Commodities & Energy Sector

Highlights Portfolio Strategy Operating leverage could surprise on the strong side this year, based on the message from our pricing power and wage growth indicators. REITs are experiencing a playable recovery following the Fed-induced sell-off earlier this year, and overweight positions will continue to pay off. Energy services activity is set to steadily accelerate this year, powering an earnings-led share price outperformance phase. Recent Changes There are no changes to our portfolio this week. Table 1 Operating Leverage To The Rescue? Operating Leverage To The Rescue? Feature Volatility has climbed to the highest level since the U.S. election, signaling that the broad market is not yet out of the woods. As stocks recalibrate to a cooling in economic growth momentum and an escalation in geopolitical threats, downside risks should be reasonably contained by mounting signs of a healthier corporate sector. Last week we posited that stronger top line revenue growth is necessary to sustain the profit upcycle, and provide justification for historically rich valuations. Chart 1 shows sales and EPS growth over the long-term. Chart 1Joined At The Hip Joined At The Hip Joined At The Hip Obviously, the two move closely together, with earnings enjoying more powerful growth phases when revenue accelerates. Since 1960, regression analysis shows that operating leverage for the S&P 500's is 1.4X. In other words, a 5% increase in sales growth typically leads to 7% EPS growth. When sales are initially recovering from a deep slump operating leverage can be even higher, with earnings often rising two to three times as fast as revenue. Clearly, that is not sustainable, but can give the illusion of powerful and sustained growth for brief periods of time. At the current juncture, there are reasons to expect investors to embrace the durability of the profit expansion. Our corporate pricing power proxy has vaulted higher. Importantly, the breadth of this surge has been impressive, which bodes well for its staying power (Chart 2, second panel). On the flip side, rising labor costs look set to take a breather. Compensation growth has crested, and according to our diffusion index, fewer than half of the 18 industries tracked have higher wages than last year. The wage growth diffusion index provides a reliable leading indication for the trend in labor expenses. In other words, pricing power is rising on a broad basis while wage inflation is decelerating on a broad basis. Consequently, there are decent odds that resilient forward operating margin expectations can be matched (Chart 2, bottom panel). Elsewhere, a revival in animal spirits, the potential for easier fiscal policy and prospects for a hiatus in the U.S. dollar bull market bode well for brisk business activity. While the budding recovery in global trade could sputter if protectionism proliferates, our working assumption is that the U.S. Administrations' bark will be worse than its bite. Thus, a self-reinforcing sales and profit upcycle could be materializing. The objective message from our S&P 500 EPS model concurs (Chart 3), underscoring that high single digit/low double digit profit growth could be broadly perceived as attainable this year. Chart 2Profit Margins Can Expand Profit Margins Can Expand Profit Margins Can Expand Chart 3Few Sectors Control The Fate Of S&P 500 EPS Few Sectors Control The Fate Of S&P500 EPS Few Sectors Control The Fate Of S&P500 EPS True, our model has recently shown tentative signs of cresting, but difficult comparisons will only arise later this year. Indeed, Q3 and Q4 2016 were all-time high EPS numbers, implying that 12% estimated growth rates are a tall order (Chart 3, middle panel). Importantly, dissecting the profit growth sectorial contribution is instructive. Calendar 2017 over 2016 S&P 500 earnings growth is concentrated in four sectors: tech, energy, health care and financials comprise over 87% of the incremental profit growth expected (Chart 3, bottom panel). The upshot is that there is a high degree of concentration risk to fulfilling overall profit growth expectations. Energy profits are wholly dependent on the oil price, and financial sector profit optimism appears to have embedded a healthy increase in both interest rates and capital markets activity. In addition, tech sector earnings are heavily influenced by the U.S. dollar. Consequently, it will be critical for monetary conditions to stay loose, otherwise estimates will be at risk of downward revisions. Adding it up, the corporate sector sales pendulum is finally swinging in a positive direction, which should support the cyclical overshoot in stocks for a while longer, notwithstanding our expectation that the current corrective phase has further to run. This week we are updating our high-conviction overweight views on both the lagging energy services index and REIT sector. Revisiting REITs REITs have staged a mini V-shaped rebound after being punished alongside rising bond yields and worries about aggressive Fed rate hikes earlier this year. As outlined in recent Weekly Reports, the reflation theme is likely to lose steam in the second half of the year as economic momentum cools, providing additional impetus for capital inflows into the more stable income profile of REITs. Even if the economy proves more resilient and Treasury yields move higher, there are few barriers to additional outperformance. Our Technical Indicator, a combination of rates of change and moving average divergences, is extremely oversold. Forward intermediate and cyclical relative returns from current readings have been solid, as occurred in 2004, 2008 and 2014 (Chart 4). REIT valuations are more than one standard deviation below normal, according to our gauge. This suggests that poor operating performance and/or higher discount rates are already expected. There may be a limit as to how high bond yields can climb, given that they are already deep in undervalued territory according to the BCA 10-year Treasury Bond Valuation Index (Chart 4). Regardless, history shows that REITs have typically had a more positive than negative correlation with bond yields. The inverse correlation has only been in place since the financial crisis, when zero interest rate policies pushed massive capital flows into all yield generating assets. Chart 5 shows that prior to 2008, REITs outperformed during periods of both rising and falling Treasury yields. Chart 4Unloved And Undervalued Unloved And Undervalued Unloved And Undervalued Chart 5No Concrete Correlation Pre GFC No Concrete Correlation Pre GFC No Concrete Correlation Pre GFC Similarly, REITs have a solid track record during periods of rising inflation pressures. Since 1975, there have been six periods of rising core PCE inflation: REITs have enjoyed meaningful rallies during five of these phases (Chart 6). Hard assets tend to hold their stock market value well when overall inflation moves higher, with REIT net asset values providing solid support to share price performance. Chart 6Buy REITs In Times Of Inflation Buy REITs In Times Of Inflation Buy REITs In Times Of Inflation Looking ahead, REITs should continue to enjoy success in boosting rental rates. Occupancy rates continue to rise (Chart 7). The unemployment rate is low, consumption is decent and businesses are growing increasingly confident. That is a recipe for higher rental demand. Our Rental Rate Composite has crested on a growth rate basis, but the advance in the CPI for homeowner's equivalent rent, a good proxy for REITs, suggests that the path of least resistance remains higher (Chart 7). REIT supply growth has also leveled off, which provides additional confidence that rental inflation will remain solid. Nevertheless, there are some areas of concern. Banks are tightening lending standards on commercial real estate loans. Some sub-categories are experiencing a mild deterioration in credit quality. For instance, Chart 8 shows that delinquency rates in the retail and office spaces have edged higher. Retail and mall REITs are likely under structural pressure owing to online competition from the likes of Amazon. Chart 7Rental Demand##br## Is Solid Rental Demand Is Solid Rental Demand Is Solid Chart 8Watch Delinquencies As ##br##Banks Tighten Credit Standards Watch Delinquencies As Banks Tighten Credit Standards Watch Delinquencies As Banks Tighten Credit Standards Overall vacancy rates are still very low (Chart 8), but if credit becomes too tight, then the relentless advance in commercial property prices may cool. For now, our REIT Demand Indicator is not signaling any imminent stress. In fact, the economy is strong enough to expect occupancy rates to keep climbing, to the benefit of underlying property valuations and rental income (Chart 7, bottom panel). In sum, the budding rebound in REIT relative performance should be embraced as the start of a sustained trend. Total return potential is very attractive on a relative basis. Bottom Line: REITs remain a very attractive high-conviction overweight. Energy Servicers Are Cleaning Up Their Act We put the S&P energy services index on our high-conviction overweight list at the start of the year, because three critical factors that typically lead to a playable rally existed, namely; the global rig count had hit an inflection point, oil supplies were easing and global oil production growth had begun to decelerate. While the pullback in oil prices has undermined relative performance for the time being, there is scope for a full recovery, and more. Oil prices have firmed, underpinned by a revival in the geopolitical risk premium following the U.S. bombing campaign in Syria. There is already a wide gap between share prices and oil prices (Chart 9, top panel), and a narrowing is probable, especially as earnings drivers reaccelerate. There are tentative signs that capital spending cuts are finally reversing. The global rig count has rebounded, and is a good leading indicator for investment (Chart 10). This message is corroborated by our Global Capex Indicator, which has recently surged anew (Chart 10). Chart 9Room For ##br##Margin Improvement... Room For Margin Improvement... Room For Margin Improvement... Chart 10...As Deflation Eases ##br##And Capex Rebounds ...As Deflation Eases And Capex Rebounds ...As Deflation Eases And Capex Rebounds The longer that oil prices can stay in their current trading range, or beyond, the more time E&P balance sheets have to heal and the greater the odds that the cost of capital will be reduced. Against this backdrop, there are high odds that previously mothballed exploration projects will be restored. The V-shaped recovery in the global oil rig count, albeit from a very low base, will eventually absorb excess capacity and allow the industry to escape deflation. A major improvement in day rates is unlikely given the scale of the previous capacity boom, but even a modest pricing power improvement should provide a nice boost given high operating leverage. EBITDA margins have considerable room to improve if pricing power grows anew (Chart 9, bottom panel). Importantly, the shifting composition of global production will allow service companies with domestic exposure to shine. Shale oil producers should recapture lost market share, given that the onus to rebalance markets has been taken on by OPEC. OPEC production is contracting, while non-OPEC output is starting to recover (Chart 11, bottom panel), culminating in a widening in the Brent-WTI oil price spread. Production restraint is helping to rebalance physical oil markets. Total OECD inventory growth is reversing, and anecdotal reports are surfacing that floating storage is rapidly being depleted. Oil supply at Cushing is on the cusp of contracting, which is notable given that this has had a high correlation with relative share price performance for the past decade (oil supply shown inverted, Chart 11). On a global basis, global inventory drawdowns have been correlated with a firming industry relative profitability, and vice versa. OECD oil supply growth is rapidly receding, which augurs well for an extension of budding earnings outperformance (Chart 12, middle panel). Chart 11Receding Inventories ##br##Should Boost Performance... Receding Inventories Should Boost Performance… Receding Inventories Should Boost Performance… Chart 12...EPS And##br## Valuations ...EPS And Valuations ...EPS And Valuations The rise in clean tanker rates reinforces that oil demand is rising quickly enough to expect additional inventory depletion (Chart 12, bottom panel). Typically, tanker rates and energy service relative valuations are positively correlated. Adding it up, a rising global rig count, decelerating inventories and restrained oil production continue to bode well for a playable rally in the high-beta S&P energy services group. Bottom Line: We reiterate our high-conviction overweight stance in the S&P energy services index. The ticker symbols for the stocks in this index are: BLBG: S5ENRE - SLB, HAL, BHI, NOV, FTI, HP, RIG. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights This week, we provide one of our occasional updates on Commodities as an Asset class (CAAC), examining the strategic case for getting long commodity index exposure. Commodity index exposure is more highly correlated with inflation than equities or bond exposure, indicating commodities - and real assets generally - provide a better hedge against inflation than financial assets. A pure investment case for getting long broad commodity index exposure can be made if backwardation is expected in one or more of the components of a given index. Given our expectation for higher inflation, and our positioning for backwardation in the oil market, we recommend getting long the energy-heavy S&P GSCI index as a strategic portfolio position. Energy: Overweight. Deeper-than-expected production cuts from OPEC were reported by Reuters Tuesday, suggesting Cartel members are at 104% of pledged output reductions.1 Our $50/bbl vs. $55/bbl WTI calls spreads in Jul-Aug-Sep settled at an average of $3.06/bbl, and we are taking profits of 76.9%, per the upside $3.00/bbl stop we established for these positions on March 23/17. We also are taking profits on our Dec/17 vs. Dec/18 WTI backwardation trade basis tonight's close, after registering a gain of more than 700% when we marked to market earlier this week. We are keeping our long Dec/17 vs. short Dec/18 Brent backwardation spread open; it is up 426.3% since we recommended it on March 23/17. We are recommending a strategic long position in the energy-heavy S&P GSCI basis today's close. Given this commodity index's overweight to oil and refined products, we believe price appreciation will offset negative roll returns until crude markets go into backwardation later this year. We expect WTI and Brent to trade on either side of $60/bbl by year end. Base Metals: Neutral. Workers at Southern Copper's Toquepala and Cuajone mines struck Monday seeking higher wages and improved working conditions, according to Metal Report. Front-line copper on the COMEX has been chopping between ~ $2.50/lb and $2.70/lb since the beginning of the year through multiple strike actions. Precious Metals: Neutral. Gold rallied slightly, but our long volatility play still is down 14.7%. Markets do not appear to be overly concerned with Fed actions over the next couple of months. Feature There's a long-standing argument among equities investors as to whether they trade the stock market or a market of stocks. In the case of the former, getting long index exposure makes sense. In the case of the latter, stock pickers sensitive to the idiosyncratic risk of individual equities outperform the broad-exposure devotees. Sometimes, both are right at the same time. Commodities are no different. There are times when broad exposure to commodities is warranted - e.g., in the early stages of a global industrial rebound or when investors expect higher inflation. However, there are periods in which sensitivity to idiosyncratic risk reflecting different fundamental states for each market works best. And, as is the case with equities, there are times when both points of view can co-exist without contradiction. The relative performance of commodities vs. equities post-Global Financial Crisis (GFC) leaves much to be desired (Chart 1A and Chart 1B). The re-balancing of commodities generally, led by crude oil, but apparent in key base metals like copper, suggests the overall commodity down-cycle - with the exception of ags - has leveled out. Fundamentals - supply, demand and inventories - will be far more important for commodities going forward, particularly as the Fed pursues its rates-normalization policy and markets are slowly weaned off the excessive monetary accommodation they've seen in the post-GFC period. Chart 1ACommodities Were Competitive Pre-GFC, ##br##Post-GFC Underperformance Will Reverse Commodities Were Competitive Pre-GFC, Post-GFC Underperformance Will Reverse Commodities Were Competitive Pre-GFC, Post-GFC Underperformance Will Reverse Chart 1BCommodities Were Competitive Pre-GFC, ##br##Post-GFC Underperformance Will Reverse Commodities Were Competitive Pre-GFC, Post-GFC Underperformance Will Reverse Commodities Were Competitive Pre-GFC, Post-GFC Underperformance Will Reverse There are two global-macro considerations driving our expectation commodities will outperform the other major asset classes going forward, which we consider below. First, consistent with our House view and recent analysis from our Global Fixed Income Strategy (GFIS) service, we expect higher inflation, which already is being reflected in the forward CPI swaps markets. This could be exacerbated if oil supplies tighten on the back of massive capex cuts following the 2015 - 16 oil-price collapse, and if U.S. fiscal stimulus overheats an economy that already is at or near full capacity and full employment. Second, backwardation in crude oil markets will be a positive development for commodity index products generally, and the energy-heavy S&P GSCI in particular. Together, these fundamentals will provide investors portfolio diversification via non-correlated returns vis-à-vis the other asset classes. Higher Inflation Expectations Support Commodity Index Exposure We have been highlighting the inflationary "tail risks" in commodity markets for a number of months. These include the possibility of 1) higher oil prices after 2018, following the more-than-$1 trillion cuts in oil-and-gas capex in the wake of the 2015 - 16 oil price collapse; and 2) a large injection of fiscal stimulus to the U.S. economy from the Republican-controlled U.S. Congress working with President Trump's White House. The fiscal stimulus could become material next year, revving an economy that is at or near full employment and an output gap at or close to being closed.2 Our colleagues on BCA's GFIS desk note, "underlying U.S. inflation pressures remain strong, particularly given the evidence that conditions in the labor market are getting progressively tighter." While inflationary forces are a bit more subdued in Europe and Japan, our colleagues continue to favor being long CPI swaps in both markets (Chart 2).3 BCA's GFIS expects inflation expectations to rise to a level of ~ 2.5% p.a. on 10-year TIPS breakevens, which are priced off the CPI index. If markets do raise the odds of higher inflation over the medium term, it most likely will continue to show up in the 5-year 5-year (5y5y) CPI Swaps in the U.S. and Europe, which we have found to be cointegrated with 3-year forward WTI futures (Chart 3). The oil market will be especially sensitive to the supply-demand balances after 2018, and will move higher if it senses a supply squeeze from too-little investment in production following the massive cuts to supply-side capex. This will feed into the 5y5y CPI swaps markets, which, in turn, will drive TIPS yields higher. Chart 2Early Days Yet, But ##br##U.S. Inflation Pressures Are Building Early Days Yet, But U.S. Inflation Pressures Are Building Early Days Yet, But U.S. Inflation Pressures Are Building Chart 3Watch 3-Year Forward WTI Futures ##br##For Early Signs Of Higher Inflation Watch 3-Year Forward WTI Futures For Early Signs Of Higher Inflation Watch 3-Year Forward WTI Futures For Early Signs Of Higher Inflation Apart from active commodity positioning, commodity index exposure offers better inflation risk coverage than equities or bonds, as can be seen in Table 1.4 Chart 4 shows the out-performance of the commodity indices, the S&P GSCI in particular, in higher-inflation environments. Table 1Correlations Between Real And Financial Assets CAAC: Time To Get Long Commodity Index Exposure CAAC: Time To Get Long Commodity Index Exposure Our own modeling supports the academic findings. When we estimated the yoy S&P GSCI returns as a function of U.S. CPI yoy changes and the difference between 1st-nearby WTI futures (CL1) and 12th nearby WTI futures (CL12), we found this specification explained just over 84% of the commodity index's annual returns. Our model indicates the S&P GSCI can be expected to increase in value by close to 15bp for every 1% increase in U.S. CPI (Chart 5). This energy-heavy index - crude oil and refined products comprise more than half of the S&P GSCI - performs much better than the more evenly disbursed Bloomberg Commodity Index (BCI) as an inflation hedge. Chart 4Commodities Outperform In##br## Inflationary Markets Commodities Outperform In Inflationary Markets Commodities Outperform In Inflationary Markets Chart 5S&P GSCI Index Exposure ##br##Moves With Inflation S&P GSCI Index Exposure Moves With Inflation S&P GSCI Index Exposure Moves With Inflation Profiting From Backwardation Long-only commodity index products generate returns from three sources: Price appreciation; roll yield - the returns generated by selling and replacing futures contracts approaching their terminal trading date (the expiring contract in the index is sold and replaced by a contract with a deferred delivery); and on the collateral posted to carry positions. An investor with a strong view on prices can express it by getting long or short futures. When an investor wants to express a view on the structure of the market - chiefly the shape of the forward curve and whether it will be backwardated (prompt delivery costs more than deferred delivery), or in contango (prompt delivery costs less than deferred delivery) - they can do so either by trading spreads (buying prompt-delivered contracts vs. selling deferred-delivered contracts, and vice versa) or getting long commodity-index exposure such as the S&P GSCI or Bloomberg Commodity Index (BCI). Typically, long-only commodity-index products largest returns are generated via price appreciation and roll yield, which simply are returns generated by "rolling" the underlying futures contracts in the index as these contracts approach the termination of trading to a deferred month. In a backwardated market, prompt-delivered contracts are sold and replaced with lower-cost contracts. In contango markets the opposite occurs. Indexes with heavy concentrations in futures that are likely to be backwardated for a length of time are preferred to indexes with futures that, on a fundamental basis, are more likely to have a flat or contango term structure. We have been positioning for a backwardation in crude oil later this year for some time. We continue to expect backwardation in crude oil markets, and remain long Dec/17 Brent vs. short Dec/18 Brent to express this view. Given the very high concentration of energy exposure in the S&P GSCI index - more than half of the index is crude oil or refined products, according to S&P - this index is best-suited, in our estimation, to benefit from a backwardated oil market.5 Indeed, our modeling, shown in Chart 5, supports our view that backwardation would significantly boost performance in the S&P GSCI index: A 1% increase in the spread between 1st-nearby WTI vs. 12th-nearby WTI contracts likely would translate into gain in the index of slightly more than 1.14%. Bottom Line: We expect higher inflation and backwardation in the oil market later this year. For this reason, we are recommending a long exposure in the energy-heavy S&P GSCI index. Commodities outperform equities and bonds in inflationary markets. In addition, this index's overweight to crude oil and refined products suggests it will outperform when markets backwardate. Given we expect WTI and Brent prices to trade on either side of $60/bbl later this year, we believe price appreciation will offset minor roll-yield losses until markets backwardate. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "Exclusive: OPEC futures show oil output cuts exceed pledge in March - sources" published by Reuters.com on April 11, 2017. 2 Please see issue of BCA Research's Commodity & Energy Strategy Weekly Report "Gold's 'Known Unknowns' And Fat Tails," dated February 23, 2017, available at ces.bcaresearch.com. 3 Please see BCA Research's Global Fixed Income Strategy weekly Report "The Song Remains The Same," dated April 11, 2017, available at gfis.bcaresearch.com. 4 Please see Bhardwaj, Geetesh, Gary Gorton and Geert Rouwenhorst (2015), "Facts and Fantasies about Commodity Futures Ten Years Later*" published by Yale University. This article updates earlier research and notes, "In the original study we found that commodities had historically offered a risk premium similar to equities, and at the same time would provide diversification to a traditional portfolio of stocks and bonds. What set commodities apart from these traditional assets was their positive correlation with inflation. (Emphasis added.) Here we provide 10 years of additional data. Although a decade is sometimes too short to draw firm conclusions, our-of-sample period is rich because it includes a global economic expansion led by the industrialization of China, a housing boom and bust in the United States, the largest financial crisis since the Great Depression, followed by a monetary policy stimulus response which has driven interest rates around the world towards zero. ... Many of the basic conclusions of the original study continue to hold." (p. 22) 5 Please see "WTI Crude Oil Remains On Top As S&P Dow Jones Indices Announces 2017 Weights For The S&P GSCI," at http://ca.spindices.com/indices/commodities/sp-gsci, website for the index. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table The Game's Afoot In Oil, But Which One? The Game's Afoot In Oil, But Which One? Summary of Trades Closed In 2016

