Emerging Markets

Highlights China's ascendancy will increase U.S.-China tensions in the medium and long term; "Xi Jinping Thought" is China's rejection of Soviet-style collapse; Xi's new policies face very few domestic political constraints; Xi is playing down GDP targets and playing up centralization; Tax cuts are still coming to the U.S. Feature Global risk assets continue to rally despite an apparent loss of faith in world leaders. In Spain, the showdown between Catalonia and Madrid is escalating as Spanish lawmakers vote to withdraw aspects of self-rule from the wealthy northeastern province. In the U.K., the Brexit negotiations are floundering, causing the Labour Party to raise the alarm against a "no deal" exit from the European Union. In Brazil, the interim president is under legislative scrutiny for corruption; in South Africa, the ruling party is grasping at government employees' pension funds to keep a struggling state airliner afloat. However, policymakers are not always as incompetent as investors (and the financial media) like to think. In China, President Xi Jinping has turned himself into the highest authority since Mao Zedong and Deng Xiaoping. And the country has sprung back from the 2015-16 deflationary spiral so well that financial authorities are tightening financial controls and contemplating interest rate hikes (Chart 1). In Japan, Prime Minister Shinzo Abe has won a two-thirds supermajority in the House of Representatives for the second time, giving him a mandate to continue his "Abenomics" agenda (Chart 2). With unemployment already exceedingly low at 2.8%, Abe could make history. He could rouse the country out of both its deflationary and pacifist slumber in the face of the historic challenges posed by a rising China and multipolar world. Less grandiose, but still highly market-relevant, the U.S. Congress has drawn closer to approving a budget resolution for fiscal 2018 that would pave the way for tax legislation to hit President Donald Trump's desk by the end of the first quarter of next year. This development is in marked contrast to informal surveys of investors around the world, including at BCA's annual New York Conference last month. The market has hardly reacted to the positive news (Chart 3). Chart 1Real Deposit Rate Is Negative Chart 2Shinzo Abe Does It Again Chart 3Market Still Doubts Trump In this report, we focus on China and the United States. Our recent assessments of Spain and Japan are on track - the former is an overstated risk, the latter an opportunity now largely priced in.1 It is the "G2" that poses the biggest risk of negative surprises over the next 12 months. First Take On The Party Congress China's nineteenth National Party Congress will conclude just as we go to press. Our assessment of the line-up of the new Politburo and specific changes to the Communist Party's constitution will have to wait for a Special Report next week. We can still draw some preliminary conclusions, however.2 First, Xi Jinping's induction into the Communist Party's constitution, under the slogan "Xi Jinping Thought on Socialism with Chinese Characteristics for a New Era," makes him second only to Chairman Mao as a philosophical guide in the party. This says as much about the spirit of the age as about Xi's (formidable) power. It is an era of "charismatic authority," in which populations are restless and political elites either adopt populist tactics (like Xi), or are populists themselves.3 The Communist Party wanted a new Mao and Xi obliged them. Why is this the case in China? The Communist Party has based its legitimacy on economic growth since Deng Xiaoping came to power in 1978. But economic growth is slowing as a result of irreversible, secular trends. The party needs a new source of legitimacy, and Xi has offered a "synthesis" of Mao and Deng: he promises to preserve the Communist regime above all, yet also to continue Deng's pragmatic use of the market to strengthen the fundamentally socialist economy. Thesis, antithesis, synthesis. Xi's focus remains on power, namely reinforcing China's ruling institutions and asserting its international influence.4 We will take the latter first, as it is the biggest source of change in the world and a key driver of market-relevant geopolitical risk. Multipolarity Chart 4U.S. Decline Vis-à-Vis China The most important takeaway from the party congress is that it perfectly captures our long-term investment theme of global multipolarity. This describes a world run by multiple independent powers as American power declines in relative terms.5 The erosion of U.S. global dominance is most striking in relativity to China (Chart 4).6 Xi has declared that it is time for China to take "center stage" in world affairs. He also modified an earlier goal to say that China will become a "leading global power" by 2050. China is unified under a single leader and a single party, its economy has been robust, and it is therefore feeling confident in its ability to take action in the global arena. The implications are disruptive over the long run: Assertive foreign policy will continue: China will continue with the bolder foreign policy it has demonstrated over the past ten years. China's military expenditures, which are widely believed to be larger than official statistics reveal, will continue to drive regional security dynamics (Chart 5).7 Maritime tensions still matter: China's "core interests" in separatist-prone regions like Tibet and Xinjiang have become more secure, whereas its interests in Taiwan and the South China Sea are less secure because of increasing pushback from the U.S. and its allies. The South China Sea is still a potential flashpoint as it governs the vital supply lines of China's major regional rivals and $4 trillion in trade (Diagram 1).8 Diagram 1The South China Sea: Still A Risk Economic statecraft is the new norm: China is using its economic heft to fill spaces left void by the United States. The U.S. is perceived across the region as relying increasingly on "hard power," ceding ground to China to create "soft power" relationships through trade and investment. Beijing is launching its own system of multilateral trade and finance that could someday operate as a sphere of influence in Asia outside of U.S.-led international norms - such as Xi's "Belt and Road Initiative," which was also enshrined in the Communist Party constitution (Chart 6). Moreover, Beijing is using its growing economic leverage to achieve political goals, having imposed informal sanctions on Japan, both Koreas, Vietnam, Taiwan and others in recent years.9 Chart 5China Raises Asian Security Fears Chart 6China's Belt And Road Club These trends were all reaffirmed at the party congress, confirming our view that U.S.-China frictions are a serious geopolitical risk. Fortunately, neither Xi nor China is a loose cannon. Most of these trends are developing over the long run. With Xi Jinping overseeing an extensive overhaul of the People's Liberation Army, there is less reason to suppose that the PLA will act aggressively independent of civilian leadership (as was a concern under the previous administration). One would also think that a transition across the armed forces is an inopportune time to instigate conflicts. Notably, the Xi administration has also tactically adopted a milder diplomatic approach since President Trump's coming to power with an arsenal of threats aimed at China. This approach is evident with Japan, India, and Southeast Asian neighbors. Trump's perceived belligerence gives China the ability to play a mediating role and promote trade and investment with other powers looking to hedge against the U.S. Finally, Beijing appears to have domestic unrest in check, at least for now. Public security disturbances have been elevated in the wake of the global financial crisis, but have declined since 2011 (Chart 7). This is a positive sign for markets because China will have greater ability to push domestic reforms - and less reason to be aggressive abroad - if unrest is subdued. Official statistics suggest that China spends about as much on public security as national defense, revealing a key vulnerability to the state (Chart 8). Chart 7Domestic Unrest Down, Though Not Out Chart 8Domestic Unrest A Risk To The State Bottom Line: The party congress has highlighted China's rising global influence. This ultimately creates higher geopolitical risk, especially in U.S.-China relations. China also has greater control over domestic factors that could instigate conflicts, at least for the time being. Thus the U.S.'s next moves will be critical. Reform And Opening Up The second major takeaway is that the Xi administration is still officially committed to the reform agenda laid out in the 2012 party congress, the 2013 Third Plenum, and the supply-side structural reforms announced in 2015. Xi's work report calling for "sustained and sound" growth is a nod to the need to reduce capital intensity and systemic risks. He also said that supply-side structural reform would be the "main task" for economic policy for the foreseeable future. His economic reform slogans also made it into the party's constitution. Significantly, there are no more GDP targets beyond 2020. Broadly, we have defined Xi's reform agenda as a combination of centralizing control, improving governance, and streamlining the economy.10 Centralization is not necessarily market-positive, but under the Xi administration it has coincided with efforts to improve governance (fighting corruption, reining in provincial freewheeling, and reducing pollution). This is a sign of growing policy responsiveness to public demands and as such is marginally positive. The clear takeaway from the congress is that the anti-corruption campaign will be institutionalized across the country through new "supervisory commissions." This campaign should improve the legitimacy of the party-state and the implementation of central government policies. We have always been skeptical of progress on structural economic reforms, but the party congress marks a new phase in the political cycle: Xi is in a better position than any Chinese leader since Deng Xiaoping to launch significant reforms. He has increased his political capital massively over the past few years, as illustrated by the dotted line in our "J-Curve of Structural Reform" (Diagram 2). Cyclically, the next opportunity for China to undertake bold reforms may not occur until 2027. Hence it is either now or never for reform. The policy focus is supposed to push along China's economic transition from investment- to consumption-led growth (Chart 9). Importantly, Xi declared that the "principle contradiction" in Chinese society has changed since the 1980s. The principle contradiction used to be that of a poor, economically and technologically "backward" country trying to meet the basic material needs of the population. Now the contradiction is that of an "imbalanced" and under-developed economy trying to provide people with "better lives." These goals can be put into perspective by comparison with South Korea, which reveals both how far China has come and how far it has to go (Chart 10). Xi's statement points to an overall shift in policy toward addressing imbalances and improving quality of life. Diagram 2The J-curve Of Structural Reform Chart 9Changing The Economic Model Chart 10From Basic Needs To 'Better Lives' To put a time frame on many of these reforms, Xi created a new long-term deadline of 2035 to become a fully "modernized" economy, which is smack in the middle of the country's previously declared two "centenary goals" of 2020 (middle income status) and 2050 (global prominence). The interim deadline includes a target for narrowing regional and income disparities. Wealth inequality in China has become extreme and ultimately poses a threat to the regime (Chart 11). Such a goal will require serious redistributionist policies as well as ongoing efforts to build a better social safety net. As expected, Xi reaffirmed China's embrace of globalization, claiming that the door of trade "will only open wider." The financial sector is likely to be at the forefront of any new opening measures - top financial officials claim that a package of reforms is forthcoming. The developed world has begun to doubt China's commitment to financial reform given the closing of the capital account last year and other negative trends, like the persistently low (and falling) share of foreign banks in domestic lending. Only recently have foreign banks begun lending again after withdrawing funds in preceding years (Chart 12). Foreign ownership of domestic equities, which is tightly controlled, has also fallen in importance (Chart 13). Chart 11Inequality: A Liability For The Party Chart 12Banks Shying Away From China Chart 13Foreign Investors Limited In China The centralization of power should speed up policy implementation, but it also raises risks. The important thing is whether we see hard evidence that Xi's "absolute power" is corrupting absolutely. This would present a new structural risk to the Chinese system, even if markets initially cheered. Why? Because an administrative (as opposed to propagandistic) turn in China in favor of a "cult of personality" as opposed to "collective leadership" would increase the odds of policy mistakes, set off factional struggle in the Communist Party, increase policy uncertainty for the foreseeable future, and jeopardize the smooth transition of power in 2022 ... or whenever "Chairman Xi" outwears his welcome. Therefore, the implementation of policy, the grooming of "heirs apparent," the position of the opposing faction in the party, and the upkeep of rules and norms will be important to monitor - not just after the party congress, but over the next five years. Bottom Line: Xi has reaffirmed formal structural economic goals like consumer-led growth and a commitment to globalization and has signaled that more reforms are in the works. Policy implementation will improve. Stay overweight H-shares within EM equities. However, excessive concentration of power in Xi himself is a serious political risk. It is only a positive in the long term if Xi uses his authority to build institutions rather than personalize them. Principal Contradictions China's declared goals are, of course, riddled with contradictions. As expected, Xi has tried to be everything to everyone. This leaves investors with a number of missing pieces to try to fit together. For example, the slogan indicating Xi's governing philosophy is a revision of Deng Xiaoping's market-oriented slogan, "Socialism with Chinese Characteristics" (Table 1). Xi is announcing that China has entered a "New Era" that will redefine Deng's formulation. Thus, by quoting Deng, he is reaffirming China's need to continue reforming and opening up. But by simultaneously qualifying Deng, he is reasserting the primacy of the state.11 Table 1Xi Jinping Thought What matters are the concrete policies China actually enacts. Nowhere are the contradictions clearer than in the party's constant assurances that it will both intensify reforms and keep the economy stable. Beijing continues to stress that it will deleverage the financial sector, restructure industry, eliminate overcapacity, and fight smog, all without any negative impact to growth. Given the sharp deceleration in the growth of China's monetary aggregates, we expect a significant slowdown in the coming year.12 "Reform" will in large part consist of demonstrating a higher-than-usual tolerance for slower growth so as to impose market discipline. Authorities will, as always, inject further stimulus if necessary to avoid a hard landing. A key risk to global markets, as discussed last week, is that fiscal spending may not offset a crunch in credit growth next year, should one occur. This is increasingly the case because the composition of fiscal spending in China is shifting as the country focuses more heavily on social stability and economic transition. Education, social security, worker training and relocation, and other public services are simply not as capital intensive as building railroads, urban infrastructure, and houses (Chart 14). Moreover, a critical test of the reform-stimulus trade-off will be Beijing's tolerance for failing companies. Bankruptcies have risen over the past year in China, which suggests that market forces are being given wider scope and that the central government is laying down the legal framework to make bankruptcy more acceptable (Chart 15), a notable reform. This is a clear sign of "short-term pain, long-term gain," but it remains to be seen how far it will go. Chart 14China's Fiscal Spending Is Becoming Less Capital Intensive Chart 15Creative Destruction At Long Last? It is also unclear whether failures will be allowed among state-owned enterprises (SOEs), which are the least profitable and most indebted Chinese companies. The future of SOE reform is no clearer than before the congress: Xi promised both to restructure the sector and to enlarge and strengthen it. The principle is in alignment with the Jiang Zemin administration's maxim, "grasp the large, let go of the small," and does not mean that reform is doomed. More than a fourth of SOEs are under water and the government is already committed to cutting the number of centrally administered SOEs in half. There are now several pilot projects for allowing partial privatization, or creating state holding companies, that can be rolled out nationally. And there are a range of perfectly un-strategic sectors (retail, chemicals, real estate, electronics, et al) that have substantial state ownership that could be liquidated. Judging by listed Chinese firms, those that are deemed to be strategic will not likely see their state share diluted much beneath 80% of ownership; yet those that are designated for partial privatization and mixed ownership could see the state share dwindle to less than 10% of ownership (Table 2). This implies that sweeping changes could occur if the government prioritized SOE reform. (This is true despite the fact that the state's hand would still be obtrusive overall.) Table 2Plenty Of Room For Privatization Bottom Line: Deleveraging and bankruptcies are a key aspect of reform but pose headwinds to growth. The profile of China's fiscal spending is changing to become less capital intensive, which will mean less stimulus for China's aging industries if reforms are pursued. This underscores a real risk to Chinese growth, capex, and imports, and hence to EM. There is no clarity on SOE reform, but it would have far-reaching consequences if prioritized in Xi's second term, given his soaring political capital. Tax Blues In The USA: Are Tax Cuts Really Coming? On the other side of the Pacific, investors remain highly skeptical that tax reform is on the legislative menu (Chart 16). This is after both houses of Congress passed their version of the budget resolution, containing reconciliation instructions for tax reform. Once the House of Representatives passes the Senate version of the budget resolution - which we assume will be swift - the reconciliation process will kick off.13 The Senate version of the budget resolution instructs the Senate Committee on Finance and the House Ways and Means Committee to limit the increase in the budget deficit to no more than $1.5 trillion through 2027.14 The resolution also instructed the Congressional Budget Office (CBO) and Joint Committee on Taxation (JCT) to consider "to the greatest extent practicable... the budgetary effects of changes in economic output, employment, capital stock, and other macroeconomic variables resulting from such major legislation." In plain English, this refers to "dynamic scoring," macroeconomic modeling that takes into account the revenue-raising potential of major tax cuts. BCA's Geopolitical Strategy has harped on "dynamic scoring" since last November. The tool is a favorite of Republican legislators when passing tax legislation. It allows them to cut taxes and then score the impact on the budget deficit holistically, taking into consideration the supposed pro-growth impact of the legislation. Democrats banned this practice when they took back the Senate in the Obama years, but the GOP promptly re-authorized it in January 2015. Fast forward a year later and two core conclusions of our November 2016 forecast on tax policy are now coming true.15 First, the tax bill will not be revenue neutral, except in the imagination of macroeconomic modeling pursued by Republican economists. The bill will be mildly stimulative, to the tune of $100-150 billion per year over the next decade. The numbers are modest, but given that the U.S. is close to full employment and wage pressures are certain to build up (Chart 17), any additional tax relief is bound to be stimulative for the economy. Chart 16High-Tax Firms Not Outperforming (Yet) Chart 17Inflation Coming Even Without Tax Cuts Second, Republican legislators are not fiscally conservative. The House budget resolution authorizing a $1.5 billion hole in the budget was passed with 18 Republicans dissenting, but 11 of them were from highly-taxed "blue states." Their contention with the bill was not that it would be profligate, but that it would do away with state and local tax deductions in order to pay for the likely $5-$6 trillion price tag. As such, they voted not to make tax cuts less, but rather more, profligate. Going forward, the real threat to the proposed tax bill is in the Senate, where Republicans hold only a slim 52-48 majority. This threat is a surprise, as 12 months ago the question was how a profligate bill would pass the supposedly conservative House. Three risks lurk in the Senate: Alabama: Judge Roy Moore, a highly conservative candidate for the December 12 special election, is holding onto a relatively slim lead against Democrat Doug Jones. A recent Fox News poll shows the two tied in public opinion. Even if the poll is unreliable, other polls suggest that Jones has narrowed the gap to single digits. This is remarkable because Alabama Republicans have defeated their Democrat opponents by an average of 36% in Senate races over the past decade.16 If Moore were to lose, the Republican majority in the Senate would fall to 51. This would leave room for only one defection in passing legislation. The Corker-Flake-McCain Axis: Senators Bob Corker (R - Tennessee), Jeff Flake (R - Arizona), and John McCain (R - Arizona) have all voted in favor of the Senate budget resolution authorizing reconciliation instructions for tax legislation. On that basis, there should be no problem. However, Corker and Flake have announced their retirement, in our view because they plan to challenge President Trump in the 2020 Republican primary. Furthermore, Corker has said in the past that he would not vote for a tax bill that is not revenue neutral. We think that Corker and Flake will ultimately vote for tax cuts, if only because their chances of successfully challenging Trump in 2020 will be higher if they stick to Republican orthodoxy. However, these three Senators are risks to our view as they have the freedom not to care about the 2018 midterms. God: The death of Massachusetts Senator Ted Kennedy on August 25, 2009 greatly changed the fortunes of President Barack Obama, who at the time was enjoying a 60-seat majority in the Senate.17 Democrats failed to move quickly on the Affordable Care Act, assuming that a Democrat would win the special election in staunchly liberal Massachusetts. (If the parallels with Alabama today seem eerie, it is because they are.) But the January 2010 election cost Democrats the 60th seat in a shocking upset. These things can happen again, especially given that the average age of a senator is 103.18 Any one of these factors could reduce the Republican majority in the Senate to 51, forcing President Trump to rely on vociferous critics McCain and Corker. The latter, by the way, is also a likely 2020 primary challenger against Trump. Could a Democrat come to the president's aid? The short answer is yes. The 2001 Economic Growth and Tax Relief Reconciliation Act, the first of two Bush-era tax cuts, passed with 58 votes in favor, including 12 Democrats. Of the 12 that voted with Republicans, only three were from blue states, while the other nine were from red states that President Bush had carried in 2000. The 2003 tax-cut bill, Jobs and Growth Tax Relief Reconciliation Act of 2003, also passed with Democratic support with only 51 votes in favor. Senators Bayh (D - Indiana), Miller (D - Georgia), and Nelson (D - Nebraska), all crossed the aisle. Bayh was facing reelection in 2004, as was Nelson in 2006, in their respective red states, while Zell Miller of Georgia effectively ceased to be a Democrat and endorsed President George W. Bush reelection at the 2004 Republican National Convention. Ominously for today's efforts, John McCain voted against both versions. Given that he is unlikely to campaign again due to terminal cancer, and given his vociferous opposition to President Trump, we have to assume that he will vote against the tax bill as well. Which Democrats could potentially cross the aisle with this year's reconciliation bill? Table 3 lists the 2018 Senate races to watch, particularly the vulnerable Democrats campaigning in red states that President Trump carried in 2016. Particularly vulnerable are Senators Nelson (D - Florida), Donnelly (D - Indiana), McCaskill (D - Missouri), Tester (D - Montana), Heitkamp (D - North Dakota), Brown (D - Ohio), and Baldwin (D - Wisconsin). That makes seven potential votes for the Trump tax cut, plenty of "slack" for the Republicans in Senate to lose one or two votes on the tax bill. Table 32018 Senate Races To Watch As far as the timing of the bill is concerned, we are sticking with our updated view that the end of Q1 2018 is far more likely for passage of tax legislation than the end of 2017. There are simply too many things on the legislative agenda between now and the end of the year, including a potential government shutdown and an immigration fight. Bottom Line: The market remains unconvinced that Republicans can pass tax legislation through Congress. However, the tax process has played out thus far almost exactly as we expected last year (aside from starting later). Republicans have proposed a profligate tax bill and are using dynamic scoring to get it through Congress. Going forward, we think that GOP can afford to lose one or two votes, as it did in 2003 with the highly controversial Bush tax cuts. This is because there are up to seven Democratic Senators who can pick up the slack. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Is King Dollar Back?" dated October 4, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy, "Strategy Outlook 2015 - Paradigm Shifts," dated January 21, 2015, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 7 Xi is also overhauling the armed forces to imitate modern American joint operations and combatant commands (as opposed to the army-centric Soviet system). 8 Please see BCA Geopolitical Strategy Special Report, "The South China Sea: Smooth Sailing?" March 28, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "Does It Pay To Pivot To China?" July 5, 2017, available at gps.bcaresearch.com. 10 See note 4 above. 11 Whether Xi is mentioned specifically, and described as the founder of a school of "Thought," or a lesser "Theory," or something else, will be a notable watchword. 12 Please see note 2 above, "How To Read Xi Jinping's Party Congress Speech," and BCA Emerging Market Strategy Weekly Report, "China: Deflation Or Inflation?" October 4, 2017, available at ems.bcaresearch.com. 13 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. 14 Please see S.Con.Res.25, available at congress.gov. 15 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcareserach.com. 16 Current U.S. Attorney General Jeff Sessions, whose retirement from the Senate has prompted the current special election, ran unopposed in 2014 and garnered 97.25% of the vote! 17 Democrats picked up eight seats in the Senate in the watershed 2008 election, boosting their majority to 57, with two Independents caucusing with the Democrats. Shortly after the election, Pennsylvania Republican Arlen Spector changed parties, giving Democrats the 60-seat, filibuster-proof, majority. 18 It is actually 62, but we wanted to make sure you were still reading. Geopolitical Calendar

