and still muted labor costs, which are driving a countercyclical rally in profit margins. The focus in Q2 for investors and corporate executives will be on the improving economic conditions in Europe and EM, the U.S. dollar and the sustainability of margins. Guidance from CEOs and CFOs on trends in 2H 2017 and beyond are more important than the actual Q2 results. Note that guidance can be tracked using Chart 2. Investors should guard against managements' over-optimism because earnings growth forecasts almost always move lower over time. Chart 22017 EPS Estimates Rebounding And 2018 Stable 2017 EPS Estimates Rebounding And 2018 Stable 2017 EPS Estimates Rebounding And 2018 Stable In Q2, firms with high overseas sales should benefit from the improved growth profile in Europe and Japan. Global GDP growth projections for this year and next have steadily escalated, in sharp contrast with prior years when forecasters have relentlessly lowered GDP estimates. On the other hand, the U.S. dollar should be a modest drag on earnings in Q2; the dollar is up 2% versus a year ago against a broad basket of currencies. Moreover, in the most recent Beige Book (May 31) mentions of a "strong dollar" were unchanged compared with a year ago, indicating that the stronger currency has faded as a primary concern of managements in recent months. Our view is that the dollar will appreciate by another 10%. This appreciation would trim EPS growth by roughly 2.5 percentage points, although most of this would occur in 2018 due to lagged effects. Another upleg in the dollar, on its own, should not provide a substantial headwind for the stock market. Indeed, the dollar would only climb in the context of robust U.S. economic growth and an expanding corporate top line. Investors are skeptical that margins can advance for the fourth consecutive quarter in Q2. Our view is that we are in a temporary sweet spot for margins and that should continue for the next quarter or two, but the secular "mean reversion" of margins will resume beyond that time. Bottom Line: Look for another solid performance for earnings and margins in Q2 and the rest of 2017, supporting our stocks-over-bonds stance for this year. However, investors should position their portfolios for decelerating earnings and compressed profit margins in 2018. Will The Real Profit Margin Stand Up While the markets focus on Q2 earnings, margins and corporate guidance for the next month or so, we take a broader view. For some time we have highlighted the importance of the mini-cycle in U.S. earnings growth; the corporate sector is in a catch-up phase following last year's profit recession, a trend that extends beyond the energy patch. EPS growth has surged this year on the back of slightly stronger sales and rising S&P 500 margins. The National Accounts (NIPA) data, on the other hand, paint a different picture. Earnings growth for the entire corporate sector fell sharply in the first quarter and margins continued to slide. If the NIPA data are telling the true story, then the equity market is in trouble because it suggests that the earnings outlook is much weaker than what is discounted in stock prices. There are many definitional differences that make it difficult to reconcile the NIPA and S&P data.1 Nonetheless, we can make some general observations. Chart 3 presents the four-quarter growth rate of NIPA profits2 and a proxy for aggregate S&P earnings. For the latter, we multiplied earnings-per-share by the divisor to obtain an estimate of the level of aggregate earnings in dollar terms (i.e. not on a per-share basis). The bottom panel of Chart 3 compares the level of profits, each indexed to be 100 in 2011 Q1. The charts highlight that while there have been marked differences in annual growth rates between the two measures, the levels were close to the same point in the first quarter of 2017. The dip in NIPA profit growth in Q1 was not reflected in the S&P measure. It appears that this is partly due to different profiles for profit growth in the energy and financials sectors. However, it does not appear that the difference in margins is linked to a significant divergence in aggregate profits. Most of the margin divergence is related to the denominator of the calculation (Chart 4). The NIPA denominator is corporate sector Gross Domestic Product (GDP). This is a value-added concept that is different from sales. It is not clear why, but GDP has grown much faster than sales since the end of 2014. We believe that the S&P data are painting a more accurate picture because sales are straight forward to measure, while value-added is complicated to construct. The slow growth of sales is not a bullish point for stocks. Nonetheless, it does not appear that financial engineering has distorted bottom-up company data to such an extent that the S&P data are falsely signaling strong profit growth. We expect the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning early in 2018. Nonetheless, the profit backdrop remains positive for stocks for now. The same is true in the Eurozone and Japan, where margins are also rising. It is worrying that a much of this year's advance in U.S. equity markets has been concentrated in only a few stocks, but that belies the breadth of the profit recovery (Chart 5). The proportion of S&P industry groups with rising earnings estimates is 75%, reflecting broad-based upgrades. Chart 3S&P And NIPA##BR##Profit Comparison S&P And NIPA Profit Comparison S&P And NIPA Profit Comparison Chart 4Denominator Explains##BR##S&P/NIPA Margin Divergence Denominator Explains S&P/NIPA Margin Divergence Denominator Explains S&P/NIPA Margin Divergence Chart 5Positive Earnings Revisions##BR##Are Broadly Based Positive Earnings Revisions Are Broadly Based Positive Earnings Revisions Are Broadly Based Such widespread participation is consistent with ongoing upward revisions to 12-month forward earnings estimates. Bottom Line: The solid earnings backdrop is why we remain overweight stocks versus bonds and cash. Stay extra vigilant for warning signs of a bear market in view of the poor valuations. Valuation has never been good leading indicator for bear markets, but it may provide information on the risks. Capital Spending Check Up Business capital spending remains in an uptrend. Investors are concerned that the below expectations readings on capex in recent months may be the start of a new trend for a significant part of the economy. We look at it another way. Managements are postponing investment decisions until