Global gold mining stocks are breaking out on the back of the bid in gold prices. The confluence of spiking geopolitical uncertainty, both in the U.S. and globally, rise in equity volatility and safe haven bid in U.S. Treasurys have raised the profile of gold-related hedges. Importantly, the top panel of the chart shows that the surge in the economic policy uncertainty index heralds additional relative gains for gold-related shares. Similarly, easing real interest rates are raising the profile of gold prices. This portfolio hedge has served our portfolio well since the broad market's peak in early-March and more gains are in store until this consolidation/correction phase fully runs its course. Bottom Line: We are reiterating our overweight stance in the global gold mining index via the GDX:US exchange traded fund. A Gold Hedge Still Makes Sense A Gold Hedge Still Makes Sense

Highlights WTI and Brent forward curves remain more or less backwardated beginning in 2018. On its face, this indicates hedgers and speculators are trading and positioning as if the OPEC - non-OPEC production deal negotiated by the Kingdom of Saudi Arabia (KSA) and Russia in late 2016 will succeed in drawing inventories, leaving the market in a physical deficit this year. Over the short-term, this induced supply shock benefits producers generally. Longer term, KSA and Russia will have to continue to manage supplies if they are to exert any influence on oil prices. This is a three-level game, which now involves U.S. shale-oil producers as a permanent feature of the market. It will be difficult to manage. But the stakes are sufficiently high for KSA and Russia that we believe it has to be played. Energy: Overweight. We closed the first quarter on an up note, with our trade recommendations still open and closed in 2017Q1 up 420.75% on average. Base Metals: Neutral. Striking miners at Freeport McMoRan's Cerro Verde facility in Peru are back on the job, as are workers at BHP's Escondido mine in Chile. Export licensing difficulties at Freeport's Grasberg facility in Indonesia are close to being resolved.1 Precious Metals: Neutral. Our long volatility play in gold is down -32.8%, which, from a macro perspective, indicates markets are not fearful of a Fed-related surprise over the next couple of months. Ags/Softs: Underweight. U.S. farmers' corn planting intentions came in 1mm acres less than expected at 90mm; beans came in at 89.5mm acres, or 1.4mm over expectations; and wheat was up 100k acres at 46.1mm. Stocks remain high, and we remain bearish. Feature KSA, Russia and their allies - OPEC 2.0 - are trying to regain control of oil fundamentals produced by one of the most unlikely combinations of events ever seen in the history of the oil market. This week, we review how we arrived at the market conditions we now confront, and consider a possible strategy evolving out of the production-cutting Agreement (the "Agreement" for short) that may allow them to do so. Current markets conditions were spawned by a surge in EM oil demand in the early part of the 21st century, which met an almost perfectly inelastic supply curve. This took prices from $55/bbl in 2005 to more than $140/bbl by the end of 2008H1 (Chart of the Week). Along the way, some 5mm b/d of DM oil demand had to be destroyed by higher prices to make room for the EM growth depicted in Chart 2, which is taken from an analysis by Hamilton (2009).2 Chart of the WeekEM Consumption Surge, Flat Production ##br##Drove Prices Past $140/bbl Pre-GFC EM Consumption Surge, Flat Production Drove Prices Past $140/bbl Pre-GFC EM Consumption Surge, Flat Production Drove Prices Past $140/bbl Pre-GFC Chart 2High Prices Were Required##br## To Balance Markets Pre-GFC The Game's Afoot In Oil, But Which One? The Game's Afoot In Oil, But Which One? These high prices combined with the post-Global Financial Crisis (GFC) low-interest rate regime into a perfect storm, which allowed the supply side to evolve the shale technology in the U.S. Steadily rising light-tight-oil (LTO) production has profoundly altered the market, forcing OPEC and non-OPEC petro-states to devise a strategy to contain this surge. Whether they can do so is yet to be determined. In this article we consider one strategy that might allow OPEC 2.0 to regain some control over pricing and the rate of growth in shale production, but it is highly dependent on them maintaining production discipline and finding a way to coordinate their production. First, though, a quick review. How Did We Get Here? The GFC dragged all markets lower, leaving oil prices just above $40/bbl by the end of 2008. In the wake of the GFC, central banks led by the Fed pursued massively accommodative monetary policies, which took interest rates to the zero lower bound. OPEC, led by KSA, drastically cut supplies to remove a huge unintended inventory accumulation that developed as demand collapsed (Chart 3). While DM oil demand remained depressed in the wake of the GFC, EM governments, led by China, massively stimulated their economies, which lifted global oil consumption more than 4% by 2010 (Chart 4). Chart 3OPEC Cut Production To Defend Prices, ##br##Make Room For Shale To End-2014H1 OPEC Cut Production To Defend Prices, Make Room For Shale To End-2014H1 OPEC Cut Production To Defend Prices, Make Room For Shale To End-2014H1 Chart 4EM Lifted Global Demand Post-GFC EM Lifted Global Demand Post-GFC EM Lifted Global Demand Post-GFC Growth in global supplies post-GFC, meanwhile, was more measured. OPEC total liquids production from 2009 to 2014 averaged just below 0.05% growth yoy. Part of this meager growth in OPEC production no doubt was explained by lower production from the Cartel resulting from civil war in Libya and nuclear-related sanctions against Iran, which reduced overall output. It also is possible the fall-out from the GFC and the euro-area crisis of 2009 - 2011 kept OPEC producers from committing to higher production as well. Be that as it may, EM demand growth, along with OPEC's lower output, allowed prices to again trade above $100/bbl by 2011 and stay there till mid-2014 (Chart 5). The years-long combination of near-zero interest rates and high oil prices allowed U.S. shale-oil production to advance in leaps and bounds, such that by 2014, yoy light-tight oil (LTO) production from the shales was growing at more than 1mm b/d (Chart 6). Chart 5EM Surge, OPEC Production Moderation##br## Keep Prices Above $100/bbl To 2014H1 EM Surge, OPEC Production Moderation Keep Prices Above $100/bbl To 2014H1 EM Surge, OPEC Production Moderation Keep Prices Above $100/bbl To 2014H1 Chart 6High Prices, Low Interest Rates Propel Shale ##br##Production To 1mm b/d+ Growth By 2014 High Prices, Low Interest Rates Propel Shale Production To 1mm b/d+ Growth By 2014 High Prices, Low Interest Rates Propel Shale Production To 1mm b/d+ Growth By 2014 Now What? OPEC underestimated the magnitude of the shale-oil revolution, as did most observers. However, KSA, the leader of the Cartel, was pre-occupied with geopolitical considerations, chiefly its ongoing proxy wars throughout the Middle East with Iran and its allies. High prices allowed it to build its reserves and fund these proxy wars. This ended when Iran and western powers began negotiating an end to sanctions, which, if successful, would once again allow Iran to access foreign capital and technology to develop its economy.3 As the negotiations to remove sanctions on Iran progressed, KSA led OPEC into a market-share war at the end of 2014, presumably to take back customers lost to shale, particularly in the U.S. We do not believe OPEC's primary aim in declaring a market-share war was to crush U.S. shale output. Indeed, we have consistently maintained the market-share war was more an extension of KSA's and Iran's proxy wars throughout the Middle East, and that KSA was using the pump-at-will strategy to limit revenues that would flow to Iran in the post-sanctions environment. The secondary target of the market-share war was U.S. shale production, but, even then we maintained shale-oil production was needed to keep prices from revisiting $140/bbl-plus levels.4 The market-share war tanked prices, as OPEC increased the quantity of oil it would supply at lower prices. In particular, Saudi Arabia surged production from November 2014, into the collapse of oil prices. Over time, the market-share strategy destroyed high-cost supply worldwide. U.S. shale production fell ~ 15% from a high of ~ 5.3mm b/d in March 2015 in the four largest LTO basins to a low of ~ 4.5mm b/d, by our reckoning, in 2017Q1. At the same time, non-Gulf OPEC production fell dramatically as well, close to 8% in 2016 yoy to an average of 7.7mm b/d. Gulf Arab producers in OPEC and Russia, however, saw production increase 6.5% and 2% yoy, respectively, to close to 25mm b/d and 11.2mm b/d in 2016. In the aftermath of the price collapse, U.S. shale producers retreated to their "core" producing properties - those areas with the lowest-cost, most accessible shale reserves - and dramatically improved their productivity (Chart 7). A collapse in services costs allowed LTO producers to maintain core operations and continue to advance shale-oil technology. At the end of the day, this made the global supply curve more elastic, in that LTO production now allowed higher demand to be met by smaller price increases than had been the case in the lead-up to the GFC. The increased elasticity of supply from U.S. shales, and the increased quantity supply by OPEC is depicted in Chart 8, which picks up from Hamilton's (2009) analysis shown in Chart 2. Chart 7U.S. Shale Productivity Surged ##br##During OPEC's Market-Share War U.S Shale Productivity Surged During OPEC's Market-Share War U.S Shale Productivity Surged During OPEC's Market-Share War Chart 8Global Oil Supply##br## Transformed By 2014H1 The Game's Afoot In Oil, But Which One? The Game's Afoot In Oil, But Which One? OPEC's Market-Share War Failed We contend the KSA - Russia production Agreement negotiated at the end of last year represents an abandonment of OPEC's market-share strategy. If, as recent research suggests, this strategy was an attempt to "squeeze" higher-cost shale production from the market by increasing OPEC crude supplies, it was a failure: The market-share strategy imperiled the finances of OPEC and non-OPEC states heavily dependent on oil revenues to sustain themselves, and left U.S. shale production more resilient than it was prior to the market-share war being declared.5 The surge in shale supplies and in OPEC's quantity supplied to the market during its market-share war, coupled with slower growth following the dramatic increase in EM demand in 2010 - 2012, led to unintended inventory accumulation worldwide, which has kept global storage at record levels. This is the central issue being addressed by the OPEC - non-OPEC production Agreement to remove up to 1.8mm b/d of production from the market. In effect, the KSA - Russia deal is inducing a supply shock to shift the global supply curve back to the left, after it was pushed down and to the right from 2014H2 to 2015H2, as depicted in Chart 9. In and of itself, this should lift and stabilize prices by the end of this year. We expect this induced supply shock will begin to force more visible inventories - e.g., in the U.S. and OECD generally - to draw rapidly. We continue to expect OECD stocks to reach 5-year average levels by year-end 2017, and for prices to reach $60/bbl by year end (Chart 10). We do not believe an extension in OPEC 2.0's production Agreement is needed to achieve this. Chart 9KSA - Russia Deal Is An Induced Supply Shock##br## Intended To Shift The Curve Back To The Left The Game's Afoot In Oil, But Which One? The Game's Afoot In Oil, But Which One? Chart 10Oil Stocks Will Fall To 5-Year ##br##Averages By End-2017 Oil Stocks Will Fall To 5-Year Averages By End-2017 Oil Stocks Will Fall To 5-Year Averages By End-2017 It goes without saying, the parties to OPEC 2.0's production-management deal must maintain production discipline for this strategy to be able to evolve to the next level, where they attempt to restore a measure of price inelasticity to the global supply curve. If they are successful, then they will be able to exercise a degree of control over prices using spare capacity, storage and forward guidance to achieve and defend specific targets. If not, the market will do the hard work of destroying high-cost supply with lower prices. The End Game For KSA - Russia For the KSA - Russia Agreement to affect U.S. shale output over the medium to longer term, they have to coordinate production in a way that keeps WTI prices from rising to the point where shale-oil producers are able to step outside their "core" production areas. We believe over the short term, this price is between $55/bbl and $60/bbl. Our colleague Matt Conlan, of the BCA Energy Sector Strategy, has illustrated that the "true" breakeven for shale producers is much closer to $50/bbl, than the $30/bbl figure oft cited in the media.6 However, above $60/bbl, more costly reserves can be developed and still produce acceptable returns for LTO drillers. Therefore, if prices can be kept below $60/bbl, and the induced supply shock engineered by KSA and Russia causes oil inventories to draw as we expect this year, we believe the resulting backwardation in WTI will limit the rate at which rigs return to the field. In our modeling, we find shale rig counts to be sensitive to the shape of the forward curve for WTI. A backwardated curve translates into fewer rigs returning to the field than a flat or contango curve. In one model we estimated, we found a 10% backwardation from mid-2017 to end-2018 resulted in a rig count that was close to 18% below the rig count that could be expected from a relatively flat forward curve. The only way we see for KSA and Russia to affect the shape of the WTI forward curve over the short term - to end 2018 - is to use their own spare capacity and storage to keep the front of the curve below $60/bbl, and to provide forward guidance that they are able to adjust supply markets over the short- to medium-term in a manner that keeps the forward curve backwardated. This will require short-term production coordination among the states comprising OPEC 2.0, so that refinery demand is met out of current production plus inventories, and that unforeseen outages are remedied quickly. This is a short-term fix. It likely can be implemented this year and carried into next year. However, beyond that, it is difficult to see how KSA and Russia, and their respective allies, will coordinate production, storage operations and forward guidance having never attempted such an effort in the past. However, we are reasonably sure members of OPEC 2.0 are discussing how to implement such coordination. Keeping the front of the curve at a price that dissuades shale producers from expanding beyond their "core" production also will limit the amount of investment that can be made in non-Gulf OPEC production, which already is in decline, and other higher-cost conventional production like deep water.7 This, coupled with the $1-trillion-plus cuts to global capex for projects that would have been producing between 2015 - 2020 resulting from the 2015 - 16 price collapse could produce a supply deficit by 2019 that only can be remedied by significantly higher prices that not only encourage new higher-cost production but destroys demand in the meantime while that production is being developed. Bottom Line: We expect the KSA - Russia Agreement to produce a physical deficit this year that draws OECD oil inventories down by ~ 300mm barrels by year end. We also expect to see deeper coordination among the petro-states that are party to this Agreement - OPEC 2.0 - this year and next, which will keep the WTI forward curve backwardated into 2018. While we expect WTI prices to average $55/bbl to 2020 - and to trade between $45 and $65/bbl most of the time - our level of conviction in that forecast is low beyond 2018. It is not clear OPEC 2.0 can endure beyond the short term (into 2018). We will be watching the response of U.S. shale producers to increasing demand, and increasing decline-curve losses outside the U.S. shales, the Gulf OPEC producers and Russia, where we expect production declines to accelerate. As we have noted often in the past, the loss of more than $1 trillion of capex will place an enormous burden on U.S. shales, Gulf Arab producers in OPEC and Russia. If any one of these cannot deliver higher volumes when called upon, prices could move sharply above $65/bbl after 2018 going forward. Likewise, we will be watching to see if OPEC 2.0 is capable of setting and meeting production and inventory goals. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Assistant hugob@bcaresearch.com 1 Please see "Workers to end strike at Peru's top copper mine Cerro Verde," published March 30, 2017, by miningweekly.com. 2 Please see "Causes and Consequences of the Oil Shock of 2007-08," by James D. Hamilton, in the Brookings Papers on Economic Activity, Spring 2009, particularly pp. 228 - 234. 3 Please see "P5+1 and Iran agree on nuclear negotiation framework in Vienna," published February 20, 2014, by cnn.com. The sanctions were lifted in early 2016; see "Iran nuclear deal: Five effects of lifting sanctions," published January 18, 2016, by bbc.com. 4 For an in-depth analysis of OPEC's market-share war, please see the Special Report entitled "End Of An Era For Oil And The Middle East," published jointly by BCA Research's Commodity & Energy Strategy and Geopolitical Strategy groups on April 9, 2015, available at ces.bcaresearch.com. 5 Please see "Ignore The KSA - Russia Production Pact, Focus Instead On Their Need For Cash," published September 8, 2016, and our "2017 Commodity Outlook: Energy," published December 8, 2016, in which we discuss the toll lower oil prices were taking on oil-dependent states including KSA and Russia. See also "The Dynamics of the Revenue Maximization - Market Share Trade-Off: Saudi Arabia's Oil Policy in the 2014 - 2015 Price Fall," by Bassam Fattouh, Rahmatallah Poudineh and Anupama Sen, published by The Oxford Institute For Energy Studies in October 2015, and "An analysis of OPEC's strategic actions, US shale growth and the 2014 oil price crash," by Alberto Behar and Robert A. Ritz, published by the IMF July 2016. Both papers consider OPEC's market-share war vis-à-vis U.S. shale-oil production, the strategy of squeezing shale producers from the market by increasing supply and lowering prices, and the likelihood for success. 6 Please see BCA Energy Sector Strategy Weekly Report, "Breakeven Analysis: Shale Companies Need ~$50 Oil To Be Self-Sufficient," dated March 15, 2017, available at nrg.bcaresearch.com. 7 Please see "The Other Guys In The Oil Market" in this week's Energy Sector Strategy, which takes an in-depth look at the stagnant-to-declining production in conventional oil-producing provinces outside the U.S. onshore, Middle East OPEC and Russia, available at nrg.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table The Game's Afoot In Oil, But Which One? The Game's Afoot In Oil, But Which One? Summary of Trades Closed In 2016

Highlights Dear Client, In this analysis, my colleague Bob Ryan of the BCA Commodity & Energy Strategy argues that there is more upside to oil prices. First, Russia and OPEC will continue to coordinate their production for at least the rest of the year. Second, oil prices are too low to incentivize high cost, non-Gulf OPEC production, such as deep-water production. Third, the world lost roughly $1-trillion-plus of capex due to the oil-price collapse. Bob collaborates frequently with the Geopolitical Strategy team. As we controversially argued in February 2016, Saudi-Iranian tensions have peaked and created the geopolitical conditions for a renewal of OPEC production coordination. With oil prices plumbing decade lows in 2015-2016, both countries have set regional differences aside for the sake of domestic stability. I hope that you will enjoy Bob's note as much as I did. Many clients with whom I have met in person already know the view well, as it forms the core of Geopolitical Strategy's view on the Middle East. For those of you who are not subscribed to BCA's Commodity & Energy Strategy, and BCA's Energy Sector Strategy, I would recommend that you reach out to your account manager for a trial of both services. Kindest Regards, Marko Papic, Senior Vice President Geopolitical Strategy Feature KSA, Russia and their allies - OPEC 2.0 - are trying to regain control of oil fundamentals produced by one of the most unlikely combinations of events ever seen in the history of the oil market. This week, we review how we arrived at the market conditions we now confront, and consider a possible strategy evolving out of the production-cutting Agreement (the "Agreement" for short) that may allow them to do so. Current markets conditions were spawned by a surge in EM oil demand in the early part of the 21st century, which met an almost perfectly inelastic supply curve. This took prices from $55/bbl in 2005 to more than $140/bbl by the end of 2008H1 (Chart Of The Week). Along the way, some 5mm b/d of DM oil demand had to be destroyed by higher prices to make room for the EM growth depicted in Chart 2, which is taken from an analysis by Hamilton (2009).1 Chart Of The WeekEM Consumption Surge, Flat Production##br## Drove Prices Past $140/bbl Pre-GFC EM Consumption Surge, Flat Production Drove Prices Past $140/bbl Pre-GFC EM Consumption Surge, Flat Production Drove Prices Past $140/bbl Pre-GFC Chart 2High Prices Were Required ##br##To Balance Markets Pre-GFC The Game's Afoot In Oil, But Which One? The Game's Afoot In Oil, But Which One? These high prices combined with the post-Global Financial Crisis (GFC) low-interest rate regime into a perfect storm, which allowed the supply side to evolve the shale technology in the U.S. Steadily rising light-tight-oil (LTO) production has profoundly altered the market, forcing OPEC and non-OPEC petro-states to devise a strategy to contain this surge. Whether they can do so is yet to be determined. In this article we consider one strategy that might allow OPEC 2.0 to regain some control over pricing and the rate of growth in shale production, but it is highly dependent on them maintaining production discipline and finding a way to coordinate their production. First, though, a quick review. How Did We Get Here? The GFC dragged all markets lower, leaving oil prices just above $40/bbl by the end of 2008. In the wake of the GFC, central banks led by the Fed pursued massively accommodative monetary policies, which took interest rates to the zero lower bound. OPEC, led by KSA, drastically cut supplies to remove a huge unintended inventory accumulation that developed as demand collapsed (Chart 3). While DM oil demand remained depressed in the wake of the GFC, EM governments, led by China, massively stimulated their economies, which lifted global oil consumption more than 4% by 2010 (Chart 4). Chart 3OPEC Cut Production To Defend Prices,##br## Make Room For Shale To End-2014H1 OPEC Cut Production To Defend Prices, Make Room For Shale To End-2014H1 OPEC Cut Production To Defend Prices, Make Room For Shale To End-2014H1 Chart 4EM Lifted Global##br## Demand Post-GFC EM Lifted Global Demand Post-GFC EM Lifted Global Demand Post-GFC Growth in global supplies post-GFC, meanwhile, was more measured. OPEC total liquids production from 2009 to 2014 averaged just below 0.05% growth yoy. Part of this meager growth in OPEC production no doubt was explained by lower production from the Cartel resulting from civil war in Libya and nuclear-related sanctions against Iran, which reduced overall output. It also is possible the fall-out from the GFC and the euro-area crisis of 2009 - 2011 kept OPEC producers from committing to higher production as well. Be that as it may, EM demand growth, along with OPEC's lower output, allowed prices to again trade above $100/bbl by 2011 and stay there till mid-2014 (Chart 5). The years-long combination