Emerging Markets

Highlights Either China's growth will slump soon, capping budding inflationary pressures, or policymakers will have to hike interest rates meaningfully to tackle inflation. If the PBoC drags its feet and does not hike interest rates amid rising inflation, the RMB will come under major selling pressure. EM/China corporate profits have expanded predominantly due to price increases. However, rapid price increases warrant higher interest rates. The latter is a formidable risk to share prices. The U.S. dollar has made a major bottom. Stay short select EM currencies. The EM equity rally momentum remains strong but the risk-reward is quite unfavorable. We expect the external backdrop - metals prices and portfolio flows to EM - to deteriorate inhibiting the current easing cycle in Peru. Stay underweight this bourse within the EM universe (page 13). Feature A key question for investors at the current juncture is whether the global economic backdrop is moving toward inflation or deflation - or whether it will remain in its present "goldilocks" state. One can cite numerous examples that support each of the three scenarios. Proponents of deflation cite low consumer price inflation in the U.S., euro area and Japan, as well as very weak money growth in China and the U.S. as being leading indicators of budding deflationary pressures. Advocates of goldilocks - improving growth with low inflation - point to robust global trade and low consumer price inflation, as well as benign financial market dynamics in the form of higher share prices and low bond yields. Last but not least, inflationists can cite very tight labor markets among advanced economies as well as rising core and services consumer price inflation rates in China (Chart I-1). Chart I-1China: Inflation Is Grinding Higher China: Inflation Is Grinding Higher China: Inflation Is Grinding Higher At BCA's annual conference in New York held last week, the broad consensus was that there is a lack of considerable inflationary pressures worldwide amid improving global growth. This is consistent with the goldilocks outcome currently priced by the financial markets - i.e., a combination of robust growth and low inflation. Given the current pricing in financial markets, one economic variable that could disturb benign global financial dynamics is inflation. This report examines inflationary dynamics in China and briefly touches on the U.S. and euro area inflation outlooks. Our take is as follows: Unless China's money and credit growth slow further and generate another deflationary slump in China and world trade, the odds are that the balance both globally and within China will tilt toward inflation in the next 12 months. To be clear, our main theme remains that a material slowdown in China's growth will dampen China/EM growth, derail the EM corporate profit recovery and cap inflationary pressures in China, at least. Therefore, to some extent, this report is counter-factual - it examines what may happen if a meaningful growth deceleration in China does not transpire. Our analysis also addresses the question of what may happen if policymakers in China allow money/credit to accelerate again, without permitting the economy to slow too much. The short response: Inflation is already slowly but surely rising in China and it will soon become a constraint, limiting Chinese policymakers' options. China/Asia Recovery: Prices Or Volumes? China's industrial revival, as well as Asia's export recovery over the past 12-18 months, has largely been due to price increases amid modest volume growth. In particular: China's manufacturing production volume growth has not improved at all, but manufacturing producer prices have surged, producing substantial recovery in nominal output growth (Chart I-2). This is strictly within manufacturing, and does not include mining and ferrous metal production, where output cuts have led to surging prices for raw materials. In brief, one can observe higher inflation beyond the steel and coal industries. Furthermore, producer price inflation has improved for consumer goods (Chart I-3, top panel), and for the first time in 17 years ex-factory producer price deflation has ended in durable consumer goods as well as in electronics goods and communication equipment (Chart I-3, middle and bottom panels). Chart I-2China's Industrial Recovery: Surging ##br##Prices Amid Subdued Volume Growth China's Industrial Recovery: Surging Prices Amid Subdued Volume Growth China's Industrial Recovery: Surging Prices Amid Subdued Volume Growth Chart I-3China: Producer Price ##br##Inflation Is Broad-Based China: Producer Price Inflation Is Broad-Based China: Producer Price Inflation Is Broad-Based Notably, China's core (ex-food and energy) consumer price inflation has moved above 2%, and consumer services price inflation has risen to 3% (Chart I-1 on page 1). Importantly, these consumer inflation measures have risen, even though food prices are deflating in China and energy prices are stable. This entails that consumer price inflation pressures are genuine and reasonably broad-based. In Asian trade, the dichotomy between prices and volumes is especially apparent in the case of Korea's exports. The U.S. dollar value of Korean exports has mushroomed, but there has been only modest revival in export volumes (Chart I-4). Remarkably, both the 2014-'15 slump and the 2016-'17 recovery in Korean exports were largely due to prices, not volumes. The latter have been expanding modestly in recent years, while prices crashed in 2013-'15 and surged in 2016-'17. Finally, Korean and Taiwanese export prices as well as U.S. import prices from Asia have risen in the past 12-18 months, following years of deflation (Chart I-5). Chart I-4Korean Export Recovery: Prices Versus Volumes Korean Export Recovery: Prices Versus Volumes Korean Export Recovery: Prices Versus Volumes Chart I-5Asian Export Prices: A Reversal? Asian Export Prices: A Reversal? Asian Export Prices: A Reversal? Beyond higher prices for steel and other commodities, Korea's export prices are climbing because of skyrocketing DRAM semiconductor prices (Chart I-6). Price changes are much more important to corporate profits than volume changes. For example, a 5% rise in prices boosts corporate profits by much more than a 5% gain in output volume. By the same token, profits decline more when prices drop by 2% than when volumes fall by 2%. We discussed this phenomenon and illustrated an example in our January 28, 2016 report.1 Rising prices across various commodities and manufactured goods have allowed Chinese and Asian companies to deliver strong profits in the past 12 months. China's industrial profits have ballooned, even though output volume growth has been modest. On the whole, the enormous money/credit injection in China in the past two years has hindered lingering price deflation and led to rising prices for various goods and services. Chart I-7 illustrates that the recovery in corporate pricing power and, hence, mushrooming industrial corporate earnings can be attributed to the mainland's credit/money impulses. Chart I-6DRAM Semi Price Has ##br##Surged 4-Fold In Last 12 Months DRAM Semi Price Has Surged 4-Fold In Last 12 Months DRAM Semi Price Has Surged 4-Fold In Last 12 Months Chart I-7China: A Peak In Producer ##br##Prices And Industrial Profits? China: A Peak In Producer Prices And Industrial Profits? China: A Peak In Producer Prices And Industrial Profits? If pricing power deteriorates, as the money/credit impulse is signaling, corporate earnings will be at risk. In such a scenario, inflation will not be a problem, as deflationary pressures will resurface. However, corporate profits will shrink. Bottom Line: EM/China corporate profits have expanded predominantly due to price increases. Investors have celebrated it by flocking into EM/Chinese stocks. However, rapid price increases warrant higher interest rates. The latter is a formidable risk to share prices. Barring a material growth deceleration in China, which is our baseline view, odds are that inflation will rise further. Why Now? Inflation is rising in China because of rampant money/credit creation complemented with a weak productivity growth rate. In addition, policymakers have engineered a reversal in raw materials price deflation since early 2016. It is impossible to know if the Chinese economy has reached a point where growth rates of 6-6.5% and above will lead to inflation. It is hard to estimate potential GDP growth rates and output gaps for advanced countries, but it is practically impossible to do so in the case of China. Its economy has undergone multiple dramatic structural transformations in the past 30 years, changes that continue today. That said, it is possible to argue that China may have reached a point where further rampant money and credit creation leads to higher inflation. The key thesis is that productivity growth has slowed because of the following: Channeling credit to SOEs - which often misallocate capital - and to property markets does not boost productivity. Infrastructure projects will take years to produce productivity gains, even if they are well thought out. Chart I-8 illustrates that in recent years an increasing share of investment has been on structures and installations rather than equipment and new technologies. Investment in structures does not boost productivity as much as equipment purchases. Meanwhile, private capital spending has been in the doldrums over the past four years, as has been the case for manufacturing investment (Chart I-9). This argues for less efficiency/productivity and, thereby, diminished potential growth. Chart I-8Unfavorable Mix For Productivity Growth Unfavorable Mix For Productivity Growth Unfavorable Mix For Productivity Growth Chart I-9Private And Manufacturing Capex Remain Weak Private And Manufacturing Capex Remain Weak Private And Manufacturing Capex Remain Weak Historically, it was private investment and manufacturing capacity expansion that fostered productivity gains in China. Private projects are often more efficient than public investment, and it is much easier to achieve higher productivity in manufacturing than in the service sector. This is not to argue that there are no innovation and rapid technological changes in China. A lot of innovation and technological advancement is happening but it might not be sufficient to boost productivity growth above 6% (Chart I-10). China's extremely fast productivity gains in the past 20 years have largely been due to rapid expansion of manufacturing and construction. Manufacturing cannot rise fast because it is hard for China to gain more market share in global trade without causing political backslashes. In turn, construction has been driven by excessive credit expansion and property market speculation and policymakers want to reduce this. It is imperative to understand that in any country productivity is much lower in the service sector than in manufacturing and construction. A shift away from manufacturing and construction toward services will surely lead to much lower productivity and, hence, potential economic growth. If policymakers allow/encourage rapid money/credit expansion to achieve growth rates above 6-6.5% or so, the outcome will be inflation. Implications For Chinese Policymakers If economic growth does not slow, odds are that inflation will continue to rise in China due to a lower potential GDP growth rate. As such, policymakers will have to tackle inflation by raising interest rates. The deposit rate in China is at 1.5%, and is presently negative when deflated by core consumer price inflation (Chart I-11). This is occurring for the first time in ten years. Chart I-10Potential Growth = Labor Force + ##br##Productivity Growth Potential Growth = Labor Force + Productivity Growth Potential Growth = Labor Force + Productivity Growth Chart I-11China: Deposit Rate In ##br##Real Terms Is Negative China: Deposit Rate In Real Terms Is Negative China: Deposit Rate In Real Terms Is Negative If inflationary pressures continue building up and policymakers do not hike interest rates, households will become even more dissatisfied by negative deposit rates and opt for converting their RMB deposits into foreign currency, or buying real estate. Both scenarios will eventually lead to financial instability, which policymakers are trying to avoid. Chart I-12 demonstrates that the current level of foreign exchange reserves of US$ 3.3 trillion is equal to only 34% of household deposits and 15% of total (corporate and household) deposits, and 10% of our broad M3 money measure. In brief, the failure to proactively hike deposit rates will likely lead to capital flight. Policymakers realize that the Chinese banking system has created so much money that even the sheer size of foreign currency reserves is insufficient to defend the currency if and when households and companies choose to convert their liquid savings into foreign currency. This argues for higher interest rates in China, unless growth downshifts very soon and caps inflation. Bottom Line: Either China's growth will slump soon, capping budding inflationary pressures, or policymakers will have to hike interest rates meaningfully to avoid another run on the exchange rate. What About DM And Non-Asian EM? In the majority of non-Asian EM economies, inflation is either muted or under control. The exceptions are Turkey and central European economies. We have discussed the inflation outbreak in central Europe in detail in past reports (also see Chart I-13 below), and will be revisiting Turkey next week.2 Chart I-12Too Much Money Has Been Created Too Much Money Has Been Created Too Much Money Has Been Created Chart I-13Inflation Outbreak In Central Europe Inflation Outbreak In Central Europe Inflation Outbreak In Central Europe The basis is that there has been little recovery in Latin American economies as well as Russia and South Africa for inflationary pressures to transpire. While some may be prone to structural inflation, cyclical business conditions are still too weak to warrant rising pricing power. In the Euro Area, investors should closely monitor German wage dynamics. Manufacturing wages and core consumer price inflation in central Europe are ramping up (Chart I-13). If and when labor shortages and rising wages in central Europe discourage German manufacturing companies from relocating/outsourcing production to the former, it will put more pressure on the already very tight German labor market and will lead to higher wages. As a result, genuine inflation in the largest European economy will heighten. In the U.S., the tight labor market and vibrant growth argue for higher inflation ahead. The Trump administration's proposed tax cuts amid robust growth will boost demand and rekindle inflation. Bottom Line: Inflation expectations are very depressed worldwide, and it will not take much in the way of upward inflation surprises to re-price interest rate expectations and, consequently, financial assets. Financial Markets Ramifications The Foreign Exchange Market: The U.S. dollar has probably made a major bottom and will stage a multi-month rally (Chart I-14). Chart I-14Will The Greenback Find ##br##Support At Current Levels? Will The Greenback Find Support At Current Levels? Will The Greenback Find Support At Current Levels? The Federal Reserve will be the first central bank to hike interest rates if global inflation or inflation expectations rise. In turn, the European Central Bank and the People's Bank of China will likely move slower in tightening policy. Such a proactive policy stance of the Fed, especially relative to its peers, will benefit the greenback. Furthermore, the potential appointment of Kevin Warsh as Fed Chairman could lead to higher interest rate expectations in the U.S., and will be currency bullish. In short, the potential mix of tight monetary policies and easy fiscal policies is bullish for the dollar. In the interim, U.S. bond yields are likely to move higher. This is true in the near term, even if Chinese growth disappoints. It will take time until China's growth deceleration caps the upside in U.S./global bond yields. Consistent with our U.S. dollar view, we believe commodities prices have reached a major peak. In sum, the path of least resistance for the U.S. dollar is up. Stay long the U.S. dollar versus a basket of EM currencies: ZAR, TRY, MYR, IDR, BRL and CLP. Local Currency Bonds: As and when EM currencies depreciate versus the greenback and U.S. bond yields grind higher, EM high-yielding local currency bonds could sell off. Chart I-15 reveals that the spread between the EM-GBI local currency benchmark yield and five-year U.S. Treasurys has fallen to a 10-year low. The risk-reward is not attractive for U.S. dollar- and euro-based investors. EM credit versus U.S. investment grade bonds. On August 16, 2017, we advised shifting our underweight EM sovereign bonds recommendation away from U.S. high yield to U.S. investment grade corporate credit. This strategy remains intact. This is consistent with EM currencies depreciating versus the U.S. dollar, U.S. bond yields moving higher and commodities prices softening. Continue underweighting EM stocks versus DM: A stronger U.S. dollar and rising U.S. bond yields will reverse EM equities' relative outperformance versus DM. In fact, manufacturing PMIs certify that EM manufacturing growth remains subdued relative to DM (Chart I-16). Chart I-15EM Local Currency Bonds: Little Yield Advantage EM Local Currency Bonds: Little Yield Advantage EM Local Currency Bonds: Little Yield Advantage Chart I-16EM Equities Versus DM: A Sign Of Reversal? EM Equities Versus DM: A Sign Of Reversal? EM Equities Versus DM: A Sign Of Reversal? If this coincides with inflation or growth concerns in China, it will create a perfect storm for all EM risk assets. As to EM stocks' absolute performance, we are approaching a major top, even though the exact timing of a major relapse is uncertain. Flows into EM equities remain robust, but they will reverse if one or more of the following transpires: rising U.S. interest rate expectations, a stronger U.S. dollar, high and rising inflation in China and policy tightening, or the opposite - an imminent growth slump in China and a relapse in commodities prices. All in all, the EM equity rally momentum remains strong but the risk-reward is quite unfavorable. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Peru: External Backdrop Holds The Key The external environment has been and will remain key to the performance of Peruvian financial markets. The Peruvian bourse has rallied massively, outperforming the EM equity benchmark over the past year, even as domestic demand in Peru has been weakening. Despite stronger global growth and higher commodities prices, GDP growth along with consumer and capital growth have not recovered at all (Chart II-1). Meanwhile, bank loan growth remains very weak (Chart II-2). Chart II-1Peru: Weak Domestic Demand... Peru: Weak Domestic Demand... Peru: Weak Domestic Demand... Chart II-2...Corroborated By Weak Credit Growth ...Corroborated By Weak Credit Growth ...Corroborated By Weak Credit Growth If metals prices stay firm and strong capital flows in EM persist, Peru's currency will remain under appreciation pressure. This will provide the central bank with more room to ease policy by cutting interest rates and adding liquidity to the banking system as it accumulates foreign exchange reserves (Chart II-3). Continued policy easing by the central bank will in turn revive bank loan growth, and the economy will recover. Chart II-3FX Reserve Accumulation = Liquidity Easing FX Reserve Accumulation = Liquidity Easing FX Reserve Accumulation = Liquidity Easing Our baseline scenario, however, is that industrial metals prices in general and copper prices in particular will relapse materially in the next 12 months. Furthermore, odds are that U.S. bond yields will drift higher and the U.S. dollar will strengthen (as discussed on pages 11-12). Under such a scenario: The Peruvian sol would come under depreciation pressure if and when metals prices relapse (Chart II-4). With precious and industrial metals representing 60% of total exports, a drop in metals prices will lead to considerable deterioration in Peru's trade balance and FDI inflows will slump. The central bank is committed to maintaining a stable exchange rate due to high foreigner ownership of government local currency bonds and a still-partially dollarized economy. Hence, if the currency comes under attack, the central bank will defend the sol by selling its international reserves, which will deplete local currency liquidity (Chart II-3). Consequently, local rates will rise and banks will curtail bank loan growth, which in turn will preclude any recovery in domestic demand. Overall, the external environment and its impact on the exchange rate holds the key for a domestic-led recovery. A relapse in industrial metals and copper prices and ensuing depreciation pressure on the currency will undo the recent loosening in monetary policy and stall a potential domestic demand recovery. In terms of financial markets strategy, we recommend the following: Despite domestic demand weakness, the Peruvian equity market has been on a tear, led by banking and mining stocks. Given our negative view on industrial metals and copper prices, we recommend staying underweight Peruvian equities relative to the EM benchmark (Chart II-5). Chart II-4Terms Of Trade Dictate The Currency Terms Of Trade Dictate The Currency Terms Of Trade Dictate The Currency Chart II-5Has Peru's Relative Equity Performance Peaked? Has Peru's Relative Equity Performance Peaked? Has Peru's Relative Equity Performance Peaked? With respect to our absolute call on bank stocks and our relative trade versus Colombian banks, we recommend closing both trades with large losses. Finally, we recommend being long Peru credit relative to Brazilian sovereign credit. Public debt burden is much lower in Peru (24% of GDP) than in Brazil (74% of GDP). Andrija Vesic, Research Assistant andrijav@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "Corporate Profits: Recession Is Bad, Deflation Is Worse," dated January 28, 2016, link available at ems.bcaresearch.com 2 Please see Emerging Markets Strategy Special Report "Central Europe: Beware Of An Inflation Outbreak," dated June 21, 2017, and Emerging Markets Strategy Weekly Report, dated September 6, 2017; pages 15-18; links are available on page 18. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Recommendation Allocation Quarterly - October 2017 Quarterly - October 2017 The global growth outlook remains strong, with corporate earnings likely to beat expectations for a couple more quarters. Inflation and Fed policy are key to asset allocation. We expect inflation to recover, which will push up interest rates and the dollar. But uncertainty is rising too: for example the composition of the FOMC next year, Chinese policy post the Party Congress, Geopolitics. We keep our pro-risk tilts, particularly overweights in euro area and Japanese equities, U.S. high-yield bonds, private equity, and cyclical sectors. But we reduce portfolio risk by bringing some allocations closer to benchmark, for example downgrading U.S. equities to neutral and reducing the underweight in EM. Feature Overview Growth Is Picking Up - But So Is Uncertainty The outlook for global economic growth remains almost unarguably positive (Chart 1). The key for asset allocation, then, comes down to whether inflation in the U.S. will rebound, and whether therefore the Fed will continue to tighten monetary policy in line with its current projections. This would likely cause long-term interest rates to rise and the dollar to appreciate, which would be positive for developed market equities and credit, but negative for government bonds, emerging market equities and commodities. This scenario has been our expectation - and the basis of our recommendations - for some time, and it remains so. In September, the market started coming around to our view - after months of pricing in that inflation would stay sluggish (which, therefore, had caused the euro and yen, government bonds, EM equities and commodities to perform well). In just a couple of weeks, the futures-market-priced probability of a December Fed hike has moved from 31% to 75%. This was triggered by little more than stabilization of core CPI (Chart 2), due mainly to shelter inflation, which anyway has a low weight in the core PCE inflation data that the Fed most closely watches. To us, this demonstrates just how sensitive the market is to any slight pickup in inflation, due to the fact that its expectations of Fed rate hikes over the next 12 months are so far below what the FOMC is signaling (Chart 3). Chart 1Lead Indicators Looking Good Lead Indicators Looking Good Lead Indicators Looking Good Chart 2Is The Softness In Inflation Over? Is The Softness In Inflation Over? Is The Softness In Inflation Over? Chart 3The Market Still Doesn't Believe The Fed The Market Still Doesn't Believe The Fed The Market Still Doesn't Believe The Fed However, a risk to BCA's view is that the Fed turns dovish. Even Janet Yellen, in the press conference after the FOMC meeting on 20 September, admitted that the Fed needs "to figure out whether the factors that have lowered inflation are likely to prove persistent". If they do, she said, "it would require an alteration of monetary policy." FOMC member (and notable dove) Lael Brainard, in an important speech earlier in September, laid out the argument that, since inflation has missed the Fed's 2% target for five years, inflation expectations have been damaged (Chart 4) and that only a period during which inflation overshot could repair them. With Yellen's term due to expire next February and four other vacancies on the FOMC, personnel changes could significantly change the Fed's direction. Online prediction sites give a somewhat high probability to President Trump's replacing Yellen, with (the rather more hawkish) Kevin Warsh, a Fed governor in 2006-11 (Chart 5). However, presidents tend to like loose monetary policy - President Trump has said as much himself - which raises the possibility of his trying to steer the Fed in a direction that is more tolerant of rising inflation. A possible scenario, then, is of an accommodative Fed which allows equities markets to have a final meltup for this cycle, similar to 1999. Chart 4Have Inflation Expectations Been Damaged? Have Inflation Expectations Been Damaged? Have Inflation Expectations Been Damaged? Chart 5Who Will Trump Choose To Lead The Fed? Quarterly - October 2017 Quarterly - October 2017 Another current source of uncertainty is China. Money supply growth there has slowed sharply this year, after being pushed upwards by the government's reflationary policies in late 2015. This historically has been a good lead indicator of growth and, indeed, many cyclical indicators have surprised to the downside recently (Chart 6). It is also hard to predict whether, after October's five-yearly Communist Party congress, newly re-elected President Xi Jinping will move ahead with implementing structural reforms, even at the expense of a short-term slowdown of growth.1 We continue to think that risk assets have further upside for this cycle. Growth is likely to remain strong, the probability of a U.S. tax cut is rising, and corporate earnings should surprise to the upside for another couple of quarters (Q3 S&P500 EPS consensus forecasts remain cautious at 5% YoY, versus our model which suggests double-digit growth). Nonetheless, the cycle is now mature, global equities have already produced a total return of almost 40% since their recent bottom in February last year, and valuations in almost every asset class are stretched (Chart 7). Moreover, geopolitical risks - such as that from North Korean missiles - will not disappear quickly. We continue to pencil in the possibility of a recession in 2019 or 2020, caused by a sharp rise in inflation, especially in the U.S., which the Fed - whoever is running it - would have to stamp on by raising rates above the equilibrium level. Chart 6Is A Downturn Coming In China? bca.gaa_qpo_2017_10_02_c6 bca.gaa_qpo_2017_10_02_c6 Chart 7Nothing Looks Cheap Nothing Looks Cheap Nothing Looks Cheap Therefore, on the 12-month horizon we continue to recommend pro-risk and pro-cyclical positioning, for example an overweight in equities versus fixed income. However, given the rising uncertainty, we are reducing the scale of our bets a little and so, for example among our equity country and regional recommendations, move a little closer to benchmark by lowering the U.S. to neutral and reducing the degree of our underweight in EM. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com What Our Clients Are Asking How worried should we be about North Korea? Chart 8Threats - But Eventually A Diplomatic Solution Threats - But Eventually A Diplomatic Solution Threats - But Eventually A Diplomatic Solution President Obama reportedly warned President Trump just prior to inauguration that North Korea would be his biggest headache. After 15 missile launches and a nuclear test this year (Chart 8, panel 1), investors are beginning to think the same. How big is the risk that the tension turns into warfare? BCA's Geopolitical strategists have written about the subject extensively.2 They conclude that military action is unlikely. An U.S. attack on North Korean missile or nuclear sites would simply provoke an attack with conventional weapons on Seoul, which is only 50 km from the border. Kim Jong-un undoubtedly knows that if he were to attack Guam or Japan, his country would be wiped out. In the end, then, a diplomatic solution is likely - but this will only be achieved after tension has risen sufficiently to force the two sides to the negotiating table. The analogy is Iran in 2012-15, where sanctions finally forced it to agree to a 10-year freeze in its nuclear plans. For the moment, sanctions seem unlikely to bite. North Korea's trade with China is not yet notably slowing (Chart 8, panel 2) and its GDP growth actually accelerated last year, albeit from stagnating levels, according to estimates from the Bank of Korea (Chart 8, panel 3). So the cycle of new threats and tougher sanctions will continue for a while. Historically, North Korean provocations caused related markets (such as South Korea stocks) to fall sharply for a few days, but this always represented a buying opportunity (Chart 8, panel 4). Given the likelihood of a diplomatic outcome, we think this remains a good rule of thumb. What will happen after China's 19th Party Congress, and will there be a slowdown in the economy? China's twice-a-decade National Party Congress will be held October 18-25. The outcome of the meeting could have important economic and market consequences. The key purpose of the Congress is to rotate China's political leaders. The 19th Party Congress is crucial because it marks the passing of a generation: President Xi Jinping will receive a second five-year term, but is predicted to consolidate his power by placing a younger generation of leaders who support his structural reforms into key positions. When Xi came to power, his reform agenda included de-emphasizing GDP targets; injecting private capital, competition and market discipline into the state-owned corporate sector; and fighting pollution. This agenda has since been compromised, with Xi reverting to infrastructure spending and credit growth to avoid painful adjustments. However, recently, there have been signs of a pullback in reflationary policies (Chart 9). Financial tightening is a key to reviving reform. Tighter controls on banks and leverage will translate into greater market discipline, and will put pressure on the sector most in need of change: SOEs. During the twice-a-decade National Financial Work Conference In late July, Yang Weimin, a key economic policymaker who is close to Xi, said, "The nation can't let leverage rise for the purpose of boosting economic expansion," signaling that the administration is willing to tackle difficult reform issues. He also mentioned the potential risks in the economy such as shadow banking, property bubbles, high leverage in SOEs, and local government debt, adding that the nation should set out its priorities and tackle them. Though it is impossible to predict the precise outcome of the Congress, the leadership reshuffle is likely to benefit Xi's reform agenda. The new leadership is likely to work on rebalancing growth toward consumption and services while encouraging private entrepreneurship and cutting back state-owned enterprises and, most importantly, deleveraging corporate debt. If China's credit impulse rolls over, the recent improvement in industrial profits and domestic demand will come under threat (Chart 9). As a result, China's cyclical growth is set to slow in 2018 as Xi reboots reform. Although economic risks will rise as the reform takes place, we still believe China H shares are attractive relative to other EM markets. In the long run, Xi's renewed reform drive should help China to get out of the "middle income trap'', which could help Chinese stocks to outperform EMs such as South Africa, Turkey and Brazil, where reforms are absent.3 Are Indian equities still a buy? In the three years since Prime Minister Narendra Modi's election, Indian stock prices have outperformed their emerging market peers by more than 20%. But the underlying growth dynamics do not justify this performance. We are turning cautious on India and downgrade Indian equities to neutral for the following reasons. India's GDP growth rate fell to a three-year low of 5.7% yoy in the April-June quarter. The administration's "Make In India" campaign is having limited impact, as seen in the near-zero growth of the manufacturing sector. Capital spending by firms has been dismal, further weighing on the outlook for productivity. Increasing layoffs and business shutdowns have produced considerable slack in the economy. Non-performing loans in the banking system have reached 11.8% of assets. As a result, credit growth to business has fallen almost to zero. This has slowed infrastructure development, as seen in the high level of stalled capital projects. The Reserve Bank of India has only just started the process of pushing banks to raise provisioning for distressed assets. The negative impact of last year's demonetization program is finally showing through. Less than 10% of Indians have ever used non-cash payment methods, and so demand for cyclical goods is slowing. Finally, Indian stocks have risen significantly in recent years, making them expensive relative to EM peers. In addition, profit growth has slowed, and return on equity converged with the EM average. Indian equities have been riding on expectations of reforms from the Modi administration. But, with the exception of the Goods & Services Tax (GST), the reform progress has been disappointing. We are turning cautious on Indian equities until we see improvements in the macro backdrop (Chart 10). Chart 9Sign of slowdown in Chinese Economy Sign of slowdown in Chinese Economy Sign of slowdown in Chinese Economy Chart 10India: Loosing Steam? India: Loosing Steam? India: Loosing Steam? How should global equity investors hedge foreign currency exposures? Chart 11Dynamic Hedging Outperforms Static Hedging Quarterly - October 2017 Quarterly - October 2017 There have been many conflicting views on how to hedge foreign currency exposures in a global equity portfolio. Full hedge,4 no hedge,5 or simply 50% hedge?6 Or should all investors hold the reserve currencies (USD, euro and Swiss Franc), avoid commodities currencies (AUD and CAD) while being neutral on GBP and JPY?7 As published in a Special Report 8 on September 29, 2017, our research has found that not only should investors with different home currencies manage their foreign currency exposures differently, but also a dynamic hedging