Sectors

Highlights French labor reforms stack up well against German and Spanish predecessors; We remain bullish on French industrials versus German industrials; Populism is overrated in Germany - European integration may not accelerate, but it will continue; The U.K.'s position remains weak in Brexit talks ... don't expect much from sterling. Feature On recent travels across Asia Pacific, the U.K., and the U.S., Europe has rarely featured in our conversations with clients. We proclaimed European politics a "trophy red herring" in our annual Strategic Outlook.1 Following the defeat of populists in Austria, the Netherlands, Spain, and particularly France, the market now agrees with us (Chart 1). Chart 1European Political Risk Was Overstated European Political Risk Was Overstated European Political Risk Was Overstated In this report, we ask whether there is anything left to say about Europe. First, we provide an update on French structural reforms, which we predicted with enthusiasm in February.2 Second, we give a post-mortem of the German election. Third, we dissect U.K. Prime Minister Theresa May's speech in Florence. We remain positive on near-term and mid-term prospects for European assets. We have recently closed our unhedged long Euro Area equities trade for a 7.88% gain (open from January 25 to September 6). We have reopened the position on September 6 with a currency hedge given our view that there is some downside risk for the euro in the near term. We also remain long French industrials / short German industrials, with gains of 9.30% since February 3. The French Revolution Continues President Emmanuel Macron has ignored tepid union protests and signed five decrees overhauling French labor rules on September 22. While there is more to be done, Macron's swift action just five months after assuming office justifies our optimism about France earlier this year. As we posited in February, investors are surprised every decade by a developed market that defies all stereotypes and catches the markets off guard with ambitious, pro-market and pro-business structural reforms. Margaret Thatcher's laissez-faire reforms pulled Britain out of the ghastly 1970s. Sweden surprised the world in the 1990s. At the turn of the century, Germany's Social Democratic Party (SPD) defied its own "socialist" label and moved the country to the right of the economic spectrum. Finally, the past decade's reform surprise came from Spain, which undertook painful labor and pension reforms that have underpinned its impressive recovery. How do French labor reforms stack up against the German and Spanish efforts? Table 1 surveys the measures and classifies them into three categories. On unemployment benefits, Macron's effort falls short of the considerable cuts implemented as part of the Hartz reforms in Germany. However, while benefits will still be generous, France's unemployed will now be cut off if they refuse job offers that pay within 25% of the salary they previously held. On increasing labor market flexibility, we give France high marks. Reforms will simplify the termination process for economic reasons and cap damages that can be awarded to employees, in line with the Spanish experience. Macron has also managed to neuter the power of national unions by allowing firm-level collective bargaining to take precedence. France's labor bargaining reform is also a carbon copy of the Spanish effort and both are attempts to create a more German-like management-employee context. Table 1Measuring French Reforms Against German And Spanish Reforms Is There Anything Left To Say About Europe? Is There Anything Left To Say About Europe? What should investors expect as a result? Spain is instructive. While its unemployment rate remains 5.8% above the Italian rate and 7.3% above the French rate, it still fell from a high of 26.3% in 2013 to 17.1% today. Meanwhile, Italian and French unemployment rates remain stubbornly high (Chart 2). In addition, Spain's export competitiveness has had one of the sharpest recoveries in Europe since 2008, whereas Italy and France continue to languish (Chart 3). Spain accomplished this feat via a considerable reduction in labor costs relative to peers (Chart 4). Chart 2Italy, France: Unemployment Still High Italy, France: Unemployment Still High Italy, France: Unemployment Still High Chart 3Spain Regained Competitiveness Spain Regained Competitiveness Spain Regained Competitiveness Chart 4Spain Cut Labor Costs Spain Cut Labor Costs Spain Cut Labor Costs The key pillar of Prime Minister Mariano Rajoy's reforms was to create a more flexible labor market so as to restore competitiveness to the economy by aligning labor costs with productivity. Reforms, passed in February 2012, removed stringent collective bargaining agreements and replaced them with firm-level agreements. This has made it easier for firms to negotiate their own labor conditions, including reducing wages as an alternative to termination of employment. France is now on the path to do the same. True, it is difficult to establish a clear causal connection between Rajoy's structural reforms and Spain's economic performance since 2008. Nevertheless, reforms also work as a signaling mechanism, encouraging investment and unleashing animal spirits by affirming the government's commitment to a pro-business agenda. Under Rajoy's leadership, Spain has moved from 62nd in the World Bank "Ease of Doing Business" survey in 2009 to 32nd in 2017, 18 spots above Italy. Given the speed and commitment of the Macron administration, we would expect an even stronger signaling effect in France. German Hartz reforms are easier to assess because more time has passed since 2005 (when the final stage, Hartz IV, was implemented). Prior to the reforms, Germany's GDP growth rate was falling and unemployment was rising (Chart 5). At least on these two broad measures, it appears that reforms were positive. Chart 5Hartz Reforms Marked Turning Point In Germany Hartz Reforms Marked Turning Point In Germany Hartz Reforms Marked Turning Point In Germany Chart 6German Long-Term Unemployment Benefits Were Cut Down To OECD Average Is There Anything Left To Say About Europe? Is There Anything Left To Say About Europe? Germany's problem prior to the Hartz reforms was that generous unemployment benefits discouraged unemployed workers from finding employment. Long-term benefits could be as high as 53% of the terminated salary and eligible for indefinite renewal! The Hartz IV reforms specifically targeted these benefits, with the intention of forcing the unemployed to get back to work. Germany brought these benefits into line with the OECD average (Chart 6). The long-term impact of the Hartz reforms was a dramatic decline in the unemployment rate from a bottom of 9.2% in 2001 to the still falling 3.7% of today! Reforms have also seen a steady increase in wage growth, despite the conventional view saying the opposite. Wages have been steadily rising since implementation in 2005, only slowing down during the global financial crisis and the subsequent European debt crisis (Chart 7). This does not mean that labor reforms failed. The intention of the Hartz reforms was to push people back into the labor force, not necessarily suppress their wages. Chart 8 shows the effect on the hours worked in the economy, with a clear uptrend after the reform was enacted. Chart 7German Wages Recovered... German Wages Recovered... German Wages Recovered... Chart 8...While Working Hours Increased ...While Working Hours Increased ...While Working Hours Increased In line with the previous labor reform efforts in Europe, we think that investors should expect three broad developments from French labor reforms: Competitiveness: As Chart 3 suggests, Spain and Germany have had the best export performance in Europe. By allowing companies some flexibility in setting costs, these economies were able to regain export competitiveness. As a play on this theme, we are long French industrials relative to German peers. Unemployment: Forcing the unemployed back to the labor market by ending their unemployment benefits if they refuse a job offer within 25% of the previous income level should encourage workers to get back to the labor force. Confidence: Macron's labor reforms are only the beginning of a packed agenda that also includes reducing the size of the public sector, reducing the wealth tax on productive assets, and cutting corporate taxes significantly. What of the opposition to the reform effort? What if the French leadership backs down in the face of protest? First, we must ask, what protest? The labor union response has been underwhelming. In part, this is because Macron's reforms are packed with pro-union clauses. The intention is to empower union activity at the firm level in order to neuter its activity at the national level. Second, Macron's electoral victory was overwhelming, both the presidential and legislative. Yes, turnout was low. And yes, many voted for Macron just so that Marine Le Pen would not become president. But the fact remains that 85% of the seats in the National Assembly are held by pro-reform parties, including the pro-business, right-wing Les Républicains, who want even stricter reforms. Bottom Line: Our clients, colleagues, friends, and family all tell us that France will not reform. But we have seen this film before, with Germany in the 2000s and Spain in the 2010s. One day, investors will wake up and France will be more competitive. Fin. A German Election Post-Mortem The media narrative before and after the German election tells of the rise of Alternative für Deutschland (AfD), a far-right party that campaigned on an anti-EU and anti-immigration platform. Indeed, the performance of the center-right Christian Democratic Union (CDU) and center-left Social-Democratic Party (SPD), which have dominated German politics since the Second World War, was historically poor (Chart 9). Chart 9Germany's Dominant Parties Underperformed... Is There Anything Left To Say About Europe? Is There Anything Left To Say About Europe? Despite the media hysterics, there were no surprises this year. The AfD performed in line with its polls, only outperforming their long-term polling average by around 2%. Meanwhile, the historic underperformance of the CDU and SPD was also due to the solid performance of the other two establishment parties, the liberal Free Democratic Party (FDP) and the center-left Greens (Chart 10). The FDP stormed back into the Bundestag by more than doubling their performance from 2013, while the Greens maintained their roughly 9% performance. Die Linke, a left-wing party whose Euroskeptic tendencies have dissipated, also gained around 9% of the vote. From a historical perspective, the combined CDU and SPD performance was bad, but roughly in line with their 2009 election result. Chart 10... While Minor Parties Outperformed Is There Anything Left To Say About Europe? Is There Anything Left To Say About Europe? That said, there was no once-in-a-lifetime global recession this time around to excuse the poor