of near-zero interest rates and high oil prices allowed U.S. shale-oil production to advance in leaps and bounds, such that by 2014, yoy light-tight oil (LTO) production from the shales was growing at more than 1mm b/d (Chart 6). Chart 5EM Surge, OPEC Production Moderation##br## Keep Prices Above 0/bbl To 2014H1 EM Surge, OPEC Production Moderation Keep Prices Above $100/bbl To 2014H1 EM Surge, OPEC Production Moderation Keep Prices Above $100/bbl To 2014H1 Chart 6High Prices, Low Interest Rates Propel Shale##br## Production To 1mm b/d+ Growth By 2014 High Prices, Low Interest Rates Propel Shale Production To 1mm b/d+ Growth By 2014 High Prices, Low Interest Rates Propel Shale Production To 1mm b/d+ Growth By 2014 Now What? OPEC underestimated the magnitude of the shale-oil revolution, as did most observers. However, KSA, the leader of the Cartel, was pre-occupied with geopolitical considerations, chiefly its ongoing proxy wars throughout the Middle East with Iran and its allies. High prices allowed it to build its reserves and fund these proxy wars. This ended when Iran and western powers began negotiating an end to sanctions, which, if successful, would once again allow Iran to access foreign capital and technology to develop its economy.2 As the negotiations to remove sanctions on Iran progressed, KSA led OPEC into a market-share war at the end of 2014, presumably to take back customers lost to shale, particularly in the U.S. We do not believe OPEC's primary aim in declaring a market-share war was to crush U.S. shale output. Indeed, we have consistently maintained the market-share war was more an extension of KSA's and Iran's proxy wars throughout the Middle East, and that KSA was using the pump-at-will strategy to limit revenues that would flow to Iran in the post-sanctions environment. The secondary target of the market-share war was U.S. shale production, but, even then we maintained shale-oil production was needed to keep prices from revisiting $140/bbl-plus levels.3 The market-share war tanked prices, as OPEC increased the quantity of oil it would supply at lower prices. In particular, Saudi Arabia surged production from November 2014, into the collapse of oil prices. Over time, the market-share strategy destroyed high-cost supply worldwide. U.S. shale production fell ~ 15% from a high of ~ 5.3mm b/d in March 2015 in the four largest LTO basins to a low of ~ 4.5mm b/d, by our reckoning, in 2017Q1. At the same time, non-Gulf OPEC production fell dramatically as well, close to 8% in 2016 yoy to an average of 7.7mm b/d. Gulf Arab producers in OPEC and Russia, however, saw production increase 6.5% and 2% yoy, respectively, to close to 25mm b/d and 11.2mm b/d in 2016. In the aftermath of the price collapse, U.S. shale producers retreated to their "core" producing properties - those areas with the lowest-cost, most accessible shale reserves - and dramatically improved their productivity (Chart 7). A collapse in services costs allowed LTO producers to maintain core operations and continue to advance shale-oil technology. At the end of the day, this made the global supply curve more elastic, in that LTO production now allowed higher demand to be met by smaller price increases than had been the case in the lead-up to the GFC. The increased elasticity of supply from U.S. shales, and the increased quantity supply by OPEC is depicted in Chart 8, which picks up from Hamilton's (2009) analysis shown in Chart 2. Chart 7U.S. Shale Productivity Surged##br## During OPEC"s Market-Share War U.S. Shale Productivity Surged During OPEC"s Market-Share War U.S. Shale Productivity Surged During OPEC"s Market-Share War Chart 8Global Oil Supply ##br##Transformed By 2014H1 The Game's Afoot In Oil, But Which One? The Game's Afoot In Oil, But Which One? OPEC's Market-Share War Failed We contend the KSA - Russia production Agreement negotiated at the end of last year represents an abandonment of OPEC's market-share strategy. If, as recent research suggests, this strategy was an attempt to "squeeze" higher-cost shale production from the market by increasing OPEC crude supplies, it was a failure: The market-share strategy imperiled the finances of OPEC and non-OPEC states heavily dependent on oil revenues to sustain themselves, and left U.S. shale production more resilient than it was prior to the market-share war being declared.4 The surge in shale supplies and in OPEC's quantity supplied to the market during its market-share war, coupled with slower growth following the dramatic increase in EM demand in 2010 - 2012, led to unintended inventory accumulation worldwide, which has kept global storage at record levels. This is the central issue being addressed by the OPEC - non-OPEC production Agreement to remove up to 1.8mm b/d of production from the market. In effect, the KSA - Russia deal is inducing a supply shock to shift the global supply curve back to the left, after it was pushed down and to the right from 2014H2 to 2015H2, as depicted in Chart 9. In and of itself, this should lift and stabilize prices by the end of this year. We expect this induced supply shock will begin to force more visible inventories - e.g., in the U.S. and OECD generally - to draw rapidly. We continue to expect OECD stocks to reach 5-year average levels by year-end 2017, and for prices to reach $60/bbl by year end (Chart 10). We do not believe an extension in OPEC 2.0's production Agreement is needed to achieve this. Chart 9KSA - Russia Deal Is An Induced Supply Shock ##br##Intended To Shift The Curve Back To The Left The Game's Afoot In Oil, But Which One? The Game's Afoot In Oil, But Which One? Chart 10Oil Stocks Will Fall To 5-Year##br## Averages By End-2017 Oil Stocks Will Fall To 5-Year Averages By End-2017 Oil Stocks Will Fall To 5-Year Averages By End-2017 It goes without saying, the parties to OPEC 2.0's production-management deal must maintain production discipline for this strategy to be able to evolve to the next level, where they attempt to restore a measure of price inelasticity to the global supply curve. If they are successful, then they will be able to exercise a degree of control over prices using spare capacity, storage and forward guidance to achieve and defend specific targets. If not, the market will do the hard work of destroying high-cost supply with lower prices. The End Game For KSA - Russia For the KSA - Russia Agreement to affect U.S. shale output over the medium to longer term, they have to coordinate production in a way that keeps WTI prices from rising to the point where shale-oil producers are able to step outside their "core" production areas. We believe over the short term, this price is between $55/bbl and $60/bbl. Our colleague Matt Conlan, of the BCA Energy Sector Strategy, has illustrated that the "true" breakeven for shale producers is much closer to $50/bbl, than the $30/bbl figure oft cited in the media.5 However, above $60/bbl, more costly reserves can be developed and still produce acceptable returns for LTO drillers. Therefore, if prices can be kept below $60/bbl, and the induced supply shock engineered by KSA and Russia causes oil inventories to draw as we expect this year, we believe the resulting backwardation in WTI will limit the rate at which rigs return to the field. In our modeling, we find shale rig counts to be sensitive to the shape of the forward curve for WTI. A backwardated curve translates into fewer rigs returning to the field than a flat or contango curve. In one model we estimated, we found a 10% backwardation from mid-2017 to end-2018 resulted in a rig count that was close to 18% below the rig count that could be expected from a relatively flat forward curve. The only way we see for KSA and Russia to affect the shape of the WTI forward curve over the short term - to end 2018 - is to use their own spare capacity and storage to keep the front of the curve below $60/bbl, and to provide forward guidance that they are able to adjust supply markets over the short- to medium-term in a manner that keeps the forward curve backwardated. This will require short-term production coordination among the states comprising OPEC 2.0, so that refinery demand is met out of current production plus inventories, and that unforeseen outages are remedied quickly. This is a short-term fix. It likely can be implemented this year and carried into next year. However, beyond that, it is difficult to see how KSA and Russia, and their respective allies, will coordinate production, storage operations and forward guidance having never attempted such an effort in the past. However, we are reasonably sure members of OPEC 2.0 are discussing how to implement such coordination. Keeping the front of the curve at a price that dissuades shale producers from expanding beyond their "core" production also will limit the amount of investment that can be made in non-Gulf OPEC production, which already is in decline, and other higher-cost conventional production like deep water.6 This, coupled with the $1-trillion-plus cuts to global capex for projects that would have been producing between 2015 - 2020 resulting from the 2015 - 16 price collapse could produce a supply deficit by 2019 that only can be remedied by significantly higher prices that not only encourage new higher-cost production but destroys demand in the meantime while that production is being developed. Bottom Line: We expect the KSA - Russia Agreement to produce a physical deficit this year that draws OECD oil inventories down by ~ 300mm barrels by year end. We also expect to see deeper coordination among the petro-states that are party to this Agreement - OPEC 2.0 - this year and next, which will keep the WTI forward curve backwardated into 2018. While we expect WTI prices to average $55/bbl to 2020 - and to trade between $45 and $65/bbl most of the time - our level of conviction in that forecast is low beyond 2018. It is not clear OPEC 2.0 can endure beyond the short term (into 2018). We will be watching the response of U.S. shale producers to increasing demand, and increasing decline-curve losses outside the U.S. shales, the Gulf OPEC producers and Russia, where we expect production declines to accelerate. As we have noted often in the past, the loss of more than $1 trillion of capex will place an enormous burden on U.S. shales, Gulf Arab producers in OPEC and Russia. If any one of these cannot deliver higher volumes when called upon, prices could move sharply above $65/bbl after 2018 going forward. Likewise, we will be watching to see if OPEC 2.0 is capable of setting and meeting production and inventory goals. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Assistant hugob@bcaresearch.com 1 Please see "Causes and Consequences of the Oil Shock of 2007-08," by James D. Hamilton, in the Brookings Papers on Economic Activity, Spring 2009, particularly pp. 228 - 234. 2 Please see "P5+1 and Iran agree on nuclear negotiation framework in Vienna," published February 20, 2014, by cnn.com. The sanctions were lifted in early 2016; see "Iran nuclear deal: Five effects of lifting sanctions," published January 18, 2016, by bbc.com. 3 For an in-depth analysis of OPEC's market-share war, please see the Special Report entitled "End Of An Era For Oil And The Middle East," published jointly by BCA Research's Commodity & Energy Strategy and Geopolitical Strategy groups on April 9, 2015, available at ces.bcaresearch.com. 4 Please see "Ignore The KSA - Russia Production Pact, Focus Instead On Their Need For Cash," published September 8, 2016, and our "2017 Commodity Outlook: Energy," published December 8, 2016, in which we discuss the toll lower oil prices were taking on oil-dependent states including KSA and Russia. See also "The Dynamics of the Revenue Maximization - Market Share Trade-Off: Saudi Arabia's Oil Policy in the 2014 - 2015 Price Fall," by Bassam Fattouh, Rahmatallah Poudineh and Anupama Sen, published by The Oxford Institute For Energy Studies in October 2015, and "An analysis of OPEC's strategic actions, US shale growth and the 2014 oil price crash," by Alberto Behar and Robert A. Ritz, published by the IMF July 2016. Both papers consider OPEC's market-share war vis-à-vis U.S. shale-oil production, the strategy of squeezing shale producers from the market by increasing supply and lowering prices, and the likelihood for success. 5 Please see BCA Energy Sector Strategy Weekly Report, "Breakeven Analysis: Shale Companies Need ~$50 Oil To Be Self-Sufficient," dated March 15, 2017, available at nrg.bcaresearch.com. 6 Please see "The Other Guys In The Oil Market" in this week's Energy Sector Strategy, which takes an in-depth look at the stagnant-to-declining production in conventional oil-producing provinces outside the U.S. onshore, Middle East OPEC and Russia, available at nrg.bcaresearch.com.

Highlights Recommended Allocation Quarterly - April 2017 Quarterly - April 2017 The sweet spot of non-inflationary accelerating growth is likely to continue. European politics will fade as a risk, and Trump should still be able to get tax cuts through. We continue to be positive on risk assets on a one-year horizon, though returns are unlikely to be as good as in the past 12 months and there is a risk of the next recession arriving in 2019. Our portfolio tilts are generally pro-risk and pro-cyclical. We are overweight equities versus fixed income. We move overweight euro area equities, which should benefit from inexpensive valuations, higher beta and a falling political risk premium. Within fixed income, we prefer credit over government bonds, and raise high-yield debt to overweight on improved valuations. We expect the dollar to appreciate further, which makes us cautious on emerging market assets and industrial commodities. Feature Overview No Reasons To Turn Cautious Markets have paused for breath following the reflation trade that began a year ago and that was given an extra boost by the election of Donald Trump in November. Since the turn of the year, the dollar, U.S. 10-year Treasury yields, credit spreads and (to a degree) equities have all eased back a little (Chart 1). We don't think the risk-on rally is over, but the going will undoubtedly get tougher from here. The momentum of global growth cannot continue to rise at the same pace, with the Global PMI already at its highest level since 2011 (Chart 2). Global equities, therefore, are unlikely to return the 16% over the next 12 months, that they have over the past 12. Chart 1A Pause For Breath A Pause For Breath A Pause For Breath Chart 2Growth Momentum Must Slow From Here Growth Momentum Must Slow From Here Growth Momentum Must Slow From Here Nonetheless, we see nothing that is likely to stop risk assets continuing to outperform over the one-year horizon: Growth is likely to rise further. While the initial pick-up was in "soft" data such as consumer sentiment and business confidence, signs are emerging that "hard" data such as household spending and production are now also improving (Chart 3). Models developed by our colleagues on The Bank Credit Analyst indicate that real GDP growth in the U.S. this year will come in above 3% and in the euro area above 2% (Chart 4),1 compared to consensus forecasts of 2.2% and 1.6% respectively. Chart 3Hard Data Also Not Picking Up Hard Data Also Not Picking Up Hard Data Also Not Picking Up Chart 4GDP Growth Could Beat Consensus GDP Growth Could Beat Consensus GDP Growth Could Beat Consensus For now, this growth is unlikely to prove inflationary. In the U.S. the diffusion index for PCE inflation shows more prices in the basket falling than rising; in the eurozone, the rise to 2% in headline inflation in January was temporary, mainly because of higher oil prices, and core inflation remains at only 0.7%. The U.S. output gap will close soon, but the eurozone's is still deeply negative (Chart 5). We see the Fed raising rates twice more this year, in line with its dots, though it may have to accelerate the pace next year if the Trump administration succeeds in passing fiscal stimulus. The ECB, however, is unlikely to raise rates until 2019 and will taper asset purchases only slowly.2 Misplaced worries that it will tighten more quickly than this have recently dragged on European equities and strengthened the euro. We think the market is wrong to price out the probability of a tax cut in the U.S. just because of the Trump administration's failure to reform healthcare. Our Geopolitical strategists argue that Republicans in Congress (even the Freedom Caucus) are united behind the idea of cutting taxes, even if these are not funded by tax reforms or spending cuts (they can be justified on the grounds of "dynamic scoring").3 We see a cut in corporate and personal taxes passing before year-end to take effect in 2018. And Trump has not abandoned the idea of infrastructure spending. The market no longer expects any of this: the prices of stocks that would most benefit from lower corporate taxes or from government spending have reverted to their pre-election levels. European political risk is likely to wane. The market continues to worry about the possibility of Marine Le Pen winning the French Presidential election, as shown in the spread of OATs over Bunds (which has widened to 60-80 bp from 20 bp last summer). We think this very unlikely: polls show her consistently at least 20 points behind Emmanuel Macron in the second round of voting (Chart 6). While Italian politics remain a risk, the parliamentary election there is unlikely to take place until March 2018. Brexit is a threat to the U.K., but should have minimal impact on the eurozone. We retain, therefore, our pro-cyclical and pro-risk tilts on a 12-month time horizon. We have even added a little more beta to our recommended portfolio by raising high-yield bonds to overweight (since their valuations now look more attractive after a recent sell-off) and by going overweight eurozone stocks (paid for by notching down our double-overweight in U.S. stocks). The eurozone has consistently been a higher beta (Chart 7), more cyclical equity market than the U.S. and, once the political risks (at least temporarily) subside, should be able to outperform for a while. Chart 5Eurozone Output Gap Still Very Negative Eurozone Output Gap Still Very Negative Eurozone Output Gap Still Very Negative Chart 6Can Le Pen Really Win From Here? Can Le Pen Really Win From Here? Can Le Pen Really Win From Here? Chart 7Eurozone Is A High Beta Stock Market Eurozone Is A High Beta Stock Market Eurozone Is A High Beta Stock Market But we warn that the good times may not last for long. Tax cuts in the U.S. would add stimulus to an economy already at full capacity. The Fed might have to raise rates sharply next year (although the timing might depend on how President Trump tries to affect monetary policy, for example whom he appoints as Fed chair to replace Janet Yellen next February). U.S. recessions have typically come two or three years after the output gap turns positive (Chart 5). As Martin Barnes, BCA's chief economist, recently wrote,4 that may point to next recession arriving as soon as 2019. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com What Our Clients Are Asking Chart 8Expensive, But Not At An Extreme Expensive, But Not At An Extreme Expensive, But Not At An Extreme Aren't You Worried About U.S. Equity Valuations? Valuation is a poor timing tool in the short term but, when it reaches extremes, it has historically added value. The valuation metrics we watch show that U.S. equities are expensive, but not at the extreme levels that have historically warranted an outright sell or underweight. First, according to MSCI, U.S. equities are currently trading at 24.4 times 12-month trailing earnings, and 25.7 times 10-year cyclically-adjusted earnings; both measures are about one standard deviation from their 10-year averages. Second, U.S. equities are trading at a premium to global equities, but the premium to the developed markets is in line with the 10-year average (Chart 8, panel 1), while the premium to emerging markets is about 1.5 standard deviations from the 10-year average (panel 2). Third, equities are cheap compared to fixed income: the earnings yield is still higher than the yields on both 10-year government bonds and investment grade corporate bonds, and the yield gaps are currently only slightly lower (more expensive) than their respective 10-year averages (panels 3 and 4). In the long run, the 10-year cyclically-adjusted PE (CAPE) has had relatively good forecasting power for 10 year forward returns. Currently, the regression indicates 143% (9.3% annualized) total returns over the next 10 years. This could be on the optimistic side given that we are no longer in an environment of declining bond yields and margins are elevated compared to the 1990s. That said, we have cut our U.S. equity overweight by half, partly due to valuation concerns. Is EM Debt Attractive? Chart 9Avoid EM Debt Avoid EM Debt Avoid EM Debt Emerging market debt has continued its run from last year, with sovereign and local currency debt providing YTD returns of 3% and 2% respectively. Over long periods, EM debt has displayed the ability to provide substantial returns while also providing robust diversification benefits to a 50/50 DM equity/bond portfolio, even more so than EM equities.5 However, over the cyclical horizon, we remain bearish on EM debt both in absolute terms and relative to global equities. EM fixed income markets have been able to defy deteriorating fundamentals for some time, but this is unsustainable. After years of leveraging, credit excesses will need to be unwound. Decelerating credit growth will be enough to dampen economic growth and damage emerging markets' ability to service their debt. Risks in EM sovereign debt markets are high. Historical returns have shown negative skewness and fat tails, suggesting high vulnerability to large downswings. This is particularly concerning given that yields are one standard deviation lower than their long-term average (Chart 9). While EM local currency debt is more fairly priced and has a more favorable risk/return profile than its sovereign debt counterpart, local currency debt returns are even more heavily influenced by their currencies. Above-trend growth in the U.S. leading to additional rate hikes, as well as rising U.S. bond yields and softer commodity prices will add further downward pressure to EM currencies. For EM dedicated investors, we suggest overweight positions in low beta/defensive markets. Regions that are less susceptible to currency weakness with high yields and low foreign funding requirements include Russia, India and Indonesia. How Will The Fed Shrink Its Balance Sheet, And Does It Matter? After the Fed's third rate hike, attention is turning to when it will begin to reduce its balance sheet. This has grown to $4.5 trillion, up from $900 billion before the Global Financial Crisis. Assets currently include $2.5 trillion of Treasury securities and $1.8 trillion of mortgage-related securities. Since asset purchases ended in October 2014, the Fed has rolled over maturing bonds to maintain the size of the balance sheet. The FOMC statement last December committed to maintaining this policy "until normalization of the level of the federal funds rate is well under way". The market takes this to mean 1-1.5%, a level likely to be reached by year-end. The view of BCA's fixed income team6 is that the Fed will start by ceasing reinvestment of Agency bonds and mortgage-backed securities (MBS) in 2018, at the same time reducing excess bank reserves on the liability side of the balance sheet (Chart 10). This will worry markets to a degree and the Fed will need to be careful how it communicates the policy: for example what size it thinks its balance sheet should ultimately be. It may also need to skip a rate hike or two in the first months of the shrinkage. The MBS market is likely to suffer from the increased supply. But the only historical precedent - the BoJ's unwinding of its 2000-3 QE - is reassuring: this had no discernible effect on rates or the yen (Chart 11). Chart 10Fed Will Cut MBSs First Fed Will Cut MBSs First Fed Will Cut MBSs First Chart 11Nobody Noticed The BoJ Taper Nobody Noticed The BoJ Taper Nobody Noticed The BoJ Taper When Will ECB Taper? Chart 12Recovery Not Permanent Recovery Not Permanent Recovery Not Permanent Euro area growth is recovering and headline inflation has hit the ECB's 2% target (Chart 12). Investors are wondering how rapidly the ECB will taper its asset purchases and when it will raise rates. Our view is that the ECB will move only slowly. The pickup in inflation is mostly driven by the base effect and by the rise in energy prices. The failure of core inflation, which remains below 1%, to pick up appreciably suggests that underlying price pressures are weak. The current program has the ECB purchasing EUR 60 Bn of assets each month until December 2017. Markets have recently become more hawkish with regards to the likely path of policy: currently futures are pricing in the first hike only 19 months away versus an expectations in January of 44 months. We expect the ECB to remain more dovish than that, given weak underlying inflation, political uncertainty, and banking system troubles. We think the ECB will announce around September this year a taper of its asset