framework based on the indicators from BCA's Foreign Exchange Strategy service's Intermediate Timing Model (ITTM)9 outperforms all the static hedging strategies for all investors with six different home currencies (USD, EUR, JPY, GBP, AUD and CAD) (Chart 11). A few key observations from Chart 11 Static hedges reduces risk with little impact on returns for the USD and JPY investors only. Unlike the CAD investors, the AUD investors are much better off to hedge than not to, on a risk adjusted basis, even though AUD is also a commodity currencies, like the CAD. The 50% "least regret" hedge ratio has lived up to its reputation as it reduced risk by more than 50% without severely jeopardizing returns. And for the USD based investors, the 50% static hedge has a similar risk/return profile as the dynamic hedge. For all other five home currencies, however, the 50% static hedge underperforms the dynamic hedge. Global Economy Overview: Globally growth has accelerated, with inflation quiescent. We expect growth to continue to be strong, but U.S. inflation will start to normalize, which should trigger further Fed hikes and a rise in long-term rates. Japanese and euro zone growth will be less inflationary, given continued slack in these economies. U.S.: Growth has rebounded sharply after the seasonally weak Q1 and excessive expectations following the presidential election. The Citi Economic Surprise Index (Chart 12, panel 1) shows strong upward surprises. First-half GDP growth came in at 2.2% (above trend, which is estimated at 1.8%), and the manufacturing ISM reached 57.7 in September. The two big hurricanes will probably knock around 0.5 points off Q3 growth but the lesson from previous disasters is that this will be more than made up over the following three quarters. Rebounding capex, and consumption aided by a probable acceleration in wages, should keep GDP growth strong. Euro Area: Due to Europe's greater cyclicality and dependence on the global cycle, growth momentum is unsurprisingly even stronger than in the U.S., with Q2 GDP growth 2.3% YoY and the manufacturing PMI at 57.4. German growth has been particularly robust with the IFO index at 115.9, close to an all-time high, and German manufacturing wages growing by 2.9% YoY. The credit impulse suggests that the strong growth should continue, although the euro appreciation this year (and consequent tightening of financial conditions) might dampen it a little. Japan: Growth continues to be good in the external sector (with exports rising 18% YOY and industrial production 5%), but weak in the domestic economy, where household spending and core inflation continue to flatline. We do, though, see some first tentative signs of inflation: the Bank of Japan's estimate suggests the output gap has now closed, and the tight labor market is showing through in part-time hourly wages, which are rising 2.9%. Emerging Markets: China's PMI has oscillated around 50 all year (Chart 13, panel 3), as the authorities tried to stabilize growth ahead of October's Party Congress. But money supply and credit growth have been slowing all year, and this is now showing through in downside surprises in fixed asset investment and retail sales data. Especially if the congress moves towards structural reform and short-term pain, growth may slow further. This would be negative for other emerging markets, which depend on China for growth. Bank loan growth and domestic consumption generally remain weak throughout EM ex China. Chart 12Global Growth Is Accelerating... Global Growth Is Accelerating... Global Growth Is Accelerating... Chart 13...Propelling Europe And Japan ...Propelling Europe And Japan ...Propelling Europe And Japan Interest Rates: Inflation has been soft this year in the U.S. but is likely to pick up in coming months reflecting stronger economic growth and dollar depreciation. We expect the Fed to raise rates in December and confirm its three hikes next year. That should be enough to push the 10-year Treasury yield up to close to 3%. In Japan and the euro area, however, underlying inflationary pressures are much weaker. So we expect the Bank of Japan to stick to its yield curve control policy, and for the ECB to emphasize, when it announces in October next year's (reduced) asset purchase program, that it will be cautious about raising rates. Global Equities Chart 14Earnings Have Been Strong... Earnings Have Been Strong... Earnings Have Been Strong... Q3 2017 was the second quarter in a row when the price appreciation in global equities was driven entirely by earnings growth, since the forward price-to-earnings ratio contracted by 2% compared to Q2 (Chart 14). Chart 15No Compelling Reasons To Make Large Bets No Compelling Reasons To Make Large Bets No Compelling Reasons To Make Large Bets The scope of the improvement in earnings so far in 2017 has been wide. Not only are forward earnings being revised up, but 12-month trailing earnings growth has also been very strong, with all 10 top-level sectors registering positive earnings growth. Margins have steadily improved globally from the lows in early 2016. Despite the slight multiple compression in Q3, equity valuations are not cheap by historical standards. As an asset class, however, equities are still attractively valued compared to bonds, especially after the recent safe-haven buying drove global bond yields to very depressed levels. We remain overweight equities versus bonds on the 9-12 month horizon. Within equities, however, we think it's prudent to reduce portfolio risk by bringing allocations closer to benchmark weighting because 1) equities are not cheap, 2) volatility is low, 3) geopolitical tension is rising, and 4) year-on-year earnings growth over coming quarters may not be as strong as it has been so far this year because earnings in the first half of the 2016 were very depressed. As such, we downgrade the U.S. to neutral from overweight (+3 percentage points), and reduce the underweight in EM (to -2 from -5). We remain overweight the euro area and Japan (but hedge the yen exposure). Within EM, we have been more positive on China and remain so on a 6-9 month horizon. Sector-wise, we maintain our pro-cyclical tilt. Country Allocations: Downgrade U.S. To Neutral We started the year being "cautiously optimistic" with a maximum overweight (+6 ppts) in U.S. equities.10 We added risk at the end of the first quarter by reducing by half the U.S. overweight in order to upgrade the higher-beta euro area to overweight (+3) from neutral.11 The change has worked well, as the euro area outperformed the U.S. by 542 basis points (bps) in Q2 and then by 370 bps in Q3 in unhedged USD terms. Our DM-only quant model also started the year with a maximum overweight in the U.S., but the overweight was gradually reduced each month until July when the model indicated a benchmark weight for the U.S. The model continued its shift away from the U.S. in August and September, and now the U.S. is the largest underweight in the model. As we have previously stated, we use the quant model as one key input into our decision-making process, but we do not follow it slavishly because 1) no model can capture all the ever-changing driving forces in the market, and 2) the model moves more often than we prefer. In light of the rising geopolitical risks and low levels of volatility in all asset classes, we conclude that there are no longer compelling reasons to make large bets among the countries (Chart 15). Valuation in the U.S. is stretched, but neither is it cheap in EM anymore; both trailing and forward earnings growth in the U.S. are below the global average. Forward earnings in the EM look likely to outpace the global average, but EM trailing earnings growth seems to be losing steam. As such, we recommend investors to be neutral in the U.S. and use the funds to reduce the underweight in EM. Sector Allocation: Stay Underweight Global Utilities Overall, our sector positioning retains its tilt towards cyclicals and against defensives (see Table 1). Our global sector quant model, however, in September reduced its underweight in defensives by upgrading utilities to overweight from underweight, mainly due to the momentum factor. We have decided to overwrite the model result and maintain our underweight recommendation for the following reasons. In October, the model again downgraded utilities to underweight. In the most recent cycle post the Global Financial Crisis (GFC), the relative performance of utilities has been closely correlated with the performance of bonds vs. equities (Chart 16, top panel). This is not surprising given the bond-like nature of the sector. The sector enjoys a higher dividend yield than the global average: other than during the GFC, the excess yield has been in the range of 1-2%. In a low bond-yield environment, this yield pick-up is no doubt attractive. However, our house view is for global bond yields to rise over the next 9-12 months and we maintain our overweight on equities vs. bonds. As such, underweight utilities is in line with our overall risk/return assessment. In addition, even though the utilities sector has a higher dividend yield, the current reading is not particularly attractive compared to the five-year average (panel 4); valuation measures such as price to book (panel 3) show a neutral reading as well. The other sector where we override our quant model is Healthcare, which we favor as a long-term play because of favorable demographic trends, while the quant model points to an underweight due to short-term factors such as momentum and valuation. Smart Beta Update Year-to-date, the equal-weighted multi-factor portfolio has outperformed the global benchmark by 54 basis point (bps). (Table 1 and Chart 17) Among the five most enduring factors - size, value, quality, minimum volatility, and momentum - momentum is the only factor that has prevailed in both DM and EM universes, while quality has outperformed in the DM, but underperformed in EM. (Table 1) Chart 16Maintain Underweight Utilities Maintain Underweight Utilities Maintain Underweight Utilities Chart 17MSCI ACW: Factor Relative Performance MSCI ACW: Factor Relative Performance MSCI ACW: Factor Relative Performance Value has underperformed growth across the board (Table 1). The size performance, however, has large regional divergences in both value and growth spaces. Small cap has outperformed large cap consistently in both the value and growth spaces in the higher-beta euro area, Japan and U.K., while underperforming in the lower-beta U.S. (Table 2) We maintain our neutral view on styles and prefer to use sector positioning to implement the underlying factors given the historically close correlation between styles and cyclicals versus defensives (Chart 17, bottom two panels). Year-to-date cyclicals have outperformed defensives (Table 1). Table 1YTD Relative Performance* Quarterly - October 2017 Quarterly - October 2017 Table 2YTD Total Returns* (%) Small Cap - Large Cap Quarterly - October 2017 Quarterly - October 2017 Government Bonds Maintain Slight Underweight Duration. U.S. bond yields declined significantly in Q3 to below fair-value levels in response to heightened geopolitical risks and hurricanes (Chart 18, top panel). This safe-haven buying spread globally, despite ample evidence of faster global growth (middle panel) and less accommodative monetary policies from the major central banks. There is now considerable upside risk for global bond yields from these current low levels. Maintain Overweight TIPS Vs. Treasuries. The fall in nominal U.S. Treasury yields, however, was concentrated in the real yields, as 10-year break-even inflation widened in Q3 (Chart 18, panel 3). In terms of relative value, TIPS are now fairly valued vs. nominal bonds. However, our U.S. Bond Strategy's core PCE model, which closely tracks the 10-year TIPS breakeven rate (Chart 18, panel 3), is sending the message that inflationary pressures are building in the economy and that core PCE should reach the Fed's 2% target by the end of this year. This suggests that the bond markets are not providing adequate compensation for the inflationary economic backdrop. Underweight Canadian Government Bonds. The Bank of Canada (BOC) delivered another surprise 25 bps rate hike in September, due to "the impressive strength of the Canadian economy" and "the more synchronized global expansion that was supporting higher industrial commodity prices." BCA's Global Fixed Income Strategy has been underweight Canada in its hedged global portfolio and recommends investors not to fight the BOC despite little inflation pressure in the Canadian economy (Chart 19). Chart 18Poor Value in Nominal Government Bonds Poor Value in Nominal Government Bonds Poor Value in Nominal Government Bonds Chart 19Bank of Canada: Shock Hawks Bank of Canada: Shock Hawks Bank of Canada: Shock Hawks Corporate Bonds As inflation recovers and the Fed moves ahead with rate hikes, we expect long-term risk-free rates to rise moderately. Fair value for the 10-year U.S. Treasury yield is currently close to 2.7%. In the context of rising rates and continued economic expansion, we continue to prefer spread product over government bonds. Investment grade bonds in the U.S. trade at an average option-adjusted spread over Treasuries of 110 bps. While Aaa corporate spreads are expensive, other investment grade credit tiers appear fairly valued. Given the deterioration in our U.S. Corporate Health Monitor (Chart 20), amid a rise in leverage, over the past two years (Chart 21) we do not expect the spread to contract further or fall back close to historic lows. However, investors should still be moderately attracted by the carry in a low interest rate environment. Our preference is for U.S. investment-grade corporate bonds over European ones, since the latter could be negatively impacted when the ECB announces its tapering of asset purchases in October. High-yield bonds look attractive after a small rise in spreads and an improvement in the cyclical outlook over the past quarter. The current spread of U.S. high-yield, 360 bps, translates into a default-adjusted yield (assuming a 2.6% default rate and 49% recovery rate over the next 12 months) of 250 bps - close to the long-run average (Chart 22). European junk debt looks less attractive from a valuation perspective. Chart 20Corporate Health Is A Worry In The U.S. Corporate Health Is A Worry In The U.S. Corporate Health Is A Worry In The U.S. Chart 21IG Spreads Unlikely To Contract Further IG Spreads Unlikely To Contract Further IG Spreads Unlikely To Contract Further Chart 22High-Yield Debt Valuations Look Attractive High-Yield Debt Valuations Look Attractive High-Yield Debt Valuations Look Attractive Commodities Chart 23Mixed View Towards Commodities Mixed View Towards Commodities Mixed View Towards Commodities Secular perspective: Bearish We hold a bearish secular outlook for commodities, mainly due to our view on China's slowing economic growth and the increasing shift from traditional energy sources to alternatives. Cyclical perspective: Neutral Our short-term commodities view remains neutral since oil inventory drawdowns will push up the crude oil price further, and because low real interest rates will keep gold from falling this year. But industrial metals are likely to react negatively to the winding down of China's reflation after the Party Congress in mid-October. Precious metal: Short-term bullish, long-term bearish. We expect the Fed to tighten rates only slowly which, over time, will mean the central bank finds itself behind the curve on inflation. Real rates are expected to remain relatively low for the foreseeable future, which will be supportive of gold. Rising tension between North Korea and the U.S. could also give gold a lift. Industrial metals: Bearish The copper price has rallied by 10% during Q3 2017, thanks to supply-side disruptions at some of the world's largest copper mines, along with better-than-expected performance of the Chinese economy. However, mine interruptions will be transitory, and the world copper market is already back in balance (Chart 23, panel 3). Although the rebound in the Chinese PMI is keeping metal prices up, we believe China after the Party Congress will try to reengineer its economy towards being more consumption and services-led, which will temper demand for industrial metals. Energy: Bullish We believe that market has been overly pessimistic on oil, and that this will change due to declining inventories and better demand and supply dynamics. (Chart 23) The U.S. Energy Information Administration revised down its shale production forecast for 2H 2017 by 200,000 barrels/day, which should lower investors' concerns over shale overproduction. Libyan oil production, the biggest threat to our bullish oil view, faltered by 300,000/day in August, keeping OPEC in compliance with its promised cuts. Currencies U.S. Dollar: Year to date, the dollar is down by 8% on a trade-weighted basis (Chart 24). However, after a period of underperformance, the U.S. economy is improving relative to its G10 peers, as seen by the strong rebound in the U.S. ISM manufacturing index. Additionally, the pick-up in money velocity points to a recovery in core inflation. As inflation starts to pick up again, markets will discount additional Fed rate hikes. Stay bullish U.S. dollar over the next 12 months. Chart 24U.S. Dollar Recovery? U.S. Dollar Recovery? U.S. Dollar Recovery? Pound: After a weak start to the year, sterling has recovered all its losses. Strong net FDI inflows have pushed the basic balance back into positive territory. However, Brexit negotiations will impact the financial sector, the largest target for FDI. Additionally, the recent sharp increase in inflation came from the pass-through effect of the weaker currency, and is not reflective of domestic economic activity. We expect increased political uncertainty to weigh down on future growth, forcing the Bank of England to maintain a dovish stance. Stay bearish over the next 12 months. Dollar: On a trade-weighted basis the currency is up 4% year to date, primarily driven by the rally in select metal prices. OECD's measure of output gap still points to substantial slack in the domestic economy, as seen in the downtrend in core inflation and nominal retail sales. However, despite improvements in global trade and domestic real estate activity, the Reserve Bank of Australia will keep policy easy in response to volatile commodity markets. Stay bearish over the next 12 months. Canadian Dollar: Driven by net portfolio inflows near record highs, the currency is up 6% on a trade-weighted basis so far this year. With improving economic activity, as seen in strong retail sales, the Bank of Canada expects the output gap to close in 2018. However, going forward, oil prices are unlikely to double again, and the combination of elevated indebtedness, bubby house prices and rising rates will create headwinds for the household sector. Stay bearish over the next 12 months. Alternatives Chart 25Favor PE, Real Assets Favor PE, Real Assets Favor PE, Real Assets Return Enhancers: Favor private equity vs. hedge funds In 2017 so far, private equity has returned 9%, whereas hedge funds have managed only a 3.5% return (Chart 25). Given their strong performance, private equity firms are raising near-record amounts of capital from investors starved for yield. By contrast, hedge funds continue to underperform both global equities and private equity, as is typical outside of recessions or bear markets. However, increasing concerns about valuations in private markets have pushed private equity dry powder to new highs of $963 billion. We continue to favor private equity over hedge funds, albeit with a more cautious outlook. Within the hedge fund space, we favor event-driven funds over the cycle, and macro funds heading into a recession. Inflation Hedges: Favor direct real estate vs. commodity futures In 2017 to date, direct real estate has returned 3.3%, whereas commodity futures are down over 10%. With energy markets likely to continue to recover lost ground over the coming months, we stress the structural nature of our negative recommendation on commodities. Depressed interest rates will keep financing cheap, making the spread between real estate and fixed income yields attractive. However, the slowdown in commercial real estate has made us more cautious on the overall real estate space. With regards to the commodity complex, the long term transition of China to a service-based economy will continue the structural decline in commodity demand. Continue to favor direct real estate vs. commodity futures. Volatility Dampeners: Favor farmland & timberland vs. structured products In 2017 to date, farmland and timberland have returned 2.2% and 1.5% respectively, whereas structured products have returned 1.4%. Farmland continues to outperform timberland given the latter's lower correlation with growth. Timberland returns have also lagged farmland given the weak recovery in the U.S. housing market. Investors can reduce the volatility of a multi-asset portfolio with the inclusion of farmland and timberland. With regards to structured products, rising rates and deteriorating credit quality in the auto loan market will weigh on returns. Given the Fed's plans to start unwinding its balance sheet this year, increased supply will put upward pressure on spreads. Risks To Our View Our pro-risk positioning would be incorrect if global growth were to slow sharply. But we see little sign that this is a significant risk over the next six to 12 months. Of our three favorite indicators of recession risk, global PMIs remain strong, and the U.S. 10-minus-2 year yield curve is still solidly positive at around 80 BP. Only a small blip up in junk bond spreads in August (Chart 26) is of any concern, and it was probably caused just by geopolitical tensions. With U.S. and European consumption and capex looking strong, probably the biggest risk to global growth would come from China, similar to 2015, if October's Party Congress signals a shift to short-term pain to achieve structural reforms. Perhaps more likely is an upside surprise to growth, with BCA's models - based on consumer and business sentiment - pointing to around 3% real GDP growth in the U.S. and 2½% in the euro area over the coming couple of quarters (Chart 27). Such an acceleration of growth would raise the risk of upside surprises to inflation, which could cause a bigger sell off in bond markets than we currently anticipate. Chart 26Any Need To Worry About Credit Spreads? Any Need To Worry About Credit Spreads? Any Need To Worry About Credit Spreads? Chart 27Could Growth Surprise On The Upside? Could Growth Surprise On The Upside? Could Growth Surprise On The Upside? Chart 28Suppose Inflation Stays Stubbornly Low Suppose Inflation Stays Stubbornly Low Suppose Inflation Stays Stubbornly Low Our positioning is not based on inflation remaining chronically low. But structural changes in the economy could cause this. While the Philips curve has not broken down completely, wage growth in the U.S. is 1-1½% lower than in previous expansions when the unemployment gap was at its current level (Chart 28). Could the Nairu be lower than the Fed's estimate of 4.6%? Has the gig economy somehow changed worker and employer behavior? 1 Please see What Our Clients Are Asking: "What Will Happen After China's 19th Party Congress, And Will There Be A Slowdown In The Economy?" of this report. 2 For their most comprehensive analysis, please see Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 3 Please see Geopolitical Strategy Special Report "China: Looking Beyond The Party Congress'' dated July 19, 2017. available at gps.bcaresearch.com). 4 Perold, A and E. Schulman, 1988, "The free lunch in currency hedging: Implications for investment policy and performance standards," Financial Analyst Journal 44, 45-50. 5 Froot K., 1993, "Currency hedging over long horizons," NBER working paper 4355. 6 Michenaud, S., and B., Solnik, 2008, "Applying Regret Theory to Investment Choices: Currency Hedging Decisions," Journal of International Money and Finance 27, 677-694. 7 Campbell, J., K. de Medeiros and L. Viceira, 2010, "Global Currency Hedging," Journal of Finance LXV, 87-122. 8 Please see Global Asset Allocation Special Report, "Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors," dated September 29, 2017, available at gaa.bcaresearch.com. 9 Please see Foreign Exchange Strategy "In Search of A Timing Model," dated July 22, 2016, available at fes.bcaresearch.com. 10 Please see Global Asset Allocation, "Quarterly - December 2016," dated December 15, 2016. 11 Please see Global Asset Allocation, "Quarterly - April 2017," dated April 3, 2017. GAA Asset Allocation

Highlights The sharp rally in Chinese developer stocks this year reflects a combination of the unwinding of "doomsday" bets and notable improvement in fundamentals rather than a bubble formation. The positive re-rating has further to run. Tighter policy imposed by local governments will probably keep developers in dormancy, but a major downturn is highly unlikely simply because there is not much excess to begin with. Urbanization still provides a powerful tailwind for residential construction from a long-term perspective. Chinese housing market will continue to experience cyclical swings, but the powerful structural tailwind will make the cyclical downturn shallow and fleeting. Feature Chart 1A Sharp Re-Rating Of Developer Stocks A Sharp Re-Rating Of Developer Stocks A Sharp Re-Rating Of Developer Stocks Chinese real estate developer stocks have more than doubled so far this year, making them the best performing sector in the investable universe - easily outpacing even the world-beating Chinese technology sector (Chart 1). The recent moves in developer stock prices have become parabolic, which combined with recent measures by some major cities to further tighten housing transactions raises the odds of profit-taking and a technical correction in the near term. However, the sharp rally since the beginning of the year has largely been a mean-reverting positive re-rating process rather than an overshoot. Moreover, the latest housing tightening measures are unlikely to have a long-lasting impact on housing demand. Therefore developer stocks should continue to advance after a period of consolidation. Beyond the cyclical horizon, residential development will remain a long-term growth driver for Chinese business activity. Positive Re-Rating Has Further To Run Chart 2Improvement In Developers' Fundamentals Improvement In Developers' Fundamentals Improvement In Developers' Fundamentals It is tempting to dismiss this year's sharp rally in developer stocks as a speculative frenzy, as the dramatic boom in stock price has been accompanied by cooling property sales and moderating home prices amid regulatory tightening in various cities. In our view, the sharp rally in property stocks has been a powerful positive re-rating in multiples after being deeply depressed for several consecutive years. The bottom panel of Chart 1 shows strong multiples expansion of developer stocks since the beginning of 2017. The message here is that China's cyclical improvement in the past two years has led to an aggressive repricing of Chinese equities, particularly in some of the hardest hit sectors. Investors' overwhelming bearishness towards China's macro situation in previous years took a heavy toll on Chinese investable stocks. The market had essentially priced in a chaotic hard-landing scenario, which is now being reversed due to growth improvement. In recent years we have consistently argued that the risk premium embedded in Chinese equities was exceptionally high and ultimately unsustainable, and one of our major investment themes has been a "positive re-rating in Chinese equities" - a view that has been quickly validated. Moreover, developers' stock prices have also reflected some notable improvements in earnings and balance sheet fundamentals, which can also be observed among their domestically listed peers (Chart 2): Deleveraging: The median liabilities-to-assets ratio of developers has dropped notably from the peak of 2015. Destocking: Developers have been focusing on selling inventories, and have been cautious on new projects. The median inventory-to-assets ratio has dropped from a peak of 63% in late 2015 to below 50% currently. Stronger cash positions: Aggressive de-stocking and conservative expansion have also significantly improved developers' cash flows. Cash position as a share of total assets has improved significantly, returning to the all-time highs reached in 2010. Total profits have also recovered strongly with strengthening margins.1 In short, the rally in developer stocks reflects a combination of the unwinding of "doomsday" bets and notable improvement in fundamentals rather than a bubble formation. There is little froth in the marketplace just yet. In fact, property stocks still remain quite cheap based on some conventional valuation indicators - even after this year's sharp rally. Property stocks are trading at 13 times trailing earnings and nine times forward earnings, and are still trading at hefty discounts to bottom-up net-asset-value (NAV) estimates. This means the bull market should have more legs in the coming months. Will Policy Constraints Lead To Another Major Downturn? Recent policy tightening on the residential market clearly creates some headwinds for the sector, and policy risk has been a key factor driving developer stock prices in previous tightening cycles. Historically, the government's tightening campaigns have typically restricted land supplies and bank credit to developers, and have been combined with tighter lending standards and higher interest rates for mortgage borrowers - and even outright bans on household investment demand for residential properties in major cities. In the current tightening cycle that began early last year, regulations on developers have remained largely unchanged, while the rein on households has been much tighter. Mortgage interest rates have also begun to inch higher (Chart 3). In the latest round of tightening measures announced late last week, eight major cities tightened controls on home sales, with a ban on reselling of homes within two to five years of purchase. The government's tightening measures have already led to a moderation in both home sales and prices, as shown in Chart 3, and the impact needs to be closely monitored. For now, our view is that policy constraints will not lead to major negative surprises both for developer stock prices and overall construction activity. On the demand side, household residential demand has been exceptionally strong of late. The central bank's most recent survey showed that a record high percentage of households intend to buy a home in the near future, a dramatic turnaround since the beginning of 2016 (Chart 4). The reason for the surge in home-buying intentions is not clear - we suspect it is the combination of pent-up demand accumulated in previous years and the herd-following mentality that typically follows a period of rapid increase in home prices. On the supply side, developers' inventory de-stocking and stronger cash positions have improved their ability to deal with sales slowdowns. In fact, home sales have significantly outpaced housing completions since 2015, leading to a sharp decline in inventories. Even including floor space under construction, the sellable inventories-to-sales ratio has dropped to its lowest level since 2010 (Chart 5). In our view, the sharp decline in inventories has been a key reason for the rampant increase in home prices since early last year. Chart 3Housing Market Has Been Moderating Housing Market Has Been Moderating Housing Market Has Been Moderating Chart 4Booming Demand For Home Purchases Booming Demand For Home Purchases Booming Demand For Home Purchases Taken together, with no inventory overhang and strong demand, we expect the impact of the current episode of housing tightening to be limited. In fact, real estate investment has been pretty subdued in recent years, despite surging home sales and improvement in business confidence among developers (Chart 6). Previous housing tightening measures were often implemented after a prolonged period of construction boom, leading to a sudden halt in investment and construction activity. This time around, tighter policy will probably keep developers in dormancy, but a major downturn is highly unlikely simply because there is not much excess to begin with. Chart 5Housing Destocking Becomes Advanced Housing Destocking Becomes Advanced Housing Destocking Becomes Advanced Chart 6Real Estate Investment Will Unlikely Slump Anew Real Estate Investment Will Unlikely Slump Anew Real Estate Investment Will Unlikely Slump Anew It's The Supply Side, Stupid! It appears that Chinese policymakers as well as global investors have perpetual fears of a "housing bubble" in China. The authorities are deeply worried about potential housing excesses and the negative impact on macro stability. Investors share similar concerns, and chronically worry about the global repercussions of a Chinese housing bust. Some have taken aggressive bets against Chinese developers and other asset classes that are leveraged on Chinese construction activity. While there are some idiosyncrasies in the motives of every tightening cycle in recent years, there is one common theme: the authorities' repeated attempts to cool off the housing sector are deeply rooted in the belief that both residential supplies and home prices were excessive, and therefore tighter controls on both supply and demand were warranted. Remarkably, concerns about housing excesses began to emerge almost immediately after the residential sector was privatized and a housing "market" began to develop in the early 2000s. In a special report dated April 29th 2004 titled, "What Housing Bubble?",2 I disputed for the first time the then-prevailing view on Chinese housing excesses. Fast forwarded 13 years and China's urban landscape has changed profoundly - yet the arguments for a "housing bubble" have remained essentially unchanged: speculative demand, excess supply, parabolic price increases and extreme unaffordability. To some China watchers, the housing sector's remarkable resilience despite repeated policy attacks from the early 2000s was simply an accumulation of a bigger accident waiting to eventually happen. In our analysis in recent years, we have repeatedly emphasized that the supply side shortages have been a key reason for the massive increase in Chinese home prices. While the government's various tightening measures to restrict speculators and cool off demand are well warranted, harsh supply side restrictions during various tightening campaigns have proven counterproductive, as they have amplified supply shortages, creating even more upward pressure on prices. Indeed, the supply-side restrictions are fairly easy to observe. China's leadership is fundamentally concerned about self-sufficiency of agricultural products, and therefore is reluctant to sacrifice farmland for urban development. Moreover, land supplies zoned for residential construction have accounted for an increasingly smaller share of total land supply, due to competition from infrastructure, industrial and commercial projects (Chart 7). Similarly, land purchased by developers plateaued in the early 2000s, and has dropped substantially in recent years. As a highly levered business by nature, developers have also been constantly challenged by limited access to bank loans due to regulatory restrictions. Loans to developers account for about 7% of banks' total loan book, largely unchanged in the past decade despite the massive construction boom. Tight credit controls have forced developers to other "shadow" financing options, which are both costlier and less reliable than formal bank loans, further limiting their ability to bring new housing projects to market. The prevailing heightened concerns on residential excesses and tougher regulations have pushed real estate companies to increasingly shift to commercial and industrial property development. Residential accounted for almost 80% of total real estate development in the early 2000s; the share has dropped to below 70% in recent years (Chart 8). Finally, the government's ill-informed judgement on the degree of excessive supply and speculative demand in the residential sector also prevented them from formulating a multi-tier residential market. Rental residential properties owned by professional institutional investors are rare, and "renters" often suffer discrimination for some public services, making homeownership essentially the only way for new families to establish themselves in urban areas. Chart 7Residential Land Supply Has Been Shrinking Residential Land Supply Has Been Shrinking Residential Land Supply Has Been Shrinking Chart 8Residential Construction's Dwindling Importance Residential Construction's Dwindling Importance Residential Construction's Dwindling Importance From a big-picture point of view, China is still in the midst of a spectacular urbanization process. Residential development is not only part of the growth process, but also an essential component to accommodating the massive increase in the urban population. Mainstream media often hype about "ghost towns" but ignore the fact that millions of young migrant workers still reside in dorm rooms provided by employers in sub-standard living conditions. Adjusting for the increase in the urban population, China's new residential construction in recent years has been a lot smaller than in other countries such as Japan and Korea at the prime stage of their respective urbanization process, according to our calculations (Chart 9) - likely the critical reason why Chinese home prices have remained stubbornly high, despite numerous rounds of government crackdowns. Chart 9China's Construction Boom In Perspective Chinese Real Estate: Which Way Will The Wind Blow? Chinese Real Estate: Which Way Will The Wind Blow? Since last year it appears the Chinese authorities have been paying more attention to increasing residential housing supply by providing more funding for social housing projects and shanty town reconstruction, as well as increasing land supply for residential projects. Meanwhile, there are recent proposals to develop rental markets in some major cities, allowing developers to build solely for rental, rather than for sales. In our view, policies boosting residential supplies will be a lot more effective in improving housing affordability for urban citizens. All in all, after the massive boom in recent years, home prices in certain major cities certainly feel a lot more "bubbly" than any time before, and it is easy to make a bearish structural case, as many have been doing over the past decade. However, urbanization still provides a powerful tailwind for residential construction from a long-term perspective. The Chinese housing market will continue to experience cyclical swings, but powerful structural tailwinds will make the cyclical downturn shallow and fleeting, as repeatedly demonstrated in previous policy tightening cycles. Looking forward, construction will remain an important growth driver for China for decades to come. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China: Earnings Scorecard And Market Tea Leaves", dated September 7, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Special Report, "What Housing Bubble?" dated April 29, 2004, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights We highlighted last month that investors should remain slightly overweight risk assets, but should also hold safe havens given the preponderance of risks. Some of the risks have since faded and the sweet spot for equities is continuing, but the potential for a correction remains elevated. Geopolitics will no doubt remain a threat for 'risk on' trades, although we may be at peak tensions with respect to North Korea. Our models point to an acceleration in growth in the major economies. Our capital spending indicators suggest that animal spirits are stirring in the business sector. In the U.S., fiscal stimulus is back on the table and investors are looking beyond the negative short-term impact of the hurricanes to the growth-enhancing rebuilding that will follow. It is also positive for the stock-to-bond return ratio that our bullish oil scenario is playing out. Stay long oil-related plays. There is a good chance that this year's downtrend in the dollar and government bond yields is over. The rise in both may be halting, but the risks are to the upside now that disappointments on U.S. growth and inflation have likely ended (notwithstanding the hurricane-distorted economic data in the near term). The Phillips curve is not dead. We do not expect Fed balance sheet normalization on its own to be a major headwind for risk assets. The bigger threat is a sudden and sharp re-assessment of the outlook for interest rates in the major countries. Our base-case view is that inflation will only grind higher in the major countries. It should be slow enough that the associated backup in bond yields does not derail the rally in risk assets, but the danger of a sharper bond market adjustment means that investors should continue to be on the conservative side. Feature It was 'risk on' in financial markets in September, despite a less dovish tone among the major central banks. The reason is that the synchronized global growth outlook continues to gather momentum, supporting the earnings backdrop, but inflation remains dormant in the major countries outside of the U.K. Investors believe that calm inflation readings will allow central banks to proceed cautiously and avoid taking risks with growth, extending the expansion in GDP and earnings. The North Korean situation changes from day to day, but investors appear to be more comfortable with it at the margin. In the U.S., fiscal stimulus is back on the table and investors are looking beyond the negative short-term impact of the hurricanes to the growth-enhancing rebuilding that will follow. Finally, rising oil prices will lift earnings in the energy patch. These developments spurred investors to embrace risk assets and carry trades again in September. However, value is poor and signs of froth are accumulating. For example, equity investors are employing record amounts of margin debt to lever up investments. The Bank for International Settlements highlighted in its Quarterly Review that margin debt outstanding in 2015 was higher than during the dotcom boom (and it has surely increased since then). The global volume of outstanding leveraged loans continues to set new highs even as covenant standards slip. Risk assets are being supported by a three-legged stool: solid earnings growth, low bond yields and depressed bond market volatility. The latter is a reflection of current market expectations that dormant inflation will continue to constrain central bankers. We agree that the economic growth and earnings outlook is positive on a 6-12 month horizon. The main item that could upset the sweet spot for risk assets, outside of a geopolitical event, is an awakening in inflation. This would shatter the consensus view that the bond market will remain well behaved. Markets are priced for little change in the inflation backdrop even in the long term. Our base-case view is that inflation will grind higher in the major countries, although it should be slow enough that the associated backup in bond yields does not derail the rally in risk assets in the next 6-12 months. But the risk of a sharper bond market adjustment means that investors should continue to be conservative (although slightly tilted to risk-over-safety). Getting Used To North Korea It appears that investors are becoming increasingly desensitized to provocation from the rogue state. Our geopolitical experts argued that the risk of a full-out war with the U.S. was less than 10%, but they warned that there could be a market-rattling political crisis or even a military skirmish before Pyongyang returned to the negotiating table. However, we may be at peak tensions now, based on several key developments over the past month. First, both China and Russia, two North Korean allies, have turned up the pressure. China appears to be enforcing sanctions according to Chinese trade data vis-à-vis North Korea (Chart I-1). Both China and Russia have also agreed to reduce fuel supplies. And there is evidence that U.S. and North Korea have held unofficial diplomatic talks behind the scenes. The implication is that North Korea is responding to pressure now that its critical fuel supplies are at risk. Chart I-1China Getting Tougher With NK China Getting Tougher With NK China Getting Tougher With NK We cannot rule out more goading from Kim Jong Un, especially with a busy political calendar in Asia this fall: the Korean Worker's Party's anniversary on October 10, the Chinese midterm leadership reshuffle on October 11-25, Japanese elections on October 22, and Trump's visit to the region in mid-November. Nevertheless, it would require a major provocation (i.e. a direct attack on the U.S. or its allies) for Pyongyang to escalate tensions from current levels. This would require the North to be very reckless with its own strategic assets, given that the U.S. would likely conduct a proportional retaliation against any serious attack. The recent backup in Treasury yields and yen pullback suggest that investors do not think tensions will escalate that far. We agree, but obviously the situation is fluid. Trump Trades Back In Play? U.S. politics have also become more equity-friendly and bond-bearish at the margin. The risk of a debt ceiling standoff has been delayed until December following President Trump's deal with the Democrats. We do not think that this represents a radical shift toward bipartisanship, but it is warning from the President that the GOP had better get cracking on tax legislation. The House Budget committee passed a FY2018 budget resolution in late July that included "reconciliation instructions" for tax legislation. Such a budget resolution approved by the Congress as a whole would allow for tax cuts that are not fully offset by spending cuts, with the proviso that the tax reductions sunset after a defined number of years. It is difficult to see tax legislation being passed before year end, but the first quarter of 2018 is certainly possible. Markets will begin to price in the legislation well before it is passed, which means that the so-called Trump trades are likely to see a revival. In particular, the legislation should favor small caps and boost the dollar. This year's devastating hurricane activity will also lift U.S. growth in 2018. History shows that natural disasters have only a passing effect on the U.S. economy and financial markets. Following the short-term negative economic impact, rebuilding adds to growth with the Federal government footing part of the bill. A 2016 Congressional Budget Office (CBO) report found that federal spending after major hurricanes can add as much as 0.6% to GDP. CBO notes that the lion's share of the economic impact is in the first year after a storm, with most of those expenditures helping victims to obtain food and shelter, fund search and rescue operations, and protect critical infrastructure. Federal outlays for public infrastructure occur after the first year and provide a much smaller lift to GDP (Chart I-2). Chart I-2Federal Government Outlays For Hurricane Relief October 2017 October 2017 Oil: Inventories Are Correcting Chart I-3Oil Inventory Correction To Lift Prices Oil Inventory Correction To Lift Prices Oil Inventory Correction To Lift Prices It is also positive for the stock-to-bond return ratio that our bullish oil scenario is playing out. Our energy strategists highlight that global oil demand is booming, at a time when the U.S. Energy Information Administration (EIA) lowered its estimated shale oil output by 200,000 bpd for the third quarter. This confirms our contention that the EIA has overestimated the pace of the shale production response during 2017. Taken together, these factors helped to improve the global net demand/supply balance by 600,000 bpd. The drawdown in global oil inventories is thus likely to continue (Chart I-3). Looking to next year, crude prices could go even higher with an extension of the OPEC/Russian production cuts beyond March 2018 and continued strong growth in global oil demand. The synchronized global expansion is reflected in rising oil demand from all parts of the world. Soft Industrial Production Readings Won't Last We have highlighted global and regional industrial production as important indicators of both economic growth corporate earnings. It is therefore a little disconcerting that our aggregate for industrial production in the advanced economies has suddenly lost momentum (Chart I-4). We are inclined to fade the recent softening for a few reasons. First, much of it is due to weakness in the U.S. where hurricanes affected the August figures. Second, most of our leading indicators remain very constructive. Chart I-5 present a simple model for real GDP growth for the G4 economies based on our consumer and capital spending indicators. Real GDP growth will continue to accelerate for the G4 economies as a group according to the model. Our aggregate consumer indicator appears to have peaked at a high level, but the capex indicator is blasting off. The bullish capital spending reading is unanimous across the major economies (Chart I-6). Chart I-4Animal Spirits Are Stirring... Animal Spirits Are Stirring... Animal Spirits Are Stirring... Chart I-5...Contributing To Stronger G4 Economic Growth ...Contributing To Stronger G4 Economic Growth ...Contributing To Stronger G4 Economic Growth Chart I-6Capital Goods Indicators Are Surging Capital Goods Indicators Are Surging Capital Goods Indicators Are Surging The Eurozone is particularly strong on both the consumer and business fronts, suggesting that euro strength has not undermined growth. Conversely, the U.K. is at the weak end of the spectrum based on the drop in its consumer spending indicator. This is the main reason why we do not believe the Bank of England will be able to make good on its warning of a rate hike this year (see below). Robust capital goods imports for our 20-country aggregate supports the view that animal spirits are stirring in boardrooms in the advanced economies (Chart I-4, third panel). These imports and our capital spending indicators suggest that the small pullback in advanced-economy industrial production will not last, purchasing managers' indexes will remain elevated, and the acceleration in global export activity is just getting started. Even U.S. small business sector has shifted into a higher gear in terms of hiring and capital spending according to the NFIB survey. These trends will favor industrial stocks, especially versus utilities. Central Banks Shedding Dovish Feathers The synchronized global growth pickup is also reflected in our Central Bank Monitors, which are all near or above the zero line (Chart I-7). The Monitors gauge pressure on central banks to adjust policy. Current readings are consistent with the relatively more hawkish tone by central bankers in Canada, the U.S., the Eurozone and the U.K. Chart I-7Central Bank Monitors Support Less Dovish Policymakers Central Bank Monitors Support Less Dovish Policymakers Central Bank Monitors Support Less Dovish Policymakers The violent reaction in the gilt market to the Bank of England's hint that it could hike rates in the next few months highlights the vulnerability of bond markets to any shift by central bankers in a less dovish direction. In this case, we do not believe the BoE will be able to follow through with its rate hike plan. The leading economic indicators are softening and inflation is about to roll over now that the pound has bottomed. In contrast, bunds are quite vulnerable to a more hawkish tilt at the European Central Bank (ECB). Eurozone policymakers confirmed at their September meeting that they plan to announce in October a reduction in the asset purchase program, to take effect in 2018. The ECB revised up its growth forecast for 2017, and left the subsequent two years unchanged. The inflation forecast was trimmed by 0.1 percentage points in 2018 and 2019. The fact that this year's surge in the euro was not enough to move the needle much on the ECB's projections speaks volumes about the central bank's confidence in the current European economic expansion, as well as its comfort level with the rising currency. Our fixed income strategists believe that the full extent of ECB tapering is not yet fully discounted in the European bond market. Phillips Curve: It's Not Dead, Just Resting Chart I-8U.S. Inflation U.S. Inflation U.S. Inflation Turning to the Fed, the bond market did not get the dovish tone it was expecting from September's FOMC meeting. Policymakers left a December rate hike on the table, as Chair Yellen downplayed this year's lagging inflation data as well as the impact of the hurricanes on the economy. Not surprisingly, the odds of a December rate hike have since jumped to 70%. The Fed announced its plan to begin shrinking its balance sheet beginning in October. In the press conference, Yellen tried to disassociate balance sheet policy from the rate outlook. Balance sheet adjustment will be on autopilot, such that short-term interest rates will be the Fed's main policy instrument going forward. While the Fed plans to deliver another rate increase in December, it will require at least a small rise in inflation. Policymakers were no doubt pleased that annual CPI core inflation edged up in August and the 3-month rate of change has moved back to 2% (Chart I-8). The CPI diffusion index also moved above the zero line, indicating that the soft patch in the inflation data may be over, although the diffusion index for the PCE inflation data fell back to the zero line. Table I-1 presents the major contributors to the 0.9 percentage point decline in the year-over-year headline CPI inflation rate since February. Energy accounts for the majority of the decline, at 0.6 percentage points. New cars, shelter, medical services and wireless telephone services account for the remainder. The deflationary wireless price effect is now unwinding, but medical services is a wildcard and our shelter model suggests that this large part of the CPI index will probably not help to lift inflation this year. Thus, higher inflation must come largely from non-shelter core services, which is the component most closely correlated with wages. Investors remain unconvinced by Yellen's assertion that the soft patch in the inflation data reflects transitory factors. Indeed, market-based long-term inflation expectations remain well below the Fed's target, and they even fell a little following the FOMC meeting. Table I-1Contribution To Change In Headline ##br##Inflation (February -August, 2017) October 2017 October 2017 One FOMC member is becoming increasingly alarmed by the market's disbelief that the Fed will hit the 2% target even in the long run (Chart I-9). In a recent speech, Governor Brainard noted that both market-based and survey evidence on inflation expectations have drifted lower in the post-Lehman years. More recently, long-term inflation breakeven rates and CPI swaps have been surprisingly sticky in the face of the rebound in oil prices. In the Fed's view, monetary policy can be used effectively in response to shifts in the cyclical drivers of inflation. However, if inflation expectations were to become unanchored, then inflation's long-run trend would be altered and monetary policy would become less effective. Japan is a glaring example of what could be the endpoint. Brainard's fears have not yet affected the FOMC consensus, which is loath to throw the Phillips curve model into the dust bin just yet. We agree that the Phillips curve is not dead. Peter Berezin, Chief Strategist for the BCA Global Investment Strategy Service, argued in a recent Special Report that the often-cited reasons for why the Phillips curve has become defunct - decreased union bargaining power, a more globalized economy, and technological trends - are less convincing than they appear. The Fed simply has to be patient because the U.S. is only now reaching the kinked part of the Phillips Curve (Chart I-10). Chart I-9Worrying Trends For The FOMC Worrying Trends For The FOMC Worrying Trends For The FOMC Chart I-10U.S. Wage Growth Accelerates Once The Unemployment Rate Falls Below 5% (1997-2017) October 2017 October 2017 Moreover, our global fixed income team has made the case that the global output gap must be taken into consideration.1 Chart I-11 presents the percentage of OECD economies that have an unemployment rate below the NAIRU rate, along with inflation in the services and goods sectors of the developed markets. While the correlation between this global NAIRU indicator and realized inflation rates declined in the years after the recession, the linkages have improved over the past couple of years. The fact that the global NAIRU indicator is only now back to pre-Lehman levels suggests that inflationary pressure could finally be near an inflection point. Market expectations for the path of real GDP growth and the unemployment rate are roughly in line with the FOMC's central tendency forecast. However, the wide gulf between the FOMC and the market on the path of interest rates remains a potential catalyst for a correction in risk assets if market rates ratchet higher. Fed balance sheet runoff could also be problematic in this regard. QE Unwind: How Much Of A Risk? Many investors equate the surge in asset prices in the years after the Great Financial Crisis with central bank largesse. Won't a reversal of this policy be negative for both bonds and stocks? Fed balance sheet runoff, together with ECB tapering and less buying by the Bank of Japan, will certainly change the supply/demand backdrop for the G4 government bond markets in 2018. We have updated our projection for the net flow of government bonds available to the private sector, taking into consideration the supply that is absorbed by central banks and other official institutions (Chart I-12). The top panel shows that the net supply of Treasurys to the private sector never contracted in recent years, but the bottom panel highlights that the net supply of G4 government bonds as a group was negative for 2015, 2016 and 2017. Central banks and other official buyers had to bid-away bonds from the private sector during these years. Chart I-11Global Slack Matters Global Slack Matters Global Slack Matters Chart I-12Major Swing In Government ##br##Bond Supply In 2018 October 2017 October 2017 We project that the net supply will swing from a contraction of almost $600 billion in 2017 to a positive net flow of almost US$200 billion next year. The Fed's projected runoff accounts for most of the swing. The supply/demand effect might push up term premia a little. Nonetheless, as discussed in this month's Special Report beginning on page 19, the balance sheet unwind is not the key threat to bonds and stocks. Rather, the main risk is the overly benign central bank outlook that is priced into the bond market. Real 5-year bond yields, five years forward, are still extremely depressed because the market has discounted negative real short-term interest rates out to 2022 in the U.S. and 2026 in the Eurozone (Chart I-13). Chart I-13Real Forward Short-Term Rates Real Forward Short-Term Rates Real Forward Short-Term Rates Time For The Nikkei To Shine Equity bourses took September's backup in bond yields in stride. Indeed, the S&P 500 and Nikkei broke to new highs during the month. The Euro Stoxx 50 also sprang to life, although has not yet reached fresh highs in local currency terms. The solid earnings backdrop remains a key support for the market. We highlighted our EPS forecasts in last month's report. Nothing of significance has changed on this front. The latest data suggest that operating margins may be peaking, but the diffusion index does not suggest an imminent decline (Chart I-14). Meanwhile, our upbeat economic assessment discussed above means that top line expansion should keep EPS growing solidly into the first half of 2018 at the global level. EPS growth will likely decelerate toward the end of next year to mid-single digits. Chart I-14Operating Margins Approaching A Peak? Operating Margins Approaching A Peak? Operating Margins Approaching A Peak? We still see a case for the Nikkei to outperform the S&P 500, at least in local currencies. Japan is on the cheap side according to our top-down indicator (Chart I-15). Japanese earnings are highly geared to economic growth at home and abroad. Japanese EPS is in an uptrend versus the U.S. in both local and common currencies (Chart I-16). We do not expect to see a peak in EPS growth until mid-2018, a good six months after the expected top in the U.S. Moreover, an Abe win in the October 22 election would mean that policy will remain highly reflationary in absolute terms and relative to the U.S. Chart I-15Valuation: Japan Cheap To The U.S., But Not Europe Valuation: Japan Cheap To The U.S., But Not Europe Valuation: Japan Cheap To The U.S., But Not Europe Chart I-16Japanese Earnings Outperforming The U.S. Japanese Earnings Outperforming The U.S. Japanese Earnings Outperforming The U.S. European stocks are a tougher call. On the plus side, the economy is flying high and there are no warning signs that this is about to end. There is hope for structural reform in France after Macron's election win this year. We give Macron's proposed labor market reforms high marks because they compare favorably with those of Spain and Germany, which helped to diminish structural unemployment in those two countries. Many doubt that Macron's reforms will see the light of day, but our geopolitical team believes that investors are underestimating the chances. The German election in September poured cold water on recent enthusiasm regarding accelerated European integration. This is because Merkel will likely have to deal with a larger contingent of Euroskeptics in the grand coalition that emerges in the coming months. However, we do not expect political developments in Germany to be a headwind for the Eurozone stock market. On the negative side, European stocks do not appear cheap to the U.S. after adjusting for the structural discount (Chart I-15). Moreover, this year's euro bull phase will take a bite out of earnings. As noted in last month's Overview, euro strength so far this year will lop three to four percentage points off of EPS growth by the middle of next year. Our model suggests that this will be overwhelmed by the robust economic expansion at home and abroad, but profit growth could fall to 5%, which is likely to be well short of that in the U.S. and Japan (local currency). Still, a lot of the negative impact of the currency on profits may already be discounted as forward earnings have been revised down. On balance, we remain overweight European stocks versus the U.S. (currency hedged). However, it appears that Japan has more latitude to outperform. Dollar: Finally Finding A Floor? Chart I-17Has The Dollar Found Bottom? Has The Dollar Found Bottom? Has The Dollar Found Bottom? The Fed's determination to stick with the 'dot plot' may have finally placed a floor under the dollar. Before the September FOMC meeting, the market had all but priced out any rate hikes between now and the end of 2018. Both the U.S. economic surprise index and the inflation surprise index have turned up relative to the G10 (Chart I-17). The dollar has more upside if we are past the period of maximum bond market strength and moving into in a window in which U.S. economic and inflation surprises will 'catch up' with the other major economies. Technically, investors appear to be quite short the dollar, especially versus the euro. Bullish sentiment on the euro is highlighted by the fact that the currency has deviated substantially from the interest rate parity relationship. Euro positioning is thus bullish the dollar from a contrary perspective. Nonetheless, our currency experts are more bullish the dollar versus the yen. Given that inflation expectations have softened in Japan and wage growth is still lacking, the Bank of Japan will have to stick with its zero percent 10-year JGB target. The yen will be forced lower versus the dollar as the U.S. yield curve shifts up. We also like the loonie. The Bank of Canada (BoC) pulled the trigger in September for the second time this year, lifting the overnight rate to 1%. Policymakers gave themselves some "wiggle room" on the outlook, but more tightening is on the way barring a significant slowdown in growth, another spike in the C$, or a housing meltdown. The statement said that the loonie's rise partly reflected the relative strength of the Canadian economy, which implies that it is justified by the fundamentals. It does not appear that the C$ has reached a "choke point" in the eyes of the central bank. Investment Conclusions: We highlighted in our last issue that investors should remain slightly overweight risk assets, but should also hold safe haven assets given the preponderance of risks. Some of the risks have since faded and the sweet spot for risk assets is continuing. We remain upbeat on global economic growth and earnings. Nonetheless, both stocks and bonds remain vulnerable to any upside surprises on inflation, especially in the U.S. While the positive trends in stock indexes and corporate bond spreads should continue over the coming 6-12 months, there is a good chance that this year's downtrend in the dollar and government bond yields is over. The rise in both may be halting, but the risks are to the upside now that disappointments on U.S. growth and inflation have likely ended (notwithstanding the hurricane-distorted economic data in the near term). The Phillips curve is not dead, which means that it is only a matter of time before inflation begins to find a little traction. Higher oil prices will also provide a tailwind for headline inflation. Geopolitics will no doubt remain a threat for 'risk on' trades, but we may be past the worst in terms of North Korean tension. We also do not expect Fed balance sheet normalization to be a major headwind for risk assets. Nonetheless, the anticipated swing the supply of G4 government bonds to private investors would serve to add to selling pressure in the fixed-income space if inflation is rising in the U.S. and/or Europe at the same time. In other words, the risk relates more to expected policy rates than the Fed's balance sheet. Stay overweight stocks versus bonds, long oil related plays, slightly short in duration in the fixed income space, and long inflation protection. We also recommend returning to long positions on the U.S. dollar. Mark McClellan Senior Vice President The Bank Credit Analyst September 28, 2017 Next Report: October 26, 2017 1 Please see BCA Global Investment Strategy Weekly Report, "Is The Phillips Curve Dead Or Dormant?" dated September 22, 2017, available at gis.bcaresearch.com II. Liquidity And The Great Balance Sheet Unwind Liquidity is the lifeblood of the economy and financial markets, but it is a slippery concept that means different things to different people. Liquidity falls into four categories: monetary, balance sheet, financial market transaction liquidity, and funding liquidity. Overall liquidity conditions are reasonably constructive for risk assets at the moment. Financial market and balance sheet liquidity are adequate. Monetary policy is extremely easy, although the low level of money and credit growth underscores that the credit channel of monetary policy is still somewhat impaired. Funding liquidity is as important as monetary liquidity for financial markets. It has recovered from the Great Financial Crisis (GFC) lows, but it is far from frothy. Unwinding the Fed's balance sheet represents a risk to investors because QE played such an important role in reducing risk premia in financial markets. The unwind should not affect transactions liquidity or balance sheet liquidity. It should not affect the broad monetary aggregates either. The bond market's reaction will be far more important than balance sheet shrinkage. As long as the Fed can limit the bond market damage via forward guidance, then funding liquidity should remain adequate and risk assets should take the Fed's unwind in stride. It will be a whole different story, however, if inflation lurches higher. The technical impact of balance sheet unwind on the inner workings of the credit market is very complicated. Asset sales could lead to a shortage of short-term high-quality assets, unless it is offset with increased T-bill issuance. However, a smaller balance sheet could, in fact, improve funding liquidity to the extent that it frees up space on banks' balance sheets. Liquidity has been an integral part of BCA's approach to financial markets going back to the early days of the company under the tutelage of Editor-in-Chief Hamilton Bolton from 1949 to 1968. Bolton was ahead of his time in terms of developing monetary indicators to forecast market trends. Back then, the focus was on bank flows such as the volume of checks cashed because capital markets were still developing and most credit flowed through the banking system. Times changed, monetary policy implementation evolved and financial markets became more important and sophisticated. When money targeting became popular among central banks in the 1970s, central bank liquidity analysis focused more on the broader monetary aggregates. These and other monetary data were used extensively by Anthony Boeckh, BCA's Editor-in-Chief from the 1968 to 2002, to forecast the economy and markets. He also highlighted the importance of balance sheet liquidity (holdings of liquid assets), and its interplay with rising debt levels. Martin Barnes continued with these themes when writing about the Debt Supercycle in the monthly Bank Credit Analyst. "Liquidity" is a slippery concept, and it means different things to different people. In this Special Report, we describe BCA's approach to liquidity and highlight its critical importance for financial markets. We provide a list of indicators to watch, and also outline how the pending shrinkage of the Fed's balance sheet could affect overall liquidity conditions. A Primer On Liquidity We believe there are four types of liquidity that are all interrelated: Central Bank Liquidity: Bank reserves lie at the heart of central bank liquidity. Reserves are under the direct control of the central bank, which are used as a tool to influence general monetary conditions in the economy. The latter are endogenous to the system and also depend on the private sector's desire to borrow, spend and hold cash. Bullish liquidity conditions are typically associated with plentiful bank reserves, low interest rates and strong growth in the monetary aggregates. Balance Sheet Liquidity: A high level of balance sheet liquidity means that plenty of short-term assets are available to meet emergencies. The desire of households, companies and institutional investors to build up balance sheet liquidity would normally increase when times are bad, and decline when confidence is high. Thus, one would expect strong economic growth to be associated with declining balance sheet liquidity, and vice versa when the economy is weak. Of course, deteriorating balance sheet liquidity during good times is a negative sign to the extent that households or business are caught in an illiquid state when the economy turns down, jobs are lost and loans are called. Financial Market Transaction Liquidity: This refers to the ability to make transactions in securities without triggering major changes in prices. Financial institutions provide