Equities

Highlights The macro environment remains positive for risk assets. Nonetheless, the shadow of the '87 stock market crash is a reminder that major market corrections can occur even when the earnings and economic growth backdrop is upbeat. Our base case remains that global growth will stay reasonably firm in 2018, although the composition of that growth will shift towards the U.S. thanks to the lagged effects of easier financial conditions and the likelihood of some fiscal stimulus next year. Positive U.S. economic growth surprises and the disappearing output gap will allow the Fed to raise rates more than is discounted by the markets, providing a lift to the dollar and widening U.S. yield spreads relative to its trading partners. The momentum in profit growth, however, will favor Japan relative to the U.S. and Europe. Investors should overweight Japanese equities and hedge the currency risk. There is still more upside for oil prices, but we are not playing the rally in base metals. The Chinese economy is performing well at the moment, but ample base metal supply and a rising dollar argue against a substantial price rise from current levels. Emerging market equities should underperform the developed markets due to a rising U.S. dollar and the largely sideways path for base metals. Our macro and profit views are consistent with cyclicals outperforming defensive stocks. Investors should also continue to bet on higher inflation expectations and be overweight corporate bonds (relative to governments). High-yield relative value is decent after accounting for the favorable default outlook. It is too early to fully retreat from risk assets and prepare for the next recession. Nonetheless, the market has entered a late cycle phase. Investors appear to have shed fears of secular stagnation, and have embraced a return to a lackluster-growth version of the Great Moderation. The risk of disappointment is therefore elevated. Low levels of market correlation and implied volatility can perhaps be justified, but only if there are no financial accidents on the horizon and any rise in inflation is gradual enough to keep the bond vigilantes at bay. Investors with less tolerance for risk should maintain an extra cash buffer to protect against swoons and provide dry powder to boost exposure after the correction. Feature The October anniversary of the '87 stock market crash was a reminder to investors that major market corrections can arrive out of the blue. With hindsight, there were some warning signs evident before the crash. Nonetheless, the speed and viciousness of the correction caught the vast majority of investors by surprise, in large part because the economy was performing well (outside of some yawning imbalances such as the U.S. current account deficit). Many worried that the 20% drop in the S&P 500 would trigger a recession, but the economy did not skip a beat and it was not long before the equity market recouped the losses. We view the '87 crash as a correction rather than a bear market. BCA's definition of a bear market is a combination of magnitude (at least a 15% decline) and duration (lasting at least for six months). Bear markets are usually associated with economic recessions. Corrections tend to be short-lived because they are not associated with an economic downturn. None of our forward-looking indicators suggest that a recession is in the cards in the near term for any of the major economies. Even the risk of a financial accident or economic pothole in China has diminished in our view. As discussed below, the global economy is firing on almost all cylinders. Chart I-1Valuation Today Is Very Stretched Vs. 1987 Nonetheless, there are some parallels today with the mid-1980s. A Special Report sent to all BCA clients in October provides a retrospective on the '87 crash.1 One concern is that the proliferation of financial computer algorithms and derivatives is a parallel to the popularity of portfolio insurance in the 1980s, which was blamed for turbocharging the selling pressure when the market downturn gathered pace in October. My colleague Doug Peta downplays the risks inherent in the ETF market in the Special Report, but argues that automatic selling will again reinforce the fall in prices once it starts. It is also worrying that equity valuation is much more stretched than was the case in the summer of 1987 based on the cyclically-adjusted P/E ratio (CAPE, Chart I-1). The CAPE is currently at levels only previously reached ahead of the 1929 and 2000 peaks. In contrast, the CAPE was close to its long-term average in 1987. Quantitative easing and extremely low interest rates have pulled forward much of the bond and stock markets' future returns. It has also contributed to today's extremely low readings on implied volatility. The fact that the Fed is slowly taking away the punchbowl and that the ECB is dialing back its asset purchase program only add to the risk of a sharp correction. The Good News For now though, investors are focusing on the improving global growth backdrop and the still-solid earnings picture. While the S&P 500 again made new highs in October, it was the Nikkei that stole the show among the major countries. Impressively, the surge in the Japanese stock market was not on the back of a significantly weaker yen. As we highlighted last month, risk assets are being supported by the three legged stool of robust earnings growth, low volatility and yield levels in government bonds, and the view that inflation will remain quiescent for the foreseeable future. The fact that the global growth impulse is broadly-based is icing on the cake because it reduces lingering fears of secular stagnation. Even emerging economies have joined the growth party, while a weak U.S. dollar has tempered fears of a financial accident in this space. Our forward-looking growth indicators are upbeat (Chart I-2). Our demand indicators in the major economies remain quite bullish, especially for capital spending (not shown). Animal spirits are beginning to stir. Moreover, financial conditions remain growth-friendly, especially in the U.S., and subdued inflation is allowing central banks to proceed cautiously for those that are tightening or tapering. The global PMI broke to a new high in October, and the economic surprise index for the major economies has surged in recent months. Our global LEI remains in a strong uptrend and its diffusion index shifted back into positive territory, having experiencing a worrisome dip into negative territory earlier this year. We expect the global growth upturn will persist for at least the next year. The U.S. will be the first major economy to enter the next recession, although this should not occur until 2019. It is thus too early to expect the equity market to begin to anticipate the associated downturn in profit growth. Earnings: Japan A Star Performer It is still early days in the Q3 earnings season, but the mini cyclical rebound from the 2015/16 profit recession in the major economies is still playing out. The bright spots at the global level outside of energy are industrials, materials, technology and consumer staples (Chart I-3). All four are benefitting from strengthening top line growth and rising operating margins. Chart I-2Upbeat Global Economic Indicators Chart I-3Global Earnings By Sector The U.S. is further advanced in the mini-cycle and EPS growth is near its peak on a 4-quarter moving total basis. The expected topping out in profit growth is more a reflection of challenging year-on-year comparisons than a deterioration in the underlying fundamentals. The hurricanes will take a bite out of third quarter earnings, but this effect will be temporary. Moreover, oil prices are turbocharging earnings in the energy patch and we expect this to continue. Our commodity strategists recently lifted their 2018 target price for both Brent and WTI to $65/bbl and $63/bbl, respectively. The global uptick in GDP growth, along with continued production discipline from OPEC 2.0 are the principal drivers of our revised outlook. We expect the fortuitous combination of fundamentals to accelerate the drawdown in oil inventories globally, which also will be supportive for prices. While U.S. financials stocks have cheered the prospects that Congress may pass a tax bill sometime in early 2018, sell-side analysts have been brutally downgrading financial sector EPS estimates. This has dealt a blow to net earnings revisions in the sector. Expected hurricane-related losses are probably the main culprit, especially in the insurance sector. Nonetheless, our equity sector strategists argue that such indiscriminate downgrades are unwarranted, and we would lean against such pessimism.2 Recent profit results corroborate our positive sector bias, although we are still early in the earnings season. European profits will suffer to some extent in the third quarter due to the lagged effects of previous euro strength. The same will be true in the fourth quarter, although we expect this headwind to diminish early in 2018. That leaves Japan as the star profit performer among the majors in the near term. The recent surge in foreign flows into the Japanese market suggests that global investors are beginning to embrace the upbeat EPS story. Abe's election win in October means that the current monetary stance will remain in place. The ruling LDP's shift away from austerity (e.g. abandoning the primary balance target) may also be lifting growth expectations. A Return To The Great Moderation? Chart I-4Market Correlation And The ERP A lot of the good news is already discounted in equity prices. The depressed level of the VIX and the drop in risk asset correlations this year signal significant complacency. Large institutional investors are reportedly selling volatility and thus dampening vol across asset classes. But there is surely more to it. It appears that investors believe we have returned to the pre-Lehman period between 1995 and 2006 when the Great Moderation in macro volatility contributed to low correlations among stocks within the equity market (Chart I-4). The idea is that low perceived macroeconomic volatility during that period had diminished the dispersion of growth and inflation forecasts, thereby trimming the variance of interest rate projections. This allowed equity investors to focus on alpha rather than beta, given less uncertainty about the macro outlook. Of course, the Great Recession and financial market crisis brought the Great Moderation to a crashing end. Correlations rocketed up and investors demanded a higher equity risk premium to hold stocks. Today, dispersion in the outlooks for growth and interest rates have fallen back to pre-Lehman levels, helping to explain the low levels of implied volatility and correlation in the equity market (Chart I-5). Some of this can be justified by fundamentals. The onset of a broadly-based global expansion phase has likely calmed lingering fears that the global economy is constantly teetering on the edge of the abyss. Investor uncertainty regarding economic policy has moderated as well (bottom panel). Historically, implied volatility tended to fall during previous periods when global industrial production was strong and global earnings were rising across a broad swath of countries (Chart I-6). Our U.S. Equity Sector Strategy service points out that, during the later stages of the cycle, equity sector correlations tend to fall as earnings fundamentals become more important performance drivers and sector differentiation generates alpha, as the broad market enters the last stage of the bull market. Similarly, the VIX can fluctuate at low levels for an extended period when global growth is broadly based. Chart I-5A Less Uncertain Macro Outlook? Chart I-6Broad-Based Growth Lower Implied Volatility Still, current levels of equity market correlation and the VIX are unnerving given a plethora of potential geopolitical crises and the pending unwinding of the Fed's balance sheet. Moreover, any meaningful pickup in inflation would upset the 'low vol' applecart. Table I-1 shows the drop in the S&P 500 index during non-recession periods when the VIX surges by more than 10% in a 13-week period. The equity price index fell by an average of 7% during the nine episodes, with a range of -3.6 to -18.1%. Table I-1Episodes When VIX Spiked The Equity Risk Premium Chart I-7Still Some Value In High-Yield On a positive note, the equity risk premium (ERP) is not overly depressed. There are many ways to define the ERP, but we present it as the 12-month forward earnings yield minus the 10-year Treasury yield in Chart I-4. It has fallen from about 760 basis points in 2011 to 310 basis points today. We do not believe that the ERP can return to the extremely low levels of 1990-2000. At best, the ERP may converge with the level that prevailed during the last equity bull market, from 2003-2007 (about 200 basis points). The current forward earnings yield is 550 basis points and the 10-year Treasury yield is 2.4%. The ERP would need to fall by 110 basis points to get back to the 2% equilibrium. This convergence can occur through some combination of a lower earnings yield or higher bond yield. If the 10-year yield is assumed to peak in this cycle at about 3% (our base case), then this leaves room for the earnings yield to fall by 50 basis points. This would boost the forward earnings multiple from 18 to 20. However, a rise in the 10-year yield to 3½% would leave no room for multiple expansion. We are not betting on any further multiple expansion but the point is that stocks at least have some padding in the event that bond yields adjust higher in a gradual way. It is the same story for speculative-grade bonds, which are not as expensive as they seem on the surface. The average index OAS is currently 326 bps, only about 100 bps above its all-time low. However, junk value appears much more attractive once the low default rate is taken into account. Chart I-7 presents the ex-post default-adjusted spreads, along with our forecast based on unchanged spreads and our projection for net default losses over the next year. The spread padding offered by the high-yield sector is actually reasonably good by historical standards, assuming there is no recession over the next year. We are not banking on much spread tightening from here, which means that high-yield is largely a carry trade now. Nonetheless, given a forecast for the default and recovery rate, we expect U.S. high-yield excess returns to be in the range of 2% and 5% (annualized) over the next 6-12 months. The bottom line is that the positive growth backdrop does not rule out a correction in risk assets, especially given rich valuations. But at least the profit, default and growth figures will remain a tailwind in the near term. The main risk is a breakout in inflation, which financial markets are not priced for. Inflation And Hidden Slack The September CPI report did little to buttress the FOMC's view that this year's inflation pullback is temporary. The report disappointed expectations again with core CPI rising only 0.13% month-over-month. For context, an environment where inflation is well anchored around the Fed's target would be consistent with core CPI prints of 0.2% every month, roughly 2.4% annualized. The inflation debate continues to rage inside and outside the Fed as to whether the previous relationship between inflation and growth have permanently changed, whether low inflation simply reflects long lags, or whether it will require tighter labor markets in this business cycle to fuel wage and price pressures. We back the latter two of these three explanations but, admittedly, predicting exactly when inflation will pick up is extremely difficult and we must keep an open mind. A Special Report in the October IMF World Economic Outlook sheds some light on this vexing issue.3 Their work suggests that the deceleration in wage growth in the post-Lehman period in the OECD countries can largely be explained by traditional macro factors: weak productivity growth, lower inflation expectations and labor market slack. The disappointing productivity figures alone account for two-thirds of the drop in wage growth. However, a key point of the research is that the headline unemployment figures are not as good a measure of labor market slack as they once were. This is because declining unemployment rates partly reflect workers that have been forced into part-time jobs, referred to as involuntary part-time employment (IPT). The rise in IPT employment could be associated with automation, the growing importance of the service sector, and a diminished and more uncertain growth outlook that is keeping firms cautious. The IMF's statistical analysis suggests that the number of involuntary part-time workers as a share of total employment (IPT ratio) is an important measure of slack that adds information when explaining the decline in wage growth. Historically, each one percentage point rise in the IPT ratio trimmed wage growth by 0.3 percentage points. Chart I-8 and Chart I-9 compare the unemployment rate gap (unemployment rate less the full-employment estimate) with the deviation in the IPT ratio from its 2007 level. The fact that the IPT ratio has had an upward trend since 2000 in many countries makes it difficult to identify a level that is consistent with full employment. Nonetheless, the change in this ratio since 2007 provides a sense of how much "hidden slack" the Great Recession generated due to forced part-time employment. Chart I-8Measures Of Labor Market Slack (I) Chart I-9Measures Of Labor Market Slack (II) For the OECD as a whole, labor market slack has been fully absorbed based on the unemployment gap. However, the IPT ratio was still elevated at the end of 2016 (latest data available), helping to explain why wage growth has remained so depressed across most countries. The IPT ratio is still above its 2007 level in three-quarters of the OECD countries. Of course, there is dispersion across countries. Japan has no labor market slack by either measure. In the U.S., the unemployment gap has fallen into negative territory, but only about half of the post-2007 rise in the IPT ratio has been unwound. For the Eurozone, the U.K. and Canada, the unemployment gap is close to zero (or well into negative territory in the U.K.). Nonetheless, little of the under-employment problem in these economies has been absorbed based on the IPT ratio. Our discussion in last month's report highlighted the importance of the global output gap in driving inflation in individual countries. Consistent with this, the IMF finds that there have been important spillover effects related to labor market slack, especially since 2007. This means that wage growth can be held down even in countries where slack has disappeared because of the existence of a surplus of available labor in their trading partners. Phillips Curve Is Not Dead That said, we still believe that the U.S. is at a point in the cycle when inflationary pressures should begin to build, even in the face of persisting labor market slack at the global level. Chart I-10 shows the ECI and the Atlanta Fed wage tracker, which are the best measures of wages because they are less affected by composition effects. Both have moved higher along with measures of labor market tightness. Wage and consumer price inflation have ebbed this year, but when we step back and look at it over a longer timeframe, the Phillips curve still appears to be broadly operating. Moreover, inflation is a lagging indicator. Table I-2 splits the post-war U.S. business cycles into short, medium, and long buckets based on the length of the expansion phase. It presents the number of months from when full employment was reached to the turning point for consumer price inflation in each expansion. There was a wide variation in this lag in the short- and medium-length expansions, but the lags were short on average. Chart I-10Phillips Curve Still (Weakly) Operating Table I-2Inflation Reacts With A Lag It is a different story for long expansions, where the lag averaged more than two years. We have pointed out in the past that it takes longer for inflation pressures to reveal themselves when the economy approaches full employment gradually, in contrast to shorter expansions when momentum is so strong the demand crashes into supply constraints. The fact that U.S. unemployment rate has only been below the estimate of full employment for eight months in this expansion suggests that perhaps we and the Fed are just being too impatient in waiting for the inflection point. Turning to Europe, the IPT ratio confirms the ECB's view that there is an abundance of under-employment, despite the relatively low unemployment rate. This suggests that the Eurozone remains behind the U.S. in the economic cycle. As expected, the ECB announced a tapering in its asset purchase program to take place next year. While policymakers are backing away from QE in the face of healthy growth and a shrinking pool of bonds to purchase, they will continue to emphasize that rate hikes are a long way off in order to avoid a surge in the euro and an associated tightening in financial conditions. U.S./Eurozone bond yield spreads are still quite wide by historical standards and thus it is popular to bet on spread narrowing