Highlights Chinese growth will slow next year, but underlying momentum remains strong. Jerome Powell is the most likely choice for Fed chair. However, no matter who is selected, the general thrust of monetary policy will not change radically next year. The transatlantic interest rate spread is not particularly wide considering that the output gap is larger in the euro area, while the neutral rate and expected inflation are lower. U.S. growth should surprise on the upside over the next few quarters, as already evidenced by the rebound in the economic surprise index. This will give the Fed greater scope to raise rates. We expect EUR/USD to reach $1.15 by the end of the year. Feature China: Let's Get This Party Congress Started China's 19th National Congress of the Communist Party of China kicked off this week. As widely expected, President Xi Jinping lauded the successes that China has enjoyed over the past few years in his opening speech, but cautioned that more must be done to reduce corruption, clean up the environment, and expedite market reforms.1 We expect Chinese growth to slow modestly in 2018 from the current above-trend pace, as the government pares back stimulus efforts. Nevertheless, the underlying trend in growth will remain reasonably solid. Chart 1 shows that real-time measures of economic activity such as electricity production, excavator sales, and railway freight traffic are all growing at a healthy pace. Despite the introduction of some tightening measures this spring, the housing market remains resilient. The share of households planning to buy a new home is close to record high levels, while the amount of land purchased by developers - a good leading indicator for housing starts - has continued to accelerate (Chart 2). Chinese property developer stocks have been on a tear this year, outperforming even the red-hot tech sector. With housing inventory levels at multi-year lows, home prices should stay firm. In the industrial sector, rampant producer price deflation last year has given way to modest inflation this year. This has boosted industrial profits, which should support corporate spending in the months ahead (Chart 3). Chart 1Chinese Economy: No Need To Be Pessimistic Chart 2Chinese Housing Market Remains Resilient Chart 3Boost In Industrial Profits Bodes Well For Corporate Spending Both money and credit growth surprised on the upside in September. As we have argued before, copious private-sector savings will forestall a credit crunch and, at least for the foreseeable future, permit the government to run large off-balance sheet budget deficits in an effort to support aggregate demand (Chart 4). Indeed, for all the talk about slowing credit growth, medium- and long-term bank lending to nonfinancial corporations - probably the best single measure of credit flows to the real economy - has continued to accelerate this year (Chart 5). Investors should continue to overweight Chinese stocks relative to the EM aggregate. Chart 4China's Fiscal Deficit Has Been Increasing Chart 5Credit To Real Economy Accelerating Musical (Fed) Chairs News reports indicate that President Trump has winnowed down the list of candidates for Fed chair to five individuals: Chief economic advisor Gary Cohn, current Fed Governor Jerome Powell, former governor Kevin Warsh, Stanford university economist John Taylor, and current chair Janet Yellen. We suspect that Cohn will not make the cut, given his apparent falling out with Trump following the President's remarks about the Charlottesville protests. Warsh and Taylor are likely to be seen as too hawkish. That just leaves Powell and Yellen. Chair Yellen's relatively dovish views on monetary policy would likely sit well with Trump, but she has two major strikes against her. One, she has generally been in favor of more financial sector regulation, which is anathema to Trump. Two, Trump accused her of abetting Hillary Clinton during the election campaign. Keeping her as Fed Chair (assuming she would actually want the job) might convey the message that he is no longer interested in shaking up the existing institutional order in Washington DC. This just leaves Powell as the default candidate, who reportedly has received the blessing of Treasury Secretary Steven Mnuchin. The prevailing wisdom is that Powell is a moderate who is only slightly more hawkish than Yellen. But the truth is that we don't really know where he stands because he has no academic publication record and has generally steered clear of taking bold views on monetary policy. Such a potentially malleable mind may be exactly what Trump is seeking! Still, the organizational structure of the Fed makes it impossible for the chair to run roughshod over other FOMC members. This suggests that no matter who is selected, the general thrust of monetary policy will not change radically next year. Thoughts On The Transatlantic Yield Spread I have been visiting clients in Europe this week and questions about the relative stance of monetary policy between the U.S. and the euro area have come up in almost every meeting. The gap between U.S. and euro area rate expectations has narrowed since the start of the year, helping to push the euro higher. Nevertheless, most interest rate spreads remain elevated by historic standards. This has led many commentators to speculate that they will continue to shrink, putting further upward pressure on EUR/USD. For example, the U.S. 5-year Overnight Index Swap rate currently stands at 1.82%. This compares to only 0.02% in the euro area. The current level of spreads can be partly explained by the fact that labor market slack is still substantially higher in the euro area than in the U.S. Outside of Germany, labor underutilization is still 6.3 percentage points higher across the euro area than in 2008 (Chart 6). In contrast, our work suggests that the U.S. labor market has returned to full employment.2 Chart 6Euro Area: Labor Market Slack Still High Outside Of Germany This is not to say that transatlantic interest rate spreads won't narrow over the coming years. They will. But what matters for investors is how spreads evolve relative to market expectations. The market is already pricing in roughly 50 basis points of spread compression in five-year rates between now and 2022. If one looks further out to 2027, the spread in expected policy rates stands at 94 basis points.3 That may still seem like a lot, but keep in mind that inflation expectations in the euro area are well below those of the U.S. The CPI swap market is predicting that U.S. inflation will exceed euro area inflation by 67 basis points over the next decade. All things equal, lower inflation in the euro area implies that nominal interest rates should be lower there too. Moreover, many euro area government bond markets trade at a discount due to country-specific default/denomination risks. While these risks have faded, they have not gone away. As such, GDP-weighted euro area government bond yields - which are arguably what the ECB cares most about - are generally higher than swap rates of the same maturity. In Search Of Fair Value Chart 7The Neutral Rate Is Lower In The Euro Area A reasonable estimate is that the market currently sees the real terminal rate in the U.S. as being roughly 40 basis points higher than in the euro area. As it happens, this is almost identical to the gap in the neutral rate between the two regions that Williams, Laubach, and Holston have calculated (Chart 7). Does that mean that the current transatlantic spread is close to fair value? Not quite. One of things that has become apparent over the past eight years is that euro area membership comes at a high price. When countries such as Italy and Spain are hit by adverse economic shocks, they are limited in how they can respond. They cannot devalue their currency because they do not have a currency to devalue; and they cannot loosen fiscal policy for fear of being attacked by the bond vigilantes. All they can do is suffer from grinding deflation in the hopes of regaining competitiveness through weak wage growth. This means that over the long haul, unemployment in the euro area is likely to be above NAIRU more often than in the U.S. This, in turn, implies that euro area policy rates will, on average, be below their neutral value more often than in the U.S. Thus, even if the gap in the real neutral rate between the two regions were 40 basis points, the expected gap in policy rates should be larger than that. Modest Downside For EUR/USD The discussion above suggests that the transatlantic interest rate spread is not especially wide if one looks further out in time. If U.S. growth surprises on the upside over the coming months, while euro area growth flatlines, spreads will widen again. Such an outcome is, in fact, quite likely. U.S. financial conditions have eased significantly relative to those of the euro area since the start of the year (Chart 8). To the extent that changes in financial conditions lead growth by about 6-to-9 months, the U.S. could start outperforming the euro area as we enter 2018. The fact the Goldman's Sachs' U.S. Current Activity Indicator has hooked higher and the economic surprise index has rebounded smartly is early evidence that this process may have already begun (Chart 9). We see EUR/USD falling to 1.15 by the end of the year. Chart 8Diverging Financial Conditions ##br##Favor U.S. Over The Euro Area Chart 9Early Evidence That U.S. May ##br##Outperform Euro Area Next Year Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Geopolitical Strategy / China Investment Strategy Special Report, "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017. 2 Please see Global Investment Strategy Weekly Report, "A Secular Bottom In Inflation," dated July 28, 2017; and "What's the Matter With Wages?" dated August 11, 2017. 3 We estimate the expected policy rates ten years out by looking at one-month, 10-year forward OIS rates (i.e., the market's expectation of where one-month OIS rates will be ten years from today). Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights U.S. credit growth is set to improve as capex has more upside and households benefits from a positive backdrop. The U.S. has substantially more room to increase leverage than the rest of the G10, pointing toward further monetary divergences. The euro is not very cheap and is trading at a significant premium to forward rate differentials. It is thus at risk if U.S. rates can rise vis-à-vis Europe. Chinese underlying inflation is becoming elevated, which could prompt additional tightening by the PBoC. Moreover, Xi Jinping's speech this week suggests a move away from the debt-fueled, investment-led growth model. The AUD is at risk. Feature A general lack of credit growth has been one of the key factors hampering both broader growth and inflation in the U.S. Not only has this muted activity and weak pricing pressure kept the Federal Reserve on the easier side of policy, the absence of lending growth has further depressed real rates as demand for loanable funds remains low. Can credit pick up from here, and what are the implications for the USD? Room For Optimism There are good reasons to lean a bit more on the positive side regarding the U.S. credit growth outlook. As Chart I-1 illustrates, U.S. commercial and industrial loan growth seems to be rebounding. Confirming that this impulse could gain momentum, it follows an easing in lending standards and a pick-up in durable goods orders - two leading indicators of business borrowings. Household debt is also showing some signs of revival. While the annual growth rate of household borrowings from banks has yet to trough, the annualized quarterly growth rate has picked up significantly - a development that tends to precede accelerations in the yearly measure. Moreover, this improvement is broad based among all the key components of household borrowings (Chart I-2). Chart I-1Upside For U.S. C&I Loans... Chart I-2... And For Household Debt As Well This has positive implications for U.S. nonfinancial private credit, which has been in the process of forming a shallow bottom relative to GDP. Moreover, based on the low level of debt servicing costs for both households and businesses, this trend has room to develop (Chart I-3). However, most of the increase in the debt-to-GDP since 1994 has been caused by financial engineering, with firms swapping equity for debt in their capital structure, and has therefore not lifted domestic demand nor created inflationary pressures. However, we posit that this phenomenon is toward its tail end, and that additional debt accretion could have a meaningful impact on growth. Why? On the business front, capex - an essential but volatile component of aggregate demand - is set to accelerate further. Business investment is led by firms' capex intentions, a series that has surged since the summer of 2016 (Chart I-4, top panel). Confirming the message from this indicator, profits from U.S.-listed businesses have also sharply rebounded, a signal that leads capex by a year, as highlighted last Monday by Anastasios Avgeriou, who heads BCA's U.S. Equity Sector Strategy service (Chart I-4, bottom panel).1 Chart I-3The U.S. Has Room To Relever Chart I-4Capex Outlook Looks Good On the household front, three factors support our assessment: First, household nominal and real wages and salaries should enjoy further upside as the labor market remains very healthy. This means more consumption and more capacity to accumulate debt, especially as household financial obligations remain near multi-generational lows (Chart I-5). In fact, U.S. real median household income already hit an all-time high in 2016. Chart I-5Supports To Household Consumption Second, household confidence is still near record-high levels, a factor which tends to lead credit growth and consumption. Optimistic households are more likely to spend their income gains and buy durable goods like houses or apartments, especially as the household formation rate has regained vigor. Third, U.S. net wealth has hit 430% of disposable income, a record, which will keep supporting consumption. As households see their net worth increase, they can boost consumption and debt as their leverage ratios improve, especially when financial obligation ratios are as low as they are today. These factors point toward a continued increase in the indebtedness of the U.S. private sector, one which this time we anticipate will add to demand through investments, real estate purchases and general consumption. This also means that real rates are likely to experience upside. More debt-fueled aggregate demand implies more demand for loanable funds, and thus higher real rates. In an economy operating near full capacity, it can also lift inflation. Tax cuts and fiscal stimulus would only be a bonus in this environment. This should give the Fed room to increase interest rates in line with its dot plot, or more than the two-and-a-half hikes priced into the OIS curve over the next two years. However, as 2017 has vividly demonstrated, movements in U.S. rates alone are not enough to make a call on the U.S. dollar. One needs to have a sense of how U.S. rates could evolve vis-à-vis the rest of the world. In the context of debt accumulation, we are optimistic that the U.S. could experience a re-leveraging relative to the rest of the G10, putting upward pressures on U.S. real rates relative to the rest of the world. To begin with, U.S. non-financial private credit stands at 150% of GDP, a drop of 20% of GDP since its peak in 2009. The rest of the G10 has not experienced the same extent of post-financial crisis deleveraging, and nonfinancial private credit there still hovers around 175% of GDP (Chart I-6). Today, the indebtedness of the U.S. relative to other advanced economies is near its lowest levels of the past 50 years. Debt levels are obviously not the only consideration; the ability to service that debt also must enter the equation to judge the capacity of an economy to accumulate debt relative to the rest of the world. Currently, according to the BIS, the debt-service ratios of the U.S. nonfinancial private sector still stand well below the GDP-weighted average of the rest of the G10 (Chart I-7). This also highlights that the U.S. has plenty of room to have both higher debt accumulation and higher real rates than the rest of the G10. Chart I-6U.S. Vs. G10: Debt Upside Chart I-7Lower Private Sector Debt-Servicing Costs In The U.S. This should support the dollar in 2018. As Chart I-8 shows, 10-year bond yield differentials between the U.S. and other large advanced economies lead tops in the dollar by one year. To highlight this relationship, this chart de-trends the DXY by plotting it as a deviation from its 10-year moving average. Not only does the current trend in real rate differentials already point to a higher dollar, but room for more debt accumulation in the U.S. relative to the rest of the G10 supports the notion that the elevated level of spreads could even expand, implying the era of monetary divergence has yet to end. As we highlighted last week, the dollar may not be as expensive as seems at first glance. We have expanded on our 'modelization' exercise this week, using methods employed by the Swiss National Bank to incorporate the Balassa -Samuelsson effect.2, 3 This metric, which incorporates the relative price of manufactured goods in each economy, further confirm our assessment from last week that the dollar is not expensive enough to warrant a sell-signal (Chart I-9). Thus, with competitiveness a non-issue for the dollar for now, the USD is likely to be able to take advantage of potentially supportive real interest rate spreads. Chart I-8Real Rates Point To A Higher Peak For The USD Chart I-9U.S. Only Sightly Expensive On the technical side, our U.S. Dollar Capitulation Index hit very depressed levels earlier this year, but is now rebounding. Crucially, it has moved meaningfully back above its 13-week moving average, an event which normally characterizes uptrends in the dollar (Chart I-10). Chart I-10Dollar: From Bearish To Bullish Mood Bottom Line: The U.S. economy looks set to enjoy an episode of rising debt supporting increasing economic activity and higher rates as capex should grow further and a supportive backdrop continues to emerge for households - whether or not tax cuts happen. Because the U.S. private sector has comparatively healthy balance sheets relative to the rest of the G10, this means that U.S. re-leveraging should outpace the rest of the world. Even if this U.S. re-leveraging is only a cyclical phenomenon and not a resumption of the debt super-cycle, it would imply that monetary policy divergences have yet to reach their apex, and thus the dollar could experience additional upside. Even Against The Euro? We tend to view the euro as the anti-dollar. It is the main vehicle to play both uptrends and downtrends in the dollar and it is also the most liquid instrument, backed with an economy similarly sized as the U.S. Thus, the views expressed above would imply a negative slant on EUR/USD. Such a framework can give an impetus to a EUR/USD view, but is also not enough. Indeed, factors more specific to this pair argue that EUR/USD does have downside. When it comes to valuations, using the SNB's methodology, the EUR/USD is more or less the mirror image of the DXY. This pair is slightly cheap, essentially within the statistical definition of fairly valued (Chart I-11). Thus, valuations alone are fully neutral for the euro. This means EUR/USD remains prisoner to relative interest rate dynamics. On this front, a key driver of this pair paints a risky picture for euro bulls. The 1-year/1-year forward risk-free rate spread between the euro area and the U.S. has been a reliable guide of the EUR/USD's trend for the past 12 years. Yet, the euro's rally has not been matched by a similar move in this spread. As a result, the gap between the currency pair and its rates-implied fair value is at its highest since the summer of 2014 (Chart I-12). Chart I-11Euro: Not That Cheap Chart I-12Forward Interest Rates Point To Euro Risk But then again, the differential between the European and U.S. 1-year/1-year forward risk-free rate is at its lowest ever over the time frame of this chart. However, it was even lower than current levels in 1999 and 1997. This suggests that if the U.S. can re-leverage relative to the rest of the G10, the spread could grow as negative as it was in these two previous instances. Supporting this assessment, we anticipate U.S. inflation to outperform euro area measures going forward. Last week, we explored the reasons why we see an upcoming uptick in U.S. inflation next year: U.S. financial conditions have eased, American velocity of money has increased, pipeline inflationary pressures are growing and underlying wage growth seems to be improving.4 Meanwhile, European financial conditions have tightened, especially against the U.S., which historically leads to an underperformance of European inflation measures. Very importantly, the euro area core CPI diffusion index has rolled over and is now below 50%, suggesting that euro area core CPI has limited upside (Chart I-13). This means potential downside vis-à-vis the U.S. and room for upside in U.S. rates relative to the euro area, especially as the European Central Bank is likely to craft its message carefully next week when it announces the tapering of its asset purchases, to prevent quick upward movement in interest rate expectations. Additionally, the dollar is still quite under-owned by speculators relative to the euro. Our favorite positioning measure, which sums long bets in the euro with short bets on the DXY - two equivalent wagers - continues to hover near record-high levels, suggesting potential downside in EUR/USD (Chart I-14). This continues to highlight the risks to the euro created by a repricing of the Fed. Chart I-13Euro Area CPI Peaking? Chart I-14Excess Bullishness In Euro Intact Bottom Line: The euro is obviously at risk if the dollar gets lifted by rising economic activity and indebtedness in the U.S., even if this cyclical upswing in debt does not represent a resumption of the debt super-cycle. Moreover, 1-year/1-year forward rates differentials point to heightened EUR/USD vulnerability, especially if U.S. inflation bottoms relative to the euro area. Moreover, long euro bets have yet to be washed out, deepening the EUR/USD's vulnerability. A Few Words On China Chart I-15China: Good Reasons For Policy Tightening Despite a marginal slowdown in Chinese real GDP growth and slightly disappointing industrial production and fixed asset investment numbers for the third quarter, some key Chinese economic activity metrics have been very robust. Imports are growing at a 19% annual pace, credit growth continues to outperform expectations and electricity production and excavator sales remain robust. Should this make investors bullish on China plays? In our view, two key risks lurk on the horizon. The first is monetary tightening. Pricing pressures in China are growing and are looking increasingly genuine. As Chart I-15 shows, core CPI is clocking in at 2.3%, the highest level since 2010-2011, a level which in the past prompted monetary tightening by the Chinese authorities. Additionally, services inflation - a purely domestic sector and thus one reflective of domestic inflationary pressures - is now above 3% and accelerating. Also, PPI has re-accelerated to 6.9%, pointing to a paucity of deflationary forces in the Chinese economy that could potentially give the People's Bank of China the green light to tighten further. We would expect the rise in the Shibor 7-day rate to continue and monetary conditions, which have been tightening since the end of 2016, to become an even bigger handicap in the future. The second risk lies around the Communist Party Congress underway in Beijing. Xi Jinping's marathon speech highlighted his vision for Chinese socialism in a new era. Xi is very clearly dedicated to the primacy of the Chinese communist party. He did highlight, however, that the new principal problem for the Chinese population is the need for a better life, with less imbalances, less inequalities. This fits with his previously revealed policy preferences. As Matt Gertken, who heads the Asian efforts on our Geopolitical Strategy team, has shown, Xi's administration has massively increased spending to protect the environment and increased financial regulation (Table 1).5 These preferences fit in the optic of addressing China's new principal problems: too much pollution and too much debt. Table 1Fiscal Priorities Of Recent Chinese Presidents Moreover, the continued fight against corruption also fits into that mold. It is a key tool to maintain the legitimacy of the Communist party, and a popular way to address some of the inequalities and imbalances plaguing China today. What does this mean? China has continued to accumulate debt over the past 10 years, with debt to GDP increasing by nearly 120% between 2008 and 2017 (Chart I-16). If a window is opening to tighten monetary policy because inflationary pressures are growing while there is political will to combat inflation and imbalances, it is likely that investment - which pollutes heavily - and debt - a byproduct of large capex programs - could be curtailed. Moreover, the Chinese government still has the wherewithal to support aggregate economic activity through fiscal stimulus. In addition, in the context of the above, much fiscal stimulus could be deployed to fight pollution and decrease inequalities by supporting households. This means that while Chinese GDP growth is unlikely to weaken substantially, the capex intensity of the economy could decrease. So would imports of raw materials and capital goods. As a result, this could be a very negative environment for metals. Metals prices have rebounded sharply since 2016 as Chinese investment has increased. But now that policy could be tightened further and that Xi's new administration has more freedom to move away from an investment-heavy, deeply polluting growth model, the rally in metals could be at risk. Copper, a bellwether for the metals complex, has surged nearly 70% since 2016, and bullish sentiment on the red metal is now at levels historically associated with imminent corrections (Chart I-17). Chart I-16Is This What Deleveraging Looks Like? Chart I-17Tighter Policy And A Reform Push Put Metal At Risk This means that currencies for which metals prices are a key driver of terms of trade are at great risk, specifically the BRL, the CLP and the AUD. Moreover, the latter is expensive, having recently been buoyed by some positive economic numbers, and is now widely owned by very bullish investors. We have a short sell AUD/USD at 0.79 and our short AUD/NZD trade at 1.11 was triggered following the Labor/NZ First/Green coalition announced Thursday in New Zealand. Bottom Line: Chinese authorities are set to tighten monetary conditions further as domestic inflationary pressures are growing. Moreover, while short on details, this week's speech by Xi Jinping at the opening of the 19th Communist Party Congress in Beijing seemed to confirm that addressing imbalances, inequalities, and environmental problems will be a key objective of this administration. This points toward a less debt-/investment-driven economic model - at least until deflationary problems re-emerge. While overall GDP growth could be supported by targeted fiscal support, investment plays linked to Chinese capex and real estate could suffer. The AUD is at risk, and we are entering our proposed short AUD/NZD trade. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see U.S. Equity Strategy Special Report, titled “Top 5 Reasons To Favor Cyclicals Over Defensives” dated October 16, 2017, available at uses.bcaresearch.com 2 The Balassa Samuelson effect is an empirical observation that countries with higher productivity tend to experience an appreciating trend in there real exchange rate. Please see Foreign Exchange Strategy Weekly Report, titled “Is The Dollar Expensive?”, dated October 13, 2017, available at fes.bcaresearch.com 3 Samuel Reynard, “What Drives the Swiss Franc?” Swiss National Bank Working Papers (2008 – 14). 4 Please see Foreign Exchange Strategy Weekly Report, titled “Is The Dollar Expensive?”, dated October 13, 2017, available at fes.bcaresearch.com 5 Please see Geopolitical Strategy Weekly Report, titled “How To Read Xi Jinping’s Party Congress Speech”, dated October 18, 2017, available at gps.bcaresearch.com Currencies U.S. Dollar Chart II-1 Chart II-2 U.S. data was mixed: Last week's CPI releases showed that inflation disappointed in September, with headline CPI increasing by only 2.2%, below the expected 2.3%; and Core CPI coming in at 1.7%, in line with expectations; However, long-term TIC data showed a large inflow of funds of USD 67.2 bn, much larger than the expected USD 14.3 bn. The labor market continues to tighten with initial jobless claims and continuing claims dropping to 222,000 and 1.888 million respectively. The DXY has rebounded this week on this news, and also helped by a somewhat disappointing ZEW survey from the euro area, but pared its gains on Wednesday. Regardless, positive developments in the U.S. fiscal space and disappearing slack will provide a tailwind for the greenback. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day -August 25, 2017 The Euro Chart II-3 Chart II-4 Data from the euro area has been mixed: Industrial production grew at an annual rate of 3.8% in August; The trade balance contracted to EUR 16.1 bn from EUR 23.2 bn on a non-seasonally-adjusted basis, but improved on a seasonally-adjusted basis. The final estimate for core CPI hit 1.1%, in line with expectations; The ZEW Survey dropped and underperformed expectations; Despite largely weak data, the euro has pared all of last week's losses. Markets may be pricing in Catalan developments as a bullish case. The Spanish government has threatened to enact Article 155 of the constitution if Catalonia does not comply, which will give Spain the authority to take measures to ensure compliance by the rogue region. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 The Yen Chart II-5 Chart II-6 Recent data in Japan has been mixed: Bank lending outperformed expectations, growing at a 3% year-on-year pace. Machinery orders yearly growth also outperformed to the upside, coming in at 4.4% However, the annual growth of both imports and exports underperformed expectations and declined significantly from last month, coming in at 12% and 14.1% respectively. The yen has remained relatively flat these past two weeks. Overall, we expect USD/JPY to have additional upside, given that the U.S. OIS curve is not pricing in enough rate hike over the next 2-years. Ultimately, the driver of USD/JPY will simply be U.S. rates as Japanese 10-year rates are capped near 0%. This situation is not likely to change any time soon, as the Japanese economy is still hampered by very low inflation. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day -August 25, 2017 British Pound Chart II-7 Chart II-8 Recent data in the U.K. has been mixed: Average hourly earnings outperformed expectations, growing at a 2.2% pace from a year ago. Both headline and core inflation came in line with expectations at 3% and 2.7% respectively. However, both retail sales and retail sales ex-fuel growth underperformed expectations, coming in at 1.2% and 1.6% respectively. Overall, we do not expect much more upside for the pound relative to the U.S. dollar, given that there is already a hike priced for November. At this point, the economic situation does not warrant any more hikes beyond just removing the emergency measures implemented after the Brexit fallout. Furthermore inflation has stopped climbing, and could start to come down in the coming months as the effects of the currency dissipate. Finally, Brexit negotiations have hit a bit of a temporary impass. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Australian Dollar Chart II-9 Chart II-10 The AUD has not seen much action this week. The RBA minutes highlighted that "slow growth in real wages and high levels of household debt were likely to be constraining influences". This is largely in line with our argument that spare capacity is limiting wage growth and inflation in the economy. Going forward, China remains a risk to our view, with the most recent import figures having provided a welcomed fillip to the AUD. Nevertheless, remarks by RBA Governors will limit the upside in the AUD. Expectations of a rate hike by the RBA depend upon growth numbers, which are unlikely to be achieved given the current trajectory of wages and consumer spending. Furthermore, high underemployment in the economy also remains a drag on spending, dampening the positive effect of a strong job report. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 New Zealand Dollar Chart II-11 Chart II-12 Recent data in New Zealand has been mixed: Electronic card retail sales year-on-year growth declined form 4.4$ to 2.9%. Business NZ PMI softened from 57.9 to 57.5. However, headline inflation came in at 1.9%, rising from the previous month reading of 1.7% and outperforming expectations. The kiwi sold off by almost 2% yesterday, as Jacinda Ardern was elected as the new prime minister of New Zealand. The market is now pricing the risk that the Labor party, which Ardern leads, could change the mandate of the central bank from just targeting inflation to also seeking full employment. Moreover, Labor and its coalition partner, NZ First, want to curtail immigration, one of the tailwind to New Zealand growth. These development would structurally limit the upside for kiwi rates, acting as a headwinds to the New Zealand dollar. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Canadian Dollar Chart II-13 Chart II-14 The CAD has been somewhat strong recently due to developments in the oil market. KSA-Russia support for an extension of supply cuts to OPEC 2.0, as well as developments in Iraq, have pointed to an increase in prices. While the path for Canadian interest rates seem fairly priced, oil prices could buoy the CAD. Risks surrounding NAFTA remain, as President Trump stays inflexible with regards to tariffs, although this is likely to have a greater effect on Mexico than on Canada. Furthermore, albeit still in its infancy Morneau's tax plan, which is anticipated to mostly affect the richest of small business, could have an effect on investment intentions. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Swiss Franc Chart II-15 Chart II-16 Recent data in Switzerland has surprised to the upside: The unemployment rate decreased from 3.2% and 3.1%, outperforming expectations. Producer and import prices yearly growth came in at 0.8%, also surprising to the upside. Finally, the trade balance also outperformed, coming in at 2.918 billion dollars for September. It seems that the fall in the franc has been very positive to the Swiss economy. Overall, it would be difficult to see much more upside in EUR/CHF, as the euro already reflects euro area positives. That being said, we are reticent to be outright bearish on this cross as the economic data is still too weak for the SNB to change its monetary policy stance. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Norwegian Krone Chart II-17 Chart II-18 Recent data in Norway has been negative: Manufacturing yearly output growth underperformed expectations, contracting at 5.7%. Both core and headline inflation also surprised to the downside, coming in at 1% and 1.6% against expectations of 1.2% and 1.7% respectively. Finally, the Norwegian trade balance declined from 12.4 billion dollars to 9.2 billion dollars USD/NOK has risen 3% since September, even as oil prices have continued their path upward. This was first and foremost reflective of the higher probability of rate hikes in the U.S. in December. Additionally, the recent Norwegian inflation and trade balance numbers are showing that the krone rebounds has tightened monetary conditions in this Scandinavian economy. Overall, we remain bullish on USD/NOK and bearish on EUR/NOK. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swedish Krona Chart II-19 Chart II-20 The most recent inflation data was slightly weak, with CPI increasing by 0.1% monthly, and 2.1% yearly. Unemployment worsened as the rate rose to 6.2% from 6%. The krona depreciated against the euro on the news, but was flat against the dollar. Despite this temporary setback, PMIs are still perky across the board, and credit is hooking up. China and Europe's recent performance has likely provided a tailwind for growth, which should translate into higher inflation as capacity utilization is extremely tight. Furthermore, the depreciation of the SEK since the beginning of September has eased monetary conditions, making way for the central bank to begin a tightening process in the wake of the ECB's tapering program. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

One of BCA's long-standing clients, Ms. Mea, recently paid us a visit at our Montreal office. Ms. Mea is an experienced and successful investor who has been reading different BCA products for many years. She noted that over the years she has both agreed and disagreed with our market views, but that she appreciates our thematic approach including themes, analysis and views, as they are important to her investment process. Like many of our clients, Ms. Mea has been disappointed by the Emerging Markets Strategy (EMS) team's EM/China call, which has not been correct over the past 18 months. My team and I spent a few hours with Ms. Mea detailing our views and methodology. Despite some tough discussions, she said she found the dialogue valuable. Reflecting on our meeting, I thought it would be beneficial to share the key points with all of EMS clients. This report is a summary of that. Ms. Mea and I agreed to continue the debate as the story plays out, so I will be meeting with her occasionally in Europe when I travel there. Ms. Mea: Clearly your recommended strategy has been wrong for some time. I am aware that your negative view on EM/China and strategy was right and profitable from 2011 until early 2016. Nevertheless, since early last year EM risk assets have rallied considerably, and not participating in this rally has been painful - not to mention being short EM risk assets. For our global equity funds, underweighting EM within the global universe did not hurt performance in 2016. However, this year the EM equity benchmark has considerably outperformed the global averages (Chart I-1). So, what has gone wrong, and why haven't you changed your view already? Chart I-1EMS's Big Picture Asset Allocation Strategy: EM Relative To DM Stock Prices Answer: My objective today is not to dispute your comments - my view and investment strategy have clearly gone wrong. Rather, I would like to highlight what has gone wrong as well as elaborate on my methodology and thought process. Let me be clear, if I thought in 2016 or early 2017 that the market would rally for more than six months and - in the case of EM equities - by more than 20%, I would have recommended clients to play this rally regardless of my big picture themes and views. The same is true today. My general view has been based on two pillars: Chinese growth and Federal Reserve policy/the U.S. dollar. 1. The first pillar of my argument has been that China's growth improvement would prove unsustainable due to lingering credit imbalances/excesses. In the April 13, 2016 report,1 I laid out the case that China's 2015-16 fiscal stimulus of RMB 850 billion would be offset by a potential slowdown in credit growth from an annual growth rate of 11.5% to 9-9.5%. Chart I-2China: Borrowing Costs Have Been Rising This thesis of credit growth deceleration was based on the natural tendency of credit growth to gravitate toward nominal GDP growth, especially since the credit-to-GDP ratio had massively overshot in the preceding seven years. Besides, since 2013 high-profile policymakers in China had been talking about the need for deleveraging, containing financial excesses, and not repeating the mistakes of 2009-2010, when money and credit was allowed to run at an extremely strong pace. In first half of 2016, I downplayed the recovery in money and credit aggregates arguing that they are temporary and unsustainable. When a country has a lingering credit bubble - which has been the case in China, I am biased to downplay upticks in money and credit growth and easing in monetary policy. At the same time, I put a greater emphasis on both monetary tightening and slowdown in money/credit when the economy suffers from credit excesses. The opposite is also true in cases where there are no excesses/imbalances. Since November 2016, the People Bank of China (PBoC) has been tightening liquidity and pushing money market rates and corporate bond yields higher (Chart I-2). This has been taking place in addition to regulatory tightening on both bank and shadow banking activities. As a result, I have been predicting that regulatory and liquidity tightening amid lingering credit and speculative excesses would weigh on money, credit and capital spending. Importantly, I reckoned that financial markets would be forward-looking and would reverse their rally in anticipation of weaker growth down the road instead of reacting to robust - yet backward looking - growth data. Indeed, money and credit growth have already slowed to all-time lows (Chart I-3). Nevertheless, broad economic growth has not slowed (Chart I-4). This has also been true for China's impact on the rest of the world - the mainland's imports have remained robust (Chart I-5). Chart I-3China: Money And Credit Aggregates Chart I-4China: Business Cycle Perspective Chart I-5China: Money Impulses And Imports Not only have I been surprised by the mainland economy's ability to withstand the slowdown in money/credit so far, but I have also been caught off guard by how financial markets have shrugged off the rise in onshore interest rates and the deceleration in money/credit. That said, liquidity tightening works with a time lag. The fact that it has not yet had an impact on the real economy does not mean it won't going forward. 2. The second pillar of my view has been that the Fed's dovish stance would prove transitory. The global market rally began in February 2016 when the Fed sounded dovish in the face of a surging U.S. dollar, collapsing commodities prices, very weak global trade and plunging global risk assets. Remarkably, global growth and corporate profits have recovered very strongly, the U.S. dollar has weakened considerably and commodities and global tradable goods prices have rebounded. As such, I expected that U.S. interest rate expectations would move higher, dampening the carry trade. Unfortunately, markets' reactionary functions does not always follow a symmetrical logic. The decline in U.S. inflation rate amid a weak dollar, rising import prices and robust U.S. growth - especially the tight labor market and some wages pressures (Chart I-6) - has puzzled me. Ms. Mea: Why have you disregarded the clear improvements in EM profits and global trade in 2017? Answer: I have been aware of improving economic data and corporate profits. Yet, these types of data are backward looking and are not a guarantee of future trends. Even though the released economic data and corporate profits have been strong, our forward-looking indicators for both EM and China have been heralding and continue to point to a major downtrend in EM profits (Chart I-7). Chart I-6Subtle Upside Risks To U.S. Inflation Chart I-7EM Profits Are At Risk Importantly, I presume stock prices lead profits. Hence, it is dangerous to turn bullish when forward-looking indicators that lead profits are already flashing red. These are empirical indicators and have a great track record. As such, I have placed substantial weight on them rather than on backward-looking economic and profit data. Since early 2017, I have been facing the following dilemma: Should I change my view based on strong, yet backward-looking, profit data, or remain cautious based on forward-looking growth indicators as well as our big-picture themes. I chose the latter, which in retrospect was wrong. Looking back, the biggest mistake I made was putting little weight on how markets have been trading. EM and global stocks continue to trade as they would in a genuine bull market: they have looked past negative news and rallied a lot in response to positives. Ms. Mea: You mentioned big-picture themes. Can you elaborate on your framework and methodology? Answer: At the core of my analytical framework lies investment themes. I formulate these themes based on a series of in-depth research reports. These themes have multi-year relevance - I expect them to have staying power beyond one year. These themes represent an anchor to my view and strategy. Without anchor themes, I would tend to change my views back and forth based on fluctuations in economic data or swings in financial markets. Having established themes, my team and I monitor cyclical data, market dynamics/signposts and any type of evidence to prove or refute those established themes. Clients have recently been asking why I only show charts/evidence that confirm my view, and rarely entertain the alternative scenario. Indeed, there are always contradictory signals, signposts and data that I identify every week. Yet, I still choose to show those that support my ongoing themes and views. Why? Because I opt to convey a well-argued coherent message to my clients. In this context, I use the limited client-time allocated to reading our reports to highlight the reasons supporting my current themes and high-conviction views. It would also be unhelpful for readers if I demonstrate several charts that herald a bullish stance, and then conclude the opposite. If I were to utilize the alternative approach, i.e., present data and evidence on both sides of the debate, the report would be ambiguous. As a result, readers would gain little conviction and would likely be left confused. Each of these approaches has advantages and disadvantages: when the view plays out, investors see the correct angle and, thereby, develop a strong conviction on the strategy, and hopefully act upon it. Conversely, when the view goes wrong, investors typically wish they had seen the opposite side as well. Chart I-8China: No Deleveraging So Far In short, my goal is to leave clients with a clear and well-argued message when I have high conviction. As to conviction level, like all investors, I am dealing with a black box when gauging the outlook for financial markets. I am never 100% certain; I make investment recommendations only when my conviction level is somewhere around 65-75%. Generally, I do not discuss the areas where my conviction level is less than 60%. Less than 60% means "I do not know". An example of this is whether the current tech rally will persist. Importantly, I try to bring to clients' attention data and evidence that they may not be aware of and analytical points that differ from commonly known market narratives. Investors are aware of overall global financial market dynamics and ongoing narratives. My goal is to add value to their knowledge with the framework of thematic investment research, and to highlight new and potentially market moving charts, data and evidence. My major theme on China in the past several years has been the following: Chinese banks have originated too much money, and the corporate sector has taken on a large amount of leverage. This, in tandem with speculative excesses in the shadow banking and property markets, pose considerable downside risks to capital spending growth in the mainland. This is especially the case given that both liquidity and regulatory tightening of banks and non-banks already begun in late 2016. While financial markets, economic data and corporate profits have gone against this theme, this does not mean credit/money excesses in China have disappeared or do not exist. On the contrary, they have gotten even bigger now (Chart I-8, top panel). The Chinese economy has recovered and benefited commodities prices and the rest of EM due to another round of substantial money/credit injection. Broad money and broad credit have surged by about RMB 45-50 trillion since the middle of 2015 - depending on which measure one uses (Chart I-8, bottom panel). In the context of mushrooming leverage, ongoing policy tightening entails a poor risk-reward profile for bullish bets on mainland growth. This is why I am reluctant to abandon this theme and the bearish view. Ms. Mea: What would it take to change your big picture theme on China? To fundamentally reverse my view on China and commodities on a multi-year time line, I would need to reject my theme that China has meaningful credit excesses and imbalances, or buy into the view that these imbalances are a natural outcome of China's excess savings and will never correct. I have strong conviction in my big picture theme and I have not seen convincing arguments to change it. That said, if I come to the conclusion that EM risk assets and China-related plays will rally for six months or longer, I will change the investment strategy and recommend playing that rally. In this case my market strategy will change even though the big picture theme remains intact. As to the relationship between national and household savings, credit, and money, I have elaborated at great length that money creation and credit excesses do not originate from excess savings.2 Hence, it is simply not natural for a country with excess savings to experience and sustain credit bubbles. Importantly, adjustments in terms of credit excesses/deleveraging in China have not even started (Chart 8, top panel). This does not imply that investors should wait until deleveraging ends before turning positive on mainland growth. Markets are forward looking and will bottom when they see the light at the end of tunnel. But it is very dangerous to be positive when the adjustment has not yet began. It appears China's capital spending in general and construction in particular - the most vulnerable and credit-dependent segments - have in recent years been fluctuating in mini-cycles, similar to what played out in Japan during the 1990s and 2000s. I am not suggesting that China resembles Japan entirely, but comparing their mini cycles is a worthwhile exercise. Chart I-9 shows that the Japanese economy, money, credit and share prices were on a rollercoaster ride in the 1990s and 2000s. Notably, the profile of Chinese H shares fits the profile of Japan's stock market during that period (Chart I-10). On average, the recovery phase of these mini-cycles/equity rallies lasted about 20-24 months. Chart I-9Mini-Cycles In Japan In The 1990-2000s Chart I-10Chinese H-Shares Now And Nikkei In 1990s My judgment is that the recovery in the Chinese economy and related financial markets over the past 18 months resembles the mini cycles Japan experienced in the 1990s and 2000s. If so, after the rally in the past 18 months, forward-looking investment strategy should be focused on identifying signposts of a reversal. Consistently, given my bias stemming from our core themes and the fact that financial markets are forward looking and have already rallied a lot, I have been looking for signs of a top in China's business cycle and Asia's trade flows. It is pointless for me to change the view if my bias is that markets will reverse their trend in the next couple of months. Investors who are bullish and long but are somewhat concerned about China's growth sustainability still may want to monitor and be aware when the business cycle and markets will reverse. This is where I believe our research is helpful and relevant to investors with a bullish bias. It is hard to forecast what would be an inflection point to overturn the current financial market trend. It could be an unambiguous message from China's Communist Party Congress in the coming days that containing financial risks - a code word for deleveraging - is a major policy priority, or it could be weak economic data in China, or lower commodities prices and weaker EM currencies, being the flipside of a stronger dollar. Chart I-11China: Beware Of Rising Inflation Ms. Mea: It seems there is no silver lining in your view. Does this mean Chinese policymakers cannot do much to generate a positive outcome for the economy and financial markets? Answer: Chinese policymakers are in a very tough position. Yet it does not mean there is no silver lining. I assign a 20-25% probability that policymakers can stabilize leverage in the economy and financial system without a meaningful growth slump. If this scenario transpires, my negative view on EM and China-related plays will continue to be wrong. There is a 40-45% probability that growth will slump as the authorities focus on deleveraging and structural reforms (allowing markets to play a greater role in resource/capital allocation), and that policy tightening will begin biting. This heralds a deflationary outcome from a cyclical perspective, but it also represents a necessary adjustment to ensure efficiency gains and productivity-led growth over the long run. In fact, this would make me structurally bullish on China's growth again. There is also a 30-35% probability that policymakers - having no tolerance for any kind of growth slump - will continue to stimulate via money/credit and fiscal deficits. The outcome of this scenario will be an inflation outbreak Notably, as I argued in the October 4th 2017 report,3 underlying inflationary pressures are rising, as shown in Chart I-11. Unless growth decelerates meaningfully, inflation will need to be tackled. If not, capital outflows from residents will escalate again, and the currency will come under depreciation pressure given that the deposit rate is at a very low 1.5%. Rising inflation limits policymakers' maneuvering room: they have to tighten and cannot stimulate rapidly and considerably when growth slows. In short, a silver-lining scenario - which would include the authorities curbing out excesses while preserving overall growth, and especially capital spending growth - is always there and is a well-known narrative in the investment community. I do not write about it because I assign a 20-25% probability of it actually panning out. Why not more? Because the imbalances and excesses are currently so large that it will be difficult to contain them without jeopardizing growth. Finally, my view on China does not spread to the entire economy - our focal point has been and remains capital expenditures in general and construction in particular. These areas are being financed by credit, and consume a lot of raw materials and capital goods. Mainland imports - which are heavy in commodities and capital goods (the two account for 95% of total imports) - are the link between mainland investment expenditures and the rest of the world in general, and EM in particular. The latter will suffer if Chinese imports contract. Ms. Mea: It seems your big-picture themes have considerable influence on your views and strategy. How have your big-picture investment themes evolved over time? Last decade, my overreaching theme was that EM and China were structurally sound and that EM/China/commodities were in a bull market. So, I went from being a staunch bull to a resolute bear. I took over the