they get more clarity on federal tax policy. In short, corporations are struggling with how much and when spend, rather than whether to invest at all. The key supports for sustained corporate spending remain despite the tepid May durable goods report. C&I loan growth has ticked back up and our model (based on non-residential fixed investment, small business optimism and the speculative-grade default rate) suggests lending is poised to move higher on a 12-month basis (Chart 6). Our research shows that sustainable capital spending cycles get underway only when businesses see evidence that consumer final demand is on the upswing. While consumer expenditures were soft (+1.1% annualized gain) in Q1, household spending in Q2 accelerated and is on track to post 3%+ growth. We expect household spending to continue to improve in the second half of 2017.3 Moreover, the recent readings on core durable goods orders and shipments show that the uptrend that began in mid-2016 persists, despite the recent monthly wiggles in the data (Chart 7). Chart 6Model Points To##BR##Further Improvement Model Points To Further Improvement Model Points To Further Improvement Chart 7Capital Spending##BR##Remains In An Uptrend Capital Spending Remains In An Uptrend Capital Spending Remains In An Uptrend CEO confidence recently soared to a 13-year high in Q1, adding to the positive backdrop for capex. The last reading on this survey was taken in the first quarter of 2017 when managements eagerly anticipated that business-friendly legislation was pending. The next survey (due in mid-July) may show a bit more restraint from CEOs given the lack of legislative progress in Washington (Chart 7, top panel). Bottom Line: The fundamentals supporting solid business spending remain in place. However, our positive capex outlook in the U.S. could be blemished if the Republicans fail to deliver on their promises to cut taxes and boost infrastructure spending. Stressing The Commercial Real Estate Market The commercial real estate sector (CRE) is beginning to show early signs of stress. The recent softening in CRE does not suggest that recession is imminent, but investors should understand whether a sustained drop in CRE prices poses a risk to the global financial system. At best, business spending on construction is coincident with the overall economy, but most often lags due to long lead times required on projects (Chart 8). Chart 8Commercial Real Estate Lags Commercial Real Estate Lags Commercial Real Estate Lags Our colleagues in the Global Investment Strategy service4 highlighted the risks to the CRE market, noting that CRE-related debt is rising, prices have surpassed pre-recessionary levels, vacancy rates outside of the industrial sector are bottoming, and rent growth is losing steam (Chart 9). Likewise, we share Boston Fed President Rosengren's5 concern that if CRE's recent tailwinds (muted inflation, low financing rates, declining unemployment rate, robust economic growth in the U.S. relative to overseas developed economies, and favorable demographics) turn to headwinds, then the impact on the market and the wider economy may have a disproportionate impact on CRE. The BCA Beige Book Real Estate Monitor corroborates a softening in recent quarters. The monitor takes the real estate (both commercial and residential) comments from each Beige Book and uses the approach outlined in our April 17 publication6 (Chart 10). Chart 9Commercial Real Estate##BR##Indicators Softening Commercial Real Estate Indicators Softening Commercial Real Estate Indicators Softening Chart 10Introducing The##BR##Beige Book CRE Monitor Introducing The Beige Book CRE Monitor Introducing The Beige Book CRE Monitor Stretched CRE valuations may exacerbate any price declines in CRE if the markets sense that the tide is turning. Falling prices may lead to a drop in the value of collateral-backing CRE loans, which in turn, could cause lenders to restrict credit in the sector and spark an additional downturn in prices. Moreover, Table 1 highlights the risk that GSE reform may cause two large holders of CRE debt to begin to curtail lending. Small banks have more absolute exposure to CRE loans than large banks, according to the table, and overall, banks' share of CRE lending (53%) is nearly four times as high as GSE's exposure. Table 1Holders Of Commercial Real Estate Loans Summer Stress Out Summer Stress Out CRE's risks are evident in the latest round of bank CCAR stress tests. The Fed modeled a 15% drop in CRE prices through Q4 2018 in its "adverse" scenario and a 35% drop in the same period in its "severely adverse" scenario. The Fed7 found that under these scenarios, common equity Tier 1 capital ratio at the participating firms would drop from 12.5% (Q4 2016) to 9.2% and 7.2% respectively by Q1 2019. Bottom Line: Commercial real estate has benefitted from a Fed-led tailwind since the end of the 2007-2009 recession. That said, some of the tailwinds are turning to headwinds and investors should be prepared for a reversal in this sector sometime in the second half of 2018 as economic and earnings growth slows, which could set the stage for a recession in 2019. That said, it is a positive sign for the economy that the commercial real estate sector is one of the few areas showing any signs of stress, implying that the conditions for a recession in the next 6 to 12 months remain low. Is Dodd-Frank Dead? The Republicans' Financial CHOICE Act, which would roll back key aspects of the landmark Dodd-Frank Wall Street reform, has hurdles to overcome before its passage through the U.S. Senate. Two of BCA's publications have examined the impact on consumers, investors and financial markets. BCA's Geopolitical Strategy8 service noted that Republicans want to overturn Dodd-Frank to increase the financial sector's profits, credit growth, economic growth and animal spirits. A repeal would also satisfy the Republicans' ideological goal to reduce state involvement, which grew due to the law. Also, the CBO estimates that the proposed rewrite would cut the budget deficit by a net $22.3 billion over 10 years, in line with the GOP's political bent. The CHOICE Act would create an "escape hatch" to allow banks to maintain a capital-to-asset ratio of over 10% to bypass Dodd-Frank regulations. Financial companies that do not meet the 10% leverage ratio could either raise funds or remain subject to Dodd-Frank oversight, including required capital ratios, stress tests, living wills and other regulations. Critically, the 10% leverage