and a stronger euro/weaker dollar. However, some narrowing in short-term rate spreads is already discounted based on the OIS forward curve (Chart I-11). The real 5-year, 5-year forward OIS spread - the market's expectation of how much higher U.S. real 5-year rates will be in five years' time relative to the euro area - stands at about 70 basis points. This spread is not wide by historical standards, and thus has room to widen again if market expectations for the fed funds rate moves up toward the Fed's 'dot plot' over the next 6-12 months. While market pricing for the ECB policy rate path appears about right in our view, market expectations for rate hikes in the U.S. are too complacent. This implies that long-term spreads could widen in favor of the U.S. dollar over the coming months, especially if U.S. growth accelerates while euro area growth cools off a bit. The fact the U.S. economic surprise index has turned positive is early evidence that this process may have already begun. Moreover, the starting point is that the dollar has been weaker than interest rate differentials warrant, such that there is some room for the dollar to 'catch up', even if interest rate differentials do not move (Chart I-12). We see EUR/USD falling to 1.15 by the end of the year. Chart I-11Room For U.S./Eurozone Spreads To Widen... Chart I-12...Giving The Dollar A Lift A New Fed Chair? Our forecast for yield spreads and currencies is not overly affected by the choice of Fed Chair for next year. President Trump's meeting with academic John Taylor reportedly went well, but we think the President will prefer someone with a less hawkish bent. Keeping Chair Yellen is an option, but she has strong views on financial sector regulation that Trump does not like. The prevailing wisdom is that Jerome Powell is a moderate who is only slightly more hawkish than Yellen. But the truth is that we don't really know where he stands because he has no academic publication record and has generally steered clear of taking bold views on monetary policy. In any event, the organizational structure of the Fed makes it impossible for the chair to run roughshod over other FOMC members. This suggests that no matter who is selected, the general thrust of monetary policy will not change radically next year. As discussed above, uncertainty is elevated, but our base case sees inflation rising enough in the coming months for the Fed to maintain their 'dot plot' forecast. The market and the Fed are correct to 'look through' the near-term growth hit from the hurricanes, to the rebound that always follows the destruction. The U.S. housing sector is a little more worrying because some softness was evident even before the hurricanes hit. Since the early 1960s, a crest in housing led the broader economic downturn by an average of seven quarters. Nonetheless, we continue to expect that the housing soft patch does not represent a peak for this cycle. Residential investment should provide fuel to the economy for at least the next two years as pent up demand is worked off, related to depressed household formation since the 2008 financial crisis. Affordability will still be favorable even if mortgage rates were to rise by another 100 basis points (Chart I-13). Robust sentiment in the homebuilder sector in October confirms that the hurricane setback in housing starts is temporary. China And Base Metals Turning to China, economic momentum is on the upswing. Real-time measures of economic activity such as electricity production, excavator sales, and railway freight traffic are all growing at double-digit rates, albeit down from recent peak levels (Chart I-14). Various price indexes also reveal a fairly broadly-based inflation pickup to levels that will unnerve the authorities. Growth will likely slow in 2018 as policymakers continue to pare back stimulus. We do not foresee a substantial growth dip next year, but it could be hard on base metals prices. Chart I-13Housing Affordability Outlook Housing ##br##Affordability Under Various Rate Assumptions Chart I-14China: Healthy ##br##Growth Indicators Policy shifts discussed in Chinese President Xi's speech in October to the Party Congress are also negative for metals prices in the medium term. The speech provided a broad outline of goals to be followed by concrete policy initiatives at the National People's Congress (NPC) in March 2018. He emphasized that policy will tackle inequality, high debt levels, overcapacity and pollution. Globalization will also remain a priority of the government. The supply side reforms required to meet these goals will be positive in the long run, but negative for growth in the short run. Restructuring industry, deleveraging the financial sector and fighting smog will all have growth ramifications. The government could use fiscal stimulus to offset the short-term hit to growth. However, while overall growth may not slow much, the shift away from an investment-heavy, deeply polluting growth model, will undermine the demand for base metals. Our commodity strategists also highlight the supply backdrop for most base metals is not supportive of an extended rally in prices. The implication is that investors who are long base metals should treat it as a trade rather than a strategic position. Despite our expectation that policy will continue to tighten, we believe that investors should overweight Chinese stocks relative to other EM markets. Investment Conclusions: Our base case remains that global growth will stay reasonably firm in 2018, although the composition of that growth will shift towards the U.S. thanks to the lagged effects of the easing in U.S. financial conditions that has taken place this year and the likelihood of some fiscal stimulus next year. The U.S. Congress has drawn closer to approving a budget resolution for fiscal 2018 that would pave the way for tax legislation to reach President Donald Trump's desk by the end of the first quarter of next year. Surveys show that investors have all but given up on the prospect of tax cuts, which means that it will be a positive surprise if it finally arrives (as we expect). Positive U.S. economic growth surprises and the disappearing output gap will allow the Fed to raise rates more than is discounted by the markets, providing a lift to the dollar and widening U.S. yield spreads relative to its trading partners. The momentum in profit growth, however, will favor Japan relative to the U.S. and Europe. Investors should favor Japanese equities and hedge the currency risk. There is still more upside for oil prices, but we are not playing the rally in base metals. The Chinese economy is performing well at the moment, but ample base metal supply and a rising dollar argue against a substantial price rise from current levels. Emerging market equities should underperform the developed markets due to a rising U.S. dollar and the largely sideways path for base metals. Our macro and profit views are consistent with cyclicals outperforming defensive stocks. Investors should also continue to bet on higher inflation expectations and be overweight corporate bonds (relative to governments) in the major developed fixed-income markets. Our base-case outlook implies that it is too early to fully retreat from risk assets and prepare for the next recession. Nonetheless, the market has entered a late-cycle phase. Calm macro readings and still-easy monetary policy have generated signs of froth. Investors appear to have shed fears of secular stagnation, and have embraced a return to a lackluster-growth version of the Great Moderation. Low levels of market correlation and implied volatility can perhaps be justified, but only if there are no financial accidents on the horizon and any rise in inflation is gradual enough to keep the bond vigilantes at bay. Upside inflation surprises would destabilize the three-legged stool supporting risk assets, especially at a time when the Fed is shrinking its balance sheet. Black Monday is a reminder that major market pullbacks can occur even when the economic outlook is bright. Thus, investors with less tolerance for risk should maintain an extra cash buffer to protect against swoons, and to ensure that they have dry powder to exploit them when they materialize. Mark McClellan Senior Vice President The Bank Credit Analyst October 26, 2017 Next Report: November 20, 2017 1 Please see BCA Special Report, "Black Monday, Thirty Years On: Revisiting The First Modern Global Financial Crisis," October 19, 2017, available at bca.bcaresearch.com 2 Please see BCA U.S. Equity Strategy Weekly Report, "Banks Hold The Key," October 24, 2017, available at uses.bcaresearch.com 3 Recent Wage Dynamics In Advanced Economies: Drivers And Implications. Chapter 2, IMF World Economic Outlook. October 2017. II. Three Demographic Megatrends Dear Client, This month's Special Report is written by my colleague, Peter Berezin, Chief Global Strategist. Peter highlights three key demographic trends that will shape financial markets in the coming decades. His non-consensus conclusions include the idea that demographic trends will be negative for both bonds and equities over the long haul, in part because the trends are inflationary. Moreover, continuing social fragmentation will not be good for business. Mark McClellan Megatrend #1: Population Aging. Aging has been deflationary over the past few decades, but will become inflationary over the coming years. Megatrend #2: Global Migration. International migration has the potential to lift millions out of poverty while boosting global productivity. However, if left unmanaged, it poses serious risks to economic stability. Megatrend #3: Social Fragmentation. Rising inequality, cultural self-segregation, and political polarization are imperilling democracy and threatening free-market institutions. On balance, these trends are likely to be negative for both bonds and equities over the long haul. In today's increasingly short-term oriented world, it is easy to lose track of megatrends that are slowly shifting the ground under investors' feet. In this report, we tackle three key social/demographic trends. Chart II-1Our Aging World Megatrend #1: Population Aging Fertility rates have fallen below replacement levels across much of the planet. This has resulted in aging populations and slower labor force growth (Chart II-1). In the standard neoclassical growth model, a decline in labor force growth pushes down the real neutral rate of interest, r*. This happens because slower labor force growth causes the capital stock to increase relative to the number of workers, resulting in a lower rate of return on capital.1 The problem with this model is that it treats the saving rate as fixed.2 In reality, the saving rate is likely to adjust to changes in the age composition of the workforce. Initially, as the median age of the population rises, aggregate savings will increase as more people move into their peak saving years (ages 30 to 50). This will put even further downward pressure on the neutral rate of interest. Eventually, however, savings will fall as these very same people enter retirement. This, in turn, will lead to a higher neutral rate of interest. If central banks drag their feet in raising policy rates in response to an increase in r*, monetary policy will end up being too stimulative. As economies overheat, inflation will pick up, leading to higher long-term nominal bond yields. Contrary to popular belief, spending actually increases later in life once health care costs are included in the tally (Chart II-2). And despite all the happy talk about how people will work much longer in the future, the unfortunate fact is that the percentage of American 65 year-olds who are unable to lead active lives because of health care problems has risen from 8.8% to 12.5% over the past 10 years (Chart II-3). Cognitive skills among 65 year-olds have also declined over this period. We are approaching the inflection point where demographic trends will morph from being deflationary to being inflationary. Globally, the ratio of workers-to-consumers - the so-called "support ratio" - has peaked after a forty-year ascent (Chart II-4). As the support ratio declines, global savings will fall. To say that global saving rates will decline is the same as saying that there will be more spending for every dollar of income. Since global income must sum to global GDP, this implies that global spending will rise relative to production. That is likely to be inflationary. Chart II-2Savings Over The Life Cycle Chart II-3Climbing Those Stairs Is ##br##Getting More And More Difficult Chart II-4The Ratio Of Workers To ##br##Consumers Has Peaked The projected evolution of support ratios varies across countries. The most dramatic change will happen in China. China's support ratio peaked a few years ago and will fall sharply during the coming decade. Nearly one billion Chinese workers entered the global labor force during the 1980s and 1990s as the country opened up to the rest of the world. According to the UN, China will lose over 400 million workers over the remainder of the century (Chart II-5). If the addition of millions of Chinese workers to the global labor force was deflationary in the past, their withdrawal will be inflationary in the future. The fabled "Chinese savings glut" will eventually dry up. Chart II-5China On Course To Lose More ##br##Than 400 Million Workers Rising female labor force participation rates have blunted the effect of population aging in Europe and Japan. This has allowed the share of the population that is employed to increase over the past few decades. However, as female participation stabilizes and more people enter retirement, both regions will also see a rapid decline in saving rates. This could lead to a deterioration in their current account balances, with potential negative implications for the yen and the euro. Population aging is generally bad news for equities. The slower expansion in the labor force will reduce the trend GDP growth. This will curb revenue growth, and by extension, earnings growth. To make matter worse, to the extent that lower savings rates lead to higher real interest rates, population aging could reduce the price-earnings multiple at which stocks trade. This could be further exacerbated by the need for households to run down their wealth as they age, which presumably would include the sale of equities. Megatrend #2: Global Migration Economist Michael Clemens once characterized the free movement of people across national boundaries as a "trillion-dollar bill" just waiting to be picked up from the sidewalk.3 Millions of workers toil away in poor countries where corruption is rife and opportunities for gainful employment are limited. Global productivity levels would rise if they could move to rich countries where they could better utilize their talents. Academic studies suggest that less restrictive immigration policies would do much more to raise global output than freer trade policies. In fact, several studies have concluded that the removal of all barriers to labor mobility would more than double global GDP (Table II-1). The problem is that many migrants today are poorly skilled. While they can produce more in rich countries than they can back home, they still tend to be less productive than the average native-born worker. This can be especially detrimental to less-skilled workers in rich countries who have to face greater competition - and ultimately, lower wages - for their labor. Chart II-6 shows that the share of U.S. income accruing to the top one percent of households has closely tracked the foreign-born share of the population. Table II-1Economic Benefits Of Open Borders Chart II-6Immigration Versus Income Distribution Low-skilled migration can also place significant strains on social safety nets. These concerns are especially pronounced in Europe. The employment rate among immigrants in a number of European countries is substantially lower than for the native-born population (Chart II-7). For example, in Sweden, the employment rate for immigrant men is about 10 percentage points lower than for native-born men. For women, the gap is 17 points. The OECD reckons that a typical 21-year old immigrant to Europe will contribute €87,000 less to public coffers in the form of lower taxes and higher welfare benefits than a non-immigrant of the same age (Chart II-8). Chart II-7Low Levels Of Immigrant Labor Participation In Parts Of Europe Chart II-8Immigration Is Straining Generous ##br##European Welfare States All of this would matter little if the children of today's immigrants converged towards the national average in terms of income and educational attainment, as has usually occurred with past immigration waves. However, the evidence that this is happening is mixed. While there is a huge amount of variation within specific immigrant communities, on average, some groups have fared better than others. The children of Asian immigrants to the U.S. have tended to excel in school, whereas college completion rates among third-generation-and-higher, self-identified Hispanics are still only half that of native-born non-Hispanic whites (Chart II-9). Across the OECD, second generation immigrant children tend to lag behind non-immigrant students, often by substantial margins (Chart II-10). Chart II-9Hispanic Educational Attainment Lags Behind Chart II-10Worries About Immigrant Assimilation Immigration policies that place emphasis on attracting skilled migrants would mitigate these concerns. While such policies have been adopted in a number of countries, they have often been opposed by right-leaning business groups that benefit from cheap and abundant labor and left-leaning political parties that want the votes that immigrants and their descendants provide. Humanitarian concerns also make it difficult to curtail migration, especially when it is coming from war-torn regions. Chart II-11The Projected Expansion ##br##In Sub-Saharan Population Europe's migration crisis has ebbed in recent months but could flare up at any time. In 2004, the United Nations estimated that sub-Saharan Africa's population will increase to 2 billion by the end of the century, up from one billion at present. In its 2017 revision, the UN doubled its projection to 4 billion. Nigeria's population is expected to rise to nearly 800 million by 2100; Congo's will soar to 370 million; Ethiopia's will hit 250 million (Chart II-11). And even that may be too conservative because the UN assumes that the average number of births per woman in sub-Saharan Africa will fall from 5.1 to 2.2 over this period. For investors, the possibility that migration flows could become disorderly raises significant risks. For one, low-skill migration could also cause fiscal balances to deteriorate, leading to higher interest rates. Moreover, as we discuss in greater detail below, it could propel more populist parties into power. This is a particularly significant worry for Europe, where populist parties have often pursued business-sceptic, anti-EU agendas. Megatrend #3: Social Fragmentation In his book "Bowling Alone," Harvard sociologist Robert Putnam documented the breakdown of social capital across America, famously exemplified by the decline in bowling leagues.4 There is no single explanation for why communal ties appear to be fraying. Those on the left cite rising income and wealth inequality. Those on the right blame the welfare state and government policies that prioritize multiculturalism over assimilation. Conservative commentators also argue that today's cultural elites are no longer interested in instilling the rest of society with middle-class values. As a result, behaviours that were once only associated with the underclass have gone mainstream.5 Technological trends are exacerbating social fragmentation. Instead of bringing people together, the internet has allowed like-minded people to self-segregate into echo chambers where members of the community simply reinforce what others already believe. It is thus no surprise that political polarization has grown by leaps and bounds (Chart II-12). When people can no longer see eye to eye, established institutions lose legitimacy. Chart II-13 shows that trust in the media has collapsed, especially among right-leaning voters. Perhaps most worrying, support for democracy itself has dwindled around the world (Chart II-14). Chart II-12U.S. Political Polarization: Growing Apart Chart II-13The Erosion Of Trust In Media It would be naïve to think that the public's rejection of the political establishment will not be mirrored in a loss of support for the business establishment. The Democrats "Better Deal" moves the party to the left on many economic issues. Nearly three-quarters of Democratic voters believe that corporations make "too much profit," up from about 60% in the 1990s (Chart II-15). Chart II-14Who Needs Democracy When You Have Tinder? Chart II-15People Versus Companies The share of Republican voters who think corporations are undertaxed has stayed stable in the low-40s, but this may not last much longer. Wall Street, Silicon Valley, and the rest of the corporate establishment tend to lean liberal on social issues and conservative on economic ones - the exact opposite of a typical Trump voter. If Trump voters abandon corporate America, this will leave the U.S. without any major party actively pushing a pro-business agenda. That can't be good for profit margins. The fact that social fragmentation is on the rise casts doubt on much of the boilerplate, feel-good commentary written about the "sharing economy." For starters, the term is absurd. Uber drivers are not sharing their vehicles. They are using them to make money. Both passengers and drivers can see one another's ratings before they meet. This reduces the need for trust. As trust falls, crime rises. The U.S. homicide rate surged by 20% between 2014 and 2016 according to a recent FBI report.6 In Chicago, the murder rate jumped by 86%. In Baltimore, it spiked by 52%. Chart II-16 shows that violent crime in Baltimore has remained elevated ever since riots gripped the city in April 2015. The number of homicides in New York, whose residents tend to support more liberal policing standards for cities other than their own, has remained flat, but that is unlikely to stay the case if crime is rising elsewhere. The multi-century decline in European homicide rates also appears to have ended (Table II-2). Much has been written about how millennials are flocking to cities to enjoy the benefits of urban life. But this trend emerged during a period when urban crime rates were falling. If that era has ended, urban real estate prices could suffer tremendously. It is perhaps not surprising that the increase in crime rates starting in the 1960s was mirrored in rising inflation (Chart II-17). If governments cannot even maintain law and order, how can they be trusted to do what it takes to preserve the value of fiat money? The implication is that greater social instability in the future is likely to lead to lower bond prices and a higher equity risk premium. Chart II-16Do You Still Want To Move Downtown? Table II-2Crime Rates Are Creeping Higher In Europe Chart II-17Homicides And Inflation Peter Berezin Chief Global Strategist Global Investment Strategy 2 Another problem with the neoclassical model is that it assumes perfectly flexible wages and prices. This ensures that the economy is always at full employment. Thus, if the saving rate rises, investment is assumed to increase to fully fill the void left by the decline in consumption. In the real world, the opposite tends to happen: When households reduce consumption, firms invest less, not more, in new capacity. One of the advantages of the traditional Keynesian framework is that it captures this reality. And interestingly, it also predicts that aging will be deflationary at first, but will eventually become inflationary. Initially, slower population growth reduces the need for firm to expand capacity, causing investment demand to fall. Aggregate savings also rises, as more people move into their peak saving years. Globally, savings must equal investment. If desired investment falls and desired savings rises, real rates will increase. At the margin, higher real rates will discourage investment and encourage saving, thus ensuring that the global savings-investment identity is satisfied. As savings ultimately begins to decline as more people retire, the equilibrium real rate of interest will rise again. 