Developed Countries

The technology sector has spiked higher of late, supported by the merger premium in semiconductor stocks. However, the fundamental justification for the recent valuation expansion remains shaky. Tech sales growth remains non-existent. A dearth of new order growth and the ongoing contraction in Asian exports warn that it is premature to position for a recovery in top-line performance. That is confirmed by the impending corporate sector retrenchment, as the steady narrowing in the gap between the return on and cost of capital warns that business investment on tech goods will stay sluggish. Consumer spending on tech has been the lone bright spot, but even that has mostly been moving in line with overall consumption in recent years, not enough to deliver sales outperformance. As a result, fading recent tech strength makes sense, given vulnerability to a valuation squeeze.

While the corporate sector has run up debt levels and is struggling to generate profit growth, consumers have rebuilt their savings and are enjoying the benefits of a positive wealth effect. The increase in real wage and salaries growth is supporting consumer income expectations, according to the latest consumer confidence survey (top panel). The implication is that consumption-oriented plays should be well positioned to deliver profit outperformance. Consumer finance stocks provide an attractively valued play on this theme, as does the S&P data processing index. The latter is levered to total transaction volumes, and a healthy consumer should translate into positive sales momentum. We are overweight both indexes.

Highlights The perceived shape of Brexit is the single most important driver of the pound and most U.K. assets. The U.K. Courts are due to deliver landmark legal rulings, which have huge implications for the perceived shape of Brexit. Expect an eventual soft Brexit if the Courts decide against the U.K. government and deem that triggering Article 50 requires parliamentary approval. Expect a much harder Brexit if the Courts decide in favour of the U.K. government. Tactical investors should consider owning some very short-term call options on pound/dollar or a combination of call and put options. Feature Within the next two weeks, the U.K. High Court will deliver a landmark legal ruling which will have huge implications for the future of the U.K. and Europe. Chart of the WeekDifferent Levels Of Brexit Mean Different Levels Of The Pound The U.K. High Court will rule whether Prime Minister Theresa May can start the legal process to exit the EU using the so-called 'royal prerogative' - the power granted to governments to make decisions without a vote from parliament. If May cannot use the royal prerogative, she will require an Act of Parliament to trigger Article 50 of the Lisbon Treaty. The High Court judgement hinges on a fundamental issue. Triggering Article 50 necessarily means that the current government will overturn previous parliamentary decisions - the European Communities Act (1972) and European Union Act (2011). Does the constitution permit a government to overturn parliamentary decisions, take away treaties, and remove the population's legal rights without obtaining parliamentary approval? Although we are not legal experts, the court could regard that as overstretching government authority. If the High Court's judgement does go against the U.K. government, expect pound/dollar to rally immediately by about 4-5 cents. Conversely, a judgement in favour of the government could see the pound sell off by about 1-2 cents. Given the possibility of this gapping, tactical investors should consider owning some very short-term call options on pound/dollar, or a combination of call and put options. Nevertheless, the story will not end with the High Court. Whichever side loses will appeal the decision and take the case to the Supreme Court, which is expected to respond by the end of the year. This ultimate pronouncement of law will have a landmark bearing on the shape of Brexit and, thereby, the future of the U.K. and the other EU 27. Where Is The Pound Headed Longer-Term? For investors, the spectrum of Brexit possibilities - no Brexit, 'soft' Brexit, 'hard' Brexit, or 'very hard' Brexit - will be the single-most important driver of the pound, and by extension, other U.K. assets. Of course, U.K. asset prices ultimately depend on economic and financial fundamentals. But Chart I-2, Chart I-3, Chart I-4, Chart I-5, Chart I-6, Chart I-7 illustrate that by far the most important fundamental for all U.K. assets right now is the perceived hardness of Brexit, as captured in the pound's value. Chart I-2Harder Brexit Means The Eurostoxx600 ##br##Underperforms The FTSE100... Chart I-3...And The FTSE250 ##br##Underperforms The FTSE100 Chart I-4Harder Brexit Means U.K. ##br##Goods Exporters Outperform... Chart I-5Harder Brexit Means ##br##Retailers Underperform... Chart I-6...Travel And Leisure Underperforms... Chart I-7...And Real Estate Underperforms Pound/dollar has (so far) traded at three distinct levels, based on three distinct levels of perceived Brexit severity: near 1.50 before the Brexit vote; near 1.30 after the Brexit vote but perceiving a soft Brexit; and near 1.20 after Theresa May announced that she would trigger Article 50 by next March and was contemplating a hard Brexit (Chart of the Week). Hence the (post-appeal) outcome of the legal case against the government carries great significance. If the government loses, and requires a parliamentary vote to trigger Article 50, several consequences follow. Theresa May's end-March deadline for firing the Brexit starting gun would become very difficult to meet, severely delaying the whole process. Would the government even win a parliamentary majority? If in doubt, would the government call a snap General Election to try and beef up its majority? The current batch of parliamentarians has a strong bias for staying in the EU, but it would be difficult to fly in the face of the referendum result. On the other hand, the checks and balances of parliament are there precisely to stop the country walking over the cliff-edge that a very hard Brexit would be. All the while, with investment slowing and higher inflation from the weaker pound squeezing household real incomes, the economic headwinds from the U.K.s limbo status would be becoming more apparent. Given the high stakes and likely irreversibility of the formal legal process, parliamentarians would rightfully want to examine and approve the U.K.'s negotiating hand. It seems that Parliament would almost certainly water down or delay Brexit before voting it through. Hence, if the government loses its legal case after appeal, Brexit will likely end up in a soft form. And pound/dollar will ultimately elevate to 1.35. Conversely, if the government wins its legal case after appeal, Theresa May will be on course to trigger Article 50 early next year, as promised. At which point, the EU 27's optimal game-theoretical first play is to be very aggressive - effectively opening with a very hard Brexit offer as described in the next section. Whereupon, pound/dollar would find its fourth, even lower, new level: near 1.10. Two Myths About Brexit It is important to debunk a couple of common myths about Brexit. First, that the U.K.'s current position as the EU 28's second largest economy will force the remaining EU 27 to give the U.K. a special status - allowing access to the three freedoms of goods, services, and capital but with controls on the fourth freedom of movement: people. This belief is misplaced. The biggest worry for the EU 27 is that a special status for Britain could catalyse other countries, under populist pressure, to ask for equivalent deals. The EU 27 does not want to give Marine Le Pen the opportunity to say "let's follow the Brits, they've negotiated a great deal." Hence, the U.K. will not get special treatment. Quite the contrary, it must be seen to be paying a substantial price for Brexit. Even for Anglophile Angela Merkel, protecting the indivisibility of the four freedoms and the integrity of the EU is the overriding priority. If the U.K. restricts free movement of people, it almost certainly means a hard Brexit: substantially restricted access to the single market. The U.K. would then have to negotiate a free trade agreement (FTA) with the EU. Given the current difficulty that Canada is experiencing in negotiating a FTA, this might not be a straightforward process for the U.K either. Furthermore, as a FTA does not usually cover services, it would handicap the services-heavy U.K. economy, while perfectly suiting the goods-heavy German economy. A second common belief is that the pound will act as an automatic economic stabilizer. That irrespective of a very tough deal from the EU 27, a weaker sterling will soothe the pain of a very hard Brexit by making British exports more