EMS strategy service in 2005, and was bullish on EM, China and commodities up until 2010 (Chart I-1 on page 1). In 2005, I published an in-depth report arguing that commodities were in secular bull market due to demand from China.4 In April 2006, I pioneered a new theme that in the case of a U.S./DM recession, EM could stimulate and boost domestic demand - an out-of-consensus thesis5 at the time. Having these themes in mind, I recommended upgrading/accumulating Chinese stocks amid the Lehman crisis in the fall of 2008.6 The message was that Chinese policymakers could and would stimulate, and that such stimulus would succeed in lifting Chinese growth, corporate profits, commodities prices and EM risk assets. That was a non-consensus trade at the time, and the exact opposite of my current view. Following the credit boom in EM/China in 2009-10, excesses and imbalances emerged, and I shifted to a negative stance on EM/China in 2010 (Chart I-1 on page 1). Furthermore, in our June 8, 2010 Special Report titled, 'How to Play EM This Decade,' I made a call on a major top and forthcoming bear market in commodities arguing that the 2010-decade leaders in terms of growth and share price performance would be the healthcare and technology sectors. I speculated that during the current decade mania will unfold either in the technology or heath care sectors or some combination of both. Since 2010, the technology and healthcare equity sectors have been the best equity sectors, while commodities have been the worst performing ones within both the global and EM equity space. Consistent with this theme, I have been overweighing EM technology stocks and bourses where tech has a large weight, such as Taiwan, China and Korea. Besides, since 2010 I have maintained a pair strategy recommendation of being long tech and short materials. Ms. Mea: It seems you have been changing the goalposts lately, using new data on Chinese money and credit instead of relying on traditional ones. Our research is an ongoing effort to understand the macro landscape better. Our objective is always to find new variables and indicators that better lead business cycles and corporate profits while continuing to track the existing ones. Thus, it is not about changing goalposts but refining existing indicators or examining alternative ones that have a better track record. The following aspects have led usintroduce new broad money measures in China: Over the past two years, official M2 has been much weaker than various credit and money measures, as illustrated in the top panel of Chart I-8 on page 8. Broad money, and hence new purchasing power, is created when banks originate credit - by lending to or buying claims on non-bank entities. Therefore, properly measuring broad money is vital to assessing the new purchasing power that is created in the economy. In brief, in 2016 and early this year I relied on China's official broad money M2 measure, but it has underestimated the amount of new purchasing power created in the past two years. This was one of the reasons we misjudged the duration and magnitude of this equity rally. In addition, the regulatory clampdown on banks and non-banks may have prompted them to shift credit assets from off balance sheet to on balance sheet, or vice versa. Banks and shadow bank entities can obscure or hide credit by classifying it differently, but the banking system cannot conceal the amount of money in the system. Therefore, by tracing broad money creation, one can trail new purchasing power originated by banks. For these reasons, we have begun calculating new broad money aggregates for China - we produced our measure of M3 (M2 plus some other banks liabilities that are not included in M2) and credit-money (broad money calculated using the asset side of commercial banks' balance sheets). Chart I-3 on page 3 illustrates that all measures of money and credit have slowed in late 2016 and this year. On balance, having examined various measures of money and credit, including official M2, we have concluded that in the past 12 months money/credit creation has been slowing in China, irrespective of which aggregate we focus on (please refer to Chart I-3 on page 3). Ms. Mea: How do you explain strong September money and credit numbers out of China? Money, credit and business activity data for September were indeed strong, but they should be adjusted for working days. In China, the annual Mid-Autumn Festival fell in October this year versus September over the past several years. During this festival, business activity grinds to a halt for several days. I conjecture that money, credit and growth data out of China and Asia in general was strong in September partially due to the increase in the number of business days in September this year versus September a year ago. We need to wait for October data and average the two months to get a better picture of the trajectory of the business cycle in Asia. Chart I-12China: Velocity Of Money Has Been Declining Ms. Mea: Your view on China, commodities and EM is largely contingent on very weak money growth. Is it possible that the correlation between money and economic growth has diminished or completely broken down in China? The only reason why broad money growth could deviate from nominal GDP growth is due to the rising velocity of money. Let's remind ourselves: Nominal GDP = Money Supply x Velocity of Money. For nominal GDP growth to rise, a considerable decelaration in money supply growth needs to be offset by an even larger acceleration in the velocity of money. It is extremely difficult to forecast velocity of money. I assume money velocity will be steady (constant) and, consequently, nominal GDP growth to be affected primarily by changes in broad money growth. Chart I-12 demonstrates that the velocity of money in China has been declining over the past eight years. So, it would be odd for the velocity of money to suddenly rise going forward, in turn making money growth a less reliable indicator for nominal GDP growth. Overall, while it is always possible that the correlation between money growth and economic activity can break down, it is not something that one can forecast or bet on with high conviction. Chart I-13EM Ex-China, Korea And Taiwan: ##br##Broad Money And Bank Loan Growth Is Weak Ms. Mea: What about other emerging markets? How dependent are they on China? Where are they in the business cycle? The link from China to other emerging markets is via commodities and EM countries' other exports to the mainland. Even non-commodity countries like Korea and Taiwan sell a lot to China. If Chinese growth decelerates, commodities prices relapse, the U.S. dollar rallies or the RMB comes under selling pressure, the outlook for other EM countries and their risk assets will be dim. I argued that EM currencies, credit, and stocks on aggregate levels are not cheap.7 Segments that appear attractively valued are cheap for a reason, while healthy segments (countries/sectors/companies) are rather expensive. Money and bank loan growth also remain lackluster in the majority of EM, excluding China, Korea and Taiwan (Chart I-13). The reason is that the banking systems in many of these developing countries have not been restructured and remain sick following years of overextended credit and rising non-performing loans. Therefore, even though EM exports to China and the rest of the world have picked up, there has been little recovery in their domestic demand. If external conditions - exports, exchange rates and borrowing costs - deteriorate anew, EM domestic demand recovery will be derailed. Investors often refer to Russia and Brazil when they cite macro adjustments in developing economies. It is true that Russia and Brazil have already gone through a lot of pain and adjustment, including provisioning for NPLs in their respective banking systems. Nevertheless, financial markets in both countries remain dependent on commodities prices and the U.S. dollar outlook. Barring external shocks, both economies will continue to revive. That said, my big-picture view entails a negative shock to EM sentiment due to China and a rally in the greenback so I cannot turn bullish on them yet. In addition, Brazil's public debt is rising in an unsustailable manner, and political risks remain significant, particularly ahead of next year's elections. It will be hard to boost nominal growth and contain the explosion of public debt without meaningful currency depreciation that reflates the economy. That cannot not bode well for foreign investors in Brazilian markets. Credit excesses continue to linger in some other EM economies, and there has been little adjustments in their leverage even when we remove China, Korea and Taiwan from the aggregate (Chart I-14). All in all, while some EM economies have undergone necessary macro adjustments, the largest economy - China - has not. When China begins its own macro adjustments, shockwaves will likely hit Asian economies and commodities producers. There are not many large developing countries outside Asia that are not raw materials exporters. Ms. Mea: What about the technology sector? It alone has been responsible for a substantial portion of price gains in the EM equity benchmark in this rally. Does your view on China's credit cycle also influence your outlook for technology stocks? Indeed, EM tech stocks have exploded in recent years, accounting for a significant portion of EM share price appreciation. Excluding tech stocks, EM equities have not rallied nearly as much (Chart I-15). Chart I-14EM Ex-China, Korea And Taiwan: ##br##Leverage Has Not Diminished Chart I-15EM Equities: Tech Versus Non-Tech Also, Table I-1 reveals that eight out of 11 equity sectors have underperformed the benchmark. Meanwhile, a large share of tech gains has been produced by five or so companies. Table I-1EM Sectors: Only Three Out Of 11 Sectors ##br##Outperformed The Benchmark I have no strong view on the technology sector's absolute performance following the exponential price gains of past years. Overweighting the technology sector has been my recommendation since 2010, as we discussed above, and it has panned out quite well. I still maintain this overweight call, but within the technology sector we prefer semis to internet and social-media stocks. On the second part of your question, my negative view on China's credit cycle does not have direct ramifications for technology stocks, including Chinese ones. Critically, the call on internet- and social media-related companies is a bottom-up call. On the macro level, I can only state the following: It is essential to realize that in the past nine years a lot of new purchasing power in China has been created because of explosive money origination by banks. If money/credit growth structurally downshifts in China in the years ahead, nominal income growth for both households and companies will slow and the growth in their spending power will also moderate. That said, I am not in a position to assess and comment on business model viability and equity valuation levels of internet and social media-related companies like Alibaba, Tencent or Baidu. As to the other two tech heavyweights - Samsung Electronics and TSMC - I continue to recommend an overweight position in semis and other tech stocks that stand to benefit from DM growth. However, I am less certain about their absolute performance given their exponential rally. Chart I-16EMS's Fully-Invested Equity Portfolio ##br##Performance Versus The Benchmark Finally, regardless of my view on EM absolute performance, we always add value to dedicated EM equity and fixed-income investors by selecting countries to overweight and underweight relative to their respective benchmarks. Our country equity allocation strategy has been very successful. Chart I-16 illustrates our country fully-invested equity portfolio performance versus the EM benchmark. The portfolio is built based on our overweight and underweight recommendations on individual bourses, and is assumed to be fully invested. Our country calls have done quite well in the past nine years, producing 58% outperformance versus the benchmark with extremely low volatility. This translates into 520 basis points of annual compound outperformance for nine years. Our recommended country allocation and other equity positions as well as fixed income and currency recommendations are published at the end of each week's report. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report titled "Revisiting China's Fiscal And Credit Impulses," dated April 13, 2016, link available at ems.bcaresearch.com 2 Please refer to the Emerging Markets Strategy Special Reports from October 26, 2016, November 23, 2016 and January 18, 2017; available on ems.bcaresearch.com 3 Please refer to the Emerging Markets Strategy Weekly Report titled, " China: Deflation Or Inflation?," dated October 4, 2017; link available on page 21. 4 Please refer to the International Bank Credit Analyst Special Report titled, "Commodities: Buy On Dips," dated April 2005. 5 Please refer to the Emerging Markets Strategy Special Report titled, "Global Monetary Tightening And Emerging Markets: Is It Different This Time?"dated April 19, 2006. 6 Please refer to the Emerging Markets Strategy Special Report titled, "Upgrade/Accumulate Chinese Stocks,"dated September 29, 2008. 7 Please see Emerging Markets Strategy Weekly Report titled "Is The Dollar Expensive, And Are EM Currencies Cheap?" dated October 11, 2017, link available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Chinese politics is shifting from a tailwind to a headwind for the economy; Policy implementation should improve in Xi's second five-year term; Tighter financial and environmental controls will continue to bite next year; Key internal and external risks are structural in nature - volatility will rise; Re-initiate our long China volatility and long Big Bank trades; stay overweight Chinese H-shares in EM portfolios Feature Xi Jinping is slated to deliver his "work report" as we go to press, at the opening of China's nineteenth National Party Congress.1 The speech will be filled with communist slogans and jargon and will not give clear "answers" to the questions so heavily debated about China. But it will be the most authoritative distillation of the party's thinking in five years and will bear Xi Jinping's imprimatur as the "core" of the Communist Party. Hence investors will need to read the tea leaves to try to get a sense of the country's policy preferences over the next five years. In this Special Report, we offer a guide to interpreting the work report and the likely changes to the party constitution. Broadly, we think the party congress will herald a period of more effective domestic policy reforms in 2018-19. The nature of these reforms is an open question, but they likely entail that government policy will shift from being a tailwind for Chinese growth, as it has been since 2015, to being a headwind. While the party will aim to maintain stability as always, more effective policy execution will in itself probably increase the risks to stability. At present levels, Chinese political risks are understated by the market (Chart 1). The Stability Imperative Xi's speech is an authoritative party document drafted over the past year. It will be part of the running narrative laid out by his predecessors, particularly former President Hu Jintao's report at the eighteenth party congress in 2012, which Xi himself drafted and which marked the transition of power from Hu to Xi.2 Going back to 1992, the reports tell a story of China's shift from focusing on rapid, market-oriented "catch-up" economic growth to focusing on social stability and consumer-led growth. Analysis of the words most often used in the speeches reveals this critical policy evolution, with terms like "rural" and "security" gaining considerable ground recently (Chart 2). Chart 1Stability Achieved For Party Congress Chart 2The Shifting Emphasis In Key Speeches Broadly, Xi is pre-committed to the following key points about the economy: Primacy of the party and state: The idea of building a "socialist market economy" means maintaining the primacy of the party and the state in the economy. State resources will still be used to prop up economic growth and public ownership will remain dominant in strategic industries. Any debate about reform must occur within this context. Reform and opening up: The period after Chairman Mao is broadly defined as a period of market reform and globalization. China, as a major exporter and growing global investor and consumer, continues to benefit from these forces, as Xi highlighted in his speech at the Davos Forum earlier this year.3 Recently, however, productivity growth has declined, and foreign companies and governments have grown resentful of China's attempts to protect its market while encroaching on their markets and capturing their technology. Foreign direct investment is at the lowest point since the height of the global financial crisis.4 Xi's administration will re-commit to reform and opening up, but the proof will be in the actual policies issued forth in the coming months. Two "Centenary Goals": China has long committed to two overriding "centenary goals" of building a "moderately prosperous society" by 2020 and becoming a "modern socialist" developed country by 2049. The essence of these goals is not only to meet middle-income GDP and income targets by 2020 (Chart 3) but also to avoid getting stuck in the "middle-income trap." The first deadline coincides with the end of the thirteenth Five-Year Plan and is integral to the symbolic hundredth anniversary of the Communist Party in 2021 - another politically sensitive year in which economic stability will be paramount.5 China's global influence: China's global influence is rising along with its economic and military heft. Hu Jintao's 2012 party congress report was the first to emphasize China's emerging status as a "maritime power" and to introduce the concept of a "new type of great power relations."6 The latter would require the U.S. to concede a much greater global leadership role for China in order to avoid conflicts as China carves out a sphere of influence. The 2012 report also focused on building closer economic ties with Asia and the emerging world. Xi is doubling down on these global trends, notably by his assertive foreign policy in the South China Sea and promotion of the Belt and Road Initiative.7 He may make tactical adjustments but the strategic path is set for him. Maintaining stability and balance: China had a tumultuous history under foreign domination and Maoist revolution for most of the past two centuries. Whatever new initiatives its policymakers undertake, they will stress the need to keep the ship of state on an even keel. This applies to the nature of the policies themselves (e.g. rebalancing growth away from investment toward consumption) as well as to the principle of cautious execution. What is the economic implication of these inherited party goals? Looking at the low growth rate in China's various monetary aggregates presents a risk that the country could face a cyclical slowdown next year (Chart 4).8 This risk could be compounded by Xi's tougher policy stance this year (for instance, his imposing curbs on the property market).9 Yet the next politically sensitive deadline is not until 2020-21, implying that Xi still has some wiggle-room to push "reforms," which for us means deleveraging and industrial restructuring. Chart 3Political Deadlines For Xi Jinping Chart 4Money Growth In China Is Slowing Over the long term, the "Socialist Put" will remain in place and growth rates will not be allowed to collapse, as long as the party can help it.10 If policy continues tightening in 2018, as we expect, it will become more accommodative as the 2020 political deadline approaches. Bottom Line: Xi's speech will not change the fact that the Communist Party remains committed to regime survival and national stability above all. The Evolution Of The Anti-Corruption Campaign The consensus view of the current party congress is that it marks Xi's consolidation of power. This is true, but it only matters if policymaking becomes more purposeful and effective. If so, then the market is in for some surprises next year, as Xi's policy agenda is ambitious. Chart 5Anti-Corruption Campaign Still Going Events over the past year suggest that surprises are coming. First, Xi has continued the sweeping anti-corruption campaign that defined his first five years. This campaign - more so than Xi's accrual of official titles - epitomizes his consolidation of power over the party and military. The latest probes culminated with the sacking of Politburo member Sun Zhengcai, heretofore the likeliest candidate to succeed Premier Li Keqiang in 2022.11 Thus Xi is actively manipulating the post-2022 leadership of China, and this process will continue in the coming years. Regardless of whether Xi overstays his term in office in 2022, he is lining himself up to be the most powerful man in China well into the 2020s. Second, while the anti-corruption campaign appears, on paper, to have passed peak intensity (Chart 5), it is apparently morphing into broader policy enforcement.12 In particular, Xi is using the Central Discipline and Inspection Commission (CDIC), the party's anti-corruption watchdog, to supercharge his policy efforts in financial and environmental regulation. Since last fall, Xi has launched a series of financial tightening and anti-pollution efforts that have proved to be fairly aggressive, especially given the need for overall stability ahead of the party congress. This aggressiveness is partly because of his use of the CDIC, and it looks to be part of the game plan for next year: Anti-corruption officials appointed to top financial regulatory bodies: In late September, the leadership put two leading anti-corruption officials in charge of overseeing anti-corruption efforts within the China Banking Regulatory Commission (CBRC) and the China Insurance Regulatory Commission (CIRC).13 These are two of the three top financial regulating bodies (the other being the China Securities Regulatory Commission). The timing of these appointments, along with other key appointments earlier this year, suggests that the "financial regulatory crackdown" will continue apace in 2018.14 Local government officials to be held accountable for debt: In June and July, Chinese authorities, including Xi, highlighted that local government officials should be held accountable for excessive debt creation - not only in their current office but over the course of their entire lives.15 The implication is that they could get expelled from the party or even imprisoned, rather than simply demoted. Moreover, officials could be punished for accruing illegal debts, and promotions could be tied to fiscal sustainability rather than just economic growth. The implication is that there will be legal ramifications, as well as financial restrictions, for local government officials who add to the country's systemic risks. Tackling systemic financial risk is a clear policy priority. Xi emphasized this at an extraordinary Politburo meeting in April as well as at the National Financial Work Conference in July.16 Not only has China accumulated more debt as a share of its GDP than any other country since the global financial crisis, but also it has done so faster than most other countries (Chart 6 A&B). Regardless of China's high national savings rate, China's top leadership sees leverage as a threat to stability and is taking action. Chart 6AChina Has Added Massive Debt... Chart 6B... And Done So Faster Than Others Something similar is taking place in the realm of environmental regulation. This is also a clear priority for the party: Hu Jintao included an "ecological" section in the work report for the first time in 2012; environmental spending grew faster than any other central government category in the beginning of Xi's first five years (Table 1). Table 1Fiscal Priorities Of Recent Chinese Presidents Here again, the powers that Xi amassed in his anti-corruption campaign are paying off. In August, the anti-pollution teams that fanned out across the country to enforce tougher environmental standards included anti-corruption watchdogs as well. This helps explain why production cuts and factory closures have been so effective in recent months, for instance cutting steel supply (Chart 7). Managers are not only facing environmental fines but also arrest and jail time. Meanwhile, ministerial-level ranking officials accompanied each environmental inspection team, giving them greater clout.17 It is unclear, so far, whether the CDIC or other tools will be brought to bear on the reform of state-owned enterprises (SOEs). SOE reform is one of the major unknowns of Xi's second term. So far, it has moved slowly, with the 2013 broad overview only put into a concrete plan in late 2015, which has since resulted in pilot projects of questionable value and little general implementation. The 2015-16 stimulus gave state companies some breathing space, as they were at last able to build up cash faster than they were borrowing it (Chart 8); but this period has ended and they are still plagued with inefficiencies (Chart 9). Chart 7Cutting Steel Supply, And Iron Demand Chart 8Stimulus Helped Corporate Balance Sheets... Chart 9...But SOEs Are Still Inefficient Chinese authorities have recently been emphasizing that reform is set to "deepen."18 If this effort is to have any teeth, it must include real encouragement to private and foreign capital, as well as real creative destruction - the sale of loss-making assets plus bankruptcies and layoffs (however carefully managed by the state). It will not suffice merely to continue the ongoing process of debt-for-equity swaps, mergers and acquisitions, and the creation of national champions. Anecdotal evidence suggests that bankruptcies are rising, but the proof will be in the pudding.19 What are the macro implications of the above? Assuming that we are right and deleveraging intensifies, the standard policy move in China would be to boost fiscal spending at the National People's Congress in March in order to compensate for the resulting slowdown in credit growth (Chart 10). This is precisely how President Jiang Zemin and Premier Zhu Rongji approached the negative growth effects of supply-side structural reforms after the fifteenth party congress in 1997: more fiscal spending. Xi's recent emphasis on poverty alleviation would seem to call for such spending as part of the broader effort to build a social safety net, reinforce social stability, and boost consumption as a driver of growth (Chart 11). There is a risk, however, as our colleagues at BCA's Emerging Market Strategy have argued, that fiscal spending may not offset a significant drop in credit growth in China. This is not the baseline case of China Investment Strategy, but it is a legitimate concern: it is not clear that any decrease in credit growth will go off seamlessly (Chart 12).20 Chart 10Two Sides Of The Same Coin Chart 11High Savings Rate Suppresses Consumer Demand Chart 12Credit Growth As Large As Government Spending If Xi seriously addresses China's long-festering financial systemic risks he could create a drag on growth that would be negative for emerging markets and certain commodity prices, like copper and iron ore.21 More broadly, the gradual transition away from China's investment-led growth model toward consumption-led growth is a headwind for the economies that have benefited the most from the status quo over the past two decades. Bottom Line: Xi's anti-corruption campaign is the clearest measure of his consolidation of power, and the party congress puts the capstone on it. Policy implementation will be more effective going forward. If Xi continues to prioritize deleveraging and industrial-environmental restructuring next year, he could create a drag on growth that