3 Michael A. Clemens, "Economics and Emigration: Trillion-Dollar Bills on the Sidewalk?" Journal of Economic Perspectives Vol. 25, no.3, pp. 83-106 (Summer 2011). 4 Robert D. Putnam, "Bowling Alone: The Collapse And Revival Of American Community," Simon and Schuster, 2001. 5 Charles Murray has been a leading proponent of this argument. Please see "Coming Apart: The State Of White America, 1960-2010," Three Rivers Press, 2013. 6 Federal Bureau of Investigation, "Crime In The United States 2016" (Accessed October 25, 2017). III. Indicators And Reference Charts Global equity markets partied in October on solid earnings and economic growth figures, and the rising chances of a tax cut in the U.S. among other bullish developments. The Nikkei has been particularly strong in local currency terms following the re-election of Abe. Our equity indicators remain upbeat on the whole, although the rally is looking stretched by some measures. The BCA monetary indicator is hovering at a benign level. Implied equity volatility is very low, investor sentiment is frothy and our Speculation Indicator is elevated. These suggest that a lot of good news is already discounted. Our valuation indicator is also closing in on the threshold of overvaluation at one standard deviation. Our technical indicator is rolling over, although it needs to fall below the zero line to send a 'sell' signal. On a constructive note, the solid rise in earnings-per-share is likely to continue in the near term, based on positive earnings surprises and the net revisions ratio. Moreover, our new Revealed Preference Indicator (RPI) continued on its bullish equity signal in September for the third consecutive month. We introduced the RPI in the July report. It combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Our Willingness-to-Pay (WTP) indicators are also bullish on stocks in the U.S., Europe and Japan. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The U.S. and European WTPs rose in October after a brief sideways move in previous months, suggesting that equity flows have turned more constructive. But the Japanese WTP is outshining the others. Given that the Japanese WTP is rising from a low level, it suggests that there is more 'dry powder' available to purchase Japanese stocks, especially relative to the U.S. market. We favor Japanese stocks relative to the other two markets in local currency terms, as highlighted in the Overview section. Oversold conditions for the U.S. dollar have now been absorbed based on our technical indicator, but there is plenty of upside for the currency before technical headwinds begin to bite. The greenback looks expensive based on PPP, but is less so on other measures. We are positive in the near term. Our composite technical indicator for U.S. Treasurys has moved above the zero line, but has not reached oversold territory. Bond valuation is close to fair value based on our long-standing valuation model. These factors suggest that yields have more upside potential before meeting resistance. Other models that specifically incorporate global economic factors suggest that the 10-year Treasury is still about 20 basis points on the expensive side. Stay below benchmark in duration. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market ##br##And Earnings: Relative Performance Chart III-8Global Stock Market ##br##And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights The potential for wrongheaded reform initiatives will be a key policy risk to monitor when judging the likely stability of the Chinese economy over the coming 6-12 months. Brash reform efforts without offsetting fiscal stimulus are unlikely, but this possibility bears monitoring. Chinese export growth will likely moderate over the coming year, but the absence of severe dislocations in the commodity and currency markets, like what occurred in 2015, will be an important factor supporting a stable deceleration in exports. Chinese stocks are outperforming the EM and global benchmarks, even after excluding the high-flying tech sector. Stay overweight. Feature China's 19th Party Congress has concluded, following yesterday's announcement of the new members of the Politburo Standing Committee. We will be providing investors will a full "postmortem" on the Party Congress and what it means for investors next week in a joint Special Report with our Geopolitical Strategy Service, but for now we have a few brief observations. The Congress has confirmed that President Xi has greatly increased his political capital, and that the implementation of his policy directives over the coming years will be greatly aided by this increase in influence. But the principle contradiction highlighted by Xi looms large for investors, as it remains unclear how he plans on managing the dual goal of further increasing living standards and shifting the country's growth model to one that is more environmentally and economically sustainable. Our view remains that brash reform efforts without offsetting fiscal stimulus are unlikely, as they would risk a major policy mistake that could undermine overall stability. But the risk of wrongheaded (and now largely unencumbered) reform initiatives from the President will be a key policy risk to monitor when judging the likely stability of the Chinese economy over the coming 6-12 months. Turning to this week's research topic, today's report is the first of two parts examining the key differences facing China today from what prevailed in mid-2015, when the Chinese economy operated below what investors and market participants considered to be a "stable" pace of growth. In part I we focus on trade, and provide answers to the following questions: What were the root causes of the extremely weak external demand environment that China faced in 2015, and should investors expect these conditions to return? Why has Chinese export growth disappointed over the past several years relative to what BCA's export model would have predicted? Are Chinese exports likely to accelerate or decelerate over the coming year, and does this outlook suggest that China's will experience a gradual or sharp deceleration in economic growth? Revisiting China's External Demand Environment In 2015 Before judging the outlook for China's export sector, it is important to revisit the dynamics of global trade since the global financial crisis. As we will illustrate below, the weak external demand environment faced by China in 2015 was a function of severe dislocations in the commodity and currency markets that are unlikely to occur again over the coming 6-12 months. While Chinese export growth will likely moderate over the coming year, the absence of these shocks is an important factor supporting a stable deceleration. Chart 1 presents the trend in global import volume over the past decade, as well as its emerging market (EM) and developed market (DM) subcomponents. From 2007 until late-2011, the coincident nature of global trade is clearly evident: EM and DM import volume growth rose and fell in lockstep with each other, with the former growing at a consistently higher rate than the latter over the period. Chart 1In 2015, China's Export Sector Suffered From A Synchronized Global Slowdown Starting in 2012, however, regional import volume growth trend began to decouple. DM import volume growth continued to decelerate in 2012 and 2013 following the end of the V-shaped post-recession recovery, largely driven by the negative economic impact of the euro area sovereign debt crisis. While euro area imports were the most affected by the crisis within the DM world, Japanese and U.S. import volume growth also eventually contracted (albeit only modestly in the case of the U.S.). Conversely, EM import volume accelerated materially during this period, boosted by material liquidity easing by Chinese policymakers. The impact of liquidity easing in China appeared very clearly in the total social financing data (excluding equity issuance), which, from mid-2012 to mid-2013, accelerated from 16 to 22%. From a global perspective, the rise in EM import volume growth from 2012 to 2013 successfully offset demand weakness in DM economies, which kept global import volume growth within a low but stable range of 1-3%. Growth in real global imports rose to the high-end of this range by mid-2014, as DM economies recovered from the end of the acute phase of the euro area crisis. The massive collapse in oil prices that began in June 2014 was clearly the trigger for a relapse in global trade from 2014 to early-2016 (which led to very weak export growth for China), but there is a particular aspect of U.S. import volume weakness during this period that is crucial to understand. Using conventional market narratives, a textbook reading of the combined U.S. dollar / oil shock of 2014 would have predicted a rise in real DM imports, which would have at least somewhat offset a decline in EM import demand (a reversal of the dynamics that were at play in 2012/2013). Lower oil prices represent a tax cut for net oil importing nations, and a higher dollar reduces the relative price (and thus increased the attractiveness) of goods imported into the U.S. Instead, however, real U.S. import growth fell in response to the dollar / oil shock, followed, with a lag, by weakness in euro area demand (Chart 2). Underestimating the importance of the oil & gas sector in the U.S. largely accounts for the failure of the textbook prediction: after having risen significantly during the expansion, real U.S. investment in mining exploration, shafts, and wells fell 63% from its peak, which caused an outright contraction in total real U.S. nonresidential fixed investment (Chart 3). The sharpness of the decline in the sector, coupled with the rise in the dollar, led to a broad-based slowdown in U.S. employment growth. Chart 2Lower Oil Prices And A Higher Dollar##br## Did Not Bolster DM Import Demand Chart 3A Collapse In U.S. Oil Productionr##br## Had A Significant Effect On Growth But Chart 4 highlights another important contributor to China's export weakness to the U.S. (and more generally) during the dollar/oil shock period: China's exports are not simply a play on consumer demand. The chart shows that U.S. capital goods imports from China have risen materially as a share of total goods imports, highlighting that the days of China exporting predominantly low value consumer goods are behind it. China's growing investment-oriented exports underscore why the sharp decline in oil prices failed to provide a net reflationary effect for the global economy from the dollar/oil shock, even if households and oil-consuming firms did in fact benefit from lower energy costs. Chart 4China's Exports Are Increasingly##br## Investment-Oriented Looking Forward Chart 5 highlights why China's export outlook over the coming year is unlikely to be buffeted from the sizeable commodity & currency market dislocations that began in 2014. Panel 1 illustrates that the global "oil bill" has fallen modestly below its long-term average from what had been the highest level since the late-1970s, implying that significant further downside for oil prices is likely limited. In fact, our Commodity & Energy Strategy service recently upgraded their oil price forecasts for 2018.1 In addition, the potential for a further sharp move higher in the U.S. dollar would also appear to have low odds, given that it has moved back to its long-term average versus major currencies and is at the high end of its range in broad trade-weighted terms (panel 2). Does this imply that China's export growth is set to stabilize at current levels, or even accelerate? At first blush, our export model would appear to support the latter conclusion, given that the model is currently predicting export growth on the order of 25%. But our model has consistently over-predicted Chinese export growth since mid-2011, and a breakdown of the causes of this gap help explain why a gradual deceleration in export growth is likely over the coming year. Using a method similar to DuPont analysis of Return on Equity, Chart 6 illustrates that China's export growth can be broken down into three component factors: Chart 5The 2015 Shock To China's Export Sector##br## Is Unlikely To Reoccur Chart 6Lower Global Import Intensity Is A Structural Anchor On China's Exports Global industrial production (IP) The import intensity of global IP, and Imports from China as a share of total global imports The chart shows that the gap between China's export growth and our model's prediction can largely be explained by the reversal of the decade-long rise in global import intensity, and more recently by a modest decline in China's share of global imports. Our measure of global import intensity is clearly impacted by fluctuations in global export prices (which are dominated by changes in commodity prices), but the end of rising global import intensity is also clear when imports are measured in real terms. A detailed examination of the causes of flat real global import intensity are beyond the scope of this report, but over the coming 6-12 months, we do not believe that either of the factors that have structurally depressed Chinese export growth over the past six years are likely to act as a major drag on China's export sector. Barring significant trade action from the Trump administration, real global import intensity in unlikely to change materially, and the recent decline in China's share of global imports appears to have been caused by prior strength in the RMB (Chart 7). The RMB has recently been strong against the dollar, but remains 8-9% below its 2015 peak in trade-weighted terms. As such, our analysis suggests that China's export outlook over the coming year will be largely determined by a single, cyclical factor: the trend in global industrial production, which should accelerate slightly over the coming months (Chart 8). While this would result in a moderation of Chinese export growth from current levels (as exports are currently growing faster than IP), the decline would be relatively modest in size and would not negatively impact Chinese domestic demand (panel 2). Chart 7The RMB-Driven Decline In China's Share ##br##Of Global Imports Is Over Chart 8A Modest Decline In Export Growth Is Likely,##br## But Nowhere Near Like 2015 Investment Conclusions We noted in our October 12 Weekly Report that the economic momentum of China's "mini-cycle" appears to have peaked earlier this year, and presented three possible scenarios for the coming year: 1) a re-acceleration of the economy and a continuation of the V-shaped rebound profile, 2) a benign, controlled deceleration and settling of growth into a stable growth range, and 3) an uncontrolled and sharp deceleration in the economy that threatens a return to the conditions that prevailed in early-2015 (or worse). The key takeaway for investors is that a modest decline in Chinese export growth to the current level of global IP growth is consistent with scenario 2, as it would be a far cry from the outright contraction of exports that occurred in 2015 and 2016. Importantly, a benign, controlled deceleration of Chinese economic growth should continue to support the relative performance of Chinese equities; Chart 9 shows that the MSCI China Free index is now in a relative uptrend vs. both emerging markets and the global benchmark, even after excluding this year's significant outperformance of the Chinese technology sector. As such, we continue to favor an overweight stance towards Chinese stocks relative to the EM benchmark, and within a "Greater China" equity universe.2 Chart 9China Is Outperforming, ##br##Even Excluding The Technology Sector Finally, a brief note on scheduling: We highlighted above that next week's report will be a joint Special Report with our Geopolitical Strategy Service, which will provide a summary "postmortem" on the Party Congress and what it means for investors. Part II of our examination of the Chinese economy today vs. mid-2015 will follow on November 9, which will focus on China's monetary policy stance. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report, "Oil Forecast Lifted As Markets Tighten", dated October 19, 2017, available at ces.bcaresearch.com. 2 In last week's joint Special Report with our Geopolitical Strategy Service (GPS), it should be noted that the investment conclusions section related to recommendations that have been made by the GPS team, rather than this publication. Specifically, China Investment Strategy's recommendation on Chinese equities continues to be an overweight stance on the MSCI China Free index vs the emerging markets benchmark, and was not adjusted to include only H-Shares as our GPS team has chosen to do. We apologize for any confusion that this may have caused. Cyclical Investment Stance Equity Sector Recommendations

