Commodities & Energy Sector

The S&P 500 failed to hold on to gains and drifted lower last week succumbing to Washington-related uncertainty. The transition from liquidity-to-growth remains the dominant macro theme which is prone to bouts of volatility. A market-neutral way to benefit from the ongoing equity overshoot phase is to go long U.S. energy stocks/short global gold miners. This high-octane trade would benefit most from the handoff of global liquidity to economic growth (top and middle panels). Relative share prices have plummeted since the mid-December 2016 peak, collapsing 34%. The selloff in oil prices along with a more accommodative Fed have propelled global gold miners and punished U.S. energy stocks. More recently, increasing geopolitical risks have also boosted flows into bullion and gold-related equities. However, if our thesis that growth will trump liquidity - posited three weeks ago1 - pans out in the coming months, then relative share prices should reverse. Our relative EPS models do an excellent job in capturing the different macro forces that drive this trade; at the current juncture, they emit an unambiguously bullish signal: energy EPS will outshine gold producers' profits as the year draws to a close (bottom panel). Bottom Line: Initiate a long S&P energy/short global gold miners pair trade to benefit from the passing of the baton from liquidity to growth. 1 Please see August 21, 2017 U.S. Equity Strategy Weekly Report titled "Fraying Around The Edges?", available at uses.bcaresearch.com. Positioning For The Handoff Of Liquidity To Growth Positioning For The Handoff Of Liquidity To Growth

Highlights Portfolio Strategy Execute a long S&P energy/short global gold miners pair trade to take advantage of the liquidity-to-growth handoff. Initiate another new trade, long S&P materials/short S&P utilities, to benefit from a shifting macro landscape. Synchronized global growth and commodity inflation are a boon for materials, but a bane for utilities. Recent Changes Initiate a long S&P energy/short global gold miners pair trade today. Initiate a long S&P materials/short utilities pair trade today. Table 1 Fraying Around The Edges? Fraying Around The Edges? Feature The S&P 500 failed to hold on to gains and drifted lower last week succumbing to Washington-related uncertainty. The transition from liquidity-to-growth remains the dominant macro theme which is prone to bouts of volatility. Nevertheless, a less hawkish Fed should, at the margin, underpin equities with easy monetary and financial conditions complementing the goldilocks equity backdrop (Chart 1). In fact, the St. Louis Fed Financial Stress Index (comprising "18 weekly data series: seven interest rate series, six yield spreads and five other indicators"1) is probing multi-decade lows. This primarily bond market-dependent indicator, has historically done an excellent job in leading the S&P 500 at major turning points at both peaks and troughs (Chart 2A). Recently, it has been more of a coincident indicator with equities, and currently waves the all-clear sign (St. Louis Fed Financial Stress Index shown inverted, Chart 2B). Chart 1Timid Fed Is Supportive Timid Fed Is Supportive Timid Fed Is Supportive Chart 2AExcellent Leading Properties Excellent Leading Properties Excellent Leading Properties Chart 2BAll Clear All Clear All Clear Nevertheless, we do not want to sound too complacent and following up from last week's brief discussion of rising geopolitical uncertainty and equity market performance, we are examining key post-WWII geopolitical events in more detail. The first three columns of Table 2, courtesy of BCA's Geopolitical Strategy Service2, update these episodes to mid-2017. While the S&P 500's drawdown from the three-month peak prior to the event to the three-month trough following the event averages out to roughly 10%, drilling beneath the surface is instructive. Table 2Geopolitical Crises And SPX Returns Fraying Around The Edges? Fraying Around The Edges? On average, broad equity market returns are muted one and three months post the event. Interestingly, on a six- and twelve-month horizon following the geopolitical incident, the S&P clearly shoots higher rising on average 5% and 8%, respectively (Table 2). Chart 3 shows the average profile of the S&P 500's returns during all of these post-WWII events, three months prior to the incident up to one year forward. Chart 3Geopolitical Opportunity? Geopolitical Opportunity? Geopolitical Opportunity? Two key takeaways stand out from this analysis. First, the coming quarter will likely prove volatile as the dust has yet to settle from the recent North Korea escalation. As a result, tactically buying some portfolio protection when the market is near all-time highs, as we cautioned last week3, is prudent and in order, especially given the seasonally challenging months of September and October. Second, on a cyclical horizon, the S&P 500 will likely resume its advance, ceteris paribus. Thus, if history at least rhymes and barring another major flare up of geopolitical risk, the path of least resistance will be higher for the overall equity market into mid-2018. This week we are executing two market neutral pair trades, one levered to the liquidity-to-growth handoff and the other to the synchronized global growth theme. Liquidity-To-Growth Handoff: Buy Energy/Sell Gold Producers A market-neutral way to benefit from the ongoing equity overshoot phase is to go long U.S. energy stocks/short global gold miners (Chart 4). This high-octane trade would benefit most from the handoff of global liquidity to economic growth. Relative share prices have plummeted since the mid-December 2016 peak, collapsing 34%. The selloff in oil prices along with a more accommodative Fed have propelled global gold miners and punished U.S. energy stocks. More recently, increasing geopolitical risks have also boosted flows into bullion and gold-related equities. However, if our thesis that growth will trump liquidity - posited three weeks ago4 - pans out in the coming months, then relative share prices should reverse. Gold prices serve as a global fear proxy, while energy prices move with the ebb and flow of global growth. Importantly, the oil/gold ratio (OGR) hit all-time lows in early 2016 and subsequently enjoyed a V-shaped recovery. But, year-to-date the OGR has relapsed on the back of rising policy uncertainty (policy uncertainty shown inverted, Chart 5). If this geopolitical uncertainty recedes, the upshot is that the OGR will rise in response. Chart 4Ready For A Bounce Ready For A Bounce Ready For A Bounce Chart 5Prefer Black Gold To Bullion Prefer Black Gold To Bullion Prefer Black Gold To Bullion Importantly, global trade is reaccelerating, also suggesting that the OGR should resume its advance (Chart 5). Chart 6 shows a simple growth/liquidity gauge using BCA's Global Synchronicity Indicator. Historically, this metric has been closely correlated with relative share price momentum, and the current message is to expect a sharp turn in oversold relative share prices. Moreover, were the liquidity thrust to convert into significantly higher output, then real interest rates should begin to reflect better growth prospects, and further boost the allure of the pair trade. As with bullion, the relative share price ratio is also overly sensitive to changes in real rates. In fact the 10-year TIPS yield does an excellent job in explaining relative share price fluctuation. Even a modest upturn in real interest rates will go a long way for relative share prices (Chart 7). Chart 6Ample Catch Up Space Ample Catch Up Space Ample Catch Up Space Chart 7Liquidity-To-Growth Beneficiary Liquidity-To-Growth Beneficiary Liquidity-To-Growth Beneficiary Meanwhile, on the relative operating front, the tide is also turning, favoring energy stocks versus gold miners. The oil and gas rig count has recovered smartly from the depths of the global manufacturing recession of late 2015/early-2016. On the flip side, demand for safe haven assets should ebb and further weigh on global gold ETF flows. Additional capital inflows into gold ETF funds from current levels would require either a sizable flare up in global geopolitical risk or another downdraft in global growth. Taken together, this relative demand indicator has surged, signaling that a catch up phase looms for the relative share price ratio (bottom panel, Chart 8). Similarly, relative pricing power is on the verge of climbing into expansionary territory. Extremely depressed pricing power for oil & gas field machinery is unlikely to deflate further, as recent anecdotes of new capital expenditure projects provide some glimmers of light for utilization rates. Conversely, bullion prices are pushing $1,300/oz. near the upper bound of the four year trading range, warning that at least a digestion phase lies ahead. The middle panel of Chart 8 shows that relative pricing power has been an excellent leading indicator of relative earnings. Our relative EPS models do an excellent job in capturing all of these different macro forces, and at the current juncture emit an unambiguously bullish signal: energy EPS will outshine gold producers' profits as the year draws to a close (Chart 9). Finally, relative valuations and technicals are both flashing a green light. Relative value is as compelling as it was during the depths of the Great Recession (middle panel, Chart 10), while our Technical Indicator is one standard deviation below the historical mean. Every time such extreme oversold levels are hit, relative performance has catapulted higher in the subsequent 3-6 months. Chart 8Relative Demand And Price Outlooks##br##Favor Energy Stocks Over Gold Miners Relative Demand And Price Outlooks Favor Energy Stocks Over Gold Miners Relative Demand And Price Outlooks Favor Energy Stocks Over Gold Miners Chart 9Earnings-Led##br## Outperformance Looms Earnings-Led Outperformance Looms Earnings-Led Outperformance Looms Chart 10Unloved ##br##And Oversold Unloved And Oversold Unloved And Oversold Bottom Line: Initiate a long S&P energy/short global gold miners pair trade to benefit from the passing of the baton from liquidity to growth. For investors seeking an alternative way to express this trade opportunity levered to the liquidity-to-growth theme, going long the S&P 1500 metals and mining index instead of the S&P energy sector would also produce similar results (bottom panel, Chart 9). New Pair Trade: Materials Vs. Utilities Macro conditions are ripe to initiate a market neutral trade: long materials/short utilities. This trade provides exposure to the budding shift in underlying portfolio strength away from defensives toward cyclicals5 and also from domestic to global-exposed market areas. In fact, our relative Cyclical Macro Indicators capture the shifting macro backdrop favoring a more cyclical portfolio tilt (Chart 11). The balance of macro evidence is skewing increasingly toward robust manufacturing growth at home and abroad. The ISM manufacturing and global PMI indexes have maintained their recent gains, signaling that the path of least resistance for the relative share price ratio is higher (Chart 12). Chart 11Reflation Trade Reflation Trade Reflation Trade Chart 12U.S. And... U.S. And... U.S. And... Reviving global growth is typically synonymous with rising inflation expectations and bond yields. BCA's view remains that a selloff in the bond markets is the most likely scenario in the coming months. The third panel of Chart 11 shows that relative share price momentum and the bond market are joined at the hip. This makes sense as materials stocks are reflationary beneficiaries, whereas the utilities sector acts as a fixed-income proxy. Not only does the pair trade benefit from rising bond yields in isolation, but also when the stock-to-bond (S/B) ratio is on fire. Currently, a wide gap has opened between the S/B and the materials/utilities ratios that will likely narrow via a catch up phase in the latter. Synchronized global growth suggests that a relative earnings-led recovery will buttress this pair trade higher. Chart 13 highlights four different ways of depicting coordinated EM and DM economic growth, giving us confidence that materials profits will outshine utilities EPS. Materials manufacturers have a sizable export component driving both the top and bottom line. In contrast, utilities are a domestic-only play. As a result, revving global trade and the significant fall in the trade-weighted U.S. dollar will buttress relative EPS prospects (Chart 14). In fact, irrespective of where the greenback ends the year, materials profits will get a lagged bump from a positive FX translation in the back half of the year. Chart 13...Global Growth Favor ##br##Materials Over Utilities ...Global Growth Favor Materials Over Utilities ...Global Growth Favor Materials Over Utilities Chart 14Cheapened Greenback = ##br##Buy Materials At The Expense Of Utilities Cheapened Greenback = Buy Materials At The Expense Of Utilities Cheapened Greenback = Buy Materials At The Expense Of Utilities The depreciating U.S. dollar is also a boon for commodity prices in general and base metals prices in particular. While natural gas prices are the marginal price setter for utilities pricing power, they represent an input feedstock cost to chemicals producers that dominate the materials sector. Taken together, a relative pricing power proxy suggests that materials stocks have the upper hand (bottom panel, Chart 14). Relative valuations and technical conditions also wave the green flag. Our valuation indicator has corrected back to the neutral zone and the technical indicator has unwound overbought conditions, offering a compelling entry point to the pair trade (Chart 15). Finally, our newly introduced relative EPS models encapsulate all of these diverging forces. Currently, the relative profit models signal that materials earnings are on track to outpace utilities profit generation for the remainder of the year (Chart 16). Chart 15Compelling Entry Point Compelling Entry Point Compelling Entry Point Chart 16Heed The Relative Profit Model Message Heed The Relative Profit Model Message Heed The Relative Profit Model Message Consequently, there is an opportunity to execute a long materials/short utilities pair trade in order to benefit from synchronized global growth and looming bond market selloff, and softening U.S. dollar and related commodity inflation. Bottom Line: Initiate a long S&P materials/short S&P utilities pair trade today. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 https://www.stlouisfed.org/news-releases/st-louis-fed-financial-stress-index/stlfsi-key 2 Please see the August 16, 2017 Geopolitical Strategy Weekly Report titled "Can Pyongyang Derail The Bull Market?", available at gps.bcaresearch.com. 3 Please see the August 14, 2017 U.S. Equity Strategy Weekly Report titled "Three Risks", available at uses.bcaresearch.com. 4 Please see July 31, 2017 U.S. Equity Strategy Weekly Report titled "Growth Trumps Liquidity", available at uses.bcaresearch.com. 5 Please see the August 14, 2017 U.S. Equity Strategy Weekly Report titled "Three Risks" for a recap of our major portfolio moves since May 1, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights Despite a tightening in Chinese monetary conditions, dollar bloc currencies have continued to rally. Rising global reserves and strong carry inflows into EM prompted by low global financial volatility have created plentiful liquidity conditions in EM, supporting dollar-bloc currencies. The beginning of the Fed's balance-sheet runoff could reverse these dynamics, hurting the AUD, CAD and NZD in the process. Monitor U.S. inflation, cross-currency basis swap spreads, gold, EM currencies and Chinese monetary conditions to judge when a break in dollar-bloc currencies will materialize. Feature The rally in the dollar-bloc currencies since July 2016 has been nothing short of stunning. We did highlight in April last year that commodity currencies had room to appreciate, but we did not anticipate such a prolonged move.1 In fact, the up leg that began in April 2017 caught us by surprise. At this juncture, it is essential to analyze whether or not the bull move in commodity currencies has further to run, or whether it is in its final innings. A principal component analysis of the returns of the AUD, the CAD, and the NZD shows that despite differing central bank postures in the three countries, a simple common factor explains 86% of their variability against the USD since 2010 (Chart I-1). Because of this result, our focus in this week's report are the global forces that may be driving this factor. Today, the key risk to the dollar-bloc currencies is global liquidity tightening. Behind this danger lies the removal of policy accommodation in the U.S., and the risks to carry trades created by the already-very-low volatility of risk assets. A China-Fueled Rebound, But Something Is Amiss... The key reason behind the rally in commodity currencies has been improvement in EM growth relative to DM economies since 2016 (Chart I-2). This growth outperformance has been underpinned by a few factors. Chart I-1One Factor To Drive Them All One Factor To Drive Them All One Factor To Drive Them All Chart I-2Commodity Currencies And EM Growth Commodity Currencies And EM Growth Commodity Currencies And EM Growth China has played an essential role. As the Chinese economy decelerated in 2015, Beijing implemented a large amount of fiscal stimulus, which saw government spending grow at a 25% annual rate in November 2015. Due to the lags of stimulus on the economy, the full force of that stimulus was felt in 2016. Direct fiscal goosing was not the only road taken by Beijing. The Chinese authorities also applied a considerable amount of monetary pressure on China. After tightening massively through 2015, Chinese monetary conditions eased greatly in 2016 as real borrowing costs collapsed from a peak of 10.5% in the fall of 2015 to a trough of -3.5% earlier this year (Chart I-3). Directed expansion of credit through banking channels was also used to support the economy, resulting in a surge in the Chinese credit impulse. However, in recent months these positives have dissipated. Chinese money growth has slowed, and the combined credit and fiscal impulse has been lessened. Yet EM equity prices, copper prices and commodity currencies are all continuing their rally, and are now re-testing their May 2015 levels - levels last experienced right before EM assets and related plays entered a vicious tailspin that lasted all the way until January 2016 (Chart I-4). Chart I-3China: From Tailwind ##br##To Headwind China: From Tailwind To Headwind China: From Tailwind To Headwind Chart I-4EM, Copper, Dollar Bloc: ##br##Back To May 2015 Levels EM, Copper, Dollar Bloc: Back To May 2015 Levels EM, Copper, Dollar Bloc: Back To May 2015 Levels Bottom Line: The rally in dollar-bloc currencies that begun in January 2016 was powered by improving growth performance within EM economies. The original driver behind this move was Chinese monetary and fiscal stimulus. However, even once the easing faded, EM plays, including the AUD, the CAD and the NZD continued to appreciate. Another factor is currently at play. ...And This Something Is Global Liquidity Our view is that global liquidity is now the key factor supporting EM plays in general and dollar-bloc currencies in particular. Since the end of 2016, we have seen a rebound in the Federal Reserve's custody holdings - one that has happened as foreign central banks resumed their purchases of Treasury securities (Chart I-5). Fed custodial holdings for other monetary authorities are a key component of our dollar-based liquidity indicator. A rebound in this indicator tends to be associated with a surge in high-powered money globally. The capital outflows from China have dissipated, helping high-powered money find its way into EM plays and the commodity-currency complex. Private FX settlements - a proxy for the Chinese private sector's selling of yuan - was CNY -43 billion in July, a massive improvement compared to the CNY 800 billion in outflows experienced in August 2015 (Chart I-6). Through stringent administrative controls and a lessening of deflation, China gained the upper hand over its capital account. This development has two implications: it means that China does not need to sell reserves anymore, and in fact has been accumulating Treasurys since February 2017. It also means that investors are now less afraid of a sudden devaluation in the CNY, which has heartened risk-taking globally - especially in assets most exposed to China, which includes EM, commodities and dollar-bloc currencies. Chart I-5Easing Global Liquidty In 2017 Easing Global Liquidty In 2017 Easing Global Liquidty In 2017 Chart I-6Chinese Capital Account Under Control Chinese Capital Account Under Control Chinese Capital Account Under Control The collapse in the volatility of risk assets has been an additional element helping global liquidity make its way into EM plays and commodity currencies. As Chart I-7 illustrates, there is a relationship between the realized volatility of the U.S. stock market and the performance of dollar-bloc currencies. The first hunch is to dismiss the relationship as an artifact of the fact that both stock prices and commodity currencies are "risk-on" instruments. But there is an economic underpinning behind this relationship. As we argued in a Special Report on carry trades last year, the main reason carry trades have been able generate high Sharpe ratios since the 1980s is because they offer investors a risk premium for taking on exposure to unforeseen spikes in volatility.2 As a result, when the volatility of risk assets collapses, as has been the case recently, carry currencies outperform. The opposite holds true when volatility spikes back up. Chart I-7Dollar Bloc Currencies Like Low Vol Dollar Bloc Currencies Like Low Vol Dollar Bloc Currencies Like Low Vol When carry trades do well, investors end up aggressively buying EM currencies. As a result of these purchases, they inject funds - i.e. liquidity - into these economies. These injections of liquidity end up boosting money growth and supporting their economic activity, which stimulates global trade, commodity prices, and thus commodity currencies - even if these are not currently "high-yielders." Bottom Line: Chinese monetary conditions have deteriorated, creating a handicap for EM assets and the dollar-bloc currencies. Nonetheless, an increase in high-powered money growth, a decline in the risk premium to compensate investors for the risk of sudden new Chinese devaluation, and a collapse in global financial volatility have reinforced each other to create the ideal breeding ground for a rally in the AUD, the CAD and the NZD. The Sweet Spot Is Passing At the current juncture, the sweet spot for the dollar-bloc currencies may be passing. To begin with, commodity currencies are trading at a significant premium to underlying commodity prices, suggesting they are expensive and vulnerable to a decrease in global liquidity (Chart I-8). The AUD and the NZD stand out as especially expensive, while the CAD is only trading at a small premium to its long-term fair value (Chart I-9). This suggests that the Canadian dollar is likely to continue to outperform the Australian and New Zealand currencies, as it has been doing in choppy fashion since November 2016. Chart I-8Dollar Bloc Currencies Are Expensive Dollar Bloc Currencies Are Expensive Dollar Bloc Currencies Are Expensive Chart I-9AUD And NZD Are Expensive AUD And NZD Are Expensive AUD And NZD Are Expensive Another problem for dollar-bloc currencies is that they have greatly overshot global liquidity metrics. Historically, the commodity currencies have moved in lockstep with the evolution of global central bank reserves - a key measure of global liquidity (Chart I-10). While global reserves have improved, the average of the AUD, the CAD and the NZD has over-discounted this positive, pointing to potential vulnerability once liquidity ebbs. The problem with this overshoot is that liquidity is likely to decline with the imminent reduction in the Fed's balance sheet size. As Chart I-11 shows, the USD has been closely linked to changes in the reserves of commercial banks held at the Fed. As commercial banks accumulate excess reserves, this provides fuel for the repo market and the Eurodollar market, creating a supply of globally available USD for offshore markets. However, mechanically, once the Fed lets the assets on its balance sheet run off (its holdings of Treasurys), a liability will also have to decrease. This liability is most likely to be excess reserves as banks buy the Treasurys sold by the Fed. A fall in the accumulation of reserves of commercial banks in the U.S. is also directly linked with weaker dollar-bloc currencies (Chart I-12). This is because falling reserves push up the dollar and hurt commodity prices - a negative terms-of-trade shock for the AUD, the CAD and the NZD. Moreover, less reserves point to less liquidity making its way into EM economies. This also hurts the expected returns of holding assets in dollar-bloc economies. This therefore means that not only is there less liquidity available to move into these markets, the rationale to do so also dissipates. Without this dollar-based liquidity support, the tightening in Chinese monetary conditions could finally show its true impact on commodity currencies. Chart I-10Commodity Currencies Have##br## Overshot Global Liquidity Commodity Currencies Have Overshot Global Liquidity Commodity Currencies Have Overshot Global Liquidity Chart I-11Falling Excess Bank Reserves##br## Equals Strong Greenback Falling Excess Bank Reserves Equals Strong Greenback Falling Excess Bank Reserves Equals Strong Greenback Chart I-12Falling Excess Reserves Equals##br## Falling Commodity Currencies Falling Excess Reserves Equals Falling Commodity Currencies Falling Excess Reserves Equals Falling Commodity Currencies The last worrisome development for the dollar-bloc currencies is the volatility of financial assets. When volatility falls, it creates a wonderful environment for these currencies. But today, historical volatility is near the bottom of its distribution of the past 28 years. Being a highly mean-reverting series, it is thus more likely to rise than fall further going forward. There are three fundamental factors pointing to a potential reversal. First, share buyback activity has been declining, which historically points to rising volatility. Second, the U.S. yield curve slope also points toward a higher level of volatility. Volatility tends to bottom before the stock market peaks, and the stock market tends to peak before the economy enters recession. The yield curve itself tends to invert a year or so before a recession emerges. As a result, the yield curve begins to flatten around two years before volatility picks up (Chart I-13). Third, the anticipated decline in bank reserves - an important factor that has supported risk-taking around the globe - is likely to be the key catalyst supporting the relationship between the yield curve and volatility. If volatility increases, carry trades are likely to perform poorly, which will hurt EM currencies and result in outflows from these markets. This will cause liquidity conditions in EM economies to dry out, hurting their growth outlook. EM M1 growth has already weakened considerably, and is currently pointing to problems for commodity currencies (Chart I-14). The dry out in liquidity resulting from a reversal in carry trades will only amplify this phenomenon. Chart I-13Listen To The Yield Curve: ##br##Volatility Will Pick Up Listen To The Yield Curve: Volatility Will Pick Up Listen To The Yield Curve: Volatility Will Pick Up Chart I-14EM M1 Growth Is Becoming ##br##A Headwind For The Dollar Bloc EM M1 Growth Is Becoming A Headwind For The Dollar Bloc EM M1 Growth Is Becoming A Headwind For The Dollar Bloc Bottom Line: Global liquidity conditions are set to begin to tighten. While it is probably not enough to cause the bull market in stock prices to end now, it could be enough to affect the area of the global economy most exposed to this risk factor: carry trades and the dollar-bloc currencies. Specifically, commodity currencies are likely to be negatively affected by their elevated valuations, their strong sensitivity to excess bank reserves, and their high responsiveness to changes in financial market volatility. Key Indicators To Monitor After the surge that the dollar-bloc currencies have experienced since the spring and the large increase in the long exposure of speculators to these currencies, they are naturally at risk of experiencing a period of weakness. However, what worries us is not a retracement of 3-4%, but rather a 10-15% move. We suggest monitoring the following: First, watch U.S. inflation closely. The U.S. dollar is only likely to genuinely rally once the market believes the Fed can actually increase rates. So long as inflation remains tepid, investors will continue to second-guess the Fed. The market's response to this week's release of the most recent Federal Open Market Committee minutes only confirmed this. Mentions of debate on inflation within the FOMC was enough to send bond yields and the dollar reeling. However, based on the dynamics in the U.S. velocity of money, we continue to expect inflation to pick up in the second half of 2017 (Chart I-15).3 Second, follow cross-currency basis swap spreads. The cost of hedging U.S. assets back into euro or yen has normalized somewhat after hitting record levels in early 2016 (Chart I-16). If the removal of excess bank reserves in the U.S. system does affect global liquidity conditions, this market will be one of the first to be affected. Third, scrutinize the price of gold. The yellow metal remains a key gauge of global liquidity. Moreover, it is extremely sensitive to real rates and the dollar - two major determinants of the cost of global liquidity. In the summer of 2015, EM and dollar-bloc currencies severely suffered once gold broke below 1150. Today, a break below 1200 would be a sign of danger ahead. Fourth, watch EM currencies. A breakdown in EM currencies would be a key indication that carry trades are being reversed, and that global liquidity is no longer making its way into EM and EM-related plays. Commodity currencies are currently trading at a premium to their historical relationship with EM currencies, suggesting they would be highly vulnerable to such an event (Chart I-17). Chart I-15Watch U.S. Inflation Watch U.S. Inflation Watch U.S. Inflation Chart I-16Monitor Cross-Currency Basis Swap Spreads Monitor Cross-Currency Basis Swap Spreads Monitor Cross-Currency Basis Swap Spreads Chart I-17Dollar-Bloc Currencies At The Mercy Of EM FX Dollar-Bloc Currencies At The Mercy Of EM FX Dollar-Bloc Currencies At The Mercy Of EM FX Finally, keep an eye on Chinese monetary conditions. If Chinese monetary conditions improve from here, it would alleviate some of the negative pressure exercised on dollar-bloc currencies by the upcoming deterioration in global liquidity. However, if Chinese monetary conditions deteriorate further, this would negatively affect commodity prices, EM returns and the commodity currency complex. It would also hurt expected returns on Chinese assets, re-kindling outflows out of China and thus raising the risk premium associated with what would become a growing risk of CNY depreciation. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled, "Pyrrhic Victories", dated April 29, 2016, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report titled, "Carry Trades: More Than Pennies And Steamrollers", dated May 6, 2016, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report titled, "Fade North Korea, And Sell The Yen", dated August 11, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 U.S. data has been mixed this week: The Empire State Manufacturing Index increased to 25.2, a significant jump and beat Retail Sales increased at a 0.5% monthly pace, with the ex. Autos measure increasing at 0.5%, both beating expectations; The Import Price Index increased by 1.5% since last year; Initial jobless claims dropped to 232,000, beating expectations significantly; However, housing starts and building permits both underperformed expectations. While the DXY has rebounded, the FOMC's July minutes discussed the recent shortfall of inflation, which was interpreted bearishly by markets. The Fed is likely to begin normalizing its balance sheet very soon, as well as raising rates again by the end of this year. The greenback will likely continue its ascent when firmer inflation data emerges. Report Links: Fade North Korea, And Sell The Yen - August 11, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Improving euro area growth prospects have propelled the euro 12% higher since the beginning of the year. However, the market seems to begin questioning the ECB's hawkishness. In its minutes, the ECB expressed worries about a potential euro overshoot. Additionally, rumors emerged that Mario Draghi will not give much guidance in Jackson Hole. Together, these stories have reversed some of the euphoria that had engulfed the euro. The tightening in euro area financial conditions relative to the U.S. has prompted a roll over in relative economic and inflation surprises, justifying these budding doubts. Furthermore, U.S. inflation should begin to meaningfully accelerate in the fall. This is likely to add to the euro's weakness, as the greenback will resume its upward trend. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Data in Japan was mixed this week: Annualized gross domestic product growth grew by 4% on an annualized basis, crushing expectations. Additionally the month-to-month growth of industrial production came in at 2.2%, also beating expectations. However both export and import growth underperformed, coming in at 13.4% and 16.3% respectively. On cue, after we placed a long USD/JPY trade last week, USD/JPY rallied half percentage point, even if it gave up some of the gain now. We continue to be bearish on the yen as we expect U.S. yields to start picking up, in an environment where market expectations are very depressed. But could a correction in EM caused by the rise in the dollar help the yen? Not in the short term, given that historically the yen only gains in very sharp EM selloffs that themselves weigh on bond yields. Report Links: Fade North Korea, And Sell The Yen - August 11, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Data in the U.K. was mixed this week: Retail sales prices increased by 3.6% year-on-year, outperforming expectations. However, The trade balance not only worsened since last month but also came in below expectations, at -4.564 Billion pounds Crucially, most inflation metrics came in below expectations, with headline inflation coming in at 2.6% while PPI core output inflation came in at 2.4%. Overall, we continue to believe that the market's rate expectations for the BoE remain too hawkish. As the pass through from the currency dissipates, inflation should also start to come down. Furthermore, one has to remember that the BoE has a higher hurdle for raising rates than other central banks due to the unique situation in which the U.K. is currently in. Lowered rate expectations will be negative for cable in the short term. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Despite initially weak data, a risk-on environment and increasing copper prices have fueled a rally in the AUD. Data from China has been soft, and Australian data has been neutral: Chinese retail sales increased annually by 10.4%, less than expected; Chinese industrial production also underperformed at 6.4%; Australian wages increased at a 1.9% annual pace, in line with expectations; Australian unemployment dropped to 5.6%; participation rate increased to 65.1%; and a net of 27,900 jobs were filled. However, full-time employment went down by 20,300 while part-time employment increased by 48,200, so hours worked contracted. This development is likely to comfort the RBA in its dovish stance. In its minutes, the RBA discussed its worries concerning the housing market, and that "borrowers investing in residential property had been facing higher interest rates". This further worries the RBA regarding the impact of higher interest rates, limiting the room for more hawkish speeches. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been positive: Retail sales and retail sales ex-autos Quarter-on-quarter growth strengthened relatively to the previous quarter, coming in at 2% and 2.1% respectively. Moreover quarter-on-quarter inflation both for producer prices in outputs and inputs outperformed expectations, coming in at 1.3% and 1.4%. Currently, differences in perception adjustment between the dovishness of the RBNZ and the RBA have pushed Australian rate expectations to the point that the market is now pricing a hike in Australia before New Zealand. Overall, this seems like a mispricing, as the kiwi economy is on a stronger footing than the aussie one. Moreover, a slowdown in China would be more harmful for Australia as iron ore is more sensitive to the Chinese industrial cycle than dairy products. Thus we remain bearish on AUD/NZD. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The CAD has regained some composure despite weak oil prices. Even with the U.S. dollar weakening and inventories drawing massively, oil dropped. This dynamic is particularly worrying for oil, as the markets are doubting the durability of the curtailment in global oil production. While this could be worrying for the CAD, we still believe the USD 40-60/bbl equilibrium price level, as postulated by the BoC, will have a limiting effect on the oil-based currency, which has been driven by interest rate differentials. Both central banks are now hiking, but we believe that markets are underpricing Fed hikes. Thus, the CAD should weaken against USD. However, it will outperform other G10 currencies. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data has continued to show a mixed picture for the Swiss economy: Consumer prices inflation, increased slightly from the previous month, coming in at 0.3%, in line with expectations. The unemployment rate also came in in line of expectations at 3.2%, unchanged from the previous month. However, producer prices contracted by 0.1%, underperforming expectations. EUR/CHF has been weakening since its August second overbought extreme. For the moment, we expect the SNB to stand pat in its ultra-dovish monetary policy, at least until inflation and other economic indicators start to strengthen considerably. USD/CHF however might appreciate, given that the euro might fall the ECB minutes this week showed that the ECB is concerned by a potential euro overshoot. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Data in Norway this week was mixed: Headline inflation came in at 1.5% in July, outperforming expectations. However, it softened from June's 1.9% reading. Core inflation came at 1.2% in July, in line with expectations, decreasing from 1.6% in June. Moreover, manufacturing output contracted by 0.6% year-on-year. We continue to be bullish on USD/NOK, as the increasing gap in real rate differentials between the United States and Norway should outweigh any oil rally. Indeed, the recent numbers in Norway illustrate the lack of inflationary pressures in this Scandinavian country. This should keep a lid on rates, and thus help USD/NOK. On the other hand EUR/NOK should follow the path of oil. Thus, the OPEC supply cuts will ultimately support oil prices and thus, weigh on this cross. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 The SEK has had a particularly strong week, as inflation surprised to the upside on both a monthly and a yearly basis, coming in at 0.5% and 2.2% respectively. While it initially appreciated against all currencies, the uptick in commodity currencies on Wednesday made it lose its gains against AUD, CAD, NZD and NOK. As inflationary pressures grow, the SEK is likely to appreciate further, especially against the EUR and GBP. Additionally, with current Riskbank governor Stefan Ingves' term coming to an end by the end of this year, the hawkish rhetoric is likely to only increase. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017 Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