is negative for the assets of EM exporters and key commodity producers. Xi Jinping Theory... What Does It Mean? Aside from Xi's big speech, the Communist Party will amend its constitution at the party congress. It is not clear what amendments may be made. The current debate is about whether and how Xi Jinping's ideas will be incorporated into the constitution and what this might mean for policy. Currently, the party constitution highlights the thinking of Marx and Lenin as well as China's top leaders since 1949. Each of China's leaders is said to have contributed something essential to the party's guiding philosophy: namely, "Mao Zedong Thought," "Deng Xiaoping Theory," "the important thinking of the Three Represents" (Jiang Zemin's contribution), and "the Scientific Outlook on Development" (Hu Jintao's contribution). These theories are outlined in Table 2. Table 2Xi Jinping Theory It is hard to draw strict correlations between these theories and economic policy, but the broad trends are well enough known: Mao founded the People's Republic and put a personal stamp on its Marxist-Leninist foundations. Deng Xiaoping brought pragmatism, enabling China to pursue a "socialist market economy," or "socialism with Chinese characteristics," thus opening the door to private and foreign capital, and profit incentives for households and businesses. National and household income surged (Chart 13). Jiang Zemin brought entrepreneurialism, building on Deng's achievement, particularly by phasing out many of the bloated SOEs and "command-style" economic controls and opening the real estate sector for consumers to buy houses (Chart 14). Hu Jintao brought social responsibility into greater focus, emphasizing the need to invest in infrastructure in undeveloped regions, reduce rural and urban disparities, and build out the social safety net (Chart 15). Chart 13Deng Unleashed China's Economic Potential Chart 14Jiang Rebooted Growth, Launched Housing Boom Chart 15Hu Jintao Sought 'Harmonious Society' If Xi's ideas are incorporated into this section, it will be notable since that honor usually occurs at the end of a general secretary's term. The precise wording will be heavily studied: e.g. whether Xi is named personally (like Mao and Deng), whether his ideas are referred to as "Thought" or "Theory" (like Mao or Deng respectively), which of his slogans are included, and what they actually mean. The real takeaway for investors is that the party is demanding a return to centralization and Xi is fulfilling this demand.22 Structurally, Xi's anti-corruption campaign has put him at the top of a more disciplined party. He has simultaneously reasserted the party's primacy over the military, which has been extensively reshuffled and reformed, and civil society, which has been muzzled. Re-centralization is also apparent in fiscal and financial management. The previous administration decentralized economic control in order to accelerate growth in the face of the global recession. This specifically meant freeing up the state banks and the provincial governments to borrow, invest, and build to their heart's content. Comparing the trajectory of central and local government spending, it is clear that Xi is overseeing a marginal re-concentration of taxation and spending into the hands of the central government vis-à-vis the provincial governments (Chart 16 A&B). Chart 16ALocal Government Gap Widened Post-Crisis... Chart 16B...But Gap Narrowed Under Xi Jinping Similarly, he is overseeing a marginal re-concentration of lending back into traditional state-owned bank loans, after nearly a decade of rapid growth in the non-bank, "shadow lending" sub-sector (Chart 17 A&B). Chart 17AShadow Loans Outpaced Bank Loans... Chart 17B...But Gap Has Narrowed Under Xi However, re-centralization is not the result of any "coup" by Xi Jinping so much as the Communist Party's strategic response to the fact that the country stands at a historic juncture with serious systemic risks: The "Thucydides Trap": The world has not seen the contest of a fully established world empire (the U.S.) and a newly emergent peer competitor (China) since the Cold War, and strictly speaking since the late 1800s, when Germany emerged as a challenger to the U.K. (Chart 18). The CPC's founding myth is the rejection of a "century of humiliation" at the hands of western powers, so there is no moment more critical than now, when China is emerging as a rival to the greatest western power. Economic reform: China's economic model is slowly evolving, and the outgoing model has left imbalances that are key vulnerabilities to China and could undermine its global emergence. The corporate debt pile is the clearest, but by no means the only, example of this internal threat (Chart 19). Lack of political reform: The country faces an inherent contradiction between its single-party system and the emergent middle class, which is still denied political participation (Chart 20). This is a source of socio-political imbalances that could also undermine China's emergence. Chart 18The 'Thucydides Trap' Chart 19An Outstanding Economic Imbalance Chart 20Not Your Father's China True, China has a single authoritative leader (with no alternative) at the head of a unified ruling party (with no alternative). Thus, it faces fewer domestic political constraints, in the strict sense, than any major country in the world. Nevertheless, the challenges themselves are structural and could outstrip any leadership's ability to address them. The policy responses to the crises of 2015-16 - when Beijing committed a series of blunders - do not suggest that Xi is nearly as omnipotent or omniscient as the media will make it sound this week.23 Of crucial importance going forward will be the deteriorating U.S.-China relationship, since the next 12 months will provide at least two major occasions for clashes: North Korea, where diplomacy is balking, and Trump's need to look tough on China ahead of midterm elections.24 Bottom Line: The possible incorporation of Xi's ruling philosophy into the Communist Party's constitution would be a symbolic nod to the concrete executive power that Xi has already achieved. However, only when new structural risks materialize will Xi's capabilities - and the Communist Party's capabilities as a ruling party - truly be put to the test in a way that yields significant information for investors. Investment Conclusions On the brink of the party congress, Xi looks to be continuing his double game of centrally driven internal reforms and external assertiveness. But between these, the key to watch is the extent to which he re-emphasizes internal reforms. Over the next few years, rebooting reforms could help Xi to waylay the Trump administration's threatened punitive measures; to use Trump as a foil to excuse the painful consequences of necessary reforms at home; and to win goodwill among other countries, which would see greater opportunities in a China that is recommitting to opening up to them (and investing more in them). Our "Reform Reboot" checklist, which focuses on deleveraging, is designed for the post-party congress period. As such, most of the points are yet to be determined (see Appendix). We would remind readers to watch for the following: Chart 21Volatility Will Go Up The composition of the next Politburo, Politburo Standing Committee, and Central Committee, expected to be revealed on October 25, for a sense of whether reformers will hold key posts and whether Xi's faction will gain the upper hand - we will report on this in subsequent weeks;25 Post-party congress leaks or discussions in state media covering new policy priorities, particularly on financial regulation, the property sector, and SOE reform; Any hints at who will replace Zhou Xiaochuan as governor of the central bank, who will be the first head of the new Financial Stability and Development Committee, and how the National Financial Work Conference's goals are implemented; Outcomes of U.S. President Donald Trump's visit to China and Asia Pacific, November 3-14 - particularly on North Korea and trade frictions; How far the latest property market curbs advance, and whether recently promised "long-term" curbs are implemented, including any nationwide property tax; Whether the financial crackdown spreads further into state-owned and domestic-oriented financial institutions; When and how the tougher scrutiny on local government debt is implemented - and whether local government budget balances rise or fall after the congress; Whether SOE "mixed ownership" and "state capital management" reforms accelerate - and whether asset sales and operational restructuring begin occurring more frequently across multiple provinces; How the party implements its recent proposals to increase the role of entrepreneurs and provide easier access to credit for small and medium-sized enterprises; Priorities for domestic reforms, especially those affecting household registration (hukou) reforms, the urbanization rate, social safety net expansion, and household credit; How foreign investment is attracted, including the implementation of the nationwide foreign investment negative list; When and how capital controls will be lifted; if the government wants "de-risking" reforms in the financial sector, it will have to do that first, before pursuing any capital account reforms. We continue to believe that Xi's second term provides a window of opportunity for rebooting reforms, within the Communist Party's stability constraint, due to his consolidation of power and the currently robust domestic and global economic backdrop. This window will likely close as the term progresses due to political deadlines in 2020 and the likelihood of the external backdrop worsening. Both internal and external risks will rise from here (Chart 21). Xi's initial attack over the next six-to-eight months will determine whether we remain optimistic about incremental progress on reforms. We are re-initiating our long China CBOE volatility ETF trade, and our long Big Five banks relative to smaller banks trade. We also remain overweight Chinese equities versus EM equities. We are adjusting this trade to include Chinese H-shares only. Xi's political recapitalization lessens domestic political constraints, and China's shift to more domestically driven growth will disfavor China-exposed, export-reliant, and commodity-producing EMs. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "China's Nineteenth Party Congress: A Primer," dated September 13, 2017. 2 For this transition, please see BCA Geopolitical Strategy, "China: Two Factions, One Party," dated September 2012, available at gps.bcaresearch.com. 3 Please see Xi Jinping, "Jointly Shoulder Responsibility Of Our Times, Promote Global Growth," dated January 17, 2017, available at america.cgtn.com. 4 Please see BCA Geopolitical Strategy, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 5 Moreover, Xi's term officially ends the following year, in 2022, which will require arrangements for a smooth transition regardless of whether Xi retains power. 6 The term is not used precisely in this way in the report but has been developed in official policy outlets since then. Please see Hu Jintao, "Firmly March On The Path Of Socialism," Report to the 18th National Congress of the Communist Party of China, November 8, 2012, available at www.china.org.cn, and Timothy Heath, "The 18th Party Congress Work Report: Policy Blueprint For The Xi Administration," China Brief 12:23, Jamestown Foundation, November 30, 2012, available at jamestown.org. 7 Please see BCA Frontier Markets Strategy and Geopolitical Strategy Special Report, "China's Belt And Road Initiative: Can It Offset A Mainland Slowdown?" dated September 13, 2017, available at gps.bcaresearch.com. 8 Please see BCA Emerging Markets Strategy Weekly Report, "China: Deflation Or Inflation?" dated October 4, 2017, available at ems.bcaresearch.com. 9 Please see BCA China Investment Strategy Weekly Report, "Chinese Real Estate: Which Way Will The Wind Blow?" dated September 28, 2017, available at cis.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Monthly Report, "The Socialism Put," dated May 11, 2016, available at gps.bcaresearch.com. 11 For our take on factional struggles in anticipation of Sun's fall, please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at gps.bcaresearch.com. 12 There is much speculation about whether anti-corruption chief Wang Qishan will make it onto the next Politburo Standing Committee (to be revealed around October 25) despite having passed the retirement age. This topic is a red herring: age limits have always been arbitrarily enforced, while Xi will maintain a hardline toward corruption even if he replaces Wang. If Xi wishes to stay in power beyond 2022, it will not depend on Wang. 13 Please see Wu Hongyuran, Yang Qiaoling and Leng Cheng, "Two Determined Graft-Busters Put In Senior Posts At Banking, Insurance Watchdogs," Caixin, dated October 11, 2017, available at www.caixinglobal.com. 14 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. 15 Please see Huang Ge, "China's First Lifelong Accountability System To Prevent Local Officials From Accruing Mountainous Debt," Global Times, dated July 24, 2017, available at www.globaltimes.cn. 16 Notably, authorities pledged to give the People's Bank of China greater regulatory powers going forward, coinciding with a generational change at the top of the central bank. Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 17 See Barry Naughton, "The General Secretary's Extended Reach: Xi Jinping Combines Economics And Politics," dated September 11, 2017, available at www.hoover.org. 18 Please see Fran Wang, "China To Take Flexible Approach To SOE Reform," Caixin, September 29, 2017, available at www.caixinglobal.com. 19 See "China bankruptcies rise steadily in 2017 amid 'zombie firm' crackdown," August 3, 2017, available at www.reuters.com. 20 Please see BCA Emerging Markets Strategy Special Report, "Revisiting China's Fiscal And Credit Impulses," dated April 13, 2016, available at ems.bcaresearch.com. 21 Please see BCA Commodity & Energy Strategy Weekly Report, "Slow-Down In China's Reflation Will Temper Steel, Iron Ore In 2018," dated September 7, 2017, available at ces.bcaresearch.com. 22 We have long highlighted this theme as critical to Xi's reforms, along with governance and productivity. Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Monthly Report, "Annus Horribilis," dated January 20, 2016, and "China: Eye Of The Storm," dated September 9, 2015, available at gps.bcaresearch.com. 24 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 25 This will be the subject of our party congress post-mortem pieces in coming weeks. Appendix

Highlights This week, we are reviewing all our current active trades in our Tactical Overlay. As a reminder, these positions (Table 1) are meant to complement our strategic GFIS Model Fixed Income Portfolio, typically with shorter holding periods and occasionally in smaller or less liquid markets outside our usual core bond market coverage (i.e. U.S. TIPS or Swedish interest rate swaps). This report includes a short summary of the rationale behind each position, as well as a decision on whether to continue holding the trade, close it out or switch to a new position that may more efficiently express our view. The trades are grouped together by the country/region that is most relevant for the performance of each trade. Table 1GFIS Tactical Overlay Trades Feature U.S. Short July 2018 Fed Funds futures (HOLD). Long 5-year U.S. Treasury (UST) bullet vs. 2-year/10-year duration-matched UST barbell (HOLD). Long U.S. TIPS vs. nominal USTs (HOLD). Short 10-year USTs vs. 10-year German Bunds (HOLD). The tactical trades that we have been recommending within U.S. markets all have a common theme - positioning for an expected rebound in U.S. inflation that will push up U.S. bond yields. We are maintaining all of them. The drift lower in realized inflation rates since the spring has been a surprise given the backdrop of above-potential growth, low unemployment and a weakening U.S. dollar. On the back of this, markets have priced out several of the Fed rates hikes that had been expected over the next year, leaving U.S. Treasury yields at overly-depressed levels. Back on July 11th, we initiated a recommendation to short the July 2018 fed funds futures contract (Chart 1). This was a position that would turn a profit if the market moved to once again discount multiple Fed rate hikes by mid-2018. The trade has a modest profit of 9bps, but with scope for additional gains if the market moves to discount 2-3 hikes by the middle of next year. Our base case scenario is that the Fed will lift rates again this December, and deliver additional increases next year amid healthy growth and with inflation likely to grind higher towards the Fed's 2% target. With the market discounting 46bps of rate hikes over the next year, there is scope for additional profits in our fed funds futures trade. Another tactical position that we've been recommending is a butterfly trade within the U.S. Treasury (UST) curve, long a 5-year UST bullet versus a duration-matched 2-year/10-year UST barbell. This is a position that would benefit from a bearish steepening of the UST curve as the market priced in higher longer-term inflation expectations (Chart 2). We have held that trade for a much longer period than a typical tactical trade, going back nearly a full year to December 20th, 2016. Yet while the UST curve has flattened since that date, our trade has delivered a return of +18bps. This outperformance can be attributed to the undervalued level of the 5-year bullet at the initiation of the trade. Chart 1Stay Short July 2018##BR##Fed Funds Futures Chart 2Stay Long The 5yr UST Bullet Vs.##BR##The 2yr/10yr UST Barbell While that valuation cushion no longer exists (bottom panel), longer-term TIPS breakevens are back to the levels seen last December (middle panel), thanks in no small part to much higher energy prices (top panel). This leaves the UST curve at risk of a bearish re-steepening on the back of rising inflation expectations. Add in a U.S. dollar that is -2.5% weaker from year-ago levels (Chart 3, middle panel), and a solid U.S. economic expansion that should eventually translate into rising core inflation momentum (bottom panel), and the case for a steeper UST curve over the next 3-6 months is a strong one. The above logic also supports our trade recommendation to go long U.S. TIPS vs. nominal USTs, which is up +248bps since inception on August 23, 2016. We have been holding this trade for much longer than our usual tactical recommendations, but we will not look to take profits until we see the 10-year breakeven (now at 186bps) return back to levels consistent with the Fed's 2% PCE inflation target (i.e. headline U.S. CPI inflation back to 2.5%). One final tactical trade that will benefit from higher UST yields is our recommendation to position for a wider spread between 10-year USTs and 10-year German Bunds. This trade was initiated on August 9th of this year, and has delivered a profit of +9bps. Yet the UST-Bund spread still looks too low relative to shorter-term interest rate differentials that favor the U.S. (Chart 4, top panel). With U.S. data starting to surprise more on the upside than Euro Area data (middle panel), and with UST positioning still quite long (bottom panel), there is potential for additional near-term UST-Bund spread widening. The upcoming decision by the European Central Bank (ECB) on potential tapering of its asset purchases next year represents a potential risk for the long Bund leg of our recommended trade. Any hawkish surprises on that front would be a likely catalyst for us to close out this position. Chart 3Stay Long U.S. TIPS Vs. Nominal USTs Chart 4Stay Short 10yr USTs Vs. German Bunds Euro Area Long 10yr Euro Area CPI swaps (HOLD). Long 5-year Spain vs. 5-year Italy in government bonds (HOLD). We have two recommended tactical trades that are specifically focused on developments in the Euro Area. We are maintaining both of them. As a way to position for an eventual pickup in European inflation, we entered a long position in 10-year Euro Area CPI swaps back on December 20th, 2016. That trade is now estimated to have a profit of +29bps, as market-based inflation expectations have drifted higher in the Euro Area. The simple reason for that increase is that realized inflation has moved higher on the back of rising energy costs, as there is a very robust correlation between the annual growth rate of oil prices (denominated in euros) and headline Euro Area inflation (Chart 5). More importantly, the booming Euro Area economy, which has eaten up much of the spare capacity in the Europe, has boosted wage growth and core inflation to levels seen prior to the disinflation shock from the 2014/15 collapse in oil prices (bottom panel). With no signs of any imminent slowing of Euro Area growth that could raise unemployment and slow underlying inflation pressures, the trend for inflation expectations in Europe is still upward. The current 10-year Euro Area CPI swap at 1.5% is still well beneath the ECB's inflation target of "just below" 2% on headline CPI, so there is room for inflation expectations to continue drifting higher. ECB tapering of asset purchases is not an immediate threat to this trade, as the central bank is still likely to keep buying bonds next year (at a slower pace), while holding off on any interest rate increases until late 2019. In other words, the ECB will not be looking to act to slow economic growth to bring down Euro Area inflation anytime soon. Our other tactical trade recommendation in Europe is a relative value spread trade, long 5-year Spanish government debt versus 5-year Italian bonds. This trade was initiated on December 13th, 2016 and currently has only a modest gain of +9bps, although the profits were much larger earlier this year. Italian bonds have been outperforming on the back of improving Italian economic growth (Chart 6, top panel) and, recently, a generalized sell-off in Spanish financial assets on the back of the political uncertainty in Catalonia. Chart 5Stay Long 10yr##BR##Euro Area CPI Swaps Chart 6Stay Long 5yr Spanish Government Bonds Vs.##BR##5-Year Italian Debt Our colleagues at BCA Geopolitical Strategy have been downplaying the threat to Spanish political stability from the Catalonian independence movement, given that the polling data shows only 35% for outright independence from Spain. At the same time, the poll numbers in Italy for the upcoming parliamentary elections are much closer, with parties favoring less integration with Europe holding a slight lead over more "establishment" parties (bottom two panels). With the bulk of the cyclical convergence between Italian and Spanish growth now largely completed, and with a greater potential for future political instability in Italy compared to Spain, we expect that Spain-Italy spreads will tighten further back to the lows seen at the beginning of 2017 (-64bps on the 5-year spread). That is a level we are targeting on our current tactical trade recommendation. Canada Short 10-year Canadian government bonds vs. 10-year USTs (TAKE PROFITS). Long Canada/U.K. 2-year/10-year government bond yield curve box, positioning for a relatively flatter Canadian curve (TAKE PROFITS). Short 5-year Canada government bond versus a duration-matched 2-year/10-year barbell (TAKE PROFITS). We have three different Canadian fixed income trades in our Tactical Overlay, all of which were biased towards tighter monetary policy in Canada: a Canada-U.S. bond spread widener, a yield curve box trade versus the U.K. and a curve flattener expressed as a barbell trade (Chart 7) All three positions are in the money, but we now recommend taking profits. We had initiated these recommendations in a very timely fashion earlier in the year at a time when the Bank of Canada (BoC) was sending a relative dovish message. In our view, the Canadian economy was building significant upward momentum that would eventually force the central bank to shift its policy bias. This would especially be true with the Fed also in a tightening cycle, given the typical tendency for the BoC to follow the Fed's policy actions. Several members of the BoC monetary policy committee began to sing a more hawkish tune over the summer, particularly after the release of the Q2 BoC Business Outlook Survey. That robust report, which was confirmed by a 2nd quarter GDP growth rate of nearly 4% (Chart 8), led the BoC to deliver not one by two unexpected interest rate hikes in July and September. Markets reacted accordingly, driving Canadian bond yields higher and flattening the yield curve. Chart 7Take Profits On Bearish Canadian Bond Trades Chart 8Canadian Growth Set To Cool Off A Bit Now, we see the market pricing as having gone a bit too far, too quickly. The Q3 Business Outlook Survey, released yesterday, was still positive but with readings softer than the booming Q2 report. Meanwhile, the commentary from the BoC has become more balanced, with BoC Governor (and BCA alumnus) Stephen Poloz describing the central bank as being more "data dependent" after the recent rate hikes. Markets are now pricing in another 72bps of rate hikes over the next year, even with our own BoC Monitor off the peak (Chart 9). Chart 9Our BoC Monitor Is Peaking From a tactical perspective, the repricing of the BoC that we expected earlier this year is now largely complete. Thus, we are taking profits on all three Canadian trades: Canada-U.S. spread trade: initiated on January 17th, profit of +43bps. Canada/U.K. box trade: initiated on May 16th, profit of +67bps. Canada 2yr/5yr/10yr butterfly trade: initiated on December 6th, 2016, profit of +95bps. From a strategic perspective, we still see a case where the BoC can deliver additional rate hikes and keep upward pressure on Canadian bond yields. The output gap in Canada is now closed, according to BoC estimates, and additional strength in the economy now has a greater chance in translating to higher inflation. Strong global growth, especially in the U.S., will also support Canadian export growth and feed into rising capital spending. While the rate hikes have help boost the value of the Canadian dollar (CAD), the exchange rate (on a trade-weighted basis) also largely reflects a rising value of energy prices and is, therefore, should provide an additional boost to growth via stronger terms-of-trade (bottom panel). In other words, the rising CAD will not prevent additional BoC rate hikes if oil prices remain strong. Thus, we are maintaining our underweight recommendation on Canadian government bonds in our strategic model bond portfolio, even as we take profits on our bearish Canadian tactical trades. Australia Long a 2-year/10-year Australia government bond curve flattener (SELL AND SWITCH TO NEW TRADE). On July 25th of this year, we entered into a 2-year/10-year curve flattener trade for Australia. Though employment was improving and house prices were booming in Australia, the wide output gap, high level of consumer indebtedness and lack of real wage growth was keeping the Reserve Bank of Australia (RBA) inactive. In our view, nothing has changed since then; the RBA remains in a very difficult position. While the yield curve flattened substantially following the initiation of our trade, the global rise in long-term yields since mid-September lifted Australian longer-maturity yields, and the yield curve with it (Chart 10). Now, Australian long-term yields are not reflecting domestic fundamentals but are instead driven by improving global growth. As such, we are closing the trade and initiating a new position - long Dec 2018 Australian Bank Bill futures - as a more focused way to express the view that the RBA will stay on hold for longer than markets expect. Markets are currently pricing in 30bps of RBA rate hikes over the next twelve months. We believe this