Please note that in addition to today's abbreviated Weekly Bulletin, we are also publishing a Special Report on Argentina. Feature Regarding recent financial market dynamics, it appears that the high-yielding EM currencies are breaking down as U.S. bond yields march higher. Several EM exchange rates have formed a tapering wedge pattern, as shown in Chart I-1. Such patterns eventually lead a major break out or break down. Our bias remains that we are witnessing a major breakdown in several EM high-yielding currencies. If this transpires, it would be a precursor for a wider selloff in EM risk assets. Below we discuss interesting dynamics that have emerged in India's onshore fixed-income market lately, and their implications for the nation's equity market. India Several signals tentatively indicate that the price of liquidity has risen at the margin in India. Onshore BBB corporate bond yields have increased and their respective credit spreads have widened (Chart I-2). In addition, the yield curve has steepened modestly. Chart I-1A Tapering Wedge: ##br##A Breakout Or Breakdown? Chart I-2India: Onshore BBB Corporate Bond ##br##Yields And Spreads Have Spiked Rising corporate bond yields and widening corporate credit spreads have been negative for share prices in the past (Chart I-3). Similarly, steepening yield curves have been associated with a pullback in equity prices in recent years (Chart I-4). Note that yields, spreads and the yield curve are shown inverted on Charts I-3 and I-4. Chart I-3India: Corporate Bond Yields ##br##And Spreads Versus Stocks Chart I-4India: Yield Curve ##br##And Share Prices Why has the market price of liquidity risen in India? In our opinion, it has to do with both the domestic and external environments. On the domestic side, the fiscal deficit has widened, implying that borrowing requirements by central and state governments have risen (Chart I-5). Increased demand for credit from the government would not have been a problem had the commercial banks accommodated for it by creating enough new money. Yet, broad money supply growth remains depressed (Chart I-6). Chart I-5India: Ballooning Fiscal Deficits ##br##And Weak Money Creation Chart I-6Indian Money Growth: ##br##New Record Low As a result, the diminished amount of new money relative to demand for money, among other reasons, pushed marginal borrowing costs higher. Chart I-7 shows our proxy for new money available to the private sector has dipped into negative territory. On the external side, the recent rise in U.S. bond yields and the rebound in the U.S. dollar against several EM currencies might have also contributed to higher borrowing costs in India. We expect this U.S. dollar rebound versus EM currencies to persist and U.S. Treasury yields to continue drifting higher. Hence, the global backdrop heralds marginally higher bond yields in India. Although the onshore corporate bond market - and its BBB segment - is not very large, investors should heed to its signals because it reflects the cost of borrowing for the marginal corporate borrower. Besides, its signals have worked quite well in the past as shown in previous Chart I-3 on page 2. Some commentators might argue that the mild rise in government bond yields has been driven by a rise in inflation and growth expectations. We will not disagree with that, but both economic growth and inflation variables are still muted. Chart I-8 shows economic activity is lukewarm at best. Chart I-7India: Proxy For New Money ##br##Available To Private Sector Chart I-8India's Growth Is ##br##Lukewarm At Best On the inflation outlook, the picture is mixed as well. Consumer price inflation, especially core measures, might have bottomed (Chart I-9). Critically, the government approved a draft bill in July that allows the central government to set minimum wages across all sectors and states. The central government is currently reviewing the formula used to set minimum wage and the new formula might lead to significant increases in minimum wages. These policy changes come on top of the pay raises that public sector workers saw earlier this year. Importantly, if consumer demand accelerates while capital spending remains in the doldrums, inflationary pressures will mount. Chart I-10 shows that since 2012 consumer spending has outpaced investment by a large margin. Chart I-9India: Consumer Inflation ##br##Might Be Bottoming Chart I-10India: Consumer Spending ##br##Has Outpaced Investment Provided India has been, and remains, an underinvested economy, if this gap persists, it will produce either inflation or a widening current account deficit. Rising consumption without an equal increase in the supply of goods and services will either lead to higher prices or mushrooming consumer goods imports. Both scenarios bode ill for the macro dynamics, the currency, and ultimately equity multiples. As to financial markets, the Indian bourse is one of the most expensive in the EM space, so it is not very surprising that share prices could react negatively to marginally higher interest rates. For dedicated EM equity investors, we downgraded India from overweight to neutral on August 23, and this stance remains intact. While near-term underperformance cannot be ruled out, the medium-term outlook for relative performance warrants a neutral stance. Bottom Line: There are signals that liquidity is tightening on the margin in India's fixed-income markets due to domestic and external reasons. This will likely hurt share prices. Dedicated EM equity investors should keep a neutral allocation on India's bourse. Mexico: Close Currency, Rates, And Credit Overweights NAFTA risks to Mexico are escalating again. According to our Geopolitical Strategy team, there is non-trivial probability that the NAFTA negotiations will become negative for Mexican financial markets. The recent relapse in Mexico's financial markets will likely endure. We are closing the following positions: long MXN / short BRL; long MXN / short ZAR; receive Mexican 2-year / pay 2-year swap rates as well as overweight positions in Mexican sovereign credit versus Colombia and Indonesia. Dedicated equity investors should stay neutral on this bourse. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Storms set a low bar for Q3 EPS. BCA's Beige Book Monitor near cycle highs despite storms. Investors should fade the Q3 housing weakness. Latest Survey Of Consumer Finances highlights student loan debt issue. Feature Chart 1Q3 GDP Growth Has Held Up##BR##Remarkably Well Despite Hurricane Impact U.S. equities hit fresh all-time highs again last week, undeterred by the downward adjustment in Q3 earnings estimates in part due to Hurricanes Harvey and Irma. Investors appear to be looking through any near-term hit to economic growth and profits. Trump's tax plan cleared a key hurdle in Congress and tax cuts would surely give the market a boost if they are eventually passed. Bond yields and the dollar edged higher on speculation that President Trump will choose John Taylor as the next Fed Chair, who many believe will be a hawk. While we agree that investors should look through the hurricane effects, we worry that equity markets appear increasingly frothy. While the storms will cast a shadow over the Q3 earnings reports, the economic data has held up remarkably well. At 2.7% and 1.5%, the Atlanta Fed GDP Now and New York Fed's Nowcast for Q3 have recouped nearly all the ground they lost in the immediate aftermath of the storms (Chart 1). The Fed's Beige Book revealed a stout underlying economy despite the most weather related disruptions since superstorm Sandy in 2012. The Beige Book and most of the other economic data released in the past few weeks, aside from the inflation data, support a December rate hike. Markets are pricing in a near 100% chance of a 25bps hike at the December 12-13 FOMC meeting. The impact of Harvey and Irma have also lowered expectations for housing and residential investment in Q3, but housing is poised to rebound in the coming quarters even if the Fed raises rates once this year and three more times as we expect next year. The Fed's latest Survey of Consumer Finances will raise more concern over student loan debt, but also show that households' low cash balances and elevated allocation to equities match consumers' elevated confidence readings. Q3 Earnings Outlook Clouded By Storms Hurricanes Harvey and Irma may temporarily undermine corporate profits in a few industries in the third quarter. The annual growth rate of the 4-quarter moving total was poised to peak anyway, given more demanding year-ago comparisons (Chart 2). Still, EPS growth is peaking at a high level and should decelerate only slowly through 2018 toward a level more commensurate with 3.5-4% nominal GDP growth. We thus expect the earnings backdrop to remain a tailwind for the equity market, albeit a smaller tailwind. This forecast excludes any positive impact on growth from tax cuts. The announcement of tax cuts would be positive for EPS and the S&P 500 price index in the short term, although this would also bring forward Fed rate hikes. Rising oil prices are turbocharging earnings in the energy patch and we expect this to continue. Indeed, BCA's Commodity & Energy Strategy service raised its 2018 target price for both Brent and WTI last week to $65.15/bbl and $62.95/bbl, respectively. These estimates are up by $5.51 and $5.98/bbl from our forecast last month.1 The soft industrial production readings in September would be a concern for BCA's profit forecast, absent the storms' impact (industrial production is included in our top-down EPS model). However, the Fed noted that "the continued effects of Hurricane Harvey and, to a lesser degree, the effects of Hurricane Irma combined to hold down the growth in total production in September by 1/4 percentage point. For the third quarter as a whole, industrial production fell 1.5 percent at an annual rate; excluding the effects of the hurricanes, the index would have risen at least 1/2 percent." Moreover, strong readings in September and October on both the New York and Philadelphia Fed's manufacturing indices imply that the aftermath of the storms did not extend beyond Texas and Florida, and suggest a rebound in IP in Q4. The elevated readings on the Cass Freight index in recent months support that view (Chart 3). Chart 2Strong EPS Growth Ahead,##BR##Will Start To Slow Soon Chart 3Storms Impacted IP In Q3 Bottom Line: The earnings season is underway and forecasts have collapsed to a mere 4.2% year-over-year growth rate for Q3. They were as high as 5.5% at the start of Q3. Financials are heavily weighing on the outlook and the sector's profits are expected to contract by 9%. While the insurance sub-sector may be behind the bulk of the negative EPS revisions owing to the hurricanes, such extreme pessimism is unwarranted and the bar is set extremely low for both financials and the overall market. Based on the September and October Beige Books, corporate managements will not be too concerned with the dollar during this earnings reporting season. The Beige Book: Beyond The Storms The Beige Book released on October 18 supports the Fed's stance that the hurricanes will not alter the U.S. economy's medium-term trajectory and will keep the Fed on track to boost rates by another 25 basis points in December. BCA's quantitative approach2 to the Beige Book's qualitative data points to underlying strength in GDP and a tighter labor market, but there is still a disconnect between the Beige Book's view of inflation and the market's stance. Moreover, the stronger dollar has disappeared from the Beige Book and despite the lack of progress in Washington on Trump's pro-business agenda, business uncertainty is down. In addition, the prospects for commercial and residential real estate remain bright. Chart 4Beige Book Monitors Support Fed's Outlook##BR##On Economy And Inflation At 63%, BCA's Beige Book Monitor stayed near its cycle highs in October, providing more confirmation that the underlying economy remained upbeat in Q3 despite Hurricanes Harvey and Irma (Chart 4). The latest Beige Book covered the period from mid-September to October 6. Hurricane Harvey hit Texas and Louisiana in late August while Irma made landfall in Florida in early September and moved on to neighboring southeastern states through mid-month. While there were only four mentions of "weather", "hurricane" was used 58 times and "storm" nine times. The total 71 puts the weather impact on the Beige Book at its highest since superstorm Sandy struck the northeastern U.S. in Q4 2012 (Chart 4, panel 2). Based on the Beige Book, the dollar should not be an issue in the Q3 or Q4 earnings seasons. The greenback is no longer a concern for small businesses and bankers, which is in sharp contrast to 2015 and early 2016 when there was a surge in Beige Book mentions of a strong dollar (Chart 4, panel 4). In October, there were no remarks at all. The past three Beige Books (July, September and October) have seen only a single reference to a stronger dollar. The last time that three consecutive Beige Books had so few mentions was in late 2014. Remarkably, business uncertainty over government policy (fiscal, regulatory and health) has moved lower in 2017. The implication is that the business community is ignoring the lack of progress by Washington policymakers on Trump's agenda (Chart 4, panel 5). Echoing the market's disagreement with the Fed on inflation, a significant discrepancy in the Beige Book was evident in the number of inflation words (Chart 4, panel 3). Expressions of inflation dipped to a 7-month low in October. However, a disconnect persists between the still-elevated mentions of inflation and the soft readings on CPI and PCE. In the past, increased references to inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may soon turn up. Bottom Line: The recent Beige Book backs BCA's view that the hurricanes will not derail the economy. Indeed, the September reading on our Beige Book monitor in early October suggests that the economy rebounded smartly as the effects of the storms waned in late Q3 and early Q4. However, the Beige Book has done little to resolve the debate around why an economy growing above potential and a tightening labor market have not boosted inflation. Moreover, the October Beige Book all but warned investors to fade the Q3 weakness in the housing data. Housing Woes Continue In Q3 The weakness in residential investment in Q3 is temporary and housing has not peaked for the cycle. The monthly data on housing in August and September were affected by Hurricanes Harvey and Irma. Housing starts for September were weaker than anticipated and below August's readings. Specifically, the 9% m/m drop in September's starts in the South followed the 5% drop in August. Existing home sales posted a modest month-over-month gain in September after a three month decline. Nonetheless, October's 68 reading on homebuilder sentiment was four points above September's reading and the highest since May (Chart 5). Rising rates are not a threat to housing affordability, even if the Fed is able to lift rates in line with its dot plot. Chart 6 shows the influence of higher rates on housing affordability and effective mortgage rates under two scenarios. A 200-basis point increase in mortgage rates (Chart 6, panel 1) would push the housing affordability index below its long-term average for the first time in nine years. BCA assigns a low probability to a rate jump given the Fed's commitment to gradually increase rates. A more plausible path for mortgage rates in the next year is a 100bps rise (Chart 6, panel 3). Under this scenario, the affordability index would deteriorate, but remain a tailwind for housing. Chart 5Solid Housing##BR##Fundamentals In Place Chart 6Housing Affordability Under##BR##Various Rate Assumptions The historically low reading on Bloomberg's Housing and Real Estate Surprise Index also suggests that housing is poised to rebound in the coming quarters (Chart 7). The last time that the index was as low as the -1.2 reading in mid-October was in late 2013 amid the taper tantrum, and prior to that in late 2008/early 2009. Moreover, the gap between Bloomberg's overall Economic Surprise Index and the Housing Surprise index has never been wider. Therefore, the weakness in the housing data is a weather-related anomaly. Chart 7Big Disconnect Between Housing Surprise And Economic Surprise It is important to assess whether residential investment has peaked for the cycle. Since the early 1960s, a crest in housing provided seven quarters of warning before a downturn commenced.3 While housing's contribution to overall economic growth plunged in Q2 and Q3, we expect housing to provide fuel for the next few years as pent up demand is worked off from the depressed household formation rate since the 2008 financial crisis. Moreover, BCA does not anticipate that rising rates will be a serious threat to housing in the next 12 months. The implication from our upbeat view on housing is that the next recession is still several years away. Reliable leading indicators of a recession such as the LEI, the yield curve and the 26-week change in claims, are not signaling a downturn (Chart 8). BCA's recession model puts the probability in the next 12 months at a meager 2%. Only one of the eight components signal a downturn. Furthermore, neither the St. Louis Fed's nor the Atlanta Fed's recession indicators is in the danger zone. BCA does not expect a buildup in the types of imbalances that previously led to economic declines. Instead, a recession may be triggered by a Fed policy mistake,4 a terrorist attack that disrupts economic activity over a large area for an extended time, or a widespread natural disaster. Chart 8Odds Of A Recession In Next Year Remain Low Bottom Line: In the next 12 months, investors should remain positioned for stocks to outperform bonds and rising rates. While markets have entered a more dangerous late-cycle "blow off" phase,5 housing's contribution to GDP has not peaked for the cycle, which means that recession is still more than a year away. Housing will rebound in Q4 after an appalling performance in Q2 and Q3. A healthy housing market will continue to support the consumer. Surveying The Consumer Table 1Household Balance Sheets Prior##BR##To Recessions And Today The Fed's latest triennial Survey of Consumer Finances (SCF) shows that the consumer is less sensitive to housing, holds less cash and more equities than in the past. However, the report also shows that households that own interests in small businesses may disproportionately benefit from the GOP's corporate tax cut proposal. The SCF data supply a detailed examination of consumer health, not provided by the macro data. Nonetheless, key household- and consumer-related spending, which are saving- and balance sheet-related concepts in the SCF, closely track similar statistics in the macro datasets such as the Flow of Funds and the NIPA accounts.6 Table 1 shows household balance sheets in 1989, 1998, 2007, a year or two before the recessions and bear markets of 1990, 2001 and 2008-2009. The latest (2016) is also shown. Households are more sensitive to business conditions than ever before. Households in 2016 hold less cash (as a percentage of financial assets) than in any other pre-recession year, while consumers' equity holdings are the highest on record. Consumers' mix of nonfinancial assets showed that while housing was still the largest single asset (42.4% in 2016), the share of household assets devoted to primary residences was the lowest on record. Vehicles were only 4.8% of a household's nonfinancial assets in 2016, a new low. In contrast, individuals' equity in business (34%) was the highest ever. The implication is that a plunge in housing prices would be as detrimental to consumers today as it was in the mid-2000s. Hence, households' higher exposure to business ventures suggests that a tax cut that favors small businesses over individuals may shore up household finances. Despite improvement in many areas of consumer finances, the household exposure to student loans in 2016 was alarmingly high (Table 2). On the surface, the SCF data do little to ease fears that student loans will compromise household balance sheets and lead to the next recession. The mean student loan debt per household in 2016 was $34,200, 37% higher than in 2007, and more than triple the 1989 level. While 22% of families had student debt in 2016, a slight improvement from 2013, only 9% of families had student debt in 1989. Moreover, educational debt accounts for 8% of household debt. While that figure is dwarfed by the 67% of family debt in housing, a scant 4% of family debt was related to student loans prior to the last recession in 2007.7 Furthermore, 42.6% of families with education debt report that they have student loan debt of more than $25,000, a sharp upsurge from 2007 and more than double the percentage reporting $25,000 or more in 1989.8 Table 2Nearly Half Of All Families With Education Debt Have Student Loan Debt Of At Least $25,000 That said, BCA's view remains that student debt is a modest drag on economic growth, and is not a threat to U.S. government finances nor does it represent the next subprime crisis.9 John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Oil Forecast Lifted As Markets Tighten," October 19, 2017. Available at ces.bcaresearch.com. 2 Please see BCA Research's U.S. Investment Strategy Weekly Report "The Great Debate Continues", dated April 17, 2017. Available at usis.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Disconnected," September 11, 2017. Available at usis.bcaresearch.com. 4 Please see BCA Research's Global Investment Strategy Weekly Report, "Strategy Outlook Fourth Quarter 2017: Goldilocks and the Recession Bear," October 4, 2017. Available at gis.bcaresearch.com. 5 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View," October 16, 2017. Available at usis.bcaresearch.com. 6 https://www.federalreserve.gov/econresdata/feds/2015/files/2015086pap.pdf 7 Sourced from 1989-2016 Survey of Consumer Finances Database at https://www.federalreserve.gov/econres/scfindex.htm. Historic Tables - Table 16 - Amount of debt of all families, distributed by purpose of debt. 8 Jeffrey P. Thompson and Jesse Bricker, "Does Education Loan Debt Influence Household Financial Distress? An Assessment Using The 2007-09 SCF Panel," October 16, 2014, Federal Reserve. 9 Please see The Bank Credit Analyst Special Report, "Student Loan Blues: Can't Replay What I Borrowed," November 2016. Available at bca.bcaresearch.com.