market liquidity to securities markets through their trading activities. Funding Liquidity: The ability to borrow to fund positions in financial markets. Financial institutions provide funding liquidity to borrowers through their lending activities. The conditions under which these intermediaries can fund their own balance sheets, in turn, depend on the willingness of banks and the shadow banking system to interact with them. The BIS definition of funding liquidity is a broad concept that captures a wide range of channels. It includes the capacity of intermediaries that participate in the securitization chain to access the necessary funding to originate loans, to acquire loans for packaging into securities, and finance various kinds of guarantees. The availability and turnover of collateral for loans is also very important for generating funding liquidity, as we discuss below. These types of liquidity are interrelated in various ways, and can positively or negatively reinforce each other. It is the interaction of these factors that determines the economy's overall ease of financing. See Box II-1 for more details. BOX II-1 How Liquidity Is Inter-Related Central bank liquidity, which is exogenously determined, is the basis for private liquidity creation (the combination of market transaction and funding liquidity). The central bank determines the short-term risk-free rate and the official liquidity that is provided to the banking system. If the central bank hikes rates or provides less official liquidity, appetite for private lending begins to dry up. Private sector liquidity is thus heavily influenced by monetary policy, but can develop a life of its own, overshooting to the upside and downside with swings in investor confidence and risk tolerance. Financial market liquidity and funding liquidity are closely interrelated. When times are good, markets are liquid and funding liquidity is ample. But when risk tolerance takes a hit, a vicious circle between market transaction and funding liquidity develops. The BIS highlights the procyclical nature of private liquidity, which means that it tends to exhibit boom-bust cycles that generate credit excesses that are followed by busts.1 The Great Financial Crisis of 2008 is a perfect example. The Fed lifted the fed funds rate by 400 basis points between 2004 and 2006. Nonetheless, the outsized contraction in private liquidity, resulting from the plunge in asset prices related to U.S. mortgage debt, was a key driver of the crash in risk asset prices. Liquidity Indicators: What To Watch (1) Monetary Liquidity Key measures of central bank liquidity include the monetary base and the broad money aggregates, such as M1 and M2 (Chart II-1). Central banks control the amount of reserves in the banking system, which is part of base money, but they do not control the broad monetary aggregates. The latter is determined by the desire to hold cash and bank deposits, as well as the demand and supply of credit. Box II-2 provides some background on the monetary transmission process and quantitative easing. BOX II-2 The Monetary Transmission Process And Qe Before the Great Recession and Financial Crisis, the monetary authorities set the level of short-term interest rates through active management of the level of bank reserves. Reserves were drained as policy tightened, and were boosted when policies eased. The level of bank reserves affected banks' lending behavior, and shifts in interest rates affected the spending and investment decisions of consumers and businesses. Of course, it has been a different story since the financial crisis. Once short-term interest rates reached the zero bound, the Fed and some other central banks adopted "quantitative easing" programs designed to depress longer-term interest rates by aggressively buying bonds and thereby stuffing the banking system with an excessive amount of reserves. Many feared the onset of inflation when QE programs were first announced because investors worried that this would contribute to a massive increase in credit and the overall money supply. Indeed, there could have been hyper-inflation if banks had gone on a lending spree. But this never happened. Banks were constrained by insufficient capital ratios, loan losses and intense regulation, while consumers and businesses had no appetite for acquiring more debt. The result was that the money multiplier - the ratio of broad money to the monetary base - collapsed (top panel in Chart II-1). Bank lending standards eventually eased and credit demand recovered. Broad money growth has been volatile since 2007 but, despite quantitative easing, it has been roughly in line with the decade before. The broad aggregates lost much of their predictive power after the 1980s. Financial innovation, such as the use of debit cards and bank machines, changed the relationship between broad money on one hand, and the economy or financial markets on the other. Despite the structural changes in the economy, investors should still keep the monetary aggregates and the other monetary indicators discussed below in their toolbox. While the year-to-year wiggles in M2, for example, have not been good predictors of growth or inflation on a one or two year horizon, Chart II-2 shows that there is a long-term relationship between money and inflation when using decade averages. Chart II-1The Monetary Aggregates The Monetary Aggregates The Monetary Aggregates Chart II-2Long-Run Relationship Between M2 And Inflation October 2017 October 2017 Other monetary indicators to watch: M2 Divided By Nominal GDP (Chart II-3): When money growth exceeds that of nominal GDP, it could be interpreted as a signal that there is more than enough liquidity to facilitate economic activity. The excess is then available to purchase financial assets. Monetary Conditions Index (Chart II-3): This combines the level of interest rates and the change in the exchange rate into one indicator. The MCI has increased over the past year, indicating a tightening of monetary conditions, but is still very low by historical standards. Dollar Based Liquidity (Chart II-3): This includes Fed holdings of Treasurys and U.S. government securities held in custody for foreign official accounts. Foreign Exchange Reserves (Chart II-3): Central banks hold reserves in the form of gold, or cash and bonds denominated in foreign currencies. For example, when the People's Bank of China accumulates foreign exchange as part of its management of the RMB, it buys government bonds in other countries, thereby adding to liquidity globally. Interest Rates Minus Nominal GDP Growth (Chart II-4): Nominal GDP growth can be thought of as a proxy for the return on capital. If interest rates are below the return on capital, then there is an incentive for firms to borrow and invest. The opposite is true if interest rates are above GDP growth. Currently, short-term rates are well below nominal GDP, signaling that central bank liquidity is plentiful. Chart II-3Monetary Indicators (I) Monetary Indicators (I) Monetary Indicators (I) Chart II-4Monetary Indicators (II) Monetary Indicators (II) Monetary Indicators (II) (2) Balance Sheet Liquidity Chart II-5 presents the ratio of short-term assets to total liabilities for the corporate and household sectors. It is a measure of readily-available cash or cash-like instruments that make it easier to weather economic downturns and/or credit tightening phases. The non-financial corporate sector is in very good shape from this perspective. The seizure of the commercial paper market during the GFC encouraged firms to hold more liquid assets on the balance sheet. However, the uptrend began in the early 1990s and likely reflects tax avoidance efforts. Households are also highly liquid when short-term assets are compared to income. Liquidity as a share of total discretionary financial portfolios is low, but this is not surprising given extraordinarily unattractive interest rates. The banking system is being forced to hold more liquid assets under the new Liquidity Coverage Ratio requirement (Chart II-6). This is positive from the perspective of reducing systemic risk, but it has negative implications for funding liquidity, as we will discuss below. Chart II-5Balance Sheet Liquidity Balance Sheet Liquidity Balance Sheet Liquidity Chart II-6Bank Balance Sheet Liquidity Bank Balance Sheet Liquidity Bank Balance Sheet Liquidity (3) Financial Market Transaction Liquidity: Transactions volumes and bid-ask spreads are the main indicators to watch to gauge financial market transaction liquidity. There was a concern shortly after the GFC that the pullback in risk-taking by important market-makers could severely undermine market liquidity, leading to lower transaction volumes and wider bid-ask spreads. The focus of concern was largely on the corporate bond market given the sharply reduced footprint of investment banks. The Fed's data on primary dealer positioning in corporates shows a massive decline from the pre-crisis peak in 2007 (Chart II-7). This represents a decline from over 10% of market cap to only 0.3%. The smaller presence of dealers could create a liquidity problem for corporate debt, especially if market-making dealers fail to adequately match sellers with buyers during market downturns. Yet, as highlighted by BCA's Global Fixed Income Strategy team, corporate bond markets have functioned well since the dark days of the Lehman crisis.2 Reduced dealer presence has not resulted in any unusual widening of typical relationships like the basis between Credit Default Swaps and corporate bond spreads. Other market participants, such as Exchange Traded Funds, have taken up the slack. Daily trading volume as a percent of market cap has returned to pre-Lehman levels in the U.S. high-yield market, although this is not quite the case for the investment-grade market (Chart II-8). Chart II-7Less Market Making Less Market Making Less Market Making Chart II-8Corporate Bond Trading Volume Corporate Bond Trading Volume Corporate Bond Trading Volume That said, it is somewhat worrying that average trade sizes in corporates are smaller now compared to pre-crisis levels - perhaps as much as 20% smaller according to estimates by the New York Fed. This is likely the result of the reduced risk-taking by the dealers and the growing share of direct electronic trading. Thus, it may feel like liquidity is impaired since it now takes longer to execute a large bond trade, even though transaction costs for individual trades have not been increasing. The bottom line is that financial market liquidity is not as good as in the pre-Lehman years. This is not a problem at the moment, but there could be some dislocations in the fixed-income space during the next period of severe market stress when funding liquidity dries up. (3) Funding Liquidity: There are few direct measures of funding liquidity. Instead, one can look for its "footprint" or confirming evidence, such as total private sector credit. If credit is growing strongly, it is a sign that funding liquidity is ample. Box II-3 explains why international credit flows are also important to watch for signs of froth in lending. BOX II-3 The Importance Of International Credit Flows The BIS highlights that swings in international borrowing amplify domestic credit trends. Cross border lending tends to display even larger boom-bust cycles than domestic credit, as can be seen in the major advanced economies in the lead up to the GFC, as well as some Asian countries just before the Asian crisis in the late 1990s (Chart II-9). When times are good, banks and the shadow banking system draw heavily on cross-border sources of funds, such that international credit expansion tends to grow faster during boom periods than the credit granted domestically by banks located in the country. Since G4 financial systems intermediate a major share of global credit, funding conditions within the G4 affect funding conditions globally, as BIS research shows.3 This research also demonstrates that financial cycles have become more highly correlated across economies due to increased financial integration. Booms in credit inflows from abroad are also associated with a low level of the VIX, which is another sign of ample funding liquidity conditions (Chart II-10). These periods of excessive funding almost always end with a financial crisis and a spike in the VIX. Chart II-9International Credit Is Highly Cyclical International Credit Is Highly Cyclical International Credit Is Highly Cyclical Chart II-10International Credit Booms Lead Spikes In The VIX International Credit Booms Lead Spikes In The VIX International Credit Booms Lead Spikes In The VIX Other measures of funding liquidity to watch include: Chart II-11Market Measures Of Funding Liquidity Market Measures Of Funding Liquidity Market Measures Of Funding Liquidity Libor-OIS Spread (Chart II-11): This is a measure of perceived credit risk of LIBOR-panel banks. The spread tends to widen during periods of banking sector stress. Spreads are currently low by historical standards. However, libor will be phased out by 2021, such that a replacement for this benchmark rate will have to be found by then. Bond-CDS Basis (Chart II-11): The basis is roughly the average difference between each bond's yield spread to Treasurys and the cost of insuring the bond in the CDS market. Arbitrage should keep these two spreads closely aligned, but increases in funding costs tied to balance sheet constraints during periods of market stress affect this arbitrage opportunity, allowing the two spreads to diverge. The U.S. high-yield or investment grade bond markets are a good bellweather, and at the moment they indicate relatively good funding liquidity. FX Basis Swap (Chart II-11): This is analogous to the bond-CDS basis. It reflects the cost of hedging currencies, which is critically important for international investors and lending institutions. The basis swap widens when there is financial stress, reflecting a pullback in funding liquidity related to currencies. The FX swap basis widened during the GFC and, unlike other spreads, has not returned to pre-Lehman levels (see below). Bank Leverage Ratios (Chart II-12): The ratio of loans to deposits is a measure of leverage in the banking system. Banks boost leverage during boom times and thereby provide more loans and funding liquidity to buy securities. In the U.S., this ratio has plunged since 2007 and shows no sign of turning up. Primary Dealers Securities Lending (Chart II-13): This is a direct measure of funding liquidity. Primary dealers make loans to other financial institutions with the purpose of buying securities, thereby providing both funding liquidity and market liquidity. Historically, shifts in dealer lending have been correlated with bid-ask spreads in the Treasury market. Securities lending is also correlated with the S&P 500, although it does not tend to lead the stock market. Dealer loans soared prior to 2007, before collapsing in 2008. Total loans have recovered, but have not reached pre-crisis highs, consistent with stricter regulations that forced the deleveraging of dealer balance sheets. Chart II-12U.S. Bank Leverage U.S. Bank Leverage U.S. Bank Leverage Chart II-13Securities Lending And Margin Debt bca.bca_mp_2017_10_01_s2_c13 bca.bca_mp_2017_10_01_s2_c13 NYSE Margin Debt (Chart II-13): Another direct measure of funding liquidity. The uptrend in recent years has been steep, although it is less impressive when expressed relative to market cap. Bank Lending Standards (Chart II-14): These surveys reflect bank lending standards for standard loans to the household or corporate sectors, but their appetite for lending for the purposes of securities purchases is no doubt highly correlated. Lending standards tightened in 2016 due to the collapse in oil prices, but they have started to ease again this year. Table II-1 provides a handy list of liquidity indicators split into our four categories. Taking all of these indicators into consideration, we would characterize liquidity conditions in the U.S. as fairly accommodative, although not nearly as abundant as the period just prior to the Lehman event. Monetary conditions are super easy, while balance sheet and financial market liquidity are reasonably constructive. In contrast, funding liquidity, while vastly improved since the GFC, is still a long way from the pre-Lehman go-go years according to several important indicators such as bank leverage. Moreover, the Fed is set to begin the process of unwinding the massive amount of monetary liquidity provided by its quantitative easing program. Chart II-14Bank Lending Standards Bank Lending Standards Bank Lending Standards Table II-1Liquidity Indicators To Watch October 2017 October 2017 Fed Balance Sheet Shrinkage: What Impact On Liquidity? Given that the era of quantitative easing has been a positive one for risk assets, it is unsurprising that investors are concerned about the looming unwind of the Fed's massive balance sheet. For example, Chart II-15 demonstrates the correlation between the change in G4 balances sheets and both the stock market and excess returns in the U.S. high-yield market. Chart II-16 presents our forecast for how quickly the Fed's balance sheet will contract. Following last week's FOMC meeting we learned that balance sheet reduction will begin October 1. For the first three months the Fed will allow a maximum of $6 billion in Treasurys and $4 billion in MBS to run off each month. Those caps will increase in steps of $6 billion and $4 billion, respectively, every three months until they level off at $30 billion per month for Treasurys and $20 billion per month for MBS. Chart II-15G4 Central Bank Balance Sheets G4 Central Bank Balance Sheets G4 Central Bank Balance Sheets Chart II-16Fed Balance Sheet Fed Balance Sheet Fed Balance Sheet We have received no official guidance on the level of bank reserves the Fed will target for the end of the run-off process. However, New York Fed President William Dudley recently recommended that this level should be higher than during the pre-QE period, and should probably fall in the $400 billion to $1 trillion range.4 In our forecasts we assume that bank reserves will level-off once they reach $650 billion. In that scenario the Fed's balance sheet will shrink by roughly $1.4 trillion by 2021. The level of excess reserves in the banking system will decline by a somewhat larger amount ($1.75 trillion). In terms of the impact of balance sheet shrinkage on overall liquidity conditions, it is useful to think about the four categories of liquidity described above. (1) Monetary Liquidity The re-absorption of excess reserves will mean that base money will contract (i.e. the sum of bank reserves held at the Fed and currency in circulation). However, we do not expect this to have a noticeable impact on the broader monetary aggregates, credit growth, the economy or inflation, outside of any effect it might have on the term premium in the bond market. The reasoning is that all those excess reserves did not have a major impact on growth and inflation when they were created in the first place. This was because the credit channel of monetary policy was blocked by a lack of demand (private sector deleveraging) and limited bank lending capacity (partly due to regulation). Banks were also less inclined to lend due to rising loan losses. Removing the excess reserves should have little effect on banks' willingness or ability to make new loans. In terms of asset prices, some investors believe that when the excess reserves were created, a portion of it found its way out of the banking system and was used to buy assets directly. That is not the case. The excess reserves were left idle, sitting on deposit at the Fed. They did not "leak" out and were not used to purchase assets. Thus, fewer excess bank reserves do not imply any forced selling. Nonetheless, the QE program certainly affected asset prices indirectly via the portfolio balance effect. Asset purchases supported both the economy and risk assets in part via a weaker dollar and to the extent that the policy lifted confidence in the system. But most importantly, QE depressed long-term interest rates, which are used to discount cash flows when valuing financial assets. QE boosted risk-seeking behavior and the search for yield, partly through the signaling mechanism that convinced investors that short-term rates would stay depressed for a long time. The result was a decline in measures of market implied volatility, such as the MOVE and VIX indexes. Could Bond Yields Spike? The risk is that the portfolio balance effect goes into reverse as the Fed unwinds the asset purchases. The negative impact on risk assets will depend importantly on the bond market's response. As highlighted in the Overview section, there will be a sharp swing in the flow of G4 government bonds available to the private sector, from a contraction of US$800 billion in 2017 to an increase of US$600 billion in 2018. Focusing on the U.S. market, empirical estimates suggest that the Fed's shedding of Treasurys could boost the 10-year yield by about 80 basis points because the private sector will require a higher term premium to absorb the higher flow of bonds. However, the impact on yields is likely to be tempered by two factors: Banks are required by regulators to hold more high-quality assets than they did in the pre-Lehman years in order to meet the new Liquidity Coverage Ratio. The BCA U.S. Bond Strategy service argues that growing bank demand for Treasurys in the coming years will absorb much of the net flow of Treasurys that the Fed is no longer buying.5 As the FOMC dials back monetary stimulus it will be concerned with overall monetary conditions, including short-term rates, long-term rates and the dollar. If long-term rates and/or the dollar rise too quickly, policymakers will moderate the pace of rate hikes and use forward guidance to talk down the long end of the curve so as to avoid allowing financial conditions to tighten too quickly. Thus, the path of short-term rates is dependent on the dollar and the reaction of the long end of the curve. It is difficult to estimate how it will shake out, but the point is that forward guidance will help to limit the impact of the shrinking Fed balance sheet on bond yields. Indeed, the Fed is trying hard to sever the link in investors' minds between balance sheet policy and signaling about future rate hikes, as highlighted by Chair Yellen's Q&A session following the September FOMC meeting. The bottom line is that the impact on monetary liquidity of a smaller Fed balance sheet should be minimal, although long-term bond yields will be marginally higher as a result. That said, much depends on inflation. If the core PCE inflation rate were to suddenly shift up to the 2% target or above, then bond prices will be hit hard, the VIX will surge and risk assets will sustain some damage. The prospect of a more aggressive pace of monetary tightening would undermine funding liquidity, compounding the negative impact on risk assets. (2) Funding Liquidity Chart II-17Tri-Party Repo Market Has Shrunk Tri-Party Repo Market Has Shrunk Tri-Party Repo Market Has Shrunk By unwinding its balance sheet, the Fed will be supplying securities into the market and removing cash. This will be occurring at a time when transactions in the tri-party repo market have fallen to less than half of their peak in 2007 due to stricter regulation (Chart II-17). This market has historically been an important source of short-term funding, helping to meet the secular rise in demand for short-term, low-risk instruments, largely from non-financial corporations, asset managers and foreign exchange reserve funds. If the Fed drains reserves from the system and T-bill issuance does not increase substantially to compensate, a supply shortage of short-maturity instruments could develop. We can see how this might undermine the Fed's ability to shift short-term interest rates higher under its new system of interest rate management, where reverse repos and the interest rate paid on reserves set the floor for other short-term interest rates. However, at the moment we do not see the risk that fewer excess reserves on its own will negatively affect funding liquidity. Again, any impact on funding liquidity would likely be felt via a sharp rise in interest rates and pullback in the portfolio balance effect, which would occur if inflation turns up. But this has more to do with rising interest rates than the size of the Fed's balance sheet. Indeed, balance sheet shrinkage could actually improve funding liquidity provided via the bilateral repo market, securities-lending, derivatives and prime brokerage channels. These are important players in the collateral supply chain. A recent IMF working paper emphasizes that collateral flows are just as important in credit creation as money itself.6 Collateral refers to financial instruments that are used as collateral to fund positions, which can be cash or cash-like equivalents. Since pledged collateral can be reused over and over, it can generate significantly more total lending than the value of the collateral itself. The Fed's overnight reverse-repo facility includes restrictions that the collateral accessed from its balance sheet can only be used in the tri-party repo system. Thus, the Fed's presence in the collateral market has reduced the "velocity of collateral." Table II-2 shows that the reuse rate of collateral, or its velocity, has fallen from 3.0 in 2007 to 1.8 in 2015. Table II-2Collateral Velocity October 2017 October 2017 The combination of tighter capital regulations and Fed asset purchases has severely limited the available space on bank balance sheets to provide funding liquidity. Regulations force banks to carry more capital for a given level of assets. Fed asset purchases have forced a large portion of those assets to be held as reserves, limiting banks' activity in the bilateral repo market. There is much uncertainty surrounding this issue, but it appears that an unwind the Fed's balance sheet will free up some space on bank balance sheets, possibly permitting more bilateral repo activity and thus a higher rate of collateral velocity. It may also relieve concerns about a shortage of safe-haven assets. Nonetheless, we probably will not see a return of collateral velocity to 2007 levels because stricter capital regulations will still be in place. What About Currency Swaps? Some have argued that this removal of cash could also lead to an appreciation of the U.S. dollar. In particular, Zoltan Pozsar of Credit Suisse has observed a correlation between U.S. bank reserves and FX basis swap spreads.7 There is also a strong correlation between FX swap spreads and the U.S. dollar (Chart II-18). Chart II-18FX Basis Swap And Reserves FX Basis Swap And Reserves FX Basis Swap And Reserves One possible chain of events is that, as the Fed drains cash from the market, there will be less liquidity in the FX swap market. Basis swap spreads will widen as a result, and this will cause the dollar to appreciate. In this framework, the unwinding of the Fed's balance sheet will put upward pressure on the U.S. dollar. However, it is also possible that the chain of causation runs in the other direction. The BIS has proposed a model8 where a stronger dollar weakens the capital positions of bank balance sheets. This causes them to back away from providing liquidity to the FX swap market, leading to wider basis swap spreads. In this model, a strong dollar leads to wider basis swap spreads and not the reverse. If this is the correct direction of causation, then we should not expect any impact on the dollar from the unwinding of the Fed's balance sheet. At the moment it is impossible to tell which of the above two theories is correct. All we can do is monitor the correlation between reserves, FX basis swap spreads and the dollar going forward. Conclusions: Overall liquidity conditions are reasonably constructive for risk assets at the moment. Financial market and balance sheet liquidity are adequate. Monetary policy is extremely easy, although the low level of money and credit growth underscores that the credit channel of monetary policy is still somewhat impaired and/or constrained relative to the pre-Lehman years. Funding liquidity has recovered from the Great Financial Crisis lows, but it is far from frothy. More intense regulation means that funding liquidity will probably never again be as favorable for risk assets as it was before the crisis. But, hopefully, efforts by the authorities to reduce perceived systemic risk mean that funding liquidity may not be as quick to dry up as was the case in 2008, in the event of another negative shock. Unwinding the Fed's balance sheet represents a risk to investors because QE played such an important role in reducing risk premia in financial markets. However, we believe that the bond market's reaction will be far more important than balance sheet shrinkage. As long as the Fed can limit the bond market damage via forward guidance, then risk assets should take the Fed's unwind in stride. It will be a whole different story, however, if inflation lurches higher. The technical impact of balance sheet unwind on the inner workings of the credit market is very complicated and difficult to forecast. Asset sales could lead to a shortage of short-term high-quality assets. However, this is more a problem in terms of the Fed's ability to raise interest rates than for funding liquidity. A smaller balance sheet could, in fact, improve funding liquidity to the extent that it frees up space on banks' balance sheets. Mark McClellan Senior Vice President The Bank Credit Analyst Ryan Swift Vice President U.S. Bond Strategy 1 D. Domanski, I. Fender and P. McGuire, "Assessing Global Liquidity," BIS Quarterly Review (December 2011). 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Global Interest Rate Strategy For The Remainder Of 2017," dated July 18, 2017, available at gfis.bcaresearch.com 3 E. Cerutti, S. Claessens and L. Ratnovski, "A Primer on 'Global Liquidity'," CEPR Policy Portal (June 8, 2014). 4 William C. Dudley, "The U.S. Economic Outlook and the Implications for Monetary Policy," Federal Reserve Bank of New York (September 07, 2017). 5 Please see BCA U.S. Bond Strategy Weekly Report, "The Great Unwind," dated September 19, 2017, available at usbs.bcaresearch.com 6 M. Singh, "Collateral Reuse and Balance Sheet Space," IMF Working Paper (May 2017). 7 Alexandra Scaggs, "Where would you prefer your balance sheet: Banks, or the Federal Reserve?" Financial Times Alphaville (April 13, 2017). 8 S. Avdjiev, W. Du, C. Koch, and Hyun S.Shin, "The dollar, bank leverage and the deviation from covered interest parity," BIS Working Papers No.592 (Revised July 2017). III. Indicators And Reference Charts Equity indexes in the U.S. and Japan broke out to new highs in September. European stocks surged as well. Investors embraced risk assets in the month on a solid earnings backdrop, strong economic indicators, continuing low inflation and revived hopes for fiscal stimulus in the U.S. and Japan, among other factors. Our indicators do not warn of any near-term stumbling blocks for the bull market. Our monetary indicator continues to hover only slightly on the restrictive side. Our equity composite technical indicator may be rolling over, but it must fall below zero to send a 'sell' signal. The speculation index is elevated, but bullish equity sentiment is only a little above the long-term mean. Meanwhile, the S&P 500 tends to increase whenever the 12-month forward EPS estimate is rising. The latter is in a solid uptrend that should continue based on the net revisions ratio and the earnings surprise index. Valuation remains poor, but has not yet reached our threshold of overvaluation. Our new Revealed Preference Indicator (RPI) continued on its bullish equity signal in August for the second consecutive month. We introduced the RPI in the July report. It combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Our Willingness-to-Pay (WTP) indicators are also bullish on stocks for the U.S., Europe and Japan. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The U.S. and Japanese WTPs are trending sideways, and Europe could be rolling over. While this is a little worrying because they indicate that flows into equity markets have moderated recently, the indicators have to clearly turn down to provide a bearish signal for stocks. Flows into the U.S. appear to be more advanced relative to Japan and the Eurozone, suggesting that there is more "dry powder" available to buy the latter two markets than for the U.S. market. Oversold conditions for the U.S. dollar are being worked off, but our technical indicator is still positive for the currency. The greenback looks expensive based on PPP, but is less so on other measures. We are positive in the near term. Our composite technical indicator for U.S. Treasurys is at neutral. Bond valuation is also at neutral based on our long-standing model. However, other models that specifically incorporate global economic factors suggest that the 10-year Treasury is still more than 30 basis points on the expensive side. Stay below benchmark in duration. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-10U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

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