will be unlikely, for several reasons. Macroprudential measures on the Australian housing market will continue to dampen credit growth. Core inflation is slowly rising but still far below the central bank's target. Additionally, there is plenty of slack in the labor market despite the spike in employment growth. This is evidenced in anemic real wage growth, stubbornly high underemployment rate, low hours worked and high percentage of part-time to full-time workers (Chart 11). Chart 10Close Australian Government##BR##Bond 2yr/10yr Flattener Chart 11RBA Unlikely To Deliver##BR##Discounted Rate Hikes The biggest risk to our new trade would if signs of a tighter Australian labor market started to feed through into faster wage growth, which would likely coincide with faster underlying price inflation and a more hawkish turn by the RBA. New Zealand Long 5-year NZ government bonds vs. 5-year USTs (currency hedged). Long 5-year NZ government bonds vs. 5-year Germany (currency unhedged). Chart 12Stay Long 5yr NZ Government Bonds##BR##Vs. U.S, & Germany We entered two New Zealand (NZ) tactical bond trades on May 30th, going long 5-year government bonds vs. U.S. and Germany (Chart 12). We expected NZ spreads to tighten faster than the forwards based on our more hawkish views on the Fed and, to a lesser extent, the ECB relative to the more dovish view on the Reserve Bank of New Zealand (RBNZ). The outright bond spreads have tightened and, on a currency-hedged basis, both trades are in the money. Our dovish view on the RBNZ came from the central bank's own forecasts, which called for slowing headline inflation on the back of softer "tradeables" inflation and a sharp cooling of domestic "non-tradeables" inflation through a slowing housing market (Chart 13, bottom two panels). Our own RBNZ Monitor has been calling for the need for higher interest rates in NZ, mostly from the strength in the labor market. Yet we have been ignoring that signal, as has the market which has priced out one full expected RBNZ rate hike since the beginning of the year. With business confidence rolling over, and with the trade-weighted NZ dollar still staying at stubbornly strong levels, the case for the RBNZ to deliver even a single rate hike is not a strong one - especially given the soft inflation forecasts of the central bank. Thus, we are sticking with our tactical spread trades for NZ versus the U.S. and Germany. We are maintaining the currency hedge on the U.S. version of the trade, as we typically do for the vast majority of our cross-country spread trade recommendations. Occasionally, however, we will make an active decision to do a spread trade UN-hedged if we felt very strongly about a currency move. We did that for our NZ-Germany spread trade and this has cost us in the performance of the trade, which is down -3.4%. This is because of a surprisingly large decline in the New Zealand dollar (NZD) versus the euro since the inception of our trade. Yet a review of the technical indicators on the NZD/EUR currency cross shows that the currency pair is now very stretched versus its medium-term trend (the 40-week moving average), with price momentum also at some of the most negative levels of the past decade (Chart 14). These measures suggest that the worst of the downturn in the currency is likely over. The relative positioning on the two individual currencies is now neutral, as long positions on the NZD have been reduced (bottom panel). Chart 13RBNZ Dovishness Is Justified Chart 14Keep NZ/Germany Position Currency Unhedged Given these technical indicators, and from these current levels, we see greater upside potential for NZD/EUR in the months ahead. This leads us to maintain our unhedged currency position on the NZ-Germany spread trade so as not to realize the current mark-to-market losses on the trade. Sweden Pay 18-month Sweden Overnight Index Swap (OIS) rate (TAKE PROFITS). We entered into a bearish Swedish rates position back on November 22nd, 2016, paying Sweden 18-month Overnight Index swap rates (Chart 15). At the time, we expected the Riksbank to begin hiking interest rates earlier than what was priced in the markets IF inflation reached the central bank target faster due to a weaker Swedish krona. We also believed that the economy would continue to expand at a robust pace when the economy had no spare capacity, creating additional upside inflation surprises. According to the Riksbank's latest Monetary Policy Statement (MPS), the central bank will likely keep the repo rate at -0.5% until mid-2018, while continuing its asset purchase program until the end of this year - even with an overheating economy. This is because realized inflation has remained below the Riksbank target for a long period of time and, although current inflation is above target, it was not necessary to immediately tighten conditions. More likely, the Riskbank is worried about the potential for the krona to appreciate - especially versus the euro - if rate hikes are delivered. It will only be a matter of time before the central bank is forced to tighten policy with the economy likely to strengthen further, led by solid domestic demand, strong productivity growth, and improving exports. Consumption is also expected to increase as households have scope to cut back their high level of savings. Combining the Riksbank's easing policy with the current strength of the economy and the tightness of the labor market, inflation is very likely to return to the 2% target in the next year or two (Chart 16). Chart 15Close Sweden OIS Trade Chart 16Riksbank More Worried About SEK Than Inflation However, if the Riskbank remains too concerned about the currency versus the euro, as we suspect, then this will prevent any shift to a more hawkish stance before any change from the ECB. That is unlikely to happen over the next year, at least, even if the ECB slows the pace of asset purchases as we expect. Thus, we are closing out our Sweden 18-month Overnight Index Swap position at a small profit of 12bps. We have already kept this trade for longer than the typical investment horizon for one of our tactical overlay trades. We will investigate the potential for more profitable trade opportunities in the Swedish fixed income markets in a future report. Korea Long a 2-year/10-year Korean government bond yield curve steepener (HOLD). We recommended entering into a 2-year/10-year steepening trade in the Korean government bond yield curve on May 30th, 2017. Since then, the yield curve has flattened by 7bps, which was mainly caused by an unexpected rise in the 2-year yield, rather than a decline in 10-year yield (Chart 17). Korea is currently enjoying a solid business cycle upturn. Leading economic indicators are rising, the year-over-year growth in exports has risen to a 7-year high and previously sluggish private consumption has also rebounded recently. The Bank of Korea (BoK) is of the view that the recovery will continue and consumer price inflation will stabilize at the target level over the medium-term. This recovery should cause the 2/10 curve to steepen as longer-term inflation expectations rise. Based on South Korean President Moon's aggressive fiscal plans to increase welfare spending and create jobs in the public sector, at a time when the economy is good shape, we still believe that long-end of the curve (10-year) will rise. In addition, as shown in Chart 18, the 26-week rolling beta of changes in the 10-year UST yield and Korean 10-year bond is very high, nearly 1. Given our bearish view on USTs, this implies Korean yields can follow suit. On the other hand, the correlation between the 2-year UST yield and equivalent maturity Korean yields is much lower (4th panel), as Korean rate expectations have not been following those of the U.S. higher - even with a stronger Korean economy. Most likely, this is due to investors downplaying the potential for the BoK to match Fed rate hikes tick-for-tick given the heightened tensions between the U.S. and North Korea. Chart 17Stay In Korea 2yr/10yr##BR##Government Bond Steepener Chart 18Long-Term Korean##BR##Yields Are Too Low We still believe the Korean curve can steepen as longer-term yields rise, although we will be monitoring the behavior of shorter-dated Korean yield as the situation between D.C. and Pyongyang evolves. If investors begin to demand a higher risk premium on Korean assets, particularly the Korean won, then 2-year Korean yields may rise much faster and our curve trade may not go our way. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Patrick Trinh, Associate Editor Patrick@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights High-Yield: High-Yield spreads are 149 bps away from being more expensive than they have ever been. But in the absence of inflation it is difficult to pinpoint a catalyst for sharp spread widening. We expect excess high-yield returns between 2% and 5% (annualized) during the next 6-12 months. EM Sovereigns: There is no compelling valuation argument in favor of hard currency EM Sovereign debt versus U.S. corporate bonds. We will look to shift into EM once the pace of Fed rate hikes starts to slow later in the cycle. Economy & Inflation: Core inflation disappointed expectations in September, but the details of the report showed some silver linings. Inflation looks to be past the worst of its downtrend and should be strong enough during the next two months for the Fed to lift rates in December. Feature Chart 110-Year Treasury Yield Breakdown Just past the three quarter mark of 2017 and stubbornly low inflation remains the story of the year in U.S. bond markets. Quite simply, if inflation rebounds during the next two-and-a-half months, as the Federal Reserve expects, then Treasury yields will move sharply higher and Treasury total returns for 2017 will be close to zero. Otherwise, yields are likely to remain near current levels and 2017 Treasury total returns will approximate carry, in the range of 2.5%. Our valuation framework for the 10-year Treasury yield underscores the importance of inflation for the duration call. The real 10-year Treasury yield (currently 0.43%) is consistent with market expectations for just under two Fed rate hikes during the next 12 months (Chart 1). With the median Fed member calling for 3-4 hikes during that period, the potential remains for somewhat higher real yields in the near-term. But with all but one Fed member forecasting a terminal fed funds rate of 3% or below (1% or below in real terms), the long-run upside in real yields appears limited. On the other hand, the compensation for inflation embedded in 10-year bond yields is still far too low. At 1.85%, the 10-year TIPS breakeven inflation rate is well below the 2.4% to 2.5% range consistent with the Fed hitting its inflation target. This continues to be the case even as our Pipeline Inflation Indicator has accelerated in recent weeks (Chart 1, bottom panel). Bond investors are waiting for inflation to show up in the core CPI and PCE data before liquidating their positions. We retain our below-benchmark duration bias on a 6-12 month horizon on the view that inflation will soon resume its cyclical uptrend. 10-year inflation compensation has 55-65 bps of upside in this scenario, while 10-year real yields will probably stay close to current levels. The outlook for core inflation is discussed in more detail in the Economy & Inflation section below. High-Yield: Just A Carry Trade At this late stage of the credit cycle, low inflation is also the key support for excess returns in both investment grade and high-yield corporate bonds. We see limited scope for further spread tightening but think it's likely that the carry trade will continue until inflation turns the corner and long-maturity TIPS breakevens settle into the 2.4% to 2.5% range consistent with the Fed's target.1 In this week's report we explore what this carry trade means for excess high-yield returns, and put those returns into context with what the asset class has typically delivered for bond investors. Table 1 shows historical annual excess returns for the Bloomberg Barclays High-Yield index since 1995.2 On average High-Yield has returned 3.42% over Treasuries each year, but with significant variation. Most of that variation results from years when the default rate is either rising quickly during a recession or falling fast in the early stages of economic recovery. Since neither of those scenarios is likely during the next 6-12 months we filter out those periods by looking at years when the average index option-adjusted spread (OAS): Widened by more than 100 bps Tightened by more than 100 bps Was range bound between -100 bps and +100 bps The average excess return is 4.9% in years when the spread is confined to a -100 bps to +100 bps range. High-Yield has returned 5.46% in excess of Treasuries so far this year, and the OAS has tightened 61 bps. It is unlikely that junk spreads will tighten by 100 bps or more during the next 12 months. The average index OAS is currently 348 bps, only 115 bps above its all-time low (Chart 2). However, to properly assess current spread levels we also need to consider that the average index duration has declined during the past fifteen years. All else equal, the same spread level is more attractive today because index duration is lower. Table 1Historical Annual High-Yield##br## Excess Returns* (%) Chart 2Junk Spreads Not Far ##br##From All-Time Tights We adjust for index duration by looking at the 12-month breakeven spread.3 At 93 bps, the breakeven spread is currently 40 bps above its all-time low (Chart 2, bottom panel). In other words, at current duration levels, the junk OAS can tighten another 149 bps before the sector is more expensive than it has ever been. Either way, what's clear from Chart 2 is that we should probably not expect much more than 100 bps of further tightening this cycle. Or, put differently, it would definitely make sense to reduce high-yield exposure as we approach all-time expensive valuations. But we can get even more specific about our expectations for high-yield excess returns. Excess junk returns can be approximated using the following formula: Excess return = Starting OAS - Default Losses - Duration*(Change in OAS) The expected return from carry during the next 12 months can be thought of as today's index spread less our expectation for default losses. Capital gains and losses can be approximated using today's index duration and the expected change in spreads. For simplicity we ignore convexity effects. This excess return approximation is shown in the second panel of Chart 3, where the dashed line assumes a base case scenario where default losses fall in line with our expectation and the OAS remains flat. Table 2 shows what 12-month excess returns would be in this base case scenario, as well as in several other scenarios. Chart 3High-Yield ##br##Expected Returns Table 2High-Yield 12-Month Excess ##br##Return* Projections In a base case scenario, where default losses are 1.09% and the OAS is flat, we would expect excess junk returns of 2.39% during the next 12 months. In a more bullish scenario where the OAS tightens by another 100 bps - bringing it to within striking distance of all-time tights - we would expect excess returns of 6.15%. We also consider scenarios where default losses differ from our forecast of 1.09%. For context, that 1.09% forecast is derived from Moody's baseline default rate forecast of 2.26% and our own model-based recovery rate forecast of 51%. For example, in a scenario where default losses are somewhat higher than expected (2%) but where the OAS stays flat, we would expect excess returns of only 1.48%. We should note that 12-month high-yield default losses have never been lower than 0.5%. So we present that optimistic scenario as an upper-bound on potential excess returns to junk. Notice that even in the most optimistic scenario we can envision, default losses reaching all-time lows and spreads contracting to within a hair of all-time tights, expected excess high-yield returns still only reach 6.74%. We would view that as the absolute best case scenario for high-yield. Realistically, default losses will probably fall into a range between 1% and 2% during the next 12 months. Assuming also that spreads come under neither strong upward nor downward pressure, we would expect excess high-yield returns between 2% and 5% (annualized) during the next 6-12 months. Bottom Line: High-Yield spreads are 149 bps away from being more expensive than they have ever been. But in the absence of inflation it is difficult to pinpoint a catalyst for sharp spread widening. We expect excess high-yield returns between 2% and 5% (annualized) during the next 6-12 months. Is Hard Currency EM Debt A Substitute For Junk? Chart 4Favor U.S. Corporates Over EM Sovereigns With relatively feeble expected returns from U.S. high-yield bonds, it's logical to explore whether there are any more attractively valued alternatives in the U.S. bond universe. One potential candidate is the U.S. dollar denominated debt of Emerging Market governments. Unfortunately, valuation in that space does not look much better than in U.S. corporates. In an effort to control for differences in both credit rating and index duration, we compare 12-month breakeven spreads between the Bloomberg Barclays EM USD Sovereign Index and a credit rating matched benchmark consisting of a combination of U.S. investment grade and high-yield corporate bond indexes. We notice that hard currency EM Sovereigns and similarly rated U.S. corporate bonds offer almost exactly the same breakeven spread, and also that EM Sovereigns have been getting comparatively cheaper since early last year (Chart 4). At the moment there is no compelling argument to favor one sector over the other on pure valuation grounds. We therefore also consider the main macro drivers of relative excess returns between EM Sovereigns and U.S. corporates (Chart 4, bottom 2 panels). The last two significant periods of EM outperformance coincided with falling U.S. rate hike expectations - as evidenced by our declining fed funds discounter - and a weaker U.S. dollar. With our 24-month fed funds discounter at only 62 bps - meaning the market expects less than three rate hikes during the next 24 months - we think it is likely to move higher from here. This should lead to one more bout of EM cheapening relative to U.S. corporates. At that point, once we are past peak rate hike expectations for the cycle, we will likely get a more attractive entry point to move into EM. Interestingly, an examination of country level spreads also does not identify any clear pockets of cheapness in EM (Chart 5). Mexico and Turkey both offer similar breakeven spreads to equivalently rated U.S. corporates, but our Emerging Markets Strategy service has a dim view of both the Turkish Lira and Mexican peso versus the U.S. dollar.4 The higher-rated EM countries: Saudi Arabia, UAE and Qatar offer the most attractive relative spreads. But, at least for Qatar, that elevated spread is most likely compensation for a highly volatile currency (Chart 6).5 Chart 5Breakeven Spreads: USD EM Sovereign Vs. U.S. Corporates Chart 6USD EM Sovereign Breakeven Spread Differentials Vs. Exchange Rate Volatility Bottom Line: There is no compelling valuation argument in favor of hard currency EM Sovereign debt versus U.S. corporate bonds. We will look to shift into EM once the pace of Fed rate hikes starts to slow later in the cycle. Economy & Inflation Some Silver Linings In September's CPI The September CPI report was released last week and it disappointed expectations with core CPI rising only 0.13% month-over-month. For context, an environment where inflation is well anchored around the Fed's target would be consistent with core CPI prints of 0.2% every month, roughly 2.4% annualized. However, despite the disappointing month-over-month figure, we continue to see evidence that inflation is past the worst of its recent downtrend. First, while year-over-year core CPI was roughly flat in September, the 3-month rate of change increased for the fourth consecutive month. The year-over-year rate of change tends to converge toward the 3-month rate of change (Chart 7). Second, a look at the underlying components of core CPI shows the following (Chart 8): Chart 7CPI Inflation Chart 8Core CPI Components Shelter inflation fell from 3.30% to 3.24% year-over-year in September. This mild deceleration is consistent with the reading from our model, and will persist going forward (Chart 8, panel 1). Chart 9Wireless No Longer A Drag Core goods inflation also fell in September, but should soon start to rise as the weaker dollar and rising import prices pass through to overall core goods prices (Chart 8, panel 2). Core services inflation, excluding shelter and medical care, increased for the third consecutive month (Chart 8, panel 3). This component of inflation is most sensitive to wage growth, and it is where we would expect most of the inflation to come from going forward. Medical care inflation continues to decelerate sharply (Chart 8, bottom panel), but as we have discussed previously, this mostly reflects a convergence between CPI and PCE inflation.6 The Fed's 2% target refers to PCE inflation. The acceleration in core services inflation (excluding shelter and medical care) is particularly important as it is yet another signal that tight labor markets are starting to pressure wages higher. This is the dynamic that must continue to play out if inflation is to return to the Fed's target, and we would tend to view increases in inflation as more sustainable if they are driven by this component. Additionally, the critical core services inflation (excluding shelter and medical care) component has been depressed in recent months by an incredibly sharp decline in cellular service (aka wireless) inflation (Chart 9). The decline occurred when both Verizon and AT&T unveiled unlimited data plans in the same month, but that drop has since reversed. When we exclude wireless from core services inflation, in addition to shelter and medical care, we see that the resulting series tracks wage growth much more closely in recent months. This underscores our conviction that core services inflation will respond to tightening labor markets and mounting wage pressure going forward. Consumer Sentiment Is Sky High There was one other notable datapoint released last week, and that was the University of Michigan's Consumer Sentiment survey which surged to its highest level since 2004 (Chart 10)! This should lend support to consumer spending (and hence GDP growth) in Q3 and Q4 and is consistent with the message from the New York Fed's GDP tracking estimate which projects GDP growth to average 2.3% in the second half of 2017. This is well above the Fed's 1.8% estimate of trend. Chart 10Consumer Spending & Sentiment With growth coming in solidly above trend, it is unlikely that September's disappointing month-over-month CPI print will be enough to prevent the Fed from lifting rates in December. As long as inflation is flat or higher during the next two months, then another rate hike this year is probably in the cards. Bottom Line: Core inflation disappointed expectations in September, but the details of the report showed some silver linings. Inflation looks to be past the worst of its downtrend and should be strong enough during the next two months for the Fed to lift rates in December. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com 2 Excess returns are calculated relative to a duration-matched position in Treasury securities. 3 The 12-month breakeven spread is the spread widening required on a 12-month investment horizon to deliver zero excess returns. For simplicity we ignore convexity effects and calculate the breakeven spread as OAS divided by duration. 4 For Turkey please see Emerging Markets Strategy Weekly Report, "Is The Dollar Expensive, And Are EM Currencies Cheap?" dated October 11, 2017. For Mexico please see Emerging Markets Strategy Weekly Report, "Questions From The Road", dated September 20, 2017. Both available at ems.bcaresearch.com 5 Both Saudi Arabia and UAE have pegged exchange rates and are not shown in Chart 6. 