performance of the two establishment parties. German GDP growth is set to be 2.1% in 2017 and the unemployment rate is at a historic 3.7%. Meanwhile, support for the euro is at 81% (Chart 11), which begs the question of why 12.6% voters decided to entrust AfD with their votes. Chart 11Germans Love The Euro Germans Love The Euro Germans Love The Euro The simple answer is immigration and the 2015 asylum crisis. The more complex answer is that AfD's performance was particularly strong in East Germany, where the party is now the second largest after the CDU. The same forces that fueled the Brexit referendum and the election of President Donald Trump are at work in Germany. Voters who feel left behind by the transition to a globalized, service-oriented economy have rebelled against a system that favors the educated and mobile voters. In Germany, the angst is particularly notable in the East, where economic progress has lagged that of the rest of the country. On the other hand, it is ludicrous to compare AfD to Brexit and Trump. After all, AfD received only 12% of the vote. This is in line with, or slightly trails, the performance of other right-wing parties in Europe (Chart 12). Yes, it is disturbing to see a far-right party back in the Bundestag, but it was also naïve to believe that Germany could remain a European outlier forever. In fact, like other right-wing parties in Europe, the party is beset with internal rivalries. Party chairwoman Frauke Petry, who represents the moderate wing of the party, decided to quit one day after the election.3 We would suspect that the party will struggle going forward, particularly now that the influx of asylum seekers has trickled down to insignificance (Chart 13). Chart 12German Far Right Performed In Line With Other European Anti-Establishment Parties Is There Anything Left To Say About Europe? Is There Anything Left To Say About Europe? Chart 13Refugee Crisis Is Over In Germany And Europe Refugee Crisis Is Over In Germany And Europe Refugee Crisis Is Over In Germany And Europe Going forward, Chancellor Angela Merkel will retain her hold on power. However, she will likely have to do so via a "Jamaica coalition" with the FDP and the Greens.4 Forming such a challenging coalition could take until the New Year. Particularly problematic are the positions of the FDP and the Greens on Europe. The former are mildly Euroskeptic, the latter are rabidly Europhile. Merkel's 2009-13 coalition with the FDP was similarly challenging. The FDP moved towards soft Euroskepticism after the Great Financial Crisis. It combined with CDU's Bavarian sister party - the Christian Social Union (CSU)5 - to vote against a number of European rescue efforts and institutional changes (Chart 14). Merkel had to rely on the opposition SPD, which is staunchly Europhile, to push several European reforms through the Bundestag. More broadly, both the FDP and the CSU were a brake on Merkel during this period, leading to Berlin's halting response to the Euro Area crisis. Chart 14The FDP Hampered German Rescue Efforts Amid Euro Crisis Is There Anything Left To Say About Europe? Is There Anything Left To Say About Europe? Going forward, a Jamaica coalition is investment-relevant for three reasons: First, it would likely pour cold water on recent enthusiasm about accelerated European integration spurred by the election of President Emmanuel Macron in France. But investors should not read too much into it. As Chart 11 clearly illustrates, Germans are not Euroskeptic. The Euro Area works for Germany. If there is a future crisis, Germany will react to it in an integrationist fashion, shoving aside any coalition agreements to the contrary. And if Merkel has to rely on opposition SPD votes to push through the evolving European agenda, she will do so, regardless of what is said between now and December. Second, Merkel will have to respond to the poor performance of her party. She has to give in to the right wing on illegal immigration. Investors should expect to see tighter border enforcement on Europe's external borders. More relevant to the markets, we expect mildly Euroskeptics critics in her own party, as well as in the FDP and CSU, to be satisfied by officially pushing for Jens Weidmann's presidency at the ECB. Weidmann has recently toned down his criticism of ECB policies - publically defending low interest rates - which is likely a strategy to make himself palatable as the next president. Third, it is widely being discussed that the FDP will demand the finance ministry from Merkel, replacing Wolfgang Schäuble. This would definitely complicate any future efforts to deal with Euro Area sovereign debt crises, were they to emerge. However, the FDP is making a mistake. If they take the finance portfolio, they will be signing off on bailouts in the future. That is a guarantee. Europe is full of moderately Euroskepic finance ministers who have done the same (see: Austria, Finland, and the Netherlands in particular). Finally, the election was a clear failure by Merkel to defend her brand. While she has not signaled a willingness to resign, it is highly likely that she will try to groom her successor over the next four years. The 63 year-old has been in power since 2005. At the moment, the list of potential names for CDU leadership is long, but devoid of star power (Box 1). The one quality of all the potential candidates, however, is that they are pro-Europe. Bottom Line: In the short term, markets have read German elections overly negatively. The euro reacted on the news as if the currency bloc breakup risk premium had risen. It hasn't. In fact, the election could prove to be a long-term bullish euro outcome, given that Merkel will likely have to acquiesce to Jens Weidmann's candidacy for the ECB presidency. The German Bundestag remains overwhelmingly pro-Europe. The now-in-opposition SPD is pro-integration, as are the likely new coalition members, the Greens. Die Linke has evolved from anti-capitalist, soft Euroskeptics to left-of-SPD Europhiles. While FDP remains committed to a mildly Euroskeptic line (pro-Europe, but opposed to further integration), its members will likely have to sacrifice this position in order to be in government in the long term. They won't say that they are doing that, but trust us, they are. The performance of Germany's populist right wing is largely in line with that of other European countries. As such, it signals that Germany is a "normal country," not that there is something particularly disturbing going on. Box 1 Likely Successors To German Chancellor Angela Merkel If Merkel decides to retire, who are her potential successors? Ursula von der Leyen (CDU): Leyen, who has served most recently as defense minister, is often cited as a likely replacement for Merkel. However, she is not seen favorably by most of the population: she has not won first place in her district in any of the past three general elections. She is a strong advocate of further European integration and has supported the creation of a "United States of Europe." Leyen has argued that the European refugee crisis and debt crisis are similar in that they will ultimately force Europe to integrate further. As a defense minister, she has promoted the creation of a robust EU army. She has also been a hardliner on Brexit, saying that the U.K. will not re-enter the EU in her lifetime. The markets and pro-EU elites in Europe would love Leyen, who handled U.S. President Trump's statements on Germany, Europe, Russia and NATO with notable tact. Thomas De Maizière (CDU): Maizière, who has served as minister of interior and minister of defense, is a close confidant of Chancellor Merkel. He was her chief of staff from 2005 to 2009. Like Schäuble, he is somewhat of a hawk on euro area issues (he drove a hard bargain during negotiations to set up a fiscal backstop, the European Financial Stability Fund, in 2010) and as such could become a compromise candidate between the Europhiles and Eurohawks within CDU ranks. Though he has been implicated in scandals as defense minister, he has remained popular by drawing a relatively hard line on immigration policy and internal security. Julia Klöckner (CDU): A CDU deputy chairwoman from Rhineland-Palatinate, Klöckner is a socially conservative protégé of Merkel and a hence a likely candidate to replace her. While remaining loyal to Merkel, she has taken a more right-wing stance on the immigration crisis. She is a staunch Europhile who has portrayed the Euroskeptic AfD as "dangerous, sometimes racist," though she has insisted that AfD voters are not all "Nazis" but are mostly in the middle of the political spectrum and need to be won back by the CDU. We think that she would be a very pro-market choice as she combines a popular, market-irrelevant wariness about immigration with a market-relevant centrism that favors further European integration. Hermann Gröhe (CDU): Gröhe last served as minister of health and is a former CDU secretary general. He is very close to Merkel. He is a staunch supporter of the euro and European integration. Markets would have no problem with Gröhe, although they may take some time to get to know who he is! Volker Bouffier (CDU): As Minister President of Hesse, home of Germany's financial center Frankfurt, Bouffier is in a position to capitalize on Brexit. He is a heavyweight within the CDU's leadership and a staunch Europhile. He has already declared he will run for the top state office again in 2018, though he will be 67 years old by then. The U.K.: Fall In Florence Prime Minister Theresa May tried to reset Brexit negotiations with the EU recently by giving a speech in Florence. We were told by clients and colleagues that it would be an important event, so we tuned in and listened. The speech was largely a dud. It confirmed to us the constraints on London's negotiating position as well as the challenges that Brexit poses to the British economy. May's team is struggling to navigate both. There are three things that investors should take from the speech - most which we have been emphasizing for over a year: The EU exit bill: The U.K. will pay. The one concrete point that Prime Minister May agreed with, for the first time ever, is that London will continue to pay into the current EU seven-year budget period (2014-2020). This should never have been in doubt. Britain's refusing to pay would be the equivalent of a tenant giving notice that he is ending his lease in 24 months, then refusing to pay in the interim. What May did not say is whether the U.K. would pay anything beyond its share of contribution to the EU budget. At the moment, the answer appears to be no, but we don't expect that to be the final word. Services really (really) matter: The U.K. has a competitive advantage in services. This is why May has tried to signal that she wants the broadest trade deal possible, since regular free trade agreements (FTAs) do not provide for deep integration in services. What will the U.K. give in return? May appears to want a Norway-type EU trade agreement with Canada-type liabilities. This