ratio for those banks that opt out of Dodd-Frank would not be calculated using risk-weightings for different assets (whereas Dodd-Frank requires both risk-weighted and non-risk-weighted capital ratios to be maintained). Therefore, banks that opt out would be able to take on greater risk while still fulfilling minimum capital requirements. The intent is to boost lending, earnings and growth. According to the Geopolitical Strategy, if the bill becomes law, U.S. banks comprising an estimated $1.5 trillion in assets would become less restricted and eligible to adopt riskier trading practices. The greatest impact will be in areas with a higher concentration of small community banks and credit unions. These banks, with under $10 billion in assets, face the most difficulty in meeting Dodd-Frank's requirements and yet tend to meet the 10% leverage ratio (Chart 11). Chart 11Banks With $1.5 Trillion Could Gain Risk Appetite Summer Stress Out Summer Stress Out Other aspects of the bill would: Repeal the FDIC's liquidation fund: The private sector would take over responsibility for managing liquidations. Eliminate the Volcker Rule: Banks would be able to trade riskier assets on their own accounts and forge closer relationships with private equity and hedge funds. Audit the Fed: The Government Accountability Office (GAO) would audit the Fed's board of governors and regional banks, including their handling of monetary policy. Reshape the Consumer Financial Protection Board: The agency would have its powers neutered and funding dependent on the Congress, rather than transfers from the Fed. Cut penalties for violating regulations. Chart 12Small Banks Benefit##BR##From Bank Deregulation Small Banks Benefit From Bank Deregulation Small Banks Benefit From Bank Deregulation Investors could capitalize on financial sector reform by favoring small U.S. bank equities over large bank stocks. The share price of small banks relative to large banks, which rallied in the aftermath of Trump's election only to subsequently fall back, has recently perked up (Chart 12). Relative earnings have been flat in the same period. If Dodd-Frank is partially watered down, then these banks should see earnings improve, and drive up their share prices. BCA's U.S. Equity Strategy is positive on global bank equities. In particular, U.S. banks have better fundamentals than their counterparts in Europe and Japan - more capital, higher net interest margins, lower or equal NPL ratios. They also stand to benefit from relatively faster rising interest rates. BCA's Fiscal Note Financial Sector Index suggests that the flow of legislative and regulatory proposals is becoming less onerous on the financial sector. Chart 13 is an aggregation of the favorability scores, which assess whether the bill would be favorable to the financial sector. It provides a snapshot of the regulatory environment for the financial sector at any point. Chart 13Financial Sector Scrutiny Softening Financial Sector Scrutiny Softening Financial Sector Scrutiny Softening Bottom Line: Repealing Dodd-Frank faces procedural hurdles and would yield few political benefits, even for Republicans in an environment of populism. However, a bill focused on lightening the regulatory load on small banks has a chance of passing if tacked on to the budget process. Large banks would remain subject to closer scrutiny and stricter international standards. The post-election rally for bank stocks is mostly over. Investors have an opportunity to favor small banks versus large ones. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 The first problem is that the S&P data are expressed on a per-share basis. Moreover, the NIPA data adjusts for inventory and depreciation allowance. S&P margins are calculated using sales in the denominator, while we generally use GDP as the denominator for calculating NIPA profits. 2 The NIPA data shown include financials and profits earned overseas, as is the case for the S&P. 3 Please see BCA's U.S. Investment Strategy Weekly Report, "Still In The Sweet Spot", June 19, 2017, available at usis.bcaresearch.com. 4 Please see BCA's Global Investment Strategy Weekly Report "The Timing Of The Next Recession," published June 16, 2017, available at gis.bcaresearch.com. 5 "Trends In Commercial Real Estate", Eric S. Rosengren, at Risk Management for Commercial Real Estate Financial Markets Conference, NYU Stern School of Business, May 9, 2017. 6 Please see BCA's U.S. Investment Strategy Weekly Report, "The Great Debate Continues", published April 17, 2017, available at usis.bcaresearch.com. 7 https://www.federalreserve.gov/publications/files/2017-ccar-assessment-framework-results-20170628.pdf 8 Please see BCA's Geopolitical Strategy Weekly Report "How Long Can The "Trump Put" Last?," published June 14, 2017, available at gps.bcaresearch.com.

Highlights The global economy remains awash in massive amounts of oversupply, reflecting extraordinary levels of capex in emerging markets. This will weigh on global inflation. Thanks to a tighter labor market, the U.S. is likely to suffer less from this force than the euro area or commodity producers. In this context, the tightening in Chinese and U.S. policy could represent a severe blow to the recent improvement in global trade. Continue to hold some yen and some dollars but stay short commodity and European currencies. Feature The U.S. is in its eighth year of recovery, yet core PCE is clocking in at a paltry 1.5% despite the headline unemployment rate standing 0.3% below its long-term equilibrium and despite incredibly low interest rates. The phenomenon is not unique to the U.S., euro area core CPI remains a meager 1% and even Germany, despite experiencing an unemployment at 26 year lows, is incapable of generating core inflation beyond 1.6%. Let us not even broach the topic of Japan... So what lies behind this low inflation environment? Not Enough Capex Or Too Much Capex? Capex in advanced economies has averaged 21% of GDP since 2008, compared to an average of 24% of GDP between 1980 and 2007, suggesting that the supply side of the economy is not expanding as fast as before (Chart I-1). Historically, countries plagued by low investment rates have tended to experience higher inflation. Simply put, these low investment rates mean these economies do not enjoy high labor productivity growth rates, causing severe bottlenecks. When these capacity constraints are hit, inflation emerges. This time around, the low investment rate in advanced economies is not yielding