Highlights Portfolio Strategy The financials sector's fortunes are linked to the path of 10-year Treasury yields. BCA's view of a selloff in the bond market bodes well for this interest rate-sensitive sector. The S&P banks index is on the cusp of flexing its earnings power muscle. Higher profits will serve as a catalyst for a valuation rerating in this key financials sub-sector. The still unloved S&P asset management & custody banks index has significant catch-up potential. We reiterate our high-conviction overweight status. Recent Changes There are no changes to our portfolio this week. Table 1 Feature The S&P 500 ended last week on a high note, cheering significant progress on the tax bill front and digesting early earnings beats. Given the equity market's lofty valuation starting point, substantial positive profit surprises are now necessary to move the needle in stocks. Encouragingly, IBM's mention of the fall in the U.S. dollar boosting EPS1 may morph into a broad-based theme this earnings season given the currency's mysterious absence we have been flagging in Q2. Beneath the surface, easy fiscal policy prospects coupled with synchronized global growth will likely continue to underpin equities. Importantly, later stages of the business cycle are synonymous with impressive gains in the S&P 500. The unemployment gap, defined as the unemployment rate minus the non-accelerating inflation rate of unemployment (NAIRU), is an excellent leading indicator of the yield curve. Granted, NAIRU is an estimate and we are using the CBO's long-term NAIRU quarterly forecast as an input to the unemployment gap indicator. When the unemployment gap disappears, inflation should start rearing its ugly head, eventually leading the Fed to tighten monetary policy to the point where the yield curve inverts and predicts the end of the business cycle. Empirical evidence suggests that first the unemployment gap closes then the yield curve inverts and the business cycle subsequently ends (Chart 1). However, this indicator has had one miss since the early-1970s, during the second leg of the early-1980s double dip recession. Chart 1Eliminated Unemployment Gap Is Bullish For Equities Table 2 shows the S&P 500 performance from when the unemployment gap clearly closes until the business cycle ends. In all five iterations that lasted, on average, 28 months, the broad market has risen, on average, by 29%. The unemployment gap has been eliminated since February 2017 and if history at least rhymes the next U.S. recession will arrive some time in 2019 as the SPX hits our peak cycle 3,000 target.2 Another later cycle phenomenon is the disappearance of volatility and the plunge in stock correlations as the Fed tightens monetary policy. While large institutional investors aggressively selling volatility this cycle is dampening vol across asset classes, there is another explanation of the non-existence of vol: synchronized global growth. Chart 2 shows that leading up to the prior three recessions, volatility was drifting lower and remained low, and the common denominator was simultaneous global growth in the late-1980s, late-1990s and mid-2000s. BCA's global (40 country) industrial production composite was expanding during the later stages of the business cycle. Similarly, our global (44 country) global EPS diffusion index and the global synchronicity indicator also depict concurrent global growth. Table 2S&P 500 Returns When##br## The Unemployment Gap Closes Chart 2Linking Low Vol To ##br##Synchronized Global Growth During the later stages of the cycle, equity sector correlations also collapse as earnings fundamentals are key performance drivers and sector differentiation generates alpha, as the broad market enters the last stage of the bull market. As we mentioned in our "SPX 3,000?" Weekly Report on July 10th, this does not mean the S&P 500's path is a linear straight line up until the next recession hits. There are high odds of a 5-10% garden variety pullback materializing which we deem a healthy development and our strategy would be to buy the dip, ceteris paribus. This week we update an early cyclical sector and two key sub-components. Financials: In The Shadows Of The Bond Market While financials stocks have cheered the prospects of a tax bill passage sometime in early 2018 (Chart 3), sell-side analysts have been brutally downgrading financials sector EPS estimates, dealing a blow to most sub-indexes net earnings revisions (Chart 4). True, hurricane-related losses may be the culprit, but such indiscriminate downgrades are unwarranted, and we would lean against such pessimism. Recent profit results corroborate our positive sector bias, but we are still early in the earnings season. Chart 3Dissecting Financials Performance Chart 4Extreme EPS Pessimism This early cyclical sector is a core overweight portfolio holding and there are high odds of significant relative gains in the coming quarters. Historically, financials stocks had been almost 100% positively correlated with the yield curve slope (Chart 5): a steepening yield curve gooses financials profits, while a flattening one eats into earnings via narrowing net interest margins. This rang true up until the Great Recession. Since then, unconventional monetary policies likely rendered this multi-decade correlation ineffective. In particular, the fed funds rate's zero lower bound caused a shift in the correlation from the yield curve to the 10-year Treasury yield (Chart 6). In fact, changes in the 10-year Treasury yield are now a carbon copy of relative share price momentum (Chart 6). Chart 5Shifting Correlations Chart 6Financials And UST Yield Are Joined At The Hip Thus, accurately forecasting long term interest rates should also dictate the direction of relative share prices, especially given the still historically low fed funds rate. On that front, the Treasury market is priced for the 10-year yield to hit 2.57% in October 2018 from roughly 2.38% currently. We expect the 10-year yield will rise more quickly than is discounted in the forward curve. Our U.S. bond strategists think core inflation will soon resume its modest cyclical uptrend. A parallel recovery in the cost of inflation protection will impart 50-60 basis points of upside to the 10-year Treasury yield by the time core inflation reaches the Fed's 2% target.3 Chart 7 plots the path of the 10-year Treasury yield discounted in the forward curve alongside a path consistent with BCA's view that inflation is poised to head higher. It also shows what this would mean for the 10-year breakeven inflation rate. If core inflation resumes its uptrend, as BCA expects, then financials will have a stellar return year in 2018, all else equal. Chart 7Lots Of Upside Meanwhile, market participants typically value financials on a price-to-book basis during calamitous times and are very slow in changing metrics once the tremors are behind the sector. We are likely on the cusp of a switch away from P/B and toward forward P/E as a key valuation metric for financials. The current 20% forward P/E discount to the broad market is highly punitive (bottom panel, Chart 5). If the key S&P banks sub-index successfully flexes its earnings power muscle, as we expect, then a valuation rerating phase looms for both banks and financials equities. Banks Hold The Key We remain constructive on the S&P banks index as all three key drivers of bank profits, namely loan growth, price of credit and credit quality, are simultaneously moving in the right direction. Tack on the increasing likelihood of a tax bill becoming law in early 2018, the continued push of the Trump administration to relax bank regulations and pent up demand for shareholder friendly activities including net share retirement and higher dividend payments/payouts, and bank stocks are well positioned to generate impressive returns in the coming quarters. Lower corporate tax rates will boost bank profits directly and indirectly. Fiscal stimulus typically translates into an economic fillip. If small and medium businesses (SME) benefit the most from lower taxes then higher SME profits will lead to a more expansionary mindset and small business owners will likely tap their bankers to finance capital spending plans. As tax certainty increases, so will animal spirits, aiding in kick-starting a virtuous economic cycle. Thus, loan growth is on an upward trajectory. Leading indicators of loan demand are also painting a bright picture for bank profits. C&I and consumer loans, two large credit categories, are both forecast to reaccelerate in the coming months. The ISM manufacturing survey has been on fire lately and consumer confidence has been following closely behind (third & fourth panels, Chart 8). Our credit growth model captures these positive forces and is sending an unambiguously positive message for loan reacceleration in the coming months (Chart 8). Moreover, residential real estate loan origination (the second largest credit category in U.S. dollar terms) should gain steam, underpinned by solid housing market's foundations: house prices are still expanding at a healthy clip (top panel, Chart 9), household formation is running higher than housing starts and mortgage rates are not prohibitive. Chart 8Bright Business And Consumer Credit Outlooks Chart 9Ongoing Valuation Rerating The V-shaped recovery in our U.S. credit impulse corroborates this fertile loan backdrop and is heralding an earnings outperformance phase (Chart 10). On the price of credit front, if BCA's bond view pans out in the next year and the 10-year Treasury yield veers closer to 2.8-3% range with rising inflation expectations in the driver's seat (Chart 11), then bank profits should continue to accelerate. Granted, the Fed will also raise rates next year and, at the margin, push up funding costs for the banking sector. However, our working assumption is that banks will remain linked to the 10-year UST yield's fortunes next year. At some point later in the Fed tightening cycle, the yield curve and bank correlation will likely get re-established. But, a flattening yield curve denting NIMs is a 2019 narrative. Finally, credit quality remains pristine despite some pockets of weakness in, subprime especially, auto loans. At this stage of the cycle, near or at full employment, NPLs will remain muted. Importantly, loan loss reserves have recently crossed above non-current loans in Q2 according to the FDIC, for the first time since 2007. Historically, a rising reserve coverage ratio has been synonymous with increasing valuations and the current message is that the banks rerating phase is in the early innings (Chart 12). Chart 10Heed The Positive Credit Impulse Signal Chart 11Price Of Credit Should Recover Chart 12Pristine Credit Quality Bottom Line: We reiterate our early-May overweight stance in the S&P financials sector and continue to overweight the heavyweight S&P banks sub-index. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT. A Few Words On Asset Management & Custody Banks The S&P asset management & custody banks (AMCB) index sits atop of our high-conviction return table (see page 15), outperforming the broad market by 7.2% since inception. While it is tempting to monetize some of these profits, we choose to remain patient. Likely more gains are in store in the coming months as this financials sub sector maintains its leadership position. If BCA's bond view of a selloff in the 10-year Treasury market transpires in 2018, then the budding rotation out of bond and into equity products will further accelerate. The stock-to-bond ratio captures this shift and it is currently flashing green (Chart 13). Overall assets under management are also rising and are a boon for the AMCB group's profit prospects, on the back of higher equity prices and also higher flows into stocks in general (bottom panel, Chart 13). Vibrant global economic sentiment, as measured by the IFO's World Economic Survey (top panel, Chart 14), and domestic (and global) manufacturing resurgence should continue to underpin M&A activity and sustain the high levels of margin debt. Both of these factors suggest that AMCB profit drivers are accelerating and will likely serve as a catalyst to unlock excellent value in this still unloved financials sub-group (middle panel, Chart 14). Chart 13Increasing AUMs... Chart 14...And Rising Animal Spirits Are Bullish For AMCB Adding it up, the still undervalued AMCB index has sizable catch-up potential, especially if the equity risk premium (ERP) continues to narrow in the coming quarters, as we expect (ERP shown inverted, bottom panel, Chart 14). Bottom Line: The S&P AMCB index remains a high-conviction overweight. The ticker symbols for the stocks in this index are: BLBG: S5AMGT-BK, BLK, STT, AMP, NTRS, TROW, BEN, IVZ, AMG. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report,"Dollar The Great Reflator" dated September 18, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report,"SPX 3,000?" dated July 10, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Bond Strategy Weekly Report,"Living With The Carry Trade" dated October 17, 2017, available at usbs.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Special Report

One of BCA's long-standing clients, Ms. Mea, recently paid us a visit at our Montreal office. Ms. Mea is an experienced and successful investor who has been reading different BCA products for many years. She noted that over the years she has both agreed and disagreed with our market views, but that she appreciates our thematic approach including themes, analysis and views, as they are important to her investment process. Like many of our clients, Ms. Mea has been disappointed by the Emerging Markets Strategy (EMS) team's EM/China call, which has not been correct over the past 18 months. My team and I spent a few hours with Ms. Mea detailing our views and methodology. Despite some tough discussions, she said she found the dialogue valuable. Reflecting on our meeting, I thought it would be beneficial to share the key points with all of EMS clients. This report is a summary of that. Ms. Mea and I agreed to continue the debate as the story plays out, so I will be meeting with her occasionally in Europe when I travel there. Ms. Mea: Clearly your recommended strategy has been wrong for some time. I am aware that your negative view on EM/China and strategy was right and profitable from 2011 until early 2016. Nevertheless, since early last year EM risk assets have rallied considerably, and not participating in this rally has been painful - not to mention being short EM risk assets. For our global equity funds, underweighting EM within the global universe did not hurt performance in 2016. However, this year the EM equity benchmark has considerably outperformed the global averages (Chart I-1). So, what has gone wrong, and why haven't you changed your view already? Chart I-1EMS's Big Picture Asset Allocation Strategy: EM Relative To DM Stock Prices Answer: My objective today is not to dispute your comments - my view and investment strategy have clearly gone wrong. Rather, I would like to highlight what has gone wrong as well as elaborate on my methodology and thought process. Let me be clear, if I thought in 2016 or early 2017 that the market would rally for more than six months and - in the case of EM equities - by more than 20%, I would have recommended clients to play this rally regardless of my big picture themes and views. The same is true today. My general view has been based on two pillars: Chinese growth and Federal Reserve policy/the U.S. dollar. 1. The first pillar of my argument has been that China's growth improvement would prove unsustainable due to lingering credit imbalances/excesses. In the April 13, 2016 report,1 I laid out the case that China's 2015-16 fiscal stimulus of RMB 850 billion would be offset by a potential slowdown in credit growth from an annual growth rate of 11.5% to 9-9.5%. Chart I-2China: Borrowing Costs Have Been Rising This thesis of credit growth deceleration was based on the natural tendency of credit growth to gravitate toward nominal GDP growth, especially since the credit-to-GDP ratio had massively overshot in the preceding seven years. Besides, since 2013 high-profile policymakers in China had been talking about the need for deleveraging, containing financial excesses, and not repeating the mistakes of 2009-2010, when money and credit was allowed to run at an extremely strong pace. In first half of 2016, I downplayed the recovery in money and credit aggregates arguing that they are temporary and unsustainable. When a country has a lingering credit bubble - which has been the case in China, I am biased to downplay upticks in money and credit growth and easing in monetary policy. At the same time, I put a greater emphasis on both monetary tightening and slowdown in money/credit when the economy suffers from credit excesses. The opposite is also true in cases where there are no excesses/imbalances. Since November 2016, the People Bank of China (PBoC) has been tightening liquidity and pushing money market rates and corporate bond yields higher (Chart I-2). This has been taking place in addition to regulatory tightening on both bank and shadow banking activities. As a result, I have been predicting that regulatory and liquidity tightening amid lingering credit and speculative excesses would weigh on money, credit and capital spending. Importantly, I reckoned that financial markets would be forward-looking and would reverse their rally in anticipation of weaker growth down the road instead of reacting to robust - yet backward looking - growth data. Indeed, money and credit growth have already slowed to all-time lows (Chart I-3). Nevertheless, broad economic growth has not slowed (Chart I-4). This has also been true for China's impact on the rest of the world - the mainland's imports have remained robust (Chart I-5). Chart I-3China: Money And Credit Aggregates Chart I-4China: Business Cycle Perspective Chart I-5China: Money Impulses And Imports Not only have I been surprised by the mainland economy's ability to withstand the slowdown in money/credit so far, but I have also been caught off guard by how financial markets have shrugged off the rise in onshore interest rates and the deceleration in money/credit. That said, liquidity tightening works with a time lag. The fact that it has not yet had an impact on the real economy does not mean it won't going forward. 