won't fly in Brussels. The transition deal will last two years at minimum: This was never in doubt. But due to domestic political pressures, May was afraid of voicing it in public until today. Below we provide excerpts of the most relevant (or irrelevant, but comical) parts of May's speech.6 Our running commentary is in brackets. Theresa May's Florence Speech On Brexit, September 2017: A Reinterpretation By GPS It's good to be here in this great city of Florence today at a critical time in the evolution of the relationship between the United Kingdom and the European Union. It was here, more than anywhere else, that the Renaissance began - a period of history that inspired centuries of creativity and critical thought across our continent and which in many ways defined what it meant to be European. [GPS: Strong opening by May. Odd location for the speech, however. Unless she was looking to ingratiate herself with Matteo Renzi, former mayor of Florence, former prime minister of Italy, and current leader of the ruling Democratic Party]. * * * The British people have decided to leave the EU; and to be a global, free-trading nation, able to chart our own way in the world. For many, this is an exciting time, full of promise; for others it is a worrying one. I look ahead with optimism, believing that if we use this moment to change not just our relationship with Europe, but also the way we do things at home, this will be a defining moment in the history of our nation. [GPS: This is a crucial argument by proponents of Brexit, that leaving the EU is not just about leaving the bloc's oversight, but also about domestic renewal. At the heart of this view is the belief that the EU has shackled the U.K.'s potential economic output with its regulatory oversight and protectionist trade policies. For this to be true, the U.K. has to replace significance labor force growth - from the EU Labor Market - with even greater productivity growth. If the U.K. fails to do this, its potential GDP growth rate will be substantively lower in the future. We do not buy the optimism. For one, the EU has not been a drag on the U.K.'s World Bank Ease Of Doing Businness rankings, where the country ranks seventh. Second, several other EU member states are in the top 20, including Sweden, Estonia, Finland, Latvia, Germany, Ireland and Austria. Third, developed economies have been dealing with sub-standard productivity growth for over a decade, both EU members and non-members. As such, we are pretty certain that the U.K.'s potential GDP growth rate will be lower over the next decade, not higher.] And it is an exciting time for many in Europe too. The European Union is beginning a new chapter in the story of its development. Just last week, President Juncker set out his ambitions for the future of the European Union. [GPS: A nod to the reality that without the U.K. stalling its integration, Europe is now better able to build its "ever closer union." May is essentially conceding here to Charles de Gaulle's argument, articulated in the 1960s, that letting Britain into the club would ultimately be a mistake.]7 There is a vibrant debate going on about the shape of the EU's institutions and the direction of the Union in the years ahead. We don't want to stand in the way of that. [GPS: Reality check: it has literally been the foreign policy of the U.K. to "stand in the way of" of a united Europe for at least six hundred years ...] * * * Our decision to leave the European Union is in no way a repudiation of this longstanding commitment. We may be leaving the European Union, but we are not leaving Europe. Our resolve to draw on the full weight of our military, intelligence, diplomatic and development resources to lead international action, with our partners, on the issues that affect the security and prosperity of our peoples is unchanged. Our commitment to the defence - and indeed the advance - of our shared values is undimmed. Our determination to defend the stability, security and prosperity of our European neighbours and friends remains steadfast. [GPS: As we have argued repeatedly, the U.K. and EU share crucial geopolitical and economic links. As such, it is difficult to see negotiations devolving into the sort of acrimony that many have expected. May understands this and is reminding Europe of how important the U.K. role is, and will continue to be, geopolitically for Europe.] * * * The strength of feeling that the British people have about this need for control and the direct accountability of their politicians is one reason why, throughout its membership, the United Kingdom has never totally felt at home being in the European Union. [GPS: A not-so-slight dig at Europe. Basically, May is saying that U.K. voters live in a democracy. EU voters live in something else.] And perhaps because of our history and geography, the European Union never felt to us like an integral part of our national story in the way it does to so many elsewhere in Europe. [GPS: This is true and can be empirically measured (Chart 15).] Chart 15Brits Have A Strong Sense Of National Identity Brits And Only Brits Brits And Only Brits * * * For while the UK's departure from the EU is inevitably a difficult process, it is in all of our interests for our negotiations to succeed. If we were to fail, or be divided, the only beneficiaries would be those who reject our values and oppose our interests. [GPS: This is all true and very well put. But it also appears to be a line of argument designed to tug at Europe's emotional strings. Like a husband asking his wife to take it easy on him in a divorce "for the sake of the children."] So I believe we share a profound sense of responsibility to make this change work smoothly and sensibly, not just for people today but for the next generation who will inherit the world we leave them. [GPS: Literally the line about the kids followed immediately!] * * * But I know there are concerns that over time the rights of EU citizens in the UK and UK citizens overseas will diverge. I want to incorporate our agreement fully into UK law and make sure the UK courts can refer directly to it. Where there is uncertainty around underlying EU law, I want the UK courts to be able to take into account the judgments of the European Court of Justice with a view to ensuring consistent interpretation. On this basis, I hope our teams can reach firm agreement quickly. [GPS: An important concession - the first in the speech so far, and we are more than halfway through: London will apparently take into account ECJ rulings when dealing with EU citizens living in the U.K. That is a huge concession to Europe and an arrangement unlike anywhere else in the world.] * * * The United Kingdom is leaving the European Union. We will no longer be members of its single market or its customs union. For we understand that the single market's four freedoms are indivisible for our European friends. We recognise that the single market is built on a balance of rights and obligations. And we do not pretend that you can have all the benefits of membership of the single market without its obligations. [GPS: As we have said in the past, May's decision to concede this point in January was a major concession to the EU and is the reason that the negotiations are not and will not be acrimonious. If the U.K. demanded access to the Common Market without accepting the "four freedoms," it would have received an acrimonious response, given that its request would have been construed as "special treatment."] So our task is to find a new framework that allows for a close economic partnership but holds those rights and obligations in a new and different balance. But as we work out together how to do so, we do not start with a blank sheet of paper, like other external partners negotiating a free trade deal from scratch have done. In fact, we start from an unprecedented position. For we have the same rules and regulations as the EU - and our EU Withdrawal Bill will ensure they are carried over into our domestic law at the moment we leave the EU. [GPS: May is correct. The EU-U.K. trade negotiations should be relatively smooth given that the U.K. is not starting from scratch in negotiating the relationship. The Canada-EU FTA took seven years because they were starting from scratch.] So the question for us now in building a new economic partnership is not how we bring our rules and regulations closer together, but what we do when one of us wants to make changes. One way of approaching this question is to put forward a stark and unimaginative choice between two models: either something based on European Economic Area membership; or a traditional Free Trade Agreement, such as that the EU has recently negotiated with Canada. I don't believe either of these options would be best for the UK or best for the European Union. European Economic Area membership would mean the UK having to adopt at home - automatically and in their entirety - new EU rules. Rules over which, in future, we will have little influence and no vote. [GPS: We pointed out why such an arrangement would be illogical in March 2016. Essentially, the U.K. would leave the EU due to its onerous regulation and infringement on sovereignty only to accept the onerous regulation as a fait accompli with no room for British sovereignty (Diagram 1)!] Diagram 1The Central Paradox Of Brexit Is There Anything Left To Say About Europe? Is There Anything Left To Say About Europe? Such a loss of democratic control could not work for the British people. I fear it would inevitably lead to friction and then a damaging re-opening of the nature of our relationship in the near future: the very last thing that anyone on either side of the Channel wants. As for a Canadian style free trade agreement, we should recognise that this is the most advanced free trade agreement the EU has yet concluded and a breakthrough in trade between Canada and the EU. But compared with what exists between Britain and the EU today, it would nevertheless represent such a restriction on our mutual market access that it would benefit neither of our economies. [GPS: This is, by far, the most critical part of May's speech. She is essentially saying that a Canadian FTA deal would benefit the EU more than it benefits the U.K., a point we have made for nearly two years now. This is true. The U.K. needs access to the EU services market, where British exporters have a comparative advantage. Were they to secure an FTA deal with the EU instead, they would be giving Europe a massive advantage, given the bloc's comparative advantage in tradable goods (Chart 16). However, this takes us back to Diagram 1. What kind of a relationship does May expect to get from the EU when she is unwilling to accept any of the liabilities inherent in such a deep trade deal? That is precisely what the Common Market is for.] Chart 16Brexit Hinders U.K.'s Comparative Advantage Brexit Hinders U.K.'s Comparative Advantage Brexit Hinders U.K.'s Comparative Advantage Bottom Line: Prime Minister May's Florence speech has shown the limits of the U.K.'s negotiating position. May set a friendly tone with Europe, but she has nothing to bargain with. Much of the speech reiterated British commitment to Europe's security and its capacity to defend the continent from external threats. In exchange, May argues, the U.K. ought to receive the deepest and most expansive access to the EU Common Market without any of the liabilities that go with it. In particular, she wants access to the EU's services market, where U.K. exporters have a comparative advantage. The problem with the tradeoff between U.K. geopolitical benefits and EU economic benefits is that it suggests that London has an alternative to being a geopolitical ally to Europe! As if it could suddenly shift its geopolitical, military, and diplomatic focus elsewhere. Berlin, Brussels, and Paris will call London's bluff. The U.K. is not in North America, it is in Europe. As such, Europe's problems are the U.K.'s problems, and the U.K. must defend against them even if it receives little in return. We expect the U.K. to succumb to the reality that the EU holds most of the cards in the negotiations. The U.K. will have a lower potential GDP growth rate after Brexit. But before Brexit is solidified, we expect considerable domestic political upheaval. In the short term, there is some upside for the pound. In the long term, it is a sell. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "The French Revolution," dated February 3, 2017, available at gps.bcaresearch.com. 3 Although she has herself played a role in kicking out the original, even more moderate, founders of the party. 4 The CDU, FDP, and Greens coalition is dubbed the "Jamaica coalition" because of their traditional colors - black, yellow, and green - which combine to make the colors of the Jamaican flag. 5 The CSU does not directly compete against the CDU on the federal level. It only fields candidates in Bavaria, where the CDU does not compete. 6 For the full transcript, please see "Theresa May's Florence speech on Brexit, full text," The Spectator, September 22, 2017, available at blogs.spectator.co.uk. 7 In turn, this will allow the EU to build up its power, develop a navy, and finally conquer the British Isles with a new armada somewhere around 2066! Geopolitical Calendar

Demand for movies and entertainment has come under pressure lately as depicted by the deceleration in recreation PCE. The softness in the ISM services survey confirms the negative signal from the consumer. All of this is transpiring in an environment of softening industry pricing power. While selling prices are still expanding, the growth rate has been cut in half since peaking early last year. Nevertheless, there is some light at the end of the tunnel for this media sub-group. Disney recently announced that it would pull content out of Netflix and start its own streaming service, disintermediating its core movie and sports (ESPN) content. Live television (news and sports in particular) remains a near-monopoly that traditional media content providers are working hard to preserve. Moreover, diversified business models also assist in cushioning the cord cutting secular decline in the content business segments. Importantly, consumer confidence is pushing decade highs and will likely make all-time highs prior to the end of the business cycle. We refrain from turning very negative on this index as we deem that most of the bearish news is already reflected in the price. Nevertheless, we recommend a downgrade in the S&P movies & entertainment index to a benchmark allocation. For more details, please see Monday’s Weekly Report. The ticker symbols for the stocks in this index are: BLBG: S5MOVI - DIS, TWX, FOXA, FOX, VIAB. Movies & Entertainment: Intermission Movies & Entertainment: Intermission

Cable & satellite stocks have been on a tear since troughing at the onset of the Great Recession (top panel). However, on the industry operating front, there are some demand cracks forming. Cable outlays are trailing overall PCE and are anchoring relative share price momentum (second panel). The fall in demand is corroborated by declining real cable spending, which peaked in early 2014 and since then has been continually losing traction (third panel). If it were not for the successful offset from price hikes, cable companies would be in dire straits. However, the cable operators' ability to lift selling prices is undeniable and unmatched with a multi-decade track record, and remains solid despite the plethora of industry woes of late. Tack on compelling relative valuations and the industry's threats are likely well reflected following the recent derating phase (bottom panel). Netting it all out, a more balanced cable industry profit backdrop is signaling that only a neutral stance is warranted in this media sub-index; downgrade the S&P cable & satellite index to neutral. For more details, please see Monday’s Weekly Report. The ticker symbols for the stocks in this index are: BLBG: S5CBST - CMCSA, CHTR, DISH. Intermittent Cable Signal Intermittent Cable Signal

Highlights Portfolio Strategy A more balanced cable & satellite and movies & entertainment industry profit backdrop is signaling that only a neutral stance is warranted in both these media sub-indexes. Trim to neutral. These moves also push our S&P consumer discretionary sector weight to a benchmark allocation. Recent Changes S&P Consumer Discretionary - Downgrade to neutral. S&P Cable & Satellite - Trim to equal weight. S&P Movies & Entertainment - Downgrade to a benchmark allocation. Table 1 Resilient Resilient Feature Equities sustained recent gains last week, largely ignoring the mildly hawkish Fed. The S&P 500 is undeterred by the prospect of another interest rate hike later this year with investors focused squarely on synchronized reaccelerating global growth. Highly-sensitive growth indicators are surging: South Korean exports are on fire, the Baltic Dry Index, lumber prices and a long forgotten global growth barometer, Brent oil prices, are breaking out (Chart 1). This suggests that S&P 500 profits are well positioned to continue expanding at a healthy clip, underpinning prices. Firming economic growth will eventually show up in inflation. In the U.S., empirical evidence signals that expanding real output growth usually does lead to a pickup in core CPI, albeit with an 18 month lag (top panel, Chart 2). A tightening labor market also corroborates this data. As the year-over-year change in the unemployment rate recedes, inflation typically rises, again with a 6 quarter lag (unemployment rate shown inverted, second panel, Chart 2). Finally, the bottom two panels of Chart 2 show the Cleveland Fed's Inflation Nowcasting1 series as a 3-month annualized rate of change in core CPI and core PCE. Both point to a continued rise in inflation. This inflation backdrop is significant as it will likely sustain the corporate sector's pricing power gains. Chart 3 updates our corporate sector pricing power proxy and the related diffusion index. We also update the business sector's overall wage inflation and associated diffusion index from the latest BLS employment report. Selling prices are recovering at a time when wages remain stable. Taken together, out margin proxy indicator suggests that the ongoing profit margin expansion phase has more legs (bottom panel, Chart 3). Chart 1Vibrant Global Growth Vibrant Global Growth Vibrant Global Growth Chart 2Inflation Comeback? Inflation Comeback? Inflation Comeback? Chart 3Margins Should Expand Margins Should Expand Margins Should Expand Table 2 shows our updated industry group pricing power gauges, which are calculated from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. The table also highlights shorter term pricing power trends and each industry's spread to overall inflation in order to identify potential profit winners and losers. Table 2Industry Group Pricing Power Resilient Resilient This analysis shows that 75% of the industries we cover are able to raise selling prices, and 45% are doing so at a faster clip than overall inflation. Importantly, inflation rates have increased since our late-June update. The outright deflating sectors dropped by one to 15 since our last update, but are still up from the 14 figure registered in April. Encouragingly, only 12 industries are experiencing a downtrend in selling price inflation, a decrease of 7 since our late-June and April reports. Chart 4Cyclicals Have The Pricing Power Advantage Cyclicals Have The Pricing Power Advantage Cyclicals Have The Pricing Power Advantage Moreover, 9 out of the top 12 industries with the highest selling price inflation are deep cyclicals/commodity-related (Chart 4), highlighting that the fall in the U.S. dollar is aiding the commodity complex to increase prices. The bottom of the table is equally split between 5 deflating tech industries and 5 consumer discretionary sectors. In sum, corporate sector pricing power is recovering painting a positive sales growth backdrop for the coming months. This will also prop up operating leverage, as we have been suggesting,2 as will still modest wage inflation. All in all, we envision a sound profit margin and EPS growth outlook for the back half of the year. This week we are executing a further early cyclical downshift to our portfolio. Consumer Discretionary Juggernaut Is Over Since the fed funds rate hit the zero line in December 2008, the S&P consumer discretionary index is not only the best performing GICS1 sector, but it is also the best performing asset class globally. In fact, it has risen by over 384% since December 1, 2008, nearly double the S&P 500's return. Even if one recalculates the GICS1 sector returns since the March 2009 broad market trough, U.S. consumer discretionary stocks still come out on top. Interestingly, relative performance bottomed in July 2008 (Chart 5), roughly two months before Lehman's collapse and in advance of that autumn's trough in deep cyclicals/China & EM levered equity plays. Simply put, U.S. discretionary equities sniffed out a massive reflationary impulse. This sector is extremely sensitive to interest rate changes and the quick slashing of the fed funds rate to zero and undertaking of unconventional monetary policies worked in their favor. Fast forward to today and our sense is that there are high odds that the consumer discretionary juggernaut is over and thus we are downgrading exposure to neutral. The Fed last week announced the commencement of the renormalization of its balance sheet. If consumer discretionary stocks are the ultimate beneficiaries of zero interest rate policy and the quantitative easing experiment, the unwinding of these emergency policies should also work in reverse (Chart 5). In other words, a winding down of the Fed's balance sheet and a rising fed funds rate should eat into consumer discretionary relative returns (top panel, Chart 6). Chart 5Mind The Fed's Balance Sheet Mind The Fed’s Balance Sheet Mind The Fed’s Balance Sheet Chart 6Rates, Money Growth... Rates, Money Growth… Rates, Money