BCA Indicators/Model

Dear Client, I am on the road visiting clients in Toronto, Chicago, and Wisconsin this week, and as such there will be no regular Weekly Report. Instead, we are sending you a Special Report written by my colleague Marko Papic, Chief Strategist of BCA's Geopolitical Strategy service. In this report, Marko argues that Hillary Clinton has not yet sealed the election, despite her high odds of winning. I hope you will find this report both interesting and informative. Best regards, Peter Berezin, Senior Vice President Global Investment Strategy Highlights Clinton has a 65.5% chance of winning the presidency. A Trump win requires a surprise - such as in voter turnout. Still, we doubt Trump can punch more than 3% above his polling. Regardless of the outcome, multinational corporate profits will suffer. Go long the USD. Feature With the conclusion of the final presidential debate on October 19, the U.S. election is now in its final inning. Donald Trump's chances of mounting a comeback are slipping away (Chart 1). Could there be a Brexit-like surprise for the markets on November 8? And what are the investment implications of this year's unprecedented election? Chart 1 How Trump Can Still Win... Paddy Power, one of the world's biggest bookies, has begun to pay out bets to people who had wagered on Secretary Hillary Clinton winning the election. Meanwhile, according to Nate Silver, America's statistical Geek-in-Chief, Donald Trump has a meager 13.7% chance of winning the election.1 While our own model gives Clinton a 65.5% chance of winning, we have not forgotten Yogi Berra's wisdom: "It ain't over till it's over." There are three reasons why we would have held onto the pay-outs if we ran Paddy Power: Turnout assumptions could be wrong: Silver's quant model - and ours - is based on the assumption that the publically available opinion polls are high-quality data points. To iron-out the noise of an occasional bad poll, political analysts aggregate the polls to create a "poll-of-polls." The problem is that this method is mathematically the same as combining bad mortgages into securities. The idea is that each individual object (mortgage or poll) may be flawed, but if you get enough of them together, the problems will all average out and you have a very low risk of something bad happening.2 If there is a bias that is common to a large part of the data, then you are in real trouble. And why would there be a bias in election polls? For one, polling is not a science. It is an art. To extrapolate the results of an opinion survey of ~1,000 individuals to the general election of ~130 million people, polling professionals have to make turnout assumptions that are based partly on previous elections and partly on guesswork. This year, these assumptions are notoriously difficult to make as both candidates are extremely unpopular (Chart 2). This is bound to throw off pollsters' assumptions and may partially explain the regular gyrations that can be gleaned in Chart 1. For Secretary Hillary Clinton, the problem is compounded by the fact that she requires a high turnout to win. She needs the "Obama Coalition" of minorities and Millennial voters to show up as they did for President Barack Obama in 2008 and 2012. But we know that she struggled with the latter, with Senator Bernie Sanders picking up 70% of the youth vote in the Democratic primaries (Chart 3). If the 2016 turnout resembles the turnout from mid-term elections - which Republicans have generally won this century - then Trump could still have a chance. Chart 2 Chart 3 People may be lying: Another concern for Clinton is that she may be the 21st century Tom Bradley. Bradley was an African-American Mayor of Los Angeles who lost the 1982 California governor's race despite being ahead in the polls right up until election day. The "Bradley effect" theory goes that white voters lied when answering the polls in 1982 for fear of appearing racially prejudiced. Today, voters may be telling pollsters what they think is "politically correct," thus favoring Clinton in the polls. In the same vein - but ideologically opposite - the former Imperial Wizard of the Knights of the Ku Klux Klan, David Duke, outperformed expectations in both the 1996 U.S. Senate election and the 1999 special election for Louisiana's First Congressional District. He lost both elections, but he managed to garner double-digit support both times. More recently, the June 23 Brexit vote surprised markets. In our view, investors and betting markets underestimated Brexit largely in spite of polls, which had been close throughout the campaign stage (Charts 4 and 5). BCA's Geopolitical Strategy outlined the case for why the probability of Brexit was much higher than the market assumption as early as March.3 Our concerns began to manifest in the polls with the "Leave" camp comfortably ahead throughout June. And then, from June 16 (one week before the vote) to June 23, the "Stay" vote surged ahead in the polls, garnering a 4% lead the day before the election. This surge in the last week was clearly false, as the "Leave" camp won by a 3.8% margin, a 7.8% swing on the day of the election. So, what happened? The vertical line in Chart 5 shows the day that Member of Parliament Jo Cox was murdered by a British ultra-nationalist. Our guess is that the stunning political assassination - an extremely rare event in the U.K. - created a "Cox effect" in the Brexit polling. Those who were polled may have mourned for Cox, or resisted being associated with the extreme views of a self-professed neo-Nazi, yet they silently stuck to their legitimate concerns regarding EU membership on the day of the referendum. Chart 4Online Betting Got Brexit Wrong... bca.gps_sr_2016_10_21_c4 bca.gps_sr_2016_10_21_c4 Chart 5...So Did Prominent Opinion Polls bca.gps_sr_2016_10_21_c5 bca.gps_sr_2016_10_21_c5 The Brexit example illustrates that lying to pollsters is not something that only happens in the past. It has happened as recently as June. Given Donald Trump's controversial statements - and particularly his misogynist rants going back to 2005 - American voters may be lying to pollsters when it comes to their choice for president. Chart 6Media Narratives Are Cyclical bca.gps_sr_2016_10_21_c6 bca.gps_sr_2016_10_21_c6 Media narratives: As our geopolitical team has stressed throughout this election, the news media work through narratives (Chart 6). These narratives appear to have influenced polls, leading to regular gyrations in support levels for the two candidates. Will the media have another "comeback kid" narrative for Trump in store ahead of the election? It cannot be discounted. And if the polls tighten to the 0-3% range again, the turnout concerns and the "Bradley/Cox effect" from above could be enough to swing the election for Trump. Bottom Line: Clinton remains the favorite to win the election, but her probability of winning is closer to 65.5% than the 85% that appears to be "priced in the market." ...And Why He Will Not Win While we are not comfortable calling the election a "done deal," we do believe that Clinton is a favorite. The BCA Geopolitical Strategy quantitative model predicts that she has about a 65.5% probability of winning.4 And the team's qualitative analysis of Trump's electoral strategy suggests that the hurdles to his victory are considerable, particularly in swing states Virginia and Colorado. Before we introduce the quantitative and qualitative models that underpin our election forecast, let us address the above concerns about turnout and the "Bradley/Cox effect" head on. In our view, the polls are telling the truth. We concede that Trump's support level may be underestimated by approximately 3%, which would not be out of line with the last five presidential elections (Chart 7). However, a Clinton lead greater than ~3% the day of the election will be insurmountable for four reasons: Chart 7 GOP primary: It was not the polling that got Trump wrong during the Republican primary race, but the pundits. The polls were generally accurate, particularly those in the swing states where polls tend to be frequent and sophisticated (Chart 8). Polls only underestimated Trump by more than 3% in Illinois, Massachusetts, New York and Pennsylvania. Some of Trump's most controversial statements were made in late 2015 and early 2016 and yet they prompted no shame from his supporters when answering pollsters' questions. Turnout seesaw: Trump's strategy - which we dubbed "The Great White Hype" back in March - is a serious and mathematically viable electoral strategy.5 The effort focuses on boosting the GOP share and overall turnout of the white, blue-collar voter. The problem with this strategy, as executed by Trump, is that its effect could be a seesaw. Trump's rhetoric and policy proposals may appeal to less-educated, lower-income white voters, but may also reduce his support among well-educated, upper-income voters. This is a serious problem for Trump given that the 2012 exit polls indicate that Romney won college graduates by 4 points and voters earning $100k or above by 10 points. In other words, upper-income, well-educated voters are a key constituency of the Republican Party. And just as Clinton may have trouble getting Millennials and minorities to vote for her by the same margin as they did for Obama, Trump could be struggling to get key conservative constituencies out as well. Debates: All scientific polls taken after the debates have Hillary Clinton as a clear winner (Chart 9). This may seem surprising given the reaction of many pundits that Trump outperformed the very low expectations for him in the debates. Many analysts scored the debates close, but