2. The second pillar of my view has been that the Fed's dovish stance would prove transitory. The global market rally began in February 2016 when the Fed sounded dovish in the face of a surging U.S. dollar, collapsing commodities prices, very weak global trade and plunging global risk assets. Remarkably, global growth and corporate profits have recovered very strongly, the U.S. dollar has weakened considerably and commodities and global tradable goods prices have rebounded. As such, I expected that U.S. interest rate expectations would move higher, dampening the carry trade. Unfortunately, markets' reactionary functions does not always follow a symmetrical logic. The decline in U.S. inflation rate amid a weak dollar, rising import prices and robust U.S. growth - especially the tight labor market and some wages pressures (Chart I-6) - has puzzled me. Ms. Mea: Why have you disregarded the clear improvements in EM profits and global trade in 2017? Answer: I have been aware of improving economic data and corporate profits. Yet, these types of data are backward looking and are not a guarantee of future trends. Even though the released economic data and corporate profits have been strong, our forward-looking indicators for both EM and China have been heralding and continue to point to a major downtrend in EM profits (Chart I-7). Chart I-6Subtle Upside Risks To U.S. Inflation Chart I-7EM Profits Are At Risk Importantly, I presume stock prices lead profits. Hence, it is dangerous to turn bullish when forward-looking indicators that lead profits are already flashing red. These are empirical indicators and have a great track record. As such, I have placed substantial weight on them rather than on backward-looking economic and profit data. Since early 2017, I have been facing the following dilemma: Should I change my view based on strong, yet backward-looking, profit data, or remain cautious based on forward-looking growth indicators as well as our big-picture themes. I chose the latter, which in retrospect was wrong. Looking back, the biggest mistake I made was putting little weight on how markets have been trading. EM and global stocks continue to trade as they would in a genuine bull market: they have looked past negative news and rallied a lot in response to positives. Ms. Mea: You mentioned big-picture themes. Can you elaborate on your framework and methodology? Answer: At the core of my analytical framework lies investment themes. I formulate these themes based on a series of in-depth research reports. These themes have multi-year relevance - I expect them to have staying power beyond one year. These themes represent an anchor to my view and strategy. Without anchor themes, I would tend to change my views back and forth based on fluctuations in economic data or swings in financial markets. Having established themes, my team and I monitor cyclical data, market dynamics/signposts and any type of evidence to prove or refute those established themes. Clients have recently been asking why I only show charts/evidence that confirm my view, and rarely entertain the alternative scenario. Indeed, there are always contradictory signals, signposts and data that I identify every week. Yet, I still choose to show those that support my ongoing themes and views. Why? Because I opt to convey a well-argued coherent message to my clients. In this context, I use the limited client-time allocated to reading our reports to highlight the reasons supporting my current themes and high-conviction views. It would also be unhelpful for readers if I demonstrate several charts that herald a bullish stance, and then conclude the opposite. If I were to utilize the alternative approach, i.e., present data and evidence on both sides of the debate, the report would be ambiguous. As a result, readers would gain little conviction and would likely be left confused. Each of these approaches has advantages and disadvantages: when the view plays out, investors see the correct angle and, thereby, develop a strong conviction on the strategy, and hopefully act upon it. Conversely, when the view goes wrong, investors typically wish they had seen the opposite side as well. Chart I-8China: No Deleveraging So Far In short, my goal is to leave clients with a clear and well-argued message when I have high conviction. As to conviction level, like all investors, I am dealing with a black box when gauging the outlook for financial markets. I am never 100% certain; I make investment recommendations only when my conviction level is somewhere around 65-75%. Generally, I do not discuss the areas where my conviction level is less than 60%. Less than 60% means "I do not know". An example of this is whether the current tech rally will persist. Importantly, I try to bring to clients' attention data and evidence that they may not be aware of and analytical points that differ from commonly known market narratives. Investors are aware of overall global financial market dynamics and ongoing narratives. My goal is to add value to their knowledge with the framework of thematic investment research, and to highlight new and potentially market moving charts, data and evidence. My major theme on China in the past several years has been the following: Chinese banks have originated too much money, and the corporate sector has taken on a large amount of leverage. This, in tandem with speculative excesses in the shadow banking and property markets, pose considerable downside risks to capital spending growth in the mainland. This is especially the case given that both liquidity and regulatory tightening of banks and non-banks already begun in late 2016. While financial markets, economic data and corporate profits have gone against this theme, this does not mean credit/money excesses in China have disappeared or do not exist. On the contrary, they have gotten even bigger now (Chart I-8, top panel). The Chinese economy has recovered and benefited commodities prices and the rest of EM due to another round of substantial money/credit injection. Broad money and broad credit have surged by about RMB 45-50 trillion since the middle of 2015 - depending on which measure one uses (Chart I-8, bottom panel). In the context of mushrooming leverage, ongoing policy tightening entails a poor risk-reward profile for bullish bets on mainland growth. This is why I am reluctant to abandon this theme and the bearish view. Ms. Mea: What would it take to change your big picture theme on China? To fundamentally reverse my view on China and commodities on a multi-year time line, I would need to reject my theme that China has meaningful credit excesses and imbalances, or buy into the view that these imbalances are a natural outcome of China's excess savings and will never correct. I have strong conviction in my big picture theme and I have not seen convincing arguments to change it. That said, if I come to the conclusion that EM risk assets and China-related plays will rally for six months or longer, I will change the investment strategy and recommend playing that rally. In this case my market strategy will change even though the big picture theme remains intact. As to the relationship between national and household savings, credit, and money, I have elaborated at great length that money creation and credit excesses do not originate from excess savings.2 Hence, it is simply not natural for a country with excess savings to experience and sustain credit bubbles. Importantly, adjustments in terms of credit excesses/deleveraging in China have not even started (Chart 8, top panel). This does not imply that investors should wait until deleveraging ends before turning positive on mainland growth. Markets are forward looking and will bottom when they see the light at the end of tunnel. But it is very dangerous to be positive when the adjustment has not yet began. It appears China's capital spending in general and construction in particular - the most vulnerable and credit-dependent segments - have in recent years been fluctuating in mini-cycles, similar to what played out in Japan during the 1990s and 2000s. I am not suggesting that China resembles Japan entirely, but comparing their mini cycles is a worthwhile exercise. Chart I-9 shows that the Japanese economy, money, credit and share prices were on a rollercoaster ride in the 1990s and 2000s. Notably, the profile of Chinese H shares fits the profile of Japan's stock market during that period (Chart I-10). On average, the recovery phase of these mini-cycles/equity rallies lasted about 20-24 months. Chart I-9Mini-Cycles In Japan In The 1990-2000s Chart I-10Chinese H-Shares Now And Nikkei In 1990s My judgment is that the recovery in the Chinese economy and related financial markets over the past 18 months resembles the mini cycles Japan experienced in the 1990s and 2000s. If so, after the rally in the past 18 months, forward-looking investment strategy should be focused on identifying signposts of a reversal. Consistently, given my bias stemming from our core themes and the fact that financial markets are forward looking and have already rallied a lot, I have been looking for signs of a top in China's business cycle and Asia's trade flows. It is pointless for me to change the view if my bias is that markets will reverse their trend in the next couple of months. Investors who are bullish and long but are somewhat concerned about China's growth sustainability still may want to monitor and be aware when the business cycle and markets will reverse. This is where I believe our research is helpful and relevant to investors with a bullish bias. It is hard to forecast what would be an inflection point to overturn the current financial market trend. It could be an unambiguous message from China's Communist Party Congress in the coming days that containing financial risks - a code word for deleveraging - is a major policy priority, or it could be weak economic data in China, or lower commodities prices and weaker EM currencies, being the flipside of a stronger dollar. Chart I-11China: Beware Of Rising Inflation Ms. Mea: It seems there is no silver lining in your view. Does this mean Chinese policymakers cannot do much to generate a positive outcome for the economy and financial markets? Answer: Chinese policymakers are in a very tough position. Yet it does not mean there is no silver lining. I assign a 20-25% probability that policymakers can stabilize leverage in the economy and financial system without a meaningful growth slump. If this scenario transpires, my negative view on EM and China-related plays will continue to be wrong. There is a 40-45% probability that growth will slump as the authorities focus on deleveraging and structural reforms (allowing markets to play a greater role in resource/capital allocation), and that policy tightening will begin biting. This heralds a deflationary outcome from a cyclical perspective, but it also represents a necessary adjustment to ensure efficiency gains and productivity-led growth over the long run. In fact, this would make me structurally bullish on China's growth again. There is also a 30-35% probability that policymakers - having no tolerance for any kind of growth slump - will continue to stimulate via money/credit and fiscal deficits. The outcome of this scenario will be an inflation outbreak Notably, as I argued in the October 4th 2017 report,3 underlying inflationary pressures are rising, as shown in Chart I-11. Unless growth decelerates meaningfully, inflation will need to be tackled. If not, capital outflows from residents will escalate again, and the currency will come under depreciation pressure given that the deposit rate is at a very low 1.5%. Rising inflation limits policymakers' maneuvering room: they have to tighten and cannot stimulate rapidly and considerably when growth slows. In short, a silver-lining scenario - which would include the authorities curbing out excesses while preserving overall growth, and especially capital spending growth - is always there and is a well-known narrative in the investment community. I do not write about it because I assign a 20-25% probability of it actually panning out. Why not more? Because the imbalances and excesses are currently so large that it will be difficult to contain them without jeopardizing growth. Finally, my view on China does not spread to the entire economy - our focal point has been and remains capital expenditures in general and construction in particular. These areas are being financed by credit, and consume a lot of raw materials and capital goods. Mainland imports - which are heavy in commodities and capital goods (the two account for 95% of total imports) - are the link between mainland investment expenditures and the rest of the world in general, and EM in particular. The latter will suffer if Chinese imports contract. Ms. Mea: It seems your big-picture themes have considerable influence on your views and strategy. How have your big-picture investment themes evolved over time? Last decade, my overreaching theme was that EM and China were structurally sound and that EM/China/commodities were in a bull market. So, I went from being a staunch bull to a resolute bear. I took over the EMS strategy service in 2005, and was bullish on EM, China and commodities up until 2010 (Chart I-1 on page 1). In 2005, I published an in-depth report arguing that commodities were in secular bull market due to demand from China.4 In April 2006, I pioneered a new theme that in the case of a U.S./DM recession, EM could stimulate and boost domestic demand - an out-of-consensus thesis5 at the time. Having these themes in mind, I recommended upgrading/accumulating Chinese stocks amid the Lehman crisis in the fall of 2008.6 The message was that Chinese policymakers could and would stimulate, and that such stimulus would succeed in lifting Chinese growth, corporate profits, commodities prices and EM risk assets. That was a non-consensus trade at the time, and the exact opposite of my current view. Following the credit boom in EM/China in 2009-10, excesses and imbalances emerged, and I shifted to a negative stance on EM/China in 2010 (Chart I-1 on page 1). Furthermore, in our June 8, 2010 Special Report titled, 'How to Play EM This Decade,' I made a call on a major top and forthcoming bear market in commodities arguing that the 2010-decade leaders in terms of growth and share price performance would be the healthcare and technology sectors. I speculated that during the current decade mania will unfold either in the technology or heath care sectors or some combination of both. Since 2010, the technology and healthcare equity sectors have been the best equity sectors, while commodities have been the worst performing ones within both the global and EM equity space. Consistent with this theme, I have been overweighing EM technology stocks and bourses where tech has a large weight, such as Taiwan, China and Korea. Besides, since 2010 I have maintained a pair strategy recommendation of being long tech and short materials. Ms. Mea: It seems you have been changing the goalposts lately, using new data on Chinese money and credit instead of relying on traditional ones. Our research is an ongoing effort to understand the macro landscape better. Our objective is always to find new variables and indicators that better lead business cycles and corporate profits while continuing to track the existing ones. Thus, it is not about changing goalposts but refining existing indicators or examining alternative ones that have a better track record. The following aspects have led usintroduce new broad money measures in China: Over the past two years, official M2 has been much weaker than various credit and money measures, as illustrated in the top panel of Chart I-8 on page 8. Broad money, and hence new purchasing power, is created when banks originate credit - by lending to or buying claims on non-bank entities. Therefore, properly measuring broad money is vital to assessing the new purchasing power that is created in the economy. In brief, in 2016 and early this year I relied on China's official broad money M2 measure, but it has underestimated the amount of new purchasing power created in the past two years. This was one of the reasons we misjudged the duration and magnitude of this equity rally. In addition, the regulatory clampdown on banks and non-banks may have prompted them to shift credit assets from off balance sheet to on balance sheet, or vice versa. Banks and shadow bank entities can obscure or hide credit by classifying it differently, but the banking system cannot conceal the amount of money in the system. Therefore, by tracing broad money creation, one can trail new purchasing power originated by banks. For these reasons, we have begun calculating new broad money aggregates for China - we produced our measure of M3 (M2 plus some other banks liabilities that are not included in M2) and credit-money (broad money calculated using the asset side of commercial banks' balance sheets). Chart I-3 on page 3 illustrates that all measures of money and credit have slowed in late 2016 and this year. On balance, having examined various measures of money and credit, including official M2, we have concluded that in the past 12 months money/credit creation has been slowing in China, irrespective of which aggregate we focus on (please refer to Chart I-3 on page 3). Ms. Mea: How do you explain strong September money and credit numbers out of China? Money, credit and business activity data for September were indeed strong, but they should be adjusted for working days. In China, the annual Mid-Autumn Festival fell in October this year versus September over the past several years. During this festival, business activity grinds to a halt for several days. I conjecture that money, credit and growth data out of China and Asia in general was strong in September partially due to the increase in the number of business days in September this year versus September a year ago. We need to wait for October data and average the two months to get a better picture of the trajectory of the business cycle in Asia. Chart I-12China: Velocity Of Money Has Been Declining Ms. Mea: Your view on China, commodities and EM is largely contingent on very weak money growth. Is it possible that the correlation between money and economic growth has diminished or completely broken down in China? The only reason why broad money growth could deviate from nominal GDP growth is due to the rising velocity of money. Let's remind ourselves: Nominal GDP = Money Supply x Velocity of Money. For nominal GDP growth to rise, a considerable decelaration in money supply growth needs to be offset by an even larger acceleration in the velocity of money. It is extremely difficult to forecast velocity of money. I assume money velocity will be steady (constant) and, consequently, nominal GDP growth to be affected primarily by changes in broad money growth. Chart I-12 demonstrates that the velocity of money in China has been declining over the past eight years. So, it would be odd for the velocity of money to suddenly rise going forward, in turn making money growth a less reliable indicator for nominal GDP growth. Overall, while it is always possible that the correlation between money growth and economic activity can break down, it is not something that one can forecast or bet on with high conviction. Chart I-13EM Ex-China, Korea And Taiwan: ##br##Broad Money And Bank Loan Growth Is Weak Ms. Mea: What about other emerging markets? How dependent are they on China? Where are they in the business cycle? The link from China to other emerging markets is via commodities and EM countries' other exports to the mainland. Even non-commodity countries like Korea and Taiwan sell a lot to China. If Chinese growth decelerates, commodities prices relapse, the U.S. dollar rallies or the RMB comes under selling pressure, the outlook for other EM countries and their risk assets will be dim. I argued that EM currencies, credit, and stocks on aggregate levels are not cheap.7 Segments that appear attractively valued are cheap for a reason, while healthy segments (countries/sectors/companies) are rather expensive. Money and bank loan growth also remain lackluster in the majority of EM, excluding China, Korea and Taiwan (Chart I-13). The reason is that the banking systems in many of these developing countries have not been restructured and remain sick following years of overextended credit and rising non-performing loans. Therefore, even though EM exports to China and the rest of the world have picked up, there has been little recovery in their domestic demand. If external conditions - exports, exchange rates and borrowing costs - deteriorate anew, EM domestic demand recovery will be derailed. Investors often refer to Russia and Brazil when they cite macro adjustments in developing economies. It is true that Russia and Brazil have already gone through a lot of pain and adjustment, including provisioning for NPLs in their respective banking systems. Nevertheless, financial markets in both countries remain dependent on commodities prices and the U.S. dollar outlook. Barring external shocks, both economies will continue to revive. That said, my big-picture view entails a negative shock to EM sentiment due to China and a rally in the greenback so I cannot turn bullish on them yet. In addition, Brazil's public debt is rising in an unsustailable manner, and political risks remain significant, particularly ahead of next year's elections. It will be hard to boost nominal growth and contain the explosion of public debt without meaningful currency depreciation that reflates the economy. That cannot not bode well for foreign investors in Brazilian markets. Credit excesses continue to linger in some other EM economies, and there has been little adjustments in their leverage even when we remove China, Korea and Taiwan from the aggregate (Chart I-14). All in all, while some EM economies have undergone necessary macro adjustments, the largest economy - China - has not. When China begins its own macro adjustments, shockwaves will likely hit Asian economies and commodities producers. There are not many large developing countries outside Asia that are not raw materials exporters. Ms. Mea: What about the technology sector? It alone has been responsible for a substantial portion of price gains