this development. Why? One reason is that demand has been hampered by the rise in savings preferences that emerged following the financial crisis (Chart I-2). But another phenomenon is also at play. Global capex has remained very elevated. Chart I-1Low Investment In DM ##br##Should Create Bottlenecks Low Investment In DM Should Create Bottlenecks Low Investment In DM Should Create Bottlenecks Chart I-2Post 2008: ##br##Marked Preference For Savings Post 2008: Marked Preference For Savings Post 2008: Marked Preference For Savings As Chart I-3 illustrates, global capex has averaged 25.2% of world GDP since 2010, well above the international average from 1980 to 2009. This is simply a reflection of the massive amount of capacity expansion that continues to materialize in the EM space, where investment has equaled more than 30% of GDP for eight years in a row. This matters because since the 1990s, the world has experienced a massive outward shift in the aggregate supply curve, resulting in an extended period of falling inflation and then, low inflation, independent of the state of growth or of long-term inflation expectations (Chart I-4). Chart I-3Global Capex Is High Global Capex Is High Global Capex Is High Chart I-437 Years Of Inflation History At A Glance 37 Years Of Inflation History At A Glance 37 Years Of Inflation History At A Glance In the 1990s, this expansion of global production capacity reflected the addition of billions of potential workers to the international capitalist system, but this phenomenon slowed massively in the 2000s and is now over (Chart I-5). Instead, the driver of the expansion of the global supply curve has since become the rampant investment taking place in developing economies, which has resulted in a massive increase in the capital-to-GDP ratio for the entire planet (Chart I-6). Chart I-5 Chart I-62000s To Present: Capital Drives##br## The Supply Expansion 2000s To Present: Capital Drives The Supply Expansion 2000s To Present: Capital Drives The Supply Expansion In the first decade of the millennium, this massive increase in the level of global capacity was still manageable. Global real GDP growth expressed in purchasing-power parity terms averaged 7% from 2000 to 2008 and was able to absorb some of the productive capacity being added to the world economy. As a result, core inflation average 2% in the OECD while short-term and long-term interest rates averaged 2.9% and 4.1%, respectively. However, since 2009, global GDP growth expressed in purchasing-power parity terms has only averaged 4.6%, despite a continued robust pace of investment globally, suggesting that now, supply growth is outstripping demand growth by a greater margin than in the previous cycle. This means that to achieve an average core inflation rate of 1.8% in the OECD, short-term and long-term interest rates have needed to average 0.7% and 2.4%, respectively. Going forward, the problem is that global excess capacity has not been expunged. With credit growth still limited in the G10 and in a downtrend in China (Chart I-7), deflationary tendencies are likely to remain a prevalent feature of the global economy for the rest of the business cycle. Thus, central banks the world over will find it very difficult to tighten monetary policy by much without re-invigorating downward spirals in inflation. While this problem applies to the Fed - a case cogently described by Lael Brainard this week - this is even truer for many other economies. The global trend in inflation is a function of this global expansion in supply, but domestic dynamics can still affect the dispersion of national inflation rates around this depressed global level. As Chart I-8 shows, countries with an unemployment rate substantially below equilibrium - a negative unemployment gap - do experience higher levels of inflation. Today, this puts the U.S. on a path toward higher inflation relative to the euro area. This suggests that there remains a valid case to expect a tightening of monetary conditions in the U.S. vis-à-vis the euro area. Chart I-7Low Credit Growth Harms Demand Growth Low Credit Growth Harms Demand Growth Low Credit Growth Harms Demand Growth Chart I-8 In this vein, Japan is an interesting case. Japan does have one of the most negative unemployment gaps among major economies, yet it experiences one of the lowest inflation rates. Japan is such an outlier that if it were excluded from the chart above, the explanatory power of the employment gap on inflation would double. This is because Japan has to grapple with another, even more pernicious problem: chronically depressed inflation expectations. Hence, the BoJ has to commit to an "irresponsibly easy" monetary policy and keep the economy growing above its potential for an extended period of time to genuinely shock inflation expectations upwards if it ever wants to remotely approach its 2% inflation target. Thus, we should remain negative the yen on a cyclical basis, only buying the JPY when asset markets are at risk. Bottom Line: The global economy remains awash in excessive supply. In the 1980s and 1990s, much of the supply expansion reflected an increase in the global labor force; since the turn of the millennium, the global supply expansion has been a function of high investment rates in developing economies. Without credit growth, the global economy will be hostage to deflationary pressures, at least for the rest of this cycle. Despite this picture, among major economies, the U.S. needs the smallest amount of monetary accommodation, supporting a bullish dollar stance. Policy Mistake In The Making? In this context of global overcapacity, low growth and underlying deflationary pressures, deflationary policy mistakes are easy to come by, and the world economy may be facing two such shocks. In and of itself, the U.S. economy may be able to handle higher rates. Even if inflation is likely to remain low by historical standards, a rebound toward 2% could happen later this year. At the very least, our diffusion index of industrial sector activity suggests that the recent inflation deceleration in the U.S. may be over (Chart I-9). However, it remains to be seen if EM economies, which is where the true excess capacity still lies, can actually handle higher global real rates. The rollover in our global leading indicator diffusion index is perplexing and points to a deceleration in global growth, a potential warning sign about the frailty of the global economy (Chart I-10). Additionally, it is true that 1% CPI inflation