Highlights Washington must establish a "credible threat" if it is to convince Pyongyang that negotiations offer the superior outcome; The process of establishing such a credible threat is volatile; U.S. Treasurys, along with Swiss and Japanese government bonds have been consistent safe haven assets; The risk of a U.S. attack against North Korea is a red herring, while the crisis itself is not; We suggest that investors hedge the risk with an equally-weighted basket of Swiss bonds and gold. Feature Brinkmanship between Pyongyang and Washington, D.C. has roiled markets over the past week. The uptick in rhetoric has not come as a surprise. Since last year, BCA's Geopolitical Strategy has stressed that souring Sino-American relations were the premier geopolitical risk to investors and that China's periphery, especially the Korean peninsula, would be the "decisive" factor for markets.1 North Korea's nuclear ambitions - which could be snuffed out immediately by a concerted and coordinated effort by China and the U.S. - are a derivative of the broader U.S.-China dynamic. The U.S. is unlikely to use military force to resolve its standoff with North Korea. There are long-standing constraints to war, ones that all of the interested parties know only too well from their experience in the Korean War of 1950-53. The first of these is that war is likely to bring a high death toll: Pyongyang can inflict massive civilian casualties in Seoul with a conventional artillery barrage; U.S. troops and Japanese troops and civilians would also likely suffer. Second, China is unlikely to remain neutral, given its behavior in the 1950s, its persistent strategic interest in the peninsula, and its huge increase in military strength relative to both the past and to the United States. However, the process by which the U.S. establishes a "credible threat" of military action is volatile.2 Such a credible threat is necessary if Washington is to convince Pyongyang that negotiations offer a superior outcome to the belligerent status quo. Viewed from this perspective - which is informed by game theory -President Donald Trump has not committed any grave mistakes so far, but has rather shrewdly manipulated the world's perception that he is mentally unhinged in order to enhance his negotiating leverage. It is unclear how long it will take Trump to convince North Korea that the threat of a U.S. preemptive strike is "credible." As such, it is unclear how long the current standoff will persist. From an investor perspective, it will be difficult to gauge whether the brinkmanship and military posturing are part of this "territorial threat display" or evidence of real preparations for an actual attack. As such, further volatility is likely. The ongoing crisis in North Korea is neither the first nor the last geopolitical crisis the world will face in today's era of paradigm shifts.3 We have long identified East Asia as the cauldron of investment-relevant geopolitical risks.4 This is a dynamic produced by the multipolar global context and the geopolitical disequilibrium in the Sino-American relationship. For now, investors have been able to ignore the rising global tensions (Chart 1) due to the ample liquidity emanating from central banks, but the day of reckoning is nigh (Chart 2). Chart 1Multipolarity Increases Conflict Frequency Multipolarity Increases Conflict Frequency Multipolarity Increases Conflict Frequency Chart 2Day Of Reckoning? Day Of Reckoning? Day Of Reckoning? Q&A On North Korea Back on April 19, we wrote a Special Report, "North Korea: Beyond Satire," which argued that North Korea had at last become a market-relevant geopolitical risk after decades of limited impact (Chart 3).5 Chart 3North Korean Provocations Rarely Affect Markets For Long North Korean Provocations Rarely Affect Markets For Long North Korean Provocations Rarely Affect Markets For Long Looking to the next steps, we introduced the "arc of diplomacy," a framework comparable to the U.S.-Iran nuclear negotiations from 2010-15 (Chart 4). We predicted that the U.S. would ultimately ramp up threats for the purpose of achieving a diplomatic solution. The U.S. was constrained and would only go to war if an act of war were committed, or appeared imminent.6 Chart 4Arc Of Diplomacy: Tensions Ramp Up As Nuclear Negotiations Begin Can Pyongyang Derail The Bull Market? Can Pyongyang Derail The Bull Market? This assessment is now playing out. But not all clients are convinced of our logic, as we have found in our travels throughout Asia Pacific and elsewhere this month. Below we offer a short Q&A based on questions we have received from clients: Q: Diplomacy has already been tried, so why won't the U.S. attack? A: The U.S. public has less appetite for war, especially a preemptive strike, in the wake of the Iraq War, and has not suffered a 9/11 or Pearl Harbor-type catalyst. The U.S. will exhaust diplomatic options before joining a catastrophic second Korean War. And the diplomatic options are far from exhausted. The latest round of sanctions are tighter and more serious than past ones, but still leave categories untouched (like fuel supplies to the North) and are still very hard to enforce (like cutting illegal North Korean labor remittances). Enforcement is always difficult, and the U.S. is currently attempting to ensure that its allies enforce the sanctions strictly, not to mention its rivals (i.e. Russia and China). While we do not think China will ever impose crippling sanctions, we do think it can tighten them up considerably, which could be enough to change the North's behavior. Q: Why doesn't China just take North Korea out? A: China is a formal political, military, and ideological ally of North Korea, and has a strategic interest in maintaining a buffer space on the Korean peninsula - which it defended at enormous human cost in the Korean War. This interest remains in place. China is far more likely to aid and abet a nuclear-armed ally in North Korea than it is to endorse (much less participate in) regime change. The fallout from a new war, such as North Korean refugees flooding into China, is extremely undesirable for China, though it could handle the problem ruthlessly. China would also prefer not to have to occupy a collapsing North, which would be an extensive and dangerous entanglement. Therefore, expect China to twist Pyongyang's arm but not to break its legs. On a more topical note, China is consumed with domestic politics ahead of the nineteenth National Party Congress. It is perhaps more likely to take action after the congress in October-November. Q: Will U.S. allies cooperate with Trump? Why not bandwagon with China to gain economic benefit? A: South Korea is the best litmus test for whether Trump is causing U.S. allies to drift. The new South Korean President Moon Jae-In, who is politically left-of-center, has played his cards very carefully and started out on good footing with President Trump. A disagreement appears to be a likely consequence of Moon's agenda, which calls for extensive engagement with the North and a review of the U.S. THAAD missile defense deployment in Korea. So far, however, Moon is reaffirming the alliance, in his own way, and Trump has not (yet) expressed misgivings about him. If this changes significantly - as in, South Korea joining with China to give North Korea significant economic aid in defiance of U.S. sanctions efforts - then it would be a sign of division among the allies that would benefit North Korea and could even increase the risk of the U.S. taking unilateral action. The odds of that are still low, however. We have been short the Korean won versus the Thai baht since March 1, and the trade is up 6.03%. We also expect greater volatility and higher prices of credit default swaps to plague South Korea while the crisis continues over the coming months. We are closing our long Korean consumer stocks trade versus Taiwanese exporters for a loss of 4.24%. Q: What is Japan's role in the current crisis? What is the impact on Japan? A: Japan is one of the few countries whose relations with the U.S. have benefited under the Trump administration. The Japanese are in lock-step so far in reacting to North Korea. The government has been sounding louder alarms about North Korea for the past year, including by conducting evacuation drills in the case of attack. Japan has long been within range of North Korea's missiles, but its successes in nuclear miniaturization pose a much greater threat. Not only does North Korea pose a legitimate security risk, but Japanese Prime Minister Shinzo Abe also stands to benefit at least marginally in terms of popular support and support for his controversial constitutional revision. This will, in turn, feed into the region's insecurities. Yen strength as a result of the crisis, however, would be a headwind to Japan's economic growth. Thus Abe has a tightrope to walk. We expect him to take actions to ensure the economy continues to reflate. Q: Is Trump rational? How do we know he won't push the nuclear button? A: Ultimately this is unknowable. It also involves one's philosophical outlook. Josef Stalin and Mao Zedong both committed atrocities by the tens of millions but did not use nuclear weapons. Nikita Khrushchev practically wrote the playbook that North Korea's Kim dynasty has used in making its belligerent nuclear threats. Yet Khrushchev ultimately agreed to détente. Kim Jong Un makes Trump look calm. The combination of Kim and Trump is worrisome; but so was the combination of Eisenhower and Khrushchev, one believing nuclear weapons should be used if needed, the other threatening wildly to use them. It may be the case that the threat of an atrocity, or (in Kim's case) of total annihilation, is enough to keep decisions restrained. As we go to press, Kim has ostensibly suspended his plan to fire missiles around Guam and U.S. officials have repeatedly stated that they would not attack unless attacked. Stairway To (Safe) Haven Revisited In expectation of increased frequency of geopolitical risks, BCA's Geopolitical Strategy has produced two quantitative analyses of safe haven assets over the past two years. The first, "Geopolitics And Safe Havens," unequivocally crowned gold as the ultimate safe haven (Table 1), while showing that the USD is not much of a defense against geopolitical events (Chart 5).7 Table 1Safe-Haven Demand Rises During Crises Can Pyongyang Derail The Bull Market? Can Pyongyang Derail The Bull Market? Table 1Safe-Haven Demand Rises During Crises Can Pyongyang Derail The Bull Market? Can Pyongyang Derail The Bull Market? As such, investors should fade the narrative that the failure of the USD to appreciate amidst the latest North Korean imbroglio is a sign of some structural weakness. The greenback continues to underperform due to weak inflation in the U.S., a fleeting condition that our macro-economist colleagues expect to reverse. Mathieu Savary, BCA's currency strategist, believes that more upside exists for the USD regardless of the geopolitical outcome: Chart 5Gold Loves Geopolitical Crises Can Pyongyang Derail The Bull Market? Can Pyongyang Derail The Bull Market? Chart 6DXY Is Cheap... DXY Is Cheap... DXY Is Cheap... Chart 7...But The Euro Is Not ...But The Euro Is Not ...But The Euro Is Not First, the dollar is currently trading at its deepest discount to the BCA Foreign Exchange Service augmented interest rate parity model since 2010 (Chart 6). The euro, which accounts for 58% of the DXY index, is its mirror image, being now overvalued by two sigma, the most since 2010 (Chart 7). Second, bullish euro bets will dissipate as Europe's economic outperformance versus the U.S. fades. Financial conditions have massively eased in the U.S., while they have tightened in Europe, resulting in the biggest upswing on euro area growth relative to the U.S. in over two years (Chart 8). Such an economic outperformance by the U.S. should lead to a strengthening greenback (Chart 9).8 Chart 8Easing Versus Tightening FCI Easing Versus Tightening FCI Easing Versus Tightening FCI Chart 9PMIs Point To USD Rally PMIs Point To USD Rally PMIs Point To USD Rally Our second attempt to quantify safe-haven assets, "Stairway To (Safe) Haven: Investing In Times Of Crisis," concluded that U.S. Treasurys, Swiss bonds, and Japanese bonds are the best performers in times of crisis.9 We considered 65 assets10 (Table 2) with five different methodologies and back-tested them empirically within the context of 25 financial and geopolitical events since January 1988. Some of these assets have been proven to perform as safe havens by previous academic research, some are commonly utilized in investment strategies, and others could provide alternatives (see Box 1 for further details). Table 2Scrutinizing The World For Safe Havens Can Pyongyang Derail The Bull Market? Can Pyongyang Derail The Bull Market? This report demystifies four key issues related to safe havens: Part I identifies what qualifies as a safe-haven asset. Unsurprisingly, the best performers are U.S. Treasurys along with Swiss and Japanese bonds due to their currency effects. Part II examines if safe havens change over time. We find that gold and Treasurys have changed places as safe havens, and that JGBs and Swiss bonds have a long history as portfolio protectors. Part III breaks down safe havens through an event analysis. We look at the country of origin, the nature of the crisis, and whether the risk is a "black swan" or "red herring" - two classifications of events that BCA's Geopolitical Strategy has established - all of which have an impact on their performance. But red herrings or black swans are only defined after the fact, thus requiring geopolitical analysis or market timing indicators to be able to act on them. Part IV demonstrates that timing plays a crucial part when investing in safe havens as their performance is coincident with that of equities. Box 1 Safe Havens - A Literature Review In a previous Geopolitical Strategy Special Report published in November 2015, it was established that shifts in economic and political regimes alter investors' preferences for safe-haven assets, and that Swiss bonds and U.S. 10-year Treasurys were at the top of that list.11 Also, statistical methods were used to demonstrate that gold had acted as a safe haven from the 1970s to the early 90s, but has since lost its status due in part to a new era of looming deflationary risks. Li and Lucey (2013) have identified a pattern in precious metals, through a series of quarterly rolling regressions testing the significance of the 1st, 5th and 10th percentile movements in U.S. equity movements against safe-haven assets, catching extreme negative events. For instance, the 1st percentile captures the very worst corrections that have occurred, the one that represent the bottom 1% of the equity performances. The 5th and 10th percentiles represent the 5% and 10% lowest returns for equities, respectively. The authors demonstrated that silver, platinum and palladium act as safe havens when gold does not.12 Similarly, Bauer and McDermott (2013) examined the 1st, 5th and 10th percentile movements in U.S. equity movements and proved that both gold and U.S. Treasurys can serve as safe havens, but that gold has the best record in times of extreme financial stress.13 Baele et al. (2015) concentrated on flight-to-safety episodes, which they characterized as events in which the VIX, TED spreads and a basket of CHF, JPY, and USD all increased drastically.14 They found that during flight-to-safety episodes, large cap stocks outperform small caps, precious metal and gold prices (measured in dollars) increase slightly, while bond returns exceed those of the equity market by 2.5-4 percentage points. Baur and Glover (2012) provide further evidence that gold can no longer be utilized as a safe haven due to increased speculation and hedging. Their main finding is that gold cannot be both an investment and a safe-haven asset. That is, gold can only be effective as a safe haven if the periods prior to the event had not generated significant investment demand for gold.15 Using high-frequency exchange rate data, Ranaldo and Soederlind (2010) conclude that the CHF, EUR and JPY have significant safe-haven characteristics, but not the GBP.16 The strongest safe havens are identified as the CHF and JPY, but the returns are partly reversed after a day of safe-haven protection. They also find that the nature of the crisis has a significant effect on safe-haven properties. For instance, a financial crisis and a natural disaster produced drastically different outcomes for the yen. Part I - Safety In Numbers Our first step in identifying safe-haven assets was to review each asset's performance against equities in times of crisis. As such, we conducted a series of threshold regressions to generate a list of true safe-haven assets - assets that have a statistically significant positive performance in times of turmoil. Our method is explained as follows: Step 1 - Percentile Dummies: Following methods from Li and Lucey (2013) and Bauer and McDermott (2013), we created dummy variables for the 1st, 5th and 10th percentile of the S&P 500 daily total returns since 1988. We then multiplied each of these dummies by their corresponding stock returns (see Box 1 for further detail). Step 2 - Regressions: Using the 64 potential safe-haven assets, we ran a series of regressions both in USD and the local currency, testing each asset's returns explained by the three percentile dummies.17 Step 3 - Identifying Safe Havens: We then quantified strong safe-havens as assets having significant coefficients for all three return thresholds (1st, 5th and 10th percentile of the S&P 500 daily total returns). Results - Seek Refuge In Currencies And Government Bonds: Our quantitative results are mainly consistent with what others have found in the past: the Japanese yen and most G10 government bonds are safe havens. Table 3 shows the safe-haven assets that generated negative coefficients versus equities for all three threshold percentiles. Table 3Seeking Protection Against Corrections Can Pyongyang Derail The Bull Market? Can Pyongyang Derail The Bull Market? In our threshold regressions expressed in USD terms, we found that the Japanese yen, Quality Stocks,18 and Japanese, Swiss and U.S. bonds acted as strong safe havens. Currencies play a crucial part in the performance of safe havens. In fact, in local-currency terms, a series of G10 government bonds (U.S., Canada, Belgium, France, Germany, Netherlands, Sweden, Switzerland, and the U.K.) proved to be the most useful safe havens. In sum, true or strong safe havens are government bonds that have currencies that add to positive returns during times of crisis. Unsurprisingly, this select group of strong safe-haven assets is comprised of U.S., Japanese, and Swiss government bonds. Quality Stocks did provide positive and statistically significant results, but the returns were very low - for this reason, we excluded them from our basket of strong safe havens. While gold, the Swiss franc, and the U.S. dollar did generate positive returns during times of crisis, they failed to generate statistically significant results at all three thresholds. Bottom Line: Based on our econometric work, most G10 government bonds can act as safe havens. But due to strong currency effects, our models favor what are already commonly known as safe havens: U.S., Japanese, and Swiss government bonds. Simply put, the difference between this select group and other G10 bonds is that their currencies rise or are stable during turmoil, while the currencies of the other G10 bonds do not. Part II - Are Safe Havens Like Fine Wines? U.S., Japanese, and Swiss government bonds were not always the top assets providing protection against the downside in equities, however. To determine whether safe-haven properties change, we examined the evolution of the relationship between safe havens and U.S. equity markets over time with the following model: Step 1 - Rolling Regressions: Considering the results obtained in Part I, we restricted our sample to G10 governments in USD and local-currency terms, Quality Stocks, gold, JPY, EUR, and USD for this statistical procedure. We put these remaining assets, both in USD and local-currency terms, through a series of 1-year rolling regressions.19 Step 2 - Identifying Trends: Each regression generated a coefficient that explained the relationship between equities and safe havens (B1). We created a new time series by collecting the coefficients for each data point and smoothing them using a five-year moving average, thus depicting a long-term pattern in the evolution of safe havens. Results - A Regime Shift In Gold And Treasurys: Our findings show that safe-haven assets fall in and out of favor through time (Charts 10A, B & C). Most striking are the changes in U.S. Treasurys and gold. Only after 2000 did Treasurys start providing a good hedge for equity corrections. The contrary is true for gold - it acted as one of the most secure investments during corrections until that time, but has since become correlated with S&P 500 total returns. That said, gold's coefficient has been falling closer to zero lately, illustrating that it could soon resurface as a proper safe haven, especially if deflation risks begin to dissipate. Given that this is precisely the conclusion stated by our colleague Peter Berezin - BCA's Chief Global Strategist - and our own political analysis, we suspect that gold may be resurrected as a safe haven very soon.20 Chart 10ASafe Havens Don't Necessarily Age Well Safe Havens Don't Necessarily Age Well Safe Havens Don't Necessarily Age Well Chart 10BSafe Havens Don't Necessarily Age Well Safe Havens Don't Necessarily Age Well Safe Havens Don't Necessarily Age Well Chart 10CSafe Havens Don't Necessarily Age Well Safe Havens Don't Necessarily Age Well Safe Havens Don't Necessarily Age Well Another important finding is that the currency effect plays a key role during recent risk-off periods (Charts 11A & B). The best protector currencies are the ones that are negatively correlated with equity returns. According to our results, the CHF and the JPY have generally been risk-off currencies, while the USD has only been one since 2007, switching places with the euro. This reinforces the case for U.S., Japanese, and Swiss government bonds, which are supported by risk-off currencies. Chart 11ACurrencies Are Difference Makers Currencies Are Difference Makers Currencies Are Difference Makers Chart 11BCurrencies Are Difference Makers Currencies Are Difference Makers Currencies Are Difference Makers Bottom Line: Safe havens change over time. Gold fell out of favor due to global deflationary dynamics. With inflation on the horizon, we will keep monitoring the relationship between gold and equities for a possible return of the yellow metal as a safe haven. Since the July 4 North Korean ICBM test, for example, gold has rallied 4.8%. Part III - Red Herrings And Black Swans Since 1988, we identified 25 economic and (geo)political events that generated instant panic or acute uncertainty in the media and financial markets.21 We analyzed the short-term reactions of the safe-haven assets, both in USD and local-currency terms. This methodology allowed for the deconstruction of the impact of the events by the following factors: Country of origin of the crisis, the nature of the crisis, and whether the event was a "red herring" or a "black swan." Generally speaking, a red herring event is a crisis of some sort with little lasting financial impact. A black swan, on the other hand, is an event that has a very low probability of occurring but has a pronounced market impact if it does. Quantitatively, our definition of a black swan is an event that produces an immediate negative response in the S&P 500 below -1%, while creating a rise in either U.S., Japanese, or Swiss government bonds above 0% (Table 4). Of course, determining which event is a red herring or a black swan is only obvious post-facto and thus requires thorough geopolitical analysis. Table 4Understanding The Crises Can Pyongyang Derail The Bull Market? Can Pyongyang Derail The Bull Market? Results - Red Herrings And Black Swans Matter: Our event analysis solidifies our findings with regards to U.S., Japanese, and Swiss government bonds, but also builds a case for some European bonds as well as gold during black swan events. Our main findings can be summarized as follows. Fade The Red Herrings: Out of the sixteen geopolitical events, ten were identified as red herrings, in which safe havens underperformed the equity market. This, then, suggests that it is not always beneficial to buy safe-haven assets when tensions are rising. What is interpreted as a major geopolitical crisis - say, Ukraine in 2014 or Greece in 2015 - often ends up being a "red herring." Geopolitical Risk = Gold: Geopolitical black swan events, on the other hand, have a significant, negative impact on the market. During these events, gold emerges as the strongest hedge against a downturn in equities. U.S. Treasurys And The Swiss Franc Provide A Baseline: Under all black swan events considered - geopolitical and non-geopolitical - U.S. Treasurys and the Swiss franc had the strongest performance, generating positive returns on the day of the stock market crash in 85% of the cases. G10 Government Bonds Will Also Do: German, Dutch, Swiss and Swedish government bonds also provided protection during black swan events in local and common-currency terms, albeit to a lesser extent. U.S. And Swiss Bonds Outperform During Financial Episodes: During black swan financial crises, Swiss and U.S. government bonds stand out as the best safe havens due to their capacity to generate positive returns both in USD and local-currency terms in eight out of the nine examined crashes. Other findings that are interesting, yet less robust due to a limited sample size, include: When the crisis originated on U.S. soil, U.S. Treasurys and the dollar performed relatively poorly compared to other safe-haven assets. This is a somewhat surprising finding, as most investors believe that U.S. assets rally even at a time of U.S.-based crises, such as the 2011 budget crisis. We show that they may perform well, but in USD, non-U.S. based assets do better. When the crisis originated in Europe, European bonds performed very well both in USD and local-currency terms. When the crisis originated in Europe, Swiss and U.K. government bonds performed poorly in USD terms, but offered strong protection in local-currency terms. When the crisis originated in Russia, precious metals acted as a poor hedge. Bottom Line: It is crucial to gain an understanding of the nature of any potential crisis. Red herrings should always be faded, not hedged against, as they produce poor results in safe-haven assets. U.S. Treasurys, Swiss and Japanese government bonds have been very consistent safe-haven assets during previous periods of acute risk. Part IV: Timing Is Everything As a final step in our quantitative approach, we put our results through numerous timing exercises to test how the assets would perform in real time. Based on our Risk Asset Spectrum (Diagram 1), which summarizes our findings, one could argue that investing in times of crisis simply boils down to buying an equal-weighted basket of U.S. Treasurys, Swiss, and Japanese government bonds. Although this is technically true, such a strategy would require perfect foresight, unparalleled timing, or dumb luck - since black swan events are, by definition, very difficult to predict. Diagram 1Risk Asset Spectrum Can Pyongyang Derail The Bull Market? Can Pyongyang Derail The Bull Market? Proof Of The Ultimate Safe Haven: The first experiment we conducted was to illustrate how powerful safe havens can be when timed perfectly in a trading strategy. We started off by comparing two baskets. The first was a benchmark portfolio comprised of 60% U.S. equities and 40% U.S. bonds. The other contained the same two assets, but with 100% allocated to a basket comprised of U.S. Treasurys, Swiss, and Japanese government bonds during times of negative returns for equities. Of course, this strategy is not realistic and would be impossible to implement, since the trading rule depends on future events. But as Chart 12 shows, if one were able to predict every single period of negative returns for global equities and hold safe-haven assets instead, the trading rule would outperform almost 10-fold. Chart 12Safe Havens Work Wonders With Perfect Information... Safe Havens Work Wonders With Perfect Information... Safe Havens Work Wonders With Perfect Information... One-Month Lag Is Already Too Late: Repeating the same exercise, but with a one-month lag in the execution, produces drastically different results. More specifically, whenever the previous month's equity return is negative (t=0), the portfolio allocates 100% to a single safe-haven asset for the current month (t=1), otherwise it keeps the allocation identical to that of the benchmark. The rationale for using such a simple rule is that average investors are generally late in identifying a crisis and only react once they have validation that the market is in a correction. Chart 13 shows that being late by one month changes the performance of the safe haven basket from astronomically outperforming the benchmark to underperforming it. Chart 13... But Timing Is Everything ... But Timing Is Everything ... But Timing Is Everything Reaction Is Key: As a final timing exercise, we analyzed the reaction function of our assets to see how quickly they react after the correction in equities begins (Chart 14). Unsurprisingly, the top assets that we identified start appreciating as soon as the crisis hits (t=0). Gold is, on average, the quickest asset to react from investors seeking refuge. Swiss bonds come in as a close second, almost mirroring gold during the first few days of the correction. But both assets start to flatten out and even roll over after a few days. Japanese bonds react slightly later than gold and Swiss bonds, but keep increasing for a longer period of time and start plateauing around the 30th day after the crisis. U.S. Treasurys and Quality Stocks, on the other hand, remain rather flat and constant over the short term. These results attest to the importance of timing the crisis using the best safe-haven assets. Chart 14Safe Havens React Instantly Can Pyongyang Derail The Bull Market? Can Pyongyang Derail The Bull Market? Bottom Line: Timing plays a crucial part in investing in safe-haven assets, as their performance is coincident to that of equities. Investment Implications: Is Pyongyang A Red Herring Or A Black Swan? The results of our quantitative analysis are clear: hedging geopolitical risk depends on whether it is persistent or fleeting. So, is Pyongyang a red herring or a black swan? From our geopolitical analysis we make three key conclusions: The U.S. is not likely to preemptively attack North Korea; However, the U.S. has an interest in signaling that it may conduct precisely such an attack; Brinkmanship could last for a long time. Even if the risk of a U.S. attack against North Korea itself is a red herring, the crisis itself is not. In fact, between now and when a negotiated solution emerges, investors may face several new crises, which may include limited military attacks or skirmishes. While markets have faded such North Korean provocations in the past, the current context is clearly different. As such, we would suggest that investors hedge the risk with an equally-weighted basket of Swiss bonds and gold. Even though a "buy and hold" strategy with such a "Doomsday Basket" will likely underperform the market if tensions with North Korea subside, we are betting that it may take time for the U.S. and North Korea to get to the negotiating table. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com David Boucher, Associate Vice President Quantitative Strategist davidb@bcaresearch.com 1 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 6, 2016, available at gis.bcaresearch.com. We upgraded North Korea to the status of a genuine market-relevant risk in "North Korea: A Red Herring No More?" in Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Client Note, "Trump Re-Establishes America's 'Credible Threat'," dated April 7, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2017 available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0," dated September 25, 2012, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. In particular, we argued, "the current saber-rattling is carefully orchestrated. But North Korea can no longer be consigned to the realm of satire. The very fact that the U.S. administration is adopting greater pressure tactics makes this year a heightened risk period. Investors should be especially wary of any missile tests that reveal North Korean long-range capabilities to be substantially better than is known to be the case today." Then, on May 13 and July 4, North Korea conducted its first ICBM launches; the UN Security Council agreed to a new round of even tighter economic sanctions on August 5; and the U.S. and North Korea engaged in an alarming war of words. 6 Specifically, we wrote: "Diplomacy is the only real option. And in fact it is already taking shape. The theatrics of the past few weeks mark the opening gestures. And theatrics are a crucial part of any foreign policy. The international context is looking remarkably similar to the lead-up to the new round of Iranian negotiations in 2012. The United States pounded the war drums and built up the potential for war before coordinating a large, multilateral sanctions-regime and then engaging in talks with real willingness to compromise." 7 Please see BCA Geopolitical Strategy Special Report, "Geopolitics And Safe Havens," dated November 11, 2015, available at gps.bcaresearch.com. 8 Please see BCA Foreign Exchange Strategy Weekly Report, "Fade North Korea, And Sell The Yen," dated August 11, 2017, available at fes.bcaresearch.com. 9 Please see BCA Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com. 10 Forty-one assets were denominated in USD only, while G10 bonds, Credit Suisse Swiss Real Estate Fund, and European 600 real estate were used both in local-currency terms and USD, for a total of 65 assets. 11 Please see Geopolitical Strategy Special Report, "Geopolitics And Safe Havens," dated November 11, 2015, available at gps.bcaresearch.com. 12 Sile Li and Brian M. Lucey, "What precious metals act as safe havens, and when? Some U.S. evidence," Applied Economic Letters, 2013. 13 Dirk G. Bauer and Thomas K.J. McDermott, "Financial Turmoil and Safe Haven Assets," 2013. 14 Lieven Baele, Geer Bekaert, Koen Inghelbrecht and Min Wei, "Flights to Safety," National Bank of Belgium Working Paper No. 230, 2015. 15 Dirk G. Baur and Kristoffer J. Glover, "The Destruction of Safe Haven Asset?,"2012. 16 Angelo Ranaldo and Paul Soederlind, "Safe Haven Currencies," Review of Finance, Vol. 10, pp. 385-407, 2010. Can Pyongyang Derail The Bull Market? Can Pyongyang Derail The Bull Market? 18 Quality stocks are defensive equity plays with high, steady earnings with an elevated return on investments. They are estimated by Deutsche Bank's Factor Index Equity Quality Excess Return in USD. Can Pyongyang Derail The Bull Market? Can Pyongyang Derail The Bull Market? 20 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation)," dated July 13, 2016, available at gps.bcaresearch.com, and BCA Global Investment Strategy Weekly Report, "A Secular Bottom In Inflation," dated July 28, 2017, available at gis.bcaresearch.com. 21 Since we were interested in the immediate, often unexpected, response to the event, we did not include economic recessions in our event analysis.

Highlights Portfolio Strategy We reiterate our recent overweight calls in banks/financials and energy. Chemicals/materials and telecom services no longer deserve a below benchmark allocation. Pharma/health care and utilities are now in the underweight column. Recent Changes There are no changes to our portfolio this week. Table 1Sector Performance Returns (%) Three Risks Three Risks Feature Equities poked higher early last week on the eve of a robust earnings season as quarterly EPS vaulted to all-time highs (Chart 1), only to give up those gains and then some as North Korea jitters spoiled the party and ignited a mini selloff later in the week. While geopolitical uncertainty is dominating the news flow and an escalation is possible, we doubt North Korea tensions in isolation can significantly derail the stock market. With regard to the SPX's future return composition, our view remains intact that the onus falls on earnings to do the heavy lifting. In other words, the multiple expansion phase has mostly run its course, and explains the bulk of the board market's return since the 2011 trough (Chart 2). Now it is time for profits to shine. Chart 1Earnings-Led Advance Earnings-Led Advance Earnings-Led Advance Chart 2EPS Has To Do The Heavy Lifting EPS Has To Do The Heavy Lifting EPS Has To Do The Heavy Lifting Low double-digit EPS growth is likely in calendar 2018. Three key factors drive our sanguine profit view. First, as we posited three weeks ago, financials and energy will command a larger slice of the earnings pie, a backdrop not yet discounted in sell-side analysts' estimates (please see Table 2 from the July 24th Weekly Report). Second, irrespective of where the U.S. dollar heads in the coming months, SPX earnings will benefit from positive FX translation gains in Q3 and Q4. Finally, as the corporate sector flexes its operating leverage muscle, even modest sales growth will go a long way in terms of profit growth generation. Operating profit margins are poised to expand especially given muted wage inflation (Chart 3). Nevertheless, lack of profit validation is a key risk to our bullish S&P 500 thesis. Considering the post-GFC period, global growth scares (and resulting anemic earnings follow through) were the primary catalysts for the 2010, 2011 and late-2015/early-2016 equity corrections. The SPX fell 16%, 19% and 14% in each of those episodes, respectively. As a reminder, early in 2010 the Fed's QE ended and the ECB was scrambling to contain the government debt crisis as the Eurozone and the IMF bailed out Greece, Portugal and Ireland. In 2011, recession fears gripped the world economy, when then ECB President Jean-Claude Trichet tightened monetary policy twice in the euro area, while in the U.S. QE2 ended (Chart 4) and the debt ceiling fiasco spiraled out of control in the late-summer. More recently, a global manufacturing recession took hold in late-2015/early-2016 and the commodity drubbing re-concentrated investor's minds. Chart 3Margin Expansion Phase Margin Expansion Phase Margin Expansion Phase Chart 4Liquidity Removal = Market Turmoil Liquidity Removal = Market Turmoil Liquidity Removal = Market Turmoil A persistent flare up in geopolitical risk (i.e. in addition to the possible escalation of North Korea tensions) may lead consumers and CEOs alike to pull in their horns and short circuit the synchronized global economic recovery. Putting this risk in perspective is instructive. Table 2 documents the historical precedent of geopolitical crises since the mid-1950s, the maximum SPX drawdowns, and bid up of safe haven assets courtesy of our Geopolitical Strategy Service.1 Under such a backdrop, low-double digit EPS growth would be at risk, also causing some equity market consternation. Table 2Safe-Haven Demand Rises During Crises Three Risks Three Risks Table 2Safe-Haven Demand Rises During Crises, Continued Three Risks Three Risks Importantly, the Chinese Congress is quickly approaching in October and the dual tightening in Chinese monetary conditions (rising currency and interest rates) is unnerving. A related Chinese/EM relapse represents a risk to our bullish overall equity market thesis. Commodity producers/sectors would suffer a setback, jeopardizing the broad-based earnings recovery. Chart 5Mini Capex Upcycle Mini Capex Upcycle Mini Capex Upcycle Second, lack of tax reform is another risk we are closely monitoring that could put our upbeat SPX view offside. Lack of traction on this front as the year draws to a close will likely sabotage business confidence and put capex plans on the backburner anew. Moreover, this would shatter the confidence of small and medium businesses, especially given their greatest bugbears: high taxes and big government. Finally, repatriation tax holiday blues would cast a double dark shadow primarily over the tech and health care sectors: not only would shareholder-friendly activities like dividends and buybacks get postponed, but so would capex plans (Chart 5). One final risk worth monitoring is the handoff of liquidity to growth. Historically, there has been significant turmoil every time the Fed has removed balance sheet accommodation in the post-GFC era. We are in uncharted territory and the unwinding of the Fed's balance sheet, likely to be announced next month, may have unintended consequences. Unlike QE and QE2 ending, this time around the ECB is also on the cusp of removing balance sheet liquidity, at the margin. Chart 6A shows that the equity market may come under pressure if history at least rhymes. While we doubt that a larger than 10% correction is in the cards -- in line with the historical S&P 500 average drawdown during geopolitical crises (middle panel, Chart 6B)2 -- and our strategy will be to "buy the dip", the time to purchase portfolio insurance is now when the S&P 500 is near all-time highs, especially given the seasonally-weak and accident-prone months of September and October. Chart 6ADay Of Reckoning? Day Of Reckoning? Day Of Reckoning? Chart 6BAsset Class Returns During Crises Three Risks Three Risks We are comfortable with our overall early-cyclical portfolio exposure, while simultaneously maintaining a bit of defense in the form of our overweight consumer staples and underweight tech positions. This week we are recapping and reiterating all the major portfolio moves we have made since early May. Banking On Faster Growth Bank profit growth is supported by three main pillars: the quantity, price and quality of credit. All three are set to improve. Solid house price inflation and a tight labor market should ensure that consumer credit growth also firms (Chart 7A), pointing to the potential for a broad-based bank balance sheet expansion. Our U.S. bank loan growth model suggests that banks could enjoy the largest upswing in credit growth of the past 30 years (Chart 7B). Soaring consumer and business confidence, rising corporate profits and a potential capital spending revival are the key model drivers. BCA's view is that a better economy and rising inflation will materialize in the back half of the year, and serve as a catalyst to higher interest rates and a steeper yield curve. Banks profit from overall rising interest rates in two ways: reinvesting at higher yields and assets repricing at a faster pace than deposits. Thus, a steepening yield curve would signal that bank profit estimates should experience a re-rating, provided the yield lift at the long end of the curve was gradual and did not choke off growth via a sudden spike (Chart 7A). Chart 7ABanks Flexing Their Muscle Banks Flexing Their Muscle Banks Flexing Their Muscle Chart 7BBCA Bank Loans & Leases Growth Model BCA Bank Loans & Leases Growth Model BCA Bank Loans & Leases Growth Model In terms of credit quality, non-performing loans and charge-offs are sinking from already low levels. It would take a significant deterioration in the labor market to warn that credit quality was about to become a profit drag. Importantly, the reserve coverage ratio has climbed to near 100%, as non-current loans have fallen faster than banks have released reserves. Historically, credit quality improvement has been positively correlated with rising valuations (Chart 7A). Finally, even a modest easing in the regulatory backdrop along with a more shareholder friendly outlook now that the banks aced the Fed's stress test should help unlock excellent value in bank equities. Bottom Line: We reiterate our overweight stance in the S&P banks index that also lifted the S&P financials sector to overweight. Buy Energy Stocks Chart 8Energy EPS Model Says Buy Energy EPS Model Says Buy Energy EPS Model Says Buy Energy equities are down roughly 20% year-to-date versus the broad market, driven by rising U.S. shale oil production, inventory accumulation, and investor doubts about whether all nations will comply with OPEC's mandated production cuts. There are tentative signs that this relative performance bear phase is drawing to a close. Three main drivers support our modestly sanguine view of energy stocks. First, the long term inverse correlation between the U.S. dollar and the commodity complex has been reestablished; global growth suggests that a tightening interest rate cycle is brewing which should be supportive to energy stocks (top panel, Chart 8). Second, the steepest drilling upcycle in recent memory is showing signs of fatigue with Baker Hughes reporting flattening growth in domestic oil rig count; At least a modest deceleration in shale oil production is likely (Chart 8). Finally, our S&P energy sector Valuation Indicator has gravitated back to the neutral zone. Technicals are also washed out with our Technical Indicator breaching one standard deviation below its historical mean, a level that typically heralds a reversal. Recent anecdotes that the sell-side is throwing in the towel on their bullish oil forecasts for the remainder of the year are also contrarily positive. Bottom Line: Our newly introduced S&P energy sector relative EPS model encapsulates this cautiously optimistic industry backdrop (Chart 8), and gave us comfort to lift the S&P energy sector to a modest overweight position. DeREITing Chart 9Lighten Up On REITs Lighten Up On REITs Lighten Up On REITs REITs have marked time year-to-date, but recently operating conditions have downshifted a notch. Three key drivers argue for lightening up exposure on this newly formed S&P GICS1 sector. First, REITs had been unable to materially benefit from the 50bps fall in the 10-year Treasury yield from the mid-December peak to the mid-June trough. As the economy recovers from the first half lull, Treasury yields will resume their advance. This is a net negative for the fixed income proxy real estate sector (Chart 9). Second, real estate occupancy rates have crested and generationally high supply additions in the apartment space are all but certain to push vacancies higher still. The implication is that rental inflation will remain under intense downward pressure (Chart 9). Finally, according to the Fed's latest Senior Loan Officer Survey, bankers are less willing to extend CRE credit. If banks continue to close the credit taps, CRE prices will suffer a setback. Bottom Line: We reiterate our downgrade of the niche S&P real estate sector to a benchmark allocation. Positive Chemical Reaction? Chart 10Chemicals Are No Longer Toxic Chemicals Are No Longer Toxic Chemicals Are No Longer Toxic In the summer of 2014 we went underweight the S&P chemicals index, anticipating an earnings underperformance phase, driven by weak revenues as chemicals manufacturers were furiously adding capacity to benefit from lower domestic feedstocks. This view has largely panned out, and now three factors underpin our more neutral bias: synchronized global growth, receding global capacity and improving domestic operating conditions. The global manufacturing PMI has recently reaccelerated and jumped to a six year high. Similarly, the U.S. ISM manufacturing survey also vaulted higher. Synchronized global growth suggests that final demand is on the upswing and should bode well for chemical top- and bottom-line growth (Chart 10). This has driven a relative weakening of the U.S. dollar, much to the benefit of U.S. chemical producers, whose exports appear to be displacing German exports. Global chemicals M&A supports our expectation of demand-driven pricing power gains. We think the benefits of consolidation are twofold: First, reduced revenues of the past decade have left the industry with outsized cost structures; consolidation should sweep that away under the guise of synergy, driving margins higher. Second, industry overcapacity has historically impaired profitability due to soaring overhead and more competitive pricing; greater scale should impose greater capital discipline. Finally, domestic operating conditions have taken a turn for the better. This improving domestic final demand backdrop is reflected in higher resource utilization rates and solid pricing power gains have staying power (Chart 10). Bottom Line: Tentative evidence suggests that the bear market in chemicals producers is over. We reiterate our recent upgrade to neutral. Given that chemicals stocks comprise over 73% of the broad materials index, this bump also moved the S&P materials sector to a benchmark allocation. Utilities: Blackout Warning Chart 11Utilities Get Short Circuited Utilities Get Short Circuited Utilities Get Short Circuited While chemicals and materials are beneficiaries of an upgrading in global economic expectations, utilities sit at the opposite end of the table (global manufacturing PMI shown inverted, top panel, Chart 11), and therefore warrant a downgrade to a below benchmark allocation. Now that the Fed is ready to start unwinding its balance sheet, the ECB is preparing the waters for QE tapering and a slew of CBs are on the cusp of a new tightening interest rate cycle, there are high odds that still overvalued fixed income proxies will continue to suffer. Synchronized global growth and coordinated tightening in monetary policy spells trouble for bonds. Our sister publication U.S. Bond Strategy expects a bond selloff for the remainder of the year. Given that utilities essentially trade as a proxy for bonds, this macro backdrop leaves them vulnerable to a significant underperformance phase (Treasury yield shown inverted, bottom panel, Chart 11). Importantly, the stock-to-bond (S/B) ratio and utilities sector relative performance also has a tight inverse correlation (S/B shown inverted, second panel, Chart 11). The implication is that downside risks remain acute. Without the support of continued declines in bond yields, or of indiscriminate capital flight from all riskier assets, utilities advances depend on improving fundamentals. The news on the domestic operating front is grim. Contracting natural gas prices, the marginal price setter for the industry, suggest that recent utilities pricing power gains are running on empty. Tack on waning productivity, with labor additions handily outpacing electricity production, and the ingredients for a margin squeeze are in place. Bottom Line: We reiterate our recent downgrade to underweight. Pharma: Tough Pill To Swallow Chart 12Pharma Relapse Pharma Relapse Pharma Relapse Pharma stock profits have moved in lockstep with consumer spending on pharmaceuticals and both have roughly doubled over the past decade. However, relative pharma consumer outlays have crested recently, causing a significant pharma profit underperformance (Chart 12). If our cautious drug pricing power thesis pans out as we portrayed in the July 31st Weekly Report, then pharma earnings will suffer and exert downward pressure on relative share prices (Chart 12). Industry balance sheet deterioration represents another warning signal. Net debt/EBITDA is skyrocketing at a time when the broad non-financial corporate (NFC) sector has been in balance sheet rebuilding mode (bottom panel). While this metric does not suggest that pharma stocks are in deep financial trouble, the deterioration in finances is undeniable, and, at the margin, a rising interest rate backdrop will likely slow down debt issuance for equity retirement and dividend payout purposes. Bottom Line: We recently trimmed the S&P pharmaceuticals index to underweight, which also took the S&P health care index to underweight. Telecom Services: Signs Of Life Chart 13Telecom: Climbing Out Of Deflation2 Telecom: Climbing Out Of Deflation Telecom: Climbing Out Of Deflation Investors have shunned telecom services stocks vehemently year-to-date (YTD) on the back of an abysmal profit showing. We had been fortunate enough to underweight this niche sector since late January, adding alpha to our portfolio. Nevertheless, we did not want to overstay our welcome and recently booked profits of 12% and lifted the S&P telecom services sector to the neutral column. Our Cyclical Macro Indicator has arrested its fall giving us comfort that at least a lateral move in relative share prices is likely in coming months (Chart 13). The steep recalibration of cost structures to the new pricing reality is buttressing our CMI, offsetting the sector's plummeting share of the consumer's wallet (Chart 13). Encouragingly, selling prices cannot contract at 10% per annum indefinitely, and on a three month-rate of change basis, pricing power has staged a V-shaped recovery (Chart 13). Anecdotally, Verizon's first full quarter post the new pricing plans was solid and suggests that the peak deflationary impulse is likely behind the industry. Impressive labor cost discipline along with even a modest pricing power rebound signal that a grinding higher margin backdrop is likely in the coming months, in line with our margin proxy reading. This will also stabilize relative profitability. In sum, the bearish S&P telecom services narrative is more than discounted in ultra-depressed relative valuations on cyclically quashed profit estimates. Green shoots on the industry's pricing power front and impressive management focus on cost structures argue against being bearish this niche sector. Bottom Line: We reiterate the recent bump to neutral in the S&P telecom services sector. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Geopolitics And Safe Havens," dated November 11, 2015, available at gps.bcaresearch.com. 2 Ibid. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights The Kingdom of Saudi Arabia (KSA) is taking a well-timed tactical decision to make room for increased Libyan and Nigerian output, by reducing allocations to refiners by more than 500k b/d in September. The bulk of these reductions will be directed at U.S. refiners, which are running their units at close to record output, while reducing their crude imports and boosting product exports. This will keep the year-on-year (yoy) reductions in OECD commercial oil stocks now showing up in the data on track, driven by continued sharp draws in U.S. inventories. Most importantly, these reductions will occur in the highly visible, high-frequency data produced by the U.S. every week. Energy: Overweight. Reports of foreign workers being pulled from Venezuelan oil fields will keep markets on edge. We remain long Dec/17 $50/bbl calls and short $55/bbl calls in Brent and WTI, which are up 127% and 74% since inception on June 22 and June 15, respectively. Base Metals: Neutral. Aluminum rallied on the back of news reports China's Shandong province ordered more than 3.2mm MT/yr of capacity shuttered by end-July. While surprising, such actions are not inconsistent with the stricter enforcement of environmental regulations in China we expect going forward. Precious Metals: Neutral. We remain long gold as a strategic portfolio hedge. Recent geopolitical tensions between the U.S. and North Korea are supporting this position, which is up 2.1% since inception on May 4, 2017. Ags/Softs: Underweight. Grains were treading water ahead of today's WASDE. We remain bearish, but continue to avoid shorting the complex. Feature Chart of the WeekU.S. Refiners Running At Close To Record Rates U.S. Refiners Running At Close To Record Rates U.S. Refiners Running At Close To Record Rates KSA's decision to reduce crude oil allocations to refiners in September, particularly in the U.S., is a well-timed tactical move.1 U.S. refinery net crude inputs hit record levels in early June at 17.3mm b/d, and remain close to that level (Chart of the Week). U.S. product exports continue at near-record levels, while imports have been trending lower (Chart 2). Crude oil exports from the U.S. are running close to record levels, and imports are trending lower (Chart 3). U.S. exports of crude and products hit a record in January at 5.9mm b/d - 5.24mm b/d of products, and just under 650k b/d for crude exports. At the end of July, total exports of crude and products stood at 5.44mm b/d, or 7.4% below the record set in January. U.S. product exports fell to 4.6mm b/d, while crude exports stood at 845k b/d. It is worthwhile pointing out that, in terms of total oil and products exports, the U.S. ranks among the top exporters in the world: KSA exports ~ 7mm b/d of crude, while Russia exports ~ 5mm b/d of crude. Chart 2U.S. Product Export Remain Strong,##BR##While Imports Continue Trending Lower ... U.S. Product Export Remain Strong, While Imports Continue Trending Lower ... U.S. Product Export Remain Strong, While Imports Continue Trending Lower ... Chart 3... While U.S. Crude Exports Remain High,##BR##And Imports Are Moderating ... While U.S. Crude Exports Remain High, And Imports Are Moderating ... While U.S. Crude Exports Remain High, And Imports Are Moderating With net U.S. crude and product imports declining (Chart 4), we expect U.S. commercial oil inventories - crude and products - to continue to draw sharply, which, since they account for close to 45% of OECD inventories, will draw down total DM stock levels as well (Chart 5). Indeed, U.S. commercial inventories drew close to 4% yoy in July, based on EIA historical data, the second month in a row the yoy comparisons came in negative in America. For the OECD as a whole, July marked the first month this year that the yoy percent change in stock levels was negative (-1.8%). Thus, as the summer driving season - and peak refiner crude demand - reaches its denouement next month, KSA's well-timed move to reduce shipments to U.S. refiners will push inventories lower and advance OPEC 2.0's agenda to clear out surplus OECD commercial oil inventories over the short term (Chart 6). Chart 4U.S. Net Crude And##BR##Product Imports Are Falling ... U.S. Net Crude And Product Imports Are Falling ... U.S. Net Crude And Product Imports Are Falling ... Chart 5... Which Will Support Continued Draws In##BR##Commercial Oil Stocks (Crude And Products) ... Which Will Support Continued Draws In Commercial Oil Stocks (Crude And Products) ... Which Will Support Continued Draws In Commercial Oil Stocks (Crude And Products) Chart 6KSA Will Continue Reducing##BR##Shipments To U.S. Refiners KSA Will Continue Reducing Shipments To U.S. Refiners KSA Will Continue Reducing Shipments To U.S. Refiners The OPEC 2.0 Agreement Is Holding ... On Average ... KSA is following through on Energy Minister Khalid al-Falih's "whatever it takes" assertion and making room for Libya and Nigeria, which together have added some 750k b/d of production to the market vs. April's level - 470k b/d for Libya and 280k b/d for Nigeria. April happens to be the month during which OPEC's producers recorded their largest production cuts vs. October's levels (1.12mm b/d), based on the EIA's historical tallies. OPEC 2.0 benchmarks to October 2016 production levels. Among OPEC members, neither Libya nor Nigeria were bound by the historic OPEC 2.0 Production Agreement. However, for those states that did obligate themselves to the agreement, compliance has been fairly high on average. OPEC member states that are party to the 2.0 deal have overproduced relative to their agreed production volumes by some 20k b/d over the January - July period on average.2 So, relative to the deal the OPEC members agreed, they've managed to cut 800k b/d of crude production on average versus their October 2016 production levels.3 During this period, Iraq stands out for its overproduction, having pumped 100k b/d on average over its agreed OPEC 2.0 volume of 4.35mm b/d (Chart 7). Among the non-OPEC members of the OPEC 2.0 coalition, Russia's compliance appears to be holding up, at close to 300k b/d below its October levels of crude and liquids production in 2Q17 and July (Chart 8). Oman produced ~ 980k b/d, over the first seven months of the deal vs. 1.02mm b/d in October, while Kazakhstan has faltered, with production averaging 1.88mm b/d in Jan - July, versus 1.79mm b/d in October. Chart 7Iraq Stands Out For Overproduction;##BR##Libya, Nigeria Not Covered In OPEC 2.0 Deal Iraq Stands Out For Overproduction; Libya, Nigeria Not Covered In OPEC 2.0 Deal Iraq Stands Out For Overproduction; Libya, Nigeria Not Covered In OPEC 2.0 Deal Chart 8Russia And KSA##BR##Continue To Lead OPEC 2.0 Russia And KSA Continue To Lead OPEC 2.0 Russia And KSA Continue To Lead OPEC 2.0 ... But Markets Await Articulated Strategy We continue to expect compliance with the OPEC 2.0 deal to remain relatively high to March 2018, which will draw OECD storage down to five-year average levels. We also are maintaining our expectation Brent prices will trade to $60/bbl by year end, with WTI trading ~ $58/bbl. Nonetheless, when we update our balances this month, we will continue to model for "compliance fatigue" among the OPEC 2.0 coalition. The fact that KSA and Russia are able to keep their rapport strong and compliance levels among OPEC and non-OPEC states relatively high, is a necessary condition for keeping OPEC 2.0 a viable coalition. However, the sufficient condition remains articulating a position on managing production via OPEC 2.0 that all these states can buy into, and support with concrete action. If, once the deal expires, the parties to the OPEC 2.0 coalition are left to go their own way and resume a production free-for-all, prices almost surely will fall, as the battle for market share is resumed. The ironic outcome of all this likely would be further destruction of capex budgets, which will set up another violent price surge that kills demand. We have no doubt the principal negotiators in OPEC 2.0 continue to discuss this, and that they are working on guidance. Bottom Line: KSA's tactical move to reduce exports to the U.S. likely will accelerate the commercial oil storage drawdown now apparent in OECD inventories, if current U.S. trends hold up - i.e., refinery runs remain high, exports of crude and products remain strong, and imports continue to fall yoy. Strategically, OPEC 2.0 still needs to convince markets there is a longer-term game plan for managing its output, short of a production free-for-all. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 This tactical move was reported by Reuters earlier this week. Please see "Saudi Arabia cuts crude oil allocations in September by more than its OPEC pledge," which was published by reuters.com August 8, 2017. 2 We are using the production levels specified by the Cartel in its "OPEC Bulletin 11 - 12/16" on p. 35. 3 This likely overstates the actual production available for export by KSA, since the Kingdom typically consumes some 500 - 600k b/d of crude domestically over the June - September period as direct-burn fuel to power generation producing electricity for air conditioners. So the reported data likely are noisy at this time of year. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades KSA's Tactics Advance OPEC 2.0's Agenda KSA's Tactics Advance OPEC 2.0's Agenda Commodity Prices and Plays Reference Table KSA's Tactics Advance OPEC 2.0's Agenda KSA's Tactics Advance OPEC 2.0's Agenda Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights Dear Clients, We are publishing a Special Report prepared by my colleague Jonathan LaBerge who examines the case for allocating capital to EM stocks within a global equity portfolio. I hope you will find this report insightful. Best regards, Garry Evans The relative performance of emerging market equities is challenging the downward trend channel that has been in place for the past seven years. This has led to renewed interest in EM from global investors, and warrants a revisit of the role of emerging market equities within a global equity portfolio. While EM recorded the highest regional equity return last cycle (2002-07), they were surprisingly not the "ideal" regional equity market in an efficient portfolio allocation. Recently, several compositional changes within the EM equity universe give the appearance of much lower commodity exposure than is truly the case. But EM equities will still be correlated with broad commodities prices because the later reflect Chinese growth dynamics. Cyclical indicators for China's economy suggest that the broad trend in commodities prices is likely to be lackluster over the coming year, at best. Consequently, EM stocks offer a poor risk/return profile, justifying an underweight stance within a global equity portfolio. Feature Chart I-1Change In Trend, Or Another Failed Rally? Change In Trend, Or Another Failed Rally? Change In Trend, Or Another Failed Rally? In U.S. dollar terms, the relative performance of emerging market (EM) stocks has been in an uptrend for over 18 months, and now appears to be challenging the downward trend channel that has been in place for the past seven years (Chart I-1). This has led to a renewed interest in EM, particularly among global investors. This report takes the recent outperformance of EM stocks as an opportunity to revisit their past and future contribution to a global equity portfolio, and what this might mean for an allocation to EM equities over the coming year. We conclude that EM's return behavior during the last economic cycle (2002-2007), its continued link to commodities prices, and China's growth dynamics all contribute to a poor risk/return profile for EM over the coming year. Barring compelling signs of a durable commodity bull market, investors should underweight EM stocks within a global equity portfolio. EM Equities In A Global Context: Some Historical Perspective When examining whether emerging markets are attractive from the perspective of global equity allocation, a starting point is to analyze the fundamental drivers of regional earnings. One major driver of global earnings over the past 20 years has been commodities prices; Chart I-2 highlights how 12-month forward EPS for stocks in all major regions have been correlated with commodities since the late-1990s. Chart I-2ACommodities Prices Are Correlated With Earnings... Commodities Prices Are Correlated With Earnings... Commodities Prices Are Correlated With Earnings... Chart I-2B...Even In Developed Markets ...Even In Developed Markets ...Even In Developed Markets This can be largely explained by the fact that commodities tend to be a pro-cyclical asset class. However, the super cycle in commodities prices in the 2000s not only bolstered the earnings of global resource companies, it also powered earnings growth for export-oriented industrials as well as domestic demand plays in commodity-producing countries. Chart I-3Strong Correlation Between ##br##Commodities And EM Strong Correlation Between Commodities And EM Strong Correlation Between Commodities And EM Emerging markets were among the largest beneficiaries of the commodity boom; net commodity-exporting countries made up roughly 45% of EM market capitalization throughout the last economic cycle, whereas stocks in the resource sector made up between 25-30% of the index by weight. Unsurprisingly, the relative performance of EM stocks closely tracked commodities prices over this period (Chart I-3). But despite this, EM was surprisingly not the "ideal" regional equity market last cycle within an active portfolio, even though it had the highest return. Chart I-4A presents a scatterplot of annualized regional equity volatility and return from 2002 - 2007, measured in US$ terms. The chart also shows the ex-post Modern Portfolio Theory (MPT) efficient frontier, with Chart I-4B presenting the efficient regional allocation at each point along the frontier. Chart I-4AEmerging Market Stocks Had The Highest Return Last Cycle... Global Equity Allocation: The Underwhelming Case For EM Global Equity Allocation: The Underwhelming Case For EM Chart I-4B...But Were Only The Favored Market For High-Risk Portfolios Global Equity Allocation: The Underwhelming Case For EM Global Equity Allocation: The Underwhelming Case For EM Chart I-5From 2002-2007, Earnings Drove More ##br##Of The Rally In DCM Than EM From 2002-2007, Earnings Drove More Of The Rally In DCM Than EM From 2002-2007, Earnings Drove More Of The Rally In DCM Than EM While the charts show that the efficient allocation to emerging market stocks did rise to a maximum of 100% during the last economic cycle, it did not become the dominant region until the portfolio became considerably more volatile than the global equity benchmark. Indeed, Chart I-4B shows that developed commodity markets (DCM) were the preferred commodity play for most of the efficient frontier, owing to their superior performance in risk-adjusted terms. This risk-adjusted outperformance may have occurred because DCM returns last cycle were driven more by earnings than by multiple expansion; Chart I-5 highlights that EM stock prices benefitted from multiple expansion last cycle by outpacing forward earnings, versus the opposite in the case of DCM. Since the onset of the U.S. recession in 2008, Chart I-6A and Chart I-6B highlight that the ex-post efficient portfolio has been much more skewed than during the last economic cycle. The charts show that the frontier since 2008 has been extremely short, with efficient allocations only accruing to three countries with typically defensive stock markets: the U.S., Japan, and Switzerland, with a heavy bias towards the former. From the perspective of a global equity portfolio, this historical review leads to two conclusions: 1) investors should not allocate to EM unless they are bullish on commodities prices and, 2) if investors are bullish towards commodities, developed commodity markets have historically been a better risk-adjusted bet than emerging markets as a commodity play. Chart I-6ASince 2008, The Efficient Frontier Has Been Highly Skewed... Global Equity Allocation: The Underwhelming Case For EM Global Equity Allocation: The Underwhelming Case For EM Chart I-6B...Towards Defensive Markets (Mostly The U.S.) Global Equity Allocation: The Underwhelming Case For EM Global Equity Allocation: The Underwhelming Case For EM Chart I-7These Trends Give The False Appearance ##br##Of Lower EM Commodity Exposure These Trends Give The False Appearance Of Lower EM Commodity Exposure These Trends Give The False Appearance Of Lower EM Commodity Exposure EM And Commodities Prices: Has The Relationship Really Changed? More recently, a narrative has developed in the market that EM stocks are now far less sensitive to commodities prices than used to be the case. Proponents of this theory point to the following changes in the composition of emerging market equity benchmarks: First, the market capitalization weight of net commodity exporting countries has fallen precipitously since the onset of the collapse in oil prices in 2014 (Chart I-7, panel 1). On average, net commodity exporters made up between 40-45% of EM equity market cap from 2000 to 2013, but their share now stands at 27%. Second, Chart I-7, panel 2, shows that the market cap weight of resource sectors (energy plus materials) in emerging markets has fallen from roughly 30% to 14% over the past five years, a trend that pre-dated the decline in the share of net commodity exporters. Third, the enormous rise in the market capitalization of technology companies as a share of total EM market cap has been specifically cited by many market participants (Chart I-7, panel 3), especially since EM is now heavily overweight the tech sector relative to the global average. Broadly speaking, a fourth compositional change within the EM equity benchmark generally captures all of the shifts noted above, and is the focus of our remaining analysis below: the rise in the weight of emerging Asia as a share of overall EM (Chart I-7, panel 4). Among emerging markets, net commodity exporters tend to be located outside of Asia (with the exception of Indonesia and Malaysia), and emerging Asia accounts for essentially all of EM tech market cap. Consequently, investors who argue that EM equities have largely or fully decoupled from commodities prices are essentially arguing that emerging Asian equities are far less affected by changes in commodity markets than they used to be. This idea is deeply flawed, as shown below: Based on export share, Chart I-8 highlights that emerging Asia is far more economically exposed to China than developed markets and EM ex-Asia. While China is gradually becoming more of a services-oriented economy, Chart I-9 highlights that the sum of primary industry (raw material extraction), secondary industry (manufacturing and construction), and real estate services still account for over half of China's economic activity, well above that of industrialized nations such as the U.S. This underscores that emerging Asia's trade exposure to China is fundamentally rooted in economic activity that is closely linked to commodity demand. Chart I-8Emerging Asia Has High ##br##Trade Exposure To China Emerging Asia Has High Trade Exposure To China Emerging Asia Has High Trade Exposure To China Chart I-9Chinese Growth Still Largely ##br##Reflects Industrial Activity Chinese Growth Still Largely Reflects Industrial Activity Chinese Growth Still Largely Reflects Industrial Activity Within the commodity-linked segment of China's economy, Chart I-10 shows that there is little evidence of a weaker relationship between output and commodities prices. Simple regression analysis underscores that the Li Keqiang index, a growth proxy for China's industrial sector, is strongly linked to the year-over-year % change in spot commodities prices since the beginning of the commodity bull market, and that this relationship has in fact been increasing in strength over time. In addition, Chart I-11 underscores that China remains by far the largest consumer of base metals globally. Demand in the global oil market is considerably more diversified than the market for base metals, but China is the second-largest end market for oil (14% of global oil consumption), and accounted for over a quarter of the growth in total oil demand in 2016.1 Chart I-10Moderating Chinese Growth Will ##br##Be Negative For Commodities Moderating Chinese Growth Will Be Negative For Commodities Moderating Chinese Growth Will Be Negative For Commodities Chart I-11China Is By Far The Most Important ##br##End Market For Base Metals China Is By Far The Most Important End Market For Base Metals China Is By Far The Most Important End Market For Base Metals Finally, Chart I-12 shows a regression model between forward earnings expectations for emerging Asia and commodities prices, both at the overall index level and even for the financial sector (which, along with real estate, accounts for almost 25% of emerging Asian market capitalization). The fit for both models is extremely strong and, similar to the increasing strength of the Li Keqiang / commodity price relationship, the chart shows that commodities prices have begun to lead the growth in forward earnings, when the relationship used to be much more coincident. Chart I-12Emerging Asian Earnings Are Strongly ##br##Correlated With Commodities Prices Emerging Asian Earnings Are Strongly Correlated With Commodities Prices Emerging Asian Earnings Are Strongly Correlated With Commodities Prices The bottom line for investors is that Charts I-8-12 show emerging Asian economies are strongly linked economically to China, and that China remains the dominant driver of aggregate commodity demand. This means that while EM stocks may not have as much direct commodity exposure as they used to, they will continue to experience a high correlation with commodities prices because that the latter will be driven by swings in China's business cycle. In brief, Chinese growth fluctuations are instrumental to emerging Asia's economic and equity market performance. This is the rationale behind the very strong link between earnings expectations for emerging Asia and commodities prices: the latter reflect cyclical variations in the Chinese economy. EM Stocks: A Lackluster Bet Given The Outlook For Commodities Our earlier discussion of EM's historical contribution to a global equity portfolio revived elements of Modern Portfolio Theory (MPT), at least from an ex-post perspective. Ex-ante, investors need to make judgements about the likely risk, return, and cross-correlation of an asset when assessing its likely contribution to a diversified portfolio. Regarding the latter factor, Chart I-13 highlights that EM's correlation with global ex-EM has actually fallen quite substantially over the past year, which is a potential argument in the minds of some investors in favor of an increased allocation to EM. When recalling the lessons from Modern Portfolio Theory, most investors tend to focus on the key insight that lowly-correlated assets are valuable from the perspective of constructing a portfolio with an attractive risk/return profile. While this is true, many investors often forget that this is only valid given an expectation of a positive return. The efficient allocation to an asset that has a strongly negative correlation with other assets but has a negative return expectation is basically zero. This means that global investors eying an increased allocation to emerging markets should be squarely focused on EM equities' absolute performance, which as we have highlighted above are likely to be closely linked to commodity returns. Over the coming 6-12 months, Chart I-14 paints an uninspiring picture for commodities prices based on two measures of China's money supply. In turn, interest rates lead money growth and the rise in the former over the past nine months heralds further deceleration in the latter. This implies that the Chinese economy will likely continue to moderate, which is negative for the broad trend in commodities prices. Chart I-13A Significant Decline, But Focus On Return ##br##Expectations, Not Correlation A Significant Decline, But Focus On Return Expectations, Not Correlation A Significant Decline, But Focus On Return Expectations, Not Correlation Chart I-14Interest Rates And Money Growth Paint ##br##A Poor Picture For Commodities Interest Rates And Money Growth Paint A Poor Picture For Commodities Interest Rates And Money Growth Paint A Poor Picture For Commodities As noted above, China's share of the global oil market is much lower than that of base metals, and we do not expect China's oil demand to shrink even if its industrial sector slumps. But from the perspective of allocating to EM equities within a global portfolio, Table I-1 highlights that broad spot commodity price indexes tend to be more relevant predictors of forward earnings growth than energy prices alone. This means that a rise in oil prices (were it to occur for idiosyncratic supply reasons) might be positive for major oil producers such as Russia,2 but is unlikely to provide a broad-based catalyst for EM stocks. Table I-1Explanatory Power Of Commodity Price Indexes In Modeling ##br##12-Month Forward Earnings Per Share Growth (2002-2016) Global Equity Allocation: The Underwhelming Case For EM Global Equity Allocation: The Underwhelming Case For EM Finally, our analysis above has focused on the fundamental drivers of EM stocks, and has shown how DM investors are likely to have little basis to be bullish about emerging markets earnings over the coming 6-12 months. Chart I-15 highlights how this is also true about the potential for EM multiple expansion relative to their global peers. The chart shows that periods of relative EM multiple expansion have, like relative earnings expectations, tended to be associated with rising commodities prices, implying that a significant re-rating of EM equities is unlikely over the coming year. This is in addition the fact that EM stocks are neither cheap nor expensive in absolute terms,3 meaning that there is less room for multiple expansion in EM than many investors believe. Chart I-15No Relative Multiple Expansion ##br##Without Rising Commodities Prices No Relative Multiple Expansion Without Rising Commodities Prices No Relative Multiple Expansion Without Rising Commodities Prices Investment Conclusions In terms of gauging the contribution of EM equities to a global equity portfolio, this report has highlighted the following points: While EM stocks had the highest return of any regional equity market during the last economic cycle (2002-2007), this return profile was accompanied by an outsized degree of volatility. For all but the riskiest portfolios, developed commodity markets were preferred as a commodity play over emerging markets. Several compositional changes within the EM equity universe give the outward appearance of much lower commodity exposure, but this exposure has merely become indirect. While EM's weight towards net commodity exporters and resource sectors has declined, this has shifted benchmark exposure to emerging Asia which has significant economic exposure to China and its industrial sector (the dominant driver of global commodities prices). As such, share prices in EM overall and emerging Asia in particular will still be strongly correlated with commodities prices even given the region's significant weight towards the technology sector.4 Cyclical indicators for China's economy suggest that broad commodity price gains over the coming year are likely to be lackluster, at best (and may very well be negative). Even if global oil prices were to rise, this is unlikely to provide a broad-based catalyst for EM stocks if industrial metals prices relapse, as we expect. These conclusions underscore that it is highly unlikely emerging market stocks will sustainably decouple from commodities prices over the cyclical investment horizon, and that the uptrend in EM relative performance since early-2016 has likely been driven significantly by expectations of further China's growth acceleration and commodity gains. In our judgement, these circumstances have created a poor risk/return profile for emerging market equities, justifying an underweight stance within a global equity portfolio over the coming year. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Source: BP Statistical Review of World Energy, June 2017. 2 Note that we recommend an overweight stance towards Russian equities within an EM equity portfolio. 3 Please refer to the Emerging Markets Strategy Weekly Report titled, "EM Equity Valuations Revisited," dated March 29, 2017, link available on page 15. 4 For a further discussion of the impact of the technology sector on the relative performance of emerging market stocks, please see Emerging Markets Strategy Weekly Report titled, "Can Tech Drive EM Stocks Higher?" dated May 17, 2017, link available on page 15.

Highlights Dear Clients, We are publishing a Special Report prepared by my colleague Jonathan LaBerge who examines the case for allocating capital to EM stocks within a global equity portfolio. I hope you will find this report insightful. Best regards, Arthur Budaghyan The relative performance of emerging market equities is challenging the downward trend channel that has been in place for the past seven years. This has led to renewed interest in EM from global investors, and warrants a revisit of the role of emerging market equities within a global equity portfolio. While EM recorded the highest regional equity return last cycle (2002-07), they were surprisingly not the "ideal" regional equity market in an efficient portfolio allocation. Recently, several compositional changes within the EM equity universe give the appearance of much lower commodity exposure than is truly the case. But EM equities will still be correlated with broad commodities prices because the latter reflect Chinese growth dynamics. Cyclical indicators for China's economy suggest that the broad trend in commodities prices is likely to be lackluster over the coming year, at best. Consequently, EM stocks offer a poor risk/return profile, justifying an underweight stance within a global equity portfolio. Feature Chart I-1Change In Trend, Or Another Failed Rally? Change In Trend, Or Another Failed Rally? Change In Trend, Or Another Failed Rally? In U.S. dollar terms, the relative performance of emerging market (EM) stocks has been in an uptrend for over 18 months, and now appears to be challenging the downward trend channel that has been in place for the past seven years (Chart I-1). This has led to a renewed interest in EM, particularly among global investors. This report takes the recent outperformance of EM stocks as an opportunity to revisit their past and future contribution to a global equity portfolio, and what this might mean for an allocation to EM equities over the coming year. We conclude that EM's return behavior during the last economic cycle (2002-2007), its continued link to commodities prices, and China's growth dynamics all contribute to a poor risk/return profile for EM over the coming year. Barring compelling signs of a durable commodity bull market, investors should underweight EM stocks within a global equity portfolio. EM Equities In A Global Context: Some Historical Perspective When examining whether emerging markets are attractive from the perspective of global equity allocation, a starting point is to analyze the fundamental drivers of regional earnings. One major driver of global earnings over the past 20 years has been commodities prices; Chart I-2 highlights how 12-month forward EPS for stocks in all major regions have been correlated with commodities since the late-1990s. Chart I-2ACommodities Prices Are Correlated With Earnings... Commodities Prices Are Correlated With Earnings... Commodities Prices Are Correlated With Earnings... Chart I-2B...Even In Developed Markets ...Even In Developed Markets ...Even In Developed Markets This can be largely explained by the fact that commodities tend to be a pro-cyclical asset class. However, the super cycle in commodities prices in the 2000s not only bolstered the earnings of global resource companies, it also powered earnings growth for export-oriented industrials as well as domestic demand plays in commodity-producing countries. Chart I-3Strong Correlation Between ##br##Commodities And EM Strong Correlation Between Commodities And EM Strong Correlation Between Commodities And EM Emerging markets were among the largest beneficiaries of the commodity boom; net commodity-exporting countries made up roughly 45% of EM market capitalization throughout the last economic cycle, whereas stocks in the resource sector made up between 25-30% of the index by weight. Unsurprisingly, the relative performance of EM stocks closely tracked commodities prices over this period (Chart I-3). But despite this, EM was surprisingly not the "ideal" regional equity market last cycle within an active portfolio, even though it had the highest return. Chart I-4A presents a scatterplot of annualized regional equity volatility and return from 2002 - 2007, measured in US$ terms. The chart also shows the ex-post Modern Portfolio Theory (MPT) efficient frontier, with Chart I-4B presenting the efficient regional allocation at each point along the frontier. Chart I-4AEmerging Market Stocks Had The Highest Return Last Cycle... Global Equity Allocation: The Underwhelming Case For EM Global Equity Allocation: The Underwhelming Case For EM Chart I-4B...But Were Only The Favored Market For High-Risk Portfolios Global Equity Allocation: The Underwhelming Case For EM Global Equity Allocation: The Underwhelming Case For EM Chart I-5From 2002-2007, Earnings Drove More ##br##Of The Rally In DCM Than EM From 2002-2007, Earnings Drove More Of The Rally In DCM Than EM From 2002-2007, Earnings Drove More Of The Rally In DCM Than EM While the charts show that the efficient allocation to emerging market stocks did rise to a maximum of 100% during the last economic cycle, it did not become the dominant region until the portfolio became considerably more volatile than the global equity benchmark. Indeed, Chart I-4B shows that developed commodity markets (DCM) were the preferred commodity play for most of the efficient frontier, owing to their superior performance in risk-adjusted terms. This risk-adjusted outperformance may have occurred because DCM returns last cycle were driven more by earnings than by multiple expansion; Chart I-5 highlights that EM stock prices benefitted from multiple expansion last cycle by outpacing forward earnings, versus the opposite in the case of DCM. Since the onset of the U.S. recession in 2008, Chart I-6A and Chart I-6B highlight that the ex-post efficient portfolio has been much more skewed than during the last economic cycle. The charts show that the frontier since 2008 has been extremely short, with efficient allocations only accruing to three countries with typically defensive stock markets: the U.S., Japan, and Switzerland, with a heavy bias towards the former. From the perspective of a global equity portfolio, this historical review leads to two conclusions: 1) investors should not allocate to EM unless they are bullish on commodities prices and, 2) if investors are bullish towards commodities, developed commodity markets have historically been a better risk-adjusted bet than emerging markets as a commodity play. Chart I-6ASince 2008, The Efficient Frontier Has Been Highly Skewed... Global Equity Allocation: The Underwhelming Case For EM Global Equity Allocation: The Underwhelming Case For EM Chart I-6B...Towards Defensive Markets (Mostly The U.S.) Global Equity Allocation: The Underwhelming Case For EM Global Equity Allocation: The Underwhelming Case For EM Chart I-7These Trends Give The False Appearance ##br##Of Lower EM Commodity Exposure These Trends Give The False Appearance Of Lower EM Commodity Exposure These Trends Give The False Appearance Of Lower EM Commodity Exposure EM And Commodities Prices: Has The Relationship Really Changed? More recently, a narrative has developed in the market that EM stocks are now far less sensitive to commodities prices than used to be the case. Proponents of this theory point to the following changes in the composition of emerging market equity benchmarks: First, the market capitalization weight of net commodity exporting countries has fallen precipitously since the onset of the collapse in oil prices in 2014 (Chart I-7, panel 1). On average, net commodity exporters made up between 40-45% of EM equity market cap from 2000 to 2013, but their share now stands at 27%. Second, Chart I-7, panel 2, shows that the market cap weight of resource sectors (energy plus materials) in emerging markets has fallen from roughly 30% to 14% over the past five years, a trend that pre-dated the decline in the share of net commodity exporters. Third, the enormous rise in the market capitalization of technology companies as a share of total EM market cap has been specifically cited by many market participants (Chart I-7, panel 3), especially since EM is now heavily overweight the tech sector relative to the global average. Broadly speaking, a fourth compositional change within the EM equity benchmark generally captures all of the shifts noted above, and is the focus of our remaining analysis below: the rise in the weight of emerging Asia as a share of overall EM (Chart I-7, panel 4). Among emerging markets, net commodity exporters tend to be located outside of Asia (with the exception of Indonesia and Malaysia), and emerging Asia accounts for essentially all of EM tech market cap. Consequently, investors who argue that EM equities have largely or fully decoupled from commodities prices are essentially arguing that emerging Asian equities are far less affected by changes in commodity markets than they used to be. This idea is deeply flawed, as shown below: Based on export share, Chart I-8 highlights that emerging Asia is far more economically exposed to China than developed markets and EM ex-Asia. While China is gradually becoming more of a services-oriented economy, Chart I-9 highlights that the sum of primary industry (raw material extraction), secondary industry (manufacturing and construction), and real estate services still account for over half of China's economic activity, well above that of industrialized nations such as the U.S. This underscores that emerging Asia's trade exposure to China is fundamentally rooted in economic activity that is closely linked to commodity demand. Chart I-8Emerging Asia Has High ##br##Trade Exposure To China Emerging Asia Has High Trade Exposure To China Emerging Asia Has High Trade Exposure To China Chart I-9Chinese Growth Still Largely ##br##Reflects Industrial Activity Chinese Growth Still Largely Reflects Industrial Activity Chinese Growth Still Largely Reflects Industrial Activity Within the commodity-linked segment of China's economy, Chart I-10 shows that there is little evidence of a weaker relationship between output and commodities prices. Simple regression analysis underscores that the Li Keqiang index, a growth proxy for China's industrial sector, is strongly linked to the year-over-year % change in spot commodities prices since the beginning of the commodity bull market, and that this relationship has in fact been increasing in strength over time. In addition, Chart I-11 underscores that China remains by far the largest consumer of base metals globally. Demand in the global oil market is considerably more diversified than the market for base metals, but China is the second-largest end market for oil (14% of global oil consumption), and accounted for over a quarter of the growth in total oil demand in 2016.1 Chart I-10Moderating Chinese Growth Will ##br##Be Negative For Commodities Moderating Chinese Growth Will Be Negative For Commodities Moderating Chinese Growth Will Be Negative For Commodities Chart I-11China Is By Far The Most Important ##br##End Market For Base Metals China Is By Far The Most Important End Market For Base Metals China Is By Far The Most Important End Market For Base Metals Finally, Chart I-12 shows a regression model between forward earnings expectations for emerging Asia and commodities prices, both at the overall index level and even for the financial sector (which, along with real estate, accounts for almost 25% of emerging Asian market capitalization). The fit for both models is extremely strong and, similar to the increasing strength of the Li Keqiang / commodity price relationship, the chart shows that commodities prices have begun to lead the growth in forward earnings, when the relationship used to be much more coincident. Chart I-12Emerging Asian Earnings Are Strongly ##br##Correlated With Commodities Prices Emerging Asian Earnings Are Strongly Correlated With Commodities Prices Emerging Asian Earnings Are Strongly Correlated With Commodities Prices The bottom line for investors is that Charts I-8-12 show emerging Asian economies are strongly linked economically to China, and that China remains the dominant driver of aggregate commodity demand. This means that while EM stocks may not have as much direct commodity exposure as they used to, they will continue to experience a high correlation with commodities prices because that the latter will be driven by swings in China's business cycle. In brief, Chinese growth fluctuations are instrumental to emerging Asia's economic and equity market performance. This is the rationale behind the very strong link between earnings expectations for emerging Asia and commodities prices: the latter reflect cyclical variations in the Chinese economy. EM Stocks: A Lackluster Bet Given The Outlook For Commodities Our earlier discussion of EM's historical contribution to a global equity portfolio revived elements of Modern Portfolio Theory (MPT), at least from an ex-post perspective. Ex-ante, investors need to make judgements about the likely risk, return, and cross-correlation of an asset when assessing its likely contribution to a diversified portfolio. Regarding the latter factor, Chart I-13 highlights that EM's correlation with global ex-EM has actually fallen quite substantially over the past year, which is a potential argument in the minds of some investors in favor of an increased allocation to EM. When recalling the lessons from Modern Portfolio Theory, most investors tend to focus on the key insight that lowly-correlated assets are valuable from the perspective of constructing a portfolio with an attractive risk/return profile. While this is true, many investors often forget that this is only valid given an expectation of a positive return. The efficient allocation to an asset that has a strongly negative correlation with other assets but has a negative return expectation is basically zero. This means that global investors eying an increased allocation to emerging markets should be squarely focused on EM equities' absolute performance, which as we have highlighted above are likely to be closely linked to commodity returns. Over the coming 6-12 months, Chart I-14 paints an uninspiring picture for commodities prices based on two measures of China's money supply. In turn, interest rates lead money growth and the rise in the former over the past nine months heralds further deceleration in the latter. This implies that the Chinese economy will likely continue to moderate, which is negative for the broad trend in commodities prices. Chart I-13A Significant Decline, But Focus On Return ##br##Expectations, Not Correlation A Significant Decline, But Focus On Return Expectations, Not Correlation A Significant Decline, But Focus On Return Expectations, Not Correlation Chart I-14Interest Rates And Money Growth Paint ##br##A Poor Picture For Commodities Interest Rates And Money Growth Paint A Poor Picture For Commodities Interest Rates And Money Growth Paint A Poor Picture For Commodities As noted above, China's share of the global oil market is much lower than that of base metals, and we do not expect China's oil demand to shrink even if its industrial sector slumps. But from the perspective of allocating to EM equities within a global portfolio, Table I-1 highlights that broad spot commodity price indexes tend to be more relevant predictors of forward earnings growth than energy prices alone. This means that a rise in oil prices (were it to occur for idiosyncratic supply reasons) might be positive for major oil producers such as Russia,2 but is unlikely to provide a broad-based catalyst for EM stocks. Table I-1Explanatory Power Of Commodity Price Indexes In Modeling ##br##12-Month Forward Earnings Per Share Growth (2002-2016) Global Equity Allocation: The Underwhelming Case For EM Global Equity Allocation: The Underwhelming Case For EM Finally, our analysis above has focused on the fundamental drivers of EM stocks, and has shown how DM investors are likely to have little basis to be bullish about emerging markets earnings over the coming 6-12 months. Chart I-15 highlights how this is also true about the potential for EM multiple expansion relative to their global peers. The chart shows that periods of relative EM multiple expansion have, like relative earnings expectations, tended to be associated with rising commodities prices, implying that a significant re-rating of EM equities is unlikely over the coming year. This is in addition the fact that EM stocks are neither cheap nor expensive in absolute terms,3 meaning that there is less room for multiple expansion in EM than many investors believe. Chart I-15No Relative Multiple Expansion ##br##Without Rising Commodities Prices No Relative Multiple Expansion Without Rising Commodities Prices No Relative Multiple Expansion Without Rising Commodities Prices Investment Conclusions In terms of gauging the contribution of EM equities to a global equity portfolio, this report has highlighted the following points: While EM stocks had the highest return of any regional equity market during the last economic cycle (2002-2007), this return profile was accompanied by an outsized degree of volatility. For all but the riskiest portfolios, developed commodity markets were preferred as a commodity play over emerging markets. Several compositional changes within the EM equity universe give the outward appearance of much lower commodity exposure, but this exposure has merely become indirect. While EM's weight towards net commodity exporters and resource sectors has declined, this has shifted benchmark exposure to emerging Asia which has significant economic exposure to China and its industrial sector (the dominant driver of global commodities prices). As such, share prices in EM overall and emerging Asia in particular will still be strongly correlated with commodities prices even given the region's significant weight towards the technology sector.4 Cyclical indicators for China's economy suggest that broad commodity price gains over the coming year are likely to be lackluster, at best (and may very well be negative). Even if global oil prices were to rise, this is unlikely to provide a broad-based catalyst for EM stocks if industrial metals prices relapse, as we expect. These conclusions underscore that it is highly unlikely emerging market stocks will sustainably decouple from commodities prices over the cyclical investment horizon, and that the uptrend in EM relative performance since early-2016 has likely been driven significantly by expectations of further China's growth acceleration and commodity gains. In our judgement, these circumstances have created a poor risk/return profile for emerging market equities, justifying an underweight stance within a global equity portfolio over the coming year. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Source: BP Statistical Review of World Energy, June 2017. 2 Note that we recommend an overweight stance towards Russian equities within an EM equity portfolio. 3 Please refer to the Emerging Markets Strategy Weekly Report titled, "EM Equity Valuations Revisited," dated March 29, 2017, link available on page 15. 4 For a further discussion of the impact of the technology sector on the relative performance of emerging market stocks, please see Emerging Markets Strategy Weekly Report titled, "Can Tech Drive EM Stocks Higher?" dated May 17, 2017, link available on page 15.

Feature Recommended Allocation Monthly Portfolio Update Monthly Portfolio Update When Central Banks Turn Hawkish It seems almost as though, when central bank governors gathered in Portugal for the ECB's annual confab in late June, they agreed to start sounding more hawkish. ECB President Mario Draghi's speech included the line: "The threat of deflation is gone and reflationary forces are at play." Bank of Canada Governor Stephen Poloz went ahead and on July 12 announced Canada's first rate hike in seven years. Indeed, BCA's Central Bank Monitors (Chart 1) suggest that, with the exceptions of Japan and possibly the euro area, all major developed central banks need to tighten monetary policy. Does this matter for risk assets, such as equities? Historical evidence suggests not, as long as the central bank is tightening because it is confident about the outlook for growth and unconcerned about financial risks (rather than, for example, reacting to a sharp rise in inflation). Equity markets typically move up in the early stages of a tightening cycle (Chart 2); it is only when the central bank tightens excessively (usually later in the cycle) that risk assets start to anticipate that this will trigger a recession. Even in the U.S. which, after four rate hikes since December 2015, is the furthest advanced in tightening, the real effective Fed Funds Rate is still -0.3%, below the 0.3% that the Fed believes to be the neutral real rate at the moment (Chart 3). The Fed expects the neutral rate to rise to 1% in the longer run. Chart 1Most Central Banks Need To Tighten Most Central Banks Need To Tighten Most Central Banks Need To Tighten Chart 2Equities Usually Rise During Rate Hike Cycle Equities Usually Rise During Rate Hike Cycle Equities Usually Rise During Rate Hike Cycle Chart 3Fed Policy Is Still Accommodative Fed Policy Is Still Accommodative Fed Policy Is Still Accommodative But the order in which central banks tighten will be a major driver of currencies (as has been clear with the sharp appreciation of the CAD and AUD in recent weeks). Our current asset recommendations are based on the belief that the market has become too complacent about the speed at which the Fed will tighten (with futures pricing only 26 bp of hikes over the next 12 months), and too nervous about the ECB (Chart 4). As the market starts to understand that the Fed has fallen a little behind the curve, and that the ECB will remain cautious (given continuing weakness in peripheral economies, and a lack of underlying inflationary pressures), we expect to see the dollar begin to appreciate again. A key to all this is whether the recent softness in U.S. inflation data (core PCE inflation has fallen from 1.8% YoY to 1.4% since January) proves to be temporary. A rebound in inflation would allow the Fed to continue to hike without bringing the real rate close to the neutral level yet. It is worth remembering that inflation is a lagging indicator: the recent weakness is largely a reflection of last year's soggy GDP growth (Chart 5), as well as some transitory technical factors (particularly drug and wireless data prices). The recent dollar depreciation should also boost inflation via the import price channel over the coming months (Chart 6). Chart 4Markets Views On Fed And ECB Have Diverged Markets Views On Fed And ECB Have Diverged Markets Views On Fed And ECB Have Diverged Chart 5Inflation Lags GDP Growth Inflation Lags GDP Growth Inflation Lags GDP Growth Chart 6Dollar Deprecation Will Raise Prices Dollar Deprecation Will Raise Prices Dollar Deprecation Will Raise Prices However, with global equities having produced a total return of 35% since their recent bottom in February last year, and 17% year to date, valuations are unattractive and, on some measures, sentiment is quite optimistic (Chart 7). What catalysts are there left to give risk assets further upside? We see two. First, earnings. The Q2 U.S. results season has seen 77% of S&P 500 companies surprising on the upside at the sales line, with EPS rising 7% compared to the same quarter in 2016. Most of our indicators suggest that earnings have further to rise this year (Chart 8), yet the consensus EPS forecast for 2017 as a whole remains at just over 10%, where it has been since January. Strong earnings momentum is likely to remain a positive at least through the end of the year. Second, tax cuts. Our Geopolitical Strategy service1 remains optimistic that the U.S. Congress will pass tax legislation to come into effect in early 2018. The failure to repeal Obamacare means that the Republican Party will need a big legislative win going into the mid-term elections in November 2017. Tax cuts (which the market is no longer pricing in - Chart 9) is one policy on which there is little disagreement within the GOP. Chart 7Are Investors Getting Too Optimistic? Are Investors Getting Too Optimistic? Are Investors Getting Too Optimistic? Chart 8Earnings Can Still Surprise On Upside Earnings Can Still Surprise On Upside Earnings Can Still Surprise On Upside Chart 9No One Expects Tax Cuts Any More No One Expects Tax Cuts Any More No One Expects Tax Cuts Any More None of the recession indicators we highlighted in our most recent Quarterly 2 (global PMIs, the shape of the yield curve, or credit spreads) are pointing to a downturn in the next 12 months. So, given the environment described above, we are happy to remain overweight equities versus bonds, and to maintain our pro-risk and pro-cyclical tilts. But we continue to warn of the risk of a recession in 2019 - probably triggered by the Fed needing to tighten more aggressively - and might look to lower our risk profile in the first half of next year. Equities: We favor DM equities over EM. An appreciating dollar, rising interest rates, weak industrial metals prices this year and uncertain growth prospects for China all represent headwinds for EM equities. Our strong dollar view points to an overweight in U.S. equities in USD terms but, in local currencies, our preference is for euro area and Japanese equities. Both are relatively high-beta, have strongly cyclical earnings momentum, and central banks that are likely to stay dovish. In Japan, the falling popularity rating of the Abe administration might compel it to ramp up fiscal spending to boost the economy, which would help the Bank of Japan in its efforts to rekindle inflation. Chart 10Everyone Has Turned Bullish On The Euro Everyone Has Turned Bullish On The Euro Everyone Has Turned Bullish On The Euro Fixed Income: Our macro outlook, with faster rate hikes and rebounding inflation in the U.S., is very negative for rates. We are underweight government bonds, short duration and prefer inflation-linked bonds to nominal ones. Valuations in credit are no longer particularly attractive but, with a 100 bp spread for U.S. investment grade bonds and a 230 bp default-adjusted spread for high-yield, returns are likely to be satisfactory as long as the economic cycle continues to improve. Currencies: Our fundamental view of the dollar is that relative monetary policy and interest rates point to further appreciation, especially against the yen and euro. The timing of the dollar's rebound, though, is harder to pinpoint. The euro could rise further over the next couple of months. However, given speculators' large net long positions in the euro - a big turnaround from the start of the year (Chart 10) - the likely announcement by the ECB in September or October of a reduction in its asset purchases might be the catalyst for a reversal (as a classic "buy the news, sell the rumor" event), particularly if Mario Draghi dresses it up as a "dovish tapering." Commodities: Oil inventories have begun to draw down in line with our expectations (Chart 11). Continued discipline by OPEC producers until next March, combined with a slowdown in the growth of U.S. shale production (reflecting the weaker crude price this year) should bring inventories down further (despite production increases in such countries as Libya and Iran), and push the price of WTI above $55 a barrel by year end. Industrial commodity prices have rebounded somewhat in the past six weeks, mainly on the back of moderately brighter economic data out of China (Chart 12). But, given uncertain prospects about the sustainability of this growth, especially beyond the Communist Party Congress in the fall, and amid some signs of weakness in Chinese monetary and credit aggregates,3 we remain cautious about the outlook for metals prices over the next 12 months. Chart 11Oil Inventories Will Draw Down Further in Oil Inventories Will Draw Down Further in Oil Inventories Will Draw Down Further in Chart 12Tick-Up In Chinese Data? Tick-Up In Chinese Data? Tick-Up In Chinese Data? Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bca.research.com. 2 Please see BCA Global Asset Allocation, "Quarterly Portfolio Review," dated July 3, 2107, available at gaa.bcaresearch.com. 3 Please see BCA Emerging Markets Strategy Weekly Report, "Follow The Money, Not The Crowd," dated July 26, 2017, available at ems.bcaresearch.com. Recommended Asset Allocation

Highlights Strengthening income growth is apparent in DM and EM trade volumes, real wages in the U.S., and industrial commodity prices, chiefly oil and copper. This indicates inflation at the consumer level will move higher in the near future, most likely in 2H2018. We believe 10-year U.S. Treasury Inflation-Indexed securities (TIPS) trading below 0.52 do not reflect the risk of higher inflation and are, therefore, going long at tonight's close. Energy: Overweight. Crude oil prices rallied 4.6% this week, following the OPEC 2.0 meeting in St. Petersburg. Although ministers did not announce additional cuts to the 1.8mm b/d agreed at the end of last year, Saudi Energy Minister Khalid al-Falih said the Kingdom would reduce August exports to 6.6mm b/d, which is more than 300k b/d below May's level, the latest month for which data are available from JODI. Given strong global demand, if this export reduction persists - and if others join the Kingdom - it would speed the drawdown in global inventories. Base Metals: Neutral. Copper pushed through $2.80/lb on the COMEX, a level not seen since May 2015. Underlying strength in EM economic activity - seen most recently in global trading activity (discussed below) - and a weaker USD are supporting base metals. Precious Metals: Neutral. Gold fell below $1,257/oz earlier this week, and was trading ~ $1,250/oz going to press Wednesday. We remain long gold as a portfolio hedge; the position is up 1.7% since it was initiated on May 4, 2017. Ags/Softs: Underweight. Harsh weather is impacting grains. The USDA rated 62% of the U.S. corn crop in the 18 states comprising 92% of total output good or excellent last week, down from 76% in 2016. For beans, the split was 58% last week vs. 71% last year. Feature The expansion in global trade that began toward the end of last year continues, which, based on our modeling, indicates inflation at the consumer level likely will move higher in the short run (Chart of the Week). Trade expansion, particularly in EM economies, is consistent with rising incomes, which, all else equal, will keep industrial commodities - oil and copper, in particular - well supported, given income and demand for these commodities are closely aligned.1 These fundamentals dovetail with other indications of stronger growth, particularly in DM economies, where trade volumes also are growing (Chart 2). In the U.S., for example, wage growth continues to outpace inflation, and monetary conditions remain benign (Chart 3). Our colleagues at BCA Research's Global Investment Strategy believe the Fed actually may be behind the curve in reacting to nascent inflationary pressures emerging in the U.S.2 Chart of the WeekRising EM Trade Volumes Consistent##BR##With Higher U.S. CPI Inflation Rising EM Trade Volumes Consistent With Higher U.S. CPI Inflation Rising EM Trade Volumes Consistent With Higher U.S. CPI Inflation Chart 2DM Trade Volumes Are Expanding##BR##At ~ 5% Pace ... DM Trade Volumes Are Expanding At ~ 5% Pace ... DM Trade Volumes Are Expanding At ~ 5% Pace ... Chart 3U.S. Labor Market Tightening,##BR##Financial Conditions Remain Loose U.S. Labor Market Tightening, Financial Conditions Remain Loose U.S. Labor Market Tightening, Financial Conditions Remain Loose Trade Growth Supports Higher Inflation U.S. CPI is highly correlated with EM trade volumes (imports and exports) as shown in the Chart of the Week. In recent research into inflation and trade, we also showed EM oil demand and world base metals demand are highly correlated with EM trade volumes.3 Chart 4EM Trade Volumes##BR##Continue To Strengthen Growth EM Trade Volumes Continue To Strengthen Growth EM Trade Volumes Continue To Strengthen Growth EM import growth continues to expand at a faster pace than DM growth (Chart 4). Year-on-year (yoy) EM import growth came in at 7.7%, a full 2 percentage points above DM growth. This is not to minimize DM growth - it finally broke out of its lethargy in May with a sharp advance of close to 6%, which will lift the trend rate of growth (the 12-month moving average, or 12mma) higher going forward. EM export growth in May was only slightly above DM growth for the month - 5.4% yoy vs. 5.2% yoy. These stout monthly trade performances will, in the next few months, offset the lethargic growth seen in EM and DM prior to the expansion begun at the end of 2016, as weaker monthly performance falls off the trend calculations. Over the year ended in May, within EM markets the annual trend in imports (the 12mma to May 2017) has barely grown more than 1% yoy, dragged down by a 6% contraction in the Middle East and Africa (MEA) and a 2.1% contraction in Latin American growth. The trend in EM - Asia's imports is up, rising 3.2% over the same period. For the year ended in May, imports into central and Eastern Europe were mostly flat; however, since November 2016, the trend turned sharply positive with 3.3% yoy growth. The trend in export volumes is expanding for in MEA and Latin America economies - 3.5% yoy trend growth (12mma) in MEA, and 4.4% growth in Latin America, which is slightly higher than the overall 2.2% rate of trend growth in EM exports. Still, lower oil and commodity prices, along with reduced volumes are curtailing an income recovery in these regions. Central and Eastern Europe's rate of export expansion leads EM generally at close to 4% yoy trend growth. Favor Gold And TIPS Ahead Of Higher Inflation As the labor market tightens and real-wage growth continues to outpace productivity growth, we expect U.S. inflation to pick up. Growth in trade volumes also will support growth in EM oil demand and world base metal demand, as noted above. This will feed into U.S. core PCE, the Fed's preferred inflation gauge (Chart 5). As we've highlighted in the past, there is very strong co-movement among these variables: We've found that, all else equal, a 1% increase in the non-OECD oil demand implies an increase in the core PCE of slightly less than 50bp. If the trend in overall EM trade volumes persists, the likelihood we will be increasing our estimate of non-OECD oil consumption for 2H17 and 2018 increases. U.S. CPI and EM trade volumes show similar co-movement properties, as the Chart of the Week shows. A 1% increase in EM import volumes translates into a 0.53% increase in the U.S. CPI, while a 1% increase in EM export volumes implies a 0.49% increase in the CPI. EM import volumes over the January - May 2017 interval have been growing at slightly more than 8% yoy, while exports have been growing at slightly more than 3%. Continued strength in the EM trade data implies U.S. CPI could grow well above what's currently being priced in inflation markets and by Fed policymakers. This leads us to favour gold and TIPS as inflation hedges. If we do get a larger-than-expected move in the U.S. CPI, gold should respond well. The modelling depicted in Chart 6 shows a 1% increase in the CPI translates into a 4.1% increase in gold. Chart 5Core PCE Will Pick Up##BR##As Commodity Demand Grows Core PCE Will Pick Up As Commodity Demand Grows Core PCE Will Pick Up As Commodity Demand Grows Chart 6Gold Will Pick Up##BR##Larger-Than-Expected CPI Moves Gold Will Pick Up Larger-Than-Expected CPI Moves Gold Will Pick Up Larger-Than-Expected CPI Moves For this reason we recommend getting long U.S. Treasury Inflation-Protected Securities (TIPS), which will appreciate as the U.S. CPI moves higher.4 We will be getting long as of tonight's close. We remain long low-risk calls spreads in Dec/17 WTI and Brent - long $50/bbl strikes vs. short $55/bbl strikes. We are up 39.3% and 32.9% on the Brent and WTI positions, respectively, from last week, and 47.2% and 89.2% since inception. U.S. Monetary Policy Remains A Huge Risk To EM Trade As we've noted in the past, U.S. monetary policy can have an outsized effect on EM trade volumes. In an update of an earlier model using U.S. M2 and the broad trade-weighted USD (TWIB), we find a 1% increase in the broad trade-weighted USD translates into a 1.1% drop in EM imports, while a 1% increase in U.S. M2 (broad money) implies an 85bp increase in EM imports (Chart 7).5 Chart 7EM Trade Volumes Highly Sensitive##BR##To U.S. Monetary Policy EM Trade Volumes Highly Sensitive To U.S. Monetary Policy EM Trade Volumes Highly Sensitive To U.S. Monetary Policy This demonstrates the feedback loop we've identified between U.S. monetary policy and EM trade. EM trade volumes affect inflation at a global level. We've found inflation in the U.S., EU and China to be co-integrated - i.e., these price gauges all follow the same long-term trend. Inflation and inflation expectations drive Fed policy, which drives the price formation of the USD - i.e., the FX rates included in the USD TWIB - and affect Fed policy on M2. These U.S. monetary variables, in turn, affect EM trade volumes. And so it goes ... Too-aggressive a tightening by the Fed as it normalizes its interest-rate policy regime could destabilize EM economies - either via too-sharp an appreciation in the USD TWIB, a larger-than-expected deceleration in M2 growth, or both - and negatively affect trade flows. At the end of the day, this would redound to the detriment of the U.S. economy, as the different feedback mechanisms kick in. This says the Fed's policy doesn't just affect the U.S. economy, or that EM economies essentially are on their own in the policy tools they deploy to adjust to Fed innovations. Like it or not, the Fed has to consider these types of feedback loops in its decision-making, since the Open Market Committee will be dealing with the fallout of its earlier policies. Bottom Line: EM trade volumes continue to grow yoy, continuing the trend that began at the end of last year. This performance, coupled with a tightening labor market in the U.S. and a still-loose financial backdrop, raises the odds inflation will exceed what's currently priced into market and Fed expectations. We are getting long U.S. 10-year TIPS at tonight's close, and remain long gold as a strategic portfolio hedge. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 The income elasticity for industrial commodities in EM economies is ~ 1.0, according to the OECD. Please see "The Price of Oil - Will It Start Rising Again?" OECD Economics Department Working Paper No. 1031, p. 6 (2013). 2 Please see BCA's Global Investment Strategy Weekly Report titled "Are Central Banks Behind The Curve Or Ahead Of It?," published on July 21, 2017. It is available at gis.bcaresearch.com. Among other things, the Global Investment Strategy team notes labor-market slack is dissipating, real wages are increasing, and easier financial conditions are spurring credit growth. Our colleagues note, "The prospect of stronger growth over the next few quarters implies that the unemployment rate is likely to fall below 4% early next year, possibly breaking through the 2000 low of 3.8%." BCA's Global Investment Strategy believes U.S. inflation could move higher by 2H18. 3 Please see BCA Commodity & Energy Strategy Weekly Reports titled "EM Trade Volumes Continue Trending Higher, Supporting Metals" and "Strong EM Trade Volumes Will Support Oil," published June 29, and June 8, 2017. Both are available at ces.bcaresearch.com. 4 U.S. TIPS increase in value as the Consumer Price Index (CPI) rises, and fall in value as the index declines. Please see "TIPS: Rates & Terms" on the UST's TreasuryDirect web page (https://www.treasurydirect.gov/indiv/research/indepth/tips/res_tips_rates.htm). 5 This model covers 2000 to the present, using monthly data. The R2 for the cointegrating regression is 0.96. These variables do not explain EM exports, which are not cointegrated with U.S. monetary variables. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade And Commodity Data Point To Higher Inflation Trade And Commodity Data Point To Higher Inflation Commodity Prices and Plays Reference Table Trade And Commodity Data Point To Higher Inflation Trade And Commodity Data Point To Higher Inflation Trades Closed in 2017 Summary of Trades Closed in 2016