Developed Countries

Special Report

Highlights Rates are going higher ... : Flight-to-quality episodes aside, the bond bear market that began in July 2016 remains in force. Investors should maintain below-benchmark Treasury duration. ... but that doesn't necessarily spell immediate trouble for stocks: Consistent with our work on the fed funds rate cycle, it appears that the level of rates matters more for equity returns than their direction. Empirical evidence of a rates tipping point is elusive ... : The notion that investors migrate from stocks to bonds at a particular level of rates exerts a powerful intuitive appeal, but the data fail to validate it. ... but a 10-year yield Treasury of 3.75 - 4% might halt the bull market in its tracks: Higher rates reliably slow equities only when they rise enough to slow the economy. We estimate that the pinch point is somewhere in the neighborhood of a 3.75 - 4% 10-year Treasury yield. Feature A share of stock is a pro rata claim on the future earnings of the company that issued it. Holding future earnings constant, the price an investor will be willing to pay for a share is wholly a function of the rate used to discount its earnings back to the present day. The simplicity and ubiquity of this valuation approach suggest that equity returns should be predictably related to moves in interest rates. It may also point the way to a tipping point - either in the level of rates, or the magnitude of their rise - at which capital and savings migrate from stocks to bonds. This Special Report reviews the historical record to see how U.S. equities have interacted with real 10-year Treasury yields. It considers the key variables that would logically seem to bear on equity performance and investors' propensity to rotate between asset classes. We find that the relationship between rates and equity returns is conditional, depending on which crosscurrent dominates in any given episode. We did not uncover any predictable rotation pattern. Do The Math As noted above, valuing a stream of future cash flows is a simple mechanical process once one settles on an appropriate discount rate for converting future dollars to current dollars. According to the security analysis textbooks, then, moves in stock prices are inversely related to changes in interest rates. But the textbooks leave out one key point: changes in interest rates don't occur in a vacuum. When they change, earnings estimates are likely to change, too, most often in the same direction as real rates. To be sure, the denominator discounting future cash flows rises when real rates rise, but the future-earnings numerator most likely rises, too. If real rates are rising, the economy is probably gaining momentum, and earnings estimates should probably be revised higher as well. Conversely, falling rates lead to a higher earnings multiple (ex-the not insignificant animal-spirits wild card), but will regularly be accompanied by downward revisions in future earnings. The net effect is uncertain, and depends on whether the multiple change outweighs the change in earnings or vice versa. Bonds Are A Snap Compared To Stocks It's far simpler to compute the impact on a bond portfolio from a given increase in interest rates because the denominator is the only variable that changes. The future-cash-flows numerator is contractually fixed, and it takes a big shift in the state of the economy to spark an economy-wide change in perceived repayment potential.1 This is why bonds' sensitivity to changes in interest rates can be captured in a single universal metric (duration). Stocks are pulled in so many different directions by factors affecting future cash flows that duration has no equity analogue. Investors should therefore be cautious about pinning too much on interest rates as they relate to equities. Bonds move in fixed orbits around the interest-rate sun, according to strictly ordered rules that establish a very clear cause-and-effect relationship. Equities improvise as they go along, taking their cues from a rotating cast of variables that interact differently over time. Attempts to stretch the concept of interest-rate sensitivity beyond bonds regularly trip up equity investors; we cannot know in advance how rates will come together with the other factors that influence equities. Confounding Intuition, Part 1: Equities Prefer Rising Rates (And Multiples Don't Care) U.S. postwar history makes it clear that equity investors need not run from rising rates. The S&P 500 has fared considerably better when real 10-year yields have risen by at least 100 basis points ("bps") than it has when they've declined by that magnitude (Chart 1), gaining 9.4% and 5%, respectively (Chart 2). Rates do not exhibit any sort of a consistent relationship with either forward (Chart 3) or trailing (Chart 4) S&P 500 multiples, though extremely high and extremely low real yields are both associated with lower trailing P/Es. Negative real yields carry an unwelcome whiff of deflation, and their scatterplot data points tend to cluster at below-the-mean forward and trailing multiples. Chart 1Stocks Actually Do Better When Rates Rise ... Chart 2... Considerably Better When Do Higher Rates Hurt The Economy? Charts 3 and 4 show that both forward and trailing multiples almost always decline when real 10-year Treasury yields cross above 5%. What's bad for multiples isn't necessarily bad for earnings, however, and a 5% real threshold is irrelevant to today's cycle. The steady decline in the average fed funds rate over the last several completed cycles (Chart 5) makes it clear that neutral rate thresholds are not constant across time periods. Assessing interest rates' impact on the economy over time requires a sliding scale. Chart 3Hard To See A Trend Through The Windshield ... Chart 4... Or The Rear-View Mirror Estimates of potential economic growth provide a useful yardstick for measuring the impact of real yields. Comparing real long rates to potential output offers insight into the burden of servicing debt across the economy. If real rates exceed the economy's potential growth rate by a material amount, several marginal borrowers are likely to be gasping for air, and their travails will weigh on the economy. Conversely, servicing debt should be easy when real rates are below potential growth, and investors are more likely to invest, businesses are more likely to expand, and consumers are more likely to spend. Chart 5One Size Does Not Fit All There have been 22 instances in the postwar era when real 10-year Treasury yields have increased by at least 100 bps, and Table 1 lists all of them, grouped by their relationship to real GDP's potential five-year growth rate. There are three possible states for interest rate increases in relation to potential output: starting and ending below trend growth, starting below trend growth and ending above it, and starting and ending above trend. The S&P 500 comfortably tops its overall postwar returns when rates go from Below-to-Below and Below-to-Above, but declines outright when rates start above potential growth and go even higher. Earnings consistently rise when rates start below potential growth, making multiples the swing factor - when they expand, S&P 500 gains tend to be very large (Box 1). Table 1Real Rates Versus Potential GDP Growth Box 1 Decomposing S&P 500 Returns Table 2 details the decomposition of S&P 500 returns during rising real rate episodes occurring after S&P 500 earnings estimates began to be compiled in 1979. Except in the crucible of 2009, when they were flat, forward earnings estimates have always risen when rates rise from a below-trend starting point, putting a tailwind behind the S&P 500 that regularly overcomes the multiple contraction that occurs in half of the Below/Above instances. Multiples are the swing factor; when they expand in conjunction with rising earnings estimates, U.S. equities soar. They always contract when rates go from high to higher, dragging stocks down against a mixed earnings expectations backdrop. The action is consistent with our fed funds rate cycle work: stocks do best when rates are below equilibrium and falling because earnings and multiples expand in tandem in that setting, but they do nearly as well after rate hikes commence, in spite of multiple contraction. Earnings surge when the Fed is confident enough about the economy to embark on a tightening cycle, but has not yet hiked enough to choke off the expansion. Multiple expansion in a majority of the Below/Above instances reveals that investors do not rotate out of equities en masse when rates rise, even by a considerable amount. The rotation story has intuitive appeal, but it doesn't show up in these data. Table 2Decomposition Of S&P 500 Returns During Rising Rate Periods A Little More Slicing And Dicing (Potential GDP Matters) Chart 6Mind The Gap Defining Below-to-Below and Below-to-Above states is easy in hindsight, but an investor cannot know in real time where a rising-rate instance that begins with rates below potential output will end. Earnings rise no matter where rates end relative to potential GDP, but re-rating in Below/Below can flip to de-rating in Below/Above, slamming the brakes on phase gains. The empirical data say investors should lighten up on S&P 500 exposure when real rates cross above real potential GDP. S&P 500 returns trounce their overall postwar gain when rates rise from below potential GDP to potential GDP but lag it once rates cross above potential GDP (Chart 6). Confounding Intuition, Part 2: Institutional Investors Don't Rotate Even if S&P 500 returns fail to demonstrate any consistent relationship with interest rates, one would expect that professional investors' asset-class positioning would. Bonds and stocks are alternatives for one another, and institutional investors presumably shift their allocations in line with the asset classes' relative prospects. We examine Pension Funds', Life Insurers', and Mutual Funds' asset-allocation profiles over time using balance-sheet data from the Federal Reserve's quarterly Flow of Funds report. The data show that asset-allocation decisions are made without apparent regard for relative valuations, at least as proxied by the equity risk premium. Pension funds' steady increase in equity allocations across the '90s appears to have been less a function of rate moves than buying into the bull market (Chart 7). Since the dot-com bubble burst in 2000, bond and equity allocations have mainly reflected the performance tides. The extended trend in pension funds' equity-to-bond allocation ratio suggests that the funds set a long-range goal and grind steadily toward achieving it, regardless of relative valuation movements. It also suggests that the funds may not bother with rebalancing, much less dynamic asset allocation. Life insurers kept their fixed income and equity allocations more or less fixed across the '70s (not shown) and most of the '80s. They then reduced equity exposure for three years after 1987's Black Monday, assiduously built it up across the '90s, and have more or less let it drift since the millennium (Chart 8). The equity risk premium does not appear to have been a consideration. Asset-allocation stasis may simply be a reflection of life insurers' stringent regulatory constraints, but their portfolio managers' limited discretion precludes opportunistic allocation shifts. Mutual fund allocations tend to depend much more on past events than future expectations. Equity holdings peak when the equity risk premium bottoms and bottom when the equity risk premium peaks (Chart 9). The problem is that mutual fund managers are structurally hostage to their investors' whims. They are sorted into narrow silos and then straitjacketed by the rigid allocation rules written into their fund prospectuses. Even if they think asset-class rotation is a great idea, only a tiny minority of fund managers can act upon it. Chart 7Pension Funds Don't Allocate Based On Yields Or The ERP ... Chart 8... While Life Insurers Appear To Allocate In Defiance Of Them Chart 9Mutual Funds##BR##Obey Their Owners ... Confounding Darwin's Intuition: Human Investors Never Learn Chart 10... Who Act On Real Emotion, Not Real Yields Kahneman and Tversky's groundbreaking research into decision-making under uncertainty revealed that our species is wired to make suboptimal investment decisions. Prospect theory, loss aversion and an unhealthy fixation on recent data all encourage retail investors to repeatedly shoot themselves in the foot. When it comes to asset allocation, households appear to focus exclusively on the action in the rear-view mirror (Chart 10). Retail investors as a group rotate between equities and fixed income retroactively, in response to recent past returns, not proactively in response to cues about future relative-return prospects. Investment Implications Despite the compelling intuition that investors should set their course by the interest-rate stars, there is no evidence in the flow of funds data that they have done so in the past. We posit that structural constraints on institutional investors, combined with humans' durable cognitive biases, offer no reason to expect that they will do so in the future. While there may not be any predictable rotation pattern, rising rates have given rise to a predictable performance pattern. Equities reliably perform better when real rates are rising by at least 100 basis points than they do when they're falling. Decomposition of S&P 500 returns indicates that the pattern holds because earnings rise a good bit more in rising-rate periods than multiples decline. And multiples don't always decline when rates rise, anyway; sometimes emotion overrides cash flow discounting mechanics. Investors should lighten up on Treasury allocations, while keeping the exposures they do hold at below-benchmark duration. They should not flee equities, however. Rates have not yet risen enough to cool off the economy in any material way, and we judge that they won't until somewhere around a 3.75% 10-year Treasury yield.2 Tight supplies in labor and goods markets will eventually stoke realized inflation and provoke the Fed into tightening enough to cut off the rally, but it hasn't happened yet, and it is far too early to de-risk portfolios on account of interest rates. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 An unusually large drop in rates may well be associated with economic distress, but default-adjusted bond payment streams are much less variable than near- and intermediate-term earnings estimates. 2 Based on the evolution of the Congressional Budget Office's longer-run estimates of real potential GDP growth, and the trend in our own model of long-term inflation expectations, it appears as if nominal potential GDP growth will be somewhere in the neighborhood of 3.75-4% next year. This is a much lower estimate than one would get from adding the Fed's 2% inflation target to the current rate of GDP growth, but we need to look past the immediate boost of the stimulus package to get a read on its longer-run effects. As with all of the estimates produced by our models, we look to it for a general guide to the future, not a precise point estimate.

Highlights We review last year's "Three Tantalizing Trades" and offer four additional ones: Trade #1: Long June 2019 Fed funds futures contract/short Dec 2020 Fed funds futures contract Trade #2: Long USD/CNY Trade #3: Short AUD/CAD Trade #4: Long EM stocks with near-term downside put protection Feature A Review Of Last Year's "Three Tantalizing Trades" I had the pleasure of speaking at BCA's last Annual Investment Conference on September 25th, 2017, where I presented the following three trade ideas (Chart 1): 1. Short December 2018 Fed funds futures We closed this trade for a profit of 70 basis points. Had we held on, it would be up 92 basis points as of the time of this writing. 2. Long global industrial equities/short utilities We closed this trade on February 1st for a gain of 12%, as downside risks to global growth began to mount. This proved to be a timely decision, as the trade would be up only 6.1% had we kept it on. We would not re-enter this trade at present. 3. Short 20-year JGBs/long 5-year JGBs This trade struggled for much of 2018 but sprung back to life in August. It is up 0.6% since we initiated it. We still like the trade over the long haul. Investors are grossly underestimating the risk that Japanese inflation will move materially higher as an aging population creates a shortage of workers and a concomitant decline in the national savings rate. We also think the government will try to egg on any acceleration in consumer prices in order to inflate away its debt burden. In the near term, however, the trade could struggle if a combination of weaker EM growth and an increase in the value of the trade-weighted yen cause inflation expectations to decline. Four Additional Trades Trade #1: Long June 2019 Fed funds futures contract/short December 2020 Fed funds futures contract Investors expect U.S. short-term rates to rise to 2.38% by the end of 2018 and 2.85% by the end of 2019. The 47 basis points in tightening priced in for next year is less than the 75 basis points in hikes implied by the Fed dots. Investors appear to have bought into Larry Summers' secular stagnation thesis. They are convinced that short rates will not be able to rise above 3% without triggering a recession (Chart 2). Chart 1Revisiting Last Year's Three Tantalizing Trades Chart 2Markets Expect No Fed Hikes Beyond Next Year Regardless of what one thinks of Summers' thesis, it must be acknowledged that it is a theory about the long-term drivers of the neutral rate of interest. Over a shorter-term cyclical horizon, many factors can influence the neutral rate. Critically, most of these factors are pushing it higher: Fiscal policy is extremely stimulative. The IMF estimates that the U.S. cyclically-adjusted budget deficit will reach 6.8% of GDP in 2019 compared to 3.6% of GDP in 2015. In contrast, the euro area is projected to run a deficit of only 0.8% of GDP next year, little changed from a deficit of 0.9% it ran in 2015 (Chart 3). The relatively more expansionary nature of U.S. fiscal policy is one key reason why the Fed can raise rates while the ECB cannot. Credit growth has picked up. After a prolonged deleveraging cycle, private-sector nonfinancial debt is rising faster than GDP (Chart 4). The recent easing in The Conference Board's Leading Credit Index suggests that this trend will continue (Chart 5). Wage growth is accelerating. Average hourly earnings surprised on the upside in August, with the year-over-year change rising to a cycle high of 2.9%. This followed a stronger reading in the Employment Cost Index in the second quarter. A simple correlation with the quits rate suggests that there is plenty of upside for wage growth (Chart 6). Faster wage growth will put more money into workers pockets who will then spend it. The savings rate has scope to fall. The personal savings rate currently stands at 6.7%, more than two percentage points higher than what one would expect based on the current ratio of household net worth-to-disposable income (Chart 7). If the savings rate were to fall by two points over the next two years, it would add 1.5% of GDP to aggregate demand. Chart 3U.S. Fiscal Policy Is More Expansionary Than The Euro Area Chart 4U.S. Private-Sector Nonfinancial Debt Is Rising At Close To Its Historic Trend Chart 5U.S. Credit Growth Will Remain Strong Chart 6Quits Rate Is Signaling That There Is Upside For Wage Growth Chart 7The Personal Savings Rate Has Room To Fall A back-of-the-envelope calculation suggests that these cyclical factors will permit the Fed to raise rates to 5% by 2020, almost double what the market is discounting.1 A more hawkish-than-expected Fed will bid up the value of the greenback. A stronger dollar, in turn, will undermine emerging markets, which have seen foreign-currency debts balloon over the past six years (Chart 8). The deflationary effects of a stronger dollar and falling commodity prices could temporarily cause investors to price out some hikes over the next few quarters. With that in mind, we recommend shorting the December 2020 Fed funds futures contract, while going long the June 2019 contract. The first leg of the trade captures our expectation that the market will revise up its estimate the terminal rate, while the second leg captures near-term risks to global growth. The gap between the two contracts has widened over the past few days as we have prepared this report, but at 21 basis points, it has plenty of room to increase further (Chart 9). Chart 8EM Dollar Debt Is High Chart 9U.S. Rate Expectations Are Too Low Beyond Mid-2019 Trade #2: Long USD/CNY China's economy is slowing, which has prompted the government to inject liquidity into the financial system. The spread in 1-year swap rates between the U.S. and China has fallen from about 3% earlier this year to 0.6% at present, taking the yuan down with it (Chart 10). It is doubtful that China will be willing to match - let alone exceed - U.S. rate hikes. This suggests that USD/CNY will appreciate. China's real trade-weighted exchange rate has weakened during the past four months, but is up 25% over the past decade (Chart 11). U.S. tariffs on $250 billion (and counting) of Chinese imports threaten to erode export competitiveness, making a further devaluation necessary. Chart 10USD/CNY Has Tracked China-U.S. Interest Rate Differentials Chart 11The RMB Is Still Quite Strong President Trump will oppose a weaker yuan. However, just as China's actions earlier this year to strengthen its currency did not prevent the U.S. from imposing tariffs, it is doubtful that efforts by the Chinese authorities to talk up the yuan would appease Trump. Besides, China needs a weaker currency. The Chinese economy produces too much and spends too little. The result is excess savings, epitomized most clearly in a national savings rate of 46%. As a matter of arithmetic, national savings need to be transformed either into domestic investment or exported abroad via a current account surplus. China has concentrated on the former strategy over the past decade. The problem is that this approach has run into diminishing returns. Chart 12 shows that the capital stock has risen dramatically as a share of GDP. As my colleague Jonathan LaBerge has documented, the rate of return on assets among Chinese state-owned companies, which have been the main driver of rising corporate leverage, has fallen below their borrowing costs (Chart 13).2 Chart 12China's Capital Stock Has Grown Alongside Rising Debt Levels Chart 13China: Rate Of Return On Assets Below Borrowing Costs For State-Owned Companies Now that the economy is awash in excess capacity, the authorities will need to steer more excess production abroad. This will require a larger current account surplus which, in turn, will necessitate a relatively cheap currency. The dollar is currently working off overbought technical conditions, a risk we flagged in our August 31st report.3 That process should be complete over the next few weeks. Meanwhile, hopes of a massive Chinese stimulus focused on fiscal/credit easing will fade. The combination of these two forces will push up USD/CNY above the psychologically-critical 7 handle by the end of the year. Trade #3: Short AUD/CAD A weaker yuan will raise raw material costs to Chinese firms. This will hurt commodity prices. Industrial metals are much more vulnerable to slower Chinese growth than oil. Chart 14 shows that China consumes close to half of all the copper, nickel, aluminum, zinc, and iron ore produced in the world, compared to only 15% of oil output. Our expectation that developed economy growth will hold up better than EM growth over the next few quarters implies that oil will outperform industrial metals. Oil is also supported by a tighter supply backdrop, particularly given the downside risks to Iranian and Venezuelan crude exports. A bet on oil over metals is a bet on DM over EM growth in general, and the Canadian dollar over the Australian dollar specifically (Chart 15). Canada exports more oil than metals, while Australian exports are dominated by ores and metals. In terms of valuations, the Canadian dollar is still somewhat cheap relative to the Aussie dollar based on our FX team's long-term valuation model (Chart 16). Chart 14China Is A More Dominant Consumer Of Metals Than Oil Chart 15Oil Over Metals = CAD Over AUD Chart 16Canadian Dollar Still Somewhat Cheap Versus The Aussie Dollar The loonie has been weighed down by ongoing fears that Canada will be left out of a renegotiated NAFTA. However, our geopolitical strategists believe that the Trump administration is trying to focus more on China, against whom the case for unfair trade practices is far easier to make. The U.S. has already negotiated a trade deal with Mexico and an agreement with Canada is more likely than not. If a new deal is struck, the Canadian dollar will rally. We recommended going short AUD/CAD on June 28. The trade is up 3.4%, carry-adjusted, since then. Stick with it. Trade #4: Long EM stocks with near-term downside put protection It is too early to call a bottom in EM assets. Valuations have not yet reached washed-out levels (Chart 17). Bottom fishers still abound, as evidenced by the fact that the number of shares outstanding in the MSCI iShares Turkish ETF has almost tripled since early April (Chart 18). However, at some point - probably in the first half of next year - investors will liquidate their remaining bullish EM bets. During the 1990s, this capitulation point occurred shortly after the collapse of Long-Term Capital Management in September 1998. EM equities fell by 26% between April 21, 1998 and June 15, 1998. After a half-hearted attempt at a rally, EM stocks tumbled again in July, falling by 35% between July 17 and September 10. The second leg of the EM selloff brought down the S&P 500 by 22%. Thanks to a series of well-telegraphed Fed rate cuts, global markets stabilized on October 8th (Chart 19). The S&P 500 surged by 68% over the next 18 months. The MSCI EM index more than doubled in dollar terms over this period. EM stocks outperformed U.S. equities by a whopping 71% between February 1999 and February 2000. Europe also outperformed the U.S. starting in mid-1999. Value stocks, which had lagged growth stocks over the prior six years, also finally gained the upper hand. Chart 17EM Assets: Valuations Not Yet At Washed Out Levels Chart 18EM Bottom Fishers Still Abound Chart 19The ''Great Equity Rotation'' Is Coming: A Roadmap From The 1990s The "Great Equity Rotation" is coming. All the trades that have suffered lately - overweight EM, long Europe/short U.S., long cyclicals/short defensives, long value/short growth - will get their day in the sun. Investors can prepare for this inflection point by scaling into EM equities today, but guarding against near-term downside risk by buying puts. With that in mind, we are going long the iShares MSCI Emerging Market ETF (EEM), while purchasing March 15, 2019 out-of-the-money puts with a strike price of $41. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Depending on which specification of the Taylor rule one uses, a one percent of GDP increase in aggregate demand will increase the neutral rate of interest by half a point (John Taylor's original specification) or by a full point (Janet Yellen's preferred specification). Fiscal policy is currently about 3% of GDP too simulative compared to a baseline where government debt-to-GDP is stable over time. Assuming a fiscal multiplier of 0.5, fiscal policy is thus boosting aggregate demand by 1.5% of GDP. Nonfinancial private credit has increased by an average of 1.5 percentage points of GDP per year since 2016. Assuming that every additional one dollar of credit increases aggregate demand by 50 cents, the revival in credit growth is raising aggregate demand by 0.75% of GDP, compared to a baseline where credit-to-GDP is flat. The labor share of income has increased by 1.25% of GDP from its lows in 2015. Assuming that every one dollar shift in income from capital to labor boosts overall spending on net by 20 cents, this would have raised aggregate demand by 0.25% of GDP. Lastly, if the savings rate falls by two points over the next two years, this would raise aggregate demand by 1.5% of GDP. Taken together, these factors are boosting the neutral rate by anywhere from 2% (Taylor's specification) to 4% (Yellen's specification). This is obviously a lot, and easily overwhelms other factors such as a stronger dollar that may be weighing on the neutral rate. 2 Please see China Investment Strategy Special Report, "Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging," dated August 29, 2018. 3 Please see Global Investment Strategy Weekly Report, "The Dollar And Global Growth: Are The Tables About To Turn?" dated August 31, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

The opposing sides of our market- and industry-neutral trade going long the S&P homebuilding index/short the S&P REITs index1 have both been on the receiving end of negative data in the last month. With respect to homebuilders, housing permits, a leading indicator of future starts, fell well short of expectations this week and took the S&P homebuilding index down with it. Meanwhile rising UST yields have been weighing heavily on REIT stocks. The end result is that our trade has given up its early gains. The macro environment tells us that it is too early to throw in the towel on this trade. We continue to believe prices in the residential real estate sector have the upper hand over their commercial real estate (CRE) peers. Existing home inventories have tightened and remain at historically low levels, which should support pricing. On the flip side, our CRE occupancy rate composite is still contracting, warning that already-slowing pricing has further to fall. The divergence in pricing should support homebuilders' returns at the expense of REITs. Bottom Line: We reiterate our long S&P homebuilding/short S&P REITs pair trade. The ticker symbols for the stocks in the S&P homebuilding and S&P REITs indexes are: BLBG: S5HOME - LEN, PHM, DHI and BLBG: S5REITS - IRM, MAA, AMT, BXP, PLD, ESS, CCI, PSA, O, VTR, VNO, WY, EQIX, DLR, EXR, DRE, FRT, WELL, SBAC, HCP, GGP, KIM, EQR, UDR, REG, MAC, HST, SPG, AVB, AIV, SLG, ARE, respectively. 1 Please see BCA U.S. Equity Strategy Special Report, "UnReal Estate Opportunity," dated July 9, 2018, available at uses.bcaresearch.com.

Highlights The U.S. dollar is likely to correct further over the coming weeks. The CAD should benefit as it is cheap and oversold, and the inflationary back-drop warrants tighter monetary conditions. This will be a bear market rally, not the ultimate trough for the loonie. EUR/SEK should correct as the Riksbank will start tightening policy in December; a pause in the global growth slowdown should also give the cheap SEK a welcome boost. Cheap long-term valuations will not help the yen in the coming weeks; instead, falling Japanese inflation expectations and growing investor expectations of Chinese stimulus will weigh on the JPY. A better opportunity to buy the yen on its crosses will emerge later this year. EUR/CHF has upside over the coming months; the swissie needs additional global growth weakness to rally further. This is unlikely to happen for a few months. Feature Chart I-1DXY Correction Has Further To Run By the middle of the summer, the dollar had hit massively overbought levels, which left it vulnerable to any signs of stabilization in global growth, especially if some key U.S. activity gauges began to soften (Chart I-1). This is exactly what is transpiring. As we highlighted last week, BCA's Global LEI Diffusion Index is rebounding, EM and Japanese exports are stabilizing and U.S. core inflation and building permits have disappointed. This bifurcation in the data suggests the dollar has more room to correct, as neither our Capitulation Index nor our Intermediate-Term Technical Indicator have hit technically oversold levels. Last week we also argued that this correction in the dollar is likely to prove a temporary reprieve, but that in the interim the euro and the Australian dollar were well placed to experience significant rebounds.1 This week, we explore if the same case can be built for the Canadian dollar, the Swedish krona, the yen and the Swiss Franc. CAD: The Bank of Canada Will Proceed Cautiously The first half of 2018 has not been kind to the Canadian dollar. A rout in EM assets, signs of softening global growth and tough rhetoric from the White House on trade generally and NAFTA and Canada in particular have conspired to create fertile grounds for loonie-selling. Since the end of June, the CAD has managed to regain some composure, rallying by 3.3% against the USD. Essentially, much bad news has been embedded in this currency, which now trades at a significant discount to BCA's estimate of its short-term fair value (Chart I-2). Moreover, speculators, who had been aggressively buying the CAD at the end of 2017, now hold large short positions in the currency (Chart I-2, bottom panel). This combination is now resulting in a situation where any pause in the USD's strength is being mirrored in CAD strength. Can this rebound continue? Canadian economic data sends a murky message. Canadian real GDP growth had overtaken that of the U.S., peaking at 3.6% in February last year. However, it is now below U.S. growth (Chart I-3). Canadian consumers have been the main source of the slowdown as Canadian capex growth is in line with the U.S. and the Trudeau government has been spending generously. Can this rebound continue? Canadian economic data sends a murky message. Canadian real GDP growth had overtaken that of the U.S., peaking at 3.6% in February last year. However, it is now below U.S. growth (Chart I-3). Canadian consumers have been the main source of the slowdown as Canadian capex growth is in line with the U.S. and the Trudeau government has been spending generously. Chart I-2No One Is Going Crazy For The Loonie Chart I-3Canada: Growth Picture Is Mixed The weakness in Canadian consumption partly reflects the underperformance of Canadian employment relative to the U.S. However, the slowdown in house prices has played a bigger role (Chart I-4). Canadian households are burdened by a debt load of 170% of disposable income. Now that mortgage rates are rising, Canadians are spending more than 14% of their disposable income servicing their debt, a burden last experienced in 2008 when mortgage rates were 220 basis points higher. Without the benefit of rapidly rising real estate assets, it is much more difficult for Canadian retail sales to grow at an 8.7% annual rate as they did three quarters ago. Despite these weaknesses, it is hard to justify that Canadian monetary conditions - as approximated by the slope of the yield curve, the level of real rates, and the trade-weighted CAD - should be as easy as they are today (Chart I-5). This is even truer when we take into account Canadian inflationary conditions. Chart I-4Canadian Consumers Have A Problem Chart I-5Canadian Monetary Conditons Are Very Easy The three inflation gauges targeted by the Bank of Canada stand between 1% and 3%, or at its objective. This means that the BoC's 1.5% policy rate is negative in real terms. Moreover, this inflationary pressure is unlikely to abate. The BoC estimates that the output gap has closed, and companies are running into growing capacity constraints (Chart I-6, top panel). Despite a correction last month, wages are in an uptrend, powered by growing and severe labor shortages (Chart I-6, bottom panel). Thanks to these conditions, we anticipate that the BoC will track the pace of rate increases by the Federal Reserve over the next 12 months. This is not very different from what is currently priced into Canadian money markets. Chart I-6Canadian Capacity Pressures Point To A Hawkish ##br##BoC Inflation Will Force The BoC's Hand If the BoC does not disappoint, the combination of a cheap and oversold CAD should help the loonie rally against the USD, so long as the current stabilization in global growth continues. A move toward USD/CAD 1.26 is likely. The biggest risk to this view is that trade negotiations between the U.S. and Canada deteriorate further. While we do not anticipate an imminent breakthrough in these negotiations, we do not see much scope for significant deterioration in the relationship either. The energy market could prove to be another positive for the loonie. Bob Ryan, who leads BCA's Commodity and Energy Strategy service, argues that the oil market is currently very tight and vulnerable to supply disruptions.2 Under these circumstances, the removal of Iranian exports, tensions in Iraq, declining Nigerian production and Venezuela's cascading implosion all risk causing a melt-up in oil prices by the first half of 2019. This could help the CAD as well, even if the Canadian oil benchmark remains at a large discount to Brent. Longer-term, the upside in the CAD is likely to be capped. There is only one rate hike priced into the U.S. OIS curve from June 2019 to December 2020. We expect the Fed to hike rates by more than that. Meanwhile, the emerging softness in the Canadian household sector suggests it will be much more difficult for the BoC to keep following the Fed higher over that period. The CAD is not cheap enough to compensate for these long-term headwinds (Chart I-7). Bottom Line: On a short-term basis, the Canadian dollar is cheap and oversold. While the Canadian consumer has begun to disappoint, the inflationary pressures present in Canada should keep the BoC on track to follow the Fed and push rates higher over the coming 12 months. The CAD should therefore benefit from any USD weakness, with USD/CAD moving toward 1.26. Once the short-term undervaluation and oversold conditions are corrected, USD/CAD should rebound toward 1.40. Chart I-7We Like The CAD For Now, But The Rally Has A Limited Shelf Life EUR/SEK Will Trade Heavy Any which way we cut it, the SEK is cheap. The trade-weighted krona is trading at its cheapest levels relative to BCA's long-term fair value since the Great Financial Crisis (Chart I-8). The SEK is not only trading at a 32% discount to its purchasing-power parity against the greenback, it is also trading at a 10% discount against its PPP relative to the euro. Chart I-8The SEK Is An Attractive Long-Term Buy... The SEK is not only cheap on a long-term basis, it is also cheap on a short-term basis. This is most evident against the euro. Currently the SEK trades at a 7% discount to the euro according to our short term fair value model based on real rate differentials, commodity prices and global risk aversion. Historically, this kind of discount in the SEK has been followed by a prompt rebound (Chart I-9). Are there any catalysts to convert this good value into good returns? We see many. First, as was the case in Canada, Sweden's Monetary Gauge has not been at such easy levels since the Great Financial Crisis (Chart I-10). Meanwhile, the economy is also experiencing rising capacity pressures. The OECD's estimate of the output gap stands at 0.7% of GDP, and inflationary pressures are building, as evidenced by the Riksbank's Capacity Utilization measure (Chart I-11). Chart I-9...And A Short-Term One As Well Chart I-10The Riksbank Is Too Easy Chart I-11Swedish Inflation Has Upside This set of circumstances suggests the Riksbank could start hiking rates as early as this coming December, well ahead of the European Central Bank. As a result, we project that Swedish real interest rates could rise further relative to the euro area. Historically, falling euro area / Swedish real interest rate spreads precede depreciations in EUR/SEK (Chart I-12). Chart I-12Real Rate Differentials Point To A Lower EUR/SEK Chart I-13Chinese Liquidity Injections Point To A Lower EUR/SEK The global context also points toward an imminent correction in EUR/SEK. The krona is much more pro-cyclical than the euro. This reflects the more volatile nature of the Swedish economy and the extraordinarily large role of trade in its GDP. EUR/SEK greatly benefited from the tightening in Chinese liquidity conditions, as evidenced by the widening between the 1-month and 1-week Chinese interbank rate (Chart I-13). EUR/SEK essentially sniffed out a slowdown in Chinese capex, a key source of ultimate demand for Swedish goods. However, now that the PBoC is injecting liquidity in the Chinese interbank system, EUR/SEK is likely to suffer. Moreover, the outperformance of Chinese infrastructure and real estate stocks in recent weeks also suggests the SEK could appreciate further against the EUR. The rally of risk assets on the day that U.S. President Donald Trump announced an additional 10% tariff on US$200 billion worth of Chinese exports further confirms that investors may be in the process of discounting additional stimulus out of China, which would further hurt EUR/SEK. To be clear, we have already noted that we do not anticipate the Chinese authorities to attempt to boost growth - we only expect them to limit the damage created by an intensifying trade war with the U.S. As a result, the positive impact of China on the krona should prove transitory. But for the time being, it could be enough to help correct the SEK's 7% discount to the euro. Since we anticipate the USD to continue to correct in the coming weeks, this also implies that USD/SEK possesses ample tactical downside. This negative EUR/SEK view is not without risks. The first comes from the fact that the Swedish current account surplus is now smaller than the euro area's, something not seen since the early 1990s. This is mitigated by the fact that Sweden's net international investment position is now 10% of GDP, while it used to be negative as recently as 2015. The euro area NIIP is still in negative territory. The second risk is that Swedish house prices have begun to contract in response to macroprudential measures. However, we believe that Sweden's inflationary backdrop is likely to dominate the Riksbank's reaction function. Bottom Line: The SEK is cheap against the dollar and the euro on both long-term and short-term metrics. As the Riksbank is set to lift rates in December, we expect EUR/SEK to decline significantly. Recent injections of liquidity by the PBoC and growing expectations among investors of Chinese stimulus could create additional downward impetus under both EUR/SEK and USD/SEK. This is a tactical view. We anticipate the reprieve in the global growth slowdown to be temporary. Once it resumes, the SEK will find it difficult to rally further. JPY: Down Now, Up Later Investors are well aware that the yen is one of the cheapest G10 currencies on a long-term basis. BCA's long-term fair value model shows that the real trade-weighted yen is trading at a 17% discount, close to its cheapest levels in 36 years. However, despite its prodigious long-term cheapness, the yen is not nearly as attractive when compared to its short-term determinants, which show a small premium in the price of the yen versus the dollar (Chart I-14). This means the direction of Japanese monetary policy and global growth will remain more important for the yen's price action over the coming months than its long-term cheapness. When it comes to growth, Japan is doing okay. We witnessed a decline in industrial production driven by foreign demand this summer, but domestic machinery orders are improving and export growth is finding a floor. Actually, BCA's real GDP model for Japan is suggesting that growth could re-accelerate significantly next quarter (Chart I-15). In our view, this improvement reflects the fact that business credit is once again growing after decades of hibernation. Chart I-14Is The JPY A Bargain? Long Term, Yes; Short Term, No! Chart I-15Japanese Growth Doing Just Fine However, we doubt this is enough to prompt any tightening in the Bank of Japan's policy. The most immediate problem facing the BoJ is that Japanese inflation expectations are in free fall (Chart I-16). Since the BoJ assigns the blame of low realized inflation on depressed inflation expectations, this aforementioned weakness, despite the yen's softness, guarantees that the BoJ will stay on the sidelines for much longer. After all, if any little shock can spur such a sharp impact on Japanese inflation expectations, despite an unemployment rate at 2.5% and an output gap at 0.8% of GDP, the BoJ has not anchored inflation expectations higher. Further reinforcing our bias that the BoJ is not set to tighten policy for many more quarters, the VAT is set to be increased to 10% in October 2019. The LDP leadership race is currently underway, and no one is mentioning postponing that hike. This suggests that significant fiscal tightening could emerge next year. The fact that the BoJ will continue to lag behind other global central banks forces us to be negative on the yen. However, could an external event push the yen higher, despite this absence of domestic support? A big downgrade in EM asset prices and global growth would do the trick. While we do think this is likely to happen over the next six to nine months, now does not appear to be the moment to implement such a bet. As we highlighted above, the deceleration in global growth seems to be pausing, and Chinese liquidity conditions have eased. Seven weeks ago, we introduced our China Play Index to track whether or not investors were discounting additional easing on the part of China.3 This indicator looks as if it is forming a base right now (Chart I-17), indicating that pro-growth plays could perform well over the coming weeks while countercyclical plays, like the yen, could perform poorly. Until this indicator begins a new down leg - something we anticipate for the backend of the year - the yen will remain under downward pressure against the dollar, the euro or the aussie. Chart I-16The BoJ's Problem Chart I-17Chinese Plays Are Stabilizing As a result, while we continue to expect more upside in the yen in the latter part of the year, for the time being we will remain on the sidelines as neither short-term valuations, monetary policy dynamics or the global growth environment point to an imminent rally in the yen. Bottom Line: The yen is an attractive long-term play as it displays prodigiously cheap long-term valuations. However, the short-term outlook is less favorable. The yen is not cheap enough based on our augmented interest rate differentials models, the BoJ will remain dovish for the foreseeable future, and an uptick in our China Play Index bodes poorly for countercyclical currencies like the yen. However, since we do expect that global growth will stabilize only on a temporary basis, we will look to open some long yen bets later this fall. Close Short EUR/CHF Trade Last March, we argued that EUR/CHF had more cyclical upside, but that bouts of volatility in global markets would cause periods of weaknesses in the cross.4 Based on this insight, we proceeded to sell EUR/CHF on April 6 as we worried that markets were set to price in a period of weakness in global growth.5 We closed this trade in August, but EUR/CHF kept falling. Now, is EUR/CHF more likely to rally or selloff in the coming quarter? We think a rebound is in the cards. First, the franc is once again highly valued, based on the Swiss National Bank's assessment. It is true that the SNB has not intervened to limit the franc's upside recently, but the CHF's strength is likely to short-circuit the increase in inflation that could have justified betting on the Swissie moving higher (Chart I-18). Ultimately, there is limited domestic inflationary pressures in Switzerland. Moreover, since the import penetration of goods and services in Switzerland is the highest of all the G10, imported deflation will soon be felt. Further, as Swiss labor costs remain very high internationally, the large improvement in full-time jobs witnessed this year is likely to peter off as Swiss businesses work to maintain their competitiveness. Second, the franc received an additional fillip this year as the breakup risk premium in Europe surged (Chart I-19). Every time investors perceive that the probability of a disintegration of the euro rises, they end up pouring money into stable Switzerland. Marko Papic, BCA's Geopolitical Strategy expert, believes that the euro break-up risk will continue to be a red herring in the coming few years. Investors will therefore price out this risk, pulling money out of Switzerland where interest rates remain 30 basis points below the euro area, and boosting EUR/CHF in the process. Chart I-18The Swissie's Strength Will Be Deflationary Chart I-19If A Euro Break-Up Is A Red Herring... Finally, if a temporary stabilization in global growth will hurt the yen, it will also hurt the Swiss franc. As a result, the stabilization in the China Play Index should support EUR/CHF. While we expect EUR/CHF to rally over the coming months, we worry that any such rebound will prove temporary. The current expansion in Chinese stimulus is only a passing phenomenon, and not one powerful enough to put a durable bottom under global growth and EM assets. Hence, while EUR/CHF could easily rally to 1.15, any such rebound should be faded. This move, if followed by a deterioration in our China Play Index, should be used to re-open EUR/CHF shorts. Bottom Line: The Swiss franc remains in a cyclical bear market, punctuated by occasional rallies against the euro when global growth sentiment sours. We just experienced such a rally in the Swissie, but it is ending as the deflationary impact of the CHF's rally will soon be felt. Moreover, the breakup risk premium in the euro is currently too large, and the pricing-in of slowing global growth is likely to take a breather. As a result, EUR/CHF is likely rally over the coming months. We will look to bet again on a CHF rally once the reprieve in global growth ends. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Policy Divergence Are Still The Name Of The Game", dated September 14, 2018, available at fes.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report, titled "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl", dated September 20, 2018, available at ces.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "The Dollar And Risk Assets Are Beholden To China's Stimulus", dated August 3, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: Retail sales and retail sales ex autos yearly growth underperformed expectations, coming in at 0.1% and 0.3% respectively. Capacity utilization and building permits also surprised to the downside, coming in at 78.1% and 1.229 million respectively. However, Housing starts and the Michigan Consumer Sentiment Index surprised positively, coming in at 9.2% and 100.8 respectively. DXY has fallen by nearly 1% this week. Overall, we continue to be bullish on the dollar on a cyclical basis, as inflationary pressures inside the U.S. will force the Fed to hike more than the market expects. That being said, the slowdown in the dollar's momentum, the growing Chinese stimulus, and accumulating signs of stabilizing global economic activity are likely to further weigh on the dollar on a more immediate basis. We will monitor these factors closely in order to gauge whether or not this pullback will remain a garden-variety correction or something more serious. Report Links: Policy Divergences Are Still The Name Of The Game - August 14, 2018 The Dollar And Risk Assets Are Beholden To China's Stimulus - August 3, 2018 Rhetoric Is Not Always Policy - July 27, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area has been positive: Labor costs growth outperformed expectations, coming in at 2.2%. Moreover, construction output yearly growth also surprised positively, coming in at 2.6%. Finally, both core and headline inflation came in line with expectations, at 1% and 2% respectively. EUR/USD has rallied by 1.1% this week We are bearish on the cyclical outlook for the euro, given that core inflation measures are continue to be too weak for the ECB to meaningfully change their dovish monetary policy stance. However, the current tactical rebound is likely to continue, as the weakness in the euro this year has eased financial conditions, which could lead to a temporary boon for the economy. Report Links: Policy Divergences Are Still The Name Of The Game - August 14, 2018 Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Industrial production yearly growth surprised negatively, coming in at 2.2%. Moreover, capacity utilization also underperformed expectations, coming in at -0.6%. Finally, both export and import yearly growth outperformed expectations, coming in at 6.6% and 15.4% respectively. USD/JPY has been relatively flat this week. We are bearish on the yen on a structural basis, given that the economy continues to suffer from strong deflationary forces, which will force the Bank of Japan to keep their ultra-easy monetary policy. Report Links: Rhetoric Is Not Always Policy - July 27, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Rome Is Burning: Is It The End? - June 1, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been positive: The retail price index yearly growth surprised to the upside, coming in at 3.5%. Moreover, both core and headline inflation outperformed expectations, coming in at 2.1% and 2.7% respectively. Finally, the DCLG House Price Index also surprised positively, coming in at 3.1%. GBP/USD has rallied by roughly 1.5% this week. The GBP's vol is likely to increase further going foirward, as very little political risks is priced into it. A practical strategy will be to lean against large weekly moves, both on the upside and downside. This strategy should be particularly profitable versus the euro. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been positive: The participation rate surprised to the upside, coming in at 65.7%. Moreover, the total change in employment also outperformed expectations, coming in at 44 thousand. Finally, the house price index yearly growth also surprised positively, coming in at -0.6%. AUD/USD has risen by roughly 1.8% this week. We continue to be cyclically bearish on the Australian dollar, as the deleveraging campaign in China will weigh on demand for industrial metals, Australia's main export. Moreover, the AUD will also have downside against the CAD, as oil should continue to hold up relative to other commodities thanks to supply cuts from OPEC. That being said, the AUD's recent rebound is likely to continue on a short-term basis. Hence, investors already shorting the Aussie should consider buying hedges. Report Links: Policy Divergences Are Still The Name Of The Game - August 14, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 NZD/USD has rallied nearly 1.9% this week. We are negative on the New Zealand dollar on a structural basis due to the measures taken by the Ardern government, which include reducing immigration, and adopting_a dual mandate for the RBNZ. Both of these measures will weigh on the real neutral rate, which means that the RBNZ will have to hold rates lower than otherwise. However, on a more tactical basis, this cross could rally, thanks to the temporary stimulus by the Chinese authorities which will help risk assets. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been mixed: Manufacturing shipments monthly growth outperformed expectations, coming in at 0.9%. However, capacity utilization surprised to the downside, coming in at 85.5%. Finally, the new house price index yearly growth was in line with expectations, coming in at 0.5% USD/CAD has depreciated by 1% this week. We remain bullish on the CAD among the dollar bloc currencies, given that inflationary pressures continue to be strong in Canada. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF has rallied by 0.5% this week. We continue to be bullish on this cross on a cyclical basis, as the Swiss economy is still too fragile for the SNB to remove its ultra-dovish monetary stance. Moreover, the recent appreciation in the franc that has taken place over the last four months should be very negative for inflation, as Switzerland is the country with the most imports as a percentage of demand in the G10, and thus the country with the most sensitive inflation to currency movements. Finally, on a tactical basis we are also bullish on this cross, as the recent easing of monetary policy by Chinese authorities should be weigh on safe heaven assets like the franc. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Yesterday, Norges Bank increased rates for the first time since 2011, yet the NOK was flat against a weak USD, and fell against the euro and the Swedish krona, suggesting that the hike was well anticipated by market participants. Despite this price action, USD/NOK has depreciated by 1.2% this week. We are positive on the NOK against other non-oil commodity currencies, as oil should outperform base metals in the current environment. After all, OPEC supply cuts and geopolitical risk in the Middle East should provide a boon for oil prices. On the other hand, while temporary easing is likely, the Chinese deleveraging campaign will continue once the Chinese economy has stabilized. Finally, the positive NIIP, and positive current account of the NOK should give it an additional advantage against the rest of the commodity currencies. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden has been negative: Headline inflation underperformed expectations, coming in at 2%. Moreover, the unemployment rate increased from 6% in July to 6.1% on the August reading. USD/SEK has depreciated by almost 2.8% this week. We expect the Riksbank to begin tightening policy in December, as Swedish inflationary pressures remain strong. Moreover, the recent stimulus from the PBoC should put additional downward pressure on EUR/SEK, given the krona's more pro-cyclical profile than the euro. Finally, valuations also support the SEK, as the krona is cheap according to multiple measures. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

  Overweight Rail stocks in general, and Union Pacific (UNP) in particular, got a major lift yesterday when UNP announced a plan to implement the principles of Precision Scheduled Railroading (PSR) in its push to improve customer deliveries and profitability. Recall that PSR was developed by Hunter Harrison first at CN Rail, then CP Rail and finally at CSX where its implementation took industry profit laggards to profit leadership. Though his recent passing was untimely, the 9% year-over-year improvement in CSX’s Q2/18 operating ratio is a testament to the success of Mr. Harrison’s strategy. The timing for a renewed approach at UNP could scarcely be better. Both demand and pricing are soaring (second and third panels) and the resulting congestion is threatening profitability. We expect the ongoing supportive macro backdrop, combined with operating improvements such as these, to sustain the operating margin improvement trend of the past two years (bottom panel). Stay overweight, despite the 20% in relative return since inception. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU.  

Highlights The latest round of tariffs on U.S. imports from China confirms that the Trump administration's confrontation with China goes beyond the mid-term elections. Desynchronization between the U.S. and China/EM growth foreshadows dollar appreciation. The latter is the right medicine for the global economy for now. A stronger dollar is required to redistribute growth and inflation away from the U.S. and towards the rest of the world. China needs a weaker currency to offset deflationary pressures stemming from domestic deleveraging and trade tariffs. For EM ex-China, the dollar rally is painful, but it is the right medicine in the long run. It will bring about the unraveling of excesses within their economies. Feature The global economy presently finds itself between two strong and opposing crosscurrents: robust growth and mounting inflationary pressures in the U.S. on the one hand, and weakening Chinese growth on the other. Desynchronization between China/EM and the U.S. has been our theme since April 2017.1 Although this theme has become evident and to a certain degree priced into the markets, we believe it is not yet time to abandon it. Before exploring this analysis in greater depth, we will address the issue of whether strong U.S. demand will reverse the slowdown in the global trade cycle, and update our thoughts on the trade wars. Global Trade And Trade Wars Our leading indicators for global trade do not herald a reversal in the global exports slowdown. Chart I-1 demonstrates that the ratio of risk-on versus safe-haven currencies2 leads global export volumes by several months, and it does not yet flag any improvement. Chart I-1Risk-On / Safe-Haven Currency Ratio As An Indicator Of Global Trade In addition, Taiwanese exports of electronic products lead the global trade cycles by a couple of months, and they are currently pointing to further deceleration in world exports (Chart I-2). It seems extremely robust U.S. domestic demand growth has not prevented a slowdown in global trade in general and EM exports in particular. The reason for this is that many developing countries' shipments to China are larger than their exports to the U.S., as illustrated in Table I-1. Chart I-2Taiwanese Electronics Exports##br## Slightly Lead Global Exports Table I-1Many Emerging Economies##br## Sell More To China Than To The U.S. The latest decision by the U.S. administration to impose a 10% tariff on $200 billion of imports from China and increase this rate to 25% starting January 1, 2019 confirms that the Trump administration's confrontation with China goes beyond the mid-term elections. The true intention of the U.S. is to contain China's geopolitical rise to preserve its global hegemony. These episodes of import tariffs will likely mark the beginning of a much longer and drawn-out geopolitical confrontation. Our colleagues at BCA's Geopolitical Strategy service have been noting for several years that a U.S.-China confrontation is unavoidable.3 In this vein, it is not clear to us why global growth-sensitive and China-leveraged plays in financial markets have rallied in recent days on the new tariff announcement. We can think of two reasons: (1) markets expect China to stimulate domestic demand aggressively to counter tariffs; and (2) gradually rising U.S. import tariffs will boost global trade in the near term, as companies front load their production and shipments before the 25% tariff rate takes hold. On the first point, there has so far been no major new fiscal stimulus announced in China. We detailed fiscal numbers in our August 23 report,4 and there have been no changes since. As to liquidity easing - which has been material - our assessment is that it is likely to be overwhelmed by ongoing regulatory tightening on banks and shadow banking. In short, lingering credit excesses and regulatory tightening will hamper the monetary transmission mechanism from lower interest rates to faster credit growth. So far, money growth in China remains very weak (Chart I-3). Chart I-3China's Narrow Money And EM Stocks On the second point, we cannot rule out a moderate and temporary improvement in global trade due to various technical factors. Yet, any rally rooted in this will prove to be short-lived and fleeting. Bottom Line: Escalating tariffs on U.S. imports from China will reinforce the tectonic macro shifts that have been in place since early this year: it will lift U.S. inflation slightly and weigh on Chinese growth. Rising U.S. Inflation U.S. core inflation is accelerating and moving above the Federal Reserve's soft target of 2%. This will substantially narrow the Fed's maneuvering room to respond to the turmoil in EM and weakening growth outside the U.S. Chart I-4 demonstrates that an equally weighted average of various core consumer inflation measures for the U.S. has been markedly accelerating. The components of this core inflation aggregate are presented in Chart I-5 and include: trimmed mean CPI, trimmed mean PCE, market-based core PCE and median CPI. Besides, the U.S. labor market is super tight, and employee compensation growth will continue to rise. This will put downward pressure on corporate profit margins and will push businesses to consider passing on their rising costs to consumers. Provided wage growth will continue accelerating and the job market and confidence both remain strong, odds are that companies will be able to raise their selling prices. Chart I-4U.S. Inflation Is Rising... Chart I-5...Based On Various Core Measures Weakening Chinese Growth Growth continues to weaken in China. In particular: The aggregate freight index (transport by railway, highway, waterway, and aviation) is sluggish and the measure of Air China's freight continues to downshift (Chart I-6). The strength in China's residential property market since 2015 has partially been due to the central bank providing very cheap financing directly to housing via its Pledged Supplementary Lending (PSL) scheme. We have argued in the past that this represents nothing less than monetization of excess housing inventories directly by the People's Bank of China.5 This has boosted property prices and sales, supporting the economy over the past two years. Having met the objective of reducing housing inventories, the PBoC has lately reduced the amount of PSL. Provided changes in PSL flows have led both housing prices and sales volumes, it is reasonable to expect a relapse in new sales in the next six months or so (Chart I-7). Chart I-6China: A Slowdown In Freight Indicators Chart I-7China: Housing Sales To Roll Over Soon Our main theme in China has been and remains shrinking construction activity - both infrastructure and property building. This is the primary rationale for our negative view on commodities prices as well as weakness in mainland aggregate imports. Chart I-8 illustrates property construction activity is already contracting. Headline fixed asset investment in real estate has been held up by booming land purchases, yet equipment purchases as well as construction and installation have been shrinking (Chart I-8). Capital expenditures for all industries, including construction and installation, purchase of equipment and instruments - but excluding land values - are also very weak (Chart I-9). Chart I-8China: Property Investment##br## Excluding Land Is Contracting Chart I-9China: Overall Capex##br## Is Very Weak   Interestingly, our proxy for marginal propensity to spend6 by Chinese companies leads global industrial metals prices, and continues pointing to more downside (Chart I-10). With respect to oil, Chinese oil import growth has downshifted considerably (Chart I-11) implying that global oil prices have been mostly propped up by supply concerns. Chart I-10Chinese Companies' Propensity##br## To Spend And Metal Prices Chart I-11China: A Slowdown##br## In Oil Imports Currency Markets As A Rebalancing Mechanism Pressures from growth desynchronization between the U.S. and China and trade wars continue to build. Left unchecked, these imbalances will enlarge and culminate into a bust. A release valve is needed to diffuse these accumulating pressures. Currency and bond markets often act as such - they move to rebalance the global economy and amend economic excesses. Odds are that exchange rates will continue to act as a rebalancing conduit. A stronger dollar is the right medicine for the global economy at the moment. A stronger dollar is required to redistribute growth away from the U.S. and towards the rest of the world. In particular, dollar appreciation is needed to cap budding U.S. inflationary pressures. China needs a weaker currency to offset deflationary pressures stemming from domestic deleveraging and trade tariffs. In turn, a stronger greenback will cause capital outflows from EM and compel the unraveling of excesses within the developing economies. While the result will be painful growth retrenchment for EM in the medium term, cheapened currencies and deleveraging (an unwinding of credit excesses) will ultimately create a foundation for stronger and healthier growth in the years ahead. As to the question of why the dollar would rally in the face of widening twin deficits, we have the following remarks. In a world where growth and inflation are scarce (i.e., in a deflationary milieu), a wider current account deficit and higher inflation - signs of robust domestic demand - will attract capital, ultimately lifting a country's currency. By contrast, in a world of strong growth and intensifying inflationary pressures, twin deficits and higher inflation will cause a country's currency to depreciate. Our assessment is that the global economic backdrop is still more deflationary than inflationary, despite intensifying inflationary pressures in the U.S. Therefore, twin deficits and inflation in the U.S. will be at a premium. That and the fact that the Federal Reserve is willing to continue tightening are conducive for dollar appreciation. As we have argued in previous reports, the U.S. dollar is not cheap,7 but it is not particularly expensive either. In fact, odds are it will get much more expensive before topping out. Bottom Line: Beyond any possible short-term countertrend moves, the path of least resistance for the U.S. dollar is up, and for the RMB and EM currencies, down. As these adjustments within the currency markets endure, EM risk assets will stay under selling pressure and underperform their developed market counterparts.   Indonesia: At The Whims Of Foreign Portfolio Flows 20 September 2018   The Indonesian currency has reached a two- decade low, and equities and bonds have sold off considerably. Is it time to turn positive on the nation's financial markets? Our bias remains that this selloff is not over and stocks, bonds as well as the currency have more downside. The basis is that Indonesia's balance of payments (BoP) will continue to deteriorate. Indonesia has been very reliant on volatile foreign portfolio flows to fund its current account deficit (Chart II-1). Not surprisingly, a reversal in foreign portfolio inflows to emerging markets (EM) has hurt this country's financial markets. We expect international capital flows to EM to be lackluster, which will continue to weigh on Indonesia's capital account. In the meantime, Indonesia's current account deficit is likely to widen in the months ahead. First, export revenues will begin rolling over on the back of lower copper and palm oil prices. Together, these commodities account for 13% of Indonesian exports. Second, the ongoing slowdown in China may eventually weigh on thermal coal prices. This commodity makes up another 12% of exports. Third, Indonesian imports remain very robust. Overall, a widening current account/trade deficit is typically negative for both share prices and the rupiah (Chart II-2). Chart II-1Indonesia: Foreign ##br##Portfolio Flows Are Key Chart II-2Deteriorating Trade Balance ##br##Is Bearish For Equities To prevent further currency depreciation, the government announced it will curb certain imports by raising tariffs.While this policy may succeed in limiting imports, it will also raise inflation by pushing prices of imported goods higher. This will allow inefficient domestic producers to stay in business. Higher inflation is fundamentally negative for the currency and local bonds. The above dynamics are making Indonesia's macro outlook increasingly toxic because Bank Indonesia (BI) will probably need to tighten monetary policy further in order to stabilize the rupiah and restrain inflation. Crucially, the BI's objective is to maintain rupiah stability in order to keep inflation tame. Further, Perry Warjiyo, the current governor of BI, has highlighted his preference for setting decisive and preemptive policies. Indonesia's central bank has already raised interest rates, and more hikes are likely if the currency continues depreciating - as we expect. On top of rate hikes, the BI will continue to deplete its foreign exchange reserves to defend the rupiah. Chart II-3 shows that foreign exchange reserve selling by the BI is shrinking local banking system liquidity (commercial bank reserves at the central bank) and lifting domestic interbank rates. In turn, higher local rates will cause bank loan growth to slow, hurting domestic demand. The latter will be very negative for profit growth and share prices because the Indonesian stock market is heavily dominated by banks and other domestic plays. The outlook for Indonesian banks is crucial for the performance of the Indonesian bourse, given they account for 42% of total MSCI market cap. Unfortunately, banks still rest on shaky foundations: Chart II-3Selling FX Reserves = Higher Interbank Rates Chart II-4Net Interest Margins Will Keep Compressing Not only will demand for loans slump as borrowing costs rise, but banks' net interest margins will also continue to compress (Chart II-4). Weaker growth and higher interest rates will also lead to a considerable rise in non-performing loans (NPLs), and cause banks' provisioning levels to spike. Higher provisions will hurt their earnings (Chart II-5). Notably, banks have boosted their profits substantially in the past two years by reducing their provisions. This process is set to reverse very soon. Finally, a word on overall equity valuations is warranted. Despite the correction that has taken place, this bourse is not yet trading at compelling valuation levels neither in absolute nor in relative terms (Chart II-6). Chart II-5Downside Ahead For Banks' Shares Chart II-6Indonesian Bourse Isn't Cheap Bottom Line: The rupiah will remain under selling pressure. This in turn will create a toxic macro mix of higher inflation, rising borrowing costs and weaker domestic demand. We recommend investors keep an underweight position in Indonesian stocks as well as local and sovereign bonds within their respective EM dedicated portfolios. We are also maintaining our short positions in the rupiah versus the U.S. dollar and on 5-year local currency bonds. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Footnotes 1 Please see Emerging Markets Strategy Weekly Report, "Toward A Desynchonized World?" dated April 26, 2017, the link is available at ems.bcaresearch.com. 2 Relative total return (carry included) of four equally weighted EM (ZAR, RUB, BRL and CLP) and three DM (AUD, NZD and CAD) commodities currencies versus an equally weighted average of two safe-haven currencies - the Japanese yen and Swiss franc. 3 Please see Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 28, 2018, the link is available at gps.bcaresearch.com. 4 Please see Emerging Markets Strategy Weekly Report, "EM: Do Not Catch A Falling Knife," dated August 23, 2018, the link is available at ems.bcaresearch.com. 5 Please see Emerging Markets Strategy Special Report, "China Real Estate: A Never-Bursting Bubble?" dated April 6, 2018, the link is available at ems.bcaresearch.com. 6 Calculated as a ratio of corporate demand deposits to time deposits. Rising demand deposits relative to time (savings) deposits entail that companies are gearing up to spend /invest money and vice versa. 7 Please see Emerging Markets Strategy Special Report, "The Dollar: Will The U.S. Invoke A "Nuclear" Option?" dated August 30, 2018, the link is available at ems.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Prediction 1: A major financial downturn will trigger the next major economic downturn, and not the other way round. Prediction 2: The straw that will break the back of a fragile financial system will be the global long bond yield rising by 60 bps within a short space of time. But for those who can fine tune, the global long bond yield must rise a further 30-50 bps before reaching the tipping point for the global risk-asset edifice. Take short-term profits in the overweight position in 30-year government bonds. Take short-term profits in the underweight position in basic materials. Take short-term profits in the underweight positions in Italy (MIB) and Spain (IBEX) and overweight position in Denmark (OMX). Feature The twenty-first century has witnessed three major downturns: the first started in 2000; the second started in 2007 culminating in the Lehman crisis a year later; and the third started in 2011 (Chart of the Week). Today, we are going to stick our necks out and make two predictions about the century's fourth major downturn. Chart of the WeekThree Episodes When Equities Underperformed Bonds By 20 Percent Or More A major financial downturn will trigger the fourth major economic downturn. The straw that will break the back of a fragile financial system will be the global long bond yield rising by 60 bps within a short space of time. Where The Consensus Is Very Wrong As investment strategists, our primary focus should be the financial markets rather than the economy. On this basis, we define a major downturn in terms of the markets: an episode in which equities underperform bonds by more than 20 percent over a period of more than six months.1 All the same, our market based definition of a major downturn perfectly captures the three occasions that the European economy went into recession or stagnation (Chart I-2). Does this mean that the economic downturns triggered the financial market downturns? No, quite the reverse. The onset of the three major financial downturns clearly preceded the onset of the three major economic downturns. Chart I-2Three Episodes When The Euro Area Economy ##br##Contracted Or Stagnated On reflection, this is hardly surprising. The twenty-first century's major economic downturns have all resulted from financial market distortions and fragilities: the bubble valuations of the technology, media and telecom sectors in 2000 (Chart I-3); the mispricing of U.S. mortgages and credit in 2007 (Chart I-4); and the mispricing of euro area sovereign credit risk in 2011 (Chart I-5). Therefore, it makes perfect sense that the downturns in financial markets should precede the downturns in the economy, even when both are measured in real time. Chart I-3The Major Downturns Stemmed From##br## Financial Market Distortions: The Dot Com ##br##Bubble In 1999/2000... Chart I-4...The Mispricing Of U.S. ##br##Mortgages And Credit##br## In 2007/2008... Chart I-5...And The Mispricing Of Euro Area ##br##Sovereign Credit Risk##br## In 2010/2011 Today, the consensus overwhelmingly believes that an economic downturn will cause the next major downturn in financial markets. But history has taught us time and time again that the causality is much more likely to run the other way. Why not learn the lesson? So here's our first prediction: a major financial downturn will trigger the fourth major economic downturn, and not the other way round. This prediction raises some obvious questions: what could be the major fragility in financial markets, and what could fracture it? A Sharp Rise In Bond Yields Triggered The Last Three Major Downturns Look carefully at the financial market downturns that started in 2000, 2007 and 2011, and you will see another striking similarity. In each episode, the global long bond yield rose by 60 bps or more in the months that preceded the onset of the financial market downturn: April 1999 through January 2000 (Chart I-6); March through July 2007 (Chart I-7); and October 2010 through April 2011 (Chart I-8). This strongly suggests that the spike in the bond yield was the trigger for the subsequent major downturn in financial markets. Chart I-6A Sharply Rising Bond Yield Triggered ##br##The Major Downturn Of 2000 Chart I-7A Sharply Rising Bond Yield Triggered##br## The Major Downturn Of 2007 And 2008 Chart I-8A Sharply Rising Bond Yield Triggered ##br##The Major Downturn Of 2011 A sharp rise in bond yields is usually the straw that breaks the back of financial market fragilities, in (at least) one of three ways: it flushes out those actors that are reliant on cheap liquidity; it pressures interest rate sensitive sectors in the economy; and it weighs on the valuations of other assets such as equities, especially if those valuations are already extremely elevated. Which segues us neatly to the current fragility in the global financial system. As we wrote last week, the post-2008 global experiment with quantitative easing, and zero and negative interest rate policy has boosted the valuations of all risk-assets across all geographies across all asset-classes. And the total value of those global risk-assets is $400 trillion, equal to about five times the size of the global economy.2 We have also consistently highlighted that not only do the rich valuations of $400 trillion of risk-assets depend (inversely) on bond yields, but that this relationship is an exponential function.3 So here's our second prediction: the straw that will break the back of a fragile financial system will be the global long bond yield rising by 60 bps within a short space of time - just as it did in 2000, 2007 and 2011. But Bond Yields Haven't Gone Up Far Enough... Yet Now comes some bullish news, at least for those who can play shorter-term moves in the market. The global long bond yield has been trapped within a tight channel and is only 20 bps up from its recent low in April (Chart I-9). Therefore, it has the scope to rise a further 30-50 bps before reaching the tipping point for the global risk-asset edifice and unleashing a 'risk-off' phase. Chart I-9In 2018, The Bond Yield Has Not Risen Sharply...Yet For those who want to fine tune their investment strategy, the journey up to that turning point would define a phase when many of this year's cyclical sector underperformances would end or even switch to a phase of modest outperformances. Bear in mind that the cyclical sector underperformances this year have been substantial: European banks have underperformed healthcare by 35 percent; global basic materials have underperformed the market by 10 percent; emerging market equities have underperformed developed market equities by 15 percent. So it is prudent to take some short-term profits, especially as these trends are likely to end, at least in the near term. Hence, three weeks ago we closed our underweight banks versus healthcare position, booking a tidy profit of 23 percent. Today, we are closing our underweight position in basic materials versus the market, booking a profit of 6 percent. In a similar vein, we are taking the modest profits in our overweight position in 30-year government bonds. Sector allocation has unavoidable implications for stock market allocation - because the mainstream stock market indexes all have dominant sector skews which determine their relative performances (Chart I-10). Chart I-10Italy Vs. Denmark = Banks Vs. Healthcare On this basis, closing our underweight banks versus healthcare removes the justification for being underweight bank-dominant Italy (MIB) and Spain (IBEX) and the justification for being overweight healthcare-dominant Denmark (OMX). These three positions now move to neutral. While we consider our next shift, our European stock market allocation is temporarily reduced to just five positions. Overweight: France, Ireland, Switzerland. Underweight: Sweden, Norway. Finally, just to say that there will be no report next week as I will be attending our annual Investment Conference which is in Toronto this year. I look forward to seeing some of you there. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Based on the relative performance of the MSCI All Country World Index versus the JP Morgan Global Government Bond Index, both in local currency terms. 2 Please see the European Investment Strategy Weekly Report 'Trapped: Have Equities Trapped Bonds?' September 13 2018 available at eis.bcaresearch.com. 3 Please see the European Investment Strategy Weekly Report 'The Rule Of 4 For Equities And Bonds' August 2 2018 available at eis.bcaresearch.com. Fractal Trading Model* This week, we note that the very strong recent outperformance of U.S. telecoms versus U.S. autos is technically extended, reaching a fractal dimension that has previously signalled the start of a countertrend move. Hence, the recommended trade is short U.S. telecoms, long U.S. autos. Set a profit target of 9% with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