in China does not necessitate much of a strong policy response by the PBoC. But the vast swathe of cumulative capital investment in China implies that this country could suffer from the greatest amount of excess capacity (Chart I-11). China required a massive amount of stimulus in 2015 and early 2016 to generate a small rebound in growth. Thus, the current tightening in Chinese monetary conditions, as small as it may be, could be enough to prompt another wave of weakness in that country. The recent softness in PMIs - with the Caixin gauge falling below 50 - could be a symptom of this problem. Chart I-9U.S. CPI Deceleration Is Ending... U.S. CPI Deceleration Is Ending... U.S. CPI Deceleration Is Ending... Chart I-10...But Global Growth Is Deteriorating ...But Global Growth Is Deteriorating ...But Global Growth Is Deteriorating Chart I-11China Is Oversupplied China Is Oversupplied China Is Oversupplied Making the situation even more precarious is that China stands at the apex of the overcapacity problem, which makes it prone to develop virtuous and vicious cycles. Chinese corporate debt stands at 180% of GDP, heavily concentrated in state-owned enterprises and heavy industries. This means that swings in producer prices can have a deep impact on real rates. Based on a 10 percentage points swing in PPI, Chinese real rates were able to collapse from 10% to -1% in the matter of 12 months last year. The problem is that for this PPI rebound to happen, Chinese monetary conditions had to ease greatly (Chart I-12). Now that Chinese monetary conditions are tightening and now that commodity prices are weakening anew, PPI could once again fall toward 0%, lifting real rates to 4.4% in the process (Chart I-13). Chart I-12Chinese MCI: From Friend To Foe Chinese MCI: From Friend To Foe Chinese MCI: From Friend To Foe Chart I-13Real Rates Are Likely To Go Up Real Rates Are Likely To Go Up Real Rates Are Likely To Go Up This means that the already emerging contraction in manufacturing and the recent deceleration in new capex projects could gather further momentum (Chart I-14). As credit flows dry up because of the increasing price of credit in a weakening and over-supplied economy, so will Chinese imports, which are so sensitive to the investment cycle and credit impulse (Chart I-15). This is a problem because the recent bright patch in the global economy was based on this rebound in Chinese demand. In the wake of the Chinese growth acceleration last year, global exports and export prices rebounded sharply (Chart I-16). However, now that China is facing a renewed slowdown, this improvement is likely to dissipate. Chart I-14Problems With Chinese Growth Problems With Chinese Growth Problems With Chinese Growth Chart I-15Slowing Chinese Credit Will Hurt Chinese Imports... bca.fes_wr_2017_06_02_s1_c15 bca.fes_wr_2017_06_02_s1_c15 Chart I-16...Which Will Weigh On Global Trade ...Which Will Weigh On Global Trade ...Which Will Weigh On Global Trade This is obviously negative for the commodity currency complex. Not only does this mean that the negative terms of trade shock that is affecting many commodity producers could deepen - for example iron ore futures continue to fall and are now down 39% since mid-march - but also, monetary policy could be eased relative to the U.S. Actually, our monetary stance gauge, based on real short rates and the slope of the yield curve, already highlights potential weaknesses for AUD/USD (Chart I-17). This development is also a problem for Europe. As we have highlighted before, European growth is three times more levered to EM dynamics than the U.S. economy is. Also, employment in the manufacturing sector in the euro area is still five percentage points above that of the U.S., underscoring the euro area's greater exposure to global manufacturing and global trade. This means that if Chinese troubles deepen, the closing of the European unemployment gap might slow, at least relative to the U.S. where the unemployment rate is already below equilibrium. Therefore, the high-time to bet on a tightening of European policy relative to the U.S. could be passing. Already, before the European economy has even been hit by a negative shock from EM, the euro looks vulnerable. Investors are very long the euro, but also EUR/USD has dissociated enough from interest rate fundamentals that it is now expensive on a short-term basis. The relative monetary stance gauge between the euro area and the U.S. is pointing toward trouble ahead (Chart I-18). This trend may be magnified if, as we expect, global goods prices weaken anew. Another problem for the euro is that now that the world has embraced president Macron with a firm handshake, political risk may be once again rearing its ugly head in Europe. The Italicum electoral reform in Italy is progressing and there may be a new prime minister sitting in the Palazzo Chigi in Rome this fall. The problem is that the Italian public remains much more euroskeptic than France and the euro is supported by barely more than 50% of the population (Chart I-19, top panel). With euroskeptic and pro-euro parties standing neck-and-neck in the polls, the risk of a referendum on the euro in the area's third largest economy is becoming increasingly real (Chart I-19, bottom panel). Chart I-17Relative Monetary Conditions ##br##Point To A Lower AUD Relative Monetary Conditions Point To A Lower AUD Relative Monetary Conditions Point To A Lower AUD Chart I-18Euro At ##br##Risk Euro At Risk Euro At Risk Chart I-19Italy Is Not ##br##France Italy Is Not France Italy Is Not France The yen could benefit if the combined impact of higher U.S. rates and tighter Chinese policy proves to be a mistake. Our composite indicator of global asset market volatility - based on implied volatility in bonds, global stocks, global commodities, and various exchange rates - is near record lows (Chart I-20). Hence, global risk assets - commodity and EM plays in particular - could suffer some damage in the face of a deeper than anticipated global growth slowdown led by China. The recent improvement in Japanese industrial production, which mirrors the improvement in EM trade, may be short-lived. This would depress Japanese inflation expectations and boost Japanese real rates, helping the yen in the process (Chart I-21). Shorting GBP/JPY may be one of the best ways to take advantages of these dynamics (Chart I-22). Chart I-20Global Cross-Asset ##br##Volatility Is Too Low Global Cross-Asset Volatility Is Too Low Global Cross-Asset Volatility Is Too