purchases in 2018. However, it is not clear whether it will cut them to, say EUR 30 Bn a month, or whether it will reduce the amount steadily each month or quarter. But we don't see an interest rate hike soon, since the euro area economy is not expected to reach full employment until 2019. Ewald Novotny, president of the Austrian central bank, spooked markets by suggesting a hike before complete withdrawal of asset purchases but, in our view, that would will send a confusing signal to investors. Nowotny has long been hawkish and we think his view is untypical of ECB council members. If our analysis is correct, ECB policy should be positive for euro area equities and bearish for the euro over the next 12 months. Will REIT Underperformance Continue? Chart 13Underweight REITs Underweight REITs Underweight REITs Relative REIT performance has continued its downtrend, underperforming the broad index by 5% YTD. While valuations have become more attractive and rental income is still robust, we expect the decline to continue given unsupportive macro factors. We previously argued that real estate is in a sweet spot, where economic growth was sufficient to generate sustainable tenant demand without triggering a new supply cycle.7 This is no longer the case. Office completions increased substantially over the past quarter and apartment completions remain in an uptrend. As we expect growth to remain robust in the U.S., the likelihood is that these two trends remain in place. REIT relative performance peaked at the beginning of August, shortly after long-term interest rates bottomed. REITs have historically outperformed when yields are falling and inflation is low (Chart 13). However, long-term rates should continue to rise over the cyclical horizon, primarily due to higher inflation expectations. Additionally, REITs typically benefit from increasing central bank asset purchases, as increased liquidity and lower interest rates boost real estate values. With the Fed clearly in tightening mode and the strong likelihood of ECB tapering next year, slowing asset purchases will be a considerable headwind to REIT performance. Within REITs, we maintain our sector tilts. Continue to favor Industrials, which will benefit in a rising USD environment and provide considerable income. Maintain underweight position in Apartments, due to rising completions and a low absorption ratio. Additionally, we continue to favor trophy over non-trophy markets given more stable rent growth as well as geopolitical risks in Europe and potential Washington disappointments. Global Economy Overview: The global economy has continued to recover from its intra-cycle slowdown in late 2015 and early 2016. Economic surprise indexes have everywhere surprised significantly on the upside since mid-2016 (Chart 14, panel 1). Although "hard" data (consumption, production etc.) have lagged "soft" data (consumer sentiment, business confidence), the former also have begun to recover recently. Although there are few negative indicators, it will get harder to beat expectations. U.S.: Lead indicators continue to improve, with the manufacturing ISM at 57.7 and new orders at 65.1. Sentiment quickly turned bullish after the presidential election, and hard data has now started to follow, with personal consumption expenditure rising 4.7% year on year and capital goods orders (+2.7% YoY in February) growing for the first time since 2014. With steady wage growth, continuing employment improvements, and a likely pick-up in capex, we expect 2017 GDP growth to beat the current consensus expectations of 2.2%. For now inflation remains quiescent, with core PCE inflation stuck at around 1.8%, below the Fed's 2% target. Euro Area: Leading indicators, such as PMIs, have rebounded in Europe too (Chart 15), suggesting that the consensus 2017 GDP forecast of 1.6% is achievable. Inflation has picked up, with the headline CPI 2.0% for the Eurozone in January, but core inflation remains low at 0.7% and headline fell back to 1.5% in February. However, the recent slowdown in bank loan growth (new credit creation is 36% below the level six months ago) suggests that continuing weakness in the banking sector is likely to keep growth sluggish. Chart 14How Long Can Growth Continue To Surprise? How Long Can Growth Continue To Surprise? How Long Can Growth Continue To Surprise? Chart 15A Synchronized Global Growth Rebound A Synchronized Global Growth Rebound A Synchronized Global Growth Rebound Japan is a tale of two segments. International-oriented data have recovered, with IP up 3.7% (Chart 15, panel 2) and exports +5.4% year on year. But domestic demand remains weak: wages are rising only 0.5% YoY (despite a tight labor market), which is holding back household spending (-1.2% YoY in January). Core inflation has shown the first signs of picking up, but remains very low at 0.1% YoY. Emerging Markets: The effects of China's reflationary policies from early 2016 continue to boost activity (Chart 15, panel 3). But the excess liquidity they triggered worries the authorities, who have clamped down on real estate purchases and capital outflows, slowed fiscal spending, and tightened monetary policy. China will prioritize stability until the Party Congress in the fall, but the impact of reflation on commodity prices and on other emerging markets will fade. Interest rates: The Fed is likely to hike twice more this year in line with its "dot plot", unless inflation surprises significantly to the upside. This, plus an acceleration of nominal GDP growth to 4.5-5%, should push the 10-year bond yield above 3% by year end. The ECB will not be as hawkish as the market expects (futures markets indicate a rate hike by end-2018), since Mario Draghi expects headline inflation to fall back once the oil price stabilizes and is concerned about political risk especially in Italy. Consequently, rates are unlikely to rise as quickly as in the U.S. The Bank of Japan will keep its 0% yield target for 10-year JGB for the foreseeable future. Global Equities Global equities continued to make impressive gains in Q1 2017, after a strong 2016. The price appreciation since the low in February 2016 has been driven by both multiple expansion and earnings growth, roughly in equal proportion, as shown in Chart 16, panel 1. Chart 16Earnings Improving But Valuation Stretched Earnings Improving But Valuation Stretched Earnings Improving But Valuation Stretched Equity valuation is expensive by historical standards but, as an asset class, equities are still attractively valued compared to bonds (see the "What Our Clients Are Asking" section on page 6). In this "TINA" (There Is No Alternative) world, we remain overweight equities versus bonds. Within equities, we maintain our call of favoring DM equities versus EM equities despite of the 6% EM outperformance in Q1, which was supported by attractive valuations. About half of that outperformance came from the appreciation of EM currencies versus the USD. Our house view is that the USD will strengthen further versus the EM currencies. Within EM, we have been more positive on China and remain so on a 6-9 month horizon. The only adjustment we make now is to upgrade euro area equities to overweight by reducing half of our large overweight in the U.S. so that now we are equally overweight the U.S. and euro area (see details on the next page). In terms of global sector positioning, we maintain a pro-cyclical tilt. Our largest overweight in Healthcare panned out very well in Q1 but the overweight in Energy did not, due to the drop in oil prices. Our Energy strategists believe this was caused by one-off technical factors on the supply side, and argue that the oil price will soon revert to $55 a barrel. Euro Area Equities: A Cheaper Alternative To The U.S. Political risks related to elections in some eurozone countries are receding. The ECB is likely to maintain its easy monetary policies, while the Fed is on track to normalize interest rates in the U.S. We have had a large overweight of 6 percentage points (ppts) on U.S. equities while being neutral on the euro area. We upgrade the eurozone to overweight by 3 ppts, so that we are now equally overweight the U.S. and the euro area. The following are the reasons: First, the relative performance of total returns between eurozone and the U.S. equities is at its lowest since 1987. Since April 2015, when the most recent brief period of eurozone outperformance ended, eurozone equities have underperformed the U.S. by over 16% in common currency terms (Chart 17, panel 1), while the euro lost only about 4% versus the USD over the same period. Second, eurozone equities are trading at a 22% discount to the U.S., compared to the five-year average discount of 17% (panel 3). Third, eurozone equities have lower margins than the U.S., but the profit margin in the eurozone has been improving (panel 2). Lastly, the PMIs in the euro area have been improving (panel 4) and this improvement is faster than the global aggregate PMI (panel 5), which implies - based on the close correlation between PMIs and earnings growth - that profitability in the eurozone should improve at a faster pace than the global average. Sector Allocation: We have had a relatively pro-cyclical tilt in our global sector positioning, overweight three cyclical sectors (Energy, Industrials and Info Tech) plus Healthcare, while underweight three defensive sectors (Consumer Staples, Telecoms and Utilities) as well as Consumer Discretionary. We have been neutral on Financials and Materials. After very strong performance in 2016, cyclical sectors underperformed in Q1 2017 (Chart 18, panel 1). The underperformance of cyclicals versus defensives can be largely attributed to the polar-opposite performance of Energy and Healthcare (Chart 19). Going forward, we maintain our current sector positioning for the following reasons: Chart 17Earnings Growth At Lower Valuation Earnings Growth At Lower Valuation Earnings Growth At Lower Valuation Chart 18Maintain The Cyclical Tilt Maintain The Cyclical Tilt Maintain The Cyclical Tilt Chart 19Global Sector Performance Quarterly - April 2017 Quarterly - April 2017 First, Energy was the only sector which fell in Q1, largely due to the decline in oil prices. BCA's Energy and Commodity Strategy attributes the oil price weakness to inventory buildup related to the production rush before the OPEC agreement to cut production, and therefore expects the WTI oil price to return to the $50-55 range. Energy stocks should benefit once oil prices turn back up. Chart 20Relative Factor Performance Relative Factor Performance Relative Factor Performance Second, the relative profitability between cyclicals and defensives is underpinned by global economic conditions, as represented by the global PMI. The PMI is on track to recover further, which bodes well for the profit outlook for cyclicals versus defensives. Third, our pro-cyclical tilt in sector positioning is hedged by an overweight in Healthcare (a defensive sector) and underweight in Consumer Discretionary (a cyclical). Smart Beta Update: No Style Bet Q1 2017 saw some significant performance reversals in the five most enduring factors: quality, minimum volatility, momentum, value, and size (Chart 20, panels 2-6). Quality and Momentum performed the best, outperforming the global benchmark by over 200 bps in Q1. The star performer in 2016, the Value factor, performed the worst, underperforming by 190 bps. According to the findings in our Special Report,8 recent factor performance seems to be pricing in a "Goldilocks" environment in which growth is rising and inflation falling. We have shown that it is very difficult to time the shift in factor performance cycles and so have advocated an equal weight in the five factors (Chart 20, panel 1) for long-term investors. We reiterate this view. Government Bonds Maintain slight underweight duration. Our 2-factor model made up of global PMI and U.S. dollar sentiment indicates the current fair value of the 10-year Treasury yield is 2.4% (Chart 21). While this suggests bonds are currently correctly priced, we still expect that long-term yields will rise over a cyclical horizon. The long end should grind higher given improving growth, rising equity prices and renewed "animal spirits." Additionally, large net short positions have been unwound, allowing for another leg higher in yields. Overweight TIPS vs. Treasuries. Diffusion indexes for both PCE and CPI inflation shifted into negative territory, suggesting realized inflation will soften in the near term. Nevertheless, with headline and core CPI readings of 2.7% and 2.2% respectively, U.S. inflation has clearly bottomed for the cycle (Chart 22). This trend should continue as a result of cost-push inflation driven by faster wage growth. Very gradual Fed hikes will not be enough to derail the upward momentum in consumer prices. Euro area growth is stable, but expectations of a rate hike from the ECB are premature (Chart 23). While the central bank opened the door slightly to a less-accommodative policy stance, it is unlikely that the ECB will hike until full employment is reached. Our expectation is for a tapering of asset purchases to occur in 2018. Once tapering is complete, rate hikes will follow by approximately 6-12 months. The implication is upward pressure on European bond yields and wider spreads for peripheral government debt. Chart 2110-Year Treasury Fair Value Model 10-Year Treasury Fair Value Model 10-Year Treasury Fair Value Model Chart 22Inflation Has Bottomed Inflation Has Bottomed Inflation Has Bottomed Chart 23Will the ECB Hike Soon? Will the ECB Hike Soon? Will the ECB Hike Soon? Corporate Bonds The BCA Corporate Health Monitor remains deeply in "Deteriorating Health" territory, indicating weakness within corporate balance sheets (Chart 24). Over the last quarter, the indicator worsened, as profit margins, return-on-capital and liquidity declined. However, leverage did improve slightly. The trend toward weaker corporate health has been firmly established over the past 12 quarters. This is consistent with the very late stages of past credit cycles. Maintain overweight to Investment Grade debt. The U.S. is in a self-reinforcing, low-inflation recovery. Economic growth should accelerate throughout 2017, with strong consumer spending, rising capex intentions, and still accommodative monetary policy. The potential sell-off from rate hikes this year should be fairly mild given that the market is already close to pricing in three. Additionally, credit has historically outperformed in the early stages of the Fed tightening cycle. Expect low but positive excess returns (Chart 25). Shift to overweight in high-yield debt. Our default model is showing improvement due to elevated interest coverage, a robust PMI reading, declining job cut announcements, softening lending standards and a rising sales/inventory ratio. The recent backup in yields has made junk bond valuations more attractive. The default adjusted spread, calculated by subtracting an ex-ante estimate of default losses from the average spread, is now approximately 220bps (Chart 26). Chart 24Balance Sheets Deteriorating Balance Sheets Deteriorating Balance Sheets Deteriorating Chart 25A Supportive Backdrop A Supportive Backdrop A Supportive Backdrop Chart 26High Yield: Valuations Becoming More Attractive High Yield: Valuations Becoming More Attractive High Yield: Valuations Becoming More Attractive Commodities Chart 27Upside To Resource Prices Limited Upside To Resource Prices Limited Upside To Resource Prices Limited Secular Perspective: Bearish A slowdown in Chinese activity, led by its transition to a services economy, coupled with unfavorable global demographics, will continue to constrain demand for commodities. This slack in demand coupled with excess capacity will continue to limit the upside in resource prices and prolong the commodities bear market which began in 2012 (Chart 27). Cyclical Perspective: Neutral Energy markets have moved from excess supply to excess demand, and so we remain positive on oil. But, with the impact of Chinese fiscal stimulus waning, excess supply in the metals market will persist, putting downward pressure on prices. Our divergent outlook for energy vs metals gives us an overall neutral view for commodities over the cyclical horizon. Energy: With a synchronized upturn in global growth and inflation, both OECD and non-OECD demand will remain strong. Following Saudi Arabia's production cuts, we expect the OPEC agreement to be honored by all members, including Russia. With strengthening demand and falling production, storage should draw through the year. We expect the oil-USD divergence to persist as improving fundamentals override the stronger dollar. Base Metals: With Chinese government spending slowing from 24% growth year on year in January 2016 to only 4%, the country's fiscal impulse has ended. Tightening in Chinese liquidity conditions have led to higher borrowing rates for the real estate sector, which is dampening its demand for materials. At the same time, inventories for key metals such as copper and steel have risen. We expect metals prices to correct over the coming months. Precious Metals: Gold has rallied 10% from last December, and another 4% following the Fed's March rate hike. These were responses to the dovish nature of the hike and continuing political risk. We expect the Fed to turn more hawkish in coming weeks, sending the dollar and real yields higher, thereby holding back the gold price from rising much further. Currencies Chart 28Return Of The Dollar Return Of The Dollar Return Of The Dollar USD: The last Fed meeting resulted in a dovish hike, as evidenced by the subsequent fall in the dollar. However, as the U.S. economy nears full employment, we expect a more hawkish tone from FOMC members in the coming weeks which will push the dollar up (Chart 28). The Fed continues to be data dependent, and sees the recent synchronized global upturn as an opportunity to deliver hikes in line with market expectations. Euro: As the economy stabilizes, as evidenced by rising headline inflation, stronger retail sales and improving PMI numbers, the ECB has opened the window for reducing monetary accommodation. However, since the economy is expected to reach full employment only in 2019, we expect rates to be kept low even after the tapering of ECB asset purchases starts next year. This will add further downward pressure on the euro. Yen: The Bank of Japan will continue its highly accommodative monetary policy, centered on its 0% yield target for 10-year government bonds, because Japanese growth and inflation is lagging the global upturn. Japan is benefitting from global growth, as seen in the improvement in its manufacturing PMI, but domestic demand remains weak as consumer confidence and retail sales stagnate. Continued downward pressure on relative interest rates will drive the only reliable source of inflation: a weaker yen. EM: A more hawkish Fed and rising bond yields will tighten global liquidity conditions, making it difficult for emerging nations that run current account deficits. The rising threat of protectionism could affect EM exports and create a new wave of deflationary pressure, forcing central banks to engineer currency devaluation. The fact that commodity prices have risen, yet EM currencies have remained weak, is a clear indications that EM fundamentals are weak. Alternatives Overweight private equity / underweight hedge funds. Leading indicators suggest that global growth continues to improve. In the absence of a recession, private equity typically outperforms as the illiquidity premium should provide a boost to returns. Additionally, surveys suggest that managers are planning on increasing their allocation percentage toward private equity over the rest of the year. Hedge funds, on the other hand, have displayed a negative correlation with global growth. Historically, they have outperformed private equity only during recessions or periods of high credit market stress (Chart 29). Overweight direct real estate / underweight commodity futures. Demand for commercial real estate (CRE) assets remains robust but the increase in completions is worrying. Favor Industrials for its income potential and Retail given resilient consumer spending. Overweight trophy markets, as demand remains robust given multiple macro risks. Commodities have bounced, but remain in a secular bear market caused by a supply glut and exacerbated by a market-share war (Chart 30). Overweight farmland & timberland / underweight structured products. The potential for trade wars, geopolitical risk in Europe and concerns over an equity market correction have increased the importance of volatility reduction. Favor farmland & timberland. Substantial portfolio diversification benefits, resulting from low correlations with traditional assets, coupled with a positive skew, make these assets highly attractive. As the most bond-like alternative, the end of the 35-year bull market in bonds presents a substantial headwind. Structured products also tend to outperform during recessions, which is not our base case (Chart 31). Chart 29PE: Tied To Real Growth PE: Tied To Real Growth PE: Tied To Real Growth Chart 30Commodities: A Secular Bear Market Commodities: A Secular Bear Market Commodities: A Secular Bear Market Chart 31Structured Products Outperform In Recessions Structured Products Outperform In Recessions Structured Products Outperform In Recessions Risks To Our View Our pro-cyclical pro-risk tilts are based on the premise that global growth will remain strong over the next 12 months. We do not see many risks to this view: leading indicators suggest that consumption and capex are likely to continue to rebound. The one major indicator that suggests downside risk is loan growth. In the U.S., loans to firms have slowed to 5.4% from over 10% last summer, and in the euro area the meager pickup in corporate loan growth seems to have faltered (Chart 32). There may be some special factors: oil companies that borrowed in early 2016 when in difficulty no longer need to tap credit lines, and U.S. companies may be holding back to see details of tax cuts. But loan growth needs to be watched closely. More granularly, our country and sector preferences - in particular, our cautious views on Emerging Markets and industrial commodities - are based partly on the expectation that the U.S. dollar will appreciate further. If the global expansion remains highly synchronized (Chart 33) this might instigate all G7 central banks to tighten, allowing the Fed to raise rates without appreciating the dollar. However, we expect continuing divergences in growth and monetary policy to push the dollar up further. Finally, some indicators suggest that investors have become too positive on the outlook for stocks (Chart 34). Sentiment has in the past not been a reliable indicator of stock market peaks, but excess euphoria could trigger a short-term correction. Chart 32Why Is Bank Loan Growth Slowing? Why Is Bank Loan Growth Slowing? Why Is Bank Loan Growth Slowing? Chart 33Could Synchronized Growth Push Down USD? Could Synchronized Growth Push Down USD? Could Synchronized Growth Push Down USD? Chart 34Are Investors Too Euphoric? Are Investors Too Euphoric? Are Investors Too Euphoric? 1 Please see The Bank Credit Analyst, March 2017, page 33, available at bca.bcaresearch.com 2 Please see What Our Clients Are Asking: When Will The ECB Taper? on page 9 of this report for a full explanation of why we think this. 3 Please see Geopolitical Strategy Weekly Report, "Donald Trump Is Who We Thought He Was", dated March 8, 2017, available at gps.bcaresearch.com 4 Please see BCA Special Report titled "Beware The 2019 Trump Recession", dated March 7, 2017, available at bca.bcaresearch.com 5 Please see Global Asset Allocation Strategy Special Report, "EM Asset Allocation: Is There Any Reason To Own Stocks?," dated November 27, 2012, available at gaa.bcaresearch.com. 6 Please see Global Fixed Income Strategy Special Report, "The Way Forward For The Fed's Balance Sheet," dated February 28, 2017, available at gfis.bcaresearch.com. 7 Please see Global Asset Allocation Strategy Special Report, "REITs Vs. Direct: How To Get Exposure To Real Estate," dated September 15, 2016, available at gaa.bcaresearch.com. 8 Please see Global Asset Allocation Strategy Special Report, "Is Smart Beta A Useful Tool In Global Asset Allocation?," dated July 8, 2016, available at gaa.bcaresearch.com. Recommended Asset Allocation Model Portfolio (USD Terms)