Growth… Money growth has also taken a backseat. M1 money supply is decelerating and so is M2 growth. Historically, money creation and relative performance have been joined at the hip and the current message is to lighten up on discretionary stocks (bottom panel, Chart 6). Beyond tighter, at the margin, monetary policy capping this early cyclical sectors future returns, energy inflation is also working against the S&P consumer discretionary index. The recent knee-jerk jump in retail gasoline prices will dent consumer disposable incomes as higher prices at the pump act as a tax on consumers. Our consumer drag indicator, capturing both rising interest rates and gasoline prices, is weighing on relative performance momentum (bottom panel, Chart 7). Nevertheless, there are some sizable positive offsets preventing us from downgrading exposure all the way to underweight. Recovering household net worth has historically been a boon for discretionary consumer outlays (second panel, Chart 8). Consumers feeling more flush, coupled with the jump in confidence, typically underpin real PCE growth. Tack on the fresh all-time highs in real median incomes, with the latest two year period registering the highest income gains since the history of the data, and the ingredients are in place for sustained gains in consumer spending (third & bottom panels, Chart 8). Finally, relative valuations and technicals have unwound previously expensive and overbought conditions, respectively. The S&P consumer discretionary forward P/E currently trades at a mild discount to the broad market and below the historical mean, and our Technical Indicator still hovers near washed out levels (Chart 9). Chart 7...And Energy Prices Weigh##br## On Consumer Discretionary …And Energy Prices Weigh On Consumer Discretionary …And Energy Prices Weigh On Consumer Discretionary Chart 8Positive ##br##Offsets... Positive Offsets… Positive Offsets… Chart 9...With Washed##br## Out Technicals …With Washed Out Technicals …With Washed Out Technicals Bottom Line: Adding it up, the Fed's historic exit from unconventional monetary policies, coupled with higher interest rates and gasoline prices, which are all income sapping, signal that only a benchmark allocation is warranted in the S&P consumer discretionary sector. We are executing this downgrade to neutral by trimming the media heavyweight sub-index (comprising cable & satellite and movies & entertainment) to a benchmark exposure. Intermittent Cable Signal Similar to the broad consumer discretionary index, cable & satellite stocks have been on a tear since troughing at the onset of the Great Recession. The more defensive in nature cable-related spending served as a catalyst to push up relative performance to all-time highs (Chart 10). This defensive industry backdrop is also evident in the positive correlation between the U.S. dollar and relative share prices. Empirical evidence shows that over the past three decades cable stocks outperform during dollar bull markets and suffer during periods of U.S. dollar weakness (Chart 10). Synchronized global growth is allowing other G10 central banks to play catch up to the Fed, which raised rates for the first time this cycle in December 2015. As a result, this looming coordinated G10 tightening monetary policy backdrop has forced investors out of the greenback. Given that the cable & satellite index sources nearly 100% of its revenues domestically, in a relative sense, the year-to-date U.S. softness is negative for sales/profits (Chart 10). On the industry operating front, there are some demand cracks forming. Cable outlays are trailing overall PCE and are anchoring relative share price momentum (middle panel, Chart 11). This message is corroborated by the softness in the ISM services survey that has been negatively diverging from ISM manufacturing. Waning services demand has historically been a bad omen for relative profit growth. At a minimum, a leveling off in the V-shaped recovery in sell-side analysts relative EPS expectations is in order (bottom panel, Chart 11). Chart 10Dollar Blues Dollar Blues Dollar Blues Chart 11Demand Softening Demand Softening Demand Softening Worrisomely, recent comments from Comcast that subscriber losses in the current quarter will likely erase all of last year's gains are disconcerting. This anecdote also confirms that demand for cable services is failing. The second panel of Chart 12 shows that real cable spending peaked in early 2014 and since then has been continually losing traction. If it were not for the successful offset from price hikes, cable companies would be in dire straits. The cable operators' ability to lift selling prices is undeniable and unmatched with a multi-decade track record, and remains solid despite the plethora of industry woes of late (Chart 13).Recent chatter that Charter Communications is about to be gobbled up is another factor underpinning cable pricing power. Additional industry M&A activity will take supply out of the market; recall that Charter bought out Time Warner Cable last year with positive industry pricing power results. The implication is that industry sales will remain resilient. Chart 12Margin Squeeze Alert Margin Squeeze Alert Margin Squeeze Alert Chart 13But Pricing Power And Valuations Are Tailwinds But Pricing Power And Valuations Are Tailwinds But Pricing Power And Valuations Are Tailwinds Tack on compelling relative valuations with the relative price-to-cash flow ratio probing 5-year lows and the industry's threats are likely well reflected following the recent derating phase (bottom panel, Chart 13). Netting it all out, a more balanced cable industry profit backdrop is signaling that only a neutral stance is warranted in this media sub-index. Bottom Line: Downgrade the S&P cable & satellite index to neutral and lock in gains of 5% since inception. The ticker symbols for the stocks in this index are: BLBG: S5CBST - CMCSA, CHTR, DISH. Movies & Entertainment: Intermission Similar to the S&P cable & satellite downgrade to neutral, the S&P movies & entertainment media sub-index no longer deserves an overweight and we recommend trimming exposure to neutral. Cord cutting is not a new phenomenon and content providers have been regrouping in order to fend off cutthroat competition from Netflix and similar outfits. This is a secular industry force that traditional media outlets must embrace and adapt to rather than be ground down by inertia. M&A activity has been a key defense mechanism for this sector and share count retirement explains a sizable part of the torrid relative performance since the Great Recession (Chart 14). This source of industry support is in late stages on the eve of the mega deal involving Time Warner. Demand for movies and entertainment has also come under pressure lately as depicted by the deceleration in recreation PCE. The softness in the ISM services survey is a yellow flag (Chart 15). The hurricane catastrophe is disquieting in the near-term, especially given the unintended consequence of the spike in gasoline prices. Historically, rising prices at the pump eat into demand for recreation activities (third panel, Chart 15). Chart 14End Of Share Retirement? End Of Share Retirement? End Of Share Retirement? Chart 15Decreasing Demand... Decreasing Demand… Decreasing Demand… In a broader context, when overall media-related consumer outlays suffer a setback, as is currently the case, relative forward profit estimates tend to follow suit and vice versa. The implication is that the earnings-led decline in relative share prices likely has more room to fall (bottom panel, Chart 15). All of this is transpiring in softening industry pricing power. While selling prices are still expanding, the growth rate has been cut in half since peaking early last year. Input cost inflation is not offering any positive offsets. Chart 3 showed that our broad based wage inflation diffusion index is plunging, but movies & entertainment executives have been fighting for talent, boosting industry wage growth. Taken together, they are sending a negative signal for sky high margins that appear vulnerable to a squeeze (Chart 16). Nevertheless, there is some light at the end of the tunnel for this media sub-group. Disney recently announced that it would pull content out of Netflix and start its own streaming service, disintermediating its core movie and sports (ESPN) content. Content providers in general are also working on introducing/beefing up their own streaming services options in order to better compete with online-only rivals. Live television (news and sports in particular) are still a near-monopoly that traditional media content providers are working hard to preserve. Moreover, diversified business models also assist in cushioning the cord cutting secular decline in the content business segments. Importantly, consumer confidence is pushing decade highs and will likely make all-time highs prior to the end of the business cycle. Historically, relative performance and consumer sentiment have been positively correlated for the better part of the past 22 years. Currently, a wide gap has opened and there are good odds of a catch up phase in the former (top panel, Chart 17). Chart 16...Showing Up In Loss Of Pricing Power …Showing Up In Loss Of Pricing Power …Showing Up In Loss Of Pricing Power Chart 17Cheap With Low EPS Growth Hurdle Cheap With Low EPS Growth Hurdle Cheap With Low EPS Growth Hurdle Finally, we refrain from turning very negative on this index as we deem that most of the bearish news is already reflected in historically inexpensive valuations on below par relative sales and EPS 12-month forward expectations (middle & bottom panels, Chart 17). Bottom Line: Downgrade the S&P movies & entertainment index to a benchmark allocation. The ticker symbols for the stocks in this index are: BLBG: S5MOVI - DIS, TWX, FOXA, FOX, VIAB. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 https://www.clevelandfed.org/our-research/indicators-and-data/inflation-nowcasting.aspx 2 Please see BCA U.S. Equity Strategy Weekly Report, "Operating Leverage To The Rescue?" dated April 17, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

The dominant theme this week in U.S. Equity Strategy has been the acceleration in global trade. South Korea, the archetypal global trade bellwether, saw its exports grow by 16% in the first seven months this year with a 31% increase in the first three weeks of September. Such growth reinforces our thesis that we are in the early stages of a global capex resurgence. Global industrial machinery is heavily levered to changes in DM capital goods orders; the recent modest shift to growth in the latter has driven a surge in highly cyclical global machine orders (second panel). Paired with strong domestic demand (third panel) and an export-accommodative currency, U.S. industrial machinery manufacturers should be particularly well positioned to see earnings growth outpace the rest of the S&P 500. The market has been somewhat less sanguine than both us and the sell-side community; earnings estimates have been outpacing the index, resulting in a fall in valuation multiples year-to-date. Validation of those estimates seems likely to be the key catalyst for the index; stay overweight industrial machinery. The ticker symbols for the stocks in this index are: BLBG: S5INDM - ITW, IR, SWK, PH, FTV, DOV, PNR, XYL, SNA, FLS. Accelerating Global Manufacturing Means More Machines Accelerating Global Manufacturing Means More Machines