competitive. Granted, the weaker pound will boost the demand for the U.K.'s goods exports. But total U.K exports are much less sensitive to devaluations compared to when the pound tumbled out of the Exchange Rate Mechanism in 1992. Then, just a quarter of the U.K's exports were services; today that proportion is approaching a half (Chart I-8) With the exception of tourism, these services tend to be high value-added financial and business services. Cutting their price will not significantly boost the demand for them. Chart I-8Almost Half Of U.K. Exports Are Services Meanwhile, U.K. consumers will feel distinctly poorer as the sterling prices of food and energy rise (Chart I-9), squeezing real household incomes and spending. In turn, this will leave the Bank of England with a major headache. How best to support real spending: defend the plunging pound to keep a lid on food and energy prices, or cut interest rates? Chart I-9Higher Sterling Prices For Food And Energy Will Squeeze Real Incomes Investment Reductionism For U.K. Assets The charts throughout this report show that the strategy for many U.K. investments reduces to an overriding question. Will the U.K largely retain access to the single market, defining a soft Brexit? Or will the U.K. largely lose access to the single market, defining a hard Brexit? In a soft Brexit: Sterling would rally 10%, taking pound/dollar to 1.35. The Eurostoxx600 and S&P500 would outperform the FTSE100. Within U.K. equities, sterling earners would outperform dollar earners, favouring small and mid-cap over large cap. The FTSE250 would outperform the FTSE100. The heavily domestic-focused retailers, travel and leisure, and real estate sectors would outperform the market. Goods exporters, such as the apparel sector would become less competitive and underperform the market. In a hard Brexit, expect the exact opposite of the above. Pound/dollar would slump 10% to 1.10, and so on. To determine which strategy to follow, await the post-appeal Supreme Court judgement on how Article 50 must be triggered, due at the end of the year. If Article 50 requires parliamentary approval, expect a soft Brexit. If it doesn't require parliamentary approval, expect the Brexit game theory to become hard and aggressive. Right now this is a coin toss, but forced to choose, we expect events may eventually prevent a damaging hard Brexit. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com Fractal Trading Model* This week's trade is another commodity pair trade: long copper / short tin. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart 10 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Highlights Dear Client, The growth of the electric-vehicle market, particularly re its implications for hydrocarbons as the primary transportation fuel in the world, will remain a key issue for energy markets, particularly oil. The IEA estimates transportation accounted for 64.5% of oil demand in 2014, the latest data available, compared to natural gas's 7% share and electricity's 1.5% share.1 Last week, Fitch Ratings published a report concluding, "Widespread adoption of battery-powered vehicles is a serious threat to the oil industry." For example, the agency contends that "in an extreme scenario, where electric cars gained a 50 per cent market share over 10 years about a quarter of European gasoline demand could disappear." This is not a widespread view in the energy markets. IHS Energy published a report in 2014 finding, "Past energy transitions took decades to unfold and were driven by a combination of market factors: cost, scarcity of supply, utility and flexibility, technology development, geopolitical developments, consumer trends, and policy.2" While our view is more aligned with IHS's, it is undeniable electric vehicles are a growing market. For this reason, we are publishing an analysis by BCA Research's EM Equity Sector Strategy written by our colleague Oleg Babanov, which explores the lithium-battery supply chain and how investors can gain exposure to this critical element of the fast-growing global electric-vehicle market. Separately, we are downgrading our strategic zinc view from neutral to bearish, and recommending a Dec/17 short if it rallies. Robert P. Ryan Senior Vice President, Commodity & Energy Strategy Lithium is a rare metal with a costly production process and a high concentration in a small number of countries. Difficulty in production is comparable to deep-sea oil drilling. Lithium is the key element in lithium-ion batteries. Demand is rapidly increasing as more countries adopt environment-protection policies and electric-car production is on the rise. We recommend an overweight on the lithium battery supply chain (Table 1), on a long-term perspective (one year plus). We estimate demand for the raw material to rise by approximately 30% over the coming years, driven by the main electric vehicle production clusters in Asia and the U.S. Table 1Single Stock Statistics For Companies##br## In The Lithium Battery Supply Chain (Oct 2016)* What Is Powering Your Battery? Being a relatively rare and difficult to produce metal, lithium demand is rapidly increasing due to the metal's unique physical characteristics, which are utilized in long-life or rechargeable batteries. Rapidly rising demand from portable electronics manufacturers, and the push of the auto industry to develop new fuel-efficient technology, backed by the widespread support of many governments to reduce transportation costs and improve CO2 emissions, are driving prices for the metal higher. We believe that companies in the electric vehicle (EV) supply chain, from miners to battery producers and down to EV manufacturers, will benefit from the change in environmental policies and the growing need for more portable devices with larger energy storage. As the focus of the wider investment community remains tilted towards the U.S. (and Tesla in particular), many companies in the lithium battery supply chain, as well as EV producers, remain overlooked and undervalued. EV Production Expected To Surge We expect a continuation of the push towards energy-saving vehicles among car manufacturers, driven by government incentives and new tougher regulations (EU regulations for CO2 emissions in 2020 will be the strictest so far). Over one million EV vehicles of different types were sold in 2015. In countries such as Norway, the penetration of PEVs is reaching up to 23% (Chart 1). Based on the current growth rates (Chart 2), the compound annual growth rate of EV production is estimated at 30% to 35% over the next 10 years. Japan will remain in top spot in EV penetration (the current HEV rate is around 20% of the overall market). Japan's market (controlled by Toyota and Honda) is dominated by the HEV type of vehicles, and we expect it to remain this way. Chart 1PEV Penetration By Country Chart 2EV Sales By Country We expect the largest boost in market share gains to happen on the European market, based on very stringent CO2 emissions regulation (Chart 3) and ambitious EV targets set by the larger countries. EV market share is set to reach 20% (from the current 5%) in the coming seven to 10 years. The EU is closely followed by South Korea. The Ministry of Trade, Industry and Energy (MOTIE) has developed an ambitious plan of growth, by which EV market share should reach 20% by 2020 and 30% by 2025. New EVs will receive special license plates, fuel incentives, and new charging stations. MOTIE wants the auto industry to be able to produce 920,000 NEVs per year, of which 70% should be exported. Among other large markets, the U.S. and China will remain the two countries with lowest EV penetration rates, although growth rates will be impressive. This will be due to low incentives from the government and cheap traditional fuel supply (in the U.S.), or a low base, some subsidy cuts, and infrastructure constraints (in China). Especially in China's case, the numbers remain striking (Chart 4). According to statistics published by the China Association of Automobile Manufacturers (CAAM), EV sales in 2015 grew 450% YOY. The market is estimated to grow at an average rate of 25% over the next 10 years. Chart 3EU CO2 Emission Targets Chart 4Monthly NEV Sales China In this report we will highlight companies from the raw material production stage: Albermarle (ALB US), Gangfeng Lithium (002460 CH), Tianqi Lithium Industries (002466 CH), and Orocobre (ORE AU); to added-value battery producers: BYD (1211 HK), LG Chem (051910 KS), and Samsung SDI (006400 KS); down to some electric vehicle companies: Geely Automobile Holdings (175 HK) and Zhengzhou Yutong Bus Company (600066 CH). The Supply Side Driven by demand from China and the U.S., the raw material base for lithium has shifted in the past 20 years from subsurface brines to more production-intensive hard-rock ores. Brine operations are mostly found in the so-called LatAm "triangle" - Argentina, Chile and Bolivia - while China and Australia produce lithium from spodumene (a mineral consisting of lithium aluminium inosilicate) and other minerals. The U.S. Geological Survey estimates world reserves at 14 million tonnes in 2015, with Bolivia and Chile on top of the table (Chart 5). The main lithium producing countries, according to the U.S. Geological Survey, are Australia, Chile, and Argentina (Chart 6). Chart 5Lithium Reserves Concentrated In LatAm Chart 6Lithium Production Dynamics By Country The lithium mining process starts with pumping lithium-containing brine to subsurface reservoirs and leaving the water to evaporate (from 12 to 24 months) until the brine reaches a 6% lithium content. From here there are three ways to process the concentrate, or the hard-rock in mineral form: Treatment with sulfuric acid (acidic method) Sintering with CaO or CaCO3 (alkali method) Treatment with K2SO4 (salt method) Further, lithium carbonate (Li2CO3), a poorly soluble solution, is isolated from the received concentrate and transferred into lithium chloride, which is purified in a vacuum distillation process. Storage is also difficult: as lithium is highly corrosive and can damage the mucous membrane, it is most commonly stored in a mineral oil lubricant. Due to the rare nature of the metal, lithium comes mainly as a by-product of other metals and comprises only a small part of the production portfolio. This is the reason why the underlying metal price and the share prices of the largest producers of lithium have low correlation (Chart 7). Albermarle, SQM, and FMC Corp currently control as much as three-quarters of global lithium production, but price performance is not keeping up with the price of the underlying metal. For best exposure to the metal, we concentrate on companies with a large degree of dedication to mining lithium and close ties to the end-users. We recommend one established market leader (by volume) - Albermarle (ALB US); one company that just started operations - Orocobre (ORE AU), whose assets are concentrated in Argentina; and two lithium miners from China - Jiangxi Ganfeng Lithium (002460 CH) and Tianqi Lithium (002466 CH). These companies display much higher correlation to the metal price (Chart 8). Chart 7FMC Corp., SQM And ##br##Albermarle Vs. Lithium Price Chart 8Orocorbe, Jiangxi Ganfeng And##br## Tianqi Lithium Vs. Lithium Price Albermarle (ALB US): U.S. company with EM exposure (Chart 9). After the acquisition of Rockwood Holdings in 2015, Albermarle became one of the largest producers of lithium and lithium derivatives. Lithium accounts for more than 35% of the company's revenue stream (+20% YOY), which compares favourably to the 20% of the Chilean producer SQM and the 8% of another large US producer FMC Corp. Chile comprises 31% of global production. Albermarle's 2Q16 results on 3 August came broadly in line with market expectations. Some deviation from expectations occurred because of discontinued operations in the Surface Treatment segment. Group sales contracted by 7%, due to divestures started in previous quarters (Chemetal). Positively, lithium sales grew 10% YOY due to both better pricing and higher volumes, and EBITDA in the segment improved by 20%. Group EBITDA (adjusted) grew by 5% YOY and the bottom-line (adjusted) expanded by 11% YOY. Management appears confident about FY16 operations, guiding 1% improvement in EBITDA, as well as 3% in FY EPS and aims to maintain EBITDA margins in the lithium segment at over 40%. We see high growth potential due to Albermarle's portfolio composition. The market is currently expecting an EPS CAGR of 9% over the next four years. Albermarle is trading at a forward P/E of 23.1x. Orocobre (ORE AU): An Australian company mining in Argentina (Chart 10). Orocobre is an Australian resource company, based in Brisbane. As in the case with Albermarle, the majority of operations are located in EM, so we see it as appropriate to include the company into our portfolio. Chart 9Performance Since October 2015: ##br##Albermarle vs MXEF Index Chart 10Performance Since October 2015: ##br##Orocobre vs MXEF Index Orocobre is at an initial stage in the lithium production process. The only division working at full capacity is Borax Argentina (acquired from Rio Tinto in 2012), an open-pit borate mining operation (producing 40 kilotonnes per annum (ktpa)). The flagship project (65% share), launched in a JV with Toyota Tsusho Corp, is the Olaroz lithium facility, a salt lake with an estimated 6.5 million tonnes of lithium carbonate (LCE) reserves. The planned capacity is at 17.5 ktpa. Due to the geological structure, it comes with one of the lowest operational costs ($3500 per tonne). The production ramp-up to 2,971 tonnes of lithium, reported on 19 July together with the 4Q16 results, came a notch below market expectations. The management lowered the production guidance, delaying full operational capacity by two months until November (realistically it might take even longer). Positive points in guidance included an LCE price exceeding $10,000/tonne in the upcoming quarter and confirmation that the company turned cash flow positive in the first half of this year.3 Orocobre is already planning capacity expansion at the Olaroz facility to 25 ktpa, with diversification into lithium hydroxide. Further exploration drilling is underway in the Cauchari facility, just south of Olaroz. The market forecasts the company to produce a positive bottom-line in FY17 and grow EPS by a CAGR of 25% for the next four years. Orocobre is currently trading at a forward P/E of 36.1x. Jiangxi Ganfeng Lithium (002460 CH): one of the largest lithium producers in China (Chart 11). Gangfeng is a unique company in the lithium space in the sense that it is a raw material producer with added processing capabilities. The main trigger for our OW recommendation was the acquisition of a 43% stake in the Mt Marion project in Australia. From 3Q16 onwards the bottleneck in raw material supply will be removed and the company can count on approximately 20 thousand tonnes (kt) of lithium spodumene. On the back of this news, the company announced a production expansion into lithium hydroxide (20 kt) from which 15 kt will be battery grade and 5 kt industry grade. This has the potential to lift Ganfeng to one of the top five producers in the world. Ganfeng reported stellar 2Q16 results on 22 August. The top-line grew two times YOY, while operating profit increased by 7.8x. Operating margin jumped from 9.8% to 35.9%, and the bottom-line expanded five-fold YOY. The profit margin also improved from 8.55% to 25.3%. We expect less strong, but still robust, YOY growth for the upcoming quarters. Market projects EPS CAGR of over 50% during the next four years, as the production run-up will continue. The company is currently trading at a forward P/E of 36.8x. Tianqi Lithium Industries (002466 CH): Making the move (Chart 12). Tianqi is the third largest producer in the world (18% of global capacity). Recently the company got into the news on rumors of its attempted expansion by taking a controlling stake in the world's largest lithium producer, Chile's SQM. Chart 11Performance Since October 2015:##br## Jiangxi Ganfeng Lithium vs MXEF Index Chart 12Performance Since October 2015: ##br##Tianqi Lithium vs MXEF Index SQM has an intricate shareholding structure, with the involvement of the Chilean government and a rule that no shareholder is currently allowed to own more than a 32% stake in the company (this rule can be changed only through an extraordinary shareholder meeting). At the moment the largest shareholder is Mr. Ponce Lerou (son-in-law of former President Augusto Pinochet), who owns just under 30% and has a strategic agreement with a Japanese company, Kowa, which makes the combined holding 32%. During the last week of September Tianqi acquired a 2% stake (for USD209 m) from US-based fund SailtingStone Capital Partners, which held a 9% stake, with the option to buy the remaining 7%. In a further step, Tianqi is trying to negotiate a deal with one of Mr. Ponce Lerou's companies which holds a 23% stake. It is said that Mr. Ponce Lerou has got into a political stalemate with the Chilean government on a production increase at one of its deposits and is looking to exit the company. Tianqi reported strong Q2 results on 22 August. Revenues grew by 2.4x YOY, and operating profit improved by 3.9x YOY. Operating margin grew from 42.99% in 2015 to 69.35% in 2Q16, and bottom-line increased twofold QOQ as production ramp-up continued. At the same time profit margin reached 48.9%, up from 2.8% a year ago. The company is currently trading at a forward P/E of 23.4x, and the market is forecasting an EPS CAGR of 13% over the next three years. The Demand Side4 Lithium is used in a wide range of products, from electronics to aluminium production and special alloys, down to ceramics and glass. But battery production takes the largest share of utilization (Charts 13A & 13B). Chart 13ALithium UsageChart 13BLithium Batteries Most Widely Used As confirmed by import statistics (from the U.S. Geological Survey), demand in many Asian countries, as well as the U.S., has been constantly rising. Among the main importers, South Korea is in fourth place with the largest number of new lithium-related projects started. In top position is the U.S., where we expect a strong demand increase, once the Tesla battery mega-factory in Nevada is completed, followed by Japan, which has the highest penetration of electric vehicles (EV), and China (Chart 14). Chart 14Composition Of Lithium Imports By Country Because of its low atomic mass, lithium has a high charge and power-to-mass ratio (a lithium battery generates up to 3V per cell, compared to 2.1V for lead-acid or 1.5V for zinc-carbon), which makes it the metal-of-choice for battery electrolytes and electrodes, and makes it difficult to replace with other metals, due to its unique physical features. Lithium is used in both disposable batteries (as an anode) and re-chargeable ones (Li-ion or LIB batteries, where lithium is used as an intercalated compound). Li-ion batteries are used in: Portable electronics, such as mobile phones (lithium cobalt oxide based); Power tools / household appliances (lithium iron phosphate or lithium manganese oxide); EVs (lithium nickel manganese cobalt oxide or NMC). The most produced battery is the cylindrical 18650 battery. Tesla's Model S uses over 7000 of these type of batteries for its 85 kWh battery pack (the largest on the market until mid-August, when Tesla announced a 100 kWh battery pack). The amount of lithium used in a battery pack depends on the kW output. Rockwood Lithium (now Albermarle), estimated in one of its annual presentations that: A hybrid electric vehicle (HEV) uses approximately 1.6kg of lithium A plug-in hybrid (PHEV) uses 12kg An electric vehicle (EV) uses more than 20kg (but all depends on make, model, and technology). An average car battery (PHEV/EV) would use over 10kg of lithium, assuming 450g per kWh (please note that real-life calculations suggest a usage of up to 800g per kWh of lithium. We have used the lower end of the range for our estimates), with Tesla's battery consuming around 70kg of lithium. Simple math suggests that with the completion of the mega-factory (estimated production of 35 GWh or 500k batteries p.a.), Tesla alone will be consuming at least half of world lithium production by 2020, and create a large overhang in demand. Among car battery producers, we like global players with dominant market positions and strong ties to end-users, such as LG Chem, Samsung SDI in Korea, and BYD in China. Those three companies together control more than half of global battery production (Chart 15) and will most likely maintain market share in the foreseeable future, as barriers to entry are high due the amount of investment required into technology and production facilities, and the end-product is difficult to differentiate on the market. BYD Corp (1211 HK): Build Your Dreams, it's in the name (Chart 16). Founded in 1995 and based in Shenzhen, BYD covers the whole value chain, from R&D and production of batteries (phone and car batteries) to automobile production and energy storage solutions. It is currently the largest battery and PHEV producer in China. The total revenues stream consists of 55% from auto and auto components sales, 33% portable electronics battery, and 12% car battery sales. Chart 15Largest Lithium ##br##Battery Producers Chart 16Performance Since October 2015: ##br##BYD Corp vs MXEF Index We believe the company is best positioned to reap multi-year rewards from the recent drive of the Chinese government to promote new electronic vehicle (NEV) growth through subsidies, support of charging infrastructure, and changes in legislation. The introduction of carbon trading in August (carbon credit will be measured on the number of gasoline-powered vehicles in the producer's fleet) will give BYD a benefit over other car manufacturers. BYD's model pipeline and battery manufacturing capacity (expected to reach 20 GWh by FY17), as well as favourable pricing ($200 kWh compared to over $400 kWh for Tesla) put the company into a leadership position. BYD reported 2Q16 results on 28 August, which came out very strong. Revenues grew by 52.5% YOY and 384% on a semi-annual perspective, driven by all three business segments and especially strong in EV sales (+29% YOY). This came with a significant beat of consensus estimates and later we saw a 68% upwards adjustment. As a result operating margin and profit margin improved from 3.8% and 2.2% in 2Q15 to 8.5% and 5.8% in 2Q16. Bottom-line was up 4x YOY. The market is currently pricing in an EPS CAGR of 12% over the next three years. BYD is trading at a forward P/E of 23.9x. LG Chem (051910 KS): Catering for the US market (Chart 17). LG Chem is the largest chemical company in South Korea, operating in three different divisions: petrochemicals (from basic distillates to polymers), which account for 71% of total revenues, information technology and electronics (displays, toners etc.), which represent 13% of total revenues, and energy solutions, 16% of total revenues. LG Chem is the third largest battery producer in the world, manufacturing a pallet from small watch and mobile phone batteries down to auto-packs. LG's North American operations in Holland, Michigan produce battery packs for the whole range of GM (Chevrolet, Cadillac) EVs (including the most popular Volt range), as well as for the Ford Focus. In Europe, customers include Renault; in Asia, LG is working with Hyundai, SAIC, and Chery. The company reported better-than-expected 2Q16 results on 21 July. Revenues grew by 3% YOY and operating profit by 8.5% YOY, driven solely by the petrochem division (up 10% YOY). Bottom-line expanded by a healthy 8% YOY. LG Chem trades at deeply discounted levels (forward P/E of 11.6x) due to the remaining negative profitability in the battery segment (partly due to licensing issues in China, which represents 32% of total revenues), but we estimate that the trend will turn in the following quarters, as Chevrolet is ramping up demand with new product lines and management is guiding for a resolution in China. Furthermore, plans released by the Korean government in June/July (renewable energy plan and EV expansion plan) will increase demand for batteries by more than 30% CAGR in the next five years. The market is forecasting an EPS CAGR of 9% over the upcoming four years. Samsung SDI (006400 KS): Investing into the future (Chart 18). In contrast to LG Chem, Samsung SDI is fully focused on Li-ion battery production, with 66.5% of total revenues coming from this division (BMW and Fiat among clients). The company also produces semiconductors and LCD displays, which account for 35.5% of total revenue. Chart 17Performance Since October 2015: ##br##LG Chem vs MXEF Index Chart 18Performance Since October 2015: ##br##Samsung SDI vs MXEF Index Samsung SDI is currently in a reorganization phase, as the company is spinning off "Samsung SDI Chemicals" and has announced it will invest $2.5 bn into further development of its car battery business. The proceeds from the sale of Samsung SDI Chemicals (taken over by Lotte Chemicals in April for around $2.6 bn) will also be directed towards the car battery segment. Samsung SDI reported weak 2Q16 results on 28 July, as expected. Revenues continued to contract on a YOY basis, although the rate of decline slowed compared to Q1 and even registered 2% QOQ growth. The bottom-line was positive due to a one-off gain (the sale of the chemical business). The main headwinds came from delays in licensing Chinese factory production and a strong Japanese yen. On the positive side, Li-ion batteries in portable devices performed well, due to better than expected Galaxy S7 sales, as well as OLED sales, due to increased demand and capacity constraints in the mobile phone and large panel spaces. Due to the high concentration of EV battery-related revenues in its portfolio, we believe that Samsung SDI will be the largest beneficiary of government's renewable energy and EV expansion plans. The company is also ideally positioned to take advantage of the fast-growing Chinese market (35% of revenues coming from China), once the issue with licensing is resolved (which management guided will happen in Q3). The recent problems with overheating or exploding batteries, reported by users of the new Samsung phones, have sent the share price lower. We believe that this offers an excellent entry point, as ultimately the company will replace/improve the technology, and, at the same time, there are no alternatives which could threaten Samsung SDI's leadership in the portable battery space. The temporary issue in China has weighted on valuations, as Samsung SDI is trading at a forward P/E of 27.7x, while the market expects EPS to increase fivefold in the coming four years. Accessing The Chinese EV Market Best access to the fast growing Chinese market is through local car manufacturers, such as Geely (Chart 19). The subsidy schemes, put in place by the National Development and Reform Commission (NDRC), currently cover only domestic-made models (except the BMW i3). Furthermore, import duties are making foreign-made vehicles uncompetitive in terms of price. We recommend to overweight Geely (0175 HK) and electric bus producer Yutong Bus (600066 CH) on the 30% NEV rule for public transport procurement. Chart 19Accessing The Chinese EV Market Geely ("Lucky" in Mandarin) Automobile Holdings (175 HK): A company with large ambitions (Chart 20). Probably best known for its two foreign car holdings, Volvo and the London Taxi Company, Geely grew from a small appliances manufacturer to the second largest EV producer in China, with an ambitious goal to manufacture 2 mn units by 2020. We see the main positive driver in Geely's big push into the EV market. The goal set by management is to have 90% of its fleet powered by electricity by 2020. The so called "Blue Geely" initiative is based on a revamp of Geely's current fleet into HEVs/PHEVs (65% as per plan) and EVs (35%). In May the company raised $400 mn in "green bonds" in a first for a Chinese car company, to support its R&D and manufacturing project, Ansty, to produce the first zero-emission TX5 black cabs in the U.K. The company reported strong 1H16 results on 18 August. Revenues were up 30% YOY, driven by higher production volume (up 10% YOY) and a sales price hike of around 15% YOY. The co-operation with Volvo seems to be working well (Volvo's design, Geely's production capabilities). The average waiting time for new models in China is approximately two months. The bottom-line expanded by 37.5% YOY despite a high density of new model launches, and we expect to see some margin improvement in the coming quarters. The market forecasts an EPS growth CAGR of 25% over the coming four years. Geely is currently trading at a forward P/E of 15.6x. Zhengzhou Yutong Bus Company (600066 CH): An unusual bus manufacturer (Chart 21). Yutong Bus Company is the world's largest, and technologically most advanced, producer of medium and large-sized buses (over 75k units produced in FY15, 10% global market share), with its own R&D and servicing capabilities. Even more important, Yutong is one of the largest producers of electric-powered buses in China and globally. Chart 20Performance Since October 2015: ##br##Geely Automobile Holdings vs MXEF Index Chart 21Performance Since October 2015:##br## Yutong Bus Company vs MXEF Index Due to the 30% EV procurement rule for local governments, the number of electric buses produced in 2015 soared 15 times to 90,000, a quarter of which were produced by Yutong. We expect this number to grow further with the introduction of the new carbon emission trading scheme. We see Yutong as best positioned in the bus manufacturers' space to take advantage of the new trading rules. Yutong reported 2Q16 results on 23 August, which came in broadly in line with market expectations. Revenue expanded by 34% YOY, driven by volume growth (7400 NEV units sold, +100% YOY). The push into EVs came with higher cost-of-sales (warranty and servicing). This did not affect gross margin (up 1% to 25%). Bottom-line grew by 50% YOY. Management maintained an upbeat outlook, guiding 25,000 units of NEV sales in FY16, with an average sales price increase due to higher sales in the large-bus segment. Management also expects to receive the national subsidy for FY15 in 3Q16 and for 2016 in 1Q17. The market currently factors in an EPS CAGR growth of 8% over the next four years. Yutong is trading at a forward P/E of 12.3x. How To Trade? The EMES team recommends gaining exposure to the sector through a basket of the listed equities, which would consist of four mining companies, three car battery pack producers, and two EV manufacturers. The main goal is active alpha generation by excluding laggards and including out-of-benchmark plays, to avoid passive index hugging via an ETF. Direct: Equity access through the tickers (Bloomberg): Albermarle (ALB US), Gangfeng Lithium (002460 CH), Orocobre (ORE AU), Tianqi Lithium Industries (002466 CH), BYD (1211 HK), LG Chem (051910 KS), Samsung SDI (006400 KS), Geely Automobile Holdings (175 HK), Zhengzhou Yutong Bus Company (600066 CH). ETFs: Global X Lithium ETF (LIT US) Funds: There are currently no funds available, which invest directly into lithium or lithium-related stocks. Please note that the trade recommendation is long-term (1Y+) and based on an OW call. We don't see a need for specific market timing for this call (for technical indicators please refer to our website link). Trades can also be implemented through our recommendation versus MXEF index either directly through equities in the recommended list or through ETFs. For convenience, the performance of both the ETFs and market cap-weighted equity baskets will be tracked (please see upcoming updates as well as the website link to follow performance). Risks To Our Investment Case Because of the broad diversification, we see our portfolio exposed to idiosyncratic risk factors, which could affect single-stock performance, as well as the following macro factors: Mining: Falling lithium prices due to lower demand or a ramp-up in production on some of the Australian projects, could hurt profitability or delay new projects (especially in case of Orocobre). We also see some political risk stemming from the region of operations (Argentina, Chile), especially taking into account the weak performance of Chile's own lithium producer SQM and its role in a Brazil-like political scandal. Battery and EV production. We identify the main risk in drastic changes to governments' environmental and subsidy policies, which would hit the whole supply chain. A slowdown in economic development can make green or power-saving initiatives too expensive and governments will have to rethink their subsidy policies or production/penetration goals. This will hurt profitability through either a negative impact on sales or through smaller subsidies, which producers and end-users are receiving from their governments. One further risk is the dramatic increase in demand for lithium after the completion of Tesla's factory in Nevada, but may also come from other large players such as BYD. We currently see this risk as muted. As with all large Tesla initiatives, you have to take them with a pinch of salt, as the exact end numbers and the time the factory will be working at full capacity are unclear. Furthermore, Tesla, unlike many Chinese competitors, has no supply of lithium of its own, so there is little chance that it can protect supply or control prices. In any case, we see the overall portfolio as balanced, as the mining companies' performance should compensate for a negative impact on the end producers. Oleg Babanov, Editor/Strategist obabanov@bcaresearch.co.uk BASE METALS China Commodity Focus: Base Metals Zinc: Downgrade To Strategically Bearish We downgrade our strategic zinc view from neutral to bearish. We believe zinc supply (both ore and refined) will rise in response to current high prices, resulting in a 10-15% decline in zinc prices over next 9-12 months. Tactically, we still remain neutral on zinc prices as we believe the market will remain in supply deficit over the near term. Chinese zinc ore production will recover in 2017, while the country's zinc demand growth will slow. China is the world's biggest zinc ore miner, refined zinc producer, and zinc consumer. We recommend selling Dec/17 zinc if it rises to $2,400/MT (current: $2,373.5/MT). If the sell order gets filled, put on a stop-loss level at $2,500/MT. Zinc has been the best-performing metal in the base-metals complex, beating copper, aluminum and nickel this year. After bottoming at $1,456.50/MT on January 12, zinc prices have rallied 64.7% to $2,399/MT on October 3 (Chart 22, panel 1). The Rally The rally was supercharged by a widening supply deficit, which was mainly due to a record shortage of zinc ores globally (Chart 22, panels 2, 3 and 4). Late last October our research showed the output loss from the closure of Australia's Century mine, the closure of Ireland's Lisheen mine and Glencore's production cuts would reduce global zinc supply by 970 - 1,020 KT in 2016, which would be equivalent to a 7.1 - 7.5% drop in global zinc ore output.5 Moreover, a 16% price decline during the November-January period spurred additional production cut worldwide. According to the WBMS data, for the first seven months of 2016, global zinc ore production declined 11.9% versus the same period of last year, a reduction never before seen in the zinc market. In comparison, there was no decline in global zinc demand (Chart 22, panel 4). As a result, the global supply deficit reached 152-thousand-metric-tons (kt) for the first seven months of 2016, versus the 230kt supply surplus during the same period last year. What Now? Tactically, We Remain Neutral. On the supply side, we do not see much new ore supply coming on stream over the next three months. On the demand side, both monetary and fiscal stimulus in China has pushed Chinese zinc demand higher. For the first seven months of 2016, the country's zinc consumption increased 209 kt, the biggest consumption gain worldwide. Because of China, global zinc demand did not fall this year. China will continue lifting global zinc demand as its auto production, highway infrastructure investment, and overseas demand for galvanized steel sheet will likely remain elevated over the near term (Chart 23, panels 1, 2 and 3). Inventories at the LME are still hovering around the lowest level since August 2009, while SHFE inventories also have been falling (Chart 23, bottom panel). Speculators seem to be running out of steam, as the open interest has dropped from the multi-year high on futures exchanges. Chart 22Zinc: Strategically Bearish, Tactically Neutral Chart 23Positive Factors In The Near Term The aforementioned factors militate against zinc prices dropping sharply in the near term. However, with prices near the 2014 and 2015 highs, and facing strong technical resistance, we do not see much upside. Strategically, We Downgrade Our Strategic Zinc View From Neutral To Bearish We believe zinc supply (both ore and refined) will rise in response to current high prices, resulting in a 10-15% decline in zinc prices over next 9-12 months. Chart 24High Prices Will Boost Supply In 2017 Zinc prices at both LME and China's SHFE markets are high (Chart 24, panel 1). Last year, many miners and producers cut their ore and refined production due to extremely low prices. If zinc prices stay high over next three to six months, we expect to see an increasing amount of news stories on either production cutbacks coming back or new supply being added to the market, which will clearly be negative to zinc prices (Chart 24, panels 2 and 3). So far, even though Glencore, the world's biggest ore producing company, is still sticking firmly to its output reduction plan, there have been some news reports about other producers raising their output, all of which will increase zinc ore supply in 2017. The CEO of the Peruvian Antamina mine said on October 10 the mine operator will aim to double its zinc output in 2017 to 340 - 350 kt, up from an estimated 170 kt - 180 kt this year, as the open pit operation transitions into richer zinc areas. This alone will add 170 kt - 180 kt new zinc supply to the market. Vedanta said last week that its zinc ore output from its Hindustan Zinc mine located in India will be significantly higher over next two quarters versus the last two quarters. Nyrstar announced in late September that it is reactivating its Middle Tennessee mines in the U.S., expecting ore production to resume during 2017Q1 and to reach full capacity of 50 kt per year of zinc in concentrate by November 2017. Red River Resource is also restarting its Thalanga zinc project in Australia, and expects to resume producing ore in early 2017. Glencore may not produce more than its 2016 zinc production guidance over next three months. But it will likely set its 2017 guidance higher, if zinc prices stay elevated. After all, the company has massive mothballed zinc mines, which are available to bring back to the market quickly. In comparison to the high probability of more supply coming on stream, global demand growth is likely to stay anemic in 2017, as the stimulus in China, which was implemented in 2016H1, will eventually run out of steam. How Will China Affect The Global Zinc Market? Chart 25Look To Short Dec/17 Zinc China is the world's largest zinc ore producing country, the world's largest refined zinc producing country, and the world's largest zinc consuming country. Last year, the country produced 35.9% of global zinc ore, 43.8% of global refined zinc, and consumed 46.7% of global zinc. Over the near term, China is a positive factor to global zinc prices. Domestic refiners are currently willing to refining zinc ores as domestic zinc prices are near their highest levels since February 2011. With inventories running low and domestic ore output falling 7.8% during the first seven months of 2016, the country may increase its zinc ore imports in the near term, further tightening global zinc ore supply. Domestic zinc demand and overseas galvanized steel demand are likely to stay strong in the near term. However, over the longer term, China will become a negative factor to global zinc prices. China's ore output the first seven months of 2016 was 221 kt lower than the same period of last year as low prices in January-March forced widespread mine closures. The country's mine output may not increase much, as the government shut 26 lead and zinc mines in August in Hunan province (the 3rd largest zinc-producing province in China) due to safety and environmental concerns. The ban will be in place until June 2017. Looking forward, elevated zinc prices and a removal of the ban will boost Chinese zinc ore output in 2017. Regarding demand, we expect much weaker Chinese zinc demand growth next year as this year's stimulus should run out of steam by then. Risks If global zinc ore supply does not increase as much as we expect, or global demand still have a robust growth next year, global zinc supply-demand balance may be more tightened, resulting in further zinc price rallies. If Chinese authorities resume their reflationary policies next year during the lead-up to the 19th National Congress of the Communist Party of China in the fall, which may increase Chinese and global zinc demand considerably, we will re-evaluate our bearish strategic zinc view. Investment Ideas As we are strategically bearish zinc, we recommend selling Dec/17 zinc if it rises to $2,400/MT (current: $2,373.5/MT) (Chart 25). If the sell order gets filled, put on a stop-loss level at $2,500/MT. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com 1 Please see p. 32 of the 2016 edition of the International Energy Agency's "Key World Energy Statistics." The IEA reckons global oil demand in 2014 averaged just over 93mm b/d. 2 Please see the Financial Times, p. 12, "Warning on electric vehicle threat to oil industry," in the October 9, 2016, re the Fitch Ratings report, and IHS Energy's Special Report, "Deflating the 'Carbon Bubble,' Reality of oil and gas company valuation," published in September 2014. 3 Because of the early stage of the project, a conventional equity analysis is not yet applicable. 4 Please see Technology Sector Strategy Special Report "Electric Vehicle Batteries", dated September 20, 2016, available at tech.bcaresearch.com 5 Please see Commodity & Energy Strategy Weekly Report for Base Metal section, "Global Oil Market Rebalancing Faster Than Expected", dated October 22, 2015, available at ces.bcaresearch.com Investment Views and Themes Recommendations Tactical Trades Commodity Prices and Plays Reference Table Closed Trades

As third quarter earnings reports trickle in for companies in the industrial sector, it is becoming increasingly clear that achieving meaningful sales growth will remain a daunting task. There is little incentive to bet on upside surprises. Commodity-related industries remain hamstrung by poor balance sheets and a dearth of free cash flow, which will limit capital availability needed for investment. Banks are tightening standards on business loans, a leading indicator for industrial sales growth (second panel). The ongoing contraction in core durable goods orders confirms that industrial sector earnings momentum remains negative. Now that sector labor costs are back on the upswing, the need for a sales recovery becomes even more urgent, otherwise profit margins will continue to get squeezed. We remain underweight the S&P industrials sector.

Consumer product stocks have had a tough few weeks, as renewed strength in the U.S. dollar threatens to undermine sales prospects. However, there are reasons to be cautiously optimistic, especially in relative terms. Consumption has a lower economic beta than capital spending, particularly among consumer staples vendors. Consumer goods exports have started to rebound, even prior to renewed strength in emerging market currencies. The latter heralds at least a mild recovery in consumer product top-line growth. Domestically, retail sales at non-discretionary stores are outpacing sales at discretionary stores by a wide margin, another indication that in relative terms, profit conditions favor non-cyclical consumer goods vendors. We are overweight the S&P household products and S&P soft drink indexes.

Highlights ECB Monetary Policy: Euro Area inflation will likely remain below the European Central Bank (ECB) 2% target for the next few years due to persistent excess capacity in Europe. The ECB will signal this at the December monetary policy meeting, providing the justification to extend their quantitative easing (QE) asset purchase program beyond the current March 2017 expiration date. ECB QE Changes: The constraints imposed on the ECB's bond purchases are self-imposed, and can be easily altered in the event of potential "shortages" of available debt for the QE program. Fears of a potential taper of ECB buying because of those constraints, which have bearish implications for Euro Area bond yields, are overstated. Country Allocation: Move to an above-benchmark stance on core European government debt, which are a low-beta safe haven in the current environment of a cyclical rise in global bond yields. Feature After spending the past couple of months fretting over the next move by the U.S. Federal Reserve or the Bank of Japan, investors' attention shifted to Europe last week. With the current European Central Bank (ECB) government bond quantitative easing (QE) program set to expire in March of next year, the markets were seeking any sort of guidance on whether the ECB will end the program as scheduled, or extend the program beyond March - perhaps with a reduction ("taper") in the size of the bond buying. ECB President Mario Draghi provided no new information at the post-meeting press conference last Thursday, leaving bond investors in limbo until the December meeting when the results of the ECB's assessment of their QE program will be published. Some alterations of the program will likely be announced, but it is too soon for the ECB to consider ending their QE program. With regards to the title of this Weekly Report - the most likely outcome is that the ECB will extend the QE program past March 2017, but will tinker with the rules of QE in an effort to pretend that the central bank is still following a prudent logic for its purchases. Fears of an early taper are overstated, and this makes core European government debt a potential oasis of safety while global bond yields remain in a bear phase. Plenty Of Reasons For The ECB Not To Taper This talk of a tapering of ECB asset purchases following the scheduled end of the current QE program seems premature. After all, neither the ECB's own economic forecasts, nor those of its Survey of Professional Forecasters, are calling for inflation to get close to the 2% target until at least 2018 (Chart of the Week). The ECB staff will prepare a new set of forecasts for the December policy meeting that will include projections for 2019 - perhaps these new estimates will have inflation finally reaching the 2% goal. But in the absence of a credible forecast of inflation returning to target, the ECB will be hard pressed to signal any move to a less-accommodative monetary policy. Headline Euro Area inflation is currently only 0.4%, despite a recent increase in the oil price denominated in Euros, which has been a reliable directional indicator for Euro Area inflation (Chart 2). Chart of the WeekNo Need For An ECB Taper Chart 2European Inflation Is Stubbornly Low The steady decline in the Euro Area unemployment rate over the past three years has coincided with a move higher in overall labor compensation, but this has been purely a "volume" effect resulting from steadily increasing employment growth. With the entire region not yet at full employment, there has been minimal upward pressure on wages or inflation in domestically focused sectors like services (bottom panel). In other words, the lack of Euro Area inflation is a direct function of the excess capacity in Euro Area product and labor markets. According to the IMF, the Euro Area output gap will not close until 2020, which will limit any rise in inflation over the rest of the decade (Chart 3). It will take a more prolonged period of above-trend economic growth to close the output gap, reducing the Euro Area unemployment rate below the full employment NAIRU level, before any recovery in wages or core inflation can take place (bottom panel). This lack of realized inflation is weighing on Euro Area inflation expectations and creating some potential credibility problems for the ECB. As we have discussed in earlier Weekly Reports, inflation expectations in much of the developed economies seem to follow an "adaptive" process, where expectations are formed in lagged response to actual inflation.1 If central banks are fully credible in their ability to use monetary policy to fight inflation (and demand) shortfalls, then those forward-looking expectations should eventually gravitate towards the central bank inflation target. However, if there is a large and persistent shock to realized inflation, then inflation expectations can deviate from the central bank target for an extended period. Using a 5-year moving average of realized headline CPI inflation as a proxy for inflation expectations is a reasonably good (albeit simple) approximation of this adaptive process (Chart 4). The current 60-month moving average for Euro Area headline inflation is 0.6%, not far from the 5-year Euro Area CPI swap rate of 0.9%. However, if the ECB's inflation forecasts for the next two years come to fruition (1.2% in 2017, 1.6% in 2018), then the 5-year moving average will continue to decline, as those higher inflation figures would not offset the sharp fall in inflation witnessed over the past few years. Chart 3Excess Capacity Holding Inflation Down Chart 4Inflation Expectations Will Stay Low Simply put, the ECB's current projections are not consistent with inflation expectations hitting the 2% target by 2018, and likely even beyond that. The ECB will be presenting new projections in December, but it would take a significant upgrade of their growth and inflation forecasts to "move the needle" on longer-term inflation expectations. Perhaps a move away from fiscal austerity across the Euro Area could trigger an upgrade on growth expectations, as that would imply a faster pace of growth and a more rapidly narrowing output gap. However, while the topic of greater fiscal spending has been heating up in the halls of governments in Washington, London and Tokyo, there has been little sign that Euro Area governments are about to open the fiscal spigots anytime soon (and certainly not before elections in Germany and France in 2017). Chart 5European Banks Getting More Cautious? ECB Still Needs To Support Loan Growth The state of Euro Area banks, and what it means for future lending activity, is another factor for the ECB to consider before contemplating any move to a less-accommodative monetary policy. The current growth rates of money and credit are showing no signs of significant deceleration (Chart 5). The latest ECB Euro Area bank lending survey, released last week, did show a modest decline in the net number of banks reporting easier lending standards to businesses, as well as a reduction in the number of banks reporting increasing loan demand from firms. The ongoing hit to European bank profitability from the current negative interest rate environment could be playing a role in the banks moving to a less easy environment for lending. As can be seen in the bottom panel of Chart 5, there is a reliable leading relationship between Euro Area bank equity prices and the growth in bank lending to businesses. The downturn in Euro Area bank stocks in 2016, which has been driven by declining profit expectations, could pose a risk to credit growth in the months ahead. According to a special question asked within the ECB's bank lending survey, a net 82% of respondents reported that the ECB's negative deposit rate has damaged banks' net interest income over the past six months.2 In that same survey, a net 12% of banks reported a boost to loan demand from the ECB's negative interest rate policy, and a net 15% of banks reported that the additional liquidity provided by the ECB bond purchases went towards extending loans to businesses. So while negative interest rates may be hurting bank profit margins, the impact of the ECB's QE is helping offset that to some degree by providing banks with capital gains on their bond portfolios that can be used to finance lending. So without any sign that inflation will soon approach the ECB's target, thus requiring a potential tapering of QE or even a move away from negative interest rates, the prudent course for the ECB to take to support Euro Area credit demand, and economic growth, is to continue with the QE program beyond the March 2017 expiration date. That will require some changes to the ECB's rules of the program, but, in the end, these are only self-imposed constraints. Bottom Line: Euro Area inflation will likely remain below the ECB 2% target over the next few years due to persistent excess capacity in Europe. The ECB will signal this at the December monetary policy meeting, providing the justification to extend their quantitative easing asset purchase program beyond the current March 2017 expiration date. The ECB Has Some Policy Options To Avoid A Taper Tantrum Core European bond yields have been depressed by the ECB's QE program, which have acted to push down both the future expected path of interest rates and the term premium (Chart 6). This has helped anchor real bond yields in negative territory, even with inflation expectations at such low levels. But any signs of potential slowing of the pace of QE buying could quickly unwind this effect, which makes the ECB's next steps so critical for the path of global bond yields. In Chart 7, we show the level and growth rate for the ECB's monetary base, along with five potential future scenarios: The ECB ends their QE program in March 2017, as currently planned; The ECB extends QE for six months to September 2017, at the current pace of €80bn in bond buying per month; The ECB extends QE program for twelve months to March 2018, at a pace of €80bn per month; The ECB extends QE to September 2017, but reduces the pace of purchases to €60bn per month; The ECB extends QE to March 2018, but cuts to €60bn per month. Chart 6ECB QE Still Holding Down Yields Chart 7ECB Needs To Keep The Monetary Base Growing As can be seen in the bottom panel of Chart 7, the growth rate of the ECB's monetary base (and the asset side of their balance sheet) will decelerate sharply in 2017 & 2018 if the ECB does end the QE program as scheduled next March. Extending the program, however, does push out the rapid deceleration phase for monetary base into 2018. This is of critical importance for the Euro Area bond market, as both the outright level and term premium component of German Bund yields have been broadly correlated with the growth rate of the monetary base (Chart 8). In other words, extending the ECB QE program into the future is most important to prevent a "taper tantrum" in European bonds, by signalling to the markets that the ECB wishes to maintain low interest rates for longer. The ECB could even announce a reduction in the pace of purchases, along with an extension, and bond yields should remain well-behaved. This will also help prevent an unwanted appreciation of the Euro, the value of which currently reflects the far easier monetary stance in Europe (Chart 9). Chart 8An ECB Taper Would Be Bad For Bunds Chart 9An Easy-For-Longer ECB Will Weigh On The Euro Given the persistent debates within the ECB (and between the ECB and some Euro Area governments) about the long-run merits of QE, the combination of both an extension and reduction in QE purchases could be the compromise option that satisfies all parties. Alternatively, the ECB could choose to maintain the pace of bond purchases but alter the selection rules governing the program. Given the recent concerns in bond markets that the ECB is "running out of bonds to buy", changing the rules of the QE program is a sensible way for the central bank to free itself from the self-imposed shackles on its bond purchases. There are three options that the ECB can consider: Moving away from strictly allocating the bond purchases according to the ECB "capital key", which essentially weights the bond purchases by the size of each economy; Raising the issuer limits on QE, which limits the ECB to holding no more than 33% of any single issuer or individual bond issue; Reducing the current yield floor on QE, which prevents the ECB from buying any bonds with yields below the ECB deposit rate, which is currently -0.4%; We think option 1 is the least likely to occur, as this would imply buying a greater share of countries with more problematic debt profiles, like Italy or Portugal. There is little chance of such a strategy being well received by the governments in Berlin and Brussels, and the ECB would likely wish to avoid a major political confrontation by allowing larger deviations from the capital key Option 2 is an easier solution to implement. The 33% issuer constraint was always an arbitrary level that was aimed more at bonds with so-called "collective action clauses", where a majority of bondholders can force a decision on all bondholders in the event of a debt restructuring. It is understandable why the ECB would not want to become to decision-making counterparty in the event of a future messy bond restructuring in Europe. However, the ECB's ownership percentages within each Euro Area country are nowhere near the 33% limit at the moment (Chart 10) and, at the current pace and composition of buying, that 33% limit will not even be reached for Germany anytime soon.3 There is room for the ECB to raise the issuer limits, as it has already done for some other parts of its asset purchase programs, like bonds issued by European Union supranationals.4 Chart 10ECB Holdings Are Far From The 33% Issuer Limit Chart 11Lowering The Yield Floor For QE Makes Sense Option 3 is the most binding constraint of all on the ECB purchases, as very large shares of the European government bond market are now trading below the ECB's -0.4% deposit rate (Chart 11). In the case of Germany, nearly 70% of all QE-eligible debt is trading below the ECB's yield floor, which has raised investor concerns that the ECB will soon be unable to buy enough German debt at the current pace of purchases. However, that yield floor constraint is completely arbitrary - there is nothing stopping the ECB from buying bonds trading at a yield below the deposit rate, other than (we suspect) a desire to impose some sort of price discipline on the QE buying to make the ECB appear more credible with its purchases. Chart 12The QE Yield Floor Can Be Changed If the ECB decided to lower the yield floor below the current -0.4% deposit rate, this would open up a greater share of the core European bond markets to QE buying (Chart 12). This would also change the current market narrative that the ECB will soon run out of German bonds to buy. In the end, the most likely path the ECB will take following its December re-assessment of its QE program is a combination of lowering the yield floor on QE bond purchases below -0.4% and raising the issuer limits above 33%. There appears to be plenty of leeway for the ECB to alter their purchases, but without necessarily reducing the monthly pace of buying. Combined with an extension of the end-date of the QE program beyond March, this should alleviate any concerns that the ECB will soon hit a wall with its asset purchases. Bottom Line: The constraints imposed on the ECB's bond purchases are self-imposed, and can be easily altered in the event of potential "shortages" of available debt for the QE program. Fears of a potential taper of ECB buying because of those constraints are overstated. Investment Implications: Move To An Above-Benchmark Stance On Core European Bonds With the ECB having no need to end its QE program early, the case for moving to an overweight stance on core Europe is a strong one. As we noted in our last Weekly Report, favoring bond markets of countries with the lowest inflation rates is a logical investment strategy in the current environment of a modest cyclical upturn in global growth and inflation.5 That justifies our current below-benchmark recommendation on U.S. and U.K. government debt, as both realized inflation and expected inflation are rising in both countries. That leaves the Euro Area and Japan as possible candidates to move to above-benchmark weightings, given their defensive properties as low-beta bond markets. Although with the Bank of Japan now pegging the Japanese government bond (JGB) yield curve with a 10-year yield at 0%, we do not see a compelling investment case for overweighting JGBs as a defensive trade. If an investor wants safety at a 0% yield - with no chance of a capital gain from a decline in yields - than owning T-bills, or even gold, is just as viable as owning JGBs. We recently upgraded Japan to neutral in our recommended portfolio allocation, and we see no reason to move from that. Thus, core European bonds stand out as the candidate to upgrade as a defensive trade during the current bond bear phase, which we expect will continue until at least December when the Fed is expected to deliver another rate hike in the U.S. We see a case for moving to above-benchmark for both Germany and France, but especially so in the latter. The beta of bond returns between France and both the U.S. (Chart 13) & U.S.(Chart 14) is very low, making French bonds a good market to favor at the expense of U.S. Treasuries and U.K. Gilts in currency-hedged bond portfolios. Chart 13French Bonds Are Low Beta To USTs... Chart 14...And To U.K. Gilts Bottom Line: Move to an above-benchmark stance on core European government debt, which are a low-beta safe haven in the current environment of a cyclical rise in global bond yields. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Why Are Global Inflation Expectations Still So Low", dated March 1, 2016, available at gfis.bcaresearch.com. 2 The Q4 2016 ECB Euro Area Bank Lending Survey can be found at https://www.ecb.europa.eu/stats/pdf/blssurvey_201610.pdf. 3 Please note that the denominator in the percentages shown in Chart 10 include only bonds with maturities that are eligible for ECB QE purchases, omitting bonds that will mature in less than 2 year and more than 30 years. 4 For more details on that change to the supranational issuer limits, please see https://www.ecb.europa.eu/mopo/implement/omt/html/pspp-qa.en.html. 5 Please see BCA Global Fixed Income Strategy Weekly Report, "Return Of The Bond Vigilantes", dated October 18, 2016, available at gfis.bcaresearch.com. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

The speed at which the health care sector has sunk toward the bottom end of this year's trading range has unnerved many investors. The hit to health care stocks reflects a rise in risk premiums related to concerns that the U.S. government will exert more control over price setting if the Democrats win the election rather than any immediate downshift in relative forward earnings drivers. The sector is extremely oversold, and once the election is over, attention will refocus on the relative forward earnings outlook. Our Indicators suggest that earnings momentum will stay positive. Our health care sector pricing power proxy has rebounded after cooling from red-hot levels, and is still much stronger than overall corporate sector pricing (second panel). That is confirmed by the pharmaceuticals producer price index, and employment cost index for health insurance, i.e. pricing strength is broad-based. There is still scant evidence of a downshift in consumer spending patterns in reaction to rising health care sector inflation. Real (volumes) personal spending on health care goods and services continues to grow at a mid-single digit rate, well in excess of the rate of overall consumption. That is consistent with ongoing earnings outperformance. Stay overweight.

This year's exodus from casual dining stocks has been justified on the basis of overvaluation and deteriorating industry performance. The National Association of Restaurants (NAR) survey of current performance has dipped into negative territory, as restaurant operators have reported a decrease in traffic. However, cost structures are being realigned to a more subdued sales run rate. The NAR survey shows that staffing plans are on the wane. That leads restaurant labor cost inflation. As the largest source of expenses, any decline in headcount would be welcome given that minimum wages in a number of states are set to climb next year. Restaurant sales growth has been unimpressive for the past several years. Subdued pricing power gains, and until recently, lackluster income growth among lower income consumers have weighed on revenue growth. The good news is that consumer confidence among low income earners is on the upswing. In addition, restaurant retail sales often follow the trend in the wealth effect. Financial wealth gains are rebounding, and provided the stock market does not suffer a sustained swoon, consumers' feeling of affluence may soon be bolstered. We recommended booking profits of 9% and lifted positions to neutral in yesterday's Weekly Report. The ticker symbols for the stocks in this index are: BLBG: S5REST - MCD, SBUX, YUM, CMG, DRI.