Highlights Economic Outlook: The global economy is in a reflationary window that will stay open until mid-2018. Growth will then slow, culminating in a recession in 2019. While the recession is likely to be mild, the policy response will be dramatic. This will set the stage for a period of stagflation beginning in the early 2020s. Overall Strategy: Investors should overweight equities and high-yield credit during the next 12 months, while underweighting safe-haven government bonds and cash. However, be prepared to scale back risk next spring. Fixed Income: For now, stay underweight U.S. Treasurys within a global fixed-income portfolio; remain neutral on the euro area and the U.K.; and overweight Japan. Bonds will rally in the second half of 2018 as growth begins to slow, but then begin a protracted bear market. Equities: Favor higher-beta developed markets such as Europe and Japan relative to the U.S. in local-currency terms over the next 12 months. Emerging markets will benefit from the reflationary tailwind, but deep structural problems will drag down returns. Currencies: The broad trade-weighted dollar will appreciate by 10% before peaking in mid-2018. The yen still has considerable downside against the dollar. The euro will grind lower, as will the Chinese yuan. The pound is close to a bottom. Commodities: Favor energy over metals. Gold will move higher once the dollar peaks in the middle of next year. Feature Reflation, Recession, And Then Stagflation The investment outlook over the next five years can be best described as a three-act play: First Act: "Reflation" (The present until mid-2018) Second Act: "Recession" (2019) Third Act: "Stagflation" (2021 onwards) Investors who remain a few steps ahead of the herd will prosper. All others will struggle to stay afloat. Let us lift the curtain and begin the play. Act 1: Reflation Reflation Continues If there is one chart that best encapsulates the reflation theme, Chart 1 is it. It shows the sum of the Citibank global economic and inflation surprise indices. The combined series currently stands at the highest level in the 14-year history of the survey. Consistent with the surprise indices, Goldman's global Current Activity Indicator (CAI) has risen to the strongest level in three years. The 3-month average for developed markets stands at a 6-year high (Chart 2). Chart 1The Reflation Trade In One Chart The Reflation Trade In One Chart The Reflation Trade In One Chart Chart 2Current Activity Indicators Have Perked Up Current Activity Indicators Have Perked Up Current Activity Indicators Have Perked Up What accounts for the acceleration in economic growth that began in earnest in mid-2016? A number of factors stand out: The drag on global growth from the plunge in commodity sector investment finally ran its course. U.S. energy sector capex, for example, tumbled by 70% between Q2 of 2014 and Q3 of 2016, knocking 0.7% off the level of U.S. real GDP. The fallout for commodity-exporting EMs such as Brazil and Russia was considerably more severe. The global economy emerged from a protracted inventory destocking cycle (Chart 3). In the U.S., inventories made a negative contribution to growth for five straight quarters starting in Q2 of 2015, the longest streak since the 1950s. The U.K., Germany, and Japan also saw notable inventory corrections. Fears of a hard landing in China and a disorderly devaluation of the RMB subsided as the Chinese government ramped up fiscal stimulus. The era of fiscal austerity ended. Chart 4 shows that the fiscal thrust in developed economies turned positive in 2016 for the first time since 2010. Financial conditions eased in most economies, delivering an impulse to growth that is still being felt. In the U.S., for example, junk bond yields dropped from a peak of 10.2% in February 2016 to 6.3% at present (Chart 5). A surging stock market and rising home prices also helped buoy consumer and business sentiment. Chart 3Inventory Destocking Was A Drag On Growth Inventory Destocking Was A Drag On Growth Inventory Destocking Was A Drag On Growth Chart 4The End Of Fiscal Austerity? Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Chart 5Corporate Borrowing Costs Have Fallen Corporate Borrowing Costs Have Fallen Corporate Borrowing Costs Have Fallen Fine For Now... Looking out, global growth should stay reasonably firm over the next 12 months. Our global Leading Economic Indicator remains in a solid uptrend. Burgeoning animal spirits are powering a recovery in business spending, as evidenced by the jump in factory orders and capex intentions (Chart 6). The lagged effects from the easing in financial conditions over the past 12 months should help support activity. Chart 7 shows that the 12-month change in our U.S. Financial Conditions Index leads the business cycle by 6-to-9 months. The current message from the index is that U.S. growth will remain sturdy for the remainder of 2017. Chart 6Global Growth Will Stay Strong In The Near Term Global Growth Will Stay Strong In The Near Term Global Growth Will Stay Strong In The Near Term Chart 7Easing Financial Conditions Will Support Activity Easing Financial Conditions Will Support Activity Easing Financial Conditions Will Support Activity ... But Storm Clouds Are Forming Home prices cannot rise faster than rents or incomes indefinitely; nor can equity prices rise faster than earnings. Corporate spreads also cannot keep falling. As the equity and housing markets cool, and borrowing costs start climbing on the back of higher government bond yields, the tailwind from easier financial conditions will dissipate. When that happens - most likely, sometime next year - GDP growth will slow. In and of itself, somewhat weaker growth would not be much of a problem. After all, the economy is currently expanding at an above-trend pace and the Fed wants to tighten financial conditions to some extent - it would not be raising rates if it didn't! The problem is that trend growth is much lower now than in the past - only 1.8% according to the Fed's Summary of Economic Projections. Living in a world of slow trend growth could prove to be challenging. The U.S. corporate sector has been feasting on credit for the past four years (Chart 8). Household balance sheets are still in reasonably good shape, but even here, there are areas of concern. Student debt is going through the roof and auto loans are nearly back to pre-recession levels as a share of disposable income (Chart 9). Together, these two categories account for over two-thirds of non-housing related consumer liabilities. Chart 8U.S. Corporate Sector Has Been Feasting On Credit U.S. Corporate Sector Has Been Feasting On Credit U.S. Corporate Sector Has Been Feasting On Credit Chart 9U.S. Household Balance Sheets Are In Good Shape, But Auto And Student Loans Are A Potential Problem U.S. Household Balance Sheets Are In Good Shape, But Auto And Student Loans Are A Potential Problem U.S. Household Balance Sheets Are In Good Shape, But Auto And Student Loans Are A Potential Problem The risk is that defaults will rise if GDP growth falls below 2%, a pace that has often been described as "stall speed." This could set in motion a vicious cycle where slower growth causes firms to pare back debt, leading to even slower growth and greater pressure on corporate balance sheets - in other words, a recipe for recession. Act 2: Recession Redefining "Tight Money" "Expansions do not die of old age," Rudi Dornbusch once remarked, "They are killed by the Fed." On the face of it, this may not seem like much of a concern. If the Fed raises rates in line with the median "dot" in the Summary of Economic Projections, the funds rate will only be about 2.5% by mid-2019 (Chart 10). That may not sound like much, but keep in mind that the so-called neutral rate - the rate consistent with full employment and stable inflation - may be a lot lower now than in the past. Also keep in mind that it can take up to 18 months before the impact of tighter financial conditions take their full effect on the economy. Thus, by the time the Fed has realized that it has tightened monetary policy by too much, it may be too late. As we have argued in the past, a variety of forces have pushed down the neutral rate over time.1 For example, the amount of investment that firms need to undertake in a slow-growing economy has fallen by nearly 2% of GDP since the late-1990s (Chart 11). And getting firms to take on even this meager amount of investment may require a lower interest rate since modern production techniques rely more on human capital than physical capital. Chart 10Will The Fed's 'Gradual' Rate Hikes End Up Being Too Much? Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Chart 11Less Investment Required Less Investment Required Less Investment Required Rising inequality has also reduced aggregate demand by shifting income towards households with high marginal propensities to save (Chart 12). This has forced central banks to lower interest rates in order to prop up spending. From this perspective, it is not too surprising that income inequality and debt levels have been positively correlated over time (Chart 13). Chart 12Savings Heavily Skewed Towards Top Earners Savings Heavily Skewed Towards Top Earners Savings Heavily Skewed Towards Top Earners Chart 13U.S.: Positive Correlation Between Income Inequality And Debt-To-GDP U.S.: Positive Correlation Between Income Inequality And Debt-To-GDP U.S.: Positive Correlation Between Income Inequality And Debt-To-GDP Then there is the issue of the dollar. The broad real trade-weighted dollar has appreciated by 19% since mid-2014 (Chart 14). According to the New York Fed's trade model, this has reduced the level of real GDP by nearly 2% relative to what it would have otherwise been. Standard "Taylor Rule" equations suggest that interest rates would need to fall by around 1%-to-2% in order to offset a loss of demand of this magnitude. This means that if the economy could withstand interest rates of 4% when the dollar was cheap, it can only withstand interest rates of 2%-to-3% today. And even that may be too high. Consider the message from Chart 15. It shows that real rates have been trending lower since 1980. The real funds rate averaged only 1% during the 2001-2007 business cycle, a period when demand was being buoyed by a massive, debt-fueled housing bubble; fiscal stimulus in the form of the two Bush tax cuts and the wars in Iraq and Afghanistan; a weakening dollar; and by a very benign global backdrop where emerging markets were recovering and Europe was doing well. Chart 14The Dollar Is In The Midst Of Its Third Great Bull Market The Dollar Is In The Midst Of Its Third Great Bull Market The Dollar Is In The Midst Of Its Third Great Bull Market Chart 15The Neutral Rate Has Fallen The Neutral Rate Has Fallen The Neutral Rate Has Fallen Today, the external backdrop is fragile, the dollar has been strengthening rather than weakening, and households have become more frugal (Chart 16). And while President Trump has promised plenty of fiscal largess, the reality may turn out to be a lot more sobering than the rhetoric. Chart 16Return To Thrift Return To Thrift Return To Thrift End Of The Trump Trade? Not Yet The failure to replace the Affordable Care Act has cast doubt in the eyes of many observers about the ability of Congress to pass other parts of Trump's agenda. As a consequence, the "Trump Trade" has gone into reverse over the past few weeks, pushing down the dollar and Treasury yields in the process. We agree that the "Trump Trade" will eventually fizzle out. However, this is likely to be more of a story for 2018 than this year. If anything, last week's fiasco may turn out to be a blessing in disguise for the Republicans. Opinion polls suggest that the GOP would have gone down in flames if the American Health Care Act had been signed into law (Table 1). Table 1Passing The American Health Care Act Could Have Cost The Republicans Dearly Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play The GOP's proposed legislation would have reduced federal government spending on health care by $1.2 trillion over ten years. Sixty-four year-olds with incomes of $26,500 would have seen their annual premiums soar from $1,700 to $14,600. Even if one includes the tax cuts in the proposed bill, the net effect would have been a major tightening in fiscal policy. That would have warranted lower bond yields and a weaker dollar. The failure to pass an Obamacare replacement serves as a reminder that comprehensive tax reform will be more difficult to achieve than many had hoped. However, even if Republicans are unable to overhaul the tax code, this will not prevent them from simply cutting corporate and personal taxes. Worries that tax cuts will lead to larger budget deficits will be brushed aside on the grounds that they will "pay for themselves" through faster growth (dynamic scoring!). Throw some infrastructure spending into the mix, and it will not take much for the "Trump Trade" to return with a vengeance. Trump's Fiscal Fantasy Where the disappointment will appear is not during the legislative process, but afterwards. The highly profitable companies that will benefit the most from corporate tax cuts are the ones who least need them. In many cases, these companies have plenty of cash and easy access to external financing. As a consequence, much of the corporate tax cuts may simply be hoarded or used to finance equity buybacks or dividend payments. A large share of personal tax cuts will also be saved, given that they will mostly accrue to higher income earners. Chart 17From Unrealistic To Even More Unrealistic From Unrealistic To Even More Unrealistic From Unrealistic To Even More Unrealistic The amount of infrastructure spending that actually takes place will likely be a tiny fraction of the headline amount. This is not just because of the dearth of "shovel ready" projects. It is also because the public-private partnership structure the GOP is touting will severely limit the universe of projects that can be considered. Most of America's infrastructure needs consist of basic maintenance, rather than the sort of marquee projects that the private sector would be keen to invest in. Indeed, the bill could turn out to be little more than a boondoggle for privatizing existing public infrastructure projects, rather than investing in new ones. Chart 18Euro Area Credit Impulse Will Fade In The Second Half Of 2018 Euro Area Credit Impulse Will Fade In The Second Half Of 2018 Euro Area Credit Impulse Will Fade In The Second Half Of 2018 Meanwhile, the Trump administration is proposing large cuts to nondefense discretionary expenditures that go above and beyond the draconian ones that are already enshrined into current law (Chart 17). As such, the risk to the economy beyond the next 12 months is that markets push up the dollar and long-term interest rates in anticipation of continued strong growth and lavish fiscal stimulus only to get neither. Euro Area: A 12-Month Window For Growth The outlook for the euro area over the next 12 months is reasonably bright, but just as in the U.S., the picture could darken later next year. Euro area private sector credit growth reached 2.5% earlier this year. This may not sound like a lot, but that is the fastest pace of growth since July 2009. A further acceleration is probable over the coming months, given rising business confidence, firm loan demand, and declining nonperforming loans. Conceptually, it is the change in credit growth that drives GDP growth. Thus, as credit growth levels off next year, the euro area's credit impulse will fall back towards zero, setting the stage for a period of slower GDP growth (Chart 18). In contrast to the U.S., the ECB is likely to resist the urge to raise the repo rate before growth slows. That's the good news. The bad news is that the market could price in some tightening in monetary policy anyway, leading to a "bund tantrum" later this year. As in the past, the ECB will be able to defuse the situation. Unfortunately, what Draghi cannot do much about is the low level of the neutral rate in the euro area. If the neutral rate is low in the U.S., it is probably even lower in the euro area, reflecting the region's worse demographics and higher debt burdens. The anti-growth features of the common currency - namely, the inability to devalue one's currency in response to an adverse economic shock, as well as the austerity bias that comes from not having a central bank that can act as a lender of last resort to solvent but illiquid governments - also imply a lower neutral rate. Chart 19Anti-Euro Sentiment Is High In Italy Anti-Euro Sentiment Is High In Italy Anti-Euro Sentiment Is High In Italy Indeed, it is entirely possible that the neutral rate is negative in the euro area, even in nominal terms. If that's the case, the ECB will find it difficult to keep inflation from falling once the economy begins to slow late next year. The U.K.: And Now The Hard Part The U.K. fared better than most pundits expected in the aftermath of the Brexit vote. Nevertheless, it would be a mistake to assume that the Brexit vote has not cast a pall over the economy. The pound has depreciated by 11% against the euro and 16% against the dollar since that fateful day, while gilt yields have fallen across the board. Had it not been for this easing in financial conditions, the economic outcome would have been far worse. As the tailwind from the pound's devaluation begins to recede next year, the U.K. economy could suffer. Slower growth in continental Europe and the rest of the world could also exacerbate matters. The severity of the slowdown will hinge on the outcome of Brexit negotiations. On the one hand, the EU has an interest in taking a hardline stance to discourage separatist forces elsewhere, particularly in Italy where pro-euro sentiment is tumbling (Chart 19). On the other hand, the EU still needs the U.K. as both a trade partner and a geopolitical ally. Investors may therefore be surprised by the relatively muted negotiations that transpire over the coming months. In fact, news reports indicate that Brussels has already offered the U.K. a three year transitional deal that will give London plenty of time to conclude a free trade agreement with the EU. In addition, the EU has dangled the carrot of revocability, suggesting that the U.K. would be welcomed back with open arms if enough British voters were to change their minds. Whatever the path, our geopolitical service believes that political risk actually bottomed with the January 17 Theresa May speech.2 If that turns out to be the case, the pound is unlikely to weaken much from current levels. China And EM: The Calm Before The Storm? The Chinese economy should continue to perform well over the coming months. The Purchasing Manager Index for manufacturing remains in expansionary territory and BCA's China Leading Economic Indicator is in a clear uptrend (Charts 20 and 21). Chart 20Bright Spots In The Chinese Economy Bright Spots In The Chinese Economy Bright Spots In The Chinese Economy Chart 21Improving LEI Points To Further Growth Acceleration Improving LEI Points To Further Growth Acceleration Improving LEI Points To Further Growth Acceleration Moreover, there has been a dramatic increase in the sales of construction equipment such as heavy trucks and excavators, with growth rates matching levels last seen during the boom years before the global financial crisis. Historically, construction machinery sales have been tightly correlated with real estate development (Chart 22). Reflecting this reflationary trend, the producer price index rose by nearly 8% year-over-year in February, a 14-point swing from the decline of 6% experienced in late-2015. Historically, rising producer prices have resulted in higher corporate profits and increased capital expenditures, especially among private enterprises (Chart 23). Chart 22An Upturn In Housing Construction? An Upturn In Housing Construction? An Upturn In Housing Construction? Chart 23Higher Producer Prices Boosting Profits Higher Producer Prices Boosting Profits Higher Producer Prices Boosting Profits The key question is how long the good news will last. As in the rest of the world, our guess is that the Chinese economy will slow late next year, setting the stage for a major growth disappointment in 2019. Weaker growth abroad will be partly to blame, but domestic factors will also play a role. The Chinese housing market has been on a tear. The authorities are increasingly worried about a property bubble and have begun to tighten the screws on the sector. The full effect of these measures should become apparent sometime next year. Fiscal policy is also likely to be tightened at the margin. The IMF estimates that China benefited from a positive fiscal thrust of 2.2% of GDP between 2014 and 2016. The fiscal thrust is likely to be close to zero in 2017 and turn negative to the tune of nearly 1% of GDP in 2018 and 2019. The growth outlook for other emerging markets is likely to mirror China's. The IMF expects real GDP in emerging and developing economies to rise by 5.1% in Q4 of 2017 relative to the same quarter a year earlier, up from 4.2% in 2016 (Table 2). The biggest acceleration is expected to occur in Brazil, where the economy is projected to grow by 1.4% in 2017 after having contracted by 1.9% in 2016. Russia and India should also see better growth numbers. Table 2World Economic Outlook: Global Growth Projections Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play We do not see any major reason to challenge these numbers for this year, but think the IMF's projections will turn out to be too rosy for 2018, and especially, 2019. As BCA's Emerging Market Strategy service has documented, the lack of structural reforms in EMs over the past few years has depressed productivity growth. High debt levels also cloud the picture. Chart 24 shows that debt levels have continued to grow as a share of GDP in most emerging markets. In EMs such as China, where banks benefit from a fiscal backstop, the likelihood of a financial crisis is low. In others such as Brazil, where government finances are in precarious shape, the chances of another major crisis remains uncomfortable high. Japan: The End Of Deflation? If there is one thing investors are certain about it is that deflationary forces in Japan are here to stay. Despite a modest increase in inflation expectations since July 2016, CPI swaps are still pricing in inflation of only 0.6% over the next two decades, nowhere close to the Bank of Japan's 2% target. But could the market be wrong? We think so. Many of the forces that have exacerbated deflation in Japan, such as corporate deleveraging and falling property prices, have run their course (Chart 25). The population continues to age, but the impact that this is having on inflation may have reached an inflection point. Over the past quarter century, slow population growth depressed aggregate demand by reducing the incentive for companies to build out new capacity. This generated a surfeit of savings relative to investment, helping to fuel deflation. Now, however, as an ever-rising share of the population enters retirement, the overabundance of savings is disappearing. The household saving rate currently stands at only 2.8% - down from 14% in the early 1990s - while the ratio of job openings-to-applicants has soared to a 25-year high (Chart 26). Chart 24What EM Deleveraging? What EM Deleveraging? What EM Deleveraging? Chart 25Japan: Easing Deflationary Forces Japan: Easing Deflationary Forces Japan: Easing Deflationary Forces Chart 26Japan: Low Household Saving Rate And A Tightening Labor Market Japan: Low Household Saving Rate And A Tightening Labor Market Japan: Low Household Saving Rate And A Tightening Labor Market Government policy is finally doing its part to slay the deflationary dragon. The Abe government shot itself in the foot by tightening fiscal policy by 3% of GDP between 2013 and 2015. It won't make the same mistake again. The Bank of Japan's efforts to pin the 10-year yield to zero also seems to be bearing fruit. As bond yields in other economies have trended higher, this has made Japanese bonds less attractive. That, in turn, has pushed down the yen, ushering in a virtuous cycle where a falling yen props up economic activity, leading to higher inflation expectations, lower real yields, and an even weaker yen. Unfortunately, external events could conspire to sabotage Japan's escape from deflation. If the global economy slows in late-2018 - leading to a recession in 2019 - Japan will be hard hit, given the highly cyclical nature of its economy. And this could cause Japanese policymakers to throw the proverbial kitchen sink at the problem, including doing something that they have so far resisted: introducing a "helicopter money" financed fiscal stimulus program. Against the backdrop of weak potential GDP growth and a shrinking reservoir of domestic savings, the government may get a lot more inflation than it bargained for. Act 3: Stagflation Who Remembers The 70s Anymore? By historical standards, the 2019 recession will be a mild one for most countries, especially in the developed world. This is simply because the excesses that preceded the subprime crisis in 2007 and, to a lesser extent the tech bust in 2000, are likely to be less severe going into the next global downturn than they were back then. The policy response may turn out to be anything but mild, however. Memories of the Great Recession are still very much vivid in most peoples' minds. No one wants to live through that again. In contrast, memories of the inflationary 1970s are fading. A recent NBER paper documented that age plays a big role in determining whether central bankers turn out to be dovish or hawkish.3 Those who experienced stagflation in the 1970s as adults are much more likely to express a hawkish bias than those who were still in their diapers back then. The implication is the future generation of central bankers is likely to see the world through more dovish eyes than their predecessors. Even if one takes the generational