voters did not. Why? Because independent and undecided voters are just now tuning into the election and want to see candidates discuss serious policy issues and show leadership. Chart 8 Chart 9 Political science research shows that the direct influence of party identification decreases in presidential elections over time, but issues gain importance, especially after the presidential debates.6 As such, voters tuning into the debates were not discounting Trump's fiery rhetoric and behavior, they were appalled by it. We can't say we were surprised, as we have been showing Chart 10 to clients since February. Chart 10 Senate: If voters are hiding their true support level for Donald Trump, then their genuine preference should be revealed in Senate races where less controversial Republicans are contesting close elections. Instead, Republicans are on a path to lose four of their Senate seats, with another three in play (Democrats need four to take the Senate, assuming that Clinton wins the presidency, since Vice-President Tim Kaine would then cast the tie-breaking vote in that body). Democrats are ahead in Indiana, Illinois, Wisconsin, and Colorado. Nevada is also expected to stay blue. Missouri, New Hampshire, North Carolina, and Pennsylvania are all still in contention, despite the GOP incumbent advantage in all three. Bottom Line: Despite the challenges that this election presents - two highly disliked candidates, questions about turnout, and concerns about polling quality - we doubt that Donald Trump can surprise his poll numbers by more than ~3%. With Hillary Clinton up by 6.4% in the latest RealClearPolitics poll of polls, this means that Trump has to start rallying now if he is going to have a chance on November 8. What Do Our Quantitative & Qualitative Models Say? Our geopolitical team's quantitative model predicts that Hillary Clinton will win the election with 335 electoral votes. The model, built using historical macroeconomic and election data since 1980, has been projecting a strong Clinton victory for some time.7 It currently shows that Clinton already has 279 electoral votes from states where she has more than a 70% chance of winning (Chart 11). These results mean that even under the unlikely scenario in which the GOP wins all the remaining swing states (North Carolina, Arizona, Florida, Ohio, and Iowa), Clinton will still win the election, all other things being equal. Chart 11 Meanwhile, our qualitative model relies on testing Trump's electoral strategy - boosting the share of the white vote accruing to the GOP - in the real world. We concluded in March that Trump did have a path to victory, albeit a very narrow one. Our research showed that Trump's strategy is mathematically viable, at least in 2016 when the white share of the total population remains large enough. We specifically showed that Trump would only need to increase white voters' support by 1.7% and 2.9% in Florida and Ohio, respectively, to flip those states, which seems quite reasonable. We also pointed out that getting a 5.7% swing in Iowa could be feasible. On the other hand, we showed that "flipping" Midwest states like Michigan, Pennsylvania, and Wisconsin would require a very large swing of white voters in Trump's favor: 13.9%, 7.8%, and 8.1%, respectively. With those numbers, Trump would have to win nearly 70% of Michigan's white voters, 65% of Pennsylvania's, and 58% of Wisconsin's. Of the three, Wisconsin looks the most achievable. On the other hand, the GOP only managed to pick up 52% of the state's white share in 2004, the last time a Republican candidate for president won an actual majority of the popular vote since 1988. So, getting to 58% is a high bar given Wisconsin's recent electoral history. How did our qualitative model hold up in terms of state-by-state polling? It did really well! As we predicted, Trump has led the race or nearly led the race in Iowa, Florida, and Ohio (Chart 12). In Michigan, Pennsylvania, and Wisconsin, Clinton's lead has remained higher than 5% through most of the election cycle, even when the media narrative shifted against her (Chart 13). Chart 12The 'White Hype' Model Works Here bca.gps_sr_2016_10_21_c12 bca.gps_sr_2016_10_21_c12 Chart 13White Hype' Does Not Work Here bca.gps_sr_2016_10_21_c13 bca.gps_sr_2016_10_21_c13 If Trump were to win all the states that our White Hype model predicts as competitive, he would still be short of the necessary 270 electoral votes. Map 1 shows the ideal distribution of states for Trump, one that ignores the polls and assigns swing states to Trump or Clinton based on whether the White Hype model is feasible or not. Notice that the two remaining major states are Virginia and Colorado. For Trump to win this election, we believe that he needs to win one of the two (Colorado in combination with either Nevada or New Hampshire), in addition to all of Florida, Ohio, North Carolina, and Iowa. This is a tall order! Particularly given that his polling in Virginia and Colorado is poor (Chart 14). Chart Chart 14Two Critical Swing States bca.gps_sr_2016_10_21_c14 bca.gps_sr_2016_10_21_c14 Bottom Line: BCA's Geopolitical Strategy quantitative and qualitative models both show that Hillary Clinton is a clear favorite to win the election, a view we have held since December 2015.8 Investment Implications: MNCs Vs. SMEs Our colleague Peter Berezin has already discussed the implications of a Trump victory: a stronger USD and a sell-off in stocks.9 We agree and would add that a rally in Treasurys would be likely in the event of a surprise Trump win (Chart 15). Chart 15Trump's Success Helps Safe-Haven Assets bca.gps_sr_2016_10_21_c15 bca.gps_sr_2016_10_21_c15 The rally in safe-haven assets would eventually give way, however, to a bear market in Treasurys as investors realized that Trump has no intention of controlling public spending or reining in the (already growing) budget deficit. Growth, and likely inflation, would surprise to the upside, allowing the Fed to hike rates beyond the 48 bps expected by the market through the end of 2018. We do not foresee that a Republican-held Congress would stand in Trump's way, despite the clear dislike between the Speaker of the House, Representative Paul Ryan, and Trump. Ryan would not go against a sitting president from the same party who just pulled off a revolutionary election. The entire House will face re-election in 2018 and moderate Republicans will be wary of standing up to Trump, lest he campaign against them in GOP primaries in a short two years. Investors are putting way too much faith in America's checks-and-balances to keep Trump from enacting his policies, at least in the short term. These are constitutional, legal, and technical checks, and political expediency often overrules all three. In case of a Clinton win, we would expect the House to remain controlled by the GOP. There are only about 38 truly competitive electoral districts in this race, according to The Cook Political Report.10 Given that the Republicans have a 60-seat majority in the House, a Democratic takeover would require Democratic candidates to defeat Republican Representatives in 30 out of 38 competitive districts. At best, this means that the current, market- bullish status quo of divided government will continue. With the House remaining in Republican hands, and Democrats clinging to a potential razor-thin control of the Senate (vulnerable to a post-Trump Republican comeback in 2018), the Clinton White House would be constrained on some of its most left-leaning policies.11 And what are the chances of cooperation on modest reforms? We think they are actually quite good. Unlike Obama, Clinton's victory will not be a popular sweep. She will not control Congress, she will likely receive less than 50% of the popular vote (due to the presence of two notable third-party candidates), and she will be the first candidate ever elected that has more voters saying they dislike her than like her. Therefore, the odds are slim that Clinton will come to power with the same level of confidence and agenda-setting vision as Obama did in 2008. Instead, we see two potential avenues for modest cooperation with the GOP-controlled House: Chart 16Corporate Taxes Have Bottomed Corporate Taxes Have Bottomed Corporate Taxes Have Bottomed Corporate tax reform: It is unlikely that we will see reform that lowers the already historically-low effective tax rates (Chart 16). However, broadening the tax base by closing various loopholes could be feasible. This will hurt S&P 500 multi-national corporations that have been able to lobby for special treatment over the past three decades. However, it will benefit America's SMEs, which are the backbone of employment and growth. Fiscal spending: Paul Ryan and moderate Republicans understand that there is a paradigm shift in America and that the median voter is moving to the left.12 After all, Donald Trump won the GOP primary with an unorthodox economic message that combined both left- and right-wing economic policies. As such, we would expect House Republicans to give in to a modest infrastructure spending plan from Clinton, in exchange for corporate tax reform. Even a modest plan could make a substantive difference for the economy given the high fiscal multipliers of infrastructure spending in an economy with low interest rates. This in turn would allow the Fed to surprise the markets with more than two rate hikes by the end of 2018 and thus sustain the USD bull market. If there is one trend that we are certain will end with the 2016 U.S. election, it is the dominance of American economic policy by the S&P 500, or perhaps the S&P 100. What Trump and Senator Bernie Sanders have shown is that challenging for the presidency no longer requires a cozy relationship with either Wall Street or the large multinational corporations (MNCs). We therefore do not expect a Clinton-Ryan coalition to care as much about the concerns of America's large corporations as otherwise might be the case. Policies that lead to higher effective corporate tax rates on major S&P 500 corporations, a dollar bull market, and higher wages are likely over the course of the next four years. The political pendulum is shifting in the U.S. and it should marginally favor growth, inflation, the USD, and SMEs.13 Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com 1 Please see FiveThirtyEight, "Who Will Win The Presidency?" dated October 20, 2016, available at fiverthirtyeight.com. 2 "You mean like the 2008 Global Financial Crisis?" Yes. Like that. 3 Please see BCA Geopolitical Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Final Forecast & Implications," dated October 12, 2016, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "U.S. Election: The Great White Hype," dated March 9, 2016, available at gps.bcaresearch.com. 6 Please see Andreas Graefe, "Issues and Leader Voting in U.S. Presidential Elections,"Electoral Studies 32:4 (2013), pp.644-657. 