Highlights U.S. Treasury yields should continue to rise as investors price-out doomsday risk; Tensions surrounding North Korea will continue, but there are signs that negotiations have started and that China is playing ball on sanctions; Meanwhile, our view that tax cuts are coming is finally coming to fruition; Fade renewed European risks regarding Brexit and Catalan independence; But the independence push by Kurds in Iraq could have market impact. Feature Early in the second quarter, BCA's Geopolitical Strategy made two predictions. First, we said that summer would be a time to stay invested in U.S. equities and largely ignore domestic politics.1 Second, that North Korea would become an investment-relevant risk and buoy safe-haven plays but would not lead to a full-scale war (and hence not cause a global correction).2 The summer proved lucrative for both risk-on and risk-off trades, best emblemized by solid returns for both the S&P 500 and 10-year U.S. Treasury (Chart 1 A & B). Chart 1ARisk Assets Have Rallied... Risk Assets Have Rallied... Risk Assets Have Rallied... Chart 1B...At The Same Time As Safe Havens ...At The Same Time As Safe Havens ...At The Same Time As Safe Havens Can this continue? We do not think so. Geopolitics can influence the 10-year Treasury yield via two mechanisms: safe-haven flows and fiscal policy. On both fronts, we see movements that should support a pickup in yields over the rest of the year, a view corroborated by our colleagues on the fixed-income team. First, investors finally have progress on tax legislation that we have been forecasting since President Trump's election. Given the markets' collective pessimism on corporate tax reform (Chart 2), we expect any good news to change the current narrative. While it is still difficult to envision tax legislation that massively stimulates the economy, it is also difficult to imagine tax legislation that is revenue-neutral. As such, fiscal policy in the U.S. should be at least mildly stimulative in 2018, supporting higher yields. Second, we remain concerned that North Korea could escalate the ongoing tensions in East Asia.3 However, Pyongyang is constrained by its military capacity, which limits what it can realistically do to threaten its neighbors. As we discuss below, there are emerging signs of both diplomatic negotiations and Chinese pressure, key signposts that we have passed the peak on our "Arc of Diplomacy." As such, investors should prepare for the bond rally to reverse and the broader risk-on phase to extend through the end of the year. We expect the "Trump reflation trade" - USD appreciation, yield-curve steepening, and small-cap outperformance (Chart 3) - to restart if our views on the U.S. legislative agenda and North Korean tensions hold. Chart 2Investors Remain Pessimistic On Tax Reform... Investors Remain Pessimistic On Tax Reform... Investors Remain Pessimistic On Tax Reform... Chart 3...And On Trump's Policy In General ...And On Trump's Policy In General ...And On Trump's Policy In General U.S. Treasuries: Fade The Doomsday Trade Our colleagues at BCA's fixed-income desk have shown that flows into safe havens over the summer have widened the disconnect between global yields and economic fundamentals (Chart 4).4 Chief Fixed-Income Strategist Rob Robis points out that BCA's own valuation model for the 10-year U.S. Treasury yield indicates that "fair value" sits at 2.67%, nearly 55bps higher than current market levels (Chart 5).5 This is a level of overvaluation that even exceeds the extreme levels seen after the U.K. Brexit vote in July of 2016. Rob believes that the summer bond rally is about safe-haven demand, depressed investor sentiment, and underwhelming inflation, in that order. It is certainly not about growth expectations, which remain buoyant (Chart 6). Chart 4Falling Yields Reflect Save Haven Demand,##br## Not Slower Growth Falling Yields Reflect Save Haven Demand, Not Slower Growth Falling Yields Reflect Save Haven Demand, Not Slower Growth Chart 5U.S. Treasuries ##br##Are Overvalued U.S. Treasuries Are Overvalued U.S. Treasuries Are Overvalued Chart 6Global Growth##br## Remains Buoyant Global Growth Remains Buoyant Global Growth Remains Buoyant To prove that underwhelming inflation has not spurred the latest rally in Treasuries, Rob decomposes developed market bond yield changes since the July 7 peak in U.S. yields. The benchmark 10-year U.S. Treasury yield has risen 20bps off those September lows as investors have priced out doomsday risk. Table 1 shows that yields declined everywhere but Canada (where the central bank has been hiking interest rates). Yet the vast majority of the yield decline has come from falling real yields and not lower inflation expectations, which have actually stabilized over the summer. This has also occurred via a bull-flattening move in government bond yield curves, which suggests it is risk-aversion that has driven yields lower. Table 1Changes In DM Bond Yields Over The Summer (From July 7th Peak In U.S. Treasury Yields) Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? The conclusion of our fixed-income team is that there is now considerable upside risk in global yields. We agree. While North Korea could retaliate against the just-imposed UN sanctions in various ways, it is difficult to see the market reacting with the same vigor as it did in July and August. Investors are becoming desensitized to North Korean provocations, especially as the latter remain confined to "expected and accepted" forms of belligerence, even in the current context of heightened tensions. Future North Korean safe-haven rallies will be of shorter amplitude and duration. The September 15 missile launch over Japan (the fourth time this has happened) has shown this to be the case. Chart 7Position For A Tactically Wider UST-Bund Spread Position For A Tactically Wider UST-Bund Spread Position For A Tactically Wider UST-Bund Spread Bottom Line: BCA's bond team remains short duration, a position that our political analysis supports. We will keep our 2-year/30-year Treasury curve-steepener trade open, despite it being in the red by 34.3bps. In addition, we are closing our short Fed Funds January 2018 futures position (for a gain of 0.51bps) and opening a new short Fed Funds December 2018 position. Any sign of emerging bipartisanship should also favor higher fiscal spending, as policymakers almost always come together to spend money rather than cut spending. In addition, we are recommending that our clients put on a U.S. Treasury-German Bund spread widening trade.6 Rob has pointed out that this is a way to profit directly from higher fiscal spending in the U.S., particularly since there is no sign that Germany will change its government spending following its unremarkable election campaign. The data also supports a tactical widening of the Treasury-Bund spread, which is correlated with the relative data surprises (Chart 7). U.S. Politics: From Impeachable To Ingenious The crucial moment for the Trump presidency was the White House purge of the "Breitbart clique" following the social unrest in Charlottesville, Virginia on August 11-12.7 That move has made headway for upcoming tax legislation and resolution of the debt ceiling imbroglio. While some investors saw the racially motivated rioting in Virginia as a harbinger of a major risk-off episode, we saw it essentially as a "Peak Stupid" moment in U.S. politics. We may not know precisely what goes on in President Trump's mind, but we know that he likes polls. And his polling with Republican voters suffered appreciably following the Charlottesville fiasco (Chart 8). Strong Republican support for President Trump is the main source of his political capital. He can use it to cajole and influence Republicans in Congress via the upcoming Republican primary process ahead of the midterm elections. If he loses that support, his political capital will erode and he could become the earliest "lame duck" president in recent U.S. history. Worse, if support among Republicans were to fall below 70%, Trump could embark upon a Nixonian trajectory that could indeed lead to impeachment (Chart 9). Chart 8Trump's Support With GOP Voters Suffered... Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? Chart 9... But Remains Well Above Nixonian Levels Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? Many clients have asked us about the debt ceiling deal that President Trump made with Democrats and whether it signals a radical shift towards bipartisanship. We do not think so. In fact, we think the deal is mostly irrelevant. As we argued throughout the summer, the idea that there would be another debt ceiling crisis this year was always a figment of the media's imagination. There was never any evidence that a sufficient number of members of the House of Representatives wanted to play brinkmanship with the debt ceiling. First, Democrats in both houses of Congress have been clear throughout the year that they would not play politics with the debt ceiling. Second, investors and the media continuously overestimate the strength of the Freedom Caucus, the fiscally conservative grouping of Tea Party-linked representatives. There are 41 members of the Freedom Caucus, whereas 55 Republicans in the House sit in districts that are at least theoretically vulnerable to a Democratic challenge (Table 2).8 The danger for House Speaker Paul Ryan is not that the Freedom Caucus abandons the establishment line, but that the 55 Republicans listed in Table 2 abandon the Republican line. This, in fact, happened throughout the Obama presidency, with centrist Republicans voting with Democrats in the House on a number of key legislative bills (Chart 10). Table 2Plenty Of Vulnerable Republican Representatives Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? Chart 10The Obama Years: A Governing 'Grand Coalition' Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? This is why Speaker Paul Ryan largely ignored the Freedom Caucus and proposed an eighteen-month extension of the debt ceiling. He was never going to allow the Freedom Caucus to play brinkmanship. That President Trump picked the shorter Democrat version is significant only in so far as it signaled that he was willing to work with Democrats. In other words, the move was a "shot across the bow" of Republicans, a message that they had better get started on tax legislation, or else ... What should investors watch now? There are three main issues to follow: Tax legislation outline: House Speaker Paul Ryan has set the week of September 25 as the deadline for Republicans to outline their tax policy plan. The good news for investors is that the outline will supposedly include an already agreed-upon framework by both the House Ways and Means Committee - Chaired by Representative Kevin Brady (R, TX) - and the Senate Finance Committee - Chaired by Senator Orin Hatch (R-UT). Brady and Hatch are serious players and their comments on tax policy should be followed closely. Both favor legislation that would be retroactively applied to FY 2017, even if the bill is actually passed in 2018. They are also part of the Republican "Big Six" group on tax policy, along with Speaker Ryan, Senate Majority Leader Mitch McConnell, Treasury Secretary Steven Mnuchin, and National Economic Council Director Gary Cohn. Reconciliation instructions: The House Budget Committee passed a FY 2018 budget resolution in late July that included "reconciliation instructions" for tax legislation. These instructions allow Republicans to use the reconciliation procedure - a process that allows the Senate to pass legislation without needing 60 votes.9 However, the House version of the budget resolution also included over $200 billion of spending cuts, which is unlikely to pass in the Senate. As such, investors have to carefully watch for the House and Senate Republicans to pass a final budget resolution in order to kick off the reconciliation process. This process will likely happen in October, after the tax legislation package is presented by the Big Six. At that point, the Freedom Caucus will have the ability to extract concessions from establishment Republicans as their votes are needed to pass the budget resolution. We suspect that no Democrats will support the budget resolution given that they have not been involved in the tax policy process thus far. Trump's involvement: President Ronald Reagan's personal support and lobbying for the 1986 tax reform proved critical in getting the bill through Congress.10 President Trump's focus and energy will have to be on par with that of Reagan's if he plans to accomplish the same. A headwind for Trump is the lack of legislative experience in his White House (Chart 11). However, since the appointment of Chief of Staff General John F. Kelly, there has been a clear shift of focus on the legislative process. Chart 11Trump Administration Is On The Low End Of Congressional Experience Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? Bottom Line: We expect investors to start gleaning the outlines of tax policy by late September, with the budget resolution containing reconciliation instructions being passed by both houses of Congress by the end of November. It may be too much to ask Congress to have an actual bill ready to pass by the end of the year, as we originally expected,11 particularly as there is now a potential immigration deal to negotiate with Democrats and last-minute effort to repeal and replace Obamacare. As such, we still think that it will take until the end of Q1 2018 for tax legislation to pass Congress (Q2 in the worst-case scenario for Republicans). Investors, however, will begin to price in a higher probability of tax policy as soon as the outline of the bill emerges in October. As such, we are reiterating our recommendation that investors go long U.S. small caps relative to large caps. Tax policy should overwhelmingly benefit small caps, which actually pay the 35% corporate tax rate. In addition, we would expect the USD to arrest its decline and rally by the end of the year. North Korea: At The Apogee Of "The Arc Of Diplomacy" To illustrate the current North Korean predicament to readers, we have referred to an "arc of diplomacy" (Chart 12), which we illustrate by referencing the rise and fall of U.S. tensions with Iran from 2010-15. The pattern is for the U.S. to increase tensions deliberately in order to convince its enemy that the military option is "on the table." Only once a "credible threat" of war has been established can the negotiations begin in earnest. Chart 12A Lesson From Iran: Tensions Ramp Up As Nuclear Negotiations Begin Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? We are at or near the peak of this process. First: what is the worst-case scenario for markets if the North causes a crisis short of a devastating war? Using our short list of geopolitical crises (Table 3),12 our colleague Anastasios Avgeriou, chief strategist of BCA's U.S. Equity Strategy, notes that while the average peak-to-trough drop of a major crisis is 9%, equity returns also tend to rise 5% within six months and 8% within twelve months after the crisis. To illustrate the trend, Anastasios has constructed an S&P 500 profile of the average geopolitical crisis, and the picture is encouraging (Chart 13). It shows that the market is likely to grind higher even if North Korea does something truly out of the box. Table 3Geopolitical Crises And SPX Returns Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? Nor is a geopolitical incident (again, short of total war) likely to cause a U.S. or global recession. Aside from direct shocks to oil, such as in 1973 and 1990, only the U.S. Civil War (that is, a war waged on U.S. turf) caused a recession at the outset. Other major wars (WWI, WWII, the Korean War) caused recessions when they concluded because of the sharp drop in federal spending as a result of reduced military spending. What makes us think we are at or near the peak of North Korea's belligerent threats? China appears to be enforcing sanctions: at least according to China's official statistics (Chart 14). There is no doubt there are discrepancies and black market activity, but it makes sense for China to dial up the pressure (while never imposing crippling sanctions) and that appears to be occurring. China and Russia agreed to reduce fuel supplies. Both sides agreed to new UN sanctions on September 11 that would partially cut off North Korean fuel. This is a significant step, given that Chart 14 indicates China is already moving in this direction. The U.S. and North Korea have begun diplomatic talks. According to Japan's NHK press on September 14, former U.S. diplomat Evans Revere met with Choe Kang-Il, the deputy director general of the North American bureau of North Korea's foreign ministry in Switzerland over the past week. The U.S. State Department spokeswoman Heather Nauert all but confirmed that some kind of communication is underway, and Secretary of State Rex Tillerson has described his diplomatic initiative as highly active. The last efforts at negotiations, via the longstanding New York channel, were discontinued in June after the death of a U.S. prisoner in North Korea. Those were focused on retrieving U.S. citizens, whereas the new talks allegedly centered on the latest UN sanctions, i.e. a crux of the relationship. The implication is that North Korea is responding to pressure now that its critical fuel supplies are at risk. South Korea is offering aid. South Korea's new government is looking to give the North humanitarian aid, as expected, and will decide on September 21 about a special package for pregnant women and infants. It is suggesting that such aid has no conditionality on the North's behavior. At the same time, the U.S. administration is talking down Trump's recent threat to discontinue the U.S.-South Korean free trade agreement - meaning that the U.S. may even condone the South Korean administration's more diplomatic approach to the North. Chart 13Who Is Afraid Of Geopolitical Crises? Who Is Afraid Of Geopolitical Crises? Who Is Afraid Of Geopolitical Crises? Chart 14Is China Finally Playing Ball? Is China Finally Playing Ball? Is China Finally Playing Ball? At the same time, North Korea is running out of options for provocations that it can commit without provoking a costly response from the U.S. and its allies. The September 15 missile test over Japan was essentially the fourth of its kind, and the market shrugged it off. Here are some options, drawn from our list of scenarios and probabilities (Table 4): Table 4North Korean Scenarios Over The Next Year Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? More of the same: Nuclear and missile tests could continue, or be conducted at higher frequencies or simultaneously. While technical advances may become apparent, they will not change the game. U.S. Territory: The North could create a bigger risk-off move than we saw in July-August if it shot ICBMs toward Guam, or other U.S. territories, as it has suggested it might do. This is especially risky because the U.S. Secretary of Defense James Mattis has repeated Trump's warning to North Korea to not even threaten the United States. However, as long as no such missile actually strikes U.S. territory, the U.S. is unlikely to respond with an attack, and thus such a scare seems likely to fade like the others. Attacking South Koreans: The North has a history of state-backed terrorist actions and military actions. An attack limited to South Korea will cause a shock, in the current context, but the military consequences are still likely to be contained given the extensive history of such attacks. If it is an attack against South Korean civilians in a non-disputed territory, it will leave a bigger mark than it otherwise would, but the South is still likely either to retaliate in strict proportionality, or to refrain from action and use the event as a way of galvanizing international sanctions. Attacking Americans or U.S. allies: The true danger in the current climate is an attack that kills U.S. citizens, or U.S. allies who are not as, shall we say, understanding as the South Koreans (such as the Japanese). This could cause the U.S. or Japan or another ally to take a retaliatory action. Even if limited, this could cause a deep correction in the market. The U.S. response would likely still be limited and proportional. Then the question would be whether the North Koreans can afford to escalate. They can't. The military asymmetry is excessive. This is not the case of the Japanese in 1941, who believed they had the potential of defeating the U.S. if they acted quickly enough and the U.S. was distracted in Europe (Diagram 1). Diagram 1North Korea Crisis: A Decision Tree Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? As the foregoing demonstrates, there could still be big ups and downs between now and the resumption of formal international negotiations, let alone a satisfactory diplomatic accord. The tensions could yet reach another peak. Nevertheless, our sense is that the pieces are falling into place for the North to moderate its behavior, sending the signal that it is ready to engage in real negotiations. Since the U.S. has consistently shown its readiness to talk directly with the North - coming from both Trump and Tillerson - we think we could see shuttle diplomacy taking place as early as this winter. Here are some dates and events to watch: Military exercises: Will the U.S., South Korea, and Japan stop or slow down the pace of military exercises? This could open space for North Korea to offer an olive branch in return. October 10 - anniversary of the Worker's Party of Korea: The North may take an extraordinary action, no action, or familiar actions like missile tests. October 11-25 - China's party congress: The North could fall silent ahead of the big event, or could attempt to disrupt it. China, in turn, could take action around this time (particularly afterwards) to send a signal to the North to tone down the belligerence. In previous periods of tension, China has reputedly drawn a harder line on North Korea in the month of December, when end-of-year quotas made certain trade measures more convenient. Late October - Japanese snap election? Rumor has it that Shinzo Abe is thinking of calling a snap election as early as this month. We normally dismiss such rumors but this time there is a certain logic: two North Korean missiles have flown over Hokkaido in as many months, while the Japanese opposition is in total disarray. If Abe calls early polls, it suggests that he thinks Korean fears are peaking. If he delays, and exploits these fears by pushing constitutional revisions through the Diet (our base case), then he may provoke a North Korean response, given that the revisions pave the way for Japan to "re-militarize." November 1 - APEC and Trump's visit to China: Trump is supposed to head to Vietnam for the APEC summit and to China to visit President Xi Jinping. Xi has recently shown his sensitivity to such summits by concluding the Doklam dispute with India just days ahead of the BRICS summit in Xiamen, China in order to ensure that Indian President Narendra Modi would attend. Xi may have also wanted to advertise his ability to negotiate solutions to international showdowns for the world (and U.S.) to see. Thus, progress on North Korea before or after Trump's arrival could improve Xi's authority both with Trump and the rest of the world. November 23 - U.S. Thanksgiving: North Korea likes to be "cute," so we cannot rule out attempts to unsettle the Americans on Thanksgiving or Christmas Day, as with the July 4 ICBM launch. Trump's visit is very consequential and it is more likely under the circumstances that China will receive him warmly, like Nixon, rather than coldly, like Obama last year. Trump is holding serious trade negotiations (via Commerce Secretary Wilbur Ross) and at the same time threatening to sanction Chinese companies and imports (via Treasury Secretary Steve Mnuchin). There are many reasons for Beijing to cooperate on North Korea in order to get advantageous treatment on the economic front. Bottom Line: The market is already discounting North Korea. We may be wrong temporarily if the North ups the ante yet again, but we are very near the peak of the latest round of tensions. The North is running out of options short of instigating a fight it would lose, while China is enforcing sanctions more seriously (including fuel), and Washington has apparently opened direct talks with Pyongyang. We will maintain our portfolio hedge of Swiss bonds and gold, for now. We are also re-opening our long CBOE China ETF volatility index to account for potential rising political uncertainty surrounding the coming October Party Congress and possibly for further North Korea related risks. However, we are closing our short KRW / THB trade for a gain of 5.33%. Europe: More Red Herrings Brexit is no longer market-relevant. Its economic effect was fully priced in when Prime Minister Theresa May announced on January 17 that the U.K. would not seek membership in the Common Market. Since then, the pound has effectively bottomed against both the dollar and the euro, as we argued it would (Chart 15).13 This does not mean that investors should necessarily go long the pound. Rather, we are pointing out that the moves in the U.K. currency have ceased to be Brexit-related since we called its bottom in January. Going forward, investors should make bets on the pound based on macroeconomic fundamentals, not on the U.K.-EU negotiations. The one political risk to the pound going forward is the potential for the Labour Party, headed by opposition leader Jeremy Corbyn, to come to power in the U.K. in the near term. Corbyn is the most left-of-center leader of a developed world economy since French president François Mitterrand in 1981. And he symbolizes a leftward shift on economic policy by the median voter. Nevertheless, the risks to PM May are overstated, for now. A key test for the Prime Minister, the EU (Withdrawal) Bill, passed its first parliamentary hurdle in Westminster on September 12. No Conservatives rebelled, with seven Labour politicians defying Corbyn's instructions to vote against the bill. The bill still faces several days of amendments, but it largely gives May a free hand to negotiate with Europe going forward. Bremain-leaning Tory backbenchers could have posed problems for May had they decided to obstruct the bill. That they did not tells us that nobody wants to challenge May and that she will likely remain the prime minister until the eventual deal with the EU is reached. Our clients often balk at our dismissal of Brexit as an investment-relevant geopolitical event. However, the crucial question post-Brexit was whether any other EU member states would follow the U.K. out of the bloc. We answered this question in the negative, with high conviction, the day of the U.K. referendum.14 Not only did no country follow U.K.'s lead, but the effect of Brexit was in fact the exact opposite of the conventional wisdom, with a slew of defeats for populists around Europe following the referendum. For the U.K. economy and assets, the key two Brexit-related questions were whether the economy's service sector would have unfettered access to the European market via membership in the Common Market (Chart 16); and whether the labor market would have access to the European labor pool (Chart 17). Both questions were answered by May during her January 17 speech in the negative, which is why we continue to cite that moment as the date when U.K. assets fully priced in Brexit. Chart 15Is Brexit##br## Still Relevant? Is Brexit Still Relevant? Is Brexit Still Relevant? Chart 16U.K. Needs A Free Services Agreement##br## With The EU, Not An FTA! U.K. Needs A Free Services Agreement With The EU, Not An FTA! U.K. Needs A Free Services Agreement With The EU, Not An FTA! Chart 17Intra-EU Migration Boosts ##br##Labor Force Growth Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? What could change our forecast? We would need to see the negotiations with Europe become a lot more acrimonious. Disputes over the amount of the "exit bill" or the status of the Irish border simply do not count as acrimony. We need to see the threat of a "Brexit cliff" - where the EU-U.K. trade relationship reverts to "WTO rules" - emerge due to a conflict between the two powers. However, this is unlikely to happen as the EU greatly values its trade relationship with the U.K. And London's demand for an FTA actually plays to the EU's strengths, since FTAs normally privilege trade in goods (where Europe is competitive) relative to trade in services (where the U.K. has an advantage). Bear in mind, as well, that the U.K. and EU are negotiating an FTA from a starting point of a high degree of economic integration: this is not the equivalent of two separate economies pursuing an FTA for the first time. Similarly overstated as a risk is the upcoming Catalan independence referendum. As we argued this February, the referendum is a non-event.15 Catalans do not want independence, but rather a renegotiation of the region's relationship with Spain (Chart 18). And as we argued in our net assessment of the issue in 2014, a surge in internal migration since the Second World War has diluted the Catalan share of the total population.16 In fact, only 31% of the population identifies Catalan as their "first language," compared with 55% who identify with Spanish.17 Another 10% identify non-Iberian languages as their first language, suggesting that migrants will further dilute support for sovereignty, as they have done in other places (most recently: Quebec). Chart 18Catalans Do Not Want Independence Catalans Do Not Want Independence Catalans Do Not Want Independence We expect the turnout of the upcoming referendum to be low. Given that Madrid will not recognize it, the only way for the Catalan referendum to be relevant is if the nationalist government is willing to enforce sovereignty. What does that mean precisely? The globally recognized definition of sovereignty is the "monopoly of the legitimate use of physical force within a defined territory." To put it bluntly: the Catalan government has to be willing to take up arms in order for its referendum to be relevant to the markets. Without recognition from Spain, and with no support for independence from fellow EU and NATO peers, Catalonia cannot win independence at the ballot box. Bottom Line: Fade Brexit and Catalonia risks. Iraq: An Emergent Risk In 2014, we wrote the following about the future of Iraq:18 "Furthermore, the recent Kurdish occupation of Kirkuk - nominally to secure it from ISIS, in reality to (re)claim it for the Kurdish Regional Government (KRG) - will not be acceptable to Baghdad. In our conversations with clients, too much optimism exists over the stability of Kurdistan and its expected oil output. While we are broadly positive on the KRG, there are many challenges. First, three-quarters of Iraqi production is, in fact, located in the Southern part of the country, far from Iraqi Kurdistan. Second, Kirkuk and its associated geography has the potential to boost production, but the Kurds (and their ally Turkey) will eventually have to face-off against Baghdad (and its ally Iran) for control over this territory. Just because the KRG secured Kirkuk today does not mean that it will stay in their control in the future. We are fairly certain that once ISIS is defeated, Baghdad will ask for Kirkuk back." In 2016, we followed up again on the situation in Iraq by pointing out that a series of defeats for the Islamic State were raising the probability that a reckoning was coming between Baghdad and Iraqi Kurds.19 Now that the Islamic State threat is in the rear-view mirror, our forecast is coming to fruition. On September 25, Kurds in Iraq will hold an independence referendum. Opposition to the referendum is uniform across the region, with the U.S. - Kurds' strongest ally - requesting that it not take place. Why should investors care? First, there is the issue of oil production. There are no reliable figures regarding KRG production, but it is thought to be around 550,000 bpd, although KRG officials have themselves downplayed their production. This figure includes production from the Kurdish-controlled Bai Hassan and Avana fields in the Kirkuk province, which is not formally part of the KRG territory but which Kurds nominally control due to their 2014 anti-ISIS intervention. A conflict over Kurdish independence could impact this production, particularly if war breaks out over Kirkuk. However, the bigger risk to global oil supply is what it would do to future efforts to boost Iraqi production. Iraq is the last major oil play on the planet that can cheaply and easily, with 1920s technologies, access significant new production. If a major war breaks out in the country, it is difficult to see how Iraq would sustain the necessary FDI inflows to develop its fields to boost production, even if the majority of production is far from the Kurdish region. Given steady global oil demand, the world is counting on Iraq to fill the gap with cheap oil. If it cannot, higher oil prices will have to incentivize tight-oil and off-shore production. Second, there are problematic regional dynamics. There are about six million Kurds in Iraq, about 20% of the total population. The Kurdish Regional Government controls the northeast corner of Iraq, but fighting against the Islamic State has allowed the Kurds to extend their control further south and almost double their territory (Map 1). Turkey has largely supported the KRG over the years, as the ruling party in the autonomous province is relatively hostile to the Kurdistan Workers' Party (PKK), which Turkey considers a terrorist organization. However, Turkey is opposed to the independence of the KRG due to fears that it would start the ball rolling on the independence of Kurds in Syria and potentially one day in Turkey as well. Also opposed to KRG secession are Iran (Baghdad's closest ally) and Syria (which is dealing with its own Kurdish question). Map 1Kurdish Gains Threaten Conflicts With Iraqi Government ... And Turkey Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? On the other hand, the KRG does have international support. Russia just recently concluded a major oil deal with KRG, promising to buy Kurdish oil and refine it in Germany. Moscow will also invest US $3 billion in KRG territory. Russia also supplied the KRG Peshmerga - armed forces - with weapons during their fight against the Islamic State. From Russia's perspective, any conflict in the Middle East is a boon. It stalls investment in the region, curbs its oil production, and potentially adds a risk premium to oil prices. In addition, a close alliance with the KRG would allow Russia to gain another ally in the region. Bottom Line: While it is difficult to see how the independence referendum will play out in the short term, we have had a high-conviction view that Iraq's stability will not improve with the fall of the Islamic State. For investors, rising tensions in Iraq are significant because they could curb investment in the long term and potentially even impact production in the short term. Unlike the Islamic State, which never threatened oil production in the Middle East in any significant way, Iraq and the KRG are both oil producers. In fact, their main conflict is over an oil-producing region centered on Kirkuk. Tensions in the region support BCA Commodity & Energy Strategy's bullish view on oil prices.20 Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017; "North Korea: No Longer A Red Herring" in BCA Geopolitical Strategy Weekly Report, "Donald Trump Is Who We Thought He Was," dated March 8, 2017; and "North Korea: A Red Herring No More?" in BCA Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, available at gps.bcaresearch.com. 4 Please see BCA Global Fixed Income Strategy Weekly Report, "Have Bond Yields Peaked For The Cycle? No," dated September 12, 2017, available at gfis.bcaresearch.com. 5 BCA Global Fixed Income Strategy 10-year Treasury yield model only uses the global manufacturing PMI and sentiment towards the U.S. dollar as inputs. 6 Please see BCA Global Fixed Income Strategy Weekly Report, "The Global Duration 'Hot Potato' Shifts Back To The U.S.," dated August 8, 2017, available at gfis.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Weekly Report, "Is The 'Trump Put' Over?" dated August 23, 2017, available at gps.bcaresearch.com. 8 We use the Cook Political Report for their assessment of how U.S. electoral districts lean. Charlie Cook is Washington's foremost election handicapper with a long record of accomplishment. Anyone interested in closely following the U.S. midterm elections should consider his research, which is found on http://www.cookpolitical.com/ 9 Please see BCA Geopolitical Strategy Weekly Report, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," dated May 31, 2017, available at gps.bcaresearch.com. 10 Please see Joseph A. Pechman, "Tax Reform: Theory and Practice," The Journal of Economic Perspectives 1:1 (1987), pp. 11-28 (15). 11 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 12 Please see footnote 3 above. 13 The GBP/USD bottomed then and there. The GBP/EUR has recently hit a new low, for reasons other than Brexit. This bottom is only slightly below its previous lows in October 2016, when May confirmed that her government would seek to leave the EU in accordance with the referendum result, and in January 2017, when May admitted what the GBP/EUR had already reflected, that this meant leaving the Common Market. Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World," dated January 25, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, and Geopolitical Strategy Special Report, "The Coming EXITentialist Crisis," dated June 24, 2016, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 16 Please see Geopolitical Strategy and European Investment Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 2014, available at gps.bcaresearch.com. 17 Please see "Language Use of the Population of Catalonia," Generalitat de Catalunya Institut d'Estadustuca de Catalunya, dated 2013, available at web.gencat.cat 18 Please see BCA Geopolitical Strategy Special Report, "Middle East: Paradigm Shift (Update)," dated July 9, 2014, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 20 Please see BCA Commodity & Energy Strategy Weekly Report, "Hurricane Recovery Obscures OPEC 2.0's Forward Guidance," dated September 14, 2017, available at ces.bcaresearch.com.