mix out of the equation, there are good reasons to aim for higher inflation in today's environment. For one thing, debt is high. The simplest way to reduce real debt burdens is by letting inflation accelerate. In addition, the zero bound is less likely to be a problem if inflation were higher. After all, if inflation were running at 1% going into a recession, real rates would not be able to fall much below -1%. But if inflation were running at 3%, real rates could fall to as low as -3%. The Politics Of Inflation Political developments will also facilitate the transition to higher inflation. In the U.S., the presidential election campaign will start coming into focus in 2019. If the economy enters a recession then, Donald Trump will go ballistic. The infrastructure program that Republicans in Congress are downplaying now will be greatly expanded. Gold-plated hotels and casinos will be built across the country. Of course, several years could pass between when an infrastructure bill is passed and when most new projects break ground. By that time, the economy will already be recovering. This will help fuel inflation. As the economy turns down in 2019, the Fed will also be forced to play ball. The market's current obsession over whether President Trump wants a "dove" or a "hawk" as Fed chair misses the point. He wants neither. He wants someone who will do what they are told. This means that the next Fed chair will likely be a "really smart" business executive with little-to-no-experience in central banking and even less interest in maintaining the Federal Reserve's institutional independence. The empirical evidence strongly suggests that inflation tends to be higher in countries that lack independent central banks (Chart 27). This may be the fate of the U.S. Chart 27Inflation Higher In Countries Lacking Independent Central Banks Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Europe's Populists: Down But Not Out Whether something similar happens in Europe will also depend on political developments. For the next 18 months at least, the populists will be held at bay (Chart 28). Le Pen currently trails Macron by 24 percentage points in a head-to-head contest. It is highly unlikely that she will be able to close this gap between now and May 7th, the date of the second round of the Presidential contest. In Germany, support for the europhile Social Democratic Party is soaring, as is support for the common currency itself. For the time being, euro area risk assets will be able to climb the proverbial political "wall of worry." However, if the European economy turns down in 2019, all this may change. Chart 29 shows the strong correlation between unemployment rates in various French départements and support for Marine Le Pen's National Front. Should French unemployment rise, her support will rise as well. The same goes for other European countries. Chart 28France And Germany: Populists Held At Bay For Now France And Germany: Populists Held At Bay For Now France And Germany: Populists Held At Bay For Now Chart 29Higher Unemployment Would Benefit Le Pen Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Meanwhile, there is a high probability that the migrant crisis will intensify at some point over the next few years. Several large states neighboring Europe are barely holding together - Egypt being a prime example - and could erupt at any time. Furthermore, demographic trends in Africa portend that the supply of migrants will only increase. In 2005, the United Nations estimated that sub-Saharan Africa's population will increase to 2 billion by the end of the century, up from one billion at present. In its 2015 revision, the UN doubled its estimate to 4 billion. And even that may be too conservative because it assumes that the average number of births per woman falls from 5.1 to 2.2 over this period (Chart 30). Chart 30Population Pressures In Africa Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play The existing European political order is not well equipped to deal with large-scale migration, as the hapless reaction to the Syrian refugee crisis demonstrates. This implies that an increasing share of the public may seek out a "new order" that is more attuned to their preferences. European history is fraught with regime shifts, and we may see yet another one in the 2020s. The eventual success of anti-establishment politicians on both sides of the Atlantic suggests that open border immigration policies and free trade - the two central features of globalization - will come under attack. Consequently, an inherently deflationary force, globalization, will give way to an inherently inflationary one: populism. The Productivity Curse Just as the "flation" part of stagflation will become more noticeable as the global economy emerges from the 2019 recession, so will the "stag." Chart 31 shows that productivity growth has fallen across almost all countries and regions. There is little compelling evidence that measurement error explains the productivity slowdown.4 Cyclical factors have played some role. Weak investment spending has curtailed the growth in the capital stock. This means that today's workers have not benefited from the same improvement in the quality and quantity of capital as they did in previous generations. However, the timing of the productivity slowdown - it began in 2004-05 in most countries, well before the financial crisis struck - suggests that structural factors have been key. Most prominently, the gains from the IT revolution have leveled off. Recent innovations have focused more on consumers than on businesses. As nice as Facebook and Instagram are, they do little to boost business productivity - in fact, they probably detract from it, given how much time people waste on social media these days. Human capital accumulation has also decelerated, dragging productivity growth down with it. Globally, the fraction of adults with a secondary degree or higher is increasing at half the pace it did in the 1990s (Chart 32). Educational achievement, as measured by standardized test scores in mathematics, is edging lower in the OECD, and is showing very limited gains in most emerging markets (Chart 33).5 Given that test scores are extremely low in most countries with rapidly growing populations, the average level of global mathematical proficiency is now declining for the first time in modern history. Chart 31Productivity Growth Has Slowed In Most Major Economies Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Chart 32The Contribution To Growth From Rising Human Capital Is Falling Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Chart 33Math Skills Around The World Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Productivity And Inflation The slowdown in potential GDP growth tends to be deflationary at the outset, but becomes inflationary later on (Chart 34). Initially, lower productivity growth reduces investment, pushing down aggregate demand. Lower productivity growth also curtails consumption, as households react to the prospect of smaller real wage gains. Chart 34A Decline In Productivity Growth Is Deflationary In The Short Run, But Inflationary In The Long Run Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Eventually, however, economies that suffer from chronically weak productivity growth tend to find themselves rubbing up against supply-side constraints. This leads to higher inflation.6 One only needs to look at the history of low-productivity economies in Africa and Latin America to see this point - or, for that matter, the U.S. in the 1970s, a decade during which productivity growth slowed and inflation accelerated. Financial Markets Overall Strategy Risk assets have enjoyed a strong rally since late last year, and a modest correction is long overdue. Still, as long as the global economy continues to grow at a robust pace, the cyclical outlook for risk assets will remain bullish. As such, investors with a 12-month horizon should stay overweight global equities and high-yield credit at the expense of government bonds and cash. Global growth is likely to slow in the second half of 2018, with the deceleration intensifying into 2019, possibly culminating in a recession in a number of countries. To what extent markets "sniff out" an economic slowdown before it happens is a matter of debate. U.S. equities did not peak until October 2007, only slightly before the Great Recession began. Commodity prices did not top out until the summer of 2008. Thus, the market's track record for predicting recessions is far from an envious one. Nevertheless, investors should err on the side of safety and start scaling back risk exposure next spring. The 2019 recession will last 6-to-12 months, followed by a gradual recovery that sees the restoration of full employment in most countries by 2021. At that point, inflation will take off, rising to over 4% by the middle of the decade. The 2020s will be remembered as a decade of intense pain for bond investors. In relative terms, equities will fare better than bonds, but in absolute terms they will struggle to generate a positive real return. As in the 1970s, gold will be the standout winner. Chart 35 presents a visual representation of how the main asset markets are likely to evolve over the next seven years. Chart 35Market Outlook For Major Asset Classes Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Equities Cyclically Favor The Euro Area And Japan Over The U.S. Stronger global growth is powering an acceleration in corporate earnings. Global EPS is expected to expand by 12% over the next 12 months. Analysts are usually too bullish when it comes to making earnings forecasts. This time around they may be too bearish. Chart 36 shows that the global earnings revision ratio has turned positive for the first time in six years, implying that analysts have been behind the curve in revising up profit projections. We prefer euro area and Japanese stocks relative to U.S. equities over a 12-month horizon. We would only buy Japanese stocks on a currency-hedged basis, as the prospect of a weaker yen is the main reason for being overweight Japan. In contrast, we would still buy euro area equities on a U.S. dollar basis, even though our central forecast is for the euro to weaken against the dollar over the next 12 months. Our cyclically bullish view on euro area equities reflects several considerations. For starters, they are cheap. Euro area stocks currently trade at a Shiller PE ratio of only 17, compared with 29 for the U.S. (Chart 37). Some of this valuation gap can be explained by different sector weights across the two regions. However, even if one controls for this factor, as well as the fact that euro area stocks have historically traded at a discount to the U.S., the euro area still comes out as being roughly one standard deviation cheap compared with the U.S. (Chart 38). Chart 36Global Earnings Picture Looking Brighter Global Earnings Picture Looking Brighter Global Earnings Picture Looking Brighter Chart 37Euro Area Stocks Are A Bargain... Euro Area Stocks Are A Bargain... Euro Area Stocks Are A Bargain... Chart 38...No Matter How You Look At It ...No Matter How You Look At It ...No Matter How You Look At It European Banks Are In A Cyclical Sweet Spot Of course, if euro area banks flounder over the next 12 months as they have for much of the past decade, none of this will matter. However, we think that the region's banks have finally turned the corner. The ECB is slowly unwinding its emergency measures and core European bond yields have risen since last summer. This has led to a steeper yield curve, helping to flatter net interest margins. Chart 39 shows that the relative performance of European banks is almost perfectly correlated with the level of German bund yields. Our European Corporate Health Monitor remains in improving territory, in contrast to the U.S., where it has been deteriorating since 2013 (Chart 40). Profit margins in Europe have room to expand, whereas in the U.S. they have already maxed out. The capital positions of European banks have also improved greatly since the euro crisis. Not all banks are out of the woods, but with nonperforming loans trending lower, the need for costly equity dilution has dissipated (Chart 41). Meanwhile, euro area credit growth is accelerating and loan demand continues to expand. Chart 39Performance Of European Banks And Bond Yields: A Good Fit Performance Of European Banks And Bond Yields: A Good Fit Performance Of European Banks And Bond Yields: A Good Fit Chart 40Corporations Healthier In The Euro Area Corporations Healthier In The Euro Area Corporations Healthier In The Euro Area Chart 41Cyclical Background Positive For Bank Stocks Cyclical Background Positive For Bank Stocks Cyclical Background Positive For Bank Stocks Beyond a 12-month horizon, the outlook for euro area banks and the broader stock market look less enticing. The region will suffer along with the rest of the world in 2019. The eventual triumph of populist governments could even lead to the dissolution of the common currency. This means that euro area stocks should be rented, not owned. The same goes for U.K. equities. EM: Uphill Climb Emerging market equities tend to perform well when global growth is strong. Thus, it would not be surprising if EM equities continue to march higher over the next 12 months. However, the structural problems plaguing emerging markets that we discussed earlier in this report will continue to cast a pall over the sector. Our EM strategists favor China, Taiwan, Korea, India, Thailand, Poland, Hungary, the Czech Republic, and Russia. They are neutral on Singapore, the Philippines, Hong Kong, Chile, Mexico, Colombia, and South Africa; and are underweight Indonesia, Malaysia, Brazil, Peru, and Turkey. Fixed Income Global Bond Yields To Rise Further We put out a note on July 5th entitled "The End Of The 35-Year Bond Bull Market" recommending that clients go structurally underweight safe-haven government bonds.7 As luck would have it, we penned this report on the very same day that the 10-year Treasury yield hit a record closing low of 1.37%. We continue to think that asset allocators should maintain an underweight position in global bonds over the next 12 months. In relative terms, we favor Japan over the U.S. and have a neutral recommendation on the euro area and the U.K. Chart 42The Market Expects 50 Basis Points Of Tightening Over The Next 12 Months The Market Expects 50 Basis Points Of Tightening Over The Next 12 Months The Market Expects 50 Basis Points Of Tightening Over The Next 12 Months Underweight The U.S. For Now We expect the U.S. 10-year Treasury yield to rise to around 3.2% over the next 12 months. The Fed is likely to raise rates by a further 100 basis points over this period, about 50 bps more than the 12-month discounter is currently pricing in (Chart 42). In addition, the Fed will announce later this year or in early 2018 that it will allow the assets on its balance sheet to run off as they mature. This could push up the term premium, giving long Treasury yields a further boost. Thus, for now, investors should underweight Treasurys on a currency-hedged basis within a fixed-income portfolio. The cyclical peak for both Treasury yields and the dollar should occur in mid-2018. Slowing growth in the second half of that year and a recession in 2019 will push the 10-year Treasury yield back towards 2%. After that, bond yields will grind higher again, with the pace accelerating in the early 2020s as the stagflationary forces described above gather steam. Neutral On Europe, Overweight Japan Yields in the euro area will follow the general contours of the U.S., but with several important qualifications. The ECB is likely to roll back some of its emergency measures over the next 12 months, including suspending the Targeted Longer-Term Refinancing Operations, or TLTROs. It could also raise the deposit rate slightly, which is currently stuck in negative territory. However, in contrast to the Fed, the ECB is unlikely to hike its key policy rate, the repo rate. And while the ECB will "taper" asset purchases, it will not take any steps to shrink the size of its balance sheet. As such, fixed-income investors should maintain a benchmark allocation to euro area bonds. Chart 43A Bit More Juice Left A Bit More Juice Left A Bit More Juice Left A benchmark weighting to gilts is also warranted. With the Brexit negotiations hanging in the air, it is doubtful that the Bank of England would want to hike rates anytime soon. On the flipside, rising inflation - though largely a function of a weak currency - will make it difficult for the BoE to increase asset purchases or take other steps to ease monetary policy. We would recommend a currency-hedged overweight position in JGBs. The Bank of Japan is committed to keeping the 10-year yield pinned to zero. Given that neither actual inflation nor inflation expectations are anywhere close to that level, it is highly unlikely that the BoJ will jettison its yield-targeting regime anytime soon. With government bond yields elsewhere likely to grind higher, this makes JGBs the winner by default. High-Yield Credit: Still A Bit Of Juice Left The fact that the world's most attractive government bond market by our rankings - Japan - is offering a yield of zero speaks volumes. As long as global growth stays strong and corporate default risk remains subdued, investors will maintain their love affair with high-yield credit. Thus, while credit spreads have fallen dramatically, they could still fall further (Chart 43). Only when corporate stress begins to boil over in late 2018 will things change. Nevertheless, investors will continue to face headwinds from rising risk-free yields in most economies even in the near term. This implies that the return from junk bonds in absolute terms will fall short of what is delivered by equities over the next 12 months. Currencies And Commodities Chart 44Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Will Support The Greenback We expect the real trade-weighted dollar to appreciate by about 10% over the next 12 months. Historically, changes in real interest rate differentials have been the dominant driver of currency movements in developed economies. The past few years have been no different. Chart 44 shows that the ascent of the trade-weighted dollar since mid-2014 has been almost perfectly matched by an increase in U.S. real rates relative to those abroad. Interest rate differentials between the U.S. and its trading partners are likely to widen further through to the middle of 2018 as the Fed raises rates more quickly than current market expectations imply, while other central banks continue to stand pat. Accordingly, we would fade the recent dollar weakness. As we discussed in "The Fed's Unhike," the March FOMC statement was not as dovish as it might have appeared at first glance.8 Given that monetary conditions eased in the aftermath of the Fed meeting - exactly the opposite of what the Fed was trying to achieve - it is likely that the FOMC's rhetoric will turn more hawkish in the coming weeks. The Yen Has The Most Downside, The Pound The Least Among the major dollar crosses, we see the most downside for the yen over the next 12 months. The Bank of Japan will continue to keep JGB yields anchored at zero. As yields elsewhere rise, investors will shift their money out of Japan, causing the yen to weaken. Only once the global economy begins to teeter into recession late next year will the yen - traditionally, a "risk off" currency - begin to rebound. The euro will also weaken against the dollar over the next 12 months, although not as much as the yen. The ECB's "months to hike" has plummeted from nearly 60 last summer to 26 today (Chart 45). That seems too extreme. Core inflation in the euro area is well below U.S. levels, even if one adjusts for measurement differences between the two regions (Chart 46). The neutral rate is also lower in the euro area, as discussed previously. This sharply limits the ability of the ECB to raise rates. Chart 45Market's Hawkish View Of The ECB Is Too Extreme Market's Hawkish View Of The ECB Is Too Extreme Market's Hawkish View Of The ECB Is Too Extreme Chart 46Core Inflation In The U.S. Is Still Higher, Even Excluding Housing Core Inflation In The U.S. Is Still Higher, Even Excluding Housing Core Inflation In The U.S. Is Still Higher, Even Excluding Housing Unlike most currencies, sterling should be able to hold its ground against the dollar over the next 12 months. The pound is very cheap by most metrics (Chart 47). The prospect of contentious negotiations over Brexit with the EU is already in the price. What may not be in the price is the possibility that the U.K. will move quickly to reach a deal with the EU. If such a deal fails to live up to the promises made by the Brexit campaign - a near certainty in our view - a new referendum may need to be scheduled. A new vote could yield a much different result than the first one. If the market begins to sniff out such an outcome, the pound could strengthen well before the dust settles. EM And Commodity Currencies The RMB will weaken modestly against the dollar over the coming year. As we have discussed in the past, China's high saving rate will keep the pressure on the government to try to export excess production abroad by running a large current account surplus. This requires a weak currency.9 Nevertheless, a major devaluation of the RMB is not in the cards. Much of the capital flight that China has experienced recently has been driven by an unwinding of the hot money flows that entered the country over the preceding years. Despite all the talk about a credit bubble, Chinese external debt has fallen by around $400 billion since its peak in mid-2014 - a decline of over 50% (Chart 48). At this point, most of the hot money has fled the country. This suggests that the pace of capital outflows will subside. Chart 47Pound: Cheap By All Accounts Pound: Cheap By All Accounts Pound: Cheap By All Accounts Chart 48Hot Money In, Hot Money Out Hot Money In, Hot Money Out Hot Money In, Hot Money Out A somewhat weaker RMB could dampen demand for base and bulk metals. A slowdown in Chinese construction activity next year could also put added pressure on metals prices. Our EM strategists are especially bearish on the South African rand, Brazilian real, Colombian peso, Turkish lira, Malaysian ringgit, and Indonesian rupiah. Crude should outperform metals over the next 12 months. This will benefit the Canadian dollar and other oil-sensitive currencies. However, Canada's housing bubble is getting out of hand and could boil over if domestic borrowing costs climb in line with rising long-term global bond yields. A sagging property sector will limit the ability of the Bank of Canada to raise short-term rates. On balance, we see modest downside for the CAD/USD over the coming year. The Aussie dollar will suffer even more, given the country's own housing excesses and its export sector's high sensitivity to metal prices. Finally, a few words on the most of ancient of all currencies: gold. We do not expect bullion to fare well over the next 12 months. A stronger dollar and rising bond yields are both bad news for the yellow metal. However, once central banks start slashing rates in 2019 and stagflationary forces begin to gather steam in the early 2020s, gold will finally have its day in the sun. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Seven Structural Reasons For A Lower Neutral Rate In The U.S.," dated March 13, 2015, available at gis.bcaresearch.com. 2 Please see Geopolitical Strategy Weekly Report, "The "What Can You Do For Me" World?" dated January 25, 2017, and Special Report, "Will Scotland Scotch Brexit?" dated March 29, 2017, available at gps.bcaresearch.com. 3 Ulrike Malmendier, Stefan Nagel, and Zhen Yan, "The Making Of Hawks And Doves: Inflation Experiences On The FOMC," NBER Working Paper No. 23228 (March 2017). 4 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 5 Please see The Bank Credit Analyst Special Report, "Taking Off The Rose-Colored Glasses: Education And Growth In The 21st Century," dated February 24, 2011, available at bca.bcaresearch.com. 6 Note to economists: We can think of this relationship within the context of the Solow growth model. The model says that the neutral real rate, r, is equal to (a/s) (n + g + d), where a is the capital share of income, s is the saving rate, n is labor force growth, g is total factor productivity growth, and d is the depreciation rate of capital. In the standard setup where the saving rate is fixed, slower population and productivity growth will always result in a lower equilibrium real interest rate. However, consider a more realistic setup where: 1) the saving rate rises initially as the population ages, but then begins to decline as a larger share of the workforce enters retirement; and 2) habit persistence affects consumer spending, so that households react to slower real wage growth by saving less rather than cutting back on consumption. In that sort of environment, the neutral rate could initially fall, but then begin to rise. If the central bank reacts slowly to changes in the neutral rate, or monetary policy is otherwise constrained by the zero bound on interest rates and/or political considerations, the initial effect of slower trend GDP growth will be deflationary while the longer-term outcome will be inflationary. 