7 For the assumptions underpinning our model, we encourage clients to read BCA Geopolitical Strategy Special Report, "U.S. Election: Final Forecast & Implications," dated October 12, 2016, available at gps.bcaresearch.com. 8 Please see The Bank Credit Analyst Strategy Outlook, "Stuck In A Rut," dated December 17, 2015, available at bca.bcaresearch.com. 9 Please see BCA Global Investment Strategy Special Report, "Three (New) Controversial Calls," dated September 30, 2016, available at gis.bcaresearch.com. 10 Please see "House: Recent Updates," accessed October 20, 2016, available at cookpolitical.com 11 We believe that it will be very difficult, if not impossible, for the Democrats to retain a razor-thin majority in the Senate if they get one in November. First, Democrats will have to defend 25 Senate seats (including two allied independent seats) out of 33 in contention in 2018. Second, Democrats always see a drop-off in voter turnout and enthusiasm in mid-term elections. 12 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Monthly Report, "King Dollar: The Agent Of Righteous Retribution," dated October 12, 2016, available at gps.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The resilience of EM industrial commodity demand, which is helping to lift inflation and inflation expectations in the U.S., will be tested over the next few months, as markets gear up for a possible oil-production deal between OPEC and Russia, and the first of perhaps three Fed rate hikes in December and next year. Any indication Janet Yellen has persuaded her colleagues to run a "high-pressure economy" will provoke us to get long gold, given its sensitivity to the Fed's preferred inflation gauge. We remain wary, however, given the higher-rates stance favored by some Fed officials, which, our modeling suggests, would reverse the pick-up in inflation and inflation expectations in the U.S. by depressing EM growth. Energy: Overweight. We continue to favor U.S. shale-oil producers at this stage in the cycle, and continue to look for opportunities to take commodity price exposure. Base Metals: Neutral. We downgraded copper to neutral from bullish last week, expecting prices to trade sideways over the next three months. Precious Metals: Neutral. We continue to be buyers of gold at $1,210/oz. If we continue to see the Fed's preferred inflation gauge increase, we will raise that target. Ags/Softs: Underweight. We are recommending a tactical long position in Mar/17 wheat versus a short in Mar/17 soybeans. Feature In her Boston Fed speech last week, Fed Chair Janet Yellen dangled catnip in front of commodity markets by discussing the possibility of "temporarily running a 'high-pressure economy,' with robust aggregate demand and a tight labor market" as a means of countering the prolonged hysteresis in the U.S. economy.1 Any indication Dr. Yellen has succeed in convincing her colleagues to pursue such a strategy would compel us to get long gold, given the sensitivity of the yellow metal to core PCE, the Fed's preferred inflation gauge (Chart of the Week).2 Indeed, we find there is a long-term equilibrium between spot gold prices and the core PCEPIand U.S. financial variables, which is extremely robust over time.3 Core PCEPI has been ticking up this year, most recently in March and appears to be leading 5-year/5-year inflation expectations tracked by the St. Louis Fed, which bottomed in June and have been trending higher since (Chart 2).4 In our modeling, we find a 1% increase in core PCE translates into a 4% increase in gold prices, suggesting gold would provide an excellent hedge against rising inflation. Chart of the WeekGet Long Gold If Pressure ##br##Builds in U.S. Economy bca.ces_wr_2016_10_20_c1 bca.ces_wr_2016_10_20_c1 Chart 2Core PCE ##br##Ticking Up bca.ces_wr_2016_10_20_c2 bca.ces_wr_2016_10_20_c2 Core PCE And EM Commodity Demand There is an enduring long-term relationship between inflation generally and EM commodity demand, which we have highlighted in previous research.5 This week we are exploring long-term equilibrium relationships between EM industrial commodity demand and core PCE, given the obvious interest among commodity investors. The big driver of core PCE is EM industrial commodity demand, as can be seen in Chart 3, which shows the output of two regressions we ran using non-OECD oil demand - our proxy for EM oil demand - and world base metals demand, which is dominated by China's roughly 50% share of global base metals demand. Core PCE is cointegrated with these measures of industrial-commodity demand, which makes perfect sense considering most - sometimes, all - of the demand growth for industrial commodities (oil and base metals, in this instance) is coming from EM economies.6 For example, of the total growth in oil demand since 2013, non-OECD demand accounted for 1.1mm b/d of an average 1.2mm b/d global demand growth. Within other markets, China accounts for more than 50% of global iron ore, copper ore, metallurgical and thermal coal demand.7 At the margin, prices in the real economy are being set by EM demand, not by DM demand. This, in turn, feeds into core and headline PCE and other inflation gauges. Feedback Between Fed Policy And EM Commodity Demand Leading economic indicators for EM growth are turning up, which is supportive for commodity demand near term (Chart 4). This has been aided by accommodative monetary policy in the U.S., which has kept the USD relatively tame after peaking in January 2016.8 Chart 3EM Industrial Commodity Demand,##br## Core PCE Share Common Trend bca.ces_wr_2016_10_20_c3 bca.ces_wr_2016_10_20_c3 Chart 4EM Leading Indicators ##br##Point to Growth Upturn bca.ces_wr_2016_10_20_c4 bca.ces_wr_2016_10_20_c4 The single biggest risk to commodity demand and commodity prices remains U.S. monetary policy. The longer-term cointegrating relationships highlighted in this week's research are consistent with earlier results we reported on the impact of U.S. financial variables on commodity demand.9 When we model EM oil demand as a function of U.S. financial variables, we find a 1% increase (decrease) in the USD broad trade-weighted index (TWI) is consistent with a 22bp decrease (increase) in consumption using these longer-dated models. For global base metals, a 1% increase (decrease) in the USD TWI corresponds with a 27bp drop (increase) in demand. As a general rule, each 1% increase (decrease) in the USD TWI is accompanied by a 25bp drop (increase) in EM demand for oil and global base metals (Charts 5 and 6). Chart 5EM Oil Demand Will Fall If ##br##The Fed Gets Too Aggressive... bca.ces_wr_2016_10_20_c5 bca.ces_wr_2016_10_20_c5 Chart 6...As Will##br## Base Metals Demand bca.ces_wr_2016_10_20_c6 bca.ces_wr_2016_10_20_c6 As mentioned above, we continue to expect a 25bp hike by the Fed at its December meeting, followed by two additional hikes next year. Our House view continues to maintain this round of rate hikes will cause the USD to appreciate by 10% over the next 12 months. If this is fully passed through, we expect this gauge to register a ~ 2.5% decline in EM demand for industrial commodities. This would reduce the core PCE's yoy rate of change to ~ 1%, vs. the current level of 1.7% yoy growth. Walking A Tightrope Chair Yellen's speech makes it clear the Fed is well aware of how its monetary policy affects the global economy and the feedback loop this creates. This is of particular moment right now, given the Fed is the only systemically important central bank even considering tightening its monetary policy. As she notes, "Broadly speaking, monetary policy actions in one country spill over to other economies through three main channels: changes in exchange rates; changes in domestic demand, which alter the economy's imports; and changes in domestic financial conditions - such as interest rates and asset prices - that, through portfolio balance and other channels, affect financial conditions abroad." The other major threat to EM commodity demand is the oil-production deal being negotiated by OPEC, led by the Kingdom of Saudi Arabia (KSA), and non-OPEC, led by Russia. Should these negotiations result in an actual cut in oil production, it would accelerate the tightening of global oil markets - likely increasing the rate at which global inventories of crude oil and refined products are drained - and put upward pressure on prices. While we do not expect a material agreement to emerge from these