Highlights A major investment theme for the coming years will be the resynchronization of developed economy monetary policies. Expect substantial further convergence between U.S. T-bond yields and both German bund yields and Swedish bond yields. This yield convergence necessarily supports the currency crosses EUR/USD and SEK/USD. Underweight U.K. consumer services versus the FTSE100. Overweight German consumer services versus the DAX. The September 24 German election and October 1 proposed referendum on Catalan independence are not major catalysts for the financial markets. Feature A major investment theme for the coming years will be the resynchronization of developed economy monetary policies. As monetary policy resynchronizes, it will become clear that the extreme desynchronization of monetary policies over the past few years was the great anomaly (Chart of the Week and Chart I-2). This anomaly reached its peak in 2014 when policies at the ECB and the Federal Reserve moved in diametrically opposite directions. The ECB signalled the start of its quantitative easing just as the Fed began to end its own. Chart of the WeekThe Desynchronization Of Monetary##br## Policy Was An Anomaly The Desynchronization Of Monetary Policy Was An Anomaly The Desynchronization Of Monetary Policy Was An Anomaly Chart I-2The Desynchronization Of Monetary##br## Policy Was An Anomaly The Desynchronization Of Monetary Policy Was An Anomaly The Desynchronization Of Monetary Policy Was An Anomaly Why Did Monetary Policy Desynchronize? The extreme desynchronization of monetary policy would not have happened if it was just about economics. On the basis of the hard economic data, the ECB could have emulated the unconventional policies of the Fed, BoJ and BoE years before it eventually did in 2015. If it had, ECB policy would have been much more synchronized with the other major central banks. However, unconventional monetary policy wasn't, and isn't, just about economics. The ECB faced, and still faces, much tougher political and technical hurdles than other central banks. The euro area does not have one government, it has 19. The ECB had to convince sceptical core euro area governments that zero and negative interest rate policy and bond buying were not just a bailout for the periphery, especially with the euro debt crisis so fresh in the mind. Likewise, the euro area does not have one sovereign bond, it has 19. To design and implement an asset purchase program in the euro area is much more complicated than in the U.S., Japan or the U.K. But by mid-2014 it had become clear that each wave of unconventional monetary easing - through its impact on exchange rates - had allowed other major economies to 'steal' some inflation from the euro area (Chart I-3). With the ECB still undershooting its inflation mandate, it was becoming a dereliction of duty for the ECB not to do what the Fed, BoJ and BoE had already done several years earlier. As the saying goes, it is better for a reputation to fail conventionally, than to succeed unconventionally. Chart I-3Currency Depreciations "Steal" Inflation From Other Economies Currency Depreciations "Steal" Inflation From Other Economies Currency Depreciations "Steal" Inflation From Other Economies Why Will Monetary Policy Resynchronize? Three years and several trillion euros later, the ECB can feel it has had a fair crack at unconventional easing (Chart I-4). At the same time, the central bank must contend with fresh political and technical hurdles. How many more German bunds can it realistically buy without irking Germany's policymakers? Chart I-4The ECB Has Had A Fair Crack At QE The ECB Has Had A Fair Crack At QE The ECB Has Had A Fair Crack At QE The ECB is also aware that ultra-loose monetary policy - by compressing banks' net interest margins - endangers banks' fragile profitability. This impairs the bank credit channel which is the mainstay of private sector credit intermediation in the euro area.1 Meanwhile, the euro area's configuration of solid economic growth, solid job growth and subdued inflation is common to most large developed economies (the exception is the U.K. which we explain below). Putting all of this together, the theme for the coming years has to be monetary policy resynchronization, one way or the other. One way is that the more hawkish central banks will become less hawkish, as subdued inflation limits the scope for monetary policy tightening. The other way is that the more dovish central banks will become less dovish as the benefits of ultra-accommodation diminish and the costs rise. Or, both ways will happen together. Nowhere are negative bond yields more absurd and more inappropriate than in Sweden (Chart I-5). In just three years the economy has grown 12% and house prices have surged 50%. Furthermore, unlike in other parts of Europe, the housing market in Sweden did not suffer a meaningful setback in either 2008 or 2011. Yet Sweden's negative interest rate policy means that it stills pays people to borrow and further bid up house prices. If anywhere is at risk of a bubble from ultra-accommodative monetary policy, Sweden must be it. For bond yield spreads and currencies - which are relative trades - it doesn't really matter how the resynchronization of monetary policies occurs. We expect substantial further convergence between U.S. T-bond yields and both German bund yields and Swedish bond yields. And this yield convergence necessarily supports the currency crosses EUR/USD and SEK/USD (Chart I-6). Chart 5A Negative Bond Yield ##br##In Sweden Is Absurd A Negative Bond Yield In Sweden Is Absurd A Negative Bond Yield In Sweden Is Absurd Chart I-6If The Swedish Bond Yield Shortfall ##br##Compresses, The Krona Will Rally If The Swedish Bond Yield Shortfall Compresses, The Krona Will Rally If The Swedish Bond Yield Shortfall Compresses, The Krona Will Rally The Myth Of The Beneficial Currency Devaluation Sharp depreciations in a currency result in an economy 'stealing' inflation from its major trading partners. Chart I-7 and Chart I-8 suggest that absent the post Brexit vote slump in the pound, the gap between U.K. and euro area inflation would be almost 1% less than it is. Chart I-7The Weaker Pound Lifted ##br##U.K. Headline Inflation... The Weaker Pound Lifted U.K. Headline Inflation... The Weaker Pound Lifted U.K. Headline Inflation... Chart I-8...And U.K. ##br##Core Inflation ...And U.K. Core Inflation ...And U.K. Core Inflation So the Brexit vote explains why the U.K. is one of the few major economies where inflation is running well north of 2%. Unfortunately for U.K. households, nominal wage inflation has not followed price inflation higher. Which means that the pound's weakness has choked households' real incomes. Against this, textbook economic theory says that a currency devaluation should make a country's exports more competitive and thereby boost the net export contribution to economic growth. But in the textbook the only thing that is supposed to change is the exchange rate. The textbook assumes that the country's trading framework with its partners remains unchanged. In the case of the U.K. leaving the EU, this assumption clearly does not apply, mitigating the concept of the 'beneficial currency devaluation'. A lot of the benefits of the textbook devaluation come because firms can trade in markets that were previously unprofitable to them. This process requires investment - for example, in marketing and distribution. If Brexit means that many of those markets are no longer available, or come with tariffs, then firms will hold off making the necessary investments - unless the currency devaluation is massive. But in this case, the corresponding surge in inflation and choke on households' real incomes would also be massive. We also hear the myth of the beneficial currency devaluation applied to the weaker members of the euro area. As in, why don't these countries just break free from the euro, and devalue their way to prosperity? The simple answer is that if they left the euro, they would also risk losing access to the largest single market in the world - defeating the whole purpose of the beneficial currency devaluation! A Tale Of Two Consumers Chart I-9A Good Pair Trade: Long German Consumer ##br##Services, Short U.K. Consumer Services A Good Pair Trade: Long German Consumer Services, Short U.K. Consumer Services A Good Pair Trade: Long German Consumer Services, Short U.K. Consumer Services For the time being, hawkish comments from the BoE have given the pound a boost. But U.K. consumer spending now faces one of two headwinds. If the BoE follows through with a rate hike, household borrowing is likely to fade as a driver of spending. Alternatively, if the BoE backs off from its threat, the pound will once again weaken, push up inflation and weigh on real incomes. So for the time being, stay underweight U.K. consumer services versus the FTSE100. In Germany, the opposite logic applies. Stay overweight German consumer services versus the DAX. Euro strength helps German consumers in as much as it reduces the prices of imported food and energy. But for German exporters, the strong euro hurts the translation of their multi-currency international profits back into local currency terms. A good pair trade is to be long German consumer services, short U.K. consumer services (Chart I-9). Finally, regarding two upcoming political events - the September 24 German election and the October 1 proposed referendum on Catalan independence, we do not see either as a major catalyst for the financial markets. In the case of the German election, it is because no likely outcome is especially malign (or benign). In the case of the Catalan referendum, it is because it will be hard to draw any meaningful conclusion from the result, given that Madrid has ruled the referendum illegal - and many 'unionists' are unlikely to participate. Please note that there is no Weekly Report scheduled for next week as I will be at our New York Conference. I hope to see some of you there. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 In the euro area, small and medium sized companies tend to access credit through banks rather than through the bond market. Fractal Trading Model This week, we note an excessive underperformance of U.K. personal and household goods (dominated by BAT, Unilever, Reckitt Benckiser) versus U.K. food and beverages (dominated by Diageo and Associated British Foods). Go long U.K. personal and household goods versus U.K. food and beverages with a profit target / stop loss of 4.5%. In other trades, short nickel / long silver hit its 8% profit target, while short MSCI China / long MSCI EM hit its 2.5% stop loss. This leaves three 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-10 Long U.K. Personal and Household Goods / Short U.K. Food and Beverages Long U.K. Personal and Household Goods / Short U.K. Food and Beverages 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. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