Low Chart I-21If China And EM Slow, Japanese ##br##CPI Expectations Will Plunge If China And EM Slow, Japanese CPI Expectations Will Plunge If China And EM Slow, Japanese CPI Expectations Will Plunge Chart I-22New Downleg In ##br##GBP/JPY? New Downleg In GBP/JPY? New Downleg In GBP/JPY? Bottom Line: An oversupplied global economy could find it difficult to withstand the combined tightening emanating from China and the U.S. The improvement in global trade and global good prices is likely to dissipate in the coming month. The euro and commodity currencies could suffer from this development and the yen could benefit. Concluding Thoughts Global policy makers will ultimately not stand pat in the face of this problem. This may in fact deepen their well-entrenched dovish biases. As a result, while the scenario above sounds dire, it is likely to be transitory. The Chinese authorities will not let growth crater; European and Japanese policymakers will fight deflation; and even the Fed may be forced to leave policy easier than it would like. We will explore this topic in more detail in future publications. A Few Words On The RMB Chart I-23China Has Regained Control ##br##Of Its Capital Account China Has Regained Control Of Its Capital Account China Has Regained Control Of Its Capital Account This week, the RMB has been well bid as the PBoC announced that the currency will increasingly be used as a countercyclical tool. The market has interpreted this move as an attack on speculators betting on a falling RMB. The conditions had become very propitious for this kind of announcement to lift the CNY. On the back of a weaker dollar the trade-weighted RMB had in fact weakened for most of 2017 (Chart I-23, top panel), implying that the RMB has continued to help the Chinese economy. Additionally, capital flight out of China has slowed in response to the enforcement of capital controls, something made clear by the collapse in import over-invoicing (Chart I-23, bottom panel). Going forward, it is not clear whether this announcement is necessarily bullish or bearish. It all depends on the Chinese economy and its deflationary pressures. If we are correct that Chinese deflationary pressures are set to increase in the coming quarters, this could imply that Chinese authorities put downward pressure on the CNY later this year. That being said, we remain reluctant to short the yuan to play Chinese deflationary forces. The capital account is well controlled and the PBoC will continue to aggressively manage the exchange rate. This implies that currencies like the AUD or BRL, which exhibit strong correlations with Chinese imports, could remain the main vehicles to play a Chinese slowdown in the forex space. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The greenback displayed further weakness as FOMC member Brainard shared her opinions questioning the future path of U.S. policy. We consider these remarks as temporary hurdles for the dollar, as fundamentals are still in favor of a stronger dollar, which is something the Fed recognizes. This week, some minor deflationary worries resurfaced as the ISM Prices Paid declined to 60.5 from the previous 68.5. While this is true, the labor market continues to tighten as the ADP survey come in very strong. Additionally, ISM Manufacturing PMI also paints a brighter picture for manufacturing, coming in at 54.9. We believe the Fed will hike this month, and will continue to highlight its tightening path going forward, which will provide a fillip for the dollar. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Europe delivered a more negative outlook this week with softer data: Services sentiment, economic sentiment indicator, industrial confidence and business climate all came in less than expected; German CPI disappointed with CPI increasing at a 1.5% rate, less than the expected 2% rate, and the harmonized index also underperformed at 1.4%; European CPI also disappointed at 1.4%, while core CPI also slowed; However, Italian unemployment improved to 11.1% from 11.5%. President Draghi also reiterated his dovish stance in a speech on Monday. While the euro is up this week, elevated short-term valuations warrant a lower euro in coming months. Furthermore, following Draghi's reiteration, rate differentials may continue to move in favor of the dollar. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Upbeat data from Japan has lifted the yen this week: Job/applicants ratio is at 1.48, a level last seen in 1974; Retail trade increased at a 3.2% annual pace, much more than the expected 2.3% rate; Industrial production increased at a 5.7% pace; Housing starts increased at 1 .9%. While data surprises to the upside in Japan, low inflation still remains entrenched in the economy. We believe the BoJ will remain dovish until inflation emerges, which will keep JPY's upside limited. That being said, risk-averse behavior can provide a temporary tailwind for the yen in the upcoming months. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 The U.K.'s consumer sector remains mixed, showing a ray of sunshine after batches of poor numbers: Gfk Consumer Confidence came in at -5, better than the expected -8; Consumer credit came in at GBP 1.525 bn,; M4 Money Supply also increased at 8.2% yoy. Mortgage approvals, however, clicked in below estimates, while net lending to individuals was GBP 4.3 billion, less than expected and previously reported. Nevertheless, cable has been relatively strong this week, lifted by the euro. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 There was some negative data out of Australia this week: Building permits are still contracting, now at a 17.2% pace, less than the 19.9% pace last month; Private sector credit is expanding at a slower pace of 4.9%; AiG Performance of Manufacturing Index decreased to 54.8 from 59.2; AUD has been considerably softened recently, as commodity prices weakened. While the Chinese NBS manufacturing PMI marginally beat expectations, the Caixin Manufacturing PMI actually weakened from 50.3 to 49.6, and is now in contraction territory. As China continues to face structural issues, which are now front and center thanks to their most recent debt rating downgrade, AUD could suffer even more. In the G10 space, it is likely it will be one of the worst performing currencies this year. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The NZD has seen a broad-based appreciation across the G10 space in the past 2 weeks due to stronger than expected trade balance and visitor arrivals. Dairy prices annual growth rate also remain robust at 56% this week. Further buoying the NZD was the release of the RNBZ Financial Stability Report, which was upbeat and states that financial risks have subsided in the past 6 months. The RBNZ also highlighted the slowdown in house price growth due to macroprudential measures. Most recently, NZD has been weak against European currencies, as upbeat data and a higher euro drove up these currencies. EUR/NZD is likely to trend downwards as growth differentials could further bifurcate central bank policies, and weigh on this cross. NZD/USD, itself, is unlikely to see much upside if the dollar bull market resumes and EM cracks deepen. However, AUD/NZD should weaken some more. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The CAD has seen downside recently as oil's gains receded after markets seemed disappointed by the OPEC deal. Data further corroborated this negative view, as both industrial and raw material prices increased by less than expected at 0.6% and 1.6% respectively. Additionally, the first quarter current account also faltered into a further deficit of CAD 14.05 bn. However, GDP growth was strong and could improve further. Investors are currently highly bearish on the CAD, with net speculative positions at the lowest level in 10 years, suggesting the bad news is well priced in. Going forward, the BoC continues to argue that the output gap is closing quicker than expected which will warrant higher rates, and help the CAD. While the CAD may not appreciate much against the USD, it will be one nonetheless one of the best performing currencies in the G10 space. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 EUR/CHF continues to drift lower as lofty short-term valuations are hurting the euro. As the ECB is likely to remain accommodative, as per Draghi's recent remarks, the recent weakness may only be the beginning of a new trend. Recent data shows that there might be a slight deceleration in the Swiss economy as the KOF leading indicator has slowed down to 101.6. However, with Italian political risks growing faster than anticipated, the CHF could find additional support. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 As oil prices falter after the OPEC deal, the NOK displayed substantial downside against the USD, the EUR, and the CAD. Despite our Commodity and Energy team seeing additional upside for oil prices, the NOK will continue to be pulled down by low rates as the Norges Bank battles against deflationary prices, falling wages, and a weak labor market. Real rate differentials will prompt upside in USD/NOK, as well as CAD/NOK, as both the U.S. and Canada have adopted a hawkish and neutral bias, respectively. Regarding data, retail sales picked up from a meager 0.1% growth rate to a still unimpressive rate of 0.2%. At 5.1%, Norway's credit Indicator also grew less than expected and continues to slowdown. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Swedish data this week showed that last quarter, the economy did not perform as well as anticipated, with GDP increasing by 2.2%, lower than the expected 2.9%. However, more recent data shows a pickup in activity, with retail sales increasing at a 4.5% rate. USD/SEK has been weak recently due to the dollar's weakness, which we think is at its tail end. EUR/SEK's recent appreciation is likely to alleviate the Riksbank's deflationary worries. However, downside is possible as the euro may retract some of its gains. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights In the near term, the PBoC is likely to set a stronger fixing rate against the dollar and dampen market expectations for further RMB declines. The PBoC hinted that the exchange rate can be used as a "countercyclical" policy tool, which could signal a major shift, as previously the central bank had mostly stressed maintaining exchange rate stability as its main policy target. Chinese growth remains reasonably buoyant. Listed firms' Q1 earnings improved significantly, confirming the profit cycle upturn. This bodes well for private sector capex, and supports our positive cyclical stance on H shares. Feature The People's Bank of China (PBoC) last week changed how it sets the RMB's official fixing rate against the dollar, making an already opaque mechanism even less transparent. With the latest tweak, it appears the PBoC intends to assert greater discretion over the RMB exchange rate, a notable departure from its recent moves toward a more market-driven system. Odds are high that the central bank will try to stabilize the trade-weighted RMB around current levels in the near term, unless the dollar takes a sudden sharp turn in either direction. Technical details aside, fundamental factors are no longer unanimously bearish for the RMB, as we discussed in a recent report.1 Meanwhile, most of Chinese-listed firms have reported first quarter earnings, which show strong improvement compared to a year ago. This buttresses our positive stance on Chinese H shares. It also bodes well for capital spending in the private sector as well as overall business activity. Why? And Does It Matter? Technically, the PBoC appears to be trying to correct a problem inherently built into its old exchange rate-setting formula. Up until the recent changes, the RMB official fixing rate was determined by the closing exchange rate of the previous trading day as well as the RMB's performance against a currency basket. As such, a lower onshore spot CNY against the dollar automatically led to a lower official fixing on the following day, which in turn anchored expectations for further RMB depreciation in the spot market - setting in motion a series of self-feeding mini-vicious circles. This became increasingly obvious in recent months (Chart 1). The dollar has depreciated broadly against other currencies since the beginning of the year, which should have led to a higher CNY/USD. In reality, the RMB official fixing rate has been essentially flat, and the onshore CNY spot rate has constantly traded below the official fixing rate, reflecting market expectations of further declines in the RMB. In the new formula, by adding in an unspecified "countercyclical" factor, the PBoC intends to reset market expectations and arrest the automatic extrapolation of the recent RMB trend into the future. More fundamentally, the PBoC hinted that the exchange rate can be used as a "countercyclical" policy tool. If true, this would signal a major shift, as previously the PBoC had mostly