in the EM equity benchmark in this rally. Does your view on China's credit cycle also influence your outlook for technology stocks? Indeed, EM tech stocks have exploded in recent years, accounting for a significant portion of EM share price appreciation. Excluding tech stocks, EM equities have not rallied nearly as much (Chart I-15). Chart I-14EM Ex-China, Korea And Taiwan: ##br##Leverage Has Not Diminished Chart I-15EM Equities: Tech Versus Non-Tech Also, Table I-1 reveals that eight out of 11 equity sectors have underperformed the benchmark. Meanwhile, a large share of tech gains has been produced by five or so companies. Table I-1EM Sectors: Only Three Out Of 11 Sectors ##br##Outperformed The Benchmark I have no strong view on the technology sector's absolute performance following the exponential price gains of past years. Overweighting the technology sector has been my recommendation since 2010, as we discussed above, and it has panned out quite well. I still maintain this overweight call, but within the technology sector we prefer semis to internet and social-media stocks. On the second part of your question, my negative view on China's credit cycle does not have direct ramifications for technology stocks, including Chinese ones. Critically, the call on internet- and social media-related companies is a bottom-up call. On the macro level, I can only state the following: It is essential to realize that in the past nine years a lot of new purchasing power in China has been created because of explosive money origination by banks. If money/credit growth structurally downshifts in China in the years ahead, nominal income growth for both households and companies will slow and the growth in their spending power will also moderate. That said, I am not in a position to assess and comment on business model viability and equity valuation levels of internet and social media-related companies like Alibaba, Tencent or Baidu. As to the other two tech heavyweights - Samsung Electronics and TSMC - I continue to recommend an overweight position in semis and other tech stocks that stand to benefit from DM growth. However, I am less certain about their absolute performance given their exponential rally. Chart I-16EMS's Fully-Invested Equity Portfolio ##br##Performance Versus The Benchmark Finally, regardless of my view on EM absolute performance, we always add value to dedicated EM equity and fixed-income investors by selecting countries to overweight and underweight relative to their respective benchmarks. Our country equity allocation strategy has been very successful. Chart I-16 illustrates our country fully-invested equity portfolio performance versus the EM benchmark. The portfolio is built based on our overweight and underweight recommendations on individual bourses, and is assumed to be fully invested. Our country calls have done quite well in the past nine years, producing 58% outperformance versus the benchmark with extremely low volatility. This translates into 520 basis points of annual compound outperformance for nine years. Our recommended country allocation and other equity positions as well as fixed income and currency recommendations are published at the end of each week's report. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report titled "Revisiting China's Fiscal And Credit Impulses," dated April 13, 2016, link available at ems.bcaresearch.com 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 Weekly Report titled, " China: Deflation Or Inflation?," dated October 4, 2017; link available on page 21. 4 Please refer to the International Bank Credit Analyst Special Report titled, "Commodities: Buy On Dips," dated April 2005. 5 Please refer to the Emerging Markets Strategy Special Report titled, "Global Monetary Tightening And Emerging Markets: Is It Different This Time?"dated April 19, 2006. 6 Please refer to the Emerging Markets Strategy Special Report titled, "Upgrade/Accumulate Chinese Stocks,"dated September 29, 2008. 7 Please see Emerging Markets Strategy Weekly Report titled "Is The Dollar Expensive, And Are EM Currencies Cheap?" dated October 11, 2017, link available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Special Report

Highlights On Black Monday, October 19, 1987, equity bourses around the world plunged amid cascading bouts of selling, recording some of their largest single-day losses of the twentieth century. The plunge, exacerbated by derivatives transactions, and transmitted swiftly around the world, marked the first contemporary global financial crisis. BCA clients were well prepared. The Bank Credit Analyst steadily warned of increasing stock market vulnerabilities across all of 1987 even as it correctly predicted that the S&P 500 would most likely soar before eventually cracking. The Federal Reserve's immediate all-out effort to contain the damage ushered in a new central bank template for responding to quaking markets and helped give rise to the Greenspan put. While we do not fear a repeat of Black Monday, the U.S. equity market's long-term prospects are dramatically less appealing than they were in 1987. Investors should be prepared for an extended stretch of public market returns that pale beside the ones earned over the last 30-plus years. Feature 30 years ago today, Black Monday erupted around the world, reaching its nadir in New York, where relentless waves of selling drove the major indexes down 20%. The contagion had spread in a rapid relay from Hong Kong to Europe and then to New York, before fetching up in Auckland and other Asia-Pacific exchanges as Black Tuesday. The event was the centerpiece of what turned out to be sharp, albeit relatively brief, bear markets around the world (Charts 1 and 2). Confounding nearly every observer, however, the crash did not amount to much in a broader economic context and financial markets quickly regained their footing, with global equities vaulting to new highs in the '90s1 amidst speculative excesses that made the '80s' mania look demure. Chart 1Great Runs... Chart 2...And Sudden Stops Like all serious investors, BCA researchers are students of history. Black Monday was the first modern global financial crisis, and its 30th anniversary affords us the chance to study its run-up and aftermath for insights into future dives. It also gives us the chance to return to BCA's extensive archives and see how our forebears assessed conditions in real time. Their ex-ante analysis and forecasts were stellar, and reinforce the robustness of our approach. Their lagging ex-post performance highlights the need for investors to maintain a flexible mindset that can accommodate all possibilities. From Fear To Greed Black Monday marked the definitive end of a historically potent bull market (Table 1) that began, as the best ones do, in revulsion. Business Week's August 1979 cover story trumpeting the death of equities has become notorious, but the S&P 500 didn't bottom for three more years, during which it lost a quarter of its inflation-adjusted value. All told from the end of September 1968 to the end of July 1982, the S&P tumbled 62.5% in real terms (Chart 3). Inflation took a heavy toll on real growth over the 55 quarters of U.S. stocks' lost decade and a half (Chart 4, top panel), but the economy had expanded nonetheless, and stocks emerged from the ashes of the Volcker double-dip recession with a lot of ground to make up. Table 1A Bull With Speed And Stamina Chart 3A Lost Decade And A Half ... Chart 4...Despite Steady, If Unspectacular, Real Growth The ensuing five-year bull market (Chart 5, top panel) unfolded in two phases: the first, which burst out of the gate on a sudden repricing before taking a full year to catch its breath, had the support of earnings growth (Chart 5, middle panel) and re-rating; the second, which went on without pause for two and a half years, was all about re-rating (Chart 5, bottom panel). It finally ended in late August 1987, when skeptical investors could no longer stomach big gains derived entirely from multiple expansion, and stocks began to retreat in earnest in October, sliding 5% and 9% in the two weeks before Black Monday. Proximate triggers included sickly trade data, a competitive devaluation threat and proposed tax legislation that stood to make corporate takeovers a good deal more costly. The first two factors pushed the dollar down and yields up, as investors fretted that the Fed would be forced to raise rates (Chart 6), and the last pulled the plug on runaway speculation in takeover targets. Chart 5A Two-Act Bull Market Chart 6Be Careful What You Wish For The Echo Chamber, ... There is career safety in numbers, but portfolio danger. As the late Barton Biggs put it, there's no investment so good that it can't be destroyed by too much capital. Portfolio insurance may not have even been a good idea, as it didn't amount to anything more than a portfolio-sized stop-loss order, souped up with computer software and derivatives contracts. But by the fall of 1987, its widespread adoption had turned it into a very bad one. Portfolio insurance was developed in the late '70s by two finance professors who sought a method that would allow investors to participate in equity market gains while limiting their downside exposure. When stocks began to decline in the direction of a set downside limit, the portfolio insurance program would reduce net equity exposure via the sale of index futures. Once the market recovered and the program determined the coast was clear, it would unwind the futures positions. Although the technique had its flaws on a micro scale - futures trading wasn't costless, and there was considerable potential for whipsawing - it was doomed at the aggregate level because the index futures market wasn't deep enough to accommodate all the selling pressure that would be unleashed by a significant correction. ... Or, From Wall Street To LaSalle Street And Back Again There was more to Black Monday than portfolio insurance - the event was global, and the technique was not a factor on other bourses - but it helped to create a self-reinforcing spiral between the cash market in New York and the futures market in Chicago. Heavy selling of stocks in New York triggered heavy selling of index futures in Chicago, as insured portfolios sold futures to mitigate their direct cash exposures. The selling redounded back to New York as the futures buyers on the other side of the trade sold the underlying stocks to balance out their long futures positions2 and opportunistic investors seized the chance to front-run the mechanical portfolio insurers.3 The new sales pushed share prices even lower in New York, triggering more index futures selling in Chicago, and cinching the vicious circle. The View From Peel Street BCA, safely removed from the madding crowd in Montreal, foresaw something quite like the crash. The September 1986 and 1987 editions of our annual New York conferences bore the respective titles, "The Escalation in Debt and Disinflation: Prelude to Financial Mania and Crash?" and "Phase II in the Escalation of Debt, Disinflation and Market Mania: Prelude to Financial Crash?" Throughout all of 1987, the monthly Bank Credit Analyst warned of the U.S. equity market's increasing vulnerability and recommended that investors reduce exposure in a disciplined fashion ahead of the inevitable bust. The investment policy recommendation, issued in accord with prudent money management principles, differed from BCA's market forecast, which was for robust, potentially parabolic, gains before the bull market ended. BCA was not trying to have it both ways: it has long been a central tenet of our work that one's investment strategy can - and regularly should - be distinct from one's market forecast. We do not attempt to squeeze every last drop out of a bull or a bear market. Empirical evidence makes it abundantly clear that no one can consistently call tops or bottoms. In the words of turn-of-the-century trading legend Jesse Livermore: "One of the most helpful things that anybody can learn is to give up trying to catch the last eighth - or the first. These two are the most expensive eighths in the world.4" The opening paragraph of the March 1987 Bank Credit Analyst, published six months before the market peak, summarizes our ongoing advice: [I]nvestors who are overexposed should reduce positions to a level comfortable to ride out what will likely become a much more volatile phase of the secular bull market in stocks. ... At some point, it is likely that the U.S. stock market will experience a 1962-type correction - a sharp decline which comes out of the blue as a result of extreme overvaluation and excessive speculation. As then, it is unlikely to be associated with a credit crunch, as almost all post-war bear markets have been. ... At present, there is nothing in the data, either fundamental or technical, which suggests that such a shakeout is imminent. However, the key for investors in this bull market is to have positions which are sufficiently comfortable so that they can ride out sudden, dramatic corrections and participate in the long upward rise, which we feel has much further to go. (pp. 3-4) Eighteen months before the August 25th peak, the March 1986 Bank Credit Analyst's Section III was titled, "The Coming Financial Mania," and its strategy prescriptions were much more aggressive, even as it acknowledged the risks: Increasing volatility should be expected both because of the still lingering risks prevailing and the dramatic price movements in recent months. Hence, conservative investors should not overtrade. To fully capitalize on the ongoing revaluation of financial assets, it is important not to lose positions as a result of the necessary sharp corrections which will be experienced along the way. The stock and bond market potential over the next 2-3 years remains extraordinary. (p.11) The great dilemma for investors is, of course, how aggressively to play the game during the latter stages. The fascination, excitement and danger is the knowledge that vast fortunes are easily made right up to the end, but there is no reliable method to get out just before the crash. [...] Frequently the bubble goes on much longer and prices go far higher than anyone can imagine [...]. Yet, the vulnerabilities grow proportionately to the power of the manic phase. (p.26) Investment strategy in [a manic] environment must be based on the historically observed phenomenon that price appreciation generally accelerates to a climax or blowoff and that the hidden risks grow exponentially with price rises. Therefore, investors must constantly guard against the natural tendency to become increasingly greedy and careless in valuation standards as prices rise. (p.41) As good as BCA's near- and intermediate-term calls were in the run-up to the '87 crash, our longer-term calls were even better. We repeatedly argued that disinflation would be a secular trend, and that it would power secular bull markets in bonds and equities. Three decades on, with the Barclays Aggregate Index, the Barclays High Yield Index and the S&P 500 having produced real annualized total returns of 5%, 9.3% and 7.6%, respectively, the call has been vindicated (Table 2). As BCA foresaw, the harsh monetary medicine administered by the Volcker Fed to slay the inflation dragon has paid hefty market dividends. Table 2A Great Three Decades For Financial Assets The Trouble With The Austrians For all that BCA achieved ahead of Black Monday, and as correct as our long-term calls from the '80s turned out to be, it must be acknowledged that we missed the boat on getting back into equities after the crash. Part of the miss is understandable: one wouldn't expect the strategist with the most prescient call ahead of a downturn to be the first one to identity the beginning of the subsequent rally. The best investors are the ones with the supplest minds, however, and the BCA archives reveal a bias that may have gotten in the way of embracing more bullish near-term outcomes. To wit, one cannot read the 1988 and 1989 Bank Credit Analysts, and indeed, our original leaders' output, without detecting strong sympathies for the Austrian School of Economics (Box 1). BOX 1 An Austrian's Lonely Lot The Austrian School of Economics most saliently parts company with neoclassical economics in its adamant opposition to government intervention and its fraught relationship with credit. Instead of intervening to counter business cycles, Austrians would prefer to let busts run their course so as to cleanse the economy of the excesses embedded in booms. They occupy the Mellonian, purge-the-rottenness-out-of-the-system end of the continuum in opposition to the Debt Supercycle's unconditional forgiveness. Austrians regard banking and credit with some measure of suspicion, as Austrian Business Cycle Theory holds that artificially low interest rates are the raw material of destabilizing booms. Encouraged by central bankers seeking to steer an economy out of recession with a bare minimum of discomfort, borrowers take on debt to invest in projects that may not be able to pay their own way were it not for intervention. Once rates rise after policy accommodation fades, the economy slows and the extent of the malinvestment is revealed. The Debt Supercycle prescribes more of the hair of the dog to alleviate the suffering from malinvestment. The debt overhang is thereby never eliminated; it instead continues to silt up, requiring larger and larger interventions. Unchecked, the degree of intervention required to keep the plates spinning will eventually exceed capacity. This analysis is logically sound, but it so thoroughly contradicts the reigning orthodoxy that an investor who becomes emotionally invested in it is at risk of serially tilting at windmills. There is nothing wrong with the Austrian School per se. We rather like its outsider status, and actively seek heterodox inputs and perspectives so as to stay out of the ruts of the well-worn consensus path. Even its pessimistic bent has its uses; investors are surely exposed to enough cheerleading. Its prescriptions are so bracing, however, that a little goes a long way and real-world users should handle them with care. A popular pair of You Tube videos of actors portraying Keynes and Hayek issuing dueling raps about their respective ideologies (Keynes: I want to steer markets/Hayek: I want them set free!) provide an entertaining example of the Austrian-inspired investor's dilemma. Keynes, drink after drink in hand, is the exuberant life of the party, while the sallow Hayek stares into the bottom of his glass, unable to capture any other partygoers' attention. The simple conceit animating the video - Keynesianism is fun; Austrians are dour scolds - resonates deeply with elected officials. Voters love free drinks, but hate being told to eat their vegetables. The Austrian School, therefore, is a poor guide to the path that policy is likely to take. It also has the problematic effect of introducing an element of moral judgment into what should be a purely objective sphere. Investors should have a laser-like focus on what is most likely to happen and should strive to suppress extraneous notions about what should happen. The Debt Supercycle is a brilliantly incisive way of viewing the interaction between constituents' desires and officials' incentives, and has predicted the long-run direction of policy to a T. Only someone with a focus on money flows, informed by exposure to Austrian Business Cycle Theory, could have come up with it. In the hands of BCA editors in the late '80s, however, it seemed to feed a desire to see the American economy get its comeuppance. Setting aside that desire for punishment - and value judgments altogether - is the clearest way that we could have done better in the aftermath of the crash 30 years ago, when BCA essentially sat out the December '87 - July '90 equity bull market. We should strive to be dispassionate and unbiased observers of the economy and markets. After all, the process illustrated by the Debt Supercycle concept has surely helped put the wind at equities' back throughout the postwar era (Chart 7). Making sense of it without decrying it could help us to provide even better counsel. Chart 7Equity Investing Is An Optimists' Game Then And Now Does 2017 look like 1987? Is another crash lurking just around the corner? Our answers are "no," and "no." We think the