We raised the S&P air freight & logistics group to overweight earlier this year based principally on the index being a chief beneficiary should green shoots in global trade proliferate. Since then, global export expectations have shot higher and global ton miles have staged the best recovery since the GFC (second panel). Anecdotally on its earnings call this week, FedEx called this year the "best year for global trade in years". Despite the overwhelmingly positive backdrop, the air freight & logistics index has barely budged. The result is that valuation multiples have collapsed to a fifteen year low (bottom panel). We continue to think the positive earnings momentum in this index can be ignored for only so long; the air freight & logistics group should see a long-overdue rerating. We reiterate our high-conviction overweight recommendation. The ticker symbols for the stocks in this index are: BLBG: S5AIRF - UPS, FDX, CHRW, EXPD. Air Freight Traffic; Slipping The Surly Bonds Of Earth Air Freight Traffic; Slipping The Surly Bonds Of Earth

Highlights A shares are under-owned and under-researched beyond Chinese borders. Global investors' interest on Chinese A shares will inevitably increase. The A-share market historically has been a low-beta play, and the Chinese domestic sectors tend to move together with one another rather than with their respective global sector benchmarks. The superior long-term performance of Chinese equities has been accompanied with much greater volatility in both earnings and prices compared with EM and DM benchmarks. Some larger-weight sectors, particularly banks, have significantly dragged down the valuation matrix of the broad A-share market, while some smaller-weight sectors are more dearly valued. Overall A shares are still more expensive compared with other global bourses. Feature The MSCI's decision of partial inclusion of Chinese domestic A shares in its widely followed EM and world equity indices has put this asset class on global investors' radar screens. The A-share market, which only began to develop some 30 years ago as a trial balloon for capitalism, has already become the world's second-largest by market capitalization. Yet it remains decisively mysterious outside Chinese borders. Not only is the market notoriously volatile, alternately driven by euphoria and panics, it has also been largely isolated from the outside world thanks to China's capital account controls. All of this has made global investors either unable or unwilling to commit to this asset class, which also means it is both under-owned and under-researched from global investors' perspective. This trend will inevitably change, as the Chinese economy continues to gain global significance and as Chinese regulators continue to liberalize capital account control measures. The People's Bank of China is reportedly drafting a policy package to further open up the country's financial sector to foreigners. This week's report intends to shed light on this obscure asset class. A Class Of Its Own The A-share market's juvenile and isolated nature has generated some unique features that are not only different from global and EM bourses, but also from their overseas-listed investable peers. First, Chinese A shares have a systemically lower correlation with other major global bourses, which is not surprising due to the market's isolation from global fund flows. The three-year moving beta of the market with the S&P 500 is slightly over 0.5, according to our calculation - much lower than both EM and Chinese investable equities.1 A shares' correlation with the rest of the world, however, has been steadily rising in the past 10 years (Chart 1). Foreign capital has indeed been given increasing access to A shares in the past decade through various channels such as qualified foreign institutional investors (QFIIs), the RMB Qualified Foreign Institutional Investors (RQFIIs) and more recently the "connect" programs linking Hong Kong Exchange with mainland bourses (Chart 2). However, we doubt A shares' rising beta has much to do with China's capital account liberation, as foreign ownership is still negligible. Rather, we suspect it is more due to China's rising importance in the global economy. In other words, global markets have become increasingly sensitive to the "China factor" that is also driving A shares. Chart 1A Shares' Low And Rising Beta A Shares' Low And Rising Beta A Shares' Low And Rising Beta Chart 2Rising Foreign Access To A shares Rising Foreign Access To A shares Rising Foreign Access To A shares Moreover, A shares' low correlation with other global markets can also be observed at the sector level. Table 1 summarizes A-share sectors' correlations with their respective EM and DM sector benchmarks as well as their China investable counterparts, which are categorically lower than the cross-sector correlations among other markets. For example, A-share energy stocks' correlations with their sector counterparts in the China investable universe, EM and DM are 0.58, 0.48 and 0.36, respectively. In comparison, China investable energy stocks have a correlation of 0.84 and 0.72, respectively with the EM and DM sector benchmarks, and the EM energy sector's correlation with its DM counterpart is 0.8. In other words, sector selection rather than country selection matters fundamentally for the performances of DM and EM focused portfolios, including investable China funds. A-share sector performances, however, have shown much greater idiosyncrasy from the general sector trends in global markets. Table 1A shares Sectors Are Less Correlated With Global Peers... A Stock Market With Chinese Characteristics A Stock Market With Chinese Characteristics Instead, there have been much stronger correlations among the performances of A-share sectors compared with their investable peers and other global bourses. Appendix 1 provides a detailed breakdown of cross-sector correlations of these major markets. Taken together, the average cross-sector correlation among A shares is 0.75, compared with about 0.55 in all other markets (Chart 3). This, in our view, is likely due to exceptionally high retail investor participation in the A-share market. Unlikely other markets that are largely driven by sophisticated institutional investors with research capabilities, Chinese A shares are to a much greater extent driven by herd-following retail investors, who put little emphasis on fundamentals. Anecdotal evidence abounds that investors buy or sell a stock based on price per share rather than per share earnings metrics, and naively chase laggards in anticipation of a catchup, even without clear fundamental catalysts. This could change as institutional investors take a greater share in A-share market trading and ownership, but the process will be slow and gradual. Chart 3... But Are Closely Correlated ##br##Among Each Other A Stock Market With Chinese Characteristics A Stock Market With Chinese Characteristics In short, the A-share market historically has been a low-beta play, and the Chinese domestic sectors tend to move together with one another rather than with their respective global sector benchmarks. From a portfolio management of view, including A shares should provide diversification benefits in managed global and EM portfolios. Greater Returns... Since its inception in the early 1990s, Chinese A shares have been on a powerful and volatile uptrend (Chart 4). The market has followed a well-defined central trendline, but with extreme price moves on both sides, alternating between massive overshoots and undershoots. Measured by the Shanghai Stock Exchange (SSE) Composite Index, launched in 1991 with the longest price history, stock prices have increased by over 20-fold since 1991 in RMB terms. Since 2000, A-shares' total return index, price appreciation and dividend income combined has rallied by about five-fold in U.S. dollar terms - massively outperforming both global and EM benchmarks as well as investable Chinese stocks (Chart 5). A-shares' outperformance against global bourses is largely due to faster earnings growth rather than multiples expansion. Earnings of Chinese domestic and investable shares have risen by seven- and 10-fold respectively since 2000, both outpacing their EM and DM peers (Chart 5, middle panel). Importantly, while DM has been the bright spot in the ongoing multi-year bull market, it has been a chronic laggard over a more extended time horizon - both earnings and total returns of DM have significantly lagged EM in general and Chinese shares in particular since 2000. It is commonly argued that economic growth has little to do with stock market performance, and therefore a country's superior growth outlook does not necessarily lead to superior equity returns for investors. We find this view plausible. There is no question that the near-term correlation between a country's economic growth and stock prices is low empirically. However, economic growth should be a defining factor for asset returns over the long run. After all, stock prices are ultimately driven by earnings, which in turn are driven by economic growth. Granted, stock markets are an emotional discounting mechanism, and prices can and do deviate from earnings fundamentals from time to time - they will inevitably mean-revert over the long run. Chinese GDP has expanded by a staggering 10-fold since 2000 in dollar terms, which is the fundamental driving force behind China's long-term earnings growth and stock market returns (Chart 5, bottom panel). Chart 4A shares Powerful And Volatile Long-term Uptrend A shares Powerful And Volatile Long-term Uptrend A shares Powerful And Volatile Long-term Uptrend Chart 5GDP, Earnings And Stocks Prices GDP, Earnings And Stocks Prices GDP, Earnings And Stocks Prices ... With Greater Risks The superior long-term performance of Chinese equities, however, has been accompanied with much greater volatility in both earnings and prices compared with EM and DM benchmarks. This is easy to observe in the dramatic fluctuations in A-share prices; from its inception, the market has been routinely characterized by massive boom-bust cycles. Table 2 summarizes the historical returns of A shares in comparison with their investable and EM/DM peers. A few points are worth highlighting. Table 2Statistical Summary A Stock Market With Chinese Characteristics A Stock Market With Chinese Characteristics Chart 6A Shares' volatility Is High... A Stock Market With Chinese Characteristics A Stock Market With Chinese Characteristics First, the A-share market has historically yielded much greater dispersion of returns compared with other bourses, including Chinese investable