negotiations - KSA and Russia already are producing at or close to maximum capacity at present. A freeze in production by these states would result in no change in production globally. The risk here is KSA actually cuts production beyond its seasonal decline by adding, say, a 500k b/d cut to the expected 500k b/d seasonal decline, and Russia agrees to something similar. This would be offset by continued production increases in Iran, and possibly in Libya and Nigeria, but would, nonetheless, surprise the market and rally prices. All else equal, higher prices would weaken EM demand growth at the margin, and feed back into lower inflation expectations. We do not believe it is in KSA's or non-OPEC producers' interest to try to tighten markets sharply, since a price spike would re-energize conservation efforts by consumers, particularly in DM economies, and incentivize alternative transportation technologies like electric cars, as happened when oil prices were above $100/bbl from 2010 to mid-2014. Nonetheless, KSA, Russia, and other parties to any production-management agreement will have to balance this risk against the likelihood U.S. shale producers step in to fill the production cutbacks before any meaningful increase in revenues accrues to these states. Bottom Line: It still is too early to discuss the implications of a production cut, given negotiations between the KSA and Russia camps ahead of OPEC's November meeting continue. However, this could become a material issue next year, just as the Fed is considering whether to hike rates two more times, as we expect. A combined oil-production cut emerging from the KSA - Russia negotiations, which is a non-trivial risk, coupled with two Fed rate hikes could set off a new round of disinflation or even deflation, just as EM commodity demand was starting to enliven inflation and inflations expectations in the U.S.10 This could force the Fed to back off further rate hikes, or even walk back previous rate hikes. If on, the other hand, Chair Yellen is successful in persuading her colleagues to run a "high-pressure economy" we would look to get long commodities generally, gold in particular, given our expectation core PCE inflation and inflation expectations will move higher. As our research has shown, the yellow metal is particularly sensitive to the Fed's preferred inflation gauge. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com SOFTS China Commodity Focus: Softs Grains: Focus On Relative-Value Trade We remain strategically bearish grains, but we are upgrading our tactical view for wheat from bearish to neutral. We believe most of the negative news already is reflected in wheat prices. Over next three to six months, we expect wheat to outperform soybeans. Wheat prices could move up on reduced U.S. acreage, rising Chinese imports, or any unfavorable winter weather in major producing countries while expanding area-sown in Brazil, Argentina, China and the U.S. will likely pressure down soybean prices. We recommend a tactical long position in March/17 wheat versus March/17 soybeans. We suggest a 5% stop-loss to limit the downside risk. Grain prices have already rebounded 10.3% since August 30, when prices collapsed to a 10-year low (Chart 7, panel 1). There were three main reasons behind the precipitous price drop from early June to late August. 1.The 25% rally grain prices in 2016H1 encouraged global planting of spring wheat, soybeans, corn and rice. 2.Favorable weather lifted yields of all grains to record highs. 3.Extremely cheap Russian, Ukraine, Argentine and Brazilian currencies boosted exports from these major grain producing countries. In addition, grain-related policy changes in Argentine and Russia also have stimulated their grain exports (wheat benefited most and corn next). Given a 10% rebound recently, as the USDA expects global grain stocks to rise 3% to a new high next year, we remain a strategical bearish view on grain. Looking forward, we will continue to focus on relative-value trades in grain markets. Tactically, we are interested in long wheat versus soybeans. Wheat: Tactically Neutral Wheat has underperformed other grains so far in 2016 (Chart 7, panel 2). Prices fell to 361 cents per bushel on August 31, which was the lowest level since June 2006 (Chart 7, panel 3). Wheat prices have already recovered 16.7% from their August bottom. We believe, over the next three to six months, wheat prices may have limited downside due to one or a combination of the following factors. U.S. farmers are currently in the process of planting winter wheat. According to the USDA, as of October 9, 59% of winter wheat acreage has been planted. As U.S. wheat production costs are well above current market prices, U.S. farmers likely will further cut their wheat acreage over the next several weeks. This year, U.S. wheat-planted acreage has already dropped to the lowest since 1971 (Chart 8, panel 1). Global wheat yields improved 2.8% this year, with 13.4% and 20.8% increases in Russian and U.S. yields, respectively. Even though Russia will raise its wheat-sown area for next season, the country's wheat crop still faces plenty of risks during its development period. Too cold a winter or too hot a summer, which may not even result in a considerable drop in yields, still could spur a temporary rally in wheat prices. Similarly, U.S. wheat yields are also likely to retreat from the record high in 2017H1. In addition, extremely low wheat prices will encourage global farmers to plant other more profitable crops instead. As a result, both global wheat acreage and yields will likely go down next year (Chart 8, panel 2). Speculators are currently holding sizable net short positions. Market sentiment is also extremely bearish. Given this backdrop, any short-covering also would drive prices up (Chart 8, panels 3 and 4). Chart 7Wheat: Cautiously Bullish bca.ces_wr_2016_10_20_c7 bca.ces_wr_2016_10_20_c7 Chart 8Wheat: Upgrade To Tactically Neutral ##br##On Supportive Factors bca.ces_wr_2016_10_20_c8 bca.ces_wr_2016_10_20_c8 Soybeans: Tactically Bearish Soybeans have outperformed other grains significantly this year (Chart 7, panel 2). As planting soybeans general is more profitable than planting corn, wheat and rice, global farmers are likely to expand their soybean acreage for the next harvest season. According Conab, Brazil's national crop agency, Brazil's soybean production next spring will increase 6.7% to 9%. Record high U.S. soybean production is likely to weigh down the market as well. According to the USDA, 7.1% jump in the yields will bring U.S. soybean crop to a record high, an 8.7% increase from last year. As of October 9, 2016, only 44% U.S. soybean has been harvested, 12 percentage points behind last year. Chart 9China Grain Imports Will Continue Rising China Grain Imports Will Continue Rising China Grain Imports Will Continue Rising How does China contribute to our grain view? As the world's largest grain producer and also the largest consumer, China is an important player in global grain market. Last year the country accounted for 20.7% of global aggregate grain production and 23% of global consumption. In terms of grain imports, as we predicted in our January 2011 Special Report "China-related Ag Winners For The Long Term," China's grain imports have been on the uptrend, despite the depreciating RMB in the most recent two years (Chart 9). In terms of individual grain markets, China has been the most significant player in the global soybean market, accounting for 62.7% of global imports last year. China is also the world's largest rice importer, accounting for 12.5% of global rice trade. However, for corn and wheat markets, China only accounted for about 2% of global trade. In late March, the Chinese government announced an end to its price-support program for corn, but the government maintained price-support policies for wheat and rice. The government also announced its temporary reserve policy will be replaced by a new market-oriented purchase mechanism for the domestic corn market. In addition, the policy of giving direct subsidies to soybean farmers will continue in the 2016-17 market year. What Are The Implications Of China's Grain-Related Policy? Domestic corn prices fell sharply with global prices, while the gap between domestic soybean prices and the international ones remains large (Chart 10, panels 1 and 2). This will discourage domestic corn sowing and encourage soybean production, which is positive to global corn markets, but negative for global soybean markets. China's imports of wheat and rice are set to rise, given a widening price gap (Chart 10, panels 3 and 4). The country's demand for high-quality wheat and rice are rising as household incomes have greatly improved. China will likely liquidate its elevated grain inventories, which account for about 45% of global stocks. This will be bearish for all grains. However, as most of the domestic grain stocks are low-quality grains, inventory liquidation may affect animal feed market rather than the good-quality grain market. Overall, China's grain policy is positive for international corn, wheat and rice prices, but negative for global soybean prices. Investment strategy As we expect wheat to outperform soybeans over the next three to six months, we recommend a tactical long position in March/17 wheat versus short March/17 soybeans with a 5% stop-loss (Chart 11). Chart 10Implications Of China Grain Related Policy bca.ces_wr_2016_10_20_c10 bca.ces_wr_2016_10_20_c10 Chart 11Go Long Wheat Versus Soybeans With Stops bca.ces_wr_2016_10_20_c11 bca.ces_wr_2016_10_20_c11 Downside risks To Our Relative-Value Trade Position Currently, global wheat inventories still are at a record highs, and almost all the major wheat exporting countries continue to hold considerable inventory for sale. If farmers in Russia, Ukraine and Argentina rush to sell to take advantage of recent price rally, wheat prices will fall. Also, a strengthening USD will put a downward pressure on grain (including wheat and soybeans) prices. For this reason, it will be important to monitor U.S. dollar strength against the currencies of these countries - too-strong a USD will keep grains from being exported, which will keep domestic U.S. prices under pressure. However, our relative-value trade may weather this risk well as a strengthening dollar affects both wheat and soybeans. Moreover, if weather continues to be favorable during the winter, wheat prices may drop below the August lows. On the other side, if unfavorable weather reappears in South America next spring like this year, soybean prices may quickly go up. To limit our downside risk, we suggest putting a 5% stop-loss to our long wheat/short soybeans trade. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com 1 Please see "Macroeconomic Research After the Crisis," Dr. Yellen's speech delivered at the October 14, 2016, Boston Fed 60th annual economic conference in Boston. She highlighted hysteresis - "the idea that persistent shortfalls in aggregate demand could adversely affect the supply side of the economy" - in her discussion on how demand affects aggregate supply. She noted, "interest in the topic has increased in light of the persistent slowdown in economic growth seen in many developed economies since the crisis. Several recent studies present cross-country evidence indicating that severe and persistent recessions have historically had these sorts of long-term effects, even for downturns that appear to have resulted largely or entirely from a shock to aggregate demand." 2 Core PCE is the Personal Consumption Expenditures (PCE) price index, which excludes food and energy prices 3 The relationship shown in the Chart Of The Week covers the period March 2000 to present. The adjusted R2 of the cointegrating regression we estimated is 0.97; the price elasticity of gold with respect to a 1% change in the core PCE is close to 4%. The model is dominated by real rates, however: a 1% increase in real rates translates to a 15% decrease in gold prices, while a 1% increase in the broad trade-weighted USD implies a decrease in gold prices of just under 2.5%. Data and modeling constraints took the last observation to August 2016, when the model suggested the "fair value" of gold was close to $1,200/oz. At the time, gold was trading at just below $1,310/oz. Prices subsequently fell into the low to mid $1,200s, and were trading at ~ $1,270/oz as we went to press). 4 For this chart, we use the St. Louis Fed's 5y5y U.S. TIPS inflation index. Please see Federal Reserve Bank of St. Louis, 5-Year, 5-Year Forward Inflation Expectation Rate [T5YIFR], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/T5YIFR , October 19, 2016. 5 Please see "Memo To Fed: EM Oil, Metals Demand Key To U.S. Inflation" and "Commodities Could Be Hit Hard By Fed Rate Hikes," in the August 4, 2016, and September 1, 2016, issues of BCA Research's Commodity & Energy Strategy. Both are available at ces.bcaresearch.com. See also "China's Evolving Demand for Commodities," by Ivan Roberts, Trent Saunders, Gareth Spence and Natasha Cassidy," presented at the Reserve Bank of Australia's Conference focused on "Structural Change in China: Implications for Australia and the World," 17 - 18 March 2016. 6 The adjusted-R2 statistics for cointegrating regressions we ran for core PCE as a function of non-OECD oil demand and world base metals demand were 0.99 and 0.98 from 2000 to present. 7 Please see discussion beginning on p. 4 of "China's Evolving Demand for Commodities," by Ivan Roberts, Trent Saunders, Gareth Spence and Natasha Cassidy," presented at the Reserve Bank of Australia's Conference focused on "Structural Change in China: Implications for Australia and the World," 17 - 18 March 2016. 8 The Fed's broad trade-weighted USD index post-Global Financial Crisis peaked in January at just under 125 and currently stands at 122.6. Please see Board of Governors of the Federal Reserve System (US), Trade Weighted U.S. Dollar Index: Broad [TWEXBMTH], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/TWEXBMTH, October 18, 2016. 9 Please see p. 3 of "Commodities Could Be Hit Hard By Fed Rate Hikes," in the September 1, 2016, issue of BCA Research's Commodity & Energy Strategy, available at ces.bcaresearch.com. 10 We define a non-trivial risk as a 1-in-6 chance of occurrence - i.e., the same odds as Russian roulette. Investment Views and Themes Recommendations Tactical Trades Commodity Prices and Plays Reference Table Closed Trades

Highlights When interest rates are ultra-low, central banks have no margin for policy error. A small loosening or tightening has the potential to produce either a stall or catastrophic turbulence. The analogy is flying a plane at high altitude. Bond investors should have a strong preference for U.S. T-bonds over German bunds (currency hedged). Currency investors should prefer the euro over the dollar. For equity investors, valuations do not appear structurally attractive anywhere, once a sufficient equity risk premium is factored in. But a setback in the region of 5-10% could create a tactical entry point. Feature As the ECB Governing Council convenes for its October monetary policy meeting, an experience familiar to pilots1 provides a perfect analogy for central banks' very limited margin for error. Pilots call the experience "flying in coffin corner." Chart of the WeekUnusually High Turbulence For The German 30-Year Bund Unusually High Turbulence For The German 30-Year Bund Unusually High Turbulence For The German 30-Year Bund Next time you're in a plane climbing to 35,000 feet, here's something to think about; or perhaps, not to think about. As the plane gains altitude, its stall speed increases while its upper speed limit simultaneously decreases. For the pilot, this means less and less margin for error (Figure I-1). The plane's stall speed is the minimum speed to generate sufficient lift. At higher altitude, as the air gets thinner, the stall speed increases. Meanwhile, the plane's upper speed limit is set by the speed of sound. Airliners cannot fly too close to the speed of sound because the sonic shockwave produces violent and catastrophic turbulence. At higher altitude, as the air temperature drops, so does the speed of sound. Which means the plane's upper speed limit decreases. By the time the plane has reached the rarefied atmosphere of 35,000 feet, these lower and upper speed limits are barely 25 knots (30mph) apart,2 leaving almost no room for flight data misinterpretation or pilot error.3 Hence, at high altitude pilots morbidly say they are "flying in coffin corner." Analogously, in the rarefied atmosphere of zero or near-zero interest rates, central bank policy is also in coffin corner. When short-term and long-term interest rates approach the zero bound, there is no room for economic data misinterpretation or policy error. A small loosening or tightening of monetary policy has the potential to produce either a stall or catastrophic turbulence (Figure I-2 and Chart of the Week). Figure I-1Flying At High Altitude ##br## Has No Margin For Error Flying At The Edge Flying At The Edge Figure I-2Monetary Policy At Ultra-Low Rates ##br##Has No Margin For Error Flying At The Edge Flying At The Edge Avoiding A Stall At today's zero or near-zero interest rates in the euro area, a small loosening of monetary policy risks stalling the banking system, and thereby stalling the economy. A bank's core business is simple. Take in deposits, and lend them out at a higher interest rate than the deposit-rate - with the difference in the two defining the bank's net interest margin. A part of the net interest margin is a compensation for the risk of non-performing loans. This should be profit-neutral if correctly priced. The other large part of the net interest margin comes from the interest rate term-structure, as loans tend to be long-term while deposits are short-term. Hence, all else being equal, the bank's profitability suffers as the term-structure flattens. For a while, the bank can protect its profitability by cutting the interest rate paid on short-term deposits to well below the policy rate. However, once the policy rate hits zero, this profit-protection strategy hits a wall - because a negative deposit rate would risk an exodus of deposits into cash or cash-substitutes. Alternatively, the bank could charge a higher rate to borrowers, but this would tighten credit conditions. The third possibility is for the bank to suffer a hit to its already-thin net lending margin, but this would also tighten credit conditions. The pressure on the bank's profitability and share price would increase the cost of equity, making it harder to raise capital (Chart I-2). Given that an insufficient capital buffer is a major constraint to euro area bank lending, this would be a de facto tightening of credit conditions. The paradox is that at the zero bound, the smallest additional monetary loosening - via interest rate cuts or QE - risks stalling euro area bank credit creation (Chart I-3). Thereby it risks stalling economic growth. Chart I-2The ECB's QE Has Hurt Bank Valuations The ECB's QE Has Hurt Bank Valuations The ECB's QE Has Hurt Bank Valuations Chart I-3The Interplay Between Bank Profits And Bank Credit Creation Flying At The Edge Flying At The Edge Avoiding Violent Turbulence An extended period of