resemblances between then and now are merely superficial. The good news is that the probability of a Black Monday-style crash is remote, and we think that even a run-of-the-mill bear market is not likely until our most reliable recession leading indicators, which are still dormant, begin to flash red.5 While that view may come as a short-term relief, 1987's long-term market outlook was vastly superior. While both today's bull market and the '82-'87 bull market began with forward earnings multiples at multi-year lows, the trough multiple in 1982 was in the low sixes, nearly two standard deviations below the mean (Chart 8). Even though it more than doubled by the August '87 peak, it only just reached what is now the mean level for the entire series. This bull market has seen the S&P 500's forward multiple rise to a full standard deviation above the mean. Valuation is not everything, of course. It is a lousy short-term indicator and only issues a reliable intermediate-term signal at extremes. Long-term returns correlate closely with the cyclically-adjusted P/E ("CAPE"), however, and it is currently at levels only previously reached ahead of the 1929 and 2000 peaks (Chart 9). The frothy CAPE portends a tepid long-run U.S. equity outlook. Chart 8Not A Lot Of Room To Grow Chart 9Not The Stuff Of Secular Rallies Both of the bull markets emerged from the ashes of nasty recessions (Chart 10), but the periods' primary economic threats were polar opposites, as were the policy settings adopted to counteract them. The Volcker Fed tightened monetary conditions to the point of pain in the early '80s, plunging the economy into a double-dip recession for the express purpose of eradicating the scourge of double-digit inflation (Chart 11). After the financial crisis, on the other hand, the clear and present danger was the potential for the credit bust to trigger a deflationary spiral. The Bernanke Fed pursued unprecedentedly accommodative policy in response. Chart 10Similarly Nasty Recessions ... Chart 11... But Opposite Inflation Backdrops The policy measures of the early '80s were an example of swapping near-term pain for long-term gain, and they set the stage for secular rallies in financial assets that continue to this day. Once inflation was removed from the equation, interest rates had to fall, and they did so for 35 years. The extraordinary accommodation in the wake of the crisis was an attempt to stave off hysteresis, which boils down to mitigating near-term pain as an insurance policy against long-term pain.6 It may well have worked, but there is no such thing as a free lunch, and the Fed's exertions have likely pulled forward much of the bond and stock markets' future returns. Black Monday And The Fed Put Before the October 20th open, the Fed issued the following statement: The Federal Reserve, consistent with its responsibilities as the Nation's central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system. Although it was only 30 words long, the statement packed a punch. It signaled the Fed's willingness to fulfill its function as the lender of last resort and may also have prodded skittish banks into fulfilling their responsibilities as intermediaries. Behind the scenes, the Federal Reserve Banks of New York and Chicago were doing their utmost to keep the system functioning. New York Fed president Corrigan was twisting lenders' arms to keep credit flowing so the crash would not infect the banking system and the real economy.7 Meanwhile, the Chicago Fed wasn't letting the letter of the law keep it from "help[ing to] engineer a solution" when one of the biggest derivatives market participants "ran short of cash.8" The statement, and the vigorous offstage exertions, countered the Fed's determinedly low profile. These were the days, after all, when monetary policy actions were still regarded as something akin to state secrets. Wall Street firms employed "Fed watchers," who were charged with studying the tea leaves to determine if the Fed had adjusted policy. As late as January 1990, the Bank Credit Analyst could devote an entire Section III to the question, "Has the Federal Reserve Eased?" Some of Alan Greenspan's comments in his memoir may reflect after-the-fact boasting or burnishing, but Black Monday can be viewed as a policy watershed. After it, the Fed's conduct of monetary policy has become transparent to the point of oversharing. More meaningfully for investors, it marked the origin of the "Greenspan Put," the widespread notion among market participants that the Fed would do its best to ward off or mitigate financial market downdrafts. Are ETFs The New Portfolio Insurance? Responsibility for the crash cannot be precisely apportioned among factors, but all post-mortem analyses agree that portfolio insurance played a leading role. While it may well have proven harmless if pursued on a modest scale by a limited number of players, it morphed into a destabilizing force once a critical mass of investors embraced it. On Black Monday, it became a paradox of safety akin to the paradox of thrift: prudent and rational when practiced by one individual, but a metastasizing disaster when followed by a crowd. A reasonable roadmap for someone trying to spot parallels between then and now is to identify market products that may have become overly popular. Wall Street's tendency to wring every last drop out of financing innovations, coupled with investors' tendency to move in herds, can lead to excesses. The latest innovation to achieve wild popularity is the ETF. Is it possible that ETFs could exert the same destabilizing influence as portfolio insurance if investors' ardor for them suddenly cools? We think not. As our Global ETF Strategy service has argued, the claims about passive investing's dangers are overheated.9 The notion that index tracking is undermining price discovery disregards the power of incentives. Passive investing strikes us as the best cure for passive investing: if so many people are pursuing it that index-trackers begin to drown out active investors, the prospective returns to active investing will soar and money will rotate out of index-tracking strategies in sufficient quantity to correct the imbalance. Chatter about a passive bubble also fails to consider the source of fund flows into index-tracking ETFs. The oft-repeated statement, "so much money is flowing into ETFs that it's distorting prices across the board," does not hold up to scrutiny. Away from Japan and Switzerland, where QE purchases of ETFs are being funded with new yen and franc notes, ETFs are not being purchased with new investment capital that has materialized out of thin air. They are being purchased with existing investment capital that has merely been reallocated away from actively managed mutual funds (Chart 12). Chart 12Mirror Image Bubbles are always the result of speculative, excess-profit-seeking activity. Index-tracking ETFs are vehicles intended to deliver market returns. They are the opposite of a get-rich-quick scheme; they're the instrument investors turn to when they give up on quick riches. We do not worry that ETFs are the object of a bubble, or that they are in any way analogous to portfolio insurance in the fall of 1987. Investment Implications Black Monday was a one-off event that remained contained within the financial markets despite widespread fears that it would spread to constrict the broader financial system and the real economy. A lot has changed in 30 years, but the collision of algorithms, derivatives and global pressures squarely places it in our time. It is entirely possible that its elements could come together to create another massive single-day drop. A key difference between future single- or intra-day swoons, and the ones that have already occurred since the crisis, is that they will arrive while the Fed is tightening policy at the margin. The future swoons, then, may not be as likely to disappear quickly without leaving much of a mark. It may go too far to say that market infrastructure is vulnerable, but it would be too optimistic to assume that it has kept pace with the advances in rapid-fire trading and the increasing prevalence of algorithms. It may make sense for investors with less tolerance for risk to maintain an extra cash buffer to protect against swoons and to ensure that they have dry powder to exploit them when they materialize. We remain constructive on the global economy, however, and our house view recommends overweighting risk assets while maintaining below-benchmark duration within bond portfolios. We sympathize with investors who lament that nothing in the public markets is cheap, but synchronized global acceleration remains intact. None of our models are warning of imminent danger. We therefore remain fully invested but vigilant, seeking out signs that the long bull market may be running out of steam. After reviewing our shortcomings in the aftermath of Black Monday, however, we will seek with an open mind and will not attenuate our efforts by awaiting the rapture of a final reckoning, when the sheep and the goats will be separated according to their virtue. The whole point of policy makers' efforts to engineer a rising tide is to keep the goats, and the broader economy, from harm. Doug Peta, Senior Vice President Global ETF Strategy dougp@bcaresearch.com 1 Except in New Zealand, where Black Tuesday popped a bubble of such notable excess that the MSCI New Zealand Index today trades at less than two-thirds of its September 1987 high, and Japan, where the mania lasted until December 1989 and the MSCI Japan Index is still nearly 40% below its all-time high. 2 Index arbitrageurs would have followed the same pattern, but they were sidelined by delayed price quotes and the failure of the NYSE's automated order execution system, which kept them from accurately identifying and exploiting true arbitrage opportunities. 3 Portfolio insurance was no secret - it was estimated that $90 billion of assets were following the strategy - and its potential to amplify selling pressures in a vicious circle had been the subject of a widely followed Wall Street Journal column published a week before the crash. 4 Lefevre, Edwin. Reminiscences of a Stock Operator, John Wiley & Sons, Inc.: Hoboken (NJ), pp. 57-8. Until 1997, the prices of NYSE-listed stocks were quoted in eighth-of-a-dollar increments. 5 For details on the interaction between recessions and equity bear markets, please see the August 16, 2017 Global ETF Strategy Special Report, "A Guide to Spotting and Weathering Bear Markets," available at etf.bcaresearch.com. 6 Hysteresis is the process by which a negative cyclical phenomenon, if left unchecked, can evolve into a secular phenomenon. 7 Greenspan, Alan. The Age of Turbulence: Adventures in a New World, Penguin (New York): 2007, p.108. Greenspan disavowed knowledge of the details, but suggested that Corrigan, "the Fed's chief enforcer," "bit off a few earlobes" while encouraging bankers to keep in mind that, "'if you shut off credit to a customer just because you're a little nervous about him, but with no concrete reason, he's going to remember that'." 8 Greenspan, p. 110.

Special Report

Feature It was an honour and privilege to welcome Professor Daniel Kahneman to our New York Conference this year. Professor Kahneman was the 2002 winner of the Nobel Prize in Economics, though the great irony is that he hasn't taken a single economics class in his life! That said, he did have a great informal mentor in the form of Richard Thaler who, coincidentally, has just become the 2017 winner of the Nobel Prize in Economics. Professor Kahneman's lifetime work demonstrates that our economic and financial decisions are often highly irrational - flying in the face of most mainstream economic models which assume fully rational behaviour. His research culminated in a school of thought called Prospect Theory, for which he ultimately won the Nobel Prize. Feature ChartBonds Become Much More Risky At Ultra-Low Yields Over lunch, Professor Kahneman summarised Prospect Theory to us. And as he spoke, the penny suddenly dropped. Prospect Theory's rich findings may have solved some of the most pressing mysteries of finance. Why do equities typically outperform bonds? Why has QE boosted equity prices so much? What happens next to financial markets? Why Do Equities Typically Outperform Bonds? Let's begin by debunking a popular myth. Many people believe that equities typically outperform bonds because equity income streams grow in line with the economy whereas bond income streams are fixed and do not grow. This reasoning is false. Any income stream can be made to generate any return depending on the price you pay for the income stream upfront. A rapidly growing income stream can still generate a deeply negative return if you overpay for it. And a fixed, or shrinking, income stream can still generate a strongly positive return if you underpay for it. It follows that equities generate a higher return than bonds simply because the financial markets typically price them to deliver this higher return. The question is: why? Prospect Theory provides an answer. One of its great insights is that we significantly overestimate the probabilities of rare but sizeable gains and losses. Indeed, this overestimation of rare events provides the entire foundation of the lottery and insurance industries. We overpay for a lottery ticket to buy the tiny possibility of a large gain, which is called positive skew. And we overpay for insurance to remove the tiny possibility of a large loss, which is called negative skew. We do this because creating the tiny possibility of immense wealth lets us dream pleasant thoughts. While removing the tiny possibility of losing our home lets us sleep soundly. The upshot from Prospect Theory is that income streams with positive skew tend to be overvalued, and so generate poor returns - like the lottery ticket. Whereas income streams with negative skew tend to be undervalued, and so generate high returns. This brings us to the first key point. Equity returns possess negative skew (Chart I-2). On rare occasions, they suffer deep losses. Because of this negative skew, it is our contention that the markets price equities to generate an excess return - a risk premium - over investments that do not have a negative skew. Chart I-2Equity Markets Have Negative Skew: "Equity Markets Walk Up The Stairs But Jump Out Of The Window" To illustrate the point, bear with us as we do some simple maths. Say an equity price could end up at 102 with probability 90%, but could plunge to 82 in a rare event with probability 10%. This makes its expected value 100 (because 102*0.9 + 82*0.1 = 100). But if, as Professor Kahneman suggests, the market overestimates the rare event probability to, say, 20%, it will underprice the equity at 98 (because 102*0.8 + 82*0.2 = 98). Clearly, this pricing will generate an excess return - a risk premium of 2% - because the correct expected value is 100. Next consider a bond price which could end up at 101 or 99 with equal probability, giving it an expected value also at 100. As it does not have negative skew, the market will just price it at 100. Observe that the equity price and bond price have exactly the same expected value of 100, but the financial markets have underpriced the equity at 98 to generate an excess return over the bond - because the equity has negative skew while the bond does not. Why Has QE Boosted Equity Prices So Much? When bond yields fall to very low levels, things get more complicated. Bond returns also exhibit extreme negative skew (Chart I-3 and Chart I-4). And the reasons are obvious. At very low bond yields, the prospects for capital appreciation rapidly disappear, while the prospects for large-scale capital losses suddenly increase ( Feature Chart). Chart I-3When Bond Yields Are Ultra-Low Bond Markets Have Negative Skew Too Chart I-4When Bond Yields Are Ultra-Low Bond Markets Have Negative Skew Too One simple way to quantify an investment's negative skew is to pick an extended period of time - say several years - when the price has gone sideways, and then to calculate the worst 3-month loss as a multiple of the best 3-month gain.1 On this metric, equities typically show a negative skew of around 1.5. Meaning that the worst loss is about 1.5 times the size of the best gain. But for bonds, negative skew varies with the bond yield. At yields above 2.5%, bonds show no skew. Worst losses broadly equal best gains. However, when yields drop below 2%, the negative skew approaches the same level as for equities. And at yields around 1%, the negative skew can even exceed that on equities (Table 1 and Chart I-5). Table 1At Low Bond Yields, ##br##Bonds Have Extreme Negative Skew Chart I-5Bonds Become Much More Risky##br## At Ultra-Low Yields This brings us to a crucial conclusion. At very low bond yields, the equity risk premium must compress, and potentially disappear, because both bonds and equities now have the same undesirable negative skew. Is there any empirical evidence for this? The prospective equity risk premium is hard to capture as it requires an accurate forecast of the prospective excess return from equities over bonds. But the realised equity risk premium is easy to measure as it is just the annualised outperformance of equities over bonds. This shows a clear downtrend in Germany, the U.K. and the U.S. Meanwhile, in Japan where bond yields have been near zero for years, the realised equity risk premium is non-existent (Charts I-6, Chart I-7, Chart I-8, Chart I-9). Chart I-6The Equity Risk Premium ##br##Has Trended Lower In Germany... Chart I-7...And In The U.K. Chart I-8The Equity Risk Premium ##br##Has Trended Lower In The U.S. Chart I-9The Equity Risk Premium Is Non-Existent ##br##In Japan One important takeaway is that central banks, perhaps unwittingly, have driven up equity valuations exponentially. This is because QE has simultaneously compressed both the bond yield and the equity risk premium, giving equity valuations a double shot in the arm. Let's reasonably say that central bank policy depressed the 10-year bond yield by 2%. The resulting increased negative skew on bonds might then reasonably depress the 10-year equity risk premium by 2%. In combination, this would reduce the 10-year required return from equities by 4% a year for ten years. Under these assumptions, central bank policy might well have boosted equity valuations by 50%.2 What Happens Next To Financial Markets? The double shot in the arm to developed market equity valuations may have boosted them by 50%, but they are broadly in the right ballpark as long as bond yields remain ultra-low. However, the conditionality on bond yields is crucial. This is because the process that exponentially boosted equity valuations can also work viciously in reverse. To reiterate, the negative skew on bond returns starts to fade when the bond yield is at 2% and completely disappears at 3%, at which point the equity risk premium must fully re-emerge. Given the tendency of equities to exhibit negative skew and to move en masse in the developed markets, we can infer that the current valuation of equities would be in jeopardy if a mainstream bond yield broke well north of 2.5%. Whereupon the reassessment of equity valuations is likely to catalyse a correction, at the very least. Chart I-10Bond Yields Can Rise More In Europe ##br##Than In The U.S. But one important investment implication is that the subsequent flight to investment havens means that no mainstream bond yield can realistically rise beyond 3% in the foreseeable future. We can also infer that European 10-year bond yields have the potential to rise more than their equivalents in the U.S., given that European yields are much further from the 2.5%-3% 'red zone'(Chart I-10). So an excellent structural position is to underweight European government bonds versus U.S. T-bonds. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Using log returns. 2 Because 1.04^10 = 1.48 Fractal Trading Model* This week we observe that Norwegian equities are technically overbought. A market neutral trade is to go short Norway/long Switzerland with a profit target/stop loss of 2%. We now have five open trades. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 Fractal Trading Model The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

Special Report

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