7 Please see Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com. 8 Please see Global Investment Strategy Weekly Report, "The Fed's Unhike," dated March 16, 2017, available at gis.bcaresearch.com. 9 Please see Global Investment Strategy Weekly Report, "Does China Have A Debt Problem Or A Savings Problem?" dated February 24, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The end game for the Kingdom of Saudi Arabia (KSA), Russia and their respective allies is fairly obvious: Remove enough production from the market to draw down storage and make the oil-supply curve, once again, more inelastic. This would allow these states to use forward guidance and small adjustments in production to influence prices, the sine qua non of petro-states desperate to maintain revenues and diversify away from near-complete dependence on hydrocarbon exports. We think the effort will succeed over the short run. Just how durable this pact will be remains to be seen, given oil is, once again, super-abundant. If production discipline breaks down, all bets are off. Energy: Overweight. We are now solidly positioned for backwardation in oil - long Dec/17 vs. short Dec/18 WTI and Brent; these positions are up 141.6% and 68.4%, respectively. We also are positioned for a rally on drawdowns in inventories as refiners come back from turnarounds over the next few weeks: We are long $50/bbl WTI calls vs. short $55/bbl calls in Jul-Aug-Sep 2017; these positions are up 7.66% on average. Base Metals: Neutral. Workers at Chile's Escondida mine are back on the job, after a 44-day strike. The strike is estimated to have cost BHP Billiton some $1 billion, according to Reuters.1 Precious Metals: Neutral. Gold has rallied by 4.3% since the FOMC raised overnight rates. Our long volatility position - long a Jun/17 put and call spread for $21/oz - is down 30%. Ags/Softs: Underweight. The long-awaited and much-anticipated USDA planting intentions report is due out tomorrow. We remain bearish, expecting an early indication stocks-to-use ratios for grains and beans will remain elevated. Feature Chart of the WeekStorage Was Well On Its Way to Drawing##br## Before the Year-End Production Surge Storage Was Well On Its Way to Drawing Before the Year-End Production Surge Storage Was Well On Its Way to Drawing Before the Year-End Production Surge KSA and Russia have to make oil supply more inelastic in order to regain some control over where prices go and, consequently, where their revenues go. Their end game is obvious - i.e., remove the excess oil production that pushed inventories to historically high levels - but their execution has been, at best, halting. Prior to KSA and Russia delivering an historic production-management Agreement at the end of last year, oil markets were well on the way to removing the storage overhang by year-end 2017, as any Econ 101 text would have suggested. Low prices following OPEC's market-share war declaration destroyed supply and lifted demand, which was drawing down stocks. This is easily seen in the Chart of the Week showing inventories beginning to head south in mid-2016. Then came the KSA - Russia Agreement between OPEC and non-OPEC producers to cut output by some 1.8mm b/d. The goal of the deal was to accelerate the drawdown in record high storage levels. Even while the deal was being negotiated, it was apparent some producers in the know were getting a jump on shipping those last barrels out the door before they were obliged to cut. This produced the end-of-year production surge, which swelled global inventories. The year-end surge by OPEC and non-OPEC producers could be expected (Chart 2), but it came at a really bad time for the market, since 1Q17 also was when refiners took units down for maintenance. This is fairly routine, but in some key markets like the U.S. Gulf, the current maintenance season was busier than average, according to the EIA (Chart 3). This left a lot of crude in storage, as product inventories were being drawn. Chart 2Year-End Production Surge ##br##Powered The Storage Build Year-End Production Surge Powered The Storage Build Year-End Production Surge Powered The Storage Build Chart 3Maintenance Season In 1Q17 ##br##Exacerbated The Storage Build Maintenance Season In 1Q17 Exacerbated The Storage Build Maintenance Season In 1Q17 Exacerbated The Storage Build Where are we today? Most of the pre-Agreement production and export surge has been absorbed, and inventories in the U.S. are drawing a bit. Floating storage has been drained. But, in an interesting economic twist, OECD storage levels are likely to reach the targeted drawdown of 10% (300mm bbl) by year-end 2017, which is exactly what would have happened absent any action by KSA and Russia at the end of last year. It is difficult to resist reiterating that had nothing been done at the end of last year by KSA and Russia, and the market was left to do its necessary work of removing high-cost production and encouraging increased demand via lower prices, the market would have ended up in the exact same place it now finds itself. Trust But Verify Be that as it may, the really hard work of the KSA - Russia deal now begins. We expect OECD inventories to hit the 10% drawdown target by year end. However, if parties to the deal do not maintain production discipline markets will almost surely take prices lower. This could easily happen if prices start to percolate as we expect in 2Q17, and cash-strapped non-OPEC producers decide to see how far they can push KSA and its Gulf-state allies on their deal. Russia has been slow to deliver on its production commitment, while KSA has over-delivered (Chart 4). The same can be said for their respective allies (Chart 5). We believe markets will remain skittish, until evidence Russia and Iraq also are abiding by the end-2016 Agreement becomes incontrovertible. It is true Russian President Vladimir Putin personally involved himself in this deal, and helped close it on the non-OPEC side, but markets will want proof production actually is falling. Like former U.S. President Ronald Reagan, markets may be willing to trust, but they certainly will want to verify compliance. Chart 4KSA Over-Delivers On Its Cuts, ##br##Russia Is Slow To Deliver KSA Over-Delivers On Its Cuts, Russia Is Slow To Deliver KSA Over-Delivers On Its Cuts, Russia Is Slow To Deliver Chart 5KSA's Allies Are Delivering, ##br##Russia's Not So Much KSA’s Allies Are Delivering, Russia’s Not So Much KSA’s Allies Are Delivering, Russia’s Not So Much While not our base case, it is possible Russia and its fellow travelers could decide to risk keeping their production above agreed volumes under the Agreement, in the belief KSA is more in need of keeping prices above $50/bbl or so over the next 18 months, given the Kingdom wants a successful IPO of state-owned Saudi Aramco. Should this occur, markets would correct violently. At the end of the day, such a gamble likely would be ruinous for both, if it provoked KSA to abandon its commitment to keep production below 10mm b/d. Short-term goals - getting OECD storage levels down to five-year averages - would be sacrificed. Importantly, long-term goals we believe are driving KSA and Russia to cooperate in the first place, namely developing a modus operandi for containing U.S. shale-oil output, will become moot, possibly returning the market to the production free-for-all that motivated the KSA - Russia dialogue. The Quest For Relevance Chart 6Odds Favor Backwardated Markets ##br##As the Production Cuts Lead To Physical Deficits Odds Favor Backwardated Markets As the Production Cuts Lead To Physical Deficits Odds Favor Backwardated Markets As the Production Cuts Lead To Physical Deficits Our base case envisions a successful KSA - Russia Agreement in which production discipline is maintained, and the deal produces its desired result - drawing storage down by ~ 300mm bbls. Forward curves then backwardate (Chart 6). This sets the stage for deeper discussions among KSA, Russia and their respective allies re how they can work together going forward to contain U.S. shale-oil production. In effect, the parties to this deal have a choice to make: Either they figure out a way to make room for shale, which has catapulted the U.S. to major-producer status once again, or they leave this to the market. We are fairly confident these discussions already are ongoing, and will be well advanced by year-end. Next week, we will be publishing a theoretical piece on how the KSA - Russia pact could provide a platform that allows these petro-states - which we are taking the liberty of dubbing OPEC 2.0 - to re-gain a modicum of control over the rate at which U.S. shale-oil resources are developed. In earlier research, we advanced a theory that shale rig counts are highly sensitive not only to the level of prices at the front of the curve, but to the curve shape itself. We were able to demonstrate that contango markets - i.e., prices for promptly delivered crude are less than prices for deferred delivery material - favor shale producers, and, all else equal, incentivize them to hedge forward so as to lock in future revenues that maximize the number of rigs they deploy.2 In backwardated markets, the number of rigs a shale operator is able to deploy is lower, all else equal, which means the revenue they can lock in by hedging forward is lower. This limits the rate at which the resource can be developed. Based on these theoretical results, we believe it is in the interest of the OPEC 2.0 states to keep the WTI forward curve in backwardation, so that, at the margin, the number of rigs deployed to the shales is contained. Our research suggests that the deeper the backwardation, the slower rig counts grow. So, if the ideal price level for KSA is, as has been reported in the media, $60/bbl for Brent, then, in the best of all worlds, the Kingdom, Russia and their respective allies target spot prices at this level and use production, storage and forward guidance to backwardate the WTI curve, which is used by shale producers to hedge.3 Such a strategy has numerous risks, particularly if OPEC 2.0 cannot react quickly enough to keep prices from rising above a level that keeps shale-oil producers restricted to their core production areas. This would allow higher-cost shale reserves to be brought on line, which would raise the likelihood of lower prices, and cost OPEC 2.0 market share.4 Such a strategy also would tempt OPEC 2.0 producers to free ride, raising production at the margin to increase their revenues. This also risks lower prices. Nonetheless, we believe such a strategy could benefit both KSA and Russia and their allies, which is why it likely will at least be considered and attempted.5 KSA would be able to IPO Aramco into a relatively stable higher-price market, which would allow it to invest in additional refinery capacity in Asia and elsewhere, and in alternative-energy resources like solar, to free up oil for export. Russia also is better off keeping prices at a level at which its economy can continue to work on diversifying its exposure away from its heavy dependence on oil and gas exports.6 We will present more of our thinking on this next week. In the meantime, we highly recommend BCA clients read Matt Conlan's article in this week's Energy Sector Strategy entitled "Shale Dynamics: Sensitivities Within Modeling A Shale Recovery."7 This is an excellent analysis of shale-oil economics. Bottom Line: We continue to expect crude and products storage to draw as production cuts become apparent and refiners bring units back up off maintenance. This will backwardate WTI and Brent forward curves. Based on our high level of conviction in this outcome, we added a long Brent Dec/17 vs. short Dec/18 Brent position to our recommended trades, along with a similar WTI position. We also are positioned for a rally on drawdowns in inventories as refiners come back from turnarounds over the next few weeks, by being long $50/bbl WTI calls vs. short $55/bbl calls in Jul-Aug-Sep 2017. We continue to expect the U.S. benchmark WTI crude prices to average $55/bbl to 2020 and for WTI prices to trade most of the time between $45/bbl and $65/bbl. For 2018 and beyond, our conviction is lower: The massive capex cuts seen in the industry will place an enormous burden on shale producers and conventional oil producers - chiefly Gulf Arab producers and Russia - to offset natural decline-curve losses and meet increasing demand. For the international benchmark, Brent crude oil, we expect the spread between Brent and WTI prices to average $1.50/bbl (Brent over). Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "Escondida outcome seen as disaster for BHP as workers return," published by Reuters.com on March 24, 2017. 2 We introduced this line of research in our February 16, 2017, issue of Commodity & Energy Strategy, in an article entitled "North American Oil Pipeline Buildout Complicates Price And Storage Expectations," it is available at ces.bcaresearch.com. We continue to delve into this topic, and will be presenting out latest thinking next week. 3 Please see "Exclusive: Saudi Arabia wants oil prices to rise to around $60 in 2017 - sources," published by Reuters February 28, 2017. Russia's budgeting assumption for 2017 to 2019 is $40/bbl, according to a Bloomberg report from March 24, 2017, entitled "OPEC Be Warned: Russia Prepares for Oil at $40." 4 It is not in KSA's, Russia's or their allies' interests to kill off shale production. The more-than-$1 trillion of capex for projects that would have been developed between 2015 and 2020, and would have translated into some 7mm b/d of oil-equivalent production will not be available to the market beginning later this decade. As we have noted, an enormous burden will be placed on shale production, Gulf OPEC producers and Russia to meet growing demand later this decade. 5 We also would note this would be a boon to long-only commodity index investors, whose returns are driven by roll yields that only exist in backwardated markets. More on that in subsequent research as well. 6 Russia's exports are dominated by oil and gas, while KSA's are dominated by crude oil and, increasingly, refined products. In 2015, the Carnegie Endowment for International Peace calculated close to 70% of Russia's economy is dependent on revenue from hydrocarbons - production, trade, investments in non-oil industries funded by oil revenues, and consumption made possible via oil and gas production and sales. We discuss this at length in the September 8, 2016, issue of Commodity & Energy Strategy, in an article entitled "Ignore The KSA - Russia Production Pact, Focus Instead On Their Need For Cash." 7 Please see Energy Sector Strategy Weekly Report entitled "Shale Dynamics: Sensitivities Within Modeling A Shale Recovery," This article was published March 29, 2017, available at nrg.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016

Highlights EM equity valuations are neutral. Relative to the U.S., EM share prices do offer some value, but this primarily reflects elevated valuations within the S&P 500. According to the cyclically-adjusted P/E ratio, EM stocks are cheap for investors with a long-term time horizon - longer than two to three years. Corporate profits are much more important than equity valuations in driving share prices in the next 12 months. Our outlook for EM EPS is downbeat for the next 12 months. Maintain a defensive posture and an underweight allocation in EM stocks versus DM. A new trade: go long Russian energy stocks / short global energy ones. Feature Chart I-1EM P/E Ratio And EPS EM P/E Ratio And EPS EM P/E Ratio And EPS There is ongoing debate in the investment community concerning whether emerging markets (EM) equities are or are not cheap, in both absolute terms and relative to developed markets (DM). In this week's report we review various equity valuation indicators and reiterate that EM stocks are neither cheap nor expensive in absolute terms. For example, the average of trailing and forward P/E ratios is slightly above its historical mean (Chart I-1, top panel). Relative to the U.S., EM share prices do offer value, but this reflects elevated valuations within the S&P 500. Despite this, we recommend underweighting EM vs U.S./DM because the cyclical growth dynamics is much better in DM than EM. EM stocks are cheap if one assumes a strong earnings recovery (Chart I-1, bottom panel). If earnings per share (EPS) begin contracting anew, as we expect, then the current rally will be reversed sooner than later. Overall, we continue to recommend a defensive posture for absolute-return investors and maintaining an underweight allocation in EM stocks versus DM for asset allocators. Valuation Perspectives Below we consider several valuation ratios: The equal-sector weighted trailing P/E ratio is 17.7 for EM (Chart I-2). Table I-1 displays equal-sector weighted P/E ratio, price-to-book value ratio and dividend yields for major equity markets globally. This is an apples-to-apples comparison, as it assigns equal weights to each of the 10 MSCI sectors - i.e., it removes sector biases. Chart I-2Equal-Sector Weighted Trailing P/E Ratio Equal-Sector Weighted Trailing P/E Ratio Equal-Sector Weighted Trailing P/E Ratio Table I-1Equal-Sector Weighted Valuation Ratios Across EM And DM EM Equity Valuations Revisited EM Equity Valuations Revisited Hence, on a comparable basis, EM equities are only slightly cheaper than DM stocks as is evident in Table I-1. Besides, the composite valuation indicator based on equal-sector weighted trailing and forward P/E, price-to-book value, price-to-cash earnings ratios and dividend yield indicate that EM stocks are fairly valued (Chart I-3). The cyclically-adjusted P/E (CAPE) ratio. The CAPE ratio is a structural valuation measure, i.e. it matters in the long run. Importantly, it assumes that real (inflation-adjusted) EPS will revert to its historical mean or trend. In short, the CAPE ratio tells us what the P/E ratio would be if EPS were to revert to its historical trend. Chart I-4 illustrates the EM CAPE ratio. If EM EPS in inflation-adjusted U.S. dollar terms reaches its historical time trend, one can safely assume that EM stocks are cheap and currently worth buying. In a nutshell, the current CAPE ratio of 15 assumes that EM EPS should rise by about 30% in nominal U.S. dollar terms over an investor's time horizon. Chart I-3EM Equities Valuations Are Neutral bca.ems_wr_2017_03_29_s1_c3 bca.ems_wr_2017_03_29_s1_c3 Chart I-4EM CAPE Ratio EM CAPE Ratio EM CAPE Ratio Given that our time horizon is 12 months, the assumption that EM EPS will surge by about 30% in U.S. dollar terms is in our view ambitious. Therefore, we posit that EM share prices do not offer compelling value at all in the next 12 months. If one's investment horizon were two-to-three years or longer, the assumption that EPS will rise by 30% or more in U.S. dollar terms is much more plausible. In this sense we would concur that EM share prices offer decent value from a longer-term perspective. Our methodology of calculating the CAPE ratio for EM varies from the well-known Robert Shiller's CAPE ratio for the U.S.1 However, even when applying our CAPE methodology to U.S. equities, the resulting ratio is not very different from Shiller's CAPE (Chart I-5). Trimmed-mean equity valuation ratios. Chart 6 illustrates 20% trimmed-mean trailing and forward P/E, price-to-book value, price-to-cash earnings ratios and dividend yields for the EM equity universe. A 20% trimmed-mean ratio excludes the top 10% and bottom 10% of industry groups, and then calculates the average. All calculations are based on 50 EM industry group data available from MSCI. Why look at trimmed-mean valuation ratios? Because by removing the top and bottom 10% of industry groups, this measure excludes outliers and provides a better perspective on valuation. A few observations are in order: First, according to the trimmed-mean valuation ratios, EM equities are not cheap. The trimmed-mean ratios are close to their historical mean (Chart I-6). Second, the trimmed-mean ratios are well above their market cap ones. This indicates that there are a few industry groups with large market caps that pull EM multiples lower. In other words, market-cap weighted multiples are skewed to the downside by a few large industry groups. There are reasons why some sectors and countries have low or high equity multiples. It makes sense to exclude them. Finally, the composite valuation indicator based on trimmed-mean trailing and forward P/Es, PBV and price-to-cash earnings ratios and dividend yield demonstrates that EM equity valuations are neutral (Chart I-7). Chart I-5U.S. CAPE Ratios U.S. CAPE Ratios U.S. CAPE Ratios Chart I-6EM Stocks Are Close to Fair Value EM Stocks Are Close to Fair Value EM Stocks Are Close to Fair Value Chart I-7EM Equities Have Neutral Value bca.ems_wr_2017_03_29_s1_c7 bca.ems_wr_2017_03_29_s1_c7 Bottom Line: EM equities by and large command a neutral valuation. According to the CAPE ratio, EM equities are cheap for investors with a long-term time horizon, say two-to-three years or longer. Profits Hold The Key Valuations are not a good timing tool. For low equity valuations to be realized, i.e., to produce solid price gains, corporate profits should grow. The reverse is also true: for an overvalued market to decline, company earnings should contract, or at least disappoint. When valuations are neutral - as they currently are for the EM equity benchmark - a recovery in EPS should entail higher share prices, while EPS shrinkage should lead to a selloff. EM EPS will continue to recover in the next three to six months, given the rally in commodities prices in 2016, amelioration in China's business cycle and the technology sector boom in Asia. However, this moderate and short-lived EPS recovery is already priced in. For the market to rally further, EPS will need to expand beyond the next three to six months. Remarkably, there has been little improvement in EM ex-China domestic demand. Besides, the risk to bank loan growth remains to the downside both in China and EM ex-China. Slower loan growth and the need to recognize and provision for potentially large NPLs will pressure banks' profits in many EM countries. Finally, we expect oil and industrial metals prices to decline considerably over the course of this year. If and as this view plays out, energy and materials stocks will fall. Energy and materials share prices correlate not with their past or current profits but rather with underlying commodities prices. One area where we remain bullish is the technology sector. Even though tech share prices are overbought and could correct in absolute terms in the months ahead, they will continue to outperform the benchmark. Bottom Line: Corporate profits are much more important in driving share prices in the next 12 months than equity valuations. Our outlook for EM EPS is downbeat for the next 12 months or so, even though EPS will continue to recover in the next three to six months. Timing Reversal: Watch Credit Quality Spreads Chart I-8Credit Quality Spreads: ##br##A Correction Or Reversal? Credit Quality Spreads: A Correction Or Reversal? Credit Quality Spreads: A Correction Or Reversal? Following are some of the indicators we are monitoring to gauge a reversal in EM share prices. EM corporate spreads have widened a notch relative to EM sovereign spreads (Chart I-8, top panel). Similarly, Chinese off-shore corporate spreads have widened versus Chinese sovereign spreads (Chart I-8, middle panel). Credit quality spreads - the gap between B- and BAA-grade corporate bonds - have widened slightly in the U.S. (Chart I-8, bottom panel). These moves are still very small, and do not constitute a definite sign of a major trend reversal. Nevertheless, such widening in credit quality spreads is an important development. If they persist, they will certainly sound the alarm for the reflation trade. Interestingly, this is the first time a simultaneous widening in credit quality spreads has occurred since the risk assets rally began in early 2016. Bottom Line: Major equity market selloffs will occur when lower quality credit begins to persistently underperform better quality credit. There have been budding signs of quality spread widening that are worth being monitored. Identifying Relative Value Within the EM equity universe, valuation ratios differ greatly. For example, banks trade at a trailing P/E of 9.7, while consumer staple stocks trade at 24.8. Table I-2 portrays the trailing P/E ratio and its historical mean as well as 12-month forward EPS growth and the forward P/E ratio for each sector - as well as average of trailing and forward P/E ratios. Table I-3 shows the same valuation measures but for EM countries. Table I-2Stock Valuation Snapshot: EM Sectors EM Equity Valuations Revisited EM Equity Valuations Revisited Table I-3Equity Valuation Snapshot: EM Countries EM Equity Valuations Revisited EM Equity Valuations Revisited It is difficult to draw any definitive conclusions from these tables. On a general level, a simplistic approach to investing based on trailing and forward P/E ratios would not have produced great outcomes in EM in recent years. When analyzing EM stock valuations, we prefer to use the trailing rather than forward P/E ratio because historically, EM forward EPS have had a very poor record forecasting actual EPS. One of our favorite ways to identify relative value is to compare the PBV ratio and return on equity (RoE) across countries/sectors. Chart I-9 plots RoE on the X-axis and the PBV ratio on the Y axis. Countries and sectors located in the bottom right corner (at the low end of the shaded area) have a low PBV ratio compared to their RoE. In contrast, in the north-west side of the distribution (at the upper end of the shaded zone), these have an elevated PBV ratio, taking into account their RoE. Chart I-9Searching For Relative Value EM Equity Valuations Revisited EM Equity Valuations Revisited Among countries, Korea, Russia, Hungary, the Czech Republic and China appear cheap, while Mexico, Brazil, South Africa, Colombia, Malaysia and Poland are on the expensive side. Chart I-10EMS's Recommended ##br##Equity Portfolio Performance EMS's Recommended Equity Portfolio Performance EMS's Recommended Equity Portfolio Performance Concerning equity sectors, utilities and financials/banks are cheap, yet consumer staples and consumer discretionary, health care, telecom and materials appear expensive in relative terms. Our recommended country equity allocation is based on a qualitative assessment of many variables including but not limited to valuation. Chart I-10 displays the performance of our fully invested EM Equity Portfolio Model versus the EM benchmark. Our overweights presently include: Korea, Taiwan, India, China, Thailand, Russia and central Europe. Our underweights are Brazil, Turkey, Indonesia, Malaysia and Peru. We are neutral on Mexico, Chile, Colombia, South Africa and the Philippines. The lists of our country allocation and other equity investment recommendations are presented each week at the end of our reports. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Bet On Russia's Non-Compliance With OPEC Odds of Russia's compliance with the OPEC agreement to cut oil output by 300k b/d in the next two months are low. This poses downside risk to oil prices. Russia has so far done only 120k b/d cuts. Hence, in the next two months it should reduce its output by 180k b/d which amounts to 1.6% of the nation's oil output. One way to bet on Russia's non-compliance, regardless the direction of oil prices, is to go long Russian energy stocks / short global energy ones (Chart II-1). There are a number of political, economic and financial motives why Russia might care less about lower oil prices than Saudi Arabia in the next 12-18 months or so. As a result, Russia might not cut as much as it is expected by the OPEC agreement. Russia is able to increase oil production due to a cheaper ruble and technology advances. BCA's Energy Sector Strategy team has been highlighting that there have been concerted efforts by Russia's largest producers to employ horizontal drilling and multi-zone hydraulic fracturing in Western Siberia.2 These have stemmed declines from those aging fields and allowed production to rise (Chart II-2). Chart II-1Long Russia Energy / ##br##Short Global Energy Stocks Long Russia Energy / Short Global Energy Stocks Long Russia Energy / Short Global Energy Stocks Chart II-2Russian Oil ##br##Production Will Increase Russian Oil Production Will Increase Russian Oil Production Will Increase Russia will not shy away from being opportunistic and increase its market share when it can ramp up oil production. A rising global oil market share will allow Russian companies to outperform their global peers regardless the direction of oil prices. There are major cyclical divergences between Russian and Saudi economies. Russia's economy is gradually picking up while there is less certainty about Saudi's growth recovery. The reason is that Russia has allowed the ruble to depreciate and act as a shock absorber. Meanwhile, Sa­­­­udis have stuck to the currency peg. ­­­Oil prices are down by 27% from their top in rubles and 55% in Saudi riyals (Chart II-3). This has reflated Russia's fiscal revenues and the economy, while Saudi Arabia is still struggling with the consequences of low ­oil prices. On the fiscal front, Russia went through a notable fiscal squeeze and its budget deficit is projected to be 3.2% of GDP in 2017 (Chart II-4). In contrast, the Saudi Arabian fiscal deficit in 2016 reached an outstanding 17% of GDP, accounting for the drawdown in reserves by our estimates.3 Chart II-3Ruble's Depreciation ##br##In 2014-15 Made a Difference Ruble's Depreciation In 2014-15 Made a Difference Ruble's Depreciation In 2014-15 Made a Difference Chart II-4Fiscal Deficit: Small In ##br##Russia & Large In Saudi Fiscal Deficit: Small In Russia & Large In Saudi Fiscal Deficit: Small In Russia & Large In Saudi More importantly, Russia's federal budget for 2017 was constructed on the oil price assumption of $40/bbl. The 2017 Saudi budget assumes oil price of $50/bbl.4 Therefore, Russia would not mind if oil prices drop toward or slightly below $40 in the second half of this year. Therefore, Saudis care much more about sustaining oil prices at a higher level than Russians do. Finally, Rosneft has already conducted its IPO while Aramco's IPO has not taken place yet. As such, the need for higher oil prices is much greater in Saudi Arabia - to justify a higher value of their oil giant - than in Russia. Bottom Line: Odds are considerable that Russia will not comply with the OPEC deal and this could cause oil prices to selloff more. Regardless of direction of oil prices, we expect the Russian energy sector to outperform their global peers due to Russia's rising market share in the global oil market. Go long Russian energy stocks / short global ones. Stephan Gabillard, Research Analyst stephang@bcaresearch.com 1 For more detailed discussion on our methodology of CAPE, please refer to January 20, 2016 Emerging Markets Strategy Special Report titled "EM Equity Valuations: A CAPE Model", available at ems. bcaresearch.com 2 Please refer to the Energy Sector Strategy Weekly Report titled, "Russian Oil Production: Surpassing Expectation", dated December 14, 2016, available at nrg.bcaresearch.com 3 Please refer to the Emerging Markets Strategy Special Report titled, "Saudi Arabia: Short-Term Gain, Long-Term Pain", dated February 1, 2017, available at ems.bcaresearch.com 4 https://mof.gov.sa/en/budget2017/Documents/The_National_Budget.pdf Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Chart of the WeekCopper Term Structure, Inventories##br## Are Not Reflecting Scarcity Copper Term Structure, Inventories Are Not Reflecting Scarcity Copper Term Structure, Inventories Are Not Reflecting Scarcity Transitory supply disruptions and financial demand have kept copper prices buoyant, but these influences will wane. A surge in inventories (Chart of the Week), coupled with slower Chinese demand growth as reflationary policies wind down, will prevent a sharp rally in copper prices. A stronger USD also will weigh on base metals in general, copper in particular. Energy: Overweight. We continue to expect oil inventories to draw throughout the rest of this year and next and are positioned for a backwardated forward curve in WTI. We are adding to our long Dec/17 vs. short Dec/18 WTI spread, which, as of our Tuesday mark to market, is up 183.33% since it was elected on Mar 13/17, and going long Dec/17 Brent vs. short Dec/18 Brent position basis tonight's close, as a strategic position. We also are adding a tactical position in WTI, buying $50/bbl calls vs. selling $55/bbl calls for July, August and September delivery basis tonight's close. Base Metals: Neutral. We remain neutral base metals longer term. Transitory supply disruptions in copper markets will subside, while reflationary stimulus in China will wane, keeping a lid on prices near term (see below). Precious Metals: Neutral. Gold rallied 3.7% following the Fed's rate hike last week. We expect this to reverse as the Fed ratchets up its hawkish rhetoric. Our long volatility position in gold - i.e., long a June put spread vs. long a June call spread - is down 27.5%, following the post-FOMC meeting rally. Ags/Softs: Underweight. We remain bearish, and are comfortable on the sidelines going into the month-end planting-intentions report from the USDA. Higher output of corn and beans in South America and a well-supported USD keep us bearish. Feature Actions taken by Chinese policymakers to slow the property market, wind down reflationary policies, and resume the pivot to services- and consumer-led growth will be critical to the evolution of copper demand, hence prices. Near term, we expect transitory supply disruptions in key mines in Chile, Peru and Indonesia will be addressed, and ore output will be restored. A stronger USD will present a headwind to copper demand, and will lower local production costs in Chile, Peru, Indonesia and elsewhere. Supply And Demand Shocks In the short-term (i.e. 2-3, months), copper prices should remain supported by the disruptions at Escondida in Chile, Grasberg in Indonesia, and more recently at Peru's biggest mine, Cerro Verde. Additionally, flooding in Peru is disrupting copper mining and transport operations beyond Cerro Verde, forcing the declaration of force majeure. BHP Billiton's third meeting with union officials at its Escondida mine failed to end to the strike. This is the world's largest mine - producing ~ 1.1mm MT/yr, or 5% of world supply. Escondida hasn't produced any copper since the strike began on Feb 9/17. This has reduced Chilean copper output 12% yoy as of February, and reduced Chile's GDP by ~ 1%. Unions this week showed interest in resuming talks with management, however. A settlement between PT Freeport Indonesia (PT-FI) and the Indonesian government re export permitting for Grasberg output has yet to materialize. PT-FI produced ~ 500k MT last year. As of this week, PT-FI restarted producing around 40% of its capacity. Lastly, strike action at the Cerro Verde mine is set to end today by order of the Peruvian government, but union officials said the strike would resume Friday if no agreement is reached with management. Cerro Verde produced ~ 500k MT of copper last year; the mine currently produces 50% of its capacity, after replacement workers were hired by the company. The lost output of these three mines accounts for ~ 10% of the global copper mine output. These developments clearly represent a transitory, albeit unexpected, supply shock with effects that should start to dissipate as these issues are resolved. It is worthwhile noting that copper is trading lower in the wake of this news, suggesting markets either prepared for labor action ahead of time - building precautionary inventories ahead of the labor-contract negotiations now underway - or that demand growth is slowing. We think a combination of both likely explains the price weakness following the transitory supply disruptions noted above. On the demand side, any optimism about rising copper prices due to an expected $1 trillion fiscal package in the U.S. is misplaced. Indeed, increased U.S. infrastructure spending - a largely unknown demand-side factor in terms of its details and dimensions - does not figure prominently in our assessment of future copper and based metals prices. The U.S contribution to global copper demand, and to base metals consumption in general, remains limited and has been decreasing in the last decades. U.S. copper demand now represents ~ 7.5% of world copper demand. Therefore, the U.S. market has a relatively small influence on copper prices compared to China, which accounts for close to 50% of global demand (Chart 2A and Chart 2B). Chart 2AU.S. Copper Consumption Pales Relatively To China U.S. Copper Consumption Pales Relatively To China U.S. Copper Consumption Pales Relatively To China Chart 2B U.S. Copper Consumption Pales Relatively To China U.S. Copper Consumption Pales Relatively To China We believe recent run-up in copper prices mainly was due to financial demand rather than physical demand (Chart 3). This elevated demand from financial investors could elevate price volatility, as any new fundamental information that provokes a sudden change in the copper outlook - e.g., faster restart to once-sidelined production, say, at Glencore's Katanga Mining facilities in the DRC, which are scheduled to be back on line later this year and next - could lead to an exodus of investors out of their long positions. Copper ETF holdings and copper open interest have been elevated in past weeks, and can have a significant effect on the evolution of copper prices (Chart 4).1 Prices have started to trend lower, a development that bears watching, given the still-high speculative holdings of the red metal. Chart 3Speculators Are Exiting Copper, ##br##Even As Supply Disruptions Mount Speculators Are Exiting Copper, Even As Supply Disruptions Mount Speculators Are Exiting Copper, Even As Supply Disruptions Mount Chart 4China PMI Vs. Copper Net Speculative Positions: ##br##Spec Positioning Matters For The Red Metal China PMI Vs. Copper Net Speculative Positions: Spec Positioning Matters For The Red Metal China PMI Vs. Copper Net Speculative Positions: Spec Positioning Matters For The Red Metal Global Copper Fundamentals Keep Us Neutral Looking at the next 6 to 12 months, we see no clear evidence to be bullish copper given supply-demand fundamentals. On the supply side, Australia's Department of Industry, Innovation and Science (DIIS) estimates mine output will be up 3.1% this year to 21mm MT - roughly in line with our estimates - and 4.1% next year to 21.8mm MT. Refined output hit a record high of almost 23.6mm MT last year, and is expected to increase 2.5% next year to 24mm MT. By 2018, the DIIS expects refined output to be up 4%, at 25mm MT. Large production gains were reported by the International Copper Study Group (ICSG) for Peru, where mine output was up 38% at 650k MT last year, offsetting lower mine production in Chile, where output was down 3.8% to 220k MT. Global production estimates by the DIIS for 2016 were in line with ICSG estimates for both mine production and world refined production. The ICSG estimates were released earlier this week. Global demand was up 3% last year at 23.4mm MT, and is expected to increase 2% this year to 24mm MT and 3% next year to 24.6mm MT, based on DIIS's estimates. These estimates also are in line with the ICSG's assessment of global sage. The ICSG estimated global demand last year was up ~ 2%. As is apparent, global supply and demand for copper have been, and will remain, relatively balanced this year and next (Chart 5).2 This will be supported by countervailing fundamentals: Global economic activity is picking up, especially in the manufacturing sectors of major economies, which will be supportive for copper prices (Chart 6); and, running counter to that, A strong USD, coupled with inventories at close to 3-year-high levels, will keep copper prices from escalating dramatically.3 Chart 5Global Copper Market Is Balanced Global Copper Market Is Balanced Global Copper Market Is Balanced Chart 6Global Growth Synchronization Is Underway Global Growth Synchronization Is Underway Global Growth Synchronization Is Underway China's Reflationary Policies Will Wind Down While reflationary policies launched over the past couple of years will continue to stimulate the Chinese economy in 2017, the fiscal and monetary impulses from them are waning. China's manufacturing sector, fixed-asset investment and the property sector are expected to stay strong during the first half of the year, which will support copper demand (Chart 7). However, this stimulus is winding down, and, following the 19th National Congress of the Communist Party in the autumn, we expect it to decline at a faster pace: These lagged effects of the wind-down of fiscal and monetary stimulus will be apparent - particularly in the property markets. Policymakers likely will reduce and re-direct policy stimulus to support consumer- and services-led growth, and continue to invest in the country's electricity grid, which accounts for about a third of China's copper demand. Net, demand likely will grow, but at a slower pace. Global copper inventories are now at an elevated level, which suggests there is no alarming scarcity in the market. This is corroborated by the contango observed in the copper futures market (Chart of the Week). An important takeaway from last week's People's Congress is that the main objective of Premier Li's work plan is to maintain economic and social stability. This primary objective is now more important than the Communist's Party's growth objective, and can be seen in the lower GDP growth target approved by policymakers (6.5%) going forward. The Chinese fiscal impulse already has started to roll over - government expenditures are now growing at a rate of close to 7.5% versus a peak of 29% in Nov/15 (Chart 8). This poses a risk to the downside for base metals prices, given that much of China's base-metals demand is dependent on government expenditures. Chart 7Fixed Asset Investments Are Resilient Fixed Asset Investments Are Resilient Fixed Asset Investments Are Resilient Chart 8Expansionary Chinese Fiscal Policy Is Slowing Down Expansionary Chinese Fiscal Policy Is Slowing Down Expansionary Chinese Fiscal Policy Is Slowing Down Chart 9China Might Have Reached A Sustainable Growth Path China Might Have Reached A Sustainable Growth Path China Might Have Reached A Sustainable Growth Path That said, recent data from China showing resilient industrial activity and fixed-asset investments despite the roll-over in government expenditures gives hope the economy reached a sustainable growth path and that it will stay buoyant throughout the year (Chart 9). China's Red-Hot Property Market Will Cool China's housing sector has, since the economy's liberalization in the late 1990s, grown into one of the most important drivers of its GDP. Most of the 2002 - 2010 increase in base metal prices - nearly 85% - can be explained by the spectacular growth in the Chinese housing sector.4 Building construction accounts for close to 45% of total copper consumption in China (Chart 10). Within that, residential construction makes up 70% of China's real estate investment, according to Australia's DIIS.5 Globally, China accounts for a third of the copper used in construction, according to the CME Group.6 This equates to ~ 10% of global copper usage. Chart 10Building Construction Is Crucial For Copper Demand Copper's Price Supports Are Fading Copper's Price Supports Are Fading In 2016, the Chinese real estate sector experienced extremely high growth, which was mainly fueled by easy access to credit, interest-rate cuts, easing of mortgage rules and an income effect from reflationary policies. This tendency reversed in late 2016 - early 2017, as can be seen in Chart 11. Looking forward, the evolution of the housing market will rely heavily on the policy path taken by the Chinese government. In the second half of 2016, the high level of speculative demand apparent in the property market red-flagged Chinese authorities that a price bubble was developing, producing an inflated debt load that posed a risk to future economic growth. President Xi repeatedly affirmed that China's priority going forward will be to keep the economy stable. This implies keeping the property market stable by nudging investment behavior and expectations to control the supply-side of the market. This is reflected in President Xi statement: "houses are for living in, not for speculating" during the recent Peoples Congress.7 Chinese authorities will maintain loan restrictions and stricter selling conditions implemented late last year, for first- and second-tier cities, where prices increased dramatically. First-tier newly constructed residential building prices were up on average by 18% year-on-year in February 2017, and the National Bureau of Statistics of China's sales price index of residential buildings in 70 large and medium-sized cities was up 11.3% in 2016. For other cities - where home inventories are still elevated and prices are relatively stable - the government could keep its facilitating policies in place, to encourage consumption and to draw down inventories of unsold homes. These developments will introduce downside risk to copper prices, given the importance of Chinese residential construction. Still, the Chinese government cannot allow real estate prices to drop suddenly, or even to slow too much, given that housing remains the main savings vehicle - directly or indirectly - for households. According to Xi and Jin (2015), Chinese citizens save around 70-80% of their wealth via the property market. It is true that financial innovation and the opening of Chinese financial markets should help households save using alternative strategies. However, changing households' savings behavior is not an instantaneous process. Moreover, we believe reflationary policies in other sectors of the economy will remain accommodative during the first half of the year, as headline and core inflation are still at relatively low levels (Chart 12). And, as mentioned previously, we expect continued investment in China's power grid, which will support copper prices this year and next. As the consumer economy grows, we would expect demand for electricity to continue to grow. Chart 11China's Property Market Peaked In 2016 China's Property Market Peaked In 2016 China's Property Market Peaked In 2016 Chart 12Inflation Close To Six-Year Lows Inflation Close To Six-Year Lows Inflation Close To Six-Year Lows Bottom Line: Combining these opposing effects, Chinese demand should remain high enough to maintain copper prices at a relatively stable level in 2017. However, following the 19th Communist Party later this year, we expect reflationary stimulus to wind down and for fiscal and monetary policy to be directed to supporting consumer- and services-led growth, which is less commodity intensive than heavy industrial and investment-led growth. We strongly believe the Communist Government will strengthen its focus on stronger enforcement of environmental regulations, which will introduce new supply-demand dynamics to the copper market. We will be exploring the "greening" of China in subsequent research, and its implications for base metals demand. Hugo Bélanger, Research Assistant Commodity & Energy Strategy hugob@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 We found that year-on-year variations in copper prices and in speculative long open interest exhibit a feedback loop - there is two-way Granger causality between them (i.e., they are endogenously related and each of their lagged values explain variation in the other's current price). The causality is stronger from copper prices to speculative long open interest; however, it also is significant the other way around. This means that in period of high speculative interest in copper - similar to what we experienced following the U.S. presidential election in late 2016 - the open interest variable is actually driving copper prices in the short term. We have also been able to explain copper prices by modeling year-on-year percentage change in the broad U.S trade-weighted index (TWI), Chinese PMI and in speculative long open interest. We find a 1% increase in the yoy speculative long open interest leads to a 0.19% increase in yoy copper prices. The adjusted R2 of the regression is 0.84. 2 The ICSG estimated there was a 50k MT deficit last year, trivial in a 23.4mm MT market. 3 We estimated the long-term relationship between copper prices, china PMI, world copper consumption and the U.S. TWI using a cointegrating regression. Interestingly, we found that, in equilibrium, a 1% increase in the China PMI variable translates to a 1.17% increase in copper prices. This relation can obviously be thrown out of equilibrium following an exogenous shock to the fundamentals of any of the variables in the model. The adjusted R2 of the regression is 0.71. 4 Please see "The Evolution of The Chinese Housing Market and Its Impact on Base Metal Prices," published by the Bank of Canada, March, 2016. It is available at http://www.bankofcanada.ca/wp-content/uploads/2016/03/sdp2016-7.pdf. Using an approach that accounts for the uncertainty around the official data, the lack of consistency in the data and the high level of seasonality and volatility in the data, the authors concluded that the Chinese GDP would have been around 9% lower at the end of 2010 in a scenario in which the housing market did not grow after 2002. Following this, they estimated two vector-error-correction models (VECM), one with the actual level of global activity, and one where the Chinese activity is 9% lower. 5 Please see "China Resources Quarterly" published by Australia's DIIA. It is available at https://industry.gov.au/Office-of-the-Chief Economist/Publications/Documents/crq/China-Resources-Quarterly-Southern-autumn-Northern-spring-2016.pdf 6 Please see "Copper: Supply and Demand Dynamics," published by the CME Group January 27, 2016. 7 Please see "Xi says China must 'unswervingly' crackdown on financial irregularities" published by Reuters. It is available at http://ca.reuters.com/article/businessNews/idCAKBN1671A0 Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016