stocks, as shown in the box-and-whisker plot (Chart 6).2 Since 2000, the A-share market has achieved the highest cumulative returns among all markets, but it has also recorded the biggest monthly gain and deepest monthly loss. It has the widest gap between first-quartile and third quartile returns, the greatest risk of loss and the biggest historical value at risk (VaR)(See Appendix 2 for return distributions of various markets). Overall, the standard deviation of A-share monthly returns historically is 8.4%, compared with 7.7% for the Chinese investable market and 6.4% and 4.4% respectively for the EM and DM benchmarks. On a risk-adjusted basis, A shares have delivered the highest risk-adjusted returns since 2000, but the risk-return profile has been decisively poorer evaluated in both a five- and 10-year horizon (Table 3). The Sharpe ratio of A shares since 2000 is 0.39, compared with 0.35 and 0.23 for EM and DM benchmarks.3 Over a five-year and 10-year period, however, A shares' Sharpe ratios were significantly lower than other markets. Similarly, A shares' Sortino ratio since 2000 was superior, but inferior over shorter-term horizons. In contrast, DM has delivered the highest risk-adjusted returns in the past five years and 10 years, but has lagged since 2000. Indeed, DM stocks, particularly the U.S. market, have delivered stellar performance since the aftermath of the global financial crisis with very low volatility, while Chinese equities and EM stocks in general have been plagued with numerous macro concerns. It remains to be seen, however, whether this divergence can be sustained going forward. Table 3Risk And Return Characteristics A Stock Market With Chinese Characteristics A Stock Market With Chinese Characteristics Chart 7...But Declining ...But Declining ...But Declining Finally, although A shares historically have been structurally more volatile than other markets, the gap has been gradually narrowing - a sign of A shares' growing maturity (Chart 7). As the market continues to institutionalize, we expect price volatility will likely continue to decline. A shares, dubbed as a highly speculative "virtual casino" in the early 1990s, will become an increasingly important venue for Chinese households to park their wealth, with more moderate risk-return tradeoffs. Sector Composition And Valuation Perspective From the humble start of a handful of listed firms in the early 1990s to the world's second-largest equity market by capitalization, A shares have experienced a dramatic expansion and significant changes. Along with the two mainboards in Shanghai and Shenzhen stock exchanges dominated by large-cap stocks, several "peripheral" boards have also been established to cater to the funding needs of small and medium-sized companies and high-tech startups. Chart 8 shows the sector components of A shares - as in most equity markets, banks and financial firms account for a disproportionally large weight in the A-share index. However, compared with the Chinese investable universe,4 A shares are more diversified and are a closer representation of the sectoral structure of the broader Chinese economy. Chart 8A Shares Sector Breakdown A Stock Market With Chinese Characteristics A Stock Market With Chinese Characteristics On an aggregate level, A shares currently look cheap compared with historical norms (Chart 9). Our composite valuation indicator, an average of conventional valuation indicators such as price-to-trailing earnings, price-to-book and dividend yield, shows that A shares are currently trading at close to one standard deviation below its historical average. Under the surface, however, the market-cap weighted aggregate valuation indicators disguise some significant differences among different sectors: large-cap A-shares, mainly banks, are trading at large discounts to their respective historical means, but smaller-weight sectors, particularly technology, consumer staples and healthcare, are trading at higher multiples. Chart 10 shows a simple average of various valuation ratios of the 10 Global Industry Classification Standard (GICS) sectors.5 With the exception of price-to-cash, the equal-weighted valuation indicators are more expensive than their respective market weight-based versions, according to our calculation. This means some larger-weight sectors, particularly banks, have significantly dragged down the valuation matrix of the broad market, while some smaller-weight sectors are more dearly valued. However, none of the valuation ratios appear extreme in a historical context. Chart 9A Shares Appear Cheap... A Shares Appear Cheap... A Shares Appear Cheap... Chart 10...But With Big Sector Gaps ...But With Big Sector Gaps ...But With Big Sector Gaps Summary And Conclusions Compared with other bourses, Chinese A shares currently are still more expensive (Table 4). A-shares' valuation premium may be justified from a long-term point of view, given its stronger earnings growth outlook. However, investable Chinese stocks currently are still much more attractively valued, and thus remain our favored "China play" at the moment. Table 4Valuation Ratio: Market Rate Vs. Sector Average A Stock Market With Chinese Characteristics A Stock Market With Chinese Characteristics Nonetheless, global investor interest in A shares will inevitably increase going forward, as the Chinese economy continues to gain global significance and regulators continue to deregulate the country's capital account controls. A shares' relatively low correlation with other global bourses also provides unique diversification benefits to managed global and EM portfolios, and foreigners' extremely low ownership in this asset class also generates constant tailwinds. In addition, as the market continues to mature, volatility will abate, further improving its attractiveness for global long-term investors. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com Stella Peng, Research Assistant stellap@bcaresearch.com 1 All based on weekly returns. China Shanghai A share index is used for A share index, and MSCI China Free USD total index is used for the China investable market. All other markets are calculated using U.S. dollar total return MSCI indexes, unless otherwise specified. 2 A box and whisker chart shows the degrees of returns concentration in a given time frame. The top and bottom lines of the box indicate the first and third quartiles of the return distribution respectively; the horizontal line inside the box is the median; and the tips of the vertical lines stand for the maximum and minimum returns. 3 The Sharpe ratio is calculated as monthly returns minus one-month U.S. dollar LIBOR (as risk free rate for dollar-denominated investors) divided by the standard deviation of returns. The Sortino ratio is a variation of the Sharpe ratio, which measures the excess returns divided by the standard deviation of negative asset returns (or the downside deviation). 4 Please see China Investment Strategy Weekly Report, "A Closer Look At Chinese Equity Valuations," dated August 31, 2017, available at cis.bcaresearch.com. 5 Includes Consumer Discretionary, Consumer Staples, Energy, Financials, Health Care, Industrials, Information Technology, Materials, Telecommunication Services and Utilities. Real Estate is included in Financials, due to its limited data availability as a stand-alone GICS sector. Appendix 1 Cross-Sector Correlations Of Major Markets China A A Stock Market With Chinese Characteristics A Stock Market With Chinese Characteristics China Investable A Stock Market With Chinese Characteristics A Stock Market With Chinese Characteristics Emerging Markets A Stock Market With Chinese Characteristics A Stock Market With Chinese Characteristics Developed Markets A Stock Market With Chinese Characteristics A Stock Market With Chinese Characteristics All Country World A Stock Market With Chinese Characteristics A Stock Market With Chinese Characteristics Appendix 2 Distribution Of Market Returns A Stock Market With Chinese Characteristics A Stock Market With Chinese Characteristics Cyclical Investment Stance Equity Sector Recommendations

The National Association of Home Builders released their housing market index (HMI) which, while still high, took a step downward. Importantly, the softness in the HMI had already commenced earlier in the summer prior to the hurricane season (second panel). Moderating housing starts confirm the weaker industry sentiment (third panel). This is hardly surprising given lumber prices, currently bumping up against five year highs (bottom panel), which will cut materially into profit margins. As a result, the S&P homebuilders index has been tightly range bound since our early summer downgrade to neutral. Conversely, home improvement retailers benefit from high lumber prices as retailers typically earn a fixed spread such that a high dollar value sold will boost profitability. With hurricane-related rebuilding driving lumber demand (and prices) higher in the near-term, the margin spread between home improvement retailers and homebuilders should be amplified in the back half of 2017. Accordingly, we reiterate our neutral homebuilders and high-conviction overweight home improvement retailers recommendations. The ticker symbols for the stocks in the S&P homebuilders index are: BLBG: S5HOME - DHI, LEN, PHM. The ticker symbols for the stocks in the S&P home improvement retailers index are BLBG: S5HOMI - HD, LOW. Homebuilder Pain Is Home Improvement Retail's Gain Homebuilder Pain Is Home Improvement Retail's Gain

Neutral Software stock relative performance has returned to its long-term uptrend, but remains far from the two standard deviations above the mean peak reached during the tech bubble (top panel). The structural pull from the proliferation of cloud computing and software-as-a-service has served as a catalyst to raise the profile of this more defensive and mature tech subsector. Beyond this constructive backdrop, cyclical forces are also painting a brighter picture for software equities. Importantly, there is tentative evidence that a fresh capex upcycle has commenced, and if software commands a larger slice of the overall spending pie, industry profits should enjoy a healthy rebound (middle panel). Supply reduction presents a bullish backdrop for software selling prices that have exited deflation at a time when overall corporate sector inflation is decelerating. The upshot is that revenue growth will likely reaccelerate (bottom panel). Adding it up, enticing structural software forces aside, a cyclical capex recovery is a boon for software outlays and, coupled with reviving animal spirits, signal that it no longer pays to underweight this tech sub-sector. Bottom Line: The S&P software index does not deserve an underweight. Lift exposure to a benchmark allocation, and refer to yesterday's Weekly Report for additional details. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, ATVI, EA, INTU, ADSK, SYMC, RHT, SNPS, CTXS, ANSS, CA. Software: A Capex Upcycle Winner? Software: A Capex Upcycle Winner?