Highlights Recent estimates by ship trackers put the loss of Iranian exports at close to 1mm b/d as of mid-September vs April levels. This loss is higher (and sooner) than our previous baseline expectation, and prompts us to raise our estimate of lost Iranian oil exports to 1.25mm b/d by November, when U.S. sanctions kick in. Venezuela still is close to collapse, but may avoid a complete meltdown with Chinese companies stepping in to safeguard the $50 billion loaned to the country's oil industry.1 We expect production to fall below 1mm b/d next year - to less than half its end-2016 level. With Fed policy likely to continue tightening into 2019 as oil prices surge, the odds of an equity bear market and recession arriving in 2H19 - vs our 2H20 House view - also increase. Our dominant scenario now includes a supply shock and higher prices in 1Q19, which is followed by a U.S. SPR release and price-induced demand destruction (Chart of the Week). As a result, we are raising the odds of Brent prices reaching or exceeding $100/bbl by as early as 1Q19, and lifting our 2019 forecast to $95/bbl. Energy: Overweight. U.S. refining capacity utilization remains close to 19-year highs. At 97.1% of operable capacity, it is within a whisker of the four-week-moving-average highs of 97.3% recorded in August, driven by strong product demand ex U.S. Base Metals: Neutral. The U.S. Treasury granted permission to Rusal's existing customers to continue signing new contracts with the aluminum producer. The announcement stopped short of a full removal of sanctions, which are set to come into effect on October 23. Precious Metals: Neutral. The strong trade-weighted USD continues to hold gold prices on either side of $1,200/oz. We remain long as a portfolio hedge. Ags/Softs: Underweight. The USDA's Crop Production report forecasts record yields for corn and soybeans - 181.3 and 52.8 bushels/acre, respectively - which continues to weigh on prices. The bean harvest is expected to be a record. Feature Chart of the WeekBCA Ensemble Forecast Lifts Brent To $95/bbl, As Market Tightens With the loss of Iranian exports occurring faster and sooner than expected, and Venezuela remaining on the brink of collapse, senior energy officials from the U.S., Russia and the Kingdom of Saudi Arabia (KSA) are going to great lengths to reassure their domestic consumers everything - particularly on the supply side - is under control. We are inclined to believe their comfort level re global oil supply is inversely proportional to the amount of reassurance they provide their domestic audiences. The more they meet and talk - particularly to the media - the more concerned they are. And right now, they're pretty concerned. Rick Perry, the U.S. Energy Secretary, held a presser in Moscow following his meeting with Alexander Novak, Russia's Energy Minister, saying the U.S., KSA and Russia can lift output over the next 18 months to compensate for the loss of exports from Iran, Venezuela, and other unplanned outages.2 That might be true, but the market's already tightening far faster and far sooner than many analysts expected. Covering a supply shortfall in 18 months does nothing for the market over the next few months, particularly with demand remaining robust (Chart 2) and OECD inventories falling (Chart 3). Since 2017, our factor model shows Brent prices have been supported by two factors acting simultaneously together: Chart 2Fundamentals Support Strong Prices Chart 3Inventory Draws Will Accelerate Strong compliance of OPEC 2.0 members to the coalition's production-cutting agreement, which reduced the OPEC Supply-and-Inventory factor's role, and The pickup in global oil demand, particularly in EM economies, which pushed our Global Demand factor up. These effects were partly counterbalanced by the rise in our non-OPEC Supply factor - driven by strong growth in U.S. shale-oil output - which became the largest negative contributor to price movements. Global demand's been strengthening since the end of 1H17 on the back of stellar EM income growth. This remains the fundamental backdrop to global oil for now. While our base case remains relatively supportive for oil prices, we are raising the odds of a price spike resulting from a supply shock as early as 1Q19 on the back of larger- and faster-than-expected Iranian export losses, and continued declines in Venezuelan production. Should this occur, we believe it would trigger a U.S. SPR release, and produce demand destruction at a rate that could be faster than historical experience would suggest (Table 1). This further tightens balances, and leads us to raise our 2019 forecast for Brent crude oil to $95/bbl on average, up from $80/bbl last month, with WTI trading $6/bbl below that (Chart 4). This forecast is highly conditional, given our assumptions re supply-side variables, a U.S. SPR release, and demand destruction estimates. Table 1BCA Global Oil Supply - Demand Balances (MMb/d) (Base Case Balances) Chart 4BCA's Oil Balances Tighter Oil Balances Tighten As Supply Contracts In our monthly balances update, we are incorporating a sharply accelerated loss of Iranian export barrels to the market, which already is evident. Bloomberg this week reported its tanker-tracking service registered a decline in Iranian exports of close to 1mm b/d between April, when sanctions were announced, and mid-September.3 At this rate, the assessment by Platts Analytics last week that as much as 1.4mm b/d of Iranian exports could be lost by the time U.S. sanctions kick in November 4 appears more likely.4 However, to be conservative, we are building in a loss of 1.25mm b/d in our balances, and have it developing over the July - November period in increments of 250k b/d, instead of the November - February interval we assumed in last month's balances. We will monitor this situation and revise our estimates as new information arrives. Also on the supply side, we are assuming the U.S. SPR releases 500k b/d starting a month after Brent prices go over $90/bbl in March 2019. This is in line with the SPR's enabling legislation, which limits drawdowns to 30mm b/d over a 60-day period, after the President authorizes such action to meet a severe energy supply interruption. Lastly, we continue to carry supply constraints arising from the lack of sufficient take-away capacity to get all of the crude produced in the Permian Basin to refining markets in our models. To wit: We continue to expect 1.2mm b/d of supply growth from the U.S. shales, driven largely by Permian production, vs an earlier expectation of 1.4mm b/d of growth. We expect the Permian to be de-bottlenecked by 4Q19. We expect the Big 3 producers Secretary Perry expects to fill supply gaps in 18 months - the U.S., Russia, and KSA - to produce 10.83mm, 11.4mm and 10.4mm b/d in 2H18, and 11.79mm, 11.43mm and 10.4mm b/d next year, respectively. They will get some help from OPEC's Gulf Arab producers - i.e., the core OPEC producers (Chart 5) - but, supply will continue to fall/stagnate in most of the rest of the world, particularly in offshore producers (Chart 6). Chart 5While Core OPEC Can Increase Supply... Chart 6... 'The Other Guys' Output Stagnates We also note the EIA and IEA have lowered their supply-growth estimates this month. The EIA this month reduced expected U.S. crude production growth by 210k b/d in 2019, and the IEA lowered its estimate of offshore production growth in Brazil from 260k b/d to just 30k b/d this year. These are non-trivial adjustments in a market that was tight prior to the downgrade in supply growth. Still, there are significant marginal disagreements on the supply side among the major data supporters (the EIA, IEA and OPEC), which can be seen in Table 2. Table 2Comparison Of Major Balances Estimates Demand Destruction Likely As Prices Spike In 1Q19 We expect the rate of growth in EM incomes and trade - a proxy for income - to slow slightly this year vs 2017, on the back of a strengthening USD. This will reduce the rate of growth in EM imports and the rate of growth in EM commodity demand, at the margin. However, y/y growth in EM incomes is expected to remain positive over the next 12 months in our baseline scenario, which will keep the level of commodity demand - particularly for oil and industrial metals - robust. This will drive global demand growth of ~ 1.6mm b/d this year, roughly unchanged from last month. Higher prices risk slowing next year's growth. This is where it gets tricky. An oil-supply shock occurring when global demand is strong most likely will produce a price spike, as we've been arguing for the past several weeks.5 This price spike, coupled with continued monetary-policy tightening by the Fed, raises the likelihood of demand destruction globally. Higher oil prices and a stronger USD act as a double-whammy on EM oil demand. The problem we have now is gauging the elasticity of oil demand, particularly in EM. Oil markets are fundamentally different now than at any point in the modern era - roughly beginning in the early 1960s with the ascendance of OPEC - because many big oil-importing EM economies removed or relaxed subsidies following the prices collapse of 2014 - 2016. Prominent among these states are China and India. OPEC states also took advantage of the price collapse to relax or remove subsidies, e.g., KSA.6 The price shock we anticipate, therefore, will be the first in the modern era in which EM consumers - the principal driver of oil demand in the world, accounting for roughly 70% of the demand growth we expect - are exposed directly to higher prices. How quickly they will respond to higher prices is unknown. For this reason, we're introducing what we consider a reasonable first approximation of how EM demand might respond to higher prices and a stronger USD into the scenarios we include in our ensemble forecast (Chart 7). As a first approximation - subject to at least monthly adjustment, as more data become available - we are modeling a 100k b/d loss of demand for every $10/bbl increase in crude oil prices.7 We will continue to iterate on this as new information becomes available. Chart 7Ensemble Scenarios Reflect New Risks Bottom Line: We've raised the odds of a supply shock in the oil markets that takes Brent prices to or through $100/bbl by 1Q19. Should this occur, we expect it will be met by a U.S. SPR release of 500k b/d a month after prices breach $90/bbl. This price spike will set off a round of demand destruction, which we expect will be quicker than history would suggest, given many large EM oil-consuming states have relaxed or eliminated fuel subsidies, leaving their consumers exposed to the price shock. This will be exacerbated by a stronger USD going forward, as the Fed likely looks through the price spike and continues with its policy-rate normalization. In this scenario, a U.S. recession could arrive in 2H19 vs our House view of 2H20 or later. In addition, we would expect an equity bear market to ensue sooner than presently anticipated. We recommend using Brent call spreads to express the view consistent with our research. At tonight's close, we will go long April, May and June 2019 calls struck at $85/bbl and short $90/bbl calls. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see "Venezuela hands China more oil presence, but no mention of new funds," published by reuters.com September 14, 2018. 2 U.S. Energy Secretary Rick Perry made this claim at a press conference after meeting with Russian Energy Minister Alexander Novak last Friday. Please see "Big Three oil states can offset fall in Iran supplies: Perry," published by reuters.com September 14, 2018. 3 Please see "Saudi Arabia Is Comfortable With Brent Oil Above $80," published by bloomberg.com September 18, 2018. 4 Please see "OPEC crude oil production rises to 32.89 mil b/d in Aug as cuts unwind: Platts survey" published by SP Platts Global September 6, 2018. 5 Please see "Oil-Supply Shock, Rising U.S. Rates Favor Gold As A Portfolio Hedge," published by BCA Research's Commodity & Energy Strategy Weekly Report on September 13, 2018. It is available at ces.bcaresearch.com. For a discussion of the effect of a stronger USD on global oil demand, please see "Trade, Dollars, Oil & Metals ... Assessing Downside Risk," published by the Commodity & Energy Strategy August 23, 2018. 6 Please see the Special Focus in the World Bank's January 2018 Global Economic Prospects entitled "With The Benefit of Hindsight: The Impact of the 2014 - 16 Oil Price Collapse," beginning on p. 49. 7 In this simulation, we employ an iterative one-step-ahead forecasting methodology that reduces demand by 100k b/d for every $10/bbl increase in prices. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2018