6 Please see U.S. Bond Strategy Weekly Report, "The Great Unwind", dated September 19, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The economic momentum of China's "mini-cycle" appears to have peaked earlier this year. A benign moderation in growth is the most likely outcome, but this report reviews some factors to watch over the coming year to track the character of the slowdown. This month's Party Congress will hopefully provide investors with some clues whether policymakers have learned from their past mistakes of failing to combine any painful structural reforms with an appropriate amount of fiscal support. Shorter-term measures of money & credit in China are hooking up, and most measures of global growth are still signaling robust export demand. An eventual stabilization in the housing market will be an important signal confirming the benign nature of China's economic slowdown. Investors should remain overweight the MSCI China Free index versus the emerging market benchmark. Feature We reiterated the case for a benign cyclical slowdown of the Chinese economy in last week's report, by highlighting several forces that are working to support stable economic activity.1 Specifically, we noted that: There is presently little risk of aggressive policy tightening on the horizon. There is likely to be reduced downside cyclicality in China's industrial and real estate sectors, owing to the past imposition of "supply side" constraints. External demand will continue to support the Chinese economy, even if global growth momentum moderates. Chart 1 presents a stylized view of the Chinese economy over the past three years, which illustrates our framework of how cyclical growth conditions have evolved over this "mini-cycle". It also highlights three possible outcomes for the coming 6-12 months. Chart 1A Stylized View Of China's Recent 'Mini-Cycle' The chart shows how the Chinese economy began to operate below what investors and market participants considered to be a "stable" pace of growth in early-2015, owing to a "double whammy" of excessively tight monetary conditions and a synchronized global downturn. Policy easing succeeded in sparking a V-shaped rebound in some sectors of the economy (particularly housing), and caused an attendant rally in Chinese relative equity performance (vs EM), emerging market relative performance (vs global), and industrial metals prices. However, based on a number of "hard" growth indicators, the economic momentum of the "mini-cycle" appears to have peaked earlier this year. This raises the question of what is likely to be the character of Chinese economic growth over the coming year, with Chart 1 presenting three distinct scenarios: 1) a re-acceleration of the economy and a continuation of the V-shaped rebound profile, 2) a benign, controlled deceleration and settling of growth into the "stable" growth range, and 3) an uncontrolled and sharp deceleration in the economy that threatens a return to the conditions that prevailed in early-2015 (or worse). Our bet is clearly on scenario 2, but this week's report reviews some factors to watch over the coming year in order to monitor the end of China's mini-cycle and its implications for investment strategy. Policy Risk And The Party Congress China's 19th Party Congress is likely to dominate media headlines about China over the coming two weeks. While it is unlikely that a major, explicit policy announcement will emerge from the Congress, investors are likely to focus on the policy implications of the leadership rotation, as well as any signals from President Xi Jinping's opening speech. Indeed, the next two reports of this publication will be devoted to the Party Congress and our assessment of the economic and financial market impact of the event. Chart 2Bold Action Can Follow ##br##Midterm Congresses We recently published a primer explaining the Party Congress,2 and noted that major new policy initiatives can emerge during the March National People's Congress that follows a "midterm" Party Congress. For instance, Premier Zhu Rongji was appointed to launch the "assault stage" of President Jiang Zemin's reforms of state-owned enterprise at the National People's Congress in March 1998 (Chart 2). Similarly, Hu Jintao's Premier Wen Jiabao launched extensive administrative reforms at the NPC meeting in early 2008. When forecasting the character of Chinese economic growth over the coming year, the relevance of the Party Congress comes into play when assessing whether policymakers have learned from their past mistakes by combining any painful structural reforms with the appropriate amount of fiscal support to manage demand in the economy during the adjustment phase. In the past, policymakers have been preoccupied with the idea that the economy needs painful but eventually rewarding economic reforms, and have viewed short term policy easing as endangering reforms and as a contributor to further structural imbalances. In essence, authorities have in the past cornered themselves into a self-imposed 'either/or' choice between supply-side reforms and demand-side countercyclical policies, rather than pursuing a sensible balance between structural reforms and policy easing to mitigate headwinds. For example, the main pillars of "Likonomics", named after the Chinese premier, were touted as "deleveraging, structural reforms and no stimulus", in stark contrast to the three arrows of Japan's "Abenomics", including fiscal stimulus, monetary easing and structural reforms. For now, our view is that policymakers will provide the fiscal support required for the economy to avoid a potentially sharp downturn were they to aggressively pursue structural reform initiatives, given what occurred in 2015. But this assessment remains a key risk to our view of a benign cyclical slowdown, and we will be watching the Party Congress closely for any indications to the contrary. Domestic Demand Momentum Chart 3Shorter-Term Measures Of ##br##Money & Credit Growth Are Positive We noted above that China's domestic growth momentum is unlikely to decelerate materially, owing to the lack of aggressive policy tightening and the fact that some of China's industries have not experienced a major cyclical upswing (and thus are less likely to experience a major downswing). Supporting this view, shorter-term measures of money & credit in China are hooking up, suggesting that year-over-year measures may soon stabilize (or even accelerate modestly). Chart 3 presents the growth in M2 and two measures of credit, both on a year-over-year and 3-month annualized basis.3 While the latter measure is highly volatile and dependent on a seasonal-adjustment process that may not perfectly capture the seasonal component of Chinese economic data, it should be noted that all three shorter-term measures are at or above their year-over-year rates of change. Despite this, an outsized slowdown in non-supply constrained industries cannot be ruled out, even if it is far from our base case scenario. At a minimum, the potential for severe data disappointments exists, as Chart 4 highlights that the Chinese economy has already been surprising modestly to the downside over the past three months. Disappointing readings from industrial production, retail sales, and fixed-asset investment were particularly noticeable last month, which is in contrast to the steady uptrend in the surprise index that has prevailed since mid-2015. One recent trend that bears particular attention over the coming months is that of a weakening housing market. Chart 5 shows that house prices are beginning to decelerate on a year-over-year basis, and the pace of appreciation in home sales continues to decline. Worryingly, a 70-city diffusion index of house prices is also falling sharply, and to a level that would tend to imply a significant further deceleration in aggregate prices. A moderation in house price appreciation was all but inevitable given the magnitude of the boom over the past 2 years, and is not concerning in isolation (in fact, it reduces risk of escalating tightening measures). But given that home sales and prices were a key bellwether of the efficacy of policymakers' reflationary efforts over the past two years, and given the sharp decline in a broadly measured diffusion index, an eventual stabilization will be an important signal confirming the benign nature of China's economic slowdown. Chart 4Recently Surprising Modestly To The Downside Chart 5A Warning Sign From House Prices Trade, And Global Growth In last week's Foreign Exchange Strategy Weekly Report, our colleague Mathieu Savary explored the potential for "yellow flags" that may herald a slowdown in global growth. A slowdown in global narrow money growth was the most notable of the potential warning signs that he highlighted, which historically has been a leading indicator of global industrial production (Chart 6). It is possible that the deceleration in narrow money growth may correctly forecast a mild slowdown in global trade, which would be negative for Chinese economic growth at the margin. Still, it is very unlikely that a gentle pullback in global growth momentum would be sufficient for China's "mini-cycle" to end in the 3rd scenario highlighted in Chart 1 above (an uncontrolled and sharp deceleration in activity). In addition, narrow money growth is but one global growth indicator among many, several of which are still painting a rosy picture for China's external demand outlook: A GDP-weighted average of our consumer and capital spending indicators for the U.S., U.K., euro area, and Japan are suggesting that global GDP growth will continue to accelerate over the coming year (Chart 7). Barring a decline in global import intensity, this would imply that the acceleration in global export activity is just getting started. Chart 6A 'Yellow Flag' From Narrow Money Growth Chart 7Stronger G4 Growth Will Support China's Export Sector A recent update of our global LEI diffusion index suggests that the LEI itself is unlikely to significantly moderate (Chart 8). This is a notable development, as it somewhat reverses the concerning loss of momentum in the diffusion index that had occurred over the past year. Excluding the U.S., the improvement in the LEI diffusion index is still present, and the uptrend since late-2013 / early-2014 is more clearly defined (panel 2). Finally, both the EM and global PMIs remain in an uptrend, and are either at or near multi-year highs (Chart 9). The resilience of the EM PMI is particularly noteworthy, as much of the improvement in the index reflects the strength of the Caixin China PMI (despite the most recent tick down in the index). In addition, it is an underappreciated point among global investors that the EM PMI correctly forecast the onset of China's "mini-cycle" in 2015, and bottomed several months before the global PMI. The improvement of the EM PMI was sufficient to help catalyze a synchronized global economic recovery, despite having persistently lagged the global PMI in level terms. Chart 8A Positive Sign From Our Global LEIs Chart 9Manufacturing PMIs Are Not Heralding ##br##A Sharp Decline In Activity The Investment Strategy Implications Of A Benign Slowdown In China Taken together, the evidence noted above is more consistent with a benign end of China's mini-cycle than an uncontrolled and sharp deceleration in the economy. We will continue to track the pace of moderating economic activity, and will adjust our investment recommendations accordingly if China slows more aggressively than we expect. But for now, we see no reason to alter our constructive view on Chinese equities, suggesting that investors should remain overweight the MSCI China Free index versus the emerging market benchmark. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Pease see China Investment Strategy Special Report "On A Higher Note," dated October 5, 2017, available at cis.bcaresearch.com 2 Pease see China Investment Strategy Special Report "China's Nineteenth Party Congress: A Primer," dated September 14, 2017, available at cis.bcaresearch.com 3 For the latter measure we use a seasonal-adjustment methodology employed by the U.S. Census Bureau to adjust all three series prior to calculating the 3-month annualized rate of change. Cyclical Investment Stance Equity Sector Recommendations

Highlights EM currencies are fairly valued at the moment - they are neither cheap nor expensive. Unit labor cost-based REER is a superior currency valuation measure to those based on consumer and producer prices. Based on this measure, the U.S. dollar is not expensive - rather its valuation is neutral. When valuations are neutral, directional market indicators are more imperative than valuations. We expect directional indicators to favor the U.S. dollar and the euro versus EM currencies. In Turkey, inflation is breaking out - the currency, stocks and bonds will be under assault (page 9). The Philippines economy is overheating warranting policy tightening. Share prices are at risk (page 16). Feature EM currencies have recently begun to sell off. Does this represent a major reversal, or just a pause in a bull market? Our bias is that it is the former. In this week's report, we discuss the valuation aspect of foreign exchange markets. One of the oft-cited bullish arguments for EM currencies is that they are cheap. Similarly, the contention goes that the U.S. dollar is expensive. Our exchange rate valuation measures do not support these claims. According to our most favored currency valuation measure - the real effective exchange rate (REER) based on unit labor costs - the U.S. dollar is currently fairly valued (Chart I-1). More specifically, the greenback is not cheap, per se, but it is not expensive either. Meanwhile, the euro is at its fair value and the yen is undervalued (Chart I-2). The source of this data is the IMF. Below we elaborate in detail why we believe the unit labor cost-based REER valuation measure is superior to those based on consumer or producer prices. Chart I-1The U.S. Dollar Is Neither Cheap Nor Expensive Chart I-2The Euro Is Fairly Valued, The Yen Is Cheap As to EM currencies, there is no data on REER based on unit labor costs across all EM countries. The IMF and OECD have data for only a few developing countries, shown in Chart I-3A and Chart I-3B. With the exception of the Mexican peso and the Polish zloty, EM currencies shown in these charts are not cheap. Chart I-3AEM Currencies Are Not Universally Cheap Chart I-3BEM Currencies Are Not Universally Cheap In the absence of unit labor cost-based REER for EM, we deduce EM currency valuations in a number of ways: First, if the U.S. dollar, the euro and yen are not expensive, EM currencies by definition cannot be cheap. Second, provided exchange rates of commodities-producing advanced countries such as Australia, New Zealand, Canada and Norway are still expensive, according to unit labor cost-based REER (Chart I-4A and Chart I-4B), it is fair to argue that currencies of commodities-producing EM economies probably are not cheap as well given they move in tandem with their advanced countries peers. Chart I-4ACAD Is At Fair Value, NOK Is Slightly Expensive Chart I-4BAUD & NZD Are Expensive Third, Chart I-5 illustrates consumer and producer prices-based REER for EM. Excluding China, Korea and Taiwan, the equity market cap-weighted EM REER based on the average of consumer and producer prices is at its historical mean (Chart I-5). This denotes that EM currencies are by and large fairly valued. Notably, the BRL is slightly above its fair value, according to the REER based on average of consumer and producer prices (Chart I-6, top panel). Similarly, the same measure for the RUB and ZAR is no longer depressed after the appreciation witnessed in both currencies over the past 18 months (Chart I-6, middle and bottom panels). Chart I-5EM Ex-China, Korea And Taiwan: ##br##Exchange Rates Valuations Are Neutral Chart I-6EM High-Yielding ##br##Currencies Are Not Cheap All in all, we conclude that EM currencies are fairly valued at the moment - they are neither cheap nor expensive. This message is also corroborated by current account profiles across EM economies. In many developing countries, current account balances have improved, but are still in deficit. Consistently, the U.S. current account deficit excluding oil is at 1.75%, and with oil is at 2.4% of GDP - not wide at all. So, the current account does not presage that the greenback is expensive. Importantly, when valuations are neutral, they do not necessarily prevent the market from either rallying or selling off. Neutral valuations in any market have little impact on the market outlook. Thereby, we conclude that valuations are not an impediment for both EM currencies and the U.S. dollar to move in any given direction. When valuations are neutral, directional market indicators are more imperative than valuations. The best directional indicators for EM currencies have been commodities prices and the EM business cycle. Chart I-7 illustrates the EM aggregate currency index has historically correlated with commodities prices and EM industrial production. If commodities prices relapse and the EM business cycle slows down, as we expect, EM currencies will depreciate. As to U.S. bond yields and the greenback, we believe U.S. interest rate expectations will rise and the U.S. dollar will strengthen, at least, relative to EM currencies. That said, there has been no historical correlation between high-yielding exchange rates such as the BRL and ZAR and their interest rate differential over the U.S. (Chart I-8). Chart I-7These Factors Drive ##br##EM Exchange Rates Chart I-8Interest Rate Differential And ##br##Exchange Rates: No Correlation The euro and European currencies have the least downside versus the U.S. dollar. Hence, we expect EM currencies to weaken materially versus both the dollar and the euro (Chart I-9). Bottom Line: EM currencies are neither cheap nor expensive. We expect commodities prices to relapse and U.S. interest rate expectations to rise. This warrants a material down leg in EM currencies. We continue recommending a short position in a basket of the following currencies: ZAR, TRY, BRL, MYR and IDR versus the U.S. dollar. Investors, who are not comfortable being long the U.S. dollar, can short these same EM currencies versus the euro. Our overweights within the EM currency space are the TWD, THB, RMB, RUB, MXN, PLN and CZK. The Superior Currency Valuation Measure Unit labor cost-based REER is a superior currency valuation measure to those based on consumer and producer prices. The key idea behind currency valuation measures in general is to gauge competitiveness. Rising consumer and producer prices relative to trading partners signifies deteriorating competitiveness, and usually entails more expensive currency valuations. However, nowadays, labor costs in many economies, especially advanced ones, represent the largest cost component, even for manufacturing businesses. Therefore, it makes sense to compare wages across trading partners, not consumer and producer prices. However, rising wages in a country relative to its trading partners do not always signify worsening competitiveness. Wages might be rising, but productivity of employees may well be growing faster than wages. Therefore, true labor costs for businesses are not wages, but unit labor costs. Unit labor costs equal wages divided by productivity. They show the labor cost per unit of output. To estimate an economy's true competitiveness, one should compare its unit labor costs relative to its trading partners. REER based on unit labor cost does that. Hence, this measure captures two critical variables to competitiveness: wages and productivity. On the whole, unit labor costs measure competitiveness better than consumer and producer prices. Therefore, we argue that REER based on unit labor costs is superior to those based on consumer and producer prices. For comparison purposes, Chart I-10 illustrates the two REER measures for the U.S. dollar. Chart I-9EM Currencies Versus The USD And Euro Chart I-10U.S. Dollar: Two Valuation Measures Based on the above analysis, we conclude that the greenback and the euro are fairly valued, while the Japanese yen is cheap. In addition, EM currency valuations are neutral and currencies of commodities producing advanced countries are modestly expensive. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Turkey: Ride The Sell-Off Turkish stocks were among the best performing equity markets worldwide in the January-August period of this year before relapsing by 16% in U.S. dollar terms since September 1st (Chart II-1). We remain bearish/underweight Turkish financial markets. A Genuine Inflation Breakout Despite the currency being stable since the beginning of the year, inflation has been rising. Core consumer price inflation has surpassed 10% for the first time in the past 14 years (Chart II-2). Chart II-1Turkish Stocks Have More Downside Chart II-2Turkey: Inflation Is Breaking Out The country's double-digit wage growth is not supported by productivity gains. The latter has been stagnant (Chart II-3, top panel). Consequently, unit labor costs have surged in both the manufacturing and services sectors (Chart II-3, bottom panel). This combination of strong wage growth paired with low productivity growth depresses companies' profit margins. This in turn will force businesses to raise prices. Provided stimulus-propelled domestic demand is robust, businesses will succeed in raising their prices leading to escalating inflation. Typically, when a country is witnessing heightening inflationary pressures, the natural policy response should be monetary and/or fiscal tightening. However, Turkish authorities have been doing the opposite - running loose monetary and fiscal policies: Government expenditure excluding interest payments have accelerated significantly (Chart II-4). The rise in government spending has been partially funded by commercial banks - the latter's holdings of government bonds have been growing, boosting money supply, as a result. Chart II-3Turkey: Surging Unit Labor Costs Chart II-4Turkey: Fiscal Expenditures Are Booming This year the Turkish authorities have been able to generate growth through the recapitalization of the Credit Guarantee Fund. The aim of this fund is to incentivize banks to lend by essentially assuming credit risk on loans extended to small and medium enterprises. Under this scheme, the government has effectively given a green light to flood the economy with credit, in turn, boosting economic growth. So far, the scheme has been responsible for the creation of TRY 200 billion, or 7% of GDP, worth of new credit out of the TRY 250 billion limit. This TRY 250 billion is considerable as it compares with a total of TRY 367 billion worth of loan origination by commercial banks last year. Turkey's banking system has been relying on enormous amounts of liquidity provisions by the central bank (Chart II-5, top panel) to sustain its ongoing credit boom and strong economic growth. On the whole, the central bank's net liquidity injections into the banking system continue to increase rapidly. Interestingly, the nature of the central bank's funding of commercial banks has increasingly shifted away from open market operations and more towards direct lending to banks (Chart II-5, bottom panel). Adding all the liquidity facilities - the intraday, overnight and late window facilities - the Central Bank Of Turkey's outstanding funding to banks is TRY 86 billion, or 3% of GDP, abnormally elevated relative to the data series' history. This entails that monetary policy is loose even though the price of liquidity provided by the central bank to banks has been rising. Consistently, local currency bank loan growth stands at 25% (Chart II-6, top panel). Chart II-5Central Bank Of Turkey's Liquidity Injections Chart II-6Turkey Is Experiencing A Credit Binge On the whole, commercial banks are requiring more and more liquidity, and the CBT is continuously supplying it. These injections maintain liquidity in the banking system to a sufficiently high level that allow money/credit creation by commercial banks to continue mushrooming (Chart II-6, bottom panel). Fiscal and monetary policies are overly simulative and the country's twin - fiscal and current account - deficit is widening (Chart II-7). The widening current account deficit - which is a form of hidden inflation - substantiates the case of an inflation outbreak in Turkey. Remarkably, despite extremely strong exports due to the robust growth in the Euro Area, Turkey's current account deficit has been unable to narrow at all. This confirms excessive growth in domestic demand. In regard to currency valuation, Chart II-8 demonstrates that the lira is not cheap, especially according to unit labor cost-based REER. It is therefore questionable how long Turkish exports can remain competitive if unit labor costs continue mushrooming at a rapid pace. Chart II-7Turkey: Widening Twin Deficit Chart II-8The Lira Is Not Cheap Bottom Line: Despite high inflation, the Turkish authorities have opted to stimulate the economy further, aiming to boost short-term growth at all costs. The outcome will be an inevitable inflation outbreak. The Monetary Regime And Exchange Rate Chart II-9Excessive Money Printing Is Bearish For Lira The monetary regime in Turkey will lead to a major lira depreciation: The money multiplier - calculated as broad local currency money divided by banks' excess reserves at the central bank - has been rising sharply since 2012 (Chart II-9, top panel). This measure illustrates the degree of leverage banks have assumed. Also, the money multiplier reveals how much broad money/purchasing power banks have created per unit of liquidity provided by the central bank. To put into perspective the vast amount of money that has been created, the bottom panel of Chart II-9 demonstrates that the current net level of foreign exchange reserves (currently US$ 32 billion) covers only 11% of broad local currency money M3. Not only is excessive money creation bearish for the currency but it is also highly inflationary. As inflation rises, residents' desire to convert their deposits from local to foreign currency will increase, further exerting downward pressure on the lira. In fact, this is already happening - households' foreign currency deposits - measured in U.S. dollars - are growing at rapid annual pace of 13%. Given this inflationary backdrop and the risk of further depreciation, interest rates will have to rise. This will inevitably trigger another NPL cycle. Banks are very under-provisioned for non-performing loans (NPL). NPLs have not risen, and NPL provisions are also very low (Chart II-10). Both are set to rise considerably, and banks' capital and ability to expand credit will be severely undermined. Lastly, higher interest rates will be negative for loan growth and bank's profitability. Bank stocks are starting to roll-over. Given the extent to which they have decoupled from interest rates, we believe there is much more downside (Chart II-11). Chart II-10Turkey: A New NPL Cycle Will Start Chart II-11Turkish Bank Stocks Have Considerable Downside The current monetary policy stance is unsustainable. Inflation is breaking out and this is bearish for Turkish financial markets. Box 1 on page 15 addresses the geopolitical dimension of Turkey's recent spat with the U.S. Investment Conclusions We expect policy makers to remain behind the curve amid rising inflation and this will weigh on the lira. As such, we suggest currency traders who are not shorting the lira to do so at this time. We remain short the lira versus the U.S. dollar but the lira will continue to plummet versus the euro too. A weaker lira will undermine U.S. dollar and euro returns on Turkish stocks and domestic bonds. Dedicated EM equity investors as well as those overseeing EM fixed income and credit portfolios should continue to underweight Turkish assets within their respective EM universes. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com BOX 1 Turkey's Unstable Geopolitical Position On the political front, the recent spat with the U.S. over visas is just another sign of how far Turkey has descended into the geopolitical unknown. The U.S. has closed its visa offices as a response to the detention of a Turkish national working for the U.S. consulate in Istanbul by the local authorities. The arrest was made over alleged links to Fethullah Gulen, the cleric that Turkish authorities blame for the July 2016 botched coup. That Gulen remains the obsession of Turkish authorities is a clear sign that President Recep Tayyip Erdogan continues to feel threatened. Whether the Gulen threat is real or imagined is not for us to determine. But it is clear that Turkey remains a deeply divided country. The April 2017 constitutional referendum giving the president greater powers barely passed, despite numerous reports of irregularities. As BCA's Geopolitical Strategy posited following the vote, the referendum did nothing to reinforce Erdogan's power or reduce domestic tensions.1 It would only deepen his instinct to use "rally-around-the-flag" strategy by emphasizing external threats to quell domestic opposition. Now Turkey finds itself at the crossroad on three different fronts: Iraq: Neighboring Kurdistan Regional Government (KRG) has just held an independence referendum, prompting Erdogan to threaten military action against the Iraqi Kurds. Although no regional or global power overtly supports KRG's moves towards independence, Turkey is under pressure to respond in order to snuff out any secessionist ambitions by the Kurds in Turkey and Syria. Syria: President Erdogan has also threatened invasion of the self-declared Kurdish canton of Afrin in northwestern Syria. The enclave is held by the U.S.-allied People's Protection Units (YPG), which fought against the Islamic State in Syria. According to various news reports, Turkish troops are amassing on the border with Syria for the intervention. This could put the Turkish military in direct contact with Russian troops, which have a presence in Afrin. The West: Relations with the West, with whom Turkey remains in a formal military alliance (NATO) remain in the doldrums. Aside from the visa spat with the U.S., Turkey's relations with Europe, and Germany in particular, are at their lowest point in years. Bottom Line: In a month's time, Turkey may have invaded both Syria and Iraq while simultaneously hitting a low point in its relationship with traditional Western allies. At the very least, this complicated geopolitical environment will make it difficult for Ankara to focus on the economy. At its greatest, it is a recipe for geopolitical overreach, military disaster, domestic crisis, or any combination of all three. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "What About Emerging Markets?," dated May 3, 2017, available at gps.bcaresearch.com. The Philippines: An Overheating Economy Requires Policy Tightening Since early 2016, the Philippine stock market has been massively lagging the EM benchmark (Chart III-1, top panel). Similarly, the Philippine peso has been extremely weak, recording new lows versus the U.S. dollar, despite the broad-based EM currency rally (Chart III-1, bottom panel). In fact, the symptoms of this economy and its financial markets are consistent with an overheating economy that is expanding above potential, and where inflationary pressures are heightening. Going forward, inflation will keep rising and the central bank will have to tighten monetary policy meaningfully. These developments will weigh on Philippine growth and financial markets. Consumer price inflation, both headline and core, are rising briskly and currently stand at 3% - in the middle of the central bank's 2-4% target (Chart III-2). With the policy rate at 3%, this entails that real rates have dropped to zero. Chart III-1Philippine Stocks Relative ##br##To EM Have Underperformed Chart III-2Philippine Inflation ##br##Is Creeping Higher The Central Bank of the Philippines (BSP) has kept monetary policy too easy for too long. It injected liquidity into the banking system on various occasions in 2013-2014 and 2016-2017 via its banking liquidity management tool - the Special Deposit Account (Chart III-3, top panel). These liquidity injections incentivized commercial banks to create enormous amounts of credit in the economy (Chart III-3, middle and bottom panels). Booming credit growth in turn is creating excessive purchasing power in the economy, resulting in a current account deficit for the first time since 2000. In addition, the fiscal deficit is now widening (Chart III-4). Chart III-3Credit Growth Is Rampant Chart III-4Philippines Twin Deficit On the wage front, non-agriculture workers' salaries are accelerating, pushing unit labor costs higher (Chart III-5). Remarkably, despite real GDP growth of about 6.5% since 2014, consumer staples EPS growth is on the verge of contracting. It seems that costs (including wages) have been mushrooming while productivity gains have been lagging. This also corroborates the overheating thesis. With Philippines' inflationary dynamics intensifying, the BSP will have to tighten monetary policy. In fact, the top panel of Chart III-3 shows that the BSP has already begun its tightening cycle by withdrawing some banking liquidity via its Special Deposit Account. In addition, interest rate hikes by the central bank are also an option. Monetary tightening amid very strong loan growth will lead a meaningful slowdown in the economy. Loan growth deceleration will affect primarily capital spending and the property market. Both segments are cooling off (Chart III-6). Chart III-5Philippines: Wages Are Accelerating Chart III-6Cyclical Slowdown On The Horizon Importantly, banks' net interest margins have been falling - a trend that will likely continue due to potential liquidity tightening and higher policy rates (Chart III-7, top panel). This, along with slow loan growth and rising NPL provisions, will intensify banks' EPS contraction (Chart III-7, bottom panel). Chart III-8 illustrates that both NPL and NPL provisions as a percent of total loans are at their lowest level since 1997. Higher borrowing costs following a decade-long lending boom, necessitates higher NPL provisions. Chart III-7Banks' Interest Rate Margins And Profits Chart III-8Bank NPLs To Rise Along With Provisions NPLs are likely to emanate from the real estate and construction sectors. Loans to these two sectors account for 20% of total bank loans. Hence, higher interest rates are negative for banks and real estate stocks which, together, account for 40% of the Philippines MSCI index market cap. If the central bank decides not to tighten, however, the economy will continue to overheat and bond yields - as well as the currency - will sell-off. Such a scenario is equally bearish for the equity market. Philippines equity valuations are elevated and, hence, are not priced for any of these scenarios. For dedicated EM equity investors, we continue recommending a neutral allocation to this bourse. We are reluctant to underweight this stock market because the Philippines remains less leveraged to China and the commodities cycle vis-à-vis other emerging markets (EM). Besides, it has already considerably underperformed the EM equity benchmark. Therefore, it might not underperform substantially relative to other EM countries - if and when commodities start selling off as a result of a growth slowdown in China. Within ASEAN, we favor Thailand, underweight Malaysia and are neutral on the Philippines, Indonesia, and India relative to the EM equity benchmark. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Slowing global money growth, export orders, and a downgrade in earnings revisions of cyclical relative to defensive equities points to a mild slowdown in non-U.S. growth. This slowdown is not worrisome, but could become so if the U.S. dollar rallies significantly. This risk should be kept in mind by investors. Short AUD/USD at 0.79 ¢. EUR/USD is trading at a premium and is over-owned. Conditions are emerging for investors to upgrade their view of the Fed relative to the ECB. EUR/USD has downside risk. Feature Chart I-1Global Growth Is Booming The world economy is on a roll. Nearly all of the world's PMI indexes are in expansionary territory, suggesting we are experiencing a rare global synchronized expansion. A key bellwether of global trade, Korean exports, are surging at a 35% annual rate, confirming that the global economy is very strong (Chart I-1). When all looks great, it is the ideal time to wonder what could go wrong. At this point, the greatest risk to this global expansion may be the dollar. A strengthening dollar would tighten global financial conditions, especially for EM borrowers, and exacerbate the impact of yellow flags that have already emerged. Yellow Flags Investors are in an ebullient mood these days, and for good reason: global growth is strong, and global policy is still very accommodative, even if some central banks have begun removing support for their economies. However, three yellow flags have emerged that in our view warrant some caution. To be clear, these are not grave signs and we do not foresee either a U.S. or a global recession until late 2019 at the earliest. With this in mind, what are the worrying signs that investors should monitor right now? The first yellow flag comes from global money supply growth. Narrow money has decelerated from a 12% annual growth rate to 9% today. Historically, this has been a leading indicator of global industrial production, global export growth and commodity prices (Chart I-2). While the surge in money growth in 2016 and 2017 was a key reason behind the rebound in global economic activity, especially outside the U.S., its recent slowdown points to an end of the economic upswing, though admittedly not toward a cataclysm. The second yellow flag comes from the U.S. ISM release. While the general tone of the report remains extremely positive, the export component has been in a downtrend since June. The key determinant of export growth for any country tends to be the vigor of its trading partners. Hence, it is not surprising that softness in the export component of the U.S. ISM manufacturing survey tends to be associated with weakening global trade and industrial activity (Chart I-3). The third yellow flag comes from earnings revisions. The earnings revision ratios of cyclical relative to defensive equities in the U.S. and globally have sharply rolled over. While still in positive territory, this development has historically been an early signal that improvements in global growth metrics are ebbing, a signal being flashed today (Chart I-4). Chart I-2Money And Global Growth: ##br##From Tailwind To Headwind Chart I-3A Blemish In An Otherwise##br## Bright Picture Chart I-4EPS Revisions: Cyclicals Have Turned ##br##Vis-A-Vis Defensives Bottom Line: The global economy is experiencing a synchronized upswing, which has left investors in an ebullient mood. However, slowing global money growth, ebbing export sentiment and weakening earnings revisions for cyclical relative to defensive equities suggest this broad-based upswing has reached its zenith. While a mild deceleration is likely to materialize soon, these indicators constitute yellow flags, not red ones. Conditions are still not in place to expect a major global growth slowdown. The Dollar Holds The Key While the factors above point to a mild slowdown, they do not yet indicate a dearth of growth that could prompt panic among investors, especially in the EM space. For this scenario to become reality, another ingredient is needed. In our view, this ingredient is a strong dollar. To begin with, the relationship between global growth and the dollar is well known in the investor community. When global growth is strong and broad-based, the dollar depreciates; when global growth is weak, the dollar appreciates (Chart I-5). The U.S. is a relatively closed economy, and is less exposed to global growth developments than the euro area, Japan or commodities producers (Chart I-6). Thus, when the global economy is in an upswing, the U.S. garners a smaller dividend than the rest of the world. Conversely, when the global economy hits a soft patch, the U.S. suffers less. Chart I-5Strong Global Growth Coincident ##br##With A Weak Dollar Chart I-6The U.S. Is Less Exposed ##br##To Global Growth Factors But the chain of causation is not only from growth to the dollar. The trend in the dollar also affects the trend in global growth. This is because in aggregate, the world remains short the dollar. According to the BIS, there is $27 trillion dollars of foreign-currency liabilities in the world, $14 trillion of which is denominated in U.S. dollars, with an extremely large proportion issued by EM borrowers. When the dollar weakens, the cost of borrowing among companies and banks that finance themselves in USD decreases, incentivizing further borrowing. This eases global liquidity conditions and decreases the cost of financing global trade, leading to increased economic activity and profits as well as expanding global capex. Meanwhile, when the dollar rises, the balance sheet of those foreign firms and governments that have borrowed in U.S. dollars becomes increasingly illiquid, resulting in strong headwinds for additional borrowing, curtailing economic activity, profits and capex. This explains why the dollar and commodities prices, the latter being extremely sensitive to growth and global capex, have displayed such a strong negative relationship over different time periods (Chart I-7). Chart I-7Rising USD Equals Declining Liquidity And Declining Commodity Prices Thanks to these dynamics, the weakness in the dollar this year has been a major boost to growth for the global economy. As Chart I-8 illustrates, the large easing in EM financial conditions was indeed related to the U.S. dollar's weakness. Therefore, as growth momentum could be peaking, a period of renewed strength in the greenback might inflict further damage to a key buttress of EM growth. Moreover, this time around, Chinese policymakers are unlikely to come to the rescue of the global economy as they did in 2015 and 2016. Back then, China was experiencing a deflationary spiral: producer prices were contracting at a 6% annual pace, profits were in free fall and outflows were growing exponentially. The People's bank of China and the central government pulled all the stops, increasing lending and fiscal expenditures and tightening capital controls. Monetary conditions eased massively (Chart I-9). Chart I-8The Falling Dollar Supported Global Growth Chart I-9Tightening Chinese Monetary Conditions Last weekend, the PBoC announced targeted cuts to reserve requirement ratios for banks extending lending to small companies. According to our China Investment Strategy sister publication, this is not a major easing.1 Instead, these are targeted measures aimed at helping small firms that are currently dependent on the predatory lending rates available in the shadow banking sector. Meanwhile, access to credit by large state-owned enterprises and the real estate sector will continue to be slowly curtailed. The mutation of deflation into inflation and the recovery of profit growth imply that China does not currently need the same shot to the arm that it did in 2015 and 2016. Thus, it is unlikely the country will initiate another round of massive credit easing that will boost investment by SOEs and the construction sector, the two main sources of capex and commodities demand. In an environment where global money growth has rolled over and where China is unlikely to press on the gas pedal as hard as it did two years ago, a strong dollar would thus have a nefarious impact on global financial conditions, global growth, and, in turn, EM currencies and commodities currencies. While we remain very negative on the yen for now, the Japanese currency could benefit from a meaningful slowdown in international growth, as such a slowdown would likely exert downward pressure on global bond yields, including in the U.S. Obviously, the rally in the USD will have to be much more pronounced than what has been experienced in the past month before its negative impact on growth begins to be felt in bond yields and the yen. Thus, we remain long USD/JPY for now. The AUD could prove to be a key victim of the developments highlighted above. The AUD is highly levered to global growth and EM financial conditions. Moreover, it is now very expensive on a long-term basis, having overshot terms of trade by a very significant margin (Chart I-10). Adding to the vulnerability in the Aussie, the Australian economy has been incapable of generating any inflationary pressures. The output gap remains very deep, the level of underemployment is still at a 37-year high, and wages continue to hover near record lows, limiting the capacity of the Reserve Bank of Australia to tilt to a hawkish stance (Chart I-11). Yet, investors expect rates to be 42 basis points higher 12 months from now. Finally, speculators are currently very long the AUD. Thus, we will use any rebound above 0.79 to short the AUD/USD, setting a limit-sell at this level with a target at 0.73. Chart I-10The AUD Is Vulnerable Chart I-11Litle Inflationary Pressures In Australia Bottom Line: While the three yellow flags highlighted do not represent a terminal danger to global growth, a stronger dollar at the hands of tightening global financial conditions, especially in EM economies, would be a much bigger threat to the global economy. We do anticipate the dollar to strengthen over the coming 12 months, but it will take a significant move before the USD puts enough of a brake on global growth to hurt global yields. We therefore remain positive on the USD/JPY. However, with this risk lurking in the background, we are implementing a short position on the AUD, a currency that is both expensive and over-owned, and underpinned by an economy full of slack. An Update On EUR/USD We continue to expect some downside to EUR/USD over the remainder of the year. As we have already highlighted, the euro has greatly overshot its implied interest rate parity (IRP) relationships. Our intermediate-term time model - an enhanced IRP model accounting for short- and long-term real rate differentials, global risk aversion, commodities prices and the trend in the pair - shows that EUR/USD remains near its largest premium to fair value since 2009. Confirming this assessment, the euro has also overshot its equilibrium implied by the level of interest rates five years out (Chart I-12). Valuations offer some insight on the potential size of the euro move, but they offer very little information in terms of timing. Instead, we should rely on technical and macro considerations. On this front, we have already highlighted that speculators are currently net long the euro by the largest margin since 2011. Philosophically, we often look at the euro as the anti-dollar, a highly liquid inverse bet on the dollar. Since EUR/USD constitutes 57.6% of the DXY, a short bet on this dollar index and a long bet on the euro are similar wagers. Currently, the sum of both bets is at a level normally followed by sharp drops in EUR/USD, suggesting that euro buying is hitting exhaustion levels (Chart 13). Meanwhile, with investors having very few short bets on the euro, especially when compared to the large stock of short bets on the DXY, a short squeeze in favor of the USD could emerge if European data disappoints relative to the U.S. (Chart I-13, bottom panel). Chart I-12Downside In EUR/USD Chart I-13Tactical Risk To EUR/USD On the macro front, a few developments have caught our eye. We are entering the window where based on historical lags, the euro area's industrial production is likely to start feeling the pain of the common currency's previous strength (Chart I-14). Compounding this worry for euro longs, euro area earnings revisions are lagging those in the U.S. by the greatest margin since 2014, suggesting the euro's strength has sapped some of the euro area's vigor and is in the process of redistributing it to the U.S. economy. Historically, this has led to a period of weakness in EUR/USD (Chart I-15). Chart I-14The Strong Euro ##br##Will Soon Be Felt Chart I-15Falling Relative EPS Revisions ##br##Equals A Weaker EUR/USD Confirming this insight are relative financial conditions. Euro area financial conditions have been tightening relative to the U.S. since the beginning of 2016 - a move that has become especially pronounced this year. The euro area's inflation outperformance vis-à-vis the U.S. this year was first and foremost a reflection of the previous easing in relative European financial conditions (Chart I-16). Thanks to these strong relative inflation dynamics, investors have brought forward the first rate hike expected from the ECB, while simultaneously removing interest rate hikes out of the U.S. OIS curve. This move has been wildly euro bullish. However, the window of opportunity for this bet is closing; the tightening in European financial conditions now points to a reversal in relative inflation, with U.S. prices set to now take the lead over the euro area. This could force a repricing of the Fed relative to the ECB, implying that monetary divergences could once again play against EUR/USD. Catalonia is not a reason to be bearish on the euro. Marko Papic, BCA's Chief Political Strategist, argues that the northeastern region is unlikely to leave Spain.2 The vast majority of Catalonia still favors remaining part of Spain (Chart I-17). Moreover, the region has received immigrants from the rest of the country for many decades, reflecting its superior economic performance. As a result, only 31% of the population speaks Catalan as a first language. In aggregate, the independentists' victory last weekend only reflects a low turnout rate, as individuals who opposed leaving Spain stayed at home, like they did in 2014. Chart I-16The Fed Will Be Repriced ##br##Against The ECB Chart I-17Will Of The People: ##br##Catalonia Will Stay In Spain Bottom Line: The euro will exhibit downside risk in the coming months. EUR/USD is trading well above its fair value implied by its IRP relationship. Additionally, euro buying has hit nosebleed levels, and the dollar is unloved. Moreover, the euro's recent strength could begin to negatively affect growth, especially as European earnings revisions have collapsed versus the U.S. Finally, financial conditions point to a fall in euro area inflation relative to the U.S., highlighting the risk that the policy path for the Fed could be upgraded against that of the ECB. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see China Investment Strategy Special Report, titled "On A Higher Note", dated October 5, 2017, available at cis.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, titled "Is King Dollar Back?", dated October 4, 2017, and Geopolitical Strategy Monthly Report, titled "The Geopolitical Risks For The Equity Bull Market", dated May 14, 2014 at gps.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S data has been strong this week: Markit and ISM Manufacturing PMIs beat expectations at 53.1 and 60.8 respectively; ISM Prices Paid rose sharply to 71.5 from 64.0; Markit Services and ISM Non-Manufacturing PMIs also beat expectations at 55.3 and 59.8 respectively; ADP employment change and continuing and initial jobless claims also came out better than expected; The DXY has rebounded meaningfully after a string of stronger data and growing hopes on the fiscal policy front recently. Bond markets have picked up on these developments, with the 10-year yield rising 30 basis points from its bottom last month. However, stronger U.S. inflation is needed in order for the greenback to meaningfully rally. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data has been mixed: The latest headline and core inflation readings for the euro area were weaker than expected, at 1.5% and 1.1% respectively; German retail sales also underperformed expectations, however, German unemployment rate decreased; Euro area manufacturing PMI also underperformed, while the services PMI outperformed; Euro area producer prices beat expectations, coming in at 2.5%. With U.S. data outperforming, the euro has softened versus the greenback, but has not displayed similar movements against other currencies. While it is true that European inflation is higher than a year ago, it is still not near the ECB's target. A stronger euro would further restrict inflationary pressures, which would be a cause for concern for ECB officials. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Japanese data has been mixed the past weeks: The jobs/applicants ratio came in at 1.52, underperforming expectations and decreasing from the previous month. Additionally, retail trade and overall housing spending yearly growth both disappointed, coming in at 1.7% and 0.6% respectively. However, on the bright side, Nikkei Manufacturing PMI outperformed expectations, coming in at 52.9. Overall, we continue to be bullish on USD/JPY, as yields in the U.S. will continue to rise vis-à-vis Japanese ones. Economic data has been tepid, and wages continue to contract or remain flat, even if some underlying pressures are slowly emerging. Furthermore we expect that the BoJ will continues its extreme measures of yield curve targeting in order to spur inflation expectations. Nevertheless, the yen could appreciate against carry currencies like the AUD or NZD if Chinese monetary conditions become tight enough. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Markit services PMI outperformed expectations coming in at 53.6, and increasing from last month's reading However, Markit manufacturing PMI came in under expectations at 55.9, and decreased from last month. Moreover Construction PMI unperformed, coming in at 48.1, the lowest level since July 2016. We would lean against any further strength of the pound against the U.S. dollar. The risks associated with Brexit still looms in the background, while data has been mixed, particularly when it comes to consumption and the housing market. Additionally, the market has already fully priced a rate hike by December. Thus, it seems that any good news for the pound are already in the price, as the BoE certainly has little incentives to follow a hawkish policy beyond removing its post-Brexit emergency measures. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data was mixed: AiG Performance of Manufacturing Index decreased to 54.2 from 59.8; TD Securities Inflation came in at 2.5%, down from 2.6%; HIA New Home Sales increased by 9.1% MoM in August, up from the 15.4% contraction in July; Building permits are still contracting 15.5% annually, but better than the expected 16.2% contraction. This week, the RBA decided to leave rates unchanged at 1.5%. The monetary policy statement focused on the lack of wage pressures in the Australian economy and on the higher exchange rate, which is "expected to contribute to continued subdued price pressures in the economy", as well as "weighing on the outlook for output and employment", stating further that "an appreciating exchange rate would be expected to result in a slower pick-up in economic activity and inflation than currently forecast." Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Last week the RBNZ decided to leave rates unchanged at 1.75%. The RBNZ continued with its dovish slant, arguing that monetary policy will remain accommodative for a considerable period. An important development, however, is that the central bank toned down its cautious tone about the kiwi. In previous instances, the RBNZ had been very aggressive in stating that the NZD was too expensive and an adjustment was needed. However, in its most recent statement the RBNZ was much less aggressive in its rhetoric, highlighting the fall in the NZD. Overall, we believe that the NZD will continue to have upside against the AUD, as domestic inflationary pressures are much stronger in New Zealand than in Australia. Meanwhile, global developments, such as a downturn in the Chinese industrial cycle would affect Australia much more than New Zealand. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canadian data was mixed: Industrial product price grew at a 0.3% monthly pace, less than the expected 0.5%; Raw materials increased by 1%, above the expected 0.3%; GDP stagnated in July on a monthly basis, below the expected 0.1% growth; Merchandise trade slipped even further into a deficit from CAD 2.6 bn to CAD 3.41 bn. Furthermore, Governor Poloz's September 27 speech sent the CAD tumbling, stating that "monetary policy will be particularly data dependent" and that it could be "surprised in either direction". Probability of a hike in October and December declined from 48% to 23%, and 75% to 63%, respectively. While growth is robust, inflation has been declining since January, which may be a cautious sign for the BoC. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Data in Switzerland has outperformed to the upside: The KOF Leading Indicator outperformed expectations, coming in at 105.8 and increasing from last month's reading. The SVME Purchasing Manager's Index also outperformed, coming in at 61.7 Finally, headline inflation also outperformed expectations, with a reading of 0.7%, increasing from 0.5% on August. This recent strength in the Swiss economy is most likely reflective of the sharp appreciation that EUR/CHF has experienced in recent months. However, despite the increase in inflation, the Swiss economy is still too weak for the SNB to stop intervening in the foreign exchange market or to remove their ultra-dovish monetary measures. Once we see both headline and core inflation climb closer to their historical averages, we will reassess this view. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Data in Norway has been mixed: Register unemployment came in line with expectations at 2.5%, decreasing from last month's 2.7% reading. However the credit growth issued by national institutions in Norway, decreased since last month, coming in at 5.6%. Finally, both retail sales and real retail sales yearly growth came below expectations, coming in at -0.6% and 0.2% respectively. These few data points are interesting given that both retail and real retail sales growth dipped into contractionary territory. This shows that the Norwegian economy is still too weak to sustain a higher krone and higher rates. For this reason we continue to be bullish on USD/NOK. This cross is more correlated with rate differentials than with oil. Thus even if oil continues to rise, rising rates in the U.S. will still put upward pressure on USD/NOK. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The 11-year ruling governor of the world's oldest central bank, Stefan Ingves, will now sit at the helm of the Riksbank for five more years, until 31 December 2022. While Sweden's economy is still performing above par with CPIF at 2.3%, our bullish case for the SEK is under threat by the extension of the governor's term, who introduced negative interest rates to Sweden and who is consistently vigilant over the SEK's appreciation, even threatening intervention if needed. EUR/SEK appreciated 0.6% on the news, but has since given up some those gains as economic data in Sweden rebounded sharply. The Riksbank will still likely hike, but the timing is now in question. It is likely that the tightening cycle will now coincide with the ECB's tapering program, which will limit the SEK's appreciation for now. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Closed Trades