Highlights EM EPS growth is set to decelerate significantly and will likely turn negative in 2018 based on the China/EM money/credit indicators. All measures of Chinese broad money growth have fallen to a record low signifying a major growth slump. The two pillars of the EM currency rally - strong growth in China that manifests in higher commodities prices and lower U.S. bond yields- are set to reverse. EM equities and credit markets relative performance versus their DM peers is about to relapse. A new fixed-income trade: receive 2-year swap rates in Mexico / pay 2-year swap rates in the U.S. Feature Last week we were on the road, meeting with some of our U.S. East Coast clients. This week we address some of the common questions we received. Q: Why do you think EM profits will relapse in the next six-to-nine months, given both global and EM growth continue to show strength? A: Our reluctance to change our view on EM risk assets in general and equities in particular has to do with EM/China business cycle/corporate profit indicators. Several indicators for EM profits - which have exhibited very good track records - presently forecast a material slowdown and possibly a contraction in EM EPS starting late this year and well into next year. In particular, China's broad and narrow money impulses lead EM EPS by about nine months, and are currently signaling that EPS growth is set to peak and begin to decline in the next nine months (Chart I-1). What's more, a few business cycle indicators from Korea and Taiwan, such as nominal manufacturing production and manufacturing shipments-to-inventory ratios, corroborate a peak in EM EPS growth (Chart I-2). Chart I-1EM EPS Is Set to Decelerate ##br##And Probably Contract EM EPS Is Set to Decelerate And Probably Contract EM EPS Is Set to Decelerate And Probably Contract Chart I-2More Signs Of Relapse##br## In EM EPS Growth More Signs Of Relapse In EM EPS Growth More Signs Of Relapse In EM EPS Growth Importantly, the EM corporate earnings slowdown will not occur in a vacuum. It will transpire amid a slowdown in Asian trade and lower commodities prices. In particular: China's broad money M3 impulse leads domestic industrial orders, nominal manufacturing production and imports (Chart I-3). Even though Asian export data were strong in August, China's container freight index signals a slowdown in Asian trade lies ahead (Chart I-4). Chart I-3China: M3 Impulse And Domestic Demand China: M3 Impulse And Domestic Demand China: M3 Impulse And Domestic Demand Chart I-4Asian Export Growth To Slow Asian Export Growth To Slow Asian Export Growth To Slow The Chinese broad money impulse also points to a rollover in Korean, Taiwanese, other EM as well as DM countries' shipments to the mainland (Chart I-5). This is how the slowdown in China's money/credit will hurt corporate profits in EM as well as in DM sectors with substantial exposure to Chinese growth. Besides, China's broad money impulse leads industrial metals prices in general and iron ore prices in particular (Chart I-6). This signifies downside risks to commodities producers. Finally, China's yield curve suggests that mainland manufacturing PMI will roll over after its recent ascent (Chart I-7). Chart I-5Shipments To China Are At Risk Shipments To China Are At Risk Shipments To China Are At Risk Chart I-6Industrial Metals Prices Have Peaked Industrial Metals Prices Have Peaked Industrial Metals Prices Have Peaked Chart I-7China: The Yield Curve And Manufacturing PMI China: The Yield Curve And Manufacturing PMI China: The Yield Curve And Manufacturing PMI In short, China has been gradually tightening monetary policy, which has already manifested in record-low broad money growth. The next phase is evidence of a material deterioration in sales and profits among China-exposed plays. The EM stock markets are unlikely to ignore it. Q: It seems you are putting a lot of emphasis on China's broad money M3 measure. Why do you look at your version of Chinese broad money M3 and not at official M2 and total social financing (TSF)? A: Over the past several months we have done a lot of research and analysis on China's money and credit, and believe that our broad money M3 measure and private and public credit aggregate calculated by BIS are presently better measures of money and credit than official broad money M2 and TSF: First, the TSF data have become distorted because of the local government financing vehicles (LGFV) debt swap program. Specifically, according to the LGFV debt swap mechanics, starting in 2015 provincial governments began issuing bonds that have been purchased by banks. The amount of bonds issued was RMB 3.2 trillion in 2015, RMB 4.9 trillion in 2016 and expected to be RMB 4.8 trillion in 2017. This amounts to total issuance of RMB 12.9 trillion since the commencement of the program. As the next step, local governments were supposed to transfer the proceeds from these bond issuances to their LGFVs, with the latter using the money to pay down their debt. The ultimate goal of the program is to shift the debt from LGFVs to provincial governments, as the latter's creditworthiness is much better than the former. This has also reduced interest rates on the debt as provincial governments borrow at lower interest rates than LGFVs. All that said, it is unclear how much of their debt LGFVs have repaid. The main problem with using TSF data is knowing the amount of proceeds from the issued debt swap bonds that were used to pay down LGFV debt. If the entire amount of these bonds issued by provincial governments was used to pay down LGFV debt, there would not be an impact on economic activity, and only a very short-term impact on money supply. When banks buy bonds from non-banks (including governments), they create new money. When debtors (including governments and their entities) pay down debt to banks, money is destroyed. Nevertheless, both official M1 growth and our measure of broad money (M3) were too strong in 2015 and 2016 – i.e., they remained strong much longer than would have been justified by the LGFV debt swap. Furthermore, private and public credit, M2 and M3 money measures have decoupled from TSF since the middle of 2015 (Chart I-8A). TSF adjusted for the LGFV debt swap – the latter is added to TSF – has also diverged from official M2, our broad money M3 and BIS’s private and public credit measures (Chart I-8B). This corroborates that TSF data can no longer serve as a reliable measure of credit/money origination. Chart I-8AChina: TSF Has Diverged From ##br##Other Money/Credit Measures China: TSF Has Diverged From Other Money/Credit Measures China: TSF Has Diverged From Other Money/Credit Measures Chart I-8BChina: TSF Adjusted For LGFV Debt Swap Has Also Decoupled From Money/Credit Measures China: TSF Adjusted for LGFV Debt Swap Has Also Decoupled From Other Money/Credit Measures China: TSF Adjusted for LGFV Debt Swap Has Also Decoupled From Other Money/Credit Measures Markedly, paying down debt by LGFVs should have reduced corporate debt outstanding by RMB 12.9 trillion, which would represent a 12% drop from the RMB 112 trillion outstanding at the end of 2015. However, corporate debt has continued to expand rapidly, even as government debt has surged. Given all of the above, we doubt all of the proceeds from bonds issued within the LGFV debt swap program were immediately used to repay LGFV debt. Instead, we suspect the proceeds from the bond issuance might have been at least partially invested into the economy in 2016, in defiance of the rules of LGFV debt swap operation. We played down the rise in M1 in late 2015 and early 2016 because we regarded it as temporary, reflecting the LGFV debt swap program. In retrospect, it was a mistake - this was one of the main reasons we did not heed the message from recovering money growth in early 2016 to turn cyclically positive on China's growth, and consequently on commodities and broader EM. Provided we do not know what portion of LGFV debt was repaid and when, corporate credit and total social financing data have become difficult to interpret. Chart I-8A and Chart I-8B demonstrate that TSF with and without the LGFV debt swap has diverged from private and public debt since the middle of 2015 when the LGFV debt swap program commenced. Apparently, one no longer can rely on TSF or adjust it by the amount of LGFV debt swap to gauge money and credit creation in China. In this context, the aggregate of private and public credit is a much more appropriate measure of credit provision and debt creation than TSF. The basis is because it includes both private and public debt. Indeed, the reshuffling of debt between local governments and LGFVs (the latter are treated as enterprises in China's banking statistics), does not affect either aggregate borrowing or amount of debt held in the economy. Second, when credit numbers are distorted, one needs to resort to money supply measures to judge credit dynamics. The reason is because financial engineering and, in the case of China, the LGFV debt swap program, can obscure the amount of outstanding credit, but they cannot conceal the amount of money banks create when they lend or purchase bonds or any other asset. Money is created when a bank originates claims on non-banks, and money is destroyed when a debt is paid back to the bank. Accordingly, money traces debt creation by banks. Banks can disguise their assets, and corporations and governments can conceal their liabilities, but none of them can camouflage the amount of money in circulation. In short, we trace money to gauge the amount of private and public sector borrowing from banks. This is why we have calculated various measures of money in China to overcome the shortcomings of the TSF. Specifically, we have calculated broad money M3 (see details of our calculation below) and credit-money. The latter is the sum of commercial banks' assets such as claims on non-financial institutions, claims on other financial institutions, claims on government and claim on other resident sectors and commerical banks' as well as the central bank's foreign currency assets. Chart I-9 demonstrates various measures of broad money and outstanding credit: official M2, our measure of broad money M3, our credit-money measure, and private and public debt (source BIS). Importantly, all measures of money and private and public credit suggest that credit origination/money creation was very strong in 2015 and 2016, and that it has slowed substantially in 2017. In brief, the message from various measures of money/credit is consistent. Chart I-9China: Money/Credit Growth Has Decelerated To New Lows China: Money/Credit Growth Has Decelerated To New Lows China: Money/Credit Growth Has Decelerated To New Lows Interestingly, broad money M3 rose by RMB 21 trillion in 2015, RMB 20 trillion in 2016 and by only RMB 16.5 trillion in the past 12 months through end of August. This is why the M3 impulse - a change in money flows - has turned negative since early this year. Third, we prefer our broad money measure M3 to official M2 because it is more consistent with the BIS's measure of private and public credit. It has also served as a better tool in forecasting the 2016-2017 recovery in Chinese growth. As can be seen in Chart 1, 3, 4, 5 and 6 on previous pages, the M3 impulse - its second derivative - has a great track record in forecasting China's business cycle dynamics. The acceleration in M2 growth in 2015-16 was milder than one would expect in order to achieve meaningful acceleration in nominal economic activity. M2 growth was more subdued than a rise in both private and public debt (Chart I-9). We suspect that M2 is no longer an encompassing measure of broad money in China, and therefore we have calculated other measures of broad money to gauge true money/credit creation. Chart I-10China: Consumer Price Inflation Is Rising China: Consumer Price Inflation Is Rising China: Consumer Price Inflation Is Rising Broad money consists of various liabilities of commercial banks. While the official M2 includes many of their liabilities such as corporate demand deposits, corporate time deposits and personal deposits. It does not include some others. We have added the following commercial banks' liabilities - transferable deposits and other deposits which are not included in M2, liabilities to other financial corporations and other liabilities - to M2 to produce a more all-inclusive measure of broad money M3. Q: Why can't the Chinese authorities stimulate and revive growth again, like they have done many times in the past? A: Of course, they can. However, if the authorities begin easing monetary/credit and fiscal policies now, it will affect growth six to nine months down the road. Based on money and credit indicators shown in the charts above, growth is set to slow over the next nine months because of the time lag that money/credit has on the economy. In the next six to nine months, economic activity and corporate profits are likely to decelerate considerably, based on the monetary/credit tightening that has already occurred in China. Provided China-related financial markets in general and EM risk assets in particular have so far not discounted the slowdown suggested by China's money/credit indicators, they are very vulnerable. Finally, the magnitude of the impending growth slump is likely to be large, as evidenced by the substantial decline in these money and credit indicators that has already occurred. In brief, policymakers have been tightening credit/money creation, and it has not yet impacted financial markets. Furthermore, inflation is rising in China (Chart I-10) and policymakers are unlikely to start easing before they witness a major growth slump. Until the latter becomes visible in economic data and on the ground, financial markets leveraged to mainland growth will sell off notably. Q: There is no indication that the Federal Reserve will turn hawkish. This will be especially true if global growth slows - as you argue it will because of China. Why do you expect the EM currency rally to peter out amid a dovish Fed? Historical empirical evidence suggests that EM currencies are often driven by commodities prices, not the interest rate differential over U.S. rates. Let's take the BRL and the ZAR as examples. Charts I-11A and Chart I-11B illustrate that the BRL and ZAR exchange rates versus the U.S. dollar have historically been closely correlated with commodities prices, not the level of or change in their interest rate differential over the U.S. Chart I-11ABrazil: What Drives The Currency? Brazil: What Drives The Currency? Brazil: What Drives The Currency? Chart I-11BSouth Africa: What Drives The Currency? South Africa: What Drives The Currency? South Africa: What Drives The Currency? This has also been true over the past 18 months. The rally in EM currencies since early 2016 can be largely attributed to the rise in commodities prices. As and when commodities prices roll over - as we expect to occur - the trade balances of commodities-producing nations will deteriorate, as will their currencies. Remarkably, there are tentative signs that the drop in U.S. bond yields and the greenback's depreciation are late and overdone. Two-year U.S. bond yields have bounced from their 200-day moving average (please refer to the middle panel of Chart II-1 in the Mexican section). Typically, such a technical profile leads to new highs. Our sense is that U.S. bond yields will rebound in the coming months, which will also weigh on EM currencies. Importantly, one of the drivers behind the U.S. dollar selloff since early this year has been the rise in banks' excess reserves at the Fed (Chart I-12). The latter was due to the debt ceiling, as the U.S. Treasury was running down its account at the Fed by issuing less paper. In short, since the beginning of this year the U.S. Treasury did not issue bonds/bills and deposit them at its Treasury General Account (TGA) at the Fed - meaning it was not destroying banking system reserves as it typically does. This boosted the supply of U.S. dollars - banks' excess reserves at the Fed rose by US$ 300 billion. More dollar supply depressed both the exchange rate and U.S. interest rates. Chart I-12 demonstrates that in the post-QE era, banks' excess reserves at the Fed have correlated with the U.S. dollar's exchange rate. The debt ceiling has been resolved for now, and the Treasury will now begin accumulating dollars in its TGA account again. It has already announced that its TGA will rise from $73 billion now to $400 billion at the end of this year. The Treasury will issue more paper, and deposit U.S. dollars in the TGA. This will shrink banks' excesses reserves. This, in tandem with the reduction in the Fed's balance sheet, will diminish banks' excess reserves. The latter will reduce U.S. dollar supply in off-shore markets and will likely trigger a U.S. dollar rebound. On the whole, the two pillars of the EM currency rally - strong growth in China that manifests in higher commodities prices and lower U.S. bond yields - are set to reverse. In turn, a potential EM currency selloff along with deteriorating EM corporate profits will likely weigh on EM equities and EM sovereign and corporate debt. Q: Does this mean EM stocks will relapse in absolute terms, or simply underperform the DM equity markets? Our strongest conviction at the moment is on EM relative equity performance versus DM equity markets. Odds are that a relapse in relative performance is imminent as and if U.S. bond yields rise (Chart I-13). Chart I-12U.S. Banks' Excess Reserves ##br##And The U.S. Dollar U.S. Banks' Excess Reserves And The U.S. Dollar U.S. Banks' Excess Reserves And The U.S. Dollar Chart I-13U.S. Stocks Outperform EM Ones When ##br##U.S. Bond Yields Are Rising U.S. Stocks Outperform EM Ones When U.S. Bond Yields Are Rising U.S. Stocks Outperform EM Ones When U.S. Bond Yields Are Rising In addition, U.S. stocks' underperformance versus the global equity index in common currency terms is at a technical support (Chart I-14, top panel), and will likely reverse as the dollar firms up. Historically, when U.S. stocks outperform the global benchmark in common currency terms - denoted by shaded periods in Chart I-14, EM stocks typically underperform the global equity index. The dynamics of EM equity absolute performance depends on investor's risk appetite. It will be hard for EM share prices to drop meaningfully as the DM rally persists. Global stocks are still trading well, and it is very difficult to pinpoint any trigger that will lead to a reversal. As our readers well know, we do not forecast triggers for the simple reason that the chances of getting it right are much lower than a coin toss. That said, in the medium term, the reason for a correction in DM stocks could well be EM/China growth, as it was in 2015. In such a scenario, EM risk assets will sell off first. As to timing, it is hard to find indicators that lead share prices, but aggregate EM narrow (M1) money growth has historically been coincident or leading with EM share prices - and it presently points to a considerable drop in EM equity prices (Chart I-15). This EM M1 aggregate is equity market-cap weighted making it relevant to investors. Chart I-14EM And U.S. Equites Typically Do Not Outperform Global Stocks Simultaneously EM And U.S. Equites Typically Do Not Outperform Global Stocks Simultaneously EM And U.S. Equites Typically Do Not Outperform Global Stocks Simultaneously Chart I-15EM M1 Growth And EM Share Prices EM M1 Growth And EM Share Prices EM M1 Growth And EM Share Prices Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com A New Trade: Receive Mexican / Pay U.S. 2-Year Swap Rates Mexico's 2-year bond yield has recently fallen through a technical support line while the U.S. 2-year bond yield has recently bounced off a major support level (Chart II-1). Our bias is that the 2-year yield in Mexico will fall relative to 2-year U.S. yield (Chart II-1, bottom panel). We recommend a new trade: receive 2-year swap rates in Mexico and pay U.S. 2-year swap rates. Historically, the domestic demand cycle in Mexico was synchronized with the business cycle in the U.S., mainly due to the fact these two economies are heavily integrated. However, the two economies have recently become desynchronized. This is evident by the fact that the Mexican export sector - which is leveraged to U.S. - is booming while the domestic demand in Mexico is slowing down (Chart II-2). Chart II-12-Year Bond Yields: Mexico And U.S. 2-Year Bond Yields: Mexico And U.S. 2-Year Bond Yields: Mexico And U.S. Chart II-2Divergence Within Mexican Economy Divergence Within Mexican Economy Divergence Within Mexican Economy The culprit behind this desynchronization is the previous collapse in the peso. Falling oil prices and excessive money/credit expansion in Mexico led to a major peso depreciation in 2014 and 2015. The election of Trump pushed it off the cliff in 2016. Inflation in Mexico spiked due to the massive currency depreciation. Consequently, the Mexican central bank has hiked interest rates by 400 basis points since the end of 2015. This, along with fiscal tightening, has choked domestic demand growth in Mexico. At this point, our bias is that the short-term interest rate differential between Mexico and the U.S. is unjustifiably wide and is about to narrow. Going forward, we expect inflation to fall in Mexico and interest rate expectations will at minimum not rise. Inflation in Mexico will roll over soon and moderate because of the following: A large part of the rise in inflation was caused by the depreciation in the peso. The peso's material appreciation this year will reduce the inflation rate (Chart II-3). Consumer spending and capital expenditure are set to continue slumping as the impact of higher interest rates continues filtering through the economy (Chart II-4, top and bottom panel). Chart II-3Mexico: Exchange Rate And Core Inflation Mexico: Exchange Rate And Core Inflation Mexico: Exchange Rate And Core Inflation Chart II-4Mexico: Domestic Demand To Disappoint Further Mexico: Domestic Demand To Disappoint Further Mexico: Domestic Demand To Disappoint Further Domestic vehicle sales are shrinking signifying no revival in interest rate-dependent sectors. Fiscal policy has been tightening and this will continue to be a headwind on economic growth (Chart II-5). Hence, despite flourishing exports to the U.S., very weak domestic demand will dampen inflation in Mexico. Finally, there were several one-off effects to inflation such as the gasoline subsidy removal that took place at the end of last year, and the minimum wage hike that was implemented at the beginning of the year. As the base effect of these fade, the inflation rate will moderate. In the U.S., our bias is that interest rate expectations are too low given the tight labor market, reasonably strong growth, and the U.S. dollar depreciation this year. Odds are that the U.S. interest rate expectations will rise as core inflation moves up (Chart II-6). Chart II-5Mexico: A Major Improvement In Fiscal Position Mexico: A Major Improvement In Fiscal Position Mexico: A Major Improvement In Fiscal Position Chart II-6U.S. Core Inflation To Rise U.S. Core Inflation To Rise U.S. Core Inflation To Rise Investment Recommendations We recommend fixed-income traders to receive Mexican / pay U.S. 2-year swap rates. The main risk to this trade lies in the event of an abrupt sell-off in the peso against the U.S dollar that could push up the 2-year swap rate differential. While we expect EM currencies, including the peso, to depreciate, this trade is still favorable in terms of risk-reward because of the starting point in interest rate differential and peso valuations: Despite the rally this year, the peso is still cheap (Chart II-7). Furthermore, its current account and fiscal balances have improved dramatically. So, the peso should depreciate less than many other EM currencies. Chart II-7The MXN Is Still Cheap The MXN Is Still Cheap The MXN Is Still Cheap In fact, the interest rate spread between Mexico and the U.S. is already historically high, and the peso depreciation might not push it much higher. We would not be recommending this trade if the peso was fairly or overvalued, or if interest rates in Mexico were not this high. Entering this position under these current circumstances reduces the downside risk and, therefore, makes the risk-reward attractive. As to Mexican financial markets in general, we remain constructive on the peso versus other EM currencies. More specifically, we continue to recommend long positions in MXN versus ZAR and BRL. Mexican local currency bonds and sovereign credit offer good value relative to their EM counterparts. Fixed income investors should continue to overweight Mexican local currency and sovereign credit within their respective EM benchmarks. Finally, the outlook for Mexican stocks in absolute terms is poor as domestic demand will slump, further hampering corporate profits. Within an EM equity portfolio we recommend neutral allocation to this bourse mainly due to our expectations of the peso outperforming other EM currencies. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Feature Valuations, whether for currencies, equities, or bonds, are always at the top of the list of the determinants of any asset's long-term performance. This means that after large FX moves like those experienced this year, it is always useful to pause and reflect on where currency valuations stand. In this context, this week we update our set of long-term valuation models for currencies that we introduced in February 2016 in a Special Report titled, "Assessing Fair Value In FX Markets". Included in these models are variables such as productivity differentials, terms-of-trade shocks, net international investment positions, real rate differentials and proxies for global risk aversion.1 The models cover 22 currencies, incorporating both G10 and EM FX markets. Twice a year, we provide clients with a comprehensive update on all of these long-term models in one stop. These models are not designed to generate short- or intermediate-term forecasts. Instead, they reflect the economic drivers of a currency's equilibrium. Their purpose is therefore threefold. First, they provide guideposts to judge whether we are at the end, beginning, or middle of a long-term currency cycle. Second, by providing strong directional signals, the models help us judge whether any given move is more likely be a countertrend development or not, offering insight on potential longevity. Finally, they assist us and our clients in cutting through the fog and understanding the key drivers of cyclical variations in a currency's value. The U.S. Dollar Chart 1The Dollar's Overvaluation Is Gone The Dollar's Overvaluation Is Gone The Dollar's Overvaluation Is Gone After its large 7.5% fall in trade-weighted terms since the end of 2016, the real effective dollar is now trading at a 2% discount vis-à-vis its fair value based on its principal long-term drivers - real yield differentials and relative productivity between the U.S. and its trading partners (Chart 1). The U.S. dollar's equilibrium - despite having been re-estimated higher earlier this year due to upward revisions by the Conference Board to its U.S. productivity series - has flattened as of late, as real rate differentials between the U.S. and the rest of the world have declined. While 2017 has been an execrable year for dollar bulls, glimmers of hope remain. First, the handicap created by expensive valuations has been purged. Second, the excessive bullishness toward the greenback that prevailed earlier this year has morphed into deep pessimism. Third, U.S. real interest rates have fallen as investor doubts that the Federal Reserve will be able to increase interest rates as much as it wants to in the face of paltry inflation have surged. However, the U.S. economy is strong and at full capacity, suggesting that inflation will hook back up at the end of 2017 and in the first half of 2018. This should once again lift the U.S. interest rate curve, the dollar's fair value, and the dollar itself. That being said, this story is unlikely to become fully relevant over the next three months. The Euro Chart 2The Euro's Fair Value Is Now Rising The Euro's Fair Value Is Now Rising The Euro's Fair Value Is Now Rising On a multi-year time horizon, the euro is driven by the relative productivity trend of the euro area with its trading partners, its net international investment position, terms-of-trade shocks and rate differentials. Thanks to its powerful rally this year, the euro's discount to its fair value has narrowed from 7% in February to 6% today (Chart 2). This narrowing is not as great as the rally in the trade-weighted euro itself as its fair value has also improved, mainly thanks to continued improvement in the euro area's net international position - a development driven by the euro zone's current account of 3% of GDP. Nonetheless, the EUR's current discount to fair value is still not in line with previous bottoms, such as those experienced in both early 1985 or in 2002. We do expect a new wave of weakness in the EUR to materialize toward the end of the year and in early 2018 as markets once again move to discount much more aggressive tightening by the Fed than what will be executed by the European Central Bank: U.S. inflation is set to move back towards the Fed's target, but European inflation will remain hampered by the large amount of labor market slack still prevalent in the European periphery. What's more, euro area inflation is about to suffer from the lagged effects of the tightening in financial conditions that have been created by a higher euro. However, the fact that the euro's fair value has increased implies it is now very unlikely for the EUR/USD to hit parity this cycle. The Yen Chart 3The Yen Is Very Cheap, But It May Not Count For Much The Yen Is Very Cheap, But It May Not Count For Much The Yen Is Very Cheap, But It May Not Count For Much The yen's long-term equilibrium is a function of Japan's net international investment position, global risk aversion, and commodity prices. The JPY discount to this fair value has deepened this year, despite the fall in USD/JPY from 118 to 108 (Chart 3). This is mainly because the euro and EM as well as commodity currencies have all appreciated against the Japanese currency. Low domestic inflation has been an additional factor that has depressed the Japanese real effective exchange rate. While valuations point to a higher yen in the coming year, this will be difficult to achieve. The Bank of Japan remains committed to boosting Japanese inflation expectations. To generate such a shock to expectations, the BoJ will have to keep policy at massively accommodative levels for an extended period. As global growth remains robust, global bond yields should experience some upside over the next 12 months. With JGB yields capped by the Japanese central bank, this will create downside for the yen. However, because the yen is so cheap, it is likely to occasionally rally furiously each time a risk-off event, such as any additional North Korean provocations, puts temporary downward pressure on global yields. The British Pound Chart 4The Pound Is Attractive On A Long-Term Basis The Pound Is Attractive On A Long-Term Basis The Pound Is Attractive On A Long-Term Basis The pound has fallen 6% against the euro this year, the currency of its largest trading partner. This has dragged down the GBP's real effective exchange rate to a large 11% discount to its fair value, the largest since the direct aftermath of the Brexit vote (Chart 4). Because Great Britain has entered a paradigm shift - the exit from the European Union will change the nature of the U.K. relationship on 43% of its trade - assessing where the pound's fair value lies is a more nebulous exercise than normal. However, signs are present that the pound is indeed cheap. British inflation remains perky, the current account has narrowed to 4% of GDP, and despite large regulatory uncertainty, net FDI into the U.K. has hit near record highs of 7% of GDP. Movements in cable are likely to remain a function of the gyrations in the U.S. dollar. However, at this level of valuation, the pound is attractive against the euro on a long-term basis. We had a target on EUR/GBP at 0.93, which was hit two weeks ago. This cross is likely to experience downside for the next 12 months. The biggest risk for the pound remains British politics - and not Brexit itself but its aftershock. The EU has made clear the transition process will be long, leaving time for the British economy to adjust. However, the conservative party has been greatly weakened, and Jeremy Corbyn's popularity is increasing. This raises the specter that, in the not-so-distant future, a Labour government could be formed. Under Corbyn's leadership, this would be the most left-of-center administration in any G10 country since François Mitterrand became French president in 1981. The early years of the Mitterrand presidency were marked by a sharp decline in the franc as he nationalized broad swaths of the French private sector, increased taxes and implemented inflationary policies. Keep this in mind. The Canadian Dollar Chart 5The CAD Has Lost Its Valuation Advantage The CAD Has Lost Its Valuation Advantage The CAD Has Lost Its Valuation Advantage The loonie's fair value is driven by commodity prices, relative productivity trends, and the Canadian net international position. In February, the CAD was trading in line with its fair value. However, after its blistering rally since May, when the Bank of Canada began to hint that policy could be tightened this year, the Canadian dollar is now expensive vis-à-vis its long-term fundamental drivers (Chart 5). In a Special Report two months ago, we argued that the BoC was one of the major global central banks best placed to increase interest rates.2 With the Canadian economy firing on all cylinders, and with the output gap closing faster than the BoC anticipated in its July Monetary Policy Statement, the two interest rate hikes recorded this year so far make sense, and another one is likely to materialize in December. However, while the CAD could continue to rise until then, traders have moved from being massively short the CAD to now holding very sizeable net long positions. Additionally, interest rate markets are now discounting more than two hikes in Canada over the next 12 months, while expecting less than one full hike in the U.S. over the same time frame. If this scenario were to pan out, the tightening in monetary conditions emanating from a massive CAD rally would likely choke the Canadian recovery. Instead, we expect U.S. rates to increase more than what is currently embedded in interest rate markets, thus limiting the downside in USD/CAD. We prefer to continue betting on a rising loonie over the next 12 months by buying it against the euro and the Australian dollar. The Australian Dollar Chart 6The AUD Is Very Expensive The AUD Is Very Expensive The AUD Is Very Expensive The fair value of the Aussie is driven by Australia's net international position and commodity prices. Even with the tailwind of stronger metal prices, the AUD's rallies have been beyond what fundamentals justify, leaving it at massively overvalued levels (Chart 6). This suggests the AUD is at great risk of poor performance over the next 24 months. Timing the beginning of this decline is trickier, and valuations offer limited insight. One of the key factors that has supported the AUD has been the large increase in fiscal and public infrastructure spending in China this year - a move by Beijing most likely designed to support the economy in preparation for the 19th National Congress of the Communist Party of China, where the new members of the Politburo are designated. As this event will soon move into the rearview mirror, China may abandon its aggressive support of the industrial and construction sectors - two key consumers of Australia's exports. The other tailwind behind the AUD has been the very supportive global liquidity backdrop. Global reserves growth has increased, dollar-based liquidity has expanded and generalized risk-taking in global financial markets has generated large inflows into EM and commodity plays.3 While U.S. inflation remains low and investors continue to price in a shy Fed, these conditions are likely to stay in place. However, a pick-up in U.S. inflation at the end of the year is likely to force a violent re-pricing of U.S. interest rates and drain much of the global excess liquidity, especially as the Fed will also be shrinking its balance sheet. This is likely to be when the AUD's stretched valuations become a binding constraint. The New Zealand Dollar Chart 7No More Premium In The NZD No More Premium In The NZD No More Premium In The NZD Natural resources prices, real rate differentials and the VIX are the key determinants of the kiwi's fair value, highlighting the NZD's nature as both a commodity currency and a carry currency. Both the fall in the VIX and the rebound in commodities prices are currently causing gradual appreciation in the New Zealand's dollar equilibrium exchange rate. However, despite these improving fundamentals, the real trade-weighted NZD has fallen this year, and now trades in line with its fair value (Chart 7). Explaining this performance, the NZD began 2017 at very expensive levels, even when compared to the already-pricey AUD. Also, despite a very strong New Zealand economy, the Reserve Bank Of New Zealand has disappointed investors by refraining from increasing interest rates, as the expensive currency has tightened monetary conditions on its behalf. Going forward, the recent weakness in the real effective NZD represents a considerable easing of policy, which could warrant higher rates in New Zealand. As a result, while a tightening of global liquidity conditions could hurt the NZD in addition to the AUD, the kiwi is likely to fare better than the much more expensive Aussie, pointing to an attractive shorting opportunity in AUD/NZD over the next 12 months. The Swiss Franc Chart 8The CHF Is Cheap, The SNB Is Happy The CHF Is Cheap, The SNB Is Happy The CHF Is Cheap, The SNB Is Happy Switzerland's enormous and growing net international investment position continues to be the most important factor lifting the fair value of the Swiss franc. The recent sharp rally in EUR/CHF has now pushed the Swissie into decisively cheap territory (Chart 8). The decline in political risk in the euro area along with the lagging economic and inflation performance of the Swiss economy fully justify the discount currently experienced by the Swiss franc: money has flown out of Switzerland, and the Swiss National Bank is doing its utmost to keep monetary policy as easy as it can. For a small open economy like Switzerland, this means keeping the exchange rate at very stimulative levels. The continued growth in the SNB's balance sheet is a testament to the strength of its will. For the time being, there is very little reason to bet against SNB policy; the CHF will remain cheap because the economy needs it. However, this peg contains the seeds of its own demise. The cheaper the CHF gets, the larger the economic distortions in the Swiss economy become. Already, Switzerland sports the most negative interest rates in the world. This directly reflects the large injections of liquidity required from the SNB to keep the CHF down. These low real rates are fueling bubble-like conditions in Switzerland real estate and are threatening the achievability of return targets for Swiss pension plans and insurance companies, forcing dangerous risk-taking. But until core inflation and wage growth can move and stabilize above 1%, these conditions will stay in place. The Swedish Krona Chart 9The Swedish Krona Has More Upside The Swedish Krona Has More Upside The Swedish Krona Has More Upside Even after its recent rebound, the Swedish krona continues to trade cheaply, even if its long-term fair value remains on a secular downward trajectory (Chart 9). Yet the undemanding valuations of the SEK hide a complex picture. It is approximately fairly valued against the GBP and expensive against the NOK, two of its largest trading partners. However, the SEK is cheap against the USD and the euro. We expect the SEK to continue appreciating. While Swedish PMIs have recently softened, the Swedish economy is running well above capacity, and the Riksbank resources utilization indicator suggests the recent surge in inflation has further to run. Moreover, Sweden is in the thralls of a dangerous real-estate bubble that has pushed nonfinancial private-sector debt above 228% of GDP. With many amortization periods on new mortgages now running above 100 years, the Swedish central bank is concerned that further inflating this bubble could result in a milder replay of the debt crisis experienced in the early 1990s. The shift in leadership at the Riksbank's helm at the beginning of 2018 is likely to be the key factor that prompts the beginning of the removal of policy accommodation in that country. We like buying the krona against the euro. The USD/SEK tends to be a high-beta play on the greenback, and thus is very much a call on the USD. However, EUR/SEK displays a much lower correlation, and thus tends to be a more effective medium to isolate the upcoming tightening in monetary policy we expect from the Riksbank. The Norwegian Krone Chart 10The NOK is The Cheapest Commodity Currency The NOK is The Cheapest Commodity Currency The NOK is The Cheapest Commodity Currency The Norwegian krone remains the cheapest commodity currency in the world, along with the Colombian peso (Chart 10). The slowdown in Norwegian inflation and a very negative output gap of 2% of GDP implies that the Norges Bank will remain one of the most accommodative central banks in the G10. Thus, the NOK should remain cheap. However, we continue to like buying the krone against the euro. EUR/NOK has only traded above current levels when Brent prices have been below US$40/bbl. Not only is Brent currently trading above US$50/bbl, but the outlook for oil remains bright: production is in control as the agreement between Russian and OPEC is still in place. Additionally, the recent carnage and refinery shutdowns caused by hurricane Harvey should result in large drawdowns to finished-products inventories in the coming months. This will contribute to an anticipated normalization in global excess petroleum inventories, which have been the most important headwind to oil prices. Finally, the fact that the Brent curve is now backwardated also represents a support for oil prices, as this creates a "positive carry" for oil investors. The Yuan Chart 11The Yuan Can Rise On A Trade-Weighed Basis The Yuan Can Rise On A Trade-Weighed Basis The Yuan Can Rise On A Trade-Weighed Basis Despite the recent strength in both the trade-weighted RMB and the yuan versus the U.S. dollar, the renminbi still trades at a discount to its long-term fair value (Chart 11). Confirming this insight, China continues to sport a sizeable current account surplus, and its share of global exports is still on an expanding path. With the RMB being cheap, now that China is once again accumulating reserves instead of spending them to create a floor under its currency, the downside risk to the CNY has decreased significantly. Thus, since the People's Bank of China targets a basket of currencies when setting the yuan's value, to legitimize any bullish view on USD/CNY one needs to have a bullish view on the USD. While we do anticipate the dollar to rally toward the end of the year, our expectation that it will remain flat until then implies that we do not see much upside for now to USD/CNY. However, our bullish medium-term USD view, along with the cheapness of the CNY, suggests that the RMB could continue to appreciate on a trade-weighted basis going forward. While Chinese policymakers have highlighted their desire to make their currency a more countercyclical tool, the recent stability in Chinese inflation implies there is no need to let the CNY depreciate to reflate China. In fact, at this point, elevated PPI readings would argue that the Chinese authorities do have a built-in incentive to let the CNY appreciate on a trade-weighted basis for the coming six to 12 months. The Brazilian Real Chart 12The BRL is Vulnerable To A Pullback In Global Liquidity The BRL is Vulnerable To A Pullback In Global Liquidity The BRL is Vulnerable To A Pullback In Global Liquidity Hampered by poor productivity trends, which weigh on the Brazilian current account balance, the fair value of the real remains quite depressed, even as commodity prices have sharply rebounded since early 2016. In fact, the violent rally in the BRL over the same timeframe has made it one of the most expensive currencies tracked by our models (Chart 12). This level of overvaluation points to poor returns for the BRL on a one-to-two-year basis, however, it gives no clue to timing. The strong sensitivity of the Brazilian real to EM asset prices implies that the BRL is unlikely to weaken significantly so long as EM bonds remain well-bid. Moreover, because the BRL still offers an elevated carry, until U.S. interest rate expectations turn the corner, U.S. market dynamics will continue to put a floor under the real. However, this combination suggests the BRL could become one of the prime casualties of any rebound in U.S. inflation. Such a development would cause global liquidity to fall, hurting EM bonds in the process and making the BRL's high-risk carry much less attractive. Confirming this danger, the fact that the USD/BRL has not been able to breakdown for more than a year despite the weakness in the USD suggests momentum under the BRL is rather weak. The Mexican Peso Chart 13Mexican Peso: From Bargain To Luxury Mexican Peso: From Bargain To Luxury Mexican Peso: From Bargain To Luxury In the direct aftermath of Trump's electoral victory, the Mexican peso quickly became one of the cheapest currencies in the world. However, the peso's 25% rally versus the U.S. dollar since January has eradicated this valuation advantage to the point where it is now one of the most expensive major currencies in the world (Chart 13). As the peso was collapsing through 2016, the Mexican central bank fought back, increasing interest rates. The massive surge in the prime lending rate points to a protracted period of weakness in the growth of nonfinancial private credit, which should weigh on consumption and investment. Actually, the growth in retail sales volumes has already begun to weaken. This could force the Banxico to cut rates, especially as inflation will slow in the face of peso's rebound this year. Lower Mexican rates, in the face of stretched long positioning in MXN by speculators, could be the key to generating a weakening in the peso over the next 12 months. To see real fireworks in the peso, one would need to see a resumption in the U.S. dollar bull market. Mexico has external debt equivalent to 66% of GDP, the highest among large EM nations. This makes the Mexican economy especially vulnerable to a strong dollar, as such a move would imply a massive increase in debt servicing costs. Thus, while the MXN may not be as vulnerable as the BRL, it could still suffer greatly if global liquidity becomes less generous next year. The Chilean Peso Chart 14CLP Needs HIgh Copper Prices CLP Needs HIgh Copper Prices CLP Needs HIgh Copper Prices The Chilean peso real effective exchange rate is driven by the country's productivity trend relative to its trading partners and the real price of copper - which proxies Chilean terms-of-trade. Thanks to the CLP's rally since the winter of 2015, the real peso is at a four-year high and is now in expensive territory (Chart 14). We expect copper to see downside from now until the end of the year, pulling down the CLP with it. Current dynamics in the Chinese real estate market and the Chinese credit cycle, which tend to be leading indicators of industrial metals prices, point to an upcoming selloff. Moreover, Chinese monetary conditions have begun to tighten, and are set to continue doing so. This will weigh on Chinese credit growth and capex, creating headwinds for copper and the peso. That being said, the CLP will likely outperform the BRL and the ZAR. M1 money growth is back in positive territory after contracting last year, while industrial activity seems to have hit a bottom and is now picking up. Moreover, since Chile's economy does not have the credit excesses of its other EM peers, we expect the CLP to show more resilience than other currencies linked to industrial metals. The Colombian Peso Chart 15COP: A Rare Bargain Among EM COP: A Rare Bargain Among EM COP: A Rare Bargain Among EM The real COP's fair value is driven by Colombia's relative productivity trends and the price of oil, the country's main export. The fall in oil prices since the beginning of the year have caused a small decline in the fair value of the COP. Nevertheless, the peso is still one standard deviation below fair value (Chart 15). This partly reflects the premium demanded by investors to compensate for Colombia's large current account deficit of 6.3% of GDP. Overall the COP looks attractive, particularly against other commodity currencies. Historically a discount of 20% or more, like what the peso has today, marks a bottom in the real effective exchange rate. Furthermore, our Commodity and Energy Strategy Service expects Brent prices to climb to US$60/bbl towards the end of year, as OPEC's and Russia's production controls translate into oil inventory drawdowns. This should further increase the value of the COP against the ZAR and the BRL. Domestic dynamics also point to outperformance of the peso against other EM currencies. As opposed to countries like Brazil, where private debt stands at nearly 85% of GDP, Colombia has a more modest 60% leverage ratio - the byproduct of an orthodox banking system. Thus, the peso should be able to withstand a liquidity drawdown in EM better than its peers. The South African Rand Chart 16Lack Of Productivity And Politics Are The Greatest Risk To The Rand Lack Of Productivity And Politics Are The Greatest Risk To The Rand Lack Of Productivity And Politics Are The Greatest Risk To The Rand South Africa's dismal productivity trend continues to be the greatest factor pulling the rand's long-term fair value lower. Due to this adverse trend, while the ZAR has been broadly stable this year, it is now slightly more expensive than it was in February (Chart 16). Not captured by the model, the political risks in South Africa remain elevated, creating a further handicap for the rand. The story behind the ZAR is very similar to the one underpinning the gyrations in the BRL. Both currencies, thanks to their elevated carries and deep liquidity - at least by EM currency standards - will continue to be buoyed by very generous global liquidity conditions. However, global real rates seem dangerously low and could move sharply higher, especially when U.S. inflation picks up at the end of the year and in early 2018. Such a move would cause the currently very supportive reflationary conditions to dissipate. This would put the expensive ZAR in a very precarious position. An additional danger for the ZAR is the price of gold. Gold and precious metals have also benefited from these generous global liquidity conditions. This has helped the South African terms of trade. However, gold is likely to be a key victim if U.S. interest rates rise because it is negatively correlated with both real interest rates and the U.S. dollar. Thus, while we do not see much upside for the expensive ZAR for the time being, it is likely to suffer greatly once U.S. inflation turns around, suggesting the ZAR possesses a very poor risk/reward ratio. The Russian Ruble Chart 17The Ruble Is Expensive But Russia Has The Best EM Fundamentals The Ruble Is Expensive But Russia Has The Best EM Fundamentals The Ruble Is Expensive But Russia Has The Best EM Fundamentals The RUB is currently trading at a very large premium to fair value (Chart 17). The risk created by such an overvaluation is only likely to materialize once U.S. inflation turns the corner and U.S. interest rates pick up - a scenario we've mentioned for late 2017 and early 2018. This risk is most pronounced against DM currencies, the U.S. dollar in particular. The RUB remains one of our favorite currencies within the EM space, especially when compared to other EM commodity producers. The Russian central bank is pursuing very orthodox policy, despite the fall in realized inflation, and is maintaining very elevated real interest rates in order to fully tame inflation expectations. Moreover, oil prices are likely to experience upside in the coming months as oil inventories are drawn down. This could result in an increase in the ruble's equilibrium exchange rate, which would help correct some of the RUB's overvaluation. The Korean Won Chart 18KRW Is Where You Can Really See The North Korean Tensions KRW Is Where You Can Really See The North Korean Tensions KRW Is Where You Can Really See The North Korean Tensions The fair value of the Korean won continues to be lifted by the combined effect of lower Asian bond spreads and Korea's current account surplus. Yet, the KRW is trading at an increasingly large discount to its equilibrium (Chart 18). At first glance, this seems highly surprising as global trade is growing at its fastest pace in six years - a situation that always benefits trading nations like South Korea. Instead, political developments are to blame. Not only is North Korea ramping up its tests of intercontinental ballistic missiles and nuclear devices, but also Seoul is within range of Pyongyang's conventional artillery. BCA's Geopolitical Strategy service does not expect the current standoff to result in military conflict. Ultimately, North Korea is no match for the military might of the U.S. and its allies. Moreover, the capacity for Pyongyang's actions to shock financial markets is exhibiting diminishing returns. This suggests the risk premium imbedded in the won should dissipate. However, the won will remain very exposed to dynamics in the USD, global liquidity and global trade. Instead, a lower-risk way for investors to take advantage of the KRW's cheapness is to buy it against the Singapore dollar. While just as exposed to global liquidity as the won, the SGD is currently trading at a premium to fair value. The Philippine Peso Chart 19The PHP Has Over-Discounted The Fall In The Current Account The PHP Has Over-Discounted The Fall In The Current Account The PHP Has Over-Discounted The Fall In The Current Account The fair value of the Philippine peso is driven by the country's net international investment position and commodity prices. After falling 6% this year, the real effective PHP now trades at a 13% discount to its fair value (Chart 19). A deteriorating current account, which is now in deficit, has fueled a selloff in the peso, making the Philippine currency one of the worst performing in the EM space. Worryingly, this has occurred alongside faltering foreign exchange reserves. However, the deficit is mainly the mirror image of large capital inflows, fueled by the government's ambitious infrastructure spending. Remittances are growing again and, with a weaker peso, will support consumer spending going forward. Employment had a setback last year, but is growing again. Higher investment and consumer spending will likely push rates up. As inflation rebounded alongside commodity prices last year, it is now at its 3% target. Bangko Sentral ng Pilipinas will need to rein in inflationary pressures to avoid overheating the economy. While the Philippines economy should expand further, the 'Duterte Discount' remains in place. Negative net portfolio flows reflect negative investor sentiment, as policy uncertainty remains elevated. The Singapore Dollar Chart 20SGD Remains Expensive SGD Remains Expensive SGD Remains Expensive The fair value of the Singapore dollar is driven by commodity prices. This is because the exchange rate is the main policy tool used by the Monetary Authority of Singapore. As a result, when commodity prices rise, which leads to inflationary pressures, MAS tightens policy by spurring appreciation in the SGD. The opposite holds true when commodity prices weaken. Based on this metric, the SGD is currently 4.2% overvalued (Chart 20). Domestically, dynamics are quite mixed. Retail sales have picked up. However, both manufacturing and construction employment are contracting and labor market slack is increasing, pointing to continued subdued wage growth. Additionally, property prices are contracting and vacancy rates are on the rise, led by the commercial property sector. Thus, the recent pickup in inflation could soon vanish, especially as it has been driven by the rebound in oil prices in 2016. This combination suggests that Singapore still needs easy monetary conditions. USD/SGD closely follows the DXY. While the Fed will be able to increase interest rates by more than the 35 basis points priced over the next 24 months, Singapore still needs a lower exchange rate to maintain competitiveness and alleviate deflationary pressures. The Hong Kong Dollar Chart 21The Fall In The USD Has Helped The HKD The Fall In The USD Has Helped The HKD The Fall In The USD Has Helped The HKD The HKD remains quite expensive. However, being pegged to the USD, its valuation premium has decreased this year (Chart 21). The fall in the greenback has driven the HKD - which itself has fallen 0.75% versus the U.S. dollar - lower against the CNY and other EM currencies. If the U.S. dollar does resume its uptrend over the next six months, the valuation improvement in the HKD will once again dissipate. However, this does not spell the end of the HKD peg. With reserves of US$414 billion, or 125% of GDP, the Hong Kong Monetary Authority has the firepower to support the peg, which has been one of the cornerstones of Hong Kong economic stability since 1983. Instead, the HKMA will tolerate deep deflationary pressures that will cause a fall in the real effective exchange rate. This is the path that Hong Kong picked in the 1990s, and it will be the path followed again in the face of any broad-based USD appreciation. This suggests that Hong Kong real estate prices could experience significant downside in the coming years. The Saudi Riyal Chart 22The Riyal Is Still Expensive The Riyal Is Still Expensive The Riyal Is Still Expensive The Saudi riyal remains prohibitively expensive, even as its valuation premium has decreased this year (Chart 22). The SAR is afflicted by similar dynamics as the HKD: its peg with the USD means the greenback's gyrations are the main source of variation in the SAR's real effective exchange rate on a cyclical basis. However, on a structural horizon, the fair value of the riyal is dominated by Saudi Arabia's poor productivity. An economy dominated by crude extraction and processing and living on one of the most sizable economic rents in the world, Saudi Arabia has not endured the competitive pressures that are often the source of productivity enhancement in most nations. Additionally, Saudi capital expenditures are heavily skewed to the oil sector, a sector whose output growth has been limited for many decades by natural constraints. We do not believe the current valuation premium in the riyal will force the Saudi Arabian Monetary Authority to devalue the SAR versus the USD. Saudi Arabia, like Hong Kong, possesses copious foreign exchange reserves, and growth has improved now that oil prices have rebounded. Additionally, the KSA is also likely to tolerate deflationary pressures. Not only has it done so in the past, but Saudi Arabia imports most of its household products, especially its food needs. A fall in the SAR would cause a large amount of food inflation, representing a massively negative price shock for a very young population. This is a recipe for disaster for the royal family of a country with no democratic outlet. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant haarisa@bcaresearch.com Juan Manuel Correa, Research Analyst juanc@bcaresearch.com 1 For a more detailed discussion of the various variables incorporated in the models, please see Foreign Exchange Strategy Special Report, "Assessing Fair Value In FX Markets", dated February 26, 2016, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy and Global Alpha Sector Strategy Special Report, "Who Hikes Next?", dated June 30, 2017, available at fes.bcaresearch.com 3 For a more detailed discussion on the global liquidity environment, please Foreign Exchange Strategy Weekly Report, "Dollar-Bloc Currencies: More Than Just China", dated August 18, 2017, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

Dear Client, We are sending you a Special Report prepared by my colleague Matt Gertken, associate vice president of our Geopolitical Strategy team. This report focuses on the upcoming 19th Party congress and discusses its implications on China’s economic and political outlook, as well as its impact on financial markets. I trust you will find this report insightful. Best regards, Yan Wang, Senior Vice President China Investment Strategy Highlights The Communist Party will hold its nineteenth National Congress on Oct. 18. This is the "midterm election" for President Xi Jinping, whose political capital will be replenished; Recent Chinese leaders have a greater impact in their second term than their first; Base case: Xi consolidates power while preserving a balance on the Politburo Standing Committee; Stay long Chinese equities versus emerging market peers. Feature China's Communist Party will hold the nineteenth National Party Congress on October 18-25. This is a critical "midterm" leadership reshuffle that will also mark the halfway point of General Secretary Xi Jinping's term in office. Investors around the world will watch closely to see what insight can be gained about the political trajectory of the world's second-largest economy. This report serves as a "primer" for readers to understand the party congress and its investment takeaways. Why Is The Party Congress Important? Because it rotates China's political leaders! Chart 1So Long To The 18th Central Committee China's Nineteenth Party Congress: A Primer China's Nineteenth Party Congress: A Primer In a political system without popular representation, the rotation of personnel according to promotion and retirement is the only way to rejuvenate the policy process. The average rate of turnover on the Communist Party's Central Committee at each five-year congress has been 62%, which is a remarkably high rate (Chart 1). It reveals an underrated dynamism in Chinese politics. This leadership rotation also allows the top leader (Xi Jinping) to consolidate power by putting his supporters into key positions. This in turn alters the policymaking environment and the way in which China formulates policies and responds to external events. China has a "parallel" political system in which the ruling Communist Party operates alongside (and above) the state. Xi Jinping is "General Secretary" of the party, president of the People's Republic of China, and (not least) chairman of the Central Military Commission. The party maintains supremacy by independently controlling the state and the army. Since fall 2016, Xi has been dubbed the "core" of the Communist Party, putting him on a par with previous core leaders Mao Zedong, Deng Xiaoping and Jiang Zemin.1 The party's nearly 90 million members convene large congresses of about 2,000 members every five years to select the membership of the key decision-making bodies (Diagram 1), a practice known as "intra-party democracy."2 The key body is the Central Committee, which consists of about 200 full members and another 100-some alternative members. The Central Committee then "elects" the General Secretary, Political Bureau (a.k.a. "Politburo," the top 25 or so leaders) and Politburo Standing Committee (the "PSC," the top five-to-nine leaders) - though in reality the Politburo and the PSC are chosen through intense negotiations among the incumbent PSC and former leaders. Diagram 1National Party Congress Of The Communist Party Of China China's Nineteenth Party Congress: A Primer China's Nineteenth Party Congress: A Primer The handful of men on the PSC are the chief decision-makers in China, often in league with the broader Politburo (and former PSC members who exercise some power through the back door). Most of the key personnel decisions will have been made before the Central Committee votes.3 Hence the current top leaders have a chance to put their loyalists and supporters in key positions, potentially improving the implementation of their agenda. The outgoing eighteenth Central Committee will meet for its last session on October 11, and then the nineteenth party congress will meet on October 18 to elect a new Central Committee. It will in turn ratify the new Politburo and PSC. At the beginning of the party congress, Xi Jinping will deliver a keynote political report on the state of the party and nation, reviewing the progress of the past five years and mapping out a vision for the next five. The party congress will also amend the Communist Party constitution.4 By the end of the week, the members of the new PSC will step out to meet the press together for the first time. Only later will the party's key decisions be incorporated by the state, i.e. China's central government, including key personnel appointments and policy initiatives. This will occur when the legislature, the National People's Congress ("NPC," not to be confused with party congress), convenes at its annual "Two Sessions" in early March 2018. Chart 2Bold Action Can Follow Midterm Congresses China's Nineteenth Party Congress: A Primer China's Nineteenth Party Congress: A Primer Any NPC session following a five-year party congress carries more weight than usual not only because it approves of the party congress's leadership decisions but also because it kicks off major new policy initiatives. For instance, Premier Zhu Rongji was appointed to launch the "assault stage" of President Jiang Zemin's reforms of state-owned enterprise at the NPC in March 1998 (Chart 2). Similarly, Hu Jintao's Premier Wen Jiabao launched extensive administrative reforms at the NPC meeting in early 2008.5 How does a "midterm" party congress differ from others? Typically, in even-numbered years, the top two leaders change over, as with Xi Jinping and Premier Li Keqiang in 2012. These transitions are highly significant as they mark a leadership succession, a transfer of power to a new general secretary in a heavily centralized, authoritarian system that does not have a codified succession process. By contrast, in odd-numbered years like 2017, the Communist Party promotes, demotes, and retires a large number of other top leaders. Thus Xi Jinping's place is assured, and Li Keqiang's place is probably assured as well, but most likely the other five members of the PSC will be gone.6 This year's transition is also significant because the total turnover on the Central Committee is expected to be higher than usual (perhaps 70%) as a result of President Xi's aggressive anti-corruption campaign and other factors (see Chart 1 above).7 Leaders often spend the bulk of their first five years consolidating power and the second five years pushing forward their true policy agenda. Even President Hu Jintao, who failed to see his preferred social safety-net policies fully implemented, had a vastly more influential second term than first term in office: the 2007-12 period saw the 4 trillion RMB stimulus package to thwart the Global Recession. Moreover, Chinese leaders do not normally become "lame ducks" toward the end of their last term: Deng Xiaoping recommitted the country to pro-market reforms in 1992, after having stepped down as general secretary, while Jiang Zemin reached the height of his power at the end of his term in 2002, when he chose to hang onto the position of top military leader for two extra years. Many observers suspect that Xi Jinping will hold onto power beyond 2022. Bottom Line: The National Party Congress coincides with a sweeping rotation of the Chinese political elites, which is a critical way of ensuring that China, unlike a monarchy or personalized "dictatorship," has an orderly way of updating its policy-makers and (hopefully) policies. Midterm reshuffles allow top leaders to promote supporters and re-energize the implementation of their policy agenda. The past two Chinese leaders were more consequential in their second term than their first. How Is The Nineteenth Congress Unique? Chart 3Xi Jinping's Generation Taking Command China's Nineteenth Party Congress: A Primer China's Nineteenth Party Congress: A Primer The most important change this year is the passing of a generation.8 China's political elites are classified into "leadership generations," with Mao Zedong symbolizing the first generation, Deng Xiaoping the second, Jiang Zemin the third, Hu Jintao the fourth, and Xi Jinping the fifth generation. The current reshuffle will see the following generational trends: The End of the Jiang Zemin Era: The key figures retiring on the PSC are those who were born before 1950 and put in place by Jiang Zemin. Thus in a very real sense, Jiang Zemin's influence is coming to a close (Chart 3).9 This generational shift is likely to force the retirement of 11 of the 25-member Politburo, and five of the seven PSC members (Table 1), as well as other major figures, such as the long-serving central bank Governor Zhou Xiaochuan. Table 1Chinese Leaders Set To Retire On Politburo And Politburo Standing Committee China's Nineteenth Party Congress: A Primer China's Nineteenth Party Congress: A Primer Jiang-era leaders are defined by certain characteristics that are now fading. As Chart 4 demonstrates, these leaders came of age in the early, idealistic days of the Revolution, leading them to have a conservative streak in ideological matters. Yet they are well-known pragmatists in economic matters. They studied engineering and natural sciences in answer to the call for the young to develop the country's heavy industry. They tended to hail from capitalist-leaning coastal provinces, and often gained first-hand experience operating China's state-owned enterprises. This last point became especially important when they pioneered pro-market corporate reforms in the 1990s. By contrast, fewer of them served as government ministers on the State Council (China's cabinet) than subsequent generations. Chart 4Leadership Characteristics Of The Politburo Standing Committee China's Nineteenth Party Congress: A Primer China's Nineteenth Party Congress: A Primer The Middle of the Hu Jintao Era: The passing of Jiang's cohort will necessarily give his successor Hu Jintao's cohort a boost in relative influence at the top levels. Hu's generation is marked by leaders who studied the "soft sciences" (like law and economics). Several of them (including Hu and Premier Wen Jiabao) have links with the politically liberal wing of the party. They have far less experience in the military or state-owned business, but are more likely to have governing experience in the central government and especially the provinces (Chart 4 above). This includes the interior provinces from which they often hail. They are thus highly attuned to the problem of maintaining social stability, arguably to the neglect of economic dynamism. Hu Jintao's influence may be underrated. Xi's administration has shown important continuities with Hu's, and Hu's followers are well positioned in the Central Committee, the Politburo, and the provincial governments (though not the current PSC). If Xi does not take decisive moves to replace some of Hu's acolytes on the PSC at the coming party congress, then Hu's men will likely outnumber Xi's on the PSC as they graduate up the ladder from the Politburo.10 A strong showing by Hu's faction could affect China's policy priorities, given that Xi showed different preferences from Hu in the first few years of his rule (Table 2). However, the factions do not maintain consistent policy platforms. The bottom line is that Hu's faction could act as more or less of a constraint on Xi regardless of what policies the latter pursues. Table 2Fiscal Priorities Of Recent Chinese Presidents China's Nineteenth Party Congress: A Primer China's Nineteenth Party Congress: A Primer The True Beginning of the Xi Jinping Era: Xi's generation has yet to reveal its full character - the demographics of the new Central Committee will help determine it. So far it is a continuation of the trends above: more likely than not to come from interior than coastal provinces, to have studied the humanities, to have governed in the provinces or central ministries, and to lack military or business experience (Chart 4 above). The coming reshuffle could initiate a change in some of these trends, given some of Xi's revealed preferences, but that will not become clear until this fall.11 Xi is not stereotypical when it comes to China's political cycles: he consolidated power rapidly in his first term.12 The question, then, is whether Xi can continue to accrue power at the party congress, or whether his second term will become complicated by an infusion of Hu Jintao supporters into top party posts. Thus the success of Hu's supporters (particularly on the PSC) is the critical moving part that could determine the political constraints on Xi Jinping from 2017-22. Will Xi be able to arrange a favorable power-sharing agreement? Or will he go further and try to remove this political constraint entirely, even at the risk of political instability? The above points raise two critical questions: Will Chinese politics become more institutionalized? Investors should expect China to maintain a stridently informal political system. Rules and norms can and will be bent, but key principles will be upheld. In other words, the goal posts can be moved, but not too far. Going beyond certain limits would be destabilizing for China's political, institutional, and factional balances, and so far Xi has exhibited poise and the desire to maintain stability that is characteristic of post-1978 Chinese leaders.13 We think there is a low probability that Xi will overthrow all the norms of leadership selection and overturn the balance of power on the Politburo and PSC. If he does, it will raise alarms that he is setting up a new "cult of personality" like Mao, which could cause domestic economic and market instability. Rather, we expect him to modify the rules to maintain control of the PSC without excluding Hu Jintao's faction from power. Will Xi initiate the succession process for 2022? Some commentators suspect that Xi will use the party congress to pave the way for him to cling to power beyond 2022. Clearly Xi could retain the top military post and stay within recent precedent. But any hints at altering recent succession patterns, despite the fact that they are informal, are dangerous for investors in the long run because they raise deep uncertainty about the range of possibilities and political conflicts that could occur upon the actual change of power in 2022. Nevertheless, bear in mind the following points: The question of succession will not be resolved this October. If Xi plans to hang on beyond 2022, then he will continue amassing power and positioning loyalists over the next five years so that he will have full institutional support at the critical moment in 2022 - like Jiang Zemin did when he chose to hang onto the military chairmanship from 2002-04. Thus while Xi may lay some groundwork that makes political observers uneasy, the question will not be resolved either way this fall. Xi's tenure will be an ongoing topic for investors to monitor. Xi is already set to be the most powerful Chinese leader well into the 2020s. Xi's anti-corruption campaign is remarkable evidence of his strength as a ruler. Significantly, this campaign has focused on rooting out Jiang Zemin's influence. Yet Jiang stepped down way back in 2004! In other words, Jiang wielded massive influence between 2004 and 2017. Indeed, Xi's boldest move this year so far was to remove Sun Zhengcai, a Jiang acolyte. It stands to reason that, even if Hu Jintao's faction pulls off a relative victory this year, Xi Jinping's faction will likely be well positioned for a victory in 2022. And if Hu loses out this year, Xi's followers will be better positioned in 2027, as well as 2022. In short, market participants are unlikely to be able to tell the difference this October between (1) Xi getting a boost of political capital for his second term and (2) Xi getting such a big boost that he is on track to overstay his second term.14 Xi might intend to become a dictator and cling to power for longer, but all the market will know for certain is that he has maintained control of the PSC and his general policy framework will be more or less continuous, which is likely a relief in the near term. Finally, investors may not initially care if Xi seizes additional power at the expense of party norms and the succession process. A-shares sold off, but H-shares rallied, when Jiang Zemin decided not to step down entirely in 2002 (Chart 5). Russian stocks and the RUB/USD only fleetingly sold off when Vladimir Putin made clear his intention to return to the presidency yet again in 2011 (Chart 6). Chart 5Foreign Investors Cheered Jiang's Clinging To Power Foreign Investors Cheered Jiang's Clinging To Power Foreign Investors Cheered Jiang's Clinging To Power Chart 6Russian Investors Cheered Putin's Second Presidency Russian Investors Cheered Putin's Second Presidency Russian Investors Cheered Putin's Second Presidency While it is impossible to know whether markets will cheer any signs of "Papa Xi" doing away with term limits, it is bad for China's governance in the long run if Xi does not clearly begin grooming a successor with this fall's promotions. An heir-apparent for 2022 would reduce the risks of disruptive power-struggle and would impose a personal deadline on Xi Jinping's reform agenda. That is, a deadline above and beyond the 2020 deadline in the 13th Five Year Plan and the 2021 deadline for the 100th anniversary of the Communist Party's founding. That reform agenda, in turn, is essential for improving China's long-term productivity.15 Bottom Line: The Chinese political system is informal, which means that rules and norms can be bent without altering the underlying principles of balance among the key factions and stability of the regime and society as a whole. Our baseline scenario is a market-positive one: that Xi Jinping will win a victory at the party congress, but that he will not overthrow Hu Jintao's followers and abandon the "collective leadership" model, since that would destroy the overall balance of power and heighten domestic political risks. If Xi loses out to the Hu faction, then we would expect Chinese and China-exposed risk assets to sell off, at least initially. If Xi romps to total victory, excluding Hu's clique from power, we would fade any market rally. Such a development would heighten political risks for the foreseeable future. Investment Conclusions The prospect of a Xi-dominated, yet stable, PSC in China is promising because it suggests that China will have at least a marginally improved policy framework for managing the immense challenges it faces. On the economic front, the loss of the demographic dividend threatens to make China old before it gets rich (Chart 7). Xi will need a unified party, as well as loyal supporters in key posts, if he is to re-energize his productivity-enhancing reforms. On the socio-political front, China's intensifying focus on domestic security is symbolized by draconian media censorship ahead of the party congress and, more broadly, a faster rate of spending on public security than national defense in recent years (Chart 8). Such trends suggest that policy makers are concerned about public support. Income inequality and regional disparities are burning issues in an authoritarian country with a larger and more connected middle class and an incipient civil rights movement. Chart 7Rising Participation Boosted Euro Area Labor Force Growth China's Demographic Challenge Rising Participation Boosted Euro Area Labor Force Growth China's Demographic Challenge Rising Participation Boosted Euro Area Labor Force Growth China's Demographic Challenge Chart 8Social Stability A Major Concern In China China's Nineteenth Party Congress: A Primer China's Nineteenth Party Congress: A Primer In terms of the likely economic and market response, we have highlighted in the past that larger macro-economic trends tend to swamp any effects of China's five-year party congresses. There is no observable correlation between these events and the deviations of China's nominal GDP, credit, or fixed investment from long-term averages going back to 1992 (Chart 9). Chart 9No Clear Policy Impact From Past Party Congresses No Clear Policy Impact From Past Party Congresses No Clear Policy Impact From Past Party Congresses Moreover, China only has two midterm party congresses to compare to today's party congress, and both occurred in the thick of global financial crises (1997, 2007). This makes it difficult to draw firm conclusions about any impact on Chinese risk assets. A-shares were mostly flat after the 1997 congress but fell after 2007, while H-shares broadly fell after both meetings, as one might expect given the crises raging around them (Chart 10 A&B). Chart 10AChinese Stocks Were Flat Or Down ... Chinese Stocks Sold Off After Past Midterm Congresses Chinese Stocks Sold Off After Past Midterm Congresses Chart 10B... After Past Midterm Party Congresses Chinese Stocks Sold Off After Past Midterm Congresses Chinese Stocks Sold Off After Past Midterm Congresses H-shares, being highly responsive to global financial market turmoil, fell relative to emerging market (EM) equities as well in 1997 and 2007. A-shares were more insulated and outperformed EM stocks during the 1997 crisis, though not in the 2007 crisis (Chart 11 A&B). What is clear - for Chinese domestic investors - is that A-shares outperformed H-shares after the party congresses in 1997 and 2007 (Chart 12). Chart 11AChinese Stocks Sold Off In Relative Terms... Chinese Stocks Sold Off In Relative Terms... Chinese Stocks Sold Off In Relative Terms... Chart 11B...Except A-Shares During The Asian Crisis ...Except A-Shares During The Asian Crisis ...Except A-Shares During The Asian Crisis Chart 12A-Shares Outperformed H-Shares After Midterm Congresses A-Shares Outperformed H-Shares After Midterm Congresses A-Shares Outperformed H-Shares After Midterm Congresses This fall, it would not be surprising to see Chinese and global risk-on attitudes prevail in the immediate aftermath of China's party congress: in the broadest sense, the meeting represents a political recapitalization for the Xi administration. Moreover, the backdrop is positive: global and Chinese growth are on a synchronized upswing, Chinese industrial profits have improved, the Fed is on hold, and China's growth risks and capital outflow pressures have diminished.16 This suggests a marginal positive impact for H-shares as well as A-shares. However, Chinese stocks are no longer trading at a discount relative to peers. Moreover, BCA's Geopolitical Strategy believes that the Xi administration's reform reboot will likely bring tougher financial and environmental regulation that will slow credit growth and cut into corporate profits.17 It also seems likely that 2018 will see the dollar stage a comeback as inflation recovers and the Fed resumes hiking rates.18 For all these reasons, we recommend staying long Chinese stocks relative to EM, on the basis that China's reform efforts will be positive for China's productivity outlook but negative for commodities and EM in 2018. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Mao's successor Hua Guofeng, and Xi's predecessor Hu Jintao, are the two leaders who did not obtain "core" status. 2 The current norms developed mostly in the 1980s and have evolved since. The list of candidates is mostly pre-arranged by the top leaders. The party congress then votes on which candidates to include, leaving a remainder of about 10% who do not take seats in the Central Committee. 3 Nevertheless, the Central Committee could produce a few surprises. It is almost inevitable that a few major personalities will fail to get promoted into key positions, while others will be catapulted to higher places. There will also be some tea leaves to read about the share of negative votes or abstentions and the implications for different candidates. 4 The political report is filled with arcane Communist Party jargon but is very important. It is a consensus document that takes multiple committees a year or more to draft, though Xi Jinping will give the finishing touches. It will cover a comprehensive range of policies and will be scrutinized closely by experts for slight changes of terminology, emphasis, or omission. Key things to watch for are whether Xi adds or removes entire sections; whether he alters developmental goals outlined in previous administrations; and whether he inserts new concepts or revises party ideology to make way for contentious reforms. As for the party's constitution, the main question of any change is whether Xi's leadership philosophy is incorporated into the Communist Party's guiding thought, and if so, whether Xi's name is explicitly attached to it. The latter in particular would be a sign that Xi's political capital within the party is massive. For additional commentary, please see Alice Miller, "How To Read Xi Jinping's 19th Party Congress Political Report," China Leadership Monitor 53 (2017), available at www.hoover.org. 5 For the "assault stage" of reform, see Robert Lawrence Kuhn, The Man Who Changed China: The Life And Legacy Of Jiang Zemin (NY: Crown, 2004). Jiang had first targeted SOE reform in 1996 in a speech, he launched the policy itself at the party congress in September 1997, and the state began to implement it at the NPC in March 1998. For Hu Jintao's and Wen Jiabao's administrative reforms after the seventeenth party congress, see Willy Wo Lap Lam, "Beijing Unveils Plan For Super Ministries," China Brief, Jamestown Foundation, February 4, 2008. These reforms, which were only part of the overall agenda after the congress, included restructuring the State Council, empowering the National Development and Reform Commission, and setting up "Super-Ministries" to streamline cabinet-level functions. 6 Rumor has it that Xi will keep his anti-corruption chief, Wang Qishan, on the PSC beyond the 69-year mandatory retirement age, and that he could even replace Premier Li Keqiang. We do not expect either to happen, but both are well within the realm of political possibility - particularly retaining Wang. 7 For this estimate, please see Cheng Li, Chinese Politics In The Xi Jinping Era: Reassessing Collective Leadership (Washington, D.C.: Brookings, 2016), chapter 9. 8 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 9 Traces of Jiang's power will persist here and there, especially if Wang Qishan remains on the PSC, but the overall effect will be a diminishment of this powerful leadership cohort. Symbolically, just as Deng Xiaoping's death loomed over the fifteenth party congress in 1997, Jiang's impending death will loom over the nineteenth party congress today. 10 Indeed judging solely by the cyclical rotation of Chinese leaders according to generation and faction, Hu Jintao's acolytes are favored to outnumber Jiang Zemin's and Xi Jinping's in the 2017 reshuffle. Please see BCA Geopolitical Strategy, "China: Two Factions, One Party," dated September 2012, available at gps.bcaresearch.com. However, Xi's effectiveness and good luck since coming to power lead us to believe that he will secure his followers on the PSC and Politburo this year: please see BCA Geopolitical Strategy Strategic Outlook 2017, "We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 11 For example, Xi Jinping's recent promotions have re-emphasized SOE managers and his policies have supported large "state champion" SOEs. Please see Cheng Li and Lucy Xu, "The rise of state-owned enterprise executives in China's provincial leadership," Brookings, February 22, 2017, available at www.brookings.edu. 12 He came to the top office at a time of significant public dissatisfaction (2012), which meant that he received a kind of "mandate" to make big changes. His faction dominated the PSC, and his sweeping anti-corruption campaign purged the party and state of formidable rivals. In the fall of 2016 he clinched his status as the "core" of the party. 13 As to specific rules, no one should be surprised if they are altered. Take the age limit, which is hotly debated: Jiang Zemin introduced a hard age limit into the PSC in 1997, specifically in a way that prevented the promotion of a heavy-hitting politician, Qiao Shi, while allowing Jiang to continue in power. Now, assume Xi alters the rules to preserve Wang Qishan: this would not necessarily mean that Xi plans to overstay his term limits, though some observers will take it that way. For market participants, the important point is that slight tweaks to informal rules are unlikely to have a big market impact. Consider that Wang has overseen a massive crackdown on corruption, helping clean up the party's image, and is known to be competent in financial regulation as well. If he is retained, will the market really protest? We doubt it. Having said that, we expect him to retire according to the existing rule of thumb. 14 The exception to this statement is if Xi reforms Communist Party political institutions, as some commentators suspect he might, in order to allow the Central Committee to elect the Politburo and PSC directly from its members, thus expanding "intra-party democracy" while also giving Xi a higher likelihood of staying in power. Please see Bo Zhiyue, "Commentary: Sweeping Reforms Expected At Party Congress, But Will Xi Jinping Get All He Wants?" Channel News Asia, August 20, 2017, available at www.channelnewsasia.com. 15 Please see BCA Geopolitical Strategy Monthly Report, "Reflections On China's Reforms," in "The Great Risk Rotation - December 2013," dated December 11, 2013; and Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. Please also see BCA China Investment Strategy, "Understanding China's Master Plan," dated November 20, 2013, available at cis.bcaresearch.com. 16 Please see BCA China Investment Strategy Weekly Reports, "China: Earnings Scorecard And Market Tea Leaves," dated September 7, 2017, and "Monitoring Chinese Capital Outflows And The RMB Internationalization Process," dated August 24, 2017, available at cis.bcaresearch.com. 17 Please see BCA China Investment Strategy Weekly Report, "A Closer Look At Chinese Equity Valuations," dated August 31, 2017, available at cis.bcaresearch.com. For the reform agenda, please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 18 Please see BCA Global Investment Strategy Weekly Report, "Central Bank Showdown," dated September 8, 2017, available at gis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights U.S. product inventories - particularly gasoline and distillates - will show sharp declines over the balance of September, as refining capacity continues to trail demand in the wake of Hurricane Harvey. U.S. crude inventories will accumulate as refineries slowly come back on line. This will keep the Brent vs. WTI spreads and crack spreads elevated, as refiners outside the U.S. Gulf scramble for crude (Chart of the Week).1 Global product storage facilities will be drained to more normal levels responding to this imbalance. It is understandable that the significance of the increased frequency of messaging from OPEC 2.0's leadership re its willingness to extend production cuts beyond March 2018 would be secondary to hurricane recovery. Nonetheless, we advise investors to stay focused on OPEC 2.0's evolution, particularly next year, as it develops a modus operandi for providing forward guidance to markets and investors. Energy: Overweight. Brent futures are backwardated to January 2018, reflecting a tight market as refiners, particularly in Europe, scramble for barrels to meet U.S. and Latin American product demand. We remain long Brent and WTI $50/bbl vs. $55/bbl call spreads in Dec/17, which are up 183.8% and 30.2%, respectively, since inception. Base Metals: Neutral. Our tactical COMEX copper short initiated last week is up 3.4%. Precious Metals: Neutral. The Dec/17 COMEX Gold contract gapped lower earlier in the week, as a strengthening USD, and a 15 - 0 vote Monday by the UN Security Council to adopt sanctions proposed by the U.S. against N. Korea took some of the luster off the metal. Our long strategic portfolio hedge is up 8.0% since it was initiated May 4, 2017. Ags/Softs: Underweight. Grains appear to be finding support around current levels. We are bearish, but do not advise shorting the complex, especially with erratic weather as a backdrop. Feature Chart of the WeekBrent - WTI Spread,##BR##Cracks Reflect Refining Scramble Brent - WTI Spread, Cracks Reflect Refining Scramble Brent - WTI Spread, Cracks Reflect Refining Scramble The Kingdom of Saudi Arabia (KSA) and Russia, the putative leaders of what we've dubbed OPEC 2.0, are taking every opportunity to signal their willingness to consider an extension of their production-cutting agreement beyond March 2018, when it is scheduled to expire.2 We believe this to be part and parcel of an evolving forward guidance strategy, which KSA and Russia will deploy to signal their production intentions over the near term. This is consistent with our view such a strategy is necessary to keep the producer coalition durable, and to work out an even larger plan to begin messaging firms and institutions allocating capital to oil and natural gas markets globally. This is critical for KSA, which will be looking to IPO Saudi ARAMCO next year, and Russia, which is preparing for elections in March and still relies heavily on hydrocarbon exports to fund its government.3 The last thing either needs is out-of-control oil production tanking the market, as it almost did at the beginning of 2016. Other members of the OPEC 2.0 coalition seeking foreign direct investment (FDI) - e.g., Gulf Arab producers and non-OPEC states like Mexico and Kazakhstan - benefit from an oil-production-management framework as well. The significance of OPEC 2.0's emerging forward guidance strategy could be lost amid the devastation of hurricanes Harvey and Irma, which is understandable. But it will be critical to understanding the coalition's strategy regarding how it intends to manage its own production, now that U.S. shale is the marginal barrel in the world, even after Hurricane Harvey disrupted production and refining in Texas, and U.S. crude and product exports from the Gulf. Thus far, OPEC 2.0 continues to deliver on its production cuts, and global demand - which we expect will dip by less than 1mm b/d over the next few weeks due to the hurricanes - remains strong. In a month or two, we expect hurricane recovery efforts will restore lost refining capacity and product demand. As rebuilding goes into high gear, we expect product demand to get a significant boost. OPEC 2.0 Maintains Discipline We will be updating our oil supply/demand balances next week, but so far it appears KSA and Russia are honoring their commitments to restrain production. This allows them to maintain credibility with their respective OPEC and non-OPEC allies within OPEC 2.0, and with the market in general (Chart 2). KSA, in particular, has led the way among OPEC members of the coalition, according to a tally done by S&P Global's Platts, which put KSA's average crude oil production over the January - August 2017 period at 9.97mm b/d vs. its quota of 10.06mm b/d. This is up slightly over the 9.93mm b/d average production for January - June 2017 reported by JODI. KSA's August production reported in the September OPEC Monthly Oil Market Report was 9.95mm b/d. For the January - August 2017 period, Russia's total crude and liquids production averaged 11.22mm b/d, according to U.S. EIA estimates. For the May - August period, it averaged 11.16mm b/d, putting total output 300k b/d below its October 2016 level, against which OPEC 2.0 benchmarks. Russia committed to reducing output by 300k b/d under the OPEC 2.0 Agreement as part of an overall effort to remove 1.8mm b/d of production from the market to end-March 2018. Russia's crude oil production averaged 10.38mm b/d over the January - June 2017 period, according to JODI data, vs. an October level of 10.51mm b/d. For 2Q17, Russia's average production reported to JODI was 10.31mm b/d, or 200k b/d below its Oct/16 output. Overall OPEC compliance of members with quotas was 112% of agreed volumes last month, meaning OPEC members with quotas under the OPEC 2.0 Agreement are producing 630k b/d below agreed volumes, according to Platts.4 Seven of the OPEC states still covered by the Agreement are producing below quota. Iraq leads in over-production at 4.46mm b/d on average in the January - August period, or 82k b/d over quota. Overall, however, production discipline is holding (Chart 3, panel 2). Chart 2KSA, Russia Leading##BR##OPEC 2.0 By Example KSA, Russia Leading OPEC 2.0 By Example KSA, Russia Leading OPEC 2.0 By Example Chart 3Production Discipline, Strong Demand##BR##Will Continue To Support Prices Production Discipline, Strong Demand Will Continue To Support Prices Production Discipline, Strong Demand Will Continue To Support Prices Bottom Line: OPEC 2.0's forward guidance to markets, firms and institutions allocating capital in the energy sector has featured frequent re-statements of the coalition's leaders' willingness to extend their production cuts if inventories have not drawn sufficiently by March 2018, when their Agreement is due to expire. We believe this reflects the desire of OPEC 2.0's leadership to maintain the coalition as a long-term production-coordinating body. This will allow the major oil producing nations to communicate production plans and allay investor fears of out-of-control production in the future. Global Demand Will Remain Strong We have noted repeatedly global economic growth has been firing on all cylinders, which will keep global oil demand robust for at least the balance of 2017, and likely into 2018 (Chart 3, panel 3). This is particularly evident in global trade data, which we also will be updating next week.5 Global economic data continue to support this thesis: All 46 countries monitored by the OECD are on track to grow this year, the first time this has happened since 2007, according to BCA's Global Investment Strategy (GIS).6 In addition, BCA's Global Investment Strategy notes U.S. growth projections have been broadly stable, but these likely will be revised higher. The easing in U.S. financial conditions since the start of the year should boost real GDP growth over the next few quarters, which, along with the expected boost to product demand coming on the back of hurricane-recovery efforts, will continue to be bullish for refined product demand. Global Product Inventory Draws Will Accelerate OPEC 2.0's efforts to draw global inventories - particularly in the OECD - received an unexpected assist from hurricanes Harvey and Irma. We expect the trend of drawdowns seen over the past few months to accelerate (Chart 4). This will return global product inventories to more normal levels, and, with crude oil inventories accumulating, favor refiners as they scramble to meet demand. Our colleagues at BCA's Energy Sector Strategy upgraded U.S. refiners last week to overweight in line with their view Harvey has the "potential to finally normalize bloated refined product inventories. Over two weeks since the hurricane made landfall, the industry still has 1.0 MMb/d of refining capacity shut down (5 refineries), 2.15 MMb/d of capacity not operating but working on restarting operations (6 refineries), and 1.4 MMb/d of capacity operating below full capacity (5 refineries). Over the past 16 days, at least 55 million barrels of refined product have not been generated, which will result in increased crude inventories and shrinking refined product inventories, benefitting refiners" (Chart 5).7 Chart 4OECD Oil Inventory Declines Will Accelerate OECD Oil Inventory Declines Will Accelerate OECD Oil Inventory Declines Will Accelerate Chart 5Refinery Outages From Harvey Persist Hurricane Recovery Obscures OPEC 2.0's Forward Guidance Hurricane Recovery Obscures OPEC 2.0's Forward Guidance Over the short term, Brent crude - and related streams pricing off Brent - and products will remain bid, keeping refiner crack spreads elevated, as operations return to normal, and Florida emerges from the economic damage and dislocations caused by Irma. Typically, product demand falls immediately after severe storms, and recovers as rebuilding begins and progresses. We will be updating our balances model next week to reflect the effects of hurricanes and the continued indications of strong global growth. Bottom Line: Demand for refined products will dip slightly - likely less than 1% of global demand - as hurricane-ravaged markets recover. As rebuilding progresses, product demand likely will be boosted. This will drain OECD product inventories in the short term, providing an unexpected assist to OPEC 2.0's efforts to bring global stocks down to five-year average levels. This evolution will favor refiners, as well. OPEC 2.0's forward guidance to markets continues to evolve. In recent weeks, it has featured frequent re-statements of the coalition's leaders' willingness to extend their production cuts if inventories have not drawn sufficiently by March 2018. We believe this messaging is designed to allay fears of another production-free-for-all of the sort that threatened to take global benchmark crude oil prices below $20/bbl last year. It is too early to expect OPEC 2.0 will replace the original OPEC Cartel. But, we believe KSA and Russia are signaling their common desire to make OPEC 2.0 a durable feature of budgeting and investment considerations over the medium term. Actions speak louder than words, in this regard. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 A "crack spread" refers to the difference in refined-product prices and crude oil prices. It takes its name from the "cracking" long-chain hydrocarbon bonds in crude oil required to produce refined products like gasoline and diesel fuel. The Brent - WTI spread is the price difference in USD/barrel ($/bbl) between the global benchmark crudes. 2 Please see, for example, "Saudi Arabia Says It's Open to Another OPEC Cuts Extension," updated on bloomberg.com September 11, 2017; "Saudi, UAE agree extension of oil cuts may be considered - statement," published on the same day on reuters.com's U.K. service; and "Russia's Novak says to consider extension of oil cut deal if glut persists" published on reuters.com September 6, 20107. We have repeated noted markets are looking for OPEC 2.0 to provide forward guidance, if the principals to the deal intend to maintain a durable coalition. Please see, e.g., "KSA's Tactics Advance OPEC 2.0's Agenda," published by BCA Research's Commodity & Energy Strategy Weekly Report August 10, 2017, and available at ces.bcaresearch.com. 3 The U.S. CIA estimates Russia exported 5.1mm b/d of crude oil in 2016, roughly half of crude production. This squares with exports reported by the Joint Organizations Data Initiative (JODI), a transnational agency headquartered in Riyadh, Saudi Arabia. Last year, Russia also exported 223 billion cubic meters of natural gas. KSA exported 7.65mm b/d of crude oil last year, according to JODI, or close to 75% of KSA's production. 4 Please see S&P Global Platts OPEC Guide published September 7, 2017, online. 5 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Trade And Commodity Data Point To Higher Inflation," published on July 27, 2017. It is available at ces.bcaresearch.com. 6 Please see BCA Research's Global Investment Strategy Weekly Report "Central Bank Showdown," published on September 8, 2017. It is available at gis.bcaresearch.com. 7 Please see BCA Research's Energy Sector Strategy Weekly Report "Rebalancing Recommendations," published on September 13, 2017. It is available at nrg.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Hurricane Recovery Obscures OPEC 2.0's Forward Guidance Hurricane Recovery Obscures OPEC 2.0's Forward Guidance Trades Closed in 2017 Summary of Trades Closed in 2016