ultra-low interest rates, and a commitment to keep them structurally low, has compressed the yields on government bonds pushing up their prices. As competing asset classes, the prices of corporate bonds and equities have also increased. This phenomenon is called the Portfolio Balance Effect. The big problem is that the prices of riskier assets have increased by more than is justified by the portfolio balance effect alone. This distortion is the result of a behavioural finance phenomenon called Mental Accounting Bias. Mental Accounting Bias describes the irrational distinction between the return from an investment's yield and that from its capital growth. The distinction is irrational because the money that comes from yield and the money that comes from capital growth is perfectly fungible.4 Rationally, what should matter is an investment's total return. But psychologically, the distinction between yield and capital is very stark. Fears about self-control cause people to compartmentalise yield as spending money and capital as saving money. Hence, people who want their investments to generate spending money - say, retirees - have an irrational focus on yield. Traditionally, the safe income from cash and government bonds satiates the people who irrationally focus on yield. However, in recent years, central banks' extended experiments with ZIRP, NIRP and QE have forced these yield-focussed investors out of cash and government bonds into risky investments. And just like every distortion, this phenomenon has generated memes to justify the act: 'reach for yield', 'search for yield', and 'there is no alternative' (TINA). But the irrational focus on yield instead of total return has artificially bid up the prices of risky investments. To the point that they no longer offer a sufficient risk premium5 for the very real possibility of substantial losses over a 5-10 year horizon (Chart I-4 and Chart I-5). The unfortunate thing is that as central bankers have little expertise in psychology or behavioural finance, they have been blind to the very dangerous behavioural distortion that their monetary policy experiments have unwittingly unleashed. Chart I-4A Positive Yield On Equities##br## Can Produce A Negative 5-Year Return... bca.eis_wr_2016_10_20_s1_c4 bca.eis_wr_2016_10_20_s1_c4 Chart I-5...And Even A Negative ##br##10-Year Return bca.eis_wr_2016_10_20_s1_c5 bca.eis_wr_2016_10_20_s1_c5 The risk is that the smallest monetary tightening could trigger an aggressive unwinding of this behavioural distortion. Recall the violent turbulence in global financial markets at the start of the year after just one 25bps rate hike from the Federal Reserve. Now consider what might happen if the Fed hiked again and the ECB simultaneously announced a rapid tapering of its QE program. How Must The Pilots Fly? In a rarefied atmosphere, pilots have very little margin to alter speed without inducing a stall or violent turbulence. The same applies to central banks today. The ECB has the hardest piloting task. It is becoming difficult to justify the current aggressive pace of QE given the danger of stalling the euro area banking system; and given that the euro area's nominal GDP and nominal wage bill are both growing at a very respectable 3% (Chart I-6). But an abrupt end to the ECB's QE could create violent turbulence in QE-distorted financial markets. Chart I-6What Deflation Threat? Euro Area Nominal GDP And The Wage Bill Growing At 3% bca.eis_wr_2016_10_20_s1_c6 bca.eis_wr_2016_10_20_s1_c6 Hence, the ECB's best course of action is to hint at a very gradual deceleration of QE to start at some point in the second half of 2017. Turning to developed economy central banks in general, we remind readers of a very powerful observation. Since 2008, no major central bank has been able to hike interest rates by more than 1.75%. And every central bank that has hiked rates has had to start unwinding those hikes within a year, ultimately taking the policy rate to a new all-time low (Chart I-7 and Chart I-8). Chart I-7Since 2008, All Rate Hikes ##br##Have Been Quickly Reversed bca.eis_wr_2016_10_20_s1_c7 bca.eis_wr_2016_10_20_s1_c7 Chart I-8Will The U.S. Be ##br##Any Different? No bca.eis_wr_2016_10_20_s1_c8 bca.eis_wr_2016_10_20_s1_c8 Given the turbulence that rate hikes will generate in the financial markets and/or the economy, we fully expect the Federal Reserve to go through exactly the same experience. The important upshot is that global central bank policy through 2017-18 will be considerably less divergent than is discounted. Bond yields could creep higher in the short term. But on a 1-year horizon, bond investors should have a strong preference for U.S. T-bonds over euro area bonds, and especially over German bunds (currency hedged). Over the same horizon, currency investors should prefer the euro over the dollar. For equity investors, valuations do not appear structurally attractive anywhere once a sufficient equity risk premium is factored in. Moreover, the potential for ECB QE-tapering combined with expectations for a Fed rate hike could generate some near-term turbulence. That said, a setback in the region of 5-10% could create an excellent entry point for a 3-month trade. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com Fractal Trading Model* There are no new trades this week. Last week's long silver/short lead pair trade has bounced sharply. And the short U.K. A-rated corporate bonds trade has achieved its 4% profit target. 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-9 Long Silver / Short Lead Long Silver / Short Lead * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. 1 Your author is a former pilot in the Royal Air Force reserve. 2 For an Airbus A330. 3 Tragically, a combination of flight data misinterpretation and pilot error at 35,000 feet was disastrous for Air France flight AF447 flying from Rio de Janeiro to Paris in June 2009. Going through a storm, the airspeed indicator started giving a false reading and the pilot took the wrong corrective action, resulting in a catastrophic stall. 4 Assuming no difference in tax treatment of income and capital gains. 5 Please see the European Investment Strategy Weekly Report "The Great Distortion... And How It will End" dated September 15, 2016 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 bca.eis_wr_2016_10_20_s2_c2 bca.eis_wr_2016_10_20_s2_c2 Chart II-3Indicators To Watch - Bond Yields bca.eis_wr_2016_10_20_s2_c3 bca.eis_wr_2016_10_20_s2_c3 Chart II-4Indicators To Watch - Bond Yields bca.eis_wr_2016_10_20_s2_c4 bca.eis_wr_2016_10_20_s2_c4 Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations bca.eis_wr_2016_10_20_s2_c5 bca.eis_wr_2016_10_20_s2_c5 Chart II-6Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_10_20_s2_c6 bca.eis_wr_2016_10_20_s2_c6 Chart II-7Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_10_20_s2_c7 bca.eis_wr_2016_10_20_s2_c7 Chart II-8Indicators To Watch ##br##- Interest Rate Expectations bca.eis_wr_2016_10_20_s2_c8 bca.eis_wr_2016_10_20_s2_c8

Highlights EM tech stocks are overbought while banks are fundamentally vulnerable due to bad-loan overhang. EM stocks have never decoupled from the U.S. dollar and commodities prices. There has been no recovery in EM corporate profitability and EPS. We reiterate two equity trades: short EM banks / long U.S. banks, and short Chinese property developers / long U.S. homebuilders. Upgrade Thai stocks to overweight within the EM equity benchmark and go long THB versus KRW. Feature Our Reflation Confirming Indicator - an equal-weighted aggregate of platinum prices (a proxy for global reflation), industrial metals prices (a proxy for China growth) and U.S. lumber prices (a proxy for U.S. reflation) - has decisively rolled over, and is spelling trouble for emerging market (EM) equities (Chart I-1). In particular, platinum prices have relapsed after hitting a major resistance at their 800-day moving average (Chart I-2). Such a technical pattern often leads to new lows. If so, it could presage a major selloff in EM markets in the months ahead. Chart I-1A Red Flag From ##br##Reflation Confirming Indicator A Red Flag From Reflation Confirming Indicator A Red Flag From Reflation Confirming Indicator Chart I-2Platinum: A Canary##br## In A Coal Mine? bca.ems_wr_2016_10_19_s1_c2 bca.ems_wr_2016_10_19_s1_c2 The rationale behind using platinum rather than gold or silver prices is because platinum is a precious metal that also has industrial uses. Besides, we have found that platinum prices correlate with EM stocks better than gold or silver. The latter two sometimes rally due to global demand for safety, even as EM markets tank. Finally, platinum seems to be the most high-beta precious metal in the sense that it "catches a cold" sooner and, thus, might be leading other reflationary plays. In short, EM share prices have been flat since August 15, and odds are that they are topping out and the next large move will be to the downside. Can EM De-Couple From The U.S. Dollar? Many investors are asking whether EM risk assets can rally if the greenback continues to rebound. Chart I-3 illustrates that since the early 1980s, there have been no periods when EM share prices rallied amid strength in the real broad trade-weighted U.S. dollar (the dollar is shown inverted on this and the proceeding charts). The same holds true if one uses the nominal narrow trade-weighted U.S. dollar1 (Chart I-4). Chart I-3Real Trade-Weighted ##br##U.S. Dollar And EM Stocks Real Trade-Weighted U.S. Dollar And EM Stocks Real Trade-Weighted U.S. Dollar And EM Stocks Chart I-4Nominal Trade-Weighted ##br##U.S. Dollar And EM Stocks Nominal Trade-Weighted U.S. Dollar And EM Stocks