stressed maintaining exchange rate stability as its main policy target. In a press release accompanying the latest change, the PBoC argued that China's recent growth improvement suggests that a weaker RMB is no longer warranted, which fits the PBoC's broader policy stance. By the same token, it also suggests the PBoC will actively guide the RMB exchange rate lower at times of weakening growth to reflate the economy. Historically, the PBoC had mostly sat idle with the exchange rate at times of heightened volatility in the global currency market, which exposed the Chinese economy to sharp swings in the trade-weighted RMB (Chart 2). For example, the PBoC effectively pegged the RMB to the dollar during the global financial crisis between mid-2008 and early 2010 - despite the rollercoaster ride other Asian currencies experienced. Similarly, the central bank held the RMB largely steady against the dollar between 2013 and mid-2015 amid sharp declines in other currencies against the dollar, leading to sharp RMB appreciation in trade-weighted terms and creating relentless deflationary pressure for the Chinese economy. The slide of the RMB against the greenback since August 2015 has been a catch-up to its Asian neighbors to the downside. Chart 1The PBoC Wants A Stronger RMB Fixing? The PBoC Wants A Stronger RMB Fixing? The PBoC Wants A Stronger RMB Fixing? Chart 2The RMB: Moving Towards Dirty Float The RMB: Moving Towards Dirty Float The RMB: Moving Towards Dirty Float How the PBoC manages the exchange rate under the new mechanism remains to be seen, and it is too soon to draw definite conclusions just yet. In the near term, the PBoC is likely to set a stronger fixing rate against the dollar and dampen market expectations for further RMB declines. Longer term, if the central bank indeed intends to use the exchange rate as a countercyclical macro policy tool, it will have to more actively manage the trade-weighted RMB according to the cyclical profile of the Chinese economy. This will move the RMB closer to a true "dirty float" currency, which also means much greater volatility for the RMB cross rate with the dollar than in the past. The Earnings Scorecard The latest macro numbers confirm that the Chinese economy is losing some steam, but overall growth momentum remains largely stable . Both manufacturing and service PMI numbers released early this week remained in expansionary territory. and some key components such as export orders, orders backlog and employment showed a pick-up compared with the previous month. We expect the economy to remain fairly buoyant in the next two to three quarters, even if year-over-year growth numbers continue to moderate. As far as investors are concerned, the important development is that China's profit cycle upturn remains in place. Total profits of industrial firms increased by 24% in the first four months of 2017 compared with a year ago. In addition, most of domestic-listed firms have released first-quarter earnings, which show similar profit growth (Chart 3). A few observations can be made: Chart 3Profit Acceleration Profit Acceleration Profit Acceleration Table 1A-Share Companies' Earnings Scorecard The RMB's New Secret Formula, And The Chinese Earnings Scorecard The RMB's New Secret Formula, And The Chinese Earnings Scorecard All domestic-listed A-share firms reported a 23% increase in Q1 earnings compared with last year, or 34% if financials and energy companies are excluded. Profit acceleration was more pronounced in the materials and energy sectors, but was also fairly broad-based (Table 1). Top line revenue growth accelerated, a key factor behind rising profits (Chart 4, top panel). Excluding financials and energy, A share-listed firms' total revenue increased by almost 20% from 2016 according to our calculation, a marked acceleration compared with previous years. Profit margins also increased modestly, which helped boost profits (Chart 4, bottom panel). Net margins still pale in comparison to pre-crisis levels, though are now close to their long-term trend line. In short, China's profit cycle upturn reflects a pickup in both price increase and volume expansion in the overall economy, and defies the assertion by some that China's growth improvement since last year has been purely driven by credit. Looking forward, our model suggests that profit growth will likely begin to roll over (Chart 5), but there is no evidence that profits will contract anytime soon. Chart 4Improvement In Both Revenue And Margin Improvement In Both Revenue And Margin Improvement In Both Revenue And Margin Chart 5Profit Growth Is Rolling Over, But No Contraction Profit Growth Is Rolling Over, But No Contraction Profit Growth Is Rolling Over, But No Contraction What does this mean? First, profit growth in the industrial sector is good news for the banking system. Materials producers and energy companies, the major trouble spots in banks' asset quality in recent years, experienced the biggest increase in profit growth among the major sectors. This should reduce non-performing loans (NPL) from these industries. The pace of banks' NPL increase will likely continue to decelerate, and asset quality stress in the banking sector should ease. Second, profit recovery in the industrial sector bodes well for capital spending, which in turn will support overall business activity. Private enterprise investment is mostly profit-driven. Therefore, rising profits should lead to stronger incentive to expand capex. We maintain the view that the multi-year downshift in China's capital spending cycle will likely bottom up going forward (Chart 6). Finally, strong profit growth should also be good news for Chinese equities. Chinese H shares are trading at 32% and 24% discounts compared with the global benchmark, based on trailing and forward price-to-earnings ratios respectively (Chart 7). Without a major profit contraction in Chinese-listed companies, the large valuation gap between Chinese shares and global equities is unreasonable and unsustainable - and will eventually narrow. In short, we remain cyclically positive on H shares, and overweight China against global/EM benchmarks. Chart 6Profit Improvement Bodes Well For Capex Profit Improvement Bodes Well For Capex Profit Improvement Bodes Well For Capex Chart 7Mind The Gap Mind The Gap Mind The Gap Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Special Report, "China: Financial Crackdown And Market Implications," dated May 18, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations