Emerging Markets

Highlights EM/JPY carry trades represent an important "canary in the coal mine" for the global economy that investors need to monitor very closely. They are currently sitting at a key resistance. A breakout above these levels would suggest that global growth will only strengthen, a move down would point to a deceleration in EM and global industrial activity. If EM/JPY carry trades indeed suffer, the key reasons are likely to be the combined onslaught of Chinese policy tightening and DM removal of monetary accommodation. While still not a base case, this breakdown would affect commodity currencies, the AUD in particular, most severely. Scandies would also suffer but the JPY and CHF would be much stronger than we currently anticipate. The ECB is unlikely to match the Fed next year, thus rate differentials will move against EUR/USD. GBP is still stuck in its post-Brexit range. It is likely to weaken anew toward its lower bound once the upper bound is hit during the coming weeks. Feature Chart I-1EM/JPY Carry Trades: ##br##A Canary To Monitor A "canary in the coal mine" for the global economy, EM / JPY crosses, have hit what has been their ceiling for the past ten years, and have begun to roll over (Chart I-1). We believe that carry trades are a key component to global liquidity that historically provide important signals for global industrial activity and EM assets. The weakness in EM/JPY carry trades is in the early innings, but further deterioration would raise dark flags heading into 2018. On the other hand, if EM/JPY carry trades manage to break out of their historical ceiling, the likelihood that the global industrial cycle accelerates further and EM assets strengthen will only grow. Therefore, EM/JPY carry trades need to be both monitored and understood. In this report, we examine one of the two key dynamics affecting these EM carry trade returns: Chinese policy and EM growth dynamics. In another report later this month, we will examine the other key factor: changes in DM monetary policy. Why Do Carry Trades Matter? In a carry trade, funds are borrowed from nations where they are plentiful and cheap - countries like Japan, with high current account surpluses, plenty of foreign assets and low interest rates. Then, these funds are lent to countries experiencing savings shortfalls, but where prospective returns are perceived to be high. These countries tend to have higher growth, current account deficits and higher interest rates. Through this activity, the funding currencies depreciate, and the high-carry currencies appreciate. Chart I-2After Carry Trades Lose Momentum, ##br##Global IP Weakens This transfer of funds supports global economic activity, as it facilitates a more efficient allocation of capital: Carry trades distribute liquidity to the faster-growing corners of the global economy where investment opportunities are plentiful. In the process, this liquidity further supports economic activity, profit growth and asset returns in those attractive markets. A virtuous loop ensues: As asset and currency returns in the high-carry nations remain elevated, further liquidity finds its way into these economies, which supports additional economic and profit growth. All that said, the virtuous loop can quickly mutate into a vicious downward spiral. If returns in the economies that need the borrowed foreign liquidity disappoint, liquidity can quickly find its way out of these nations. This outflow of funds not only hurts the exchange rate of the high-returns economies, it creates a dearth of liquidity in their domestic markets, which hurts domestic asset returns, profits and growth. This invites further outflows, further currency depreciation, and further economic pain. As Chart I-2 illustrates, when EM carry currencies outperform the yen, this tends to support global industrial activity. However, when EM carry currencies weaken relative to the yen, this tends to lead to a sharp deceleration in global growth by an average of three months. What is surprising is the reliability of the signals, especially when picking episodes of decelerating growth. We posit that this relationship works because of three factors. On one hand, EM are where most of the global capex happens (Chart I-3). Capital goods are the key driver of both global industrial production and global trade. Moreover, EM excluding China still needs foreign capital, as they are expected to run a combined current account deficit of US$300 billion in 2018. Thus, industrial activity is greatly influenced by the cost of financing of EM economies. On the other hand, Japan is still the greatest creditor nation in the world, with a net international investment position (NIIP) of US$3 trillion (Chart I-4). Chart I-3EM Are Where Capex Happens Chart I-4Japan Is The World's Biggest Creditor As a result of these dynamics, when EM currencies underperform the yen, it is a symptom that a key source of liquidity is leaving EM economies, and that global industrial activity is set to suffer. Chart I-5EMU PMIs Follow The EM/JPY Carry Trade Unsurprisingly, the performance of EM currencies vis-à-vis the yen also tends to lead dynamics for euro area industrial growth. As Chart I-5 illustrates, the euro area manufacturing PMI is a function of the performance of this supercharged carry trade. The European economy and its manufacturing sector in particular are very exposed to the EM business cycle. This relationship is a confirmation of the validity of the link between EM carry trades and global growth. Bottom Line: EM/JPY carry trades provide a reliable leading signal on global industrial activity. It is because carry trades are a key mechanism of redistributing global liquidity - taking savings from countries where they are oversupplied, and bringing them to countries where they are needed. EM countries are where the marginal capex in the global economy takes place today. Hence, a deterioration in carry trades' returns signals a deterioration of liquidity conditions in the economies that matter most for the global industrial cycle. It is noteworthy that EM/JPY carry trades have recently begun to lose steam. What Lies behind the Weakness in EM/JPY carry Trades? Chinese Policy! What could explains the recent slowdown in EM carry trades? The yen does not seem to be the culprit, as USD/JPY continues to follow the path charted by U.S 10-year yields this year. Instead, we posit that the source of the weakness is Chinese dynamics, the other key driver of EM returns beyond global liquidity conditions. Chinese policymakers have been curtailing their support to the domestic economy this year. Fiscal spending had decelerated massively, and Chinese monetary conditions have been on a tightening path since the end of 2016 (Chart I-6). Moreover, the administrative and regulatory tightening of the shadow banking system is also beginning to leave its mark. Small financial institutions have not been borrowing as aggressively as in recent years. Historically, this leads to a slowdown in the Chinese credit impulse (Chart I-6, bottom panel). Chart I-6Key Risk To Chinese Credit Growth Chinese##br## Policy Has Been Tightened Chart I-7The Chinese Economy Depends On Policy##br## Because Excess Savings Are Deflationary This is especially important as China is very reliant on policy support. As Chart I-7 shows, fiscal spending and credit creation contributed nearly twice as much to Chinese GDP as exports. This is because the Chinese economy's private savings exceed investments by 5% of GDP. If government spending or the lending machine slows, these excess savings are not used, creating deficient demand which imparts a deep deflationary influence on China and the global economy. We are already seeing early signs that the removal of stimulus is beginning to bite. The diffusion index of Chinese house prices, a key leading indicator of prices themselves, has fallen below the 50% line. Since Chinese real estate construction tends to lag prices, a slowdown in this sector is likely to emerge (Chart 8). Additionally, the slowdown in the leading economic indicator also highlights the risks to China's industrial activity as measured by the Keqiang Index (Chart I-8, bottom panel). The implications for EM are straightforward. EM economies outside of China have exhibited little domestic momentum, with poor credit growth of 5.5% and retail sales growth of 1.1%. Thus, a slowdown in Chinese monetary conditions could do what it historically does: lead to a slowdown in EM industrial production that will reverberate throughout the world (Chart I-9). Chart I-8Policy Is ##br##Biting Chart I-9EM Economies Don't Respond ##br##Well When China Tightens Bottom Line: The crucial factor that could explain why our favorite canary in the coal mine has begun to lose momentum is most likely to be tightening Chinese policy. China is dependent on policy actions to allocate its vast amount of savings. The tightening that began this year is already causing some symptoms to pop up in the Chinese economy. Since China has been the key driver of growth in other EM economies, these dynamics could begin to weigh on EM returns. EM/JPY carry trades will be the canary in the coal mine to judge whether or not these risks begin to weigh on global growth. Other Considerations And Some Implications Positioning considerations could exacerbate the negative impulse emanating from Chinese policy. To begin with, investors are not positioned for this. Not only are risk reversals in EM currencies still pricing in a very benign outcome, short interest in popular EM bond plays remain very low. Thus, the risk of a sharp repositioning in EM plays is high; in fact, it is much higher than for much-maligned assets like the supposedly over-loved S&P 500 (Chart I-10). Japanese investors have been heavily investing outside of their country, and since 2016, EM markets have been the recipients of these portfolio flows. But as Chart I-11 shows, these Japanese flows seem to have been chasing momentum into EM. Thus, if EM assets begin to suffer from a tightening of policy in China, the Japanese flows could reverse, causing a drying out of liquidity conditions in EM and exacerbating the pain already induced by China. Chart I-10Investors Are Oblivious ##br##To EM Risks Chart I-11Japanese Investors Are ##br##Chasing EM Momentum DM monetary policy and inflation dynamics also can play a key role. Carry trades have historically been a play on low volatility in capital markets. An environment of improving growth, low inflation surprises, and easy monetary policy has been key to support this low-volatility state. However, BCA believes that U.S. inflation is set to surprise to the upside, which will contribute to a tighter Federal Reserve. The European Central Bank will begin tapering its asset purchases and the Bank of Japan has ramped up its hawkishness despite the absence of inflation in Japan. This is likely to contribute to an increase in volatility that should prove especially harmful for carry trades in the FX space. This should tighten global liquidity conditions, especially in emerging markets. We will explore this angle in more detail in an upcoming report. Chart I-12EM/JPY Carry Informs EUR/USD In terms of investment implications, if EM carry trades were to break down in the near future, this would represent a major risk to the views espoused in the BCA Outlook and the investment recommendations associated with it. Most obviously, it would have an immediate negative impact on commodity currencies, since it would point to tightening liquidity and financial conditions in EM economies that will impact global industrial activity. The expensive AUD would be the currency most likely to suffer in this environment. The Scandinavian currencies would also suffer against the euro. Scandinavian economies have been highly levered to EM growth, and historically the SEK and the NOK have been greatly affected by EM spreads and commodity prices.1 The dovish bend of the Norges Bank and the Riksbank would only strengthen these negative impulses. EUR/USD would also likely suffer. As we argued two weeks ago, in the past 12 months, the euro has not behaved as a risk-off currency. In fact, quite the contrary, the euro has rallied alongside traditional EM plays, as the euro area has benefited from the positive economic impulse emanating from EM economies.2 Moreover, historically, EUR/USD has weakened when EM/JPY canaries have depreciated (Chart I-12). Finally, the yen would obviously enjoy such an unwinding of carry trades. We are currently negative the yen on U.S. bond yield dynamics. However, an underperformance of carry trades would prompt much short covering in the JPY as well as repatriation flows into Japan. If the EM canaries weaken further. We will be forced to change our stance on the JPY. Bottom Line: Investors are not positioned for any meaningful weakness in EM/JPY carries, and Japanese flows could move in reverse in a heartbeat. DM policy too is becoming a risk for these carry plays. China's tightening is thus coming at a terrible time for these carry trades. If canaries were to weaken, the AUD would bear the brunt of the pain among G10 currencies. The NOK and the SEK would also underperform a euro that would be falling against the USD. The yen would likely be able to rally in this environment. EUR/USD: Focus On The Western Shores Of The Atlantic Last week, data from Europe once again confirmed that growth in the euro area is stellar. Meanwhile, rate expectations declined in the U.S. as the Fed minutes displayed an FOMC increasingly concerned with the conundrum of a very tight labor market and weak inflation. EUR/USD rallied by 1%. But what really drove the rally in EUR/USD this year? It first and foremost reflected a massive repricing in relative rate expectations between the euro area and the U.S. However, most of this repricing was caused by a decline in the U.S. terminal rate, not an upward adjustment in the European policy end-point (Chart I-13). Chart I-13EUR/USD: All About Falling ##br##U.S. Terminal Rates Chart I-14Most Major Euro Area Economies Experienced##br## Little Inflationary Pressures In 2017 U.S terminal rates have fallen because the market doesn't believe the Fed's interest rate forecast, as core PCE has collapsed by nearly 45 basis points despite a U.S. economy at full employment. Meanwhile, long-term rate expectations in the euro area have remained flat because core inflation did not move much in the major euro area economies (Chart I-14). Going forward, the U.S. terminal rate is likely to move higher against that of the euro area. U.S. inflation is set to accelerate versus the euro area as financial conditions in Europe have tightened massively versus the U.S. since early 2016, a factor we have highlighted in the past.3 The strength in the U.S. economy is also considerable, and would argue that since the U.S. is more advanced in the business cycle than the euro area, this strength is more likely to generate inflationary pressures in the U.S. than in the euro area (Chart I-15). Moreover, U.S. tax cuts are looking increasingly likely in 2018, which will only add fuel to the U.S. fire. We continue to expect the Fed to follow its "dots," generating a policy outcome well in excess of what is currently priced into the OIS curve. If our base-case scenario for the Fed unfolds, for interest rate differentials to stay constant, the EONIA rate would need to be at 1% by the end of 2020 (Chart I-16). In our view, this is highly unlikely, and we expect rate differentials to move in favor of the USD. Chart I-15Europe Is Strong, ##br##But So Is The U.S. Chart I-16Fed Funds Rate Scenarios ECB Rates Will Have To ##br##Rise Much More To Match What The Fed Will Deliver An EONIA rate of 1% by the end of 2020 will not only defy what the ECB is currently forecasting, it will also be the highest rates since Trichet committed his infamous 2011 policy mistake of hiking rates. In order for European rates to be that high by that date, global growth will have to still be stellar. If this is the case, U.S. rates are likely to be even higher than what the Fed dots are currently implying. This means that based on our expectations for global growth, U.S. inflation and European inflation, the most likely path for rate differentials is that they widen in favor of the U.S. as the Fed still is in a better position to increase rates than the ECB. This expected widening in spreads between the U.S. and the euro area will favor a move in EUR/USD toward 1.10 by the middle of 2018. An adverse move in EM liquidity conditions only adds credence to these dynamics as it will affect European growth more than it will affect U.S. growth. Moreover, safe-haven flows associated with EM weakness would only add to global demand for the USD. Bottom Line: EUR/USD rallied in line with changes in relative terminal rates in 2018. However, this did not reflect an upgrade to the expected terminal rate in the euro area; it mostly reflected a downgrade to the U.S. terminal rate. We do anticipate this downgrade in the expected U.S. terminal rate to reverse course, especially when compared to the euro area. U.S. growth will accelerate further and U.S. inflation will outpace that of the euro area. In an environment where the Fed hikes in line with its "dots," the EONIA rate will not be able to follow, which will put downward pressure on EUR/USD. GBP/USD: Divorce-Bill Rally? This week, the U.K. agreed that its share of liabilities to the EU is around EUR100 billion, which would mean a net payment of around EUR50 billion. The GBP rallied massively in response to this news as markets interpreted this as a sign that negotiations on future trade relationships would start. The pound is very cheap on a PPP basis, and is likely to generate attractive returns on a long-term time horizon. However, Brexit is far from being over. Nagging questions regarding the Irish border remain, and the EU clearly has the upper hand in the negotiations. Moreover, Brexit would hurt both British trade and British potential growth. While abandoning Brexit down the road would help the GBP, this would happen around much political turmoil and result in a likely Corbyn government. When we compare all these positives and negatives, at the current juncture, it is highly unlikely that GBP/USD and EUR/GBP will escape their post-June 2016 trading range. In the short term, EUR/GBP is likely to hit 0.84, and cable, 1.37. We would use moves to such levels to sell the pound on a tactical basis. A move below the post Brexit lows is also highly unlikely as long as the stalemate continues. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Juan Manuel Correa, Research Analyst juanc@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, titled "Global Perspective On Currencies: A PCA Approach For The FX Market", dated September 16, 2016, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "Euro: Risk On Or Risk Off?", dated November 17, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "The Best Of Possible Worlds?", dated October 6, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was positive this week: Annualized GDP growth came in at 3.3%, above the expected 3.2%; The PCE price deflator grew at a 1.6% annual rate, above the expected 1.5%, while the core PCE deflator stayed in line with expectations at 1.4%; Initial jobless claims were lower than expected at 238,000; However, the dollar was only up against the CAD and the NZD, while down against all other G10 currencies as the nomination of Marvin Goodfriend as a member of the FOMC was interpreted as a potential dovish move by the markets. The U.S. 10-year yield was up 4 basis points on higher inflation expectations. U.S. growth is now beginning to outperform Germany's 3.2% annualized GDP growth which should help translate into higher inflation relative to the euro area next year, which will shift upside risk in the favor of the dollar. Report Links: The Xs And The Currency Market - November 24, 2017 It's Not My Cross To Bear - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data was mixed: German CPI was strong, with the headline measure growing at 1.8%, and the harmonized index also at 1.8%; German retail sales contracted at an annual rate of 1.4%; The number of unemployed people in Germany declined by 18,000 yet the unemployment rate stayed flat at 5.6%; European unemployment decreased to 8.8% from 8.9%; Euro area inflation increased by less than expected at 1.5% on an annual basis. Despite this mixed data, the euro was up 0.6% against the dollar on Thursday. Certain European metrics such as Industrial Confidence are also at all-time highs, levels at which a reversal is increasingly likely. Robust U.S. growth and higher inflation could serve as an indicator that the tide is about to turn in the favor of the greenback as the Fed resumes its hiking cycle. Report Links: The Xs And The Currency Market - November 24, 2017 Temporary Short-Term Rates - November 10, 2017 Market Update - October 27, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Nikkei Manufacturing PMI outperformed expectations, coming in at 53.8. Meanwhile, large retailers sales growth also outperformed expectations, coming at -0.7%. Nevertheless, this was a decline from last month's 1.9% expansion. Industrial production growth surprised to the downside, coming in at 5.9%. Finally housing starts also underperformed expectations, coming in at -4.8% and declining even more from last month's -2.9% reading. On Sunday, the BoJ unexpectedly shifted to a less dovish stance, as they hinted that their yield curve control program might be watered down next year. This change in rhetoric could limit the JPY's downside. In fact, the risk growing risk that EM carry trades could begin to crack down even raises the probability that a yen rally unfolds. In this environment trades like short AUD/JPY and short NZD/JPY would benefit greatly. Report Links: The Xs And The Currency Market - November 24, 2017 Temporary Short-Term Rates - November 10, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been negative Consumer credit underperformed expectations, coming in at 1.451 billion pounds, and declining from the previous month's number. Moreover, mortgage approvals also underperformed expectations, coming in at 64,575. This number was also decline from last month's reading. GBP/USD has appreciated by almost 1% this week, as the United Kingdom and the European Union seem to have agreed that the cost to the U.K. for leaving the EU will be 50 billion euro. Overall, it is unclear whether this breakthrough in the negotiations will be positive or negative for the pound, as many details are yet to be defined. We continue to be negative on cable on the short term, as we expect rate differentials to favor the U.S. over the U.K. Report Links: The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Data for Australia was mixed: Private sector credit grew at a 5.3% annual pace, albeit slower than the previous 5.4% figure; Building permits increased sharply by 18.4% annually; Private capital expenditure grew in line with expectations at 1%; Chinese Manufacturing PMI was strong, coming in at 51.8 - stronger than the previous 51.6 and the expected 51.4; Stronger Chinese data buoyed the AUD, however, the Aussie is still weighed down by low wages and a dovish RBA stance. The recent outperformance of the yen versus high carry currencies could be foreshadowing a growth-negative event, especially as Chinese authorities are tightening policy. Report Links: The Xs And The Currency Market - November 24, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 On Tuesday, the RBNZ announced that they will ease mortgage lending restrictions, as it expects policies by the new government to dampen the housing market. After January 1st, banks will be allowed to provide more low-deposit home loans to owner occupiers. Moreover the down payment required to obtain a mortgage will also decline. This announcement by the RBNZ goes in line with our view that the new populist government, will curb immigration, and thus curb pressures in the kiwi economy. Overall we remain bearish on the NZD against the U.S. dollar and against the yen, as we expect global growth to slow down momentarily by the end of the year, as China continues to tighten monetary policy. However, we remain bearish on AUD/NZD as the AUD would suffer more than the NZD in this environment. Report Links: The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Data out of Canada was decent: Industrial product prices are growing at a 1% monthly pace, higher than the expected 0.5% pace; Raw materials Index increased by 3.8% in October, higher than the previous 0.2% contraction, pointing to higher inflation; The current account deficit grew to CAD -19.53 bn, better than the expected CAD -19.50 bn. However, the CAD has displayed some weakness recently following Governor Poloz's comments about financial stability within the economy. These fragilities mostly involve household debt and the housing market, which continue to be carefully monitored by the BoC. Report Links: The Xs And The Currency Market - November 24, 2017 Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: Gross domestic Product growth outperformed expectations, coming in at 1.2%. This measure also increased form a growth rate of 0.5% the previous quarter. Moreover, the KOF leading indicator also surprised to the upside, coming in at 110.3. Industrial production yearly growth also continued to increase, coming in at 5.5% However real retail sales growth underperformed expectations substantially, contracting at a 3% pace, after a 0.5% growth in September. EUR/CHF has appreciated by nearly 0.8% this week. Overall we continue to believe that Swiss inflation is still too weak for the SNB to stop intervening in the franc. We will continue to monitor the Swiss economy and global economy for inflationary pressures, to get an idea when the SNB might shift its monetary stance. Report Links: The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been negative: Retail sales growth underperformed expectations, coming in at -0.2%. Moreover Norway's credit indicator also underperformed coming in at 5.7%. USD/NOK has rallied by roughly 2% this week, as the NOK has experienced a dramatic sell off across the board. This sell off has been caused by the decline in oil prices that we have experienced this week. This is partly because positioning in oil seems to be over stretched, thus a tactical correction in oil prices is expected. Overall, regardless of the outlook for oil prices, we continue to be bullish on USD/NOK, as this cross will mostly trade on rate differentials between Norway and the U.S. rather than on oil prices. Report Links: The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Data out of Sweden was disappointing: Retail sales growth slowed to 0.1% monthly and 2.6% annually, compared to the expected 0.2% and 3.4% rates, respectively; The trade balance went into negative territory, coming in at SEK -3.1 bn, compared to the previous SEK 3.2 bn; Annual GDP growth in Q3 was only 2.9% compared to the expected 3.5%. The Q2 data point was also revised downwards from 4% to 2.7%. While quarterly growth was in line with expectations at 0.8%, it still weakened from the previous quarterly growth of 1.2% - which was also revised down from 1.7%. The Riksbank will take these data points into account in their next meeting in two weeks and is likely to stay dovish especially as Stefan Ingves has been re-appointed as governor, adding downward pressure on the krona against the dollar. Report Links: The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Dear Client, In this report, we image a hypothetical timeline of key economic and financial events spanning the next five years. The events described in the report correspond with our view that the global economy will continue to expand into the second half of 2019, before succumbing to a recession and a decade of stagflation in the 2020s. This warrants an overweight position in risk assets for the next 6-to-12 months, but a much more cautious stance thereafter. Charts 1-4 provide a visual representation of how we see the main asset classes evolving over the coming years. Best regards, Peter Berezin, Chief Global Strategist Feature I. The Blow-Off Phase December 4, 2017: U.S. stocks fall by 1.7% on reports that Mitch McConnell does not have enough votes to get the tax bill through the Senate. A sell-off in high-yield markets and a tightening of financial conditions in China aggravate the situation. December 13, 2017: The Fed hikes rates by 25 basis points, taking the Fed funds target range to 1.25%-to-1.5%. December 14, 2017: Global equities continue to weaken. The S&P 500 suffers its first 5% correction since June 2016. December 15, 2017: The correction ends on news that the Senate will consider a revised bill which trims the size of corporate tax cuts and uses the savings to finance a temporary reduction in payroll taxes. President Trump and House leaders promise to go along with the proposal. The PBoC also injects fresh liquidity into the Chinese financial system. December 29, 2017: Global equities rally into year-end. The S&P 500 hits 2571 on December 29, placing it just shy of its November high. The dollar also strengthens, with EUR/USD closing at 1.162. The 10-year Treasury yield finishes the year at 2.42%. January 10, 2018: The global cyclical bull market in stocks continues. European and Japanese indices power higher. Both the NASDAQ and the S&P 500 hit fresh record highs. EM stocks move up but lag their DM peers, weighed down by a stronger dollar. January 12, 2018: U.S. retail sales surprise on the upside. Department store stocks, having been written off for dead just a few months earlier, end up rising by an average of 40% between November 2017 and the end of January. February 14, 2018: The euro area economy continues to grow at an above-trend pace. Nevertheless, inflation stays muted due to high levels of spare capacity across most of the region and the lagged effects of a stronger euro. The 2-year OIS spread between the U.S. and the euro area widens to a multi-year high. February 26, 2018: China's construction sector cools a notch, but industrial activity remains robust, spurred on by a cheap currency, strong global growth, and rising producer prices. Chinese H-shares rise 13% year-to-date, beating out most other EM equity indices. March 14, 2018: The U.S., Canada, and Mexico reach a last-minute deal to preserve NAFTA. The Canadian dollar and Mexican peso breathe a sigh of relief. March 16, 2018: In a surprise decision, Donald Trump nominates Kevin Hassett as Fed vice-chair. Trump cites the "tremendous job" Hassett did in selling the GOP's tax cuts. A number of Fed appointments follow. Most of the picks turn out to be more hawkish than investors had expected. This gives the greenback further support. March 18, 2018: Pro-EU parties do better than anticipated in the Italian elections. Italian bond spreads compress versus the rest of Europe. March 21, 2018: The Fed raises rates again, bringing the fed funds target range up to 1.50%-to-1.75%. April 8, 2018: Bank of Japan governor Kuroda is granted another term in office. He pledges to remain single-mindedly focused on eradicating deflation. April 11, 2018: Chinese core CPI inflation reaches 2.9%. Producer price inflation stays elevated at 6%. A major market theme in 2018 turns out to be how China went from being a source of global deflationary pressures to a source of inflationary ones. April 30, 2018: U.S. core PCE inflation jumps 0.3% in March, reaching 1.7% on a year-over-year basis. Goods and service inflation both pick up, while the base effects from lower cell phone data charges in the prior year drop out of the calculations. May 17, 2018: Oil prices continue to rise on the back of ongoing discipline from OPEC and Russia, smaller-than-expected shale output growth, and production disruptions in Libya, Iraq, Nigeria, and Venezuela. June 13, 2018: Strong U.S. growth in the first half of the year, a larger-than-projected decline in the unemployment rate, and higher inflation keep the Fed in tightening mode. The FOMC hikes rates again. June 25, 2018: Global capital spending accelerates further. Global industrial stocks go on to have a banner year. June 27, 2018: Wage growth in the U.S. accelerates to a cycle high. Donald Trump takes credit, stating that "this wouldn't have happened" without him or his tax cuts. July 31, 2018: The Japanese labor market tightens further. The unemployment rate falls to 2.6%, 1.2 percentage points below 2007 levels, while the ratio of job vacancies-to-applicants moves further above its early-1990s bubble high. A number of high-profile companies announce plans to raise wages. August 2, 2018: A brief summer sell-off sees global equities dip temporarily, but strong global earnings growth keeps the cyclical bull market in stocks intact. August 28, 2018: The London housing market continues to weaken, with home prices falling by 9% from their peak. The rest of the U.K. economy remains fairly resilient, however. EUR/GBP closes at 0.87. August 31, 2018: The Greek bailout program ends and a new one begins. Greece's economy continues to recover, but Tsipras fails to obtain debt relief from creditors. September 7, 2018: The U.S. unemployment rate falls to a 49-year low of 3.7%, nearly a full percentage below the Fed's estimate of NAIRU. September 26, 2018: The Fed raises rates again. By now, the market has gone from pricing in only two hikes for 2018 at the start of the year to pricing in almost four. September 27, 2018: Profit growth in the U.S. moderates somewhat as higher wage costs take a bite out of earnings. Nevertheless, stock market sentiment remains buoyant. Retail participation, which had been dormant for years, takes off. CNBC sees a surge in viewers. Micro cap stocks go wild. October 7, 2018: The outcome of Brazil's elections shows little appetite for major structural reforms. Economic populism lives on. October 31, 2018: Realized inflation and inflation expectations continue grinding higher in Japan, triggering market speculation that the BoJ will abandon its yield-curve targeting policy. The resulting rally in the yen is short-lived, however. At its monetary policy meeting, the Bank of Japan indicates that it has no near-term plans to modify its existing strategy. November 6, 2018: The Democrats narrowly regain control of the House but fail to recapture the Senate. Investors shrug off the results, figuring correctly that a Republican Senate will keep Trump's corporate tax cuts in place and that Democrats will agree to extend the expiring payroll tax cut and other tax measures that benefit the middle class. December 7, 2018: The U.S. unemployment rate falls to 3.5%. Donald Trump tweets "You're welcome, America". December 19, 2018: The Fed raises rates for the fourth time that year - one more hike than it had signaled in its December 2017 "dot plot" - taking the fed funds target range to 2.25%-2.5%. December 31, 2018: The MSCI All-Country Index finishes up 12% for the year (in local-currency terms), led by the euro area and Japan. U.S. stocks gain 8%. EM equities manage to rise 6%. Small caps edge out large caps, value stocks beat growth stocks, and cyclical stocks outperform defensives. December 31, 2018: The 10-year U.S. Treasury yield finishes the year at 3.05%. German bund yields reach 0.82%, U.K. gilt yields rise to 1.7%, Canadian yields hit 2.3%, and Australian yields back up to 3%. Japanese 10-year yields remain broadly flat, but the 20-year yield moves up 40 basis points to nearly 1%. Credit spreads finish the year close to where they started, providing a modest carry pick-up over high-quality government bonds. December 31, 2018: The DXY index rises 4% to 98. EUR/USD closes at 1.11, USD/JPY at 123, GBP/USD at 1.31, and AUD/USD at 0.76. The Canadian dollar manages to edge up against the greenback on the year, with CAD/USD finishing at 0.81. The Chinese yuan also strengthens to 6.4 versus the dollar. December 31, 2018: Brent and WTI spot prices finish the year at $65 and $63, respectively. Copper and metal prices are broadly flat for the year, having faced the dueling forces of a stronger dollar (a negative) and above-trend global growth (a positive). Gold sinks to $1,226. II. The Clouds Darken February 22, 2019: The global economy starts to decelerate. The slowdown is led by China, where the government's crackdown on shadow banking activities begins to take a bigger toll on growth. Most measures of U.S. economic activity also soften somewhat in the first two months of the year. Investors take heart in the hope that the economy will achieve a soft landing, allowing the Fed to moderate the pace of rate hikes. February 27, 2019: In an otherwise mundane day, the S&P 500 edges up 0.3% to 2832. Little do investors know that this marks the cyclical peak in the U.S. stock market. March 13, 2019: Hopes that the Fed can take its foot off the brake are dashed when the Bureau of Labor Statistics reveals that inflation rose by more than expected in February. U.S. core CPI inflation increases to 2.9% while the core PCE deflator accelerates to 2.4%. Market chatter turns from whether the Fed can slow the pace of rate hikes to whether it needs to start hiking more rapidly than once-per-quarter. The S&P falls 2.1% on the day. March 20, 2019: The Fed lifts the funds rate target range to 2.5%-to-2.75% and signals a readiness to keep hiking rates. The 10-year Treasury yield rises to 3.3%. EUR/USD sinks to 1.08. The first quarter of 2019 marks a watershed of sorts. In 2018, the Fed raised rates because of stronger growth; in 2019, it kept raising them because of brewing inflation. As it turned out, risk assets were able to tolerate the former, but not the latter. March 29, 2019: The U.K. does not leave the EU two years after Britain invoked Article 50 of the Lisbon Treaty. The EU votes to prolong negotiations given growing political support within Britain for the country to remain part of the European bloc. April 5, 2019: The S&P 500 sinks further and is now 10% below its February high, returning close to where it was at the start of 2018. The increasingly sour mood on Wall Street does not appear to be hurting Main Street very much, however. The U.S. unemployment rate edges down further to 3.4%. Euro area growth remains resilient. May 31, 2019: The Brazilian government announces that the fiscal deficit will come in larger than originally expected. USD/BRL slips to 3.45. June 4, 2019: Jens Weidmann, who had gone out of his way to soften his hawkish rhetoric over the preceding months, is chosen to succeed Mario Draghi, whose term expires in October. Nevertheless, the euro still strengthens on the news. June 6, 2019: Markets temporarily regain their composure. The S&P 500 gets back to within 4% of its all-time high. The reprieve does not last long, however. June 12, 2019: The Fed hikes rates, taking the fed funds target range to 2.75%-to-3%. The FOMC cites inflation as its primary concern. July 8, 2019: Global risk assets weaken anew as a fiscal crisis grips Brazil. Turkey, South Africa, and a number of other emerging markets show increasing signs of fragility. August 20, 2019: Korean exports, a leading indicator of the global business cycle, decelerate once again. Global PMIs sag, as do most measures of business confidence. September 25, 2019: Despite a slowing U.S. economy, the Fed hikes rates again, bringing the fed funds target range to 3%-to-3.25%. The FOMC justifies the decision based on the fact that the unemployment rate is below NAIRU, core inflation is above the Fed's 2% target, and real rates are less than 1%. To assuage markets, Jay Powell suggests that the Fed could keep rates on hold in December. This turns out to be more prescient than he realizes. It will be another three years before the Fed raises rates again. By then, Powell is no longer the Fed chair. September 30, 2019: Commodity prices tumble, further adding to the pressure facing emerging markets. The U.S. yield curve inverts for the first time during this business cycle. The dollar, which previously strengthened due to a hawkish Fed, now starts strengthening on flight-to-safety flows back into the U.S. The yen appreciates even more than the greenback. October 15, 2019: The bottom falls out of the Canadian housing market. Home sales dry up and prices begin to sink. The Canadian dollar, which peaked back in February at 83 cents, falls to 74 cents against the U.S. dollar. October 19, 2019: A failed North Korean launch lands a missile 80 kilometres from Japanese shores. Prime Minister Abe pledges swift retaliation. October 21, 2019: The negative feedback loop between a rising dollar, falling commodity prices, and EM stress intensifies. Sentiment towards emerging markets deteriorates dramatically. Rumours begin to swirl that Brazil will miss a debt payment. October 23, 2019: Trump tweets "Dopey Rocketman thinks he is so smart, but we know where all his hideouts are. Sweet dreams!" October 24, 2019: News reports are abuzz about a massive buildup of troops on the North Korean side of the border. Panic grips Seoul. Asian bourses sell-off, taking global stock markets down with them. III. The Reckoning October 25, 2019: All hell breaks loose. North Korea's state broadcaster announces that Kim Jong-un has been "incapacitated". It later turns out that the tubby tyrant was killed by a group of military officers. Having not slept for days, Kim had become increasingly erratic and paranoid. Convinced that he was surrounded by spies and that Trump had deployed a secret weapon to read his mind, he ordered the execution of many people in his inner circle. Fearing for their lives, his henchmen decided to strike first. October 31, 2019: North Korea's new military rulers signal a desire for closer relations with China and a less belligerent posture towards the South. Over the coming decades, historians will debate whether Trump's tactics were a reckless gambit that luckily paid off, or the work of a master strategist playing 3D chess while everyone else was playing backgammon. Trump himself wastes no time in taking credit for ousting the Kim dynasty. November 4, 2019: The relief investors feel from the ebbing of tensions in the Korean Peninsula does not last long. The turmoil in emerging markets intensifies. A series of high-profile defaults rock the Chinese corporate debt market. Copper and iron ore prices nosedive. Brent swoons to $39/bbl. November 5, 2019: The head of Brazil's central bank resigns after the government pressures it to increase its holdings of government bonds in an effort to ward off an imminent default. The Brazilian real falls to nearly 6 against the dollar. Other EM currencies plunge. The Turkish lira is particularly badly hurt. December 6, 2019: The pain on Wall Street finally spreads to Main Street. U.S. payrolls rise by only 19,000 in November. Subsequent revisions ultimately show a drop of 45,000 for that month. The NBER will eventually go on to declare November as the start of the recession. December 11, 2019: Having raised rates just three months earlier, the FOMC cuts rates by 25 basis points and signals that it is willing to keep easing if economic conditions deteriorate further. December 16, 2019: Markets initially cheer the prospect of lower rates, but the euphoria is quickly forgotten. Credit spreads soar as investors price in an increasingly bleak economic outlook. Commercial real estate prices fall. Banks further tighten lending standards. IV. A Global Recession December 19, 2019: The recession spreads around the world. The ECB ditches plans to raise rates. The U.K., Sweden, Norway, Canada, Australia, and New Zealand all cut rates. In the emerging world, Korea, Taiwan, and Poland reduce interest rates, but a number of other countries - most notably, Turkey, South Africa, and Malaysia raise rates in a desperate bid to prop up their currencies so as to keep the local-currency value of their foreign-currency obligations from spiraling out of control. December 31, 2019: The S&P 500 closes at 2194, down 21% for the year. Most other bourses fare even worse. The U.S. dollar, which peaked against the euro at $1.02 just six weeks earlier, finishes at $1.07. The 10-year Treasury yield closes at 2.37%, down 68 basis points on the year. The 10-year German bund yield falls back to 0.5%. January 11, 2020: In a surprise twist, WikiLeaks reveals that the CIA has found no credible evidence that Russia had any material influence over the 2016 elections, but that Putin has been trying to cultivate the impression that it did. The document disparagingly notes that "Putin has relished the U.S. media's characterization of him as a master political manipulator with global reach, when in fact he is just the ruler of an impoverished, demographically depleted, militarily overextended country." The Mueller probe fizzles out. January 27, 2020: Voting in the Democratic primaries begins. Kamala Harris, Elizabeth Warren, and Sherrod Brown lead a crowded field of hopefuls. Bernie Sanders and Joe Biden choose not to run. Brown enjoys the biggest lead against Trump in head-to-head polls, but his support among primary voters is weighed down by his status as a cisgendered white male. January 28, 2020: On the other side of the Atlantic, the U.K. holds another referendum - this one to ratify the separation agreement reached with the EU. The terms of the agreement are widely regarded as being highly unfavorable to the U.K. Prime Minister Corbyn, having formed a coalition government with the Liberal Democrats and the SNP following elections in late 2018, makes it clear that a rejection of the deal is tantamount to a vote to stay in the EU. With the British economy in the doldrums, 53% of voters reject the deal. The U.K. remains in the EU. EUR/GBP falls to 0.84. January 29, 2020: The Fed cuts rates by another 25 basis points. Hiking rates once per quarter was good enough when unemployment was falling. However, now that the economy is on the rocks, the Fed reverts to a more aggressive loosening cycle, cutting rates once per meeting. Even so, a growing chorus of voices both inside and outside the Fed argue that it is not doing enough. February 17, 2020: Kamala Harris and Elizabeth Warren pull out ahead in the Democratic primaries. Similar to the Clinton/Sanders duel in 2016, Warren polls best among younger, whiter voters, while Harris leads among minorities and establishment Democrats. March 10, 2020: Donald Trump, seeing his poll numbers tank after the post-Korea bump, unilaterally raises trade barriers across a wide variety of industries. Foreign producers retaliate, leading to a contraction in global trade. April 26, 2020: Warren's relentless characterization of Harris as a shill for moneyed interests pays off. The Massachusetts senator secures the Democratic nomination. Hollywood celebrities line up to support Warren. Taylor Swift's silence on the matter is deafening, leading to a further increase in her album sales. June 5, 2020: The U.S. unemployment rate surges to 5.1%. Corporate America sees a wave of business closings, with the retail sector being particularly badly hit. July 21, 2020: The bellwether German IFO index falls to a multi-year low. Germany's manufacturing sector feels the pinch from the collapse in demand for capital equipment, especially from emerging markets. Merkel's popularity plummets after it is revealed that she tried to suppress data that more than half of asylum seekers classified as children were actually adults. Support for the Alternative for Deutschland Party, which by this time has greatly moderated its anti-EU rhetoric, rises sharply. August 17, 2020: The trade-weighted yen continues to strengthen, pushing Japan deeper into recession. In response, the Japanese government announces a major new stimulus package. In the clearest attempt yet to link fiscal with monetary policy, the authorities pledge to start issuing consumption vouchers to households, the value of which will be incrementally increased until long-term inflation expectations rise to the Bank of Japan's 2% target. The policy proves to be a smashing success. September 9, 2020: The U.S. presidential campaign ends up being even more divisive than the one in 2016. Unlike four years earlier, equities rally at any glimmer of hope that Trump will win. However, with unemployment rising, such moments prove few and far between. September 22, 2020: Senator Warren states on the campaign trail that she will not renominate Jay Powell in 2022 for a second term as Fed chair if she is elected president. Lael Brainard's name is floated as a likely replacement. V. The Return Of Stagflation October 13, 2020: Green shoots appear in the U.S. economy, marking the end of the recession. The unemployment rate rises for another two months, peaking at 6.8% in December. Other economies also begin to turn the corner. November 3, 2020: The tentative improvement in U.S. economic data happens too late to bail out Trump. Elizabeth Warren wins the presidential election. Warren loses Ohio but picks up Pennsylvania, Michigan, and Wisconsin. An influx of Democratic voters from Puerto Rico puts her over the top in Florida. The Democrats take back control of the Senate. November 4, 2020: The S&P 500 barely moves the day after the election, having already priced in the outcome months earlier. Still, at 2085, the index is 26% below its February 2019 peak. December 2, 2020: President-elect Warren pledges to introduce a major spending package after she is inaugurated. She brushes off concerns from some economists that fiscal stimulus is coming too late, noting that the unemployment rate is more than three points higher than it was one year earlier. Stocks rally on the news. January 27, 2021: The FOMC votes to keep rates on hold at 1%. Lael Brainard dissents, arguing that further monetary stimulus is necessary. March 19, 2021: The Chinese government shifts more bad loans from commercial banks into specially-designed state-owned asset management companies. The banks generally receive well above-market prices for their loans. Chinese bank shares move higher. April 2, 2021: Congress proposes to significantly raise taxes on higher-income earners and corporations with more than 500 employees and use the proceeds to fund an expansion of the Affordable Care Act. It also promises to introduces a "Tobin tax" on financial transactions. The post-election stock market rally fades. June 8, 2021: In a seminal speech, Lael Brainard argues that current inflation measures fail to adequately correct for technological improvements and other methodological issues. She suggests that this leads to an overstatement of the true level of inflation. The implication, she concludes, is that an inflation target of 2.5%-to-3% would be consistent with the Fed's existing mandate. September 24, 2021: Many Trump-era deregulation measures are rolled back. Anti-trust efforts are also ramped up. Despite an improving economy, the S&P 500 sinks to 2031, marking a five-year low. November 17, 2021: A wave of panic selling grips Wall Street. The S&P 500 crashes to 1969, down 31% from its February 2019 peak. As is often the case, this marks the bottom of the equity bear market. The subsequent recovery, however, proves to be tepid and prone to numerous setbacks. January 31, 2022: Thanks to ample fiscal stimulus, inflation in Japan rebounds from its recession lows. Aggregate income growth slows as more Japanese workers exit the labor force, but spending holds up as health care expenditures continue to climb. Japan's current account moves into a structural deficit position. February 16, 2022: Lael Brainard succeeds Jay Powell as Fed chair. The decision by Republicans in 2013 to reduce the number of senators necessary to approve appointments to the Fed board from 60 to 51 ensures smooth sailing for Brainard during congressional hearings and the confirmation of a slew of highly dovish candidates over the subsequent two years. April 6, 2022: China belatedly introduces modest financial incentives to encourage couples to have more children. The public jokingly dubs this as the new "at least one child policy". It ends up having little effect. Future Chinese scholars will end up describing China's failure to arrest the decline in its population as its greatest geopolitical blunder. July 20, 2022: The U.S. becomes the latest country to introduce strict restrictions on the use of bitcoin. Although the U.S. government never says so, fears that bitcoin and other cryptocurrencies will eat into the $75 billion in seigniorage revenue that the Treasury earns every year underpins the decision. The price of bitcoin falls to $550, down 95% from its all-time high. September 29, 2022: Japan officially abandons its yield-curve targeting regime. The 30-year yield rises to 2.5%. Faced with onerous long-term debt-servicing costs and stagnant tax revenues, the government starts refinancing much more of its debt through short-term borrowings. The Bank of Japan obliges, keeping short-term rates near zero. The combination of negative short-term real rates and higher inflation allows Japan to reduce its debt-to-GDP ratio over time. This proves to be the modus operandi for Japan and many other fiscally-challenged governments over the coming decades. October 18, 2022: Productivity growth in most developed economies continues to disappoint. For the first time in modern history, the flow of new workers entering the labor force are no better skilled or educated than the ones leaving. With potential GDP growing at a lackluster pace, output gaps disappear, setting in motion the acceleration in inflation over the remainder of the decade. The U.S. 10-year Treasury yield rises to 4%. It will be over 6% by the middle of the decade. November 22, 2022: The price of gold surpasses its previous high of $1895/oz. The 2020s turn out to be an excellent decade for bullion. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Chart 1Market Outlook: Equities Chart 2Market Outlook: Bonds Chart 3Market Outlook: Currencies Chart 4Market Outlook: Commodities Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Special Report

Highlights In this report we use a statistical approach to test the ability of a broad array of macro data series to reliably predict the Chinese business cycle. Out of 40 series that we examined, only 6 passed our test criteria. All 6 of these series are measures of money & credit, supporting the view that money growth deserves to be closely watched as an indicator for the Chinese economy. A composite leading indicator of the 6 "passing" series suggests that the Chinese economy will continue to slow over the coming months, but in a benign, controlled fashion. Investors should stay overweight investable Chinese stocks in US$ terms, versus both the EM and global equity benchmark. Feature Over the past two months we have significantly heightened our focus on the cyclical condition of China's economy. We presented our framework for tracking the end of China's mini-cycle in our October 12 Weekly Report,1 and recently followed up with a two-part report that examined the key differences facing China today from what prevailed in mid-2015, when the economy operated below what investors and market participants considered to be a "stable" pace of growth.2 All of these reports have been anchored by our view that China's economy suffered from a "double whammy" in 2015; a weak external demand environment and overly tight monetary conditions. In this report, we take a different approach to gauging the slowdown in China's economy by testing a wide range of commonly-watched macro data series for signs that they reliably lead economic activity. While our criteria for testing these series in our "data lab" are statistical in nature, they are not overly difficult for investors to grasp, and they help provide an empirical basis for understanding what data are relevant in predicting the direction and magnitude of China's economic growth trend. The conclusions of our study are revealing, in that they strongly point to measures of money & credit as the most reliable predictors of the Chinese economy since 2010. While a composite leading indicator of these predictors suggests that the Chinese economy will continue to slow over the coming months, the pace and magnitude of the decline are both consistent with our view that China will experience a benign, controlled deceleration. A Brief Methodological Overview Below we provide a brief overview of our approach, by addressing three key questions: what are we trying to predict, what series do we use as predictors, and how do we judge what series are "useful" in explaining the Chinese business cycle? What are we trying to predict? We use the Li Keqiang Index (LKI) as a proxy for the Chinese business cycle in this report, for three reasons (described below): Despite the potential to eventually become a consumer-oriented society, the Chinese economy remains highly geared to investment (and the industrial sector more generally). Investors are very familiar with the LKI, ever since a 2007 U.S. diplomatic cable (leaked in late-2010) quoted Li, then Communist Party Secretary of Liaoning, as saying to U.S. Ambassador Randt that China's GDP figures are "man-made" and unreliable. Li's focus on electricity consumption, rail cargo volume, and bank loans have since become a standard metric for China analysts to track. More importantly, however, we use the LKI as a proxy because it continues to provide important information about the Chinese economy: Chart 1 shows that it correlates well with the growth in earnings for the MSCI China index ex technology, and Chart 2 highlights that it also leads China's nominal import growth. As such, the index is particularly relevant for global investors, who are most concerned with China's investible stock performance and the country's impact on global exports. What series were used in our approach? Chart 1The Li Keqiang Index Predicts Investable EPS... Chart 2...And Nominal Import Growth In order to test the predictability of China's business cycle, we compiled a list of 40 highly-tracked macroeconomic variables (presented in Table 1) and grouped them into six distinct categories: Economy-wide measures, such as composite LEIs and models of GDP growth Measures related to investment and the corporate sector, such as PMIs, fixed-asset investment, and industrial production Variables related to the consumer sector, such consumer confidence, retail sales, and the employment component of the official PMIs Housing indicators, such as house price indexes and residential floor space sold Government spending, and A variety of money, credit, and financial conditions measures Table 1List Of Macroeconomic Data Series Included In Our Study As part of this analysis, all series, including the LKI, were smoothed with a 3-month moving average. Government spending was the exception, which was smoothed with a 6-month average. How do we judge which series help predict the business cycle? Using a sample of January 2010 to September 2017, we test whether any of these measures can reliably predict the LKI using two statistical concepts: a lead/lag correlation profile, and the Granger causality test. A summary of these concepts is presented below: Lead/Lag Correlation Profile: While most investors are quite familiar with the Pearson correlation coefficient, in this report we present it in a unique way. For each variable, we calculate the correlation between the Li Keqiang index and leading and lagged values of the variable, to create a series of correlations which we present as a function of time. Variables that reliably lead the LKI should have a higher correlation with future values of the LKI, and vice versa. Chart 3 presents the ideal correlation profile for a predictor of the LKI (which we will use as a reference point), given that it illustrates the correlation profile of the LKI with itself in six-months. Granger Causality Test: While somewhat technical, the concept of Granger causality is fairly simple and is similar to the correlation profile presented above. The logic of the test is that if one variable predicts another, lagged values of the predictor should help explain the dependent variable in a regression model. Granger causality simply takes the extra step of controlling for the possibility that the dependent variable predicts itself, by including lagged values of itself in the regression. Our criteria for a good leading indicator for the LKI is thus: A correlation profile that leads rather than lags (i.e., a profile that peaks in advance of t=0, like that shown in Chart 3) A relatively strong correlation profile, defined as a peak correlation coefficient that exceeds 0.5 A causality test result that suggests the indicator "Granger-causes" the LKI. Chart 3The Best Profile Will Look Like The Correlation Of The LKI With Future Values Of Itself The Importance Of Money & Credit: Results From The "Data Lab" Chart 4 presents the average correlation profiles for the six data categories described above, alongside the "ideal" profile. Individual correlation profiles for all 40 of the underlying macro series used in this report are available in Appendix I. Chart 4Measures Of Money & Credit Are ##br##The Best Predictors Of The LKI The chart presents several important conclusions: First, it highlights that while economy-wide measures and those related to investment and the corporate sector have tended to have a high correlation with the LKI, their correlation profiles lag rather than lead. In other words, the LKI tends to predict these variables, not the other way around. The Markit/Caixin and NBS manufacturing PMIs stand out as notable exceptions to this conclusion. Second, variables related to both consumer spending and government expenditure appear to have little ability to predict the Chinese business cycle as defined in this report. In fact, in the case of government spending, the evidence points to the fact that the LKI reliably leads expenditure by approximately a year, which suggests that fiscal policy in China is responsive and countercyclical (but not leading). Third, measures of money and credit, and housing indicators to a lesser degree, appear to fulfill the first two of our criteria for a good leading indicator of the LKI. Both profiles peak in advance of t=0, and at least in the case of money & credit, have a decently strong relationship. To test the third criterion listed above, we selected all of the individual macro series that passed the correlation profile test and subjected them to a Granger causality test. Table 2 presents the variables that were selected as well as the results of the test, expressed as a probability that the variable in question "Granger-causes" the LKI, and vice versa. Of the 12 variables that were selected, Table 2 highlights that only 6 passed, all of which belong to the money & credit category. This is noteworthy, especially given the focus of many investors on the private and official manufacturing PMIs. Among these 6 remaining variables, the relative strength of the probabilities shown in columns 3 and 4 suggest that monetary conditions and the Bloomberg China Credit Impulse Index (the flow of adjusted total social financing expressed as a percent of GDP) appear to be the most reliable, with money measures being the least. Table 2Granger Causality Test Results For Select Macro Series Still, our results show that it is more accurate to state that money supply measures "cause" the LKI than vice versa, supporting the view that money growth deserves to be closely watched as an indicator for the Chinese economy. Investment Implications Chart 5 presents a composite leading indicator for the Li Keqiang index based on the six variables presented above. The indicator is advanced by 4 months, and currently suggests that the LKI will end up retracing about 50% of its late-2015 to early-2017 rise. For now, this is consistent with our view that the Chinese economy will experience a benign, controlled deceleration. An additional factor that strengthens our conviction in this view is the fact that the weakest components of the indicator on a YoY basis, M2 and M3 (as defined by our Emerging Markets Strategy service), have been growing more rapidly over the past three months (Chart 6). Chart 5Our Composite LKI Indicator Suggests ##br##A Benign Slowdown In Growth Chart 6Money Supply Growth ##br##Has Recently Rebounded Given this economic outlook, our view is that investors should remain overweight Chinese investible stocks relative to the EM and global benchmarks. The first factor in favor of an allocation towards China is its tech sector weight; 42% of the index is made up of technology stocks, versus 29% and 19% in the EM and global benchmarks. While China's tech sector has already massively outperformed this year, Chart 7 highlights that it is a clear domestic/consumer play and thus unlikely to underperform significantly over the coming year. Chart 7Chinese Tech Companies ##br##Are A Domestic Play Excluding technology, we noted in our November 9 Weekly Report3 that while a deceleration in the LKI would weigh on the earnings growth of ex-tech investable stocks, we also expect earnings growth to moderate in the developed world. However, this ambiguous ex-tech relative earnings outlook is buttressed by the fact that Chinese ex-tech stocks are extremely undervalued compared to their global peers, a valuation gap that we believe will lessen if the end of China's recent mini-cycle is truly benign. Bottom Line: A broad test of China's macro data suggests that several money & credit measures have been the best predictors of the Chinese business cycle since early-2010. While these measures suggest that Chinese economic activity is set to decelerate even further, a return to 2015-like conditions does not appear to be likely. Investors should stay overweight Chinese investable stocks in US$ terms, versus both the EM and global equity benchmark. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Tracking The End Of China's Mini-Cycle", dated October 12, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Reports, "China's Economy - 2015 Vs Today (Part I): Trade", dated October 26, 2017, and "China's Economy - 2015 Vs Today (Part II): Monetary Policy", dated November 9, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "China's Economy - 2015 Vs Today (Part II): Monetary Policy", dated November 9, 2017, available at cis.bcaresearch.com. Appendix I Li Keqiang Lead/Lag Correlation Profile For All Variables In Our Study Chart A1 Chart A2 Chart A3 Chart A4 Chart A5 Chart A6 Chart A7 Chart A8 Cyclical Investment Stance Equity Sector Recommendations

Highlights Agricultural markets are informationally efficient for the most part, which is to say that at any given time, prices already reflect most public information available to traders, and a lot of private information as well. Even so, we believe markets are underestimating the Fed's resolve in normalizing interest-rate policy next year - particularly when it comes to the number of rate hikes we are likely to see - and thus are underestimating the likelihood of lower grain prices in 2018. Energy: Overweight. Oil markets will emerge from their suspended animation following OPEC 2.0's Vienna meeting today. Our Brent and WTI call spreads in May, July and December 2018 - long $55/bbl calls vs. short $60/bbl calls - are up an average 50.2%. Our long Jul/18 WTI vs. short Dec/18 WTI trade anticipating steepening backwardation is up 13.3%. Base Metals: Neutral. China's refined zinc imports were up 145% yoy to 61,355 MT in October, based on customs data. Metal Bulletin noted tight domestic supplies accounted for the increase. Precious Metals: Neutral. Gold is breaking away from its attachment to $1,280/oz., as the USD weakens. Our long gold portfolio hedge is up 5.2% since inception May 4, 2017. Ags/Softs: Neutral. Global financial conditions will become increasingly important to grain prices going forward, a trend we explore below. Feature Record output and ending stocks will ensure that ag markets remain well supplied globally next year. While we see risks as balanced in the upcoming year, and remain neutral ags generally, we believe markets are underestimating the Fed's resolve when it comes to normalizing interest rates, and thus underestimate upside USD potential. This means the likelihood of lower grain prices also is being underestimated. Weather will add volatility to the mix, as well. We believe the fundamentals supporting the assessment of record output and season-ending stocks-to-use ratios are fully reflected in prices. However, financial conditions - particularly USD strength next year - are not being fully priced by markets. This makes grains, in particular, vulnerable to the downside. Financial conditions driving ag markets: Fed policy & real rates: we expect U.S. financial conditions to tighten, and for the Fed to hike rates once more this year, and up to three more times in 2018.1 FX rates: With higher U.S. policy rates next year, the USD is likely to strengthen. This will weaken grain prices generally. Wheat, in particular, is most vulnerable to a strengthening USD and a weakening of the currencies of some of the commodity's top exporters - the European Union, Russia, and Australia. We've narrowed down the fundamental factors to look out for in 2018 as follows: Strong demand amid an extension of supply cuts by the OPEC 2.0 coalition will support oil prices in 2018. Higher energy prices will increase profit-margin pressure in ag markets through input and shipping costs. Weather risks from La Nina threaten to curb yields this winter, especially in Argentina and Brazil, which will add volatility to prices. Policy shifts in Argentina, China, and Brazil will influence farmers' planting decisions in the upcoming crop year. A Look Back At 2017 Chart of the WeekGrains Outperformed Softs This Year As predicted in our 2017 outlook, grains reversed their 2016 underperformance vis-à-vis softs this year, and outperformed them.2 While prices for sugar, coffee, and cotton were up 28%, 8%, and 12% in 2016, they have since declined by 21%, 8%, and 2%, respectively. In fact, sugar - our top ag in 2016 - took the biggest hit this year (Chart of the Week). On the other hand, as a complex, grains currently stand at largely the same level as the beginning of last year. However, there are some idiosyncrasies within the class. The two worst performing grains last year - rice and wheat - have been the strongest performers so far this year. Rice rallied 30% year-to-date (ytd) on the back of tighter supplies, completely reversing its 19% decline in 2016. Similarly, wheat, which lost 13% of its value last year, is up a modest 3% ytd. On the other hand, soybeans surrendered its title as the most profitable grain in 2016. After gaining 14% last year, its fate turned and it fell 3% ytd. Finally, out of the lot, corn is the only ag we cover that has fallen in both years consecutively, by a minor 1.9% in 2016, and an additional 4.4% so far this year. A Recap Of Long Term Trends According to the International Grains Council's November estimates, grains production is projected to come down this crop year. With an increase in consumption, this will ultimately lead to a 5.2% decline in ending stocks - the first drawdown in five years. Despite the year-on-year (y-o-y) decline, grain inventories are expected to stand at their second highest level on record (Table 1). Table 1Grain Production Down While Consumption Inches Higher The decline in expected grain ending stocks is mainly driven by corn, which - despite a large upwards revision to U.S. yields in the most recent WASDE - is expected to experience a 3.6% decline in production. This, together with a boost in consumption, leads to a 13.6% fall in ending stocks - the first drawdown since the 2010/11 crop year. The decline in corn expectations reflects a shift in the planting preferences of some of the major producers. The U.S., Brazil, Argentina, and China are the top soybean and corn exporters - accounting for 78% and 49% of global soybean and corn area harvested in the 2016/17 crop year, respectively. What is significant in the current cycle is that farmers in these countries are moving away from planting corn and towards more soybeans (Chart 2). China, which accounted for 19% of global corn area harvested and 6% of global soybean area harvested in 2016/17, is leading this change. While corn area harvested fell by an average 4.2% in the 2015 and 2016 crop years, soybean area harvested gained 9.8% during that period. Similarly, in Brazil, which accounted for 10% and 28% of global corn and soybean area harvested in 2016/17, respectively, corn area harvested by farmers has been growing at a much slower rate than soybean area harvested, with the former expanding by 16.4% and the latter by 39.6% since 2010/11. Likewise, harvested area in the U.S., which accounted for 18% and 29% of global corn and soybean area harvested, respectively, shrunk by 0.9% in the case of corn, and expanded by 21.3% in the case of soybeans since 2010/11. The exception to this rule is Argentina. Argentine farmland accounted for 3% and 15% of global corn and soybean area harvested in 2016/17, respectively. Since 2010/11, both corn area harvested as well as soybean area harvested increased by roughly the same level - 1.6 Mn Ha for the former and 1.5 Mn Ha for the latter - representing a 44.4% and 8.6% increase in area harvested for corn and soybeans, respectively. However, this is due to export policies, which in effect, encourage corn production over soybeans. As we discuss below, soybean export tariffs will be phased out in the coming years, likely changing the incentives structure for Argentine farmers. This trend is mirrored in production data, with global soybean output gaining 32% since 2010/11, compared to a 25% increase in global corn production. However, this shift is in large part due to demand patterns which also favor soybeans to corn. Over the same period, global soybean consumption increased by 36%, compared to 24% in the case of corn (Chart 3). Chart 2Farmers Favor Soybeans Over Corn... Chart 3...As Do Consumers In fact, at 28%, global soybean stock-to-use ratios are significantly more elevated than that of corn, which stand at 19%. Furthermore, while soybeans are expected to record a 3.9mm MT surplus by the end of the current crop year, corn is projected to experience a 17.7mm MT deficit. Powell's Fed And Dollar Movements Our modelling of ags reveals that U.S. financial factors are important determinants of agriculture commodity price developments.3 Fed policy decisions and their impact on real rates have a direct effect on ag commodity prices, as well as an indirect effect through the exchange rate channel (Chart 4). Chart 4Fed Policy Drives Ag Markets While U.S. inflation has remained stubbornly low, forcing the Fed to slow down their interest rate normalization process, the anticipation - and eventual acceleration - of the Fed tightening cycle will weigh on ag prices. However, thanks in part to softer-than-expected inflation readings coming out of the U.S. this year, the USD broad trade-weighted index (TWIB) has weakened by 6.8% since the beginning of the year. In terms of the impact of real rates, monetary policy impacts agriculture markets through the following channels: The Fed's interest-rate normalization process will, all else equal, increase borrowing costs for farmers, and discourage investments in general - impacting both agricultural investments as well as outlays in research and development. Tighter credit also leads to a slowdown in growth which - ceteris paribus - depresses consumption and demand for goods and services generally, and agricultural commodities specifically. Finally, real rates have an indirect effect on agricultural commodity prices through its effect on the U.S. dollar. Higher U.S. rates encourage investment in U.S. bonds and entail a strengthening of the U.S. dollar making U.S. exports less competitive vis-à-vis those of its international competitors. Since commodities are priced in U.S. dollars while costs are priced in local currencies, a weakening of the domestic currency vis-à-vis the dollar would increase profitability for farmers selling in international markets. This can incentivize farmers to plant more, despite depressed global ag prices, which increases supply. As our modelling reveals, the net effect is an inverse relationship, whereby easier monetary policy is generally more favorable for agriculture markets. The Fed Will Remain Behind The Inflation Curve Our U.S. Bond Strategy team expects the Fed to remain behind inflation, in which case the USD will remain weak in the beginning of next year. The 2/10 Treasury curve is flat highlighting the market's belief that the Fed will continue with interest rate normalization despite below target levels of inflation.4 Since this would be a huge error on the part of new Chairman Powell, our U.S. bond strategists believe that the Fed will avoid such a policy mistake. Consequently, if inflation does not pick up soon, the Fed will be forced to turn dovish. In any case, U.S. monetary policy will "fall behind the curve." This means that the U.S. dollar will remain weak until inflation starts to tick higher, and the Fed can resume its interest rate normalization process. In fact, our bond strategists find that there is a resemblance between the current cycle and that of the late 1990s where the unemployment rate significantly undershot its natural level before inflation started to accelerate. Thus, they find it significant that most of the indicators that predicted the 1999 increase in inflation are now positive. This reinforces our faith that inflation will soon rebound, allowing the Fed to fall behind the curve and simultaneously hike rates at a pace of one more hike this year, and three more in 2018.5 In terms of the future path of the U.S. dollar, our foreign exchange strategists argue interest rate differentials will be a more significant determinant of dollar dynamics going forward. They expect inflation will start its ascent sometime before the end of 1H2018, which would lift the interest rate curve and the dollar. Our expectation is that inflation will bottom towards the end of this year/beginning of next, giving room for the Fed to proceed with its anticipated rate-hiking cycle, resulting in two to three hikes next year. Markets are pricing one to two rate hikes next year, which means our out-of-consensus rates call could cause the USD to rally far more than what markets have priced in to the USD TWIB. Following a 4.4% appreciation in trade weighted terms in 2016, the U.S. dollar has depreciated by 6.8% so far this year. The U.S. accounts for a larger share of global exports of corn and soybeans than rice and wheat, which means a strengthening of the USD TWIB will likely have a bigger impact on wheat and rice, in which the U.S. faces greater international competition for market share (Table 2). Table 2Wheat & Rice Vulnerable To USD Dynamics This is, in fact, in line with the price behavior that we have observed. Wheat and rice prices fell the most in 2016 as the U.S. dollar appreciated, and have outperformed soybeans and corn so far this year, as the U.S. dollar depreciated. Thus, in the absence of supply shocks that affect a particular grain, changes in the U.S. dollar going forward will have a greater impact on rice and wheat than on corn and soybeans. Keep An Eye On The Brazilian Real Of the major ag exporters, Brazil is most vulnerable to USD depreciation risk. Poor productivity trends have made our foreign exchange strategists single out the Brazilian Real (BRL) as one of the most expensive currencies they track. While they expect the BRL to depreciate over a one- to two-year horizon, the current strength in EM asset prices means that the BRL is likely to remain at its current level in the near term. However, given that the BRL provides an high carry, it will likely move sideways until U.S. interest rate expectations adjust to a rebound in inflation - which we expect toward the end of this year, or beginning of next. Brazil is a major ag producer - making up 45%, 44%, 27%, 23% and 12% share of the global export pies for soybeans, sugar, coffee, corn and cotton, respectively. Thus, a weaker BRL vis-à-vis the USD is a major downside risk to these commodity prices. Downside FX Risks Will Keep Wheat Prices Depressed Chart 5Downside FX Risks For Wheat Exporters In addition to the risks from an overvalued BRL, our foreign exchange strategists have highlighted the EUR, RUB, and AUD as currencies that are at risk of falling back to their fair value in the near term. Given that these regions are major wheat exporters, this would weigh on the grain's price as exports increase (Chart 5).6 On the back of expectations that the European Central Bank will adopt a significantly less aggressive monetary policy than the Fed, our foreign exchange strategists expect the EUR to weaken toward the end of the year and beginning of next. Given that Europe is a major wheat exporter - making up ~20% of global exports - a weaker EUR would make European wheat more attractive, weighing on prices in 2018. The currencies of other major exporters could be drawn in different directions in the near term. Our FX strategists see the Russian Rouble (RUB) as overvalued and at risk of weakening when U.S. inflation starts accelerating late this year or early next. However, higher oil prices would push up the ruble's fair value, correcting some of its overvaluation. As with the EUR, the wheat market is most vulnerable to a weaker RUB since Russia accounts for 14% of global wheat exports. Likewise, Australia - another major wheat exporter which accounts for 10% of world exports - has been identified as having an expensive currency. It is at risk of a depreciation over the next 24 months, but could rally if iron ore markets turn higher. Some Additional (Potential) Fundamental Forces Among the news and noise in the ags sphere, we see higher oil prices and La Nina as the most significant near-term risks to current supply/demand dynamics. Longer term, shifting policies in China, Argentina, and Brazil will become more relevant in determining the trajectory of ag markets. Our Out-Of-Consensus Call On Oil Is Bullish For Ags Chart 6Higher Energy Prices Upside Risk We expect oil prices will tread higher next year - averaging $65/bbl for Brent and $63/bbl for WTI - on the back of stronger demand and an extension of the OPEC 2.0 coalition's supply restrictions.7 This will support ag commodity prices. Higher oil prices affect ags by increasing input costs and global shipping prices. In addition, the supply of ocean-going transport for grains is tight. The Baltic Dry index, a measure of the global cost of shipping dry goods, and has been on the uptrend this year, as freight costs have more than doubled since mid-February, mostly on the back of a slowdown in shipping transportation supply (Chart 6). La Nina: A Literal Tailwind? Against a backdrop of falling stocks-to-use ratios in the corn and soybean markets, weather will add volatility to prices into 1H2018. In the near term La Nina, which is predicted to continue through the 2017-18 Northern Hemisphere winter, threatens to curb agricultural output. This phenomenon affects weather and rainfall, causing floods and droughts, by cooling the Pacific Ocean. Australia's Bureau of Meteorology recently pegged the chance of a La Nina at 70%, expecting it to last from December to at least February. However, this season's La Nina is forecast to be weak and weather conditions are expected to neutralize in 1Q2018.8 In the case of ags, the greatest threat from La Nina is the risk of droughts in Brazil and Argentina which could hurt the regions soybean, corn, sugar, and cotton harvests. Furthermore, excess rainfall in Australia and Colombia threaten wheat, cotton, and sugar yields in the former and coffee output in the latter. Furthermore, the weather phenomenon raises chances of a potential drought in the U.S. Midwest.9 However, it is noteworthy that by the time La Nina hits, much of the harvest in the Northern Hemisphere will have been completed. So the main risk will be to harvests in the Southern Hemisphere. Gradualismo In Argentina, Stockpiling In China, And Ethanol In Brazil 1. Since taking office late 2015, Argentine President Mauricio Macri has reversed his predecessor's unfavorable agricultural policies - allowing the Argentine peso to float, and eliminating export taxes on wheat and corn. Marci's Gradualismo reforms have been successful - incentivizing plantings and leading to record harvests (Chart 7). While a 30% export tax remains on soybeans - Argentina's main cash crop - it is down from 35% under the presidency of Macri's predecessor. Further cuts to soybean export taxes have been delayed in order to finance the country's fiscal deficit, however they are expected to resume next year with a 0.5pp reduction/month for the next two years. This would stimulate soybean plantings, if it materializes. Argentine farmers produce 18% of global soybean output, and account for 9% of global soybean exports. The change in export policy, as it unfolds, will thus weigh on soybean prices as Argentine farmers increase their soybean acreage in the coming crop years. 2. Although we will likely get more clarity regarding Chinese ag policies with the release of China's Number 1 Central document - which for the past 14 years has focused on agriculture - in February, we expect Beijing to continue incentivizing soybean farming over corn. China's soybean inventory levels stand significantly lower than its notoriously massive stocks of corn, wheat, and cotton (Chart 8). Chart 7Argentine Reforms Will Raise Soybean Exports Chart 8China's Soybean Stocks Are Relatively Low As such, China's top corn producing province - Heilongjian - cut the subsidy for corn farmers by 13 percent this year. Farmers there now receive 8.90 yuan/hectare of corn, down from the 10.26 yuan/hectare they received last year. This compares with subsidies for soybean farmers which at 11.56 yuan/hectare is much higher. According to the China National Grain and Oils Information Center, corn acreage in Heilongjiang is down 9.3 percent in 2016/17. However, with corn prices in China increasing, the higher subsidy for soybeans may not be sufficient. Nonetheless, according to a report by the Brazilian state Mato Grosso's official news agency, over the next five years the Chinese commodities trader COFCO intends to almost double its soybean imports from the Brazilian grains state. This means that China's demand for soybeans will drive the market in the near term as they look to buildup soybean reserves and bring down their corn stocks.10 Chart 9Higher Oil Prices Incentivize Ethanol Over Sugar 3. Ethanol Demand will raise the opportunity costs of bringing sugar and corn to market. In addition to the direct effect of higher oil prices on ag commodities in general, our forecast of increasing prices will pressure sugar prices indirectly through the ethanol channel in Brazil. Since July, Brazil's state-controlled oil company, Petrobras, has shifted its pricing policy allowing gasoline and diesel prices to follow those of international oil markets. As a result, the gasoline-ethanol price gap is widening.11 This will revive demand for the biofuel, which will cause mills to divert sugarcane away from the sweetener in favor of producing more ethanol (Chart 9). In fact, according to UNICA - the Brazilian sugarcane industry association - mills in the country's center-south region - from which 90% of Brazil's sugar output is derived - are favoring ethanol production over sugar. Data for the first half of October shows that 46.5% of sugarcane was diverted to producing sugar, down from 49.6% in the same period last year. However, in the near term, increased production from the EU amid their scrapping of domestic sugar production quotas will likely keep the global market in balance.12 Global sugar supply is forecast to remain strong on the back of supplies from Thailand, Europe and India. There are reports that ethanol producers in Brazil are evaluating the adoption of "corn-cane flex" ethanol plants.13 However this is a longer run risk which would increase demand for corn, and reduce demand for sugar. Bottom Line: Financial conditions will drive ag prices in 2018. The Fed's resolve to normalize interest rates - more so than markets expect - will keep a lid on prices. This will offset risks from higher energy prices. Nonetheless, some weather induced volatility is likely into 1Q2018. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 In fact, our Global Investment Strategists expect the Fed to hike rates in December 2017, and again four more times in 2018. Please see BCA Research's Global Investment Strategy Weekly Report titled "A Timeline For the Next Five Years: Part I," dated November 24, 2017, available at gis.bcaresearch.com. 2 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "2017 Commodity Outlook: Grains & Softs," dated December 22, 2016, available at ces.bcaresearch.com. 3 A 1% move in the USD TWI is associated with a 1.4% change in the CCI Grains & Oilseed Index, in the opposite direction. Similarly, a 1pp move in 5-year real rates is associated with a 18% change in the CCI Grains & Oilseed Index, in the opposite direction. The adjusted R2 is 0.84. 4 Please see BCA Research's U.S. Bond Strategy Portfolio Allocation Summary titled "Into The Fire," dated November 7, 2017, available at usbs.bcaresearch.com. 5 Please see BCA Research's U.S. Bond Strategy Weekly Report titled "The Fed Will Fall Behind The Curve," dated October 24, 2017, available at usbs.bcaresearch.com. 6 Please see BCA Research's Foreign Exchange Strategy Weekly Report titled "Updating Our Long-Term Fair Value Models," dated September 15, 2017, available at fes.bcaresearch.com. 7 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "Oil Balances Continue To Point To Higher Prices," dated November 23, 2017, available at ces.bcaresearch.com. 8 El Nino/Southern Oscillation (ENSO) alternates between warm ("El Nino") and cool ("La Nina") phases, impacting global precipitation and temperatures. These episodes are identified by looking at temperatures in the "Nino region 3.4" whereby readings of at least 0.5 degrees Celsius above or below seasonal average for several months would qualify as an El Nino or La Nina. 9 La Nina is often associated with wet conditions in eastern Australia, Indonesia, the Philippines, Thailand, and South Asia. It usually leads to increased rainfall in northeastern Brazil, Colombia, and other northern parts of South America, and drier than normal conditions in Uruguay, parts of Argentina, coastal Ecuador and northwestern Peru. The effect on the U.S. and Canada tends to be milder since they are located further away from the heart of ENSO, on the other hand it has the greatest impact on countries around the Pacific and Indian Oceans. 10 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "Ags in 2017/18: Move To Neutral," dated October 5, 2017, available at ces.bcaresearch.com. 11 Flex-fuel vehicles in Brazil means that ethanol demand is not constrained by a "blending wall". Thus ethanol is a substitute for gasoline- rather than a complement to, as in the U.S. 12 France, Belgium, Germany and Poland reportedly have the capacity to ramp up sugar beet production. 13 Please see "Brazil mills eye corn-cane flex plant to extend production cycle," dated November 7, 2017, available at reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trade Recommendation Performance In 3Q17 Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights China stands out as the most likely candidate to send negative shock waves through EM and commodities in 2018. Granted the ongoing policy tightening in China will likely dampen money growth further, the only way mainland nominal GDP growth can hold up is if the velocity of money rises meaningfully, offsetting the drop in money growth. Assigning equal probabilities to various scenarios of velocity of money, the outcome is as follows: one-third probability of robust nominal growth (continuation of the rally in China-related plays) and two-third odds of a non-trivial slowdown in nominal growth with negative ramifications for China-related plays. Hence, we reiterate our negative stance on EM risk assets Feature The key question for emerging markets (EM) in 2018 is whether a slowdown in Chinese money growth will translate into a meaningful growth deceleration in this economy, and in turn produce a reversal in EM risk assets. This week we address the above question in detail elaborating on what could make China's business cycle defy the slowdown in its monetary aggregates and how investors should approach such uncertainty. Before this, we review the status of financial markets going into 2018. Priced To Perfection Or A New Paradigm? Several financial markets are at extremes. Our chart on the history of financial market manias reveals that some parts of technology/new concept stocks may be entering uncharted territory (Chart I-1). Tencent's share price, for instance, has surged 11-fold since January 2010. Chart I-1History Of Financial Markets Manias: They Lasted A Decade This is roughly on par with the prior manias' average 10-year gains. As this chart indicates, the manias of previous decades run wild until the turn of the decade. It is impossible to know whether technology/new concept stocks will peak in 2018 or run for another two years. Regardless whether or not the mania in tech/new concept stocks endures up until 2020, some sort of mean reversion in their share prices is likely next year. This has relevance to EM because the magnitude of the EM equity rally in 2017 has been enormously boosted by four large tech/concept stocks in Asia. Our measure of the cyclically-adjusted P/E (CAPE) ratio for the U.S. market suggests that equity valuations are reaching their 2000 overvaluation levels (Chart I-2, top panel). The difference between our measure and Shiller's measure of CAPE is that Shiller's CAPE is derived by dividing share prices by the 10-year moving average of EPS in real terms (deflated by consumer price inflation). Our measure is calculated by dividing equity prices by the time trend in real EPS (Chart I-2, bottom panel). Our CAPE measure assumes that in the long run, U.S. EPS in real terms will revert to its time trend. Meanwhile, the Shiller CAPE is based on the assumption that real EPS will revert to its 10-year mean. Hence, the assumptions behind our CAPE model are quite reasonable if not preferable to those of Shiller's P/E. Remarkably, the U.S. (Wilshire 5000) market cap-to-GDP ratio is close to its 2000 peak (Chart I-3). With respect to EM equity valuations, the non-financial P/E ratio is at its highest level in the past 15 years (Chart I-4). EM banks have low multiples and seem "cheap" because many of them have not provisioned for NPLs. Hence, their profits and book values are artificially inflated. In short, excluding financials, EM stocks are not cheap at all, neither in absolute terms nor relative to DM bourses. Chart I-2A Perspective On U.S. Equity Valuation Chart I-3The U.S. Market Cap-To-GDP ##br##Ratio Is Close To 2000 Peak Chart I-4EM Non-Financial Equities Are Not Cheap Such elevated DM & EM stock market valuations might be justified by currently low global long-term bond yields. Yet, if and when long-term bond yields rise, multiples will likely shrink. The latter will overpower the profit growth impact on share prices, as multiples are disproportionately and negatively linked to interest rates - especially when interest rates are low - but are proportionately and positively linked to EPS.1 As a result, a small rise in long-term bond yields will lead to a meaningful P/E de-rating. Despite very high equity valuations, U.S. advisors and traders are extremely bullish on American stocks. Their sentiment measures are at all time and 11-year highs, respectively. So are copper traders on red metal prices (Chart I-5). The mirror image of the strong and steady rally in global stocks is record-low implied volatility. The aggregate financial markets' implied volatility index is at a multi-year low (Chart I-6). Finally, yields on junk (high-yield) EM corporate and sovereign bonds are at all-time lows (Chart I-7). They are priced for perfection. Chart I-5Bullish Sentiment On Copper Is Very Elevated Chart I-6Aggregate Global Financial Markets ##br##Implied VOL Is At Record Low Chart I-7EM Junk Bond Yields Are At Record Low Are we in a new paradigm, or are we witnessing financial market extremes that are unsustainable? In regard to the timing, can these dynamics last throughout 2018 or at least the first half of next year, or will they reverse in the coming months? We have less conviction on the durability of the U.S. equity rally, but our bet is that EM risk assets will roll over in absolute terms and begin underperforming their DM peers very soon. What could cause such a reversal in EM risk assets? China stands out as the most likely candidate to send negative shock waves through emerging markets and commodities. China: "Financial Stability" Priority Entails Tighter Policy The Chinese authorities are facing unprecedented challenges: The outstanding value of broad money in China (measured in U.S. dollars) is now larger than the combined U.S. and euro area broad money supply (Chart I-8, top panel). Chart I-8Beware Of Money Excesses In China As a share of its own GDP, broad money in China is much higher compared to any other nation in history (Chart I-8, bottom panel). In brief, there is too much money in China and most of it - $21 trillion out of $29 trillion - has been created by the banking system since early 2009. We maintain that the enormous overhang of money and credit in China represents major excess/imbalances and has nothing to do with the nation's high savings rate.2 Rather, it is an outcome of animal spirits running wild among bankers and borrowers over the past nine years. Easy money often flows into real estate and China has not been an exception. Needless to say, property prices are hyped and expensive relative to household income. Policy tightening amid lingering excesses and imbalances makes us negative on China's growth outlook. In a nutshell, we place more weight on tightening when there are excesses in the system, and downplay the importance of tightening in a healthy system without excesses. Importantly, excessive money creation seems to finally be pushing inflation higher. Consumer price services and core consumer price inflation rates are on a rising trajectory (Chart I-9, top and middle panels). As a result, banks' deposit rates in real terms (deflated by core CPI) have plunged into negative territory for the first time in the past 12 years (Chart I-9, bottom panel). Remarkably, the People's Bank of China's existing $3 trillion of international reserves is sufficient to "back up" only 13% and 11% of official M2 and our measure of M3, respectively (Chart I-10). If Chinese households and companies decide to convert 10-15% of their deposits into foreign currency and the PBoC takes the other side of the trade, its reserves will be exhausted. Chart I-9China: Inflation Is Rising And ##br##Real Deposit Rate Is Negative Chart I-10China: Low Coverage Of ##br##Money Supply By FX Reserves Therefore, reining money and credit expansion is of paramount importance to China's long-term financial and economic stability. "Financial stability" has become the key policy priority. "Financial stability" is policymakers' code word for containing and curbing financial imbalances and bubbles. Having experienced the equity bubble bust in 2015, policymakers are determined to preclude another bubble formation and its subsequent bust. Consequently, the ongoing tightening campaign will not be reversed in the near term unless damage to the economy becomes substantial and visible. By the time the authorities and investors are able to identify such damage in the real economy, China-related plays in financial markets will be down substantially. Chart I-11China: Corporate Bond Yields And Yield Curve Faced with significant excesses in money, leverage and property markets, the Chinese authorities have been tightening - and have reinforced their policy stance following the Party's Congress in October. There is triple tightening currently ongoing in China: 1. Liquidity tightening: Money market rates have climbed, and onshore corporate bond yields are rising (Chart I-11, top panel). Remarkably, the yield curve is flat, pointing to weaker growth ahead (Chart I-11, bottom panel). 2. Regulatory tightening: The China Banking Regulatory Commission (CBRC) is forcing banks to bring off-balance-sheet assets onto their balance sheets, and is reining banks' involvement in shadow banking activities. In addition, financial regulators are trying to remove the government's implicit "put" from the financial system, and thereby curb speculative and irresponsible investment behavior. Finally, many local governments are tightening investors' participation in the real estate market. 3. Anti-corruption campaign is embracing the financial institutions: The powerful anti-corruption commission is planning to dispatch groups of inspectors to examine financial institutions' activities. This could dampen animal spirits among bankers and shadow banking organizations. The Outlook: The "Knowns"... In China, broad money growth has already slumped to an all-time low (Chart I-12). The money as well as the credit plus fiscal spending impulses both point to a considerable slowdown in the mainland's industrial cycle and overall economic activity (Chart I-13). Chart I-12China: Broad Money ##br##Growth Is At All-Time Low Chart I-13China: Money And Credit & ##br##Fiscal Impulses Are Negative The slowdown is not limited to money growth; there are a few real business cycle indicators that are already weakening. For example, the growth rate of property floor space sold and started has slumped to zero (Chart I-14). Electricity output and aggregate freight volume growth have both decisively rolled over (Chart I-15). Chart I-14China: Property Starts Are Set To Contract Again Chart I-15China: A Few Signs Of Slowdown That said, based on the past correlation between money and credit impulses on the one hand and the business cycle on the other, China's economy should have slowed much more, and its negative impact on the rest of the world should have already been felt (Chart I-13, on page 9). This has been the key pillar of our view on EM, but it has not yet transpired. Is it possible that the relationship between money/credit impulses and the business cycle has broken down? If so, why? And how should investors handle such uncertainty? Bottom Line: China's ongoing policy tightening will ensure that money and credit impulses remain negative for some time. Can the country's industrial sectors de-couple from its past tight correlation with money and credit? ...And The "Unknowns" By definition, the only way to sustain nominal economic growth in the face of a decelerating money supply is if the velocity of money increases. This is true for any economy. Nominal GDP = Money Supply x Velocity of Money Provided China's policy tightening will likely further dampen money growth, the only way nominal GDP growth can hold up is if the velocity of money rises meaningfully, offsetting the drop in money growth. This is the main risk to our view and strategy. Chart I-16 portrays all three variables. Chart I-16China: Money, Nominal GDP ##br##And Velocity Of Money Even though the velocity of money has fallen structurally over the past nine years (Chart I-16, bottom panel), it has risen marginally in 2017, allowing the mainland's nominal economic growth to hold up despite a considerable relapse in money supply growth. Notably, this has been the reason why our view has not worked this year. What is the velocity of money, and how can we forecast its fluctuations and, importantly, the magnitude of its variations? The velocity of money is one of the least understood concepts in economic theory. The velocity of money is anything but stable. In our opinion, the velocity of money reflects animal spirits of households and businesses as well as government spending decisions. Forecasting animal spirits and the magnitude of their variations is not very a reliable exercise. In a nutshell, the banking system (commercial banks and the central bank) creates money via expanding its balance sheet - making loans to or acquiring assets from non-banks. However, commercial banks have little direct influence on the velocity of money. The latter is shaped by non-banks' decisions to spend or not (i.e., save). Significantly, non-banks' spending and saving decisions do not alter the amount of money in the system. Yet they directly impact the velocity of money. The banking system creates money, and non-banks churn money (make it circulate). At any level of money supply, a rising number of transactions will boost nominal output, and vice versa. Further, there is a great deal of complexity in the interaction between money supply and its velocity. Both are sometimes independent, i.e. they do not influence one another, but in some other cases one affects the other. For example, with the ongoing triple tightening in China and less money being originated by the banking system, will households and businesses increase or decrease their spending? Our bias is that they will not increase spending. This is especially true for the corporate sector, which has record-high leverage and where access to funding has been tightening. It is also possible that rising velocity will lead to more money creation as more spending leads to higher loan demand and banks accommodate it - i.e., originating more loans/money. These examples corroborate that money supply and the velocity of money are not always independent of each other. On the whole, it is almost impossible to reliably forecast the magnitude of changes in velocity of money. In the same vein, it is difficult to forecast animal spirit dynamics in any economy. Chart I-17U.S.: The Rise In Velocity Of Money ##br##Overwhelmed Slowdown In Money One recent example where nominal GDP has decoupled from broad money growth is the U.S. Chart I-17 demonstrates that in the past 12 months, U.S. nominal GDP growth has firmed up even though broad money (M2) growth has slumped. This decoupling can only be explained by a spike in the velocity of M2. In other words, soaring confidence and animal spirits among U.S. households and businesses have boosted their willingness to spend, even as the banking system has created less money and credit growth has slowed considerably over the past 12 months. Going back to China, how should investors consider such uncertainty in changes in the velocity of money? Investing is about the future, which is inherently uncertain. Hence, an investment process is about assigning probabilities to various scenarios. Provided the velocity of money is impossible to forecast, we assign equal probabilities to each of the following scenarios for China in 2018 (Figure I-1): One-third odds that the velocity of money rises more than the decline in broad money growth, producing robust nominal GDP growth; One-third probability that the velocity of money stays broadly flat - the outcome being meaningful deceleration in nominal GDP growth; A one-third chance that the velocity of money declines - the result being a severe growth slump. Figure I-1How Investors Can Consider Uncertainty Related To Velocity Of Money In short, a positive outcome on China-related plays has a one-third probability of playing out, while a negative outcome carries a two-thirds chance. This is why we continue to maintain our negative view on EM and commodities. Commodities Our view on commodities and commodity plays is by and large shaped by our view on China's capital spending. Given the credit plus fiscal spending impulse is already very weak, the path of least resistance for capital expenditures is down. Besides, the government is clamping down on local governments' off-balance-sheet borrowing and spending (via Local Government Financing Vehicles). A deceleration in capital expenditures in general and construction (both infrastructure and property development) in particular is bearish for industrial metals (Chart I-18). Money and credit impulses herald a major downturn in Chinese imports values and volumes (Chart I-19). Chart I-18Industrial Metals / Copper Are At Risk Chart I-19China Will Be A Drag On Its Suppliers As to China's commodities output reductions, last week we published a Special Report3 on China's "de-capacity" reforms in steel and coal. The report concludes the following: The path of least resistance for steel, coal and iron ore prices is down over the next 12-24 months. China's "de-capacity" reforms in steel and coal will continue into 2018 and 2019, but the scale and pace of "de-capacity" will diminish. Importantly, the mainland's steel and coal output will likely rise going forward as new capacity using more efficient and ecologically friendly technologies come on stream. The capacity swap policy introduced by the authorities has been allowing steel and coal producers to add new capacity in order to replace almost entirely obsolete capacity. The combination of demand slowdown and modest production recovery will weigh on non-oil raw materials. As for oil, the picture is much more complicated. Oil prices have been climbing in reaction to declining OECD inventories as well as on expectations of an extension to oil output cuts into 2018. One essential piece of missing information in the bullish oil narrative is China's oil inventories. In recent years, China has been importing more crude oil than its consumption trend justifies. Specifically, the sum of its net imports and domestic output of crude oil has exceeded the amount of refined processed oil. This difference between the sum of net imports and production of crude oil and processed crude oil constitutes our proxy for the net change of crude oil inventories. Chart I-20 shows that our proxy for mainland crude oil inventories has risen sharply in recent years. This includes both the nation's strategic oil reserves as well as commercial inventories. There is no reliable data on the former. Therefore, it is impossible to estimate the country's commercial crude oil inventories. Chart I-20China: Beware Of High Chinese Oil Inventories Nevertheless, whether crude oil inventories have risen due to a build-up of strategic petroleum reserves or commercial reserves, the fact remains that crude oil inventories in China have surged and appear to be reaching the size of OECD total crude and liquid inventories (Chart I-20). In short, China has been a stabilizing force for the oil market over the past three years by buying more than it consumes. Without such excess purchases from China, oil prices would likely have been much weaker. Going forward, the pace of Chinese purchases of crude oil will likely slow due to several factors: (a) China prefers buying commodities on dips, especially when it is for strategic inventory building. With crude oil prices having rallied to around $60, the authorities might reduce their purchases temporarily, creating an air pocket for prices, and then accelerate their purchases at lower prices; (b) Commercial purchases of oil will likely decelerate due to tighter money/credit, possibly high inventories and a general slowdown in industrial demand for fuel. Bottom Line: Raw materials and oil prices4 are at risk from China and overly bullish investor sentiment. Beyond Commodities The slowdown in China will impact not only commodities but also non-commodity shipments to the mainland (Chart I-21). In fact, 47% of the nation's imports are commodities and raw materials and 45% are industrial/capital goods - i.e., China's imports are heavily exposed to investment expenditures, not consumer spending. This is why money/credit impulses correlate so well with this country's imports. Consistently, China's broad money (M3) impulse leads EM corporate profit growth by 12 months - and currently heralds a major EPS downtrend (Chart I-22). In addition, aggregate EM narrow money (M1) growth also points to a material slump in EM EPS (Chart I-23). Chart I-21China Is A Risk To ##br##Non-Commodity Economies Too Chart I-22Downside Risk To EM EPS The only EM countries that are not materially exposed to China and commodities are Turkey and India. The former is a basket case on its own. Indian stocks are expensive and will have a difficult time rallying in absolute terms when the EM equity benchmark relapses. As for Korea and Taiwan, their largest export destination is not advanced economies but China. China accounts for 25% of Korea's exports and 28% of Taiwan's. This compares to a combined 22% of total Korean exports and 20% of total Taiwanese exports going to the U.S. and EU combined Can robust growth in the U.S. and EU derail the growth slowdown in China when capital spending slows? This is very unlikely, in our view. Chart I-24 portends that China's shipments to the U.S. and EU account for only 6.6% of Chinese GDP, while capital spending and credit origination constitute 45% and 25% of GDP, respectively. Chart I-23EM M1 And EM EPS Chart I-24What Drives Chinese Growth? A final word on tech stocks. EM's four large-cap tech stocks (Tencent, Ali-Baba, Samsung and TSMC) have gone exponential and are extremely overbought. At this juncture, any strong opinion on tech stocks is not warranted because they can sell off or continue advancing for no fundamental reason. We have been recommending an overweight position in tech stocks, and continue recommending overweighting them, especially Korean and Taiwanese semiconductor companies. As for Tencent and Alibaba, these are concept stocks, and as a top-down house we have little expertise to judge whether or not they are expensive. These are bottom-up calls. Investment Strategy EM Stocks: Asset allocators should continue to underweight EM versus DM, and absolute-return investors should stay put. Our overweights are Taiwan, China, Korean tech stocks, Thailand, Russia and central Europe. Our underweights are Turkey, South Africa, Brazil, Peru and Malaysia. Chart I-25EM Currencies: A Canary In ##br##Coal Mine For EM Credit? Stay short a basket of the following EM currencies: ZAR, TRY, BRL, IDR and MYR. We are also shorting the COP and CLP. Unlike in 2014-2015, EM currencies will depreciate not only versus the U.S. dollar but also the euro. For traders who prefer a market neutral currency portfolio, our recommended longs (or our currency overweights) are TWD, THB, SGD, ARS, RUB, PLN and CZK. INR and CNH will also outperform other EM currencies. Continue underweighting EM sovereign and corporate credit relative to U.S. investment grade bonds. The mix of weaker EM/China growth, lower commodities prices and EM currency depreciation bode ill for already very tight EM credit spreads (Chart I-25). Within the sovereign credit space, our underweights are Brazil, Venezuela, South Africa and Malaysia and our overweights are Russia, Argentina and low beta defensive credits. The main risk to EM local currency bonds is EM currency depreciation. With foreign ownership of EM domestic bonds at all-time highs, exchange rate depreciation could trigger non-trivial selling pressure. Among local currency bond markets, the most vulnerable are Turkey, South Africa, Indonesia and Malaysia. The least vulnerable are Korea, Russia, China, India, Argentina and Central Europe. Other high-conviction market-neutral recommendations: Long U.S. banks / short EM banks. Long U.S. homebuilders / short Chinese property developers. Long the Russian ruble / short oil. Long the Chilean peso / short copper. Long Big Five state-owned Chinese banks / short small- and medium-sized banks. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 For example, given that interest rates are in the denominator of the Gordon Growth model, a one percentage point change in interest rates from a low level can have a significant impact on the fair value P/E ratio. 2 Please refer to the Emerging Markets Strategy Special Reports from October 26, 2016, November 23, 2016 and January 18, 2017; available on ems.bcaresearch.com 3 Please refer to the Emerging Markets Strategy Special Report titled "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017, link available on page 22. 4 This is the Emerging Markets Strategy team's view and is different from BCA's house view on commodities. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Special Report

Dear Client, Today we are sending you a two-part Special Report prepared by my colleague Billy Zicheng Huang of our Emerging Markets Equity Sector Strategy team, entitled “A Sector Guide To A-shares”. Part I of the report was published in September, and emphasized the key takeaways from MSCI’s decision to include A-shares in the MSCI EM index beginning in June 2018. More importantly, it provided a comprehensive analysis of the financials, industrials, consumer discretionary, and consumer staples sectors. Part II of the report was published at the end of October, and provided an analysis of the remaining sectors not included in Part I. The reports underscore that while the top-down impact of MSCI’s decision is limited, it is significant in terms of expanding potential alpha from security selection. I trust that you will find this report to be useful. Best regards, Jonathan LaBerge, CFA, Vice President Special Reports Part I of the Special Report discussed the market impact of MSCI's decision to include A-shares in the MSCI Emerging Markets Index, followed by a comprehensive analysis of the four most investment-relevant sectors with corresponding company calls in each sector. In the second part of the Special Report, the EMES team will analyze the remaining sectors, and provide investment recommendations. We will publish an Investment Case by the end of this year, highlighting our best sector picks from Part I and Part II of the Special Reports to construct an A-share portfolio. A Recap In the first part of our A-shares special report, the EMES team discussed the key takeaways from A-shares' inclusion in the MSCI EM index and concluded that, despite a limited near-term impact on the market from a passive investment standpoint, the MSCI's decision will provide an expansion of the investable universe for active EM investors, and more opportunities to allocate assets and generate alpha.1 Moreover, we looked at the four sectors most relevant for investors - financials, industrials, consumer discretionary, and consumer staples - analyzing valuations, profitability, leverage, and the growth outlook. In this special report, we will continue our journey through the remaining sectors: energy, healthcare, IT, materials, real estate, and utilities. Please note that only one company, Dr.Peng Telecom & Media (CH 600804), will be added to telecoms, and will not result in material changes to the sector. Thus we omitted analysis of this sector. Energy Seven companies from the energy sector will be included into the MSCI EM index, including six from the oil & gas industry. The equally weighted basket of the seven A-share energy companies has underperformed the MSCI EM index year to date by 26.2%, and by 19.8% over a one-year period (Table 1). With the Chinese government's mandate to cut excess capacity, capex growth in the energy sector will continue to be weak, which will weigh on the growth outlook for the sector. In terms of valuation, stripping out two dual-listed names that are already in the MSCI EM Index (Sinopec and PetroChina - please see Appendix I for the full list), Lu'an Environmental and Xishan Coal & Electric Power are trading at significantly cheaper valuations than their peers. On the other end of the spectrum, Guanghui Energy and Wintime Energy's P/Es have expensive valuations. Looking at profitability, low P/E names tend to have high ROEs, while Guanghui Energy suffers from the weakest ROE (Charts 1A & 1B). From a profitability-versus-valuation perspective, Lu'an Environmental offers a superior risk-reward profile, while Guanghui Energy has the least favorable risk-reward profile (Chart 1C). Wintime and Lu'an reported the strongest operating margins, while Offshore Oil Engineering has the weakest margin among peers (Chart 1D). On leverage, Offshore Oil Engineering has the lowest debt-to-equity (D/E) ratio, mainly because its core business is energy equipment and service rather than oil & gas exploration. All energy producers are highly leveraged, with Wintime and Guanghui topping the list. On free cash flow yield, Lu'an leads the table, while both Guanghui and Wintime have negative yields which, together with high leverage, is a negative combination (Charts 1E, 1F, 1G). The A-share Energy companies have a dividend yield of less than 2%, with Offshore Oil Engineering enjoying the highest yield among peers, while Xishan Coal & Electric Power has the lowest yield (Chart 1H). Screening the earnings forecasts, all companies' EPS are expected to growth by more than 10%, led by Offshore Oil Engineering and Guanghui Energy (Chart 1I). Taking all the factors into consideration, we suggest investors should be cautious on the energy sector, and should be especially cautious about betting on the likelihood of Guanghui Energy's turnaround. The company registered surprising positive bottom-line growth in 1H17, but this was mainly due to a low base in 2016. The commencement of its new liquefied natural gas (LNG) terminal in Jiangsu Province will not help much to lift sales volumes or margins, given little LNG price recovery and growing competition from well-positioned larger players such as Kunlun and CNOOC. Healthcare There are 13 companies in the A-share healthcare sector. Stocks in the sector have a heavy tilt towards pharmaceutical producers. The equally weighted basket has underperformed the MSCI EM index year to date by 1.8%, and outperformed by 0.9% over a one-year period (Table 2). On an absolute return basis performance was resilient across various time horizons. The EMES team has been bullish on healthcare sector on a long-term investment horizon, with overweight calls on Fosun Pharma (2196 HK) from among the current MSCI EM constituents.2 We prefer companies with innovative drug R&D pipelines, which will more likely take advantage of the new China FDA rule encouraging biopharmaceutical innovation. Shanghai Pharma and Fosun Pharma are excluded from our analysis, as their H-listed shares are already in the MSCI EM index. Examining valuations, on a trailing P/E basis we favor Sanjiu Medical and Dong-E-E-Jiao. By contrast, Hengrui Medicine and Guizhou Bailing look expensive (Chart 2A). Looking at the profitability side, Salubris Pharma and Dong-E-E-Jiao have the strongest ROE, while Tongrentang and Baiyunshan Pharma lie on the other end of the spectrum (Chart 2B). In summary, Salubris Pharma and Dong-E-E-Jiao will likely outperform, based on a valuation-versus-profitability comparison (Chart 2C). Furthermore, Salubris Pharma and Dong-E-E-Jiao also lead by operating margin, with relatively safe leverage levels at the same time (Chart 2D). On the other hand, Jointown suffers from the highest debt level, the only one with debt-to-equity surpassing 100%. In terms of free cash flow, Sanjiu Medical and Salubris have the most attractive FCF yield, while Jointown and Tasly, both companies with the highest debt levels, also display a worryingly negative FCF yield (Charts 2E, 2F, 2G). Salubris and Baiyun Shan dominate the dividend yield rank (Chart 2H). Concerning the earnings outlook, Huadong Medicine and Kangmei are expected to see fast bottom-line growth in 2018, driven by robust antibiotic and cardiovascular sales respectively, while Tongrentang and Baiyunshan are likely to fall behind the industry average (Chart 2I). In summary, we prefer Salubris Pharma among the A-share healthcare basket, supported by its stronger fundamentals and the bullish outlook on innovative drug R&D and sales in China, in which Salubris Pharma is specialized. IT 14 names from the IT sector will be added to the MSCI EM index. The equally weighted basket has outperformed the MSCI EM index year to date by 22.3%, and outperformed by 23.3% over a one-year period (Table 3), with most stocks performing strongly across various investment horizons. We believe the A-share IT basket provides investors with attractive opportunities in the investable universe given that it is less expensive than its H-share counterpart. The inclusion will also dilute the weight of IT sector ADRs, such as Alibaba and Sina Weibo, in the index. Please note that Protruly Vision Tech has been suspended from trading due to legal issues, with no further detail released by the court. Stripping out ZTE because of its H-share listing already in the MSCI EM index, there are 12 names left. Regarding valuations, most companies are trading at a below-50 trailing P/E, with the exceptions of Hundsun Tech and iFlytek, both of which are above 150x, while Aisino and BOE are relatively undervalued compared to other names in the sector. It is worth mentioning that Hundsun is 100% owned by Zhejiang Finance Credit Network Technology, a company 99% owned by Alibaba. From a profitability perspective, Hikvision Digital and Dahua Tech have the highest ROE, while Hundsun Tech and Tsinghua Unisplendour lie at the other end of the spectrum (Charts 3A & 3B). Taking these two factors into consideration, we highlight Hikvision Digital and Dahua Tech as the most attractive based on their risk-reward profile (Chart 3C). When looking at the income statement, Sanan Optoelectronics displays robust operating margins, with 2345 Network following suit. By contrast, Hundsun Tech and Tsinghua Unisplendour report the most disappointing margins (Chart 3D). On the positive side, Hundsun Tech has virtually zero debt on the balance sheet, while Dongxu Optoelectronic is more than 80% leveraged. Meanwhile, only four companies register positive FCF yields. Taking both metrics into account, Aisino can most easily service its debt with free cash flow (Charts 3E, 3F, 3G). By dividend yield, Aisino and Hikvision rank top (Chart 3H). With respect to forward EPS growth, iFlytek and Hundsun Tech are expected to see the fastest bottom-line expansion, while Aisino's and BOE Tech's bottom lines will increase at the slowest pace (Chart 3I). Based on our criteria, we like video surveillance manufacturers Hikvision and Dahua Tech for their robust fundamentals and reasonable valuations. In particular, Hikvision is likely to have the largest market cap among A-share tech companies newly included in the MSCI indexes. Materials Currently only seven Chinese companies from the materials sector are included into the MSCI EM Index. After the inclusion, some 26 more companies will be added, substantially expanding the investable universe. Two subsectors will most likely draw investors' attention due to the significant exposure increase: metals & mining, and chemicals. The equally weighted basket has underperformed the MSCI EM index year to date by 2%, but outperformed by 4.6% over a one-year period (Table 4). We exclude five names, which are already in the current MSCI EM index: Sinopec Shanghai Petrochem, Anhui Conch Cement, Aluminum Corp of China, Jiangxi Copper, and Zijin Mining. Among the other companies, we have been underweight Maanshan Iron & Steel (H-share listing) and Aluminum Corp of China (H-share listing) in our China Materials trade, and overweight Tianqi Lithium in the lithium supply chain trade. Maanshan Iron & Steel and Angang Steel have attractive valuations, with trailing P/Es below 15. On the other end of this scale, China Northern Rare Earth and Baotou Steel appear very expensive (Chart 4A). On profitability, Wanhua Chemical and Tianqi Lithium top the ROE rank, while Jinduicheng Molybdenum and Baotou Steel sit at the bottom (Chart 4B). Screening the risk-reward profile, it is noticeable that chemicals normally demonstrate a better ROE vs. P/E metric than companies from the metals & mining industry. Specifically, Wanhua Chemical and Tianqi Lithium are the most attractive, while Jindiucheng Molybdenum is the least attractive (Chart 4C). In terms of operations, Tianqi Lithium reported the strongest operating margin, followed by Junzheng, while Hainan Rubber and Jinduicheng Molybdenum are the only companies that registered negative operating margins (Chart 4D). Looking at the balance sheet, Jinduicheng Molybdenum has the healthiest leverage, while Hesteel shows the most worrisome leverage. Moreover, it has the lowest FCF yield. In terms of FCF yield versus leverage, Kingenta offers the best tradeoff, while Hesteel is the least attractive (Charts 4E, 4F, 4G). Furthermore, dividend yield favors Longsheng and disfavors Northern Rare Earth (Chart 4H). In terms of projected EPS growth, Jinduicheng Molybdenum and Shandong Gold Mining have the strongest outlook for next year, while Maanshan Iron & Steel and Angang Steel are likely to report profit declines (Chart 4I). In summary, apart from Maanshan Iron & Steel, Hainan Rubber is a good candidate for the underweight basket due to its relatively expensive valuation, negative margin and FCF yield. Moreover, its focus on the rubber business diversifies the portfolio risk from metal & mining-concentrated underweight exposure. China Molybdenum, with its above-average risk-reward profile, moderately strong operations and financial position, as well as robust growth outlook, is a good candidate for the overweight basket of our lithium supply trade to replace Ganfeng Lithium. The company has a strong market presence in Congo, where over 60% of cobalt is mined. Real Estate Some 14 developers will be added to the existing MSCI EM index. Among the top 10 Chinese developers, measured by contracted sales and floor space sold, existing MSCI EM constituents account for six, while the A-share list will add two (Poly Real Estate and China Fortune Land). In the environment of property market tightening in China, primary land supply has remained stagnant. The government is unlikely to ease the supply restrictions in the near-term, especially in the residential land space. In this vein, we believe large market players will be better-positioned in this market, due to their bargaining power. Also, developers with heavy exposure to commercial property will be less affected by policy uncertainty than their residential counterparts. Looking at historical performance, the equally weighted basket has underperformed the MSCI EM index year to date by 20.5%, and by 17.1% over a one-year period (Table 5). Xinhu Zhongbao and Financial Street are trading at the cheapest valuations, while Zhejiang China Commodities and China Fortune Land seem to be slightly overpriced compared to peers. The ROE for Xinhu Zhongbao is remarkable, while Zhangjiang High-tech Park is the only company with ROE under 10% (Charts 5A, 5B). Taking both dimensions into account, Xinhu Zhongbao and Gemdale display an attractive risk-reward profile (Chart 5C). Looking at operational metrics, Zhejiang China Commodities and Financial Street enjoy the highest margin, while Xinhu Zhongbao and Tahoe lie on the other end of the spectrum (Chart 5D). Due to the nature of business, leverage is high across the sector. In particular, Oceanwide and Tahoe have a high debt-to-equity ratio, while Zhejiang China Commodities and Gemdale have a more prudent capital structure. Furthermore, FCF yields vary a lot across companies, with Financial Street and Xinhu Zhongbao on the positive end, and Tahoe and Oceanwide on the negative. Financial Street also beats other developers in terms of cash generation for debt payment (Charts 5E, 5F, 5G). Gemdale and Risesun have the highest dividend yield, while Tahoe and Zhejiang China Commodities have the lowest (Chart 5H). Regarding the full-year 2018 expectations, Financial Street and Zhejiang China Commodities have a robust growth outlook with respect to funds from operations (FFO) and EPS respectively, while Gemdale is likely to see sluggish growth on both metrics (Charts 5I & 5J). In summary, we believe Financial Street Holding is likely to outperform in the real estate sector, given its appealing risk-reward profile, decent dividend yield, superior cash flow yield and operating margin, reasonable debt ratio, and robust FFO growth. Its large-scale and commercial property exposure is expected to be more immune to policy tightening in China. Utilities Some 12 utility companies will be added to the existing MSCI EM index, most of which are in power generation and renewables. EMES published in July an investment case on China utilities, underlining our preference toward companies with a focus on the environment and clean power, in line with the Chinese government's emphasis in the 13th five-year plan.3 In the A-share basket, we highlight Yangtze Power, the hydro power large cap, National Nuclear, as its name suggests the state-owned nuclear power operator, and Beijing Capital, the water utility provider. The equally weighted basket has underperformed the MSCI EM index year to date by 19.2%, and by 14.2% over a one-year period (Table 6). Huaneng Power is excluded from our analysis, as its H-share is already in the MSCI EM Index. Screening valuations, the trailing P/E factor favors Shenery and Chuantou Energy. By contrast, Huadian Power and Beijing Capital look expensive (Chart 6A). On profitability, Yangtze Power and Chuantou Energy have the strongest ROE, while Huadian Power and Shenzhen Energy fall far behind the average (Chart 6B). Based on valuation versus profitability, Chuantou Energy, Yangtze Power, and SDIC Power will likely outperform (Chart 6C). Yangtze Power and SDIC Power have remarkably high operating margins, while Shenery and Beijing Capital are at the other end of the spectrum (Chart 6D). Concerning leverage, most large-scale players such as Datang International Power and National Nuclear Power are highly leveraged. By contrast, low leveraged players, such as Hubei Energy and Shenergy, tend to have small market caps of around US$ 5 bn. In terms of FCF yield, we highlight Yangtze Power and Chuantou Energy, while we are cautious on Shenzhen Energy and National Nuclear Power due to their deeply negative yields. In summary, we like Chuantou Energy, Yangzte Power, Zheneng Electric, and Shenergy with respect to FCF yield versus leverage, which also coincides with dividend yield rank (Charts 6E, 6F, 6G, 6H). Finally, Huadian Power and Datang are expected to show the fastest bottom-line growth next year, while Yangtze Power and Chuantou Energy are likely to see limited earnings expansion (Chart 6I). Therefore, within utilities sector, we expect Yangtze Power to outperform in the long term, supported by its appealing risk-reward profile, margin expansion, and debt service ability. We also like the fact that the company's dominant strength of hydropower is the Yangtze River Delta. Billy Zicheng Huang, Research Analyst billyh@bcaresearch.com 1 Please see EM Equity Sector Strategy Special Report "A Sector Guide To A-shares - Part I ", dated September 19, 2017, available at emes.bcaresearch.com 2 Please see EM Equity Sector Strategy Investment case "China Healthcare, Getting Healthier", dated August 9, 2016, available at emes.bcaresearch.com 3 Please see EM Equity Sector Strategy Investment case "Budding Green Equities In China", dated July 11, 2017, available at emes.bcaresearch.com Appendix - I Appendix - II Overweight Company Profile Underweight Company Profile

Special Report

Dear Client, Today we are sending you a two-part Special Report prepared by my colleague Billy Zicheng Huang of our Emerging Markets Equity Sector Strategy team, entitled “A Sector Guide To A-shares”. Part I of the report was published in September, and emphasized the key takeaways from MSCI’s decision to include A-shares in the MSCI EM index beginning in June 2018. More importantly, it provided a comprehensive analysis of the financials, industrials, consumer discretionary, and consumer staples sectors. Part II of the report was published at the end of October, and provided an analysis of the remaining sectors not included in Part I. The reports underscore that while the top-down impact of MSCI’s decision is limited, it is significant in terms of expanding potential alpha from security selection. I trust that you will find this report to be useful. Best regards, Jonathan LaBerge, CFA, Vice President Special Reports The EMES team will be publishing a series of Special Reports in the coming weeks, analyzing sector dynamics and company highlights of Chinese A shares that MSCI has decided to include in the MSCI EM index from next June. In the first part of our report, we emphasize the key takeaways from A-shares' inclusion, followed by a comprehensive analysis of the four sectors that investors will probably most focus on. The second part of our report to be released in the coming weeks will analyze the remaining sectors. MSCI's decision to include Chinese A shares will likely have only a limited near-term impact on the market from a passive investment perspective. A 5% inclusion factor will not cause significant changes to the current sector weightings of the MSCI EM index or the MSCI China index. The symbolic effect - that global investors are becoming more confident in the Chinese market's efficiency and transparency - is likely to have a larger impact. From an active investment perspective, however, an expansion of the investable universe will give investors with EM mandates more opportunities to allocate assets and generate alpha. Impact Is Limited On A Macro Perspective... On June 20, MSCI announced its decision to include Chinese A shares in the MSCI EM index and the MSCI ACWI index on a gradual basis starting from June 2018.1 The inclusion process will be finalized in two steps following the May semi-annual index review and August quarterly review in 2018, at a 5% inclusion factor. Full inclusion of the remaining A-share universe is expected to take place gradually over five to 10 years. After three previous proposals of an A-shares inclusion having been rejected by investors surveyed by MSCI, the successful start of the inclusion process signifies that the A-share market is gaining broad support from institutional investors. This follows the Chinese government's and regulators' focus on improving market accessibility via stock connect programs (Hong Kong-Shanghai connect, and Hong Kong-Shenzhen connect) as well as improving market liquidity via loosening requirements for index-linked financial instruments. Further steps regarding capital movement and better reporting standards are expected to be implemented in due course. influence of the inclusion is minimal from a broad market perspective. As is planned, 222 A-share companies will be added to the MSCI EM index, accounting for a pro-forma weight of only 0.73% of the MSCI EM index, or 2.5% of the MSCI China index (Charts 1A and 1B). A shares will boost China's weight in the MSCI EM by approximately only 1%, given the 5% inclusion factor. Sector-wise, it will not substantially move the current weights of each sector either. Company wise, all selected stocks are large caps, with 43 being "A" and "H" dual-listed companies already included in the current MSCI EM index, mostly concentrated in the financials, industrials and materials sectors (see Appendix I). This means the inclusions are unlikely to make any meaningful contribution to index performance in the upcoming year. Similarly, capital inflows from passive fund trackers are expected to be negligible, only marginally adding to the trading income of the Hong Kong Exchange through the northbound stock connect program. refore, we believe the impact from an investor perspective is more symbolic, confirming a positive outlook on market transparency and corporate governance. ...But Significant In Stock Selection Despite immaterial near-term market impact, the 222 A-share large-cap stocks will expand the investable universe, providing active investors with plenty of opportunities to extract alpha. In particular, compared to the current weights of the 11 sectors, industrials, financials, consumer staples, materials, healthcare, utilities, and real estate would see weight expansion, while IT, telecom, energy, and consumer discretionary would see weight contraction (Table 1). Newly added stocks mainly come from the financial and industrial sectors, with the name count by far outpacing other sectors. Given an overall larger market cap, these two sectors will experience the most substantial incremental weight boost under the full inclusion scenario. However, this does not mean sectors with fewer companies to be added are negligible. Instead, liquidity in these sectors is expected to improve significantly, with specific stocks drawing strong interest from investors. Since the launch of BCA's EMES service, we have made several calls on A-share stocks as out-of-benchmark plays, including Yutong Bus (600066 CH) and Tianqi Lithium (002466 CH) from our best-performing trade, overweight the lithium supply chain. In this vein, in this Special Report we will identify and analyze four sectors that we believe are most investment-relevant. A second Special Report examining the remaining sectors will follow in the coming weeks. Financials Some 50 companies from the financials sector will be included in the MSCI EM index, with a strong tilt toward brokerage firms (27). The rest will be split between banks (19) and insurers (4). Banks The equally weighted basket of 19 A-share banks has underperformed the MSCI EM index year to date by 13.4%, and underperformed by 11.6% over a one-year period (Table 2). In absolute return terms, however, performance has been resilient across various time horizons. It is worth mentioning that the "big five banks" are all listed in both mainland China and Hong Kong. Therefore, investors will focus more on joint-stock banks and regional banks in the A-share universe, which makes analysis on shadow banking activities within the earnings profile crucial. In terms of valuation, stripping out dual-listed banks that already exist in the MSCI EM index, Huaxia Bank and CITIC Bank are trading below their book values, displaying relatively cheap valuations. Looking at profitability, three regional banks top the earnings profile: Bank of Guiyang, Bank of Ningbo, and Bank of Nanjing, while the two "cheapest" banks, Huaxia and CITIC, display the lowest ROE (Charts 2A & 2B). From a profitability versus valuation perspective, companies such as Huaxia Bank, Industrial Bank, Bank of Beijing and Pudong Development Bank offer a superior risk-reward profile (Chart 3). Bank of Guiyang and Ping An Bank report the highest net interest margins, but pay a relatively low dividend yield. On the other hand, Industrial Bank and Bank of Beijing have the lowest net interest margins, but relatively high dividend yields (Charts 4A & 4B). In terms of asset quality, Bank of Nanjing and Bank of Ningbo report the lowest NPL ratios, both under 1%, while Pudong Development Bank and Ping An Bank are at the top of the table. Meanwhile, Bank of Nanjing and Bank of Guiyang show the most robust loan growth, while Bank of Shanghai and Huaxia Bank suffer from the most sluggish loan growth (Charts 5A & 5B). Therefore, on a two-dimensional measure, we prefer Bank of Nanjing, and Bank of Guiyang (Chart 6). Screening the earnings forecast, Bank of Guiyang and Bank of Ningbo are expected to see the fastest growth in two years, while CITIC Bank and Ping An Bank will see the slowest growth (Chart 7). Diversified Financials The equally-weighted basket of 27 diversified financial companies has underperformed the MSCI EM index year to date by 26.5%, and by 27.8% over a one-year period (Table 3). Currently there are only nine diversified financial companies in the MSCI EM, with seven securities companies and two state-owned asset management companies specializing in distressed asset management. As mentioned, the inclusion of A shares will not improve brokerage fees dramatically in the near term, but this milestone event could trigger a positive outlook on market sentiment, especially for the broad A-share market, where the dominant players are retail investors. This could explain the subsector's resilient performance over the past three months. Therefore, it is reasonable to be bullish on diversified financials, with the largest securities names expecting a revenue boost in the longer term. Some pure A-share names include Shenwan Hongyuan, Guosen, and Avic Capital. Similar to banks, after stripping out dual-listed names already included in MSCI EM (CITIC, Everbright, GF, Haitong, and Huatai), Northeast Securities and Guotai Junan Securities have the cheapest valuations, while Anxin Trust seems to be the overpriced compared to its peers. Accordingly, its ROE is remarkable (Charts 8A & 8B). Taking both dimensions into account, Guotai Junan Securities and Northeast Securities display attractive risk-reward profile (Chart 9). Looking at the top line, performances diverge across various securities companies. Pacific and Guoyuan generate the highest net interest margin, while Orient and Northeast suffer from serious top-line contraction (Chart 10A). Meanwhile, Guoyuan and Anxin score the highest dividend yield, exceeding 2%, while Sinolink pays less than a 0.5% dividend yield (Chart 10B). Looking at the earnings forecast, Western Securities, AVIC Capital and Sealand Securities are expected to see the strongest bottom-line growth in 2018, while local securities companies Shanxi and Huaan rank at the bottom of the spectrum (Chart 11). Insurance The following four insurers are already constituents of the MSCI EM index: China Life, China Pacific, New China Life and Ping An. The equally weighted basket has outperformed the MSCI EM index year to date by 12.4%, and outperformed by 21.2% over a one-year period (Table 4). We will not analyze the subsector in much detail, given none of them are pure A-share companies. As such, market impact from the inclusion will not be material. EMES has been overweight Ping An's H shares since August 9, 2016.2 Industrials There are 44 companies in the industrials sector, the second-largest name count after financials. This sector is also expected to make the greatest impact on sector weights, assuming full A-shares inclusion. Stocks in the sector are split between airlines, national defense, machinery, construction and transportation. The equally weighted basket has underperformed the MSCI EM index year to date by 20.5%, and by 22.8% over a one-year period (Table 5). We believe increasing construction activity boosted by the 'One Belt, One Road' initiative will drive sales growth of construction equipment, while disputes in the South China Sea, India, Tibet and Xinjiang autonomous districts will continue to boost the defense industry. Air China, Southern Airline, China Communications Construction, China Railway Construction, China Railway Group, China State Construction Engineering, CRRC, Weichai Power, and COSCO are excluded from our analysis, as their H-listed shares are already in the MSCI EM index. Looking at valuations, the trailing P/E varies significantly across companies. Defense stocks in general are more expensive compared to other industries. By contrast, Daqin Railway stands on the lowest end of the P/E ranking, while electrical equipment companies normally display lower valuations (Chart 12A). Looking at the profitability side, Yutong Bus, one of our overweight calls, leads the ROE ranking, while Zoomlion lies on the lowest end by registering a net loss (Chart 12B). In summary, Yutong Bus, Chint Electrics, Gold Mantis and Beijing Orient Landscape will likely outperform, based on a valuation versus profitability profile comparison (Chart 13). Furthermore, the EV/EBITDA forecast for 2017 coincides with our overweight call on national defense stocks. It is worth noting that Eastern Airline would likely see unsatisfactory growth in terms of firm value (Chart 14A). Shanghai International Airport, Tus-sound Environment and Beijing Landscape rank as the top three measured by operating margin, while XCMG Construction Machine displays a negative margin, despite excavator sales in China surging year over year (Chart 14B). In terms of dividend and free cash flow, Yutong Bus and Zoomlion score highest on dividend yield, and Sany Heavy Industry, Daqin Railway, and XCMG secure highest free cash flow yield. On the other hand, Sany and other (check) defense stocks generate the least in dividend yields, and more than half of the companies post negative free cash flow yield (Charts 14C & 14D). Investors should be cautious on airline companies with negative free cash flow, such as Eastern Airline and Hainan Airline. Looking at leverage, Shanghai International Airport and AECC Aero-engine Control have the lowest debt-to-equity ratio, while Power Construction and China Eastern Airline are highly leveraged (Chart 14E). Last but not least, looking at expected growth profile, XCMG is forecast to see the highest bottom-line growth, driven by growing demand for excavators, while China Eastern Airline and Zoomlion are expected to suffer from negative growth (Chart 15). Consumer Discretionary Some 26 names from the consumer discretionary sector will be added to the MSCI EM index. Stripping out Fuyao Glass, BYD, Guangzhou Auto, and Haier, which are already included in the index, there are still six automakers and auto components manufacturers to be included. This should provide investors with enough investable stocks for an auto industry play. Furthermore, six A-share media companies will be added to the index over a one-year period (Table 6). Sector performance has been overall disappointing, with some exceptions being CITIC Guoan Information, Chinese Universe Publishing, Wanxiang Qianchao and China International Travel. Regarding valuations, CITIC Guoan Information, Suning Commerce and Alpha Group are the most expensive, with trailing P/Es surging above 50, while two automakers (SAIC and Huayu) along with a travel agency (Shenzhen Overseas Chinese Town) are relatively undervalued in the sector. From a profitability perspective, Robam Appliances and Midea Group generate solid ROE, while CITIC Guoan Information and Sunning Commerce dominate the other end of the spectrum (Charts 16A & 16B). Taking these two factors into consideration, we highlight Robam Appliances, Midea Group, and Xinhua Media as the most attractive (Chart 17) based on a risk/reward profile. Investors should be cautious on Suning Commerce, not only from a fundamental perspective but also because its acquisition of Inter Milan is unlikely to generate synergy amid the Chinese government's tightening of rules on overseas M&A in the entertainment and leisure industries. Looking at the income statement, Shenzhen Overseas Chinese Town displays robust operating performance, matching its high valuation. Robam Appliances and China South Publishing follow suit. By contrast, Suning Commerce suffers from negative margins (Chart 18A). When comparing free cash flow, Midea Group and China South Publishing register the highest yield, while Shenzhen Overseas Chinese Town, Gran Automotive Service, and CITIC Guoan Information have negative yields (Chart 18B). Meanwhile, autos and auto components manufacturers enjoy the highest dividend yields, such as SAIC Motor, Huayu Automotive System, Weifu High-Tech, and Grand Automotive Service (Chart 18C). With respect to leverage, the media industry normally displays the lowest D/E ratio, seen in firms such as China Film, Xinhua Media and China South Publishing. On the other hand, auto and auto component manufacturers as well as large retailers are highly leveraged (Chart 18D). Based on our criteria, Guoan Information and Robam Appliances are expected to see the fastest bottom-line growth, while Xinhua Media, Wanxiang Qiaochao, and Xinjiekou Dept.'s bottom lines would remain stagnant (Chart 19). Consumer Staples Currently only nine Chinese consumer staples constituents are included in the MSCI EM Index. After the inclusion, 14 more companies will be added, substantially expanding the investable universe. Two subsectors will most likely draw investors' attention: food producers such as Yili and Henan Shuanghui, as well as beverage producers, especially premium liquor producers such as Moutai, Wuliangye Yibin and Yanghe Brewery. The equally weighted basket has underperformed the MSCI EM index year to date by 19.6%, and by 11% over a one-year period (Table 7). The sector has not deviated much from the EM benchmark across the selected time horizon. In particular, premium liquor manufacturers have been the main contributor to overall sector performance. Their sales are expected to experience a seasonal peak in September and October during the Chinese mid-autumn festival and National Day. Both Wuliangye Yibin and Moutai announced robust top-line and bottom-line growth in their second-quarter financial results, largely beating market expectations. Stripping out the one dual-listed name already in the MSCI EM index (Tsingtao Brewery), Changyu Pioneer, New Hope Liuhe, and Shuanghui display attractive valuations, with trailing P/Es under 20. On the other end of the metrics, Yonghui Superstores, and Luzhou Laojiao are the most expensive (Chart 20A). Examining profitability measures, Shuanghui and Moutai top the ROE rank, while Bailian Group and Yonghui Superstores sit at the bottom of the rank (Chart 20B). Looking at risk/reward profile, it is noticeable that Shuanghui, Yili and Yanghe Brewery are well positioned (Chart 21). In terms of operations, premium liquor makers reported overall strong operating margins, led by Moutai and Yanghe Brewery, while Bailian Group and New Hope Liuhe stand at the other end of the spectrum (Chart 22A). Looking at the capex-to-sales ratio, Wuliangye and Shuanghui score the best measures, driven by strong sales with less capex. While Changyu Pioneer demonstrates a much higher ratio compared to all peers (Chart 22B), this can be partially explained by its high capex requirement, as it is the only wine maker in the sector. Nonetheless, we believe its top line is expected to be under downward pressure as the wine market in China becomes increasingly competitive, and as premium products from France, Australia, and the U.S. gain easier market access through not only traditional in-store sales but also authorized e-commerce platforms like JD.com. Similarly, free cash flow measure also indicates that Changyu Pioneer is the only liquor player that suffers from negative yield (Chart 22C). In terms of financial position, with the exception of COFCO Tunhe Sugar, all companies in the sector display reasonable levels of leverage (Chart 22D). Looking at top-line growth, sales forecasts in FY2017 are more in favor of Moutai, Dabeinong Technology, and Luzhou Laojiao, but less in favor of Bailian Group, Shuanghui, and Changyu Pioneer (Chart 23A). Moreover, when looking at bottom-line growth two years out, Luzhou Laojiao and Yonghui Superstores score the highest rankings, while Changyu Pioneer and Shuanghui are at the other end of the spectrum (Chart 23B). In summary, among food producers, we are inclined to overweight Shuanghui. Among beverage producers, we like Yanghe Brewery, and Wuliangye, but are avoiding Changyu Pioneer. What's Next? We will highlight the following sectors in part 2 of our Special Report: Materials, energy, IT, telecoms, healthcare, and real estate. Billy Zicheng Huang, Research Analyst billyh@bcaresearch.com Appendix - I Appendix - II Overweight Company Profile Underweight Company Profile 1 For the full MSCI press release, please visit: https://www.msci.com/eqb/pressreleases/archive/2017_Market_Classification_Announcement_Press_Release_FINAL.pdf 2 Please see EM Equity Sector Strategy - Investment case "China Healthcare, Getting Healthier", dated August 9, 2016, available at emes.bcaresearch.com

Special Report

Highlights The path of least resistance for steel, coal and iron ore prices is down over the next 12-24 months. China's "de-capacity" reforms in steel and coal will continue into 2018 and 2019, but the scale and pace of "de-capacity" will diminish. The Mainland's steel and coal output will likely rise going forward as new capacity using more efficient and ecologically friendly technologies come on stream. Both the steel and coal industries in China are becoming more efficient and more competitive, with low-quality output falling and high-quality supply rising. Feature Reducing capacity (also called "de-capacity") in the oversupplied commodities markets (e.g., steel, coal, cement, and aluminum) has been a key priority within China's structural supply side reforms over the past two years. The reforms were announced by President Xi Jinping in November 2015 and have focused primarily on steel and coal, and to a lesser extent on the aluminum and cement sectors. China's "de-capacity" reforms have been aiming to reduce inefficient productive capacity and low-quality output of the above mentioned commodities, as well as boost medium-to-high-quality production. The main focus of this report is to dissect China's supply side "de-capacity" reforms, and to assess their impact on steel, coal and iron ore prices. The de-capacity reforms were announced in late 2015 and, coincidentally, all major industrial commodities prices made a synchronized bottom in late 2015/early 2016 (Chart I-1). Chart I-1ASynchronized Bottom & Rally: ##br##Due To Chinese 'De-Capacity' Reforms? Chart I-1BSynchronized Bottom & Rally: ##br##Due To Chinese 'De-Capacity' Reforms? China is the largest producer and consumer of various raw materials, ranging from steel and coal to base metals. Hence, two interesting questions arise: was it the "de-capacity" reforms or other factors that caused the various raw materials to bottom in early 2016 and rally thereafter? How will China's ongoing "de-capacity" reforms affect steel, coal, and iron ore prices going into 2018 and 2019? Progress Of "De-Capacity" Reforms Three main approaches have been used by policymakers with respect to de-capacity reforms: The government sets up capacity reduction targets and then implements concrete plans to achieve these targets. The government conducts inspections to ensure the reforms are being implemented or for environmental protection purposes. The government aims to eliminate outdated capacity by setting up electricity price rules (higher electricity prices for producers with inefficient technologies) as well as ordering banks to curtail lending to those producers. In terms of timelines, the Chinese supply side "de-capacity" reforms so far have been rolled out in three phases: Phase I: Initiation and preparation phase (2015 Q4 - 2016 H1): The first phase involved policy makers drawing related policies and capacity reduction targets in the steel and coal industries. Local governments and related SOEs began implementing the so-called "de-capacity" reforms. During this period, only 30% of the 2016 capacity reduction targets for both steel and coal markets were achieved. Phase II: The accelerating implementation phase (2016 H2): The second phase included a ramp-up of "de-capacity" reforms, with over 70% of 2016 steel and coal capacity reduction targets being implemented. Meanwhile, steel production disruptions increased due to more stringent environmental rules, more frequent inspections, and government-ordered closures of low-quality steel (called "Ditiaogang" in Chinese) production in Jiangsu and Shandong provinces. Phase III: The reform-deepening phase (2017): The third phase, implemented in the first half of this year, was a clamping down on overcapacity to eliminate all illegal sub-standard steel (Ditiaogang) production and capacity by the end of June 2017. To date, the Chinese authorities have succeeded in their "de-capacity" reforms in steel and coal: both the steel and coal industries in China have become more efficient, more competitive, and have much less obsolete excess capacity: The government's plan was to reduce capacity by 100-150 million metric tons in steel and 1 billion metric tons in coal within "three to five years." This equated to a 9-13% and 18% reduction of existing 2015 Chinese capacity in steel and coal, respectively. In addition, this is equivalent to 7-9% for steel and 10% for coal of 2015's global output (Table I-1). As of August 2017, within less than two years since the beginning of the supply side reforms, 77% of the steel "de-capacity" target (or 10% of 2015 capacity) and 52% of the coal "de-capacity" target (or 7% of 2015 capacity) have been achieved (Table I-1). Table I-1Chinese Supply-Side Reform - Capacity Reduction Target And Actual Achievement With declining capacity and rising production, the capacity utilization rates (CUR) of the steel and coal industries have increased meaningfully. The National Bureau of Statistics (NBS) reported that as of the third quarter of 2017, the CUR for the steel industry has risen to 76.7% (the highest since 2013, and an increase of 4.4 percentage points from a year ago). As for the coal sector, the CUR reached 69% (the highest since 2015, and an increase of 10.6 percentage points from a year ago). With outdated and illegal production capacity exiting the marketplace, the number of companies and the number of employees have declined significantly in both the steel and coal industries (Chart I-2 and Chart I-3). Since the start of the "de-capacity" reforms, the central government has allocated 100 billion yuan (0.1% of GDP and 3.6% of central government spending) to a special fund for the relocation of employees in the coal and steel industries. Chart I-2Consolidation In Chinese Steel ##br##And Coal Sectors: Fewer Companies... Chart I-3...And Fewer Employees Higher prices for steel and coal have greatly boosted producers' profitability. From January 2016 to September 2017, the number of loss-making enterprises as a share of all enterprises has dropped from 25% to 17% in the steel industry and from 34% to 21% in the coal sector. Improving financial conditions have enhanced steel and coal companies' ability to invest in industrial upgrades (i.e., more investment in advanced technologies and new equipment). Bottom Line: Chinese "de-capacity" reforms have been successfully implemented, which has improved economic efficiency in the steel and coal industries by reducing high-cost and low-quality supply, and by increasing lower-cost and high-quality output. Understanding The Cycle In this section, we try to connect the dots between the progress of China's supply side reforms, and steel and coal prices. Chart I-4A and Chart I-4B show the fascinating dynamics among policy actions, production and prices. Chart I-4APolicy Actions And Market Dynamics: Coal Sector Chart I-4BPolicy Actions And Market Dynamics: Steel Sector Here are our major findings: (A) Except for coal, Chinese "de-capacity" reforms were not the major trigger for the price bottom in major industrial commodities in early 2016. As the period from November 2015 to June 2016 was only the initiation stage of the reforms, not much steel capacity reduction - only 1.2% of total existing 2015 capacity - occurred in the first half year of 2016. Moreover, most of the reduced capacity was outdated capacity and probably had been offline for years. Therefore, the policy driven capacity cut in the first half of 2016 was unlikely the reason for the rally in steel prices. The reasons behind the bottom in raw materials prices in general and steel in particular during the first half of 2016 were the following: 1. Production cuts in both 2015 and the first half of 2016 was market-driven. In other words, it was not government reforms but natural market forces (the dramatic drop in raw materials prices in 2015) that caused company closures and declines in various raw materials output in both 2015 and the first half of 2016 (Chart I-4A). The price recovery in the first half of 2016 was not sufficient to make most producers profitable. 2. Remarkably, the authorities injected considerable amounts of credit and fiscal stimulus in late 2015 and early 2016. As a result, demand recovery was another major trigger for the synchronized bottom in early 2016. The rise in the aggregate credit and fiscal spending impulse led to a revival in property construction, automobile production and infrastructure investment in the first half of 2016 (Chart I-5). 3. Financial/speculative demand for commodities was also a driving force behind the early 2016 price recovery. Chart I-6 illustrates that Mainland trading volumes in various commodities futures surged in the first half of 2016, and specifically in coal in the third quarter of 2016, coinciding with their respective price spikes. Chart I-5Strong Demand Recovery In 2016 Chart I-6Speculative Buying In Early 2016 All of these factors contributed to the synchronized price bottom in early 2016 and the consequent price rally in the first half of 2016, in which Chinese "de-capacity" reforms only played a minor role, especially in the steel market. (B) Chinese "de-capacity" reforms were the determining factor for the coal price spike in 2016 and steel price appreciation in 2017. Coal in 2016: "De-capacity" reforms were behind the surge in coal and coke prices throughout 2016. In February 2016, the National Development and Reform Commission (NDRC) stipulated that domestic coal mines could operate no more than 276 working days in one year, down from 330 working days in the past. This was equivalent to the immediate removal of 16% of existing operating capacity off the market. Before this decision, Chinese coal production had already declined 2.5% in 2014 and 3.3% in 2015 (Chart I-4B on page 6). On top of this decision, the government enforced a 250 million metric ton capacity cut target in the coal industry in 2016. Furthermore, actual coal capacity reduction in 2016 was 116% of that year's target (Table I-1). The end result was a 10% decline in Chinese coal production during the period of January and September of 2016 from the same period of 2015, triggering an exponential rise in both thermal coal and coking coal prices (Chart I-1 on page 2). Coking coal is mainly used for coke production, and coke is employed as a fuel in smelting iron ore in a blast furnace to produce steel. Therefore, a shortage of coking coal combined with a revival in steel production made coke the best-performing commodity last year, with its price skyrocketing by 300%. Chart I-7Diverging Prices In 2017 Towards the end of last year, the authorities realized that "de-capacity" in the coal market was too aggressive, and began loosening up coal production restrictions in September 2016. Last November the NDRC further eased policy by allowing companies to operate 330 days a year again (Chart I-4B on page 6). In response to these adjustments, thermal coal, coking coal and coke prices all peaked in December 2016/early 2017 (Chart I-1 on page 2). This reveals how Chinese supply side reforms can be a determining factor for global commodities prices. Steel prices in 2017: Steel prices have exhibited a steady rally throughout 2017, even though prices for coal, coke and iron ore all declined. There has been considerable price divergence this year between steel, on one hand, and coal, coke and iron ore, on the other. Prices for thermal coal, coking coal, coke and iron ore all peaked in late 2016/early 2017, while prices for steel continued to rise and reached a six-year high in September, expanding profit margins for steel producers (Chart I-7). The resilience of steel prices this year was because the Mainland had dismantled all "Ditiaogang" capacity by the end of June 2017, resulting in an accelerated drop in steel products production (Chart I-4A on page 6). "Ditiaogang" is low-quality steel made by melting scrap metal in cheap and easy-to-install induction furnaces. These steel products are of poor quality, and also lead to environmental degradation. "Ditiaogang" is often converted into products like rebar and wire rods. As steel produced this way is illegal, it is not recorded in official crude steel production data. However, after it is converted into steel products, official steel products production data do include it. Both falling steel products production and surging scrap steel exports entail that the "Ditiaogang" capacity elimination policy has been very effective (Chart I-8). Chart I-8The Removal Of 'Ditiaogang' Has ##br##Been Successfully Implemented As reported by the government, about 120 million metric tons per year of "Ditiaogang" capacity has been eliminated, more than double this year's steel "de-capacity" target of 50 million metric tons. A considerable portion of the 120 million metric ton "Ditiaogang" capacity was still in operation early this year when "Ditiaogang" producers enjoyed higher profit margins than large steel producers. This rapid change created a sudden squeeze on steel products supply, which consequently boosted their prices. Bottom Line: China's "de-capacity" reforms have played a major role in driving the rallies in steel prices in 2017 and in the coal markets in 2016. In short, China's supply-side reforms have been effective in shaping prices and boosting efficiency in Mainland industries by eliminating weak/inefficient producers or forcing their industrial upgrade. However, the government efforts at times have also produced large price swings, as in the case of both coal and coke. The Outlook For 2018 And 2019 Given past success and the nation's leadership adherence to reforms, China will firmly proceed with its "de-capacity" reform strategy over the next two years. However, steel and coal prices are likely to decline going forward. The most aggressive phase of "de-capacity" reforms is now behind us. The pace of capacity reduction for both steel and coal will decrease over the next two years as more than half of the 2016-2020 target has already been achieved for both sectors. Both steel and coal producers currently enjoy near-decade high profit margins, and their profits have swelled (Chart I-9A and Chart I-9B). Not surprisingly, steel and coal producers have already sped up their investment in advanced technologies to augment their capacity - by introducing ecologically friendly equipment that can produce medium- to high-end quality products. Chart I-9AStrong Profits For Steel And Coal Producers Chart I-9BRising Profit Margins For Steel And Coal Producers Importantly, the capacity swap policy introduced by the authorities has been allowing steel and coal producers to add new capacity to replace obsolete capacity at a ratio of 1:1-1.25 (the range depends on region). In short, having eliminated the inefficient/outdated capacity, producers are now allowed to add as much capacity as they had before, but using efficient technologies. This will weigh on steel and coal prices as output gains and production costs will likely be lower with new technologies. In addition, Chinese steel producers are accelerating the expansion of advanced electric furnace (EF) capacity. At 6%, current Chinese EF steel output as a share of total steel production is much lower than the same ratio for the major world steel producers and the world average (Chart I-10). The Chinese government's target is to raise the share of EF crude steel production as a share of total production to 15% by 2020. It usually takes at least 1-2 years to build a new EF plant. Hence, newly installed EF capacity will likely come into operation in 2018-'19. On the whole, this points to lower prices for crude steel and steel products. The EF steel-making process only requires scrap steel and electricity to produce crude steel. It does not need either iron ore or coke. This is negative for iron ore and coke prices. With the abundance of used cars and used home appliances in China, the domestic availability of scrap steel has significantly improved over the past few decades. In addition, electricity prices for industrial use have declined by about 5% since March 2015. Therefore, easing resource constraints (availability of scrap steel) and lower electricity costs will facilitate EF steel capacity expansion in China. Some words about the policy-driven steel production cut during the winter season. More than two dozen cities in northern China drew up detailed action plans during September and October to fight the notorious winter smog. China has set a target to reduce the level of Particulate Matter (PM) 2.5 pollution by at least 15% in cities around the Beijing-Tianjin-Hebei region between October 2017 and March 2018. The new rules will require seasonal suspensions or production cuts of steel, aluminum and cement (with the most focus on steel) during the winter heating season from November 15 to March 15. Therefore, over the next four months, downside in steel and coal prices may be limited due to support from these output cuts. This also entails less short-term demand for coke and iron ore, prices for these commodities may remain under downward pressure. Nonetheless, Chinese crude steel output is set to continue rising over the next two years, which in turn will eventually reverse the recent decline in steel products production and assure expansion in steel products production in 2018-'19 (Chart I-11). Chart I-10Chinese Electric Furnace Crude ##br##Steel Production Will Go Up Chart I-11Steel Products Output Will Soon Catch Up For coal, production will accelerate in 2018. The NDRC expects coal production capacity to rise by a net 200 million metric tons this year as increases at more "advanced" mines exceed shutdowns of outmoded facilities. This will be a 50 million metric ton gain over this year's 150 million metric ton obsolete capacity reduction target. In addition, China's coal utilization rate as of the third quarter of 2017 was still below 70%, implying substantial additional capacity remains, potentially boosting coal output, so long as the government does not alter the 330 working-day rule. Importantly, on the demand side, China is aiming to reduce coal usage for electricity generation while promoting renewable energy like hydro, nuclear, wind and solar. This constitutes a structural headwind to coal prices. This is especially significant, given than China accounts for half of global coal consumption. The supply side reforms of the past two years (shutting down inferior capacity) along with the adoption of new, more efficient technologies, has already strengthened the competitiveness of Chinese steel and coal producers. This entails that China will soon resume net exports of steel products, and that its net imports of coal will drop (Chart I-12). This is bad news for international steel and coal producers, who in the past two years have benefited from higher steel and coal prices on the back of a revival in Chinese demand, and curtailed supply. Last but not least, our broad money impulse as well as the aggregate credit and fiscal spending impulse shows that economic growth in general and demand for industrial metals in particular are set to decelerate considerably in the next nine to 12 months or so (Chart I-13). Chart I-12China May Increase Its Net Steel Exports ##br##And Decrease Its Net Coal Imports Chart I-13Demand Is Set To Decelerate Chinese steel and coal markets will determine the direction of coke and iron ore prices, both of which will likely be headed lower as well. Coke: Rising coking coal output as a result of coal production ramping up will increase coke supply sizably. As an increasing share of steel output will come from non-coke-reliant EF capacity, coke demand growth will be constrained. Iron ore: Recovering domestic iron ore production could cap China's imports of iron ore (Chart I-14). First, a marginal rise in profit margins for Chinese iron ore domestic producers and a declining number of loss-generating companies heralds modest upside for iron ore output in China (Chart I-15). Chart I-14Chinese Iron Ore Output Will Rise Chart I-15Chinese Iron Ore Producers: ##br##Marginal Rise In Profit Margins Second, more vertical integration - a rising number of Chinese steel producers that have bought iron ore mines - will result in higher domestic iron ore output. Steel companies' current fat profit margins could prompt them to boost iron ore output from the mines that they have integrated into their production chain. Although profits from iron ore production specifically are likely to be limited. This will be the case especially if the government encourages them to do so. Last year, Chinese iron ore imports accounted for 87% of national total consumption - an all-time high. The authorities dislike such great dependence on resource imports, and the government will likely introduce policies such as reducing taxes for domestic iron ore producers or other efforts to boost domestic production. Bottom Line: China's "de-capacity" reforms in steel and coal will continue into 2018 and 2019, but the scale and pace of "de-capacity" will diminish. The Mainland's steel and coal output will likely rise going forward as new capacity using more efficient and ecologically friendly technologies come on stream. The path of least resistance for steel, coal and iron ore prices is down over the next 12-24 months. Ellen JingYuan He, Editor/Strategist EllenJ@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Overstated geopolitical risks in 2017 are giving way to understated risks in 2018; The reshuffle of China's government raises policy headwinds for global growth and EM assets; U.S. politics will be roiled by a leftward turn and Trump's protectionism and foreign policy; Italian politics, more than German, is the chief threat to European risk assets; Volatility and the USD will rise; shift to neutral on European risk assets; close tactical long on Chinese Big Banks. Feature BCA's Geopolitical Strategy has operated this year on a high conviction view that geopolitical risks would be overstated, thus generating considerable upside for risk assets. Our analysis focused on three particular "red herrings": European populism, U.S. politics, and Brexit.1 Meanwhile we identified North Korea as a genuine geopolitical risk, though not one that would cause us to change our "risk on" outlook. We therefore take issue - and perhaps offense - with the contemporary narrative that "geopolitics did not matter" in a year when the S&P 500 rose by 15% and VIX plumbed historic lows (Chart 1). Stocks rose and the VIX stayed muted precisely because geopolitical risks were overstated earlier in the year. Investors who correctly assessed the balance of geopolitical risks and opportunities would have known to "buy in May and enjoy your day."2 At the same time that we encouraged investors to load up on risk this year, we cautioned that 2018 would be a challenging year.3 Three themes are now coming into focus as 2017 draws to a close: Politics has become a headwind to growth in China as Beijing intensifies deleveraging and structural reforms; U.S. fiscal and monetary policy favor the USD, which will reignite trade protectionism from Washington D.C.; Italian elections may reignite Euro Area breakup risk. In this report, we update our view on these three risks. Data out of China are particularly concerning: broad money (M3) growth has decelerated sharply with negative implications for the economy (Chart 2).4 M3 is at last ticking up but the consequences of its steep drop have not yet translated to the economy. Our message to clients since 2016 has been that the nineteenth Party Congress would mark a turning point in President Xi Jinping's tenure, that he would see his political capital replenished, and that Beijing's pain threshold would therefore rise appreciably in 2018. Hence we do not expect any new stimulus to be quick in coming or very large. Chart 1Buy In May And Enjoy Your Day Chart 2China's Money Impulse Spells Slowdown What happens in China will not stay in China. Signs of cracks are emerging in the buoyant global growth narrative (Chart 3), with potentially serious consequences for emerging markets (EM) (Chart 4).5 Chart 3Signs Of Cracks Forming Chart 4EM Manufacturing: Rolling Over China: Ramping Up For The New Year Crackdown The aftermath of the Communist Party's nineteenth National Party Congress is unfolding largely as we expected: with a reboot of President Xi Jinping's reform agenda. Chinese economic data are starting to reflect the consequences of tighter policy since late last year (Chart 5), and BCA's China Investment Strategy has shown consumer-oriented sectors outperforming industrials and materials since the party congress, as the reform drive would have one expect.6 China's policymakers have already allowed the monetary impulse - the rate of growth in the supply of money - to slow to the lowest levels in recent memory. This bodes ill for Chinese imports and base metal prices (Chart 6), as BCA's Emerging Market Strategy has emphasized.7 Chart 5Expect More Disappointments From China Chart 6Chinese Imports And Base Metals At Risk It is true that policymakers will re-stimulate the economy when they reach their pain threshold, but with Xi Jinping's political capital replenished and the party and state unified under him, we expect that threshold to have moved higher than financial markets expect. Yes, the government will try to prevent its policies from being highly disruptive and destabilizing - as with the People's Bank of China injecting liquidity to ease rapidly rising bond yields (Chart 7) - but the bottom line is that it is pressing forward with tightening. How can we be so sure that this policy trajectory is set? The initiatives in the early stages of implementation after the congress confirm our view that the central government is hardening the line on several key economic-political fronts: Financial regulatory overhaul: People's Bank Governor Zhou Xiaochuan has made a series of dire comments about China's financial risks and the danger that it is reaching a "Minsky Moment," or accumulation of risks that will end in a catastrophe.8 Zhou's likeliest replacements are both financial reformers, and one of them, Guo Shuqing, is the hawkish regulator who has led the crackdown on shadow lending this year (Chart 8). Moreover, whoever heads the central bank will have the benefit of new financial oversight capabilities. The Financial Stability and Development Commission (FSDC), a new entity charged with coordinating the country's various financial regulatory agencies, has just held its first meeting. Its inaugural chairman, Vice-Premier Ma Kai, is likely to retire soon, but rumors are swirling that his replacement will be Liu He, President Xi's top economic thinker and a reformist, who wrote an ominous article about excessive leverage in the People's Daily in May 2016 and has now made it onto the Politburo. If Liu He takes charge, given his very close relationship with Xi, the FSDC will be irresistible. If not, the FSDC will still be effective, judging by the fact that Ma Kai's replacement will likely be someone, like Ma, who sits on both the Politburo and State Council. Chart 7China's Bond Yields Rising Sharply Chart 8Shadow Banking Has Peaked Local government crackdown: Local government officials in two cities in Inner Mongolia have canceled urban metro projects due to excessive debt, reportedly under orders from the central government. Other cities in other provinces have suggested that approvals for such projects are being delayed.9 In other words, the central government is no longer endlessly accommodating debt-financed local government projects, even projects that support priority goals like urbanization and interior development. This news, so soon after the party congress, is likely to be the tip of the iceberg, which suggests that local government spending cannot be assumed to shake off its weakening trend anytime soon (Chart 9). Top officials pointed out local government leverage as a systemic risk, along with shadow banking, at the National Financial Work Conference in July, and both the outgoing finance minister and the outgoing central bank chief have called for reining in local governments. The latter's comments were formally endorsed by being included in the Communist Party's official "party congress study guide," suggesting that they are more than just the parting advice of a soon-to-be retiree. Property tightening: China's real estate sector, which provides 22% of investment in the country, is feeling the squeeze from financial tightening and targeted measures to drive out speculation since October 2016 (Chart 10). More, not less, of a squeeze is expected in both the short and long term. In the short term, inspections of commercial housing for corruption and speculative excesses could exert an additional dampening effect. In the medium and long term, the Xi administration plans to roll out a nationwide property tax, according to Huang Qifan, an economic policymaker tied to the legislature, "in the near future, not ... 10-20 years. It could happen in the next several years."10 The tax was delayed in 2016 amid economic turmoil. A national property tax would be an important fiscal reform that would tamp down on the asset bubble, rebalance the growth model, and enable the government to redistribute wealth from multiple homeowners to lower income groups. Chart 9Local Government Spending Is Weak Chart 10Property Tightening Continues Industrial restructuring: Environmental curbs on outdated and excess industrial capacity are continuing. Although China aggressively cut overcapacity in coal, steel and other sub-sectors over the past twelve months, it continues to face larger overcapacity than other economies (Chart 11), particularly in glass, cement, chemical fertilizers, electricity generation and home construction. It is also possible that SOE restructuring will become more aggressive. Currently, SOEs listed on the Shanghai exchange are rallying relative to the A-share market, as they have tended to do when the Communist Party reaffirms its backing of the state sector (Chart 12). However, announcements of SOE reforms in this administration have also triggered phases of under-performance. SOEs targeted for reforms face greater scrutiny of their finances and operations.11 Moreover, any SOE is vulnerable to the new wave of the anti-corruption campaign.12 National Supervision Commission: The new anti-corruption czar, Zhao Leji, will be a very influential figure if he is even to hold a candle to his predecessor, Wang Qishan. Zhao is to oversee the creation of a nationwide anti-corruption system that targets not only the Communist Party, as before, but every public official. The new commission will have branches at each level of administration (city, province, central government) and will combine the various existing anti-corruption agencies under one head. The purpose is not merely to root out political enemies (as administration critics, with some justice, would argue) but also to improve the effectiveness of policy implementation and address public grievances that threaten to undermine the regime. The latest environmental curbs have shown that employing anti-corruption teams to help enforce broader economic policy can be highly effective. Xi and Zhao Leji look set to extend this practice to state ministries, including financial regulators.13 It is not clear whether they will succeed in rebuilding the regime's legitimacy in public eyes, but in the short term an initiative like this should send a chilling effect throughout the state bureaucracy, similar to that which occurred among local government party chiefs in 2014 after the initial anti-corruption campaign was launched.14 Chart 11Overcapacity Still A Problem For China Chart 12SOEs Preserved, But Face Reforms In short, preparations are under way for Xi's second five-year term in office. (Perhaps not his last term, as the party congress also made clear.)15 New agencies and personnel suggest that the administration is embarking on an intensification of policy tightening. Tougher policy is viewed as necessary, not optional: top leadership has repeatedly stated that a lack of action on systemic threats will lead to regime-threatening crises down the road.16 Chart 13China's Impact On Global Growth How will this agenda impact the rest of the world? Our colleagues at China Investment Strategy hold that China may step up reforms but will not do so in a way that will negatively impact China's imports or key assets like base metal prices.17 However, from a political perspective, we view the combination of Xi's political capital with the new financial and anti-corruption commissions as likely to increase policy effectiveness to an extent that causes banks to lend less eagerly and local governments and SOEs to err on the side of less borrowing and spending. This will reduce demand for imports and commodities and will also raise the tail-risk of excessive tightening. China's contribution to global growth had fallen over the years, but has recently rebounded on the back of stimulus in 2015-16 (Chart 13). As such, it will not take much of a drag on import growth in 2018 to have a global impact. The most exposed commodity exporters to China (outside of oil) are Brazil, Chile and Peru (with Indonesia and South Africa also at risk), while the most exposed exporters of capital goods are Taiwan and South Korea, followed by Southeast Asia (the Philippines, Malaysia, Vietnam and Thailand). Looking at the China-exposed countries whose stocks rallied the most while China stimulated in 2016, the prime candidates for a negative impact in 2018 will be Brazil and Peru, and less so Hungary and Thailand. Bottom Line: The Xi administration is rebooting its reform agenda and has a higher tolerance for pain than the market yet realizes. Centralization, deleveraging and industrial restructuring have been deemed necessary to secure the long-term stability of the regime. China's policy risks are understated and the next wave of stimulus will not be as rapidly forthcoming as financial markets expect. U.S.: Trouble In (GOP) Paradise Markets have rallied throughout the year despite a lack of policy initiatives from the U.S. Congress. Judging by the performance of highly taxed S&P 500 equities, the rally this year has not been about the prospects of tax reform (Chart 14).18 Rather, markets have responded to strong earnings data and a lack of policy initiatives. Wait, what? Yes, markets have rallied because nothing has been accomplished. Investors just want President Trump and the Republican-held Congress to maintain a pro-business regulatory stance (Chart 15) and not do anything anti-corporate. Doing nothing is just fine. Chart 14Market Has Doubted Tax Reform Chart 15Market Has Cheered De-Regulation Here Come The Socialists Dems The Democratic Party leads the 2018 generic Congressional vote polling by 10.8%, up from 5.9% in May (Chart 16). The generic ballot polling is notoriously unreliable as most U.S. electoral districts are politically designed to be safe seats - "gerrymandered" - and as such are unlikely to respond to nation-wide polling (Chart 17). However, Republican support has fallen and Democratic candidates have performed extremely well this year. Chart 16U.S. Public Leans Democratic Chart 17Electoral System Reduces Competition First, candidates for governor in Virginia and New Jersey have outperformed their polling in November elections. Second, in the four special elections this summer, Democrats narrowed Republican leads by 18%. If the electoral results from Table 1 are replicated in 2018, Republicans could face a massacre in the House of Representatives. In addition, Republicans are suddenly vulnerable in Alabama, where the anti-establishment Senate candidate, and Breitbart-endorsee, Roy Moore is struggling with accusations of pedophilia (Chart 18). Table 12017 Special Elections Are Ominous For The GOP Chart 18Republican Senate Majority May Lose A Seat Why should investors fear a Democratic takeover of the House of Representatives? Yes, the odds of impeachment proceedings against President Trump would rise, but we are on record saying that investors should fade any impeachment risk to assets.19 The greater risk is that the Democratic Party has turned firmly to the left with its new manifesto, "A Better Deal." A strong performance by unusually left-of-center Democratic candidates could spook financial markets that have been lulled into complacency by the lack of genuine populism from the (thus far) pluto-populist president. Protectionism While most investors are focused on the ongoing NAFTA negotiations - which we addressed in last week's Special Report20 - we would draw attention again to the shift towards protectionism by the Republicans in the Senate. Normally a bastion of pro-business free-traders, the Senate has turned to the left on free trade. Senator John Cornyn (R, Texas) has introduced a bill to make significant reforms to the process by which the United States reviews foreign investments for national security, led by the Committee on Foreign Investment in the United States (CFIUS). Two further bills, one in the House and another in the Senate, would also significantly tighten access to the U.S. by foreign investors. China is foremost in their sights. In early 2018, investors will also be greeted by two significant decisions. First, on tariffs: Trump will have to decide on January 12 and February 3 whether to impose tariffs on solar panels and washing machines, respectively, under Section 201 of the U.S. Trade Act of 1974. The International Trade Commission has already determined that imports of these goods can cause material injury to U.S. industries, so Trump merely has to decide whether to impose tariffs (likely from 35% to 50%), import quotas (which have never received limits from courts), or bilaterally negotiated export limitations from trade partners.21 The consequences would go beyond the current, country-specific tariffs on these items, setting a precedent that would expose a wide range of similar imports to punitive action, and more broadly would signal to the world that the U.S.'s protectionist turn under Trump is real.22 Second, the White House has allegedly completed a comprehensive review of China policy under way since June.23 The review is said to focus on economic rather than strategic matters and to call for the use of punitive measures to insist that China alter tactics long complained about by the United States, including intellectual property theft, export subsidies, and forced tech transfer from joint ventures in China. Already the U.S. is investigating China for intellectual property theft under Section 301 of the 1974 Trade Act, with results that could prompt tariffs no later than August 2018.24 As if on cue, Wang Yang, a new inductee on China's Politburo Standing Committee and a prominent reformer, wrote an editorial in the People's Daily declaring that China should protect intellectual property, not require tech transfers, and give foreign firms equal treatment under the "Made in China 2025" plan.25 China has made similar promises and the U.S. has made similar threats many times before, so decisions in the coming months will be telling. Ultimately we fear that President Trump may feel compelled to ratchet up protectionism in 2018 for two reasons. First, Americans within his populist base will grow restless as they do the math on the tax legislation and realize that their champion is not quite the populist they voted for. Trump will need to re-convince them of his protectionist credentials and independence from Washington elites and the policy status quo. Second, if our view on Chinese slowdown and American fiscal thrust is correct, the USD bull market should restart in 2018. This would hurt U.S. export competitiveness, expand the trade deficit, and motivate U.S. companies to invest abroad, a paradox of President Trump's tax and fiscal policy. The White House may, therefore, be compelled to reach for mercantilist solutions to an FX problem. Foreign Policy The final reason to worry is a "Lame Duck" presidency. Far more predictable presidents sought relevancy abroad late in their mandate. For example, President George H. W. Bush committed troops to Somalia on his way out of the White House. President Bill Clinton bombed Yugoslavia. Given Trump's dismal approval polling and a potentially historic "wave" election for the Democrats in November, President Trump could similarly shift focus to geopolitics. If that shift includes confronting regional powers like China (and/or North Korea), or Iran, risk premiums may rise. In the meantime, we expect tax cuts to pass. The going is getting tougher in the Senate. The decision to include the repeal of the Obamacare individual mandate - designed to cut another $300 billion in government spending over the next ten years - will make it more difficult to secure 51 Senate votes. We maintain our view that the final legislation may need until Q1 to pass. Between now and then, legislators may need a failure or two in order to realize that the clock is ticking toward the midterms. Bottom Line: Markets have cheered lack of action from the Congress. However, the going will get tougher in 2018 as investors fret about protectionism, President Trump's itch to remain relevant, and a potential takeover of the House by the most left-of-center Democratic Party in a generation. Europe: Germany Is A Passing Risk, Focus On Italy The collapse of coalition talks in Germany is not a structural concern for Europe. The breakdown in the negotiations occurred because of the immigration debate, in which the right-of-center Christian Social Union (CSU) and the Free Democratic Party (FDP) struck out a different position from the ruling Christian Democratic Union (CDU) and the liberal Green Party. Of course, the disagreement is not about immigration today, given that inflows of asylum seekers this year has been well below past flows (Chart 19A). Rather, the fundamental disagreement is over how the CDU and its leader Angela Merkel handled the 2015 migration crisis and how it will be handled in the future. Chart 19ANo Immigration Crisis Today Chart 19BGermans Love Europe For investors, what matters is that there is no substantive disagreement over the EU, European integration, or Germany's role in it. The mildly euroskeptic FDP did not draw any red lines. The reason is obvious: the German euroskeptic constituency is small, shrinking, and largely already captured by the Alternative for Germany (AfD) anti-establishment party (Chart 19B). Germans are objectively the most europhile people in Europe. Going forward, a new election would cause further political uncertainty. On the margin, it could cause business confidence to stall. However, Germany runs a 14 billion euro budget surplus and is not expected to launch any structural reforms or fundamental economic changes. As such, if the formation of a government is delayed by three-to-six months, the economic implications will be fleeting. In fact, the result of a new election could be a Grand Coalition between the CDU and Socialists, which would be positive for European integration. However, as we have argued before, hopes for a significant restart of integration have probably run ahead of reality.26 For us, Italy is the immediate concern. Italy passed a new electoral law in late October, setting the stage for the election due by May 2018. The consensus in the news media is that the president will call elections in January, with the vote taking place sometime in March.27 The consensus is that the new law will make it more difficult for the populist Five Star Movement (M5S) to win a majority of seats in the Italian Parliament. In addition, it will give a lift to the parties with strong regional ties - such as the governing Democratic Party (PD) and Lega Nord. Chart 20Italy Set For A Hung Parliament The nuances of the new law are largely irrelevant, however, given the close polling of the three electoral blocs. The most likely outcome will be a hung parliament (Chart 20). Nonetheless, we can still learn something from the law: the Italian establishment parties are cooperating to subvert the electoral chances of M5S. The ruling PD and the center-right Forza Italia of former Prime Minister Silvio Berlusconi are working together to design an electoral system that favors the pre-election norm of coalition-building and parties with strong regional representation. Neither of these factors fits M5S's profile. This suggests that the two centrist blocs will be able to put together an establishment coalition following the election. On one hand, this will give stability to the Euro Area for at least the duration of that government. On the other hand, the underlying data continues to point to structural euroskepticism in Italy. Unlike their European peers, Italians seem to be flirting with overt euroskepticism. When it comes to support for the common currency, Italians are clear outliers, with support levels around 55% (Chart 21). Similarly, over 40% of Italians appears to be confident in the country's future outside the EU (Chart 22). These are ominous signs for the future. Still, both M5S and the mildly euroskeptic Lega Nord have tempered their demands for an exit from the common currency union. The official stance of the M5S is that the exit from the Euro Area is only "option B," that is, an option if the bloc is not reformed. Meanwhile, Lega Nord is on record opposing a referendum on membership in the currency union because it is illegal.28 Chart 21Italians Stand Out For Distrust Of Euro Chart 22Italians Not Enthusiastic About EU The stance of Italy's euroskeptics will change as soon as it is convenient. The country's establishment is likely making a mistake by contemplating a grand coalition alliance. Unless such a government develops a serious plan for painful structural reforms - it will not - it will likely waste its mandate and fall at the first sign of recession or crisis. At that point, the only alternative will be the M5S, which will stand alone in opposition to such an ineffective government. Investors can therefore breathe a sigh of relief in the medium term. Italy will likely not be a source of risk-off in 2018 or even 2019, although it is still the main risk in Europe for next year and bears monitoring. However, in the long term, we maintain that Italy will be a catalyst for a serious global risk-off episode within the next five years. We remain optimistic that such a crisis will ultimately strengthen Italy's commitment to the Euro Area, as we outlined in a recent Special Report.29 But that is a low conviction view that will require constant monitoring. Could there be another scenario? Several clients have asked us if an Emmanuel Macron could emerge in Italy? Our answer is that there already was an Emmanuel Macron: Matteo Renzi, the former prime minister and current PD leader, was Macron before Macron. And yet he failed to enact significant structural and constitutional reforms. Yet two potential candidates may be ready to swoop in from the "radical center" position that Renzi and Macron characterize. The first is ECB President Mario Draghi. He is widely respected in Italy and is seen as someone who not only allayed the Euro Area sovereign debt crisis, but also stood up to German monetarist demands in doing so. The second is Fiat-Chrysler CEO Sergio Marchionne, one of the world's most recognizable business leaders and a media star inside and outside Italy. If the centrist coalition begins to fray by the end of 2019, both of these individuals may be available to launch a star-studded campaign to "save Italy." Bottom Line: We remain cautiously optimistic about the upcoming Italian elections. While our baseline case is that Italian elections will produce a weak and ineffective government, though crucially not a euroskeptic one, nevertheless risks abound and require monitoring. Investment Implications There are a lot of unknowns heading into 2018. What will become of U.S. tax cuts? How deep will the policy-induced slowdown become in China? What will President Trump do if he becomes the earliest "Lame Duck" president in recent U.S. history? Will he embark on military or protectionist adventures abroad? Asset implications are unclear, but we offer several broad takeaways. First, the VIX will not stay low in 2018. Second, the USD should rally. Both should happen because investors are far too complacent about the Fed's pace of hikes and because of potential global growth disappointments as Beijing tinkers with the financial and industrial sectors. Chart 23AEuro Area Versus U.S. Growth: Don't Ignore China (I) Chart 23BEuro Area Versus U.S. Growth: Don't Ignore China (II) Third, it is time to close our recommendation to be overweight European risk assets. European equities have a higher beta to global growth due to the continent's link to Chinese demand. As our colleague Mathieu Savary has pointed out, when Chinese investment slows, Europe feels it more acutely than the U.S. (Chart 23). Chart 24U.S. Dollar Rebound = EM Pullback We are also closing our tactical long position on China's big banks versus its small-to-medium-sized banks. This position has been stopped out at a loss of 5%, despite the riskier profile of the latter banks and the fact that their non-performing loans are rising. Faced with these challenges, Beijing decided to open the door to foreign investment and too ease regulations on these banks so that they can lend to small cap companies as part of the reform drive. These actions inspired a rally relative to the Big Banks that worked against our trade. As financial tightening will continue, however, we expect this rally to be short-lived, and for big banks to benefit from state backing. Our highest conviction view is that it is time to short emerging markets. Our two core views - that politics will become a tailwind to growth in the U.S. and a headwind to growth in China - should create a policy mix that will act as a headwind to EM (Chart 24). The year 2017 may therefore turn out to have been an anomaly. Emerging markets outperformed as China aggressively stimulated in 2016 and as both the U.S. dollar and bond yields declined. This mix of global fiscal and liquidity conditions proved to be a boon for EM, giving it a liquidity-driven year to remember. That year is now coming to an end. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day," dated April 26, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 4 China's official broad money (M2) measure has also sharply decelerated, as have all measures of China's money. We prefer BCA's Emerging Market Strategy's broader M3 measure. The official M2 has underestimated the amount of new money in China because banks and shadow banks have done extensive off balance sheet lending. The M3 measure includes bank liabilities excluded from M2, it is calculated by taking the total of non-financial institution and household deposits, plus other financial corporation deposits, and other liabilities. Please see BCA Emerging Market Strategy, "Ms. Mea Challenges The EMS View," dated October 19, 2017, available at ems.bcaresearch.com. 5 Please see BCA Foreign Exchange Strategy Weekly Report, "Temporary Short-Term Risks," dated November 10, 2017, available at fes.bcaresearch.com and BCA Emerging Markets Strategy Weekly Report, "EM: Cracks Are Appearing," dated November 15, 2017, available at ems.bcaresearch.com. 6 Please see BCA China Investment Strategy Weekly Report, "Messages From The Market, Post-Party Congress," dated November 16, 2017, available at cis.bcaresearch.com. 7 Please see BCA Emerging Markets Strategy Special Report, "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017, available at ems.bcaresearch.com. 8 Zhou's comments should not be interpreted merely as a farewell speech of a retiring central bank governor, since they echo the general policy shift in the administration since December 2016's Central Economic Work Conference, and April 2016's Politburo meeting, toward tackling financial risk. For Zhou's comments, please see "China's central bank chief lays out plans to avert future financial crisis," South China Morning Post, November 4, 2017, available at www.scmp.com. 9 Xianyang in Shaanxi, and Wuhan in Hubei. Please see Wu Hongyuran and Han Wei, "Another City Halts Subway Projects Amid Financing Concerns," Caixin, November 13, 2017, available at www.caixinglobal.com. 10 Please see Kevin Yao, "China central bank adviser expects less forceful deleveraging in 2018," Reuters, November 15, 2017, available at www.reuters.com. 11 The latest official announcement claims that an additional 31 SOEs will be listed for restructuring. Please see "More SOEs to be included in reform plan," People's Daily, November 16, 2017, available at en.people.cn. 12 We fully expect SOEs to be subjected to rigorous treatment from the National Supervision Commission. Note that the crackdown on overseas investment earlier this year merely touches the tip of the iceberg in terms of the SOE corruption that could be revealed by probes. See, for example, the following report on the National Audit Office's public notice on SOE fraud and irregularities, "20 Central Enterprises Overseas Investment Audit Revealed A Lot Of Problems," Pengpai News (Shanghai), June 26, 2017, available at news.163.com. 13 Please see BCA Geopolitical Strategy Special Report, "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017, available at gps.bcaresearch.com. 14 Please see BCA China Investment Strategy Weekly Report, "Policy Mistakes And Silver Linings," dated October 7, 2015, and "Legacies Of 2014," dated December 17, 2014, available at cis.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 16 Xi Jinping has called financial security an important part of national security and declared that "safeguarding financial security is a strategic and fundamental task in the economic and social development of our country." Please see Wang Yanfei, "Leaders aim to fend off financial risks," China Daily, April 26, 2017, available at www.chinadailyasia.com. For Zhao Leji's post-congress comments on this topic in the People's Daily, please see "China faces historic corruption battle, new graft buster says," The Guardian, November 11, 2017, available at www.theguardian.com. 17 See footnote 6. 18 More anecdotally, a clear majority of our clients disagrees with our bullish prospects of tax cuts. 19 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 21 Please see Chad P. Bown, "Donald Trump Now Has The Excuse He Needs To Open The Floodgates Of Protectionism," Peterson Institute of International Economics, October 9, 2017, available at piie.com. 22 Other measures could follow thereafter. For instance, the Commerce Department will issue its final report on steel and aluminum in January and Trump could decide to take punitive actions on these goods under Section 232 of the 1962 Trade Expansion Act. Please see Ana Swanson, "Democrats Pressure Trump to Fulfill Promise to Impose Steel Tariffs," New York Times, October 26, 2017, available at www.nytimes.com. 23 The review itself began in June, around the time when Trump's and Xi's initial "100-day plan" to improve trade relations expired. The report that the review is completed is from Lingling Wei et al, "Beyond Trump-Xi Bond, White House Looks to Toughen China Policy," Fox Business News, November 19, 2017, available at www.foxbusiness.com. See also Adam Behsudi et al, "White House conducting wide-ranging review of China policy," Politico, September 28, 2017, available at www.politico.com. 24 The U.S. Trade Representative Robert Lighthizer is supposed to finish his investigation into intellectual property under Section 301 of the 1974 Trade Act within a year of August 18, 2017. Please see Gary M. Hnath and Jing Zhang, "Trump Administration Initiates Section 301 Investigation of China's Acts, Policies and Practices Related to Technology Transfer, Intellectual Property and Innovation," dated August 25, 2017, available at www.lexology.com. 25 Please see "Chinese vice premier pledges fair treatment of foreign firms as China opens up," Reuters, November 10, 2017, available at www.reuters.com. 26 Please see BCA Geopolitical Strategy Weekly Report, "Stick To The Macro(n) Picture," dated May 10, 2017, available at gps.bcaresearch.com. 27 Just in time to get a new government in place ahead of the World Cup! Oh wait... Too soon? 28 Which is an odd position to take given their supposed anti-establishment orientation. For example, the U.K. referendum on EU membership was non-binding, and yet it took place and had relatively binding political consequences. 29 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com.

Special Report

Mr. X is a long-time BCA client who visits our offices toward the end of each year to discuss the economic and financial market outlook. This year, Mr. X introduced us to his daughter, who we shall identify as Ms. X. She has many years of experience as a portfolio manager, initially in a wealth management firm, and subsequently in two major hedge funds. In 2017, she joined her father to help him run the family office portfolio. She took an active role in our recent discussion and this report is an edited transcript of our conversation. Mr. X: As always, it is a great pleasure to sit down with you to discuss the economic and investment outlook. And I am thrilled to bring my daughter to the meeting. She and I do not always agree on the market outlook and appropriate investment strategy, but even in her first year working with me she has added tremendous value to our decisions and performance. As you know, I have a very conservative bias in my approach and this means I sometimes miss out on opportunities. My daughter is more willing than me to take risks, so we make a good team. I am happy that our investment portfolio has performed well over the past year, but am puzzled by the high level of investor complacency. I can't understand why investors do not share my concerns about by sky-high valuations, a volatile geopolitical environment and the considerable potential for financial instability. Over the years, you have made me appreciate the power of easy money to create financial bubbles and also that market overshoots can last for a surprisingly long time. Thus, I am fully aware that we could easily have another year of strong gains, but were that to happen, I would worry about the potential for a sudden 1987-style crash. I remember that event well and it was an unpleasant experience. My inclination is to move right now to an underweight equity position. Ms. X: Let me add that I am delighted to finally attend the annual BCA meeting with my father. Over the years, he has talked to me at length about your discussions, making me very jealous that I was not there. He and I do frequently disagree about the outlook so it will be good to have BCA's independent and objective perspective. As my father noted, I do not always share his cautious bias. When I joined the family firm in early 2017, I persuaded him to raise our equity exposure and that was the right decision. I have been in the business long enough to know that it is dangerous to get more bullish as the market rises and I agree there probably is too much complacency. However, I do not see an early end to the conditions that are driving the bull market and I am inclined to stay overweight equities for a while longer. Thus, the big debate between us is whether or not we should now book profits from the past year's strong performance and move to an underweight stance in risk assets. Hopefully, this meeting will help us make the right decision. Chart 1An Impressive Bull Market BCA: First of all, we are delighted to see you both and look forward to getting to know Ms. X in the years to come. It is not a surprise that you are debating whether to cut exposure to risk assets because that question is on the mind of many of our clients. We share your surprise about complacency - investors have been seduced by the relentless upward drift of prices since early 2016. The global equity index has not suffered any setback above 2% during the past year, and that has to be close to a record (Chart 1). The conditions that have underpinned this remarkable performance are indeed still in place but we expect that to change during the coming year. Thus, if equity prices continue to rise, it would make sense to reduce exposure to risk assets to a neutral position over the next few months. A blow-off phase with a final spike in prices cannot be ruled out, but trying to catch those moves is a very high-risk strategy. We are not yet recommending underweight positions in risk assets, but if our economic and policy views pan out, we likely will shift in that direction in the second half of 2018. Ms. X: It seems that you are siding with my father in terms of wanting to scale back exposure to risk assets. That would be premature in my view and I look forward to discussing this in more detail. But first, I would be interested in reviewing your forecasts from last year. BCA: Of course. A year ago, our key conclusions were that: A number of important regime shifts will impact the economic and investment outlook over the next few years. These include the end of the era of falling inflation and interest rates, a move away from fiscal conservatism, a policy pushback against globalization, and a rise in the labor share of income at the expense of profit margins. Together with an earlier regime shift when the Debt Supercycle ended, these trends are consistent with very modest returns from financial assets over the next decade. The failure of low interest rates to trigger a vigorous rebound in private credit growth is consistent with our end-of-Debt Supercycle thesis. The end point for dealing with high debt levels may ultimately be sharply higher inflation, but only after the next downturn triggers a new deflationary scare. The potential for trade restrictions by the incoming U.S. administration poses a threat to the outlook, but the odds of a global trade war are low. Time lags in implementing policy mean that the fiscal plans of President-elect Trump will boost U.S. growth in 2018 more than 2017. This raises the risk of an overheated economy in 2018 leading to a monetary squeeze and recession in 2019. The key issue will be whether the supply side of the economy expands alongside increased demand and it will be critical to monitor business capital spending. Lingering structural problems will prevent any growth acceleration outside the U.S. The euro area and emerging economies are still in the midst of a deleveraging cycle and demographics remain a headwind for Japan. Not many countries will follow the U.S. example of fiscal stimulus. Nevertheless, for the first time since the recovery began, global growth forecasts are likely avoid a downgrade over the next couple of years. China remains an unbalanced and fragile economy but the authorities have enough policy flexibility to avoid a hard landing, at least over the year or two. The longer-run outlook is more bearish unless the government moves away from its stop-go policy approach and pursues more supply-side reforms. Inflation has bottomed in the U.S., but the upturn will be gradual in 2017 and it will stay subdued in the euro area and Japan. Divergences in monetary policy between the U.S. and other developed economies will continue to build in 2017 as the Fed tightens and other central banks stay on hold. Unlike a year ago, the Fed's rate expectations look reasonable. Bond yields in the U.S. may fall in the near run after their recent sharp rise, but the cyclical trend is up against a backdrop of monetary tightening, fiscal stimulus and rising inflation. Yields in the euro area will be held down by ongoing QE, while the 10-year yield will stay capped at zero in Japan. The secular bull market in bonds is over although yields could retest their recent lows in the next downturn. The search for yield will remain an important investment theme, but rich valuations dictate only a neutral weighting in investment-grade corporate bonds and a modest underweight in high-yielders. The U.S. equity market is modestly overvalued but the conditions are ripe for an overshoot in 2017 given optimism about a boost to profits from the new administration's policies. Earnings expectations are far too high and ignore the likelihood that rising labor costs will squeeze margins. Nevertheless, that need not preclude equity prices moving higher. There is a good chance of a sell-off in early 2017 and that would be a buying opportunity. Valuations are better in Japan and several European markets than in the U.S. and relative monetary conditions also favor these markets. We expect the U.S. to underperform in 2017. We expect emerging markets to underperform developed markets. The oil price should average around $55 a barrel over the next one or two years, with some risk to the upside. Although shale production should increase, the cutbacks in oil industry capital spending and planned production cuts by OPEC and some other producers will ensure that inventories will have to be drawn down in the second half of 2017. Non-oil commodity prices will stay in a trading range after healthy gains in 2016, but the long-run outlook is still bearish. The dollar bull market should stay intact over the coming year with the trade-weighted index rising by around 5%. Relative policy stances and economic trends should all stay supportive of the dollar. The outlook for the yen is especially gloomy. A stabilization in resource prices will keep commodity prices in a range. We remain bearish on EM currencies. The biggest geopolitical risks relate to U.S.-China relations, especially given President-elect Trump's inclination to engage in China-bashing. Meanwhile, the defeat of ISIS could create a power vacuum in the Middle East that could draw Turkey into a disastrous conflict with the Kurds and Iran/Russia. The coming year is important for elections in Europe but we do not expect any serious threat to the EU or single currency to emerge. The most important prediction that we got right was our view that conditions were ripe for an overshoot in equity prices. The MSCI all-country index has delivered an impressive total return of around 20% in dollar terms since the end of 2016, one of the best calendar year performances of the current cycle (Table 1). So it was good that your daughter persuaded you to keep a healthy equity exposure. It is all the more impressive that the market powered ahead in the face of all the concerns that you noted earlier. Our preference for European markets over the U.S. worked out well in common currency terms, but only because the dollar declined. Emerging markets did much better than we expected, with significant outperformance relative to their developed counterparts. Table 1Market Performance With regard to the overall economic environment, we were correct in forecasting a modest improvement in 2017 global economic activity and that growth would not fall short of the IMF's predictions for the first time in the current expansion. However, one big surprise, not only for us, but also for policymakers, was that inflation drifted lower in the major economies. Latest data show the core inflation rate for the G7 economies is running at only 1.4%, down from 1.6% at the end of 2016. We will return to this critical issue later as the trend in inflation outlook will be a key determinant of the market outlook for the coming year and beyond. Regionally, the Euro area and Japanese economies registered the biggest upside surprises relative to our forecast and those of the IMF (Table 2). That goes a long way to explaining why the U.S. dollar was weaker than we expected. In addition, the dollar was not helped by a market downgrading of the scale and timing of U.S. fiscal stimulus. Nonetheless, it is worth noting that the dollar has merely unwound the 2016 Trump rally and recently has shown some renewed strength. Table 2IMF Economic Forecasts A year ago, there were major concerns about potential political turmoil from important elections in Europe, the risk of U.S.-led trade wars and a credit bust-up in China. We downplayed these issues as near-term threats to the markets and that turned out to be appropriate. Nevertheless, there are many lingering risks to the outlook and market complacency is a much bigger concern now than it was a year ago. Mr. X: As you just noted, a key theme of your Outlook last year was "Shifting Regimes" such as the end of disinflation and fiscal conservatism, a retreat from globalization, and the start of a rebalancing in income shares away from profits toward labor. And of course, you talked about the End of the Debt Supercycle a few years ago. Do you still have confidence that these regime shifts are underway? BCA: Absolutely! These are all trends that we expect to play out over a number of years and thus can't be judged by short-term developments. There have been particularly important shifts in the policy environment. The 2007-09 economic and financial meltdown led central banks to fight deflation rather than inflation and we would not bet against them in this battle. Inflation has been lower than expected, but there has been a clear turning point. On fiscal policy, governments have largely given up on austerity against a background of a disappointingly slow economic recovery in recent years and rising populist pressures (Chart 2). The U.S. budget deficit could rise particularly sharply over the next few years. In the U.S., the relative income shares going to profits and labor have started to shift direction, but there is a long way to go. Finally, the same forces driving government to loosen fiscal purse strings have also undermined support for globalization with the U.S. even threatening to abandon NAFTA. The ratio of global trade to output has trended sideways for several years and is unlikely to turn higher any time soon. All these trends are part of our Regime Shift thesis. Chart 2Regime Shifts The remarkable macro backdrop of low inflation, easy money and healthy profits has been incredibly positive for financial markets in recent years. You would have to be an extreme optimist to believe that such an environment will persist. Our big concern for the coming year is that we are setting up for a collision between the markets and looming changes in economic policy. The Coming Collision Between Policy And The Markets BCA: As you mentioned earlier, we attach enormous importance to the role of easy money in supporting asset prices and it is hard to imagine that we could have had a more stimulative monetary environment than has existed in recent years. Central banks have been in panic mode since the 2007-09 downturn with an unprecedented period of negative real interest rates in the advanced economies, coupled with an extraordinary expansion of central bank balance sheets (Chart 3). Initially, the fear was for another Great Depression and as that threat receded, the focus switched to getting inflation back to the 2% target favored by most developed countries. In a post-Debt Supercycle world, negative real rates have failed to trigger the typical rebound in credit demand that was so characteristic of the pre-downturn era. Central banks have expanded base money in the form of bank reserves, but this has not translated into markedly faster growth in broad money or nominal GDP. This is highlighted by the collapse in money multipliers (the ratio of broad to base money) and in velocity (the ratio of GDP to broad money). This has been a double whammy: there is less broad money generated for each dollar of base money and less GDP for every dollar of broad money (Chart 4). Chart 3An Extraordinary Period Of Easy Money Chart 4Monetary Policy: Pushing On A String Historically, monetary policy acted primarily through the credit channel with lower rates making households and companies more willing to borrow, and lenders more willing to supply funds. In the post-Debt Supercycle world, the credit channel has become partly blocked, forcing policymakers to rely more on the other channels of monetary transmission, the main one being boosting asset prices. However, there is a limit to how far this can go because the end result is massively overvalued assets and building financial excesses. The Fed and many other central banks now realize that this strategy cannot be pushed much further. The economic recovery in the U.S. and other developed economies has been the weakest of the post-WWII period. But potential growth rates also have slowed which means that spare capacity has gradually been absorbed. According to the IMF, the U.S. output gap closed in 2015 having been as high as 2% of potential GDP in 2013. The IMF estimates that the economy was operating slightly above potential in 2017 with a further rise forecast in 2018 (Chart 5). According to IMF estimates, the median output gap for 20 advanced economies will shift from -0.1% in 2017 to +0.3% in 2018 (i.e. they will be operating above potential). This makes it hard to justify the maintenance of hyper-stimulative monetary policies. Chart 5No More Output Gaps The low U.S. inflation rate is giving the Fed the luxury of moving cautiously and that is keeping the markets buoyant. Indeed, the markets don't even believe the Fed will be able to raise rates as much they expect. The most recent FOMC projections show a median federal funds rate of 2.1% by the end of 2018 but the markets are discounting a move to only 1.8%. The markets probably have this wrong because inflation is likely to wake up from its slumber in the second half of the year. Ms. X: This is another area where my father and I disagree. I view the world as essentially deflationary. We all know that technological innovations have opened up competition in a lot of markets, driving down prices. Two obvious examples are Uber and Airbnb, but these are just the tip of the iceberg. Amazon's purchase of Whole Foods is another example of how increased competitive pressures will continue to sweep through previously relatively stable industries. And such changes have an important impact on employee psychology and thus bargaining power. These days, people are glad to just keep their jobs and this means companies hold the upper hand when it comes to wage negotiations. So I don't see a pickup in inflation being a threat to the markets any time soon. Mr. X: I have a different perspective. First of all, I do not even believe the official inflation data because most of the things I buy have risen a lot in price over the past couple of years. Secondly, given the extremely stimulative stance of monetary policy in recent years, a pickup in inflation would not surprise me at all. So I am sympathetic to the BCA view. But, even if the data is correct, why have inflation forecasts proved so wrong and what underpins your view that it will increase in the coming year? BCA: There is an interesting disconnect between the official data and the inflation views of many consumers and economic/statistics experts. According to the Conference Board, U.S. consumers' one-year ahead inflation expectations have persistently exceeded the published data and the latest reading is close to 5% (Chart 6). That ties in with your perception. Consumer surveys by the New York Fed and University of Michigan have year-ahead inflation expectations at a more reasonable 2.5%. At the same time, many "experts" believe the official data is overstated because it fails to take enough account of technological changes and new lower-priced goods and services. The markets also have a moderately optimistic view with the five-year CPI swap rate at 2%. This is optimistic because it is consistent with inflation below the Fed's 2% target, if one allows for an inflation risk premium built in to the swap price. We are prepared to take the inflation data broadly at face value. Low inflation is consistent with an ongoing tough competitive environment in most sectors, boosted by the disruptive impact of technological changes that Ms. X described. The inflation rate for core goods (ex-food and energy) has been in negative territory for several years while that for services ex-shelter is at the low end of its historical range (Chart 7). Chart 6Differing Perspectives Of Inflation Chart 7Not Much Inflation Here There is no simple explanation of why inflation has fallen short of forecasts. Economic theory assumes that price pressures build as an economy moves closer to full employment and the U.S. is at that point. This raises several possibilities: There is more slack in the economy than suggested by the low unemployment rate. The lags are unusually long in the current cycle. Technological disruption is having a greater impact than expected. The link between economic slack and inflationary pressures is typically captured by the Phillips Curve which shows the relationship between the unemployment rate and inflation. In the U.S., the current unemployment rate of 4.1% is believed to be very close to a full-employment level. Yet, inflation recently has trended lower and while wage growth is in an uptrend, it has remained softer than expected (Chart 8). Chart 8Inflationary Pressures Are Turning We agree with Ms. X that employee bargaining power has been undermined over the years by globalization and technological change and by the impact of the 2007-09 economic downturn. That would certainly explain a weakened relationship between the unemployment rate and wage growth, but does not completely negate the theory. The historical evidence still suggests that once the labor market becomes tight, inflation eventually does accelerate. A broad range of data indicates that the U.S. labor market is indeed tight and the Atlanta Fed's wage tracker is in an uptrend, albeit modestly. Two other factors consistent with an end to disinflation are the lagged effects of dollar weakness and a firming in oil prices. Non-oil prices have now moved decisively out of deflationary territory while oil prices in 2017 have averaged more than 20% above year-ago levels. As far as the impact of technology is concerned, there is no doubt that innovations like Uber and Airbnb are deflationary. However, our analysis suggests that the growth in online spending has not had a major impact on the inflation numbers. E-commerce still represents a small fraction of total U.S. consumer spending, depressing overall consumer inflation by only 0.1 to 0.2 percentage points. The deceleration of inflation since the global financial crisis has been in areas largely unaffected by online sales, such as energy and rent. Moreover, today's creative destruction in the retail sector is no more deflationary than the earlier shift to 'big box' stores. We are not looking for a dramatic acceleration in either wage growth or inflation - just enough to convince the Fed that it needs to carry on with its plan to raise interest rates. And the pressure to do this will increase if the Administration is able to deliver on its planned tax cuts. Ms. X: You make it sound as if cutting taxes would be a bad thing. Surely the U.S. would benefit from the Administration's tax plan? A reduction in the corporate tax rate would be very bullish for equities. BCA: The U.S. tax system is desperately in need of reform via eliminating loopholes and distortions and using the savings to lower marginal rates. That would make it more efficient and hopefully boost the supply side of the economy without undermining revenues. However, the economy does not need stimulus from net tax giveaways given that it is operating close to potential. That would simply boost demand relative to supply, create overheating, and give the Fed more reason to get aggressive. The Republican's initial tax plan has some good elements of reform such as cutting back the personal mortgage interest deduction, eliminating some other deductions and making it less attractive for companies to shift operations overseas. However, many of these proposals are unlikely to survive the lobbying efforts of special interest groups. The net result probably will be tax giveaways without much actual reform. Importantly, there is not a strong case for personal tax cuts given that a married worker on the average wage and with two children paid an average income tax rate of only 14% in 2016, according to OECD calculations. There inevitably will be contentious negotiations in Congress but we assume that the Republicans will eventually come together to pass some tax cuts by early next year. The combination of easier fiscal policy and Fed rate hikes will be bullish for the dollar and this will contribute to tighter overall financial conditions. That is why we see a coming collision between economic policy and the markets. The narrative for the so-called Trump rally in markets was based on the assumption that the Administration's platform of increased spending, tax cuts and reduced regulations would be bullish for the economy and thus risk assets. That was always a misplaced notion. The perfect environment for markets has been moderate economic growth, low inflation and easy money. The Trump agenda would be appropriate for an economy that had a lot of spare capacity and needed a big boost in demand. It is less suited for an economy with little spare capacity. Reduced regulations and lower corporate tax rates are good for the supply side of the economy and could boost the potential growth rate. However, if a key move is large personal tax cuts then the boost to demand will dominate. Mr. X: It seems that you are making the case for a serious policy error in the U.S. in the coming year - both on fiscal and monetary policy. I can't argue against that because everything that has happened over the past few years tells me that policymakers don't have a good grip on either the economy or the implications of their actions. I never believed that printing money and creating financial bubbles was a sensible approach to an over-indebted economy. I always expected it to end badly. BCA: Major tightening cycles frequently end in recession because monetary policy is a very blunt tool. Central banks would like to raise rates by just enough to cool things down but that is hard to achieve. The problem with fiscal policy is that implementation lags mean that it often is pro-cyclical. In other words, there is pressure for fiscal stimulus in a downturn, but by the time legislation is passed, the economy typically has already recovered and does not really need a big fiscal boost. And that certainly applies to the current environment. The other area of potential policy error is on trade. Having already pulled the U.S. out of the Trans-Pacific Partnership, the Trump Administration is taking a hardline attitude toward a renegotiation of NAFTA. This could even end up with the deal being scrapped and that would add another element of risk to the North American economies. Ms. X: Your scenario assumes that the Fed will be quite hawkish. However, everything I have read about Jerome Powell, the new Fed chair, suggests that he will err on the side of caution when it comes to raising rates. So monetary policy may not collide with markets at all over the coming year. BCA: It is certainly true that Powell does not have any particular bias when it comes to the conduct of monetary policy. That would not have been the case if either John Taylor or Kevin Warsh had been given the job - they both have a hawkish bias. Powell is not an economist so will likely follow a middle path and be heavily influenced by the Fed's staff forecasts and by the opinions of other FOMC members. There are still several vacancies on the Fed's Board so much will depend on who is appointed to those positions. The latest FOMC forecasts are for growth and inflation of only 2% in 2018 and these numbers seem too low. Meanwhile, the prediction that unemployment will still be at 4.1% at end-2018 is too high. We expect projections of growth and inflation to be revised up and unemployment to be revised down. That will embolden the Fed to keep raising rates. So, even with Powell at the helm, monetary policy is set to get tighter than the market currently expects. Ms. X: So far, we have talked mainly about the U.S. What about other central banks? I can't believe that inflation will be much of a problem in the euro area or in Japan any time soon. Does that not mean that the overall global monetary environment will stay favorable for risk assets? BCA: The Fed is at the leading edge of the shift away from extreme monetary ease by hiking interest rates and starting the process of balance sheet reduction. But the Bank of Canada also has raised rates and the ECB has announced that it will cut its asset purchases in half beginning January 2018, as a first step in normalizing policy. Even the Bank of England has raised rates despite Brexit-related downside risks for the economy. The BoJ will keep an accommodative stance for the foreseeable future. You are correct that financial conditions will be tightening more in the U.S. than in other developed economies. Moreover, equity valuations are more stretched in the U.S. than elsewhere leaving that market especially vulnerable. Yet, market correlations are such that any sell-off in U.S. risk assets is likely to become a global affair. Another key issue relates to the potential for financial shocks. Long periods of extreme monetary ease always fuel excesses and sometimes these remain hidden until they blow up. We know that companies have taken on a lot of debt, largely to fund financial transactions such as share buybacks and merger and acquisitions activity. That is unlikely to be the direct cause of a financial accident but might well become a problem in the next downturn. It typically is increased leverage within the financial sector itself that poses the greatest risk and that is very opaque. The banking system is much better capitalized than before the 2007-09 downturn so the risks lie elsewhere. As would be expected, margin debt has climbed higher with the equity market, and is at a historically high level relative to market capitalization (Chart 9). We don't have good data on the degree of leverage among non-bank financial institutions such as hedge funds but that is where leverage surprises are likely to occur. And the level of interest rates that causes financial stress is almost certainly to be a lot lower than in the past. Chart 9Financial Leverage Has Risen Mr. X: That is the perfect lead-in to my perennial concern - the high level of debt in the major economies. I realize high debt levels are not a problem when interest rates are close to zero, but that will change if your view on the Fed is correct. Ms. X: I would just add that this is one area where I share my father's concerns, but with an important caveat. I wholeheartedly agree that high debt levels pose a threat to economic and financial stability, but I see this as a long-term issue. Even with rising interest rates, debt servicing costs will stay low for at least the next year. It seems to me that rates will have to rise a lot before debt levels in the major economies pose a serious threat to the system. Even if the Fed tightens policy in line with its plans, real short rates will still stay low by historical standards. This will not only keep debt financing manageable but will also sustain the search for yield and support equity prices. BCA: We would be disappointed if you both had not raised the issue of debt. Debt levels do indeed remain very elevated among advanced and emerging economies (Chart 10). The growth in private debt remains far below pre-crisis levels in the advanced countries, but this has been offset by the continued high level of government borrowing. As a result, the total debt-to-GDP ratio has stayed close to a peak. And both private and public debt ratios have climbed to new highs in the emerging economies, with China leading the charge. Chart 10ADebt Levels Remain Elevated Chart 10BDebt Levels Remain Elevated As we have discussed in the past, there is not an inconsistency between our End of Debt Supercycle thesis and the continued high levels of debt in most countries. As noted earlier, record-low interest rates have not triggered the kind of private credit resurgence that occurred in the pre-crisis period. For example, household borrowing has remained far below historical levels as a percent of income in the U.S., despite low borrowing costs (Chart 11). At the same time, it is not a surprise that debt-to-income ratios are high given the modest growth in nominal incomes in most countries. Chart 11Low Rates Have Not Triggered ##br##A Borrowing Surge In U.S. Debt growth is not benign everywhere. In the developed world, Canada's debt growth is worryingly high, both in the household and corporate sectors. As is also the case with Australia, Canada's overheated housing market has fueled rapid growth in mortgage debt. These are accidents waiting to happen when borrowing costs increase. In the emerging word, China has yet to see the end of its Debt Supercycle. Fortunately, with most banks under state control, the authorities should be able to contain any systemic risks, at least in the near run. With regard to timing, we agree that debt levels are not likely to pose an economic or financial problem in next year. It is right to point out that debt-servicing costs are very low by historical standards and it will take time for rising rates to have an impact given that a lot of debt is locked in at low rates. For example, in the U.S., the ratio of household debt-servicing to income and the non-financial business sector's ratio of interest payments to EBITD are at relatively benign levels (Chart 12). However, changes occur at the margin and the example of the Bernanke taper tantrum highlighted investor sensitivity to even modest changes in the monetary environment. You may well be right Ms. X that risk assets will continue to climb higher in the face of a tighter financial conditions. But given elevated valuations, we lean toward a cautious rather than aggressive approach to strategy. We would rather leave some money on the table than risk being caught in a sudden downdraft. Other investors, including yourself, might prefer to wait for clearer signals that a turning point is imminent. Returning to the issue of indebtedness, the end-game for high debt levels continues to be a topic of intense interest. There really are only three options: to grow out of it, to write it off, or to try and inflate it away. The first option obviously would be best - to have fast enough growth in real incomes that allowed debtors to start paying down their debt. Unfortunately, that is the least likely prospect given adverse demographic trends throughout the developed world and disappointing productivity growth (Chart 13). Chart 12Borrowing Costs Are Benign Chart 13It's Hard To Grow Out Of Debt ##br##With These Structural Headwinds Writing the debt off - i.e. defaulting - is a desperate measure that would be the very last resort after all other approaches had failed. In this case, we are talking mainly about government debt, because private debt always has to be written off when borrowers become bankrupt. Japan is the one developed country where government debt probably will be written off eventually. Given that the Bank of Japan owns around 45% of outstanding government debt, those holdings can be neutralized by converting them to perpetuals - securities that are never redeemed. If the first two options are not viable, then inflation becomes the preferred solution to over-indebtedness. To make a big impact, inflation would need to rise far above the 2% level currently favored by central banks, and it would have to stay elevated for quite some time. Central banks are not yet ready to allow such an environment, but that could change after the next economic downturn. Central banks have made it clear that they are prepared to pursue radical policies in order to prevent deflation. This sets the scene for increasingly aggressive actions after the next recession and the end result could be a period of significantly higher inflation. Mr. X: I don't disagree with that view which is why I always like to hold some physical gold in my portfolio. It is interesting that you are worried about a looming setback for risk assets because you are positive on the near-run economic outlook. That is contrary to the typical view that sees a decent economy as supporting higher equity prices. Let's spend a bit more time on your view of the economic outlook. Ms. X: Before we do that, I would just emphasize that it is far too early to worry about debt end games and the potential for sharply rising inflation. I don't disagree that monetary policy could be forced to embrace massive reflation during the next downturn and perhaps that will make me change my view of the inflation outlook. But the sequencing is important because we would first have to deal with a recession that could be a very deflationary episode. And before the next recession we could have period of continued decent growth, which would be positive for risk assets. So I agree that the near-term view of the economic outlook is important. The Economic Outlook BCA: This recovery cycle has been characterized by a series of shocks and headwinds that constrained growth in various regions. In no particular order, these included fiscal austerity, the euro crisis, a brief U.S. government shutdown, the Japanese earthquake, and a spike in oil prices above $100. As we discussed a year ago, in the absence of any new shocks, we expected global growth to improve and that is what occurred in 2017. A broad range of indicators shows that activity has picked up steam in most areas. Purchasing managers' indexes are in an uptrend, business and consumer confidence are at cyclical highs and leading indicators have turned up (Chart 14). This is hardly a surprise given easy monetary conditions and a more relaxed fiscal stance almost everywhere. Chart 14Global Activity On An Uptrend The outlook for 2018 is positive and the IMF's projections for growth is probably too low (see Table 2). So, for the second year in a row, the next set of updates due in the spring are likely to be revised up. Ms. X: Let's talk about the U.S. economy. You are concerned that tax cuts could contribute to overheating, tighter monetary policy and an eventual collision with the markets. But there are two alternative scenarios, both quite optimistic for risk assets. On the one hand, a cut in the corporate tax rate could trigger a further improvement in business confidence and thus acceleration in capital spending. This would boost the supply side of the economy and mean that faster growth need not lead to higher inflation. It would be the perfect world of a low inflation boom. At the other extreme, if political gridlock prevents any meaningful tax cuts, we will be left with the status quo of moderate growth and low inflation that has been very positive for markets during the past several years. Mr. X: You can always rely on my daughter to emphasize the potential for optimistic outcomes. I would suggest another entirely different scenario. The cycle is very mature and I fear it would not take much to tip the economy into recession, even if we get some tax relief. So I am more concerned with near-term downside risks to the U.S. economy. A recession in the coming year would be catastrophic for the stock market in my view. BCA: Before we get to the outlook, let's agree on where we are right now. As we already noted, the U.S. economy currently is operating very close to its potential level. The Congressional Budget Office estimates potential growth to be only 1.6% a year at present, which explains why the unemployment rate has dropped even though growth has averaged a modest 2% pace in recent years. The consumer sector has generally been a source of stability with real spending growing at a 2¾% pace over the past several years (Chart 15). And, encouragingly, business investment has recently picked up from its earlier disappointing level. On the negative side, the recovery in housing has lost steam and government spending has been a source of drag. Looking ahead, the pattern of growth may change a bit. With regard to consumer spending, the pace of employment growth is more likely to slow than accelerate given the tight market and growing lack of available skilled employees. According to the National Federation of Independent Business survey, 88% of small companies hiring or trying to hire reported "few or no qualified applicants for the positions they were trying to fill". Companies in manufacturing and construction say that the difficulty in finding qualified workers is their single biggest problem, beating taxes and regulations. In addition, we should not assume that the personal saving rate will keep falling given that it has hit a recovery low of 3.1% (Chart 16). On the other hand, wage growth should continue to firm and there is the prospect of tax cuts. Overall, this suggests that consumer spending should continue to grow by at least a 2% pace in 2018. Chart 15Trends In U.S. Growth Chart 16Personal Saving At A Recovery Low Survey data suggests that business investment spending should remain strong in the coming year, even without any additional boost from corporate tax cuts. Meanwhile, rebuilding and renovations in the wake of Hurricanes Harvey and Irma should provide a short-term boost to housing investment and a more lasting improvement will occur if the millennial generation finally moves out of their parents' basements. On that note, it is encouraging that the 10-year slide in the homeownership rate appears to have run its course (Chart 17). And although housing affordability is down from its peak, it remains at an attractive level from a historical perspective. Chart 17A Weak Housing Recovery Last, but not least, government spending will face countervailing forces. The Administration plans to increase spending on defense and infrastructure but there could be some offsetting cutbacks in other areas. Overall, government spending should make a positive contribution to 2018 after being a drag in 2017. Putting all this together, the U.S. economy should manage to sustain a growth rate of around 2.5% in 2018, putting GDP further above its potential level. And it could rise above that if tax cuts are at the higher end of the range. You suggested three alternative scenarios to our base case: a supply-side boom, continued moderate growth and a near-term recession. A supply-side revival that leads to strong growth and continued low inflation would be extremely bullish, but we are skeptical about that possibility. The revival in capital spending is good news, but this will take time to feed into faster productivity growth. Overall, any tax cuts will have a greater impact on demand than supply, putting even greater pressure on an already tight labor market. The second scenario of a continuation of the recent status quo is more possible, especially if we end up with a very watered-down tax package. However, growth would actually have to drop below 2% in order to prevent GDP from rising above potential. We will closely monitor leading indicators for signs that growth is about to lose momentum. The bearish scenario of a near-term recession cannot be completely discounted, but there currently is no compelling evidence of such a development. Recessions can arrive with little warning if there is an unanticipated shock, but that is rare. Historically, a flat or inverted yield curve has provided a warning sign ahead of most recessions and the curve currently is still positively sloped (Chart 18). Another leading indicator is when cyclical spending1 falls as a share of GDP, reflecting the increased sensitivity of those items to changes in financial conditions. Cyclical spending is still at a historically low level relative to GDP and we expect this to rise rather than fall over the coming quarters. While a near-term recession does not seem likely, the odds will change during the course of 2018. By late year, there is a good chance that the yield curve will be flat or inverted, giving a warning signal for a recession in 2019. Our base case view is for a U.S. recession to start in the second half of 2019, making the current expansion the longest on record. At this stage, it is too early to predict whether it would be a mild recession along the lines of 1990-91 and 2000-01 or a deeper downturn. Chart 18No Recession Signals For The U.S. ...Yet Mr. X: I hope that you are right that a U.S. recession is more than a year away. I am not entirely convinced but will keep an open mind, and my daughter will no doubt keep me fully informed of any positive trends. Ms. X: You can be sure of that. Although I lean toward the optimistic side on the U.S. economy, I have been rather surprised at how well the euro area economy has done in the past year. Latest data show that the euro area's real GDP increased by 2.5% in the year to 2017 Q3 compared to 2.3% for the U.S. Can that be sustained? BCA: The relative performance of the euro area economy has been even better if you allow for the fact that the region's population growth is 0.5% a year below that of the U.S. So the economic growth gap is even greater on a per capita basis. The euro area economy performed poorly during their sovereign debt crisis years of 2011-13, but the subsequent improvement has meant that the region's real per capita GDP has matched that of the U.S. over the past four years. And even Japan's GDP has not lagged much behind on a per capita basis (Chart 19). Chart 19No Clear Winner On Growth The recovery in the euro area has been broadly based but the big change was the end of a fiscal squeeze in the periphery countries. Between 2010 and 2013, fiscal drag (the change in the structural primary deficit) was equivalent to around 10% of GDP in Greece and Portugal and 7% of GDP in Ireland and Spain. There was little fiscal tightening in the subsequent three years, allowing those economies to recover lost ground. Meanwhile, Germany's economy has continued to power ahead, benefiting from much easier financial conditions than the economy has warranted. That has been the inevitable consequence of a one size fits all monetary policy that has had to accommodate the weakest members of the region. The French and Italian economies have disappointed, but there are hopes that the new French government will pursue pro-growth policies. And Italy should also pick up given signs that it is finally starting to deal with its fragile banking system. Both Spain and Italy faced a sharp rise in non-performing bank loans during the great recession, but Italy lagged Spain in dealing with the problem (Chart 20). That goes a long way to explaining why the Italian economic recovery has been so poor relative to Spain. With Italian banks raising capital and writing off non-performing loans more aggressively, the Italian economy should start to improve, finally catching up with the rest of the region. Overall, the euro area economy should manage to sustain growth above the 2.1% forecast by the IMF for 2018. Overall financial conditions are likely to stay favorable for at least another year and we do not anticipate any major changes in fiscal policy. If, as we fear, the U.S. moves into recession in 2019, there will be negative fallout for Europe, largely via the impact on financial markets. However, in relative terms, the euro area should outperform the U.S. during the next downturn. Mr. X: A year ago, you said that Brexit posed downside risks for the U.K. economy. For a while, that seemed too pessimistic as the economy performed quite well, but recent data show things have taken a turn for the worse. How do you see things playing out with this issue? BCA: It was apparent a year ago that the U.K. government had no concrete plans to deal with Brexit and little has changed since then. The negotiations with the EU are not going particularly well and the odds of a "hard" exit have risen. This means withdrawing from the EU without any agreement on a new regime for trade, labor movements or financial transactions. A growing number of firms are taking the precaution of shifting some operations from the U.K. to other EU countries. As you noted, there are signs that Brexit is starting to undermine the U.K. economy. For example, London house prices have turned down and the leading economic index has softened (Chart 21). The poor performance of U.K. consumer service and real estate equities relative to those of Germany suggest investors are becoming more wary of the U.K. outlook. Of course, a lot will depend on the nature of any deal between the U.K. and the EU and that remains a source of great uncertainty. Chart 20A Turning Point For Italian Banks? Chart 21U.K. Consumer Services Equities Are ##br##Underperforming Brexit Effects Show Up At the moment, there are no real grounds for optimism. The U.K. holds few cards in the bargaining process and the country's strong antipathy toward the free movement of people within the EU will be a big obstacle to an amicable separation agreement. Ms. X: I think the U.K. made the right decision to leave the EU and am more optimistic than you about the outlook. There may be some short-term disruption but the long-term outlook for the U.K. will be good once the country is freed from the stifling bureaucratic constraints of EU membership. The U.K. has a more dynamic economy than most EU members and it will be able to attract plenty of overseas capital if the government pursues appropriate policies toward taxes and regulations. It will take a few years to find out who is correct about this. In the meantime, given the uncertainties, I am inclined to have limited exposure to sterling and the U.K. equity market. Let's now talk about China, another country facing complex challenges. This is a topic where my father and I again have a lot of debates. As you might guess, I have been on the more optimistic side while he has sided with those who have feared a hard landing. And I know that similar debates have occurred in BCA. BCA: It is not a surprise that there are lots of debates about the China outlook. The country's impressive economic growth has been accompanied by an unprecedented build-up of debt and supply excesses in several sectors. The large imbalances would have led to a collapse by now in any other economy. However, China has benefited from the heavy state involvement in the economy and, in particular, the banking sector. The big question is whether the government has enough control over economic developments to avoid an economic and financial crisis. The good news is that China's government debt is relatively low, giving them the fiscal flexibility to write-off bad debts from zombie state-owned enterprises (SOEs). The problems of excessive leverage and over-capacity are particularly acute in SOEs that still comprise a large share of economic activity. The government is well aware of the need to reform SOEs and various measures have been announced, but progress has been relatively limited thus far. The IMF projects that the ratio of total non-financial debt to GDP will remain in an uptrend over the next several years, rising from 236% in 2016 to 298% by 2022 (Chart 22). Yet, growth is expected to slow only modestly over the period. Of course, one would not expect the IMF to build a crisis into their forecast. Some investors have been concerned that a peak in China's mini-cycle of the past two years may herald a return to the economic conditions that prevailed in 2015, when the industrial sector grew at a slower pace than during the acute phase of the global financial crisis. These conditions occurred due to the combination of excessively tight monetary conditions and weak global growth. While China's export growth may slow over the coming year, monetary policy remains accommodative. Monetary conditions appear to have peaked early this year but are still considerably easier than in mid-2015. Shifts in the monetary conditions index have done a good job of leading economic activity and they paint a reasonably positive picture (Chart 23). The industrial sector has finally moved out of deflation, with producer prices rising 6.9% in the year ended October. This has been accompanied by a solid revival in profits. Chart 22China: Debt-Fueled Growth To Continue Chart 23China Leaves Deflation Behind On balance, we assume that the Chinese economy will be able to muddle through for the foreseeable future. President Xi Jinping has strengthened his grip on power and he will go to great lengths to ensure that his reign is not sullied with an economic crisis. The longer-term outlook will depend on how far the government goes with reforms and deleveraging and we are keeping an open mind at this point. In sum, for the moment, we are siding with Ms. X on this issue. Mr. X: I have been too bearish on China for the past several years, but I still worry about the downside risks given the massive imbalances and excesses. I can't think of any example of a country achieving a soft landing after such a massive rise in debt. I will give you and my daughter the benefit of the doubt, but am not totally convinced that you will be right. BCA has been cautious on emerging economies in general: has that changed? BCA: The emerging world went through a tough time in 2015-16 with median growth of only 2.6% for the 23 constituent countries of the MSCI EM index (Chart 24). This recovered to 3% in 2017 according to IMF estimates, but that is still far below the average 5% pace of the period 2000-07. Chart 24Emerging Economy Growth: ##br##The Boom Years Are Over It is always dangerous to generalize about the emerging world because the group comprises economies with very different characteristics and growth drivers. Two of the largest countries - Brazil and Russia - went through particularly bad downturns in the past couple of years and those economies are now in a modest recovery. In contrast, India has continued to grow at a healthy albeit slowing pace, while Korea and the ASEAN region have not suffered much of a slowdown. If, as seems likely, Chinese growth holds above a 6% pace over the next year, then those countries with strong links to China should do fine. And it also points to reasonably steady commodity prices, supporting resource-dependent economies. Longer-run, there are reasons to be cautious about many emerging economies, particularly if the U.S. goes into recession 2019, as we fear. That would be associated with renewed weakness in commodity prices, and capital flight from those economies with high external debt such as Turkey and South Africa. As we stated a year ago, the heady days of emerging economy growth are in the past. Mr. X: It seems that both my daughter and I can find some areas of agreement with your views about the economic outlook. You share her expectation that the global growth outlook will stay healthy over the coming year, but you worry about a U.S.-led recession in 2019, something that I certainly sympathize with. But we differ on timing: I fear the downturn could occur even sooner and I know my daughter believes in a longer-lasting upturn. Let's now move onto what this all means for financial markets, starting with bonds. Bond Market Prospects Ms. X: I expect this to be a short discussion as I can see little attraction in bonds at current yields. Even though I expect inflation to stay muted, bonds offer no prospect of capital gains in the year ahead and even the running yield offers little advantage over the equity dividend yield. BCA: As you know, we have believed for some time that the secular bull market in bonds has ended. We expect yields to be under upward pressure in most major markets during 2018 and thus share your view that equities offer better return prospects. By late 2018, it might well be appropriate to switch back into bonds against a backdrop of higher yields and a likely bear market in equities. For the moment, we recommend underweight bond exposure. It is hard to like government bonds when the yield on 10-year U.S. Treasuries is less than 50 basis points above the dividend yield of the S&P 500 while the euro area bond yield is 260 basis points below divided yields (Chart 25). Real yields, using the 10-year CPI swap rate as a measure of inflation expectations, are less than 20 basis points in the U.S. and a negative 113 basis points in the euro area. Even if we did not expect inflation to rise, it would be difficult to recommend an overweight position in any developed country government bonds. One measure of valuation is to compare the level of real yields to their historical average, adjusted by the standard deviation of the gap. On this basis, the most overvalued markets are the core euro area countries, where real yields are 1.5 to 2 standard deviations below their historical average (Chart 26). There are only two developed bond markets where real 10-year government yields currently are above their historical average: Greece and Portugal. This is warranted in Greece where there needs to be a risk premium in case the country is forced to leave the single currency at some point. This is less of a risk for Portugal, making it a more interesting market. Real yields in New Zealand are broadly in line with their historical average, also making it one of the more attractive markets. Chart 25Bonds Yields Offer Little Appeal Chart 26Valuation Ranking Of Developed Bond Markets Mr. X: Given your expectation of higher inflation, would you recommend inflation-protected Treasuries? BCA: Yes, in the sense that they should outperform conventional Treasuries. The 10-year TIPS are discounting average inflation of 1.85% and we would expect this to be revised up during the coming year. However, the caveat is that absolute returns will still be mediocre. Ms. X: You showed earlier that corporate bonds had a reasonable year in 2017, albeit falling far short of the returns from equities. A year ago, you recommended only neutral weighting in investment-grade bonds and an underweight in high yield. But you became more optimistic toward both early in 2017, shifting to an overweight position. Are you thinking of scaling back exposure once again, given the tight level of spreads? BCA: Yes, we were cautious on U.S. corporates a year ago because valuation was insufficient to compensate for the deterioration in corporate balance sheet health. Nonetheless, value improved enough early in 2017 to warrant an upgrade to overweight given our constructive macro and default rate outlook. The cyclical sweet spot for carry trades should continue to support spread product for a while longer. Moreover, value is better than it appears at first glance. The dotted line in Chart 27 shows the expected 12-month option-adjusted spread for U.S. junk bonds after adjusting for our base case forecast for net default losses. At 260 basis points, this excess spread is in line with the historical average. In the absence of any further spread narrowing, speculative-grade bonds would return 230 basis points more than Treasurys in 2018. If high-yield spreads were to tighten by another 150 basis points, then valuations would be at a historical extreme, and that seems unwarranted. An optimistic scenario would have another 100 basis point spread tightening, delivering excess returns of 5%. Of course, if spreads widen, then corporates will underperform. If financial conditions tighten in 2018 as we expect then it will be appropriate to lower exposure to corporates. In the meantime, you should favor U.S. and U.K. corporate bonds to issues in the Eurozone because ECB tapering is likely to spark some spread widening in that market. Mr. X: What about EM hard-currency bonds? BCA: The global economic background is indeed positive for EM assets. However, EM debt is expensive relative to DM investment-grade bonds which, historically, has heralded a period of underperformance (Chart 28). We expect that relative growth dynamics will be more supportive of U.S. corporates because EM growth will lag. Any commodity price weakness and/or a stronger U.S. dollar would also weigh on EM bonds and currencies. Chart 27Not Much Value In U.S. Corporates Chart 28Emerging Market Bonds Are Expensive Mr. X: We have not been excited about the bond market outlook for some time and nothing you have said changes my mind. I am inclined to keep our bond exposure to the bare minimum. Ms. X: I agree. So let's talk about the stock market which is much more interesting. As I mentioned before, I am inclined to remain fully invested in equities for a while longer, while my father wants to start cutting exposure. Equity Market Outlook BCA: This is one of those times when it is important to draw a distinction between one's forecast of where markets are likely to go and the appropriate investment strategy. We fully agree that the conditions that have driven this impressive equity bull market are likely to stay in place for much of the next year. Interest rates in the U.S. and some other countries are headed higher, but they will remain at historically low levels for some time. Meanwhile, in the absence of recession, corporate earnings still have upside, albeit not as much as analysts project. However, we have a conservative streak at BCA that makes us reluctant to chase markets into the stratosphere. For long-term investors, our recommended strategy is to gradually lower equity exposure to neutral. However, those who are trying to maximize short-term returns should stay overweight and wait for clearer signs that tighter financial conditions are starting to bite on economic activity. Chart 29Reasons For Caution On U.S. Stocks Getting down to specifics, here are the trends that give us cause for concern and they are all highlighted in Chart 29. Valuation: Relative to both earnings and book value, the U.S. equity market is more expensive than at any time since the late 1990s tech bubble. The price-earnings ratio (PER) for the S&P 500 is around 30% above its 60-year average on the basis of both trailing operating earnings and a 10-year average of earnings. The market is not expensive on a relative yield basis because interest rates are so low, but that will change as rates inevitably move higher. Other developed markets are not as overvalued as the U.S., but neither are they cheap. Earnings expectations: The performance of corporate earnings throughout this cycle - particularly in the U.S. - has been extremely impressive give the weaker-than-normal pace of economic growth. However, current expectations are ridiculously high. According to IBES data, analysts expect long-run earnings growth of around 14% a year in both the U.S. and Europe. Even allowing for analysts' normal optimistic bias, the sharp upward revision to growth expectations over the past year makes no sense and is bound to be disappointed. Investor complacency: We all know that the VIX index is at a historical low, indicating that investors see little need to protect themselves against market turmoil. Our composite sentiment indicator for the U.S. is at a high extreme, further evidence of investor complacency. These are classic contrarian signs of a vulnerable market. Most bear markets are associated with recessions, with the stock market typically leading the economy by 6 to 12 months (Chart 30). The lead in 2007 was an unusually short three months. As discussed earlier, we do not anticipate a U.S. recession before 2019. If a recession were to start in mid-2019, it would imply the U.S. market would be at risk from the middle of 2018, but the rally could persist all year. Of course, the timing of a recession and market is uncertain. So it boils down to potential upside gains over the next year versus the downside risks, plus your confidence in being able to time the top. Chart 30Bear Markets And Recessions Usually Overlap We are not yet ready to recommend that you shift to an underweight position in equities. A prudent course of action would be to move to a broadly neutral position over the next few months, but we realize that Ms. X has a higher risk tolerance than Mr. X so we will leave you to fight over that decision. The timing of when we move to an underweight will depend on our various economic, monetary and market indicators and our assessment of the risks. It could well happen in the second half of the year. Mr. X: My daughter was more right than me regarding our equity strategy during the past year, so maybe I should give her the benefit of the doubt and wait for clearer signs of a market top. Thus far, you have focused on the U.S. market. Last year you preferred developed markets outside the U.S. on the grounds of relative valuations and relative monetary conditions. Is that still your stance? BCA: Yes it is. The economic cycle and thus the monetary cycle is far less advanced in Europe and Japan than in the U.S. This will provide extra support to these markets. At the same time, profit margins are less vulnerable outside the U.S. and, as you noted, valuations are less of a problem. In Chart 31, we show a valuation ranking of developed equity markets, based on the deviation of cyclically-adjusted PERs from their historical averages. The chart is not meant to measure the extent to which Portugal is cheap relative to the U.S., but it indicates that Portugal is trading at a PER far below its historical average while that of the U.S. is above. You can see that the "cheaper" markets tend to be outside the U.S. Japan's reading is flattered by the fact that its historical valuation was extremely high during the bubble years of the 1980s, but it still is a relatively attractive market. Chart 31Valuation Ranking Of Developed Equity Markets From a cyclical standpoint, we are still recommending overweight positions in European and Japanese stocks relative to the U.S., on a currency-hedged basis. Nevertheless, market correlations are such that a sell-off in the U.S. will be transmitted around the world (Chart 32). Chart 32When the U.S. Market Sneezes, The World Catches A Cold Ms. X: I would like to turn the focus to emerging equity markets. You have been cautious on these for several years and that worked out extremely well until 2017. I note from your regular EM reports that you have not changed your stance. Why are you staying bearish given that you see an improvement in global growth and further potential upside in developed equity prices? BCA: The emerging world did extremely well over many years when global trade was expanding rapidly, China was booming, commodity prices were in a powerful bull market and capital inflows were strong. Those trends fostered a rapid expansion in credit-fueled growth across the EM universe and meant that there was little pressure to pursue structural reforms. However, the 2007-09 economic and financial crisis marked a major turning point in the supports to EM outperformance. As we noted earlier, the era of rapid globalization has ended, marking an important regime shift. Meanwhile, China's growth rate has moderated and the secular bull market in commodities ended several years ago. We do not view the past year's rebound in commodities as the start of a major new uptrend. Many emerging equity markets remain highly leveraged to the Chinese economy and to commodity prices (Chart 33). Although we expect the Chinese economy to hold up, growth is becoming less commodity intensive. Finally, the rise in U.S. interest rates is a problem for those countries that have taken on a marked increase in foreign currency debt. This will be made even worse if the dollar appreciates. Obviously, the very term "emerging" implies that this group of countries has a lot of upside potential. However, the key to success is pursuing market-friendly reforms, rooting out corruption and investing in productive assets. Many countries pay only lip service to these issues. India is a case in point where there is growing skepticism about the Modi government's ability to deliver on major reforms. The overall EM index does not appear expensive, with the PER trading broadly in line with its historical average (Chart 34). However, as we have noted in the past, the picture is less compelling when the PER is calculated using equally-weighted sectors. The financials and materials components are trading at historically low multiples, dragging down the overall index PER. Emerging market equities will continue to rise as long as the bull market in developed markets persists, but we expect them to underperform on a relative basis. Chart 33Drivers Of EM Performance Chart 34Emerging Markets Fundamentals Mr. X: One last question on equities from me: do you have any high conviction calls on sectors? BCA: A key theme of our sector view is that cyclical stocks should outperform defensives given the mature stage of the economic cycle. We are seeing the typical late-cycle improvement in capital spending and that will benefit industrials, and we recommend an overweight stance in that sector. Technology also is a beneficiary of higher capex but of course those stocks have already risen a lot, pushing valuations to extreme levels. Thus, that sector warrants only a neutral weighting. Our two other overweights are financials and energy. The former should benefit from rising rates and a steeper yield curve while the latter will benefit from firm oil prices. If, as we fear, a recession takes hold in 2019, then obviously that would warrant a major shift back into defensive stocks. For the moment, the positive growth outlook will dominate sector performance. Ms. X: I agree that the bull market in equities, particularly in the U.S., is very mature and there are worrying signs of complacency. However, the final stages of a market cycle can sometimes be very rewarding and I would hate to miss out on what could be an exciting blow-off phase in 2018. As I mentioned earlier, my inclination is to stay heavily invested in equities for a while longer and I have confidence that BCA will give me enough of a warning when risks become unacceptably high. Of course, I will have to persuade my father and that may not be easy. Mr. X: You can say that again, but we won't bother our BCA friends with that conversation now. It's time to shift the focus to commodities and currencies and I would start by commending you on your oil call. You were far out of consensus a year ago when you said the risks to crude prices were in the upside and you stuck to your guns even as the market weakened in the first half. We made a lot of money following your energy recommendations. What is your latest thinking? Commodities And Currencies BCA: We had a lot of conviction in our analysis that the oil market would tighten during 2017 against a backdrop of rising demand and OPEC production cuts, and that view turned out to be correct. As we entered the year, the big reason to be bearish on oil prices was the bloated level of inventories. We forecast that inventories would drop to their five-year average by late 2017, and although that turned out to be a bit too optimistic, the market tightened by enough to push prices higher (Chart 35). Chart 35Oil Market Trends The forces that have pushed prices up will remain in force over the next year. Specifically, our economic view implies that demand will continue to expand, and we expect OPEC 2.0 - the producer coalition of OPEC and non-OPEC states, led by Saudi Arabia and Russia - to extend its 1.8 million b/d production cuts to at least end-June. On that basis, OECD inventories should fall below their five-year average by the end of 2018. We recently raised our 2018 oil price target to an average of $65 in 2018. Of course, the spot market is already close to that level, but the futures curve is backwardated and that is likely to change. We continue to see upside risks to prices, not least because of potential production shortfalls from Venezuela, Nigeria, Iraq and Libya. Mr. X: The big disruptor in the oil market in recent years was the dramatic expansion in U.S. shale production. Given the rise in prices, could we not see a rapid rebound in shale output that, once again, undermines prices? BCA: Our modeling indicates that U.S. shale output will increase from 5.1 mb/d to 6.0 mb/d over the next year, in response to higher prices. This is significant, but will not be enough to materially change the global oil demand/supply balance. Longer run, the expansion of U.S. shale output will certainly be enough to prevent any sustained price rise, assuming no large-scale production losses elsewhere. A recent report by the International Energy Agency projected that the U.S. is destined to become the global leader in oil and gas production for decades to come, accounting for 80% of the rise in global oil and gas supply between 2010 and 2025. Ms. X: You have suggested that China's economic growth is becoming less commodity intensive. Also, you have shown in the past that real commodity prices tend to fall over time, largely because of technological innovations. What does all this imply for base metals prices over the coming year? BCA: The base metals story will continue to be highly dependent on developments in China. While the government is attempting to engineer a shift toward less commodity-intensive growth, it also wants to reduce excess capacity in commodity-producing sectors such as coal and steel. Base metals are likely to move sideways until we get a clearer reading on the nature and speed of economic reforms. We model base metals as a function of China's PMIs and this supports our broadly neutral stance on these commodities (Chart 36). Chart 36China Drives Metals Prices Mr. X: As usual, I must end our commodity discussion by asking about gold. Last year, you agreed that an uncertain geopolitical environment coupled with continued low interest rates should support bullion prices, and that was the case with a respectable 12% gain since the end of 2016. You also suggested that I should not have more than 5% of my portfolio in gold which is less than I am inclined to own. It still looks like a gold-friendly environment to me. Ms. X: Let me just add that this is one area where my father and I agree. I do not consider myself to be a gold bug, but I think bullion does provide a good hedge against shocks in a very uncertain economic and political world. I would also be inclined to hold more than 5% of our portfolio in gold. BCA: There will be opposing forces on gold during the coming year. On the positive side, it is safe to assume that geopolitical uncertainties will persist and may even intensify, and there also is the potential for an increase in inflation expectations that would support bullion. On the negative side, rising interest rates are not normally good for gold and there likely will be an added headwind from a firmer U.S. dollar. Gold appears to be at an important point from a technical perspective (Chart 37). It currently is perched just above its 200-day average and a key trend line. A decisive drop below these levels would be bearish. At the same time, there is overhead resistance at around 1350-1360 and prices would have to break above that level to indicate a bullish breakout. Traders' sentiment is at a broadly neutral level, consistent with no clear conviction about which way prices will break. There is no science behind our recommendation of keeping gold exposure below 5%. That just seems appropriate for an asset that delivers no income and where the risk/reward balance is fairly balanced. Ms. X: You referred to the likelihood of a firmer dollar as a depressant on the gold price. You also were bullish on the dollar a year ago, but that did not work out too well. How confident are you that your forecast will fare better in 2018? BCA: We did anticipate that the dollar would experience a correction at the beginning of 2017, but we underestimated how profound this move would be. A combination of factors explains this miscalculation. Chart 37Gold At A Key Level It first began with positioning. We should have paid more attention to that fact that investors were massively bullish and long the dollar at the end of 2016, making the market vulnerable to disappointments. And disappointment did come with U.S. inflation weakening and accelerating in the euro area. Additionally, there were positive political surprises in Europe, especially the presidential victory of Emmanuel Macron in France. In the U.S., the government's failure to repeal Obamacare forced investors to lower expectations about fiscal stimulus. As a result, while investors were able to price in an earlier first hike by the ECB, they cut down the number of rate hikes they anticipated out of the Fed over the next 24 months. In terms of the current environment, positioning could not be more different because investors are aggressively shorting the dollar (Chart 38). The hurdle for the dollar to deliver positive surprises is thus much lower than a year ago. Also, we remain confident that tax cuts will be passed in the U.S. by early 2018. As we discussed earlier, U.S. GDP will remain above potential, causing inflation pressures to build. This will give the Fed the leeway to implement its planned rate hikes, and thus beat what is currently priced in the market. This development should support the dollar in 2018. Ms. X: A bullish view on the U.S. dollar necessarily implies a negative view on the euro. However, the European economy seems to have a lot of momentum, and inflation has picked up, while U.S. prices have been decelerating. To me, this suggests that the ECB also could surprise by being more hawkish than anticipated, arguing against any major weakness in the euro. BCA: The European economy has indeed done better than generally expected in the past year. Also, geopolitical risks were overstated by market participants at the beginning of 2017, leaving less reason to hide in the dollar. However, the good news in Europe is now well known and largely discounted in the market. Investors are very long the euro, by both buying EUR/USD and shorting the dollar index (Chart 39). In that sense, the euro today is where the dollar stood at the end of 2016. Chart 38Too Much Pessimism On The Dollar Chart 39Positioning Risk In EUR/USD Valuations show a similar picture. The euro might appear cheap on a long-term basis, but not so much so that its purchasing power parity estimate - which only works at extremes and over long-time periods - screams a buy. Moreover, the euro has moved out of line with historical interest rate parity relationships, warning that the currency is at risk if the economy disappoints. Overall, we expect EUR/USD to trade around 1.10 in 2018. Long-run, the picture is different because a U.S. recession in 2019 would trigger renewed broad-based weakness in the dollar. Mr. X: I have been perplexed by the yen's firmness in the past year, with the currency still above its end-2016 level versus the dollar. I expected a lot more weakness with the central bank capping bond yields at zero and more or less monetizing the government deficit. A year ago you also predicted a weak yen. Will it finally drop in 2018? BCA: We were not completely wrong on the yen as it has weakened over the past year on a trade-weighted basis and currently is about 2% below its end-2016 level. But it has risen slightly against the U.S. dollar. In the past couple of years, the yen/dollar rate has been highly correlated with real bond yield differentials (Chart 40). These did not move against the yen as much as we expected because U.S. yields drifted lower and there was no major change in relative inflation expectations. Chart 40Bond Yield Differentials Drive The Yen The real yield gap is likely to move in the dollar's favor over the next year, putting some downward pressure on the yen. Meanwhile, the Bank of Japan will continue to pursue a hyper-easy monetary stance, in contrast to the Fed's normalization policy. However, it is not all negative: the yen is cheap on a long-term basis, and Japan is an international net creditor to the tune of more than 60% of GDP. Investors are also quite short the yen as it remains a key funding currency for carry trades. Thus, it will continue to benefit each time global markets are gripped with bouts of volatility. It remains a good portfolio hedge. Ms. X: Are any other currency views worth noting? BCA: The outlook for sterling obviously will be tied to the Brexit negotiations. Having fallen sharply after the Brexit vote, sterling looks cheap relative to its history. This has allowed it to hold in a broad trading range over the past 18 months, even though the negotiations with the EU have not been going well. At this stage, it is hard to know what kind of deal, if any, will emerge regarding Brexit so we would hedge exposure to sterling. Our optimism toward the oil price is consistent with a firm Canadian dollar, but developments in the NAFTA negotiations represent a significant risk. At the moment, we are overweight the Canadian dollar, but that could change if the NAFTA talks end badly. We still can't get enthusiastic about emerging market currencies even though some now offer reasonable value after falling sharply over the past few years. Mr. X: We can't leave currencies without talking about Bitcoin and cryptocurrencies in general. I like the idea of a currency that cannot be printed at will by governments. There are too many examples of currency debasement under a fiat money system and the actions of central banks in recent years have only served to increase my mistrust of the current monetary system. But I can't profess to fully understand how these cryptocurrencies work and that makes me nervous about investing in them. What are your thoughts? BCA: You are right to be nervous. There have been numerous cases of hackers stealing Bitcoins and other cryptocurrencies. Also, while there is a limit to the number of Bitcoins that can be issued, there is no constraint on the number of possible cryptocurrencies that can be created. Thus, currency debasement is still possible if developers continue creating currencies that are only cosmetically different from the ones already in existence. Moreover, we doubt that governments will sit idly by and allow these upstart digital currencies to become increasingly prevalent. The U.S. Treasury derives $70 billion a year in seigniorage revenue from its ability to issue currency which it can then redeem for goods and services. At some point, governments could simply criminalize the use of cryptocurrencies. This does not mean that Bitcoin prices cannot rise further, but the price trend is following the path of other manias making it a highly speculative play (Chart 41). If you want more detail about our thoughts on this complex topic then you can read the report we published last September.2 Chart 41Bitcoin Looks Like Other Bubbles Ms. X: I don't fear bubbles and manias as much as my father and have made a lot of money during such episodes in the past. But I am inclined to agree that Bitcoin is best avoided. The topic of manic events presents a nice segue into the geopolitical environment which seems as volatile as ever. Geopolitics Ms. X: Which geopolitical events do you think will have the biggest impact on the markets over the coming year? BCA: Domestic politics in the U.S. and China will be very much in focus in 2018. In the U.S., as we discussed, the Republicans will pass tax cuts but it is unclear whether this will help the GOP in the November midterm elections. At this point, all of our data and modeling suggests that Democrats have a good chance of picking up the House of Representatives, setting a stage for epic battles with President Trump about everything under the sun. In China, we are watching carefully for any sign that Beijing is willing to stomach economic pain in the pursuit of economic reforms. The two reforms that would matter the most are increased financial regulation and more aggressive purging of excess capacity in the industrial sector. The 19th Party Congress marked a serious reduction in political constraints impeding President Xi's domestic agenda. This means he could launch ambitious reforms, akin to what President Jiang Zemin did in the late 1990s. While this is a low-conviction view, and requires constant monitoring of the news and data flow out of China, it would be a considerable risk to global growth. Reforms would be good for China's long-term outlook, but could put a significant damper on short-term growth. The jury is out, but the next several months will be crucial. Three other issues that could become market-relevant are the ongoing North Korean nuclear crisis, trade protectionism, and tensions between the Trump administration and Iran. The first two are connected because a calming of tensions with North Korea would give the U.S. greater maneuvering room against China. The ongoing economic détente between the U.S. and China is merely a function of President Trump needing President Xi's cooperation on pressuring North Korea. But if President Trump no longer needs China's help with Kim Jong-Un, he may be encouraged to go after China on trade. As for Iran, it is not yet clear if the administration is serious about ratcheting up tensions or whether it is playing domestic politics. We suspect it is the latter implying that the market impact of any brinkmanship will be minor. But our conviction view is low. Mr. X: We seem to be getting mixed messages regarding populist pressures in Europe. The far right did not do as well as expected in the Netherlands or France, but did well in Austria. Also, Merkel is under some pressure in Germany. BCA: We don't see much in the way of mixed messages, at least when it comes to support for European integration. In Austria, the populists learned a valuable lesson from the defeats of their peers in the Netherlands and France: stay clear of the euro. Thus the Freedom Party committed itself to calling a referendum on Austria's EU membership if Turkey was invited to join the bloc. As the probability of that is literally zero, the right-wing in Austria signaled to the wider public that it was not anti-establishment on the issue of European integration. In Germany, the Alternative for Germany only gained 12.6%, but it too focused on an anti-immigration platform. The bottom line for investors is that the European anti-establishment right is falling over itself to de-emphasize its Euroskepticism and focus instead on anti-immigration policies. For investors, the former is far more relevant than the latter, meaning that the market relevance of European politics has declined. One potential risk in 2018 is the Italian election, likely to be held by the end of the first quarter. However, as with Austria, the anti-establishment parties have all moved away from overt Euroskepticism. At some point over the next five years, Italy will be a source of market risk, but in this electoral cycle and not with economic growth improving. Ms. X: The tensions between the U.S. and North Korea, fueled by two unpredictable leaders, have me very concerned. I worry that name-calling may slide into something more serious. How serious is the threat? BCA: The U.S.-Iran nuclear negotiations are a good analog for the North Korean crisis. The U.S. had to establish a "credible threat" of war in order to move Iran towards negotiations. As such, the Obama administration ramped up the war rhetoric - using Israel as a proxy - in 2011-2012. The negotiations with Iran did not end until mid-2015, almost four years later. We likely have seen the peak in "credible threat" display this summer between the U.S. and North Korea. The next two-to-three months could revisit those highs as North Korea responds to President Trump's visit to the region, as well as to the deployment of the three U.S. aircraft carriers off the coast of the Korean Peninsula. However, we believe that we have entered the period of "negotiations." It is too early to tell how the North Korean crisis will end. We do not see a full out war between either of the main actors. We also do not see North Korea ever giving up its nuclear arsenal, although limiting its ballistic technology and toning down its "fire and brimstone' rhetoric is a must. The bottom line is that this issue will remain a source of concern and uncertainty for a while longer. Conclusions Mr. X: This seems a good place to end our discussion. We have covered a lot of ground and your views have reinforced my belief that it would make good sense to start lowering the risk in our portfolio. I know that such a policy could leave money on the table as there is a reasonable chance that equity prices may rise further. But that is a risk I am prepared to take. Ms. X: I foresee some interesting discussions with my father when we get back to our office. At the risk of sounding reckless, I remain inclined to stay overweight equities for a while longer. I am sympathetic to the view that the era of hyper-easy money is ending and at some point that may cause a problem for risk assets. However, timing is important because, in my experience, the final stages of a bull market can deliver strong gains. BCA: Good luck with those discussions! We have similar debates within BCA between those who want to maximize short-run returns and those who take a longer-term view. Historically, BCA has had a conservative bias toward investment strategy and the bulk of evidence suggests that this is one of these times when long-run investors should focus on preservation of capital rather than stretching for gains. Our thinking also is influenced by our view that long-run returns will be very poor from current market levels. Our estimates indicate that a balanced portfolio will deliver average returns of only 3.3% a year over the coming decade, or 1.3% after inflation (Table 3). That is down from the 4% and 1.9% nominal and real annual returns that we estimated a year ago, reflecting the current more adverse starting point for valuations. There is a negligible equity risk premium on offer, implying that stock prices have to fall at some point to establish higher prospective returns. Table 310-Year Asset Return Projections The return calculations for equities assume profit margins decline modestly over the period and that multiples mean revert to their historical average. These assumptions may turn out to be too pessimistic if there is no redistribution of income shares from the corporate sector back to labor and/or PERs stay at historically high levels. In that case, equities obviously would do better than our estimates. In terms of the outlook for the coming year, a lot will depend on the pace of economic growth. We are assuming that growth is strong enough to encourage central banks to keep moving away from hyper-easy policies, setting up for a collision with markets. If growth slows enough that recession fears spike, then that also would be bad for risk assets. Sustaining the bull market requires a goldilocks growth outcome of not too hot and not too cold. That is possible, but we would not make it our base case scenario. Ms. X: You have left us with much to think about and I am so glad to have finally attended one of these meetings. My father has always looked forward to these discussions every year and I am very happy to be joining him. Many thanks for taking the time to talk to us. Before we go, it would be helpful to have a recap of your key views. BCA: That will be our pleasure. The key points are as follows: The environment of easy money, low inflation and healthy profit growth that has been so bullish for risk assets will start to change during the coming year. Financial conditions, especially in the U.S., will gradually tighten as decent growth leads to building inflation pressures, encouraging central banks to withdraw stimulus. With U.S. equities at an overvalued extreme and investor sentiment overly optimistic, this will set the scene for an eventual collision between policy and the markets. The conditions underpinning the bull market will erode only slowly which means that risk asset prices should continue to rise for at least the next six months. However, long-run investors should start shifting to a neutral exposure. Given our economic and policy views, there is a good chance that we will move to an underweight position in risk assets during the second half of 2018. The U.S. economy is already operating above potential and thus does not need any boost from easier fiscal policy. Any major tax cuts risk overheating the economy, encouraging the Federal Reserve to hike interest rates and boosting the odds of a recession in 2019. This is at odds with the popular view that tax cuts will be good for the equity market. A U.S. move to scrap NAFTA would add to downside risks. For the second year in a row, the IMF forecasts of economic growth for the coming year are likely to prove too pessimistic. The end of fiscal austerity has allowed the euro area economy to gather steam and this should be sustained in 2018. However, the slow progress in negotiating a Brexit deal with the EU poses a threat to the U.K. economy. China's economy is saddled with excessive debt and excess capacity in a number of areas. Any other economy would have collapsed by now, but the government has enough control over banking and other sectors to prevent a crisis. Growth should hold above 6% in the next year or two, although much will depend on how aggressively President Xi pursues painful reforms. The market is too optimistic in assuming that the Fed will not raise interest rates by as much as indicated in their "dots" projections. There is a good chance that the U.S. yield curve will become flat or inverted by late 2018. Bonds are not an attractive investment at current yields. Only Greece and Portugal currently have 10-year government bond real yields above their historical average. Corporate bonds should outperform governments, but a tightening in financial conditions will put these at risk in the second half of 2018. The euro area and Japanese equity markets should outperform the U.S. over the next year reflecting their better valuations and more favorable financial conditions. Developed markets should outperform the emerging market index. Historically, the U.S. equity market has led recessions by between 3 and 12 months. If, as we fear, a U.S. recession starts in the second half of 2019, then the stock market would be at risk from the middle of 2018. The improving trend in capital spending should favor industrial stocks. Our other two overweight sectors are energy and financials. The oil price will be well supported by strong demand and output restraint by OPEC and Russia. The Brent price should average $65 a barrel over the coming year, with risks to the upside. We expect base metals prices to trade broadly sideways but will remain highly dependent on developments in China. Modest positions in gold are warranted. Relative economic and policy trends will favor a firm dollar in 2018. Unlike at the start of 2017, investors are significantly short the dollar which is bullish from a contrary perspective. Sterling is quite cheap but Brexit poses downside risks. The key market-relevant geopolitical events to monitor will be fiscal policy and mid-term elections in the U.S., and reform policies in China. With the former, the Democrats have a good chance of winning back control of the House of Representatives, creating a scenario of complete policy gridlock. A balanced portfolio is likely to generate average returns of only 3.3% a year in nominal terms over the next decade. This compares to average returns of around 10% a year between 1982 and 2017. Let us take this opportunity to wish you and all of our clients a very peaceful, healthy and prosperous New Year. The Editors November 20, 2017 1 This comprises consumer spending on durables, housing and business investment in equipment and software. 2 Please see 'Bitcoin's Macro Impact', BCA Global Investment Strategy Special Report, September 15, 2017.