Nominal Trade-Weighted U.S. Dollar And EM Stocks One could disregard these charts and argue that this time around is different. We don't quite see it that way. Chart I-5Nominal Trade-Weighted ##br##U.S. Dollar And Commodities Nominal Trade-Weighted U.S. Dollar And Commodities Nominal Trade-Weighted U.S. Dollar And Commodities Notably, the narrative behind the EM rally since February's lows has been based on the Federal Reserve backing off from rate hikes and the U.S. dollar weakening - with the latter propelling a rally in commodities prices. These arguments appear to be reversing: the U.S. dollar is already firming up and commodities prices are at best mixed. The broad index for commodities prices always drops when the U.S. dollar rallies (Chart I-5). In recent months, the advance in commodities prices has been uneven and narrow based. While oil prices have spiked substantially, industrial metals prices have advanced very little. The current oil price rally is proving a bit more durable and lasting than we thought a few months ago. Nevertheless, China's apparent consumption of petroleum products is beginning to contract (Chart I-6). Consequently, resurfacing worries about EM/China's demand for commodities will lead to a meaningful pullback in crude prices in the months ahead, especially since the likelihood that oil producers act to restrain supply at the current prices is very low. As for commodities trading in China such as steel, iron ore, rubber, plate glass and others, they have been on a roller-coaster ride in recent months (Chart I-7). Chart I-6China's Demand For Oil Products Is Very Weak China's Demand For Oil Products Is Very Weak China's Demand For Oil Products Is Very Weak Chart I-7Commodities Prices In China Commodities Prices In China Commodities Prices In China Bottom Line: There are reasonably high odds that as the U.S. dollar strengthens and commodities prices roll over, EM risk assets (stocks, currencies and credit markets) will start to relapse. EM Beyond Commodities: Still Shrinking Profits Table I-1EM Sectors Weights: In 2011 And Now The EM Rally: Running Out Of Steam? The EM Rally: Running Out Of Steam? Another question that many investors have been asking is as follows: Is there not a positive story in EM beyond commodities? Given that the weight of the EM equity market benchmark in commodities stocks - energy and materials - has drastically declined in recent years, from 29.2% in 2011 to 13.7% now (Table I-1), and the weight in technology stocks has risen substantially (from 12.9% in 2011 to 23.9% now), couldn't non-commodities stocks drive the index higher? In this regard, we have the following observations: Information technology stocks are overbought. The EM information technology equity index has surged to its previous highs (Chart I-8, top panel). This sector is dominated by five companies that have a very large weight also in the overall EM benchmark: Samsung (3.6% weight in the EM equity benchmark), TMSC (3.5%), Alibaba (2.9%), Hon Hai Precision (1%) and Tencent (3.8%). Their share price performance has been spectacular, and some of them have gone ballistic (Chart I-9). TMSC and to a lesser extent Samsung have benefited from the rising prices of semiconductors (Chart I-9, second panel from top). However, it is not assured that semiconductor prices will continue soaring from these levels as global aggregate demand remains very weak. In short, the outlook for semi stocks is by and large a semiconductor industry call, not a macro one. As for Alibaba and Tencent, they are bottom-up stories - not macro bets at all. At the macro level, we reassert that EM/China demand for technology goods and services as well as for health care will stay robust. Hence, from a revenue perspective, technology and health care companies will outperform other EM sectors. This still warrants an overweight allocation to technology and health care stocks, a recommendation that we have had in place since June 2010 (Chart I-8, bottom panel). Odds are that tech outperformance will persist, but we are not sure about absolute performance, given overbought conditions and not-so-cheap valuations. Excluding information technology, the EM benchmark is somewhat weaker (Chart I-10). Chart I-8EM Technology Stocks: Sky Is Limit? bca.ems_wr_2016_10_19_s1_c8 bca.ems_wr_2016_10_19_s1_c8 Chart I-9Individual Tech Names Are Overbought Individual Tech Names Are Overbought Individual Tech Names Are Overbought Chart I-10EM Equities: Overall And Excluding Tech EM Equities: Overall And Excluding Tech EM Equities: Overall And Excluding Tech There is no improvement in EM corporate profitability The return on equity (RoE) for EM non-financial listed companies has stabilized at very low levels, but it has not improved at all (Chart I-11, top panel). The reason we use non-financials' RoE rather than overall RoE is because in EM the latter is artificially inflated at the moment, as banks are originating a lot of new loans but are not sufficiently provisioning for bad loans. Among the three components of non-financials RoE, net profit margins have stabilized but asset turnover is falling and leverage continues to mushroom (Chart I-11, bottom two panels). Remarkably, the relative performance between EM and U.S. stocks has historically been driven by relative RoE. When non-financial RoE in EM is above that of the U.S., EM stocks outperform U.S. ones, and vice-versa (Chart I-12). This relationships argues for EM stocks underperformance versus the S&P 500. Chart I-11EM Non-Financials: ##br##RoE And Its Components EM Non-Financials: RoE And Its Components EM Non-Financials: RoE And Its Components Chart I-12EM Versus U.S.: ##br##Relative RoE And Share Prices EM Versus U.S.: Relative RoE And Share Prices EM Versus U.S.: Relative RoE And Share Prices Overall EM EPS is still contracting in both local currency and U.S. dollar terms (Chart I-13). Even though the rate of contraction is easing for EPS in U.S. dollar terms, it is due to EM exchange rate appreciation versus the greenback this year. Furthermore, EPS in U.S. dollars is contracting in a majority of non-commodities sectors (Chart I-13A, Chart I-13B). The exceptions are utilities and industrials, which both exhibit strong EPS growth despite poor share price performance. The latter could be a sign that strong industrials and utilities EPS have been due to temporary factors and are not sustainable. Chart I-13AEM EPS Growth: Overall And By Sector EM EPS Growth: Overall And By Sector EM EPS Growth: Overall And By Sector Chart I-13BEM EPS Growth: Overall And By Sector EM EPS Growth: Overall And By Sector EM EPS Growth: Overall And By Sector Banks hold the key. Apart from commodities/the U.S. dollar and tech stocks, EM banks' share prices are probably the most important precursor to the direction of the overall EM benchmark. Financials are the second-largest sector in the EM equity benchmark (26.4% weight), so if bank share prices break down, the broader EM index will likely relapse. Our analysis of bank health in various EM countries leads us to believe that banks are under-provisioned for non-performing loans (NPL) (Chart I-14A, Chart I-14B). As EM growth disappointments resurface, investors will question the quality of banks' balance sheets and push down bank equity valuation. Hence, odds are bank share prices will drop sooner than later. Chart I-14AEM NPLs Are Unrecognized ##br##And Under-Provisioned EM NPLs Are Unrecognized And Under-Provisioned EM NPLs Are Unrecognized And Under-Provisioned Chart I-14BEM NPLs Are Unrecognized ##br##And Under-Provisioned EM NPLs Are Unrecognized And Under-Provisioned EM NPLs Are Unrecognized And Under-Provisioned In turn, concerns about EM banks will heighten doubts about overall EM growth and the EM equity benchmark will sell off. Bottom Line: EM tech stocks are overbought, while banks are fundamentally vulnerable due to the bad-loan overhang. As commodities prices relapse anew and worries about the EM credit cycle resurface, the EM benchmark will drop considerably. An Update On Two Relative Equity Trades We reiterate two relative equity trades: short EM banks / long U.S. banks, and short Chinese property developers / long U.S. homebuilders. For investors who do not have these positions, now is a good time to initiate them. Short EM banks / long U.S. banks (Chart I-15). The credit cycle in EM/China will undergo a further downturn: credit growth is set to decelerate as banks recognize NPLs and seek to raise capital. Even if a crisis is avoided, the need to raise substantial amounts of equity will considerably erode the value of EM bank shares. Meanwhile, risks to U.S. banks such as a flat yield curve and a possible spillover effect from European banking tremors are considerably less severe than the problems faced by EM banks. Importantly, unlike EM banks, U.S. banks' balance sheets are very healthy. Short Chinese property developers / long U.S. homebuilders (Chart I-16). Chart I-15Stay Short EM Banks##br## Versus U.S. Banks Stay Short EM Banks Versus U.S. Banks Stay Short EM Banks Versus U.S. Banks Chart I-16Stay Short Chinese Property ##br##Developers Versus U.S. Homebuilders Stay Short Chinese Property Developers Versus U.S. Homebuilders Stay Short Chinese Property Developers Versus U.S. Homebuilders Chinese property developers are on the verge of another downturn, as the authorities have tightened policy surrounding housing. Residential and non-residential property sales have boomed in the past 12 months, but starts have been less robust (Chart I-17). The upshot could still be high shadow inventories. Going forward, as speculative demand for housing cools off, property developers' chronic malaise - high leverage and lack of cash flow - will come back to play. Remarkably, property stocks trading in Hong Kong have failed to break out amid the buoyant residential market frenzy in the past 12 months, and are likely to break down as demand growth falters in the coming months (Chart I-18). Chart I-17China's Real Estate: ##br##Sales And Starts Will Contract China's Real Estate: Sales And Starts Will Contract China's Real Estate: Sales And Starts Will Contract Chart I-18Chinese Property Developers: ##br##On A Verge Of Breakdown? Chinese Property Developers: On A Verge Of Breakdown? Chinese Property Developers: On A Verge Of Breakdown? Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com Thailand: Upgrade Stocks To Overweight And Go Long THB Versus KRW The death of King Bhumibol Adulyadej marks the end of an era not only because he symbolized national unity but also because his entire generation is passing. This generational shift has far-reaching consequences for Thailand's political establishment: in the long run it could hurt the Thai military's - and its allies' - attempt to cement their dominance over parliament. However, as Box II-1 (on page 17) explains, there is a low probability of serious domestic instability over the next 12 months2 - although beyond that risks will be heating up. For now, the military junta faces no major political or economic constraints: The junta has already consolidated control over all major organs of government and has purged or intimidated political enemies. The military will have to turn power back to parliament, or make a major policy mistake, for the opposition movement to rise again. The government's fiscal deficit has been stable (around 3% of GDP) over the past few years, public debt is at 33% of GDP, government bond yields are low and debt servicing costs are at 5% of total expenditures (Chart II-1). Hence, the military government can ramp up expenditures further to appease the disaffected. Indeed, the military junta has already accelerated public capital expenditures (Chart II-2) and investments have poured into the Northeast, a populous base of opposition to the junta. Chart II-1Thailand: More Room ##br##For Fiscal Stimulus Thailand: More Room For Fiscal Stimulus Thailand: More Room For Fiscal Stimulus Chart II-2Thailand: Government ##br##Capex Has Been Booming bca.ems_wr_2016_10_19_s2_c2 bca.ems_wr_2016_10_19_s2_c2 Likewise, fiscal expenditure has also accelerated in areas such as general public services, defense, and social protection (Chart II-3). Additionally, the Bank of Thailand (BoT) has scope to cut interest rates as the policy rate is still above a very low inflation rate (Chart II-4). This will limit the downside for credit growth and contribute to economic and political stability. Chart II-3Rising Public Spending bca.ems_wr_2016_10_19_s2_c3 bca.ems_wr_2016_10_19_s2_c3 Chart II-4Thailand: No Inflation; Room To Cut Rates bca.ems_wr_2016_10_19_s2_c4 bca.ems_wr_2016_10_19_s2_c4 The large current account surplus - standing at 11% of GDP - provides the authorities with plenty of fiscal and monetary maneuverability without having to worry about a major depreciation in the Thai baht (Chart II-5). Amid this sensitive political transition, the central bank will likely defend the currency if downward pressure on the baht emerges due to U.S. dollar strength. Therefore, we recommend traders to go long the Thai baht versus the Korean won (Chart II-6). Despite Korea's enormous current account, the won is at risk from depreciation in the RMB and the Japanese yen. Chart II-5Enormous Current Account ##br##Surplus Will Support The Baht Enormous Current Account Surplus Will Support The Baht Enormous Current Account Surplus Will Support The Baht Chart II-6Go Long THB Against KRW bca.ems_wr_2016_10_19_s2_c6 bca.ems_wr_2016_10_19_s2_c6 On the whole, although the Thai economy has been stagnant (Chart II-7), fiscal spending and low interest rates will limit the downside in growth. Bottom Line: We expect relative calm on the political surface in Thailand over the next 12 months and a stable macro backdrop. Therefore, we are using the latest weakness to upgrade this bourse from neutral to overweight within an EM equity portfolio (Chart II-8). Chart II-7Thai Growth Has Been Stagnant bca.ems_wr_2016_10_19_s2_c7 bca.ems_wr_2016_10_19_s2_c7 Chart II-8Upgrade Thai Stocks ##br##From Neutral To Overweight Upgrade Thai Stocks From Neutral To Overweight Upgrade Thai Stocks From Neutral To Overweight In addition, currency traders should go long THB versus KRW. Ayman Kawtharani, Research Analyst aymank@bcaresearch.com Matt Gertken, Associate Editor mattg@bcaresearch.com BOX 1 The Military Coup In 2014 Pre-empted The King's Death... The May 2014 military coup was timed to pre-empt this event. The king's health had been declining for years and it was only a matter of time until he died. This raised the prospect of an intense political struggle that could have escalated into a full-blown succession crisis. Thus the military moved preemptively so that it would be in control of the country ahead of the king's death and could reshape the constitutional system in the military's favor before his death, as it has done. ... And This Means Stability For Now If the populist, anti-royalist faction had been in control of government at the time of the king's death, it could have attempted to manipulate the less popular new king and take advantage of the vacuum of royal authority in order to reduce the role of the military and their allies. That in turn could have sparked a wave of mass protests from royalists, pressuring the government to collapse, or a military coup that would not have carried the king's implicit approval like the 2014 coup. That would have fed the narrative that a final showdown between the factions was finally emerging, and would have been highly alarming to foreign investors. But Risks Still Linger Make no mistake: a new long-term cycle of political instability is now emerging. Potential military mistakes and the return to parliamentary rule are potential dangers. The country's deep divisions - between (1) the Bangkok-centered royalist bureaucratic and military establishment and (2) the provincial opposition -have not been healed but aggravated since the 2014 coup and the new pro-military constitution: The junta's constitutional and electoral reforms will weaken the representation of the largest opposition party, the Pheu Thai Party, and will marginalize a large share of the 65% of the country's population that lives in the opposition-sympathetic provinces. It is also conceivable that the new king could trigger conflict by lending support to the populist opposition. For instance, he could pardon the exiled leader of the rural opposition movement, or he could transform the powerful Privy Council. However, we do not expect discontent to flare up significantly until late 2017 or 2018 when the military steps back and a new election cycle begins.3 We will reassess and alert investors if we foresee a rapid deterioration in the palace-military network, or in the military's ability to prevent seething resistance in the provinces. 1 The narrow U.S. dollar is a trade-weighted exchange rate versus the euro, Canadian dollar, Japanese yen, British pound, Swiss franc, Australian dollar, and Swedish krona. Source: The Federal Reserve. 2 The exception is that isolated acts of terrorism remain likely and could well strike key areas in Bangkok, signaling the reality that the underground opposition to military dictatorship remains alive and well. 3 The junta will use the one-year national period of mourning to its advantage and opposition forces will not want to be targeted for causing any trouble during a time of mourning. The junta could very easily delay the transition to nominal civilian rule, including the elections slated for November 2017. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Equities, bonds and commodities are becoming suddenly, unusually, and dangerously correlated. But it cannot last.

We are pleased to share this <i>Special Report</i> rolling out our Global ETF Strategy (GETF) service's model ETF portfolios.
We are in the latter stages of developing the digital interface that will serve as the central nervous system for the GETF service and are excited to be rolling it out next month. In the meantime, the GETF team has embarked on its regular bi-weekly publication schedule. An ETF Primer <i>Special Report</i> will follow on October 26. It will discuss ETF architecture, operation and trading, and is meant to help investors determine how they can best deploy ETFs to accomplish their tactical and strategic goals.

Hillary Clinton has a 65% chance of winning the election; she receives 334 electoral college votes according to our model. Trump still requires an exogenous shock to win. Meanwhile, the USD is poised to rally - and leftward-moving policymakers will applaud its redistributive effects while MNCs suffer the consequences.

Hillary Clinton has a 65% chance of winning the election; she receives 334 electoral college votes according to our model. Trump still requires an exogenous shock to win. Meanwhile, the USD is poised to rally - and leftward-moving policymakers will applaud its redistributive effects while MNCs suffer the consequences.

Global bond yields continue to grind higher, led by signs of improving growth, moderately higher inflation and central banks having difficulty staying credibly dovish. Maintain a below-benchmark duration stance.

The DM Country Model favors the U.S., with Japan and U.K. being the two large underweights. The Sector Model continues to recommend a cyclical tilt.